[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
FULL COMMITTEE HEARING ON
SARBANES-OXLEY SECTION 404:
NEW EVIDENCE ON THE COSTS
FOR SMALL BUSINESSES
=======================================================================
COMMITTEE ON SMALL BUSINESS
UNITED STATES HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
FIRST SESSION
__________
DECEMBER 12, 2007
__________
Serial Number 110-63
__________
Printed for the use of the Committee on Small Business
Available via the World Wide Web: http://www.access.gpo.gov/congress/
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HOUSE COMMITTEE ON SMALL BUSINESS
NYDIA M. VELAZQUEZ, New York, Chairwoman
HEATH SHULER, North Carolina STEVE CHABOT, Ohio, Ranking Member
CHARLIE GONZALEZ, Texas ROSCOE BARTLETT, Maryland
RICK LARSEN, Washington SAM GRAVES, Missouri
RAUL GRIJALVA, Arizona TODD AKIN, Missouri
MICHAEL MICHAUD, Maine BILL SHUSTER, Pennsylvania
MELISSA BEAN, Illinois MARILYN MUSGRAVE, Colorado
HENRY CUELLAR, Texas STEVE KING, Iowa
DAN LIPINSKI, Illinois JEFF FORTENBERRY, Nebraska
GWEN MOORE, Wisconsin LYNN WESTMORELAND, Georgia
JASON ALTMIRE, Pennsylvania LOUIE GOHMERT, Texas
BRUCE BRALEY, Iowa DEAN HELLER, Nevada
YVETTE CLARKE, New York DAVID DAVIS, Tennessee
BRAD ELLSWORTH, Indiana MARY FALLIN, Oklahoma
HANK JOHNSON, Georgia VERN BUCHANAN, Florida
JOE SESTAK, Pennsylvania JIM JORDAN, Ohio
BRIAN HIGGINS, New York
MAZIE HIRONO, Hawaii
Michael Day, Majority Staff Director
Adam Minehardt, Deputy Staff Director
Tim Slattery, Chief Counsel
Kevin Fitzpatrick, Minority Staff Director
______
STANDING SUBCOMMITTEES
Subcommittee on Finance and Tax
MELISSA BEAN, Illinois, Chairwoman
RAUL GRIJALVA, Arizona DEAN HELLER, Nevada, Ranking
MICHAEL MICHAUD, Maine BILL SHUSTER, Pennsylvania
BRAD ELLSWORTH, Indiana STEVE KING, Iowa
HANK JOHNSON, Georgia VERN BUCHANAN, Florida
JOE SESTAK, Pennsylvania JIM JORDAN, Ohio
______
Subcommittee on Contracting and Technology
BRUCE BRALEY, IOWA, Chairman
HENRY CUELLAR, Texas DAVID DAVIS, Tennessee, Ranking
GWEN MOORE, Wisconsin ROSCOE BARTLETT, Maryland
YVETTE CLARKE, New York SAM GRAVES, Missouri
JOE SESTAK, Pennsylvania TODD AKIN, Missouri
MARY FALLIN, Oklahoma
.........................................................
(ii)
Subcommittee on Regulations, Health Care and Trade
CHARLES GONZALEZ, Texas, Chairman
RICK LARSEN, Washington LYNN WESTMORELAND, Georgia,
DAN LIPINSKI, Illinois Ranking
MELISSA BEAN, Illinois BILL SHUSTER, Pennsylvania
GWEN MOORE, Wisconsin STEVE KING, Iowa
JASON ALTMIRE, Pennsylvania MARILYN MUSGRAVE, Colorado
JOE SESTAK, Pennsylvania MARY FALLIN, Oklahoma
VERN BUCHANAN, Florida
JIM JORDAN, Ohio
______
Subcommittee on Urban and Rural Entrepreneurship
HEATH SHULER, North Carolina, Chairman
RICK LARSEN, Washington JEFF FORTENBERRY, Nebraska,
MICHAEL MICHAUD, Maine Ranking
GWEN MOORE, Wisconsin ROSCOE BARTLETT, Maryland
YVETTE CLARKE, New York MARILYN MUSGRAVE, Colorado
BRAD ELLSWORTH, Indiana DEAN HELLER, Nevada
HANK JOHNSON, Georgia DAVID DAVIS, Tennessee
______
Subcommittee on Investigations and Oversight
JASON ALTMIRE, PENNSYLVANIA, Chairman
CHARLIE GONZALEZ, Texas LOUIE GOHMERT, Texas, Ranking
RAUL GRIJALVA, Arizona LYNN WESTMORELAND, Georgia
(iii)
C O N T E N T S
----------
OPENING STATEMENTS
Page
Velazquez, Hon. Nydia M.......................................... 1
Chabot, Hon. Steve............................................... 2
WITNESSES
PANEL I
Cox, Hon. Christopher, Chairman, Securities and Exchange
Commission..................................................... 4
PANEL II
Ryan, Jr., Mitchell, U.S. Chamber of Commerce.................... 16
Grossblatt, Harvey, Universal Security Instruments, Inc., AMEX... 18
Loving, Bill, Pendleton Community Bank, Independent Community
Bankers Association............................................ 20
Brandt, Jr., Thomas, TeleCommunication Systems, Inc., AeA........ 21
Greene, Shannon, Tandy Leather Factory, Inc...................... 23
APPENDIX
Prepared Statements:
Velazquez, Hon. Nydia M.......................................... 35
Chabot, Hon. Steve............................................... 37
Cox, Hon. Christopher, Securities and Exchange Commission........ 38
Ryan, Jr., Mitchell, U.S. Chamber of Commerce.................... 43
Grossblatt, Harvey, Universal Security Instruments, Inc., AMEX... 50
Loving, Bill, Pendleton Community Bank, Independent Community
Bankers Association............................................ 53
Brandt, Jr., Thomas, TeleCommunication Systems, Inc., AeA........ 61
Greene, Shannon, Tandy Leather Factory, Inc...................... 67
Statements for the Record:
Biotechnology Industry Organization.............................. 72
American Federation of Labor and Congress of Industrial
Organizations.................................................. 76
(v)
FULL COMMITTEE HEARING ON
SARBANES-OXLEY SECTION 404:
NEW EVIDENCE ON THE COSTS
FOR SMALL BUSINESSES
----------
Wednesday, December 12, 2007
Committee on Small Business,
Washington, DC.
The Committee met, pursuant to call, at 10:00 a.m., in Room
2360 Rayburn House Office Building, Hon. Nydia Velazquez
[chairwoman of the Committee] presiding.
Present: Representatives Velazquez, Gonzalez, Cuellar,
Altmire, Clarke, Sestak, Hirono, Chabot, Akin, Westmoreland,
Davis, Fallin, and Buchanan.
OPENING STATEMENT OF CHAIRWOMAN VELAZQUEZ
Chairwoman Velazquez. Good morning. I call this hearing to
order.
This morning the Committee will continue its oversight of
the implementation of Section 404 of the Sarbanes-Oxley Act.
With businesses beginning the process of meeting these
requirements, now it is an appropriate time to reevaluate the
burden associated with compliance.
Since its inception, SOX 404 has presented a unique
challenge for small firms. While they saw the importance of its
core goals, many could not afford the high expenses associated
with compliance. In fact, the cost of implementing it has
caused many entrepreneurs to reconsider whether the benefit of
being a public company is worth it at all. The rise of foreign
stock exchanges in so-called Sarbanes-Oxley free zones has
started to turn what many considered a myth into reality.
Section 404, as currently configured, may be undermining the
competitiveness of American companies.
I am glad that the SEC recognizes that SOX 404 is a
substantial burden for small firms. Chairman Cox is to be
commended for soon undertaking an intensive analysis of
compliance data and proposing an extension of the compliance
date for Section 404(b). This will allow all interested parties
to better understand the impact that this regulation will have
before it is mandated.
The recent study by the U.S. Chamber of Commerce, along
with the American Bankers Association, the American Stock
Exchange, and the Institute of Management Accountants, has
provided a foundation for the SEC's subsequent work. The
Chamber's survey was designed to collect data directly from
small companies about the actual and expected costs related to
meeting the requirements of Section 404.
This constitutes the first and only data concerning SOX 404
costs that has been released since July when the SEC approved a
revised auditing standard. When the Committee last examined
this issue in June, we did not have meaningful data with
respect to compliance costs. The lack of this information
limited the Committee's ability to fully assess the deadlines
that the SEC has established for small firms.
The survey data confirms what many have suspected--that the
costs are, in fact, significant, and small companies are
already incurring steep expenses. More than half of respondents
indicated that they will spend more than 3 percent of net
income implementing the requirements of Section 404(a) alone.
And many small firms are beginning to prepare for 404(b), even
though it is more than a year away. Sixty-six percent of survey
respondents have already engaged an auditor as they prepare to
comply with this requirement.
The survey data highlights that a postponement, if it is to
provide meaningful relief for small firms, must be issued as
soon as possible. It is my hope that the SEC will act on the
proposed delay immediately. Doing so will allow the Commission
the time it needs to gather meaningful data before small firms
are forced to comply with the untested revised rules.
With Chairman Cox's proposal today, our attention now turns
to ensuring that the agency's collection and analysis is
accurate and thorough. This assessment is key in ensuring that
SOX 404 regulations are right-sized and do not unnecessarily
burden small companies. I look forward to working with the SEC
on this evaluation.
SOX 404, like so many regulations, is very burdensome and
expensive for small companies. The SEC--and all federal
agencies for that matter--must do more to ensure that we do the
up front analysis to limit the impact on such a key segment of
our economy.
That is why this Committee will soon be considering
legislation to expand and strengthen the Regulatory Flexibility
Act--a key tool that gives small firms a voice in the
rulemaking process. By doing so, we will be better able to
preserve the entrepreneurial environment that has made the
United States a global leader in so many industries.
I would like to thank in advance Chairman Cox and all of
the witnesses for their testimony today. And I now recognize
Mr. Chabot for his opening statement.
OPENING STATEMENT OF MR. CHABOT
Mr. Chabot. I want to thank the Chairwoman for holding this
second hearing on the implementation of Section 404 of the
Sarbanes-Oxley Act and its impact on small publicly-traded
companies. And I want to extend a very warm welcome to our
former colleague from California, Chris Cox, the Chairman of
the Securities and Exchange Commission. He was certainly a very
valuable member of Congress when he was here, one of the top
leaders in Congress during those years, and he is once again
serving his country very well in his capacity. So we welcome
you here this morning, Mr. Chairman.
Of particular concern is whether the financial controls and
audit standards required for compliance with Section 404
imposes undue costs on small companies and impedes their
ability to raise capital. Like the securities laws of the New
Deal, Sarbanes-Oxley, or SOX, was a response by Congress to a
crisis in confidence about the market for publicly-traded
securities.
Unlike the endemic problems that caused the stock market
crash back in 1929, and resulted in much tougher securities
laws, SOX was a response to a few spectacular but isolated
instances of extreme corporate greed and criminal behavior on
the part of a small coterie of corporate executives from
companies, including Enron, WorldCom, Adelphia, and
HealthSouth, for example.
One of the broad issues that the Committee continues to
consider is whether SOX, especially Section 404, represents the
appropriate response to these criminal acts or an overreaction
that has unnecessarily burdened small public companies. Today's
hearing will examine some recent data developed by the United
States Chamber of Commerce concerning the cost that small
public companies will incur to comply with the requirements of
SOX.
I think it is particularly relevant to focus on how the
Securities and Exchange Commission considered costs in the
development of its most recent interpretations on SOX
compliance. The assessment of costs is a key component of an
agency's compliance with the Regulatory Flexibility Act,
something that the Committee recently assessed in two separate
hearings.
I raise the issue of compliance with the RFA, because a
review of the Commission's most recent issuances demonstrates a
greater need for more accurate cost data to understand the
impact that the SEC's rules concerning SOX compliance will have
on small public companies. I am heartened to read in your
testimony that the Commission, under your leadership, will do a
full study of the costs faced by small companies.
This data, then, should be used to perform a regulatory
flexibility analysis, so the Commission can assess appropriate
alternative methods for compliance with Section 404(b) of SOX.
I look forward to hearing from our distinguished group of
witnesses on these other issues concerning the implementation
of SOX.
And I must mention that I, unfortunately, am going to be
called to another Committee, the Judiciary Committee. We are
working on the subprime mortgage crisis that has hit the whole
country, but four states thus far in particular, one being
Ohio, my State, the others California, Florida, and Michigan
especially. And we have reached a manager's amendment in a
bipartisan manner, and so I, unfortunately, need to be over
there. So I apologize to any of the witnesses, and I apologize
to you, Mr. Chairman.
However, we are going to have Dave Davis, who is going to
fill in here for us, to make sure the Democrats don't get too
out of hand here on this Committee.
[Laughter.]
No. Just kidding. This is one of the committees that really
has a very excellent relationship, both between the chair and
the ranking member and the staff and the members of the
Committee. So this is one that really does work around here and
has been responsible for passing quite a few bills in a
bipartisan manner.
So I want to, once again, commend the Chairwoman for her
hard work in this, and I want to thank Mr. Davis for filling
in. And if he has to go, I believe Mr. Westmoreland is also
going to fill in for a while. And I will be back just as soon
as I possibly can, and I yield back.
Chairwoman Velazquez. For the record, not just some bills,
20 bills.
Mr. Chabot. Twenty bills.
Chairwoman Velazquez. Most productive in the last two
decades.
Mr. Chabot. Most productive Committee in Congress, right?
Chairwoman Velazquez. That is right.
Mr. Chabot. That is right.
Chairwoman Velazquez. So now we will proceed with our first
panel, and I just want to extend the warmest welcome to our
former colleague, The Honorable Christopher Cox. Mr. Cox is the
28th Chairman of the Securities and Exchange Commission. He was
appointed by President Bush on June 2, 2005, and unanimously
confirmed by the Senate on July 29, 2005.
During his tenure at the SEC, Chairman Cox has brought
ground-breaking cases against a variety of market abuses,
including hedge funds, inside trading, stock options
backdating, and securities scams on the Internet. Prior to
joining the Securities and Exchange Commission, Chairman Cox
served for 17 years in Congress where he held a number of
positions of leadership in the United States House of
Representatives.
Mr. Cox, welcome.
STATEMENT OF THE HONORABLE CHRISTOPHER COX, CHAIRMAN,
SECURITIES AND EXCHANGE COMMISSION, WASHINGTON, D.C.
Mr. Cox. Thank you very much, Madam Chairman, and members
of the Committee. It is a pleasure to be here to testify on
behalf of the Securities and Exchange Commission concerning the
costs and benefits of Sarbanes-Oxley Section 404 for small
businesses.
The Commission, just like this Committee, shares an abiding
concern for America's smaller public companies. Since Sarbanes-
Oxley became law in 2002, the Securities and Exchange
Commission has not applied Section 404 to smaller public
companies. In addition, we recently issued guidance intended to
make the process for smaller public companies more economical
and more efficient for the time when eventually they do come
into compliance.
The Commission's decision to proceed cautiously in
deference to smaller public companies and their investors is
due in significant part to the fact that the cost of
regulation, as you all well know, falls heaviest on smaller
companies, both on a per employee basis and as a proportion of
revenues. It would be impossible for us at the SEC to succeed
in our mission if we didn't focus directly on the needs of
smaller public companies. For that very reason, the SEC has a
long history of listening to smaller public companies and
assisting them in their efforts to raise capital.
Just three weeks ago, we adopted new rules designed to make
it much simpler and easier for smaller public companies to
raise capital. Now any small public company with a public float
of up to $75 million can use these simpler rules, compared to
the $25 million cap that used to be in place under the old
rule. That means another 1,500 public companies will be able to
use our simplified disclosure and reporting.
We also further simplified the rules themselves. We
eliminated five forms, and we eliminated 36 separate items that
used to comprise Regulation S-B. We have also made it more
economical for smaller companies to sell restricted securities
under Rule 144 by reducing the holding period from one year to
six months, and by eliminating many of the other restrictions.
And non-affiliates won't have to file forms at all anymore.
That change will reduce the number of Form 144s filed with the
Securities and Exchange Commission by nearly 60 percent. These
are all ways to cut the cost of capital for smaller public
companies and for small businesses without sacrificing investor
protection.
We also changed the rules to protect private companies that
offer stock option plans for their employees. Many small,
privately-held companies were concerned that they might
accidentally be required to register as public companies even
though they don't have any public shareholders. Our new rule
fixes that.
In taking these steps, we have been responding to several
key recommendations of the SEC's Advisory Committee on Smaller
Public Companies. One of the Advisory Committee's most
important recommendations is the topic that we are focused on
this morning. Specifically, the Advisory Committee recommended
that smaller companies should not be made to comply with
Section 404's external audit requirement ``unless and until
there is a framework for assessing internal control over
financial reporting for such companies that recognizes their
characteristics and needs.''
With that very recommendation in mind, the Commission
delayed Section 404 compliance for smaller public companies and
set to work on providing guidance for those companies that
would recognize that their needs are different than those of
larger companies. During the last few years, the Commission and
the Public Company Accounting Oversight Board have worked
together to completely repeal the old, inefficient system of
implementing Section 404.
The SEC published guidance specifically for management,
which had not been done before, and both we and the PCAOB
approved a completely new standard for Section 404, AS-5--that
is, top-down, risk-based materiality focused and scalable for
companies of all sizes.
Our SEC management guidance, intended for the company's own
use, will relieve smaller companies from having to rely on the
audit standard as their de facto rule book. For smaller public
companies, the guidance will be in place the very first time
that they come into compliance, so that they can avoid wasteful
and unnecessary compliance efforts that others have had to
endure under the old standard.
When eventually smaller public companies do come into full
compliance, as the law requires, the new audit standard will
encourage the scaling of all audits to reflect each company's
circumstances rather than a single checklist for all
situations. And to ensure that this is what actually happens,
the SEC will conduct a study, as you have all mentioned here
this morning, of the costs and benefits of 404 compliance under
the new auditing standard and the new management guidance.
Currently, under the direction of the Office of Economic
Analysis, the SEC staff is preparing to gather and analyze
real-world data. The study will seek to identify trends and
provide a comparison to costs under the old standard. The study
will also pay special attention to those small companies that
are complying with Section 404 for the first time.
This survey of cost and benefits will have two main parts.
First, there will be a web-based survey of companies that are
subject to Section 404; and, second, we will conduct in-depth
interviews with a subset of companies, including those that are
just now beginning their 404 compliance. This dual approach
will allow us to gather data from a large cross-section of
companies, while providing more detailed information about what
drives the costs and where companies derive the benefits.
Because we are intent on using real-world data based on
companies' actual experiences, this survey will be taking place
in the coming months as companies for the first time use the
new auditing standard and the new management guidance. Because
we have to rely on the actual costs that haven't been incurred
yet, the study and analysis of the results can't be completed
before June 2008.
Under the current schedule, smaller public companies would
be expected to begin complying with Section 404(b) for fiscal
years ending after December 15, 2008, so the result is that
unless there is an additional deferral companies would incur
compliance costs before the SEC has the benefit of the study
and the analysis. As a result, I intend to propose to the
Commission that we authorize a further one-year delay in
implementation for small businesses in order to base our
decision on final implementation of Section 404(b) on the best-
available cost data.
Since I last testified before the Committee this summer,
the SEC and the PCAOB have undertaken comprehensive outreach to
help the small business community prepare to meet their
obligations under Section 404(a). This outreach has included a
half-dozen forums around the country. To make sure that our
guidance is useful and understandable for smaller companies, we
have also published a brochure designed specifically for the
management of small businesses. It explains in plain English
how to evaluate internal controls and how to determine whether
they are effective.
We have spent a lot of time distilling the key principles
of our management guidance into this easy-to-read brochure, and
we hope that all companies, large and small, will read it. It
is, of course, available on the web at www.sec.gov.
Madam Chairman, it is the SEC's intention that our new
guidance for management and the PCAOB's new standard for
auditors will lower overall compliance costs for companies of
all sizes, and significantly so compared to the old standard.
We expect that compliance costs under Section 404(a) should
come down disproportionately for small business, because the
new SEC guidance that has been developed specifically for
management will allow each small business to exercise
significant judgment in designing an evaluation that is
tailored to its individual circumstances.
Unlike external audits, management in a small company tends
to work with its internal controls on a daily basis. They have
a great deal of knowledge about how their company works, what
goes on inside, and how the firms operate. The new guidance
allows management to make use of that knowledge, which should
lead to a much more efficient assessment process.
We state clearly in the brochure for small business that
under normal circumstances they don't need to hire extra help
to do their assessment. They certainly don't need to engage an
outside auditor for this purpose. The normal company personnel
who are responsible for this work should be able to do it as
part of their routine duties. The goal of all of these efforts
is to implement Section 404 just as Congress intended--in the
most efficient and effective way to meet our objectives of
investor protection, well functioning financial markets, and
healthy capital formation for companies of all sizes.
We won't forget the failures that led to the passage of the
Sarbanes-Oxley Act in the first place, and we won't forget that
for a small business to continue to prosper in America both
strong investor protection and healthy capital formation must
go hand in hand.
Thank you again for the opportunity to speak on behalf of
the Commission. I would be happy to answer your questions.
[The prepared statement of Mr. Cox may be found in the
Appendix on page 38.]
Chairwoman Velazquez. Thank you, Mr. Chairman. And I am
very, very encouraged by your announcement this morning. Mr.
Chairman, during the Committee's hearing on June 5, you
indicated that you would be willing to consider supporting such
a delay, if it was warranted. At that time, you also indicated
that you did not believe that a delay was necessary. You now
support a delay. What changed your mind?
Mr. Cox. The schedule really requires that if we are going
to use cost data that we have at least a one-year delay.
Otherwise, what will happen is that companies will have to
incur costs waiting for our decision based on the real-world
data, and then we might at the eleventh hour tell them, ``We
are sorry. Never mind. Let us wait until we get this right.''
There is a better way to do it, and that is to take all of
the real-world data, analyze it, make a decision, and then go
forward.
Chairwoman Velazquez. When do you expect that the SEC will
vote on your proposed delay?
Mr. Cox. Madam Chairman, that is an excellent question. I
have had the opportunity to talk to all of the Commissioners
about this, so that while there has not been formal Commission
action yet, I do have an informal sense of Commissioner support
for this proposal. And I hope that reasonably early in 2008 we
will be able to have an open meeting to do this.
It is also possible, in fact, I will have to consult with
the General Counsel and with the Division of Corporation
Finance, that as has been done in the past this could be done
by staff action without need of a formal Commission open
meeting, in which case we could do it even more quickly.
Chairwoman Velazquez. So if there are procedural steps that
accompany this rule change, when do you expect that an SEC
decision in favor of a potential delay will be finalized, if
there are procedural steps that need to go with the delay?
Mr. Cox. Well, you know, but for the fact that we are just
now entering on the holiday season, and New Year's Day is less
than three weeks away, I would say we could do it even this
year. But I think realistically the earliest we could do this
would be during the month of January.
Chairwoman Velazquez. The month of January.
Mr. Cox. Yes.
Chairwoman Velazquez. I understand that the SEC will soon
undertake its own data collection effort with respect to SOX
404. And the data the Commission collects will undoubtedly be
very helpful in determining whether SOX 404 compliance
continues to be burdensome for small firms. Can you provide
details as to what companies will be surveyed, when it will
begin, and how the data will be analyzed?
Mr. Cox. Yes, I can do so in a general way in this hearing,
and in a more detailed way between the Committee staff and our
staff, as you might imagine, because the study is being
designed by the Office of Economic Analysis. There are some
general descriptors I can use, but there is also a fair amount
of detail that you might be more comfortable getting from the
experts.
As I described in my opening statement, there are two main
parts to the survey. We are trying to be both broadly
horizontal and also do a deep dive into some companies'
experiences in detail to make sure that we are not missing
anything. The broad-based survey could potentially include
virtually every company in this category, depending on the
level of response to a web-based survey and how successful we
are in eliciting that response.
The detailed analysis will be based on the experiences of
companies that are selected because of their typicality, and
because we think we can infer the most useful information from
their experiences.
Chairwoman Velazquez. But let me ask you, my concern is
if--will small companies and other interested parties will be
able to contribute their recommendations about how to conduct
the most effective data collection effort?
Mr. Cox. Yes. The kind of input that you are talking about
into the design process is very much a part of what we have in
mind.
Chairwoman Velazquez. Once the data has been collected,
would you be able to share that data publicly?
Mr. Cox. I would expect so. I think the entirety of this
needs to be public in order for the public rulemaking process,
public program of the SEC, and public company compliance all to
work.
Chairwoman Velazquez. Mr. Chairman, the SEC's data
collection effort will be critically important to small
companies, no doubt about it. It may provide the evidence that
SOX 404, in particular Section 404(b), needs to be further
revised for small companies. What sort of results would the SEC
have to see to significantly revise how 404(b) is implemented?
Mr. Cox. Well, ultimately, we are constrained by the
statute itself, and so while there are a great deal of
accommodations that can be made in terms of implementation such
as have already been spelled out in our management guidance,
and in the audit standard, I think that wholesale change in the
way that 404(b) applies is a matter not for the SEC but for
Congress.
Chairwoman Velazquez. Thank you. And now I recognize Mr.
Davis.
Mr. Davis. Thank you, Madam Chairman, and thank you, Mr.
Chairman. Thank you for being with us today. We appreciate your
leadership.
You mention in your written testimony that you would
propose a delay in implementation to the small business in
order to base your decisions on final implementation of Section
404(b). Will that decision--will the decision on whether to
implement a further delay of implementation be based solely on
the results of the data gathered?
Mr. Cox. I think that it will be based on the totality of
information that we possess, but the only new information will
be the results of the cost study.
Mr. Davis. And what type of factors will you be looking at
on the delay? It looks like it is going to happen, the delay
will be put forth. But what type of factors will you be looking
for?
Mr. Cox. Oh, I am sorry. I may have misunderstood your
question. I thought you were talking about what we might do
after we got the cost data. But you are asking me about--
Mr. Davis. What type of factors will go into making that
decision?
Mr. Cox. Well, that analysis is actually very simple. It is
a question of whether or not we believe that it would be
beneficial for investors, for issuers, and for the markets to
have the benefits of this cost study and analysis before we
make a final decision. Speaking for myself as Chairman, I think
that is the better part of wisdom. That is the most orderly
process.
Otherwise, we will find ourselves halfway or three-quarters
of the way down the road of the first year of compliance for
smaller companies with 404(b) at a time when we then take a
look at cost data and say, ``We did not expect this result. We
are going to reverse course.'' It would be very disruptive for
companies that are trying to comply in an orderly way.
Mr. Davis. Okay. What efforts is the SEC doing to ensure
that auditors do not take advantage of small business filers?
Mr. Cox. We have been, and the PCAOB has been, engaged very
directly with auditing firms of all sizes, but particularly
those who cater to smaller public companies, to make sure that
they understand when the PCAOB and the SEC repealed AS-2 and
substituted the new top-down, risk-based materiality-focused,
scalable AS-5, that we did so with a strong view to gaining
efficiencies.
The costs of Section 404 implementation have got to be
outweighed by the benefits. That is what Congress intended. I
know this from speaking to all of the members, both the House
and Senate side, who have been so concerned about this. I know
this from speaking to companies, issues, and investors at our
roundtables.
People want the benefits of Section 404. Nobody is saying
we shouldn't get those benefits, but they are trying to make
sure that there is some correlation between the way the thing
is implemented and the benefits that the market gets. And so we
are going to keep all of those factors in mind in making these
decisions.
Mr. Davis. Thank you for your dialogue with those that fall
in with members of Congress to make sure that we have that open
debate. You stated that the SEC will monitor the effectiveness
of public company accounting oversight boards inspections of
whether audit firms are implementing the new auditing
standards. Could you explain how this process will work?
Mr. Cox. Yes. It works in a number of ways. In the most
formal way, it is a function of the inspection process being
carried out first by the Public Company Accounting Oversight
Board, which is inspecting the audit firms for 404
efficiencies, and then by our own inspection at the SEC of the
PCAOB's inspection process with a view to the same
efficiencies.
So the firms, the auditing firms, who are being inspected
by the PCAOB are getting the full force and effect of the SEC
and PCAOB inspection process aimed at efficiency. They know
that we are quite serious about making sure that AS-5 is
implemented as intended.
Second, the PCAOB and the SEC are routinely engaged with
the firms in discussions of these issues. Our Office of the
Chief Accountant, for example, on a daily basis discusses these
topics with the auditing firms. And, thirdly, I and the other
Commissioners and the staff of the SEC have a number of
informal opportunities, some of them slightly more formal--for
example, at our roundtables and others, a part of our
interaction through meetings and our officers and around the
country, as I have described in my testimony, to focus
attention on these matters.
But changing the way that people operate is very much what
the PCAOB and the SEC had in mind by repealing AS-2 and
substituting AS-5.
Mr. Davis. You stated earlier this year that Congress never
intended the 404 process to become inflexible, burdensome, and
wasteful. Do you still hold those views? And what is your
response?
Mr. Cox. I do. And because I was a member of the House
Senate Conference Committee that wrote Sarbanes-Oxley, and
because I was there on the floor when we were all speaking
about it, I know that not a single member from any state got up
and said, ``I want a process that is inefficient, costly, and
burdensome, that destroys American competitiveness.'' Nobody
said that. Nobody thinks that that is what this law is all
about.
What people wanted was a law that gave investors greater
confidence that the numbers that they were relying on to make
their financial choices were solid and good, that the
pathologies that we saw manifested in the cases that
Congressman Chabot listed--Enron, Worldcom, Adelphia, and so
on--that all of those things would be dealt with in the most
serious fashion by our law enforcement system, that reliability
would be the touch-tone of our financial reporting in the
United States. That is what this was all about. And there is a
way to do all of that without crushing the whole enterprise in
the process.
Mr. Davis. One final question. A moment ago you talked
about collecting data. Once you have that data, what will SEC's
decision process be dealing with Sarbanes-Oxley compliance?
Mr. Cox. Yes. I apologize for beginning to answer that
question earlier, because I thought that was your earlier
question. At that point, we will take the cost data and put it
together with the totality of information that we have acquired
through extensive examination of 404 implementation over the
last several years, and then make a decision about what to do
next.
This is the same kind of decision that we have already
taken with respect to small business on multiple occasions with
respect to foreign private issuers, with respect to accelerated
filers, and large accelerated filers in the United States.
Mr. Davis. Thank you. and thank you, Madam Chairman. I
yield back.
Chairwoman Velazquez. Mr. Gonzalez?
Mr. Gonzalez. Thank you very much, Madam Chairwoman. And
welcome, Chairman Cox. Good to see you again. And I am glad you
alluded to the fact that we were all there in 2002 when
Sarbanes-Oxley was adopted. As a matter of fact, the
Chairwoman, you, and yours truly were members of the Financial
Services Committee that probably were the focus of all of the
hearings, and it was exciting times for all of the wrong
reasons.
The witnesses were very, very interesting. Most of those
witnesses are today in prison, and some of those--and most--
[Laughter.]
--of the companies are no longer in existence. And I guess,
you know, and I don't mean to be flippant about it, but do you
recall--during all of the hearings that were conducted, and,
you know, we had Bernie Ebbers there, we had everybody from
Enron, we had Arthur Andersen, we had everybody there, and it
was, like I said, exciting times. But do you recall any
witnesses that were summonsed and testified that represented
small business public trading companies?
Mr. Cox. I think the answer to your question is no, and I
believe--I imagine you don't recall it either, because that
seemed not to be the focus at the time--and so we can infer
from the answer to your question--is that this part of the
analysis is a very important auxiliary.
Mr. Gonzalez. Yes. And I guess I am just making the point
that that really wasn't the problem. It wasn't the small
business publicly-traded companies that created the situation
that called for Congress to act, which I think was the
appropriate thing to do. But like in most instances, obviously,
you know, we cast a wide net many times, and we bring many
people into it, but it doesn't mean that we can't review what
we did in 2002 and tweak it, maybe not a wholesale revision,
and so on.
I know that former Chairman Oxley was not receptive to the
idea of visiting Sarbanes-Oxley. That was my understanding a
year ago. Now we have Chairman Frank. I really don't know his
position and how flexible he might be in entertaining maybe
some revisions, again some tweaking to see if we can make it a
little easier in its application.
Still provide the public the safeguards that are really the
essence of the legislation that were a result of certain
misconduct at a certain level that truly impacted our economy,
investor confidence, and so on. I think that is the appropriate
thing.
And see if I am reading you right in your testimony. There
is only so much the SEC can do in the implementation to take
care of the cost, the inconvenience, and of course I think
there is diminishing return as to the objectives of Sarbanes-
Oxley at the end of this thing. But, really, it probably is up
to the United States Congress to look at it and to see if
anything can be done legislatively. Would you agree with that?
Mr. Cox. Well, I always have a great respect, which I have
built up over my time serving in this institution, for the role
of the legislative process and the choices that policymakers
have before them. That is not our job at the SEC. Our job is to
make the laws that we did pass work in the best way possible. I
am of the view, having had--going to my third year experience
as a regulator looking at this, that it should be able to work
without legislative change, and that is what we are trying to
do.
I say that because while we didn't have small businesses up
at those hearings focused on Enron and the rest, we all well
know that financial fraud exists also in smaller public
companies. And, in fact, in many cases some of the pathologies
are even worse because the lack of internal controls in some
small companies are more egregious than could possibly exist in
a larger company with more routinized processes.
So the focus on internal controls is not misplaced. It is
something that small public companies need just like large
public companies. But what happened, because we had all of our
focus on enormous firms, is that the system that was designed
to implement it just didn't fit. We once in a while allude to
the mythology tale of Procrustes who used to stretch his
victims onto Procrustean beds, so that eventually they would
fit. That is a little bit of what we saw going on with small
business and 404 compliance.
Lastly, I would just say that while there is enormous
concern in the small business community about the potential
effects of SOX 404(b), the small business sector is the one
group that has never done it. And there is now a new system in
place which we fully intend will be vastly different than the
one that they observed other companies having so much trouble
with.
So I think the first opportunity we should take is to get
it right, the way Congress wrote the law, and only failing that
would policymakers have to come in and do something else.
Mr. Gonzalez. All right. Well, I appreciate your service,
and, of course, your testimony today. I yield back.
Chairwoman Velazquez. Time has expired. Ms. Fallin?
Ms. Fallin. Thank you, Madam Chairman. Appreciate you
coming today and talking about a very important issue to our
business community and the United States. I had a couple of
questions. Are you going to survey companies that are private,
but might want to go public?
Mr. Cox. It is an excellent question. The cost study that
we are talking about is literally focused on the costs of
complying with the new management guidance, and the new audit
standard. And so it would be impossible to derive that
information from companies that aren't complying and are
incurring those costs. But survey data of companies that are
thinking about going public would be enormously useful for
other purposes.
Ms. Fallin. Okay. And once the Commission has collected the
data, what types of action could it take to reduce Sarbanes-
Oxley compliance for the smaller companies?
Mr. Cox. I think we are going to have to stay with this. I
have thought all along that writing a new audit standard, and
writing management guidance that is directed to small business
and takes into account their special concerns, is only half the
job. After that, you know, starting with user-friendly things,
like a brochure for small business that explains in plain
English what modest steps people can take to get started on
this, and extending to talking to the audit firms and making
sure that they are focused on efficiencies and they are not
taking advantage of their clients, all of these things are
going to require constant vigilance and maintenance by the SEC.
Ms. Fallin. Thank you, Madam Chairman. Thank you.
Chairwoman Velazquez. Ms. Hirono?
Ms. Hirono. Thank you, Madam Chair. Mr. Cox, I note in
your testimony that you state clearly in your brochure as to
the small companies that under normal circumstances they would
not need to hire an outside auditor to do this assessment as
required. Now, the reality might be, however, that because
there are penalties involved in not complying, wouldn't it be
the case that for most companies that they would want to have
an outside auditor do this?
Mr. Cox. I don't think so.
Ms. Hirono. An auditor do this assessment?
Mr. Cox. I think the external audit piece clearly
contemplated as the 404(b), and what we have been careful to do
is parse that for small businesses as we phase in their
compliance. So at this point what smaller public companies are
going to be expected to do is their own assessment.
Of course, they all have auditors to do their financial
statements, and the statute itself, you know, contemplates that
this is something of an integrated process. So there is no rule
against talking to your auditor and having a good healthy
dialogue at all times and asking your question about what they
think.
But the idea that it is the auditor's job either to design
the self-assessment or to attest to it as part of this 404(a)
process I think is very misplaced. And we have been trying to
focus everyone on that, in the brochure talk about what special
expertise companies have about this. Companies know how they
work best of all. They know the risks of their business. They
know sometimes at a very detailed level what checks might be in
place--for example, a clerk taking money out of the cash
register or whatever are the special risks of their business.
Ms. Hirono. If I could just focus--
Mr. Cox. Getting an auditor involved in that kind of level
of detail I think is one of the big problems that we had under
the old standard.
Ms. Hirono. I understand what you are saying. It is
laudable that you would want to say to the small companies,
``You don't need to go out and spend money and have an outside
auditor.'' However, because of the penalties that would be
involved, and you also noted that for small companies there may
be more concern about in-house kinds of assessments and--
Mr. Cox. I should just add that the penalties that attach
are the penalties that have always attached to having something
wrong with your financial statements. In the phase-in that--as
we have laid it out for smaller business, the 404(a) process
results in a management's assessment that is furnished and not
filed with the SEC. That means there is no different penalty
that attaches.
The only penalties are the ones that they have always had
and have right now, and that is for filing financial statements
with something wrong with them. But nothing different about the
internal controls assessment.
Ms. Hirono. Well, that is also reassuring. So your feeling
is that once you are able to, through a brochure like this, and
your efforts to meet with the small business community, and to
reassure them that they do not have to spend all kinds of money
to be able to comply with 404(b), that in fact the new rules
that you have adopted will not have such an adverse impact on
small business companies' ability to comply.
Mr. Cox. Yes. In fact, I--
Ms. Hirono. What is your expectation?
Mr. Cox. --would go so far as to say that if we get this
right, ultimately the greater investor confidence that would
result from this process could reduce the cost of capital for
smaller businesses. Not to say they won't have an outlay to do
the compliance, but if cost of capital is a function of
investor conference or concern at some level, and appreciation
of risk, there is I think a way for--
Ms. Hirono. I think that is a good point.
Mr. Cox. --us all to win at this.
Ms. Hirono. Thank you. Thank you, Madam Chair.
Chairwoman Velazquez. Mr. Westmoreland?
Mr. Westmoreland. I don't really have any questions or
comments. Good to see you again, and appreciate you all taking
a good look at this. And hopefully you will come up with a
decision to maybe put it off another year, but I do appreciate
your being here and coming to testify.
Chairwoman Velazquez. Okay. Thank you. Mr. Chairman, I know
you don't want to stay for the--to listen for the second panel.
And I would like for you later, before you leave, to identify
the staff person that will stay here.
Mr. Cox. Yes. In fact, I think we will have more than one.
Chairwoman Velazquez. Okay. Great.
Mr. Cox. But during this morning's second panel, we will
hear testimony from senior representatives from small
companies. The witnesses' written statements include clear
indication of SOX 404 costs, actual and projected, and I would
like to read to you a few of the figures they will cite.
University Security Instruments, a non-accelerated filer,
estimates implementation of SOX 404 as revised will cost the
company $150,000 to $200,000. Furthermore, they estimate the
company will incur $100,000 in extra fees each year once their
company adopts SOX 404. Pendleton Community Bank, a non-
accelerated filer, has already spent $70,000 to comply with the
revised Section 404 and estimates that coming into full
compliance will cost the company a total of $218,000. This is
8.9 percent of anticipated 2007 net income for the bank.
Tandy Leather Factory, a non-accelerated filer preparing
for SOX 404 compliance in 2004, spent $157,000 in fees. This
amounted to 6 percent of the company's earnings in 2004.
Tandy's auditors indicated in 2006 that the work Tandy has done
in preparation for SOX 404 compliance was very basic and
preliminary.
Mr. Chairman, are these costs in line with your and
Commission's expectations about reasonable SOX 404 costs for
non-accelerated filers?
Mr. Cox. Well, I think we are going to be very interested
in taking a look at what kinds of activity results in these
expenses, and comparing it to over the broadest possible sample
that we can, to provide you with a rigorous answer to that
question. But that anecdotal evidence is the sort of thing that
I am sure animates your concerns, because those expenses are
much higher than what were originally estimated by the
Commission when the impending rule was adopted and when PCAOB
first adopted AS-2, the old standard.
We expect it to be less expensive than that old standard.
These numbers indicate that that is not so.
Chairwoman Velazquez. Are there any other members who wish
to make questions at this point?
[No response.]
Mr. Buchanan, we are about to end this first panel. Do you
have any questions for Mr. Cox?
Mr. Buchanan. No, thank you.
Chairwoman Velazquez. Mr. Chairman, I really want to thank
you for your appearance here this morning, and your willingness
to listen to small companies. And I want to state for the
record that I truly personally believe after listening to small
companies, and holding a hearing not only here in the Small
Business Committee but also on Financial Services.
That Section 404(b) is a huge regulation that will redefine
how small companies access the public market. And I want to
state that I welcome your reevaluation of this issue, and that
I want to thank you for the decision that you are making
regarding delaying the implementation or the compliance of
Section 404, because this is going to be meaningful to small
companies. And not only to small companies, but to the auditors
and to their investors.
Nobody wants to see small companies fail because of an
inadvertently burdensome regulation. The delay will also help
us--Congress and the Commission--assess whether the revised
rules and auditing standards appropriately balance the costs
and the benefits of SOX 404 for America's smaller companies.
And that is our next challenge.
But before we tackle that one, however, I would like to
express my personal appreciation to you for your leadership on
this issue.
Mr. Cox. Thank you, Madam Chairman. And you also asked that
I identify the key staff that are here today to listen to the
next panel. They include the Deputy Chief Accountant for Audit,
Zoe-Vonna Palmrose, and the Director of the Office of Small
Business at the SEC, Gerry Laporte.
Chairwoman Velazquez. And with that, Mr. Chairman, you are
excused.
Mr. Cox. Thank you.
Chairwoman Velazquez. May I ask for the second panel to
please come forward?
And now we are going to proceed with the second panel. Our
first witness is Mr. Michael Ryan, Jr. Mr. Ryan is Senior Vice
President of the U.S. Chamber of Commerce, and Executive
Director of the Chamber's Center for Capital Markets
Competitiveness. The U.S. Chamber of Commerce is the world's
largest business federation representing three million
organizations of every size, sector, and region.
Welcome, Mr. Ryan, and you will have five minutes to make
your presentation.
STATEMENTS OF MICHAEL J. RYAN, JR., U.S. CHAMBER OF COMMERCE
Mr. Ryan. Thank you very much. Good morning, Madam
Chairman, and members of the Committee. As the Chairwoman said,
my name is Michael Ryan. I am Executive Director and Senior
Vice President of the U.S. Chamber of Commerce's Center for
Capital Markets Competitiveness.
On behalf of the Chamber, and our small business members, I
want to thank you for holding this hearing and focusing
attention on this very important issue. On June 5th, this
Committee held a similar hearing concerning the
disproportionate and unnecessary burden that immediate
application of SOX 404 would have on small companies. Since
then, the Committee has asked questions of and received answers
from the SEC concerning its cost-benefit analysis in connection
with SOX 404 implementation for small public companies.
More recently, the U.S. Chamber, working with others,
released the results of a survey conducted to quantify the
expected cost to small businesses of immediate application of
Section 404(a) and the application of Section 404(b) beginning
a year from now, which is the current timeline for these two
provisions.
As I begin my testimony, I would like to make several basic
points. First, small businesses are critical to the long-term
health and vibrancy of the U.S. economy. They are the source of
millions of jobs and the incubator of many of the next
generation of innovative products and services. Second, the
U.S. Chamber supports the purposes of the Sarbanes-Oxley Act,
including the application of Section 404 internal control
provisions to small companies.
Third, while the recent changes to Section 404
implementation are positive steps forward, these changes are
complex and will necessarily be more costly to implement during
the first year than in future years. Fourth, almost all
regulation disproportionately burdens small businesses, and
this will undoubtedly be the case with Section 404, even when
we get it right.
Fifth, a one-year delay for small public companies while
the kinks are worked out would significantly reduce the
disproportionate burden. And, finally, to realize the maximum
benefit from a delay, we need that delay to be announced
immediately. Our survey shows that companies are already
spending money, and each day that passes undermines the benefit
a delay would provide.
Since this Committee's hearing this past summer, new data
have been collected that sheds light on some small companies'
cost of compliance with 404. On November 8th, we released a
study showing that, despite recent reforms, Section 404 will
disproportionately burden small businesses. Unless the SEC or
Congress takes action, the current timeline will require small
public companies with a calendar year end to begin complying
with 404(a) in early 2008 and 404(b) in early 2009.
While the SEC has predicted that non-accelerated filers
would not engage their auditors for SOX 404 compliance until
the first half of 2008, more than 83 percent of the respondents
have already done so with respect to 404(a) and 58--more than
58 percent have done so with respect to 404(b). The study also
shows that more than half of the companies responding with less
than $75 million in market value will spend more than 3 percent
on net income--of net income on Section 404(a). Sixty-three
percent anticipate a cost increase in the next year due to
compliance with 404(a) and (b). Finally, more than 58 percent
of the respondents believe that 404 will not help detect and
prevent fraud.
Our study shows why small companies complying for the first
time should not be guinea pigs for the improved rules adopted
by the SEC and the PCAOB. We continue to support strong
internal controls and believe that the improved rules, if
implemented as intended, will address many of the challenges
companies face in complying with Sarbanes-Oxley.
We once again applaud the initiatives made by the SEC and
the PCAOB to fix the implementation process for Section 404 to
better reflect the intent of Congress and the needs of
investors and companies. We view the PCAOB's new auditing
standard, as well as the SEC's management guidance for
companies, as a significant step forward. And we commend
Chairman Cox and Chairman Olson and their respective agencies
for their leadership, time, and energy to bring balance back to
the system.
In the end, we are hopeful that these changes will restore
the balance we believe Congress intended all along and will
bring costs more in line with the benefits. Further, we
recognize and strongly support the efforts the SEC and the
PCAOB have put forth since May to ensure that auditors and
public companies alike fully understand the new rule and
guidance and implement them in as cost effective a manner as
possible.
These efforts have taken many forms, including hosting town
hall meetings around the country and issuing detailed guidance.
We believe, however, that the need for these efforts--and we
agree they were needed--only goes to support our argument for
further delay for small businesses. That is, the changes put in
place in May by the SEC and the PCAOB are complex, not easily
understood, and will require a great deal of time and energy to
work out the details.
Therefore, implementation in 2007 and 2008 will necessarily
be more costly than will be the case in future years when much
of the transition pain will be behind us. In the meantime, U.S.
small businesses should not have to shoulder the
disproportionate regulatory burden.
With a further delay for small businesses we will be better
able to leverage the experiences of large companies, the
auditing profession, and regulators to ensure that
implementation costs are minimized. Failure to do so--failure
to do this could significantly undermine the cost-cutting
objectives of the new standards.
We also need to remain prepared to make additional changes
if the new rules don't work as intended. At least two of the
five SEC Commissioners, Commissioners Atkins and Casey, have
publicly indicated a willingness to consider such a delay. And
based on the testimony we heard from Chairman Cox just a few
moments ago, I would add him to that list.
The Senate Committee on Small Business and
Entrepreneurship, led by Chairman Kerry and Ranking Member
Snowe, held a hearing this past April, and these Senators have
publicly called for further delay. The Office of Advocacy at
the Small Business Administration has also just--has also
joined in and asked the SEC to revisit the compliance
deadlines.
And just this past week Representative Spencer Bachus,
ranking member of the House Financial Services Committee, sent
a letter to Chairman Cox asking for a one-year delay in
implementation of 404(b). In summary, we believe that we will
only know if the efforts of the SEC and the PCAOB have been
successful until after we have experience with the
implementation.
Therefore, we are again calling for the immediate
announcement for a one-year delay for smaller public companies
before they must comply with Section 404, and we urge this
Committee to support this call for delay.
Thank you for the opportunity to be here today.
[The prepared statement of Mr. Ryan may be found in the
Appendix on page 43.]
Chairwoman Velazquez. Thank you, Mr. Ryan.
Our next witness is Mr. Harvey Grossblatt. He is the CEO of
Universal Security Instruments based in Owings Mill, Maryland.
Universal is the manufacturer and distributor of residential
fire and smoke alarms. Universal has been a public company
since 1973 and was included in Fortune Small Business
Magazine's top 100 fastest growing small companies in 2006 and
2007. Universal Security Instruments is listed on the American
Stock Exchange.
Each one of the witnesses will have five minutes. When the
light is green, you will start. When the light is yellow, it
means that the five minutes is about to expire.
STATEMENT OF HARVEY GROSSBLATT, UNIVERSAL SECURITY INSTRUMENTS,
INC. ON BEHALF OF AMEX
Mr. Grossblatt. Madam Chairman and members of the
Committee, I am Harvey Grossblatt, and I would like to thank
you for the opportunity to comment on the Sarbanes-Oxley Act,
Section 404, about which I feel quite strongly.
I will attempt to summarize my written testimony.
Although I fully agree with the need for the legislation to
protect our investor confidence in capital markets, it is the
method used to protect the last six percent of the total market
capitalization not covered by Section 404 with which I
disagree.
My company has been a public company since 1973, and it is
a non-accelerated filer. Before I became CEO, I was the CFO,
and I would prepare our 10(q) in one day and our 10(k) in two
to three days. Now, without Section 404, it takes us three days
for the preparation of the 10(q) and almost two weeks to
prepare our 10(k).
Additionally, our auditors and lawyers spend 50 percent
more time reviewing the documents.
When Sarbanes-Oxley passed, I did not realize our legal and
accounting fees would increase 50 percent immediately as I
mistakenly thought that most of the cost would be 404 and
believed small companies would eventually be exempt.
I now realize how wrong I was. The implementation of
Section 404 will cost approximately $200,000, plus an
additional $100,000 covering the 50 percent increase in our
legal and audit fees. In a small company like mine, the
management will have to divert valuable time from growing the
business to make sure that we comply with these rules, spending
considerable money without any return on our investment.
I wish I could have understood how this benefits our
shareholders. When investors buy stock in small public
companies, they are buying the management, and I believe they
would rather have us grow their business instead of spending
profits without any return. I do not understand how the
Congress can expect a small corporation with 20 employees to
have the same accounting and control systems that multi-billion
dollar companies have.
I realize that Congress tried to help with the
implementation of these regulations, but it is still a one size
fits all approach without regard to the impact of the cost of
compliance.
These costs may be spread over two years, but they do not
go away. It seems to me the only beneficiaries of these rules
will be the consultants, lawyers, and auditors and not the
shareholders whom this law was implemented to protect.
And before I end, I would like to make two comments on
Commissioner Cox's statement. The first, one question was about
Commissioner Cox brought out that most companies could do this
themselves. I do not believe this will happen as all public
companies have an independent audit committee made up of
independent directors who take fiduciary responsibilities very
seriously, and I cannot believe anyone will let the company's
management review itself without having independent consultants
come in.
Secondly, the more important point, if this Committee could
follow up with Commissioner Cox, the biggest problem with all
of these new recommendations at PCAOB and the SEC that come
out, it is not clear enough to the auditors. If I told you how
many times we have to argue with our auditors and they say,
``Well, we do not have a clear direction,'' so they go from one
extreme to the other extreme.
That is the biggest problem that we experience. The
management side is fine. We understand what we have to do for
404, but we need clear guidance for our accountants.
And I would like to end by thanking you for the opportunity
to provide my personal experience and input to this important
issue, and I will be happy to answer any questions you may
have.
[The prepared statement of Mr. Grossblatt may be found in
the Appendix on page 50.]
Chairwoman Velazquez. Thank you, Mr. Grossblatt.
Our next witness is Mr. Bill Loving. Mr. Loving is CEO of
Pendleton Community Bank based in Franklin, West Virginia.
Pendleton Community Bank serves six counties in West Virginia
and Virginia. Pendleton Community Bank has four branches, 66
employees, 710 registered shareholders.
Mr. Loving is testifying on behalf of the Independent
Community Bankers Association. ICBA represents 5,000 community
banks of all sizes and charter types throughout the United
States.
Welcome, sir.
STATEMENT OF BILL LOVING, PENDLETON COMMUNITY BANK, ON BEHALF
OF THE INDEPENDENT COMMUNITY BANKERS OF AMERICA
Mr. Loving. Good morning. My name is Bill Loving, and I am
the Executive Vice President and Chief Executive Officer of
Pendleton Community Bank in Franklin, West Virginia.
Chairwoman Velazquez and members of the Committee, I
appreciate the opportunity to testify on behalf of the
Independent Community Bankers of America, ICBA, concerning
Section 404 of the Sarbanes-Oxley Act of 2002, or SOX, and the
results of the Chamber of Commerce cost of SOX 404 survey.
On November 8th, 2007, the Chamber released the results of
a survey on the projected 2007 and 2008 cost of SOX Section 404
and its impact on small businesses. Since approximately 25
percent of the respondents were from the financial service
industry and many were community banks, ICBA believes the
survey's results are a good reflection of the costs that
publicly held community banks are experiencing with Section
404.
The Chamber survey indicated that over half of the
respondents expect internal and external costs to implement SOX
404(a) this year to exceed $200,000, while 44 percent of the
respondents expect next year's implementation cost of 404(b) to
also exceed $200,000. For non-accelerated filers, this amounted
to more than three percent of net income. These results confirm
ICBA's 2005 SOX 404 community bank survey which showed that the
average community bank would be spending more than $200,000,
devoting over 2,000 internal staff hours, and spending
approximately three to five percent of their net income to
comply with Section 404.
I can tell you that as CEO of a community bank that is also
a non-accelerated SEC filer, the Chamber's survey accurately
reflects the disproportionate burden that community banks like
mine are facing to comply with Section 404. This year we have
spent about $70,000 to comply with 404, which includes cost
associated with 580 man-hours. While the impact on net income
for 2007 is approximately three percent, the combined cost to
date, if accounted for in one calendar year would be $168,640
or 6.88 percent of 2007's projected net income.
Like many publicly held community banks, Pendleton
Community Bank is a good example of a small company that should
not be subject to the reporting requirements of Section 12 of
the Securities Exchange Act of 1934 and to all of the
regulatory burdens of SOX. With 710 shareholders, we have
considered going private to avoid these costs, but considering
the small community where our bank is located, it would be a
significant loss both to our community and to our bank's
reputation if our bank were to go private and repurchase most
of its stock or participate in a reverse stock split, a process
that forces out shareholders below a certain level of
ownership.
Now that we have reached the end of 2007 and most non-
accelerated filers have completed their management internal
control reports, ICBA supports Chairwoman Velazquez's request
to the SEC to delay the implementation of the auditor
attestation requirements required by Section 404(b), which for
calendar year filers would begin in 2008. The one-year delay
would give the SEC and the PCAOB an opportunity to evaluate the
impact of this new guidance on accelerated and large
accelerated filers and would give non-accelerated filers that
have no experience with Section 404 additional time to
understand and apply AS-5.
We comment Chairman Cox's decision today to recommend
another delay in implementation of Section 404(b) for the non-
accelerated filers, an action we applaud and certainly welcome.
ICBA applauds Chairwoman Velazquez's effort to obtain hard
dollar estimates from the SEC on the impact that SOX 404 has on
smaller public companies. The SEC should have made those
estimates prior to adopting AS-5. However, we are pleased that
as a result of Chairwoman Velazquez's efforts SEC Chairman
Chris Cox has committed the Commission to a data collection
program beginning next year.
ICBA believes that the SEC and the PCAOB should establish
benchmarks or goals for AS-5 that are tied to reduction in
overall 404 costs. For instance, SEC and the PCAOB should state
that the goal of AS-5 is to reduce average internal control
costs by a certain percentage, say, 20 percent.
ICBA supports the community banks serving the Communities
First Act of 2007 by Chairwoman Velazquez, which would relieve
community banks with assets of less than one billion from the
requirements of 404(b) and raise the threshold under the
Exchange Act to 1,000 providing relief for hundreds of
community banks like mine that are struggling.
We appreciate the opportunity to testify and thank you.
[The prepared statement of Mr. Loving may be found in the
Appendix on page 53.]
Chairwoman Velazquez. Thank you, Mr. Loving.
Our next witness is Mr. Thomas Brandt. He is the CFO,
TeleCommunication Systems, Inc., based in Annapolis, Maryland.
TCS provides mission critical wireless technology solutions to
carriers, public safety, and government customers. Mr. Brandt
serves as Chairman of AeA's Sarbanes-Oxley Committee and is
testifying on behalf of AeA, a trade association representing
roughly 2,500 high tech companies.
Welcome, sir.
STATEMENT OF THOMAS M. BRANDT, JR., TELECOMMUNICATION SYSTEMS,
INC., ON BEHALF OF AEA
Mr. Brandt. Thank you.
The AeA, which is the nation's largest high tech trade
association, appreciates this committee's efforts relating to
Section 404 of the Sarbanes-Oxley Act, and we thank you for
holding today's hearing.
In addition to serving as the Chairman of AeA's Sarbanes-
Oxley Committee, I am the Chief Financial Officer of
TeleCommunication Systems, Inc., or TCS, based in Annapolis,
Maryland.
TCS was bootstrapped by the founder as an 8(a) company and
is now a 500 employee, $150 million accelerated filer under SOX
404. I have served as a corporate financial officer for more
than 20 years and started my career as a Price Waterhouse
auditor of public companies, where I worked for 12 years.
When I learned of today's hearing, I wanted to testify
because I am convinced that the application of Section 404 to
small public companies is bad public policy. Based on my
experience as both a corporate officer and an auditor and as
someone who is completing the fourth year of Section 404
compliance, it is clear to me that Section 404's cost far
outweighs any benefit to investors in small cap companies.
For TCS the incremental Section 404 compliance cost
relative to the company's market cap and float continues to be
very high. For perspective, the average pretext profitability
of our business over the last three years averaged around two
million dollars a year. Annual outside audit fees of more than
$600,000 represent a big bite out of investors' hides.
As inefficient as this regulatory impact has been on
companies like mine, the adverse impact of ever imposing this
burden on non-accelerated filers is alarming. Although we
appreciate the SEC's and PCAOB's efforts to address this issue
through the issuance of new guidance, I believe that its effect
will be minor and that the SEC Advisory Committee on smaller
public companies' recommendations to provide tiered exemptions
should be revisited.
Since TCS' $135 million market cap is meaningfully
comparable to the $75 million cutoff between accelerated and
non-accelerated filers, ours is a good case study of the burden
of Section 404 on smaller companies. My written testimony
contains more detail to illustrate how our fees have increased,
but briefly, between 1999, just before our IPO, and 2003, we
experienced a sevenfold increase, from about $50,000 a year to
$370,000, in recurring audit costs, when revenues only doubled.
This cost reflects a lot of outside scrutiny for a small
company before layering on Section 404.
In 2004, the first year of SOX compliance, our audit fees
more than doubled to $770,000. For 2005, when we were supposed
to realize the benefits of a second time through cycle, our
fees actually increased 13 percent to $871,000. For 2006, our
fees were $621,000.
The PCAOB's AS-5 and recent related SEC guidance is
supposed to lower the cost for companies like mine, but for
2007, our Big Four audit team told us that we had already taken
advantage of substantially all the top-down risk-based
incremental efficiency that AS-5 has reiterated. So we should
expect our fees to remain around $620,000.
Over the four-year period, the nature and scope of our
company operations and financial statements has been
sufficiently constant to make our numbers a fair small cap
example. Based on discussions with my peers, many other
companies have been hit much harder. While the number of hours
to do the recurring extra audit work since the first years of
SOX 404 may have modestly declined, the average hourly billing
rates for auditors have risen sharply. As a former auditor, I
am sympathetic that as deep pockets, the Big Four firms are
compelled to charge more to cover their insurance and possible
outlays for tort claims, as well as higher salaries and partner
compensation to attract more people to do Sarbanes-Oxley work.
But that cost burden should not be so disproportionately
applied to the small companies. For small public companies,
which represent a very small portion of the capital traded in
the U.S. public markets, the bar of audit oversight and
compliance was already high enough before 404 and expensive
enough to reasonably protect investors from the risks of bad
accounting.
For the people who are bold and successful enough to grow a
company that's a candidate to go public, our country's small
cap markets have represented a valuable alternative to being
forced to sell their companies or slow down their growth and
risk losing a competitive advantage.
I believe that entrepreneurs like my company's founder
should have fewer, not more obstacles to grow a business and
that investors are already sufficiently informed about the
risks involved. When they can attract the support of public
investors, entrepreneurs should have the freedom to pursue
their visions rather than sell out.
Excessive, recurring regulatory compliance costs are an
unnecessary barrier to investor capital. The SEC Advisory
Committee on Smaller Public Companies, which included an AeA
representative, very thoughtfully developed advice as to levels
of company size, including some companies larger than the non-
accelerated filers, which should be exempted from some or all
SOX 404 work.
I believe the recommended tiered relief should be revisited
and made effective.
[The prepared statement of Mr. Brandt may be found in the
Appendix on page 61.]
Chairwoman Velazquez. Thank you, Mr. Brandt.
Our next witness is Ms. Shannon Greene. Ms. Greene is Chief
Financial Officer and Treasurer of the Tandy Leather Factory,
where she has worked since 1996. Based in Fort Worth, Texas,
Tandy Leather has been the resource for over four generations
of leather crafters providing quality leather, tools, kits, and
teaching resources since 1919.
Ms. Greene was appointed to serve on the board of directors
of Tandy Leather in January 2001.
Welcome.
STATEMENT OF SHANNON L. GREENE, TANDY LEATHER FACTORY, INC.
Ms. Greene. Good morning, Madam Chairman and members of the
Committee. My name is Shannon Greene, and I am the Chief
Financial Officer of Tandy Leather Factory. We are a non-
accelerated filer. We are headquartered in Fort Worth, Texas.
I am also a member of the newly formed Corporate Leadership
Advisory Council, which is the U.S. Chamber's voice of mid-
market businesses. The purpose of my being here today is to
provide some perspective from a small business trying to
maintain our position as a legitimate public company in today's
market.
While I would prefer that we were discussing the potential
elimination of Section 404, I acknowledge that such a
discussion is irrelevant at this time.
With that said, I applaud the SEC and the PCAOB for
recognizing the need to provide scalable rules and guidance to
smaller companies like ours as it pertains to Section 404.
I would like to present several points for consideration.
First, I believe that most small businesses support the concept
of a strong internal control system.
Second, non-accelerated filers who have not had to comply
with Section 404 yet should not be the testing ground for the
revised rules and guidance.
Third, if a delay for non-accelerated filers is being
considered, the decision to delay needs to be made now, as many
companies will be engaging their auditors soon for 404(b), if
they haven't done so already.
Fourth, the management teams of small businesses wear many
hats as they generally do not have the financial resources for
large staffs. The process required to comply with Section 404
further burdens the management that is already stretched thin.
It is important that their process of compliance with Section
404 be as efficient and as cost effective as possible.
Fifth, it has been my experience that investors, whether
individuals or institutions, are not as concerned with a
company's internal control system as one might think. Many, if
not all, of our investors would prefer continued growth in
company profits rather than formal documentation and an
assessment of our internal control system.
I think we all agree that the 404 process as originally
implemented was much more burdensome and costly to all
companies than Congress intended, and we have already seen that
a mere 168 words, as was the original Section 404, had far
reaching, unintended consequences and implications.
It is important that we get it right this time, and the
best companies to make that assessment are those who have
already gone through the process under the original rules.
Small companies in their first year of compliance cannot be
expected to assess the improvement in the rules as they have no
basis for comparison.
The 404 process needs to be as streamlined as possible for
companies so that management teams can focus primarily on
growing their business. It would be unfortunate to trade
dollars spent on jobs or product development for inefficient
regulatory compliance.
Small companies should not be the testing ground for the
new rules, given that 404 tends to have a disproportionate cost
impact on smaller companies with the first year being the most
expensive. I would like to know that the revised regulations
are going to work before we have to apply them to our small
company.
It is important to emphasize that if a delay is being
considered for non-accelerated filers, the decision needs to be
made very soon. Four, oh, four (b) applies to us for 2008. We
do not have the luxury of waiting until the summer or fall to
engage our auditors. As a result, announcing a delay then will
significant minimize the benefit of that delay for a company
like ours, as we will have already incurred sizable costs in
the form of additional audit fees during the first half of the
year.
We are considered a micro cap in the world of public
companies. Approximately 35 percent of our outstanding stock is
owned by institutions. I meet with a number of these
institutions, as well as individual stockholders either via
telephone or in person numerous times a year. Many of our
stockholders own our stock because they believe in the
potential of our company and are comfortable that the
management team knows how to grow the company and, therefore,
increase its value.
In all of my discussions with stockholders, I have yet to
be asked whether we are or expect to be in compliance with
Section 404. However, I am frequently asked about how much we
have and will spend trying to comply and how much of a negative
impact it will have on our earnings.
While most investors want to invest in ethical companies, I
do not get the impression that the internal control system is
what helps those investors make that determination. It is the
people of the company.
Due to the immense regulatory burden on public companies
large and small, I would suggest that we are discouraging
companies from participating in public markets because it's not
worth the effort. The objective of 404 is to provide meaningful
disclosure to investors about the effectiveness of the
company's internal control system. Said in a different way,
investors should be able to rely on the information they are
getting from a public company.
Rather than penalizing all companies with increased
regulation, I think stiffer and swifter penalties for offenders
is a more effective deterrent and would contribute more to the
goal of a reputable public market. I am not minimizing the
importance of regulatory compliance. While I do not always
agree in principle with the rules and regulations set forth, I
can assure you that my company takes this very seriously. We
choose to operate our business within the rules, whether we
agree with them or not, and we will comply with the rules of
404. I would just like to know that the cost to comply is money
well spent.
I appreciate the opportunity to be here today and hope you
found my thoughts and opinions helpful. In summary, please
consider my request to delay Section 404 compliance for small
companies until it has been proven that the rules are achieving
the intended results.
Thanks.
[The prepared statement of Ms. Greene may be found in the
Appendix on page 67.]
Chairwoman Velazquez. Thank you, Ms. Greene.
Mr. Ryan, I would like to address my first question to you.
As you have heard this morning, the SEC is planning to collect
data related to SOX 404 compliance costs. From your
perspective, what are some of the most important data that the
Commission must collect?
Mr. Ryan. Well, I, first of all, would suggest that they
stratify that data collection. I think it was already suggested
by looking at the smaller companies that are already complying
with the 404 and seeing how the transition to the new rules
plays out in that first year, and in particular, how the
auditors respond to that, and also try to get a sense from
companies and auditors, in particular, where the more expensive
costs are coming from so that as we drill down into this area
and try to solve this problem we know exactly where to target
and address as we go forward.
Chairwoman Velazquez. Any other witness who would like to
comment on this question? Yes, Mr. Grossblatt.
Mr. Grossblatt. Yes. In addition, I think the SEC should
consider the management time and internal corporate resources
that have to be spent besides the outside cost.
Mr. Brandt. It is just worth noting that the outside audit
fees are an obligatory disclosure in the proxy statements of
all of us filers. So there's objective information that's
readily collectible for that dimension of the compliance cost.
Chairwoman Velazquez. Mr. Brandt, your company as a larger
small company has already implemented SOX 404.
Mr. Brandt. Yes.
Chairwoman Velazquez. And yet without any self-interest
associated with the potential delay in the SEC's SOX 404
compliance deadline, you volunteered to testify this morning.
Can you explain the reasons why you thought it is so important
to provide testimony on this issue?
Mr. Brandt. Certainly. Having lived this for four years and
having been an auditor before, the marginal benefit of what
we've been paying for has been painfully apparent, and it is
nil; it is negative.
The costs we are incurring at $600,000 for our small
company are grossly disproportionate to the amount of capital
at risk in the market that we have had invested in our company,
and over the last several years working with the AeA and my
peers and hearing the stories of others who have been through
this, the prospect of applying this to still smaller companies
is hard to accept.
Chairwoman Velazquez. Ms. Greene, as an accounting
professional, you recommend a delay in small companies'
compliance with SOX 404 so that large companies have the
opportunity to implement and test the new auditing standard
before small firms are required to comply.
So you believe a one-year delay in Section 404(b) will
allow large companies sufficient time to work out any problems?
Ms. Greene. I think it will certainly help. You know, the
small business that has not had to comply yet, even though the
scaled down rules, I think, are going to be helpful for small
companies. I don't think that we are a good basis of comparison
because we have not had to do it yet.
Will one year be enough? I do not know. It depends on how
well it goes, how the auditors do. A year is better than
nothing, but I do not think we will know until we get farther
into it whether that is adequate or not.
Chairwoman Velazquez. Mr. Loving, in the past this
Committee has received testimony that some banks are likely to
consider going private because of the burdens of SOX 404
compliance. From your perspective, what would it mean for the
town to have its community bank go private?
Mr. Loving. Well, from my perspective, I think you have a
reputation risk to consider if the bank would go private.
Obviously many of the shareholders are, in fact, customers, and
they know customers. And so a negative reaction could take
place because of going private, obviously repurchasing the
stock against their will, and once that would happen, they
would potentially look for other options for banking.
And you know, I am a firm believer that the community bank
is the life blood of the community, and I think it would be
very detrimental to many communities if the community banks go
private.
Chairwoman Velazquez. Mr. Brandt, again, since you have
already implemented Section 404, do you have recommendations
about how SEC can best study the impact of SOX on small
companies?
Mr. Brandt. Well, as was suggested, the audit fee data that
can be collected objectively from our proxy filings could be
stratified, and the correlations between those outside costs
and market cap or revenue or profitability could produce some
useful information.
Chairwoman Velazquez. Ms. Greene, this morning a lot has
been made of the date by which a company engages an auditor.
There seems to be some uncertainty as to what engaging an
auditor means in terms of financial commitment by the company
implementing SOX 404. As the person responsible for her
company's SOX 404 implementation, when your company engaged an
auditor, was your company committing to pay a certain amount in
fees?
Ms. Greene. Auditors have indicated to us that we can
expect our audit fees to increased by 50 percent when they
start their assessment work. Our fees have already gone up
substantially in the last year or so, the premise from the
auditors being that they are trying to cover insurance costs.
I think we run a very efficient audit. I think our auditors
would tell you that, but we have seen substantial increase
already, and we are not even SOX 404, working on that yet. They
are telling us to expect a minimum of a 50 percent increase
when they get ready to start their work on the assessment.
Chairwoman Velazquez. Thank you.
Yes, Mr. Brandt.
Mr. Brandt. If I may add, I think there is sometimes a
misunderstanding between the audit work and the preparation
work for Sarbanes-Oxley 404 review by outside auditors. Most
companies even my size in the first time through have hired
another outside firm, whether it is a Big Four or now there are
specialist consulting firms that have sprung up for the purpose
of helping relatively small businesses write up their processes
and execute the tests that are required under the law, which
are all additional costs before the outside audit fees are
incurred.
I learned from my AeA peers that many of them spent as much
on that as they did on their incremental outside audit fee
cost. Now, that is data that is not captured in proxies, but
the term ``audit'' has multiple meanings in the context of this
discussion. That is one of the reasons I wanted to try to be
here, because of having been on both sides.
Chairwoman Velazquez. Thank you.
Yes, Mr. Loving.
Mr. Loving. If I could mirror that, most of all our costs
have been from hiring a consultant to help us in preparing to
comply with Section 404, and only to mention that the external
audit firm that we used for years chose to remove themselves
from public company work, and so we had to go through the
process of filing a new audit firm because of 404.
And so most of the costs will not be outlined explicitly in
the financials, but there are costs to comply with 404 before
you get to compliance with 404(b).
Chairwoman Velazquez. Thank you.
Yes, Mr. Grossblatt.
Mr. Grossblatt. We were told by our auditors if we did use
an outside firm that the audit fee would be two or three times
what they will charge to review the independents because it
becomes an issue about if internal people do it there is an
independence issue. So you really do not save anything by doing
it yourself because what you will save on the consultants you
will pay twice or three times on the audit fee.
Chairwoman Velazquez. Thank you.
Mr. Ryan, how important is it that the SEC vote on delaying
and finalize the announcement of the delays sooner rather than
later?
Mr. Ryan. I think that is critical. I think it is
everything. If the SEC waits to do their study in I believe
Chairman Cox suggested it was going to be some time this summer
for the results, we realize many of these companies will have
already spent the money, made the commitments and, back to the
testimony of Mr. Grossblatt, management time will have been
spent on it, which is a very significant cost here.
So we think that our data shows this, and I think the
testimony here shows that the companies are getting started
sooner rather than later, and I think that is particularly true
for companies that really care about these issues. They are the
ones being hurt by a delay. So we think that is critical.
Chairwoman Velazquez. I cannot stress enough to the
Chairman how important it is for them to make the announcement
as early as possible, as early as January.
Mr. Ryan. My sense is he understood that, too.
Chairwoman Velazquez. Yes. Okay, and now I recognize Mr.
Westmoreland.
Mr. Westmoreland. Thank you, Madam Chairman.
And since I was not here for opening remarks, I do want to
compliment the Chairwoman on her commitment to small business
and working to get the Chairman to look at delaying the
implementation of this for one year. And I certainly support
you in that.
Mr. Loving, is your bank audited by state bank regulators?
Mr. Loving. Yes, sir. It is a very good question. We are
regulated by state regulators, FDIC regulators. Plus we have to
comply with SEC regulations, not to mention internal audit,
external audit, IT audit, compliance audit. I believe that
mentions most of the audits that we have to comply with or are
regulated by.
Mr. Westmoreland. So what you are telling me is that
basically you already had to jump through a lot of hoops to
make sure that you were within the laws of the banking
industry. Is that not true?
Mr. Loving. Yes, sir, that is correct. We, as senior
officers of the institution, have to sign a quarterly call
report that we are testing that the financial information is
correct. That is publicly available to anyone that goes to the
FDIC Web site.
So the overlay of 404 is redundance and duplication of
effort in many cases for community banks, one we cannot
eliminate in order to comply with 404.
Mr. Westmoreland. And is it not true that even though
community banks are probably hit the hardest on their bottom
line, it is kind of redundant for any bank that has to go
through those same audits that you have to go through?
Mr. Loving. That is correct, sir.
Mr. Westmoreland. Do you think we will ever pass a law that
makes people completely honest?
Mr. Loving. I do not think we will ever pass a law that
will make people completely honest. I certainly applaud the
efforts, but I think in the case of 404, the cost is too
prohibitive.
Mr. Westmoreland. Thank you.
Mr. Brandt, you made a couple of comments about CEO
compensation and officers' compensation, I guess, about trying
to find people to serve on some of these committees that look
at some of these audits.
You know the Big Three. We had Tyco, Enron, WorldCom that
did some things that were not correct. Those guys are in
prison, and as I understand it correctly, these CEOs and people
that are on these different committees have to sign up and have
really put a lot on the line for what they may be being paid.
Is that true or would you say that there is more of a risk now
having to sign some of these affidavits than there was?
Mr. Brandt. Well, Section 302 of Sarbanes-Oxley provides
for some representations that we have to make every time we
submit financial statements, that are very strong
consciousness-raisers if an officer did not otherwise take
seriously that responsibility. I have never shown my wife the
words that I am signing to that put our assets at risk every
time I fulfill that obligation.
And I think that attitude is pervasive. It is the rare
exceptions that do not recognize how serious the responsibility
is.
Mr. Westmoreland. Yes, sir, but I mean, you could have been
put in jail before Sarbanes-Oxley for doing some of the things
these other people did, right? It is not just signing that 302
that makes you liable. There were other laws that would have
made you liable, too. Is that not true?
Mr. Brandt. That is absolutely right.
Mr. Westmoreland. So from what you and Mr. Loving say,
Sarbanes-Oxley in a lot of ways, not just the 404 but other
sections, is kind of piling on, so to speak.
Mr. Brandt. Yes.
Mr. Westmoreland. Would you agree with that?
Mr. Brandt. Yes.
Mr. Westmoreland. I have one question--
Chairwoman Velazquez. Would the gentleman yield?
Mr. Westmoreland. Yes.
Chairwoman Velazquez. I just would like to say that Mr.
Grossblatt's wife is here today.
[Laughter.]
Chairwoman Velazquez. And I hope that this hearing is not
going to be any trouble to you.
Mr. Grossblatt. I was just trying to give some
understanding of what we have to put up with on a regular
basis.
Mr. Westmoreland. Hopefully you will not be going off.
And my last question is for Mr. Grossblatt. So that we will
not misunderstand anything, you mentioned that your company had
an extra cost of 200,000 and about another $100,000 increase, I
think. Who is eventually going to pay that increase that your
business suffers?
Mr. Grossblatt. Public shareholders.
Mr. Westmoreland. Absolutely. Okay. So, I mean, this is
something that, you know, you just cannot absorb this. I mean,
the company just cannot absorb this kind of cost, and so
Congress, and I think the Chairwoman would agree with me, you
know, we have got a couple of speeds up here, but our main
speed is knee-jerk, and this was done while some terrible
things were done to some of the stockholders in some of these
companies.
I was not here, but I have seen the knee-jerk speed, and I
think it was a knee-jerk and that there really was not enough
attention paid to the end user in what this was actually going
to cost especially small business and who was going to be the
people actually paying for this piling on or double and
tripling and quadrupling some of these things that we already
had laws to cover.
But, Madam Chairman, that is all I have and thank you so
much.
Chairwoman Velazquez. Thanks.
Mr. Gonzalez.
Mr. Gonzalez. Thank you very much, Madam Chairwoman.
As indicated earlier with the Chairman of the SEC, some of
us were here in 2002 and we were right in the middle of it and
voted for it. It was an appropriate response, I think, at that
time. It was referred to as corporate governance. It was quite
relevant, and we knew there would be some consequences, some
intended and others not intended.
Maybe what we are viewing here are the unintended and what
we are really going to do. But the question really comes down
to--and I posed this to the Chairman, Mr. Cox, and he indicated
that, at least the way I interpreted his response was that we
probably do not need a real legislative fix or tweaking,
definitely not a wholesale revision of Sarbanes-Oxley, and that
much can be done within the regulatory scheme and the
promulgation of rules and guidelines.
I do not totally agree with that, but I am not on Financial
Services. I am not on the other committees, but I am hard
pressed to believe that universal security instruments in the
past created special purpose entities, if you recall what those
things used to be, based on the advice of the same accounting
firm that was conducting your auditing because they were also
doing your consulting.
I do not believe that your enterprise and its officers were
exercising questionable stock option and sales based on insider
information. But that is the scenario. That is what we were
reacting to. And as I said earlier, we cast a very wide net,
and maybe it is time to review where we are today.
What was our goal then? What is our goal now, given the
history and the implementation of the act?
It is clear and, I think, back in the June hearing and
today's hearing, that we really do have to do what businesses
do, and that is maybe look at a cost-benefit analysis. Are we
really getting the result that we need or require?
But it does appear to me that Chairman Cox has expressed a
clear opinion that corporate governance at all levels is
important, and I think you heard him actually articulate its
application to the small publicly traded countries in this
country.
But I really would like to get a feel from where you all
are coming from. We may have a year delay. We may tweak this.
My prediction is we will have the delay; we will have the
information gathering. The SEC will do everything under its
power to make it more cost effective and simpler, but we are
still going to run into the same problem.
I mean I just really believe that. We do this all the time.
We do a one-year fix, a two-year fix, and you know, the old
thing about where I come from we simply say ``manana.`` You
know, I mean, we will just figure it tomorrow. Not good, not
good.
But I'm going to ask Mr. Brandt. You know, you're talking
about tiered exemptions. How do you accomplish that? Can you do
it within regulatory guidelines, the Commission, and so on, or
are we talking about a legislative fix?
Mr. Brandt. I started coming to Washington to talk about
Sarbanes-Oxley 404 when the AeA first invited us here in 2004,
and I observed sort of what I guess you are saying. We would
talk to regulators and they would say this has to be dealt with
by Congress, and we would talk to Congress people or their
staff and they would say this has to be dealt with by
regulators.
It happens that Senator Sarbanes is my Senator, was my
Senator, and I had an opportunity to address him directly, and
he believed that this was a regulatory matter insofar as the
impact of 404 on small caps.
You know, I am here to speak to anybody would will listen
that I think resources are being misallocated.
Mr. Gonzalez. So what is the best remedy? How do you see
it?
I mean we are going to have the year delay. We are going to
have the information gathering. We are going to streamline it,
but it seems from your testimony you are saying you really are
viewing something that goes beyond what I anticipate is being
contemplated, and you are talking about some sort of exemption.
Mr. Brandt. I am, and without repeating that whole Small
Business Committee report, and I did participate along with our
other representatives in its preparation, there was a lot of
thought given to the strata in the capital markets where the
risk relative to confidence of outsiders in the integrity of
our regulatory process was immaterial to anybody rationally
reaching that conclusion.
So there was a cutoff suggested for self-review and
reporting on internal control and a lower level where neither
self-review nor outside auditor review and attestation would be
necessary. And I believe that was a prudent approach.
Mr. Gonzalez. And if you did adopt that, could you square
that with Chairman Cox's concern regarding small publicly
traded companies and how important it is to have good, solid
corporate governance at all levels?
Mr. Brandt. Yes, I can because I believe there are so many
other regulations and controls and audit processes to which we
are subject that the risk of misstatement of financial
statements is already relatively low. If we make a mistake it
might be on applying an obscure algorithm like FAS-123(r) for
stock option accounting or some obscure lease rule, but unless
somebody is very willfully trying to cheat, it is not likely
our financial statements are going to be bad, and most of us
have the self-interest when sign our 302 statements or just
otherwise acknowledge our fiduciary responsibilities to try to
walk the straight and narrow.
Mr. Gonzalez. Well, thanks. I want to extend my thanks to
all the witnesses.
I yield back.
Chairwoman Velazquez. Ms. Hirono.
Ms. Hirono. Thank you, Madam Chair.
The reason I asked Chairman Cox the question about the
expenditures of outside auditors is that in spite of his
testimony, I did think that probably most of the companies
would do that, and all of your testimony indicates that that
would, in fact, be the case.
So then the SEC does their study and the study will show
that most of the companies will be incurring these kinds of
additional expenses and so they could say, ``Well, we are not
telling you that you should do that. In fact, you should be
able to do it with in-house personnel.''
So then we are left and again, I agree with my colleague
back there that we will be here discussing this again with
having probably obtained a one-year delay. So I think the
bottom line really is, Mr. Brandt, what you have brought out
and I have a feeling what the rest of you probably would like
us to address, is a statutory kind of legislative fix. Is that
correct?
Mr. Loving. Yes, ma'am. I believe that it will take a
statutory fix to complete the revision of 404 and to improve
the profitability of small public companies. The new study may
show an opportunity to reduce cost, but I do not believe that
it will be able to reduce cost to a point that I can eliminate
eight percent or even six percent of net income to comply with
404. There is going to be a dollar specific that we will have
to pay to comply with 404 even under new guidance, and someone
spoke earlier about the auditors and the simplicity or the
communication to the auditors. That is the second issue.
It was mentioned we know what it takes to comply, but
oftentimes what we are hearing from the auditors is we are not
sure what the ruling is. So, therefore, you need to do this.
Well, obviously they are going to err on the side of
caution, and that usually brings about additional cost. So I do
think legislative change is necessary.
Ms. Hirono. Madam Chair, I would just like to say that I
was not here when SOX was adopted, but I would certainly be
open to some kind of a legislative addressing as long as I can
refer to what Mr. Brandt said, that there are plenty of other
checks on what companies are doing to make sure that their
processes are as they should be.
Thank you, Madam Chair.
Chairwoman Velazquez. Mr. Westmoreland.
Mr. Westmoreland. Thank you.
Just one last question for Mr. Brandt.
You said you worked for Price Waterhouse for several years.
Mr. Brandt. I did, 12 years, yes.
Mr. Westmoreland. Twelve years. These audit firms, the Big
Four, and you mentioned some of the other ones, were they
involved in the Tyco or Enron or WorldCom, any of the auditing
firms that are doing your audits now or that do these audits
now?
Mr. Brandt. Well, I understand, of course, it is gone, but
pretty much every other public company of any size is audited
by a Big Four firm.
Mr. Westmoreland. Did SOX put any additional requirements
on these auditing firms?
Mr. Brandt. Well, the creation of the PCAOB provided a new
level of regulation on their profession. So that has become,
you know, an issue with them, that they are not a self-
regulated profession any longer, but they have a new entity
checking their work papers and determining whether they did
enough work, which has the impact as I think was said earlier
that, well, we need to do this extra work now because we want
to make sure we have enough material in our work papers for
when the PCAOB looks over our shoulders.
Mr. Westmoreland. So they are auditing the auditors.
Mr. Brandt. Yes, they are.
Mr. Westmoreland. Okay. Thank you.
No further questions, Madam Chairwoman.
Chairwoman Velazquez. Well, I want to take this opportunity
again to thank all of the witnesses for taking time from your
busy schedule and your companies to be here this morning with
us.
And I just would like to issue a note of caution here in
the sense that I hear some of the witnesses and the members
here talking about a legislative fix, but this is the United
States Congress. It is not going to be that easy. So I do not
want anyone to be in that mindset.
You know, our hope is and we are happy this morning and
grateful that Chairman Cox is taking the lead in doing right on
behalf of small companies in this country by doing the cost
analysis and collecting data in a scientific manner, and I just
hope that they do this in a very close partnership with those
companies that will be impacted.
And with that I ask unanimous consent that members will
have five days to submit a statement and supporting materials
for the record.
Without objection, so ordered.
This hearing is now adjourned.
[Whereupon, at 11:59 a.m., the Committee meeting was
adjourned.]
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