[House Hearing, 119 Congress]
[From the U.S. Government Publishing Office]
REASSESSING SARBANES-OXLEY: THE COST OF
COMPLIANCE IN TODAY'S CAPITAL MARKETS
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON CAPITAL MARKETS
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED NINETEENTH CONGRESS
FIRST SESSION
__________
JUNE 25, 2025
__________
Serial No. 119-31
Printed for the use of the Committee on Financial Services
[GRAPHIC NOT AVAILABLE IN TIFF FORMAT]
www.govinfo.gov
__________
U.S. GOVERNMENT PUBLISHING OFFICE
60-990 PDF WASHINGTON : 2025
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HOUSE COMMITTEE ON FINANCIAL SERVICES
FRENCH HILL, Arkansas, Chairman
BILL HUIZENGA, Michigan, Vice MAXINE WATERS, California, Ranking
Chairman Member
FRANK D. LUCAS, Oklahoma SYLVIA R. GARCIA, Texas, Vice
PETE SESSIONS, Texas Ranking Member
ANN WAGNER, Missouri NYDIA M. VELAZQUEZ, New York
ANDY BARR, Kentucky BRAD SHERMAN, California
ROGER WILLIAMS, Texas GREGORY W. MEEKS, New York
TOM EMMER, Minnesota DAVID SCOTT, Georgia
BARRY LOUDERMILK, Georgia STEPHEN F. LYNCH, Massachusetts
WARREN DAVIDSON, Ohio AL GREEN, Texas
JOHN W. ROSE, Tennessee EMANUEL CLEAVER, Missouri
BRYAN STEIL, Wisconsin JAMES A. HIMES, Connecticut
WILLIAM R. TIMMONS, IV, South BILL FOSTER, Illinois
Carolina JOYCE BEATTY, Ohio
MARLIN STUTZMAN, Indiana JUAN VARGAS, California
RALPH NORMAN, South Carolina JOSH GOTTHEIMER, New Jersey
DANIEL MEUSER, Pennsylvania VICENTE GONZALEZ, Texas
YOUNG KIM, California SEAN CASTEN, Illinois
BYRON DONALDS, Florida AYANNA PRESSLEY, Massachusetts
ANDREW R. GARBARINO, New York RASHIDA TLAIB, Michigan
SCOTT FITZGERALD, Wisconsin RITCHIE TORRES, New York
MIKE FLOOD, Nebraska NIKEMA WILLIAMS, Georgia
MICHAEL LAWLER, New York BRITTANY PETTERSEN, Colorado
MONICA DE LA CRUZ, Texas CLEO FIELDS, Louisiana
ANDREW OGLES, Tennessee JANELLE BYNUM, Oregon
ZACHARY NUNN, Iowa SAM LICCARDO, California
LISA McCLAIN, Michigan
MARIA SALAZAR, Florida
TROY DOWNING, Montana
MIKE HARIDOPOLOS, Florida
TIM MOORE, North Carolina
Ben Johnson, Staff Director
------
SUBCOMMITTEE ON CAPITAL MARKETS
ANN WAGNER, Missouri, Chairman
ANDREW R. GARBARINO, New York, BRAD SHERMAN, California,
Vice Chairman Ranking Member
FRANK D. LUCAS, Oklahoma DAVID SCOTT, Georgia
PETE SESSIONS, Texas GREGORY W. MEEKS, New York
WARREN DAVIDSON, Ohio JUAN VARGAS, California
BRYAN STEIL, Wisconsin JOSH GOTTHEIMER, New Jersey
MARLIN STUTZMAN, Indiana VICENTE GONZALEZ, Texas
MICHAEL LAWLER, New York SEAN CASTEN, Illinois
ANDREW OGLES, Tennessee EMANUEL CLEAVER II, Missouri
ZACHARY NUNN, Iowa STEPHEN F. LYNCH, Massachusetts
LISA McCLAIN, Michigan CLEO FIELDS, Louisiana
MARIA SALAZAR, Florida JANELLE BYNUM, Oregon
TROY DOWNING, Montana
MIKE HARIDOPOLOS, Florida
C O N T E N T S
----------
Wednesday, June 25, 2025
OPENING STATEMENTS
Page
Hon. Ann Wagner, Chairwoman of the Subcommittee on Capital
Markets, a U.S. Representative from Missouri................... 1
Hon. Brad Sherman, Ranking Member of the Subcommittee on Capital
Markets, a U.S. Representative from California................. 2
STATEMENTS
Hon. French Hill, Chairman of the Committee on Financial
Services, a U.S. Representative from Arkansas.................. 3
Hon. Maxine Waters, Ranking Member of the Committee on Financial
Services, a U.S. Representative from California................ 4
WITNESSES
Dr. Abigail Allen, Associate Professor of Accounting, Marriott
School of Business, Brigham Young University................... 4
Prepared Statement........................................... 7
Mr. Lawrence Cunningham, Director, Weinberg Center for Corporate
Governance, University of Delaware............................. 21
Prepared Statement........................................... 23
Mr. Frank Watanabe, President and Chief Executive Officer,
Arcutis Biotherapeutics........................................ 53
Prepared Statement........................................... 55
Mr. John Coates, Professor of Law and Economics, and Deputy Dean,
Harvard Law School............................................. 61
Prepared Statement........................................... 63
APPENDIX
ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD
Hon. Warren Davidson:
National Association of Manufactures (NAM)................... 102
Hon. Marlin Stutzman:
American Securities Association (ASA)........................ 108
Hon. Mike Haridopolos:
Society for Corporated Governance............................ 111
RESPONSES TO QUESTIONS FOR THE RECORD
Written responses to questions for the record from Representative
Maxine Waters
Dr. Abigail Allen............................................ 119
Mr. Lawrence Cunningham...................................... 122
Mr. Frank Watanabe........................................... 123
Mr. John Coates.............................................. 124
LEGISLATION
H.R. ------, a bill to require the Securities and Exchange
Commission to revise certain thresholds related to smaller
reporting companies, accelerated filers, and large accelerated
filers......................................................... 125
H.R. ------, a bill to require auditor independence standards of
the Public Company Accounting Oversight Board and the
Securities and Exchange Commission applicable to past audits of
a company occurring before it was a public company to treat an
auditor as independent if the auditor meets established
professional standards......................................... 129
REASSESSING SARBANES-OXLEY:
THE COST OF COMPLIANCE IN TODAY'S CAPITAL MARKETS
----------
Wednesday, June 25, 2025
U.S. House of Representatives,
Subcommittee on Capital Markets,
Committee on Financial Services,
Washington, DC.
The subcommittee met, pursuant to notice, at 10:05 a.m., in
2128, Rayburn House Office Building, Hon. Ann Wagner
[chairwoman of the subcommittee] presiding.
Present: Representatives Wagner, Hill, Lucas, Sessions,
Davidson, Steil, Stutzman, Lawler, Downing, Haridopolos,
Sherman, Waters, Scott, Vargas, Casten, Lynch, Fields, and
Bynum.
Chairwoman Wagner. Good morning. The Subcommittee on
Capital Markets will come to order.
Without objection, the chair is authorized to declare a
recess of the committee at any time.
This hearing is titled, ``Reassessing Sarbanes-Oxley: The
Cost of Compliance in Today's Capital Markets.''
Without objection, all members will have 5 legislative days
within which to submit extraneous materials to the chair for
inclusion in the record.
I now recognize myself for 4 minutes for an opening
statement.
OPENING STATEMENT OF HON. ANN WAGNER, CHAIRWOMAN OF THE
SUBCOMMITTEE ON CAPITAL MARKETS, A U.S. REPRESENTATIVE FROM
MISSOURI
Good morning again and thank you to our witnesses for being
here today. Today's hearing is about making our public markets
work again for the companies that fuel our economy, small,
innovative firms that want to grow higher and bring new
products to market. We are here to examine whether parts of the
Sarbanes-Oxley Act, particularly Section 404, are doing more to
burden those companies than to protect investors.
When Sarbanes-Oxley, or SOX, was passed in 2002, it had a
clear purpose: to restore trust in financial reporting after
several major corporate scandals, but more than 2 decades
later, it is time to ask whether its most burdensome provisions
are still serving investors or merely discouraging companies
from ever going public in the first place. For many small
companies, Section 404(b) has become a major obstacle. It
requires companies not only to assess their own internal
financial controls, but also to pay for an external auditor to
effectively repeat that process. That is why many refer to it
as a ``double audit.'' The costs can exceed $1 million per
year, and even for pre-revenue biotech firms and small cap
innovators, these costs do not scale. Again, they do not scale.
Whether a company generates $50 million or $5 billion, the
compliance checklist is largely the same. For a large company,
that may be manageable, but for a startup, it is often the
difference between expanding operations or laying off staff.
Compliance costs have not gone down over time. In fact,
recent surveys show costs are rising, driving more hours, more
documentation, and broader audit scopes. At the end of the day,
Main Street investors are footing the bill, whether it is
through reduced returns, fewer initial public offerings (IPOs),
or the lost chance to invest early in the next great American
company. Meanwhile, the benefits are unclear. Internal control
weaknesses remain stubbornly high. Many firms only disclose
problems after issuing financial restatements. That is not a
sign of a healthy system. We have also heard from companies
that structure their growth, fundraising, and even equity float
to avoid triggering 404(b). That is an indictment of the rule's
real-world impact.
Capital formation should not be driven by how to avoid a
duplicative audit. A regulatory framework that deters companies
from entering the public markets does not strengthen investors'
confidence. It weakens long-term economic competitiveness. To
be clear, this is not about undermining investor protection. It
is about ensuring those protections are effective and
proportionate. Congress and the Securities Exchange Commission
(SEC) have taken steps to tailor SOX obligations for emerging-
growth companies and smaller reporting companies, but the
current framework remains overly complex and poorly suited to
today's economy, especially for firms that are asset light, IP
driven, and increasingly global in structure. Today's hearing
is an opportunity to hear directly from the people who live
these rules every day. Our job is to ensure that the path to
becoming a public company is not paved with unnecessary
barriers. Public markets should be open to companies of all
sizes, not just those that can afford to navigate an outdated
compliance regime.
I would now like to recognize my friend, the ranking member
of the subcommittee, Mr. Sherman, for 4 minutes for an opening
statement.
OPENING STATEMENT OF HON. BRAD SHERMAN, RANKING MEMBER OF THE
SUBCOMMITTEE ON CAPITAL MARKETS, A U.S. REPRESENTATIVE FROM
CALIFORNIA
Mr. Sherman. Thank you. I believe I am the only one here
who is here for----
Voice. Mr. Lucas.
Mr. Sherman. Oh, and then Mr. Lucas was also here for
Sarbanes-Oxley.
Mr. Lucas. I was here.
Mr. Sherman. And you were here.
Mr. Lucas. Yes.
Mr. Sherman. I am not as old as I think I am. A few of us
were here for Sarbanes-Oxley. We remember WorldCom. We remember
Enron and the need for a Public Company Accounting Oversight
Board (PCAOB). Even more of us were here for Madoff and the
need to apply the PCAOB to broker dealers. We then reformed the
PCAOB by making sure that China and Chinese-based companies
would be subject to it. That was my bill along with Senator
Kennedy, and then we accelerated that process with a separate
bill. Then the most recent development was this committee
voting to defund the PCAOB, transfer it to the SEC, and not
give the SEC any funding or ability to charge fees in order to
carry out the functions of the PCAOB. I want to thank the most
powerful unknown person in Washington, Elizabeth MacDonough,
the Senate parliamentarian, for striking that provision. We
should not defund the police in the streets, and we should not
defund the police in the suites. That includes the Consumer
Financial Protection Bureau (CFPB), and it includes the PCAOB.
The bills that we are considering today include one that
would allow auditing firms not to register with the PCAOB but
instead, simply meet the standards of the Intergrated Council
of Professional Accountants (ICPA). The ICPA was not consulted,
the Certified Public Accountants (CPA) caucus was not
consulted, and the only standards that would apply to auditing
firms were those meeting independence, not those dealing with
their competence and breadth of experience for the audit that
they were attempting to do. A second bill raises the dollar
floor on which companies would be exempt and not have to have
reports or as many reports on their internal controls. This
makes some sense because we have not adjusted that figure, I
believe, since Sarbanes-Oxley. So, if the policy was right
then, the dollar amount has to be changed now because $250
million then is very different from $250 million now.
So, I look forward to these hearings and working on these
bills. As I said, I think the last time we were all in this
room, the most fascinating issues that really the entire
country faces are those dealing with auditing and accounting,
and they are also the most important issues. So, Sarbanes-Oxley
was passed virtually unanimously. We need internal control. We
need auditors to audit the internal control, and we need PCAOB
to audit the auditors. While this process may be expensive,
what is more expensive? An Enron or a WorldCom or both, pretty
much at the same time. I think the losses to investors between
the two of those were well over $200 billion, but it is not
just that. The loss of confidence in our capital markets cost
this country even more than the $200 billion to $250 billion
lost on those two stocks. I yield back.
Chairwoman Wagner. I now recognize the chairman of the full
committee, Mr. Hill, for 1 minute for an opening statement.
STATEMENT OF HON. FRENCH HILL, CHAIRMAN OF THE COMMITTEE ON
FINANCIAL SERVICES, A U.S. REPRESENTATIVE FROM ARKANSAS
Mr. Hill. Thank you, Chair Wagner. I appreciate you holding
this hearing. Today we examine the long-term regulatory impact
of Sarbanes-Oxley Act of 2002, and while my colleagues may have
been here voting for this bill, some of us were in the private
sector living under it for the past 20 years. I can tell you
our perspectives are quite different, even though we share an
important point of agreement, which is we want investors
protected, and we want managements and public companies held
accountable, and we want high-quality audit standards, but all
that is subject to now looking back 20 years, which is why I
think Chair Wagner has done an excellent job in having this
hearing.
Implementation of the law, particularly under Section
404(b), is something that is the most expensive feature in our
public securities rulebook. Reports show these companies are
spending over $1 million a year purely on SOX compliance. So,
the fact that we want to take a look at these issues and think
through them, I commend the chairwoman, and I yield back the
balance of my time.
Chairwoman Wagner. The gentleman yields back. The chair now
recognizes the ranking member of the full committee, Ms.
Waters, for 1 minute for an opening statement.
STATEMENT OF HON. MAXINE WATERS, RANKING MEMBER OF THE
COMMITTEE ON FINANCIAL SERVICES, A U.S. REPRESENTATIVE FROM
CALIFORNIA
Ms. Waters. Thank you very much, Chairwoman Wagner. I am
pleased that we are holding a hearing to commemorate the
Sarbanes-Oxley Act. However, it would have been more meaningful
if we could have had this hearing convened before today. Let me
just say that the Sarbanes-Oxley Act is the crown jewel of the
Public Company Accounting Oversight Board. I have to ask, will
what you are doing with this legislation, would it enable
paying for a tax cut for billionaires?
Perhaps I can remind you that if you had held this hearing
beforehand, you would have realized that the PCAOB is the only
regulator that has access to auditors and large public
companies in China. Maybe we need to have you think more about
realizing that shutting this regulator down does not just hurt
U.S. investors, but it helps the Chinese Communist Party.
Hopefully, my Republican colleagues are now paying attention.
Thank you very much. I yield back.
Chairwoman Wagner. The gentlewoman yields back. Today we
welcome the testimony of Dr. Abigail Allen, Associate Professor
of Accounting at the Marriott School of Business at Brigham
Young University; and then Mr. Lawrence Cunningham, Director of
the Weinberg Center for Corporate Governance at the University
of Delaware; Mr. Frank Watanabe, President and CEO of Arcutis;
and then Mr. John Coates, a Professor of Law and Economics and
Deputy Dean of the Harvard Law School. We thank each of you for
you taking the time to be here. Each of you will be recognized
for 5 minutes to give an oral presentation of your testimony,
and without objection, your written statements will be made
part of the record. Dr. Allen, you are now recognized for 5
minutes for your oral statements.
STATEMENT OF DR. ABIGAIL ALLEN, ASSOCIATE PROFESSOR OF
ACCOUNTING, MARRIOTT SCHOOL OF BUSINESS, BRIGHAM YOUNG
UNIVERSITY
Dr. Allen. Thank you. Chairwoman Wagner, Vice Chairman
Garbarino, Ranking Member Sherman, and members of the
subcommittee, thank you for the opportunity to be here to
testify. As mentioned, I am an Associate Professor at Brigham
Young University. I hold a CPA and also a doctorate in business
administration. I am here on behalf of myself as well as my co-
authors, Melissa Lewis-Western and Kristen Valentine, to
testify about the findings from a recent research study that we
conducted examining the costs and benefits of Sarbanes-Oxley,
and, in particular, Section 404, which deals with the audit of
internal controls.
We appreciate the subcommittee's interest in reexamining
SOX in today's capital markets, as well as recent initiatives
like the 2012 Jumpstart Our Business Startups (JOBS) Act and
recent SEC carveouts, which acknowledge that the costs of SOX
are not borne equally across all firms. A common thread across
regulatory exemptions so far is a size-based litmus test, which
recognizes that the direct costs associated with compliance may
be overly heavy for small issuers. Our research also speaks to
the existence of indirect costs, which manifest for firms of
both small and large sizes, so our research focuses on a group
of firms that we refer to as young lifecycle-stage firms. These
are firms that can be large and high growth but are early in
their development as they explore strategic entry into new
products or new markets. They invest heavily in research and
development (R&D), are not yet profitable from a cash-flow
perspective and play a critical role in driving economic growth
through exploratory innovation.
Our research suggests that SOX 404(b) had negative
consequences for innovation for these firms. Specifically, we
find that SOX negatively impacts both the quantity and quality
of innovation produced by young lifecycle-stage firms. These
firms spend less on R&D, produce fewer patents with lower
citation counts. We also find that SOX has negative
consequences for the type of research being conducted.
Following SOX, young lifecycle firms shift their research
pursuits toward safer, less groundbreaking innovation. The
patents that they produce are narrower in scope and less likely
to lead to future technological advances. Why is that?
Our research identifies two mechanisms through which SOX
can harm innovation. The first is resource diversion. Young
firms, like small firms, are cash constrained. Every dollar or
hour spent on compliance is a dollar or hour not spent on
innovation. This same logic, which applies to small firms, is
the rationale that motivates current size-based exemptions. The
second mechanism is called innovation hindrance. We know SOX
imposes centralized control structures, and we believe that
sometimes those structures are at odds with the decentralized,
flexible environments needed for exploratory innovation. This
type of mismatch can stifle the type of risk-taking and
creativity that drives breakthrough discoveries for young
lifecycle-stage firms.
Importantly, while we document these negative consequences
for innovation, we are unable to detect any evidence that the
costs are offset by the intended benefits of SOX for these
young lifecycle-stage firms. While we do see improvements in
financial reporting quality for mature firms consistent with
prior literature, we find no evidence that SOX improves
financial reporting quality for this subset of young lifecycle-
stage firms, no reductions in restatements, no improvements in
accrual quality, no gains in future performance. Why? We
theorize that these intended benefits do not materialize for
young lifecycle-stage firms because their limited free cash-
flow and more concentrated ownership structures lessen the type
of agency concerns that financial reporting oversight is
intended to mitigate.
Putting these findings together, a clear takeaway from our
research is that the impacts of SOX on financial reporting
quality and innovation is not uniform. Instead, it varies based
on firm-specific characteristics that, in addition to size, may
include factors like firm lifecycle-stage and strategic
orientation. Accordingly, we advise that any policy solution
must involve a complex consideration of both direct and
indirect costs against the offsetting benefits by firm type. We
also advise that the costs and benefits do not always manifest
in the same time period. Like insurance, a regulatory approach
that leans toward prevention will necessarily impose heavier
costs today in exchange for some presumed security surrounding
future financial reporting outcomes. By contrast, relaxing
regulations alleviate current cost burdens while increasing
future risk associated with remediation.
Our results highlight that the goals of innovation and
economic development are not always in contrast, but when they
are, policy-based evidence is essential. Thank you for your
time.
[The prepared statement of Dr. Allen follows:]
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Chairwoman Wagner. Thank you. Mr. Cunningham, you are now
recognized for 5 minutes for your oral statement.
STATEMENT OF MR. LAWRENCE CUNNINGHAM, DIRECTOR, WEINBERG CENTER
FOR CORPORATE GOVERNANCE, UNIVERSITY OF DELAWARE
Mr. Cunningham. Chair Wagner, Ranking Member Sherman,
committee members, thank you for the opportunity to testify
today. It is an honor to be here. I am Lawrence Cunningham,
Director of the John L. Weinberg Center for Corporate
Governance at the University of Delaware. I have been writing
about Sarbanes-Oxley--SOX--since its inception and ever since,
carving a niche in the legal academy at the intersection
between law and accounting. SOX was an effective congressional
response to several massive frauds. It restored investor
confidence at a critical time and helped deter earnings
manipulation, but over time, it became clear that SOX missed
its mark in important ways, channeling excessive resources into
internal controls at the expense of financial reporting.
Let me stress this core insight. Compliance is not the same
as accuracy. A company can have strong internal controls and
still misreport its financials or weak controls and report
accurately. Yet, SOX treats internal controls as equivalent to
financial reporting, as if they are the goal rather than the
means. Over 2 decades, SOX has fostered a sprawling compliance
industry where controls proliferate, and auditability of
controls becomes more important than utility. The system often
prizes procedural auditing checklists over substantive
accounting judgments. That is why, despite SOX, financial
restatements persist, including recently at marquee companies
like CSX, Archer Daniels Midland, and Macy's. Last year saw the
most reissued financials in many years, and over the past
decade, internal control reports flagged fewer than a quarter
of the issues in advance. They have become postmortems, not
early warnings.
The costs are real. SOX imposes fixed costs that hit small
firms the hardest. The average is $1.5 million per year, with a
quarter of companies paying more than $2 million. For small
firms, from biotech companies to regional banks, that is money
not invested in R&D, employee hiring, training, growth, and
other important business matters, and the impact on capital
markets is pretty clear, too. SOX contributed to a sharp drop
in the number of public companies, from 6,500 or so back then
to around 4,000 today, even as the number of large private
companies has grown dramatically. Nordstrom and Walgreens are
just two of the companies recently indicating they prefer to be
private than public, underscoring the costs. Investor
perspectives are divided. Many investors believe that the
external audit of internal controls adds little or no value.
That is especially true of the long-term focused investors who
prefer to do their own analysis. On the other hand, some
support the audit of internal control, especially the index
fund community that does not conduct firm-specific analysis,
but that division underscores the need for flexibility in this
area.
Congress has modernized every other major securities law.
SOX deserves the same reassessment and reform. The reform
should focus on three things: first, to reinforce the primacy
of financial statement reporting over internal control; second,
focus audit standards on judgment and substance, not process
and system; and third, tailor compliance to risk. Let us
reaffirm that the North star of our capital markets is accurate
financial reporting, not well-documented internal controls. The
two pending bills are a good step in that direction.
Thank you. I look forward to your questions.
[The prepared statement of Mr. Cunningham follows:]
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Chairwoman Wagner. Mr. Watanabe, you are now recognized for
5 minutes for your oral statement.
STATEMENT OF MR. FRANK WATANABE, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, ARCUTIS BIOTHERAPEUTICS
Mr. Watanabe. Chair Wagner, Ranking Member Sherman, and
distinguished members of the subcommittee, thank you for the
opportunity to testify today. My name is Frank Watanabe, and I
am the President and CEO of Arcutis Biotherapeutics, a public
biopharmaceutical company based in California. I am also the
Vice Chairman of Bio, which represents over 1,200 growth-stage
biotechs that are driving the search for the next generation of
breakthrough medicines.
Arcutis is a young biotechnology company that develops
innovative treatments for serious skin diseases like psoriasis
and eczema. We were founded in 2016 and went public in January
2020. We received our first Food and Drug Administration (FDA)
approval in July 2022, have since received FDA approval for two
additional treatments, and we continue to invest in our
portfolio of innovative drug candidates. Since inception, we
have invested about $1.4 billion in developing our products and
have grown from 3 employees to 350, with operations in all 50
States and employees in 39, but we have yet to turn a profit,
let alone recoup our massive investments in R&D.
I would like to share some of the challenges that Arcutis
faces due to Section 404(b) of the Sarbanes-Oxley Act. While I
fully support regulation, it needs to be smart regulation that
accounts for a company's size and the cost of compliance. I
believe it is unreasonable and wasteful to impose the same
compliance requirements on a 350-person biotech with revenues
below $200 million as those for an 80,000-person company with
$60 billion in revenues as the law currently requires.
We first experienced the overwhelming burden of 404(b) in
2021 when, although we had not generated any sales and we had
just gone public the prior year; we became subject to 404(b)
when our market cap exceeded $700 million. Two years later, we
rolled off of 404(b) when our public float dipped below $700
million, but we could not scale back our costly compliance
systems knowing that we would likely need to meet the
requirements again, which happened in 2024 when our public
float, again, exceeded the 404(b) thresholds. To date, we have
spent around $11 million on compliance with 404(b), and those
are costs that are rising inexorably. For example, last year
alone, our auditor fees were increased by 24 percent. Our
switch to 404(b) roughly doubled our auditor fees, and as a
small firm, we had to bring in outside control and compliance
resources that cost us about half a million dollars a year.
The money we spend on unnecessary compliance is money that
we do not have to invest in developing life-altering drugs. I
understand the reason for enhanced controls required by SOX. I
am old enough to remember those abuses. We all remember, I
think, the egregious business abuses that led to the passage of
this legislation, but the current thresholds for 404(b) are too
low, and Congress and the SEC should take steps to adjust those
thresholds. We are grateful to Congress and the SEC for their
previous efforts to reduce the burdens of 404(b) on small
businesses, but there is still more work to be done.
Congress can take commonsense steps to reduce the burden of
404(b) on small companies, for example, by adjusting the public
float and revenue thresholds as you are considering. It might
also amend the 2020 exemption so that companies are exempt if
they qualify as SRCs or report revenues of less than $250
million. These changes would reflect the fact that many
companies are still small businesses despite having high market
capitalizations. Another smart reform might be to use soft
triggers for the public float threshold, measuring float over
an averaging period of, say, 12 months rather than a single
point in time, as is now. I also applaud the proposal that
implements a 3-year rolling average threshold for revenue
instead of a 1-year snapshot.
Congress should also consider revising the definitions of
accelerated and large accelerated filers to better account for
low-revenue companies with high valuations, and you might
consider establishing a new intermediate tier of filers,
helping to ensure that low-revenue innovators like Arcutis are
not subject to the same burdensome compliance requirements as
mature, highly profitable multinational corporations. Revising
the timelines for emerging-company growth status, for instance,
by extending EGC from 5 to 10 years post-IPO and raising the
public float threshold, would better account for the long
development timelines typical in the biotech sector and offer
immense release to smaller companies.
While it is not the major focus of the hearing today; I
also want to applaud you for your recent hearings on
institutional proxy advisory firms. We have suffered struggles
with them, and I think it is high time that Congress reformed
that sector. Congress has a critical opportunity to support
American innovation and competitiveness by modernizing 404(b).
Small companies, like Arcutis, are critical to U.S. biotech and
the U.S. economy, but we cannot thrive if precious capital is
consumed by regulatory requirements of little practical
benefit.
Thank you again for inviting me today, and I look forward
to the committee's questions.
[The prepared statement of Mr. Watanabe follows:]
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Chairwoman Wagner. Thank you. Mr. Coates, you are now
recognized for 5 minutes for your oral statement.
STATEMENT OF MR. JOHN COATES, PROFESSOR OF LAW AND ECONOMICS,
AND DEPUTY DEAN, HARVARD LAW SCHOOL
Mr. Coates. Chair Wagner, Ranking Member Sherman, Ranking
Member Waters, Chair Hill, thank you, members, for the
opportunity to speak here. The last time I testified before you
was during coronavirus disease (COVID), so I did not get to be
in this nice room. Good to be here in person.
I am going to quickly go through a few themes that I think
provide some counterpoints to what you have heard so far.
First, SOX--I just want to make sure everybody has this right--
is a disclosure law. It does not actually require a company to
do anything different than its management believes is correct
or controls. It can report publicly that it disagrees with its
auditor as to some of those judgments, and many companies do.
So, Frank, you might want to talk to your lawyers if they are
telling you you have to follow the auditor's directions about
your controls, even when you think the costs outweigh the
benefits. You do not have to.
The disclosure elements of this law make it a less costly
law than some of the alternatives. Other countries, in some
places, actually directly specify the kinds of controls
companies have. We do not in this country. We rely on companies
in the first instance and then disclosure so that investors
whose money is being risked with the control systems in
question can judge for themselves how and when to price their
investments in those companies.
The benefits of the law are clear. Professor Allen's study,
which I commend as a very good study, and she said this in
passing, but I just want to make sure everybody heard it, shows
that most companies--most companies--are subject to 404(b)
benefit. Their financial quality is better as a result, and
even in the period that she was studying, the costs did not
outweigh the benefits. Now, something that was not mentioned so
far is that PCAOB softened 404(b) in 2007, using its discretion
under the law to do so, and I would think the kinds of issues
that have been raised where the 404(b) may not be translated
properly for a given company could be addressed by the PCAOB or
the SEC.
I will note that under a public administration, nothing
happened 2 terms ago. The PCAOB could have, at that point, made
more modifications. They could have said for an early stage
company with 300 employees, we do not need the auditors to do
quite the testing that they do for Goldman Sachs. The PCAOB was
not, under Republican leadership, willing to take up that
challenge. You can ask the members who ran it back then why. It
could be done today. The SEC is now under Republican
Administration and could take up this challenge directly. The
kinds of things that I heard Frank suggesting earlier, they are
perfectly appropriate things, I think, for the SEC to consider,
but I am not sure that a Federal statute is the right vehicle
for doing the kind of fine-tuning that goes to average versus
point in time, et cetera, because, in fact, we are probably not
going to know in advance what the right calibration is, and it
is the kind of thing you would want the agency to be able to
fine-tune over time. If you block it into a statute--we all
know in this room how hard it is to pass statutes--it is likely
to get outdated fairly quickly. I will note SOX does not do
that. SOX delegates to the PCAOB and the SEC authority to make
changes in how auditors go about their work, and so that could
be done under current authority.
A few other things. Many companies choose, even though not
required, to comply with 404(b) today. There are many private
companies who have voluntarily done this. There are many
companies that float bonds when they could float leveraged
loans and be able to get out of 404(b), but they choose not to.
That suggests that the debate over this issue is not nearly as
clear-cut as it sometimes is presented. Other countries have
followed the United States. Most countries now have the
equivalent of SOX, so it is not the case that the United States
is some outlier in this respect.
Last thing I would say about the proposals is that you
really need to think hard about the risk that a statutory
change will open the door again to the kinds of bad reporting
that went on leading up to the passage of SOX. Chair Hill's
family's bank, when it was bought by a public company, was
bought by a public company bank subject to SOX. They paid about
$5 million for a total audit, including 404(b), in the year of
that deal. I believe the stock that was paid as part of the
consideration of that deal was more accurately priced and
reliable as a result of Sarbanes-Oxley and that the deal might
have been a little bit more fraught if there had been the kind
of accounting that went on in the 1990s present at the time of
that deal.
Thank you. I will stop here.
[The prepared statement of Mr. Coates follows:]
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Chairwoman Wagner. Now I will turn to member questions, and
I recognize myself for 5 minutes for questioning.
Mr. Watanabe, experts have argued that the benefits of
requiring an external audit testing to internal controls under
Section 404(b) are outweighed by the annual costs for early
stage or biotech companies which can amount to over $800,000.
In your case, you cited much higher. Can you discuss your
experience in running Arcutis Biotherapeutics, a small public
biotech firm, and whether the funds spent on Section 404(b)
compliance had to be reallocated from, let us say, R&D and
product development and other things?
Mr. Watanabe. Yes, thank you for the question, Chairwoman.
Yes, it has been a significant expense for our company. Our
audit fees alone last year were $2.2 million. We still are in
the middle of this year. I would estimate we will probably be
in the range of $2.5 million plus this year just for our audit
fees. In addition to, as I mentioned, I think, before, we are
spending about $500,000 a year for support for our compliance
program to meet the standards that are imposed on us by our
auditors, and that is money that has to come out of R&D. That
is the variable cost in a biotech company like ours, and so we
are not investing that money in developing the next generation
of cures. I would also say that our audit fees about doubled
when we went from 404(a) to 404(b) just given the complexity of
the audit that the auditors required.
Chairwoman Wagner. Thank you. Dr. Allen, according to your
research, young lifecycle firms experience a significant
decline in innovation after becoming subject to SOX. Your
findings estimated declines between 9 and 12 percent in R&D
intensity and 6 percent decline in patent filings for young
lifecycle firms relative to pre-SOX levels. In addition to the
decline in the level of innovative activities, your research
also found that post-SOX young lifecycle firms pursued less
valuable patents. I found that interesting. Can you discuss how
SOX implementation forces young lifecycle firms to alter their
innovation process?
Dr. Allen. Certainly. I would say that the idea here is
that in addition to diverting direct resources, spending on
research and development, or time spent on research and
development, the centralized control formalization of
processes, and reduced flexibility that often accompanies the
implementation of internal controls can be at odds or
mismatched with the decentralized flexible risk-taking
environments in which exploratory innovation thrive. So, I will
just put a sub-point there, two types of innovation:
exploratory innovation, which is strategically oriented toward
new markets, new products, has a high probability of failure,
and exploitative innovation, which actually takes incremental
steps using existing processes and knowledge. While
exploitative innovation conducted by more mature firms might
actually benefit from more centralized controls processes, the
exploratory innovation that young lifecycle-stage firms are
engaging in is often mismatched with the control environment
imposed by SOX and that is where we think the difference comes
from.
Chairwoman Wagner. Thank you. Mr. Cunningham, despite the
costs and disruptions to innovation processes due to SOX
compliance, research suggests that young firms do not
experience compensating benefits, such as substantial
improvements in financial reporting quality, to offset these
challenges. Can you discuss how the incremental improvement in
quality achieved through SOX compliance might not be as
significant for smaller issuers compared to complex,
multinational corporations?
Mr. Cunningham. Yes. It is very important to appreciate
that when an auditor conducts an audit of the financial
statements, it is required to test the internal controls and
assess the controlled environment. So, that is an activity that
is part of the regular financial audit, and for relatively
simple firms, low-revenue firms, early stage firms, that is
sufficient, and you are not going to get a big bang, a big
incremental gain if you then say the auditor also has to give a
certification and attestation, a full audit of the entire
control environment.
Chairwoman Wagner. Thank you. Mr. Cunningham, many
companies cite SOX as a factor in their decision to go or
remain private, including in the recent cases of Nordstrom,
Staples, Twitter, now X, and Walgreens. If large, established
companies with robust resources find SOX compliance burdensome
enough to consider privatization, this begs the question, how
are smaller public companies supposed to cope? I am out of
time. I will let you respond in writing if that is all right.
Mr. Cunningham. Yes, fine.
[The information referred to was not submitted prior to
printing.]
Chairwoman Wagner. Next, the chair will recognize the
gentleman from Georgia, Mr. Scott, for 5 minutes for
questioning.
Mr. Scott. Thank you very much. Twenty two years ago, when
I first was appointed to this committee, I served with one
Barney Frank and worked closely with Barney on this bill. I
want to point out at the outset that my Republican friends are
unilaterally disarming the United States against China and
cutting our regulators' access to audit firms, exposing working
families and investors to greater risk. This is so seriously,
and I urge my Republicans, do not destroy this wonderful
mechanism, this bill that gives the American public protection
against China.
Mr. Coates, if foreign-based auditors can operate with no
oversight, will this not create an unfair competitive advantage
for companies using those firms?
Mr. Coates. Yes, sir, it would, and it would return us to
the period before this body passed the bill that led the PCAOB
to negotiate the memorandum with the People's Republic of
China, during which China companies defrauded U.S. investors
with a greater propensity and severity than they are doing
today. I will note, too, some have suggested the SEC could take
over that role that the PCAOB has provided. Those memoranda are
with the PCAOB. The People's Republic of China would get to
walk away from them if the attempt was made to transfer
inspection authority to the SEC instead.
Mr. Scott. Yes, and can you speak a little more about this
uneven playing field and the potential for distorting capital
allocation and market confidence?
Mr. Coates. You raised a very excellent point that has not
come up yet. The principal driver, I think, for SOX was fraud,
but the biggest benefit it has provided is to improve the
allocation of capital to firms like Mr. Watanabe's. The
precision with which you can price stock depends on the
reliability of the financial statements, which includes the
reliability of controls. One quick word on controls: controls
are kind of basic. Most companies have them, just to be clear.
I am quite sure that your company had controls before it even
ran into SOX. There may be layers of cost added onto them, but
to not have any requirement that anyone check whether the
controls are adequately designed for China-based companies will
tilt the playing field in a way that means that some of the
capital that appropriately should be allocated to U.S.
companies will be misallocated, I believe, to China companies.
Mr. Scott. Yes. Now, let me make this point, and I think
you touched upon it, but it is very important. Private
enforcement through securities litigation relies on public
disclosures and audit reliability, so if regulators cannot
inspect or investigate audits, will investors not have fewer
tools to pursue legal remedies for fraud or misleading
statements?
Mr. Coates. I believe you are absolutely right about that,
too. It was said earlier that restatements have continued, and
that is true. Many companies still make mistakes today, but the
incidence of fraudulent misstatements have not risen anywhere
close to the levels that they were before Sarbanes-Oxley. That
is partly because the private litigation and the inspections
together are a more powerful deterrent to fraud.
Mr. Scott. Now, I want my good Republican friends to
understand this major point. If investors believe that Chinese
or foreign companies are exempt from scrutiny, this will erode
trust in our financial statements of all U.S.-listed companies
with foreign operations or auditors. This is significant. Thank
you.
Chairwoman Wagner. The gentleman yields back. The chair now
recognizes the gentleman from Arkansas, Mr. Hill, the Chair of
our full Financial Services Committee, for 5 minutes for
questioning.
Mr. Hill. Thanks, Chair Wagner. Let me thank the panel for
a great testimony. I appreciate it very much. I want, Mr.
Cunningham, to start with you and maybe reflect on Professor
Coates' comment that somehow this is all optional, that if a
company wants to do it, they can do it, but a company does not
have to do it. Could you start out by just giving us your view
on that comment? I thought it was a thoughtful comment. I want
to make sure we are clear on the record about that.
Mr. Cunningham. Yes, thank you very much. Professor Coates'
assertion is that Sarbanes-Oxley is all about disclosure. It
only requires disclosure. It does not require any substantive
activity. At a high level of theory, there is some truth to
that, but there are some very important practical exceptions.
Just to take an example, the audit committee rules are
mandatory. You have to have independence. Literacy, oversight,
very prescriptive, very substantive, has virtually nothing to
do with disclosure. The SOX audit, the external audit of
internal controls, is required by the statute. The auditor has
to do that work. The auditor has to comply with Auditing
Standard No. 5 of the PCAOB. It has to do certain things. It
has to ask for certain things. It has to get certain responses.
If a company--if John is advising Frank to just ignore what the
auditors are saying, I think as a practical matter that it is
highly unlikely. There is a cooperative need to get the job
done, and so there is enormous pressure from this, so
disclosure only is a very high level of theory. As a practical
matter, it is a quasi-mandatory auditing system.
Mr. Hill. Yes. I thought that was a good exchange, and I
thought it was helpful to get that in the record because there
are many things that there is a bit of discretion in, but legal
liability costs and abundance of caution err on the size of
spending all the money and dotting every I, even if it is not
totally prescriptively required. Another example of that is the
accredited investor rule for a Reg D private placement. You are
allowed up to 35 non-accredited investors in a Reg D private
placement under the SEC rules, but I do not know anybody whose
lawyer will facilitate that. You have strong external auditor
improvements in SOX. You have strong CFO/CEO attestation in
SOX, and now you have internal control requirements that were
outlined in SOX, including the audit you suggest. So, we have
been doing it for 20 years.
What about the idea for a less frequent audit required for
even a large filer if they have a good track record and they
have been in full compliance? What about the business judgment
rule? Where is the audit committee in this? Do they not have
some right to outline the scope for their audit? What are your
thoughts on that?
Mr. Cunningham. Yes, I think you have identified some very
important features of SOX that are often overlooked. The main
culprit behind Enron was a very cooperative auditing firm in
Arthur Andersen. All of those frauds were audited by that same
firm. That same firm went out of business, went bankrupt, is
gone, and is not part of the auditing culture today. So,
Sarbanes-Oxley prohibited public auditing companies from
providing non-audit services to their public audit clients.
That was a huge change, and it is probably more important than
any of these other things, and I do not have any notion that it
is going to be changed. I think that is a very important
change. The audit committee rules are extremely important. I
think audit committees are much more effective, much more
energetic, much more leaning in, and probably can be relied
upon more these days. So, I think the excessive investment of
resources into that internal control audit is really something
that you all ought to focus on. It is, I think, the highest
priority. It has created a culture of excess, and the primary
beneficiaries are those same auditing firms who are no longer
allowed to do non-audit.
Mr. Hill. Yes, there is no doubt this has been a nice
revenue opportunity for that, but I think if you have the high
standards of the C-suite officers, and the audit committee
independents, and the rotation of the public accounting firm,
and that discipline is put in SOX, then why could not an audit
committee say we are going to do the audit of internal controls
every 3 years instead of annually when it is such a box-
checking exercise? I agree with you; I think audit committees
are substantially improved than when they were in 2002, 2003.
Quoting your pal, Warren Buffett, I mean, he was always arguing
that the compensation committee ought to have a saber-toothed
tiger as the chair, not a pussycat. I think that is true for
auditing firms and auditing committees, and I think that has
been a positive result from Sarbanes, but I think the
compliance costs need to be reviewed. I yield back to the
chair.
Chairwoman Wagner. The gentleman yields back. The chair now
recognizes the gentlewoman from California, Ms. Waters, who is
also the Ranking Member of our full Financial Services
Committee. You are recognized for 5 minutes for questions,
ma'am.
Ms. Waters. Thank you very much, Chair Wagner. Professor
Coates, as you know, Republican's so-called Big Beautiful Bill
has a provision that would dismantle the PCAOB and move its
functions under the SEC. The PCAOB is the crown jewel of the
Sarbanes-Oxley Act of 2002, which was passed by Congress in
response to a number of major accounting scandals in the early
2000s. The Republicans have done nothing to increase the SEC's
budget, which seems to be the only way the Commission could
continue the PCAOB's important work. The PCAOB is currently
budget neutral as it funds itself by fees on public companies
and broker-dealers, so the provision would not save taxpayers
any money whatsoever. Furthermore, both the SEC and the PCAOB
have confirmed to my staff, in writing, that the SEC is not a
party to the agreements the PCAOB has in reach with foreign
governments to inspect companies and auditors based in their
jurisdictions.
Again, if we are shutting down the PCAOB, the SEC cannot
inspect auditors in China or in many other foreign
jurisdictions. Can you talk more about the potential disaster
dismantling the PCAOB would be for investors and our broader
financial markets?
Mr. Coates. Yes. Thank you, Ranking Member Waters. I am
glad to hear in this hearing so far, no one on either side is
proposing to abolish the PCAOB, even though that is what the
budget bill would have done but for the Senate parliamentarian.
I assume that it is because of a recognition of the points you
are asking me about, that abolishing the PCAOB would save no
money. In fact, I think it would actually increase the burden
on the taxpayer because the transfer to the SEC would be an
unplanned, unfunded, disastrous, overnight transfer. The SEC,
where I worked, I know in Washington, it is actually a small
Agency, but it is quite big and it has a lot of things to do,
and for it to suddenly, overnight, take on the role of the
PCAOB would be quite expensive as a matter of transition and
certainly even more expensive without any planning. It would
fail, and the result would be a return to, basically, lack of
inspections with any kind of meaningful backbone.
The American Institute of Certified Public Accountants
(AICPA), which is a perfectly excellent organization--my uncle
was a CPA; CPAs are great--AICPA is a good organization, but it
is not up to, nor was it in the 1990s, up to the task of
checking the audit standards of the biggest audit firms for
most public companies. If you abolished the PCAOB, I believe,
or transferred significant authority to States or to self-
regulation, you would see a resumption of bad audit practices.
They would look the other way, not simply at controls, but at
the basic financial statements that Professor Cunningham has
emphasized so much, and you would, again, find a resurgence of
restatements and, ultimately, of fraud.
That, by the way, would affect companies that are not
fraudulent themselves. An important research finding that has
been repeated several times is that when a company in an
industry like biotech commits fraud, not only does it lose
enormously when the fraud is revealed, but other companies in
the same industry do as well.
Ms. Waters. Wow. Furthermore, as I previously mentioned,
the Sarbanes-Oxley Act--that is, SOX--was enacted in 2002 in
response to a series of high-profile corporate accounting
scandals, like Enron and WorldCom, which collectively cost
investors billions of dollars and eroded public confidence in
financial markets. Those scandals exposed systemic issues, like
fraudulent accounting practices, conflicts of interest, and
inadequate oversight. SOX passed with overwhelming bipartisan
support, 423 to 3 in the House and 99 to zero in the Senate.
Nevertheless, Republicans looking to fund a tax cut for
billionaires have decided to eliminate this Agency without
convening a single hearing and maybe looking to weaken the rest
of the law that authorized it.
Professor Coates, you do not have time. I would like you to
talk through some of the key tenets of Sarbanes-Oxley and why
they have been so beneficial for investors and U.S. economies
overall. Since we do not have time, we certainly hope that they
will hold a hearing so that you could be able to talk more
about why it is so important for us to have an independent
PCAOB. With that, I yield back the balance of my time. Thank
you.
Chairwoman Wagner. Thank you. The gentlelady yields back.
The chair now recognizes the gentleman from Oklahoma, Mr.
Lucas, who is also the Chair of the Task Force on Monetary
Policy, Treasury Market Resilience, and Economic Prosperity.
You are recognized, sir, for 5 minutes for questioning.
Mr. Lucas. Thank you, Madam Chairwoman, and thank you to
our witnesses for testifying today.
We benefit from the deepest, most liquid capital markets in
the world, and that is why it is important for us to always
look at how we can improve access for everyone in the economy,
so our markets stay strong, resilient and attractive. One of
the challenges we face today is the prohibitive cost of going
public: overreaching compliance requirements and reporting
regulations that discourage companies from entering public
markets. Dr. Allen, can you talk more about some of the
disincentives that we should address so our public markets
remain a viable option for companies to raise capital?
Dr. Allen. Thank you, Congressman Lucas. I think it is
important to recognize that in any discussion of the cost and
benefits to being public, our research highlights that those
costs and benefits are not uniform across firms. So, what I
take away from this hearing today and the bills that were
proposed is a desire, which I commend, of the committee to
investigate and think about carefully where the benefits are
most likely to manifest for what type of firm, and to avoid
prescribing costly regulation in places where those benefits
are less likely to manifest and the costs are supposed to be
higher.
In terms of the academic research, to your question on how
firms enter and perhaps exit public markets, I am aware of an
excellent academic study by Ewens and co-authors that was
conducted last year, where they try to quantify the costs of
being a public firm. They estimate that as a consequence of the
JOBS Act, for example, which provided regulatory relief,
roughly 28 more firms per year will go public, so there is
something certainly to be said for that careful analysis. The
flip of that, of course, is that there is also academic
research that suggests, as Professor Coates has testified, that
there are benefits to investor confidence in the markets that
may lead to more investment. So, I think careful consideration
of those complex costs and benefits is warranted.
Mr. Lucas. Mr. Watanabe, can continue to speak to your own
experience about what challenges did you face as your company
was growing and how can we ensure that our compliance reporting
regimes are appropriately tailored to the size of business they
regulate? Can you expand on that some more, please?
Mr. Watanabe. Yes, certainly, and I think to Dr. Allen's
point, the JOBS Act and the lower thresholds for newer
companies to go public were key to our decision to go public in
2020 and certainly facilitated that process. It is still a
costly and cumbersome process, but it is a lot less costly and
cumbersome thanks to the JOBS Act, and, even when we first went
public, we were not subject to 404(b), right? We were 404(a),
and there were considerable requirements on us as a 404(a)
company as well. When we tripped into 404(b) the following year
because of our market cap, as I mentioned before, there was a
very significant cost increase associated with that, a doubling
roughly in our audit fees and the additional cost of having
compliance resources come in to design the internal control
systems that were required for us to meet the standards of our
auditors. That was money that I had to take out of the bank,
effectively, to take my investors' money to spend on the
auditors and the compliance resources, and it was money that I
did not then have to invest in R&D.
Mr. Lucas. Mr. Cunningham, you have studied the effects on
business when Federal regulations are not well suited for
present challenges. In your view, how can we modernize
Sarbanes-Oxley in a way that maintains robust financial
integrity while making our public markets more attractive to
firms? Can we still protect investors while competing on the
global stage? I would note I was here for and voted for the
passage of Sarbanes-Oxley, but even the United States
Constitution has required occasional adjustments to reflect the
times. Could you touch on that?
Mr. Cunningham. Yes, thank you very much. I think investor
protection and capital formation are the two objectives, and
this hearing, I hope, will focus and is focusing on investor
protection. I think several of the immediate steps that Frank
has outlined would be very useful and that appear in one of the
bills. So, raising the 404(b) exemption, and even Ranking
Member Chairman Sherman has said we need to adjust those things
for inflation, so that seems obvious. Averaging it over several
periods would be a good idea, perhaps extending the emerging
growth company period from 5 to 7 or 9 years, but overall, to
refocus on the primacy of financial reporting, that is the
information that investors need. The integrity of internal
controls is a means to that end, and I think we have lost sight
of that. So, if you can guide the PCAOB or the SEC to
recalibrate, I think that would be extremely helpful.
Mr. Lucas. Thank you, Madam Chair. My time has expired.
Chairwoman Wagner. The gentleman yields back. The chair now
recognizes the gentleman from California, Mr. Vargas, for 5
minutes for questioning.
Mr. Vargas. Thank you very much, Madam Chair. I appreciate
very much the opportunity and also the ranking member and all
the witnesses here today. I do not often quote President George
W. Bush, other than for his malapropism for strategery--I did
enjoy that one--but I do want to quote him when he signed the
Sarbanes-Oxley bill in 2002. As the ranking member noted, it
passed 423 to 3 in the House and 99 to zero in the Senate. He
said this: ``America's system of free enterprise, with all its
risks and all its rewards, is a strength of our country and a
model for the world. Yet free markets are not a jungle in which
only the unscrupulous survive or a financially free-for-all
guided only by greed. The fundamentals of a free market
--buying and selling, saving and investing--require clear
rules and confidence in the basic fairness. The only risks--the
only fair risks--are based on honest information.'' I think
that is what Sarbanes-Oxley did, and I think what the rules
here are.
Now earlier, Professor Coates, some words were put in your
mouth that you said that this was optional. Is that what you
said?
Mr. Coates. No, and to be clear, it is not a matter of
theory that companies can choose not to do everything their
auditors recommend. Ten to 20 percent of all public companies
report material weaknesses in their control systems. Some of
them report them year after year, so this is not just theory,
this is actually borne out in practice. It is not, to be clear,
my advice that you just ignore the auditors. That was not what
I was saying, but, rather, that if they ask you to do something
that you in your judgment can explain as too costly for the
benefit, you have the ability to do that as long as you explain
that to your investors. Now if you cannot explain it to your
investors, then okay. Then I can see why you might want to then
do it anyway, but then you have to ask yourself, if it cannot
be explained, why exactly are you resisting? So, it is not
optional in a general sense, but it absolutely provides
companies currently with the flexibility to resist pressures by
auditors when they think it is a bad idea.
Mr. Vargas. Talking about flexibility then, let us stay on
that issue for a second. You know, one of the best arguments, I
think, that they make about some of these disclosure rules and
the rest is there is a big company, there is a small company.
The costs, they do not scale. You know, if you are a little
company, you have to pay a million bucks. If you are a big
company, you can absorb that easily. However, in 2007, when you
were evaluating SOX, you said this: ``Perhaps the most
important component of the Sarbanes-Oxley was precisely to
delegate power to the PCAOB so that it could customize rules
and respond to feedback much more rapidly than Congress could
do on its own.'' So, could it do that?
Mr. Coates. Absolutely, and I just want to emphasize, I
think that the ideas that Mr. Watanabe sketched in his opening
remarks are absolutely worthy of serious consideration. Some of
them may be better than what we have right now, but to do it
through a statute as opposed to doing it at the level of the
PCAOB or, if necessary, at the level of the SEC, who can move
more quickly to allow companies to respond to their auditors
when they feel they are being pressured to do things they
should not first, and then second, to carve out different kinds
of companies from some of the requirements or to stretch them
out, use averages, over 3 years. If it is a 200-person employee
company, those, I think, are all fairly taken, but they are
things that can be done without changing the statute. All you
need is a hearing where you bring people from the SEC and PCAOB
over and say, what about these ideas, guys? Let us do these at
the regulatory level.
Mr. Vargas. Okay. Last, I do want to ask you about this
because the world has changed, and we do have now other
regulations in other parts of the world, and you said that
there are similar regulations in other parts of the world. We
are not the only ones here. We are not an outlier. Could you
comment?
Mr. Coates. It is completely right. Following Sarbanes-
Oxley, virtually every major economic political system adopted
similar requirements. There is no observable regulatory
arbitrage opportunity to move to, say, the Cayman Islands, or
Bermuda, or France, or England, and raise capital there. In
fact, the British, these days, are very unhappy about the fact
that the biggest British companies are listing in the United
States rather than in England because the combination of a
strong regulatory system and deep capital markets reinforce one
another and help capital raising.
Mr. Vargas. Thank you, and last, I would just like to say
this, a point of pride. I see that you are at Harvard. Thank
God for Harvard. There are a number of us that went to school
there, and we can proudly say it now. I hope you guys stick to
your guns. Thank you.
Mr. Coates. We are the most popular we have ever been. It
is amazing.
Mr. Vargas. Yes, I know.
Chairwoman Wagner. The gentleman yields back. The chair now
recognizes the gentleman from Ohio, Mr. Davidson, who is also
the Chair of the Subcommittee on National Security, Illicit
Finance, and International Financial Institution. You are
recognized, sir, for 5 minutes for questioning.
Mr. Davidson. Thank you, Madam Chairwoman. Sarbanes-Oxley
was born out of good intention in the wake of Enron's collapse
but let us be clear: this statute is not sacred scripture which
is not supposed to be added to or taken from. Even the
Constitution, which might be the closest thing we have to
something sacred in our own country, has been amended quite a
lot. So the idea that, oh, how dare you amend the statute, I
think it merits at least some consideration, and that is the
point of this hearing, so thank you for convening it. It is
clear that the burdensome compliance costs have crushed
businesses, especially smaller ones that do not have the deep
pockets to navigate this red tape. Frankly, some of the bigger
companies view this as an opportunity. It creates deal flow
because it creates regulatory barriers that, just to get to the
next phase, might say it is easier just to go ahead and exit
and sell.
As someone who owned and operated manufacturing businesses
in Ohio, I know firsthand the struggle of juggling tight
margins and deadlines and regulation. I empathize with smaller
public companies facing duplicative audits mandated by Section
404. These regulations can choke innovation and slow growth for
companies that are the backbone of our economy. With that, I
have a letter from the National Association of Manufacturers
that I request to submit for record with it.
Chairwoman Wagner. So ordered.
[The information referred to can be found in the appendix.]
Mr. Davidson. Thank you, Chairwoman. In this letter,
National Association of Manufactures (NAM), who represents 13
million people in the manufacturing industry, takes aim at
Section 404(b), which requires companies to hire an outside
auditor to publicly attest to management's assessment of the
effectiveness of the company's internal controls and financial
reporting. This is in addition to normal audits. NAM's findings
conclude that the costs far exceed the SEC's rosy estimates,
hitting smaller public companies the hardest. After 2 decades
of this regulatory overreach, it is time for Congress to act
and free smaller firms from this unnecessary burden. It also
supports why I backed today's noticed legislation to raise the
revenue and public float thresholds for smaller reporting
companies and adjust their filer category transitions. This is
a commonsense step to let businesses focus on creating jobs,
not feeding bureaucracy.
Mr. Cunningham, you have highlighted how SOX 404(b)
disproportionately hit smaller companies. Can you impact the
real-world impact of these regulations, and how can we scale it
back?
Mr. Cunningham. Thank you very much. You have heard a lot
of testimony today about the extraordinarily hard hit that
small companies take from this because the costs do not scale,
and the costs are substantially duplicative because an audit of
financial statements requires an examination of the controls
and a testing of the controls. So, I think the cost benefit is
quite out of whack, and I think Congress is right: it is
Congress' responsibility to update and review its statutes, not
just to delegate to agencies.
Mr. Davidson. Yes. That was, in fact, the finally hard-
fought win in the Chevron deference case in the Supreme Court.
So, in the wake of that, it creates an even bigger burden for
Congress to act, so thank you for that. Dr. Allen, I agree with
your statement that for early lifecycle firms, diversion of
resources and innovation hindrance are notable effects, maybe
not the intent, but certainly the effects of Sarbanes-Oxley's
regulatory regime, the impact on cash-flow and everything else.
Could you just discuss from an entrepreneurial perspective what
modernization of SOX could do for industry?
Dr. Allen. Yes, so thank you. It is important that our
research acknowledges that this is not just a small firm
effect. It is very similar from the standpoint of the costs and
benefits manifesting differentially, but it is a different type
of group. When we think about these highly innovative
companies, the challenge is that although one set of controls
is not mandated, as Professor Coates has articulated very well,
there is often a compliance mindset that is very rigid in form.
I worked at Mattel when they were in the early stages of
implementing their SOX 404, and essentially, they hired out
another audit firm to help them design what would be the
appropriate controls, which then would pass for another audit
company as it was very standard practice to have consultants
help. While a firm can disclose an internal controls weakness,
my understanding is that recently, the SEC has communicated
with firms that it is inappropriate to just let those sit over
time, that the objective of controls is to move forward, to
remediate controls as to ensure financial reporting quality. So
overall, what happens to firms, I think, as the audit comes in,
is that it imposes a mindset or a structure that, again, is
pushed more toward centralization, formalization of processes
that are deconstructive or devaluative to the exploratory
innovation process for this particular firm subset.
Mr. Davidson. Yes. Thank you for that, and I will just
close by saying I appreciate your nod to the late Thomas Sowell
in your written testimony. So with that, I yield back.
Chairwoman Wagner. The gentleman yields back. The chair now
recognizes the gentleman from Illinois, Mr. Casten, for 5
minutes for questioning.
Mr. Casten. Thank you, Madam Chair. Thanks, witnesses. So
not for the first time this term, I feel like we are sort of
here in, like, a British Bake Off competition, and our
contestant has served up a giant horse manure cake, and we have
brought you in to opine on the quality of the flour. We have a
markup here. One of the bills we are marking up is looking at
auditor independent standards of the PCAOB, even as we have a
budget that would eliminate the PCAOB. We are sitting here
talking about the nuances of audit standards, even as this
committee has voted to exempt entire industries from any kind
of a disclosure-based regulatory regime. I say that not to
criticize any of your expertise as grain millers, but I would
like to talk about the dung cake. I am pushing that metaphor as
hard as I can, but bear with me. I am at least making a smile.
Mr. Watanabe, I read an interview with you in 2021 where
you talked about your process of taking your company public.
You said that one of the benefits of the IPO process is that
law firms, accountants, investors do an excruciating amount of
due diligence in the company. Everybody knows what they are
investing in. Transparency and integrity are important when
money is involved. I hope you still agree with those
statements.
Mr. Watanabe. Yes.
Mr. Casten. In that context, would you agree that audited
financial statements are critical to make sure that we have
public confidence in markets and so that people know they are
efficiently allocating their capital?
Mr. Watanabe. I certainly agree with that, but I would also
point out that I had to have audited financial statements when
I was subject to Section 404(a) as well.
Mr. Casten. No, no, understand, and, again, like, I am not
criticizing like that there are different qualities of flour. I
am just saying we are talking about audit because the Congress
right now is drafting stablecoin legislation, the idea that you
could buy some piece of computer code that is neither stable
nor a coin, but you could buy this piece of computer code, and
in exchange for buying that code, it is redeemable for $1, and
yet, the Senate just passed a bill that said that unless you
have $50 billion in assets or more, you are not required to
have an audit. You just have an attestation. So, you could
shuffle money in on the 29th day of the month, shuffle it out
on the 30th, take a snapshot, and that qualifies. It is like
running a casino and having your dad buy $3.4 million of tokens
and using that to disguise whether or not you had a solvency
problem.
Mr. Coates, considering that stablecoins are sold to retail
participants, used for investors, if my Republican colleagues
are right, are going to be tightly integrated into our
financial system, do you think they should be subject to audit
standards like banks are, like public companies are, or is an
attestation sufficient?
Mr. Coates. I would have thought that we as a country and
as an economy learned that lesson in 1934, not recently, audits
are foundational for financial investment. My mother-in-law,
bless her heart, does not understand that and has, on occasion,
fallen for illegal unregistered securities offerings by people
who do not get audits and have lost money. So a stablecoin
product, as framed by the so-called Guiding and Establishing
National Innovation for U.S. Stablecoins (GENIUS) Act, would
extend the capacity of, let us call them entrepreneurs for
politeness, to take that and make it perfectly legal.
Mr. Casten. Let me----
Mr. Coates. I think it is terrible.
Mr. Casten. Let me say, and look, you are generous saying
1930s. We have a White House that seems to have fallen in love
with 1890s economic policy. Stay on that for a second because
it is insane that we had an amendment to put audit standards in
that was voted down by all the Republicans in this committee.
There is recent news that Justin Sun, who is one of the many
committers of emoluments violations, has provided a bunch of
money to the President of United States to bail him out of
World Liberty Financial, got to go and have the crypto dinner,
that he is now trying to do a reverse merger to take his crypto
company public in the United States that would allow him to
access public IPO markets without having to go through the kind
of disclosure that you went through before doing an IPO, Mr.
Watanabe. So, I guess, Mr. Coates, could you talk about some of
the concerns that happen through the reverse merger process,
particularly with foreign entities of concern that might be
able to access public markets with lower disclosure standards?
Mr. Coates. Yes. It is well established that even when
companies that are subject to full regulation and audit use the
reverse merger process, they are more prone to fraud, more
prone to misreporting than companies that go through a fully
underwritten process, and as annoying as the underwriters can
be during the process, sometimes they really do perform a very
valuable service, not only to the investors, but to the company
if it is a long-term company that has real future to it. So
reverse mergers, bad signs, and the idea of removing regulation
from the process of doing that, even less good idea.
Mr. Casten. I am out of time. I yield back but let us just
stay focused on the fact that audits are important. The details
of an audit, we can talk about later. I yield back.
Chairwoman Wagner. The gentleman's time has expired. The
chair now recognizes the gentleman from Wisconsin, Mr. Steil,
who is also the Chair of the Subcommittee on Digital Assets,
Financial Technology, and Artificial Intelligence. Sir, you are
now recognized for 5 minutes for questioning.
Mr. Steil. Thanks, Chair Wagner. Thanks for being here.
Thanks for the dialog on an important topic. I want to start
with you, if I can, Mr. Frank Watanabe when it is ``Style,'' it
is ``Steel,'' but it is good, but thanks for being here. You
built out a great company, grew a dermatology biotech company
from a handful of employees to a large, publicly traded
company. I want to focus in particular in your experience
leading a startup through that process. Mr. Liccardo and I have
legislation to extend the EGC
--Emerging Growth Company--onramp for certain companies so
that they do not age out of EGC status before reaching
maturity, and I appreciate you expressing support in your
testimony for that today. I just want to ask you to put a
little color on that, to talk about how your business, in
particular, benefited from EGC status and the implications that
would have occurred if you had lost that status too soon.
Mr. Watanabe. Yes. So when we went public, we were probably
about 100 people in the organization, and vast majority of
those people were involved in researching our products or
manufacturing our products. Having the emerging-growth company
status allowed us to do our IPO given that size because their
requirements are clearly lower as an emerging-growth company,
and we enjoyed that benefit for a couple of years as well. I
think if the JOBS Act had not passed and that pathway had not
existed, the cost for us, the complexity for us to have gone
public would have been substantially greater, and we very well
may have reevaluated our decision to go public. Now, we lost
that status as time went on.
Mr. Steil. When you did lose that status? What did you see
as an implication on your compliance costs?
Mr. Watanabe. I would say losing the EGC status probably
was less of an implication than 404(b). 404(b) is really the
thing that we saw the most significant implication for us in
terms of compliance costs. I think I mentioned earlier my
testimony, it has more than doubled the cost of our compliance
activities at our----
Mr. Steil. In real-world terms, that takes it from, like,
$5 million to $10 million. What does double mean as we kind of
think about this for companies of your scale?
Mr. Watanabe. Sure, sure. So, the year before we triggered
404(b), we spent about $650,000 on our audit, and we did not
have an external compliance provider. The year that we fell
into 404(b), those doubled to $1.1 million in 2021. As I
mentioned, last year, it was $2.2 million, which was up 24
percent the prior year. We are expecting something like that
this year in terms of an increase as well.
Mr. Steil. Let me hit one additional topic. Commissioner
Peirce said, I think, ``The process of determining whether a
company is a smaller reporting company (SRC) and a non-
accelerated filer, or an SRC and an accelerated filer, or even
outside of both categories, so complicated that even we at the
SEC need diagrams to figure it out.'' Can you just comment on
the complexity of that system?
Mr. Watanabe. One of the challenges, and I suspect that
quote refers to, is that there are different standards for
different things, and so you can be an SRC and an accelerated
filer, for example. So, I think to the extent that those
triggers are harmonized across different regulations or
legislation, whether it is the SEC or PCAOB or Congress that
does it, I think that would be a very positive step, because
you can----
Mr. Steil. I agree with you. I think we have room to clean
that up. I have about 75 seconds left, and I know you uniquely
were impacted by proxy advisors. I think this duopoly of
Institutional Shareholder Services (ISS) and Glass Lewis is
atrocious. It is maybe just a step beyond the topic of this
committee but hit me with what ISS and Glass Lewis and the
proxy advisor duopoly did to you.
Mr. Watanabe. Well, I think we have struggled with several
things when there have been factual inaccuracies, and our
inability to review their reports on us in advance is a problem
so that we cannot correct them.
Mr. Steil. So, they just put out the information----
Mr. Watanabe. And it is----
Mr. Steil [continuing]. and off people go voting, and you
do not even have a chance to raise your hand and say that is
not true.
Mr. Watanabe. That is correct. We have to fix it on the
back side. The other issue is that they have a set of standards
that do not align, for example, with the SEC's own standards
for things like independence, and that has been an issue for
us.
Mr. Steil. Because they are not fully regulated under the
SEC in a manner that you and I probably think that they should
be, right?
Mr. Watanabe. They are not really regulated at all, yes,
and it is the Wild West. In the ESG area, they will pay you to
tell you how to improve your ESG score, so there is a clear
conflict of interest.
Mr. Steil. The conflict of interest is they claim there is
a Chinese wall, that this side of the entity is going to take
the money, this side is going to report, but do not worry,
there is no talking between those two. We are out of time. I
appreciate your testimony. Big opportunity on proxy advisors.
Yield back.
Chairwoman Wagner. The gentleman yields back. The chair
recognizes the gentleman from Massachusetts, Mr. Lynch, for 5
minutes of questioning.
Mr. Lynch. Thank you, Madam Chair. I thank the witnesses
for your help today. It was earlier said that Sarbanes-Oxley is
not sacred text. Now that is very, very true, but let us be
clear, though. I served on this committee back in the early
2000s and witnessed the collapse of Enron and WorldCom and Tyco
early in the 2000s. These high-profile corporate accounting
scandals collectively cost investors billions of dollars and
eroded public confidence. It really created a crisis here. The
fall of Enron alone cost about 20,000 jobs. It was a scandal
and more than $2.1 billion in retirement assets. People were
talking about bailouts and, as well, about $67 billion in
losses for shareholders. So, the scandal-exposed systemic
issues in corporate accounting, including a lot of fraudulent
accounting practices, those accounting firms were being
purchased by their clients to give misleading audits of their
companies, and as a result, this committee passed the Sarbanes-
Oxley Act. Any time you get 400 votes in the House for a bill,
that says something, and when you get 99 to zero in the Senate
that says something. This was a crisis.
Sometimes, they say it takes a crisis to get Congress to
act, especially in unison, in a purposeful way. We had a crisis
back then. The bill created the PCAOB, the Public Company
Accounting Oversight Board, whose primary purpose was actually
to get at those audits and to stop the fraud, and that is what
it does today. I want to be clear: this hearing is not tweaking
the PCAOB. It eliminates it. It obliterates, to borrow a
phrase, obliterates the PCAOB. It goes away. The funding for
that function of making sure that the audits are accurate, the
funding for that goes away. Mr. Coates, can you talk about
that? So, Section 50002 of the reconciliation bill, basically,
like I said, obliterates the PCAOB and the funding stream that
supports the auditing function that this not-for-profit
corporation, the PCAOB performs, and what do you think the
result of that is going to be for people who rely on those
audits?
Mr. Coates. I firmly believe that the investment community
would, with growing speed, cease to believe that audited
financial statements actually represented what they purport to
represent. It would increase the cost of capital for every
small-and medium-sized company that wants to raise outside
equity capital. It would harm the American economy. I have no
doubt about that.
Mr. Lynch. Yes. One of the other red flags I see is that
the Trump Administration, with respect to the SEC, which is
where I guess some of this responsibility would flow, the Trump
Administration also opposes the SEC fiduciary rule, which
basically says financial advisors have to act in the best
interest of their clients, so, I mean, there is a direct attack
on financial advisors' responsibilities to their clients. They
want that to go away, and, I mean, there are other firms out
there that actually lean into fiduciary duty. You got firms out
there that are doing really, really well, that say, you know
what? We are a fiduciary. We accept and we are proud of our
responsibility to act in the best interest of our clients. Yet
the Trump Administration wants to get rid of that, and they
want to get rid of the PCAOB. They want to defund the Financial
Protection Board. That has been rejected, I guess, by the
parliamentarian over in the Senate, but collectively, these
aggregate attacks on responsible regulation, successful
regulation is really problematic, but it does show, it does
reveal the attitude of the White House in this matter. Thank
you. I yield back.
Chairwoman Wagner. The gentleman yields back. The chair now
recognizes the gentleman from Indiana, Mr. Stutzman, for 5
minutes of questioning.
Mr. Stutzman. Thank you, Madam Chair, and I would like to
submit a letter from the American Securities Association to the
committee for the record.
Chairwoman Wagner. So ordered.
[The information referred to can be found in the appendix.]
Mr. Stutzman. Thank you to all of the folks here for
testifying today. This is a really important issue, especially
for businesses across the country. My previous career or
service outside of public service in the private sector dealt
with startup companies, turnaround companies, but also publicly
traded companies, and there are a lot of companies out there,
people that are investing in their local communities, creating
jobs that want to grow and want to give back to the community,
give back to their shareholders, create wealth and new
opportunities. So, I think that this committee hearing is
really critical for the growth of our country.
While we know that Sarbanes-Oxley was intended to prevent
fraud, over the past 20 years, we have seen the negative
impacts of these regulations on growing companies and their
access to capital. The cost and regulatory burden of these
requirements are excessive as even small companies, as I
mentioned, must pay, on average, $723,000 a year to comply with
this act. These costs have deterred small companies from going
public, which I experienced personally, gaining access to
capital and propelling economic growth. The median age for a
firm seeking an IPO increased from 6.9 years in 2014 to 10.7
years today. I had a business attorney tell me that if you wait
10 years, you will become an overnight success, and that seems
like what is happening today because of the regulatory
environment.
Dr. Allen, I would like to ask you, in your testimony, you
cited research finding that firms tend to manage their public
float downward to avoid exceeding the $75 million and $700
million regulatory market cap thresholds for qualifying as
accelerated and large accelerated filers, respectively. How
much market valuation are firms willing to sacrifice in order
to avoid having to comply with SOX?
Dr. Allen. Thank you, this is the Ewens study that I was
citing here. They estimated that for firms just below the $75
million threshold, they are essentially willing to pay $132,000
annually to stay below that threshold, or give up about 1.8
percent of their market cap. For firms seeking to avoid the
$700 million threshold, the equivalent is more like $900,000
per year in costs that they are incurring and giving up about
1.2 percent of their market cap. The way they stay below the
threshold is that they shift their financing toward debt and
away from equity.
Mr. Stutzman. Yes. No, that is right. So, is managing float
downward a concerning trend for you, and if so, does not lower
stock float typically lead to higher volatility in the stock's
price because it is easier for a smaller number of shares to
move the price?
Dr. Allen. We do have some evidence of that from outside of
U.S. markets. I do not know that we have tested it specifically
in the United States, but, yes, anytime we see firms incurring
real cost to manage their market cap, it suggests that they at
least perceive that the net costs are heavier than the net
benefits.
Mr. Stutzman. Yes, very good. Mr. Cunningham, going back to
the compliance barriers, could you speak to that and how it is
hurting American communities, like I mentioned, those in my
district, smaller companies? Maybe it is manufacturing, maybe
it is tech, great ideas. We have a large orthopedic sector in
Northern Indiana as well. How does that affect them because I
know for a fact, I mean, it is hard to go public. It is almost
easier just to build the company up and sell it to a publicly
traded company, or do a Special Purpose Acauistion Company
(SPAC) and just go in backward, which has its challenges as
well.
Mr. Cunningham. There are real costs to communities of
overregulation, and especially there is over-auditing of
internal controls. It is exceedingly expensive and prohibitive
for many companies. Every entrepreneur is going to assess the
costs and benefits of sourcing capital, deciding whether to
stay private or access to public capital markets, and there is
no question that there are significant costs, significant
barriers, and so businesses in your district and other
communities across America are certainly adversely affected by
this. So, I commend you and the committee for focusing
attention on it.
Mr. Stutzman. Well, there needs to be a balance, but it
seems like we are too far to the one side, and, ultimately, it
is money going to the government versus money going back into
building a business or going to shareholders and generating
more velocity in the marketplace. Thank you for your testimony.
Madam Chair, I yield back.
Chairwoman Wagner. The gentleman yields back. The chair now
recognizes the gentleman from Louisiana, Mr. Fields, for 5
minutes of questioning.
Mr. Fields. Thank you, Madam Chairwoman, and let me thank
all the witnesses for being here today. I just have a few
questions, first, to Mr. Coates. Following the devastating
Enron/WorldCom scandal that costs investors billions, can you
walk us through the specific failures that SOX was designed to
actually address and what measurable improvements and audit
quality and financial reporting reliability we have seen since
the PCAOB began its oversight ward?
Mr. Coates. Thank you, Congressman Fields, for that. My
written testimony refers to scholarship. I have published on
this, and that will give you a much more comprehensive answer
than what I am going to summarize, but I will say a couple of
things.
First, to reiterate, before Sarbanes-Oxley, there was no
PCAOB. If you have no PCAOB, then you have audit firms self-
regulating whether they do a good job of the basic audit of
financial statements. In the period leading up to Sarbanes-
Oxley, they failed over and over with increasing frequency, in
part because of another thing Sarbanes-Oxley changed was they
were, at the time, permitted to engage in significant non-audit
work for the same company they were auditing. They were, in
effect, partly auditing themselves, and they were being paid
lots of money for the overall relationship, which meant that
they were less inclined to fight hard during the audit. That
led to a dramatic increase in the number of mistakes and of
fraud.
You can just see to the numbers they were going up and up
every year through Sarbanes-Oxley. Once the PCAOB's audit
standards kicked in, they began to decline, and they have
remained at much lower levels over the past 10 years. It never
gone to zero. It is not like the PCAOB is perfect. Sarbanes-
Oxley is not perfect. We are never going to get to perfect, but
it has significantly improved financial reporting quality. As
my colleague down the bench here has shown in her work as well,
it is not just me, it is consistently found better reporting
quality as a result of audit standards.
Mr. Fields. Thank you. Dr. Allen, from an academic
standpoint, what evidence do you see that the current
independent PCAOB structure is more or less effective than
following these specialized functions into a broader SEC
mandate, and how would you assess the risk of diluting these
focus on expertise across the SEC's much wider regulatory
responsibilities?
Dr. Allen. Thank you for the question. My own research has
not looked into the PCAOB. I think certainly points that have
been raised regarding funding and independence are important
questions to assess when thinking about who will perform these
functions. As Dr. Coates has mentioned, we do see a drop in
restatement rates following the implementation of the PCAOB,
but it is also correspondent to a time when we saw the
independence rules for auditors changing, which was an
important shift as well. So, research of examining the strength
of those two forces would be important to understanding what is
going on there. That would be my assessment of current
research.
Mr. Fields. Thank you, and my final question is to Mr.
Cunningham. Section 404, internal controls assessments have
been criticized as costly, yet they require companies to
establish and maintain systems to prevent fraud. In your view,
what would be the market-wide implications if we signal to
investors that we are prioritizing compliance cost reduction
over fundamental fraud prevention mechanisms?
Mr. Cunningham. I think the signal to markets and to
investors of this review would be to signal that Congress is
attentive and concerned about making sure that resources are
deployed in ways that protect investors and are not deployed in
excessive resourcing on internal controls. I would just add on
404(b), Dr. Allen is right that SOX made so many changes, it
was very difficult for a long period of time to determine the
effect of particular provisions. You know, we banned conflicts
of interest and have good audit committees, officer
certificates, and these internal controls. After the SEC
increased the exemptions under 404(b) in 2020, we have
empirical research on whether the quality of reporting went
down or internal controls.
Mr. Fields. I want to thank you. I am out of time. I want
to yield back to the chair. Thank you.
Chairwoman Wagner. The gentleman's time has expired, and
the chair now recognizes the gentleman from Montana, Mr.
Downing, for 5 minutes of questioning.
Mr. Downing. Thank you, Madam Chair, and thank you to the
witnesses for being here. As a recovering regulator, this is a
very interesting topic to me. I was formerly the Commissioner
of Securities and Insurance for the State of Montana, and I
firmly believe that the best way to evaluate any regulations is
to determine whether the benefits outweigh the costs. I am
happy we are having this hearing on Sarbanes-Oxley, a law that
Congress has not changed since 2002. I am going to start with
Mr. Watanabe. You have spoken a lot on the subcommittee about
the many barriers that companies have going and staying public,
and I think about compliance costs a lot. So, all the
compliance costs that public companies face, where would you
rank SOX in those costs?
Mr. Watanabe. I think that the thing that I can quantify
most clearly is the cost differential between 404(a) and
404(b), and I think I mentioned in my testimony earlier, we
have spent about $11 million complying with 404(b) since we
started being subject to it, and to quantify that is the cost
of me running a phase 2 efficacy trial on a new drug, right?
That is money that I did not have to spend on developing
another new drug to treat another serious disease. When we were
under 404(a), I still was subject to audit every year. I still
had to sign the attestation every year. I think about it every
quarter very carefully, as I know you did, Congressman, as an
entrepreneur. I do not look good in orange, right? So, I take
that very seriously. So, it is not that I am suggesting a lack
of regulation. I think it is really more titrating the
regulation so that smaller companies are not overly burdened
with the cost of compliance in the same way that a gigantic,
multibillion dollar corporation is.
Mr. Downing. Thank you. I am going to move to Mr.
Cunningham. Some contend that any serious reforms of SOX will
lead to more corporate accounting scandals like Enron. In 2020,
the SEC amended the accelerated filer and large accelerated
filer definitions to carve out some smaller issues from the
404(b) requirements. Have you seen any decline in the quality
of financial statements from these companies since this change?
Mr. Cunningham. Thank you very much for that question. I
have not, and indeed there is empirical research by independent
professors demonstrating that there was no adverse effect on
the quality of the reporting or the strength of the controls.
Mr. Downing. Well, would you not say that proves that
Congress can make necessary and targeted reform without
jeopardizing audit quality?
Mr. Cunningham. Yes, sir.
Mr. Downing. Thank you. Many public companies see the
404(a) and the 404(b) requirements as duplicative auditing. Is
there any way to reform these requirements to reduce this
duplicative auditing while maintaining investor confidence? For
example, why not just keep the 404(a) requirements in place?
Mr. Cunningham. Yes, I support this avenue of inquiry. I am
glad Professor Coates agreed that we should consider many of
the proposals that Frank has suggested and this committee has
suggested. So, I think it is eminently within the scope of
Congress' jurisdiction to tackle that and not give it over to
the SEC or PCAOB.
Mr. Downing. I appreciate that. Are there any essential
provisions of SOX that you think have worked as intended and do
not need to be reformed?
Mr. Cunningham. I do think that the audit committee
regulations, I was first quite skeptical of the very
prescriptive and intrusive approach, but on reflection over the
years, I think the audit committees are now leaning in very
effectively, and so I think I would be satisfied with that. The
officer certifications, I think, have heightened the
attentiveness of leadership, and the ban on conflicts of
interest with the auditors, I think that was the most important
and successful accomplishment of the statute. So, there are
quite a few good things, but there are a lot of missteps.
Mr. Downing. Right. Right. I appreciate that, and, again,
just going back to this inquiry of understanding whether the
benefits are worth the cost. I appreciate you all being here,
and on that, Madam Chair, I am going to yield.
Chairwoman Wagner. The gentleman yields back. The chair now
recognizes the gentleman from California, Mr. Sherman, the
Ranking Member of the Subcommittee on Capital Markets. You are
recognized for 5 minutes for questioning.
Mr. Sherman. It is hard to know how much to invest in
making sure that audits are accurate and that fraud is avoided.
Reminds me of a bank that had a bank guard there that said,
hey, well, we have not had a robbery in 20 years, might as well
fire the bank guard. You do not know until you find out. The
harm of Enron and WorldCom, and I think Mr. Coates has pointed
this out, is not just to the individual companies and their
employers and their stockholders, but entire industries and the
market overall. With Enron, I take it very personally because
they also destroyed my State for several months by creating an
artificial shortage of electricity and artificial blackouts
when we had plenty of electric-generating capacity. Also
destroyed a Governor of my State.
There has been discussion of the proxy advisors. I am
concerned that they also offer advice on how to get a good
score, but as to complaining that right before there is going
to be a vote, somebody could publish something that affects how
people vote, and it might be a duopoly. Well, welcome to my
world. The LA Times publishes things right before a vote. They
do not let me see it in advance, and maybe it is a duopoly
because we also have the Los Angeles Daily News, but it is at
most a duopoly. We have to explore the scope of what is
required under Sarbanes-Oxley. I think people have mentioned
the frequency, but I think the quarterly and annual are
probably the right frequency, and then most of this hearing is
focused on who is exempted. We exempt on the basis of dollar
thresholds, which tend to focus on the equity that is out
there, but, Mr. Coates, do not public bondholders also rely on
these financial statements, and is there any reason to exclude
the publicly held debt when we are also looking at the publicly
held stock in disturbing these thresholds?
Mr. Coates. So the current exemptions, some of which are
built into statutes, are crude, as you just noted, equity is
not the only source of capital. Outside equity investors are
not the only ones relying on financial statements. They could
be more carefully designed. I want to emphasize, however----
Mr. Sherman. Yes. Let me move on to another question. Does
the PCAOB or the SEC have the authority under current law to
make some of the adjustments we are talking about, because
there is an argument that these are arcane details that perhaps
regulators can deal with better than us or at least more
frequently.
Mr. Coates. More frequently, more quickly, and they can
monitor----
Mr. Sherman. Do they have the authority under present
statute?
Mr. Coates. They absolutely do. The one exception, this is
something you guys could consider, letting them more carefully
design experiments with their regulations. Currently, they are
constrained to do that. I think you could consider giving the
SEC the authority to test and then quickly change----
Mr. Sherman. One thing that failed the test was the
structure of Arthur Andersen. When I was doing audits, you had
the audit partner, whose job it was to golf with the CFO, and
the technical review department. Arthur Andersen had a do not
ask/do not tell approach with their technical review
department. I do not think any accounting firm has replicated
that, but is it clear that under current regulations, you have
to have a technical review department inside the accounting
firm sign off whether the audit partner wants that or not?
Mr. Coates. Thanks to the PCAOB and its standards and its
inspections, audit firms routinely avoid that kind of cabining
of information that helped trigger Enron, yes.
Mr. Sherman. Then one of the proposals, and the one I think
I like least, is the idea that the auditor would not have to
register with the PCAOB, but, rather, just meet the standards
of the AICPA. As I pointed out, the AICPA was not consulted on
that bill. I saw with Madoff that maybe the auditor was in
technical compliance with the AICPA standards but was
manifestly incapable of doing the audit. They had a couple of
CPAs, and Madoff had a big empire to audit. What are the
downsides of not having the audit firms be approved by the
PCAOB?
Mr. Coates. I do not think we want to return to the Bernie
Madoff scandal, so, no, it would not be, in my opinion, a good
idea.
Mr. Sherman. Thank you.
Chairwoman Wagner. The gentleman's time has expired. The
chair now recognizes the gentleman from Florida, Mr.
Haridopolos, for 5 minutes of questioning.
Mr. Haridopolos. Thank you, Madam Chair, and I first want
to submit a letter from the Society of Corporate Governance
regarding scaling disclosure and obligations for the record.
Chairwoman Wagner. So ordered.
[The information referred to can be found in the appendix.]
Mr. Haridopolos. I also want to thank the chair for
bringing this issue forth. As a new member of the committee, it
is very helpful to understand the history and hear from the
experts in the field about a bill that is over 20 years old and
some of the changes that have taken place in our society since.
I think one of the things we have talked a lot about in this
committee is the power of the blockchain and the power of
technology in general so that more people could put their eyes
on things, so that when bad things happen, we can be alerted
earlier as opposed to later on so many different subjects.
One of the issues, Mr. Watanabe, if you could, you have
mentioned this term a couple of times: 24-percent increases.
Are these prices that you are getting from your lawyers and
accountants and so forth that are going through these records,
or are these new rules that are being instituted each year and
year out that force you to hire more accountants and lawyers?
Mr. Watanabe. Thank you for the question. The 24-percent
increase that I mentioned was a year-over-year increase in the
fees charged by our auditors. You know, it is not something
that I have a lot of negotiating leverage with. My shareholders
appoint our auditors annually at our annual general meeting, as
I think all public companies do. Once our auditors are in
place, they look at the scope of work and they tell me how much
it is going to cost me, and it goes up quite a bit every year.
It has more than doubled just since we fell into 404(b), so the
costs go up every year, and the company has really no ability
to negotiate those fees.
Mr. Haridopolos. Thank you, and, Dr. Allen, if I could,
with your question. We have heard the testimony today. You live
this. Clearly you understand this better than most. If you had
a magic wand and pick one item that could be changed within
Sarbanes-Oxley to still have the oversight that we are all
looking for, but also looking at the everyday costs that
businesses are trying to make the decision, do they go public,
do they stay public, do they sell to a different public company
if they are a private company, all these things in place. If
you had a magic wand, you could say, here is one change I would
make to keep the oversight in place but reduce some of these
costs so the companies might go public who are making these
difficult decisions, what would you use as that magic wand?
Dr. Allen. Can I give two things?
Mr. Haridopolos. Sure.
Dr. Allen. One, I really like the idea of rolling averages
because I think it is very hard for companies to come in and
out of exemption status, and two, it would be more granular
regulation that allows for thoughtful exemptions based on
things like low revenue where we have lower risks or high
innovation environments where control environments are more
damaging.
Mr. Haridopolos. Mr. Cunningham, same to you. Do you agree
with Dr. Allen? Are there other issues that are out there that
you think is not the magic bullet, but at least try to reduce
some of these 24-percent costs or change the way we are doing
business from 23 years ago?
Ms. Cunningham. I agree with Dr. Allen, and so that means I
get three. I agree with Chair Hill, too, his idea of having,
instead of an annual test, have it every second year or every
third year depending on risk profiles, complexity of the
company, development stage, revenue, and so on. I think that is
a worthy topic.
Mr. Haridopolos. Mr. Watanabe, do you want to add to that
as well?
Mr. Watanabe. I would agree with all three of those.
Mr. Haridopolos. Mr. Coates, you made some good statements
today. I want to give you an opportunity, too. You have
obviously seen this law in effect for 20 years. There has got
to be some issues where we thought it was a great idea in 2002,
but maybe it has either outlived its usefulness, or technology
has allowed us to look at things more quickly as opposed to the
paperwork shuffle from 20-odd years ago.
Mr. Coates. I think the most important thing that this body
could do is bring the PCAOB and SEC folks here and push them on
the kinds of suggestions that you have just heard about because
I do think they can do it more quickly. If they get it wrong,
suppose they titrate too far one way or the other, they can
reverse that more quickly than Congress can as a body. So, I
would have a hearing specifically on some of these specific
ideas. That would be the natural next step.
Mr. Haridopolos. Madam Chair, I appreciate the opportunity,
and I yield back.
Chairwoman Wagner. The gentleman yields back. The chair now
recognizes the gentleman from Texas, Mr. Sessions, for 5
minutes of questioning.
Mr. Sessions. Madam Chairwoman, thank you very much. I
think you did an awesome job to gather together people that do
not compete against each other but have a same or similar story
to tell, and I applaud you for doing this.
Mr. Coates, I will be quite blunt. I like where you come
from, and your value-add to today is not an answer. It is
giving the regulatory bodies the opportunity to come and, in
essence, work with companies on some negotiation about what
they will do. This is important because Mr. Watanabe's
testimony, page 3, says the compliance cost for emerging
growing biotechs, on average, is $800,000 a year. Then you go
on and actually list what that price tag costs you in research
and development to bring your clear biotech ideas that may save
lives, may fix problems, may be a breakthrough. We are spending
time on compliance costs rather than doing those things. I note
Dr. Allen spoke well about this. Mr. Cunningham, very
impressive, and I do not think that it says something somewhere
and delete something later, but I do find that you have tried
to focus the activity, off of, that compliance costs can have
significant effects for firm IPO decisions, and so I would like
to go at that level as opposed to beginning, middle, end, how
big they are.
It is causing people who actually are business leaders and
entrepreneurs, who want to get something to marketplace, that
are worried about the FDA, that are worried about an FDA trial,
that are worried about something else, and they are having to
worry about am I saying everything right? Am I getting exactly
what it does or not do, my biotech company, or otherwise? I
just think, Mr. Cunningham, Dr. Allen, if you take just a
minute, which is all I have left because I spoke too long, what
do you think about Mr. Coates' idea of us using this tape of
this hearing that Congresswoman Wagner has been really good at
narrowing down and going to regulators and saying we charge you
with trying to come up with a plan, not picking winners or
losers, but by picking things, and they could strike that
balance? Dr. Allen?
Dr. Allen. I support the idea that Professor Coates had put
forward of consulting with the SEC, with members of the PCAOB,
to think about the costs and benefits and how they differ
across firms. I think, also, as he suggested, some level of
experimentation. It is very hard to calibrate standards
appropriately on the first go, so an openness to trying it,
examining the data, and revising is good policymaking.
Mr. Sessions. Then making sure you hold them accountable,
but there is a variance that is allowed there. Mr. Cunningham,
one of the statements that has been made is time. When I was at
Southwestern University taking my business classes, we learned
time is money. Well, Mr. Watanabe would also say time is also
people's lives, delaying things because you are having to
shift. Tell us about the flexibility that you should be given,
that these companies should be given by the regulator.
Mr. Cunningham. I think that is an excellent point, and it
would be prudent I think for this committee--I do not mean to
tell you how to do your job--but to have the SEC here, have the
PCAOB here, and to give an accounting of their perspective,
what they see the cost-benefit matrix, and develop strategies
for right-sizing and balancing. I think that it would be a very
productive thing to help address the lost time due to red tape,
due to excessive resourcing into the internal control
environment.
Mr. Sessions. We care very much, as well do you, about an
investor who could be duped into the wrong thing, but I think
almost anybody that has money to invest, I would like to think,
would recognize that getting to the FDA trial is the plus or
minus. That is the go or no-go for lots of these things. Madam
Chairman, this is, in my opinion, the best hearing you have
had. I remain confident that we can make a difference, that we
have built an argument that is available on a bipartisan basis,
and you have proved it with your committee here today. Thank
you very much. I yield back my time.
Chairwoman Wagner. The gentleman's time has expired, and I
would like to thank all my colleagues for their robust
participation today. I want to thank our witnesses for their
testimony today.
Without objection, all members will have 5 legislative days
to submit additional written questions for the witnesses to the
chair. The questions will be forwarded to the witnesses for
their response. I would ask the witnesses to please respond no
later than July 30, 2025.
[The information referred to can be found in the appendix.]
Chairwoman Wagner. This hearing stands adjourned.
[Whereupon, at 12 p.m., the subcommittee was adjourned.]
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