[Federal Register Volume 71, Number 42 (Friday, March 3, 2006)]
[Notices]
[Pages 11090-11133]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 06-1992]



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Part IV





Securities and Exchange Commission





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Advisory Committee on Smaller Public Companies; Notice

  Federal Register / Vol. 71, No. 42 / Friday, March 3, 2006 / 
Notices  

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SECURITIES AND EXCHANGE COMMISSION

[Release Nos. 33-8666; 34-53385; File No. 265-23]


Exposure Draft of Final Report of Advisory Committee on Smaller 
Public Companies

AGENCY: Securities and Exchange Commission.

ACTION: Publication of Exposure Draft of Advisory Committee Final 
Report, Request for Public Comment.

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SUMMARY: The Securities and Exchange Commission Advisory Committee on 
Smaller Public Companies is publishing an exposure draft of its Final 
Report and requesting public comment on it.

DATES: Comments should be received on or before April 3, 2006.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Statements

     Use the Commission's Internet submission form (http://www.sec.gov/info/smallbus/acspc.shtml); or
     Send an e-mail message to [email protected]. Please 
include File Number 265-23 on the subject line; or

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Federal Advisory Committee Management Officer, Securities and Exchange 
Commission, 100 F Street, NE., Washington, DC 20549-1090. You may also 
fax your submission to 202-772-9324, Attn: Federal Advisory Committee 
Management Officer.

All submissions should refer to File No. 265-23. This file number 
should be included on the subject line if e-mail is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on its Web site (http://www.sec.gov./info/smallbus/acspc.shtml).
    Comments also will be available for public inspection and copying 
in the Commission's Public Reference Room, 100 F Street, NE., 
Washington, DC 20549. All comments received will be posted without 
change; we do not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly.

FOR FURTHER INFORMATION CONTACT: Questions about this release should be 
referred to William A. Hines, Special Counsel, at (202) 551-3320, or 
Kevin M. O'Neill, Special Counsel, at (202) 551-3260, Office of Small 
Business Policy, Division of Corporation Finance, Securities and 
Exchange Commission, 100 F Street, NE., Washington, DC 20549-3628.

SUPPLEMENTARY INFORMATION: The SEC Advisory Committee on Smaller Public 
Companies is publishing an exposure draft of its Final Report to 
solicit public comment on the draft. The draft contains proposed 
recommendations of the Committee on improving the current securities 
regulatory system for smaller companies. All interested parties are 
invited to submit their comments in the manner described above. The 
Advisory Committee is especially interested in receiving comments from 
investors in microcap and smallcap companies, as well as from their 
managements. The draft has been approved as an exposure draft by the 
Advisory Committee. It does not necessarily reflect any position or 
regulatory agenda of the Commission or its staff.
    The text of the exposure draft follows:

Final Report of the Advisory Committee on Smaller Public Companies to 
the U.S. Securities and Exchange Commission

[April 23], 2006

Table of Contents

Transmittal Letter
Members, Official Observers and Staff of Advisory Committee
Part I. Committee History
Part II. Scaling Securities Regulation for Smaller Companies
Part III. Internal Control Over Financial Reporting
Part IV. Capital Formation, Corporate Governance and Disclosure
Part V. Accounting Standards
Part VI. Epilogue
Part VII. Separate Statement of Mr. Jensen
Part VIII. Separate Statement of Mr. Schacht
Part IX. Separate Statement of Mr. Veihmeyer
Appendices*
    A. Official Notice of Establishment of Committee
    B. Committee Charter
    C. Committee Agenda
    D. SEC Press Release Announcing Intent To Establish Committee
    E. SEC Press Release Announcing Full Membership of Committee
    F. Committee By-Laws
    G. Request for Public Comments on Committee Agenda
    H. Request for Public Input
    I. Background Statistics for All Public Companies
    J. Universe of Publicly Traded Equity Securities and Their 
Governance
    K. List of Witnesses
    L. Letter from Committee Co-Chairs to SEC Chairman Christopher 
Cox dated August 18, 2005
    M. SEC Statement of Policy on Accounting Provisions of Foreign 
Corrupt Practices Act

*Access to each appendix is available by clicking its name on the 
copy of this page posted on the Internet at http://www.sec.gov/info/smallbus/acscp-finalreport_ed.pdf.

Transmittal Letter--SEC Advisory Committee on Smaller Public Companies

Washington, DC 20549-3628.

[April 23], 2006

The Honorable Christopher Cox, Chairman, U.S. Securities and 
Exchange Commission, 100 F Street, NE, Washington, DC 20549-1070.

    Dear Chairman Cox: On behalf of the Commission's Advisory 
Committee on Smaller Public Companies, we are pleased to submit our 
Final Report.

[Contents of letter to be included in Final Report.]

    Respectfully submitted on behalf of the Committee.

Herbert S. Wander,
Committee Co-Chair.

James C. Thyen,
Committee Co-Chair.

Enclosure

cc: Commissioner Cynthia A. Glassman
    Commissioner Paul S. Atkins
    Commissioner Roel C. Campos
    Commissioner Annette L. Nazareth; Ms. Nancy M. Morris

Members, Official Observers and Staff of Advisory Committee

Members

Herbert S. Wander, Co-Chair, Partner, Katten Muchin Zavis Rosenman (Ex 
Officio Member of All Subcommittees and Size Task Force)
James C. Thyen, Co-Chair, President and CEO, Kimball International, 
Inc. (Ex Officio Member of All Subcommittees, Chairperson of Size Task 
Force)
Patrick C. Barry, Chief Financial Officer and Chief Operating Officer, 
Bluefly, Inc. (Accounting Standards Subcommittee, Size Task Force)
Steven E. Bochner, Partner, Wilson Sonsini Goodrich & Rosati, 
Professional Corporation (Chairperson, Corporate Governance and 
Disclosure Subcommittee)
Richard D. Brounstein, Executive Vice President and Chief Financial 
Officer, Calypte Biomedical Corp. (Internal Control Over Financial 
Reporting Subcommittee)
C.R. ``Rusty'' Cloutier, President and Chief Executive Officer, 
MidSouth Bancorp, Inc. (Corporate Governance and Disclosure 
Subcommittee)
James A. ``Drew'' Connolly III, President, IBA Capital Funding (Capital 
Formation Subcommittee)
E. David Coolidge III, Vice Chairman, William Blair & Company 
(Chairperson, Capital Formation Subcommittee)
Alex Davern, Chief Financial Officer and Senior Vice President of

[[Page 11091]]

Manufacturing and Information Technology Operations, National 
Instruments Corp. (Internal Control Over Financial Reporting 
Subcommittee, Size Task Force)
Joseph ``Leroy'' Dennis, Executive Partner, McGladrey & Pullen 
(Chairperson, Accounting Standards Subcommittee)
Janet Dolan, Former Chief Executive Officer, Tennant Company 
(Chairperson, Internal Control Over Financial Reporting Subcommittee)
Richard M. Jaffee, Chairman of the Board, Oil-Dri Corporation of 
America (Corporate Governance and Disclosure Subcommittee, Size Task 
Force)
Mark Jensen, National Director, Venture Capital Services, Deloitte & 
Touche (Internal Control Over Financial Reporting Subcommittee)
Deborah D. Lambert, Co-Founder, Johnson Lambert & Co. (Internal Control 
Over Financial Reporting Subcommittee)
Richard M. Leisner, Partner, Trenam Kemker (Capital Formation 
Subcommittee, Size Task Force)
Robert E. Robotti, President and Managing Director, Robotti & Company, 
LLC (Corporate Governance and Disclosure Subcommittee)
Scott R. Royster, Executive Vice President & Chief Financial Officer, 
Radio One, Inc. (Capital Formation Subcommittee)
Pastora San Juan Cafferty, Professor, School of Social Service 
Administration, University of Chicago (Corporate Governance and 
Disclosure Subcommittee)
Kurt Schacht, Executive Director, CFA Centre for Financial Market 
Integrity (Internal Control Over Financial Reporting Subcommittee)
Ted Schlein, Managing Partner, Kleiner Perkins Caufield & Byers 
(Capital Formation Subcommittee)
John B. Veihmeyer, Deputy Chairman, KPMG LLP (Accounting Standards 
Subcommittee)

Official Observers

George J. Batavick, Member, Financial Accounting Standards Board (FASB) 
(Accounting Standards Subcommittee)
Daniel L. Goelzer, Member, Public Company Accounting Oversight Board 
(Internal Control Over Financial Reporting Subcommittee)
Jack E. Herstein, Assistant Director, Nebraska Bureau of Securities 
(Capital Formation Subcommittee)

SEC Staff

Alan L. Beller, Director (until February 2006) Division of Corporation 
Finance
Martin P. Dunn, Deputy Director, Division of Corporation Finance
Mauri L. Osheroff, Associate Director (Regulatory Policy), Division of 
Corporation Finance
Gerald J. Laporte, Committee Staff Director Chief, Office of Small 
Business Policy, Division of Corporation Finance
Kevin M. O'Neill, Committee Deputy Staff Director, Special Counsel, 
Office of Small Business Policy, Division of Corporation Finance
Cindy Alexander, Assistant Chief Economist, Corporate Finance and 
Disclosure, Office of Economic Analysis
Anthony G. Barone, Special Counsel, Office of Small Business Policy, 
Division of Corporation Finance
Jennifer Burns, Public Accounting Fellow, Office of the Chief 
Accountant
Mark W. Green, Senior Special Counsel, Division of Corporation Finance
Kathleen Weiss Hanley, Economic Fellow, Office of Economic Analysis
William A. Hines, Special Counsel, Office of Small Business Policy, 
Division of Corporation Finance
Alison Spivey, Associate Chief Accountant, Office of the Chief 
Accountant

Executive Summary \1\

Background

    The U.S. Securities and Exchange Commission (the ``Commission'' or 
``SEC'') chartered the Advisory Committee on Smaller Public Companies 
on March 23, 2005. The Charter provided that our objective was to 
assess the current regulatory system for smaller companies under the 
securities laws of the United States, and make recommendations for 
changes. The Charter also directed that we specifically consider the 
following areas of inquiry, including the impact in each area of the 
Sarbanes-Oxley Act of 2002: \2\
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    \1\ This report has been approved by the Committee and reflects 
the views of a majority of its members. It does not necessarily 
reflect any position or regulatory agenda of the Commission or its 
staff.
    Note on Terminology: To aid understanding and improve 
readability, we have tried to avoid using defined terms with initial 
capital letters in this report. We generally use the terms ``public 
company'' and ``reporting company'' interchangeably to refer to any 
company that is required to file annual and quarterly reports with 
the SEC in accordance with either Section 13 or 15(d) of the 
Securities Exchange Act of 1934, 15 U.S.C. 78m or 78o(d). When we 
refer to ``microcap companies,'' we are referring to public 
companies with equity capitalizations of approximately $128 million 
or less. When we discuss ``smallcap companies,'' we are talking 
about public companies with equity capitalizations of approximately 
$128 million to $787 million. We believe these labels generally are 
consistent with securities industry custom and usage. When we refer 
to ``smaller public companies,'' we are referring to public 
companies with equity capitalizations of approximately $787 million 
and less, which includes both microcap and smallcap companies. We 
recognize that formal legal definitions of these terms may be 
necessary to implement some of our recommendations that use them, 
and we discuss our recommendations as to how some of them should be 
defined in Part II.
    \2\ Pub. L. No. 107-204, 116 Stat. 745 (July 30, 2002).
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     Frameworks for internal control over financial reporting 
applicable to smaller public companies, methods for management's 
assessment of such internal control, and standards for auditing such 
internal control;
     Corporate disclosure and reporting requirements and 
federally imposed corporate governance requirements for smaller public 
companies, including differing regulatory requirements based on market 
capitalization, other measurements of size or market characteristics;
     Accounting standards and financial reporting requirements 
applicable to smaller public companies; and
     The process, requirements and exemptions relating to 
offerings of securities by smaller companies, particularly public 
offerings.
    The Charter further directed us to conduct our work with a view to 
furthering the Commission's investor protection mandate, and to 
consider whether the costs imposed by the current regulatory system for 
smaller companies are proportionate to the benefits, identify methods 
of minimizing costs and maximizing benefits and facilitate capital 
formation by smaller companies. The language of our Charter specified 
that we should consider providing recommendations as to where and how 
the Commission should draw lines to scale regulatory treatment for 
companies based on size.
    Our chartering documents \3\ purposely did not define the phrase 
``smaller public company.'' Rather, it was intended that we recommend 
how the term should be defined. In addition, we were advised that we 
were charged with assessing the securities regulatory system for all 
smaller companies, both public and private, and were not limited to 
considering regulations applicable to public companies. The 
Commissioners and the SEC staff did advise us, however, that they hoped 
we would focus primarily on public companies, because of the apparent 
need for prompt attention to that area of concern, especially in view 
of problems in implementing the Sarbanes-Oxley Act of 2002.
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    \3\ The official notice of establishment of the Committee and 
its Charter, included in this report as Appendices A and B, 
respectively, constitute our chartering documents.

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    Our 21 members voted unanimously on April 20, 2006 to adopt this 
Final Report and transmit it to the Commission. The recommendations set 
forth in this report were for the most part adopted unanimously. Where 
one or more members dissented or, while present, abstained from voting 
with respect to a specific recommendation, that fact has been noted in 
the text. Additionally, Parts VII, VIII and IX of this report contains 
separate statements submitted by Mark Jensen, Kurt Schacht and John B. 
Veihmeyer that describe briefly their reasons for disagreeing with 
specific recommendations of the majority of our voting members.

Recommendations

    Our final recommendations are discussed in the remainder of this 
report. Before summarizing our highest priority recommendations below, 
we would like to explain why we have presented them in the order that 
we have. As detailed under the caption ``Part I--Committee History--
Committee Activities,'' we conducted most of our preliminary 
deliberations in four subcommittees, and a ``size task force'' 
comprised of a representative of each subcommittee and Committee Co-
Chair James C. Thyen, who chaired the size task force. The 
subcommittees and the size task force generated preliminary 
recommendations that were discussed and approved by the full Committee. 
We agreed at our meeting on April 20, 2006 to submit to the Commission 
the 32 final recommendations contained in this report.\4\
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    \4\ This does not include two recommendations, which the 
Committee adopted on August 10, 2005 and submitted to the Commission 
in a separate report dated August 18, 2005 (included as Appendix L 
of this report and discussed therein). The Commission acted 
favorably upon these two recommendations in September 2005. See 
Revisions to Accelerated Filer Definition and Accelerated Deadlines 
for Filing Periodic Reports, SEC Release No. 33-8617 (Sept. 22, 
2005); Management's Report on Internal Over Financial Reporting and 
Certification of Disclosure in Exchange Act Reports of Companies 
that are Not Accelerated Filers, SEC Release No. 33-8618 (Sept. 22, 
2005).
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    We recognize that it is unlikely that the Commission and its staff 
will be able to consider, much less act upon, all 32 of these 
recommendations at once. Furthermore, submitting such a large number of 
recommendations, without any indication of the importance or priority 
we ascribe to them, might make the Commission less likely to act upon 
recommendations in areas where we believe the need for action is most 
urgent. Accordingly, we have adopted a two-tiered approach towards the 
prioritization of our recommendations.
    The first tier--the recommendations to which we assign the highest 
priority--we refer to as our ``primary recommendations.'' Our primary 
recommendations are set forth under the specific topic to which they 
relate: Our recommendation concerning establishment of a scaled 
securities regulation system is discussed under the caption ``Part II. 
Scaling Securities Regulation for Smaller Companies''; recommendations 
related to internal control over financial reporting are discussed 
under the caption ``Part III. Internal Control Over Financial 
Reporting''; capital formation, corporate governance and disclosure 
recommendations are discussed under the caption ``Part IV. Capital 
Formation, Corporate Governance and Disclosure''; and accounting 
standards recommendations are discussed under the caption ``Part V. 
Accounting Standards.''
    Before addressing our recommendations, the Committee wishes to 
emphasize that each of our members fully embraces the concepts of good 
governance and transparency. We believe our recommendations are 
designed to further these goals while establishing cost effective 
methods of achieving them.
    Our first primary recommendation concerns establishment of a new 
system of scaled or proportional securities regulation for smaller 
public companies based on a stratification of smaller public companies 
into two groups, microcap companies and smallcap companies. Under this 
recommendation, microcap companies would consist of companies whose 
outstanding common stock (or equivalent) in the aggregate comprises the 
lowest 1% of total U.S. equity market capitalization, and smallcap 
companies would consist of companies whose outstanding common stock (or 
equivalent) in the aggregate comprises the next lowest 5% of total U.S. 
equity market capitalization. Smaller public companies, consisting of 
microcap and smallcap companies, would thus in the aggregate comprise 
the lowest 6% of total U.S. equity market capitalization. While they 
account for only a small percentage of total U.S. equity market 
capitalization, these companies represent a substantial percentage of 
all U.S. public companies, as shown in the table below:

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                                                                                Percentage of
                                                                 Market          total U.S.       Percentage of
                                                             capitalization     equity market    all U.S. public
                                                            cutoff (million)   capitalization       companies
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Microcap Companies........................................            $128.2                 1              52.6
Smallcap Companies........................................       128.2-787.1                 5              25.9
Smaller Public Companies..................................            <787.1                 6              78.5
Larger Public Companies...................................            >787.1                94              21.5
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Source: SEC Office of Economic Analysis, Background Statistics: Market Capitalization and Revenue of Public
  Companies, Table 2 (Aug. 2, 2005) (included as Appendix I). Table includes only the 9,428 U.S. companies
  listed on the New York and American Stock Exchanges, the NASDAQ Stock Market and the OTC Bulletin Board, with
  a total market capitalization of $16,891 million as of June 10, 2005. Table does not include the approximately
  4,586 securities of 4,504 U.S. public companies whose stock trades only on the Pink Sheets, a number of which
  are not required to file annual and quarterly reports with the SEC in accordance with either Section 13 or
  15(d) of the Securities Exchange Act of 1934 and accordingly do not fall within the definition of ``public
  company'' as used in this report. The omission of data concerning Pink Sheets companies understates the
  percentage of U.S. public companies represented by microcap companies. See Appendix J.

    We believe that the Commission should establish this scaled system 
before or in connection with proceeding to examine individual 
securities regulations to determine whether they are candidates for 
integration of scaling treatment under the new system. Because of its 
significance, we felt that this recommendation merited discussion under 
a separate caption. Accordingly, we discuss this recommendation and our 
thoughts about implementing in this approach ``Part II. Scaling 
Securities Regulation for Smaller Companies.''
    Below is a list of our remaining primary recommendations, and the

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location in this report where they are described in greater detail: \5\
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    \5\ We have labeled our recommendations by section in which 
their full description appears, status (either primary (P) or 
secondary (S)), and rank within a given section. Hence the first 
primary recommendation in Part III is Recommendation III.P.1; the 
third secondary recommendation in Part IV is Recommendation IV.S.3, 
etc.
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     Establish a new system of scaled or proportional 
securities regulation for smaller public companies using the following 
six determinants to define a ``smaller public company'':
    [ssbox] The total market capitalization of the company;
    [ssbox] A measurement metric that facilitates scaling of 
regulation;
    [ssbox] A measurement metric that is self-calibrating;
    [ssbox] A standardized measurement and methodology for 
computing market capitalization;
    [ssbox] A date for determining total market 
capitalization; and
    [ssbox] Clear and firm transition rules, i.e., small to 
large and large to small (Recommendation II.P.1).
    Develop specific scaled or proportional regulation for companies 
under the system if they qualify as ``microcap companies'' because 
their equity market capitalization places them in the lowest 1% of 
total U.S. equity market capitalization or as ``smallcap companies'' 
because their equity market capitalization places them in the next 
lowest 1% to 5% of total U.S. equity market capitalization, with the 
result that all companies comprising the lowest 6% would be considered 
for scaled or proportional regulation.
     Unless and until a framework for assessing internal 
control over financial reporting for microcap companies is developed 
that recognizes the characteristics and needs of those companies, 
provide exemptive relief from the requirements of Section 404 of the 
Sarbanes-Oxley Act \6\ to microcap companies with less than $125 
million in annual revenue and to smallcap companies with less than $10 
million in annual product revenue that have or expand their corporate 
governance controls to include:
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    \6\ 15 U.S.C. 7262.
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    [ssbox] Adherence to standards relating to audit committees in 
conformity with Rule 10A-3 under the Securities Exchange Act of 1934; 
\7\ and
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    \7\ 15 U.S.C. 78a et seq.
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     Adoption of a code of ethics within the meaning of Item 
406 of Regulation S-K \8\ applicable to all directors, officers and 
employees and compliance with the further obligations under Item 406(c) 
relating to the disclosure of the code of ethics.
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    \8\ 17 CFR 229.
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    In addition, as part of this recommendation, we recommend that the 
Commission confirm, and if necessary clarify, the application to all 
microcap companies, and indeed to all smallcap companies also, the 
existing general legal requirements regarding internal controls, 
including the requirement that companies maintain a system of effective 
internal control over financial reporting, disclose modifications to 
internal control over financial reporting and their material 
consequences, and apply CEO and CFO certifications to such disclosures. 
Moreover, management should be required to report on any known material 
weaknesses. In this regard, the Proposed Statement on Auditing 
Standards of the AICPA, ``Communications of Internal Control Related 
Matters Noted in an Audit,'' if adopted by the AICPA and the Public 
Company Accounting Oversight Board (PCAOB), would strengthen this 
disclosure requirement and provide some external auditor involvement in 
the internal control over financial reporting process. (Recommendation 
III.P.1).
     Unless and until a framework for assessing internal 
control over financial reporting for smallcap companies is developed 
that recognizes the characteristics and needs of those companies, 
provide exemptive relief from external auditor involvement in the 
Section 404 process to smallcap companies with less than $250 million 
but greater than $10 million in annual product revenues, subject to 
their compliance with the same corporate governance standards detailed 
in the recommendation above (Recommendation III.P.2).
     While we believe that the costs of the requirement for an 
external audit of the effectiveness of internal control over financial 
reporting are disproportionate to the benefits, and have therefore 
adopted the second Section 404 recommendation above, we also believe 
that if the Commission reaches a public policy conclusion that an audit 
requirement is required, we recommend that changes be made to the 
requirements for implementing Section 404's external auditor 
requirement to a cost-effective standard, which we call ``ASX,'' 
providing for an external audit of the design and implementation of 
internal controls (Recommendation III.P.3).
     Incorporate the scaled disclosure accommodations currently 
available to small business issuers under Regulation S-B into 
Regulation S-K, make them available to all microcap companies, and 
cease prescribing separate specialized disclosure forms for smaller 
companies (Recommendation IV.P.1).
     Incorporate the primary scaled financial statement 
accommodations currently available to small business issuers under 
Regulation S-B into Regulation S-K or Regulation S-X and make them 
available to all microcap and smallcap companies (Recommendation 
IV.P.2).
     Allow all reporting companies listed on a national 
securities exchange, NASDAQ or the OTC Bulletin Board to be eligible to 
use Form S-3, if they have been reporting under the Exchange Act for at 
least one year and are current in their reporting at the time of filing 
(Recommendation IV.P.3).
     Adopt policies that encourage and promote the 
dissemination of research on smaller public companies (Recommendation 
IV.P.4).
     Adopt a new private offering exemption from the 
registration requirements of the Securities Act of 1933 (the 
``Securities Act'') \9\ that does not prohibit general solicitation and 
advertising for transactions with purchasers who do not need all the 
protections of the Securities Act's registration requirements. 
Additionally, relax prohibitions against general solicitation and 
advertising found in Rule 502(c) under the Securities Act to parallel 
the ``test the waters'' model of Rule 254 under that Act 
(Recommendation IV.P.5).
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    \9\ 15 U.S.C. 77a et seq.
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     Spearhead a multi-agency effort to create a streamlined 
NASD registration process for finders, M&A advisors and institutional 
private placement practitioners (Recommendation IV.P.6).
     Develop a ``safe-harbor'' protocol for accounting for 
transactions that would protect well-intentioned preparers from 
regulatory or legal action when the process is appropriately followed 
(Recommendation V.P.1).
     In implementing new accounting standards, the FASB should 
permit microcap companies to apply the same extended effective dates 
that it provides for private companies (Recommendation V.P.2).
     Consider additional guidance for all public companies with 
respect to materiality related to previously issued financial 
statements (Recommendation V.P.3).
     Implement a de minimis provision in the application of the 
SEC's auditor independence rules (Recommendation V.P.4).
    Our second tier consists of all of the remaining recommendations, 
which we

[[Page 11094]]

refer to in this report as ``secondary recommendations.'' Although we 
have assigned these a lower priority than the recommendations set forth 
above, we do not in any way intend to diminish their importance. In 
this regard, we note that importance is at times not only a function of 
the perceived need for change but also the perceived ease with which 
the Commission could enact such change; as noted throughout the report, 
many problems simply defy easy solution. Moreover, several of these 
recommendations are aspirational in nature, and do not involve specific 
Commission action. As with the primary recommendations, these secondary 
recommendations are set forth under the specific topics to which they 
relate, and within each such section, recommendations are presented in 
descending order of importance (i.e., the secondary recommendation that 
we would most like to see adopted is listed first, etc.).

Part I. Committee History

    On December 16, 2004, then SEC Chairman William H. Donaldson 
announced the Commission's intent to establish the SEC Advisory 
Committee on Smaller Public Companies.\10\ At the same time, Chairman 
Donaldson announced his intention to name Herbert S. Wander and James 
C. Thyen as Co-Chairs of the Committee. The official notice of our 
establishment was published in the Federal Register five days 
later.\11\ The Committee's membership was completed on March 7, 2005, 
with members drawn from a wide range of professions, backgrounds and 
experiences.\12\ The Committee's Charter was filed with the Senate 
Committee on Banking, Housing and Urban Affairs and the House Committee 
on Financial Services on March 23, 2005, initiating our 13-month 
existence.\13\
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    \10\ SEC Establishes Advisory Committee to Examine Impact of 
Sarbanes-Oxley Act on Smaller Public Companies, SEC Press Release 
No. 2004-174 (Dec. 16, 2004) (included as Appendix D).
    \11\ Advisory Committee on Smaller Public Companies, SEC Release 
No. 33-8514 (Dec. 21, 2004) [69 FR 76498] (included as Appendix B).
    \12\ SEC Chairman Donaldson Announces Members of Advisory 
Committee on Smaller Public Companies, SEC Press Release No. 2005-30 
(Mar. 7, 2005) (included as Appendix E). This press release 
describes the diverse backgrounds of the Committee members.
    \13\ See Committee Charter (included as Appendix B).
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Committee Activities

    We held our organizational meeting on April 12, 2005 in Washington, 
DC, where Chairman Donaldson swore in and addressed our members. Also 
at that meeting, we adopted our by-laws, proposed a Committee Agenda to 
be published for public comment \14\ and reviewed a subcommittee 
structure and Master Schedule prepared by our Co-Chairs. This and all 
of our subsequent meetings were open to the public and conducted in 
accordance with the requirements of the Federal Advisory Committee 
Act.\15\ All meetings of the full Committee also were Web cast over the 
Internet.
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    \14\ The Record of Proceedings of this and subsequent meetings 
of the Committee are available on our Web site at http://www.sec.gov/info/smallbus/ascpc.shtml. See Record of Proceedings, 
Meeting of the Securities and Exchange Commission Advisory Committee 
on Smaller Public Companies (Apr. 12, June 16, June 17, Aug. 9, Aug. 
10, Sept. 19, Sept. 20, Oct. 24, Oct. 25 & Dec. 14, 2005 & Feb. 21, 
Apr. 11 & Apr. 20, 2006) (on file in SEC Public Reference Room File 
No. 265-23), available at http://www.sec.gov/info/smallbus/ascpc.shtml (hereinafter Record of Proceedings (with appropriate 
date)).
    \15\ 5 U.S.C.--App. 1 et seq.
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    Shortly following our formation, we adopted several overarching 
principles to guide our efforts:
     Further Commission's investor protection mandate.
     Seek cost choice/benefit inputs.
     Keep it simple.
     Maintain culture of entrepreneurship.
     Capital formation should be encouraged.
     Recommendations should be prioritized.
    We held subsequent meetings in 2005 on June 16 and 17 in New York 
City, August 9 and 10 in Chicago, September 19 and 20 in San Francisco, 
and October 14 again in New York City. A total of 42 witnesses 
testified at these meetings.\16\ We adopted our Committee Agenda at the 
June 16 meeting in New York.\17\ We adopted two recommendations to the 
Commission at our Chicago meeting, where we also adopted an internal 
working definition of the term ``smaller public company.'' \18\ We held 
additional meetings in Washington on October 24 and 25 and December 14, 
2005 and February 21, 2006 to consider and vote on recommendations and 
the draft of our final report to the Commission. SEC Chairman 
Christopher Cox, who had succeeded Chairman Donaldson on August 3, 
2005, addressed us at the October 24 meeting in Washington. No 
witnesses testified at the additional meetings in Washington.
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    \16\ Appendix K contains a list of witnesses who testified 
before the Committee.
    \17\ The Committee Agenda is included as Appendix C.
    \18\ The Chicago recommendations were submitted to the 
Commission by letter dated August 18, 2005 to SEC Chairman 
Christopher Cox, who had succeeded Chairman Donaldson. The text of 
the letter is included as Appendix L. The letter included copies of 
documents entitled ``Six Determinants of a Smaller Public Company'' 
and ``Definition of Smaller Public Company,'' which had been made 
available to the Committee before it adopted its definition of the 
term ``smaller public company.''
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    The Committee, through the Commission, published three releases in 
the Federal Register formally seeking public comment on issues it was 
considering. On April 29, 2005, we published a release seeking comments 
on our proposed Committee Agenda,\19\ in response to which we received 
---- written submissions. On August 2, 2005, we published 29 questions 
on which we sought public input, to which we received 266 
responses.\20\ Finally, on ------ ------, 2006, we published an 
exposure draft of our final report,\21\ which generated ---- written 
submissions. In addition, each meeting of the Committee was announced 
by formal notice in a Federal Register release, and each such notice 
included an invitation to submit written statements to be considered in 
connection with the meeting. In total, we received ---- written 
statements in response to Federal Register releases.\22\
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    \19\ Summary of Proposed Committee Agenda of Advisory Committee 
on Smaller Public Companies, SEC Release No. 33-8571, (Apr. 29, 
2005) [70 FR 22378].
    \20\ See Request for Public Input by Advisory Committee on 
Smaller Public Companies, SEC Release No. 33-8599 (Aug. 5, 2005) [70 
FR 45446] (included as Appendix H).
    \21\ ---- -------- ----, SEC Release No. 33----- (2006).
    \22\ All of the written submissions made to the Committee are 
available in the SEC's Public Reference Room in File No. 265-23 and 
on the Committee's Web page at http://www.sec.gov/rules/other/265-23.shtml. To avoid duplicative material in footnotes, citations to 
the written submissions made to the Committee in this Final Report 
do not reference the Public Reference Room or repeat the Public 
Reference Room file number.
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    In addition to work carried out by the full Committee, fact finding 
and deliberations also took place within four subcommittees appointed 
by our Co-Chairs. The subcommittees were organized according to their 
principal areas of focus: Accounting Standards, Capital Formation, 
Corporate Governance and Disclosure, and Internal Control Over 
Financial Reporting. Each of the subcommittees prepared recommendations 
for consideration by the full Committee. We approved preliminary 
versions of most recommendations at our December 14, 2005 meeting. A 
fifth subgroup, sometimes referred to as the ``size task force'' in our 
deliberations, consisted of one volunteer from each subcommittee and 
our Co-Chair James C. Thyen. The size task force met to consider common 
issues faced by the subcommittees relating to establishment of 
parameters for eventual recommendations on

[[Page 11095]]

scalability of regulations based on company size. The task force 
developed internal working guidelines for the subcommittees to use for 
this purpose and reported them to the full Committee at our August 10, 
2005 meeting.\23\ We voted to approve the guidelines, which are 
discussed in the next part of this report.
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    \23\ See Record of Proceedings 62-103 (Aug. 10, 2005).
---------------------------------------------------------------------------

Part II. Scaling Securities Regulation for Smaller Companies

    We developed a number of recommendations concerning the 
Commission's overall policies relating to the scaling of securities 
regulation for smaller public companies. As discussed below, we believe 
that these recommendations are fully consistent with the original 
intent and purpose of our Nation's securities laws.\24\ We believe 
that, over the years, some of the original principles underlying our 
securities laws, including proportionality, have been underemphasized, 
and that the Commission should seek to restore balance in these areas 
where appropriate.
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    \24\ For background on the history of scaling federal securities 
regulation for smaller companies, see the discussion under the 
caption ``--Commission Has a Long History of Scaling Regulation'' 
below.
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    Our primary recommendation concerning scaling, and one that 
underlies several other recommendations that follow in this report, is 
as follows:
Recommendation II.P.1
    Establish a new system of scaled or proportional securities 
regulation for smaller public companies using the following six 
determinants to define a ``smaller public company'':
    The total market capitalization of the company;
    [ssbox] A measurement metric that facilitates scaling of 
regulation;
    [ssbox] A measurement metric that is self-calibrating;
    [squf] A standardized measurement and methodology for 
computing market capitalization;
    [squf] A date for determining total market 
capitalization; and
    [squf] Clear and firm transition rules, i.e., small to 
large and large to small.
    Develop specific scaled or proportional regulation for companies 
under the system if they qualify as ``microcap companies'' because 
their equity market capitalization places them in the lowest 1% of 
total U.S. equity market capitalization or as ``smallcap companies'' 
because their equity market capitalization places them in the next 
lowest 1% to 5% of total U.S. equity market capitalization, with the 
result that all companies comprising the lowest 6% would be considered 
for scaled or proportional regulation.\25\
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    \25\ Mr. Schacht abstained from voting on this recommendation. 
All other members present voted in favor of this recommendation.
---------------------------------------------------------------------------

    This new system would replace the SEC's current scaling system for 
``small business issuers'' eligible to use Regulation S-B \26\ as well 
as the current scaling system based on ``non-accelerated filer'' 
status,\27\ but would provide eligibility for scaled regulation for 
companies based on their size relative to larger companies.\28\
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    \26\ Regulation S-B can be found at 17 CFR 228.
    \27\ ``Non-accelerated filers'' are public companies that do not 
qualify as ``accelerated filers'' under the SEC's definition of the 
latter term in 17 CFR 240.12b-2, generally because they have a 
public float of less than $75 million. Companies that do not qualify 
as accelerated filers have more time to file their annual and 
quarterly reports with the SEC and have not yet been required to 
comply with the internal control over financial reporting 
requirements of Sarbanes-Oxley Act Section 404.
    \28\ We believe our recommended system complements the SEC's 
recently promulgated securities offering reforms, which are 
principally available to a category of public companies with over 
$700 million in public float known as ``well-known seasoned 
issuers.'' We recognize, however, that the Commission will need to 
assure that our recommendations, if adopted, are integrated well 
with the categories of companies established in the securities 
offering reform initiatives.
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    Under our recommended system, companies would be eligible for 
special scaled or proportional regulation if they fall into one of two 
categories of smaller public companies based on size. We call one 
category ``microcap companies'' and the other ``smallcap companies.'' 
Both categories of companies would be included in the category of 
``smaller public companies'' that qualify for the new scaled regulatory 
system. Companies whose common stock (or equivalent) in the aggregate 
comprises the lowest 1% of total U.S. equity market capitalization 
(companies with equity capitalizations below approximately $128 million 
\29\) would qualify as microcap companies. Companies whose common stock 
(or equivalent) in the aggregate comprises the next lowest 5% of total 
U.S. equity market capitalization (companies with equity 
capitalizations between approximately $128 million and $787 million) 
generally would qualify as smallcap companies.\30\ Smallcap companies 
would be entitled to the regulatory scaling provided by SEC regulations 
for companies of that size after study of their characteristics and 
special needs.
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    \29\ SEC Office of Economic Analysis, Background Statistics: 
Market Capitalization and Revenue of Public Companies (Aug. 2, 2005) 
(included as Appendix I). Data was derived from Center for Research 
in Security Prices (CRSP) for 9,428 New York and American Stock 
Exchange companies as of March 31, 2005 and from NASDAQ for NASDAQ 
Stock Market and OTC Bulletin Board firms as of June 10, 2005.
    \30\ Id.
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    Under the system we are recommending, microcap companies generally 
would be entitled to the accommodations afforded to small business 
issuers and non-accelerated filers under the SEC's current rules. 
Smallcap companies would be entitled to whatever accommodations the SEC 
decides to provide them in the future. As discussed below, we are 
recommending that the SEC provide certain relief under Sarbanes-Oxley 
Act Section 404 to certain smaller public companies.\31\ We also are 
recommending that the SEC permit smaller public companies to follow the 
financial statement rules now followed by small business issuers under 
Item 310 of Regulation S-B rather than the financial statement rules in 
Regulation S-X currently followed by all companies that are not small 
business issuers.\32\
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    \31\ See the discussion in Part III below.
    \32\ See the discussion in Part IV below.
---------------------------------------------------------------------------

    Our primary reason for recommending special scaled regulation for 
companies falling in the aggregate in the lowest 6% of total U.S. 
equity market capitalization is that this cutoff assures the full 
benefits and protection of federal securities regulation for companies 
and investors in 94% of the total public U.S. equity capital 
markets.\33\ This limits risk and exposure to investors and protects 
investors from serious losses (e.g., 100 bankruptcies companies with 
$10 million total market capitalization would be required to equal the 
potential loss of the bankruptcy of a company with $1 billion of market 
capitalization). Our recommended standard acknowledges the relative 
risk to investors and the capital markets as it is currently used by 
professional investors.
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    \33\ We recognize that, if the Commission determines to 
implement our recommendation, it may want to examine the 
distinguishing characteristics of the group of ``smaller public 
companies'' to which it intends to provide specific regulatory 
relief. We have done this in developing our recommendations set out 
in ``Part III. Internal Control Over Financial Reporting.'' A 
comment letter recently sent to the Commission also went through 
this exercise in making recommendations with respect to application 
of Section 404 of the Sarbanes-Oxley Act to smaller public 
companies. See Letter from BDO Seidman, LLP, at 2-3 (Oct. 31, 2005) 
(on file in SEC Public Reference Room File No. S7-06-03), available 
at http://www.sec.gov/rules/proposed/s70603/bdoseidman103105.pdf.
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    In addition, we considered the SEC's recent adoption of rules 
reforming the

[[Page 11096]]

securities offering process.\34\ Reporting companies with a public 
float of $700 million or more, called ``well-known seasoned issuers,'' 
generally will be permitted to benefit to the greatest degree from 
securities offering reform. We are hopeful that the Commission will see 
fit to adopt a disclosure system applicable to ``smaller public 
companies'' that integrates well with the disclosure and other rules 
applicable to ``well-known seasoned issuers.'' We believe that 
companies that qualify as ``smaller public companies'' on the basis of 
equity market capitalization should not also qualify as ``well-known 
seasoned issuers.''
---------------------------------------------------------------------------

    \34\ See Securities Offering Reform, SEC Release No. 33-8591 
(July 19, 2005) [70 FR 44722].
---------------------------------------------------------------------------

    We recommend that the SEC implement this recommendation by 
promulgating regulations under which all U.S. companies with equity 
securities registered under the Exchange Act would be ranked from 
largest to smallest equity market capitalization at each recalculation 
date.\35\ The ranges of market capitalizations entitling public 
companies to qualify as a ``microcap company'' and ``smallcap company'' 
would be published soon after the recalculation. These ranges would 
remain valid until the next recalculation date. Companies would be able 
to determine whether they qualify for microcap and smallcap company 
treatment by comparing their market capitalization on their 
determination date, presumably the last day of their previous fiscal 
year, with the ranges published by the SEC for the most recent 
recalculation date.\36\ The determination so would then be used to by 
companies to determine their status for the next fiscal year. This is 
what we mean when we say that the measurement metric for determining 
smaller public company status should be ``self-calibrating.''
---------------------------------------------------------------------------

    \35\ We leave to the Commission's discretion the frequency with 
which this recalculation should occur, but note that frequent 
recalculation, even on an annual basis, could introduce an 
undesirable level of uncertainty into the process for companies 
trying to determine where they fall within the three categories.
    \36\ In formulating this recommendation, we looked for guidance 
at the method used to calculate the Russell U.S. Equity Indexes. For 
more information on Russell's method, see Russell U.S. Equity 
Indexes, Construction and Methodology (July 2005)), available at 
www.russell.com.
---------------------------------------------------------------------------

    In promulgating these rules, the SEC will need to establish clear 
transition rules providing how companies would graduate from the 
microcap category to the smallcap category to the realm where they 
would not be entitled to smaller public company scaling. The transition 
rules would also need to specify how companies would move from one 
category to another in the reverse order, from no scaling entitlement 
to smallcap company treatment to microcap entitlement. The SEC has 
experience and precedents to follow in its transition rules governing 
movement to and from Regulation S-B and Regulation S-K, non-accelerated 
filer status and accelerated filer status, and well-known seasoned 
issuer eligibility and non-eligibility.
    We believe that our plan for providing scaled regulatory treatment 
for smaller public companies contains features that recommend it over 
some other SEC regulatory formats. For example, it provides for a 
flexible measurement that can move up and down, depending on stock 
price and other market levels. It avoids the problem of setting a 
dollar amount standard that needs to be revisited and rewritten from 
time to time, and consequently provides a long-term solution to the 
problem of re-scaling securities regulation for smaller public 
companies every few years. Finally, assuming the plan is implemented as 
we intend, the system would provide full transparency and allow each 
company and its investors to determine the company's status in advance 
or at any time based on publicly available information. This would 
allow companies to plan for transitions suitably in advance of 
compliance with new regulations.
    We recommend that the SEC use equity market capitalization, rather 
than public float, to determine eligibility for smaller public company 
treatment for several reasons.\37\ We are aware that the SEC 
historically has used public float as a measurement in analogous 
regulatory contexts.\38\ However, we recommend that the SEC use equity 
capitalization, rather than public float, to determine eligibility for 
smaller public companies for several reasons. First, we believe that 
equity market capitalization better measures total risk to investors 
(including affiliates, some of whom may not have adequate access to 
information) and the U.S. capital markets than public float, and 
consequently that it is the most relevant measure in determining which 
companies initially should qualify for scaled securities regulatory 
treatment based on size. We also believe that using market 
capitalization has the additional advantage of simplicity, as it avoids 
what can be the difficult problem of deciding for legal purposes which 
holdings are public float and which are not.\39\ This can be a 
subjective determination; not all companies reach the same conclusions 
on this issue based on similar facts, which can lead to problems of 
comparability.
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    \37\ The Commission would, of course, need to prescribe a 
standardized methodology for computing market capitalization.
    \38\ For example, a public float test is used to determine a 
company's eligibility to use Forms SB-2, F-3 and S-3 and non-
accelerated filer status.
    \39\ Because public float by definition excludes shares held by 
affiliates, calculation of public float relies upon an accurate 
assessment of affiliate status of officers, directors and 
shareholders. As the Commission acknowledged in the Rule 144 
context, this requires a subjective, facts and circumstances 
determination that entails a great deal of uncertainty. See Revision 
of Rule 144, Rule 145 and Form 144, SEC Release No. 33-7391 (Feb. 
20, 1997) [62 FR 9246].
---------------------------------------------------------------------------

    In formulating our scaling recommendation, we considered a number 
of alternatives to market capitalization as the primary metric for 
determining eligibility for scaling, including revenues. Ultimately, 
however, we felt that any benefits to be derived from adding additional 
metrics to the primary formula were outweighed by the additional 
complexity that introduction of those additional size parameters would 
entail. We wish to make it clear, however, that we believe that 
additional determinants based on other metrics of size may be 
appropriate in the context of individual securities regulations. For 
example, our own recommendations on internal control over financial 
reporting contain metrics conditioning the availability of scaling 
treatment on company annual revenues.

Commission Has a Long History of Scaling Regulation

    Since federal securities regulation began in the 1930's, it has 
been recognized that some companies and transactions are of 
insufficient magnitude to warrant full federal regulation, or any 
federal regulation at all. Smaller public companies primarily have been 
subject to two securities statutes, the Securities Act and the Exchange 
Act. The Securities Act, originally enacted to cover distributions of 
securities, has from the beginning contained a ``small issue'' 
exemption in Section 3(b) \40\ that gives the SEC rulemaking authority 
to exempt any securities issue up to a specified maximum amount. This 
amount has grown in stages, from $100,000 in 1933 to $5 million since 
late 1980.\41\ The Exchange Act originally was enacted to regulate 
post-distribution trading in securities. It did so by requiring 
registration by companies of classes of

[[Page 11097]]

their securities. At first, the Exchange Act required companies to 
register only if their securities were traded on a national securities 
exchange. This assured that smaller companies of insufficient size to 
warrant exchange listing would not be subject to overly burdensome 
federal securities regulation.
---------------------------------------------------------------------------

    \40\ 15 U.S.C. 77c(b).
    \41\ Louis Loss & Joel Seligman, Fundamentals of Securities 
Regulation 387 (2004). The Commission has adopted a number of 
exemptive measures for small issuers pursuant to its authority under 
Section 3(b), including Rules 504 and 505, Regulation A and the 
original version of Rule 701.
---------------------------------------------------------------------------

    In 1964, Congress extended the reach of most of the Exchange Act's 
public company provisions to cover companies whose securities trade 
over-the-counter.\42\ Since all securities other than exchange-listed 
securities technically trade ``over-the-counter,'' this expansion 
required limiting the companies covered to avoid creating a burden on 
issuers and the Commission that was ``unwarranted by the number of 
investors protected, the size of companies affected, and other factors 
bearing on the public interest.'' \43\ Congress wanted to ensure that 
``the flow of reports and proxy statements [would] be manageable from 
the regulatory standpoint and not disproportionately burdensome on 
issuers in relation to the national public interest to be served.'' 
\44\ Accordingly, Congress chose to limit coverage to companies with a 
class of equity security held of record by at least 500 persons and net 
assets above $1 million.\45\ Over time, the standard set by Congress at 
500 equity holders of record and $1 million in net assets required 
adjustment to assure that the burdens placed on issuers and the 
Commission were justified by the number of investors protected, the 
size of companies affected, and other factors bearing on the public 
interest, as originally intended by Congress. The Commission has raised 
the minimum net asset level several times; it now stands at $10 
million.\46\
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    \42\ Securities Acts Amendments of 1964, Pub. L. No. 88-467, 78 
Stat. 565 (adding Section 12(g), among other provisions, to the 
Exchange Act).
    \43\ S. Rep. No. 88-379, at 19 (1963).
    \44\ Id.
    \45\ 15 U.S.C. 78l(g).
    \46\ 17 CFR 240.12g5-1.
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    In 1992, the Commission adopted Regulation S-B,\47\ a major 
initiative that allows companies qualifying as ``small business 
issuers'' (currently, companies with revenues and a public float of 
less than $25 million \48\) to use a set of abbreviated disclosure 
rules scaled for smaller companies. In 2002, the Commission divided 
public companies into two categories, ``accelerated filers'' and ``non-
accelerated filers,'' and in 2005 added a third category of ``large 
accelerated filers,'' providing scaled securities regulation for these 
three tiers of reporting companies.\49\ Non-accelerated filers are 
fundamentally public companies with a public float below $75 million, 
and large accelerated filers are public companies with a public float 
of $700 million or more.\50\
    Notwithstanding the benefits to which smaller business issuers and 
non-accelerated filers are entitled under the Commission's current 
rules, we believe significant changes to the federal securities 
regulatory system for smaller public companies, such as those 
recommended in this report, are required to assure that it is properly 
scaled for smaller public companies. Our experience with smaller public 
companies, as well as the testimony and written statements we received, 
support this view. We believe that the problem of improper scaling for 
smaller public companies has existed for many years, and that the 
additional regulations imposed by the Sarbanes-Oxley Act only 
exacerbated the problem and caused it to become more visible.
---------------------------------------------------------------------------

    \47\ 17 CFR 228.10 et seq.
    \48\ 17 CFR 228.10(a)(1). ``Small business issuers'' must also 
be U.S. or Canadian companies, not investment companies and not 
majority owned subsidiaries of companies that are not small business 
issuers.
    \49\ See Acceleration of Periodic Report Filing Dates and 
Disclosure Concerning Web site Access to Report, SEC Release No. 33-
8128 (Sept. 16, 2002) [67 FR 58480].
    \50\ 17 CFR 240.12b-2. Both accelerated filers and large 
accelerated filers must also have been reporting for at least 12 
months, have filed at least one annual report and not be eligible to 
use Forms 10-KSB and 10-QSB.
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Part III. Internal Control Over Financial Reporting

Introduction

    From the earliest stages of its implementation, Sarbanes-Oxley Act 
Section 404 has posed special challenges for smaller public companies. 
To some extent, the problems smaller companies have in complying with 
Section 404 are the problems of companies generally:
     Lack of clear guidance;
     An unfamiliar regulatory environment;
     An unfriendly legal and enforcement atmosphere that 
diminishes the use and acceptance of professional judgment because of 
fears of second-guessing by regulators and the plaintiff's bar; \51\
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    \51\ See Conference Panelists Discuss Earnings Guidance and 
Accounting Issues, SEC Today (Feb. 14, 2006), at 2 (quoting Teresa 
Iannaconi as stating that while she believes the PCAOB is sincere in 
its attempt to bring greater efficiency to the audit process, 
accounting firms are not ready to step back, because they have all 
received deficiency letters, none of which say that the auditors 
should be doing less rather than more).
---------------------------------------------------------------------------

     A focus on detailed control activities by auditors; and
     The lack of sufficient resources and competencies in an 
area in which companies and auditors have previously placed less 
emphasis.
    But because of their different operating structures, smaller public 
companies have felt the effects of Section 404 in a manner different 
from their larger counterparts. With more limited resources, fewer 
internal personnel and less revenue with which to offset both 
implementation costs and the disproportionate fixed costs of Section 
404 compliance, these companies have been disproportionately subject to 
the burdens associated with Section 404 compliance. Moreover, the 
benefits of documenting,\52\ testing and certifying the adequacy of 
internal controls, while of obvious importance for large multinational 
corporations, are of less certain value for smaller public companies, 
who rely to a greater degree on ``tone at the top'' and high-level 
monitoring controls, which may be undocumented and untested, to 
influence accurate financial reporting. The result is a cost/benefit 
equation that, many believe, diminishes shareholder value, makes 
smaller public companies less attractive as investment opportunities 
and impedes their ability to compete.
---------------------------------------------------------------------------

    \52\ SEC rules require that a company maintain evidential 
matter, including documentation, to provide reasonable support for 
management's assessment of the effectiveness of the company's 
internal control over financial reporting. See Section II.B. of 
Management's Reports on Internal Control Over Financial Reporting 
and Certification of Disclosure in Exchange Act Periodic Reports, 
SEC Release No. 33-8238 (June 5, 2003) [68 FR 36636]. See note 58 
infra.
---------------------------------------------------------------------------

    This last factor is particularly problematic in light of the 
crucial role smaller public companies play in job creation and economic 
growth. In addition, we are increasingly participating in a global 
economy and (1) the much higher costs for Sarbanes-Oxley compliance in 
general, and Section 404 compliance in particular, (2) the loss of 
foreign issuers who are either not listing in the U.S. or are departing 
from U.S. markets and (3) domestic issuers who are going dark or 
private could pose significant competitive risks to U.S. companies and 
markets.\53\
---------------------------------------------------------------------------

    \53\ See William J. Carney, The Costs of Being Public After 
Sarbanes-Oxley: The Irony of `Going Private,' Emory Law and 
Economics Research Paper No. 05-4 at 1 (Feb. 2005), available at 
SSRN: http://ssrn.com/abstract=672761 (``In an economically rational 
world we don't want to prevent all fraud, because that would be too 
expensive. Instead, the goal should be to keep on spending on fraud 
prevention until the returns on a dollar invested in prevention are 
no more than a dollar. There is an `Optimal Amount of Fraud.' ''); 
Roberta Romano, The Sarbanes-Oxley Act and the Making of Quack 
Corporate Governance, 114 Yale L. J. 1521, 1587-91 (2005); Joseph A. 
Grundfest, Fixing 404 (2005) (unpublished manuscript, on file in SEC 
Public Reference Room File No. 265-23) (``While there is substantial 
debate over the costs and benefits of Section 404 as implemented by 
PCAOB Statement No. 2, there is far greater consensus that these 
rules are not cost effective. Put another way, regardless of whether 
Section 404's social benefits exceed its social costs, a very large 
portion of Section 404's benefits can be generated while imposing 
substantially lower costs on the economy. Consistent with this view, 
the current head of the PCAOB states `It is * * * clear to us that 
the first sound of internal control audits cost too much.' '') 
Moreover, Congress, in the form of Securities Act Section 2(b), has 
mandated that whenever the SEC engages in rulemaking it is required 
to consider in addition to the protection of investors, whether the 
action will promote efficiency, competition and capital formation. 
See Peter J. Wallison, Buried Treasure: A Court Rediscovers A 
Congressional Mandate the SEC Has Ignored, AEI Online (Oct. 2005) 
available at http://www.aei.org/publications/pubID.23310/pub_detail.asp. See also infra notes 87 through 90 and accompanying 
text.

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[[Page 11098]]

    We acknowledge that in the course of our deliberations we heard 
certain respected persons question whether the Section 404 problem for 
smaller public companies is, in fact, overstated.\54\ In the view of 
some, the benefits of Section 404 for small companies outweigh the 
costs, authoritative guidance for smaller public companies will provide 
issuers with sufficient guidance in areas where clarity is currently 
lacking, and at any rate Section 404 expenditures will decrease 
substantially as issuers and their auditors become more familiar with 
the law's requirements. However, the experience of most of our members, 
and the outpouring of testimony, comment letters and input we received, 
suggests otherwise.
---------------------------------------------------------------------------

    \54\ See, e.g., Record of Proceedings 64 (Sept. 19, 2005) 
(testimony of Lynn E. Turner), available at http://www.sec.gov/info/smallbus/acspc/acspctranscript091905.pdf.
---------------------------------------------------------------------------

    After thorough consideration of the evidence presented, we believe 
that Section 404 represents a clear problem for smaller public 
companies and their investors, one for which relief is urgently needed. 
Our recommendations as to how to improve the existing structure, 
consistent with investor protections, are discussed below. Although 
these recommendations are based upon 13 months of intensive study and 
debate, they essentially derive from a few fundamental ideas: the 
primary objective of internal control over financial reporting 
requirements should be the prevention of materially inaccurate 
financial statements; companies operate differently, depending on size, 
and internal control rules should reflect this fact; and the benefits 
of any regulatory burden--Section 404-related or otherwise--should 
outweigh the costs.
    Because an appreciation of the existing Section 404 problem 
requires an understanding of the problem's origin, we have included 
below a brief background section, followed by an overview of our 
recommendations and the recommendations themselves.

Background of Section 404

    Sarbanes-Oxley Act Section 404 directed the SEC to adopt rules 
requiring all reporting companies, other than registered investment 
companies, to include in their annual reports a statement of 
management's responsibility for establishing and maintaining adequate 
internal control over financial reporting, together with an assessment 
of the effectiveness of those internal controls. Section 404 further 
required that the company's independent auditors attest to, and report 
on, this management assessment.
    In accordance with Congress' directive, on June 5, 2003 the 
Commission adopted the basic rules implementing Section 404 with regard 
to management's obligations to report on internal control over 
financial reporting.\55\ In addition, on June 17, 2004 the Commission 
issued an order approving PCAOB Auditing Standard No. 2, entitled An 
Audit of Internal Control over Financial Reporting Performed in 
Conjunction with an Audit of the Financial Statements (AS2), which 
established the requirements that apply to an independent auditor when 
performing an audit of a company's internal control over financial 
reporting.\56\ The rules adopted by the Commission and the PCAOB 
implementing Section 404 require management to base its evaluation of 
internal control over financial reporting on a suitable, recognized 
control framework that is established by a body or group that has 
followed due-process procedures, including the broad distribution of 
the framework for public comment.\57\ Commission rules implementing 
both Section 404 and AS2 specifically identify the internal control 
framework published by the Committee of Sponsoring Organizations of the 
Treadway Commission (COSO) (the COSO Framework) as suitable for such 
purposes, and indeed, the COSO Framework has emerged as the only 
internal control framework available in the U.S. and the framework used 
by virtually all U.S. companies.\58\
---------------------------------------------------------------------------

    \55\ SEC Release No. 33-8238 (June 5, 2003) [68 FR 36636].
    \56\ SEC Release No. 34-49884 (June 17, 2004) [69 FR 35083].
    \57\ See Exchange Act Rules 13a-15(c) and 15d-15(c), 17 CFR 
240.13a-15(c) & 240.15d-15(c).
    \58\ COSO is a voluntary private sector organization sponsored 
by the American Institute of Certified Public Accountants (AICPA), 
the American Accounting Association, Financial Executives 
International, the Institute of Internal Auditors, and the Institute 
of Management Accountants. COSO published the COSO Framework, 
formally titled ``Internal Control--Integrated Framework, in 1992. 
The COSO Framework is available at http://www.coso.org/publications/executive_summary_integrated_framework.htm. The COSO Framework 
presents a common definition of internal control and provides a 
framework against which internal controls within a company can be 
assessed and improved. Under the COSO Framework, internal control 
over financial reporting is defined as a process, effected by an 
entity's board of directors, management and other personnel, 
designed to provide reasonable assurance regarding the achievement 
of objectives in the reliability of financial reporting. Internal 
control over financial reporting includes five interrelated 
components: Control environment, risk assessment, control 
activities, information and communication, and monitoring. The COSO 
Framework recognizes that formal documentation is not always 
necessary, and that informal and undocumented controls, even when 
communicated orally, can be highly effective. See COSO Framework at 
30, 73.
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    As noted above, during the early stages of implementation of 
Section 404, it became clear that smaller public companies, due to 
their size and structure, were experiencing significant challenges, 
both in implementing that provision's requirements and in applying the 
SEC and PCAOB-endorsed COSO Framework. Many expressed serious concerns 
about the ability to apply Section 404 to smaller public companies in a 
cost-effective manner, and also about the need for additional guidance 
for smaller businesses in applying the COSO Framework. Against this 
backdrop, and at the encouragement of the SEC staff, COSO in October 
2005 issued for public comment an exposure draft entitled ``Guidance 
for Smaller Public Companies Reporting on Internal Control over 
Financial Reporting.'' \59\ While intended to provide much needed 
clarity, the guidance has to date received mixed reviews, with many 
questioning whether it will significantly change the disproportionate 
cost and other burdens or the cost/benefit equation associated with 
Section 404 compliance for smaller public companies.\60\
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    \59\ Available at http://www.ic.coso.org.
    \60\ Several comment letters submitted to COSO in respect of the 
guidance are illustrative, including the following: Letter from 
PCAOB to COSO (Jan. 18, 2006) (``[S]ome of the approaches and 
examples in the draft may be inappropriate or impractical for the 
smallest public companies. We recommend that COSO reconsider whether 
there is additional, more practical advice that COSO could give to 
such companies.''); Letter from Institute of Management Accountants 
to COSO (Oct. 24, 2005) (``The IMA is unclear as to how this 
guidance, built on the existing COSO Framework, tangibly reduces SOX 
compliance costs for small businesses or businesses of any size.''); 
Letter from Deloitte & Touche LLP to COSO (Dec. 30, 2005 (``We 
believe that many of the examples in the exposure draft are too 
high-level and generic and do not address the issues faced by 
smaller public companies.''); Letter from Crowe Chizek and Company 
LLC to COSO (Dec. 29, 2005) (``While the document will help smaller 
companies, we do not believe that it will result in substantial 
reduction in the cost of evaluating and documenting the internal 
control process by management, and on the cost to audit internal 
controls by companies' auditing firms.''); Letter from Ernst & Young 
LLP to COSO (Jan. 15, 2006) (``[A]lthough we believe the Guidance 
will be an excellent implementation aid, we are less convinced that 
it will significantly reduce the cost of 404 implementation for 
smaller companies, at least to the degree expected by some.''). All 
such comment letters are available at http://www.ic.coso.org/coso/cosospc.nsf/COSO%20Public%20Comments%20Document.pdf. The Chairman of 
COSO made a presentation at our San Francisco meeting and met 
informally with members of our Internal Control Over Financial 
Reporting Subcommittee.

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[[Page 11099]]

    Reporting companies initially were to be required to comply with 
the internal control reporting provisions for the first time in 
connection with their fiscal years ending on or after June 15, 2004 
(accelerated filers) \61\ or April 15, 2005 (non-accelerated filers and 
foreign private issuers). Recognizing the importance of these 
provisions and the time necessary to implement them properly, on 
February 24, 2004 the Commission extended these compliance dates to 
fiscal years ending after November 15, 2004 for accelerated filers and 
July 15, 2005 for non-accelerated filers and foreign private 
issuers.\62\
    On March 2, 2005, the Commission further extended the compliance 
dates for non-accelerated filers and foreign private issuers to fiscal 
years ending after July 15, 2006.\63\ Additionally, due to the 
continuing evaluation of the impact of the Section 404 requirements on 
smaller public companies by this Committee, on September 21, 2005, the 
Commission provided an additional one-year extension of the compliance 
deadline for non-accelerated (but not larger foreign) filers to fiscal 
years ending after July 15, 2007.\64\
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    \61\ The term ``accelerated filer'' is defined in Rule 12b-2, 17 
CFR 240.12b-2, under the Exchange Act, 15 U.S.C. 78a et seq.
    \62\ SEC Release No. 33-8392 (Feb. 24, 2004) [69 FR 9722].
    \63\ SEC Release No. 33-8545 (Mar. 2, 2005) [70 FR 11528].
    \64\ SEC Release No. 33-8545 (Sept. 22, 2005) [70 FR 11528].
---------------------------------------------------------------------------

Unintended Consequences of Attempts To Address Internal Controls

    The legislative history of Section 404 makes clear that regulators 
and members of Congress never anticipated many of the challenges that 
Section 404 compliance has presented. Section 404 itself states that 
the auditor's attestation ``shall not be the subject of a separate 
engagement.'' \65\ Moreover, the Senate Committee Report that 
accompanied Section 404 to the Senate floor included the following 
language:
---------------------------------------------------------------------------

    \65\ 15 U.S.C. 7262.

    In requiring the registered public accounting firm preparing the 
audit report to attest to and report on management's assessment of 
internal controls, the Committee does not intend that the auditor's 
evaluation be the subject of a separate engagement or the basis for 
increased charges or fees. High quality audits typically incorporate 
extensive internal control testing. The Committee intends that the 
auditor's assessment of the issuer's system of internal controls 
should be considered to be a core responsibility of the auditor and 
an integral part of the audit report.\66\
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    \66\ S. Rep. No. 107-205, at 31 (2002).

    Additionally, the Commission's June 2003 release adopting internal 
control rules, which predated adoption and approval of AS2, estimated 
that the average annual internal cost of compliance with Section 404 
over the first three years would be $91,000, and that cost would be 
proportional relative to the size of the company.\67\ The reality has, 
of course, been much different.
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    \67\ See Sections IV and V of Management's Reports on Internal 
Control Over Financial Reporting and Certification of Disclosure in 
Exchange Act Periodic Reports, SEC Release No. 33-8238 (June 5, 
2003) [68 FR 36636] (``[W]e assumed that there is a direct 
correlation between the extent of the burden and the size of the 
reporting company, with the burden increasing commensurate with the 
size of the company.''). The Commission did, however, anticipate 
that for many companies the first-year internal cost of compliance 
would be well in excess of the average.
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    The anxieties that Section 404 has produced, and the heavy expenses 
that have been incurred in an attempt to comply with its requirements, 
parallel those experienced as a result of Congress' last major 
initiative to address internal accounting controls, the Foreign Corrupt 
Practices Act of 1977, or FCPA.\68\ That statute added two accounting 
requirements applicable to public companies under the Exchange Act, 
including Section 13(b)(2)(B), the provision that requires public 
companies to devise and maintain a system of internal accounting 
controls sufficient to provide reasonable assurance that specified 
objectives are attained.\69\ Then, as now, Congress acted to address 
public concerns following several high profile cases of corporate 
malfeasance. And then, as now, arguably uncertain standards of 
compliance, combined with the threat of significant liability for non-
compliance, worked to create an atmosphere in which companies and their 
advisors strayed far from the statute's original intent. In both 
instances, what began with an idea with which few would disagree--that 
companies should have in place effective controls over their 
transactions and dispositions of assets--unexpectedly became a source 
of significant anxiety, activity and expense.
---------------------------------------------------------------------------

    \68\ Pub. L. No. 95-213, tit. I (1977).
    \69\ 15 U.S.C. 78m(b)(2)(B).
---------------------------------------------------------------------------

    With respect to the FCPA, the fears of public companies and their 
advisors were put to rest by a speech that then SEC Chairman Harold 
Williams gave in 1981, in which he outlined a Commission approach to 
FCPA compliance based upon reasonableness and minimal intrusion in 
internal corporate decision making.\70\ The speech was adopted by the 
Commission as an official agency interpretation and policy statement, 
and retains that status to this day.\71\ Chairman Williams' approach 
served to calm much of the anxiety that had arisen, and his address and 
the Commission's adoption of it as official agency policy are not only 
instructive, but also are relevant to today's Section 404 environment. 
We urge the Commission to republish and re-emphasize the Williams 
statement and make it the framework for management's establishment of 
internal controls.
---------------------------------------------------------------------------

    \70\ See Foreign Corrupt Practices Act of 1977: Statement of 
Policy, SEC Release No. 34-17500 (Jan. 29, 1981) [46 FR 11544] 
(presenting address by SEC Chairman Harold Williams to AICPA Annual 
Conference as Commission statement of policy) (included as Appendix 
M).
    \71\ 17 CFR 241 (citing id.).
---------------------------------------------------------------------------

Origin of the Current Problem

    The expectation on the part of lawmakers and regulators in enacting 
and implementing Section 404 was that if internal controls over 
financial reporting are operating effectively, then confidence in the 
financial statements ipso facto will be higher. In theory, this idea 
appears sound, particularly for larger companies, where financial 
statement preparation relies heavily on the effective operation of 
business process controls. The requirements that management assess, and 
that the external auditor attest to the adequacy of, internal controls 
likewise appear to be sensible objectives.
    In practice, however, several factors have led to an unexpected 
explosion of activity in connection with implementing Section 404. 
First, although AS2 was developed as a guide for external auditors in 
determining whether internal control over financial reporting is 
effective, no similar guide has been developed for management. SEC 
rules require management to base its assessment of internal control 
over financial reporting on a suitable,

[[Page 11100]]

recognized control framework. Although the COSO Framework provides 
criteria against which to assess internal control, it does not provide 
management with guidance on how to document and test internal control 
or how to evaluate deficiencies identified. Consequently AS2 has become 
the de facto guide for management, even though it was only intended to 
be used as an auditing standard; management has tried to meet the same 
requirements as auditors in performing their assessments, when in fact 
management and auditors likely perform their assessments of internal 
controls differently. Adding to the problem has been the absence of any 
clear definition or guide as to what constitutes adequate internal 
controls for smaller companies. This problem has been compounded by the 
different requirements in Section 404 for management and for their 
external auditors.\72\ Management must assess the effectiveness of the 
internal controls over financial reporting, while the external auditor 
must report on whether management's assessment of the effectiveness of 
internal control is fairly stated and provide (attest to) a separate 
opinion on whether the company's internal control is effective.
---------------------------------------------------------------------------

    \72\ The distinction between the Section 404 requirements for 
management versus those for the external auditors is misunderstood, 
and often overlooked. This distinction is important because our 
recommendation is that as companies grow in size and complexity, 
they should take on more expansive Section 404 requirements. For 
smaller companies, we think there should be a management assertion 
as to the adequacy of the internal control over financial reporting, 
but that the need for the external auditor involvement does not 
arise until a company reaches a certain size and complexity. 
Therefore, there is a need for a definition and guide for management 
on what are adequate internal controls for smaller companies.
---------------------------------------------------------------------------

    Second, as both accelerated filers and non-accelerated filers 
busily prepared for the first audit of internal control and as Section 
404 implementation efforts were taking place, there had been little 
attempt to tailor, or ``scale'' regulation to address the specific 
manner in which smaller companies operate. Although many feel that 
smaller companies are operationally different from larger companies in 
ways relevant to internal controls, and hence that small companies' 
internal controls and methods of evaluating them should be scaled 
accordingly, neither AS2 nor any other source provides a clear 
definition or guide for management as to what constitutes adequate 
internal controls for smaller companies.\73\ As noted above, COSO is 
developing guidance intended to facilitate the application of the COSO 
Framework in the small business environment; however, the draft 
guidance recently exposed for public comment by COSO does not fully 
offer a solution for small businesses and may not reduce costs of 
implementing Section 404 in a small business environment.
---------------------------------------------------------------------------

    \73\ Many believe that AS2, in practice, has proven not to be 
scalable in a manner that would make it applicable in a cost-
effective way to smaller companies. Although the PCAOB proposed for 
comment a draft AS2 that included an appendix for smaller companies, 
the appendix was not included in the version of AS2 that the PCAOB 
and, later, the Commission approved. Additionally, the COSO 
Framework includes some guidance regarding smaller companies but it 
is minimal. Many observers acknowledge the need to scale for smaller 
public companies, but because of the challenges involved, have 
avoided attempting to scale despite such need.
---------------------------------------------------------------------------

    Moreover, even though auditors maintain that they are already 
taking a risk-based approach to the AS2 audit, we heard significant 
testimony from companies suggesting that implementation of AS2 has 
resulted in very rigid, prescriptive audits as a result of onerous AS2 
requirements. Most issuer comments we received indicated that auditors 
applied a one-size-fits-all standard, even as auditors maintained that 
each audit stands on its own; as the Commission's May 2005 guidance 
suggests, and the input we received confirms, auditors in many 
instances utilize an approach that is ``bottom-up'' rather than ``top-
down.'' \74\ This results in audits that are not risk-based and, in 
particular, involve extensive testing of information technology (IT) 
controls. The result is extensive focus by auditors on detailed 
processes, a number of which create little or no risk to the integrity 
of the financial statements.
---------------------------------------------------------------------------

    \74\ Despite the May 2005 guidance's call for a more top-down, 
risk-based approach, testimony we heard indicated that such guidance 
has not substantially altered the approach of auditors.
---------------------------------------------------------------------------

    Finally, the Sarbanes-Oxley Act created the PCAOB to monitor the 
performance of the external auditors. The creation of this regulatory 
watchdog, the introduction of PCAOB inspectors and the subsequent 
issuance of AS2 have altered auditor behavior and, we believe, has 
diminished the exercise of professional judgment.\75\
---------------------------------------------------------------------------

    \75\ See After Sarbanes-Oxley, National Law Journal Online (Dec. 
12, 2005) (remarks of former SEC Commissioner Joseph Grundfest).
---------------------------------------------------------------------------

Disproportionate Impact: The Smaller You Are, the Larger the Hit

    Studies into the consequences of Section 404 indicate that actual 
average costs of Section 404 compliance have in fact been far in excess 
of what was originally anticipated. In addition, although costs 
generally decline following the first year of implementation, a recent 
study commissioned by the Big Four accounting firms acknowledges that 
second year total costs for public companies with a market 
capitalization between $75 million and $700 million will still equal, 
on average, approximately $900,000.\76\
---------------------------------------------------------------------------

    \76\ See CRA International Sarbanes-Oxley Section 404 Costs and 
Implementation Issues: Survey Update, at 1. For further information 
concerning the impact of Section 404, see American Electronics 
Association, Sarbanes-Oxley Section 404: The ``Section'' of 
Unintended Consequences and Its Impact on Small Business (Feb. 2005) 
and Financial Executives International, FEI Special Survey on 
Sarbanes-Oxley Section 404 Implementation (Mar. 2005). Although 
these studies are subject to further critical analysis, they 
indicate considerably higher Section 404 compliance costs than the 
Senate, the SEC and others estimated.
---------------------------------------------------------------------------

    But beyond the aggregate costs involved with Section 404 
compliance, costs have been disproportionately borne by smaller public 
companies. The lack of proportionality of the cost and amount of 
resources devoted to Section 404 compliance for smaller public 
companies is evidenced by data which shows that the expected cost of 
Section 404 implementation, as a percentage of revenue, is dramatically 
higher for smaller public companies than it is for larger public 
companies. The following chart illustrates this disparity: \77\
---------------------------------------------------------------------------

    \77\ This table is based on data from the Financial Executives' 
International study and estimates of the Section 404 working group 
of the American Electronics Association. We note that companies with 
a market capitalization of less than $75 million generally did not 
have to comply with Section 404 in 2004. Many expect that compliance 
costs for the smallest companies in the chart will consequently be 
much higher when such companies are required to comply.

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[[Page 11101]]

[GRAPHIC] [TIFF OMITTED] TN03MR06.000

    We also note that external auditor fees have overall been 
increasing, both before and after implementation of the Sarbanes-Oxley 
Act. The graph below illustrates the change in external audit fees and 
audit related fees as a percentage of revenue that has occurred for 
companies of varying market capitalizations, between 2000 and 2004.\78\ 
This shows that external fees for smaller public companies have roughly 
tripled as a percentage of revenue between 2000 and 2004, and that the 
fees for these smaller public companies as a percentage of revenue have 
remained many times higher than for larger public companies over this 
period.\79\
---------------------------------------------------------------------------

    \78\ Source: SEC Office of Economic Analysis, Background 
Statistics: Market Capitalization and Revenue of Public Companies 
(Aug. 2, 2005) (included as Appendix I). We note that this graph 
shows changes in fees for companies affected by Section 404 and non-
accelerated filers that have not been required to comply with that 
provision's requirements.
    \79\ Percentage growth varies depending on the size of the 
company and measurement method. See Tables 8, 10 & 23 in Appendix I.
[GRAPHIC] [TIFF OMITTED] TN03MR06.001

    Many commentators, including the Commission, the Big Four audit 
firms, NASDAQ and the American Electronics Association, have estimated 
that the external audit fees represent between one quarter and one 
third of the total cost of implementing Section 404. When one factors 
in this multiplier (i.e., that total Section 404 implementation costs 
are three to four times external audit fees) on the cost borne by 
smaller public companies, it is clear that this results in a 
significant disproportionate cost for their shareholders.

Management Override and the Resulting Increase in Cost Structure for 
Smaller Public Companies

    We believe that the risk of management override in any company is a 
key risk, and effective internal controls, particularly at the entity 
level, need to be in place to prevent such overrides from 
occurring.\80\ In a smaller public company, this risk is increased due 
to top management's wider span of control and more direct channels of 
communication. The concentration of decision-making authority at the 
top of a typical smaller company results in

[[Page 11102]]

both an increased chance of fraud due to management override, and also, 
conversely and more importantly, a significant increase in the 
probability that errors or fraud in financial reporting will be 
discovered through an honest senior management process that directly 
oversees financial reporting.\81\ This dichotomy creates much of the 
tension in the debate over Section 404. Some members of this Committee 
believe that this fundamental difference in how large and small 
companies are managed deserves more focus and, as a result, are of the 
view that strengthening internal controls over top management in the 
smaller company will reduce the risk of management override and will 
provide investors better protection from a material fraud. Some also 
believe that, in a smaller company, it is difficult if not impossible 
for a widespread fraud to occur that does not involve senior 
management.
---------------------------------------------------------------------------

    \80\ See American Institute of Certified Public Accountants, 
Management Override of Internal Controls: The Achilles' Heel of 
Fraud Prevention (2005), available at ttp://www.aicpa.org/audcommctr/download/achilles_heel.pdf.
    \81\ The COSO Framework described management control activities 
for small and mid-size companies as follows: ``Further, smaller 
entities may find that certain types of control activities are not 
always relevant because of highly effective controls applied by 
management of the small or mid-size entity. For example, direct 
involvement by the CEO and other key managers in a new marketing 
plan, and retention of authority for credit sales, significant 
purchases and draw downs on lines of credit, can provide strong 
control over those activities, lessening or obviating the need for 
more detailed control activities. Direct hands-on knowledge of sales 
to key customers and careful review of key ratios and other 
performance indicators often can serve the purpose of lower level 
control activities typically found in large companies.'' COSO 
Framework at 56.
---------------------------------------------------------------------------

    In smaller companies, people wear multiple hats. It simply is not 
feasible to have a person who focuses on a single area. It also means 
that personnel need to be cross trained in multiple jobs in order to 
fill in as needed or when someone is absent. The result is that 
segregation of duties, a key element of effective internal control, may 
not be achievable to the extent desired. This lack of segregation of 
duties requires senior management to be involved in all material 
transactions and directly involved in financial reporting.\82\ Smaller 
companies, by their nature, need to be flexible and the environment 
they operate in requires them to make changes quickly in order to 
compete effectively with much larger and more entrenched competitors. 
In fact, it is this versatility and the ability to change quickly that 
is their single most effective competitive strength. By their nature, 
smaller companies are more dynamic and are constantly evolving, 
changing and growing more rapidly than larger companies. This dynamic 
nature requires frequent changes in process and more frequent job 
changes inside the company, which limits their ability to have static 
processes that are well documented. It also creates the need for top 
management involvement and review over financial reporting. Larger 
companies have more rigidly defined roles and processes that enable 
them to segregate duties to the extent that the internal control 
environment can be relied on for financial reporting. In fact, it is 
essential that larger companies have well-defined processes that enable 
them to create ``boundaries'' in order to be efficient and effective in 
competing with other companies, both large and small. This is the basic 
difference between large and small companies and is at the heart of the 
Committee's recommendations. Simply put, well established boundaries 
and flexibility are incompatible and not totally possible in a smaller 
company. Section 404 and AS2 can be effective in larger companies 
because of the boundaries inherent in those companies. Many believe 
that in a smaller company these requirements cause the company to lose 
its flexibility, and as a result put these companies at a competitive 
disadvantage without significantly improving investor protection.
---------------------------------------------------------------------------

    \82\ The COSO Framework states: ``An appropriate segregation of 
duties often appears to present difficulties in smaller 
organizations, at least on the surface. Even companies that have 
only a few employees, however, can usually parcel out their 
responsibilities to achieve the necessary checks and balances. But 
if that is not possible--as may occasionally be the case--direct 
oversight of the incompatible activities by the owner-manager can 
provide the necessary control.'' Id.
---------------------------------------------------------------------------

    In our deliberations we focused on three financial reporting 
concerns as they relate to Section 404 applicability to smaller public 
companies. First, the lack of segregation of duties in these companies 
creates an internal control environment that is not primarily relied 
upon for financial reporting purposes by either management or 
auditors.\83\ It is important to note that we believe these companies 
should be concerned with internal control, and we note that ample law 
is on the books today that requires all public companies to have an 
effective internal control system in place.\84\ The point is that in 
the smaller public company, these controls are not primarily relied 
upon for financial reporting and are at times ineffective at preventing 
fraud at the executive level.
---------------------------------------------------------------------------

    \83\ Id.
    \84\ See Exchange Act Sec.  13(b)(2)(B), 15 U.S.C. 78m(b)(2)(B) 
(codifying part of Foreign Corrupt Practices Act of 1977, Sec.  102, 
Pub. L. 95-213).
---------------------------------------------------------------------------

    Second, the significant risk of management override in all 
companies creates an increased need for entity level controls and board 
oversight. At the process level, controls are not effective at 
controlling this risk; we believe there are more effective controls 
that can be put in place to reduce the risk of management override, 
especially at smaller companies. These include an increased oversight 
role for the board and audit committee, a more robust communication 
system between the board and the executive levels of the company, and 
increased scrutiny from external auditors in key areas where override 
can occur.\85\
---------------------------------------------------------------------------

    \85\ The COSO Framework states: ``Because of the critical 
importance of a board of directors or comparable body, even small 
entities generally need the benefit of such a body for effective 
internal controls.'' p. 31. See also Exposure Draft of AICPA, 
Communication of Internal Control Related Matters Noted in an Audit 
(Sept. 1, 2005).
---------------------------------------------------------------------------

    Third, the requirements of AS2 and the requirements of auditors to 
document controls and the redundancy of control testing creates an 
environment in smaller companies that limit their ability to be 
flexible, and thereby hinders their competitiveness. We believe 
strongly that the formation of new companies and their ability to 
access the U.S. capital markets in a responsible manner should be 
encouraged by all market participants. Therefore we believe investor 
risk protection should be encouraged. We also strongly believe that a 
company must focus on value creation for its investors, and that our 
recommendations strike a more appropriate balance between the costs and 
benefits of Section 404.
    We also note that the AICPA's Proposed Statement on Auditing 
Standards, Communication of Internal Control Related Matters Noted in 
an Audit, could be adopted by the PCAOB to improve communication on 
internal control matters between the auditor and audit committee in the 
case of companies whose internal controls are not audited pursuant to 
our recommendation.
    Moreover and very importantly, the application of not only Section 
404 but the other regulations adopted under Sarbanes-Oxley have serious 
cost and profitability ramifications for smaller public companies in 
addition to the financial reporting and management override aspects.
    First, the flexibility and requirement to change quickly is imposed 
on the smaller company by the customer; i.e., it is not management's 
choice. It is what the customer expects--indeed demands--for the 
smaller company's price, which often times is slightly higher than that 
charged by a larger company. Flexibility and quick change often means 
that processes and controls change, and consequently that the

[[Page 11103]]

documentation of those controls change, resulting in a cost of keeping 
documentation that remains more or less constant each year. Given this 
dynamic, for smaller companies the cost of documentation, preparation 
and testing under AS2 will not likely be reduced as much as 
anticipated, and not to the extent it will in larger companies with 
more stable, rigid processes.
    Second, larger companies frequently have lower material costs and 
can leverage their buying power. It is not unusual to see a whole 
percentage point difference in material costs between a large company 
and a small company. The small company must offset that large company 
advantage with their package of value (service, superior product, 
flexibility, adaptability). Because the price is often set by the 
customer, a smaller company must squeeze profitability out of overhead. 
That aspect of the cost structure must be smaller when compared to the 
large company. It must both offset the higher material costs and also 
support profitability, which is the ultimate determination of 
shareholder value. Increasing the burden for a small company directly 
and quickly erodes shareholder value. Because the estimate of the costs 
for Section 404 implementation was underestimated so dramatically 
(millions of dollars per year, versus $91,000), the pain and loss of 
value has been significantly greater for a small company.
    Third, the Sarbanes-Oxley Act not only added Section 404 costs and 
other burdens that fell disproportionately on smaller companies, it 
introduced burdens that, because of the nature of smaller companies, 
will be ongoing rather than one time. The incremental cost of operating 
a board of directors, for example, has increased because of higher 
director and officer insurance costs, the increased activity and 
oversight responsibilities of the compensation, audit and nominating 
committee, more costly legal and audit fees, and increased fees for 
independent advisors to the committees, a new and sometimes 
uncontrollable expense. The pass-through cost from the supply chain 
(for Sarbanes-Oxley) is starting to find its way into the overall cost 
structure. These are compounding the increased burden cost and they are 
repetitive--not one time--costs.
    In summary, these characteristics, result in frequent documentation 
change and sustained review and testing for certification under Section 
404, the cost of which is more of a sustained annual cost. This forced 
cost choice, combined with increased board operation costs and other 
costs incurred as a result of Sarbanes-Oxley dramatically and adversely 
affect the cost structure of a small company.

Overview of Recommendations

    As noted above, we believe that the crux of the existing problem, 
and the cornerstone of our recommended solution, is that smaller and 
larger public companies operate in a very different manner. As 
companies grow in size and complexity, they rely more on formal, 
prescriptive and transactional internal controls to maintain the 
operations of the company. This sentiment was confirmed by the 
significant input we received indicating that small and typically less 
complex companies are very different from larger companies and 
therefore, the reforms made by the Commission and the stock exchanges 
should be applied differently, depending on the size of the company. A 
number of witnesses challenged the application of AS2 to smaller, less 
complex businesses, regardless of structure, size or strategy. Faced 
with this reality, and in order to properly scale Section 404 treatment 
to ensure that the benefits of implementation outweigh burdens, we 
propose differing 404 compliance requirements based upon company size. 
By way of introduction to the recommendations below, we believe that 
two items bear mentioning at the outset: (1) The opt-in approach of our 
recommendations and (2) the use of revenue filters as a means of 
capturing company complexity and consequently the cost-effectiveness of 
applying Section 404 requirements.
Opt-In Approach
    An essential component of the exemptive relief we are proposing for 
smaller public companies is that an issuer, through its board of 
directors, and in consultation with its audit committee and external 
auditor, could very well decide not to take advantage of the exemptive 
relief available and instead comply with the Section 404 rules 
applicable to larger public companies.\86\
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    \86\ For a discussion of the benefits of such an optional 
approach, as well as the circumstances that led to the formation of 
our Committee, see Roberta Romano, The Sarbanes-Oxley Act and the 
Making of Quack Corporate Governance, 114 Yale L.J. 1521, 1595-1597 
(2005).
---------------------------------------------------------------------------

    Some argue that internal control over financial reporting should be 
beneficial to smaller public companies because it will make it easier 
for them to attract capital. At this point in the development of the 
internal control requirements, we think the evidence is quite mixed on 
this question and, if anything, is tending in the opposite direction. A 
number of data points lead us in this direction, but we recognize that 
the evidence has not been fully analyzed and it may be premature to 
make any conclusions. Nevertheless, the following developments should 
be carefully monitored:
     Some companies are either going dark or going private or 
considering doing so; \87\
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    \87\ We received several answers to this effect in response to 
Question 1 of Request for Public Input by Advisory Committee on 
Smaller Public Companies, SEC Release No. 33-8599 (Aug. 5, 2005) 
available at http://www.sec.gov/rules/other/265-23survey.shtml. See 
William J. Carney, The Costs of Being Public After Sarbanes-Oxley: 
The Irony of `Going Private,' Emory Law and Economics Research Paper 
No. 05-4 at 1 (February 2005) available at SSRN: http://ssrn.com/abstract=672761; Joseph N. DiStefano, Some Public Firms See Benefit 
in Going Private, Phil. Inq., Jan. 21, 2006 (reporting on a 
discussion at the 11th Annual Wharton Private Equity Conference), 
available at http://www.philly.com/mld/inquirer/business/13676241.htm. The Ziegler Companies, Inc. is an example of a public 
company that decided to delist from the American Stock Exchange and 
deregister under the Exchange Act. As reasons for the delisting and 
deregistration, Ziegler said, among other things: ``the costs 
associated with being a reporting company under the `34 Act are 
significant and are expected to continue to rise, thereby 
diminishing the Company's future profitability; the benefits of 
remaining a listed company with continued '34 Act reporting 
obligations are not sufficient to justify the current and expected 
future costs and no analysts cover the Company's shares.'' Ziegler's 
shares are now traded in the Pink Sheets and the company provides 
its shareholders with, among other items, annual reports including 
audited financial statements, news of important events and a proxy 
statement. It also has a Web page including financial and governance 
information.
---------------------------------------------------------------------------

     The London Exchange's Alternative Investment Market (AIM) 
for smaller public companies is gaining momentum;\88\
---------------------------------------------------------------------------

    \88\ The AIM Market is actively and successfully prospecting for 
listing companies in the United States. See G. Karmin and A. 
Luchetti, New York Loses Edge in Snagging Foreign Listings, Wall St. 
J., Jan. 26, 2006, at C1, and Stephen Taub, VCs Look For Payday in 
London, CFO.com, Feb. 3, 2006, available at http://www.cfo.com/article.cfm/5487545/c_5486496?f=TodayInFinance_Inside. See also 
Letter from John P. O'Shea to Committee (June 16, 2005), available 
at http://www.sec.gov/rules/other/265-23/jposhea061605.pdf. See also 
Record of Proceedings 189 (Aug. 9, 2005) (testimony of James P. 
Hickey, Principal, Co-Head of Technology Group, William Blair & Co. 
indicating that strong IPO candidate elected to go public on the AIM 
exchange expressly to avoid costs and burdens of Sarbanes-Oxley Act 
compliance).
---------------------------------------------------------------------------

     Foreign new listings in the United States during 2005 
dropped considerably from the previous year; \89\
---------------------------------------------------------------------------

    \89\ See Patrick Hosking, Cull of U.S. Investors Set a Worrying 
Precedent, Times Online, Feb. 2, 2006. available at http://business.timesonline.co.uk/article/0,,13129-2020817,00.html.
---------------------------------------------------------------------------

     Foreign issuers are departing from the U.S. market (and 
their institutional investors are voting for their going offshore); and
     U.S. investors continue to invest in foreign securities 
even though the

[[Page 11104]]

issuers are not subject to internal control requirements like those 
promulgated under Section 404.\90\
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    \90\ Record of Proceedings 100 (Oct. 14, 2005) (testimony of 
Gerald I. White). See also Rebecca Buckman, Tougher Venture: IPO 
Obstacles Hinder Start-ups, Wall St. J., Jan. 25, 2006, at C1 
(stating that ``[l]ast year, 41 start-ups backed by venture-capital 
investors became publicly traded U.S. companies, down from 67 in 
2004 and 250 in the boom year of 1999'' and that ``[o]verall IPO's 
of U.S. companies also declined last year, but not as sharply, to 
215, from 237 in 2004'').
---------------------------------------------------------------------------

    Without deciding whether Section 404 is beneficial for investors in 
smaller public companies, we believe that in light of our reasons for 
recommending exemptive relief for these companies, permitting them to 
comply or take advantage of the relief is the appropriate course of 
action to recommend.
Use of Revenue Filters
    We would add a revenue filter or criterion as a condition to 
providing Section 404 exemptive relief for smaller public companies, 
because we think that when evaluating the costs and benefits of 
applying the Section 404 requirements to smaller public companies, 
revenues are a very important factor. We believe that companies with 
revenues in excess of $250 million are generally complex, and hence 
rely more on process controls to generate their financial statements. 
Because auditors of such companies, as part of the financial audit, are 
likely to have relied on and thus tested these internal controls as 
part of the financial audit in the past, it is likely to be relatively 
less expensive, when compared to smaller, less complex companies with 
respect to which controls weren't previously tested for purposes of the 
financial audit, to comply with Section 404. Conversely, we believe 
that companies with large market capitalizations and minimal revenues, 
such as development stage companies that trade on very large multiples 
because of potential, are generally simple in terms of operations and 
pose a lesser risk of material financial fraud. Therefore, our 
recommendations provide that a smallcap company whose annual product 
revenue in the last fiscal year did not exceed $10 million would, 
solely for purposes of our Section 404 recommendations, be treated the 
same as a microcap company.
    We acknowledge that there exists no clear, obvious line for 
distinguishing between companies based on revenues. Our collective 
experience indicates, however, that companies with revenues of $250 
million or more a year are getting large enough and complex enough that 
auditors rely more on the internal controls to conduct the financial 
statement audit than they do for companies with less revenues. 
Specifically, auditors of smaller companies and internal financial 
teams of smaller companies confirm that the smaller the company, the 
less valuable the internal control audit is to the financial statement 
audit. For smaller companies, the financial audits tend to become more 
substantive in nature, with particular attention on key, high risk 
areas (inventory, revenue recognition, etc.). Indeed, financial experts 
testified that the larger the company the more the auditor relies on 
the operation of internal controls to perform the financial statement 
audit. This is because, the larger the company, the more far flung and 
complex the operations become and the less practical it is to test 
significant numbers of transactions.
Internal Control Over Financial Reporting--Primary Recommendations
    We recommend that the Commission and other bodies, as applicable, 
effectuate the following:
Recommendation III.P.1
    Unless and until a framework for assessing internal control over 
financial reporting for such companies is developed that recognizes 
their characteristics and needs, provide exemptive relief from Section 
404 requirements to microcap companies with less than $125 million in 
annual revenue and to smallcap companies with less than $10 million in 
annual product revenue that have or expand their corporate governance 
controls that include:
     Adherence to standards relating to audit committees in 
conformity with Rule 10A-3 under the Exchange Act;
     Adoption of a code of ethics within the meaning of Item 
406 of Regulation S-K applicable to all directors, officers and 
employees and compliance with the further obligations under Item 406(c) 
relating to the disclosure of the code of ethics; and
     Design and maintain effective internal controls over 
financial reporting.
    In addition, as part of this recommendation, we recommend that the 
Commission confirm, and if necessary clarify, the application to all 
microcap companies, and indeed to all smallcap companies also, of the 
existing general legal requirements regarding internal controls, 
including the requirement that companies maintain a system of effective 
internal control over financial reporting, disclose modifications to 
internal control over financial reporting and their material 
consequences and apply CEO and CFO certifications to such 
disclosures.\91\
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    \91\ Messrs. Jensen, Schacht and Veihmeyer dissented from the 
majority vote on this recommendation. The reasons for their dissents 
are contained in Parts VII, VIII and IX of this report. All other 
members present voted in favor of this recommendation.
---------------------------------------------------------------------------

    Moreover, management should be required to report on any known 
material weaknesses. In this regard, the Proposed Statement on Auditing 
Standards of the AICPA, ``Communications of Internal Control Related 
Matters Noted in an Audit,'' if adopted by the AICPA and the PCAOB, 
would strengthen this disclosure requirement and provide some external 
auditor involvement in the internal control over financial reporting 
process.
    Our first recommendation primarily concerns microcap companies, 
which represent the lowest 1% of total U.S. equity market 
capitalization.\92\ In our view, these companies should be entitled to 
full Section 404 exemptive relief, preconditioned upon their compliance 
with the enhanced corporate governance provisions described above.\93\ 
The following federal securities law requirements would remain 
applicable to all companies that would qualify for full Section 404 
relief in accordance with this recommendation:
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    \92\ The statistics we were provided indicate that 4,641, or 
49%, of the 9,428 U.S. public companies would be eligible for 
exemptive relief under this recommendation. See SEC Office of 
Economic Analysis, Background Statistics: Market Capitalization and 
Revenue of Public Companies, Tables 2, 19 & 26 (Aug. 2, 2005) 
(included as Appendix I).
    \93\ The approach adopted by the Committee has been raised as a 
possibility by various parties. See, e.g., Letter from Ernst & Young 
LLP to SEC, at 16 (Apr. 4, 2005) (Ernst & Young said, with a number 
of reservations, including the lack of sufficient information and 
longer term experience with 404: ``Should the level of costs 
necessary to do the job right be determined to be unacceptable in 
relation to the benefits provided to investors in smaller public 
companies, the SEC could then consider using its exemptive authority 
to provide alternatives, including annual reporting by management on 
the issuer's internal controls over financial reporting with no 
auditor attestations or with less frequent auditor attestations (for 
example, auditor attestations every other year) or even complete 
elimination of annual reporting by management on the issuer's 
internal controls over financial reporting.'') (on file in SEC 
Public Reference Room File No. 4-497), available at http://www.sec.gov/news/press/4-497/eyllp040405.pdf. We note that Mr. 
Veihmeyer, in his discussion of reasons for dissenting from this 
recommendation (included in Part IX of this report), states that 
after further study and experience with Section 404 ``it may become 
evident * * * that an audit of internal control over financial 
reporting may not be justified for certain very small public 
companies that evidence certain characteristics.''
---------------------------------------------------------------------------

     Maintain a system of internal controls that provides 
reasonable assurances as to accuracy, as required

[[Page 11105]]

by Exchange Act Section 13(b)(2)(B) enacted under the FCPA;
     Provide chief executive officer and chief financial 
officer certifications under Sarbanes-Oxley Act Section 302; \94\
---------------------------------------------------------------------------

    \94\ We expect that the Section 302 certifications of companies 
receiving exemptive relief from Section 404 would still be required 
to include the introductory language in paragraph 4 of that 
provision (which refers to the certifying officers' responsibility 
for establishing and maintaining internal control over financial 
reporting) and paragraph 4(b) (which refers to the internal control 
over financial reporting having been designed to provide reasonable 
assurance regarding the reliability of financial reporting and the 
preparation of financial statements).
---------------------------------------------------------------------------

     Receive external financial audits;
     Comply with the requirements of Item 9A of Form 10-K and 
Item 4 of Part I of Form 10-Q; and
     Disclose, consistent with current Section 404 rules, all 
material weaknesses known to management, including those uncovered by 
the external auditor and reported to the audit committee.\95\
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    \95\ We considered other possible corporate governance and 
disclosure standards that might be imposed as a condition to any 
Section 404 relief for smaller public companies. In the final 
analysis, however, we felt that imposing conditions beyond those 
described above could result in hardship for smaller public 
companies that would not be commensurate with the benefits received 
from an investor protection standpoint.
---------------------------------------------------------------------------

    For microcap companies that comply with these requirements, we 
envision that full Section 404 relief would be effective immediately.
    While we are convinced that the costs associated with Section 404 
compliance are disproportionate and unduly burdensome to smaller public 
companies, we are also mindful of the Commission's investor protection 
mandate. We believe that our recommendation provides a more cost-
effective method of enhancing investor protection. We believe that 
enhanced audit committee standards and practices and the adoption and 
enforcement of ethics and compliance programs are effective, as well as 
cost-effective, means of maintaining investor protections.
    Rule 10A-3 under the Exchange Act requires national securities 
exchanges and associations to prohibit the initial or continued listing 
of a security of an issuer that is not in compliance with specified 
listing standards relating to audit committees. These standards relate 
to: Audit committee member independence; responsibility for the 
appointment, compensation, retention and oversight of an issuer's 
registered public accounting firm; the establishment of procedures for 
the receipt of accounting-related complaints, including anonymous 
submissions by employees; the authority to engage advisors; and 
funding. The New York and American Stock Exchanges and the NASDAQ Stock 
Market have now incorporated the requirements of Rule 10A-3 into their 
respective listing standards. The audit committee standards mandated by 
Rule 10A-3 currently do not apply to any smaller public companies that 
are not subject to those listing standards. We believe that if Section 
404 relief is granted to the microcap and smallcap companies that we 
recommend for relief, those companies should, as a condition to such 
relief, be required to adhere to the audit committee standards embodied 
in Rule 10A-3.
    Item 406 of Regulation S-K requires a reporting company to disclose 
whether it has adopted a code of ethics that applies to its principal 
executive officer, chief financial officer and other appropriate 
executives and, if it has not adopted such a code, to state why it has 
not done so. Item 406 defines a code of ethics to be written standards 
that are reasonably designed to deter wrongdoing and to promote: Honest 
and ethical conduct, including handling of conflicts of interest; full, 
fair, accurate, timely and understandable disclosure in reports and 
documents filed with the Commission and in other public communications; 
compliance with applicable governmental laws, rules and regulations; 
prompt internal reporting of violations of the code; and accountability 
for adherence to the code. A reporting company is also required to file 
a copy of its code of ethics with the Commission as an exhibit to its 
annual report, or to post the text of the code on its Web site. Item 
406 mandates disclosure as to whether a code of ethics exists, but does 
not require the adoption of a code. The major exchanges, including the 
NYSE, AMEX and the NASDAQ Stock Market, go further and require, as part 
of their listing standards, the adoption of a code of ethics meeting 
the fundamental requirements embodied in Item 406, and extend the 
coverage to the directors and employees of listed companies.\96\ As is 
the case with the audit committee standards described above, issuers 
not subject to listing standards requiring the adoption of a code of 
ethics are not obligated to do so under Commission rules. We believe 
that the adoption and enforcement of a code of ethics is both cost 
effective and appropriate for smaller public companies that receive 
relief from the attestation requirements of Section 404. A recent 
integrity survey undertaken by KPMG Forensic noted that employees who 
work in companies with comprehensive ethics and compliance programs 
reported fewer observations of misconduct and higher levels of 
confidence in management's commitment to integrity.\97\
---------------------------------------------------------------------------

    \96\ New York Stock Exchange Rule 303A.10; NASDAQ Stock Market 
Rule 4350(n); AMEX Company Guide Sec. 807.
    \97\ KPMG Forensic Integrity Survey 2005-2006.
---------------------------------------------------------------------------

    With regard to the penultimate paragraph of the recommendation 
above, we simply wish for the Commission to make clear, to the extent 
clarity is lacking, that those smaller public companies qualifying for 
exemptive relief will continue to be required to (1) maintain a system 
of internal control sufficient to provide reasonable assurance that, 
among other things, transactions are recorded as necessary to permit 
preparation of financial statements in conformity with GAAP, (2) 
disclose any modifications to internal control over financial reporting 
and (3) certify such disclosures.
Recommendation III.P.2
    Unless and until a framework for assessing internal control over 
financial reporting for such companies is developed that recognizes 
their characteristics and needs, provide exemptive relief from external 
auditor involvement in the Section 404 process to the following 
companies, subject to their compliance with the same corporate 
governance standards as detailed in the recommendation above: \98\
---------------------------------------------------------------------------

    \98\ Messrs. Jensen, Schacht and Veihmeyer dissented from the 
majority vote on this recommendation. The reasons for their dissents 
are contained in Parts VII, VIII and IX of this report. All other 
members present voted in favor of this recommendation.
---------------------------------------------------------------------------

     Smallcap companies with less than $250 million in annual 
revenues but greater than $10 million in annual product revenue; and
     Microcap companies with between $125 and $250 million in 
annual revenue.\99\
---------------------------------------------------------------------------

    \99\ The statistics we were provided indicate that 1,957, or 
21%, of the 9,428 U.S. public companies would be eligible for 
exemptive relief under this recommendation. See SEC Office of 
Economic Analysis, Background Statistics: Market Capitalization and 
Revenue of Public Companies, Tables 2, 19 & 26 (Aug. 2, 2005) 
(included as Appendix I).
---------------------------------------------------------------------------

    Smallcap companies that qualify for the Section 404 external audit 
of internal control relief still would be subject to the rest of 
Section 404's requirements, all otherwise applicable federal securities 
law requirements and, in addition, in the case of companies not listed 
on the NYSE, AMEX or NASDAQ Stock Market, all of the corporate 
governance standards

[[Page 11106]]

specified above applicable to companies so listed. Among the federal 
securities law requirements that would remain applicable to all 
smallcap companies that qualify for the Section 404 external audit of 
internal control exemptive relief would be the requirements to:
     Maintain a system of internal controls that provides 
reasonable assurances as to accuracy, as required by Exchange Act 
Section 13(b)(2)(B) enacted under the FCPA;
     Complete and report on management's assessment of internal 
control under Section 404;
     Provide chief executive officer and chief financial 
officer certifications under Section 302;
     Receive external financial audits;
     Comply with the requirements of Item 9A of Form 10-K and 
Item 4 of Part I of Form 10-Q; and
     Disclose, consistent with current Section 404 rules, all 
material weaknesses known to management, including those uncovered by 
the external auditor and reported to the audit committee.
    For smallcap companies that comply with these requirements, we 
envision that Section 404 external audit of internal control relief 
would be effective immediately.\100\
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    \100\ We are aware that questions have arisen regarding the 
Commission's authority to provide exemptive relief from full 
compliance with the requirements of Section 404 in accordance with 
this recommendation and the recommendation above. As a committee, we 
are not authorized or capable of rendering legal opinions on this 
issue. We are aware, however, that Section 3(a) of the Sarbanes-
Oxley Act, 15 U.S.C. 7202(a), provides the Commission with broad 
authority to promulgate ``such rules and regulations as may be 
necessary or appropriate in the public interest or for the 
protection of investors'' in furtherance of Section 404. We believe 
that the relief we propose satisfies this standard and that the 
reasoning we have provided for our recommendations demonstrates the 
reasonableness of this conclusion. Furthermore, we are aware of the 
view expressed by the Committee on Federal Regulation of Securities 
of the American Bar Association's Section of Business Law that the 
Commission has authority to provide exemptive relief for smaller 
public companies from strict adherence to technical requirements of 
Section 404, as follows:
    ``We believe the Commission's authority [to provide relief from 
the auditor attestation requirements in Section 404(b) for smaller 
public companies] stems from both the [Exchange Act] and [the 
Sarbanes-Oxley Act] itself. Section 36(a)(1) of the Exchange Act 
gives the Commission broad exemptive authority under the Exchange 
Act. [Sarbanes-Oxley] section 3(b)(1) provides that a violation of 
[the Act's provisions] will be treated as a violation of the 
Exchange Act. Therefore, under Exchange Act Section 36(a)(1), the 
Commission can adopt rules exempting classes of persons (here, 
smaller public companies) from compliance with [Sarbanes-Oxley] 
provisions, including * * * Section 404(b).''
    Letter from Committee on Federal Regulation of Securities, 
American Bar Ass'n, to SEC, p.4 n.2 (Nov. 28, 2005) (on file in SEC 
Public Reference Room File Nos. S7-40-02 & S7-06-03), available at 
http://www.sec.gov/rules/proposed/s70603/aba112805.pdf. We also are 
aware that the Commission's broad rulemaking authority under Section 
36(a)(1) of the Exchange Act may be exercised to provide exemptive 
relief from the requirements of Section 13(b)(2)(B) of the Exchange 
Act, the provision that requires public companies to devise and 
maintain the systems of internal accounting controls that are the 
subject of management's internal control report and the auditor's 
report required under Section 404. We also are aware that the 
Commission itself already has provided exemptive relief from Section 
404 for certain reporting entities, such as asset-backed issuers, 
indicating that the SEC believes it has exemptive authority to 
provide relief from technical compliance with Section 404. We 
believe the Commission could cite these and other authorities to 
demonstrate its authority to provide exemptive relief from the 
requirements of Section 404. In addition, the Commission could 
consider applying the canon of construction known as ``in pari 
materia'' to construe Section 404 as subject to the Commission's 
broad exemptive authority in the Exchange Act because the two 
statutes relate to the same subject matter and must be construed 
harmoniously.
---------------------------------------------------------------------------

Recommendation III.P.3
    While we believe that the costs of the requirement for an external 
audit of the effectiveness of internal control over financial reporting 
are disproportionate to the benefits, and have therefore adopted the 
second Section 404 recommendation above, we also believe that if the 
Commission reaches a public policy conclusion that an audit requirement 
is required, we recommend that changes be made to the requirements for 
implementing Section 404's external auditor requirement to a cost-
effective standard, which we call ``ASX,'' providing for an external 
audit of the design and implementation of internal controls.\101\
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    \101\ Mr. Barry abstained from the vote on this recommendation. 
Messrs. Jensen, Schlein and Veihmeyer dissented from the majority 
vote on this recommendation. Mr. Jensen's and Mr. Veihmeyer's 
reasons for their dissents are set forth in separate statements in 
Parts VII and IX, respectively, of this report.
---------------------------------------------------------------------------

    If the Commission decides to pursue this non-preferred alternative 
recommendation, we recommend that it direct the PCAOB to take certain 
steps, and consider taking certain other steps, in connection with 
developing the necessary new Audit Standard No. X, or ASX, described 
below. If those steps have been taken and considered, respectively, and 
complementary additional guidance is available that enables management 
to assess internal controls in a cost-effective manner,\102\ this 
alternative recommendation should be made effective for fiscal years 
starting one year after the PCAOB issues ASX.\103\
---------------------------------------------------------------------------

    \102\ The recommendation immediately below provides details 
regarding the additional guidance.
    \103\ We expect that the alternative recommendation could be 
effective for fiscal years beginning after December 31, 2007.
---------------------------------------------------------------------------

    The Commission should direct the PCAOB to take the following steps:
     Develop a new audit standard for smaller public companies 
(ASX) that provides guidance for the external audit of only the design 
and implementation of internal controls to make the work performed by 
auditors on internal controls more efficient for these companies;
     Have the standard specify a report that would be similar 
in scope to the report described in Section 501.71 of Standards for 
Attestation engagements (plus walkthroughs) of the AICPA; and
     Help to ensure that the standard would meet the cost-
effectiveness requirement of the alternative recommendation, by 
performing a cost-benefit analysis before the standard is issued in 
proposed form and a follow-up analysis before the standard is 
considered for adoption.
    The Commission should direct the PCAOB to consider taking the 
following steps in developing ASX:
     Involve all stakeholders in audits of internal control and 
include a field trial period to ensure that the approach is practical 
and results in achievement of required objectives;
     Take into account that a company would more likely engage 
its auditors to conduct an AS2 audit as the company gets more complex 
and the auditor plans or needs to place a high degree of reliance on 
internal controls to significantly reduce substantive audit procedures 
(but an auditor still would be permitted to place reliance on controls 
to reduce substantive testing in selected areas by testing specific 
controls without performing an AS2 audit); and
     Require that:
    [squf] The same auditor perform and integrate the ASX 
and financial statement audits;
    [squf] The auditor evaluate control deficiencies 
identified during the financial statement audit to determine their 
impact as to the ASX audit; and
    [squf] An auditor who identifies material weaknesses in 
either the design or operation of controls, should disclose the 
material weaknesses in its report and state that internal controls are 
not effective.
Internal Control Over Financial Reporting--Secondary Recommendations
    In addition to the foregoing primary recommendations in the area of 
internal control over financial reporting, we also set forth below for 
the Commission's consideration the following secondary recommendations:

[[Page 11107]]

Recommendation III.S.1
    Provide, and request that COSO and the PCAOB provide, additional 
guidance to help facilitate the assessment and design of internal 
controls and make processes related to internal controls more cost-
effective; also, assess if and when it would be advisable to reevaluate 
and consider amending AS2.
    Clear guidance does not yet exist for smaller public company 
managers on how to develop and support a proper Section 404 assessment 
of the effectiveness of internal control.
    Section 404 requires management to report on its assessment of the 
effectiveness of the company's internal controls and requires an 
external auditor to report on its audit of management's assessment and 
control effectiveness. As the COSO Framework is currently the most 
widely used internal control framework in the U.S., managements and 
auditors have used it to assess internal control. Based on the input 
provided by COSO on its framework, we have concluded that clear 
guidance does not yet exist for smaller public company managers on how 
to support a proper Section 404 assessment of internal control absent 
AS2.
    While COSO has proposed additional guidance for smaller companies, 
there is currently little practical guidance available to assist 
smaller companies in implementing the COSO Framework in a cost-
effective manner. AS2 provides guidance for an auditor to assess 
internal control effectiveness. It was not intended to provide 
management guidance. As a practical matter, however, because AS2 
provides detailed guidance for assessing internal control, it is by 
default the standard that management uses. We do not think that COSO's 
revised guidance for smaller companies will result in a cost effective 
or proportional alternative for implementing Section 404.
    The Commission should ask COSO to provide additional guidance to 
help management of smaller companies assess internal controls because 
of the lack of practical guidance and the absence of a standard to 
enable management of smaller companies to address internal control.
    The Commission could, for example, ask COSO to:
     Add post-year one monitoring guidance with selective 
testing where appropriate (in this regard, we note that the PCAOB, in 
its January 17, 2006 comment letter to COSO, noted that ``auditability 
should not be the primary goal of the guidance.''); and
     Emphasize that ``materiality'' for the purposes of 
evaluating a ``material weakness'' is to be determined on an annual but 
not on a quarterly basis (we note that this might require amendments to 
AS2 and SEC rules).
    The Commission should also ask the PCAOB to:
     Address the ability to rely on compensating controls 
(especially for smaller public companies);
     Describe ways to reduce compliance costs relating to 
information technology controls, a significant source of internal 
control compliance costs, consistent with the underlying risks; and
     Provide for smaller public companies:
     If no external audit of internal control is required, 
guidance on how management, in general, can assess internal controls 
efficiently and on a stand-alone (i.e., no external auditor 
involvement) basis; \104\ and
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    \104\ While AS2 provides a way to assess internal controls, it 
is designed for external auditors rather than management and has not 
proven to be a cost-effective tool in regard to smaller companies.
---------------------------------------------------------------------------

     If ASX is required, guidance on how management, in 
general, can assess internal controls efficiently and in satisfaction 
of the requirements of the external auditor acting under ASX without 
following the auditor-directed guidance in ASX or AS2.
    The PCAOB in its January 17, 2006 comment letter to COSO 
recommended that COSO reconsider whether there is additional, more 
practical guidance that COSO could provide to smaller public companies. 
We support this goal and consider such practical guidance as critical 
to smaller public companies having a cost-effective approach to 
assessing their internal controls.
    We believe that the Commission also should assess, in light of, 
among other factors, existing and suggested guidance, when it would be 
advisable to reevaluate and consider amending AS2. Furthermore, the 
Commission should provide additional guidance by clarifying 
considerations, and encouraging cost-effectiveness, relating to 
management's design and assessment of internal controls and by 
developing resources to enhance the availability of additional 
guidance.
    In order to provide this clarification and encouragement, the 
Commission could, for example,
     State that ``materiality'' for the purposes of assessing a 
``material weakness'' under Section 404 is to be determined on an 
annual but not on a quarterly basis;
     Note the ability to rely on compensating controls, 
especially for smaller public companies; and
     Suggest methods to reduce compliance costs relating to 
information technology controls, a significant source of internal 
control compliance costs, consistent with the underlying risks.
    In order to develop resources to enhance the availability of 
additional guidance, the Commission could, for example, allocate 
resources to develop a free Web site with a title such as ``Center of 
Excellence for Reporting and Corporate Governance for Smaller Public 
Companies.'' The Web site could contain, for example, best practices, 
frequently asked questions and complex transaction accounting advice.
    The Commission should also ask the PCAOB to provide additional 
guidance to help clarify and encourage greater cost-effectiveness in 
the application of AS2. The Commission should, for example, ask the 
PCAOB to reinforce and re-emphasize (including through the inspection 
process \105\) the helpful points made in the PCAOB's May 16 guidance 
\106\ and its November 30, 2005 report,\107\ including, in particular, 
the following:
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    \105\ See Conference Panelists Discuss Earnings Guidance and 
Accounting Issues, SEC Today (Feb. 14, 2006), at 2 (quoting Teresa 
Iannaconi as stating that while she believes the PCAOB is sincere in 
its attempt to bring greater efficiency to the audit process, 
accounting firms are not ready to ``step back,'' because they have 
all received deficiency letters, none of which say that the auditors 
should be doing less rather than more).
    \106\ PCAOB Release No. 2005-009, Policy Statement Regarding 
Implementation of Auditing Standard No. 2, an Audit of Internal 
Control Over Financial Reporting Performed in Conjunction with an 
Audit of Financial Statements (May 16, 2005).
    \107\ PCAOB Release No. 2005-023, Report on the Initial 
Implementation of Auditing Standard No. 2, An Audit of Internal 
Control Over Financial Reporting Performed in Conjunction with an 
Audit of Financial Statements (Nov. 30, 2005).
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     A risk-based approach is needed;
     Controls should provide management with reasonable 
assurance, not absolute or perfect certainty;
     ``More than remote'' means ``reasonably possible'' ;
     Control testing is to find material weaknesses, and other 
testing should be scaled back (i.e. testing is not to find deficiencies 
and significant deficiencies);
     The financial and internal control audits should be 
integrated (especially at smaller companies);
     All restatements should not be treated as material 
weaknesses because accounting complexity not control deficiencies are 
at the root of many restatements; and
     Management's consultation with the external auditor 
regarding the

[[Page 11108]]

proper accounting for a transaction should not lead the auditor 
conclude a material weakness exists.
    In addition, the Commission could ask the PCAOB to:
     State that materiality for the purposes of assessing a 
``material weakness'' under Section 404 should be determined on an 
annual rather than quarterly basis;
     Describe ways to reduce compliance costs relating to 
information technology controls, a significant source of internal 
control compliance costs, consistent with the underlying risks; and
     Consider and publicize additional ways to reduce the 
complexity of AS2 as currently being implemented.
Recommendation III.S.2
    Determine the necessary structure for COSO to strengthen it in 
light of its role in the standard-setting process in internal control 
reporting.
    COSO has been placed in an elevated role by virtue of being 
referenced in AS2 and the Commission's release adopting the Section 404 
rules. While the rules do not require the use of the COSO Framework in 
performing Section 404 assessments, COSO is by far the most widely used 
internal control framework for such purposes.
    In addition, COSO has issued preliminary guidance for smaller 
public companies. As a result, COSO has become a de facto standard 
setting body for preparers of financial statements though it is not 
recognized as an official standard setter, nor is it funded and 
structured as one.
    The Commission, in conjunction with other interested bodies, as 
appropriate, should determine the necessary structure for COSO, 
including a broader member constituency, to strengthen it in light of 
its important role in establishing and providing guidance with respect 
to the internal control framework used by most companies and auditors 
to evaluate the effectiveness of internal control over financial 
reporting.
* * * * *
    We fully agree with the goals of recent regulatory reforms, 
including the Sarbanes-Oxley Act, and believe that they have helped to 
improve corporate governance and restore investor confidence. These 
include reforms relating to board independence, management 
certifications and whistleblower programs. We disagree strongly, 
however, with the assertion that Section 404, as currently being 
implemented, is worth the significant ``tax'' it has placed on American 
business, in terms of dollars spent, time committed, and organizational 
mindshare that has been diverted from operating and growing their 
businesses.
    The proportionately larger costs for smaller public companies to 
comply with Section 404 may not generate commensurate benefits, 
adversely affecting their ability to compete with larger U.S. public 
companies, U.S. private companies and foreign competitors. Smaller 
companies would have to allocate their limited resources toward Section 
404 compliance even though the required control processes may not add 
significant value to their financial statements. If their ability to 
compete is diminished, these smaller U.S. companies may find it more 
difficult to raise capital to engage in value-producing investments.
    The significant, disproportionate compliance burden placed on the 
shareholders of smaller public companies has had a negative effect on 
their ability to compete with their larger U.S. public company 
competitors, and, to an even greater extent, their foreign competitors. 
This reduction in the competitiveness of U.S. smaller public companies 
will hurt their capital formation ability and, as a result, hurt the 
U.S. economy. Smaller companies have limited resources, which are being 
allocated unnecessarily to internal processes for Section 404 
compliance. Since these processes play less of a role in the 
preparation of financial statements for smaller companies, this effort 
results in diminished shareholder value that makes these companies less 
attractive investments and, thereby, harms their capital formation 
ability.
    The major drivers of the disproportionate burden are that smaller 
companies lack the scale to cost-effectively implement standards 
designed for large enterprises and that there are no guides available 
for management on how to make its own independent Section 404 
assessment or for auditors on how to ``right-size AS2'' for smaller 
companies.
    The ``cost/benefit'' challenge is being raised by companies of all 
sizes, but most acutely by smaller companies on which the burden of 
cost, time and mindshare diversion fall most heavily.

Part IV. Capital Formation, Corporate Governance and Disclosure

    We have conducted a full review of corporate governance and 
disclosure requirements applicable to smaller public companies. We 
concluded that, in general, aside from the significant regulatory 
scaling deficiencies outlined above, the current securities regulatory 
system for smaller public companies works well to protect investors. 
The oral testimony and written statements we received generally 
supported this conclusion. We did identify some areas, however, where 
we believe changes in regulation could be made that would reduce 
compliance costs without compromising investor protection.
    In terms of capital formation matters, we heard ample testimony and 
reviewed a significant amount of data regarding the disproportionate 
burden that the Sarbanes-Oxley Act, particularly Section 404, imposes 
on smaller companies. In terms of capital formation, we believe that 
the increased burden brought about by implementation of Section 404 and 
other regulatory measures have had a significant effect on both the 
nature of the relationship between private and public capital markets 
and on the attractiveness of the U.S. capital markets in relation to 
their foreign counterparts.
    In our view, public companies today must be more mature \108\ and 
sophisticated, have a more substantial administrative infrastructure 
and expend substantially more resources simply to comply with the 
increased securities regulatory burden. Additionally, the liquidity 
demands of institutional investors, the consolidation of the 
underwriting industry and the increased cost of going public have 
dictated that companies be larger,\109\ and effect larger transactions, 
in order to undertake an initial public offering. Stated simply, we 
believe that it is today far more difficult and expensive to go--and to 
remain--public than just a decade ago, and as a consequence, companies 
are increasingly turning to the private capital markets to satisfy 
their capital needs.
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    \108\ With respect to venture-backed startups, the average time 
from initial venture financing to initial public offering has 
increased from less than three years in 1998 to more than five and a 
half years today. Rebecca Buckman, Tougher Venture: IPO Obstacles 
Hinder Start-ups, Wall St. J., Jan. 25, 2006, at C1.
    \109\ The median stock market value of a venture-backed company 
going public last was $216 million, a marked increase from the $138 
million median value in 1997 and the just under $80 million median 
value in 1992. Id. at 3.
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    In light of the continued importance of the private markets, and 
our perception that most of the more obvious regulatory impediments to 
the efficient formation of capital lie in the private realm, we are 
making a number of recommendations that we believe will improve the 
ability of private companies to efficiently reach and communicate with 
investors, while continuing to protect those investors most in need of 
the protections afforded by registration under the Securities Act.
    In terms of the public markets, there is a concern that U.S. 
markets may

[[Page 11109]]

become increasingly less attractive for companies wishing to raise 
capital. The U.S. percentage of all money raised from foreign companies 
undertaking a new stock offering declined from 90% of all such money 
raised in 2000 to less than ten percent in 2005.\110\
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    \110\ G. Karmin and A. Luchetti, New York Loses Edge in Snagging 
Foreign Listings, Wall St. J., Jan. 26, 2006, at C1 (``[Undertaking 
an offering outside the U.S.] would have been an unusual move as 
recently as 2000, when nine out of every 10 dollars raised by 
foreign companies through new stock offerings were done in New York 
rather than London or Luxembourg * * * But by 2005, the reverse was 
true: Nine of every 10 dollars were raised through new company 
listings in London or Luxembourg, the biggest spread favoring London 
since 1990.'').
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    To address these issues, and to promote healthier and more robust 
capital markets, will require removing duplicative regulation, 
enhancing disclosure and promoting an improved atmosphere for 
independent analyst coverage of smaller public companies.

Capital Formation, Corporate Governance and Disclosure--Primary 
Recommendations

    We recommend that the Commission and other bodies, as applicable, 
effectuate the following:
Recommendation IV.P.1
    Incorporate the scaled disclosure accommodations currently 
available to small business issuers under Regulation S-B into 
Regulation S-K, make them available to all microcap companies, and 
cease prescribing separate specialized disclosure forms for smaller 
companies.
    As discussed above, we are recommending that the Commission 
establish a new system of scaled or proportional securities regulation 
for smaller public companies that would replace Regulation S-B and make 
scaled regulation available to a much larger group of smaller public 
companies. We are not recommending, however, that the scaled disclosure 
accommodations now available to small business issuers under Regulation 
S-B be discarded. Instead, we are recommending that they be integrated 
into Regulation S-K and made available to all microcap companies, 
defined as we recommend under ``Part II. Scaling Securities Regulation 
for Smaller Companies.'' In Recommendation IV.P.2 immediately below, we 
recommend that all scaled financial statement accommodations now 
available to small business issuers under Regulation S-B be made 
available to all smaller public companies, defined as we recommend 
under ``Part II. Scaling Securities Regulation for Smaller Companies.'' 
In addition, we are recommending that the Commission cease prescribing 
separate disclosure Forms 10-KSB, 10-QSB, 10-SB, SB-1 and SB-2 for 
smaller companies. All public companies would then use the same set of 
forms, such as Forms 10-K, 10-Q, 10, S-1 and S-3.
    As discussed briefly above, Regulation S-B was adopted by the 
Commission in 1992 as an integrated registration and reporting system 
covering both disclosure and financial statement rules for ``small 
business issuers.'' \111\ ``Small business issuer'' is defined as an 
issuer that with both revenues and a public float of less than $25 
million.\112\ The system provides specialized forms under the 
Securities and Exchange Acts with disclosure and financial statement 
requirements that are somewhat less rigorous than the requirements 
applicable to larger companies under Regulation S-K, the integrated 
disclosure system, and Regulation S-X, the integrated financial 
statement system, for larger companies.\113\
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    \111\ Small Business Initiatives, SEC Release No. 33-6949 (July 
30, 1992) [57 FR 36442]. Regulation S-B is codified at 17 CFR 228.10 
et seq.
    \112\ In addition, small business issuers must be U.S. or 
Canadian companies, cannot be investment companies or asset-backed 
issuers and cannot be majority owned subsidiaries of companies that 
are not small business issuers. 17 CFR 228.10(a)(1).
    \113\ Regulation S-K is codified at 17 CFR 229.10 et seq. 
Regulation S-X, which provides accounting rules for larger 
companies, is codified at 17 CFR 210.01.01 et seq. The accounting 
rules for small business issuers using Regulation S-B generally are 
contained in Item 310 of Regulation S-B, 17 CFR 228.310.
---------------------------------------------------------------------------

    We reviewed the benefits and drawbacks of Regulation S-B and 
considered whether the accommodations in Regulation S-B should be 
expanded, contracted, or extended to a broader range of smaller public 
companies. We considered oral and written testimony as to the benefits 
and limitations of Regulation S-B, including testimony and discussion 
during a joint meeting with the Commission's annual Forum on Small 
Business Capital Formation.\114\
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    \114\ See Record of Proceedings 48, 143, 148 (June 17, 2005) 
(testimony of William A. Loving, David N. Feldman and John P. 
O'Shea. See also Letter from Brad Smith to Committee (May 24, 2005) 
(on file in SEC Public Reference Room), available at http://www.sec.gov/rules/other/265-23/bsmith2573.htm; Letter from Kathryn 
Burns to Committee (May 24, 2005), available at http://www.sec.gov/rules/other/265-23/kburns052405.pdf; Letter from David N. Feldman to 
Committee (May 30, 2005, available at http://www.sec.gov/rules/other/265-23/dnfeldman053005.htm; Letter from Michael T. Williams to 
Committee (May 30, 2005), available at http://www.sec.gov/rules/other/265-23/mtwilliams6614.pdf; Letter from KPMG to Committee (May 
31, 2005), available at http://www.sec.gov/rules/other/265-23/kpmg053105.pdf; Letter from BDO Seidman to Committee (May 31, 2005), 
available at http://www.sec.gov/rules/other/265-23/bdoseidman053105.pdf; Letter from Stephen M. Brock (May 31, 2005), 
available at http://www.sec.gov/rules/other/265-23/smbrock1317.pdf; 
Letter from Ernst & Young (May 31, 2005), available at http://www.sec.gov/rules/other/265-23/ey053105.pdf; Letter from Small 
Business & Entrepreneurship Council to Committee (May 31, 2005), 
available at http://www.sec.gov/rules/other/265-23/kkerrigan8306.pdf; Letter from Society of Corporate Secretaries & 
Governance Professionals (June 7, 2005), available at http://www.sec.gov/rules/other/265-23/sspc-slc-scsgp060705.pdf; Letter from 
Mark B. Barnes to Committee (August 2, 2005), available at http://www.sec.gov/rules/other/265-23/mbbarnes080205.pdf; and Letter from 
Gregory C. Yardley, Jean Harris, Stanley Keller, A. John Murphy, and 
A. Yvonne Walker to Committee (Sept. 12, 2005), available at http://www.sec.gov/rules/other/265-23/gcyadley091205.pdf.
---------------------------------------------------------------------------

    Listed below are the primary disclosure accommodations currently 
available to small business issuers under Regulation S-B. We are 
recommending that all of these be integrated into Regulation S-K and be 
made available to all microcap companies. Microcap companies would have 
the option of following the disclosure requirements for larger 
companies if they chose to do so.
     Under Item 101 of Regulation S-B, small business issuers 
are required to provide a less detailed description of their business 
and to disclose business development activities for only three years, 
instead of the five years required of larger companies by Regulation S-
K.
     Regulation S-B currently does not include an Item 301 
(selected financial data) or Item 302 (supplementary financial 
information), which are included in Regulation S-K, meaning that small 
business issuers are not required to disclose this information.
     Regulation S-B provides for more streamlined disclosure 
for management's discussion and analysis of financial condition and 
results of operations by requiring only two years of analysis if the 
company is presenting only two years of financial statements, instead 
of the three years required of companies that present three years of 
financial statements, as required under Regulation S-K.\115\
---------------------------------------------------------------------------

    \115\ MD&A requirements are found in Item 303 of both Regulation 
S-K and Regulation S-B, 17 CFR 229.303 & 17 CFR 228.303.
---------------------------------------------------------------------------

     Regulation S-B does not require smaller companies to 
provide a tabular disclosure of contractual obligations as larger 
companies must do under Item 303(a)(5) of Regulation S-K.\116\
---------------------------------------------------------------------------

    \116\ 17 CFR 229.303(a)(5).
---------------------------------------------------------------------------

     Regulation S-B does not require small business issuer 
filings to contain quantitative and qualitative disclosure about market 
risk section as required of larger companies under Item 305 of 
Regulation S-K.\117\
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    \117\ 17 CFR 229.305.

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[[Page 11110]]

     Under Item 402 of Regulation S-B, small business issuers 
currently are not required to include a compensation committee report 
or a stock performance graph in their executive compensation 
disclosures, as larger companies are required to do under Item 402 of 
Regulation S-K.\118\
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    \118\ Executive compensation disclosure requirements are found 
in Item 402 of both Regulation S-K and Regulation S-B, 17 CFR 
228.402 and 17 CFR 229.402. The Commission recently proposed major 
amendments to the executive compensation disclosure rules under both 
Regulation S-B and Regulation S-K. See Executive Compensation and 
Related Party Disclosure, SEC Release No. 33-8655 (Jan. 27, 2006) 
[71 FR 6541]. We recommend that the Commission apply whatever 
executive compensation disclosure rules ultimately are adopted for 
smaller issuers to microcap companies as we propose to define that 
term rather than only to small business issuers as currently defined 
under Regulation S-B.
---------------------------------------------------------------------------

    We have numerous reasons for recommending the abandonment of 
Regulation S-B as a separate, stand alone integrated disclosure system, 
including the abandonment of separate prescribed forms for small 
business issuers. The drawbacks associated with Regulation S-B include 
a lack of acceptance of ``S-B filers'' in the marketplace, a possible 
stigma associated with being an S-B filer, and the complexity for the 
SEC and public companies and their counsel of maintaining and staying 
abreast of two sets of disclosure rules that are substantially similar. 
Further, we received input that many securities lawyers saying they are 
not familiar with Regulation S-B and therefore are hesitant to 
recommend that their clients use this alternative disclosure 
system.\119\
---------------------------------------------------------------------------

    \119\ See Record of Proceedings 48, 143, 148 (June 17, 2005) 
(testimony of William A. Loving, David N. Feldman and John P. 
O'Shea).
---------------------------------------------------------------------------

    We heard numerous comments to the effect that the thresholds for 
using Regulation S-B are too low and should be increased to permit a 
broader range of smaller public companies to be eligible for its 
benefits, particularly in light of the increased costs associated with 
reporting obligations under the Exchange Act since passage of the 
Sarbanes-Oxley Act.\120\
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    \120\ See Letter from Brad Smith to Committee (May 24, 2005) 
available at http://www.sec.gov/rules/other/265-23/bsmith2573.htm); 
Letter from Kathryn Burns to Committee (May 24, 2005), available at 
http://www.sec.gov/rules/other/265-23/kburns052405.pdf; Letter from 
David N. Feldman to Committee (May 30, 2005) available at http://www.sec.gov/rules/other/265-23/dnfeldman053005.htm; Letter from 
Michael T. Williams to Committee (May 30, 2005), available at http://www.sec.gov/rules/other/265-23/mtwilliams6614.pdf; Letter from KPMG 
to Committee (May 31, 2005), available at http://www.sec.gov/rules/other/265-23/kpmg053105.pdf; Letter from BDO Seidman to Committee 
(May 31, 2005), available at http://www.sec.gov/rules/other/265-23/bdoseidman053105.pdf; Letter from Stephen M. Brock to Committee (May 
31, 2005), available at http://www.sec.gov/rules/other/265-23/smbrock1317.pdf; Letter from Ernst & Young to Committee (May 31, 
2005), available at http://www.sec.gov/rules/other/265-23/ey053105.pdf; Letter from Small Business & Entrepreneurship Council 
to Committee (May 31, 2005), available at http://www.sec.gov/rules/other/265-23/kkerrigan8306.pdf; Letter from Society of Corporate 
Secretaries & Governance Professionals to Committee (June 7, 2005), 
available at http://www.sec.gov/rules/other/265-23/sspc-slc-scsgp060705.pdf; Letter from Mark B. Barnes to Committee (Aug. 2, 
2005). available at http://www.sec.gov/rules/other/265-23/mbbarnes080205.pdf; and Letter from Gregory C. Yardley, Jean Harris, 
Stanley Keller, A. John Murphy, and A. Yvonne Walker to Committee 
(Sept. 12, 2005), available at http://www.sec.gov/rules/other/265-23/gcyadley091205.pdf.
---------------------------------------------------------------------------

    In summary, we believe that incorporating the disclosure 
accommodations currently available to small business issuers under 
Regulation S-B into Regulation S-K, rather than retaining them in a 
separate but similar and parallel system, will result in many benefits. 
Among them, any stigma associated with taking advantage of the 
accommodations would be lessened. In addition, this would reduce the 
complexity of SEC rules, in keeping with the overarching goal expressed 
in our Committee Agenda of ``keeping things simple.''
Recommendation IV.P.2
    Incorporate the primary scaled financial statement accommodations 
currently available to small business issuers under Regulation S-B into 
Regulation S-K or Regulation S-X and make them available to all 
microcap and smallcap companies.
    As discussed above, we are recommending that the Commission 
establish a new system of scaled or proportional securities regulation 
for smaller public companies that would replace Regulation S-B. In 
Recommendation IV.P.1 immediately above, we recommend that the 
disclosure accommodations currently available to small business issuers 
under Regulation S-B be made available to all microcap companies, as we 
have recommended that term be defined in ``Part II. Scaling Securities 
Regulation for Smaller Companies'' above. In this recommendation, we 
recommend that the primary financial statement accommodations currently 
afforded to small business issuers under Regulation S-B be made 
available to all ``smaller public companies'' as we have recommended 
that term be defined above. Adopting this recommendation would mean 
that both microcap companies and smallcap companies, as we would have 
the Commission define those terms, would be entitled to take advantage 
of financial statement accommodations now available only to small 
business issuers.
    The primary financial statement accommodation now afforded to small 
business issuers is provided under Item 310 of Regulation S-B. That 
provision permits small business issuers to file two years of audited 
income statements, cash flows, and changes in stockholders equity and 
one year of audited balance sheet data in annual reports and 
registration statements. Larger public companies are required to file 
three years of audited income statement and other data and two years of 
audited balance sheet data under Regulation S-X.\121\ We recommend that 
smaller public companies be required to file only two years of audited 
income statements, cash flows, and changes in stockholders equity but 
two years of audited balance sheet data in annual reports and 
registration statements.
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    \121\ 17 CFR 210.1-01 et seq. The financial statement rules 
applicable to small business issuers appear in Item 310 as part of 
Regulation S-B, whereas the financial statement rules applicable to 
larger companies appear in Regulation S-X, an entirely separate 
regulation. We take no position on whether the financial statement 
rules that would apply to all smaller public companies under our 
recommendation should appear in Regulation S-K as a separate set of 
rules applicable to all smaller public companies, or in Regulation 
S-X.
---------------------------------------------------------------------------

    We believe that requiring a second year of audited balance sheet 
data for smaller public companies provides investors with a basis for 
comparison with the current period, without substantially increasing 
audit costs. On the other hand, we believe that eliminating the third 
year of audited income statement, cash flow and changes in stockholders 
equity data for smaller public companies will reduce costs and simplify 
disclosure while not adversely impacting investor protection in any 
significant way. Third year data and corresponding analysis is 
generally less relevant to investors than the more current data and 
third year data is often readily obtainable online.\122\ If the company 
has been a reporting company for three years, the third year data 
should be readily accessible through the Commission's EDGAR system and 
other sources. Investors today have access to numerous years of 
financial information about any reporting company because of the 
significant technological advances in obtaining financial information 
about reporting issuers. We do not believe that investors will be 
harmed in any significant way if the Commission adopts this 
recommendation.
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    \122\ See Internet Availability of Proxy Materials, SEC Release 
No. 34-52926 (Dec. 15, 2005) [70 FR 74598].

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[[Page 11111]]

    Moreover, we believe that eliminating the third year of income 
statement, cash flow and stockholders equity data for smaller public 
companies will reduce costs and simplify disclosure. Eliminating the 
third year of audited income statement and other data may serve to 
reduce costs associated with changing audit firms by eliminating 
certain of the expenses and processes associated with predecessor 
auditor consent requirements. An issuer's prior auditors must execute 
consents in order for financial statements previously audited by that 
firm to be included in SEC reports and registration statements. 
Adopting this recommendation may make it easier for smaller public 
companies to change their auditors, thereby increasing competition 
among auditing firms.
    In addition, we believe that the following financial statement 
accommodations currently provided to small business issuers would be 
afforded to all smaller public companies if this recommendation is 
adopted:
     In an initial public offering, small business issuers have 
a longer period of time in which they do not have to provide updated 
audited financial statements in their registration statements. For 
example, for non-small business issuers, if the effective date of the 
registration statement for the initial public offering falls after 45 
days of the end of the issuer's fiscal year, the non-small business 
issuer must provide audited financial statements in their registration 
statement for the most recently completed year, with no exceptions. For 
small business issuers, if the effective date of the registration 
statement falls after 45 days but within 90 days of the end of the 
small business issuer's fiscal year, the small business issuer is not 
required to provide the audited financial statements for such year end, 
provided that the small business issuer has reported income for at 
least one of the two previous years and expects to report income for 
the recently-completed year.\123\
---------------------------------------------------------------------------

    \123\ See 17 CFR 228.310(g)(2).
---------------------------------------------------------------------------

     Issuers filing a registration statement under the Exchange 
Act (which is currently filed on Form 10-SB but would be filed on Form 
10 if our previous recommendation is adopted) need not audit the 
financial statements for the previous year if those financial 
statements have not been audited previously. This also applies to any 
financial statements of recently acquired businesses or pending 
acquisitions that are included in an Exchange Act registration 
statement.
     Small business issuers need not provide financial 
statements of significant equity investees, as required by Rule 3-09 of 
Regulation S-X, in any document filed with the SEC.
    Small business issuers domiciled in Canada may present their 
financial statements in accordance with Canadian GAAP and reconcile 
those financial statements to U.S. GAAP. Any non-small business issuer 
filing a registration statement on a domestic form, such as Form S-1, 
S-3 or S-4, must present its financial statements in accordance with 
U.S. GAAP and provide all disclosures required under U.S. GAAP.
Recommendation IV.P.3
    Allow all reporting companies on a national securities exchange, 
NASDAQ or the OTCBB to be eligible to use Form S-3, if they have been 
reporting under the Exchange Act for at least one year and are current 
in their reporting at the time of filing.
    Form S-3 is a short-form registration statement under the 
Securities Act that allows companies eligible to use it maximum use of 
incorporation by reference to information previously filed with the 
Commission.\124\ As discussed below, we recommend that the efficiencies 
associated with the use of Form S-3 be made available to all companies 
that have been reporting under the Exchange Act for at least one year, 
and are current in their Exchange Act reporting at the time of filing. 
Additionally, we recommend elimination of the current condition to the 
use of Form S-3 that the issuer has timely filed all required reports 
in the last year.
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    \124\ Form S-3 can be found at 2 Fed. Sec. L. Rep. (CCH) ] 7151. 
Form S-3 was originally adopted in Revisions of Certain Exemptions 
from Registration for Transactions Involving Limited Offers and 
Sales, SEC Release No. 33-6383 (Mar. 3, 1982) [47 FR 11380].
---------------------------------------------------------------------------

    Current SEC rules allow issuers with over $75 million in public 
float to use Form S-3 in primary offerings. Additionally, Form S-3 may 
be used for secondary offerings for the account of any person other 
than the issuer if securities of the same class are listed and 
registered on a national securities exchange or are quoted on NASDAQ. 
Many smaller public companies are not eligible to use Form S-3 in 
primary offerings because their public float is below $75 million; they 
also cannot use Form S-3 in secondary offerings because their 
securities are not listed on a national securities exchange or quoted 
on NASDAQ.
    Since 1999, the NASD has required companies traded on its Over-the-
Counter Bulletin Board (``OTCBB'') \125\ to file reports under the 
Exchange Act. Under Exchange Act rules, registrants must file annual 
and quarterly reports disclosing information about their companies. 
Registrants also have an obligation to file current reports when 
certain events occur. All reporting companies have the same disclosure 
obligations as the largest of public companies. And, in order to take 
advantage of the Section 404 exemptive relief we are recommending for 
microcap companies, all those reporting companies included in the Pink 
Sheets would need to be current in their SEC periodic reporting 
obligations. Their disclosure should be sufficient to protect investors 
and inform the marketplace about developments in these companies. As 
online accessibility to previously filed documents on corporate and 
other Web sites, including the SEC's EDGAR Web site, increases; smaller 
public companies should be permitted to take advantage of the 
efficiency and cost savings of incorporation by reference to 
information already on file. The Commission has recently taken several 
steps acknowledging the widespread accessibility over the Internet of 
documents filed with the SEC. In its recent release concerning Internet 
delivery of proxy materials,\126\ the Commission noted that recent data 
indicates that up to 75% of Americans have access to the Internet in 
their homes, and that this percentage is increasing steadily among all 
age groups. As a result, we believe that investor protection would not 
be materially diminished if all reporting companies on a national 
securities exchange, NASDAQ or the OTCBB were permitted to utilize Form 
S-3 and the associated benefits of incorporation by reference. Further, 
the smaller public companies that would be newly entitled to use Form 
S-3 if this recommendation is adopted would not enjoy the automatic 
effectiveness of registration statements, as is the case with well 
known seasoned issuers under the SEC's recent Securities Act Reform 
rules.\127\ Accordingly, the SEC staff can elect to review the 
registration statement and documents of smaller public companies

[[Page 11112]]

incorporated by reference if it chooses to do so. Additionally, the 
Sarbanes-Oxley Act has required more frequent SEC review of periodic 
reports as well as enhanced processes, such as disclosure controls and 
procedures and certifications by the chief executive and chief 
financial officers, which further enhances investor protection. We 
believe the adoption of this recommendation will also facilitate 
capital formation by reducing costs of smaller public companies and 
providing more rapid access to the capital markets. We further 
recommend that corresponding changes be made to other forms providing 
similar streamlined disclosure for S-3 eligible issuers, such as Form 
S-4.
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    \125\ The OTCBB is a regulated quotation service that displays 
real-time quotes, last-sale prices, and volume information in over-
the-counter (OTC) equity securities. An OTC equity security 
generally is any equity security that is not listed or traded on 
NASDAQ or a national securities exchange.
    \126\ See Internet Availability of Proxy Materials, SEC Release 
No. 34-52926 (Dec. 15, 2005) [70 FR 74598].
    \127\ See Securities Offering Reform, SEC Release No. 33-8591 
(July 19, 2005) [70 FR 44722].
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    We acknowledge that some members of the public may believe that 
recommending Form S-3 eligibility for all reporting companies is 
contrary to our recommendation seeking relief from Sarbanes-Oxley Act 
Section 404 but we believe strongly that all reporting companies should 
have the same efficient access to the market as large reporting 
companies. Microcap companies have the same reporting obligations as 
the largest of reporting companies and should not be penalized because 
of size. The changes in reporting requirements of microcap companies on 
the OTCBB support this recommendation.
    We recommend that the Commission eliminate the requirement that the 
registrant has filed in a timely manner all reports required to be 
filed during the preceding 12 calendar months as a condition to the use 
of Form S-3, if the issuer has been reporting under the Exchange Act 
for at least 12 months and, at the time of such filing, has filed all 
required reports. We believe that the risk of SEC enforcement action, 
delisting notifications and accompanying disclosure, and associated 
negative market reactions are sufficient and more appropriate 
deterrents to late filings, and depriving late filers of an efficient 
means to access the capital markets is unduly burdensome to issuers, 
both large and small.\128\
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    \128\ To prevent issuers from taking advantage of the system by, 
for instance, becoming current on day one and filing a Form S-3 on 
day two, the Commission could require that the issuer be current for 
at least 30 days before filing a Form S-3.
---------------------------------------------------------------------------

    General Instructions to Form S-3 limit the use of that form for 
secondary offerings to securities ``listed and registered on a national 
securities exchange or * * * quoted on the automated quotation system 
of a national securities association,'' a restriction that by 
definition excludes the securities of OTCBB issuers. As a consequence, 
OTCBB issuers that undertake private placements with associated 
registration rights, or that are required to register affiliate or Rule 
145 shares, are required to file a registration statement on Form S-1 
or Form SB-2 and incur the substantial burden and expense that the 
continuous updating of those forms require.
    When the Commission adopted Form S-3 in 1982, the distinction drawn 
between OTCBB and exchange and NASDAQ-traded securities was logical. 
OTCBB issuers were not at the time required to file Exchange Act 
reports with the SEC. In 1999, however, the NASD promulgated new 
eligibility rules that required all issuers of securities quoted on the 
OTCBB to become SEC reporting companies and be current in its Exchange 
Act filings, making the need for such a distinction less apparent.\129\
---------------------------------------------------------------------------

    \129\ Press Release, NASD, NASD Announces SEC Approval of OTC 
Bulletin Board Eligibility Rule (Jan. 6, 1999).
---------------------------------------------------------------------------

    We concur with the Commission's original analysis in 1982 that 
``most secondary offerings are more in the nature of ordinary market 
transactions than primary offerings by the registrant, and, thus, that 
Exchange Act reports may be relied upon to provide the marketplace 
information needed respecting the registrant.'' \130\ In light of the 
current requirement that OTCBB issuers also be SEC reporting companies, 
we believe that extending Form S-3 eligibility for secondary 
transactions to OTCBB issuers is consistent with the rationale 
underlying Form S-3 at the time of its adoption. Moreover, allowing 
such use of Form S-3 would benefit OTCBB issuers by (1) eliminating 
unnecessary, duplicative disclosure while ensuring that security 
holders, investors and the marketplace are provided with the necessary 
information upon which to base an investment decision and (2) 
substantially reducing the costs associated with undertaking a private 
financing.
---------------------------------------------------------------------------

    \130\ See Revisions of Certain Exemptions from Registration for 
Transactions Involving Limited Offers and Sales, SEC Release No. 33-
6383, at 10 (Mar. 3, 1982) [47 FR 11380].
---------------------------------------------------------------------------

Recommendation IV.P.4
    Adopt policies that encourage and promote the dissemination of 
research on smaller public companies.
    The trading markets for public companies are assisted in great 
measure by the dissemination of quality investment research. Investment 
research coverage for public companies in general, and for smaller 
public companies in particular, has declined dramatically in recent 
years, however, as economic and regulatory pressures have led the 
financial industry to dramatically reduce research budgets.\131\ The 
problem is particularly pronounced in the case of smallcap companies, 
of which less than half receive coverage by even a single analyst, and 
in the microcap universe, where analyst coverage is virtually non-
existent.\132\
---------------------------------------------------------------------------

    \131\ A recent article notes, for instance, that fewer companies 
are receiving analyst coverage today than at any time since 1995. 
Where's the Coverage?, CFO Magazine (Jan. 20, 2005), available at 
http://www.cfo.com/article.cfm/3516678/c_3576955?f=home_todayinfinance.
    \132\ Testimony provided to the Committee indicated that 
approximately 1,200 of the 3,200 NASDAQ-listed companies, and 35% of 
all public companies, receive no analyst coverage at all. See Record 
of Proceedings 17 (June 17, 2005) (testimony of Ed Knight, Vice 
President and General Counsel of NASDAQ). Statistics provided by the 
SEC Office of Economic Analysis indicate that in 2004 approximately 
52% of companies with a market capitalization between $125 million 
and $750 million and 83% of companies with a market capitalization 
less than $125 million had no analyst coverage.
---------------------------------------------------------------------------

    The existing regulatory framework and business environment 
exacerbates this problem, and commission rates have declined for firms 
that historically used these revenue streams to fund research. Business 
models have emerged to create published research in order to fill the 
resulting void, although their involvement with independent research 
providers that also participate in the global settlement agreement has 
until recently been uncertain.\133\
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    \133\ In the course of the Advisory Committee's proceedings, we 
were made aware of one informal clarification regarding 
administration of the global settlement agreement in the recent 
analyst coverage enforcement cases that will likely have a 
beneficial effect on the availability of independent research. As 
members of the Commission are aware, one aspect of the global 
settlement agreement provides that, for a period of five years 
commencing in 2004, investment banks that are parties to the 
settlement are required to provide to their U.S. customers 
independent research reports alongside their own research reports on 
certain companies that their analysts cover. Entities that provide 
independent research reports to the settling banks (``independent 
research providers'' or ``IRPs'') cannot also conduct ``paid-for'' 
research, i.e., research done on behalf of, and paid for by, 
individual companies. Because many IRPs do not want to be excluded 
from participating in the global settlement, the effect of this 
prohibition--at least in the view of some--was to limit the number 
of entities willing to undertake paid-for research on behalf of 
individual companies.
    In October 2005, the five regulators overseeing implementation 
of the global settlement informed the independent consultants 
(essentially the persons responsible for procuring the independent 
research under the settlement) of how the settlement applies to 
independent research intermediaries that match companies and IRPs on 
a ``blind pool'' basis (i.e., a complete wall is maintained between 
the entity that purchases the research, most likely the company 
being analyzed, and the selection of an IRP to conduct the 
research). Although no formal pronouncement was issued, regulators 
responsible for the enforcement of the global settlement told the 
independent consultants that they have the discretion to decide 
whether or not to procure independent research from IRPs that also 
contract with independent research intermediaries, provided that 
certain conditions are met.

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[[Page 11113]]

    A lack of independent analyst coverage has several adverse effects, 
both for individual companies and for the capital markets as a whole:
     Companies with no independent analyst coverage have a 
reduced market capitalization in comparison with companies that do have 
such coverage, and are subject to higher financing costs when compared 
with their analyst-covered peers; \134\
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    \134\ A recent study on the effects of Regulation FD finds that 
when smaller companies lost analyst coverage after the regulation 
was enacted their cost of capital increased significantly. See 
Armando Gomes et al., SEC Regulation Fair Disclosure, Information, 
and the Cost of Capital (Rodney L. White Center for Fin. Research, 
Wharton School U. Pa., Working Paper No. 10567) (July 8, 2004).
---------------------------------------------------------------------------

     A lack of coverage by independent analysts limits 
shareholders' and prospective shareholders' ability to obtain an 
informed outsider's perspective on identifying strengths and weaknesses 
and areas for improvement;
     The lack of coverage lessens the entire ``mix of 
information'' made available to investment bankers, fund managers and 
individual investors, which make markets less efficient; and
     Because analyst reports trigger the buying and selling of 
shares, the lack of such reports frustrates the formation of a robust 
trading market.\135\
---------------------------------------------------------------------------

    \135\ Rebecca Buckman, Tougher Venture: IPO Obstacles Hinder 
Start-ups, Wall St. J., Jan. 25, 2006, at C1.
---------------------------------------------------------------------------

    In order to address the need for more independent research for 
smaller public companies, we recommend that the Commission:
     Maintain policies that allow company-sponsored research to 
occur with full disclosure by the research provider as to the nature of 
the relationship with the company being covered. Entities providing 
such research should disclose and adhere to a set of ethical standards 
that ensure quality and transparency and minimize conflicts of 
interest.\136\
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    \136\ Section 17(b) of the Securities Act provides: ``It shall 
be unlawful for any person, by the use of any means or instruments 
of transportation or communication in interstate commerce or by the 
use of the mails, to publish, give publicity to, or circulate any 
notice, circular, advertisement, newspaper, article, letter, 
investment service, or communication which, though not purporting to 
offer a security for sale, describes such security for a 
consideration received or to be received, directly or indirectly, 
from an issuer, underwriter, or dealer, without fully disclosing the 
receipt, whether past or prospective, of such consideration and the 
amount thereof.''
---------------------------------------------------------------------------

     Continue to permit ``soft dollar'' payments (i.e., the use 
of client commissions to pay for research services) under the safe 
harbor provisions of current Exchange Act Section 28(e), as amplified 
by guidance set forth in SEC Release No. 34-52635.
    We acknowledge that these two recommendations do not request 
significant changes in existing SEC policies, but rather, call for more 
or less continuation of existing policies. Despite a shared conviction 
that independent analyst coverage is critical to the success of smaller 
public companies and to the efficient operation of our capital markets, 
we were unable to identify specify regulatory impediments that could be 
modified in a manner that would be consistent with the Commission's 
investor protection mandate. We nonetheless have included these two 
recommendations in order to highlight for the Commission the existing 
problem, to ask that existing policies be maintained and to request 
that the Commission continue to search for new ways to promote analyst 
coverage for smaller public companies.
Recommendation IV.P.5
    Adopt a new private offering exemption from the registration 
requirements of the Securities Act that does not prohibit general 
solicitation and advertising for transactions with purchasers who do 
not need all the protections of the Securities Act's registration 
requirements. Additionally, relax prohibitions against general 
solicitation and advertising found in Rule 502(c) under the Securities 
Act to parallel the ``test the waters'' model of Rule 254 under that 
Act.
    The ban on general solicitation and advertising in connection with 
exempt private offerings dates back to some of the earliest SEC staff 
interpretations of the Securities Act.\137\ Although the initial 
intention of the ban is straightforward, over time its application has 
become complex. Few bright-line tests exist, and issuers are required 
to make highly subjective determinations concerning whether their 
actions might be construed as impermissible. Among the factors the SEC 
staff has considered in determining if a general solicitation has 
occurred are: the number of offerees; their suitability as potential 
investors; how the offerees were contacted; and whether the offerees 
have a pre-existing business relationship with the issuer.
---------------------------------------------------------------------------

    \137\ See, e.g., SEC Release No. 33-285 (Jan. 24, 1935).
---------------------------------------------------------------------------

    Beyond the difficulty of determining if particular contact is 
impermissible, however, the current ban on general solicitation and 
advertising effectively prohibits issuers from taking advantage of the 
tremendous efficiencies and reach of the Internet to communicate with 
potential investors who do not need all the protections of the 
Securities Act's registration requirements. In our view, this is a 
significant impediment to the efficient formation of capital for 
smaller companies, one that could easily be corrected by modernizing 
the existing prohibitions on advertising and general solicitation.
    Traditionally, both federal and state private offering exemptions 
have been conditioned on the absence of ``advertising or general 
solicitation.'' These concepts and SEC interpretations have not 
provided bright-line objective criteria for issuers and their advisers. 
Nevertheless, when it comes to exempt transactions, issuers face 
draconian risks to the viability of the entire offering for non-
compliance with just one of the many required exemption elements. For 
example, even if all purchasers (A) are accredited investors, (B) have 
pre-existing business relationships with the issuing company and (C) 
are contacted in face-to-face meetings, some case law supports the view 
that the exemption will nevertheless be lost for the entire offering if 
other issuer activities are found to have involved general solicitation 
or advertising. This could occur, for example, if the issuer made 
offers at a social function to 50 prospective purchasers, all of whom 
were social friends of the issuing company's principals but with whom 
the company did not enjoy pre-existing business relationships. A 
similar adverse result could occur if the issuer or an agent of the 
issuer placed an advertisement on a local cable TV show, Internet web 
page or newspaper that featured the issuer's capital formation 
interests. In these examples, the exemption could be lost (and all 
purchasers could seek a return of their invested funds) even though 
none of the offerees contacted in an impermissible manner became 
purchasers. As a result, prudence dictates that the available methods 
used to contact offerees be very limited. In our view, concerns with 
avoiding improper general solicitation or advertising have the effect 
of focusing a disproportionate amount of time and effort on persons who 
may never purchase securities--rather than on the actual investors and 
their need for protection under the Securities Act.
    Accordingly, we recommend the adoption of a new private offering 
exemption that would permit sales made only to certain eligible 
purchasers who do not require the full protections afforded by the 
securities registration

[[Page 11114]]

process under the Securities Act because of (1) financial wherewithal, 
(2) investment sophistication, (3) relationship to the issuer or (4) 
institutional status. An offering whose purchasers consisted solely of 
eligible purchasers of these types would qualify for the exemption 
regardless of the means by which they were contacted--even through 
advertising or general solicitation activities, subject to the 
restrictions noted below.
     The class of eligible purchasers would be comprised of 
several categories of natural persons and legal entities and would be 
defined in a manner similar to that used in Regulation D under the 
Securities Act \138\ to define the term ``accredited investors.'' \139\
---------------------------------------------------------------------------

    \138\ 17 CFR 230.501-508.
    \139\ See Securities Act Rule 501(a) under Regulation D, 17 CFR 
230.501(a).
---------------------------------------------------------------------------

     Natural persons would qualify as eligible purchasers based 
on (1) wealth or annual income, (2) investment sophistication,\140\ (3) 
position with or relationship to the issuer (officer, director, key 
employee, existing significant stockholder, etc.) or (4) pre-existing 
business relationship with the issuer. Persons closely related to or 
associated with eligible purchasers would also qualify as eligible 
purchasers.
---------------------------------------------------------------------------

    \140\ Under Regulation D, investment sophistication is the 
ability, acting alone or with the assistance of others, to 
understand the merits and risks of making a particular investment.
---------------------------------------------------------------------------

     The financial wherewithal standards for natural persons to 
qualify as eligible purchasers would be substantially higher than those 
currently in effect for natural person Accredited Investors.\141\ We 
suggest $2 million in joint net worth or $300,000 in annual income for 
natural persons and $400,000 for joint annual income.\142\
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    \141\ Under Regulation D as currently in effect, natural person 
accredited investors must have a net worth of $1 million (including 
property held jointly with spouse) or $200,000 in individual or 
$300,000 joint annual income. Rule 501(a)(6).
    \142\ There was support in the subcommittee for recommending the 
use of the financial wherewithal standards for natural person 
Accredited Investor in Regulation D for the eligible purchaser 
standards. It was our impression from informal discussions with 
federal and state regulatory officials that an increase in the 
financial wherewithal standards for natural persons was the sine qua 
non for obtaining regulatory support for this proposal.
---------------------------------------------------------------------------

     Legal entities would qualify as eligible purchasers if 
they qualify as accredited investors under Regulation D.
     The SEC should adopt the new exemption amending Regulation 
D or adopt an entirely new amendment under Section 4(2) of the 
Securities Act, so that securities sold in reliance on the new 
exemption would be ``covered securities'' within the meaning of Section 
18 of the Securities Act and generally exempted from the securities 
registration requirements of individual state securities laws. This 
course of action is crucial to the efficacy of the new exemption.
     The new exemption will need a two-way integration or 
aggregation \143\ safe harbor similar to that included in SEC Rule 
701.\144\ Under such a safe harbor, offers and sales made in compliance 
with the new exemption would not be subject to integration or 
aggregation with offers and sales made under other exemptions or in 
registered offerings. Similarly, offers and sales made under other 
exemptions or in registered offerings would not be subject to 
integration or aggregation with transactions under the new exemption.
---------------------------------------------------------------------------

    \143\ As the Commission is aware, ``integration'' refers to the 
SEC doctrine by which all offers and sales separated by time or 
other factors are nevertheless treated as part of a single offering. 
Offers and sales believed to be part of separate offerings that are 
integrated into a single offering are required to either comply with 
a single exemption from registration or be registered. Otherwise, 
they will violate Section 5 and trigger rescission rights for all 
purchasers. The SEC integration doctrine underpins much of the 
existing Securities Act registration exemption framework; without 
it, evading the Securities Act's registration requirements would be 
possible by artificially separating an otherwise non-exempt offering 
into two more distinct transactions and claiming an exemption for 
each transaction.
    \144\ 17 CFR 230.701.
---------------------------------------------------------------------------

     As a means of guarding against potential abuse, we 
envision that all solicitations made by means of mass media (e.g., 
newspapers, magazines, mass mailings or the Internet) would be 
restricted in scope to basic information about the issuer, similar to 
that found in Securities Act Rule 135c (currently a permissive rather 
than restrictive provision, and one applicable only to Exchange Act 
reporting companies).\145\ Solicitations made in face-to-face meetings 
would not be subject to these restrictions.
---------------------------------------------------------------------------

    \145\ 17 CFR 230.135c. A somewhat similar structure has been 
established by the North American Securities Administrators 
Association and adopted in 23 states. See, e.g., Texas 
Administrative Code Rule 139.19, which sets forth the information 
that can be included in the announcement.
---------------------------------------------------------------------------

    The proposed exemption would not remove the SEC's authority to 
regulate offers of securities. All offering activities conducted under 
the new exemption would continue to be fully subject to the antifraud 
provisions of the federal securities laws. Moreover, disclosure 
restrictions modeled after the current safe harbor found in Rule 135c 
would ensure that issuers could not utilize the Internet, television, 
radio, newspapers and other mass media to engage in ``pump and dump'' 
or other manipulative schemes.
    The proposed exemption is not a radical change in the fundamental 
regulatory rationale regarding exempt private offerings. In all the 
private offerings since the beginning of regulatory time, no offeree 
has ever lost any money unless he or she became a purchaser. The new 
exemption reduces the issuer's obligations regarding non-investors and 
refocuses on the need (or lack thereof) that actual purchasers have for 
the protections afforded by the securities registration process.
    We believe that this suggested change can be viewed as a logical 
continuation of an established regulatory trend to loosen the 
restrictions on what can be done with non-purchasers consistent with 
investor protection. The SEC has relaxed restrictions on offers in 
other, less bold ways.\146\ Almost a decade ago, Linda Quinn, the long-
time Director of the Division of Corporation Finance, proposed adopting 
an exemption substantially similar to that being recommended.\147\
---------------------------------------------------------------------------

    \146\ Rule 254, 17 U.S.C. 230.254, which is available for use 
only in Regulation A exempt offerings, allows issuers before 
approval of the offering by the SEC to ``test the waters'' with 
activities that would otherwise be considered improper advertising 
or general solicitation; because of the extremely infrequent use of 
Regulation A offerings and an incompatibility with comparable state 
securities laws, ``test the waters'' has been of little practical 
utility to the capital formation process. In addition, the SEC staff 
has issued interpretive letters advising registered broker-dealers 
that certain limited generic solicitation activities (including 
Internet-based solicitation) would not amount to impermissible 
advertising or general solicitation. See, e.g., Interpretative 
Letters E.F. Hutton Co. (Dec. 3, 1985), H.B. Shaine & Co, Inc. (May 
1, 1987) and IPOnet (July 26, 1996). But for these favorable 
interpretations, the conduct described in the letters might have 
been interpreted as impermissible advertising and general 
solicitation. In this regard, the staff has not extended its 
interpretation to cover conduct by issuers (or other non-broker-
dealers) that would allow them to engage in the solicitation 
activities described in the broker-dealer interpretative letters.
    \147\ Expressing her views about securities reform when she was 
leaving the staff of the Division of Corporation Finance, Ms. Quinn 
endorsed modifications in the Securities Act exemption regime 
consistent with the proposed exemption. See L. Quinn, Reforming the 
Securities Act of 1933: A Conceptual Framework, 10 Insights 1, 25 
(Jan. 1996). Ms. Quinn supported the use of ``public offers'' in 
exempt private offerings whose purchasers were limited to 
``qualified buyers'':
    In sum, offers would not be a Section 5 event and therefore 
would not be a source of Section 12(1) liability. * * * Offering 
communications would and should still be subject to the antifraud 
laws. * * * This approach could be effected by the Commission 
defining these communications as outside the scope of offers for 
purposes of Section 5 of the Securities Act, subject to conditions 
deemed appropriate. The test-the-waters proposal makes such use of 
the Commission's definitional authority. * * * Id. at 27.

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[[Page 11115]]

    As a corollary to our recommendation concerning a lifting of the 
ban on general solicitation when sales are made to certain eligible 
purchasers who do not need the full protection of Securities Act 
registration, we further recommend that the Commission relax 
prohibitions against general solicitation and advertising found in Rule 
502(c) under the Securities Act to parallel the ``test the waters'' 
model of Rule 254 under that Act. Whereas the former would generally 
maintain investor protection by limiting sales of securities to persons 
that time and experience have demonstrated do not need protections 
afforded by full registration, this recommendation would do so by 
limiting the information included in a general solicitation similar to 
that allowed in a Regulation A ``test the waters'' solicitation.\148\ 
Both measures would, in our view, significantly ease the difficulties 
that smaller companies, the largest users of private offering 
exemptions, encounter in locating suitable investors.
---------------------------------------------------------------------------

    \148\ 17 CFR 230.254.
---------------------------------------------------------------------------

    Although we defer to the Commission as to the exact parameters of 
permissible solicitation, we anticipate that any soliciting materials 
would be subject to restrictions modeled on those found in current Rule 
254.\149\ Issuers would be required to include disclosure to the effect 
that no money or other consideration is being solicited, that an 
indication of interest by a prospective investor involves no obligation 
or commitment of any kind, and that no sales of securities will be made 
until after the suitability of a potential investor for purposes of the 
applicable Regulation D exemption has been determined. Companies would 
also be required to include contact information, in order to 
communicate with those expressing interest and thereafter establish 
whether they fit within the suitability/accreditation standards for the 
offering before making a formal offer of securities, and a disclaimer 
to the effect that the offering itself may only be made to investors 
that satisfy the standards of the Securities Act exemption upon which 
the company intends to rely.\150\ By restricting solicitations in this 
manner, we believe that much benefit, and very little harm, would 
result from a relaxation of the current advertising/solicitation ban of 
Rule 502(c).
---------------------------------------------------------------------------

    \149\ Rule 254 was adopted in 1992 and has not been updated. We 
recommend that the SEC staff review the provisions of Rule 254 and 
harmonize the recommended changes to take into account the changes 
in SEC policy and practice since 1992, including the SEC's recently 
adopted securities offering reforms.
    \150\ As noted by a former Director of the SEC Division of 
Corporation Finance, the use of such disclaimers is an accepted 
practice under existing securities laws: ``Almost all 50 states 
recognize that if you advertise on the Internet but disclaim that 
you are not selling securities to their residents, and, in fact, do 
not sell to their residents, you have not made an illegal offering 
in that state. The Commission has used the same approach for 
offerings posted by foreign companies on their web sites. As long as 
foreign companies indicate they are not offering securities to U.S. 
citizens, their Internet posting is not an offering in the United 
States subject to the registration requirements of the federal 
securities laws. Why then prohibit a private placement as long as 
(1) it includes a warning that it will not sell to investors who do 
not meet the definition of an accredited investor and (2) does not, 
in fact, sell to unsophisticated investors? Who is harmed?'' Speech 
by Brian J. Lane to the American Bar Association (Nov. 13, 1999), 
available at http://www.sec.gov/news/speech/speecharchive/1999/spch339.htm.
---------------------------------------------------------------------------

    As with the recommendation immediately above, in order to work 
effectively the new exemption will need to be implemented by adoption 
of a new or amended rule under Section 4(2) of the Securities Act, such 
that securities sold in reliance on the new exemption would be 
``covered securities'' within the meaning of Section 18 of the 
Securities Act and consequently exempted from state securities 
registration requirements.
Recommendation IV.P.6
    Spearhead a multi-agency effort to create a streamlined NASD 
registration process for finders, M&A advisors and institutional 
private placement practitioners.
    As detailed in a recent report published in the Business 
Lawyer,\151\ there exists an unregulated underground ``money finding'' 
community that services companies unable to attract the attention of 
registered broker-dealers, venture capitalists or traditional angel 
investors.\152\ Many smaller companies rely on this community to assist 
them in raising capital. A separate community of unregistered and 
therefore unregulated M&A consultants who assist buyers and sellers 
with services and receive compensation substantially similar to those 
provided and earned by traditional registered investment bankers also 
exists. Virtually all of the services provided in support of capital 
formation and M&A activities amount to unregistered broker-dealer 
activities that violate federal and state broker-dealer registration 
and regulation law. For the most part, the services provided do not 
involve holding customers' funds, which is a traditional function of 
many registered broker-dealers. These unregulated service providers 
have a great reluctance to register as broker-dealers under the current 
regulatory framework. The enforcement activity against them seems 
minimal. The cost and administrative burdens of the current regulatory 
scheme are daunting to both the money finding and M&A communities. The 
absence of a workable registration scheme means that issuers cannot 
currently use broker-dealer registration as an element in 
differentiating between such providers. The proposal seeks to foster a 
scheme of registration and regulation, substantially in accordance with 
the ABA Task Force Proposal outlined in the Business Lawyer article 
referenced above, that will be cost-effective for the unregistered 
community and support the investor protection goals of securities 
regulation.
---------------------------------------------------------------------------

    \151\ Task Force on Private Placement Broker-Dealers, ABA 
Section of Business Law, Report and Recommendations of the Task 
Force on Private Placement Broker-Dealers, 60 Bus. Lawyer 959-1028 
(May 2005), available at http://www.abanet.org/buslaw/tbl/tblonline/2005_060_03/home.shtml#1. We note that the Texas State Securities 
Board is also drafting a finder proposal.
    \152\ Section 15(a)(1) of the Exchange Act defines broker-
dealers as persons who ``effect any transaction in, or * * * induce 
or attempt to induce the purchase or sale of, any security'' and 
makes it unlawful to carry on broker-dealer activities in the 
absence of SEC registration or exemption. Most state securities laws 
include similarly broad general definitions and prohibitions.
---------------------------------------------------------------------------

    An unregistered money finder will never ``come in from the cold'' 
to register if the regulators reserve the right to institute 
enforcement actions based solely on past failure to register. 
Accordingly, a workable amnesty program is also crucial to the success 
of the proposal. Regulatory amnesty should not extend to fraud nor be a 
defense against private causes of action.
    The private placement broker-dealer proposal is not new. It has 
been ``on the table'' for a number of years, and indeed, has been a top 
recommendation of the annual SEC Government-Business Forum on Small 
Business Capital Formation for nine of the past ten years. This 
demonstrates that other individuals and groups agree with our view that 
this proposal is important to improve small business capital formation. 
To date, however, none of the affected regulatory bodies have taken 
action. We believe the SEC must provide leadership if this proposal is 
to succeed. That leadership must come first from the Commission itself, 
and then the agency must reach out to the NASD and the state 
regulators.

Corporate Governance, Disclosure and Capital Formation--Secondary 
Recommendations

    In addition to the foregoing primary recommendations in the area of 
capital formation, corporate governance and disclosure, we also submit 
for the

[[Page 11116]]

Commission's consideration the following secondary recommendations:
Recommendation IV.S.1
    Amend SEC Rule 12g5-1 to interpret ``held of record'' in Exchange 
Act Sections 12(g) and 15(d) to mean held by actual beneficial 
holders.\153\
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    \153\ Although overall this recommendation passed unanimously, 
Messrs. Schacht and Dennis dissented from the majority vote with 
respect to that portion of the recommendation specifying that 
holders of unexercised stock options issued in compliance with Rule 
701 not be included as holders for purposes of Rule 12g5-1.
---------------------------------------------------------------------------

    In order for our recommendation that the Commission establish a new 
system of scaled or proportional securities regulation for smaller 
public companies to apply uniformly and to adequately protect 
investors, the rules under which companies are required to enter and 
allowed to exit the underlying disclosure system must not be subject to 
manipulation and circumvention. By law, companies must enter the system 
under Section 12(b) of the Exchange Act when they register a class of 
securities on a national securities exchange, under Section 12(g) of 
the Exchange Act when they have 500 equity shareholders of record and 
$10 million in assets, and under Section 15(d) of the Exchange Act when 
they have filed a registration statement under the Securities Act that 
becomes effective.\154\ Companies may be entitled to exit the system 
when their securities are removed from listing on a national securities 
exchange and when they have fewer than 300, or sometimes fewer than 
500, equity shareholders of record.\155\ The rules for entering and 
exiting the Exchange Act reporting system have come into increasingly 
sharp focus in recent years, due in part to the increasing costs 
associated with complying with the reporting and other obligations of 
reporting companies under the Exchange Act.
---------------------------------------------------------------------------

    \154\ 15 U.S.C. 78l(b), 78l(g) & 78o(d).
    \155\ 17 CFR 240.12h-3 & 17 CFR 240.12g-4.
---------------------------------------------------------------------------

    We have concluded that, because of the way that SEC rules permit 
the counting of equity shareholders ``of record'' under Exchange Act 
Rule 12g5-1,\156\ circumvention and manipulation of the entry and exit 
rules for the SEC's public company disclosure system is possible and 
occurs. Rule 12g5-1, which was adopted by the Commission in 1965, 
interprets the term ``security held of record'' in Section 12(g) for 
U.S. companies to include only securities held by persons identified as 
holders in the issuing company's stock ledger.\157\ This excludes 
securities held in street or nominee name, which is very common today, 
because shares held in street or nominee name are listed in the stock 
ledger as held in the names of brokers, dealers, banks and nominees. 
This interpretation originally was adopted to simplify the process of 
determining whether an issuer is required to report under Section 
12(g).
---------------------------------------------------------------------------

    \156\ 17 CFR 240.12g5-1.
    \157\ 17 CFR 240.12g5-1.
---------------------------------------------------------------------------

    As noted above, Congress added Section 12(g) to the Exchange Act in 
1964 to extend the reach of most of the Exchange Act's public company 
reporting and disclosure provisions to equity securities traded over-
the counter. That provision requires all companies with a class of 
equity securities held of record by at least 500 persons to register 
with the Commission.\158\ Companies registered with the Commission are 
required to file annual and quarterly reports with the SEC and to 
comply with the other rules and regulations applicable to public 
companies.\159\
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    \158\ 15 U.S.C. 781(g). Section 12(g) does not require 
registration if the company does not have a minimal level of assets. 
The level was $1 million in the original statute, but the Commission 
had raised the threshold to $10 million by rule by 1996. See Relief 
from Reporting by Small Issuers, SEC Release No. 34-37157 (May 1, 
1996) [61 FR 21354].
    \159\ Section 13(a) of the Exchange Act requires companies 
registered with the Commission to file annual and quarterly reports 
with the SEC.
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    Exchange Act Rules 12g-4 and 12h-3 \160\ regulate when an issuer 
can exit the reporting system under Section 12(g) or Section 15(d). 
These rules allow an issuer to terminate its Exchange Act reporting 
with respect to a class of securities held of record by fewer than 300 
persons, or fewer than 500 persons where the total assets of the issuer 
have not exceeded $10 million on the last day of the three most recent 
fiscal years.
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    \160\ 17 CFR 240.12g-4 and 240.12h-3.
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    The Nelson Law Firm, on behalf of a group of institutional 
investors, recently filed a rulemaking petition with the SEC requesting 
the Commission to take immediate action to amend Rule 12g5-1 to count 
all accounts as holders of record.\161\ This petition highlighted the 
practice by some issuers of using street or nominee holders as a 
technique to reduce the number of record holders below 300 and exit the 
Exchange Act reporting system. The petition cited numerous companies 
that had fewer than 300 record holders as determined in accordance with 
Rule 12g5-1, but thousands of beneficial owners and total assets of 
approximately $100 million or more. We also received a letter 
discussing and supporting the rulemaking petition.\162\ We received 
other letters in support of rulemaking in this area.\163\
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    \161\ See Rulemaking Petition of Nelson Law Firm to SEC (July 3, 
2003), available at http://www.sec.gov/rules/petitions/petn4-483.htm.
    \162\ Letter from Nelson Obus to Committee (Apr. 7, 2005), 
available at http://www.sec.gov/rules/other/265-23/26523-1.pdf.
    \163\ Letter from James Brodie to Committee (Apr. 12, 2005), 
available at http://www.sec.gov/rules/other/265-23/jabrodie9204.htm; 
Letter from Stephen Nelson to Committee (June 8, 2005), available at 
http://www.sec.gov/rules/other/265-23/sjnelson060805.pdf.
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    The trend of going dark is an area of concern to us. An issuer 
``goes dark'' when holders of record of all classes of securities fall 
below the 300 holder threshold and it files a Form 15 terminating its 
reporting obligations under Section 12(g) or suspends its obligations 
under Section 15(d).\164\ This procedure of going dark is contrasted 
with the going private procedures pursuant to Rule 13e-3.\165\ 
Companies that go private typically buy back securities from 
shareholders through an offering document using Rule 13e-3, which is 
filed with the Commission.
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    \164\ See Christian Leuz et al., Why do Firms go Dark? Causes 
and Economic Consequences of Voluntary SEC Deregistrations, Wharton 
Fin'l Inst. Center Paper No. 04-19 (Nov. 2004), available at http://fic.wharton.upenn.edu/fic/papers/04/0419.pdf; see also Andras Marosi 
& Nadia Massoud, Why Do Firms Go Dark? (3d ver. Nov. 2004), 
available at http://www.umanitoba.ca/faculties/management/cgafinance/Massoud.pdf#search= search='Andras%20Marosi%20Why%20 
firms%20go%20dark%3F.
    \165\ 17 CFR 240.13e-3. For a detailed explanation of going 
private transactions, see Marc Morgenstern & Peter Nealis, Going 
Private: A Reasoned Response to Sarbanes-Oxley?, (2004), available 
at http://www.sec.gov/info/smallbus/pnealis.pdf.
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    When the Commission first adopted Rule 12g5-1 in 1965, 
approximately 23.7% of securities were held in nominee or street 
name.\166\ In late 2002, it was estimated that over 84% of securities 
were held in nominee or street name.\167\ The Nelson Law Firm and other 
proponents of such an amendment to Rule 12g5-1 believe that the current 
definition of ``held of record'' allows a company to

[[Page 11117]]

manipulate its number of record holders to circumvent the intent of 
Section 12(g) of the Exchange Act.
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    \166\ Final Report of the Securities and Exchange Commission on 
the Practice of Recording the Ownership of Securities in the Records 
of the Issuer in Other than the Name of the Beneficial Owner of Such 
Securities Pursuant to Section 12(m) of the Securities Exchange Act 
of 1934, at 53-55 (Dec. 3, 1976) (the ``Street Name Study'').
    \167\ As of June 23, 2004, the DTCC estimated that approximately 
85% of the equity securities listed on the NYSE, and better than 80% 
of equity securities listed on the NASDAQ and AMEX, are immobilized. 
See Letter from Jill M. Considine, Chairman and CEO of DTCC, 
commenting on Securities Transaction Settlements, SEC Release No. 
33-8398 (Mar. 18, 2004) [69 FR 12922] (on file in SEC Public 
Reference Room File No. S7-13-04, available at http://www.sec.gov/rules/concept/s71304/s71304-26.pdf. The DTCC immobilization program 
is aimed at eliminating physical securities certificates and its 
ultimate objective is to place all equity securities ownership in a 
direct registration system which is a street name system.
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    The substantial increase in securities held by nominees or in 
street name has led to the circumvention of the intention of Section 
12(g) by enabling issuers with a significant number of shareholders to 
avoid registration, or deregister, if their equity holders are 
aggregated into a smaller number of nominee or record holders.
    In light of the above considerations, we recommend that the 
Commission amend Rule 12g5-1 or its interpretation so that all 
beneficial owners are counted for purposes of calculating the number of 
shareholders for purposes of Section 12(g) of the Exchange Act and the 
rules thereunder. We recommend that the Commission request its Office 
of Economic Analysis or some other professional organization conduct a 
study to determine the effects on the number of companies required to 
register if this recommendation is adopted. The study should also 
consider whether a standard other than number of shareholders would be 
a better determinant of when a company should be required to enter or 
allowed to exit the SEC disclosure system. After the study is 
completed, the Commission or Congress can decide whether the intent of 
Section 12(g) would be better served by changing the number of 
shareholders that triggers Exchange Act reporting from 500 to some 
other number. We believe that such a study is important because of the 
possibility of circumvention and manipulation of the SEC's rules for 
entering and exiting the disclosure system. The significant increase of 
costs associated with compliance with the registration and ongoing 
reporting obligations of the Exchange Act make this issue urgent.
    We also received testimony \168\ suggesting that employee stock 
options (those issued in compensatory transactions) not be considered a 
class of equity securities for purposes of triggering the registration 
requirements under Section 12(g) of the Exchange Act. We support this 
view. As exemplified by the policy underlying the Rule 701 exemption 
under the Securities Act, we believe that holders of employee stock 
options received in compensatory transactions are less likely to 
require the full protections afforded under the registration 
requirements of the federal securities laws. Therefore, we believe that 
such stock options should not be a factor in determining the point an 
issuer becomes subject to the burdens of a reporting company under the 
Exchange Act.
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    \168\ Record of Proceedings 64 (Sept. 19, 2005) (testimony of 
Ann Walker, Esq. before the joint meeting of the Committee and the 
Small Business Forum), available at http://www.sec.gov/rules/other/265-23/jh-sk-ajm-ayw-gcy091205.pdf.
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Recommendation IV.S.2
    Make public information filed under Rule 15c2-11.
    A major problem with the market for over-the-counter securities, 
where many issuers are not required to file reports with the SEC, is 
the lack of reliable, publicly available information on issuers.\169\ 
In theory, Exchange Act Rule 15c2-11, which prohibits brokers from 
publishing quotations on an OTC security unless they have obtained and 
reviewed current information about the issuer, could operate as a 
modest disclosure system under which investors could access basic 
issuer information if the company is not required to become a reporting 
company under Section 12(g) or 15(d). In practical terms, however, 
access to 15c2-11 information is extremely limited. Broker-dealers are 
required to file 15c2-11 information with the NASD only,\170\ to retain 
such information in their files and to provide such information, upon 
request, to individual investors. Broker-dealers are not required to 
publish this information in a widely available location or provide it 
to investors on an ongoing and systematic basis. The result is an over-
the-counter market in which the securities of literally thousands of 
issuers are traded, but about which current public information is 
uneven and in some cases non-existent. In our view, these conditions 
create the potential for fraud and manipulative abuse.
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    \169\ For statistics concerning over-the-counter issuers not 
required to file reports with the SEC, see Appendices I and J.
    \170\ See NASD Rule 6740 (Submission of Rule 15c2-11 Information 
on Non-NASDAQ Securities). To demonstrate compliance with both NASD 
Rule 6740 and SEC Rule 15c2-11, a member must file with NASD a Form 
211, together with the information required under SEC Rule 15c2-
11(a), at least three business days before the quotation is 
published or displayed.
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    In order to address this problem, we recommend that the Commission 
take action to provide for public availability of Rule 15c2-11 
information. Although we defer to the Commission on the exact means by 
which this information would be made available, we feel that an orderly 
and reliable disclosure system adopted under the SEC's antifraud 
authority could place the burden of disclosure on issuers, by requiring 
that they post a minimal level of documentation on their company web 
site, and on the NASD, by requiring that it create and maintain an 
information repository of Form 211s it has received, rather than on 
brokers and market-makers.
Recommendation IV.S.3
    Form a task force, consisting of officials from the SEC and 
appropriate federal bank regulatory agencies to discuss ways to reduce 
inefficiencies associated with SEC and other governmental filings, 
including synchronizing filing requirements involving substantially 
similar information, such as financial statements, and studying the 
feasibility of extending incorporation by reference privileges to other 
governmental filings containing substantially equivalent information.
    We received a number of comment letters from banks and banking 
trade associations expressing concern about what they consider 
duplicative filing requirements of the SEC and other governmental 
agencies and the costs and efficiencies that have resulted.\171\ 
Additionally, banks have advised us that they are subject to 
duplicative internal control requirements of various governmental 
regulators. We believe this recommendation is extremely important. 
Although we leave it to the Commission's discretion as to how best to 
implement this recommendation, we further believe that the introduction 
of XBRL may make this recommendation a more attractive option in 
today's world. We wish to state that in making this recommendation, we 
are in no way advocating an expansion of disclosure of personal bank 
information beyond what is currently permitted.
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    \171\ See Record of Proceeding 48 (June 17, 2005) (testimony of 
William A. Loving, Chairman and CEO of Pendleton County Bank 
representing the Independent Community Bankers of America); Letter 
from Independent Community Bankers of America to Committee (Mar. 31, 
2005), available at http://www.sec.gov/info/smallbus/acspc/icba.pdf; 
Letter from Christopher Cole of Independent Community Bankers of 
America to Committee (Apr. 8, 2005), available at http://www.sec.gov/rules/other/265-23/ccole040805.pdf; Letter from Kathryn 
Burns, Vice President and Director of Finance, Monroe Bank to 
Committee (May 24, 2005), available at http://www.sec.gov/rules/other/265-23/kburns052405.pdf; Letter from Charlotte Bahin, Senior 
Vice President, America's Community Bankers to Committee (July 19, 
2005), available at http://www.sec.gov/rules/other/265-23/acbankers071905.pdf; Letter from Mark A. Schroeder, President and 
CEO, German American Bankcorp to Committee (August 3, 2005), 
available at http://www.sec.gov/rules/other/265-23/maschroeder080305.pdf; Letter from Charlotte Bahin, Senior Vice 
President, America's Community Bankers, to Committee (Aug. 9, 2005), 
available at http://www.sec.gov/rules/other/265-23/cmbahin080905.pdf; Letter from David Bochnowski, President and CEO 
of Northwest Indiana Bancorp to Committee (Aug. 9, 2005), available 
at http://www.sec.gov/rules/other/265-23/dbochnowski080905.pdf.

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[[Page 11118]]

Recommendation IV.S.4
    Allow companies to compensate market-makers for work performed in 
connection with the filing of a Form 211, with full disclosure of such 
compensation arrangements.
    The filing of a Form 211, and compliance with the diligence and 
NASD review and comment process that such a filing entails, generally 
requires that a market-maker expend substantial time, effort and funds. 
Current NASD rules, however, prohibit market-makers from recouping any 
compensation or reimbursement for their outlay.\172\ While 
acknowledging the need for restrictions on payments by issuers to 
market-makers, we believe that in the limited context of the Form 211 
filing process, NASD rules act to discourage market-making activity and 
impede the creation of a fair and orderly trading market in securities 
of over-the-counter companies, most of which are smaller public 
companies. If Rule 15c2-11 is to remain focused on broker-dealer rather 
than issuer disclosure (see our recommendation immediately above) then 
we recommend that the Commission encourage the NASD to modify its rules 
to allow issuers to compensate market-makers for work they perform in 
connection with the filing of a Form 211 (including diligence costs and 
costs associated with the NASD review process), if the compensation 
arrangement is fully disclosed. We believe this approach will encourage 
dealers to engage in market-making and foster a more efficient and 
viable market for over-the-counter securities issuers.
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    \172\ NASD Rule 2460 (Payments for Market Making) provides: ``No 
member or person associated with a member shall accept any payment 
or other consideration, directly or indirectly, from an issuer of a 
security, or any affiliate or promoter thereof, for publishing a 
quotation, acting as market-maker in a security, or submitting an 
application in connection therewith.''
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Recommendation IV.S.5
    Evaluate upgrades or technological alternatives to the EDGAR system 
so that smaller public companies can make their required SEC filings 
without the need for third party intervention and associated costs.
    Since the SEC's EDGAR system \173\ was inaugurated in 1993, 
significant technological advances have occurred, including pervasive 
market deployment of Internet standards and protocols, software 
interoperability and embedded features. Computers with Internet 
capability are available in almost all workplaces and most homes and 
public libraries. The EDGAR system has not been updated to reflect 
these advances.
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    \173\ EDGAR is an abbreviation for the SEC's Electronic Data 
Gathering, Analysis, and Retrieval System, which must be used by 
reporting companies to file their reports with the SEC.
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    Many companies, but especially smaller public companies, find the 
EDGAR system unnecessarily complex and costly, and usually must engage 
costly third party vendors to file their reports with the Commission. 
We believe that the system's complexity and cost serves as an 
unnecessary burden on capital formation for smaller public companies.
    In this regard, we encourage the Commission to pursue the use of 
Internet standards (e.g., eXtensible Business Reporting Language, or 
XBRL) and protocols (e.g., web services) in the announced EDGAR 
modernization project as a method to reduce costs associated with the 
preparation of registrant filings and the subsequent access and use of 
filed information by the Commission's staff and the financial 
community. We believe that the use of highly interoperable business 
reporting formats will lower information access costs by the analyst 
and investor community and thereby enhance the analysis and liquidity 
of the securities of smaller public companies.
Recommendation IV.S.6
    Make it easier for microcap companies to exit the Exchange Act 
reporting system.
    As noted elsewhere in this report,\174\ we have found that the 
costs associated with implementing the requirements of the Sarbanes-
Oxley Act are borne disproportionately by smaller public companies. For 
a significant percentage of companies--particularly those at the lower 
end of the market capitalization spectrum, many of which went public in 
the pre-Sarbanes-Oxley era--these disproportionate costs are compounded 
because they enjoy none of the traditional benefits of being public: 
their stock receives little or no analyst coverage, has a limited 
trading market, provides limited liquidity for their shareholders, and 
attracts little institutional investment. They also experience a 
diminished ability to gain access to investment capital in the public 
markets, particularly during a market downturn. For such companies, the 
burdens of public company status may far outweigh the benefits.
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    \174\ See discussion under the caption ``Part II. Scaling 
Securities Regulation for Smaller Companies.''
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    At the same time, current SEC regulations require companies that 
wish to go private to submit to a lengthy SEC review process, in which 
a company must provide detailed disclosure as to the fairness of the 
transaction. The going private process generally includes the 
participation of investment banking firms, law firms and accountants, 
and hence results in substantial transaction costs.
    While the significance of the transaction and the possibility for 
conflicts of interest and insider abuse in a true ``going private'' 
transaction (i.e., one in which a controlling group undertakes a 
corporate transaction in order to acquire the entire equity interest in 
a corporation) justify this heightened scrutiny, the Committee believes 
that microcap companies that wish to go dark should be entitled to a 
simplified SEC review process conditioned on the issuer undertaking to 
provide the remaining shareholders with periodic financial and other 
pertinent information, such as unaudited quarterly financial 
statements, annual GAAP audited financial statements and narrative 
information about basic corporate governance, executive compensation 
and related party transactions as long as their shares trade in a 
public market. This approach would ensure that investors in such 
companies receive information necessary for operations transparency and 
protection of their interests.
Recommendation IV.S.7
    Increase the disclosure threshold of Securities Act Rule 701(e) 
from $5 million to $20 million.
    The SEC adopted Rule 701 in April 1988 to provide an exemption from 
the registration requirements under the Securities Act for offers and 
sales of securities by non-reporting companies to their employees. The 
Commission amended Rule 701 in 1999 to, among other things, replace the 
fixed aggregate $5 million offering ceiling contained in the original 
rule with a more flexible limit that required, among other items, 
disclosure of financial statement and risk factor information if the 
aggregate amount of securities sold under Rule 701 exceeded $5 million 
in any 12-month period.
    Over time, Rule 701 has proved to be an extraordinarily useful 
exemption for both small businesses and large private companies, and 
for the most part continues to work well. Nonetheless, the disclosure 
of financial statement information has been problematic for growing 
companies in recent years as a result of the recent trend towards 
longer IPO incubation periods, particularly in a ``down'' market 
environment, as well as the increased use of equity awards as an 
incentive for attracting/retaining employees. For private companies 
that

[[Page 11119]]

hope to maintain the confidentiality of their financial information for 
competitive reasons, the increasing need for equity compensation 
presents a dilemma: Disclose such information, and expose yourself to 
potential competitive harm (particularly relative to other private 
companies that are not required to disclose such information), or 
restrict equity awards to a limit below that which business conditions 
and sound judgment might otherwise dictate.
    Based on the foregoing, we believe that an increase in the 
disclosure threshold of Rule 701(e) to $20 million represents a more 
appropriate balance between the informational needs of employee-
investors and the confidentiality needs of private company issuers. The 
$5 million threshold was actually established in 1988, based upon the 
Commission's small issue exemptive limit at the time.\175\ The 
Committee's proposed increase would account for the amount of the 
original threshold that has been diminished due to inflation (as a 
point of reference, $5 million in 1988 would equal approximately $8.35 
million today) as well as provide issuers with increased flexibility 
for granting equity awards without compromising confidentiality.
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    \175\ Rule 701 was originally adopted under Securities Act 
Section 3(b), which has a $5 million limit, but was re-adopted in 
1999 under Securities Act Section 28, which was no such limit. See 
Rule 701--Exempt Offerings Pursuant to Compensatory Arrangements 
(Mar. 8, 1999) [64 FR 11095].
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    In the event that the Commission finds such increase in the 
disclosure threshold to be inadvisable, we recommend as an alternative 
that the financial statement disclosure requirements be eliminated or 
modified significantly if (1) options are non-transferable except by 
law and (2) options may only be exercised on a ``net'' basis with no 
employee funds paid to the issuer/employer.
Recommendation IV.S.8
    Extend the ``access equals delivery'' model to a broader range of 
SEC filings.
    Since 1995, the Commission has published guidance regarding the 
electronic delivery of materials under the federal securities 
laws.\176\ Recent studies indicate that 75% of Americans have access to 
the Internet in their homes, and that this percentage is increasing 
steadily among all age groups.\177\
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    \176\ Use of Electronic Media for Delivery Purpose; Action: 
Interpretation; Solicitation of Comment, SEC Release No. 33-7233 
(Oct. 6, 1995) [60 FR 53458], provided the initial guidance on 
electronic delivery of prospectuses, annual reports, and proxy 
materials under the Securities and Exchange Acts.
    \177\ See Internet Availability of Proxy Materials, SEC Release 
No. 34-52926 (Dec. 8, 2005) [70 FR 74597], citing Three Out of Four 
Americans Have Access to the Internet, Nielson/NetRatings (Mar. 18, 
2004).
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    The SEC recently has taken several steps to facilitate electronic 
delivery of filed documents filed with the Agency. In connection with 
the recent Securities Offering Reform effort, the Commission adopted 
Securities Act Rule 172 implementing an ``access equals delivery'' 
model in the context of final prospectus delivery. The Commission has 
also recently proposed a rule facilitating the electronic delivery of 
proxy materials.\178\ In that release, the Commission stated that its 
members ``believe that continuing technological developments and the 
expanded use of the Internet now merit consideration of alternative 
methods for the dissemination of proxy materials.'' \179\ In the access 
equals delivery model investors would be assumed to have access to the 
Internet thereby allowing delivery to be accomplished solely by an 
issuer posting a document on the issuer's or third party's Web site. 
This presumption differs from the current consent model where an 
investor must affirmatively consent to receiving documents 
electronically.
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    \178\ Id.
    \179\ See Acceleration of Periodic Report Filing Dates and 
Disclosure Concerning Website Access to Reports, SEC Release No. 34-
46464 (Apr. 8, 2003) [67 FR 58480]; Acceleration of Periodic Report 
Filing Dates and Disclosure Concerning Website Access to Reports; 
Correction, SEC Release No. 34-46464A (Sept. 5, 2003) [67 FR 17880].
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    We strongly support the proposed amendments to the proxy delivery 
rules. We believe these changes will reduce the printing and mailing 
costs associated with furnishing proxy materials to shareholders, while 
not impairing investor protection, as shareholders desiring paper 
versions of such documents are able to obtain them at no cost under the 
proposal. We believe, however, that the Commission should go further 
and recommend that the Commission extend the access equals delivery 
model for delivery to all SEC filings, thereby providing the 
efficiencies and cost savings of electronic delivery to all documents 
required to be delivered under the federal securities laws. The only 
exception to our recommendation is delivery of preliminary prospectuses 
in initial public offerings in Rule 15c2-8.\180\
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    \180\ 17 CFR 240.15c2-8.
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Recommendation IV.S.9
    Shorten the integration safe harbor from six months to 30 
days.\181\
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    \181\ Although the Committee is recommending a 30-day period, we 
are flexible in this regard.
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    The concept of integration, discussed above,\182\ has been the 
subject of intense criticism, almost since its inception,\183\ and 
small business issuers and their legal advisors have long expressed 
concerns about the absence of clarity in being able to determine the 
circumstances under which integration does (or does not) apply. Though 
the SEC attempted to introduce more certainty into the determination by 
introduction of a five-factor test in 1961,\184\ as a practical matter 
the question of integration remains for smaller companies an area 
fraught with uncertainty--and therefore risk.\185\
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    \182\ See text accompanying note 208.
    \183\ See Stanley Keller, Basic Securities Act Concepts 
Revisited, Insights (May 1995).
    \184\ See, e.g., Perry E. Wallace, Jr., Integration of 
Securities Offerings: Obstacles to Capital Formation Remain for 
Small Business, 45 Wash. & Lee L. Rev. 935, 937, 972-975 (1988) 
(integration doctrine ``frustrates issuers engaged in the capital 
formation process, engulfing them in a sea of ambiguity, uncertainty 
and potential liability'' and ``of the various sources of angst 
facing the small issuer, none has proved more frustrating and 
elusive than the doctrine of integration of securities offerings''). 
Faced with these difficulties, academics and practitioners have long 
argued for change to the existing system, with some even arguing 
that the very concept of integration should be abolished. In our 
view, however, this goes too far, as issuers could then split their 
offerings among several different exemptions, thus vitiating the 
registration process upon which the Securities Act is premised.
    \185\ The confusion over making an integration determination is 
made more difficult because the SEC staff does not currently render 
advice or provide no-action relief concerning integration questions.
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    Because of the link between integration and the availability of 
Regulation D and other registration exemptions, and consequently the 
ability of a smaller company to undertake a private financing, we 
believe that the SEC should provide smaller companies with clearer 
guidance concerning the circumstances under which two or more 
apparently separate offerings will or will not be integrated. After 
considering the difficulties of modifying the five-factor test in order 
to encompass the entire range of potential offering scenarios, we 
concluded that shortcomings of the existing framework can most easily 
be addressed by shortening the six-month safe harbor of Regulation D 
and applying the shortened safe harbor across the entire universe of 
private offering exemptions.
    The Regulation D safe harbor provides generally that offers and 
sales made more than six months before the start of

[[Page 11120]]

a Regulation D offering or more than six months after completion of a 
Regulation D offering will not be considered part of that Regulation D 
offering.\186\ The safe harbor is particularly significant for smaller 
companies, who rely heavily on Regulation D exemptions. Although it 
provides certainty, however, the safe harbor does so at the expense of 
flexibility, as it requires that as much as a full year elapse between 
offerings. For smaller companies, whose financing needs are often 
erratic and unpredictable, the duration of the safe harbor period is 
often problematic; even a well meaning issuer that needs access to 
capital, because of changed circumstances or greater than anticipated 
need for funding, may be unable to access such funds without running 
afoul of Section 5.
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    \186\ Rule 502(a) provides in pertinent part: ``Offers and sales 
that are made more than six months before the start of a Regulation 
D offering or are made more than six months after completion of a 
Regulation D offering will not be considered part of that Regulation 
D offering, so long as during those six month periods there are no 
offers or sales of securities by or for the issuer that are of the 
same or a similar class as those offered or sold under Regulation D, 
other than those offers or sales of securities under an employee 
benefit plan as defined in Rule 405 under the Act, 17 CFR 230.405.''
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    Inasmuch as the alternative to the safe harbor is the inherent 
uncertainty of the five-factor test, the practical effect of the 
waiting period between Regulation D offerings is to undermine issuers' 
flexibility and impede them from obtaining financing at a time that 
business goals, and good judgment, would otherwise dictate.
    In short, we believe that the dual six-month safe harbor period 
represents an unnecessary restriction on companies that may very well 
be subject to changing financial circumstances, and weighs too heavily 
in favor of investor protection, at the expense of facilitating capital 
formation. We believe that a shorter safe harbor period between 
offerings of 30 days strikes a more appropriate balance between the 
financing needs of smaller companies and investor protection, while 
preserving both investor protection and the integrity of the existing 
registration/exemption framework.
Recommendation IV.S.10
    Clarify the Sarbanes-Oxley Act Section 402 loan prohibition.
    Section 402, of the Sarbanes-Oxley Act, which added Section 13(k) 
\187\ to the Exchange Act, prohibits public companies from extending 
personal loans to directors or executive officers.\188\ The prohibition 
was enacted following abuses associated with company loans in several 
well-publicized corporate scandals. To date, the SEC's Division of 
Corporation Finance has not provided interpretive guidance with respect 
to Section 13(k). We believe that confusion exists among public 
companies and their attorneys concerning the applicability of the loan 
prohibition to a number of transactions that could be construed as 
loans.
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    \187\ 15 U.S.C. 78m(k).
    \187\ 17 CFR 230.405.
    \188\ Pub. L. 107-04, Sec.  402, 166 Stat. 745 (2002).
---------------------------------------------------------------------------

    We strongly support the loan prohibition contained in Section 13(k) 
of the Exchange Act. We recommend that the SEC staff seek to provide 
clarifying guidance as to the types of transactions that fall outside 
the prohibition.
    In particular, we recommend that the SEC's Division of Corporation 
Finance clarify whether Section 13(k) prohibits the cashless exercise 
of stock options, indemnity advances, relocation accommodations to new 
hires and split dollar life insurance polices. We believe that these 
transactions, if approved by independent directors, are unlikely to 
lead to the abuses envisioned under Section 402 of the Sarbanes-Oxley 
Act.
Recommendation IV.S.11
    Increase uniformity and cooperation between federal and state 
regulatory systems by defining the term ``qualified investor'' in the 
Securities Act and making the NASDAQ Capital Market and OTCBB stocks 
``covered securities'' under NSMIA.
    In fulfillment of our basic mandate--to identify methods of 
minimizing costs and maximizing benefits--we believe it is important to 
increase uniformity and cooperation between federal and state 
securities regulatory systems by eliminating unnecessary and 
duplicative regulations.
    In our view, this can be accomplished by both (1) defining 
``qualified purchaser'' as permitted by the National Securities Markets 
Improvement Act of 1996,\189\ or NSMIA, allowing transactions to 
involve ``covered securities'' and (2) making NASDAQ Capital Market and 
OTCBB stocks ``covered securities,'' thereby preempting most state 
securities registration provisions.
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    \189\ Pub. L. No. 104-290, 110 Stat. 3416 (1996).
---------------------------------------------------------------------------

    In connection with its passage of NSMIA, Congress authorized the 
SEC to define the term ``qualified purchaser'' under Securities Act 
Section 18 to include, among others, ``sophisticated investors, capable 
of protecting themselves in a manner that renders regulation by state 
authorities unnecessary.'' Section 18 also provides that sales to 
``qualified purchasers'' are by definition ``covered securities.'' The 
effect of defining ``qualified purchasers,'' therefore, would be to 
exempt offers and sales to persons included in the definition from 
unnecessary state registration requirements.
    The Commission in 2001 issued a release in which it proposed to 
define ``qualified purchaser'' to have the same meaning as the term 
``accredited investor'' under Rule 501(a) of Regulation D.\190\ 
Although the Commission solicited comment from interested parties, it 
took no further action on the proposal, in part because of the 
opposition of state securities regulators.\191\
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    \190\ Defining the Term ``Qualified Purchaser'' Under the 
Securities Act, SEC Release No. 33-8041 (Dec. 19, 2001) [66 FR 
66839].
    \191\ See, e.g., Letter from Joseph P. Borg, NASAA President and 
Director, Alabama Securities Commission, on behalf of the North 
American Securities Administrators Association to Committee (Mar. 4, 
2002), available at http://www.sec.gov/rules/proposed/s72301.shtml.
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    The Committee applauds the SEC's initiative in issuing the 
qualified purchaser release, and recommends that the ideas expressed in 
the release, principally, that all ``accredited investors'' be deemed 
``qualified purchasers,'' be adopted substantially as proposed. The 
release states, and we agree, that defining ``qualified purchaser'' to 
mean ``accredited investor'' would strike the appropriate balance 
between the need for investor protection and meaningful regulatory 
relief from duplicative state regulation for issuers offering 
securities, in particular small businesses.\192\ Investor protection 
would be maintained, as accredited investors have long been deemed not 
to require the full protection of Securities Act registration and have 
sufficient bargaining power to gain access to information with which to 
make informed investment decisions.
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    \192\ Supra note 190, at 4.
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    As the Commission is aware, in 1996 NSMIA realigned the 
relationship between federal and state regulation of the nation's 
securities markets in order to eliminate duplicative costs and improve 
market efficiency, while maintaining necessary investor protections. 
Although NSMIA greatly benefited large businesses, it had a more 
limited effect on small businesses, the securities of many of which 
trade on the NASDAQ Capital Market and the OTCBB and consequently do 
not qualify for the favorable exemptive treatment accorded ``covered 
securities.'' For these smaller public companies, the added

[[Page 11121]]

burden, complexity and transaction costs that result from a need to 
comply with numerous sets of laws and regulations, rather than just 
one, places them at a distinct disadvantage in comparison with their 
larger counterparts.
    In our view, the two-tiered regulatory structure to which the 
NASDAQ Capital Market and OTCBB-traded securities are subject 
represents an unnecessary and duplicative level of regulation that 
impedes the free flow of capital, while adding little in terms of 
investor protection. All companies traded in both markets are required 
to be Exchange Act reporting companies. Therefore, we recommend that 
the Securities Act Section 18(b) definition of ``covered securities'' 
be expanded to include the shares of all NASDAQ Capital Market and 
OTCBB issuers, provided that such companies (1) are current in their 
Exchange Act filings and (2) adhere to the corporate governance 
standards, detailed in Part III of this Committee report, that 
companies would be required to observe in order to get relief from 
certain requirements of Sarbanes-Oxley Act Section 404. We believe that 
this action would be consistent with the sentiment expressed in 
Securities Act Section 19(d), which mandates greater federal and state 
cooperation in securities matters in order to provide both maximum 
uniformity in federal and state regulatory standards and to minimize 
interference with capital formation. Further, investor protection would 
be preserved, as states would retain their anti-fraud authority and the 
SEC would maintain its supervisory role through review of issuer 
registration statements and Exchange Act filings.
    A final word should be said concerning the manner in which this 
recommendation is implemented. Although not entirely clear, it appears 
that the express language of Section 18 may not provide the Commission 
with the authority to expand the definition of ``covered securities'' 
to encompass NASDAQ Capital Market and OTCBB securities without further 
Congressional action. In such event, we recommend that the Commission 
petition Congress to enact legislative changes to Section 18 in order 
to effect such changes.
Recommendation IV.S.12
    Clarify the interpretation of or amend the language of the Rule 152 
integration safe harbor to permit a registered initial public offering 
to commence immediately after the completion of an otherwise valid 
private offering the stated purpose of which was to raise capital with 
which to fund the IPO process.
    Rule 152 provides an integration safe harbor that protects against 
integration of a private offering followed closely by a registered 
public offering. By its terms, the language of Rule 152 appears to 
require that an issuer ``decide'' to file for the public offering after 
the private offering.\193\ In other words, the safe harbor protection 
from integration would not appear to be available to an issuer that 
contemporaneously plans a private placement (for among other reasons, 
to raise funds necessary to sustain it through the IPO process) and a 
subsequent registered offering. Moreover, Rule 152 does not apply to 
private offerings undertaken pursuant to Rules 504 or 505, which are 
exempt pursuant to Securities Act Section 3(b), not Section 4(2) as set 
forth in the rule. Although the staff of the Division of Corporation 
Finance has indicated that it does not interpret Rule 152 literally, 
and will extend safe harbor treatment even in cases where an issuer 
concurrently plans a private placement and registered offering,\194\ we 
believe that it is time to clarify or amend the language of the rule 
appropriately.
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    \193\ Rule 152 provides as follows: ``The phrase `transactions 
by an issuer not involving any public offering' in Section 4(2) 
shall be deemed to apply to transactions not involving any public 
offering at the time of said transaction although subsequently 
thereto the issuer decides to make a public offering and/or files a 
registration statement.'' 17 CFR 230.152.
    \194\ See, e.g., SEC No Action Letter, Verticom, Inc. (Feb. 12, 
1986).
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Part V. Accounting Standards

    We devoted a considerable amount of time and effort surveying the 
current state of U.S. GAAP that apply to smaller public companies and 
certain of the processes related to the audits of their financial 
statements. In general, we believe that current regulations and 
processes in these areas serve smaller public companies and their 
investors very well. We did, however, identify several concerns in this 
area which, we acknowledge, are not all unique to smaller public 
companies. In decreasing order of concern, these areas are:
     Complexity of current accounting standards;
     Diminished use and acceptance of professional judgment 
because of fears of being second-guessed by regulators and the 
plaintiffs bar;
     Perception of lack of choice in selection of an audit 
firm;
     Lack of judgment concerning application of auditor 
independence rules; and
     Lack of professional education requirements covering SEC 
reporting matters for auditors of public companies.

Accounting Standards--Primary Recommendations

    We recommend that the Commission and other bodies, as applicable, 
effectuate the following:
Recommendation V.P.1
    Develop a ``safe-harbor'' protocol for accounting for transactions 
that would protect well-intentioned preparers from regulatory or legal 
action when the process is appropriately followed.
    This recommendation represents an attempt by us to address the 
diminished use of professional judgment caused in part by fears of 
second-guessing by regulators and the plaintiff's bar. This is a very 
serious issue for smaller public companies. Testimony taken by us, as 
well as written communications we received, strongly supported this 
view.
    Accounting standards for public companies vary in nature, ranging 
from standards containing principles and implementation guidance on 
broad accounting topics to those containing guidance pertaining to 
specific business transactions or industry events. Even with the broad 
spectrum of existing accounting standards, transactions or other 
business events frequently arise in practice for which there is no 
explicit guidance. In these situations, public companies and their 
auditors consider other relevant accounting standards and evaluate 
whether it would be appropriate to apply the guidance in those 
standards by analogy. Preparers often find it difficult to make these 
determinations, particularly in new or emerging areas. Even when 
accounting guidance is applied by analogy, questions frequently arise 
as to whether the analogy is appropriate based on a company's 
particular facts and circumstances. The result is that companies 
frequently end up adopting an approach dictated by their auditors, 
which the companies believe is caused by their auditors' concerns about 
regulators questioning their judgments, or for other reasons.
    In view of this situation, we are recommending that a ``safe-
harbor'' protocol be developed that would protect well-intentioned 
preparers from regulatory or legal action when a prescribed process is 
appropriately followed and results in an accounting conclusion that has 
a reasonable basis. A possible outline for the protocol for the 
preparer to follow would be as follows:
     Identify all relevant facts.
     Determine if there is appropriate ``on-point'' accounting 
guidance.

[[Page 11122]]

     If no on-point guidance exists, develop and timely 
document the preparer's conceptual basis for their conclusion as to the 
appropriate accounting treatment.
     Determine and timely document how the proposed accounting 
treatment reflects the economic realities of the transaction.
     Disclose in the financial statements and in Management's 
Discussion & Analysis the nature of the transaction, the possible 
alternative accounting treatments, and the rationale for the approach 
adopted.
    We believe that a ``safe harbor'' approach is suitable for dealing 
with this problem. In general, a safe harbor provision in a law serves 
to excuse liability if an attempt to comply in good faith can be 
demonstrated. Safe harbor provisions are used in many areas of the 
federal securities laws. One well-known safe-harbor that may serve as a 
model for crafting a safe-harbor for accounting transactions is the 
safe-harbor for forward-looking statements under the Private Securities 
Litigation Reform Act of 1995. The PSRLA provides a safe harbor from 
liability in private claims under the Securities Act and Exchange Act 
to a reporting company, its officers, directors and employees, as well 
as underwriters, for projections and other forward-looking information 
that later prove to be inaccurate, if certain conditions are met. The 
PSLRA's safe-harbor was based on aspects of SEC Rule 175 under the 
Securities Act and Rule 3b-6 under the Exchange Act.\195\ Both of these 
rules, adopted in 1979, provide a safe-harbor for certain forward-
looking statements published in documents filed with the SEC, provided 
the filer had a reasonable basis to make the statement and was acting 
in good faith. By combining aspects of, but not eliminating, Rules 175 
and 3b-6 with the judicially created ``bespeaks caution'' doctrine, 
Congress created a statutory safe-harbor based on the belief that the 
existing SEC rule-based and judicial safe-harbor protections did not 
provide adequate protections to reporting companies from abusive 
private securities litigation.\196\
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    \195\ 17 CFR 230.175, 240.3b-6.
    \196\ The PSLRA provides a safe-harbor from liability under the 
Securities Act and Exchange Act to the reporting company, its 
officers, directors, employees and underwriters, if the forward-
looking statements later prove to be inaccurate, if:
    1. The forward-looking statement is identified as such and is 
accompanied with meaningful cautionary statements identifying 
important factors that could cause actual results to differ 
materially; or
    2. The forward-looking statement is immaterial; or
    3. The plaintiff fails to prove the statement was made with 
actual knowledge that it was materially false or misleading.
    See Jay B. Kasner, The Safe Harbor for Forward-Looking 
Statements Under the Private Securities Litigation Reform Act of 
1995, Practising Law Institute (Sept. 2000); See also Stephen J. 
Schulte and Alan R. Glickman, Safe Harbors for Forward-Looking 
Statements: An Overview for the Practitioner, Practising Law 
Institute (Nov. 1997).
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    We believe that implementation of this recommendation has the 
potential to assist smaller public companies when working with their 
audit firms and other parties involved in the financial reporting 
system. This, in turn, should reduce excessive and unnecessary 
regulatory burdens on smaller public companies.
    We do not believe that implementation of our recommendation would 
fully address the diminished use of professional judgment due to fears 
of being second-guessed. This is a deep seated problem related to the 
excessive litigiousness of our society.\197\ Accordingly, we urge the 
Commission, other regulators and federal and state legislators to 
continue to search for appropriate and effective ways to lessen this 
problem and reduce unnecessary regulatory burdens on smaller companies.
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    \197\ See Record of Proceedings 95-100 (June 16, 2006) 
(statements of George Batavick, Adv. Comm. Observer, and Mark 
Jensen, Adv. Comm. Member, on the importance of tort reform to 
reduce litigation costs and facilitate a return to principles-based 
accounting).
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Recommendation V.P.2
    In implementing new accounting standards, the FASB should permit 
microcap companies to apply the same extended effective dates that it 
provides for private companies.
    New accounting standards typically introduce new accounting 
requirements or change existing requirements. In order to allow 
sufficient time for companies to gather information required by the new 
accounting standards, the FASB does not require new standards to be 
effective immediately upon issuance. Instead, the FASB establishes a 
date in the future when the accounting standards should be adopted, or 
become effective. The amount of time allowed by the FASB between the 
issuance of a new standard and its effective date varies and depends on 
the nature of the accounting requirements and the number of companies 
impacted. In addition, the FASB may establish different effective dates 
for private companies and public companies.\198\
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    \198\ FASB standards that distinguish between private and public 
companies usually define those terms. For examples where the FASB 
has deferred the effective dates for non-public entities, as defined 
therein, see FASB Statement of Financial Accounting Standards No. 
150, Accounting for Certain Financial Instruments with 
Characteristics of both Liabilities and Equity ] 29 (May 2003) and 
FASB Staff Position 150-3 (Nov. 2003).
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    In some cases, a company will need to gather and analyze a 
significant amount of information in order to adopt an accounting 
standard. Smaller public companies oftentimes may not have the 
resources of larger companies to assist with this effort.\199\ For 
example, companies may not have sufficient information technology or 
valuation specialists on staff and would need to consider hiring 
external parties. In addition, as business transactions have become 
more complex in recent years, accounting standards also have become 
more complex, requiring greater study and expertise by the preparers 
and auditors' of financial statements.\200\
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    \199\ See Letter from Ernst & Young LLP to Committee (May 31, 
2005); Letter from American Bankers Association to Committee (Aug. 
31, 2005).
    \200\ See Letter from BDO Seidman, LLP to Committee (May 31, 
2005).
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    We note that some of the more complicated accounting standards 
recently issued by the FASB permit private companies an extended period 
of time in which to adopt the new standard.\201\ We believe that 
allowing microcap companies more time to implement new accounting 
standards is appropriate. We are recommending that microcap companies 
be allowed to apply the same effective dates that the FASB provides for 
private companies in implementing new accounting standards. The 
Committee considered and rejected the notion that smallcap companies, 
in addition to microcap companies, also should be allowed extended 
effective dates. We believe that, in general, smallcap companies have 
more resources than microcap companies and should be able to adopt new 
accounting standards on the same time line as larger public companies.
---------------------------------------------------------------------------

    \201\ See Statement 150, paragraph 29. See also FASB Statement 
of Financial Accounting Standards No. 123, Share-Based Payment Sec.  
69, B248 (revised 2004) (permitting small business issuers, as 
defined, to defer adoption of the standard on the basis that those 
companies may have fewer resources to devote to implementing new 
accounting standards and thus may need additional time to do so).
---------------------------------------------------------------------------

    While making this recommendation, we do not propose to establish 
different accounting standards for smaller and larger public companies. 
Primarily through our Accounting Standards Subcommittee, we considered 
the so-called Big GAAP versus Little GAAP debate. This debate involves 
the advisability of adopting two different accounting standards for 
smaller and larger public companies, and whether U.S. GAAP should be 
made scalable for smaller public companies. The

[[Page 11123]]

Committee considered whether the needs of users of smaller public 
company financial statements are different from the needs of users of 
larger public company financial statements, whether smaller public 
companies incur disproportionate costs to provide certain financial 
information, and whether such information is actually used. The 
Committee discussed whether smaller public companies should have 
accounting standards with recognition, measurement and/or disclosure 
requirements that are different from those of larger public companies, 
and whether unintended adverse consequences would result from having 
two sets of GAAP.
    We have determined that different accounting standards should not 
be created for smaller and larger public companies. We believe such an 
approach would confuse investors and that, in many cases, the financial 
community would require smaller public companies to follow the more 
stringent accounting standards applicable to larger companies. We 
believe that if a two-tiered system of accounting standards existed, 
many smaller public companies would voluntarily follow the more 
stringent standards, so as not to be perceived as less sophisticated. 
We also believe that two different accounting standards for public 
companies would add significant costs to the financial reporting system 
and could potentially increase the cost of capital to smaller public 
companies, as risk premiums could attach to what might be perceived as 
less stringent accounting standards.\202\ Finally, we did not see 
evidence of any overwhelming support for a two-tiered system of 
accounting standards in the written and oral submissions we 
received.\203\
---------------------------------------------------------------------------

    \202\ See, e.g., Letter from Council of Institutional Investors 
to Committee (Aug. 26, 2005).
    \203\ See Record of Proceedings 24-26, 42 (Oct. 14, 2005) 
(testimony of Jane Adams, Maverick Capital Ltd., New York, New York, 
stating that companies by virtue of size should not be able to 
choose among multiple GAAP's to structure transactions and keep 
relevant information from investors, and if different standards are 
permitted, whether GAAP or internal controls, any financial 
statements and filings prepared under this light version should warn 
investors that this information did not come with the full package 
of protections and controls). See also Letter from 
PricewaterhouseCoopers LLP to Committee (Sept. 2, 2005); Letter from 
Grace & White, Inc. to Committee (Oct. 6, 2005); Letter from Glass 
Lewis & Co. to Committee (Sept. 14, 2005). See also responses to 
Questions 16 and 21 of Request for Public Input by Advisory 
Committee on Smaller Public Companies, SEC Release No. 33-8599 (Aug. 
5, 2005) available at http://www.sec.gov/rules/other/265-23survey.shtml.
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Recommendation V.P.3
    Consider additional guidance for all public companies with respect 
to materiality related to previously issued financial statements.
    We heard testimony related to a recent increase in financial 
statement restatements for previously undetected accounting 
errors.\204\ The Committee is concerned that these restatements are 
occurring where the impact of the error is not likely to be meaningful 
to a reasonable investor. The determination as to whether an event or 
transaction is material to the financial statements can be highly 
subjective and judgmental. One source of information for public 
companies to consider when making this determination is SEC Staff 
Accounting Bulletin No. 99, Materiality (SAB 99). SAB 99 expresses the 
staff's views regarding reliance on certain quantitative benchmarks to 
assess materiality in preparing financial statements and performing 
audits of those financial statements. One issue that is not addressed 
in SAB 99 relates to the assessment of materiality in quarterly 
reporting periods, including quarterly reporting periods of previously 
reported annual periods. We discussed whether one reason for these 
restatements might be the lack of guidance pertaining to assessing 
materiality in quarterly periods.
---------------------------------------------------------------------------

    \204\ Record of Proceedings 30-31 (Sept. 19, 2005) (testimony of 
Lynn E. Turner, Managing Director of Research, Glass Lewis & Co., 
noting that Huron Consulting Group reported that 75% of the 
restatements over the last five years have come from small 
companies); Record of Proceedings 105 (Sept. 19, 2005) (testimony of 
Michael McConnell, Managing Director, Shamrock Capital Advisors, 
Burbank, Calif., citing several studies that show half to three 
quarters of the restatements of public companies in the last several 
years have been by companies with either revenues under a half 
billion or market cap under $100 million). But see Record of 
Proceedings 108 (Sept. 19, 2005) (statement of Robert E. Robotti, 
Adv. Comm. Member, noting that the amount of restatements by smaller 
companies is proportionate to that of larger companies, since 
microcap companies represent 50% of all public companies). 
Institutional investor advisory firm Glass, Lewis & Co. estimates 
that a record 1,200 of the total 15,000 public companies will have 
announced accounting restatements by the time annual reports are 
filed for 2005. This compares with 619 restatements in 2004, 514 in 
2003, 330 in 2002 and 270 in 2001, the year before the Sarbanes-
Oxley Act was passed. The threat of criminal penalties for 
executives and the focus on internal controls by the Sarbanes-Oxley 
Act has created an environment of second-guessing by auditors, where 
minor accounting errors can now result in a full investigation of a 
company's accounting procedures. Excavations in Accounting: To 
Monitor Internal Controls, Firms Dig Ever Deeper Into Their Books, 
Wash. Post, Jan. 30, 2006, at D1.
---------------------------------------------------------------------------

    We recommend that the SEC consider providing additional guidance 
for all public companies with respect to materiality related to 
previously issued financial statements, to ensure that investor 
confidence in the U.S. capital markets is not being adversely impacted 
by restatements that may be unwarranted. Two specific fact patterns 
should be considered in developing additional guidance:
     The effect of the previously undetected error is not 
material to any prior annual or quarterly financial statements, the 
effect of correcting the cumulative error is not expected to be 
material to the current annual period, but the impact of correcting the 
cumulative error is material to the current quarter's financial 
statements. In this circumstance, we recommend the SEC consider whether 
the appropriate treatment would be to correct the cumulative error in 
the current period financial statements, with full and clear disclosure 
of the item and its impact on the current quarter, with no restatement 
of prior year or quarterly financial statements. We believe this 
treatment is consistent with the guidance in paragraph 29 of Accounting 
Principles Board Opinion No. 28, Interim Financial Reporting.\205\
---------------------------------------------------------------------------

    \205\ The Accounting Principles Board (APB) was the predecessor 
entity to the FASB.
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     The effect of a previously undetected error is not 
material to the financial statements for a prior annual period, but is 
material to one or more of the quarters within that year. In addition, 
the impact of correcting the cumulative error in the current quarter's 
financial statement would be material to the current quarter, but is 
not expected to be material to the current annual period. In this 
circumstance, we recommend the SEC consider whether the appropriate 
treatment would be the same as described above since the impact on the 
previously issued annual financial statements is not material. In this 
event, full disclosure in the current quarter financial statements 
should be required.
Recommendation V.P.4
    Implement a de minimis exception in the application of the SEC's 
auditor independence rules.
    The Commission's rules on the independence of public company 
auditors include a general standard of auditor independence.\206\ In 
determining whether a relationship or provision of a service not 
specifically prohibited by the rules impairs the auditor's 
independence, four principles must be considered.\207\ The

[[Page 11124]]

Commission's rules also set forth specific prohibitions on financial, 
employment, and business relationships between an auditor and an audit 
client, as well as prohibitions on an auditor providing certain non-
audit services to an audit client, and augment the general standard and 
related principles.\208\ One of the principles is that an auditor 
cannot audit his or her own work. The Committee considered whether the 
current auditor independence rules should be modified for smaller 
public companies to make it clear that an auditor may provide some 
assistance.
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    \206\ The most recent revision to the auditor independence rules 
occurred in Jan. 2003. See Strengthening the Commission's 
Requirements Regarding Auditor Independence, SEC Release No. 33-8183 
(Jan. 28, 2003) (68 FR 6006).
    \207\ See Remarks by Edmund W. Bailey, Senior Associate Chief 
Accountant, U.S. Securities and Exchange Commission, Before the 2005 
AICPA National Conference on Current SEC and PCAOB Developments 
(``Bailey 2005 AICPA Remarks'') (discussing principles regarding 
auditor independence).
    \208\ See Preliminary Note to Rule 2-01 of Regulation S-X and 
Item 201(c)(4) of Regulation S-X, 17 CFR 210.2-01(c)(4); Exchange 
Act Section 10A(g).
---------------------------------------------------------------------------

    In May 2005, the Commission issued a statement related to internal 
control reporting requirements that also discussed this issue.\209\ The 
Commission stated that as long as management makes the final 
determination regarding the accounting to be used for a transaction and 
does not rely on the auditor to design or implement internal controls 
related to that accounting, it did not believe that the auditor's 
providing advice or assistance, in itself, constitutes a violation of 
the independence rules. The Committee considered whether this guidance 
would enable an auditor to provide assistance to smaller public company 
related to new and/or complicated accounting standards or with unusual/
complicated transactions.
---------------------------------------------------------------------------

    \209\ See Commission Statement on Implementation of Internal 
Control Reporting Requirements, May 16, 2005.
---------------------------------------------------------------------------

    Ultimately, we concluded that no modification to the Commission's 
independence rules is warranted with respect to auditors providing 
assistance to smaller public companies. In making this recommendation, 
we noted the principle that auditors should not audit their own work 
and believe this basic premise is critical to ensuring auditor 
independence and the resulting confidence of investors in the financial 
statements of all companies, including smaller public companies. The 
Committee concluded that a separate set of auditor independence rules 
for larger and smaller publicly-held companies would be inappropriate. 
We believe that our recommendation to apply the same extended effective 
dates for microcap companies that the FASB provides for private 
companies will help serve to alleviate the pressure and costs to 
microcap companies in implementing new accounting standards and reduce 
their need for significant assistance from their auditors.
    As a separate matter, we acknowledged that the current auditor 
independence rules do not provide relief for violations of the rules 
based on materiality considerations. As a result, we believe that a 
seemingly insignificant violation of the auditor independence rules 
could have significant consequences.\210\ These consequences could 
require a company to immediately change audit firms, to declare its 
previous filings invalid and to engage an audit firm to re-audit its 
prior financial statements, creating significant cost and disruption to 
the company and its stockholders. The Committee therefore recommends 
that the SEC examine its independence rules and consider establishing a 
rule provision that provides relief for certain types of violations 
that are de minimis in nature as long as these are discussed with and 
approved by the company's audit committee.\211\
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    \210\ One witness testified that audit firms are somewhat 
paranoid about violating these independent rules and rightfully so. 
The SEC and PCAOB need to go further to provide very clear 
guidelines for audit firms as to what they can do and cannot do. In 
order to facilitate audit firms assist smaller public companies with 
their SEC reporting, some degree of proportionality in limiting the 
amount of the penalty for an inadvertent violation of the auditor 
independence rules should be used. Record of Proceedings 14 (Aug. 9, 
2005) (testimony of Mark Schroeder, Chief Executive Officer, German 
American Bancorp).
    \211\ See Bailey 2005 AICPA Remarks (discussing some of the 
information considered by the SEC Office of the Chief Accountant 
when making assessments regarding the impact of an independence 
rules violation).
---------------------------------------------------------------------------

Accounting Standards--Secondary Recommendations

    In addition to the foregoing primary accounting standards 
recommendations, we also submit for the Commission's consideration the 
following secondary recommendations:
Recommendation V.S.1
    Together with the PCAOB and the FASB, promote competition and 
reduce the perception of the lack of choice in selecting audit firms by 
using their influence to include non-Big Four firms in committees, 
public forums, and other venues that would increase the awareness of 
these firms in the marketplace.
    This recommendation represents our best attempt to deal with the 
very serious problem of the lack of competition in the auditing 
industry, stemming in large part from market concentration. Smaller 
companies are seriously harmed by this state of affairs.\212\ A large 
concentration of both large and small public companies is audited by 
the Big Four audit firms.\213\ Notwithstanding that the Big Four audit 
firms have earned a well-deserved reputation of expertise in auditing 
public companies, we heard testimony from several non-Big Four audit 
firms that indicated that they too are capable of serving smaller 
public companies.\214\

[[Page 11125]]

The PCAOB has registered and oversees over 900 U.S. public audit firms. 
The experience of some of our members, as well as submissions made to 
us, confirms a trend for smaller public companies to consider options 
other than the Big Four audit firms.\215\ More encouragement should be 
given to audit committees and underwriters to seriously consider 
engaging a non-Big Four audit firm. We believe that market forces 
ultimately will determine which firms will audit public companies. We 
recognize the Commission's, the PCAOB's and the FASB's limited 
authority to affect concentration in the auditing industry. We also 
recognize that some of our recommendations concerning internal control 
may increase the concentration of smaller public companies with 
revenues over $250 million who are audited by the Big Four.\216\
---------------------------------------------------------------------------

    \212\ One witness testified that smaller public companies are 
having trouble timely filing their annual and quarterly reports with 
the SEC, because the Big Four audit firms are dropping them as 
clients, generally because they fall outside the Big Four's profiles 
for acceptable risk. Record of Proceedings 12 (June 17, 2006) 
(testimony of Edward S. Knight, Executive Vice President and General 
Counsel, NASDAQ Stock Market, Inc.). Another witness testified that, 
due to changes in the accounting industry resulting from the 
Sarbanes-Oxley Act and consequent pressure from institutional and 
retail investors, increasing importance has been placed on using a 
Big Four firm. As a result, smaller public companies, who are the 
least prepared to negotiate, are increasingly facing oligopolies, 
resulting in a disruption in the normally balanced relationship 
between a company and its accounting firm. Young smaller public 
companies are now in constant fear that their auditors will either 
increase their audit fees or abandon them because of the pressure on 
the auditing firm to obtain more profitable business from larger 
companies. He recommended that emphasis be placed on the 
acceptability of more regional accounting firms for use by smaller 
public companies, as well as the establishment or encouragement of a 
fifth or sixth Big Four audit firm to restore a more appropriate 
balance between accounting firms and their client companies in order 
to contain costs and at the same time provide an alternative audit 
firm that is generally accepted by the investment community. Record 
of Proceedings 32-33, 37-38 (June 17, 2005) (testimony of Alan 
Patricof, Co-Founder, Apax Partners). See also Remarks by 
Christopher Cox, Chairman, U.S. Securities and Exchange Commission, 
Before the 2005 AICPA National Conference on Current SEC and PCAOB 
Developments (Dec. 5, 2005) (stating that competition is essential 
for the proper functioning of any market, and a broader and more 
competitive market for audit services should be encouraged).
    \213\ See United States General Accounting Office, Report to the 
Senate Committee on Banking, Housing, and Urban Affairs and the 
House Committee on Financial Services, Public Accounting Firms, 
Mandated Study on Consolidation and Competition (GAO-03-864) (July 
2003).
    \214\ Record of Proceedings 19 (Sept. 19, 2005) (testimony of 
Richard Ueltschy, Executive, Crowe Chizek and Company, LLC) 
(``[S]maller public companies, virtually all of them could be served 
adequately by more than the Big Four, certainly the eight largest 
firms that are subject to annual review by the PCAOB. And, in fact, 
many of those smaller public companies could also be effectively 
served by the dozens of qualified regional C.P.A. firms.''); Record 
of Proceedings 129, 130-133 (Aug. 9, 2005) (testimony of Bill 
Travis, Managing Partner, McGladrey & Pullen LLP, commenting that 
his firm, as well as many other second-tier non-Big Four audit 
firms, have a level of expertise and resource capabilities that can 
certainly serve the needs of very large mid-market companies with 
global facilities around the world, as well as a much greater 
percentage of small and mid-size publicly-traded companies). See 
also Record of Proceedings 92 (Oct. 14, 2005) (testimony of Gerald 
I. White, Grace & White, Inc., New York, New York) (``I don't see 
any evidence that the large firms do any better job than the small 
ones.'').
    \215\ One witness testified that, although the bottom line is 
whether audit committees and investment banks are willing to advise 
choosing a non-Big Four firm, current market conditions are 
fortunately driving some changes in the industry out of necessity. 
Big Four firms have limited resources and are allocating their 
resources to wherever the best use of those resources may be used by 
their major clients. Non-Big Four firms are benefiting from this 
market development in that very high quality public companies have 
to go find other non-Big Four firms to do their audits. Accordingly, 
he indicated that firms like his are receiving many inquiries as to 
whether they are capable of doing the work, and are in fact winning 
the work, including such firms as Grant Thornton, LLP and BDO 
Seidman, LLP. Accordingly, he believes that market conditions are 
doing a lot more to win work for the non-Big Four audit firms than 
any marketing communications could have done. See Record of 
Proceedings 130-131 (Aug. 9, 2005) (testimony of Bill Travis, 
Managing Partner, McGladrey & Pullen LLP). See also Record of 
Proceedings 19 (Sept. 19, 2005) (testimony of Richard Ueltschy, 
Executive, Crowe Chizek and Company, LLC) (``We are seeing today 
many companies at * * * the smaller end of the large company 
classification, as this group's defined it, that are now choosing to 
look outside the Big Four for their audit services. And they're 
doing so largely because of an attempt to introduce a bit of market 
competition into the pricing for the service. * * * [T]here's a fair 
amount of activity in terms of auditor change, there's real price 
competition being introduced into that process.''); Record of 
Proceedings 92 (Oct. 14, 2005) (testimony of Gerald I. White, Grace 
& White, Inc., New York, New York) (``[S]maller firms seem to be 
clearly gravitating away from the largest auditors to smaller 
auditors. And I suspect that not just audit costs, but 404 costs are 
driving that process.'').
    \216\ See Letter from Crowe Chizek and Company LLC to Committee 
(Feb. 20, 2006), available at http://www.sec.gov/rules/other/265-23/mhildebrand022006.pdf (``Removing the auditor involvement 
requirement for Smallcap companies will cause firms other than the 
Big Four to have very few internal control audit clients * * * This 
will create a large, unintended competitive advantage to the Big 
Four and foster further consolidation in the audit profession.'') 
and Letter from McGladrey and Pullen LLP to Committee (Feb. 21, 
2006), available at http://www.sec.gov/rules/other/265-23/btravis022106.pdf (supporting the efforts of the Advisory Committee 
but expressing concern that the Committee's Section 404 
recommendations will further concentrate audit services of public 
companies with the Big 4 audit firms and suggesting that the SEC 
take further measures to ensure that there is no further audit 
concentration of audit services in the United States).
---------------------------------------------------------------------------

    We nevertheless believe that efforts to promote competition in the 
auditing industry and educate registrants in the choice of selecting 
audit firms is essential to maintain pricing discipline and to address 
the perceived lack of competition in the auditing industry. We are 
therefore recommending that the SEC, the PCAOB promote competition 
among audit firms and that the FASB further this effort by ensuring 
that non-Big Four firms are included in committees, public forums, and 
other venues that would increase the awareness of these firms in the 
marketplace.\217\
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    \217\ See, e.g., Record of Proceedings 84 (June 17, 2005) 
(testimony of Wayne A. Kolins, National Director of Assurance and 
Chairman of the Board, BDO Seidman, LLP, encouraging the use of 
symposiums, whereby the CEO's and CFO's of smaller public companies 
meet to discuss their experiences using non-Big Four audit firms); 
Record of Proceedings 130 (Aug. 9, 2005) (testimony of Bill Travis, 
Managing Partner, McGladrey & Pullen LLP, encouraging non-Big Four 
audit firms to become more active with regulatory organizations like 
the PCAOB and SEC and others to build awareness of the capabilities 
of the non-Big Four audit firms); Record of Proceedings 63-64, 82-83 
(June 17, 2005) (testimony of Alan Patricof, Co-Founder, Apax 
Partners, recommending that regulatory bodies use the bully pulpit 
and moral suasion to increase awareness and acceptance of the good 
quality of regional non-Big Four auditing firms, including 
encouraging investment banking firms to rely upon these non-Big Four 
firms).
---------------------------------------------------------------------------

Recommendation V.S.2
    Formally encourage the FASB to continue to pursue objectives-based 
accounting standards.\218\ In addition, simplicity and the ease of 
application should be important considerations when new accounting 
standards are established.
---------------------------------------------------------------------------

    \218\ See SEC Staff's Study Pursuant to Section 108(d) of the 
Sarbanes-Oxley Act of 2002 on the Adoption by the United States 
Financial Reporting System of a Principles-Based Accounting System, 
released in July 2003 (``Principles-Based Accounting System Staff 
Study'') (``objectives-oriented'' standards are distinguished from 
``principles-based'' or ``rules-based'' standards).
---------------------------------------------------------------------------

    This recommendation is an attempt to deal with the issue of 
excessive complexity in accounting standards.\219\ This complexity 
disproportionately impacts smaller public companies due to their lack 
of resources. Complexity is created because of:
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    \219\ See Remarks by Robert H. Herz, Chairman, Financial 
Accounting Standards Board, Before the 2005 AICPA National 
Conference on Current SEC and PCAOB Developments (Dec. 6, 
2005)(discussing the complexity in financial reporting). See also 
Remarks by Christopher Cox, Chairman, U.S. Securities and Exchange 
Commission, Before the 2005 AICPA National Conference on Current SEC 
and PCAOB Developments (Dec. 5, 2005); Remarks by Scott A. Taub, 
Acting Chief Accountant, U.S. Securities and Exchange Commission, 
Before the 2005 AICPA National Conference on Current SEC and PCAOB 
Developments (Dec. 5, 2005).
---------------------------------------------------------------------------

     An unfriendly legal and enforcement environment that 
diminishes the use and acceptance of professional judgment in today's 
financial reporting system because of fears of second-guessing by 
regulators and the plaintiff's bar.\220\
---------------------------------------------------------------------------

    \220\ One witness encouraged a move towards more of a 
principles-based and a judgment-based approach to accounting so that 
competent people on the audit committees, in management and in the 
audit firms can work together to use their respective intellect, 
judgment and knowledge of the business to determine where best to 
spend their time each year, in such areas, for example, as internal 
control compliance with Section 404 of the Sarbanes-Oxley Act. He 
commented that all the guidance provided so far by the SEC and the 
PCAOB on the use of professional judgment is tempered, however, by 
the current uncertainty as to what will be the expectations of 
company management, the audit committee and the auditor once there 
is a major failure due to an unintended mistake reported in the 
system. Until we see the results of such a mistake, he believes 
there will continue to be conservatism in the practice of audit 
firms, management teams and audit committees. Record of Proceedings 
117-118 (Aug. 9, 2005) (testimony of Bill Travis, Managing Partner, 
McGladrey & Pullen LLP).
---------------------------------------------------------------------------

     Development of complex business arrangements and 
accounting-motivated transactions.\221\
---------------------------------------------------------------------------

    \221\ The SEC Staff's report entitled Report and Recommendations 
Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On 
Arrangements with Off-Balance Sheet Implications, Special Purpose 
Entities, and Transparency of Filings by Issuers (``Off-Balance 
Sheet Staff Study''), released in June 2005, refers to an 
accounting-motivated structured transaction as a transaction 
structured in an attempt to achieve reporting results that are not 
consistent with the economics of the transaction. As an example, the 
report cites to the restructuring of lease arrangements to avoid the 
recognition of liabilities on the balance sheet following the 
issuance of the FASB's Statement No. 13, Accounting for Leases, 
released in 1976.
---------------------------------------------------------------------------

     Constituent concerns about earnings volatility and desire 
for industry-specific guidance and exceptions.\222\
---------------------------------------------------------------------------

    \222\ See Principles-Based Accounting System Staff Study 
(listing three of the more commonly-accepted shortcomings of rules-
based standards, such as numerous bright-line tests, exceptions to 
principles underlying the accounting standards, and complexity in 
and uncertainty about the application of a standard reflected in the 
demand for detailed implementation guidance).
---------------------------------------------------------------------------

     Frequent requests by preparers and auditors for detailed 
accounting guidance to limit potential inconsistencies in the 
application of accounting standards and second-guessing by the legal 
community and enforcement authorities.\223\
---------------------------------------------------------------------------

    \223\ Id. See also FASB Staff Position No. 123(R)-2, Practical 
Accommodation to the Application of Grant Date as Defined in FASB 
Statement No. 123(R) (Oct. 18, 2005).
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    Certain accounting standards create complexity because:

[[Page 11126]]

     The lack of a fully developed conceptual framework leads 
to inconsistent concepts and principles being applied across accounting 
standards.\224\
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    \224\ For example, related to the accounting for revenue 
transactions, FASB Statement of Concepts No. 5, Recognition and 
Measurement in Financial Statements of Business Enterprises, states 
that revenues are not recognized until earned. FASB Statement of 
Concepts No. 6, Elements of Financial Statements, defines revenues 
as inflows or other enhancements of assets or liabilities. The FASB 
currently has a revenue recognition project on its agenda designed 
in part to eliminate this inconsistency. The FASB also has on its 
agenda a joint project with the International Accounting Standards 
Board to develop a common conceptual framework that is complete and 
internally consistent.
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     Scopes in standards are at times unclear and may contain 
exceptions.\225\
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    \225\ For example, FASB Interpretation No. 45, Guarantor's 
Accounting and Disclosure Requirements for Guarantees, Including 
Indirect Guarantees of Indebtedness of Others, clarifies the scope 
of FASB Statement No. 5, Accounting for Contingencies. This 
interpretation excludes certain guarantees from its scope and also 
excludes other guarantees from the initial recognition and 
measurement provisions of the interpretation.
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     The standards have different measurement attributes (such 
as historical cost versus fair value) and treatment alternatives.\226\
---------------------------------------------------------------------------

    \226\ See, e.g., FASB Statement No. 115, Accounting for Certain 
Investments in Debt and Equity Securities (providing classification 
alternatives for investments in debt and equity securities, 
resulting in different measurement alternatives).
---------------------------------------------------------------------------

     Rules and bright-line standards provide opportunities for 
accounting-motivated transactions that are not necessarily driven by 
economics.\227\
---------------------------------------------------------------------------

    \227\ See Off-Balance Sheet Staff Study.
---------------------------------------------------------------------------

     The standards themselves have become extremely lengthy and 
difficult to read.\228\
---------------------------------------------------------------------------

    \228\ See, e.g., FASB Statement No. 133, Accounting for 
Derivative Instruments and Hedging Activities (June 1998) (exceeding 
800 pages of authoritative guidance and over 180 implementation and 
interpretive issues).
---------------------------------------------------------------------------

    Additional complexity in accounting standards also comes about 
because:
     In prior years, multiple parties set standards, such as 
the SEC, the FASB, the AICPA, the Accounting Principles Board (APB), 
and the Emerging Issues Task Force (EITF).
     Differing views exist on the application of fair value 
measurement techniques and models.\229\
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    \229\ The FASB currently has a project on its agenda to provide 
guidance regarding the application of the fair value measurement 
objective in generally accepted accounting principles.
---------------------------------------------------------------------------

     Phased projects produce only interim changes.\230\
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    \230\ For example, FASB Statement No. 150 is part of the FASB's 
broad project on financial instruments that was added to the FASB's 
agenda in 1986.
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    We believe that the current financial reporting environment could 
be modified to reduce the reporting burden on smaller public companies, 
as well as larger public companies, while improving the quality of 
financial reporting.
    We commend the efforts of the SEC and FASB to pursue ``objectives-
based accounting standards,'' as this should help to reduce 
complexity.\231\ The Committee recognizes that success will require 
preparers, financial advisors and auditors to apply the intent of the 
rules to specific transactions rather than using ``bright-line'' 
interpretations to achieve a more desirable accounting treatment. The 
Committee also believes that simplicity and the ease of application of 
accounting standards should be important considerations when new, 
conceptually-sound accounting standards are established. Success will 
also require regulators and the courts to accept good faith judgments 
in the application of objectives-based accounting standards. We believe 
these goals will only be accomplished by long-term changes in culture 
versus short-term changes in regulations. This will allow for greater 
consistency and comparability between financial statements.
---------------------------------------------------------------------------

    \231\ See, e.g., SEC Staff Study, The Principles-Based 
Accounting System. See also FASB Response to SEC Study on the 
Adoption of a Principles-Based Accounting System (June 2004).
---------------------------------------------------------------------------

    Accordingly, we offer the following suggestions aimed at 
simplifying future accounting standards:
     There should be fewer (or no) exceptions for special 
interests.
     Industry and other considerations that do not necessarily 
apply to a broad array of companies should be addressed by FASB staff 
positions rather than in FASB statements.
     FASB statements should attempt to reduce or eliminate 
``bright-line tests'' in accounting standards, and in cases where the 
standard-setter intends that a ``bright-line'' test be applied make 
that clear in the guidance.
    The Committee is making this recommendation in lieu of recommending 
modifications to certain existing accounting standards for smaller 
public companies. Primarily through our Accounting Standards 
Subcommittee, we identified certain accounting standards where 
modifications might be considered in the future for smaller public 
companies. The Committee recognized that smaller public companies, as 
well as larger public companies, struggle with the application of 
certain accounting standards, such as FASB Interpretation No. 46 
(revised December 2003), Consolidation of Variable Interest Entities. 
The Committee also looked for certain common themes in those standards 
that could be used to develop recommendations regarding accounting 
pronouncements.
    In reviewing existing accounting standards, we considered the 
effect of their measurement and disclosure requirements on smaller 
public companies. The Committee also considered possible screening 
criteria that could be used to determine whether an accounting standard 
should be modified for smaller public companies. The objective of our 
efforts was to determine whether for certain accounting standards, the 
information is very costly for a small business to prepare and yet the 
information is not being utilized by its investors or other users of 
its financial statements.
    After deliberating these questions, we unanimously concluded that, 
since we believe it is inappropriate to create different standards of 
accounting for smaller public companies (i.e., Big GAAP versus Little 
GAAP), we should not propose recommendations to modify existing 
accounting standards for smaller public companies.
    In sum, we agreed that the current financial reporting environment 
could be improved to reduce the reporting burden on both smaller public 
companies, as well as for larger public companies, while improving the 
quality of financial reporting. In this light, we formulated the above 
recommendation to have the SEC formally encourage the FASB to continue 
to pursue objectives-based accounting standards. The Committee also 
recommended that simplicity and the ease of application should be key 
considerations when establishing new conceptually-sound accounting 
standards.
Recommendation V.S.3
    Require the PCAOB to consider minimum annual continuing 
professional education requirements covering topics specific to SEC 
matters for firms that wish to practice before the SEC.
    Of the 939 U.S. audit firms registered with the PCAOB, we noted 
that approximately 82% of them audit five or fewer public companies. We 
believe that continuing professional education pertaining to SEC-
related topics would be useful to the professional personnel of 
registered firms, especially for those firms that do not audit many 
public companies and for which this training would improve their 
ability to serve public companies. While several different groups and 
governmental bodies, such as the individual state licensing boards, 
establish continuing professional education requirements for

[[Page 11127]]

accountants, the PCAOB does not currently have any minimum annual 
training standards for registered firms' partners and employees who 
serve public companies. The Committee suggests, therefore, that minimum 
annual SEC training requirements be established for applicable partners 
and employees of audit firms registered with the PCAOB.
Recommendation V.S.4
    Monitor the state of interactions between auditors and their 
clients in evaluating internal controls over financial reporting and 
take further action to improve the situation if warranted.
    The recent implementation of Sarbanes-Oxley Act Section 404 by 
certain public companies has raised many questions and issues. One 
issue that has been identified pertains to the adverse impact Section 
404 has had on the relationship between audit firms and the management 
of smaller public companies and the nature and extent of their 
communications on accounting and financial reporting matters.\232\ We 
noted the substantial amount of testimony on this issue.\233\ We also 
noted that the PCAOB and the SEC had issued guidance in May 2005 
regarding the implementation of Section 404 and the interaction between 
an auditor and its client.\234\
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    \232\ The SEC Staff's Statement on Management's Report on 
Internal Control Over Financial Reporting, released in May 2005, 
stated that feedback from both auditors and registrants revealed 
that one potential unintended consequence of implementing Section 
404 and Auditing Standard No. 2, An Audit of Internal Control Over 
Financial Reporting Performed in Conjunction with An Audit of 
Financial Statements, has been a chilling effect in the level and 
extent of communications between auditors and management regarding 
accounting and financial reporting issues.
    \233\ One witness commented that audit firms are too fearful to 
provide guidance and advice to any inquiry by a public client, as 
such inquiry could be interpreted as an admission of an internal 
control weakness by the company in that area. Although he recognizes 
that auditing firms cannot provide non-audit services to their 
clients, he believes that they should be able to point their clients 
in the right direction so that the client can do the work. He 
indicated that audit firms are unclear as to where the line of 
auditor independence is drawn. As a result, when in doubt, audit 
firms take the safe route and do nothing out of fear that if they 
cross the line, they will put the entire audit firm at risk. Record 
of Proceedings 24 (Aug. 9, 2005) (testimony of Mark Schroeder, Chief 
Executive Officer, German American Bancorp.). Similarly, another 
witness testified that auditors and audit committees are too fearful 
of lawsuits to rely upon their judgment in implementing Section 404 
internal controls. He believes explicit common sense standards 
applied universally to all companies of a given size need to be 
developed by the regulators to indicate clearly what the auditors 
need to cover, and what the materiality levels are. Record of 
Proceedings 189 (Aug. 9, 2005) (testimony of James P. Hickey, 
Principal, Co-Head of Technology Group, William Blair & Co.). See 
also Record of Proceedings 126-127, 139 (August 9, 2005) (testimony 
of Bill Travis, Managing Partner, McGladrey & Pullen LLP, commenting 
that once there is greater consistency and clarification on what is 
expected by the PCAOB and its inspectors with regard to Auditing 
Standard No. 2, the time, effort and costs incurred by the auditors 
will be reduced and the willingness of auditors to use their 
professional judgment will increase); Record of Proceedings 9-18, 56 
(Oct. 14, 2005) (testimony of Thomas A. Russo, Russo & Gardner, 
Lancaster, Penn., describing a very stark tension growing between 
companies and their auditors, due to the lack of PCAOB Section 404 
guidelines which has resulted in a zero percent sort of materiality 
test as auditors are unwilling to exercise judgment, but rather go 
to the end of the earth to confirm the integrity of control 
systems); Record of Proceedings 57, 61 (Sept. 19, 2005) (testimony 
of Kenneth Hahn, Senior Vice President, Chief Financial Officer, 
Borland Software Corp., Cupertino, Calif., commenting that the 
dynamics of risk make it virtually impossible for the control 
portion of Section 404 to be cost effective for small and mid-size 
companies, as both auditors and boards will make the decision to 
over-engineer the testing of a company's internal control systems); 
Record of Proceedings 100 (June 17, 2005) (testimony of Prof. 
William J. Carney, Emory University School of Law, referring to a 
study indicating that auditing fees have increased by as much as 
58%, due to the increased costs associated with the new requirements 
of the Sarbanes-Oxley Act). But see Record of Proceedings 33-34 and 
41 (Sept. 19, 2005) (testimony of Lynn E. Turner, Managing Director 
of Research, Glass Lewis & Co., predicting the costs of Section 404 
internal controls to come down after the first year of 
implementation, and commenting that both in-house accountants and 
external auditors are working together to make the implementation of 
Section 404 internal controls for smaller companies much more 
difficult than warranted); Record of Proceedings 18-19 (Sept. 19, 
2005) (testimony of Richard Ueltschy, Executive, Crowe Chizek and 
Company, LLC, anticipating costs to implement Section 404 internal 
controls for the second year to fall, and noting that auditors are 
now willing to provide fixed fee quotes both for smaller public 
companies in their second year of 404 implementation, as well as for 
new accelerated filers undertaking their fist year of 404 
implementation); Record of Proceedings 106 (Sept. 19, 2005) 
(testimony of Michael McConnell, Managing Director, Shamrock Capital 
Advisors, Burbank, Calif., indicating that most investors, including 
both direct investors and institutional capital, do not have a 
problem with the costs of Section 404, as opposed to the capital 
raising agency community, such as the lawyers, bankers and managers, 
that are uncomfortable in general with any heightened standards of 
accountability). One witness testified that several public equity 
offerings in which he was involved experienced unprecedented delays 
due to the inability or unwillingness of the auditors to provide 
timely responses during the registration process with the SEC. He 
believes that auditors can no longer be looked to for advice on how 
to handle various issues, as it seems that almost every issue now 
needs to be ``run through the national office'' of the auditor. He 
notes that as auditor responses may now take weeks longer to be 
produced than was the case a couple of years ago, he believes such 
delays leave potential issuers subject to additional market risk 
that did not exist in the past. Record of Proceedings 176 (Aug. 9, 
2005) (testimony of James P. Hickey, Principal, Co-Head of 
Technology Group, William Blair & Company). See also Record of 
Proceedings 33 (June 17, 2005) (testimony of Alan Patricof, Co-
Founder, Apax Partners, explaining that an unnatural relationship 
has developed between companies and their auditors as accountants 
have become more gun shy about taking a risk-focused approach to 
their audit and express concerns about the pressure to comply with 
PCAOB requirements which has caused the relationship between 
auditors and companies to go from one of cooperation and 
consultation to that of an adversarial nature).
    \234\ See SEC Statement on Implementation of Internal Control 
Reporting Requirements, May 16, 2005.
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    It appears that audit firms are starting to become more comfortable 
with the idea that it is acceptable to advise their clients with 
respect to new accounting standards and/or complicated transactions, 
consistent with the guidance issued by the PCAOB and SEC, while 
remaining fully cognizant of the need for company management to take 
full responsibility for its financial statements and the underlying 
decisions on the application of accounting principles. We recommend 
that the SEC and the PCAOB remain vigilant in monitoring the impact of 
its guidance through the Spring of 2006 reporting season. If the 
guidance is being appropriately applied, no further action with respect 
to the interaction of the auditor and its clients would be required, 
except for implementation of our recommendation on implementing a de 
minimis exception for certain immaterial violations of the SEC's 
independence rules.

Part VI. Epilogue

[Content of Part VI To Be Included in Final Report.]

Part VII. Separate Statement of Mr. Jensen

Introduction

    I am dissenting to recommendations III.P.1, III.P.2 and III.P.3 
contained in the Final Report of the Advisory Committee. Since the time 
of the original vote on the recommendations, I have become aware that 
certain investor groups are concerned with the removal of Section 404 
of the Sarbanes-Oxley Act of 2002 requirements for a large number of 
public companies. While no one knows the exact extent of investor 
opposition, I believe this group is too important to the health of our 
capital markets to ignore their point of view. Specifically, I believe 
that providing a permanent exemption for smaller public companies from 
these requirements may ultimately harm investors of those companies. In 
addition, I disagree with the adoption of a weakened auditing standard 
for Section 404 compliance by certain companies.
    The fact that the Advisory Committee heard so many different points 
of view on these critical issues supports the fact that we do not yet 
have sufficient experience with implementation of Section 404 to know 
with certainty that a permanent exemption is a better

[[Page 11128]]

answer, or whether any change in auditing standards is warranted. In 
light of these factors, my recommendation calls for additional 
temporary deferrals coupled with a study of key implementation elements 
and a definitive timetable for resolution.

Dissenting Views and Rationale

    I agree with the rationale in the Final Report describing the need 
to scale securities regulation for smaller companies. As a member of 
the Advisory Committee I heard testimony from many on the potentially 
damaging impact of the costs of Section 404 on the growth potential of 
smaller public companies. Additionally, many parties provided written 
comment on the disproportionate burden of Section 404 related costs on 
smaller public companies. The Final Report includes a number of 
examples and anecdotes on the reasons for this disproportionate burden 
including constraints caused by limited internal and external 
resources, lack of guidance tailored to smaller companies and less 
revenue with which to offset implementation and ongoing compliance 
costs. I acknowledge that this cost issue necessitates a significant 
and substantial effort to develop an appropriate application of 
Auditing Standard No. 2 in the small public company environment.
    I am also cognizant of testimony and written comments the Committee 
received on the significant benefits of Section 404. Many reminded the 
Advisory Committee of the corporate failures that resulted in Congress 
enacting the Sarbanes-Oxley Act of 2002. Other investors gave testimony 
on the benefits of Section 404 both to themselves and to the companies 
in which they invest and the increased confidence instilled in the 
investor community as a result of the additional checks and balances 
required by the Act. A smaller public company, as information provided 
to the Advisory Committee indicates, is more likely to suffer control 
deficiencies than a larger company. This fact logically means that 
investors will consider their investment in smaller public companies a 
higher risk. It seems, therefore, that smaller public companies could 
benefit from a process that improves investor confidence in their 
financial reporting thereby helping them achieve a wider and more 
diverse investor base. If such benefits for both companies and 
investors can be derived from Section 404, then it seems to me that 
eliminating the requirement for these companies is unwarranted. Rather, 
more effort should be expended to scale the approach to smaller public 
companies.
    The key is to balance the needs of the users of financial 
statements with the costs to companies in supplying the required 
information. Balancing what preparers of financial statements can 
reasonably provide and what users of financial statements can 
reasonably expect to receive is a basic principle of our financial 
reporting and regulatory systems. The current debate around Section 404 
demonstrates clearly that this required balance does not exist at 
smaller public companies today. Many smaller public companies have 
indicated that the solution to this problem is to eliminate their 
compliance with Section 404. However, simply eliminating the 
requirement will tip the scales and investors, who will not receive the 
information and assurances intended to be provided under the Act, will 
likely believe that the system is out of balance to their detriment. I 
believe that through additional implementation experience, guidance and 
tools, Section 404 reporting can become more efficient and cost-
effective for smaller public companies.
    I disagree with the adoption of an alternative auditing standard. A 
lesser standard may prove not to be in the interest of the smaller 
public company as it creates a two tier system. The existence of a two 
tiered system could reduce investor confidence in the smaller public 
companies' financial reporting process and would thereby eliminate all 
of the benefits of Section 404 which, as discussed above, may be an 
important benefit that could be derived by smaller public companies. I 
believe that effective Section 404 compliance in the smaller public 
company will continue to improve investor confidence and I also 
strongly believe that compliance can be achieved in a cost effective 
manner.

Further Consideration

    Accordingly, in lieu of permanent exemptions, I recommend an 
additional temporary deferral of the Section 404 reporting for non-
accelerated filers that have not yet reported under Section 404, 
coupled with a definitive action plan led by the SEC as outlined below. 
This plan includes participation by smaller public companies, the 
auditing profession and the PCAOB. Given the cost concerns provided to 
the Advisory Committee on smaller public companies, such an additional 
temporary deferral could include an optional, temporary suspension of 
certain of the requirements for smaller public companies that recently 
implemented the Section 404 requirements and meet the market 
capitalization and revenue criteria in recommendations III.P.1 and 2. 
On this latter point, the SEC would have to weigh the implications of 
this proposal with the likelihood that many of the companies already 
complying would nonetheless choose to continue to comply.
    The steps that I would propose would be subject to a defined 
timeline and a set of actions to definitively resolve the scope of 
Section 404 implementation for smaller public companies prior to the 
2008 year-end. For example, these actions could include:
     Reconsideration of the end product in the ongoing process 
to tailor the COSO requirements for smaller businesses. This project 
has been underway for some time. It is essential that the final 
document succeed in being truly useful to smaller companies. It is 
vitally important that the final document be replete with guidance, 
examples and tools, which permit the efficient implementation and 
testing of COSO requirements for smaller businesses. A definitive guide 
for performing management's assessment of internal control 
effectiveness for smaller public companies would be the single most 
useful element of this effort.
     The conduct of an SEC-led pilot program for a prescribed 
number of micro-cap and smaller public companies during 2006 that would 
serve as a field test and lead to the development of guidance on 
application of AS2 in that environment for auditors, as well as the 
development of internal control and Section 404 compliance tools for 
management of micro-cap and smaller public companies.
     An in-depth study of the companies that have two years of 
experience in complying with Section 404, perhaps by focusing on the 
smaller of the complying companies in order to gain an in depth 
understanding of the costs and benefits. The criticality of reliable, 
not anecdotal, cost-benefit information is a fundamental predicate to 
finalizing the important regulatory and public policy decisions that 
the SEC needs to make.
    The basic timeline for this action plan could be: Pilot program and 
study in 2006, develop and field test guidance and rules in 2007, and 
implement in 2008.
    Should this recommendation be adopted, my firm would be willing 
dedicate resources to participate in any efforts to gather evidence, 
field test new guidance, or develop tools for management and auditors 
that will further support this process. We would look forward to 
working with others in the accounting profession, vendors of

[[Page 11129]]

technology solutions, and companies in the program and other public and 
private-sector organizations to achieve success in this endeavor.
    It is important to note that this timeline includes only one 
additional annual deferral of the Section 404 requirements for non-
accelerated filers; however, it should also include specific, defined 
steps during this period, to significantly improve guidance and tools, 
and increase the cost effectiveness of implementation for smaller 
public companies.
    This recommendation is made with our mutual public interest goals 
in mind. It reflects my opinion that after only two years of 
implementation for accelerated filers, market participants and 
regulators do not have sufficient information to make final decisions 
regarding the long-term application of these important internal control 
requirements for smaller public companies. I recommend that a process 
be developed to gather empirical, field-driven information to resolve 
this important question, and that an additional deferral be granted 
until this can be accomplished.

Part VIII. Separate Statement of Mr. Schacht

    This Separate Statement to the Final Report of The Advisory 
Committee on Smaller Public Companies (the ``Report'') is submitted for 
the purpose of dissenting on several of the primary recommendations of 
the Advisory Committee. These relate to the work of the sub-committee 
on Internal Controls Over Financial Reporting (the ``Sub-Committee''). 
As a member of the Sub-Committee and consistent with our dissenting 
opinion of December 14, 2005, a copy of which is attached, we remain 
opposed to key portions of the Report.
    Observers and committee participants agree that the most 
substantive recommendations in the Report relate to the application of 
Section 404 of Sarbanes-Oxley (``Section 404'') to smaller public 
companies. As a Committee, we reviewed several issues impacting smaller 
public companies. It is clear however, that the impacts of Section 404, 
particularly the resource demands and costs of implementing 404, have 
proven to be the most challenging. During our deliberations, the Sub-
Committee discussed dozens of ways and options for reducing costs, 
while maintaining investor protections.

Cost-Benefit Analysis

    The Advisory Committee members generally agree that the costs of 
Sarbanes- Oxley (``SOX'') are the real issue. While minimization of 
regulatory costs is always a desirable goal, the Report confirms what 
we knew coming into this Committee process, that the costs have 
exceeded all estimates, and have significantly impacted small 
companies. There have been numerous cost studies and other anecdotal 
comments on whether these costs are, or will be, coming down in 
subsequent years. The evidence will only be clear once we have actual 
data in the coming months. For many companies that have yet to go 
through the process, the initial costs will be high. But the analysis 
must not end there. It suggests that whatever the benefits of Section 
404 might be, they are surely far outweighed by these more obvious cost 
figures. The Report states that the benefits are of less certain value 
and moves on to other matters.
    The Advisory Committee, by and large, agrees that internal controls 
over financial reporting at public companies are important. More 
specifically, we assert they are an important feature for accurate 
financial reporting, investor protection, and market integrity. But is 
there a measurable benefit? It is impossible to measure the value of a 
financial/accounting fraud avoided. In 2005, there were approximately 
1300 restatements and weaknesses in financial reporting revealed and 
fixed by a Section 404 inspired process, more than double the number in 
2004. This dramatic increase will have an inestimable and far-reaching 
impact on financial reporting reform. Some argue this is a reflection 
of deferred maintenance on an internal controls process that has been 
neglected and that SOX represents a renaissance for proper internal 
control process and environments. Whatever the reason, these are 
benefits that are significant and certain. Moreover, they are benefits 
which, we believe, balance the cost of a properly scaled and verified 
internal control structure.

Section 404 Exemption vs. Improved Section 404 Implementation

    The Sub-Committee set about its work with the focus of adjusting 
the main cost driver of Section 404, the level to which internal 
controls need to be documented, verified and tested by management and 
outside auditors. The original objectives were to reduce the cost 
burdens but maintain the investor protections associated with Section 
404. The Sub-Committee focused on a variety of ways to meet the 
objectives but narrowed its attention to two. The first is creating a 
more tailored and cost-efficient internal control structure and 
verification process for small companies, i.e., reducing the cost and 
resource drain of Section 404 through better implementation. The second 
is providing small companies with an exemption from the main 
requirements of Section 404.
    The objectives of cost control and investor protection need not be 
mutually exclusive. However, the Report's primary recommendations make 
them so. Our strongest objection is that the Report recommends a flat-
out exemption from all auditor 404 involvement in reviewing and 
confirming internal controls. This is not for just a few, but for what 
will effectively be more than 70 to 80 percent of the public companies 
in this country.
    One could cite any number of flaws in this approach, but several in 
particular stand out:
     First, the entire premise of SOX was to bolster investor 
confidence by requiring meaningful corporate governance and financial 
reporting reforms. Likewise, maintaining investor protections is a 
primary tenet of the Committee Charter. Properly designed and 
functioning internal controls over financial reporting were and are a 
cornerstone of this legislation. Proper structuring and implementation 
of 404 requirements are very different from eliminating these 
completely for a broad segment of U.S. companies. That approach works 
against the statute's legislative intent and the directive that we 
heard from both Chairman Donaldson and Chairman Cox.
     Second, it is unclear to many whether the broad exempting 
recommendations of this subcommittee are even within the commission's 
legal authority. Comprehensive, sweeping exemptions from Section 404 
may not be possible under the current legislation, which specifically 
excluded Section 404 from the Securities and Exchange Act of 1934. As 
the full Commission works toward final recommendations, it would be 
well served to resolve that potential legal uncertainty so as to avoid 
further litigation delays in addressing Section 404 concerns.
     Third, with regard to MicroCaps as defined, the Report 
recommends exemptive relief from not only auditor involvement in 
reviewing internal controls but also exempts the managers of these 
firms from having to do their own internal assessment of such controls. 
Essentially, no one has to check the design, implementation and 
effectiveness of internal controls over financial reporting at these 
companies. The reason for this complete 404 exemption according to the 
Report is that there is no specific directions/

[[Page 11130]]

guidance available to such small company managers to know how to create 
an appropriate internal control structure. We wonder about two things 
in this context. First, how have these firms been able to meet the on 
going legal requirements for maintaining an effective system of 
internal controls (actually mentioned as part of the recommendation) 
and more importantly, if such guidance is missing for micro caps, how 
does it suddenly become clear for managers of small companies above 
$125 million in market cap? In the event any of these exemptive 
recommendations are adopted by the SEC, we believe logic dictates that 
managers in all public firms be required to complete an annual Section 
404 assessment of internal controls.
     Fourth and maybe most important, small public companies 
need checks and balances over financial reporting. This includes the 
Section 404 checks and balances in our view. The Report indicates that: 
Small cap firms have less need for internal controls; requiring 
external verification of internal controls is a waste of corporate 
resources; and, that better corporate governance is a substitute for 
such verification. It further suggests that investors in these 
companies don't particularly care about internal control protections 
and that these companies represent an inconsequential bottom 6% of 
total U.S. market capitalization, rendering even an Enron-like blowup a 
minor event. At the same time, the Report characterizes such small 
companies as a critical link in economic growth and competitiveness and 
that Section 404 is the regulatory tipping point and barrier to 
accessing public markets. Parsing through these contrasting views of 
inconsequential vs. critical seems to suggest incorrectly that venture 
capital exit strategies are more important to protect than public 
investors providing risk capital. A number of experts we heard from 
feel that properly structured and verified internal controls are 
probably more important for the riskier, smaller firms and that 
additional corporate governance provisions are in no way a substitute 
for properly working internal controls. For example, these small firms 
consistently have more misstatements and restatements of financial 
information, nearly twice the rate of large firms, according to one 
report. Alarmingly, these small firms also make up the bulk of 
accounting fraud cases under review by regulators and the courts (one 
study puts it at 75 percent of the cases from 1998-2003).
     Finally, we note that as part of each of the 
recommendations for Section 404 exemption, the Report suggests these 
companies be reminded of pre-SOX legal requirements to have an 
effective system of internal controls in place. This legal reminder 
simply points out how ineffective the rules were pre-SOX and how they 
are no substitute for having some level of external verification of 
controls as prescribed by Section 404.

Better Implementation of Section 404 & SOX ``LIGHT'

    A more balanced approach to fixing the cost concerns of Section 404 
is to continue requiring manager assertions and auditor attestation of 
internal controls, but direct the appropriate regulatory and de facto 
standard-setting bodies (the Committee of Sponsoring Organizations of 
the Treadway Commission (COSO), the Public Company Accounting Oversight 
Board) and the SEC to develop specific guidance for small companies. 
This approach has been referred to as a ``404 Light'' or ``SOX Light'' 
approach. However, the term has become confusing over the course of the 
Committee debate.
    Much of the outline for this approach appeared in preliminary 
recommendations of the Sub-Committee. We encourage the Committee to be 
clear on the options for better implementation and for the Commission 
to consider a broad range of approaches. These may include: (1) 
Reviewing/refining the existing AS-2 standards; (2) possible 
development of an alternative auditing standard (the Report references 
AS-X) that provides for a meaningful, but more cost effective audit; 
and (3) development of specific directives from COSO and PCAOB on how 
to ``right-size'' for small issuers, the control structure, the 
requirements for managers assessment and the scope of an internal 
controls audit.
    This ``Better Implementation'' approach appears in the Report, but 
comes only as a fall-back alternative to the exemptive recommendations. 
To ensure continued investor confidence in our markets, we support the 
approach that preserves the investor protection aspects of 404 while 
lowering costs to implement and verify proper internal controls over 
financial reporting.

Investors Support Section 404

    It is clear that we need to do something for small companies. 
Investors in these companies, more than anyone, have a significant 
stake in making sure we balance the regulatory burden with the need to 
grow and access capital markets. Investors and the economy are ill-
served by a system that neglects either.
    We heard commentary from several professional investors and 
institutional managers in support of Section 404 requirements. The 
weight of such testimony has been questioned since many do not invest 
directly in micro cap firms. Moreover, the lack of specific individual 
testimony from micro cap and small cap investors along with the 
observation that people still invest in these firms without Section 404 
protections, both in U.S. and foreign markets, has been suggested as 
evidence that investors do not care about section 404 protections.
    While we encourage more of these small company investors to come 
forward and participate in the next comment period, we believe the 
investor base involved in these firms is very fragmented. These 
companies represent somewhere between 70 and 80 percent of public 
companies and collectively have millions of individual retail and 
private shareholders. It is unlikely this group will magically coalesce 
and speak with a collective voice on this or any other regulatory or 
financial reporting issue affecting the companies in which they invest. 
That silence should not be misinterpreted. These are precisely the 
investors that need the formal and self-regulatory ``system'' to 
provide the necessary protections, transparency and honesty that 
ensures a fair game. It is what continues to make U.S. markets the gold 
standard.
    We appreciate the opportunity to serve on the Advisory Committee 
and to serve as a representative for investor views. We encourage 
investors to provide timely commentary to this Report. As with any 
regulation, it is important to reach the proper balance between cost 
burden on the issuer and investor protection. We firmly support 
realignment and better implementation, not elimination of Section 404, 
as the proper balance.

Statement of Mr. Schacht Dated December 14, 2005

    I appreciate the opportunity to address the entire committee on the 
work of the 404 subcommittee and want to acknowledge all of my 
colleagues' hard work. It was a pleasure working with them.
    As a committee, we have reviewed several issues affecting smaller 
public companies. It is clear however, that the impacts of Section 404 
of Sarbanes-Oxley, particularly the implementation costs, have proven 
to be by far the most challenging. While I do not agree with several 
subcommittee

[[Page 11131]]

recommendations, Section 404 is one of the key issues to focus on. 
Solutions to its overly burdensome cost, particularly on small issuers, 
are not simple.
    Notwithstanding that I am the lone dissenting vote on the 
subcommittee, I do want to acknowledge that this group has examined 
this topic closely. They fully considered my concerns and those of 
others who commented on the proper ways to ``fix'' 404. We discussed 
dozens of ways and options for reducing costs, while maintaining 
investor protections.
    We all agree that the costs of SOX are the real issue. They have 
been too high, exceeding all estimates, and they hit small companies 
much more significantly. There have been numerous cost studies and 
other anecdotal comments on whether these costs are or will be coming 
down in subsequent years. I think the evidence will only be clear once 
we have actual data in the coming months, because this is clearly not 
yet at a point of equilibrium. For many companies that have yet to go 
through the process, the initial costs will be high. There is no 
question about this.
    Also, we all agree that internal controls at public companies are 
important. They are an important feature for accurate financial 
reporting, investor protection, and market integrity. Some argue that 
internal controls have been somewhat neglected, and SOX has tried to 
bring about some assurance that adequate controls are in place and 
working as desired. How the markets get that assurance--that is, the 
level to which these internal controls need to be verified and tested 
by management and outside auditors--is the rub.
    The subcommittee goal was to reduce the cost burdens but maintain 
the investor protections associated with Section 404. These need not be 
mutually exclusive. My concern, and the basis for my dissent, is that 
the panel's recommendations make them mutually exclusive. We seem to 
say you can't have meaningful cost reductions unless you eliminate 404, 
including the investor protections.
    Our biggest concern is that the main recommendations give a flat-
out exemption from all auditor 404 involvement in reviewing and 
confirming internal controls. This is not for just a few, but for what 
will effectively be more than 80 percent of the public companies in 
this country.
    One could cite any number of flaws in this approach, but three in 
particular stand out:
     First, the entire premise of SOX was to bolster investor 
confidence by requiring meaningful corporate governance and financial 
reporting reforms. Properly designed and functioning internal controls 
over financial reporting were and are a cornerstone of this 
legislation. Proper structuring and implementation of 404 requirements 
are very different from eliminating these completely for a broad 
segment of U.S. companies. That approach works against the statute's 
legislative intent and the directive that we heard from both Chairman 
Donaldson and Chairman Cox.
     Second, it is unclear to many whether the broad exemptive 
recommendations of this subcommittee are even within the commission's 
legal authority. Comprehensive, sweeping exemptions from Section 404 
may not be possible under the current legislation, which specifically 
excluded Section 404 from the Securities and Exchange Act of 1934. As 
the full committee works toward final recommendations, it would be well 
served to resolve that issue, as I expect there will be legal 
challenges of this authority.
     Finally, and maybe most importantly, small public 
companies need checks and balances over financial reporting. They 
consistently have more misstatements and restatements of financial 
information, nearly twice the rate of large firms, according to one 
report. Alarmingly, they also make up the bulk of accounting fraud 
cases under review by regulators and the courts (one study puts it at 
75 percent of the cases from 1998-2003).
    A more balanced approach to fixing SOX 404 is to continue requiring 
manager assertions and auditor attestation of internal controls, but 
direct the appropriate regulatory and defacto standard-setting bodies 
(the Committee of Sponsoring Organizations of the Treadway Commission 
(COSO), the Public Company Accounting Oversight Board) and the SEC to 
develop specific guidance for small companies. These would specifically 
outline appropriate control structures and the auditing scope for small 
companies under 404--a SOX `light' approach.
    Much of the outline for this approach appears in Recommendation 3 
of the subcommittee's report. However, it comes only as a fall-back 
alternative to the exemptive recommendations. To ensure continued 
investor confidence in our markets, we deserve an approach that 
preserves the investor protection aspects of 404 while lowering costs 
to implement and verify proper internal controls over financial 
reporting.
    It is clear that we need to do something for small companies. But 
giving them a pass on any verification and oversight of internal 
controls will come back to haunt us.
    The subcommittee's recommendations will now attract a fuller public 
debate on some very important public policy issues. I would offer this 
challenge to investors and, indeed, all participants in the financial 
reporting process to get involved in commenting on these 
recommendations. It is important to reach the proper balance between 
cost and investor protection. Realignment not elimination of Section 
404 is needed to accomplish that.

Part IX. Separate Statement of Mr. Veihmeyer

    Section 404 of Sarbanes-Oxley has contributed significantly to the 
improvement of financial reporting, oversight of internal controls, and 
audit quality. The public interest and the capital markets have been 
well served by this legislation. At the same time, compliance with the 
provisions of Section 404 has placed important responsibilities on 
issuers and auditors that are both expensive and time consuming. 
Clearly, the important goals of Section 404 must be achieved in the 
most cost-effective and least burdensome manner, to ensure that the 
costs of Section 404 do not outweigh the benefits. This is particularly 
challenging with respect to smaller public companies. The Advisory 
Committee on Smaller Public Companies has worked very hard to determine 
where to strike the appropriate balance between the benefits to 
investors and the burdens on issuers. The Final Report of the Advisory 
Committee is the result of that work. While I respect the Committee's 
efforts to find the best possible solutions to these difficult 
problems, I differ with the majority over one fundamental principle. In 
my judgment, sound public policy dictates that the protections provided 
by Section 404 should be available to investors in all public 
companies, regardless of size. Accordingly, our focus at this time 
should not be on exempting companies from Section 404, but on 
developing implementation guidance for assessing and auditing internal 
control over financial reporting for smaller public companies that 
recognizes the characteristics and needs of those companies. This 
guidance should be jointly developed by regulators, issuers and the 
accounting profession and should be field-tested for effectiveness, 
including appropriate cost analysis, before implementation.
    The Final Report provides extensive root-cause analysis of the 
costs of

[[Page 11132]]

compliance with Section 404, but fails to address the reality that 
economies of scale do influence the relative cost of regulatory 
compliance and professional services, including audits of financial 
statements. Therefore, there is need for additional steps to be taken 
to further improve the execution of Section 404 compliance relative to 
smaller companies, as described below.
    I also believe that PCAOB Auditing Standard No. 2 is fundamentally 
sound and scalable, and it is not prudent to consider amending the 
Standard at this time. The first year of integrating the financial 
statement audit with the requirements of Auditing Standard No. 2 was a 
difficult process due to a number of environmental issues that have 
been well-documented. Simply stated, the full integration of the 
financial statement and internal control audit did not occur in year 
one. However, my firm's experience is that the additional year of 
experience, coupled with the May 2005 guidance from the SEC and the 
PCAOB, and the efforts of issuers and auditors to improve their 
respective approaches, has resulted in further integration of the 
financial statement and internal control audit and is reducing the 
total cost of compliance. I believe that issuers and auditors should be 
allowed the opportunity to introduce incremental effectiveness and 
efficiency into the compliance process--a migration that will occur 
naturally as issuers and auditors move forward on the learning curve 
associated with reporting on internal control over financial reporting.
    Because I believe that compliance with the provisions of Section 
404 provides needed protection to investors in all public companies, 
regardless of size, I do not support recommendations III.P.1, III.P.2, 
and III.P.3 in the Final Report, as each would serve to dilute this 
protection.
    Specifically, Recommendation III.P.3 referencing a standard 
providing for an audit of the design and implementation of internal 
control, but not the testing by the auditor of the operating 
effectiveness, is in my view not advisable. While clear disclosure that 
a company has not undergone an audit of internal control over financial 
reporting is understandable to users, those same users cannot be 
expected to assess the relative gradations of assurance provided by 
this proposed distinction in reporting on internal control. An 
alternative providing for an auditor's report only on design and 
implementation of internal controls, at a time when much attention has 
been directed toward reporting on the effective operation of internal 
controls, will result in users' misunderstanding the level of assurance 
provided by the auditor. It is important to note that a well-designed 
system of internal control, while vital, does not equate to the 
generation of reliable financial information in the absence of 
effective operation of internal control. Accordingly, I believe that 
Recommendation III.P.3 would serve to widen an already existing 
expectation gap with respect to audit services at a time when emphasis 
should be directed toward reducing that gap.
    I do not support Recommendations III.P.1 and III.P.2 based on my 
belief that Section 404 of Sarbanes-Oxley has made and will continue to 
make significant contributions to improving financial reporting, 
oversight of internal controls, and audit quality. In my judgment, 
sound public policy dictates that the protections derived from these 
contributions should be available to investors in all public companies, 
regardless of size.
    I believe that compliance with the provisions of Section 404 by 
issuers, and application of the principles of Auditing Standard No. 2 
by auditors, represent evolutionary skills that will become more 
effective and efficient with more experience. As noted above, the 
effectiveness and cost-efficiencies of Section 404 execution have 
improved over the first two years. However, additional efficiencies and 
experience with Auditing Standard No. 2 are not likely to fully address 
the concerns of certain-sized smaller public companies. Accordingly, I 
recommend that regulators, issuers and the accounting profession work 
expeditiously to develop specific guidance, focused on the 
characteristics of these smaller companies and their internal control 
structures, which will further improve the execution of Section 404 
compliance. I will commit resources of my firm to participate in and 
support this effort. Additional implementation guidance specifically 
tailored to the application of internal control concepts in a smaller 
company environment should, at a minimum, address the following: 
significance of monitoring controls, risk of management override, lack 
of segregation of duties, extent and formality of company documentation 
and assessment, and evaluation of the competency of a smaller company's 
accounting and financial reporting function. This guidance should 
address both the assessment to be made by management and the auditor's 
performance requirements relevant to such assessment, as well as the 
execution of auditing procedures pursuant to the provisions of Auditing 
Standard No. 2. In addition, I believe that field testing the 
effectiveness of this additional guidance, including appropriate cost 
analyses, should be performed to facilitate well-informed decisions 
regarding the reasonable application of the provisions of Section 404 
in a smaller public company environment. It may become evident, as a 
result of field testing and meaningful cost analyses, that an audit of 
internal control over financial reporting may not be justified for 
certain very small public companies that evidence certain 
characteristics. For those smaller public companies, an exemption from 
the provisions of Section 404 may be warranted, but such an exemption 
should be considered only after careful analysis of the data derived 
from the field tests. In short, we simply do not have sufficient 
implementation guidance, experience, or information available at this 
time to make a permanent reduction in the protections provided by 
Section 404.
    It is essential that the additional implementation guidance, 
specifically tailored to the application of internal control concepts 
in a smaller public company environment, be developed and tested 
expeditiously, given the importance of this issue to smaller public 
companies and investors. While this guidance is being developed and 
field tested, I recommend the continued deferral of the Section 404 
requirements for all smaller public companies that have not already 
been required to implement Section 404. However, I would envision that 
such deferral would not extend more than a year beyond the current 
implementation date for non-accelerated filers.
    It should be noted that this separate statement focuses solely on 
the recommendations to which I dissent, and not to any specific 
statements or opinions contained in the Final Report which are 
inconsistent with my own views.
    The work of the Advisory Committee and our Final Report has raised 
important issues relative to application of the provisions of Section 
404. To address those issues, I propose additional guidance for smaller 
public companies, and the field testing of that guidance, relative to 
reporting on internal control over financial reporting as well as the 
continued deferral for non-accelerated filers for an additional year if 
these activities cannot be completed within one year. I believe these 
proposals are consistent with our Charter to further the SEC's investor 
protection mandate, and to consider whether the costs imposed by the 
current regulatory system for small

[[Page 11133]]

companies are proportionate to the benefits, to identify methods of 
minimizing costs and maximizing benefits, and to facilitate capital 
formation by smaller companies.

Appendices*

Index of Appendices

A. Official Notice of Establishment of Committee
B. Committee Charter
C. Committee Agenda
D. SEC Press Release Announcing Intent to Establish Committee
E. SEC Press Release Announcing Full Membership of Committee
F. Committee By-Laws
G. Request for Public Comments on Committee Agenda
H. Request for Public Input
I. Background Statistics for All Public Companies
J. Universe of Publicly Traded Equity Securities and Their 
Governance
K. List of Witnesses
L. Letter from Committee Co-Chairs to SEC Chairman Christopher Cox 
dated August 18, 2005
M. SEC Statement of Policy on Accounting Provisions of Foreign 
Corrupt Practices Act

    *Access to each appendix is available by clicking its name on 
the copy of this page posted on the Internet at www.sec.gov/info/smallbus/acscp-finalreport_ed.pdf

    Authority: In accordance with Section 10(a) of the Federal 
Advisory Committee Act, 5 U.S.C. App. 1, Sec.  10(a), Gerald J. 
Laporte, Designated Federal Officer of the Committee, has approved 
publication of this release at the request of the Committee. The 
action being taken through the publication of this release is being 
taken solely by the Committee and not by the Commission. The 
Commission is merely providing its facilities to assist the 
Committee in taking this action.

    Dated: February 28, 2006.
Nancy M. Morris,
Committee Management Officer.
[FR Doc. 06-1992 Filed 3-2-06; 8:45 am]
BILLING CODE 8010-01-U