[Federal Register: March 3, 2006 (Volume 71, Number 42)]
[Notices]
[Page 11089-11133]
[DOCID:fr03mr06-137]

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Part IV

Securities and Exchange Commission

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Advisory Committee on Smaller Public Companies; Notice

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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_ADDRESS>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<PHONE_NUMBER>, 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<PHONE_NUMBER>, or
Kevin M. O'Neill, Special Counsel, at<PHONE_NUMBER>, 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

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

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

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.
---------------------------------------------------------------------------

    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

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.

---------------------------------------------------------------------------

    In addition, we considered the SEC's recent adoption of rules
reforming the

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
http://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.
---------------------------------------------------------------------------

    \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

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.

---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.

---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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,

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.

---------------------------------------------------------------------------

[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

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://http://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

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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

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

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     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

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'').
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    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.
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    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.''
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     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;
     Provide chief executive officer and chief financial
officer certifications under Sarbanes-Oxley Act Section 302; \94\
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    \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).
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     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.
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    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