Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

Current SEC reporting requirements establish three different filer statuses that categorizes issuers subject to Exchange Act reporting requirements as non-accelerated, accelerated, and large accelerated filers. Section 404(a) of the Sarbanes-Oxley Act, or SOX, requires almost all SEC reporting issuers, regardless of filer status, to establish and maintain internal control over financial reporting, or ICFR, and have their management assess the effectiveness of their ICFR.

A significant requirement that applies to accelerated and large accelerated filers, but not to non-accelerated filers, is the requirement that accelerated and large accelerated filers have an ICFR auditor attestation. An ICFR auditor attestation requires the independent accounting firm that prepares or issues the issuer’s financial statement audit report to also attest to, and report on, management’s assessment of the effectiveness of the issuer’s ICFR. SOX Section 404(c), however, exempts non-accelerated filers from the ICFR auditor attestation requirement. The Jumpstart Our Business Startups Act also exempted a category of newly public companies referred to as emerging growth companies, or EGCs, from the ICFR auditor attestation requirement.

The ICFR auditor attestation requirement is intended to improve the accuracy and reliability of corporate disclosures. If verified internal controls are in place, it is likely disclosures and financial statements are accurate.   However, the ICFR auditor attestation requirement has long been criticized as a requirement where the costs outweigh the benefits and suppress the number of issuers that would like to conduct an IPO. Others assert the ICFR auditor attestation requirement can divert capital from core business needs of an issuer which are especially burdensome for emerging and growing biotechnology issuers.

The other principal difference between issuers that have different filer status is the deadline for filing Forms 10-K and 10-Q. Non-accelerated filers have more generous filing deadlines, and are required to file a Form 10-Q within 45 days after the end of a quarter and file a Form 10-K within 90 days after year end. In contrast, accelerated filers and large accelerated filers must file their Form 10-Q within 40 days after the end of a quarter while accelerated filers and large accelerated filers have 75 days and 60 days, respectively, after year end to file Form 10-K.

In addition to distinguishing between issuers based on filer status, the SEC has also adopted rules that provide for less onerous reporting requirements for issuers that meet the definition of smaller reporting company, or SRC, which the SEC refers to as scaled disclosure. Historically, the SEC aligned SRC and non-accelerated filer categories, to the extent feasible, to avoid unnecessary complexity. As a result, an SRC generally was not an accelerated or large accelerated filer and did not have to comply with the accelerated or large accelerated filing deadlines or the ICFR auditor attestation requirement. This alignment changed in June 2018 when the SEC adopted amendments to the SRC definition to expand the number of issuers that qualify for scaled disclosure accommodations. The revised SRC definition allows an issuer to use either a public float test or a revenue test to determine whether it is an SRC.

Proposed Amendments

The SEC held an open meeting on May 9th to issue long-awaited proposed modifications to the filer status definitions. The proposed rule dovetails with the SEC’s similar expansion of the SRC standard adopted in June 2018 and eliminate the requirement under SOX for certain issuers to provide an ICFR auditor attestation.

In particular, the proposed amendments would:

  • exclude from the accelerated and large accelerated filer definitions an issuer that is eligible to be an SRC and had no revenue or annual revenues of less than $100 million in the most recent fiscal year for which audited financial statements are available and therefore eliminate the requirement to provide an ICFR auditor attestation; and
  • adjust the transition thresholds for issuers exiting accelerated and large accelerated filer status.

While the proposed definitional changes are, in the staff’s view, intended to comport with the widely-supported aim of “promot[ing] capital formation for smaller reporting issuers by more appropriately tailoring the types of issuers that are included in the categories of accelerated and large accelerated filers,” the elimination of the ICFR auditor attestation requirement seems likely to be the key gating issue on the path to the Commission’s adoption of final rules.

Disparate Views of SEC commissioners

The Commissioners are well known to hold disparate views on the ICFR auditor attestation requirement and most have previously expressed those views in public statements. And those views were reflected in their respective votes on whether or not to propose the amended rules.

The proposed rules were drafted by the staff at the direction of SEC Chair Jay Clayton who has previously noted his view that the ICFR auditor attestation requirement impacts capital formation. Unsurprisingly, Chair Clayton expressed support for the proposal consistent with his prior views. In his public statement at the open meeting, Chair Clayton highlighted the “proposed rules are aimed at that subset of issuers where the added step of an ICFR auditor attestation is likely to add significant costs and is unlikely to enhance financial reporting or investor protection” and noted that “[t]he proposed amendments are intended to reduce costs without harming investors for certain smaller public companies and, importantly, encourage more companies to enter our public markets.”

Commissioner Hester Peirce’s views on the ICFR auditor attestation requirement align somewhat with Chair Clayton’s, and she also supported the staff’s proposed rules. In connection with the issuance of the rule proposal, Commissioner Peirce noted “I suspect that we also are missing the substantive mark. We are not proposing to exempt all SRCs from [the ICFR auditor attestation requirement}, and the SRCs that are not exempt will continue to receive auditor bills for 404(b). We currently lack the data to provide a clear picture of what the costs of 404(b) compliance are, especially for smaller companies.”

Newly-appointed Commissioner Elad Roisman does not have a history of commenting on the subject but expressed interest in further investigation of the economic impact of the amendments and also voted to release the proposed rules for public comment. Commissioner Roisman noted “I do question, however, whether the benefits of [the ICFR auditor attestation requirement] outweigh the burdens for smaller companies that, even in the absence of [the ICFR auditor attestation requirement], must still establish and maintain ICFR and have their management assess and report on the effectiveness of their ICFR.”

Commissioner Robert Jackson was the sole dissenter amongst the Commissioners and voted against proposing the amendments. Commissioner Jackson has previously stated his opposition to expanded availability of exemptions to the ICFR auditor attestation requirement. In his public statement opposing the newly proposed changes, Commissioner Jackson reached the conclusion that the proposal “has no apparent basis in evidence.” Commissioner Jackson also noted his view that while the proposal would provide the most relief for smaller companies, it is also “equally possible that these are the firms—high-growth companies where the risk, and consequences, of fraud are greatest—where the benefits of the auditor’s presence are highest.”

The future of the newly proposed rules seems likely to hinge upon a similar debate amongst the Commissioners.

Advantages and Disadvantages to Affected Issuers

The SEC estimates the rule proposal, to the extent it relates to elimination of the ICFR auditor attestation requirement, would benefit only 282 issuers. Using a complex analysis, the SEC estimated it would save these issuers $110,000 in audit fees and another $100,000 in non-audit costs. The case can be made however, that these savings are significant for issuers with less than $100 million in revenue and would free up resources for uses such as capital investments or research and development. For the investing public, these cost savings could be offset by potentially less accurate financial reporting when the requirement of an ICFR auditor attestation is eliminated. Also open is the question of whether eligible issuers that eliminate the ICFR auditor attestation will have an increased cost of capital or a somewhat depressed stock price due to investors discounting the reliability of financial reporting for issuers that do not provide an ICFR auditor attestation.

Commissioner Jackson noted that the SEC benefits analysis relied on “decade-old data to examine the costs of attestation and makes no serious effort to evaluate the benefits” and offered an alternative analysis. Commissioner Jackson did not offer an alternative costs-saved analysis but provided evidence that in his view demonstrates that since issuers no longer take steps to avoid accelerated filer status then one is entitled to conclude the cost the ICFR auditor attestation is not significant.

As noted, issuers newly qualifying as non-accelerated filers if the rule proposal is adopted will also have extended deadlines to file Forms 10-Q and 10-K. The SEC describes this benefit as modest, noting that some issuers file these reports before the required due date.

Many small cap and newly public companies will continue to confront a perplexing array of SEC rules relating to filer status, SRC status and EGC status, and more particularized rules when transitioning in and out of the categories. The perplexing menu and analyzing costs of choosing a newly available relaxed disclosure regime, or having to comply with a required increased disclosure regime, will likely increase costs for many SEC registrants.

The text of the proposed rule is available here.

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