SEC Commissioner Mark Uyeda in a speech suggested reducing rule compliance burdens, among other measures, to help smaller companies go and stay public.
For example, he said that the commission could consider ways to get more companies to qualify as “smaller reporting companies” (SRCs). While he did not spell out the regulatory benefits of being an SRC in his speech, this class of companies do not need to get their independent auditor’s attestation of the management’s internal control over financial reporting (ICFR) under Section 404(b) of the Sarbanes-Oxley Act of 2002.
SRCs still need to comply with Section 404(a), which requires management to maintain ICFR and evaluate its effectiveness.
When the SEC changed the rules three years ago to exempt more categories of companies from Section 404(b), it was a big victory for businesses as they claimed that the provision was one of the biggest hurdles for companies going or staying public. Previously, only companies with less than $75 million—or non-accelerated filers—in public float got the regulatory relief.
The 2020 rules, adopted when Jay Clayton ran the agency, were intended to benefit low revenue companies even if the funds raised in the public stock markets are not small by changing the definition of accelerated and larger accelerated filer definition. In particular, the amendments were in response to complaints by biotech companies and the U.S. Chamber of Commerce. The rule exempted SRCs from Section 404(b). SRCs have less than $250 million in public float. A company with no public float or with a public float of less than $700 million also qualifies as an SRC if it had annual revenues of less than $100 million during its most recently completed fiscal year.
Commissioner Uyeda’s March 3, 2023, speech during a Columbia Law School/Business School Program comes as there has been a decline in the number of public companies and initial public offerings (IPOs) over the years. But this decline has been more pronounced among smaller companies. While he does not claim that burdensome regulation is the sole culprit behind the decline, Uyeda believes that it is a major factor.
The percentage of listed companies with less than $100 million in revenue decreased by about 60 percent from 1998 to 2017. Between 1990 and 2000, the percentage of IPOs of a company that had less than $1 million in revenue in the trailing 12 months was 72 percent. Since 2001, that percentage has gone down to 55 percent.
As for the public market overall, there were 4,194 IPOs between 1990 and 2000. Between 2001 to 2021, there were only 2,276 IPOs, Uyeda said.
At the same time, private markets, where companies comply with a simpler set of rules, have been booming.
“Unsurprisingly, smaller companies with less revenue and less gross profit have fewer resources to pay for the increasing compliance costs of being a public company,” Uyeda said at the conference in New York.
In discussing the 2020 rule, Uyeda said that a public float only measures the value of the public’s investment in a company. It does not measure a company’s ability or resources to pay their attorneys, accountants, consultants and internal staff to prepare Form 10-Ks, proxy statements and other regulatory filings with the SEC.
“Instead, a test based on revenue or gross profit, either in addition to, or in lieu of, public float is better suited to determine whether a company can qualify for the ability to provide scaled disclosure,” Uyeda explained. “Gross profit may be more appropriate than revenue because it somewhat neutralizes the impact of the company’s industry and better reflects the company’s ability to pay its ‘below the line’ compliance costs from a financial statements perspective.”
Moreover, he said that any disclosure rule should have some degree of scaled requirement for SRCs.
Further, he said that the default compliance dates for SRCs should be at least one year on any new disclosure rule.
“This allows smaller companies to benefit from the legal, consulting, and accounting work received by larger companies on new rules,” he explained. “These new rules can be complex and raise issues not clearly addressed in the rulemaking. Professionals will typically spend most of their time analyzing the rule and drafting the required forms and disclosures in the first year after a rule is effective. Accordingly, the compliance costs in the first year are likely the highest. If smaller public companies can benefit from implementation efforts by larger companies, then smaller companies might be able to significantly reduce their compliance costs associated with new rules.”
Financial Materiality
Another way to reduce regulatory compliance burdens, Uyeda said, is for the SEC to stick to the concept of financial materiality when writing disclosure rules.
The concept of materiality is used to determine what is important enough to be included and what can be left out of disclosures.
Today, the SEC, the FASB, the PCAOB and the AICPA use a judicial interpretation for materiality.
In interpreting the federal securities laws, the Supreme Court has held that a fact is material if there is “a substantial likelihood that the … fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”
Thus, in Uyeda’s view, the SEC’s rulemaking on climate change disclosure, human capital, cybersecurity and stock buybacks, among other topics, might not exactly fit the materiality definition because it discusses the “reasonable investor.”
He believes that only particular investors might find those rules material.
“For the rulemakings where the Commission has issued proposals, the required disclosure is often one-size-fits-all and prescriptive,” Uyeda explained. “The disclosure requirements do not appear to be rooted in whether a reasonable investor would consider the information important in his or her decision to invest in a company’s stock. Receiving comments from market participants and the public on whether the Commission’s proposed rules sufficiently considered materiality is very important, and the Commission should evaluate and address any comments as part of any final rule.”
Almost every investor will agree that financial factors affect their returns on investment. But there may not be a consensus among investors about the significance of disclosures that have no apparent financial impact.
“As a result, it may be difficult to establish a reasonable investor standard for non-financial factors. The costs of providing such disclosure, however, are quite real,” he said.
Thus, when the SEC’s rules move away from financial materiality, they could impose significant costs on companies. At the same time, he believes the disclosures made based on the rules would not provide much benefit to a reasonable investor.
“To the extent that disclosures that are not financially material are added at the whims of the Commission, companies, over time, will face a collection of immaterial topics that will need to be disclosed and that will be subject to litigation,” Uyeda said. “The costs to prepare such disclosure and defend any litigation will likely be passed on to the companies’ investors in the form of lower investment returns or to their customers in the form of higher prices. Such costs may also disincentive private companies from going public. Moreover, the mere possibility that new, burdensome and immaterial disclosure requirements may be imposed in the future could similarly cause private companies to think twice about going public.”
In the meantime, SEC Chair Gary Gensler believes that climate change disclosure is material because many investors say it is so for their decisions. Moreover, the number of green funds has skyrocketed in response to demand, proving that it is not only a small segment of investors that want information related to sustainability.
This article originally appeared in the March 9, 2023 edition of Accounting & Compliance Alert, available on Checkpoint.
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