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US Securities and Exchange Commission

SEC Has Over 50 Rulemaking Projects, but a ‘Phenomenally Important’ One is Missing

Soyoung Ho  Senior Editor, Accounting and Compliance Alert

· 10 minute read

Soyoung Ho  Senior Editor, Accounting and Compliance Alert

· 10 minute read

There is no doubt that SEC Chair Gary Gensler’s near-term rulemaking agenda is ambitious with over 50 items.

But there is one glaring omission: revisiting rules that exempted more classes of public companies from Section 404(b) of the Sarbanes-Oxley of 2002 adopted by his predecessor, Jay Clayton, during his last year of tenure.

Everyone knows that Gensler was a tough regulator when he headed up the Commodity Futures Trading Commission during the Obama administration. What is less known is that he was a senior adviser to Sen. Paul Sarbanes in writing Sarbanes-Oxley.

“A revisit does not sound like a priority for Gary Gensler. Silence usually means it’s okay,” said Jack Ciesielski, founder of investment research firm R.G. Associates who is currently a member of the FASB’s Emerging Issues Task Force. “I would be for revisiting it because I did not like the exemptions in the first place. Small companies are most often where the accounting skank takes place, so why should they get a pass on having controls to prevent foul accounting?”

James Cox, a law professor at Duke University, agreed.

“I think it’s phenomenally important to investors,” said Cox, who previously served on an advisory panel of the Public Company Accounting Oversight Board (PCAOB), which was established by Sarbanes-Oxley to supervise audit firms. “I think at the end of the day, we are going to look back and say ‘ok, we still need to make the changes. It makes no sense to carve out the smallest firms.’”

This is especially relevant as Gensler’s agenda includes several items intended to revisit business-friendly rules that were adopted in 2020. Clayton’s SEC largely followed the Trump administration’s deregulatory policy and put an emphasis on capital raising by small companies.

By contrast, the Biden administration has been reversing course. Gensler has stressed investor protection.

Sarbanes-Oxley was passed in the aftermath of Enron and WorldCom accounting scandals that cost investors an estimated $85 billion two decades ago, and most agree that the law has a good track record of protecting investors. And a major part of the law is Sections 404(a) and 404(b): it requires company management to put in and assess its internal control over financial reporting (ICFR), and then auditors must attest to management’s evaluation, respectively.

But this had been a big-ticket deregulatory item for the U.S. Chamber of Commerce and biotechnology companies for several years. And finally in a March 2020 rule, the exemption was expanded to include smaller reporting companies (SRCs) that have annual revenues of less than $100 million. SRCs have less than $250 million public float. The previous exemption threshold was $75 million in market cap.

Business groups had argued that companies do not want to go public mostly because of the cost of Section 404(b).

However, investor protection advocates believe Section 404 makes it less likely that management will manipulate the company’s financials. Moreover, studies have shown that a strong emphasis on internal controls has substantially reduced the risk of material misstatement. Further, over the past several years, material misstatements have gone down.

Thus, this has always been a tricky balancing act for regulators.

“There is one side of the world that says if we want to support startups, we can’t make the compliance barriers to entry so high that it is impossible for them to actually do their business,” said Michael Mann, a partner with Crowell & Moring LLP who was the first director of the SEC’s Office of International Affairs. “The other side says, ‘well, if we are going to let these people get money from public investors, the public investors need to have assurances that there are controls in place for the accounting system.’ What is missing is the compromise that recognizes investor needs for oversight in an efficient and thus reasonable manner.”

Faulty Cost-Benefit Analysis?

But to some critics, Clayton’s tenure was marked with making rules less burdensome while downplaying the investor protection aspect of the SEC’s mission, and they even pointed out that the agency’s cost-benefit analysis at the time was flawed.

In 2019, when the market regulator first issued the proposal to exempt SRCs, investor groups, including the CFA Institute questioned the commission’s cost-benefit analysis in a comment letter.

The group, which did its own analysis, wrote that companies that will get the exemption are more prone to accounting issues. In particular, it said that it was not able to replicate the 539 estimated companies that the commission said will be exempted.

The CFA Institute also said the SEC’s analysis does not articulate how the most affected industries will spur capital raises other than by saving the audit fees. The banking industry, for example, would represent 44 percent of companies to be exempted—with 39 percent of public float, 53 percent of revenue, and 86 percent of assets. Of those, small depository institutions account for $178.7 billion of the assets, which the SEC did not flag in its proposal. But any rule that affects asset-heavy industry should consider the effect on assets, not just revenue or public float.

The CFA Institute said the SEC must reconsider exempting the smaller banks because of the 2008 financial crisis when there was not sufficient focus on asset impairment and the challenges of these banks in implementing so-called current expected credit losses (CECL). Moreover, the group said internal controls will play an important role in the adoption and audit of CECL model, which requires banks to recognize loan losses earlier.

In addition, the group noted that the PCAOB’s 2018 inspection findings showed loan impairments remain a key problem area.

“The potential risks of removing the attestation seem substantial relative to any capital formation spurred by reducing audit fees by $210,000 for some (those under $1 billion in assets) of these institutions,” the CFA Institute wrote in 2019.

In an interview, Sandy Peters, senior head of global financial reporting policy with the CFA Institute, said that they ended up spending more time on preparing the comment letter than they had intended.

“Once we started looking at the data, it was clear that this wasn’t going to be about creating less compliance for tech companies,” said Peters, who is a member of the SEC’s Investor Advisory Committee. “Financial institutions were most affected. They don’t need to raise capital.”

Clayton’s commission largely sold it as benefiting biotech startups that need to raise money for R&D to develop life-saving medicine.

“This should have been immediately obvious to all readers of the proposed rule,” Peters said. “If an industry is significantly impacted, there should have been consideration about what rule is appropriate.”

Thus, even Rep. Maxine Waters, a Democrat who chairs the House Financial Services Committee, in letters to then President-elect Biden in December 2020 and January 2021, asked for reversals of rules that included Section 404(b).

Not Enough Bandwidth

So, why is Section 404(b) missing from the agenda?

Former SEC Chief Accountant Lynn Turner, an outspoken investor advocate, said the biggest issue is the 50 items that Gensler already has on the agenda.

“He just doesn’t have staff bandwidth to have that many,” said Turner, who was actively involved in the legislative process leading up to passage of Sarbanes-Oxley. “So, the question becomes which of the top 10 list would you take something off and put on 404.”

Clayton did about two dozen rulemakings a year, and many of those were small ones.

“And that was after he’s been chairman for a couple of years,” Turner said. “Gensler will not be able to do any more.”

Besides, Clayton had the backing of all the business community, the powerful Wall Street. Further, small businesses have an outsize voice in America that the SEC cannot ignore. By contrast, “Gensler will have the business community working against him,” Turner said.

Gensler is already facing backlash over his effort to write a standardized climate change disclosure rule. Business groups already threatened him with lawsuits. Thus, the SEC has to choose its fights wisely.

In addition, the Council of Institutional Investors (CII), which strongly opposed further Section 404(b) exemptions, has stayed silent on the matter when Gensler became chair, focusing more on shareholder rights and corporate governance issues.

“But if a proposal is floated, we will be all over it,” CII General Counsel Jeffrey Mahoney said.

Waiting for New PCAOB Leadership?

At the end of the day, Duke law professor Cox wants to give Gensler the benefit of the doubt and pointed to house cleaning at the PCAOB whose previous members were appointed by Clayton. Investors were furious that under then-Chairman William Duhnke’s tenure, the board strayed from its mission of protecting investors and were too lenient with auditors.

In November last year, Gensler put in new board members, and they are expected to reverse course under the leadership of Erica Williams, who was sworn in as PCAOB chair on January 10, 2022. The SEC oversees the board.

“I believe on his part, he wants to see if the new board members, particularly the new chair who just came in, can they get their feet on the ground, take care of their house and advise him and the SEC about what other steps we might want to be taking,” Cox said. “So, being more cautious than I normally am, being more understanding than I normally am, I could see giving the new chair of the SEC the benefit of the doubt.”

“It’s premature to take any action here to reverse these positions taken by Clayton,” he added. “So, let’s just wait.”

Are Auditors Doing a Good Job with Section 404?

In the meantime, Turner and others want auditors to do a better job to fulfil the promise of Section 404.

“It’s not as useful as it should have been,” he said “You just gotta ask yourself: companies never reported material weakness until right after they have had a restatement.”

Tom Selling, author of The Accounting Onion blog, who is writing a book on financial reporting, agreed.

“The problem with 404 is that most material weaknesses were identified after an accountant identifies an accounting error,” said Selling, who was a member of the PCAOB’s Standing Advisory Group. “The auditor really doesn’t do a good job of testing to understand the effectiveness of internal controls.”

Indeed, the PCAOB audit inspection often finds problems with ICFR audits.


This article originally appeared in the January 18, 2022 edition of Accounting & Compliance Alert, available on Checkpoint.

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