The new Sarbanes-Oxley compliance guidelines issued by the Securities & Exchange Commission and the Public Company Accounting Oversight Board last month should make life easier for smaller public companies, experts say (see BusinessWeek.com, 6/8/07, "SOX Revisions: A Break for Small Biz?"). They should also go a long way toward reducing the inequities for small public firms that have been documented since the corporate reform law, commonly called SOX, was passed in 2002.
"SOX section 404 was intended to restore investor confidence and correct corporate problems," says Jeffry Netter, a professor of finance and adjunct professor of law at the Terry College of Business, University of Georgia. "It was never intended to become inflexible, burdensome, and wasteful. What these new guidelines aim to do is to 'right-size' the evaluation and assessment efforts for companies of all sizes. Under them, management will be able to scale and tailor their evaluation procedures and investors will benefit from reduced compliance costs. Smaller companies will particularly benefit from the scalability and flexibility that's been proposed."
Less Burdensome Guidelines
The new guidelines came about in response to a growing outcry about SOX, and in particular about its extension to companies defined as having market value of equity of less than $75 million—which includes a majority of publicly traded firms. They have been exempt from compliance since the law passed, but are expected to have to comply with one portion of SOX Section 404 this year. The second 404 compliance piece, involving an external audit, will apply in 2008 under the new guidelines.
"These guidelines are designed to alleviate unnecessary burdens on smaller companies," says James Linck, Netter's colleague and an associate professor of finance at Terry College of Business. "The proposals are directly responsive to the recommendations of an advisory committee that was focused on capital formation and the removal of obstacles that impede the growth of small companies."
The new guidelines should signal audit firms that they are off the hook somewhat, Linck says. "They were following the letter of the law and putting a significant burden on companies. The new ruling said that while smaller companies will now have to comply, there are some principles they can follow to ease the burden. Generally, they've been told to focus on financial areas that matter by using what's called a top-down, risk-based approach to management review."
Linck and Netter recently released the results of a study they did on the impact of some of the other auditing standards, disclosure rules, and corporate governance rules mandated by SOX, and the rule changes of the major U.S. stock exchanges on corporate boards. They say the results indicate that while the changes are increasing the cost of running a board for all companies, they are imposing a disproportionate burden on small firms.
"The law and the exchange rules mandate that firms have more outside directors and that those directors do more work. Thus, costs rise both because more directors are hired and because each director must be made to do more," Linck says. That affects smaller public companies unfairly, he notes, because small firms pay nearly 10 times more in directors' fees per dollar of sales than do larger firms. Their study showed that small firms paid $3.19 in directors' fees per $1,000 of net sales in 2004, an 84¢ increase from 2001. In contrast, large firms paid 32¢ in directors' fees per $1,000 of net sales in 2004, only a 7¢ increase over 2001.
"The impact of this law isn't necessarily being felt, to the same extent, by the companies it was intended for," says Linck. "It's easier for big firms like Wal-Mart to hire more directors than Joe's candy shop. As the costs of being public increase, it's likely some of these small firms will exit the public equity market. At some point, the benefits of being a public company will no longer outweigh the costs. Further, firms contemplating raising public equity may find that listing their equity on exchanges outside the U.S. to be relatively more attractive, and forgo listing in the U.S."
Small vs. Large Firms
For the study, Linck and Netter collaborated with Tina Yang from Clemson University's College of Business and Behavior Science. They studied the boards of more than 8,000 firms—large and small—and found that from 1998 to 2004, median cash compensation for non-employee directors increased by 132% within small public firms. Combining the cash and equity components, the median small firm paid directors fees of over $20,000 in 2004, compared to just over $11,000 in 1998. The authors also found that from 1998 to 2004 small firms raised the median number of audit committee meetings per year from one to five, and that the number of small firms that had nominating and governance committees increased dramatically.
While the costs of SOX compliance are demonstrably higher for small public companies, Linck says, he is hopeful that the Section 404 compliance guidelines will make them less onerous for small firms when they go into effect this year. "Before, many large companies were not doing a top-down, risk-management approach, they were into a coverage approach and trying to make sure that they got a certain large percentage of their balance sheet covered in their internal management assessment and external audit," he says. "There's no reason why a smaller business can't do this effectively. It won't be a walk in the park, but it should be more affordable if you're looking at high-risk areas that matter, not at everything."