<DOC>
[109th Congress House Hearings]
[From the U.S. Government Printing Office via GPO Access]
[DOCID: f:33393.wais]
A BALANCING ACT: COST, COMPLIANCE, AND COMPETITIVENESS AFTER SARBANES-
OXLEY
=======================================================================
HEARING
before the
SUBCOMMITTEE ON REGULATORY AFFAIRS
of the
COMMITTEE ON
GOVERNMENT REFORM
HOUSE OF REPRESENTATIVES
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
__________
JUNE 19, 2006
__________
Serial No. 109-217
__________
Printed for the use of the Committee on Government Reform
Available via the World Wide Web: http://www.gpoaccess.gov/congress/
index.html
http://www.house.gov/reform
U.S. GOVERNMENT PRINTING OFFICE
33-393 PDF WASHINGTON : 2007
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COMMITTEE ON GOVERNMENT REFORM
TOM DAVIS, Virginia, Chairman
CHRISTOPHER SHAYS, Connecticut HENRY A. WAXMAN, California
DAN BURTON, Indiana TOM LANTOS, California
ILEANA ROS-LEHTINEN, Florida MAJOR R. OWENS, New York
JOHN M. McHUGH, New York EDOLPHUS TOWNS, New York
JOHN L. MICA, Florida PAUL E. KANJORSKI, Pennsylvania
GIL GUTKNECHT, Minnesota CAROLYN B. MALONEY, New York
MARK E. SOUDER, Indiana ELIJAH E. CUMMINGS, Maryland
STEVEN C. LaTOURETTE, Ohio DENNIS J. KUCINICH, Ohio
TODD RUSSELL PLATTS, Pennsylvania DANNY K. DAVIS, Illinois
CHRIS CANNON, Utah WM. LACY CLAY, Missouri
JOHN J. DUNCAN, Jr., Tennessee DIANE E. WATSON, California
CANDICE S. MILLER, Michigan STEPHEN F. LYNCH, Massachusetts
MICHAEL R. TURNER, Ohio CHRIS VAN HOLLEN, Maryland
DARRELL E. ISSA, California LINDA T. SANCHEZ, California
JON C. PORTER, Nevada C.A. DUTCH RUPPERSBERGER, Maryland
KENNY MARCHANT, Texas BRIAN HIGGINS, New York
LYNN A. WESTMORELAND, Georgia ELEANOR HOLMES NORTON, District of
PATRICK T. McHENRY, North Carolina Columbia
CHARLES W. DENT, Pennsylvania ------
VIRGINIA FOXX, North Carolina BERNARD SANDERS, Vermont
JEAN SCMIDT, Ohio (Independent)
------ ------
David Marin, Staff Director
Lawrence Halloran, Deputy Staff Director
Teresa Austin, Chief Clerk
Phil Barnett, Minority Chief of Staff/Chief Counsel
Subcommittee on Regulatory Affairs
CANDICE S. MILLER, Michigan, Chairman
CHRIS CANNON, Utah STEPHEN F. LYNCH, Massachusetts
MICHAEL R. TURNER, Ohio WM. LACY CLAY, Missouri
LYNN A. WESTMORELAND, Georgia CHRIS VAN HOLLEN, Maryland
JEAN SCHMIDT, Ohio
Ex Officio
TOM DAVIS, Virginia HENRY A. WAXMAN, California
Ed Schrock, Staff Director
Kristina Husar, Professional Staff Member
Benjamin Chance, Clerk
Krista Boyd, Minority Professional Staff Member
C O N T E N T S
----------
Page
Hearing held on June 19, 2006.................................... 1
Statement of:
Robotti, Robert, president, Robotti & Co.; William W. Beach,
director for data analysis, the Heritage Foundation; John
P. O'Shea, president and CEO, Westminster Securities Corp.;
and David Lawrence, chief financial officer, Acorda
Therapeutics, Inc.......................................... 48
Beach, William W......................................... 58
Lawrence, David.......................................... 73
O'Shea, John P........................................... 65
Robotti, Robert.......................................... 48
Wolkoff, Neal, CEO, the American Stock Exchange; R. Cromwell
Coulson, CEO, the Pink Sheets; and Mallory Factor,
chairman, Free Enterprise Fund............................. 8
Coulson, R. Cromwell..................................... 19
Factor, Mallory.......................................... 30
Wolkoff, Neal............................................ 8
Letters, statements, etc., submitted for the record by:
Beach, William W., director for data analysis, the Heritage
Foundation, prepared statement of.......................... 60
Coulson, R. Cromwell, CEO, the Pink Sheets, prepared
statement of............................................... 22
Factor, Mallory, chairman, Free Enterprise Fund, prepared
statement of............................................... 32
Lawrence, David, chief financial officer, Acorda
Therapeutics, Inc., prepared statement of.................. 75
McHenry, Hon. Patrick T., a Representative in Congress from
the State of North Carolina, prepared statement of......... 3
O'Shea, John P., president and CEO, Westminster Securities
Corp., prepared statement of............................... 68
Robotti, Robert, president, Robotti & Co., prepared statement
of......................................................... 51
Wolkoff, Neal, CEO, the American Stock Exchange, prepared
statement of............................................... 11
A BALANCING ACT: COST, COMPLIANCE, AND COMPETITIVENESS AFTER SARBANES-
OXLEY
----------
MONDAY, JUNE 19, 2006
House of Representatives,
Subcommittee on Regulatory Affairs,
Committee on Government Reform,
New York, NY.
The subcommittee met, pursuant to notice, at 10 a.m., in
the Auditorium of the U.S. Customs House, 1 Bowling Green, New
York, NY, Hon. Patrick T. McHenry (chairman of the
subcommittee) presiding.
Present: Representatives McHenry, Dent, and Maloney.
Also present: Representatives Kelly, and Feeney.
Mr. McHenry. Come to order. Good morning. I'm Congressman
Patrick McHenry from North Carolina. I am chairing this
subcommittee in Candice Miller's stead. She has been detained
in Michigan due to a family health emergency. She's OK. She
wanted me to communicate that, but unfortunately she cannot be
here today.
I'm joined this morning by my colleagues from everywhere
from New York to Florida. To my immediate right would be Mrs.
Maloney, who actually represents Manhattan. And to my left, my
good friend and fellow class representative, Charlie Dent from
the 15th Congressional District of Pennsylvania, representing
the Lehigh Valley. Next to him is Sue Kelly, representing just
to the north of the city, Westchester and the Hudson Valley,
representing New York's 19th Congressional District. And to her
left is Tom Feeney from Florida, representing the space coast
and Florida's 24th Congressional District. And we are looking
forward to this hearing today on ``A Balancing Act: Cost,
Compliance and Competitiveness after Sarbanes-Oxley.''
Both Tom Feeney, Mrs. Kelly and I are members of the House
Financial Services Committee. I am also a member of the House
Government Reform Committee. And under the auspices of the
House Government Reform Committee, of which Charlie Dent and I
both sit on, we're having this hearing today.
I am very pleased to be here in this historic setting
discussing an important issue for our financial markets. New
York has long been considered the financial capital of the
world, although we in North Carolina are very pleased about our
banking center in Charlotte and I'm pleased to represent a
number of folks that work there. The reason why we're holding
this hearing today is because of a growing concern that due to
certain regulations and regulatory matters and legislation that
we've passed, America and New York is losing its lead as a
financial capital to foreign exchanges.
To illustrate the point, I would draw your attention to a
Wall Street Journal article of January 26, 2006 that reported:
``In 2000, nine out of every ten dollars raised by foreign
companies through new stock offerings were done in New York. By
2005, the reverse was true. Nine out of every ten dollars were
raised through new company listings in London or Luxembourg.''
Furthermore, on Tuesday, May 30, 2006, the Journal noted
that the world's top 10 Initial Public Offerings since the
passage of Sarbanes-Oxley, only 1 occurred on Wall Street.
Finally, it's not hard to conclude that the announced
merger of the New York Stock Exchange with Euronext is due in
part to their desire to recapture these lost listings. Indeed,
the Wall Street Journal on Friday, June 2nd said this: that one
factor pushing the New York Stock Exchange toward Euronext is
the shriveling of initial public offerings by international
companies amid a tougher U.S. regulatory environment.
Certainly, Sarbanes-Oxley was a reaction to World Com and
Enron-style scandals. But this bill does offer some solid
guidance to businesses. But unfortunately, the implementation,
in particular of Section 404, a section just 168 words long,
has resulted in some unintended consequences that have become a
huge handicap for American businesses.
I've met with a number of business and banking leaders
about this subject around the country and in North Carolina and
they agree. Sarbanes-Oxley has made a dramatic and sometimes
negative impact on the capital markets. Transparency is very
important in corporate governance. We understand that as public
policymakers. However, as a rule, less government regulation
translates to more productivity, economic expansion and job
growth. So we have to balance those competing interests and
needs.
Congress did not intend to handicap U.S. businesses with
these huge costs and the original SEC estimates said that
annual compliance cost of the average firm would be somewhere
around $91,000. Today, the average firm spends $3.7 million to
comply with the requirements of Sarbanes-Oxley. The SEC
underestimated the cost by a factor of 40 and that is after
compliance costs have decreased. In fact, a moderate size
community bank in my District spent $500,000 last year in
direct costs associated with compliance of Sarbanes-Oxley, on
top of all the other indirect costs they tally into many
millions. And this is for a small community bank.
So we have to look at competitiveness around the world, if
we're to draw that capital here to the United States and that's
what this hearing is about today. I look forward to the
distinguished panels that we have here today and my colleagues'
questions as well.
And with that, I would now like to recognize my colleague,
Mr. Dent, from Pennsylvania.
[The prepared statement of Hon. Patrick T. McHenry
follows:]
[GRAPHIC] [TIFF OMITTED] 33393.001
[GRAPHIC] [TIFF OMITTED] 33393.002
Mr. Dent. Thank you, Mr. Chairman. I'd also like to thank
Chairman Miller for holding this critical hearing today on
Sarbanes-Oxley Act and also thanks to Mr. McHenry for pinch
hitting for her this morning. As a result of the accounting
scandals of Enron and World Com, Congress passed the Sarbanes-
Oxley Act of 2002 with the intent to restore public confidence
in the financial market. SOX requires extensive disclosures
about internal controls for public companies. Specifically,
Section 302 requires corporate managers to attest to the
accuracy and reliability of financial reports and disclose
material witnesses in internal controls.
Section 404 requires that public companies must disclose
their own financial controls as part of their annual report and
requires an outside accounting firm to audit internal controls
and the company's attestment before being considered compliant.
While the intent may have been positive, regulatory demands of
SOX compliance has become extremely expensive for companies to
meet and become a major obstacle, perhaps prohibiting smaller
businesses from going public.
I have had extensive discussions of this act with several
constituents in my District. In fact, my good friend and
constituent, Dave Lobach, is here today or will be here
momentarily if he can park his car. Dave is the CEO of Embassy
Bank in the Lehigh Valley. Dave and Elmer Gates, the chairman
of Embassy, have given me a firsthand perspective as to the
obstacles they face as a result of Sarbanes-Oxley.
Banking is a highly regulated industry in the United States
and as community bankers, they are consistently inundated with
various rules and regulations that go well beyond simple
regulation and I believe it's safe to say well into the realm
of debilitating. Currently, and this bank in particular,
Embassy Bank is reviewed on an annual basis by the state and
the FDIC. Furthermore, in addition to conducting its own
internal audit process, Embassy also has a number of external
auditors who consistently assess a variety of different
criteria ensuring regulatory compliance on many levels.
I can say with certainty that many of the small businesses
in my District see SOX as an anti-competitive initiative which
adds additional process to an already over-regulated industry
and adds tremendous cost in a business where the spreads are
very thin.
I have concerns that when the financial markets become too
duplicative and over-regulated, the cost will be passed on to
or absorbed by the consumer. I was shocked when Mr. Lobach
informed me that the costs--he informed me that the costs
Embassy Bank will accrue this year to be SOX compliant will
equal the cost of opening and operating another branch office
for a single year.
I'm quite interested in this issue and the effects that the
Sarbanes-Oxley Act has on the small businesses and banks in my
District. I do not sit on this subcommittee or the Financial
Services Committee, nor was I a Member of Congress when SOX was
enacted in 2002. That said, I'm extremely interested in the
testimony of these expert witnesses assembled here today and
I'm eager to hear a bit about it, about their perspective as to
the effects of Sarbanes-Oxley and the evaluation to cost and
benefits of being SOX compliant.
Thank you, Mr. Chairman.
Mr. McHenry. At this point I recognize Congresswoman Kelly
for the purposes of an opening statement.
Ms. Kelly. Thank you, Chairman McHenry, for holding this
hearing.
I'd like to welcome Members of the subcommittee to New York
and I really am very pleased to have the honor to have a
constituent testify and to participate in a much needed
discussion of the impacts of Sarbanes-Oxley Act on businesses
in our country and in New York.
In 2002, I voted for the original Sarbanes-Oxley Act. At
that time it was a much needed response to the scandals at
Enron and World Com that had already hurt millions of small
investors and threatened to destroy confidence in America's
securities markets. As chairman of oversight and
investigations, I held the first Enron and World Com hearings.
Voting for Sarbanes-Oxley then was the right thing to do.
Four years later, America's economy is growing strong and
consumer confidence is high. For all the success of this law,
we do see some issues that demand attention. Employers in New
York's Hudson Valley and around the Nation have experienced
problems meeting the costs imposed by the regulators'
interpretation of the law. We will hear the experiences of one
of my constituents, David Lawrence of Warwick, NY, whose
employer has brought numerous jobs to my District, but is
struggling to meet the costs.
When Congress passed Sarbanes-Oxley, it never intended to
force any company to choose between following the law and
creating jobs. Sadly, bureaucratic regulation has chosen to
interpret the law in ways that no longer seem to make sense.
Although accounting costs for audits are declining, businesses
with less than $100 million market cap are having to divert
precious personnel and resources to comply with a law that was
never intended to cover America's smaller or startup companies.
Smaller companies are increasingly raising capital outside
the public markets and the IPOs have been delayed and many have
moved off-shore. Given this situation, I think it's important
that Congress examine how to ensure that our financial system
remains strong, transparent and clean while allowing innovation
and growth to flourish. Even the best laws need continued
oversight in perfecting modifications.
Today's witnesses from academia and industry will allow us
to explore the best way to comply with the spirit and the
substance of Sarbanes-Oxley in a way that makes sense for this
Nation.
I thank you for holding this hearing and I yield back.
Mr. McHenry. Thank you, Ms. Kelly. Mr. Feeney.
Mr. Feeney. Thank you, Mr. Chairman. I'm especially
grateful to you, to Chairman Davis and Chairman Miller for
letting Congresswoman Kelly and I kibbutz on your
subcommittee's hearings because it's something very important
to me. I'll tell you that there are a couple of traditional
truisms in Congress that Sarbanes-Oxley has, I think, proven in
my view. One is that Congress has typically two speeds, zero
and over-react and the second is that often the law of
unintended, unforeseen consequences means that the adverse
consequences of a well-intentioned bill are much greater than
the positive consequences.
I have engaged for the last 9, 10 months in a listening
tour, along with Congressman Meeks, Congressman Pete Sessions,
Congressman Mark Kirk, and a few others at times and we have
visited all three of the major exchanges in Chicago. We've been
to the New York Stock Exchange, to the NASDAQ. I look forward
to hearing Mr. Wolkoff's testimony which I've read. And I have
come to a conclusion that it is time for a serious review of
Sarbanes-Oxley. We now have enough empirical and anecdotal
evidence across the board to know that the way it has been
implemented, especially 404, has been counter productive.
Ultimately, the test is not how many headaches we create
for members of the board of directors, for the CFO or the CEO,
ultimately, the test is are we giving net added value to
investors? And I believe the answer is in many cases an
overwhelming no and as we now put small cap companies under the
gun, the deadline has been extended I think until December 16th
of this year, but I am concerned that we are going to have a
massive adverse reaction to imposing these enormously complex
requirements on small companies.
The bottom line is we have a conspiracy of two major
problems that have come under the gun here. No. 1 is the way
that Sarbanes-Oxley 404 has been implemented is very ambiguous
in terms of what is a de minimis accounting error. There are
lots of other standards that are not clearly set and you
combine that with the fact that everybody involved, from the
internal and the external auditors to the members of the board
to the CFO, the CEO is under the gun for both civil and
criminal liability. So over-zealous regulation is always the
result when you have ambiguous rules and when you have
essentially the death sentence for everybody involved.
You talked about the $35 billion estimated direct cost of
compliance. I am much more concerned about the indirect cost of
compliance with Sarbanes-Oxley. The estimates are as much as
$1.1 trillion by two separate sources, which means that
effectively this is an 8 or 9 percent regulatory tax on every
transaction that occurs in the United States of America, and I
believe that we are quickly outsourcing our lead in America's
capital markets which we've had for about 100 years.
With that, Mr. Chairman, I'd like to just note that along
with about 22 co-sponsors, I have filed a bill called the
Compete Act. I would encourage people interested in Sarbanes-
Oxley issues to take a look at that bill. We've got eight
sponsors and co-sponsors led by Senator Jim Demint in the U.S.
Senate and I'm just again really thrilled to be here.
Mr. McHenry. Thank you, Mr. Feeney. Because the Government
Reform Committee has subpoena power, we always swear in our
witnesses, so if you would all please rise with me, raise your
right hands.
[Witnesses sworn.]
Mr. McHenry. Due to time restrictions, we'd ask you to
please limit your opening remarks to 5 minutes. Your time will
begin and be noted by the green light. They'll signify--when
the yellow light flashes, it will signify you have 1 minute
left. And I would ask you to please abide by that because we'd
like to get to questions and we'd like to have a full hearing
and the interaction that we have with the questions between
Members of Congress and the panel is really where we'll gain
the most knowledge.
So with that, I'd like to recognize Mrs. Kelly for the
purposes of introducing Mr. Factor.
Ms. Kelly. It gives me great pleasure to introduce Mr. Neal
Wolkoff, who is chairman and chief executive officer of the
American Stock Exchange and was appointed to the post in April
2005, after serving as an Acting CEO. Previously, he served as
chief operating officer and several other senior level
executive positions in the New York Mercantile Exchange, a
member of the bar of the State of New York, and the U.S.
District Court, Southern District of New York. Mr. Wolkoff
received a B.A. from the College of Columbia University and a
J.D. from Boston University School of Law.
Next is Mr. R. Cromwell Coulson. Mr. Coulson is the
chairman and chief executive officer for Pink Sheets LLC. In
1997, he led a group of investors in acquiring Pink Sheets'
predecessor, the National Quotation Bureau, reforming the
company into the corporation which now exists. Prior to the
acquisition of Pink Sheets, he was a trader specializing in
distressed and value-oriented investments of over-the-counter
market maker. He received a BBA from the Southern Methodist
University in Dallas, TX.
Next, we have Mr. Mallory Factor. Mallory Factor is
chairman of the Free Enterprise Fund and president and founder
of Mallory Factor, Inc. He is also the chairman of the New York
Public Asset Fund and Blue Cross Blue Shield Investment
Advisory Board. He serves as a member of the Board of Governors
of the New York State Banking Department. He is a member of the
Council on Foreign Relations and served as vice chair of the
Council on Foreign Relations Task Force on Terrorism Financing.
He was appointed by President Ronald Reagan to the Federal
Savings and Loan Advisory Council of the Federal Home Loan
Bank. He's a graduate of Wesleyan University in Connecticut,
attended Columbia University graduate business and law program.
We welcome you all and look forward to your testimony.
Mr. McHenry. And we'll begin with Mr. Wolkoff.
STATEMENTS OF NEAL WOLKOFF, CEO, THE AMERICAN STOCK EXCHANGE;
R. CROMWELL COULSON, CEO, THE PINK SHEETS; AND MALLORY FACTOR,
CHAIRMAN, FREE ENTERPRISE FUND
STATEMENT OF NEAL WOLKOFF
Mr. Wolkoff. Thank you. Chairman McHenry and members of the
subcommittee, on behalf of the American Stock Exchange, I would
like to thank you for allowing me the opportunity to testify.
As was stated before, I have submitted written testimony which
I would like to become part of the official record.
I would like to briefly summarize the written testimony.
The American Stock Exchange is the only national stock exchange
whose business focus is on listing small and mid-cap companies.
And therefore, we feel that the impact of Sarbanes-Oxley on
listed companies, particularly those companies that are in the
small-cap arena are of particular concern to us, among the
other national exchanges.
While some of our 600-listed companies are large cap, the
vast majority has capitalization between $50 million and $1
billion and we find that any regulatory system that discourages
these companies from participating in the public markets is of
vital importance to our exchange and our listed companies.
Our experience in the 4-years since the law was enacted has
been that regulators have yet to determine how best to address
these corporate governance issues without disadvantaging
smaller companies that lack the same resources as larger
companies. Key problems that confront smaller companies involve
Section 404 Sarbanes-Oxley, which requires designing,
documenting and ordering of financial controls. Neither the
PCAOB nor the accounting industry have adequately defined what
it means or what is necessary to comply. This lack of clarity
has increased costs so that the auditing firms leave no stone
unturned no matter how remote or immaterial the issue may be.
The new regulations make no distinction between a $50
billion large-cap company and a $75 million small-cap company.
The law's failures to recognize the differences makes it
extremely difficult for smaller companies to compete and to
grow in this current regulatory environment.
The lack of differentiation also places AMEX, as well as
other U.S. exchanges, at a steep competitive disadvantage in
listing foreign-based companies who instead choose to avoid
U.S. capital markets. The lack of regulatory clarity allows
foreign exchanges to arbitrarily fill in the blanks of Section
404 compliance as they cross the United States and market their
own major benefit which is, of course, avoidance of Sarbanes-
Oxley.
In a recent trip to Tel Aviv, which is a hot bed of
entrepreneurship, particularly in health science and
technology, I witnessed the London-based exchange AIM,
aggressively marketing its lesser requirements and lower costs
of governance contrasted with the United States. We're seeing
firsthand some of the impacts of Sarbanes-Oxley on smaller
companies and our experience to date raises serious concerns.
Last month, the exchange received a letter from one of our
listed companies advising of its decision to delist its stock
from trading on the AMEX. It went back to the Toronto Stock
Exchange, citing the costs associated with Sarbanes-Oxley as
the primary reason.
Another example of the impact of Sarbanes-Oxley occurred in
conjunction with a marketing effort in which I participated
several weeks ago in London. After expressing initial interest
in listing on the AMEX, the chief executive of one of the
target companies sent a message to me, explaining that the
Sarbanes-Oxley requirements, as explained to him by his
counsel, prevented any further consideration of the idea and he
declined the invitation to attend dinner.
The SEC-appointed Advisory Committee on Smaller Public
Companies has issued a report recommending that the SEC exempt
some smaller and small-cap companies that comply with enhanced
corporate governance provisions from Section 404 compliance. We
support the conclusions of the advisory committee, believing
that they represent a sound balancing of interest between
regulation and economic growth. However, shortly after our May
conference of SOX implementation issues, the SEC and the PCAOB
said that they did support exemption for smaller companies,
though they indicated willingness to work with companies on
implementation of the regulators.
This one size fits all approach is taken without regard to
the impact of the cost and regulatory burden on the small, but
important segment of the capital market place that smaller
companies represent. In response to growing concerns of small
business, Congressman Feeney introduced H.R. 5405, a bill that
would modify Section 404, largely along the lines of the
advisory committee recommendations.
We believe that something must be done. Even if the full
range of the advisory committee's recommendations is not
followed either by the SEC and the PCAOB or if a legislative
solution is not enacted.
I'd be happy to answer questions, time permitting later on,
as to a possible middle ground, because the American Stock
Exchange is very interested in this issue.
Thank you.
[The prepared statement of Mr. Wolkoff follows:]
[GRAPHIC] [TIFF OMITTED] 33393.003
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[GRAPHIC] [TIFF OMITTED] 33393.008
[GRAPHIC] [TIFF OMITTED] 33393.009
[GRAPHIC] [TIFF OMITTED] 33393.010
Mr. Feeney. Mr. Coulson.
STATEMENT OF R. CROMWELL COULSON
Mr. Coulson. I very much appreciate the opportunity to
provide testimony to this subcommittee in connection with its
investigation of the health, liquidity and competitiveness of
U.S. equity markets during the implementation of the Sarbanes-
Oxley Act.
Pink Sheets is the leading provider of pricing and
financial information for the over-the-counter securities
markets and, among other things, operates an electronic
quotation and trade negotiation service for broker-dealers.
While Pink Sheets is well known as the primary trading venue
for the stocks of smaller public companies, the bulk of Pink
Sheets trading by dollar volume takes place in distressed or
reorganizing issuers and the securities of large international
issuers.
My message today has four parts. First, we will share some
of our thoughts about SOX, based on what we are hearing from
smaller public companies; second, some statistics on
deregistration; third, a few general observations about the
competitiveness of U.S. markets; and fourth, we will describe
our efforts to encourage cost-effective disclosure that
protects investors.
We agree with everything about SOX, except for its costs.
SOX has rightfully forced management to be responsible for
their company's disclosure and accountants to stand behind
their audits. Unfortunately, by removing the vendor-client
tension from the audit process, accounting costs are no longer
within the audit client's control. Regulators have given no
guidance so the client can push back. We sincerely hope that
the SEC's recent initiative to repair Section 404 audit process
will rebalance the client-vendor relationship and rein in the
cost burden for all issuers, large and small.
Approximately 500 issuers that have gone dark are currently
trading in the Pink Sheets system. While the number of issuers
going dark may seem high, from 2000 to 2005, over 5,000 issuers
filed Form S-1s or SBTs to register securities in the public
markets for the first time. Already this year over 500 issuers
have filed with the SEC to be registered. So while there's been
an increase in deregistration activity, it is simply not true
that issuers have been exiting the registration system en
masse.
It is true that many small issuers are still watching and
if the costs become too burdensome, those numbers may change.
But this brings us to our third topic, the competitiveness
of our equity capital markets for small companies. There's been
much discussion lately suggesting that due to SOX 404, smaller
U.S. companies are flocking to the LSE's alternative investment
market. We don't really buy the argument that the success of
the AIM is due to SOX 404. We see substantially more Canadian
and Australian companies listing on the AIM than American
companies and neither of those countries has adopted SOX or
requires a Section 404 audit.
If you look at the Toronto Stock Exchange, who has a very
successful tier for smaller issuers, most of their marketing
materials now are saying why we're better than the AIM. And so
that said, we think that much can be learned from other
markets. In studying the AIM and other successful markets for
small companies, we are very impressed by the fact that capital
raising is perceived as an integral part of the listing
process. The London Stock Exchange publicized extensively the
capital raised for its listed issuers to an extent that seems
odd when compared to U.S. exchanges.
The AIM was designed to provide a successful opportunity
for smaller U.K. companies to raise capital. That has created a
community of advisors and capital providers for smaller U.K.
companies. It is not surprising that by offering attractive
capital-raising opportunities for smaller companies, the AIM is
now finding a worldwide audience.
We have learned much from the AIM. I would respectfully
suggest that the subcommittee's work would be enhanced by a
thorough study of the AIM and what ideas can be brought to
America.
Fourth, disclosure requirements must be effectively
tailored for smaller companies. The challenge is to encourage
disclosure that will protect investors from questionable
issuers without giving--without driving good companies away.
The AIM has an excellent solution. Smaller companies are
required to appoint a professional gatekeeper which they call
the NOMAD who works with the issuer and performs due diligence
so that material information is disclosed to investors.
Our new OTCQX listing concept has been borrowed, in large
measure, from the AIM process. Companies listing on the Pink
Sheets OTCQX premium tiers, are required to appoint and pay for
an attorney or broker dealer to review their disclosure. We
believe that this review of an issuer's disclosure will benefit
investors because much of the disclosure necessary to make good
investment decisions is not contained in a company's GAAP
financial statements or 404 controls.
Investment decisions for smaller issuers are usually based
on the company's prospects. In contrast, the focus of a U.S.
GAAP audit is on the disclosure of historical numbers. This has
been lost in a lot of what the value of SOX brings. We all know
historical performance is no guarantee of future results, as
even truer of the smaller issuer working on a cure for cancer
or some new technology that has no revenues. These plans and
prospects must therefore be clearly described in the
nonfinancial portions of an issuer's disclosure.
We think that the OTCQX disclosure review process will play
such a valuable role for smaller issuers that we are agnostic
of OTCQX issuers are SEC registered or just have audited GAAP
finances. While we expect to attract companies that deregister
with our more intelligent disclosure process, we believe that
almost all of the OTCQX issuers who are interested in raising
capital will still be registered with the SEC. That is because
the most attractive U.S. capital pools for small issuers demand
registration rights.
Even with registered issuers, we think the OTCQX review
will serve the useful function of helping the issuer to get it
right which should inspire greater investor confidence in OTCQX
issuer disclosure. At Pink Sheets, we see great opportunities
to create a vibrant and successful secondary market for small
companies. A study commissioned by the AIM, states that a
vibrant market for small to medium enterprises can add as much
as 1 percent to the GDP growth of a country's economy. We hope
OTCQX becomes a part of that. Thank you.
[The prepared statement of Mr. Coulson follows:]
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Mr. McHenry. Thank you, Mr. Coulson.
Mr. Factor.
STATEMENT OF MALLORY FACTOR
Mr. Factor. Chairman McHenry, distinguished members of the
subcommittee, I'm honored to testify here today about my views
on Sarbanes-Oxley legislation. My remarks are based on the work
that I've undertaken as chairman of the Free Enterprise Fund
and Free Enterprise Institute.
Recently, you may know the Free Enterprise Institute has
joined with a small Nevada accounting firm to launch a legal
challenge to the constitutionality of the Public Company
Accounting Oversight Board [PCAOB].
Today, I'll focus on the economic concerns about Sarbanes-
Oxley in four main areas: its cost to our public companies, its
discouragement of American entrepreneurship, its
disproportionate burdens on small businesses, and finally, its
adverse effects on the global competitiveness of our capital
markets.
In my written testimony I also discuss the unintended
beneficiaries of Sarbanes-Oxley and the unconstitutional Public
Company Accounting Oversight Board. I welcome the opportunity
to discuss any of these issues in response to your questions.
First, Sarbanes-Oxley has imposed enormous costs both
direct and indirect on our public companies. The passage of
Sarbanes-Oxley coincided with the loss of $1.4 trillion of
shareholders' wealth. No more than $400 billion of that loss
could be explained by other factors. In other words, Sarbanes-
Oxley had a $1 trillion negative impact on the U.S. economy, a
$1 trillion decrease in shareholder value is just the opposite
of the growth to increased investor confidence that supporters
of the legislation predicted would result in the passage of
Sarbanes-Oxley.
Estimates from the American Electronics Association showed
that U.S. companies are spending an aggregate of $35 billion a
year just on Section 404 compliance, almost 3,000 percent more
than the SEC's projected cost of $1.2 billion in June 2003.
The cost of being a public company in the United States has
increased dramatically. The average cost of being a U.S. public
company has increased by $1.8 million, a stunning 174 percent
increase. This cannot be what Congress intended. These costs
must be reduced for the sake of America's economic health.
Second, Sarbanes-Oxley is discouraging entrepreneurship.
Inaccessible public capital markets have ripple effects that
touch even the earliest stage investments. With fewer liquidity
events on the horizon for most startups, fewer early stage
investments are economical. Many of the startups that do get
funded will have difficulty raising enough capital to succeed
as they begin to grow out of their development phase. The
capital that is available, often takes the form of expensive
equity, private equity of mezzanine financing.
In addition, the criminal provisions put a further chill on
entrepreneurship. CEOs and CFOs are required to certify
corporate reports without traditional good-faith protections.
They can also be held criminally liable for honest mistakes in
those reports.
The Nobel Prize winning economist, Milton Friedman said,
``it's costing the country a great deal. Sarbanes-Oxley says to
every entrepreneur for God's sakes don't innovate, don't take
chances because down will come the hatchet. We're going to
knock your head off.''
Third, Sarbanes-Oxley has a disproportionate negative
effect on small business. Compliance costs are not coming down.
Last week a study showed audit fees for small cap companies
jumped over 20 percent in 2005 alone. From 2003 to 2005, audit
fees have increased a startling 141 percent for small-cap
companies. This increase is significantly higher than the still
costly increase of 104 percent for medium size companies and 62
percent for large capitalization companies over the same
period.
For companies with less than $1 billion in yearly revenues,
average Sarbanes-Oxley compliance costs have increased 174
percent overall since inception. I believe that relief for
small and medium-sized companies is the most urgent aspect of
reform which Congress should address immediately.
Fourth and finally, Sarbanes-Oxley hinders America's
standing in the global economy. Last year, the London Stock
Exchange had a record year for foreign listings. In a survey of
these new listings, they discovered that 90 percent of the
companies that considered listing in the United States said
London's Exchange was more attractive because the companies
listing there did not have to comply with Sarbanes-Oxley.
In 2005, 23 of 24 companies that raised over $1 billion in
capital chose not to register on U.S. exchanges, according to
the New York Stock Exchange. In 2000, prior to Sarbanes-Oxley,
9 out of 10 of the largest IPOs in the world involved the U.S.
public markets. In sharp contrast, last year 9 out of 10 of the
top IPOs avoided the U.S. markets all together.
If Sarbanes-Oxley is good for investors, they should be
willing to be paid for the benefits, but a study by Professor
Kate Latvic of the University of Texas School of Law shows that
investors, in fact, do not prefer such regulated companies. Her
study found that investors preferred companies not subject to
Sarbanes-Oxley.
In conclusion, I believe that the common interest of
businesses, investors and all Americans require a thoughtful
revision of Sarbanes-Oxley. Such reform to reduce the counter-
productive and unintended ill-effects of Sarbanes-Oxley will
enable our entrepreneurs, our investors and our workers to have
confidence that America will continue to lead the world in
competitiveness, productivity and economic abundance.
I look forward to your questions and I also wish quick
recovery for Chairman Miller's husband and I thank her for
putting this together.
[The prepared statement of Ms. Factor follows:]
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Mr. McHenry. Thank you. Thank you, Mr. Factor. I'll start
off the questions and we'll put the 5-minutes on the clock
which we'll try to stick to.
I enjoyed your testimony. I think you all have three unique
perspectives and that's why it's wonderful to have you on the
same panel.
Mr. Coulson, have you seen an uptick in your business with
Pink Sheets well, since the passage of Sarbanes-Oxley?
Mr. Coulson. Since Sarbanes-Oxley, we've seen tradings and
uptick in trading in our business, but it's not--the companies
that are deregistered are not currently actively trading
securities for the most part because they fall into--from that
side, if you look at the 500 companies that are in the Pink
Sheets, about half of their stock trade is below 50 percent, so
I'd say they're economically distressed and they were having
trouble any way and they may not have remained public
companies. And other ones are the quiet, the guys who have
deregistered, their companies are not accessing capital markets
and they're not seeing the value portion of other companies
controlled by a large shareholder who says it's not worth it to
them.
But there hasn't yet been a windfall from SOX and what
we're building with OTCQX, we're really building it to fit to
either side because we look at the regulatory environment today
and don't hope that it will change either way.
Mr. McHenry. Mr. Wolkoff, have you seen activity in terms
of, or a slackening in activity, in terms of IPOs new listings
on your exchange? Or, have you seen companies going dark or
delisting from your exchange since Sarbanes-Oxley?
Mr. Wolkoff. It's not a simple answer because I think that
up until about 2 years ago the AMEX was not being an effective
competitor as far as attracting new listings. And over the last
2 or 3 years, we've seen an uptick because we've increased our
efforts, our spending and so we have been actually taking quite
a few companies both from IPOs or who have left the NASDAQ.
Those seem to be the two.
We have seen some companies that have chosen to go private.
One can always ask whether it might have been a more
appropriate decision for that company in the first place and we
have seen certainly a difficulty in attracting companies from
outside the U.S. jurisdiction. Particularly for us, we have
about 20 percent of our market in natural resources,
exploration and production. Canada is a natural marketing place
for us. And we've found that it's difficult, although we've had
success, it is difficult success. It's challenging success.
Mr. McHenry. Someone put forth the idea that in essence
small cap companies have a disproportionate share of their
profit being spent on compliance costs. So the idea would be a
larger entity could purchase them and roll in their compliance
costs and thereby increase shareholder value.
Have you seen mergers and acquisitions driven in that
direction?
Mr. Wolkoff. I've seen mergers and acquisitions. I could
not say that's the cause or that should even be a desirable
cause. The fact that entrepreneurial companies get absorbed
into conglomerates or into companies that are simply larger,
may not be the best growth engine for the economy. We've always
seen small companies being bought. In the pharmaceutical
industry, a company, just to name one like a Pfizer, rather
than spending 10 years developing a new pharmaceutical in-
house, may simply choose to buy a company that has promise----
Mr. McHenry. I have a quick question. I'll get back to you.
Mr. Factor, in about 30 seconds, what do you advocate in
terms of public policy? I mean short of repealing Sarbanes-
Oxley which from your testimony I think would be a desirable
thing, what would you say?
Mr. Factor. I think the most immediate need is to grossly
exempt small and medium-size companies from Sarbanes-Oxley, No.
1. No. 2, I think you have to create PCAOB in a constitutional
way. We believe it's totally unconstitutional under Section 2,
Article 2 of the Constitution.
Mr. McHenry. OK, Mr. Wolkoff, in conclusion here, what can
we do short of passing legislation to amend Sarbanes-Oxley
right now, what would you advocate?
Mr. Wolkoff. Yes, I think that some relatively straight-
forward actions could be taken. No. 1, define Section 404 and
what it might mean for companies of different revenues and of
different market capitalizations, perhaps even in different
lines of business. Require the accounting companies to put
specificity within audit programs as to what the goals of a 404
audit would be. With respect to 404, depending upon the
capitalization and revenues of the company, I would highly
recommend that once a company complies with 404, that the
certification be done not on an annual, but a biannual or a
triennial basis, hence improving the cost factor.
And last, as to those smaller companies and I think there
are quibbles about the actual market capitalization, but there
should be a level of company that provided they have
independent audit committee and other ethical-promoting
corporate governance factors within the company should be
permitted to choose and disclose that they're exempt from
Section 404 and that the investor on the basis of that
disclosure can choose to buy or not buy the particular stock.
Mr. McHenry. Thank you, Mr. Wolkoff.
Mr. Dent.
Mr. Dent. Thank you, Mr. Chairman. Thank you all for being
here today.
As someone who represents a district where we have a lot of
Main Streets as opposed to a Wall Street, I mentioned in my
remarks about a lot of the small banks, in particular, have
been very, very concerned about this law and the cost of
compliance and it's been outrageous.
The question I have and it's probably directed to Mr.
Factor, some of the supporters of Section 404 say that these
compliance costs will dramatically decrease as businesses get
streamline control processes. It would seem to me that
regardless of the level of cost down the line, that the initial
compliance costs associated with going public are a large
enough deterrent to listing on U.S. exchanges. So how do you
answer those----
Mr. Factor. I would say there are a number of people who
say that, in particular, the accountants whose profitability
has soared since Section 404 compliance has been made necessary
by this.
I also believe that a number of the larger firms feel that
Section 404 compliance should be kept because it's become a
barrier to entry for small companies that really are the engine
of America.
Section 404 is a disaster. I consider it my theory of
holes. Section 404 came about because of the problems that
occurred with Enron and World Com and we knew at that point
that we were in a hole because of that. And what frequently is
done and I quote Mr. Oxley ``in a hothouse atmosphere excessive
regulation comes about.'' And those are his words,
``excessive'' and ``hothouse atmosphere.''
What they did to get out of the hole, you just dug it
deeper.
Mr. Dent. Well, thank you for that answer. And on the issue
of mezzanine financing, can you explain what you mean by that
term, one, and two, how does this distort the public capital
markets?
Mr. Factor. The most efficient markets are the capital, are
the public capital markets. They're extraordinarily efficient.
They bring the cost of capital down. When you use private
equity firms, the costs go up. There are not as many people
involved.
Liquid markets bring the cost of capital down. Mezzanine
financing firms are firms that are supplying equity, debt, sort
of middle of the road instruments that capital markets and
public capital markets, had supplied. But because of Sarbanes-
Oxley, and the compliance costs, people have been avoiding it.
Remember, in an AEA study, companies under $100 million in
revenues, 2.5 percent of revenues were spent on Sarbanes-Oxley
compliance. That takes companies from profitability to
unprofitability.
Mr. Dent. Thank you for that answer and I guess there's a
question for all of you. I'll start with Mr. Wolkoff. You've
all indicated there's a growing trend of smaller companies to
list overseas. Basically, if the trend continues, what is this
going to mean for Wall Street?
Mr. Wolkoff. It's a loss of influence. It's a loss of jobs.
Certainly, it's a lack of opportunity for us to grow. I think
that the fact that Canadian companies and Australian companies
choose to list on the AIM Market rather than their home markets
is not really a positive about Sarbanes-Oxley. It simply means
that their home markets are very small as far as access to
capital and they need access to a larger market. The point
being, they don't consider us.
When I was in Tel Aviv and London, recently, I could tell
that my compatriots at the other national exchanges hadn't been
there. They basically, I think, have thrown in the towel
because the message is that it's too difficult to list in the
United States. We haven't thrown in the towel, but what we're
looking for is some ability to market U.S. capital markets and
that means some modification in the requirement.
Mr. Dent. Are your foreign competitors aggressively
marketing Sarbanes-Oxley against us?
Mr. Wolkoff. Very aggressively. It's--in fact, for the AIM
market, it is the major selling point. It is Sarbanes-Oxley on
page 1, Sarbanes-Oxley on page 5 and Sarbanes-Oxley on the
concluding page. And in fact, one of the reasons that we have a
chance is that Sarbanes-Oxley alone is not enough to overcome
some of the problems with liquidity that these foreign
exchanges have.
There's a quest to be in the United States. Companies want
to be here if we show even a small amount of good faith in
modifying some of the heavy-handedness of some of the rules.
I'm not saying do away with it. I'm saying modify it and make
it more sensible. Give us some tools to market to these foreign
companies.
Mr. Dent. Thank you and I see my time is up. I yield back.
Mr. McHenry. Thank you, Mr. Dent. Ms. Kelly.
Ms. Kelly. Mr. Coulson, you mentioned in your testimony
that a liquid market for the micro cap stocks can boost the GDP
of our country by as much as 1 percent.
Do you think that the current SOX regulatory regime is
really retarding growth in the Pink Sheet companies?
Mr. Coulson. There's two sides. The Pink Sheet companies
has--a lot of Pink Sheet companies that are raising capital,
there are issues where there should be more criminal and civil
charges against the fraudsters which is needed more. And
that's--there's an issue where there's a subset of smaller
companies that just should be run out of town by the sheriff.
And then there's another side on legitimate smaller companies
that they don't understand the costs of what it will be to be
public. They are not sophisticated. They don't have access to
reams of law firms who can research a question. They need to be
treated much more like the IRS treats a taxpayer, an individual
taxpayer by the SEC, rather than how the IRS treats a
corporation. And they need to be educated and they need to be
brought into the system.
And that really doesn't happen from the SEC's viewpoint
because they don't get phone calls when someone successfully
invests in a smaller company that grows. They get a phone call
when someone loses money in a smaller company. So their
viewpoint is quite different and it's very enforcement based.
And I wished there was more enforcement. There's more
enforcement, but they also work to help companies engage in
capital formation and that's really what they've done a great
job with at the AIM. They have built a market for capital
formation and the London capital--the capital of London has
really directed itself at smaller companies. And that's what
brings in entrepreneurship and GDP growth and all the good
things.
Ms. Kelly. I'd like to go to Mr. Factor. You talked about
the smaller companies having very high opportunity costs
because of SOX 404.
I'd like you to elaborate a little bit on some of what the
opportunity costs are and what--how much of an impact do you
think that this is going to have on--not only the further
growth in the industry sector, but also I'd be interested in
your thoughts about what the impact of Sarbanes-Oxley is on New
York State.
Mr. Factor. Well, I think New York State financial services
industry has had preeminence around the world. And has been
known--I think it's putting a very, very big dent in it. If you
look at the major firms that are here, and they're also around
the world as well, and they can move their people personnel and
their transactions almost anywhere. We have seen a book by Tom
Friedman called the World is Flat, how the world is flattening
out and how we have to be more competitive because things are
becoming more equal. But what Sarbanes-Oxley does is tilt the
world to other countries. We are really hurting our
opportunities to create jobs, to create infrastructure and to
grow and be productive.
Ms. Kelly. Do you think that this Section 404 has a strong
impact on the smaller companies to the extent that it's going
to really harm the market here?
Mr. Factor. It is harming it already. We've seen IPOs going
overseas. We've seen the growth of private equity which is not
as efficient from a cost point of view. We've seen companies
choosing to go private. We've seen companies not choosing to go
public. It means they don't have access to capital in order to
grow. That's how we create jobs. That's how this country is
built.
Ms. Kelly. That takes me right to Mr. Wolkoff who having
been on--going on the American Exchange, I was very impressed
with the active role that investors have in the smaller
companies. And I'd like very much to have you elaborate a bit,
if you would, on the burden that 404 places on the family
controlled public companies where you have these very active
investors.
Mr. Wolkoff. I think there's a couple of categories. For
the U.S. company, I think by and large, companies are
internalizing the costs and continuing to list somewhere, if
they're able to list. I think that the costs are significant.
If one did a cost benefit analysis, I have no doubt that the
cost benefit analysis would be much more heavily weighted
toward costs than toward benefits. That being said, I can't say
that Sarbanes-Oxley doesn't have certain good aspects to it or
isn't appropriate in some cases, but for many companies,
particularly science companies, like a company forming a new
drug, they have a patent. They have no revenue, they have
Sarbanes-Oxley costs that they have to incur and that just
requires them to divert resources from the other things that
they're doing.
Ms. Kelly. Thank you. My time is up.
Mr. Wolkoff. May I just make one quick comment?
Ms. Kelly. Yes.
Mr. Wolkoff. It will be under 15 seconds. You're talking
about $35 billion that's being spent on Sarbanes-Oxley
compliance under 404 that could be used for infrastructure,
that could be used for innovation, that could be used to help
us grow our economy and create jobs instead of being used for a
full employment program for accountants.
Mr. McHenry. Thank you, Ms. Kelly. Mr. Feeney.
Mr. Feeney. Yes, Mr. Wolkoff, I wanted to followup on some
questions that Ms. Kelly had for Mr. Factor and I'm like
Representative Dent. I don't have any exchanges in central
Florida. Nothing is more liquid that I know of other than air
and water than cash. And as investors can increasingly go on
the Internet and invest their money in investments all over the
world, I spoke to the chief financial officer in Hong Kong, Mr.
Tong, I believe it is, and asked him whether or not a Hong Kong
entrepreneur would think about listing on one of the New York
exchanges and he laughed at me.
But why should an investor care? I mean the bottom line is
as I have more opportunities to invest in Luxembourg or London,
you know, 100 years ago, America took the lead, companies,
houses like J.P. Morgan moved their central locations from
London to the United States, why should my constituents worry
if more money is going to be raised through private equity
firms. Mr. Coulson is developing a private regulatory network
that doesn't have some of the absurd consequences. If Congress,
the PCAOB and the SEC, deliberately or unintentionally, decide
just to totally outsource liquid capital markets, other than
the fact that folks on your exchange will lose jobs and Ms.
Kelly may be hurt, why will this hurt investors in central
Florida?
Mr. Wolkoff. I'll admit, it wouldn't be a good thing for
the American Stock Exchange, but we have to look at this in the
context of two fairly discrete components, one being the
companies themselves that seek to raise capital and the other
being the investors. As far as companies that seek to raise
capital, the more regulatory costs that are imposed on the
company, the more expensive the cost of capital becomes the
more likely it is that company will look to source capital
either in some other jurisdiction or privately.
Mr. Feeney. If I can interrupt, do you have an opinion on
whether or not under Sarbanes-Oxley, as currently implemented,
an Apple, a Dell or a Microsoft would have had an easy a time
going for $50 or $75 million in capitalization to where they
ended up?
Mr. Wolkoff. I recently was on a panel with the CFO of Dell
and I made the point and he didn't reject it entirely that the
next Dell very well might be in the dorm room of a university
located in Hong Kong or in Mumbai, but probably not in Texas,
given the difficulty of companies to startup.
To the other part of your question, as to why investors
would care, people have over-emphasized or over-stated, I
think, the ease with which American investors can access
foreign markets. It is expensive. There is a lack of
transparency. There is a lack of access to regulatory
assistance, regulatory certainty and there are currency issues
that keep it from being as easily accessible as one might want.
I think that is not an issue that would be resolved with
Sarbanes-Oxley unless some modification began to get companies
to do a list and bring their listings into the United States
and accept U.S. jurisdiction and I believe that there is a
great hunger in the rest of the world to access American
capital markets, but that they're being deterred from doing so.
Mr. Feeney. Mr. Wolkoff, in your testimony, you talked
about, one of the things we do in the Compete Act is we allow
companies to voluntarily comply or disclose if they're not
going to comply and let the investors determine what the
premium would be to comply with certain regulations. If the
regulations turn out to be absurd, then the liquid will follow
the rational regulatory scheme.
But in addition, two things that we think are important and
tell me how this would play on AMEX, because you do have a few
large cap companies listed.
Mr. Wolkoff. Yes, we do.
Mr. Feeney. We require a very strenuous definition of what
a de minimis standard is, so that not every box of paper clips
on the planet is--we have this sort of this race to the absurd
in the regulatory scheme because everybody's threatened with
civil and criminal liabilities.
How important would that be?
And then second, we suggest that the outside audits which
are totally redundant, I mean they do keep people honest, but
those people already are subject to civil and criminal death
penalties. So they're redundant.
Supposing we made the external audits random so that the
AMEX could decide, for example, every 10 percent of its
companies, randomly selected, do you think it would have the
same chilling effect against fraud that SOX was designed to get
at? Can you address those two issues, the de minimis standard
and the potential for random external audits?
Mr. Wolkoff. Yes, Congressman, I liked your bill. I thought
it was well thought through and considered the important
issues----
Mr. Feeney. Mr. Levitt didn't think so. He was the author
of SOX or claims. He wasn't so happy.
Mr. Wolkoff. Mr. Levitt and I don't necessarily agree on a
number of issues, so that's not really the standard of whether
you've done a good job or not. I think you have done a good
job. I think that one, the need to have definition, the need to
provide rationality to what's required so that how you maintain
a box of paper clips, as you say, really doesn't come into an
overview of your internal controls. I also agree with you as
far as the ability to opt out of regulations so long as that's
disclosed and there are some other protections.
I think that any effort to provide clarity, to provide
lesser scope of regulation on smaller companies, to allow the
investor to make up his or her own mind based upon appropriate
disclosures, I think those are all good things and I agree with
my colleague from the Pink Sheets, that an increase in
enforcement dollars would also go a long way. I think seeing
Mr. Lay and Mr. Skilling convicted has done more benefit for
American capital markets and the trust in them than all the
bills in the history of the U.S. Congress possibly could have.
Mr. McHenry. Any further questions from the panel?
Ms. Kelly. I'd like to throw one out if you don't mind.
Mr. McHenry. Certainly.
Ms. Kelly. We're trying to look at what will generate a
liquid market that will grow the economy. To do that, it's very
difficult because we don't have a statutory--a real statutory
definition on what we should be regulating here. As you've all
pointed out, the large companies don't have a great deal of--it
doesn't have that big of an impact, but these smaller, these
nascent companies that are coming into the market, things that
Mr. Coulson, the entities Mr. Coulson, and you, Mr. Wolkoff,
often deal with, should we look at a cap on the capitalization
of a company? Where would you set the marker if you were
rewriting this bill? And Mr. Feeney's bill does the kinds of
things that I feel are good. That gets the government, let
industry itself decide. But if we have to rewrite the bill in
some way, would you put a cap on it--on capitalization, on the
amount--certainly not the profitability, but where would you go
with trying to rewrite this so it makes sense?
Mr. Wolkoff. Are you asking me?
Ms. Kelly. I'm asking all of you.
Mr. Wolkoff. I think that there should be exemptive
authority. I think that there are some companies that should be
able to disclose that they're not complying and the reasons why
and I think in the case of say companies that are looking to
discover a new medical device or a new pharmaceutical, and have
very little revenues, Sarbanes-Oxley is not the reason people
are buying those stocks and I think that would be completely
understandable.
I believe that there's probably quite a bit that can be
done, even in the absence of legislation, simply by giving
definition, by continuing certain exemptions as they exist, by
giving a break, really, to foreign companies, who want to try
to access American capital markets and aren't going to have
half of their shareholders be U.S. citizens, but some smaller
amount. I think that all of these things are worth trying. I
think that there are people with greater knowledge of the
application of accounting rules and securities laws than
perhaps I have, but like the panel, I do have concerns that
what we have right now is heavy handed, is excessive, is
hurting American capital markets and is hurting American
business as well, and should be rethought in every fundamental
way in order that we can become competitive with the rest of
the world without lessening those standards that are most
important to investors.
Mr. Factor. What I think needs to be done is 404 needs to
be done away with. Mr. Wolkoff talked about two people who got
convicted. There were over 700 convictions since Sarbanes-Oxley
was enacted, well over 700 and fines galore, none of them under
Sarbanes-Oxley.
What we don't need is additional legislation and
regulation. What we need is to take the regulation that we have
and legislation that we have and use it properly. The
fundamental problem is that once the--once you have in power
town D.C., once you have an Enron and World Com, it's like that
the regulatory dinner bell ringing and the bureaucrats come
rushing to the table with new organizations that just add
enormous costs to our society. And it's hard to dislodge it.
And what we need to do is dislodge them under 404. We need to
dislodge them by getting rid of 302 which criminalizes, in many
cases, taking risks. We need to really think this thing--this
thing needs to be thought through thoroughly and say what
legislation do we really need to give America the opportunity
to grow and prosper and create jobs.
The only thing I can tell you is we filed a lawsuit to
challenge the constitutionality of the Public Company Oversight
Accounting Board [PCAOB]. On the day we filed it, it was the
day that PUHCA, which is the Public Utilities Holding Company
Act of 1935, finally was gotten rid of. It was an overreaction
in 1935 to Sam Ingersoll and in many ways it was a Stalinist
act in the way it was written. It allowed the SEC to bust any
multi-state utility holding company. Sometimes the gross
overreaction really hurts our country and Sarbanes-Oxley does
that.
Mr. Feeney. Mr. Chairman, I wonder if I could ask one more
and with respect to 302, my bill doesn't touch that, but if you
do define de minimis standards, the criminal penalties become a
lot less arbitrary.
Does any of the three panelists have a very quick opinion,
the PCAOB and the SEC appointed a small business advisory
committee. I thought their recommendations--I've been working
on this for 8 or 9 months and I thought their recommendations
were prescient since my bill was written, but not quite filed
yet.
Does anybody have an opinion why they, for the most part,
nodded and then went about their merry way without adopting the
most important of the advice given by their own advisory
committee?
Mr. Coulson. I watched that panel very closely and I think
their report is actually a great report on the state of small
company market past 404 and Sarbanes-Oxley. And there's a lot
of other points they raised that should be followed through on.
They went for the long pass, get rid of it. And it's much
harder to go through and decide which controls are material to
investors and I think a great process will be if the SEC can do
it and the PCAOB is go through, figure out what the controls
are at small companies and figure out which ones are material
to investors and what's the cost benefit and say OK, here's 10
controls you need when you're this market cap. Here's 50. And
let's really, because SOX 404 is like a rule in Small Town, USA
that says every house has to be painted every year, but the
painter decides when he's done and you're paying him by the
hour. That can't work.
You need to be able to cutoff your accountant and say we're
done on the audit and this is what the regulators say you have
to do. And that hasn't been done. And that's the real nightmare
and people are running around, the sky is falling. There are
SOX consultants who will say pay me hourly and I'll tell you
how the sky is falling.
There needs to be reined in and while--I agree with many
points of Mr. Factor, and maybe we should get rid of it, but
dealing with going forward, we really need to rein in the cost
for the small company and give them some comfort.
Mr. McHenry. And with that, thank you so much for
testifying today. Mr. Coulson, I think you had a great line
there at the end about the housepainter. I think it's very well
stated.
Mr. Coulson. Thank you.
Mr. McHenry. And thank you so much for taking the time to
testify before us. This information is very important to us, to
ensure the strong nature of our financial markets going
forward.
With that, we're going to have a set for 5 minutes for the
next panel, and this panel will stand in recess for 5 minutes.
[Recess.]
Mr. McHenry. The committee will come back to order. I
welcome the second panel. Thank you for taking the time to be
with us today. Thank you for waiting your turn.
Because the Government Reform Committee has subpoena power,
we always swear in the witnesses as you heard with the previous
panel, so if you would all please rise and join me. Raise your
right hands.
[Witnesses sworn.]
Mr. McHenry. We note in the record that all the witnesses
responded in the affirmative. With that, I'd like to recognize
my colleague from Pennsylvania, Mr. Dent, for the purposes of
three introductions and Ms. Kelly for the fourth.
Mr. Dent. Well, first I'd like to introduce our next
witness today which is Mr. Robert Robotti. Mr. Robotti is the
president and managing director of Robotti & Co. He recently
served with distinction on the Securities and Exchange
Commission's Advisory Board on Smaller Public Companies. He
holds a B.S. degree from Bucknell University, about 100 miles
up the road from me and an M.B.A. in taxation from Pace
University. We're glad to have you with us here today, Mr.
Robotti.
I'd also like to welcome Mr. William Beach, director of the
Center for Data Analysis [CDA], at the Heritage Foundation. Mr.
Beach previously served as president of the Institute of Humane
Studies at George Mason University in Fairfax, VA; previously,
unranked basketball team, by the way, which made it in this
year's Final Four. He is a graduate of Washburn University and
he also holds an M.A. in history and economics from the
University of Missouri, Columbia. Thank you for being here.
And then we'll also hear today from Mr. John O'Shea. Mr.
O'Shea is the president and chief executive officer of
Westminister Securities Corp. He is an allied member of the New
York Stock Exchange and a member of the New York Board of Trade
and Securities Traders Association. He holds both a B.A. and
M.A. in economics from the University of Cincinnati. Welcome.
Ms. Kelly.
Ms. Kelly. Thank you. Our final witness today is Mr. David
Lawrence who is the chief financial officer of Acorda
Therapeutics, Incorporated. Mr. Lawrence is a founding member
and currently serves on the Board of Directors as treasurer of
the Brian Hearn Children's Fund. He is a graduate of Roger
Williams College and received his MBA in Finance from Iona
College. And we thank you all for being here.
Mr. McHenry. And with that, we'll start, just a reminder
for this panel, as you heard before, there's a 5-minute time
limit for opening statements. You'll see the yellow light come
on. We have 1 minute left at that point. I'd wrap up if I were
you.
And with that, Mr. Robotti.
STATEMENTS OF ROBERT ROBOTTI, PRESIDENT, ROBOTTI & CO.; WILLIAM
W. BEACH, DIRECTOR FOR DATA ANALYSIS, THE HERITAGE FOUNDATION;
JOHN P. O'SHEA, PRESIDENT AND CEO, WESTMINSTER SECURITIES
CORP.; AND DAVID LAWRENCE, CHIEF FINANCIAL OFFICER, ACORDA
THERAPEUTICS, INC.
STATEMENT OF ROBERT ROBOTTI
Mr. Robotti. Hi. Thank you for the opportunity to testify
today. I was recently a member of the Securities and Exchange
Commission's Advisory Committee on Smaller Public Companies
and, as such, served as a member of the Corporate Governance
and Disclosure Subcommittee. The SEC, of course, established
the Advisory Committee to examine the impact of Sarbanes-Oxley
and other aspects of Federal securities laws on smaller
companies.
Professionally, I am both the Founder and Managing member
of an investment partnership, which SEC rules require me not to
name, and the Founder and Portfolio Manager of Robotti &
Company Advisors, LLC, an SEC-registered investment advisor.
Both of those entities, I direct the investment of slightly
over $300 million, the vast majority of which is invested in
small cap and micro cap companies.
I am also a director of Panhandle Royalty Co., a publicly
traded $160 million market cap company. I am a member of
Panhandle's Audit and Compensation Committees and as such I am
familiar with one company's travails with Sarbanes-Oxley's
Section 404. I would point out that, as a board member, it is a
logical predisposition to reduce one's potential personal
liability by encouraging a company to overspend on Section 404
compliance.
I will address you today primarily as an investor in small
cap and micro cap companies, i.e., someone to whom the benefits
of Sarbanes-Oxley are directed. Let me start by describing our
investment process. We are what is commonly characterized as
bottom-up equity investors. Our stock selection is predicated
on the research and evaluation of fundamental company data.
Therefore, we are primarily interested in an issuer's annual
audited reports as well as its interim financial statements
which companies registered with SEC are required to publicly
disclose. It goes without saying that the reliability of that
data is paramount to our investment decisions. Once we invest,
we think and act like owners. This includes continuous
evaluation of management and the board's oversight through
assessing their capital allocation decisions.
Again, both audited annual reports and interim financial
statements are fundamental tools utilized in this investment
process. Therefore, I am a proponent of expenditures of time
and money in producing such reports which benefit us, the
investors and owners, by providing us with timely financial and
other information abut an issuer.
Let me point out that we know, from many years of
investment in public markets, managements and boards
occasionally fail to act in shareholders' best interest or even
fail to attempt to act in shareholders' best interest. The
document, the critical evaluation on our part of managements
and boards, I can point to the fact that I and the entities I
direct have been named plaintiffs in numerous lawsuits against
companies in which we had invested as a result of our efforts
to protect and we took these efforts to protect shareholder
interests.
So when management of our invested companies states ``the
cost and effort of compliance with Section 404 is
disproportionate to its benefits,'' I listen with healthy
skepticism.
I think it's important to point out that I strongly support
the vast majority of the investor predictions provided by
Sarbanes-Oxley: the independence requirements for the audit
committee, the restrictions on loans to insiders, the
whistleblower provisions as well as other restrictions on
services by independent auditors, etc. The vast majority of the
law is a tremendous step forward for shareholders. There are
costs, both hard and subtle, exist, but my personal investing
experience convinces me that the net benefit to shareholders is
significant. Therefore, we support--and the support of these
protections enumerated in SARBOX is documented by our
committee's work at the SEC also.
But then there is Section 404, where I believe some
moderation with respect to its implementation would be
practical. Conceptually, Section 404 compliance requires
detailing, documenting and testing data pertinent to the
reporting process. Realistically, Section 404 needs to be
significantly right-sized. I further believe that the time and
attention now required by top management of small companies to
fully comply misapprpriates shareholder value. This is subtly
more relevant to smaller companies than it is to larger ones,
for large companies the time and effort required by 404 can be
delegated to staff who are not charged with running company.
For smaller companies, senior management spends a substantial
amount of their time on 404 when they could be running the
business. Instead, they're dealing with the compliance of
Section 404. My perspective is based on my years of experience,
observations and evaluations of companies and their
managements.
The misallocation of management's time and attention, as
well as the hard costs paid to outside auditors and consultants
are not the only negatives. The costs associated with complying
with Section 404 continue to motivate small companies which do
not plan on raising capital to deregister or go dark. When a
company deregisters or goes dark the company can do this in a
relatively short period of time. It ceases to be required to
make annual financial statements and interim reports publicly
available. It becomes, in essence, a private company with
public shareholders. Since the vast majority of the universe of
small companies has no plans on raising capital, the majority
of these companies are candidates to go dark. It is probably in
their fiduciary duty actually as directors and managements to
consider this option.
Small companies that have deregistered or that are part of
the--planning to deregister, have to consider the huge costs
associated with Section 404 compliance. And this is one of the
unintended consequences. The GAO report itself identifies this
as a problem and identifies that there was a significant
increase in the companies that are deregistering. Out of 5,971
SEC registered companies today who are non-accelerated filers.
I'm going to skip through since I've got plenty more.
We're concerned also about that impact that it was because
a lot of the discussion really talks about companies raising
capital, becoming public. What we're forgetting about is that
there's a huge disenfranchised investor base out there who are
shareholders in these companies and potentially are going to be
subject to--there are almost no regulations in terms of what
information will be available to and how they can evaluate
these companies. That's a significant factor.
Thank you.
[The prepared statement of Mr. Robotti follows:]
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Mr. McHenry. Thank you, Mr. Robotti.
Mr. Beach.
STATEMENT OF WILLIAM BEACH
Mr. Beach. Thank you for the opportunity to testify before
you today, to come all the way from Washington to New York
where it's even warmer, apparently, than down there.
Policymakers at all levels of government, but particularly
at the Federal level have a number of prime directives that
govern their work: design and run efficient programs, change
policy in line with the changing world in which the policy
lives, listen to citizens and their elected representatives and
due no harm.
Within that list, clearly the last ranks highest in my
view. At the risk of using an inappropriate analogy, the cure
must not be worse than the disease. Doubtless, the most
profound change in financial market regulation in the past
decade occurred with the passage of the properly titled
Sarbanes-Oxley legislation in 2002. There's an adage that I
learned in the law and that is hard cases make bad law.
Today, analysts are acquiring evidence that the reaction of
Congress to transitory financial market problems and to the
enveloping recession created law and subsequent regulation that
has harmed markets, the creation of new businesses and consumer
well-being, as well as the general level and quality of U.S.
economic activity.
Our own research in the Center for Data Analysis indicates
that Sarbanes-Oxley may have had a negative effect on the
volume of private equity deals independent of the influence of
a poorly performing economy that surrounded investment
decisions in the first 2 years following the passage of the
act.
The key ingredients of a well-functioning dynamic system of
financial markets or financial information and
entrepreneurship, there's no question about that. There are
hardly any two factors more important unless it is the sheer
volume of new business ideas and supporting entrepreneurial
activity that produce markets in the first place. Economic
activity can be harmed by government and these things can be
harmed by your acts. While no one denies that good reporting of
financial results is important to market performance, honest
10Ks are preferred over dishonest ones. Markets can punish
crooked companies much faster than you can and more severely
than you can or the courts. In fact, the price system can move
so swiftly against businesses that some stock exchanges
actually have rules for stopping trading in a company's
equities when prices fall by a certain percentage.
Let me describe the research that we have done. There is
increasing anecdotal and statistical evidence that Sarbanes-
Oxley has created damaging distortions in the price system.
Ladies and gentlemen, the price system is a natural resource,
all right? It isn't something that you've created or we've
created. It's what we human beings have created and it's your
duty to defend it.
Our own research on this possibility has focused on changes
to venture capital funding after passage of SARBOX. Venture
capital funding reflects all aspects of the problem described
here; entrepreneurial activity, it has capital costs, investor
decisions, financial reporting requirements and in some cases,
it will even have a public-traded moment.
If Sarbanes-Oxley appears now to exercise a deleterious
effect on financial markets, then the venture capital industry
should provide an early indication of that effect, kind of like
the canary in the cave. The staff of the Center for Data
Analysis collected monthly data on venture capital deals from
1995 onwards. Our data came from Thompson Financial Services
Venture Economics Web site. These data included the volume of
deals in their total value, commitments in IPOs. Data were also
assembled from other CDA economic models on the U.S. economy.
After all, the venture capital industry was severely affected
by the collapse of the dot com bubble in the fall of 2000 and
2001. The time period also saw the debate over more financial
regulation heating up. So the key problem that we had to solve
was how do you separate the collapse of the venture capital
market from the effects of Sarbanes-Oxley? It's a very
delicate, statistical problem.
The analytical results from running a model of private
equity deals contains ways of tickling out these effects,
indicates that the anecdotal evidence is, in fact, very correct
and that Sarbanes-Oxley actually reduced deals and we are
currently updating the model with new and more recent data and
we'll supply this committee with that when it becomes
available.
We also tested the same model with an appropriate number of
time period lags for two additional measurements: fund
commitments and initial public offerings with the same result.
Now why was this result there and I'll conclude on this and we
can do it in the queries that follow. What happens in Sarbanes-
Oxley is that the regulatory cost and the uncertainty adds to
the cost of capital. It's the uncertainty factor which is
actually the worse part as far as we can tell from the data.
And the uncertainty factor raising the cost of capital and also
raising the possibility of failure in the future has caused the
deals to collapse in the way that we saw them. And we don't see
that as something that's recovering any time soon.
Remember, for every one tenth of a point, in capital costs
brought about through government's own actions, there's 100,000
or so jobs lost, potential jobs in the economy. So there's a
direct result outside of the deals to the general macro
economy.
I'd be happy to answer questions.
[The prepared statement of Mr. Beach follows:]
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Mr. McHenry. Thank you, sir.
Mr. O'Shea.
STATEMENT OF JOHN P. O'SHEA
Mr. O'Shea. I would like to first express my appreciation
for the opportunity to speak before the Subcommittee on
Regulatory Affairs and share my views with regard to the costs
and benefits of Sarbanes-Oxley. This is an issue of great
importance to small businesses in America, as well as the
financial community, regulators, and others who provide
services to this vital segment of the American economy.
I'm speaking before the subcommittee from a dual
perspective: first, as president, CEO and owner of a New York
Stock Exchange and NASD member firm and as a small business
issuers as clients; and second, as an individual who has
invested personally in many SBIs and also has acted as an
officer and director of SBIs.
I've worked with SBIs for over 20 years, and have witnessed
numerous changes in regulations that have significantly
improved the transparency of small capital markets,
particularly the Over-the-Counter Bulletin Board. While some of
these regulations placed increased burdens on issuers, they
were regulations aimed specifically at smaller issuers for the
purpose of enhancing disclosure and market liquidity for
smaller public companies. By contrast, the Sarbanes-Oxley Act
has placed a broad-based burden on publicly held companies of
all shapes, sizes and characteristics. While there are many
positive aspects of the act, such as those regarding conduct
and related-party transactions, the audit and review standards
are particularly onerous.
In the case of larger companies, I believe the burden can
be absorbed with reasonable impact and the benefits are
realized by a large number of investors. In the case of smaller
public companies, however, I believe the cost, in terms of both
financial impact and management resources, has a
disproportionately large effect. These impacts and expense are
not commensurate with the benefit received, resulting in two
trends that are having a negative effect on capital formation
for small companies in the United States.
Many issuers are choosing to terminate their registration
or go dark. Additionally, an increasing number of issuers are
choosing to go public in markets outside of the United States.
Both of these fall under the ``law of unintended
consequences,'' having the effect that this is the exact
opposite of what SOX attempts to accomplish. Rather than
increasing disclosure and providing stronger controls for
companies, many issuers are terminating previously available
disclosures, or, by going public elsewhere, not providing them
at all.
According to a study at the University of Maryland,
approximately 200 companies petitioned to delist their stock in
2003, with an estimated similar number in 2004. This compares
with just 67 companies in 2002, prior to the implementation of
SOX. Their securities are either moved to the pink sheets where
they frequently decline in price, or they stop trading
altogether. As the investors are left in the dark, having
significantly less knowledge about the actions of management
and operational results of the company, they are left with
little leverage with which to form the basis of a more accurate
valuation.
The second trend is the growth of competing, non-U.S.
marketplaces that cater to small cap companies, particularly
the AIM in London. The number of foreign companies listed on
the AIM has nearly doubled every year since the year 2003 when
SOX was first implemented. With only 60 foreign countries
listed on the AIM in 2003, the number jumped to 116 in 2004;
220 in 2005; and 262 through May of this year.
Among it's listed companies, the AIM includes 37 U.S.
companies up from 17 1 year ago. Some of these abandon their
U.S. trading status in order to join the AIM. Some never pursue
U.S. trading at all. Further, emphasizing this attraction is
the fact that newer markets are being formulated that are
emulating the AIM system, not the NASDAQ. As these alternatives
become increasingly available and credible issuers, both United
States and international, will have less incentive to face the
complexities and costs of trading in comparable U.S. markets.
The two trends presented above reflected the general
pushback smaller public companies are having against SOX. While
many smaller public companies are choosing to stay the course
and comply with the newer regulations as they become applicable
to them, there is a significant discontent and concern
regarding the disproportionately high cost to them. A study by
Foley & Lardner found that in fiscal year 2005, the percentage
increase in average audit fees was significantly higher for
small cap companies at 22 percent than mid cap at 6 percent and
S&P companies at 4 percent. The year-to-year percentage
increases were greatest during the phase-in of Section 404
requirements, with the largest increases being felt by small
cap companies.
In preparation for this testimony, we surveyed smaller
companies to get feedback regarding their experience with SOX.
In this informal survey, approximately 70 percent felt that SOX
had no effect on communications with shareholders,
communications with analysts or other information useful to
management. Sixty-seven percent of those surveyed also felt the
quality of their financial reporting was the same, although 31
percent did feel that it had improved since the implementation
of SOX. Seventy-four percent believed that the results obtained
were not worth the expense and effort in implementing them.
As an additional gauge of the perception of the effects of
SOX, we surveyed investors, including 27 individuals and
institutions. We asked these investors about the effects of SOX
on the small and micro cap companies they invest in or would
like to invest in. While 33 percent of the group believed SOX
had the potential to reduce the risk of management fraud, 56
percent believed it had no effect. Almost the entire group, 93
percent, felt that SOX had a negative effective on issuer
profitability, and 100 percent believed SOX has caused small
and micro cap companies to be less likely to go public in the
United States. When rating the effect of various factors on
positive share performance, 85 percent felt that earnings and
revenue growth was the most important, while 85 percent felt
that compliance with SOX was least important. This indicates
that, while investors find there are some positive aspects to
SOX, those aspects are not as highly valued in the marketplace
in light of the negative impact it has on profitability.
Thank you very much.
[The prepared statement of Mr. O'Shea follows:]
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Mr. McHenry. Thank you, sir.
Mr. Lawrence.
STATEMENT OF DAVID LAWRENCE
Mr. Lawrence. Thank you for providing the opportunity to
testify before you today on Sarbanes-Oxley Act, Section 404,
and finding the proper balance among cost burdens, investor
protection and U.S. competitiveness.
I currently serve as the chief financial officer of Acorda
Therapeutics. We are a public biotechnology company located in
Hawthorne, NY. I have been involved with the management of
corporate governance and finances in biotech and high tech
companies for over 15 years. Founded in 1995, Acorda is a
biotechnology company focusing on the development of next
generation therapies that restore neurological function to
people with spinal cord injury, multiple sclerosis and related
conditions of the nervous system.
Our company has clinical and pre-clinical drug candidates
for MS, the focus on novel approaches to repairing damaged
components of the central nervous system. We are currently a
net loss company with one drug on the market. Our market cap of
approximately $76 million as of June of this year is at the
bottom 0.5 percent of total U.S. market cap.
We completed our initial public offering in February 2006
and are currently beginning the process of complying with the
Sarbanes-Oxley Act.
Today, I'm here to testify on behalf of the biotechnology
industry organization, an organization representing more than
1,100 biotech companies, academic institutions, State bio
technology centers and related organizations in 50 U.S. States
and 31 nations. The majority of bio member companies are small,
research and development-oriented companies pursuing
innovations that have the potential to improve human health,
expand our food supply and provide new sources of energy.
Acorda Therapeutics has a profile that's typical of the
high-risk, capital-intensive, long-lead time regulated business
environment of the biotech industry. As a representative of one
of the most innovative high growth sectors of our Nation's
economy, one in which the United States maintains a global
leadership position, my testimony is tailored to the issues
faced currently or that will be faced by emerging companies in
the biotech sector.
Let me start by saying that we fully appreciate and agree
with the congressional intent behind Section 404, ensuring that
companies have in place effective procedures and controls to
enhance investor protection and protect against fraud. Where
Section 404 has gone awry is in the implementation. The current
implementation of Section 404 is not tailored and does not work
well for small public companies.
The one size fits all approach of Section 404 is highly
burdensome and smaller companies are bearing disproportionate
costs on a relative basis. This has been recognized and
documented, not only by the SEC advisory committee for smaller
public companies, where members voted 18 to 3 in favor of
Section 404 reform, but also by the GAO, where it found that
smaller companies at the bottom 6 percent of total U.S. market
cap pay up to $1.4 million on external auditors for Section 404
compliance. The GAO also found that 47 percent of the companies
reported significant opportunity costs related to Section 404,
draining resources away from innovation and research.
Even the SEC recognized in its recent statement that
Section 404 might need reform based on a top down risk-based
and scaled approach, which would make Section 404 more
responsive to the individual size and complexity of the
companies. For most biotech companies, the cost burdens
associated with Section 404 compliance include both internal
costs, as well as external auditor costs and are substantial.
Our experience as a newly public, non-accelerated company is
very similar to those experienced by BIO members. Due to
limited internal resources, we will have to immediately
contract with an outside consulting firm in order to comply
with SOX requirements by the 2007 deadline.
For many of the newly public companies, Section 404 costs
could mean having to spend a large portion of their research
funding for a leading drug or therapy on Section 404
compliance, forcing many of the companies to make reductions in
research spending in order to meet the requirements imposed by
Section 404.
For the investors, their confidence and trust in public
companies may have increased as a result of SOX as a whole, but
not necessarily due to Section 404. As we saw in the first and
second years of Section 404 implementation, investors were less
concerned when a company reported a material weakness in
internal controls under Section 404, than on how much a small
company was paying to meet Section 404 requirements.
Here, the cost of implementing Section 404, particularly
for smaller public companies, appear to outweigh many of the
benefits that are directly related to Section 404.
As embraced by the Advisory Committee in its final
recommendations, it is critical that Section 404 reform
framework establishing a risk-based approach that provides
scaled reforms based on a revenue filter condition. This
approach recognizes that level of risk, the level of
complexity, and the level of product revenues are clearly
interrelated and that product revenue should drive the level of
internal control procedures.
Without Section 404 reform, evidence points to the fact
that innovation may be stifled and U.S. competitiveness
compromised. With recent submission of the Advisory Committee's
final recommendations and the SEC's statement of intent for
reform, it appears that now is the opportune time for the SEC
to fully engage and follow through with reforms consistent with
the original principles upon which SOX was enacted.
Thank you for your time and consideration of BIO's views.
BIO urges the subcommittee to request expeditious action by the
Commission on the reform framework endorsed by the Advisory
Committee.
[The prepared statement of Mr. Lawrence follows:]
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Mr. McHenry. Thank you, sir, and I'll begin the
questioning. We'll start the clock with 5 minutes.
Mr. Robotti, a question for you. How much do you rely on
Section 404, in terms of making decisions about companies? What
is your reliance on Section 404?
Mr. Robotti. Well, one of the points I raised is that I
don't think the public market really ascribes much value to it
because if you look at the micro cap companies that are not
accelerated filers, less than $75 million of unaffiliated
market cap today, there's no repricing of the securities in
those markets. They don't have a higher multiple, but you've
got to pay for those stocks. They don't sell a higher multiple,
a lower multiple for books. So it doesn't seem to me, because
part of the portfolio companies that we invest in are still not
404 compliant and others are. So you know, I, as an investor,
look at these companies, have met with managements, look at the
financial reports they have, look at what they've done in the
past in terms of restating their financials, and make my own
subtle assessments about the reliability of management and
internal controls. And so it's really not an assessment,
because from the outset, it's, of course, always difficult to
understand exactly the process that they went through in 404.
The companies that I am familiar with the 404 processes
that they have gone through, you know there are some benefits
that do come from kind of reviewing top down, everything they
do, but the time and effort involved--there's a lot more detail
work that really is relatively irrelevant. So that's my
opinion. And I clearly have talked to companies who have said,
listen, who have said to me, the cost of being a public company
is not that significant, so I don't know why company XYZ who is
a competitor of ours did deregister--this is 2 or 3 years ago--
for other reasons. And then I come back to them a couple of
months later and they say gee, we've looked at this 404 and
we're looking at what the time and effort is going to be
involved and the cost of it. I'm considering that we would
really deregister.
So that's a specific company where I've had conversation
where clearly the guy said it's not significant being a public
company and the costs aren't that significant to evaluating 404
and saying: ``I don't know if I really want to go through that
process and incur all these incremental expenses and I don't
really see the benefit added.'' And I could understand, yeah, I
own 19 percent of the company and yet I'm not really an
insider. I'm not really privy to any information that any
outside investor isn't, but I understand his process. And if I
were a director, I would think yeah, maybe that is really
relevant for you to not be a reporting company.
Mr. McHenry. All right, I think it's pretty clear we
understand the problems in the marketplace and I appreciate you
touching on that. Now if we could transition, if we all, all
four of you could take just 30 seconds and explain what we
should do, what Congress should do, what action we should take
and we'll begin with you, Mr. Robotti, but please keep it at 30
seconds. We've got to keep to the time.
Mr. Robotti. 404 is extremely poorly designed and
implemented. The idea that you need additional work done on
internal controls is logical and in the testimony given by an
ex-SEC Commissioner who said what you've got to do, he said
take 1 day for the CFO, 5 days for the order and that's what he
said he designed the law when he implemented the law and wrote
the law and that's not what's happening. So the implementation
is vastly off.
Internal controls are good. You need it. 404, way overkill.
Mr. McHenry. Mr. Beach.
Mr. Beach. I'm not on the market, so I won't give you that
kind of a detailed response, but let me just say that I think
you should commission research on the economic effects of 168
words. I honestly think that Congress needs to have more
information and reliable peer-reviewed information about what
this has done, so you can get past the anecdotes which are all
very important and into something that's more solid than that,
something that you can rely on.
Mr. McHenry. Mr. O'Shea.
Mr. O'Shea. At the very least, I think you should delay
implementing some of the more onerous provisions of the act,
particularly 404, to do cost benefit studies, to understand the
effect and perhaps consider having some companies, small cap
companies or different industries being exempt from those
provisions.
Mr. McHenry. Mr. Lawrence.
Mr. Lawrence. Similar. It's the 404 provisions that are
especially difficult for small companies such as Acorda and
others in the biotech industry. It really is either--put on
hold so it can be further studied and analyzed or some sort of
a leveled approach or scaled approach based on revenue and
market cap.
Mr. McHenry. All right, I appreciate your input.
Mr. Dent.
Mr. Dent. Thank you, Mr. Chairman. Mr. Beach, I do
appreciate your comment just a moment ago about the impact of
168 words on the economy. And I'm always reminded in this
business of legislating that we pass laws to stop people, bad
people from doing bad things and the corollary to that is
oftentimes it prevents good people from doing good things and I
think you drove that point home.
Mr. Lawrence, I represent an area of the country where
there's a lot of biotech interest and activity. And I'd be
curious to know have you, are you aware of any research that
has been foregone or discoveries that are not being made
because of the compliance costs associated with Section 404?
Mr. Lawrence. It's tough to say what discoveries have not
been made, if the funds haven't been directed toward them. In
our case, we will probably be similar to other biotech
companies where you could spend upwards of $1 million or more
in the implementation of SOX, so for a small company like us,
that's $1 million that will not be used to bring in more
researchers and license additional technology or things that
could accelerate the development of breakthrough drug in the
future.
Mr. Dent. With respect to these opportunity costs for these
small companies, I mean just elaborate on that. What do these
opportunity costs--what opportunities are being missed?
Mr. Lawrence. Just the opportunity to--you may have drugs
reaching a certain development stage where additional funding
could take it to the next level. Get it into a clinical trial,
bring it into a Phase 2 clinical trial. Get it out of the
laboratory and into human testing. Those are questions that you
will ask yourself, if you're spending money on things that are
not going to the research and development, primarily what
investors have invested in our company for.
Mr. Dent. Mr. Beach, can you just elaborate too on the
impact on jobs. We're always talking about jobs around here and
what do you see the impact on jobs because of this statute,
Sarbanes-Oxley, and its implementation, I should say?
Mr. Beach. Well, our own research is beginning to indicate
pretty strongly, Congressman, that Sarbanes-Oxley has, in fact,
added to the cost of capital and we know that in looking at
large models of the U.S. economy, as well as industry specific
models, that capital costs are really the big driver in
business expansion, in reinvestment and new technology, all of
which has immediately two areas, one, and that is the
improvement in salaries and wages. It makes workers more
productive and they're able to command higher pay and so if
capital costs are going up, that will reduce the potential
wages and salaries and also in achieving new employment. And
when Congress acts to increase the cost of capital, that is
worse than when any other institution in the United States
acts, for example, just capital market increases because people
who are borrowing now have to also calculate that you will
followup this action with other deleterious actions and so we
say in our modeling that at one-tenth of an increase in capital
costs that's due to your actions results in 100,000 lost
potential jobs, not actual jobs, but potential employment falls
by that amount.
Mr. Dent. And what industries do you think, looking
forward, will be most impacted by this law, knowing that $9 out
of $10 raised for these new companies are being listed
elsewhere, outside of this country?
Mr. Beach. That's why I think our research in the venture
capital data was so important and revealing, Congressman. And
just very, very quickly, we saw a real movement away from
companies that would have difficult decisionmaking by the
private boards. An unwillingness to take a company public, in
other words. High technology companies. Of course, the area of
the economy which has been benefited by Sarbanes-Oxley was made
in the previous panel. We saw an increase, not only in
compensation, but in numbers in the financial services sector,
but particularly accountants and those subsectors. That's what
the research indicates at this particular point.
Mr. Dent. Thank you, Mr. Chairman. I will yield back.
Mr. McHenry. Ms. Kelly.
Ms. Kelly. Thank you. I'd like to ask Mr. Lawrence, biotech
companies have really very low product revenues comparable to
their market capitalization. And it's not uncommon for a newly
public biotech company to have a market capitalization of $700
million, but have product revenues of less than $1 million.
The SEC Advisory Committee for Smaller Public Companies
defines a smaller public company in terms of revenue and market
capitalization. Now I asked the prior panel, is that an
appropriate way to define or should we do it only on market
capitalization alone? Should we--how do we redefine that so
that it makes some sense?
Mr. Lawrence. The market cap is an important piece. The
revenue portion and it is true that when a company begins to
have revenue, it does create more complex financial statements.
Case in point, we recently went public and we acquired a
product last year in 2004 and there was a large amount of work
that went into revenue recognition on this product and how to
report it on the books. Very detailed, very--intricate
accounting policies had to be followed.
So I think that the revenue piece is an important piece
because it does add a sense of complexity to the financial
statements and creates another layer of potential accounting
discrepancies.
Ms. Kelly. Let me ask another question. I've been sitting
here thinking, listening. Are we holding the companies liable
for something that we ought to perhaps because we're talking in
Section 404 about figures that the accountants have? Perhaps we
should talk about where the accountants are being held because
when an accountant goes into a firm, the only way they're going
to get any information about the firm really is if they've been
doing it repeatedly and they know the firm very well or
whatever the firm tells them, that's what they get.
Should we perhaps be looking at accountancy, along with
what we're talking about with trying to get some--the whole
basis for 404 was transparency and the whole idea for
transparency was to get some honesty out there in the
marketplace to help an investor be able to invest with all of
the available information. But perhaps there should be
something we should be looking at in terms of accountancy with
relationship to what this Section 404 is demanding of
companies. I'm asking this of all of the panel.
I'd like to start with you, Mr. Robotti. Have you thought
about that? And I'd like to hear your thoughts.
Mr. Robotti. Accounts play a key role in the total equation
here and of course, they're driving--I think that's one of the
problems with 404 is of course, you know their interpretation
of PCAOB rules are how do you do an internal 404 review is
what's adding to costs because that's one of the
recommendations, of course, the committee did make that for
small companies, not micro companies, so therefore between $700
million and market cap and over $128 million, that
qualification would move over time because it's as small as 1
percent. Those companies would be exempt from the external
auditor opinion on Section 404.
My personal experience with one company where I am director
today and on the audit committee, we just the other day met and
our internal, our external audit was $100,000 incremental the
first year and we paid $100,000 to hire a consultant to work
with us to implement 404 and to put in internal controls and of
course, there's the time and effort internally.
The second year, the auditors charging us the same $100,000
to do the audit, no cost savings the second year. There was a
100-hour reduction from 580 to 480, but they raised the rates.
So it's the same price. The external consultant went from
$100,000 to $30,000 the second year. The external consultant
clearly was important helping the company organize, demonstrate
and categorize all of the internal controls that happen and put
in controls that needed to be done the second year, but became
more efficient. The external auditor, I don't know what they
did the first year other than act as the oversight person to
make sure that the internal work was done. The second year, I
don't know what they're doing because I just don't understand
that process. So that's what I'm saying, the implementation of
404, I think is a problem. I think auditors are a key part of
the problem.
An extra reason why you don't need 404 today, the auditors
kind of run the show because if they say listen, we don't like
the data you gave us, then you know, we're going to say you've
got to give us more data and more information. They control
that relationship today.
Ms. Kelly. Well, should there be some liability there? I
don't know----
Mr. Robotti. There is liability. They're concerned about
liability. It's what's causing them to over-implement, over-
design 404. That's what's driving that.
Mr. Beach. Congresswoman, I just wanted to say that I think
you're on to something important there and we've noticed it
too. This is not only an intervention into the financial side
of private businesses and publicly traded companies and so
forth, but the accounting industry should be in--it should be
something that you should be concerned about because it was an
intervention in their industry.
Good accountancy leads to good information, leads to good
pricing of companies, leads to a good allocation of resources
in the economy. So I think accountants are absolutely critical
to all of this and if we have damaged that industry
inadvertently, we need to now pay a lot of attention to the
rectification of that industry.
Ms. Kelly. Mr. O'Shea.
Mr. O'Shea. 404, in my view, has cause for two things to
reinforce what Bob said. It could cause for very tough
relationships between the auditors and the issuers because the
auditors are constantly looking over their shoulder and the
costs, both in monetary and running of the business by the
issuers has gone up dramatically.
Additionally, 404 causes the auditors to have to learn a
lot more about the businesses than they've ever had to in the
past. They should really be focused on their job which is
analyzing the financial statements.
Mr. Lawrence. I think that some additional clarity around
exactly what the auditing firms need to be doing, separate and
apart from a financial audit is part of the problem. I'm not
sure they understand, speaking of liability, where it ends and
where they're off the hook and where they're not and what they
need to do and what they don't need to do. So that's part of
the problem. So basically what they're doing is looking at
everything.
Ms. Kelly. Thank you.
Mr. McHenry. Thank you, Ms. Kelly.
Mr. Feeney.
Mr. Feeney. Well, thank you, Mr. Chairman, and in fairness,
somebody has to speak up for the accountants here. They're not
here to defend themselves. To the extent the Big Four were
endowed by Congress, intentionally or unintentionally, with
control of the marketplace, Pepsi needs an internal auditor and
an external auditor. Assuming they don't want to hire the same
two that Coke has already signed up, we have created this
monopoly rent-seeking opportunity and I don't particularly
blame the accountants for taking advantage of something that we
in the SEC and PCAOB have endowed them with. I do think that
it's one of the problems we haven't talked about here today,
but that's probably best talked about when we have some folks
from the accounting industry, both big firms and small firms.
Mr. Robotti, you control about $300 million of investment,
your firm does. Do you, as part of your due diligence, when you
make an investment decision, do you go down and pull a 404
report and pour over the pages 1 through 480 or whatever?
Mr. Robotti. There is no external--404 is just a sentence.
There's no detail, no information.
Mr. Feeney. OK, but the compilation of that report by the
external, I mean there is a report that the external auditors
do, is there not?
Mr. Robotti. No.
Mr. Feeney. Well----
Mr. Robotti. There is no outward available public
dissemination of information that is the culmination of the 404
report, other than the opinion of the auditor.
Mr. Feeney. OK, Mr. Robotti, you indicated in your
testimony that you think that small companies, given the--they
were bumping up against this December 16th date and even some
companies that have complied, I think the way you put it was
that they have a duty to consider going--a duty to their
investors, a duty to consider going dark. Does that also
include maybe a duty to consider going offshore with respect to
where they list and whether or not they delist? I mean Mr.
Coulson has a proposal he refers to as DOD that's sort of a
private regulatory proposal.
Mr. Robotti. I think all of those things potentially make
sense. I can see where it is logical for a board of directors
to decide to register as a public company to trade in the pink
sheets. The problem with that is that decision is unilaterally
in the decisions of the board of directors, what to do, and
then once that's happened how does that company act and how
does it treat those shareholders who potentially are
disenfranchised because instead of having all of the
disclosures and the protections and of course, that's what it
is. It's the disclosure of information that potentially
provides investors with the ability to understand that
something is going wrong and if we were to seek some kind of
redress whether that's to change the board, whether it's court
action, if you don't have the information, you can't do that
and that is unilaterally decided by the management in the board
today. That's the problem with the process.
Mr. Feeney. I don't know whether you've read Mr. Coulson's
testimony, but he's got a private regulatory proposal he thinks
takes care of some of those.
Mr. Robotti. But that's a voluntary, on the part of the
company process. I, as a shareholder, really have no say in
whether that company--I have a company that just last week
announced that it's going to deregister with the SEC. IT's an
ex-New York Stock Exchange company. It will do $700 to $800 in
revenue and I don't know what they're going to do tomorrow.
Mr. Feeney. That's true, that's a problem. But as an
investor going forward, you have a choice when you're choosing
where to put your money, company A or B, to determine whether
or not the private regulatory scheme or 404 compliance is a
better place.
Mr. Robotti. But I disagree with the fundamental, that
concept. You are forgetting about every shareholder of those
companies that currently had invested, when they were a
reporting company, when they took on that obligation. Now
suddenly, they're not any more. It's not my new investment of
capital. It's not the new creation of company giving capital,
that's a problem, but you've forgotten about the guy who was a
shareholder who bought in under a presumption that----
Mr. Feeney. I couldn't agree with you more. We don't have
any argument at all. It's one of the unintended perverse
consequences of the way we've implemented Section 404.
Mr. Beach, you're not an economist, you're a data analyst,
is that right?
Mr. Beach. I am an economist, sir.
Mr. Feeney. You are an economist.
Mr. Beach. With due apologies.
Mr. Feeney. I'll ask you your opinion on a big question and
ask you whether or not we can ever quantify it because you have
some obvious expertise in the quantification and the scientific
approach.
I want to know your opinion whether the cost of SOX
compliance has resulted in the loss of more jobs and the more
net value to the American economy than Enron and World Com
combined, and then I want to know because your methodology, as
I understood it, is you're going to look at the companies that
have basically gone dark or delisted or are availing themselves
of private equity markets where they would have probably stayed
in the public equity markets. Then you're going to look at the
inefficiencies and the cost of raising capital and you're going
to give us a number.
That method seems to me woefully inadequate to talk about
the total impact on the economy, because Mr. Lawrence just
explained that he's got his best and brightest scientists, in
some cases, spending a good portion of their time instead of
finding the next cure for multiple sclerosis, they're talking
to their internal accountants, their external accountants,
their lawyers and others. So it's almost impossible to quantify
the loss of opportunity, isn't it and I'll let you answer those
questions.
Mr. Beach. With any precision, it certainly is. What we try
to do in this particular case is go through the following
exercise. We're taking a lot at what we think is a leading
industry in this whole debate and that is the venture capital
industry. That's just one of many and we are saying can we
isolate the effects of changes in that industry due to Sarb-Ox
on the cost of capital and several other, Congressman, economic
concepts. If we can, then I can take those results and move
them into another model of the U.S. economy which has been used
for a long, long time by economists, a very good detailed
model, in fact, I imagine you even used it.
And from there, we can then say this is the effect of Sarb-
Ox on the economy. Same exercise. Look at Enron, World Com,
Global Crossing. Did they have that kind of tangible effect on
these key economic drivers? Move those results into the same
model and then compare the effects of these companies having
that increase in cost of capital as opposed to Sarb-Ox. That is
exactly what we're doing right now in my unit.
It's a real good economics question. It's a real good data
analyst question and we will reach a conclusion contrary to the
old saying that if you lay all economists end to end, they
never, in fact, reach a conclusion. I think we're very close to
being able to advise the committee that Sarb-Ox has a long-
reaching and very deep effect on the economy.
Mr. McHenry. Any further questions from the committee?
Well, hearing none, I want to thank the panel for taking the
time to be here and for sharing information. We're going to
take this back to Washington and as Mr. Feeney said, he already
has legislation that he has filed. And there's a lot of
interest growing to make needed reform. So thank you for being
here today and this includes our Government Reform Committee
hearing.
Ms. Kelly. Mr. Chairman, I would like to say I do thank the
staff from Washington from this committee that came here and
did all the work to set this up. They did an excellent job.
Mr. McHenry. Yes.
[Whereupon, the subcommittee was adjourned.]
[Additional information submitted for the hearing record
follows:]
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