September 2010
»
Financial Reform Gives with One...
The long-anticipated financial reform legislation has arrived. The DoddFrank Wall Street Reform and Consumer Protection Act was signed into law on July 21, 2010. It is intended to overhaul financial regulation and restore stability to U.S. markets and has been touted as the solution to our economic ills. Its proponents say it will do so by—
creating a new independent watchdog within the Federal Reserve;
avoiding future “too big to fail” dilemmas;
identifying and preemptively addressing systemic risks to economic stability;
bringing transparency and accountability to complex financial instruments, such as derivatives and hedge funds;
clarifying responsibility for bank supervision;
enhancing corporate governance and investor protection; and
strengthening regulatory oversight and enforcement.
If small companies are disproportionately damaged by fraud, why aren't they voluntarily seeking to protect themselves?
If that isn't enough, it also calls for 47 studies, 74 reports, and seven new governmental entities. Many people are encouraged by these impending changes and expect that they will help to reduce fraud and restore public confidence.
Nevertheless, in a misguided effort to ease compliance costs for small public companies with a market capitalization of less than $75 million, Congress provided an exemption from section 404(b) of the SarbanesOxley Act of 2002 (SOX), which requires an independent audit of the effectiveness of a company's internal controls over financial reporting. Since SOX passed, the SEC has delayed implementation of this section of the law for small businesses. Now section 989G of dodo-Frank officially gives nonaccelerated filers a permanent exemption. Although an SEC study on the subject confirmed that SOX section 404(b) compliance initially placed a disproportionately large expense burden on small businesses, it also found that these costs were not ongoing. Furthermore, as the financial burden has eased over time, the benefits related to compliance have continued.
Penny Wise, Pound Foolish
Approximately half of all U.S. public companies fall below the $75 million market capitalization threshold and will not be required to comply with SOX section 404(b). Yet, according to the 2010 Association of Certified Fraud Examiners (ACFE) Report to the Nations, a biennial global fraud study on occupational fraud and abuse, smaller organizations historically experience the greatest percentage of fraud and suffer larger losses due to fraud (http://www.acfe.com/rttn/rttn-2010.pdf). Smaller companies also have fewer controls in place than do large organizations. Because internal controls have proved to be an effective deterrent for fraud, this factor may contribute to the greater impact of fraud on these companies. So if small companies are disproportionately damaged by fraud, why aren't they voluntarily seeking to protect themselves?
Some argue that the cost of SOX section 404(b) compliance redirects a busi-ness's scarce resources away from job creation and capital investment. But fraud losses do the same. How can we build a solid economic foundation and prevent another financial crisis without protecting the economic resources and integrity of the financial reporting process of half our publicly traded companies? To make matters worse, Dodd-Frank section 989G authorizes the SEC and Government Accountability Office (GAO) to conduct a study on how the costs of complying with SOX section 404(b) may be reduced for companies whose market capitalization is between $75 million and $250 million (and it asks that this be accomplished without compromising investor protections).
Legislators and proponents of exempting small companies from SOX section 404(b) compliance (and its related costs) believe that this exemption will provide a powerful economic incentive. They may be right. What they might not have counted on is that the incentives may actually aid the fraudsters among us.
As always, I welcome your comments.