The Wall Street Reform and Consumer Protection Act of 2009, passed by the U.S. House of Representatives in early December, includes a provision calling for a permanent exemption from certain elements of the Sarbanes-Oxley Act of 2002 (SOX) for small public companies.  That would seem to be cause for celebration in the reverse merger community.
   
For more than six years, filers with market caps under $75 million - a classification that covers the bulk of reverse mergers - have been sweating it out, living from one extension of the SOX exemption to the next.  If the bill passes, the so-called non-accelerated filers will no longer have to depend on the fickle generosity of the Securities and Exchange Commission and will be freed from some of the more onerous provisions of SOX.

"We got a New Year's present," said David Feldman, the managing partner of law firm Feldman LLP.  "Potentially."

The asterisks are many, beginning with the fact that the bill is not nearly law.  While it passed the House, the statute is controversial, loaded up with a lot that is unapologetically interventionist, such as allowing the government to  break up companies and mandating the creation of new government bureaucracy.

The non-accelerated filer provision itself, just one bit of the proposed legislation, is also facing challenges, and for the opposite reason:  It's a bit too business friendly and laissez-faire.  While the atmosphere has cooled from mid-crisis, lawmakers may not be ready to give an entire section of the economy, and one known historically for scams, a pass.

"The bill is really up in the air," said Bob Benoit, president and director of SOX research at Lord & Benoit, an intern-control compliance firm in Worcester, Mass.

Observers point to Koss Corp., a Nasdaq-listed headhphone company based in Milwaukee with a $40 million market cap that recently lost $20 million to embezzlement.  The theft, according to accountants, would have been easily caught by a SOX-compliant company.  With shenanigans like this going on, it's a challenge to argue that small companies don't need more regulation.

SOX Costs Prohibitive

The motivation behind the exemption is simple:  SOX is expensive.

To be clear, non-accelerated filers are already required under section 404 to design and implement internal financial controls and attest that they are comfortable with the adequacy of these controls.  There's no exception for that part.

What they have been permitted to skip, and may be allowed to forgo permanently if the bill becomes law, is having their work signed off by their auditor.  This requirement is known as Rule 404(b).  The first task is certainly a cost.  The second is the real burden.

Estimates vary widely, with numbers ranging from about $75,000 to more than $2 million a year for SOX compliance and audits.  But what everyone agrees on is that as a percentage of sales or market cap, small companies get hit harder.  In some cases, the cost of an initial SOX audit for a new public company can depress its stock price.  For reverse merged companies hoping to do a follow-on financing, the dip in earnings due to an audit can make that fund raising prohibitively expensive.

"The issue is cost," said Elliot Taylor, an attorney at Parsons Behle & Latimer in Salt Lake City.  "And everyone is concerned about costs these days."

404 Difficulties

SOX can indeed be almost impossible for a small company to implement.  It requires, for example, a separation of duties, so the person inputting information for payment needs to be different from the person who signs the checks.  For a tiny operation, that may mean hiring another employee or outsourcing bill payment.  For a shell with few assets and no employees, SOX compliance is almost comical, suggesting the need for split personalities and processes that protect what's not there in the first place.

"404 is a pain," said Hank Bourg, a certified public accountant at Dezan Shira & Associates in Shanghai.  "I have been there, done that.  "It's a complete pain."

But that's not the whole story.  It's not just a matter of SOX being bad, exemption being good.  Even the biggest critics of the law say that the debate is complicated and that there are as many reasons to require a SOX audit for small companies as there are reasons to allow them to be free of it.  So if the bill does not pass and non-accelerated filers run out the latest extension, which ends June 15 protest could be quite minimal.

The cost issue, many say, has been a bit overdone.  Sure the year is hefty and for a small company the additional audit hours may hit the bottom line, but accountants say that the number should not sink a good company.  The cost of going public is by definition high.  You have listing fees, legal fees, accounting fees, and investor relations costs.  SOX is just another expense.  A solid business, said one accountant, can handle SOX, and companies that blame the law for their failure are often just using it as an excuse for other problems.

"I don't think the costs are material.  People come up with all sorts of wild numbers," said Benoit.  "Our research indicates that it will cost about $75,000.  For a company with $50 million in sales, $75,000 is not a huge number.

Most of all, observers are calm about SOX for small companies because it seems to work.  While the law has been cast by some as an unwarranted intrusion and a great threat to the workings of the market economy, over time many skeptics have been won over.  SOX may have increased confidence in the U.S. capital markets enough to justify the expense.

SOX Exodus

When SOX was originally passed, the fear amongst many was that it would lead to an exodus of companies to other more lightly regulated markets.  That happened.  But over time the rush for the doors ended and SOX revisionism started to set in.  There were problems.  SOX addressed the problems.  And now the U.S. markets are better for it.
              
"The Sarbanes that has already hit small companies has become the new normal, said Feldman.  "People are pretty used to it.  Those that have chosen to list in other venues have seen that it is easy to get on those markets and there is a little bit less regulation, but what they often don't see is liquidity in their stock."

Indeed, according to Benoit, SOX is a proven good.  In one study of non-accelerated filers, Lord & Benoit found that all of the companies in the survey were vulnerable to at least two ways embezzling funds without being caught.  One public company had 28 ways.  In another study conducted by the accountancy, companies that had effective 404 controls outperformed the Russell 3000 Index, while those with ineffective controls underperformed.

We see benefits that are hard to quantify," said Benoit.  "What is the right cost for potentially saving $20 million?  There is a return on investment in looking at internal controls."

"I know some people who see Sarbox as a positive," said Teresa Bockwoldt, chief executive of Vibato, a San Francisco company that helps small companies with 404 compliance.  "I know others that think Sarbanes-Oxley has single-handedly bankrupted the country, and I know people in between.  But a lot of our private company clients go through the process because they think it will give them a higher valuation once they do go public" she added.

So far, Chinese companies have been little concerned by SOX.  They have always been biased toward the U.S. markets and have been relatively, perhaps at times to a fault, price insensitive.  They are willing to spend money if that's what it will take to get publicly listed.

Bockwoldt, who had gone to China for SOX implement work, said that she finds Chinese clients quite willing and able to do the work necessary.

The real test for Chinese companies is whether the requirement for 404(b) pushes them more toward domestic exchanges.  In particular, the ending of the exemption could start to make the new Shenzhen Stock Exchange's Growth Enterprise Market more attractive.  So far, Chinese companies remain enamored with the U.S. markets, but the question is whether a SOX audit won't tip the scales.  When they reverse merge in the U.S., they already going around the world and raising money under a very different legal system and in a language not their own.  404(b) maybe just a bit too much and may make a China Securities Regulatory Commission shakedown seem bearable.