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Schmalzl Testimony Before Congressional Committee

June 5, 2007

Opening Remarks

Good afternoon, Madame Chairwoman Velázquez, Ranking Member Chabot, and Members of the Committee.  Thank you for inviting me to testify on the new standards for internal controls over financial reporting recently established by the Securities and Exchange Commission and the Public Company Accounting Oversight Board.  The costs and related burdens of implementing  Section 404 of Sarbanes-Oxley have been, and continue to be, a serious problem for public companies, particularly smaller companies.  I appreciate the Committee’s desire to further investigate ways to alleviate these problems.

I am a partner in the Cincinnati, Ohio office of the law firm of Graydon Head & Ritchey LLP.   As the Chair of our securities law practice, I work with both large and small public companies in a variety of industries.  My testimony today is based on my 25 years of experience in representing, counseling and building relationships with my firm’s public company clients and  their boards of directors, chief executive officers and chief financial officers in their real world experiences in navigating the regulatory requirements imposed upon public companies.  Since the enactment of Sarbanes-Oxley nearly five years ago, I have worked more closely than ever with public companies in helping them become Sarbanes-Oxley compliant.  As a result, I have gained substantial insights as to how directors and officers view these increasingly complex  requirements.

In preparing my testimony, I have asked a number of officers of several different public companies about their current thoughts and expectations about Section 404 and the new SEC and PCAOB standards.  However, the views that I share with the Committee today are my own views and should not be attributed to Graydon Head & Ritchey or to any client of my law firm.

My objective is to address three primary topics with the Committee:  (1)  the most significant problems that implementation of Section 404 has caused for public companies; (2)  whether the  SEC’s and PCAOB’s new standards are likely to effectively alleviate those problems; and (3) the need to continue to evaluate whether Section 404 is serving its intended purposes.

1.           Significant Problems Caused by Section 404
This Committee, the SEC and the PCAOB are well aware that the implementation of Section 404 of Sarbanes-Oxley has been problematic.  I will not attempt to identify every problem that public companies have encountered in seeking to comply with the Section 404 requirements for internal controls over financial reporting as the myriad of problems are well documented in various reports compiled by the SEC.  What I will do is to emphasize that the most significant and troubling problems facing public companies, and particularly smaller public companies, are (1) out-of-pocket costs, (2) diversion of limited internal resources, and (3) deteriorating relationships with their independent, outside auditors.

-        Out-of Pocket Costs:  The additional out-of-pocket costs required to comply with Section 404 are extremely high.  Virtually every public company that I have talked with has experienced at least a doubling of its audit costs each year since being subjected to Section 404 compliance.  Initially, the extra cost burden in the first year of implementation was seen as extreme by most companies, however, they have now discovered that these costs do not significantly reduce in subsequent years.

Importantly, studies have also confirmed that the cost of Section 404 compliance is disproportionately higher with respect to smaller public companies.  Although a larger company may have incurred an additional $2.0 million of auditing costs attributable to Section 404 compared to only $500,000 by a smaller company, the larger company typically is offsetting those costs against a much larger bottom line.  If the smaller company only generated $1.0 or 2.0 million in net income to begin with, the extra compliance costs very materially reduce such net income and directly lowers the value of the company for its shareholders.

-        Diversion of Limited Internal Resources:  In addition to direct costs, public companies must also allocate substantial internal human resources to the Section 404 compliance process.  Those costs are hard to measure precisely, but public companies firmly believe that the substantial time that many key employees must devote to Section 404 compliance would better benefit shareholders if focused on running and growing the company’s business.  Again, this problem is even more pronounced for smaller public companies who have fewer employees and who frequently have significant budget restraints on hiring additional employees.  The result is that highly qualified chief financial officers and controllers must do much of this work themselves in smaller public companies, yet the involvement of these individuals is greatly needed in other aspects of the business as well.

-        Deteriorating Relationships with Independent, Outside Auditors:  Section 404 compliance has been a major contributor to a deteriorating relationship between public companies and their auditors.  In the past several years, I have heard numerous public company officers describe their relationship with their outside auditors as “adversarial.”  I don’t recall ever having heard such comments prior to the implementation of Section 404.  We all agree that it is critically important that a company’s outside auditors be independent of management, but Section 404 has had the unintended consequence of cutting off productive and necessary consultations with the auditors who historically had been among a company’s most trusted advisors.

The reason for this problem is that many companies discovered that if they had to ask their auditors for advice on how to handle complex accounting issues, then the auditors felt compelled to characterize the need to ask as either a significant deficiency or worse, a material weakness because the company should have known.  Of course, this is a fallacy in that many accounting, tax and other issues require much judgment and analysis.  Nonetheless, the fear of being tagged with having material weaknesses causes smaller public companies to no longer ask legitimate questions for needed advice.  The company either makes a judgment the best it can based on the amount of time its key people can devote to analyzing the relevant issues, or the company can incur even more additional expense by engaging yet another accounting firm to advise it on those matters notwithstanding that such other accounting firm does not know nearly as much about the company as does the company’s current audit firm.  The frustration experienced by small public companies in these cases is exacerbated by the fact that the outside auditors also frequently would not have had definitive answers, yet management is not even able to determine the auditors’ general thinking on these complex matters until the Section 404 audit is underway months later.

The relationship between a company and its auditors has been further strained by the Section 404 process in cases where a company perceives their outside auditors as being inflexible, lacking judgment and/or conducting excessive testing and analysis of internal controls regardless of materiality.  Although the auditors in the field historically are very familiar with their audit client’s business, many audit firms have taken a centralized approach to Section 404 which has resulted in a “if it’s good for Company A, then it must be good for Company B” mentality.  This has caused auditors to insist on implementation of various procedures and the undertaking of extensive testing on many matters that are not seen as being at all relevant to the particular company being audited.  Because these requirements are being imposed from above, i.e. the audit firm’s national office or in some cases the PCAOB, the auditors in the field are powerless to adapt even if they would otherwise be so inclined.  The reluctance of audit firms to make modifications is undoubtedly (and justifiably) also tied to liability concerns given that the accountants have been the deep pockets for substantial claims based upon their client company misconduct or mistakes.

I emphasize these problems because I can assure you that these problems are in fact being experienced virtually everyday by our nation’s public companies.  These problems are draining not only cash from otherwise solid and viable companies, but also adversely impact the entrepreneurial spirit of these officers in wanting to build a company for the long term.  More and more public companies have no choice other than to at least consider the possibility of going private and exiting the public markets altogether.

I also work with many successful privately held companies, including entrepreneurial new ventures.  Ten years ago, it was very common for these companies to aspire to someday go public and to use the public capital markets as a way to grow the company.  In today’s environment, these types of companies express virtually no interest in going public and cite the regulatory burdens as the main concerns.  While the aggregate dollar volume of IPOs may be on the rise in recent years, increasingly it is the case that the public markets are not truly open for smaller companies.  My first underwritten public offering in 1986 raised a whopping $600,000 in gross proceeds.  While that was atypically small even then, it would be difficult to recommend that any company conduct an IPO today for less than $100 million.

Yet another ominous sign for the U.S. public markets is the new unregistered stock trading system recently devised by Goldman Sachs.  This system is designed to create a trading market in privately held companies but to keep them at less than 500 shareholders so not to trigger SEC reporting obligations.  Investments in these “listed private companies” will be limited to institutional investors, thereby limiting investment opportunities for the general public.  Perhaps even more telling is that a leading investment banking firm would believe that such an unregistered trading system is advantageous given that the public capital markets have been the life blood of investment banking.

I believe the case is clear that small companies need relief from the enormous regulatory burdens being imposed upon them.  While Section 404 is by no means the sole cause of those burdens, it is an area ripe for improvement as I will next discuss.

2.         Anticipated Ability of New SEC and PCAOB Standards to Remedy Section 404 Problems

The SEC and PCAOB have expended extraordinary time and effort to identify, analyze and attempt to develop solutions for the myriad of problems resulting from Section 404.  This is evidenced by the large number of hearings, public meetings, proposal drafts, comment solicitations and other related actions to try to balance the needs and burdens on public companies with the need for quality reporting and confidence in the public markets.  These actions are highly commendable and should be greatly appreciated.  I believe that the SEC and PCAOB have done an excellent job of developing standards that, in theory, should alleviate some of the above problems.

The SEC and PCAOB’s new standards contain many concepts that do address the main problems posed by Section 404.  Companies and auditors are being guided to take a top down approach focusing on identifying the true risk areas and materiality.  The new standards also contemplate scalability and recognize that all companies are not the same and that the nature and types of controls needed in various companies can vary.  Of great significance is that the new standards allow for the auditors to undertake work relating to internal controls if the company’s audit committee approves.  The new standards also allow the auditors to rely on the work of company employees, not just the internal auditors which many smaller public companies do not have.  The combination of these factors should reduce costs and improve relationships between companies and their auditors.

Unfortunately, I must report to you that smaller public companies are for the most part highly skeptical that the new standards will bring actual relief.  In some instances, this skepticism results from conversations that have already transpired between the public company and its  auditors.  Those conversations have made clear that the auditors are not anticipating any significant changes in the way they approach the Section 404 audits, notwithstanding the new standards.  If the auditors are not willing in practice to buy into the new standards, then it is highly doubtful that public companies will experience any meaningful cost reduction in Section 404 compliance or that internal resources will be freed to focus on the company’s operations, strategy and vision which ultimately build shareholder value.  While we can only speculate at this point at to why auditors may not embrace the new standards, reluctance to change their processes may well be due to concerns of potential liability if their practices are not uniformly applied.

Even as to those companies which are more optimistic about the willingness of their auditors to work within the new standards, their expectation as to cost savings is modest.  At this point, they anticipate that a 10 – 15% reduction in audit costs is about the best that would result.  Those companies that are already complying with Section 404 also have concern that it will be costly to convert to the new standards as much of the same work that was needed in the initial implementation of Section 404 would have to be repeated in order to determine what items can be scaled back.  Now that they have experienced at least two years of the Section 404 audit, it may be easier and more cost effective to simply keep the existing processes substantially in place.  These companies believe that as long as they can continue to demonstrate to their auditors that they are following the established internal control procedures that were sufficient to allow  the company to get a “clean” Section 404 report, then it would not be prudent to change those procedures at the risk of getting a different result.

Recommendation #1.  The primary perceived obstacle to the potential success of the SEC’s and PCAOB’s new standards is the willingness and ability of the outside auditors to adapt their thinking and procedures to align with the principles and guidance set forth in those standards.  Because the PCAOB is charged with overseeing and evaluating public accounting firms, the PCAOB should make clear that part of its evaluation process will be to determine whether the audit firms are changing from a “one size fits all” and “everything is material” standard.  Although the PCAOB has limited powers, the PCAOB needs to strongly encourage public accounting firms to buy into the new standards and to be critical of firms that do not.  While beyond the power of the PCAOB and the SEC, reducing the potential liability of auditors for Section 404 audits could be warranted.

Recommendation #2.  The SEC should grant non-accelerated filers another extension of time before compliance with the new standards is required.  So far, the SEC has determined not to provide additional time notwithstanding the cry of many interested parties requesting such an extension.

An extension is warranted for several reasons, including:

-        First, to begin with, the phased implementation of Section 404 presumably was to allow smaller companies to learn from the experiences of larger companies and their auditors in implementing Section 404.  The new standards create a substantially new and different framework for implementing and auditing internal controls than what the large accelerated filers and accelerated filers have experienced in prior years.  The smaller public companies should not be the guinea pigs in determining how to implement the new standards.

-        Second, the accounting firms need time to review their practices and procedures in light of the new standards and to modify those practices and procedures as they deem appropriate.  The accounting firms also need time to educate their own staffs on such changes before the internal control auditing process is undertaken.  Moreover, if the non-accelerated filers are now added to the number of companies for which internal controls must be audited, there undoubtedly will be even more new hires by the accounting firms to handle the increased demand, many of which new hires may have little or no experience in auditing internal controls under either the old or new standards.

-        Third, the non-accelerated filers have already lagged behind their larger public company counterparts in implementing Section 404 without any indication that the public markets and investors have been clamoring for these companies to commence compliance.  Another time extension of one or more years, if not permanently, would not appear to greatly increase risk to the markets or investors.

3.         Continued Evaluation of the Effectiveness of Section 404

In reading the various proposals and related materials prepared by the SEC and the PCAOB, it is apparent to me that they have concluded that (1) Section 404 is improving the quality of financial reporting, decreasing the risk of fraud and improving investor confidence, and (2) reducing the cost of implementing Section 404 will eliminate the majority of concerns and objections that public companies have regarding Section 404.

I believe that declaring Section 404 to be effective in the above respects is premature, if not entirely incorrect.  I also believe that reducing the Section 404 costs will not mean that Section 404 compliance is cost effective.

In talking with public companies about Section 404, they are virtually unanimous in their strong belief that they had good internal controls before Section 404 was thrust upon them and that Section 404 has not been effective, and cite the following examples:

-        The additional documentation and procedures that they have been forced to adopt in order to satisfy the auditors have been largely focused on minutiae and are unnecessary.

-        Their financial reporting is not significantly improved as a result of implementing Section 404, and believe that the public markets and investors do not place significant value on the internal control reports.

-        Many companies have had to restate their financial statements in recent years, but not because their internal controls were more effective.  Large numbers of restatements have been necessary due to the ever increasing complexity of accounting rules and tax laws, which require companies to use their best judgment on how to report certain items.  In subsequent years, as companies and auditors gain more experience in applying those new  rules and standards begin to emerge, it is not uncommon for companies to later discover  that their best judgment did not comport with the prevailing view and then the prior years’ numbers must be adjusted.  Fortunately, knowledgeable investors are increasingly able to distinguish between restatements that are driven by highly technical rules and restatements that indicate serious problems within a company.

It is also clear that many of the restatements are being made by companies that had received clean audit reports on their internal controls for the years being restated.  In many of those cases, the need to restate triggers a determination by the company and/or the auditors that a material weakness had existed so the audit report gets changed months or even years later.  In those cases, it is difficult to conclude that financial reporting has been improved or that the financial statements are more reliable because of the auditor’s Section 404 audit report.

While many of the Sarbanes-Oxley requirements have been beneficial to companies, their shareholders and the investing public, the jury should remain out on Section 404.  Many public companies would urge Congress to repeal Section 404 for the various reasons, including those  discussed above.

Although it is my understanding is that it is highly unlikely that Section 404 will be repealed, I would be remiss if I did not ask this Committee to at least remain open to that possibility.  Failing the complete repeal of Section 404, I would suggest to the Committee that the current batch of non-accelerated filers who have not yet been required to comply with Section 404 and new public companies in the future be exempt from Section 404 implementation until such time as they achieve certain thresholds.  The market capitalization threshold should be increased substantially, at least to $500 million and arguably higher.  A net income test should also be established to alleviate the disproportionate impact of compliance costs on smaller companies.  While changing these thresholds will not benefit companies that have already complied with Section 404, this step would help minimize concerns of companies considering going public that the ongoing compliance costs are too high to overcome.

Conclusions
The implementation of Section 404 continues to be a significant burden for public companies, even more so for smaller companies.  The SEC’s and PCAOB’s new standards may alleviate some of those problems, but Section 404 is likely to continue to be particularly burdensome on small public companies for years to come.  Ideally, Section 404 itself would be repealed, or at least the nation’s small public companies could be granted a longer term exemption from compliance. 
I appreciate the opportunity to appear before you today to address these important issues.  I will welcome any questions that you may have.  Thank you.