Risk & Compliance

House Committee Chair Wants 404 Reform

Biotech CEO also testifies that compliance difficulties keep small companies' costs high.
Marie LeoneMay 5, 2006

The Chairman of the House Committee on Small Business is calling on the Securities and Exchange Commission to exempt small public companies from the Sarbox 404 reporting because the cost of compliance with the provision’s rules outweighs the benefits.

At a hearing on Wednesday, Committee Chairman Don Manzullo, an Illinois Republican, urged the SEC to heed recommendations by its Advisory Committee on Smaller Public Companies calling for exemptions for diminutive issuers from the internal-controls rules. The SEC should provide “waivers to smaller companies that can’t afford the huge auditing and accounting cost of complying with Section 404,” according to a press release issued by Manzullo’s staff.

The Congressman’s views were supported by Herbert Wander, the chairman of the SEC advisory committee, who was on hand to testify on the report’s findings. Wander reiterated his committee’s proposal to exempt micro-cap and small-cap companies from Section 404 if certain governance practices are in place. The SEC committee called for waivers for micro-caps with less than $125 million in annual revenue and for small-caps with less than $10 million in sales. (Overall, the committee defines micro-caps as companies with equity capitalizations of $128 million or less and small-caps as ones with equity capitalization of $128 million to $787 million.)

Also testifying was James Burns, president and CEO of EntreMed Inc., a small biotech company that is in its second year of 404 compliance. Speaking on behalf of the 1,100 companies that make up the Biotechnology Industry Organization, Burns asserted that the current “one size fits all” approach to Section 404 compliance doesn’t work. Instead, BIO advocates a risk-based approach to compliance that is scaled to the size of the company based on revenue. Since levels of risk are linked to levels of product revenues, revenue amounts should drive the scope of internal control procedures, the trade association contends.

In a interview following his testimony, Burns told CFO.com that one of the results of 404 is that compliance with the provision produces what amounts to a huge “fixed cost” for smaller companies.

Burns reasons that the rules are scaled to apply to big companies and their accounting complexities. Such companies have the wherewithal to develop compliance systems to match those compliance challenges. Once those systems are set up, the big companies’ compliance costs drop. Under current internal-controls rules, however, smaller companies—even those with much less complex accounting systems—must adhere to the same strictures that govern bigger ones. Since the smaller corporations will never be able to have the resources to develop the systems needed to cope with the rules, their compliance costs will always remain high.

Small companies are struggling to jury-rig systems to comply with rules that are scaled to much larger outfits, he says. For example, to adhere to 404-related separation-of-duties rules that require that the person who signs checks can’t be the one who processes them, EntreMed had to assign a lab technician to accounts-payable duties. The reason: EntreMed, which generates under $6 million in revenues, doesn’t have the cash to hire an additional staffer for its three-person accounts payable team.

Cash is often at a premium for biotech companies, which often can have market capitalizations of $700 million or more but revenues of $1 million, because products in the pipeline have yet to be commercialized. So far, Burns says, audit fees and consulting services for biotech companies range between $500,000 and $1 million annually, which is a significant percentage of revenues for companies that generally are funded by investor bets on research and development, rather than by product revenues. “One million dollars would allow a [biotech] company to hire five to 10 senior researchers,” he says.

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