July 18, 2017
House Financial Services – Capital Markets Subcommittee: The Cost of Being a Public Company in Light of Sarbanes-Oxley and the Federalization of Corporate Governance
Key Topics & Takeaways
- Impact of Sarbanes-Oxley: During the hearing, numerous witnesses argued in favor of granting small and mid-sized companies various exemptions from Sarbanes-Oxley requirements, arguing the act deters these firms from going public. Democratic Representatives generally argued in favor of retaining key portions of the bill, noting it improved investor confidence in corporate disclosures, though many qualified that by saying they were open to exploring changes to the law.
- Trends in Public Markets: Running throughout the hearing was a discussion on the decline in total public companies and the decline in initial public offerings (IPOs) in the U.S. Many witnesses and Republican Congressmen used the hearing to call for changes to disclosure laws, arguing that Sarbanes-Oxley and the Dodd-Frank Act have deterred private companies from entering public capital markets. There was also bipartisan support for the Jumpstart our Business Startups (JOBS) Act and its various provisions that encouraged companies to go public.
- Proxy Advisor Firms: Rep. Sean Duffy (R-Wis.) drew attention to the practices of proxy advisor firms during the hearing, and asked witnesses for their thoughts on possibly regulating these firms and their activity. Several witnesses endorsed this approach, saying that proxy advisors put their financial interests ahead of their clients and ahead of shareholders at the firms they monitor.
- Thomas Farley, President, NYSE Group
- John Blake, SVP of Finance, aTyr Pharma, Inc., on behalf of the Biotechnology Innovation Organization
- Tom Quaadman, EVP, Center for Capital Markets Competitiveness, U.S. Chamber of Commerce
- Professor J. Robert Brown, Professor, University of Denver Sturm College of Law
- John Berlau, Senior Fellow, Competitive Enterprise Institute
In his opening statement, subcommittee Chairman Bill Huizenga (R-Mich.) introduced the topic of the hearing and said he was concerned by the precipitous decline in both total public companies and annual initial public offerings (IPOs) over the last twenty years. Huizenga detailed several estimates of the cost of compliance for public companies that he believes have contributed to those declines, and criticized the “extensive corporate disclosure regime” that public companies must navigate, which he says exposes companies to legal and competition risks. Huizenga criticized former Securities and Exchange Commission (SEC) Chair Mary Jo White, saying she “politicized” the disclosure regulations for public companies and veered away from the SEC’s mission of protecting investors and maintaining orderly and efficient markets.
In her opening statement, subcommittee Ranking Member Carolyn Maloney (D-N.Y.) urged her colleagues to remember why Congress initially passed the Sarbanes-Oxley act – to protect investors after fraudulent disclosures by high-profile companies resulted in immense losses. Maloney defended Sarbanes-Oxley’s regulatory requirements, saying they improved investor confidence in corporate disclosures.
In his opening statement, subcommittee vice chairman Randy Hultgren (R-Ill.) discussed the decline in total public companies over the last twenty years, which he called “a serious problem.” Hultgren laid much of the blame for the decline on regulatory burdens for public companies, and he praised the Jumpstart Our Business Startups (JOBS) Act for helping ameliorate that burden. Hultgren then lauded the recent decision by the SEC’s Office of Corporate Finance to extend confidential filing exemptions, previously available only to emerging growth companies (EGCs), to all companies.
Thomas Farley, President, NYSE Group
In his testimony, Farley discussed the importance of entrepreneurship to economic growth and job creation and said that young, dynamic companies are eschewing public markets and staying private. Farley drew attention to the decline of IPOs and called on Congress to 1) end regulatory “mission creep,” 2) help smaller companies deal with serial litigants and proxy advisor firms, and 3) focus on improving the business climate for small and mid-sized businesses. Farley conceded that Sarbanes-Oxley was passed with good intentions, but said the compliance costs have proven burdensome, especially for smaller companies. Farley specifically called on Congress to eliminate the requirement that external auditors attest to internal controls at public companies. Farley also endorsed a “loser pays” model for shareholder class action lawsuits, and proposals to require proxy advisor firms to register with the SEC and disclose conflicts of interest.
John Blake, SVP of Finance, aTyr Pharma, Inc. on behalf of the Biotechnology Innovation Organization
In his testimony, Blake discussed issues that small biotechnology companies face when trying to access the public market, and said the compliance costs are disproportionately large for them. Blake praised Reps Kristin Sinema (D-Ariz.) and Trey Hollingsworth (R-Ind.) for introducing H.R. 1645, the Fostering Innovation Act, and said this bill would build on the successes of the JOBS Act and help low-revenue securities issuers. Blake also endorsed legislation introduced by Rep. Sean Duffy’s (R-Wisc.) during the 114th Congress (H.R. 5311, the Corporate Governance Reform and Transparency Act) saying it would benefit shareholders by curbing the influence of proxy advisor companies. Blake closed by criticizing what he called “manipulative” short-selling and called for a short disclosure regime.
Tom Quaadman, EVP, Center for Capital Markets Competitiveness, U.S. Chamber of Commerce
In his testimony, Quaadman discussed the decline in absolute total of public companies since 1996, noting that the United States has the same number of public companies as it did in 1982, despite population and gross domestic product (GDP) growth. Quaadman was especially critical of proxy advisor firms and what he called “increasing intervention” from “special interest activists” in the corporate disclosure process. Quaadman argued that changes to the regulatory regime for public companies could help reverse the trend towards private ownership.
Professor J. Robert Brown, Professor, University of Denver Sturm College of Law
In his testimony, Brown said that capital markets today have a level of transparency that encourages investors to take risks. Brown discussed Enron’s collapse in the early 2000s and said this event rattled investor confidence in the public markets. Brown praised Sarbanes-Oxley for its auditing and internal controls requirements, and he said these provisions promoted investor confidence in issuer disclosures. Brown said that the key question for policymakers should not be how to decrease regulatory costs, but how to improve investor confidence.
John Berlau, Senior Fellow, Competitive Enterprise Institute
In his testimony, Berlau said that Public Company Accounting Oversight Board (PCAOB) regulations and Sarbanes-Oxley are key stumbling blocks for companies exploring an IPO in U.S. markets. Berlau said the declining attractiveness of public markets has harmed middle-class investors the most, as these investors have been less able to take advantage of the success of new, high-growth companies, while accredited investors have reaped most of the gains. To reverse the decline in public companies, Berlau said that small companies should be exempted from the most onerous public company requirements and called on Congress to adjust the current definition of internal controls.
Question and Answer
Impact of Sarbanes-Oxley
Rep. Maxine Waters (D-Calif.) asked Brown to describe what he thought the most important Sarbanes-Oxley provisions were. Brown said that the act did a “remarkable job” in restoring investor confidence in corporate disclosures, and praised the improvement in internal controls, which he called the “backbone” of disclosure. Rep. Stephen Lynch (D-Mass.) asked witnesses how to strike a balance between requiring thorough disclosures that help investors without burdening small companies to the point that they avoid public markets altogether. Brown said that public companies should be encouraged to stay with smaller auditors, which could make the market for auditing more competitive.
Rep. French Hill (R-Ark.) asked witnesses for ideas to tailor Sarbanes-Oxley to help companies of different sizes, akin to tailoring bank regulation for firms of different size. Berlau said the SEC could help by narrowing the definition of attestation and allow smaller companies to avoid “full blown audits.”
Rep. Keith Ellison (D-Minn.) said he was skeptical that Sarbanes-Oxley is contributing to the decline in total public companies. Ellison asked if increased numbers of mergers and acquisitions could be contributing more to the decline than regulatory hurdles. Blake said that there is no single cause of the decline in public companies, but noted that Sarbanes-Oxley discourages small companies from going public. Ellison said that may be the case, but that the Act still prevents fraud.
Trends in Public Markets
Huizenga began by discussing the decline in public companies in the U.S., and asked witnesses for their ideas on how to reduce the estimated $2.5 million cost of launching an IPO and the $1.5 million in annual reporting costs for public companies. Farley suggested eliminating the requirement that an independent auditor attest to the internal controls at an issuer, and narrow the definition of “internal controls.” Farley also suggested expanding the availability of certain EGC regulatory exemptions.
Maloney claimed that 74% of the decline in total public companies occurred prior to the passage of Sarbanes-Oxley, that the total number of listed companies has stabilized since 2008, and that the number of foreign companies listing in the U.S. has increased since 2008, positing that perhaps public markets are not in as dire of straights as some witnesses claimed. Maloney asked Brown if the JOBS Act’s private security provisions – such as increasing the threshold for corporate reporting to the SEC from 500 shareholders to 2000 – have contributed to the decline in IPOs. Brown said that there is “no question” that part of the decline in IPOs is due to the vibrancy of private capital markets. Brown noted that accredited investors can now also receive general solicitations, and have reaped many of the gains of the JOBS Act.
Maloney asked Farley to outline the public policy benefits of having more public companies? Farley noted that public companies are important for job creation and benefit retail, not just accredited, investors. Quaadman answered a similar question later, from Rep. Steve Stivers (R-Ohio) and he argued that accredited investors reap the gains of private companies, while retail investors cannot.
Rep. Tom MacArthur (R-N.J.) argued that the “cumulative impact” of regulations is to discourage companies from going public. Rep. Brad Sherman (D-Calif.) rejoined this comment, saying that businesses could be merging at increased levels due to activist investors. Sherman also noted that foreign company registrations in the U.S. have increased while the domestic IPO market has stabilized, indicating the U.S. is not an unattractive destination for listing. He also said that because the JOBS Act made it easier to raise capital in private markets, it could also be discouraging IPOs.
Proxy Advisory Firms
Duffy asked the witnesses if they had concerns about the amount of transparency around proxy advisor firms. Quaadman described Glass-Lewis as “a black box” and said that ISS had serious transparency problems as well. Quaadman also said both firms have major conflicts of interest. Farley said that proxy advisor firms are a major problem for small companies, as errors in proxy advisor opinions can be difficult for small companies to rebut. Quaadman argued that the pecuniary interests of the proxy advisors take precedent over providing advice to their clients, and that many proxy advisor actions end up harming shareholders.
Waters asked Brown if shareholder proposals can have a “significant, positive impact” on corporate governance. Brown defended the practice, saying that shareholder proposals on environmental and social issues receive on average 30% of shareholder votes, indicating serious shareholder interest in these topics.
Hultgren discussed the SEC’s Shareholder Proposal Rule (Rule 14a-8), and asked Quaadman for the U.S. Chamber’s recommendations on changes to Rule 14a-8. Quaadman said that the Chamber would propose a resubmission threshold to prevent repetitive, unpopular shareholder proposals from consuming at annual meetings.
Internal Controls / Section 404
Rep. David Scott (D-Ga.) asked Farley how Section 404 of Sarbanes-Oxley – which requires public companies assess the effectiveness of internal controls – could hurt small and mid-sized companies. Farley said that the time is ripe for reevaluating Section 404, noting that the costs of compliance are high for all companies, but disproportionately borne by small and mid-sized firms. Farley recommended eliminating auditor attestation of internal controls for all companies, and for extending several other perks currently available only to EGCs.
Rep. Jim Himes (D-Conn.) noted that since Sarbanes-Oxley passed, there are far fewer restatements of earnings reports, and asked if this is evidence that Section 404 is working. Brown agreed, saying there used to be hundreds of restatements before the attestation requirements of Sarbanes-Oxley improved reporting. Blake agreed that Section 404 is important, but noted that small companies still face high auditing costs because of it.
Sinema discussed a bill she sponsored – H.R. 1645, the Fostering Innovation Act – which would amend Sarbanes-Oxley to exempt low-revenue issuers from Section 404. Sinema asked if this legislation would help biopharma companies, and Blake said the act would free up money at pre-revenue and low-revenue biopharma firms for research and development.
Rep. Bill Foster (D-Ill.) argued that major cyberattacks can pose material risks to companies and their investors, and noted that many pharmaceutical companies are the targets of cyberattacks designed to steal their intellectual property. Foster asked if the definition of internal controls should include cybersecurity controls. Blake argued that putting that requirement on firms should be contingent on the type of data from individuals they store. Quaadman called for dialogue between all stakeholders on the topic of cybersecurity internal controls, while Farley said he did not support a new mandate for cybersecurity internal controls, but would support more information sharing between companies and regulators.
Rep. Ann Wagner (R-Mo.) said she believes corporate disclosures should cover only material information, and asked witnesses how they would define materiality. Quaadman argued for using the standard set by the Supreme Court in TSC v Northway and criticized the “expanding definitions of materiality” which raise regulatory costs for firms.
For more information on this hearing, please click here.