Trouble often comes in small packages.
The Securities and Exchange Commission's decision late last month to give the smallest public companies more time to comply with the so-called internal-controls rule of Sarbanes-Oxley has got some corporate-governance watchers crying foul.
Their frustration stems from evidence that the tiniest companies are most in need of the strictures in the 2002 law aimed at ensuring that public companies' books and processes are shipshape.
SEC commissioners voted Sept. 21 to give companies with less than $75 million of stock available for investors another year to meet the internal-controls guidelines. Covered under Section 404 of the law, these guidelines compel companies to find and plug holes in their financial-reporting procedures. Most of the smallest public companies will have until early 2008 to comply, a decision that effectively acknowledges widespread complaints from executives that the additional checks required are particularly expensive for small companies. Herbert Wander, co-chair of an SEC advisory committee on small companies, said it's "better to nurture and encourage these companies" rather than place more burdens on them.
Critics of the decision point out that small companies have disproportionately more accounting snafus and SEC actions, and these same companies often end up pointing to weak internal controls. If tiny companies toe the Sarbanes-Oxley line sooner, they say, the problems might be caught sooner. Critics point out that small companies raise money from investors just as larger companies do, so why not hold them to an equal standard?
Despite the headline dominance of Enron Corp. and WorldCom Inc., tiny companies have made up a huge amount of the SEC's caseload. A 1999 survey by the Committee of Sponsoring Organizations of the Treadway Commission -- an alliance of accounting and finance groups, and the very organization that set up the framework for compliance with the internal-control rules -- found that the typical company targeted by an SEC enforcement case was tiny: The median company had $16 million in assets, $13 million in revenue and only $5 million in shareholder equity. The study's authors warned that regulatory focus on larger companies "may fail to target companies with greater risk for financial-statement fraud activities."
Joseph Carcello, a University of Tennessee professor who was one of the authors of the 1999 report, said about 75% of companies that were the subject of fraud allegations described in SEC enforcement releases from 1998 to 2003 had market capitalizations of less than $700 million, and 40% had market capitalizations less than $100 million.
"A good internal-control system within these companies would have prevented a good number of these," said Thomas Weirich, an accounting professor at Central Michigan University.
For restatements, the trend is similar. A survey by proxy-advisory firm Glass Lewis & Co. found that small companies, those with less than $100 million in annual revenue, restated earnings in 2004 at more than twice the rate of the largest companies.
Mr. Ciesielski cites Fountain Powerboat Industries Inc. as an example of why smaller companies shouldn't get more time on internal controls. The Washington, N.C., company, which has about $9 million worth of stock publicly available, said a restatement would erase more than half its originally reported fiscal 2004 income of $1.3 million and affect some 2005 earnings. The boat maker cited "human error, coupled with certain weaknesses in internal controls over financial reporting." A spokeswoman declined further comment.
Another example: Xybernaut Corp. The Fairfax, Va., maker of wearable computers received an SEC subpoena Feb. 1, inquiring about the sale of securities by people identified as selling shareholders in Xybernaut's SEC filings. Xybernaut hired a law firm Feb. 28 to help it conduct an internal investigation of concerns brought to its attention "relating to the internal control environment of the company," among other things. Yet it didn't disclose these developments to investors, or warn that it had weaknesses in its internal controls, until March 31, at which point its stock plummeted. The company has since filed for Chapter 11 bankruptcy protection and has said it is under criminal investigation. A Xybernaut spokesman declined to comment.
There isn't a guarantee that problems like these would have been uncovered earlier if the companies had had to conduct internal-control inspections.
An SEC spokesman declined comment. Mr. Wander said the other corporate-governance reforms in the past few years have mitigated the degree to which fraud is a problem at smaller companies.
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