Sarbox a Relief for Small Companies: But Unlikely to Stop Outflows from Small-Cap Funds
August 6, 2007
Relaxation of Sarbanes-Oxley audit and reporting rules passed unanimously by the Securities and Exchange Commission last month may address the burdensome compliance costs of the law that companies-especially small ones-complained about, but it probably won't be enough to reverse the small-cap slide.
Since January, small-cap funds, which represent $443 billion under management, have seen $2.5 billion in outflows, according to data from Boston-based Financial Research Corp. Compliance costs are chief among the factors smaller companies-once the market sweethearts-cite for their more recent slump in performance. Year-to-date through Aug. 1, small growth funds have returned 5.85%, whereas large growth funds are up 6.86% and mid-cap growth funds are up 9.9%, according to Morningstar of Chicago.
Commissioners voted unanimously at a July 26th meeting to amend the audit requirements associated with the much-maligned auditor's certification Section 404 of the five-year-old law.
"This is a giant step forward toward a more efficient, effective and appropriate implementation to Section 404," SEC Chairman Christopher Cox said before the vote.
The move swaps Auditing Standard No. 2, which required companies to pay outside auditors to certify all findings internal audits produced, for a more relaxed Auditing Standard No. 5, which scales down the auditors' mandates to a more a-la-carte review, focusing on material controls and items central to the company's business, which can be adjusted according to the size of the company.
Cox lauded the work of the Public Company Accounting Oversight Board, which sets the auditing standards, for its work studying the old guideline and writing the new one. "Small public companies should particularly benefit from the scalability built into the new auditing standard," he said.
The SEC has also commissioned a study to examine the cost to small companies, or those with $75 million or less in market capitalization, of 404 compliance. Since the law was first passed, small companies especially had complained about the burdensome cost and time involved in having an independent auditor conduct the comprehensive review.
Compliance with the Section 404 provisions under the old Auditing Standard No. 2 cost the average company $3.8 million in 2005 alone, according to a survey of 238 members of Financial Executives International, a 1,500 member organization of financial officers. Larger member companies may skew that average, but in a comment letter this year, the industry organization noted that for a small company, even a fraction of that can be a serious burden, borne, in part, by shareholders.
Smaller businesses have been begging for SEC mercy since the law was implemented. Last week, Cox said that another extension for small companies is not out of the question. As of now, small companies will not be required to provide outside audits until 2008. Cox said that may be delayed until 2009.
But it won't be abandoned on his watch. Cox branded exempting small public companies a "mistake."
Because of the 2002 law that came in the wake of accounting scandals at Enron and WorldCom, Cox said, "We can be proud that confidence in our capital markets has been restored."
But not everyone is as convinced that the value of the stock price is outweighed by the costs. The Sarbanes-Oxley rules may have renewed public faith at a time when everyone, from shareholder citizens to the President, was clamoring for tighter oversight. But the good will the law engendered among investors was probably short-lived.
"It's completely non-productive spending," said Bart Geer, lead portfolio manager of Putnam Investments' $3.9 billion Equity Income Fund, of the outside auditing and reporting costs. "There is no benefit to the shareholders and no benefit to the companies," he said.
Although relaxed auditing requirements will deliver some cost savings to small companies' balance sheets, it's unlikely to revive the performance of or restore the flows to small-cap funds any time soon.
"I haven't heard anybody say Hallelujah!'" said Todd Trubey, a small-cap fund analyst with Morningstar.
The requirements represented by Auditing Standard No. 5 will yield savings that Geer, who leads the fundamental analysis of companies filtered though his fund's quantitative screens, characterized as "moderately significant, but not enormous."
If the increased faith in public accounting has helped any sector, it may be the large-cap companies, which got a bad-boy rep after large-scale scandals that set off accounting reforms.
While small-cap funds have slumped, large-cap funds have enjoyed $785 million of inflows in 2007 so far. Flows are an imperfect indicator, as they measure investor actions, which notoriously lag performance. Furthermore, for retail investors especially, large companies signify stability in an otherwise choppy market, Trubey said.
But even size-agnostic managers like Geer say that there's still good value to be had in large-cap land, and certainly more value buys now than five or six years ago, he said.
When it comes to small caps, the options are far fewer, and the relaxed auditing rules are not likely to change that.
"The sense I have gotten is that the regulations still make it less attractive for small firms to come public than was the case pre-Sarbanes-Oxley," Trubey said. Besides discouraging new companies from going public, such challenges have fueled the wave of small companies that have merged, been acquired or delisted, he added.
In a speech he gave before the vote, Cox noted that the SEC is sensitive to concerns about cost to companies and the investors who own them, especially in an increasingly global economy.
"Investors will demand more and more things from SEC regulation," said Cox. "They will want to know that the costs are in line with the benefits."
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