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Considering SOX in Choosing the OTCBB or Frankfurt Exchange

December 4, 2010 Leave a comment

One of the considerations that must be taken into account when deciding on the best facility to go public is the additional administration and cost of complying with the Sarbanes-Oxley Act (SOX) in the U.S. The Sarbanes-Oxley Act of 2002 is legislation enacted in response to the high-profile Enron and WorldCom financial scandals to protect shareholders and the general public from accounting errors and fraudulent practices in the enterprise.

The Sarbanes-Oxley Act, is composed of eleven sections. The 6 main objectives of the Sarbanes-Oxley Act are as follows:

  1. To ensure that auditors remain independent;
  2. Corporations and auditors are accountable to the public for the numbers they publish;
  3. An independent body governs financial reporting processes;
  4. Sufficient measures are in place to deter fraudulent activity;
  5. Financial activities are transparent enough to allow fraud detection to occur;
  6. And if fraud is detected, someone is held responsible.

The 11 Sections of Sarbanes-Oxley are summarized as follows:

Title I – Public Company Accounting Oversight Board

Establishes the Public Company Accounting Oversight Board. As its name implies, the oversight of auditing firms was shifted from self-regulation to PCAOB oversight. Firms that prepare or issue audit reports for publicly traded companies must register with the PCAOB and are subject to inspection. There are currently over 1,800 auditing firms registered. The PCAOB also sets auditing standards, and investigates and disciplines firms not in compliance with the SOX Act.

Title II – Auditor Independence

Serves to limit potential conflicts of interests for auditing firms. For example, it prohibits auditors from performing much more lucrative consulting services for the companies they audit. It also includes requirements for new auditors and audit partner rotations.

Title III – Corporate Responsibility

Focuses on corporate responsibility for a company’s financial reports, and decrees that a company’s audit committee be independent of and oversee the work of its accounting firm. It further requires that corporate officers attest to the integrity of the company’s financial reports. The section also prohibits insider trading during pension fund blackout periods Sarbanes-Oxley.

Title IV – Enhanced Financial Disclosures

Regulates many of the shady accounting practices that led to the downfall of companies like Enron, Adelphia, and WorldCom, such as off-balance sheet transactions, pro forma figures, and personal loans to executives. Section 404 of Title IV is often cited as the most significant aspect of The SOX Act, and as the most costly provision to implement. Section 404 mandates that auditors submit an annual management report that gauges the efficacy of a company’s internal controls, as well as a second report from management and auditors that assesses internal controls over financial reporting.

Title V – Analyst Conflicts of Interest

Outlines the disclosure requirements for securities analysts, who may have conflicts of interest that preclude them from objectively making recommendations to their clients and to the public.

Title VI – Commission Resources and Authority

Gives the SEC the authority to censure stock brokers and advisors or prevent them from engaging in their professions. It also authorizes the courts to restrict the ability of brokers to offer penny stocks.

Title VII – Studies and Reports

Orders the Government Accountability Office to study the consolidation of public accounting firms and the impact these mergers have on the ability of firms to conduct impartial audits, as well as to provide solutions to problems that may emerge in its findings. It also provides for the study of credit rating agencies and investment banks, as well as for the study of securities professionals (including accountants and investment bankers) who have violated Federal securities laws.

Title VIII – Corporate and Criminal Fraud Accountability

Addresses criminal penalties for specific acts of corporate fraud – including destruction, alteration, or falsification of corporate records, and defrauding shareholders – and reviews the Federal sentencing guidelines for obstruction of justice and extensive criminal fraud. It also includes whistleblower protections for employees of publicly traded companies.

Title IX – White Collar Crime Penalty Enhancements

Includes enhanced sentencing guidelines for those that engage in corporate malfeasance and mandates that failure to certify corporate financial reports is a crime. Gives the SEC the authority to seek court freeze of extraordinary payments to directors, partners and other employees.

Title X – Corporate Tax Returns

Dictates that the CEO of a company must sign the company’s Federal income tax return.

Title XI – Corporate Fraud and Accountability

Empowers the SEC to petition a Federal court to freeze payments about to be made to corporate officers, directors, or employees during a fraud or securities violation investigation. In addition, the SEC can prohibit a person from serving as an officer or director of a public company. Sarbanes-Oxley.

OTCBB listed companies must comply with many of the requirements of Sarbanes Oxley rules.   Under SOX, the CEO and CFO of a public corporation are required to personally certify and sign off on the financial statements.  They become personally responsible for the accuracy of the statements and that there are no material errors or materially misleading information contained therein.

One of the most controversial areas has been with Section 404b, which requires companies to assess their own internal controls over financial reporting and to obtain an independent auditor’s assessment regarding the effectiveness of such controls.  In short, this is an extremely onerous undertaking, incurring significant internal and external labor which can be a material disincentive to going public in the U.S. Companies with market capitalizations.  To date, there have been exemptions for smaller cap companies (less than $75 million in market capitalization).

Interestingly, the argument for and against extension of section 404 to smaller cap companies is much like a catch 22 scenario.  It is estimated that over 90% of public companies fall under the small cap exemption for this rule.  It has been argued that these smaller companies are exactly the ones that need better financial controls due to their relative lack of resources and the theoretical risk of fraud given the weaker controls in place.  However, the cost of compliance is truly onerous on smaller companies, especially micro-cap and smaller entities, and they are not in a position to afford compliance easily.

However, there is also limited risk to the public of the negative impact of a massive fraud, as these smaller companies represent only 20% of the total market, therefore limiting the impact of a major fraud, should it occur.

The argument can also be made that the massive frauds that led to SOX in the first place occurred in very large companies, not small cap companies, and were exacerbated by C level executives, if not necessarily directed by them in an overt manner.

Small cap companies are also not under the same level of public scrutiny and pressure to achieve short term results as are larger cap companies – thus reducing the pressure to ‘cook the books’ to meet market expectations.

At Merger Law Associates, our opinion is that these smaller cap companies will be less susceptible to major fraud, as the signing officers are in a better position to know if there is something not quite kosher in their financial statements.  The requirement for them to personally certify the accuracy of the financial statements coupled with the significant penalties should there be material defects in the statements would seem to be enough deterrent to ensure their accuracy.

From the big picture analysis, Merger Law Associates takes the position that choosing the Frankfurt Exchange, which does not require the expensive compliance of SOX is often a better choice for smaller cap companies seeking to go public.

Find out more at our website www.mergerlawassociates.com