The Case Against Exempting Smaller Reporting Companies from Sarbanes-Oxley Section 404: Why Market-Based Solutions are Likely to Harm Ordinary Investors

Section 404 is arguably the most controversial provision of Sarbanes-Oxley (“SOX”). The controversy focuses on whether Section 404’s substantial compliance costs exceed the statute’s benefits, with no consensus on Section 404’s cost-effectiveness. If Section 404 turns out to be cost-ineffective, the companies that are most threatened are smaller companies, as cost-ineffective regulations tend to disproportionately harm smaller companies. This Article considers whether Congress and the SEC should exempt smaller reporting companies from Section 404 compliance, as that would allow for a market-based resolution to the uncertain value of Section 404 for smaller reporting companies. Smaller reporting companies would be relieved from mandatory compliance, but would retain the ability to voluntarily choose to comply with Section 404 if they found it to be cost-effective. Rather than debate the cost-effectiveness of Section 404, Section 404 relief proposals appear to provide a definitive mechanism for answering the cost-benefit question by allowing investors to express their demand (or lack of demand) for the services provided by Section 404 through the price they pay for securities. While empowering smaller reporting companies with such market-based regulatory solutions might seem appealing at first glance, this Article explains why structural factors within the public securities markets for smaller reporting companies will prevent such market-based proposals from accurately determining the net effect of Section 404. Instead, exempting smaller reporting companies from Section 404 is likely to significantly increase the information asymmetry between smaller reporting companies and their investors. This outcome would be particularly problematic since ordinary shareholders (rather than institutional shareholders) are the predominant external shareholders for smaller reporting companies and have historically demonstrated themselves to be vulnerable to just this type of information asymmetry. This Article constructs a model for analyzing the probable impact of granting Section 404 relief to smaller reporting companies and concludes that making Section 404 voluntary for smaller reporting companies would almost certainly guarantee an insufficient amount of investment by those companies in their “internal control over financial reporting” (“ICFR”), with the cost for that insufficient dedication of resources to ICFR being borne primarily and unknowingly by unsophisticated ordinary investors