The pressure has been coming from all directions—the Congress, the Treasury—indeed, there’s been nary an advisory committee that hasn’t weighed in on this topic: time for the SEC to change the definition of “smaller reporting company.” After all, today is the second birthday for this proposal—has it aged like a fine wine or is it moldy and stinky like an old piece of cheese? The verdict: moldy cheese that made no one happy, but they all ate it anyway.
This morning, the SEC unanimously voted to amend the definition of “smaller reporting company” to allow more companies to take advantage of the scaled disclosures permitted for companies that meet the definition. (Here is the press release.) The amendments raise the SRC cap from “less than $75 million” in public float to “less than $250 million” and include as SRCs companies with less than $100 million in annual revenues if they also have either no public float or, in a change from the proposal, a public float that is less than $700 million. The change was intended to promote capital formation and to reduce compliance costs for small public companies. (The SEC also voted to mandate Inline XBRL and to propose a number of changes to the whistleblower program, but those will be covered in subsequent posts.)
The SEC staff estimated that, under the new definition, 966 additional companies will be eligible for SRC status in the first year, including “779 companies with a public float of $75 million or more and less than $250 million; 161 companies with a public float of $250 million or more and less than $700 million and revenues of less than $100 million; and 26 companies with no public float and revenues of $50 million or more and less than $100 million.” The change to the SRC definition was recommended in a Treasury report, as well as by numerous advisory groups, all of which have been clamoring relentlessly for relief from the burdens of disclosure and other regulation for smaller public companies. (See this PubCo post, this PubCo post, and this PubCo post.)
Smaller reporting companies are allowed to comply with the SEC’s disclosures requirements on a scaled item-by-item basis, and may, for example, omit some disclosures that many view as fairly onerous, including several of the otherwise required compensation tables, CD&A and, da DAH, the pay-ratio disclosure. In addition, SRCs may be slow-walked into new requirements with extended phase-ins (e.g., the limited conflict minerals disclosure phase-in and proposed pay-for-performance disclosure rules discussed in this PubCo post). Notably, there are some requirements in S-K Item 404 that are more rigorous, and SRCs must comply with those requirements.
Under current rules, a registrant qualifies as a smaller reporting company if it has either (1) less than $75 million in public float as of the last business day of its most recently completed second fiscal quarter or (2) no public float (e.g., because it has no public equity outstanding or no market price exists for its equity) and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available. Smaller reporting company status is determined annually.
Under the new definition, the cap to qualify as a smaller reporting company would be raised to “less than $250 million” in public float. In addition, a registrant with no public float or a public float less than $700 million could qualify as a smaller reporting company if it had annual revenues of less than $100 million during its most recently completed fiscal year.
Under the new definition, a registrant that determines that it does not qualify as a smaller reporting company would remain unqualified until it hit caps set at 80% of the initial qualification caps, i.e., until it determines that its public float is less than $200 million or, under the revenue test, until it had annual revenues of less than $80 million during its previous fiscal year, if it previously had $100 million or more of annual revenues, and less than $560 million of public float, if it previously had $700 million or more of public float. This structure is designed to avoid situations in which companies enter and exit smaller reporting company status due to small fluctuations in their public float or revenues.
The final rules also include amendments related to financial statements of acquired businesses. Rule 3-05(b)(2)(iv) of Reg S-X is being amended to increase the net revenue cap from $50 million to $100 million, allowing companies to omit financial statements of businesses acquired or to be acquired for the earliest of the three fiscal years otherwise required by Rule 3-05 if the net revenues of that business are less than $100 million.
There are also conforming amendments to the definition in Rule 12b-2 of “accelerated filer” to provide that, even though they might qualify as SRCs, companies with $75 million or more of public float would remain subject to the “accelerated filer” requirements, including the accelerated timing of filing of periodic reports and the requirement to provide a SOX 404(b) auditor’s internal control attestation. Chair Clayton did, however, direct the staff to formulate recommendations “for possible additional changes to the ‘accelerated filer’ definition that, if adopted, would have the effect of reducing the number of companies that qualify as accelerated filers in order to promote capital formation by reducing compliance costs for those companies, while maintaining appropriate investor protections.”
(The following is based solely on notes, so standard caveats apply.)
And here’s where the moldy, stinky part comes in: none of the Commissioners seemed to view the change to the SRC definition as particularly consequential on its own and, none was happy, except probably the Chair, with the Solomonic decision regarding the “accelerated filer” definition. (See this PubCo post.) Commissioner Stein was not confident that the rule change would accomplish its goal and thought it could actually lead to higher costs of capital because of the reduction in disclosure. In essence, she did not believe that the number selected as the new cap had been adequately studied to be sure that it was the smallest increase needed to achieve the goal. In addition, she contended, it had not been shown that the regulatory burden at which the rule was directed actually discourages capital formation (see, e.g., this PubCo post); however, she maintained, it has been shown that investors apply a discount where companies provide reduced disclosure. The rules, she argued, should be data driven, but these changes are not. Moreover, the Chair’s direction to provide recommendations regarding the accelerated filer definition and potential reduction in the number of companies subject to SOX 404(b) was especially troubling. She viewed SOX 404(b) as a critical investor protection, noting the 2011 staff study that found no evidence that the savings from a reduced application of SOX 404(b) would justify the loss of investor protection. For example, she pointed out, the evidence showed that companies subject to 404(b) had a lower rate of financial restatement and lower cost of capital as a result of increased investor confidence. Her preference was for a concept release to consider various views on the issue of SOX 404(b) instead of moving directly to a proposal. Nevertheless, she supported the proposal because SRCs have choices about the level of disclosure they can provide. She also welcomed a staff study of the results. (For a discussion of the pros and cons related to SOX 404(b), see this PubCo post.)
Commissioner Jackson likewise found the rule change generally unobjectionable, but took issue with the underlying message that cutting red tape would promote capital formation. Rather, he contended that there was no basis for that view. Instead, the evidence supported the conclusion that reductions in regulation can increase the cost of capital. In particular, he pointed out that prior efforts to reduce regulation did not result in the predicted “torrent of IPOs.” In addition, the evidence showed that reductions of regulation make it harder for retail investors to participate. He argued that the data showed that the potential changes to the accelerated filer definition would likely be bad policy, pointing again to the staff’s 2011 study.
In his last open meeting appearance, Commission Piwowar was “disappointed” with the action to be taken, but for the opposite reason: he didn’t think it would accomplish much without a contemporaneous change to the accelerated filer definition to limit the application of SOX 404(b)—without that change, the new rules were like “a sidecar without a motorcycle.” He could foresee only modest effects from the rule change (compliance cost savings) but little effect on capital formation. Nevertheless, he saw no harm to it, and so he supported the proposal.
Commissioner Peirce (apparently pronounced “purse”) also voted in favor, but agreed with Commissioner Piwowar that this change to the SRC definition was just a “cautious prelude,” and not enough on its own to have a significant effect on the number of smaller companies accessing the public markets. Also, she believed that the change, without a comparable change to the accelerated filer definition to better align the definitions, could be confusing to registrants. In her view, the real change would come when the SEC tackled 404(b).