Friday, July 14, 2006

On the Calendar

Smaller companies often get short shrift by legislators and rule makers at both the state and federal level. When it comes to the analysis of important financial issues and the implementation of new legislation or regulation, small companies…well, get overlooked. Nonetheless, 2006 may turn out to be a watershed year for smaller companies. SEC officials have been busy as bees on topics pertinent to smaller companies.

Expansion of the Scaling Concept

The SEC’s Advisory Committee on Smaller Public Companies published its Final Report on April 23, 2006. The Committee was appointed in 2005 to assess the current regulatory system for smaller companies, in particular the impact of Sarbanes-Oxley Act of 2002. Just so you know the Committee made the cut-off for “smaller” at $787 million in market capitalization. Companies falling into this category command only 6% of the total U.S. equity market capitalization but represent 79% of all U.S. public companies.

The Committee had so many suggestions, they divided them into two tiers - primary and secondary - just in case the Commission could not wrap around the whole lot. Indeed, thirty-three recommendations were made in the report, so it is a worthwhile read for any one either running a small public company. At the top of the list is the Committee’s recommendation to establish a scaled or proportional securities regulation system for smaller companies based on a stratification of smaller public companies into two groups, micro-cap and small-cap companies.

If adopted, the scaling concept could have significant ramifications for smaller companies as it would provide relief for Sarbanes-Oxley compliance and that could improve the prospects for profitability for some companies. The American Electronics Association (AeA) reported that SOX has disproportionately impacted smaller companies, with companies under $100 million in annual revenue paying as much as 2.6% of revenue for SOX Section 404 compliance efforts compared to less than 1% by companies over $100 million.

Almost everyone expected first year compliance to carry a hefty price tag to institute new procedures and pay auditors. Unfortunately, second year experiences show that annual SOX compliance costs are likely to remain high. The Committee reported that a study conducted by the largest four audit firms show that total annual costs average $900,000 for public companies in the $75 million to $700 million market capitalization range. During the proposal and debate stage $91,000 was bandied about as the estimated annual cost. Now there is an estimate well off the mark!

For the micro-cap group that has been facing fiscal year 2006 as a deadline for compliance, the Committee's scaling recommendation is encouraging. Given the disproportionate burden that smaller companies face with regard to SOX compliance, a lifting of the onerous compliance mandate should help elevate profitability expectations for some companies by a material amount.

Next Steps

Mid-May 2006 the SEC issued a press release outlining its intentions to makes some improvements in Sarbanes-Oxley. The press release cites the Smaller Company Report among other reports the Commission is reviewing. The Smaller Company Report along with several others noted the need for additional guidance for management on how to complete its assessment of internal controls over financial reporting. The SEC issued a Concept Release this week looking even more comments before issuing any such guidelines. Comments are due around mid-September 2006. In the meantime, the Commission is cutting smaller companies a break by giving non-accelerated filers a short postponement of the effective date for implementing Section 404. Non-accelerated filers must still make the management assessment beginning with fiscal year 2006.

Capital Markets Access

The scaling concept would also open up eligibility for using alternative filing provisions that will improve the prospects for smaller companies in attracting capital. The Committee recommended folding Regulation S-B disclosure accommodations into Regulation S-K. Reg S-B has a negative connotation in some quarters anyway and the consolidation would reduce the complexity of SEC rules.

The Committee also recommended that all reporting companies listed on Nasdaq, the Over-the-Counter Bulletin Board or one of the national exchanges should be eligible to use Form S-3 for registering securities. Form S-3 is a short-form registration statement that makes for a more efficient process through incorporation by reference of information previously filed with the SEC. Using it would decrease an issuer’s costs when issuing new securities.

Small-Cap Research

The Smaller Company Committee also weighed in on research on small-cap companies, noting that business conditions and regulatory actions have served to reduce research budgets in the financial industry. The Committee called for a continuation of current policies that allow for company-sponsored research and permit the use of client commissions to pay for research services, as both are considered important to provide financial support for small-cap research.

A number of new firms have sprung up offering various types of company-sponsored research. My firm offers a Company-sponsored Research Program for companies under a certain size, which meets the Committee’s criteria for full disclosure. I have long hold the view that all companies, large and small, have always “sponsored” research coverage through the conventional “business for coverage” model offered by investment banking and full-service brokerage firms. I discussed the economics of conventional research coverage as well as how soft-dollar payment arrangements have been a key facilitator of brokerage firm research in a market paper entitled “Company-Specific Research: Coverage or Camouflage.” The so-called “soft-dollars” are credits given to money managers by brokerage firms from trading commissions and often used to pay for brokerage as well as third-party research.

Soft-dollar Payments for Research

The Smaller Company Committee is not the only SEC group looking at soft-dollar arrangements. The SEC floated a revised interpretation of Section 28(e) of the 1934 Act - the safe-harbor section which allows money managers to use client funds to purchase “brokerage and research services” - in a communiqué entitled Commission Guidance Regarding Client Commission Practices. Regulators want a clearer view on what is being purchased with soft-dollars generated from trade commissions at brokerage firms. Investors have been increasingly suspicious that more than just research is being purchased - so-called “mixed use” items that can include also sorts of purchases from computer equipment to plane tickets.

Comments on the Section 28(e) proposal, which were due by November 2005, ran the gamut from full support to caustic criticism of the SEC as a spoil sport. The SEC just issued final guidance this week, restricting but not eliminating soft-dollar expenditures. The guidance eliminates payment for computer hardware and mass market publications. Authorities in the United Kingdom already took action on the same matter, moving in January 2005 to require fund managers to break out trading costs from research costs.

The Street, being the forward-looking animal that it is, already anticipated a similar move in the U.S. Fidelity Investments inked new arrangements with Lehman Brothers and Deutsche Bank that separates compensation for trading and research services. Fidelity will pay the two firms a flat fee for research out of its own pocket rather than using client funds.

Finalization of the SEC’s revised guidance gives both fund managers and research providers the certainty needed to continue and perhaps even increase the use of soft-dollars for research payments. The key is documentation and adequate proof that the best price is being paid for both the trading component and the research component. According to Greenwich Associates, during the period the SEC’s revised interpretation has been under discussion, soft-dollar commissions already declined to $970 million in 2005 from $1.5 billion in 2003. I predict resurgence in the soft-dollar spending as brokerage firms improve reporting mechanisms and research packaging concepts that meet the revised guidance. That should bode well for small-cap research in particular.

Regulation SHO

The SEC is hosting a Roundtable in September on the first year of implementation of Regulation SHO, which was intended to eliminate illegal short-selling activity. The SEC staged a pilot study beginning January 2005, during which the price limits to comply with the Tick Test and Bid Test were lifted. Now the Commission is trying to decide whether to permanently remove the price restrictions and is looking for empirical data. The deadline for comments on Regulation SHO Pilot is August 15, 2006. (Cite File Number 4-520.)

We expect the various exchanges (Nasdaq, NYSE, AMEX, CSE and ArcaEx) to have plenty to say, as they form the front line in stopping abusive trading. Regulation SHO requires the self-regulatory agencies to disseminate a daily list of securities for which there has been excessive failures to deliver securities.

Failure to deliver can be for legitimate reason, but often results from “naked” short selling. Smaller companies are particularly susceptible to the manipulative tactics of short-sellers, who often target thinly traded stocks and use chat rooms and other promotion venues to stimulate interest with false, misleading or unfounded information. On the flip side, some promoters use the prospect of a “short squeeze” to engender interest as short-sellers will be forced to cover positions at higher prices. The company is rarely the beneficiary of such tactics.

The calendar is full, but for the small cap company it appears to be “all good.”

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