In a July 28 article titled, “Though Stock Is Publicly Held, Firms Adopt Private Mentality,” the Wall Street Journal wrote, “At a time when tougher corporate-disclosure laws are making life more and more difficult for publicly traded companies, deregistering could become even more attractive. So far this year, the SEC’s database of corporate filings shows that 421 U.S. companies have deregistered — a pace that means last year’s total of 675 likely will be surpassed with ease.”


The process of deregistration — where a company either goes private or moves to an exchange like the Pink Sheets that generally has fewer filing requirements — is likely to reduce the quality and quantity of financial and business information available to shareholders. In the wake of disclosure-focused regulation and legislation, including the SEC Eligibility Rule and the Sarbanes-Oxley Act, the Journal’s readers might well have scratched their heads and asked, “What’s going on? Are we moving forwards or backwards?”


The SEC Eligibility Rule, which aims at shoring up the Over the Counter Bulletin Board (OTCBB), has expanded the financial disclosure required to maintain a corporate listing on the electronic market. Meanwhile, the Sarbanes-Oxley Act, among other requirements, expands the range and depth of financial statements and other disclosure requirements of many publicly held companies and substantially shortens the period for making certain SEC filings. But these steps, aimed at increasing the financial transparency of U.S. companies, could backfire if companies respond by going private instead. In these post-Enron, post-WorldCom times, that would deal a body blow to confidence in capital markets.


What, then, can be done? Wharton accounting professors Brian J. Bushee and Christian Leuz say they have an explanation — and a possible solution.


Bushee and Leuz believe that the costs associated with increased disclosure could be helping drive small-cap and micro-cap firms (generally defined as companies with outstanding shares, or market cap, of less than $200 million) out of the highly regulated markets. In response, says Leuz, regulators may wish to consider establishing multi-tiered equity markets featuring a variety of standards. “The U.S. economy is built on the idea that young and small firms find it easy to raise public equity,” he says. “But I worry that the cost of complying with SEC and other regulations may be too much for some companies to bear and that tough regulation could crowd out new ventures.”


Penny Stock Reform

For many small-cap stocks, January 4, 1999 was a significant date, marking the implementation of the Eligibility Rule for the OTCBB. Established in June 1990, partially in response to the Penny Stock Reform Act of 1990, the Bulletin Board is essentially an electronic quotation medium for small-cap securities not traded on NASDAQ or listed on one of the national exchanges. It is operated and regulated by the National Association of Securities Dealers (NASD), a not-for-profit association of brokers and dealers that is also responsible for the NASDAQ.


Before the passage of the eligibility rule — which was immediately effective for new OTCBB quotations, but provided a phase-in period from July 1999 through June 2000 for existing quoted securities — issuers in the OTC markets did not have to file periodic financial reports with the SEC if they met certain conditions. But in the late 1990s, note the professors, the relatively unregulated environment of the OTCBB was thought to be driving a surge of OTC securities fraud.


In response, after the SEC and the NASD jointly considered improving the disclosure of financial information by OTCBB firms, the eligibility rule was created. Among its other effects, the new rule “implies that OTCBB companies have to file annual reports using Form 10-K as well as quarterly and current reports using Form 10-Q and 8-K, respectively,” note Professors Bushee and Leuz. “Moreover, the filings are made easily accessible through the SEC’s EDGAR database. Thus, the eligibility rule considerably increases mandatory disclosures for firms that were previously not filing with the SEC.”


According to Bushee’s and Leuz’s research, on January 4, 1999, there were 5,613 firms listed on the OTCBB that were subject to the eligibility rule phase-in schedule. By June 2001 (the terminating date under their study) only 1,920, or 34%, still traded on the OTCBB. The majority of firms, almost 59%, were delisted for noncompliance either with the eligibility rule (3,190 during phase-in, 399 after). Even more strikingly, 74% of those that previously did not file with the SEC chose to be delisted from the Bulletin Board, rather than comply with the new filing requirements.


Most of these firms moved to the Pink Sheets of the National Quotations Bureau after they were delisted from the OTCBB. In fact, note the professors, the Pink Sheets doubled its number of quoted securities from around 3,000 to more than 6,000 due to the delistings from the OTCBB.


“The point is that firms always have a way to respond to regulatory changes. For instance, they may decide to stay private if the burden is too high,” says Leuz. He notes that when it comes to regulations, most people “tend to think of large companies like Microsoft and GE. At that level, comprehensive disclosure may be appropriate and may in fact help them raise equity, since it means investors will be assured of access to information. But we need to be careful not to overburden smaller firms with regulations.”


Costs vs. Benefits

Referring specifically to OTCBB firms, the paper notes that, for the vast majority, the costs of mandatory SEC disclosures appear to outweigh the benefits. The writers add that, an important consequence of mandatory SEC disclosures is to push smaller firms with lower outside financing needs into a less regulated market, rather than to compel them to adopt higher disclosure standards.


In line with that reasoning, other observers have suggested that passage of the Sarbanes-Oxley Act has also driven a significant number of smaller companies to flee to the Pink Sheets, or to simply go private. For example, a February 21 letter from the board of the New York Stock Exchange to the SEC noted that the Exchange had received letters from “companies that cite as the basis for delisting the companies’ unwillingness to comply with the proposed provisions of the Sarbanes-Oxley Act.”


While the companies noted in the letter were primarily foreign-issuers and debt-only listed companies, a PricewaterhouseCoopers survey released in July, titled, “Senior Executives Divided on Cost of Complying with Sarbanes-Oxley Act,” reports that executives at smaller companies — defined as firms with total revenues under $1 billion — are more likely to perceive compliance with Sarbanes-Oxley as costly than those at larger companies. According to the report, 58% of small-company executives said compliance was costly, compared to 38% of executives at companies over $1 billion.


“How companies view the added administrative cost of complying with the new law appears to be a function of size and preparedness,” notes Frank Brown, global leader of PricewaterhouseCoopers’ Assurance and Business Advisory Services. “Larger companies with a well-established corporate reporting infrastructure are better able to handle the added certification and disclosure requirements of the new law. For smaller companies, compliance has been more of a burden.”


They tend to be companies like Comtrex Systems (OTC Bulletin Board: COMX), which designs, develops, assembles and markets computer software and electronic terminals for retailers, and had $6.7 million in revenues for the fiscal year ended March 31, 2002. In a June 2003 press release announcing it would deregister, and was likely move to the less-regulated Pink Sheets, the company cited “the expected substantial increase in costs associated with being a public company in light of new regulations promulgated by the SEC under the Sarbanes-Oxley Act of 2002” as one of the reasons for its action.


For Howard Schilit, an analyst and founder of the Center for Financial Research & Analysis, compliance with initiatives like Sarbanes-Oxley “may result in more headaches than it’s worth, and may have pushed some companies over the line.” He adds, though, that perhaps some of these companies “went public during a strong market, but they really should not have done so. Now, as the market cools, their ability to go back to the market for capital is limited, and the cost to remain publicly held may just be too high.”


Meanwhile, Leuz is careful to note that the issue is not too much or too little regulation in general. Instead, he says, “The key problem is that the right amount may differ across firms.” He advises rethinking the current one-size-fits-all approach to regulation, and suggests that the markets may consider establishing exchanges that clearly feature different tiers or levels of disclosure and other standards. They might range, for example, from the high level of the major exchanges, like the NYSE, to a less-regulated environment where “buyer beware” warnings are clearly posted.


“This might strike a balance between the SEC’s job of protecting investors and the desire not to overburden companies with regulations,” he says. “Balancing those needs is the job of regulators and politicians.”