Give Smaller Companies a Choice: Solving Sarbanes-Oxley Section 404 Inefficiency

This Note argues that smaller public companies should have the option to opt out of Section 404 of the Sarbanes-Oxley Act of 2002. Optional compliance is economically preferable to the current approach of mandatory compliance. Companies that choose to comply with Section 404 will send a signal to the financial markets that their internal controls meet the high standards Section 404 demands, and investors will reward such companies if they actually value the benefit of that company’s additional controls. Similarly, companies that benefit less from additional internal accounting will be able to avoid Section 404’s high costs. To clarify the economics of this argument, this Note develops a framework that models the choice companies make when Section 404 compliance is optional. Under the proposed system, independent auditors would continue to certify Section 404 compliance, providing clarity and simplicity for investors. This Note also examines the issues of imperfect market information and agency costs, concluding that they are not as problematic as they initially appear, and that they are still preferable to the excessive costs and burdens Section 404 places on smaller public companies. Finally, this Note argues that the Securities and Exchange Commission has the legal authority to adopt optional Section 404 compliance given Sarbanes-Oxley’s text and legislative intent.