Regulation and Compliance—JOBS Act Raises Concerns

A bill working its way through Congress is drawing a rare combination of bi-partisan Congressional and Presidential support. The bill also has its share of critics in both the regulatory and investment communities.

Overview
The bill, widely referred to as the JOBS Act, an acronym for “Jumpstart Our Business Startups,” is more formally known as H.R.3606, Reopening American Capital Markets to Emerging Growth Companies Act of 2011.

The bill is intended, among other things, to make it easier for certain small businesses to attract public capital through the initial public offering (IPO) process. This would be accomplished by:

• Allowing qualifying companies to utilize unregulated marketing materials to promote their IPOs;
• Exempting these companies from expensive audits of internal accounting controls for up to five years following an IPO; and
• Enabling these companies to take advantage of Internet “crowd funding” strategies to raise capital from small investors.

The bill also exempts analysts from regulations designed to protect investors from the potential harm associated with conflicts of interests arising when analysts promote IPO stocks underwritten by investment bankers of the same firm or affiliated firms.

Current Status
The US House overwhelmingly passed the measure 390-23 in early March. On March 20, the bill cleared another hurdle when it was fast-tracked for a vote in the US Senate. The White House has said President Barack Obama will sign the legislation.

Controversy
Not surprisingly, regulators and some Democratic lawmakers have come out against the bill for failing to adequately protect investors. SEC Chairman Mary L. Schapiro added her voice to the criticism in a letter sent to leaders of the Senate banking committee.

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“Too often, investors are the target of fraudulent schemes disguised as investment opportunities,” Schapiro wrote. “As you know, if the balance is tipped to the point where investors are not confident that there are appropriate protections, investors will lose confidence in our markets, and capital formation will ultimately be made more difficult and expensive.”

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The SEC highlighted the risks of pre-IPO investments in recent enforcement action, charging that investment managers misled investors trading in shares of Facebook and other technology companies.

On the other hand, the investment and entrepreneurial communities have generally come out in favor of the bill. They point to the need to spur entrepreneurial investment in the current economic environment and the relatively high cost of audits on internal controls of smaller companies. They further argue that a $2 million per-investor cap in connection with the crowd funding provisions goes a long way toward protecting small investors from pre-IPO misrepresentations and hype.

A rare exception to the chorus of support for the bill among investors is Bloomberg news. A recent editorial argues that SEC exemptions for small companies—those with less than $75 million in annual sales—already exist, and that proposed amendments to the bill more reasonably limit the regulatory exemptions to companies with no more than $350 million rather than the bill’s $1 billion in sales. Another amendment supported by Bloomberg would lower the crowd funding cap to $1 million per investor.

Citing an SEC study, Bloomberg also argues that relaxing rules requiring audits of internal controls actually hurts small companies. According to the study, such audits helped companies avoid costly financial restatements, which often drive down share prices.

Finally, Bloomberg points out that recent efforts at deregulation including the 1999 Gramm-Leach-Bliley Act, which ended the Depression-era ban against mixing investment and commercial banking, and the 2000 Commodity Futures Modernization Act, which allowed explosive, but unregulated, growth in over-the-counter derivatives, helped set the stage for the 2008 financial collapse.

Bottom Line
Barring unforeseen circumstances, the bill is likely to pass the Senate within days and be signed into law by the President. Whatever your position on the bill, we can all agree that if investors lose confidence in the market due to pre-IPO hyping, fraudulent accounting, or any other reason, the cost of capital is likely to go up. That’s in no one’s best interest.

Furthermore, if the bill is passed, analysts and investment bankers may find themselves on a short leash as the SEC seeks to accomplish by regulatory oversight what it has not been able to accomplish in Congress—defeat of the JOBS Act.

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