By: Jordan Cafritz
Passed by an overwhelming showing of bipartisan support, the JOBS Act reshapes the IPO process for qualified companies in an attempt to stimulate investment opportunities and to promote job creation. The JOBS Act was the brainchild of the Council on Jobs and Competitiveness, a 27-person group of corporate chairmen and CEOs. The law passed by a 380-41 vote in the House and by a 73-26 vote in the Senate. The law amends the Securities Act of 1933, the Securities Exchange Act of 1934, and the Sarbanes–Oxley Act of 2002, creating a new classification of companies known as Emerging Growth Companies (EGC), that are held to different regulatory standards than larger corporations. Although these new standards may appear beneficial to the company, they significantly reduce certain consumer protection barriers and therefore could negatively impact investors.
The Act is intended to ease the public reporting requirements and lower the regulatory cost of an initial public offering (IPO) for EGCs by removing or reducing certain costs and barriers associated with the IPO process. EGC’s are defined by annual gross revenue of less than $1 billion. All public issuers with revenues of less than $1 billion for its most recently completed fiscal year are capable of claiming EGC status. EGCs wishing to go public will be subject to new standards of regulation, reporting, and guidelines for the period within which they are classified as an EGC. These new standards: remove participation and communication barriers between company officers, investors, and research analysts in the offering process; allow for confidential review for a EGC’s IPO registration statement by the SEC; reduce the financial information needed in an IPO registration statement; and authorizes communication between the EGC and accredited investors to gauge potential interest at an early stage in the IPO process.
As part of the Act, an EGC is exempt from providing an attestation report on its internal controls for financial reporting from its auditors. This requirement, a core piece of the Sarbanes-Oxley Act, has had a cumbersome effect on the desire of smaller companies to go public because of the costly burden of securing and complying with the attestation report. A final, and significant, adjustment created by the JOBS Act is the exemption of EGCs from any new accounting standards or auditing requirements until they are applied universally to those companies not reporting under the SEC regulations (Non-Public Companies).
While these changes may appear to promote the prevalence of IPO’s and therefore stimulate job growth, there are a number of pitfalls worth noting. Typically, a company would be barred from gauging potential interest in a public offering without committing the time and expense necessary to file a registration statement with the SEC, but EGC’s are permitted to discreetly contact the SEC regarding potential IPO filings. This change allows an EGC and the SEC to work out issues relating to an IPO registration statement without public transparency. Although this may seem to promote efficiency by allowing for future completed and mistake free IPO registration statements completed before public consultation, the secrecy of the initial review may result in significant deficiencies being identified by the SEC but not disseminated to the public. Furthermore, the JOBS Act allows EGCs to communicate with Accredited Investors, either before or after filing a registration statement. However, the SEC does not govern these communications and there is no requirement to file these communications. This creates a risk that different investors may receive different or conflicting reports on the EGC’s financial health, posing a risk of faulty or insufficient disclosure.
Additionally, EGCs are only required to include two years of audited financial statements in IPO registration statements instead of the current three-year requirement. Also, the EGC is not required to present selected financial information or any management’s discussion for any period prior to the earliest audited period presented in its IPO registration statement. This time frame is reduced from the typical five-year period generally required under the current rules. Although these changes can be expected to reduce compliance costs for the EGC, the lack of an auditor attestation report and the reduction in reportable information can adversely affect both the EGC and the market in a significant way. These changes will limit the information potential investors have when guiding their decision regarding the EGC. If reduced disclosures affect the marketability and price of the EGC’s securities, the Act may inadvertently promote market inefficiency. Some harmful byproducts of this may result in negatively shaping the level, size, and quality of investment.
In regard to the implementation of new or revised financial accounting standards, EGCs are not subject to such standards until the standards are applied to companies not reporting companies under the Securities Exchange Act. This means that although the EGC is going public, it will still be governed by rules applicable to non-public companies. Permitting EGCs to ignore accounting rules could permit deceitful practices to linger on the balance sheet of an EGC. This worry is also shared in another caveats to the JOBS Act. The JOBS Act also provides that any rules of the Public Company Accounting Oversight Board (“PCAOB”) requiring mandatory audit firm rotation or supplementary information about an audit and an issuer’s financial statements will not apply to an audit of an EGC. Moreover, any additional rules adopted by the PCAOB following the date on which the JOBS Act is enacted will not apply to an EGC unless the SEC determines that such application is necessary for the public interest and has considered the protection of investors and whether the new requirement will promote efficiency, competition and capital formation.
Finally, under the JOBS Act, EGCs and third-party research analysts are exempt from any conflict of interest rules and restrictions on communication between management, research analysts and investment bankers. The SEC had previously banned these “three way” communications in 2005 in order to protect the integrity of analyst’s reports and address conflicts of interest among investment bankers and research analysts selling IPOs. As a result of the Act, Research Analysts will be permitted to publically tout the stock while at the same time participating in meetings with EGCs and investment bankers. The JOBS Act expressly prohibits the SEC and the Financial Industry Regulatory Authority (“FINRA”) from restricting this behavior and publishing research reports during the pendency of the IPO or after the IPO. In this situation, the JOBS Act creates a significant void in restricting conflict of interest between the three parties.
While the meaning behind the JOBS Act was benevolent, it is clear that many of the changes could affect the prevalence of fraud in the business community. SEC Commissioner Luis Aguilar stated of the Act that:
[I]n its current form weakens or eliminates many regulations designed to safeguard investors. I must voice my concerns because as an SEC Commissioner, I cannot sit idly by when I see potential legislation that could harm investors. This bill seems to impose tremendous costs and potential harm on investors with little to no corresponding benefit.
(Public Statement by Commissioner: Investor Protection is Needed for True Capital Formation: Views on the JOBS Act, available at http://www.sec.gov/news/speech/2012/spch031612laa.htm). Despite the imperfect and convoluted nature of America’s regulatory framework, the JOBS Act goes too far in removing a multitude of safeguards that ensured honest reporting of a company’s financial health and investor protection. Because EGCs won’t have to have their internal processes independently verified from before they go public until up to five years after they do so, potential investors will possibly be given a skewed outlook on the stock that could change rapidly once that five year period has ended. Furthermore the repeal of the conflict of interest ban on three-way communications will likely result in a crooked IPO market. Bank analysts will be permitted to talk up certain corporations in an attempt to curry favors and business, while management and their representatives will be permitted to pitch their company without being held liable by the SEC for misrepresentations. The JOBS Act has provided an easier path to an IPO for smaller companies, but the rules and regulations that it supplants may result in causing more harm than benefit to the average investor.
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