JOBS Act Inspires Criticism of Regulatory and Governance Rollback

The newest members of Corporate America will now have five years to avoid the corporate governance requirements that have become standard fare for their older siblings over the last 10 years.

External auditor's review of internal controls? Gone. Shareholder votes on executive pay packages? Nope. Three years of audited financial statements to file for an initial public offering? Make it two.

All those governance requirements and more will be on hold for the first five years of a newly public company's life thanks to the JOBS Act passed by Congress last week, assuming the House of Representatives approves a Senate amendment. The bill is meant to give companies an easier time to go public. In reality, many say, it will do far more to harm investors than to create jobs.

Rushed through the Senate in near-emergency fashion in recent weeks, the Jumpstart Our Business Startups Act creates a new category of “emerging growth company” exempt from numerous regulatory provisions, including the notorious Section 404(b) of the Sarbanes-Oxley Act, an external auditor's review of internal control.

The law defines an emerging growth company is one with less than $1 billion in revenue or less than $700 million in market capitalization. “EGCs” would be exempt from various SOX and Dodd-Frank Act compliance mandates for five years, or until they lose their EGC status. The law even exempts EGCs from requirements that don't yet exist, such as possible mandatory auditor rotation rules and other auditor requirements that are being studied by the Public Company Accounting Oversight Board.

Critics say the legislation guts hard-won investor protections. “I'm really concerned about the notion that we should have less regulations, especially since it was less regulation that put us in the spot we are in right now,” says Jim Houser, a small-business owner who is part of the Main Street Alliance that lobbied against the bill. “It's like you bring in your pick-up truck for scheduled maintenance, and I'm not going to tell you what I'm doing or about the parts or labor,” added Houser, who owns Hawthorne Auto Clinic in Portland, Ore. Houser questions whether the bill will have the effect suggested by its name. “I hire people when I have more customers,” he says. “I can't see any evidence that regulations have any impact on job creation.”

The law also relaxes solicitation of accredited investors so emerging companies can  appeal directly to more sophisticated investors, and it permits a method of Internet-based investing called “crowdfunding,” where entrepreneurs will be able to pitch virtually anyone through Websites and social media.

Crowdfunding will work somewhat like Groupon, where the deal doesn't happen unless the entrepreneur reaches a minimum capital target. The company can raise up to $2 million through crowdfunding, and investors are limited to contributing no more than $10,000 or 10 percent of their annual income. Further provisions of the new law include raising the limit on Regulation A securities offerings from $5 million to $50 million, and raising the minimum shareholder threshold that triggers public reporting from 500 to 2,000 shareholders—which would help companies like Faceboook and Twitter that are not public, but have a growing share base of employees and insiders.

Groups like the U.S. Chamber of Commerce, the American Bankers Association, the National Venture Capital Association, and the major stock exchanges all applaud the bill as a way to stimulate economic growth and create jobs. The legislation “allows these promising companies to continue on their growth trajectories, further develop their products and services, and hire more employees without compromising investor protection—all at no additional cost to taxpayers,” NVCA chairman Paul Maeder said in a statement.

Securities regulators and investor advocates, however, are dumbfounded. Former and current members of the Securities and Exchange Commission, the Council of Institutional Investors, the Consumer Federation of America, and many more lobbied Congress at least to relax investor protections rather than abolish them outright, yet Senate amendments meant to address concerns about investor protections failed to get the 60 votes necessary to survive.

“There are a lot of claims about why it is that start-up firms are not doing well attracting capital. Very few claims by economists fault regulation as a significant cause here.”

—Robert Hockett,

Law Professor,

Cornell

Lynn Turner, former chief accountant for the SEC and a staunch investor activist, says that while the raising of capital could be improved—giving investors a path via the Internet that works around Wall Street fees, for example—the JOBS Act goes to an anti-investor extreme. “With securities fraud running at a record level and having just gone through a dire financial market collapse, any reasonable person would understand there needs to be adequate protection of investors,” he says.

For a capital markets adviser like David Weild of Grant Thornton, the adrenalin is already flowing over new capital-raising possibilities created by the legislation. “Before the dot-com bubble, we were doing 520 IPOs a year,” he says. “Since then, we've done an average of 128 a year. But if you look at our [gross domestic product] rate, we should be doing on order of 950 a year. That's the problem right there,” he says.

Downside Risks

Still, Weild acknowledges that some provisions about investor protection and auditing standards leave accountants uneasy. “But that may not be the bigger problem from the perspective of capital formation,” he says. “The bigger problem is a lack of economic incentive to support companies once they become public.”

Sherwood Neiss and Jason Best are entrepreneurs who helped develop the crowdfunding framework and propose it on behalf of the Small Business & Entrepreneurship Council. They say the JOBS Act in general, and crowdfunding in particular, are critical to restart the pipeline for initial public offerings. “Before the 2008 financial meltdown, entrepreneurs were able to grow their businesses and create jobs,” says Neiss. “After the meltdown, we're not able to do the same thing. Credit is gone. We try using credit cards and home equity lines, but all the traditional means of starting up have disappeared.”

ABA'S VIEWS ON JOBS ACT

Below is a letter from the American Bankers Association to the United States Senate regarding the JOBS Act.

On behalf of the members of the American Bankers Association (ABA), I am writing to share our views on H.R. 3606, the Jumpstart Our Business Startups (JOBS) Act, a package of bills designed to help small businesses create jobs. H.R. 3606 is scheduled for Senate floor consideration on Tuesday, March 20, 2012, and we urge passage of the legislation.

We are pleased that the legislation includes a provision to raise the shareholder threshold for Securities and Exchange Commission (SEC) registration for financial institutions, from the current 500 shareholders to 2,000 shareholders, a change that ABA and community bankers have long advocated. This change would enable community based banks to deploy their capital in lending, rather than spending it on regulatory requirements that provide little incremental benefit to the banks, shareholders, or the public.

Many community banks have had to deal with the 500-shareholder rule, which has remained in place for over 40 years without being updated, and which causes small, local banks to be subject to the same costly reporting requirements as large public firms. Many banks that are nearing the 500-shareholder threshold have limited sources from which to raise the capital necessary to meet the credit needs of their communities without increasing the number of shareholders and triggering registration with the SEC. Once registered as public companies, community banks then become subject to additional regulation and disproportionately high financial and opportunity costs when compared to other smaller public companies. Community banks are already subject to comprehensive supervision by banking regulators. SEC Chairman Shapiro agreed—in a recent letter to the Senate—that “different treatment may be appropriate for community banks that are subject to an extensive reporting and regulatory regime.” Additional requirements and costs will only further eat into capital and limit banks' ability to make loans in their communities.

The legislation also would address the threshold for deregistration, which can occur when the number of shareholders decreases and once-public businesses can become private. Raising the threshold for deregistration from the current 300 shareholders to 1,200 makes a lot of sense from a business and corporate governance perspective.

We urge the Senate to reject a substitute amendment being offered by Senator Jack Reed (D-RI). The Reed amendment falls well short of the shareholder threshold provisions included in the underlying legislation. The Reed amendment only raises the registration threshold to 750 shareholders and does nothing to address the threshold for deregistration. This provision does little to help community banks and we strongly urge the Senate to reject this amendment.

In addition, the JOBS Act includes several provisions designed to help the economy and spur job creation. Although these bills are not specifically focused on financial institutions, we believe these are thoughtful pieces of legislation and encourage Senate passage.

Source: American Bankers Association.

Best says crowdfunding will let nascent businesses get off the ground, which will then show larger investors that the business is worth more serious support. “This will solve the problem of that $20,000 or $50,000 that most entrepreneurs are looking for,” he says. “It's an opportunity to get the capital they need to grow.”

Robert Hockett, a law professor at Cornell University, agrees the premise for the bill -- that relaxing regulation will create jobs -- is sketchy. “That's an empirical premise, and it requires careful empirical investigation to determine if it's true,” he says. “There are a lot of claims about why it is that startup firms aren't doing well attracting capital. Very few claims by economists fault regulation as a significant cause here.”

Investor advocates have harped that the legislation could backfire, give investors even less confidence in markets, and harm small companies as they close their checkbooks. “This might make it even harder for small companies to grow and might cause them to disemploy even more people,” Hockett says. “That's a pretty high-risk proposition.”

David Millard, a partner at the law firm Barnes & Thornburg, supports measures to ease capital formation for smaller companies, but admits he has his reservations about weakening investor protections. Current rules that prohibit companies from soliciting investors directly have outlived their time, he says, and SOX and Dodd-Frank have all but eliminated small IPOs from the pipeline. But, he says, “There needs to be some proxy for investors, so we don't put Main Street America in jeopardy again. It's a balancing of regulation and the negative economic effects.”

Another proponent of the capital formation potential of the new legislation, William Mower, a partner with law firm Maslon Edelman Borman & Brand, believes the benefits outweigh the risks. “If you add up all the losses from all the small-company frauds in the history of our capital markets, it wouldn't add up to one big fraud like we've seen in recent years,” he says. “Are we spending too much to protect the little stuff? One of these little guys could become a big company.”