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JOBS Act May Employ the Unscrupulous

Will less regulation really help companies raise capital? Not if it increases the chances of fraud.

  • Stephen Taub

When President Obama signs into law the JOBS Act sometime in April, it will be a big blow to small investors and opponents of corporate accounting shenanigans — for the bill reads like a full employment act for unscrupulous executives, accountants and others.

Sure, in a recent report to clients, law firm Gibson, Dunn & Crutcher proclaimed the JOBS Act as “the most significant modernization of the federal securities laws since the Securities and Exchange Commission’s 2005 Securities Offering Reform.” The reason for this euphoria: The law firm asserts the new initiative will make it easier for companies to go public, raise private capital to stay private longer, and reduce the cost and burden on newly public companies during their first few years as public companies.

The act creates a new category of publicly held companies called “emerging growth companies.” These companies will then enjoy relaxed financial disclosure requirements. For example, they will be required to provide just two years of audited financial statements when they go public, compared to three years of such statements that are required currently. Also, less financial data will be required in registration statements and in reports filed with the commission. And they needn’t comply with new or revised financial accounting standards or Section 404(b) of the Sarbanes-Oxley Act, which currently requires their auditor to attest to their internal controls over financial reporting, until their revenues top $1 billion. Such companies will also be able to disclose less about their executive compensation. 

While proponents of the bill act like it is the next best thing to repealing Obamacare when it comes to business-friendly actions, it could have the opposite effect of what its proponents expect — by raising instead of lowering the cost of capital for such companies, since their investors face a higher risk of fraud and thus may demand a higher risk premium in terms of equity pricing.

True, less sophisticated individual investors are more likely to invest in the stocks of fledgling and other small companies. Institutions prefer to emphasize companies with larger market capitalizations mostly because their large size makes it harder to make a meaningful investment in a small-cap company without winding up with a large stake. And while institutions are big buyers of IPOs, they are interested only in high profile deals with sweetheart offering prices designed for underwriters’ best clients to feast at the opening.

Small, individual investors generally are only provided access to the IPOs the big boys and girls are not interested in.

But once the smaller investors get burned on the smaller companies, they, too, are likely to steer clear. How likely is that? Historical data consistently reminds us that the smaller the company the more likely they are to commit fraud or require some sort of adjustment, restatement, revision, or some other action that hurts investors. Glass, Lewis & Co., a corporate governance research firm, for example, has found that companies with more than $250 million in market capitalization but less than $1 billion in revenue have accounted for more than 60 percent of all filed restatements in each of the past five years. This group accounted for two thirds of announced restatements in three of the past five years and as much as 84 percent of the total in 2009.

In December 2009 Lord & Benoit, a Sarbox research and compliance firm, published a study of U.S. nonaccelerated filers (companies whose public float was under $75 million) that underwent SOX 404(a) for the first time. The study involved testing and documenting the likelihood of fraud while performing a Sarbanes-Oxley Section 404(a) review of internal controls over financial reporting. None of these companies had complied at that point with SOX 404(b), the part that required auditor attestation.

The study found that every single company in this control group were vulnerable in two or more ways to the embezzlement of internal funds. This included check signing, wire transfers, cash receipts and the use of fictitious employees. The study found that one of these companies exhibited 28 ways of committing fraud.

The study also found that 95.8 percent exhibited the ability to commit fraud through IT operations, 79.2 percent were vulnerable through their financial reporting operations and 100 percent failed to regularly report deficiencies to their audit committee.

Altogether, 1,338 control deficiencies were found, which worked out to 56 per company, on average. The study also reported an average of eight fraud-related instances noted per company.

Also, auditors at 50 percent of the companies expressed doubts about their ability to surive through so-called going concern opinions prior to Sarbanes-Oxley Section 404(a) being enacted. “Since their outside auditors’ report questioned the company’s ability to survive before SOX, one might argue against the theory that some companies left the U.S. market due to ‘costs of compliance,’ the study noted, adding, “These companies exhausted their investors’ resources prior to the Sarbanes-Oxley Act.”

A different study published in 2008 by Lord & Benoit found that that 32 percent of nonaccelerated-filer public companies assessing their internal controls for the first time reported that their controls were ineffective. This was nearly double the number of accelerated filers that made a similar assertion in their first-ever reports four years earlier and about four times greater than those of accelerated filers at the time.

There is another provision in the JOBS Act that will probably impact small investors more than large investors. This is the feature that will allow hedge funds and other alternatives investments to more aggressively market themselves to investors. Why will this impact the little guy more than the large institution?

Because reality tells you that the huge hedge funds are not the ones who will suddenly choose to become transparent and desperately peddle their funds. Rather, it will be the fledgling, smaller funds seeking to grow assets. These are the ones with smaller compliance departments, flimsier investing histories and less attractive credentials among the founding investors and staff.

And remember, while many hedge funds are currently scrambling to register with the SEC thanks to a requirement under Dodd-Frank, those with less than $150 million in assets are exempt.