4 Really Scary Things About the JOBS Act

Congress and the White House are well on their way to passing a massive bipartisan overhaul of U.S. initial public offerings. The House version of the Jumpstart Our Business Startups Act -- a bill to create more IPOs by weakening accounting standards and other investor protections -- passed 390-23.

The Senate is considering a similar bill tomorrow.

Step 1: Gut investor protections... Step 3: Create eleventy billion jobs.
Justification for the act comes from a statistic by the National Venture Capital Association, which says that for the top IPOs, 92% of jobs were created after the company went public.

Therefore, we need to make it easier for venture capital firms to sell their companies to the public by eliminating rules that protect investors from fraud.

Huh?

If that logic seems fishy to you, you're not alone. Most U.S. Olympic gold medals are won by athletes after they graduate from middle school. But that fact probably has more to do with completing adolescence than it does with gym class.

And, no, reducing middle school teaching standards in order to "limit the burden on gym teachers and middle school athletes" wouldn't produce more high-quality U.S. athletes.

Likewise, gutting investor protections could mean more investors get bilked, but it probably won't do much to increase the quality of public companies.

Which brings us to four really scary things about the JOBS Act:

Every business is a "small business"
Small companies would get a pass on reporting critical information to shareholders for the first five years they're public. But the law defines small companies as anything valued below $700 million and earning less than $1 billion in revenues.

In other words, not small. Roughly 90% of IPOs meet these criteria.

Investors in those companies would look forward to

• The legalization of Wall Street pump-and-dump behavior that was banned after the Enron and WorldCom frauds.
• Less clarity in executive compensation and golden parachute disclosure.
• Weaker auditing standards.

What legitimate reason is there to hide executive compensation from investors who have to pick up the tab? How many $1 billion businesses do we really think aren't going public because they can't afford to hire an independent auditor?

Accounting matters
When investors lose faith in accounting standards, they're less willing to buy stocks. That's one of the reasons why Bank of America (NYSE: BAC) and JPMorgan (NYSE: JPM) can't cheaply raise equity capital. No one knows whether the amounts written down on troubled mortgages, particularly second liens, are reflective of real losses.

But to get a real picture of accounting gone wrong, you have to turn to China, where American investors have been burned by a slew of Chinese small-cap frauds. It's gotten so bad that the market is unable to distinguish the frauds from non-frauds. Investors assume almost everyone's accounting is rotten. (Just one of many examples: On a single day in February 2011, an unknown blogger shaved 10% -- $40 million -- off the value of Yongye International (Nasdaq: YONG), a fertilizer manufacturer that only months later would receive a vote of confidence from Morgan Stanley's due diligence team. Whether deserved in this particular instance or not, that kind of volatility has become the norm in China.)

Needless to say, it's not an environment that's conducive to capital formation. Since November 2010, the median P/E for Chinese stocks fitting the size characteristics of an "emerging growth company" has fallen to an amazing 3.3 times earnings, meaning their cost of equity has ballooned 160% in less than a year and a half. At the same time, larger Chinese companies only lost 12% and the Dow (INDEX: ^DJI) gained 17%.

Today, investors charge these small Chinese companies five times as much for their equity as they charge their U.S. peers, whose accounting they correctly view as more trustworthy. That's not to say this bill would quintuple the cost of capital, but making it easier to defraud the public has consequences beyond the damage it causes small investors.

A bigger Facebook loophole
The bill contains a reasonable provision that would increase the number of investors who can own shares of private companies and exclude employees from the count. But by counting "shareholders of record" instead of "beneficial shareholders," the bill preserves a loophole that companies could potentially use to attract an unlimited number of investors without going public. Last year, Goldman Sachs (NYSE: GS) planned to create a "special purpose vehicle," basically a fund that could pool money from its clients so that they would only count as one shareholder.

The limits on private placements need to count beneficial shareholders. Otherwise, we could see fewer IPOs, as companies raise unlimited funds from investors without actually making proper financial disclosures.

More boiler-room frauds
The bill sets up a new mechanism for "crowd-funding," whereby tiny companies could raise seed money from the public. This could be really cool, or it could be a total disaster. Every investor with an email address knows that penny stock scams are already a huge problem.

Unless there are rules to make sure that crowd-funded companies have to, you know, provide true information about their financial performance to would-be investors, the crowd-funding market would quickly turn into a major racket for pump-and-dump scams instead of a capital source for legitimate enterprises.

The Foolish bottom line
I'm all in favor of streamlining IPOs, but the so-called JOBS Act is pretty scary as it is written.

Although the House has already passed the worst elements of the bill, the Senate is considering the Reed-Landrieu-Levin amendment, which would help clean up most of these problems.

Among other things, the Reed-Landrieu-Levin amendment would make sure investors still get clear executive pay disclosures, reduce the number of companies that get exempted from accounting rules, and help ensure that crowd-funding companies give true information to investors.

They're voting on it tomorrow.

What do you think? You can let your senators know here.

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