Regulatory Relief for Thieves

One of the most dangerous portions of the JOBS Act is the pass it gives new IPOs on their accounting. For up to five years, companies with $700 million or less in public float and with less than $1 billion in revenue -- so-called emerging growth companies, or EGCs, which make up about 90% of IPOs -- can choose to face lower accounting scrutiny.

Although some of the accounting requirements can be costly for the smallest companies coming public, the costs of non-compliance are high for society at large, as many of these rules were created in the wake of corporate accounting scandals that took down Enron and Arthur Andersen and cost investors billions.

And how many $1 billion businesses really aren't going public because they can't afford to hire an auditor?

Fake numbers
The quality of even "independent" auditors is, all too frequently, laughable. Consider that Groupon (Nasdaq: GRPN  ) , one of 2011's most high-profile public offerings, recently had to reduce its reported revenue by about one-half. The error hadn't been corrected by auditor Ernst &Young (or offering banks Morgan Stanley, Credit Suisse, and Goldman Sachs (NYSE: GS  ) ) until after the IPO that valued the company at $28 billion.

The JOBS Act will worsen these already lax standards. To name a few examples:

First, EGCs will be allowed to submit their IPO filing paperwork confidentially to the SEC in dry runs before the final draft is revealed to the public.

Second, auditors of EGCs will no longer need to affirm that management has effective controls to prevent or catch fraud. A study by The Wall Street Journal and AuditAnalytics.com found that "104 companies that have had issues with their anti-error, anti-fraud procedures ... would have been exempt from auditor scrutiny of those procedures if the JOBS Act had been in effect [since 2004]."

Finally, EGCs will no longer need to present more than two years of audited financial statements. Nor will they need to provide financial data from previous years that would otherwise be "necessary to keep the information from being misleading."

Two years is extraordinarily short period of time for mistakes to go unnoticed or frauds to pass inspections. Years ago, the now-defunct retailer Crazy Eddie easily produced five years of clean results prior to coming public in order to perpetrate a $600 million retail fraud. As Sam Antar, the convicted former CFO, said of the JOBS Act: "It should be called 'The License to Steal Act' ... Criminals are laughing -- they're having a field day."

Fraud and the cost of capital
While these changes may seem academic, the results are most definitely real.

Consider the ongoing collapse in Chinese small caps. Since late 2010, various websites and bloggers have cast doubt on the accounting legitimacy of a number of small Chinese companies listed on U.S. exchanges. The SEC has even launched a probe to investigate whether various Chinese companies have been creating false financial statements while their U.S.-based auditors looked the other way.

It turns out that there probably are a lot of frauds, many of them gaining access to exchanges through the "reverse-merger" loophole that allows companies to avoid listing requirements.

Investors have rightly concluded not only that fraud is rampant, but that it's impossible for outside investors to do auditors' jobs for them. Since no one can easily separate frauds from non-frauds, "potential fraud" has become a risk factor for all Chinese small caps. Many investors now avoid small Chinese companies altogether, from Gushan Environmental (NYSE: GU  ) to China Nepstar Drugstores (NYSE: NPD  ) to Deer Consumer Products (Nasdaq: DEER  ) , while those who stay are only willing to buy shares at absurdly cheap prices.

Sources: S&P Capital IQ and author's calculations.

The result has been $11 billion in lost market value and soaring costs of capital for legitimate companies as well.

So what can the SEC do to protect investors from the worst implications?
We have two recommendations. First, if a company decides to take advantage of the new accounting exemptions in order to raise capital, then that IPO money should go to the company, not to insiders who want to get rid of their shares. Additionally, there should be a rule that says that insiders have to hold onto their shares until at least half a year after the company is subject to normal accounting rules. (This would be similar to how common "lock-up" contracts worked before the JOBS Act was passed). If insiders want to sell, then that company should first get its accounting in order. Second, companies that decide to take advantage of the JOBS Act's accounting exemptions should clearly notify investors that they're doing so at the beginning of financial filings so that investors know what they're buying.

Let the SEC know how you feel about the JOBS Act by following this link. Simply tell them you're an individual investor and feel free to share your concerns or suggestions.

Click here to read how the JOBS Act creates a hedge fund heaven.



Ilan Moscovitz doesn't own shares of any companies mentioned. Motley Fool newsletter services have recommended buying shares of Goldman Sachs. The Motley Fool has a disclosure policy.
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  • Report this Comment On August 14, 2012, at 7:31 PM, NanooGeek wrote:

    Would be interesting to know the status of various lawsuits filed against Carnes (if he is still writing these).

  • Report this Comment On August 14, 2012, at 7:33 PM, NanooGeek wrote:

    Meant to add: Another report by 'Alfred Little' was posted at SeekingAlpha today.

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