Much ink has been spilled bemoaning the gridlock and culture of mistrust between the political parties in Washington. I happen to believe that these concerns are based upon a supreme misunderstanding of just how dangerous our Congress can be when they actually agree on something.
As Exhibit A, I present the bipartisan effort known as the Jumpstart Our Business Startups Act, which conveniently shortens to JOBS Act, even if you ignore the logical impossibility that is "jumpstarting startups."
Other names they might have considered:
- Perhaps Grandma Really Likes Dog Food Act
- SEC Enforcement Division Was Getting Bored Anyway Act
- We Bailed Out Bankers, Now It's the Venture Capitalists' Turn Act
- Why Did We Pass Sarbanes-Oxley Again? Act
Like many highly destructive, extremely stupid things, the JOBS Act comes wrapped in good intentions. In this case, the goal of the act is to create opportunities for American small businesses by making it easier and cheaper for them to access capital, primarily by lowering the barriers for them to become publicly traded entities. This, as the name of the act implies, will spur job growth by making capital formation easier.
Never mind that it won't, and never mind that in order to do so, the JOBS Act essentially rolls back investor protections in a way that has been shown in the past to increase the incidence of securities fraud.
How not to solve a nonexistent problem
You have to understand: As admirers and lifelong students of the stock market, we at The Motley Fool are predisposed to supporting efforts to make it easier for investors to participate in the growth of America's great companies.
And we would not in any way make the case that American regulatory framework is a picture of perfection. The two largest investor protection bills of the last decade, the Sarbanes-Oxley Act (which enhanced accounting, board, and management standards at publicly traded firms) and Dodd-Frank (which created regulatory changes covering capital investment by banks and insurance companies) came on the heels of massive frauds, and as a result made their ways to the president's desk rather hastily. There should be no doubt that a number of the statutes that sprang from these massive pieces of legislation are inhibiting capital formation without actually creating much in the way of additional consumer or investor protection.
But the big-boy way of solving these problems would have been to review and streamline Sarbanes-Oxley and Dodd-Frank, not by slashing investor protection for new and speculative companies, the very segment of the stock market where in the past fraud has been most rampant. It's as if every person who voted for the bill (and President Obama, who signed it) has forgotten how utterly corrupt the initial public offering market became during the tech boom. Go back and look up terms like "laddering" and "spinning" to see how Wall Street artificially propped up newly listed company share prices to guarantee a "successful" IPO. Individual investors bore the ultimate brunt of these overhyped companies, suffering losses in the hundreds of billions.
True to its name, the JOBS Act's premise is that regulation is holding back the American economy, and as proof they point to the large decline in the number of companies that are publicly listed on American exchanges, noting that 90% of job growth occurs after companies go public.
Of course, legislation that seeks to "reopen" American markets raises the question of how closed they are. In 2011, more than 260 companies filed IPOs, raising approximately $36.3 billion. That's less than $140 million per initial public offering, which suggests quite strongly that smaller companies are most certainly not shut out of the American exchanges. Case in point: Pacira Pharmaceuticals (Nasdaq: PCRX ) , which reported less than $15 million in revenue in 2010 and raised $42 million in a March 2011 IPO.
Nor does evidence suggest that speculative companies have been cut off from funding. Adult social networking site FriendFinder (Nasdaq: FFN ) came public in May 2011, raising a little more than $50 million. This company has not shown an annual net profit since 2002, and has fairly static revenue and substantial debt. It joins much more celebrated newly public companies like Groupon (Nasdaq: GRPN ) , Pandora (NYSE: P ) , and Angie's List (Nasdaq: ANGI ) as firms that held successful listings despite rivers of red ink.
To review: 2011 was a huge year for IPOs in number and in dollar amount raised, and some companies were able to go public despite the absence of either a) meaningful revenue, or b) sustained profitability. Sound like a crisis that needs fixing to you?
What our high entry barriers have wrought
Investors have lost billions recently due to a spate of fraud allegations surrounding Chinese companies that listed in the U.S. either by going public directly or through a reverse merger (buying shell companies that have little value other than their stock tickers). A reverse merger allows companies to sidestep the main difficulty of going public: the process of initial disclosure and due diligence conducted by an investment bank.
Additionally, the U.S. Public Company Accounting Oversight Board, or PCAOB, has long had difficulty getting Chinese accounting firms to cooperate with inspections regarding their U.S.-related audit work. The exchanges knew that the auditors with primary responsibility to audit Chinese companies were essentially unsupervised by the PCAOB, yet still allowed hundreds of companies to list.
In November 2011, Democratic Sen. Chuck Schumer of New York drafted a letter detailing the clear and present danger should Chinese auditors refuse to cooperate in PCAOB inspections, and pointed out that the accounting scandals had already cost American investors billions of dollars. Yes, this is one of the men who led the charge to lower the barriers for companies going public on the U.S. exchanges through the JOBS Act.
Going public is supposed to be hard. It wasn't so long ago that the main requirement for a company to make it onto the stock market was to take a word and add ".com" to it. The losses from that experience were in the hundreds of billions of dollars.
There are always paths to improvement for any complex system -- American stock exchanges included. But how quickly this Congress seems to have forgotten why many such regulations were enacted in the first place. (Last year marked the 10-year anniversary of the collapse of Enron.)
Regulations that prevent capital-multiplying companies from going public are bad. Ones that prevent capital-destroying ones from becoming public nuisances are good. No job creation will be generated through the process of socializing capital destruction to the general public at large. In fact, a look at the foreign markets with which we have experience suggests the exact opposite: Investor protection is beneficial for growth and absolutely essential for a healthy capital market.
Capital formation will not come on the same terms or cost for entrepreneurs with durable business ideas, because lower official protection will mean that the investors will demand higher implied returns in order to invest. What the JOBS Act will mean is that investors are liable to be ripped off more. That, in effect, will reduce capital formation, and is why investors demand substantially lower risk premiums to put their money in the U.S. than, say, in Nigeria.
Want to know why the JOBS Act exists?
Which brings me to my key question, the one someone should always ask when non-crisis legislation gets passed through Washington: Who benefits?
Well, outright fraudsters, but I doubt their lobbying group is very good. There is one group that would benefit from lower barriers to companies going public: venture capitalists. According to the Cambridge Associates U.S. Venture Capital Index, the average net returns to limited partners for venture over the last decade has been 2.5% -- worse than bonds, and barely better than a passbook account. Venture capitalist capital-raising has collapsed. What they need, then, are liquidity events -- namely, for their investee companies to either be purchased by a large company, or, even better, for them to go public.
If you need proof, consider this: In March 2011 the Treasury Department convened an IPO task force, which was chaired by Kate Mitchell, who once headed the National Venture Capital Association. You should not be surprised that many of the key elements of the JOBS Act originated as proposals from this task force's report.
The website of House Majority Leader Eric Cantor, R-Va., is a paean to the JOBS Act, stating that it has "broad bipartisan support from Congress, President Obama and successful entrepreneurs like Steve Case, the former Chair and Founder of AOL."
Note that Case's current job isn't listed. He's the chairman of Revolution, a venture capital firm.
But it seems that the JOBS Act is now the law of the land, and will benefit a bunch of folks who may already be wealthy, but are overwhelmingly not you. Such a deal.
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.
To continue learning about the JOBS Act, click here to read about crowdfunding.