On July 10, the House Financial Services Committee's Subcommittee on Capital Markets and Government-Sponsored Enterprises, chaired by Scott Garrett, R-N.J., held the second in a series of hearings of indeterminate length on the problems faced by entrepreneurs who are seeking to access the capital markets in order to create jobs.
That's the case as advanced last year by the bipartisan proponents of the Jumpstart Our Business Startups (JOBS) Act. Ironically, the Securities and Exchange Commission (SEC) met on the other side of Capitol Hill to adopt a set of regulations to implement the Act in response to pressure from this subcommittee and from equally zealous backers of the Act in the Senate.
In his opening remarks, Garrett made it clear that the sponsors of the JOBS Act are not satisfied with their handiwork and are looking for new ideas, such as larger tick sizes for the stocks of small companies, establishing a special stock exchange for them and exempting small companies from having to file their financial statements in the XBRL format.
The ranking Democrat, Carolyn Maloney, D-N.Y., whose district encompasses Wall Street, pointed out that U.S. capital markets are far larger than competing foreign markets are, yet small companies have difficulty raising capital. She repeated the mantra that these companies should be enabled to spend more money on their businesses and less on compliance, and she asserted that capital markets run more on trust than on capital (implying that investors should trust companies that lack a culture of compliance and complete and accurate financial disclosure).
The rest of this article will summarize the statements of the witnesses, provide some highlights of the Q&A and conclude with some critical comments.
Raymond Leach, CEO of JumpStart Inc., testified on behalf of the National Venture Capital Association. He repeated the oft-cited stat that 92 percent of jobs created by emerging public companies occur after they go public. He said that after a year, the JOBS Act is starting to show results, but he complained that the growth of high-frequency trading and exchange-traded funds favor large companies and leave small companies without research coverage and promotion.
Kenneth Moch, the CEO of Chimerix Inc. who spoke on behalf the Biotechnology Industry Association, explained that companies in his industry spend about $10 million to go public and are "unencumbered by revenues" for as long as 15 or 20years. Therefore, they consider it a waste of money to have to comply with the internal controls provisions of the Sarbanes-Oxley Act at a cost of $1.5 million, given that the offering may not succeed and that investors care only about the progress of the company's research and development effort and not about the financial statements.
Christopher Nagy, president and founder of KOR Trading, stated that his firm engages in "startup advocacy and consulting." He praised an expansion in the scope of the Small Business Investment Company (SBIC) program of the Small Business Administration to permit funding of companies that have yet to establish profitability, and he also called for protection against patent litigation by requiring plaintiffs to bear the costs.
Wayne Souza, executive vice president of law and corporate secretary at Walton International Group (USA) Inc., represented the Investment Program Association, which is composed of companies that sell real estate investment trusts and oil and gas deals totaling $1 billion to approximately 1.25 million investors who have accounts averaging $30,000. He urged two clarifications of the JOBS Act, one that would exempt materials circulated to accredited investors during the "testing the waters" phase of solicitation and the other that would prohibit the SEC from adding requirements regarding disclosure or content. (Evidently the quality of materials provided by companies that sponsor these deals is an issue.)
Under committee rules, the Democrats are entitled to provide a witness for each panel, and for this hearing it was Robert Thompson, a professor of business law at Georgetown University Law Center. His testimony included data from a study by Latham & Watkins on the different rates at which newly public companies have taken advantage of the five major provisions of the Act.
He stated that the increase in the number of shareholders small public companies may have before they are required to comply fully with SEC disclosure requirements calls for improvement in the ability to maintain data as to who a company's investors are, so the records need to reflect advances in technology of the electronic age in order to track beneficial ownership and not merely street names.
Some of the most telling points were made by Democrats who have deep personal experience with startup companies.
Jim Himes, D-Conn., lamented the fact that since he worked in the industry, fees for initial public offerings (IPOs) have declined only from 7.5 percent to 7 percent, whereas in theory competition and advances in technology should have resulted in a significant reduction in the cost to go public.
He questioned why small companies don't stress this issue more than the cost of Sarbanes-Oxley compliance, given that IPO fees would amount to $14 million, whereas section 404B compliances costs $1.5 million.
The answers from Nagy and Thompson were unconvincing, and Nagy seemed satisfied that, "At the end of the day, the methods are still old."
Bill Foster, D-Ill., a scientist who invested $500 borrowed from family and grew it to a $150 million company, questioned whether general solicitation might not have the effect of recruiting less experienced investors and transferring money from them to more seasoned investors. He stated that he grew his company by bringing in well-informed investors.
He advised that there is little point in seeking the support of traders, because small companies aren't worth their time. Leach insisted that innovative companies require access to public markets in order to grow and create jobs.
In conclusion, from a big-picture standpoint, I have discerned a pattern in the aftermath of the 2008 episode of the ongoing financial crisis of trying to rehabilitate business models that have failed in the past in order to restore the flow of fees, in this case from IPO deals, but also from mortgage securitizations and risky over-the-counter derivatives.
With regard to the IPO market, removal of restrictions on general solicitation could trigger another round of "dot-bomb" offerings hardly a decade after the abuses that led to the enactment of Sarbanes-Oxley.
That is why it is noteworthy that as the SEC voted to implement several provisions of the JOBS Act a year after it was signed, SEC Commissioner Luis Aguilar felt compelled to vote against the rule because it does not provide sufficient protection for investors against fraud. Given that an advisory committee of the SEC itself has raised this concern, that state securities regulators have warned that this is likely to unleash a wave of fraud and that the new Chairman, Mary Jo White, is supposed to have an interest in bolstering the stature of this troubled agency, it is rather amazing that the arguments Aguilar has laid out in such detail and over such a long period of time would not receive more consideration from his colleagues.
Perhaps they believe that Aguilar is not with the program, but perhaps he is right.
The lobbies that are behind the JOBS Act are building a more extensive agenda that contemplates tinkering with the machinery of capital markets by measures like adjusting tick sizes in order to attract promoters and market makers to the stocks of small companies.
Maybe more fundamental changes are needed and more attention needs to be given to the risk that companies that depend more on promotion than on achievement can quickly collapse and leave legions of victims in worse shape than before they decided to speculate in this version of the American Dream.
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