The crown jewel of the recently passed Jumpstart our Business Startups, or JOBS, Act is the "IPO on-ramp" -- a raft of provisions reducing disclosure and auditing requirements in an effort to make it easier for "emerging growth companies" to raise capital from the public. While this legislation may make it cheaper for many companies to go public, it may also mark a return to the kinds of accounting fraud we have not seen in this country for more than a decade.
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The U.S. has traditionally prided itself on the strict standards to which public companies are held. Many of these rules reflect lessons that regulators learned the hard way, from accounting scandals that rocked the markets in the past. Few of these scandals were more epic in scope, and more influential on regulations, than those that unfolded at energy giant Enron over a decade ago.
In the spring of 2001, Enron, then the nation's seventh largest company, elated investors by reporting $100.8 billion in operating revenue, up from only $13.3 billion for 1996. Just a few months later, the company announced that it would restate its financial statements for the previous four years because it had drastically overstated earnings and failed to disclose billions of dollars in debt. Before the close of 2001, Enron was forced to file for bankruptcy protection and lay off thousands of workers. The price of the company's common stock, which had reached an all-time high that year of more than $90 per share, fell below $1.
Eventually, the public learned that Enron's executives had used manipulative accounting practices in preparing the company's financial statements and that it had pressured its accounting firm, the now-defunct Arthur Andersen, to look the other way.
Arthur Andersen was not the only accounting firm to find itself in the headlines. In fact, a remarkable number of major accounting scandals came to light around the same time, implicating the world's largest accounting firms and leading to the collapse of some of the nation's biggest and best-known public companies, including Adelphia, Tyco and Worldcom. A wave of restatements and government investigations revealed the widespread financial statement fraud that was plaguing companies of all sizes.
Congress responded with the Sarbanes-Oxley Act, which was signed into law in July 2002. SOX, and the Securities and Exchange Commission rules promulgated thereunder, were designed to improve the accuracy and reliability of corporate financial reporting, to protect the interests of workers and shareholders, and to restore investor confidence.
Perhaps most important, SOX created more demanding accounting requirements for public companies and their management. For example, public companies are now required to have audit committees that are independent of management.
A key piece of SOX is Section 404. Under 404(a), the management of a public company must document and evaluate the effectiveness of the company's internal control structure and procedures for financial reporting. Under Section 404(b), in connection with a company's annual Form 10-K filing, an independent auditor must attest to, and report on, management's assessment. At the same time, SOX created the Public Company Accounting Oversight Board to set standards and provide oversight for the auditors of public companies, which were previously self-regulated.
ROLLING BACK SOX?
There can be little doubt that the legislation was very effective in combating accounting fraud. In a recent interview on the tenth anniversary of SOX, its drafters, former U.S. Senator Paul Sarbanes and former U.S. Representative Michael Oxley, highlighted the way the law changed the tone at the top of corporate management, strengthened corporate ethics, and increased transparency and accountability in the financial reporting process. Sarbanes said that, after an initial increase, companies have issued restatements less frequently, and he pointed out that there was very little accounting fraud involved in the most recent financial crisis.
While the costs associated with compliance with SOX have been the subject of intense debate, Oxley noted that the costs of complying with Section 404 have declined over time and that they are offset by the prevention of frauds, emphasizing that what happened at Enron and other companies was far more costly to U.S. capital markets.
This reasoning has not persuaded many corporations, however, who have latched on to the expenses associated with SOX compliance as a reason to roll back the protections embodied in the statute. They pointed to a study by the Staff Office of the Chief Accountant of the SEC concluding that the annual cost of compliance with Section 404(b) for large companies with a public float greater than $700 million is almost $2 million on average, and more than $400,000 for companies with a public float of less than $75 million.
In light of these expenses, a central piece of the JOBS legislation enacted on April 5 of this year is a provision that effectively waives compliance with Section 404(b) of SOX, at least temporarily, for a new class of "emerging growth companies" or EGCs.
Under the JOBS Act, every new issuer qualifies as an EGC until the fifth anniversary of its initial public offering (if its IPO occurred after Dec. 8, 2011) unless the company reaches $1 billion in annual gross revenue or $700 million in public float, or it issues more than $1 billion in non-convertible debt during the previous three-year period.
There is some irony in the notion that, in the wake of a financial crisis fueled by a catastrophic collapse in investor confidence, the best way to goose the lagging economy is to reduce the quality of information available to investors - even if it means reduced regulatory compliance costs for public companies. This course is especially troubling because, by suspending the strong accounting oversight regulations created by Sarbanes-Oxley Section 404(b), legislators may have made it easier for executives at emerging growth companies to follow the same path as their predecessors from the Enron era.
Indeed, this danger appears to be recognized by EGCs themselves. In offering documents filed this year, dozens of companies that intend to take advantage of the reduced JOBS Act reporting and auditing obligations are warning investors that this may amount to a material risk. By the time the next wave of accounting fraud takes flight five years from now, however, it will be too late for many investors.