A bill advertised as creating jobs at small businesses and increasing their access to capital from the public markets would also knock down many of the auditing controls protecting investors.
The so-called JOBS Act has already passed in the House and is making steady progress in the Senate, thanks to bipartisan support from lawmakers in Congress, in addition to the White House. While the bill has a number of positive features that are appealing to both parties, it also contains worrisome provisions that are beginning to raise warning flags from the Securities and Exchange Commission and auditing watchdogs like the Center for Audit Quality.
CAQ executive director Cindy Fornelli commented, “The CAQ is concerned about any attempts to further weaken investor protections in the Sarbanes-Oxley Act and encourages lawmakers to refrain from doing so.”
The Jumpstart Our Business Startups Act would create a category of companies known as “emerging growth companies” that could have annual revenue of up to $1 billion and go public with some key investor protections missing. Instead of three years of audited financial information, they could go public with only two. They would also be exempted from Sarbanes-Oxley rules requiring audits of internal controls.
The $1 billion threshold for an “emerging growth company” is so high that former SEC chief accountant Lynn Turner estimated at a Senate Banking Committee hearing that 98 percent of all IPOs since 1970 would have fit into the category, according to The New York Times.
SEC chair Mary Schapiro has also warned against the weakening of investor protections in the bill (see Senate Fails to Pass Energy Tax Credit Extensions). She is rightly worried that dubious companies could easily get access to the capital markets and leave investors holding the bag when they collapse. Questionable provisions in the bill would allow for so-called “crowdfunding” of companies, allowing them to raise money through social media and over the Web. This could well lead to Internet scams.
“Too often, investors are the target of fraudulent schemes disguised as investment opportunities,” Schapiro wrote, according to the Washington Post. “As you know, if the balance is tipped to the point where investors are not confident that there are appropriate protections, investors will lose confidence in our markets, and capital formation will ultimately be made more difficult and expensive.”
The American Institute of CPAs has also warned about the changes to the Sarbanes-Oxley 404(b) internal control audit requirements in the legislation, noting that under the Dodd-Frank Act of 2010, only companies with a public float of less than $75 million were exempted from the audits. In the JOBS Act, the market capitalization level would rise to $700 million. Emerging growth companies would be exempt from the internal control audits for five years, or until they reached that $700 million market cap.
Ironically, when the bill was introduced last month by House Majority Leader Eric Cantor, R-Va., a fact sheet on his Web site explicitly stated that investors in emerging growth companies would be protected “by requiring the ECGs to provide audited financial statements as well as establishing and maintaining internal controls over financial reporting” (see Congress Cooperates on Small Business Bills).
The legislation actually combines six different bills that had advanced through various House committees last year. The provisions creating the category of emerging growth companies came from a bill introduced by Rep. Stephen Fincher, R-Tenn. However, last September and November, the CAQ and the Council of Institutional Investors wrote to the Republican and Democratic leaders of the House Finance Services Committee cautioning them against the weakening of the SOX internal audit controls. Nevertheless, the bill was approved by the House Financial Services Committee by a vote of 54-1 and has now been included in the larger JOBS Act.
The Council of Institutional Investors more recently has written a letter earlier this month to House Speaker John Boehner, R-Ohio, and House Minority Leader Nancy Pelosi, D-Calif., to urge them away from the weakening of investor protections in the new bill. Another problematic portion of the bill includes limitations on shareholders to voice their collective concerns about executive compensation and "golden parachute" severance packages at emerging growth companies. These would weaken the so-called “say on pay” provisions in the Dodd-Frank Act.
Other provisions would effectively impair the independence of private sector accounting and auditing standard setting, respectively, the CII noted.
“More specifically, Sec. 102(b)(2) would prohibit the independent private sector Financial Accounting Standards Board from exercising their own expert judgment, after a thorough public due process in which the views of investors and other interested parties are solicited and carefully considered, in determining the appropriate effective date for new or revised accounting standards applicable to EGCs,” the CII wrote. “Similarly, Sec. 104 would prohibit the independent private sector Public Company Accounting Oversight Board from exercising their own expert judgment, after a thorough public due process in which the view of investors and other interested parties are solicited and carefully considered, in determining improvements to certain standards applicable to the audits of EGCs.”
The Council noted that its membership “has consistently supported the view that the responsibility to promulgate accounting and auditing standards should reside with independent private sector organizations,” and thus opposes legislative provisions that would “override or unduly interfere with the technical decisions and judgments (including the timing of the implementation of standards) of private sector standard setters.”
The Council pointed to a 2010 joint letter that it wrote with the AICPA, the CAQ, the CFA Institute, Financial Executives International, the Investment Company Institute, and the U.S. Chamber of Commerce, explaining their strong support for the independence of private sector standard setters. The Council also reiterated its objections to the provisions exempting the emerging growth companies from Sarbanes-Oxley audits of internal controls. The Council noted that some of the most knowledgeable and active advocates for small business capital formation have in the past agreed that a company with more than $250 million of public float generally has the resources and infrastructure to comply with existing U.S. securities regulations.
An amendment introduced by Senators Jack Reed, D-R.I., Mary Landrieu, D-La., and Carl Levin, D-Mich., would raise the threshold level for emerging growth companies to those with less than $350 million in gross revenue, and eliminate the House bill’s exemptions from accounting rules, say-on-pay and golden parachute requirements, and executive compensation disclosures.
“We should listen to the American Institute of Certified Public Accountants, which warns us that the House bill ‘would create marketplace and investor confusion’ that dampens, rather than strengthens, investment in growing companies,” Levin said in a speech on the Senate floor on Tuesday. Nevertheless, the amendment was defeated in the Senate on Tuesday in a 55-44 vote, not enough to surpass the 60 votes needed in the Senate nowadays to pass most measures.
The House bill appears to be on a fast track to passage in the Senate. While it’s heartening to see Democrats and Republicans uniting on a measure to promote small business job creation and access to capital, the bill could end up benefiting Wall Street and shady stock promoters more than small businesses, at the expense of the auditing profession and the investing public.