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four amended versions that had been submitted to the SEC out of the public eye.
––Easier to “test the waters”
The Jobs Act exempted EGCs from a rule that dates back to 1933, when the Securities Act was passed to bring company fundraising under a regulatory scheme to protect investors, prevent securities fraud, and inform the public. Companies were forbidden to “test the waters,” or approach potential investors without first filing a mandatory registration statement containing essential information for review by the SEC. Although a number of exemptions now exist, this prohibition is still currently enforced for IPO candidates that are not EGCs.
On February 19, however, the SEC formally proposed a rule allowing all companies planning to issue securities to gauge market interest in their offerings by discussing them with qualified institutional buyers and institutional accredited investors before filing a registration statement with the SEC. The proposal triggered a 60-day public comment period before the new rule can be published in the Federal Register.
“Extending the test-the-waters reform to a broader range of issuers is designed to enhance their ability to conduct successful public securities offerings and lower their cost of capital, and ultimately to provide investors with more opportunities to invest in public companies,” said Clayton, the SEC chair, in a statement included in the announcement. “I have seen first-hand how the modernization reforms of the JOBS Act have helped companies and investors. The proposed rules would allow companies to more effectively consult with investors and better identify information that is important to them in advance of a public offering.”
—Looser audit requirements
The JOBS Act allows EGCs to skip a requirement set up by the Sarbanes-Oxley Act of 2002 in the wake of the Enron and WorldCom fraud scandals. Under section 404(b) of the federal law, companies must hire auditors to examine the company’s methods of ensuring that its accounting practices are sound, and that it has procedures to correct mistakes quickly and prevent fraud.
“The data suggest that this exemption is potentially the most important effect” of the JOBS Act, Taylor says. The American Institute of CPAs (AICPA), an association representing the accounting profession, holds that all publicly held companies should comply with section 404(b) without exceptions because it leads to “improved financial reporting and greater transparency.’’
However, the SEC has been mulling proposals to broaden exemptions to the 404(b) requirement for an auditor’s opinion on a company’s assessment of its own internal financial controls. Companies with a market capitalization up to $75 million are already exempt, but raising that cap to $250 million is contemplated, as MarketWatch reported. Some industry advocates also seek the same break for other classes of companies, such as biotechnology firms that went public more than five years ago—losing their EGC status—but still bring in very low revenues.
Why EGCs use the breaks
Research studies indicate that emerging growth companies can reduce the underpricing of their IPO shares if they increase the quality and breadth of their pre-IPO disclosures, according to the 2017 journal article Taylor co-authored with Mary Barth and Wayne Landsman, accounting professors at Stanford University and the University of North Carolina at Chapel Hill, respectively.
“The more transparent you are, the more money you’re able to raise,” Taylor says.
Nevertheless, some EGCs, especially those in competitive tech fields, may take advantage of the JOBS Act’s reporting exemptions to avoid disclosing proprietary information, the research team said.
However, the management teams at some EGCs may prefer reduced disclosures to hide their inside knowledge of a company’s poor performance, or “details of an excessive pay package,” according to the journal article. Managers who hold stock options may also derive a direct financial benefit from the underpricing of their company IPO, if the exercise price of their options is pegged to the offering price per share. Like investors in the IPO shares, managers may count on profiting from a later share price bump in trading. When these are the motivations, company leaders may gain advantages at the expense of other shareholders, the researchers say.
Costs and benefits of the JOBS Act breaks
Taylor challenges the underlying assumption of the JOBS Act—that relaxing the financial reporting rules would spare IPO candidates a substantial extra expense in payments to accountants, auditors, and legal advisors.
He points to a 2017 research study that didn’t support that cost-savings claim in the three-year period after the JOBS Act took effect. “We find no reduction in the direct costs of issuance, accounting, legal, or underwriting fees, for EGC IPOs,” three business school researchers said.
“They’re not saving money,” Taylor says.
On the other hand, he argues, the reporting exemptions create extra costs across the board for investors and asset managers who invest money for others, he says. When information is lacking about a company—such as its financial performance three years back—investment firms will try to ferret out the data themselves so they can reduce risks and try to maximize their returns compared with other asset managers.
This leads to a massive duplication of effort, Taylor says. “They’re not going to share with each other,” he says.
That “deadweight loss’’ across many financial institutions is substantially greater than the cost of requiring the IPO candidate to comply with all the usual disclosure rules, Taylor says. And small investors could be at a disadvantage compared with wealthier individuals who qualify to have their accounts managed by entities such as hedge funds with sophisticated research units, he says. He concludes that little is gained, and much can be lost, by maintaining the disclosure exemptions in the JOBS Act.
“It’s the opposite of evidence-based policy-making, because all the evidence suggests it harms investors,” Taylor says.