The recently passed Jumpstart Our Business Startups ("JOBS 2012") Act had the laudable goal of giving small companies easier passage to IPOs, but it did so by unwinding some Sarbanes-Oxley protections and permitting a new method of financing called crowd-funding.
Did it introduce unnecessary risks for investors in the process? Only time will tell. What is certain is that when risk increases, we in the insurance field tend to take note.
The rationale behind the loosening of the rules is that it will now be easier for small companies (with revenues less than one billion dollars) to raise funds in the capital market. Officers of startups, or "emerging growth companies" as defined by the act, and the management of financial institutions involved in the underwriting of such companies may be facing greater risks.
Managers of companies that take funds from smaller and potentially less sophisticated investors but are not required to disclose the same level of information as required under Sarbanes-Oxley may be more likely to become the subject of shareholder lawsuits.
Why loosen these rules, and why now? By making it less burdensome for companies to raise funds in the capital markets it is thought that these emerging growth companies will be able to expand more quickly and hire more staff. Whether the act will succeed in this goal will only be determined long after the November elections are over and both political parties have claimed credit for taking steps to ease unemployment.
The law unwinds a number of provisions introduced by 2002's Sarbanes-Oxley Act. It reduces the disclosure requirements for companies seeking to launch IPOs and removes some of the restrictions placed on underwriters offering analyst coverage of startups and their stock. The new law also introduces a new fund raising process called "crowd-funding" that will allow start-ups to attract small investors through online sites and social media. These are all measures reasonably likely to improve the chances of a small company or "emerging growth company," defined by the act as having less than $1 billion in revenue, successfully raising funds in the capital market. But these measures may come at a cost.
Securities regulation in this country has always had two guiding principles: 1) Disclose all relevant information and let sophisticated investors decide for themselves; and 2) Protect the little guy. Crowd-funding in particular, while appealing to our internet sensibilities, may be inviting the uninformed public to gamble on startup securities. Insurers of directors and officers of both startups, and their underwriters, may be wary that while new securities regulation could allow reduced disclosure and smaller investments, the legislation does not prevent a potential increase in shareholder suits. Will the act create more Jobs? And when? Is the increase in risk worth it?
To answer that last question we need to look at the most obvious impacts. We begin with disclosure. The amount of disclosure required under current regulation prior to a small company launching an IPO can be truly onerous. Often management of capital-hungry start-ups will seek non-public sources of seed capital, even if more expensive, simply to avoid the stringent disclosure demands associated with public subscription. There is no doubt that less disclosure will make the process of raising funds easier for start-ups. However, if you are on the board of directors of an emerging growth company, you may want to make sure the company has adequately insured its directors and officers and you will certainly want to remain particularly diligent at critical board meetings.
Next is research. Sarbanes-Oxley placed constraints on underwriters issuing research and recommendations on start-ups. So for the last decade start-ups have also been hampered by the constraints on underwriters’ ability to offer research on companies that they are seeking to underwrite. JOBS 2012 allows securities underwriters for emerging growth companies at least, to call on potential IPO customers marketing their underwriting services while also issuing analysis of the company. There is a potential conflict when a bank is allowed to sell investment banking services to a company while also assessing the worth of that company's stock. This potential conflict should be apparent to regulators and the market in general -there have been number of high profile incidents involving flagrant conflicts. (One analyst, later banned from the securities industry, gave a favorable assessment of a stock in order to get his children into private school.)
These new research regulations create risk. Justifiable risk? Maybe, if it stimulates the IPO market in the manner hoped. Yet another, newer, potential risk is introduced by JOBS 2012 — "crowd-funding." The concept behind crowd-funding runs counter to all that the securities code has instilled over the last 80 years — that protection of the little guy. The theory behind allowing "crowds" to invest is that the amounts are so small that no one investor can be injured too seriously. The act limits annual fund-raising to $1 million and individual investors may not invest more than the greater of $2,000 or 5% of their annual income or net worth. Limiting the amount one person may lose certainly reduces that individual's risk. However, endorsing a system of online fund-raising with less disclosure may create an incredible opportunity for fraud.
Reduced disclosure, conflicted research and social network fund-raising? We are introducing a lot of risk. I hope it's worth it.
Richard Magrann-Wells is a senior vice president and the financial services consulting practice leader for Willis North America.