The JOBS Act

Theodore A. PARADISE

As you can see, there are various parts to the Jumpstart Our Business Startups (JOBS) Act. Some parts are designed to help smaller companies complete their initial public offerings (IPO), whereas other parts are designed to help smaller companies with other forms of capital raising such as crowdfunding. Today's audience appears to be interested mostly in the IPO part, so this presentation will focus primarily on how the JOBS Act will help companies conduct IPOs and, from that, whether or not this kind of a concept would benefit Japan can be considered.

In the United States, we have a long tradition of the entrepreneurial spirit, which contrasts that of other parts of the world. As an example, we tend to view companies such as Microsoft, Apple, Google, or Facebook in a very positive light. These kinds of companies are viewed as the future of the United States. Not only can they be successful domestically, but they can also implement their business models effectively on a global scale, which in turn supports the economy. Due to this positive image in the United States, the technology industry is strong not only economically, but also on a political level. Our national government will make efforts to help the technology industry and, more broadly, the kinds of companies which are entrepreneurial. This is an important part of the background as to where the JOBS Act has come from.

Last year, the IPO Task Force, a group consisting of members comprising venture capitalists, executives, public investors, securities lawyers, academicians, and investment bankers, participated in a study of what must be done in the United States in order to help emerging growth companies. This subject was deemed important for two reasons. The first was the decline of the U.S. economy starting in 2007, and so the feeling that economic growth must be stimulated began to strengthen. It became especially important to stimulate new job development. The second reason why the study became important was that the notion of helping to develop the venture capital industry had become significant. In the United States, the majority of new jobs are created by small- or mid-sized companies. This means that in order to stimulate job growth, such companies need to be supported and aided. Small- and mid-sized companies need capital and investments in order to expand and create new jobs; however, capital coming from the venture capital industry had been seriously restricted for a decade. In the 1990s, the United States had a very flourishing venture capital industry; however, in 2001, the Enron scandal caused the government to determine that a stricter control of business was necessary. Congress passed a new legislation called the Sarbanes-Oxley Act (SOX) which included very heavy regulation of financial statements and audits. This in turn caused an unintended consequence of making IPOs a very difficult procedure to undertake. Growing companies found that the expense of doing IPOs was much higher than in the past. With IPOs being difficult and expensive, it became harder for venture capitalist investors to make profit and also harder for companies to advance to the next phase of growth. From the passing of SOX until today, the venture capital industry has been suffering. In comparison to the 1990s, the number of IPOs and the profits of venture capital are perhaps as low as 10% of previous levels.

The IPO Task Force got together to discuss how to deal with such issues and concluded, as a result of its study, that IPOs were suffering from the high cost of regulation and going public. The average cost of going public was found to be $2.5 million, the equivalent of possibly several years' worth of company profits. This cost potentially acted as an obstacle for a company wishing to go or stay public. This study was published last year and was used as the basis for creating the new JOBS Act legislation introduced to Congress. The abbreviated title of the act was chosen because of its politically attractive title, suggesting the potential for the creation of new jobs through this new legislation. Coincidentally, the title is also the same as the surname of Apple's Steve Jobs, who passed away around that time. The death of Steve Jobs created new positive publicity in relation to this legislation, as he was highly respected as an entrepreneur who created a company which grew to be a global leader and large employer in the United States. Those things all came together to create the very attractive political package of the JOBS Act.

The JOBS Act was not seen as being a positive force by everybody. Some people were opposed to it, in particular, the chairman of the Securities and Exchange Commission (SEC), Mary Shapiro. Her reasoning was that if the audit and accounting controls on the IPO company were reduced, the risk of it committing fraud will increase. Other organizations concerned with the financial integrity of public companies were also opposed to the JOBS Act, stating that it would seriously impair investors under the U.S. securities laws. Congress rapidly passed the JOBS Act with almost no debate due to how attractive it seemed. Last year, when the committee was preparing a study to support this new legislation, it also drafted a long list of proposals to include in the legislation. Not all of the items on the list were actually desired. The long list was created to allow for bargaining and negotiation in Congress. However, this legislation was so popular that nobody actually debated any of the proposals. Therefore, all of the proposals in the legislation were accepted.

With regard to the content of the JOBS Act, at its core is the concept of emerging growth companies (EGCs). This term was specifically chosen because it sounds positive and something that should be encouraged, where growth and job creating is taking place. However, the actual definition of an EGC is that of a small company. An EGC refers to a company with less than $1 billion in revenue, and doesn't need to be growing in size to fit the criteria. Japanese and foreign companies wanting to access the U.S. market can possibly do so by taking advantage of the JOBS Act. It may appear unusual that the United States would allow foreign EGCs to create jobs in their own countries through making use of the JOBS Act-supported IPOs. The reason was that it wasn't thought out thoroughly, and a very simple definition of an EGC was created. Potential fraudulent acts from foreign EGCs weren't fully accounted for in Congress. Therefore, a foreign company can take advantage of the JOBS Act to do an IPO in the United States and make use of the benefits which this would bring. At some point, an EGC grows enough to stop being classified as one. There are four criteria used to define this point. If a company exceeds $1 billion in revenue, makes use of the benefits of having the status of an EGC for more than five years, issues a large amount of debt, or becomes larger than $700 million by market capitalization, it will no longer be allowed to be classified as an EGC.

IPO process reforms have created several technical amendments allowing for EGCs to move more smoothly through the process. Companies usually must provide three full years of audited financial statements in IPO registration, though this has been reduced to two years for EGCs. This reduces the expense of producing the audit, opening up more flexibility to go public. Another benefit concerns executive compensation. Even before the collapse of Enron, negative impression existed of management in large companies receiving high salaries, bonuses, and stock options even as their companies were losing money. Therefore, during the 2000s, a series of new restrictions on executive compensation were imposed in the form of disclosure. In other words, companies were expected to provide more detailed information on the financial compensation of executives. Such disclosure requirements are considered as a burden for companies, thus the JOBS Act allows for the omission of selected financial dates for any period prior to the earliest audit period for EGCs, whereas other companies have to provide five years' worth of data. Another reform benefitting EGCs is that, under the JOBS Act, EGCs are now authorized to contact investors prior to the IPO. Previously, it was illegal to contact investors to discuss IPOs prior to filing proper registration statements. This is important in that it allows companies unsure of undergoing an IPO to assess the costs and benefits in advance. Another benefit brought about the JOBS Act is that a company can now file an IPO registration statement and negotiate disclosures in private. There are often cases where a company had made the decision to do an IPO and go public. Completing an IPO can be very time consuming such that by the time it finally goes public, the market has taken a turn for the worse. Withdrawing the application after announcing that your company will go public may hurt business as employees and investors lose faith. This benefit allows for an EGC to file a public registration statement only 21 days prior to formal registration. Therefore, the period of market risk is significantly reduced for those companies. Perhaps the most important part of the JOBS Act is in relation to SOX Section 404. SOX sets a requirement that an outside auditor must audit both the financial statements and internal controls of a company. This places significant responsibility on auditing firms, which in turn puts pressure on companies seeking IPOs to show that their internal controls are adequate. This process is very time-consuming and costly. The JOBS Act allows for EGCs to be exempt from the requirement to provide such audit reports, therefore further simplifying the process of completing an IPO.

Another part of the IPO process which the JOBS Act changes is the IPO research. In the 1990s, a company which wanted to do an IPO would often hire firms based on their equity research analysts. The reason for this was that the equity research analysts could persuade investors to buy shares in a company which is losing money. This created a conflict of interests, as there was an incentive for the equity research analysts to publish favorable research in order to get hired. Such conflict of interests became the subject of prosecutor investigations. As a result, restrictions were put on IPO-related research. Before the JOBS Act, there was a period of more than 10 years in which no equity research was allowed until several weeks after the IPO. This significantly reduced the marketing tools for an IPO. The JOBS Act reverses those conditions back to the same as those of the 1990s for EGCs. Equity research analysts can once again write about and support the marketing of IPO companies. The theory is that those equity research analysts will be able to explain EGCs better to the market so that investors will support growth in the U.S. markets.

There are other provisions of the JOBS Act which relate to capital raising, but are not related to the IPO process or going public. One such is the relaxing of standards for private placement. Most private placements in the United States in growing companies would fall under Rule 144A, or Regulation D under the 1933 Act. Until the JOBS Act came into effect, it was illegal to market private placement by promoting it broadly through newspaper advertisements, seminars open to the public, mass email, and other forms of mass media. The JOBS Act now deems such advertising as legal. Investors will still be restricted to qualified institutional buyers (QIBs) or qualified investors, but marketing can now occur in a much broader sense.

Another exemption which came in to effect through the JOBS Act is that of the private placement platform exemption. The concept is that some companies which don't enjoy strong support from venture capital firms might want to find a better way to market their securities to a broader group of investors. They can now do so through private placement platforms. This is typically an internet-based marketing tool allowing private companies to place their shares privately. Private placement platforms can perform this business without the necessity of becoming registered broker-dealers or being subjected to the heavy burdens of registering with the SEC, net capital requirements, and inspections.

Regulation A offering is another concept which helps companies complete IPOs. Regulation A allows a company to do a small IPO without having to file a registration statement with the SEC. In the past, the maximum size of Regulation A offering was $5 million, however now it is $50 million. This law is not yet in effect and won't be until the SEC adopts new regulations. Those regulations will cover the requirements for a Regulation A IPO. If the SEC adopts strict regulations, there may not be much advantage to proceeding with a Regulation A IPO. However, if they adopt looser regulations, there may be some positive advantages to doing the Regulation A.

The last topic today will be that of crowdfunding. Crowdfunding allows a company to raise up to $1 million every year from investors who put in a small amount of money. It can do this without filing any registration statement with the SEC. A company can also raise money from any source, although the amount which can be received from a single investor is also limited. Therefore, a person of lesser means can only contribute a maximum of $2,000, whereas a person with more savings can contribute up to $100,000 into the company. The money which a person can invest in a company depends on the individual's income and assets. Crowdfunding is a way for smaller companies to solicit a broader group of potential investors to raise money without interference from the SEC. Whether this is a good idea or not is debatable, as it could result in cases of fraud and, in time, the anti-crowdfunding legislation may find its way to Congress. For the time being, this is another new way to raise capital.

ADACHI Toshihisa

This epoch-making legislation was passed on April 5. As mentioned, the venture capital industry in the United States has been suffering from a poor IPO market over the last 10 years. Kate Mitchell led the IPO Task Force very strongly and, in an email, expressed her confidence that a similar process to the JOBS Act could be done in Japan. This was a very encouraging statement. We have to change Japan by means of entrepreneurship and new industry. However, there are many issues which must be resolved in order to do this. One is that of the IPO market. Since 2006 or 2007, the number of IPOs has been decreasing. The peak was in 2000, when 204 were completed. In 2008, only 18 or 19 were completed. One of the reasons why entrepreneurs don't want to go public is the cost and time involved in the process. In particular, internal controls regulated by the SOX law are considered to be a difficult obstacle to overcome for young companies. We must relax or remove this regulation in order to stimulate the growth of new companies, which will eventually lead to the generation of new jobs and industries. Unfortunately, many young entrepreneurs have gone abroad to set up headquarters in other countries due to the difficulty of raising money and the high costs of going public in Japan. An act similar to the JOBS Act could help change the landscape of venture capital and the business industry in Japan.

Q1: Marie Shapiro is concerned that the JOBS Act seriously impairs the protection of investors. Are there concerns in the United States of potential cases of IPO fraud?

Theodore A. PARADISE
Yes, it could be said that the possibility of fraud in the United States is a roller coaster phenomenon. Sometimes when our legislation becomes very relaxed, such as it was in the 1980s and late 1990s, we tend to see increasing cases of fraud. On the other hand, as a result of such frauds, there have been times when a severe counter-reaction has resulted in the law becoming too strict. Examples of this are the effects of the Securities Act of 1933 and SOX, which resulted in a dramatic negative effect on the IPO market. The United States tends to have either too many IPOs and too much fraud, or not enough IPOs and very little fraud, rather than being able to find a good middle area.

Q2: What would be the most effective and beneficial items of the JOBS Act for companies doing business in the United States? What would be the best way to boost a sluggish economy currently facing Japan in terms of security regulations?

Theodore A. PARADISE
Concerning the best way to boost the economy in Japan in terms of security regulations, unfortunately I am not an expert in Japanese law. Therefore, I don't give Japanese law advice to clients. Clients also don't consult me on the procedures of going public in Japan so far as the domestic requirements are concerned. I am not able to give a good perspective on this issue. Regarding beneficial reforms of the JOBS Act for job creation in the United States, the first would be the reduction of cost associated with internal controls. The high internal costs resulting from SOX was the biggest focus of the venture capital industry, which led to the JOBS Act. The second most important benefit would be some of the process-related reforms, in particular, the ability for EGCs to test the waters before committing to an IPO in order to find out the levels of investor interest and valuation. The ability to keep the IPO a secret until just before the IPO process is a third major benefit.

Q3: I would like to ask about the restriction against foreign issuers in terms of the JOBS Act. At this moment, no research about the issuing of foreign companies in the United States using this JOBS Act is being carried out. Perhaps it is anxious about any wrongdoing or fraud being committed by foreign companies in taking advantage of the JOBS Act. What is your personal opinion on the kind of limitations or restrictions that are expected to be placed on foreign issuers in the future?

Theodore A. PARADISE
As you said, it is quite possible that in the future Congress might make some changes in relation to the foreign issuer. However, this is unlikely to happen for a long time. This is partly because it is difficult and time-consuming to get a new law passed in Congress. Also, even without a new law, the SEC has many tools available to fight fraud committed by the foreign issuer doing an IPO in the United States. One example of this is that, last year, the SEC took action against fraudulent IPOs by foreign issuers by requiring them to make the public registration statement filings at least three weeks before the IPO. In the past, most foreign issuers could do confidential filings with the SEC, and there was no need for public registration statement filings until the IPO began. However, some Chinese companies were discovered to be fraudulent post-IPO thanks to whistleblowers. The whistleblowers only came forward after the public filings took place, so the SEC decided to make them take place at an earlier stage so that whistleblowers would have more time to come forward. This in turn would allow for a higher probability of potentially fraudulent IPOs to be stopped in advance.

Another example is the stricter scrutiny of audits by the auditors who are examining those foreign companies. SOX created the Public Company Accounting Oversight Board (PCAOB), which can now inspect every audit firm authorized to audit public or IPO companies. If the SEC pressures the PCAOB to make a stricter audit of overseas audit operations, it will further help to reduce the changes of a fraudulent foreign IPO from being created.

Q4: How much do you expect the actual number of IPOs to increase due to the JOBS Act? Also, are there any debates on policies to help increase the IPOs currently taking place in the United States other than the JOBS Act?

Theodore A. PARADISE
Concerning the number of IPOs following the JOBS Act, it is likely that the number of IPOs will increase based on the reforms. Some companies will probably go public sooner than they had planned. However, the JOBS Act came into effect just as the number of IPOs was falling. When the IPO market recovers, there will be more IPOs in comparison to prior to the JOBS Act. In terms of having something other than the JOBS Act supporting IPOs, there is nothing concrete being debated at the moment. However, if the Republican Party wins the next election, it is likely that more acts like the JOBS Act will be created to reduce the burden on EGCs.

Q5: I have a question about accounting fraud issues. There is always a risk involved in making investments, and fraud is part of this. What is your take on the paranoia of fraud in the United States?

Theodore A. PARADISE
Due to the bubble economy in the 1990s, it was easy for many companies to engage in fraud without being caught. After the market collapsed in the 2000s, many fraudulent companies were exposed, which resulted in SOX. In a way, the economic bubble could be blamed for this. Interestingly, this act also provides protection for whistleblowers, in that a company cannot punish a whistleblower working for them. In 2010, a financial incentive provided by the Dodd-Frank Act was added to compensate whistleblowers for exposing fraud. This should stimulate corporate whistleblowers to come forward more often in the future. Perhaps in the future, there may be too many whistleblowers, resulting social costs, and a policy may be put in place to change this. In the meantime, the current trend is a continuing increase in whistleblower acts.