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Justin Fox is editorial director of the Harvard Business Review Group and author of The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.
The Jumpstart Our Business Startups (JOBS) Act, whatever its eventual impact on entrepreneurship and economic growth, has already accomplished some remarkable things. For one, it temporarily healed the deep political divide in Washington, bringing together overwhelming bipartisan majorities of 380 votes in the House of Representatives and 73 in the Senate. For another, it has united the nation's financial journalists in tut-tutting disapproval. And the most amazing thing is that in this case the members of Congress appear to have slightly better arguments on their side than the journalists.
The argument for the legislation is that the number of companies going public has fallen dramatically over the past decade, and the cost of complying with disclosure rules, especially those imposed by the Sarbanes-Oxley Act of 2002, is part of the problem. Exempt smaller companies from most of those requirements, and enable a new "crowdfunding" model that allows firms to bypass traditional channels and raise money online, and you get more fast-growing young companies, the reasoning goes.
The argument against the legislation is basically that, as Andrew Ross Sorkin put it in The New York Times, it "dismantles some of the most basic protections for the most susceptible investors apt to be drawn into get-rich-quick scams and too-good-to-be-true investment 'opportunities.' " He cites in particular the case of Groupon, which announced a downward restatement of its earnings Friday. Given Groupon's past history of inventive accounting, this should have been a shock to no one, but if it had been able to go public under the JOBS Act rules, Sorkin hypothesizes, it might have been able to cover that up.
My initial impression is that both the pro- and anti-JOBS Act arguments might be getting some things backwards. That's because increased disclosure generally leads to higher stock prices — and thus more capital — for listed companies. Yet I doubt it does much of anything to protect the most gullible investors.
The Sarbanes-Oxley Act was the last big attempt to improve financial disclosure. Companies were required to certify their financial statements, follow new rules in reporting pro-forma earnings and off-balance sheet transactions, and issue voluminous reports on their internal financial controls. The accounting firms that audit financial statements were subjected to tougher conflict-of-interest rules and oversight by a new federal agency. I had gotten the impression that most of the Sarbox rules were meaningless busy work, but an informal examination of recent research on the subject (I went to ssrn.com and searched on "sarbanes-oxley") reveals that audit opinions and financial statements contain more information than they did before, and that this has brought more efficient markets, better internal governance, and higher valuations for IPOs. This did come at a significant cost in legal and accounting fees that weigh heaviest on smaller companies trying to go public — offering some backup for the JOBS Act. But the general message is that the more information companies share with investors, and the more honestly they do it, the better off they are. And since many corporate executives seem congenitally incapable of learning this lesson, there's a place for regulations that push them toward more disclosure.
Such regulations, if they succeed in increasing the information flow between managements and markets, are also good news for investors in general. But it's highly doubtful they'll do anything to protect the gullible. The only real way to protect the "most susceptible investors" Sorkin is talking about is to keep them away from the stock market. That won't happen, of course, but the quiet transformation of 401ks (for non-U.S. readers, that's what we call our main form of defined-contribution retirement plan) in recent years from self-directed free-for-alls to simpler plans with sensible default options has been a welcome step in this direction.
Most of the money lost by individual investors in financial markets is lost to bad luck and poor decision-making, not inadequate accounting rules or financial regulation. Individual investors should be disabused of the notion that investing in IPOs like Groupon's is a safe and responsible path to financial security. So is the way to do that with more rules and disclosure, or by offering fewer regulatory assurances and cultivating more of a caveat emptor attitude among investors?
I don't know the answer to that question. I do get the feeling, though, that we might get more accomplished if we worried less about "susceptible investors" in the stock market — who are after all a pretty affluent, educated bunch — and focused instead on how to maximize the flow of information from companies to investors. Doing this is not always as simple as adopting new rules. There's some evidence that Regulation FD, which required public companies to make immediate public disclosure of any information they share with any investors, may have actually reduced the flow of information to markets — especially for smaller companies — by cutting back on informal communication channels. Trying to protect small investors from unequal sharing of information left everybody with less information.
The Jumpstart Our Business Startups (JOBS) Act, whatever its eventual impact on entrepreneurship and economic growth, has already accomplished some remarkable things. For one, it temporarily healed the deep political divide in Washington, bringing together overwhelming bipartisan majorities of 380 votes in the House of Representatives and 73 in the Senate. For another, it has united the nation's financial journalists in tut-tutting disapproval. And the most amazing thing is that in this case the members of Congress appear to have slightly better arguments on their side than the journalists.
The argument for the legislation is that the number of companies going public has fallen dramatically over the past decade, and the cost of complying with disclosure rules, especially those imposed by the Sarbanes-Oxley Act of 2002, is part of the problem. Exempt smaller companies from most of those requirements, and enable a new "crowdfunding" model that allows firms to bypass traditional channels and raise money online, and you get more fast-growing young companies, the reasoning goes.
The argument against the legislation is basically that, as Andrew Ross Sorkin put it in The New York Times, it "dismantles some of the most basic protections for the most susceptible investors apt to be drawn into get-rich-quick scams and too-good-to-be-true investment 'opportunities.' " He cites in particular the case of Groupon, which announced a downward restatement of its earnings Friday. Given Groupon's past history of inventive accounting, this should have been a shock to no one, but if it had been able to go public under the JOBS Act rules, Sorkin hypothesizes, it might have been able to cover that up.
My initial impression is that both the pro- and anti-JOBS Act arguments might be getting some things backwards. That's because increased disclosure generally leads to higher stock prices — and thus more capital — for listed companies. Yet I doubt it does much of anything to protect the most gullible investors.
The Sarbanes-Oxley Act was the last big attempt to improve financial disclosure. Companies were required to certify their financial statements, follow new rules in reporting pro-forma earnings and off-balance sheet transactions, and issue voluminous reports on their internal financial controls. The accounting firms that audit financial statements were subjected to tougher conflict-of-interest rules and oversight by a new federal agency. I had gotten the impression that most of the Sarbox rules were meaningless busy work, but an informal examination of recent research on the subject (I went to ssrn.com and searched on "sarbanes-oxley") reveals that audit opinions and financial statements contain more information than they did before, and that this has brought more efficient markets, better internal governance, and higher valuations for IPOs. This did come at a significant cost in legal and accounting fees that weigh heaviest on smaller companies trying to go public — offering some backup for the JOBS Act. But the general message is that the more information companies share with investors, and the more honestly they do it, the better off they are. And since many corporate executives seem congenitally incapable of learning this lesson, there's a place for regulations that push them toward more disclosure.
Such regulations, if they succeed in increasing the information flow between managements and markets, are also good news for investors in general. But it's highly doubtful they'll do anything to protect the gullible. The only real way to protect the "most susceptible investors" Sorkin is talking about is to keep them away from the stock market. That won't happen, of course, but the quiet transformation of 401ks (for non-U.S. readers, that's what we call our main form of defined-contribution retirement plan) in recent years from self-directed free-for-alls to simpler plans with sensible default options has been a welcome step in this direction.
Most of the money lost by individual investors in financial markets is lost to bad luck and poor decision-making, not inadequate accounting rules or financial regulation. Individual investors should be disabused of the notion that investing in IPOs like Groupon's is a safe and responsible path to financial security. So is the way to do that with more rules and disclosure, or by offering fewer regulatory assurances and cultivating more of a caveat emptor attitude among investors?
I don't know the answer to that question. I do get the feeling, though, that we might get more accomplished if we worried less about "susceptible investors" in the stock market — who are after all a pretty affluent, educated bunch — and focused instead on how to maximize the flow of information from companies to investors. Doing this is not always as simple as adopting new rules. There's some evidence that Regulation FD, which required public companies to make immediate public disclosure of any information they share with any investors, may have actually reduced the flow of information to markets — especially for smaller companies — by cutting back on informal communication channels. Trying to protect small investors from unequal sharing of information left everybody with less information.
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