The danger of rolling back investor protections

Right about now, the Senate is scheduled to vote on H.R. 3606, the “JumpStart Our Business Start-ups Act” (or “JOBS Act”), which passed the House 390 to 23. The bill would roll back investor protections for a wide swath of mid-sized companies. Last week, Harvard Law School’s John Coates and I wrote an Op-Ed for the Washington Post arguing that the reforms would go too far.

 According to conservatives, this deregulation will help businesses raise capital, and thus create jobs. In fact, I believe that it could have the opposite effect. As I argued in John and my op-ed, removing vital disclosures and legal protections would reduce investor confidence. This reduced confidence would make investors less willing to bear risk—making it harder for businesses to raise capital.

Ilan Moscovitz of the Motley Fool provides evidence that strong investor protections reduce the cost of raising capital:

When investors lose faith in accounting standards, they’re less willing to buy stocks. That’s one of the reasons why Bank of America and JPMorgan can’t cheaply raise equity capital. No one knows whether the amounts written down on troubled mortgages, particularly second liens, are reflective of real losses.

But to get a real picture of accounting gone wrong, you have to turn to China, where American investors have been burned by a slew of Chinese small-cap frauds. It’s gotten so bad that the market is unable to distinguish the frauds from non-frauds. Investors assume almost everyone’s accounting is rotten. (Just one of many examples: On a single day in February 2011, an unknown blogger shaved 10% — $40 million—off the value of Yongye International, a fertilizer manufacturer that only months later would receive a vote of confidence from Morgan Stanley’s due diligence team. Whether deserved in this particular instance or not, that kind of volatility has become the norm in China.)

Needless to say, it’s not an environment that’s conducive to capital formation. Since November 2010, the median P/E for Chinese stocks fitting the size characteristics of an “emerging growth company” has fallen to an amazing 3.3 times earnings, meaning their cost of equity has ballooned 160% in less than a year and a half. At the same time, larger Chinese companies only lost 12% and the Dow gained 17%.

Today, investors charge these small Chinese companies five times as much for their equity as they charge their U.S. peers, whose accounting they correctly view as more trustworthy. That’s not to say this bill would quintuple the cost of capital, but making it easier to defraud the public has consequences beyond the damage it causes small investors.

Fortunately, it appears that some Senate Democrats have gotten the message. Senators Reed (RI), Landrieu (LA) and Levin (MI) have proposed an alternative to the JOBS Act, titled the “Invest in America Act.” It would fix some of the problems with the House bill—for instance, by subjecting websites engaged in crowdfunding to more oversight. There are certainly some quibbles to be had with the details of the Reed-Landrieu-Levin amendment, but it’s certainly much more palatable than the original House bill.



Bob Pozen is a Senior Lecturer at Harvard Business School and a Senior Fellow at the Brookings Institution. His latest book, Extreme Productivity, is now available at your favorite local or online bookstore.

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