The JOBS Act (formally, the “Jumpstart Our Business Startups Act”) was designed to facilitate raising capital by reducing regulatory burdens. Specifically, the Act creates a separate class of issuers under the U.S. Securities Act of 1933 and the Exchange Act of 1934 for “emerging growth companies.” Emerging growth companies, you will recall, were defined as issuers with annual gross revenues of less than $1 billion and a public float of less than $700 million.
Encouraging Analyst Coverage
The new law essentially unwinds the rules affecting analysts enacted in July 2002 as part of the Sarbanes-Oxley Act—at least as they relate to the newly defined emerging growth companies. Prior to 2002 small companies planning IPOs were often only followed by the broker or investment bank planning on leading their IPO. Potential conflicts would arise when analysts at a firm were predisposed to give IPO prospects favorable ratings, despite negative financials, in hopes of winning more business from the newly public company.
Small firms seeking to do IPOs are frequently not of sufficient size or profit potential for investment bank analysts to cover the fledgling public companies. So for the past decade (since Sarbanes-Oxley) these emerging growth companies have had a difficult time getting investment bank analysts to cover and publish their analysis. Supporters of the JOBS Act felt that investors were reluctant to invest in a firm that had no analyst coverage and that the need to encourage IPO investors overcame any potential risk of a conflict of interest.
The JOBS Act therefore amends the definition of “sale” in Sec. 2(a)(3) of the Securities Act so that an analyst report will no longer qualify as an offer to sell. The portion of the Securities Exchange Act amended by Sarbanes-Oxley (Sec 15D) is adjusted to once again allow securities analysts to call on companies (emerging growth companies at least), with investment bankers, a practice that had been banned for the past decade. The ban on publishing and releasing reports on companies that have an underwriting relationship is also lifted with a revision of Section 15A of the Securities Exchange Act.
Introducing Conflicts of Interest?
The change is not inconsequential. Last year more than 90% of companies launching IPOs qualified as emerging growth companies. Underwriters of those companies may once again issue research and recommendation on the qualifying companies they are underwriting.
Opponents to the new legislation fear that unwinding this particular piece of Sarbanes Oxley legislation will open the floodgates on the type of conflicts of interests that occurred at the end of the internet bubble and lead analysts to issue buy recommendations on stocks that are clearly overvalued.
While banks and brokers are once again free to issue analyst reports on client-companies with less than a billion dollars in revenue, they are still bound by all other securities regulations and will be liable if they publish fraudulent statements about stocks in general.
What remains to be seen is how quickly securities underwriters will take before they are once again offering to cover customers and prospective customers.
While not required by the current law, prudent financial institutions will develop clear internal guidelines for when and how underwriting teams and research teams interact.
Ann Longmore and I are examining each of these revisions in individual articles over a series of weeks and discussing their potential impact and insurance ramifications.