Does the SEC Fail Small Internet Businesses?

As retailing migrates online, an increasing number of ecommerce and Internet business will seek to raise public capital. Many of them will be smaller companies.

But a growing number of observers believe the U.S. Securities and Exchange Commission is failing smaller businesses and Internet-based companies, which hampers the growth of of those firms and of innovation generally.

The Mission Eludes the SEC

“The mission of the U.S. Securities and Exchange Commission (SEC) is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation….Crucial to the SEC’s effectiveness in each of these areas is its enforcement authority,” according to the SEC website.

Unfortunately, the SEC is failing to meet almost all of its objectives and is remarkably ineffective in exercising its enforcement authority. As for maintaining fair and orderly markets, the SEC has let down a huge segment of the investment community. The sales process in initial public offerings (IPOs) shows favoritism to large institutional investors and shortchanges retail shareholders. Investment banks that underwrite IPOs sell shares only to institutional investors and wealthy individuals that are their clients. Profits from these sales are often huge. For instance, we recently covered LinkedIn’s IPO, which had a first-day gain greater than 100 percent. Retail shareholders were excluded from enjoying these benefits as they could only participate after the first-day sale. The SEC has done nothing to rectify this situation.

Many observers believe the IPO process favors large companies, and that the SEC is struggling with Internet-based businesses.

Many observers believe the IPO process favors large companies, and that the SEC is struggling with Internet-based businesses.

Shortchanging Small Businesses

Additionally, IPO underwriters have abandoned the small-issuer market. Their position is that they cannot make a profit on smaller deals. Steven Davidoff reported in The New York Times that in 1996, according to Dealogic, 309 IPOs raised less than $25 million each while in 2010, the number declined to 13 . Again, the SEC has done nothing to help smaller companies access the public market.

In its role as a facilitator of capital formation, the SEC should be keeping up with new trends in start-up financing. For instance, crowdfunding and micro financing — raising capital via small contributions from a large number of investors — is illegal in the United States if the company facilitating the funding is located here. The SEC considers these investments as securities that need to be registered. The Sustainable Economies Law Center has petitioned the SEC to exempt securities offerings up to $100,000 and a $100 maximum per investor from registration under Section 5 of the Securities Act of 1933. The SEC has accepted this proposal and has been receiving comments on it since July 2010. This change would greatly assist start-ups that require minimal seed money. The SEC has given no time frame for making a decision. Meanwhile, Internet companies based outside the United States operate successful crowdfunding financing systems.

Chinese Companies Take Advantage of the Reverse Merger Loophole

Besides an IPO, another way for a company to get a stock market listing is through a reverse merger, which does not require an underwriting vetting process. A reverse merger utilizes a shell company — a firm without real assets or operations but which is already listed on a stock exchange — as a conduit for transactions. As there is no IPO involved, there is no regulatory oversight. In the past few years Chinese companies have been using brokers to acquire and then sell them shells so they can trade on a U.S. exchange. Numerous Chinese companies listed on American exchanges have collapsed, costing duped American investors billions of dollars. Lax accounting regulations in China have led to widespread fraud and several investigations, including one by the SEC. Since March, at least 25 Chinese reverse merger companies have been delisted at American stock exchanges and their independent auditors have resigned. The SEC has suspended trading in at least three other stocks.

Despite the fact that there have been 600 reverse merger registrations since 2007 with more than 150 based in China, the SEC only this year started looking into this loophole. The Sarbanes-Oxley law that was meant to clean up accounting fraud does not reach to China. The SEC has been slow to recognize that phony firms have been taking advantage of weaknesses in U.S. regulations. Lynn Turner, a former chief accountant at the SEC told Reuters, “I think the public is looking for an SEC that is proactive and in front of these issues, and they have yet to do that in this instance.”

Internet Business Models Cause Problems

The Federal Accounting Standards Advisory Board developed and updates generally accepted accounting principles (GAAP). The SEC expects companies that file an S-1 — the prospectus that details a business’s status when it decides to go public — to present their financials in a way that complies with the standards. A few of the Internet companies that have recently filed have taken liberties with GAAP. We pointed out that Groupon created its own accounting metric (“adjusted consolidated segment operating income”) and it took the SEC a good deal of time, after much public questioning, to challenge Groupon on this. Zynga, another recent IPO we covered, receives revenue by selling virtual goods and no GAAP standards exist for recognizing revenue from the sale of virtual goods. We realize that the SEC cannot anticipate the new wrinkles that the Internet brings to the business world, but it is slow to react to new models that put investors at risk.

The SEC must cooperate with a variety of governmental agencies as well as take direction from Congress, and bureaucracies always work slowly. However, the SEC could be more assertive In analyzing the loopholes in its regulations, responding to the creative accounting techniques of start-ups, and eliminating onerous regulations that adversely affect capital formation and penalize American small businesses.

Major SEC Overhaul Is Possible

The House Financial Services Committee Chairman Spencer Bachus, (R-Alabama) is drafting legislation to restructure the Securities and Exchange Commission. “The SEC is structurally flawed and suffers from operational inefficiencies and organizational incoherence,” he stated in an August 2 press release. If enacted, the SEC Modernization Act would radically restructure the agency. A study by the Boston Consulting Group asserts that the SEC needs 400 more employees to adequately do its job, but Representative Bachus is opposed to hiring more staff.

Whether it requires more staff, different staff, or drastic restructuring, change at the SEC is necessary because the agency is failing in its mission of protecting investors, encouraging capital formation, and maintaining a fair investment environment that includes small businesses and small investors.

Marcia Kaplan
Marcia Kaplan
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