The Private Market Stresses Driving SOX Compliance Debate

If you want to understand the forces pushing to roll back compliance with the Sarbanes-Oxley Act—and if you work in corporate compliance, you should—then spend time today reading a superb Wall Street Journal article about the conflicted state of investment in the private markets. We can’t ignore the uncertainty there, because it’s a big driver of the increasing uncertainty about SOX compliance here.

The WSJ article notes a nasty truth about recent tech IPOs such as Snap and Blue Apron: they kinda stunk. Both companies now trade below their opening price. Snap ($SNAP) went public on March 2 at $17 a share, and closed yesterday at $13.22. Blue Apron ($APRN) debuted on June 28 at $10 a share (down from earlier plans to debut at $15 to $17), and closed yesterday at $6.37.

Reflect for a moment on what happened here. Snap and Blue Apron had inflated values in the private markets, which were corrected in the public markets. In other words, their IPOs were mechanisms to find the true price for Snap and Blue Apron shares.

The push from Republicans in Congress and new leadership in the Securities and Exchange Commission to open the IPO window again, and let many more small companies go public earlier— this what that push is all about. It’s about finding the correct price for these privately funded companies, because right now their prices in the private market are totally screwy.

The WSJ article is a whirlwind tour of that screwy world. Those startup darlings in Silicon Valley—the Ubers, the AirBnBs, the Pinterests, and many more—have nosebleed valuations their operations might not support, because their operations often don’t make actual profit. Nearly 170 private companies now have valuations of $1 billion or more, up from only 60 in 2014.

Have we really created so much fresh value in the last three years, that 110 more companies are now worth at least $1 billion? Or are private investors blowing smoke up their own backsides, anxious to get their capital back (with a nice rate of return) before unpleasant reality sets in?

There are two ways to find out. The startup can sell itself to a larger business or to private equity, and many do exactly that.

Or the startup can go public, which brings us back to that high hurdle all businesses face when going public—a hurdle more commonly known as Sarbanes-Oxley compliance.

Lowering the SOX Compliance Hurdle

Jay Clayton

When SEC chairman Jay Clayton talks about rolling back SOX compliance obligations so companies can go public earlier in their corporate lives, this is a big reason why. Sure, Clayton sugarcoats that goal with talk of giving “Mr. and Mrs. 401(k)” the opportunity to invest in startups early, so their retirement accounts can enjoy the same appreciation in startup value that only private investors do now.

That’s one way to describe the situation, and it’s not wrong. But the photo negative version of that reality is this: we have a bubble in private equity investments, and private equity investors want to alleviate that pressure rather than see the bubble burst in their faces. Relaxing SOX compliance obligations is one way to alleviate that pressure. It allows more companies to go public earlier in their corporate lives, and that passes along “pricing risk” to retail investors rather than leave it concentrated in the hands of fewer, wealthier, private investors. Who seem to have made a muck of startup pricing so far.

Which side is right or wrong? You tell me. If you’re old enough to have experienced the dot-com collapse in 2000, you probably don’t like the idea of companies going public when they have terrible business models and no earthly reason to be public, and then their share prices crater. (Fun fact: the president of the NYSE, Thomas Farley, who testified before Congress the other week on the allegedly great need to let more companies go public, was only 25 in 2000.)

Companies with poor SOX compliance programs, or don’t follow SOX compliance rules at all, have weaker internal control over financial reporting. They are more at risk for financial restatements. Financial restatements are a gut punch to Mr. and Mrs. 401(k) when they get their account statements at the end of the month. Those are facts.

Then again, if you have a pension fund, or want more financial aid from your child’s college, or want to keep your state and local taxes low, or have just enough wealth to qualify as an accredited investor—well, you have a stake in the health of those “private investors” we grumble about. Pension funds, university endowments, hedge funds, private investment funds: more people are more closely connected to them than we first assume. If the bubble bursts on them, we’ll feel the squeeze eventually.

At its highest level, that is what the debate over SOX rollbacks is all about; that is the question confronting Clayton and members of Congress. How they answer it will have great bearing on compliance professionals: the jobs you do, the career prospects you have, and yes, even the size of your 401(k) balances. If these macro-economic forces are a chess game, your compliance livelihood is the pawn. Clayton, Congress, and other regulators are the players.

Two Parting, Cynical Thoughts

Thought 1: Clayton is in an awkward political position. If he reduces SOX compliance obligations somehow (and clearly that is what he wants to do), people will accuse Clayton of relaxing investor protections to enrich Wall Street bankers and lawyers who help companies go public. And for many years before he was named chairman of the SEC, Clayton himself was a Wall Street lawyer who got rich helping companies go public.

That criticism isn’t entirely fair, because there are legitimate questions about how to let the most investors enjoy the most economic benefit, with the least necessary risk. Then again, that criticism isn’t wrong. When we relax SOX compliance rules, investors are at higher risk;  Clayton’s former colleagues on Wall Street do enrich themselves.

Thought 2: At the House hearing on July 18, Republicans talked about IPOs as “lottery tickets,” and retail investors should have the right to take their shot at one of those fabled, lucrative payouts.

That’s not how most IPOs work. Those lucrative pre-IPO shares, valued at X dollars before the price “pops” to 10X—retail investors never get them. Wall Street insiders (see Clayton and Co., above; getting rich) helping companies go public distribute those shares to favored clients just before the IPO. Then the company starts trading, and almost all retail investors end up buying shares after the pop.

Comparing IPOs to lottery tickets is a  stupid statement. If anyone other than a congressman said it, I wouldn’t believe it.