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JOBS Act Best at Creating Shell Companies

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I didn't think I would be starting with a political story but if your heard my podcast segment regarding the JOBS Act, you'd understand why this Wall Street Journal Article would peak my interest. If you didn't know a bipartisan collation, including President Obama, were able to get the JOBS Act passed through Congress. This bill was understandably viewed as controversial by a number of economists who claimed that this would lead to another bubble similar to the one during the .com boom of the late 90's.  If you want to read more there is a great article by Matt Taibbi regarding this but regardless of the resistance  proponents of the bill argued that this was going to allow for prosperity among our budding emerging growth companies and therefore lead to job creation.

 Funny enough, just eight weeks after the passing of the JOBS Act, it is already having some unintended consequences. From the article: 

 

"Special-purpose acquisition companies" and "blank check" companies, basically empty shells with almost no employees that are used in mergers or as a backdoor route to U.S. stock listings, have been quick to identify themselves in regulatory filings as "emerging growth companies."

 The new law uses that phrase to describe which companies—once they have applied to go public—should be exempt from some financial-reporting and corporate-governance requirements.

 The Securities and Exchange Commission also has been fielding questions about whether trusts that collect music and movie-royalty payments, or structures used to create tax-free corporate spinoffs, could qualify as emerging-growth companies, according to Meredith Cross, director of the SEC's Division of Corporation Finance.

 

If you are not familiar with a blank check company, this is an organization which according to the SEC, "has no specific business plan or purpose". At first glance, the fact that these types of companies even exist is humorous in itself. Why would anyone with half a brain invest in a blank check company when they explicitly label themselves as an organization with no purpose? DISCLAIMER: If you are a holder of Yahoo stock this is not an insult towards you.

The answer of why these exist though is because of a practice called reverse mergers:

 

One way companies can get their stock listed on a U.S. exchange without doing their own initial public offerings is to merge with a publicly traded blank-check company in a deal called a reverse merger. So, a blank-check company "could become a job creator," Ms. Cross said.

 

So how this works is one of these blank check companies applies under the statutes of the JOBS Act to become an emerging growth company. With this designation, the company is allowed to avoid independent accounting requirements which usually most companies would be obligated to have available to their investors. Once an emerging growth company, generating investors is much easier because the executives of these companies are largely not culpable for any fraudulent forecasts or statements they make. Once they go public, they then find a large established private company (internationally based typically) and get acquired. Once this reverse merger is complete, the public company becomes what is known as a shell company and now can generate investment capital for their parent organization.

This has a number of serious ramifications. The first is that it allows for an international company to generate capital via the shell company while mostly avoiding larger exposure to that pesky US Corporate Tax. This capital then can be used by the international company to grow their business which in theory should allow them to better compete with U.S. based companies.

Additionally, there is this troubling tidbit from the piece:

 

The use of shell companies for reverse mergers has been a serious concern at the SEC over the past year, amid accounting and governance scandals at some Chinese companies that have used that route to go public in the U.S.

 

Not surprisingly, just this year we saw a third company from China (who trades in the US via a shell company) being investigated for stock manipulation:

 

In its AutoChina lawsuit, filed in federal court in Boston, the SEC alleges the defendants boosted AutoChina's daily trading volume more than sevenfold through hundreds of fraudulent trades, using about $60 million they deposited into brokerage accounts. The trades included coordinated "matched orders" as well as "wash trades," in which the true ownership of the shares doesn't change, according to the SEC. On some days, the defendants and related accounts represented as much as 70% of the trading in AutoChina stock, the SEC said.

 

Do we really want this kind of nonsense on top of all the other things wrong in our exchanges? A large number of investors in the US stock market are American workers via 401K plans.  Bringing these shady shell fronts exposes normal investors to potential losses and could lead to volatility of the markets.

So what does a supporter of the JOBS Act have to say about all this? 

 

Former Nasdaq Vice Chairman David Weild, who lobbied for the passage of the JOBS Act and testified before a House subcommittee on IPO reform last year, said, "Congress was interested in making it easier for entrepreneurs that were going to raise capital and build companies and employ people. I don't think anybody was thinking this was going to be applied to reverse mergers and the like."

 

What an astonishing confession. This man has spent the last year writing numerous whitepapers and Op-EDs stating that we needed to encourage IPOs through deregulation. He is considered an "expert" who through his extensive research of the market determined we needed the JOBS Act, yet couldn't see this coming despite being a former chairman of an exchange.

However, maybe I shouldn't be so surprised that Weild didn't see this issue because he was vice chairman of Nasdaq during the devastating dot com bust. A period where Nasdaq lost 5 trillion dollars in wealth  under his watch and led to failures like pets.com, Webvan and countless others. 

However Weild, despite all this, wanted to deregulate and tempt fate again. Even worse, Congress listened to this "expert" and mostly backed the JOBS Act despite the multiple failings of Weild. Then President Obama signed it. Now in just eight weeks we are already seeing disturbing use of the emerging growth company designation being used by these purposeless companies. So purposeless in fact, they will likely generate marginal job growth if any at all. 

Maybe this JOBS Act will create jobs through growth, I'm just worried they will be not in this country but somewhere else.