How the NY Times Got the JOBS Act Wrong

3/15/12

One of the great dilemmas in the modern economy is balancing risk and reward, cost and benefit. That is true for investors, corporate managers, citizens, and elected officials. The financial crisis was caused by excessive risk taking by almost every player in the system. Investors stretched for return but didn’t understand the risks to which they were exposed. Corporate managers, particularly in the financial sector, engaged in activities that had limited upside but almost unlimited (lose your company) downside. People bought houses in deals that would only work out if house prices kept going up, the economy boomed, and they could refinance at ever more attractive terms. And, politicians played the same game, betting, for example, that having government-sponsored entities like Fannie Mae and Freddie Mac guarantee over $5 trillion in loans with under $100 billion in equity would work out. Meanwhile, regulators were pressed to let the good times roll; and, they couldn’t even catch Bernie Madoff, whose all return-no risk model was ludicrously implausible.

Inevitably, the pendulum goes the other way and everyone today is fleeing risk. Investors are hunkered down in one-day T-Bills. Corporate managers are sitting on piles of cash. Banks are loath to lend. The public has increased savings and decreased consumption. Regulators are intently focused on making sure no one will ever lose money and that excessive risk taking is squeezed out of the system.

It is in this context that the recent New York Times editorial casting aspersions on new legislation that is designed to make it easier for smaller companies to raise capital (The JOBS Act) seems almost plausible. After all, didn’t deregulation cause “the dot-com crash, Enron, the mortgage meltdown?” Didn’t each of these episodes cause “mass joblessness?” I believe the only correct answer to these questions, respectively, is “no” and “no, ” and by implication the author’s conclusions are deeply flawed.

Take the dot-com bubble and subsequent crash. Yes, most valuations at the peak in early 2000 were absurd. Yes, many investors lost money. Yes, people lost jobs. The overall impact on the economy of the Internet “over-investment” era, however, was remarkably positive. Ultimately, a massive amount of (sustainable) value and many high-paying jobs were created. Consider companies like eBay, Amazon, Google, LinkedIn, and, more recently, Facebook. Even Apple’s success can be attributed in part to the explosion in content, storage, processing, bandwidth, and business model variations that were the direct result of the Internet “bubble.”

To lump the dot-com era in with Enron and the mortgage crisis is patently absurd, and dangerous. The distinguishing feature of the American economy that makes entrepreneurship possible is our tolerance for failure. Smart people constantly scan the environment for opportunities; they can get other people to join them; they can raise capital; they can adapt as new information comes in; they can sell their business; and, yes, they can fail. As long as they don’t lie, cheat, or steal, they are considered experienced, not fatally flawed. Oh, and the investors can lose money, too, which professional venture capitalists do in over 50 percent of the investments they make.

Now imagine a world in which we preclude anyone from making an investment in which they might lose money. Or, imagine a world in which we legislate that accountants double-check every transaction in every company. Or, imagine that we put in place draconian penalties for all errors, after-the-fact, intentional, or unintentional. That’s a world in which FedEx, Apple, Intel, Genentech, and Facebook, just to name a few prominent American success stories, wouldn’t exist. Neither would Wal-Mart or IBM.

Of course, this “It’s a wonderful life” vignette, in which the unintended consequences of decisions are disastrous, is as unlikely to occur as the “mass job destruction” the author foretells in his editorial. We need regulation just as we need laws. We also need common sense. The JOBS Act does not dismantle existing regulation. Instead, it is based on the premise that the benefits of having more new companies formed and able to go public outweighs the potential costs of bad behavior. History suggests that fraud in newly public companies is not a problem, which makes sense given the intense vetting process by lawyers, accountants, the SEC, underwriters, and investors.

When you lower the cost of doing something, more of it gets done. That’s simple economics, and that’s the thrust of the JOBS Act. The other caustic comments by the author also reflect a lack of understanding about the actual provisions in the ACT. There are safeguards against unscrupulous people taking advantage of unsophisticated investors. Again, if we take the author’s argument to its illogical conclusion, and try to keep everyone safe from everything, then the economy will crash and the inevitable result will indeed be mass joblessness.

A final note: the author makes the implicit assumption that legislation like Sarbanes Oxley provides the right level of protection against fraud and bad behavior. That faith is misplaced. Sarbanes Oxley did not protect the economy from a loss measured in the $ trillions in the financial crisis. I suspect Sarbanes Oxley resulted in us having a more accurate count of the chairs on the deck of the Titanic, not recognizing that an iceberg was approaching. Moreover, had our existing laws been enforced, people like Bernie Madoff would never have been able to inflict such a large cost on the capital markets. If common sense (and decency), as well as better governance, had prevailed, we would never have allowed Enron to get so far out on a rotten limb.

We desperately need more entrepreneurial ventures in this economy. We need more capital allocated to this part of the economy. By implication, we need more failure. We also need common sense assessments of the benefits and costs of regulation. And, as the comment about the Madoff and Enron suggest, we need common sense and competence in our regulators and regulatory framework. Of course, we also need organizations like the New York Times to be more thoughtful about presenting a balanced view of any new legislation, not one that dogmatically asserts that all deregulation is bad and all existing regulation accomplishes some important goal.

William Sahlman is the Dimitri V. D'Arbeloff – Class of 1955 Professor of Business Administration at Harvard Business School. The d'Arbeloff Chair was established in 1986 to support teaching and research on the entrepreneurial process. Follow @

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  • http://www.SeeingBothSides.com Jeff Bussgang

    Bill – Thank you for writing this article. You are dead on. I don’t know why the New York Times would choose to speak out against entrepreneurship and innovation, but perhaps the editorial board should have spent more time talking to job creators than job destroyers in doing their research about this bill. And perhaps the New York Times is afraid of unleashing yet more innovation that, inevitably, is disrupting their own, flawed business model!

  • Joey

    >>The JOBS Act does not dismantle existing regulation. Instead, it is based on the premise that the benefits of having more new companies formed and able to go public outweighs the potential costs of bad behavior.

    Oh please. The JOBS Act is premised on the idea that Wall Street banks are reaping insufficiently massive profits right now, so they are using their lackeys in Washington to loosen the standards for taking a company public, and thus reap more fees. There’s a reason that Sen. Chuck Schumer, D-NY, supports this bill so much.

    The Sarbanes-Oxley Act was passed to improve the reliability of financial statements, so investors would not be surprised by accounting frauds and see the value of their investments collapse. That is exactly what it achieved: restatements jumped 2004-2006, as companies discovered al manner of weaknesses in their financial reporting and started fixing them. They’ve been falling ever since, and today are at levels lower than we’ve seen in a decade.

    Indeed, it’s worth noting that the only group of companies seeing MORE restatements are small filers, exempt from a review of their internal controls– and the JOBS bill seeks to expand that un-regulated group dramatically.

    SOX was never designed to prevent the financial crisis, which was caused by companies refusing to take ownership of the risks they introduced into the financial system. It was intended to clean up corporate accounting and make financial statements more reliable, which has happened. Do you want to say that financial reporting rules have grown too complex? I agree. But wishing away the need to test controls is not the solution, any more than wishing away the building inspector makes a complex construction project safer to build.

  • http://www.thegrowthgroup.com Elliott Dahan

    Mr Sahlman writes, “The financial crisis was caused by excessive risk taking by almost every player in the system.” No – the financial crisis was caused by folks with little or no conscience and morality selling crap – and in some cases shorting the very crap they were selling. Venal.

    Mr. Sahlman also writes (re: the dot come bubble), “Yes, many investors lost money. Yes, people lost jobs. The overall impact on the economy of the Internet “over-investment” era, however, was remarkably positive. ”

    It doesn’t make sense when Mitt Romney says this and it doesn’t make sense when Mr. Sahlman says this.

  • http://www.democraticcapitalism.com John

    Mr. Shalhman,

    Thank you for your informed response and commentary. The fact of the matter is that we have been faced with an outdated regulatory infrastructure for small business for many years. This has resulted in “regulatory paternalism” which you stated stifles risk-taking and growth.

    The Jobs Act simply brings us back to the future (with the help of technology) to a time where the entrepreneur and investor personally met under the Button Wood tree on Wall Street. This was an era devoid of hedge fund managers, derivatives, and day traders. This was a time in which “real investment” was made into the factors of production such as land, labor, and capital. Not the high tech paramutual betting game we experience today.

  • Bob Pavey

    This is an excellent and balanced article by Bill Sahlman – thank you for writing it, Bill. Bill doesn’t say that all regulation is bad – in fact he says that sensible regulation is needed. Clearly we can under-regulate and we did in the cases of Bernie Madoff and Enron and the excessive mortgage lending to borrowers who borrowed more than any sensible lender would have allowed. I already see, however, several responses to this article by people who seem to believe that no amount of regulation is too much and all the blame should be placed on “Wall Street”. These comments are foolish and make no more sense than I would make if I argued for zero regulation or if I blamed the entire problem on the regulators. If fact, the vast majority of jobs created in our economy are created by growth companies that require capital to grow. Without growth capital (often called risk capital) our economy cannot create the jobs that we need to be competitive in an increasingly competitive world. The bottom line is that without sensible and thoughtful regulation, that capital will simply go to other countries.

  • Joey

    >>In fact, the vast majority of jobs created in our economy are created by growth companies that require capital to grow.

    In fact, the vast majority of jobs created in our economy come from truly small, private businesses– those that are not public, and have no intention of ever being public. Those investors who do dabble in public markets need a way to understand the true risk of their potential investments, and the JOBS bill specifically moves to rescind those mechanisms. It is a give-away to the banking sector, which will use that opportunity to drum up more IPO and trading business, far more than it is anything at all that will help small businesses to create more jobs.

    I’m dismayed to see people arguing here that investors should not have proper tools and assurances to see how their capital is spent, which seems like an assault on what the free market is all about.

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  • mike gettelman

    i have been a securites lawyer for almost 50 years. this piece of legislation guts the Securities Act of 1933 where it is most necessary. the burdens of the 1933 Act have been much overstated by those pandering to de-regulation. the Issie winds of washington are taking over the asylum. if/when this bill passes, the amended law should thereafter be the “Securities Act of 2012.” mr. sahlman, i can only assume you are a righty whose supposed academic views are dominated by your politics,

    mg

  • L.G. Fuentes

    “…if we take the author’s argument to its illogical conclusion, and try to keep everyone safe from everything, then the economy will crash and the inevitable result will indeed be mass joblessness.”

    Really? So let me see if I get this right… an author cautioning about further deregulation of the banking industry is illogical?

    Fact is that repeal of Glass Steagall, in the hopes of creating “more jobs” is what caused our recession. With the cat away the mice played and did so for a decade that nearly ruined us. Many trillions in shareholder value were erased by that ill-thought-through short term fix.

    How is that for some “common sense assessment” of the “cost of deregulation”?

    Sometimes I wonder if you guys will not be happy unless the world is brought to complete ruin. Don’t you see that we are the pillar of stability for all of the world? Shake it and you shake the world out of sorts. Is your gamble really worth that?

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