We take a break from our discussion of secondary liability.  On Monday we will resume with a discussion of the recent decision arisng out of the Enron collapse, Regents v. Credit Suisse. 

For now, we take the opportunity to comment on further evidence of the importance of SOX to the US capital markets.  Much has been written about the decline of IPOs in the US, often with the conclusion that this was the fault of SOX.  In fact, the decline began before the adoption of SOX and the numbers have since recovered somewhat.  We have discussed that here.  Dodgy analysis from the anti-SOX crowd.

Another explanation for the higher number of IPOs before the adoption of SOX was the highly speculative bubble that encouraged companies to go public without having the requisite financial history or pattern of profitable activity.  Who wouldn't want to try to sell shares in a market where almost any company with a good yarn could raise millions in the capital markets?   

Which brings us to an article in Wall Street Journal on the increase in the number of IPOs by unprofitable companies.  Nearly half of the companies that have gone public this year have not been profitable (46% of the 84 offerings). This compares with 71% of the 406 offerings in 2000. The percentage bottomed out in 2002 when only 20% of the public offerings were unprofitable. The nature of the companies going public has also changed since 1999, with finance, biotechnology and energy out pacing hi-tech.

These statistics are an opportunity to note one of the most unique attributes of US capital markets.  The practice of unprofitable companies going public is a hallmark of the US capital markets and one of the reasons why the capital markets here are so vibrant.   It was the case in the 1990s, as I wrote in my piece on the development of capital markets in Russia, that in most countries, bank financing was a more important source of corporate funding than capital markets.  While this may not impact the total amount of available capital, it does affect the companies eligible for funding.  Companies that lack substantial assets or significant cash flow have a hard time obtaining the necessary funding in bank dominated systems.

In the United States, unprofitable companies and companies without a sizeable asset base (service industries, for example), can turn to the capital markets as an alternative source of funding. This was true of biotechnology companies in the 1980s and Internet companies in the 1990s.  I’m guessing that alternative energy companies will be one of the next concentrations of companies that will do the same thing.  The capital markets in the US, therefore, permit funding of higher risk companies in nascent industries. 

It is another way of saying that in many ways the capital markets in the United State are unique and critical to developing industries. Even unprofitable companies, many of which may have limited access to debt markets, can sell equity and raise capital, as the statistics in the Wall Street Journal illustrate.  It is a reflection of the risk taking nature of US investors.  Investors, however, need to know that their only significant risk is the business prospects of the particular business.  The mechanisms put in place by Sarbanes-Oxley – certification, meaningful internal controls, independent audit committees – seek to reduce fraud and ensure accurate financial statements, helping to assure investors that business risk is the only significant risk they take when they invest.