Regulating Secondary Markets in the Facebook Era
A 1964 amendment to the Securities Exchange Act of 1934 is receiving a great deal of attention these days, thanks to the spotlight that seems to follow Facebook wherever it turns. Section 12(g)(1) of the Exchange Act imposes the reporting requirements of § 12(b) on companies with more than 500 shareholders. If Facebook were to offer its shares officially to a broader segment of the public at large, the notoriously private company would have to disclose to the SEC details about its organizational structure, financial results, material obligations, and a host of other information. In a deal involving Goldman Sachs, however, that created a special purpose vehicle (“SPV”) to act as a single investor on behalf of many, Facebook adhered to the letter of the law while accepting more than $1 billion in outside capital from a multitude of investors. While Goldman’s decision to limit its SPV only to foreign investors has, for the time being, rendered the issue moot, should the SEC continue to focus on this area, there may be similar scenarios involving other companies that would require the SEC to revisit the definition of who exactly constitutes a “record owner” of securities under Rule 12g5-1.
The SEC has already indicated its interest in two types of secondary market deals in the technology sector: (1) large SPVs like that featured in the Goldman Sachs deal, and (2) marketplaces for smaller portions of private stock held by employees, consultants, and investors of the issuer. The Wall Street Journal reported on Tuesday, January 18, that SEC scrutiny of the deal played a role in Goldman’s decision to limit its SPV to foreign investors. Public clamoring for pieces of the deal left Goldman vulnerable to allegations of soliciting and advertising the private offering to U.S. investors, which would violate SEC regulations. Additionally, according to The New York Times, the SEC has sent inquiries to several participants in the secondary markets for Facebook, Twitter, Zynga, and LinkedIn, though the identity of the recipients remains unknown. Two major participants, SecondMarket and SharesPost, provide forums for employees and the like to trade their private stock, though they can also help facilitate SPV deals. SecondMarket, which told Reuters that it was not approached by the SEC in this instance, has recently received an SEC inquiry about pooling investors for private company stock.
Why might the SEC be so focused on the secondary market? In addition to addressing the torrent of publicity that came with the disclosure of Facebook and Goldman’s plans, the SEC may consider secondary markets too risky even for the accredited and sophisticated buyers who are allowed to purchase private stock. These markets are characterized by a lack of information, as they are the domain of companies not subject to comprehensive disclosure requirements. There is no publication of shareholders’ rights in these markets, nor do potential buyers know how many shares are outstanding. And while sellers – employees, consultants, and venture capitalists – may have special insight into the financial health of the private companies, buyers generally do not. The lack of transparency in these markets may be a key target of the SEC in its inquiries. The SEC may also be sending a message to “unregulated” segments of the market that they are not beyond the SEC’s jurisdiction. The Enforcement Division has recently brought high profile cases, using traditional fraud allegations, against hedge funds, traders of credit default swaps and a life settlement industry player. Pursuing secondary market activities would fit this pattern.
Short of a Congressional amendment to the Exchange Act, the SEC has at least two potential methods of addressing concerns about trading in private companies in secondary markets. The first is an enforcement-based approach, in which the SEC could bring civil enforcement actions (or settled actions) against those it believes to have violated the spirit of the law. The SEC could posit a broad interpretation of Rule 12g5-1(b)(3), which currently states that “[i]f the issuer knows or has reason to know that the form of holding securities of record is used primarily to circumvent the provisions of section 12(g) . . . of the Act, the beneficial owners of such securities shall be deemed to be the record owners thereof.” In the case of Facebook, this would have meant that each participant in the SPV would be deemed a separate shareholder, putting the company over the 500 mark and triggering reporting requirements.
This approach would give the SEC wide latitude, as the language of Rule 12g5-1(b)(3) is open to varied interpretation: Does the phrase “knows or has reason to know” incorporate an objective or subjective standard? How would the SEC decide, where there may be numerous, sensible reasons for adopting a particular form for holding securities, whether the form chosen was “primarily” to circumvent Section 12(g)? In our view, using a case-by-case approach to answer these questions would seem to be an incremental and imprecise process that would not provide helpful guidance to companies currently seeking to comply with the law. Companies and underwriters would be much more hesitant to enter into Facebook-type deals without clarity regarding their exposure to an enforcement action. It could also have a negative effect on firms like SecondMarket and SharesPost, beyond the extent to which they facilitate larger deals. Expanded enforcement without clear and objective rules could lead to private companies severely limiting or putting heavy restrictions on private shares, depriving venture-backed companies and their employees of the benefits of these markets: providing a pre-IPO evaluation of the issuer by accredited and sophisticated investors, and giving employees a forum in which to mitigate their risks.
The other – and in our opinion more efficient and beneficial – option would be for the SEC to adopt a rule-making approach. Section 12(g)(5) of the Exchange Act gives the SEC the power to redefine “‘held of record’ as it deems necessary or appropriate in the public interest or for the protection of investors in order to prevent circumvention of the provisions of this subsection.” Given the substantial changes in how private company shares are traded since Rule 12g5-1 was originally adopted, it may be time for the SEC to take advantage of this authority. A rule-making approach would allow the SEC to answer the questions posed above (and others that we, no doubt, have not yet considered). A new rule could also define certain situations as designed primarily to circumvent Section 12(g), such as an SPV in which multiple sub-SPVs are shareholders. The rule-making process would allow the SEC to shape secondary market transactions, allowing only those that follow what it believes to be the spirit of the laws, with the added benefit of input from a public comment period. Finally, companies would have the opportunity to comply directly with the law, rather than act and then face a potential enforcement action, preserving the benefits of the secondary market.