From scaring Goldman Sachs into scrapping its Facebook’s share offer to Americans to sweating SecondMarket and other private exchanges down, the SEC seems to be discouraging U.S. investors from funding hot social media companies thus stemming the flow of vital cheap capital to these young firms.
This is about the little rule that could.
In the span of a modest half a page in the 363-page architecture of the securities laws of public companies, the rule says a company ought to have 500 or fewer investors if it wants to stay private, i.e. avoid governmental regulation.
Now the simple, brightline rule finds itself implicated twice during the recent regulatory snooping in the world of private share trading. In both the Goldman and the Secondmarket inquiry, authorities have thrown the rule at private companies such as Facebook and Twitter and effectively given them this stark choice: become public or forgo raising cheap capital.
Becoming public is no picnic — it means you have to comply with very onerous financial and disclosure reporting requirements and are subject to the litigious plaintiff’s bar. Forgoing cheap capital is no picnic, either, for a young company.
Is this legitimate policing of the securities markets or outdated, inefficient meddling with them?
In early January, Goldman planned to raise $1.5 billion through a private placement of Facebook shares to its top U.S. and foreign clients, while itself investing $450 million in the company at a price that valued it at a then-staggering $50 billion (some now peg the firm’s worth at nearly $84 billion).
A week later, Goldman abruptly withdrew the offer to its U.S. clients.
The bank claimed the decision was not due to pressure from anybody but nobody believed it. The about-face just happened to come too soon after the SEC ramped up its scrutiny of the deal.
Nobody said it out loud but the 500-investor rule was behind the entire event.
Goldman’s plan was to buy Facebook shares in a one-on-one private sale from Facebook, put the shares in a structure similar to a small mutual fund designed to only own Facebook shares, and then sell interests in that fund to its clients. Technically speaking, that fund would only count as one “holder of record” in Facebook.
The fund itself, however, would have many more investors, so disregarding the fund structure one could say that all the fund’s investors were in a way also Facebook investors.
But if that were so, Facebook could suddenly find itself with many more than 500 investors.
So, how would the law view the fund — as one investor or as many, possibly as many as there are investors in the fund itself?
That is only up to the law’s interpreter, the SEC. If the agency thinks the fund was put together for the specific purpose of avoiding the rule, then it may well decide to count each fund investor as a Facebook investor.
Not wanting to bet the farm on reading the government’s mind correctly, Goldman blinked and shut down its placement efforts in the U.S., though not abroad.
Now, the SEC is investigating the fast-growing market for trading shares of the likes of Facebook, Twitter, LinkedIn and Zynga. This market, run on platforms provided by Secondmarket and SharePost, allows investors to easily trade shares of private companies offering a quick and cheap funding source for these hot ventures.
SecondMarket reported that there was about $158 million worth of trading on its market in the last quarter of 2010. Overall since its inception in April 2009, it said there has been $500 million worth of trading activity.
These markets face the same uncertainty Goldman did. When an employee or early investor goes to sell their Twitter shares, the buyer could actually be a fund, similar to Goldman’s “mutual” fund, which acts as one holder of record with possibly hundreds behind the scenes.
Will a similar scenario play out here? Will government scrutiny of SecondMarket also force them to shut down their U.S. business or face fines and private litigation on account of violating the securities laws?
Shutting down these online platforms may harm young social media companies like Twitter and Zynga. Many think it’s largely because of markets such as SecondMarket that Facebook’s valuation shot to $50 billion in January 2011 from $14 billion just a year earlier.
Without such platforms private companies may never reach their full potential.
Some also argue the rule is obsolete and arbitrary.
Vincent Molinari, CEO of trading platform producer Gate Technologies, said in a March 1 interview for Inside Counsel that technology and the globalized economy have lead to a skyrocketing demand for private share deals, while firms such as Secondmarket have brought unprecedented transparency to this once-opaque market. The SEC is simply behind the market in terms of relevance, he added.
He also questioned the logic behind setting the cap at 500 investors or having a cap, at all.
But some legal practitioners do not share his views. “We must draw some lines to define what is a ‘public company’ and what is not,” hedge fund expert Michael Renetzky told Who’s In My Fund?, “and the 500-investor rule is a reasonable definition.”
Renetzky also thought the media circus that accompanied Goldman’s Facebook offer was a welcome development. It shone a light on the issue and on the need for the rule to be policed, he explained, which will benefit securities regulation in the US.
In the end, all this ado about Facebook and the like could be nothing more than the validation of a pernicious bubble. The great valuation leaps of these asset-light, traffic-heavy companies may turn out to be just the latest excesses of herd-like investors.
In which case, the regulator’s cold water hosing may well be welcome.
The debate goes on and will hardly cease until one side is borne out by the facts of the future.
That is cold comfort to both U.S. investors and online companies who, not having a crystal ball, spend their time worrying about what they are losing in the here and now.
In that respect, the questions to ask are obvious.
Why is the U.S. punishing its own investors to the delight of foreigners? Why are authorities cutting off a vital, cheap and quick supply line for young popular private companies?
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