Monday, January 3, 2011

SEC inquires into secondary trading activities by large private companies

Last week the New York Times published an article ( regarding the SEC investigation of trading in shares of some of the largest domestic private companies, such as Facebook and Twitter. Since these are privately held companies, any secondary trading in their shares is restricted. Such shares can only be resold in private placements compliant with the SEC rules, which, according to Rule 506 of Regulation D, means that such shares can only be sold:

• to accredited investors;
• without general solicitation or advertising;
• to a maximum of 35 nonaccredited investors (in which case specified disclosure has to be made); and
• with resale restrictions.

Such rules place limitations on the secondary trading in private companies’ stock, and for good reason. There is little publicly available financial information about the privately held companies, so investment in such companies presents greater risks. Of course, if one thinks of Facebook with its millions of subscribers and astronomical advertising revenues, the risks seem to be minor. After all, if this company is not stable financially, then which one is?

Another question then comes to mind: why is Facebook not public? A company becomes a public company when it sells its stock to the general public, usually through a national exchange (such as NYSE or Nasdaq). Then the company becomes subject to reporting obligations under the Securities and Exchange Act of 1934, which means that the company has to file its annual, quarterly and current reports with the SEC, revealing its financial information and information about its business operations. The same disclosure obligations apply once a private company has 500 or more equity holders.

Periodic reporting has become an expansive undertaking for many companies that are struggling with high legal and accounting costs associated with being “public”: preparation of reports, attestation requirements, internal controls over financial reporting, etc. The main advantage of being a public company is the ability to quickly raise large amounts of capital (there is no need to write extensive disclosures since such information is already available to the market through periodic reporting and offerings can be made to all investors, not just the accredited ones). On the other hand, as the economy is still in the “recovery” stage, raising capital from the public may not be as advantageous (public companies may have lower stock price than if they were private companies issuing shares through private placements).

For example, Facebook does not seem to have difficulty raising capital while being a private company. It has just announced raising $500 million from Goldman Sachs and an unnamed Russian investor. Even though Goldman Sachs would count as one investor for the purposes of a “500 shareholders threshold”, it is likely that there may be hundreds of smaller investors behind Goldman Sachs. However, the rule does not provide for “look through” to the beneficial shareholder level.

It is suspected that the SEC is focusing on the fact that there may already be 500 or more equity holders in any of these private companies but the real question, at least to me, is when these companies are going to become “public”.

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