The Facebook Effect: New Rules, New Risks

The Facebook Effect: New Rules, New Risks

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Last week, news broke that the SEC is considering easing restrictions on the securities of private companies. In particular, the Wall Street Journal reported that changes could include lifting or loosening the limit of 499 shareholders that a private company can have. The SEC is also considering changing rules regarding the “general solicitation” of investors when marketing securities.  These issues made headlines earlier this year when it was revealed Goldman Sachs was planning to offer shares of Facebook to some of its clients.

The Good:
These changes would be welcomed by the owners and managers of private companies as they could improve their ability to value companies raise money without having to meet the strict reporting requirements of publicly-traded companies. Looser regulations could also encourage more investment in startup businesses. The SEC disclosure standards for publicly traded companies are relatively time-consuming for managers and costly to companies. This time and money is particularly valuable and already limited for private companies in the infancy stages of business.

The Bad:
However, moves to loosen regulations would also open the doors for increased levels of risk-taking, abuse, and fraud. Indeed, last week we also heard that the SEC would review the practice of backdoor mergers between private companies and public companies. According to the WSJ, small private companies have been merging with public shell companies in an effort to circumvent the onerous process of going public as a standalone company. While this loophole in securities laws has been a godsend for legitimate small businesses wishing to tap the liquid public capital markets, it has also been the vehicle for rampant fraud.

It is imaginable that private companies burying fraud in their undisclosed and unaudited financial statements could see their market values balloon in the secondary private markets thanks to the looser restrictions on their securities. In other words, the ultimate collapse of fraudulent private companies could become much more costly.

The Ugly:
Generally, I would favor any revisions to regulation that would allow capital to flow more freely, enabling more businesses to connect with more investors. However, the relaxation of regulation regarding securities must come with large, visible caveat emptor warnings. These warnings should come with the implicit recommendation that the investor should do even more homework than usual before committing to a new investment. This homework could involve hiring lawyers, accountants, and rating agencies to evaluate these companies. In effect, the responsibilities and costs of monitoring the company get shifted from the private company to the investor.

Ultimately, no level of regulation will eliminate the risks of fraud and failure, which are relatively high in private companies with limited transparency. As such, it’s probably a good thing that there is little discussion of revising the definition of an accredited investor. According to the SEC, private companies can sell unregistered securities to accredited investors. These investors include those with annual income of at least $200,000 or net worth of at least $1,000,000.  In the worst case scenario, those investors would be able to walk away in better shape than the investor with less income and wealth.

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