by Tanner C. Dowdy, Notes and Comments Editor, University of Cincinnati Law Review Vol. 91
Secondary markets for securities cannot function properly without information integrity.1See, e.g., Stephen J. Choi & A.C. Pritchard, Securities Regulation: Cases and Analysis 22-36 (5th ed. 2019). That is, without assurance that market information is (at least somewhat) accurate, investors will lack the confidence to invest in securities being marketed.2Id. Information integrity carries added importance where information on companies is not widely disseminated.3Id. Such is the case in the market for private company shares.4Matthew Wansley, Taming Unicorns, 97 Ind. L. J. 1203, 1206 (2022). In contrast to the private market, mandatory disclosure rules are imposed on public companies (companies that trade on a public stock exchange).5Stephen J. Choi & A.C. Pritchard, Securities Regulation: Cases and Analysis 231-32 (5th ed. 2019). Because these disclosures are microscopically examined by auditors, analysts, journalists and short sellers, fraud risk is ostensibly reduced among public companies.6Wansley, supra note 4, at 1205.
Regulation Fair Disclosure (“Reg FD”) is an important element of the public company disclosure regime.7Choi & Pritchard, supra note 5, at 231-32. The thrust of Reg FD is simple: Public companies (and a defined list of covered individuals that work for those companies) cannot disclose non-public material information to certain “covered persons” without simultaneously disclosing the material information to the public.8Id. (emphasis added). Think of Reg FD as the rule that bars the cocky CEO from being too chatty at a cocktail bar.9Id. If the CEO wants to disclose secret material information to his investment advisor pal, he better simultaneously disclose that secret to the public.10Id.
In private markets—where information asymmetry between issuers and investors is greater—the risk of fraud is ostensibly higher.11Wansley, supra note 4, at 1206-07. And as the number of public companies in the United States continues to decline, commentators have expressed worry that the risk of fraud in private markets is getting too high.12Id. The worry is largely directed towards the growing market for trading in unicorn companies—“late stage startups with reported valuations over $1 billion.”13Id. at 1204. See also Choi & Pritchard, supra note 5, at 203-04. To thwart the growing fraud risk among unicorns, calls have been made for a liberalization of the securities laws to promote a more liquid secondary market for private company shares.14Id. at 1208-10. One prominent piece argues that Congress should: (1) suspend the Exchange Act’s Section 12(g) requirements for public company status so that accredited investors can freely resell private company shares among each other; (2) institute a most-favored-nation status for private shares; and (3) mandate periodic disclosure for private companies who elect to register their shares for secondary trading.15Id.
This article does not grapple with the merits of those proposals. What this article does is make one simple point: If a secondary market for private unicorns is to be explored, Reg FD—or some equivalent—must be adopted to prevent private company insiders from selectively disclosing non-public material information to covered persons. To arrive at this point, this article will proceed as follows. Part II will introduce public company status, private company status, and the secondary markets for each. Part II will also introduce how Reg FD operates. Part III pivots to the argument; positing that a secondary market for unicorns without a Reg FD equivalent would be dangerous for many accredited investors.
II. Public Companies, Private Companies, and Reg FD
This Part will briefly highlight the differences between private and public companies. Additionally, this Part will describe the differences between public and private secondary markets, as well as how Reg FD operates to promote fair disclosures in the public market.
A. Public Company Status
There are three paths to becoming a public company.16Id. at 1210. One way is by listing on a national stock exchange under Section 12(a).17Id. A second way is by meeting a host of requirements outlined in Section 12(g).18Id. Section 12(g) captures any company that (1) has $10 million in assets; and (2) a class of securities “held of record” by 2,000 shareholders or 500 shareholders who are not accredited investors.19Id. (emphasis added). The statute defines “accredited investors” as those individuals and firms that (in theory) are most capable of bearing the risk of investment loss—financial institutions, venture capital firms, and businesses with assets over $5 million.20Id. at 1242. Also included in the accredited investor definition are persons who have an annual income over $200,000 or a net worth over $1 million.21Id. Finally, under Section 15(d), any company that completes a public registration of its securities must comply with regulations imposed on public companies.22Id. at 1210.
B. Private Company Status
At the expense of stating the obvious, private companies do not have to comply with public company regulations.23Choi & Pritchard, supra note 5, at 202. Staying private has its upsides.24Id. For one, being private can be cheaper.25Id. The compliance costs involved with being a reporting company can be difficult to justify for companies that could go public but are unsure of their chances of success in a public offering.26Id. A second benefit of staying private has to do with control: founders and early investors typically retain more control over private companies.27See, e.g., Brad Feld & Jason Mendelson, Venture Deals: Be Smarter Than Your Venture Capitalist 81-90 (4th ed. 2019). By retaining control, the business is better protected from hostile takeovers.28Id.
C. Private and Public Secondary Markets
The differences between the regulatory regimes for private and public companies is stark. This Part will illuminate the laws that lead to the stark differences.
1. Public Secondary Markets
To access the public market, companies must comply with the extensive disclosure regime the SEC mandates.29Choi & Pritchard, supra note 5, at 200. The cornerstone of the disclosure system is the Form 8-K, Form 10-K, and Form 10-Q.30Id. at 206-14. Companies incur great expense mulling over these documents to ensure they are accurate and responsive to investor concerns, while at the same time not overly disclosive.31Id. In theory, the increase in available information from mandated disclosures makes public shares easier to price and profit from.32Wansley, supra note 4, at 1205. But information is not the only reason public shares are more liquid.33Choi & Pritchard, supra note 5, at 775. Another reason is the exemption from registration of secondary trades made by investors under Section 4(a)(1) of the Securities Act.34Id. Section 4(a)(1) exempts from registration any transaction not involving an issuer, underwriter, or dealer.35Id. Unencumbered with the burden of registration, shares on the public market are more easily tradable among investors.36Id.
2. Private Secondary Markets
The secondary market for private company shares is opaque.37Wansley, supra note 4, at 1206-08. This is so for several reasons; but primarily because information asymmetries in private markets are countered by the securities laws, which impose stringent restrictions on the resell of shares issued through private offerings.38Id. at 1206. In theory, these restrictions protect secondary market investors from exploitation at the hands of purchaser-resellers who may exploit an informational advantage post offering.39Choi & Pritchard, supra note 5, at 775-76. For example, Reg D’s 506(b) offering exemption—the most commonly used private placement—imposes restrictions on resale.40Id. There are two commonly used exceptions to this statutory lock up: Rule 144 and the recently adopted Section 4(a)(7).41Wansley, supra note 4, at 1243. Rule 144 allows restricted securities to be resold after one year, whereas Section 4(a)(7) permits resells so long as the shares are sold to accredited investors.42Id.
Even where the exemptions are used, the monitoring of restricted shares is an important priority for private companies.43Id. Just think: if enough Section 4(a)(7) resells occur, the company may begin to flirt with the Section 12(g) shareholder record threshold that would then require the company to publicly register.44Id. To make matters worse, on top of the statutory resale restrictions, many founders and investors impose their own lock-up provisions to secure their rights as a private company marches through funding rounds.45See, e.g., Feld & Mendelson, supra note 27, at 81-90.
D. Regulation FD
Regulation FD covers all domestic public companies, as well as those who work on behalf of such companies.46Choi & Pritchard, supra note 5, at 231-32. Generally, the regulation prevents the company or those who work on behalf of the company to disclose non-public material information to certain “covered” parties.47Id. “Covered parties” include broker dealers, investment advisors, investment companies, or any investor in the company “reasonably expected to trade on the information.”48Id. The gist: if a company wants to disclose material information to any of those actors, it must simultaneously disclose that information to the public.49Id. Typically, public disclosures made to comply with Reg FD are accomplished through a press release or Form 8-K filing.50Id.
III. Don’t Forget Reg FD in a Secondary Market for Unicorns
To be sure, a secondary market for unicorn shares would have several benefits. For one, founders and shareholders would no longer suffer from the illiquidity discount investors demand for the risk they incur.51Wansley, supra note 4, at 1246. And second, a secondary market would likely reduce fraud for the same reasons information in the public market reduces the risk of fraud. But such benefits would be for nil if there were no Reg FD equivalent for selective disclosures on private company shares. By directing information flow towards the public, Reg FD is a critical protection against (1) the improper disclosure of material information by insiders to parties most proximate to the issuer, and (2) the exploitation of non-public material information at the hands of parties most proximate to issuers.
Keeping the market closed to just accredited investors may not be the best way to protect investors. The truth is that the accredited investor standard is, at best, a rough way to gauge risk tolerance. Because the SEC does not update its numbers to keep pace with inflation, 13% of U.S. households (hardly a small number) now qualify as accredited.52Id. at 1242. Even if one puts the sheer number of investors to the side, limiting investor access to a market solely on wealth terms can lead to questionable outcomes: “A trust fund kid might fit the definition, yet a finance professor might not.”53Id. at 1251.
Reg FD was adopted for the public market precisely because the SEC was concerned that the hot IPO market of the 1990s was incentivizing companies to selectively disclose information to certain “favored parties rather than broadly disclosing” the material information.54Choi & Pritchard, supra note 5, at 231. That is, by currying favor with market analysts and brokers, the fear was that companies were affecting their stock price at the expense of retail investors left out of the club.55Id.
Now think about the private market. One can quickly see that it comes with preconditions that make selective disclosure even more problematic than public markets. First, in the private unicorn space, there is more risk about company performance. Many startups fail, and the operating history of companies that have just launched are less predictive of future success. Information about a company’s plans or acquisitions is extremely important, especially where a company may be operating at a loss (as Amazon and Tesla did for years). Where hype is the primary valuation tool, the following question must be asked: If the CEO of a hot unicorn was allowed to selectively disclose information to an analyst without disclosing the material information to the public, would we really expect the analyst to produce unbiased information for other investors, who, though accredited, may be no more sophisticated than a trust fund kid?
The bottom line: participants in a liquid secondary market must be confident in the information they are provided. Therefore, if regulators want to liberalize the secondary market for private shares, they should ensure that a selective disclosure rule is included in the new framework. If Reg FD—or some equivalent—were not adopted for a future unicorn trading regime, then the new secondary market would suffer from an increased risk that material changes in private companies (changes that can occur quickly) are selectively disclosed to covered sources for future funding rounds. This incentive would, in the end, encourage the mispricing of shares and be a net loss to the capital market. Additionally, it would further stratify the 13% of American households that qualify as accredited away from the remainder of the market; as well as place certain “accredited investors” in a privileged position over others.
- 1See, e.g., Stephen J. Choi & A.C. Pritchard, Securities Regulation: Cases and Analysis 22-36 (5th ed. 2019).
- 4Matthew Wansley, Taming Unicorns, 97 Ind. L. J. 1203, 1206 (2022).
- 5Stephen J. Choi & A.C. Pritchard, Securities Regulation: Cases and Analysis 231-32 (5th ed. 2019).
- 6Wansley, supra note 4, at 1205.
- 7Choi & Pritchard, supra note 5, at 231-32.
- 8Id. (emphasis added).
- 11Wansley, supra note 4, at 1206-07.
- 13Id. at 1204. See also Choi & Pritchard, supra note 5, at 203-04.
- 14Id. at 1208-10.
- 16Id. at 1210.
- 19Id. (emphasis added).
- 20Id. at 1242.
- 22Id. at 1210.
- 23Choi & Pritchard, supra note 5, at 202.
- 27See, e.g., Brad Feld & Jason Mendelson, Venture Deals: Be Smarter Than Your Venture Capitalist 81-90 (4th ed. 2019).
- 29Choi & Pritchard, supra note 5, at 200.
- 30Id. at 206-14.
- 32Wansley, supra note 4, at 1205.
- 33Choi & Pritchard, supra note 5, at 775.
- 37Wansley, supra note 4, at 1206-08.
- 38Id. at 1206.
- 39Choi & Pritchard, supra note 5, at 775-76.
- 41Wansley, supra note 4, at 1243.
- 45See, e.g., Feld & Mendelson, supra note 27, at 81-90.
- 46Choi & Pritchard, supra note 5, at 231-32.
- 51Wansley, supra note 4, at 1246.
- 52Id. at 1242.
- 53Id. at 1251.
- 54Choi & Pritchard, supra note 5, at 231.