At the Northwestern/Pritzker 50th Annual Securities Regulation Institute in San Diego this week, SEC Commissioner Caroline Crenshaw gave the Alan B. Levenson Keynote Address. Her topic: exempt offerings and the private capital markets. The rapid growth of the private markets in recent decades, Crenshaw observes, has been “hotly debated”; private offerings have increased at a faster rate than public offerings, as companies delay public offerings or eschew them altogether and instead turn to the private markets to raise enormous amounts of capital, essentially through Reg D. According to Crenshaw, “Reg D, among other legal and regulatory mechanisms, has allowed for the development of pools of private capital sufficient to satisfy the needs of even the largest private issuers.” Hence the unicorn! But are these exemptions serving the purpose they were originally intended to provide? Are they providing adequate safeguards for investors? For example, should large private issuers be required to provide more disclosure? Crenshaw has some ideas for, as she characterized it, “modest reforms.”
Crenshaw begins at the beginning: when the federal securities laws were first enacted, “companies could choose to offer to the broad investing public by taking on substantial disclosure obligations in exchange for exclusive access to the relatively unlimited pool of public capital; private companies, on the other hand, had to raise capital from insiders or certain large financial institutions, and were subject to restrictions on transfer and resale. Private markets were meant to be the exception to the proverbial rule.” The public offering process was designed “to reduce the stark information asymmetry between the issuer of securities and its current and potential investors.” Private companies engaging in exempt offerings did not offer this level of information and, therefore, were “intentionally constrained” in their ability to raise capital. As SCOTUS noted in 1953, “determining whether registration is required or exempt turns on whether investors have access to ‘the kind of information which registration would disclose.’”
Since Reg D was adopted in 1982, the SEC has continued its expansion to facilitate capital formation for small and medium-sized businesses. The SEC “coalesced around a narrow exception to the registration requirement for certain (i) private securities offerings, (ii) to a limited type of investor who had access to baseline disclosures, in order to (iii) allow our small business community to grow and thrive.” However, over time, Rule 506 of Reg D (and other exemptions) “have changed the landscape of the private markets entirely,” as its “unfettered access to capital through Rule 506 has had a bloating effect on private issuers.” Crenshaw suggests that the “clearest evidence” of this effect may be the proliferation of “unicorns”: “private issuers purportedly valued at over a billion dollars. When the term was first coined in 2013, there were 43 unicorns. There are now roughly 1,205 [with] purported overall valuations of about $4 trillion.” These unicorns, she asserts, “have consistently relied on Rule 506 of Reg D to raise billions of dollars in U.S. capital.” While these companies may initially raise capital under Reg D as small businesses, “they can keep raising capital, and keep growing, indefinitely while staying in private markets. The exception is no longer narrow.”
However, she contends, allowing companies to grow so large without registration can have adverse consequences.
First, of course, is investor protection. While some may argue that, given their sophistication, accredited investors do not need the disclosure provided by registration or the protection provided by corporate governance requirements, Crenshaw is concerned that “sophistication is not quite the safeguard it’s presumed to be. The relevant question perhaps should be, as the Fifth Circuit noted, whether investors have the information needed to bring ‘their sophisticated knowledge of business affairs to bear in deciding whether or not to invest.’” In her view, the presumption that sophisticated investors don’t need these protections has fallen short. In support of that contention, she points to a series of problematic private companies. And there can be spillover effects, she said, from these failures to other companies and investors.
Second, she has concerns regarding inflated valuations—”investors may not receive complete or reliable information; securities are generally illiquid, there is limited price discovery and trading can be expensive; and, investors are not guaranteed the best available price when buying or selling the securities.” She also indicated that there are “endemic incentives among institutional private markets to show growth in valuations, all to collect fees.” Those incentives apply to fund managers as well as portfolio companies that want to reflect success, justify earlier valuations and avoid investor write-downs.
Third, Crenshaw suggests that inflated valuations can also impact corporate governance: “[a]cademic work has shown the ancillary or collateral effects of private companies that used their amassed market power to distort traditional corporate governance protections—from dual-class share structures, inconsistent disclosure across investors, and conditions that create lax or deficient systems of internal controls.”
Finally, she contends that a “perverse consequence of the unlimited nature of Reg D is that it may actually be hurting small businesses it was designed to help.” Large private issuers have “locked up” large proportions of the capital available under Reg D in illiquid markets, “so that certain small businesses may be looking to other sources of funding, rather relying than on Rule 506 Reg D.”
To address these adverse consequences, recognizing the enormous disparity in the disclosure requirements for public and private offerings, Crenshaw offers her vision of potential reforms:
Reforms to Form D. First, she suggests requiring that Form D be filed prior to any solicitation under Reg D and imposing consequences for failure to timely file a Form D, such as elimination of the availability of Reg D for future offerings. In addition, she suggests that disclosure requirements be added to Form D—such as the company’s “size (by assets, investors and employees), its operations, its management, its financial condition and revenues, and the volume and nature of the securities offerings”—but not at the level of detail of a registration statement. And it could be signed and certified by an executive officer, who would be accountable for the contents. These changes, she suggests, could mitigate the information asymmetry and provide systemic information for further study, including some insight into potential fraud.
Heightened disclosure obligations for large private issuers and issuances. Here, Crenshaw is advocating adoption of a two-tier system that would impose greater disclosure obligations on the larger private issuers and issuances, much like under Reg A (which, notably, is infrequently used) and the scaled disclosure system for Smaller Reporting Companies. Her conception of these tiers is that, “like Reg A, different sizes of offerings would trigger different disclosure obligations. But unlike Reg A, additional obligations would be triggered by the size of the company, in terms of market cap, value or the size of the investor base…. I believe that, at a minimum, large private issuers could bear heightened disclosure obligations, over and above what would be required of Form D, at offering and on an ongoing basis. For example, they could be required to engage independent auditors and would have to provide prospective and committed investors with financial statements audited in accordance with GAAS, along with auditor opinion letters, confirming the adequacy of the company’s internal controls over financial reporting.”
In her view, this system would, by imposing heightened obligations on larger private companies, provide some “reprieve to smaller businesses, and also help eliminate the benefit and effective subsidy being given to large private issuers on the backs of these same small businesses. Second, it provides broader disclosure to investors, which acknowledges again that, even among a set of accredited and sophisticated investors, private market investors are entitled to a certain basic set of information.”
The SEC’s agenda indicates that Corp Fin is considering recommending that the SEC propose amendments to Reg D, including updates to the accredited investor definition and to Form D, with a target date for a proposal of April 2023. (See this PubCo post.) Whether any of Crenshaw’s “modest reforms” are among the changes contemplated remains to be seen.
At PLI’s “SEC Speaks” conference in 2021, then-Commissioner Allison Herren Lee addressed the same issue, but offered a different solution. Lee began by highlighting “[p]erhaps the single most significant development in securities markets in the new millennium”—the “explosive growth of private markets.” In her view, the vast amount of capital that piled into these markets was “attributable in part to policy choices made by the Commission over the past few decades,” as Congress and the SEC have “steadily relaxed restrictions around private markets in a manner that has spurred their dramatic growth.” Like Crenshaw, she contended that one of the significant consequences has been that “companies can remain in the private markets nearly indefinitely, with some growing large enough to exceed the GDPs of all but the top sector of the world’s national economies.” This capital inflow has led to creation of not just unicorns, but now also “‘Decacorns’ (estimated valuations of $10 billion) and even ‘Hectocorns’ with valuations approaching and exceeding $100 billion.” Lee added that unicorns are “notable not just for their size, but for their transformational impacts on our way of life.” However, their size and impact notwithstanding, in many cases, “there is little public information available about their activities.”
Lee contended that the explosive growth in private markets had brought us to a “familiar crossroads, one at which we must evaluate the opacity of large and important segments of the economy and what that opacity means for investors and our public markets.” We’ve been at this crossroads twice before, she observed: “First, in the early 1930s at the inception of the federal securities laws, when lack of transparency had contributed to misallocations of capital and other market disruptions. Congress addressed this opacity in capital markets, and determined that it was in the public interest to create public companies and periodic reporting requirements for those listed on national exchanges.” And again, in the early 1960s, Congress recognized that the OTC market had grown substantially, but only exchange-listed companies had to comply with the periodic reporting requirements. To restore transparency, Section 12(g) was added to the Exchange Act, and the SEC adopted related rules, requiring that periodic disclosures be made by all issuers with at least 500 holders of record (and a minimum amount of assets). The absence of transparency, she asserted, affects investors (including retirees who invest through institutions), equity-holding employees, policymakers and the public. Will this “growing lack of transparency in capital markets…lead once again to the misallocation of capital that we saw at the inception of the federal securities laws”?
(Note that, previously, under the Exchange Act, a company that had more than $10 million in total assets and a class of equity securities “held of record” by 500 or more persons at the end of its fiscal year was required to register under the Exchange Act, subject to corresponding compliance and reporting obligations. The JOBS Act amended Section 12(g)(1) of the Exchange Act to raise the threshold for the number of holders of record, measured at the end of a fiscal year, that triggers registration: a company that reaches either 2,000 holders of record or 500 holders of record that are not accredited investors, whichever first occurs, is required to register under the Exchange Act. In addition, the JOBS Act excluded persons from the definition of “held of record” if they hold only securities issued to them pursuant to an employee compensation plan in transactions exempted from the registration requirements of the Securities Act.)
What was Lee’s solution to address this issue? When Section 12(g) was added to the Exchange Act, the number of beneficial owners was considered to be “modest” and “difficult to count.” Although, she observed, the SEC initially proposed to include “known beneficial owners” in the count, the final rule did not include the concept. Today, she pointed out, most shares in U.S. markets are held in street name (although presumably much less so for privately held companies), with the result that “record ownership has plummeted and in most cases has no meaningful relationship to the number of actual investors.” According to Lee, “[e]ven some of the largest and most widely traded issuers do not have enough record owners (as that term is currently defined) to meet the requirements of Section 12(g). As a result, the decision to file periodic reports has increasingly become optional. In addition, issuers can exit the periodic reporting process, perhaps by engaging in ‘creative’ shareholder recording methods. And there is a growing possibility that an issuer could have active secondary markets with hundreds perhaps thousands of investors and no obligation to file periodic reports.”
Under current guidance, in counting holders, companies look through record ownership only to banks and brokers, not to beneficial owners. Should that still be the case? Lee advocated that “we should consider whether to recalibrate the way issuers must count shareholders of record under Section 12(g) (and Rule 12g5-1) in order to hew more closely to the intent of Congress and the Commission in requiring issuers to count shareholders to begin with. In other words, it’s time for us to reassess what it means to be a holder of record under Section 12(g).” In that context, she suggested, the SEC should also broadly consider the following:
- “We should better understand the issue of disclosure arbitrage and the circumstances under which public companies may deregister because they have fewer than 300 shareholders of record yet in fact have a sizeable investor base. Data shows that the number of shareholders of record (as currently defined) in public companies has dropped dramatically over time. What opportunities has this created for deregistration and do we think it wise and consistent with our mission to permit this?
- We should better understand how the growing lack of transparency is affecting ordinary investors such as retirees invested through mutual and pension funds, and employees who may become overinvested in a company’s shares without the ability to assess their true value.
- We should analyze how shares are held in the private markets. Although street name ownership is common in the public markets, some evidence suggests it may be less common in the private markets. And if shares in private markets are more commonly held in the names of beneficial owners, might those accounts be transferred into street name later in a company’s life cycle in ways that could escape notice under the anti-evasion provisions of Rule 12g5-1(b)(3)?”
There are, of course, other ways to approach the issue, Lee observed. But regardless of the specific approach undertaken, she urged that we focus on the “fundamental importance of transparency in capital markets, and the need to continually reassess whether we have the right balance between public and private markets—one that supports both innovation and a well-informed, optimized allocation of capital.”
Notably, on the SEC’s agenda with a target date for a proposal of April 2023 is a proposal to amend the definition of “held of record” for purposes of section 12(g) of the Exchange Act.