Information issues on Wall Street 2.0.

• Author: Pollman, Elizabeth
• Position: IV. Possible Responses to Information Issues in the Secondary Markets for Private Company Stock through Conclusion, with footnotes, p. 221-241

4. POSSIBLE RESPONSES TO INFORMATION ISSUES IN THE SECONDARY MARKETS FOR PRIVATE COMPANY STOCK

   The previous Parts have built on existing literature recognizing the potentially beneficial role of the secondary markets for private stock, while drawing new attention to significant information issues in these markets. The secondary markets are still relatively new, and their future is unclear. Thus, the practical challenge going forward is determining whether these markets should be embraced, whether adequate responses to the information issues can be devised, and, more broadly, whether the markets can be regulated in a way consistent with the SEC's mandate to promote investor protection, capital formation, and market integrity. This Part explores potential responses to the information issues.

   1. Lack of Information, Asymmetric Information, and Conflicts of Interest

      Virtually no legal scholarship has offered a response to the information issues that threaten the legitimacy and efficiency of these markets. Popular media commentary addressing the issue has varied primarily between two polar viewpoints. Some observers have argued that the markets should be allowed to flourish unfettered since accredited investors are either sophisticated or wealthy enough to withstand a loss. (227) Conversely, others have expressed strong reservations about the surging, perhaps bubble-like, and potentially inaccurate valuations of some companies on these markets, suggesting that these markets should be subject to more regulatory oversight. (228)

      This Article argues for a middle path. The Supreme Court established more than a half-century ago that sophisticated investors do not need the same protections as the unsophisticated. (229) With access to information, sophisticated investors are presumably able to "fend for themselves." (230) That is, they are assumed to be in a position to get the information they need before investing or, alternatively, to take any lack of information into consideration in pricing stock. (231) As only accredited investors and QIBs can buy private company stock on the secondary markets, there is arguably no need to expand regulation of secondary trading of private company stock. Yet, as Section III.A explained, investors on these private secondary markets may not have the appropriate type and amount of information, and access to this information may be difficult to obtain, particularly as investors are not in privity with the company in a secondary transaction. Given that the relevant regulatory structure was devised years before the rise of these new private secondary markets, some regulatory tweaking may be necessary to strengthen the markets and promote investor protection.

      This Article proposes two reforms to this end: a specified minimum level of disclosure for private secondary trading to fit within a registration exemption and a reevaluation of the accredited investor standard.

      One way to address the lack of information and the asymmetric information in the secondary markets would be for the SEC to require a certain minimum level of disclosure in order for private company stock to be traded in secondary transactions. The SEC could issue new rules or interpretive guidance that specified certain disclosures required for secondary transactions to fit within the established securities exemptions. For instance, the SEC could amend Rule 144 such that both affiliates and nonaffiliates would be subject to information requirements.

      The information required could include basic information critical to evaluating a company's financial fundamentals and stock value. The disclosure required under Rule 701 of the Securities Act could serve as a useful reference point. (232) Rule 701 provides a registration exemption for compensatory stock options, and requires private companies issuing over $5 million in stock options within a twelve-month period to provide option-holders with risk information and financial statements no more than 180 days old. (233) The SEC could also consider, by contrast, less and more stringent reference points--such as the Rule 144 exemption for affiliates selling restricted stock, and the full registration requirements or the JOBS Act on-ramp for newly public companies. (234) In addition to considering these reference points, the SEC should seek public comment and engage in cost-benefit analysis to require disclosures properly tailored to the private secondary market context. (235)

      The goal would not be to replicate the extensive governance and reporting requirements of public companies, but rather to standardize a modest level of required information that would not overly burden the private companies and that sophisticated investors would find critical for basic valuation. (236) In other words, the disclosure requirement is meant to address the concern that there is not enough information available to make prudent decisions, regardless of an investor's accredited status. (237) As one managing director of an investment firm said, "It's hard enough to get information on Facebook. I'm an accredited [investor], I have an M.B.A. in finance, how do I know what these things should be valued at?" (238) A moderate mandatory disclosure rule could correct for a market failure in information production and thereby strengthen these markets. (239)

      As this requirement could be structured as specific guidance for fitting any given transaction within an exemption, the information would not have to be disclosed to the public at large, but rather only to the secondary transaction participants. Such a requirement would allow companies to continue to use secure electronic data rooms and confidentiality agreements to maintain some level of control and confidentiality. Mature private companies whose stock is likely to be traded on secondary markets may have already prepared the same type of information for compliance with the disclosure requirements of Rule 701, and possibly for affiliate sellers who have sold stock pursuant to Rule 144.

      This idea reflects changes in the venture capital cycle--that the lengthening period of time from a company's formation to a major liquidity event has created mature private companies that straddle or blur the lines between previously held notions of public and private. (240) SharesPost has said that it is "trying to create an interim market between the VC investing world and the public markets;" (241) this proposal would establish a corresponding interim level of disclosure. This idea might become increasingly important as the secondary markets continue to develop and change, particularly in times of bubble-like exuberance. (242)

      The idea has limitations, however, and some of the concerns about information issues in these markets would likely remain. One can imagine scenarios where, despite the availability of certain basic information, private companies would not disclose other important information for valuing their stock. Participants in these markets would still have to make their own determinations of whether they had sufficient information to make investment decisions. This proposal would only set a standard minimum level of disclosure to address a fundamental information failure.

      Furthermore, while an interim level of disclosure responds to the lack of information and asymmetric information, it does not directly address conflicts of interest. While a certain base level of information might help counteract biased research reports, a separate response to the conflict of interest issue may be necessary.

      In addition, there is, of course, a cost associated with requiring disclosure, however modest. Companies could be concerned that the information disclosed would not remain confidential and might refuse to make the required disclosures, effectively preventing shareholders from selling their stock on the secondary markets. Such a move could decrease the liquidity of some private company stock relative to the current situation, and constrain the growth of these markets. Furthermore, a minimum information mandate might require more company involvement than SharesPost currently includes in its model. Requiring information disclosures might necessitate moving to a model that creates controlled liquidity events rather than one that aims for an active marketplace.

      The cost could, however, be kept moderate, similar to Rule 701's information requirements, which apply to companies issuing significant stock options or compensatory equity awards. (243) If so, many companies might voluntarily cooperate, as evidenced by SecondMarket's newer business model, which is based on significant issuer involvement. While companies may be sensitive to the number of shareholders and other concerns related to secondary trading, (244) they may also find they benefit in the long run from the presence of vibrant secondary markets. (245) Further, over time, investors may be able to exert leverage over companies for minimal disclosures, either because of their size or number.

      A second way to address concerns about information issues is to reexamine the definition of "accredited investor," established in Rule 501 of Regulation D. (246) This proposal does not directly deal with the amount or quality of information available, but rather addresses the concern that there are individuals participating in the secondary markets who cannot fend for themselves.

      The definition of "accredited investor" aims to capture investors who are sophisticated enough to make their own trades, or who can afford to hire advisors, and so do not need securities law protections. (247) Net worth and income serve as objective proxies for this ability to fend for oneself. (248) As a result, the accredited investor definition is notoriously under- and over-inclusive. (249) It is underinclusive because financially knowledgeable investors may not meet the minimum wealth requirements for accredited status, and overinclusive...