Fuente: Harvard Law School Forum on Corporate Governance
Autora: Allison Herren Lee, U.S. Securities and Exchange Commission
Perhaps the single most significant development in securities markets in the new millennium has been the explosive growth of private markets. We’ve become all too familiar with the statistics: more capital has been raised in these markets than in public markets each year for over a decade [1] with no signs of a change in the trend. The increasing inflows into these markets have also significantly increased the overall portion of our equities markets and our economy that is non-transparent to investors, markets, policymakers, and the public. [2]
The vast amount of capital in these markets, attributable in part to policy choices made by the Commission over the past few decades, has also created a new, but no longer rare or mythical, kind of business known as Unicorns—private companies with valuations of $1 billion or more. So christened in 2013 when their existence and number was more fittingly associated with fairy tales, they have since grown dramatically in both number and, importantly, in size, reaching dizzying valuations nearing and even exceeding $100 billion. [3] In today’s markets, companies can and do stay private far longer than ever before, despite the fact that they often dwarf their public counterparts in size and influence.
These private businesses are not just big, but also consequential, making significant positive contributions to innovation. They shift paradigms, create jobs, stimulate the need for new services and supply chains. They’ve even changed the infrastructure of the nation’s labor force, ushering in the so-called “gig” worker. In other words, they have a dramatic and lasting impact on our economy, at the local, state, and even national level. [4] But investors, policymakers, and the public know relatively little about them compared to their public counterparts.
The shift toward private markets in recent decades has brought us back 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 down this road before—twice, in fact. 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. [5] 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.
Three decades later, in the early 1960s, Congress recognized that opacity in capital markets had again become a problem. The periodic reporting requirements applied only to exchange listed companies, and the over-the-counter (or OTC) markets had grown significantly in the intervening decades. Thus, both Congress and the SEC acted again, creating Section 12(g) of the Exchange Act, and rules thereunder, requiring all issuers with a sufficient number of shareholders (and a minimum amount of assets) to make periodic disclosures, thereby restoring transparency to what had become a significant segment of the capital markets.
And here we are again watching a growing portion of the US economy go dark, a dynamic the Commission has fostered—both by action and inaction. [6] So today I want to talk about the role, really the obligation, of the SEC to examine and consider whether we should take steps, including pursuant to the broad authority Congress gave us under Section 12(g) of the Securities Exchange Act, [7] to address the reduced transparency in US equity markets.
I. Going Dark
The expansion of private markets is not the natural result of the evolution of “free” market forces. Rather, it is a product of the framework of laws and regulations through which markets operate. As one observer described it succinctly and directly:
“A market economy is at its core a collection of rules. No rules, no market. Just as every competitive sport has clear rules, competitive markets need rules: no rules, no game.” [8]
When we relax or repeal certain of these laws or regulations, we do not move closer to a so-called free market, but rather simply alter incentives and magnify the force and impact of the remaining rules on the books. [9]
Congress and the Commission have steadily relaxed restrictions around private markets in a manner that has spurred their dramatic growth. As a result, an ever-increasing amount of capital is raised in these markets each year, with private offerings accounting for approximately 70 percent of new capital raised in 2019. [10] Because of the vast capital available, relaxed legal restrictions, [11] and greater opportunities for founders and early investors to cash out, [12] 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. [13]
Current estimates vary, but generally put the number of Unicorns worldwide at roughly 900, up from an estimated 39 in 2013. [14] The list now includes not just Unicorns (those with an estimated valuation of at least $1 billion) but also so-called “Decacorns” (estimated valuations of $10 billion) and even “Hectocorns” with valuations approaching and exceeding $100 billion. [15] Although some of these large firms are subject to industry-specific regulation, such regulation may be quite sparse (as with the growing number of crypto-related Unicorns) [16] or does little to address financial transparency.
Unicorns are notable not just for their size, but for their transformational impacts on our way of life. They have, for example, changed the transportation [17] and travel [18] habits of millions across the globe, spawned billions in litigation, changed the legal underpinnings of entire markets, [19] and launched civilians into space. [20]
Yet, despite their outsize impact, there is little public information available about their activities. They are not required to file periodic reports or make the disclosures required in proxy statements. They are not even required to obtain, much less distribute, audited financial statements. This has consequences for investors and policymakers alike, which in turn may have consequences for the broader economy.
To begin with, investors may lack adequate information about the business and operations of these companies. While large sophisticated investors have some ability to obtain disclosure, they sometimes almost inexplicably fail to do so. [21]
In many cases, remaining informed requires a position on the board, an avenue open only to a limited number of investors. And the disclosure obligations that do exist are mostly a matter of contract rather than regulation, an approach that may affect both compliance and accuracy. [22]
Then there’s the category of investors in these markets with much at stake and sometimes little to no negotiating power to obtain needed information: employees. Employees who hold equity in the firms where they work often don’t have the information they need to determine, for example, the full financial consequences of leaving their jobs when their stock is subject to a mandatory resale obligation. Quitting can become an investment decision that must be made in the dark. [23] They also may not know whether to dispose of shares in a funding round, or sell into secondary markets that have developed for the stock of numerous private firms. [24] Note too that unions bargaining for employee rights and protections may lack important financial information about companies employing tens of thousands of workers.
Consider also another category of investors: those saving for retirement who may indirectly access private markets through institutional investors. More and more of the capital in private markets comes from pension plans, mutual funds, and other institutions, [25] a trend that will likely continue. [26] Because these institutions are stewards for the savings and retirement assets of millions of Americans, the savings of everyday investors is increasingly exposed to the potential risks associated with a lack of transparency. [27]
Importantly, policymakers and the public also have a reduced ability to assess the impact of these issuers on the US economy as a whole. The fact that more capital is now being raised in private markets means that a burgeoning portion of the US economy itself is going dark. Twenty years ago private markets represented (by some estimates) roughly two percent of global investable equity assets. Today, that percentage has increased more than threefold to a current estimate of seven percent. [28] Other estimates reflect that global private equity net asset values have grown twice as fast as public market capitalization in the new millennium, with that trend expected to continue. [29]
The diminishing incentives to raise capital in the public markets portend problems for private markets as well. Private markets may depend in large part on the ability to free ride on the transparency of information and prices in public markets; as public markets continue to shrink, so does the value of that subsidy. [30]
And finally, we must consider whether the growing lack of transparency in capital markets will lead once again to the misallocation of capital that we saw at the inception of the federal securities laws. For example, this opacity could operate to obscure systemic risks such as those posed by climate change. [31]
II. History Repeats
Round 1: 1933-34
As I mentioned, we have been here before. Concern over adequate transparency in the securities markets was the driving force behind the advent of federal securities laws. A relatively small segment of the US population was invested in stock markets at the time, yet the weaknesses in those markets led to “[n]ational emergencies [producing] widespread unemployment and the dislocation of trade, transportation, and industry.” [32] The foundational statutory language made clear that the securities laws were intended to protect the “general welfare.” The principal remedy was disclosure. Thus, Congress passed the Securities Act of 1933, which essentially required companies seeking capital from the public to file a registration statement. But right away, Congress saw that a one-time obligation to file information was insufficient, and a year later it passed the Securities Exchange Act of 1934 to, among other things, create ongoing periodic reporting obligations. [33]
The ’34 Act required all exchange traded companies to file annual, quarterly and other reports, including audited financial statements. The approach went well beyond then-existing disclosure requirements at the New York Stock Exchange, [34] and was described by the bill’s sponsor, Rep. Sam Rayburn, as needed to make increasingly complex markets become more honest and “justifiably self-trusting.” [35]
The new reporting provisions applied only to listed companies, not over-the-counter markets. At the time, this was a logical approach given that wealth was heavily concentrated in the largest companies [36] and those companies largely traded on exchanges, making them responsible for a “very substantial part of the entire national wealth.” [37] Moreover, little trading activity appeared to be occurring in the over-the-counter markets [38] and companies in those markets were not considered to be in the same “class” as those listed on an exchange. [39]
Round 2: 1963-64
However, by the early 1960s, over-the-counter markets had grown substantially. The increase was described at the time as “tremendous” [40] and “dramatic,” [41] adjectives often used today to describe the evolution of the private markets. Commentators at the time also observed that companies were moving to these markets to avoid required disclosure. [42] In response, Congress commissioned a comprehensive study by the SEC, [43] which found, among other things, a problematic lack of transparency in the growing OTC market, as well as a correlation between lack of disclosure and fraud. [44] Thus an increasing portion of US equity markets lacked transparency, similar to conditions that led to the establishment of the federal securities laws, because regulations had failed “to keep pace with [market] growth and change since enactment of the original securities laws.”
It was time to reassess. [45] Because, unfortunately, as they knew then and we know today, what happens in capital markets, doesn’t stay in capital markets [46]—fault lines on Wall Street can crack and spread across the entire country upending the lives of all Americans.
In devising recommendations, the Commission focused on the purpose of the federal securities laws, taking into account the public interest [47] and the effect of the securities markets on “the general economy.” [48] The study described the over-the-counter markets as “large and important” but still “relatively obscure and even mysterious for most investors.” [49] Increased transparency through disclosure was the solution. [50]
In considering which companies should be subject to disclosure, the Commission determined, and Congress ultimately agreed, that the purposes of the securities laws would be best served by a test that looked to the number of investors. [51]
Congress implemented the recommendations of the Special Study by enacting Section 12(g) of the Exchange Act, under which issuers with 500 shareholders of record [52] and, at the time, at least $1 million in assets [53] became subject to periodic reporting. [54] In counting “holders of record,” Congress and the Commission were aware that shares were sometimes held in “street name” accounts, [55] meaning held in the names of the brokers and banks through which they purchased. These beneficial owners thus would not show up as a holder of record. The number of such beneficial owners at the time, however, was modest [56] and considered difficult to count. [57]
Still the Commission did propose to include “known beneficial owners,” in the shareholder count. [58] The concept was not adopted in the final rule, however, and there was no analysis of the change other than to state that it was for “simplification.” [59]
While the Commission did not ultimately exercise its authority at the time to require issuers to look through to beneficial owners, it is clear the Commission has the authority to do so. [60] In fact, it has already exercised that authority to require issuers to look beyond their list of record holders through to the level of brokers and banks, but no further. [61]
In the JOBS Act, Congress spoke again to the issue, raising the threshold from 500 to 2000, but keeping the threshold at 500 for non-accredited investors. [62] Thus, while expanding only the number of allowable accredited investor shareholders, Congress reaffirmed the view that the number of shareholders (and even the nature of those shareholders) is the proper metric to consider in requiring periodic reporting, so long as a company meets a minimum asset level, now set at $10 million. [63]
But ownership in the securities markets has undergone a fundamental shift since the 1960s. [64] Today, almost no one holds shares in record name, [65] with stock certificates increasingly going the way of landlines and 8-track tapes. [66] Indeed, individuals wanting to be listed as a holder of record can confront unwilling brokers [67] or hefty fees. [68]
As a result, record ownership has plummeted and in most cases has no meaningful relationship to the number of actual investors. Even 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). [69] As a result, the decision to file periodic reports has increasingly become optional. [70] In addition, issuers can exit the periodic reporting process, perhaps by engaging in “creative” shareholder recording methods. [71] 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. [72]
The tie between the actual number of shareholders and periodic reporting has come untethered from its moorings in today’s markets. Our reporting regime is now to closer to where it was in 1964, before Congress intervened to add Section 12(g), with a large and important market segment increasingly obscured, and our rules and regulations ripe for reappraisal. [73]
III. Looking Forward
Where does this leave us? Investors and the public are increasingly left in the dark when it comes to ever expanding segments of the economy. This has implications for the future vitality of the private markets (which depend in many ways on the transparency and discipline of public markets) and it has implications for optimizing capital allocation across both markets.
Time and again, we take regulatory action on the grounds that it may encourage companies to go public. [74] But if that is a legitimate goal of the securities laws, then we should also work to ensure that the boundaries between public and private markets are sensibly drawn and maintained, and that the incentives for going public remain balanced.
Accordingly, 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). We have received rulemaking petitions asking us to examine this issue. [75] The North American Securities Administrators Association has supported a reexamination, [76] as have academics [77] and other experts. [78] A former Chair of the SEC flagged the issue in Congressional testimony as well. [79]
As we reexamine how issuers should count shareholders, we should broadly consider a number of important factors that may implicate our public-private boundary:
- 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. [80] Data shows that the number of shareholders of record (as currently defined) in public companies has dropped dramatically over time. [81] 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. [82]
- 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. [83] 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)? [84]
If the number of shareholders is to have any meaning at all as a trigger for going public, we should look broadly at the different forms of beneficial ownership. This means considering to what extent issuers should have to look through to the actual investors whose economic well-being is at stake, including looking beyond street name accounts held at brokers and banks, as well as potentially looking through special purpose vehicles and partnerships. [85]
Of course re-evaluating how issuers count shareholders is not the only potential avenue for addressing policy concerns related to how we determine public company status. Others have suggested additional approaches (beyond just number of shareholders). They include, for example, considering revenues or market capitalization, a certain level of “public float” in private trading venues, or number of employees. [86] Some of these approaches may require Congressional action. But the Commission can and should act now within our existing authority to restore transparency in capital markets. That means, at a minimum, it’s time to revisit how we define shareholders of record under 12(g). And more broadly, it means recalling 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.
