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Facebook Versus The SEC

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Facebook

Facebook’s practice of raising capital on private markets largely out of the direct oversight of regulators has spurred an inquiry by the Securities and Exchange Commission.

Facebook recently cut a deal with Goldman Sachs and a Russian investment company called Ditigal Sky Technologies that will raise $500 million for the company. The terms of the deal reportedly value the company at $50 billion.

The SEC is reportedly concerned that Facebook and its backers are evading US securities laws by refusing to go the traditional route of raising money through an initial public offering. Instead, Facebook has chosen to avoid coming under regulatory scrutiny by issuing only SEC- exempted restricted stock units to employees and raising money through private placements with venture capital firms, investment banks and hedge funds.

To some critics of regulation, this is evidence that the burden of government regulation may now be too great. The regulations—including Sarbanes Oxley accounting and disclosure rules—may be holding back tech companies like Facebook from entering the public markets, the critics say. Investors, in this view, could be losing out on a chance to profit from the growth of one of the most important companies on the Internet.

Many on Wall Street share this point of view—and with good reason. Fees from public offerings are great sources of profits for broker-dealers. Publicly-traded stock in hot companies give brokerages another way of enticing customers to put more of their money “to work” in the markets. Anything that keeps companies out of public markets hurts brokers and investment bankers specializing in public offerings.

It’s hard to see what the SEC’s interest in Facebook might be. It is clearly not engaged in a probe of how its own policies might be putting constraints on IPOs. But since the investors in Facebook are highly sophisticated institutions, the goal of an SEC probe cannot be protecting ordinary investors.

One concern may be that the investors in Facebook are selling stakes in the vehicles they use to buy Facebook shares. Goldman Sachs, for example, plans a special purpose investment vehicle that will own the Facebook shares as its assets, allowing outside investors to purchase shares in Sachsbook—or whatever they call it. In this way, many more investors could share in the potential upside of owning a stake in Facebook than would otherwise be permitted by a private company.

The rules that restrict ownership of non-public companies are antiquated. They were put in place 47 years ago and require firms with more than 500 investors to publicly disclose certain financial information. Those disclosure requirements are so high that most companies decide they might as well go public if they are meeting the disclosure requirements of public companies anyway.

The SEC may be preparing to expand this rule to include the kind of derivative ownership rights created by the likes of Sachsbook. It likely views such arrangements as a way of undermining the regulations put in place to protect investors.

That position, however, seems far less rational when anyone looks at the details of the transaction between Goldman Sachs and Facebook. Even if Goldman succeeds in raising another $1.5 billion from outside investors, it intends to set the minimum purchase in Sachsbook shares at $2 million. In other words, not a lot of ordinary investors are likely to be invited to participate.

SEC
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SEC

The SEC is apparently trying to force Facebook off its path of financial innovation and onto the well-trodden ground of public markets. It appears that regulators want the reality of how Facebook raises money to conform with the model against which the regulatory structure was built. The SEC could simply be attempting to make the costs of Facebook-style innovation so onerous that the company—and other tech stars—chose to stick to the traditional path that leads from start-ups to IPOs.

This would be ironic. It was this traditional path that lead to disasterous results for many investors in the last decade when the stock bubble of the late 1990s and early 2000s imploded. Perhaps the SEC should decide that it can declare victory and go home because a company like Facebook—which still hasn’t explained exactly how it will make money for investors—has decided to stay out of the public markets.

In any case, the SEC’s role here certainly diverges from its traditional focus on protecting ordinary investors. But this trend has been in evidence for some time. When the SEC accused Goldman of misleading a German bank on a synthetic collateralized debt obligations—the famous Abacus deal that lead to a $550 million settlement—there were many who wondered why deals between a Wall Street investment bank and a German bank concerned the SEC at all. Much the same could be said with the recent concentration on insider trading by regulators—they almost don’t even bother to point to harm to ordinary investors any more.

This doesn’t mean that critics of the regulations that make IPOs burdensome are entirely right. A company like Facebook may simply never “go public” in the traditional sense of offering common shares to ordinary investors, even if some of the rules of the last decade accused of constraining the IPO market are repealed. The future of finance may hold a far smaller role for the publicly-traded corporation as many companies become widely held partnerships or privately-traded 'uncorporations'.

From the perspective of a regulator, this development may be distressing. It can look to a regulator as if the companies that raise money through private markets are “unregulated.” But this is not true in any meaningful sense. The companies are regulated quite strictly—by the investors to whom they must continue to appeal for additional capital.

Look at it this way. When a company raises permanent capital in an IPO, it creates a huge capital base that is constantly in danger of exploitation by management. But when a company must continually seek infusions of capital from its partners or a small set of investors, the opportunities for exploitation are fewer. The investors become the regulators because of the lack of an IPO-created capital base.

What we’re seeing right now is the first clash in the battle for the future of finance. No matter who wins which battles, one outcome is certain—it won’t look very much like the ghost of financial transactions past.

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