“Publicness” in Contemporary Securities Regulation after the JOBS Act

In our article “Publicness” in Contemporary Securities Regulation after the JOBS Act, forthcoming in the Georgetown Law Journal, we focus on the ideologically-charged question of when a private enterprise should be forced to take on public status, an extraordinarily significant change in its legal obligations and freedom to maneuver. The JOBS Act, which became law in April 2012, makes the first change in almost a half century in the criteria specified for companies that must meet public obligations under the Securities Exchange Act of 1934. Congress increased the “private space” by raising the 500 shareholder threshold to 2000 (so long as no more than 499 of those are not “accredited investors”) and permitting most new IPO companies to skip a host of regulatory obligations during their first five years as a public company.

Yet the reforms were not the product of any coherent theory about the appropriate scope of securities regulation, not just because of the political dimension but because the public-private divide has long been an entirely under-theorized aspect of securities regulation. This is illustrated by the gross inconsistency in how the two main securities statutes—the Securities Exchange Act of 1934 and the Securities Act of 1933—approach this divide Putting aside the voluntary acts of listing on an exchange or making a registered public offering, Section 12(g) of the ’34 Act has, until 2012, simply counted assets and shareholders to determine companies subject to reporting and other obligations under the Act The ’33 Act, by contrast, uses investor wealth and sophistication, i.e., investor qualification.

As evidenced by the attention to which Congress and the SEC have now given these subjects, there is often a strong political dimension to finding the right balance between investor protection and capital formation. Securities regulation has long balanced these two goals, though rarely with much candor as to the trade-offs. Sometimes these interests coincide—by most accounts, there is a baseline of regulation that efficiently lowers the cost of capital, benefiting both—but other times not. We have no problem with making these trade-offs more candid, which takes us to the task of identifying the costs and benefits associated with securities regulation. As we explore the terrain along the public-private border, we will give considerable attention to the difficulties of doing a cost-benefit analysis, which arise largely because there are so many externalities associated with regulation—positive and negative—and so many contingencies.

Indeed, as we will argue, we suspect that some portion of what we call securities regulation follows from an effort to create more accountability of large, economically powerful business institutions that is only loosely coupled with orthodox (and arguably more measurable) notions of investor protection. This is the more general meaning of the term “publicness” —what society demands of powerful institutions, in terms of transparency, accountability and openness, in order for that power to be legitimate. The narrower meaning, which is our specific focus here, refers to the legal rules that securities law imposes on companies that are deemed public. We argue that, to a greater extent than generally acknowledged, the broader demands of publicness drive the creation of contemporary securities regulation, so that the two meanings are necessarily linked.

This understanding leads us to conclude that there should be two key breakpoints in the ’34 Act. One—the familiar one—is the threshold point at which companies must undertake basic public disclosure obligations, leaving behind the privacy they previously had. Congress tinkered with this line in the JOBS Act, but without adequately addressing technological change that has already rendered parts of the statutory metrics archaic and is quickly reducing the ability of other parts of the statutory structure to carry out the policy choices inherent in the public-private divide. To see how and why, Part I of our article surveys some of the history of the public-private divide in securities regulation, and then looks at how technology has blurred the distinctions that have long been used by regulators. Here we look, for example, at the emergence of SharesPost and SecondMarket as trading markets to facilitate resales of securities for private companies, as well as changes in what once was known as the “pink sheets.”

Part II then looks at the issue that first piqued our interest in this topic–Facebook’s 2010 effort to postpone acquiring public status by raising capital from a sizeable number of private investors whose interest would be bundled in a single investment vehicle—and at the JOBS Act response. Given the technological changes covered in Part I, we argue that Congress missed the real issue when it increased the trigger for a company to have obligations under the ’34 Act from 500 investors to 2000 because it continues to base that number on shareholders “of record”, an archaic metric that has lost its ability to accurately describe the real number of owners in modern markets; a standard focusing on a company’s trading volume captures much better the realities of the contemporary marketplace. If anything, the result is likely to be a de facto repeal of Section 12(g), rendering the shareholder threshold no longer a binding constraint in terms of requiring companies to step up to the disclosure and other obligations of the ’34 Act. This leaves the real work to be done by the other two statutory thresholds that themselves are being eroded by technological and market changes. If these development continue apace, even if not in the immediate future, there may well be a much larger trading market outside of ’34 Act obligations that Congress didn’t consider and the SEC hasn’t yet planned for. We are also concerned with the idea borrowed by the JOBS Act from the ’33 Act that accredited or otherwise sophisticated, wealthy investors should not be counted in assessing public status for issuers who accrue obligations under the ’34 Act. Finally, we offer some thoughts about balancing costs and benefits with respect to drawing the line between public and private issuers.

There is a second breakpoint that we think should be just as important, to which we turn in Part III. Our focus here is on the extent to which Congress has articulated public company responsibility and accountability with the implicit image of the very large issuer in mind. Many of the modern demands on public companies are for reasons having less to do with investor protection as traditionally imagined, and more with setting standards to protect constituencies well beyond their investor base. The implication thus seems clear: contemporary securities regulation should have two distinct tiers of companies, with the tier of smaller companies facing only core disclosure obligations and governance requirements. Full publicness treatment should be reserved for companies with a larger societal footprint. This shift would, among other things, ease the costs associated with transition from private to public company. There is a similarity in purpose here to “on ramp” part of the JOBS Act which provides a useful comparison and contrast to the much more expansive idea we advocate.

Part IV discusses the regulatory challenge that arises from rapid technological innovation, almost always one step ahead of the regulators. Settings like Facebook’s pre-IPO capital raising effort while staying outside of the regulatory reach of the ‘34 Act illustrate a process in which entrepreneurs and their advisors occupy new unregulated (or less regulated) space created in the wake of technological change or by gaps in regulation revealed as markets evolve. The regulatory response is often piecemeal and reactive, shaped by the frame that the occupiers have already defined. Overall, the process is more informal than the administrative process is often described, relying on staff interpretations more than Commission involvement for example and sometimes making it difficult to address concepts that may have become antiquated. We suspect that the JOBS Act will set in motion a new round of similar occupations.

The full text of the article is available here.