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The SEC Investigation Into Private Stock Sales Is All About The Glaring Lack Of Disclosure

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The Securities and Exchange Commission is asking questions about private stock markets like SecondMarket and SharesPost. The SEC has sent “information requests to several participants in the buying and selling of stock” to a number of companies, reports the New York Times (although private market SecondMarket says they have received no request from the SEC). [Update: An earlier version of this story indicated that the private markets themselves received the information requests from the SEC, but the New York Times does not specify which firms were contacted].

Over the past year, trading in shares of still-private companies such as Facebook, Zynga, and LinkedIn has skyrocketed, allowing employees and early investors to sell their shares even without an IPO. About $400 million worth of shares will pass hands this year on SecondMarket, which is the largest of the private exchanges, up from about $100 million in 2009. The lack of liquidity because of the general postponement of IPOs among many Internet startups is fueling this growth. Only qualified institutions and high net-worth individual investors are allowed to participate in these markets, but as more and more shares trade hands the SEC’s 500-shareholder rule could be triggered which would require the companies to report audited financial results just like a publicly-traded company.

Investors are buying shares on these markets with little to no knowledge of the actual financial results of the underlying companies. There are no disclosure requirements because these markets take advantage of employees or early shareholders who want to unload their shares to the highest bidder. Investors see these markets as a chance to get in on hot, pre-IPO, Internet startups.

Facebook shares are the ones most in demand on these markets. They recently traded at an implied valuation of above $50 billion on SecondMarket, and $42.4 billion on SharesPost. A couple years ago, Facebook won an exemption from the SEC’s 500-shareholder rule by arguing that the shares were mostly held by employees, and it also changed the way it issued restricted stock. But if the number of external shareholders exceeds 500 investors, the SEC might want to revisit that exemption. The same issue would hold for other private companies who end up with more than 500 shareholders through these private sales.

The SEC is obviously concerned about the growth of these unregulated markets, especially now that funds are being created specifically to invest in these types of securities. To the extent that they become an alternative to public markets, the SEC may require the same sorts of disclosures for companies which gain more than 500 shareholders as a result of their shares being traded there. At that point the companies may as well go public because they gain nothing from these secondary markets other than as a release valve for employees and early investors. (Companies typically do not sell their own shares through these markets, nor do they benefit financially from the trading). In the end, it is all about disclosure. Because nobody can really know what these companies are worth without knowing their true profits, losses, revenue growth, and other financial metrics. If it looks like a public company and trades like a public company then the SEC might just end up regulating it like a public company.

Update 1/3/2011: Now SecondMarket has also received an SEC request, despite its protestations earlier that it wasn’t involved in the inquiry. SecondMarket issued the following statement:

We have now received a voluntary request for information from the SEC regarding “Pre-IPO Pooled Investment Funds.” We are fully cooperating with the SEC in this inquiry

The investigation definitely seems to be focussed pooled investment vehicles designed specifically to invest in private shares, much like the one Goldman Sachs is contemplating for its clients to invest in Facebook.

Photo credit: Flickr/andrecismo

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