Trading on the Secondary Market

Insight June 29, 2011

In recent years, the secondary market for stocks – a platform through which investors can buy and trade shares of private companies – has grown exponentially in size and use.  This year,    transactions on the online platforms of SharesPost and SecondMarket alone have totaled over $ 4.6 billion, and are projected to exceed $ 6.9 billion next year. This does not include the much larger volume of trading by traditional broker-dealers and financial advisers, or other online platforms. 

At first glance, this seems to be a good deal for all parties involved: holders of mature private company shares can sell to get instant cash and liquidity instead of having to wait for the company to go public, and buyers are able to acquire shares and get ownership of companies at (theoretically) much lower prices than they would on the open market after an initial public offering.  However, two key differences between trading privately and trading on a public market highlight the secondary market’s major drawback. 

First, there is a lack of disclosure requirements.  Companies listed on the secondary markets are not heavily regulated by the SEC, unlike publicly traded Section 12 companies, which are subject to the public disclosure requirements of the Securities Exchange Act of 1934 (generally Sections 10(b)(5),12, 13, 14, and16(b) as well as Sarbanes-Oxley).  The Act protects investors by forcing publicly traded companies to publish annual financial reports, disclose material information on pending transactions, and explicitly prohibits fraudulent information and insider trading.  As such, secondary market buyers could be said to be making risky and blind investments. 

Second, generally only the owners of private shares (typically employees) can sell, and only “accredited investors” can buy on secondary markets.  An “accredited investor” is defined as a person with either a net worth of more than $ 1 million, or an income consistently exceeding $ 200,000 ($ 300,000 if married) annually.  The SEC assumes that wealthy (and therefore “sophisticated”) investors can take care of themselves. Therefore, when accredited investors enter into private sale transactions, the SEC doesn't require the kind of financial disclosures that public companies have to make.  The logic of this rule is that wealthy investors can afford to either take a potential hit, or pay to research the market themselves.  In fact many companies like GreenCrest exist solely to research financial reports for private companies involved in the secondary market. 

SEC developments
Currently, Section 12 of the Securities Exchange Act requires a company to go public after it acquires 500 shareholders. One question is whether that number should be increased in light of the ease with which a company can acquire additional shareholders through secondary market trades.  Otherwise, a company can essentially be forced to go public before it is ready.  The SEC began to address this issue back in 2008 when it granted Facebook an exemption that allowed them to stay private despite going above 500 shareholders, as long as most of the shares stay within the company. 

The Private Company Flexibility and Growth Act bill, an amendment to the Securities Exchange Act of 1934, was introduced in Congress on June 14, 2011, and proposes to extend similar concessions to private companies. The legislation proposes to:

1.      Increase the 500 shareholder limit to 1000 before requiring disclosures;.

2.      Exempt employees from the shareholder limit; and

3.      Exempt “accredited investors” from the shareholder limit, which includes not only wealthy individuals, but venture capital firms and other institutions.

In practical terms, this would allow a private company to remain private almost indefinitely.  The bill would greatly stunt the IPO market, and the secondary market would become the only way for many people to get value for their shares.  However, the bill is at least several months from coming into effect, so the impact on the large cluster of pending IPOs (Facebook, Zynga, Twitter) remains to be seen.

Surprisingly, the SEC hasn’t taken any overt actions to require secondary market disclosures.  The trend, with the Private Company Flexibility and Growth Act bill basically encouraging the secondary market, actually appears to be moving towards relaxing restraints on private companies. But only recently have reliable platforms such as SharesPost and SecondMarket become widespread in use – last month, LinkedIn was the first company traded on the secondary market to actually go public (http://www.rimonlaw.com/blog/2011/05/27/linkedin-ipos-to-astronomic-figures).  And with the valuations of companies and number of IPOs both drastically rising, the volume of business is projected to increase dramatically as well.  At that point, the SEC will likely take a harder look at regulating the secondary market.