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SEC Loosens Control on Shareholder Limit under the Private Company Flexibility and Growth Act

Insight Michael Moradzadeh Michael Moradzadeh · November 01, 2011

This blog post was prepared by Inna S. Wood and Michael Moradzadeh.

The Private Company Flexibility and Growth Act (H.R. 2167), referred to as the “Facebook Rule” by many internet bloggers, was introduced in the House by Rep. David Schweikert (R-AZ) on June 14, 2011. Its main theme is to increase the shareholders of record threshold requiring the mandatory registration of a private company with the SEC from 500 to 1,000 shareholders. The act modifies the original shareholder limit that was established by Section 12 (g) of the Securities Exchange Act in 1964 and has not been revised since. It also exempts accredited investors and employees from that count.

According to recent news posts, the bill is quickly moving its way through the House. Supported by many legislators as well as a majority of business people, it has a good chance for becoming law by the end of this year. After several hearings held by the Subcommittee on Capital Markets and Government Sponsored Enterprises it was approved by a voice vote in the beginning of October and forwarded to the Full Committee for further consideration.

The main purpose of the bill, as claimed by its proponents, is to provide private companies with more opportunities for business growth and flexibility in planning their development strategies. According to the current requirements of the Exchange Act, each private company having over $10 million in assets and over 499 shareholders is obliged to register with the SEC.

It is not the first time that the shareholder limit became an obstacle. It seems that businesses were fighting it since its early days. Previously, however, they quickly found their way around the requirement by combining numerous investors into larger pools, thus, decreasing the number of their shareholders of record and avoiding the SEC’s regulation. It is worth noting that the SEC was also very liberal in this respect and allowed such practices to survive and become commonly used in the investments sphere.

Recently, compliance with the threshold became problematic again, to a great extent due to the boost in the number of secondary market transactions. By providing an opportunity to shareholders to freely transfer their privately held stock or entitlements thereto, the new trading platforms, such as SecondMarket and SharesPost, also lessened the control that companies had over the quantity of their equity owners. As a consequence, more and more emerging companies, mainly Silicon Valley start-ups, came closer to exceeding the prescribed shareholder limit.

Historically, when such an event happened, companies mainly faced two options, i.e., either to register with the SEC or to do an IPO. Most companies went with the last choice deciding that if they had to comply with the SEC reporting procedures, they would rather combine it with raising additional funds for their operations. This was the choice for Google, LinkedIn and would likely soon be a choice for Facebook if the legislative efforts of Rep. Schweikert and his colleagues fail. The question that remains unanswered, however, is whether such companies are prepared to go public.

It is hard to disagree with Mr. Schweikert and other supporters of the bill: a company should go public when it has determined that it is ready, not when it is forced to do so by regulators. As a rule, it is easier to manage a company when it is smaller and not overburdened by compliance with different government rules. Indeed, it takes time for a business to mature, design the products it wants to offer to its customers, work out its strategy, and attract talented professionals and supervisors to its team. From this point, it is rather unlikely that such a time period should be measured by the number of its shareholders, even though they are “of record”. 

On the other hand, there is also some truth in the statements of those few opponents who caution against the enactment of the bill. Among the main concerns expressed by them are generally: the lack of information disclosure by private companies, low transparency and unregulated investment practices as well as a possible economic harm caused by a potential increase in the price for their stock due to delayed IPOs. The first three of these concerns are easier to agree with - despite broad powers of internet search engines and efforts of the secondary markets to provide more information about their participants, there is still less data on them in comparison with public companies. The final concern, however, seems to be more questionable simply because it is not clear what will harm the economy more: less IPOs and probability of overpriced shares or premature public offerings.

In any case, it will be the task of Congress and regulators to find that “golden middle” between the representatives on both sides of the bill and make a final decision considering the current economic environment. Based on the numerous discussions and reports heard in the House during the last few months, it appears that lawmakers are focusing a lot of attention on this bill. The SEC has also announced its intention to do a complete study of the issue and formulate its position soon.

We will keep you informed about further developments in this area. You can also track the current status of the act here: http://politics.nytimes.com/congress/bills/112/hr2167.