May 13, 2011
More Pondering on the 500 Shareholder Rule
Posted by Christine Hurt

Usha posted a few days ago with the question of whether the 500 shareholder rule (Section 12g of the '34 Act and Rule 12g-1) is outdated or still serves a good purpose.  For some reason, mostly because I'm a bit geeky, this question has stuck in my head.  I apologize, but I have more questions than answers at this point.

So, to catch up, the Securities Exchange Act requires the registration of securities in public offerings and tells us what is a security, what is public, what is an offering.  The theory being that purchasers of securities in qualifying private offerings have the ability to negotiate for themselves and gain access to pertinent information without the need for expensive registration and ongoing disclosure duties.  But, this theory may be thwarted if either because of resales or repeated private offerings, a large company has a really large number of shareholders trading in a (let's borrow the term) shadow market.  So, the SEC requires companies hitting the 500 mark to register lickety-split.  Google was there in 2003, Facebook is about to be there.

So, Usha was asking if 500 is still a good number or if the rule is still a good rule.  If you look at it from the role of protecting the purchaser, then you may not care about the rule.  This is probably right.  Purchasers in these companies know they are getting less-than-full information about these companies but either take the risk for higher reward or use venture-backed status as a signal or otherwise make their own investment bed. 

As Usha noted, a few very large companies in the U.S. are privately held:  Mars, Koch Industries, Cargill.  These companies make up one type of private company.  These companies don't bump up against the 500 shareholder rule because they want ownership concentrated, not dispersed.  The other type are the pre-publics:  venture-backed start-ups whose shareholders are relying on some sort of liquidity event such as a public offering.  Issuing pre-IPO securities allows these companies to recruit employees and gain venture funding.  These companies may stay out of the SEC radar for awhile, but they intend to truly go public at some time.  Are we that interested in protecting these speculating investors during an extended pre-IPO period?

However, what if the goal of the securities laws have gotten a little broader?  One does not have to think very hard to realize that in the past decade many so-called securities laws are really governance laws:  Sarbanes-Oxley; Dodd-Frank.  Many of these provisions are corporate governance laws in disguise, and the federal government is able to promulgate these rules and apply them to state-chartered corporations because of the link of federal registration of securities.  Reporting companies come under these laws through virtue of registration.  However, these laws don't apply to non-reporting companies.  So, if we throw out the 500 rules or allow loopholes, then potentially large companies important to our market will be out of the reach of these federal laws.

But for the pre-IPO crowd, the amount of time that they remain outside of registration seems to be finite.  Facebook has a very high valuation and so might be important to the economy as a whole, but it surely will IPO at some point or be acquired.  Repealing the 500 shareholder rule would seem to only postpone registration but not make it unnecessary.  It may be, however, that the 500 shareholder rule is a proxy not only for the need to protect purchasers of resold shares but a proxy for "so important to our economy that we think other stakeholders need disclosure information and we think that they should have federal corporate governance via the Securities Exchange Act."  Perhaps the SEC can stomach the occasional Cargill or Koch Industries, but does not want a new wave of large, privately held corporations whose shares have liquidity via the Internet.

The Dodd-Frank Act talks a lot of systemically important financial institutions that need additional regulation.  Can a nonfinancial institution be sytemically important?  So much so that it needs to come under the federal securities laws even if its shares are not publicly traded?  Is the 500 shareholder rule a good proxy for that? 

Lastly, why does 12(g) only talk about equity security holders?  What about a very large, possibly important company with thousands of bondholders?

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