by Adi Osovsky

The primary mission of the U.S. Securities and Exchange Commission (hereinafter: the “SEC”) is to protect investors.  However, current securities regulation clearly separates between public markets and private markets with respect to investor protection. While the federal securities laws impose strict and costly disclosure and anti-fraud requirements on issuers that offer their securities to the public, they exempt private offerings from such rigid regime.

The comparatively relaxed approach toward private offerings is based on the assumption that investors in private markets are sophisticated and thus can “fend for themselves”.  Under this assumption, and in order to decrease issuers’ uncertainty regarding the application of such exemption, the SEC adopted a wealth-based safe harbor as a proxy of sophistication.

This Article explores the validity of such traditional dichotomy between the public market and the private market in a relatively new, organized secondary market for ownership interests in private companies with retail investor access—the “Secondary Market”. The Secondary Market evolved shortly after the burst of the dot-com bubble in the late 1990’s and since then has expanded rapidly to reach sales exceeding a billion dollars a year. It has created a platform for the trading of private company shares, thus providing investors and employees with an opportunity to sell their holdings even before the first exit event. Such liquidity also benefits private companies, who will no longer be forced into expensive initial public offerings (IPOs) to satisfy their investors’ need. Moreover, private market transactions allow greater flexibility in capital formation, which may enhance productivity and job growth.

The Secondary Market, however, also raises serious questions with regard to investor protection. As this Article shows, the rapid growth of the Secondary Market has revealed conspicuous cracks in the wall traditionally separating the public and the private markets and the two markets’ participants—the sophisticated investors versus the unsophisticated investors. This separation has been undermined by the ability of unsophisticated investors to participate in the private market sphere and by the erosion of the assumptions regarding the ability of the Secondary Market’s participants to fend for themselves.

As opposed to private offering transactions, where both sellers and buyers are considered sophisticated, the participants in the Secondary Market are mixed. While the buyers consist of accredited investors (at least purportedly) and other sophisticated funds, the vast majority of the sellers are employees and ex-employees, who are not required to be accredited and are not necessarily sophisticated. These non-accredited investors trade in a regulatory sphere that is not designed for them, unarmed with information and having weaker weapons in their litigation arsenal.

The traditional dichotomy between public and private markets with regard to investor protection is problematic in the Secondary Market not only due to the penetration of non-accredited investors to the private market sphere, but also due to the refutation of the outdated assumption that all accredited investors can indeed “fend for themselves.” Electronic marketplaces for Secondary Market transactions require that all buyers be “accredited investors” as defined in Regulation D.  Under this definition, accredited investors include natural persons with a $1 million net worth or annual income that exceeds $200,000—or $300,000 combined with spousal income—in each of the two most recent years.  The accreditation objective standard assumes that investors’ wealth is a proxy for a determination that such investors are capable of fending for themselves, either because they are sophisticated or because they can hire a knowledgeable advisor.

As this Article shows, such assumption has been undermined by recent academic research that questions whether sophisticated investors can exercise their skills with limited information, whether wealth is a valid proxy for sophistication, and whether sophisticated investors are immune to cognitive biases that affect investment decisions.

The Article suggests that the erosion of the sophistication presumption deems the classic dichotomy between the heavily regulated public market and the lightly regulated private market artificial. It calls for a reexamination of the current regulatory regime with respect to investor protection. As explained below, such reexamination is of particular importance in light of the new Jumpstart Our Business Startup (JOBS) Act that will enable private companies to stay private longer, and the Secondary Market to thrive.

The main aim of this Article is to draw attention to what has the potential to be a very big problem. Lack of investor protection in the mostly unregulated and rapidly growing Secondary Market may have severe economic consequences in the future. Since the Secondary Market is only in its infancy, this Article will not make specific recommendations but rather will provide a new framework for analyzing investor protection in this sphere. The Article will also give rise to important questions that may assist in designing a better regulatory regime in the future.

The rest of this Article proceeds as follows. Part I introduces the traditional dichotomy in the federal securities regulation between the public market and the private market with respect to investor protection. It first describes the regulation imposed on public companies, which includes costly disclosure obligations and extensive liability exposure. Part I then describes the relatively relaxed regulation of the private market sphere, focusing on the exemption for private offerings, the transition of the regulation from sophistication to wealth, and on resale of private company shares.  The last section of Part I describes the rules that under certain circumstances force a private company to become public and the new JOBS Act.

Part II discusses the rise of the Secondary Market. This Part, inter alia, analyzes the factors that have contributed to the expansion of the Secondary Market beginning in the early 2000s, and the challenges the Secondary Market faces.

Part III explores the advantages and disadvantages of the Secondary Market’s promise to increase the liquidity of private company shares from the perspective of venture capitalists and employees.

Part IV, the heart of the Article, suggests that the traditional dichotomy between the public and the private market is artificial with respect to the Secondary Market. It begins by describing the erosion of the sophistication presumption as a result of the entry of non-accredited investors to the private market sphere. It then explores the limitations of individual accredited investors, and specifically addresses the problem of limited information, the doubtful correlation between wealth and sophistication, and investors’ cognitive biases that may lead to inefficient decision making.

Finally, Part V offers some thoughts on the policy implications of protecting investors in the Secondary Market and suggests future research that is essential to determine the right balance between investor protection and capital formation.

 

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