Something new and significant is taking shape. For a variety of reasons—the impact of the JOBS Act, the growing popularity of equity private placements, the appearance of new trading markets for venture capital and other non-reporting companies—a new tier of companies is growing rapidly that is composed of issuers that are not “reporting” companies, but that do have a significant number of shareholders. In terms of the size of their shareholder class, these companies overlap with public companies, but they trade in the dark—and actively. More importantly, as their number grows, it is predictable that existing and new trading venues will begin to compete to attract and capture the trading interest in these stocks. This column will call these firms “semi-public companies” to reflect their intermediate status, midway between truly private firms (such as early stage venture capital startups and family-held firms) and public companies.

The development that is most associated with the appearance of these new semi-public companies is the enactment of the JOBS Act earlier this year. In truth, that legislation was not responsible for the appearance of semi-public companies, but, much like a shot of steroids, that act will grow their size and number rapidly. By amending §12(g)(1) of the Securities Exchange Act to raise the mandatory threshold for “reporting company” status to 2,000 shareholders of record,1 the JOBS Act has also ensured that all companies that are not yet a “reporting company” will have considerable discretion and a debatable choice about whether to become one.

The impact of a 2,000 shareholder of record ceiling has not been fully appreciated because it was not well understood how few companies have in fact anywhere near 2,000 shareholders of record. A recent SEC study, released last month, underscores just how high this ceiling is.2 In calendar year 2011, there were approximately 2,983 companies with a class of securities registered under §12(g) (i.e., “reporting companies”). While complete data was not available, the SEC could identify only 318 companies that had more than 2,000 shareholders of record. Thus, it concluded that:

[Only] 13% of current Section 12(g) registrants would be required to initially register with the Commission pursuant to the new thresholds of Section 12(g) today.3

Of course, most existing reporting companies do not gain any right to exit the periodic disclosure system of the 1934 Act by virtue of the JOBS Act. For most companies, it will be necessary to reduce their shareholders of record to less than 300 persons under §12(g)(4) of the 1934 Act to be able to escape “reporting company” status.4 The one exception to this generalization involves “bank holding companies,” and the JOBS Act amended both §12(g)(4) and 15(d)(2) to permit them to exit the 1934 Act’s periodic disclosure system and de-register if they have less than 1,200 shareholders of record. A quick survey of recent no-action letters shows that some bank holding companies are doing just that, but no massive trend is apparent.5

Indeed, the more revealing statistic is that there are currently 1,321 companies who are registered under §12(g) even though they are eligible to de-register because they have less than 300 shareholders of record.6 Presumably, either their shareholders (or their bondholders) want them to remain reporting companies, or possibly they fear the impact on their stock price if they were to leave Nasdaq or the New York Stock Exchange (as de-registration would require them to do).7

The point here is not that a flood of companies are about to escape disclosure and de-register, but that virtually all non-reporting companies in the future should make a conscious choice about whether to become true “public” companies and register under §§12(g) or 15(d). Only for a small handful will the choice be compelled by the 2,000 shareholder threshold. However, many companies will need to focus on the 500 non-accredited investor ceiling that was also built into §12(g) by the JOBS Act. That ceiling, which compels registration under the 1934 Act if more than 500 shareholders of record are not accredited investors, is not nearly as capacious, and it may produce more attempts at circumvention that could violate SEC Rule 12g5-1—a little known, but increasingly important, SEC rule that is far from a model of clarity.8

Finally, it seems predictable that many companies that stay on the private side of the line and do not register under §112(g) will still want liquidity for their shareholders. Denied access to Nasdaq by this decision, they may begin to explore the potential for trading on venues other than a national securities exchange, e.g., over-the-counter trading, bulletin boards, or the new private trading systems that SecondMarket and SharesPost have pioneered for venture capital companies. Here, pressures may build for additional trading venues, and here also the SEC needs to recognize that its only existing rule requiring disclosure to the secondary market that applies in this context to non-reporting companies—Rule 15c2-119—is woefully inadequate and needs revision.

Reporting Company Choice

No one doubts that public companies face higher accounting, auditing, and other costs. Still, these costs reflect less the costs of SEC reporting than the higher litigation risk associated with public companies. The greatest cost differential between public and private firm status probably arises with respect to D&O liability insurance. Similarly, accounting costs go up in the case of a public company not primarily because the work is that much more difficult, but because the auditor recognizes that it faces a greater risk of securities litigation in the case of the public company and so charges ex ante for that risk in its fees.

In this light, the uncertain question for the future is whether the costs for a semi-public company will approach those of a public company. To be sure, such a company will avoid the SEC reporting costs, but these are relatively trivial. Other costs may approximate those of a public company, depending on the relative litigation risk. A semi-public company with 1,500 or more shareholders is certainly a candidate for a securities class action if its stock price falls suddenly. The one advantage such a defendant will have is that it does not trade in an efficient market and hence the “fraud on the market” doctrine will likely be inapplicable, thereby generally precluding class certification.

A semi-public company will need to defer any initial public offering because, even if it does not list on an exchange, §15(d)(1) of the 1934 Act would still require it to begin filing periodic reports (unless it had less than 300 shareholders of record or 1,200 in the case of a bank holding company). But this deferral may be inevitable in any event, as smaller IPOs have become close to extinct. As a generalization, unless a company will have a public float after its IPO in the neighborhood of $400 to $500 million, its stock will not be of interest to most institutional investors, who want more liquidity than companies with market capitalizations below that level can offer. Thus, the glamorous prospect of a “hot” IPO is a delusion for most smaller non-public companies (and most now know this). Realistically, only companies that anticipate an IPO producing a public float above this $400 to $500 million level are likely to have a strong incentive to become public companies.

But there are some countervailing reasons why a semi-public company with 2,000 beneficial owners (and a smaller number of record holders) may still want to register under §12(g). First, the protections of the Williams Act are largely available only to a company that becomes a §12(g) reporting company. Consider, for example, a non-reporting company with 2,000 or more beneficial owners (but, of course, less shareholders of record) and with a founder or management group that now holds only 20 percent of its voting stock. Such a management group is exposed to a “creeping control” raid by an acquirer that is under no obligation to file a Schedule 13(d) when it crosses the 5 percent threshold.10 To be sure, a poison pill could still be used, but its effectiveness is undercut when management does not know the structure of its own share ownership and cannot detect if a §13(d) “group” has been formed.

Next, because a non-reporting company is not subject to the proxy rules, activist shareholders could secretly solicit proxies and then, in the case of a Delaware corporation, seek to replace the board by means of a consent signed by a majority of the shareholders.11 Similarly, Rule 14a-9 would not apply to false statements made in any such solicitation because it only applies to proxy or consent solicitations subject to §14.

Further, only some of the Williams Act’s tender offer rules apply to a tender offer made to shareholders of a non-reporting company (i.e., those rules adopted pursuant to §14(e) of the Williams Act, but not the §14(d) rules). The net result would be that a 20-business-day tender offer period would still be required, but bidders could find ways by which to coerce shareholders into an early tender.

Still, another unanticipated consequence of remaining private lies in the unforeseen application of state law to such companies. In the case of a public company, shareholders who are dissatisfied with management’s policies (but unable to show fraud) are largely limited to a derivative action, and these are seldom successful. However, a corporation incorporated under New York law that does not list on a securities exchange will be subject to New York’s “oppression” statute.12 Under it, a 20 percent shareholder or shareholder group can seek judicial dissolution (or a mandatory buyout of their shares at a judicially determined fair value) if they can show that they have been subjected to “oppressive actions” by management that “frustrated” their reasonable expectations.13 Unlike a derivative action, there is no “demand rule” under these oppression statutes by which a disinterested board can reject the action.

On the other side of the coin, managements of private companies gain exemption from the SEC’s “going private” rules, as §13(e) of the 1934 Act applies only to reporting companies. Indeed, this could be a motive for some bank holding companies to de-register under §12(g) and de-list from their exchange. Their stock price will predictably sink (if there is any trading at all), and presumably minority shareholders denied liquidity may become willing to sell in a “going private” transaction at a lesser price. Time will tell.

Recent changes in both Regulation A and Regulation D, each mandated by the JOBS Act, should strengthen the willingness of private companies to remain private and not register under §12(g). Even private companies need equity capital, and the classic way to raise such capital was the initial public offering. But now there are alternatives: The ceiling on Regulation A has been raised from $5 to $50 million,14 and issuers can conduct a general solicitation of investors in a Rule 506 offering (as least if they sell only to accredited investors).15 For an issuer that wishes to remain a private company, a key advantage of either technique is that it does not trigger §15(d) of the 1934 Act and require the issuer to begin making periodic reports under the 1934 Act. In contrast, even if an issuer does not list on Nasdaq or some other exchange, an issuer who files a registration statement that is declared effective is required by §15(d) to become a reporting company.

The bottom line is that issuers will generally still want to maximize their share prices, but with the IPO market currently cool and smaller IPOs disfavored, many issuers seem likely to remain privately-held “semi-public companies” longer, relying for capital on Regulation D and possibly Regulation A.

Traps for the Unwary

Staying private is not as easy as it sounds. Although the new 2,000 shareholder of record ceiling would have allowed 87 percent of all existing reporting companies to remain private,16 the limitation of 500 non-accredited shareholders of record is more problematic. How does an issuer even know the financial status of its shareholders? What happens if a determined investor deliberately transfers shares to new record owners, who are not accredited investors, precisely in order to force the issuer to become a reporting company? This last scenario might make sense if the investor believed that the shares of a reporting company would trade at a higher price.

The practical answer for most private issuers will be to minimize the number of record owners by inducing shareholders to hold securities in street name with a broker or bank. Street name ownership seems to be acceptable to most retail investors, as the SEC estimated last month (based on an analysis of data from 2008 to 2010) that over 85 percent of the holders of securities in the U.S. market hold through a broker or bank.17 This is roughly three times the 28.6 percent figure for “street name” ownership in 197518 and suggests that the public is comfortable with “street name” ownership. Those who do hold record ownership are typically institutional investors, who thus qualify as accredited investors in any event and would not count against the 500 non-accredited investor ceiling.

But suppose a company seeks to do more to prevent transfers to non-accredited investors. It might, for example, seek to impose share transfer restrictions under which its shares can only be transferred to accredited investors. This may violate state law if such a restriction is imposed retroactively on outstanding shares. Also, it would offend shareholders by reducing the marketability (and thus price) of its shares. Alternatively, an issuer might issue shares to a trust, which would then issue beneficial interests in the trust giving the beneficiaries the functional equivalent of share ownership. Here, we encounter SEC Rule 12g5-1(b)(3), which provides that:

If the issuer knows or has reason to know that the form of holding securities of record is used primarily to circumvent the provisions of Section 12(g) or 15(d) of the Act, the beneficial owners of such securities shall be deemed to be the record owners thereof.19

But what creates an intention “to circumvent” that triggers this rule? In Tankersley v. Albright,20 the Seventh Circuit found that a trust for employees with 151 beneficiaries that controlled 53 percent of the common stock of the publisher of the Chicago Tribune was not a “device created to avoid having the employee beneficiaries included as shareholders of record.”21 There, the court found that the trust served other legitimate purposes.22 That may be an easy conclusion to reach in the case of family-controlled companies or employee trusts, but a similar inference does not follow easily when a corporation establishes a new trust with an investment bank.

Broad as the language of Rule 12g5-1(b)(3) is, the SEC’s staff may have created an inadvertently broad loophole in its recent report on its authority under Rule 12g5-1. Suppose a private issuer issues a large 15 percent block of its stock to an investment banking firm (hypothetically, called Goldman, Stanley). Goldman Stanley then places this stock into a trust and sells beneficial interest to investors in either a registered or exempt transaction. The goal may be to market the stock broadly to retail investors, including both accredited and non-accredited investors. However obvious the investment bank’s motives here are, the SEC’s staff recently concluded that:

[I]t seems reasonable to assume that ‘primarily to circumvent’ elements of the Rule 12g5-1(b)(3) would not ordinarily be met without some involvement by the issuer, insiders or controlling shareholders.23

This loophole, which is roughly the width of the Washington Square Arch, invites issuers to enter into implicit (but never documented) understandings with investment bankers under which the latter broadly distribute the shares, potentially to non-accredited investors, in a manner that arguably should violate Rule 12g5-1(b)(3). Why the staff wrote this broad a statement without more protective caveats is difficult to discern.

Suppose, alternatively, that a record shareholder wants to force the issuer into “reporting company” status and so transfers some of his shares to 100 revocable trusts created by him. This has in fact happened, and the decisions on this fact pattern are mixed.24 Even if the SEC can disregard incestuous transfers, such as the above transfer to trusts that the shareholder controls, the same shareholder, owning perhaps one million shares, can probably transfer 20 shares each to 500 other persons who will all hold of record. The original investor has only sold 10,000 shares (or 1 percent of his holdings), but may have placed the issuer over the 500 non-accredited investor line—and possibly enhanced his stock’s value in so doing. Such confrontations between a determined investor and the issuer seem predictable when liquidity is denied investors.

Other Trading Forums

Stock exchanges are off limits to the private issuer because of both their listing rules and §12(b) of the 1934 Act. Over-the-counter markets (such as the Pink Sheets) are available, but shareholders who acquired their shares in a private placement or similar exempt transaction may still need to find an exemption permitting their resale. The most obvious candidate is Rule 144, but in the case of a non-reporting issuer, Rule 144(c)(2) requires that the information be made publicly available that complies with provisions of Rule 15c2-11 under the 1934 Act. Even if the stock was not issued in a private placement (for example, it might have been sold under Regulation A or Rule 147), no broker or dealer may publish or submit any quotation for such a security “to any quotation medium,” unless certain information specified in Rule 15c2-11 is made available.25 Even this modest requirement can be avoided if the stock was not sold in a private placement and the broker does not publish or submit a quotation to “any quotation medium.”26 This would be possible if the investor uses a private brokerage firm, such as SecondMarket or SharesPost, which act as private brokers intermediating transactions between buyers and sellers, but do not post their own quotations. If they do not submit quotations, directly or for others, such brokers are not subject to Rule 15c2-11.

Still, the greater problem is that Rule 15c2-11 requires very little, if any, disclosure and is subject to many exceptions.27 As a result, to the extent that the minimum level of disclosure is set only by it, many securities will trade largely in the dark. That might be acceptable in the past, but in the future, it is possible that a 1,000 or more companies may fall into the zone where they have many beneficial shareholders (possibly several thousand), but still less than 2,000 shareholders of record. This is a growing dark zone well removed from the sunlight of full disclosure. An overworked and underfunded SEC may prefer to sweep this problem under the rug for the time being, but it needs to recognize that the Rule 15c2-11 provides woefully inadequate disclosure for a growing proportion of the market.

John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.

Endnotes:

1. Prior to the passage of the JOBS Act, §12(g) of the Securities Exchange Act required an issuer to register a class of equity securities if, at the end of the issuer’s fiscal year, that class was “held of record” by 500 or more persons and the issuer had total assets exceeding $10 million. The JOBS Act increased this threshold to 2,000 holders of record or 500 holders of record who are not accredited investors. Special additional rules were also passed for banks and bank holding companies.

2. See Staff of the U.S. Securities and Exchange Commission, Report on Authority to Enforce Exchange Act Rule 12g5-1 and Subsection (b)(3) (Oct. 15, 2012) (Staff Report).

3. Id. at 26.

4. See §12(g)(4) of the Securities Exchange Act, 15 U.S.C. §78 l(g)(4).

5. The pace indeed seems to be picking up. In the following four no-action letters, all since August 2012, the SEC’s Staff did not object to de-registration by a bank holding company. See (1) Britton & Koontz Capital, 2012 SEC No-Act LEXIS 444 (Sept. 17, 2012); (2) First Citizen Bankshares, 2012 SEC No-Act LEXIS 442 (Sept. 26, 2012); (3) Peoples Financial Services, 2012 SEC No-Act LEXIS 422 (Aug. 16, 2012); (4) Central Virginia Bankshares, 2012 SEC No-Act LEXIS 418 (Aug. 8, 2012).

6. See Staff Report at 26, n.84.

7. Section 12(b) of the Securities Exchange Act requires “listed” companies on a national securities exchange (which term now includes Nasdaq) to become a reporting company.

8. See 17 C.F.R. §240. 12g5-1(b)(3). The history of this rule, which is modest, is covered in the Staff Report.

9. See 17 C.F.R. §240. 15c2-11.

10. Section 13(d) applies by its terms only to equity securities “of a class which is registered pursuant to Section 12 of this title” (and certain securities of insurance companies). See 15 U.S.C. §78m(d).

11. See Delaware General Corporation Law §228. This provision is subject to a contrary charter provision, but not a by-law.

12. See New York Business Corporation Law, §1104-a. (requiring plaintiffs owning 20 percent or more of an unlisted company to show that those “in control of the corporation have been guilty of illegal, fraudulent or oppressive actions towards the complaining shareholders”).

13. This standard is set forth in In re the Application of Topper, 433 N.Y.S. 2d 359 (1980).

14. See §3(b)(2)(A) of the Securities Act of 1933, 15 U.S.C. §77c(b)(2)(A).

15. See §201 of the JOBS Act. For the Adopting Release, see Securities Act Release No. 33-9354 (Aug. 29, 2012).

16. See Staff Report at 26 (noting that only 13 percent of reporting companies had more than 2,000 shareholders of record as of the end of 2011).

17. Id. at 8.

18. Id.

19. See Rule 12g5-1(b)(3), 17 C.F.R. §240.12(g)(5)-1(b)(3).

20. 514 F.2d 956 (7th Cir. 1974).

21. Id. at 969.

22. Id. at 970.

23. Staff Report at 21. Elsewhere, the Staff indicates that the mental state under Rule 12g5-1′s “knows or has reason to know” language “appears most similar to a negligence-type standard.” Id. at 22. True, but the issuer is generally under no duty to monitor its shareholders, at least when there is no reason to believe that they are making an unlawful distribution of securities.

24. Compare In the Matter of Bacardi Corporation, Exchange Act Release No. 34-27255 (Sept. 18, 1989) with “Order Granting an Application of BF Enterprises, Inc. under the Securities Exchange Act of 1934,” Exchange Release No. 34-66541 (March 14, 2012). See also Staff Report at 14–18.

25. See Rule 15c2-11(a) (barring submission to “any quotation medium”), 17 C.F.R. §240. 15c2-11(a).

26. Absent a published quotation or a submission to a quotation medium, Rule 15c2-11 appears by its terms to be inapplicable.

27. In particular, there is the “piggyback” exemption, under which the broker-dealer need not comply with the information review if the security has been the subject of quotations on at least 12 business days during the previous 30 calendar says. See Staff Report at 12. Given the size of the shareholder class at semi-public companies (i.e., 2,000 or more beneficial owners in some cases), regular quotations meeting the above standard seem predictable, and hence information would not have to be reviewed or updated.