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May 08, 2012 Articles

Staying Private Avoids SEC, but Not All Regulation

Companies that stay private may avoid making disclosures about themselves to the public, but those that broaden their circle of investors still face significant risk.

By Matthew J. O'Hara

In January 2011, Facebook announced it would raise $500 million in capital while remaining a privately held company. Even though Facebook later decided to go public, this investment was widely viewed as a sign that major private companies believe they can raise large amounts of capital while remaining private. There is much debate over why such companies would remain private rather than go public.

Some suggest that Congress has over-regulated companies with publicly traded securities, making the costs of going public outweigh the tangible and intangible rewards. See, e.g.,Michael Helft, “Facebook Deal Offers Freedom From Scrutiny,” New York Times, Jan. 3, 2011. But much of the discourse revolves around whether the Securities and Exchange Commission (SEC) will continue to allow major private companies like Facebook and Twitter to raise capital by going to a wide circle of well-heeled investors—such as a Saudi prince who recently invested $300 million in Twitter—without being subjected to regulatory oversight. Congress recently enacted a change to the Securities and Exchange Act of 1934 that increases the number of investors at which a company must register its securities with the SEC from 500 persons to either 2,000 persons or 500 persons who are not accredited investors. 15 U.S.C. § 78l(g).

The idea of private companies raising capital by granting equity stakes to outsiders is not limited to highly exceptional companies like Facebook and Twitter. Exchanges such as SecondMarket and SharesPost have been established to create a market in the shares of privately held companies, which are typically very illiquid investments. SecondMarket describes itself as “an SEC-regulated alternative trading system, registered broker dealer and member of FINRA, MSRB and SIPC” that specializes in “designing and implementing fully-customized liquidity programs for private companies,” thus allowing private company shareholders to sell stock to “company-approved investors.” Similarly, “SharesPost connects leading private companies with their current and future investors and provides the data, analysis and assistance they need to support their capital markets needs.”

Largely neglected in this debate is the other side of the coin: whether private companies that raise large amounts of capital from outside investors and remain outside the SEC’s reach are any better off regulated by state legislatures and state courts. Moreover, as courts apply such law to companies with larger networks of non-insider investors, there is also a question of whether disputes involving such companies will affect the private common-law regulatory scheme.

Much of the law regulating disputes brought by investors in private companies has developed in the context of small, closely held companies and is guided by state corporation statutes and court decisions. However, there are stark differences between major private companies and small, closely held companies. Major private companies seeking a broad base for raising capital may have a larger number of investors, institutional investors, and the potential for a secondary market in investments through exchanges like the ones discussed above. In contrast, small, closely held companies often have a relatively small number of investors, many of whom are involved in management, and there is typically no liquid secondary market for equity or debt investments.

These differences highlight potential problems that may arise by applying state-law principles to this new vision of a major private company. This regulatory structure may pose more risks in some respects than being regulated by the SEC, and it may present problems that are no less significant than those faced by a public company. The risks and problems may grow when a major private company is faced with an aggressive litigation adversary pressing to stretch state laws to new limits. State law has already evolved to provide more protection to investors in closely held companies who do not have a ready means of exiting their investments. However, that trend may be affected by major private companies capitalized by hundreds of institutional investors if courts are called upon to regulate companies that do not fall within the realm of public regulation. Litigation against this new breed of company or its investors could have unintended consequences and significantly impact the existing private common-law regulatory scheme.

Why Stay Private?
The Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 have presented companies with myriad new reasons to remain private and avoid the expense and trouble of reporting in a public regulatory scheme. For example, Sarbanes-Oxley imposes accounting-related requirements on public companies by requiring them to develop effective internal controls for financial reporting and requiring auditors to attest to their opinion of the company’s internal controls. 15 U.S.C. § 7262. Sarbanes-Oxley also established the Public Company Accounting Oversight Board to oversee the audit of public companies that are subject to the securities laws. 15 U.S.C. § 7211.

The Dodd-Frank Act is more sweeping in scope than Sarbanes-Oxley, and it implements requirements that reach previously unregulated financial activities and imposes new regulatory requirements on publicly traded companies. Two regulations of note include an enhanced “clawback” provision and “say on pay” requirements. Under the clawback provision, the CEO and CFO of any public company that had an accounting restatement as a result of misconduct must repay any bonuses or stock-based compensations and any profits made from trading in company stock during the preceding three-year period. 15 U.S.C. § 78j-4(b)(2). “Say on pay” requires public companies to ask their shareholders at least every three years whether they approve of the compensation plans for certain executives, and, at least every six years, companies must submit to shareholders the question of how often to have such a “say on pay” question on the proxy ballot. Further, in proxies for mergers and acquisitions, companies must also ask shareholders whether they approve of “golden parachute” arrangements for top executives of the company. 15 U.S.C. § 78n-1(a)-(b).

Even before Dodd-Frank, the number of public companies in the United States had declined notably. From 1997 to 2009, public companies traded on major exchanges in the United States fell from almost 9,000 to slightly more than 5,000. Alix Stuart, “Is Going Public Going Out of Style?” CFO, at 15 (May 2011). It is debatable whether this was a reaction to an already stiffer regulatory environment embodied by Sarbanes-Oxley or a sign of other economic forces at work. Public companies leave the markets in a number of ways, including going private, engaging in mergers and acquisitions, and delisting when stock prices or other attributes no longer meet the requirements of the listing exchange. Further, a dwindling number of IPOs has failed to replenish the number of publicly traded equity securities. Id. In this environment of greater regulation and less-receptive capital markets, it is no surprise that companies that can go public may elect not to or delay doing so. Although this may mitigate ongoing regulatory-related costs and avoid public scrutiny, it does not necessarily leave a more lenient privately regulated environment in its place.

No Public Regulation Does Not Mean No Regulation
Privately held companies have a different set of issues to consider, including audits, shareholder fiduciary duty restrictions, and shareholder remedy statutes. Typically, privately held companies are controlled by their owners and key managers. Such companies that can avoid the need to borrow often opt for unaudited financial statements because the costs of compiled or even reviewed financials are significantly less than audits, and the insiders feel they know the company and don’t need an audit. However, private companies that wish to obtain equity capital infusions beyond a closely held base must forego this option, because outside investors are unlikely to invest without the level of assurance that an audit brings. Audits of private companies, while less demanding than those required by Sarbanes-Oxley with its required audits of internal controls, nevertheless add one layer of expense as a result of expanding the equity base in this manner.

Fiduciary duty among shareholders is an area where private-company regulation may raise as many concerns as public-company regulation. It is commonplace that corporate directors, officers, and employees owe fiduciary duties to the corporation and its shareholders. See, e.g., Stamp v. Touche Ross & Co., 636 N.E.2d 616, 620 (Ill. App. Ct. 1993); Alessi v. Beracha, 849 A.2d 939, 950 (Del. Ch. 2004); Small v. Fritz Co., Inc., 65 P.3d 1255, 1262 (Cal. 2003); Morales v. Galeazzi, 72 A.D.3d 765, 766 (N.Y. App. Div. 2010). However, in the typical public company with a large number of outside, passive investors, shareholders do not owe one another a fiduciary duty. In contrast, the exact opposite is true for shareholders in a private company. Several state courts have decided that shareholders in closely held corporations do owe one another fiduciary duties akin to those they would owe one another if they were partners. See, e.g., Hagshenas v. Gaylord, 557 N.E.2d 316, 321 (Ill. App. Ct. 1990), Brodie v. Jordan, 857 N.E.2d 1076, 1079 (Mass. 2006); Brunetti v. Musallam, 11 A.D.3d 280, 281 (N.Y. App. Div. 2004).

Illinois law provides fertile ground for analyzing the possible consequences of shareholder fiduciary duties in a Twitter-like company because the Model Business Corporation Act of 1950 was largely based on Illinois experience and the Illinois Business Corporation Act of 1933. See Jackson v. Nicolai-Neppach Co., 348 P.2d 9, 14 (Ore. 1959). Over the years, the Model Business Corporation Act, in turn, has served as the basis for many states’ corporate codes. In Illinois, this principle of shareholder fiduciary duties evolved from the rather groundbreaking opinion of the Illinois Appellate Court in 1990 in HagshenassupraHagshenas involved a prototypical closely held corporation—a small business with only three shareholders. 557 N.E.2dat 323. The court reasoned that the corporation effectively resembled a partnership, and, therefore, its shareholders should one another other the same fiduciary duties that partners do. Id. A subsequent Illinois opinion suggested drawing the line as to when shareholders owe fiduciary duties at whether a shareholder has the ability to “hinder, influence, or control the corporation.” Dowell v. Bitner, 652 N.E.2d 1372, 1379 (Ill. App. Ct. 1995). The use of the word “hinder” makes this concept very elastic.

Though Hagshenas involved a small, closely held corporation, its reasoning is not necessarily limited to such a setting. One need only consider that there are many partnerships, including law firms and accounting firms, with hundreds of partners. If the principles of partnership law apply in such large partnerships, why should they not extend to a private corporation with up to 499 shareholders? In shareholder disputes, creative and aggressive plaintiff’s lawyers could be expected to advance such an argument.

While not all states go as far in imputing partner-like obligations to shareholders in private companies, the implications for deciding to stay private remain great. Although public-company shareholders can treat one another like the strangers that they are, the shareholders of Twitter, or a private company with equity interests traded on a secondary market, may not have that luxury. To see why, one need only look to the types of duties that are imposed on partners or, by extension, on owners of business entities that the law views as tantamount to partnerships.

Under the Uniform Partnership Act, partners may not enter into a partnership agreement that eliminates the duty of loyalty, eliminates the obligation of good faith and fair dealing, or unreasonably reduces the duty of care. Uniform Partnership Act § 103(b) (1997). At the same time, however, partners may identify specific activities that are not violations of a partnership agreement “if not manifestly unreasonable.” Id. Some courts have gone as far as to effectively invalidate provisions in partnership agreements that restrict fiduciary duties. See, e.g., 1515 N. Wells, L.P. v. 1513 North Wells, LLC, 913 N.E.2d 1, 11 (Ill. App. Ct. 2009) (“There is no authority ‘for the proposition that there can be a priori waiver of fiduciary duties in a partnership’”); BT-I v. Equitable Life Assurance Society of the U.S., 75 Cal. App. 4th 1406, 1411–12 (1999); Konover Dev. Corp. v Zeller, 635 A.2d 789 (Conn. 1994). Drawing the line between activities that do not violate partnership duties and those that do, even if expressly agreed otherwise in advance, is one fraught with peril, because fiduciary duty claims often arise in instances in which parties owe one another fiduciary duties and also have independent business activities of their own.

Consider a 400-shareholder private corporation in which many shareholders are investors with no management role in the company and no family ties inside the company structure. If there is no shareholder agreement to which all shareholders are a party (and such a requirement is at least a potential impediment to creating a secondary market for private-company stocks), these principles could wind up creating fiduciaries among strangers, to the extent that advocates successfully press courts to see such investors as having partner-like roles. If there is a shareholders’ agreement, will a provision that “ownership interests in other businesses shall not be considered a breach of duty” be seen as “not manifestly unreasonable,” or will it be considered unenforceable? If a shareholder buys a 1-percent stake in a communications business, can he or she be sued by other shareholders for competing with the corporation if that shareholder starts a closely held communications-related business of his or her own? Arguably, there is no principled reason why not, unless the courts are willing to recognize that a major private company that blurs the line between public and private is not subject to the same legal principles as the closely held corporation at issue in Hagshenas. At least in the context of a shareholder agreement that specifies types of activities that are not breaches of duty, increasing the size and passivity of an investment may weigh in favor of courts enforcing such agreements. Whether courts will do so remains to be seen, but this uncertainty serves as at least one reason for investors to consider whether they should invest in a major private company rather than invest in a public company with a similar market profile.

Remedies for Breach of Fiduciary Duty May Be Harsh
When one considers the remedies that are potentially available for a breach of fiduciary duty, public securities regulation may appear to be a more hospitable place to situate a company. For example, consider an executive that takes advantage of a business opportunity, arguably within the scope of the business, and then conceals that competition by causing certain transactions to be mischaracterized on the financial statements. Some draconian results are possible in the private-company arena. For example, where a fiduciary takes advantage of a corporate opportunity without presenting it to his or her corporation, or uses some assets of the company to develop his or her own business, that fiduciary may face the remedy of forfeiture of all income from the investment. See Restatement (Third) of Restitution & Unjust Enrichment § 51(4) (2011); Seaboard Indus. Inc. v. Monaco, 276 A.2d 305, 309 (Del. 1971); Levy v. Markal Sales Corp., 643 N.E.2d 1206, 1215–17, 1219 (Ill. App. Ct. 1994). While the holding in Levy, for example, discussed the forfeiture of salary and benefits, creative litigants may press for the forfeiture of other income, such as dividends or other forms of profit that a shareholder may receive. In contrast, under the heightened compensation clawback provisions for public companies in the Dodd-Frank Act, if the financials must be restated when the wrongdoing comes to light, the executive faces the loss of incentive compensation in the past three years that was awarded as a result of the previous misstated earnings, as well as a possible SEC enforcement action seeking other remedies. But he or she probably does not risk the loss of all compensation during the period in which fiduciary duties were breached.

The concept of burden of proof highlights another feature of common-law fiduciary duties that may make regulation by private litigants more onerous than SEC regulation. When a fiduciary engages in self-dealing, the burden of proof shifts to the fiduciary to prove that the transaction was fair. See, e.g., Bakalis v. Bressler, 115 N.E.2d 323, 325, 328 (Ill. 1953); Ostrowski v. Avery, 703 A.2d 117, 121 (Conn. 2005); Miller v. Miller, 222 N.W.2d 71, 82 (Minn. 1974). In contrast, the burden of proof in a federal securities action on the same facts would be on the plaintiff, whether it is a private litigant or the SEC.

Private litigants can also invoke “shareholder remedies” statutes that are often found in state corporation acts. See, e.g., 805 Ill Comp. Stat. 5/12.56; Wis. Stat. Ann. § 180.1833 (2002); Mo. Ann. Stat. §§ 351.850–351.865 (2001); Ga. Code Ann. §§ 14-2-940–14-2-943 (2011). These statutes invite private parties to seek judicial intervention in circumstances not set forth in the securities laws and provide courts with vast discretion to remedy such complaints. When a private corporation suffers from deadlock among its directors or its shareholders, when some shareholders engage in “oppressive” conduct toward other shareholders, or when the corporation’s assets are being wasted, any shareholder may petition a court with jurisdiction over the parties for a panoply of potential relief. 805 Ill Comp. Stat. 5/12.56.

Once one of these preconditions is satisfied, a court may order the corporation to engage or rescind in particular actions, alter corporate bylaws, remove and appoint directors, remove officers, call for an accounting, appoint a custodian, order the payment of dividends, award damages, direct the purchase of the petitioning shareholder’s shares by other shareholders or the company, or even dissolve the corporation. Id. In addition, these shareholders remedy statutes have generally become more friendly to individual minority shareholders. Several states eliminated the well-established concept of discounts for lack of marketability and lack of control and instead require the payment of “fair value” or effectively the shareholder’s proportionate stake in the value of the entire businessId.; see also Model Bus. Corp. Act § 13.01(4) (2005); Pueblo Bancorp. v. Lindoe, Inc., 63 P.3d 353, 364-67 (Colo. 2003) (summarizing states’ approaches to “fair value”).

In contrast, while the SEC may investigate public companies, remedies exist only when there is a violation of the securities laws, not simply when decision-makers in a company are deadlocked or when some shareholders are being disadvantaged by others. 15 U.S.C. § 78u(a)(1). Even then, the SEC has a narrower range of remedies: injunctions against violations of the securities laws, the prohibition of violators from serving as directors or officers of public companies, disgorgement of personal gains derived from such violations, and civil penalties. Id. § 78u(d).

In a private action brought under the securities laws where a plaintiff seeks damages based on the movement of a company’s stock price, damages are generally limited to the difference between what the shareholder received and the average price of the stock after the dissemination of corrective information to the market. 15 U.S.C. § 78u-4(e)(1). Private securities plaintiffs suing over public securities-law violations must also jump through a number of higher-than-ordinary hoops, including very strict pleading requirements concerning both alleged misleading statements and defendants’ states of mind, an automatic stay of discovery while a motion to dismiss is pending, and the burden of proving loss causation. 15 U.S.C. § 78u-4(b)(1)-(4). Given these procedural protections, directors and officers of a company that chooses to go public may actually face less risk in the event of litigation than one that remains subject to state private shareholder remedies statutes that lack such procedural hurdles.

Finally, companies that have the option of going public but that opt to remain private should consider that derivative actions may provide more benefit to shareholders in companies with fewer shareholders. Because a derivative action is brought in the name of and on behalf of the corporation, any recovery goes not to the nominal plaintiff directly, but rather to the corporation. See, e.g., 805 Ill. Comp. Stat. 5/7.80; 8 Del. Code § 327; Delaware Chancery Court Rule 23.1. It is then up to the company or the court whether to distribute any proceeds pro rata to the shareholders. Logic dictates that where there are fewer shareholders to share in the recovery and a large company is at issue, derivative suits will appear more attractive than they would where shareholders are legion and own relatively minuscule stakes in the company.

A company that has the option of raising capital by issuing public securities faces difficult choices. By staying private, it may reduce the expenses associated with regulation and avoid making disclosures about itself to the public. However, the regulatory environment for private companies that broaden their circle of investors is fraught with risk and not necessarily more hospitable than regulation by the SEC. In addition, companies that choose to expand their capital base while staying private may affect the existing laws regulating private companies in ways that they and we cannot fully anticipate. If Facebook and Twitter are the harbingers of a trend rather than isolated events, the development of these issues could present a bumpy future for companies and shareholders alike.

Keywords: litigation, business torts, public securities, regulations, Securities and Exchange Commission

Matthew J. O'Hara – May 8, 2012