remain a private company. The deal has also prompted increased scrutiny on the relatively-new phenomenon of online private markets, which have allowed the wealthy to buy and sell shares of companies the average investor cannot.

The basic disclosure issue surrounding Goldman’s investment is that Section 12(g) of the Securities Exchange Act of 1934 — amended by later SEC rule-making — requires companies with assets exceeding $10 million and equity held by more than 500 people to register its securities with the federal government.

In other words, if a company has any real assets to speak of, and is owned by more than 500 people, it must register with the SEC. At that point, the SEC’s transparency rules kick in, requiring the company to provide greater financial disclosures to the public even as it remains a private company not subject to a raft of other transparency requirements.

The law and subsequent rule-making was designed to protect average investors from losing money betting on companies that aren’t held to the same strict disclosure requirements as public companies.

For the last several years, there has been a brisk market in Facebook equity on places like SharesPost, which bills itself as “The Online Marketplace for Private Investments.” Another firm in this business is SecondMarket.

This has allowed Facebook employees to sell some of shares they were granted when they were hired, and it has allowed outside individuals to snap them up. A few years ago, Facebook got an exemption on the 500-shareholder rule for its own employees, but the exemption does not apply to outside shareholders of the company.

Who are these outside individuals buying Facebook equity? Rich, sophisticated investors who have both the means to invest and the wherewithal to even know what SharesPost is in the first place.

As the SharesPost website says:

SharesPost is a passive bulletin board that enables its registered members, who are sophisticated buyers and sellers of private company securities, to view existing portfolio items held by other members that may be available for purchase as well as items of interest to prospective buyers.

SharesPost is not a registered broker-dealer or registered securities exchange. SharesPost is not registered as an Investment Advisor with the Securities and Exchange Commission or any state authority.

In other words, SharesPost has facilitated a brisk private market for rich people in the shares of a multi-billion-dollar company — Facebook — with little oversight from any financial regulator.

It’s little wonder that the SEC is looking into these markets. In recent days, SecondMarket was hit with a federal probe, and said it is “fully cooperating with the SEC in this inquiry.”

Which brings us to Goldman Sachs, and where things get tricky.

As Professor Steven M. Davidoff, one of the top securities law authorities in the country has pointed out, Section 12(g) applies to shareholders “of record” — basically direct owners — not shareholders who own equity “beneficially” — basically indirect owners, as in the case of a trust.

What Goldman Sachs is proposing to do is create a $1.5 billion, so-called “special purpose vehicle” — a term that could only have been conjured on Wall Street — that would allow its high-net worth clients to invest in Facebook.

The participants in Goldman’s Facebook “special purpose vehicle” would not be considered Facebook owners “of record,” but rather “beneficial” owners. In other words, for the purposes of the Securities Exchange Act, Goldman’s Facebook “special purpose vehicle” would constitute one owner “of record,” no matter how many Goldman clients participate.

Thus, it would appear that Goldman Sachs and Facebook are attempting to avoid SEC disclosure rules and allow Facebook to remain private for as long as possible, but still make it easy for Goldman’s rich clients to invest in the company.

“We do not know the number of record holders of Facebook shares, but in the case of Facebook, this appears to be how Goldman is planning to get around the S.E.C.’s reporting rule,” Davidoff wrote.

But there’s a catch. The SEC thought that some might attempt to evade its disclosure rules, so it further defines owners “of record” as follows.

If the [company] knows or has reason to know that the form of holding securities of record is used primarily to circumvent the provisions of [the Securities Act], the beneficial owners of such securities shall be deemed to be the record owners thereof.

It’s important to note, as Davidoff points out, that exceeding the 500-shareholder limit would not force Facebook to go public, it would merely trigger SEC disclosure rules that require companies to file quarterly and annual reports.

It would appear that Facebook is not interested in such disclosure.

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Authors: Sam Gustin

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