Saturday, February 1, 2020

The Eroding Public/Private Distinction

These days, it often seems like technology is eradicating the difference between our public and private selves, and apparently, the SEC is going down the same path with respect to companies.

Matt Levine at Bloomberg is fond of saying that private markets are the new public markets, by which he means that companies no longer seek to raise capital by tapping the public markets; instead, they do that in private offerings, and turn to public markets when early investors want to cash out.  This is made possible by the fact that Congress and the SEC have, over the years, loosened many of the rules that required companies seeking large capital infusions to register their shares publicly.  Today, due to Rule 506 and other exemptions, companies can grow to enormous sizes solely based on the investment of accredited investors.  These investors are usually institutions, like venture capital funds, but also the stray mutual fund or sovereign wealth fund.  Other rule amendments have made it easier for private companies to pay their employees in stock and stock options, which allows them to free up capital.

But now the SEC is working to make it easier for new classes of individuals to invest in these private companies.  First, it has proposed changes to the definition of “accredited investor,” to allow people to qualify based on their expertise.  The expansion is relatively narrow now, but I assume it’s a foot in the door for further rule changes that will open the door for more “expert” individuals to invest in private companies.  And apparently, the Commission is also considering a program to allow platform workers for private companies – like Airbnb hosts, and so forth – to receive equity as part of their compensation.

Now, I posted before about the risks to private company workers when they receive equity compensation.  The current rules were enacted on the theory that company employees are likely to have intimate knowledge of the business and therefore don’t need the protections of mandatory disclosure, but that’s not likely to be true of the enormous private companies that exist today.  Plus, employees are unlikely to understand how the preferences granted venture capital investors dilute the value of their common stock holdings.  That’s why, for example, Yifat Aran has proposed amendments to the rules that would recognize employees’ informational disadvantage in larger companies.

Given that – not to mention the spectacular recent failures of large startups, like WeWork, and the obvious fact that even “hot” private companies like Uber and Lyft have struggled in the public markets – it seems particularly incongruous that the SEC is considering allowing gig workers (who are likely to have even less insight into corporate operations than ordinary employees) to invest. 

But the implications go further.

The SEC and Delaware are in a peculiar sort of dance; federal changes to the relationships between investors and managers necessarily shape Delaware law.  I’ve mentioned before that Delaware has reformed a lot of its corporate law around the expectation that most investors are large institutions trading in public markets, who are less in need of judicial protection.  Thus, as I’ve written about and discussed in this space, the rise of large private companies is one factor that has strained Delaware's definition of a controlling shareholder.  Meanwhile, newly proposed federal regulatory moves to limit shareholder power may have the perverse effect of causing Delaware to engage in more muscular oversight of management.  And that’s equally true when federal regulation works at the retail investor end, by encouraging more ordinary persons to invest in private companies.  As Elizabeth Pollman has documented, these companies may have exceedingly complex capital structures that are fraught with different kinds of conflicts, which, of course, is likely to give rise to more litigation. 

In In re Trados Shareholder Litigation, 73 A.3d 17 (Del. Ch. 2013), VC Laster fired a shot across that bow by warning venture capitalists that they have fiduciary obligations to prioritize the common stockholders in their management of the company.  A survey by Abe Cable found that Trados’s impact on venture capital practices has been modest, though boards may express more concern for the common when in sale mode.  But I’m betting there’s going to be more where that came from, because as the SEC encourages unsophisticated investors to leap into private markets – where the protections of disclosure, common trading, and federal board independence requirements are lacking – Delaware will be drawn into the fray, and will no longer be able to comfortably rely on simple maxims that a shareholder vote ratifies all.

We even have a preview of coming attractions in a current dispute involving Juul.  Juul apparently required its employee-shareholders to waive their inspection rights under Section 220, and the enforceability of that waiver is currently being litigated.  If Delaware finds waivers are permissible, the next step will be for companies to insert such waivers in their charters or bylaws – and apart from the effect on public companies, these moves will leave private company investors, specifically, without access to information unless they bargain for it.  And that’s going to mean employees, gig workers, and similar investors will be at an extraordinary informational disadvantage.  (You can read more about on issues of waiver and inspection rights in George Geis’s paper, Information Litigation in Corporate Law)

Of course, it may turn out that all of these companies simply contract for individualized arbitration of shareholder disputes and leave Delaware out of it entirely, which will be much easier to do if they remain private, and thus maintain contractual privity with their investors.  And even if “private” secondary market platforms expand and companies no longer directly contract with purchasing shareholders - so that there is no obvious contract in which to insert the arbitration clause - companies may simply adopt charter and bylaw provisions that require individualized arbitration.  Yes, of course, Delaware law currently prohibits that, but if the Delaware Supreme Court decides that charters and bylaws are just ordinary contractual terms that can include limits on securities claims, and if we then move to the obvious next step of putting securities arbitration provisions in corporate bylaws and charters, Delaware will have a harder time maintaining that its current arbitration prohibition passes muster under the Federal Arbitration Act.  So maybe it is the death of corporate law, after all.

In any event, what we’re seeing in broad strokes is the erosion of the public/private distinction in securities law, in favor of something that looks more like a continuum.  (We may even see limits on the ability of retail investors to buy public company shares that are deemed too risky).  And that, of course, not only threatens to rob the market of the valuable externalities provided by generalized public trading subject to standardized comprehensive disclosures (see Elisabeth DeFontenay, The Deregulation of Private Capital and the Decline of the Public Company; see also Jesse Fried and Jeffrey Gordon on bubbles in private markets and, ahem, me on the implications of the WeWork debacle), but also places enormous weight on regulators’ judgment as to who, precisely, has the exact level of sophistication and risk tolerance to invest in what kind of company.

Ann Lipton | Permalink


The waiver of 220 inspection rights has been going on in Silicon Valley for some time. I think these agreements generally should be upheld (just like the DE courts recently confirmed you can waive appraisal rights In advance). I don’t think you can deny inspection rights, however, through the charter or bylaws. Section 220 does not include any language suggesting it is a default right (e.g., “except as otherwise provided in the COI or the bylaws...”). In addition, even if this could be waived, it could be construed as a “right” that, per Section 151, has to be in the COI.

Posted by: Observer | Feb 3, 2020 8:37:20 AM

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