Sunday, January 9, 2011

Dealing With the Anti-IPO Sentiment

We usually come across reports of companies preparing or filing for IPOs in order to take advantage of listings on stock exchanges. On the other hand, companies also often display resistance for undertaking IPOs as they are accompanied by costs such as full-blown regulatory oversight and public scrutiny. This is so even when the companies have grown to a significant size and there is a vibrant private market created for their securities. In this post, we will examine this issue in the context of a high profile U.S. company and an Indian company that are testing the borders of securities regulation by staying outside the purview of public listing. 
In the U.S., speculation is rife as to whether Facebook will go down the route of offering its shares to the public. Apart from a private market having been created in its shares, Facebook recently raised monies from a special purpose vehicle of Goldman Sachs that in turn allows various Goldman clients to take indirect interest in Facebook shares. Steven Davidoff has an analysis of the implications of this transaction under U.S. securities regulation: 
Goldman Sachs’s investment in Facebook once again raises the issue of whether the Securities and Exchange Commission will force the social networking company into an initial public offering. In particular, this issue arises because of the special purpose vehicle that Goldman plans to create in order to allow its clients to invest up to $1.5 billion in Facebook. 
The reason lies on the technical shores of the federal securities laws. The Securities Exchange Act of 1934 sets forth certain requirements for companies to register their shares with the S.E.C. 
Specifically, Section 12(g) requires that a company register its securities with the S.E.C. if it “has total assets exceeding $1,000,000 and a class of equity security … held of record by five hundred or more … persons…”
… 
The issue comes with the 500-person requirement. This speaks only of shareholder-of-record ownership. Shares can be held “of record” or “beneficially,” but the rule is only set off based on the number of shareholders who hold shares “of record.” 
The S.E.C. defines “of record” for these purposes to mean securities held “by each person who is identified as the owner of such securities on records of security holders maintained by or on behalf of the issuer.” 
Record ownership is thus clear. It is the shareholders who are recorded as such on the books of the company that issued the securities.
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. Goldman will form a special purpose investment vehicle for its super-wealthy clients to invest in Facebook. 
Technically, there would then be only one shareholder of record here, the investment vehicle. … 
Davidoff argues, however, that the use of such special purpose vehicles to overcome the 500-person rule “certainly appear[s] to be cutting it close”. Separately, Larry Ribstein comments on the underlying rationale for such structures and the factors that drive companies to maintain private markets for securities rather than public listings. 
Note that the key principle in U.S. securities regulation is the number of shareholders on record in a company. Once the threshold (set at 500) is breached, companies need to report their financial and other information to the SEC. Although companies are not compelled to do an IPO at this point, it nevertheless makes eminent sense for them to make a public offering as they are subject to the reporting requirements in any case and there is no merit in remaining as an unlisted company. 
The contemporaneous example in India relates to the Sahara group of companies, which has witnessed a number of legal developments within a short span of time (as discussed earlier - 1, 2, 3 and 4). The current position is that SEBI has issued a public notice to investors of two Sahara companies advising them to make their own decisions (and at their own risk) while investing in securities issued by those companies and cautioning that SEBI would not be able to provide any redressal if grievances do arise. 
The underlying legal principle in India for private markets is somewhat different. First, there is no concept of companies merely reporting their financial results to a regulator or the public without undertaking an IPO. In other words, companies which breach the limits are faced with only one consequence: to make an IPO. Second, the threshold for an IPO is defined differently from the U.S. The reference point is the proviso to Section 67(3) of the Companies Act, 1956 which reads: 
“Provided that nothing contained in this sub-section shall apply in a case where the offer or invitation to subscribe for shares or debentures is made to fifty persons or more.” 
The obligation to do an IPO arises when an “offer” is made to 50 persons or more. Under this method of reckoning, companies may make separate offers so long as each offer is made to less than 50 persons. Questions have been raised in the past whether this method can be subject to abuse because it is not entirely clearly as to what distinguishes one offer of securities from another when they are made by the same company. Is it the type of securities issued, the time-gap between two offers or involvement of separate processes? The answers are not readily available. Although it does not appear that Sahara has advanced the argument of separate offers (with each being to less than 50 persons), that could potentially be used as an escape to stay outside the purview of public offer requirements. 
That leaves us with the question as to whether the simple threshold of absolute number of shareholders (as in the U.S.) or a threshold based on the number of persons to whom each offer of securities is made (as in India) is more rationale and practical and therefore desirable. Both have their share of deficiencies. The rule involving absolute number of shareholders appears simple at first blush. However, it is capable of circumvention as we have seen in the Facebook case. Nevertheless, one way of addressing this would be to provide that the number of shareholders to be taken into account would include holders of record (i.e. legal shareholders) as well as those holding beneficial interests. As far as the scenario in India is concerned, far more clarity is required as to what constitutes an “offer” for purposes of Section 67(3), failing which there would be less certainty for companies issuing securities without public listings and also for investors taking up those securities.