Facebook/Goldman Sachs Challenge the SEC in $2 billion deal

It’s been only a few months since Goldman Sachs was raked over the coals in front of Congress in the wake of their role in the mortgage crisis. But they are once again challenging Washington for control of the financial markets.

This time they are joined by Facebook, one of Silicon Valley’s most successful and hubristic startups.

Goldman is reportedly planning a $500 million investment in Facebook and is also shopping around a further $1.5 billion investment in the company on behalf of its high net worth clients.

It is conceivable to see this deal as within the legal framework of the securities laws despite all the public commentary about the so-called 500 shareholder rule found in the Securities Exchange Act of 1934. That rule says that once a company has 500 shareholders (of record) it must make a filing with the SEC. That filing would contain disclosures about the company’s business model and financial records that are roughly equivalent as that provided investors in an initial public offering of securities by the company.

Because the 34 Act however only says 500 shareholders “of record” if the $1.5 billion piece of the deal is sold to fewer than 500 shareholders there would be no challenge to the ceiling (of course, there are already Facebook shareholders among some employees and former employees whose options may have vested as well as early stage investors in the company, so they have to be counted towards the ceiling).

But it has been reported that Goldman will set up an intermediary body, a special purpose vehicle, to be the shareholder “of record” while the investors in the SPV are only beneficial owners. Then there would, technically, be only one additional security holder.

That does not exhaust the problem with this deal, however.

A related problem that has not been discussed is whether or not the entire transaction constitutes a “public offering” with Goldman acting as an underwriter. Since public offerings trigger a registration statement requirement, if the deal were viewed as a public offering then Facebook would have to file that statement including a prospectus that contained detailed discussion of its business model, financial history and risk factors associated with the firm.

Goldman apparently is confident that the transaction is not a public offering because it is already distributing information about Facebook to potential investors in the $1.5 billion SPV that state new user numbers for the website.

The SEC, however, will view the entire transaction from the point of view of the wider investing public and ask whether a deal of this size by its very nature is a public offering. Granted, the investors in the SPV are formally considered “accredited investors” but at some point that term may not have real meaning. Are these investors being taken in by the frenzy surrounding Facebook shares? After all only a few weeks ago, Facebook was valued on secondary private trading markets at “only” $42 billion yet now GS is saying the company is worth $50 billion. What did Goldman learn about Facebook that those investors did not know?

It is that kind of problem – informational asymmetries among investors – that should concern the SEC when so many investors are now involved in the company and there is such widespread public attention. None of them has been able to conduct the kind of due diligence that is undertaken by the formal underwriting and registration process that goes into an IPO supervised by the SEC itself.

In sum, while Goldman and Facebook may have secured legal opinions as to their technical compliance with the exemptions available to issuers and financial intermediaries for such a transaction, investors should be wary here. And Goldman and Facebook should be reminded that those legal opinions come with caveats.

One caveat available to the SEC is the language in Regulation D (the exemption for the sale of Facebook shares to Goldman*) which states that:

“Regulation D is not available to any issuer for any transaction or chain of transactions that, although in technical compliance with these rules, is part of a plan or scheme to evade the registration provisions of the Act. In such cases, registration under the Act is required.”

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*If the sale of shares to Goldman is by existing employees then a different exemption is used – Section 4(1) of the 33 Act but the analysis is similar.

2 thoughts on “Facebook/Goldman Sachs Challenge the SEC in $2 billion deal”

  1. You raise an important point and thank you for the link to your site.

    Two comments: first, while the disclosure rules under a private placement to US offerees are substantially weaker than under a registered public offering, they are not non-existent. If any of the offerees are non-accredited investors then they would get disclosure of financial statements, including in most cases audited financial statements. These are typically then provided to accredited investors as well. If the offer is only to accredited investors they certainly have the sophistication to analyze any financial information provided so the question is whether they have the bargaining power to get access to that information. Since the structure of the deal is that Goldman is in fact the initial purchaser they clearly would have the leverage to get financial information and there are press reports that they spent substantial time examining financial information at Facebook in December before announcing the deal.

    Second, of course now the deal looks likely to be broken into two parts: a domestic sale of $500 million worth of shares to Goldman under Reg D and then another $1.5 billion piece sold to offshore investors. Goldman likely will act as the distributor for the $1.5 billion piece and then complete the sale under Regulation S which allows sales offshore to non US persons of equity in US firms as long as the equity is then held off shore and only resold in the US pursuant to registration (requiring audited numbers) or an appropriate exemption.

  2. Stephen I am a professor of accounting ethics and have some concerns about the Facebook-Goldman Sachs deal. In particular, just how does Facebook determine its revenues. Absent audited financialstatements, I’m not convinced the company’s reported revenue is accurate. My concerns were heightened by the announcement that only non-US investors would be able to participate in its private offering. I fear the company may have something to hide and is doing what it can to avoid SEC scrutiny.

    I thought you might be interested in reading a blog that I wrote on this issue. Here’s the direct link
    (http://bit.ly/eqZcUi).

    Respectfully, Steve Mintz

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