The details of the $2 billion Goldman Sachs deal with Facebook have not been made public but one question stands out: where will the shares come from?
On that question turns an important issue – is the deal legal under federal (and comparable state) securities laws?
The overriding concern when shares in a company are issued and sold is whether the purchasers or even those to whom the shares are just offered have sufficient information to make a decision about whether to buy them.
Because insiders of a firm typically have more information about their company than outsiders the concern heightens when shares are being sold to outside investors by either the firm itself or by employees.
But the SEC’s view of these transactions differs in subtle but important ways depending on whether it is the company itself or a company’s shareholders who are selling their shares.
There is some indication that the real motivation for the Facebook/Goldman deal is that Facebook employees are getting restless – without an IPO they cannot cash in on what appear to be valuable shares or options to buy shares. So Facebook may have approached Goldman with the idea of creating some liquidity for those securities without conducting an IPO. An IPO would create significant headaches for Facebook, including obligations regarding transparency and corporate governance that it may wish to avoid.
But as this useful background essay by securities lawyer Jennifer Hagan points out there are important constraints on the ability of employees from selling their shares. At the heart of such a resale is the need to satisfy the requirements of the so-called 4(1-1/2) exemption. This is not an actual rule but a doctrine in securities law fashioned from the Securities Act of 1933 based on both sections 4(1) and 4(2) of the Act.
If a shareholder who wishes to sell their shares to someone else meets its requirements it means that original shareholder is not an “underwriter” and so can freely resell their shares without registering the sale with the SEC. Registration would require the preparation of a detailed registration statement including a prospectus discussing the business model, financial records and risk factors associated with the firm.
To protect purchasers of such shares, Hagan points out, the SEC “suggests” that the following steps be taken:
1. Resale purchasers must be solicited directly by the holder of the stock, not by the issuing entity
2. Resale purchasers must be limited in number.
3. Resale purchasers must be provided with full disclosure of the type of information found in registration statements or Private Placement Memorandums.
4. The resale must include the typical characteristics of a private placement, including disclosure of company information and compliance with the purchaser qualification requirements of sophistication and ability to bear risk.
5. The holder must demonstrate that he/she is not making the sale with a view to distribution of securities and not on behalf of the issuer company. This is typically done by having the resale Purchaser make investment representations similar to those originally required by the issuer company.
Hagan concludes: “In general, the resale of restricted securities should not be untaken unless the seller scrupulously observes the suggested methods of resale set forth above. Even then, there is always the risk of being found to be an “underwriter” if the reseller is a ‘Control Person’, or an ‘Affiliate’.”
In other words there are serious hurdles for Facebook employees to overcome in order to resell their shares. Because of these hurdles the SEC did fashion a so-called safe harbor that enables resales of restricted shares (such as those issued privately to Facebook employees) in Rule 144. But a review of the conditions that must be met there makes clear it is just as much a challenge as using the 4(1-1/2) doctrine!
The advantage of using Rule 144 is that the purchaser on the receiving end of a 144 resale would then own, in most cases, unrestricted securities which could be freely resold without needing to comply with 144 again or with 4(1-1/2).
One way around these problems for Facebook would be to create new shares and sell those directly to Goldman or Goldman’s Special Purpose Vehicle. But as I have said in earlier posts that would dilute existing shareholders and as the above discussion indicates, those new owners of Facebook shares would face the very same problem that current Facebook employee-shareholders do: they would hold restricted shares and if they try to resell them they must meet the requirements of Rule 144 or the 4(1-1/2) doctrine.
Failure to abide by these rules means the reselling shareholder (either employees or Goldman’s investors or the SPV) could be deemed an underwriter of Facebook shares and that would trigger the registration requirement. Failure to register could mean civil or even criminal charges of securities fraud.