A number of well-financed players are competing to be the first to bring a viable private securities exchange to market.
A number of well-financed players are competing to be the first to bring a viable private securities exchange to market. The objective is not a new one. We are in the middle of a thirty-year trend of increased efficiencies and liquidity in privately held securities, but the race does seem to be heating up.
In just the past couple of months:
- Carta, a leader in the capitalization table management space, announced CartaX, its private share trading platform that promises to replace Nasdaq and the NYSE as the exchange of choice for issuers;
- GTS, one of the top high speed trading firms in the world, announced ClearList, a new initiative to bring liquidity to private markets by utilizing GTS’ market making capabilities while undercutting the typical high-cost fee structures associated with brokered transactions; and
- Forge and Sharespost, the two largest secondary players in the private markets ecosystem, announced their merger in an effort to create one of the largest global private securities marketplaces, bringing liquidity and transparency at scale to pre-IPO companies and investors.
The demand for a well-functioning private securities marketplace is surging and with good reason.1 In addition to the typical early-stage investors (angel investors, venture capital funds and growth-stage private equity shops), a persistently low-interest rate environment has driven historically “public-only” investors to the private markets in search of yield. Large mutual funds, hedge funds, sovereign wealth funds and family offices are now all active participants in secondary private markets, and they are looking for a product that can mimic the public market experience.
Bringing buyers and sellers together on an exchange is only half the battle. Private market trading is much more complicated than public market trading because it falls outside of the standard registration and disclosure regime that generally ensures a level playing field. In addition, secondary market trading of private securities can be antithetical to issuer management and investor desires as trades have a real impact on valuation and may permit otherwise undesirable holders onto the capitalization table. From investor onboarding and credentials verification to risks associated with information asymmetries, the winner in this race to develop a functioning private securities exchange will have to maintain a thorough understanding of the framework underpinning securities trading and develop a product that minimizes the burden its users face in an effort to comply with those rules.
This note is an attempt to fill the information gap between the promise of fluid, exchange-based trading for private securities and the practical features the winning exchange will have to offer users given the current regulatory regime.
This analysis can largely be boiled down into three sections: (1) federal exemption identification, (2) state securities law preemption and (3) additional considerations. What emerges from the following note is the need to develop infrastructure to support private market trading with an emphasis on empowering users via a portable digital identity that conveys credentials and other necessary information to various counterparties.
The level of information required to successfully navigate private market transactions is much more extensive than that required to navigate public market transactions. Aspects of identity that are largely irrelevant to public transactions (investor credentials, investments under management, holding period, etc.) are all essential pieces to a compliant private trade.
Note on context: This note focuses exclusively on certain regulatory restrictions and does not address the considerable challenges contractual restrictions present to an efficient private securities market. There are a whole host of contractual issues present in the private markets that have the potential to complicate trading, but detailing them all is outside the scope of this article.
United States securities regulations require all offers and sales of securities to be either (i) registered with the SEC or (ii) otherwise exempt from registration.2 The various exemptions from registration are quite nuanced, and certain facts that are less relevant in public markets (e.g., type of trading counterparty, relationship between counterparties, holding period limitations, amount to be sold, etc.) can have dramatic effects on what is required to compliantly execute a trade in the private market context. While public market exchanges can maintain rules of general applicability across market participants, any robust private market securities exchange must tailor trade execution across a number of potential categories. The complexity introduced by this trade-specific paradigm presents one of the most serious hurdles, if not the most serious hurdle, in effectively developing a successful private securities exchange.
Below is a summary of the relevant exemptions most likely to be used on private exchanges, along with the details, benefits and drawbacks of each. The most relevant exemptions for purposes of a private securities exchange are Section 4(a)(1) and Rule 144, Rule 144A, Rule 4(a)(1½) and Rule 4(a)(7), each of which will be discussed in turn. Certain exemptions that are perhaps more familiar to market participants but that only apply in the primary issuance context (e.g., Regulation D and Section 4(a)(2)) will only be discussed incidentally.
Securities Act Section 4(a)(1) and Rule 144
The starting point for examining permissible resales of privately held securities on a secondary market is Section 4(a)(1) of the Securities Act. Section 4(a)(1) specifically exempts from registration resales of securities “by any person other than an issuer, underwriter, or dealer.”3 The general idea here is that resales by investors not related to the company or involved in the securities business are not broad distributions of securities subject to registration. While this exemption on its face seems to provide for relatively free trading of private securities (investors in privately held companies are typically neither an issuer nor a dealer themselves4), in practice the term “underwriter” is applied very broadly to include resellers that may not appear to be in the “underwriting” business at first glance.
The SEC defines the term “underwriter” as any person who either (i) purchases securities from an issuer with a view to distribute them or (ii) offers or sells securities on behalf of an issuer or affiliate in connection with a distribution. The term “distribute” is specifically not defined by the SEC, and (this is critically important) the term has been interpreted by courts as anything that moves securities along a chain from the issuer to the investing public.5 Given the broad interpretation of the word “distribute,” most resellers prefer to structure sales to fall within SEC-defined safe harbors that ensure the transaction complies with the Section 4(a)(1) exemption.
The most relevant safe harbor is Rule 144, which provides brightline rules to ensure any transaction thereunder is not a “distribution” for purposes of Section 4(a)(1). Since the sale is definitionally not a “distribution,” the reseller cannot be defined as an “underwriter” and can therefore rely on the Section 4(a)(1) exemption. Both restricted securities6 and control securities7 are permitted to be resold under the Section 4(a)(1) exemption via Rule 144, and any securities sold thereunder are no longer deemed restricted securities.
The prerequisites necessary to fall within the Rule 144 safe harbor depend on whether the seller is an Affiliate and whether the issuer is a public reporting company. Given this article’s focus on private market exchanges, the below will only detail Rule 144 as applied to private company securities. The reader will quickly gather how complicated keeping track of all this information becomes in a very short span.
Non-Affiliates. Any person who is not an Affiliate of the issuer at the time of sale (and has not been an Affiliate of the issuer for three months prior to the sale) may rely on Rule 144 so long as they have held the securities for one year.
Affiliates. Any person who is an Affiliate of the issuer at the time of sale (or has been an Affiliate of the issuer within the three months prior to the sale) may only rely on Rule 144 so long as five requirements are met: (1) current public information, including things like balance sheet and income statement, must be available,8 (2) the seller must satisfy a one year holding period prior to sale, (3) certain volume limitations in terms of the amount that may be sold must not be met,9 (4) use of a broker is mandated and (5) certain notices must be given.
The practical implications of the above for a private securities exchange are profound. The level of detail necessary to ensure compliance with a Section 4(a)(1) exemption and the Rule 144 safe harbor is extensive. In addition to typical “know-your-customer” and brokerage onboarding information, trading counterparties will need to know the applicable holding period, every selling shareholder’s affiliate status (both at time of trade and within the previous three months) and, depending on that status, additional information regarding the issuer’s capitalization table, trading volume and information dissemination in order to feel confident that a trade complies with the applicable regulations.
The necessity of providing and verifying pertinent and difficult-to-obtain shareholder information will be a recurring theme across all private market exemptions discussed below. Efficiently enabling the sharing of this information is a critical piece of infrastructure currently missing from the market. While the exchange itself may not necessarily be responsible for compliance with an applicable exemption, the dream of free-flowing, privately-held securities cannot be realized unless and until an easy avenue for information dissemination exists.
The Rule 144A exemption from registration (note the slight difference in name from Rule 144 discussed above — Rule 144 and Rule 144A are drastically different exemptions) has historically been the standard method under which: (i) large, institutional buyers access purchase blocks of an issuer’s securities and (ii) those large, institutional buyers trade among themselves for liquidity. The only entities that may invest in Rule 144A transactions are those that maintain investments totaling at least $100 million worth of securities on a discretionary basis — these entities are known as “qualified institutional buyers” (“QIBs”). The Rule 144A exemption is justified under a regulatory rationale that investors of a certain size do not need the protections of the securities laws and that, so long as the secondary market solely consists of large players similarly situated, re-sales among that select group do also not require the protections of the securities laws. Similar to Rule 144, the key to Rule 144A is that a reseller that meets all Rule 144A requirements is deemed not to be involved in a “distribution” and is therefore not an underwriter per Section 4(a)(1).
Rule 144A deals are typically private in nature, but the JOBS Act specifically provides an avenue for resellers to engage in general solicitation and advertising so long as the securities sold ultimately wind up in the hands of entities the reseller reasonably believe are QIBs. This is important for two reasons: (i) any exchange that permits both retail investors and QIBs to participate must be sure to help issuers keep their applicable exemptions straight (for example, the requirements for a Rule 144A trade amongst QIBs are dramatically different from those required under Rule 144 described above) and (ii) permissible general solicitation and advertising means QIB-only offers may be viewable by all participants on an exchange, which may enable non-institutional level investors to piggy-back off the evaluation done by larger groups. However, and as will be discussed separately below, the state securities laws issues associated with general solicitation and advertising likely present an insurmountable barrier to full utilization of Rule 144A as the exemption of choice for a private market exchange.
The key requirements for a reseller to successfully utilize Rule 144A are as follows: (i) the securities must be eligible for Rule 144A treatment,10 (ii) the resale must only be to QIBs, (iii) certain notice requirements must be met11 and (iv) certain information about the issuer must be available to the purchasers. Items (ii) and (iv) are of particular relevance for an efficient private securities exchange, so they will be discussed in more detail here.
Re-Sales Only to QIBs. This requirement means that an individual (i.e., a person, not an institution) may never purchase securities in a 144A resale and that any reseller will require additional, detailed information about the purchaser in order to verify its status as a QIB prior to a successful trade. In practice, resellers may rely on a number of avenues to verify a prospective purchaser’s QIB status. These include: (i) analyzing publicly available financial information about the purchaser dated within 16 months of the Rule 144A resale, (ii) obtaining a certification from the Chief Financial Officer of the prospective purchaser as to the size and discretionary nature of its holdings or (iii) reliance on third-parties to prepare lists of verified QIBs.12
Information Requirements. Any purchaser in a Rule 144A resale is entitled to “reasonably current” information about the issuer upon request. “Reasonably current” information includes audited financial statements for the prior two years, a balance sheet dated within 16 months of the date of resale, income statements and statements of shareholders equity dated within 12 months of the balance sheet and a business description dated within 12 months of the date of resale. Given the detail and level of information required, Rule 144A deals are somewhat self-selecting in the sense that they typically fall within the purview of more mature companies able to meet these information demands. The purchase agreement governing the primary issuance of the securities will include information rights, which are passed along to subsequent purchasers as third-party beneficiaries.
Rule 144A provides a relatively well-trodden path for secondary market liquidity on a private exchange, albeit limited to QIBs. A recurring theme across this article is the disparate levels of information required of purchasers in order for a reseller to avail itself of an exemption from registration. Here, additional information around entity type and assets invested on the purchaser side and ability to comply with information demand rights on the issuer side are critical to the free-flowing movement of privately held securities.
Importantly, Rule 144A does not bridge the gap between institutions who may buy the securities initially and retail accredited investors who would need to rely on a separate exemption.
The Rule 4(a)(1½) exemption does not appear in any formal SEC rule or regulation. It is a judicially-made doctrine that has been developed by securities practitioners over time using a similar justification as Rule 144A resales. The general idea is that, so long as subsequent purchasers of securities could have participated under the exemption used for the primary issuance, then the protections of the Securities Act similarly ought not to apply simply because those securities are being re-sold. Once again, the goal under this exemption is to avoid classification as a “distribution”, meaning the reseller is not an underwriter and therefore exempt per Section 4(a)(1).
Resellers accomplish this by satisfying a number of requirements that help characterize the sale as private in nature.13 An overly-simple way of thinking about Rule 4(a)(1½) is to ask whether, had the issuer stepped into the shoes of the reseller, the sale would have been exempt from registration. While seemingly simple to state, the ultimate determination of whether the offering would have complied under Section 4(a)(2) is very much a facts and circumstances analysis that takes a great deal of time and effort on the part of attorneys to verify. What’s more, Rule 4(a)(1½) has typically been relied upon solely by institutions and not natural persons — that is, participation is limited to QIBs and institutional accredited investors only.14 A typical “144A-eligible” offering involves resales to QIBs utilizing Rule 144A discussed above and resales to institutional accredited investors under Rule 4(a)(1½).
In practice, Rule 4(a)(1½) is utilized by obtaining a great deal of information from prospective purchasers, including certifications as to accredited investor or QIB status, investment intent (i.e., purchasing for own account and without intent to distribute), suitability and ability to have a law firm issue an opinion that registration of the securities is not required as part of the re-sale. Further, the reseller will typically have to provide a similar level of information to the prospective purchaser as was provided to them in the primary offering.
Of all the exemptions that may be utilized by a private securities exchange, Rule 4(a)(1½) carries with it the greatest risk as the contours of satisfying the exemption are not provided in brightline rules promulgated by the SEC. Instead, Rule 4(a)(1½) relies on judicial doctrine and precedent as a guiding force. Facilitating compliance in a scalable manner for this exemption is an extremely difficult undertaking that, once again, necessitates the ability for counterparties to quickly and securely convey sensitive information.
The last exemption examined in this note is new Rule 4(a)(7), and it is the rule with the potential to enable a truly efficient private securities exchange. Rule 4(a)(7) emerged from the Fixing America’s Surface Transportation Act (“FAST Act”) enacted on December 4, 2015. Under the FAST Act, Rule 4(a)(7) takes certain aspects of the Rule 4(a)(1½) exemption and codifies them into a scalable procedure for the resale of private, restricted securities.
In practice, Rule 4(a)(7) mandates the following: (i) all purchasers must be accredited investors, (ii) resales may not rely on general solicitation or advertising, (iii) issuer information around financials and security type must be provided,15 (iv) to the extent the seller is a control person, the seller must provide a statement detailing their relationship with the issuer and certifying they are not in violation of securities laws, (v) no “bad actors” are permitted to participate,16 (vi) the underlying issuer must be an operating company (and not, for example, a shell or blank check company), (vii) the resale may not be conducted by an underwriter and (viii) all securities must have been outstanding for at least 90 days.
Notice that, of all the requirements listed above, the only information resellers and purchasers need to exchange are proof of accreditation, confirmation that the participant is not a “bad actor” and, to the extent the seller is a control person, a certification as to status and securities law compliance. The rest of the requirements are fairly straightforward applications of known information, and the burden on the issuer to provide information is de minimis compared to what is required under the other exemptions examined above. Importantly, and as will be detailed below, securities re-sold under Rule 4(a)(7) are exempt from state blue sky requirements, which will be vital for a well-functioning exchange.
In facilitating the smooth transfer of privately held securities from one investor to another, Rule 4(a)(7) provides a clearly defined procedure that helps ensure transparency and confidence in regulatory compliance. By expanding the category of potential participants to accredited investors, the rule broadens the pool of potential liquidity while simultaneously ensuring those transacting in the private markets are those most able to handle a potential loss. In the balancing act to provide adequate liquidity without onerous regulatory burden, Rule 4(a)(7) is the clear frontrunner.
State Securities Laws Considerations
States securities law compliance presents an often overlooked issue in the facilitation of secondary trading on private markets. Securities sales in the United States are governed by an overlapping set of rules and regulations that implicate both federal and state law, including (potentially) multiple state requirements related to a single trade. The piecemeal, state-by-state securities laws are collectively referred to as “blue sky” laws. Oftentimes, these multiple rulesets provide consistent requirements, but there are occasions when blue sky laws differ from federal law in important ways. For example, recent federal rules have opened up the possibility for general solicitation and advertising related to certain private market exemptions. State laws, on the other hand, generally maintain prohibitions against these open forms of outreach.
The key concept to understand for private market exchanges is that of federal preemption, which means that compliance with federal securities law is sufficient to establish a safe harbor under state law requirements for a selling shareholder. Securities that fall within federal preemption doctrine are known as “covered securities” under the National Securities Markets Improvement Act of 1996 (the “NSMIA”).17 The purpose of this section to identify where federal preemption applies and where it does not. In cases where federal preemption is not available, selling shareholders and exchanges will need to tread carefully as state-by-state compliance can lead to tremendous friction and a poor user experience.
A Note on Named Markets
The NSMIA allows the SEC to name certain exchanges under which all securities listed therein are automatically deemed to be covered securities. Most recently, IEX successfully had its exchange added to the list of “Named Markets” maintained by the SEC, which is a critical step as the frequency at which trades occur on public exchanges vastly outstrips the speed exchanges or trading parties can run state-by-state legal analysis to ensure compliance. For private market exchanges, being listed as a “Named Market” is likely a bridge too far as standard listing requirements include levels of disclosure that would be akin to those of a public company. Instead, a private market exchange should gear its trading around exemptions that provide “covered” status to securities traded utilizing that particular exemption.
Of all the exemptions listed above, the ones the NSMIA categorizes as covered for purposes of federal preemption are sales under Section 4(a)(1) (including Rule 144 and Rule 144A re-sales, but only in limited circumstances) and Section 4(a)(7).
The major defect for Rule 144 and Rule 144A resales is that the NSMIA specifically provides that 4(a)(1) exempted securities are covered securities only if the underlying issuer itself is a reporting issuer (that is, only if the issuer is a public company). This means that Rule 144 and Rule 144A resales will only be covered securities to the extent the issuer is already public. Any private market securities exchange looking to provide real-time trading would have to conduct a state-by-state analysis as determined by the state of residence of a potential purchaser to overcome this hurdle. There is also the possibility that a state will attempt to claim jurisdiction to the extent a potential trade otherwise “reaches in” to the state (for example, by having an server execute the trade within the state or an email client receiving an offer for a trade within the state). A silver lining for private exchanges is that state securities laws typically do provide similar exemptions for entities like QIBs; however, delving into 50 separate state securities regimes to determine general applicability will be a considerable undertaking and one that is outside the scope of this article.
Resales under Section 4(a)(7), on the other hand, will be considered covered securities. This obviates the need for the state-by-state analysis typically handled by law firms for each trade and provides a real avenue for active private market securities trading.
By (i) requiring pertinent information without full-blown public disclosure, (ii) permitting institutions and sophisticated individuals that can withstand the risk of loss that comes with private market investing to participate and (iii) minimizing the burdens of overlapping regulations by imposing federal preemption, Section 4(a)(7) strikes a near perfect balance between regulatory burden and investor protection.
The previous sections in this article all dealt with federal and state exemptions from registration. In addition to those concerns, private market exchanges will face potential issues in a number of other contexts, including insider trading, fraud, public company thresholds and valuation. While each of these is substantial enough to warrant its own article, the below provides a quick overview of the relevant concerns.
Section 10(b) of the Exchange Act is an anti-fraud statute that makes it unlawful to employ any “manipulative or deceptive device” in connection with the purchase or sale of any security. The SEC is empowered to promulgate rules to enforce this statute, and the most relevant rule for private market exchanges is Rule 10b-5. Rule 10b-5 prohibits any material misstatement or omission in connection with the sale of a security.
For public markets, these information asymmetries are less relevant for day-to-day trading because issuers are required to report all material events as they happen. Private markets, on the other hand, almost definitionally maintain large information asymmetries between buyers and sellers due to existing holder information rights and relationship to the company (e.g., if the seller is an employee) without a regulated disclosure regime. Private issuers typically prefer that their sensitive information be kept confidential. These asymmetries have the potential to create a “heads-I-win-tails-you-lose” dynamic where lawsuits for failure to disclose material information follow any dip in a private company’s shares.
WeWork provides a great example — as WeWork’s value plummeted in the second half of 2019, investors who purchased shares on the secondary market (and with whom the issuer did not directly transact!) filed suit. The WeWork suit runs against the issuer rather than selling shareholders (maybe — Softbank is a listed party and may have participated in secondaries), but that is more indicative of whom investors believe are the deep pockets — purchasers could very well have sued whomever they bought securities from as well.
As large numbers of sellers on private market exchanges are likely to be persons who invested early or received equity compensation from the issuer, successfully identifying these sellers and providing adequate disclosure to pre-empt these sorts of lawsuits will be critical. Further, any material misstatement or omission on an initial transaction can create a chain of liability through subsequent trading. Although “big boy” letters (essentially, side contracts with a purchaser attesting as to sophistication and promising not to sue) may be useful in certain contexts, they are largely insufficient to mitigate Rule 10(b) liability.
Exchange Act Registration
Section 12(g) of the Exchange Act requires any issuer with assets greater than $10 million and holders of record in excess of 2,000 (or 500 non-accredited holders) on the last day of its fiscal year to register as a reporting company. This threshold is less of a problem for companies already intending to go public — the remedy for tripping the 12(g) requirement is to become a reporting company within 120 days of its fiscal year end. However, an actively traded security on the secondary market risks tripping this threshold and unintentionally triggering reporting requirements.
While a number of institutions have tried to avoid 12(g) reporting requirements via various structuring mechanisms (most notably, SPVs that count as only one holder of record and aggregate a number of individuals into a single investment), the SEC has largely looked through these structures to the underlying nature of the transaction. Similarly, theories around trusts, brokerages and other holding companies that can mimic the DTCC’s membership system to reduce the number of holders of record are likely to fail if the economic result is widespread access to securities that would otherwise require registration.
The 409A valuation is the mechanism that underpins all options pricing and incentive compensation for privately held securities. Typically, a privately held company hires an independent third party to value its common stock, and the company is then able to issue stock options with favorable tax treatment to its employees on the basis of that valuation. The ability to adequately incentivize employees with equity rewards is critical for early stage entities that likely do not have the requisite capital to compete on a salary basis.
To the extent that a robust secondary market reveals either a fair market value greatly in excess of or below a recent 409A valuation, someone is bound to be unhappy. For current employees and investors, a lower trading price than strike price implies their equity compensation is worthless. For future employees, grants may need to have a higher strike price, which requires the company to grow even more in order for the equity compensation to be valuable. Further, secondary trading complicates the typical 409A process as the third party evaluators must account for the limited nature of the trading, diversity in type of shares traded and availability of information related to the trades that have occurred.
Private capital markets have undergone a thirty-year transformation from niche industry to the single most dominant form of capital raising today. As increased regulation on the public company side deterred issuer management from pursuing IPOs, a number of well-financed institutional players began entering early-stage investments. Attracted by impressive returns from unicorn (and decacorn!) startups, even more well-capitalized players are entering the private market ecosystem, which further obviates the need for companies to access the traditionally deeper pools of capital available on the public markets.
Companies are staying private for longer than ever before, early-stage investors and employees are craving liquidity to de-risk their positions and yield-starved/traditionally public market investors are demanding access to these fast-growing private companies. First generation private marketplaces that popped up to handle this demand are evolving into new exchanges that promise to bring a level of standardization, efficiency and certainty typically only available on public exchanges. These private marketplaces face a number of hurdles not present in public markets because the regulatory regime that applies to privately held securities leads to significant complications in trade execution. The exchange that wins this space must be able to quickly identify applicable exemptions to be applied to a particular transaction and facilitate trades in accordance with the relevant rules. In addition, issuers will likely look to the exchanges to handle additional compliance hurdles, including dissemination of information to support secondary trading, maintaining holder of record lists, providing secondary trading information relevant for an issuer’s valuation purposes and other controls to ensure regulatory compliance.
At its most fundamental level, the key to a successful secondary market for privately held securities is all about information verification and sharing. Standard forms of identity verification (government documentation and address confirmation) are necessary but insufficient to facilitate a smooth-functioning private marketplace. Counterparties and companies must be able to easily share credentials specific to an INVESTOR IDENTITY. Relevant data points include accreditation, QIB verification, Affiliate status, “bad actor” disqualification and permission to access issuer materials. The infrastructure to efficiently support private market trading is being built today, and it promises to be the key that unlocks the full potential of the private market ecosystem.
Disclaimer The information contained in this article is provided for informational purposes only and should not be construed as legal advice on any subject matter. You should not act or refrain from acting on the basis of any content included in this article without seeking legal or other professional advice.