Financial Poise

A new private trading platform for restricted securities: Liquidity for accredited investors at what price?

On March 6, 2013, NASDAQ OMX Group, Inc. announced a joint venture with SharesPost, Inc. to launch a new secondary market trading platform for the purchase and sale of private company securities. The new marketplace, to be called The Nasdaq Private Market (NPM,) will be a private market for resales of restricted securities, with the main objective of providing increased liquidity for early investors, founders, and employees of private companies by enabling the efficient buying and selling of private company shares. Subject to regulatory approval, NPM is slated to become operational later in 2013. The new private trading platform presents an opportunity for accredited investors who have held restricted securities of a private company for at least one year to exit their investments. NPM will compete with other established electronic trading platforms, most prominently SecondMarket Holdings, Inc. (“SecondMarket”), that have with varying degrees of efficiency operated private markets for the purchase and sale of illiquid restricted securities by accredited investors.

Accredited investors holding restricted securities of private companies have historically faced the regulatory reality that, having acquired their securities in transactions for which no registration statement was filed by the issuer under Section 5 of the Securities Act of 1933 (the “Securities Act”), they may not resell their shares (“restricted securities”) except pursuant to an effective registration statement or an exemption from registration. Any resale of restricted securities presents a risk that the seller will be deemed to be a statutory underwriter, and as such, may not rely on the exemption from Securities Act registration requirements otherwise provided by Section 4(a)(1) of the Securities Act for transactions by any person “other than an issuer, underwriter or dealer.” To address the issue, SEC Rule 144 under the Securities Act, adopted in 1972, established a safe harbor through which private sales of restricted securities can be made without the risk of underwriter status, and to ensure the availability of the Section 4(a)(1) exemption from registration. Depending on the status of a seller as an affiliate (control relationship) or non-affiliate of the issuer, Rule 144 imposes conditions on resales, including a holding period, and other amount and manner of sale restrictions.

In 2007, Rule 144 was amended to permit non-affiliate holders of restricted securities of a private company to resell their shares after a one year holding period, free of any other restrictions or requirements. The change in regulatory landscape meant that non-affiliate accredited investors satisfying the one year holding period were, unless otherwise restricted by the issuer, free to seek out a path to liquidity. However, no well-developed  secondary “market” for the sale and purchase of restricted securities existed.

Certain types of web-based systems to facilitate transactions restricted securities have existed since 1996, when the SEC Staff first approved what amounted to “passive bulletin boards” –systems posting information to prospective buyers and sellers of restricted stock that enabled them to effect transactions by direct personal contact between them independent of the Internet facility that brought them together. These facilities served only an informational or listing function, and played no role in effecting actual transactions between participants. Some operated on a subscription or fee basis. The key to their regulatory approval, however, was the facilitation of direct interaction between participants, in almost all cases issuers and pre-qualified accredited investors having password protected access to the facility. The focus was not on true secondary market trading by qualified investors in restricted securities of “listed” private companies. And in any case, the strictures of SEC Rule 144 rendered a secondary market trading platform for restricted securities problematic without regard to other regulatory issues.

Other electronic platforms emerged specifically to facilitate purchases and sales of illiquid assets, including private company stock. SecondMarket, which began in 2004 as “Restricted Stock Partners,” first addressed the need for liquidity for holders of restricted securities of, at the time, public companies. SecondMarket established a market for restricted stock of private companies in 2009 — bringing together buyers and sellers in a centralized, transparent on-line marketplace. SharesPost Inc. and others likewise emerged as web-based platforms for secondary market transactions in restricted securities. In 2007, NASDAQ itself launched the “PORTAL Market” as a trading market for unlisted securities available to an elite class of investing institutions –“Qualified Institutional Buyers” (QIBs)–having at least $100 million in assets. However, in 2008 the PORTAL Market ceased operations, with NASDAQ moving instead to a consortium that controls and operates an electronic platform for over-the-counter trading in restricted securities by QIBs.

In their fairly short evolution, in addition to providing electronic trading platforms, both SecondMarket and SharesPost moved increasingly to facilitating private company capital formation through private firm access to pre-qualified accredited investors.  Prequalification of accredited investors for access to these markets presents a greater challenge today as the SEC grapples with rulemaking implementing accredited investor status “verification” requirements under Regulation D of the Securities Act that must go beyond former pre-qualification procedures based on questionnaires and self-accreditation procedures for accessing the on-line platforms. These markets also expanded to assist private growth companies in the creation of issuer-controlled shareholder liquidity programs, which is also an announced aim of the NPM in enabling a private company to control the marketplace for its shares.

The announced joint venture between NASDAQ OMX Group, Inc. and SharesPost, Inc. to create the Nasdaq Private Market is aimed specifically at providing improved access to liquidity –enabling the efficient buying and selling of private company restricted shares. A driving consideration behind NPM is the fact that an increasing number of private companies are choosing to remain private longer. The impetus for doing so is even stronger today in the wake of the Jumpstart Our Business Start-Ups (JOBS) Act, which significantly increases the shareholder threshold for companies to remain private. Under the JOBS Act private companies may have up to 2000 shareholders (1500 of whom must be accredited investors), up from the previous 500 shareholder threshold. In this environment, both NASDAQ and SharesPost have emphasized the need for an efficient means to access liquidity for private company employees and investors.

A key consideration in the establishment of NPM, as it has been previously for other secondary market trading platforms, is control by the issuer of the marketplace for its shares, in both the design and implementation of “liquidity programs.” SecondMarket, for example, has emphasized that companies have full control over which accredited investors are allowed to buy their stock. Among other things, companies can set limitations on the total amount of shares any single investor may purchase. Companies may also decide who can sell shares, limiting the program to certain investors, for example. Companies may also decide when transactions –liquidity events– may occur, and may formulate a mechanism to determine the price per share that all buyers will pay and all sellers will receive.

With the strong emphasis on issuer control over the secondary marketplace for restricted shares, NPM may actually erect a practical barrier to its effective operation. Although non-affiliate accredited investors are free from Rule 144 restrictions and conditions in reselling their securities after satisfying the one year holding period, private issuers, in establishing liquidity programs implemented through NPM, may impose significant restrictions on resales.  In addition to the kind of restrictions noted above, issuers might, for example, limit resales only to sales to current shareholders, or require the sale of all of one’s current holdings. The issuer might require granting the company a right of first refusal, all in the name of controlling the marketplace for its shares. A secondary trading market accessible by accredited investors becomes markedly less attractive in the face of such restrictions that interfere with its efficient operation.

It is also true that NPM will operate in an informational void. Private companies have no obligation to the marketplace to disseminate information concerning their business and financial position, and accredited investor participants in the market have no right to obtain it from such issuers. The price discovery function of markets is negatively impacted, if not prevented from operating at all. Recent history illustrates the problem. Ahead of the ill-fated initial public offering, restricted shares of Facebook traded in an on-line secondary market at prices far away from the value assigned by an open and efficient post-IPO market.

It remains possible that NPM will impose basic information dissemination requirements as a qualification for “listing” restricted securities for trading, but the fact is that participants in this market are likely to have limited and unequal access to information upon which to make a reasoned value determination and investment decision. In the private offering setting, accredited investors are presumed to be able to fend for themselves in the course of direct interaction or prior relationship with an issuer, or the ability to obtain or require disclosure of material information. However, NPM, as with currently operating on-line secondary trading platforms, will be accessible by any verified accredited investor, the universe of which encompasses investors with no means to have, acquire or know necessary information on which to make a reasoned investment decision and in doing so, bring about a fair value determination in the marketplace.

The emphasis on providing liquidity for early investors, founders and employees of private companies in establishing NPM, and, as NASDAQ and SharesPost announced, establishing “the preeminent marketplace for private growth companies” is laudable.  Indeed, the liquidity function of markets, along with price discovery, is critical in all settings.  If NPM is truly to be a step forward, however, the market must function unfettered by artificial constraints or restrictions, and must to the greatest extent possible require the creation and dissemination of information to participants, and allow the free interaction of qualified sellers and buyers.  The new market should not exist principally to support private company liquidity “programs” or to assure private company “control” of the marketplace for its shares. If there is to be an efficient means for private company employees and investors to access liquidity, and if a more efficient private market is to be created based on market operating expertise and combined technological resources of NASDAQ OMX Group and SharesPost, it should be one that operates freely and fairly.

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About Robert Rapp

Partner at Calfee, Halter & Griswold LLP, lecturer and author of Blue Sky Regulation.

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