Consider this: At the end of 2020, the U.S. had about 220 private companies with a valuation north of $1 billion (so-called “unicorns”). By the end of 2021, that number more than doubled to just shy of 500, and totals nearly 1000 worldwide. Among the most well-known and highest valued is aerospace manufacturer SpaceX and payment processor Stripe, each of which boasts valuations of just about $100 billion. But unlike their public counterparts, there is little-to-no public transparency into their finances and operations.
As things currently stand, only publicly traded companies are subject to the SEC’s mandatory disclosure regime; private companies are exempt, and thus avoid both the considerable costs of compliance and visibility into their finances and operations. But recently, the SEC announced it is in the formative stages of plans to narrow this disclosure gap, and while no specifics are available yet, the agency seems particularly focused on EESG (Employee, Environmental, Social, and Governance) disclosures.
Why?
The rapid growth in private capital markets is the starting point, but it’s only that. More acute is the increasingly pervasive role these companies play in modern society, by uprooting conventional markets (i.e., transportation, payments, housing) and pioneering new ones (i.e., cryptocurrencies, space travel, and reusable rockets), reshaping employee compensation practices, and even their carbon footprint. As Commissioner Allison H. Lee put it in an October 2021 speech, “[i]nvestors and the public are increasingly left in the dark when it comes to ever-expanding segments of the economy.”
What changes?
While any changes remain speculative, there are a few hints where the SEC might be focusing. The first comes from statements by SEC leadership, including the aforementioned Commissioner Lee, who (while serving as Acting Chair) simultaneously sought public comment on new climate disclosures for public companies and suggestions for how best to expand disclosure requirements to “the increasingly consequential private markets.” One hardly needs to be cynical to view the public markets as just the first step. In fact, there’s a strong case that it undermines the value of a publicly-traded company’s EESG disclosure if businesses of similar type and scope, let alone vast swaths of the economy, were exempt from making similar disclosures.
Another area of emphasis for the SEC is what it perceives as private issuers and investors exploiting loopholes that permit these companies to remain private longer than they ought to. Under federal law, companies with over 2,000 shareholders “of record” are required to register with the SEC and periodically disclose key information, regardless of whether they have actually conducted an IPO. But these rules permit an unlimited number of “street name” shareholders (i.e., where various investors pool money through broker-dealers or investment vehicles). As a result, the private investment funds that directly invest in these companies will only be counted as one shareholder regardless of the number of persons they’re investing on behalf of. As Commissioner Lee argues, record ownership is an anachronistic way of counting even public company investors and “in most cases has no meaningful relationship to the number of actual investors.” She’s floated changes to Section 12(g) of the Exchange Act (and Rule 12g5-1) to change the way issuers count shareholders of record and, thus, trigger mandatory disclosure requirements.
Another hint may come from looking across the pond, where UK and EU regulators have already moved forward with similar measures. As of April 2022, the UK will require EESG-related disclosures from public and private companies with over 500 employees and revenues of 500 pounds sterling, and the EU’s proposed Corporate Sustainability Reporting Directive sets out a regime for reporting on “sustainability-related risks” and covers all businesses of 500 or more employees, regardless of whether they’re public or private, as well as all listed small- and medium-sized companies.
The arguments
One powerful pro-rule change argument is that the private capital markets have become a sellers’ market, where management has its choice of investor and can pick based on who will offer the best terms (i.e., least oversight). Theranos is the bad governance poster child of late, where investors neither demanded nor received even basic audited financial statements. This essentially flips the more conservative position around by arguing that investors simply can’t police these companies.
But while there may be a kernel of truth to this argument, it also proves too much. For starters, Theranos is hardly representative (though not alone), and private companies hardly have a monopoly on financial fraud. One persuasive argument against such a regime—or at least one brought about hastily—is that the SEC risks going beyond its remit by making society-enhancing goals the ends to which its policies seek to achieve, lacking the expertise to make those determinations and the tools to see them through. There’s also the argument that the costs associated with going public are what incentivize companies to remain private or get bought out, and that decreasing these burdens would cause more public companies covered by the SEC’s disclosure regime.
There’s no doubt that regulatory action in this area is gaining momentum, both here and abroad. In one sense, it can border on the absurd to think how some of the largest and best-funded companies with an undeniable public impact operate with little to no financial transparency. However, it’s not without reason that this sort of rule change strikes at the sensibilities of American financiers and entrepreneurs, who see this as imposing all the costs and restrictions of being public without its benefits.
Sources
1. TracXN – Unicorns in the United States (last updated: 12/1/21)
2. WSJ—SEC Pushes for More Transparency From Private Companies (1/11/22)
3. HLS Corp Gov—The SEC Takes Aim at the Public-Private Disclosure Gap (1/28/22)
4. SEC—Request for Public Comment re Exempt Offerings (Fall 2021)
5. SEC—Falling Further Back—Statement on Chair Gensler’s Regulatory Agenda (Joint Statement of Commissioner Hester M. Peirce and then-Commissioner Elad L. Roisman (12/13/21)
6. SEC—Commissioner Allison H. Lee: Remarks at The SEC Speaks in 2021 (10/12/21)
7. Corporate Sustainability Reporting Directive (4/21/2021)