Rule 10b-5, the federal antifraud catch-all, applies to both public and private company securities. Yet the voluminous case law, and the related scholarly literature, has focused primarily on public corporations and markets.
This state of the world sufficed for a time. Most corporations of significant size had publicly-traded stock and faced the threat of securities class actions. By contrast, private corporations generally issued stock through private placements to sophisticated investors, and there was little secondary trading in their stock. Startups typically were acquired or went public within a few years, and valuations did not surpass, or even approach, the billion-dollar mark.
This 20th century model of a dominant public capital market has, however, been transformed, with capital formation through private placements exploding in the past decade. Companies have stayed private longer on average and those that go public tend to be larger in size. This means that a significant part of the lifecycle of a growth company typically occurs on the private rather than the public market. The rise of the private market has consequently sharpened scholarly and regulatory focus on maintaining the health of the public market and democratizing retail investors’ opportunities to fund high-risk and potentially high-growth private companies.
In a new article in the Georgetown Law Journal, I argue that it is time to examine in-depth securities fraud in private companies. Federal securities law and doctrine has oriented our system around a public-private divide, with class actions serving as the driving force in enforcement – but only against public companies. Due to a variety of obstacles and economic realities, securities fraud class actions have largely been absent in the private market. Although public enforcement plays an important role in policing securities fraud, it has not kept pace with recent developments. Meanwhile, significant information asymmetries characterize stock issuances and trading in the private market, as well as the kind of pressure, opportunity, and rationalization that can foster misconduct and deception.
Given the potential for harm, particularly to unsophisticated shareholders and other stakeholders, as well as the importance of deterring fraud to ensure efficient capital allocation, my article examines several potential responses. The path forward should aim to protect the integrity of the private market and those affected by securities fraud, while carefully avoiding chilling the flow of funding for innovation and new business.
Increasing SEC enforcement through clear and consistent action presents a promising solution. It is not sensitive to the issues that impede private class actions in this context such as opaque stock pricing, judgment-proof defendants, and the difficulty of aggregating plaintiffs who might be differently situated and lack standing or incentive to bring suit. Moreover, public enforcement can help to fill the oversight gap that venture capitalists and other private investors might leave and can be calibrated over time and with further study. Federal prosecutors and state regulators might also play a role in increasing oversight, enforcement, and accountability.
Finally, my article explores two additional responses to securities fraud in the private market – both reinforcing the argument for increasing public enforcement and presenting opportunity for future regulatory change. First, the article contributes to a growing literature on the public footprint of large private corporations and possible gradations or tiers of publicness. To date this literature has focused primarily on the need for the sunlight of public disclosure – by contrast, this article contributes the securities fraud piece of the argument, rooted in our federal framework that envisioned both as being key mechanisms for the protection of investors and the general public. The growth of the private market, relatively free from securities fraud scrutiny, presents a new argument in favor of taking a hard look at the public-private line. Second, the article highlights that the response to securities fraud need not look the same in the private as in the public market. Alternative mechanisms to increase accountability such as giving startup employees additional information and empowering gatekeepers to play a stronger role in monitoring could provide finely-tuned responses to information problems that could supplement increased public enforcement.
This post comes to us from Professor Elizabeth Pollman at the University of Pennsylvania Law School. It is based on her recent article, “Private Company Lies,” available here.