The Breakdown of the Public–Private Divide in Securities Law

Securities law in the United States has traditionally been designed around a set of lines – the “public–private divide” – which separate public companies, public capital, and public markets from private companies, private capital, and private markets. Until the early 2000s, the lines were successful in establishing two largely coherent legal realms – a highly regulated public realm and a lightly regulated private realm – with investor protection by way of disclosure and governance obligations limited to the public realm. A series of bold and often-inconsistent reforms, however, has transformed this longstanding regime into a low-friction system where public capital flows to both public and private companies, private capital is ever more abundant, and firms can effectively eschew public company status, which is both more costly and much less essential to firm success than ever before.

In a new article, I argue that, taken together, these developments have led to the breakdown of the traditional public–private divide. In effect, the boundaries between the regulated and unregulated realms have been removed, and the public–private distinction has lost its descriptive and explanatory power as an organizing principle of securities law. The article contributes to the literature by (1) offering a novel and comprehensive analytical account of the breakdown of the public–private divide (up through the completion of the deregulatory cycle in late 2020), (2) analyzing the adverse consequences of these developments on investors, employee-investors, and the regulatory regime as a whole, and (3) investigating possible reforms and their expected effectiveness.

Capital Markets in the 21st Century

Many of the deregulatory reforms at issue have received inadequate attention due to their technical nature and piecemeal implementation. These reforms, however, have contributed to large-scale shifts in capital markets, which are worth highlighting up front. The dramatic rise of unicorns (private firms with an implied market valuation of at least $1 billion) has been particularly prominent. Whereas there were approximately 43 unicorns in the United States when the term was coined in 2013, at the end of 2020, their number stood at 251, and by the end of 2021, it had nearly doubled to 488. The aggregate implied valuation of U.S. unicorns was $1.67 trillion at the end of 2021, which is an eleven-fold increase since 2013, and a nearly three-fold increase in 2021 alone. The annual number of initial public offerings (IPOs) in the United States has fluctuated considerably, from fewer than 100 IPOs per year for parts of the 2000s, to over 400 IPOs in 2020, and over 900 IPOs in 2021 (including SPACs). The figures below illustrate these record-breaking trends.

There is more: Whereas the number of U.S. public companies exceeded the number of U.S. private equity-owned companies by a considerable margin in 2000, two decades later these positions have been reversed. Assets under management in the U.S. buyout industry, a key source of private capital, have grown steadily—and more than ten-fold—between 1990 and 2019. While data on capital-raising in the opaque private markets are incomplete, they still show that during the 2010s more capital was raised on the private markets than on the public markets. Today’s unicorns rely on the private markets for the growth-intensive stages of their lifecycle, whereas older-generation tech companies, such as Amazon, Google/Alphabet, and Facebook, relied predominantly on the public markets. The typical age of tech firms going public was 7.8 years between 1980 and 2011; since 2012, the year the JOBS Act was enacted, it has increased to 11 years.

The Public Company Regulatory Paradox

Changes in law and the resulting market responses have given rise to the following regulatory paradox: It is possible today for two firms that are identical in virtually every respect – business model, size and scope of operations, enterprise value, access to capital, number of shareholders, number of employees, and so on – to have widely different regulatory obligations. The firm that is a public company (Firm A) would need to regularly provide public disclosure about its results of operations, financial condition, trends and risks affecting the business, executive compensation, corporate governance arrangements, and various other topics. It would need to establish and maintain robust internal controls and procedures over financial reporting. Its board of directors would need to have specially designated committees with strict qualification requirements for those serving on them.

By contrast, the firm that is a private company (Firm B) would have to do none of that. It could operate in secrecy, avoid public scrutiny, and eschew the internal governance structures required of public companies. And while both firms would be covered by the anti-fraud provisions of SEC Rule 10b-5, Firm A would still be much more likely to face an enforcement action. The key to understanding the paradox is that (1) public company regulation generally kicks in only if a firm elects to finance itself on the public capital markets instead of the private capital markets, and (2) private markets are now just as abundant, which renders public company status virtually irrelevant from an access-to-capital point of view.

The paradox is reinforced by the fact that deregulatory developments now allow virtually all investors to invest with the same ease in both Firm A and Firm B while benefiting from investor protections in the first case but not in the second. Even more bizarrely, both firms would likely be contained in the broadly diversified portfolios that have become a staple of standard 401(k) retirement plans and other popular investment vehicles. Accordingly, it would be difficult for an investor to avoid putting money in the unregulated firm (Firm B), even if this were an express goal based on an informed choice. Today’s investors, in other words, are routinely exposed to both regulated and unregulated firms, which undermines the foundational logic of investor protection.

Causes of the Breakdown of the Public–Private Divide

How did we end up here? The breakdown of the public–private divide can be attributed to a deregulatory cascade in the name of capital formation, which took place primarily during the 2010s, and which, in turn, was set off by the perceived malaise of U.S. capital markets in the prior decade. The cycle kicked off with the 2012 JOBS Act and related SEC rulemaking, continued with the 2015 FAST Act, and concluded in November 2020 during the last days of the Trump administration. Some of the reforms exacerbated the very problems they set out to address, which, in turn, became the rationale for yet more deregulation. In retrospect, the actions of Congress, the SEC, and, to a more limited extent, the Department of Labor furthered an agenda with six mutually-overlapping elements: enabling the rise of unicorns; emphasizing capital raising on the private markets over the public markets; enabling the rise of private equity; allowing public capital into private companies; transforming public capital into private capital; and promoting regulation-lite regimes.

In the aggregate, these developments have changed the legal framework for capital raising beyond recognition. The two figures below illustrate this transformation. As shown on the left, prior to the 2000s, public companies raised public capital from public investors on the public markets, whereas private firms obtained private capital from a narrow class of qualified investors through the much-smaller private markets; going public via an IPO was the only way for a private firm to acquire a large investor base and grow. As shown by the figure on the right (and described further in the article), the public and private sides today are connected in a variety of new ways, which has led to the breakdown of the public–private divide.

Consequences of the Breakdown of the Public–Private Divide

The consequences are profound and implicate constituencies within and outside the firm. Four broad themes emerge. First, the federalization of corporate governance, much criticized in academic and policy circles over the past two decades, today looks more like quasi-federalization: The regulatory provisions at issue are tied to public capital-raising and can now be easily avoided or circumvented by raising capital on the private markets instead. This is a backdoor, market-based “issuer choice” regulatory regime, whose merits remain contested in the academic literature and have never been seriously considered, much less endorsed, by policymakers. Second, and relatedly, the breakdown of the public–private divide has undermined the regulatory capacity of securities law: Firms can avoid important disclosure and governance mandates by delaying or never going public, by going private, or by selling off “bad” assets to a private company. Since public company regulation has become important in ensuring corporate transparency and accountability – and to the extent this development is a desirable – the breakdown of the public–private divide is a problem not just for capital market participants but for society as a whole.

The third and fourth sets of consequences relate to mainstream investors and employee-investors, respectively. As regards mainstream investors, there has been a decoupling of the exclusive relationship between public companies and mainstream investors and, consequently, an attenuation of the logic of investor protection upon which much of securities regulation rests. The investor protection issues concern both efficient pricing, i.e., the most basic term of any securities transaction, and matters such as the difficulties in maximizing risk-adjusted returns within an investment portfolio due to information asymmetries, suboptimal corporate governance, and inadequate access to appropriate investment opportunities.

The breakdown of the public–private divide also compounds the problems faced by a special class of investors: employees of startup companies who usually receive a considerable amount of their total compensation in illiquid and hard-to-value private company stock and stock options. These employee-investors are incapable of mitigating through diversification the firm-specific risk associated with their investment of both financial and human capital via the employment relationship. Unlike in the past, these problems are no longer capped in size or duration, because startups can now raise unlimited amounts of private capital (with larger private startups having more employees and, accordingly, more employee-investors), and because startups can remain private, and thus untouched by federal corporate governance regulation, virtually indefinitely. The issues faced by employee-investors at private firms stand in marked contrast to public companies’ intensifying regard for human capital management concerns.

Potential Reforms

The scale of the problems suggests that the necessary reforms are likely to be foundational – and exceedingly difficult. One set of options relates to rebuilding the public–private divide, either by filling various regulatory gaps in the lightly regulated private realm or by adjusting regulation to expand the size of the public realm. As an example of the latter, SEC Commissioner Allison Herren Lee recently put forward a simple, yet bold proposal: The SEC should revise the concept of “shareholder of record” used in existing legislation to more accurately capture the true number of beneficial owners, a change that would automatically push a number of large private companies into the heavily regulated public realm. An analysis of this proposal suggests that it will be an effective tool for rebuilding the original public–private divide, though its blunt nature may put its feasibility into question. While Commissioner Lee’s proposal would address most of the problems stemming from the breakdown of the public–private divide, it would not solve, and could indeed exacerbate, problems related to employee-investors.

A second set of reform options entails circumventing the public–private divide rather than rebuilding it. This can be done by shifting some of the economic regulation that currently operates through securities law to other regulatory domains, in effect lowering the distinction between public and private companies. These options are not mutually exclusive, but they are likely to be difficult and costly to implement. Given historical patterns of regulation, as well as the political and logistical roadblocks to reform, the article posits that securities law may well need to wait until the next big market crisis – or its next “critical juncture” – before the issues discussed here can be addressed.

Despite the unspecified timing and outcome, this conclusion need not be viewed as defeatist. There is much that the SEC, capital market participants, and other corporate governance stakeholders can do today to ensure that, when the opportunity for reform arises, it will be used to optimize the regulatory landscape. Specifically, the SEC should as soon as possible initiate a broad deliberative process involving multiple stakeholders to come up with a blueprint for capital market regulatory reform to address the breakdown of the public–private divide. Even if this blueprint is not put into immediate use due to congressional inaction, having such a blueprint will help the agency navigate the next occasion when Congress is focused on financial and capital market regulation. It will also make it more difficult for special interests to capture the regulatory process; recent experience shows that, in the absence of an SEC blueprint, private actors supply their own blueprints, which then become the regulatory agenda.

The breakdown of the public–private divide around which securities regulation has been organized since the 1930s puts the field in disarray, but it also offers opportunities for blue sky thinking and innovation. In order to seize on these opportunities, it is crucial to understand exactly where we are today and how we got here – a core goal of the article.

This post comes to us from Professor George S. Georgiev at Emory University School of Law. It is based on his recent article, “The Breakdown of the Public–Private Divide in Securities Law: Causes, Consequences, and Reforms,” available here.