Legal Guardrails for a Unicorn Crackdown

The SEC is undertaking an historic effort to redraw the boundary between public and private companies.  After years of watching – and sometimes encouraging – the explosive growth in less tightly regulated private markets and the proliferation of so-called “unicorns,” the agency is now reclaiming jurisdiction.

A key arrow in the agency’s regulatory quiver is its authority under Exchange Act Section 12(g) to force private companies to “go public” when they reach a certain size. The provision requires any company whose shares are “held of record” by more than 2,000 persons to take on the obligations imposed by federal securities regulations on public companies, including extensive disclosure.  But, today, this 2,000 shareholder trigger has no real constraining effect; because a single holder “of record” can easily (and often does) stand in for tens, hundreds, or even thousands of real beneficial owners, private companies can easily raise endless amounts of capital without tripping the 2,000 threshold.

Now, the SEC plans to close this loophole by mandating a “look through” to the beneficial owners of the securities for purposes of the shareholder count. The details remain to be seen. But the agency is apparently eager to leverage this power to significantly curtail private companies’ ability to grow outside of the regulatory scrutiny that accompanies public company status.

So far, it has been assumed that SEC has legal authority to do this and new legislation isn’t required. SEC Commissioner Allison Herren Lee recently claimed that it is “clear” that the SEC has legal authority to “require issuers to look through to beneficial owners” for purposes of Section § 12(g).   Donald Langevoort and Robert Thompson observed that the SEC “presumably” could modify the rule “to refer to beneficial ownership known or reasonably available to the issuer.”  George Georgiev wrote that the SEC could implement this change “fairly easily by acting on its existing authority, without the need for additional congressional action” and that its authority to do this was “beyond question.”  And an influential report from the Duke Global Financial Markets Center asserted the “change can be made without legislation.”

The reality is more complicated. In a new paper, I show how the text and legislative history of Section 12(g) appear to indicate that the SEC may not redefine “held of record” as “beneficially held” and has only limited authority to mandate any kind of look-through for purposes of the shareholder count. Key evidence for this more limited interpretation of the agency’s look-through power includes the following:

  • Text of the Exchange ActThe Exchange Act assigns distinct rights and obligations depending on the specific nature of a person’s interest in securities: Some provisions (like Section 12(g)) focus on “record” holders; others on “beneficial” owners; and still others on persons with “investment discretion.” Statutory interpretation 101 dictates that these choices should be respected – that Section 12(g)’s use of “record” holders is properly interpreted as a purposeful decision not to use “beneficial owners.”
  • JOBS Act Legislative History – The JOBS Act of 2012 raised the Section 12(g) shareholder limit from 500 to 2,000 and preserved the pre-existing language identifying shareholders “of record” as the relevant metric for this count. As the bill moved through Congress, Democrats tried and failed no fewer than four times to insert a provision explicitly authorizing the SEC to redefine “held of record” as “beneficially owned” for purposes of Section 12(g). Democrats lobbying for these amendments publicly registered doubts as to the SEC’s existing authority to do this absent new legislative authorization, as did then-SEC Commissioner Luis Aguilar. A key Republican explained his opposition to these amendments by arguing that Congress, not the SEC, should have the exclusive discretion to make such an important change. A court may hesitate to override Congress’ apparent decision not to authorize the SEC to look-through to the beneficial owners.
  • Legislative History of the 1964 Securities Act Amendments – Section 12(g) was added to the Exchange Act in 1964, but the SEC had been asking Congress to add a shareholder-count based registration trigger for decades prior to that. Several of the SEC’s earlier legislative proposals would have set the trigger based on the number of persons holding shares “directly or indirectly,” but in 1963, the agency specifically explained to Congress that it had decided to substitute “record” holders in its new proposal. Again, Congress’ choice of “record” holders in Section 12(g) appears to have also reflected a deliberate rejection of “beneficial” holders.

Based on this and other evidence reviewed in my paper, I believe a court may find the agency’s authority to look through to the beneficial owners for purposes of the Section 12(g) shareholder count is substantially constrained. The paper walks through this evidence, articulates limited interpretations of the SEC’s look-through authority that are consistent with this evidence, and then shows how these limited interpretations would constrain the SEC’s budding efforts to crack down on private markets.   Any fundamental  redrawing of the boundary between public and private markets will likely have to come from Congress – just as it did in 1933 and 1964.

This post comes to us from Associate Professor Alexander I. Platt at the University of Kansas School of Law. It is based on his recent article, “Legal Guardrails for a Unicorn Crackdown,” available here.