What everyone missed in Facebook's IPO filing

Buried on page 93 of Facebook's registration for its $5 billion initial public offering is a very interesting disclosure.

"The Enforcement Division of the Securities and Exchange Commission has been conducting an inquiry into secondary transactions involving the sale of private company securities as well as the number of our stockholders of record," the disclosure said. "In connection with this inquiry, we have received both formal and informal requests for information from the staff of the SEC and we have been fully cooperating with the staff. We have provided all information requested and there are no requests for documents or information that remain outstanding. We believe that we have been in compliance with the provisions of the federal securities laws relating to these matters."

The fact of that paragraph alone is news. The New York Times reported in December 2010 that the SEC was looking into the red-hot secondary market for trading in the privately-held shares of Facebook, Zynga, LinkedIn, Twitter, and some other Internet darlings. The leading market-maker for such trading, SecondMarket, confirmed in January of last year that it had received a voluntary request for information from the SEC (which has never confirmed the investigation). But Facebook is the first company to offer any hard facts about what the agency is probing.

The key disclosure is Facebook's mention of "the number of our stockholders of record." Federal securities laws restrict the number of shareholders in privately held companies to 500. To distribute shares more widely, a corporation must register as a public company, which, of course, entails a whole bunch of regulatory complications. The 500-shareholder limit, however, was enacted in the 1960s, before the explosive growth in secondary-market trading of private shares. You can see why companies like Facebook would be worried about inadvertently crossing the line: Facebook can control the number of people to whom it issues stock directly, but not necessarily the number of investors who buy the private shares.

What did you miss?

One solution to that problem is selling shares to a group of aggregated investors. According to Adam Pritchard of the University of Michigan Law School, an investment fund with a portfolio of stock, for instance, would count as one shareholder in the SEC's eyes. So might a special-purpose vehicle devised specifically to buy shares of one private company on behalf of a group of investors. (An SPV, according to Pritchard, has more leeway with non-accredited investors than an investment fund.) When Goldman Sachs planned to invest $1.5 billion in Facebook last January, it was to be through a special-purpose vehicle that would have allowed Goldman clients to participate.

But if Facebook was aware that Goldman or any other investor was using a special-purpose vehicle to get around the limited-holding rule, it could be in trouble with the SEC, according to Pritchard. "The question would be whether Facebook has been involved with creating or encouraging the vehicles," he said. If the SEC determined that it was, Pritchard said, it could potentially be subject to an enforcement action for violating the Exchange Act -- which could cause a delay in the IPO.

Pritchard is quick to note that it's extremely unlikely Facebook is in line for an enforcement action, since it disclosed no hint of an SEC target letter in its IPO filing. Instead, the professor said, Facebook's lawyers at Fenwick & West and Simpson Thacher & Bartlett were probably just being careful in choosing to disclose the existence of the SEC investigation. (Interestingly, neither LinkedIn nor Zynga mentioned anything about the SEC's secondary market investigation in their IPO registration filings.)

Stanford Law School professor (and securities-law maven) Joseph Grundfest agreed that Facebook's disclosure indicates the company is not an SEC target. In fact, Grundfest told me his understanding is that the SEC isn't looking at private-stock issuers, but is trying to understand how the secondary market operates. The agency is focused on buyers, sellers, and intermediaries, he said. "There's not even a whiff of suspicion that issuers have violated the law," Grundfest said. "(Facebook's) disclosure is exactly right."