Brent M. Westrop*
Noted professor Louis Loss described the function of federal securities law as “disclosure, again disclosure and still more disclosure.” Why disclosure? As Congress stated in enacting the Securities Exchange Act of 1934:
No investor, no speculator, can safely buy and sell securities upon exchanges without having an intelligent basis for forming his judgment as to the value of the securities he buys or sells.
And yet it appears that shares in a number of popular privately held companies, such as Facebook, are actively bought and sold in private secondary markets or held by numerous investors through special purpose investment vehicles while remaining outside of the disclosure regime of the federal securities laws. Recent scrutiny by securities regulators could mean that, just as they did over 47 years ago, Congress and the Securities and Exchange Commission (SEC) will look to rewrite the disclosure rules for privately held firms to ensure that investors in such companies have access to adequate disclosure, including publicly filed annual, quarterly and periodic financial information.
In December 2010, it was reported that the SEC was investigating the trading of shares in privately held companies such as Facebook, Twitter, Zynga, and LinkedIn. The SEC is likely concerned about whether these nonpublic companies are improperly skirting registration and public disclosure requirements. With the rise of private online exchanges such as SecondMarket and SharesPost, holders of private-company stock, often former employees, are able to sell their shares to willing buyers. At the same time, some brokerage firms have been forming investment pools to buy these companies’ shares. News broke in January 2011 that investment bank Goldman Sachs was going to raise as much as $1.5 billion for Facebook through the creation of such an investment vehicle. Goldman’s clients would be able to invest in a special fund which would in turn own shares of Facebook. In a regulatory system focused on disclosure, the fact that investors who do not have adequate information may be buying and selling securities in nonpublic companies, or investment funds owning securities in such nonpublic companies, is cause for concern.
Such concern about the lack of disclosure by privately held companies is not a new development. Over 47 years ago, the SEC was worried that investors in unlisted companies traded in over-the-counter markets were not getting enough information. The seminal Report of the Special Study of Securities Markets delivered in 1963 found “to no one’s surprise, that the disclosures voluntarily made by unlisted companies left a great deal to be desired.” Congress responded to the Special Study by passing the Security Acts Amendments of 1964.
One of the principal objectives of the 1964 Amendments was to extend to investors in securities traded over-the-counter the same fundamental disclosure and insider trading protections as were previously afforded by the Exchange Act to investors in securities listed on a national stock exchange. This was done through the addition of a new Section 12(g) to the Exchange Act. Under Section 12(g), an issuer with 500 or more “holders of record” of a class of equity security and assets in excess of $10 million at the end of its most recently completed fiscal year must register that class of equity security, unless there is an available exemption from registration. The requirement to register and begin reporting is effective 120 days after the end of the fiscal year in which a company exceeds the 500 holders of record threshold.
Section 12(g)(5) of the Exchange Act gave the SEC the authority to implement rules defining the term “held of record.” Rule 12g5-1, “Definition of Securities Held of Record,” was enacted in 1965. Rule 12g5-1 generally includes as a separate holder each person who is identified as the owner of such securities on records of security holders maintained by a company in accordance with accepted practice. The fact that Rule 12g5-1 only counts stockholders appearing on a company’s stock ledger as holders of record may be convenient for companies, but means that many stockholders will not in fact be included. This is because with the drastic changes in clearing and settlement procedures that have occurred since the passage of the rule, most beneficial owners of securities now hold their securities through their broker-dealer in nominee or street name (rather than holding physical share certificates). The staff of the SEC has made clear that securities held in street name by a broker-dealer are held of record under the rule only by the broker-dealer.
The “holders of record” definition therefore results in private companies which may have more than 500 actual shareholders, but not be required to register under the Exchange Act as the number of shareholders on their books is below the 500 holders of record threshold.  Some have suggested that special purpose investment vehicles, such as Goldman’s Facebook fund, were being created to circumvent the rule, and keep the applicable private company under the 500 shareholder threshold, since the vehicles would each count as only one shareholder of record, regardless of the number of investors in the vehicle. Although that may be the case, Rule 12g5-1 states that if the issuer knows or has reason to know that the form of holding securities of record is used primarily to circumvent the provisions of the Exchange Act, then the beneficial owners shall be deemed to be the record holders thereof. So if the SEC was to determine that Facebook knew that the Goldman fund was being set up to allow Facebook to remain below 500 holders of record, the SEC could look through the fund and count each investor in the fund as a holder of record of Facebook. This risk may have been the reason that Goldman ultimately decided to limit investments in Facebook to non-US accounts. However, according to a Facebook press release, even before the investment from Goldman Sachs, Facebook had expected to pass 500 shareholders at some point in 2011, and therefore expects to start filing public financial reports no later than April 30, 2012.
Although Facebook has declared that it intends to register under the Exchange Act and therefore become a public company by 2012, the SEC’s review of trading in shares of privately held companies and the scrutiny that surrounded the proposed Facebook/Goldman offering may ultimately spur it to tighten its regulation of other private companies by re-thinking the holders of record definition. At the time of the adoption of Rule 12g5-1, the SEC indicated that it would continue to evaluate the rule to determine whether it may be necessary or appropriate, in order to prevent circumvention of the Exchange Act and to achieve the intended coverage on a uniform and acceptable basis, to count securities held in customers’ accounts, but registered in the name of a broker, dealer or bank, as being “held of record” by the number of separate accounts for which they are held. Although the clearing and settlement system has changed drastically since the rule was adopted, with most shares now being traded by computer in book-entry form, and the number of holders holding securities in street name vastly increased, the SEC has done little to re-evaluate the rule.
In 2003, the Nelson Law Firm, on behalf of a group of institutional investors, filed a rulemaking petition with the SEC requesting the SEC to take immediate action to amend Rule 12g5-1 to count all accounts as holders of record. It received no public response from the SEC. More recently, the Advisory Committee on Smaller Public Companies, in its 2006 Final Report, recommended that the SEC amend Rule 12g5-1 to interpret “held of record” in Exchange Act Sections 12(g) and 15(d) to mean held by actual beneficial holders and that the SEC commission a study to determine whether a standard other than number of shareholders would be a better determinant of when a company should be required to enter or exit the SEC disclosure system.
While the SEC has given no clear indication of its intentions regarding its examination of trading in private company shares, its investigation may lead it to finally review Rule 12g5-1. Still, even if the SEC were to take a fresh look at Rule 12g5-1, it is unclear whether it would move to a beneficial holder test. Although the Nelson Petition makes the case that through the use of the SEC’s shareholder communications rules determining the number of beneficial owners is not burdensome, some commenters to the Final Report of the Advisory Committee noted that it is not often easy for an issuer to know the precise number of beneficial holders of its stock. Though it is difficult to guess the contents of future regulatory proposals, recent events including the SEC’s scrutiny of Facebook make it more likely that Congress and the SEC will look to rewrite the disclosure rules for privately held firms, just as they did in 1963-64.
* Brent M. Westrop is an attorney in the Business Department of Sherman & Howard L.L.C. in Denver, Colorado. Prior to joining Sherman & Howard in 2010, Mr. Westrop was an attorney at law firms in Toronto, Ontario and New York, New York, and was in-house counsel to an international financial services firm in New York, New York.
 Louis Loss, Securities Regulation 21 (2d ed. 1961).
 Exchange Act, 15 U.S.C. §78a-7800 (2006).
 H.R. Rep. No. 1383, 73d Cong., 2d Sess.at 11 (1934).
 Companies are generally required to register under the Exchange Act, and therefore file a detailed registration statement with the SEC and become subject to the Exchange Act’s annual, quarterly and periodic reporting, proxy solicitation and insider reporting and trading provisions: (i) under Section 12(b) when they register a class of securities on a national securities exchange, (ii) under Section 12(g) when they have 500 equity shareholders of record and $10 million in assets, or (iii) under Section 15(d) when they have filed a registration statement under the Securities Act of 1933 that becomes effective.
 See, e.g., Peter Lattman, Stock Trading in Private Companies Draws S.E.C. Scrutiny, DealBook - N.Y. Times (Dec. 27, 2010), available at http://dealbook.nytimes.com/2010/12/27/stock-trading-in-private-companies-draws-scrutiny/.
 See, e.g., Susanne Craig & Andrew Ross Sorkin. Goldman Offering Clients a Chance to Invest in Facebook, DealBook – N.Y. Times (Jan. 2, 2011), available at http://dealbook.nytimes.com/2011/01/02/goldman-invests-in-facebook-at-50-billion-valuation/.
 Special Study of Securities Markets, H.R. Doc. No. 88-95 (1963) (“Special Study”).
 Hugh F. Owens, Commissioner, SEC, The Securities Acts Amendments of 1964, Address before the Practising Law Institute, at 5 (Oct. 16, 1964) (transcript available at http://www.sec.gov/news/speech/1964/101664owens.pdf).
 1964 Amendments, Pub L. No. 88-467, 78 Stat. 565 (1964).
 Summary and Interpretation of Amendments to Securities Act of 1933 and Securities Exchange Act of 1934 Contained in the Securities Acts Amendments of 1964, Exchange Act Release No. 33-4725, Exchange Act Release No. 34-7425, 1964 WL 67875 at 1 (Sep. 29, 1964).
 The asset threshold was originally set at $1 million in Section 12(g). Pursuant to its authority under Section 12(h) of the Exchange Act, the Securities and Exchange Commission has increased the amount three times: from $1 million to $3 million in 1982, System of Classification for Purposes of Exempting Smaller Issuers From Certain Reporting and Other Requirements, Exchange Act Release No. 34-18647, 47 Fed. Reg. 17046 (Apr. 13, 1982); from $3 million to $5 million in 1986, Reporting by Small Issuers, Exchange Act Release No. 34-23406, 51 Fed. Reg. 253601 (Jul. 8, 1986); and from $5 million to $10 million in 1996, Relief from Reporting by Small Issuers, Exchange Act Release No. 34-37157, 61 Fed. Reg. 21353 (May 1, 1996).
 17 C.F.R. § 240.12g5-1.
 U.S. Securities and Exchange Commission, Compliance and Disclosure Interpretations: Exchange Act Rules Question 152.01 (updated February 11, 2011), available at http://www.sec.gov/divisions/corpfin/guidance/exchangeactrules-interps.htm.
 In addition, Section 12(g)(4) of the Exchange Act allows for the termination of registration if the number of holders of record is reduced to less than 300 persons. Although beyond the scope of this article, the fact that “holders of record” does not accurately count the total number of a company’s shareholders also makes it easier for public companies to “go dark” and get out of the Exchange Act disclosure system.
 Craig, supra note 6.
 The amount of publicity surrounding the investment may have also led to worries that Facebook could not complete a proper private placement of securities in the United States. See, e.g., Andrew Ross Sorkin, Goldman Limits Facebook Investment to Foreign Clients, Dealbook – N.Y. Times, (Jan. 17, 2011), available at http://dealbook.nytimes.com/2011/01/17/goldman-limits-facebook-investment-to-foreign-clients/.
 Facebook Raises $1.5 Billion, Facebook (Jan. 21, 2011), available at http://www.facebook.com/press/releases.php?p=205070.
 Adoption of Rules 12g5-1 and 12g5-2, Exchange Act Release No. 34-7492, 1965 WL 89090 at 2 (Jan. 5, 1965).
 Petition for Commission Action to Require Exchange Act Registration of Over-the-Counter Equity Securities (the “Nelson Petition”) (July 3, 2003), available at http://www.sec.gov/rules/petitions/petn4-483.htm.
 SEC Advisory Committee On Smaller Public Companies, Final Report of the Advisory Committee on Smaller Public Companies to the U.S. Securities and Exchange Commission (“Final Report of the Advisory Committee”), at 83-86 (Apr. 23, 2006).
 See, e.g., Exchange Act Rules 14a-13, 14b-1 and 14b-2.
 See, e.g., Letter from Sarah A. Miller & Donna J. Fisher, American Bankers Association, to Nancy M. Morris, SEC (Apr. 3, 2006), available at http://www.sec.gov/rules/other/265-23/aba040306.pdf.