UPDATED 09:03 EDT / MAY 09 2011

Private Markets Seek SEC Guidance

There has been a good deal of discussion in recent weeks about the Securities and Exchange Commission (SEC) pondering changes in regulations governing the trading in the private markets of shares of non-public companies such as Facebook, Groupon, Zynga, LinkedIn, and Twitter (LinkedIn is planning an IPO but is still a private company). Now comes word that the private exchanges upon which this trading occurs are actively seeking guidance from the SEC.

An item in today’s Wall Street Journal (wsj.com) notes that SecondMarket Holdings Inc., one of the biggest players in the booming “shadow market” for trading shares of closely held non-public companies such as Facebook Inc. and Twitter Inc., is seeking U.S. approval for how it handles those transactions. The New York firm has held preliminary talks with the Securities and Exchange Commission about a potential “no-action letter” that would essentially guide SecondMarket on how to operate. SEC officials issue such letters in response to requests from individuals or entities who aren’t certain whether a particular product or action would violate U.S. securities laws. SecondMarket Holdings and SharesPost are two firms currently handling the exchange of private shares between buyers and sellers.

“There has to be guidance here,” Annemarie Tierney, SecondMarket’s general counsel, said in an interview. “There have to be regulations that specify how the SEC wants this market to work, and clarity on how the rules apply to the secondary market doesn’t exist yet.”

About $4.6 billion worth of shares of closely held companies changed hands last year, up 92% from $2.4 billion in 2009, according to Nyppex Holdings LLC, a research firm and broker-dealer in Rye Brook, N.Y. Volume is expected to reach $6.9 billion this year. The surge in transactions, often involving shares sold by former employees and other existing shareholders, rather than the company, has helped fuel a gravity-defying climb in the valuations of some private companies, especially in the technology industry, as we have previously noted.

The real concern seems to be the application of SEC rules and regulations governing insider trading to the private markets, since the shares being traded in the private markets are often being sold by company employees and investors and not shares issued directly by the companies themselves. Some legal experts foresee a flurry of lawsuits from investors who bought privately traded shares at sky-high prices. “This is litigation waiting to happen, and it will arise when the downturn comes,” former SEC commissioner Joseph Grundfest recently told a seminar at Stanford University, where he is a law professor.

Frank Currie, a partner at law firm Davis Polk & Wardwell LLP, said holders of shares in Silicon Valley’s highest-profile closely held companies are “now coming to realize” that securities laws on insider trading at public companies apply with equal force to them. “Suppose a Facebook former employee, who has inside information about the company, sells his or her shares to a doctor or a dentist on SharesPost at a $70 billion valuation, and Facebook happens to go public at a mere $40 billion,” he said. “That insider could well have a lawsuit on his hands.”

Some private companies are unhappy about the booming market for their shares because it gives them less control over who owns the stock. In a statement, Zynga said the secondary market has “added to the complexity of legal compliance, particularly where buyers and sellers may have asymmetrical information” regarding the valuation of the shares and the financials of the company.


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