The SEC should change the definition of “holder of record” to reflect true owners: The SEC’s current interpretation of “holder of record” is outdated and effectively permitting companies to have thousands of investors without having to comply with the SEC’s disclosure and accountability framework, as Congress intended.
Congress should amend the Securities Act to make large, widely held companies public: Exemptions and loopholes from the public markets framework have enabled very large companies to remain in the private markets while receiving support from a broad swath of investors and affecting the lives of millions of people.
Congress and the SEC should condition any exemptions on fair and timely access to essential information to investors: Regardless of wealth or market power, all investors should have the same essential information needed to make informed investment decisions.
The SEC and Congress should review all exemptions from the public registration and disclosure framework and restore its broad application: More importantly, exemptions from the SEC’s transparency and accountability framework should be rare and narrowly construed.
The SEC should collect more data on private markets: The SEC should require private issuers and investment funds to provide the agency with more detailed and timely information about their use of exemptions, including prefiling and post-closing data. The provision of these data should be a prerequisite to the use of any exemption from the public disclosure framework.
Introduction and summary
The federal securities laws, enacted in the depths of the Great Depression, established one of the most important principles for capital markets: Businesses that seek to raise money from the public must first provide the public with sufficient information to make informed investment decisions. The public disclosure framework established in the 1930s functioned well until the deregulation movement of the 1980s set in motion a series of exemptions that have increasingly weakened investor protections and undermined the transparency and accountability of U.S. capital markets.
Through clever use of these exemptions, virtually all companies and private funds can access public capital today without registering with the U.S. Securities and Exchange Commission (SEC) or complying with its disclosure and accountability frameworks.
Read a summary
The growth in exemptions from registration and information reporting has led to a corresponding rapid growth of opaque private markets, which now include trillions of dollars of investors’ capital. In fact, through the use of these exemptions, companies raise more private capital annually than is raised through public offerings. For example, from 2009 to 2019, $15.5 trillion was raised in the private markets using just one set of exemptions: Regulation D. In 2019 alone, Regulation D offerings raised $1.5 trillion, easily outpacing the capital raised by the entire public markets, in which only $1.2 trillion was raised.1
Coinciding with this massive diversion of capital from the public to the private markets, the number of private startup companies valued at more than $1 billion has increased dramatically.2 While these “unicorns” used to be considered rare—in 2014, there were an estimated 40 such companies worldwide3—they no longer are. As of December 2022, there were more than 651 unicorns in the United States alone.4 The incredible growth in the number and size of private operational companies has been mirrored by a similar increase in number and assets of private equity and hedge funds, which together grew to an estimated gross asset value of $17 trillion by the end of 2020.5
What is Regulation D?
In the 1980s, the SEC created Regulation D, which assembled and updated a set of existing exemptions from public registration and reporting requirements. The most widely used rule under Regulation D allows any company to offer an unlimited number of securities to investors who satisfy at least one of a broad set of criteria that qualify them as “accredited.” The criteria for being an accredited individual investor in many cases use high income and wealth as proxies for sophistication.6
What is a unicorn?
When new companies, or startups, that are owned by private funds or accredited investors and not publicly registered grow to a value of more than $1 billion, they are called unicorns. Unicorns, by definition, are not registered with the SEC or listed on a public stock exchange. Thus, they are not required to provide the types of disclosures that public companies must make, even though their values may soar to the tens of billions of dollars, their shareholders may number in the tens of thousands, and millions of people may purchase their products or services. Examples of current unicorns include SpaceX, Impossible Foods, Circle, Reddit, and JUUL Labs.
The overwhelming majority of Americans are now exposed, either directly or indirectly, to the hidden risks of the private markets. While state pension funds, insurance companies, endowments, and other large investors have long had access to these markets, many have significantly increased their allocations to private markets in recent years. These institutional investors are responsible for managing the retirement and educational savings of millions of Americans.7 At the same time, enabled by sweeping deregulation and lured by claims of incredible returns, individual investors—many of whom are not wealthy and can ill afford potential losses—have also increasingly invested directly in the private markets.8 Finally, American consumers and workers buy products from and work for private companies, which are not required to participate in the disclosure and accountability framework for public companies.
The overwhelming majority of Americans are now exposed, either directly or indirectly, to the hidden risks of the private markets.
This report describes the foundations of the public market disclosure and reporting framework that helped build the strong and trusted reputation of American capital markets. It then explains how a complex web of exemptions from that public framework, along with related rules, have proliferated in recent decades, leading to the rapid growth of the private markets. The report also reveals how this private market juggernaut is harming investors, putting average Americans’ savings at risk, undermining principles of fairness in the marketplace, and misallocating capital toward insiders and away from critical investments, such as those needed for the transition to a clean economy and to prepare for future pandemics. Finally, the report makes recommendations for reform to restore investor protections, fairness in capital markets, and healthy capital formation.
Background: Public disclosure framework
Understanding the dangers posed by the expansion of exemptions from public disclosure and the corresponding rapid growth of private markets in recent years requires a look at how U.S. securities laws and the public disclosure framework began.
Transparency and accountability are the hallmarks of U.S. capital markets
The capital markets leading up to the great crash of 1929 were exciting.9 New technologies, from automobiles to telephones, rapidly became central features of society. Wages were rising. At the same time, brokers and investment banks were rapidly expanding beyond Wall Street to collect and allocate capital from American families and businesses that had never participated in the financial markets.
The markets roared. From autumn 1921 to autumn 1929, the vaunted Dow Jones Industrial Average increased sixfold.10 As Congress later explained, “Alluring promises of easy wealth were freely made with little or no attempt to bring to the investors’ attention those facts essential to estimating the worth of any security.”11 The speculative frenzy was also fed by the “complete abandonment by many underwriters and dealers in securities of those [basic] standards of fair, honest and prudent dealing.”12
In the fall of 1929, the markets crashed. Approximately half of the $50 billion in securities sold during the decade following the first World War ultimately became worthless.13 Investors lost fortunes, valuable resources were wasted, and the U.S. and the world economy entered a depression. However, the damage was not just limited to those who had invested in the markets, as millions of people who had never invested lost their jobs, savings, homes, and worse.
Only through the steady flow of timely, comprehensive, and accurate information can people make sound investment decisions.
U.S. Securities and Exchange Commission
After years of investigations,14 Congress determined that the massive economic collapse had occurred largely because investors simply did not have enough accurate information, and market intermediaries chased “abnormal profits possible from the business of selling securities,” in part by creating and selling high-risk investments.15 When passing the first of the modern federal securities laws, Congress noted, “Whatever may be the full catalogue of the forces that brought to pass the present depression, not least among these has been this wanton misdirection of the capital resources of the Nation.”16
To address this problem, Congress enacted the Securities Act of 1933 to require companies selling securities to the public to provide full and fair disclosure of the nature of the securities,17 including any information that would be necessary to determining the securities’ value.18 The new law required that “all those responsible for statements upon the face of which the public is solicited to invest its money shall be held to standards like those imposed by law upon a fiduciary.”19 Congress considered, but rejected, a regulatory regime where the government would “verify,” “guarantee,” or “approve” the securities offered.20 Rather, Congress decided to require comprehensive disclosures, prohibit fraud and deceit, and let informed investors make their own judgments on the merits and values of securities.
The following year, Congress expanded the federal securities laws with the Securities Exchange Act of 1934, which established rules for the trading—as opposed to the initial offering—of securities, imposed ongoing disclosures for public issuers, and established the SEC to oversee the new laws.21
Collectively, these laws require companies to publicly disclose basic information about their operations, financial condition, and governance.22 Furthermore, companies must take steps to ensure the information provided is accurate, such as by retaining independent auditors. The companies and the people involved in selling securities to the public may be liable for misstatements in cases brought by investors and/or the SEC. This is essential because, as the SEC has explained:
Only through the steady flow of timely, comprehensive, and accurate information can people make sound investment decisions. The result of this information flow is a far more active, efficient, and transparent capital market that facilitates the capital formation so important to our nation’s economy.23
Securities that are subject to these rules are sold in what are called the “public” markets. The guardrails of registration and disclosure help explain why U.S. capital markets are the largest, deepest, and most liquid in the world.
Exemptions from public disclosure create opaque private markets
Beginning in the late 1970s and 1980s, however, the information flow began to break down and today threatens to disrupt trust in U.S. capital markets. Instead of continuing to require businesses seeking to raise money from the public to first provide basic information to the public, Congress and the SEC began creating what has become a complex web of exemptions and related rules that are responsible for the alarming growth of what is known as the “private” markets, where securities are sold without mandatory public disclosures and with limited investor rights.24
There is a strong correlation between these exemptions and the growth of the private markets. In addition, private market growth has been at the expense of the public markets. These two points are confirmed by the SEC25 and by several academics who specialize in securities law,26 and they are consistent with the research of private markets data firms.27 According to the SEC, through the use of just one exemption—Rule 506(b) of Regulation D—an estimated $1.5 trillion was raised in 2018.28 Law professor Elisabeth de Fontenay, a legal expert who has researched this phenomenon, observed in a 2017 paper that “we are already witnessing a sharp decline in initial public offerings and stock exchange listings.”29
The following timeline shows how the exemptions accelerated, particularly in the past decade:
Compared with public markets, private markets are opaque and subject to manipulation
A company seeking capital typically makes an initial public offering (IPO) in the public markets. To offer securities for sale to the public, a company must provide the information required by the securities laws. Furthermore, for its securities to be listed for trade on an exchange, the company must continue providing information in periodic reports and at certain events, such as a merger or acquisition. In addition, an independent auditor must audit all financial statements. Exchanges, where securities are bought and sold, also impose listing standards beyond what the SEC requires, further protecting investors.
Trillions of dollars in equity securities are traded each year in the United States,30 and that trading helps establish the valuations of thousands of public companies. The prices are set through the process of potential buyers bidding based on information from the company, their peers, customers, suppliers, and other sources. These valuations are critical to the movement of capital and the smooth functioning of the financial system; investors can determine an investment’s value at any time and thus buy and sell shares relatively quickly and cheaply, enabling capital to move efficiently and effectively.31
In the private markets, however, without standardized mandatory public reporting, information is sporadic, often unreliable, or simply nonexistent, making the risks of investing much higher.32 Whereas information in the public markets is fairly accessible to all public market participants, access to information in the private markets often depends on who is buying or selling.33
Companies looking to raise capital in the private markets often have the upper hand. They may choose to disclose certain information, but that information may not be reliable or complete,34 nor is it standardized so that investors can compare one investment with another or with a competing public market investment.
Private companies are not legally obligated to disclose bad news, or facts that might hurt their sales, unless failure to do so is egregious enough to meet the strict requirements of fraud.35 They only disclose when pressed by certain investors, not regulators. Moreover, these private companies give up only the rights demanded by their most well-connected investors, not regulators.
Congress originally intended to limit investing in the private markets, given the lack of information and accountability. Historically, there was not a lot of competition between private and public companies. But that is no longer true. The rapid growth of the private markets is undermining public markets.
A complex web of exemptions provides multiple pathways to avoid public disclosure
The federal securities laws generally apply to public offerings of securities. They essentially require registration with the SEC for any sale of securities to any person,36 except in specified circumstances—originally only very small offerings37 or transactions that did not involve a public offering.38
But the statutes did not provide a specific definition of what “public” means. As a result, for decades, both the SEC and the courts construed the definition of a public offering broadly, recognizing that allowing significant exemptions could harm investors and the overall health of the markets.
For example, while stating in 1935 that determining whether an offering was public “is essentially a question of fact [and] in no sense is the question to be determined exclusively by the number of prospective offerees,” the SEC’s general counsel opined that, in general, an offering to 25 or more potential investors was likely to be a “public” offering.39 In 1953, however, the Supreme Court held that an offering to just a handful of employees was a public offering.40 In fact, for many years, an offering was only private if it was made to someone associated with the issuer, and the issuer provided the offeree with the same type of information as could be contained in a registration.41 Thus, “private” offerings were conditioned on investors being provided the same type of information provided by registration.42
Thus, by design, investor participation in private markets historically was limited.
Over the past 40 years, however, few things in the securities laws have changed more than what constitutes a “private” offering of securities. Companies seeking to raise capital, investment banks, and their respective allies generally began lobbying for less oversight, claiming that the rules created unnecessary costs and burdens on them.43 As deregulation swept in during the late 1970s and 1980s, Congress and the SEC started expanding and creating new exemptions from public registration and reporting of securities.
The first significant move in this direction came in 1982, when the SEC finalized Regulation D. In the name of simplifying the small offering and nonpublic offering exemptions in the original statutes, the SEC essentially eliminated the registration and disclosure rules for small offerings to the public of up to $10 million per year and for transactions of any value with “accredited investors.”44 As such, Regulation D was a major departure from the original statutory intent of limiting exemptions from the public framework to truly small offerings and to a small number of investors with close enough relationships to the transaction to understand the risks.
Put simply, Regulation D pivoted the discussion away from focusing solely on the characteristics of the offering (for example, whether it was “public” as the layperson might think of the term) to focusing mostly on the characteristics of the offerees (for example, whether potential investors were wealthy).45 Yet since Regulation D was promulgated, Congress and the SEC have expanded these exemptions.
As discussed further below, the concept of “accredited investors”—individuals who theoretically can assess the risks and bear potential losses—has been greatly expanded to include a wide range of individuals who have no connection to or information about the underlying transaction. Moreover, the ball set in motion by Regulation D gained momentum such that, collectively, there are now nearly a dozen significant exemptions to the public offering framework.46
The following list describes several of these exemptions:
Offerings exempt from public registration and disclosure, by common name
- Rule 506(b) allows any issuer to sell an unlimited number of securities to a range of accredited investors, plus up to 35 investors who are not accredited, without having to provide public disclosures. Specified information must be disclosed to investors who are not accredited. Public solicitation is prohibited.
- Rule 506(c) is essentially the same as 506(b) except limited to accredited investors, and it permits public solicitation to those investors.
- Rule 504 permits any issuer except an underwriter to sell $10 million or less of securities within a 12-month period.
- Regulation A permits two tiers of public offerings, with varied requirements. Tier I permits public offerings up to $20 million; Tier II originally permitted offerings up to $50 million, until the SEC increased the limit to $75 million in 2020. Issuers must file an abbreviated registration, and Tier II securities may be listed for trading on an exchange.
- Crowdfunding: In 2012, the Jumpstart Our Business Startups (JOBS) Act also permitted public internet offerings of up to $5 million per year, with limits on how much a single investor can invest. In 2020, the SEC revised the crowdfunding rules.
- Employee compensation plans permit companies whose shares are not publicly traded to offer shares to their employee compensation plans.47 Availability of exemption is based on size of firm and number of shares, but there is no dollar cap and no significant disclosures are required until the aggregate 12-month contribution exceeds $10 million.
- Rule 147 (intrastate offerings) permits a company to avoid registration of securities if it has a “reasonable basis” for believing potential investors are all within a single state.48 Also, the issuing company need only be mostly—80 percent—within the same state.49
Although a company may raise money based on just one exemption, it may also combine these different exemptions to raise billions of dollars from a diffuse, unaffiliated, and large investor base.50 Moreover, even though many of these exemptions are technically narrow, they overlap in exceedingly complicated ways, enabling private companies and funds to take advantage of several exemptions at a time. In 2020, the SEC attempted to “harmonize” these exemptions by simply allowing them to be even more easily combined.51
Thus, private companies are often able to avoid the SEC’s disclosure and accountability framework while nevertheless raising an unlimited sum from an unlimited number of unaffiliated investors—in other words, the public.
The faulty concept of sophisticated investors
As mentioned above, an important aspect of the offering exemptions is that the SEC has not only expanded the types of offerings that are exempt from public registration—for example, small or intrastate offerings—but also dramatically expanded who may invest in these exempt offerings.
Initially, the federal securities laws generally did not distinguish between investors or treat some differently from others. In fact, Congress explicitly sought to put all investors on the same level playing field. As a result, investing in the private markets 50 years ago was limited to a handful of individuals who were family members or had a close enough relationship to private company owners that they had access to information that would normally be afforded to them under the public company disclosure rules.52
However, that changed dramatically with the adoption of Regulation D, which introduced the construct that some members of the public do not require protection and can essentially “fend for themselves,” generally meaning that they are wealthy and sophisticated enough to absorb any losses.53 Initially, this group included only the wealthiest individual investors and institutions. Over time, the SEC and Congress created different tiers of investors based on wealth and purported sophistication and, in so doing, substantially lowered the bar for who may invest in the private markets.
Today, there are many ways for individuals and small entities to qualify as “accredited” investors,54 including being:
- An officer or director of the company selling the securities
- An individual with more than $200,000 in income or $1 million in net worth55
- A bank, broker, or investment adviser
- A state retirement plan with more than $5 million in assets
- An employee benefit plan with more than $5 million in assets
- A nonprofit with more than $5 million in assets
- A company or partnership with more than $5 million in assets
- A “family office” with more than $5 million in assets
- An individual with a securities representative license, an investment adviser representative license, or a private securities offerings representative license
While many of these categories were established by the SEC as recently as 2020,56 none of the thresholds in existing or new categories are adjusted for inflation, effectively lowering the thresholds in real terms over time and increasing the share of households that could qualify and thus be exposed to risky private market investments.57
In addition to the accredited investor designation, some exemptions rely on other classifications of purchasers with a sheen of sophistication. This group includes “qualified institutional buyers,” which are essentially very large financial firms,58 and “qualified purchasers,” which are individuals or family-owned businesses holding an investment portfolio with a value of at least $5 million.59
Collectively, these definitions—based on often amorphous notions of sophistication—have created a large and growing pool of potential investors in the private markets. Yet there has never been a robust economic or legal analysis of the extent to which income or wealth are useful proxies for whether investors can sufficiently fend for themselves—and, more importantly, whether an individual or institution of any sophistication can sufficiently analyze an investment opportunity without full and fair disclosure of the facts surrounding the offering.60 A widower, a small-town church, or a local firefighter’s pension fund are not de facto imbued with the extreme capital markets expertise of Wall Street veterans simply because they may meet the above definitions. Furthermore, no investor, no matter how wealthy or sophisticated, can make sound investment decisions without the benefit of all the relevant information, opportunities, or rights.61
With private companies and funds growing so prominent today, it is tortured reasoning to say that anyone with a six-figure salary or a lifetime of savings, or any “knowledgeable employee” of an investment fund, possesses the necessary information to make sound investment decisions.
All investors clearly benefit from the comprehensive, consistent, reliable, and comparable information mandated by the securities laws.
A federal appellate court once explained the importance of securities disclosures for all investors, saying, “[T]he shrewdest investor’s acuity will be blunted without specifications about the issuer. For an investor to be invested with exemptive status [t]he[y] must have the required data for judgment.”62 All investors clearly benefit from the comprehensive, consistent, reliable, and comparable information mandated by the securities laws.
Instead, trillions of dollars in retirement fund losses from the 2008 global financial crisis and evidence from state securities regulators’ enforcement dockets, which are replete with frauds targeted at seniors and other accredited investors, suggest that all investors, regardless of their level of sophistication, would benefit from the full and fair disclosure mandated by the public disclosure regime.63
Expanding exemptions encourage companies to stay private
Armed with multiple ways to raise capital from the public without complying with the public disclosure framework, companies have sought ways to remain private for much longer.
Resale of private securities without public disclosures
The above exemptions from public disclosures are available to the issuer of the securities—that is, the company with shares being offered. In most cases, investors who purchase or hold unregistered securities in the private markets—for example, through one of the above exemptions—cannot immediately sell those securities to the public; otherwise, it would be easy for an issuer to get around public disclosure requirements simply by initially selling unregistered securities to an intermediary. Thus, the shares can only be resold to the public or traded when they are registered and essential information is disclosed.
However, this, too, is changing. Rule 144, which was updated by the SEC in 1972, specifies holding periods of up to one year before unregistered securities can be resold to the public.64 And in 1990, the SEC adopted Rule 144A, allowing unlimited resale of unregistered securities to qualified institutional buyers.65 Still, the unregistered securities were difficult to sell without being listed on an exchange, which would require registration and information disclosure.
The creation of the issuer exemptions enabled private companies to gain access to capital from more investors. As these companies grew and more investors participated, some investors wanted to liquidate their investments, but they could only do so if and when the company went public. On the other hand, many companies preferred to stay in the private markets since they could raise the capital they needed without having to comply with the public disclosure framework, leaving their shareholders with limited options, and limited information, if they wanted to cash out.
However, in recent years, several large brokers have created elaborate mechanisms for establishing a secondary or trading market for private securities, making the market more liquid and allowing original investors to cash out.66 In addition, brokers—some of which may not be registered with the SEC—bring private security sellers and buyers together and help navigate them through the process, often having significant impacts on the valuations of the securities and rights transferred. For example, these intermediaries often make recommendations regarding the values of the securities or commit to engaging in additional services for one or more parties.
Critically, these secondary markets for private securities make private market investments through all of the other exemptions more attractive because investors can cash out more easily. Often, these trades may occur despite the new investor having significantly less information about the security than the seller. In fact, as mentioned in more detail below, private secondary markets allow early employees holding stock options and early investors to cash out at often inflated prices by selling to unwary and uninformed investors.
The Section 12(g) backstop and “holders of record” loophole
Since 1964, Section 12(g) of the Securities Exchange Act has sought to ensure that large, widely held companies—regardless of how they raise capital—comply with the SEC’s disclosure and accountability framework.67 That provision, however, no longer works as envisioned.
For decades, Section 12(g) ensured that companies with more than 500 shareholders “of record” and a sufficient level of assets were required to make public disclosures and otherwise comply with the securities laws. Thus, even without engaging in a public offering, these companies were deemed sufficiently “public” to warrant requiring them to make basic disclosures about their operations, financial condition, and governance.
Over time, however, that backstop has been rendered essentially worthless by technology, evolving practices, and deregulation. At the time it was established, investors often held securities in their own names, and often had paper stock shares shipped to them for safekeeping. Those shareholders were “holders of record” both then and today. However, since the 1970s, investor ownership has shifted from paper stored in vaults to electronic records kept by investors’ financial intermediaries, such as brokers or investment funds, with some investment funds holding hundreds of thousands of securities owned by thousands or tens of thousands of investors.68
Collectively, these changes have allowed even extremely widely held companies to remain private despite having thousands of shareholders.
Today, for purposes of calculating the number of holders of record, the SEC now counts the intermediaries, not the actual security owners or “beneficial owners.” This form-over-substance approach means that a single investment firm managing shares on behalf of thousands of individual investors is counted as one holder of record, and private companies with even thousands of shareholders have been able to avoid triggering the disclosures that Congress intended widely held companies to make.69 Because of this purposeful and immense undercounting of shareholders, many popular, widely held public companies are well below the threshold. This is also how, for example, Facebook was able to remain in the private markets for years, even after it had thousands of investors.70
To make matters worse, the 2012 JOBS Act increased the number of holders of record needed to trigger reporting under Section 12(g) from 500 to 2,000.71 In addition, certain employee compensation plan securities have been exempted from the definition of “holder of record.”72 Collectively, these changes have allowed even extremely widely held companies to remain private—and not disclose important information about their operations, finances, or governance—despite having thousands of shareholders.
With these changes—and with the many new avenues for raising capital from the public through exempt offerings—private companies have been able to grow extremely large, with their shares widely distributed, without having to register as public companies. The time between a company’s founding and its initial public offering has exploded from just a few years to often more than 10, if at all.73 A public listing exchange’s greatest competition for securities listings is no longer other public listing exchanges—whether in the United States or abroad—but rather private markets.74 Companies routinely raise hundreds of millions of dollars from broad swaths of investors at multibillion-dollar valuations in the private markets.75
Today, there has been astounding proliferation of unicorns—private startup companies worth at least $1 billion dollars and, in many cases, much more, including companies worth tens of billions of dollars or even more than $100 billion.76 Examples include SpaceX, Impossible Foods, Circle, Reddit, and JUUL Labs.77 Unicorns across numerous industries compete directly today with large public companies but without having to disclose important information to investors and the public.
Exemptions from public market requirements are eroding investor protection, fair markets, and capital formation
Today, the basic bargain underlying the securities laws—companies seeking capital from the public must first provide basic reliable information about their operations, finances, and governance—is broken. Mainly due to the rapid growth of exemptions enacted by Congress and the SEC over the past four decades, private companies can freely access public capital, including the savings and retirement accounts of millions of Americans, without becoming public and providing the information that public companies must disclose. An alarming number of companies are benefiting from capital provided by a broad segment of investors to whom they have disclosed little or no information. Moreover, as former SEC Commissioner Allison Herren Lee stated, when private companies become very large, “[T]hey can have a huge impact on thousands of people’s lives with absolutely no visibility for investors, employees and their unions, regulators, or the public.”78
Accountability to investors is often meaningless in private markets
The rapid growth of private markets lacking in disclosures of information critical to sound investing has dramatically reduced company accountability to investors.79 Companies raising capital in the private markets are often able to negotiate terms with investors that insulate the company from accountability. As a result, corporate governance weaknesses at private companies are often hidden. For example, even though WeWork sold securities to some of the most sophisticated institutional investors in the world, the company’s CEO, Adam Neumann, secretly engaged in self-dealing, giving himself millions of dollars’ worth of intellectual property rights. However, once the deal was disclosed as part of the company’s mandatory disclosures in preparation for an IPO, public pressure resulted in the CEO returning the money he had gained from licensing those intellectual property rights.80
Third-party mechanisms designed to ensure corporate accountability—legally mandated in the public markets, including through independent audits of internal controls and SEC enforcement actions—do not exist for private companies, further weakening company and executive accountability to investors.
The rapid growth of private markets lacking in disclosures of information critical to sound investing has dramatically reduced company accountability to investors.
Finally, it is extremely challenging for investors to hold private companies and executives legally liable for inaccuracies in the claims they make. At an initial level, since private issuers typically are not required to make specific written disclosures, they may avoid making statements that could subject them to legal liability. Furthermore, while the securities laws may impose strict liability for misstatements in the offer and sale of securities,81 which places the burden of proving otherwise on the company, that standard does not apply in the private markets, as strict liability only applies to registered offerings.82 And even when investors are concerned that they were misled, they often have far fewer mechanisms for recourse. For example, mandatory investor arbitration is commonplace in private markets but generally disfavored in the public markets.83
Employee-investors of a private company who receive company stock options as part of their compensation face additional risks. If the company fails to do well, they are exposed both as employees—who may lose their jobs—and as investors.84 Professor George S. Georgiev of Emory University School of Law points out that providing compensation in the form of equity capital benefits a private company by diminishing the need to seek external financing and delays the decision to go public.85 And, as previously mentioned, employee-investors do not count for purposes of the Section 12(g) reporting threshold of 2,000 “holders of record.” Based on his analysis of U.S.-based unicorns, Georgiev estimates that there are hundreds of thousands of startup employees who are exposed to the stock of their employers in the private markets.86
Recently, the SEC has increased its enforcement actions against private investment funds and other private market actors.87 However, with the rapid growth of private markets and the exploding use of exemptions from the public disclosure framework, the SEC’s duty to protect investors will become increasingly challenging.
Private markets are fundamentally unfair
The private capital markets are inherently unfair and discriminatory, exacerbating investor protection concerns, especially as traditional private investment firms increasingly target retail investors—as opposed to institutions such as endowments and pensions—for private securities offerings.88
The largest private market fund companies have dramatically increased their capital-raising from individual investors.89 Yet many of the private investment opportunities for these investors are in assets and strategies that larger institutional investors have disfavored or rejected, often based on the risks.90 Thus, the most sophisticated financial market participants and company insiders are increasingly unloading the riskiest investments onto less-informed investors who cannot make prudent investment decisions that accurately take into account risks and rewards or who are not large enough to negotiate better terms. Moreover, the expansive definition of accredited investor and the web of exemptions now available enable insiders and better-connected investors to essentially take advantage of smaller investors in ways that would be impossible in the public markets.
Of course, the lack of disclosure prevents a clear view into the operation of these markets and invites unfair tactics. But securities experts and the media have exposed at least two areas of unfairness in the private markets: 1) the relative differences in treatment of different groups of investors and 2) the fees investment funds charge.
Investors are often treated differently
Private markets are built on discrimination. Companies raising capital can and often do cut different deals with different investors. In the private markets, the large, powerful, and connected can exploit their advantages at the expense of everyone else. When companies and private funds choose to disclose information, they do not have to disclose the same information to everyone or give everyone the same rights.
Large and well-connected investors and insiders compete for opportunities and information. Everyone else participates on far worse terms, with typically fewer opportunities, higher expenses, fewer rights, and ultimately inferior returns.
Institutional buyers and large, well-connected investors in the private markets are likely to have access to the best investment opportunities, such as hot startups.91 In addition, companies will often turn to smaller investors only after they cannot raise what they seek on the desired terms from larger investors.92 Furthermore, it is commonplace for companies to selectively share important information in the private markets, unlike in the public markets, which prohibit companies from selectively sharing information with favored investors.93
Fees are often hidden and excessive
In addition to treating groups of investors differently, private markets often involve unfair fees, many of them hidden. Private fund firms hold the vast majority of assets in the private markets, and as a result, the fees associated with private funds are often much greater than those of public investment companies.94 Importantly, fees are often not factored into far-fetched claims about higher returns in the private markets. They belie the assertion that capital formation is somehow more efficient in the private markets.
Outside of private funds, the fees associated with trading individual private company securities are often orders of magnitude greater than they are in the public markets. For example, when an individual investor wants to buy public company stock, they will often pay the broker a commission of around 0.01 percent,95 or nothing at all,96 and a broker-dealer trading on behalf of an institutional client may charge a commission on a public stock trade of $0.005 per share. These fees must be clearly disclosed.97
In addition to treating groups of investors differently, private markets often involve unfair fees, many of them hidden.
But transaction fees for individual investors buying private securities in a marketplace can be up to 5 percent per transaction,98 and while these fees may change somewhat for institutional-sized traders, the difference in transaction costs between private and public securities is still significant. This transaction cost does not benefit the issuer, capital formation, or investor returns but instead adds revenues for market intermediaries.
The lack of standard disclosure requirements prevents private market participants from knowing whether private fund managers are acting in their own self-interests or as fiduciaries for those who invest in their funds. In such an environment, investors are more likely to be overcharged or mischarged.99 For example, after years of investigating private fund advisers, the SEC released deeply disturbing findings in January 2022, including that many fund advisers had presented inaccurate track records and overcharged customers.100 Unfortunately, without the transparency and audits required of public securities, investors are generally unable to identify—much less stop—these abuses.
In fact, a recent examination of private fund expenses at 27 U.S. public pension plans found that only one-third of the funds said that they track the actual “total costs” of their private equity portfolios, and only two of the public pension plans even claimed to have expense details.101 One of the primary challenges for individual investors seeking to track this information is that they often are unable to obtain it from their advisers. In February 2022, the SEC proposed dramatically expanding fee and expense disclosures for private funds, as well as other reforms.102 However, even the proposed reforms would be inadequate to provide a full understanding of the private fees.
Misvaluations and hidden risks distort capital formation
The rapidly growing number of private companies and funds that can access abundant public capital without adhering to the public disclosure and accountability framework is distorting healthy capital formation. When companies do not adhere to a standardized, reliable disclosure regime, investors cannot be certain that valuations of those companies are accurate or that all material risks have been disclosed. Over time, investors’ capital will not flow to the most economically beneficial uses.
Private market valuations are often unreliable
There is considerable evidence that valuations are often inaccurate or even manipulated in the private markets, which distorts investment decisions and negatively affects the savings of millions of Americans.103
Securities of private companies are not subject to the same scrutiny as public companies. To begin with, the methods used for determining the values are often very different. For publicly traded stocks, prices to buy and sell different amounts of stock are posted on exchanges and other trading venues, and trades are disseminated nearly instantly around the world. An investor who owns 10 shares of XYZ Company stock can quickly ascertain a reasonably reliable value of their position within seconds. In addition, publicly traded stock prices and public company valuations are based, in part, on the regulatorily mandated, reliable, timely information about the company’s operations, financials, and governance, as well as those of the company’s peers, competitors, customers, and suppliers.
By contrast, valuations of private securities can be set by the company’s executives or investors who already own or are about to buy the securities. Thus, these internally formed valuations are often based on the self-interests of a single person or a very small number of people. The valuations may be based on incomplete or inaccurate information about a company’s operations, financials, or governance. These private market valuations are often made by people with conflicts of interest or hidden incentives—for example, by investment bankers looking to spur more business with a company or a single investor trying to inflate the value of an existing holding. A private company’s major investors may each assess the company at different values,104 or a private company’s management may unilaterally change its assessment of its value without explanation, with limited ability for other market participants to assess the basis for the change.105 Valuations may also be changed for tax purposes or to attract or compensate executives.106
Perhaps unsurprisingly, valuations for private securities are often slow to reflect a market downturn.107 Without a public dissemination of essential information about the issuer and a ready market for trading, valuations tend to change slowly, if at all. As the financial markets turned gloomy in 2022, the chief executive officer of Harvard Management Corporation—Narv Narvekar, one of the most sophisticated private markets investors in the world—warned that his fund’s performance for the year-end June 2022 was likely overstated, in part because it did not yet reflect adequate valuation write-downs. He explained: “[Private] managers have not yet marked their portfolios to reflect general market conditions. … We expect that the end of the current calendar year might present meaningful adjustments to these valuations, as investment managers audit their portfolios.”108 This delay in valuation corrections may give the appearance that private companies are more resilient, but, as another expert has explained, “[T]he custom of highly leveraged [private] firms falling less in value than public companies strains credulity.”109
Over the past several years, private funds, the holdings of which include many once-public companies, have reported hard-to-believe returns.110
The lag in valuation correction in the private markets also gives rise to questions about whether some investors may receive priority in redeeming their shares at the higher value before the correction is made,111 especially if newer investors are not fully aware of the overvaluations.112 The fact that many private funds are simultaneously aggressively seeking new investment from both retail and institutional investors—in some cases by lowering investment minimums—heightens this concern.113
Additional evidence suggesting misvaluations in private markets comes from the market performance of formerly private companies once they reach the public markets.
Over the past several years, hundreds of companies have gone public only to, shortly thereafter, trade much lower than their private market valuations. In fact, since 1980, companies that transition from the private to the public markets consistently underperform the broader public markets for the first three years after the IPO.114 At least two dozen companies that have transitioned from the private markets to the public markets in 2020 and 2021 have already issued “going concern” warnings, a public disclosure that a company may not have enough money to survive, and some have already started to fail.115
In fact, by mid-December 2022, 1 in 4 of the more than 600 companies that engaged in an initial public offering over the past two years were trading below $2 per share, placing them at risk of delisting.116 Moreover, these companies all transitioned from the private to public markets at valuations far greater than where they are now. Worse, these troubling statistics do not include some of the largest U.S. listings of the past few years, which have cost millions of investors billions of dollars in losses.
Ride-sharing company Uber provides a clear example. When Uber was a private company, it was estimated to have a value as high as $120 billion.117 Yet once its audited financials and other initial disclosures were made in preparation for going public, the company was valued at about $80 billion. And as the company’s financials continued to be digested by investment professionals, its valuation continued to fall, reaching less than $50 billion just five months after its IPO,118 even though nothing else significantly changed with the company.
In another example, office space-sharing company WeWork was estimated to have a value of $47 billion in early 2019 in the private markets.119 However, once investors began to scrutinize its filings in preparation for an IPO, the company’s “valuation” in the private markets went from nearly $50 billion to about $10 billion over a few months, and the IPO was canceled.120 Again, nothing significant changed with the company.121
Importantly, Uber’s and WeWork’s key backers in the private markets were qualified institutional buyers that bought shares under Regulation D offerings, permitted under the presumption that such investors did not need the securities laws to obtain essential, accurate information.122 These examples suggest that this assumption may be incorrect.
Despite the rapidly increasing frequency and scope of warnings related to valuations in the private markets, public pensions and retirement funds are more exposed than ever to the private markets, with many continuing to increase their exposures to private securities.123 Over the past decade, many pension funds, insurance companies, and endowments have sought higher returns in the private markets because the decade of historically low interest rates that followed meant lower returns from investments they typically make in the public markets.124 That is accelerating now. For example, in December 2022, the New York state governor signed new legislation to increase the permissible allocations of the state and of the New York city pensions to private funds from 25 percent to 35 percent.125
Private market investments may hide risks from investors and financial regulators
Investors in private markets cannot rely on valuations and cannot be certain that all material risks have been disclosed. And without adequate information, investors are likely to be unaware of the risks to their investments or how the companies in which they are invested are addressing them. Moreover, without a legal mandate to identify, assess, and disclose risks on an ongoing basis, companies and their management teams may have little incentive to voluntarily do so and thus may also underappreciate risks. Transparency is one of the SEC’s primary tools for addressing information asymmetries in the capital markets. Ultimately, lack of transparency undermines the United States’ ability to compete in the global marketplace because the capital markets cannot effectively price and allocate capital without it.126
Some risks that seem unimportant to one company may be correlated with similar risks in other companies or, when aggregated, result in significant harms to the financial system or the economy. Financial regulators are responsible for detecting these correlated risks that may pose risks to the stability of the financial system as a whole or even to the economy. Without transparency and accountability of companies in the economy, however, financial regulators lack the information necessary to evaluate and plan for addressing these risks. Financial risks associated with the physical risks of climate change—coupled with risks associated with changes in consumer behavior and technology as well as other risks that occur as the economy transitions to lower-carbon-emission products and services—could add up to trouble for the financial system or the larger economy, particularly if those risks occur suddenly.
Some risks that seem unimportant to one company may be correlated with similar risks in other companies or, when aggregated, result in significant harms to the financial system or the economy.
Risks that are correlated in this way are exacerbated in the private markets, in part because they are hidden from regulators and the public but also because the opaque nature of private markets may create incentives to hide risky assets or businesses there. For example, a significant portion of fossil fuel exploration, storage, and transportation infrastructure is financed not by public companies but through private equity and debt. These assets may have very material risks to investors and to capital formation as the economy transitions to clean energy. Still, the identification, assessment, and disclosures of those risks are often not required by law—and, for obvious reasons, are rarely made. Furthermore, as the SEC moves forward with its proposals to require more disclosures from public companies and funds about their climate-related risks and impacts, these investments will likely continue to go dark by simply turning to the private markets. This has significant negative implications for capital formation that is fit for purpose as the country strives to address the evolving economy and world amid increasing droughts, floods, wildfires, extreme storms, and more. It could also lead to instability in the financial system or the economy.
From the Great Depression to the 2008 global financial crisis, the United States has already seen the potential for economic damage when there is inadequate information underpinning market transactions and capital formation. The surrounding circumstances and the players may change, but the underlying problems are the same: lack of transparency and accountability.
Allowing large companies and investment funds to raise capital without providing basic information about their operations, finances, and governance is increasingly harmful to investors, fair markets, and capital formation. Given the exponential expansion of the private markets over the past few decades in terms of market capitalization and sheer number and range of investors, combined with the fact that the savings of so many are at risk, it is vital for the SEC and Congress to take significant steps to reinstate transparency and accountability to most capital market transactions.
For decades following the Great Depression, administrations of both political parties, Congress, and the SEC developed important disclosure requirements intended to ensure investors are protected; instill public trust that markets will be fair, orderly, and efficient; and facilitate effective capital formation. Unfortunately, much of that work has been undone, creating massive market inefficiencies, investor risks, and misallocations of precious capital.
Over the past few years, some in Congress and the SEC have taken notice of the growing lack of transparency and accountability for large companies and funds. As a result, they have proposed some modest measures aimed at restoring the public markets. But much more needs to be done. Below are some additional steps that the SEC and Congress could take to make capital markets more transparent and accountable.
The SEC should change the definition of “holder of record” to reflect true owners
The SEC’s current interpretation of “holder of record” is outdated and is effectively permitting companies to have thousands of investors without having to comply with the SEC’s disclosure and accountability framework, as Congress intended. Enacted in 1964, Section 12(g)(5) of the Securities Exchange Act granted authority to the SEC to promulgate rules defining the meaning of the term “held of record.”127 The following year, the SEC promulgated Rule 12g5-1(a)(3), which allows securities held in a fiduciary capacity on behalf of many investors to be counted as held by one person.128 The SEC should revise the definition to mean actual beneficial owners and thus restore the rule and effectuate the clear objectives and plain meaning of the law.
In addition, the threshold should be reduced to 500 shareholders—the threshold that existed for nearly 50 years before the 2012 JOBS Act increased it to 2,000.
Congress should amend the Securities Act to make large, widely held companies public
Exemptions and loopholes from the public markets framework have enabled very large companies to remain in the private markets while receiving support from a broad swath of investors and affecting the lives of millions of people.
In 2022, U.S. Sen. Jack Reed (D-RI) introduced the Private Markets Transparency and Accountability Act along with his colleagues Sens. Catherine Cortez Masto (D-NV) and Elizabeth Warren (D-MA).129 The bill would have required companies valued at more than $700 million or that have more than 5,000 employees and $5 billion in revenues to comply with SEC public reporting and disclosure requirements.130
This proposal could be even stronger by lowering the thresholds for public reporting. For example, it could require public reporting for companies with at least 500 employees and gross revenues of at least $1 billion or with valuations of at least $200 million, to adhere to the public reporting framework.
Congress and the SEC should condition exemptions on fair and timely access to essential information to investors
When the Supreme Court first clearly articulated the private offering exemption, it explicitly stated that the exemption was conditioned on investors having access to the same type of information that would be available if the offering were publicly registered. While that condition has been undermined by Congress and the SEC in the years since, the central premise should be restored.
For any exemptions that remain, companies should be required to make significantly more disclosures. For example, without exception, all private companies offering securities or whose securities are subject to resale or trading in the secondary private markets should be required to provide their investors with current audited financial statements. Qualification for any remaining exemptions should also be conditioned on potential investors receiving equal access to basic, essential information about the company, including basic information about operations, financials, and governance.131 And all offerings should be subject to Regulation FD, which requires that any information disclosed to one investor or group of investors must be disclosed to all.132 Regardless of wealth or market power, all investors should have the same essential information needed to make informed investment decisions.
The SEC and Congress should review all exemptions from the public registration and disclosure framework and restore its broad application
For decades following the Great Depression, Congress, the courts, and the SEC all recognized that exemptions from the SEC’s transparency and accountability framework should be rare and narrowly construed. Unfortunately, that lesson has been lost in the decadeslong push against regulation and oversight of capital markets.
Given the enormous growth of nontransparent, risky, and often unaccountable private companies and funds, Congress and the SEC should review all the exemptions from the public reporting regime and revise, condition, or eliminate them. For example, Regulation A+ offerings, which were created by the JOBS Act, have proven to be disasters for investors and should be eliminated.133 There should be fewer exemptions, with fewer people qualifying for them. And the few investors who do qualify should do so based on their actual financial expertise and the information they have, not just their wealth or income.
The SEC should collect more data on private markets
It is difficult for the SEC to do its job of protecting investors and the public without adequate information from all those seeking public capital. To the extent that the SEC has tried to analyze the use of exemptions, it has had to make estimates.134 While companies are required to file a notice of its intent to use an exemption,135 the SEC does not require or collect comprehensive information regarding the use of exemptions. Nevertheless, it continues to make rules that affect both private and public markets using rough estimates that it admits have a wide margin of error. The SEC should collect basic information to inform not just its own regulatory decision-making and enforcement agenda but also the analysis and decisions of policymakers.
Accordingly, to carry out its mission to protect investors and the public, the SEC should require private issuers and investment funds to provide the agency with more detailed and timely information about their use of exemptions, including prefiling and post-closing data. The provision of this data should be a prerequisite to the use of any exemption from the public disclosure framework.
The exposure of millions of American families and businesses to markets that lack the disclosure and accountability protections of the public markets should ring loud alarm bells, not just for regulators and investors but for anyone who cares about the integrity and prosperity of America’s capital markets. The SEC has the authority to begin addressing this growing problem. The agency should act quickly to do so and work with Congress to scale back or eliminate remaining exemptions that allow companies and funds to access public capital without adhering to the public disclosure framework.
The authors would like to thank their reviewers and advisers on this report, who were immensely helpful. Any mistakes are the authors’ own.