Letter or Spirit?

Business Insider posted a story recently about Facebook and the news the company has made working with Goldman Sachs to obtain significant capital investment without going public.

The story boils down to Facebook wanting to trade stock for a capital infusion. There is no shortage of people wanting to invest in Facebook stock. A thorny issue arises, however, if the number of Facebook stock owners of record increase to 500 or more individuals. If that is the case, Facebook must comply with the Securities and Exchange Commission (SEC) disclosure laws, which are expensive to comply with and  reveal sensitive financial and strategic information. Facebook is not quite ready for that step and has enlisted the financial experts at Goldman Sachs to engineer a special purpose entity that would buy up to $1.5 billion in Facebook stock and become the owner of record.

The rub lies in the fact that Goldman Sachs would then sell the shares to potentially hundreds of private client investors. The Business Insider story discusses that Facebook and Goldman Sachs may have legal grounds under the SEC rules to argue that the transaction does not increase shareholders beyond a single owner, the special purpose entity. The rule, however, may prove to be a sword of Damocles, since the SEC rule does not allow the transaction if the stock issuer knows, or has reason to know, that the special purpose entity is used primarily to circumvent the rule concerning 500 shareholders or more. By engaging in the transaction, Facebook may be heading for going public and complying with the SEC disclosure laws without listing on a major stock exchange.

As a professor, I found this to be a good case to discuss in class, not just because many students enjoy hearing about Facebook. The case also illustrates an important point about a bigger issue facing business and legal regulation. The point is whether a business should strive to comply with the letter of the law, or go beyond this and seek to comply with its spirit. The SEC rule mentioned above has a built-in provision that guides enforcement of the law’s spirit. Many other important regulations lack this type of provision, however.

Ultimately, the whole issue of compliance with the SEC’s disclosure rules triggered by reaching 500 shareholders or more may amount to little more than a smokescreen for Facebook. The transaction with Goldman Sachs using the special-purpose vehicle places a much higher value on Facebook stock. Those who invested in Facebook prior to this transaction just saw their paper net worth increase substantially. Also, at the time of Facebook’s inevitable public offering and listing on a stock exchange, whoever is the lead book runner and investment banker to the transaction (Goldman Sachs?) will have strong precedent and argument to sell the stock to the public (the rest of of us) for at least as much as it was valued during this most recent transaction.

As with most legal issues involving Facebook, this is a case worth watching.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s