Goldman, in fact, disallowed American clients from participating in the investment, reportedly because of an SEC inquiry into whether or not these investment pools are a vehicle to circumvent the rules.
Absent official word from the SEC, opinions vary on whether or not the investment pools subvert the intent of the Securities Exchange Act of 1934′s Section 12(g), introduced in 1964. “In my view, these vehicles count as a single shareholder for purposes of the 500-shareholder rule,” says Littenberg. But others, like Ralph De Martino, co-chair of the securities practice group and partner in the Washington, D.C., office of law firm Cozen O’Connor, believe they are a “dangerous approach” to getting around it. Says De Martino: “Unless there is a valid business purpose for forming an investment pool, I can see the SEC saying it’s just a ruse.”
Perils of Publicity
Protecting privacy is a key concern for many high-growth-company finance executives. Gemvara CFO Eric Sockol, for example, anticipates that his company, a recently launched Internet jewelry retailer, will see a compounded annual growth rate of 100% over the next five years, fueled in part by a business model that lets shoppers customize their purchases without Gemvara having to carry inventory. “Right now, we want to be private, to execute our business strategy without being distracted by quarterly shareholder pressures and expectations,” says Sockol, or, for that matter, spending millions of dollars on SEC compliance. “We just don’t want those headaches — not yet,” he says.
The risk of lawsuits may increase when “going public” happens incrementally, rather than as the result of a careful plan. “If the company breaches the 500-shareholder limit and must disclose its financials, it now runs the risk of not having told the same things to outsiders that it told insiders, and vice versa,” says Peter Aronstam, a partner at B2B CFO, a CFO-services firm for growing companies. If the company’s value falls, “the risk of litigation from outside investors rises appreciably.”
Litigation aside, there is also the uncomfortable possibility of SEC-levied fines and penalties. “Say the SEC concludes that these pools have indeed circumvented the intent of Section 12(g),” says Denis Gagnon, former CFO of MMC Energy and also a partner at B2B CFO. “In a worst-case scenario, it could lead to all types of sanctions being thrown at the company, including fines levied against the CEO, the CFO, and board directors.” In theory, a CFO could even be prohibited from taking a finance position at another public company or engaging in the securities business, he says.
Don’t Share Your Shares
CFOs have several options for avoiding such problems. One, of course, is to tightly limit the number of shares given to employees. At Gemvara, for example, “we’ve got a formal process for deciding who gets what,” says Sockol.
Private companies also can put restrictions on the shares or options they issue to prevent their trading without prior knowledge. Restrictions can include waiting for a specific event (like an IPO or the sale of the company), or a financial-performance target, or certain employee milestones, like retirement.