Frontiers of Regulatory Arbitrage

A “private” company, roughly speaking, is one that’s not traded on a stock exchange. And yet people might want to trade shares in such firms. So it seems folks have been setting up various kinds of exchanges and vehicles where you can do just that. Peter Lattman reports on the beginnings of an SEC inquiry into the trading in some of the hottest private stocks:

It is uncertain what exactly the S.E.C. is looking into, but several securities lawyers say it could relate to understanding the number of shareholders at these companies.

That would be relevant to regulators because Facebook and other start-ups have a reason to keep the number of shareholders to under 499. If they had 500 shareholders, S.E.C. rules would require them to disclose their financial results to the public.

The pooled vehicles being set up to acquire Facebook stock, for instance, could push the company’s shareholder count above 499 if the S.E.C. counted the number of investors in the funds.

I have no opinion about the underlying issue here, but I think this illustrates several points about financial regulation. One is that regulatory arbitrage is pretty easy. Even a seemingly straightforward rule about how you can’t have 500 or more shareholders turns out to have a loophole big enough to drive a truck through. But you also see that stopping regulatory arbitrage isn’t some kind of impossible task. Neither the SEC nor the financial press is really in the dark about what’s happening here and there may be a crackdown. This is also one of the reasons that regulatory discretion, much bemoaned during the Dodd-Frank debate, is sometimes a very good thing. Pretty much any hard-and-fast rule about this that you could write will have some kind of loophole in it. Only an agency with some discretion at its disposal will be able to enforce the spirit of the 500 shareholder rule.