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                        DEMOCRATIZING STARTUPS

                                 Seth C. Oranburg*

                                          Abstract
President Obama signed the Jumpstart Our Business Startups (“JOBS Act”) o ---  2012 into law to “help entrepreneurs raise the capital they need to put Americans back to work and create an economy that’s built to last.” The goal is to “democratize startups” by making capital available to diverse entrepreneurs in new geographies. Yet the net e ---

ect o — securities regulations and market conditions is the opposite. Startup companies are encouraged to stay private so capital is consolidating in large, mature — irms instead o — recycling into new startups. Evidence o —

consolidation is that once-rare “Unicorns” (billion-dollar startups) now number at least 170. More money is going into huge private companies, yet total venture capital investment is — lat, so less is going to new startups. This could stall out the innovation economy. Democratizing startups requires sa — e-harbor exemptions — rom securities regulations — or both original issuance and resale o — stock, but securities regulations do not permit resale on exchanges. This Article proposes “Rule 144B,” a regulatory provision that could be enacted without an act o — Congress, to permit transparent web-based venture exchanges with — raud-prevention intermediaries termed “independent analysts.” This Article answers the SEC’s call — or rulemaking comments and in — orms Congress’s new work on JOBS Act 2.0.

                                 TABLE OF CONTENTS INTRODUCTION ........................................................................................ 1014 PART I. SECURITIES REGULATION ........................................................... 1017
  A. Sunlight and Disclosures..................................................... 1018
  B. Regulatory Exemptions ........................................................ 1024
  C. The JOBS Act ....................................................................... 1029


* Assistant Pro --- essor, Duquesne University School o ---  Law; J.D., University o ---

Chicago Law School, cum laude; B.A., University o

Florida, magna cum laude. I am grate — ul — or comments — rom Katharine Baker, Felice Batlan, Alexander Boni-Saenz, Christopher Bucca — usco, Eli Elias, Cesar Rosado, Christopher Schmidt, and research assistance — rom Clare Willis.

                                            1013




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1014 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

PART II. PRIVATE PROBLEMS ………………………………………………………… 1031 A. Illiquidity Discount Asymmetry …………………………………… 1037 B. De Facto Non-Competes ………………………………………………. 1040 C. Systemic Risks ……………………………………………………………. 1044 1. Breaking the Startup Financing Cycle ………………………… 1045 2. Trading in Unregulated Dark Pools …………………………….. 1047 3. Trading in O —

shore Stock Markets ……………………………… 1050 PART III. DEMOCRATIZING PRIVATE STOCK EXCHANGES…………………… 1051 A. Venture Exchanges ……………………………………………………… 1053 B. Private Independent Analysts ……………………………………… 1058 C. Application ………………………………………………………………… 1063 CONCLUSION ………………………………………………………………………………. 1065

                                   INTRODUCTION

“Startup America” is the initiative by President Obama to create strong startup ecosystems in every state.1 The initiative is supported by recent legislation, the Jumpstart Our Business Startups Act o ---  2012 (“JOBS Act”),2 which passed quickly with wide bipartisan support  --- or its goal to “allow Main Street small businesses and high-growth enterprises to raise capital  --- rom investors more e ---

iciently, allowing small and young — irms across the country to grow and hire — aster.”3 Americans overwhelmingly support the policy goal o — democratizing startups, which means providing more capital to diverse entrepreneurs—including women and minorities in novel geographies outside o — Silicon Valley— — or new business projects beyond high technology. But Silicon Valley—and the entire startup economy— cannot diversi — y under current securities regulations and market conditions. In addition to allowing startups to sell stock through crowd — unding and mini-IPOs, securities regulations must also allow investors to resell that stock. This Article provides a novel and — easible regulatory solution to — acilitate resale exchanges.

1. Fact Sheet: White House Launches “Startup America” Initiative, WHITE HOUSE, https://www.whitehouse.gov/startup-america- --- act-sheet      [http://perma.cc/9JAZ-6KNN] (last visited Mar. 26, 2016).
2. Pub. L. No. 112-106, 126 Stat. 306 (2012) (codi --- ied as amended in scattered sections o ---  15 U.S.C.).
3. O ---

ice o — the Press Sec’y, President Obama to Sign Jumpstart Our Business Startups (JOBS) Act, WHITE HOUSE (Apr. 5, 2012), https://www.whitehouse.gov/the-press- o —

ice/2012/04/05/president-obama-sign-jumpstart-our-business-startups-jobs-act [http:// perma.cc/Z5GZ-9L2J].

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2016] DEMOCRATIZING STARTUPS 1015

The JOBS Act’s goal o ---  democratizing startups is stymied by other securities regulations working at cross-purposes. Securities regulations have three goals, as stated by the Securities and Exchange Commission (the “SEC”)—the agency created to carry out these goals: protecting investors, maintaining orderly capital markets, and  --- acilitating e ---

icient capital — ormation.4 The JOBS Act prioritizes capital — ormation, but other laws prioritize protecting investors through sa — eguards and mandatory disclosures, which can make capital — ormation less e —

icient.5 The net impact o — these securities regulations and capital markets is to encourage startups to stay private instead o — going public. This trend o —

startups staying private leads to consolidation o

capital in a — ew large startups instead o — recycling it into many smaller startups across the country.6 Staying private limits liquidity and undermines democratizing startups in three ways. First, the new, smaller investors that the JOBS Act hopes to attract will be discouraged by the inability to resell their stock, especially because the established, larger investors have better access to o —

-exchange resale markets.7 Second, mainly young companies create jobs, but staying private means capital is consolidated in more mature companies instead o — recycled into young organizations. Moreover, startup employees paid in stock options — ind themselves with a de — acto non-compete until the company goes public, which distorts labor markets in unexpected ways.8 Third, wealthy and in — luential investors who need to resell large blocks o — stock can do so only in secret trading environments, which, like “dark pools,”9 promote opportunism

4. The Investor’s Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation, U.S. SEC. & EXCHANGE COMMISSION, http://www.sec.gov/about/whatwedo.shtml [http://perma.cc/HV7J-RRFA] (last modi --- ied June 10, 2013).
5. See, e.g., Stuart R. Cohn, The New Crowd --- unding Registration Exemption: Good Idea, Bad Execution, 64 FLA. L. REV. 1433, 1439−44 (2012).
6. For a discussion o ---  how and why startups are staying private, see in --- ra Part II. Staying private—which the JOBS Act encourages—undermines the stated purposes o ---  the JOBS Act in the  --- ollowing way: (1) small investors are disadvantaged; (2) stock options are devalued; and (3) “dark pools” persist. See in --- ra note 9  --- or a discussion o ---  “dark pools.”
7. See in --- ra Part II.A.
8. See in --- ra Part II.B.
9. Dark pools are trading markets available and known to very  --- ew investors. Brian G. Cartwright, General Counsel, U.S. Sec. & Exch. Comm’n, Speech by SEC Sta ---

: The Future o — Securities Regulation (Oct. 24, 2007), https://www.sec.gov/news/speech/2007/ spch102407bgc.htm. Common traders cannot get liquidity in dark pools—only big banks and hardcore analysists know they exist. Id. (“The second — orm o — deretailization I want to discuss is the development and growth over the last several decades o — important new trading markets that are entirely closed to retail investors. The ‘dark pools’ o — liquidity that have garnered some press o — late are one example, but perhaps the most — amiliar is

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1016 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

and

raud while providing none o — the virtues o — public exchanges like price discovery.10 Without liquidity, startup capital cannot be recycled. Today’s private stock markets have not developed exchanges— markets — or the easy resale o — standardized units o — private-company stock—because such exchanges would almost certainly be unlaw — ul under current securities regulations. Without secondary markets, private-company stock is hard to resell, or is “illiquid,” which creates a number o — problems discussed in detail in this Article. SharesPost appears to interpret SEC no-action letters to prohibit it — rom making o —

ers to buy or sell securities because its own guidelines, promulgated a — ter the SEC guidance was issued, explain that SharesPost re — rains

rom this behavior.11 FundersClub obtained a no-action letter — rom the SEC that permits it to solicit investment in select private companies only i — it does not receive any transaction-based compensation.12 AngelList received a no-action letter permitting it to aggregate investors only i — it will not handle any customer — unds or securities.13 SecondMarket stopped operating its resale auction and has shut out retail investors completely.14 Firms will not develop a private-stock exchange unless there is a clear legal way to operate it.

the 144A debt market. Promulgated by the SEC in 1990, Rule 144A removed most o

the regulatory impediments to secondary market transactions between large institutions that quali — y as ‘QIBs.’ ‘QIB’ or ‘Q-I-B’ is the acronym — or ‘quali — ied institutional buyer,’ a term de — ined in Rule 144A generally to mean institutions that have at least $100 million invested in securities.”).

1. See in

   ra Part II.C.

2. See S HARES P OST F IN . C ORP ., A SHARESPOST PRIMER ON SECONDARY MARKET SECURITIES LAW (2012), https://sharespost.com/site/assets/ — iles/3063/primer_on_second ary_market_securities_law.pd — [http://perma.cc/SEX4-8LLA] (“Furthermore, in a series o —

no-action letters, the SEC has indicated that a private o

ering distributed electronically is not a general solicitation so long as the — ollowing circumstances apply: The postings are made on a password-protected web page that cannot be accessed by the general public. The password-protected web page is available to a particular investor only a — ter a determination is made that the investor is accredited. The questionnaires or — orms by which accredited investors are quali — ied do not re — erence any speci — ic transaction posted or to be posted to the site. A potential investor can purchase securities only in transactions that are posted a — ter the investor’s quali — ication.”).

1. FundersClub Inc. & FundersClub Mgmt. LLC, SEC No-Action Letter, 2013 WL 1229456, at *3 (Mar. 26, 2013) (“The o —

icers, directors and employees o — FundersClub and FC Inc. and FC Management personally do not receive transaction-based compensation

or their e —

orts in raising investments — or the investment — unds.”).

1. AngelList LLC, SEC No-Action Letter, 2013 WL 1279194, at *4 (Mar. 28, 2013) (“Neither AngelList Advisors nor any Lead Angel will handle any customer — unds or securities.”).

2. Jen Wieczner, Investing in Private Startups Is a Hot Trend. But, Sorry, You’re Not Invited, FORTUNE (Aug. 14, 2014, 7:36 AM), http:// — ortune.com/2014/08/14/private-equity- retail-investors-buy-private-company-shares/ (“While the old model allowed shareholders

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2016] DEMOCRATIZING STARTUPS 1017

SEC Commissioner Luis A. Aguilar recently asked  --- or “any and all viable suggestions as to how to improve the secondary [resale] trading environment  --- or shares o ---  small business securities.”15 Meanwhile, Congress is working on JOBS Act 2.0.16 This Article addresses the concerns o ---  both regulators and legislators by providing the regulatory solution that  --- ollows  --- rom its theoretical analysis: the SEC should institute a sa --- e-harbor exemption that allows public venture stock exchanges to  --- acilitate web-based transactions.17 To prevent  --- raud and solve rational apathy and in --- ormation asymmetry problems, this Article proposes a new “Rule 144B” sa --- e harbor that requires exchanges employ “independent analysts.”18 This hybridized public stock analyst and venture capital manager  --- ills a new role  --- or this new type o ---  stock market. The 144B exchange provides liquidity and investor protections that are necessary  --- or e ---

icient capital markets. This Article proceeds as — ollows. Part I explores securities regulation in a novel light, with an emphasis on how the normative goals o — the JOBS Act are unique among securities regulation statutes. Part II contributes a new analysis o — the phenomenon o — staying private, which demonstrates how this growing trend — rustrates democratizing startups. Part III argues that securities regulations can achieve the goal o — democratizing startups while protecting investors through a new regulatory solution that the SEC can implement without an act o — Congress. This Article concludes with brie — insights about the

uture o — securities regulations.

                    PART I. SECURITIES REGULATION

Securities regulation has three goals: protecting investors, maintaining orderly capital markets, and — acilitating e —

icient capital

to auction their stakes to any willing buyer, sometimes independent o

the company’s approval, SecondMarket today only works with the private companies themselves to host o —

icial secondary transactions where the companies set the price o — their own shares and choose the buyers.”).

1. Luis A. Aguilar, Comm’r, U.S. Sec. & Exch. Comm’n, Public Statement, The Need

or Greater Secondary Market Liquidity — or Small Businesses (Mar. 4, 2015), http://www.sec.gov/news/statement/need- — or-greater-secondary-market-liquidity- — or-small -businesses.html.

1. Sarah N. Lynch, U.S. House Republicans Prepare a Second JOBS Act Bill; Critics See Dangers, THOMSON REUTERS (Apr. 9, 2014, 2:41 PM), http://www.reuters. com/article/2014/04/09/house-sec-bills-idUSL2N0N10ZJ20140409 [http://perma.cc/E69H- HJZN] (statement o — Representative Scott Garrett, R-NJ) (“The costs to these companies o — going and staying public remains [sic] unacceptably high.”).

2. See in

   ra Part III.A.

3. See in

   ra Part III.B.

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ormation.19 These goals are o — ten in tension, and this Part will explain how the normative goals o — securities regulation have con — licted over time by situating their legislative history in their historical and academic contexts. The very brie — history is that Congress enacted disclosure rules in response to scandals and economic pessimism, and Congress exacted exemptive rules in response to optimism and economic growth. Section A explains that the U.S. government inaugurated the — ederal securities laws and created new securities regulations in this context o — economic catastrophes and anti-Wall Street sentiments to protect investors through mandatory disclosures. Section B describes exemptions to those disclosure rules that the SEC created to balance investor protection with the need — or capital — ormation. Section C introduces the JOBS Act, the most remarkably deregulatory securities law statute, which created new exemptions — rom disclosures — or entrepreneurs to — acilitate startup capital — ormation and thereby create jobs. This Part reveals how — ederal securities laws work at cross-purposes, which — rustrates the goals o — the JOBS Act.

A. Sunlight and Disclosures

The initial  --- ederal securities laws developed in response to economic catastrophe. In the so-called “Roaring Twenties,” post-World War I America experienced incredible economic growth. “[A]pproximately $50 billion o ---  new securities were sold in the United States” that decade.20 This bull market collapsed on the in --- amous Black Thursday, October 24, 1929.21 By the  --- ollowing Tuesday, the stock market lost thirty billion dollars.22 From September 1, 1929 to July 1, 1932, the NYSE  --- ell eighty-three percent.23 This crash a ---

ected the entire nation.

1. See, e.g., SEC Budget Hearing Be

   ore the Subcomm. on Fin. Servs. & Gen. Gov’t o —

the S. Comm. on Appropriations, 113th Cong. (2013) (testimony o

Mary Jo White, Chair, U.S. Securities and Exchange Commission) (remarking on the SEC’s “three-part mission: to protect investors, maintain . . . e —

icient markets, and — acilitate capital — ormation”).

1. J OEL S ELIGMAN , THE TRANSFORMATION OF WALL STREET: A HISTORY OF THE SECURITIES AND EXCHANGE COMMISSION AND MODERN CORPORATE FINANCE 1 (rev. ed. 1995).
2. Id. at 2−3.

3. Timeline: Timeline o

   the Great Depression, PBS, http://www.pbs.org/wgbh/ americanexperience/ — eatures/timeline/rails-timeline/ [http://perma.cc/X9H3-2BTZ] (last visited Mar. 27, 2016).

4. SELIGMAN, supra note 20, at 1; see also Cynthia A. Williams, The Securities and Exchange Commission and Corporate Social Transparency, 112 HARV. L. REV. 1197, 1223 (1999).

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Unemployment skyrocketed

rom 1.5 million in 1929 to twelve million in 1932.24 When President Franklin Roosevelt was elected in 1932, America was locked in the grip o — the Great Depression. The public outcry against Wall Street led the Senate Committee on Banking and Currency to hold the Pecora hearings, which examined securities dealings and stock exchange practices.25 These hearings — ound evidence o — extensive problems in securities markets.26 The U.S. Congress introduced — ederal securities laws in the 1930s to restore investor con — idence, which was destroyed by the Great Depression and the scandals that led up to that economic disaster. At the time, scholars, legislators, and judges seemed to agree with Supreme Court Justice Louis D. Brandeis’s 1914 observation about

inancial markets: “Sunlight is said to be the best o — disin — ectants; electric light the most e —

icient policeman.”27 The Securities Act o — 1933 embodies Brandeis’s “sunlight” policy by creating a comprehensive disclosure regime that requires companies to produce public in — ormation be — ore selling stock in public capital markets.28 Pro — essor Felix Frank — urter, who assembled the dra — ting team — or the Securities Act, explained that the primary goal o — early — ederal securities disclosure rules was to illuminate corporate activity o —

securities issuers: “The in

ormation that must be — urnished in the registration statement is intended to reveal — acts essential to a — air judgment upon the security o —

ered.”29 Congress was also explicit about using mandatory disclosure requirements to make corporations more

1. LEONARD BAKER, BRANDEIS AND FRANKFURTER: A DUAL BIOGRAPHY 275 (1984).
2. Williams, supra note 23, at 1223–24.

3. Id. at 1224. The Pecora hearings

   ound evidence o — “unsound credit practices leading to excess speculation”; “manipulative devices . . . [that] produced a — alse impression o — market activity and/or manipulated or depressed the prices o — the securities” (such as wash sales, matched orders, and short sales); “un — air or manipulative market activities by insiders and directors”; “deceptive and manipulative devices” by underwriters; “monopolistic practices by investment banks”; and “un — air practices, such as the use o — ‘pre — erred lists’ — or distributing securities.” Id. at 1224–26.

4. L OUIS D. B RANDEIS , OTHER PEOPLE’S MONEY AND HOW THE BANKERS USE IT 92 (1914).

5. Williams, supra note 23, at 1212–13 (“Brandeis had a great deal o

   in — luence on President Roosevelt’s thinking about disclosure as the proper approach to securities regulation (Roosevelt had asked to be introduced to Brandeis soon a — ter Roosevelt’s election). Brandeis also strongly in — luenced the thinking o — Felix Frank — urter, who oversaw the writing o — the Securities Act and its passage through Congress.” ( — ootnote omitted)).

6. Felix Frank

   urter, The Federal Securities Act: II, FORTUNE, Aug. 1933, at 55.

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accountable to the public.30 This was speci

ically designed to change corporate behavior by inter — ering with business activity.31 The normative goal o — protecting investors, and thereby the whole economy, was so strong that corporate governance discussion shi — ted

rom — ree market to interventionist theories. In — luential scholars Adol —

A. Berle and Gardiner C. Means encouraged the

ederal government to directly regulate corporate a —

airs by preempting state incorporation laws by a — ederal incorporation regime.32 Although Congress expressly agreed with Berle and Means that a key — eature o — a modern corporation is the separation o — ownership (by stockholders) and control (by managers),33 which creates agency problems that cannot be solved by contractual bargaining or private ordering,34 Congress never enacted a — ederal incorporation statute because that was deemed to unduly hinder business — ormation and development.35 This inconsistency re — lects the consistent tension in securities laws between its competing goals o — protecting investors, maintaining orderly capital markets, and

acilitating capital — ormation. Congress continued to advance the sunlight-on-securities agenda with the Exchange Act o — 1934, which created the SEC. SEC Director Annette L. Nazareth recently issued a 2003 press release restating the goals o — the SEC:

The SEC is a “ --- ull disclosure” agency, and one o ---  its primary
missions is to strive to close in --- ormation asymmetries that may
exist among market participants. In the words o ---  Justice

1. Williams, supra note 23, at 1227 (“The legislative history o

   the Securities Act is quite explicit about the use o — disclosure (supported by broad liability provisions — or inaccurate and incomplete disclosure) as a regulatory means to — oster greater public accountability in the corporate enterprise.”).

2. 77 CONG. REC. 2951 (1933) (statement o

   Rep. Reilly) (“Yes; the bill is intended to inter — ere with business—that is, a certain kind o — undesirable business—that has — leeced the American investors out o — billions o — dollars in the past decade.”).

3. Letter

   rom William O. Douglas to Adol — A. Berle, Jr. (Jan. 3, 1943) (on — ile with the Library o — Congress).

4. 77 CONG. REC. 2917−18 (1933) (statement o

   Rep. Rayburn) (“[T]oday the owner o —

shares in a corporation possesses a mere symbol o

ownership, while the power, the responsibility, and the substance which have characterized ownership in the past have been trans — erred to a separate group which holds control.”).

1. See generally ADOLF A. BERLE & GARDINER C. MEANS, THE MODERN CORPORATION AND PRIVATE PROPERTY (1932) (describing corporations as entities that separate ownership and control and identi — ying problems that arise — rom this dynamic).

2. See Williams, supra note 23, at 1220 (“Adol

   Berle had suggested more direct approaches to President Roosevelt — or ensuring corporate accountability, including — ederal incorporation, but Roosevelt rejected — ederal incorporation in — avor o — a disclosure-based approach drawn — rom Brandeis’s and Frank — urter’s ideas.” ( — ootnote omitted)).

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2016] DEMOCRATIZING STARTUPS 1021

Brandeis, “Sunshine is the best disin --- ectant.” Only through the
steady  --- low o ---  timely, comprehensive and accurate in --- ormation
can people make sound investment decisions.36

In modern times, economic crisis has also compelled Congress to enact new  --- ederal securities disclosure regulations. Starting in the  --- all o ---  2001, one huge public corporation a --- ter another became embroiled in massive scandals.37 First Enron, which purported to be the seventh largest corporation in the world,38 and then WorldCom, which acquired sixty telecommunications  --- irms in the prior  --- i --- teen years,39 turned out to be mere paper tigers ensconced by “accounting irregularities” that were perpetuated by management.40 Other major  --- irms like Tyco,41

1. Annette L. Nazareth, Dir., Div. o

   Mkt. Regulation, U.S. Sec. & Exch. Comm’n, Remarks Be — ore the Brown University Commencement Forum: Come with Me to the SEC (May 24, 2003), http://www.sec.gov/news/speech/spch052403aln.htm [http://perma.cc/ 9Y5M-LWHQ].

2. Larry E. Ribstein, Market vs. Regulatory Responses to Corporate Fraud: A Critique o — the Sarbanes-Oxley Act o — 2002, 28 J. CORP. L. 1, 2−3 (2002) (“These — irms’ managers have become poster boys — or the problems o — separation o — ownership and control.”).
3. Dan Ackman, Enron the Incredible, FORBES (Jan. 15, 2002, 12:00 PM), http:// www. — orbes.com/2002/01/15/0115enron.html (“[F]ew investors⎯and — ew Wall Street analysts⎯understood how Enron was booking revenue, even though the distorting technique is what allowed Enron to be billed as the ‘seventh-largest company in America.’”).
4. Kurt Eichenwald, For WorldCom, Acquisitions Were Behinds Its Rise and Fall, N.Y. TIMES (Aug. 8, 2002), http://www.nytimes.com/2002/08/08/business/ — or-worldcom- acquisitions-were-behind-its-rise-and- — all.html?pagewanted=all (“Mr. Ebbers talked o —

how his company had grown enormously through no

ewer than 65 mergers, capped by the granddaddy o — them all, its acquisition o — MCI.”).

1. John C. Co

ee, Jr., Re — orming the Securities Class Action: An Essay on Deterrence and Its Implementation, 106 COLUM. L. REV. 1534, 1572 (2006) (“The persons most responsible — or the accounting irregularities at Enron, WorldCom, and a host o — other companies were managers who, beginning in the 1990s, began to be primarily compensated with equity compensation and so had a strong incentive to recognize income prematurely in order to in — late reported income.”).

1. Press Release, U.S. Sec. & Exch. Comm’n, SEC Sues Former Tyco CEO Kozlowski, Two Others — or Fraud (Sept. 12, 2002), https://www.sec.gov/news/press/2002-135.htm. The CEO and CFO o — Tyco were sentenced to eight to twenty- — ive years in prison — or stealing $150 million — rom the corporate — unds and in — lating income by $500 million. Catherine Fredenburgh, Ex-Tyco CEO Demands Insurer Foot $17.8M Legal Bill, LAW360, http://www.law360.com/articles/6835/ex-tyco-ceo-demands-insurer- — oot-17-8m-legal-bill (last visited May 7, 2016) (“Tyco was accused by the SEC o — in — lating its operating income by at least $500 million through improper accounting practices related to some o — the hundreds o — corporate acquisitions that Tyco engaged in as part o — a massive expansion that began in 1991.”); Shayna Jacobs & Corinne Lestch, Ex-Tyco CEO, Convicted o —

Stealing $150M

rom Company, Set — or Release on Parole in January, DAILY NEWS (Dec. 4, 2013, 1:36 AM), http://www.nydailynews.com/new-york/nyc-crime/tyco-ceo-convicted- stealing-150m- — ree-article-1.1536865 (“A disgraced — ormer Tyco CEO is expected to be

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HealthSouth,42 Freddie Mac,43 American Insurance Group,44 Lehman Brothers,45 and others — ollowed in scandalous suit. The massive public outcry against — inancial manipulation galvanized Congress to pass sweeping regulations governing corporate behavior, including the Sarbanes-Oxley Act o — 2002 (“SOX”).46

paroled next month on his sentence

or pil — ering $150 million — rom the company, state o —

icials said.”).

1. Press Release, U.S. Sec. & Exch. Comm’n, SEC Charges HealthSouth Corp. CEO Richard Scrushy with $1.4 Billion Accounting Fraud (Mar. 19, 2003), https://www.sec.gov/ news/press/2003-34.htm. The CEO o — HealthSouth was indicted — or thirty-six counts o —

accounting

raud — or allegedly in — lating earnings by $1.4 billion and convicted o — bribing the Governor o — Alabama. Id.; Krysten Craw — ord, Ex-HealthSouth CEO Scrushy Walks, CNN MONEY (June 28, 2005, 4:37 PM), http://money.cnn.com/2005/06/28/news/ news makers/scrushy_outcome/ (“The 52-year-old — ounder and ex-CEO o — HealthSouth — aced 36 counts, including — raud, money laundering and conspiracy charges.”); Carrie Johnson, Jury Convicts HealthSouth Founder in Bribery Trial, WASH. POST (June 30, 2006), http:// www.washingtonpost.com/wp-dyn/content/article/2006/06/29/AR2006062901912.html (“An Alabama jury yesterday convicted HealthSouth Corp. — ounder Richard M. Scrushy— acquitted last year o —

ederal accounting- — raud charges—o — paying hal — a million dollars in bribes to — ormer governor Don Siegelman in exchange — or a seat on a state health-care board. . . . [T]he jury convicted [HealthSouth CEO] Scrushy o — all six bribery, mail — raud and conspiracy charges.”).

1. Press Release, U.S. Sec. & Exch. Comm’n, Freddie Mac, Four Former Executives Settle SEC Action Relating to Multi-Billion Dollar Accounting Fraud (Sept. 27, 2007), https://www.sec.gov/news/press/2007/2007-205.htm. CEO, COO, and — ormer senior management o — Freddie Mac misstated $5 billion in earnings and were — ined $125 million by the SEC, plus $50 million to settle — ederal charges. Freddie Mac Pays $50M to Settle Fraud Charges, ABC NEWS, http://abcnews.go.com/Business/story?id=3664473&page=1 (last visited May 7, 2016) (“Mortgage — inance company Freddie Mac FRE will pay $50 million to settle — ederal charges that it — raudulently misstated earnings over a — our-year period. . . . Freddie paid a then-record $125 million civil — ine in 2003 in a settlement with the O —

ice o — Federal Housing Enterprise Oversight . . . .”); Jonathan D. Glater, Freddie Mac Understated Its Earnings by $5 Billion, N.Y. TIMES (Nov. 22, 2003), http://www.nytimes.com/2003/11/22/business/ — reddie-mac-understated-its-earnings-by-5- billion.html (“Freddie Mac said yesterday that it had understated its earnings by nearly $5 billion over more than three years.”).

1. Erik Holm, AIG, Other Insurers Settle Suit over Bid-Rigging, WALL ST. J. (Mar. 21, 2011, 7:25 PM), http://www.wsj.com/articles/SB10001424052748703858404576214972

2. The CEO o

   American International Group settled with multiple plainti —

s — or over $2 billion — or allegations o — bid-ridding and stock-price manipulation and $3.9 billion

or — raud. Id.; see also Case Summary: American International Group, Inc. (AIG) Securities Litigation, STAN L. SCH., http://securities.stan — ord.edu/ — ilings-case.html?id= 103311 (last visited May 7, 2006) (reviewing the entire history o — AIG’s settlement, showing a total o — more than $2 billion in settlement).

1. Michael J. de la Merced & Andrew Ross Sorkin, Report Details How Lehman Hid Its Woes, N.Y. TIMES (Mar. 11, 2010), http://www.nytimes.com/2010/03/12/business/12 lehman.html?pagewanted=all&_r=0. Lehman executives and its accountants at Ernst & Young allegedly hid — i — ty billion dollars in loans disguised as sales. Id.

2. Pub. L. No. 107-204, 116 Stat. 745 (codi

   ied as amended in scattered sections o —

11, 15, 18, 28, 29 U.S.C.).

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2016] DEMOCRATIZING STARTUPS 1023

At the time o

its promulgation, SOX was called “the most important securities legislation since the original Federal securities laws o — the 1930’s.”47

SOX creat[ed] the Public Company Accounting Oversight Board;
. . . enhanc[ed] the independence o ---  public company auditors;
regulat[ed] corporate governance and responsibility; enhanc[ed]

inancial disclosure; regulat[ed] securities analyst con — licts o —

interest; . . . add[ed] several new substantive crimes under the
securities laws and enhanc[ed] penalties  --- or violations o ---  the
securities and other laws[;] . . . provided  --- or additional  --- unding
o ---  the SEC and enhancement o ---  the SEC’s regulatory
authority[;] commissioned several studies that required reports
back to Congress[;] and contained an editorial comment on
corporate tax returns.48

Despite SOX’s disclosure requirements, another  --- inancial crisis occurred soon a --- ter its enactment. The Great Recession started in 2007 with the subprime mortgage crisis and quickly expanded into a global

inancial crisis in which the global stock market dropped over — i — ty percent.49 National securities experts worried the Great Recession could destabilize the entire geo-political economy.50 Once again, Congress advanced the “sunlight” policy o — securities regulation to advance the normative goals o — protecting investors and stabilizing markets by passing the Dodd-Frank Wall Street Re — orm and Consumer Protection Act o — 2010 (“Dodd-Frank”).51 Dodd-Frank — urther increases the

1. Implementation o

   the Sarbanes-Oxley Act o — 2002: Hearing Be — ore the S. Comm. on Banking, Hous., & Urban A —

airs, 108th Cong. 6 (2003) (statement o — William H. Donaldson, Chairman, U.S. Securities and Exchange Commission).

1. Lyman P.Q. Johnson & Mark A. Sides, The Sarbanes-Oxley Act and Fiduciary Duties, 30 WM. MITCHELL L. REV. 1149, 1154 (2004) ( — ootnotes omitted).

2. Sher Verick & Iyanatul Islam, The Great Recession o

   2008−2009: Causes, Consequences and Policy Responses 23 (May 2010) (unpublished manuscript), http:// — tp.iza.org/dp4934.pd — [http://perma.cc/C6E2-PMFX]; see also Barry Eichengreen & Kevin Hjortshoj O’Rourke, What Do [sic] the New Data Tell Us?, VOX (Mar. 8, 2016), http://voxeu.org/article/tale-two-depressions-what-do-new-data-tell-us- — ebruary-2010-up date (“At their trough [world equity markets] were 50% below peak.”).

3. See, e.g., Tom Gjelten, Economic Crisis Poses Threat to Global Stability, NAT’L PUB. RADIO (Feb. 18, 2009, 12:07 AM), http://www.npr.org/templates/story/story.php?story Id=100781975.

4. Pub. L. No. 111-203, 124 Stat. 1376 (codi

   ied as amended in scattered sections o —

112 U.S.C.).

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1024 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

demands on public companies and requires them to make disclosures with six provisions that pertain to corporate governance.52 These “sunlight” policies may protect investors and prevent systemic economic — ailure,53 but they are not — ree. They make it very expensive, di —

icult, and time-consuming to be a public company. Cumulatively, the Securities Act, the Exchange Act, SOX, Dodd-Frank, and other securities regulations — orce an average company to incur about $5.7 million in one-time costs to “go public” in an initial public o —

ering (“IPO”)—which allows it to raise money in the public capital market—plus about — ive to seven percent o — gross proceeds raised in the IPO and another $1.5 million in annual recurring costs as a result o —

being public.54 In addition, public-company managers have to spend time and e —

ort on regulatory compliance instead o — running and growing the business.

B. Regulatory Exemptions

Periodically, the SEC has recognized that sunlight policies and disclosure regimes  --- rustrate the goal o ---  capital  --- ormation. This administrative agency has broad rulemaking power, which it has

1. The six provisions o

   Dodd-Frank that pertain to corporate governance are: requiring periodic shareholder advisory votes on executive compensation (the “say-on-pay” mandate); mandating — ully independent compensation committees — or reporting companies with speci — ied oversight responsibilities; requiring companies to provide additional disclosures with respect to executive compensation; expanding SOX’s rules regarding clawbacks o — executive compensation; a —

irming SEC authority to allow shareholders to use the company’s proxy statement to nominate candidates to the board o —

directors (the “shareholder access rule”); and requiring companies to disclose whether the same person holds both the CEO and chairman o — the board positions and why they either do or do not do so. Id.

1. However, many scholars argue that the sunlight policies are ine

ective in that they do not actually protect investors or prevent system — ailure. See, e.g., Stephen M. Bainbridge, Dodd-Frank: Quack Federal Corporate Governance Round II, 95 MINN. L. REV. 1779, 1821 (2011) (“Like their predecessors in SOX, the six key corporate governance provisions o — Dodd-Frank satis — y the key criteria o — quack corporate governance.”); Roberta Romano, The Sarbanes-Oxley Act and the Making o — Quack Corporate Governance, 114 YALE L.J. 1521, 1602 (2005) (“An extensive empirical literature suggests that those mandates were seriously misconceived, because they are not likely to improve audit quality or otherwise enhance — irm per — ormance and thereby bene — it investors as Congress intended.”).

1. P RICEWATERHOUSE C OOPER , CONSIDERING AN IPO?: THE COSTS OF GOING AND BEING PUBLIC MAY SURPRISE YOU 1 — ig.1 (2012), http://www.pwc.com/en_us/us/ transaction-services/publications/assets/pwc-cost-o — -ipo.pd — [http://perma.cc/CNX5-9VZL] (providing that there are $3.7 million directly attributable costs, plus $1 million other incremental costs, plus $1 million to convert to a public company, equaling $5.7 million). Additionally $1.5 million are incurred per year to stay public. Id.

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2016] DEMOCRATIZING STARTUPS 1025

exercised to create exemptions to

ederal securities regulations that it deems necessary — or e —

icient capital — ormation. This Subpart discusses the most important regulatory exemptions created by the SEC: Regulation D,55 Rule 144,56 and Rule 144A.57 The next Subpart discusses the new statutory exemption created by Congress. The SEC promulgated Regulation D in 1982 speci — ically to — acilitate capital — ormation.58 Section 5 o — the Securities Act requires all o —

ers to sell securities in interstate commerce to be registered with the SEC or exempted — rom registration.59 Regulation D provides three exemptions

rom registration requirements—Rules 504, 505, and 506— — or the original issuance o — securities.60 Rule 504 allows issuers to sell up to one million dollars in securities in any twelve-month period to anyone.61 Rule 505 allows sales o — up to — ive million dollars to unlimited “accredited investors” (“AIs”)62 and up to thirty- — ive other non- accredited investors.63 Rule 506 allows unlimited sales to AIs.64 It is critical to note that Regulation D pertains only to original issuances ( — irst o —

ers or sales) o — stock.65 Regulation D is not a resale exemption. Stock sold under Regulation D cannot be resold unless the

1. 17 C.F.R. § 230.501−.508 (2015).
2. Id. § 230.144.
3. Id. § 230.144A.
4. Mark A. Sargent, The New Regulation D: Deregulation, Federalism and the Dynamics o — Regulatory Re — orm, 68 WASH. U. L.Q. 225, 227 (1990) (“The SEC promulgated Regulation D in 1982 as part o — a major e —

ort to reduce regulatory constraints on capital — ormation—particularly by small business—to the greatest extent compatible with investor protection.”).

1. 15 U.S.C. § 77e (2012).

2. Regulation D O

erings, U.S. SEC. & EXCHANGE COMMISSION, https://www.sec.gov/ answers/regd.htm (last visited Apr. 4, 2016).

1. Rule 504 o

   Regulation D, U.S. SEC. & EXCHANGE COMMISSION, https://www.sec. gov/answers/rule504.htm (last visited Apr. 4, 2016); see also Revision o — Certain Exemptions — rom Registration — or Transactions Involving Limited O —

ers and Sales, Securities Act Release No. 6389, 47 Fed. Reg. 11,251, 11,257−58 (Mar. 8, 1982).

1. An “accredited investor” is an individual with at least $200,000 in annual income or $1 million in net wealth, or a married couple with at least $300,000 in annual income. 17 C.F.R. § 230.501(a)(5)−(6) (“Accredited investor shall mean . . . [a]ny natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000 . . . [or] [a]ny natural person who had an individual income in excess o —

$200,000 in each o

the two most recent years or joint income with that person’s spouse in excess o — $300,000 in each o — those years and has a reasonable expectation o — reaching the same income level in the current year.”).

1. Revision o

   Certain Exemptions — rom Registration — or Transactions Involving Limited O —

ers and Sales, 47 Fed. Reg. at 11,252.

1. Id.

2. 17 C.F.R. § 230.500(d).

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1026 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

stock is registered with the SEC or meets an exemption.66 The main resale exemptions are Rule 144 and Rule 144A.67 Rule 144 was originally adopted in 1972 to permit resale o —

unregistered securities, but its ability to provide liquidity is substantially limited by holding-period and selling-volume restrictions.68 To bene — it — rom this non-exclusive sa — e harbor, resellers originally had to hold the securities — or at least two years prior to resale, but in 1997 the SEC shortened the holding period to one year.69 The holding period begins when the purchase price o — the shares are

ully paid,70 which means that stock options must be exercised and then held — or one year be — ore they can be resold under Rule 144.71 A — ter the holding period is met, sellers can only sell up to one percent o — the company’s outstanding shares o — that class o — stock, or the average reported weekly trading volume o — the — our preceding calendar weeks.72 Scholars have recognized that Rule 144 can only provide limited liquidity because o — its holding-period and selling-volume restrictions.73 Critically — or present purposes, Rule 144’s holding period only permits tacking between holders so long as sales are made privately,74 so this rule is virtually useless — or public-exchange transactions. Resale exemptions achieved their goal o — reducing compliance costs and making capital — ormation more e —

icient.75 Regulation D and Rule

1. Id.

2. Stephen J. Choi, Company Registration: Toward a Status-Based Anti

   raud Regime, 64 U. CHI. L. REV. 567, 638−39 (1997).

3. See Notice o

   Adoption o — Rule 144, Securities Act Release No. 5223, 37 Fed. Reg. 591 (Jan. 11, 1972).

4. Revision o

   Holding Period Requirements in Rules 144 and 145, Securities Act Release No. 7390, 62 Fed. Reg. 9242, 9242 (Feb. 28, 1997) (codi — ied at 17 C.F.R. pt. 230) (“Today, — or the — irst time since the adoption o — Rule 144 in 1972, the Commission is adopting amendments to shorten the holding period that must be satis — ied be — ore limited resales o — restricted securities may be made by a —

iliates and non-a —

iliates in reliance upon the rule.” ( — ootnote omitted)).

1. 17 C.F.R. § 230.144(d)(1).
2. Darian M. Ibrahim, The New Exit in Venture Capital, 65 VAND. L. REV. 1, 40 (2012) (“Rule 144 does not count the length o — time that a stock option is held; rather, the holding period begins when the option is actually exercised. Consequently, Rule 144 is not available to resell recently exercised stock options.” ( — ootnote omitted)).
3. 17 C.F.R. § 230.144(e)(1)(i)–(iii).

4. E.g., Mira Ganor, Note, Improving the Legal Environment

   or Start-up Financing by Rationalizing Rule 144, 33 WM. MITCHELL L. REV. 1447, 1451 (2007) (“Both the holding-period restriction and the selling-volume restriction impair investor liquidity.”).

5. See 17 C.F.R. § 230.144(d)(1).

6. Revision o

   Holding Period Requirements in Rules 144 and 145, Securities Act Release No. 7390, 62 Fed. Reg. 9242, 9243 (Feb. 28, 1997) (codi — ied at 17 C.F.R. pt. 230) (“The Commission believes, and the public comments support the view, that reduction in the Rule 144 holding periods will reduce compliance burdens and costs without signi — icant

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2016] DEMOCRATIZING STARTUPS 1027

144A proved to encourage venture capital

ormation. Prior to the Regulation D sa — e-harbor exemption, investment in private stock totaled $18 billion in 1981.76 These “private placements” quickly increased under Regulation D “to $139 billion in 1987 and then to $202 billion in 1988.”77 This success led the SEC to promulgate an additional sa — e-harbor exemption, Rule 144A, which allows resale without any holding period to a quali — ied institutional buyer (“QIB”).78 This resale rule accelerated private placements, which exceeded $1.3 trillion in 2012.79 The dramatic increase in private-company investment — ollowing each successive exemption — or private-stock resale highlights the importance o — a resale exemption—not just an original sale exemption— to — acilitate — ormation o — venture capital — unds and their investment into startups. These “exemptive” policies have proven that both original issuance and resale sa — e harbors are necessary — or private placements and, there — ore, critical — or startups and the entire venture capital industry. But exempting companies — rom making disclosures — or the sake o —

capital

ormation is clearly at odds with the “sunlight” policies and their goal o — protecting investors by making in — ormation available to them. The Supreme Court attempted to resolve this seemingly schizophrenic approach to securities regulations in the seminal 1953 case SEC v. Ralston Purina Co., which held that only sales to sophisticated investors are not public o —

erings and there — ore do not require

impact on investor protection. The Commission also believes that the action being taken will promote market e —

iciency, investment and capital — ormation by reducing the liquidity costs o — holding restricted securities and reducing issuers’ cost o — raising capital through the sale o — restricted securities.”).

1. Roberta S. Karmel, Regulation by Exemption: The Changing De

   inition o — an Accredited Investor, 39 RUTGERS L.J. 681, 689 (2008) (“A — ter Regulation D was passed, the total amount o — securities sold in private placements increased — rom $18 billion in 1981 to $139 billion in 1987 and then to $202 billion in 1988.”).

2. Id.
3. 17 C.F.R. § 230.144A(d). A QIB is an institution that has at least $100 million in net investments. Id. § 230.144A(a)(1)(i) (“For purposes o — this section, quali — ied institutional buyer shall mean . . . [a]ny o — the — ollowing entities, acting — or its own account or the accounts o — other quali — ied institutional buyers, that in the aggregate owns and invests on a discretionary basis at least $100 million in securities o — issuers that are not a —

iliated with the entity.”).

1. Cheryl Conner, A Trillion Dollar Source o

   New Funding? The SEC’s New ‘Reg D,’ FORBES (July 13, 2013, 11:28 AM), http://www. — orbes.com/sites/cherylsnappconner/2013/ 07/13/a-trillion-dollar-source-o — -new- — unding-the-secs-new-reg-d/#774ed1071 — dd (“The existing ‘Reg D’ program exemption has already been responsible — or more than $1.3 trillion in — unding in 2012, and more than 37,000 Regulation D o —

erings have been executed since 2009.”).

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1028 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

mandatory public disclosures.80 SEC exemptions

ollow the Ralston Purina doctrine and permit only certain investors to participate in private stock markets. The issuance exemptions in Regulation D and the resale exemption in Rules 144 and 144A enabled modern venture capital — inancing.81 Venture capital is where institutional investors make passive investments in venture capital — unds, which are run by venture capital managers who make active investments in new business ventures.82 The venture capital market is o — ten regarded as the “crown jewel” o — the American economy.83 These new business ventures are colloquially called “startups,” which generally re — ers to high-growth, high-risk, early-stage businesses that are backed by venture capital — inancing.84 Startups have historically developed in the Silicon Valley region o —

Cali

ornia and — ocused on high-tech projects. These regulations achieved their purpose o — exempting venture capital — inancing — rom securities regulations. Venture capital — inancing exemptions are based on the AI concept as proxy — or sophistication. The AI concept assumes that wealthier investors have the knowledge and bargaining power to guarantee access to appropriate in — ormation through contracting. Alternatively, the SEC assumes that AIs can a —

ord to lose their investment. An AI is an

1. 346 U.S. 119, 125 (1953) (“[T]he applicability o

   § 4(1) should turn on whether the particular class o — persons a —

ected need the protection o — the Act. An o —

ering to those who are shown to be able to — end — or themselves is a transaction ‘not involving any public o —

ering.’”).

1. See J OSEPH W. B ARTLETT , EQUITY FINANCE: VENTURE CAPITAL, BUYOUTS, RESTRUCTURINGS AND REORGANIZATIONS § 14.12, at 342–49 (2d ed. 1995); Karmel, supra note 76, at 689 (“As a result o — Regulation D and Rule 144, the private placement market in the United States grew quickly.”); Alan R. Palmiter, Toward Disclosure Choice in Securities O —

erings, 1999 COLUM. BUS. L. REV. 1, 90 n.250, 135 (“Easing the restrictions on secondary distributions should have a bene — icial e —

ect on primary o —

erings, particularly to venture capitalists who will want to sell a — ter a public o —

ering.”).

1. Ronald J. Gilson, Engineering a Venture Capital Market: Lessons

   rom the American Experience, 55 STAN. L. REV. 1067, 1070 (2003) (“The typical transactional pattern in the U.S. venture capital market is — or institutional investors—pension — unds, banks, insurance companies, and endowments and — oundations—to invest through intermediaries, venture capital limited partnerships usually called ‘venture capital — unds,’ in which the investors are passive limited partners.”).

2. Id. at 1068 (“The venture capital market and

   irms whose creation and early stages were — inanced by venture capital are among the crown jewels o — the American economy.”).

3. Darian M. Ibrahim, The (Not So) Puzzling Behavior o

   Angel Investors, 61 VAND. L. REV. 1405, 1411−12 (2008) (“Start-ups have little or no operating history or tangible assets with which to predict — uture per — ormance, and scienti — ic or technological novelty like that — ound in the typical Silicon Valley start-up adds another layer o — uncertainty.”).

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2016] DEMOCRATIZING STARTUPS 1029

individual with more than $1 million in net worth (excluding primary residence) or more than $200,000 in annual income ($300,000 — or married couples).85 This was a high threshold when the rule was promulgated in 1982, but it has never been adjusted — or in — lation, so the threshold has much less signi — icance now. There were 9.63 million households in America in 2013 with a net worth o — $1 million or more.86 Consequently, the AI concept has come under scrutiny recently — or

ailing to be a valid proxy — or sophistication o — investors.87 Rule 144 and 144A are not up to the task o —

acilitating smaller resale transactions — or retail investors. Rule 144 and 144A transactions must be private, which requires the services o — an investment banker, lawyer, and/or registered broker-dealer. The transaction costs o — Rule 144 and 144A transactions make small resale transactions una —

ordable. That means securities regulations may be encouraging smaller investors to purchase stock — rom original issuers, yet it is locking them out o — opportunities to resell those securities.

C. The JOBS Act

Congress recently passed groundbreaking legislation that is designed to make it much easier  --- or the general public to invest in private companies. Title III o ---  the JOBS Act amended the Securities Act to allow a company to o ---

er and sell up to one million dollars worth o —

equity securities (stock) in a twelve-month period to the general public without registering the securities with the SEC.88 This new exemption to registration under the Securities Act is called “crowd — unding.”89 President Barack Obama made the normative goals o — the JOBS Act quite clear. At the bill’s signing, the President said: “These proposals

1. See supra note 62.

2. Emily Jane Fox, Number o

   U.S. Millionaires Hits New High, CNN MONEY (Mar. 14, 2014, 10:55 AM), http://money.cnn.com/2014/03/14/news/economy/us-millionaires- households/ [http://perma.cc/53Y9-8XGW].

3. Wallis K. Finger, Note, Unsophisticated Wealth: Reconsidering the SEC’s “Accredited Investor” De — inition Under the 1933 Act, 86 WASH. U. L. REV. 733, 766 (2009) (“Recent proposed revisions to the current accredited investor de — inition — or natural persons and the exponential growth o — the hedge — und industry make it clear that a review o — the accredited investor de — inition — or natural persons is relevant and that adjustments are necessary.”).

4. Pub. L. No. 112-106, § 302, 126 Stat. 306, 315 (2012) (codi

   ied as amended in scattered sections o — 15 U.S.C.).

5. See, e.g., Jumpstart Our Business Startups Act: Frequently Asked Questions About Crowd — unding Intermediaries: Division o — Trading and Markets, U.S. SEC. & EXCHANGE COMMISSION (May 7, 2012), http://www.sec.gov/divisions/marketreg/tmjobsact-crowd

undingintermediaries — aq.htm [http:// perma.cc/TS3J-QUTY].

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1030 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

will help entrepreneurs raise the capital they need to put Americans back to work and create an economy that’s built to last.”90 The associated White House press release elaborated: “The JOBS Act will allow Main Street small businesses and high-growth enterprises to raise capital — rom investors more e —

iciently, allowing small and young

irms across the country to grow and hire — aster.”91 The JOBS Act stands in stark contrast to the Securities Act, the Exchange Act, SOX, and Dodd-Frank because the JOBS Act is the only securities statute to emphasize e —

icient capital — ormation above investor protections. In — act, critics o — the law point out that the legislative history o — the JOBS Act “is bere — t o — any evidence o — serious consideration o — investor protection concerns.”92 As Pro — essor Robert Thompson joked: “The JOBS Act is the biggest deregulatory statute in the history o — American securities regulation. That’s not a high barrier to cross.”93 The JOBS Act implicitly recognizes that sunlight, like many disin — ectants, can kill desirable activity as well as undesirable activity. Startups grow quickly in part because they are able to take risks that public companies cannot take. Quarterly disclosures and annual shareholder meetings give shareholders the incentive and the opportunity to — ire managers that do not turn a quarterly pro — it,94 but startups can — ocus on a long-term plan that may pay greater dividends overall. Young startups o — ten operate in “stealth mode” because it can be di —

icult — or young — irms to protect their intellectual property.95 In

act, the JOBS Act expressly makes it much easier — or startups to stay private longer by raising the maximum private-company record- shareholder limit — rom 500 to 2000.96

1. O

ice o — the Press Sec’y, supra note 3.

1. Id.

2. Michael D. Guttentag, Protection

   rom What? Investor Protection and the JOBS Act, 13 U.C. DAVIS BUS. L.J. 207, 253 (2013).

3. Deregulating the Markets: The JOBS Act, 38 DEL. J. CORP. L. 476, 488 (2013) (statement o — Robert B. Thompson, Pro — essor o — Business Law, Georgetown University Law Center).
4. See, e.g., Richi Jennings, Twitter Boss Costolo Says He Wasn’t Fired (but, Yeah, He Was), COMPUTERWORLD (June 12, 2015, 3:25 AM), http://www.computerworld.com/ article/2934788/social-media/twitter-ceo-costolo- — ired-itbwcw.html (“Last week, one o — the company’s biggest shareholders and cheerleaders, Chris Sacca, publicly called — or change.”).
5. Matt Villano, Why Startups Launch in ‘Stealth Mode’ and Others Don’t, ENTREPRENEUR (Oct. 17, 2013), http://www.entrepreneur.com/article/229461 (“Operating in stealth mode also can help protect intellectual property until launch.”).

6. Jumpstart Our Business Startups Act Frequently Asked Questions: Changes to the Requirements — or Exchange Act Registration and Deregistration, U.S. SEC. & EXCHANGE

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2016] DEMOCRATIZING STARTUPS 1031

Much has already been said about whether the JOBS Act mandates su ---

icient “sunshine” disclosures to protect investors — rom — raud.97 Even the SEC is concerned about whether it can provide su —

icient investor protections while complying with its congressional mandate to implement the JOBS Act.98 This Article does not opine on whether the JOBS Act, as it has been passed into law, should have prioritized investor protections over capital — ormation. Rather, this Article considers whether the JOBS Act can actually achieve its purported goals: (1) democratizing access to capital — or new entrepreneurs in new geographies outside o — Silicon Valley and democratizing access to startup investments — or new investors; (2) creating jobs; and (3) growing the innovation economy.99 Part II next discusses how the JOBS Act is likely to — ail in these goals because it does not account — or unintended consequences o — the staying private trend.

                       PART II. PRIVATE PROBLEMS

The private/public dichotomy is a hallmark o ---  securities regulation. Securities regulations categorize a company as private i ---  it has not registered its stock with the SEC.100 Registration brings the obligation

COMMISSION (Apr. 11, 2012), https://www.sec.gov/divisions/corp

in/guidance/c — jjobsact — aq- 12g.htm (“Title V and Title VI o — the JOBS Act amend Section 12(g) and Section 15(d) o —

the Exchange Act as

ollows: The holders o — record threshold — or triggering Section 12(g) registration — or issuers (other than banks and bank holding companies) has been raised

rom 500 or more persons to either (1) 2000 or more persons or (2) 500 or more persons who are not accredited investors.”). Many have speculated that exceeding the 500 shareholder limit is the reason Facebook went public. See, e.g., Steven Davido —

Solomon, Facebook and the 500-Person Threshold, N.Y. TIMES: DEALBOOK (Jan. 3, 2011, 4:03 PM), http://dealbook.nytimes.com/2011/01/03/ — acebook-and-the-500-person-threshold/?_r=2.

1. See, e.g., Thomas Lee Hazen, Crowd

   unding or Fraud — unding? Social Networks and the Securities Laws—Why the Specially Tailored Exemption Must Be Conditioned on Meaning — ul Disclosure, 90 N.C. L. REV. 1735, 1739 (2012) (“This Article discusses the importance o — disclosure in any crowd — unding exemption and concludes that with the new exemption, Congress has given the SEC the tools to implement a viable exemption without unduly sacri — icing investor protection.”).

2. See Luis A. Aguilar, Comm’r, U.S. Sec. & Exch. Comm’n, Public Statement, Investor Protection Is Needed — or True Capital Formation: Views on the JOBS Act (Mar. 16, 2012), http://www.sec.gov/News/PublicStmt/Detail/PublicStmt/1365171490120 (“This bill seems to impose tremendous costs and potential harm on investors with little to no corresponding bene — it.”).

3. See O

ice o — the Press Sec’y, supra note 3.

1. Ronald J. Gilson, A Structural Approach to Corporations: The Case Against De — ensive Tactics in Tender O —

ers, 33 STAN. L. REV. 819, 846 n.101 (1981) (“Where the transaction involves the issuance o — the o —

eror’s securities, the o —

er must be registered with the Securities and Exchange Commission pursuant to the Securities Act o — 1933

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to make periodic disclosures to the public and the opportunity to raise money by selling stock in public markets. Startups traditionally sought to “go public” by registering and having an initial public o —

ering within about seven years o —

ormation because the venture capital — unds that

inance startups are established with a ten-year term. The invested money needs to be returned to the — und investors when the term expires.101 The ideal way — or this money to be returned is when a startup has an IPO, which is regarded as the “gold standard” in venture capital success.102 The ten-year term limit on venture capital — unds drove startups to go public within that time — rame. The IPO was the crowning event at the culmination o — a process known as the startup — inancing cycle.103 This cycle begins with incorporation and initial capitalization.104 Friends and — amily provide a small amount o — initial — unding. Angel investors provide most o — the initial capital.105 The startup begins operating at a loss. About hal — o —

the startups

ail to earn pro — its; they go broke and liquidate.106 The other hal — manage to either generate revenues that cover costs107 or secure venture capital — inancing in an investment called the “Series A.”108 Venture capital investors reinvest in the startup in later staged investments called Series B, C, D, and so on.109 These investments are illiquid. They are locked up in the startup until the startup exits the private market ideally through an IPO (or sub-optimally through a mergers and acquisitions (“M&A”) event) that allows the investors to divest their investment.110

unless an exemption

rom registration is available.”). See generally R. JENNINGS & H. MARSH, SECURITIES REGULATION: CASES AND MATERIALS 464−95 (4th ed. 1977).

1. Susan Pulliam & Jean Eaglesham, Investor Hazard: ‘Zombie Funds,’ WALL ST. J. (May 31, 2012, 10:09 PM), http://www.wsj.com/articles/SB10001424052702304444604577 339843949806370.
2. Ibrahim, supra note 71, at 11.
3. DOUGLAS J. CUMMING & SOFIA A. JOHAN, VENTURE CAPITAL AND PRIVATE EQUITY CONTRACTING: AN INTERNATIONAL PERSPECTIVE 5 (2d ed. 2014).
4. Id.
5. Andrew Wong, Mihir Bhatia & Zachary Freeman, Angel Finance: The Other Venture Capital, 18 STRATEGIC CHANGE 221, 221–22 (2009). But see Laura Entis, Where Startup Funding Really Comes From (In — ographic), ENTREPRENEUR (Nov. 20, 2013), http://www.entrepreneur.com/article/230011 (“[P]ersonal loans and credit⎯along with investments — rom — riends and — amily⎯make up the lion’s share o —

unding — or startups in the U.S.”).

1. See R OBERT W ILTBANK & W ARREN B OEKER , RETURNS TO ANGEL INVESTORS IN GROUPS 1 (2007), http://sites.kau —

man.org/pd — /angel_groups_111207.pd — .

1. This is called the “break even.” CUMMING & JOHAN, supra note 103, at 7

   ig.1.2.

2. Id.
3. Id.

4. Id. at 592.

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2016] DEMOCRATIZING STARTUPS 1033

It was once very rare  --- or a privately  --- unded startup to be worth more than one billion dollars and rare  --- or a startup to stay private  --- or long a --- ter being valued at more than one billion dollars. The startup worth more than one billion dollars was so rare it was called a “Unicorn.”111 Startups, however, are not going public in an IPO or liquidating in an M&A event. Increasingly, they are staying private.112 As o ---  August 16, 2016, there are at least 170 so-called Unicorns, with a cumulative valuation o ---  over $620 billion.113 The biggest private companies—like Uber, Airbnb, and Pinterest—are so large they prompted the new coinage “Decacorn,” a private startup valued at over $10 billion.114

1. De

   inition o — Unicorn, INVESTOPEDIA, http://www.investopedia.com/terms/u/uni corn.asp (last visited May 7, 2016).

2. E.g., Yuliya Chernova, For Billion-Dollar Companies, Venture Deals Outstrip Going Public, WALL ST. J. (Aug. 19, 2014, 2:40 PM), http://blogs.wsj.com/venturecapital/ 2014/08/19/ — or-billion-dollar-companies-venture-deals-outstrip-going-public/.
3. The Unicorn List: Current Private Companies Valued at $1B and Above, CB INSIGHTS, https://www.cbinsights.com/research-unicorn-companies (last visited Aug. 17, 2016).

4. Sarah Frier & Eric Newcomer, The Fuzzy, Insane Math That’s Creating So Many Billion-Dollar Tech Companies, BLOOMBERG TECH. (Mar. 17, 2015, 9:00 AM), http://www.bloomberg.com/news/articles/2015-03-17/the- — uzzy-insane-math-that-s-creat ing-so-many-billion-dollar-tech-companies (“But there are more than 50 [Unicorns] now. There’s a new buzzword, ‘decacorn,’ — or those over $10 billion, which includes Airbnb, Dropbox, Pinterest, Snapchat, and Uber.”).

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1034 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

                                   Figure 1

There are more private startup companies valued at over $1 billion (“Unicorns”) than elements on the periodic table.115

1. The Periodic Table o

   Unicorns, CB INSIGHTS (June 16, 2015), https://www.cb insights.com/blog/periodic-table-unicorns-list-companies-one-billion/ [https://perma.cc/39 ZS-C7NY].

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2016] DEMOCRATIZING STARTUPS 1035

Staying private and growing extremely valuable is a new phenomenon that a ---

ects all startup stakeholders, including investors, employees, and society at large. This trend is the unintended consequence o — the securities regulations and market — actors described in Part I, the result o — which is a large and growing gap between large private — inancing rounds and initial public o —

erings.116 In other words, startups are now able to stay private, yet access plenty o — capital. Staying private longer undermines many assumptions about private securities.

                                Figure 2




         Gap Between Private Deals and Public O ---

erings117

The causes o ---  the “staying private” trend are attributable to several

actors, including the increased expense o — going public, the uncertainty o — greater regulatory costs in the — uture — or being public, the relatively easy access to capital while staying private, the greater agility — or a non-disclosing company, management’s pre — erence — or staying private, increased public com — ort with private corporations, technology that

1. Chernova, supra note 112.

2. Id.

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1036 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

acilitates investment in private companies, volatility in public markets, access to overseas venture stock exchanges, and other — actors. But the e —

ects o — staying private are clear. Staying private creates new problems — or investors, employees, labor markets, and the economy. In particular, staying private — rustrates the — undamental goals o — a new law that is designed to “democratize” startup investment and — uel the innovation economy. This Part will next identi — y and analyze three problems that con — ound the JOBS Act’s stated goal o — democratizing startup investment. The — irst and — oundational problem is the emergence o —

what this Article terms an “illiquidity discount asymmetry,”118 which means that startup stock is worth substantially less when held by employees and poorer investors, yet that exact same stock is worth much more in the hands o — upper management and the wealthiest investors. This raises obvious — airness concerns. It also — rustrates the JOBS Act by chilling venture investment by poorer investors. Second, the staying private trend creates a de — acto non-compete that locks employees to their companies and distorts the labor market. The illiquidity discount asymmetry also devalues stock options, which threatens to destroy the purpose o — stock options to incentivize employees to work harder — or less salary. Startup culture is — ueled by the perception that employees are pari pasu with management in taking on startup risk. The innovation economy is built upon motivating employees this way, and that — oundation is threatened by the devaluation o — increasingly illiquid stock options. In addition,

airness concerns are even stronger here than with investors because startup employees—who traded o —

higher salary — or more stock options—do not receive the bene — it o — that bargain when they — ind that they are holding worthless securities. Third, staying private threatens to curtain the innovation economy and disrupt the entire startup — inancing li — ecycle by inhibiting the recycling o — early stage investment capital. Additional systemic risks arise where venture capitalists (“VCs”) can law — ully access liquidity only in the types o — unregulated markets that generally concern scholars and regulators. The staying private trend has driven wealthy investors to seek liquidity in unregulated dark pools where there is documented opportunistic behavior—i.e., pushing domestic stock transactions to o —

shore stock markets, outside the auspices o — SEC regulation.

1. See in

   ra Part II.A.

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2016] DEMOCRATIZING STARTUPS 1037

A. Illiquidity Discount Asymmetry

 Liquidity re --- ers to the ability to buy or sell something. Something that is hard to resell, or “illiquid,” is worth less than a similar thing that is easy to resell because resale o ---  an illiquid thing requires more time, money, and risk. When illiquidity is the result o ---  a trade restriction like securities regulations, the extent o ---  the marketability or illiquidity discount is a  --- unction o ---  the trade restriction period. This is true  --- or securities such as stock and stock options, as illustrated in the

igure below, which shows that the longer a security must be held, the less that security is worth.119

                                 Figure 3




 Illiquidity Discount as a Function o ---  Trade Restriction Period120

The un --- ortunate truth o ---  our securities regulations is that they require poorer investors to hold private stock  --- or longer than the wealthiest investors. Laws  --- urther restrict poorer investors’ access to resale markets. This causes private stock to have a bigger illiquidity

1. ASWATH DAMODARAN, MARKETABILITY AND VALUE: MEASURING THE ILLIQUIDITY DISCOUNT 23 (2005), http://people.stern.nyu.edu/adamodar/pd — iles/papers/liquidity. pd —

[http://perma.cc/Q58R-YCUE].

1. Id. at 23

   ig.3.

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1038 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

discount and thus be less valuable in the hands o

poorer investors than in the hands o — wealthier ones, who can access the resale market quicker and easier. Ironically, this is the unintended consequence o —

securities regulations that were designed to protect poorer investors, yet those regulations have the actual e —

ect o — creating an illiquidity discount asymmetry — avoring wealthier investors over poorer ones. Securities regulations create the illiquidity discount asymmetry by allowing large banks to host private stock markets — or their QIBs, who must have more than $100 million in net investments.121 Smaller stockholders, and employees with stock options, are systematically disadvantaged by Rule 144A, which creates the QIB restriction on private-stock resale.122 The lack o — an equal-access sa — e-harbor exemption—such as the new Rule 144B that this Article proposes123— harms poorer stockholders and employees disproportionately more than it harms wealthier stockholders and management. And the lack o — a general solicitation provision keeps transactions o —

exchanges, so trading mainly occurs in over-the-counter transactions in private stock markets called “dark pools.”124 Accordingly, Rule 144A—and the VC secondary exchange that it allows—does not provide a — ramework — or a — air, transparent, and liquid market — or companies that are staying private. SEC Commissioner Luis A. Aguilar recently went on record stating that “[v]enture exchanges . . . have — ared poorly.”125 The Commissioner explained that venture exchanges su —

er — rom low liquidity and high volatility.126 In Part III,

1. See supra note 78.
2. 17 C.F.R. § 230.144A (2015).

3. See in

   ra Part III.

4. See supra note 9.
5. Aguilar, supra note 15; see also Reena Aggarwal & James J. Angel, The Rise and Fall o — the Amex Emerging Company Marketplace, 53 J. FIN. ECON. 257, 257 (1999).
6. Aguilar, supra note 15; see also SRIDHAR ARCOT, JULIA BLACK & GEOFFREY OWEN, THE LONDON SCH. OF ECON. & POLITICAL SCI., FROM LOCAL TO GLOBAL: THE RISE OF AIM AS A STOCK MARKET FOR GROWING COMPANIES 7 (2007), http://www.lse.ac.uk/intranet/ LSEServices/communications/pressAndIn — ormationO —

ice/PDF/FULLREPORTAIM.pd —

[http://perma.cc/2Y8Y-KX3Q] (“Liquidity among AIM stocks varies widely; stocks with the highest capitalisation and the largest — ree — loat show liquidity levels that are comparable to the Main Market, but at the lower end o — the market there is a large number o — illiquid stocks.”); Aggarwal & Angel, supra note 125, at 264, 281; Aaron Hoddinott, TSX Venture Exchange . . . Buy or Sell?, PINNACLE DIG. (Apr. 29, 2012), http://www.pinnacledigest.com/ blog/aaron-hoddinott/tsx-venture-exchangebuy-or-sell [http://perma.cc/596E-92GG] (“[T]he TSX Venture has always been a boom/bust exchange. It’s extremely volatile. The exchange has existed — or 11 years and during that time, it has gone through 7 bear markets o — its own (market downturns o — 20% or more).”); Peter Koven, Can the Once- Mighty TSX Venture Exchange Be Saved?, FIN. POST (Dec. 27, 2014), http://business.

inancialpost.com/investing/can-the-once-mighty-tsx-venture-exchange-be-saved?__lsa=

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2016] DEMOCRATIZING STARTUPS 1039

this Article responds to the SEC’s request

or suggestions on the development o — a viable secondary trading environment — or restricted securities.127 This Part o — this Article sets the — oundation — or those suggestions by analyzing why our current securities regulation regime does not provide the necessary liquidity. In short, Rule 144A’s sa — e harbor provides liquidity only — or QIBs, who are large institutions that own over $100 million in net investments.128 It does not provide liquidity to many other startup investors. Angels, who invest about twenty- — ive billion dollars annually in startups,129 are generally classi — ied as AIs.130 They need only have one million dollars in net assets or $200,000 in annual income to purchase private-company equities in the large Regulation D market.131 Wealthy angels and small venture capital — unds may also be classi — ied as quali — ied purchasers (“QPs”),132 but even QPs with ninety-nine million dollars in net investments cannot purchase equities on a 144A market. This disparity in access to a resale market means that AIs and QPs have an “illiquidity discount”133 on their shares, while QIBs enjoy the

2516-3866 [http://perma.cc/8G7E-M7XR] (“Liquidity on most [TSX Venture] stocks is very poor, which makes it di —

icult — or them to be bid anywhere but down.”).

1. Aguilar, supra note 15 (“Ultimately, the goal is to develop a viable secondary trading environment that promotes a — air, transparent, and liquid market — or the securities o — small businesses—a market in which investors can have con — idence that they are being treated — airly. There is no better way to protect investors’ interests, while promoting the success — ul expansion o — small businesses. I look — orward to a robust discussion on any and all viable suggestions as to how to improve the secondary trading environment — or shares o — small business securities.”).
2. See supra note 78.
3. JEFFREY SOHL, CTR. FOR VENTURE RES., THE ANGEL INVESTOR MARKET IN 2014: A MARKET CORRECTION IN DEAL SIZE (2015), https://paulcollege.unh.edu/sites/paulcollege. unh.edu/ — iles/web — orm/2014%20Analysis%20Report.pd — [https://perma.cc/2TCE-JM62] (“Total investments in 2014 were $24.1 billion, a decrease o — 2.8% over 2013 . . . .”).
4. See supra note 62.
5. See supra note 62; see also VLADIMIR IVANOV & SCOTT BAUGUESS, U.S. SEC. & EXCH. COMM’N, CAPITAL RAISING IN THE U.S.: AN ANALYSIS OF UNREGISTERED OFFERINGS USING THE REGULATION D EXEMPTION, 2009−2012 (2013), https://www.sec.gov/divisions/ risk — in/whitepapers/dera-unregistered-o —

erings-reg-d.pd — (“Capital raised through Regulation D o —

erings continues to be large—$863 billion reported in 2011 and $903 billion in 2012.”).

1. 15 U.S.C. § 80a-2(51)(A) (2012) (“‘Quali

   ied purchaser’ means (i) any natural person . . . who owns not less than $5,000,000 in investments[;] . . . (ii) any company that owns not less than $5,000,000 in investments and that is owned directly or indirectly by or — or 2 or more natural persons who are related[;] . . . (iv) any person, acting — or its own account or the accounts o — other quali — ied purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $25,000,000 in investments.”).

2. Spencer P. Patton, Note, Archangel Problems: The SEC and Corporate Liability, 92 TEX. L. REV. 1717, 1732 n.89 (2014) (“An illiquidity discount is a reduction in the price o — a security that must be made in order — or the price to re — lect the — act that the security

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ull value o — their shares. In other words, the 144A regime makes private-company stock most valuable to the wealthiest class o — investor and least valuable to the poorest class o — investor. This problem will be exacerbated when crowd — unding allows all people, even those who do not quali — y as AIs, to invest in startups.

B. De Facto Non-Competes

Stock options are a popular way  --- or private startup companies to pay employees. Employees generally have to work  --- or a startup  --- or  --- our years to be able to exercise all their stock options, whose value increases i ---  the company does well.134 This may align the interests o ---

employees, management, and investors, who otherwise would su

er

rom agency problems. Plus, this allows the cash-strapped startup to use its capital — or other purposes. Stock options are risky because a private company (or its employee) may — ail (or be terminated) in the

our years be — ore the options “vest” and can be exercised. Even when the vested shares are exercised, the resulting shares have an illiquidity discount because they generally cannot be resold until the company goes public. The number o — options that an employee receives is inversely related to salary, and, as the — igure below illustrates, the risk o — these options is inversely related to the proximity to the IPO.135

cannot be sold as easily as other securities.”).

1. “The cheap common stock purchased by the

   ounders and management is o — ten subject to an ownership vesting arrangement with the company. Typically, the stock vests evenly over — our or — ive years.” Duncan M. Davidson, Common Law: Uncommon So — tware, 47 U. PITT. L. REV. 1037, 1049 (1986). “The evidence is that the managers o — ten exercise their options as soon as they vest[—]i — they are in the money . . . ; that the typical period over which options vest is two to — our years; and that companies — requently grant additional, later-vesting options during the original vesting period.” Je —

rey N. Gordon, Governance Failures o — the Enron Board and the New In — ormation Order o — Sarbanes- Oxley, 35 CONN. L. REV. 1125, 1130 (2003). Typically, the stock is restricted and vests over a — our-year period. Victor Fleischer, Taxing Founders’ Stock, 59 UCLA L. REV. 60, 72 (2011).

1. Johanna Schlegel, Understanding Your Options, SALARY.COM, http://www.salary. com/advice/layouthtmls/advl_display_nocat_Ser56_Par123.html (last visited Apr. 6, 2016).

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2016] DEMOCRATIZING STARTUPS 1041

                                    Figure 4

Inverse Relationship o

Proximity to Going Public and Option Risk136

As companies stay private longer, the employees’ option shares get riskier as their illiquidity discount grows. In other words, stock options become worthless as the startup stays private longer. Meanwhile, management and VC investors do not su ---

er — rom this problem because they have other liquidity options. Staying private there — ore disrupts the alignment between labor and management because management can liquidate its investment through a 144A transaction on a VC secondary market, while labor cannot. Labor may be — orced to hold their equity inde — initely. This threatens to undermine the value o — stock options, which have been called the “central pillar o — innovation.”137

1. Option Grant Practices in High-Tech Companies, PHOTONICS MEDIA, http://www. photonics.com/Article.aspx?AID=28203 (last visited Apr. 6, 2016).

2. Thomas A. Smith, The Zynga Clawback: Shoring Up the Central Pillar o

Innovation, 53 SANTA CLARA L. REV. 577, 581 (2013) (“A central pillar o

Silicon Valley business culture . . . is that ‘start-ups with limited cash and a risk o —

ailure dangle the

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This problem came to light when  --- rustrated Facebook employees tried to sell their stock options on a new market called SharesPost.138 Un --- ortunately, the employees were bamboozled by unscrupulous traders, and the SEC shut down SharesPost.139 The alleged  --- raud occurred precisely because SharesPost was not an exchange that executed transactions. To comply with securities regulations, SharesPost  --- unctioned like a bulletin board that connected buyers and sellers who would then transact privately o ---

the exchange.140 Mazzola allegedly took advantage o — the o —

-exchange transactions by elevating the Facebook stock price to include a — ive percent secret commission and

alsely claimed to hold positions in other startup stock to attract investors to their — und.141 Facebook employees would not have been so exposed to these — raudsters i — their stock was trading on an exchange that provided transparency, price discovery, and oversight. Without a secondary market like SharesPost on which to sell their equity, labor has to wait until management elects to do an IPO or M&A, which they may choose to never do because management has a third option — or liquidation through a VC secondary market. In other words, employees who traded higher salaries — or stock options on the premise that “we’re all in this together”142 were misled, which is simply un — air. A 2013 survey realized that seventy-one percent o — employee stock options become liquid only at a value-realizing event (like an IPO or M&A).143

possibility o

stock riches in order to lure talent.’”).

1. It is understandable that the ordinary people who work at success

   ul startup companies like Facebook (as opposed to venture capital — und managers) want their — air share o — the company’s success, and ordinary people cannot always a —

ord to wait until a company goes public to get the cash they need to buy a house, send a child to college, or pay o —

credit card bills.

1. See Press Release, U.S. Sec. & Exch. Comm’n, SEC Announces Charges

   rom Investigation o — Secondary Market Trading o — Private Company Shares (Mar. 14, 2012), http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171487740.

2. SecondMarket and SharesPost: The New Market, ECONINTERSECT.COM (Jan. 23, 2011), http://econintersect.com/b2evolution/blog1.php/2011/01/23/secondmarket-and-shar espost-the-new-market (“SharesPost operates under a di —

erent business model as a ‘passive bulletin board’ within the meaning established by the SEC in certain No-Action letters.”).

1. Complaint ¶¶ 1, 19, SEC v. Mazzola, No. CV-12-1258 (N.D. Cal. Mar. 14, 2012), 2012 WL 836186, at *1, *6.
2. PAUL OYER, STAN. INST. ECON. POL’Y RES., STOCK OPTIONS—IT’S NOT JUST ABOUT MOTIVATION (2002), http://web.stan — ord.edu/group/siepr/cgi-bin/siepr/?q=system/ — iles/ shared/pubs/papers/brie — s/policybrie — _oct02.pd — .

3. WORLDATWORK & VIVIENT CONSULTING, INCENTIVE PAY PRACTICES SURVEY: PRIVATELY HELD COMPANIES 10 (2014), http://www.worldatwork.org/waw/adimLink?id= 74765.

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2016] DEMOCRATIZING STARTUPS 1043

But management and VC investors can, and do, obtain liquidity much earlier. This is not just a huge burden — or individual employees. It also distorts the labor market by tying employees to their employers beyond what they bargained — or. Startup employees understand that they

or — eit their stock options i — they quit be — ore the stock vests. But tax law mandates that employees must purchase their stock options within ninety days o — leaving their employer.144 Private-company employees do not always have the cash to exercise their options, and it is hard to borrow cash to exercise shares that cannot be resold or used as collateral. There — ore, employees who quit without the cash to buy out the stock options in a private company — or — eit their equity position, which means they have worked — or below-market cash compensation.145 Management, which has access to other liquidity options on the VC secondary markets, can e —

ectively claw back the option grants to labor through attrition. This incentivizes employees to stay with — irms longer than they otherwise would and, there — ore, may be the source o — a labor- market distortion.146 The labor-market distortion cannot be solved by private ordering because stock option contracts are, like all complex contracts, incomplete.147 Common stock contracts are deliberately incomplete: it is

1. I.R.C. § 422 (2012). The ninety-day rule is one o

   several — eatures a stock option must have to quali — y as an incentive stock option (“ISO”), and “the ISO rules provide additional employee-level bene — its.” David I. Walker, Is Equity Compensation Tax Advantaged?, 84 B.U. L. REV. 695, 712 (2004).

2. While it is commonly understood that employees will

   or — eit their stock options i —

they quit be

ore the options vest, this Article goes — urther and suggests that employees

or — eit even vested stock options i — they lack the cash to exercise them upon their termination. For the conventional understanding o — how stock options are designed to encourage employees to share risk with the — irm, see Curtis J. Milhaupt, The Market — or Innovation in the United States and Japan: Venture Capital and the Comparative Corporate Governance Debate, 91 NW. U. L. REV. 865, 887 (1997) (“Because the stock options vest over time, i — key employees are terminated or quit, they will have worked — or below-market monetary compensation while — or — eiting their equity stake in the venture.”) and William A. Sahlman, Insights — rom the Venture Capital Model o — Project Governance, 29 BUS. ECON. 35, 36 (1994) (“The vesting requirement means that i — employees are terminated, they will likely lose their stock. In most cases, they will have worked — or below-market cash compensation, and they will — or — eit their equity position.”).

1. See BRUCE BRUMBERG, THE STOCK OPTION TAX DILEMMA FACED BY PRE-IPO COMPANY EMPLOYEES (2012), https://sharespost.com/site/assets/ — iles/3071/the_stock_ option_tax_dilemma_ — aced_by_pre-ipo_company_employeess.pd — [https://perma.cc/NXH2- UFUK].

2. There is a robust discussion in the literature about incomplete common stock contracts. See, e.g., William W. Bratton & Michael L. Wachter, A Theory o — Pre — erred Stock, 161 U. PA. L. REV. 1815, 1839 (2013) (“Since stockholder interests are so broad as to be non-contractible, incomplete transactions are inevitable, and there — ore make — iduciary

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more e

icient to deal with certain issues only when they arise because the huge set o — possible contingencies — or residual claimants “make[s] ex ante contractual speci — ication un — easible.”148 To the extent that common stock contracts are incomplete, stock option contracts are even more incomplete because they introduce the additional layer o — an option contract on top o — the common stock contract. Incomplete stock option contracts do not necessarily account — or the possibility that the interests o — management and option-holders diverge on whether to have a liquidity event, and there is no corporate law backdrop to address this problem with de — ault rules.

C. Systemic Risks

Staying private creates three substantial and systemic risks. First, an IPO or other liquidity event liberates capital to be deployed in new ventures. While VCs are able to obtain some liquidity in today’s secondary markets, many VC investments cannot be completely or even partially cashed out without a liquidity event.149 Without cashing out, VCs there --- ore cannot reinvest in new companies, and the startup

inancing cycle shuts down. Second, without IPOs or a robust and liquid stock exchange on which to trade, VCs must sell these stocks in o —

- exchange environments similar to so-called “dark pools.” These low- in — ormation environments create opportunity — or bad behavior and pre — erential treatment, which have been the subject o — recent SEC indictments.150 Third, startups that need greater liquidity — or their shareholders than SharesPost-style secondary markets or dark pools can list their stock on — oreign “venture exchanges” in Canada, Europe, and South America.151 American investors in these — oreign-listed

protection necessary.”).

1. Id. (“Protecting that reliance with

   iduciary principles is thought to be more e —

icient than — orcing common stock investors to speci — y their rights ex ante. Indeed, the set o — possible contingencies — or the common is so large as to make ex ante contractual speci — ication un — easible.” ( — ootnote omitted)).

1. See sources cited supra note 126; see also Aggarwal & Angel, supra note 125, at 281 (noting that European venture exchanges “su —

ered — rom severe illiquidity”).

1. Press Release, U.S. Sec. & Exch. Comm’n, SEC Charges New York-Based Dark Pool Operator with Failing to Sa — eguard Con — idential Trading In — ormation (June 6, 2014), https://www.sec.gov/News/PressRelease/Detail/PressRelease/1370542011574 (“The Securities and Exchange Commission today charged a New York-based brokerage — irm that operates a dark pool alternative trading system with improperly using subscribers’ con — idential trading in — ormation in marketing its services.”).

2. John C. Co

ee, Jr., The Future as History: The Prospects — or Global Convergence in Corporate Governance and Its Implications, 93 NW. U. L. REV. 641, 673 (1999) (“[F]irms seeking any o — a variety o — goals—to raise equity capital, to increase share value, or to

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startups, and domestic employees who received stock options in lieu o

salary, cannot be e

ectively protected by domestic regulators like the SEC and the Department o — Justice. This is particularly disconcerting because many o — these — oreign exchanges have been described as the “Wild West,” and they are prone to spectacular — ailure.152

 1.   Breaking the Startup Financing Cycle

 Staying private threatens to disrupt the entire startup  --- inancing li --- ecycle by inhibiting the recycling o ---  early stage investment capital into new venture. Pro --- essor Je ---

Schwartz explained in his article, The Twilight o — Equity Liquidity, that the — ailure o — U.S. equity markets to o —

er a stock exchange — or young companies mani — ests in “a less robust entrepreneurial ecosystem and weaker equity markets.”153 He recognized that the innovation economy relies on a steady — low o —

capital that VCs provide by exiting success

ul older startups and investing in younger ones.154 Furthermore, IPOs are the gold standard in startup exits — or VC liquidity.155 M&A events (which Schwartz calls “trade sales”)156 do not o —

er complete liquidity because a company’s acquisitions are o — ten paid — or with a mix o — cash and stock.157 I — the acquirer is also a private company, then the target company’s stockholders end up still holding restricted private stock.158 From a broader economic perspective, M&A exits may be in — erior to IPO exits because acquisitions may destroy jobs, whereas IPOs create jobs.159

make acquisitions

or stock—may decide to list on a — oreign stock exchange and thereby opt into — oreign governance standards.”).

1. Aggarwal & Angel, supra note 125, at 258 (noting the “many

   ailed attempts to launch public equity markets — or small stocks in the US and Europe”).

2. Je

Schwartz, The Twilight o — Equity Liquidity, 34 CARDOZO L. REV. 531, 533 (2012).

1. Id. at 541 (“This cycle o

irms impacts equity markets. In the short term, i — new

irms are not added, an equity market loses its vitality. Since established — irms tend to have lower growth, i — yesterday’s companies are the only ones on a market, it stagnates. The story worsens in the long term. Over time, without new — irms joining its ranks, a once robust equity market will eventually — ade away. Worse yet, i — U.S. equity markets as a whole become unattractive, they will collectively languish and decay.”).

1. Ibrahim, supra note 71, at 11.
2. Schwartz, supra note 153, at 541−42.
3. See, e.g., Roberta Romano, A Guide to Takeovers: Theory, Evidence, and Regulation, 9 YALE J. ON REG. 119, 123 n.11 (1992) (“[W]hen a bidder thinks its stock is overvalued, it uses stock rather than cash — or the acquisition . . . .”).
4. Schwartz, supra note 153, at 541–42; see also JOHN HAWKEY, EXIT STRATEGY PLANNING: GROOMING YOUR BUSINESS FOR SALE OR SUCCESSION 171–82 (2002) (discussing trade sales).

5. Schwartz, supra note 153, at 542 (“In addition, a trade-sale undermines job-

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1046 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

In other words, Pro --- essor Schwartz analyzed alternative sources o ---

liquidity and

ound that the markets — or private shares “have little to o —

er.”160 Secondary markets built on section 4(1½) o — the Securities Act,161 Rule 144,162 and Rule 144A163 do not provide the certainty,

lexibility, and reliability that markets need to — unction properly. In

act, 92.7% o — VCs polled in 2009 were either “worried” or “most worried” about the uncertain state o — exit markets.164 Without well-

unctioning exit markets, the VC — unds that have been — ueling the innovation economy will eventually dry up.

creation. I

an entrepreneurial — irm is simply merged into another, job growth is stymied. In — act, in the short term, jobs are likely lost as redundant employees are eliminated. IPOs create jobs; trade-sales kill them.”).

1. Id. at 551.

2. Id. at 553 (“Essentially, the rule

   or section 4(1½) is that a resale to a limited number o — sophisticated and in — ormed investors, with whom the seller has a preexisting relationship, who themselves do not intend to — lip the stock, is permissible, so long as the seller held the shares — or a su —

icient amount o — time. As the ambiguity o — the language suggests, the boundaries o — these criteria are hazy. Such haziness means that this rule is ill-suited to serve as the — oundation — or a liquid market.” ( — ootnotes omitted)).

1. Id. at 555 (“Rule 144 poses a number o

   theoretical and practical problems. Looking — irst at the regulation o — nona —

iliate transactions, the one-year rule poses the same concerns as the three-year rule under the 4(1½) doctrine. It lays the groundwork — or an unregulated marketplace in the resale o — private securities once the holding period is complete. Again, this runs counter to the overriding investor-protection purpose o —

securities law and chills liquidity.” (

ootnote omitted)).

1. Id. at 561–62 (“Although the rule and this ambition apply to unregistered securities more broadly, its use in connection with shares o — private U.S. issuers is all that matters here. With respect to this type o — security, the rule’s impact has been muted. For a great while, there were no markets speci — ically designed to — acilitate transactions — or such shares under 144A. This changed with the launch o — several new trading venues a

ew years ago, but these plat — orms have met with little success.” ( — ootnote omitted)).

1. Scott Austin, Majority o

   VCs in Survey Call Industry ‘Broken,’ WALL ST. J. (June 29, 2009, 4:38 PM), http://blogs.wsj.com/venturecapital/2009/06/29/majority-o — -vcs-in-sur vey-call-industry-broken/.

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                                 Figure 5

The Start-Up Financing Timeline illustrates the path venture-

unding startups traditionally took — rom initial private — inancing to initial public o —

ering.

    2.   Trading in Unregulated Dark Pools

This Subpart explains how the problems with trading public- company stock in private dark-pool markets also apply to private- company stock that is traded in similarly “dark” markets. Dark pools are private stock markets that are not accessible by the general investing public.165 In  --- act, dark pools are designed so institutions can hide their orders  --- rom the marketplace.166 Many scholars have expressed serious concerns that this “shadow banking system” creates dangerous systemic risks.167 Dark pool transactions are secret, one-o ---

,

1. See supra note 9.
2. BRIAN R. BROWN, CHASING THE SAME SIGNALS: HOW BLACK-BOX TRADING INFLUENCES STOCK MARKETS FROM WALL STREET TO SHANGHAI 116 (2010).

3. See, e.g., Frank Pasquale, Restoring Transparency to Automated Authority, 9 J. ON TELECOMM. & HIGH TECH. L. 235, 252 (2011) (“Though the rise o — the ‘shadow banking system’ and ‘dark pools’ may make its spread inevitable, trade secrecy appears inappropriate when a Gordian knot o — gambles can put the entire global — inancial system at risk.”).

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1048 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

idiosyncratic deals that do not reveal a market price.168 They reduce liquidity in exchanges, making retail investment less e —

icient,169 and raise transparency concerns.170 The use o — dark pools to trade public- company stock is growing rapidly.171

                                    Figure 6

More transactions are happening o

exchanges, in dark pools housed inside big banks.172

1. Robert Hatch, Re

   orming the Murky Depths o — Wall Street: Putting the Spotlight on the Security and Exchange Commission’s Regulatory Proposal Concerning Dark Pools o — Liquidity, 78 GEO. WASH. L. REV. 1032, 1039 (2010) (“[C]ritics worried that by hiding in — ormation — rom the public at large, the activity in dark pools would harm the validity o —

public price quotes by making it di

icult — or investors to know i — they were getting either the best price or the appropriate price — or their transactions.”).

1. Id. (“[C]ritics worried that the lure o

   higher prices in dark pools would suck liquidity out o — conventional exchanges, making it harder and more expensive — or retail investors to conduct trades.”).

2. Michael C. Schouten, The Case

   or Mandatory Ownership Disclosure, 15 STAN. J.L. BUS. & FIN. 127, 142 n.64 (2009) (“Not surprisingly, dark pools are increasingly raising transparency concerns.”).

3. William A. Birdthistle & M. Todd Henderson, Becoming a Fi

   th Branch, 99 CORNELL L. REV. 1, 68 (2013) (“There is a growing phenomenon o — securities being traded in so-called dark pools.”).

4. Sam Mamudi, Dark Pools: Private Stock Trading vs. Public Exchanges, BLOOMBERG QUICKTAKE, http://www.bloombergview.com/quicktake/dark-pools (last updated Feb. 1, 2016).

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The private stock market is  --- ragmented into approximately  --- i --- ty individual marketplaces, commonly called “dark pools,” that are owned and operated by the world’s largest banks.173 The percentage o ---  stock trades that happen in private dark pools, not on public stock markets, is rising sharply, as the  --- igure above illustrates.174 Critics argue that higher dark-pool trading results in lower market quality, including more volatility, lower liquidity, and rampant opportunism.175 Wrongdoing is clearly occurring in dark pools. Despite di ---

iculty policing these secret trading environments, SEC investigations have — ound massive banks like UBS privileging certain market participants over others.176 The Rule 144A venture stock resale market is really just a series o —

transactions in small,

ragmented markets which are very similar to what are traditionally re — erred to as dark pools. These 144A resales are virtually invisible to regulators like the SEC.177 Market participants cannot learn the price o — securities traded in dark pools because there is no price disclosure mechanism. The price disclosure problem is more pronounced in private-stock markets because there is no public- exchange price to help determine the private-market price. This is particularly harm — ul to employees and smaller investors who have less access to private bankers, valuation — irms, or other sources o —

in

ormation that can help value private securities. Dark pools and other over-the-counter (o —

-market) transactions are a predictable consequence o — inadequate markets. Even though these markets have high transaction — ees, limited ability to provide price discovery, hard-to-detect opportunism, and other disadvantages,178 they

1. Robert Lenzner, Dark Pools Fragment the Stock Market into 50 Private Stock Markets, FORBES: INV. (June 27, 2014, 12:08 PM), http://www. — orbes.com/sites/ robertlenzner/2014/06/27/dark-pools- — ragment-the-stock-market-into-50-private-stock- markets/.
2. Mamudi, supra note 172.

3. See, e.g., Memorandum

   rom Cristie L. March, Senior Adviser, O —

ice o — the Chairman to File No. S7-02-10 (Apr. 10, 2013), http://www.sec.gov/comments/s7-02- 10/s70210-396.pd — [http://perma.cc/GR33-L7W3].

1. Press Release, U.S. Sec. & Exch. Comm’n, SEC Charges UBS Subsidiary with Disclosure Violations and Other Regulatory Failures in Operating Dark Pool (Jan. 15, 2015), http://www.sec.gov/news/pressrelease/2015-7.html (“An SEC examination and investigation o — UBS revealed that the — irm — ailed to properly disclose to all subscribers the existence o — an order type that it pitched almost exclusively to market makers and high- — requency trading — irms.”).
2. BROWN, supra note 166, at 116 (“A dark pool is an anonymous crossing network that allows institutions to hide their orders — rom the marketplace.”).
3. The Congressional Research Service’s report, Dark Pools in Equity Trading, lists

ive regulatory concerns: market — ragmentation, — airness and access, price manipulation,

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1050 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

are growing because they remain better than any available alternatives.

 3.   Trading in O ---

shore Stock Markets

I ---  they do not want to transact in dark pools, QIBs can convince management to list their stock on a  --- oreign “venture exchange,” such as the Alternative Investment Market (“AIM”) in London. When stock is traded o ---

shore, the SEC cannot protect American investors. These venture exchanges have been described as “a market — or lemons”179 and the “Wild West”180 by scholars and regulators. This sort o — international “regulatory dualism”181 or “regulatory arbitrage”182 diminishes the e —

ectiveness o — any domestic regime. Moreover, empirical studies have shown that listing outside the United States diminishes shareholder value.183 This is particularly problematic here, where the largest and wealthiest investors can obtain liquidity by listing outside the United States at the expense o — smaller and poorer investors and employees

improper trade, and lack o

price discovery. GARY SHORTER & RENA S. MILLER, CONG. RESEARCH SERV., R43739, DARK POOLS IN EQUITY TRADING: POLICY CONCERNS AND RECENT DEVELOPMENTS 6−8 (2014), https://www. — as.org/sgp/crs/misc/R43739.pd — .

1. Cécile Carpentier & Jean-Marc Suret, Entrepreneurial Equity Financing and Securities Regulation: An Empirical Analysis, 30 INT’L SMALL BUS. J. 41, 41 (2010) (“The quality o —

irms, their post-listing operating per — ormance and strategy, and their — ate largely support the opinion that strong listing requirements are essential to prevent the emergence o — a lemon market.”).

1. Aguilar, supra note 15 (“Scandals involving some ECM companies only cemented the exchange’s reputation as a lawless Wild West.”).
2. Ronald J. Gilson, Henry Hansmann & Mariana Pargendler, Regulatory Dualism as a Development Strategy: Corporate Re — orm in Brazil, the United States, and the European Union, 63 STAN. L. REV. 475, 478 (2011) (“Regulatory dualism seeks to avoid, or at least mitigate, the Olson problem by permitting the existing business elite to be governed by the prere — orm regime, while pursuing development by allowing other businesses to be governed by a re — ormed regime. Put in terms o — capital market and shareholder protection, regulatory dualism establishes a new and more rigorous shareholder protection regime, operating parallel to the existing one, that is open to any new or existing — irm that wishes to make use o — it.”).

3. Amir N. Licht, Regulatory Arbitrage

   or Real: International Securities Regulation in a World o — Interacting Securities Markets, 38 VA. J. INT’L L. 563, 567 (1998) (“Regulatory arbitrage traditionally indicates a phenomenon whereby regulated entities migrate to jurisdictions imposing lower regulatory burdens. By doing so they exert a downward pressure on those jurisdictions that want to retain the regulated activity within their borders.”).

4. Id. at 634 (“Notwithstanding the above, a certain amount o

   support may be — ound in the results o — expected returns tests o —

oreign listings incoming to the United States versus those outgoing — rom the United States. As a broad generalization, the — ormer systematically tend to increase shareholder value whereas the latter tend to do the opposite and exhibit negative abnormal returns.”).

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who cannot access those markets and whose shares also have an illiquidity discount.184 Listing on o —

shore stock markets also creates a number o — problems

or the issuing company. The most signi — icant problem is the massive transaction costs that a U.S. company will spend to list on a — oreign stock exchange in order to understand and comply with — oreign regulatory regimes.185 Furthermore, this solution exacerbates the illiquidity discount asymmetry problem because it is more di —

icult — or smaller stockholders to — ind an international broker willing to sell just a

ew shares on a — oreign stock exchange than it is — or a larger stockholder to — ind a broker willing to make a large block sale.186

       PART III. DEMOCRATIZING PRIVATE STOCK EXCHANGES

New securities regulations unintentionally encourage startups to stay private. Staying private creates a number o ---  problems that hurt smaller investors, devalue employee stock options, create systemic risks, and threaten to break the startup  --- inancing cycle. One solution could be to reverse these new securities regulations. Many scholars have advanced the position that SOX and Dodd-Frank are bad laws,187 but as one o ---  SOX’s most  --- ervent critics points out, “[c]ongressional repeal o ---  SOX’s corporate governance mandates is not on the near-term political horizon.”188
Moreover, SOX and Dodd-Frank are not the only reasons why companies are staying private. Even be --- ore SOX and Dodd-Frank, going

1. See Schwartz, supra note 153, at 543 (“[F]orcing U.S. investors to look abroad

   or U.S. companies undermines investor protection.”).

2. Id. at 542 (“The key issue is that going overseas involves signi

   icant transaction costs.”).

3. Steven M. Davido

, Regulating Listings in a Global Market, 86 N.C. L. REV. 89, 136–37 (2007).

1. See, e.g., Bainbridge, supra note 53, at 1821 (“Like their predecessors in SOX, the six key corporate governance provisions o — Dodd-Frank satis — y the key criteria o — quack corporate governance.”); Kristin N. Johnson, Things Fall Apart: Regulating the Credit De — ault Swap Commons, 82 U. COLO. L. REV. 167, 242 (2011) (“[T]he Dodd-Frank Act leaves much to be desired.”); Ribstein, supra note 37, at 3 (“Post-Enron re — orms, including Sarbanes-Oxley, rely on increased monitoring by independent directors, auditors, and regulators who have both weak incentives and low-level access to in — ormation. This monitoring has not been, and cannot be, an e —

ective way to deal with — raud by highly motivated insiders. Moreover, the laws are likely to have signi — icant costs . . . .”); Romano, supra note 53, at 1602 (“An extensive empirical literature suggests that those mandates were seriously misconceived, because they are not likely to improve audit quality or otherwise enhance — irm per — ormance and thereby bene — it investors as Congress intended.”).

1. Romano, supra note 53, at 1602.

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1052 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

public was expensive not just once but on an on-going basis to comply with the Securities Act and the Exchange Act. In addition to the cost o —

complying with those laws, going public also risks subjecting the company and its management to whatever additional regulations Congress demands a — ter the next crisis. Staying private also o —

ers many bene — its. Private-company managers have more — reedom and less liability.189 VCs get protected access to a rare and valuable class o —

assets. Private startups have more

lexibility with pricing their employee stock options. And there is a certain allure to being private that is ameliorated when securities regulations require a public company to “open the kimono” at least every three months. This Article there — ore does not recommend a reactionary response to securities laws. Indeed, in other work I argue that crowd — unding is inherently di —

erent — rom traditional — undraising, and so it requires progressive new approaches.190 Rather, this Part proposes a new sa — e- harbor exemption that allows — or domestic private stock exchanges to

acilitate transactions o — private-company stock. Such a rule would have three primary bene — its. First, it would give employees access to a domestic venture exchange that is transparent, liquid, and — air. Second, it would encourage QIBs to transact on venture exchanges instead o — in unregulated dark pools. Third, it would move transactions — rom o —

shore locations to American soil, where the lemons and Wild West problems can be mitigated by SEC oversight. This Article also acknowledges that a domestic “venture exchange” could be problematic by creating an environment where investors can trade stock about which they have no good in — ormation. This problem is exacerbated where investors only have a small stake in each company and there — ore are “rationally apathetic” about monitoring their investment. Fortunately, this problem can be addressed. In public markets, rational apathy is countered somewhat by analysts whose pro — ession is to monitor and report on public companies. This distributes the cost o — monitoring across all investors who purchase the report. The problem in venture exchanges—and in small-cap public- company stocks—is the lack o — analyst coverage on listed companies.

1. Consider,

   or example, how Twitter CEO Dick Costolo was — orced to retire by shareholders who were upset that Twitter was not growing revenue — ast enough. Erin Gri —

ith, Where Did Dick Costolo Go Wrong?, FORTUNE (June 12, 2015, 6:44 AM), http:// — ortune.com/2015/06/12/twitter-ceo-dick-costolo-resigns/. When the company was private, Costolo was subject only to scrutiny by a — ew VCs and — ounder Jack Dorsey. Id.

1. See generally Seth C. Oranburg, A Place o

   Their Own: Crowds in the New Market

or Equity Crowd — unding, 100 MINN. L. REV. HEADNOTES 147 (2016), http://www. minnesotalawreview.org/wp-content/uploads/2016/08/Oranburg-FINAL.pd — .

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This Article’s proposed Rule 144B addresses that problem by instituting a private independent analyst (“PIA”) who must monitor and report to shareholders on each company listed on a 144B domestic venture exchange. This Part explains how the 144B market will be de — ined by two characteristics. First, Rule 144B would allow — or the development o —

stock exchanges—unlike Rule 144A which only allows

or stock markets—that do not restrict access to the stock exchange based on wealth. This “equal access” principle is necessary to reduce or remove the illiquidity discount asymmetry. Second, all companies listed on a 144B exchange must have a PIA. The PIA shall have access to board meetings and books and records, much like a VC would, but unlike a VC the PIA cannot have any interest in the stock price. This Part will discuss criticism and limitations o — a 144B market.

A. Venture Exchanges

This Article recommends a new securities regulation  --- ostering a domestic venture exchange. To be clear, there already exists a domestic venture market  --- or the resale o ---  startup stock that is legal under current regulations. But the existing “Rule 144A Market” is merely an in --- ormal market, not a structured exchange. A market is any sort o ---

system, institution, process, relationship, or in

rastructure where market participants can trade goods, services, or in — ormation — or money or other goods, services, or in — ormation.191 Market participants consist o — buyers and sellers who set prices based on supply and demand.192 The price re — lects the true value o — the thing that is traded only when the market is e —

icient and per — ectly competitive.193 Market ine —

iciencies include time-inconsistent pre — erences,194 in — ormation

1. See JEFFREY M. PERLOFF, MICROECONOMICS 3 (Donna Battista et al. eds., 5th ed. 2009).
2. Id. at 11–26.

3. This is called the e

icient-market hypothesis, a theory in — inancial economics which states that the price re — lects all the available in — ormation about a stock. Burton G. Malkiel, The E —

icient Market Hypothesis and Its Critics 3 (Princeton Univ., CEPS Working Paper No. 91, 2003), https://www.princeton.edu/ceps/workingpapers/91malkiel. pd — . No real-world markets are per — ectly e —

icient, however, and the price only re — lects the value to the extent that markets are e —

icient. Id. at 3−4.

1. See Manual A. Utset, Corporate Actors, Corporate Crimes and Time-Inconsistent Pre — erences, 1 VA. J. CRIM. L. 265, 276–77 (2013) (“It turns out that individuals become increasingly impatient the closer that they get to immediate payo —

s; or, equivalently,

rom a short-term perspective they discount immediate payo —

s by a greater amount than they did when those payo —

s were all still in the — uture. It is this asymmetry between long- term and short-term impatience that leads people to procrastinate and overconsume.”

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asymmetries,195 principal-agent problems,196 externalities,197 or public goods.198 Per — ect competition requires a large number o — buyers and sellers.199 Without e —

iciency and competition, the market price is distorted. A — inancial market is a market — or trading o — securities (like stock and bonds), currencies, — ungible commodities, derivatives, — utures, insurance, and other — inancial products. Financial market transactions can occur either on or o —

an exchange. An o —

-exchange, or over-the- counter (“OTC”) transaction, is done directly between two parties.200 In

(

ootnote omitted)).

1. Ian Ayres & Robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory o — De — ault Rules, 99 YALE L.J. 87, 102 n.68 (1989) (“In the economics literature several articles examine situations in which asymmetric in — ormation induces ine —

icient contracting.”).

1. Robert Sitko

, The Economic Structure o — Fiduciary Law, 91 B.U. L. REV. 1039, 1040 (2011) (“[A]n agency problem arises whenever one person, the principal, engages another person, the agent, to undertake imper — ectly observable discretionary actions that a —

ect the wealth o — the principal. The concern is that in exercising this unobservable discretionary authority, the agent will — avor the agent’s interests when the agent’s interests diverge — rom those o — the principal.” ( — ootnote omitted)).

1. Externalities are costs or bene

   its con — erred upon others that are not taken into account by the person taking the action. See generally A. C. PIGOU, THE ECONOMICS OF WELFARE (4th ed. 1932).

2. Wendy J. Gordon, Fair Use as Market Failure: A Structural and Economic Analysis o — the Betamax Case and Its Predecessors, 82 COLUM. L. REV. 1600, 1610–11 (1982) (“A public good is o — ten described as having two de — ining traits. First, it is virtually inexhaustible once produced, in the sense that supplying additional access to new users would not deplete the supply available to others. Second, and more important — or the instant purposes, persons who have not paid — or access cannot readily be prevented — rom using a public good. Because it is di —

icult or expensive to prevent ‘ — ree riders’ — rom using such goods, public goods usually will be under-produced i — le — t to the private market. A

amiliar example o — a public good is national de — ense.” ( — ootnotes omitted)).

1. On the other hand, a market with a single seller is a monopoly, and a market with a single buyer is a monopsony, which “are the polar opposites o — per — ect competition.” ROBERT S. PINDYCK & DANIEL L. RUBINFELD, MICROECONOMICS 349 (7th ed. 2009). Some have even suggested that a market with only a single buyer and a single seller is not a market at all. ARTHUR O’SULLIVAN & STEVEN M. SHEFFRIN, ECONOMICS: PRINCIPLES IN ACTION 28 (2003).

2. See Henry T.C. Hu, Misunderstood Derivatives: The Causes o

   In — ormational Failure and the Promise o — Regulatory Incrementalism, 102 YALE L.J. 1457, 1458−59, 1464−67 (1993) (“Innovation has been especially striking in the market — or over-the- counter (OTC) derivatives, a type o —

inancial contract individually negotiated among major — inancial institutions and between such institutions and their sophisticated clients.” ( — ootnotes omitted)); Arthur E. Wilmarth, Jr., The Trans — ormation o — the U.S. Financial Services Industry, 1975−2000: Competition, Consolidation, and Increased Risks, 2002 U. ILL. L. REV. 215, 333 n.486 (“Exchange-traded derivatives are standardized contracts, including — utures and options based on commodities and stock indexes, that are traded on an organized exchange and are governed by the rules o — that exchange. In contrast, OTC derivatives are contracts that are individually negotiated between a ‘dealer’ (typically a

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OTC

inancial markets, buyers and sellers must incur searching costs and opportunity costs to — ind each other and then incur transaction costs to complete the trade.201 OTC market transactions may be private, in which case there is no price discovery process, and again price may be distorted.202 Venture transactions today occur mainly in OTC markets. The call — or a “144B” venture-exchange sa — e harbor, in addition to the “144A” venture OTC-market sa — e harbor, is solidly grounded in legal and economic theories and empirical evidence that exchanges are superior to OTC markets. Exchanges can solve — ree rider problems and coordination problems that OTC markets cannot.203 Even i — markets can

money center bank, a large securities

irm, or a major insurance company) and an ‘end- user’ (usually a smaller — inancial institution, business — irm, or investor that wishes to buy the derivatives either — or speculation or — or hedging against risks arising out o — its operations or its investment port — olio). Thus, OTC derivatives, such as — orwards, options, and swaps, are highly customized instruments and are not traded in any organized secondary market.”); see also ALFRED STEINHERR, DERIVATIVES: THE WILD BEAST OF FINANCE 170−223, 237−38 (1998); Peter H. Huang, A Normative Analysis o — New Financially Engineered Derivatives, 73 S. CAL. L. REV. 471, 485 (2000); Roberta Romano, A Thumbnail Sketch o — Derivative Securities and Their Regulation, 55 MD. L. REV. 1, 7−31, 40−51 (1996).

1. Darrell Du

ie, Nicolae Garleanu & Lasse Heje Pedersen, Over-the-Counter Markets, 71 ECONOMETRICA 1815, 1815 (2005) (“In over-the-counter markets, an investor who wishes to sell must search — or a buyer, incurring opportunity or other costs until one is — ound. Some over-the-counter (OTC) markets there — ore have intermediaries. Contact with relevant intermediaries, however, is not immediate. O — ten, intermediaries must be approached sequentially. Hence, when two counterparties meet, their bilateral relationship is inherently strategic. Prices are set through a bargaining process.”).

1. For example, OTC

   inancial markets — or credit derivatives, commercial paper, municipal bonds, securitized student loans, and other products became di —

icult to value in the — inancial crisis o — 2007–2009, which led to a downward spiral o — illiquidity, which

urther inhibit price discovery, which then increased illiquidity, under which entire markets seized up and became dys — unctional. See Randall Dodd, Markets: Exchange or Over-the-Counter, INT’L MONETARY FUND, http://www.im — .org/external/pubs/ — t/ — andd/ basics/markets.htm (last updated Mar. 28, 2012) (“Without liquid and orderly markets, there was no price discovery process and in turn no easy and de — initive way to value the securities. The — ailure o — the price discovery process aggravated the problems at banks and other — inancial — irms during the recent crisis by making it more di —

icult to meet disclosure and reporting requirements on the value o — their securities and derivatives positions. Not only were there no e —

icient direct market prices, there were o — ten no benchmark prices (which are prices o — assets similar to the one being valued). As a result, the assets and positions that were once valued at market prices were instead valued through models that sometimes were not adequately in — ormed by benchmark prices. These valuation problems — urther depressed prices o — a —

ected securities.”).

1. Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 YALE L.J. 2359, 2399 (1998) (“Exchanges can solve — ree rider problems concerning in — ormation production encountered by individual — irms, as well as coordination problems presented by investors’ need — or standardized disclosure. Thus

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be only relatively and not

ully e —

icient,204 exchanges are more e —

icient than OTC markets.205 The SEC’s power to police OTC transactions is more limited than its power to police exchange transactions.206 Private litigants may be deprived o — “ — raud-on-the-market” claims in OTC markets.207 Empirical economic studies strongly support the claim that exchanges like the NYSE are e —

icient markets.208 Exchanges produce valuable in — ormation as a byproduct o — market trading.209 Exchanges are more resilient and less prone to systemic — ailure than OTC markets.210 And exchanges and OTC markets compete with each other, making both — unction more e —

iciently.211

exchanges could replace the government as the solution to a securities market

ailure.”).

1. Je

rey N. Gordon & Lewis A. Kornhauser, E —

icient Markets, Costly In — ormation, and Securities Research, 60 N.Y.U. L. REV. 761, 830 (1985) (“I — markets are only relatively e —

icient, as we expect, then it is wrong to regard the search — or undervalued securities by institutional investors as irrational behavior.”).

1. Donald C. Langevoort, Theories, Assumptions, and Securities Regulation: Market E —

iciency Revisited, 140 U. PA. L. REV. 851, 873 n.70 (1992) (“By hypothesis, the over-the- counter markets are presumed to be less e —

icient because o — the lower levels o — liquidity and pro — essional investor/analyst interest.”).

1. See Securities Exchange Act o

   1934 § 15, 15 U.S.C. § 78o (2012), amended by Pub. L. No. 114-94, 129 Stat. 1312 (2015).

2. See Brad

   ord Cornell & R. Gregory Morgan, Using Finance Theory to Measure Damages in Fraud on the Market Cases, 37 UCLA L. REV. 883, 918 (1990) (noting that the de — endants’ argument regarding the — raud-on-the-market theory o — reliance was inappropriate because the securities were traded in the over-the-counter market, not on a stock exchange).

3. Eugene F. Fama, E

icient Capital Markets: A Review o — Theory and Empirical Work, 25 J. FIN. 383, 416 (1970) (“In short, the evidence in support o — the e —

icient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is sparse.”).

1. Ronald J. Gilson & Reinier H. Kraakman, The Mechanisms o

   Market E —

iciency, 70 VA. L. REV. 549, 609 (1984) (“This [historical price] in — ormation is an ordinary byproduct o — market trading: the organized securities exchanges produce it as a routine service, and the — inancial press serves to collectivize its low cost dissemination.” ( — ootnote omitted)).

1. SEC Legislation, 1963: Hearings on S. 1642 Be

   ore the Subcomm. o — the S. Comm. on Banking & Currency, 88th Cong. 12 (1963) (statement o — William L. Cary, Chairman, U.S. Securities and Exchange Commission) (“It is well known that the over-the-counter market has not shown the same resiliency since that sharp decline as the exchange markets, both in terms o — price and o — volume.”).

2. John C. Co

ee, Jr., Regulating the Market — or Corporate Control: A Critical Assessment o — the Tender O —

er’s Role in Corporate Governance, 84 COLUM. L. REV. 1145, 1257 (1984) (“Increasingly, the stock exchanges are in competition with the over-the- counter market, where the emergence o — a computerized inter-dealer quotation system gives issuers an inviting alternative to the exchanges.”); Paul G. Mahoney, The Exchange as Regulator, 83 VA. L. REV. 1453, 1457 (1997) (“As a provider o — liquidity, an exchange competes with other exchanges and over-the-counter markets, both to attract companies to list and to induce investors to purchase listed securities.”).

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Considering the many bene --- its o ---  exchanges over OTC markets, it is curious that the SEC has not already acted to create a domestic venture exchange. One explanation  --- or the SEC’s inaction is regulatory capture o ---  the SEC by the wealthiest  --- irms who bene --- it  --- rom the illiquidity discount asymmetry and pro --- it  --- rom the lack o ---  an equal-access venture exchange.212 Regulatory capture typically results in policies that  --- avor a concentrated and power --- ul interest group.213 The lack o ---  a rule like the proposed Rule 144B may simply re --- lect that such a rule would bene --- it a diverse, heterogeneous, disempowered group, like startup employees and poorer stockholders.
Another explanation  --- or the lack o ---  an equal-access venture- exchange rule is bounded rationality o ---  regulators.214 Many legal scholars have pointed out how the bounded rationality o ---  the SEC may inhibit that agency  --- rom promulgating  --- orward-looking regulations that help grow the economy (instead o ---  merely preventing the last crisis  --- rom occurring again).215 This line o ---  economic argument has legal implications, such as discouraging the use o ---  regulators to set prices.216

1. For an explanation o

   regulatory capture in the context o — corporate governance regulation, see William W. Bratton & Joseph A. McCahery, Regulatory Competition, Regulatory Capture, and Corporate Sel — -Regulation, 73 N.C. L. REV. 1861, 1885–86 (1995) (“Under capture theories o — regulation, interest groups and political decision makers enter into jointly maximizing relationships. The simple demand model o — capture asserts that lawmaking — ollows the lawmakers’ responses to demand patterns. Particular responses depend on interactions between the lawmakers’ risk pro — iles and the projected bene — its o —

legislative action. The lawmaker, being risk averse, tries to avoid con

licts—given no demand — or legislation, nothing is done; given organized demand, the lawmaker attempts to satis — y the interest group making the demand with bene — icial legislation. In addition, interest groups desiring to in — luence legislation encounter collective action problems. Di —

erent groups have di —

erent abilities to overcome them—the smaller the group and the higher the per capita stake o — its members, the greater the likelihood that the members will work out a collective arrangement and enjoy the bene — its o — governmental in — luence. This activity results, according to the theorists o — the Virginia School, in a social loss — rom rent-seeking. Legislators create rents — or the bene — it o — success — ul interest groups, distributing them based on a sel — -seeking vote calculus.” ( — ootnotes omitted)).

1. See Gary S. Becker, A Theory o

   Competition Among Pressure Groups — or Political In — luence, 98 Q.J. ECON. 371, 372 (1983) (explaining how regulatory capture in — luences public policy).

2. Bounded rationality generally means that humans have limited cognitive abilities and there — ore must rely or heuristics and other mental shortcuts to make decisions. See Herbert A. Simon, A Behavioral Model o — Rational Choice, 69 Q.J. ECON. 99, 99 (1955); see also Russell B. Korobkin & Thomas S. Ulen, Law and Behavioral Science: Removing the Rationality Assumption — rom Law and Economics, 88 CALIF. L. REV. 1051, 1069 (2000) (“This ‘bounded rationality’ results — rom the high cost o — processing in — ormation, the cognitive limitations o — human beings, or a combination o — the two.”).

3. See, e.g., Stephen M. Bainbridge, Mandatory Disclosure: A Behavioral Analysis, 68 U. CIN. L. REV. 1023, 1057–58 (2000) (“[L]egislators and regulators are no less subject to bounded rationality and other cognitive biases than any other decisionmakers.”); Stephen

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I ---  the regulatory capture and bounded rationality explanations are true, it may be di ---

icult — or the SEC to create a rule like the proposed 144B. But a di —

erent explanation may better explain SEC behavior and

rame the solution. The SEC may have recognized that investors su —

er

rom cognitive — ailings.217 It could be di —

icult — or the SEC to — ul — ill its mission o — “protecting investors” i — it were to permit a domestic venture exchange in which investors could employ — lawed heuristics to make bad decisions. One must ask whether the SEC is — orbidding a venture exchange in order to protect investors — rom — raud or simply to protect investors — rom themselves. The — ormer explanation re — lects appropriate agency behavior. The latter “smacks o — an unthinking paternalism that reveals its own institutional shortcomings.”218 This Article assumes that the SEC is capable o — overcoming regulatory capture and bounded rationality, i — any, provided that a proposed rule like 144B has su —

icient protections — rom — raud. The next Subpart analyzes why — raud occurred in other venture exchanges and then proposes employing a PIA as a solution to mitigate — raud and help investors make better decisions in 144B exchange transactions.

B. Private Independent Analysts

The SEC has good reason to be concerned about  --- raud in secondary private stock marketplaces. SEC Commissioner Aguilar said: “Venture exchanges are hardly a new idea, however, and prior e ---

orts to establish them in this country have — ared poorly. Accordingly, we need a thought — ul and prudent approach that care — ully examines why the prior attempts — ailed” because “[t]hose who cannot remember the past are condemned to repeat it.”219 This Subpart will explain why prior

J. Choi & A.C. Pritchard, Behavioral Economics and the SEC, 56 STAN. L. REV. 1, 25 (2003) (“Closely related to bounded rationality are the heuristics that regulators use to manage the deluge o — in — ormation and problems stemming — rom the — inancial markets. Like investors, regulators su —

er — rom the availability heuristic, — ocusing too much attention on recent and immediately available in — ormation.”).

1. Edward L. Rubin, Commentary, The New Legal Process, the Synthesis o

Discourse, and the Microanalysis o

Institutions, 109 HARV. L. REV. 1393, 1431 (1996) (“Li — eline banking may be a promising idea, but the bounded rationality o — banking regulators may render them unable to set prices at the proper level.”).

1. Choi & Pritchard, supra note 215, at 71 (“The evidence that investors su

er — rom cognitive — ailings is impressive.”).

1. Richard A. Epstein, Regulatory Paternalism in the Market

   or Drugs: Lessons — rom Vioxx and Celebrex, 5 YALE J. HEALTH POL’Y L. & ETHICS 741, 748 (2005) (“Protection against — raud is one thing; paternalism, whether or not intended, is quite another.”).

2. Id.

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attempts

ailed and provide a solution to prevent such — ailures in the

uture. Venture stock exchanges have been — ailed experiments across the globe. The only domestic venture exchange, the American Stock Exchange Emerging Company Marketplace, launched on March 18, 1992 and closed on May 11, 1995, ending in what can only be described as a “ — ailure.”220 Overseas, the French Nouveau Marché launched in 1996, the German Neuer Markt launched in 1997, and the Italian Nuovo Mercato launched in 1999 “to attract early stage, innovative and high-growth — irms that would not have been viable candidates — or public equity — inancing on the main markets o — European stock exchanges.”221 Instead, “[i]nsider trading scandals and accounting — rauds tarnished the reputation o — new markets. As a result, investor con — idence quickly disappeared.”222 The — ailure o — venture exchanges can be attributed to the — act that listed companies have the worst o — corporate governance problems o —

both private corporations and public corporations, with

ew o — the bene — its. On the one hand, exchange participants lack the investor protections typically — ound in VC arrangements, such as active monitoring and restrictive covenants, that protect against in — ormation asymmetries and entrepreneurs’ opportunism. On the other hand, exchange participants lack the in — ormation typically provided by public- company listing requirements. The in — ormation problem is compounded by the — act that exchanges may lack incentives to require their listed companies to make disclosures or to police those disclosures — or completeness and accuracy. To — rame this argument in more theoretical terms, a VC- — unded company allocates a disproportionate amount o — control to its VC owners.223 In addition to these contractual VC control rights, VCs also control their port — olio companies through staged — inancing.224 The VC-

1. Aggarwal & Angel, supra note 125, at 258.

2. Pre

   ace to 10 THE RISE AND FALL OF EUROPE’S NEW STOCK MARKETS ix (Giancarlo Giudici & Peter Roosenboom eds., 2004).

3. Id.
4. Gilson, supra note 82, at 1096 (“In the United States, the venture capital contracting structure turns the Berle-Means problem on its head. Instead o — assuming less control than their proportion o — equity would dictate, venture capital investors in the United States take greater control positions than their proportion o — equity. Not only do they obtain veto rights over major decisions, retain the continuation decision, and o — ten control a majority o — the board, but they also retain the right to terminate the entrepreneur.”).

5. Id. at 1074 (“[S]taged

   inancing in e —

ect delegates to the investors, in the — orm o —

the decision whether to provide additional

inancing, the decision whether to continue the

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1060 RUTGERS UNIVERSITY LAW REVIEW[Vol. 68:101313

unded company thus stands in sharp contrast to the Berle-Means corporation, where there is the endemic problem o — the separation o —

ownership and control.225 The VC-

unded company is also di —

erent — rom a nexus-o — -contract public company because VCs have the authority and tools to deal with excessive agency costs.226 The advantages that VC-

unded companies have in dealing with agency problems are lost when the VC sells shares on an exchange to third parties that are not in privity with the issuer. Without privity, investors may lack the contractual power to discipline management, the ability to in — luence management through staged investment, and the tools to monitor management. Instead o — taking on the worst problems o — both VC- — unded and publicly-traded companies, the 144B exchange could be used to incentivize corporations seeking liquidity to adopt corporate governance that re — lects their most success — ul practices. There — ore, the crux o — the 144B exchange must be to return the power o — monitoring and disciplining management to the stockholders. This can be accomplished by installing a quasi-VC called the PIA. The PIA would represent the shareholders on the venture exchange much like a VC manager represents the members o — its VC — und, except the PIA’s compensation is not based on stock per — ormance. Rule 144B could require all companies listed on a 144B exchange to provide contractual control rights to the PIA, similar to those — ound in VC contracts. For example, the PIA would have the right to attend board meetings, vote on

undamental corporate transactions (including mergers, major acquisitions, and sales o — substantially all assets), prevent the company

company’s project.”).

1. Id. at 1073–74 (“In direct contrast to the

   amiliar Berle-Means governance structure o — outside investors having disproportionately less control than equity, the governance structure o — a venture capital-backed early stage, high technology company allocates to the venture capital investors disproportionately greater control than equity. It is common — or venture capital investors to have the right to name a majority o — a port — olio company’s directors even though their stock represents less than a majority o — the port — olio company’s voting power. Additionally, the port — olio company will have the bene — it o — a series o — contractual negative covenants that require the venture capital investors’ approval be — ore the port — olio company can make important business decisions, such as acquisition or disposition o — signi — icant amounts o — assets, or a material deviation

rom the business plan.” ( — ootnote omitted)).

1. Frank H. Easterbrook & Daniel R. Fischel, The Proper Role o

   a Target’s Management in Responding to a Tender O —

er, 94 HARV. L. REV. 1161, 1171 (1981) (“The

ree riding problems that inhibit monitoring by shareholders are aggravated by the di —

iculty any shareholder would — ace in doing anything about the — irm’s managers once he discovered the existence o — excessive agency costs. The shareholder who makes the discovery has no authority to compel the — irm to change its ways.”).

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rom issuing more stock, prevent the company — rom taking on a large senior debt, and vote on management salaries. In addition to contractual control rights that are similar to what a VC would receive, the PIA would also have responsibilities to produce valuable public in — ormation. In the public-company context, stock analysts review publicly available in — ormation and o — ten have private access to corporate management.227 The analyst reviews corporate and systemic in — ormation and reports whether the company is correctly valued by its stock price. This is a valuable service because it centralizes e —

orts that would otherwise have to be duplicated by all stockholders. This reduces the cost o — monitoring a corporation and reduces shareholders’ rational apathy problems. Analyst reports are integral to overcoming corporate governance problems, but it is hard — or smaller — irms to attract analyst coverage.228 By requiring 144B exchange-traded companies to produce analyst reports, the micro-cap companies on 144B exchanges could actually have — ewer corporate governance problems than small-cap companies on national stock exchanges. The PIA concept is rein — orced by the real-world example o — the advisors and brokers (called nominated advisors or “Nomads”) that are required by the world’s most success — ul venture exchange, the AIM.229

1. One problem public stock analysts

   ace is that their private access may be cut o —

i —

they issue negative reports. See, e.g., Bernard S. Black, Shareholder Passivity Reexamined, 89 MICH. L. REV. 520, 602 (1990) (“Companies o — ten cut o —

access — or stock analysts who issue negative reports.”). This is a problem that would be solved in the 144B exchange, where analyst access is a prerequisite — or listing.

1. Marcel Kahan & Edward Rock, The Insigni

   icance o — Proxy Access, 97 VA. L. REV. 1347, 1369–70 (2011) (“But when a company — alls below the $300 million market cap, it is extremely di —

icult to attract attention — rom analysts or investors. These — irms are lucky i —

a single analyst

ollows them. With so little attention, the market — or such companies’ shares is — ar less in — ormationally e —

icient than — or mid-cap or large-cap companies. Similarly, micro-cap companies present distinctive governance challenges.” ( — ootnotes omitted)); see also Joshua M. Koenig, A Brie — Roadmap to Going Private, 2004 COLUM. BUS. L. REV. 505, 512 (“In addition, many companies have been hurt by regulatory e —

orts to separate stock research — rom investment banking, which has led Wall Street to cut analyst coverage o — small-cap stocks.”).

1. The AIM lists over 1000 companies that have a combined market value (or total market capitalization) o — $115 billion and an average daily trading volume o — over $200 million. LONDON STOCK EXCH. GRP., AIM FACTSHEET (2015), http://www.londonstock exchange.com/statistics/historic/aim/aim-statistics-archive-2015/june-15.pd — . To put those

igures in context, the NYSE, which is the largest stock exchange in the world, has about 25,000 listed companies with a total market capitalization o — $20 trillion and an average daily trading volume o — over $3 billion, and NASDAQ has almost 30,000 listings with a total market capitalization o — $7 trillion and an average daily trading volume o — around $1.7 billion. Market Data Center, WALL ST. J., http://online.wsj.com/mdc/public/page/ 2_3021-tradingdiary2.html (last updated Apr. 8, 2016). But not all stock exchanges are so

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Scholars such as Pro

essor William K. Sjostrom, Jr. have explained how this AIM Nomad model has proved quite success — ul.230 The Nomad is responsible — or guaranteeing the quality o — the company to investors, and the broker is tasked with providing liquidity with “bid and ask prices.”231 Nomads include accounting — irms and investment banks that must be pre-approved by the London Stock Exchange.232 A Nomad determines a company’s suitability — or listing on AIM, manages the o —

ering process, and advises the company on regulatory matters.233 There is a market — or Nomads, where their reputation is their currency, which incentivizes Nomads to per — orm their role diligently.234

large: the NYSE and NASDAQ together are larger than the next ten largest exchanges combined. Andy Kiersz, The NYSE Makes Stock Exchanges Around the World Look Tiny, BUS. INSIDER (Nov. 18, 2014, 11:02 AM), http://www.businessinsider.com/global-stock- market-capitalization-chart-2014-11 (“[T]he two U.S. exchanges together have a larger market cap than the next ten exchanges combined.”). In — act, the AIM is about the same size as public national stock markets, including the Santiago Stock Exchange ($221 billion), the Tel Aviv Stock Exchange ($223 billion), and the Oslo Børs ($227 billion). Monthly Reports, WORLD FED’N OF EXCHANGES, http://www.world- exchanges.org/statistics/monthly-reports (last visited July 30, 2015). In other words, while the AIM is dwar — ed by the NYSE and NASDAQ, so are most o — the other stock exchanges in the world. The AIM, there — ore, is capable o — providing a level o — liquidity to private stockholders on par with the liquidity available to holders o — public stock listed on many other national exchanges. See AIM, LONDON STOCK EXCHANGE, http://www.londonstock exchange.com/companies-and-advisors/aim/aim/aim.htm (last visited Apr. 10, 2016).

1. William K. Sjostrom, Jr., Carving a New Path to Equity Capital and Share Liquidity, 50 B.C. L. REV. 639, 673–74 (2009).
2. Giancarlo Giudici & Peter Roosenboom, Venture Capital and New Stock Markets in Europe, in 10 THE RISE AND FALL OF EUROPE’S NEW STOCK MARKETS, supra note 221, at 16–17; see also Hse-Yu Chiu, Can UK Small Businesses Obtain Growth Capital in the Public Equity Markets?—An Overview o — the Shortcomings in UK and European Securities Regulation and Considerations — or Re — orm, 28 DEL. J. CORP. L. 933, 950 n.87 (2003) (“[T]he Alternative Investment Market run by the London Stock Exchange reduces costs

or small business issuers by requiring only a nominated broker and nominated adviser

or trading and compliance purposes.”); Stéphane Rousseau, London Calling?: The Experience o — the Alternative Investment Market and the Competitiveness o — Canadian Stock Exchanges, 23 BANKING & FIN. L. REV. 51, 60 (2007) (“AIM rules do not establish speci — ic requirements to be met by companies seeking admission. Rather they require that every company seeking admission appoint a nominated advisor (‘nomad’) and a broker.”).

1. LONDON STOCK EXCH., A GUIDE TO AIM 12 (2015), https://www.londonstock exchange.com/companies-and-advisors/aim/publications/ documents/a-guide-to-aim.pd — .
2. LONDON STOCK EXCH., AIM RULES FOR NOMINATED ADVISERS 8–10 (2014), http://www.londonstockexchange.com/companies-and-advisors/aim/publications/aim-rules-

or-nominated-advisers.pd — [http://perma.cc/JVQ8-3VUX].

1. Jose Miguel Mendoza, Securities Regulation in Low-Tier Listing Venues: The Rise o — the Alternative Investment Market, 13 FORDHAM J. CORP. & FIN. L. 257, 295 (2008) (“Speci — ically, Nomads bear signi — icant damages — or tolerating misdemeanors on behal — o —

their supervised companies, including the loss o

‘reputational capital.’”).

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Applying the PIA model to 144B exchanges potentially solves the most serious problem  --- aced by venture exchanges. Venture exchanges have a “market  --- or lemons”235 problem because companies typically use the venture exchange as a staging ground. The most success --- ul companies on a venture exchange may trans --- er to a better-regarded exchange in order to signal that the company is o ---  higher quality. But this also signals that the remaining  --- irms on the exchange are o ---  lower quality, which encourages the next best  --- irms to leave that exchange in order to separate themselves  --- rom that pooling equilibrium. This creates a downward spiral that ends with only the lowest quality

irms—the lemons—le — t on the venture exchange. The PIA model solves the lemons problem by trans — erring the quality signal — rom the exchange to the PIA. Having a highly regarded PIA approve a company sends a strong signal about — irm quality even i —

that

irm is trading on an exchange o — no repute. The — irm no longer has to leave the exchange in order to separate itsel —

rom low quality exchange participants because the 144B exchange creates a reputation market — or PIAs as well as — irms.236

C. Application

A highlight o ---  this Article’s 144B proposal is that this rule can be promulgated by the SEC without an act o ---  Congress. Generally, an agency may implement its delegated authority through rulemaking.237 When Congress explicitly delegates to an agency rulemaking authority to e ---

ectuate a statute, “[s]uch legislative regulations are given controlling weight unless they are arbitrary, capricious, or mani — estly contrary to the statute.”238 “[T]he [Exchange] Act con — erred [broad,] open-ended rulemaking authority on the SEC.”239 The JOBS Act also granted speci — ic rulemaking authority to the SEC to create new

1. See generally Darian M. Ibrahim, Equity Crowd

   unding: A Market — or Lemons?, 100 MINN. L. REV. 561 (2015).

2. This is similar to what has occurred in the AIM Nomad model. Mendoza, supra note 234, at 295–96 (“Accordingly, AIM can be considered a ‘reputational market,’ in which investors rely on the standing o — Nomads as a proxy — or the quality o — listed companies, rather than on the market’s regulation.”).

3. See John F. Manning, Constitutional Structure and Judicial De

   erence to Agency Interpretations o — Agency Rules, 96 COLUM. L. REV. 612, 664 (1996).

4. Chevron, U.S.A., Inc. v. Nat. Res. De

   . Council, Inc., 467 U.S. 837, 844 (1984).

5. Steve Thel, The Original Conception o

   Section 10(b) o — the Securities Exchange Act, 42 STAN. L. REV. 385, 394 (1990) (“The sophisticated, interested participants in the debates, as well as the authors o — the [Exchange] Act, understood that the Act con — erred open-ended rulemaking authority on the SEC.”).

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exemptions to securities regulations.240 General legal principles, rulemaking history, and speci — ic statutory language demonstrate that the SEC is authorized to promulgate Rule 144B. The SEC has authority to promulgate exemptions to securities regulations. The SEC promulgated the other exemptions to securities regulations—including Regulation D, Rule 144, and Rule 144A—under its rulemaking power.241 The recent and similar exemption, Rule 144A, was proposed by the SEC and adopted pursuant to the SEC’s notice- and-comment process, without any action by Congress.242 That Rule has never been challenged — or improper delegation or abuse o — agency power. It could even be argued that the SEC has an a —

irmative obligation to promulgate a venture-exchange, sa — e-harbor exemption. Section 503 o — the JOBS Act stipulates that “[t]he Commission shall also adopt sa — e harbor provisions that issuers can — ollow when determining whether holders o — their securities received the securities pursuant to an employee compensation plan in transactions that were exempt — rom the registration requirements o — section 5 o — the Securities Act o — 1933.”243 This command seems to direct the SEC to promulgate rulemaking, allowing employees to resell their exercised stock options. The employee-stock resale exemption as mandated by Congress would be

1. A. C. Pritchard, Revisiting “Truth in Securities” Revisited: Abolishing IPOs and Harnessing Private Markets in the Public Good, 36 SEATTLE U. L. REV. 999, 1001 (2013) (“Congress has partially addressed this problem with its recent adoption o — the Jumpstart Our Business Startups Act (JOBS Act). Unhappy with the SEC’s somewhat tepid e —

orts to — acilitate capital raising by smaller companies, Congress gave the SEC new authority to exempt o —

erings — rom the requirements — or registered o —

erings.”).

1. See James R. Doty, Toward a Reg. FCPA: A Modest Proposal

   or Change in Administering the Foreign Corrupt Practices Act, 62 BUS. LAW. 1233, 1234−35 (2007) (“Regulation D and Regulation S under the Securities Act o — 1933, Rules 144, 144A and 415 thereunder, and Regulation M under the Securities Exchange Act o — 1934 are all examples o — SEC rulemaking intended to provide clarity and de — inition in connection with the requirements o — the statutory scheme.” ( — ootnotes omitted)); see also Robert W. Tarun & Peter P. Tomczak, A Proposal — or a United States Department o — Justice Foreign Corrupt Practices Act Leniency Policy, 47 AM. CRIM. L. REV. 153, 170 (2010) (“Modeled a — ter precedent SEC regulation such as Regulation D and Rules 144 and 144A, Reg. FCPA would establish a permissive — iling regime, created through SEC rule-making . . . .”).

2. Resale o

   Restricted Securities; Changes to Method o — Determining Holding Period o — Restricted Securities Under Rules 144 and 145, Securities Act Release No. 6862, 46 SEC Docket 26 (Apr. 23, 1990) (“On October 25, 1988, the Commission proposed Rule 144A (the ‘Rule’) to provide a non-exclusive sa — e harbor exemption — rom the registration requirements o — the Securities Act o — 1933 (the ‘Securities Act’) — or speci — ied resales o —

restricted securities to institutional investors.” (

ootnote omitted)).

1. Jumpstart Our Business Startups Act, Pub. L. No. 112-106, § 503, 126 Stat. 306, 326 (2012) (codi — ied as amended in scattered sections o — 15 U.S.C.).

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2016] DEMOCRATIZING STARTUPS 1065

achieved by promulgating a rule like 144B. No such a

irmative obligation mandated Rule 144A, so the SEC’s authority — or Rule 144B is even stronger.

                            CONCLUSION

This Article has explained why staying private is antithetical to democratizing startups. Yet even the law that speci --- ically intends to democratize startups, the JOBS Act, has some provisions that encourage startups to stay private. This may seem schizophrenic, but staying private o ---

ers many economic advantages. Moreover, there are market — orces beyond securities regulations that also encourage startups to stay private. The problem is not that startups are staying private; rather, the problem is that securities laws have not adapted to this new reality. Staying private, in itsel — , is neither good nor bad. It is a trend that needs to be understood by scholars and applied to securities regulations. This trend is readily understandable in an environment where being public is quite expensive and burdensome. The law must produce bright-line solutions — or staying private in an evolving economy. Otherwise, companies will — ind their own solutions in the shadows. Securities regulations have not produced a coherent solution because there are trade-o —

s between — orming capital, protecting investors, and democratizing startups. Staying private — acilitates certain types o — capital — ormation but — rustrates the democratizing capability o — startups. Enabling startups to stay private encourages concentrated capital — ormation. The — lip side is that it discourages recycling capital in new and diverse enterprises. Capital — ormation may be enhanced by allowing new investors who are currently not permitted to buy private-company stock to invest in startups, but these investors are also the most susceptible to — raud, rational apathy, bounced rationality, and other cognitive — ailures. There has not yet been a solution that balances these equities in a resale market — or private- company stock. This Article suggests that a 144B sa — e-harbor exemption—a rule that the SEC can promulgate without an act o — Congress—provides — or an “independent analyst” to monitor and sa — eguard investments and strikes an acceptable balance. Without a resale exemption, small, private-company stockholders — ace many disadvantages. Yet a resale exemption subjects those same small stockholders to the risk o —

raud- on-the-market. One solution is to create a resale exemption that

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balances su

icient investor protections with limited disclosure requirements. The development o — liquid, transparent, and — air 144B exchanges — or the transaction o — private-company stock could — acilitate recycling o — capital and promote democratizing startups. An exemption like 144B expressly contemplates the development o —

multiple private-stock exchanges. Exchanges can experiment with various levels o — disclosure requirements and investor protections. The result could be a market — or stock markets where issuing startups, stockholders, and investors can shop around — or the optimal mix o —

sunlight and e

iciency. This — lexibility would help to keep securities regulations — rom becoming quickly outdated as the nature o — investment changes. The SEC could retain the right to permit only certain types o —

investors into certain markets based on risk o

the exchange, amount o —

investment, sophistication o

investor, age o — the issuing company, or other — actors. The concern — or the SEC is to avoid creating new — inancial asymmetries by giving the wealthiest investors exclusive access to the best markets, as it did with Rule 144A. Modernizing securities regulations to protect investors while capitalizing the — uture o — innovative startups requires a deeper review o — the entire body o — securities regulation, which is beyond the scope o —

this Article. For example, the accredited investor standard, which is based solely on wealth, could potentially be replaced by a more nuanced standard o — investor sophistication. Modern technology, like online

eedback tools and reputation networks, could provide novel solutions to eighty-year-old securities regulation problems. Promulgation o — Rule 144B could signal the beginning o — the SEC’s recognition o — a paradigm shi — t in business associations. By implementing a rule designed — or the continued operation o — large, private companies, the academy and the regulators can start to re — orm the securities regulations to accommodate the modern reality o — staying private. More and more companies choose to be large, widely-held organizations that never intend to go public, and our securities regulations need to account — or this new reality.

   Electronic copy available at: https://ssrn.com/abstract=2639879