The Form D market has also funded Theranos and has overtaken public IPOs as a way to raise funds for investors in recent times. Opacity in Form D fundraising has benefits and costs. I suspect the Form D market is under-regulated.
When I heard about the explosion of FTX-Binance, my first instinct was to go and get a financial statement for these companies. I was curious how these companies make money and how sustainable these companies are? Of course, there’s not much in the public domain. Binance does not appear to have raised any public funds. FTX has raised funds in the obscure but very large Form D market, which I want to focus on in this article. FTX raised $890 million on 8/5/21 and $415.3 million in equity on 11/2/21 via Form Ds. Interestingly enough, FTX refuses to disclose even its earnings on Form D, let alone how the funds will be used. Theranos, the infamous blood testing startup, also raised funds through the Form D market: $582 million on 5/17/15.
Let’s step back a bit and understand the market for Form D. Form D must be filed in case of private placement of capital by companies under the so-called Reg D. Private placements have exploded in recent times, in especially after the Sarbanes-Oxley Act.
One of our graduate students, Yiran Kang, wrote an article on the labor market that looked at the magnitude of the funds raised by Form D offers and the data that Form D issuers share with these accredited investors. It reports surprising figures. In 2015, $91 billion was raised in the Form D market, limiting the focus to issuers who raised funds for the first time via Form Ds, compared to $93 billion in the IPO market this that year. The analogous figures for (i) $164 billion in Form Ds and $94 billion in the IPO market for 2016; (ii) $84 billion in each market for 2017; (iii) $182 billion in Form D compared to $97 billion in 2018; (iv) $102 billion in the Form D market versus $77 billion through IPOs in 2019; and (v) $160 billion in Form D versus $162 billion via IPOs in 2020.
The Form D market arose as Congress’s response to the perceived burden of excessive public disclosure and attestation by auditors. In May 2007, the private placement market gained momentum when Oakland Capital Management sold a 15% stake for $880 million. As a stand-alone offering, this issue would have been the eighth public IPO in 2007.
The other issue that needs to be clarified is that Form D is supposed to be the “big boy/girl” market. In other words, most Form D offers are meant to target only “accredited” investors defined as someone who has earned an income greater than $200,000 (or $300,000 with a spouse) in each of the previous two years. , and reasonably expects the same for the current year, or has a net worth greater than $1 million, alone or with a spouse or a broker or other financial professional holding certain certifications, designations or valid credentials.
Form D contains the identity of issuers and key managers (occasionally), very coarse information on the total amount raised and the amount of the planned raising, the number of investors, the payments made to promoters and brokers, the names of officers and board members (occasionally). That’s all to collect the hundreds of millions! There is virtually no subsequent public disclosure by issuers who choose to remain private, as seen in the FTX case. The application also seems quite lax.
My impression is that the SEC does not review Form Ds in general compared to the scrutiny that a Form S-1, filed by an issuer prior to an IPO, gets. Instead of a proactive review regime, the SEC potentially follows a reactive model and prosecutes Form D issuers that are found ex post (after the fact) to be questionable or fraudulent. That’s not to say that the failure rate of IPOs, due to risk taking, not fraud, is lower than Form D issuers. In fact, I’d like to see work comparing these failure rate. It is quite difficult to conduct such a study because we know next to nothing in the public domain about Form D issuers.
The policy compromise then is that Congress has approved no public financial statements so long as the “big boys/girls” can do their due diligence on the viability and governance of these companies before investing in these Form D markets. Note the grand assumption that the “big boys/girls” will absorb all losses into their account without imposing a payroll tax. But that’s not entirely clear as such outbursts eventually trickle down to public markets.
Consider high-profile investors who have indicated they will take writedowns on FTX. Softbank said it would write down $100 million. Sequoia reported an impairment of $210 million. Coinbase states that it will take a writedown of $15 million in their corporate arm. Ontario Teachers reported $95 million exposure to FTX.
It would be interesting to investigate how many other public pension funds have invested directly in FTX or indirectly through these companies taking writedowns. More troubling, what are public pension funds investing in individual stocks like FTX that are highly speculative?
The lack of transparency and public oversight in the Form D market is potentially concerning. I wonder how many other Form D blasts have happened but weren’t reported because the “big boys/girls” wanted to avoid public embarrassment or prosecution. I can report that at least one very large institutional investor told me privately that he had done due diligence on Theranos and politely passed on the investment. How costly or redundant is it for, say, 10 other institutions to repeat due diligence at Theranos due to lack of public disclosures?
Much of the Form D market has been used to fund “crypto” projects as part of my own research. How much was used to launder money? What about the spillover or “systemic risk” from the “big boy/girl” market to the mainstream market, as evidenced by the sharp decline in the price of bitcoin following the failure of FTX? Who manages this “systemic risk”?
More fundamentally, in today’s highly integrated capital markets, there is the idea that the “big boy/girl” market is capitalism pure and simple (take risks, make or lose money you itself) without somehow socializing or passing on the losses to the public capital markets. even plausible? The other side of this debate, of course, is that more mandatory disclosure in the Form D marketplace will hurt risk-taking and innovation. Perhaps a detailed cost-benefit analysis of the Form D market is in order.
At the very least, I hope we can agree that institutional investors should be discouraged from investing in individual securities. And, perhaps after further study, consider increasing the mandatory disclosure of Form D raises if public pension funds are involved or if a Form D company increases the risk of spilling into public markets.
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