Facebook’s Mistrial

The social networking company may indeed not be a good fit for certain Goldman clients, but ‘too much attention’ should not be among the reasons why.

The US legal system has in recent years faced a growing problem that is a direct result of our society’s 24/7 internet connectivity. Despite the attempt by judges to prevent jurors from seeking outside information, many jury members just can’t help it. They seek, they share and, unable to avert their eyes, they are bombarded by incoming information about their court cases, resulting in the rising incidence of mistrials.

It would appear that rules created in the pre-internet era are ill-equipped to govern the Post-Internet Citizen, who suffers withdrawal symptoms when not allowed to gaze upon an iPhone screen every five minutes.

The recent news that Goldman Sachs will not allow its US-based clients to invest in its Facebook offering reminded me of a mistrial, because the US offering got yanked largely due to concerns that clients were exposed to too much information, and that this exposure might be viewed as running afoul of investor-protection rules.

Goldman today released a statement to the Wall Street Journal saying that the bank had “concluded the level of media attention might not be consistent with the proper completion of a U.S. private placement under U.S. law.”

The bank reportedly had been offering its global private banking clients a chance to join an investment round of as much as $1.5 billion in the social networking company, reportedly after the private equity arm of Goldman declined the opportunity. Private banks have a long track record of creating “feeder funds” that bundle client money for private partnerships that in turn invest in a diversified collection of underlying assets. These are sometimes called “blind pool” funds because the investors do not know at the outset what the investment managers will ultimately invest in. But a direct investment vehicle of the size and specificity created for Facebook, and designed for high-net-worth clients, is unusual.

In fact, if it weren’t for pesky, somewhat fuzzily defined securities rules, the Goldman/Facebook vehicle could stand as a new form of mega-investor loosed on the world. We have already seen the emergence of sophisticated institutional investors, such as sovereign wealth funds, as direct investors standing side-by-side with private investment firms in direct deals. With Facebook, Goldman showed that it could rapidly form big capital from its network of eager high-net-worth clients. There are many other powerful networks of private clients that, given the right mechanisms and opportunities, could become significant direct players in private finance. But the fame of Facebook no doubt added to the speed of Goldman’s commitment-gathering, and that was the problem.

Rule 502 of Regulation D of the Securities Act of 1933 describes how you may offer securities to investors without registering those securities with the Securities and Exchange Commission, and among other requirements you may not use “any form of general solicitation or general advertising.”

Goldman of course did not take out an ad in The Robb Report offering private Facebook shares, but the internet-fueled notoriety of the company created a media frenzy around an otherwise very private offering. Although Goldman could argue convincingly that the media attention was not its fault, unfortunately there has never been a clear understanding on how to interpret “general solicitation” when raising private funds.

My experience with “Reg D” over the years has been that each private firm will define the rule differently, based mostly on what their own legal counsel tell them. Some general partners will happily tell a reporter “on background” that they are raising a private fund, and will be happy to see an accurate report on it, sourced anonymously. Others will not only not speak to reporters at all during fundraising, but will strip their websites of almost any useful information out of fear that any communication with the outside world will be seen as a “solicitation.” In a number of memorable cases, the lead counsel or founding partner of firms have called me and demanded that an (accurate) article about their fundraising not be posted. The mere existence of such an article would “blow” their “exemption” and cause them to postpone or cancel fundraising, they claim, even if the information came from an external source.

With regard to Facebook, Goldman Sachs appears to be falling into this most extreme camp of Reg D interpretation – the mere existence of press surrounding the offering has caused them to yank the offering to all US investors. It is unclear whether this is the result of the Goldman legal team acting out of a routine abundance of caution, or based on information that the SEC was going to treat the Facebook offering as an exceptional circumstance. You won’t find Blackstone yanking its US fundraising simply because the effort has been much chronicled in the press, for example. But maybe there is something about the overlap of high-net-worth individual investors with Facebook’s high profile and Goldman’s recent public relations challenges that has caused the SEC to intimate that hype created by other peoplehas ruined the “safe harbor” in which these private securities were to have been sold.

The principle behind restricting jury information is that jurors are supposed to decide their case based solely on what they learn in the trial. The principle behind Rule 504 is that issuers should only offer unregistered securities to people they know to be sophisticated enough to understand the risks of such an investment. This is a flawed principle. What matters most is whether an issuer actually sells an unregistered security to an unqualified investor. I.e., knowingly taking money from a poor, confused widow. The circumstances surrounding the marketing of the security shouldn’t matter at all. All issuers remain bound by anti-fraud rules regardless of how many tweets their private offerings inspire.

The Reg D logic Goldman’s move appears to be that the bank’s (US) wealthy clients have been done a disservice by being exposed to all kinds of information about Facebook and the Facebook offering. This information might have caused some of them to frantically call up their Goldman private banker and ask to be included in the Facebook deal, without knowing the first thing about conflicts of interest, social media over-valuation, etc. These high-net-worth clients may have even seen a critically acclaimed movie about Facebook that gave them a crazy urge to be part of history by joining the offering.

As a fiduciary, it is Goldman’s duty to ensure that the investors in its Facebook deal are sophisticated enough to understand its risks. They should also be required to present those risks in very clear language, ie “you might get your face ripped off.”

If the SEC wants to promote transparency and accountability in the private investment market, the rules governing private investment need to be updated, because Regulation D isn’t doing the trick. Scaring investment managers into shipping their private offerings overseas is a poor substitute for addressing the regulatory shortcomings that a new era of communications has unveiled.