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The SEC's Facebook Fiasco—A Commentary by Jonathan Macey ’82

The following commentary was published in The Wall Street Journal on January 20, 2011.

The SEC's Facebook Fiasco
By Jonathan Macey ’82

Goldman Sachs announced this week that it will exclude U.S. investors from the opportunity to invest in new shares of Facebook. Instead it will sell the shares exclusively to foreign investors. This has been portrayed as a victory for the Securities and Exchange Commission. And as Andrew Sorkin wrote in the New York Times, it is "considered a serious embarrassment for Goldman." It is the SEC that should be embarrassed.

Goldman's move shows how banking has become so international that companies can sidestep the SEC's rules with ease. It also shows that the commission's rules regarding stock sales are crippling for U.S. investors.

Facebook will raise just as much capital, $1.5 billion, as was planned originally. The terms of the deal are also the same: Investors will still put up a minimum of $2 million and commit to hold the shares until 2013.

The deal won't hurt Goldman either—it will earn at least as much in fees and commissions as before. The reality is that investment banks like Goldman have been moving brokerage and banking business offshore for decades. They are well positioned in Asian and European capitals to continue to do so.

Thanks to SEC regulation and the litigious atmosphere it fosters—not to mention Sarbanes-Oxley's onerous burdens on corporate executives—the whole capital formation process is moving offshore. The U.S. share of total equity raised in the world's capital markets is shrinking, while the number of U.S. companies listing their shares for trading exclusively in foreign markets has risen steadily for the past five years.

The SEC's fundamental approach to regulation involves depriving investors of opportunities in order to protect them. This was not much of a problem in the immediate post-World War II period. Before Japan and Europe rebuilt, and before China emerged as an economic giant, the U.S. had the only large pools of investment capital in the world and dominated the financial scene. During this happy period of U.S. primacy, the SEC, along with most academics, took the rather ludicrous view that it actually deserved the credit for the primacy of U.S. capital markets. That world is long gone.

Still, according to the SEC, all investors large and small must be protected against the danger that they will succumb to a feeding frenzy of enthusiasm when given the opportunity to invest in a new deal. For example, the SEC rules governing the Facebook offering until Goldman pulled the plug include the requirement that the stock being sold "cannot be the subject of advertising, general promotional seminars or public meetings in connection with the offering." The concern here is that publicity about a deal might, heaven forbid, create interest among investors.

Goldman's offering was structured as a private placement to a limited number of sophisticated investors because the alternative—a public offering available to all investors—would subject Facebook to the SEC's burdensome reporting rules. It would also make the company highly vulnerable to attack by the SEC's close allies in the plaintiffs' class action securities bar.

In a public offering, shares are bought by representatives of plaintiffs' law firms, and if the share price goes down significantly after the offering, the issuer and underwriters typically get sued for having misrepresented the merits of the deal. This is far less likely to happen in a private placement.

In other words, Goldman and Facebook tried to avoid the more egregious and intrusive regulations that govern public offerings. Yet Goldman still had to worry that the publicity surrounding a private placement in the U.S. would make it difficult for Facebook to do a public offering in the future without running afoul of the SEC's rules prohibiting the publicizing of such offerings.

The investors who supposedly are being protected by the SEC's rules here are not unsophisticated small investors. Goldman had limited the marketing of Facebook's shares to the billionaires and large institutions that constitute its wealthiest clients.

Ironically, the Goldman decision to move the Facebook deal offshore was announced just as President Obama was acknowledging in these editorial pages that "regulations do have costs" and saying that he would order a government-wide review to eliminate rules that cripple economic growth. That review should include the rules promulgated by the SEC, lest we continue to see U.S. capital markets fade into irrelevance.

Mr. Macey is a professor at Yale Law School and a member of the Hoover Institution Task Force on Property Rights.