Companies staying private, rational apathy

Welcome to shareholder Primacy from free float media. A podcast about activist investing Securities Law, and all the ways, the financial and legal world's intersect and Collide in real life. We're together with and Lipton law professor at Tulane in New Orleans who teaches in research and securities and business loss. She holds up the legal end of this little podcast and that's Mike Levin and activist investor who lives and works in Chicago. He covers the financial side of our podcast. Let's this week talk about a couple of fun subjects first. There's been some interesting developments news about how and why companies private companies stay private and keep raising Capital attracting money. And sort of not go, the IP out, IPO initial public offering route, which was sort of the traditional, kind of denouement for most most companies. So, we'll talk about that. And we'll dive into rational, apathy as subject with both academic and practical applications. All righty. Let's begin with this idea of public or private companies. It's been a long-standing debate, of course. About when and if and how a private company that gets big and successful enough should basically expose himself to public money. And most recently in the last few weeks David Solomon who is the CEO of Goldman Sachs said in a public statement or an interview. There's just no need for IPOs anymore. They can just stay private which I'm sure made the bankers at Goldman. Oh a little a little nervous but like is this is this true? Let's let's dive into that. Is there is there a need for IPOs anymore? Or is that is that is a thing of the past. Yeah so I mean as you know we have the Securities Act of 1933 in the exchange Act of 1934. They were passed in the wake of the 29 market crash. And these laws, say if you sell stock to the public, you need to start filing regular disclosures with the SEC. And of course, these are very comprehensive reports. They have details about your financial condition, your business operations, your capital structure, and 10K, exactly. And it can be very burdensome for a company. It's expensive. You have to disclose competitively sensitive information, you risk liability, if you're disclosures aren't accurate, But the law doesn't require disclosure for Private Sales, which leads to the question, what is a private sale? Because what defines a privacy? Exactly, exactly. So what's happened is that over the past 30 years or so Congress, in the SEC have tinkered with the Securities laws in a way that really broadens the category. So it used to be if you were a private Equity Fund, or a venture capital fund, if you wanted to stay private, you couldn't have more than 100 investors in 1996, they lifted that cap. Now it's basically 2000 as long as the investors are high net worth. So it's a lot easier for a single fund to raise a lot of money, while staying private, and that means that if you're an operating company, you can get all the money you need from like one or two funds. Since each fund only counts as a single investor that all looks like the company is just raising money from a small circle of people from two investors and those sales count as private as well. So as a practical matter, you can be aggregating that capital of hundreds or thousands of invest Teachers, but the investor buy shares in the fund and a private sale, the fund buy shares in the company in a private sale and voila, no public disclosure. So, the law has also changed to make it easier for companies to pay employee in employees, in stock without triggering public disclosure requirements. Because otherwise, that would be a sale to the public, but it's not treated as such. So companies can have a large number of employee investors and still be considered private, so, stop right there. So the the idea that you're got your LPS, or your investors and so forth, they could be stockholders. That's one kind of Dimension to public ownership or how many people own it before, it's declared to be public and has to register and do all these exposures. But when you start paying and some of these companies can get pretty big, 100, whatever number of employees, in stock. Exactly. You can start paying and the law basically makes it much much easier to do that without calling it public. So now you have all of these employees investors and Then the rules of all made it easier, for private company, investors to trade their stock among themselves. It used to be that. Okay, fine. You can invest in the company, but you can't really easily resell your sharp. Right? So that made those, it made it investors hesitant to invest in the first place, not anymore. Congress in the SEC have made that much easier, too. So, the combined effect is that over the past few decades, it's become easier. And easier for companies to raise staggering amounts of capital and become very large, and influential without any accompanying disclosure. So these days, why companies go public isn't really to raise Capital. They can get as much Capital as they want. It's because insiders either want to cash out in a way that even private trading won't accommodate, and that is becoming a smaller and smaller category or the company wants to make Acquisitions using its own stock is currency. And so, then it finally needs to stock to have a public value. Okay? So yeah. Normally the decision. In whether to have an IPO or public stock was, because we needed the money, right? Yeah. But the biggest and this is because the SEC lets all of these and Congress. Essentially, let's the aggregation of a lot of people's money, but still call it only one investor so it doesn't count towards, you know, being a public sale, right? All right, so then then we get back to these other couple read and you didn't mention kind of vanity. Yeah, well, frequently refer to vanity listings or or companies that don't shouldn't be that are public, should be should be private because it's somebody's expenses over. That's okay. But then the two main reasons would be second. You mentioned for Being able to use your stock to in transactions to buy other companies. And then the other reason why check cashing out, which again more that but even, but the SEC and Congress have made it easier and easier to trade privately. So you really have to rid a point where even that's not sufficient for somebody who wants to go. So employees. So you have employees that that have a lot of their like their net worth. Yeah. It was tied up in their company and they say, I want to diverse on my diversify, my portfolio over something, and the company will have these events with they'll let them trade and sell to other investors. And again, this is all considered private Essentially, because of tweets to the Securities laws that have happened over time, right? And interestingly, because it's all private, it's kind of outside of the purview and scrutiny of the SEC. That's, yeah. So that's, that's a problem, I think. Yes. So this is what you're driving at. Okay. Yeah, so, I mean, some people take from this that it's unfair that under the rules companies can only do this, if they limit themselves to wealthy investors or wealthy investors and employees. So accredited accredited, accredited? Or sometimes like it depends on like which rule you're talking about. They were qualified. Pressures are accredited purchase their qualified and socialize But ultimately people a lot of money or institutions like, so one argument is that we should let ordinary people invest in private companies as well. And that is not my takeaway, is that we're rapidly losing insight into the economy and I think that that has really deleterious effects. So when you go out and you value a company, you do that by looking at stock prices, you look at the stock price of similar companies. You look at the Capital asset pricing model, but either way, you need stock prices. But now a lot of stock prices are out of you. So the models that everyone uses kind of become less accurate. And the reason they're right if you isn't because we can't see them, it's because they don't exist. Yeah, yeah. It's because there's no real Market. I mean, you can sometimes get some secondary market trading data. It's just nothing like an efficient Market and you don't, and you don't have an income statement, you don't have a balance sheet. So in these, and also in these points, you don't have a public. You have a public information, but a very often, very there's like, there's no information even to some investors for some hot companies, they get not, oh, that, that upsets me. That happens to be sometimes, or I'm in a private company and I know information, right? And in these private markets, you can't short the stock. It's very hard to express negative sentiment so that facilitates bubbles which isn't just a problem for the investors in those companies, it's a problem when those companies collapse because there's a blast radius, like my big example of this is we were, we work with so overvalued due to a lack of information that when it finally imploded, it disrupted, real estate markets on, two continents. That was a big disaster for for everybody, everyone who touched it for real estate, tenants. So this is a problem for investors but all the secrecy, it's also a problem for everyone else. So think about it this way, when a company Has to make these comprehensive disclosures, it's not just investors who see them the entire public. It's insight into how the company works. So competitors read them with so we maybe we get more competitive markets, labor reads them, they demand higher wages. They bargain based on this consumers, read them. I mean probably not consumers directly, but definitely consumer groups customers, right? And, and they can make judgments about whether this company is somebody they want to do business with and Regulators use them to get basic insight into the economy. Like this is a great story Airbnb, stayed private for this really, really long time, even though it became bigger than some of the largest hotel chains in the world. To the point where I swear to God, local officials started paying one random guy to scrape its website just so they can get a sense of what land use look like in their area. Oh wow. And you say have that from from like public schools? Exactly but they don't have it when it's private. So I mean and also I mean this is really like fuzzy but when a company Knows that its internal operations are open to public scrutiny. I think that kind of professionals their behavior like CEOs or the directors when their public company. I think they understand in a general way that they have to justify their choices to the public and that constrains what they're willing to do. So I think honestly this explains a lot about start-up culture in Silicon Valley, I mean, you have these companies that God very big and very powerful and operated entirely in a black box and they develop their own move fast and break things ethos, and then that kind of extended outward even when they went public eventually. So, um, right. We've talked about shareholder agreements so times under Delaware law until recently. It was understood you couldn't have shareholders just contract to control, major aspects of corporate functioning Boards of directors needed to maintain their discretion about how to run a company. But in these private companies, shareholder agreements, became common even after lawyers warn their clients, they not not be enforceable in the companies were private. So no one saw them, no one cared at that, you don't have, you didn't have public. And if public shareholders that exactly. So, you had this fiduciary duty to, to kind of look over your shoulders, it was employees over the company, they're not gonna challenge anything and then the shareholders who agreed to it, then the companies went public. But by the time they did and then by the time, these agreements were challenged. They were so common. And so, and such a powerful ecosystem, it kind of grown up around them that the companies were able to muscle through changes to Della were a lot of retroactively make them legal. So I think that's so that was the Morales. That was the whole house thing, right? Yeah, exactly that. Which we did a whole show. And so, that's right, thing. That happens when companies grow to enormous sizes without any public schooling, right? And, and, and in this sense, The public scrutiny is a valuable critical. Almost byproduct of this kind of decision to be a public to take public money. Yeah, exactly it. Yeah. It comes to this group in academic terms, we call it a positive externality, right? Well, you in economic terms, too, that's really? Yeah, I don't know. But there's actually, I mean, so this is the best part. There's actually this really interesting history. The idea that big companies should be subject to basic disclosures so that the public knows what they're up to. That idea has been around for over 100 years. So right. Throughout the early 1900s, when we first saw the rise of massive corporations, there were a lot of proposals to require that all companies. Make basic disclosures to the public as a means of controlling them. So there was testimony before Congress in 1913 where someone said, and I'm quoting this testimony in 1913. I think any man who has been abroad, as much as I have and seeing the difference between a young man, the way they behave at home. Home. And the way he behaves in Turkey, will agree that a little publicity. The watchful eye of a friend, there is a very powerful influence in making him decent. So who was, oh, I don't like an academic test before Christmas. Yeah, to make all these because there were all of these proposals for General Corporate disclosure. It was viewed as this really important tool to regulate corporate Behavior, but when that got translated into actual legislation in 33 and 34 and this is remember, FDR ran on a campaign challenging. The princes of property controlling corporations was a really big theme at the time but when this idea got turned into legislation the legislation was not disclosure for the public. It was disclosure for investors for only information that investors need on the theory that it may be. It's aimed at investors but it's still available to the public except today we have a real question of what happens when investors are wealthy institutions. And don't need disclosure but the rest of us still kind of do Or or can sort of tailor, you know, you know you know one investor may say I want this, another investor may say I want something different and so I've been particularly in these private markets where nobody else but it's all private exactly. So they don't need mandatory disclosure anymore. Wow you know it's funny I hadn't really thought about these kind of second and third order. Yeah. Ramifications to this to what Solomon was kind of hinting at here about about no more IPOs you know, no more IPOs and I say, you know, as an investor I'm not an IPO investor. I'm not I'm not big enough, I'm not important enough to get allocations that way but even so, you know, from an investing standpoint, I don't love hot IPOs anyway. Yeah, I think the governance and IPOs kind of is predictions because it's still kind of founder. Base is designed to protect. That's Where a lot of the dual-class stuff comes from? Yeah. In terms of the, you know, ramifications of okay, you know, if you are IPOs okay, great, you know, there'd be specs, I don't know, whatever. Okay. But this kind of as I said second or third order, Implication for, you know, lack of just transparency and disclosure about what about, what's kind of going? Is you say going on the economy? Yeah, I mean, that's, that's pretty, that's pretty, that's pretty, pretty interesting, that's what worries me and I mean, the thing is that in the Trump Administration, I think we're moving, like, in the wrong direction. I think Trump says he is actually going to make it even easier for companies to just stay private. So there's a really interesting story though in Europe because Europe recently adopted legislation called the corporate sustainability reporting directive or the csrd. It requires company to companies to issue these extensive like reports on their environmental impact Labor Relations, human rights impact consumer impact, its supposed to phase in over time. Some of those requirements are just kicking in now. So, all these companies have to meet the csrd reporting requirements. And when you read news about it in the American Press its treated as though, this is just ESG reporting. Really? Really extensive issue reporting. But what is getting missed here? Is that the csrd is explicitly intended? For non-investor audiences, all of this ESG information. The companies have to disclose is intended for consumption by the general public. It's explicitly for unions for ngos, for voters, if that's who the information is for. And because of that the csrd applies, not just to companies who shares are actually traded in Europe. It applies to any company that is operations in Europe and as big enough to have a social impact that applies to big companies, not just publicly traded companies public companies. Okay, exactly. So it's this throwback to the original ideas of the Progressive Era that big business can be like a political threat, and the companies can have as much power as governments, and we should require that they operate with a certain level of transparency, just like a democratic government, but It's not happening there. Already being like, Oh no, this is too burdensome. This is too much and all ready. They're seeking to like amended and possibly dial back, a lot of the requirements. So I don't know if the csrd is really going to survive at least not in its current form, but they were trying they were trying to get at this problem of. It's not about just investors and sometimes it's worth it to the public to have information, right? But let's go back to sort of A quick question, which is, you know, the SEC with all this disclosure. And again the two main planks of the sec's work to protect investors is registration and disclosure so we know what's going on. So they know what's out there and they and there's a certain level of disclosure and we're talking in a really interesting and fascinating way about the disclosure aspect of that, I mean, the general Public's nice, but isn't the SEC really supposed to just protect investors? Yeah. Oh it actually, is it absolutely is. So like if it were going to like I think that disclosure for the general public is sort of outside the sec's mission, and I think that If we ever were to get something like that here, it wouldn't necessarily come out of the SEC. Actually, it might even come out of the FTC, which was originally supposed to be the SEC before there was an SEC, like 33 act assumed. This would all be handled by the FTC, so, but you know, and politically none of that's happening. Right? I think there's, I think there's bigger priorities and yeah right now, but but it's like, you know, it's been a problem. It's been a growing problem over time, right? And so, and it's exacerbated and symbolized by these, by what, by what Solomon said, yeah. Last month through last week or whatever it was. Wow. I I hadn't thought about like I said, there's kind of second order, these kind of deeper implications of. This are really kind of interesting. So, all right, I think I think we want to give people a break here first. There's a lot that's a consider. So let's do that, we're taking that break right now and return in a moment to talk more about Rational apathy here at shareholder Primacy. Shareholder Primacy is brought to you by free flow analytics.com. The only free database of corporate directors, their influence and their performance. If you want a Stocker, retirement plan go to freeflow analytics.com. And look up which of your elected directors are performing well and which aren't use your vote in the alternative democracy and get your data at free flow. Analytics.com. Now, back to the show, Privacy. I'm lifting here with Mike Levin. So, Mike, let's talk about rational, apathy. What do we mean by? What do you think we mean? I mean, it's really kind of a subtle term but rational apathy. What's your, what's your two seconds? Things that it's just not worth it for me to care about that. It does not like, for example, when I, I don't know, download a song from Amazon, I do not read the terms and conditions. I'm telling you right now. Okay, absolutely. But they could be saying something like, I gave up my first board and I just There was a card, it's funny. There was a cartoon of Scott Adams used to have a bit years ago when I used to read him. He's he's evolved where the main guy Dilbert used to download that and at one point, he became Bill Gates's towel boy? Yeah, actually. There are companies that hide little things. Like the first person to read this gets 100,000 dollars, right? A little Easter eggs in their, in their terms and conditions. All right. So you absolutely at that, it would be rat. You would be rational to be apathetic about the terms and conditions about downloading music from. Yeah. I mean for the you know, for the 99 Cents song, it's not worth spending an hour reading the contract. Well, there is an analog here to investing. and a corporate governance, which is that it it makes sense despite what a lot of people, you know, jump up and down to Argue to the contrary, it makes sense for a lot of investors to not care about voting. And it really about voting. Excuse me, voting on at annual meetings, okay? So when the the rationale apathy we're going to talk about here, culminates in weather, shareholders of a public US public company vote their shares, their entitled to vote their shares. There's lots of people on all over the place and say you you're an owner right? You should be able to vote. You should care about this stuff in a lot of shareholders say. Huh? I don't and in fact that is rational in the strictest Enlightenment sense of of reasoned reasoned way to behave And and that's that's what I I would want to be interested in exploring, you're gonna say something for a second. Yeah, no. I mean, I just know that like, there's there are definitely been situations where companies had large really needed retail to vote to get this like right Tesla, reincorporate or Disney, and yeah, I mean, trying to get a quarter actually creates like great materials for corporate law, professors because when those companies reach out to reach out, they try to like do things. That is going to attract retail attention, which then gives me a really great classroom example, like Disney made a little video. Did you play that video? I saved it. I played you know excite retail and get retailers. McDuck. Yeah Disney voters to support and explains how to go about voting. It's a great. So that's a that's a great example of how companies sometimes you have to try to fight rationally. Apathy, but why rational, apathy kind of exists is really Kind of interesting. So It's been around for. I mean, the idea has been around for a long time. It was like, Berlin means, you know, there are two founding Scholars of corporate governance and ownership and control. They called it passivity rather. Yeah. Apathy. But they kind of identified it in their work and the early 30s. And and there was a more recent manifestation of it that a lot Professor kind of wrote up. And and I love the definition. It was she said it was rational decision-making by utility maximizing investors and efficient thing. And those tugged at my heartstrings, she always, I can't remember after it was A Sarah Hahn, a university, right? Yeah, yeah. So she wrote that. And she also referred to the person is doing, it was explained by incentives operating and Homo economicus. I was so gratified that Professor was referring to homo economicus, who, who was born at my, my graduate institution in the university. And, anyway, so anyway, there's been a bunch of research over the years about, you know, what rationally, apathy kind of means and how it works. There's actually not been a ton when I looked around to try to see if you know I just not a whole lot of papers but there's been a few couple who were at our favorite Harvard Law, corporate governance, Center a Kobe Castillo. I did some really good papers on this anyway. It saddened me a little bit that mostly it was legal Scholars. Oh, it's not really having. It was like, I mean it's it's it's it's there's a little bit of research in the financial and economics journals but mostly it was law review papers. Anyway. So um, so so that was the the whole founding idea about about what this is. And so there's some observations that I wanted to kind of make, or I took away from a read of this first, is that rationally? Apathy kind of arises from something from something very economic, which is a comparison of benefits and costs, right? You know, what's the benefit of an individual shareholder voting? You know, in one share, right? Because shareholders got a tiny stake, there doesn't make that much of a difference. You're not going to have that much of an impact, and they have to put in a lot of effort, just to, you know, read the proxy materials. Exactly. And then it one of the scholars actually wrote had a very elaborate model about about the cost, about trying to identify the cost of benefits. And so there's there's kind of two Kind of costs. That were worth kind of observing. The first was the actual cost to become educated about The subject of a vote. Okay, a lot of this stuff is really Arcane, you know, trying to get educated about what the directors, you know, which directors make sense, and activists or companies, you know about this? Yeah, I'm sorry. Yeah. Even to know what the issues are, you know what the issues, you know, voting on an equity plan. And so that's also where, you know, where the proxy advisors come in, they kind of try to lower that, that information cost for you or convert it to money. So you just pay them and they and you trust them. There's a hole that but so there's a whole cost to try and get up to speed about what you're voting. Okay and then the second cost is the system. Just had a navigate this system of voting, you know, the whole proxy plumbing and so forth. You know, where is the proxy card which color, you know, how does this work? You know what's my control number? There's a whole very right. You know, crappy system for voting. That is also a cost and so those two costs kind of together, add up to the cost of voting. And again, the benefit is that, you know, it's, you know, most shareholders even institutions have a have a negligible impact, you know, they're marginal, I mean, it could matter in a really close kind of. Yeah, well, it was actually these companies that have lots of retail, like, not every company is the same shirt holder base and Laura, a lot of consumer facing ones that have this, a lot of retail, right? So, most of what I saw on what I thought about, in terms of rationale, apathy addresses, basically how to lower the cost of voting, right? Rather than kind of increasing the benefits, okay? Okay, so, you know, making information more accessible and clearer. That's again where the proxy advisors coming right trying to make the proxy, the voting process, a little easier. Seems to be the the effort to try to deal with rational apathy and to try to try to make it less and less of a problem. Now, you know another, another interesting observation is that you'd sort of think that this is mostly a problem that's confined to that of individual shareholders. You know, Mom and Pop Widow and orphan kind of thing, right? You know they don't know where to read a proxy and how to vote a proxy. This is also a problem for institutions. Oh okay. Okay. The idea applies equally to them that again, most of the analysis is to try to, you know, encourage you heard tested, we talked about them, you know, Tesla trying to get all the individual individuals out there but even institutions like with significant Holdings You know, they may have a little more of an impact than a single shareholder, but they still have the same problem of trying to get up to speed rightly because, you know, they're going to have a lot more Holdings probably than the usual, right? Right, the several times a year. Okay. Right. But, you know, they're probably a little better able to navigate the cost of of casting a vote, you know, they're the ones who, you know, pay ISS or class Lewis, not only to for voting advice but actually to cast the vote. But nonetheless this can be a problem for institutions as well. Um, so that then the last kind of interesting Factor here was that size of size of a holding? Okay, you know, normally, you know, the extreme Edge case of, you know, one person owning one share in an enormous company. Of course, they're not going to vote. Yeah. Okay. That is, that is totally rational to be, you know, apathetic there, okay? But as size of holding increases, it sort of makes it at least the benefit a little more relevant here, right? Okay. And and we can talk about size of holding sort of, in two ways. First, you know, the obvious way is size a holding as a percentage of the company's outstanding shares. Okay. So, you know, my one or whatever share is is one thing. But if, if you're black rocking, you own, 15% of some company, right? You know, that may be really impactful, right? So yeah, the larger you're holding the more likely your vote is to make a difference. Exactly. Okay. Um, but you there's a, there's another aspect of this to is how much of the investment in the company, what? Percentage of the portfolio of the Investment Portfolio. All right, it is there. Okay, so if you own a tiny percent of a company but nonetheless, it's a big part of your Investment Portfolio. You still may decide to kind of get up to speed and figure out what the issues are. You don't try to overcome the cost, right voting because that matters a lot to you, right? Exactly. So there's so those kind of two, you know, issues interact. So if you, if you're an institution, as we said this, rational, apathy can be a problem for institution too. And and it becomes one where Ah, the percent of the company is big enough and the percentage of your portfolio is big enough. You'll figure out a way to vote. You'll overcome that apathy, or you, it'll become rational for you to figure out, you know, what, the issues are and how to navigate the voting system. So anyway, once you start to think about rational apathy in this way, it becomes very much more of a factor in how you see problems. So like We talked about the proxy advisors right? You know, I SS and glasses there there they exist to overcome rational, apathy, that's one explanation of their of their of their whole business. They, you know, there's and, you know, it reflects back, then on how there's certain regulation, you know, SEC or Department of Labor regulations that require Pension funds to vote. Okay, so it doesn't really require it just strongly encourages that'll change in the United States. Yes, it says that that the vote is a plan asset and yeah, exactly. Yeah. Exercise reduceri Duty over that. But you can become, it can become rational for you to say, okay, this isn't a big enough deal to me. And I, so I have to kind of explain, okay, or conversely, the SEC came out with regular three years ago that essentially allowed funds, not Pension funds. But like, hedge funds to affirmatively, not vote, shares in particularly to not recall Lynch shares. Oh yeah, to lenders out for vote and not recall them and not worth it, right? Because because it was rationally, economically better for them to collecting fees right? Then for them to to vote. So anyway, so there's this comes up and all sorts of ways, you know, pass through voting is intended to try it overcome rational apathy and you know, Vanguard There was a news item of this really, Vanguard doesn't have to take a stand on all the social issues to propose. But on the other hand it didn't make, you know, no one else cared either. So yeah, their passive voting wasn't. There's all sorts of other year we know. Fine. Okay. Um, so there's lots of other Innovations. If you start to kind of look at them, through the lens of this, rational, rational apathy thinking, it starts to make a little more sense. And so that kind of fascinated me at the time, right? I read some of the papers and it was kind of kind of fun and it was it was really in some way. A really kind of Ideal intersection as we've set about the theme of what you and I talked about intersection between law and the economics, part of it about how the law was, you know, try to encourage one thing or another in the academy Behavior tries to counter to reinforce it. So that's that was rational apathy it was It was kind of interesting to learn about and put a label put a name on something we've been observing all along so yeah. So that was that, was it? Oh that's anyway. I think we've I think we've done this plenty for one day, don't you? Let's wrap up. And it's been wonderful talking about all these subjects. This is shareholder, Primacy hosted by Ann Lipton and me, Mike Levin. I'm an independent activist investor and advisor to investors about their activist situations, and is the Michelin Fleischman professor in business, law, and Entrepreneurship at Duane law school and an affiliate of two lanes, Murphy Institute, you can find me Mike at the activist investor.com and an at law.edu, our podcast is produced and distributed by free float media. Thanks for listening and we will talk again soon.