FTX Raised Funds Using The Opaque Form D Market: “Lite” Regulation Has Costs
The Form D market also financed Theranos and has surpassed public IPOs as a way to raise investor funds in recent times. Opacity in Form D fund raising has benefits and costs. I suspect that the Form D market is under regulated.
When I heard about the FTX-Binance blow up, my first instinct was to go pull up a financial statement for these companies. I was curious about how these firms make money and how sustainable were these businesses? Of course, there is nothing much in the public domain. Binance does not seem to have raised public money. FTX has raised money in the obscure but very large Form D market which is what I want to focus on in this piece. FTX has raised $890 million on 08/05/21 and $415.3 million in equity on 11/02/21 via Form Ds. It is quite interesting to note that FTX declines to disclose even its revenue on the Form D, let alone how the funds will be used. Theranos, the infamous blood testing start up, also raised funds via the Form D market: $582 million on 05/17/15.
Let’s step back a bit and understand the Form D market. Form D is required to be filed in the event of a private placement of capital made by firms under the so-called Reg D. Private placements have sky-rocketed in the recent past especially after the Sarbanes-Oxley Act.
One of our graduate students, Yiran Kang, has a job market paper that looked into the magnitude of funds raised by Form D offerings and the data that Form D issuers share with these accredited investors. She reports startling numbers. In 2015, $91 billion was raised in the Form D market, restricting attention to issuers that raised funds for the first time via Form Ds relative to $93 billion in the IPO market that year. The analogous numbers for (i) $164 billion for 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 relative to $97 billion via IPOs in 2018; (iv) $102 billion in the Form D market v/s $77 billion via IPOs in 2019; and (v) $160 billion in Form Ds v/s $162 billion via IPOs in 2020.
The Form D market came into being as a Congressional response to the perceived burden of excessive public disclosure and attestation by auditors. In May 2007, the private placement market came into prominence when Oakland Capital Management sold a 15% stake for $880 million. As a stand- alone offering that issue would have been the eighth largest public IPO in 2007.
The other issue that needs to be clarified is that the Form D is supposed to be the “big boy/girl” market. That is, most Form D offerings are supposed to be only targeted at “accredited” investors defined as an individual who earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or has a net worth over $1 million, either alone or together with a spouse or a broker or other financial professional holding certain certifications, designations or credentials in good standing.
Form D contains the identity of issuers and key executives (occasionally), very coarse information about the total amount raised and planned raising amount, number of investors, payments made to promoters and brokers, names of executives and board members (occasionally). That’s it to raise the hundreds of millions! There is virtually no subsequent public disclosure by issuers that choose to stay private, as seen in the FTX case. Enforcement appears to be pretty lax as well.
My impression is that the SEC does not review Form Ds in general relative to the scrutiny that a form S-1, filed by an issuer before an IPO, gets. Instead of a proactive scrutiny regime, the SEC potentially follows a reactive model and pursues Form D issuers that are ex post (after the fact) revealed to be unsound or fraudulent. This is not to say that the failure rate of IPOs, on account of risk taking not fraud, is smaller than that of Form D issuers. In fact, I would love to see some work comparing such failure rates. It is quite difficult to conduct such a study as we know virtually nothing in the public domain about Form D issuers.
The policy trade off then is that Congress has approved the absence of public financial statements as long as the “big boys/girls” can do the due diligence about viability and governance in these ventures before investing in these Form D markets. Note the big assumption that “big boys/girls” will absorb any losses on their account without imposing a social burden. But that is not entirely clear as such blow ups eventually spill over into public markets.
Consider the prominent investors who have indicated that they will take impairments on FTX. Softbank has stated that they will take a $100 million write down. Sequoia has indicated a write down of $210 million. Coinbase states it will take a $15 million impairment in their ventures arm. Ontario Teachers has declared an exposure of $95 million to FTX.
It would be interesting to investigate how many other public pension funds had invested directly in FTX or indirectly via these companies taking write downs. More troubling, what are public pension funds investing in individual securities such as FTX that are highly speculative?
The lack of transparency and public scrutiny in the form D market is potentially a worry. I wonder how many more Form D blow ups have happened but gone unreported as the “big boys/girls” wanted to avoid embarrassment or public lawsuits. I can report that at least one very large institutional investor has shared privately with me that they conducted due diligence on Theranos and politely passed on investing. How expensive or duplicative is it for say 10 other institutions to repeat the due diligence in Theranos because of the absence of public disclosures?
A big chunk of the Form D market was used to fund “crypto” projects in my own going research. How much of this was used to launder money? What about spillovers or “systemic risk” from the “big boy/girl” market to the mainstream market, as seen by the large fall in the price of bitcoin following the failure of FTX? Who is managing that “systemic risk”?
More fundamentally, in today’s highly integrated capital markets, is the idea that the “big boy/girl” market is capitalism pure and simple (take risks, make or lose money yourself) without somehow socializing or spilling over 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 market will hurt risk taking and innovation. Perhaps, a detailed analysis of the costs and benefits 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 deeper study, consider an increase in the mandatory disclosure of Form D raisings if public pension funds are involved or if a Form D venture raises the risk of spilling over to public markets.