FTX Raises Funds Using Opaque Form D Market: “Lite” Regulation Has Costs

Form D Markets also funds Theranos and has gone through a public IPO as a way to raise investor funds in recent times. Opacity in Form D fundraising has benefits and costs. I suspect that the Form D market is under regulated.

When I heard about FTX-Binance blow, my first instinct is to pull a financial statement for this company. I’m curious about how this company makes money and how sustainable is this business? Of course, there isn’t much in the public domain. Binance does not appear to be raising public funds. FTX has raised money in the obscure but huge Form D market which is what I want to focus on in this piece. FTX 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 refuses to disclose its revenue in Form D, let alone how the funds will be used. Theranos, the famous blood-testing startup, is also raising funds through the Form D marketplace: $582 million as of 05/17/15.

Let’s go back a little and understand the Form D market. Form D is required to be filed in the event of 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 looks at the magnitude of funding generated by Form D offerings and the data that Form D issuers share with these accredited investors. She reported startling numbers. In 2015, $91 billion was raised in the Form D market, limiting attention to issuers raising funds for the first time via Form Ds relative to $93 billion in the IPO market that year. The analog 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 in 2018; (iv) $102 billion in Form D market v/s $77 billion via IPO in 2019; and (v) $160 billion in Form Ds v/s $162 billion via IPO in 2020.

The Form D market came about as a response by Congress to the perceived burden of excessive public disclosure and testimony by auditors. In May 2007, the private placement market came into prominence when Oakland Capital Management sold 15% stake for $ 880 million. As a stand-alone offering the issue would be the 8th largest public IPO of 2007.

Another issue that needs to be clarified is that Form D should be a “boy/girl” market. That is, most of the offerings of Form D are supposed to be targeted “accredited” investors. defined as an individual who has earned income that exceeds $200,000 (or $300,000 together with a spouse) in each of the previous two years, and the same reason is expected for the current year, or has a net worth of more than $1 million, either alone or together with a partner or broker or financial professional others hold certain certifications, designations or credentials in good standing.

Form D contains the identity of issuers and key executives (sometimes), very rough 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 (sometimes). That’s to raise hundreds of millions! There is almost no subsequent public disclosure by issuers who choose to remain private, as seen in the case of FTX. The enforcement seems to be pretty lax as well.

My impression is that the SEC does not review the Form Ds in general relative to the scrutiny that the S-1 form, filed by the issuer before an IPO, gets. Instead of a proactive scrutiny regime, the SEC potentially follows a reactive model and pursues Form D issuers who are ex post (after the fact) revealed to be unsound or fraudulent. This is not to say that the rate of failure of IPOs, on account of risk taking and not fraud, is smaller than that of issuers of Form D. In fact, I would like to see some works comparing failure rates for example. It is quite difficult to conduct research as we know almost nothing is in the public domain about the issuer of Form D.

The exit trade policy is that Congress has approved the absence of public financial statements as long as the “big boys/girls” can do due diligence on the viability and governance of these businesses before investing in these Form D markets. Note the big assumption that the “big boys/girls” will absorb all the losses in their accounts without imposing a social burden. But it is not entirely clear because such explosions eventually spill over into the general market.

Consider 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 that it wrote down $210 million. Coinbase said it will take a $15 million impairment on its business arm. Ontario Teachers has declared an exposure of $ 95 million for FTX.

It will be interesting to investigate how many other public pension funds have invested directly in FTX or indirectly via this company taking write downs. More troubling, what public pension funds invest in individual securities like FTX that are highly speculative?

The lack of transparency and public scrutiny in the D-form market is potentially worrying. I wonder how many more Form D blow ups happen but go unreported as “boys/girls” want to avoid public shame or prosecution. I can report that at least one very large institutional investor has shared with me personally that they did their due diligence on Theranos and were politely passed on the investment. How expensive or duplicative would it be to tell 10 other institutions to repeat their due diligence on Theranos because of the lack of public disclosure?

A large chunk of the Form D market was used to fund “crypto” projects in my own research. How much of this is used to launder money? What about spillovers or “systemic risk” from the “big boy/girl” market to the mainstream market, as seen by big fall in price of bitcoin after the FTX failure? Who manages that “systemic risk”?

The point, in today’s highly integrated capital market, is the idea that the “boy/girl” market is pure and simple capitalism (taking risks, making or losing money alone) without any socialization or elimination of common capital market losses. does it even make sense? The other side of this debate, of course, is that more mandatory disclosure in the Form D market will harm risk-taking and innovation. Perhaps a detailed analysis of the costs and benefits of the Form D market is in order.

At least, I hope we can agree that institutional investors should be discouraged from investing in individual securities. And, maybe after a deeper study, consider an increase in the mandatory disclosure of Form D raisings if the public pension fund is involved or if the effort Form D raises the risk of spilling over to the public market.

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