Just six months after paying a record $550 million to settle a federal fraud case, Goldman Sachs finds itself in a new controversy over an investment in Facebook, the social networking site. The firm’s plan had been to raise about $1.5 billion for the social networking company by allowing individuals to invest in a special fund that would count as a single investor. Some critics say the deal was designed to skirt securities regulations and is marred by conflict of interest, while others argue this type of investment puts taxpayers at risk, since Goldman can support its business with cheap government loans.

Amid these criticisms, Goldman abruptly changed course on January 17 and announced that, contrary to the original plan, U.S. investors would be barred from a Facebook private stock offering. Many observers saw the move — limiting investment to foreigners — as a serious embarrassment, if not an admission that Goldman had been treading too close to the regulatory line.

Despite the controversy, many experts note that it is not unusual for a big Wall Street firm to take part in deals not open to ordinary investors. Nor is it unusual for such firms to wear multiple hats — investing their own money in deals also marketed to clients, underwriting stock offerings while evaluating stocks for investors, or managing money for corporations and their executives while doing other business involving those firms.

So, is the Facebook deal business as usual — or is it crossing the line?

“Investment banks are always looking for innovation; they’re always looking for new markets,” says Wharton adjunct finance professor David Wessels. Often, he notes, that means looking for “ways around existing regulations…. They are paid to be creative.”

But, he adds, Goldman’s use of a special purpose vehicle for the Facebook deal is unusual. The vehicle is similar to a small mutual fund that will only own Facebook shares. The fund will count as one Facebook investor, allowing Facebook to avoid regulations that would require detailed financial and accounting disclosures if it had more than 499 shareholders. This approach, says Wessels, “might follow the letter of the law but it certainly doesn’t follow the spirit of the law.” (Goldman did not respond to requests for comment before Knowledge at Wharton’s publication deadline.)

‘Private Placements’

Complaints about the deal are not as severe as those involving last summer’s Abacus case, where Goldman was accused of urging clients to buy securities that were designed to fail. Those securities were created for a hedge fund that wanted to bet the mortgage market would decline. To work as planned, the securities had to be sold to investors who would bet the market would go up.

Still, the Facebook deal was somewhat out of the ordinary from the start, even though Wall Street firms have long been involved in “private placements,” or helping privately held companies sell shares to investors. “This is a little bit different, because it is a fund and they [Goldman] are putting their own money in, so it’s not exactly the same as a private placement,” according to Wharton finance professor Franklin Allen.

“They were able to avoid some of the SEC regulations … by creating a partnership in which there was only one ownership, but ownership could be factored into 500 individual clients,” notes Wharton finance professor Marshall E. Blume. According to Wessels, Goldman is likely to receive “a tremendous amount of pushback” from the SEC, which may see Goldman’s approach as undercutting the transparency requirements that make the U.S. securities markets appealing to investors.

While many high-profile business deals are announced with fanfare, Goldman and Facebook had intended to keep their arrangement quiet to satisfy U.S. securities laws that distinguish public stock offerings from private ones. But news of the deal leaked early in January, showing Goldman planned to invest $450 million of its own money in Facebook as part of a plan to raise about $1.5 billion for the social networking company. Even if unintended, the deal’s public disclosure threatened to violate a regulation prohibiting “general solicitation” of shareholders sought in private placements, says Steven M. Davidoff, a law professor at the University of Connecticut. The rule is meant to prevent inflated claims that cannot be verified because private companies disclose so little.

Davidoff believes Goldman and Facebook did adhere to the securities regulations, and that the SEC would have a hard time proving a violation. But he thinks Goldman “blinked” — in its decision to bar U.S. investors from the offering — to prevent the damage its reputation would have suffered in an SEC investigation. Goldman apparently failed to anticipate the criticisms the deal would attract, he says, noting that the firm could have avoided the mess with a standard private placement quietly offered to just a few clients.

Federal regulations demand a high level of disclosure for public deals, such as initial public offerings of stock, to assure that investors get sufficient information to weigh risks and opportunities. Among the disclosures are extensive financial details that reveal much about a firm’s health and business strategy. Many firms would prefer not to provide all that business intelligence to competitors, or to shoulder the costs that regulatory compliance entails. “Once you go public, you have all sorts of onerous regulations,” Blume notes. “What [Goldman and Facebook] did is avoid some of those regulations — reporting requirements and things like that.”

Privately held firms like Facebook do not have to make such elaborate disclosures, and it is much easier for their executives and owners to maintain control and to manage with a free hand than it is if they go public. But staying private cuts the firm off from a deep pool of capital — money from individual investors and institutions like pensions and mutual funds which, by regulation or preference, will only invest in publicly traded securities. The Facebook deal was designed to raise money to cover the company’s needs until it was ready to raise more money by going public, probably in 2012.

Skirting Regulation?

According to Blume, the route chosen by Facebook may simply have been the cheapest way to raise money for the time being. To raise a relatively small sum of $1.5 billion, it makes sense to target wealthy individuals because large institutions have too much money to bother with small opportunities. The special purpose vehicle, Blume says, offers a convenient way to appeal to wealthy individuals, though Goldman and Facebook are using it in an unusual way.

As a convenience, for example, a brokerage may use a single entity to hold all the Google shares owned by all the firm’s customers, and the vehicle would count as just one shareholder. But federal law prohibits using a single entity to circumvent the 499-investor rule, and the Securities and Exchange Commission is reportedly looking at whether the Facebook deal is designed to improperly skirt the regulation. Goldman’s sudden decision to allow only foreign investors into the Facebook investment appears to be designed to assure the rule is not violated.

“Facebook and Goldman are well represented by legal counsel and they are aware of this issue,” says Davidoff, noting that the 499-investor rule was put in place in 1964 amid concerns that too many stocks were trading without enough disclosure.

Though Facebook shares are privately held, they can be traded on special exchanges set up for the purpose and generally open only to “accredited” investors — those with at least $1 million in assets and annual incomes of $200,000 or more, or $300,000 for couples. In theory, these are sophisticated investors who can afford to take risks that ordinary small investors should not.

Private exchanges like SharesPost and SecondMarket have grown rapidly in the past decade or so, allowing firms like Facebook to stay private a bit longer. They make it easier, for example, for a firm’s original investors to sell, and they make it easy to see the current price of a private firm’s shares. Advances in computer and communication technology has fueled the growth of private exchanges, Wessel says. Now, he adds, they are large enough to warrant a closer look from regulators to make sure that only accredited investors are using the systems.

Although the private exchanges display up-to-date prices, those prices do not reflect as many factors as govern prices on public exchanges, Blume says. He notes, for example, that there are no derivatives linked to privately traded shares — no options contracts or credit default swaps. It also may be impossible for traders with a negative view of a privately traded stock to engage in short sales, or bets it will decline. On public exchanges, short sales have an important role in the balance of supply and demand, keeping prices accurate. Also, because trading on private exchanges is light, it is difficult for traders to flip stocks quickly, so prices can lag events. All this makes it harder to determine whether prices on a private exchange accurately reflect demand, making it easier for an individual stock to be over- or under-priced.

Inflated Prices and Conflicts of Interest

In the Facebook case, some experts think the process may have inflated the price. Recent trades indicate, for example, that Facebook has a total market capitalization in excess of $50 billion. An analysis by The Wall Street Journal finds that price is 25 times annual revenue, which would be a huge premium given that Google, a proven success, trades at just six times revenue.

“It’s a little scary because you’re talking about extremely high valuations for a company that very few people know very much about,” Wessel says. “The valuation of Facebook seems very high,” Allen adds, noting that Goldman’s role serves to endorse the high price. “I think they’re giving their stamp of approval to these kinds of valuations, particularly if they are investing their own money in it.”

The high price helps set the stage for a high price in any future initial public offering of Facebook. That could make Goldman’s share of Facebook more valuable and boost any fees the firm might earn underwriting the IPO. “I presume they will do an IPO next year,” Allen says. “I think this [current marketing of shares] might be part of an attempt to create demand for it.”

Ultimately, notes Blume, Facebook will have to go public if it is to raise large amounts of money, since a special purpose vehicle cannot be opened to large numbers of investors, and institutional investors want the liquidity and transparency only available after a stock starts public trading.  “A regular endowment fund like the University of Pennsylvania’s, or a pension fund like the State of Pennsylvania’s, would want to be assured of a ready market.”

If Facebook’s share price is inflated, Goldman is making a risky investment, analysts say. That has raised questions about potential conflicts of interest posed by Goldman’s multiple roles in the deal — a problem common to big financial institutions that wear many hats. Goldman’s $450 million investment in Facebook puts Goldman shareholders at risk. In marketing Facebook shares to its clients, Goldman has an incentive to argue the shares will go up in value despite the risk. Goldman, presumably, would also be interested in underwriting Facebook’s public offering, again giving an incentive to accentuate the positive while an objective analysis might see serious hazards.

“Goldman has a problem in terms of conflict of interest…. It’s an ongoing problem,” according to Allen. It’s up to Goldman’s clients to decide how severe the conflicts are, he adds.

Risk, of course, is part of the daily life of any Wall Street firm. But critics point out that Goldman is no longer a traditional investment bank. At the height of the financial crisis in 2008, Goldman received government assistance, which it has paid back, and it converted to a commercial bank holding company, which gives it access to inexpensive loans through the Federal Reserve’s discount window. Because Goldman is an enormous firm with financial connections to many others, it could well be deemed “too big to fail,” and might be eligible for a government bailout in a crisis. Critics question whether it is proper for the firm to put the public at risk with speculative ventures like the Facebook deal.

Simon Johnson, a professor of entrepreneurship at MIT’s Sloan School of Management and former chief economist at the International Monetary Fund, says it is improper for a bank with implicit government backing to be acting like a risk-embracing venture capital fund. “Banks like Goldman have made big mistakes in the past,” Johnson states. “We shouldn’t be encouraging them to take more risk.”

In effect, he says, Goldman is using debt to finance its Facebook investment. It is more appropriate to finance risky ventures with equity, he notes, arguing that equity limits losses to shareholders while debt financing can spread the damage to lenders, including taxpayers. “Whether that would have systemic consequences depends on who holds the debt.”

Assessing the risk is especially hard because Facebook does not have to make detailed disclosures, Johnson notes. “That worries me, and it worries a lot of people.” Allen adds: “They’re taking a lot of risk, but we’re subsidizing them — we, the government. These [kinds of] deals would be priced differently if they weren’t guaranteed by the government.”

Johnson notes that the Dodd-Frank financial reform act passed last year includes the so-called Volker Rule to curb speculative trading by banks. Those rules, however, were watered down at the last minute, and have yet to be written into enforceable regulations and won’t take effect until 2012. At the moment, it is therefore unclear just what constitutes improper proprietary trading, says Allen. “What exactly is proprietary trading?” he asks. “Where are they going to draw the line?”