Back before the SEC implemented the 500 shareholder threshold, many fraudulent activities around stocks were widespread. These activities included anything from pump-and-dump schemes —artificially inflating a self-owned stock price through misleading statements—and Ponzi schemes—investment fund where companies obtain profit through successive investors rather than investment activities. SEC tried to mitigate this issue by forcing companies with at least 500 distinct shareholders to go public and reveal their financial situations.

The formal stock exchange lists big corporations like Google and Ford, making it possible for them to publicly and centrally trade securities. On the other hand, smaller companies that can't meet the requirements, such as NASDAQ, have no choice but to trade securities via broker-dealer. We know this as over-the-counter (OTC) trading where securities exchange is not centralized. OTC trading is riskier for investors, as regulators like the SEC can't thoroughly monitor the marketplace. The 500 shareholder threshold was one of the main tools SEC used to address this issue.

The Securities and Exchange Commission enacted the 500 shareholder threshold rule from 1964 to 2012. The rule bound all companies, even if private parties owned some or part of them. That said, if a company fell below 500 or more shareholders, then there was no longer any reason to disclose this information publicly. As of 2012, SEC replaced the 500 shareholder threshold with a 2,000 investor limit to accommodate startups' increasing popularity. This limit ensures that modern startups can maintain their privacy until they are big enough.

Real-World Example of 500 Shareholder Threshold

Like Ponzi schemes, securities fraud is the main reason why the SEC introduced the 500 shareholder threshold in 1964. A Ponzi scheme is a term based on a real-life con artist and swindler Charles Ponzi. In the 1920s, Ponzi ran a fraudulent scheme for more than a year. Investors lost money totaling around $20 million ($250 million today).

At the time, Ponzi founded a stock company to raise funds from public investors and claimed that they would gain 50% interest in just 45 days. According to Ponzi, such a high return was possible by purchasing cheaper postal reply coupons in other countries and selling them for significantly higher U.S. prices. In reality, he used the money from new investors to pay the old investors' interest. After a series of investigations conducted by The Boston Post and federal agencies, Ponzi's scheme came to a screeching halt.

Someone can attract many investors and run such a fraudulent scheme for so long in part due to lack of transparency. There was virtually zero transparency in Ponzi's stock company. The 500 shareholder threshold rule encouraged transparency. That written Ponzi schemes and other forms of corporate fraud are still prevalent even today. Investors must use their discretion to prevent themselves from being a victim. As a regulator, the SEC can only help prevent frauds from happening, not eliminate them.