On March 31, SEC Chair Mary Jo White gave a keynote address at Stanford University in which she discussed some of the SEC’s emerging priorities with respect to pre-IPO stage companies, private capital markets and fintech. According to Chair White, the SEC is paying particular attention to the risks of fraud and investor confusion that can arise when companies choose to stay private longer.
The federal securities laws historically have subjected private securities markets to reduced levels of regulation, so long as these markets are largely restricted to sophisticated investors—i.e., angel investors, venture capital firms and private equity firms—who are deemed to understand the risk that many of their investments may lose money, and quickly, along the way to a successful moonshot. Chair White is concerned that this risk can be compounded by market pressures to show high valuations (particularly “unicorn” valuations of $1 billion), akin to the pressures faced by public companies to meet market expectations and projections. In her view, the risk of loss from an overinflated valuation is ultimately borne not just by the sophisticated venture capital or sophisticated institutional investors, but also employees, retail investors and other deserving startups. To mitigate the risk, Chair White suggested that large private companies consider, as appropriate, implementing enhanced governance structures and controls and adding to their boards outsiders with public company experience and regulatory, financial and industry expertise.
As pre-IPO companies have stayed private longer, both primary and secondary markets for equity securities of pre-IPO companies have expanded significantly. Chair White noted that the SEC is monitoring these markets for, among other things, disclosure and transparency issues, liquidity issues, unregistered broker-dealer activity, undisclosed compensation, conflict of interest issues, and fraudulent offers of pooled investment vehicles purporting to hold pre-IPO stock. Chair White also voiced concerns regarding the use of derivative structures, which can be used to transfer the economic interest in a pre-IPO company without transacting in its stock. Among other things, the SEC is concerned that use of these derivative structures may amplify any valuation errors. Chair White stated that the SEC is relying on financial advisers to serve as gatekeepers with respect to the private securities markets.
Chair White also reported that the SEC is monitoring the new methods of capital-raising created under the JOBS Act including: Rule 506(c) (permitting general solicitation in Regulation D private placements), Regulation A+ (permitting offerings of up to $50 million in 12 months to accredited and unaccredited investors) and Regulation Crowdfunding (permitting equity investment through crowdfunding, effective in May 2016). The intent of these regulations is to allow smaller companies to access the capital markets and to allow smaller investors to pursue early stage investment opportunities. However, Chair White indicated that the SEC is also watching how these markets develop in light of its investor protection mandate. In the past, Chair White has discussed general solicitation and Regulation A+ in other settings, so in this area her remarks were focused on crowdfunding. While crowdfunding has previously involved donations or contributions in return for a product or memento, Regulation Crowdfunding will allow investors to acquire small equity stakes in new companies. The capital raise will be required to be conducted through a registered broker or a “funding portal”, a new type of SEC registrant. Chair White said that the SEC plans to hold these brokers and funding portals responsible for investor protection and plans to monitor the funding portals closely. In essence, the funding portals will be viewed as gate-keepers.
In the fintech area, Chair White said that the SEC is watching online marketplace lending platforms through the lens of the federal securities laws: If they offer securities, they need either to register or to comply with an available exemption. She noted that the SEC is particularly concerned about investors’ access to material information regarding borrowers’ ability to repay as well as platforms’ proprietary risk and lending models. Also in the fintech area, Chair White indicated that the SEC is considering whether and how to analyze blockchain technology and automated investment platforms under existing transfer/clearing agency regulations and the Investment Advisers Act of 1940, respectively.
It remains to be seen what rulemaking, enforcement or other action, if any, will come of the priorities outlined in Chair White’s address. However, her remarks suggest that the SEC intends to pursue its objective of investor protection all the way to the cutting edge of the financial markets. In light of Chair White’s remarks, as late-stage private companies grow and develop to sizes and scales more typical of public companies, those companies may wish to consider, as appropriate, implementing disclosure, governance and control regimes that more closely resemble their public company counterparts.
The full text of Chairperson White’s address is available at https://www.sec.gov/news/speech/chair-white-silicon-valley-initiative-3-31-16.html
Thank you to John Lawrence for his assistance with this post.