Securities Enforcement Alert: SEC Increases Scrutiny of “Unicorns” and Other Private Companies and Secondary Market Trading of Pre-IPO Shares

In an unprecedented one-day blitz, the Chair of the Securities and Exchange Commission was joined by the SEC Enforcement Director in events in Silicon Valley and San Francisco on March 31 focused on one message: the SEC is closely watching the conduct of private companies as well as emerging platforms that trade in private company securities, and will bring enforcement cases as needed to protect investors. Dubbed the “Silicon Valley Initiative,” the senior officials emphasized that although the SEC wants to encourage capital formation for innovative Bay Area companies, because they play such a critical role in our economy and our markets, the SEC expects even private companies to embrace and demonstrate sound corporate governance.

Financial Controls and Corporate Governance

At an informal morning reception sponsored by Women In Securities (WISe), SEC Chair Mary Jo White emphasized that private companies who reach a certain size and maturity are not immune from SEC scrutiny or shareholder complaints. Chair White reminded her listeners that private companies are subject to Exchange Act Section 10(b) and Rule 10b-5 and owe fiduciary duties to shareholders. Chair White recommended that private companies take steps to enhance internal controls and governance procedures.

Later that evening in a speech at Stanford Law School, Chair White proposed questions that directors, officers, advisors and pre-IPO companies should be asking themselves:

• Does your board include outsiders with public company or large company experience?
• Do you have board members with regulatory and financial experience?
• Does your board have expertise in the industry so that you can analyze different viewpoints and spot critical issues?
• Is the company run and governed for the benefit of all of its investors?

As an illustration, Chair White noted the case of Marrone Bio Innovations, Inc. Charges were brought against the company and one of its former executives in February 2016 for inflating financial results in order to meet its projections during its first year as a public company. This occurred, Chair White said, “[b]ecause, in part, of insufficient internal controls” that allowed the executive to direct subordinates to obtain false documents and intentionally ship the wrong product in order to book sales.

Enforcement Director Andrew Ceresney, participating in a panel after the Chair’s remarks at Stanford, emphasized that companies “can’t simply just turn on effective controls” once they become public; instead companies need to develop such controls while they are still private.

Secondary Market Trading

In addition to internal controls and corporate governance, Chair White noted that the SEC was also focused on the secondary market for trading pre-IPO shares. The SEC’s core mission is to protect investors, including employees of private companies or other shareholders who hold what may be illiquid shares. In fact, the SEC already has brought at least one case alleging that a private company and its CEO defrauded shareholders—some of whom had been employees—by failing to disclose material information as part of a share buy-back.

In particular, enforcement chief Ceresney singled out the SEC’s concern about trading platforms that enable investors to purchase derivative interests in private shares. He noted that this new model has arisen because companies have restricted the transfer of shares, leading to employees and others retaining the shares themselves but selling an economic interest in the shares or promising to deliver shares after a liquidity event. Ceresney noted that, depending on the structure of the deals, such transactions may be securities-based swaps which are most likely illegal if sold to retail investors under SEC rules passed in the wake of Dodd-Frank. Last year, the SEC brought its first enforcement case under these rules against a Silicon-Valley start-up who was offering investors swap contracts based on the value of pre-IPO shares.

These comments appear to herald what may be the beginning of increased scrutiny as the SEC turns its attention to private companies. In an April 1 news article in The Recorder, Fenwick’s Mike Dicke noted the fear that the SEC will attempt to use the proliferation of secondary market trading in pre-IPO shares as “a hook to more closely police private companies.” Despite arguments that most transactions in Silicon Valley involve sophisticated parties on both sides who understand the risks, Director Ceresney stated that the SEC’s mission includes protecting even sophisticated investors, and pointed to a danger that investors broadly will lose faith in the markets if the SEC fails to prosecute fraud or misstatements involving securities transactions, in whatever sectors those transgressions occur.

Suggestions for What Private Companies and their Boards Should Be Doing Now:

In the wake of the SEC’s increasing scrutiny, private companies should consider doing the following:

• Develop written and enforceable compliance policies and procedures over financial reporting, disclosure, compensation (including the granting of equity-based compensation), cybersecurity, insider trading, and policies designed to prevent violations of the Foreign Corrupt Practices Act (if the company does business overseas).
• Develop a whistleblower program that provides an avenue for employees and consultants to bring issues to the attention of senior management and the Board. As public companies have learned, if employees do not feel they have an effective way to bring concerns to senior leadership, employees will instead bring those concerns to the government. As the SEC increases its interest in the affairs of private companies, whistleblowers are likely to avail themselves of the SEC whistleblower process, thereby potentially triggering an SEC inquiry.
• If their shares trade in the secondary market, companies should develop procedures to monitor and review company disclosures or other publicly available information that may impact trading, as well as monitoring what material, nonpublic information is available to directors, employees and others who may be selling shares in the secondary market.
• Boards should consider meeting with experienced regulatory counsel on a regular basis—as public companies do—to keep abreast of current issues and best practices. In addition to the inherent benefits of having improved corporate governance, should regulators undertake an investigation, it is important to be able to show that the Board and the company are sophisticated and have heeded the SEC’s recommendation to adopt improved internal controls.