Regulatory shockwaves threaten Silicon Valley – when private investments become public problems

October 2016 | EXPERT BRIEFING | FINANCE & INVESTMENT

financierworldwide.com

According to its website, the US Securities and Exchange Commission (SEC) has three fundamental goals. The first, protecting investors, is achieved by regulating the flow of accurate and complete investment information disclosure. The second, maintaining fair, orderly and efficient markets, coexists peacefully alongside the pursuit of investor protection. However, the third, facilitating capital formation, often conflicts with the former two.

Specifically, there is an inverse relationship between the amount of time and money a company must spend to comply with heightened SEC mandatory disclosure requirements, on the one hand, and the amount of ultimate capital formation, on the other. It is simple economics: the higher the input costs of compliance, the smaller the output in the form of capital formation.

Ultimately, a balance of these opposing interests must be struck, but this is often easier said than done. There are powerful forces on both sides of this important regulatory fault line, meaning shake-ups often occur. Currently, these conflicts may be most starkly presented in Silicon Valley, the breeding ground of technological disruption and high-risk private start-ups.

On one side of the divide stands SEC Chair, Mary Jo White, who recently addressed what she views as a potential systemic threat to both primary and secondary investors and downstream market participants from value-inflated ‘unicorn’ firms – private start-ups with valuations that exceed $1bn. On the other side sits the influential private venture capital sector, which generally hopes to maintain the status quo of continued exemption from SEC disclosure regulations traditionally required only of publicly traded companies.

What is the problem that White wishes to address when it comes to private start-up valuations? In her recent keynote address at the SEC-Rock Center on Corporate Governance Silicon Valley Initiative, White explained that, for new and evolving markets to thrive, “all investors need confidence that they are being treated fairly and that the full range of risks are transparently disclosed”. According to White, with regard to ‘unicorn’ firms, it becomes challenging to “look past the eye-popping valuations and carefully examine the implications of this trend for investors, including employees of these companies, who are typically paid, in part, in stock and options”.

Her concerns appear to revolve around whether the hype, headlines and prestige associated with sky-high valuations are actively driving certain companies to engage in less-than-ideal practices that make them appear more valuable than they actually are. White appears concerned that the risks associated with distorted and inaccurate value-amplification are compounded by the fact that “start-up companies, even quite mature ones, often have far less robust internal controls and governance procedures than most public companies”.

The other side of the argument comes from those whose stance may more closely reflect the originally envisioned regulatory scope of the 1933 Securities Act. One of the driving theories behind the lack of an SEC regulatory regime for the private markets is that the sophisticated, risk-seeking investors participating in these markets do not need the exhaustive disclosures mandated by the US securities laws, which were designed for the protection of unsophisticated investors in public markets. Why shouldn’t sophisticated investors with the ability to fend for themselves be allowed to make high-risk investments as long as the investor is entitled to general anti-fraud protections and approaches the investment with a healthy understanding of the lack of regulation in place?

White believes we must look beyond the detriment to the individual investor, and should instead concentrate on the “downstream effects on other market participants”. When industry practices begin to have negative systemic effects in the financial markets as a whole, then, in her view, it may be time to step in and regulate private actors to protect the innocent public.

In her speech, White calls for “[v]igilance by private companies about the accuracy of their financial results and other disclosures”, and a willingness to “work together to ensure that [investor] confidence is well-placed, so that investors feel comfortable providing the capital essential for business development and growth”. With White’s suggestions in mind, a question arises: will the SEC attempt to extend its regulatory reach to private investments to protect investors if the private sector ignores White’s advice regarding industry self-regulation of disclosure?

It is quite possible the SEC will attempt to step in, given White’s recent emphasis on the dangers involved with inaccurate private start-up valuation. If the industry cannot come to an agreement regarding appropriate valuation practices for ‘unicorn’ start-ups, then we may find out what White had in mind when she explained that the SEC “will provide the appropriate regulatory oversight to protect investors so that they can have confidence in continuing to support the marvelous technologies for which [Silicon] Valley is famous”.

Commentators have begun speculating as to whether this oversight will come in the form of crackdowns against fraud in valuation practices, retroactive penalties during the IPO process for artificially inflating pre-IPO company values, or some other novel expansion – all possibilities inferred from White’s recent comments.

White has expressed that the rules and regulatory actions of the SEC must create an “environment that fosters innovation and growth” to “facilitate capital formation”. However, according to White, entrepreneurs and issuers in new markets themselves need to recognise that “protecting investors is at the core of the SEC’s mission and it should be something that they too hold at the core of what they do”.

If the SEC sees the potential for substantial downstream detrimental effects and systemic failure of investor protection, then the agency may not choose to wait until after a market meltdown to act on the valuation problems it says it perceives.

Michael Woronoff is co-head of the global Mergers & Acquisitions and Private Equity Groups, and Liam Gallagher is a summer associate, at Proskauer Rose LLP. Mr. Woronoff can be contacted on +1 (310) 284 4550 or by email: mworonoff@proskauer.com.

Michael Woronoff and Liam Gallagher

Proskauer Rose LLP