The Securities and Exchange Commission is primarily concerned with public companies and the securities markets in which the shares of public companies trade. However, in a series of recent speeches and presentations as part of what the agency had called the “Silicon Valley Initiative,” the agency made it clear that it is increasingly concerned with private and pre-IPO companies as well, particularly so-called “unicorns” – that is, the private start-up firms with valuations greater than $1 billion. SEC Chairman Mary Jo White highlighted these concerns in a March 31, 2016 speech at the Rock Center for Corporate Governance at Stanford Law School, a copy of which can be found here.
As summarized in an April 4, 2016 memo from the Fenwick & West law firm about the SEC’s Silicon Valley Initiative, “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.” The agency’s recent presentations and SEC Chair White’s speech, the memo said, underscored that “the SEC expects even private companies to embrace and demonstrate sound corporate governance.”
As discussed below, these pronouncements from the SEC raise troublesome questions about what has in the past been viewed as a clear demarcation between the potential liability exposures for private and public companies.
SEC Chair White’s March 31, 2016 Speech
In her March 31, 2016 Stanford Law School speech SEC Chair Mary Jo White noted that the agency’s core mission is to protect investors and she emphasized that that mission includes protecting investors in private companies.
As she said in her opening remarks, “Being a private company obviously does not mean that you can disregard the interests of investors. Indeed, being a private company comes with serious obligations to investors and the markets.” She also stressed that “some of the principles that characterize public companies – transparency with investors, controls on financial reporting, strong corporate governance – have applicability to private companies, especially those pre-IPO companies that aspire to go public, and should not be overlooked or avoided.”
Although White’s remarks were intended to apply to all private companies, she directed her comments in particular to so-called “unicorns” – that is, start ups with valuations in excess of $1 billion. She highlighted the concerns that can surround companies with these kinds of lofty valuations, and particularly the question whether the information supplied to investors in these companies is “accurate and complete – that is, whether it accurately reflects the performance and prospects of the company.” These concerns are even “more compelling” when the “transactions are smaller and the investors are more retail.”
White pointedly underscored that “it is axiomatic that all private and public securities transactions, no matter the sophistication of the parties, must be free from fraud. Exchange Act Section 10(b) and Rule 10b-5 apply to all companies and we must be vigorous in ferreting out and punishing wrongdoers wherever they operate.”
Of particular concern is the possibility that start-up firms might distort their financial reporting in order to try to achieve these kinds of lofty valuations, just as some public companies have been known in the past to alter reported results in order to meet prior projections. She noted that “the risk of distortion and inaccuracy is amplified because start-up companies, even quite mature ones, often have far less robust internal controls and governance procedures that most public companies.”
White also addressed concerns regarding secondary market trading platforms that have emerged in which early stage employees and others can trade their shares in pre-IPO companies, in order to be able to sell their shares to outside investors. White noted that these kinds of platforms have “had some problems,” particularly where secondary market investors did not have access to accurate information concerning the value of the companies in which they were investing.”
For private companies, particularly those on a pre-IPO track, these concerns have important implications. She said that “while internal controls over financial reporting, and the regulations and certifications that apply to them, do not apply to private companies,” all companies “should consider enhanced structures and controls for conducting their operations, especially in anticipation of going public.”
As start ups mature, it is “important to assess whether they are likewise maturing their governance structures and internal controls environments to match their size and market impact.” White said that there are four questions that entrepreneurs and their advisors and financial backers should be asking:
- Is your board expanding from founders and venture seats to include outsiders with larger, and ideally public, company experience?
- Do you have the right regulatory and financial expertise on your boards to appropriately make decisions on behalf of all investors?
- Do you have the relevant expertise in the particular industry in which your company functions to bring to bear different viewpoints and spot critical issues?
- Is you company being run and governed for the benefit of all of your investors, “a requirement whether the company is public or private and it is the responsibility of all market participants and their advisers to ensure that this overarching obligation is being fulfilled.”
Until recently, the standard view had been that there was a sharp difference between private and public companies, particularly with respect to the liability exposures associated with the two types of companies. However, as a result of various regulatory and legal changes, this distinction, which in the past has seen quite clear, has started to blur. Thus, for example, the JOBS Act provisions that allow small private companies to raise financing through crowdfunding include provisions subjecting these companies to potential liability under the federal securities laws. There are similar kinds of concerns in connection with the SEC’s recent Regulation A+ financing regulations (about which refer here).
Perhaps the distinction between private and public companies’ liabilities was never as sharp as was generally assumed in the past. But SEC Chair White’s comments underscore the fact that private as well as public company officials potentially can incur liabilities under the federal securities laws. In particular, she made a point of emphasizing in her speech that the liability provisions of Section 10(b) and Rule 10b-5 apply to both public and private companies. Her statement in reference to the applicability of these provisions to private companies that the agency must be “vigorous” in “punishing wrongdoers wherever they operate” makes it clear that the agency considers its remit to extend even to private companies, and that the agency will use its enforcement powers if it believes a private company has violated the anti-fraud provisions.
These comments obviously have important implications for private companies. To be sure, her remarks are most relevant to the larger private companies and the so-called unicorns, and to private companies on a pre-IPO track. But while the remarks are most relevant to these large and pre-IPO companies, from an analytic perspective there is nothing the limit the applicability of her remarks just to these larger and pre-IPO companies. By the same token, her helpful framework of questions that companies and their advisors should be asking is relevant for all private companies, but most obviously for those larger and pre-IPO companies.
White’s comments also raise important concerns for D&O insurance underwriters. The D&O insurance marketplace is built around a basic premise that private and public companies are fundamentally different. The D&O insurance for these two categories of companies are written in entirely different forms, in part based on the assumption that public companies have potential liability exposures under the securities laws, while private companies generally do not. SEC Chair White’s recent speech makes it clear that private companies have potential liability exposures under the federal securities laws.
There are a number of policy term and condition implications from all of this. First and foremost, in light of the potential liability exposures that private companies may face (as described in White’s speech), the Securities Exclusion in private company policies may need to be reviewed in order to ensure that the exclusion would not preclude coverage for securities law claims that might arise even while the company is still private. These concerns are most apparent for the larger private companies and for pre-IPO companies, but the concerns are not restricted to these kinds of companies alone.
The D&O underwriting implications of all this are a little harder to sort out. Obviously the suggestion of possible private company liability in SEC Chair White’s comments presents the most significant concerns of potential liabilities for the larger private companies, particularly the so-called “unicorns.” However, her comments also raise concerns for pre-IPO companies as well. Knowing that these concerns exist is not quite the same as knowing what to make of them.
White’s comments obviously raise the possibility of that the SEC might pursue an enforcement action against a large private company. But how pervasive is this risk? That is hard to know when to date there have been no enforcement actions filed yet against these kinds of companies. And do White’s comments include a suggestion of the possibility of private investor actions under the federal securities laws as well? The possibility of a private investor action in many instances will be remote, because in many instances the investors in these companies are accredited investors and qualified institutional buyers, who are sophisticated, well-informed, and relatively unlikely to filed lawsuits. On the other hand, the possibility of some time of private investor action increases to the extent retail investors become involved in company ownership.
Whatever the extent of the possibility of either a regulatory enforcement action or a private investor action, the possibility is less than zero. SEC Chair’s White’s comments suggest that this possibility is greater than may have been perceived in the past. This possibility is a concern that D&O insurance underwriters will have to consider, particularly in underwriting the larger private companies and pre-IPO companies.
Respect for Aretha: In his April 4, 2016 biographical sketch of Aretha Franklin in The New Yorker, David Remnick notes that his lifetime interest in the vocalist had been “reawakened” by the video of Franklin singing “(You Make Me Feel Like) A Natural Women” at the December 2015 Kennedy Center Honors. Franklin’s performance moved audience members, including President Obama, to tears. Remnick says of the video, “Watch it if you haven’t: in under five minutes, your life will improve by a minimum of forty-seven percent.” Here, to improve your life, is the video (listen to the intro, it is part of the scene; watch for Aretha to drop the mink coat):