One contributing factor as to why companies stay (or go) private is to avoid the costs, burdens, and regulatory and legal risks associated with being a public company. But private companies are not as insulated from SEC scrutiny as they may think—a fact underscored by two recent events: (1) a speech by SEC Chair Mary Jo White on March 31, 2016 and (2) news reports that Theranos—a private company estimated to be worth more than $1 billion—is the subject of a current SEC investigation.
On one hand, the SEC’s expressed interest in scrutinizing private companies may not seem so convincing. The SEC has only a few tools to police the conduct of private companies, although the SEC’s most powerful anti-fraud tool—Section 10(b) and Rule 10b-5 promulgated thereunder—are applicable when private companies buy or sell their securities (with that term being defined quite broadly). The SEC also lacks the same type of visibility into the operations of private companies as it has with public companies. Private companies also tend to have larger and more sophisticated investors who can understand the risks, spot red flags, and have the financial ability to seek their own legal remedies for any harm they suffer as a result of their investment (a fact that White acknowledged in her speech).
But all that aside, it does make sense to take White at her word that the SEC is “monitoring and responding to developments in the private markets”? Here are a few key areas where private companies can expect to see the most vigilance:
Pre-IPO stage. White emphasized the importance of complying with the federal securities laws for any company anticipating or planning for an initial public offering (IPO). She also explained the importance of incorporating many of the obligations arising under those laws, such as maintaining proper books and records and having adequate internal controls. This is not particularly surprising as companies planning for an IPO already anticipate the scrutiny from the SEC that that process will bring. But pre-IPO private companies should be aware of two other tools that the SEC can utilize. First, if a company seeks to withdraw its registration statement for any reason, the SEC can refuse the withdrawal request, thereby precluding—for all practical purposes—the company from doing a private placement with a similar structure as the proposed IPO. Second, the SEC can administratively issue a “stop order” if it determines that the registration statement contains an untrue or misleading statement. Of even more consequence, the SEC can initiate an investigation into whether the registration statement contains any untrue or misleading statements, and the registration statement will not be effective while that investigation is proceeding.
Employees paid with private company stock. While investors in private companies tend to have sufficient sophistication to look out for themselves, the SEC views employees of private companies as among the more potentially vulnerable victims of any potential fraud. Accordingly, White articulated that the SEC would be vigilant with respect to private companies that issue employees stock as part of their compensation. In fact, one of the more recent and high-profile enforcement actions involving a private company focused on this issue.
Unicorns and valuation issues. White, perhaps unsurprisingly, expressed potential concern with respect to “unicorns”—private companies with valuations over $1 billion. She questioned whether the prestige and status associated with becoming (or remaining) a unicorn could lead to inflation or distortion of a company’s true value, especially given her perception that private companies do not have the same level of internal accounting resources and controls as most public companies.
Monitoring of issuances under new regulations. In passing Regulation A+ and Regulation Crowdfunding, the SEC sought to make the capital markets more accessible to smaller companies by creating more ways to sell securities without being subject to registration requirements. While the practical impact of these regulations remains open to debate, White emphasized that she has directed staff from across the SEC to monitor these issuances for potential problems or abuses.
Secondary market trading. White noted the increase in secondary markets for pre-IPO shares of private companies, and emphasized how these markets raise issues with respect to valuation and liquidity, and that the SEC would “scrutinize these emerging platforms to ensure they provide a functioning market that operates within the parameters disclosed to investors.”
In closing, the limited toolbox the SEC has to work with in regard to regulation of private companies, coupled with the lack of visibility it has into their operations, suggests that there will not be a significant uptick in the number of enforcement actions against private companies. This possibility, however, will be cold comfort to any private company that does find itself in the SEC’s crosshairs, and so private companies operating in the areas outlined above should be particularly conscious of this heightened scrutiny.