SEC compliance: the SEC and growing scrutiny of private companies

Public companies are subject to detailed disclosure laws regarding financial condition, operating results, management compensation and other business areas. However, private companies are not entirely exempt from SEC scrutiny.

In March 2018, the SEC brought extraordinary charges against privately-held, Silicon Valley-based company, Theranos Inc., founder Elizabeth Holmes and former President Ramesh “Sunny” Balwani. They were charged with raising over $700 million from investors through exaggerated and false claims regarding the company’s technology, business and financial performance. More recently in April 2019, the SEC charged former Jumio CEO, Daniel Mattes, with defrauding investors and CFO Chad Starkey for failing to exercise reasonable care concerning Jumio’s financial statements. Jumio, like Theranos, was a privately-owned, Silicon Valley startup.

With the SEC paying increasingly closer attention to private companies, it is important to understand how to stay in SEC compliance and avoid intense scrutiny.

Who is the SEC?

The United States Securities and Exchange Commission (SEC) is an independent government agency organized to protect investors, preserve fair and organized functionality of the securities market and facilitate capital formation. Founded in 1934 following the 1929 stock market crash, the SEC has long worked to inspire investor confidence. As a means of doing so, the SEC oversees organizations and individuals in the securities markets, including securities exchanges, brokerage firms, dealers, investment advisors and investment funds.

Generally speaking, the SEC requires registration of securities offered in interstate commerce before they are sold to investors. Additionally, the agency mandates registration of financial service firms, including broker-dealers, advisory firms and asset managers, as well as their professional representatives.

In terms of punishment, the SEC is restricted to only bringing civil action. However, they do work with the Department of Justice to provide evidence and assist with court proceedings in criminal cases. In civil suits, the SEC seeks two primary sanctions:

1. Injunctions
2. Civil money penalty and disgorgement of illegal profits. In select cases, the SEC may also seek a court order to bar or suspend individuals from acting as corporate officers or directors (as in the case of Elizabeth Holmes).

SEC Compliance: What is the SEC focusing in on?

In recent years the SEC has not been shy about discussing their intentions to ramp up scrutiny of privately-held companies. In 2016, then-Chairwoman Mary Jo White delivered a groundbreaking keynote address at the SEC-Rock Center on Corporate Governance Silicon Valley Initiative regarding the rise of technology companies and the evolution of the financial markets. Throughout her speech, she highlighted the growing commitment by the SEC to evaluate private companies. She states:

“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.  Whether the source of the obligation is the federal securities laws or the fiduciary duty that is owed to shareholders, the resulting candor and fair dealing should be fundamentally the same.  And beyond any specific regulatory requirements, some of the principles that characterize public companies – transparency with investors, controls on financial reporting, strong corporate governance – have applicability and relevance to private companies, especially those pre-IPO companies that aspire to go public, and should not be overlooked or avoided, whether or not mandated by federal law or an SEC regulation.”

Additionally, former Chairwoman White, Enforcement Director Andrew Ceresney and then-Director of the San Francisco regional office of the SEC Jina Choi have also talked about a focus on secondary market trading of pre-IPO shares. In wake of the technology surge, a pre-IPO secondary market developed. This market allowed early stage employees to sell their stock to outside investors.

However, the market was fraught with problems. These concerns included unregistered broker-dealer activity, conflicts of interest, undisclosed compensation and fraudulent offers of pooled investment vehicles that purported to hold pre-IPO stock. The SEC believes many of these issues are a result of secondary market investors being denied access to accurate information regarding company valuation.

Other areas of concern involving private companies are financial controls and corporate governance. As privately-held companies are holding out from an initial public offering (IPO) for longer periods of time, some SEC compliance procedures may not be in place. For instance, the SEC is concerned that these companies of great size and valuation may not have an audit committee or disclosure controls and procedures. As such, the SEC has heightened awareness of internal controls of large private companies.

More specifically, as startups mature and generate revenue to achieve significant valuations while remaining private, it is important to assess whether their governance structure and internal controls environment align with their size and market impact. This is especially of concern for companies on the cusp of becoming public.

SEC Compliance: So who is receiving greater scrutiny from the SEC?

Primarily, “unicorns” are drawing the greatest scrutiny from the SEC. Unicorns are private startup firms with valuations exceeding $1 billion. As of the 2016 address, there were nearly 150 unicorns throughout the world. With a growing number of these companies in the United States, the SEC is looking past the exorbitant valuations and examining the implications for investors, as well as employees paid in stock and options.

Furthermore, since the launch of the “Silicon Valley Initiative,” the SEC’s enforcement division has targeted private companies whose employee equity plans fail to satisfy the safe harbor elements of Rule 701 of the Securities Act. Most notably, in March 2018 Credit Karma, private financial technology (fintech) company received a $160,000 penalty for failing to provide detailed financial information and risk disclosures to employees as required by Rule 701.

More generally speaking, the SEC is growing increasingly aware of private companies that may be acquired by a public company or are large enough to consider an initial public offering.

What do you need to report to stay in SEC compliance?

As Elizabeth Holmes and Daniel Mattes have learned, misrepresenting actual financial and operational performance can lead to dramatic results. Holmes herself agreed to pay a $500,000 penalty, return her 18.9 million shares, and relinquish voting control of Theranos. She is also barred from serving as an officer or director of a public company for 10 years. Thus, it is vital to take proactive steps to comply with SEC regulations and avoid significant and devastating punishment.

Frankly, the reporting requirements for private companies vary based on the agreements set in place by stakeholders. However, the SEC requires a private company to file financial reports when it has amassed more than 500 common shareholders and $10 million in assets.

Furthermore, a privately-held company must file Form 10 when their stock ownership and assets exceed the above limits. Form 10 describes the business and officers in a manner similar to an initial public offering. Upon filing the form, the SEC expects said company to file quarterly and annual reports.

What are some other proactive SEC compliance strategies to stay ahead of an investigation?

Instituting extra SEC compliance protocols is beneficial whether or not a company intends to go public. Some other suggestions are:

• Develop written and enforceable compliance policies and processes regarding financial reporting, disclosure, compensation, cybersecurity, insider trading and policies designed to prevent violations of the Foreign Corrupt Practices Act (if the business partakes in international ventures).
• Develop a whistleblower program. While the SEC has a similar organization in place, it is ideal to introduce a program that provides an avenue for employees and consultants to bring issues to the attention of senior management and the Board of Directors. Employees may turn to the government if they do not have an effective method of addressing concerns with senior leadership.
• If shares are traded in the secondary market: Develop procedures to monitor and review company disclosures or other publicly available information impacting trading. Also, monitor which material and nonpublic information is available to the directors, employees and others who are selling shares in the secondary market.
• Have Boards meet with experienced regulatory counsel on a regular basis, much like public companies. This helps to stay in line with current issues and best practices. Furthermore, this demonstrates a high degree of sophistication, as well as a serious understanding of the SEC’s recommendation to adopt improved internal controls.
• Ensure that statements regarding key technology are accurate.

For more information on this topic or to learn how Baker Tilly specialists can help, contact our team.