Q&A with Troy Paredes: How the SEC Regulates Silicon Valley (Part 1)

Shriram Bhashyam
Apr 5th, 2017
The change in administrations at the White House has multifold ramifications for startups. Important among those areas is the Securities and Exchange Commission’s (“SEC”) posture towards Silicon Valley and how that agenda may shift under incoming Chair Jay Clayton. We’ve tapped friend of EquityZen, and former Commissioner at the SEC, Troy A. Paredes to shed some light.

Shri Bhashyam: There has been an uptick in media attention and shareholder lawsuits related to possible securities fraud at big, later stage (“Unicorn”) startups, such as Theranos and Hampton Creek  (whose investigations by the SEC and Department of Justice were recently dropped). First, what are the main legal issues underlying these controversies?

Troy A. Paredes: The typical securities fraud case, whether it is brought by investors or the government, alleges that there was a material misstatement or omission – in other words, that information provided to investors was wrong in an important way.  Investors need accurate information to make informed decisions; they can’t be misled.  So protecting investors from fraud is key.  That’s true whether investors are investing in private companies or public ones.  At the same time, there’s a difference between fraud, on the one hand, and things simply not going as well as expected at a company, on the other.  Indeed, courts have consistently cautioned against so-called “fraud by hindsight” – a caution that matters a lot for startups and other emerging companies for which there often are genuinely high hopes that just don’t pan out.

SB: To what extent can startups rely on the fact that the investors coming in to their funding rounds are sophisticated folks or entities who can fend for themselves?

TAP: Routinely, private securities offerings are limited to “accredited investors” – certain institutional investors and people who meet income or wealth qualifications under SEC Regulation D. The idea is that if the investors buying into an offering can “fend for themselves,” then the government is justified in easing up on its regulation.  In practice, this means that a valid private placement under Reg D doesn’t have to meet the many Securities Act requirements that a public offering does.  Along these lines, two points are worth noting. 

First, even when a company raises money only from accredited investors, the company is still subject to the antifraud provisions of the federal securities laws.  Reg D may exempt a company from having to file a registration statement with the SEC, but it does not exempt a company from Rule 10b-5 prohibiting fraud. 

Second, the SEC has been reconsidering the definition of accredited investor, which has been on the books for years.  I’d like to see the definition modernized to help startups and other early-stage companies more easily raise the capital they need to grow and prosper.  Furthermore, if you’re not “accredited,” the law effectively puts you on the outside looking in when it comes to getting in on the ground floor, to mix my metaphors.  So changing the definition of accredited investor to give more investors more opportunity to invest in emerging companies can be good for investors too.  People who today don’t qualify as “accredited” but who would under an updated definition – if the SEC ends up adopting one – would have more freedom in deciding for themselves how to invest since private offerings would be more open to them.  That said, there are no guarantees when investing, and the chance to earn outsize returns can come with the potential to lose a lot.

SB: Are there any common threads among the Unicorn stories that are tied to securities fraud?

TAP: Compliance has to be taken seriously.  Integrating compliance, along with reputational risk, into a firm’s overall risk management framework can help ensure that it’s front-and-center.  Even for a startup, let alone a Unicorn, you should have good governance and sound controls.

That said, one size doesn’t fit all.  Policy makers should avoid over-regulating new and emerging companies.  In fact, what we need to do is continue promoting small business capital formation.  The reason is simple: entrepreneurs help drive economic growth and job creation.  Their ideas lead to breakthroughs that make our lives better.  That’s why I focused on helping small business when I was in government, including by supporting the JOBS Act.  While we’re at it, we should also adopt common-sense reforms to spur the IPO market.

Troy A. Paredes is the founder of Paredes Strategies LLC and is a Senior Advisor at CamberView Partners, LLC.  From 2008-2013, Paredes was a Commissioner of the U.S. Securities and Exchange Commission, having been appointed by President George W. Bush.  Paredes advises companies on financial regulation, corporate governance, compliance, political risk, and government investigations.  Before becoming a Commissioner, Paredes was a professor of law at Washington University in St. Louis.  Currently, he is a Distinguished Scholar in Residence at NYU School of Law and a Lecturer on Law at Harvard Law School.  And he is the co-host of a fintech podcast called “Appetite for Disruption.”

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