EquityZen Knowledge Center

EquityZen has curated this list of quality resources for secondary investors, shareholders and company representatives.
Have additional questions? We'd love to hear from you.

SEC Charges Theranos With Fraud: Initial Thoughts

SECElizabeth HolmesfraudTheranostheranos ruling
...show more tags

Shriram Bhashyam   March 14, 2018

The SEC announced today that it has charged Theranos, Elizabeth Holmes (founder and CEO), and Sunny Balwani (former President) with what it is calling a "massive" fraud. This story is still developing, but since it is an important one we are going to dive in to some preliminary reactions.

  1. The SEC's anti-fraud provisions apply to private companies too. While long known to securities law nerds (I proudly claim that tribe), the startup community may not have been aware that the SEC's rules around fraud in securities transactions apply to Silicon Valley startups who have not yet IPO'ed. While there are a variety of anti-fraud rules, the most pertinent ones are that companies, and their founders and executives, can be held liable for material misstatements or material omissions in connection with their fundraising activities. This applies to fundraising decks, demo days, phone calls, emails, and even media appearances or quotes.

  2. Theranos is an outlier, don't extrapolate too far. In my view, the Theranos case is not representative of the conduct of startups or of their founders. The conduct of the company, Holmes, and Bulwani, if true as alleged by the SEC (I'd bet that it is), is exceptional. While founders are generally prone to optimism (it's basically required to build a company), the facts here go well beyond an exuberant view of what could be. According to the SEC, Theranos, Holmes, and Bulwani claimed that their products were deployed by the US Department of Defense on the battlefield in Afghanistan. This was not true. This was one among several egregious misstatements they made to investors.

    Zooming out a bit, one of the main themes of the fraud was that, through a variety of misstatements, they deceived investors into believing that their portable blood analyzer could conduct comprehensive blood tests from mere finger drops of blood, revolutionizing the blood testing industry. In reality, the defendants greatly exaggerated the capabilities of their product; it could conduct only a small range of tests and the vast majority of tests they conducted were done on modified or third-party analyzers—not the product they were pitching.

  3. Companies and boards need to improve governance. Uber, Zenefits, Hampton Creek, Theranos. While Theranos stands apart as an outright fraud, there is a theme of weak governance at startups.  Since the SEC came to Silicon Valley and announced it was concerned about "eye-popping" valuations in March 2016, its gaze has grown sharper in focus. Now is the time for companies to step up internal governance and controls. I'm thankful that it appears we are moving beyond the days where investors would look the other way at founder indiscretion or mismanagement.





  4. Three ways to improve governance. Companies should examine whether their internal controls (financial, legal, HR) are in proportion to their scale. As an example, look at how quickly Uber scaled as an organization while keeping a small HR function that was not empowered to address real culture and employee workplace issues. Second, large startups should have independent board members. Let's have a fresh voice who may not be concerned about being "founder-friendly." Third, large startups should have a whistleblower hotline. Companies should encourage the internal reporting of problems, as it's better to identify issues early before the media or regulators come knocking.

  5. Management should be careful about what they say to potential investors. Theranos should be a wake-up call to founders to use caution in how aggressively they pitch their companies. They should make sure they are including all the important facts, that the important facts are accurately disclosed, and that any claims or projections are well-reasoned. Founders should be ready to provide back up for what's in the deck and make sure they include any assumptions on which the claims are made. 

Neither EquityZen nor its affiliates have conducted a transaction in Theranos.
Read more...

Q&A with Troy Paredes: How the SEC Regulates Silicon Valley (Part 2)

SECRegulationInvestorFintechLegal

Shriram Bhashyam   April 13, 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. You can read Part 1 here.



Shri Bhashyam: I’m glad you raised your views on where regulation needs to go.​ Under most recent SEC Chair Mary Jo White, it seemed the drumbeat had grown steadily. It started with Theranos, and then Chair White gave a friendly warning of sorts to Silicon Valley, and then controversies at Hampton Creek and Lending Club came to light, and finally some shareholder lawsuits. How would you contrast a prospective SEC agenda under Chair Jay Clayton (assuming he is confirmed) to that of most recent Chair Mary Jo White?

Troy A. Paredes: SEC Chairs (as well as Commissioners) take enforcement very seriously, even if they have different ways of going about it.  Each and every part of the SEC’s mission – protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation – requires the regulator to identify misconduct and hold wrongdoers accountable. 

In an environment where there often is a lot of disagreement, one item stands out to me for the bi-partisan support it gets – namely, there is widespread agreement that the SEC should use data and technology as part of its examinations, inspections, and enforcement.  Data analytics has become an important part of how the SEC goes after fraud and manipulation.  I expect that to continue, regardless of the SEC’s political makeup.  It will be particularly interesting to see how things like artificial intelligence and machine learning end up factoring in.

Stepping back a bit, I expect this SEC to focus on economic growth by taking sensible steps to make it easier for companies to raise capital – in other words, by giving new life to the SEC’s capital formation mission.  It will take some time to see which exact rules and regulations may be up for reform.  But generally speaking, I think the effort should include a “retrospective” review that evaluates whether and how the regulatory regime has proven too costly and burdensome, working against the best interests of both companies and investors. 

SB: What will the change in administrations mean generally for financial regulation?

TAP: One place to look is the President’s recent Executive Order on Core Principles for Regulating the United States Financial System.  In short, I think attention be will paid to how regulation, notwithstanding the best of intentions, can end up being counterproductive, disadvantaging our markets, companies, investors, and taxpayers.  Cost-benefit analysis and data-based regulatory decision making can help ensure that we do more good than harm.  I advocated for both during my time at the SEC.

SB: What are some big regulatory topics fintech firms should pay attention to in 2017?

TAP: Across our economy – indeed, across our lives – technology will continue to give us new opportunities and new ways of doing things faster and cheaper.  That’s good.  At the same time, precisely because it can be disruptive, innovation can cause dislocations as machines and software are used instead of people to do certain jobs.  We need to take seriously the difficulties people face when they are displaced by technology, even as we appreciate the new jobs that technology creates.

As for fintech specifically, I think we’re still in the early days, with much more ahead of us.  Part of what lies ahead is how regulators respond.  Financial regulators, including the SEC, have been paying more-and-more attention to how fintech affects how parties transact, how capital flows, how advice is given, how trading occurs, how markets are interconnected, and how personal information is vulnerable.  While regulators welcome innovation and the choice, competition, and cost-savings it spawns, they still have to ask a simple question:  Do we need to adapt our rules and regulations to account for the changes fintech is bringing about?  The SEC, for example, held a roundtable on this very question last year.  That was just the beginning of the SEC’s focus, not the end of it.  Fortunately, the predilection isn’t necessarily for more regulation.  In the minds of many, rules and regulations should be updated to facilitate innovation – 21st century regulation for 21st century technology.

In addition, regulators are themselves users of fintech.  Financial regulators will increasingly use technology – algorithms, machine learning, artificial intelligence – to detect misconduct and to develop their enforcement actions.   For those the regulators regulate, then, technology should become a more robust part of their compliance programs.  Traditional written policies and procedures soon will not be enough.  This is the fast-growing field of regtech.  I encourage companies to get on board by evaluating how they can take advantage of technology to bolster compliance.  

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.”


Read more...

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

SECRegulationInvestorLegal

Shriram Bhashyam   April 05, 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.”

Read more...
Have questions?