The SEC is understood to have subpoenaed a number of firms in connection with an investigation into the sale of private pre-IPO technology stocks, following an increase in the trading of these private shares. Shares of private tech start-up companies are generally issued to investors and insiders who hope that the company will eventually launch an initial public offering and that the private shares will dramatically appreciate in value. Because the shares can explode in value once the IPO occurs, they are extremely desirable. Moreover, as tech companies remain private for longer periods of time, there is a greater desire among the companies and their employees to seek to monetize the value of pre-IPO shares. Thus, a market has been created to provide a vehicle for trading in pre-IPO shares.
The SEC is particularly concerned about whether such trading is taking place through the use of swaps and other derivatives, something which is generally prohibited under section 5(e) of the Securities Act of 1933 and Section 6(l) of the Securities Exchange Act of 1934. These provisions prohibit any person from effecting a transaction in a security-based swap with or for a person who is not an eligible contract participant (or, in other words, an accredited investor), unless (1) there is an effective registration statement; and (2) the transaction is effected on a national securities exchange. The purpose of the rules is to make financial information about the offering transparent to retail investors and to limit such transactions to regulated platforms.
The SEC's investigation follows its first enforcement action under these regulatory rules after they were imposed under Title VII of the Dodd-Frank Act of 2010. In June 2015, the SEC settled an enforcement action with Silicon Valley-based Sand Hill Exchange ("Sand Hill"), after it was found to be offering and selling security-based swap contracts to retail investors outside of a national securities exchange and without effective registration statements. Sand Hill started out as an online business that was similar to a fantasy sports league but, instead of athletic performance, it measured the valuation of private start-up companies in the tech sector. The firm morphed into an online platform where investors used dollars or bitcoins to buy and sell contracts referencing the pre-IPO companies and their value. Because these so-called "smart contracts" were based on the value of private companies at a liquidity event (e.g. merger, IPO or dissolution), they constituted derivatives that required registration or investor accreditation under the Dodd-Frank Act. As part of the SEC action, Sand Hill and its principals agreed to (1) stop offering "smart contracts"; (2) cease and desist from committing or causing and future violations of the securities laws and (3) pay a fine of $20,000.
In the release announcing the Sand Hill charges, the Deputy Chief of the SEC Enforcement Division's Complex Financial Instruments Unit made clear that the SEC "will continue to scrutinize this space for companies circumventing the law to offer security-based swaps without safeguards provided to retail investors."
A number of firms have been established in recent months which offer derivative transactions to employees of private tech firms who want to sell their employee shares. The SEC is understood to be seeking information from several of such firms about these transactions. It bears mention that, as well as potentially breaching securities regulations, such trades may also violate company policies.
The SEC is also understood to be looking into whether hedge funds have misled investors about special purpose vehicles that purport to invest in pre-IPO tech shares. The SEC is questioning whether the funds have accurately stated their access to pre-IPO shares of well-known private tech companies or their valuation methodology.
Private companies, hedge funds, and individual investors would be well-advised to tread carefully in transactions involving private, pre-IPO shares of tech companies, especially derivative transactions. While such shares present an extremely attractive upside if the IPO takes off, there are numerous legal and business considerations that must be taken into account in connection with any transaction or investment in a pre-IPO stock.