One of the best ways to learn what bugs a regulator is to look at who they're going after. The SEC's recent enforcement action against StraightPath Ventures and its principals teaches an intriguing lesson. That lesson, at least when it comes to certain high-risk investments, is to bare it all. See the SEC's complaint here. https://www.sec.gov/litigation/complaints/2022/comp-pr2022-83.pdf
StraightPath is one of many private equity funds that buys shares in private companies that one hopes will someday score an IPO, and then sells fund interests to investors looking to profit from that IPO when and if it ever comes. It is a fundamentally simple business. The private shares are usually sold by employees of the company who got stock for compensation, and who now find themselves worth millions on paper but still living in their childhood bedrooms because there's no public market for their shares. Private equity funds like StraightPath buy up those shares and hold them waiting for the IPO payoff. These so-called pre-IPO funds then sell pieces of themselves to smaller investors. Basically, they buy at wholesale and sell, indirectly through the fund, at retail. And of course and invariably, they sell at a higher price than what they paid.
The SEC accused StraightPath of many things. StraightPath allegedly did not own all the stock they said they did, it moved cash and assets between funds while telling investors each fund was independent of others, it paid sales commissions without registering as a broker-dealer. My personal favorite is the accusation that it deleted email accounts that the SEC had subpoenaed. How did the SEC know? Because of text messages like these, as alleged in the following paragraphs of the SEC's complaint:
161. That same day, Castillero discussed the sales agent emails with Martinsen by text message. Martinsen privately admitted in this discussion that certain sale agent emails "put[ ] us at risk." Castillero agreed, writing "[a]n asshole regulator would have a field day" with these emails.
162. On May 5, 2021, the date Commission staff told Martinsen that communications (including email) with the first ten sales agents were due, Martinsen confided in Castillero by text message: "We r going to claim they they [sic] don't have emails and we don't. Have archives . . . "Just delete there [sic] emails. Fuck it."
This suggests a best practice, and if you can't figure it out you should just call me.
But what interests me here is not any of that, but rather the SEC's accusation that StraightPath sold its pre-IPO shares for prices that were on average 19% to 65% higher than it paid for them. The SEC decried these as "high," "excessive," and (in its Memorandum of Law to the Court) "exorbitant" markups. By using such a crescendo of pejoratives, the SEC would have us be shocked. But this is 2022. We've seen enough in the past few months, not to mention the past several years, that's it's going to take a lot more than stock jocks making a few extra bucks to move our outrage needle.
No, the real issue was not that StraightPath's markups were "high," "excessive" and "exorbitant." It was that they were not disclosed. The SEC's legal claims are all predicated in fraud, which necessarily implies a failure to disclose when there was a duty to do so. According to the SEC's complaint, that duty came from two sources: first, that the StraightPath offering documents claimed that all upfront fees were waived; and second, that the markups were principal transactions that needed to be disclosed under Section 206(3) of the Investment Advisors Act of 1940. In other words, had StraightPath disclosed its markups, the SEC might still have thought them high, excessive and exorbitant, but it wouldn't have been able to do much about them.
As we securities lawyers know, disclosure cures most ills, and virtually all of them when it comes to dealing with investors. But here's the interesting thing: Disclosing StraightPath's profits probably would not have deterred any investors from buying its funds. I know that because for several years I have advised clients who operate pre-IPO funds similar to StraightPath's to do just that, and no investors have shied away from them. On one occasion one of our clients revised its offering documents to disclose exactly how many pre-IPO shares it purchased, when and for how much, the higher nominal per share price offered to its investors, and how much profit the fund sponsors would make. It then offered to rescind the purchases of all previous investors who wanted out after seeing the revised offering.
Not one investor rescinded. To the contrary, one investor offered to buy up the interests of any who might have.
Whether out of shame or modesty -- probably not modesty -- StraightPath chose to hide the profit it made on its offerings. It thought investors would care how much profit they made. It turns out they don't. That all fund promoters make a profit is as obvious as that everyone is naked underneath their clothes, and no one really cares about either fact.
At least no one cares when it comes to pre-IPO funds, and no one should. If an investor is looking to achieve a 5% return on an investment, then hidden fees or markups will matter. If the investment costs more than the investor thinks, that extra cost will mean the investment will have to perform better than expected to yield the expected return. But no investor buys into a pre-IPO fund looking to make a 5% return. Those investors are looking for more like a 5X return, and they know their investment will either win big in an IPO or be worthless. Investing in pre-IPO shares is win or lose, like playing the lottery. When one is chasing a dream, it hardly matters whether the ticket costs one dollar or two. That's why how much profit you make in selling a pre-IPO fund won't matter to investors, and why it is safe to disclose it, from both a legal and a business perspective.
But there's another angle to this. When it comes to disclosure, the key concept is materiality. Only material information needs to be disclosed, and what is "material" is whatever a reasonable investor thinks is important. If I'm right that a reasonable investor in a pre-IPO fund doesn't care how much profit the fund sponsor makes, then by legal definition that profit is not "material." Arguably, then, it needn't be disclosed at all.
Maybe, but don't try it at home. When it comes to selling pre-IPO funds, full frontal disclosure of markups and profits is the onliest way to go.
Aegis Frumento co-heads the Financial Markets Practice of Stern Tannenbaum & Bell, New York City. He represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations). He has decades of experience representing SEC, CFTC and FINRA regulated firms and persons in regulatory enforcement investigations, hearings and lawsuits. Drawing on his five years managing the Executive Financial Services Department of Morgan Stanley Smith Barney, Aegis has rare depth of experience in the securities and corporate governance laws affecting senior executives of public corporations. When not litigating, Aegis enjoys working with new and existing broker-dealers, registered investment advisers, and private equity funds, covering all legal aspects from formation to capital raising. Those clients now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises, including the use of cryptosecurities to represent equity and debt interests.
Aegis's long and distinguished career includes having been a Managing Director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP. He graduated from Harvard College in 1976 and New York University School of Law in 1979. Aegis is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments. He is the current Chairman of the New York City Bar Association's standing Committee on Professional Responsibility.
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