While sophisticated participants in private markets have historically been seen as capable of bargaining for information or withstanding losses better than mom-and-pop investors, current events signal that the U.S. Securities and Exchange Commission (SEC) intends to increase regulation and scrutiny of private companies. Based on recent public statements and enforcement activity, the SEC appears to be growing more aggressive in protecting private investors who have invested in early-stage startup companies. By way of example, on April 4, 2023, the SEC announced an action against Charlie Javice, founder and CEO of TAPD, Inc. (doing business as Frank), a private startup company that was sold to a financial institution for $175 million based on alleged false and fabricated data concerning the number of student customers. According to the SEC’s complaint, Javice hired a university professor to create “synthetic data” so that it appeared the company had data on 4.25 million student customers. The SEC alleges that the company only had data on 300,000 student customers. Other recent headline-grabbing cases involve Theranos Inc., a privately held company founded by Elizabeth Holmes and touted as a breakthrough health technology company, the cryptocurrency exchange, FTX, HeadSpin, YouPlus, and others.

This increased enforcement activity has been driven by the volume of exempt private securities offerings over the past decade, which have steadily grown to significantly outpace public offerings. According to the SEC, during the period of July 2, 2021, through June 30, 2022, exempt private offerings accounted for approximately $4.5 trillion in capital raising, compared with $1.23 trillion raised through registered offerings. This amounts to roughly 3.5 times more capital raised in private markets than in the public markets.

In a January 2023 keynote speech, SEC Commissioner Caroline Crenshaw called for increased disclosure and accountability for private companies that raise funds under the Rule 506 exemption. Among her proposed reforms is the creation of a two-tiered scaled disclosure framework for Rule 506 in which some private issuers (based on market cap, value, or size of investor base, among other factors) would be “subject to heightened requirements,” analogous to Regulation A - Tier 2 disclosure requirements, and potentially ongoing public disclosure obligations like Regulation A - Tier 2 issuers. The adoption of a tiered framework, according to Commissioner Crenshaw, recognizes that not all offerings are created equally.

Commissioner Crenshaw acknowledged the exponential growth of private securities offerings due, at least in part, to current disclosure requirements unintentionally incentivizing companies to remain private rather than go public and become subject to an invasive regulatory disclosure process. Despite conceding the unintended consequences of regulation, Commissioner Crenshaw posited that more fulsome information by private companies is essential to maintain the integrity of the securities markets and to allow private investors and regulators to make informed decisions. Meanwhile, others maintain that such disclosure obligations will be particularly challenging for startup companies and are likely to stifle innovation through increased regulation and costs.

The SEC is also considering amending Form D, the disclosure form that governs most private placements, to increase investigations relating to disclosures being made to private investors.

The SEC’s enforcement action against Javice, seen alongside proposed disclosure requirements, signals to all privately held companies that they should be mindful of their representations to investors, regardless of whether they are sophisticated investors. While the number of SEC enforcement cases against startup companies still pales in comparison to cases involving public companies, recent SEC enforcement activity and comments from the regulator suggest considerable forthcoming vigilance.

Although privately held companies may not be required to make the same level of disclosures to investors as publicly traded companies, it is still imperative to maintain transparency and provide relevant information to build trust and credibility. Here are some key takeaways to consider: