By: Aleksandra Conway Silina
The proposed regulation from the Securities and Exchange Commission (“SEC”) is causing concern amongst venture capitalists. The new rule would make it easier to hold investors accountable for negligence, increasing venture capitalists’ (“VCs’”) responsibility for the failures of the startups they fund. Aimed at addressing issues such as “lack of transparency” and “conflicts of interest” in the private market, this regulation could have a significant impact during times of market uncertainty.
The recent string of scandals in the startup industry includes the downfall of FTX, a once highly-regarded crypto exchange that received support from prominent venture capitalists. The SEC’s new regulation and amendments under the 1940 Investment Advisers Act bans registered investment advisers from outsourcing certain services and duties without thoroughly evaluating and monitoring service providers. Before engaging with a service provider for a “covered function,” investment advisers must evaluate the provider and determine its suitability. The assessment must cover six specific elements: the nature and scope of the services; potential risks resulting from outsourcing the function to the service provider, plus risk mitigation strategies; the service provider’s competence, capacity, and resources to perform the covered function; the service provider’s subcontracting arrangements related to the covered function; coordination with the service provider regarding compliance with applicable law; and the orderly termination of the service provider’s engagement. The proposed regulation mandates investment advisers to fulfill specific “due diligence” criteria prior to hiring a service provider for certain advisory services or functions, and to continuously monitor the provider’s performance. It applies to advisers outsourcing “covered functions,” defined as necessary services for compliance with federal securities laws, which if performed inadequately, would harm clients by misusing their funds and making risky investments. The regulation also requires advisers to thoroughly evaluate and monitor all third-party recordkeepers, ensuring they meet necessary standards, and to keep records of their oversight duties, reporting census-style information on covered service providers. Earlier last year, the SEC had already threatened to increase required transparency for large private companies, as regulators expressed alarm regarding the absence of monitoring for the private fundraising driving their growth.
There is a growing concern that if the rule is adopted by the SEC as proposed, startup companies might be the ones suffering most. The proposed regulation has been met with strong opposition, with VCs arguing that the rule interferes with their central role of supporting portfolio companies. The National Venture Capital Association states that under the current proposal, the closer a VC is to a company, the more liable they could be for future issues. VCs’ concerns go beyond legal protection, as the SEC has proposed a regulation which could also affect venture firms’ fundraising methods. It restricts the terms VCs can negotiate with investors and mandates disclosure of all terms, making it difficult for new VC firms to raise their initial funds. This is because the favorable terms offered to first anchor investors would become public information and could be expected by other investors. This could be devastating for the startup companies, especially considering how unstable the economy in the United States is right now. It may be hard for newer companies to secure funding since completing the six-element check described above is both expensive and time-consuming.
VC firms invest in early-stage startups, often based only on ideas. The biggest challenge for due diligence is the lack of data. In these cases, research must rely more on external market information and potential customer willingness to pay for the portfolio company’s services. If the idea has shown some traction, then both internal and external analysis is necessary. Internal analysis involves details about the company’s operations, finance, and market opportunity. Another challenge is to maintain an active deal pipeline to allow for multiple due diligence exercises. Due diligence often raises red flags, so having multiple deals in the pipeline allows a VC firm to walk away from a potential investment until they find a company that justifies the investment of both money and time. Basing investments on personal relationships or biased networks can lead to suboptimal results and overvalued assets, as these deals may also be evaluated by others, causing fear of missing out among VCs.
While the SEC did accept comments on the proposed rule, there is little hope that it will change course and consider the complexity of outsourcing with the proper due diligence and its effects on the young, small companies. However, only time will show if the proposed rule has more disadvantages.
Student Bio: Aleksandra Conway Silina is a second-year student at Suffolk University Law School. She is a staff writer on the Journal of High Technology Law. Aleksandra has received her first law degree with a concentration in corporate and business law from Higher School of Economics in Russia.
Disclaimer: The views expressed in this blog are the views of the author alone and do not represent the views of JHTL or Suffolk University Law School.
