Private Investment Diligence and Fraud Prevention: Will New Regulations Change the Game?

07 February 2023 Blog
Author(s): Andrew A. Howell Shabbi S. Khan Nikhil T. Pradhan Alidad Vakili
Published To: Foley Funds Legal Focus Innovative Technology Insights

Venture capital and other private funding sources continue to be an important pathway for financing early-stage companies. Unfortunately some startups that raised money did so by misrepresentation and in certain cases fraud, only to end up failing when the truth was finally discovered - resulting in significant losses for their investors.

Given the high-profile nature of a few of these failed startups and the resulting losses, there has been a call for increased scrutiny. The U.S. Securities and Exchange Commission (SEC) in particular appears to have heard the call and has proposed new regulations that may result in requiring certain investors to exercise a higher level of scrutiny when considering an investment. In this article we will explore the implications of such proposals and how they may affect investment firms’ obligations to their investors, as well as the overall startup investment landscape.

Current Landscape and New Regulations on the Horizon

The three key players involved in VC (or other private market) investments are (1) the companies seeking funding, (2) the investment firms making the investments, and (3) the investors who provide the capital to the investment firms. Generally, investment firms and investors have a mutual understanding that both parties have the expertise, sophistication, and diligence capabilities to allocate capital across investments in a manner that outweighs the (perhaps greater) risk of such investments relative to public market investing. However, factors such as fraud, misrepresentation, and other misdeeds can be difficult to quickly identify during standard diligence, which oftentimes is focused on a high level or red flag review that may not get into enough depth, especially when it comes to independently validating a technology or product. Additionally, many earlier stage startups do not have the resources to have audited financials, thereby eliminating another important diligence process. As a result, the call for greater scrutiny may even become louder as more avenues for retail investors to access private markets open up.

For example, the SEC is finalizing a proposed rule that would make it easier for investors to sue venture capital firms, private equity firms, hedge funds, and certain real estate investment companies (i.e., any private investment fund subject to SEC oversight) for failures at the startups they back. The SEC has been working on the proposed rule for a year, which could go into effect as soon as April 2023. In particular, the proposed rule would, if enacted, require:

- registered investment advisers to private funds to provide transparency to their investors regarding the full cost of investing in private funds and the performance of such private funds

- a registered private fund adviser to obtain an annual financial statement audit of each private fund it advises and, in connection with an adviser-led secondary transaction, a fairness opinion from an independent opinion provider

- prohibit all private fund advisers, including those that are not registered with the SEC, from engaging in certain sales practices, conflicts of interest, and compensation schemes that are contrary to the public interest and the protection of investors

- prohibit all private fund advisers from providing preferential treatment to certain investors in a private fund, unless the adviser discloses such treatment to other current and prospective investors

Reactions and Impacts

To comply with these types of requirements, investment firms may have to adjust how they monitor and audit both the business models and underlying financials of the portfolio companies they invest in. While the proposed rule is designed to deal with lack of transparency, conflicts of interest, and other problems seen in private markets, it has received negative feedback from the industry. According to the National Venture Capital Association (NVCA), under the new rule the more involved a VC gets with a company it invests in, the more responsible that VC can be held for problems down the line—so much so that the NVCA asked the SEC to abandon the proposed rule, calling it “profoundly flawed.”

Nevertheless, current diligence practices have been recognized to have shortcomings: “As an investor, when the environment is ‘frothy’ you are much more likely to run into these problems,” Bill Gurley, a general partner at the Silicon Valley venture fund Benchmark, recently wrote. “Ironically this is also the precise time when raising concerns will make you look like a washed up veteran who is unable to adjust to the new ‘realities.’”

One key impact of such rules that we will undoubtedly see is an increase in litigation filed by unsatisfied investors. In the current unsettled market environment, investors will see the rule as an opportunity to recover losses from investment companies that would not have previously been culpable. As a result, the role of these investment companies may change and that may change the entire landscape of the investment market.

Investment companies may have to increase their diligence efforts to fulfill obligations and limit their potential exposure. Whether this will translate into hiring more professionals to conduct the diligence internally or hire more outside professionals so that liability can be passed or shared is yet to be seen, but either would impact the fees and expenses charged and therefore investors’ bottom line. Indeed, it could create a new subset of services and professionals in the industry. In addition, investment companies that often follow a lead investor’s credibility and diligence may choose to increase their independent diligence review of a possible investment. Early stage companies seeking investment may also find ways to standardize how they present their business models and financials in order to streamline increased diligence.

The new rule may also impact the process investment companies use to vet and diligence the startups they want to invest in. Today, getting involved with and helping startups is one key aspect of what many investment companies do.  Without access to private capital from venture capital and other investment companies, many startups will be unable to commercialize their technology.  Will the SEC’s proposed rule lessen the investment companies’ appetite for investing in startups, leaving them unable to obtain the financing to get off the ground, or will it lead to an increased level of scrutiny and diligence that may result in investment companies becoming even more selective in the companies they fund, thereby restricting access to financing? Either one will likely have a significant impact on the investment market environment as we know them today.

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