A San Francisco-based firm settled charges with the SEC for violating federal securities laws by offering and selling security-based swaps to pre-IPO-company shareholders and investors who were not "eligible contract participants" ("ECPs"). According to the SEC Order, the firm sought to provide liquidity for the employees of private growth-stage companies in Silicon Valley, and for others who held restricted shares of the companies' stock, by allowing investors to purchase the rights to the economic upside or downside of an equity security from the shareholders – an operation that is similar to that of a total return swap.
Dodd-Frank sought to regulate the sale of security-based swaps to persons who are not ECPs (typically, individuals must have at least $5 to $10 million invested on a discretionary basis to qualify as ECPs) by making the offering or selling of security-based swaps to non-ECPs a violation of federal securities laws unless each transaction is carried out pursuant to an effective registration statement and on a national securities exchange. However, the SEC reported that many of the shareholders and investors with whom the San Francisco-based firm transacted were not ECPs, and yet the firm neither (i) filed a registration statement for any of the security-based swaps it offered nor (ii) sold them through a national securities exchange.
SEC San Francisco Regional Office Director Jina Choi stated that firms must prioritize the protection of investors:
"Market participants are free to capitalize on the growth of private technology companies . . . but [securities] laws must be followed to ensure security-based swaps are registered and sold through platforms where investors have full disclosure and protections."
In a separate no-action letter, the SEC Division of Corporation Finance waived the disqualification of the firm under the "bad actor" provisions of Securities Act Rules 506(d) of Regulation D and 262(b) of Regulation A. The waiver was required by the settlement of the SEC enforcement action and is contingent on the firm's continued compliance with the terms of the SEC Order.
Commentary - Steven Lofchie
This is the second significant enforcement action that the SEC has brought against a firm for illegally entering into or arranging security-based swaps with retail investors. (See also Company Settles SEC Charge of Failing to Register "Fantasy Sports for Stocks" Mobile Phone Game.) The second action is as troubling as the first, but not because the charged party might have been undeserving of sanction. It is troubling because the violation was not primarily the act of selling swaps to unsophisticated investors. In the previous case, the real crime was that the swaps company had run a bucket shop for betting on stocks. In this case, the crime was that the swaps arranger likely had tried to help sellers and buyers do an end-around on any prohibitions on the sale of the underlying stock, whether the prohibitions arose under the Securities Act or were part of the sellers' agreements with their employers. Ultimately, the true crime was not the firm's use of swaps. It was the method by which the so-called crime was committed.
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