Private Markets Experience Another Influential SEC Action

On Monday, an article on the cover of the WSJ highlighted a recent enforcement action against California-based Sand Hill Exchange. The article details a cease and desist order that covers a number of violations of federal securities laws. As egregious as some of these violations are, it’s interesting that the SEC moved so quickly in this case. Less than sixty days after the activity started they were in contact with the company and the company had stopped the actions that were causing them to be in violation.

The Sand Hill Exchange followed the mantra of a lot of early equity crowdfunding sites. Many seemed to believe that if they grew quickly enough, the law would have to fit their business model or they may even find a way around the law (see my previous post about a similar enforcement action). Until recently they were right, the regulators have moved at a deliberately measured pace in regulating this space.

Private markets are like the Wild West because of a lack of standardization and transparency. This makes it difficult for regulators to do their jobs in the space through their traditional means. As is the case with any large organization, the risk for an individual to break rank and try something new is generally higher than the potential reward. In addition to this, just like everyone else, regulators have a hundred different priorities and the larger recent fraud actions were generally concentrated in public markets.

I completely agree with most of the findings in the Sand Hill Exchange cease and desist order. They essentially operated a liquid exchange of "Contracts for Difference" (CFD), a complex financial instrument that is currently prohibited in the U.S. To get around this prohibition, Sand Hill Exchange appears to have tried to transact via Bitcoin, but that obviously would not exempt them from the ban on CFDs. In addition to that, they did not do basic things like monitor their communication with the public to be fair or truthful, do any suitability on potential investors, or ensure clear disclosure around security ownership. Plus, they manipulated their own marketplace by painting the tape with artificial trader bots as well as made many false and misleading claims.

The thing that troubled me is how the SEC interpreted the definition of a security-based swap and the potential far-reaching effects it will carry forward. Defined as any agreement, contract, or transaction that is based on the occurrence or nonoccurrence of an event that directly affects the financial statements, financial condition, or financial obligations of a single issuer, unregistered security-based swaps are only available to eligible contract participants. In the Sand Hill study, the CFDs are interpreted to be security-based swaps since their value is derived from the value of private companies at an aforementioned event, like a merger, IPO, or dissolution.

If the SEC consistently applied this logic, an argument may be made that the entire capital market structure is in violation of federal securities laws. For example, what about popular fantasy sports sites such as FanDuel, is that a security-based swap?

I’m sure there’s more to come regarding this, and I hope the SEC applied the definition of a security-based swap due to some of the potentially dangerous actions that Sand Hill Exchange facilitated. Hopefully common sense rules the day and nobody makes any rash decisions in applying Dodd-Frank rules to areas it was not intended to change. If you’re interested in reading a deeper analysis on the Sand Hill Exchange, here’s a fantastic article.

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