Private Company Employee Stock Sales Highlight Hidden Dangers of Compliance Failures

By Jessica Nall

We noted with interest the latest moves by some Bay Area tech giants to permit their employees to sell restricted stock to help them realize the stock value as part of their compensation:  See New York Times reporting here.  

It should come as no surprise that private company employees in our tech economy rely on their potential restricted stock value as an important part of their compensation package, and also their decision whether to work for, or stay working for, one of the “hot” pre-IPO companies (which are legion in Northern California).  What may surprise private companies is that this kind of restricted stock sale by employees creates a very easy “in” for the SEC to bring a case should any hidden compliance failures or fraud later be revealed.

As we’ve discussed elsewhere in this blog, the SEC sounded the clarion call back in March at Stanford Law School that delaying IPO would not protect private companies from enforcement scrutiny should fraud or other compliance failures be revealed.  See transcript of Chairperson Mary Jo White’s speech here.  

While the SEC has stated that they will not hesitate to apply Rule 10b-5 (which broadly outlaws securities fraud including in manipulating or otherwise over- or under-stating information released to “the market”) to private companies, employee trading provides the perfect “hook” for jurisdiction.  The reason is relatively simple: most private company investors are sophisticated VCs that do not fit well into the “victim” role.  

This may not stop the SEC from investigating or bringing enforcement actions in egregious cases of fraud.  But when you bring employees into it, the SEC’s case for jurisdiction over even minor compliance failures gets even clearer.  And though Chairperson White suggested in her March 31 remarks that the prevalence of employee stock option grants as part of compensation at private companies may in general provide SEC jurisdiction, there is no question that when employees are permitted to make stock sales decisions, even if they decide not to sell, the door to SEC jurisdiction is open wide. 

If companies that permit employee stock sales like those discussed in the New York Times article are later revealed to have allowed compliance failures, fraud, or other mis-reporting in their financial statements, they may be subject not only to suits by the employees themselves, but also to the full fury of the SEC Enforcement Division.  And believe me, the SEC is looking for a poster child case of private company enforcement.  Because in a world where some of the richest and most successful companies on the planet are delaying IPO in order, in part, to avoid being in the sights of the regulators, those regulators are hungry for a chance to show their strength.  

The more that private companies find ways to reap the benefits of the stock market, even in closed sales like the ones reported, the more they must comply with all the rules applicable to public companies, or risk the consequences.   In an “up” economy like we have been enjoying, this may not ever be an issue.  But a falling tide reveals all faults; should we enter another downturn, private company employees may well be the first to cry foul should their stock valuation be negatively impacted.  And the SEC will be happy to apply hindsight to review, in detail, every compliance shortcoming as they bring their investigative might to bear.

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