In 2021, FTX Trading Ltd. (FTX), the now-infamous cryptocurrency exchange, reported raising over $1 billion from investors.[1] As recently as November 6, 2022, FTX’s shares had investor interest in the secondary market at an estimated valuation of $33 billion.[2] By mid-November 2022, FTX had filed for bankruptcy, wiping out its shareholder value and sending the crypto market into a downward spiral. If the criminal and regulatory authorities are correct in their assertions, this destruction had one primary cause: fraud.[3]
FTX’s downfall is being framed by most as a failure to regulate complex digital assets, but that framing is misguided. The failure was not due to the technology used in FTX’s business, but, instead, due to a lack of information available to the SEC and investors in understanding the risks of FTX’s business and, relatedly, in holding FTX stock. Specifically, because FTX raised capital under an exemption that does not require the robust disclosure provisions normally mandated by the SEC, only a few facts about the offering were public, and none of those raised serious concerns.
An Outdated Regulatory Theory Applied to a Reimagined Market
The regulatory theory behind allowing private companies to raise funds under exemptions and safe harbors – like Regulation D, which FTX used – is that sophisticated investors (generally known as “accredited investors”) do not need the protections afforded to retail investors in the public markets. Instead, private issuers offering shares to accredited investors under Regulation D are only required to fill out sparse information on the Form D. A Form D has fields for high-level information such as the name of the issuer, the amount offered and raised, and the number of investors. but no detailed information is required. In fact, an important metric for determining the significance of an issuer – its size – can be marked as “Decline to Disclose,” the option FTX chose.
Investments in private markets are now more accessible than in the days when that theory was formed. Legislation under the JOBS Act and attendant SEC rulemakings propelled some of this accessibility by permitting general solicitation and creating a new exemption known as crowdfunding. As a result, companies are now staying private longer and, unsurprisingly, approaches to providing secondary market liquidity have become almost commonplace even though pricing in the non-public markets is opaque at best.
In 2016, then-Chair of the SEC Mary Jo White gave a keynote,[4] which was prescient in hindsight to preventing an FTX:
“…transparency with investors, controls on financial reporting, strong corporate governance – have applicability and relevance to private companies, … and should not be overlooked or avoided, whether or not mandated by federal law or an SEC regulation.”
Similar sentiments were expressed by former SEC Commissioner Allison Lee[5] and most recently by Commissioner Caroline Crenshaw[6] in subsequent public speeches.
As FTX demonstrated, allowing the private company issuers to self-regulate is insufficient for investor protection. Moreover, the SEC is reportedly questioning whether the VC funds that invested in FTX are adequately conducting their due diligence to ensure fund investors were protected.[7]
A Joint? Goal
The SEC and the industry are showing signs of alignment in regulating this space. The SEC’s Regulatory Flexibility Act agenda published in January 2023[8] reflects the agency’s priorities for rulemaking and demonstrates an undeniable focus on strengthening investor protections related to private companies including consideration of
- Amendments to Regulation D and Form D to improve protections for investors such as updates to the accredited investor definition;
- Reproposing longer holding periods under Rule 144, a safe harbor that permits the public resale of restricted securities;
- Revisions to the “held of record” definition, which is key when determining whether an issuer is required to register with the SEC;
- Amendments to Form PF to amend and enhance reporting from fund advisers; and
- Rules to address lack of transparency and conflicts of interest for private fund advisers.
Moreover, this month on February 7, 2023, the SEC’s Division of Examinations announced its examination priorities for the year.[9] Examinations of private fund advisers scored second on the list of significant focus areas.
The industry itself appears to be conceptually aligned with shining some amount of light onto the market as big and small players alike struggle to understand the future of their one-time-unicorn investments, such as FTX. Case in point, based on the regulatory call and market demand for more transparency, private market participants like Caplight are offering tools to assess private company stock prices, valuations, and secondary market trading.[10] It follows that the more information that is available, the more investors and private fund advisers will be able to make sound decisions and give sound investment advice, which, ultimately, is also the goal of the SEC.
Looking Ahead
SEC Chairman Gensler has sanctioned a number of SEC enforcement actions tied to FTX and crypto broadly, but this push to step up the SEC’s oversight of the private markets is positioned to be the most efficient and impactful of the regulatory efforts surrounding FTX to date. The industry has started adopting a like-minded approach to transparency for price discovery, and we are likely to see further alignment as investor decision-makers are held more accountable than they have been in the past coming off the heels of this market downturn.
Preventing another FTX is no small task and will require vigilant effort from both regulators and industry to do what makes sense for all – creating a robust and fair private marketplace. Transparency in the private markets is the key to showing investors the true value of a company like FTX.
[1] See FTX Form Ds filed with the SEC on August 5, 2021 and November 2, 2021.
[2] Information provided by Caplight, a data market provider.
[3] See Press Releases dated December 13, 2022: “United States Attorney Announces Charges Against FTX Founder Samuel Bankman-Fried,” “SEC Charges Samuel Bankman-Fried with Defrauding Investors in Crypto Asset Trading Platform FTX,” and “CFTC Charges Sam Bankman-Fried, FTX Trading and Alameda with Fraud and Material Misrepresentations.”
[4] See Chair Mary Jo White’s March 31, 2016 Speech “Keynote Address at the SEC-Rock Center on Corporate Governance Silicon Valley Initiative.”
[5] See Commissioner Allison Lee’s October 12, 2021 Speech “Going Dark: The Growth of Private Markets and the Impact on Investors and the Economy.”
[6] See Commissioner Caroline Crenshaw’s January 30, 2023 Speech “Big “Issues” in the Small Business Safe Harbor: Remarks at the 50th Annual Securities Regulation Institute.”
[7] See January 5, 2023 Reuters report “U.S. securities regulator probes FTX investors’ due diligence -sources.”
[8] See the SEC’s Fall 2022 Regulatory Flexibility Act Agenda.
[9] See Division of Examinations 2023 Examination Priorities.
[10] See January 4, 2023 announcement of Caplight Data.
The author is an advisor to private companies including Compliance.ai and Caplight Technologies, Inc.
