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MAKING SENSE OF DODD-FRANK

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Dodd-Frank

SEC Finds Pre-IPO Transactions Were Unlawful Security-Based Swaps

by   |   December 6, 2016

The SEC announced that Equidate Inc. agreed to settle charges that it violated federal securities laws by failing to register security-based swaps that were offered and sold online to shareholders in pre-IPO companies. Equidate did not admit or deny the SEC’s findings.

The SEC instituted an order finding that Equidate sought to provide liquidity for employees of private, growth-stage companies in the Silicon Valley and others holding restricted shares of their stock, and its platform essentially matched these shareholders with investors seeking to invest in the potential economic return on those shares. Equidate conducted transactions through contracts that its subsidiary entered into with the shareholders and investors, and payment provisions were triggered by such events as a merger, acquisition, or IPO at the underlying company.  But Equidate never filed a registration statement for the swaps nor sold them through a national securities exchange as required.

In broad economic terms, Equidate designed its structure to allow investors to purchase the rights to the economic upside or downside of an equity security, similar to the operation of a total return swap. Typically, Equidate Holdings entered into separate contracts with both the shareholder and the investor. The contract with the shareholder was called a Shareholder Note (“SHN”). The contract with the investor was called a Payment-Dependent Note (“PDN”). The contracts were designed to work together to transfer the potential economic return in a set of reference shares from the shareholder to the investor through defendants, despite the payment obligations under both instruments being legally separate, and the investor not having a direct right to the shareholder’s payment. In exchange for providing the potential economic return to the investors, the shareholder received an up-front cash payment from the investors via a subsidiary known as Equidate Holdings based on an agreed-upon price for the shares.

The Commodity Exchange Act contains a number of exclusions from the definition of “swap,” including for any note, bond, or evidence of indebtedness. Although the instruments bore the title of a “note,” as a matter of economic reality, the defendants conceded that they were not designed to operate as a note, bond, or evidence of indebtedness. There is also an exemption for security forward contracts.  The fact that the SHN contemplated the physical delivery of the underlying backup shares (or their equivalent) in certain limited circumstances did not render it a security forward or a purchase or sale of a security on a fixed or contingent basis.

Dodd-Frank and Section 5(e) of the Securities Act makes it unlawful for any person to offer to sell, offer to buy, or purchase or sell a security-based swap to any person who is not an eligible contract participant without an effective registration statement. An “eligible contract participant” includes several categories of persons and, in certain cases, monetary thresholds that vary depending on the particular type of person or entity involved. For example, individuals need at least $5 million and often $10 million invested on a discretionary basis to qualify as eligible contract participants.

Dodd-Frank also makes it unlawful:

  • for any person to offer to sell, offer to buy, or purchase or sell a security-based swap to any person who is not an eligible contract participant without an effective registration statement; and
  • for any person to effect a transaction in a security-based swap with or for a person that is not an eligible contract participant, unless such transaction is effected on a national securities exchange.

Many shareholders and investors who entered into defendants’ SHN and PDN contracts were not eligible contract participants. Therefore, according to the SEC, the defendants violated the Securities Act because the transactions were not executed with eligible contract participants, no registration statements were in effect and the contracts were not effected on a national securities exchange.