BY TOM ZANKI
Originally published in Law360 (May 9, 2017, 6:38 PM EDT)
U.S. Securities and Exchange Commission member Michael Piwowar on Tuesday urged investors to be wary of the pitfalls of so-called SAFE investments — a sophisticated financing instrument for startup companies — that are increasingly being marketed to the broader retail investing public.
Piwowar said that SAFE investments — which stands for “simple agreement for future equity” — have been used in some equity crowdfunding offerings that are sold to mostly retail investors even though such investors are likely not well acquainted with this kind of investment.
A SAFE is an agreement in which the company promises to give an investor a future equity stake in that company assuming certain triggering events occur, such as a future financing round or an initial public offering. SAFE investments have been used in recent years to provide startup financing for venture-backed companies, which tend to be supported by sophisticated investors.
Speaking to state regulators, Piwowar noted that an investor only receives an equity stake in a SAFE offering if specific terms of that security are met. Plus, terms vary from offering to offering, he said.
"In short, despite its name, a so-called SAFE is neither “simple” nor “safe,'" Piwowar said in a conference with the National Securities Administrators Association in Washington, D.C.
Piwowar said the SEC’s Office of Investor Education and Advocacy will release an investor bulletin this week describing SAFE instruments. SAFEs have been compared to convertible note offerings except they don’t involve debt, pay no interest or dividends, and do not offer voting rights.
The idea behind SAFEs developed in Silicon Valley as a way for venture capitalists to quickly buy future stakes in hot companies without burdening the startup with intense negotiations that equity offerings typically entail. Piwowar said the details of SAFEs, from trigger events to conversion terms, are designed to help startups secure future capital from sophisticated venture investors.
Equity crowdfunding, by contrast, is intended to enable mom-and-pop-type enterprises to raise capital from small investors — often social media followers and other fans of a particular business — who may not be as savvy as Silicon Valley institutions.
Plus, with crowdfunding, Piwowar noted that intermediaries are responsible for educating investors and explaining risks associated with the securities being sold. But explaining SAFEs can be difficult for those intermediaries, the Republican commissioner suggested.
“Intermediaries face a real challenge in educating potential investors about this high-risk, complex and nonstandard security when the security itself is entitled ‘SAFE,’” Piwowar said. “Companies and their intermediaries should think carefully about how they name or describe their securities. Securities marketed as 'safe' or 'simple' ought to be just that.”
SAFEs are considered risky largely because they provide no assurance of return, unlike a convertible bond that pays the holder interest. An academic study published last year by the Virginia Law Review Online described a SAFE as essentially "a contractual derivative instrument that amounts to a deferred equity investment" whose value can only be realized in the event of a future financing round, sale or IPO.
Piwowar, who filled in as acting chairman before new chairman Jay Clayton was confirmed last week, began several initiatives aimed at easing capital raising during his interim tenure earlier this year. The commissioner said Tuesday he directed SEC staff to begin work on amending certain rules designed to assure auditor independence but, according to Piwowar, don’t achieve their purpose and instead create “unnecessary compliance issues” for entities like mutual funds.
Piwowar targeted the “loan provision” rule that deems an auditor not to be independent if that auditor has received a loan from its audit-client. The rule also includes lending relationships between auditors and entities holding more than 10 percent of the audit-client’s securities.
Piwowar said that threshold is triggered even in situations where a lender may not be able to assert any influence over the shares it owns, such as instances where the lender holds securities as a custodian or an omnibus account holder for its customers without beneficial ownership.
“More critically, these situations may not have any effect on an auditor’s objectivity and impartiality, because the lender does not have significant influence over the audit client,” Piwowar said. “Yet these compliance challenges threaten to disrupt the operation of the asset management industry, which is relied upon to manage and invest trillions of dollars of investors’ retirement savings.”