The legal threat coming for venture capital

From: POLITICO's Morning Money - Friday Jan 06,2023 01:08 pm

Jan 06, 2023

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After being battered by rising interest rates and choppy markets, the venture capital industry is sweating new regulations that could expose fund managers to legal risks.

The SEC is putting the final touches on a rule that would make it easier for investors to sue VCs for bad behavior, negligence or recklessness. It would “open up all types of litigation risk to being a venture capitalist,” Justin Field, the National Venture Capital Association’s senior vice president of government affairs, told MM.

The proposal, which could be finalized as soon as this quarter, would “drive a wedge between VCs and portfolio companies that will hurt both innovation in this country as well as [investor] returns, which is what the SEC is supposed to be trying to protect,” he added.

Of course, the rule wouldn’t just apply to venture capitalists. It would also cover private equity firms, hedge funds and certain real estate investment companies – any private investment fund that’s already subject to SEC oversight.

But the proposed changes might be especially vexing for VCs because of their investment model. Most venture-backed companies fail. And while the vast majority of those businesses peter out because they can’t attract a buyer (or make beaucoup bucks via public markets like Facebook or Google), a handful will go under because their founders are either frauds or comically inept.

And as we’ve learned over the last years, venture firms don’t always catch that in due diligence.

“As an investor, when the environment is ‘frothy’ you are much more likely to run into these problems,” Bill Gurley, a general partner at the Silicon Valley venture fund Benchmark, wrote in a recent blog post. “Ironically this is also the precise time when raising concerns will make you look like a washed up veteran who is unable to adjust to the new ‘realities.’”

It gets a lot harder to cover up those mistakes when markets go down. With economists pegging the odds of a recession at 70 percent — that’s hardly an inevitability, writes our Victoria Guida — more bad bets will be exposed and, in all likelihood, some venture-backed CEOs will be found to have cut corners.

When that happens, investors are going to have questions about the fund managers who boosted those businesses. (Lawmakers posed similar questions during last month’s FTX hearings, and Reuters is reporting the SEC is also probing the matter).

From the NVCA’s perspective, exposing VC to new legal claims wouldn’t do much to change that. And it might make it that much more difficult for new startups to attract capital in the meantime.

“This is going to significantly increase the cost of operating a venture capital fund without materially impacting outcomes,” Field said.

IT’S FRIDAY — And we still don’t have a speaker. Please send tips to ssutton@politico.com and zwarmbrodt@politico.com.

Driving The Day

Officials from Treasury, the Fed and other agencies speak at the American Bar Association's Banking Law Committee annual meeting today and Saturday … Jobs report will be released at 8:30 a.m. … Atlanta Fed President Raphael Bostic speaks at 11:15 a.m. … Fed Gov. Lisa Cook speaks at 11:15 a.m. … Richmond Fed President Tom Barkin speaks at 12:15 p.m. … Kansas City Fed President Esther George speaks at 1:15 p.m.

JOBS INCOMING —Bloomberg’s Reade Pickert: "Hiring at US companies far exceeded expectations and applications for jobless benefits fell to a three-month low, reinforcing the strength of the labor market, new data showed Thursday. Private payrolls increased 235,000 last month, led by small- and medium-sized businesses, according to data from ADP Research Institute in collaboration with Stanford Digital Economy Lab.”

"The figures precede the government’s payrolls report on Friday, which is forecast to show companies added 183,000 jobs in December and a moderation in wage growth. The unemployment rate is seen holding at a historically low level of 3.7%.”

In Congress

I SCREAM, YOU SCREAM, WE ALL SCREAM FOR CAPITAL MARKETS: Our Eleanor Mueller: GOP Rep. Warren Davidson — the Freedom Caucus member who nominated Kevin McCarthy for House speaker Wednesday — is among those interested in chairing the House Financial Services Committee’s capital markets panel this session.

Financial Services’ most-wanted gavel: “Over half of us have said we would love to be capital markets chairman,” the Ohioan told Eleanor off the House floor between speaker votes Thursday. “But [soon-to-be Chair Patrick McHenry (R-N.C.)] has got to make his decisions about how he would do it.”

The subcommittee’s current top Republican, Rep. Bill Huizenga (R-Mich.), is facing potential term limits — but told POLITICO in December that he would like to regain the gavel anyway. Rep. Blaine Luetkemeyer (R-Mo.) could gun for the role if he has to give up the financial institutions subcommittee because of his own term limits. And Rep. Ann Wagner (R-Mo.) has also been floated for the position.

“I've always been a member of the capital markets subcommittee, and so I hope to be working in that arena,” Wagner told Eleanor off the House floor Thursday. “I believe that I’ll have a leadership role.”

“Capital formation is always number one for me … and getting the government off the backs and out of the way of those that are trying to help true retail investors save,” she added. “There are a lot of priorities I think we're going to have as a committee — but [most are] actually in the arena of capital markets for me.”

Paging Kevin McCarthy: When will committee members know more about assignments? Hearings? “After we get a speaker,” Davidson said with a laugh.

“Committees haven't been populated; gavels haven't been handed out; and we don't even know what the ratios are at this point in time,” Wagner said. “Because that's really all part of these kinds of negotiations.”

NEW CONGRESS, WHO’S THIS? — Our Oliva Beavers got a tip from a GOP staffer that the IRS isn’t fulfilling basic requests from congressional offices because “the congressman is still technically a congressman-elect.”

Crypto

STABENOW STEPS DOWN — Sen. Debbie Stabenow said on Thursday that she will not seek reelection, adding another wrinkle to an already difficult map for Democrats in 2024. Stabenow’s departure could also complicate matters on the crypto policy front; the Michigan Democrat has used her perch as chair of the Senate Agriculture Committee to push bipartisan legislation that would task the Commodity Futures Trading Commission — chaired by one of her former advisers, Rostin Behnam — with regulating crypto exchanges where Bitcoin and other digital commodities are traded.

That bill ran aground late last year after the collapse of FTX, whose disgraced founder Sam Bankman-Fried was among the measure’s biggest champions within industry. Stabenow and Sen. John Boozman, the committee’s top Republican, insist that they still plan to move forward with an amended version. But as lawmakers like McHenry of House Financial Services and Senate Banking Chair Sherrod Brown (D-Ohio.) vie for jurisdiction over the crypto industry, many lobbyists don’t expect those efforts to take flight anytime soon.

“I don't know how she introduces something in Q1 without [the FTX collapse] being still too fresh in the minds of legislators,” one lobbyist told MM. “We hope to work with them again, but I think with two years remaining it’s a question of motivation, especially with so many other committees interested.”

"In the wake of the FTX collapse the consumer protections in the Digital Commodities Consumer Protection Act are needed more [than] ever. Senator Stabenow remains dedicated to moving this bipartisan legislation forward,” a committee spokesperson said in a statement.

— Stabenow isn’t the only policymaker whose efforts to regulate digital assets hit a snag amid the crypto industry scandals. LAT’s Freddy Brewster: “Gov. Gavin Newsom is one of the Democratic Party’s most prominent promoters and defenders of blockchain and crypto technology. But Newsom’s recent efforts to boost the sector and fend off new state-level regulation of it have suffered from awkward timing.”

CELSIUS — From Sam: “New York Attorney General Tish James on Thursday filed a civil lawsuit accusing the founder of the bankrupt crypto lending platform Celsius Network of fraud and alleging that he engaged in a years-long scheme to bilk billions of dollars in digital assets from his customers.”

TELL US HOW YOU REALLY FEEL — Acting Office of the Comptroller of the Currency Michael Hsu didn’t pull any punches in his agency’s annual report on Thursday: “Crypto industry risk management practices lack maturity, stablecoins may be unstable, and contagion risk is high within the crypto industry.”

CASE IN POINT — Bloomberg’s Yueqi Yang: “Silvergate Capital Corp. made one of the US banking world’s biggest bets on crypto. Now it’s reeling from a run on deposits and a massive loss, intensifying fears the collapse of crypto exchange FTX may seep elsewhere into the financial system.”

— WSJ’s Caitlin Ostroff, Alexander Saeedy and Vicky Ge Huang: “Massive crypto lender Genesis Global Trading Inc. laid off 30% of its staff and is considering filing for bankruptcy.”

Jobs Report

Goldman Sachs Managing Director Geoffrey Okamoto has joined Atlantic Council’s GeoEconomics Center as a nonresident senior fellow. He previously served as first deputy managing director of the International Monetary Fund and acting Treasury undersecretary for international affairs.

The American Council of Life Insurers has hired Sarah Montgomery as assistant vice president for paid family and medical leave implementation. She was most recently assistant vice president and senior counsel at Lincoln Financial Group. — Daniel Lippman

Regulatory Corner

THE LABOR MARKET FOR SANDWICH ARTISTS GETS INTERESTING— Our Josh Sisco and Nick Niedzwiadek: “The Federal Trade Commission on Thursday kicked off the process for regulating non-compete clauses in employment agreements, issuing a proposed rule that would largely ban the practice.”

Markets

KING OF THE HILL — WSJ’s Juliet Chung and Alexander Osipovich: “Citadel’s winning streak continued in 2022, with Kenneth Griffin’s hedge-fund and electronic-trading businesses both posting record revenues even as markets swooned, people familiar with the matter said.”

JOBS REPORT — Bloomberg’s Spencer Soper and Matt Day: “Amazon.com Inc. is laying off more than 18,000 employees — the biggest reduction in its history — in the latest sign that a tech-industry slump is deepening.”

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