Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

The SEC issued an Investor Alert which says fantasy stock trading for small amounts of money can violate provisions of securities laws implemented by the Dodd-Frank Act.  I bet the Congressional drafters of these provisions who were trying to prevent another financial meltdown are surprised at this result, or at least I would hope so.

According to the SEC, the terms “swap,” “security-based swap,” and “derivative” includes any agreement, contract, or transaction whose value is based upon – or “derivative” of – the value or performance of some other financial product, event, or characteristic.  The SEC stated there are many different ways that virtual games referencing securities could involve a security-based swap.  For example, a website could charge people an entry fee to join an online fantasy stock trading competition in which they would “buy” or “sell” a virtual portfolio of securities and in which they could win a prize.  Although any actual situation would need to be analyzed based on the particular facts and circumstances involved, the SEC thinks the facts presented in this hypothetical suggest that this website may be offering security-based swaps.

The Investor Alert notes that SEC staff have recently observed websites offering many different kinds of financial instruments that may raise concerns under the federal securities laws.  SEC staff continue to investigate other websites, entities, and companies that may be taking investor money without complying with the federal securities laws.

Simultaneously with issuing the Investor Alert, the SEC announced the first settlement with a company that illegally offered complex derivatives products to retail investors.  The Dodd-Frank Act implemented two key requirements for any security-based swaps offering to a retail investor who doesn’t meet the high standard of an “eligible contract participant” defined in the law.  A registration statement must be effective for the offering, and the contracts must be sold on a national securities exchange.  These requirements are intended to make financial information and other significant details about the offering fully transparent to retail investors, and limit the transactions to platforms subject to the highest level of regulation.

The SEC asserted an SEC investigation found that Silicon Valley-based Sand Hill Exchange was offering and selling security-based swaps contracts to retail investors outside the regulatory framework of a national securities exchange and without the required registration statements in effect.  The violations were detected shortly after the offering process began, and with cooperation from the company the platform was shut down before any investor harm occurred.

According to the SEC’s order instituting a settled administrative proceeding against Sand Hill and two individuals:

  • Sand Hill began as two Silicon Valley entrepreneurs creating an online business involving the valuation of private startup companies in the region along the lines of a fantasy sports league.  But Gerrit Hall and Elaine Ou changed their business model multiple times, and earlier this year Sand Hill evolved to invite web users to use real money to buy and sell contracts referencing pre-IPO companies and their value.
  • Sand Hill sought people to fund accounts using dollars or bitcoins.  Hall and Ou did not ask users about their financial holdings or limit the offering to users with any specific amount of assets.  In fact, they wrote on the Sand Hill website: “We accept everybody regardless of accreditation status.”  Hall and Ou intended to pay users who profited from their contracts.
  • Hall and Ou understood that they were buying and selling derivatives linked to the value of private companies, and Ou falsely claimed that they were in the process of seeking regulatory approval for Sand Hill’s contracts.
  • For about seven weeks, Sand Hill offered, bought, and sold contracts through the website in violation of the Dodd-Frank provisions that limit security-based swaps transactions with people who don’t meet the definition of an eligible contract participant.  Hall and Ou exaggerated Sand Hill’s trading, operations, controls, and financial backing.
  • Sand Hill, Hall, and Ou ceased offering and selling security-based swaps following inquiries from the SEC in early April.

The SEC’s order found that Sand Hill, Hall, and Ou violated Section 5(e) of the Securities Act and Section 6(l) of the Securities Exchange Act of 1934.  Without admitting or denying the findings, Sand Hill, Hall, and Ou agreed to cease and desist from committing or causing any future violations of the securities laws.  Sand Hill agreed to pay a $20,000 penalty.

The SEC warns that its Complex Financial Instruments Unit will continue its scrutiny of the retail market for conduct that may violate the Dodd-Frank Act’s swaps provisions, including online competitions creatively monetizing what actually constitute security-based swaps transactions.


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