Friday Letter: It’s time to get serious about the F word

Venture capitalists are fond of the words “innovation” and “disruption.” Rarely do you hear them use the word “fiduciary,” as in, “I have a fiduciary duty to my LPs.” That needs to change if they want the SEC to keep its nose out of their business.

For the first time in many years, the regulator is taking a harder look at venture capital as part of its increased scrutiny of all private markets. It has already put forth some proposals that – if adopted as is – would have a big impact on how VCs do business. But I get the sense that Gensler & Co aren’t going to stop there after reading recent comments from SEC commissioner Caroline Crenshaw.

In an April 14 speech at the University of Chicago, Crenshaw said:

“The influx of capital to the private side of the industry, coupled with the severity and frequency of misconduct that our agency is uncovering (even with the limited information we are able to collect) suggests to me that our recent rulemaking may not have been the right approach to serve our goals. The incomplete visibility that we have into the private markets tells me that we need more information to regulate and to ensure every American can adequately save for their children’s education and their own retirement. Quite simply, we need more insight, more education, indeed more data, to be able to effectively protect investors, before the big frauds occur.”

Crenshaw could not have known how prescient her comments would be. Just three days after her speech, Sequoia Capital India rocked the venture business with a blog post entitled, “Corporate Governance: The Cornerstone of an Enduring Company.”

The revered investor wrote:

“Recently some portfolio founders have been under investigation for potential fraudulent practices or poor governance. These allegations are deeply disturbing… It makes us reflect on what we could have done, along with other investors who have partnered in these companies, to prevent such situations.”

Sequoia didn’t mention the portfolio companies by name, but three of its companies have been in the news lately for alleged lapses in corporate governance:

• BharatPe, a payment app maker for merchants, in March issued a statement accusing co-founder and former CEO Ashneer Grover and his relatives of “extensive misappropriation of company funds,” according to press reports.
• Trell, maker of a social commerce app, in March was being investigated by its board for alleged financial irregularities, according to the Economic Times.
• Zilingo, a supply chain platform for the fashion industry, suspended its CEO this month after an investigation into the company’s accounting practices, according to a Bloomberg report.

I recommend digging into the allegations in all three cases. The details are hair-raising.

‘Proactive steps’

In light of the scandals, Sequoia India pledged to “take a set of proactive steps… to drive increased compliance across our portfolio companies including, but not limited to, governance trainings for founders and senior management, implementation of whistleblower policies, more independent board representation, asking for more disclosures and more rigorous adoption of internal audits and controls.”

It went on to say:

“When whistleblowers call us to report on issues, we always take them seriously. We know in some cases they may turn out to be baseless – but we still have to look into them as it is a board member’s fiduciary duty [emphasis mine]. We will continue to have zero tolerance towards proven wrongdoing. We won’t hesitate to act to protect the interest of the company and employees, even if it costs us financially. We will take tough calls where needed in the interest of doing what is right.”

While it is true that the alleged misdeeds occurred at companies based in India and Singapore, it would be a mistake for US-based investors to say it couldn’t happen here. Circling back to Crenshaw’s speech, the commissioner noted that the SEC’s Division of Examinations has seen a growing number of deficiencies at registered private fund managers, including:

• Misleading material information about track records.
• Inaccurate performance calculations.
• Failure[s] to invest in accordance with fund disclosures regarding investment strategy.
• Failure[s] to obtain informed consent from limited partnership advisory boards or committees required under fund disclosures.
• Lack of reasonable investigation into underlying investments or funds.

“And, we are seeing a steady stream of private fund enforcement actions, including frauds relating to Ponzi-like frauds, fee and expense frauds [and] valuation practices, among many other troubling cases,” Crenshaw said.

GPs should heed the comments from Crenshaw and Sequoia as a wake-up call to pay closer attention to corporate governance. Ignoring the call will only lead to more scandals and, ultimately, to more regulation. That would be a terrible outcome for an industry that is a testament to the great financial and societal good that occurs when regulators apply a light touch.