NOTE: This article originally appeared
in the March 2009 issue of Flawless Compliance, under the "Center
Stage " section. The link to the actual issue is at the bottom
of this article.
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Copyright 2009 AP. U.S. Treasury Secretary
Timothy Geithner is proposing changes that could affect venture
capitalists. Picture
Source |
Thanks in part to Bernie Madoff and the failure of AIG, venture capitalists
may now be facing a new wave of oversight and regulation. To me this seems
a little odd, as it doesn’t seem like VCs had anything to do with
the current state of the financial meltdown. However, on behalf of the
frustrated and angry US citizens of America, US Treasury Secretary Timothy
Geithner has had enough with financial institutions putting our country
at risk, and venture capitalists are no exception.
On March 26th, Geithner testified before the House Financial Services
Committee, explaining what he feels are the root causes of the current
economic crisis, and his views on how to better regulate the financial
system. The Wall
Street Journal captured the text of his testimony. According to
Geithner:
“Market discipline failed to constrain dangerous
levels of risk-taking throughout the financial system. New financial
products were created to meet demand from investors, and the complexity
outmatched the risk-management capabilities of even the most sophisticated
financial institutions. Financial activity migrated outside the banking
system, relying on the assumption that liquidity would always be available.”
This is an interesting statement that I barely agree with. Implying
that investors demanded financial instruments that were so complex nobody
could understand them is a somewhat indigestible idea for me. Nonetheless,
I agree that complexity invites disaster, which is why I always advise
to keep things as simple as possible (without oversimplifying). Part
of Geithner’s solution involves consolidating the function of
financial oversight:
“We must end the practice of allowing banks and
other financial companies to choose their regulator simply by changing
their charters; regulators must choose who to regulate. Moreover,
our regulatory system must be comprehensive and eliminate gaps in
coverage. Our regulatory structure must assign clear regulatory authority,
resources, and accountability for each of the key regulatory functions.
We must not let turf wars or concerns about the shape of organizational
charts prevent us from establishing a substantive system of regulation
that meets the needs of the American people.”
Once again, on the surface this may sound like a good idea, but consolidated
entities like this run the risk of turning into ineffective bottlenecks.
I don’t disagree with the mass inefficiencies caused by multiple
regulatory bodies, but solving this with one super-oversight agency
to take care of all twist and turns of the financial landscape is a
big mistake. The better way to handle this situation is with a federated
system of oversight that communicates well with each other. Financial
institutions function very differently from each other, and trying to
create a “one-size-fits-all” regulatory body is a mistake.
Regardless of the validity of the approach, it looks like venture capitalists
are in the line of fire:
“… in the wake of the Madoff episode it is
clear that, in order to protect investors, we must close gaps and
weaknesses in regulation of investment advisors and the funds they
manage.
Accordingly, we recommend that all advisers to hedge
funds (and other private pools of capital, including private equity
funds and venture capital funds) with assets under management over
a certain threshold be required to register with the SEC. All such
funds advised by an SEC-registered investment adviser should be subject
to investor and counterparty disclosure requirements and regulatory
reporting requirements…”
Although the proposal is very high level at this point and void of
details, I would urge venture capitalists to start taking action right
away. Geithner is not messing around, and whatever comes out of this
must be treated with extreme seriousness. Here’s what I recommend
venture capitalists do to prepare for the upcoming regulation:
Immediate Action #1: Organize your Compliance Team
You need to quickly identify the resources that will support your
compliance efforts. Keep in mind that you will need both content experts
(i.e. lawyers and accountants that understand the regulations), and
process experts (i.e. Six Sigma black belts, and others that understand
process efficiency and program management). Use a combination of consultants
and in-house personnel to make sure you’re getting accurate
guidance without total dependence on outside resources.
Immediate Action #2: Get Your Financial Reporting Under Control
Most likely, the new regulations will look a lot like Sarbanes-Oxley
(SOX). There will be disclosures and attestations, however at the
end of the day the government will want to know that you have your
own financial operations under control. Leverage the lessons learned
from SOX to avoid bloated compliance efforts which abuse precious
resources. As mentioned before, if you don’t have the expertise
in-house, leverage consultants.
Immediate Action #3: Get the Financial Reporting of your
Investments Under Control
Unlike most other companies, you are not only responsible for your
own operations, but you’re also responsible for all the companies
you control as a result of your investments. Leverage the investment
in your own financial control, to make sure the companies you invest
in are exercising prudent fiscal control. This not only takes the
heat off of you, but it also gives you increased confidence in your
investments.
Although venture capitalists had very little to do with the current
economic mess that we’re in, they seem to be included in the institutional
line-up targeted by the new administration for regulatory overhaul.
Taking immediate action is paramount. A team of experts should be identified
and a compliance team formed to get things under control as quickly
as possible. Remember to keep things as simple as possible, and avoid
monolithic entities that try to control too much. There’s no doubt
about it, the regulatory wave is coming. Will you be prepared when it
hits?
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