The recent news of Silicon Valley Bank’s collapse sent shockwaves through the industry. But what can in-house legal teams learn from the SVB disaster?
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Silicon Valley Bank was a trusted partner and influential player in the fast-paced world of startups and venture capital for many years.
The recent news of Silicon Valley Bank’s collapse sent shockwaves through the industry, leaving many wondering what went wrong and how it will impact their business and the wider tech ecosystem.
With risk mitigation and regulation being ever-evolving topics that in-house legal teams need to navigate, it’s critical to understand the legal context surrounding the SVB disaster and what it means for future legal operations.
In this article, we explore what happened, why it happened, and the legal implications of the collapse. We consider the potential impact on the startup ecosystems in the US, the UK, and the EU, as well as what in-house legal teams can learn from this event.
In this article, we will cover the following:
So, what happened with Silicon Valley Bank?
On March 10 2023, Silicon Valley Bank (SVB), one of the largest and most trusted banks in the startup and venture capital industry, collapsed without warning.
The bank, which had $212bn of assets, is the biggest lender to collapse since the 2008 global financial crisis.
In March, SVB faced a huge number of deposit withdrawal requests, totaling $42 billion, which pushed the already wavering bank over the edge. Regulators were required to step in and close the bank when it couldn’t raise the cash necessary to cover such outgoings.
The news came as a shock to many in the industry who had relied on SVB for their banking and financing needs for many years. Moreover, it has emphasized the need for robust compliance and controls for companies and their legal departments globally.
While the U.S. government took action to protect uninsured deposits at SVB, the bank’s downfall will likely create a series of question marks and concerns around the startup ecosystem.
What caused the collapse of SVB?
The collapse of SBV has been attributed to several factors. While it seems to have been a sum of numerous failings pushed over the edge by an incident in the face of inadequate risk mechanisms, below we explore a few of the key reasons thought to have caused the demise of SVB.
A lack of diversity in the SBV portfolio
A lack of diversity in a bank’s portfolio can create several problems. A concentrated portfolio exposes vulnerabilities to economic downturns or industry-specific events. This vulnerability can translate into increased credit risk and greater exposure to compliance violations.
Many are pointing their finger at the SVB’s overexposure to certain tech sectors including the cryptocurrency market. An article in Politico states:
This is the point where the outbreak of risk in the crypto industry might have jumped species into the banking sector.
Ed Moya, senior market analyst at Oanda, explains that SVB may not be alone. He suggested that banks that are disproportionately tied to cash-strapped industries like tech and crypto may be in for a rough ride.
SVB had invested heavily in cryptocurrency – including Bitcoin and Ethereum – and had lent money to startups that were focused on blockchain technology. However, as the cryptocurrency market experienced a significant downturn, SVB’s investments and loans began to lose value, leading to a substantial loss of capital for the bank. Evidently, failing to ensure a balanced and diverse portfolio put the bank in a precarious situation.
Regulatory challenges
Regulatory challenges played a significant factor in the collapse of SVB. The bank was subject to a range of regulatory requirements that were designed to ensure its safety and soundness, but these requirements also imposed significant costs and limitations on the bank’s operations.
One of the primary regulatory challenges facing SVB was the requirement to maintain high levels of capital and liquidity. This meant that the bank had to maintain a large sum of reserves to protect against potential losses, which limited its ability to lend and invest in new business opportunities (a common frustration but the nature of the industry for many bankers).
In addition, SVB was subject to a range of regulatory restrictions on its lending and investment activities. For example, the bank was required to comply with strict anti-money laundering (AML) and anti-terrorism financing regulations, which imposed additional costs and compliance burdens.
The bank also faced intense regulatory scrutiny in the wake of the 2008 financial crisis, which resulted in increased oversight and supervision from regulatory authorities. This scrutiny placed additional pressure on the bank and its executives to maintain high levels of compliance and risk management, which further limited its ability to pursue new business opportunities.
Despite the external pressures, SVB failed to adequately address these regulatory issues. Instead, the bank continued to operate in a manner that was not fully compliant with regulatory requirements, which ultimately led to significant fines and legal penalties.
In fact, SVB had been under investigation by the US Securities and Exchange Commission (SEC) for potential violations of anti-money laundering regulations. The investigation had been ongoing for several months, and it is believed that the potential fines and penalties associated with the investigation may have played a role in the bank’s decision to file for bankruptcy.
Inadequate risk management
Effective risk management is critical for the long-term success of any organization, particularly in the banking industry due to the significant risks associated with lending and investing.
Unfortunately, SVB failed to effectively manage its risks, which many believe played a major role in the bank’s collapse.
A lack of oversight and accountability concerning risk management was certainly an issue at SVB. The extent of this oversight was highlighted by the fact that the bank’s CFO – who was responsible for overseeing risk management – was absent for an extended period of time. This curbed the focus on risk management and created a leadership structure and culture that allowed for risky lending practices and conflicts of interest to go unchecked.
SVB did indeed engage in risky lending practices including lending money to high-risk clients without proper due diligence. As a result, SVB suffered significant losses and defaults that undermined its financial stability and reputation.
Furthermore, SVB failed to implement adequate risk management policies and procedures, which left the bank vulnerable to potential fraud and misconduct. This lack of control and oversight left room for some employees to engage in fraudulent activities, which further eroded the bank’s stability and reputation. In fact, a recent LinkedIn poll from investor and news editor Marcel van Oost found that 74% of people believed the former CEO and CFO of SBV should be sued for their actions.
Had SVB’s legal department prioritized risk management and ensured that the appropriate controls were in place to prevent and manage such failures, it’s likely that the impact of such activities would have been less severe.
Ineffective leadership
In recent years, SVB’s reputation has been tarnished by a series of scandals, including allegations of mismanagement and fraud. Since the collapse, bad management has been cited as a key reason for the bank’s downfall.
The bank was plagued by a lack of accountability and oversight, which allowed for risky lending practices and conflicts of interest to go unchecked.
For instance, former CEO Greg Becker was criticized for his close ties to certain clients and for failing to properly disclose potential conflicts of interest. This lack of transparency eroded trust in the bank’s leadership and ultimately led to Becker’s resignation.
In addition, SVB was accused of engaging in risky lending practices, including lending to high-risk clients without proper due diligence. This situation highlights the importance of Know Your Customer (KYC) procedures. Proper KYC procedures could have helped identify any red flags or suspicious activities associated with clients, potentially preventing or limiting the impact of these issues. Overall, this lack of executive direction resulted in a number of defaults and loan losses, which put the bank’s financial stability at risk.
Not to mention, it’s said that the bank’s employees received large bonuses that were paid out just hours before regulators seized the bank. This might be deemed as carelessness and can reflect a lack of effective leadership from the top.
At a higher level, management at SVB was slow to respond to changing market conditions and, ironically, technological advancements, which left the bank ill-prepared to compete in a rapidly evolving industry. This failure to innovate and adapt likely also contributed to the bank’s decline.
Insider trading
In-house legal teams play a crucial role in ensuring that their organizations comply with relevant laws and regulations. In the banking industry, insider trading is an area of particular concern.
In 2003, the Securities and Exchange Commission (SEC) accused a former SVB executive, Keith Ligon, of engaging in insider trading. According to the SEC, Ligon had tipped off several hedge fund managers about upcoming mergers involving SVB clients. The hedge fund managers then traded on this information, making significant profits at the expense of other investors.
The SEC’s investigation revealed that Ligon had not acted alone. Several other SVB employees were also implicated, including one who is said to have leaked information to Ligon in the first place. The investigation also uncovered evidence of lax internal controls at the bank, which had allowed the insider trading to occur.
The fallout from this event was severe. SVB was forced to pay a $5.5 million fine and to implement stricter internal controls to prevent future incidents of insider trading. Several executives, including Ligon, were also charged with criminal offences and faced jail time.
This scandal highlights the importance of vigilant compliance management by legal departments. By implementing robust internal controls and ensuring that employees are aware of their obligations under the law, in-house legal teams can help to prevent insider trading and protect their organizations from the reputational and financial damage.
Withdrawal frenzy triggered by a powerful VC
Peter Thiel, a prominent venture capitalist and co-founder of PayPal, has been widely credited with helping to shape the early years of the Silicon Valley technology scene. However, in recent years, Thiel has become something of a controversial figure, particularly when it comes to his involvement with SVB.
It was reported that Thiel advised his portfolio companies to withdraw their money from SVB, apparently due to his concerns about the bank's increasing risk exposure, particularly in the areas of real estate and international lending.
While Thiel's concerns may have been valid, his advice to withdraw money from the bank had serious consequences. The bank saw a significant outflow of deposits as a result of Thiel's advice, which meant the bank was unable to meet its regulatory capital requirements. This resulted in the bank being placed under increased scrutiny by regulators and, in turn, led to the series of regulatory sanctions and fines that ultimately led to the bank's downfall.
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The impact on the startup ecosystem
The collapse of SVB has had significant implications for the startup ecosystem, particularly in the US. Roshan Patel, Founder & CEO of Walnut, shared a conversation he had with one of the company’s investors on Twitter. The investor shared their concerns that this is a “sector-wide issue”, but with a comic twist. So what do we need to understand about how this event will impact the ecosystem?
A more cautious funding and investment landscape
There’s no denying the boom in tech funding, and venture capital in particular, over the last decade or so. Significant funding rounds and lavish celebrations have glamorized raising capital from particular sources.
However, this approach and the growth-at-all-costs attitude have fostered a culture of unsustainable practices and unprofitable business models.
SVB was a major lender to startups and venture capital firms. The bank’s downfall has created a void in the funding and investment landscape, which may lead to tighter credit conditions, increased competition for capital, and a shift in the balance of power between startups and investors.
Emphasizing this point, Maelle Gavet, CEO at Techstars, stated in a LinkedIn post:
Thanks to the explosion in tech startup investing, the proliferation of VCs, and the scale-at-all-costs culture it unleashed, we created a world where unprofitable startups (AKA nearly all startups) are perpetually fundraising, and require continuous lines of credit.
The potential for greater financing options for startups (but not yet…)
The demise of SVB will no doubt leave a gap in the market. Considering the startup ecosystem in the US, UK, and Europe does bring in economic and cultural value, there is the potential that mainstream financial institutions will view the collapse as an opportunity to offer their own versions of funding for this segment. Might we see a reinvention of the banking industry and how it supports startups more broadly? Only time will tell.
The potential for a more healthy risk appetite as it relates to funding
One of the great appeals of SVB for startups was the lack of liability required. SVB was one of the only banks on the market that offered such financing without the need to put up collateral. While it will take time and a significant shift in the perception of funding in the sector, there is an opportunity to reimagine financing in the startup ecosystem. This may be using different financing mechanisms or shifting mindsets to view offering collateral in exchange for capital as a motivation to operate more sustainably and profitably – in some cases, offering collateral can encourage more innovative enterprising activity.
Regulatory scrutiny
SVB’s insider trading scandal was only the first step that attracted regulatory scrutiny, with the SEC imposing fines and sanctions on the bank and some of its employees. This increased regulatory attention may result in more rigorous compliance requirements for startups and venture capital firms, potentially increasing the cost and complexity of doing business.
Reputational damage to the tech ecosystem
The downfall of SVB has tarnished the reputation of the bank, as well as the wider startup ecosystem in which it operated. In-house legal teams may need to work harder to rebuild trust and restore confidence in the industry, including through improved transparency, accountability, and ethical conduct.
Reduced barriers to entry
Lastly, the demise of SVB may create opportunities for new players to enter the market and fill the void left by the bank’s departure. In-house legal teams should be aware of new entities in the market, and be prepared to assess the risks and opportunities associated with working with these new players.
Learnings for in-house legal teams
The demise of SVB serves as a valuable lesson for in-house legal teams on the importance of robust legal and cultural practices. Below we explore the top five learnings that legal departments can take from the bank’s downfall.
1. The importance of risk management
SVB’s demise was due, in part, to its exposure to high-risk sectors, such as the technology industry. In-house legal teams should work with their organizations to identify and manage potential risks, including exposure to high-risk industries, investments, or counterparties.
2. The need for robust internal controls
As mentioned, SVB’s inadequate internal controls played a role in both the insider trading scandal and ultimately the bank’s downfall. Legal departments should ensure that their organizations have strong internal controls in place, including policies and procedures for risk management, compliance, and reporting.
3. Build a culture of compliance
A strong culture of compliance is essential for preventing misconduct and ensuring that employees act in the best interests of the organization. In-house legal teams should work to promote a culture of compliance throughout their organizations, including through training, communications, and incentives that encourage ethical behavior.
4. The value of transparency and accountability
The demise of SVB highlights the importance of transparency and accountability in ensuring that organizations are operating in a responsible, ethical, and sustainable manner. In-house legal teams should work to promote transparency and accountability throughout their organizations, including through robust reporting mechanisms and a commitment to ethical conduct at all levels. These qualities must be evident both internally and externally - and you can learn more about the value of transparency in corporate governance here.
To evidence the impact of these themes, you simply need to look at the Wirecard fraud case currently being tried in Germany. This is a significant corporate fraud case and one that reflects poorly on the country’s regulatory authorities. You can learn more about it in our “Challenges in Corporate Governance” blog here.
5. Innovative financing options
Finally, among the drama, there is an opportunity to be creative. The startup ecosystem might see an emergence of different funding options for growth, focusing on sustainability and risk management. Whether it be bootstrapping or crowdfunding, in-house legal teams will no doubt have a rise in responsibility when it comes to strategic matters such as business and financing strategies.
Summary
The collapse of Silicon Valley Bank serves as a reminder of the importance of risk management, strong internal controls, a culture of compliance, and transparency and accountability in ensuring long-term business viability. By taking steps to address these areas, in-house legal teams can help to protect their organizations from potential legal and reputational risks, and promote a culture of ethical behavior and responsibility.
How can Newton help with corporate governance?
Newton delivers an easy and intuitive platform to manage and automate your legal entities’ information, governance, and compliance. If your entity management processes have an important role to play in the sustainability and performance of your business (which they do for most), be sure to get in touch to explore how Newton can help you have everything you need to be in control of your entity portfolio.
Following the SVB disaster, you’ll understand the importance of having strong KYC (Know Your Customer) and KYB (Know Your Business) processes in place. But you also know how time-consuming and complex it can be to ensure compliance with ever-changing regulations and requirements.
That’s where Newton comes in. We are working on customized KYC/KYB processes where you can streamline your administrative procedures and simplify previously intricate tasks. This not only helps you save time and resources, but it also helps you establish better B2B relationships and ensures adequate legal support.
But that’s not all. By partnering with Newton, businesses can establish internal compliance policies that cover a wider range of issues related to their dealings with customers and suppliers.
So if you’re looking to help your business stay ahead of the curve when it comes to compliance and legal support, chat with our team about partnering with Newton today.
About this article
Sources
EY (2021). The General Counsel Imperative: How can you evolve entity management into effective governance?
ACC (2022). Legal Entity Management Practices
The Wall Street Journal (2023). What Happened With Silicon Valley Bank?
Fast Company (2023): Silicon Valley Bank: An ‘It’s a Wonderful Life’ bank run for the digital age
Politico (2023): The crypto ‘contagion’ that helped bring down SVB
CNN Business (2023): Silicon Valley Bank collapses after failing to raise capital
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Featured Image: Photo by Robert Bye on Unsplash
Featured CTA blog post: Photo by Jurica Koletić on Unsplash / Photo by Christina @ wocintechchat.com on Unsplash
