reblogged from Venture Beyond With Trevor Loy
reblogged from Venture Beyond With Trevor Loy
A terrific scene from a terrific movie … The ‘Trading Places’ Exchange Floor Scene. Personally, I never fully ‘got’ the complex, final trading scene in the 1983 Eddie Murphy/Dan Aykroyd classic Trading Places, and in particular I never understood why the whole affair wasn’t patently illegal. I mean, there are all sorts of laws governing commodities trading, right … like the Commodity Exchange Act and the Regulations of the Commodity Futures Trading Commission (the “CFTC”). Isn’t there?
Conveniently, NPR recently analyzed the question … See What Actually Happens At The End of ‘Trading Places’? or Listen NPR Planet Money.
The Explanation in 10 Steps.
… #1 – As Randoph Duke (Ralph Bellamy) explains to Billy Ray Valentine (Eddie Murphy), the Duke Brothers …
… are ‘commodities brokers’[.] … Now, what are commodities? Commodities are agricultural products … like coffee that you had for breakfast … wheat, which is used to make bread … pork bellies, which is used to make bacon, which you might find in a ‘bacon and lettuce and tomato’ sandwich. Then there are other commodities, like frozen orange juice …
… #2 – In the climactic scene, the Duke Brothers have arranged to steal an advance copy of the Department of Agriculture’s report regarding the coming year’s orange crop. This will give them advance knowledge of the price of frozen concentrated orange juice futures (trading symbol FCOJ) on what is presumably meant to be the New York Mercantile Exchange (NYMEX) (the movie takes place in New York).
… #3 – In the movie, Louis Winthorpe (Dan Aykroyd) and Billy Ray Valentine (Eddie Murphy) manage to steal the stolen agricultural report before the Dukes can get a look at it.
… #4 – From Winthorpe and Valentine, we learn that the Department of Agriculture predicts that there will be a terrific orange crop with lots of oranges in the coming year. When this information is released to the public, FCOJ prices will fall.
… #5 – Winthorpe and Valentine create a fake Department of Agriculture report that says the orange crop will be disastrously bad. No oranges, with big orange juice shortage to follow. In such a scenario, FCOJ prices would rise. By a lot.
… #6 – Winthorpe and Valentine manage to put the fake report in the hands of the Duke Brothers. As a result, the Dukes think they have material nonpublic information that the orange crop will be bad, and that FCOJ prices are going to rise after the report is finally made public. As they say to Wilson (the late Richard Hunt, a famous Muppets puppeteer and voice) …
Mortimer Duke (Don Ameche): We want you to buy as much OJ as you can the instant trading starts … Don’t worry if the price starts going up, just keep buying.
Wilson: But gentlemen, they’re going to broadcast the crop report in an hour. What if the …
Randolph Duke (Ralph Bellamy): Let us worry about that Wilson.”
Wilson: Yes sir!
… #7 – When the commodity market opens, Wilson starts buying up FCOJ at any price he can get. Predictably, other traders on the commodity exchange floor take notice …
Trader 1: Hey, hey, the Dukes are trying to corner the [orange juice] market!
Trader 2: They know something … I can feel it! Let’s get in on it!
An FCOJ buying frenzy begins and the FCOJ price skyrockets.
… #8 – Enter Winthorpe and Valentine with the key line that almost no one understands:
Winthorpe: Sell 30 April at 142!
This is ‘commodity-speak’ for the proposition that Winthorpe/Aykroyd will “sell orange juice in April for $1.42 per pound.” The number ‘30’ means that “he wants to start by selling 30 contracts … where one contract [equals] many, many pounds of [frozen concentrated orange juice].” See NPR. As a result, Winthorpe and Valentine are mobbed by traders, all of whom are still following the Duke Brothers’ lead and thinking that the price of FCOJ is going to rise massively above $1.42 per pound.
… #9 – Enter the Secretary of Agriculture with the real crop report. As Winthorpe and Valentine already know, the orange crop is fine. This means that (1) the price of oranges and thus orange juice is going to be low in the coming year, and (2) the price of FCOJ futures will be correspondingly low, and (3) all of the frenzied trading has made the price of FCOJ futures artificially high. Time to sell. As NPR notes …
All those traders who, a minute ago, were buying all they could, now suddenly need to sell. So the price starts falling. When the price hits 29 cents a pound, Winthorpe and Valentine start agreeing to buy orange juice in April. In other words, Winthorpe and Valentine have contracts allowing them to buy millions of pounds of orange juice in April for 29 cents a pound, and to sell it for $1.42 a pound. They sold high and bought low. They’re rich. The Dukes made the opposite bet and went broke.
… #10 – We never learn how much Winthorpe and Valentine actually made from their plan beyond a vague impression that it is a lot. Conversely, the film tells us that the Duke Brothers lost $394,000,000 in 1983 dollars. Adjusted for inflation, that comes out to something just short of $1 billion in 2013 dollars. The Duke Brothers are out of business and disappear until saved in a cameo five years later by Prince Akeem (Eddie Murphy again) in Coming to America.
So Why Isn’t It Illegal?
As the WSJ explains to my surprise …
Unlike most stock markets, insider trading isn’t generally illegal in commodities trading. An oil company can take advantage of inside information about its production outlook when it makes trades. However, if traders intentionally create an artificial price and use it to make money, charges of manipulation may arise. MarketBeat, March 4. 2010.
So, putting aside the theft and manipulation of a confidential federal report as, well, dramatic license, the actual trading on material nonpublic information depicted was not per se illegal. Of course, today, we have the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Summary and Statute) which creates, at Section 746 thereof, the appropriately named “Eddie Murphy Rule” …
We have recommended banning using misappropriated government information to trade in the commodity markets. In the movie “Trading Places,” starring Eddie Murphy, the Duke brothers intended to profit from trades in frozen concentrated orange juice futures contracts using an illicitly obtained and not yet public Department of Agriculture orange crop report. Characters played by Eddie Murphy and Dan Aykroyd intercept the misappropriated report and trade on it to profit and ruin the Duke brothers. In real life, using such misappropriated government information actually is not illegal under our statute. To protect our markets, we have recommended what we call the “Eddie Murphy” rule to ban insider trading using nonpublic information misappropriated from a government source.
With apologies to Oscar Wilde, it would seem that life responded to art after art imitated life. See Oscar Wilde, The Decay of Lying (1891) (“life imitates art far more than art imitates life”).
For the whole scene, see Trading Places.
© david jargiello 2013 all rights reserved
On July 10, 2013 and with much ado the Securities and Exchange Commission issued two sets of final rules that will greatly alter the startup funding landscape: Release No. 33-9415 (“Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings”) and Release No. 33-9414 (“Disqualification of Felons and Other Bad Actors from Rule 506 Offerings”). As Upstart notes, the new rules “have the operators of crowdfunding sites giddy.” Upstart Business Journal, July 11, 2013. For what I think is the best overall review see TechCrunch, July 10, 2013.
Section 4(a)(2) (the old “Section 4(2)”) of the Securities Act of 1933 (the “33 Act”) exempts transactions by an issuer “not involving any public offering” from the burdensome registration requirements of Section 5 thereof. Any startup raising money by selling stock (or something that looks like stock) must therefore do one of two things … (1) file a registration statement (aka “go public”), or (2) find an exemption from the legal requirement to do so. Venture capital securities law practice is thus in large part an exercise in finding the correct “exemption from registration” and structuring a venture capital fundraising transaction accordingly.
As a technical legal matter, “Regulation D” is a set of rules created by the SEC to effect such “private placements” and creates three basic exemptions from registration … Rule 504 (summary here and rule here), Rule 505 (summary here and rule here) and Rule 506 (summary and rule here). For rules geeks, the Regulation D issuing release (“Revision of Certain Exemptions from Registration for Transactions Involving Limited Offers and Sales”) is at SEC Release 33-6389, or 47 Federal Register 11, 251 (March 8, 1982), or 1982 WL 35662.
Of those three exemptions, Rule 506 dominates the capital raising landscape.
The SEC estimates that Rule 506 accounts for 90 to 95% of all Regulation D offerings by number of deals (Release No. 33-9414, at 4-5) and approximately 99% of the absolute dollars raised in private placements generally. Release No. 33-9415, at 64. To the latter point, the SEC further reports from issuer filings that operating companies raised approximately $71 billion and $173 billion in “Rule 506 deals” in 2011 and 2012, respectively. Release No. 33-9415, at 64-65. Likewise, venture capital funds and private equity funds – which also rely on Rule 506 in their fundraising – raised approximately $778 billion and $725 billion in “Rule 506 deals” in 2011 and 2012, respectively. Release No. 33-9415, at 64–65.
Rule 506 is therefore both the workhorse of venture capital financings and the “Big Boy” exemption, i.e., companies can, in a Rule 506 deal, (1) raise a theoretically infinite amount of money, from (2) a theoretically infinite number of “accredited investors.” As the SEC notes
Under existing Rule 506, an issuer may sell securities, without any limitation on the offering amount, to an unlimited number of “accredited investors” … and to no more than 35 non-accredited investors who meet certain ‘sophistication’ requirements. Release No. 33-9415, at 6-7.
The two basic mechanical limitations on Rule 506 fundraising are the rules regarding disclosure of information (required) and solicitation of investors (prohibited).
Regarding disclosure, if all of the investors in a Rule 506 deal are “accredited investors,” then there are no specific disclosure requirements … the company must simply provide such information as may be required by the (always applicable) antifraud rules. On the other hand, if any of the investors a Rule 506 deal are not “accredited investors” (i.e., if any of them are what the rule calls merely “sophisticated”) then there is a detailed matrix of business and financial information that must be provided to all investors. Think “private placement memo with exhibits.” From a disclosure standpoint, the practical result is that most venture capital Rule 506 deals are “accredited investor”-only affairs.
Conversely, the public advertisement of any Rule 506 deal – whether it is of the “accredited-only” sort or not - has been expressly forbidden for decades …
The availability of Rule 506 is subject to a number of requirements and is currently conditioned on the issuer, or any person acting on its behalf, not offering or selling securities through any form of ‘general solicitation or general advertising.’ … [E]xamples of ‘general solicitation and general advertising,’ including advertisements published in newspapers and magazines, communications broadcast over television and radio, … [advertised] seminars … [as well as any] other uses of publicly available media.” Release No. 33-9415, at 6-7.
C. The New ”With or Without” Regime
One of the things the Jumpstart Our Business Startups Act (the “JOBS Act”) did was require the SEC to eliminate this prohibition against ‘general solicitation’ for offers and sales of securities made to “accredited investors” under Rule 506. To implement the JOBS Act mandate, the new SEC rules do three basic things:
First, the SEC has kept the current Rule 506 exactly as is and re-numbered it “Rule 506(b).” Thus, venture capital financings can still be done the “old way,” i.e., a company can (1) raise a theoretically infinite amount of money, from (2) up to 35 “sophisticated” investors and a theoretically infinite number of “accredited investors,” provided that (3) there is no ‘general solicitation,’ and provided further that (4) the disclosure requirements described above are met.
Second, the SEC has created a new Rule 506(c) that eliminates the ban on ‘general solicitation.’ Thus, venture capital financings can now be conducted in a “new way,” i.e., a company can (1) raise a theoretically infinite amount of money, from (2) a theoretically infinite number of “accredited investors,” who have been (3) contacted via any available means of ‘general solicitation,’ provided that (4) the company “takes reasonable steps to verify that [the investors] are ‘accredited investors.’” Although the Staff gives guidance on the nature of such “reasonable steps,” presumably best practices will evolve over time.
Finally, the SEC has created a tracking mechanism for “old” vs. “new” style deals. Thus,whether a company chooses the “old way” (without ‘general solicitation’) or the “new way” (with ‘general solicitation’) must be indicated in a “check the box” manner on the SEC’s customary form for Regulation D deals (“Form D”).
(1) Why Keep The “Old” Rule?
According the SEC, the “old rule” was kept for several reasons:
… . #1 - Some companies may not want to advertise their financing to the public for business reasons (e.g., the existence of an already established investor base, or operation in stealth mode);
… . #2 - Some companies may not want to advertise their financing to the public in order to avoid the ambiguous new requirement to take “reasonable steps to verify” the “accredited investor” status of purchasers; or
… . #3 - Some companies may want to issue shares to non-accredited investors who meet the Rule 506 “sophistication requirements,” i.e., do a non-accredited deal.
Makes sense. Good rulemaking IMO.
(2) No Bad Boys.
In what the SEC calls an effort to “preserv[e] the integrity of the Rule 506(c) market and minimize[e] the incidence of fraud,” at the same time it adopted the new Rule 506(c) it extended the “bad actor disqualification” to cover such transactions. In the SEC’s words
“Bad actor” disqualification requirements, sometimes called “bad boy” provisions, disqualify securities offerings from reliance on exemptions if the issuer or other relevant persons (such as underwriters, placement agents and the directors, officers and significant shareholders of the issuer) have been convicted of, or are subject to court or administrative sanctions for, securities fraud or other violations of specified laws. Rule 506 in its current form does not impose any bad actor disqualification requirements.” Release No. 33-9414, at 7-8.
Acting under authority granted by the Dodd-Frank Wall Street Reform and Consumer Protection Act (summary here and statute here), the SEC has barred any company from using either the “old” Rule 506 (without ‘general solicitation’) or the “new” Rule 506 (with ‘general solicitation’) if (1) any director of the company, (2) any executive officer of the company, (3) any other officer of the company participating in the financing, (4) any 20% stockholder of the company, (5) any promoter, broker, dealer or “finder” associated with the financing, or (6) certain others, are “Bad Boys” (i.e., have been convicted of any one of a long list of enumerated crimes or disciplined for violating a host of different rules related to the sale of securities).
Good rule, IMO overdue.
(3) Cottage Industry
Although I would quibble with the use of the term “whale" in any securities law context, TechCrunch correctly notes that the ability to openly solicit startup investors “will fuel a new cottage industry of investor matching-making sites that aim to broaden the investment pool to financial whales …” Casino lexicon aside, point taken. Matching capital seeking advertisers with accredited ‘advertisees’ will no doubt be big business. Likewise, stand by for a host of practice pointers on the business and legal side for what constitutes a “reasonable” set of steps to “verify accredited investor” status.
Net: Overall, “Wait and See.” The mechanics of a “solicited Rule 506(c) deal” will evolve in two respects … (1) the logistics of matching investors with companies and confirming accredited status to the satisfaction of the rule, and (2) the nature of third party legal opinion practice (if any) in the context of these quasi-public offerings.
(4) Rolling The Dice
On the subject of “financial whales,” I continue to marvel at the use of gambling analogies to support the “democratization” of venture capital investing, be it through equity crowdfunding or solicited Rule 506(c) deals.
For example, regarding the JOBS Act generally …
“Americans are allowed to gamble unlimited amounts at casinos … [y]et are legally prevented from making even modest investments in job-creating small businesses.” Sen. Scott Brown (R-MA), in Wired, November 30, 2011.
[G]ambling is legal in parts of the United States and has seen expansion recently thanks to promises of increased tax revenue for participating states. [In Ohio we] also have a robust lottery that allocates millions of dollars to schools and public projects. My chances of winning the lottery jackpot in Ohio? 1 in 13,983,816. The house always wins. The argument that equity crowdfunding is too risky for the average investor is a bogus narrative. Crowdfunder Charles Luzar, in VentureBeat, October 6, 2012.
And today regarding the new ability to solicit private investors …
“People go to the casinos every year and spend over $49 billion without any limitations.” Crowdfunder Alejandro Cremades, in support of the new Rule 506(c), in Upstart Business Journal, July 11, 2013.
For my part, I think such gambling analogies are deeply misplaced. “Car Czar” Steven Rattner is closer to the mark …
Its enticing acronym notwithstanding, the JOBS Act has little to do with employment; it is a hodgepodge of provisions that together constitute the greatest loosening of securities regulation in modern history. … For the first time, private equity [funds,] hedge funds [and startups] will be able to advertise — and thereby separate inexpert individuals from their savings. … I’ll wager that most of this new advertising will come from firms that sophisticated institutional investors wouldn’t consider investing in … The largest number of jobs likely to be created by the JOBS Act will [therefore] be for lawyers needed to clean up the mess that it will create.” A Sneaky Way to Deregulate, NYTimes Opinionator, March 3, 2013 (emphasis added).
In a word, yep. See “Lawyering Up For The JOBS Act,” March 19, 2012.
© david jargiello 2013 all rights reserved
Simply stated, Carsanaro v. Bloodhound Technologies, C.A. 7301-VCL (Mar. 15, 2013) is a 76 page tour-de-force of Delaware corporate law regarding the liability of venture capitalists for highly dilutive (aka “washout”) financings. Although Carsanaro has been reviewed by better bloggers than this one (see e.g., Pileggi blog, PotterAnderson blog, or Kennerly blog), several “between the lines” practical points caught my eye.
A. Backstory Highlights
Carsanaro formed Bloodhound Technologies (“Bloodhound" or the "Company”) in 1998. As the Company’s CEO, Carsanaro negotiated and closed a Series A Preferred Stock round in 1999 with VC#1, and, a Series B Preferred Stock round in early 2000 with VC#2. With venture capitalists in control of the Bloodhound board, Carsanaro was ousted from all positions with the Company in December 2000. A Series C Preferred Stock round with VC#3 was closed in early 2001, and a Series D Preferred Stock round with board insiders (i.e., VC#1, VC#2 and VC#3) was closed later that same year. For purposes of this post, Bloodhound’s pre-money valuation increased with each successive round from Series A to Series D.
Between 2002 and 2006, the board insiders (VC#1, VC#2 and VC#3) continued to finance the Company via a series of highly dilutive “down rounds.” The dilutive security in each instance was a cheaper Series E Preferred Stock that also sported a 3x liquidation preference. Notably, despite alleged steady improvements in Bloodhound’s business, the price of the Series E Preferred Stock never changed during the four year period in question. In 2011, Bloodhound was sold for $82.5 million. Based on facts stated in the underlying complaint, the proceeds of that sale were allocated as follows:
*** As a result of liquidation preferences on the Preferred Stock, VC#1 received approximately $2.1M, VC#2 received approximately $13.9M and VC#3 received approximately $27M. Carsanaro, at 14.
*** As a result of a “management incentive plan” approved at the time of the merger, $15M was allocated to management. Carsanaro, at 14.
*** Finally, since all of the Preferred Stock was apparently “participating,” the remaining amount (approximately $4.5M) was allocated pro rata among all stockholders on an as converted basis. Carsanaro, at 14.
Upon receipt of just over $29,000 based on his (by then massively diluted) holdings, Carsanaro brought this action against VC#1, VC#2 and VC#3 challenging the “insider” rounds and the allocation of merger proceeds on a variety of legal theories. Defendant VC’s moved to dismiss. By this ruling, the Court of Chancery largely held for Carsanaro, meaning that he had stated colorable - though not necessarily valid - claims under applicable Delaware law.
… #1 - Scrivener’s Error.
In connection with the very first of the Series E down rounds, Bloodhound effected a 10-for-1 reverse stock split (the “Reverse Split”). Mechanically, counsel undertook this process in two steps: (1) a Certificate of Amendment to Bloodhound’s Certificate of Incorporation was filed effecting the reverse split, and then immediately thereafter (2) an Amended and Restated Certificate of Incorporation (the “Series E Charter”) was filed to authorize the new Series E Preferred Stock.
As the Court of Chancery reports …
"Bloodhound filed the certificate of amendment effecting the Reverse Split, then filed the Series E Charter shortly thereafter. But the Series E Charter did not adjust the conversion prices of the Series A, B, or C Preferred to account for the Reverse Split. By keeping the conversion prices constant, the Series E Charter made those shares’ conversion rights ten times more valuable.” Carsanaro, at 9 (original emphasis).
Hmmm … An intentional business move or a scrivener’s error? The Board’s behavior suggests the latter …
"Because the failure to adjust the conversion prices would dilute not only the [C]ommon [S]tock but also the Series D and E Preferred, Bloodhound entered into separate agreements with the holders of Series D and E Preferred to issue them additional shares. The dilution from the failure to adjust the conversion prices fell squarely on the Common Stock.” Carsanaro, at 9 – 10 (emphasis added).
Although it is impossible to know for sure from the published opinion, it appears from this characterization of events that (1) Bloodhound filed a Series E Charter with a typographical error, and then (2) “fixed it” by “grossing up” certain insider stockholders with extra shares to compensate them for the unintended economic consequences (as opposed to the correcting it by appropriate statutory instrument (e.g., a Certificate of Correction)).
My Comment … "Grossing-up" a scrivener’s error for the benefit of some - but not all - of the affected stockholders is, well, ill-advised. Viewed in the most charitable possible light such an action creates an appearance of impropriety that will allow a claim to survive a motion to dismiss, as was the case here.
… #2 - Board Consent Problem.
On a related note, the Court of Chancery observed that …
"The failure to adjust the conversion prices [in the Series E Charter] was contrary to the board resolutions that authorized the Series E Financing.
That resolution stated:
'[I]n connection with the [Reverse Split] … the respective conversion prices of the issued and outstanding shares of Series A Preferred Stock, Series B Preferred Stock, Series C Preferred Stock and Series D Preferred Stock of the Company … shall be proportionately adjusted in accordance with the terms of the Amended and Restated Certificate of Incorporation.' ”
Carsanaro, at 10 (emphasis added).
Thus, because “[t]he actual certificate filed by Bloodhound with the Secretary of State did not revise the conversion prices of the Series A, B, or C Preferred,” the Series E Charter was in violation of Section 242(b)(1) [of the Delaware General Corporation Law] in that it failed to “conform to the resolution adopted by the board.” Carsanaro, at 27 (original emphasis).
As a ruling on a motion to dismiss, Carsanaro includes no discussion of the consequences of this violation other than to conclude that plaintiffs stated a valid claim. That leaves it to bloggers to ponder the practical meaning of such a Section 242(b)(1) violation … . Was the Series E Charter “voidable” (as opposed to “void”) and if so, to what end? See, e.g., Bigler and Tillman, Void or Voidable (2008). For example, any third party legal opinions delivered by company counsel would presumably be in error, and counsel would more generally be exposed for the consequential damages flowing from the issuance of a voidable series of preferred stock.
My Comment … Yet another reason that an erroneous Certificate of Incorporation should be corrected through an appropriate statutory instrument, and not otherwise “fixed” through what might appear to be “easier” inter-stockholder business dealings.
… #3 - Stockholder Consent Problem.
Carsanaro gives a moment of pause regarding the common practice of “circulating sig pages” in the usual hubbub surrounding a venture capital closing … “[L]ess than four hours before filing the amendment giving effect to the Reverse Split,” the Company emailed an “Action by Written Consent” to a holder of Common Stock whose vote was essential. The form consent referenced certain documentation for the Reverse Split supposedly – but not in fact - attached as exhibits. Carsanaro, at 12.
In response, the stockholder sent an email to the Company … .
"I‘ve reviewed the [stockholder consent form] and while I have no problem signing the document in principle, I would very much appreciate getting [the exhibits] so I can understand the full scope of what I am signing … . I am ready to sign this document as soon as I‘ve had a chance to review the above mentioned exhibits and resolutions." Carsanaro, at 12.
Feeling pressured, the stockholder nevertheless signed the consent and the Reverse Split became effective; one month later, he received the exhibits in question. Carsanaro, at 12.
Per the Court of Chancery …
Because Section 228 [of the Delaware General Corporation Law] permits immediate action without prior notice to minority stockholders, the statute involves great potential for mischief and its requirements must be strictly complied with if any semblance of corporate order is to be maintained … When a consent specifically refers to exhibits and incorporates their terms, the plain language of Section 228(a) requires that a stockholder have the exhibits to execute a valid consent. [As a result,] [t]his aspect of [the subject count] states a claim. Carsanaro, at 28.
My Comment … Carsanaro sends a shot across the proverbial bow with respect to this not uncommon venture capital practice … “Sig pages attached - Sign ASAP so we can close - Attachments later.”
… #4 - Redemption Rights Can Be Illusory.
The VC defendants sought dismissal of Carsanaro’s claims …
" … on the theory that the preferred stockholders could have acted together to take 100% of the value of the Company by exercising their redemption rights. According to the [VC] defendants, the preferred investors had a … right under the certificate of incorporation to force the Company to redeem their preferred shares at any time. … The [VC] defendants say they cannot be held liable in connection with [a sale of the Company] in which the common stockholders received at least something, because they had a … right to take everything.” Carsanaro, at 33.
Hmmm … That makes sense, right? We have redemption rights worth more than the company is worth, so it’s our company, right?
As the Court of Chancery correctly notes “[a] redemption right does not give the holder the absolute, unfettered ability to force the corporation to redeem shares under any circumstances,” but rather the right to be repurchased under the specific circumstances stated in Section 160 of the DGCL. Carsanaro, at 33.
In short, Section 160 says that a corporation can only redeem (1) out of “surplus” (the value of a corporation’s net assets less the par value of outstanding capital stock), and (2) when there are “legally available funds” (a facts-and-circumstances driven determination balancing (a) whether the redemption would result in insolvency, (b) whether the redemption would jeopardize the corporation’s ability to continue as a going concern, (c) whether the redemption would jeopardize the long term financial health of the corporation, (d) whether the redemption would jeopardize the corporation’s ability to pay its debts when due, and (e) whether the redemption would lessen the security of the corporation’s creditors).
My Comment … It is a common misconception - one that is heard time and again - that a redemption right gives the VC’s the right to “take” the company. A redemption right gives the VC’s a right to have their shares repurchased under certain limited circumstances that rarely occur in the real start up company world. Further, the real practical “value” of redemption rights is that as a matter of law they distinguish preferred stock from debt. See, e.g., Harbinger Capital Partners Master Fund I, Ltd. v. Granite Broad. Corp., 906 A.2d 218, 225-26 (Del. Ch. 2006) (restrictions on redemption imposed by Section 160 are one critical factor that distinguishes preferred stock from debt).
… #5 - “Dual Fiduciary” Problem.
Carsanaro is good read and reminder on several points regarding venture capital board seats.
For clarity here, I’ll define a “Venture Capital Board Representative” as (1) a member of the Board of Directors of “StartUp,” that is also (2) a venture capitalist, in (3) a venture capital fund that owns some sort of traditional NVCA-esque Preferred Stock in StartUp. Using that definition, a Venture Capital Board Representative is a classic “dual fiduciary,” with parallel obligations running to (1) the stockholders of StartUp, and (2) the limited partner investors in his or her venture capital fund.
Reminders from Carsanaro …
*** First, at a personal level, a Venture Capital Board Representative does not get a “break” or some sort of lesser obligation(s) by virtue of being a dual fiduciary … “[t]here is no dilution of [fiduciary] obligation where one holds dual or multiple directorships or otherwise confronts the conflicting pull of competing fiduciary roles.” Carsanaro, at 22 (citing Weinberger v. UOP, Inc. 457 A.2d 701 (Del. 1983)).
*** Second, at a transactional level, with respect to a corporate matter that benefits the holders of StartUp’s Preferred Stock, a Venture Capital Board Representative is “interested” for pleading purposes if his or her venture capital fund is a holder of any of StartUp’s Preferred Stock. Carsanaro, at 22 (citing In Re Trados Incorporated Shareholder Litigation No. 1512-CC (July 24 2009)).
*** Third, at a Board of Directors level, “[a] board that is evenly divided between “interested” and independent members is not considered independent and disinterested.” Carsanaro, at 20.
*** Finally, at a "rules" level, a Board of Directors that is “not … independent and disinterested” as to a particular matter does not enjoy the protection of the Business Judgment Rule, but rather bears the burden of proving - if challenged - that such matter was “entirely fair.” Carsanaro, at 20-23.
My Comment … Simply stated, good stuff that is often forgotten, overlooked and/or misunderstood.
… #6 - Director Behavior.
Finally,Carsanaro is also a good read and reminder on the topic of the “Business Judgment Rule” and the practical functioning of “interested” boards in venture backed companies. A quick recap on the Business Judgment Rule …
(a) Under Delaware law, the business judgment rule is a presumption that in making a business decision the Board of Directors acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.
(b) A party challenging a decision made by the Board of Directors has the burden of rebutting that presumption.
(c) If a party challenging a decision made by the Board of Directors cannot rebut that presumption, then no court will “second-guess” the Board’s decision.
(d) If a party challenging a decision made by the Board of Directors can rebut the presumption, then the burden shifts to the Board to prove the “entire fairness” of the transaction or act in question vis-à-vis the company’s stockholders.
With that in mind, following are some tidbits from Carsanaro …
Regarding the “Inside” and “Upside” Series D Round:
“The business judgment rule is rebutted with respect to the Series D Financing because only two of the six members of the [Board of Directors] … were disinterested and independent. The complaint‘s allegations about the unilateral setting of the terms of the Series D Financing, without any market canvass [for outside investors] … give rise to a reasonable inference of unfairness.” Carsanaro, at 23.
Regarding the “Inside” and “Downside” Series E Rounds:
The business judgment rule is rebutted with respect to the Series E Financing because “only one member of the [Board of Directors] was disinterested and independent. The complaint‘s allegation that the [Board of Directors] accepted the [insiders’] opening proposal, without negotiation or any effort to explore alternative financing, supports a reasonable inference of unfairness … [as does] the failure to adjust the conversion prices of the Series A, B, and C Preferred and the self-interested step of mitigating the dilution for holders of Series D and E Preferred, but not for the holders of the common.” Carsanaro, at 24.
Regarding the Management Incentive Plan:
“The diversion of 18.87% of the Merger consideration through [a management incentive plan benefiting a majority of the Board of Directors] support[ed] a reasonable inference that the Merger was unfair.” Carsanaro, at 29.
My Comment … Process, Process, Process, Process. Process. There is absolutely nothing “wrong” per se with an “interested” Board of Directors. In fact, it is more common than not in venture capital circles. Rather, when the Board is “interested” what is important is director behavior. My personal “Big Four” … (1) attend meetings, read board material, understand the business and its financials; (2) actively deliberate matters that come before the board (i.e., consider alternatives, discuss strategies and differences of opinion); (3) appropriately document the deliberative process in the minutes; and (4) know the limits of the attorney client privilege as it relates to board discussions with counsel, as well as the scope of electronic discovery.
As noted above, just some practical pointers I extracted from the published opinion text. As a Delaware law matter there is much more to Carsanaro than reported here … see the Pileggi blog, PotterAnderson blog, or Kennerly blog, or the published opinion for details.
© david jargiello 2013 all rights reserved
Let’s say, hypothetically, that Founder starts Startup. Startup hits some speed bumps. Founder leaves. New management turns the company around. Venture capital investors, equipped with the usual panoply of information rights, board observer rights, and board seats, are aware that there are some “bluebirds of happiness” in Startup’s future. Founder – out of the loop and out of nowhere – reappears with notice that he wants to sell his Common Stock to a third party buyer on the cheap. In accordance with the terms of a customary venture capital right of first refusal, he asks whether the VC’s will waive or exercise their ROFR. Do the insider VC’s have to say anything about the coming good news, or can they just exercise their purchase right and jump on a cheap stock windfall?
Amazingly, as of 2009 this was “a matter of first impression both in Delaware courts and … elsewhere.” Latesco, L.P. v. Wayport, Inc., C.A. No. 4167-VCL Del. Ch. (July 24, 2009) (“Wayport One”), at 17. Already an important venture capital ROFR case, Wayport One skidded to a halt this month with a page turner out of the Court of Chancery called In re Wayport, Inc. Litigation, Cons., C.A. No. 4167-VCL Del. Ch. May 1, 2013 (“Wayport Two”). For ROFR basics, see AskVenture, Feld and Startup.
The Backstory: Got Wireless?
Way back in 1996, Wayport was a pioneer in the development of WiFi hotspots, i.e., the use of a wireless router to provide internet access within a defined local area. Although there was a complex stew of plaintiffs and defendants in the subject litigation, for simplicity this post will refer only to the lead plaintiff (the “Founder”) and the venture capital fund ultimately found liable for damages (referred to as “Venture Fund”). Founder was Wayport’s initial CEO and the named inventor on most of the company’s patents. As with most internet-related startups in the late 1990’s, life for venture-backed, Austin-based Wayport was good. In 1998-1999 the company closed several Preferred Stock financing rounds. Of analytical relevance is that the investors, including Venture Fund, received what appear to have been customary venture capital rights of first refusal on any sale of Founder’s shares.
As things turned out, Wayport’s business went sideways in the dot com bust. Founder transitioned from CEO to President in 2000, and left the company altogether in late 2001. Under new management, Wayport rebounded. By 2005, it was generating some $100M in annual revenue, it was profitable, and the board was thinking IPO. Strategies for monetizing the company’s still substantial patent portfolio took center stage in the board’s strategic discussions. Founder - an outsider but still the named inventor possessed of relevant technical knowledge - reappeared on the scene as an ersatz participant in those efforts … variously offering opinions and disparaging the new management team. Wayport Two, at 7-11.
Against this backdrop the events which gave rise to nearly FIVE years of litigation unfolded … . (1) Founder made a series of secondary sales of his Wayport Common Stock to a third party and to Venture Fund, (2) in the midst of Founder’s secondary sales and without informing him, Wayport sold a material portion of its patent portfolio to Cisco for (the “Cisco Patent Sale”), and (3) shortly after Founder consummated the last of his secondary sales, Wayport was acquired by ATT at roughly 5x the price per share at which he had been selling.
Founder, “certain that he had been wronged but searching for a theory of recovery,” sued Wayport, Venture Fund, Wayport’s General Counsel and others, “alleg[ing] a variety of claims sounding variously in fiduciary duty, contract, fraud, and restitution.” Wayport One, at 12. Conflating the alleged wrongs, Founder’s complaint was that in failing to inform him of, well … something, Wayport and its management misled him into selling his shares on the cheap.
Both cases are important reads with ample technical analysis. My own view of the combined, practical learning follows below.
A. Not a Securities Law Case
First and foremost, it is important to note that neither Wayport One nor Wayport Two are securities law cases. The Wayport cases analyze insiders’ disclosure obligations under Delaware law relating to corporate fiduciaries. Thus, the statements made in either case – for example, that there is a duty to disclose [this] or no obligation to disclose [that] – are grounded in (1) Delaware corporate laws regarding the duty of care and duty of loyalty, and (2) common law fraud as such is viewed in Delaware. There may or may not be wholly different conclusions as a matter of federal and state securities laws. More below.
B. Two Types of Transactions
Second, IMHO much of the blogging and discussion of the Wayport cases conflate and therefore confuse two fundamentally different transactions:
The first is the exercise of a standard, contractual, venture capital right of first refusal by corporate insiders in accordance with its terms (a “ROFR Exercise”). An example of a ROFR Exercise would be thus: When startup founder wants to sell his startup shares to a third party, he or she must first offer those shares for sale at the same price and on the same terms to [x], where [x] is generally one or more venture capital investors/insiders. I think of ROFR Exercises as a sort of "quasi-call option" where the founder is short and the ROFR holders – [x] in this lexicon - are long. Therefore, vis-à-vis “party [x],” Founder makes his or her investment decision at the time of entering into the ROFR. The ROFR holder - [x] - makes its investment decision to exercise/buy or waive at downstream times, prices and terms determined by Founder.
The second type of transaction relevant here is the de novo, negotiated purchase of any stockholder’s shares by a corporate insider, where that insider is at an informational advantage (i.e., the insider is “inside” as it regards material information about the business and the stockholder is “outside” that flow of information) (a “De Novo Purchase”). Note that the term "De Novo Purchase" is my verbiage meant to convey the fact that a new transaction with a new investment decision is taking place, i.e., both outsider/seller and insider/buyer are making their respective investment decisions – again, vis-à-vis each other - at the same point in time.
In my view, the Wayport cases are important not only because they provide an analytical framework for distinguishing between these transactions as a matter of Delaware law, but also because they illustrate the steep and slippery slope that can exist between them.
C. Safe Ground
As it relates to a vanilla ROFR Exercise, Wayport One says it all in plain English:
[W]hat disclosures [are required of] an insider … when exercising [a right of first refusal][?] … This appears to be a matter of first impression both in Delaware courts, and, to the best of the court’s research, elsewhere. Courts have addressed the similar, but not entirely analogous, issues that arise when corporations [repurchase unvested employee shares upon] termination of employment, but it is hard to discern any general rule …
[Nevertheless, it is possible to view a customary venture capital ROFR as granting its holder with] the unconstrained right to buy shares when a notice of an intent to sell is given [even if that holder is a fiduciary]. Many factors beyond the mere existence of a contract distinguish the exercise of a right of first refusal from situations in which the law imposes strict fiduciary fidelity[:] First, it must be said that the exercise of a right of first refusal does not involve the fiduciary in soliciting sales or even offers to sell; on the contrary, the impetus for the transaction comes from the selling stockholder who has already arranged a separate sale requiring performance under the right of first refusal. Second, the fiduciary is not involved in any price negotiation with the selling stockholder; instead, the pertinent price negotiation is between the selling stockholder and the purchaser. Third … the selling stockholder often signs a right of first refusal agreement that contains no contractual right to information; thus, he has reason to know that any decision he makes to sell once he is no longer an insider will be made without access to the broad scope of information available to insiders. These factors all suggest the justice of enforcing a right of first refusal according to its terms. Wayport One, at 17-18.
Clear enough, and hard to argue any differently.
D. Soft Ground.
In my view, Wayport was litigated for five years and through trial because what began as a ROFR Exercise morphed into a De Novo Purchase, giving rise to a fundamentally different set of perceived and actual duties. Reducing a convoluted set of facts to an analytically relevant core, the dispute at bar involved Founder’s sale of shares of Wayport Common Stock in three tranches as follows.
** Sale #1: Wayport and certain ROFR holders waived their right of first refusal, allowing Founder to sell shares to an independent third party. Sale #1 was not ultimately at issue. Sound Bite … noncontroversial ROFR waiver.
** Sale #2: While Wayport and certain ROFR holders waived their right of first refusal, Venture Fund exercised its ROFR. Effectively, Founder sold shares to Venture Fund pursuant to the terms of an enforceable ROFR agreement. Sale #2 was not ultimately at issue. Sound Bite … noncontroversial ROFR Exercise.
** Sale #3: The wheels come off. When Founder attempts to sell more shares to an independent third party, Wayport suggests that Founder “sell additional … shares” to various corporate insiders in order to secure a further ROFR waiver from the holders thereof. After much sturm and drang, and with what the court called “transactional facilita[tion]” by Wayport’s General Counsel, Founder closes Sale #3 with various corporate insiders, including Venture Fund. Sound Bite … By asking Founder to put “additional shares” in play, Wayport converted a ROFR Exercise into a De Novo Purchase giving rise to different duties and a different analysis. As the Court of Chancery said …
[T]he request for extra shares is presumed … to distinguish the case from [a ROFR Exercise]. Because [Sale #3 is] not well cabined within the four corners of the [Right of First Refusal] Agreement, general fiduciary principles apply. Wayport One, at 19-20.
E. Special Facts.
In finding that that Sale #3 was a De Novo Purchase, Wayport Two confirms that the “Special Facts Doctrine” is the current, applicable Delaware law … at least for the time being. Thus, when a director, officer or other fiduciary seeks to buy shares from or sell shares to an “outside” stockholder, there is a duty to disclose “Special Facts.” My own formulation of this [rather murky] rule of law is this: A “Special Fact” is (1) a fact, event or circumstance, (2) known to the fiduciary but not to the “outside stockholder,” that (3) substantially affects the value of the stock in question. Typical examples include “important transactions, prospective mergers, probable sales of the entire assets or business, agreements with third parties to buy large blocks of stock at a high price, and impending declarations of unusual dividends.” Wayport Two, at 33-34, citing Ballantine. Importantly, Wayport Two reminds us that a “Special Fact” is always material, but a “material fact” is not necessarily special … “[t]he standard of materiality is … lower than the standard for a special fact.” Wayport Two, at 40.
Thus, per Wayport Two
Under the “special facts” doctrine, [insider venture capital funds are] free to purchase shares from other Wayport stockholders [in a De Novo Purchase], without any fiduciary duty to disclose information about [Wayport] or its prospects, unless the information related to an event of sufficient magnitude to constitute a “special fact.” If they knew of a “special fact,” then they had a duty to speak and could be liable if they deliberately misled the plaintiffs by remaining silent. Wayport Two, at 40.
Again, clear enough.
F. Trip Wire.
After parsing through the various transactions in dispute, the Court of Chancery dismissed all of Founder’s claims against all defendants save one: A finding of common law fraud – as opposed to a breach of fiduciary duty - in connection with Venture Fund’s De Novo Purchase in Sale #3.
How the Court of Chancery reasoned to this one finding of liability gives us the practical learning of the case in my view …
*** Chancery Analysis Part 1 - Special Facts?: Since Venture Fund was a majority stockholder with a board representative and therefore a fiduciary, were there any “Special Facts” under the Special Facts Doctrine that had to be revealed to Founder in connection with Sale #3? … .
The [Cisco Patent Sale] was a milestone in [Wayport’s] process of monetizing its patent portfolio, and it was sufficiently large to enter into the decisionmaking of a reasonable stockholder. But [Founder] did not prove at trial that the [Cisco Patent Sale] substantially affected the value of [his] stock to the extent necessary to trigger the special facts doctrine. [Founder] admitted that the [Cisco Patent Sale] did not necessarily imply anything about the market value of the remaining patents, and he himself believed - before and after learning of the Cisco sale - that the rest of [Wayport’s] patent portfolio was still worth hundreds of millions of dollars… . [Thus,] [b]ecause [it] did not know of any “special facts,” [Venture Fund] did not have a fiduciary duty to speak when purchasing shares from [Founder]. Wayport Two, at 42.
So … . Nope. No Special Facts. No need to say anything.
*** Chancery Analysis Part 2 - Did Buyer Create a Duty to Speak?: Of course, as a matter of law, if a director, officer or other fiduciary chooses to speak in connection the purchase or sale of shares from “outside” stockholder, they must do so truthfully. Wayport Two, at 28-29 and 45-48. So, did Venture Fund say anything?
Yep … In the build up to Sale #3 and before the Cisco Patent Sale closed, Venture Fund emailed the following to Founder:
[In connection our purchase of your shares, we] are not aware of any bluebirds of happiness in the Wayport world right now and have graciously offered to rep that [in the stock purchase agreement]. Wayport One, at 8; Wayport Two, at 20 (emphasis added).
Not surprisingly, the meaning of the phrase “bluebird of happiness” was “hotly disputed” at trial. Read in context, the Court of Chancery agreed with Founder’s view that the term meant “any unspecified good news” rather than [Venture Fund’s] narrower interpretation that it meant “an acquisition.” Wayport Two, at 20. In any event, and while there ought to be a rule about using the phrase “bluebird of happiness” in any document associated with any sale of securities, the email was true enough as a purely factual matter when written.
*** Chancery Analysis Part 3 - The Bluebird Lands: Three weeks after the “bluebird” email, Wayport closed the Cisco Patent Sale … .
Once the Cisco sale occurred and [Venture Fund] learned of it, the “no bluebird” [email] became materially misleading, and [Venture Fund] therefore had a duty to speak. Instead, [Venture Fund] remained silent. For purposes of fraud, the decision to remain silent placed [Venture Fund] in the same position as if [it] knowingly made a false representation … Wayport Two, at 48.
*** Chancery Analysis Part 4 - Damages: Thereafter, Sale #3 was consummated. In the court’s view, Venture Fund engaged in actionable common law fraud by closing the purchase of Founder’s shares without speaking. As damages, the Court of Chancery awarded Founder an amount equal to (x) the price per share he would have received in the sale of Wayport to ATT for the shares in question, less (y) the amount he received in Sale #3 from Venture Fund … in absolute dollars approximately $470,000 in the aggregate.
G. Take Aways.
#1 - ROFR Creep.
In the final analysis, the Wayport cases boil down to this: Instead of purchasing its contractually allotted portion of shares under the terms of the applicable ROFR agreement, Venture Fund purchased (1) an allotment of supplemental shares, (2) made available for Venture Fund’s benefit, (3) by Founder, (4) at the request of a corporate officer. While there is absolutely nothing wrong with this in concept, it does alter the fiduciary duty analysis. Sound Bite … Be alert when you exceed a ROFR because different rules apply.
#2 – Email-palooza.
Wayport Two is, if nothing else, a study in the use of email. Putting aside the “bluebird” email that single-handedly created the only liability running to any defendant, Wayport Two reads like a multi-year email log among the venture capital investors, the Founder, Wayport management and outside counsel. Sound Bite … Yet another reason to remember that email is forever.
#3 – The Dangers of Being a “Transactional Facilitator.”
Although he was absolved of all liability by the Court of Chancery, Wayport’s general counsel was an individually named defendant in the suit all the way through trial. From the available public record it is hard to find fault in anything he did … . he communicated with Founder, Venture Fund, and other stockholders, he communicated with Wayport’s board and officers, he prepared at least some of the stock purchase agreements and related transfer documentation, and he supervised “his paralegal” in parts of the mechanical stock sale process. One possibility: The Court of Chancery expressly noted that it was the general counsel who first proposed to Founder that “additional shares” be made available for Venture Fund (Wayport Two, at 14). This, plus what the court described as counsel’s role as a “transactional facilitator” (Wayport Two, at 43) seemed to create sufficient questions of fact to keep him ensnared. Hmmm … a law practice post by itself for another day.
#4 – The Securities Laws Still Apply.
Nothing in the Wayport cases changes the general applicability of the securities laws to secondary sales of private company securities. For the broad reach of the antifraud rules under the federal securities laws see, e.g., Sec. & Exch. Comm’n v. Stiefel Labs. Inc., No. 11-cv-24438-WJZ (S.D. Fl. filed Dec. 12, 2011); and see also Stiefel Employees and Stiefel Retirement Plan. Sound Bite … I would submit that a founder makes an investment decision when they agree to sign a ROFR agreement, arguably making the strict execution of that agreement by its terms perfunctory; on the other hand, IMO a founder asked to pony up “additional shares” is being asked to make a new investment decision, exposing the buyer to scrutiny under the full panoply of securities laws. Complex topic, and also a post for another day.
#5 – Corporate Law Nuance.
Wayport Two reminds us that a corporation does not owe a fiduciary duty to its stockholders. Wayport Two, at 44. It is the corporation’s directors and officers that owe fiduciary duties to the corporation’s stockholders.
#6 – Corporate Hygiene.
Although it is impossible to tell from the published opinions, it appears that up to six right of first refusal agreements arguably controlled the right of first refusal at issue. At the time of the events in question, plaintiffs alleged that the operative ROFR agreements spanned a Third Amended and Restated Right of First Refusal and Co-Sale Agreement all the way through and including an Eighth Amended and Restated Right of First Refusal and Co-Sale Agreement. See Wayport One, at 6, note 2. While there is nothing per se improper about parallel ROFR agreements, I submit that the apparent ambiguity and therefore questions of fact created by the multiple operative agreements proved unhelpful when the rubber met the road in this matter. Sound Bite … Generally speaking, single, master, amended and restated agreements as to venture capital rights are a good thing (i.e., one master voting agreement, not several in parallel; one master ROFR agreement, not several in parallel, etc.).
© david jargiello 2013 all rights reserved
Well written WaPo piece yesterday (here).
It would seem the drama has been reduced to the correct three questions: (1) the admitted Nasdaq software failure, (2) the alleged selective disclosure, and (3) the alleged conflicting business narrative given to investors.
Great quote from Morgan Stanley …
“People who thought they were buying this stock so they could get an enormous pop were both naive and ordered [shares] under the wrong pretenses … [we’re] confident that we followed exactly [lawful] procedures …”
Of course, that, in turn, leads me to wonder if the real business misstep here was to open the offering to retail investors in the first place. It seems to me that Facebook - in effect not substance of course - ran a retail “directed shares" program. Ill-advised in retrospect. While Morgan Stanley may well be right that they ran the deal in hypertechnical compliance with the law, the retail component has guaranteed the persistent and negative press coverage, not to mention appropriate/predictable regulatory attention and political grandstanding.
You have to wonder why someone thought this had any upside for Facebook.
Prediction: Don’t look for this gimmick to be repeated anytime soon in a tech deal.
© david Jargiello 2012 all rights reserved
The news on the Facebook IPO shows no sign of letting up. Here’s how I break it down.
1 - The Masterpiece Part.
Yesterday I noted one of my favorite quotes on this topic:
"[FB IPO] a huge disappointment [because] investors were expecting easy money on this one." See NYTimes.
Here are some other good ones I saw today:
“Like a lead balloon falling from a stormy sky, the Facebook IPO was a big disappointment.” See Blog.
“It’s a total disaster because the stock is trading right at the IPO price … They didn’t want that in a million years.” See LATimes.
“[A] strong argument can be made that Facebook’s shaky start as a public company demonstrates that the entire IPO process, which is supposed to spread the rewards to [sic] innovation, is broken. By the time Facebook’s stock started trading on the public market, insiders - the company’s founders, employees, and venture - capitalist backers - had bagged most, if not all, of the company’s value for themselves.” See NewYorker.
Strong stuff, all.
Here’s what I say … I stand by my prior posts on the transactional aspects of this thing. Facebook masterfully pulled every dollar of market value into its own bank account, and that is precisely what is supposed to happen. The point of the transaction is not to make speculators looking for “easy money” rich via IPO day churn. Although the latter happens more often than not, it is a sideshow to the reality of the corporate transaction afoot. And the suggestion that Facebook’s two whole days of trading presages a collapse of the public financing of innovation is, well, just silly.
In the final analysis, what I said yesterday stands: The offering itself was a remarkable piece of work. What happens to the stock price from here is an entirely separate question.
2 - The Theater Part.
** Nasdaq “Bungling.” Now this is an issue with legs. Per Reuters, an investor has sought class action status for what Nasdaq has openly admitted to be “mistakes in the Facebook listing.” See Goldberg v. Nasdaq OMX Group Inc et al, U.S. District Court, Southern District of New York, No. 12-04054. Interesting report on the Nasdaq conference call with brokers in the San Jose Business Journal, too: “In retrospect, [going forward with the FB IPO in light of Nasdaq software problems] was incorrect.” Hoo boy. Stay tuned for more action on this one.
** Selective Disclosure … [?]. Reuters is separately reporting today that lead underwriter Morgan Stanley reduced its revenue forecast for Facebook in the middle of the roadshow. More precisely, the downward forecast apparently came just after the Company filed an S-1/A (No. 6) on May 9, 2012 advising “caution” about revenue growth in light of the general shift to mobile (the latter having less lucrative advertising revenue prospects). As to who was told what and when on this topic … Reuters is reporting “No Comment” from Facebook, Morgan Stanley, Goldman Sachs and JPMorgan Chase. By itself, the “No Comment” neither surprises nor alarms me. Good advice of counsel. Also, from publicly available information it is hard to say what all of this is about, if anything. That said … . One thing is for sure: Alleged selective disclosure on the roadshow is serious business and classic securities class action litigation stuff. Consider the following quote from an IPO research firm buried in the Reuters piece:
"[FB] definitely lowered their numbers and there was some concern about that … [Our] biggest hedge fund client told [us that the underwriters] lowered [FB’s revenue forecasts] right around mid-road show. [That hedge fund still bought the issue but] flipped [its] IPO allocation and went short on the first day.”
Translation: Someone with road show access bought, flipped and then shorted on day one of trading. Hoo Boy. Capital “B” this time. This is a part of the story to watch.
© david Jargiello 2012 all rights reserved
So read the (in)famous banner headline of the Chicago Tribune on November 3, 1948. “Truman,” of course, is Democrat Harry Truman, successfully reelected for a second term in office. Nearly forgotten today is the “Dewey” of newspaper headline fame: Republican Thomas Dewey. Governor of New York. Manhattan Special Prosecutor that convicted Salvatore Lucania (aka “Lucky Luciano”). Three-time candidate for the Presidency of the United States (1940 (lost primary to Wendell Willkie), 1944 (lost general election to Roosevelt) and 1948 (lost general election to Truman). And eventually … name partner of Dewey Ballantine Bushby Palmer & Wood. Later renamed Dewey Ballantine. Later still, Dewey & Leboeuf through merger.
Dewey & Leboeuf, of course, has been in the news for all the wrong reasons for a while now … (1) a merger with Orrick announced in October 2006, fell apart in January 2007; (2) a (hasty?) merger with LeBoeuf Lamb Greene & MacRae was announced in August 2007 and closed October 2007; (3) profits have been “essentially flat” since 2008 (with 2011 “an okay year” per Chairman Davis); (4) roughly 12% of the firm’s partners have left since January 2012; (5) the firm announced a “proactive … [alignment of] resources with anticipated demand” (i.e., layoffs) in March 2012; (6) a $100M line of credit is reportedly being “renegotiated”; and (7) the debt on the firm’s novel, once vaunted $125M bond offering begins to mature next year (as to the latter, see Bloomberg-DeweyBond and AmLaw-DeweyBond).
Wow. Is that all?
Unfortunately, no. Just last week the firm hired the crisis management consultant that represented Paris Hilton (jail time debacle), Michael Vick (dog fighting/jail debacle) and Patricia Dunn (HP spying scandal). See TheLawyer.
Geez. That’s it, right?
** Chairman: Position eliminated; ex-Chairman Steven Davis “relocating to London” and “restarting his practice.”
** Executive Director: Position eliminated; ex-ED Stephen DiCarmine now a “member of the professional staff” reporting to a newly titled “Executive Partner.”
** Executive Committee: 20-partner executive committee to remain intact.
** Office of the Chairman: New “super committee” (my terminology) comprised of five (5) Executive Committee members and tasked with “carrying out the firm’s strategy to restructure … and concentrate on core strengths.”
** Executive Partner: New position to be held by top London M&A partner; “will carry out the day-to-day responsibilities of implementing the directions of the Executive Committee and Office of Chairman.”
What I Think
A – Sounds Familiar. As a prosecutor, Thomas Dewey relentlessly pursued gangster Arthur Flegenheimer (aka “Dutch Schultz,” aka the “Beer Baron of the Bronx”). Acting without the approval of The Commission (i.e., the heads of the Five Mafia Families), Schultz ordered a “hit” on Dewey. For this breach of protocol (and no doubt other things), Schultz was gunned down in classic gangland fashion by the infamous “Murder Inc.” at the Palace Chop House in Newark. Dewey was saved and went on to win many convictions, including that of Commission member Lucky Luciano himself. History buffs see Dewey and Schultz.
Sadly, it’s hard to envision a similarly dramatic save for Dewey’s namesake firm. The fact is that large law firms unravel in an almost formulaic manner, and Dewey & Leboeuf appears to be deep into a death spiral. I offer the following from my 2009 White Paper (written with co-author Phyllis Gardner) …
Generally speaking, [a] downward spiral is triggered when a number of partners with material portable business – “revenue controlling partners” - become disaffected with leadership, and conclude that their own interests are no longer coincident with the direction of the law firm. … The spiral begins in earnest when the disaffected revenue controlling partners leave the law firm for what they perceive to be a better managed, better run, and therefore superior platform. Defection, in turn, creates financial distress that manifests immediately. The departing partners (1) strip out their capital (immediately or through a balance sheet adjustment), (2) take with them as many of their paying client accounts as possible, (3) render their outstanding receivables less collectible, and (4) leave behind overhead in the form of vacant offices, and unnecessary associates and staff. Being cash-constrained, Sisyphean businesses to begin with – all are incentivized to distribute the maximum practicable amount of cash at year end to keep PPEP at competitive levels - a law firm will experience immediate cash flow pressure as a result of any material defection.
Accordingly, unless the affected firm can quickly fill the revenue gap created by the defection – by lateral hiring or increased revenue generation by remaining partners – projected PPEP is jeopardized, as well as the organization’s ability to service previously manageable lease or debt levels. In such cases, some degree of “right-sizing” or “strategic re-alignment” is inevitable as the firm struggles to make the anticipated year end partner distributions. How much of either is of course a function of the firm’s ability to replace the revenue lost to defection. In any case, “falling profits,” “right-sizing” and “strategic re-alignment” in the hallway lexicon of a law firm is akin to yelling “fire” in a crowded theater. More revenue controlling partners will question leadership, and more will defect, resulting in still more financial stress and fear. If not contained, the foregoing cycle repeats like a closed feedback loop with no “off” switch until the financial stress overwhelms the business and forces closure.
Hmmm … .
B – When It Absolutely, Positively Matters. Well, what about that management reorg? That’s a pretty good containment strategy, right? Well, maybe. Consider the following, also from our White Paper:
In many cases, large firms today are organizations with the attributes of a corporate, for-profit business – management professionals, governing committees, strategic plans, financial controls, marketing strategies, and management consultants of every flavor - superimposed on an entity that is both technically and philosophically a partnership. This gives rise to the core paradox of such firms’ management structure: a professionally managed, for-profit veneer atop a partnership of free agents, the most powerful of which – the revenue controlling partners - may or may not even be on the formally elected/appointed management team. Said another way, a law firm can put in place the biggest, most expensive management structures and processes available, and they will serve the business well while the sailing is smooth and enough money is being made. However, in our own [research] we see ample evidence that the management wisdom du jour is irrelevant when something “really” matters or when enterprise survival is at stake. In the latter case, the reality of the law business is that the revenue controlling partners can and do decide the firm’s fate regardless of whether they have any “management” role whatsoever. (emphasis added).
What’s the point? Here is how I interpret today’s events at Dewey & Leboeuf … Operational control of the business now rests with partners who command a controlling block of what’s left of the firm’s business, and this control group will now drive events for good or ill. As firmwide, global litigation department chair and “super committee” member Jeffrey Kessler put it: "In some ways, this is a formalization of what was already evolving." I bet.
C – Predictions. Although the reported facts are grim Dewey & Leboeuf may or may not “have” to close. The fact of the matter is that there is much we do not know and it is therefore simply impossible to predict the firm’s fate from publicly available data. Nevertheless, following are some thoughts in no particular order …
1 - IMO whether or not the firm fails is largely a function of how dedicated the remaining revenue controlling partners are to the survival of the brand.
2 - IMO the single most problematic item in the reported press is what I have read about the firm’s apparent debt load. Why? To continue as a going concern the debt load goes to (1) ongoing profitability and potential therefore, (2) de facto control by creditors (e.g., via negative covenants and such), and (3) partner liability (i.e., guarantees if such exist or are asked for in light of current events). Conversely, as a merger target one has to wonder if the reported debt load renders the firm “unmergeable.” “Unmergeability” is a core legal industry problem … The Coudert dissolution revealed a law firm unpalatable to suitors due to massive, worldwide real estate obligations. Likewise, many large firms carry unfunded pension plans for retired partners that have the identical business effect. Does the Dewey & Leboeuf bond overhang create a similar problem? Hard to tell, but you have to think that the bondholders (some of whom are clients, BTW) have a significant say in the firm’s future.
3 - Finally, “troubled law firm” discussions in the press and blogosphere tend to narrowly focus on dissolution, bankruptcy and merger of necessity as the available options. In reading all of the press about Dewey & Leboeuf I am reminded of the elegantly structured Chapter 11 wind down of Ruden McClosky last year. As I said in a prior post, I think that was among the most interesting law firm transactions in decades. Food for thought.
© david jargiello 2012 all rights reserved
So … the Jumpstart Our Business Startups Act (aka the “JOBS Act”) has now sailed through the House and Senate with the exuberant nodding of the White House. I recently posted a ponderous analysis of the House Bill and its component parts - see JOBS One. After expressly limited debate (i.e., “cloture,” see JOBS Two), last week the Senate sent a revised version of the JOBS Act back to the House for reconciliation and certain approval.
What’s been revised?
S. 2190 - The “Crowdfund Act”
What has specifically gone back to the House is the Senate’s revised version of Title III of the JOBS Act, the latter known in House lexicon as H.R. 2930, or the “Entrepreneur Access to Capital Act.” The new Senate bill – S. 2190 – goes by the burlier name of the “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012.” Wow. Mercifully, Section 1 thereof also designates an alternative moniker … the “Crowdfund Act.” Similar to the House bill, S. 2190 adds two new provisions to the Securities Act of 1933:
A – As with the House bill, the first technical change effected by S. 2190 is to add a new category of exempt transaction enumerated “Section 4(6).” A financing is exempt from SEC registration under the Section 4(6) Crowdfunding Exemption if:
1 – The issuer raises no more than $1M in any 12-month period under Section 4(6); and
2 – The maximum amount sold to any particular investor under Section 4(6) stays within certain limits based on the investor’s annual income/net worth. Investors with an annual income (or net worth) of less than $100,000 may not invest more than $2,000 or 5% of annual income (or net worth), whichever is greater, in any 12-month period, and, investors with an annual income (or net worth) of more than $100,000 may not invest more than 10% of annual income (or net worth), in any 12-month period. For the latter group, there is also a cap on investment of $100,000 in any 12-month period.
The notion of increasing the aggregate limit to $2M if purchasers are provided with the issuer’s audited financials – as articulated in the House Bill – has been eliminated from the new Section 4(6). A wise change, I think. As I noted in my prior post, since startups rarely have audited financials, the $2M limit rule was irrelevant in practical terms.
B - Also like the House bill, the second technical change effected by S. 2190 is to add a new Section 4A to the Securities Act entitled “Requirements With Respect To Certain Small Transactions.” Section 4A articulates the conditions for the Section 4(6) Crowdfunding Exemption. The biggest differences between the House Bill and the Senate Bill lie here …
1 – Intermediary. Under S. 2190, a Crowdfunding Transaction must be effected through a registered broker or through a “Funding Portal.” The latter is defined in a proposed new Section 3(a)(80) of the Securities Exchange Act of 1934 and means, in effect, an intermediary that mechanically processes the transfer of investment funds without soliciting purchases or providing investment advice. Funding Portals will be regulated entities subject to SEC oversight independent of the crowdfunding rules applicable to issuers.
2 – Information. Under S. 2190, a considerable amount of information must be made available to prospective purchasers, including information regarding the issuer, its business, management team, capital structure, risk factors, and anticipated use of offering proceeds. Also required are disclosures regarding the terms of the proposed offering.
3 – “Tiered” Financials. Under S. 2190, how much and what kind of financial information must be provided to prospective purchasers depends on the amount raised by the issuer under Section 4(6) in the prior 12 months. If, in the prior 12 months, the issuer has raised in a Crowdfunding Transaction …
** $100,000 or less, then it must provide a copy of the prior years tax returns (if any) and financial statements certified by an executive officer as correct;
** $100,001 to $500,000, then it must provide financial statements “reviewed” by an independent auditor per rules to be promulgated by the SEC; and
** more than $500,000, then it must provide audited financial statements per rules to be promulgated by the SEC.
4 – No Advertising. Under S. 2190, general solicitation or advertisement of the offering is prohibited, “except for notices which direct investors to the funding portal or broker.”
What I Think
IMO the Senate Bill is a massive improvement for all concerned. More plainly, S. 2190 converts a proposal to allow willy-nilly sales of unregistered stock over the internet to unsophisticated investors into something relatively well reasoned and in line with established securities laws. Some supplemental thoughts, in no particular order …
A – Oddly, in the Senate bill there is apparently still no limit on the number of purchasers. So, the crowd doing the funding is still of theoretically infinite size. It will be interesting to see if the SEC promulgates regulations in this regard. IMO a large shareholder base is a bad idea for cash-constrained private issuers in any business sector.
B – Further to the latter point, S. 2190 continues to exclude crowdfund investors from what is known today as the “500-Shareholder Rule.” As it exists today, the “500-Shareholder Rule” subjects a company to the full panoply of SEC “public company” reporting when it reaches $1M in assets and 500 “shareholders of record.” The JOBS Act dramatically alters this calculus by increasing the absolute number of “shareholders of record” that triggers reporting, and, by excluding both employees and crowdfunders from the count. While backing employees out of the shareholder count is an important change in line with emerging company business reality, eliminating crowdfunders still strikes me as ill-advised.
As I queried in my prior post …
[Under the new JOBS Act calculus, the] number of all (accredited and non-accredited) holders of capital shares minus employees minus [crowdfunders] must be less than 2,000; and the number of non-accredited holders of capital shares minus employees minus [crowdfunders] must be less than 500. Here’s my question: Since there are no limits on the number of [crowdfunders], can an issuer (1) raise money from, say 10,000 non-accredited [crowdfunders], (2) issue shares to say, 1,000 non-accredited employees, and still (3) be exempt from public company reporting? (original emphasis).
Hmmm … I stand by the question. Just doesn’t sound right to me.
C – Also in my prior post I mentioned that crowdfunding reminded me of the Spring Street Brewing Company story. It still does. When the SEC dropped in on Spring Street Brewing – recall that it was 1996 and “www” was a brand new concept – one of the things it demanded was an independent intermediary:
Access to and control of investor funds must be handled carefully to provide investors using your system with adequate protections … [W]e suggest you modify your system to eliminate [Spring Street's] control over these funds. At a minimum, [Spring Street] should use an independent agent, such as a bank or escrow agent, to receive checks from buyers payable to the seller of the security of the bank (rather than payable to Spring Street Brewing Company). Investors should send their checks directly to this independent agent, rather than to Spring Street. See Letter to Spring Street Brewing (March 22, 1996).
The point … . long ago shades of a “Funding Portal.”
D – Buried in the issuer disclosure requirements of S. 2190 is, for lack of a better description at the moment, a sort of “quasi-cooling-off period.” Specifically, the proposed statute says that “prior to [consummating the sale of securities] each investor shall be provided in writing the final price and all required disclosures, with a reasonable opportunity to rescind the commitment to purchase the securities …” (emphasis added). Unusual for a securities transaction, but since we are talking about unregistered offerings to the general public, apropos IMO.
Despite its remarkably swift passage, sometimes it’s hard to tell from the rhetoric if pundits and politicians are talking about the same subject. In the final analysis, of all the opinions floating about, I think Steve Case gets it right: the Crowdfund Act “democratizes … access to [venture capital] investments.”
What remains to be seen is whether that is a good thing … (1) for the army of “unpreferred retail investors” looking for the next big thing, or (2) for issuers newly owned by the crowd, or (3) for mainline venture capital investors who now have a supplemental due diligence item (i.e., was the company crowdfunded, how big is the crowd, who’s in the crowd, are there actual or de facto voting blocks within the crowd, and can management control it/them?).
Lots of things to look for in the coming months …
** Companies lining up to act as Funding Portals;
** Correspondence from Funding Portals and lawyers about how to do a Crowdfunding Transaction; and
** Last but hardly least, a wave of SEC rules putting meat to the bones of S. 2190. The Senate Bill includes a lot of enabling language directing the SEC to promulgate regs necessary “for the protection of investors and in the public interest.” No doubt they will. All things considered, not a bad thing in this instance.
Well, that’s what I think anyway …
© david jargiello 2012 all rights reserved