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 …”
While the “lawful” part remains to be seen, the “naive” part is spot on IMHO and per my prior posts on this topic (here and here).
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
Easy money .... ? -
Pundits of every stripe giving FB a beating today. My favorite …
“[FB IPO] a huge disappointment [because] investors were expecting easy money on this one.”
Seems to me that FB masterfully pulled every dollar of market value into its own bank account. Isn’t that what’s supposed to happen? Call me crazy, but since when is making day traders and brokers rich via IPO day churn the point of the thing? I stand by my prior posts … the offering itself was a remarkable piece of work. What happens to the stock price from here is an entirely separate question.
That’s what I think, anyway.
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?
Nope … there’s more. Today Dewey & Leboeuf announced a significant management reorganization (see NYTimes and AmLaw) …
** 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
Today, the U.S. Senate invoked cloture on the JOBS Act, or to use the parliamentary term more appropriate these days, the “guillotine” has dropped. Whatever parliamentary verbiage you prefer, it means that debate is now officially time constrained and a vote on JOBS Act passage is imminent. Despite rumblings from consumer advocates, White House support of the measure makes passage about as swift and certain as such things can be. See Politico.
In that regard, two quotes today caught my eye …
These bills on their own certainly won’t solve the jobs crisis, but they will make it a lot easier for entrepreneurs and innovators to get the capital they need to build businesses and create jobs. Senate Minority Leader Mitch McConnell (R-Ky).
This is not a bill which will allow new opportunities for American workers but one which will create new opportunities for fraudsters, [and] carries the false label of a jobs bill. Sen. Carl Levin (D-Mich.).
Why noteworthy? Because both quotes are, IMHO, exactly correct.
After a painful slog through the proposed legislation and the source House Bills, here’s what I had to say in my prior post:
The JOBS Act variously tinkers with and takes a hammer to two pillars of the New Deal – the Securities Act and the Securities Exchange Act. Most of the tinkering – such as the IPO On-Ramp and the proposal to exclude employees from the 500-Shareholder Rule – represents thoughtful, intelligent adjustment of the regulatory framework to emerging company business reality. By contrast, “hamfisted” is how I would characterize the rulemaking that enables (1) unfiltered, unlimited solicitation of unregistered investments, (2) Crowd Funding, and (3) creation of private-company behemoths with thousands of “unpreferred retail” shareholders trading in a murky online world of secondary sales. As to the latter changes, John Coates’ JOBS Act testimony was correct IMO … any decrease in the transactional costs of raising capital effected by these changes is illusory.
I stand by that analysis. The JOBS Act is neither good nor bad. Rather, by mixing good, important law with bad law it is both at once. Legislative sausage in the truest sense of the term.
So, what to do? Pass it of course … we are in a presidential election year, and the economy still teeters on the brink, and a dysfunctional Congress is unlikely to reach any other deal. Therefore, the best available move is to (1) pass it to secure the immediate advantages of the IPO On-Ramp, and (2) deal with the debris from the rest of it later. Democracy is a contact sport and rarely pretty. Of course, I can’t help but wonder if this is the reasoning Bill Clinton used when he signed away Glass-Steagall with a stroke of a pen in 1999 … .
For film buffs wondering where you may have heard “point of parliamentary procedure … ! ” before, See Animal House.
© david jargiello 2012 all rights reserved
So, the Jumpstart Our Business Startups Act (aka the “JOBS Act” … nice touch) is afloat and headed to the Senate for almost certain approval. In mechanical terms, the “JOBS Act” is a “legislative package,” i.e., a series of six interrelated bills affecting startup businesses. If (when) approved, private companies will be able to (1) have a lot more shareholders and therefore stay private longer, (2) raise money from more people with fewer securities law restrictions, and (3) when ready, go public and be public with less regulatory hassle from the SEC.
Terrific political theater, but is it good law and/or good business?
IMHO, parts of the JOBS Act are well done and overdue (principally the “IPO On-Ramp”). As to other parts, well, we’ll see. One thing is for sure … after you get past the political chaff there is a lot of complex lawyering afoot in all of this. Whether or not the JOBS Act stimulates the economy as its supporters say remains to be seen, but one thing is certain … it will create a lot of jobs for lawyers. My thoughts follow below. Of course, this post is based on the JOBS Act as proposed, not as finally enacted. Further, much of the proposed statutory language instructs the SEC to promulgate enabling regulations. Thus, while the broad strokes below are probably correct, details will change as the statute is finalized. Stay tuned.
My thoughts …
“IPO On-Ramp” - The Reopening American Capital Markets to Emerging Growth Companies Act.
A – Technical. Title I of the JOBS Act began as H.R. 3606. The core technical change enacted by Title I is to amend Section 2 of the Securities Act of 1933 to create a new defined term … the “Emerging Growth Company.” In short, an issuer has “Emerging Growth Company” status for five years after its IPO, or until it exceeds $1 billion in annual gross revenue, or until it becomes a “large accelerated filer,” whichever comes first. A “large accelerated filer” is one with a public float of $700M. See Rule 12b-2(b). Thereafter, to effect the contemplated business result(s), the term “Emerging Growth Company” cascades through the Securities Act of 1933, the Securities Exchange Act of 1934, the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 with the net effect of exempting such entities from a host of regulatory requirements. Here’s the scoop …
1 - Quiet Filings. Section 6 of the Securities Act articulates the statutory architecture for filing a registration statement with the SEC. As proposed, Title I would amend Section 6 to allow – for the first time - submission of a registration statement by an Emerging Growth Company for “confidential nonpublic review” by the SEC staff. Though recently limited (see SEC), such “quiet filing” has long been available to foreign issuers. By contrast, in domestic practice “quiet filing” has meant filing a registration statement without issuing a press release, an anachronism given the availability of information today. Since a filed S-1 is almost instantaneously available online - allowing a deep dive into an issuer’s technology, business strategy and financials by global competitors months before there is market certainty - a “quiet filing” takes some of the competitive risk out of an IPO filing for U.S. issuers. Net: Good stuff.
2 - “Testing the Waters” And Other Talk. Section 2(a)(3) of the Securities Act sets forth a long list of actions that are deemed to constitute a “sale” of securities for regulatory purposes. As proposed, Title I would amend Section 2(a)(3) to exclude therefrom “research reports” about an Emerging Growth Company both prior to and immediately after its IPO, even if the analyst works for a bank that is underwriting the offering (i.e., such a report would not be deemed a “prospectus”). Further, Title I would amend Section 5 of the Securities Act and Section 15D (“Securities Analyst and Research Reports”) of the Securities Exchange Act to increase the range of allowable communication between an Emerging Growth Company, prospective institutional investors, and analysts, again both before and after an IPO. The theory behind these changes is that they will allow a company to “test-the-waters” with certain qualified purchasers before incurring the costs of registration. Likewise, the loosening of rules regarding research and analyst communication is intended to increase the amount of information available to the investing public and thus – theoretically – the success of the offering. Net: This is the only part of the On-Ramp that gives me pause. No specific objection I can articulate, but nearly 80 years of securities jurisprudence has focused on limiting the pre-effective chat. In the final analysis, I think this will prove more complex in practice than it appears on paper. We’ll see.
3 - Limited SOX. Section 404(b) of the Sarbanes-Oxley Act requires that public companies retain an outside auditor to attest to its internal controls and procedures. See AICPA. As proposed, Title I would amend Section 404(b) to exclude Emerging Growth Companies. The purpose of this exemption is to reduce the cost of “being public” for companies that have just undertaken an IPO by eliminating this (expensive) audit requirement. Notably, management liability is unchanged in that Emerging Growth Company executives would still have to certify to the public that their controls are adequate. Net: Continuing liability of executives (which protects the public) while eliminating the gigantic accounting bill (providing cash flow relief to the business) is, IMO, a nice balance of real world practicalities. Good stuff.
4 - No “Say-On-Pay.” A web of federal laws, including Section 14A and Section 14(i) (“Disclosure of Pay Versus Performance”) of the Securities Exchange Act require shareholder votes on executive compensation arrangements, including golden parachutes. See SEC and NYTimes. Existing Section 14A(e) of the Securities Exchange Act creates a regulatory “placeholder” pursuant to which the SEC has authority to exempt issuers from such obligations specifically including when deemed to “disproportionately [burden] small issuers.” Title I drives Emerging Growth Companies through that gap by expressly exempting them from shareholder advisory votes on executive compensation in proposed new Sections 14A(e)(1) and (2). Likewise, the disclosure of pay-vs-performance under Section 14(i) - added to the Securities Exchange Act only recently (as Section 953(a) of the Dodd-Frank Act) – is amended by Title I to expressly exclude Emerging Growth Companies. Net: I personally don’t think the risk in newly public investments is on the executive comp side. At this stage management is playing for massive stock appreciation just like the investing public. So, with the phase-in as the company matures, IMO another good balance of real world practicalities. Good stuff.
5 - Financials – Not So Much. Finally, Title I would amend Section 7(a) of the Securities Act (regarding information required in the IPO registration statement) and in Section 13(a) of the Securities Exchange Act (regarding information required in post-public periodic reports) such that no more than two years of audited financials be required to be disclosed. This change is intended to reduce audit costs relative to the current requirement (five year look back on financials). Net: Good stuff.
B – Practical. There is a tremendous groundswell of support in the business and venture capital communities, and in both political parties, for the passage of the IPO-On Ramp. See NVCA(1) and NVCA(2). Not surprising. As noted above I think that these are logical edits to real world regulatory pressure points for emerging companies. Overall, the IPO On-Ramp is also a vast improvement on (or, depending on your point of view, a logical extension of) the awkward “smaller reporting company” regime created by the SEC in 2008. See Release 33-8876. A “smaller reporting company,” under those rules, was one with less than $75M in public equity float, or less than $50M in annual revenue. See Interpretations. In mechanical terms, the “smaller reporting company” rules poured Regulation SB “small business issuers” into a scaled version of the Regulation SK disclosure requirements applicable to all public companies. Confusing verbiage and rules structure, IMO. The “Emerging Growth Company” moniker of the On-Ramp is a vastly more understandable and practicable rules regime.
“Crowd Funding” – The Entrepreneur Access to Capital Act.
A – Technical. Title III of the JOBS Act began as H.R. 2930. As proposed, Title III adds two new provisions to the Securities Act:
The first of these is a new category of exempt transaction enumerated “Section 4(6)” whereby issuers may sell up to $1M in any 12-month period without registration. The aggregate limit is increased to $2M in any 12-month period if purchasers are provided with the issuer’s audited financial statements. Since startups rarely have audited financials, the $2M limit rule is largely irrelevant. In contrast to the extensive jurisprudence surrounding the Section 4(2) exemption (access to information, sophistication of purchasers, etc.), under the new Section 4(6) the sole purchaser qualification would be a limitation on amount invested, i.e., $10,000 or 10 percent of the investor’s annual income, whichever is less. Oddly, there is apparently no limit on the number of purchasers. So, the Crowd doing the Funding is of theoretically infinite size … ?
The second new provision is a new Section 4A entitled “Requirements With Respect To Certain Small Transactions.” As proposed, Section 4A articulates the conditions for a Section 4(6) transaction, including specific risk factors that must be stated, specific questions that must be directed to prospective purchasers (in short … “do you understand that this is risky stuff?”), an SEC notice requirement, and, notably, a requirement that a third party custodian manage the inflow of investment funds from the offering. Look for lots of marketing pamphlets from law firms on “how to do a 4(6) deal.” Ditto a jostling for custodial duties. As a legal practice point, query whether law firms will look to step into this void. Bad idea, IMO, but that’s another post for another day.
B – Practical. It is hard to overstate the enthusiasm for Crowd Funding. See Forbes (“The potential for [Crowd Fund] investing to transform that [sic] way startups access capital is staggering.”), Inc.(1) (“[Crowd Funding is] the grease that keeps the gears in the American economy churning.”), and Inc.(2) (“Imagine … [t]he next Steve Jobs being held back by rules from the age of the typewriter. When are we going to give the tools and resources to our job creators? [Crowd Funding] is an innovative way to look outside the box and get up with the times to open up capital markets to new businesses and existing small businesses. It has the potential to be a powerful venture capital model.”).
Nevertheless, IMO the Crowd Funding legislation is ill-advised. As proposed, it strikes me as a quasi-private version of the Spring Street Brewing Company saga. Founded by former Cravath associate Andrew Klein, Spring Street Brewing completed what is generally considered the first internet direct public offering, or “DPO,” in February 1996. For a terrific analysis, see Hass (SoCalLawRev). Though a groundbreaking use of the then brand new “world wide web,” the real success of the Spring Street Brewing DPO is that it opened the world of online investing; in fact, the very next year Mr. Klein shifted his efforts to Wit Capital, the first online investment bank (“fat-cat investing at the click of a mouse”). The microbrewery? Well, as Klein said in a 1999 interview:
[A]lthough we had around 500,000 people who came and saw the [Spring Street] prospectus on our site, only 3,500 of them invested. Yeah, we raised nearly $2 million, but the conversion rate - that is, the rate at which people who heard about the offering and looked at the prospectus were willing to buy in a direct offering - was very, very small. [Why?] Because people aren’t that stupid. … I mean, our beer company was a very decent offering, a perfectly legitimate effort to raise capital. But the average investor is smart enough to know that if there’s not an intermediary who’s in the business of evaluating the company, doing due diligence, and putting its reputation on the line with the company’s reputation, that investors should beware.
So … what about the
idiots investors who put $2M into Spring Street Brewing? According to Crowd Funding evangelist Scott Brown (R-MA):
[S]ome have voiced concerns that [Crowd Funding] is an avenue for fraud and abuse. But, consider this: Americans are allowed to gamble unlimited amounts at casinos, and can send donations to charities halfway around the world with one tap of a trackpad. Yet, we are legally prevented from making even modest investments in job-creating small businesses.
Casinos? Hoo boy.
Putting aside the merits of targeting an unlimited number of unsophisticated investors (“unpreferred retail investors” in Crowd Funding parlance), for a financing capped in practical terms at $1M, as a business matter there is the inconvenient truth that shareholders (1) have legal rights, and (2) create administrative cost/hassle. The online platforms cited as evidence of Crowd Funding power – Peerbackers, IndieGoGo, Kickstarter, PledgeMusic and RocketHub – solicit donations. “Micro-patronage” in industry-speak. Others, like Prosper, broker loans. Thus, missed in the exuberance of selling equity to the general public is the fact that the Crowd doing the Funding thereafter owns the business. As owners …
** They have statutory rights to records and information.
** They have statutory authority to sue in the name of the company (aka a “derivative” suit).
** They have voting rights, and their votes may or may not be needed to undertake various future corporate actions. You have to think that Crowd Funded startup essentials will include: drag alongs (are they enforceable?), voting agreements, and a super-voting class of Common held by solely management (per Facebook). Said another way, some expensive lawyering will be needed to offset the risk that the Crowd will want too much of a say in corporate affairs.
** They are owed a fiduciary duty by both management and majority shareholders. Think Board of Directors and management control group - of a startup with limited resources - vis-à-vis hundreds (thousands? … remember, no cap on numbers) of mom-and-pop, general public, minority shareholders.
** Finally, the Crowd is going to (reasonably) expect management to communicate with them, answer questions and keep them informed. In my view, the Crowd Funding evangelists are ignoring the practical, in-the-trenches administrative burden of carrying a shareholder base of hundreds (thousands?).
Net: IMO, bona fide control issues arising from a large, unsophisticated shareholder base plus the administrative cost of managing same plus management liability exposure to same plus likely disinterest of mainline venture investors in all of the foregoing … together offset the advantages of $1M in funding. Thus, I would say that the proposed Crowd Funding legislation is ill-advised in practical, real world business terms. My guess is that most venture backed startups will avoid the process, rendering the law largely irrelevant to mainstream business backed by professional money.
Title 5 and Title 6
“500-Shareholder Rule” - The Private Company Flexibility and Growth Act and The Capital Expansion Act.
A – Technical. Title V and Title VI of the JOBS Act began as H.R. 2167 and H.R. 4088, respectively. I have no opinions on the latter, which deals with the number of shareholders permitted to invest in a community bank. The former, however, directly impacts emerging company practice. As proposed, Title V amends Section 12(g)(1)(B) of the Securities Exchange Act – aka the (in)famous “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.” H.R. 2167 appears to be the simplest of the proposed amendments, i.e., it amends Section 12(g)(1)(B) by increasing the asset threshold to $10M (non-controversial), and, the shareholder threshold from 500 to (a) 2,000 total or (b) 500 non-accredited “shareholders of record,” whichever comes first. The real action, however, lies in how the new rule defines “shareholders of record.” Under existing law the term has its plain English meaning (essentially holders of outstanding securities). The JOBS Act dramatically alters this calculus in two ways: First, under Title V, employees are excluded if they receive their securities under equity compensation plans (Query: what’s a “plan” for this purpose?). Second, hidden in Section 302 of Title III (Crowd Funding), is the nuance that persons who purchase shares in a Section 4(6) Crowd Funding transaction are not counted either. In technical terms, Title III (not Title V) amends Section 12(g)(5) of the Securities Exchange Act to exclude Crowd Funding shares.
So … Putting that all together: The number of all (accredited and non-accredited) holders of capital shares minus employees minus Crowd Funders must be less than 2,000; and the number of non-accredited holders of capital shares minus employees minus Crowd Funders must be less than 500. Here’s my question: Since there are no limits on the number of Crowd Funders, can an issuer (1) raise money from, say 10,000 non-accredited Crowd Funders, (2) issue shares to say, 1,000 non-accredited employees, and still (3) be exempt from public company reporting? Sounds crazy, but that’s how I read it … .
B – Practical. As with Crowd Funding, it is hard to overstate the excitement about changing the 500-Shareholder Rule. See Bloomberg (“The 500 shareholder rule is outdated, overly restrictive, and limits U.S. job creation and American global competitiveness.”). Google, Twitter, Zynga and Facebook – variously forced to go public, structure contorted beneficial ownership arrangements and/or seek an SEC exemption – are generally cited as the poster children for rule’s negative impact. See Deal and DealBook. Much is made of the fact that the 500-Shareholder Rule was first articulated in 1964, the year in which Section 12(g) was added to the Securities Exchange Act. Since then, as the argument goes, the size of the stock market, the number of corporations and the number of investing shareholders have all grown substantially, thus changing the meaning of what constitutes a “public market,” thus driving a need to increase the 500 shareholder threshold.
** First, obviously the stock market is bigger today than in 1964, as is the size of a now global investing public. Try watching television for any particular 30 minute period without seeing an ad for online investment services. That said, I personally don’t see a straight line between that data and the number of shareholders in a privately-held company that indicates an investor footprint of sufficient size to warrant public reporting. So, the “1964 = old = bad” argument? I don’t get it.
** Second, by focusing on the “old = bad” angle, I think much of the debate in the blogosphere misses the core issue, i.e., how many shareholders does a private company have to have before it should be deemed to have a public market for its shares? In this regard, the JOBS Act properly takes a hatchet to employee shares. This is the Google, Twitter, Zynga and Facebook problem: companies growing at meteoric speed and issuing gobs of employee stock and options that “count” in the “public market” calculus. To this extent, Title V is good stuff and overdue.
** Third, while I can’t say that 500 shareholders is the correct standard, I also don’t know how or why 2,000 total holders or 500 non-accredited holders is right either. The new number choices strike me as arbitrary as the old one. I will say this, however: After you factor out the employees, 500 shareholders is a lot of people. 2,000 is a lot more. Managing 1,999 non-employee shareholders – answering their questions, responding to their requests for information, keeping them informed of events as corporate laws require, soliciting their vote(s) when necessary and generally managing their expectations – is a big job. If a privately-held company has so many shareholders that it requires an internal investor relations function isn’t it, like, “public-ish”? Just a thought.
** Finally, assuming you back the employees out of the calculation, who benefits from massive 2,000+ shareholder, privately-held companies loathe to dive into the public markets? Certainly not mainline venture capital investors with presumptively extended liquidity paths. In that regard, it’s no surprise that some of the biggest supporters of a “2,000-Shareholder Rule” are the purveyors secondary markets (SecondMarket and SharesPost). The secondary market phenomenon is a topic for another day, but two comments are apropos here: (1) many people – myself included – believe that much secondary market activity defies the spirit if not the letter of the federal securities laws, and (2) the way venture capital documents are drafted companies generally have an effective veto over who can and cannot sell into the secondary market and as a result some issuers are “gaming” who “gets” to “cash out.” Regarding the former (securities laws), the word on the street has long been that the SEC is aware of the abuses but under orders from the Obama Administration to let it slide – for now. To my knowledge, only one investigation has transpired to date (see Bloomberg). Regarding the latter (issuers letting “friends” cash out), this is almost certainly actionable on a variety of legal theories. No one has sued anyone (yet) because for the time being everyone wants to play nice and get liquid. However, with 2,000 shareholder companies floating around – with active secondary markets - look for that legal ground to be plowed sooner rather than later.
Title 2 and Title 4
Reg D and Reg A – The Access to Capital for Job Creators Act and The Small Company Capital Formation Act.
A – Technical. Title II and Title IV of the JOBS Act began as H.R. 2940 and H.R. 1070, respectively. The latter is noncontroversial and probably not greatly relevant to tech startups; as proposed Title IV amends Regulation A under the Securities Act to increase the offering threshold for companies exempted from SEC registration from $5M to $50M. Conversely, Title II plows new securities law ground … As proposed, the core change effected by Title II is to amend Regulation D under the Securities Act to say that (1) offerings exempt under Rule 506, in which (2) all purchasers are accredited investors, can (3) be effected without regard to the general advertising and general solicitation restrictions of Rule 502(c). Various conforming changes then ripple through the Securities Act. So, in English … 35 accredited purchasers, no dollar limit on the offering, with general advertising/solicitation = OK under Rule 506.
B – Practical. Personally, I’m hard pressed to see the merits of abolishing the general solicitation rule in any context. Remember, the latter is there to protect investors and issuers (the former from fraud, and the latter from lawsuits for failure to disclose material information in said solicitations). Barry Silbert, CEO of SecondMarket explained it thus in a House Subcommittee hearing on September 21, 2011:
[T]he general solicitation prohibition unnecessarily limits the pool of potential investors, thereby restricting companies’ ability to raise capital to fuel growth … [I]f only accredited investors are eligible to purchase unregistered securities, shouldn’t we strive to maximize the pool of accredited investors that have access to the offering? [S]ophisticated, accredited individual and institutional investors have greater capacity for risk and do not require the enhanced protections provided to the average retail investor.
The phrase “the devil is in the details” was created for situations like this. Should it be adopted as proposed, abuse of the new rule as well as increased instances of outright fraud are, IMO, a given. Ditto hand-wringing by lawyers for legitimate offerings on the subject of what must be disclosed in a “Rule 506 General Solicitation” to minimize issuer and management liability. Does issuer’s counsel hold a sort of quasi-drafting session for solicitation material, or just wash his or her hands of it as a non-legal business matter? Since it goes to the exemption, hard to imagine the latter. Further, what happens to third party legal opinion practice? Rote for 506 deals today, but if the rule goes through as proposed look for much rumbling over exceptions and assumptions in what were once routine transactions. Net: By allowing unregistered general solicitation Congress is cutting to the core of the federal securities law regime. IMO, this will create more problems than it will solve and create more jobs in the legal industry than any other sector. Crank up the legal budget for these deals.
Final Note: Erosion of the New Deal
In 1932 Roosevelt swept to power with an electoral victory that is stunning by today blue state/red state standards. In 1936, the electoral map was even more so. Roosevelt used his electoral mandate (control of Congress helped) to usher in the “New Deal,” a cluster of legislative activity intended to deal with the national financial debacle of the time.
Some pieces of New Deal legislation served their purpose and were repealed (e.g., rules creating the Civilian Conservation Corps and Public Works Administration). Some were doomed by the politics of the day (e.g., the Civil Works Administration, see Slate). Others were ruled unconstitutional by the Supreme Court (e.g., the Agricultural Adjustment Act of 1933 and the National Industrial Recovery Act of 1933), leading to FDR’s ill-advised and doomed “court packing” maneuver. Finally, a lot of the “New Deal” still exists today … the Banking Acts of 1933 and 1935 (creating the Federal Deposit Insurance Corporation), the Securities Act of 1933, the Securities Exchange Act of 1934, the Social Security Act of 1935, the National Labor Relations Act of 1935, the Investment Company Act of 1940, and the Investment Advisers Act of 1940.
Notable by its absence in the above discussion is the “Glass-Steagall Act,” a confusing term that variously refers to (1) 1932 legislation put forth by Henry Glass (D-VA) and Henry Steagall (D-AL) related to the Federal Reserve, or (2) the entire Banking Act of 1933, or (3) Sections 16, 20, 21 and 32 of the Banking Act of 1933 dealing broadly with the separation of commercial and investment banking, or (4) Sections 20 and 32 of the Banking Act of 1933 dealing specifically with the ability of commercial banks to participate in securities underwriting and investment. Historically, references to “Glass-Steagall” and the “Glass-Steagall Act” have meant the four provisions of the Banking Act drawing a line between commercial and investment banking. However, it was Sections 20 and 32 thereof – federal statutes expressly forbidding commercial banks from underwriting activity - that were (dubiously) repealed by the Gramm-Leach-Bliley Act of 1999. Consumer advocates draw a straight line between the repeal of Glass-Steagall and the financial crisis of the late 2000’s. See Kuttner and Weissman. Some – primarily those in the banking industry – dismiss the assertion. Me? I’m with Elizabeth Warren: FDIC insurance, Glass-Steagall’s separation of investment banking and SEC regulations provided “50 years without a crisis,” and generally kept banks from doing “crazy things.”
What’s the point?
The JOBS Act variously tinkers with and takes a hammer to two pillars of the New Deal – the Securities Act and the Securities Exchange Act. Most of the tinkering – such as the IPO On-Ramp and the proposal to exclude employees from the 500-Shareholder Rule – represents thoughtful, intelligent adjustment of the regulatory framework to emerging company business reality. By contrast, “hamfisted” is how I would characterize the rulemaking that enables (1) unfiltered, unlimited solicitation of unregistered investments, (2) Crowd Funding, and (3) creation of private-company behemoths with thousands of “unpreferred retail” shareholders trading in a murky online world of secondary sales. As to the latter changes, John Coates’ JOBS Act testimony was correct IMO … any decrease in the transactional costs of raising capital effected by these changes is illusory. See Coates.
For reasons that I personally don’t understand, there seems to be a groundswell of belief that the New Deal was a bad thing. “Bad for business” is an oft articulated point of view and one that permeates JOBS Act political discussion. My view is that the 1929 Crash and ensuing Great Depression was bad for business. So was the S&L crisis, Enron, and the subprime mortgage meltdown. All failures to regulate properly, not failures of over-regulation. My view is that the federal securities laws should be bad for bad business and short-term profiteering. They should also prevent people from doing crazy things. Some parts of the JOBS Act qualify … others don’t.
Stay tuned … .
© david jargiello 2012 all rights reserved
A sentence like this in a firmwide memo is never a good thing:
Notwithstanding our results in 2011 and so far this year, the firm’s Executive Committee has decided to take proactive steps to align the firm’s resources with anticipated demand and strengthen the firm’s competitiveness in the global marketplace.
Hoo boy. Makes you want to stop reading right there. A sentence like that presages, well, exactly what is in the next two: partners have left, more are leaving, associates and staff are being fired. The blogosphere is chock full of discussion about Dewey LeBoeuf (something that apparently triggered the memo in the first place) … see ABL and LegalWeek.
As is often the case, I liked Steve Harper’s analysis the best:
1 - If a consultant advised them on this memo, a refund is in order. As Harper notes, the memo admits that management is behind the press on the one hand, and is variously foreboding/disquieting on the other.
2 - Dewey LeBoeuf is almost certainly – as they themselves say – “moving into a new part of the cycle,” but you can’t really tell what that means from publicly available data. The new phase may be a good thing. Or not.
3 - As usual these days, the real story is probably not in the cost cutting per se, but rather in a sputtering model (see here) and an insufficient delta between highest and lowest paid equity partners (see here).
Interesting times …
© david jargiello 2012 all rights reserved
California Senate Bill No. 978 was recently introduced by Senators Juan Vargas (D) (District 40, San Diego) and Curren D. Price, Jr. (D) (District 26, Los Angeles) and is apparently threading its way through the legislative process. SB 978 is lawmaking at its worst, IMHO, at least as far as the venture capital and legal industries are concerned.
1 - What It Does. SB 978 would change two longstanding securities law exemptions used in venture capital financings – Sections 25102(e) and 25102(f) of the California Securities Law – to say that failure to timely file a notice of transaction with the state Commissioner of Corporations would result in loss of the exemption. Under current law failure to file this form can result in penalties but not loss of the exemption. Why is that bad? Because the proposed new law converts a ministerial failure to make a one-page “notice” filing into a material violation of California Securities Law that (a) triggers the full panoply of enforcement horribles, most notably, rescission rights, and (b) will inevitably result in claims against lawyers for legal malpractice and/or invalid third party closing opinions. In short, it’s a “file-or-die” rule and an ugly victory of form (no pun intended) over substance.
2 – Technically Speaking. In purely technical terms, venture financings that rely on Rule 506 should be unaffected by SB 978 by virtue of the continuing preemption by the National Securities Markets Improvement Act of 1996 (“NSMIA”). By its terms, NSMIA applies to Rule 506 transactions, but not to transactions effected under Rule 504, Rule 505 or Section 4(2) of the Securities Act of 1933. Thus, only financings done in reliance on any of the latter exemptions would feel the wrath of SB 978.
3 – In Practical Terms. So, what does all of that mean, exactly, in the real world? Well, not much as far as Rule 504 is concerned. Rule 504 has never been a significant exemption for venture capital financing purposes because of its $1M aggregate offering limit. Ditto Rule 505 with its $5M aggregate offering limit. Rule 506 and Section 4(2), on the other hand, are the workhorses of nearly all venture capital financings and the impact here is significant for issuers, investors and their respective lawyers alike.
» 506 Traps. As noted, SB 978 should be irrelevant to valid Rule 506 transactions by operation of NSMIA. However, the key word here is “valid.” I’ve seen more than a few venture financings done with a hand wave toward that rule and the filing of a Form D. What sometimes gets lost is that lurking in Rule 506 is a trap for the unwary. As the SEC itself says:
Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. But companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings. (emphasis added).
So, Rule 506 transactions that involve only accredited investors … all good. But, Rule 506 transactions with a handful of the proverbial non-accredited “friends and family” … not so much. Why? Because the information and financial statement requirements are rarely met or even practicable to meet by a start-up comprised of the proverbial two engineers, an idea, a dog and no money. The point: A lot of “Rule 506” transactions are technically not for failure to comply with the information delivery requirements.
» The Final Frontier. That leads us to Section 4(2) – the longstanding private offering exemption with the wonderfully vague guidelines as to purchaser sophistication, the number of purchasers, dollar amount of stock sold, and information provided. Whether used as the primary exemption for a securities offering or as the “back up” for an invalid Rule 506offering, Section 4(2) has been a backbone of Silicon Valley capital raising for decades on end. With respect to SB 978, this is where the rubber meets the road. The California Commissioner of Corporations has long called out the fact that Section 4(2) transactions are not preempted by NSMIA – see Release 103-C. Thus, Section 4(2)transactions are subject to regulation by the State of California, and would be expressly affected by SB 978. In real world terms, here’s how things go bad … . Classic bootstrapped start-up does a “friends and family” round of financing in reliance on Section 4(2) and therefore California Section 25102(f). Oops, accidently miss that one page notice filing, even by one day? Sorry, no exemption, the entire offering is unlawful for lack of a valid California exemption, the purchasers have recission rights, and the issuer is, at least potentially, a “bad boy” (aka a “disqualified bad actor”). Welcome to California.
4 - Bad Timing. Putting aside the wisdom of complicating the capital raising process in the current economic environment, the timing of SB 978 is also unfortunate vis-à-vis two other recent legislative developments: First, it is “harder” to be an “accredited investor” today. As a result of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), the value of one’s primary residence does not count as an asset for purposes of calculating “net worth” to determine “accredited investor” status. Second, under a still proposed rule driven by Dodd-Frank, “bad boys” would be barred from participation in any Rule 506 offerings. Barred forever? I don’t know. It’s a proposed rule, so stay tuned. Notably, the existing federal “bad boy” rules are triggered by federal bad acts (e.g., acts before the SEC) and not by state-level misconduct. At least theoretically, the proposed Rule 506(c) sweeps in the “final orders of certain state regulators” as a “disqualifying event.” The broad point is that, juxtaposed against concurrent federal rulemaking, SB 978 comes at a time when (a) the pool of accredited investors is smaller and issuers are more likely to rely on Section 4(2) as a primary exemption, and (b) the federal consequence of being a state-level “bad boy” is in flux.
5- Ignoring History. One of the remarkable things about SB 978 is that we’ve been down this path before with unhappy results. Section 25102(o) of the California Securities Law articulates the standard exemption for sales of securities pursuant to a compensatory benefit plan (i.e., the issuance of stock and options to employees and consultants). When Section 25102(o) was first enacted, failure to make a similar “notice filing” was fatal to the availability of the exemption. This led to a host of problems, and the simple fact that many start-ups engaged in expensive (and largely pointless) employee rescission offers on the eve of their initial public offering in order to cure a ministerial dysfunction. In recognition of the “undue burden on businesses creating jobs … in California” imposed by Section 25102(o) generally, a wave of changes in 2007 brought it into line with corresponding federal securities law. Among those changes was the elimination of the “file-or-die” element … . “The failure to file the notice of transaction within the time specified in this subdivision [Section 25102(o)] shall not affect the availability of this exemption” (emphasis added). Precisely the language to be deleted from Sections 25102(e) and 25102(f) by the backward looking SB 978.
6– Risk Management. If SB 978 actually becomes law, then failure to timely file Section 25102(f) notices would be material and legal malpractice claims inevitable. For knowledgeable start-up lawyers, think Section 83(b) elections. Under SB 978, the stakes would be similar. Failure to file, even by one day … . Investors with buyers’ remorse will have a rescission right that the issuer will look to the lawyers to make good on. Company unable to raise additional capital because it is a “bad boy” with a documented unlawful issuance? Try on the consequential damages for size. Ditto lawyers who render third party legal opinions to the investors at the closing of venture financings. The customary opinion regarding the availability of an exemption? Suddenly much riskier to give. Expect a good deal of hand-wringing, theorizing and negotiated exceptions on that stead.
Net: SB 978 – as proposed - is the worst sort of regulatory sausage … . (1) a punishment vastly out of context for the violation, (2) guaranteed to generate a wave of socially useless litigation in order to sort out the debris field that such punishment will leave in its wake, all for (3) zero actual benefit to the investing public it is presumably intended to aid.
Here’s to hoping that cooler heads prevail.
© david jargiello 2012 all rights reserved
First Posted February 23, 2012, Re-Posted March 7, 2012
“All said, not a bad year …”
Really? To be fair, here’s the whole quote from Citi Private Bank: “All said, not a bad year and we suspect likely to be the new definition of a good year for the legal industry at least for the foreseeable future.” Much ado about the Citi report this past week. See WSJ LawBlog and Hildebrandt.
Here’s what I think about 2011, 2012 and the Great Beyond … .
1 - Eggshell LLP. Yet another year in which profits are driven by increases in (already extraordinary) billing rates is, IMHO, a sign of an unhealthy and unsustainable business. To be sure, pockets of profitability, even extraordinary profitability exist. However, as a whole the industry remains one in which many members still grapple with the reality of what its clients and a sophisticated global economy demand.
2 - Buggy Whips. Much of the dialogue about how U.S. law firms fared in 2011 continues to focus on the industry’s omnipresent efforts to reduce expenses in a top line business. For example, “Orrick-ing” - my word for on shoring back room operations to cheap parts of the United States - remains a strategy firms are keen to emulate in whole or in part. See Orrick, Weil, and Wilmer. So are “strategic staffing solutions” … law firm code for flattening the work force by (1) converting partners to associates (aka “de-equitizing”), (2) eliminating associates or replacing them with staff, and (3) eliminating redundant secretarial/paralegal coverage. Also in vogue are “project management solutions” that from a balance sheet standpoint equate to the elimination of fixed staffing costs (i.e., people). There is nothing wrong with any of the foregoing. Nothing at all. It’s just that as a business fundamental - for law firms, anyway - they are largely ways of easing the symptoms of dysfunction, not vehicles for curing it. Think buggy whips. Whether you credit Theodore Levitt (“Marketing Myopia,” Harvard Business Review, 1960) or George A. Steiner (“Strategic Planning,” 1979) (personally, I like Levitt’s piece better), imagine the “buggy whip manufacturer in 1910,” scoffing at the idiotic looking contraption that rolled off Henry Ford’s assembly line in Highland Park, Michigan. As Steiner (or Levitt) said it, to the extent such companies saw themselves as the creators of superb buggy whips - as opposed to the facilitators of transportation in an industrializing society - they were doomed. My point is that many law firms remain notoriously, intractably and similarly myopic … Lean, mean, legal machines with 4-to-1 attorney-to-secretary ratios, back offices in Nebraska, marketing departments that produce expensive and largely pointless posters for publication in airports (where people ignore them) and magazines (that only lawyers read), but only a vague sense of why rate increases drive their profits.
3 - The Blue-Plate Special. Of course, 2011 was not without some top line buzz. Just google “alternative fee arrangements,” aka “AFA’s.” Hildebrandt and Citi apparently see this as the wave of the future. Personally, I think the dialogue on this point is confusing because it simultaneously conflates and overstates two entirely separate business practices. The first “type” of AFA involves different ways of paying cash for legal services, i.e., contingency fee deals, fixed fee deals, blended rates, fixed rates, discounted rates and structured write offs. In other words, things that lawyers and law firms in every part of the country in every practice area have been doing for decades. People who practiced law before anyone reading this post was born did all of this stuff and just called it client relations and marketing. That’s not a bad thing and it is certainly not a criticism of anyone jumping on the AFA bandwagon. It is just not “new.” The second “type” of AFA is at the same time riskier and more interesting, i.e., genuinely different ways to value and compensate legal services. This is the “out there” stuff … stock-for-fees, or taking a cut of royalties or some other revenue stream from the client’s business. While such things are newer in the sense that they were once seen as unseemly, they are also not “new” in the sense that a lot of lawyers have been doing these things with varying degrees of success for many years.
All of that said, I do agree with the conventional wisdom that there is something different afoot in the current AFA hubbub: (1) under massive price pressure from clients, law firms now openly embrace the price-cutting they usually did quietly on a one-off basis, and (2) AFA’s have been forced into law firm budgeting in a systematic way because of the reality that billing rates are too high everywhere. Where I differ from much of what I read in the blogosphere is in the interpretation of the foregoing: In my view, offering a law firm equivalent of the blue-plate special is good stuff (a) for improving already lucrative client relationships, (b) as a loss-leader for building new client relationships with lucrative long-term potential, and/or (c) for market positioning (i.e., taking less for a high-profile (or market invasive) gig). However, it is not going to move anyone up the AmLaw charts or alter already sick business fundamentals. Upward AmLaw mobility - and sustainable profitability - will still come the old fashioned way … by systematically capturing and retaining market share in high-paying, high-realization practice areas.
4 - Lateral Binging. Buying revenue through the acquisition of free agent laterals is, today, de rigueur law firm strategy. Personally, I think of lateral hiring in broad business terms … (1) “rifle shot” poaching of partners with portable revenue from the competition, or (2) whole scale acquisition of law firms for the same purpose. You do the former when you can, and the latter when the accretive nuggets cannot be neatly separated from the chaff (tilled later) of overhead lawyers, staff, debt and real estate. IMO, both are sound business strategies, and Steve Harper’s recent piece, The Lateral Bubble, was one of the most interesting pieces I’ve read on the topic.
My favorite part thereof:
[T]he income gap within equity partnerships has exploded … [A] few years ago the equity partner pay spread was typically three-to-one; some places it’s now ten-to-one or even twelve-to-one. ‘Over the last few years there has been a dramatic change in the balance of compensation, to a large degree undisclosed, in which increasing numbers of partners fall below the firm’s reported average profits per equity partner. Typically, two-thirds of the equity partners earn less, and some earn only perhaps half, of the average PPP.’ [quoting Reeser and McKenna, AmLaw, February 1, 2012)]. [Thus, a] firm’s average PPP isn’t luring high-powered lawyers; the money at the top is(emphasis added). Perhaps the desire to provide clients with a better global platform plays a role in some laterals’ decisions, but most of the firms experiencing the highest number of lateral partner departures in 2011 are already worldwide players. In fact, four firms — DLA Piper, K&L Gates, Jones Day, and SNR Denton — are simultaneously on both the most departures and most hires list.
Whoa. So the biggest poach-ers are also the biggest poach-ees? It is difficult to tell from publicly available information what that means, if anything. Here is what I would say … . Buying a stream of revenue – partners with portable books in law firm parlance - makes sense unless it doesn’t. Exactly one year ago, DLA lured litigator Jamie Wareham from Paul Hastings with a salary of $5M per year. There is almost no imaginable scenario in which that move doesn’t make sense for Wareham. Why? DLA is paying, Paul Hastings was apparently not, and if DLA doesn’t work out there will be no shortage of offers for his massive book. End of analysis. What is harder to tell - as Harper astutely notes – is whether the move made sense for DLA, and it will likely take several years for that question to sort itself out. The same can be said of law firm mergers, BTW. See here.
So what do I say about the great lawyer migration of 2011 [and 2012]? This: In the final analysis lateral hiring is a business strategy and no more or less of a panacea than any other business strategy. Done well, it’s a great thing. A game changer. Done willy nilly, not so much. What separates the good hire from the bad hire? Here is my advice for those with laterals in the pipeline:
» Due diligence, due diligence, due diligence. Make sure you are not picking the proverbial Door No. 3 (containing the goat) in a Monty Hall Problem. In plainer terms, maybe the lateral (or the law firm, in the case of acquisitions) is in the market for good reason. What I advise my clients to look for - as opposed to what law firms often mistakenly look for - is a blog post for another day.
» Avoid Tulipomania. At the height of the Dutch tulip debacle in the 1600’s, a single tulip bulb could be priced at 3,000 guilders. That’s roughly equal to the annual wages of the wealthiest merchants of the day, and double what Rembrandt could squeeze out of someone for The Night Watch at the same time. Maybe the lateral and his or her book is worth a bidding war. Or maybe they are not. It is a plain fact that whole law firms have collapsed by making this sort of miscalculation.
» Choose wisely. Neither growing for growing’s sake nor merging for merging’s sake is a business strategy. Why? Because big isn’t necessarily better, it is just bigger. Haphazardly shoveling aboard the laterals artificially inflates PPEP and is, well, just not a very good idea.
5 - Finally, the Great Beyond. So, where does it all end? IMO and broadly speaking, three basic kinds of law firms in our lifetimes: (1) Big Law, (2) Niche Law, and (3) Tesco Law.
» Big Law = Under any rational foreseeable economic environment there will be a continuing need for large firms with bottomless talent that can be seamlessly deployed worldwide. Whether we are talking about enormously complex, trans-national business deals, or the proverbial “bet the company” litigation for which money is almost literally no object, I see no end to the need for law firms of enormous size with true global presence. Think law firm version of the “Big Four” … . multinational giants comprised of perhaps 5,000+ lawyers worldwide. The more interesting question is how many of these giants can the global economy support? As an order of magnitude I’ll guess here … . maybe twenty. Oh, and the number of bona fide partner/owners of those Big Law giants? Exquisitely small. The vast majority of partners (“equity” or not) in such firms will be (and in fact, are today) simply highly compensated employees.
» Niche Law = IMO, much of the AmLaw 200 fights a two-front war that cannot be won … Ruthless competition for business and lateral books of business from “above,” and, ruthless nipping at the heels from swifter, cheaper and more practical alternatives from “below.” Most will lose this war, being either acquired in mergers of necessity and subsequently dismantled for accretive parts, or, dissolved. That said, survival at a level beneath Big Law is clearly possible through differentiation. This is where the real rough-and-tumble action is. As I define the term, “Niche Firms” are (1) smaller than the multinationals in absolute size, (2) equal to or better than them in profitability, and (3) successfully differentiated by geography or expertise. Importantly, “differentiation” is vastly different than “marketing.” Spending money on glossy brochures and posters - all of which say “we’re smarter than other lawyers so hire us” - doesn’t mean you are differentiating yourself. Neither does hosting seminars, cocktail parties or fancy dinners. Rather, in a ferociously competitive marketplace in which the weak fear the strong, and the strong fear the stronger, differentiation means the bona fide capture and retention of a revenue stream along practice, geographic or other lines; a success story of the first order. Think Wachtell. They have one office but are second in their business to no law firm on the planet. As noted by Gary Hamel in a different - but analogous - context: “The lesson here: you don’t have to be the biggest to be the most profitable—but you have to be the most highly differentiated.”
» Tesco Law = In prior posts (here and here) I argued that (1) vast numbers of people require basic legal representation at a rational price, (2) the profession has been unsuccessful in serving them, and (3) in a chronically underserved market lies opportunity. For all of the reasons I articulate in those posts, it strikes me as inevitable that this void will in due course be filled (to the detriment of backward-thinking law firms, BTW) by the likes of LegalZoom (apx $100M from top tier venture investors), RocketLawyer (apx $30M from top tier venture investors), and QualitySolicitors.
Well, that’s what I think, anyway … .
© david jargiello 2012 all rights reserved
First Posted February 18, 2012, Re-Posted March 7, 2012