SEC Warns of SAFE Investment Instrument Popular in Equity Crowdfunding Campaigns

The SEC issued a bulletin warning investors about SAFE securities used in equity crowdfunding offerings.

Issuers in equity crowdfunding campaigns have offered various types of securities since it became legal to do so, such as various classes of stock, notes and instruments known as SAFE instruments.  ‘SAFE’ stands for ‘Simple Agreement for Future Equity.’

SAFEs were originally designed to be an alternative to convertible notes for early-stage technology investments.  The idea was that they would become simple, standardized vehicles for investing in very young companies without dealing with a lot the terms needed to make a convertible note or stock investment.

As the SEC points out, a SAFE is not like investing in common stock.  It is an agreement that converts into issuer securities in the event of future triggering events, such as a future investment round, an IPO, a change of control or a liquidation.

Some people seem to think of them like convertible notes.  However, convertible notes have maturity dates, among other terms.  SAFEs do not and may never convert.  SAFEs are more like derivative contracts with springing conversion based on listed events.

SAFEs have been increasing in use in the venture capital and angel investing worlds, and more recently other investors have gained some exposure and comfort with them.  However, the SEC wants investors to know that:

  • SAFEs do not represent a current equity stake in the company in which you are investing.
  • SAFEs may only convert to equity if certain triggering events occur.
  • Depending on its terms, a SAFE may not be triggered.

To the people who have seen them before, none of this is a surprise.  To a new investor, the SEC is concerned that these terms may be unexpected.  As the SEC said:

SAFEs were developed in Silicon Valley as a way for venture capital investors to quickly invest in a hot startup without burdening the startup with the more labored negotiations an equity offering may entail.  Oftentimes, for the venture capital investor, it was more important to get the investment opportunity, and possible future opportunities, with the startup than it was to protect the relatively small investment represented by the SAFE.  In addition, the various mechanisms of the SAFE, from the triggering events to the conversion terms, were designed to best operate in the context of a fast growing startup likely to need and attract additional capital from sophisticated venture capital investors.  This may or may not be the case with the crowdfunding investment opportunity you are exploring.

SAFEs can make a lot of sense to particular parties in particular deals, but investors such as crowdfunding investors should make sure to understand exactly what rights they have in what they are purchasing.

SEC issues warning about SAFE instruments in equity crowdfunding campaigns.
SEC issues warning about SAFE instruments in equity crowdfunding campaigns.

Equity Crowdfunding Risks and Liabilities – Yes, They Do Exist

Sorry startups, you actually have to be careful with equity crowdfunding disclosures. There is substantial risk of liability for securities fraud.

Based on discussions with the equity crowdfunding-curious, people seem to believe that equity crowdfunding is the wild west where anything goes.  Raise lots of money and do it cheaply! Do what you want, say what you want and the SEC does not care!  Look at the Form C’s, there were probably no lawyers anywhere near them.  Think of the savings!!!!

None of that is true.

Done correctly, an equity crowdfunding offering should be done with as much care as any private placement.  The actual information requirements are more extensive than a typical Rule 506 offering.  Most importantly, crowdfunding issuers are subject to the same liability as any other securities selling issuer.

Securities Act Section 4A(c) provides that an issuer will be liable to a purchaser of its securities in a transaction exempted by Section 4(a)(6) if the issuer, in the offer or sale of the securities, makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which they were made, not misleading . . .

Sound familiar?  What is the difference between this liability and private placements?  Equity crowdfunding is done publicly to more people who are potential claimants.

What does this mean for issuers?  It means the Form C and the offering page on the platform site need to be done carefully and in compliance with SEC rules.  Those rules sound a lot like watered down Regulation S-K rules for MD&A, description of securities, related party transactions, etc…  If you have never complied with them, good luck doing this without experienced help.

Well, at least the platforms are safe, right?  They are just dumb pipes for crowdfunding deals and have no responsibility for what the issuers do on their site, right?

Well, no.  While the SEC did not impose issuer liability on the platforms, it specifically declined to exempt the platforms from liability under Section 4A(c).  Why?  So investors could bring suits against the platforms to make sure that the platforms take steps to keep from becoming conduits of fraud.

The SEC believes that the platforms should take steps to protect themselves.  Congress provided them a defense if they could not have known of an untruth or omission in the exercise of reasonable care.  In other words, the “head in the sand” defense will not work.  In addition, I have seen them provide and even require standard language and provisions in their issuers Form Cs and offering pages.  I doubt the SEC will ignore this if this becomes misleading.

As the SEC stated:

These steps may include establishing policies and procedure that are reasonably designed to achieve compliance with the requirements of Regulation Crowdfunding, and conducting a review of the issuer’s offering documents, before posting them to the platform, to evaluate whether they contain materially false or misleading information.

We are coming up on the one year anniversary of equity crowdfunding.  It is still very early in the equity crowdfunding world to see where the liability issues will shake out.  However, it is clear that the SEC and the state securities regulators take these liability issues seriously, and the issuers and platforms should too.

Equity Crowdfunding. Missing Category: Liability
Equity Crowdfunding. Missing Category: Liability

Equity Crowdfunding Publicity, Or What Not To Do

Rules on marketing and advertising your equity crowdfunding campaign are more restrictive than you think.  Startups accostomed to blogging your every thoughts and feelings beware.

When the SEC adopted the crowdfunding rules under Regulation CF, it included severe restraints on a company’s ability to publicize its crowdfunding campaign.  Many people think the SEC allows general solicitation and it applies to everything.  Wrong.  It does not apply to crowdfunding.

You know those cool tombstone ads in the Wall Street Journal showing off an IPO?  That shows the type of information that your crowdfunding notices can include.

A crowdfunding advertising is limited to:

  • a statement that the issuer is conducting a crowdfunding offering in reliance on section 4(a)(6) of the Securities Act of 1933
  • the name of the platform
  • a link directing the investor to the intermediary’s platform;
  • the terms of the offering; and
  • factual information about the legal identity and business location of the issuer, limited to:
    • the name of the issuer of the security
    • the address of the issuer
    • phone number of the issuer
    • website of the issuer
    • the e-mail address of a representative of the issuer and
    • a brief description of the business of the issuer.

The description of the terms of the offering must be limited to:

  • the amount of securities offered;
  • the nature of the securities;
  • the price of the securities; and
  • the closing date of the offering period.

That’s it.  Some short bullet-pointy info dots.

There’s no “this is the Internet and I can say whatever I want.”  There’s no “This is the new world and old rules don’t apply.”

Is it limiting?  Yes.

Is there a reason?  Yes.

As with public offerings, there is a required disclosure document, in this case Form C.  The SEC wants to make sure you have access to it before you make an investment decision.  The SEC does not want a hyped-up ad to entice you to purchase before you have the ability to review 50 to 100 pages of required disclosure.

Any good news?  Well, the company does not have to file the notices with the SEC.  The company is not limited to newspapers.  The notices can go anywhere, such as social media or the company’s website.

Also, the company can communicate with investors through the crowdfunding platform.  The SEC believes that this ability will facilitate the wisdom of the “crowd” in crowdfunding.  The company must identify itself as the company and not as “Random Guy Who Believes Company Will Be the Next UBER x Google.”

Old timey Ford tombstone. Crowdfunding companies need to get used to this.
Old timey Ford tombstone. Crowdfunding companies need to get used to this.

JPMorgan Beating Startups to the AI Revolution. Artificial Intelligence to Eat White Collar Jobs – Is Going Solo in the Freelance Economy the Answer?

It is not just startups shaking up the AI world.  JPMorgan discusses its artificial intelligence program. Going Solo in the Freelance Economy starts looking better.

When I left Big Firm, it was for personal reasons.  I did not leave shaking my fist at a horrible culture and history of injustice.  I did not experience that.  I started thinking about a professional life staring at a different set of walls.  I began to question my place in the Big Firm ecosystem and whether I could succeed without the safety net.  Lucky me, I could.

For many attorneys, the choice will not be theirs to make.  Technology is coming for their jobs.

Junior attorneys in bigger firms spend most of their time in some sort of document review and document processing roles.  This is necessary grunt work, and it is how junior attorneys learn, when they pay attention.

Billable rates have continued to increase, and clients push back when they can.  However, discovery in litigation and due diligence in transactional work must get done.  What happens when software can take the place of expensive junior associates?

It is about to happen.

There have been a number of articles lately about first generation artificial intelligence tools for this type of work and their early adopter law firms.

Last week, Bloomberg reported on JPMorgan’s COIN, or Contract Intelligence, program.  It reviews commercial loan agreements, something that consumed 360,000 hours of work by lawyers and loan officers each year.  That task now takes seconds, has fewer errors, does not ask for vacations or have the other baggage associated with human employees.

In addition, JPMorgan’s machine learning and big data system helps automate software coding.

In legal circles, litigation document review was seen as the low-hanging fruit for AI software.  However, any white collar position that provides a service that is based on rote activities can and will be replaced by software.  It may not be tomorrow, but it is sooner than you think.  JPMorgan is already planning to license its service to its bigger clients who are staffed to the rafters with white collar “thought employees” who are about to be replaced by code.

Many people believe their job cannot be at risk to computers because computers do not have the judgement capabilities of humans.  But:

As for COIN, the program has helped JPMorgan cut down on loan-servicing mistakes, most of which stemmed from human error in interpreting 12,000 new wholesale contracts per year, according to its designers.

The software is doing other tasks that lots of humans now perform:

For simpler tasks, the bank has created bots to perform functions like granting access to software systems and responding to IT requests, such as resetting an employee’s password, Zames said. Bots are expected to handle 1.7 million access requests this year, doing the work of 140 people.

I am not writing this as a doom-and-gloom article about lost employment.  I think this is ultimately a good thing.  No one knows about the opportunities that will arise from this shift.

It does mean that people should recognize the shift and their place in it.  Stability, comfort and complacency in large organizations has been an antiquated notion for a while.  Maybe Going Solo and finding your place in the Freelance Economy is a path forward.

Artificial intelligence drives the Freelance Economy, eats white collar jobs.
Artificial intelligence drives the Freelance Economy, eats white collar jobs.  Some large enterprise companies are beating startups to the AI revolution.

Monster Books and Records; Unrequited Demands and Other Lessons for Startups and Seasoned Companies

Everyone from startups to seasoned companies and their shareholders can take a lesson from the Monster books and records demand debacle.

I know what you’re thinking:  “How lucky am I to have two books and records articles in two weeks!”

Monster Worldwide (of job board fame) was acquired and merged out of existence.  A shareholder had made a books and records demand prior to the merger but did not bring suit to enforce it until after the merger.  The demand letter said it would assume Monster would not take certain actions unless Monster said otherwise by a deadline.  Monster did nothing. Former shareholder loses.

Here’s a timeline that will be helpful:

  • August 8 – Monster and Acquiror enter into a merger agreement
  • September 6 – Acquiror commences a tender offer to Monster shareholders under the merger agreement
  • October 19 – Shareholder sends demand letter to Monster seeking access to books and records
  • October 26 – Monster rejects demand in current form but offers to cooperate on limited access
  • October 26 – Shareholder emails about the limited offer and stating that if the merger closes before he files a complaint, he expects that the company will refrain from asserting any argument that he lost standing to inspect documents because the merger closed before he filed his complaint. If the company will not refrain from making any such argument, please tell me by 10:00 a.m. Eastern time tomorrow.”
  • October 28 – Withdrawal rights for the tender offer expire; Monster responds to Shareholder refusing to refrain from anything
  • November 1 – Merger completed
  • November 4 – Monster notifies Shareholder that its request was moot since the merger occurred
  • November 22 – Shareholder files complaint

The Shareholder claimed he still had standing according to some policy arguments based on the timing of his demands to Monster, but the court noted that this was simple:

The language of Section 220(c) is plain and unambiguous. By requiring that a plaintiff under Section 220, to seek relief from this Court, demonstrate both that it “has”—past tense—complied with the demand requirement, and that it “is”—present tense—a stockholder, the legislature has made clear that only those who are stockholders at the time of filing have standing to invoke this Court’s assistance under Section 220.

Since the merger had occurred, the Shareholder was no longer a shareholder at the time of the complaint.  Therefore, he did not have standing under DGCL Section 220(c) to file a suit to enforce his right to books and records.

As we mentioned in our previous post, all corporations are bound by the books and records requirements of their jurisdiction of incorporation.  Startups are not exempt just because they like confidentiality and “stealth mode.”

Likewise, shareholders making a demand must conform to strict requirements of the statute.  A company can refuse and delay access on the basis of an improper request.

Joe Weingarten v. Monster Worldwide, Inc.

Monster denies books and records request since it doesn't really exist anymore in its old form.
Monster Worldwide – You can have our job listings, but not our books and records

 

Do Startups and Other Private Companies Have to Provide Info to Employees?

If the employee is a stockholder, private companies, including secretive tech startups and other private emerging growth companies, must provide some company information, as confirmed by old law and new case.

Some ink is being spilled regarding the Biederman v. Domo case about a former employee and current stockholder suing Domo for financial information.  Some of the ink tells the story, but some get it wrong.  Let’s take a look.

I’m using news reports since I could not find an opinion or ruling, so accuracy may vary as we will see.

Domo usually keeps its financial information secret, like most companies.  Domo also pays its employees in stock and options, like many tech and startup companies.  Domo was richly valued in VC rounds, like many tech and startup companies.  Domo’s value may have declined, like many tech and startup companies that were richly valued in VC rounds.

Biederman wanted information about Domo’s financial condition, Domo wanted a confidentiality agreement.  Biederman refused.  According to the Information, this

“highlighted an obscure Delaware law that gives investors the right to financial information of private tech firms in which they hold stock.”

The San Francisco Business Times (the “SFBT“) misreports the Information by stating that

The Information reports that a Delaware law applies to any privately held company that has issued more than $5 million in stock awards in a year and is incorporated in the state. The rule allows employees of any U.S. private company a right to detailed financial information — even if they work for the famously opaque and sometimes secretive tech sector.”

Let’s unpack this a bit.

First, Section 220 of the Delaware General Corporation Law is not obscure.  It is commonly invoked by stockholders who demand information.  The universe of documents available to the stockholder is limited and related to the stockholder’s purpose for requesting the information.

Second, with respect to the SFBT, Delaware law cannot apply “to any privately held company,” only those subject to Delaware’s jurisdiction.  The $5 million figure refers to SEC Rule 701, which exempts certain compensation benefit plans from SEC registration requirements and has nothing to do with Delaware law.  Basically, certain disclosure requirements are triggered if the value of equity awards in a 12-month period exceeds $5 million.

None of this is new.  There are those, particularly in the tech world, who don’t understand that old rules apply to them.  You can’t force a stockholder to sign an agreement as a condition to exercising statutory rights.  I suppose you can try, but a court may disagree.  In some states, a company may be subject to penalties for refusing access to books and records.

Generally speaking, private companies do not have to make disclosures to stockholders (employee or otherwise).  However, there are circumstances where statutes and regs require opening up, such as:

  • pursuant to a proper books and records inspection request (most states have statutes requiring this, and the request has to be in proper form);
  • while there are usually no specific disclosure requirements for stockholder meetings, fiduciary considerations apply when asking for stockholder vote, such as M&A transactions; and
  • state and federal antifraud and registration/exemption rules apply when securities are involved.
Probably a different Domo, but Domo wants his stockholder books and records information.
Probably a different Domo, but Domo wants his Biederman stockholder books and records information.

Snap Common Stock and Structuring Lessons for Startups and Those Aspiring to an IPO

Does the non-voting feature of Snap’s Class A common stock offer lessons to startups or corporate governance gurus?

No.

Even before Snap’s Form S-1 filing a few weeks ago, commentators were shocked and appalled that Snap dared to offer non-voting shares to investors willing to purchase non-voting shares.  There are people who believe deeply in “best practices” and one-size-fits-all corporate governance rules. Erin Griffith at Fortune’s Term Sheet newsletter has declared that “This isn’t a rational investment.”

Griffith then goes on to describe how Snap and companies like it need to constantly change to be ahead of trends, and describes why Snap management needs the freedom to operate:

“Aside from pent-up IPO demand, Snap’s selling point is its ability to repeatedly tap into the next trend before its competitors. Ben Thompson calls this the “Gingerbread Man strategy.” (As in “Run, run, as fast as you can, you’ll never catch me, I’m the gingerbread man!”) By the time competitors start ripping them off (ahem, Facebook…), it doesn’t matter. They’re already working on the next thing.”

By the time the IPO closes, there will be about 4.5 billion shares of Snap outstanding of various classes.  Does anyone really expect that owning even a few million voting shares would have made a dent in their ability to be heard?

The demand for this offering is not based on their ability to bend Evan Speigel’s ear and provide ideas about kids messaging.

At their last shareholder meeting, Google* had about 294 million shares of Class A with one vote per share and about 49 million shares of Class B with 10 votes per share.  Management controlled almost 60% of the vote.  How meaningful was the Class A vote?  Feel empowered when you filled out that proxy?

I remember when Twitter was applauded for the plain vanilla structure of their common stock, as it was compared to the then-recent Facebook IPO, which had voting rights similar to Google.

Since their IPOs:

  • Google went from $50.12/share on August 19, 2004 to $831.66 as of this writing
  • Facebook went from $38.23/share on May 18, 2012 to $136.16 as of this writing
  • Twitter went from $44.90/share on November 7, 2013 to $16.10 as of this writing

Even Enron, the poster boy for all that is bad in corporate behavior, had state of the art governance structures in place:

“Whatever its flaws, the committee followed all the rules laid down by federal regulators, stock exchanges, and governance experts regarding director pay, independence, disclosure, and financial expertise. Enron collapsed in large part because the rules didn’t accomplish what the experts hoped they would.”

This is not to say that “oppressive” structures lead to good results.  It is to say that structures that deemed “not rational” by commentators may have a purpose that benefits shareholders.  Maybe one-size doesn’t fit all.

Snapchat doesn't care about your opinion.

Reg CF’s Crowdfunding Green Shoots

SEC notes early Regulation Crowdfunding results

Regulation Crowdfunding finally went live in May 2016 to much fanfare.  Detractors saw the beginning of a new age of fraud.  Optimists saw the beginning of a free flow of capital to small companies and a flow of riches to investors traditionally shut out of private, early-stage investments.

The answer?  Who knows?

What we do know is that the SEC released some early stats about how Reg CF has been doing since last May.

First, there are 21 funding portals. Each one of those portals is competing for the business of facilitating funding for private companies.  It will be really interesting to see how these early-stage portals survive.

Of the 163 deals that have been initiated, 33 have been completed.  There was no indication of how many are still pending or how many have been withdrawn.

The amount raised is approximately $10 million. *chicken-scratch on back of envelope to get about $300,000 per deal*

It will be educational to see if the SEC breaks out those numbers on a per-deal basis since a simple average does not tell us much.

Did one very successful deal account for a large part of the $10 million?

Did one or more deals stop at a few thousand?

How many of them are restaurants or breweries?  There seems to be a lot of those when I look at the portal homepages.
Early equity crowdfunding results from Reg CF and SEC

Insider Trading Law Tightens Up for Tippers and Tippees

The Supreme Court speaks about insider trading, and it is not good for tippers and tippees.

I’m still going through the backlog of recent stuff.  Here’s an important update on insider trading.

For the first time in a long time, the Supreme Court provided new guidance on insider trading laws. The government had suffered a few high-profile defeats in this area over the last few years, but Salman v. United States provided more insight into indirect liabilities for insider trading while providing more ammunition to the government to go after indirect (tippee) insider trading defendants.

In Salman, A was an investment banker in Citigroup’s healthcare investment banking group. Over time, he regularly tipped off B, his brother. B also provided the information to other people, including C, B’s friend who was also A’s brother-in-law. A tangled web and all that . . .

In the classic Dirks case, a tippee, in this case C, is exposed to liability to insider trading if the tippee participates in a breach of the tipper’s fiduciary duty. The test is whether the insider will benefit, directly or indirectly, from the disclosure. Disclosure without personal benefit is not enough. However, a close, personal relationship can create an inference of benefit.

In 2014, the Second Circuit in Newman, a case involving a more distant relationship between the traders and the insider information, did not permit the inference without proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.

The Ninth Circuit and the Supreme Court disagreed.

The Supreme Court said that the test is whether the insider personally will benefit, directly or indirectly, from the disclosure. Disclosure without personal benefit is not enough. However, the benefit can be inferred from objective facts and circumstances such as a relationship between the parties that suggests a quid or quo or intention to benefit the tippee.

The takeaway is that insider trading is not worth it. If caught, it is not that difficult to convict.* It just got easier. If the prosecution can show that there is a close enough relationship between the tipper and tippee, a jury can infer a benefit assuming that the transaction is no different than the tipper doing the trading and gifting the proceeds to the tippee.

*Sort of.  There are some pending articles about some more difficult cases for the SEC and prosecutors.

Interesting (believe it or not) Developments in Delaware Bylaw Law

Case tests company attempt to shift expenses related to stockholder violations of exclusive forum clause in corporate bylaws.

I’ve been out of the blog game for a while, so I am now catching up on older stuff that I find interesting.  Hopefully, it is not completely out of date.  But what could be more interesting than laws about corporate bylaws?

This post involves some recent developments in Delaware bylaws.  The short answer:

  • Exclusive forum clauses are okay
  • Fee shifting provisions, even for stockholder action violating the exclusive forum clauses are not okay.

So far, so good.

Case:  Solak v. Paylocity Holding Corporation, et al.

Brief Background

In response to another case, Delaware made a couple of changes to its corporations statute:

  • Section 115 was added to permit corporations to adopt bylaws requiring claims to be brought solely in Delaware if they are based upon a violation of a duty by a current or former director or officer or stockholder in such capacity, or under the jurisdiction of the Court of Chancery; and
  • Section 109(b) was amended to provide that bylaws may not impose liability on a stockholder for attorneys’ fees or expenses of the corporation or any other party in connection with Section 115 claims.

Paylocity amended its bylaws to adopt exclusive forum bylaws and to impose liability on a stockholder who brings a Section 115 claim outside of Delaware.  Stockholders were not amused by the fee-shifting provision.

The court said that the plain text of the fee-shifting bylaw violates Section 109(b) despite Paylocity’s arguments that:

  • Section 109(b) must be read with Section 115, thus permitting fee shifting for violations of an exclusive forum bylaw (Court:  No exception in either provision to permit this exception to fee-shifting prohibition);
  • common law permits fee-shifting (Court: Fee-shifting is allowed in private contracts, which are not subject to the prohibition of Section 109(b)); and
  • the bylaw says “to the fullest extent permitted by law,” so it is limited (Court:  There is no extent to which it is permitted, so it is invalid.)