On March 22, the Subcommittee on Capital Markets, Securities, and Investment of the Financial Services Committee conducted a hearing entitled “The JOBS Act at Five: Examining Its Impact and Ensuring the Competitiveness of the U.S. Capital Markets”, focusing on the impact of JOBS Act at 5the JOBS Act on the U.S. capital markets and its effect on capital formation, job creation and economic growth. The archived webcast of the hearing can be found here. Most people won’t have the patience to sit through two hours and 44 minutes of testimony (although the running national debt scoreboard on the right side of the home page showing in real time the national debt increasing by $100,000 every three seconds, and by $1 million every 30 seconds, etc., is eyepopping). At the risk of being accused of having too much time on my hands, but as an act of community service, I watched the hearing (or at least most of it) and will offer some takeaways.

Raymond Keating, Chief Economist of the Small Business & Entrepreneurship Council, testified about some disturbing trends in angel and VC investment. The value and number of angel deals is down from pre-recession levels.  VC investment showed the most life but a decline in raymond keating2016 is troubling. So what’s going on?  Keating believes it’s about reduced levels of entrepreneurship stemming in large part from regulatory burdens that limit entrepreneurs’ access to capital and investors’ freedom to make investments in entrepreneurial ventures. He also testified on the need for further reform, particularly in Regulation Crowdfunding under Title III which allows companies for the first time to raise capital from anyone, not just accredited investors, without filing a registration statement with the SEC, and identified the following reform targets:

  • Issuer Cap. Currently, issuers are capped at $1 million during any rolling twelve-month period. There’s been a push to increase that cap, perhaps to $5 million.
  • Investor Cap. Currently, investors with annual income or net worth of less than $100,000 are limited during a 12-month period to the greater of $2,000 or 5% of the lesser of annual income or net worth, and if both annual income and net worth exceed $100,000, then the limit is 10% of the lesser of income or net worth. The proposal here would be to change the application of the cap from the lower of annual income or net worth to the higher of annual income or net worth.
  • Funding Portal Liability. Currently, funding portals can be held liable for material misstatements and omissions by issuers. That poses tremendous and arguably unfair risk to funding portals and may deter funding portals from getting in the business in the first place. The proposal here would be that a funding portal should not be held liable for material misstatements and omissions by an issuer, unless the portal itself is guilty of fraud or negligence. Such a safe harbor for online platforms would be similar to the protection that traditional broker dealers have enjoyed for decades. A funding platform is just a technology-enabled way for entrepreneurs to connect with investors, and they don’t have the domain expertise of issuers and can’t verify the accuracy of all statements made by issuers.  Part of the role of the crowd in crowdfunding is to scrutinize an issuer, a role that should remain with the investors, not with the platform.
  • Syndicated Investments. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors to invest in a special purpose vehicle whose only purpose is to invest in the operating company. Essentially, a lead investor validates a company’s valuation, strategy and investment worthiness. Traditionally, angel investors have operated in groups and often follow a lead investor, a model which puts all investors on a level playing field.
  • $25 Million Asset Registration Trigger.  Under current rules, any Regulation CF funded company that crosses a $25 million asset threshold would be required to register under the Securities Exchange Act and become an SEC reporting company. Seems inconsistent with the spirit of Regulation Crowdfunding, which for the first time allows companies to offer securities to the public without registering with the SEC.

As to the continuing challenge for companies to go and remain public, Thomas Quaadman, Vice President of the U.S. Chamber of Commerce, testified that the public markets are in worse shape today than they were five years ago and that we have fewer than half the public companies quaadmantoday than we had in 1996, a number that has decreased in 19 of the last 20 years. Mr. Quaadman blamed this in part on an antiquated disclosure regime that is increasingly used to embarrass companies rather than provide decision useful information to investors. In order to rebalance the system and reverse the negative trend, he suggested a numbere of reform measures the SEC and Congress should undertake. The disclosure effectiveness proposal should be a top priority for the SEC to bring the disclosure regime into the 21st century. We need proxy advisory firm reform that brings transparency, accountability and oversight to proxy advisory firms. Also, there should be recognition that capital formation and corporate governance are inextricably linked and there should be reform of the shareholder proposal process under Rule 14a-8.

Snap IPOThe just completed IPO of Snap Inc. has received enormous buzz and plenty of press coverage, mostly about its eye-popping valuation and offering proceeds, the big winners among the founders and early investors and the millennials who bought shares. But not nearly as much attention has been given to Snap’s tri-class capital structure and the nature of the shares that were actually issued in the IPO: the shares of Class A Common Stock sold in the IPO are non-voting. By its own admission, Snap may have pulled off the first ever IPO of non-voting stock.

Snap’s capital now consists of the non-voting Class A shares held by public investors, Class B shares snapIPO2with one vote per share held by early round investors, employees and directors and Class C shares with ten votes per share held by the founders. As a result of the Class C common stock that they hold, co-founders Evan Spiegel and Robert Murphy will be able to exercise voting rights with respect to an aggregate of 215,887,848 shares, representing approximately 88.5% of the voting power immediately following the offering. Consequently, Spiegel and Murphy, and potentially either one of them alone (see below), have the ability to control the outcome of all matters submitted to stockholders for approval, including election, removal, and replacement of directors and any merger or sale of all or substantially all of the assets.

Multiple class structures are not unusual, and several high profile companies went public with them in recent years. What’s unusual here is that whereas the shares sold in those other multiple class structure IPOs had at least some voting rights (typically, one vote per share vs. 10 for the founder class), Snap’s public offering shares have no voting rights. Technically, Delaware law would permit holders of Snap’s Class A non-voting stock nevertheless to vote with one vote per share on any proposal to amend the certificate of incorporation in any way that would adversely affect the holders of the Class A. For example, if a proposed amendment provided for the Class A to rank junior to the Class B and Class C with respect to dividends or acquisition proceeds, a Class A vote would be required and the holders of a majority of Class A shares could defeat that amendment. Such a proposal would be extremely rare, however, and the Class A holders would have no say in the much more typical matters of board elections and any proposed sale of the company.

Multiple share classes are especially useful to public technology companies because they give them the freedom to innovate without the constraints of “short termism” and also serve as a deterrence to takeover bids because of activists’ inability to manipulate the voting machinery for election of directors.

Snap’s Class A common stock will be its only class registered under Section 12 of the Securities Exchange Act, and because the Class A is non-voting, Snap will not be required to file proxy statements except for a rare case where a vote of the Class A common stock is required (see above). Nevertheless, Snap indicated in its S-1 that it will provide Class A holders any information that it provides voluntarily to Class B and Class C holders.

What makes Snap’s structure even more unusual is survivability and portability.  According to Snap’s S-1, If Spiegel’s or Murphy’s employment is terminated (which, because of their control, could only happen if they turn on each other), they will continue to have the ability to exercise the same significant voting power and continue to control the outcome of all matters submitted to stockholders for approval. A founder’s Class C shares will automatically convert into Class B shares, on a one-for-one basis, nine months following such founder’s zuckerbergdeath or on the date on which the number of outstanding Class C shares held by such holder represents less than 30% of the Class C (or 32,383,178 shares) held by such holder at the time of the IPO. Facebook, on the other hand, amended its certificate of incorporation so that Mark Zuckerberg’s majority voting control is good only while he is an executive at the company.

Snap’s capital structure has drawn some criticism. In a New York Times piece, Cal Berkley law professor Steven Davidoff Solomon referred to Snap’s IPO as “the most stockholder-unfriendly governance in an initial public offering, ever.” In the Harvard Law School Forum on Corporate Governance and Financial Regulation, Rob Kalb and Rob Yates of Institutional Stockholder Services cited a 2016 ISS study that showed that controlled companies had weaker governance standards and tended to underperform “with respect to total stockholder returns, revenue growth, return on equity, and dividend payout ratios.” And the Council of Institutional Investors sent a letter to Snap’s co-founders objecting to the capital structure and urging them to adopt a single class structure. While acknowledging that similar emerging companies with dynamic leadership and promising products have successfully raised capital despite having dual class structures, Snap’s structure is unusual in that the investors would have no voting rights and dual class company performance has been mixed at best.

When Google, Facebook and Under Armour went public, they each did so with a dual-class share structure that at least afforded public stockholders one vote per share. Nevertheless, each company subsequently requested stockholder approval for the issuance of a third class of non-voting shares. In each case, the purpose of creating a new non-voting class was to maintain founder voting control while simultaneously providing insider liquidity.

Despite the overall positive outcomes achieved by Google and Facebook for their stockholders, going public as a controlled company with an unequal-voting-rights structure is no guaranty for financial success. Groupon, Zynga and GoPro each went public with a dual-class structure, received poor ISS corporate governance scores indicating the highest levels of governance risk, and the share price of all three dropped precipitously since their respective IPOs.

Adding salt to the corporate governance wound, Snap is taking advantage of emerging growth company status under the JOBS Act, meaning that it is not required to comply with the auditor attestation requirements under Sarbanes-Oxley and the reduced executive compensation disclosure requirements and may delay adoption of new public-company accounting principles.

In the final analysis, investors will need to decide which Mark the Snap founders better resemble, Facebook’s Zuckerberg or Zynga’s Pincus. And looking beyond Snap, it remains to be seen whether other emerging companies adopt the Snap IPO playbook by launching IPOs with multiple-class structures that preserve founder control and give public stockholders little or no governance voice.

On July 11, 2016, the Wall Street Journal reported that the Securities and tesla logoExchange Commission is investigating whether Tesla Motors Inc. violated the securities laws, apparently by not disclosing timely a fatal crash involving a Tesla Model S. Tesla’s handling of the incident from a disclosure standpoint raises interesting issues involving materiality and risk factors.

It seems the SEC is examining whether Tesla should have disclosed information regarding the fatal crash in offering documents relating to the sale of approximately $2.8 billion of Tesla common stock, nearly $600 million of which were sold by Tesla CEO, Elon Musk.

tesla crashHere are the facts. On May 7, 2016, a Model S Tesla featuring Tesla’s autonomous driving technology “Autopilot” collided with a tractor trailer that had turned in front of it, killing the driver of the Model S.  Ironically, the driver, Joshua Brown, regularly posted videos of his rides in the car, and he was clearly a big fan of Autopilot. On May 10, Tesla filed its first quarter 10-Q without any reference to the crash.  Eight days later, Tesla filed a preliminary prospectus with the SEC to sell up to 10,697,674 shares of common stock without mentioning the crash.  Two days after that, Tesla filed a prospectus supplement disclosing the pricing of the offering (up to $2 billion of stock, approximately $1.4 billion by Tesla and nearly $600 million by Musk), and again with no disclosure regarding the crash.  On June 29, Tesla learned the National Highway Traffic Safety Administration would conduct a preliminary evaluation of the crash, which Tesla addressed in a blog post after the markets closed the following day.

As to Tesla’s blog post, one thing that caught my attention was the part that states that Tesla informed the NHTSA about the accident “immediately after it occurred”. Yet the accident took place on May 7 and Tesla didn’t notify the NHTSA until May 16, a full nine days later.  In Tesla’s defense, it claimed that the extent of the wreckage made remote data analysis impossible, and it had to dispatch its internal investigators to the scene of the accident which slowed down the process.

As a general rule, SEC reporting companies must disclose categories of information specifically mandated by regulation as well as any information that’s material to investors. But there is no clearly defined standard for whether the May 7 accident was “material” enough to require disclosure. Instead, general standards regarding materiality have been established in SEC rules, judicial decisions and administrative guidance.  As a general proposition, information is deemed material if “there is a substantial likelihood that a reasonable shareholder would consider it important in making an investment decision”.  For a fact to be material, there must be a substantial likelihood that the fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.

So is the crash material to Tesla investors? If so, the failure to disclose it would be deemed to be a material omission. One place to look for evidence of materiality is the stock market. In this case, the reaction of the stock market tesla stockseems to indicate that the crash is not material.  The day the news broke about the NHTSA investigation (June 29), the stock closed at $210.19, up from 201.79 the day before.  It rose to $212.29 on the first day after Tesla blogged about the crash (July 1), and it closed at $234.79 on July 29, the last trading day before this blog post.  In fact, the only noticeable drop in price after the crash date of May 7 occurred on June 22, when Tesla shares cratered (down $22.95 from the previous close of $219.61) in reaction to Tesla’s bid for Solar City.

The history of auto fatalities may be another reason the crash itself should not be deemed to be material. In 2015, there were an estimated 38,000 auto fatalities in the United States. Nearly 1.3 million people die in road crashes each year worldwide, an average of 3,287 deaths per day.  In its June 30 blog post, Tesla asserted that the May 7 crash was the first fatality in the 130 million miles driven with Autopilot.  By comparison, Tesla asserted that there is a fatality every 94 million miles for all American vehicles and one every 60 million miles worldwide, which Tesla asserts proves it has a “better-than-human” driving capability.  Companies do disclose safety recalls and product liability suits when they trigger significant financial charges, but not fatal crashes.  Perhaps the reason may be that fatal car crashes in and of themselves are not perceived to have a material adverse effect on a company.

But perhaps an argument in favor of materiality here is that Tesla had been aggressively promoting its Autopilot technology, which it bills as the most tesla autopilotadvanced self-driving system on the road. Investors have been drawn to Tesla shares in large part on the conviction that the company is on the cutting edge of technology, particularly with Autopilot, and may be poised to leap ahead of more traditional car manufacturers. A fatal crash, however, could lead to a change in perception of autonomous vehicles in general, and Autopilot in particular, on the part of both the public and the insurance industry. But even assuming as much, it appears that Tesla did not determine that the car was actually on Autopilot at the time of the crash until after it filed its 10-Q and offering prospectus.

One of the stranger aspects of this story is the email and tweet battle that broke fortuneout between Musk and Fortune Magazine. Fortune editor Alan Murray tweeted “[s]eems pretty material to me,” with a link to the magazine’s online article in which Musk is quoted saying in an email that the matter was “not material” to Tesla shareholders. Musk then retorted to Murray on Twitter: “Yes, it was material to you — BS article increased your advertising revenue. Just wasn’t material to [Tesla], as shown by market.”  Murray then predicted that the materiality issue would be resolved in a lawsuit, implicitly inviting shareholders to sue (sort of like Trump inviting the Russians to find Hillary Clinton’s deleted emails).

Another interesting aspect to all this is Tesla’s risk factor disclosure. Tesla’s 10-Q filed on May 10 for the quarter ended March 31 contained a risk factor entitled “We may become subject to product liability claims, which could harm our financial condition and liquidity if we are not able to successfully defend or insure against such claims”, in which it stated that a successful liability claim associated with its technology, including the Autopilot feature, could harm the company’s financial condition, “could generate substantial negative publicity about [its] products and business and would have material adverse effect on [its] brand, business, prospects and operating results” (emphasis added).  Seems like Tesla is careful to draw a distinction between an isolated crash and a products liability claim.  Also, in its June 30 blog post, Tesla referred to the foregoing risk factor as “boilerplate”, something Tesla may regret saying as the SEC has a long history of discouraging intensely boilerplate disclosures.  And finally, the part of that risk factor that really jumped off the page at me was that “We self-insure against the risk of product liability claims, meaning that any product liability claims will have to be paid from company funds, not by insurance.”  My hunch is that self-insurance is not very common in the industry, and it will be interesting to see whether Tesla revisits its insurance approach in the aftermath of all of the post-crash scrutiny.

On July 3, 2012, Netflix CEO Reed Hastings kicked off the holiday weekend with some fireworks of his own by posting on his personal Facebook page that Netflix had streamed a billion hours of content in the month of June.  Hastings designated the post as “public,” making it available to anyone on the Internet, including Facebook’s billion users and Hastings’ own 200,000 Facebook “friends”.  What followed were thousands of “likes”, comments and “shares”, extensive media coverage and a spike in Netflix’s stock price.  And oh yes, an SEC investigation.  Both Netflix and Hastings received a “Wells Notice” from the SEC’s Enforcement Staff indicating its intent to recommend that the SEC bring enforcement proceedings for violations of Regulation FD.

On April 2, 2013, the SEC issued its Report on the investigation, stating that it would indeed not seek enforcement proceedings in this case, and declaring more broadly that companies may use social media such as Facebook and Twitter to disseminate material, non-public information under Reg FD provided that investors are properly alerted in advance that the company intends to use those particular channels of distribution to disseminate material information.

Reg FD requires that when an issuer, or a person acting on its behalf, discloses material, non-public information to securities market professionals or shareholders where it is reasonably foreseeable that they will trade on the basis of the information, it must distribute that information in a manner reasonably designed to achieve broad and non-exclusionary distribution to the public.  Reg FD was intended to level the playing field, and was adopted out of concern that issuers were selectively disclosing important non-public information, such as advance warning of earnings results, to securities analysts or selected institutional investors before making full disclosure of the information to the general public.

The SEC had previously provided guidance in 2008 on the disclosure of material non-public information on company websites and other “push” technology forms of communication such as email alerts and RSS feeds, along with “interactive” communication tools such as blogs.  In the 2008 guidance, the SEC stated that a company makes Reg FD-compliant public disclosure when it distributes information “through a recognized channel of distribution.”  It spoke of the vital role of the Internet and electronic communications in modernizing the disclosure system and promoting transparency, liquidity and efficiency in trading markets.  The guidance offered a non-exhaustive list of factors to be considered in evaluating whether a corporate web site constitutes a recognized channel of distribution.  The central focus of the inquiry is whether the company has made investors, the market and the media aware of the channels of distribution it expects to use, so that these parties know where to look for disclosures of material information about the company.

The SEC’s April 2 Report extends the 2008 guidance on corporate website disclosure to social media.  Specifically, the Report states that (i) issuer communications made through social media channels require careful Reg FD analysis comparable to communications made through more traditional channels; and (ii) the principles outlined in the 2008 guidance, particularly that markets should be alerted to the channels of distribution a company will use to disseminate material information, apply to disclosures made through social media channels as well.  The rationale is that identifying the specific social media channels a company intends to use for material non-public information disclosure will give investors the opportunity to take the steps necessary to be in a position to receive important disclosures, such as subscribing, joining, registering, and reviewing the designated channels.

Under these standards, it would seem that Hastings and Netflix were grossly non-compliant.  Hastings’ personal Facebook page had not been previously used to announce company metrics, and Netflix had not previously informed shareholders that Hastings’ Facebook page would be used to disclose information about Netflix.  The post was not accompanied by a press release, a post on the corporate web site or Facebook page or a Form 8-K.  Nevertheless, the SEC chose not to bring enforcement proceedings, apparently because the proliferation of the use of social media to communicate with shareholders had created uncertainty over how Reg FD and the 2008 guidance would apply to social media disclosures, and the SEC felt obligated to provide some guidance.

For its part, Netflix isn’t taking any chances.  Within a few days after the SEC’s Report, Netflix filed an 8-K designating the social media channels where investors, the media and others should review information about Netflix, including two Netflix blogs, Netflix’s Facebook page and Twitter Feed and Reed Hastings’ public Facebook page.

Interestingly, Hastings’ post should not have even been a Reg FD issue because the streaming metric arguably should not even be relevant to Netflix’s revenues, much less material to Netflix, inasmuch as its revenues are derived through fixed subscriber fees that are not based on the number of hours of programming viewed.  Ironically, Hastings himself may have helped decide the issue of materiality to Netflix’s detriment while on an earnings call in January 2012 when, in answer to a question on relevance, he stated that the metric was a measure of engagement and scale in terms of use of service and that Netflix would update that metric on a milestone basis.