There are generally two ways you can control a corporation.  One is by owning a majority of the stock, in which case you control the board of directors.  The other is to secure control contractually, through agreements and charter provisions that provide protections such as board representation or vetos over major transactions.  But what happens when those contractual and charter provisions interfere with the statutory authority of a board of directors to manage a company’s affairs as mandated by state corporate law?  A recent Delaware Chancery Court decision in West Palm Beach Firefighters’ Pension Fund v. Moelis & Co. invalidated provisions of a stockholders agreement because they constituted an impermissible delegation of the board’s managerial authority in contravention of Delaware law. The decision throws into question the enforceability of corporate governance provisions routinely included in stockholder agreements, investor rights agreements and voting agreements.

Statutory Authority of Board of Directors

Section 141(a) of the Delaware General Corporation Law (the “DGCL”) provides that:

“the business and affairs of every [Delaware] corporation … shall be managed by or under the direction of a board of directors, except as may be otherwise provided [under the DGCL] or in its certificate of incorporation.”

Section 141(c)(2) empowers the board to designate one or more committees and to determine the composition of those committees.

The Moelis Stockholders Agreement

Just before its IPO, boutique global investment bank Moelis & Co. entered into a stockholders agreement with its founder, CEO and principal stockholder, Ken Moelis, and three of his affiliates.  The agreement gave Mr. Moelis three types of broad governance rights, which the Court categorized as Pre-Approval Requirements, Board Composition Provisions and a Committee Composition Provision.

The Pre-Approval Requirements mandated that the company obtain Moelis’ prior written consent before engaging in any of eighteen different significant actions, including issuing stock, incurring debt, entering into a new line of business, appointing or removing an officer, amending the certificate of incorporation or by-laws, adopting a budget, declaring a dividend or merging or selling the company or all or substantially all of its assets.

Under the Board Composition Provisions, the board was contractually obligated to maintain its size at not more than eleven seats, nominate Moelis’ designees which were to constitute a majority, recommend those nominees to the stockholders for a vote and fill vacancies of Moelis seats with new Moelis designees.

The Committee Composition Provision gave Moelis the right to have a proportionate number of his designees serve on any board committee.

The Stockholder Challenge

A Moelis stockholder sued the Company, claiming that the challenged provisions violated Sections 141(a) and 141(c)(2) of the DGCL. The plaintiff pointed to Delaware law precedent under the seminal Abercrombie case that a governance restriction in a contract (as opposed to the certificate of incorporation) is invalid if it:

“has the effect of removing from directors in a very substantial way their duty to use their own best judgment on management matters” or “tends to limit in a substantial way the freedom of director decisions on matters of management policy…”

The stockholder argued that the challenged provisions fail the Abercrombie test.  The Pre-Approval Requirements mean that Moelis determines what action the board could take, meaning the directors can’t exercise their own judgment.  The Board Composition Provisions prevent the directors from using independent judgment when determining board size, selecting nominees and filling vacancies.  The Committee Composition Provision prevents the directors from exercising their judgment when populating committees.

The company’s defense centered around the sanctity of contracts and the notion that many contracts necessarily constrain a board’s freedom of action.  For example, exclusive supply agreements deny a board the freedom to contract with another party.  A credit agreement typically contains negative covenants that constrain a board’s freedom of action, such as declaring dividends or redeeming shares.  No one would suggest that either of these agreements violates Section 141(a). 

The Court’s Decision

The Court distinguished between external commercial agreements, which do not raise Section 141(a) concerns, and invalid restrictions on board authority, which do.

In its analysis, the Court created a two-pronged test to determine the validity of stockholders agreements under Section 141(a).  Under the first prong, a determination is made as to whether or not a contractual provision is part of an internal governance arrangement.  If it isn’t, Section 141(a) does not apply and the inquiry ends there.  If it is, the second prong is triggered, which is whether the challenged provision constitutes a restriction on board authority and therefore violates Section 141(a).

The Court stated that the challenged provisions in this case “look like something a law professor dreamed up for students to use as a prototypical Section 141(a) violation” and that they resemble the type of governance rights associated with preferred stock. With limited exceptions, they were drafted to bind the board, not the company.  No one would mistake them for a supply agreement, credit agreement or other commercial contract.

Once the Court determined that the challenged provisions were part of an internal governance arrangement and thus subject to Section 141(a), the question then became whether they violate the Abercrombie test by substantially removing from directors their duty to use their own best judgment on management matters or substantially limiting the freedom of director decisions on management.

The Court found the Pre-Approval Requirements, taken as a whole, fail the Abercrombie test because they force the Board to obtain Moelis’ prior written consent before taking virtually any meaningful action.  The directors can only manage the company to the extent Moelis gives them permission to do so. Hence, the Pre-Approval Requirements, taken as a whole, violate Section 141(a).

As to the Board Composition Provisions, the Court determined that three of them also violate Section 141(a): the recommendation requirement improperly compels the board to recommend Moelis’ designees for election; the vacancy requirement improperly compels the board to fill a Moelis seat vacancy with another Moelis designee; and the board size requirement improperly enables Moelis to prevent the board from increasing the number of board seats beyond eleven.

Finally, the Court found that the Committee Composition Provision violates both Section 141(a) and Section 141(c)(2) because determining the composition of committees falls within the Board’s authority and a stockholder cannot determine who serves on a committee.

The Moelis decision will likely shine a light on the validity of stockholders agreements, investor rights agreements, voting agreements and other agreements granting similar governance rights to stockholders, and could spark a flood of litigation challenging these types of arrangements.

In reaction to the expansive use of governance rights in stockholder agreements, the Court stated in a footnote that “greater statutory guidance may be beneficial”.  The Delaware State Bar Association’s ears may have been ringing.  On March 28, 2024, the Council of the Corporation Law Section of the DSBA approved a proposed amendment to the DGCL which would set forth a non-exclusive list of provisions that a corporation may include in a stockholders’ agreement, including without limitation restricting or prohibiting itself from taking actions specified in the contract; requiring the approval or consent of one or more persons or bodies before the corporation may take actions specified in the contract; and covenanting that the corporation will take, or refrain from taking, actions specified in the contract. The proposed amendments must be approved by the DSBA’s Corporation Law Section and Executive Committee at meetings expected to be held in April, and then submitted to Delaware’s General Assembly. If adopted by the General Assembly and signed into law by the governor, the amendments would generally become effective August 1, 2024.

Identifying potential investors is one of the most difficult challenges facing early-stage companies.  The range of amounts sought at this stage is typically greater than what could be provided by the founders and friends and family, but below what would attract a VC or a registered broker-dealer.  The problem is even more acute in geographic regions with weak investor networks. 

Finders play an important role in filling this gap.  But many finders choose to operate without being licensed because the existing securities broker regulatory regime, appropriate for full-service broker-dealers, is disproportionately complex for those merely acting as finders.  The resulting uncertainty is a problem for companies, unregistered finders, lawyers and regulators. 

A few states have adopted their own exemptions or limited registration regimes for finders, but the vast majority have not.  The SEC in 2020 proposed a new exemption for finders who comply with certain conditions, but ultimately never acted on the proposal.

In its 2023 Annual Report, the SEC’s Office of the Advocate for Small Business Capital Formation included in its official policy recommendations that the SEC provide regulatory clarity for finders.

It’s time for the SEC to adopt common sense rules to create a realistic regulatory framework for finders.

Regulatory Background

Federal and state law prohibit any person from engaging in the business of effecting transactions in securities unless the person is registered as a broker-dealer with the SEC and is a member of FINRA. Any person who accepts a commission or other form of transaction-based compensation for raising capital is deemed to “engage in the business” and thus required to register. There’s a limited exception for introducing a potential investor to an issuer and accepting a “finder’s fee” irrespective of whether an investment occurs, but it’s the position of the SEC and most state securities administrators that anyone accepting a fee for investor introductions more than once is probably “engaged in the business of selling securities for compensation” and thus required to register as a broker-dealer. The JOBS Act of 2012 also included a limited exemption for persons brokering Rule 506 transactions provided they don’t receive transaction-based compensation.

Risks to Issuers

Using an unregistered broker to help raise capital could result in investors having a right of rescission under federal securities law, which if successfully exercised would require the company to return funds to investors.   Section 29(b) of the Securities Exchange Act provides that any contract made in violation of the Exchange Act is void as to the rights of any person in violation of the relevant provision.  Section 29(b) is broad enough that it can be interpreted to void a purchase agreement with any investor located through a finder that was acting in violation of the Exchange Act’s broker-dealer registration requirement.  The right of rescission may be exercised until the later of three years following the date of issuance of the securities and one year from the date of discovery of the violation.

For companies that have used unregistered finders in the past, the risk of potential rescission rights often raises significant risks in future rounds because of the uncertainty as to how long rescission rights may be exercised.  Companies that use unregistered broker-dealers could also be hit with SEC enforcement actions for aiding and abetting an Exchange Act violation.

Risks to Finders

Issuers may have rescission rights against unregistered finders.  Issuers could claim their obligations to a finder under a finder’s engagement letter are void if the finder acted in violation of the Exchange Act’s broker-dealer registration requirements.  A finder acting as an unregistered broker-dealer may also be at risk of an SEC enforcement action, the most common of which is a temporary or permanent injunction barring the finder from participating in the purchase or sale of securities. The SEC has the power to impose more severe sanctions, including disgorgement of funds, which are no longer limited to cases just involving fraud.

Finder Issues Unique to Early-Stage Companies

So why don’t finders just register as broker-dealers and become members of FINRA?  The problem is that broker-dealer registration and the FINRA membership application process are disproportionately complex for someone acting only as a finder. The ongoing regulatory requirements – appropriate for a full-service broker-dealer, i.e., one that engages in market making, over-the-counter trading for customers, proprietary trading, holding customer funds or securities, making margin loans, etc. – are similarly overwhelming for a finder.

Most startups raise early-stage rounds from angel investors in the range of $100,000 to a few million dollars.  Connecting with angels, particularly outside of the major investment hubs is particularly challenging for entrepreneurs, so finders could theoretically serve a critical role in bridging this gap.  But registered broker-dealer placement agents are generally not interested in these deals because the success fees, which are a function of deal size, are too low.  Also, the risks associated with small deals are similar to those of larger ones, but without the upside.  Early-stage companies usually lack internal recordkeeping and controls, and their financials are rarely audited, which means more work and risk for the intermediary in preparing offering materials.

2020 Proposed Exemption

In October 2020, the SEC issued a proposal that would have allowed individuals to engage in certain limited finder activities without registering with the SEC. I blogged about it at the time here.

The exemption would have applied to natural persons and only be applicable with respect to accredited investors. The finder would not be allowed to engage in general solicitation, help structure a deal, negotiate terms, handle customer funds or securities, have authority to bind the issuer, participate in preparing offering materials, engage in due diligence, provide or arrange for financing or render valuation advice. Any finder satisfying the applicable requirements would be permitted to receive transaction-based compensation.

The proposal would have created two classes of finders, Tier I and Tier II, based on the type of finder activities, with exemption conditions tailored to the scope of activities.

The activity of Tier I finders would have been limited to providing contact information of potential investors for only one capital raise by a single issuer within a 12-month period, but no contact with the potential investor about the issuer, i.e., no solicitation.

A Tier II finder satisfying the above conditions would have been allowed to engage in certain solicitation activities on behalf of an issuer. Those activities would have been limited to identifying and contacting potential investors, distributing offering materials, discussing information in the materials (but no investment advice) and arranging or participating in meetings between the issuer and investor.  Tier II finders would have been required to make certain disclosures, including the compensation arrangement and any conflicts of interest.

The SEC has not acted on the proposal and, consequently, it may not be relied upon.

Need for Reform

The absence of regulatory clarity on the role of finders in facilitating introductions between companies and investors harms both investors and issuers. The lack of a clear framework makes it easier for unscrupulous intermediaries to solicit investors without disclosing hidden conflicts of interest. Unregistered broker-dealer activity could expose a company to rescission rights, which could require the company to return to investors their investment plus interest. Market participants deserve clarity here.

The 2020 SEC proposal promoted a meaningful dialogue regarding the proper role of finders in the startup ecosystem and offered a good starting point for addressing the problem of unregistered finders.  I would expand the exemption beyond natural persons to include entities as well.  The SEC should also consider allowing Tier II finders some leeway for making recommendations, which is what is at least implicitly happening when they are allowed to contact prospective investors and participate in meetings between issuers and investors.  The SEC should also allow finders to solicit non-accredited investors, perhaps with an investment cap to address the investor protection concern.  Finally, finders within the exemption should be allowed to engage in due diligence, inasmuch as a finder should be encouraged to be reasonably well-informed about the terms of the investment and the suitability of prospective investors. 

A finder exemption in the form of the SEC’s 2020 proposal, especially with the foregoing modifications, would result in a more realistic regulatory framework for finders.

Takeaway:

Early-stage companies often struggle to identify potential investors, with ‘finders’ playing a key role in bridging this gap. However, the current regulatory framework for finders is complex and unclear, causing uncertainty and potential legal risks for companies, finders, and investors. It’s crucial for the SEC to adopt clear, common-sense rules to regulate finders and facilitate startup investment.

Process still matters.  That’s the main takeaway from the Delaware Court of Chancery’s 200-page opinion striking down Tesla’s 2018 incentive package awarded to Elon Musk.  The court rescinded the incentive package mainly because Musk was found to control Tesla and the process, the directors authorizing the package were not independent and the stockholder vote approving it was not properly informed.  The ruling is a stark reminder of the importance of both director independence and an informed stockholder vote when transacting with a control stockholder.

The 2018 Stock Option Grant

In 2018, the Tesla board approved a new stock option package for Elon Musk and then submitted the proposal for stockholder approval. At a special meeting of stockholders, 81% of the shares voted in favor (or 73% without counting Musk’s and his brother’s shares). If exercised in full, the option package would have allowed Musk to purchase a number of shares constituting 12% of Tesla’s outstanding stock, subject to both milestone and leadership-based vesting.  The options vested in 12 tranches, with each tranche vesting on Tesla achieving one capitalization milestone and one operational milestone, and only if Musk continued serving as either CEO or both executive chairman and chief product officer at each vesting juncture.  In the most optimistic case, if Tesla’s capitalization grew from $59 billion at the time of the grant in 2018 to $650 billion by 2028 (the option expiration), all the options would vest and be worth approximately $56 billion.  As things turned out, Tesla’s market cap did hit $650 billion by the end of 2020 and all the options vested in full. 

Was Musk a Controlling Stockholder?

Normally, corporate boards may compensate their executives however lavishly as they wish because Delaware courts will show tremendous deference to board decisions under the business judgment rule and not second guess them.  The exception to the general rule is when the compensation is being paid to a controlling stockholder, in which case the compensation or transaction is evaluated under the stricter entire fairness standard which demands a fair price and fair process.  The threshold issue then is whether Elon Musk was a controlling stockholder at the time of the 2018 grant.

Control can be established either through mathematical voting control or effective operational control.  On the surface, Musk’s 22% ownership stake at the time of the 2018 grant did not constitute mathematical voting control.  But perhaps it did when combined with Tesla’s supermajority vote requirement for any amendment to its bylaws governing stockholder meetings, directors, indemnification rights and the supermajority vote requirement itself.  The court’s main focus, however, was on Musk’s “outsized influence” over Tesla’s business affairs in general and over the compensation package in particular.

As to general control, the court found Musk exerted significant influence over Tesla’s board, and that as founder, CEO and chairman he “occupied the most powerful trifecta of roles”. Musk also frequently exercised managerial authority over all aspects of Tesla, in many cases ignoring the Board’s authority such as when he appointed himself Tesla’s “Technoking”, disclosed in a Form 8-K, without consulting the Board.  The Court was also swayed by Musk’s “Superstar CEO” status, which it said resulted in shifting the balance of power toward himself and away from the board, which was supposed to exercise authority over him.

The court also found Musk exerted transaction-specific control.  He almost unilaterally controlled the timing of the grant. There was no negotiation between Musk and the Board over the size of the grant, and no meaningful negotiation over the other terms.  Neither the compensation committee nor the board engaged in any benchmarking analysis.  Directors testified at the trial that they viewed the process as “cooperation”, not a negotiation.

Musk’s controlling stockholder status meant that the applicable standard of review would be the entire fairness standard.  As a procedural matter, the defendants have the burden of proving fair price and fair process.  But defendants (in this case, Musk, the other directors and Tesla) can shift the burden to the plaintiff if the transaction was approved by either a well-functioning committee of independent directors, or an informed vote of the majority of the minority stockholders.  As a practical matter, burden of proof in these cases is determinative; the party with the burden almost always loses.

Continue Reading Out of Control!  What the Elon Musk Compensation Case Reminds Us about Transactions with Controlling Stockholders

Starting January 1, 2024, virtually all private companies will be required to report information about their beneficial owners to the Treasury Department’s Financial Crimes Enforcement Network “FinCEN”) under the Corporate Transparency Act (the “CTA”).  But the CTA presents unique analytical and reporting challenges for startups and venture backed companies because of the special economic and governance rights negotiated with investors in early stage and venture funding rounds.

Continue Reading Corporate Transparency Act Risks for Startups and Venture-Backed Companies

The Securities and Exchange Commission recently brought its first two enforcement actions against issuers of non-fungible tokens (NFTs), resulting in cease-and-desist orders, penalties and other remedies, finding that the NFTs were investment contracts and that each of the issuers had engaged in an offering of securities without registration in violation of Section 5 of the Securities Act of 1933.  These enforcement actions create legal ambiguity and risk for NFT developers regarding the marketing, transferability and royalty generating capacity of NFTs.

Continue Reading SEC’s First Two NFT Enforcement Actions Cast Shadow of Ambiguity

Judge Analisa Torres’ greatly anticipated Order in the SEC’s lawsuit against Ripple is a split decision.  The Order basically finds that Ripple’s digital token XRP is a security when sold privately to individuals and institutional investors pursuant to purchase agreements, but is not a security when sold on a digital asset exchange where sellers don’t know who’s buying and buyers don’t know who’s selling.[1]  Although the Order should be perceived as at least a partial victory for crypto, it perversely upends a fundamental tenet of the securities laws which is that the laws are designed to protect those who cannot fend for themselves.  Moreover, the finding that digital tokens sold anonymously on digital asset exchanges is not a security also seems to contradict the “fraud on the market” theory of securities liability.

Continue Reading Parting the Crypto Sea:  Ripple’s XRP Ruled to be a Security When Sold to Private Investors, But Not When Sold on an Exchange

The anti-child trafficking thriller “Sound of Freedom” just opened in theatres on July 4th.  Based on a true story, it stars Jim Caviezal as former Homeland Security special agent Tim Ballard who quits his job with the agency and embarks on a mission to rescue children from traffickers in Latin America.  Another true story relating to the film is that the cost of marketing it has been funded through an equity crowdfunding campaign under Regulation CF.  What makes it even more interesting is that the investment instrument issued in this crowdfunding offering was not your typical stock, convertible note or SAFE, but rather something called a revenue participation right.

Continue Reading Revenue Participation Rights as a Crowdfunding Instrument Alternative

In the world of venture capital, there are certain investor rights that ensure the smooth execution of exit transactions.  The primary such mechanism is the drag-along provision, under which one group of stockholders agrees in advance to sell or vote their shares in a sale of the company approved by another group of stockholders and/or by the board.  Drag-along provisions often include a covenant by the drag-along shareholders not to sue over a drag-along sale, often including waivers of claims for breach of fiduciary duties.  But are fiduciary duties of directors too important to allow them to be waived by stockholders?  A recent Delaware Chancery Court decision puts guard rails on such waivers.

Continue Reading Too Big to Waive?  Enforceability of Drag-Along Covenants Not-to-Sue

A major theme of this Blog has always been ongoing legislative, regulatory and market initiatives to reform capital markets by targeting unreasonable or outdated impediments to capital formation to make it easier for early-stage companies to raise capital.  These impediments are not always obvious or direct.  One such indirect impediment has been the venture capital adviser exemption under the Investment Advisors Act of 1940, the eligibility requirements of which disincentivize VC investment in secondary transactions and in other VC funds, thereby unnecessarily hampering liquidity in the innovation ecosystem.  If a new piece of proposed legislation passed by the House Financial Services Committee becomes law, however, this impediment will be eliminated.

Continue Reading Proposed Reform of Venture Capital Fund Advisor Exemption Will Boost Startup Investment and Founder Liquidity

The collapse of Silicon Valley Bank will have enormous repercussions for startups and VCs in ways seen and unseen.  As for the unseen, SVB had deep relationships among the various players in the venture ecosystem.  Founders and investors established banking relationships with SVB in part because of the opportunities SVB provided to network within the space.  It will be difficult for other lenders who don’t have these deep relationships to replace SVB in this capacity and fill this valuable role.

Continue Reading Bumpy Ride Ahead for Startups After Silicon Valley Bank Crash