A new federal law goes into effect March 29, 2023 that conditionally exempts from broker-dealer registration persons who solely intermediate small, private company M&A deals.  Persons who intermediate larger private company M&A transactions will not be eligible for the new exemption and will need to continue to rely on the SEC’s 2014 no-action letter.  The new Federal legislation also does not preempt the states, so M&A intermediaries will need to continue to be mindful of state registration requirements.


Most brokers are required to register with the SEC and join a “self-regulatory organization” such as FINRA.  Section 3(a)(4)(A) of the Securities Exchange Act generally defines a “broker” broadly as any person engaged in the business of effecting transactions in securities for the account of others.  Ordinarily, it’s fairly easy to determine whether someone is a broker.  A person who executes transactions for others on a securities exchange is clearly a broker.   Less clear is whether a person who intermediates only private M&A transactions, often structured as acquisitions of stock or as mergers in which securities get converted, is also a broker and required to register.

When you look at the general rationale for regulating broker dealers, it’s tough to justify applying such regulation on private company M&A brokers. Broker-dealer regulation is generally designed to prevent abuses involving high pressure selling tactics and custody of funds, two features that typically don’t apply to private company M&A deals. In a typical M&A transaction, unlike a stock trade, the acquiror usually engages in its own exhaustive due diligence of the target, and the intermediary does not typically custody funds. Nevertheless, the U.S. Supreme Court in 1985 opined that an M&A transaction involving a target’s stock is deemed to be a securities transaction. Consequently, many M&A advisors began registering with the SEC as broker dealers following the 1985 opinion.

2014 No-Action Letter

Since 2014, M&A brokers have sought to rely on an SEC no-action letter (the “NAL”), in which the SEC’s Division of Trading and Markets stated that it would not recommend enforcement action to the SEC if the M&A broker who requested the letter were to intermediate the transfer of ownership of privately-held companies and refrain from engaging in certain activities identified in the NAL. The NAL listed a bunch of deal activities that would make the relief unavailable, however, including providing financing for the deal, custodying funds or securities, arranging for a group of buyers and intermediating a sale to a “passive” buyer.  All buyers would be required to control and actively operate the company or the business conducted with the assets of the acquired business. 

But reliance on SEC no-action letters generally has risks.  No-action relief is provided to the requester based on the specific facts and circumstances set forth in the request.  In some cases, the SEC staff may permit parties other than the requestor to rely on the no-action relief to the extent that the third party’s facts and circumstances are substantially similar to those described in the underlying request, but the SEC staff always reserves the right to change the positions reflected in prior no-action letters.

NASAA Model Rule

The NAL also did not preempt state regulation, however, and in 2015 (the year after the NAL was issued) the North American Securities Administrators Association adopted a model state rule intended to codify the NAL.  Only a handful of states have adopted the model rule, while a few others have enacted exclusions from the broker definition for brokers who transact solely with institutional investors or with a de minimis number of annual transactions.

New Federal Exemption

The new Federal exemption appears on page 1080 of the Consolidated Appropriations Act.  It amends Section 15(b) of the Securities Exchange Act by providing an exemption for “M&A brokers”.

M&A Brokers

M&A broker is defined as a broker engaged in the business of effecting securities transactions solely in connection with the transfer of ownership of an “eligible privately held company”.  Accordingly, a broker who intermediates private company M&A deals as well as other types of strategic transactions involving securities would not qualify.

The broker also has to reasonably believe that, as required in the NAL, the buyer in each intermediated transaction will “control” and “actively manage” the acquired company or business.  Finally, in any transaction in which the seller receives securities of the buyer as acquisition currency, the broker must reasonably believe that the seller receives, or has reasonable access to, mandated financial information of the buyer.

Control and Active Management

Exempt M&A brokers must reasonably believe the seller in each intermediated transaction will control and actively manage the target post-closing. Control is defined as the power to direct the management or policies of a company, whether through ownership, by contract or otherwise.  There is a presumption of control if the buyer has the right to vote or sell 25% or more of a class of the target’s voting securities, or in the case of a partnership or LLC, the right to receive 25% or more of the capital upon dissolution.  Although not defined, “active management” can be established if the buyer elects officers, approves the annual budget or serves as an officer.

Eligible Privately Held Company

To qualify for the exemption, brokers may only intermediate acquisitions of “eligible privately held companies”.  To qualify, the privately held company must not have any class of securities registered, or be required to file periodic reports, with the SEC.  Also, in the fiscal year ending immediately before the fiscal year in which the broker was engaged, the company must either have EBITDA of less than $25 million or gross revenues of less than $250 million.  This EBITDA and gross revenue cap is the most significant difference between the new statutory exemption and the NAL, which did not have a size of company test.  The dollar caps are subject to an inflation adjustment every five years.

Excluded Activities

To qualify and maintain the exemption, an M&A broker has to avoid engaging in each of the following activities, any of which would lead to forfeiture of the exemption: taking custody of funds, participating in a public offering of securities, engaging in a transaction involving a shell company (other than acquisition vehicles), providing acquisition financing, arranging for acquisition financing without complying with applicable regulations or disclosing compensation therefor, representing both buyer and seller in a transaction without written consent from each, facilitating the formation of a buyer group, intermediating a transfer to a passive buyer or binding a party to a transaction.

Primary Takeaways

The new federal exemption is welcome relief for middle market M&A dealmakers.  It removes the uncertainty associated with reliance on the NAL.  But the federal exemption’s utility is unfortunately somewhat limited by the arbitrary size of target limitation, which will limit the range of transactions an M&A broker will be permitted to intermediate without forfeiting exemption eligibility.  Eligible M&A brokers will also need to continue to be mindful of state registration requirements.

Will employment non-competes soon be banned nationally?  Perhaps, if the Federal Trade Commission gets its way.  Last month, the FTC issued a Notice of Proposed Rulemaking (the “NPRM”) that would prohibit just about all employment non-competes. The proposal is now going through a 60-day comment period.  If ultimately adopted in anything close to its current form and survives inevitable legal challenges, the ban will significantly impede the ability of employers to safeguard proprietary information.

Once upon a time, non-competition covenants were imposed only on senior executives and limited others who had access to proprietary company information.  But over time, employers have expanded the use of non-competes and imposed them on rank-and-file employees as well.  According to the FTC, 30 million workers are subject to non-competes.  Many of these employees don’t even know it applies to them.  The clauses are often buried in on-boarding documents which are often glossed over or not read at all.  Even if employees are mindful of it, they typically don’t have the leverage to do anything about it.

There are certain limited exceptions built into the proposed rule.  Most notably, the ban would not apply in the context of a sale of a business, a concession that non-competition covenants from sellers of a business may be necessary to protect the value of the business acquired by the buyer.  But the exception is limited to “substantial” owners of the business entity being acquired. The rule would define “substantial” as owning at least a 25% ownership interest.  The NPRM states that designating a percentage provides more certainly to selling business owners and their buyers but provides no rationale for the arbitrary percentage threshold other than to say that “51% may be too high” and that 25% strikes the right balance.  Sounds like Goldilocks.

The ban would also except out those in franchiser/franchisee relationships, certain banks, savings and loan institutions, federal credit unions, common carriers, air carriers, non-profits and state and local governments.

In reaction to the proposed ban on non-competes, employers may seek to protect their proprietary information through other post-termination restrictive covenants.  These include non-disclosure agreements, non-solicitation agreements and no-business agreements, the latter of which prohibit an employee from doing business with former clients or customers of the employer, whether or not solicited by the employee. These other restrictive covenants affect the way an employee may compete with a former employer post-termination, but don’t prevent the employee from competing with the former employer altogether or other employers from competing for that employee.  Nevertheless, the FTC in the NPRM expressed concern that some employers may seek to evade the requirements of the proposed rule by implementing other restrictive covenants that are so restrictive as to constitute “de facto non-compete clauses”. Accordingly, under the proposed rule, these “functional equivalents” would also be included within the scope of the ban, whether drafted for purposes of evasion or not.

Notably, there would be no grandfathering of existing agreements.  The proposed rule would also prohibit maintaining existing non-compete covenants and require companies to rescind any previously executed non-compete agreements. If companies do not do so, they would be found to be engaged in unfair competition.   To lessen the burden of the rescission requirement, however, the FTC is proposing a safe harbor under which employers would satisfy the requirement by notifying relevant employees that their non-compete is no longer valid, and offers the following proposed language that could be included in the notice:

“A new rule enforced by the Federal Trade Commission makes it unlawful for us to maintain a non-compete clause in your employment contract. As of [180 days after date of publication of the final rule], the non-compete clause in your contract is no longer in effect. This means that once you stop working for [Employer Name]:

· You may seek or accept a job with any company or any person—even if they compete with [Employer Name].

· You may run your own business—even if it competes with [Employer Name].

· You may compete with [EMPLOYER NAME] at any time following your employment with [Employer Name].

The FTC’s new rule does not affect any other terms of your employment contract.

For more information about the rule, visit [link to final rule landing page].”

The proposed rule is not unanimously supported within the FTC.  In her dissenting statement, Commissioner Christine S. Wilson questioned the FTC’s authority to issue the rule and asserted the proposed federal ban would constitute a sharp departure from hundreds of years of precedent for fact-specific inquiry.  Only three states – California, North Dakota and Oklahoma – have made employment non-competes unenforceable for nearly all workers.  The other 47 states apply a fact specific reasonableness analysis and recognize as a legitimate interest the protection of an employer’s trade secrets.  These states generally recognize an employer’s interest in protecting its investment in training or in preventing a worker who provides “unique” services from working for a competitor.  On the other hand, courts in these states will generally not enforce non-competes that prohibit a greater scope of activity than necessary to protect the employer’s legitimate interests, generally when the covenants cover a geographic area more extensive, or last longer than needed, to protect those interests.  Some states, including Illinois and Washington, have passed laws limiting the use of non-competes among low-wage workers.

The substantive arguments cut both ways.  The FTC contends that non-compete clauses decrease competition for workers resulting in lower wages, prevent new businesses from forming and stifle entrepreneurship and innovation.  According to dissenting Commissioner Wilson, however, studies in this area are scant and have produced mixed results. The FTC also contends that employers can use NDA’s and non-solicitation covenants to protect proprietary information which don’t generally prevent workers from competing with former employers.  But NDAs and non-solicitation covenants in the absence of non-competes are largely effective only in theory.  In the real world, proprietary information could be disclosed by a former employee to a competitor long before the former employer discovers it, if he discovers it at all.

The public is encouraged to communicate comments to the FTC during the comment period which expires March 10, 2023.  Comments may be submitted here.  The FTC appears to have the necessary majority to adopt the new rule and will likely do so with some modifications based on submitted comments.  Litigation will certainly follow, if not commenced even before adoption.  Nevertheless, employers should perform a review of their employment agreements and other documents containing restrictive covenants to determine what modifications will need to be made in light of the proposed non-compete ban.  Employers should also be mindful that NDAs and non-solicitation covenants may also be prohibited if they are deemed too restrictive under the standards set forth in the rule.

“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” Such was the lament of John Ray, the legendary restructuring executive tasked with the unenviable assignment of serving as the caretaker CEO of bankrupt FTX Trading Ltd.  As the criminal and civil cases by the DOJ, SEC and CFTC against FTX founder and former CEO Sam Bankman-Fried play out in the courts, what does the “complete failure of corporate controls” at FTX teach us about corporate governance, unchecked founder control and the importance of proper oversight?

Factual Background

In 2017, Sam Bankman-Fried aka SBF co-founded Alameda Research LLC, a quantitative trading firm specializing in crypto assets.  Two years later, he founded FTX Trading Ltd. to operate a global crypto asset trading platform.  FTX then raised nearly $2 billion in four preferred stock funding rounds, during which it and SBF represented to prospective investors that FTX had appropriate controls and risk management mechanisms to protect customer assets, that those assets were safe and that Alameda was just another platform customer with no special privileges.  It turns out that Alameda was exempt from whatever risk mitigation measures were put in place and was given significant special treatment on the FTX platform, including a virtually unlimited line of credit unwittingly funded by the platform’s customers. Also unbeknownst to FTX’s investors and trading customers was that SBF improperly diverted billions of dollars of customer assets to Alameda, and then used those funds to make risky venture investments, purchase Bahamian real estate for himself, his parents and other FTX executives, extend big loans to FTX executives (including SBF himself) and make large political campaign donations (he was the second largest donor to Democrat campaigns in 2022 behind only George Soros).  None of this was disclosed to FTX investors or customers.

According to the SEC’s complaint, SBF’s “house of cards” began to crumble in May when crypto asset prices plummeted.  Lenders demanded repayment of loans made to Alameda, and SBF directed Alameda to draw down billions of dollars from its “line of credit” from FTX to repay some of those loans.  He also used those proceeds for additional venture investments and loans to himself and other FTX executives.  In November, Binance, the world’s largest crypto exchange by volume, announced it will sell off its substantial holdings of FTX’s native token FTT (received in connection with the buyout of Binance’s 2021 investment in FTX), which caused the price of FTT to crater.  FTX then entered into an LOI with Binance for Binance to acquire FTX, subject to due diligence.  The next day, Binance announced it wasn’t going to proceed with the transaction because of issues it uncovered as part of its due diligence which were beyond its ability to help, as well news reports regarding mishandled customer funds and alleged Federal agency investigations.  Faced with billions of dollars in customer withdrawal demands that FTX could not fulfill, FTX, Alameda and their affiliated entities filed for bankruptcy.

Related Party Transactions

From time to time, a company may have opportunities to do business with other entities that happen to be controlled by a director, officer or large stockholder of the company.  Such related party transactions pose inherent risks to a company, namely that the related party will receive favored terms to the detriment of the company and its stockholders.  Investors typically seek to guard against this risk in two general ways.  First, by identifying at the outset during due diligence whether any related party transactions exist and whether adequate safeguards are in place to ensure that the terms of any such transactions are no less favorable to the company than could be secured in arms’ length transactions.  Second, by negotiating for enhanced safeguards going forward to ensure that any such proposed transactions are properly vetted.

Two of the most effective mechanisms that investors negotiate for to mitigate against the risk of related party transactions are board representation and director vetos.  As to the former, board representation proportionate to equity ownership is generally considered fair.  For example, if a VC owns 25% of a company’s outstanding shares and the board consists of eight seats, it would be fairly typical for that VC to have the right to designate two directors on that eight person board.  That board representation right would be set forth in the company’s amended and restated certificate of incorporation.  Director vetos are typically set forth in an investors’ rights agreement between the investors and the company, which identifies a list of designated transactions that require the affirmative vote of the investor’s board designee(s).  A typical director veto provision of this sort would look like this:

Matters Requiring Investor Director Approval.  So long as the holders of Series A Preferred Stock are entitled to elect a Series A Director, the Company hereby covenants and agrees with each of the Investors that it shall not, without approval of the Board of Directors, which approval must include the affirmative vote of the Series A Director,…enter into or be a party to any transaction with any director, officer, or employee of the Company or any “associate” (as defined in Rule 12b-2 promulgated under the Exchange Act) of any such Person.”

Looking the Other Way?

John Ray’s Declaration in the FTX bankruptcy case identifies “unprecedented” breakdowns in governance, oversight and controls.  Among these were the absence of investor representation on the board, which in turn meant FTX was not required to obtain investor director approval for related party transactions.  How did the VCs allow for this?

According to Bloomberg, the preferred stock investors in FTX included such VC luminaries as Sequoia Capital, Lightspeed Venture Partners, Iconiq Capital, Insight Partners, Thoma Bravo and SoftBank Group Corp., none of whom served as lead investor.  With no lead investor, none of the VCs had the leverage to dictate terms.  Also, all of the VCs made their investment in FTX when investor fervor for cryptocurrency startups hit an all-time high, giving those startups significant leverage. 

It appears that FTX used its leverage to thwart any meaningful due diligence that could have identified the existing conflict with Alameda, as well as any effort to negotiate for board representation and director vetos.  According to The Wall Street Journal, when Sequoia and other VCs “asked for a seat on the company’s board of directors, Mr. Bankman-Fried repeatedly pushed back, telling them their ownership in the company was too small to warrant it”.  Maybe the VCs didn’t press the issue.  Or maybe they did, but SBF was too busy playing League of Legends during the meeting at which the board representation proposal was made, just as he reportedly did while originally pitching Sequoia.

Or maybe the VCs were too smitten with SBF that they didn’t want to know.  SBF had cultivated an image of a responsible, visionary leader of the crypto industry. He characterized FTX and himself as playing an important role in stabilizing the industry, and seemingly backed that up by providing credit to and taking over other failing crypto firms.  During SBF’s pitch to Sequoia, a Sequoia partner reportedly typed “I LOVE THIS FOUNDER” to his colleagues. An inspiring founder can overwhelm otherwise cautious investors who end up abstaining from due diligence.  Also, as I mention above, SBF was a top campaign contributor to Democrats. He also hired multiple former regulators to serve in senior positions at FTX, and his parents are both professors at Stanford Law School.

For its part, Sequoia insists that it performed adequate due diligence and that, in any event, its fund that invested in FTX had $7.5 billion worth of gains and that the FTX investment accounted for less than 3% of the committed capital for that fund.  Fair enough.  The damage may not be material to Sequoia and its limited partners.  But the FTX debacle is devastating to tens of thousands of individuals who may have viewed Sequoia’s and the other VCs’ investment in FTX as a seal of approval. 

In Noam Wasserman’s The Founder’s Dilemmas, he describes a key tradeoff that entrepreneurs face: they can be rich or they can be king. By that he meant that if an entrepreneur insists on maintaining complete control, his company is less likely to grow because he’ll have trouble raising capital, attracting key employees and achieving growth. If he raises capital to maximize growth potential, he’ll need to give up some control.  Wasserman shows how all parties benefit from a proper growth-control tradeoff.  Founders benefit from oversight because it makes the company more credible and thus more investable and ultimately more valuable.  For the same reasons, oversight also helps investors and employees.  As we see from the FTX fiasco, unchecked founder control runs the risk of value destruction.  

Just last week, special purpose acquisition company The Music Acquisition Corporation (“TMAC”) called a special meeting of its stockholders.  It wasn’t the special meeting it originally envisioned.  TMAC was launched in February 2021 by long-time Geffen Records President Neil Jacobson to acquire a music business with the $230 million of SPAC IPO proceeds it raised.  The special meeting it envisioned at that time was one to approve an acquisition of a music company.  Instead, the special meeting to be held on November 30 is for the stockholders to approve an early liquidation of the SPAC and the return of remaining IPO proceeds to the stockholders.

TMAC is not alone in calling for early liquidation.  CNBC reports that 27 SPACs worth $12.8 billion have been liquidated so far this year through mid-October.  Along with this spate of SPAC liquidations, 143 SPAC IPOs have withdrawn this year and 46 de-SPAC transactions (acquisitions of operating companies by SPACs) were terminated.  This is an incredible turn of events from the SPAC hysteria we went through in 2020 and most of last year, when SPACs constituted more than half of the record number of IPOs.

One way that SPAC sponsors got lots of investors to invest in SPACs in the first place is by giving them redemption rights.  A SPAC investor may opt out of a proposed de-SPAC transaction and be entitled to his pro rata share of the IPO proceeds which are required to be held in trust.  Another investor protection is that a SPAC must liquidate and distribute those proceeds to the SPAC investors if it fails to complete a de-SPAC acquisition within a set timeline, typically two years. That two-year deadline has proven to be a ticking time bomb:  too many buyers chasing too few viable targets.

The increasing propensity of SPAC investors to seek redemption has created multiple problems for SPACs and their sponsors.  A standard condition to a target’s obligation to close a de-SPAC transaction is that there be a minimum amount of combined cash available from the trust account and from PIPE investments (private investments in public equity).  When aggregate redemptions get too big, the SPAC may fail to satisfy the cash condition, causing the de-SPAC transaction to crater.  Even if a de-SPAC transaction is able to close, excessive redemptions may threaten the financial viability of future operations of the post de-SPAC operating company because of the lack of available cash.  And more redemptions also mean a smaller stockholder base, which results in reduced liquidity in the surviving company’s stock.

The sponsor faces significant losses as well.  First, the transaction fees associated with effecting the IPO, sourcing, performing due diligence on, negotiating and documenting potential de-SPAC deals and getting them past the SEC regulatory process is an enormously expensive process and represents sunk costs to the sponsor; those expenses are not paid out of the trust account. These transaction fees have been estimated to average approximately $5-$10 million.  Second, the typical 20% promote to the sponsor in the form of shares in a de-SPAC’ed company is only worth something if an acquisition deal gets done.  If the SPAC fails to acquire an operating company and is forced to liquidate, the SPAC’s public shareholders at least get the IPO proceeds back with interest; the sponsor neither shares in the trust proceeds nor benefits from the 20% share allocation.  

But redemptions aren’t the sole cause for the recent string of SPAC liquidations. Another reason being cited by sponsors for liquidating now is the new excise tax under the Inflation Reduction Act, which imposes a 1% excise tax on any domestic corporation that repurchases its stock after December 31, 2022.  TMAC cited the excise tax as the primary reason it was seeking stockholder approval for a charter amendment to accelerate its liquidation.  Under its certificate of incorporation, TMAC could not otherwise liquidate until after the designated two-year deadline for completing a deal, or February 5, 2023.

A sponsor facing excessive redemptions has few options.  Sponsors will be loath to let a possible deal fall through and will thus have every incentive to negotiate with individual investors in an effort to change their minds regarding redemption.  This likely means some kind of concession from the sponsor, often in the form of a cut-back in the sponsor’s share allocation, typically 20%, in the company post-acquisition.  In fact, sponsors are getting squeezed on both ends as competition has been stiff among SPAC sponsors for targets.  This means sponsors are also under pressure to sweeten the pot for potential target companies by offering to decrease the 20% promote even further. Alternatively, the sponsor could seek supplemental funding to make up for the redemptions, either in the form of additional acquisition financing or as a line of credit post-closing to fund ongoing operations.

2022 was predicted by many to be the year of the red wave (turned out to be more of a red ripple).  It may be better remembered for another wave beginning with the letter “R”: a redemption wave.  Over the next few weeks, I expect to see those sponsors who are sitting on signed merger agreements trying to negotiate with SPAC shareholders to stem the tide of redemptions in an effort to satisfy cash closing conditions and close their de-SPAC transactions.  On the other hand, sponsors further away from consummating a de-SPAC transaction will have few good options and will be under enormous pressure to liquidate this year before the excise tax kicks in.

Elon Musk has lobbed in two additional termination letters since his original July 8 letter seeking to terminate his agreement to acquire Twitter for $44 billion.  Each termination letter cites alleged false representations and blown covenants by Twitter in the merger agreement, purportedly justifying termination.  Twitter’s response to each letter has been the equivalent of saying: “So what?”.

Musk’s first termination letter alleged that Twitter overstated the number of its monetizable users, understated the percentage of users that are fake accounts or bots and failed to provide information Musk needs to complete the transaction or to secure financing.

Musk’s second termination letter was sent after the Washington Post published a whistleblower report to Congress, the SEC, the FTC and the DOJ filed by Peiter “Mudge” Zatko, Twitter’s former chief security officer, on July 6, 2022.  The second letter asserts that the allegations in the whistleblower report, if true, would demonstrate Twitter violated several provisions of the merger agreement.  The allegations include that Twitter has been violating an FTC consent decree requiring the company to maintain a comprehensive information security plan (purported breach of the representation that Twitter is in compliance with applicable laws), that it failed to disclose in SEC documents the significant privacy, data protection, safety and cybersecurity risks Mr. Zatko alerted the board to (purported breach of the representation that Twitter’s SEC filings were truthful), that Twitter’s CEO presented false information to the board to cover up vulnerabilities in Twitter’s security and data protection infrastructure (purported breach of the representation regarding disclosure controls and procedures), that Twitter is facing multiple regulatory investigations relating to privacy and cybersecurity (purported breach of the representation that there are no threatened lawsuits that would constitute a material adverse effect), and that Twitter never acquired the rights to its core machine learning models (purported violation of the representation that Twitter was not infringing on anyone else’s intellectual property).

The third termination letter, dated September 9, 2022, asserts that Twitter’s $7.75 million severance payment to Mr. Zatko (the whistleblower) violated Twitter’s merger agreement covenant not to make any severance payments prior to closing other than in the ordinary course of business and consistent with past practice, in each case without Musk’s consent.

Normally, you don’t get to pile on to a previously delivered termination letter by sending subsequent letters with additional or alternative allegations.  Musk is maintaining in his second and third termination letters, however, that new facts have come to light since the previous termination letter(s) (i.e., the whistleblower allegations and severance payment) that provide additional and distinct bases to terminate the merger agreement.

Twitter’s responses to the second and third termination letters begin with a perfunctory denial of the allegations that it is in breach of the merger agreement.  But the thrust of its response to each of the letters is the same:  that the purported termination by Musk is invalid because (even if the allegations about Twitter are true) Musk himself has violated numerous obligations under the merger agreement, which serves to contractually prevent him from terminating the agreement.  Under Section 8.1(d) of the merger agreement, Musk’s right to terminate over a breach by Twitter of any representation or covenant is conditioned on one major requirement: that Musk himself not be in material breach of any of his representations, warranties or covenants in the agreement.

And what obligations does Twitter allege Musk breached?  First, his obligation to use reasonable best efforts to complete the merger.  Second, his “hell-or-high-water” covenant requiring him to do all things necessary to consummate and finalize the acquisition financing.  Third, to provide Twitter with information regarding the status of debt financing.  Fourth, to refrain from unreasonably withholding consent to operational decisions (e.g., by unreasonably withholding consent for employee retention programs).  Fifth, to seek Twitter’s consent for public comments about the deal.  Sixth, to refrain from disparaging Twitter or its representatives in tweets about the merger.  And finally, not to misuse Twitter’s confidential information.

It will be interesting to see how all this plays out in the trial, expected to begin October 17.  Although Chancellor McCormick denied Musk’s motion to delay the start date, she did allow him to add the whistleblower claims to his countersuit.  There will be a lot of arguing about whether any of the allegations by Musk constitute misrepresentations by Twitter and if so whether any such misrepresented matters would have a material adverse effect on the company.  His best shot would seem to be the $7.7 million severance payment to Mr. Zatko if Musk could prove it was not in the ordinary course of business or consistent with past practice.  That would be a covenant breach, and unlike representation breaches, he would not need to also prove material adverse effect.  In any event, Twitter will then invoke the unclean hands provision of Section 8.1(d) by seeking to establish that Musk himself is in violation of his own covenants, which seemingly would deny Musk the ability to terminate over any Twitter breach.

Two startups with competing, equally compelling technologies at the same stage of development are pitching venture capital investors for Series A funding.  One startup is led by a serial entrepreneur founder, the other by a novice.  Assume each will get funded.  In all likelihood, the deal will happen quicker and the amount funded and pre-money valuation will be higher for the serial entrepreneur led startup than its novice competitor.  That according to Pitchbook’s latest report (the “Report”) on the impact of entrepreneurial experience on the venture capital ecosystem, which finds that founder experience has a material impact on VC fundraising.  Moreover, this disparity among serial and novice entrepreneurs actually grows as startups progress through the capital raising lifecycle.  But does this apparent advantage enjoyed by serial entrepreneurs come at any cost?

To build a successful startup, an entrepreneur needs to be able to assemble and manage a strong team, raise capital and execute a business plan.  Some of the skills necessary to pull this off an entrepreneur may be born with, while other skills may be acquired in the classroom.  But much of what characterizes a successful entrepreneur is intangible and learned in the process of doing, and for that reason an entrepreneur who has previously started up is perceived to have a more complete set of skills and more likely to build a successful startup.  In the course of building his first company, an entrepreneur has also likely developed relationships with a diverse community of professionals whose services will be important in building a subsequent company as well, such as angel and venture capital investors, corporate finance lawyers, scientific advisers and human resource experts.  And if he’s previously executed an exit, the entrepreneur’s contacts would also include exit specific professionals such as investment bankers, underwriters and mergers and acquisitions lawyers.

So it should come as no surprise that the Report finds that serial entrepreneurs (repeat entrepreneurs with one or more previous exits) raise VC rounds earlier in each stage of the startup’s corporate life than novices or even unproven serial entrepreneurs (repeat entrepreneurs who have not yet exited).  The median number of years between founding and first VC round for serial entrepreneurs remained at 1.13 years as compared with Pitchbook’s 2019 study, and the median period of time for unproven and novice founders increased to 1.34 and 1.92 years, respectively.

Serial entrepreneurs also enjoy an advantage in terms of deal size.  Median angel and seed[1] deal sizes for serial entrepreneurs in 2022 year-to-date were 2.5 times larger than novice-led deals, while early- and late-stage rounds led by serial entrepreneurs were roughly 3.4 times larger.

Valuations are also progressively higher for serial entrepreneur-led startups.  Pre-money valuations for serial entrepreneur-led startups had median valuations that were 1.9 times higher than those of novice-led companies, with the variances between serial and novice entrepreneurs increasing to 2.5 times for early stage rounds and 3.7 times for late stage deals.

The larger divergence in deal size and pre-money valuations between serial and novice entrepreneurs in later stages vs. the angel and seed rounds suggests that even the emergence of objective performance metrics in later rounds such as market proven products and demonstrated revenue growth cannot overcome the inherent investor confidence afforded to serial entrepreneurs.  The Report also suggests that the seed stage fundraising momentum that serial entrepreneurs benefit from could be allowing their startups to mature more quickly and display stronger financial performance than novice-led companies, thus leading to an even greater deal size disparity in later stage rounds.  The exit track record of a serial entrepreneur may be even more valued in later rounds as exit comes more into focus.

Earlier, larger and higher valuation rounds enable serial entrepreneur-led startups to scale and exit faster.  But the Report points out that this advantage comes with a price: dilution.  Bigger deal sizes in early rounds when valuations are lower than they would be in later rounds means larger amounts of equity are being issued to investors, resulting in greater dilution to the founders.   During angel and seed funding stages, serial entrepreneurs are giving up a greater percentage of the equity in their company, nearly 2% more than unproven entrepreneurs and 6% more than novices. This trend is maintained in early stage deals (Series A and B).  Apparently, the higher pre-money valuations given to serial entrepreneur-led startups are not enough to offset the effect of larger amounts being raised at low-valuation points in the corporate cycle.  The trend reverses course in late stage rounds, however, as much higher pre-money valuations result in less equity being issued to the investor for any given amount of investment in late stage rounds and less dilution to the founder.

A related question is whether prior exits alone are a reliable predicter of startup success.  In a 2016 Harvard Business Review piece entitled “Why Serial Entrepreneurs Don’t Learn from Failure”, the authors focus on the concept of overoptimism in relation to failure.  The authors find that overoptimism is a trait shared by most entrepreneurs, but that serial entrepreneurs are just as likely to be overoptimistic after failure as before, which poses a significant risk for investors who fund serial entrepreneur-led startups.  Although overoptimism is generally helpful in founding a startup, it can also help cause it to fail if it is associated with a greater tendency to commit to and overinvest in risky projects, to neglect to plan for the unexpected and to throw good money after bad while postponing the inevitable.  The authors argue that experiencing failure helps temper this overoptimism among some entrepreneurs, but not serial entrepreneurs.


[1] Here’s how Pitchbook generally identifies the stages of startup funding:

    • “angel round”: if there are no VC funds on the company’s cap table and it’s unclear whether any VC fund participated in the round, or if a press release identifies the round as an angel round or only mentions individuals as investors.
    • “seed round”: if the investors and/or press release state that a round is such, or if it is for less than $500,000 and is the first round as reported by a government filing.
    • “early stage”: Series A or B.
    • “late stage”: Series C or higher.

What do founders, employees and investors in privately held companies all have in common?  Limited opportunity to sell their shares.  That’s because of various legal, contractual and market factors that impede the sale of such securities, so liquidity is usually limited to acquisition of or public offering by the company. In recent years, there’s been a push to facilitate secondary market trading of private securities, and the Securities and Exchange Commission’s Small Business Capital Formation Advisory Committee has scheduled a meeting for August 2 to discuss how to improve liquidity in private companies.

So what are those legal, contractual and market impediments?

Securities Laws

All sales of securities in the United States, whether by companies in primary offerings or by shareholders in secondary offerings, must either be registered with the SEC or satisfy the requirements for an exemption from registration.  With rare exceptions (basically resales by institutional investors (e.g., venture capital funds) with leverage to negotiate registration rights in advance), SEC registration is too expensive and time consuming to be a viable alternative.

The most obvious resale exemption is under Section 4(a)(1) of the Securities Act of 1933 for sales by anyone other than an issuer, underwriter or dealer.  A founder, employee or investor is clearly not an issuer, and would not be deemed a dealer so long as he or she isn’t buying and selling securities as a business.  The real issue is whether the seller is an “underwriter”, broadly defined as anyone who has “purchased from an issuer with a view to … the distribution of any security”.

Because of the ambiguity in the definition of “underwriter”, the SEC promulgated Rule 144, a safe harbor, meaning if the specific requirements of the rule are satisfied the seller will not be deemed to be an underwriter for the purpose of Section 4(a)(1).  The rule applies differently to different sellers, depending on whether or not they are affiliates of the issuer and depending on whether the issuer is an SEC reporting company.  A non-affiliate seller need only satisfy the holding period, which for restricted securities is six months for shares in a reporting company and one year for a non-reporting company.  An affiliate, on the other hand, must satisfy the holding period, volume limitation, manner of sale and information requirements.

Contractual Restrictions

Private issuers typically require shareholders to sign agreements containing various restrictions on transfer.  These may include prohibitions on transferring shares without company consent, rights of first refusal in favor of other shareholders and/or the issuer and tag along or co-sale rights in favor of other investors allowing them to sell their shares pro rata with any sale by the shareholder.  Many companies also impose restrictions on insiders selling shares while in possession of material non-public information.  Any Seller seeking to comply with such insider trading restrictions by providing company information to a buyer would need to be mindful of impediments under confidentiality agreements.  In addition to making it harder to sell, these contractual restrictions tend to depress price for selling holders and increase cost for companies, which must monitor compliance with applicable law, gather and provide information, review transfer documentation and provide legal opinions.

Market Factors

Despite the proliferation of funding portals and other platforms for issuers and investors to find each other, secondary markets remain underdeveloped.  Much of that I suspect has to do with the lack of transparency in secondary market transactions.  As I mention above, non-affiliates selling under Rule 144 need not satisfy the rule’s information requirement.  That’s good for the seller, but the lack of transparency makes the shares less attractive to potential buyers.  Even if a seller would be inclined to volunteer company information, his ability to do so would largely depend on the company’s willingness to cooperate in providing the information and waiving disclosure restrictions.

Small Business Capital Formation Advisory Committee

The SEC’s Small Business Capital Formation Advisory Committee last week released the agenda for its virtual meeting on Aug. 2, which will address liquidity challenges for investors in private companies.  Under the released agenda, the Committee will explore (i) what exit opportunities exist for investors in Regulation A and Regulation Crowdfunding deals where the companies continue to provide ongoing reports, (ii) what secondary market liquidity challenges private and smaller public companies and their investors encounter, and (iii) what changes could help facilitate secondary liquidity for these investors.

Another week, another chapter in the Elon Musk-Twitter saga.  Last month, Musk posted tweets questioning longtime Twitter claims that automated “spambots” make up fewer than 5% of monetizable daily active users.  But on June 6, Musk upped the ante by having his lawyers at Skadden send a demand letter to Twitter reiterating his demand for data he claims is necessary to facilitate his independent evaluation of spam and fake accounts on the company’s platform, which he asserts the company is required to provide under the merger agreement.

So what are those merger agreement provisions that would require Twitter to provide the requested information?  There are two relevant provisions.

Section 6.4, Access to Information, obligates Twitter to provide Musk with “all information concerning the business … of the Company … as may reasonably be requested … for any reasonable business purpose related to the consummation of the transactions contemplated by this Agreement”.  One plausible way to link the information needed to evaluate the prevalence of spam and fake accounts to consummation of the closing is through Twitter’s representation in the agreement regarding its SEC filings.  Twitter represented that its SEC filings since January do not contain any material misstatements or omissions.  Twitter disclosed in its most recent 10-Q, that based on its internal review of a sample of accounts, it estimated that false or spam accounts represented fewer than 5% of its monetizable daily active users.  Twitter carefully hedges that estimate by stating that in making that determination, it “applies significant judgment, so [its] estimation of false or spam accounts may not accurately represent the actual number of such accounts, and the actual number of false or spam accounts could be higher than … estimated”.  Musk’s suggestion that the percentage of spambots may be significantly higher is an indirect allegation that Twitter has breached its SEC filing representation in the merger agreement.  In any event, a condition to Musk’s obligation to consummate the transaction is that all of Twitter’s representations be materially true as of the closing.  Hence, the information requested by Musk is arguably “related to the consummation” of the merger because it enables Musk to determine whether Twitter has breached one its representations, and consequently whether Musk may terminate the agreement.

The other provision of the merger agreement that Musk’s lawyers assert obligates Twitter to provide the requested fake account analysis information is Section 6.11, Financing Cooperation.  That section of the agreement generally obligates Twitter to “provide any reasonable cooperation reasonably requested by [Musk] in writing in connection with [his] … debt financing”.[1]

The Skadden letter ends ominously by stating that Musk reserves his rights resulting from Twitter’s alleged information covenant breach, including his right to terminate the merger agreement and not proceed with the acquisition.  Musk has the right to terminate the agreement if Twitter breaches any of its obligations in the agreement (including the covenant to provide information) and the breach is not cured within thirty days following notice.  The Skadden letter could be deemed to be such notice, which means Musk, assuming he prevails in his allegations of breach, may be able to terminate the agreement on or about July 6.

Or maybe not.  Built into the information and cooperation covenants are a bunch of carveouts which Twitter may be able to rely on as a defense.  Most relevant is that Twitter has no obligation to provide the information required under Section 6.4 if doing so would cause significant competitive harm to Twitter if the acquisition doesn’t close.  In the past, Twitter CEO Parag Agrawal has said he “doesn’t believe that the … [bot] estimation can be performed externally, given the critical need to use both public and private information (which we can’t share).”  Similarly, the financing cooperation covenant in Section 6.11 provides that Twitter is not required to disclose any material, non-public information except under agreed upon confidentiality arrangements.  The Skadden letter, for its part, makes a point of saying that anyone reviewing the data would be bound by a non-disclosure agreement, and that Musk would not use any competitively sensitive information if the acquisition doesn’t close.

Ironically, it’s possible Musk may have breached the merger agreement by prematurely alleging a violation by Twitter of the financing cooperation covenant.  Section 6.11 states that Twitter will be deemed to be in compliance with the covenant unless Musk’s failure to obtain the debt financing was due solely to a material breach by Twitter of its obligations under that section.  It also states that Musk may not even allege that Twitter is not in compliance with Section 6.11 unless the same condition applies, i.e., that Musk’s failure to obtain the debt financing was due solely to a material breach by Twitter of its obligations under the section, which implies that he can’t even make the allegation unless the debt financing has fallen through, which it hasn’t.

[1] The Skadden demand letter states the contractual obligation to provide cooperation in connection with the debt financing includes “providing information ‘reasonably requested’ by Mr. Musk”, but I don’t see that specific requirement in Section 6.11 of the merger agreement.

In what seems like one of the speediest transaction processes ever for a deal of its size, Twitter agreed on April 25, 2022 to be acquired by Elon Musk for $54.20 per share or about $44 billion.  It all started with Musk disclosing on April 4 that he had taken a 9.2% stake in Twitter, followed by Twitter announcing the next day that it will appoint Musk to the board, Musk declining the appointment around April 11 and offering on April 13 to buy the company for $54.20 per share, Twitter adopting a poison pill on April 15, Musk announcing on April 21 he had secured $46.5 billion in funding commitments and finally the announcement on April 25 that the parties had signed a merger agreement (the “Merger Agreement”).  Only 12 days elapsed between offer and signing, and only four days between the funding announcement and signing.  That’s about as speedy a transaction as a SpaceX rocket.

Elon Musk’s acquisition of Twitter (the “Acquisition”) is structured as a reverse triangular merger, meaning that a shell subsidiary of the acquirer (or of an entity controlled by the acquirer) merges into the target with the target surviving as a wholly-owned subsidiary of the acquiring entity.  Musk formed two entities to effectuate the merger, X Holdings I, Inc. (“Parent”) and its wholly-owned subsidiary, X Holdings II, Inc., which will merge into Twitter at the closing with Twitter surviving as a wholly-owned subsidiary of Parent.  Parent is wholly owned by Musk.

Poison Pill Exemption

Before signing the Merger Agreement, Twitter first had to exempt Musk from the poison pill the company adopted in the form of a preferred stock rights agreement.  Under the rights agreement, if anyone crossed a 15% ownership threshold, all stockholders other than the 15% holder would have had the right to buy new shares at a 50% discount, resulting in massive dilution to the acquirer. The purpose of the poison pill/rights agreement was for the Twitter board to buy time and build leverage by effectively forcing Musk to negotiate with the board rather than launch a tender offer directly to the stockholders.   A useful feature of the rights agreement is that the board retained the right to amend the agreement without the consent of the rights holders. To avoid having the Acquisition trigger the pill, Twitter amended the rights agreement on April 25 to provide that neither the execution of the Merger Agreement nor the Acquisition itself will trigger the pill.

Material Adverse Effect

From the outset, Elon Musk’s offer for Twitter generated a great deal of skepticism.  He didn’t have either the cash or (initially) the funding, and his own credibility was called into question, not least because of his infamous 2018 tweet that he was “considering taking Tesla private … funding secured”, for which he was sued by the SEC for securities fraud.  So the Merger Agreement contains several features that are intended to protect Twitter and its stockholders from Musk walking away.

Most acquisition agreements allow the buyer to walk away if the target has suffered a material adverse effect (“MAE”) between the signing of the agreement and the closing.  The devil in this detail is what exactly constitutes a MAE.  The current trend with MAE clauses, particularly when the seller has some amount of leverage, is to include a long list of specific circumstances that are expressly stated to not constitute a MAE.

The Merger Agreement contains nine such MAE carveouts: (i) changes to the industry, (ii) changes to any law or to GAAP, (iii) general economic, regulatory or political conditions, or in the financial, credit or securities markets, in the U.S. or anywhere in the world, (iv) any act of God, force majeure, terrorism, cyberattack, war, etc., (v) any epidemic pandemic (including COVID-19), any measures in reaction thereto, or any political or civil unrest, (vi) the negotiation, execution, announcement or consummation of the Merger Agreement, including the identity of Elon Musk or his financing sources, (vii) any action taken pursuant to the Merger Agreement or will the consent of Musk or his affiliates, (viii) changes in Twitter’s stock price or trading volume, failure to meet analyst estimates or credit rating changes (unless thing giving rise to the foregoing is itself a MAE not otherwise excluded), and (ix) anything previously disclosed in an SEC filing.

Reverse Breakup Fee

Buyers often seek to protect themselves against the target terminating the deal and agreeing to be acquired by a third party bidder making a superior offer.  The standard protection for buyers in this regard is a breakup fee that the seller would be required to pay to the buyer if the seller accepts such a third party offer.  Sellers, on the other hand, also have an interest in protecting themselves against a buyer walking away other than for failure of the target to satisfy a condition to closing.  The remedy to the seller is referred to as a reverse breakup fee, payable by the buyer.

The Merger Agreement requires Musk-owned Parent to pay Twitter a reverse breakup fee equal to $1 billion if the conditions to Parent’s obligations to close are satisfied and Parent nevertheless fails to close, or if Parent breaches any of its representations, warranties or covenants in a manner that would cause a closing condition to not be satisfied.  Importantly, Elon Musk agreed to provide a limited guarantee in favor of Twitter to back up Parent’s obligation to pay the reverse breakup fee.  The Merger Agreement also requires Twitter to pay a breakup fee to Musk if Twitter enters into a definitive agreement with a third party bidder for a “superior proposal”, defined as a proposal to acquire at least 90% of Twitter or of its assets that the Twitter board determines in good faith is more favorable to Twitter’s stockholders than the Musk offer.

Ordinary Course Covenant

Buyers also typically seek protection against a target making significant changes to its business or its assets between signing and closing, such as terminating employees, customers or suppliers.  The applicable protection here is in the form of a covenant to operate the target in the ordinary course in between signing and closing, coupled with a right to terminate if this covenant is breached.

The Merger Agreement’s ordinary course covenant, however, has two important features that protect Twitter against Elon Musk using ordinary course as an excuse to walk away.  First, Twitter’s obligation with regard to operating in the ordinary course is qualified by “commercially reasonable efforts”, i.e., it must use “its commercially reasonable efforts to conduct the business of [Twitter] in the ordinary course of business”.  Many practitioners believe that “best efforts”, “reasonable efforts” and “commercially reasonable efforts” represent a hierarchy of standards to determine the level of effort that must be employed by the target to satisfy its ordinary course obligation, with “best efforts” demanding the greatest effort and “commercially reasonable efforts” the least.

The second pro-seller feature here is a carveout for COVID-19 measures.  The covenant states that Twitter must use commercially reasonable efforts to conduct its business in the ordinary course between signing and closing “except with respect to actions or omissions that constitute COVID-19 Measures”.  “COVID-19 Measures” are defined broadly to include every conceivable response to COVID-19 and any variants, mutations or associated epidemics, pandemics or disease outbreaks, including quarantine, “shelter in place,” “stay at home,” workforce reduction, shut down and closure, whether recommended or promulgated by any governmental authority, or other reasonable actions taken in response to the foregoing.


But not everyone is ready to concede that the Twitter board did its job of adequately protecting the stockholders (at least not when there’s potential money to be made).  One plaintiff’s firm has already reared its inevitable head, announcing it is investigating Twitter for possible breaches of fiduciary duty and other violations of law in connection with the Acquisition, and inviting stockholders to “join the action”.  The firm’s press release alleges the Merger Agreement unreasonably limits competing bids by prohibiting solicitation of further bids and imposing a significant penalty if Twitter accepts a superior bid.  That’s a reference to the Merger Agreement’s “no-shop” restriction and the aforementioned $1 billion breakup fee.  The no-shop provision prohibits Twitter from soliciting any offer from, or engaging in negotiations with, or furnishing any material non-public information to any third party relating to a possible competing acquisition proposal.  The Merger Agreement does provide Twitter with a fiduciary out, however, allowing Twitter to speak to third parties if the board determines in good faith that such discussions could result in a superior proposal.

Elon Musk’s contentious relationship with the Securities and Exchange Commission is likely to become even more complicated as a result of Mr. Musk’s filings with the Commission to report his recent purchases of shares in Twitter, Inc.

On April 4, 2022, Elon Musk filed a Schedule 13G  with the SEC to report his ownership of 73,486,938 shares or 9.2% of Twitter, Inc.  Schedule 13G is a short form beneficial ownership filing used by passive investors.  The next morning, Twitter filed a Current Report on Form 8-K to announce that it had agreed to appoint Mr. Musk to the board of directors with a term expiring in 2024 and that Musk’s ownership in Twitter may not exceed 14.9% for the duration of his tenure and for 90 days thereafter.  Later that day on April 5, Musk filed a long-form Schedule 13D as to the same shares he previously reported on his 13G, along with other detailed information required in a 13D.

What seems crystal clear is that Elon Musk missed the applicable 10-day filing deadline under Sections 13(d) and 13(g) of the Securities Exchange Act of 1934 to report 5% ownership in a public company. The chronology of Musk’s Twitter stock purchases as listed on Schedule I of his 13D indicates that by March 14, 2022, his ownership of Twitter stock exceeded 40,032,058 shares, which is 5% of the 800,641,166 shares outstanding as per Twitter’s 10-K.  Crossing the 5% threshold on March 14 means that the deadline for filing either a 13G or 13D would have been March 24, yet Mr. Musk didn’t file until April 4.  That gave him an extra 10 days in which to buy additional shares (he increased his ownership during that time by an extra 4.1%) before the per share price spike that occurred when he finally announced his holdings on April 4.  On the day of Musk’s initial announcement, Twitter closed at $49.97 per share, an increase of 27% over the previous day’s close.

Failing to file on time may not have been the only possible securities law infraction here.  The particular form Musk used initially to report his holdings also raises questions.  Schedule 13G and Schedule 13D are alternative forms used to disclose ownership of more than 5% of a class of equity security in a company.  Passive investors may use the short-form Schedule 13G in lieu of the more onerous Schedule 13D.  Among the categories of information required in a Schedule 13D but not in Schedule 13G are a list of the investor’s transactions in the company’s stock during the last 60 days, source and amount of funds used, method of acquisition, purpose of the acquisition, and plans or proposals that would result in a material change in the company, such as corporate transactions, changes in board composition, by-law changes and material changes in the issuer’s business.  A Schedule 13D must also include as exhibits copies of all written agreements related to the acquisition and holdings.

The key issue then is: what does it mean to be a passive investor (and thus eligible for the less burdensome 13G), and was Elon Musk a passive investor when he filed his Schedule 13G with respect to his 5% ownership in Twitter?  Rule 13d-1(c) provides that a 5% owner could file a short-form 13G instead of the more detailed 13D if the person “has not acquired the securities with any purpose, or with the effect, of changing or influencing the control of the issuer, or in connection with or as a participant in any transaction having that purpose or effect”.

Several commentators have suggested that Elon Musk was not eligible to use Schedule 13G because of numerous tweets calling for changes in business policies at Twitter, such as implementation of an edit feature on its social media platform.  These commentators assert that the foregoing tweets and similar advocacy by Mr. Musk for changes in the Twitter platform indicate that he was not passive.  I’m not so sure.

The aforementioned Rule 13d-1(c) regarding Schedule 13G eligibility focuses on whether or not the shareholder is seeking to change or influence control of a company.  Control is a different concept from business practices.  In a Compliance and Disclosure Interpretation (“CDI”) dated July 14, 2016, the SEC offered guidance on this issue, sharply contrasting efforts to influence basic business decisions with seeking changes in control.  It stated that merely participating in the “formulation, determination, or direction of the basic business decisions” of a company would not render a shareholder ineligible to use Schedule 13G.  Instead, 13G eligibility hinges on whether the shareholder acquired or is holding equity securities “with the purpose or effect of changing or influencing control” of the company, a determination based upon all relevant facts and circumstances.  By way of example, the CDI states that engagement on corporate governance topics, such as removal of staggered boards, majority voting standards in director elections and elimination of poison pills, without more, generally would not disqualify an otherwise eligible shareholder from filing on Schedule 13G if the discussion is being undertaken by the shareholder as part of a broad effort to promote the investor’s view of good corporate governance practices for all of its portfolio companies, rather than to facilitate a specific change in control in a particular company.  By contrast, Schedule 13G would be unavailable if a shareholder engages with the issuer’s management on matters that specifically call for the sale of the issuer to another company, the sale of a significant amount of the issuer’s assets, the restructuring of the issuer or a contested election of directors.

Here, Elon Musk would argue that in advocating for an edit button and other similar policy changes, he was merely trying to influence basic business decisions of Twitter relating to the functionality of its social media platform, and that such advocacy did not in any way seek to bring about change in the control of the company.

But of course there are other facts and circumstances to consider.  Twitter announced the day after Mr. Musk’s 13G filing that the company would appoint Mr. Musk as a director.  The SEC has taken the position that a director cannot be deemed a passive investor for the purpose of 13G eligibility.  The letter agreement filed by Twitter as an exhibit to its 8-K, in which it agreed to appoint Musk as a director, was dated April 4, the day Musk filed his 13G.  Moreover, Twitter’s CEO Parag Agrawal tweeted on April 5 that “through conversations with Elon in recent weeks, it became clear to us that he would bring great value to our Board”, implying the company and Musk had for weeks been engaged in discussions about him joining the board.  So given the SEC’s position that a director cannot be a passive investor for 13G/13D purposes, the discussions referred to by Mr. Agrawal, and certainly the agreement to appoint Musk to the board, would seem to have disqualified Musk from using Schedule 13G and required him to report his ownership on the more detailed Schedule 13D.

Another noteworthy aspect to Mr. Musk’s Twitter ownership filings is his failure to provide a required certification in his original 13G.  Musk indicated on the facing page of his 13G that he was filing pursuant to Rule 13d-1(c), the rule that allows a passive investor to file the short-form 13G rather than the more detailed 13D.  But Item 10 of Schedule 13G requires the filer to include the following certification if the statement is filed pursuant to Rule 13d-1(c):

By signing below I certify that, to the best of my knowledge and belief, the securities referred to above were not acquired and are not held for the purpose of or with the effect of changing or influencing the control of the issuer of the securities and were not acquired and are not held in connection with or as a participant in any transaction having that purpose or effect, other than activities solely in connection with a nomination under § 240.14a-11.

Instead of certifying that his purchase of Twitter shares was not made for the purpose or with the effect of changing or influencing the control of Twitter, Mr. Musk just inserted “Not Applicable”.  Could Mr. Musk have been trying to have it both ways, filing the short form 13G while not certifying that his shares in Twitter were not acquired or held for the purpose or with the effect of changing or influencing the control of Twitter, Inc.?

Leaving aside the omission of the “no control” certification, an argument could be made that Mr. Musk should be deemed to have been passive at the time of his 13G filing because he was merely advocating for changes in Twitter’s business practices, and that his status as a passive investor only changed when Twitter announced the agreement to appoint him to the board.  Like Twitter, the SEC does not have an edit feature, so when the board appointment was formalized, Musk had no choice but to file a 13D.

Mr. Musk has shown himself to be defiant when it comes to the SEC, at times mocking.  After tweeting in 2018 that he had “funding secured” for his proposal to take Tesla private, the SEC alleged that Mr. Musk had never previously discussed such a deal and that his statement, which caused Tesla’s stock to skyrocket, constituted fraud. Musk and the SEC entered into a consent decree which, among other sanctions, required Musk to obtain company pre-approval of any written communications that contain information material to Tesla or its shareholders.  After the SEC asked for information on whether Tesla was satisfying its obligation to monitor his public messages, as per the consent decree, Musk tweeted an apparent reference to a sex act: “SEC, three letter acronym, middle word is Elon’s”.  Musk recently filed a motion seeking to terminate the consent decree.  And earlier this year, it was reported the SEC was investigating whether Mr. Musk and his brother violated insider-trading rules after his brother sold $108 million of Tesla shares one day before Elon Musk polled Twitter users on whether he should sell 10% of his stake in Tesla and pledging to abide by the vote’s results.

It remains to be seen to what extent the apparent issues surrounding Mr. Musk’s beneficial ownership filings regarding his shares in Twitter, Inc. will further complicate his existing battles with the SEC.