It’s not often that the House of Representatives votes nearly unanimously on anything noteworthy these days, but that’s exactly what the House did on July 17 in voting 406-4 for the “JOBS and Investor Confidence Act of 2018”, also known on the street as “JOBS Act 3.0”, which is the latest iteration of the effort to improve on the capital markets reform initiative started in the original JOBS Act of 2012. JOBS Act 3.0 consists of 32 individual pieces of legislation that have passed the Financial Services Committee or the House, the substance of several of which I have blogged about previously. If passed by the Senate in some form or another and signed by the President, the reforms included in JOBS Act 3.0 will continue the process of removing unreasonable impediments to capital formation by early stage companies and address perceived problems with the original JOBS Act.

The highlights of JOBS Act 3.0 passed by the House are as follows:

Demo Days: Helping Angels Lead Our Startups Act” or the “HALOS Act”

The bill would direct the SEC to amend Regulation D to make clear that activities associated with demo day or pitch night events satisfying certain criteria would not constitute prohibited “general solicitation” under Regulation D. Specifically, the new exemption would cover events with specified types of sponsors, such as “angel investor groups”, venture forums and venture capital associations, so long as the event advertising doesn’t refer to any specific offering of securities by the issuer, the sponsor doesn’t provide investment advice to attendees or engage in investment negotiations with attendees, charge certain fees, or receive certain compensation, and no specific information regarding a securities offering is communicated at the event beyond the type and amount of securities being offered, the amount of securities already subscribed for and the intended use of proceeds from the offering.

I previously blogged about the issue of demo days and the ban on general solicitation here.

Private Company M&A Brokers: Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act of 2017

The bill would exempt from SEC broker-dealer registration mergers-and-acquisitions brokers that facilitate transfers of ownership in privately held companies with earnings or revenues under a specified threshold. The exemption would not apply to any broker who takes custody of funds or securities, participates in a public offering of registered securities, engages in a transaction involving certain shell companies, provides or facilitates financing related to the transfer of ownership, represents both buyer and seller without disclosure and consent, assists in the formation of a group of buyers, engages in transferring ownership to a passive buyer, binds a party to a transfer of ownership or is a “bad actor”.

Since 2014, private company M&A brokers could at best be guided by an SEC no-action letter, although there had been previous Congressional efforts to codify the protection, which I had blogged about here.

Accredited Investor Definition: Fair Investment Opportunities for Professional Experts Act

The bill would direct the SEC to expand the definition of “accredited investor” under Regulation D beyond the net worth and income test to include individuals licensed as a broker or investment advisor and individuals determined by the SEC to have demonstrable education or job experience to qualify as having professional knowledge of a subject related to a particular investment.

Venture Exchanges: Main Street Growth Act

Although the JOBS Act created an IPO on-ramp for emerging growth companies, it did comparatively little to address secondary market trading in these companies. This portion of the bill seeks to remedy that shortcoming by providing a tailored trading platform for EGCs and stocks with distressed liquidity. Companies that choose to list on a venture exchange would have their shares traded on a single venue, thereby concentrating liquidity and exempting their shares from rules that are more appropriate for deeply liquid and highly valued stocks. Venture exchanges would also be afforded the flexibility to develop appropriate “tick sizes” that could help incentivize market makers to trade in the shares of companies listed on the exchange.

VC Fund Exemption – Investment Advisor Registration: Developing and Empowering our Aspiring Leaders Act

Dodd-Frank requires private equity and hedge fund managers to register with the SEC under the Investment Advisors Act but allows venture capital fund managers to become “exempt reporting advisors” and be relieved from the regulatory requirements encountered by registered investment advisors. Currently, to qualify under the venture capital fund definition and register with the SEC as an exempt reporting advisor, VCs must ensure that more than 80% of their activities are in qualifying investments, which are defined only as direct investments in private companies.

The bill would require the SEC to revise the definitions of a qualifying portfolio company and a qualifying investment to include an emerging growth company and the equity securities of an emerging growth company, “whether acquired directly from the company or in a secondary acquisition”, for purposes of the exemption from registration for venture capital fund advisers under the Investment Advisers Act.  A company qualifies as an emerging growth company if it has total annual gross revenues of less than $1.07 billion during its most recently completed fiscal year and continues to be an emerging growth company for the first five fiscal years after it completes an IPO unless its total annual gross revenues are $1.07 billion or more, it has issued more than $1 billion in non-convertible debt in the past three years or it becomes a “large accelerated filer”.

Founders often leave startups, voluntarily or involuntarily, and it may be in everyone’s interest to have their shares purchased by other existing shareholders rather than sold to an outsider or held by a disgruntled founder.  VC funds should have the flexibility to be able to buy those shares.  Similarly, the inclusion of emerging growth companies in the category of qualifying portfolio company will benefit the innovation ecosystem by encouraging VC funds to invest further in their portfolio companies post-IPO.

Special Purpose Crowdfunding Vehicles: Crowdfunding Amendments Act

One of the perceived defects of the rules governing equity crowdfunding under Regulation CF is the ineligibility of investment vehicles. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors under Regulation D to invest in a special purpose vehicle whose only purpose is to invest in an operating company. Essentially, a lead investor validates a company’s valuation, strategy and investment worthiness. Traditionally, angel investors have operated in groups and often follow a lead investor, a model which puts all investors on a level playing field. The additional benefit to the portfolio company from this model is that the company ends up with only one additional investor on its cap table, instead of the hundreds that can result under current rules.  Due to the fear of having to collect thousands of signatures every time shareholder consent is required for a transaction, higher-quality issuers with other financing options are less likely to crowdfund without a single-purpose-vehicle. I suspect that many companies are shying away from Reg CF or not reaching potential raise targets because of this reason alone.

The bill would allow equity crowdfunding offerings under Reg CF through special purpose vehicles that issue only one class of securities, receive no compensation in connection with the offering and are advised by a registered investment adviser.  Special-purpose-vehicles allow small investors to invest alongside a sophisticated lead investor with a fiduciary duty to advocate for their interests. The lead investor may negotiate better terms and represent small investors on the board.  Retail investors don’t enjoy these benefits under Reg CF.

On June 28, 2018, the Securities and Exchange Commission issued a release amending the definition of “smaller reporting company” (“SRC”) to expand the number of reporting companies eligible for relaxed or scaled disclosure. The change is estimated to benefit nearly 1,000 additional small public companies currently outside the SRC definition. But equally noteworthy in the SRC release is that the Commission staff has been directed, and has begun, to formulate recommendations to the Commission for possible changes to another definition, that of “accelerated filer”, to reduce the number of companies that qualify as accelerated filers in order to further reduce compliance costs. That change would likely be more significant than expanding the SRC definition because “accelerated filer” status triggers the expensive requirement to obtain auditor attestation for management’s assessment of internal control over financial reporting.

Background

Smaller Reporting Company

The Commission established the SRC category in 2008 in an effort to provide general regulatory relief for smaller companies. SRCs are allowed to provide scaled disclosures under Regulation S-K and Regulation S-X. Under the previous SRC definition, SRCs generally were companies with less than $75 million in public float (i.e., aggregate market capitalization of a company’s shares held by non-affiliates). Companies with no public float − because they have no public equity outstanding or no market price for their public equity − were considered SRCs if they had less than $50 million in annual revenues.

Examples of scaled disclosure available to SRCs are two year management discussion and analysis comparisons rather than three years, no compensation discussion and analysis and no risk factor disclosure in Exchange Act filings. A table summarizing the scaled disclosure accommodations for SRCs can be found in the Annex at the bottom of this post.

Under previous rules, SRCs were also automatically excluded from being categorized as “accelerated filers” or “large accelerated filers”, the requirements of which are discussed below. As a result, existing public float thresholds in the accelerated filer definition aligned with the public float threshold in the SRC definition.

Accelerated Filer

In December 2005, the SEC voted to adopt amendments that redefined “accelerated filers” as companies that have at least $75 million, but less than $700 million, in public float, and created a new category of “large accelerated filers” that includes companies with a public float of $700 million or more. In addition to the requirement to file periodic reports on an accelerated basis, accelerated filers must also have their auditor provide an attestation report on management’s assessment of internal control over financial reporting under Section 404(b) of Sarbanes-Oxley.

The determinations of public float thresholds for SRC and accelerated filer status are both made as of the last business day of a registrant’s most recently completed second fiscal quarter for purposes of the following fiscal year.

Amendments to Smaller Reporting Company and Accelerated Filer Definitions

The new rules define SRCs as companies with less than $250 million of public float, as compared with the $75 million threshold under the previous definition. The final rules also expand the definition to include companies with less than $100 million in annual revenues if they have either no public float or a public float of less than $700 million. This reflects a change from the revenue test in the prior definition, under which a company would be categorized as an SRC only if it had no public float and less than $50 million in annual revenues.

The final rules will become effective September 10, 2018.

The amended SRC thresholds are summarized in the following chart:

Criterion

Current Definition

Revised Definition

Public Float Public float of less than $75 million Public float of less than $250 million
Revenue Less than $50 million of annual revenue and no public float Less than $100 million of annual revenues and:

  • no public float, or
  • public float of less than $700 million

The increase in SRC public float thresholds will lead to a dramatic expansion in companies eligible for scaled disclosure. The Commission estimates that 966 additional registrants will be eligible for SRC status in the first year under the new definition. These registrants estimated to be eligible in the first year comprise 779 registrants with a public float of $75 million or more and less than $250 million, 26 registrants with no public float and revenues of $50 million or more and less than $100 million, and 161 registrants with revenues below $100 million and a public float of $250 million or more and less than $700 million.

The SRC amendments also eliminate the automatic exclusion of SRCs from accelerated filer status. The definitions of accelerated filer and large accelerated filer are based on public float, but previously contained a provision excluding SRCs from accelerated filer status. As a result, raising the SRC public float threshold without eliminating that provision effectively would raise the accelerated filer public float threshold as well.

Accordingly, the Commission had also considered increasing the public float thresholds in the accelerated filer definition, consistent with the changes to the SRC definition, to reduce compliance costs and maintain uniformity across relevant rules. Opponents viewed a parallel increase in the accelerated filer thresholds as a weakening of investor protections. Some cited a 2011 Staff Section 404(b) Study finding that accelerated filers subject to Section 404(b)’s attestation requirement had a lower restatement rate compared to non-accelerated filers not subject to Section 404(b). But supporters argued that the attestation requirement is particularly costly for SRCs and that audit costs associated with Section 404(b) divert capital from core business needs. One maintained that a Section 404(b) audit represents over $1 million of capital diversion. Another cited the same 2011 Staff Section 404(b) Study which estimated that companies with a public float between $75 million and $250 million spend, on average, $840,276 to comply with Section 404(b). Interestingly, one commenter that stated that its public float was more than $75 million but less than $250 million estimated that relief from Section 404(b) would result in a 35% reduction in compliance costs whereas there would be no material change in such costs from the SRC amendments qualifying him for scaled disclosure as an SRC.

In the final rules release, the Commission determined to eliminate the exclusion of SRCs from accelerated filer status, effectively deciding not to increase the accelerated filer thresholds.

As indicated in the chart below, the increase in the SRC thresholds coupled with the elimination of the automatic exclusion of SRCs from accelerated filer status (i.e., no increase in the accelerated filer threshold) means good news/bad news for companies with a public float between $75 million and $250 million: they benefit from scaled disclosure (unlike under previous rules), but must continue to provide auditor attestations to management’s assessment of the effectiveness of internal control over financial reporting, an enormously expensive proposition.

 

But as I mentioned at the top of this post, auditor attestation relief may be on the way.  SEC Chairman Clayton has directed the Commission staff to formulate recommendations for possible changes to the accelerated filer definition to reduce the number of companies that fall under its requirements, including the auditor attestation requirement. Perhaps, the staff will recommend to increase the accelerated filer public float threshold to $250 million from its current $75 million. That would appear to bring far more practical regulatory relief than the expansion of the SRC definition.

 

Annex

Smaller Reporting Company Scaled Disclosure

 

Regulation S-K

Item Scaled Disclosure Accommodation
101 − Description of Business May satisfy disclosure obligations by describing the development of the registrant’s business during the last three years rather than five years. Business development description requirements are less detailed than disclosure requirements for non-SRCs.
201 − Market Price of and Dividends on the Registrant’s Common Equity and Related Stock performance graph not required.
301 – Selected Financial Data Not required.
302 – Supplementary Financial Information Not required.
303 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”)

Two-year MD&A comparison rather than three-year comparison.

Two year discussion of impact of inflation and changes in prices rather than three years.

Tabular disclosure of contractual obligations not required.

305 – Quantitative and Qualitative Disclosures About Market Risk Not required.
402 – Executive Compensation

Three named executive officers rather than five.

Two years of summary compensation table information rather than three. Not required:

·      Compensation discussion and analysis.

·      Grants of plan-based awards table.

·      Option exercises and stock vested table.

·      Pension benefits table.

·      Nonqualified deferred compensation table.

·      Disclosure of compensation policies and practices related to risk management.

·      Pay ratio disclosure.

404 – Transactions With Related Persons, Promoters and Certain Control Persons Description of policies/procedures for the review, approval or ratification of related party transactions not required.
407 – Corporate Governance

Audit committee financial expert disclosure not required in first annual report

Compensation committee interlocks and insider participation disclosure not required.

Compensation committee report not required.

503 – Prospectus Summary, Risk Factors and Ratio of Earnings to Fixed Charges No ratio of earnings to fixed charges disclosure required. No risk factors required in Exchange Act filings.
601 – Exhibits Statements regarding computation of ratios not required.

Regulation S-X

Rule Scaled Disclosure
8-02 – Annual Financial Statements

Two years of income statements rather than three years. Two years of cash flow statements rather than three years.

Two years of changes in stockholders’ equity statements rather than three years.

8-03 – Interim Financial Statements Permits certain historical financial data in lieu of separate historical financial statements of equity investees.
8-04 – Financial Statements of Businesses Acquired or to Be Acquired Maximum of two years of acquiree financial statements rather than three years.
8-05 – Pro forma Financial Information Fewer circumstances under which pro forma financial statements are required.
8-06 – Real Estate Operations Acquired or to Be Acquired Maximum of two years of financial statements for acquisition of properties from related parties rather than three years.
8-08 – Age of Financial Statements Less stringent age of financial statements requirements.

 

 

 

 

“Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?”

Such was the question posed by William Hinman, Director of the Securities and Exchange Commission’s Division of Corporation Finance, in his speech at the Yahoo Finance All Markets Summit: Crypto event in San Francisco on June 14. Hinman’s answer: a qualified “yes” where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created. This may be the most positive guidance yet from the SEC on when a digital asset might be deemed not to be a security under the Howey test. It may help create a pathway for blockchain startups to sell without registration or exemption digital tokens that had previously been sold in securities offerings, and should provide a measure of comfort to past and future issuers of SAFT-based ICOs.

After making his overarching point that a digital asset originally offered in a securities offering could be later sold in a manner that does not constitute an offering of a security when there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created, Hinman went on to describe the circumstances under which he believes that could occur. In doing so, Hinman concentrated primarily on the last prong of the Howey test, namely whether an expectation of profit derived through the efforts of others, and suggested that the inquiry should focus on two areas: (i) who are the participants, and (ii) how is the digital asset structured?

Who are the Participants?

When determining whether a digital asset should be deemed to be an investment contract, Hinman stated that one should “consider whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return.”

He suggested that this question will always depend on the particular facts and circumstances of a transaction, and offered the following non-exhaustive list of factors:

  • Promoter’s efforts play a significant role in the development and maintenance of the digital asset and its potential increase in value.
  • Promoter retains a stake or other interest in the digital asset such that he would be motivated to expend efforts to cause an increase in its value, particularly where purchasers are made to reasonably believe such efforts will be undertaken.
  • Amount raised in the ICO exceeds amount needed to establish a functional network and use of proceeds includes supporting the token’s value or increasing enterprise’s value
  • Promoter continues to expend funds from proceeds or operations to enhance functionality and/or value of system within which the tokens operate.
  • No persons or entities other than the promoter exercise governance rights or meaningful influence.

How is the digital asset structured?

Hinman then pointed to the existence of contractual or technical methods to structure digital assets so they function more like consumer items and less like a security, including the following:

  • Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
  • Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
  • Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
  • Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
  • Is the asset marketed and distributed to potential users or the general public?
  • Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
  • Is the application fully functioning or in early stages of development?

Information Asymmetry

Director Hinman also pointed out that one of the rationales for the securities laws is to remove the information asymmetry between promoters and investors by mandating adequate disclosure to address that asymmetry. That disclosure regime is needed when a token purchaser relies on a token seller’s efforts to develop a network and generate a potential return on investment for the token purchaser.

Conversely, when the promoter’s efforts are no longer an important factor in determining the enterprise’s success, “material information asymmetries recede” and the protections of the securities laws may no longer be necessary. Moreover, as a practical matter, when a network becomes decentralized, the ability to identify a promoter to make the mandated disclosures “becomes difficult, and less meaningful.”

Implication for SAFTs

The Simple Agreement for Future Tokens or SAFT is modeled after Y Combinator’s Simple Agreement for Future Equity, or SAFE, which has been a popular mechanism for funding startups. With both the SAFE and the SAFT, the investor receives a right to something of value in the future in exchange for the current investment. With a SAFE, the investor gets the right to receive the security issued in the issuer’s next major funding round, typically preferred stock and usually at a discount to the next round’s price. In a SAFT, the investor is given the right to receive tokens, also at a discount, typically once the network is created and the tokens are fully functional.

In a SAFT-based ICO, the SAFT itself is generally acknowledged to be an investment contract and thus a security, and sold to accredited investors under Rule 506(c) of Regulation D. A quick search on EDGAR reveals there have been 37 Form D filings identifying the type of security offered as a SAFT. No court or regulator has interpreted the SAFT framework and whether or not the tokens to be ultimately issued are securities.

Director Hinman’s view that certain tokens initially issued by blockchain startups as securities may have the potential to become part of a decentralized network and no longer bear the attributes of securities may give legitimacy to SAFT-based ICOs. Interestingly, the only place where the word SAFT appears in the speech is in footnote 15 of the written version. In that footnote, Hinman states that although nothing in his remarks should be construed as opining on the legality of a SAFT (because the analysis of a particular SAFT must turn on the economic realities of the particular case), “it is clear from [his speech that he believes] that a token once offered in a security offering can, depending on the circumstances, later be offered in a non-securities transaction.”

Buried in new legislation mainly intended to ease Dodd-Frank restrictions on small banks is an expansion of Regulation A eligibility to include SEC reporting companies. Previously, such companies were not eligible. The new access to Regulation A will create a viable mini-public offering pathway for SEC reporting companies, particularly those not eligible for registering securities on the streamlined Form S-3 registration statement.

Regulation A is an exemption from registration requirements for offerings of up to $50 million in any 12-month period, subject to eligibility, disclosure and reporting requirements.  The exemption, often referred to as Regulation A+, provides for two tiers of offerings: Tier 1 for offerings of up to $20 million and Tier 2 for offerings of up to $50 million, in each case during any 12-month period. Tier 2 offerings are subject to additional disclosure and ongoing reporting requirements, but consequently benefit from preemption of state securities law registration and qualification requirements. As originally adopted, SEC reporting companies were not eligible to use Regulation A+.

On May 24, 2018, President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act, which primarily is intended to ease the burdens on smaller banks under Dodd-Frank. Buried in the Act is Section 508, entitled “Improving Access to Capital”, which expands the availability of Regulation A+ by requiring the SEC to remove the requirement that the issuer not be an SEC reporting company. Section 508 also requires the SEC to amend Regulation A+ so that any company subject to Section 13 or 15(d) of the Exchange Act will be deemed to have met the periodic and current reporting requirements of Regulation A+ if it satisfies the Section 13 reporting requirements.

Currently, public companies seeking to conduct small public offerings in the range of up to $50 million would likely register such offering with the SEC through a streamlined registration statement on Form S-3, which has certain significant benefits. Form S-3 is a short-form registration statement which allows the issuer to update the registration statement’s disclosure prospectively through incorporation by reference of the issuer’s subsequently filed current reports on Form 8-K and periodic reports on Form 10-Q and Form 10-K. This “evergreen” feature means that a company generally will not need to file any post-effective amendments to the registration statement, a time and cost saving advantage.

The process of completing a registered offering on Form S-3 is generally quicker and cheaper than even a Reg A+ offering. So as a practical matter, it’s unlikely that S-3 eligible issuers will opt to do a Reg A+ offering over S-3.

But use of Form S-3 is subject to several stringent issuer and transaction eligibility requirements, including that the issuer be organized and have its principal business operations in the United States and that it have a public float, i.e., aggregate market value of common equity held by non-affiliates, of at least $75 million (unless it’s a listed company, limits the offering amount to not more than one-third of the company’s public float during any 12-month period and is not a shell company).

So issuers that are not S-3 eligible may decide that a Reg A+ offering is an attractive alternative for raising up to $50 million. The benefits of Reg A+, even to an SEC reporting company, could be significant: freedom to “test the waters” with investors prior to launch, faster SEC review relative to registered offerings and preemption of state blue sky registration in Tier 2 offerings.

Initial coin offerings so far have gone through two major phases in their brief lifespan. The initial phase flew under the regulatory radar in an explosion of deals that raised billions of dollars seemingly overnight and without either registering the offerings with the SEC or complying with an exemption from registration. The ICO atmosphere changed drastically when the SEC issued its now famous DAO report in July 2017, which together with subsequent speecheswritten statements and enforcement actions took the position that tokens will generally be considered securities whose offering would need either to be registered with the SEC or qualify for a registration exemption such as Regulation D. That led to a second phase of issuers launching bifurcated ICOs consisting first of a sale of SAFTs to accredited investors under Regulation D, followed by the public sale of fully function tokens that sponsors would argue are not securities.

During the Senate’s February 6, 2018 committee hearing on cryptocurrencies, SEC Chairman Jay Clayton stressed the importance of disclosure for making informed decisions, but warned investors that no ICO had been registered with the SEC yet. That all seemed to change a month later when a group calling itself The Praetorian Group filed with the SEC a registration statement on Form S-1 to publicly offer and sell its cryptocurrency called PAX. With that S-1 filing, might we be entering a third phase of SEC-registered ICOs? For the reasons covered in this post, probably not.

The Registrant

The S-1 registration statement was filed by a company calling itself The Praetorian Group, and describes a dual business plan to be carried out in two phases. In the first phase, Praetorian will operate as a self-styled cryptocurrency real estate investment vehicle, or CREIV, through which it will purchase and upgrade residential and commercial real estate properties in lower income areas in New York, and then fund “outreach programs” to enrich the quality of life for the residents living in those properties. The second phase is projected to begin 12 months after the commencement of the first, and would involve the creation of a digital wallet that will convert cryptocurrencies (e.g., BTC, ETH, LTC, NEO, XLM) into local fiat currency and enable users to earn a reward in the form of PAX tokens for every purchase they make, which they can then spend, hold or sell.

What’s Wrong with this S-1?

The Praetorian S-1 is so deficient from a disclosure standpoint and so sloppy in its drafting that if the SEC bothered to review it, it may set some sort of record for number of comments in a comment letter.

Not to get overly picky, but the sloppiness starts right on the facing page. For starters, the registrant designates “The Praetorian Group” as its “exact name … as specified in its charter”, leaving out the “Inc.” It provides that the approximate date of commencement of the proposed sale to the public is “upon SEC registration as a ‘security’”. Technically, issuers may only proceed with a public offering after their registration statement is declared effective by the SEC. Also, it appears Praetorian may have marked up the facing page from an old S-1 filing, as Praetorian’s facing page form is missing a reference to emerging growth companies (EGCs).

The EGC facing page omission leads me to a more substantive observation, which is that a registrant more serious about its offering would arguably have availed itself of a JOBS Act feature that allows EGCs to submit an S-1 confidentially and undergo an initial review off the EDGAR radar screen. Why not file confidentially and clear up any disclosure and accounting issues before having to file publicly? On that score, it’s entirely possible that Praetorian isn’t even the first ICO to file an S-1, and may have been beaten in a race to the SEC by a confidential EGC filer we don’t even know about yet.

One of the sections in the S-1 that really jumped out at me is a rather bizarre liability disclaimer, which reads as follows:

To the maximum extent permitted by the applicable laws, regulations and rules the Company and/or the Distributor shall not be liable for any indirect, special, incidental, consequential, or other losses of any kind, in tort, contract, tax or otherwise (including but not limited to loss of revenue, income or profits, and loss of use or data), arising out of or in connection with any acceptance of or reliance on this Prospectus or any part thereof by you.”

Talk about an exercise in wishful thinking. Suffice it to say that I have never seen an issuer in a Securities Act registration statement attempt to disclaim liability for losses of any kind resulting from reliance on a prospectus. Federal securities law clearly allows a private plaintiff to recover damages for economic loss sustained as a result of an issuer’s material misstatements, omissions or fraud.

Pretty interesting given that Praetorian actually states that it’s “mindful of the uncertainties associated with the [SEC]’s view as to whether or not an [ICO] would constitute a ‘security’ under applicable federal securities laws” and consequently that they “believe it is more prudent to register the offering with the SEC to avoid any unanticipated regulatory issues”. It’s as if Praetorian is under the view that a registration statement is a notice filing, rather than a disclosure document to be vetted in great detail in a review process involving typically multiple rounds of comments followed by responses and registration statement amendments, and where issuers may not proceed with selling until the SEC is satisfied that all mandated disclosures have been made and accounting and other issues resolved and the SEC has declared the registration statement effective.

Another bizarre aspect of the S-1 is that Praetorian appears to be confused over whom it may sell to, or that it’s forgotten that it has filed a registration statement (which, if declared effective, would allow it to sell to anyone) and is not seeking to sell within the purchaser requirements of a given exemption:

We strongly encourage each “accredited investor” to access the various SEC websites to gain a deeper and more knowledgeable understanding of this new form of digital currency prior to investing in the PAX token.”

Either Praetorian believes it may only sell in the public offering to accredited investors (as is the case in a private offering exemption under Rule 506(c)), or it strangely thinks that only accredited investors (which by definition must have a minimum net worth or annual income) need to be encouraged to inform themselves of the risks associated with ICOs.

Another glaring deficiency is the lack of risk factor disclosure. The only risk included in the section entitled “Risks and Uncertainties” is the risk that it may not be successful in achieving secondary market listings of the PAX token. Otherwise, the section simply consists of a conclusory statement that prospective purchasers of tokens should evaluate all risks and uncertainties associated with the company, the tokens, the token sale and the business plan prior to any purchase of tokens.

Finally, Praetorian’s S-1 omits in totality all of the information required in Part II of S-1. This includes expenses of issuance and distribution, indemnification of directors and officers, recent sales of unregistered securities, exhibits, financial statement schedules and certain required undertakings.

Conclusion

The Praetorian Guard was an elite unit of the Imperial Roman Army whose members served as personal bodyguards to the Roman emperors, sort of like the Roman equivalent of today’s Secret Service that protects the President. Although the ancient Praetorians continued to serve in that capacity for roughly three centuries, they became notable for their intrigue and interference in Roman politics, including overthrowing emperors and proclaiming successors. In the year 312, the Praetorian Guard was disbanded by Constantine the Great. Like its namesake, The Praetorian Group has generated a fair amount of intrigue with its S-1 filing, but I can only imagine that the great examiners of the SEC will take a page out of Constantine’s playbook and disband this Praetorian Group’s S-1 registration statement.

The Wall Street Journal ominously reported on February 28 that the Securities and Exchange Commission recently issued dozens of subpoenas to initial coin offering issuers and their advisors demanding information about the structure of their ICOs. Although the Commission has yet to officially acknowledge them, the subpoenas are consistent with a series of SEC enforcement actions alleging fraud or illegal sale of securities (see, e.g., here and here) and public speeches and statements warning ICO participants about regulatory compliance and promising greater scrutiny and enforcement (see, e.g., here, here and here).  Nevertheless, the enforcement actions and speeches don’t appear to have had much success in slowing down the pace of the ICO market.  Coinschedule reports that ICOs have raised over $3.3 billion in 88 deals already in 2018 through March 16, and is on pace to exceed the estimated $5.6 billion raised in 2017. The latest SEC subpoena campaign coupled with the accelerating pace of deals suggests the Commission believes its message is not resonating in the ICO market.

Although I’m grateful I didn’t find one of the subpoenas in my mailbox, I’m definitely curious about their contents.  Coindesk quotes industry sources who have seen several of the ICO subpoenas as saying that the requested information includes investor lists, emails, marketing materials, organizational structures, amounts raised, location of funds and people involved and their locations. It also cites an anonymous industry lawyer saying that the 25-page subpoena received by his client was “hyper-detailed” and that it asked for “every bit of communication around the token launch.”

So what exactly is the Commission focusing on?  Many naturally believe the Commission is primarily targeting fraud.  But the Journal, Coindesk and others suggest a different focus: Simple Agreements for Future Tokens or SAFTs.

The SAFT is modeled after Y Combinator’s Simple Agreement for Future Equity, or SAFE, which has been a popular mechanism for funding startups. With both the SAFE and the SAFT, the investor receives a right to something of value in the future in exchange for the current investment. With a SAFE, the investor gets the right to receive the security issued in the issuer’s next major funding round, typically preferred stock and usually at a discount to the next round’s price.  In a SAFT, the investor is given the right to receive tokens, also at a discount, typically once the network is created and the tokens are fully functional.

My first observation is that there may be some confusion in the media regarding SAFTs and Federal securities law, with some seeming to suggest that there may be a conflict of opinion about whether the SAFT itself is a security or whether the contract itself is illegal or non-compliant.  I’ve seen statements such as “what will happen to those who invested time and money if SAFTs don’t satisfy securities law?” and “what happens if the SEC comes out and says SAFTs are illegal”? Crowdfund Insider ran a piece with this provocative title: “Bad News: SAFTs May Not Be ‘Compliant’ After All”.

There should be no controversy regarding the SAFT itself (as opposed to the tokens that ultimately get issued). Protocol Labs and Cooley’s SAFT White Paper states in no uncertain terms that the SAFT is a security and must satisfy an exemption from registration, and contemplates compliance with Rule 506(c) under Regulation D.  I haven’t seen or heard anyone suggesting otherwise.  In fact, each SAFT investor is required to represent in the SAFT that it “has no intent to use or consume any or all Tokens on the corresponding blockchain network for the Tokens after Network Launch” and “enters into this security instrument purely to realize profits that accrue from purchasing Tokens at the Discount Price”. Accordingly, there should be no Federal securities law issue with the issuance of the SAFT itself, assuming of course that the issuer complies with Rule 506(c)’s requirements, i.e., disclosure obligations, selling only to accredited investors, using reasonable methods to verify accredited investor status and filing Form D.

The real issue is whether the eventual tokens, assuming they are issued to investors only when the network is created and the tokens fully functional, are necessarily not securities because of their full functionality.  SAFT proponents argue that fully functional tokens fail the “expectation of profits” and/or the “through the efforts of others” prongs of the Howey test, and thus should not be deemed to be securities. The SAFT White Paper analyzes these two prongs of the test from the perspective of the two likely categories of purchasers of tokens: actual token users and investors.  In the case of actual users, their bona fide desire to make direct use of the relevant consumptive aspect of a token on a blockchain-based platform predominates their profit-seeking motives, so arguably they fail the “expectation of profit” prong of Howey.  Investors, on the other hand, clearly expect a profit from resale of the tokens on a secondary market; that profit expectation, however, is usually not predominantly “through the efforts of others” (because management has already brought the tokens to full functionality) but rather from the myriad of factors that cause the price of assets to increase or decrease on an open market.

Opponents of the SAFT approach (see, e.g., Cardozo Blockchain Project’s Not So Fast—Risks Related to the Use of a “SAFT” for Token Sales) reject the concept of a bright-line test, i.e., they reject the notion that the question of whether a utility token will be deemed a security solely turns on whether the token is “fully functional”.  They maintain that courts and the SEC have repeatedly, and unambiguously, stated that the question of whether or not an instrument is a security is not subject to a bright-line test but rather an examination of the facts, circumstances and economic realities of the transaction.  Opponents also assert that the SAFT approach actually runs the risk of increasing regulatory scrutiny of utility token issuers because of the emphasis on the speculative, profit-generating aspects of the utility tokens (e.g., the investor reps referred to above), which could ironically transform an inherently consumptive digital good (the token itself) into an investment contract subject to federal securities laws.  Others have suggested that reliance on the efforts of management doesn’t end with full functionality of the tokens, and that ultimately the success of the network and hence the investment will turn on whether management is successful in overcoming competition.

If anything, the Commission’s subpoena campaign suggests that the SAFT opponents correctly predicted the increased regulatory scrutiny.  And the increased regulatory scrutiny through the subpoena campaign is a stark warning to ICO issuers and counsel that SAFTs may not be completely safe after all.

Dual or multi-class capitalization structures generally allow companies to sell large amounts of shares to the public while maintaining control in the hands of the founders and early investors. Popularized by the Google IPO in 2004, weighted voting rights have since been featured in the high profile IPOs of LinkedIn, Groupon, Zynga, Facebook, Fitbit and Blue Apron.  Snap then took them to a new level last year when it acknowledged (or boasted) that it was the first company to launch an IPO with shares having zero voting rights.  I blogged about Snap’s IPO here.

Dropbox, Inc. is now the latest to go public with a multi-class structure. Having submitted its registration statement confidentially in early January, Dropbox finally filed its S-1 publicly on February 23. Dropbox’s S-1 shows that its capital structure consists of three classes of authorized common – Class A, Class B and Class C – with the rights of the holders of all three classes being identical except with respect to voting. Class A shares (offered to the public) are entitled to one vote per share, Class B shares are entitled to ten votes per share and Class C shares have no voting rights, except as otherwise required by law.  Although the general rule in Delaware is that each share receives one vote, a corporation may provide in its certificate of incorporation that a particular class or series has limited or no voting rights.

Because of the ten-to-one vote ratio between Dropbox’s Class B and Class A, the Class B stockholders – basically the co-founders and lead VCs Sequoia, Accel and T. Rowe Price — will continue to control a majority of the combined voting power, and therefore be able to control all matters submitted to stockholders for approval. This concentrated control will limit or preclude the Series A holders from having an influence over corporate matters for the foreseeable future, including the election of directors, amendments of the certificate of incorporation and by-laws and any merger, sale of all or substantially all the assets or other major transaction requiring stockholder approval. The concentration of voting power may also discourage unsolicited acquisition proposals.

The concentration of power in the Dropbox founders will likely only grow over time. Under an automatic conversion feature, future transfers of Class B shares will generally result in conversion into the lower voting Class A shares, subject to limited carve-outs for estate planning transfers and transfers between co-founders. The conversion of Class B shares to Class A will have the effect, over time, of increasing the relative voting power of those Class B holders who retain their shares.  Moreover, any future offerings of Class C shares will increase the concentration of ownership and control by the founders even further than would be the case in an offering of A shares because the C shares carry no voting rights at all (except as otherwise required by law). Consequently, the cumulative effect of the disproportionate voting power of the B shares, the automatic conversion feature upon transfer of B shares and the possibility of issuance of C shares is that the founders may be able to elect all of Dropbox’s directors and to determine the outcome of most matters submitted to a stockholder vote indefinitely.

Dual-class structures have been the subject of a great deal of controversy.  Some stock exchanges had banned them, only to reverse course because of stiff competition for listings. See here for case in point regarding Hong Kong, the NYSE and Ali Baba.  Investors have loudly objected to this structure, both through the SEC’s Investor Advisory Committee and the Council of Institutional Investors.  As a result of that opposition, FTSE Russell and Standard & Poor’s announced last year that they would cease to allow most newly public companies utilizing dual or multi-class capital structures to be included in their broad stock indices. Affected indices include the Russell 2000 and the S&P 500, S&P MidCap 400 and S&P SmallCap 600.  Consequently, mutual funds, exchange-traded funds and other investment vehicles that attempt to passively track these indices will not be investing in the stock of any company with dual-class shares. Although it’s too early to tell for sure what impact, if any, these new index policies will have on the valuations of Dropbox and other publicly traded companies excluded from the indices, it’s entirely possible that the exclusions may depress these valuations compared to those of similar companies that are included in the indices.  Interestingly, just two weeks ago, SEC Commissioner Robert J. Jackson Jr. gave his first speech since being appointed, entitled “Perpetual Dual-Class Stock: The Case Against Corporate Royalty“, in which he expressed his opposition to index exclusions despite his serious concerns regarding dual-class stock, calling index exclusion a blunt instrument and worrying that “Main Street investors may lose out on the chance to be a part of the growth of our most innovative companies”.

And how do companies like Dropbox defend dual-class structures? They would assert that weighted voting rights enable management to make long term decisions that are in the best interests of the company and to resist the short-termism that typically results from pressure brought by major stockholders to maximize quarterly results which often means sacrificing long term interests and performance.  They would further argue that efforts to exclude companies with weighted voting rights from stock indices are counter-productive because they serve to discourage those companies from going public in the first place, thus denying public company investors the opportunity to invest in innovative, high growth companies.

Perhaps the sensible compromise here would be sunset provisions, under which dual-class structures would sunset after a fixed period of time, such as five, ten or fifteen years, unless their extension is approved by stockholders unaffiliated with the controlling group.  Snap’s muti-class structure has no sunset provision; the only way the two founders could ever effectively lose control of Snap is if both died.  By contrast, Google has a sunset provision on its dual-class shares. The Council of Institutional Investors sent a noisy letter to Blue Apron just before its IPO last year urging the company to adopt a five-year sunset.  And Harvard Professor Lucien Bebchuck published a paper last year called “The Untenable Case for Perpetual Dual-Class Stock”, arguing that the potential advantages of dual-class structures tend to recede, and the potential costs tend to rise, as time passes from the IPO, and advocating for finite-term dual-class structures.

A recent report on the state of Regulation Crowdfunding published by a major crowdfunding advisory firm is cause for both celebration and renewed reform efforts. The $100 million aggregate funding milestone and the prorated year over year growth data indicate that the market, while still in its infancy, is growing at a nice pace. Nevertheless, a closer look at the data suggests that Regulation Crowdfunding in its current framework is not reaching its potential and remains in serious need of reform.

The Report

The 2017 State of Regulation Crowdfunding, published by crowdfunding advisory firm Crowdfund Capital Advisors, contains several helpful points of data and analysis. The data in the report were retrieved from the various forms that are required to be filed by issuers in Regulation CF equity crowdfunding transactions under Title III of the JOBS Act, which are publicly available on the SEC’s EDGAR website. These include offering statements on Form C, amendments to those statements on Form C/A, offering progress updates on Form C-U and annual reports on Form C-AR.

The report could be downloaded for free here. Some of the key findings are as follows:

  • The number of unique offerings increased 267% from 178 in 2016 to 481 in 2017.
  • Proceeds increased 178% from $27.6 million in 2016 to $49.2 million in 2017.
  • As of today, there are $100,072,759 in aggregate capital commitments.
  • The number of successful offerings increased 202% from 99 in 2016 to 200 in 2017
  • The total number of investors in Reg CF investments increased 158% from 28,180 in 2016 to 44,433 in 2017.

The foregoing data need to be put into some context. First, Reg CF only went live on May 16, 2016, and so the year against which 2017 is compared is only slightly over one-half of a calendar year; data from that year should be annualized to reflect the fact that deals were only happening for approximately 65% of the year. Also, on the advice of funding portals, issuers are setting extremely low target offering amounts, in some cases as low as $10,700 (1% of the maximum allowed in any rolling 12-month period). Accordingly, the above data on successful offerings may need to be viewed somewhat skeptically to the extent “successful offering” is determined based on whether or not an issuer exceeded its own stated targeted offering amount.

The report also offers the following points of analysis:

  • The market is growing at a rapid pace.
  • The pace of capital into funded offerings appears to be steady without showing signs of abnormal activity or irrational investor behavior.
  • The rapid increase in the number of offerings and investors proves that there is appetite for Reg CF from both issuers and investors.
  • Given the lack of irregularities or fraud, Reg CF (and the structure under which it provides for transparency) should be advocated by policy makers and government organizations.

The report does not offer data to support the premise of that last point, i.e., that there exists a lack of irregularities or fraud.

But We Still Need Further Reform

While the $100 million milestone should be cheered, there are objective reasons to believe that Reg CF is grossly underperforming as a capital raising pathway and failing to meet its potential. It was intended to democratize startup investment, to enable hundreds of millions of people who were effectively shut out of private offerings because of their lack of accredited investor status to invest in these deals for the first time. It’s believed that over 90% of the U.S. population would fall into that category and that there’s an estimated $30 trillion socked away in their savings accounts. If only 1% of that were to be reallocated to Reg CF deals, we’d be seeing a market of $300 billion dollars, which would dwarf the $72 billion in U.S. VC investment in 2017.

Which leads me to the need for further reform. Much has already been said about the low $1.07 million cap on issuers. Although the cap should certainly be raised to balance out the amount raised with the disclosure, filing and other burdensome requirements as well as to make Reg CF more competitive with other available pathways, the reality is that most Reg CF offerings are not even reaching the existing cap. That suggests that there must be other impediments in the rules that should be addressed to help companies raise permissible amounts.

Chief among these impediments in my view is the exclusion of investment vehicles from Reg CF. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors to invest in a special purpose vehicle whose only purpose is to invest in the operating company. Essentially, a lead investor validates a company’s valuation, strategy and investment worthiness. Traditionally, angel investors have operated in groups and often follow a lead investor, a model which puts all investors on a level playing field. The additional benefit to the portfolio company from this model is that the company ends up with only one additional investor on its cap table, instead of the hundreds that can result under current rules. I suspect that many companies are shying away from Reg CF or not reaching potential raise targets because of this reason alone.

Reg CF should also be reformed to raise the investment caps for investors. Currently, investors are capped based on their income or net worth, with a separate hard cap irrespective of net worth or income. At a minimum, there should be no hard cap for accredited investors. Makes no sense that Mark Zuckerberg be capped at $107,000.

Finally, under current rules, any Reg CF funded company that crosses a $25 million asset threshold would be required to register with the SEC under the Securities Exchange Act and become an SEC reporting company. This would have the potential to create a perverse incentive for a company not to grow, and seems inconsistent with the spirit of Reg CF, which for the first time allows companies to fund their growth by offering securities to the public without registering with the SEC. The asset threshold triggering Exchange Act registration should either be raised or eliminated.

Although Reg CF is still in its infancy and the data in the report could be read to indicate steady growth in a seemingly healthy emerging market, there is also reason to believe that the market has not even begun to tap its potential, a potential that may never be realized if perceived impediments are not mitigated or removed.

Last month, Secretary of the Commonwealth of Massachusetts William Galvin made good on his promise to conduct an exam sweep of ICOs in Massachusetts.  On January 17, the Enforcement Section of the Massachusetts Securities Division brought its first ICO related enforcement action, an administrative complaint against a company called Caviar and its founder Kirill Bensonoff for violations of state securities laws in connection with Caviar’s ICO. The complaint likely portends increased willingness on the part of state securities administrators to bring enforcement actions against ICO sponsors.  It also offers important lessons about how to conduct offshore ICOs so as to minimize the risk of offers and sales being deemed to be made to U.S. residents.

The complaint tells us that Caviar is a Cayman Islands company that has no actual place of business there, operating instead principally in founder Bensonoff’s home in Massachusetts.

The Caviar token offered in the ICO (CAV) was clearly a securities token; no pretense of a utility token here. Proceeds from the ICO were to be pooled and used to finance the acquisition of a portfolio of various cryptocurrencies, and also to finance short term “flips” of residential real estate properties. Purchasers of CAV tokens were told they would receive quarterly dividends equal to their pro rata share of 75% of the combined profits from this pooled investment fund of cryptocurrencies and real estate debt. Basically, Caviar was a virtual hedge fund and its tokens had key attributes of limited partnership or membership interests, i.e., they were securities.

The real interesting issue in this dispute would seem to be whether the offering was properly conducted offshore as intended and thus outside the jurisdiction of Massachusetts’ Securities Division (or any other securities regulators in the U.S.). Caviar’s argument would seem to be that the offering was made offshore and that they employed safeguards to ensure that no offers and sales were made to United States persons. Caviar’s ICO white paper states that United States persons (within the meaning of Rule 902 of Regulation S) are excluded from the offering and are explicitly restricted from purchasing CAV.

Before the complaint was filed, investors apparently had been purchasing CAV by visiting Caviar’s website at www.caviar.io (after the complaint was filed, the site was modified to greet U.S. persons with the following message: “It appears you are accessing caviar.io from United States of America.  Unfortunately, this website is not available in the United States of America.”).  To register for the offering, prospective investors were asked to provide an e-mail address and check two boxes. The first box indicated “Not U.S. person”, and the second box stated that the investor consulted with an experienced lawyer who advised the investor that he or she is eligible to invest. Caviar retained the services of an independent third party to screen out ineligible persons based on internet protocol addresses, i.e., numeric labels assigned to users or devices by internet service providers. If an individual was identified as a potentially prohibited purchaser, he or she would be prompted to upload copies of a government-issued photo identification. In sworn testimony given by Bensonoff before the Securities Division in this matter, he stated that “as far as [he knows], there’s not a single U.S. investor who has contributed.”

In the complaint, the Securities Division asserts that Caviar’s procedures to prevent the sale of CAV to U.S. investors are inadequate because Caviar’s identity verification procedures were relatively easy to circumvent. To prove the point, it had one of its investigators apply to participate in the Caviar ICO using the name of a “popular cartoon character”. The complaint doesn’t identify the cartoon character, perhaps in an effort to protect the Securities Division’s sources (if not its methods). When prompted to upload a photo ID (apparently because the investigator’s IP address indicated he was located in the U.S.), the investigator uploaded a photo of a government-issued photo ID obtained using a Google Image search. But the name, address, and date of birth listed on the submitted ID image didn’t match the personal information provided earlier by the investigator. Nevertheless, the investigator’s identity was “verified,” and the investigator was approved to participate in the Caviar ICO.

The complaint brought by the Massachusetts Securities Division offers some useful lessons for properly conducting an offshore ICO.  First, investor check-the-box self-certification will not suffice in the absence of effective verification measures by the sponsor to screen out ineligible persons. Second, inasmuch as it’s possible to identify applicants’ approximate geolocation based on internet protocol addresses, offshore ICO sponsors should carefully monitor the IP addresses of online investor applicants. Third, all applicants should be prompted to upload a copy of a government-issued photo ID, which should be carefully checked by the sponsor (either directly or through independent third parties) against other personal information provided by the investor.  Fourth, any attempt emanating from a U.S. IP address to open a link to an offshore ICO site should be directed to an alternate dead-end page that states nothing more than that the person seeking access appears to be in the U.S. and that the website is not available in the U.S.  Finally, a sponsor’s culpability will not be mitigated by lack of actual knowledge of any U.S. person purchases.

What happens when corporate directors approve their own awards under an equity incentive plan? Under Delaware law, so long as the plan is approved by a majority of the fully informed, uncoerced and disinterested stockholders, the awards will generally be protected by the business judgment rule and judges will not second guess them. Or will they?

Last month, the Delaware Supreme Court in In re Investors Bancorp, Inc. Stockholder Litigation ruled that awards made by directors to themselves under equity incentive plans approved by the stockholders should nevertheless be subject to the more demanding entire fairness standard, requiring the directors to prove that the terms are fair to the corporation, if the plan lacks fixed criteria and gives the board discretion in granting themselves awards. The ruling represents a departure from an earlier line of Delaware cases that held that the ratification defense would be available and the business judgment rule would protect grants to directors so long as the plan approved by the stockholders contained meaningful limits on awards to directors. After Investors Bancorp, director awards under stockholder-approved equity incentive plans will only benefit from the business judgment rule if the plan gives directors no discretion in making awards to themselves.

Delaware law authorizes a board of directors to determine its own compensation. Because directors are necessarily conflicted when compensating themselves, however, such decisions generally fall outside the protection of the business judgment rule and instead are subject to the entire fairness standard, meaning that if properly challenged as a breach of fiduciary duty the directors must prove those compensation arrangements are fair to the corporation. Depending on the circumstances, however, conflicted director transactions can generally avoid application of the entire fairness standard through stockholder ratification.

Courts have traditionally recognized the ratification defense in three situations involving director awards: (i) when stockholders approve the specific director awards, (ii) when the plan is self-executing (meaning the directors have no discretion in making the awards), and (iii) when directors exercise discretion and determine the amounts and terms of the awards after stockholder approval. The first two scenarios present no real substantive problems. The third scenario is more challenging, and was the issue addressed in Investors Bancorp.

Stockholders of Investors Bancorp approved an equity incentive plan that gave discretion to the directors to allocate up to 30% of all option or restricted stock shares under the plan to themselves, but the number, types and terms of awards to be made pursuant to the plan were subject to the discretion of the board’s compensation committee. After the Investors Bancorp stockholders approved the plan, the board granted just under half of the stock options available to the directors and nearly thirty percent of the shares available to the directors as restricted stock awards.

The plaintiffs argued that the directors breached their fiduciary duties by granting themselves these awards because they were unfair and excessive. According to the plaintiffs, the stockholders were told the plan would reward future performance, but the board instead used the awards to reward past efforts which the directors had already accounted for in determining their compensation packages. Also, according to the plaintiffs, the rewards were inordinately higher than those at peer companies. The court ruled that the plaintiffs properly alleged that the directors acted inequitably in exercising their discretion and granting themselves unfair and excessive awards, and, because the stockholders did not ratify the specific awards under the plan, the affirmative defense of ratification was unavailable.

There are two key takeaways here. First, inasmuch as director grants under discretionary plans will no longer benefit from stockholder ratification after Investors Bancorp, companies contemplating adoption of equity incentive plans should think seriously about making sure those plans are self-executing and contain no discretionary elements as to grants to directors. An example of a self-executing plan would be one in which each director is granted an option to purchase “x” shares upon election to the board and an additional “y” shares on the anniversary of his or her election. Second, existing equity incentive plans should be carefully reviewed to determine whether or not they are discretionary, and any proposed grants under discretionary plans, even if ratified by the stockholders, should be carefully vetted to ensure they are consistent with information disclosed to stockholders at the time of plan approval and reasonable under objective standards such as in relation to a peer group.