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

Background

The SEC brought this lawsuit against Ripple and two of its executives in December 2020, arguing the defendants offered and sold over $1.5 billion of XRP without registration or exemption in violation of Section 5 of the Securities Act of 1933.  You can read more in my blog post here from two years ago about Ripple and about the SEC’s complaint.  In September of 2022, both sides filed motions for summary judgment.  On July 13, Judge Torres granted the SEC’s motion for summary judgment as to private “institutional sales”, and granted Ripple’s motion for summary judgment as to “programmatic sales” on digital asset exchanges.

At the heart of this case was the issue that’s been central to just about every other enforcement action brought by the SEC in the digital asset space: whether XRP is an “investment contract” and thus a type of security as defined by the Securities Act of 1933.  Under the standard set forth in the seminal 1946 Howey case, an investment contract requires (i) an investment of money, (ii) in a common enterprise, (iii) with a reasonable expectation of earning a profit through the efforts of others. 

Ripple engaged in two distinct types of XRP sales: private “institutional sales” under written contracts for which it received $728 million, and “programmatic sales” on digital asset exchanges for which it received $757 million.  Judge Torres analyzed the two transaction types through the lens of Howey, and both turned on Howey’s third prong: whether or not the investors had a reasonable expectation of earning a profit through the efforts of others.

Institutional Sales

Ripple sold $728 million of XRP to sophisticated individuals and entities (the “institutional buyers”) pursuant to written contracts.     

The court cited precedent showing that “profit” includes increased value of the Investment. Further, “reasonable expectation of profit from the efforts of others” need not be the sole reason a purchaser buys an investment, as an asset can be sold for both consumptive and speculative uses. The inquiry is an objective one, focusing on the promises and offers made to investors; it is not a search for the precise motivation of each individual participant.

Based on the totality of the circumstances, the Court found that reasonable investors in the position of the institutional buyers would have purchased XRP with the expectation that they would derive profits from Ripple’s efforts.  Based on Ripple’s communications and marketing campaign and the nature of the institutional sales, the Court determined that reasonable investors would have understood that Ripple would use the capital to improve the market for XRP and develop uses for the XRP network, thereby increasing the value of XRP.

Programmatic Sales

The Court reached the opposite conclusion as to the $757 million of “programmatic sales” to public buyers on digital asset exchanges.  Whereas the institutional buyers reasonably expected that Ripple would use the capital it received from them to improve the XRP network and increase the price of XRP, programmatic buyers on digital asset exchanges could not reasonably expect the same.  

Ripple’s programmatic sales were blind bid/ask transactions, and buyers could not have known if their payments of money went to Ripple, or any other seller of XRP. Also, Ripple’s programmatic sales represented less than 1% of the global XRP trading volume, meaning that the vast majority of XRP buyers on digital asset exchanges did not invest their money in Ripple at all.  Unlike institutional buyers who purchased XRP directly from Ripple pursuant to a contract, programmatic buyers stood in the same shoes as secondary market purchasers who don’t know to whom they were paying their money.

While some programmatic buyers may have purchased XRP with the expectation of profits to be derived from Ripple’s efforts, a proper inquiry focuses objectively on the promises and offers made to investors, and is not a search for the precise motivation of each individual participant. Ripple didn’t make any promises or offers to these buyers because Ripple didn’t know who was buying the XRP, and the purchasers didn’t know who was selling.  There was also no evidence that any of the promotional materials that Ripple provided to the institutional buyers were distributed to the general public.

Closing Thoughts

The Court’s split decision provides helpful guidance to the crypto industry as to circumstances under which a digital token would be deemed a security and when it wouldn’t.

But the ruling that a digital token is a security when it’s sold to sophisticated investors but not when it’s sold to retail investors would lead to perverse results as a matter of policy in that those who have the wherewithal to defend themselves and have the leverage to negotiate for contractual safeguards will nevertheless receive the protections of the securities laws, yet retail investors will not.  That seems to upend a fundamental tenet of the securities laws which is that they are intended to protect those who cannot fend for themselves.

Also, the ruling seems to contradict the “fraud on the market” theory of the securities laws.  In a securities fraud case, a plaintiff does not need to prove that he relied on a company’s fraudulent misstatements or omissions.  A plaintiff need only show that the company’s misrepresentations were material and publicly known, that the stock traded in an efficient market and that the plaintiff traded in the company’s stock during that time.  The rationale here is that an investor who trades in a public market stock relies on the integrity of the price of that stock, and because most publicly available information is reflected in the market price, an investor’s reliance on any public material misrepresentations is presumed for purposes of a securities fraud action.

In his July 14 Money Stuff column, the ever creative Bloomberg columnist Matt Levine analogizes this to a company like Meta, which once upon a time sold an aggregate of approximately $11 billion in its IPO and one follow-on offering, but hasn’t sold any shares to the public in many years.  People buy and sell approximately that much of Meta stock to each other — on any given day! – yet very few of those people ever look at Meta’s SEC filings.  Nevertheless, if it turned out that Meta had made a material misstatement or omission in one of those filings, it would not be able to argue that the case should be dismissed because most of the retail traders in the stock didn’t even read the disclosures in the filings.  Yet that is the implication of the Court’s ruling in Ripple.

[1]  The Order also found that XRP is not an investment contract and thus not a security when offered and sold by Ripple to employees as compensation (because it failed the “investment of money” prong inasmuch as no consideration was paid for the Tokens) and when insiders sold XRP on digital asset exchanges (for the same reason that XRP sold by Ripple on exchanges were not deemed investment contracts, i.e., seller and buyer anonymity).

Clapperboard,With,Rolls,Of,Film,In,The,Retro,Concept,Cinema.

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

Angel Studios, which acquired the distribution rights to “Sound of Freedom”, is a non-traditional film distribution studio, even on indie standards.  The films it distributes get selected through a crowdsourcing process in which filmmakers pitch projects to a community of thousands of Angel Studio platform users from all over the world who share Angel Studios’ mission to create meaningful films that the big studios won’t promote.  “Stories that amplify light” is the studio’s tag line.  Angel Studios then launches equity crowdfunding campaigns on its affiliated crowdfunding portal Angel Funding to fund the cost of marketing the crowdsourced films.

Angel Studios raised the money to fund the distribution costs of “Sound of Freedom” through a crowdfunding offering under Regulation CF, which allows issuers to raise up to $5 million in any 12-month period from anyone, not just accredited investors, online without a full SEC registration.  Most Reg CF offerings don’t even come close to raising the $5 million maximum amount.  Angel Studios successfully raised the maximum $5 million in this offering from approximately 7,000 investors. 

As is required by Reg CF, all sales and communications were made through one crowdfunding portal.  In this case, that funding portal was Angel Funding, a sister company of Angel Studios.  Angel Funding does Reg CF crowdfunding raises primarily for the same film production companies whose films are distributed by Angel Studios after the films have been produced.

Angel Studios conducted this offering in order to fund the “prints and advertising” expenses associated with the theatrical distribution of “Sound of Freedom”.  “Print and advertising” or “P&A” generally refers to the money spent to release and market a completed feature film.  Funding P&A is attractive to investors because it’s less risky.  The money is only raised after the film is already made and investors are investing in a finished product they could actually evaluate.

As was the case with the manner of funding, the investment instrument used in this offering was also unconventional.  Instead of issuing stock, convertible notes or SAFEs, Angel Studios issued “revenue participation rights” under a revenue participation agreement each investor was required to sign with the studio. 

Under the revenue participation agreement, Angel Studios is required to pay the investors on a first priority basis all of the gross receipts from the theatrical release of “Sound of Freedom” until the investors have received a maximum return of 120% of the amount they invested. If gross receipts from the film don’t exceed the total amount invested in the offering plus 20%, the investors will be paid 100% of the film’s gross receipts on a pro-rata basis.

“Gross receipts” are defined as all revenues received and earned by Angel Studios from the theatrical release of “Sound of Freedom”.  Investors won’t be entitled to receive payments from any other sources of revenue that may be generated by the film (presumably, such as proceeds from streaming service downloads). Unlike stock, investors don’t share in any upside beyond a return of up to 20%. The revenue participation rights are not common equity, are not entitled to any distributions or voting rights and are not secured by a security interest in any assets of Angel Studios.

The revenue participation rights issued here look like a variation on a traditional revenue participation financing where an agreed-upon percentage of general revenues are paid to the investors until they’ve achieved a designated percentage return. In both cases, investors don’t become equityholders in the issuer.  Nor do they become creditors in the traditional sense inasmuch as there’s no promise by the issuer to repay the investors except to the extent the issuer generates gross revenues sufficient to fund the revenue participation commitment.

The difference in the “Sound of Freedom” revenue participation is that the revenues supporting the participation rights are limited to one discreet project, the “Sound of Freedom”, and not the general revenues of Angel Studios.  Also, while a typical revenue participation arrangement provides for an agreed upon portion of revenues to go to the investors until they’ve achieved the agreed-upon return, the investors here have the right to receive 100% of the film’s revenues until the designated return is achieved.

Revenue participation arrangements have features that benefit both issuers and investors.  The deal structure is easy to explain and there’s no need to argue over valuation, a common stumbling block in investment negotiations.  Issuers appreciate the absence of equity participation and the lack of pressure to produce an exit event.  Investors on the other hand are attracted to the first call on revenues and the multiple rate return.  But the arrangement of course only makes sense when the issuer’s business model calls for reasonably predictable and adequate gross revenues. 

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

Drag-Along Provisions and Covenants Not-to-Sue

A drag-along provision compels a group of stockholders to vote in favor of a transaction approved by another group of stockholders and/or the company’s board of directors. A drag-along right can be particularly important in an acquisition where approval by all or almost all stockholders may be required. It can also be used to allow a minority of stockholders to drag the majority, which is often the case in the context of a VC-backed company where the drag-along may require most or all stockholders to vote in favor of any sale transaction approved by the investors.

Drag-along rights facilitate exits by preventing common stockholders from thwarting a sale of the company. The drag-along is most likely to be exercised if a company is presented with a modest acquisition proposal in which the common would receive little or no proceeds after payment of the investors’ liquidation preference.  It could also be exercised any time the investors and common stockholders disagree about the merits of a potential acquisition. In such a scenario, the investors want the ability to force the common stockholders to approve a transaction the investors believe is in their (i.e., the investors’) best interests.

An increasingly common feature of drag-along provisions is a related covenant by the drag-along shareholders not to sue over a drag-along sale, including with respect to claims for breach of fiduciary duty.  Without such covenants, shareholders in a drag-along sale, although powerless to stop the sale, could still bring claims for breach of fiduciary duty.

New Enterprise Associates 14, L.P. v. Rich

The plaintiffs in this case were VC funds (the “Funds”) that invested in a cloud security startup called Fugue, Inc. Six years later, the Funds encouraged management to seek a liquidity event. After a fruitless six-month search for a buyer, the company needed capital. When the Funds declined to invest further, the company’s only option appeared to be a recapitalization led by an investor named George Rich that would put his group in control of the company.  Under the terms of the recapitalization, the Funds agreed to execute a voting agreement containing a drag-along right in favor of Rich and a related covenant not to sue Rich or his affiliates over any drag-along sale, including any suit for breach of fiduciary duty (the “Covenant”).

Certain conflict transactions occurred in the aftermath of the recapitalization. A potential acquirer contacted the company, and subsequently the company’s independent directors resigned.  The Rich-controlled board then approved an issuance of shares to many of the original recapitalization investors at the same distressed price per share as their original investment. In connection with these issuances, the company allegedly failed to comply with the Funds’ right of first offer and to deliver a notice of stockholder action to the Funds under Section 228(e) of the Delaware General Corporation Law.  The board then approved an issuance of stock options, mostly to themselves, with vesting provisions that accelerated upon a change of control.

Shortly after these interested issuances, the company’s management negotiated a merger with Snyk Limited, a cybersecurity company.  The Funds were asked to join the merger, but declined when Rich and another director refused to attest that they had not communicated with the acquirer regarding a potential transaction before the recapitalization.  After the merger closed, the plaintiffs learned of the conflict transactions and sued the company’s directors for breach of fiduciary duty.

In analyzing whether the suit should survive the Covenant, the court noted that this seems on the surface like an easy case for enforcement: sophisticated stockholders granted another investor a contract right to engage in a transaction that met specified criteria, and promised not to sue the investor or his affiliates if the investor exercised that right. The investor committed capital to the company in reliance on the stockholders’ promise. When the investor later exercised his contract right, the stockholders did what they agreed they wouldn’t do: sue over the transaction.

The court cited specific features of the Covenant that supported enforcement.  The Covenant is sufficiently specific because it only applies to a transaction that meets identified criteria required for a drag-along sale. The Funds did not broadly covenant not to assert any claims for breach of fiduciary duty. They agreed not to sue over a specific transaction with specific characteristics.  Accordingly, the court determined the Covenant is not invalid on its face.

The court also determined the Covenant is not invalid on the facts of the case.  The court cited a series of dispositive factors from an earlier case, including (i) the presence of a written contract, (ii) the clarity of the waiver, (iii) the stockholder’s understanding of the waiver’s implications, (iv) the stockholder’s ability to reject the provision, (v) the existence of bargained-for consideration, and (vi) the stockholder’s sophistication. 

The court found that on these factors, the facts of this case merit enforcement. The Covenant appears in a voting agreement. It is clear and specific. The Funds are sophisticated actors. The Covenant tracks a provision that appears in a model voting agreement sponsored by the National Venture Capital Association and widely used in the industry. The Covenant was part of a bargained-for exchange that induced Rich to lead the recapitalization, his fellow investors to participate and Rich and his colleague to serve on the board. If the Funds didn’t like the recapitalization, they could have blocked it, forced the company to seek different terms or funded the company themselves. If they saw no alternative but thought Rich had secured a great deal, they could have joined the investor group. Instead, they decided to pass, agreed to the Covenant and let Rich and his investor group take the risk.

Although the court determined the Covenant is not invalid on its face or as applied to the facts, it held nevertheless that the Covenant’s scope still stretched beyond what Delaware law allows. Delaware law generally prohibits contractual provisions that purport to exculpate a party for tort liability resulting from intentional or reckless harm. The Covenant purports to bar all challenges to a drag-along sale.  According to the court, however, a covenant not-to-sue cannot insulate the defendants from tort liability based on intentional wrongdoing.  In the context of opposing a motion to dismiss, the court determined that the plaintiffs’ allegations rely on facts supporting an inference that the defendants could have acted intentionally and in bad faith to benefit themselves and harm the common stockholders during the lead up to the drag-along sale. Consequently, the court ruled that the plaintiffs’ counts relating to the drag-along sale cannot be dismissed at the pleading stage, and denied the defendants’ motion to dismiss.

Takeaways

The New Enterprise Associates ruling against defendants seeking to enforce a drag-along covenant not-to-sue should be considered in its procedural context.  On a motion to dismiss, the Court determined that the plaintiffs’ allegations relied on facts supporting an inference that the defendants could have acted intentionally and in bad faith to benefit themselves and harm the common stockholders during the lead up to the drag-along sale when they caused the company to issue to themselves allegedly discounted shares and options with accelerated vesting on a change in control, all while breaching the plaintiffs right of first offer and their own statutory obligation to notify the plaintiffs.  This case thus involved unique facts pertaining to the run-up to a drag-along sale, not the sale itself, and it is unclear whether alleged misconduct pertaining directly to a drag-along sale will overcome an NVCA style covenant not-to-sue made by sophisticated parties.  This case shows that the analysis into whether a drag-along covenant not-to-sue over fiduciary duties is enforceable is highly fact-specific, and investors and practitioners should strictly adhere to the criteria presented in this opinion.

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

Background

Before Dodd Frank, venture capital fund advisers didn’t have to worry seriously about Investment Advisors Act regulation.  That’s because the Advisers Act exempted any investment advisor that had fewer than 15 clients and didn’t hold itself out to the public as an investment adviser.  For the purpose of the 15-client cap, the SEC treated each fund as one client. As a result, investment advisers could advise up to 14 private funds, regardless of the total number of LPs investing in a fund or the amount of assets in the funds, without the need to register with the SEC.

But as part of Dodd Frank, Congress repealed the exemption for advisers with fewer than 15 clients and replaced it with three more limited exemptions under the Advisers Act, one of which is an exemption for investment advisers that solely advise “venture capital funds”.  The SEC definition of “venture capital fund” contains five components, one of which is that the fund may not invest more than 20% of its aggregate capital contributions and uncalled committed capital in assets that are not “qualifying investments”. Qualifying investments are generally direct investments in qualifying portfolio companies, which exclude private funds or other pooled investment vehicles. Secondaries and fund-of-fund investments are considered non-qualifying investments because the assets obtained through such transactions are not acquired directly from a qualifying private company.  

The “directly acquired” requirement means that secondary investments, i.e., purchases from non-issuers such as founders, employees and other investors, do not constitute qualifying investments.  Also, investments in other VC funds are excluded from the definition of qualifying investments.  That means VCs must carefully monitor their secondary and investment vehicle investments to make sure they don’t exceed 20% of committed capital, and I suspect some VCs as a matter of policy avoid these transactions entirely to avoid the compliance headache.

Secondary Transactions

The SEC’s stated rationale for the direct investment rule is its desire to distinguish between VC funds, which are the subject of the investment advisor exemption, and other investment funds which are not. The SEC observes that one of the features of VC funds that distinguishes them from hedge funds and private equity funds is that they invest capital directly in portfolio companies for the purpose of funding expansion and development of a company’s business rather than buying out existing security holders.

The inclusion within non-qualifying investments of secondary and fund-of-funds investments, however, has been perceived by many in the VC space as contributing to an unnecessary impediment to liquidity in the innovation ecosystem.

Secondary transactions have become increasingly common in the venture capital industry.  As companies remain private longer and defer exits, the desire for liquidity grows among founders and other shareholders.  Founders and employees typically have most of their net worth tied up in their company’s shares and have an understandable desire to diversify and generate some liquidity currently.  Angel investors seek liquidity to be able to fund new investment opportunities.  Syndicate members often just get tired and want out. 

VCs often make secondary purchases of shares from founders and other holders to increase their ownership. The additional shares purchased by VC funds in secondary transactions often serve as a critical bridge between the needs of a fund to obtain sufficient ownership in a portfolio company to generate enhanced returns for LPs and the concerns of entrepreneurs and angel investors over the dilution they would experience if such additional shares were purchased directly from the company. Without secondary transactions, many venture funds and prospective portfolio companies may be unable to bridge that gap, resulting in a decline in VC investing in early-stage companies. Secondary transactions also serve to align the goals of VC funds and founders to continue to grow the company rather than selling it early to achieve founder liquidity.

VC Investment in VC and Other Vehicles

It’s become common for VC funds to allocate some of their investment to other VC funds as well as other investment vehicles such as “feeder”, “incubator”, “accelerator” or “micro-VC” funds. These seed or seed-type funds in turn invest at the very earliest stages of a portfolio company’s life and then rely on larger VC funds to participate in follow-on Series A or other future rounds.  Seed funds are a great asset to both startups and larger VCs, as they allow for a significantly larger pool of companies to receive seed funding and form a larger universe of investable companies for larger VCs.

Another group of VC funds that receives investment from larger VC funds is emerging funds.  Emerging fund manager sponsored funds tend to invest in startups developing new disruptive technologies, and thus play an important role in the venture economy.  Investing in these emerging VC funds is perceived by many asset managers as posing higher risk but offering greater upside potential than more established funds with track records.  

Institutional LPs are often interested in higher risk, higher reward emerging funds but may be constrained by their own minimum investment requirements which typically exceed the round size of a typical emerging fund.  Other interested institutional LPs may want to mitigate against the risk of investing in a smaller emerging fund by taking a diversified approach to their investment in the space.  For such institutional LPs, it would make sense to allocate some investment to a fund-of-VC funds that invests partly in emerging VC funds and partly in traditional VC funds.

VCs make investments in still other types of investment vehicles.  One example is technology incubators that create and spin out start-ups.  Another is companies that are in the “invention business” whose assets consist almost entirely of patent portfolios.  VCs also sometimes invest in investment vehicles whose other members are well-connected technology entrepreneurs who help VCs identify prospective portfolio companies and then invest in them side by side with the VCs through the vehicle.

All these indirect investments currently fall within the 20% limitation, resulting in impediments to both capital formation and liquidity in the innovation ecosystem.

The DEAL Act

Last month, the House Financial Services Committee passed and introduced to the full House of Representatives a focused piece of legislation to revise the definition of “qualifying investment” for purposes of the exemption from registration for venture capital fund advisers under the Investment Advisers Act.  Called the Developing and Empowering our Aspiring Leaders Act of 2023 or the “DEAL Act of 2023” (Congress loves catchy acronyms), it specifically orders the SEC to revise the venture capital fund adviser exemption’s definition of a “qualifying investment” to include secondary acquisitions and investments in other venture capital funds.  Under the new rule, shares purchased by VC funds in secondary transactions or in other venture capital funds will no longer be deemed non-qualifying investments and thus not included in the portion of a VC fund’s investment portfolio that may not exceed 20% of committed capital. 

If passed by Congress and signed into law, this reform of the venture capital fund exemption could lead to greater investment in early-stage companies and significantly more liquidity for founders and other early investors.  The bill is part of a larger piece of legislation called the Expanding Access to Capital Act of 2023 and now moves through the legislative process.

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

But SVB’s downfall will impact startups in tangible ways as well.  SVB was the largest provider of venture debt, a niche category of lower cost financing that was tailored for early stage, venture backed companies.  Venture debt provides an attractive means for startups to extend runway with less dilution, at lower interest rates than with standard commercial loans (typically, 50 basis points above prime) and looser credit protection mechanisms.  Less dilution rather than no dilution (as is the case with most loans) because venture debt almost always involves an equity kicker in the form of warrants. Venture debt is predicated on venture investors providing equity in subsequent rounds to take out the earlier venture loans.  Interest rate and loan size tend to vary based on the scale of the company, the amount of equity previously raised and the use of proceeds.  Venture lenders typically agree to lend between 25% to 35% of the amount raised in the most recent equity round.  

Interestingly, it’s possible that SVB borrowers breached their loan covenants as a result of their run on the bank that precipitated its collapse.  Most venture debt loan agreements mandate that the lender be the borrower’s principal depository and disbursement bank, and require the borrower to conduct all of its primary banking business with the lender, including primary deposits. SVB’s loan agreements typically included this banking relationship covenant, which would have been breached by the withdrawing depositors absent a waiver from SVB.  In any event, with SVB’s collapse, venture debt will now be more expensive and scarce.

The anticipated contraction in the venture debt market will also likely result in lower valuations.  In a recent research brief, the good folks at CB Insights picked up on two telling statements contained in SVB’s mid-quarter update for first quarter 2023.  The first of these quotes is that “[c]lients [of SVB] continue to opt for debt over raising equity at pressured valuations.”  As to “pressured valuations”, CB Insights offers data illustrating a tangible disconnect between public and private tech company valuations.  According to CB Insights, the combined market cap of the companies that went public in the 50 largest tech IPOs since 2020 is down 59% as compared with their combined market cap at the time of their respective IPOs. On the other hand, Series C and Series D valuations were actually up 20% and 30%, respectively, as compared with 2020.  CB Insights’ theory on the disconnect is plausible:  many venture backed companies would have faced down rounds, but avoided a lower valuation by opting for venture debt.  Further, CB Insights also believes the fittest companies were the ones securing equity funding at lofty valuations, while the weaker ones were being funded with venture debt to avoid down rounds, further feeding the disconnect between public and private company valuations.  With venture debt now harder to come by, however, it stands to reason that more companies will need to seek equity funding and that, with VCs far more discerning than they were a year ago, such rounds will necessarily be at lower valuations, meaning more down rounds.

The headwinds in the venture debt market may also impact headcount.  Another telling quote in SVB’s mid-quarter update for first quarter 2023 was that “[c]lient cash burn remains ~2x higher than pre-2021 levels.”  CB Insights’ analysis bears this out, finding that 86% of unicorns increased headcount since Q1’22, and that 37% of unicorns have grown headcount by more than 50%.  Hence, it seems that companies have been able to avoid tough headcount decisions either by closing equity rounds at valuations that thus far have remained persistently high (in the case of the stronger companies) or by securing venture debt (in the case of weaker companies).  Consequently, with the coming challenges in venture debt, coupled with the already contracting venture equity market, it stands to reason that, in addition to lower valuations, we’ll also likely be seeing increasing layoffs.  Looks like a bumpy road ahead for startups.

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.

Background

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.

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FTX

“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.