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.

December 11, 2017 was a day of reckoning for entrepreneurs conducting or contemplating initial coin offerings, and for securities professionals who advise them.  First, a company selling digital tokens to investors to raise capital for its blockchain-based food review service abandoned its initial coin offering after being “contacted” by the Securities and Exchange Commission, and agreed to a cease-and-desist order in which the SEC found that its ICO constituted an unregistered offer and sale of securities. On the same day, SEC Chairman Jay Clayton issued a “Statement on Cryptocurrencies and Initial Coin Offerings”, warning “Main Street” investors and market professionals about investing and participating in ICOs, and reiterated the SEC’s determination to apply the securities laws to transactions in digital tokens. These two actions are the latest in a series of steps by the SEC to send a clear message that it intends generally to enforce the securities laws with respect to ICOs that emphasize the profit potential of tokens where such profit derives from the efforts of the entrepreneurs of the underlying project.

Cease and Desist Order

Munchee Inc. is a California-based company that developed an iPhone app for people to review restaurant meals. In October and November 2017, Munchee offered and then sold digital tokens it called “MUN” to be issued on a blockchain, seeking to raise approximately $15 million to improve the app and recruit users to eventually buy ads, write reviews, sell food and conduct other transactions using MUN. On or about October 31, 2017, Munchee started selling the MUN tokens. The next day, Munchee was “contacted” by the SEC staff, probably threatening cease and desist proceedings. The message was communicated loud and clear, because within hours Munchee stopped selling MUN tokens and promptly returned to purchasers the proceeds that it had already received. In anticipation of the institution of cease and desist proceedings, Munchee submitted an offer of settlement and consented to entry of the cease-and-desist order.

Despite Munchee holding itself out as offering a utility token that is not a security, the SEC’s position was that the MUN token was a security because the totality of Munchee’s efforts relating to the ICO resulted in a purchasers’ reasonable expectation of profits from the entrepreneurial efforts of Munchee’s management team. Interestingly, Munchee’s white paper included a three page legal disclaimer stating that it conducted a Howey analysis with the assistance of counsel and concluded that its MUN utility token didn’t pose a “significant risk of implicating federal securities laws”. As the order notes, however, the white paper did not set forth the actual analysis.

The SEC’s case that Munchee’s ICO of MUN tokens was a securities offering rests largely on the following arguments:

  • Token purchasers were led to believe that efforts by Munchee would result in an increase in value of the tokens.
  • Increase in value of the MUN tokens would occur whether or not purchasers ever used the Munchee restaurant app or otherwise participated in the MUN “ecosystem”.
  • Munchee emphasized it would take steps to create and support a secondary market for the tokens.
  • Promotional efforts included blatant predictions of increase in value of the token.
  • The ICO targeted digital asset investors, as opposed to targeting current users of the Munchee app or restaurant owners regarding the utility of the tokens.
  • ICO was promoted in worldwide publications, despite the app only being available in the United States.
  • Munchee paid people to translate offering documents into multiple languages, presumably to reach potential investors in other countries where the Munchee app was unavailable.

The order asserts that in the course of the ICO, Munchie and its promoters emphasized that investors could expect that there would be an increase in value of the MUN tokens resulting from efforts by Munchie, including paying users in MUN tokens for writing food reviews, selling both advertising to restaurants and “in-app” purchases to app users in exchange for MUN tokens, and working with restaurant owners so diners could buy food with MUN tokens and so that restaurant owners could reward app users in MUN tokens.

Munchee also emphasized in the ICO that it would take steps to create and support a secondary market for its tokens, including potentially burning (i.e., taking out of circulation) a small fraction of MUN tokens whenever a restaurant pays Munchee an advertising fee and buying or selling MUN tokens using its retained holdings in order to ensure there was a liquid secondary market for MUN tokens.

The SEC chose not to impose a civil penalty here, largely because of the remedial acts promptly undertaken by Munchee and the cooperation it afforded to the SEC staff.  Instead, the SEC ordered Munchee to cease and desist from committing or causing any violations and any future violations of Sections 5(a) and (c) of the Securities Act.  This is no slap on the wrist, however, inasmuch as it disqualifies Munchee from engaging in the next five years in an offering exempt under Regulation A or Rule 506 of Regulation D, the two likely securities exemptions for ICOs.

Chairman Clayton’s Statement

On the same day as the Munchee cease-and-desist order, SEC Chairman Jay Clayton issued a “Statement on Cryptocurrencies and Initial Coin Offerings” directed principally at “Main Street” investors and market professionals (including broker-dealers, investment advisers, exchanges, lawyers and accountants). The Statement asserts that in the aftermath of the SEC’s July 2017 investigative report applying securities law principles to demonstrate that the DAO token constituted an investment contract and therefore was a security, certain market professionals had attempted to highlight utility characteristics of their proposed tokens in an effort to claim that the tokens were not securities. “Many of these assertions appear to elevate form over substance”, Chairman Clayton noted, and that “replacing a traditional corporate interest recorded in a central ledger with an enterprise interest recorded through a blockchain entry on a distributed ledger may change the form of the transaction, but it does not change the substance”.

Particularly chilling for me as a securities lawyer was the following admonition by Chairman Clayton:

“On this and other points where the application of expertise and judgment is expected, I believe that gatekeepers and others, including securities lawyers, accountants and consultants, need to focus on their responsibilities. I urge you to be guided by the principal motivation for our registration, offering process and disclosure requirements: investor protection and, in particular, the protection of our Main Street investors” (bold appears in original Statement).”

In the Statement, Chairman Clayton presents interesting hypothetical contrasting business models for the distribution of books to illustrate the difference between a utility token and a securities token. An example of what would be characterized as a utility token that’s not a security would be a book-of the-month club selling tokens representing participation interests in the club as simply an efficient way for the club’s operators to fund the future acquisition of books and facilitate the distribution of those books to token holders. In contrast are interests in a yet-to-be-built publishing house where the token purchasers have a reasonable expectation of profit through the entrepreneurial efforts of the founders to organize the publisher’s authors, books and distribution networks. Chairman Clayton added that an additional circumstance contributing to a conclusion that a utility token is a security would be when promoters tout the secondary market trading potential of their tokens and the potential for the tokens to increase in value, which are “key hallmarks of a security and a securities offering”.

There should be no doubt about the seriousness with which Chairman Clayton is approaching the issue.  Toward the end of the Statement, he states that he has “asked the SEC’s Division of Enforcement to continue to police this area vigorously and recommend enforcement actions against those that conduct initial coin offerings in violation of the federal securities laws”.

Bloomberg reported on October 16 that over $3 billion dollars have been raised in over 200 initial coin offerings so far this year. It remains to be seen whether the pace of ICOs will slow down in the face of regulatory headwinds such as the outright ICO bans in China and South Korea. Here in the United States, the Securities and Exchange Commission has been sounding alarm bells. On July 25, the SEC’s Division of Enforcement issued a Report of Investigation finding that tokens offered and sold by a virtual organization known as “The DAO” were securities and therefore subject to the federal securities laws. I blogged about it here. On the same day the SEC issued the report, its Office of Investor Education and Advocacy issued an investor bulletin to make investors aware of potential risks of participating in ICOs.  Then on September 29, it charged a businessman and two companies with defrauding investors in a pair of ICOs purportedly backed by investments in real estate and diamonds. And on November 1, it issued a “Statement on Potentially Unlawful Promotion of Initial Coin Offerings and Other Investments by Celebrities and Others”, warning that any celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion.

Needless to say, the days of ICOs flying below the SEC’s radar are over, and developers conducting token sales to fund the development of a network need to be aware of the securities law implications of the sale.  In its Report of Investigation, the SEC made clear (what most of us suspected all along) that the traditional Howey test for determining whether a funding mechanism is an ”investment contract” and thus a “security” applies to blockchain based tokens. I won’t go into a deep dive here. For those wanting to jump into the weeds, Debevoise has done a pretty good job on this. But the basic test under Howey is that an agreement constitutes an investment contract that meets the definition of a “security” if there is (i) an investment of money, (ii) in a common enterprise, (iii) with an expectation of profits, (iv) solely from the efforts of others.

It’s useful to consider that blockchain tokens fall generally into two broad categories. “Securities tokens” are basically like shares in a corporation or membership interests in a limited liability company where the purchaser receives an economic right to a proportional share of distributions from profits or a sale of the company. On the other hand, “utility tokens” don’t purport to offer purchasers an interest or share in the seller entity itself but rather access to the product or service the seller is developing or has developed. Unfortunately, there exists virtually no SEC or case law guidance on securities law aspects of utility tokens. The token at issue in the SEC’s investigative report on The DAO was a securities token. The DAO was a smart contract on the Ethereum blockchain that operated like a virtual venture fund. Purchasers would share in profits from the DAO’s investments and so the tokens were like limited partnership interests.

The question of whether utility tokens are securities may turn on whether the blockchain network for which the tokens will function is fully functional or still in development, and an interesting debate has emerged as to whether there should be a bright line test on that basis.

One side of the debate, advanced by Cooley (Marco Santori) and Protocol Labs (Juan Batiz-Benet and Jesse Clayburgh), is that purchasers of utility tokens prior to network launch and before genuine utility necessarily rely on the managerial and technical efforts of the developers to realize value from their tokens. Accordingly, agreements for the sale of pre-functional tokens meet the “expectation of profit” and “through the efforts of others” prongs of Howey and should be characterized as securities. On the other hand, fully functional utility tokens should not be considered securities because they fail the “through the efforts of others” prong of Howey and maybe even the “expectation of profit” prong.  Purchasers of fully functional tokens are likely to be people seeking access to the seller’s network as consumers or app developers with any expectation of profit from appreciation of the tokens being a secondary motivation, so the expectation of profit prong of Howey fails as to those purchasers. The same conclusion should apply even as to the other type of purchaser who is motivated primarily by the prospect of a token resale for profit because the profit that is hoped for is not expected to come through the managerial or entrepreneurial efforts of the developers, but rather through the many different independent forces that drive supply and demand for the tokens. There is a line of cases involving contracts for the purchase of commodities holding that they are not securities because the expectation of profit was solely from fluctuations in the secondary market, and not from any efforts on the part of the producer. Fully functional tokens are analogous to commodities in that the token developers have completed development of the network, and so there should not be any expectation that profit will result from any further efforts by the seller.

On the other side of the debate is Debevoise, which advocates for a facts and circumstances approach, rejects the bright line test of whether or not a utility token is fully functional and offers several arguments. The determination of whether an agreement is an investment contract and thus a security has long been based upon a facts and circumstances analysis. A blockchain token is not a homogenous asset class; a token could be a digital representation of an equity or debt security but it could also represent things like hospital records or a person’s identity, and that particular character of the token is unaffected by whether the network is or is not fully functional. Also, there is an implicit recognition in the JOBS Act that pre-order sales on non-equity crowdfunding sites like Kickstarter and Indiegogo are not sales of securities, and that pre-functional utility token sales should be analyzed the same way.  It also questions whether agreements by a mature company to presell a new product in development would automatically be deemed an investment contract. Finally, there’s the difficulty of determining when exactly a token is fully-functional given the complexity of software and network development.

Seems to me that the arguments on both sides of the utility token debate have merit.  I do think there’s a distinction, though, between pre-order sales of product by a mature company and a sale of pre-functional tokens, in that the tokens most likely can be sold on a secondary market, with any profit likely resulting from the entrepreneurial efforts of the developer.  I also think that until we have guidance from the SEC and/or judicial opinions on the issue, the better approach is to treat clearly pre-functional tokens as investment contracts and conduct their sale under an exemption from registration.

A recent Delaware Chancery Court decision provides important guidance on what types of defective corporate acts may be ratified under Section 204 of the Delaware General Corporation Law (the “DGCL”), and what types may not.  Paul Nguyen v. View, Inc. also underscores the importance of focusing on whether to opt out of the class vote required by DGCL Section 242(b)(2) for changes in authorized capital, which effectively gives the common stock a veto over future funding rounds.

The facts of the case are as follows. View, Inc. develops smart windows that allow the light, heat, shade and glare properties of the glass to be controlled manually or electronically, thus enhancing comfort and reducing energy consumption and greenhouse gas emissions. After closing on a Series A round, View replaced its founder, Paul Nguyen, as CEO and CTO. While in mediation over the termination, View proposed a new Series B round of funding, which under Section 242(b)(2) of the DGCL required the consent of Nguyen as holder of a majority of the common. The parties then signed a settlement agreement in which Nguyen consented to the Series B, subject to a seven day revocation right. When Nguyen discovered the terms of the Series B would materially diminish his rights, he revoked his consent within the revocation period. Unbeknownst to him, View had already closed on the Series B. Nguyen then brought an arbitration proceeding against View, seeking a declaration that the revocation was valid and the Series B funding invalid. While the arbitration was pending, View closed on additional rounds C through F in an aggregate amount of over $500 million. After View filed two certificates of validation under DGCL Section 204 seeking to ratify the increase in authorized capital, Nguyen commenced the Chancery Court suit, which the parties agreed to stay pending the arbitrator’s decision on the validity of the consent revocation.

The arbitrator ruled that the revocation was valid and the Series B invalid. The ruling effectively meant that all of the related transaction documents were likewise invalid and void because Nguyen had not consented to them either. And since each of the subsequent rounds of financing rested on the Series B funding, the invalidation of the Series B effectively invalidated the Series C through Series F rounds as well, basically blowing up View’s capital structure. The Series A stockholders responded by seeking to resurrect the funding rounds through the ratification provisions of Section 204, initially by converting their preferred shares into common (thus becoming the majority holders of the class) and then by authorizing the filing of certificates of validation with the Delaware Secretary of State under Section 204.

The key issue in the case was whether an act that the holder of a majority of shares of a class entitled to vote deliberately declined to authorize, but that the corporation nevertheless determined to pursue, may be deemed a “defective corporate act” under Section 204 that is subject to later validation by ratification of the stockholders, an issue of first impression.

In 2014, the Delaware legislature created two alternative pathways for corporations to cure defective corporate acts. Section 204 provides that “no defective corporate act or putative stock shall be void or voidable solely as a result of a failure of authorization if ratified as provided [in Section 204] or validated by the Court of Chancery in a proceeding brought under Section 205.” Previously, acts deemed “voidable” could be subsequently ratified, but acts deemed “void”, such as the issuance of shares beyond what is authorized in a company’s charter, were deemed invalid. Prior to Sections 204 and 205, corporations had no way to remedy “void” corporate acts, even if the failure to properly authorize the act was inadvertent. The ability to cure defective acts is critical. Startups often need to clean up such acts prior to a funding round or acquisition, both to satisfy investor or acquirer due diligence issues and to enable counsel to issue opinion letters.

The court found that the Series B round was not a “defective corporate act” that is subject to ratification under Section 204 and ruled that View should not be allowed to invoke ratification to validate a deliberately unauthorized corporate act. As the holder of a majority of the outstanding common which was entitled to a class vote, Nguyen’s vote was required in order to authorize the Series B. The failure to obtain such authorization was not an oversight; it was the result of an affirmative rejection by Nguyen. Thus, the distinction here is between a defective corporate act that results from an oversight, which is curable under Section 204, and a defective corporate act resulting from an affirmative rejection by the stockholders, which is not curable under Section 204 (or 205).

One obvious takeaway is that companies should respect arbitrators’ rulings and should not proceed with a transaction, let alone a series of transactions, until stockholder authorization has been secured. View’s pursuit of the Series B round during the revocation period, and thereafter of the Series C through F rounds while the arbitrator’s ruling on the consent revocation was pending, was reckless to say the least. As the court put it, “[o]ne must presume that View understood that if the arbitrator found in favor of Nguyen on the consent issue, then the later rounds of financing that rested on the Series B Financing would collapse when that block was removed from the tower of blocks that comprised the Company’s preferred stock offerings”.  One can only presume further that it did so against the advice of counsel or despite counsel’s warning of the risk.

The other takeaway here is that companies should consider carefully whether to opt out of the class vote requirement under DGCL Section 224(b)(2) for changes in capital structure. Section 224(b)(2) requires any increase or decrease in authorized shares to be approved by holders of a majority of each class of stock entitled to vote, but allows corporations to opt out by providing as much in the charter. The National Venture Capital Association’s model amended and restated certificate of incorporation has an optional provision that states that the common and preferred will vote together as a single class on all proposals to increase or decrease the authorized capital, irrespective of the provisions of Section 242(b)(2). Failure to opt out effectively provides the common stockholders with a veto over future capital raises because each subsequent round requires an amendment to the charter not just to create the new series of preferred, but also to increase the number of authorized common to accommodate conversion of the preferred. Failure to eliminate the class vote requirement will force the company to have to seek the consent of holders of a majority of the common, providing them with unintended leverage in connection with a deal that’s presumably in the best interests of the company and its shareholders.

Cornell Tech celebrated a historic milestone today with the dedication of its new campus on Roosevelt Island in New York City. A collaboration of Cornell University (yes, my law school) and The Technion – Israel Institute of Technology, the 12 acre applied science and engineering campus is one of the most significant additions to the NYC landscape in the last several decades and will help solidify the City’s claim as the number two technology hub behind only Silicon Valley.

Hard to believe it’s been six years since the splashy news conference in which Cornell and The Technion were introduced as the winners of what had become a grueling competition for who would build the new campus. That announcement was itself the culmination of a strategic process that started in 2008, when a study commissioned by then Mayor Bloomberg determined that the best opportunity to replace the thousands of jobs lost in New York City in the financial crisis was in the technology sector through the creation of startup incubators, accelerators and investment funds, and that the success of these initiatives depended on the recruitment and retention of talent. In response to the study’s recommendations, Mayor Bloomberg launched a competition to build an applied science campus in New York City with a focus on entrepreneurship and job creation, with the winner to receive $100 million (a mere fraction of the ultimate cost which turned out to be in the billions) and free land.

As would be expected, the campus has some of the most environmentally friendly and energy efficient buildings in the world.  And as Technion President Peretz Lavie said to me, “the campus is the most beautiful I have ever seen”.  High praise.

Cornell Tech’s mission is to create “pioneering leaders and technologies for the digital age, through research, technology commercialization, and graduate-level education at the professional masters, doctoral and postdoctoral levels.” The campus will undoubtedly have an enormous impact on the innovation ecosystem in the New York City area. It will serve as a tremendous pipeline for high end technology talent. Most tech startup founders would say that their single biggest challenge is recruiting and retaining talent. Many Cornell Tech graduates will be recruited into existing startups. Others will join big tech companies. Many others will be founders themselves, and it’s predicted that there will be 600 spinouts from the campus over the next three decades. Over 30 startups have spun out already in the digital technology space, spanning consumer applications, devices, medical, media and communications.

This is just the first stage of development of the campus, which is not expected to be completed until 2043. The current faculty of 30 tenured and 60 overall is expected to grow to four times as big, and the plan is to expand the student body, currently 300, to up to as many as 2,500.

The dedication ceremony can be viewed here.  And here‘s a cool interactive 360° presentation.

On August 1, 2017, Delaware became the first state to allow corporations to record issuances, transfers and ownership of stock using blockchain technology.  Amendments to the Delaware General Corporation Law authorizing blockchain stock ledgers were passed by the Delaware State Senate and House of Representatives in June, signed by Governor John C. Carney Jr. in July and became law August 1. The amendments have enormous potential advantages for emerging companies, including cost savings, error avoidance, accuracy of ownership records and automation of administrative functions.

Blockchain is essentially an automated, decentralized, distributed database or ledger that allows participants on a given network to create an indelible, secure record of asset ownership and transfers directly and without the additional cost and delay associated with intermediaries. Each transaction is cryptographically signed and time stamped. While conventional transfers of assets typically require verification by third party intermediaries, blockchain based transfers rely on algorithms to confirm transaction authenticity.

Delaware law has required corporations to record stock transfers on a stock ledger and to maintain ownership records on the ledger. Stock ledgers are typically maintained by the corporate secretary or the company’s transfer agent who makes entries on paper or on an excel spreadsheet to reflect all transactions in the company’s stock. Under the current system, the corporate secretary or transfer agent must be notified of a stock issuance or transfer in order for the transfer to be recorded on the ledger and for the transferee to be treated as the record owner of the shares. The requirement for intermediaries to record stock transfers creates friction in the form of delay, expense and potential for error.

Prior to the blockchain amendments, Section 224 of the Delaware General Corporation Law provided that corporate records including stock ledgers could be maintained on any “information storage device”, but didn’t specifically allow for storage or recordation on electronic networks or databases, let alone any distributed electronic network or database. Section 224 has now been amended to provide that the information storage devices on which corporate records including stock ledgers could be stored may include “electronic networks or databases (including one or more distributed electronic networks or databases.”

The State of Delaware published an information sheet outlining the benefits to companies from registering issuances and transfers of shares in blockchain form, identifying three categories of benefits: cost savings, accurate ownership records and automation of administrative tasks. For privately held companies, maintaining a stock ledger on blockchain would:

  • enhance accuracy and ease management of the cap table
  • facilitate direct communications with investors
  • enable option grants to remain in sync with authorized shares
  • increase transparency of the shareholder voting process
  • prevent certain “foot faults” common to administering private companies
  • reduce likelihood of disputes

So if a corporation organizing in Delaware elects to use blockchain technology for its stock ledger, the Division of Corporations would cryptographically transfer to the company on the distributed ledger just those shares identified in the corporation’s certificate of incorporation as authorized. By doing so, the Division of Corporations establishes a perfect record of authorized shares, and the distributed ledger then reliably tracks subsequent issuances by the company and transfers by stockholders to produce a reliable record of issued and outstanding shares.

Under existing methods of share transfer and ownership recordation, an issuance or transfer could easily slip through the cracks. It’s not uncommon to discover gaps in a company’s cap table, often at the most inopportune time such as on the eve of closing a transaction, where the company inadvertently issued a number of shares in excess of the amount authorized, thus triggering the necessity for a filing under Section 204 of the DGCL to cure the defective corporate act. Blockchain based stock ledgers would eliminate this possibility.

Finally, the amendments impose certain requirements on blockchain based stock ledgers. First, electronic corporate records must be capable of being converted into legible paper form within a reasonable period of time. Second, as required of other stock ledger formats, blockchain based ledgers must be able to (i) be used to prepare a list of stockholders entitled to vote, (ii) record information required by the DGCL to be maintained in the ledger and (iii) record transfers of stock pursuant to Article 8 of the Delaware Uniform Commercial Code.

On July 25, 2017, the SEC’s Division of Enforcement issued a Report of Investigation (the “Report”) that concluded that the tokens issued in an initial coin offering (“ICO”) by a decentralized autonomous organization called “The DAO” were “securities” and that the ICO itself should either have been registered with the SEC under the Securities Act of 1933 or qualified for an exemption therefrom. Importantly, the Report does not conclude that all ICO tokens are securities or that ICOs must either be registered or satisfy the requirements for an exemption from registration. The Report provides important guidance, however, to blockchain startups and other entities seeking to raise capital in the United States through ICOs as to how to structure those offerings from a regulatory standpoint.

Initial Coin Offerings

An initial coin offering is a crowdfunding technique used primarily by blockchain startups in which the issuer sells cryptocurrency tokens or coins that entitle the purchaser to certain rights ranging from access to the issuer’s product or service once it is available (similar to pre-order based non-equity crowdfunding on sites such as Kickstarter or Indiegogo) to a share in the issuer’s profits (similar to equity based crowdfunding). Purchasers also typically have the right to resell their tokens on an online exchange. Purchasers make their contributions in the form of either fiat currency (e.g., U.S. dollars) or, more typically, virtual currency (e.g., bitcoin or ether). The offering and sale of the tokens are made directly to the public using blockchain technology to bypass conventional capital markets intermediaries and regulatory regimes. Advertising and information releases occur on the issuer’s website and on online forums such as Bitcointalk and Reddit.

Looming over the emerging ICO industry is the issue of whether ICOs are offerings of securities. Some issuers have chosen not to take the risk of offering and selling unregistered securities in the United States and have instead offered and sold ICO tokens only to non-U.S. persons. Among the most popular non-U.S. markets are Singapore, one of the first jurisdictions to adopt a regulatory sandbox and other regulatory relief initiatives for fintech companies, and Switzerland, whose “Crypto Valley” is a major center of blockchain startups. Other issuers in the U.S. have attempted to steer clear of possible regulation by limiting rights of token holders to access to products or services upon availability.

The DAO Initial Coin Offering

The DAO was a virtual entity referred to as a decentralized autonomous organization (i.e., not a corporation, LLC or other legal entity) formed to sell virtual tokens to raise capital for future projects, a variation on an investment fund.  DAO token holders would have the right to share in the earnings from the projects and could otherwise monetize their investments in DAO tokens by reselling them in online platforms serving as secondary markets.  The idea behind this virtual organization was to replace traditional corporate governance and decision making with smart contract coding on a blockchain.  But in addition to the automated governance structure, the DAO did have a human component as well in the form of “curators” who maintained ultimate control over which proposals would be submitted to and voted on by token holders and then funded by the DAO. A majority vote of the DAO token holders was required for a project to be funded.

The SEC’s Analysis

Section 5 of the Securities Act requires that every offer and sale of securities in the United States either be registered with the SEC or satisfy the requirements of an exemption from registration.  But are ICO tokens securities?  Under Section 2(a)(1) of the Securities Act, a security includes an “investment contract”, which was determined in the seminal case of SEC v. W.J. Howey Co. to mean an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.   In determining whether an investment contract exists, the investment of “money” need not take the form of cash. Investors in the DAO used ETH to make their investments. The Report makes clear that such investment is the type of contribution of value that can create an investment contract under Howey.

The Report then found that investors who purchased DAO tokens were investing in a common enterprise and reasonably expected to earn profits through that enterprise when they contributed ETH to the DAO in exchange for DAO tokens. The DAO’s various promotional materials informed investors that the DAO was a for-profit entity whose objective was to fund projects in exchange for a return on investment. The Report also found that investors expected profits to be derived from the managerial efforts of others—specifically, the DAO’s founders and curators. Because the investors did have an ostensible management role – voting on proposed projects — the central issue was whether the efforts of “others” were undeniably significant and essential to the failure or success of the enterprise. In this regard, the Report found that the DAO’s investors relied on the managerial and entrepreneurial efforts of the founders and the DAO’s curators to manage the DAO and put forth project proposals that could generate profits for the investors. The founders of the DAO also held themselves out to investors as experts in Ethereum, the blockchain protocol on which the DAO operated, and told investors that they had selected persons to serve as curators based on their expertise and credentials. Although DAO token holders were afforded voting rights, the SEC determined that such rights did not provide the holders with meaningful control over the enterprise because (1) their ability to vote for contracts was largely “perfunctory” (they could only vote on proposals that had been cleared by the curators); and (2) their pseudonymity and dispersion made it difficult for them to communicate or join together to effect change or exercise meaningful control.

A second major issue weighing on the ICO industry has been whether the online platforms on which ICO tokens are traded need to be registered under the Securities Exchange Act of 1934 as national securities exchanges.   Section 3(a)(1) of the Exchange Act defines an “exchange” as any group or entity that “provides a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange…”.  Under Exchange Act Rule 3b-16(a), a trading system meets the definition of “exchange” under Section 3(a)(1) if the platform “(1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade”. Alternatively, a platform could operate as an alternative trading system exempted from the definition of “exchange” if it registers as a broker-dealer, files a Form ATS with the SEC to provide notice of its operations and complies with the other requirements of Regulation ATS. The Report concluded that the platforms on which the DAO tokens were traded were exchanges under the foregoing Rule 3b-16(a) criteria, and thus should have been registered, because they provided users with an electronic system that matched orders from multiple parties to buy and sell DAO tokens for execution based on non-discretionary methods.

Key Takeaways

It’s unclear why the SEC determined to issue an investigative report rather than pursue an enforcement action against the DAO, its promoters and the exchanges on which the ICO tokens were traded. The underlying conclusions, however, are not surprising. Virtual currencies such as bitcoin and ether are “value” and ICOs in which purchasers have a reasonable expectation of profit through the efforts of the issuer’s promoters are securities offerings which must either be registered or qualify for an exemption. Giving investors “perfunctory” voting rights on proposals presented by promoters’ agents will not be enough to overcome a presumption that the investors expect a profit through the efforts of others. It’s worth noting that the SEC did not address ICOs of so called “access tokens” in which purchasers are given only a right to future products or services but no opportunity for profit. Such ICOs would need to be structured very carefully to ensure that contributors have no “reasonable expectation of profit”, and it’s unclear whether as a practical matter issuers will be able to raise significant amounts without offering a profit incentive. Finally, the Report puts ICO platforms on notice that electronic systems that match orders from multiple parties to buy and sell tokens based on non-discretionary methods must register either as a national securities exchange or as a broker dealer under Regulation ATS.

Since 2014, many private company mergers and acquisitions intermediaries have chosen not to register as broker-dealers. That’s because a 2014 SEC no-action letter took the position that intermediaries that limited their activities to representing private companies in M&A deals were not required to register with the SEC as broker-dealers.  But as a no-action letter, the relief provided was limited to the specific facts presented, and the letter implied that such relief would not be available to any intermediary that engaged in any of several listed activities. Greater certainty may be on the way, however, in the form of a small part of proposed legislation recently passed by the House of Representatives that would effectively codify the SEC’s 2014 no-action position and even expand on it.

Background

Section 15(a) of the Securities Exchange Act of 1934 requires any broker-dealer engaging in interstate commerce to register with the SEC and be subject to its regulatory regime. The term “broker” is defined broadly in Section 3(a)(4) of the Exchange Act to include any person who effects transactions in securities on behalf of others, and the SEC has historically interpreted the meaning of “effects transactions in securities” to include anyone engaged in significant aspects of a securities transaction, including solicitation, negotiation and execution. The inclusion of a transaction based or success fee has long been interpreted as a strong presumption that the intermediary receiving the fee must register as a broker-dealer.

So is an acquisition of a company considered to be a securities transaction such that intermediaries should have to register as broker-dealers? The broker-dealer regulations were designed to prevent abuses in the form of high pressure selling tactics and third party custody of funds, two aspects that typically don’t apply to M&A deals. Moreover, 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 custody funds. Nevertheless, the U.S. Supreme Court thought otherwise and in 1985 opined that an M&A transaction involving a target’s stock is a securities transaction, and consequently many M&A advisors began registering as broker dealers.

The 2014 No-Action Letter

In the 2014 no-action letter, the SEC Division of Trading and Markets stated that it would not recommend enforcement action to the SEC if an intermediary were to effect securities transactions in connection with the transfer of ownership of a privately-held company. The letter 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 sale of a company to a “passive” buyer.

Financial CHOICE Act of 2017

On June 8, 2017, the U.S. House of Representatives passed the Financial CHOICE Act of 2017, which repeals or modifies significant portions of Dodd-Frank but also includes a broad range of important provisions aimed at facilitating capital formation pro-growth policies generally, including an exemption from broker dealer registration for private company M&A intermediaries.   Like the 2014 no-action letter, the Financial CHOICE Act would deny the exemption to any broker intermediating an acquisition of a shell company or a transaction involving the public offering of securities or engaging in the custody of funds or securities. But unlike the 2014 no-action letter, the Financial CHOICE Act would not exclude brokers that put together groups of buyers or provide acquisition financing, or intermediate a sale of a company to a passive acquiror.  One feature present in the Financial CHOICE Act that was not included in the 2014 no-action letter is a size of target test. Specifically, under the Financial CHOICE Act, the exemption is only available if the target has gross revenues below $250 million and EBITDA below $25 million in the fiscal year ending immediately before the fiscal year in which the services of the M&A broker are initially engaged with respect to the transaction.

The legislation has moved to the Senate, and hopefully any final version would include some form of private company M&A broker-dealer registration exemption. Of particular significance in the proposed legislation is the apparent allowance for a non-registered broker to organize groups of buyers which would enable private equity club deals. Nevertheless, even if the legislation passes, private company intermediaries should consider carefully the consequences of non-registration (or withdrawal of those already registered). These would include complications under certain state regulatory regimes and exclusion from the possibility of intermediating public company deals or deals involving targets exceeding either the gross revenue or EBITDA thresholds.