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

Statutory Authority of Board of Directors

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

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

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

Continue Reading Stay in Your Lane! Delaware Court Invalidates Stockholder Agreement Provisions that Encroach on Board Authority
SEC

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

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

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

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

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

Regulatory Background

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

Risks to Issuers

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

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

Risks to Finders

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

Finder Issues Unique to Early-Stage Companies

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

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

2020 Proposed Exemption

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

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

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

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

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

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

Need for Reform

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

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

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

Takeaway:

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

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

The 2018 Stock Option Grant

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

Was Musk a Controlling Stockholder?

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

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

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

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

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

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

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

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

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

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

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

Continue Reading Revenue Participation Rights as a Crowdfunding Instrument Alternative

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

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

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

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

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

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