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Friedman v. Dolan: Substituting Ineffective Process for Substance (Part 4)

We are discussing Friedman v. Dolan.

Where does this leave things?  In the court's analysis: 

  • The controlled nature of the company was irrelevant; 
  • The allegation that the family held a majority of the seats on the board and more than 70% of the voting power was irrelevant;   
  • The fact that the total compensation obtained by directors in 2011 was in the vicinity of $200,000 and was irrelevant in determining director independence (see 2012 proxy statement at 48) (similar amounts were provided in 2012 and 2013 and 2014).  
  • The desire to maintain a board position and continue to be paid as a director was deemed irrelevant (the court stated that the fact of compensation was "not enough" to affect independence without bothering to examine whether the amounts were actually material);     
  • The reality that directors on the compensation committee, had they approved less lucrative compensation packages, would have had to interact with the same individuals (and their family members) at subsequent board meetings was irrelevant;   
  • The allegations that one of the family members assisted in "choosing and evaluating the peer group" used by the board in connection with the compensation was irrelevant; 
  • The allegations that the chair of the compensation committee served on the board since 1996, with Charles having been Executive Chairman since 1985 and James a member of the board since 1995 was irrelevant; and 
  • The allegation that the chair of the compensation committee served as a director for MSG, "another company under the Dolan family's control" (and where his brother also worked) was considered irrelevant.

Leave aside that in other countries, the fact that directors are elected by a controlling shareholder matters. Leave aside that, in other countries, the number of years serving on the board matters.  Delaware courts categorically dismiss these factors but have never really explained how these factors are irrelevant to a determination of director independence.  Leave aside that fees paid to directors can be material but that Delaware courts refuse to analyze the materiality of the amount.  And leave aside that the only thing shareholders really asked in this case was to have the compensation reviewed for fairness.    

The ultimate outcome may or may note have been fair to the company.  But certainly, given these allegations, an examine of the fairness of the compensation was in order.  The court, however, examined the allegations individually, as if they stood alone.  A holistic examination of the facts alleged by plaintiff would have dictated more than a court coming away "troubled." It would have dictated an examination of the fairness of the amounts paid.  

In Delaware, compensation need not be fair.  It is enough that there process.  Process in Delaware, however, is a quantitative rather than a qualitative standard.  It is enough that certain boxes are checked.   

Because inadequate process does not guarantee fairness, the system used in Delaware will continue to impose no meaningful restraints on compensation.  If meaningful restraints are to be imposed, they will have to come from the federal government and occur through preemption, a process that SOX and Dodd-Frank have already shown is well underway.      

For primary materials in this case, go to the DU Corporate Governance web site.


Friedman v. Dolan: Substituting Ineffective Process for Substance (Part 3)

We are discussing Friedman v. Dolan, C.A. No. 9425–VCN, June 30, 2015.  

In analyzing the claims against the Compensation Committee, the court noted that the decision was presumptive protected by the business judgment rule.  To survive a motion to dismiss, the plaintiff had to “show either that the “committee that approved the compensation lacked independence (in which case the burden shifts to the defendant director to show that the compensation was objectively reasonable), or to plead facts sufficient to show that the board or committee lacked good faith in making the award.” 

Plaintiffs argued for the “entire fairness” standard given the control of the board by the Dolan family.  The Complaint alleged that the Dolan family consisted of a majority of the board.  The court, however, declined to apply the standard.  

  • the Court hesitates to endorse the principle that every controlled company, regardless of use of an independent committee, must demonstrate the entire fairness of its executive compensation in court whenever questioned by a shareholder. It is especially undesirable to make such a pronouncement here, where annual compensation is not a “transformative” or major decision. In light of Tyson and the nature of executive compensation decisions, the Court will apply the business judgment rule initially. 

Instead, the plaintiff had to demonstrate that the directors on the compensation committee were “beholden to” the controlling party. To do so, the plaintiff must establish that the relationship or tie is material.   

  • The fact of compensation, even from both a parent and a subsidiary company, is not enough. Neither long-term board service nor the mere fact that one was appointed by a controller suffices. Similarly, being retired or having attained a certain age does not cast a reasonable doubt on independence. Close familial ties, such as those between parent and child, can prevent a director from acting independently. Again, the test for independence generally asks whether, based on the alleged conflict, “the director is unable to base his or her decisions on the corporate merits of the issue before the board.”  

Even with these factors ruled out, the plaintiff still alleged that the chair of the compensation committee performed “service at other Dolan-controlled entities” and the fact of “a sibling's employment”.  The court summarily dismissed the allegations. “Unfortunately for Plaintiff, long-term service or relationships, compensation itself, and appointment by a controller do not necessarily rebut the business judgment rule.”  Moreover, “[t]here are no allegations of how [the Chair of the compensation committee’s] decisions were tied to his brother's general employment that would lead the Court to deem his discretion sterilized.”  All of these allegations notwithstanding, the court concluded that “Plaintiff's allegations that the compensation committee could not “say no” are conclusory.”

The plaintiff also raised concern about process. According to the allegations, the compensation committee permited participation by the CEO in setting the compensation.  As the Complaint alleged:    

  • the Compensation Committee reviewed and compared the compensation paid to the CEOs at the Company Peer Group companies when setting James’ compensation. However, as described in the Proxies, the Compensation Committee allowed James to “assist the Compensation Committee and its compensation consultant in determining the Company’s core peer group and the peer group comparisons.” 

The court considered the allegations in the context of bad faith.  They were not enough to establish such a claim.  "A board is not forbidden from seeking management's input in compensation decisions, and the Compensation Committee Defendants retained a compensation consultant.The Court has no reason to believe, from the complaint, that the compensation decisions were uninformed, hastily made, or manipulated by James and Charles." 


Friedman v. Dolan: Substituting Ineffective Process for Substance (Part 2)

We are discussing Friedman v. Dolan.  According to the complaint, a majority of the board of directors of Cablevision consisted of members of the Dolan family.  As the complaint alleged: 

  • Cablevision is controlled by the Dolan family, who collectively hold 72.9% of the total voting power of all the outstanding Cablevision common stock.  Charles F. Dolan (“Charles”), the family’s patriarch, founded Cablevision and has served as the Company’s Executive Chairman since 1985. James L. Dolan (“James”), Charles’ son, has served as Chief Executive Officer (“CEO”) of the Company since 1995 and a director since 1991. Eight other Dolan family members serve on the Board, and along with James and Charles, they constitute a majority of the Board. Cablevision is controlled by the Dolan family, who collectively hold72.9% of the total voting power of all the outstanding Cablevision common stock.Charles F. Dolan (“Charles”), the family’s patriarch, founded Cablevision and hasserved as the Company’s Executive Chairman since 1985. James L. Dolan (“James”),Charles’ son, has served as Chief Executive Officer (“CEO”) of the Company since1995 and a director since 1991. Eight other Dolan family members serve on the Board,and along with James and Charles, they constitute a majority of the Board.

The plaintiff asserted that the company paid an excessive amount of compensation.  As the court described: 

  • The pending litigation asserts claims related to compensation awarded to the Dolan Defendants. From fiscal years 2010 through 2012, Cablevision paid James and Charles compensation worth $41.18 million and $40.27 million, respectively. 12 The executive compensation packages for James and Charles included “a base salary, perquisites, annual cash bonuses, and long-term incentive awards.”13 The perquisites, including a company car and driver and a security program, were valued at $476,000 and $792,000. Also included was a March 2012 “‘special’ one-time grant of stock options,” awarding James and Charles options valued at $6.85 and $7.09 million.

In addition, plaintiff challenged the compensation paid to three members of the Dolan family who served as directors of the company.  

Compensation for non-executive directors was determined by the board.  Compensation for Charles and James was determined by the compensation committee. The compensation committee consisted of three directors characterized by the company as independent. As the plaintiff alleged, the chair of the committee had been a Cablevision director since 1996, had been on the compensation committee since 2004, and served as a director of Madison Square Gardens, "another company under the Dolan family’s control". Moreover, his brother also worked for MSG.   

The court had to determine whether plaintiff sufficiently alleged facts that would be sufficient to get past a motion to dismiss.


Friedman v. Dolan: Substituting Ineffective Process for Substance (Part 1)

There can’t be a better decision in recent years from the Delaware courts that shows the need for preemption of the standards for determining executive compensation.  The Delaware courts have, for the most part, substituted process for substantive review.  Unfortunately, the courts do not interpret the process in a manner that ensures the fairness of the compensation.  This was made very clear by the decision in Friedman v. Dolan, C.A. No. 9425–VCN, June 30, 2015.  

In Friedman, the Chancery Court described the allegations surrounding compensations this way:  

  • It is hard to look at the facts of this case without going away troubled. A compensation committee with various ties to the controlling shareholder family awarded considerable executive compensation and benefits to the patriarch of that family and his son. Additionally, a board dominated by members of the controlling family approved non-executive director compensation, which accrued to three family-member directors with qualifications and attendance records that have been called into question. 

Expressions of concern or even outrage is never a good sign at the introduction of an opinion.  Thus, after noting these “concerns,” the court had this to say: 

  • Nonetheless, compensation decisions are not the expertise of trial judges, and the Court should not second-guess an independent compensation committee's business decisions that are not irrational. The Court also lacks a principled way to evaluate a director's decision to accept a position and her performance as a director. Although the amount of compensation and board composition raise some concern, that concern does not justify judicial intervention into that thicket here.

We will explore these "concerns" in the next several posts.  


Crowdfunding In Colorado Is Now Available: Let The Offerings Roll! (Part 4)

Is There a Role for Attorneys?

Although crowdfunding is intended to be a simple concept for small businesses and startups in Colorado to raise capital (as described by Representative Lee in his press release issued August 5, 2015), and even though the rules and the forms are written in a step-by-step nature, anticipating that most issuers will proceed without sophisticated legal counsel, there remain sophisticated legal issues that each issuer will have to address. Crowdfunding issuers proceeding without legal counsel will be well-advised to understand the rules and the statute. On-line intermediaries and other advisors need to consider issues surrounding the unauthorized practice of law before assisting prospective issuers in their efforts to comply with the CF Act.

Among the legal questions that issuers and on-line intermediaries will need to address in each crowdfunding offering will be:

  • What is a “single plan of financing” under Rule 147 and how is that interpreted with the limitations of C.R.S. § 11-51-308.5(3)(a)(XI)? Does any prior securities offering by the issuer restrict the issuer’s ability to conduct a crowdfunding offering?
  • Where do the actions of the on-line intermediary become the actions of an unlicensed broker-dealer? Where does the advice provided to the issuer by the on-line intermediary become the unauthorized practice of law?
  • Who drafts the escrow agreement and the agreement with the on-line intermediary, and interprets it for the issuer? This is unlikely to be an off-the-shelf form and will have to be tailored to each issuer, on-line intermediary, and offering.
  • What is “adequate disclosure” for the purposes of Form CF-2?
  • What level of due diligence and documentation will be sufficient to meet the issuer’s and on-line intermediary’s obligations when determining residency of investors and whether they are accredited?
  • How does the issuer manage the future transferability of the securities issued under the CF Act, and what in fact are the limitations?
  • Does the “reasonable basis” requirement for on-line intermediaries under Rule 3.28.C require that the on-line intermediary take affirmative steps, or does it merely prohibit willful blindness?
  • Does the issuer’s notice to the crowd meet the requirements of being “within Colorado” as defined in Rule 3.24.I?

These legal questions have to be considered based on a specific set of facts—facts that likely change from issuer to issuer, on-line intermediary to on-line intermediary, and offering to offering. Those issuers and on-line intermediaries who proceed without competent legal assistance will be taking risks. Unfortunately, lawyers usually want to be paid whether or not the offering is successful, or even commenced. This may be a significant investment for the prospective crowdfunding issuer.

Another consideration for prospective crowdfunding issuers is how to deal with the resulting investors. Assuming that the crowdfunding offering is successful, the issuer may have several hundred to perhaps several thousand new security holders. The CF Act (C.R.S. § 11-51-308.5(3)(a)(XIII)) requires quarterly reporting to these owners. The larger the number of owners, the more difficult reporting will be. Furthermore, experience in the public company world indicates that these owners will be seeking information from the issuer on a regular basis, lodging complaints where performance is not as expected, and trying to develop a trading market. Each security holder is likely to have a different, personalized agenda that may result in significant management time and expense to resolve.

Thoughts on Crowdfunding in Colorado

If the risks can be managed to the satisfaction of the participants, the CF Act may become an extremely useful tool in capital formation for small businesses. It is new, the rules and the Act itself are untested, and there will undoubtedly be many issues that develop. One of the biggest may be whether any depository institution (defined in C.R.S. § 11-51-101) will be willing to act as an escrow agent in a crowdfunding offering at a reasonable cost, recognizing that many investments are likely to be small—$100 or so per person. In brief discussions with certain local banks, they have expressed reluctance to participate in these untested offerings, even though the CF Act specifically provides (in § 11-51-308.5(3)(a)(IV)(D)) that the escrow agent “does not have any duty or liability, contractual or otherwise, to any purchaser or other person.”

It is likely that crowdfunding offerings will be targeted to affinity groups by the issuers—perhaps a broader version of a “family and friends” private placement. Karl Dakin has written a number of blogs that relate to crowdfunding including one entitled “Characteristics of a Crowd” (May 11, 2015). As Professor Dakin indicates, “any message within a crowdfunding campaign must address the perspective of the investor.” Included in the perspective of the investor is whether the investor is considering investing “pocket change” or an investment that could be characterized as “a major life decision.” As Professor Dakin advises with respect to the issuer’s disclosure and other communications with prospective investors:

Too often, entrepreneurs fail to address the perspectives of the investors. They either assume that all investors are alike or that their deal is so good that all investors will invest. This is not true for classical investments based upon seeking a return on investment. And, it will represent a greater error in thinking with regard to crowdfunding.

As a result, Professor Dakin notes that too many issuers are “looking for money in all the wrong places,” “pitching to the wrong people,” “pitching too early” before the issuer is ready, “not knowing the investor,” and considering “investors as ATMs.”

In his paper Teenage Crowdfunding, Professor Andrew A. Schwartz of the University of Colorado Law School predicts that younger entrepreneurs will take advantage of crowdfunding because of their social media and networking skills. Chris Tyrell of Crowdfund Insider suggests that “Crowdfunding is Changing the Female Entrepreneurial Landscape.” Crowdfunding may in fact become the capital formation tool that the Colorado legislature and the U.S. Congress envisioned, but expectations have to be moderated to fit within reality.


Because of the lesser formality of the crowdfunding process, abuse and fraud are possible. Because of the smaller amounts raised, it is hoped that such abuse will be nominal. Nevertheless, prospective investors and attorneys who advise them must be alert for warning signs. Knowing your principals is your best protection, which is why affinity crowdfunding offerings are more likely to succeed than blind offerings to unknown investors. On the other hand, there has been plenty of affinity fraud in the annals of the Securities and Exchange Commission. (See “Affinity Fraud: How To Avoid Investment Scams That Target Groups” (last visited July 15, 2015)).

Properly used and constructed, however, crowdfunding in Colorado may be a very successful tool for smaller businesses seeking to raise capital within their sphere of influence—customers, clients, vendors, friends, family, and others. Although contemplated in the CF Act, it is unlikely that broker-dealers or sales representatives will be involved in the offerings because of their due diligence obligations under their regulatory rules (and the related cost which would be passed on to the crowdfunding issuer). It is also unlikely that issuers will use sophisticated legal guidance, again because of the cost which can quickly make a smaller offering unaffordable.

The best advice for an issuer looking for a crowdfunding offering is to be familiar with the statute and the rules, and to seek an on-line intermediary that will be competent and provide assistance, not only posting the disclosure, but also ensuring the residency of the investors, the required record keeping, arrangements with an affordable escrow agent, and perhaps providing other help in exchange for the non-percentage based fee. On-line intermediaries that are not broker-dealers are operating in other states that have already authorized crowdfunding; as the CF market develops, on-line intermediaries can be expected to appear in Colorado. This may be sooner; this may be later, and it will depend on the market. There will likely be competent on-line intermediaries, and unfortunately there will likely be incompetent on-line intermediaries; issuers should make all relevant inquiries to be comfortable that they are dealing with the correct on-line intermediary.

Let the offerings roll!

By Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C., republished from Newsletter, Business Law Section, Colorado Bar Association,  August 2015


Crowdfunding In Colorado Is Now Available: Let The Offerings Roll! (Part 3b)

All Crowdfunding Offerings Must Be Through Escrow. Importantly, the CF Act requires that all crowdfunding offerings be funded through an escrow at a depository institution, such as a bank or savings and loan (C.R.S. §§ 11-51-308.5(3)(a)(IV)(D); 11-51-308.5(3)(a)(IV)(F); and 11-51-308.5(3)(a)(IX)). The maximum amount of the offering to be raised can be no more than twice the minimum amount of the offering, and funds cannot be released from escrow until at least the minimum offering is raised.

The CF Act provides that the escrow agent must be “a bank, regulated trust company or corporate fiduciary, savings bank, savings and loan association, or credit union authorized to do business in Colorado” (C.R.S. §§ 11-51-308.5(3)(a)(IV)(D)). This is somewhat different than the definition of “depository institution” found in C.R.S. 11-51-201(5), but hopefully will be interpreted similarly.

When the issuer has raised at least the minimum offering in the escrow and desires the release of the offering proceeds (whether or not the issuer wishes to continue the offering), the issuer must file a Form ES-CF with the Securities Commissioner and wait seven days before having the funds released from escrow. As a condition to the release from escrow, the issuer must also provide for the delivery of the securities and certain notices to the persons participating in the crowdfunding offering as defined in the rules. It is likely that many of the crowdfunded securities will be uncertificated.

  • Corporate stock may be certificated or uncertificated. If uncertificated, C.R.S. § 7-106-207 sets forth the information that must be included in a written statement that (according to the CF Act and the rules) must be sent to the purchaser at or before the release of the escrow funds. C.R.S. § 7-106-206 sets forth the information that must be included on certificates for corporate stock.
  • Neither the Colorado LLC Act nor the partnership acts contemplate certificates representing ownership interests. Even an issuer-made certificate would not constitute a “certificate” in the corporate sense unless the election contemplated under § 4-8-202 is made in the operating agreement or partnership agreement.
  • Where the securities consist of a debt instrument (such as a promissory note), the debt instrument should be in writing and delivered at or before the release of the escrow funds.

In any case, it is important that the issuer maintain records accurately reflecting the ownership of the securities issued in the crowdfunding offering and any other outstanding securities of the issuer. The issuer may choose to do this directly or by retaining a transfer agent to do so.

While the issuer may continue the crowdfunding offering after obtaining the release of funds from escrow, all funds must still go through the escrow account and releases from the escrow must be accomplished in accordance with the rules. Furthermore, any release of funds from the escrow is likely a material event for which the issuer would be obligated to update its disclosure; the expenditure of those funds after release from escrow may also be a material event requiring updated disclosure.

Data Collection, Record-Keeping, and Reporting. The on-line intermediary may provide a method of collecting data from investors who deposit funds into escrow, and may provide a portal to the escrow agent for the transfer of funds by ACH. These are among the records that the issuer must obtain and retain, although the rules provide that the issuer may contract with the on-line portal to maintain the records retention on the issuer’s behalf.

During and following the offering, the issuer has certain reporting obligations to all of its owners, including the new investors. These reports are defined in the CF Act and the rules, and the obligation continues indefinitely. Wise issuers will report more frequently to their owners and investors than the quarterly report required by the CF Act (C.R.S. § 11-51-308.5(3)(a)(XIII)) and the rules (Rule 3.24.D, Notice of Completion of the Transaction and Rule 3.24.H, Quarterly Report Timing). The CF Act does set forth the minimum requirements for these reports, however, including an obligation to report the compensation being paid to the directors and executive officers and to provide a management analysis of the issuer’s business operations and financial condition.

Bad Actors Are Prohibited. Certain persons are prohibited from using the exemption from registration provided by the CF Act. These are referred to as “bad actors” and the definition is similar to the similar definition found in SEC Rule 506(d). The CF Act has provisions that the “bad actor” prohibition to both issuers (C.R.S. § 11-51-3-8.5(3)(a)(XIII)) and on-line intermediaries (§ 11-51-308.5(3)(c)(VII)), but Rule 3.30 expands the disqualification for issuers well beyond the SEC Rule 506(d) definition of “bad actors.”

The rules provide that where an issuer is subject to a bad actor disqualification, the Securities Commissioner can waive certain of the bases for disqualification. The Securities Commissioner will not waive a disqualification based on certain felony convictions and certain final orders issued by the SEC or state securities administrators. Before issuing a waiver, the Commissioner must make the following finding:

In balancing all relevant factors, granting the waiver is consistent with the objective of the Colorado Securities Act to protect investors and maintain public confidence in securities markets while avoiding unreasonable burdens on participants in capital markets.

Liability Risk From Crowdfunding

Unlike the rewards-based crowdfunding models of Kickstarter, Indiegogo, and other similar sites, crowdfunding under the CF Act involves the offer and sale of securities which is subject to regulation under and compliance with federal law (the Securities Act of 1933 and the Securities Exchange Act of 1934) and, in Colorado, the Colorado Securities Act. Strict compliance with the CF Act and the rules does not exempt the issuer or the other participants in the offering from potential liability; a failure to comply strictly with the CF Act and the rules may lead to potential administrative civil, or even criminal, liability.

Federal Compliance. The first issue under the CF Act, as under the crowdfunding legislation adopted in more than 20 other states, is compliance with SEC Rule 147 which provides an exemption from the registration requirements of § 5 of the 1933 Act. A failure to comply with Rule 147 leads to a violation of the registration requirements of the 1933 Act and the risk of issuer liability for rescission (§ 12(a)(1) of the 1933 Act) and the liability of the persons controlling the issuer (§ 15 of the 1933 Act).

Even strict compliance with the requirements of Rule 147 does not preclude the risk of future liability. Like all exemptions from registration, Rule 147 merely exempts the offering from the registration requirements of the 1933 Act; it does not provide an exemption from the disclosure and anti-fraud requirements.

  • Where the disclosure in the Colorado Form CF-2 is inadequate, incomplete, or inaccurate in any material respect, the issuer (under 1933 Act § 12(a)(2) and 1934 Act Rule 10b-5) and persons controlling the issuer are potentially liable, as are (potentially) other participants in the offering.
  • Where the issuer or its controlling persons take actions (such as spending the proceeds raised) contrary to the disclosure, they have significant risk of liability.

When broker-dealers or sales representatives are involved in the offering, they have the risk of liability under both federal law and the rules of their governing organization, the Financial Industry Regulatory Authority (“FINRA”). When an on-line intermediary is involved, the liability of the on-line intermediary is lesser as long as the on-line intermediary does not participate in the offering beyond merely posting the disclosure documents and perhaps gathering information and maintaining certain limited records.

Of course, where the on-line intermediary (or any other participant in the offering) knows, or reasonably should know, that the disclosure is inadequate, incomplete, or inaccurate in any material respect, such persons have significantly increased their risk of liability in an administrative, civil, or even criminal forum.

Colorado Compliance. Strict compliance with the CF Act and the rules also creates an exemption from the registration requirements found in § 11-51-301 of the Colorado Securities Act. Disclosure in the Form CF-2 that is accurate and complete in all material respects also limits the risk of liability for securities fraud. Where there is a failure to comply with the exemption or the disclosure requirements in any material respect, issuers and persons controlling the issuer are potentially liable in a state administrative, civil, or even criminal forum.

In Colorado, § 11-51-501 makes it unlawful for any person (issuer, broker-dealer, sales representative, or investment advisor) or controlling person (§ 11-51-604(5)) to “employ any device, scheme, or artifice to defraud” an investor, to “make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading,” or to “engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.” Where the Securities Commissioner suspects a violation of the registration requirements, the broker-dealer licensing requirements, or the disclosure requirements, he may initiate an investigation (§ 11-51-601) or seek enforcement by an administrative cease-and-desist proceeding (§ 11-51-606(1.5)), injunction (§ 11-51-602), civil action (§ 11-51-604), or through a criminal proceeding (§ 11-51-603). Under § 11-51-604, investors may also seek civil damages against the issuer and controlling persons for violations of the anti-fraud rules.

Colorado Crowdfunding Act. The CF Act provides certain exemptions from liability which are applicable to the Colorado Securities Act but which would not be applicable under a federal complaint.

  • There is no provision exempting issuers or the issuer’s controlling persons from liability for disclosure that is inadequate, incomplete, or inaccurate in any material respect, or for post-offering actions that are inconsistent with the disclosure made.
  • Escrow agents are the key to the success (and even the ability to conduct) an offering under the CF Act. The Act (in § 11-51-308.5(3)(a)(IV)(D)) provides that the escrow agent “does not have any duty or liability, contractual or otherwise, to any purchaser or other person.” Most escrow agreements will provide contractual exoneration of the escrow agent except in the case of bad faith or willful misconduct by the escrow agent.
  • Broker-dealers and sales representatives participating in any offering under the CF Act remain subject to their regulatory obligations, including due diligence and “know your customer.” Because of these continuing requirements, broker-dealers and sales representatives will want to complete due diligence investigations and hire legal counsel—all of which will make a crowdfunding offering much more expensive to the issuer.
  • On-line intermediaries (defined in § 11-51-201(11.5)) are more likely participants in crowdfunding offerings in Colorado than are broker-dealers and sales representatives. On-line intermediaries are specifically exempted from the definition of “broker-dealer” under § 11-51-402(1)(c) provided the on-line intermediary limits its activities as contemplated in the CF Act and the rules. Even though originally contemplated to be passive bulletin boards who may provide some services, the rules impose certain additional obligations not specifically contemplated in the CF Act, including the obligations described in Rule 3.28.C to deny access to the on-line intermediary where the on-line intermediary has a “reasonable basis” for believing that the issuer is not acting in compliance with the CF Act, that the issuer does not have adequate record-keeping capabilities, or that the issuer raises investor protection concerns.

The Risk of Fraud. Fraud is one of the principal risks of a crowdfunding offering as it is with any capital raising transaction involving the offer and sale of securities. It is likely that offerings under the CF Act will follow the national trend—where purchasers invest from $100 to $300 in equity or debt securities. In most cases, this will be “pocket change” or “slot machine money.” Where the purchaser loses her investment either through a bad business decision or even fraud, it likely will not be worth the purchaser’s time and expenditure to take legal action. Perhaps the purchaser will file a complaint with the Colorado Division of Securities, but it is unlikely that the purchaser will take any more extensive action to recover her investment.

Thus, purchasers of crowdfund securities seeking to protect themselves should follow the typical mantra of investor advocates—know and trust your management. This again leads to the most-likely-to-be-successful crowdfunding offering—those within affinity groups where the investors know management or have other bases to trust management.

By Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C., republished from Newsletter, Business Law Section, Colorado Bar Association,  August 2015


Crowdfunding In Colorado Is Now Available: Let The Offerings Roll! (Part 3a)

The Rules

The rules, as adopted, are intended to implement the legislative intent as expressed in the statute and to make crowdfunding a feasible alternative to the normal methods of capital formation by small businesses in Colorado—a “friends and family” private placement or intrastate offering, venture capital financing, or a state- or federally-registered public offering. Because the CF Act is based on the federal intrastate exemption, it can only be used by Colorado businesses soliciting funds from Colorado residents, primarily for use in Colorado. The securities offered and sold pursuant to the CF Act must “come to rest” in Colorado—meaning that there have to be transfer restrictions imposed under Rule 147 to ensure that, for at least twelve months, they are not transferred to persons who are not Colorado residents.

The Issuer and Disclosure. The CF Act contemplates, and the rules provide for, the issuer giving a broad public notice to persons who may be interested in the offering. The notice may be in print format or in electronic format (through email, social media, or otherwise), but must be limited to Colorado residents. Following the guidance of SEC Compliance and Disclosure Interpretation 141.04, Colorado Rule 3.24.I provides that where an electronic-based notice “sent by or on behalf of the issuer” has appropriate legends and warnings, the public notification is permitted, even where it may be accessible to non-Colorado residents.

The CF Act and the rules (especially Rule 3.22.B) impose the obligation for full and fair disclosure on the issuer seeking to raise funds from the crowd. The rules include Form CF-2 which forms the basis for disclosure, although it is expected that many issuers will also use a memorandum format or a business plan for disclosure which they will incorporate by reference into the Form CF-2. It is likely that prospective investors will want to perform further due diligence and make inquiries of the issuer. Where the discussions with prospective investors lead the issuer to disclose material information not already contained in the Form CF-2 disclosure, the issuer must amend the Form CF-2 disclosure within five business days (Rule 3.22.D). Where material events have occurred after the filing of the initial Form CF-2 (or after the filing of any amendment), the issuer must appropriately amend the disclosure within five days.

The Investors. The investors must be Colorado residents. In fact, using language similar to SEC Rule 506(c), the CF Act requires that before making any sales, “the issuer shall obtain documentary evidence from each prospective purchaser that provides the seller with a reasonable basis to believe that the purchaser meets the [Colorado residency] requirements.” (C.R.S. §§ 11-51-308.5(3)(a)(I) and (VIII)) This arguably requires more than a simple investor affirmation as to residency since it requires “documentary evidence.” This language suggests that the issuer must review and maintain copies of the investor’s driver’s license, state voting registration, utility bills, or other documentary evidence to establish residency in addition to the investor’s affirmation.

No person may invest more than $5,000 in a crowdfunding offering unless that person is an “accredited investor” as that term is defined by the SEC. If a person is an accredited investor, there is no statutory limitation on the investment amount (subject to the maximum limits of the crowdfunding offering). In determining whether a person is an accredited investor, Rule 3.24.A.1 requires the issuer to have a “reasonable basis” for establishing the accredited investor status. This is language that is similar to Rule 506(c)(2)(ii) (which requires that the issuer “take reasonable steps to verify that purchasers” are accredited investors). It is not likely that an investor self-certification will be sufficient if challenged.

In any crowdfunding offering in Colorado, the prudent issuer will require the purchaser to sign (electronically or on paper) a subscription agreement or investment letter warranting residency and acknowledging the restrictions on ownership and further transferability of the security. The subscription agreement or investment letter will also likely follow the normal form for such documents and include warranties by the purchaser that:

  • he/she has been fully informed about the transaction, the risks, and the issuer;
  • the purchaser is acquiring the securities for investment purposes only and without a view toward further distribution;
  • the purchaser is aware of the transferability restrictions to which the crowdfunding securities are subject; and
  • the purchaser has consulted with legal counsel and other advisors as the purchaser has determined to be necessary or appropriate in the circumstances.

These investor representations and supporting documentation are information that the issuer and the on-line intermediary must maintain for at least five years. (Rules 3.23 and 3.25)

The On-Line Intermediaries. The CF Act contemplates, and the rules provide for, the crowdfunding offerings being accomplished through broker-dealers, sales representatives, or on-line intermediaries. Where broker-dealers or sales representatives are involved, the CF Act and the rules defer to FINRA which regulates broker-dealers and sales representatives. The Colorado Securities Act was amended to define “on-line intermediary” (C.R.S. § 11-51-201(11.5)) and to describe certain prohibited activities (C.R.S. § 11-51-308.5(3)(c)(III)). As set forth in the statute and the rules (and especially Rule 3.29.A):

  • On-line intermediaries cannot handle or possess funds or securities in the offering process.
  • On-line intermediaries cannot own a financial interest in any crowdfunding participant or receive compensation that is based on the amount raised.
  • On-line intermediaries cannot be affiliated with or under common control with an issuer conducting a crowdfunding offering through that intermediary.
  • On-line intermediaries cannot offer investment advice or recommendations or solicit purchases or sales of securities displayed on its website (but is merely a repository for the information displayed).
  • On-line intermediaries must post the disclosure documents, and likely will have extensive terms and conditions, risk warnings, and investor acknowledgements that must be accepted as a condition precedent to the investor continuing to the funding site.
  • On-line intermediaries have specific record-keeping obligations, and must take steps to ascertain that the persons viewing crowdfunding offerings through their website are in fact Colorado residents.
  • On-line intermediaries may generally advertise their website but may not “identify, promote, or otherwise refer to a security offered by it.’ (C.R.S. § 11-51-308.5(3)(c)(V)).

The CF Act amended the Colorado Securities Act to exempt on-line intermediaries acting within the limitations of the CF Act from the registration requirements for broker-dealers and sales representatives. (C.R.S. § 11-51-402(1)(c)) Where an on-line intermediary reaches beyond the narrow scope of permissible actions described in the statute and the rules, the on-line intermediary may venture into broker-dealer territory. For example, an on-line intermediary who sends out an issuer-specific notification to its email list may be considered to be “engaged in a solicitation”; on the other hand, an affiliate of the on-line intermediary that is not an alter ego of the on-line intermediary may be able to provide these and other services in the nature of “marketing” or “crowd formation” to the issuer. Transaction-based compensation and direct solicitation and marketing is likely to result in broker-dealer classification, however. In this consideration, it is important to note that a number of on-line intermediaries doing business in other states are in fact licensed broker-dealers.

Subject to the requirements of Rules 3.27 and 3.28.C (discussed below), the role of an on-line intermediary may be passive—a bulletin-board like posting service. In some cases, the on-line intermediary may have a more active role. The rules contemplate that an issuer may contract with an on-line intermediary to collect residency information and preserve records for the benefit of the issuer, but this remains the issuer’s responsibility. (Rule 3.23.B) To help on-line intermediaries identify the boundaries of its role as compared to that of a broker-dealer, the rules also provide that an on-line intermediary that “does nothing more than collect information regarding the purchase of securities” and “provides a link to transmit funds to the escrow agent” is not conducting a prohibited act. (Rule 3.29.B)

Rules 3.27 and 3.28.C impose certain obligations on on-line intermediaries which require the on-line intermediary to be more involved than the typical bulletin-board posting.

  • Rule 3.27 requires on-line intermediaries to establish “written supervisory procedures and a system for applying such procedures that is reasonably expected to prevent and detect violations of the Colorado Securities Act, given the limited role of the on-line intermediary under the CF Act.”
  • More significantly, Rule 3.28.C requires that the on-line intermediary affirmatively “deny access” to an issuer where the on-line intermediary has a “reasonable basis for believing”:
    • that the issuer is not in compliance with § 11-51-308.5;
    • has not established a means to keep accurate records; or
    • that the issuer or offering presents the potential for fraud or otherwise raises concerns regarding investor protection.

The use of the phrase “reasonable basis” in the context of Rule 3.28.C does not necessarily impose a due diligence obligation on the on-line intermediary; it does not permit the on-line intermediary to ignore facts that would come to its attention that might suggest the negatives set forth in the Rule. The wording of this rule creates an affirmative obligation to “deny access” only when the intermediary reasonably believes wrongdoing is occurring. This prohibits “willful blindness” on the part of the on-line intermediary; however, it does not require the same level of due diligence as (for example) the rule requiring the issuer to reasonably believe that the investor is a Colorado resident (C.R.S. §§ 11-51-308.5(3)(a)(I) and (VIII)), which requires documentary confirmation, or Rule 3.24.A.1, which requires an affirmative “reasonable basis” for determining that a purchaser is an “accredited investor” to take advantage of that provision.

With experience, the on-line intermediary may become the driving force behind crowdfunding in Colorado. Where the on-line intermediary has established a successful track record of relationships with escrow agents and investors, they may attract issuers. Where the on-line intermediary has offered record retention services and other permitted services at a reasonable cost, the on-line intermediaries will be instrumental in the success of the offering and compliance with the CF Act. Because an investor may use an on-line intermediary for more than one crowdfunding investment, the on-line intermediaries will likely look at the investors as their clients—not the issuers. Hopefully this will assist in the goal of investor protection which is the focus of the Colorado Securities Act.

By Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C., republished from Newsletter, Business Law Section, Colorado Bar Association,  August 2015


Crowdfunding In Colorado Is Now Available: Let The Offerings Roll! (Part 2)

The Colorado Crowdfunding Act

The CF Act requires that the issuer and the offering be exempt from the registration requirements of federal law pursuant to the intrastate exemption set forth in § 3(a)(11) of the Securities Act of 1933 and Rule 147 adopted by the Securities and Exchange Commission (the “SEC”). The CF Act was discussed in detail in the April 2015 Business Law Section Newsletter, but the CF Act was not self-implementing. Although effective August 5, 2015, the CF Act required rulemaking from the Colorado Division of Securities (the “Division”) to be implemented.

In order to be adopted before the effective date of the CF Act, on July 29, 2015, the Division acted on an emergency basis to adopt Rules 3.20 through 3.30 after publishing draft rules and receiving public input. (The rules are found in the Code of Colorado Regulations available through the Secretary of State’s website at 3 CCR 704-1:51-3.20 et seq.) Formal decision making under the Colorado Administrative Procedure Act (C.R.S. § 24-4-101 et seq.) will occur this fall. C.R.S. § 24-4-103(6)(a) provides that emergency rules are effective for no more than 120 days after adoption. The final rules will be considered at a hearing to be held on August 31, 2015, at 1:30 pm.

It is important to note that no issuer may use the CF Act “in conjunction with any other exemption pursuant to section 11-51-307, 11-51-308, or 11-51-309 during the immediately preceding twelve-month period” (C.R.S. § 11-51-308.5(3)(a)(XI)). The precise meaning of this statutory language is not clear. Does it mean that an issuer that has issued securities pursuant to one of those Colorado exemptions in the prior twelve months is unable to raise funds under the CF Act? Or does it mean that the prior offering and the crowdfunding offering somehow have to be related, part of a “single plan of financing”?

By Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C., republished from Newsletter, Business Law Section, Colorado Bar Association,  August 2015


Crowdfunding In Colorado Is Now Available: Let The Offerings Roll! (Part 1)

House Bill 2015-1246, the Colorado Crowdfunding Act (“CF Act”), became effective August 5, 2015. The CF Act added C.R.S. § 11-51-308.5 to the Colorado Securities Act (§§ 11-51-101 et seq.) to establish an exemption from registration under the Colorado Securities Act for capital formation for small businesses seeking up to $1 million ($2 million if audited financial statements are available) from a crowd of prospective investors in what looks much like a public offering of securities. The primary sponsors were Representatives Pete Lee and Dan Pabon and Senators Mark Scheffel and Owen Hill, and it passed through the 2015 Colorado General Assembly almost unanimously. According to the legislative declaration:

  • Start-up companies play a critical role in expanding economic opportunities, creating new jobs, and generating revenues; and
  • Lack of access to capital is an obstacle to starting and expanding small business, inhibits job growth, and has negatively affected the state’s economy.

The General Assembly also determined that, in its judgment, costs and complexities of compliance with the existing registration or exemption requirements of the federal and state securities laws “can outweigh the benefits to Colorado businesses seeking to raise capital by small securities offerings” and that “crowdfunding…raising money on-line through small contributions from a large number of investors…will enable Colorado businesses to obtain capital, democratize venture capital formation, and facilitate investment by Colorado residents in Colorado start-ups, thereby promoting the formation and growth of local companies and the accompanying job creation.” Will the CF Act meet these goals?

By Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C., republished from Newsletter, Business Law Section, Colorado Bar Association,  August 2015


Trinity Wall Street v. Wal-Mart Stores, Inc: Judicial Rewriting of the Proxy Rules (Part 3)

We are discussing Trinity Wall Street v. Wal-Mart Stores, Inc   792 F.3d 323 (3rdCir. 2015).

The majority purports to “empathize” with “those who labor with the ordinary business exclusion and a social-policy exception that requires not only significance but 'transcendence. . .'" Id.  The majority ascribes this need for empathy to the Commission,  Id. (“Despite the substantial uptick in proposals attempting to raise social policy issues that bat down the business operations bar, the SEC's last word on the subject came in the 1990s, and we have no hint that any change from it or Congress is forthcoming.”), and calls on the Commission to revisit the area.  Id. (“We thus suggest that it consider revising its regulation of proxy contests and issue fresh interpretive guidance.”). 

But in fact the “transcend” concept is not a problem of the Commission's making but a fabrication of the majority of the panel.  


Trinity Wall Street v. Wal-Mart Stores, Inc: Judicial Rewriting of the Proxy Rules (Part 2)

We are discussing Trinity Wall Street v. Wal-Mart Stores, Inc   792 F.3d 323 (3rdCir. 2015).

There are any number of problems with the court’s reasoning.  First, the court adopted an interpretation that is simply not there. In relying on the "transcend" element, the court quoted language from a staff bulletin adopted in 2009.  See SEC Staff Legal Bulletin No. 14E, 2009 WL 4363205, at *2 (Oct. 27, 2009)  ("where “a proposal's underlying subject matter transcends the day-to-day business matters of the company and raises policy issues so significant that it would be appropriate for a shareholder vote, the proposal generally will not be excludable under Rule 14a–8(i)(7).”).  According to the court, the term was used by the Commission “to refer to a policy issue that is divorced from how a company approaches the nitty-gritty of its core business.” 

In fact, the use of the term "transcend" by the Commission had no such connotation.  The language appeared for the first time in a 1998 release that rewrote Rule 14a-8 into plain English. As a result, there was no attempt to add a new “transcend” element to the exclusion.  In fact, in that Release, the Commission had this to say:      

  • The policy underlying the ordinary business exclusion rests on two central considerations. The first relates to the subject matter of the proposal. Certain tasks are so fundamental to management's ability to run a company on a day-to-day basis that they could not, as a practical matter, be subject to direct shareholder oversight. Examples include the management of the workforce, such as the hiring, promotion, and termination of employees, decisions on production quality and quantity, and the retention of suppliers. However, proposals relating to such matters but focusing on sufficiently significant social policy issues (e.g., significant discrimination matters) generally would not be considered to be excludable, because the proposals would transcend the day-to-day business matters and raise policy issues so significant that it would be appropriate for a shareholder vote. 

In other words, the quote is essentially the exact opposite of the Third Circuit’s interpretation.  The first sentence referenced nitty gritty matters (hiring, promotion, termination, decisions on production quality and quantity).  The second, however, noted these matters were overridden by the public policy exception.  

Second, the interpretation flies in the face of accepted interpretation.  In 1976, the SEC expressly added the “public policy” exception as part of the ordinary business exclusion after having been chastised by the court for allowing the omission of a proposal dealing with the manufacture of napalm by Down Chemical.  See Medical Comm. for Human Rights v. SEC, 432 F.2d 659 (DC Cir. 1971), vacated as moot, 92 S. Ct. 577 (1972).  Under the Third Circuit’s interpretation, however, napalm involves the nitty gritty of product selection and is presumably not subject to the public policy exception. 

Indeed, the traditional standard was only that the ordinary business matter “relate” to a public policy concerns.  As one of the originators of the exclusion described: “Innovative ways sometimes were found in these discussions to allow more proposals to be included in proxy statement than had previously been the case. . . . Another was to create an informal exception to the provision that allowed proposals relating to a company’s ordinary business operations to be excluded from the company’s proxy materials.  If the proposal was deemed to involve a matter of significant public policy interest, the Division expressed the view that the ‘ordinary business operations’ provision did not apply.” Statement of Peter Romeo, SEC Historical Society, Feb. 20, 2014 

Third, the word transcend appears in a 1998 release that only added “minor conforming changes” to the ordinary business exclusion.   Exchange Act Release No. 40018 (May 21, 1998).  Nothing in the adopting or proposing release suggests that the Commission intended to make a major substantive change in the public policy exception.  To the extent that there was any additional guidance, it came from the Commission reversing Cracker Barrel by concluding that the public policy should be expanded not narrowed when it came to employment practices. 

Fourth, the court made untenable distinctions.  Public policy does not apply to the mix of products sold by a large retailer.  Id. (“For major retailers of myriad products, a policy issue is rarely transcendent if it treads on the meat of management's responsibility: crafting a product mix that satisfies consumer demand.”).  On the other hand, it does apply to “employment practices” of companies.  Id. (‘By contrast, a proposal raising the impropriety of a supermarket's discriminatory hiring or compensation practices generally is not excludable because, even though human resources management is a core business function, it is disengaged from the essence of a supermarket's business.”).  Yet both very much involve day to day business activities, the nitty gritty so to speak, and both involve the “meat of management’s responsibilities”.  The court does not really include a principled basis for distinguishing the two situations.

In effect, the court has read out of the rule a public policy exception for ordinary business matters (relabeled "core" business areas).  The court seems to object to the ability of shareholders to make an issue out of ordinary business matters.  Thus, the court explicitly determined that the “transcend” concept was necessary, otherwise “shareholders would be free to submit ‘proposals dealing with ordinary business matters yet cabined in social policy concern.’” 

But of course that is exactly what shareholders are allowed to do. As the concurring opinion notes: “The Majority's test, insofar as it practically gives companies carte blanche to exclude any proposal raising social policy issues that are directly related to core business operations, undermines the principle of fair corporate suffrage animating Rule 14a–8: shareholders' ‘ability to exercise their right—some would say their duty—to control the important decisions which affect them in their capacity as ... owners of [a] corporation.


Trinity Wall Street v. Wal-Mart Stores, Inc: Judicial Rewriting of the Proxy Rules (Part 1)

In Trinity Wall Street v. Wal-Mart Stores, Inc   792 F.3d 323 (3rd Cir. 2015), a majority of the Third Circuit upheld the exclusion of a proposal submitted to Wal Mart because the proposal involved the ordinary business of the company and did not "transcend" the day to day business.  In doing so, the court invented a new test that effectively eliminated the public policy exception for broad categories of ordinary business matters.  

Shareholders submitted a proposal to Wal-Mart that requested that the board to "amend the Compensation, Nominating and Governance Committee charter ... as follows: 

  • Providing oversight concerning [and the public reporting of] the formulation and implementation of ... policies and standards that determine whether or not the Company should sell a product that:
  • 1) especially endangers public safety and well-being;
  • 2) has the substantial potential to impair the reputation of the Company; and/or
  • 3) would reasonably be considered by many offensive to the family and community *330 values integral to the Company's promotion of its brand.” 

The staff granted no action relief finding that the proposal implicated the company's ordinary business and did not fall into the public policy exception.  Shareholders sued, alleging that the omission of the proposal violated Rule 14a-8.  In effect, the case asserted that the staff of the SEC was wrong in allowing exclusion.

The district court agreed with shareholder but the Third Circuit reversed.  The Third Circuit found that the proposal implicated the company's ordinary business.  The court suggested that the proposal raised public policy considerations.  Nonetheless, the court upheld the exclusion of the proposal because the public policy implications did not "transcend" the company's business.  

We will discuss the reasoning in the next post.


Investor Shaming, Disclosure, and Shareholder Access

The WSJ published an article suggesting the need for the elimination of some quarterly reports.  The article is here.  Wachtell Lipton circulated a memorandum that discussed efforts in Europe to seek the "discontinuation of company quarterly reporting".  

The analysis was based upon efforts this summer by "Legal & General Investment Management, a major European asset manager and global investor with over £700 billion in total assets under management" and the contacts made by the firm with "the Boards of the London Stock Exchange’s 350 largest companies to support the discontinuation of company quarterly reporting"  The memo, posted on the Harvard Governance site, is here.  

The idea of scrapping quarterly reports is largely based upon the view that these reports encourage corporate management to take short term perspectives in connection with the management of the company.  But share prices are based upon the future expectation of profits and future profits require long and short term planning. Companies like Amazon do amazingly well even with low profitability because investors believe that the company is managing in a manner that will benefit shareholders in the long term.

To the extent that companies have an excessively short term perspective, it is hard not to call this mismanagement.  The decision about the day to day business of the company is made by management and it is management that has the fiduciary obligation to manage in the best interest of investors.  Delaware courts routinely overturn efforts by shareholders to intrude into the ordinary business of the company and the SEC staff use this prohibition as a significant basis for excluding proposals under Rule 14a-8.  The idea of protecting management from short term strategies by denying investors information is really a form of blaming or "shaming" investors for the failures of those managing the company.

Moreover, the elimination of some quarterly reports needs to be considered in the context of the fight over shareholder access.  Long term shareholders want the right to include nominees in the company's proxy statement.  In this proxy season, a record number of shareholder access proposals were submitted.  Of the 81 proposals that went to a vote, only "[t]wo companies, including Citigroup, determined to support the proxy access shareholder proposal contained in their proxy statements." In other words, for the most part, management objected to a process that would make easier the election of directors nominated by large shareholders. Of course, shareholders had other ideas, providing majority support for 48 proposals and giving all 81 an average of 54.7%.  

So putting these together, companies will be better run if the owners of the business receive less relevant information and are excluded from participation in the board of directors. That is certainly a point of view but one unlikely to receive much traction for actual owners.  


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 9) 

As suspected, the Commission has appealed Duka and Bebo is front and center.  The Commission as asked the district court to stay the preliminary injunction pending appeal.  In addition to the "inferior officer" issue, the Commission asserted

  • To start, the district court lacks jurisdiction over this matter, as the Seventh Circuit recently held in a case involving constitutional challenges to an SEC administrative proceeding (including an Article II challenge to the presiding ALJ). Relying upon the Supreme Court’s decisions in Elgin v. Department of Treasury, 132 S. Ct. 2126 (2012), and Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477 (2010), the Seventh Circuit ruled that it is “fairly discernible” from the securities laws that “Congress intended plaintiffs [bringing Article II challenges to SEC administrative proceedings] ‘to proceed exclusively through the statutory review scheme’ set forth in 15 U.S.C. § 78y.” Bebo v. SEC, -- F.3d --, 2015 WL 4998489, at *1 (7th Cir. Aug. 24, 2015) (quoting Elgin, 132 S. Ct. at 2132-33). In so ruling, the Seventh Circuit rejected the basis upon which this Court found jurisdiction, holding instead that judicial review is not inadequate merely because it occurs after the allegedly unconstitutional administrative proceeding had taken place. Id. at *9. The Seventh Circuit’s decision is in accord with binding Second Circuit precedent, as the Second Circuit has held that the securities laws generally require respondents in SEC administrative proceedings “to bring challenges in the Court of Appeals or not at all.” Altman v. SEC, 687 F.3d 44, 45-46 (2d Cir. 2012) (per curiam). In accordance with Altman— which this Court did not cite—the only other judges in this Court to have considered the precise question here have likewise held that they have no jurisdiction. See Tilton v. SEC, No. 1:15-cv- 02472, 2015 WL 4006165 (S.D.N.Y. June 30, 2015) (Abrams, J.), appeal pending, No. 15-2103 (2d Cir.); Order, Spring Hill Capital Partners, LLC v. SEC, No. 1:15-cv-04542, ECF No. 23 (S.D.N.Y June 29, 2015) (Ramos, J.). In light of this overwhelming precedent, the SEC is likely to prevail on the jurisdictional issue.

So it may but this only postpones the ultimate day of reckoning.  This saga is destined to continue.



Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 8)

As all of this plays out, the SEC did win a major victory in the 7th Circuit in Bebo v. SEC.  

The case did not involve a challenge to the system of ALJs under the Appointments Clause but did raise other issues in a collateral challenge to the administrative hearing process.  See Id. ('Bebo contends that § 929P(a) of Dodd-Frank is facially unconstitutional under the Fifth Amendment because it provides the SEC “unguided” authority to choose which respondents will and which will not receive the procedural protections of a federal district court, in violation of equal protection and due process guarantees. She also contends that the SEC’s administrative proceedings are unconstitutional under Article II because the ALJs who preside over SEC enforcement proceedings are protected from removal by multiple layers of for-cause protection."). 

The 7th Circuit held that the district court did not have jurisdiction to hear the collateral challenge.  Instead, the issues needed to be raised in the administrative hearing where they would be reviewed (assuming the case got that far) by the US Court of Appeals.  As the court reasoned: 

  • We affirm. It is “fairly discernible” from the statute that Congress intended plaintiffs in Bebo’s position “to proceed exclusively through the statutory review scheme” set forth in 15 U.S.C. § 78y. See Elgin v. Dep’t of Treasury, 567 U.S. —, 132 S. Ct. 2126, 2132–33 (2012). Although § 78y is not “an exclusive route to review” for all types of constitutional challenges, the relevant factors identified by the Court in Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477, 489 (2010), do not adequately support Bebo’s attempt to skip the administrative and judicial review process here. Although Bebo’s suit can reasonably be characterized as “wholly collateral” to the statute’s review provisions and outside the scope of the agency’s expertise, a finding of preclusion does not foreclose all meaningful judicial review. If aggrieved by the SEC’s final decision, Bebo will be able to raise her constitutional claims in this circuit or in the D.C. Circuit. Both courts are fully capable of addressing her claims. And because she is already a respondent in a pending administrative proceeding, she would not have to “‘bet the farm … by taking the violative action’ before ‘testing the validity of the law.’” Id. at 490, quoting MedImmune, Inc. v. Genentech, Inc., 549 U.S. 118, 129 (2007). Unlike the plaintiffs in Free Enterprise Fund, Bebo can find meaningful review of her claims under § 78y. As a result, she must pursue judicial review in the manner prescribed by the statute. 

The reasoning would seem to apply with equal vigor to the cases challenging the SEC's system for appointing ALJs.  This is only one circuit and, for administrative law purposes, not the critical DC Circuit.  Nonetheless, the reasoning will at a minimum need to be addressed in other cases where the SEC appeals (Hill for example) and argues that the district court never should have heard the case in the first instance.

To the extent that the appellate courts fall into line with Bebo, the approach takes the matter out of the hands of the district courts and gives the SEC the first crack at taking a substantive position on the issue.  Moreover, the approach ultimately delays a determination of the constitutionality of the ALJ appointment process until the matter can make it through the SEC's AP process and it can get to the court of appeals.

Finally, once the SEC has ruled in one case (the matter is before the SEC in Timbervest) and assuming the Commission finds the system of appointment constitutional (because the ALJs are employees and not inferior officers), courts may, at least psychologically, be more open to collateral challenges.  After all, forcing a party through an administrative process when the outcome has already been determined may be viewed as an unnecessary burden.


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 7)

So where does that leave the Commission?

Hill is on appeal.  In Duka, the government "is actively considering whether to appeal the preliminary injunction". Letter to Judge Berman from SEC, August 12, 2015.  The issue is apparently before the Commission as part of an appeal of an AP.  See DEFENDANT’S OPPOSITION TO PLAINTIFFS’ MOTION FOR PRELIMINARY INJUNCTION, Timbervest v. SEC, No. 15-cv-2106, ND Ga., June 29, 2015), at 2 (“The Commission has heard oral argument in the appeals from the SEC ALJ’s initial decision, including argument on Plaintiffs’ Appointments Clause challenge.”).  To the extent that the Commission does not find the appointment process unconstitutional, the matter will presumably be appealed, most likely to the DC Circuit.

Resolution, therefore, may not occur until the appellate courts have spoken.  Moreover, they may not all say the same thing, requiring the matter to go to the Supreme Court.  Until resolution, any party wanting to take their chances in district court rather than in an AP have a ready made argument.

Perhaps some courts will come out on the side of the Commission by finding that ALJs are not inferior officers. Moreover, at least one ALJ may be insulated from these challenges.  Commission involvement in the designation of Judge Murray as the Chief provides an argument that in fact the appointment process meets constitutional requirements.  Whether designation as chief is the same as appointment to the position of ALJ remains to be determined.  

Nonetheless, mysteries remain.  It is unclear why the SEC has not tried harder to develop a fall back in the event that the courts find that ALJs are inferior officers.  While its clear that the Commission has not approved the ALJs at the SEC (Chief Judge Murray a possible exception), it is possible, for example, that Judge Elliot was properly appointed as an ALJ while at Social Security.  If true, this appointment may be sufficient for constitutional purposes.  

More directly, however, there would presumably be available an argument that those appointing ALJs at the SEC (whether HR or the Chief Judge) are doing so pursuant to delegated authority from the Commission and, as a result, meet constitutional requirements.  

Section 4A of the Exchange Act specifies the requirements for delegations.  As the provision provides:   

  • In addition to its existing authority, the Securities and Exchange Commission shall have the authority to delegate, by published order or rule, any of its functions to a division of the Commission, an individual Commissioner, an administrative law judge, or an employee or employee board, including functions with respect to hearing, determining, ordering, certifying, reporting, or otherwise acting as to any work, business, or matter.  

15 U.S.C. § 78d-1(a). To the extent applicable, the SEC must delegate through order or rule, which was not done here.  Of course, it is open whether the Commission can delegate hiring authority without an order or rule or can delegate in a manner that is inconsistent with the statute but sufficient to meet constitutional standards. Moreover, delegation presumably can be implicit.  The whole concept of Chevron deference is built around implicit delegation by Congress to agencies.  The same should be true of delegation within an agency. One wonders whether there is an argument that the Commission has the authority as a Department Head and has delegated the authority to the Chief Judge.

The other possible "fall back" is to have the Commission go ahead and appoint the existing ALJs.  Presumably this is the "cure" that the court in Duka anticipated. Commissoin appointment would at least cut off arguments on a going forward basis. There is no explanation as to why this step has not been taken.

Perhaps there is a Commission that is divided on the issue.  Perhaps the Commission is concerned that approval would somehow constitute an admission that the system was unconstitutional. To the extent the latter, the approval could be phrased in a manner that approved the appointment but specified that the Commission did so out of an abundance of caution and should not, therefore, be characterized as some type of admission. Moreover, having the Commission approve commissioners as a matter of bureaucratic practice is probably a good idea.

For primary materials in the Duka case, go to the DU Corporate Governance web site


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 5)

In Duka v. SEC, the plaintiff challenged the appointment process for ALJs at the SEC as part of a collateral attack on the SEC's efforts to initiate an administrative proceeding against plaintiff.  This case arose in the SD of NY.

Following the institution of an administrative proceeding on January 2015, Duka moved for a temporary restraining order and a preliminary injunction in an effort to prevent the AP from moving forward.  The court denied the motion in April.  It looked like the hearing scheduled for Sept. 16, 2015 would proceed.  

A second round of motions, however, began in July.  This time plaintiff argued that the system for designating ALJs violated the appointments clause.  Once again, the SEC defended the allegation by arguing that ALJs were not inferior officers and therefore not subject to the Appointments Clause.  As for the process of appointment, the Commission acknowledged that “it remains unclear who appoints SEC ALJs”.  Plaintiff described the Commission’s position as one of “apparent disarray.”  See MEMORANDUM OF LAW IN SUPPORT OF PLAINTIFF BARBARA DUKA’S MOTION FOR A PRELIMINARY INJUNCTION, at 3. 

Whatever the precise method, the one undisputed fact was that the ALJs were not appointed by the Commission.  That was enough for the court.   

  • There appears to be no dispute that the ALJs at issue in this case are not appointed by the the SEC Commissioners. Indeed, in an Affidavit, dated June 4, 2015 that was taken in In the Matter ofTimbervest, LLC et al, Jayne L. Seidman, Deputy Chief Operating Officer ofthe SEC, stated that, "[b ]ased on [her] knowledge of the Commission's ALJ hiring process, [SEC] ALJ [Cameron] Elliot was not hired through a process involving the approval of the individual members ofthe Commission." In the Matter ofTimbervest, LLC et al., Admin. Proc. File No. 3- 15519 (attached as Ex. 1 to Am. Compl., dated June 10, 2015). 

The decision, however, had a cure.  As the court noted:   

  • Judge May [in Hill] also determined that "the ALJ's appointment could be easily cured by having the SEC Commissioners issue an appointment or preside over the matter themselves." (Id. at 44.) Plaintiffs counsel in the instant case reached the same conclusion at a conference held on June 1 7, 2015, stating that "I think that [having the Commissioners appoint the ALJ s] is one of [the easy cures]." (See Tr. of Proceedings, dated June 17,2015, at 4.) 

Moreover, the Commission was apparently mulling its choices.  Id. ("And, it appears that the Commission is reviewing its options regarding potential "cures" of any Appointments Clause violation(s). (See Tr. of Proceedings, dated June 17, 2015, at 10.)").  The court, therefore, delayed implementation of the injunction and gave the SEC 7 days to "notify the Court of its intention to cure any violation of the Appointments Clause."

The Commission ultimately informed the court that there would be no cure.  As counsel noted in a letter to the judge: 

  • As this Court is aware, respondents in several pending SEC administrative proceedings have raised before the Commission Appointments Clause challenges to the authority of the SEC ALJs who presided over the initial stage of their proceedings. In at least one proceeding, the Commission has heard argument on the constitutional challenge and has also ordered supplemental briefing. Although the Commission in its adjudicatory capacity may decide in due course whether SEC ALJs’ appointments violate the Constitution and, if so, the appropriate remedy for such a violation, as of the filing of this letter, the Commission has not issued a decision or otherwise taken any public action on these questions. 

A few days later, the court granted the injunction sought by plaintiff, finding a likelihood of success on the claim that the process of designating ALJs at the SEC violated the Appointments Clause.  The court reiterated that the SEC did not appoint ALJs as required by the Clause. Opinion, Aug. 12, 2015 ("Here, the Court has determined that the ALJs at issue were not appointed by the SEC Commissioners. See August Decision & Order at 5. As they were not appropriately appointed pursuant to Article II, their appointment is likely unconstitutional in violation of the Appointments Clause.”).  

For primary materials in the Duka case, go to the DU Corporate Governance web site.  


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 4)

The lack of direct Commission involvement in the ALJ selection process provided an opening for challenging the constitutionality of the appointment process.  

In Hill v. SEC, plaintiff seeking to halt an impending AP argued that ALJs at the SEC were “not appointed by the President, the Courts, or the [SEC] Commissioners. Instead, they are hired by the SEC’s Office of Administrative Law Judges, with input from the Chief Administrative Law Judge, human resource functions, and the Office of Personnel Management”.  In other words, the ALJs were not appointed by the SEC.

The Commission (through the DOJ lawyers handling the case) conceded this point. See DEFENDANT’S OPPOSITION TO PLAINTIFF’S EMERGENCY MOTION TO SUPPLEMENT BRIEF, No. 15-cv-1801, May 29, 2015, at 2 ("In light of Plaintiff’s intention to amend the Complaint to add an Appointments Clause claim, SEC now similarly acknowledges in this case that, consistent with SEC ALJ James E. Grimes’s status as an agency employee and not a constitutional officer, he was not appointed by the SEC Commissioners.").  

The Commission contested the constitutional challenge mostly by asserting that ALJs were not inferior officers and therefore need not be appointed by the Head of a Department. The approach, however, left little room for a constitutional appointment process in the event that the court found that the ALJs were inferior officers. The district court in Hill made exactly that finding, concluding that the ALJs at the SEC were inferior officers. As a result, the court enjoined the SEC from pursuing the administrative proceeding against plaintiff.  Nor would a stay pending appeal be granted.     

  • the Court finds that the SEC has not made a strong showing it is likely to succeed on the merits. As well, the Court notes that the SEC is only foreclosed from conducting an administrative proceeding in front of an ALJ who was not appointed by the SEC itself—the SEC Commissioners may conduct the hearing against Plaintiff at any time or appoint the SEC ALJ directly. They may also elect to bring their claims in district court. Thus, the Court does not find the SEC is irreparably injured or the public interest is affected as the SEC still has a channel to pursue Plaintiff—even through an administrative proceeding if it chooses. However, if the stay is lifted, Plaintiff would have to participate in a likely unconstitutional proceeding which would cause a substantial injury.

The same court made similar findings in Timbervest LLC v. SEC. Because, however, the challenge came after completion of the administrative proceeding, the court declined to enjoin the SEC.  As the court reasoned: 

  • Plaintiffs waited until the ALJ had issued his initial decision and this case was before the SEC itself before filing this motion. Plaintiffs have already gone through the entirety of the administrative procedure before the ALJ—thus, no injunction will cure or prevent Plaintiffs’ prior obligation to defend itself before the ALJ. And any harm which Plaintiffs have already suffered by virtue of the initial decision being published has already been experienced; removing the ALJ’s initial decision from the website would not prevent a future harm.

The Georgia court, therefore, became the first to rule that the appointment process for ALJs at the SEC was unconstitutional.  The SEC has appealed the decision in Hill.   The isolated decision was not, however, to last.

For primary materials in Duka can be found at the DU Corporate Governance web site.  


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 3)

So how are ALJs appointed at the SEC?

In In re Timbervest, the SEC staff explained the appointment process this way:   

  • Pursuant to current statutes and regulations, the hiring process for Commission ALJs is overseen by the U.S. Office of Personnel Management ("OPM"), which administers the competitive examination for selecting all ALJs across the federal government. See 5 U.S.C. §§ 1104, 1302; 5 C.F.R. § 930.201(d)-(e). As do other agencies, the Commission hires its ALJs through this OPM process. See 5 U.S.C. § 3105; 5 C.F.R. § 930.20l(f). When the Commission seeks to hire a new ALJ, Chief ALJ Murray obtains from OPM a list of eligible candidates; a selection is made from the top three candidates on that list. See 5 U.S.C. ·§§ 3317, 3318; 5 C.F.R. §§ 332.402, 332.404, 930.204(a). Chief ALJ Murray and an interview committee then make a preliminary selection from among the available candidates. Their recommendation is subject to final approval and processing by the Commission's Office of Human Resources.  It is the Division's understanding that the above process was employed as to ALJ Elliot, who began work at the agency in 2011. 

The staff, however, acknowledged that the process may have been different in the past.

  • As for earlier hires, it is likely the Commission employed a similar, if not identical, hiring process. But the Division acknowledges that it is possible that internal processes have shifted over time with changing laws and circumstances, and thus the hiring process may have been somewhat different with respect to previously hired ALJs. For instance, Chief ALJ Murray began work at the agency in 1988 and information regarding hiring practices at that time is not readily accessible.

See Notice of Filing, In re Timbervest, Admin File No. 3-15519 (admin proc June 4, 2015).  

The process was apparently followed with some ALJs but, as quickly became clear, not with respect to Judge Elliot.  As he noted, the description was "erroneous" with respect to his appointment.  The description fit the appointment of Judges Patil and Grimes.  Transcript, In re Bebo ("And just by way of background, there’s two ways for a federal agency to hire an administrative law judge.  One is in the manner described in this paragraph, and that is in fact how Judge Patil and Judge Grimes were hired at the SEC, within the last year, roughly.").  

Judge Elliot, however, was already an ALJ at Social Security when he applied to the SEC.  As a result, he did not need to repeat the entire OPM vetting process.   As he described:   

  • the other way of being hired is if you are already an administrative law judge for a federal agency, then you don’t have to go through this process.  Instead, you just go through the process that essentially everyone else with the federal government goes through, which is you have USA Jobs, which is the federal government’s job-posting website, you respond to the advertisement, and then you get hired in the usual fashion.  

Thus, the vetting process by OPM had been done when Judge Elliot applied at Social Security, not when he applied at the SEC. 

  • So in my case, for example, I saw a posting on USA Jobs when I was at Social Security.  I sent in my resume, I had an interview, I got an offer; its as simple as that.  What’s described in the Division’s notice of filing in Timbervest is if you’ve never been an ALJ before.  And, as I said, I did in fact go through that process, just not when I was hired by the SEC.  

The actual selection process, however, did not involve the Commission.  As he described:   

  • I interviewed with Judge Murray, with Jayne Seidman, who at the time was – I think she was with human resources, and an attorney with the general counsel’s office, whose name escapes me at the moment.  I was supposed to interview with the general counsel himself at the time, but he didn’t bother to show up.

He received an offer, something confirmed by HR.  Id.  ("And then . . . once I accepted the offer, I don’t know for sure exactly what the process was, but when I – I pulled out one of my forms that I got from HR, and it appears that someone in HR did sign off on my hiring, ok?").  Although signing the papers, HR was not responsible for the appointment.  Id.  ("I mentioned about my hiring, that someone in HR had signed a paper, and I want to make it clear.  I’m not saying that the person who signed the paper or the paper itself was my appointment.  It was simply an SP50, as Standard Form 50, which is the customary document for the federal civil service – the document changes to personnel status, and it was signed by someone in HR, because they always are signed by someone in HR.").  

As for the source of the apppointment, he didn't know.  Id. ("I would have to say no, I don’t know.  I have an educated guess, but its really just an educated guess.  No, I don’t know the answer.").  There was, however, no direct involvement in the appointment process by the Commission.  Id.  ("The bottom line, for purposes of the Article II arguments, is that I was – I was not appointed by the Commission.  The Commission, as far as I know, did not issue any sort of order appointing me as an ALJ.").  

The process for joining the Commission, therefore, seemed clear enough.  The actual source of the appointment, however, was less clear.  HR was one possibility; the Chief ALJ was another.  Given the disclaimer, it wasn't OPM.  There seemed to be agreement that the Commission played no role in the process, except that sometimes it did.  As Chief Judge Murray stated in another case, "I was appointed as Chief Administrative Law Judge by the Commission on March 20, 1994."  In In re Bama Biotech, Release No. 836 (admin proc July 20, 2015).  

The statement is a bit delphic, noting only that she had been designated Chief by the Commission, not that she had been appointed as an ALJ by the Commission.  

For primary materials in the Duka case, go to the DU Corporate Governance web site


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 2)

The Appointments Clause provides that the President has the authority to appoint Officers of the United States but allows Congress to vest the appointment of "inferior officers" "in the President alone, in the Courts of Law, or in the Heads of Department."  To the extent that ALJs at the SEC are "inferior officers" (as opposed to employees), therefore, they must be appointed by the Commission. 

With respect to the appointment of ALJs, each agency is allowed to determine the number that it needs. See 5 U.S. Code § 3105 ("Each agency shall appoint as many administrative law judges as are necessary for proceedings required to be conducted in accordance with sections 556 and 557 of this title. . . .").  

After having determined the number, the actuall appointment process involves substantial input from the Office of Personnel Management ("OPM").  OPM screens the candidates and must approve a selection or povide a list of eligible candidates.  See 5 CFR § 930.203a ("An agency may make an appointment to an administrative law judge position only with the prior approval of OPM, except when it makes its selection from a certificate of eligibles furnished by OPM.").  

OPM, however, emphatically disavows any final decision making with respect to ALJs.  See 5 CFR 930.201 ("OPM does not hire administrative law judges for other agencies").  The law seems clear, therefore, that agencies, not OPM, select ALJs.

Within each agency, the system for appointment often rests with the head of the agency.  See 42 U.S.C.A. § 2000e-4 (Chairman of EEOC, on behalf of the Commission, approves ALJs); 50 U.S.C.A. § 2412(c)(4) ("An administrative law judge referred to in this subsection shall be appointed by the Secretary [of Commerce] from among those considered qualified for selection and appointment"); 29 U.S.C.A. § 661(e)("The Chairman [of OSHA] shall be responsible on behalf of the Commission for the administrative operations of the Commission and shallappoint such administrative law judges and other employees as he deems necessary to assist in the performance of the Commission's functions"); 30 U.S.C.A. § 823 ("The [Federal Mine Safety and Health Review] Commission shall appoint such additional administrative law judges as it deems necessary to carry out the functions of the Commission.");  20 U.S.C.A. § 1234 ("The administrative law judges (hereinafter "judges") of the Office shall be appointed by the Secretary [of Education] in accordance with section 3105 of Title 5.").  

The appointment process at the SEC, however, is less clear.

For primary materials in the Duka case, go to the DU Corporate Governance web site