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Trinity v. Wal-Mart: Banning Shareholders from the Sugar Debate

Trinity v. Wal-Mart is a very poorly reasoned decision.  The court conceded that the shareholder proposal at issue involved matters of important public policy.  Nonetheless, in a made-up test, the court concluded that public policy only trumped the "ordinary business" exclusion of it "transcended" the business of the corporation.

The court gave as an example of its reasoning, the following:  

  • To illustrate the distinction, a proposal that asks a supermarket chain to evaluate its sale of sugary sodas because of the effect on childhood obesity should be excludable because, although the proposal raises a significant social policy issue, the request is too entwined with the fundamentals of the daily activities of a supermarket running its business: deciding which food products will occupy its shelves. 

Coincidentally, the NYT last sunday had an article on this very topic.  See The Decline of Big Soda.  The issue has been much discussed, with consumer behavior changing significantly.  As the article noted: 

  • The drop in soda consumption represents the single largest change in the American diet in the last decade and is responsible for a substantial reduction in the number of daily calories consumed by the average American child. From 2004 to 2012, children consumed 79 fewer sugar-sweetened beverage calories a day, according to a large government survey, representing a 4 percent cut in calories over all. As total calorie intake has declined, obesity rates among school-age children appear to have leveled off.

The issue, therefore, has clear social importance. The majority opinion in Trinity reflects a judicial predilection against the use of the rule to debate matters of public policy that are implicated by the business activities of a public company. To those judges, shareholders ought to have no say in the debate over sugary drinks and obesity. The decision contradicts both the longstanding use of Rule 14a-8 and the growing desire of shareholders to provide advice to companies on matters of important public policy.        


The SEC and Shifting Away from Stats

Professor Urska Velikonja at Emory has written an article that unpacks the enforcement statistics ("stats") annually issued by the Securities and Exchange Commission.  The paper is here.  

That a federal agency would have an incentive to develop a counting system that maximizes numbers is no surprise and I am guessing it is common.  In truth, stats (and their constant increase) have little value except to reduce the inevitable criticism from SEC critics that would occur if the stats dropped.   

Irrespective of how they are counted, the broader issue is whether the SEC should rely on stats as heavily as a measure of success.  In truth, an effective approach to enforcement should involve a certain amount of investigation designed to “look around the corner” and find fraud or misbehavior before it becomes public.  You want to find the Madoff’s before they are on the front page of the Wall Street Journal.  This approach would, by definition, result in investigations that ended without cases being filed.  Under the current system, they would not produce any stats. 

The SEC is presumably heading in this direction.  Nonetheless, the agency is still under pressure to maintain stats.  Hopefully the article will not just encourage a conversation on the best method of calculation but will also encourage a conversation on the need to reduce reliance on this metric as a measure of success.


Oversight of the Regulatory Function at the NYSE (Part 4)  

The debate notwithstanding, the staff, by delegated authority, approved the NYSE proposals without significant change.  See Exchange Act Release No. 75991 (Sept. 28, 2015).  

The concerns with the structure?  Dismissed.  The reason?  The approach was consistent with other exchanges.  As the staff wrote: 

  • As a preliminary matter, the Commission notes that several concerns raised by the commenter relate to the fact that the Exchange is part of a holding company structure. In that regard, the commenter suggests that the replacement of NYSE Regulation with the ROC would not provide sufficient insulation of the Exchange's regulatory functions from the commercial interests of the holding company. The Commission notes that, although the Exchange may be part of a holding company structure, the Exchange is obligated to satisfy its self-regulatory obligations under the Act and rules and regulations thereunder. The Commission believes that the regulatory structure proposed by the Exchange is consistent with the Act and the rules and regulations thereunder, and is substantially similar to regulatory structures that were approved by the Commission for other exchanges.  

With respect to the lack of authority by the ROC over the regulatory mission of the exchange, the staff did not address the issue in any detail but simply concluded that the NYSE approach was adequate. 

  • The commenter expresses the view that the ROC would not have sufficient substantive authority over the Exchange's regulatory program. In response, the Exchange states that the ROC was modeled on the NASDAQ ROC and has the same powers, including the power to review the regulatory budget and inquire about available regulatory resources. The Commission believes that the Exchange's proposal to establish a ROC, as an independent committee of the Exchange to oversee the adequacy and effectiveness of the Exchange's regulatory operations, should help the Exchange to fulfill its statutory obligation to comply, and to enforce compliance by its members and persons associated with its members, with the Act, the rules and regulations thereunder, and the rules of the Exchange. In addition, the Commission believes that the composition of the ROC, which would consist of at least three members of the Board that satisfy the Company Director Independence Policy, should help ensure the independence of the regulatory function of the ROC. 

The influence of the holding company with respect to the regulatory mission was more or less ignored.  The fact that the structure could have been modestly changed to significantly reduce this potential influence (by for example requiring that a majority of the directors of the ROC not also be directors of the holding company) was ignored.

There is a great ongoing debate about whether exchanges should retain their SRO status.  SIFMA, for example, has criticized the regulatory differences between SROs and ATSs.  Certainly as a matter of optics and likely as a matter of substance, the new structure adopted by the NYSE makes it harder to argue that the regulatory function is anything more than another functional aspect of its business.  The changes add to the weight of those arguing that the NYSE and the other exchanges, as for profit companies, should no longer has any regulatory responsibility.  

For my first letter critiquing the NYSE proposal, go  here.  


Oversight of the Regulatory Function at the NYSE (Part 3) 

The proposal submitted by the NYSE provided that the board would no longer rely on NYSE Regulation to perform oversight of the regulatory functions of the Exchange.  Instead, the functions would be overseen by a a regulatory oversight committee (ROC) created by the board of the exchange.  Pursuant to delegated authority, the staff approved the revisions

The proposal contemplated that the regulatory function would be overseen by a committee of the board conisting entirely of independent directors (albeit directors who could all serve on the board of the holding company).  Thus, the structure promised some separation between the ROC and the entire board.  Only the actual authority of the ROC, as stated in the proposed language, included no substantive authority except for the power to set goals.  As the proposed amendment provided:  

  • The ROC shall oversee the Company’s regulatory and self-regulatory organization responsibilities and evaluate the adequacy and effectiveness of the Company’s regulatory and self-regulatory organization responsibilities; assess the Company’s regulatory performance; and advise and make recommendations to the Board or other committees of the Board about the Company’s regulatory compliance, effectiveness and plans.  

Thus, the ROC had the authority to oversee, evaulate, assess, advise, and make recommendations. None of this, however provides that the ROC actually has final authority to act.  Instead, final actions are presumably left with the Board of the Exchange, the same Board that could be dominated by directors of the holding company.  

The proposed language to the Operating Agreement also provided that the ROC shall: 

  • (A) review the regulatory budget of the Company and specifically inquire into the adequacy of resources available in the budget for regulatory activities; (B) meet regularly with the Chief Regulatory Officer in executive session; (C) in consultation with the Chief Executive Officer of the Company, establish the goals, assess the performance, and recommend the compensation of the Chief Regulatory Officer; and (D) keep the Board informed with respect to the foregoing.  

Thus the power of the ROC over the budget was to review and inquire but not make final decisions.  The power with respect to the compensation of the Chief Regulatory Officer was to recommend, but only in consultation with the CEO of the Exchange.  

The ROC does, apparently, have the authority to hire and fire the CRO but this was not set out in the proposal. According to the Letter from the NYSE: 

  • Moreover, given that the CRO reports to the ROC, the ROC clearly has the power to retain or dismiss the CRO, only it must do so in consultation with the Exchange’s Chief Executive Officer as part of the process of establishing the goals, assessing the performance, and recommending the CRO’s compensation.  

Thus, even if the ROC consisted of independent directors who were also not directors of the holding company, the final decisions for many functions such as the regulatory budget or the CEO's compensation would be made by the full Board (which could have a supermajority of directors from the holding company) or the CEO (which could have been appointed by a board consiting of a supermajority of directors from the holding company).  

So how did the staff react to the proposal?  That will be in the next post.

The exchange of letters discussing this proposal, including the letter from the NYSE, can be found here.



Oversight of the Regulatory Function at the NYSE (Part 2)

The proposal submitted by the NYSE provided that the board would no longer rely on NYSE Regulation to perform oversight of the regulatory functions of the Exchange.  Instead, the functions would be overseen by a a regulatory oversight committee (ROC) created by the board of the exchange.  

As proposed, the structure would permit significant potential influence from the holding company.  

First, the ROC is to be appointed by the Board of the Exchange.  There is nothing in the Operating Agreement of the Exchange that prevents the board from being under the control of directors from the holding company. The board of the Exchange must have a majority of independent directors and at least 20% of the directors must be non-affiliated directors (directors who are not members of the board of the holding company).  The operating agreement is here.  Thus, 80% of the board can consist of directors from the holding company.  

Moreover, because the board of the Exchange is only required to have a majority of independent directors, the board can include directors from the holding company who do not meet the independence standards of the Exchange.  

In addition, the ROC itself must consist only of independent directors but nothing in the proposal prevents those directors from also being directors of the holding company, so long as they are independent.  

Thus, under the NYSE proposal, the regulatory function would be under the oversight of a committee appointed by a board that could include a supermajority of directors from the holding company, including at least some directors from the holding company who do not meet the independence standards of the Exchange. The Board would have the authority to designate directors annually and to remove directors at any time "for cause." Finally, the ROC itself could consist of independent directors entirely from the holding company.  

These issues are discussed in an exchange of letters with the NYSE.  The letters are here


Oversight of the Regulatory Function at the NYSE (Part 1)

When the NYSE went public in 2006, a spirited debate arose over whether a for profit company could adequately insulate its regulatory function from the for profit motives of the holding company. 

In seeking to insulate the regulatory function, the NYSE formed NYSE Regulation, a non-profit with a board consisting entirely of independent directors (save only the CEO).  The bylaws provided that NYSE Regulation could not have a majority of directors from the holding company.  In addition, NYSE Regulation had its own compensation and nominating committee, both of which could not have a majority of directors from the holding company.  The Exchange, pursuant to a delegation agreement, assigned regulatory functions to NYSE Regulation (although legal responsibility remained with the Exchange).

Thus, the structure created a number of safeguards designed to separate the regulatory and business functions of the exchange. 

In June 2015, the Exchange proposed to end the structural separation of the regulatory and business function and replace it with a functional separation.  The proposal is here.  

Under the proposal, regulatory authority of the Exchange would no longer be delegated to NYSE Regulation. Instead, the proposal called for the creation of a regulatory oversight committee (ROC) of the board of the exchange and a chief regulatory officer (CRO).  The proposal, however, allowed for greater potential influence from the directors of the for profit holding company than the NYSE Regulation structure.  Moreover, the express language creating the ROC provided the committee with little substantive authority over the regulatory mission of the Exchange.  Despite these concerns, the staff approved the proposal without significant change.  The adopting release is here.  We will discuss these issues in the next few posts.

These issues are discussed in an exchange of letters with the NYSE.  The letters are here.  


Voting Records of SEC Commissioners

The divided nature of the Commission is not news.  At public meetings, more and more decisions are a 3-2 vote.  The public meetings involve only a small percentage for the decisions made by the Commission.  Divided votes at non-public meetings are generally not known. 

One exception concerns decisions resulting in a Commission order.  In those circumstances, the vote is noted by hand in an order maintained by the Commission.  To the extent commissioners dissented, that will be noted on the Order.  To obtain the information, however, it has, in the past, been necessary to examine the Order, something that can be obtained through a FOIA Request.  In other words, the information, unlike a division at a public meeting, was not easily available.

That is no longer the case.  The information can be obtained on line on a page maintained by the SEC that contains "Frequently Requested FOIA Documents."  The page includes a category titled "Final Commissioner Votes" from April 2006 through August 2015. The File includes votes in rules (final and proposed) and orders in administrative proceedings.  The notations note when a particular commissioner is "not participating."  Sometimes the notations state only "Dissapproved."  In those circumstances, the reasons for dissapproval are not apparent.  Commissioners may, however, issue dissents in other forums that disclose the reasons.  Those dissents are not in this file. 

In August 2015, for example, Commissioners Stein and Piwowar "Dissapproved" in In re Citigroup, Securities Act Release No. 9894 (admin proc Aug. 17, 2015) and In re Citigroup, Securities Act Release No. 9896 (admin proc Aug. 19, 2015). The latter is a "waiver release" under the advisers

In July, in connection with Exchange Act Release No. (July 1, 2015), the proposed "clawback rule", Commissioners Gallagher and Piwowar "Dissapproved."  Unlike the Orders, this information is already available in the record of the open meeting that addressed the proposal.  Moreover, the Commissioners both explained the basis for their dissents at he meeting.  (The dissent for Commissioner Gallagher is here and for Commissioner Piwowar here). 

In In re Dickson, Exchange Act Release No. 75418 (admin proc July 9, 2015), the notation in the file states
"Commissioner Gallagher Commissioner Piwowar dissented as to the Municipal Advisor and NRSRO Bars". The same notation appeared on the Order for In re Holdman, Exchange Act Release No. 75462 (admin proc July 15, 2015).  In In re Edwards, Exchange Act Release No. 75563 (admin proc July 30, 2015), Commissioner Piwowar "Disapproved." Interestingly, in this case, two commissioners were listed as "not participating" suggesting that th evote was 2-1. 

Over time, we may explore more of the voting records set out in these files.  Nonetheless, they provide an important source of information on the views of, and the divisions in, the Commission. 


The Dark Side of the Pools (Part 3)

We are discussing The Dark Side of the Pools, a report on dark pools recently issued by Healthy Markets.

The Health Markets Report recommends a variety of reforms, ranging from regulatory intervention to self help. The most profound suggestion is only tangentially related to Dark Pools.  Investors need the information needed to assess best execution, irrespective of the trading venue.  As the Report notes: 

  • investors also need more and better data about order routing and executions. Investors should be able to quantitatively test the quality of the services available to them. While private industry efforts are currently pushing data availability forward, there have not been any organized, concerted efforts to establish data standards, impose clock synchronization standards, or require brokers to make critical data available to investors. 

Nonetheless, in the absence of this type of information, investors are left with the need to take prudent steps designed to reduce but not eliminate risk.  These include:  

Demanding Better Disclosure. "Investors should demand better public and private disclosures. To the extent possible, these disclosures should be standardized across market venues. Investors need to know how dark pools operate and how their orders are handled. At the same time, investors and regulators need to have high-quality order routing and execution data against which to test brokers’ and venues’ performance."

Mitigating Conflicts of Interest.  "Investors should demand lesser conflicts of interest from dark pools and their operators. Investors should make informed decisions about the risks of interacting with dark pools that have an affiliate trading for profit in the pool, and should determine whether or not those trading operations are adequately disclosed. Even with disclosure, the risk of abuse remains high."

Updating Policies.  "Investors should update and modernize their practices regarding best execution and fiduciary obligations. This is essential for investors to minimize their trading costs and fulfilling their fiduciary obligations to their clients."

Rewarding Less Conflicted Venues. "Over the long term, investors should continue their efforts to promote independent alternative trading venues whose business models are better aligned to protect the interests of their underlying customers. In addition to providing higher quality venues for investors, these efforts may act as a powerful catalyst to drive reforms at other trading venues."


The Dark Side of the Pools (Part 2)

We are discussing The Dark Side of the Pools, a report on dark pools recently issued by Healthy Markets.

Dark pools are not regulated exchanges but are regulated under Regulation ATS.  Regulation ATS was adopted in 1998, well before the degree of fragmentation that has occurred in the markets.  As a result, the Regulation was not designed to address many of the problems that have arisen in an era of for profit exchanges, high frequency trader, and a market with 50 or more trading centers.  

Dark pools provide trading centers that do not disclose the "identity of counterparties or display[] specific order information."  The lack of transparency, therefore, has its advantages.  It also, however, had disadvantages. As the Report from Health Markets notes, dark pools confront a common competitive concern.    

  • Increasing their fill rates and executions meant that dark pools had to find counterparties for their resting orders. This task has always been a significant challenge. Simply stated, it is relatively rare that at the exact same time one mutual fund complex wishes to sell one million shares of a particular stock, another institution in the pool will just happen to want the same million shares. Of course, from a trader’s perspective, the longer an order rests in a dark pool, the greater the risk of information leakage and increased opportunity costs.

One way to accomplish this task is to allow high frequency traders into the pool.  The Dark Pools are not, therefore, a collection of like minded institutions looking to make block trades.  Instead, trading patters began to resemble those in the lit markets.  See Healthy Markets Report at 9 ("As high-speed traders entered the pools, trading volumes sky-rocketed, but the characteristics of dark pools changed. Execution sizes came down, . . .  ultimately converging at the same value as on lit markets.").   

In assessing the quality of trades in Dark Pools, institutions can try to engage in self help.  This, according to the Healthy Markets Report, is not easy or, in some cases, possible.   

  • One reason is that most investors lack comprehensive market data against which to compare their trading. In recent months, some firms have sought to quickly fill this need through enhanced analyses by comparing their customers’ information against public market information about executions. Detailed trading analyses are important, but they are also subject to the quality and breadth of information provided, as well as to the technical expertise, biases, and analytical capabilities of providers.
  • These analyses will also take time to complete, and once completed, will likely provide little illumination. Of course, if a venue is shown to perform extremely poorly, then an investor or broker should immediately suspend trading at that venue, and route elsewhere. But if the analysis was already clear-cut enough to make this determination, we suspect that such poor performance would have already been identified and order flow to that venue curtailed. 

So, other than the abandonment of Dark Pools, what can be done? 


The Dark Side of the Pools (Part 1)

Market structure remains a significant issue.  With dark pools, registered exchanges, and internalizers, the number of trading centers has proliferated.  The percentage of trades in the dark markets has increased.  At the same time, the trading in the lit markets has become less centralized, with the NYSE, Bats and Nasdaq each taking about 20% of the market.

Some of the concerns that have arisen are technological. Trading centers can break down, as happened recently at the NYSE. But as Healthy Markets ("a not-for-profit association of institutional investors working together with other market participants to promote data-driven reforms to market structure challenges") recently highlighted in a report, The Dark Side of the Pools, substantial concern remains with the lack of transparency in the dark markets.  

Trading in the dark markets has increased significantly over the last decade.  As the SEC noted:  "from February 2005 to February 2014, the collective share of dark venue trading in NYSE stocks increased from 13% to 35%, and the collective share of dark venue trading in NASDAQ stocks increased from 29% to 39%."

Despite the ominous sounding name (perhaps dark pools as a group should put in for a name change), the growth reflects market demand.  As the Healthy Markets Report noted: 

  • For institutional investors, the need for dark pools has never been greater. High-speed traders armed with cutting-edge technology have grown stunningly adept at identifying, exploiting, and profiting from large orders. To gain even more of an edge, some of these high-speed traders have been awarded special—and sometimes secret—privileges from market centers, such as greater or faster access to information, or specialized order types.

Yet despite this demand, concern continues over the practices of dark pools.  Many are chronicled in the review by Healthy Markets of the recent cases brought by the SEC (against Pipeline, UBS and ITG) and the NY AG (Barclays and Credit Suisse).  We will discuss some of these concerns in the next several posts. 


Espinoza v. Dimon: Helping the Hapless Second Circuit

The Second Circuit certified the following question to the Delaware Supreme Court: 

  • If a shareholder demands that a board of directors investigate both an underlying wrongdoing and subsequent misstatements by corporate officers about that wrongdoing, what factors should a court consider in deciding whether the board acted in a grossly negligent fashion by focusing its investigation solely on the underlying wrongdoing? 

The Delaware Supreme Court was more than happy to help the hapless Second Circuit deal with such a basic question. 

  • We appreciate our colleagues‘ concern about applying principles of Delaware law with fidelity and their willingness to ask for our input.6 In fact, we were honored to answer two prior requests from our colleagues on the Second Circuit within the past year. In that same spirit, we accept our colleagues‘ current request for certification and we will try to be as helpful as we can, consistent with the careful and precise manner in which the tool of answering certified questions of law should be employed.

Ultimately, the Court rejected the certified question. Id. ("in providing an answer, we feel obliged to decline to answer the question as formulated or to try to reformulate the question more narrowly.").  Nonetheless, the Court was kind enough to provide four or so additional pages providing some "thoughts" on the decision "and an explanation of why we do not go further."  Perhaps with this helpful guidance, the Second Circuit will be able to get the question right the next time around. 


Trinity v. Wal-Mart Stores: Certiorari Sought

The shareholder in Trinity v. Wal-Mart has filed a petition for cert in connection with the rule of the Third Circuit. The issue, as framed by Trinity:
  • Did the Third Circuit depart from the need for judicial neutrality as to the merit of a shareholder proposal in holding that SEC proxy rules were violated because of what the Court felt was ambiguity in a proposed board committee charter amendment?

The petition, among other things, suggests that the case is an appropriate vehicle for a reexamination of the degree of deference (if any) given to staff interpretation of its own rules.  Several justices on the Court have suggested that this should be reexamined.

We will have the cert petition posted later today at the DU Corporate Governance web site.


In re Lucia, Exchange Act Release No. 75837 (Sept. 3, 2015): The Appointments Clause Debate Continues

As we have discussed on the Blog, the system of ALJs at the SEC has been under constitutional attack.  The focus has been on whether the designation of ALJs was done in violation of the Appointments Clause of the Constitution.  Under the Appointments Clause, Inferior Officers must be appointed by the President, the Courts of Law, or the Heads of Departments.  

The SEC has staked its defense on the argument that ALJs are not inferior officers.  The Commission has not asserted and indeed has disavowed that the ALJs were appointed by the Commission.  If the agency loses on the inferior officer issue, the system of ALJs is perforce unconstitutional.

The Commission issued its first decision in an administrative law context on the issue In re Lucia.  The outcome was the same.  ALJs are not inferior officers.  As the opinion stated: 

  • The great majority of government personnel are neither principal nor inferior officers, but rather “mere employees” whose appointments are not restricted by the Appointments Clause. It is undisputed that ALJ Elliot was not appointed by the President, the head of a department, or a court of law. Respondents therefore contend that his appointment violates the Appointments Clause because, in their view, he should be deemed an inferior officer. The Division counters that he is an employee and thus there was no violation of the Appointments Clause

The Commission concluded that ALJs are not inferior officers. 

  • we conclude that the mix of duties and powers of our ALJs is similar in all material respects to the duties and role of the FDIC's ALJs in Landry. Accordingly, we follow Landry, and we conclude that our ALJs are not “inferior officers” under the Appointments Clause

The analysis was repeated in In re Timbervest.  Next stop, the US Court of Appeals.  But the parties get to choose and its likely not to be the DC Circuit where Landry was decided.  See Section 25(a) of the Exchange Act (party may "obtain review of the order in the United States Court of Appeals for the circuit in which he resides or has his principal place of business, or for the District of Columbia Circuit").  The uncertainty as to the constitutionality of the system of ALJ appointments continues.  


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