“That government is best which governs least.”
— Henry David Thoreau
My first column in New England In-House appeared on Oct. 1, 2003. The publishers have invited me to look over the past 16 years and identify significant legal trends. Most columns have addressed either the role of corporate director or government control in early-stage capital formation.
Directorships became nuanced
When I started writing about corporate governance, director roles were clear: earn dollars for shareholders. Directors only had to avoid fraud and self-interest. Over time, only the ways of defining delivery of profit had evolved, focusing first on appreciation of share price, then focusing on short-term profits vs. long-term profits, and then the sometimes-maligned but generally accepted concept of TSR (Total Shareholder Return).
In January 2008, when the “Great Recession” grew out of the subprime mortgage crisis, I reported that shareholders were proposing “say on pay” votes concerning “mushrooming executive compensation which sometimes appears to be insufficiently aligned with the creation of shareholder value.”
In April 2008, I reported that the Wall Street Journal noted the “substantial increase” in 2007 CEO compensation notwithstanding newly imposed SEC disclosure rules requiring ever more granular disclosure concerning executive compensation.
Since 2008, the SEC became more intrusive in board functions: CEO compensation, mandatory “say on pay” for public companies, and promulgating ever more complex filing disclosures (even my first column in October 2003 bemoaned proxy disclosure requirements for independent nominating committees).
By mid-2009, I was writing about proposed SEC rules making it easier for shareholders to include board nominees in proxy materials (or alternately to be reimbursed for independent solicitation).
Additionally, in light of the “bailouts,” and General Motors and Chrysler bankruptcies, the federal government pressed Bank of America to revamp its board with individuals with banking experience, the FDIC pushed Citigroup to change top management, and the federal courts caused the firing of GM’s CEO and dictated its capital structure.
Coupled with SEC action against Countrywide Financial’s CEO, CFO and COO for misleading investors concerning the strength of their mortgage portfolio, I concluded that “American corporate governance is being rapidly and radically altered. This alteration, by and large, is accepted in many political, financial and legal quarters as either penance for financial failures or an unavoidable price for being bailed out.”
Articles in 2009 and 2010 emphasized board obligations to focus on systemic risk (until then, risk was viewed as financial and its governance resided in F&A committees), and moving into the teens my writing reflected discussion as to whether good governance actually improved profitability and stock prices.
Also during the teens we saw proliferation of litigation against directors, driven by complex Delaware jurisprudence defining the obligation of directors in M&A. These transactions sometimes benefitted management, or investors cashing out with significant profits.
During that time, I was suggesting to directors that there was protection in properly recording corporate minutes (one column defined corporate minutes as a “Trojan horse”); what was written was “evidence.”
The confusion for directors was focused in my February 2015 article, “Fiduciary duties in Delaware: complexity trumps clarity.” In discussion of the traditional view of fiduciary duties, a Delaware bankruptcy court held that the owner-manager of a company had a duty “only to manage the affairs … in the best interest of the … shareholders.”
Touching upon the concept of “zone of insolvency,” the court made clear that mismanagement causing an insolvency does not create a claim by creditors for breach of director duty. Directors owe a duty to creditors only if both liability exceeded assets and there was no reasonable prospect that the business could successfully continue.
At the same time, I wrote about directors representing investors who benefitted by recapitalization, in a case in which interested directors excluded an independent director from participating, accepted a “back of the envelope” valuation proposed by one of the VC investors, and failed to disclose a side financial deal.
The court determined that the board breached its fiduciary duty by not hiring outside independent financial advice and by absence of viable financial projections. The lesson: Boards are held to a dual standard of not only fairness in price, but of a robust process.
In 2015, the buzz was about expanding director duties in the face of cyber risk: what did directors have to know, upon whose information should they rely? Other issues were protection for the independent director, and the role of directors in monitoring corporate political contributions, recently permitted by the Citizens United case.
Articles in late 2016 and in 2017 chronicled difficulties in sitting on a board. The practice of combining the role of CEO and chair fell under substantial criticism from proxy advisory firms; half the S&P 500 companies had separated the functions. When the roles are split, the question became “who does what?”
Additionally, I noted the growth of the role of “lead director,” an independent person counterbalancing the unified CEO/chair.
At this time, the Delaware Bankruptcy Court addressed “zone of insolvency”: There is no “zone.” But if you are insolvent, for example when directors have decided to fire employees, you have arrived at “ground zero” and boards now owe a duty to creditors.
In my article “Constituent directorships: That dog don’t hunt,” I concluded that, by 2017, the risk of being an investor designated director had become so great that no designee could meet the independent fiduciary status demanded by Delaware courts.
Since that time, we have seen such directors more often abstaining from voting on anything wherein their principal has economic interest, and the practice of adding additional “independent” directors when considering transactions in which different share classes are treated differently.
Recently, articles have touched upon “enterprise risk” and the obligation of directors not only to monitor finances but also to provide strategic business guidance in order to limit risk (and to consider risk in conjunction with new business strategies).
Finally, we have recently seen suggested redefinitions of the role of corporations, from the pronouncement of the Business Roundtable to articles by former Delaware Supreme Court Chief Justice Leo E. Strine Jr. Corporations should not be guided solely for the benefit of investors, but also by broader obligation to different constituencies (workers and society at large). Indeed, even the very backgrounds of the people who serve on boards were focused in my article last May exploring “Diversity on corporate boards: a tortuous path.”
Bottom line: Directors are being held to stricter fiduciary duties, are subject to greater government intervention through courts and SEC regulation, and are being advised to reorient their thinking from just “making money” to “making money while doing good.”
Depression to innovation economy
After the 1929 Depression, investor protection from speculative securities markets was government policy. The Securities Act of 1933 and the Securities Exchange Act of 1934 established sharp lines for the protection of the retail investor.
Securities regulation over the years had evolved in two contradictory directions: first, to improve the quality of disclosure and governance rules so that investors are better protected, but second, to slowly loosen restrictions barring the less wealthy, less sophisticated investor from risky investments absent robust SEC disclosure and regulation).
Since the beginning of the Great Recession, my articles have tracked those two trends. January 2008 saw the arrival of XBRL, the interactive “tag” of financial statements in SEC filings to provide investors with comparability among registered companies.
In 2008, the SEC also tackled “finders.” Emerging companies often rely on “friends and family” investors but often need more capital. The “Main Street investor” required a path to fill those needs. However, by 2008 we knew that any Main Street investor wouldn’t suffice; such investor had to be “accredited” by wealth to be permitted.
But even being accredited did not provide investors with access to emerging companies. Main Street investors needed finders. SEC and state securities regulators viewed finders, compensated for bringing investors to unregistered small deals, as violating law as unregistered broker dealers.
Finders nonetheless went ahead being paid for introductions, believing that they would not be caught. In November 2008, my column noted that the quixotic treatment previously afforded by the SEC to finders had ended, and even individuals described as “consultants” (but compensated upon closing of a financing) would be acting illegally if not registered. That led to many corporate counsel refusing to permit client companies from dealing with finders.
In a March 2011 article (“Pornography and common law private placements”), I drew the analogy between an undefined illegal private placement and Justice Stewart’s Supreme Court statement that while he could not define obscenity, he would know it when he saw it.
I recommended that the SEC effect a “total revision of the SEC regulatory attitude toward all placements” not under Regulation D. At common law, you were exempt in a private placement if an unknown number of offerees (or was it purchasers?) met a certain financial standard (undefined), received adequate information (undefined), and agreed to hold the securities for some period of time (undefined) absent a “change in circumstances” (undefined).
Between not knowing how to regulate finders and not having a comprehensive definition of an exempt private placement, there were many unknowns in 2011 for an emerging company.
In the middle of 2012, I revisited the question of finders. Optimistically prodded by ABA Task Force proposals to provide a minimal and inexpensive way to register finders (“broker/dealer lite”), I foresaw the permissibility of finders being compensated for making investor introductions, facilitating access to the Main Street investor. That proved an idea well ahead of its time.
In October 2012, I trumpeted SEC proposals to permit limited public solicitation in exempt Regulation D private placements. By that time, Regulation D had become standard practice; few practitioners relied on the common law exemption except in the clearest of cases (institutional investors; investment by friends and family closely related to the offering company). The realization of general solicitation in Regulation D offerings was confirmed in the August 2013 column, trumpeting SEC approval of “mass mailings, Emails, websites and social and broadcast media.”
In tracing further efforts to permit Main Street investment in early stage companies, I reported in December 2013 the introduction by the SEC of a “crowd funding” regulatory regime, designed so that the “ordinary middle-class Joe should be able to purchase valuable shares of startup companies, just like the big boys do … .”
With final adoption of crowdfunding, smaller offerings (around $1 million during any 12-month period), with limited general solicitation, could be made in limited amounts to non-accredited investors. Restrictions on resale terminated after 12 months (although usually there was no market for the shares).
In 2014, the SEC provided guidance to permit finders to work in M&A transactions (although not providing a state law exemption). Alas, the SEC adamantly refused to change its rules with respect to finders bringing investors (as opposed to acquirers) into securities situations. Such remains the case to this day.
You can download on the SEC website a chart of various exemptions from registration requirements for sale of securities to retail investors. Aside from the undefined “common law” exemption, and aside from the little-used short-form Regulation A exemption, there are several other columns indicating ways in which investors can play the VC game, in some instances without being wealthy (accredited), which brings us to the subject of my next NEIH column (spoiler alert).
Remember that most registration exemptions require accredited status either expressly under Regulation D (Rules 506 (b) and 506 (c)) or de facto under both Rule 504 and in most instances under common law. In the face of searing criticism that allowing Main Street investors into the VC space is akin to allowing children to play with fire, the SEC on Dec. 20 proposed updates to the definition of “accredited.”
While at this publication a 60-day comment period has yet to expire, the definition of “accredited” could include: any entity owning $5 million in investments; individuals holding certain SEC professional licenses or certain educational degrees; certain registered investment advisors and rural business investment companies; certain Indian tribes; certain family offices with $5 million in assets together with their “family clients;” and “spousal equivalents” (permitting accreditation of people in the equivalent of a spousal relationship).
So, starting with the Great Recession, how far have we come in freeing up Main Street investment in early stage companies?
Not very far, as a matter of practice. “Finders” remain anathema. Most deals are done under the parts of Regulation D that require investors be accredited. Platforms for crowdfunding, at least for the Massachusetts practitioner, have not proven very popular.
There is speculation that Republican SEC commissioners will push increased investment opportunities for all. Commissioner Elad Roisman believes that the definition of accredited investor should be expanded: “while this barrier was intended to protect investors from downside risk, it has also shut out all but the wealthiest from upside gains that private companies have made over the last several decades.”
That statement, reflecting success of rare Unicorn companies, appears overly enthusiastic, since many early stage companies fail to perform near projections. What appears to be an invitation to a feast may be, rather, an invitation to famine.
Stephen M. Honig practices at Duane Morris in Boston.