Cyber Security Risk Profiles

I will be speaking on Tuesday October 6, 2015 at an unfortunately early breakfast meeting, on Cyber Security Risk and Compliance.

Busy SEC Proposed Clawback, Approves Pay Ratio Rules

Law Week Colorado, Corporate Counsel Insight, by Doug Chartier – August 10, 2015

LW_CCI_ClawbackPayRatio8-12-2015

The Colorado Crowdfunding Act – The Online Intermediary (Part 2 of 2)

May 15, 2015 – On April 13, 2015 Governor Hickenlooper of Colorado signed the Colorado Crowdfunding Act. The Crowdfunding Act becomes law on August 5, 2015, and on May 7, 2015 Colorado Securities Commissioner Gerald Rome said that he anticipates the regulations will be final by that date so that Colorado businesses will be able to raise money in a crowdfunded offering beginning August 5, 2015. Under the Crowdfunding Act, offers can be made solely in Colorado, under the federal intrastate offering exemption. This means that the offers may be made only to Colorado residents, and only Colorado residents may invest. In addition, the offering must comply with the federal intrastate exemption, which means, among other things, ownership of the stock must not leave Colorado for 9-months after it is purchased.

I discussed the requirements for crowdfund offerings in Part 1 of this article; this Part 2 discusses the role and requirements for “intermediaries” who provide the Internet website for offerings.

Before the JOBS Act was passed three years ago, “crowdfunding” in the U.S. comprised only donations, or pre-sale purchase of goods or services, through websites such as gofundme, KickStarter, and indiegogo, and not the sale of securities. The JOBS Act required the SEC to establish a procedure for small securities offerings to a large number of investors, and in 2013 the SEC published proposed “crowd funding” rules, but they have not yet been approved and adopted. As a result states have begun to adopt their own laws and regulations to enable businesses to raise money by offering securities to “the crowd,” and now Colorado has followed suit.

In a private placement, the issuer may, and often does, sell its securities directly to investors. However, the issuer cannot sell its securities directly to the public in a crowdfund offering, for example, through its own website. In Colorado securities can be sold in a crowdfund offering by a registered broker-dealer, a registered sales representative (stockbroker) or an online “intermediary.”

An online intermediary is a website that is not a broker-dealer or stockbroker, and does not offer securities except for crowdfund offerings. Before offering online intermediary services, the intermediary must:

1. File a statement or form with the Colorado Division of Securities disclosing the following:
   • identity, address, contact information, and names of the officers, directors, managers, or other persons who control the company;
   • a consent to service of process; and
   • an undertaking to provide investors the offering information required by the Crowdfunding Act.
2. Comply with reporting and filing rules of the Securities Division. The rules have not been published yet, but the Crowdfunding Act says the Securities Commissioner may require intermediaries to file financial information, make and retain specified records for 5 years, and establish written supervisory procedures to prevent and detect violations of the Crowdfunding Act and rules. I anticipate the rules will include all of these requirements
3. Maintain records of all its offers, which must be available to the Securities Division on request and subject to division examination at any time.
4. Not have any ownership or financial interest in, or be affiliated with, any issuer it conducts offerings for.

Intermediaries cannot charge commissions on securities sold. Under both federal and state securities laws, only registered and regulated persons such as broker-dealers and stockbrokers can be paid commissions. Since intermediaries are not registered, they cannot be paid based on the amount of securities sold. Intermediaries have two fee options, and they can use one or a combination. They may charge (1) a fixed fee for each offering, or (2) a variable amount based on the length of time the securities are offered. As a result, intermediaries will have several fee options. For example:

• a flat fee unless the offering is not sold within a number of weeks, and then an additional fee for every week the offering remains open;
• or a fee for every week the offering remains open, but not less than a fixed amount, which will guaranty the intermediary a minimum fee even for offerings that sell out very quickly.

No Advertising?

An intermediary cannot promote a crowdfund offering – the Act says: “An on-line intermediary shall not identify, promote, or otherwise refer to any individual security offering by it in any advertising for or on behalf of the on-line intermediary.”

An issuer cannot promote its crowd fund offering either, because issuers are restricted to distributing a notice that can only state the company is conducting an offering, the name of the intermediary, and a link to the intermediary’s website.

Non-securities crowdfunding offers, like the recently extremely successful effort by Alan Tudyk and Nathan Fillion to raise funding for the series Con Man on indiegogo, can use social media to publicize the opportunity. Tudyk and Fillion used their extensive Twitter and facebook followers to gain momentum and attention for the Con Man fund raise. Companies selling securities in a crowd funded offering through an intermediary will not be able to undertake any similar advertising, promotion, or sales campaigns, and will instead have to rely on investors who follow intermediaries looking for investment opportunities.

Although the Colorado Crowdfunding Act has several advantages over the proposed SEC rules, it is still a very expensive option when compared to a traditional private placement, and only time will tell if it presents a viable funding option for companies who cannot raise the needed funds through traditional private placements.

The Colorado Crowdfunding Act – The Issuer (Part 1 of 2)

May 5, 2015 – On April 13, 2015 Governor Hickenlooper signed the Colorado Crowdfunding Act into law. The Crowdfunding Act becomes law 90 days after the current legislative session adjourns (around August 5, 2015). However, raising money under the Act will not be allowed until the Colorado Securities Commissioner adopts crowdfunding regulations, so there is not yet any crowdfunding in Colorado.

When the regulations are adopted, Colorado businesses will be able to raise money in a crowdfunded offering solely in Colorado, under the federal intrastate offering exemption. That means the offers may be made only to Colorado residents, and only Colorado residents may invest.

As of the date of this article, there is no U.S. federally allowed crowdfunding equity investment regime. On October 23, 2013 the SEC published proposed “crowd funding” rules, as required by the JOBs Act, and they have not yet been approved and adopted. “Crowdfunding” in the U.S. currently applies only to (1) donations, or pre-sale purchase of goods or services, through websites such as gofundme, KickStarter, indiegogo, etc., and does not involve sale of equity, or (2) state crowdfunding registration exemptions.

The crowdfunding rules proposed by the SEC are functionally limited and if adopted as proposed would have little utility. The SEC proposal has low fundraising limits, and very high costs, such as audited financial statements, meaning that the cost of crowdfunding would use up most of the funds raised, and would not be financially prudent in light of other, less expensive fund raising methods such as traditional private placements. To counter the vacuum on crowdfunding left by the SEC, several states have begun passing their own crowdfunding exemptions. Most of those rely on the intrastate offering exemption from federal registration requirements, allowing offers and sales only to residents of that state, though Maine’s recent rules allow investment from non-Maine residents. Texas, Indiana, Wisconsin, Washington, and Michigan are some of the states that have pending proposed, or adopted, intrastate crowdfunding rules. Click here for a rundown of state exemptions.

The Colorado Crowdfunding Act joins that list. Under the Colorado Act there is a firm $1 million limit on how much money an issuer may raise through crowdfunding in any 12-month period, unless the issuer has audited financial statements on file with the Colorado securities commissioner, and then the amount increases to $2 million.

There is no limit on how much accredited investors can buy in crowdfunding offers, but non-accredited investors cannot invest more than $5,000 in crowdfunding offers in any 12-month period. Individual accredited investors are people who have more than $1 million in assets (excluding the equity value in their home), or who make more than $200,000 a year, or $300,000 a year with their spouse.

Each crowdfunding offer must comply with relatively strict rules, when compared with the flexibility issuers have when conducting a private placement. The issuer must provide a disclosure document with certain required language (legends) to each potential investor. A disclosure document (commonly called an offering circular, offering memorandum, or prospectus), although highly recommended in almost all offerings, is not required by law for some private placements.

The offering must be a “minimum – maximum” offering; that is, all investor funds must be held in a bank escrow account until the minimum amount of investment is raised, and all sales in the offering must cease once the maximum is raised. Oversubscriptions are not allowed. The minimum cannot be less than 50% of the maximum. For example, an issuer who does not have audited financial statements will probably structure the offering for $1 million maximum, $500,000 minimum. This means the issuer will not have access to any of the money it is raising in the crowdfunding until it has raised $500,000, at which point the issuer may start withdrawing money from the escrow account.

At least 10 days before the offering starts, the issuer must:

1. file a form with the Colorado Securities Commissioner giving notice of the offering;
2. pay a fee (which has not yet been established);
3. file a copy of the issuer’s disclosure document (discussed below); and
4. file a copy of the issuer’s bank escrow agreement.

After the offering the issuer must provide quarterly reports to its owners, either directly or by posting on the intermediary’s website. The quarterly report must include executive compensation and management’s analysis of operations and financial condition, and must be filed with the Colorado Securities Commission.

In spite of these many requirements, which are similar to but less onerous than a registered public offering, the company also cannot advertise its crowdfund offering, except through a public statement saying only that it is conducting an offering and directing interested persons to the intermediary’s website.

Unlike in a private placement, the company cannot sell its shares directly to investors in a crowdfunding offer. Instead, the offering is done via (1) a licensed broker-dealer, (2) a licensed sales representative, or (3) on the Internet by a website authorized to make crowdfund offers, called an “intermediary.” Intermediaries are discussed in detail in Part 2 of this article.

Finally, the Colorado Crowdfunding Act specifies that a crowdfund offering “shall not be used in conjunction with any other [private placement] exemption…during the immediately preceding twelve-month period.” I can only speculate what that sentence means. It may mean that an issuer cannot conduct a crowdfund offering if they have conducted an exempt private placement in the preceding 12-months, or that an issuer cannot convert their private placement into a crowdfund offering. Hopefully it will be clarified in the rules to be issued by the Colorado Securities Commission.

In passing the Colorado Crowdfunding Act the legislature included this statement:

“Creating a Colorado crowdfunding option, with limitations to protect 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.”

While the Colorado Crowdfunding Act increases the amount that can be raised in crowdfunding offers from that initially proposed by the SEC, it retains many of the filing and continuous reporting requirements that make the SEC crowdfunding proposal so unworkable. It remains to be seen whether crowdfunded equity offerings will be a useful or viable alternative to traditional private placements.

Part 2 of this article will discuss the requirements for “intermediaries.”

Hurdles Persist For Cannabis Company Banking, Crowdfunding

Law Week Colorado, April 20, 2015   LW-CannabisBanking

Can SEC Greenlight Cannabis IPOs?

Law Week Colorado, February 18, 2105

http://www.keepandshare.com/doc11/8647/lw-cannabisipos-pdf-3-2-meg?da=y

Shell Games: Going Public Through Reverse Merger and Lying to the SEC

Denver CO, April 22, 2015 – In the last year I have seen proposals for clients to go public through a reverse merger with a public operating company that was really a shell or “blank-check” company. In both cases during the listing process the SEC commented that the registering company appeared not to have any real assets or operations, appeared to be a shell or blank-check company, and the SEC asked whether the company intended to do a reverse merger in the near future. The companies responded that they did too have a real business (they didn’t), and they had no intention of merging with any company in the future. Almost as soon as the company was registered they were trying to sell a reverse merger / back-door-listing to my client.

A “shell company” is prohibited from taking advantage of many favorable SEC rules for three years after it is no longer a shell, and has extensive 8-K filing requirements. In addition, “blank check” companies are subject to restrictive escrow and use of funds requirements, along with clear risk and disclosure obligations. I advised my client that it would likely bear substantial costs from the previous founders’ lies to the SEC, since the original promoters would be cashed-out and long gone when it came time to pay the piper. We walked away.

Last week the SEC charged 10 people with fraud for lying to the SEC about the shell or “blank-check” status of registered companies bound for reverse mergers.

The SEC announced the charges in a press release on April 16, 2015, stating it brought fraud charges “against 10 individuals involved in a scheme to offer and sell penny stock in undisclosed “blank check” companies bound for reverse mergers while misrepresenting to the public that they were promising startups with business plans. Blank check companies generally have no operations and no value other than their status as a registered entity, which makes them attractive targets for unscrupulous individuals seeking reverse mergers with clean shells ripe for pump-and-dump schemes.”

According to the SEC, the group created undisclosed blank check companies, installed figurehead officers, falsely claimed in registration statements and other SEC filings that the companies were pursuing real business ventures, and concealed from the public that the sole purpose of the companies was entering into reverse mergers so they could profit from the sales.

The SEC is seeking disgorgement of approximately $ 6 million in ill-gotten gains plus prejudgment interest, financial penalties, and permanent injunctions as well as officer-and-director bars and penny stock bars.

Careers In International Law Presentation

Brad Hamilton will be speaking on the Careers in International Law Panel at Colorado University Wolf Law Building Room 207 on March 3, 2015 at 6:00 pm. Sponsored by the CU Law Careers Office, CBA Young Lawyers Division, and CBA International Law Section.

DOES RECENT DELAWARE CASE PUT FINAL NAIL IN COFFIN OF “ZONE OF INSOLVENCY” CLAIMS?

In Quadrant Structured Products v. Vertin et al, the Delaware Court of Chancery held in an opinion issued October 1, 2014, and again confirmed in relevant part on October 28, 2014, that lenders do not have direct claims against directors of a company for breach of fiduciary duty, and the directors do not owe fiduciary duties to the company’s lenders, but if a company is in the zone of insolvency, lenders do have the right to bring a derivative claim, just as a shareholder would under normal circumstances.

Background

When a company is in financial difficulty, its shareholders and lenders often find themselves at odds. This is particularly true when the company has been through several rounds of financing, because holders of preferred stock have first right to the company’s assets in a liquidation, and even though they are shareholders, they are also pseudo-creditors. During the last recession, lender’s lawyers creatively asserted claims against company directors, first claiming that when a company was broke or nearly broke (in the “zone of insolvency”), the directors owed fiduciary duties to the lenders. When that didn’t work, they claimed that directors breached their fiduciary duties to the company by making risky business decisions that put a troubled company deeper in debt. These came to be known as the “zone of insolvency” claims.

Because a large percentage of U.S. companies are incorporated in Delaware, and many other states follow Delaware law on matters of corporate governance and fiduciary duties, Delaware courts addressed these arguments frequently from 2004 through 2010.

Company Directors or Mangers do NOT Owe Fiduciary Duties to Lenders

First, Delaware courts made it clear that directors (corporations), managers (LLCs), and general partners (partnerships) owe fiduciary duties to the entity, not to its owners, and not to its creditors. Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 792 (Del. Ch. 2004); North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007). It has long been law that shareholders cannot sue directors for breach of fiduciary duty, because fiduciary duties are owed to the company, not to individual shareholders. Instead, they must bring a “derivative” action – a law suit against the company, to cause the company to sue its directors. When lenders tried to sue directors for breach of fiduciary duty, Delaware courts turned them away also – in Gheewalla the court held: “The directors of Delaware corporations have the legal responsibility to manage the business of a corporation for the benefit of its shareholder owners,” and denied creditors the right to sue directors for breach of fiduciary duty. However, the court also held that once a company is broke, its creditors also have the right to bring a derivative suit for breach of fiduciary duty – like shareholders, lenders can sue the company to cause the company to sue its directors for breach of fiduciary duties.

Insolvency Does Not Expand the Usual Fiduciary Duties

Based on the decisions in Production Resources and Gheewalla, lenders next brought derivative claims asserting that if a company is in financial trouble (in the zone of insolvency), the directors have a duty to manage the company for the benefit of its creditors, and not make risky decisions that could lead to the company going broke, or “deepening its insolvency.” The argument goes like this: When a company is in trouble, the directors often take big risks, entering into questionable deals that, if successful will save the company, but have a high risk of failure. A risky deal that destroys the company leaves little for the creditors, but if the directors instead act to preserve the remaining assets for the creditors, they will at least get some if not all of their money back. If a company has significant debt, shareholders of troubled companies support taking bet-the-company risk – they have already lost their investment to the lenders, who get first pick. Thus, they have nothing to lose.

Delaware courts do not support the lenders argument that fiduciary duties shift to benefit the lenders: “…if a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.” Gheewalla, 930 A.2d at 101, See also Trenwick American Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 202-203 (Del. Ch. 2006) affd., 931 A.2d 438 (Del. Supr. 14 Aug 2007). The business judgment rule, as developed and refined over the years, particularly in Delaware, encourages risk and protects directors from risky decisions that do not work out, so long as they are taken properly and fairly.

Quandrant Structured Products v. Vertin

The Delaware Court of Chancery addressed this issue again recently. In Quadrant Structured Products v. Vertin et al, Athilon Capital, a company that sells credit protection to large financial institutions, guaranteed credit default swaps on collateralized debt obligations sold by its wholly-owned subsidiary. During the 2008 financial crisis, Athilon was deep into the zone of insolvency. Another company, EBF, bought all of the Athilon’s Junior Subordinated Notes and all of its equity, gaining control over Athilon. Thereafter, Quadrant Structured Product bought Athilon’s Senior Subordinated Notes.

EBF, now in control of Athilon, but in a junior security position, decided (1) not to exercise its right to defer interest payments to itself on the junior notes, (2) to pay above-market service and licensing fees to its own affiliate, and (3) to adopt a new, riskier business strategy instead of dissolving Athilon, which would have benefited other creditors like Quadrant. Since EBF’s notes were junior to Quadrant’s notes, EBF would get nothing in a liquidation, but could benefit if the risky strategy worked – they already had nothing, so all of the risk of EBF’s strategy fell on Quadrant. In short, a junior lender was able to improve its position over a senior lender by taking over the company and making decisions to its benefit. Quadrant, the senior creditor, sued the new directors, claiming that since the company was in the zone of insolvency, the directors breached their fiduciary duties by not making business decisions to benefit the senior lenders.

The Delaware court held that the directors’ decision to try to increase the value of the insolvent corporation by adopting a highly risky investment strategy was allowed under the “business judgment rule,” even though Quadrant and other senior creditors bore the full risk if the strategy failed. Vice Chancellor Laster held: “In the case of an insolvent corporation, board decisions that appear rationally designed to increase the value of the firm as a whole will be reviewed under the business judgment rule, without speculation as to whether those decisions might benefit some residual claimants more than others.”

The ruling makes it clear that, at least in Delaware, even though creditors gain the rights of shareholders to bring a derivative action when a company is in the zone of insolvency, that right does not include a shift of fiduciary duty from the company to the creditors. The directors’ duty remains to the company, and decisions normally protected by the business judgment rule do not lose that protection just because a company is going broke.

It should also be noted that the Delaware court remained consistent by holding that the directors’ decisions not to defer interest on the notes held by the junior creditor, and to pay above-market fees to an affiliate of the junior creditor, were conflicting interest transactions subject to entire fairness review, and not purely protected by the business judgment rule. That portion of the decision would have been the same without a “zone of insolvency” situation, and those claims were not dismissed

SEC ALLOWS CANNABIS COMPANY TO REGISTER SHARES

The U.S. Securities and Exchange Commission has allowed a marijuana company to register its shares. Terra Tech Corp of Irvine, California is a Nevada corporation that primarily manufactures and sells hydroponic agriculture equipment and supplies. According to The Cannabist, hydroponics is booming: “Supplying the lighting, nutrient and water needs of … plants has resulted in huge growth in hydroponics stores and grow operation supply retailers. According to a market research report published by IBISWorld, the hydroponic equipment retail industry has grown by 7.2 percent per year nationwide since 2009, with California and Colorado growing at a whopping 32 percent.”

Terra Tech stock trades on the OTCBB under the symbol TRTC.

According to Terra Tech’s Prospectus and recently allowed Form S-1 Registration Statement,

“[Terra Tech] recently formed three majority-owned subsidiaries for the purposes of cultivation or production of medical marijuana and/or operation of dispensary facilities in various locations in Nevada upon obtaining the necessary government approvals and permits, as to which there can be no assurance. Each subsidiary was formed with different investors, thus necessitating the need for multiple entities with different strategic partners and advisory board members.  In addition, we anticipate each subsidiary will service a different geographical market in Nevada.  Effectuation of the proposed business of each of (i) MediFarm, LLC (a Nevada limited liability company (“MediFarm”), (ii) MediFarm I, LLC, a Nevada limited liability company (“MediFarm I”), and (iii) MediFarm II, LLC, a Nevada limited liability company (“MediFarm II”) is dependent upon the continued legislative authorization of medical marijuana at the state level. We expect to allocate future business opportunities among MediFarm, MediFarm I and MediFarm II based on the locations of such opportunities.”

Thus, Terra Tech is not yet in the marijuana cultivation and sales business, but will commence that business if and when it receives the necessary licenses in Nevada. This appears to be the first SEC allowance of registration of shares of a cannabis grower and seller, albeit one not yet in production.

In November 2014 Terra Tech filed a registration statement for the resale of stock owned by one of its investors. The Wall Street Journal LawBlog reports that the SEC recently allowed the registration statement to go effective without action, which means it becomes effective 20-days after the SEC approves the disclosures in the registration statement. Typically, an issuer will request, and the SEC will grant, acceleration of the effective date to allow the issuer to immediately sell its shares. The SEC refused to grant Terra Tech’s request for acceleration. The article at the WSJLawBlog includes a good discussion of the significance to issuers of not receiving accelerated effectiveness – it makes it difficult if not impossible to do an underwritten public offering. However, that was not an issue in this case because Terra Tech was registering for resale stock acquired earlier by an institutional investor, Dominion Capital LLC, who purchased convertible notes and warrants from Terra Tech. Under the terms of the notes and warrant, Dominion had a right to require that stock be registered for resale in the future (registration rights). Therefore, Terra Tech was not registering its own stock for sale, and will not directly receive any of the proceeds from the sale of the registered stock for use in the marijuana business. It will be interesting to see whether the SEC allows a registration statement for direct sale to the public by a marijuana company.

What About Colorado?

Terra Tech is a Nevada corporation that plans to conduct its marijuana business in Nevada through Nevada subsidiaries. Currently, Colorado law prohibits ownership or beneficial financial interest in a Colorado licensed cannabis business, by any person who is not a Colorado resident as defined under Colorado marijuana regulations. To qualify, the owners must submit exhaustive and detailed identification information, including fingerprints, to the Colorado Marijuana Enforcement Division, and be approved for ownership by the MED. Under current Colorado law, there would be no reason for a Colorado licensed marijuana company to register its shares with SEC, unless it can also control the sale of those shares solely to persons who qualify to own a financial interest in a licensed company. Failure to do so would cause the loss of its license. Colorado’s regulatory scheme precludes registration and public trading of shares in a marijuana company on any exchange or bulletin board, since it is not possible to limit ownership to qualified Colorado residents. Only time will tell if allowance and registration by the SEC of stock in marijuana companies will provide some incentive for Colorado regulators to loosen the ownership restrictions on licensed Colorado marijuana companies, long term.