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



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



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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.

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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.”

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Law Week Colorado, April 20, 2015   LW-CannabisBanking

CannabisBanking.JPLW G

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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.

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In Cigna Health and Life Insurance Company v. Audax Health Solutions, Inc., the Delaware Court of Chancery invalidated (1) the buyer’s post-closing requirement of releases from the selling stockholders, that were not specifically set out in the merger agreement, and (2) indemnifications or “clawbacks” from the merger target’s stockholders that were not limited by time or amount.

The ruling in Cigna v. Audax effectively eliminates, at least in Delaware, a “work-around” often used by some lawyers to implement an acquisition of a private company by merger, but with terms typically found in a stock purchase.

Company Combinations Generally

There are three primary ways to combine companies:

1. an asset purchase;
2. an acquisition (where the buyer buys the equity of the target); and
3. a merger.

Of those three methods, only a merger is governed by state laws with specific, detailed requirements (often called a “statutory merger”). Mergers can take many forms, including a direct merger of two entities (forward or reverse), and triangular mergers (forward or reverse). The structure of a merger is normally chosen to minimize taxes payable as a result of the merger, and to be effective, the merger must be conducted in compliance with the merger law of the applicable state or states.

Generally, the ruling in Cigna v. Audax does not impact public company mergers, because the process of merging public companies is governed by SEC and stock exchange rules, and indemnifications and releases of the type addressed in Cigna v. Audax are uncommon in that context. Not so for combinations of private companies. For simplicity, I will use the corporation example; however, the same issues may arise in a combination between LLC’s or between a corporation and an LLC, depending on the law of the state or states involved.

Representations, Warranties, and Indemnification

In business combination agreements, representations, warranties, and indemnity obligations combine to protect the buyer and help maximize the purchase price to the sellers. Typically, the agreement will include representations and warranties respecting a broad array of matters reflecting the business, operations, and legal status of the company. The buyer relies on these representations and warranties, in part, in setting the price it is willing to pay for the company. If the representations or warranties turn out to be untrue in any material respect, the value of the company would be diminished and the buyer will have paid too much. As a remedy, the seller agrees to indemnify the buyer for damages or loss of value if any of the representations or warranties turns out to be untrue. For example, the seller will represent to the buyer that the company owns all of its assets free and clear. If it turns out that one of the target company’s assets was encumbered by a $100,000 lien in violation of the representation that all of the assets were free and clear, the buyer would reduce the purchase price by $100,000, and, if already paid, “clawback” the $100,000 from the sellers. With these protections, the buyer will theoretically be willing to pay a higher price, because its risk of overpayment is reduced.

Indemnification agreements in business combinations have become very complex, and can vary as widely as the creativity of the lawyers and negotiators involved. Often, some of the purchase price will be placed in escrow for a period of time after closing to fund the indemnification. In addition, the parties may employ a “basket” whereby all indemnified amounts are aggregated and the stockholders don’t have to pay until the amount exceeds a minimum threshold, and a “cap” placing an upper limit on the amount that must be indemnified. Each of these has a number of variations. Indemnification obligations are also typically time-limited, either by their own terms, such as an escrow that only lasts for one year, or by a limit on the length of time the representations and warranties will “survive” after closing the deal.

When the combination is an asset purchase, the representations, warranties and indemnity are provided by the target company. In an acquisition, the buyer purchases all of the stock of the target directly from the stockholders. The stock purchase agreement between the buyer and the stockholders will include representations and warranties from all of the stockholders, or from a group comprising the largest or controlling stockholders. If the combination is a merger, the representations and warranties are provided by the target company, and sometimes by its controlling stockholders. However, a statutory merger is legally and procedurally different than an acquisition by stock purchase agreement. A merger is authorized and governed by state merger law; a stock purchase is not. This is because an acquisition by stock purchase is a private contract, and must be entered into by each stockholder. A merger does not require the consent of each stockholder, and can be forced on dissenting shareholders by law.

It is not uncommon for a successful private company to have scores or even hundreds of shareholders. It may have gone through multiple rounds of equity financing, issued stock and stock options to employees who have long since departed the company, and some of those stockholders may be hard to locate or generally disagreeable to anything the company proposes. In that situation it may be very difficult or impossible to enter a stock purchase agreement with each stockholder, and since a statutory merger requires only the affirmative vote from a specified number of stockholders, it is the better alternative. Minority shareholders who do not approve the merger have the choice to either accept the deal or exercise their statutory “dissenter’s right” and get a valuation of their shares. Either way, they are required by law to give up their stock in the company in the merger, and the merger may conclude without their approval.

Problems may arise, as reflected in Cigna v. Audax, when buyers (or their lawyers, at least) try to impose stock purchase terms like indemnification on the merged company’s stockholders as though they had entered into a private stock purchase agreement, even though some of those stockholders did not approve the merger, and would not have signed a contract containing those terms – they want their cake (private contract indemnification) and to eat it too (force dissenting shareholders to sell). To be fair to buyers and their lawyers, such terms can benefit the target company’s stockholders in the form of a higher purchase price; the buyer is typically willing to pay a higher purchase price when its risk is lower, and will reduce the purchase price if it must accept a greater risk of reduction in value from promises the stockholders won’t stand behind.

Cigna v. Audax

This brings us to the case of Cigna v. Audax. Cigna was a substantial shareholder in Optum Services, a medical services provider. Audax, a Cigna competitor, acquired Optum through a merger. Cigna voted against the merger, but the merger was approved by the required stockholder vote. Audax then sent the stockholders a “Transmittal Letter” and required each stockholder to sign and return it before receiving its money from the merger. The Transmittal Letter included the stockholder’s agreement to be bound by the indemnification provisions in the merger agreement, the appointment of a shareholder representative to deal with any indemnification claims in the future, and a release by each stockholder of any claims against Audax and Optum. Cigna refused to sign the Transmittal Letter and demanded its money, and when Audax refused to pay unless Cigna signed, Cigna sued.

Invalidation of Unlimited Indemnification

The Optum merger agreement included the typically extensive representations and warranties discussed above, and extensive indemnification obligations from the stockholders. Some of the representations and warranties survived for 18-months, and some for 36-months, but a substantial portion had no time limit, surviving forever. Moreover, there was no “cap” or limit on the amount the stockholders would have to pay if any of the surviving representations or warranties turned out someday to be untrue.

Cigna argued, and the court ruled, that the unlimited indemnification violated Delaware merger law, which requires that shareholders be able to determine the value of the merger consideration before approving the merger. Specifically, DGCL § 251(b)(5) requires the merger agreement to state “the cash, property, rights or securities of any other corporation or entity which the holders of such shares are to receive.” The court held that a shareholder indemnification that continues indefinitely, and has no limit on the amount, leaves the stockholders unable to determine what they are receiving as merger consideration, as required by Delaware law. The court stated: “…this case raises the novel problem that, … the value of the merger consideration itself is not, in fact, ascertainable, either precisely or within a reasonable range of values,” and, since the indemnity obligation is indefinite, “There is no point in time at which the merger consideration in this case ever becomes firm or determinable.”

As a result, the court invalidated the indemnification. However, the court took care to clarify that its ruling applies only to indemnification obligations in statutory mergers that (1) have no monetary limit, and (2) continue indefinitely. The ruling does not invalidate escrow agreements. The ruling does not invalidate post-closing adjustment provisions, but it does call them into question. The court said:

• “Post-closing price adjustments that could require individual stockholders to repay part of their merger consideration occupy an uncertain status under Delaware law;” and
• “This Opinion does not … rule on the general validity of post-closing price adjustments requiring direct repayment from the stockholders. This Opinion does not address whether such a price adjustment that covers all of the merger consideration may be permissible if time-limited, or whether an indefinite adjustment period as to some portion of the merger consideration would be valid.”

Accordingly, to be enforceable in Delaware, merger agreement post-closing price adjustment mechanisms, escrow provisions, indemnifications, and “claw-backs,” should be time limited, and also limited as to a reasonable and foreseeable portion of the purchase price. Failure to provide such limits in the merger agreement will leave buyers at risk for challenges based on uncertainty of purchase price.

Invalidation of Stockholder Releases

The merger agreement between Audax and Optum did not mention stockholder releases. Instead, it required a Transmittal Letter “in form and substance reasonably acceptable to Buyer,” including, “among other things,” indemnification. Merger agreements typically provide that when all of the merger conditions are satisfied, the companies are merged and the stockholder’s shares in the company are converted into the right to receive the merger consideration “without any further action by any party.” Cigna argued, and the court agreed, that the merger had already occurred when Audax sent the Transmittal Letter, Cigna had the right to receive its money, and there was no consideration for requiring releases not included in the merger agreement.

While this holding may seem significant, it is not. It is common drafting practice to provide that a related document must be signed and delivered in the future “in form and substance reasonably acceptable to” the parties. Such a provision does not allow one party to add new terms or obligations that go beyond the original agreement. The stockholder releases would have been enforceable if they had been detailed in the merger agreement, or the form of Transmittal Letter, including releases, had been attached to the merger agreement in final form. It is black letter law that one party cannot dictate new terms after a deal has closed.

What Does it mean in Colorado?

Could Colorado courts follow the decision in Cigna v. Audax? The decision to invalidate the releases is not unique to Delaware law; it is based on the common law of contracts applicable across the land. No consideration equals no contract, and that is as true in Colorado as it is in Delaware.

Invalidation of the unlimited indemnification is less certain, since it is based on interpretation of the language in the Delaware merger law. Delaware and Colorado merger laws are compared below. Delaware’s requirements are more detailed than Colorado, which on its face provides more flexibility:

Delaware Section 251(b)(5): The [merger] agreement shall state . . . The manner, if any, of converting the shares of each of the constituent corporations into shares or other securities of the corporation surviving or resulting from the merger or consolidation, or of cancelling some or all of such shares, and, if any shares of any of the constituent corporations are not to remain outstanding, to be converted solely into shares or other securities of the surviving or resulting corporation or to be cancelled, the cash, property, rights or securities of any other corporation or entity which the holders of such shares are to receive in exchange for, or upon conversion of such shares and the surrender of any certificates evidencing them…

Colorado Section 7-90-203.3: A plan of merger shall state . . . (c) the terms and conditions of the merger, including the manner and basis of changing the owners’ interest of each merging entity into owners’ interests or obligations of the surviving entity or into money or other property in whole or in part.

Delaware law requires a statement of the cash, property, rights or securities the stockholders will receive. Colorado law requires only “the terms and conditions of the merger” and the manner of exchanging the stock into money or property. However, despite the difference in statutory language, the concept behind the decision in Cigna v. Audax is sound and could be persuasive to a Colorado court – that is, stockholders cannot be expected to approve and accept a merger agreement, or have one imposed on them, if they cannot tell by its terms what consideration they will receive for their stock. If the terms of the merger could reduce their consideration to zero over time because of clawbacks for unknown liabilities, then one could argue that the “terms and conditions of the merger” are not sufficiently certain to allow approval of the merger, and therefore an unlimited indemnification should be invalid.

Practice Pointers

The way forward in Delaware is clear for now – indemnifications from stockholders in mergers should be limited in time and amount, such that the stockholders can determine the consideration they will receive in the merger, at least within a reasonable range. Colorado law appears to provide more flexibility, and it is difficult to predict how a Colorado court might decide the same question.

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