I. Introduction

The recent popularity of cryptocurrencies and blockchain-based tokens among investors has raised implications under U.S. securities laws, including whether these tokens are securities.

Legal issues aside, as a simplified illustration, a blockchain is a “shared digital ledger, also called a distributed ledger, for storing and tracking transactions,” with each peer user of the ledger holding a unique digital key to the ledger.[1] Blockchains and, more broadly, distributed digital ledgers[2] are often touted as having an revolutionary effect on how transactions can be conducted and how people can interact with each other by eliminating intermediaries.[3] Numerous variations of such digital ledgers currently exist on the market; they were mostly developed by different consortiums that consist of technology companies and/or financial institutions.[4]

The digital assets that move across a blockchain or a distributed ledger are termed “tokens,” “coins,” or “cryptocurrencies.” Among the most common existing coins are bitcoin (originated on the original blockchain) and ether (originated on the well-known ethereum ledger), which can be easily exchanged for fiat currencies (e.g., U.S. dollars) in the open market and used to purchase other digital (and even nondigital) products, thus bearing a strong resemblance to the traditional concept of currency.[5]

Technology companies and even traditional business entities have come to realize the potential of blockchain’s commercial use and are using it in a number of ways. One of those ways is an initial coin offering (ICO) that is expected to lead to the completion of blockchain-based projects. An ICO is an event in which a blockchain-based project or entity raises capital by issuing tokens to purchasers in exchange for a contribution of value in the form of either fiat currency or digital currencies.[6]

The rest of this article will explain why ICOs and digital assets in general implicate the U.S. securities laws. Part II gives an overview of the orders, actions, and statements by the Securities and Exchange Commission (SEC) leading up to Director Hinman’s speech (the Hinman Speech),[7] including the famous “The DAO Report” and the SEC’s cease-and-desist order against Munchee Inc. (Munchee Order).[8] Part III points to alternatives to ICOs that are less likely to run afoul of the securities laws and SEC regulations. The purpose of this article is two-fold: (1) to analyze how the SEC applies old laws to emerging issues and develops its jurisprudence, and (2) to provide some guidance to counsels and practitioners who are or will be structuring a transaction involving digital assets.

II. The SEC’s Developing View on Digital Assets

Like bitcoin or ether, digital assets sold today can function as a medium of exchange, unit of account, or store of value.[9] Increasingly, however, these tokens begin to represent other rights, such as a right to participate in the developer’s profit distribution or a right to access the blockchain-based platform once it is placed into commercial production. Depending on the circumstances, these other rights could cause digital assets to fall in the definition of “securities” under the Securities Act of 1933 and the Securities Exchange Act of 1934 (collectively, the Securities Laws).[10]

Under the Securities Laws, all securities offered and sold in the United States must be registered with the SEC or must qualify for an exemption from the registration requirements. In addition, any entity or person engaging in the activities of an exchange must register as a national securities exchange or operate pursuant to an exemption from such registration. Thus, whether a token is a security becomes crucial for token issuers and people who facilitate the promotion and issuance of tokens. As discussed below, the SEC evaluates whether tokens are securities by considering whether they are “investment contracts,”[11] which must satisfy the Howey test: The instrument is (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profits, (4) to be derived from the entrepreneurial or managerial efforts of others.[12]

1. Pre-Munchee Order SEC Actions and The DAO Report

Before ICOs heated up in the latter half of 2017,[13] the SEC brought sporadic actions against security intermediaries alleging fraudulent behaviors. However, in those administrative proceedings or cases, bitcoins or digital tokens were only tangential ingredients that were not the focus of the SEC’s analyses.[14]

The DAO Report published in July 2017 represented the first instance in which the SEC truly opined on the nature of digital tokens.[15] The blockchain company Slock.it created and sold DAO tokens to the public in exchange for ether. DAO tokens granted token holders certain voting and ownership rights.[16] According to the company’s promotional materials, DAO token holders would share in the anticipated earnings from projects funded by their investment in DAO tokens and would have the ability to make a profit by reselling DAO tokens in a secondary market.[17]

In evaluating whether DAO tokens are securities, the SEC did not hesitate to apply the Howey test: “[A] security includes ‘an investment contract’ . . . . This definition embodies a ‘flexible rather than a static principle’ [and] in analyzing whether something is a security ‘form should be disregarded for substance.’”[18]

Observing that “‘money’ need not take the form of cash” and that DAO token holders gave something of value (i.e., ether), the SEC quickly concluded that the first prong is met.[19] Next, given that ether contributed by DAO token holders was pooled and made available to the DAO platform to fund projects, the returns on which would be shared by holders, purchasers of DAO tokens invested in a common enterprise and reasonably expected profits in the form of “increased value of investment.”[20]

Most ink was spilled on the last prong that the profit is to be derived from “the entrepreneurial or managerial efforts of others.” The trick, compared to the facts that made the first three prongs an easy pass, is that DAO token holders did have some voting right to decide what business projects to be deployed. The question was whether the managerial efforts of Slock.it were nonetheless the significant ones driving the value of The DAO in light of DAO token holder’s decision-making power as to projects. The SEC answered in the affirmative because: (1) Slock.it and its co-founders held themselves out as experts in the ethereum network and led investors to believe they could be relied on to make The DAO a success; (2) Slock.it and its co-founders actively monitored, operated, and safeguarded The DAO and investor funds; (3) DAO token holders could vote only on proposals filtered by Slock.it and its co-founders using limited information provided to the holders and had no role in negotiating terms of the contracts; and (4) there was no practical way for DAO token holders to consolidate their votes into powerful blocs.[21] In other words, “the voting DAO Token holders [had were] akin to those of a corporate shareholder.”[22] Because DAO token holders were unable to assert actual control over the business, they necessarily relied on the managerial and entrepreneurial efforts of Slock.it and its co-founders.

Through The DAO Report, the SEC spoke directly to digital token issuers for the first time. In a certain sense, the message conveyed in The DAO Report was a mild, friendly warning given that the SEC decided not to pursue any enforcement action, and a considerable portion of the report reiterated the Securities Laws, which in retrospect might be unfortunate because practitioners and businesses mistook it for an opportunity to test the regulator’s limit. Another aspect of The DAO Report that tends to be downplayed is the SEC’s reminder that a marketplace meeting the definition of an “exchange” under the Exchange Act on which securities (including digital assets that are securities) transactions take place must register with the SEC pursuant to the Securities Laws and regulations. This “afterthought” that was squeezed in to the end of The DAO Report turned out to be crucial in the SEC’s more recent enforcement activities, as discussed below.

2. The Munchee Order

Many think The DAO is not even a close case; after all, except that the instruments were called “tokens,” not “shares,” DAO tokens shared many of the attributes of a traditional equity stock.[23] Creative people predictably would not allow their tokens to be pigeonholed to the type of “security tokens” created by The DAO.

The thinking prompted the burgeoning of the so-called utility tokens, which replaced the profit-sharing attribute of DAO tokens (or the like) with a certain consumer utility attribute. In fact, token issuers can customize the terms of the tokens in whatever way they see fit, typically in an informational “white paper” document from which prospective purchasers know to what features of the tokens they are subscribing. Utility tokens represent a right to use the issuer company’s products or services instead of any interest in the company itself. After The DAO Report, an increasing number of companies began issuing utility tokens to raise funds for the development of its products or services to which prospective token holders will have access.

On December 11, 2017, the SEC issued a cease-and-desist order against Munchee Inc., a California company that created an iPhone app for reviewing restaurants, for offering and selling unregistered tokens, which in the SEC’s view was a security. Notably, the Munchee Order was the first SEC enforcement action against an ICO that made no fraud allegations.[24] The tokens sold by Munchee (MUN tokens) were utility tokens allowing holders to purchase goods or services in the to-be-improved “ecosystem” of the app.[25] The SEC found that Munchee indicated that it would take steps to increase the value of the tokens, which made purchasers of MUN tokens to have a reasonable expectation of obtaining future profits predominantly from the efforts of Munchee and its agents.[26] Accordingly, the SEC found that MUN tokens were securities, and the offering and sale of MUN tokens was subject to the Securities Laws.

Applying the same Howey test, the Munchee Order focused on the third prong: a “reasonable expectation of profits.” This is a sensible approach because when people buy a garden-variety merchandise, they are paying for the utility offered by the merchandise, not its potential to appreciate in value; even though it is plausible that certain consumer goods could increase in value over time, this alone usually is not what motivated consumers to make the purchase in the first place.[27] By building in MUN tokens a feature that would allow holders to engage in various activities in the new app ecosystem (i.e., consumer utility), Munchee was pulling MUN tokens out of the investment instrument basket and putting them into the consumer goods basket. The implication was that purchasers of MUN tokens probably did not have a reasonable expectation of profits.

The SEC took issue with Munchee’s strategy, and the Munchee Order on the whole exemplified how the SEC interpreted “form should be disregarded for substance.” Not limited by Munchee’s self-labeling, the SEC looked at facts evidencing a reasonable expectation of profits among MUN token purchasers, including: (1) although Munchee told potential purchasers MUN tokens could be exchanged for goods or services after Munchee created an ecosystem, no one was able to buy any good or service with MUN tokens before the ecosystem became operational;[28] (2) on Munchee’s website and in its white paper, Munchee indicated that “MUN tokens would increase in value”;[29] (3) in public appearances, Munchee and its agents primed purchasers’ expectation of profit through statements and endorsements of others’ statements that MUN tokens would increase in value and that purchasers would receive a significant return by buying MUN tokens early;[30] (4) Munchee specifically targeted potential purchasers interested in investing in cryptocurrencies, not its app users or restaurants, by promoting MUN tokens in digital asset investment forums where prospective investors gather and paying third parties to publish promotional statements in those forums;[31] and (5) Munchee intended that MUN tokens would trade in a secondary market, and Munchee represented that it would buy or sell MUN tokens using its retained holdings in order to ensure a liquid secondary market.[32] Munchee did much more than a garden-variety retailer would do to promote its merchandise but at the same time neglected what a retailer should do—to market the good to people who find it most useful. Taken together, these facts support the SEC’s conclusion that Munchee was priming prospective purchasers’ expectation of profits.

The Munchee Order tells us that whether a token is called an investment token or a consumer good, the inquiry does not stop there. The Munchee Order went so far as to say, “Even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security.”[33] It is unnecessary for the SEC to make statements on facts that were not present in the instant case; perhaps the SEC wanted to show its strong determination that the economic-reality analysis would be applied in each and every case involving ICOs and to deter issuers who would try evading scrutiny by introducing the slightest variation to its digital assets.

3. Post-Munchee Order SEC Actions

On the same day that the Munchee Order was issued, SEC Chairman Jay Clayton released a statement to both main street investors and securities market professionals who play a role in ICOs.^[34] Predictably, the statement picked on utility tokens: “Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.”[35] Chairman Clayton, however, left it open to structuring an ICO not involving the offering of securities. He noted that, “a participation interest in a book-of-the-month club may not implicate [] securities laws,” whereas “many [utility] token offerings appear[ed] to have gone beyond this construct and [were] more analogous to interests in a yet-to-be-built publishing house with the authors, books and distribution networks all to come.” It is yet to be seen what kind of utility tokens is (or is not) akin to a participation interest in a book club that is already built and running.[36] All we know is that no lines will be drawn, and the same case-by-case factual analysis will continue to apply.

The Munchee Order set in motion a series of efforts targeting the ICO market in a broader scope. The Clayton statement not only cautioned investors against investing in cryptocurrencies or ICOs without making adequate inquiry into the specifics of an offering, but also called on market professionals (e.g., broker-dealers, investment advisers, exchanges, and lawyers) to focus on “the protection of our Main Street investors” by ensuring that offerings of securities be accompanied by important disclosures, and the Securities Laws be complied with in all respects. This message echoes The DAO Report’s warning that a marketplace where trading of securities occurs must register as a national exchange or, if certain conditions are met, a broker-dealer. Lastly, the Clayton Statement “promised” that “the SEC’s Division of Enforcement [would] continue to police this area vigorously.”

In the same vein as the Munchee Order and the Clayton statement, the SEC continued to closely monitor ICO-related activities,[39] but the SEC’s post-Munchee Order focus seemed to be shifting from token issuers to market professionals who facilitated ICOs. In January this year, Chairman Clayton sent additional warning signals to securities professionals, especially lawyers, that when the ICOs had many of the key features of a securities offering they should counsel clients that the product being promoted was likely a security.[40] The chairman observed that “federal securities laws apply regardless of whether the offered security . . . is labeled a ‘coin’ or ‘utility token,’” and that the SEC was “disturbed” by “form-based arguments” made by lawyers, trading venues, and financial services firms that “depriv[ed] investors of mandatory protections.”[41]

On February 21, 2018, the SEC filed a complaint against a bitcoin-denominated platform and its founder for, among other things, operating an unregistered securities exchange.[42] An SEC official stressed that “[p]latforms that engage in the activity of a national securities exchange, regardless of whether that activity involves digital assets, tokens, or coins, must register with the SEC or operate pursuant to an exemption.”[43] As already reminded in The DAO Report, a system meeting the definition of an “exchange” is “any organization, association or group of persons . . . which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities”[44] and must register as a national securities exchange or operate pursuant to an appropriate exemption, one such frequently used exemption being an alternative trade system (ATS) that can register as a broker-dealer and comply with only Regulation ATS.[45] In any event, for an entity operating a digital token system or considering to operate one, as well as lawyers advising such an entity, it is worth reading the Regulation ATS adopting release and studying the illustrations in that release.[46]

4. The Hinman Speech

Half a year after the Munchee Order, the Hinman Speech marks another milestone in the SEC’s public dialogue in the digital assets field. Perhaps most interesting to the digital asset industry is the much-anticipated reassurance that ether is not a security.[47] From the perspective of the Securities Laws, the Hinman Speech repeats and continues The DAO Report and the Munchee Order: (1) how the instrument is labeled bears no significance on the Howey analysis;[48] (2) the prong analyzing investor’s reliance on a third-party promoter should be given primary consideration when applying the Howey test to digital assets;[49] and (3) whether the creation of a digital asset has a consumer purpose and whether people purchase it out of consumptive motivation will be evaluated based on various objective factors.[50] Whether a digital asset is a security does not inhere to the instrument; rather, the real question is whether the manner in which it is offered and sold creates a reasonable expectation of profits to be derived predominantly from the promoter’s efforts. This explains why simply restyling a digital asset as a “utility token” is doomed to fail.

Apart from crystalizing the entire Howey test into the last two prongs in the context of applying the Securities Laws to digital assets, Hinman implicitly made a pragmatic argument when addressing why ether and bitcoin should not be securities:

The disclosures required under the federal securities laws nicely complement the Howey investment contract element about the efforts of others. As an investor, the success of the enterprise . . . turns on the efforts of the third party. . . . Without a regulatory framework that promotes disclosure of what the third party alone knows of these topics and the risks associated with the venture, investors will be uninformed and are at risk. . . . [I]f the network on which the token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts—the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede.[51]

Because both bitcoin’s and ether’s operation and their respective networks are so decentralized that basically every user is on the same page and no central third party determines the fate of the network, “applying the disclosure regime of the federal securities laws to the offer and resale of [bitcoin and ether] . . . would add little value.”[52] In other words, protection under the Securities Laws will be meaningless because there will not be a promoter to be sued and be held accountable in the event bad things happen.

Hinman noted that most of the ICOs he has seen have touted promoters’ ability to create an innovative application of the distributed ledger technology and targeted passive investors, and the lack of a clear business model often left purchasers no choice but to rely on the efforts of the promoters to build the network. Therefore, even though digital assets offered in those ICOs are not technically securities themselves, just like orange groves in Howey, “[a]t that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.”[53] Hinman indicated, however, that the network on which certain digital assets operate may eventually mature, and at some point those digital assets would become the new “ether” to which the application of the Securities Laws would add little value.

III. Alternatives to Noncompliant ICOs

If a network could achieve the same degree of decentralization as the bitcoin network or the ethereum network, then it would probably be blessed by the SEC. Outside bitcoin and ether, however, regulatory uncertainty still accompanies each and every coin offering in the United States, and it is rare, if ever possible, for a network to begin in a sufficiently decentralized form. As suggested by Hinman, one way around this is to begin fundraising through traditional equity or debt offering, and once the network is up and running, distribute blockchain-based digital assets to potential users. Nevertheless, this route may not be desirable or executable for all digital asset issuers, and separating fundraising from token sale may deprive some crypto-enthusiasts’ opportunity to participate in the early stage of developing a perhaps groundbreaking project. The rest of this Part III briefly outlines three options for structuring legally compliant ICOs: Regulation D, Regulation S, and Regulation A.

Citing Regulation D, Chairman Clayton acknowledged that “[i]t is possible to conduct an ICO without triggering the SEC’s registration requirements,” which provides a private placement exemption.[54] The private placement exemption, Rule 506(c), allows an issuer to raise an unlimited amount of capital so long as there are no more than 35 purchasers who are not “accredited investors”[55] (AI), and the non-AI purchasers, either alone or with their representatives, possess a certain level of financial sophistication.[56]

Similar to what people can do in other unregistered offerings, an ICO can be structured to comply with Regulation S such that the digital assets will be deemed to be offered and sold outside the United States and not subject to the SEC’s jurisdiction.[57] Regulation S requires that each offer or sale of securities by an issuer be made outside the United States: (1) in an “offshore transaction,”[58] (2) with no direct selling efforts in the United States, and (3) be subject to any additional conditions as determined by the category of the securities being offered or sold.[59]

 The third alternative is Regulation A, which as amended by the JOBS Act in 2015, allows a qualified issuer[60] to raise up to $50 million from the public without complying with the full SEC registration process. However, the issuer may only sell to non-AIs if the purchase price paid by such non-AIs does not exceed 10 percent of the greater of their annual income or net worth (for natural persons) or 10 percent of the greater of its revenue or net assets (for entities).[61] The issuer must file an offering statement, and the SEC must qualify it before the issuer can start to sell the securities.[62]

There are, however, obvious tradeoffs associated with the exempted offerings discussed above, including restrictions on publicity, investor qualifications, and limited resales, which may in some cases decrease the appeal of an ICO as a means of raising capital. For example, under Regulation D, general solicitation is disallowed if the digital assets, assuming they are securities, end up being sold to non-AIs.[63] In addition, digital assets offered pursuant to Regulation D and Regulation S are not freely transferrable in a secondary market.[64] From the perspective of a prospective purchaser, digital assets offered pursuant to these exemptions might be less desirable because the investor verification process (i.e., to verify the AI status for Regulation D offerings, and for Regulation S offerings to verify the non-U.S. person status) goes against the pseudonymous principle of most distributed ledgers. Regulation A, on the other hand, seems to have fewer publicity and resale limitations, but the $50 million cap may not satisfy ambitious entrepreneurs’ capital need (or expectation).[65]

IV. Conclusion

At the end of 2017, the SEC began to send subpoenas and information requests to technology companies and, remarkably, to their advisors and lawyers as well.[66] “[T]he wave of subpoenas includes demands for information about the structure for sales and pre-sales of the ICOs”—the “most concrete sign of the SEC’s intention to crack down on the sudden emergence of coin offerings.”[67]

Before any congressional action to carve out a special regulatory regime for blockchain and cryptocurrency, the 1946 Howey test will continue to guide the SEC’s analysis and perhaps the courts’ analysis as well. As the SEC becomes impatient with token issuers and their advisors, it is difficult to make more creative arguments without confronting the SEC head on,[68] and it is probably more prudent to seek the SEC’s view before proceeding with any definitive offering plan. According to Director Hinman, “[the SEC is] happy to help promoters and their counsel work through these issues. We stand prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use.”[69]

What all this means for lawyers is that when clients seek advice in connection with ICOs, which clients may include token issuers, ICO promoters who played a similar role to underwriters, and trading platforms that may be viewed as unregistered exchanges, lawyers should ask whether the proposed action will compromise the purpose of investor protection laws and regulations, the lens through which the SEC is determined to scrutinize the markets for digital assets.

Of course, none of the above is relevant to fraudulent ICOs. Any fraud, not just fraudulent ICOs, deserves to be hit as hard as possible.

*I am grateful to Rebecca Simmons for her helpful guidance and comments. All views expressed in this article are my own.

[1]           Tawnya Plumb, Blockchain: What’s in It for Lawyers?, 41 Wy. Law., Feb. 2018, at 50. The decentralized feature of blockchains is thought to make a blockchain more immune to hacking than a centralized database. Id.

[2]           For the rest of the article, blockchain and digital or distributed ledger will be used interchangeably.

[3]           For a general overview of what distributed ledger technology can do for the business community, see Bryce Suzuki, Todd Taylor & Gary Marchant, Blockchain, 54 Az. Atty. 12, 14–17. (Feb. 2018).

[4]           See Peter Gratzke, David Schatsky & Eric Piscini, Banking Together for Blockchain: Does It Make Sense for Your Company to Join a Consortium?, Deloitte Insights, Aug. 16, 2017 (noting that a growing number of companies join together to develop new distributed ledger-based infrastructures).

[5]           See Arjun Kharpal, All You Need to Know About the Top 5 Cryptocurrencies, CNBC, Dec. 14, 2017 (showing that, as of the end of 2017, market cap of bitcoin was $275.1 billion and that of ether was $71.1 billion); Elise Moreau, 13 Major Retailers and Services That Accept Bitcoin, Lifewire, Mar. 7, 2018 (listing major consumer vendors that accept bitcoins as payment method). Bitcoin, ether, and other coins having similar attributes to real-world currency are sometimes called “cryptocurrencies.” Cryptocurrencies and other types of tokens are generally referred to as “digital assets” in this article.

[6]           See SEC Investor Bulletin: Initial Coin Offerings (July 25, 2017) [hereinafter SEC Investor Bulletin] (noting that developers, businesses and individuals are using token sales to raise money for developing digital platforms). In fact, an ICO turned out to be an astounding device for raising money. As an example, the initial offering of “Basic Attention Tokens,” which allows holders to access a blockchain-based publishing and advertising platform, raised $35 million in 24 seconds. Becker Goldstein et al., Basic Attention Token (BAT) Token Launch Research Report (Oct. 30, 2017).

[7]           William Hinman, Dir., SEC Div. of Corp. Fin., Remarks at the Yahoo Finance All Markets Summit: Digital Asset Transactions: When Howey Met Gary (Plastic) (June 14, 2018) [hereinafter Hinman Speech].

[8]           In re Munchee Inc., SEC Release No. 10445, File No. 3-18304 (Dec. 11, 2017) [hereinafter Munchee Order].

[9]           SEC Investor Bulletin, supra note 7.

[10]         15 U.S.C. §§ 77b(a)(1) (2016).

[11]         Id. (“The term ‘security’ means any note, stock . . . investment contract . . . or warrant or right to subscribe to or purchase, any of the foregoing.”).

[12]         United Hous. Found., Inc. v. Forman, 421 U.S. 837, 852 (1975); SEC v. Howey, 328 U.S. 293, 301 (1946).

[13]         Holden Page, 2017’s ICO Market Grew Nearly 100X from Q1 to Q4, Crunchbase, Jan. 11, 2018, (showing that the ICO market saw an exponential growth in the third and fourth quarters of 2017).

[14]         Cyber Enforcement Actions (last updated Sept. 26, 2018) [hereinafter SEC Enforcement Actions] (listing up-to-date enforcement actions with respect to digital currency/ICOs). In these cases, the SEC alleges fraudulent behavior of certain broker dealers and exchange platforms, but none of these concerns the question of whether the tokens are unregistered securities.

[15]         Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, SEC Release No. 81207 (July 25, 2017) [hereinafter The DAO Report] (concluding that The DAO tokens, a digital asset, were securities).

[16]         Id. at 5.

[17]         Id. at 1.

[18]         Id. at 11 (citing Tcherepnin v. Knight, 389 U.S. 332, 336 (1967); SEC v. Howey, 328 U.S. 293, 299 (1946)).

[19]         Id.

[20]         Id. at 11–12.

[21]         Id. at 12–15.

[22]         Id. at 15.

[23]         The Supreme Court identified the characteristics associated with common stock to be: (1) the right to receive dividends contingent upon an apportionment of profits; (2) negotiability; (3) the ability to be pledged or hypothecated; (4) the conferring of voting rights in proportion to the number of shares owned; and (5) the capacity to appreciate in value. Landreth Timber Co. v. Landreth, 471 U.S. 681, 686 (1985).

[24]         Since The DAO Report, the SEC filed a complaint on September 29, 2017, against Recoin Group Foundation, LLC; DRC World Inc. a/k/a/ Diamond Reserve Club; and Maksim Zaslavskiy, alleging that a businessman and two companies defrauded investors in a pair of ICOs purportedly backed by investments in real estate and diamonds, and the SEC filed complaint in December 2017 against Plexcorps (a/k/a and d/b/a Plexcoin and Sidepay.Ca), Dominic Lacroix, and Sabrina Paradis-Royer halting an ICO-based fraud that had raised up to $15 million from thousands of investors since August by falsely promising a 13-fold return in less than one month’s time. SEC Enforcement Actions, supra note 15.

[25]         See Munchee Order, supra note 9, at 1–2.

[26]         Id. at 2.

[27]         In the context of applying the Howey test, the Supreme Court drew the line between the motivation of a consumer and that of an investor, and only the presence of an investing motivation is relevant to the question whether the instrument is a security: “[W]hen a purchaser is motivated by a desire to use or consume the item purchased . . . the securities laws do not apply.” United Hous. Found., Inc. v. Forman, 421 U.S. 837, 854–53 (1975).

[28]         Munchee Order, supra note 9, at 9.

[29]         Id. at 4.

[30]         Id. at 5–6.

[31]         Id.

[32]         Id. at 5.

[33]         Id. at 9.

[34]         Public Statement, SEC Chairman Jay Clayton Statement on Cryptocurrencies and Initial Coin Offerings (Dec. 11, 2017) [hereinafter Clayton Statement]. The Clayton statement is not formal SEC guidance or a statement of the SEC, but is instead an informal statement by the chairman.

[35]         Id.

[36]         The chairman suggested that all (or almost all) of the token offerings he had seen as of his statement involved the offer or sale of securities. The SEC has yet to bring another enforcement action against a nonfraudulent ICO after the Munchee Order.

[37]         Clayton Statement, supra note 35

[38]         Id.

[39]         To date, the SEC brought seven enforcement actions involving ICOs or digital assets since the Munchee Order, but none involved analysis of whether the token being offered is a security. SEC Enforcement Actions, supra note 15.

[40]         SEC Chairman Jay Clayton, Opening Remarks at the Securities Regulation Institute (Jan. 22, 2018).

[41]         Jay Clayton & J. Christopher Giancarlo, Regulators Are Looking at Cryptocurrency, Wall St. J., Jan. 24, 2018.

[42]         Press Release 2018-23, Security Exchange Commission, SEC Charges Former Bitcoin-Denominated Exchange and Operator with Fraud (Feb. 21, 2018).

[43]         Id. See also 15 U.S.C. § 78e (making it unlawful for any broker, dealer, or exchange, directly or indirectly, to effect any transaction in a security or to report any such transaction unless the exchange is registered as a national securities exchange or is exempted from such registration).

[44]         15 U.S.C. § 78c(a)(1). The SEC Rule 3b-16(a) further refines the definition into a two-part test that the organization must: (1) bring together the orders for securities of multiple buyers and sellers; and (2) use established, nondiscretionary methods under which such orders interact with each other, and the buyers and sellers entering such orders must agree to the terms of the trade. 17 C.F.R. § 240.3b-16(a).

[45]         The DAO Report, supra note 16, at 16–17.

[46]         63 Fed. Reg. 70844 (Dec. 22, 1998).

[47]         The SEC leadership has previously indirectly conceded that bitcoin is not a security. See, e.g., Clayton Statement, supra note 35, at n.2 (stating that bitcoin is a commodity and is subject to the regulations of the Commodities Futures Trading Commission). Ether is the second largest virtual currency by market cap (the largest being bitcoin) that can be held and transferred on blockchains, function as a medium of exchange for other goods or services, and be used to create decentralized applications on the ethereum network, making it a much more versatile digital asset than bitcoin. Therefore, considerable legal consequences and commercial disruptions would follow if the SEC declared ether a security.

[48]         Hinman analogized digital assets, which are essentially computer codes, to orange groves in Howey. Neither digital assets nor orange groves are securities by nature, but if promoters offer and sell digital assets in the same way the Howey company sold orange groves (i.e., to cause prospective purchasers to believe that profit can be derived solely from the efforts of promoters), then the offer and sale of computer codes becomes an offer and sale of securities. See Hinman Speech, supra note 8.

[49]         Hinman cited a nonexhaustive list of factors to assess whether a third party—a person, entity, or coordinated group of actors—drives the expectation of a return on the digital asset. Id.

[50]         Id. (listing nonexclusive factors to consider how digital assets can be structured like a consumer item).

[51]         Id. (emphasis added).

[52]         Id.

[53]         Id. (emphasis added).

[54]         Clayton Statement, supra note 35. Notably, Kodak and its partner filed an SEC notice to offer rights to purchase KODAKCoins in future sales pursuant to Rule 506(c). JD Alois, KODAKCoin to Issue SAFT, Seeks $176.5 Million ICO, Crowdfund Insider, Mar. 19, 2018.

[55]         In the case of an individual, to qualify as an AI, the investor must meet certain thresholds concerning its net worth and annual income. See 17 C.F.R. § 230.215.

[56]         17 C.F.R. § 230.506(b)(2)(ii).

[57]         17 C.F.R. § 230.901.

[58]         “Offshore transaction” means (1) the offer is not made to a person in the United States, and (2) the buyer is outside the United States or the transaction is executed outside the United States. 17 C.F.R. § 230.902(h).

[59]         Regulation S divides securities into three categories. Category 1 securities include those issued by “foreign private issuers” as defined in SEC Rule 405. Among other alternatives that are irrelevant here, an offering or sale of Category 1 securities complies with Regulation S if there is no “substantial U.S. market interest” as defined under Regulation S or, if there is substantial U.S. market interest in the securities, the offering or sale is directed to a single country other than the United States in accordance with local laws. Categories 2 and 3 securities consist of securities offered by foreign reporting issuers and U.S. domestic issuers. Regulation S imposes more onerous conditions on these two categories of securities which include, among other things, placing legends on marketing materials, additional undertakings by distributors to comply with Regulation S, and a distribution compliance period during which offer or sale cannot be made to U.S. persons other than distributors. 17 C.F.R. § 230.903.

[60]         One of the qualifications is that the issuer is a nonreporting company organized under the laws of the United States of Canada. 17 C.F.R. § 230.251(b)(1), (2).

[61]         17 C.F.R. § 230.251(d)(2).

[62]         The offering statement consists of two parts: (1) notification and (2) an offering circular. 17 C.F.R. § 230.252(a). An offering circular is an abridged version of the traditional disclosure document. Some blockchain companies have filed Form 1-A with the SEC (i.e., the form for Regulation A offerings), but we have yet to see one qualified by the SEC.

[63]         17 C.F.R. §§ 230.502(c) and 506(c).

[64]         Securities offered pursuant to Rule 506 are “restricted securities,” and any resale must comply with Rule 144 to avoid being viewed as a distribution and, thus, the reseller an underwriter. 17 C.F.R. § 230.202(d). For purpose of Regulation S, a resale transaction will be deemed to occur outside the United States if it is made in an offshore transaction without directed selling efforts in the United States. 17 C.F.R. § 230.904.

[65]         Funderbeam, Initial Coin Offerings Funding Report (Oct. 2017), at 11 (showing that funds raised for the top 10 ICOs in 2017 all exceed $50 million); id. at 4 (average size of ICOs increasing rapidly).

[66]         Jean Eaglesham & Paul Vigna, Cryptocurrency Firms Targeted in SEC Probes, Wall St. J., Feb. 28, 2018.

[67]         Id.; see also Nathaniel Popper, Subpoenas Signal S.E.C. Crackdown on Initial Coin Offerings, N.Y. Times, Dec. 28, 2018.

[68]         As an example, the so-called Simple Agreement for Future Tokens (SAFT) is structured as a sale of the right to purchase utility tokens that will be released in the future; although such rights are admittedly securities and to be offered to AIs only, people using SAFT contemplate that once the investors exercise their right to purchase the utility tokens, the securities (i.e., the rights) disappear and all that is left is the utility tokens, which are pure nonsecurities. Predictably, there is indication that the SEC had SAFT in mind when sending out the waves of subpoenas. See Brady Dale, What If the SEC Is Going After the SAFT?, Coindesk, Mar. 6, 2018.

[69]         Interestingly, Hinman called out SAFT specifically. He warned against applying the opinion expressed in the Hinman Speech to a hypothetical SAFT in the abstract. Instead, he encouraged people with questions on a particular SAFT to consult with securities counsel or the SEC directly. Hinman Speech, supra note 8, at n.15.

Subject to court approval, Tesla will appoint two additional new independent directors in connection with its settlement of fraud charges brought against Tesla CEO Elon Musk and settlement of other charges against the company. 

Tesla at present has nine directors. One is Musk, who will step down as chairman of Tesla for at least three years as part of the SEC settlement; one is Musk’s brother; and the other seven directors are independent under NASDAQ independence standards, according to Tesla’s most recent proxy statement. 

Of those seven independent directors, however, three have ties to SpaceX, the private rocketry company also founded by Musk. Accordingly, five of nine Tesla directors are either Musk family members or have connections to other Musk projects beyond Tesla Board of Directors membership. The board may, technically, have a majority of directors who are independent, but it also has a majority of directors with actual or potential conflicts of interest.

Director independence in any company is not valuable for its own sake. Independence is a proxy for what investors actually need: decision makers with integrity, whose judgments on behalf of the company and its shareholders are rendered after thoughtful and fair consideration of the salient facts, untainted by favoritism, or undue deference to management.

In Tesla’s circumstances, regardless of whether specific exchange standards for independence are met, it is fair to consider whether any director can truly be independent.

After all, Musk’s vision, personality and history of business success have driven the company.  Musk has a unique ability to bring capital, engineering talent, and a grasp of an emerging market into a package that investors will value. Tesla lists its dependence upon Musk as a Risk Factor in its Form 10-K.  And Musk owns more than 20% of the company.

Can any board really be expected to fire Musk as CEO, or take disciplinary steps that might cause him to leave the company? And if a board doesn’t have that level of freedom in its oversight of CEO, is the board truly independent?

The short answer: maybe.

Compared to CEOs at other companies, who lack Musk’s celebrity and wealth and who are not visionary genius founders with a huge stock position, Musk has more leverage in negotiating with the Tesla Board of Directors over matters such as business strategy, personnel, pay, and similar issues.

However, it is possible that at this point in Tesla’s development, Musk is no longer an indispensable figure. The market for electric vehicles is proven, and key technologies have been developed. If Tesla’s remaining business issues are dealing with supply chain and financial questions, while maintaining cutting edge research and engineering into the future, genius may be less important than execution.

If Musk’s chief contribution to the company now is the ability to use his celebrity to generate publicity that Tesla doesn’t have to pay for, the board may have greater freedom, and success, in demanding that Musk meet the standards for CEO behavior that apply to everyone else.

At a minimum, the Tesla Board of Directors needs to ensure that the company has a succession plan in place and an organizational structure that permits Tesla to survive the departure of Musk, with or without a continuing relationship. Such business planning, as a question of sustainability, would be part of planning against a sudden death of visionary founder anyway.  Anything that is in Musk’s head and hasn’t already been reduced to paper, or that is kept as trade secret, needs to be made available to the next generation of leaders. 

Other tech companies with visionary founders have transitioned to operating without them. HP continued beyond Hewlett and Packard. Microsoft weathered Bill Gates’ departure from an operational role. Apple survived the first departure of Steve Jobs in the 1990s, and then after his return survived his death.

Two independent directors, by themselves, do not ensure that Musk will no longer engage in the behavior that gave rise to the SEC charges in the first place. The board acts as a group, and no individual director can act alone to rein in a CEO whose behavior is, at a minimum, erratic regardless of whether it rises to the level of fraud.  

Tesla’s need for capital, more than the independence of its directors, may provide the board the upper hand.  Musk didn’t build a company by himself.  To be realized, his vision needed engineers, designers, marketing personnel—and, most of all, investors. As Tesla’s recent stock price in the public market has shown, regardless of whether the  board is willing or able to hold Musk accountable, investors don’t like reckless behavior. 

The SEC brought serious charges against Musk: securities fraud, specifically, sending out knowingly false Twitter comments whose purpose seemed to be inflicting economic punishment on Tesla short sellers. Musk’s behavior not only generated a combined $40 million in SEC fines for him and the company, it also exposed Tesla to economic damage from private securities claims. 

A board cannot allow dishonest or illegal behavior by an executive to go without consequences, regardless of whether the SEC steps in. An oversight body that ignores erratic executive behavior or tolerates executive dishonesty has failed in its duties. That means Musk’s next misstep will not be just a problem for him, it will be a problem for the board. 

Which might be enough to keep them truly independent.

The Eleventh Circuit recently found in favor of Blue Bell Creameries, Inc. by rejecting its own earlier dicta and explicitly expanding the preference payment defense known as “new value.” This provides additional protection for companies doing business with a debtor in the 90 days prior to bankruptcy.

The Scoop: Bruno’s v. Blue Bell

In 2008, Blue Bell Creameries (Blue Bell) was a steady supplier of ice cream to Bruno’s Supermarkets, LLC (Bruno’s). In the 90 days before Bruno’s bankruptcy filing, Bruno’s paid Blue Bell approximately $560,000. Meanwhile, during those 90 days, Blue Bell delivered approximately $435,000 in products to Bruno’s, only some of which was paid for.

Bruno’s filed for bankruptcy and then sued Blue Bell, claiming that the entire $560,000 was a “preference.” A “preference” in bankruptcy vernacular is any transfer of an interest of the debtor in property to or for the benefit of a creditor, based on an antecedent debt, made while the debtor was insolvent, and made within 90 days of the bankruptcy, that provides the creditor with more than it would receive in a chapter 7 liquidation. See 11 U.S.C. § 547(b). A common example of a preference applicable here is when a debtor seeks to claw back payments it made within 90 days before the bankruptcy to an unsecured supplier, despite the debtor having received the goods or services related to such payments. Although this may seem inherently unfair to the supplier, the underlying bankruptcy policy is that equally situated creditors should be treated equally—no one creditor should be “preferred,” or receive payment leading up to bankruptcy, while others do not.

Chocolate or Vanilla?: Eleventh Circuit Dicta Conflates Unavoidable and Unpaid

Here, the $560,000 was admittedly a preference on its face. However, Blue Bell asserted the statutory defense known as “new value.” Basically, a trustee may not avoid a preference to the extent that, after such transfer, such creditor gave new value to the debtor. The wrinkle is that such new value must not have been satisfied by an “otherwise unavoidable transfer . . . .” 11 U.S.C. § 547(c)(4)(B) (emphasis added). The Eleventh Circuit previously stated that this phrase had “generally been read to require . . . that the new value must remain unpaid.” Charisma Inv. Co. v. Airport Sys., Inc. (In re Jet Florida Sys., Inc.), 841 F.2d 1082, 1083 (11th Cir. 1988) (emphasis added). Blue Bell challenged the “unpaid” language of Jet Florida, arguing that it should be able to utilize all new value delivered during the 90-day preference period, whether paid for or not, to shield that same dollar amount from being clawed back.

The bankruptcy court, relying on the “unpaid” language in Jet Florida, gave Blue Bell credit only for amounts that were unpaid, and ultimately held that the trustee could avoid about $440,000 of the over $560,000.

Dessert Is Served: Paid New Value Still Counts

On appeal, the Eleventh Circuit disagreed with the bankruptcy court. The Circuit Court rejected its own Jet Florida language as nonbinding dicta and joined the Fourth, Fifth, Eighth, and Ninth Circuits in holding that new value need not remain unpaid for the creditor to use the new value defense. Three factors swayed the court.

First, the plain language of the statute reads “unavoidable,” not “unpaid.” As both parties agreed, the transfers were preferences and therefore avoidable by the trustee, thus satisfying the “not . . . otherwise unavoidable” requirement of the statute. Second, although the predecessor statute to section 547(c)(4) required new value to remain unpaid, the current statute abandoned that language. One can reasonably conclude that Congress intentionally removed the unpaid limitation to the new value defense by removing the explicit language. Finally, policy considerations indicated that new value need not remain unpaid. If courts decided otherwise, then creditors such as Blue Bell would be hesitant to extend credit to distressed businesses such as Bruno’s in their run up to bankruptcy. This would thwart a key purpose of chapter 11 bankruptcy, which is to reorganize a debtor’s business so that it may pay creditors and regain profitability in the future. In addition, encouraging short-term creditors such as Blue Bell to extend credit to distressed businesses such as Bruno’s will help longer-term creditors. This extension of credit will therefore help distressed businesses from entering bankruptcy in the first place—a better result for all involved.

On August 13, 2018, President Donald Trump signed into law the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) as part of the John S. McCain National Defense Authorization Act for Fiscal Year 2019. FIRRMA amends section 721 of the Defense Production Act of 1950, the statute that governs the operations and powers of the Committee on Foreign Investment in the United States (CFIUS, or the Committee).

Prior to FIRRMA, CFIUS had jurisdiction to review a transaction by or with any foreign person that could result in control of a U.S. business by a foreign person.  Although “control” for purposes of CFIUS jurisdiction is a flexible concept that can reach a large number of minority investments, the legislative sponsors of FIRRMA were concerned that there were a number of foreign investment transactions that did not qualify as involving the acquisition of “control,” or did not involve an investment in a U.S. business, but that still presented threats to national security that needed to be addressed. One of the central concerns of the sponsors was that foreign government-sponsored investment could be used as part of a strategy to neutralize or surpass the United States’ advantages in technology by gaining access to technologies with potential military applications such as robotics, artificial intelligence and automation through non-control investments.  In addition to expanding CFIUS’s jurisdiction, FIRRMA also reforms certain elements of the CFIUS review process that will have impacts on all transactions that are subject to CFIUS jurisdiction.

FIRRMA will have a significant impact on structuring considerations and the parties’ assessment of deal risk where foreign parties are involved in a transaction, and especially foreign governments or foreign government-controlled parties. As a result of the jurisdictional expansions pursuant to FIRRMA (although not yet effective, pending regulations to be issued by CFIUS), transactions involving foreign parties are significantly more likely to be subject to CFIUS review than they have been in the past. 

Jurisdictional Expansions

New Categories of “Covered Transactions”

FIRRMA expands CFIUS’s jurisdiction to include as “covered transactions” subject to CFIUS review four new types of transactions that would not result in control of a U.S. business by a foreign person: 

1. Real Estate Transactions. The purchase or lease by a foreign person of, or a concession offered to a foreign person with respect to, real estate located in the United States that is a part of an air or maritime port or is in “close proximity” to a U.S. military installation or another United States Government facility or property that is sensitive for reasons relating to national security, could reasonably provide the foreign person with the ability to collect intelligence on activities at such a installation, facility or property, or otherwise could expose national security activities at such an installation, facility or property to the risk of foreign surveillance has been made subject to CFIUS jurisdiction, even if the purchase, lease or concession does not relate to a U.S. business. Real estate transactions involving a single “housing unit” or real estate in “urbanized areas” are excepted, subject to regulations that CFIUS may adopt in consultation with the Department of Defense that may reduce the scope of these exceptions. 
2. Non-controlling Investments in Companies that Deal in Critical Technology, Critical Infrastructure and Personal Data of U.S. Citizens. FIRRMA provides CFIUS with jurisdiction to review any “other investment” by a foreign person in any unaffiliated U.S. business that (i) owns, operates, manufacturers, supplies or services critical infrastructure, (ii) produces, designs, tests, manufactures, fabricates or develops one or more critical technologies, or (iii) maintains or collects sensitive personal data of U.S. citizens that may be exploited in a manner that threatens national security.

   For purposes of FIRRMA, “other investment” means any non-controlling investment (meaning an acquisition of equity interest, including contingent equity interests), direct or indirect and regardless of size, that affords the foreign person (1) access to any material nonpublic technical information relating to critical infrastructure or critical technologies in the possession of the U.S. business; (2) membership or observer rights on the board or equivalent governing body of the U.S. business or the right to nominate an individual to a position on the board of directors or equivalent governing body; or (3) any involvement (other than through voting of shares) in substantive decision-making regarding critical infrastructure, critical technologies or sensitive personal data of U.S. citizens. CFIUS will prescribe regulations providing guidance on the types of transactions that the Committee considers to be “other investments.”

3. Changes in Rights of a Foreign Person with Respect to its Investment in a U.S. Business. Any change in the rights that a foreign person has with respect to a U.S. business in which the foreign person has an investment, if that change could result in foreign control of the U.S. business or an “other investment.”
4. Transactions Structured To Evade CFIUS Review. Any other transaction, transfer, agreement or arrangement the structure of which is designed or intended to evade or circumvent the application of the covered transaction definition, subject to regulations prescribed by the Committee.

Potential Expansion of Target Businesses Subject to CFIUS Jurisdiction

Another potentially significant jurisdictional expansion relates to the definition of “U.S. business.”  FIRRMA defines “U.S. business” to mean “a person engaged in interstate commerce in the United States.”  In contrast, the current definition in CFIUS regulations includes a limiting clause “but only to the extent of its activities in interstate commerce.” Without this limiting clause from the current CFIUS regulations, FIRRMA appears to have the potential to provide CFIUS with jurisdiction to review elements of a transaction affecting an entity that provides goods or services in the United States without limiting that review to the entity’s U.S.-based activities. Depending on the regulations that are promulgated by the Committee under FIRRMA, this definition of “U.S. business” could entail oversight over transactions with much less of a U.S. nexus than is currently the case.

Clarification of “Other Investment” for Investment Fund Investments

FIRRMA clarifies and limits CFIUS’s jurisdiction over investments by U.S.-controlled investment funds that may receive capital contributions from foreign limited partners or the equivalent. Subject to regulations prescribed by the Committee, FIRRMA provides that an indirect investment by a foreign person through an investment fund in a U.S. critical infrastructure, critical technology or personal data business that affords the foreign person (or a designee of the foreign person) membership as a limited partner or equivalent on an advisory board or committee of the fund will not be considered an “other investment” as long as (i) the fund is managed exclusively by a general partner or equivalent that is not a foreign person; (ii) the advisory board does not have the ability to approve, disapprove or otherwise control investment decisions of the fund or decisions made by the general partner or equivalent related to entities in which the fund is invested; (iii) the foreign investor does not otherwise have the ability to control the fund, including the authority to approve, disapprove or otherwise control investment decisions of the fund or decisions made by the general partner or equivalent related to entities in which the fund is invested, or to unilaterally dismiss, prevent the dismissal of, select or determine the compensation of the general partner or equivalent; and (iv) the foreign person does not have access to material nonpublic technical information relating to critical infrastructure or critical technologies in the possession of the U.S. business as a result of its participation on the advisory board or committee.

Accordingly, investments in the types of sensitive businesses identified by FIRRMA by U.S.-controlled investment funds with foreign limited partners will not necessarily be subject to CFIUS review.  These provisions will have potentially significant implications for U.S.-controlled investment funds that receive investments from foreign investors, and both U.S.-controlled funds and foreign investors already invested or who are seeking to invest in such funds will need to understand and consider the implications of these rules with respect to fund governance and other limited partner rights afforded to foreign investors.

Although the clarification of how to treat indirect investment through U.S. investment funds was included to clarify the circumstances in which a limited partner’s governance or other rights in a U.S.-controlled fund could give rise to jurisdiction as an “other investment,” it is not unreasonable to expect that CFIUS may use such indicia by analogy in considering whether investment by a foreign-controlled investment fund whose general partner is located in one foreign country poses a greater threat because of foreign limited partners from one or more other foreign countries than if such limited partners had no such rights. For example, in assessing the potential threat posed by an investment by an investment fund with a general partner located in the United Kingdom or Canada (which would be jurisdictionally covered as a transaction that gives a foreign person control of a U.S. business), CFIUS might apply the four criteria in assessing the significance and potential threats posed by Chinese limited partners in that fund.

Effectiveness of Jurisdictional Expansions

The jurisdictional expansions discussed above are not immediately effective. According to the U.S. Department of Treasury’s FIRRMA FAQs, CFIUS will provide further guidance as to the timing for the effectiveness of these provisions. FIRRMA also authorizes CFIUS to conduct pilot programs to implement any provisions of FIRRMA that are not immediately effective.  The FIRRMA FAQs indicate that the scope and procedures of any such pilot program will be published in the Federal Register.  Although FIRRMA’s jurisdictional expansions will take effect only upon the Committee’s issuance of regulations or the implementation of one or more pilot programs, as a matter of prudence, parties should evaluate potential transactions under the expanded jurisdictional provisions.

Process Reforms

Additional Time for CFIUS Review

Under the prior version of the statute, the CFIUS review process consisted of a 30-day review period, potentially followed by a 45-day investigation period.  Although parties to a transaction may in certain cases withdraw and refile the notice at the end of the investigation period, and thus start a new sequence of review and investigation periods, the core CFIUS review process under the old statute lasted for up to 75 days.

FIRRMA extends the initial review period to 45 days and authorizes CFIUS to extend the subsequent investigation period by an additional 15 days in “extraordinary circumstances,” to be defined by CFIUS regulations. With these modifications, the core CFIUS review process has been extended to 90 days, and the CFIUS review process could take as long as 105 days before taking account for any time related to the pre-filing process and before accounting for any withdrawals and resubmissions of the written notice.

Timing for Review of Draft Filings and Acceptance of Filings

FIRRMA requires that CFIUS provide comments on draft notices submitted by the parties to a transaction in advance of a formal filing within 10 business days, and further requires CFIUS to accept formal filings — and thus start the review period “clock” — within 10 business days following submission. If CFIUS determines that the submission is incomplete, it must explain to the parties why the filing is incomplete. In order for the 10-day deadlines to apply, the parties must stipulate that the transaction is a “covered transaction” subject to CFIUS jurisdiction.

Declarations and Mandatory Declarations

FIRRMA establishes a new form of “light” filing, called a “declaration,” that contains basic information regarding the transaction and generally would  not exceed five pages in length. FIRRMA directs CFIUS to prescribe regulations establishing specific requirements for declarations, and the provisions relating to declarations are not yet effective.

FIRRMA provides that, upon receiving a declaration, CFIUS may request that the parties to the transaction file a written notice, initiate a unilateral review of the transaction, notify the parties in writing that the Committee has completed all action with respect to the transaction or inform the parties that the Committee is unable to complete action with respect to the transaction on the basis of the declaration alone and invite the parties to the transaction to file a written notice with complete responses to all the items that CFIUS expects to be included in a filing. FIRRMA requires the Committee to take action in respect of a declaration within 30 days following receipt. 

FIRRMA provides that a declaration (or, at the election of the parties, a written notice in lieu of a mandatory declaration) is mandatory in respect of certain transactions that would result in the direct or indirect acquisition of a substantial interest in a United States business by a foreign person in which a foreign government has a direct or indirect substantial interest. The transactions at issue include those that involve investment in a U.S. business that is the target of the “other investment” provision described above – U.S. businesses in critical infrastructure, critical technology or with personal data of U.S. citizens that may be exploited in a manner that threatens national security.  FIRRMA authorizes CFIUS to identify through regulations other categories of transactions that involve critical technologies (but not critical infrastructure or sensitive data on U.S. citizens) beyond those that involve a substantial interest in a United States business by a foreign person in which a foreign government has a direct or indirect substantial interest for which declarations will be mandatory.

For purposes of the mandatory declaration, the term “substantial interest” will be defined by CFIUS regulations. In developing those regulations, the Committee is required to consider the means by which a foreign government could influence the actions of the foreign person, including through board membership, ownership interest or shareholder rights. However, FIRRMA specifies that an interest that is excluded from the term “other investment” or that is less than a 10-percent voting interest will not be considered a “substantial interest.” Mandatory declarations also will not be required for investment funds that are structured consistent with the clarification of “other investment” in the investment fund context, as discussed above. FIRRMA also authorizes CFIUS to waive, with respect to a foreign person, the requirement to submit a mandatory declaration if the Committee determines that the foreign person has demonstrated that the investments of the foreign person are not directed by a foreign government and that the foreign person has a history of cooperation with the Committee. This waiver provision could potentially benefit government-sponsored pension funds that have a long history of investment in the United States. 

Under FIRRMA, CFIUS may not require mandatory declarations to be submitted more than 45 days before the completion of the transaction, and FIRRMA provides CFIUS with authority to impose civil penalties on any party that fails to comply with a mandatory declaration requirement.  CFIUS may not request or recommend that a mandatory declaration be withdrawn and refiled, except to permit the parties to correct material errors or omissions.  This means that CFIUS will have to make the decision to do one of the following: (1) request that the parties to the transaction file a written notice; (2) initiate a unilateral review of the transaction; (3) notify the parties in writing that the Committee has completed all action with respect to the transaction; or (4) inform the parties that the Committee is unable to complete action with respect to the transaction on the basis of the declaration alone and invite the parties to the transaction to file a written notice with complete responses to all of the items that CFIUS expects to be included in a filing.  CFIUS is required to make such decision within 30 days after it receives a mandatory declaration, but if CFIUS decides that a written notice is necessary, then a full review and investigation period could be required.

Filing Fee

Under the prior version of the statute, there was no filing fee associated with any notification to CFIUS. FIRRMA authorizes CFIUS to impose a fee of no more than one percent of the value of the transaction or $300,000 (adjusted annually for inflation pursuant to regulations prescribed by the Committee), whichever is less.  CFIUS has not yet taken steps to impose this fee, and will do so by regulation at a later date.

In addition, FIRRMA establishes a fund to be administered by the CFIUS chairperson and authorizes $20 million in appropriations to this fund for each of fiscal years 2019 through 2023 to enable the Committee to perform its functions.

Implications

Parties will need to consider carefully both the statutory and regulatory definitions and examples of key terms such as “critical technology,” “critical infrastructure,” “sensitive personal data” and “U.S. business” to determine whether the nature of the U.S. business brings any particular transaction within CFIUS’s purview. Real estate transactions that previously were not subject to CFIUS review because they did not involve a U.S. business will potentially be subject to CFIUS jurisdiction. Parties to transactions will need to analyze whether a foreign government has a “substantial interest” in any foreign party to the transaction, as well as whether that foreign party is acquiring a substantial interest in a U.S. business involved in one of the specified categories, to determine whether a declaration of the transaction to CFIUS is mandatory.

Investment fund managers will need to consider carefully the implications of the structure of their funds and the rights given to foreign limited partners.  U.S.-based investment fund managers that provide governance and informational rights to foreign limited partners will need to be aware that those rights may give rise to CFIUS jurisdiction in respect of the fund’s investments, so that any acquisition by that fund of U.S. businesses involved in critical infrastructure, critical technology or personal data of U.S. citizens could potentially be subject to CFIUS jurisdiction.  Foreign-based investment fund managers will also need to consider the rights they give to limited partners located in foreign countries that are generally deemed to present greater national security threats, such as China, because those rights could affect how CFIUS views the potential threat posed by a proposed acquisition by that investment fund.

Certain provisions, such as the introduction of declarations as a form of “light” filing or the specification of a time period during which CFIUS must comment on draft notices or accept certain formal notices, may serve to reduce the length of the CFIUS review process for parties to certain transactions. However, FIRRMA’s extension of the initial review period to 45 days and introduction of the possibility that parties’ submission of a declaration may be followed by a request from the Committee for a full notice filing means that in other cases parties will certainly face a longer review process than they would have under prior law.

In addition, since FIRRMA leaves many details to be prescribed by Committee regulations, the full implications of the CFIUS reform affected by FIRRMA will not be known for many months.  However, parties will have substantial opportunities to engage with the Committee throughout the rulemaking process and to provide the Committee with valuable insight into essential aspects of transactions involving foreign investment in the United States.

The law regarding sandbagging (which refers to a buyer that brings a claim for misrepresentation post-closing even though the buyer knew the representation was false before closing)[1] in Delaware seemed clear to many practitioners. Vice Chancellor Laster stated in a 2015 oral ruling that “Delaware is what is affectionately known as a ‘sandbagging’ state.”[2] In addition, then-Vice Chancellor Strine held that a buyer need not establish justifiable reliance in order to bring a breach of contract claim arising out of an acquisition agreement,[3] and given that the reliance element is what creates a problem for a buyer attempting to sandbag, this decision is often interpreted as a pro-sandbagging holding. Additionally, the 2017 ABA Deal Point study seems to confirm that practitioners have this view by finding that 51 percent of deals were silent on the point.[4] After all, many buyers reason that if Delaware is a pro-sandbagging state, why use negotiating capital to get a clause that is unnecessary?

However, this approach is dangerous after the May 24, 2018 Delaware Supreme Court’s decision in Eagle Force Holdings, LLC v. Stanley Campbell.[5] In a footnote, the majority opinion explained that there is a debate about whether a buyer can recover for a breach-of-warranty claim when the buyer knew at signing that the representation was not true. Although the majority observed that most states follow New York’s CBS Inc. v. Ziff-Davis Publishing Co.[6] (which held that traditional reliance is not required, and that the only “reliance” required is that the express warranty is part of the bargain of the parties), the majority did not decide this “interesting issue” because the claims were not before the court. Similarly, the dissent did not determine how this issue should be decided but emphasized Delaware’s anti-sandbagging jurisprudence.[7]

How Did Delaware Law Get Here?

To understand why the law is unclear on the sandbagging issue, it is helpful to discuss the path of the law. Early on, courts did not consider mere representations to be promises. Consequently, a buyer could not sue a seller for a breach of representation in a contract dispute because the representation was effectively not part of the contract. [8] To provide a buyer relief for being lied to, however, courts allowed the buyer to make a tort claim for misrepresentation, and one element of such a claim is reliance. Thus, under the traditional tort-based framework, a buyer must prove that it relied on the misrepresentation. Under the modern view, however, representations are actionable under contract law, and given that reliance is not part of contract law, the buyer need not show reliance.[9] It is this history of the importation of tort law to fill a gap in contract law (which gap, by the way, no longer exists) that has created uncertainty.

As a side note, this history of tort law and contract law is part of the reason acquisition agreements refer to “representations and warranties.” The representation refers to a tort concept and the warranty to a contract concept. As the debate about these near synonyms has been discussed in prior years in this publication, we will not relitigate the issue.[10]

Returning back to Delaware sandbagging case law, in the 1910s the Delaware Superior Court held that reliance was a necessary requirement of a breach-of-warranty claim.[11] This was reaffirmed in 2002.[12] However, in 2005, the Superior Court shifted and held that reliance was not an element of a claim for breach.[13] Shortly thereafter, the Chancery Court came out in favor of sandbagging in the often-cited Cobalt Operating, LLC v. James Crystal Enterprises case.[14] This is one of the cases mentioned in the introduction, but the Cobalt case might not be as strong as it first appears because the contract in Cobalt contained a clause that representations would not be affected by due diligence, and the court found that the Cobalt defendant intentionally obscured its fraud and gave misleading explanations when the plaintiff inquired about inconsistencies that arose in due diligence. These two facts can make it easy for a court to distinguish the case, and in fact, Delaware courts continued to have decisions that were inconsistent regarding sandbagging. The Delaware Supreme Court had not ruled on this issue[15]—that is, until the dicta comments in Eagle Force.

Conclusion

Although the majority and dissent in Eagle Force leave some clues as to how they might rule on the sandbagging issue, it is not productive to speculate about the outcome. Instead, buyers are best advised to include a pro-sandbagging clause (which is commonly referred to as a knowledge savings clause) in the purchase agreement. The following is an example of such a clause:

The post-Closing indemnification rights of the parties pursuant to Article [●] (Indemnification) shall not be affected by any waiver of condition set forth in Article [●] (Conditions to Closing) or any knowledge, obtained from any source at or before the execution hereof or at or before the Closing, of any breach of representation, warranty, covenant or agreement, and the parties shall be deemed to have reasonably relied upon the representation, warranty, covenant and agreement notwithstanding such knowledge.

Eagle Force has put buyers on notice that they might need to update their approach to sandbagging. To be silent is to leave the matter ambiguous.

This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content herein does not reflect the views of Sidley Austin LLP.

[1]              The term “sandbagging” dates back to the 19th century when street gangs would craft a homemade weapon by pouring sand into socks. Although the sock looked innocuous enough, when swung at an enemy, the concealed lump of sand could inflict substantial damage. The term has evolved to represent concealing or misrepresenting with the purpose of deceiving another. See Glenn West & Kim Shah, Debunking the Myth of the Sandbagging Buyer, M&A Lawyer, Jan. 2007, at 3.

[2]              See NASDI Holdings v. North Am. Leasing, No. 10540-VCL, slip op. at 57 (Del. Ch. Oct. 23, 2015).

[3]              See Cobalt Operating, LLC v. James Crystal Enters., LLC, 2007 WL 2142926, at *28 (Del. Ch. July 20, 2007), aff’d without op., 945 A.2d 594 (Del. 2008).

[4]              See ABA M&A Mkt. Trends Subcomm., Private Target Mergers & Acquisitions Deal Points Study 66 (Jessica C. Pearlman ed., 2017).

[5]              See Eagle Force Holdings, LLC v. Campbell, C.A. No. 10803-VCMR at 47, n.185 (Del. May 24, 2018).

[6]              See CBS Inc. v. Ziff-Davis Publ’g Co., 553 N.E.2d 997 (N.Y. 1990). It is interesting that the majority opinion did not did not discuss the subsequent case law that has significantly narrowed Ziff-Davis’s impact.

[7]              See Eagle Force, No. 10803-VCMR at 10 (Strine, J. & Vaughn, J., dissenting) (“[T]o the extent Kay is seeking damages because Campbell supposedly made promises that were false, there is doubt that he can turn around and sue because what he knew to be false remained so. Venerable Delaware law casts doubt on Kay’s ability to do so . . . .”).

[8]              See West & Shah, supra note 2, at 4–5.

[9]              See Charles K. Whitehead, Sandbagging: Default Rules and Acquisition Agreements, Del. J. Corp. L. 1081, 1084–86.

[10]             See Kenneth A. Adams, A lesson in drafting contracts: What’s up with “representations and warranties”?, Bus. L. Today, Nov.-Dec. 2005; Tina L. Stark, Nonbinding Opinion: Another view on reps and warranties, Bus. L. Today, Jan.–Feb. 2006. Interestingly, the footnote in the majority opinion in Eagle Force cites to Professor Stark’s article (but for a different proposition).

[11]             See Clough v. Cook, 87 A. 1017, 1018 (Del. Ch. 1913); Loper v. Lingo, 97 A. 585, 586 (Del. Super. Ct. 1916). The dissent in Eagle Force cited the Clough case for the proposition that a party who signs a contract with knowledge that a representation is false may not later claim reliance on it. See Eagle Force, No. 10803-VCMR at 10 n.39 (Strine, J. & Vaughn, J., dissenting).

[12]             See Kelly v. McKesson HBOC, Inc., 2002 WL 88939, at *8 (Del. Super. Ct. Jan. 17, 2002) (“According to sound Delaware law, a plaintiff must establish reliance as a prerequisite for a breach of warranty claim.”).

[13]             See Interim Healthcare, Inc. v. Spherion Corp., 884 A.2d 513, 548 (Del. Super. Ct. 2005). The court also noted that “the extent or quality of plaintiffs’ due diligence is not relevant to the determination of whether [defendant] breached its representations and warranties in the Agreement. . . . [P]laintiffs were entitled to rely upon the accuracy of the representation irregardless [sic] of what their due diligence may have or should have revealed.” Id.

[14]             See Cobalt Operating, LLC v. James Crystal Enters., LLC, 2007 WL 2142926, at *28 (Del. Ch. July 20, 2007), aff’d without op., 945 A.2d 594 (Del. 2008).

[15]             The Delaware Supreme Court did affirm Cobalt, but it did so without a written opinion. James Crystal Enters. v. Cobalt Operating, LLC, 945 A.2d 594 (Del. 2008).

In Janus v. AFSCME Council 31, 138 S. Ct. 2448 (2018), the United States Supreme Court recently held that legislation requiring public-sector employees in units represented by public-sector unions to pay “fair share fees” (sometimes referred to as “agency fees”) violates the First Amendment because it compels individuals to subsidize the speech of other private parties. Writing for the majority, Justice Samuel Alito stated, “Neither an agency fee nor any other payment to the union may be deducted from a nonmember’s wages, nor may any other attempt be made to collect such a payment, unless the employee affirmatively consents to pay [the union].” The immediate impact of Janus is that public-sector employees cannot be required to pay for any union activity without their clear and affirmative consent. This article explores the practical considerations of Janus and provides a framework for public employers to follow prospectively.

Life Before Janus

Janus’s roots date back to the Court’s 1977 decision in Abood v. Detroit Board of Education, 97 S. Ct. 1782 (1977), which evaluated the legality of a Michigan statute permitting unions and public-sector employers to agree to an “agency shop” arrangement. In an agency shop, the union is designated as the exclusive representative of all the unit employees, even those who do not join. Individuals who opt out of membership are still required to pay a service fee to the union. The Abood Court held that the payment of some fee by nonmembers was necessary to maintain labor peace as envisioned by federal labor laws and to avoid the risk of “free riders”—employees receiving the benefit of union protections at the expense of dues-paying members. On the other hand, the Abood Court recognized that the First Amendment prohibits the government from forcing contributions for political purposes. The resulting compromise was the so-called fair share fee—a percentage of union dues calculated by subtracting any portion the union expends on political or ideological activities from what the union allocates toward negotiating terms of employment on behalf of employees. Some viewed this percentage as difficult to quantify, and it left a significant gray area as to what exactly qualified as representation versus political/ideological activities. (Since 1977, the Supreme Court had tiptoed around the continuing validity of Abood. In 2012, in Knox v. SEIU, 132 S. Ct. 2277 (2012), Justice Alito noted in dicta that the constitutional justification for public-sector agency fees was “something of an anomaly.” Two years later, in Harris v. Quinn, 134 S. Ct. 2618 (2014), Justice Alito again criticized Abood.)

The Janus Decision

Mark Janus, a child-support specialist for the Illinois Department of Healthcare and Family Services, refused to join the AFSCME Council because he opposed the union’s public-policy positions as well as its stance toward collective bargaining which, in his view, did not recognize Illinois’ fiscal crises. Nevertheless, as permitted by Abood, the AFSCME Council required Janus to pay a fair share fee to the union—over 70 percent of total membership dues. As a result, Janus filed a complaint to challenge the constitutionality of such fees.

When the case reached the Supreme Court, the majority ruled that the First Amendment protected Janus from being mandated to pay such fees, effectively overruling Abood. The Court explained that Abood was based on the faulty assumption that “designation of a union as the exclusive representative of all the employees in a unit and the exaction of agency fees are inextricably linked[.]” Janus, 138 S. Ct. at 2465. In the end, the majority found fair share fees to be unconstitutional because they compel nonmembers to subsidize private speech on matters of substantial public concern.

Janus’s Impact

Practically, public-sector unions across the country anticipate that a significant number of nonmembers will cease their financial support and that current members may resign their membership to take advantage of newly discovered disposable income. To counteract such defections, unions representing public-sector employees are likely to invest in campaigns designed to educate both members and nonmembers about the value of union representation and the negative implications of a free-rider system. The efficacy of these campaigns in light of Janus is an open question.

Several states with high percentages of union density (especially in the public sector) anticipated the outcome in Janus and proactively adopted legislation. For example, in New York and New Jersey, new legislation gives unions access to new employees’ personal contact information. These states also allow unions the right to meet with new hires during work hours. Further, the New York legislation makes clear that unions cannot be forced to provide full membership benefits to nonmembers. In California, Governor Brown signed Senate Bill 866 regulating how public employers and unions manage membership dues and fees, and how public employers communicate with employees about their rights relating to union membership. Specifically, the California law requires public employers to refer employees with questions or requests concerning fees or dues to the union. It also mandates that dues or fees be deducted from payroll once the union notifies the employer of an employee’s valid authorization.

Other states may consider a more tailored alternative to agency fees, which would prevent free ridership while imposing a lesser burden on First Amendment rights. (See, e.g., Cal. Govt. Code Ann. § 3546.3 (West 2010); cf. Ill. Comp. Stat., ch. 5, § 315/6(g) (2016). These California and Illinois statutes allow public employees with religious objections to opt out of agency fees while permitting the union to charge those employees for particular services.) Such laws could provide that, if an employee with an objection to paying an agency fee “requests the [union] to use the grievance procedure or arbitration procedure on the employee’s behalf, the [union] is authorized to charge the employee for the reasonable cost of using such procedure.” Janus, 138 S. Ct. at 2469, n.6.

Practical Guidance

The Janus mandate is clear: public-sector unions cannot demand fair share fees, and public-sector employers cannot collect such fees absent clear and affirmative consent. However, the practical impact of Janus raises a myriad of questions that public employers must address now. For example, how should employers communicate the impact of Janus to employees? What type of consent is required to withhold dues or fees from employees? Can a public employer seek indemnity from the union for any claims made by employees as a result of the payroll deductions? Is there a duty to bargain over the impact of Janus? How these questions are answered will vary by locality.

Public employers may wish to affirmatively communicate with employees about the impact of Janus. However, before doing so, public employers should become familiar with recently enacted legislation that may govern such communications. For example, the California law discussed above places restrictions on “mass communications” to employees. Any mass communication sent to employees or applicants concerning their rights to join or support an employee organization, or refrain from joining or supporting an employee organization, require the employer to meet and confer with the union.

In order to prepare for a possible influx of employees seeking to cease financially supporting a union, public employers should also review applicable collective bargaining agreements and dues authorization forms on file. If such authorizations exist, employers may wish to question whether the authorizations are “clear and affirmative” as required by Janus, 138 S. Ct. at 2486. If authorizations are missing, employers may consider reaching out to the union to verify that a valid authorization exists, but again, state statutes may be implicated when an employer seeks to verify dues authorization information. For example, under the new California law, a public employer must rely on the information provided by the union concerning such authorizations. As a counterbalance, California public-sector unions must indemnify the employer for any claims made by employees that payroll deductions were improperly made. Similar indemnity legislation may follow in other states.

Since agency fee provisions are but one part of an overall collective bargaining agreement, public employers must carefully review such agreements for any contract language that requires agency (or service fee) deductions because Janus now renders such language unlawful. This issue is further complicated if the applicable collective bargaining agreement does not contain a severability clause. Additionally, depending upon the jurisdiction, unions may seek to negotiate over the “impact” of Janus. Many states’ public-sector labor laws require “impact bargaining,” referring to negotiations over the impact of management rights decisions on union employees. However, public employers may argue that negotiations are not required because this issue does not directly relate to employees’ terms and conditions of employment but rather is an intra-union matter.

Conclusion

Although the full impact of the Janus decision will play out over the course of years, public employers must grapple with the immediate impact of Janus and resulting legislation today. These practical considerations are intended to serve as a general guide to public employers to minimize disruption in the workplace during the post-Janus transition.

On August 17, 2018, the SEC adopted final amendments relating to an ambitious housekeeping effort, “Disclosure Update and Simplification,” a component of the SEC’s disclosure effectiveness project. The final amendments address certain disclosure requirements that have become redundant, duplicative, overlapping, outdated, or superseded in light of other SEC disclosure requirements, US GAAP or “changes in the information environment.” The “demonstration version” of the final amendments provides a blacklined version displaying the changes. The final rules become effective 30 days after publication in the Federal Register, and the staff has indicated that it will review the impact of the amendments within five years thereafter.

The final amendments eliminate entirely a number of provisions that are completely duplicative, as well as a variety of references to obsolete terms such as “pooling-of-interests accounting” and “extraordinary items.” In another nod to modernity, the SEC removed the requirement to identify the SEC’s Public Reference Room and disclose its physical location and phone number; instead, the SEC will retain the requirement to disclose the SEC’s internet address and require all issuers to disclose their internet addresses if they have one. SEC disclosure requirements that overlap with GAAP, IFRS, or other SEC disclosure requirements have, in some instances, been deleted and, in other instances, where the requirement involved incremental material information, been integrated into other requirements. In some cases where the disclosure requirements overlap with GAAP but require material incremental information, the SEC retained the requirement, but referred the items to FASB for potential incorporation into GAAP in the future.

For the most part, the changes are not particularly earth-shaking; however, where the amendments result in relocation of disclosure into the financial statements, the effect can be burdensome in that it subjects the new disclosure to audit or interim review and audit of internal control over financial reporting, which could create potential verification and auditability issues. In addition, XBRL tagging requirements apply to information in the financial statements. Moreover, because the safe harbor for forward-looking information under the Private Securities Litigation Reform Act of 1995 does not apply to financial statements, potential liability concerns are introduced. In this regard, relocation of disclosure into the financial statements, together with the absence of the PSLRA safe harbor protection, may make issuers warier about supplementing required disclosures in the financial statements with forward-looking information. However, the SEC noted that it did not adopt any requirements to disclose forward-looking information in the financial statements, and further observed that issuers retain the option of providing forward-looking information outside of the financial statements (and, in some cases, are required to provide that information). Of course, relocating disclosures outside the financial statements will have the opposite effect, no longer subjecting the information to requirements for audit, review, or XBRL and providing the potential for PSLRA protection. Other changes may simply affect the relative prominence of the disclosure or impose or remove a bright-line disclosure threshold.

Some Notable Changes

To convey the flavor of the changes, below are selected changes affecting Regulation S-K. Note, however, that many of the changes effected by the amendments relate to Regulation S-X and the financial statements.

Item 101—Description of Business

Segments and geographic information. In light of existing GAAP and Item 303(b) disclosure requirements, the amendments eliminate the mandates in Item 101 to provide segment financial information and financial information by geographic area. The current rule explicitly permits issuers to avoid duplication by cross-referencing to the applicable notes to the financial statements, and that is how most companies have historically addressed this requirement. Now, companies will not have to bother with that cross-reference.

Foreign operations. Similarly, the SEC eliminated the requirements to disclose under Item 101 material risks associated with an issuer’s foreign operations and any segment’s dependence on foreign operations. Those matters, the SEC concluded, are more appropriately disclosed under “Risk Factors” and, where appropriate, in MD&A. To make that point explicit, the SEC has added a specific reference to “geographic areas” to the MD&A requirement to disclose trends and uncertainties by segment.

R&D. Similarly, because the information is comparable to information already required by GAAP, the SEC has eliminated the mandate to disclose under Item 101 the amount spent on R&D activities for all years presented.

Major customers; product revenue. However, the SEC elected to retain some of the overlapping provisions that require disclosure of information incremental to GAAP and to instead refer them to FASB for potential incorporation into GAAP. For example, both GAAP and Item 101 require disclosures about major customers: Regulation S-K requires disclosure if loss of one or a few customers would have a material adverse effect on a segment, while GAAP requires certain disclosures for each customer that accounts for 10 percent or more of total revenue. In addition, Regulation S-K requires disclosure of the name of any customer that represents 10 percent or more of revenues and the loss of which would have a material adverse effect, while  GAAP does not. Similarly, both GAAP and Regulation S-K require disclosure regarding revenue from products and services; however, the Regulation S-K mandate has a 10-percent threshold, while GAAP requires disclosure for each product or service, or group of similar products and services, unless impracticable. Depending on FASB’s decision regarding integration of this information into the applicable GAAP requirement, modifications could result in PSLRA safe harbor and other financial statement disclosure issues, as well as issues arising out of the elimination or inclusion of bright-line disclosure thresholds.

Item 201—Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters

Market prices. The SEC has updated the market price disclosure requirements: instead of requiring disclosure of the high and low sales prices and sales price as of the latest practicable date—which are readily available for free on numerous websites on a daily basis and likely more up to date—Item 201(a)(1) is amended to eliminate the detailed disclosure requirement to provide sale or bid prices for most issuers with common equity traded in an established public trading market and replaced with disclosure of the trading symbol. More specifically:

• Issuers with one or more classes of common equity will be required to identify the principal S. markets where each class is traded and the corresponding trading symbols used by the markets for each class of common equity. Foreign issuers will also be required to identify the principal foreign public trading markets, if any, and the trading symbols, for each class of their common equity.
• Issuers with common equity that is not traded on an exchange will be required to indicate, as applicable, that any over-the-counter market quotations in these trading systems reflect inter-dealer prices without retail mark- up, mark-down, or commission and may not necessarily represent actual
• Issuers with no class of common equity traded in an established public trading market will be required to state that fact and disclose the range of high and low bid information, if applicable, for each full quarter within the last two fiscal years and any subsequent interim In addition, these issuers must disclose the source and explain the nature of the quotations.

Dividends. The amendments also streamline the various redundant and overlapping requirements in Regulations S-X and S-K to discuss dividends. The SEC is eliminating the requirement in Item 201 to disclose restrictions that currently or are likely to materially limit the company’s ability to pay dividends on its common equity; instead, companies will be required to provide disclosure of material restrictions on dividends only in the notes to the financial statements under Regulation S-X. Likewise, the amendments eliminate the requirement in Item 201 to disclose the frequency and amount of cash dividends declared for the two most recent fiscal years and any subsequent interim period; rather, the amendments will mandate that Rule 3-04 of Regulation S-X, which currently requires financial statement disclosure of the amount of dividends per share and in the aggregate, be applied to interim periods.

Convertible/exercisable securities. In light of the broader GAAP requirement to disclose the terms of significant contracts to issue additional shares and other reasonably similar information, the SEC has eliminated the Item 201 requirement to disclose on Form S-1 or Form 10 the amount of common equity subject to outstanding options, warrants, or convertible securities when the class of common equity has no established U.S. public trading market.

Equity compensation plan table. Another overlapping provision that was proposed to be eliminated is instead being retained and referred to FASB for potential incorporation into GAAP: the SEC decided not to eliminate the mandate in Item 201(d) to provide tabular disclosure regarding existing equity compensation plans approved and not approved by shareholders. This information is currently required in a number of different forms, including Forms 10-K and proxy statements. In the proposal, the SEC had suggested elimination of the provision because it overlapped with a similar GAAP requirement and because the SEC believed that drawing the distinction between plans approved and not approved by shareholders was no longer useful to investors because the major exchanges now require, with limited exceptions, plan approvals by shareholders. However, relocating the disclosure to the financial statement notes would raise potential liability issues in the absence of PSLRA protection and would mean that the disclosure would no longer appear alongside information about equity compensation plans subject to shareholder action. At the end of the day, the SEC decided to retain and refer to FASB the overlapping requirement, recognizing the concerns expressed by commenters that GAAP does not explicitly require certain information that could be material to investors, such as the formula for calculating the number of securities available for issuance under the applicable plan. Note, however, that, although the final rules currently retain Item 201(d), referring it to FASB, they surprisingly still eliminate the provisions in Schedule 14A (proxy statements) and Form 10-K that currently mandate the inclusion of Item 201(d) disclosure in those documents. As a result, although item 201(d) disclosure would continue to be required in Form S-1 and Form 10, unless the staff indicates otherwise, under the new amendments, Item 201(d) disclosure would not be required in proxy statements or Forms 10-K. In informal discussions with the staff, we have been advised that the staff is aware of the issue and is considering it.

Item 303—Management’s Discussion and Analysis of Financial Condition and Results of Operations

Seasonality. The amendments eliminate Instruction 5 to Item 303(b) regarding seasonality because it required disclosures that convey reasonably similar information to that required under GAAP and the remainder of Item 303.

Item 503—Prospectus Summary, Risk Factors, and Ratio of Earnings to Fixed Charges

Ratio of earnings to fixed charges. The amendments eliminate the requirement in Item 503(d) to disclose the historical and pro forma ratio of earnings to fixed charges (and ratio of combined fixed charges and preference dividends to earnings) in connection with the registration of debt securities and preference equity securities. The SEC observed that now a “variety of analytical tools are available to investors that may accomplish a similar objective as the ratio of earnings to fixed charges.” In addition, the SEC noted, debt investors often negotiate covenants requiring issuers to provide more relevant financial information.

Item 601—Exhibits

Earnings per share. The final amendments eliminate Item 601(b)(11), which requires a statement showing the calculation of per-share earnings (unless the computation can be determined from information already in the report) in annual filings. According to the SEC, that requirement is duplicative of information required under GAAP, Regulation S-X, and IFRS.

Ratio of earnings to fixed charges. In connection with the elimination of Item 503(d), the related Item 601(b)(12) exhibit filing requirement has been eliminated.

Reports to shareholders. Various reports to security holders, required to be filed as exhibits under Items 601(b)(19) and (22), are also eliminated in light of, in the former case, other exhibit provisions or, in the latter case, the requirement to disclose shareholder voting results in a Form 8- K.

On the Horizon

With regard to those incremental disclosure requirements that were referred to FASB for consideration of whether they should be incorporated into GAAP, the SEC requested that FASB determine whether to add these items to its agenda within 18 months after publication of the adopting release in the Federal Register. In a statement to Bloomberg BNA, FASB indicated that it was “reviewing the SEC’s recommendations, and that board members will discuss the request at an upcoming public meeting.” Accordingly, depending on the position ultimately taken by FASB, financial reporting requirements could become more burdensome for all companies—and especially for smaller reporting companies—if FASB determines to incorporate these incremental disclosures into GAAP.

In addition, the SEC indicated that it planned to continue to study the question of the potential integration of the mandate under GAAP to disclose loss contingencies and the requirement under Item 103 of Regulation S-K to disclose certain legal proceedings, which are one type of loss contingency. Item 103 includes a bright line disclosure threshold in some cases of 10 percent of the issuer’s consolidated current assets, while GAAP provides a more general materiality threshold. However, the overlap has historically led many companies to either repeat the disclosures or cross-reference to them. In the proposing release, the SEC had considered referring the issue to FASB for potential incorporation into GAAP. As described by the SEC in the proposing release, incorporation of Item 103 requirements into GAAP would result in more instances of disclosure of the possible range of loss; more disclosure that is subject to audit or review, internal control, and XBRL requirements; more disclosure of prescribed facts (such as the court or agency, the date instituted, the principal parties involved, the alleged factual basis of the proceeding, and the relief sought); and a more general materiality threshold in connection with environmental legal proceedings (instead of the bright-line thresholds in Regulation S-K). It would also give rise to PSLRA safe-harbor protection issues and other financial statement concerns. The SEC observed in the adopting release that many commenters opposed the integration on a variety of bases, including the possible need to revisit the ABA policy statement regarding lawyers’ responses to auditors’ requests for information. Some commenters supported the integration, noting the repetition in many filings, and some recommended that the SEC conduct more analysis and outreach. Ultimately, the SEC apparently took that advice and determined to retain the current requirements and study the issue further.

Recently, the Securities and Exchange Commission (SEC) adopted amendments to the smaller reporting company (SRC) definition to increase the thresholds for eligibility and to adopt certain other changes. Under the new SRC definition, a company with less than $250 million of public float will be eligible to provide scaled disclosures. Companies with less than $100 million in annual revenues and either no public float or a public float that is less than $700 million will also be eligible to provide scaled disclosures. The SEC made no revisions to the actual scaled disclosure requirements available to SRCs. The revised SRC qualification rules are effective on September 10, 2018. 

What Is An SRC and What Did the SEC Change?

The SEC historically has recognized that a single-size regulatory structure for public companies does not fit all. As a result, the SEC has adopted a number of rules that, in effect, have created a graduated disclosure regime for public companies from accelerated filing requirements for larger companies to reduced disclosure requirements for emerging growth companies and SRCs. The SEC expects about 1,000 companies to qualify as an SRC as a result of the revised definition and to possibly take advantage of the new rule changes. Do you represent companies eligible to take advantage of these new changes, and if so should they take advantage of these new changes? What occurs if a company is initially not eligible, but becomes eligible at a later time? What exactly is “scaled disclosure,” and with which of the many SEC rules does a SRC need not comply? This article explores these and other related topics. 

The SEC’s new thresholds for determining SRC status are based on (1) having a public float of $250 million, or (2) a revenue test which also includes a public float component. Once a company determines that it qualifies as an SRC, it will remain an SRC until it exceeds the initial qualification thresholds. The new rules provide three paths to becoming an SRC: one for companies doing an initial public offering and two for existing public companies—a transition rule for this year using the IPO thresholds and, for companies that failed to meet the initial thresholds, the ability to become an SRC if it meets lower revenue and market cap thresholds. 

Initial Qualification 

The following table summarizes the amendments to the SRC thresholds for companies making an initial determination under the revised rules, or a current SRC confirming its continued compliance. A company must meet only one of the two thresholds. 

What If a Company Is Already Public?

Transition Rule for Existing Public Companies 

For the first fiscal year after September 10, 2018, existing public companies may qualify by applying the new initial qualification thresholds (summarized above) rather than the lower, subsequent qualification thresholds (summarized below). A calendar year company will test its status based on its revenues for the year ended December 31, 2017, and its public float as of June 29, 2018. 

What If a Company Is Initially Not Eligible, But Becomes Eligible At a Later Time?

Subsequent Qualification 

If a public company determines that it does not qualify for SRC status because it met neither of the foregoing thresholds, it will remain unqualified unless, when making a subsequent annual determination, it meets one or more lower qualification thresholds. The subsequent qualification thresholds, set forth in the table below, are set at 80 percent of the initial qualification thresholds. Stated differently, this test is for issuers that are currently required to file reports under sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended. 

The SEC provided the following example in its guidance: 

Example: A company has a December 31 fiscal year end. Its public float as of June 28, 2019 was $710 million and its annual revenues for the fiscal year ended December 31, 2018 were $90 million. It therefore does not qualify as a SRC. At the next determination date (June 30, 2020), it will remain unqualified for SRC status unless it determines that its public float as of June 30, 2020 was less than $560 million and its annual revenues for the fiscal year ended December 31, 2019 remained less than $100 million. 

What Is “Scaled Disclosure” And With Which Of The Many SEC Rules Does An SRC Need Not Comply?

The advantage of being an SRC is that such a company can comply with certain SEC rules and regulations that are less onerous. An SRC can pick and choose between scaled or nonscaled, financial and nonfinancial disclosure requirements on an item-by-item basis. For a side-by-side comparison of the SRC rules and rules applicable to non-SRCs, see Appendix A. 

There are specific rules regarding entering and exiting the SRC reporting regime, and most companies solicit expert advice regarding compliance with such rules. A larger reporting company that determines it qualifies to be an SRC as of the last business day of its most recently completed, second fiscal quarter is permitted to file as an SRC in its quarterly report for such quarter. When a company no longer qualifies as an SRC as of the end of its most recently completed, second fiscal quarter, it can continue to use the scaled disclosure accommodations available to SRCs through its subsequent annual report Form 10-K. The filing deadline for the Form 10-K will be based on the company’s filing status as of the end of the fiscal year covered by the Form 10-K. 

Is It Always Better To Be An SRC?

No. SRCs are subject to additional disclosure requirements with respect to transactions with related persons, promoters, and certain control persons under Regulation S-K, Item 404. However, rather than the $120,000 threshold under Item 404, SRCs are subject to a threshold that is the lesser of $120,000 or one percent of total assets. The resulting disclosure must address the two preceding years. In addition, SRCs are also subject to additional Item 404 disclosure requirements regarding any underwriting compensation received by their corporate parent or any related persons. This Item 404 disclosure is mandatory for all companies qualifying as an SRC, regardless of whether it elects to take advantage of the scaled disclosure accommodations for SRCs. 

Must SRCs File Auditors’ Attestation Reports Under Section 404(B) Of the Sarbanes-Oxley Act I?

Sometimes. Only “nonaccelerated filers” and “emerging-growth companies” are exempt from the requirement to provide an auditors’ attestation report. As a result, it is possible that a company could qualify as an SRC and be eligible to provide scaled disclosure, but at the same time meet the definition as an accelerated filer required to provide an auditors’ attestation report. Note that SEC Chairman Jay Clayton has directed SEC staff to exempt some companies from the Sarbanes-Oxley Act Section 404(b) auditors’ attestation report. 

Pointers:

• Companies that have completed an initial public offering in the last five years will soon lose their emerging growth company eligibility due to the passage of time. Qualifying for SRC status will enable them to take advantage of the scaled disclosure regime. 
• There will be a greater number of companies that qualify as both an SRC and an accelerated filer, and will be required to check both boxes on the cover page. 
• Companies should keep in mind the status of their competitors and whether qualifying as an SRC may negatively impact market perception of the company. Given the complexity of the federal securities laws, it is prudent to consider some of these issues sufficiently in advance. In addition, companies should keep in mind their long-term capital raising plans as the market practices develop. 
• Given the rampant use of stock buy-backs, a company could plan its entry into the SRC regime based on its revenues and public float. 
• It is possible for a company not to have a public float. This could occur if a company does not have any public common equity outstanding, or no market price for its common equity exists. 
• If you are a tech company, or a pre-clinical life sciences company, with no revenue, it is highly likely that you will qualify as an SRC. 

Appendix A 

A recent decision by the Louisiana Court of Appeals considered the effect of the seriatim deaths of several members of an LLC and, ultimately, whether an action for judicial dissolution initiated by a member who subsequently passed away could continue. In this instance, the court found that the action for judicial dissolution of the LLC could continue.  Schauf v Schauf, No. 51, 919-CA, __ So.3d __, 2018 WL 1937068 (La. App. 2d Cir. Apr. 25, 2018).

Angela Schauf organized the Schauf Family LLC in 2001, keeping 50 percent of the ownership for herself and distributing to each of her four children a 12.5-percent interest. Those four children were Peter, Paul, Mary, and Kathryn. Angela and all of the children executed an operating agreement. The LLC’s only asset was farmland that was leased out. Angela passed away, and her interest in the LLC was divided among the four children, resulting in each of them becoming a 25-percent member. Then, each of Peter and Kathryn passed away, leaving their interests in the LLC to their respective spouses, Jo Ann and Michael.

Thereafter, disagreements arose with respect to the LLC, and each of Jo Ann (assignee of Peter) and Michael (assignee of Kathryn), as well as Mary, an original member, sought to dissolve the LLC, sell its assets, and distribute the proceeds. Paul objected to any dissolution and also rejected the proposal that he buy out the other members. Nonetheless, everyone except Paul voted to dissolve the LLC and appoint Jo Ann as its liquidator.

Thereafter, Paul filed suit, asking for a ruling that the appointment of the liquidator and the vote to dissolve the LLC were null and void. Mary then passed away, and a motion was filed to substitute Jo Ann, Mary’s executrix, in the lawsuit. In turn, the trial court granted Paul’s application for summary judgment, in which the vote to liquidate and the appointment of Jo Ann as the LLC’s liquidator was declared void. Conversely, the defendants’ motion for summary judgment was denied on the basis that they had no authority to dissolve the LLC and liquidate its assets. The defendants filed this appeal.

The court’s opinion begins with a review of the status of the estate of a deceased member under the Louisiana LLC Act. Specifically, the estate does not become a member (absent a contrary provision in either the articles or operating agreement).

Thus, an LLC’s articles of organization or a written operating agreement could, but have not in this case, provide that a person who inherits a decedent member’s interest in the LLC would become a member of the LLC or would have certain rights that are provided only to members.

From there, the court offered some observations as to the status of a decedent member’s estate vis-a-vis the LLC, namely:

The rule treating a decedent member’s legal representative as an assignee of the decedent’s interest may be problematic. As an assignee of the decedent member’s interest, the decedent’s legal representative is entitled only to receive distributions from the LLC as authorized by the LLC’s operating agreement or by the members, to share in the LLC’s profits and losses, and to receive allocations of the LLC’s items of income, gain, loss, deduction, and credit. A decedent member’s legal representative may not become a member of the LLC or exercise any of the rights or powers of a member unless the LLC’s articles of organization or a written operating agreement provides otherwise or the legal representative is admitted as a member of the LLC. Thus, the legal representative of a decedent member may not participate in the management of the LLC, vote on the LLC’s affairs, or inspect the LLC’s records unless the LLC’s articles of organization or an operating agreement specifically accords such management rights to the decedent’s legal representative or the legal representative is admitted as a member of the LLC. Without the right to vote or inspect records, a decedent member’s legal representative will have little ability to protect the interests of the decedent’s estate or heirs with respect to the decedent’s interest in the LLC. Id. at *6–*7.

Still, the court noted that an action for judicial dissolution may be brought by any member on the grounds that it “is not reasonably practicable to carry on the business of the LLC in conformity with its articles of organization and operating agreement.” Id. at *3, quoting La. R. S. 12:1335. The court went on to find that Mary had been a member of the LLC at the time the petition for judicial dissolution was filed, that “[h]er death did not terminate the dissolution process once it had been initiated.” and that JoAnn, as Mary’s executrix, could continue the dissolution action. Id. at *8.

Almost in passing, the court rejected the suggestion that because the articles of organization provided that the LLC would dissolve after 25 years, it could not be dissolved prior to that time.

If this decision is restricted to its facts—namely, an action for judicial dissolution—it is an entirely reasonable outcome. At the time the action for judicial dissolution was filed, three of the four persons having a derivative economic interest in the LLC’s assets no longer wish to be in business together. Likewise, one-half of the members did not want to be in business with the other half. It would be dangerous, however, to extend this decision beyond the context of an action for judicial dissolution. If, in contrast, the suit were to have involved a derivative action or a request to inspect documents by a member who then passes away, different policy concerns focused upon the LLC’s internal management would arise.

Among the most important recent developments in Delaware corporate law is the establishment (or re-establishment) of the potentially case-dispositive impact of an affirmative stockholder vote in M&A litigation. The Supreme Court of Delaware’s 2015 decision in Corwin v. KKR Financial Holdings LLC held that a fully informed vote in favor of a transaction by disinterested stockholders invokes the application of the business judgment standard of review. Given that application of the deferential business judgment standard of review renders the challenged transaction almost certainly immune from further judicial scrutiny, it is difficult to overstate Corwin’s impact. Few cases survive Corwin’s application, an unsurprising result given that a faithful application of the doctrine places a significant burden on a stockholder plaintiff to allege, without the aid of discovery, a material omission or misstatement in connection with a stockholder vote. Due to this trend, the Delaware Supreme Court’s decision in Morrison v. Berry, which reversed a Court of Chancery decision dismissing a merger challenge based on Corwin, presents an important step in the continued development of the Corwin doctrine. As discussed below, it is apparent that Delaware’s high court expects the Court of Chancery to apply Corwin in a careful, searching manner that is consistent with the plaintiff-friendly motion to dismiss standard. Indeed, Morrison is the second of two recent Delaware Supreme Court cases (the first being Appel v. Berkman) that stress the careful application of Corwin.

The Corwin Decisions

Stockholders of KKR Financial Holdings LLC (KKR Financial) challenged its acquisition by KKR & Co., L.P. (KKR), alleging breaches of fiduciary duty against KKR, as controlling stockholder, and KKR Financial’s board. In opposing the defendants’ motion to dismiss, the plaintiffs argued that the entire fairness standard of review should apply because KKR was allegedly a controlling stockholder of KKR Financial and because, with respect to the claim against KKR Financial’s board, the complaint contained sufficient allegations to rebut the business judgment standard of review.

The Court of Chancery granted the defendants’ motion in full. Regarding plaintiffs’ claim against KKR, the court held that KKR was not a controlling stockholder and therefore owed no fiduciary duties to KKR Financial or its stockholders. As to the claims against KKR Financial’s board, the court first held that the complaint failed to allege facts sufficient to rebut the business judgment rule. Although the court could have ended its decision there, it went on to hold that, even if the complaint had adequately alleged such facts, “business judgment review would still apply because the merger was approved by a majority of disinterested stockholders in a fully-informed vote.” The Supreme Court of Delaware affirmed, likewise holding that “when a transaction not subject to the entire fairness standard is approved by a fully informed, uncoerced vote of the disinterested stockholders, the business judgment rule applies.”

Fully Informed Stockholder Vote

Given that the plaintiffs in Corwin did not allege that the merger-related disclosures were deficient or contest the defendants’ argument that the business judgment rule was invoked by virtue of the affirmative stockholder vote, the Corwin decisions did not discuss what constitutes a “fully informed” stockholder vote sufficient to invoke the business judgment standard of review. In subsequent decisions by the Court of Chancery, the court has looked to the existing standards under Delaware law in the context of disclosure-based fiduciary duty claims regarding what is or is not material to the stockholders’ decision-making. Where a plaintiff adequately alleges that the merger disclosures were materially incomplete or misleading, the court has found that the stockholder vote was not fully informed.

Morrison v. Berry

The action relates to the 2016 acquisition of The Fresh Market (the Company) by Apollo Global Management LLC (Apollo) through a tender offer. Apollo submitted an unsolicited offer to acquire the Company in October 2015, noting that it had discussed the proposal with Ray Berry, the Company’s founder and a member of the board who, together with his son Brett, owned 9.8 percent of the Company’s outstanding stock. After a five-month process, a special committee of the board and the board recommended a transaction with Apollo that involved a tender offer and an equity rollover by Ray and Brett Berry. The tender offer closed in April 2016 with over 68 percent of outstanding shares validly tendered.

Following the announcement of the tender offer, a stockholder of the Company demanded books and records under section 220 of the Delaware General Corporation Law, through which she received “several key documents,” including board minutes and e-mails between Ray Berry’s counsel and Company counsel. The stockholder then filed suit alleging breaches of fiduciary duty against the board and a claim for aiding and abetting breaches of fiduciary duty against Brett Berry. The defendants moved to dismiss under Corwin, which had been applied to tender offers in an earlier Court of Chancery decision captioned In re Volcano Corp. Stockholder Litigation. The stockholder plaintiff argued that Corwin did not apply because the Company failed to disclose all material facts in its Schedule 14D-9; therefore, the stockholders’ decision to accept the tender offer was not fully informed. In a short letter opinion, the Court of Chancery granted the motion to dismiss, ruling that the alleged disclosure issues were immaterial and that the action was “an exemplary case of the utility of th[e] ratification doctrine, as set forth in Corwin and Volcano.”

On appeal, the Delaware Supreme Court reversed, finding that the stockholder plaintiff alleged four disclosure deficiencies that rendered the 14D-9 materially incomplete and misleading.

First, the Supreme Court concluded that the complaint adequately alleged that the 14D-9 omitted material information about Ray Berry’s agreement with Apollo and his representations to the board about the agreement. After withdrawing its initial offer, Apollo renewed its offer on November 25, 2015. A November 28, 2015 e-mail from Berry’s counsel to Company counsel read that Berry had one conversation with Apollo in the interim, during which “he agreed, as he did in October” to roll over his equity if Apollo reached an agreement with the Company. The 14D-9 did not include any reference to an agreement between Berry and Apollo in October. Whereas the Court of Chancery determined that this information was not material because Berry’s “position as of the time of the auction process and go-shop—that is, at the time material to stockholders—was adequately disclosed,” the Supreme Court determined that this information was material, especially in light of the 14D-9’s disclosure that Berry stated during an October 15 board meeting that he had not committed to a transaction with Apollo. The Supreme Court held that a reasonable stockholder would want to know both about Berry’s “level of commitment” to Apollo in October and that Berry was not forthcoming with the board about that commitment.

Second, the Supreme Court held that the 14D-9 was materially misleading because it included statements that Berry was open to considering other bidders and rolling over his equity in such transactions. The minutes from the board’s October 15 board meeting indicated, however, that Berry only committed to rolling over his equity if he was confident in the purchaser’s experience in the retail food industry, and he stated that Apollo was “uniquely qualified” in that respect. Without specifically addressing this alleged disclosure deficiency, the Court of Chancery held that Berry’s involvement with and commitment to Apollo was adequately disclosed. In contrast, the Supreme Court reasoned that stockholders would want to know facts suggesting that Berry preferred Apollo because these facts concern “the openness of the sale process.”

Third, the Supreme Court focused on statements in the November 28 e-mail from Berry’s counsel to Company counsel that Berry believed the board should pursue a sale of the Company “at this time,” and that he would sell his shares if the board failed to act. The Court of Chancery concluded that the omission of these facts from the 14D-9 was not material because “it would not have made investors less likely to tender.” The Supreme Court emphasized that the materiality standard considers whether there is a substantial likelihood that a reasonable stockholder would have considered the omitted fact important—not whether it would have caused the stockholder to change his or her vote. To this end, the Supreme Court held that stockholders “would want to know the rationale that Ray Berry gave the Board in encouraging it to pursue the sale, as well as his communication of his intent to sell his shares if such a transaction were not consummated.” In so reasoning, the Supreme Court cited to the decision it issued earlier this year in Appel v. Berkman, which held that the Schedule 14D-9 issued by Diamond Resorts International was materially misleading because it omitted information about why the company’s founder, chairman, and largest stockholder abstained from voting on proceeding with merger discussions. The company’s founder abstained because he thought mismanagement of the company had depressed the sale price and it was the wrong time to sell the company—facts the Supreme Court concluded would have been of interest to stockholders. Likewise, in Morrison, the Supreme Court held that stockholders would have been interested to know Berry’s rationale for pursuing the Apollo transaction.

Finally, the Supreme Court held that the 14D-9 was materially misleading in that it stated the Company created a special committee in October 2015 because it “could become the subject of shareholder pressure,” when in fact the contemporaneous board minutes reflected that the Company had already encountered “a significant amount” of stockholder pressure. The Supreme Court reasoned that, because the Company chose to address why the special committee was created, “stockholders were entitled to know the depth and breadth of the pressure confronting the Company” and that “it already existed.”

Because the 14D-9 was materially incomplete and misleading, the Supreme Court concluded that the stockholders’ decision to tender their shares was not fully informed, and the business judgment standard did not apply under Corwin. In so holding, the court warned directors and the attorneys who advise them to avoid “partial and elliptical disclosures,” which “cannot facilitate the protection of the business judgment rule under the Corwin doctrine.”

Takeaways

• Morrison demonstrates the Supreme Court’s willingness to closely scrutinize a company’s contemporaneous documents to see if they support the facts disclosed to stockholders. The court’s apparent willingness to so scrutinize the underlying record appears motivated by its recognition that “[c]areful application of Corwin is important due to its potentially case-dispositive impact.”
• In light of the court’s willingness to carefully examine the underlying record, Morrison reminds practitioners of the importance of full and accurate disclosures. This is especially so considering stockholder plaintiffs’ growing reliance on section 220 of the Delaware General Corporation Law as a means of avoiding dismissal by showing discrepancies between the record and the disclosures.
• Particular attention should be given to disclosures relating to the motivations and analysis of key board members and stockholders, given the Supreme Court’s decisions in Morrison and Appel.