Reviewing the CROWDFUND Act

The JOBS Act (backronymed to “Jumpstart Our Business Startups Act”), which has passed both houses of Congress and is awaiting signature by President Obama, contains a provision known as the CROWDFUND Act (also backronymed to “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act”), which provides an exemption to federal securities registration for business that sell equity through the crowdfunding method to raise capital.

Here’s a breakdown of the provisions in the CROWDFUND Act portion in the JOBS Act:

  • Issuers cannot raise more than $1 million from the sale of securities in a 12-month period
  • Investors are limited during any 12 month period in the amount they can invest in crowdfunding companies, depending on their net worth and annual incomes:
    • The greater of $2000 or 5% of the annual income or net worth of investors with an annual income or net worth less than $100,000
    • The lesser of $10,000 or 10% of the annual income or net worth of investors with an annual income or net worth equal to or greater than $100,000
  • Crowdfunding transactions must be conducted through a broker or funding portal that complies with several provisions:
    • Be registered with the SEC as a broker, or be an exempt funding portal
    • Register with a self-regulatory organization
    • Provide investor education materials and disclose risks of investment (including risk of loss, illiquidity of shares, etc.)
    • Perform background and securities regulatory enforcement checks on issuers, their officers, directors, and persons holding more than 20% of the equity in an issuer
    • Provide to the SEC and potential investors any and all information provided by the issuer at least 21 days before the sale of securities
    • Only permit distribution of proceeds once capital raised hits target amount; allow investors to cancel commitments to purchase pursuant to conditions as to be determined by the SEC
    • Ensure that no investor has exceeded their investment limits
    • Avoid compensation for solicitation of or leads on potential investors
    • Prohibit investment or other financial interest in issuers using its services
    • Funding portals are exempt from having to register with the SEC as a broker or dealer so long as it:
    • Remains subject to examination, enforcement, and authority of the SEC
    • Is a member of a national securities association
    • Does not engage in the following activities:
      • Offer investment advice or recommendations
      • Solicit purchases, sales, or offers to buy securities
      • Compensate individuals for solicitation or otherwise based on the sale of securities
      • Hold investor funds or securities
  • Issuers must also comply with numerous provisions:
    • Provide the SEC with the following information:
      • Name, legal status, physical and website address of the issuer
      • Names of offers and directors (or anyone acting in a like capacity)
      • Description of the business and anticipated business plan
      • Description of financial condition:
        • For offerings less than $100,000, the latest tax return for the business, and financial statements certified by a corporate officer to be true and complete
        • For offerings between $100,000 and $500,000, financial statements reviewed by an independent public accountant
        • For offers above $500,000, audited financial statements
      • Description of the intended use of the capital sought
      • The target offering amount, the deadline for reaching the target, and regular progress reports in meeting the target
      • The price of the securities or the method for determining the price (prior to final sale, investors must be provided the final price in writing along with all required disclosures, with an opportunity to rescind commitment to purchase)
      • Description of the capital structure and ownership of the issuer:
        • Terms of the security being offered, and the terms of all other classes of securities
        • How terms may be modified and a summary of differences between classes of securities
        • Descriptions of how the securities being offered may be materially limited, diluted, or qualified by any other class of securities
        • How the rights of principal shareholders may negatively affect purchasers of the securities being offered
        • The names and equity positions of each person holding more than 20% equity
        • How the securities are being valued and how they may be valued by the issuer in the future
        • The risks to purchasers relating to minority ownership, the issuance of additional securities, a sale of company assets, or a sale of the company
    • Issuers must not advertise terms of the offering, except to direct potential investors to the broker or funding portal
    • Avoid compensation for promotion of offerings through the broker or funding portal without adequately disclosing such compensation
    • File with the SEC and provide to investors annual (or more frequently as the issuer may choose) reports of operations and financials
  • Purchasers may bring a cause of action against an issuer to rescind a transaction for any material misstatement or omission (issuer’s agents are also liable)
  • Purchasers may not transfer securities within one year of the date of purchase, except to the issuer, an accredited investor, as part of a public offering, or to a family member in connection with death or divorce
  • Issuers may be disqualified based on conditions to be determined by the SEC, including any individual who has been convicted of securities laws violations

With almost each of these provisions, the CROWDFUND Act gives the SEC the authority to promulgate additional rules as necessary.

The ultimate crowdfunding legislation turned out much more complicated than Congressman Patrick McHenry’s original bill in the House, largely due to Senate Democrats’ fears that crowdfunding exemptions would erode important investor protections and lead to a return of so-called “boiler room” operations and increased securities fraud. The CROWDFUND Act contains multiple provisions regarding information issuers must provide to the SEC and potential investors and rules funding portals or brokers must comply with in order to provide a crowdfunding service, aimed largely at assuaging the fears of crowdfunding opponents. What is troublesome about the CROWDFUND Act is its creation of a cause of action for material misstatements or omissions, akin to Section 10b-5 liability. However, 10b-5 liability applies to registration statements — the CROWDFUND Act is an exemption to registration — and doesn’t hold issuer agents, such as attorneys, who don’t necessarily provide the figures and opinions contained in a registration statement, whereas the CROWDFUND Act’s liability provision appears to do so. The CROWDFUND Act also doesn’t appear to address how it will operate with state securities laws (ideally, a crowdfunding exemption would have a Rule 502 offering-like preemption of state securities registration requirements).

It remains to be seen over the next six to nine months what additional rules and regulations the SEC adopts pursuant to the CROWDFUND Act, particularly if they address the Act’s relationship to state securities laws, and whether they adopt safeharbor provisions for things like purchaser qualifications or the Act’s liability provision.

Should Employers Require Prospective Hires to Provide Access to their Social Media Profiles?

There has been recent buzz regarding the new trend among employers to require prospective hires to provide the company their are applying to with the username and passwords to their Facebook, Twitter, or private email accounts, or log into and browse said accounts in the presence of the interviewer, or friend the employer or a human resources representative so they can view the prospect’s social media profiles. Ostensibly, such a policy is designed to allow employers to get a look into the personal lives of prospective hires to ensure that they, say, are not involved in criminal activity, or otherwise undertake public activity that may reflect poorly on the company.

However, a firestorm has erupted over such policies, not only from privacy advocates who consider the practice too intrusive, but also over the questionable legality of the practice. Although the consensus of the “Facebook generation”, whether they are employees — or employers — is likely to be generally against the practice, given the large proportion of startup employees who are of the Facebook generation and the fact that every employee of a startup or small company reflects significantly on the company, policies requiring disclosure of access to prospective hires’ social media profiles may be something that some startups are considering.

I am of the opinion the practice is likely illegal; if it is technically legal, at the very least, the practice asks for more trouble than it is worth. Every employer knows (or should know) that there are facts about a prospective hire the company may not ask, such as the individual’s race, national origin, religion, martial status, family status, or sexual orientation, for example. However, information such as this may be found on or gleaned from a person’s social media profiles. In my view, asking a prospective hire for access to his or her Facebook profile is like asking about his or her religious affiliation or sexual orientation — the employer will learn the information either way.

If even the courts were to disagree with me, the practice still leaves employers at risk for litigation. For example, if an employer were to request and receive access to a prospective hire’s Facebook profile, and on that profile saw that the individual was of a different national origin, and then failed to hire the prospect, the prospect might launch a discrimination suit against the company on the basis that the company learned he or she was from a different country from his or her Facebook profile and then refused to hire him or her on that basis. Regardless of the merits of the suit, the company will still have to expend time and money addressing it, not to mention the bad press that will result from an employment discrimination suit. Moreover, by requesting access to a prospective hire’s social media profiles, the employer must take on the burden of protecting information from those profiles and securing it from leaking outside of the employer (which would most certainly constitute a violation of the prospect’s privacy), which is a burden that employers may not be willing or able to take on.

In any event, this week Congress introduced legislation that would make it illegal for employers to request access to a prospective hire’s social media profiles. Given the generally negative public reaction to this practice, it is likely that even this Congress will pass legislation on this issue fairly quickly. So for any company considering asking prospective hires for access to their Facebook, Twitter, or email accounts, I would discourage they initiate the practice. Instead, if businesses are concerned about employees’ social media profile reflecting poorly on the company, I would recommend that employers put social media policies in their employee handbooks requiring that employees refrain from making personal social media postings that disparage the company.

Securities Reform Bills in Congress

The U.S. Senate is currently debating the Jump-Start Our Business Start-ups Act (JOBS Act), which recently passed the House by a nearly 375-vote margin. The aim of the bill is to make access to public capital markets easier for smaller businesses. However, opponents of the Act claim it will have the effect of stripping away important securities regulation protections, requiring only the largest companies to have to comply with the stringent registration and filing requirements of the SEC. For starters, the JOBS Act defines a small business — referred to in the bill as an “emerging growth company” — as one with annual revenues below $1 billion. Companies that fall under the definition of an “emerging growth company” have relaxed standards on the information they must provide in their prospectus to potential shareholders, and is also exempted from the executive compensation rules under Sarbanes-Oxley and Dodd-Frank. The bill also raises the limit on shareholders in a private company from 500 to 2,000. Furthermore, the bill also allows for the blurring of roles between investment bankers underwriting an offering whose job it is to sell the securities, and the securities analysts whose job it is to provide impartial advice and analysis to investors.

More targeted towards startups and early stage ventures is legislation also being debated in the Senate to approve crowdfunding. I recently attended a panel forum with Congressman Patrick McHenry and Senator Scott Brown, two of the primary proponents of crowdfunding in Congress and who have sponsored bills to authorize it. Congressman McHenry’s bill, which also recently passed the House by a nearly 400-vote margin, is perhaps the most liberal of the crowdfunding bills in Congress — it authorizes offerings of up to $1 million, which do not count against the the limits in other securities registration exemptions; individuals are allowed (depending on their personal financial situation) to invest up to $10,000 a year in crowdfunding offerings. Most importantly, the McHenry bill allows true general advertising and solicitation, in that companies can likely offer their securities through social networks like Twitter and Facebook.

On the Senate side, Senator Brown recently merged his bill with another crowdfunding bill sponsored in the Senate by Senator Jeff Merkley. The new combined Brown/Merkley bill is much stricter than the McHenry bill that passed the House — it too allows up to $1 million in crowdfunding offerings, but counts it against other securities registration exemption limits, and also limited individual investors from only investing up to $2,000 a year in crowdfunding offerings. Companies are also required to use some sort of intermediary (including perhaps an online crowdfunding portal) to sell the securities. The bill also creates a cause of action against any director, partner, executive officer, controller, or other top management official in a company for materially false or misleading statements. Finally, the bill directs the SEC to establish a new regulatory scheme for crowdfunding offerings.

Although the Brown/Merkley bill looks likely to ultimately pass the Senate, it is still unclear at this point what shape the bill will take when the House and Senate versions are merged in conference committee.

Further reading: “In Latest Jobs Bill, a Billion-Dollar Is Now Small”

Majority-owning LLC Managers in Delaware Have Fiduciary Duties to Minority Owners

The Delaware Chancery Court passed down a decision this week in the case Auriga Capital Corp. v. Gatz Properties LLC, C.A. No. 4390-CS (Del. Ch., Jan. 27, 2012) involving majority-stake-owning LLC managers’ fiduciary duties to minority stakeholders in the LLC. The case involved a golf course property owned by the LLC; the manager of the LLC, who along with his family owned the majority stake in the LLC, used his position as manager to effectively squeeze out minority owners and obtain total control of the LLC at a less than fair price by vetoing potential bids and conducting a sham auction with himself as the only bidder.

The Delaware Chancery Court ruled that default fiduciary duties apply to LLC managers unless those duties (with the exception of the duty of good faith and fair dealing) are expressly limited or eliminated by the LLC’s operating agreement. A manager’s fiduciary duties towards minority stakeholders requires the manager not to economically oppress or otherwise coerce or duress minority stakeholders into unfavorable positions (in this case, selling full control of the LLC to the majority-stakeholder manager for less than the fair value of the minority’s stake).

Although the case nominally affects Delaware law, it is worth being mindful of in other states whose courts have yet to tackle the issue of LLC majority stakeholder manager fiduciary duties, especially in respect to the minority stakeholders of the LLC, as Delaware has often been a trendsetter in the area of business law. It is also further important for entrepreneurs and startup owners to be cognizant of this potential trend in LLC law, particularly as many startup ventures are organized as LLCs. Entrepreneurs must be mindful to exercise fiduciary duties, especially the duties of good faith and fair dealing, towards particularly passive minority investors such as family/friends and nonprofessional angel investors.

Who owns the Twitter Feed? Why your business needs a social media policy.

The intellectual property series will be back next week; today I’d like to discuss a story that’s been in the news recently…

You may or may not have already heard the story of Noah Kravitz, a man from Oakland, CA who worked at a mobile phone website start-up,, until October 2010. While working at, Kravitz opened a Twitter account under the handle Phonedog_Noah, eventually gaining over 17,000 followers. When Kravitz left in October 2010, he claims he and the company agreed that Kravitz could keep the Twitter account so long as he tweeted on behalf of the company from the account from time to time. Kravitz changed the handle to NoahKravitz and continued tweeting from the account, until eight months later when sued Kravitz for control of the Twitter account, claiming it represented a customer list that the company was entitled to.

Based on what I’ve read of the case, I do not believe’s argument that the Twitter account represents a customer list holds up — not only is it likely untrue that every follower on the feed is also a customer or potential customer of the company, but in order to protect against disclosure of customer lists the law requires that companies protect the lists as well, taking reasonable steps to keep them private and secret. In this case, Twitter accounts’ followers lists are publicly viewable, so the customer list argument must fail.

The better argument, and what I believe is truly at the crux of the case and ones like it currently in courts around the country, is whether a Twitter feed operated by an employee, wholly or in part for the benefit of the company, is part of the company’s goodwill (in the accounting/business sense) and therefore belongs to the company, or whether the account truly is the personal property of the employee operating it. A number of factors can go into analyzing this issue, including: whether the individual who created and is operating the account does so at the direction of the company, whether other employees not operating the account have or can gain access to the account, whether the handle includes part or all of the company name or the look and image of the account is otherwise identifiable with the company (for example, using the company’s logo in the avatar or website background), whether the content is dedicated wholly or in part to the company, and whether users consider the content to be the official message of the company or otherwise coming directly from the company. Under this analysis, I believe may have a better argument that the account belongs to it and not to Mr. Kravitz.

This story and others like it should serve as a warning to start-ups, most of which rely heavily on social media and networking as part of its marketing and public relations strategy. When companies direct or encourage employees to create company-related social media accounts, they should have written agreements in place that clearly state such accounts are the property of the company. In addition, businesses should also consider taking steps to ensure they maintain control over the company’s social media message by reasonably limiting employees’ ability to post social media content relating to the company — for example, prohibiting employees, without prior authorization, from making accounts with the company’s name or logo, or posting content that claims to be or can reasonably be inferred as the official message of the company.

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