Tuesday, July 22, 2014

Bainbridge on Law Reviews

Steve Bainbridge has an interesting response to yesterday's post on law reviews, linking to a number of other interesting posts he has written. Definitely worth reading. (He agrees with me, so he must be correct.)

A number of you commented on my post yesterday. I will get those posted sometime today.  Sorry for the delay. My wife and I got back home this morning at 2:30 a.m. from a wonderful vacation trip to San Diego. (Yesterday's post was scheduled in advance; we have a firm no-work rule during vacations.) 

July 22, 2014 in C. Steven Bradford, Law School | Permalink | Comments (0)

Monday, July 21, 2014

Remind Me: What's the Point of Law Reviews?

A couple of weeks ago, I posted a review of an article on mutual fund fee litigation. In my post, I apologized for reviewing the article “late.”

I thought about the use of the word “late” after I posted. The article has been available on SSRN, the Social Science Research Network, since March, but it has not yet been published in a law review. But, in the world of blogs and instant access to everything, waiting until publication in print truly is late.

Most legal articles are now posted on SSRN as soon as they are finished, and I, like many other law professors, don’t wait until publication to read articles in my areas of interest. I pull those articles straight off SSRN. SSRN helpfully provides subject-specific emails with abstracts and links to newly posted articles.

My first crowdfunding article had hundreds of downloads before it appeared in print. It came out in a law review at almost the same time the final crowdfunding bill passed Congress; if I had not posted it on SSRN, it would have had no chance to affect the debate. (I’m not sure it had much effect anyway. The drafters of the final bill may have heard some of the notes of my composition, but they certainly missed the melody.)

So, in a world where articles are publicly available and read long before they appear in law reviews, what exactly is the value of law reviews? Most of their content is stale by the time it’s published.

Law reviews as filters

Law reviews certainly don’t do much to filter “unworthy” publications. Law reviews have proliferated to the point that almost anything can be published in a law review somewhere.

Law reviews as signals of quality

The law review in which an article appears may signal the article’s quality; if so, that signal usually comes too late. By the time an article appears in print, I and many others have already decided whether to read it. And reading an article’s abstract and introduction usually provides a much better sense of its quality than the journal name attached to it. Faculty members and expert practitioners are much better judges of the quality of articles in our fields than a student editor without significant expertise in the area. I know this is heresy, but even Harvard and Yale sometimes publish crap.

Law review placement also shouldn’t be used as a quality signal in evaluating untenured faculty members. Tenured faculty members who cede judgments of quality to second and third year law students, even the law review editors at prestigious law schools, aren’t doing their job.

Law reviews as editors

Law reviews provide editing, but, in my experience, that editing is as likely to reduce the quality of an article as to improve it. I can think of several instances where student editing made my article marginally better—including one brilliant addition to a footnote in a humorous article I wrote. (Thank you, Northwestern Law Review editors.) But I can also think of several edits inserted at the last minute without my approval that made articles significantly worse. I can’t think of a single instance where student editing kept me from making a serious substantive mistake.

Law reviews and accessibility

Once articles are published in law reviews, they’re available on Westlaw and Lexis, and thus more broadly accessible. But there’s no reason why availability needs to be tied to law review publication. If law reviews didn’t exist, Westlaw and Lexis would find a way to tie into the SSRN system. Or the free, publicly available SSRN system might eventually supplant Westlaw and Lexis, at least for law review articles.

Law review as an educational experience

I have been focusing on the needs of authors and readers. But what about the student editors? Don’t law reviews provide them with a valuable educational experience?

I see little value in educating students in the fine minutiae of Bluebook citation form, and most actual editing is done by students with little or no professional instruction or supervision. Advanced courses in writing, editing, and legal research could provide better instruction more efficiently.

So I repeat—what’s the value of law reviews?

July 21, 2014 in C. Steven Bradford, Law School | Permalink | Comments (19)

Monday, July 14, 2014

The Key to Economic Recovery? Paying Me More

Reason.com has an interesting piece on the use of fallacious or unsupportable economic arguments by politicians.

My favorite economic fallacy, which the Reason article doesn’t discuss, is the use of multipliers to falsely exaggerate the effect of government spending. Universities tend to do this a lot: “Every taxpayer dollar spent at Enormous State University results in a $50 gain to the state economy.” To justify claims like this, you simply trace the dollars spent through multiple levels. If the university spends $100 to repair a window, that’s $100 of additional business for a local company. That company, in turn, uses the $100 to pay an employee. The employee uses the $100 to buy groceries at a local grocery store. The store then pays the $100 to a local farmer for her produce. The farmer then spends the $100 to buy supplies, etc. We’re already up to a $500 effect, and there’s no need to stop there. If you trace it through a sufficient number of transactions, the effect is enormous, even though it’s still only $100.

Using that same reasoning, it’s obvious that the key to economic recovery is to significantly increase my salary. Each dollar I receive has an enormous effect on the national economy. I use some of the money to buy groceries, gas, books, and a number of other consumer goods, helping to sustain a variety of retailers and service providers. They in turn, use my money to hire employees and buy products from producers, who in turn hire additional employees and buy additional goods and services. The money I don’t spend is put into accounts at banks and mutual funds, which use the money to invest in new and existing businesses, promoting economic growth and facilitating the hiring of additional employees.

Given the enormous multiplier effect paying me has on the economy, the solution to our current economic stagnation is obvious: pay me more.

July 14, 2014 in C. Steven Bradford | Permalink | Comments (2)

Thursday, July 3, 2014

Lawyers: Be Careful with Email

Monday, June 30, 2014

The Flawed Mechanics of Mutual Fund Fee Litigation

I have been catching up on my long backlist of reading and recently read an excellent article on litigation challenging the fees of mutual fund advisers: Quinn Curtis and John Morley, The Flawed Mechanics of Mutual Fund Fee Litigation.

As you may know, section 36(b) of the Investment Company Act of 1940 gives mutual fund investors and the SEC a cause of action to challenge excessive investment adviser fees.
Section 36(b) has generated quite a bit of academic commentary; Curtis and Morley’s footnote listing those articles (fn. 4, if you’re interested) takes up more than a page of single-spaced text. The Supreme Court has also recently chimed in on section 36(b). Jones v. Harris Assocs. L.P., 559 U.S. 335 (2010) discussed the standard for reviewing advisors’ fees under section 36(b).

Don’t worry; Curtis and Morley don’t rehash all of the earlier commentary. Instead, they take the existence of a section 36(b) cause of action as a given and ask how it can be improved to better achieve its purposes. Here’s the abstract:

We identify a number of serious mechanical flaws in the statutes and judicial doctrines that organize fee liability for mutual fund managers. Originating in section 36(b) of the Investment Company Act, this form of liability allows investors to sue managers for charging fees above a judicially created standard. Commentators have extensively debated whether this form of liability should exist, but in this paper we focus instead on improving the mechanics of how it actually works. We identify a number of problems. Among other things, statutes and case law give recoveries to investors who did not actually pay the relevant fees. Statutes and case law also impose no penalties to provide deterrence; they treat similar categories of fees differently; they create an unusual settlement process that prevents litigants from settling their full claims; they expose low-cost advisers to serious litigation risk; they exhibit deep confusion about what makes fees excessive; and they provide unduly small incentives for plaintiffs’ lawyers that are only adequate in cases of low merit. Most of these problems appear to be the unintended results of accidents and confusion, rather than deliberate policy choices. We conclude by offering specific ideas for reform.

The article, to be published in the Yale Journal of Regulation, was posted on SSRN in March, but it’s been sitting in my computer reading file since then. Better late than never. If you’re interested in the regulation of mutual funds and investment advisers, it’s definitely worth reading.

June 30, 2014 in C. Steven Bradford, Securities Regulation | Permalink | Comments (0)

Monday, June 9, 2014

Best Country for a Securities Professor to Visit?

Today, rather than my usual profound insights, I’m going to pose a question to our readers. (What do you mean, what “usual profound insights”?)

I have been thinking about applying for a Fulbright to teach overseas. The problem is that Fulbright applications are country-specific and I’m having trouble deciding where I would like to teach.

There are several ways to approach this problem. The first approach would be to look for the greatest possible geographical distance from Lincoln, Nebraska. I think this would be my Dean’s preference. But, as my Dean will tell you, pleasing her is almost never one of my criteria.

The second approach would be to choose the place with the greatest beach. This seems like a sound approach to me, but there seems to be a serious shortage of teaching opportunities in places like Tahiti.

That leaves but one possibility—choosing a location that best fits my particular teaching and research interests. My primary focus is securities regulation, particularly the application of securities law to small businesses. Given that focus what would be the best country to visit? Where would I find both (1) interesting things going on in securities regulation of small businesses and (2) people interested in learning about the U.S. approach to these issues?

China is an obvious choice, but what other countries would make sense? (I’m a coward, so please don’t suggest any countries that would require me to dodge bullets.)

Here’s your chance, blog readers: tell me where to go. (Keep it nice.)

June 9, 2014 in C. Steven Bradford, Securities Regulation, Travel | Permalink | Comments (8)

Monday, April 14, 2014

Will Delaware Plug the 102(b)(7) Hole?

Delaware, like most states, has a provision in its corporate statutes allowing corporations to limit directors’ liability for breaches of fiduciary duty. Delaware section 102(b)(7) allows corporations to include in their charter “a provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages" for certain breaches of fiduciary duty.

A recent Delaware case plows a huge hole through the protection provided by a section 102(b)(7) charter provision. In the Rural Metro case [In Re Rural Metro Corp. Stockholders Litigation, 2014 WL 971718 (Del. Ch. Mar. 7, 2014)], the Delaware Court of Chancery held that a 102(b)(7) provision does not protect against claims that non-directors aided and abetted a duty-of-care violation by directors, even when the directors themselves are protected.

The Chancery Court’s reasoning is sound. Section 102(b)(7), and the associated charter provision, don’t say there’s no breach of fiduciary duty, just that directors aren’t personally liable for damages. The underlying conduct by the directors is still a breach of fiduciary duty, and injunctive relief is still available, just no money damages.Since there’s still a breach of duty, and the statute says nothing about the liability of aiders and abettors, the court concluded that aiders and abettors can still be liable if: (1) the directors breached their fiduciary duties; (2) the third party knew the directors were breaching their fiduciary duties; and (3) the third party participated in the breach.

The court ultimately held that RBC Capital Markets, LLC was liable for aiding and abetting. I can't do justice to the facts in the space available here; I highly recommend a reading of this important opinion.

The real question is whether the Delaware legislature will let this holding stand. The Chancery Court’s statutory reasoning is sound, but that doesn’t mean the result is necessarily good policy. Investment bankers, brokers, accounting firms, and other third party providers, perhaps even lawyers in some cases, are exposed to the risk of liability under this holding. Even if they ultimately win on the merits, as I suspect many will, the litigation itself will be costly. That cost will, of course, be passed on to the corporations using the services of those third parties.

There’s a possible gain associated with that cost, of course: the possible increased deterrence of breaches of fiduciary duty by corporate directors. But the Delaware legislature, in adopting section 102(b)(7), has already decided that other considerations outweigh the deterrent effect of imposing liability on the directors themselves.

Two Legislative Options

Plugging the Rural Metro hole is easy. A simple amendment to 102(b)(7) would do the trick. But how the Delaware legislature chooses to amend the statute (if it does) is important.

One way would be to authorize corporations to include provisions in their charters protecting not only directors, but also people who aid and abet violations by the directors. If that's all the Delaware legislature did, the protection from liability would not be automatic. Companies with 102(b)(7) exculpation provisions would have to amend their charters to protect aiders and abettors.

A simpler, neater solution would make the protection of aiders and abettors automatic. The legislature could just add a sentence at the end of 102(b)(7) providing that aiders and abettors are not liable when the directors themselves are protected from liability. Something like the following would work: “Unless otherwise specified in the certificate of incorporation, no person shall be liable for money damages for aiding and abetting an action protected by such a provision.”  If the legislature did this, no further corporate action would be needed to make this protection effective. Only companies that did not want aiders and abettors protected would have to amend their charters.

Stay tuned to see what, if anything, the Delaware legislature does.

April 14, 2014 in Business Associations, C. Steven Bradford, Corporations, Delaware | Permalink | Comments (0)

Monday, March 24, 2014

Comprehensive Law School Bibliography

  Faculty Bib book cover

Two of the reference librarians at my school, Marcia Dority Baker and Stefanie Perlman, have compiled and published a bibliography of all the scholarship by Nebraska College of Law faculty going back to 1892: Marcia L. Dority Baker & Stefanie S. Perlman, A BIBLIOGRAPHY OF UNIVERSITY OF NEBRASKA COLLEGE OF LAW FACULTY SCHOLARSHIP 1892-2013 (2014).

I don’t know if others schools have done anything like this, but I think it’s a great idea. It’s really interesting to look at what people were writing one hundred years ago, and to consider the body of work of my current colleagues, only a couple of whom I believe were here a hundred years ago. I found the 14 pages of entries for the great legal scholar Roscoe Pound, including dozens of books, humbling.

On the domestic front, I’m happy to report that my listing is twice as long as my wife’s, although I’m not sure she will be happy to know that I reported that. I want to make it clear that she was not here a hundred years ago.

March 24, 2014 in Books, C. Steven Bradford, Law School | Permalink | Comments (0)

Monday, March 10, 2014

It's Time to Update the Securities Act

The federal restrictions on offering securities are a mess. Section 5, even with the recent additions of subsections (d) and (e), is short—less than 600 words by my count. However, as every Securities Regulation student comes to appreciate, that brevity is deceptive. Section 5 is incredibly complex. The SEC regulations increase that complexity: almost everything in Section 5 has been modified or displaced by SEC regulations.

Consider just the question of what an issuer may say before filing its registration statement. Section 5(c) says the issuer may not make an offer to sell the securities. But the SEC says “offer to sell” means more than just asking people to buy the securities. It includes any communication, even if you don’t mention the offering, that might generate public interest in buying the security, what the SEC calls conditioning the market. But, if it’s more than 30 days prior to when you’re going to file your registration statement, see Rule 163A. After that, see Rule 163, Rule 168, or Rule 169, depending on what type of company you are. But don’t mention the offering in any of those communications, unless, of course, you fit within Rule 135.

Or consider section 5(b)(1)’s bar on transmitting a written offer to sell. Rule 433, the free-writing prospectus rule, has rewritten that statutory prohibition so extensively that the Rule 433 tail now wags the section 5(b)(1) dog. And then there’s Rules 172 and 173, which almost completely displace the final prospectus delivery requirements of sections 5(b)(1) and 5(b)(2).

Many of these regulations improve the statutory scheme, although simpler rules would be even better. But isn’t it about time to revise the statute, instead of constantly engrafting regulatory exceptions and rewrites on to the aging, obsolete statutory structure?

A statute that says “x” and a rule that says “but not x” don’t exactly promote public respect for the rule of law. Consider the way Rule 172(b) is written—it essentially says that any obligation under section 5(b)(2) to deliver a prospectus is satisfied if you don’t deliver a prospectus.

Wouldn’t it be better to have the rules assembled in an organized, coherent whole, instead of having to jump from place to place to figure out what’s allowed and what isn’t? If the SEC’s approach makes more sense, and in many cases I think it does, then let’s change the statute to reflect the SEC’s approach. In many cases, all the existing statute does is complicate the SEC’s rulemaking task.

It’s against my interest to suggest this. I teach two securities law classes, and statutory changes just mean more work for me. But I think it’s time we rewrote the Securities Act.

March 10, 2014 in C. Steven Bradford, Securities Regulation | Permalink | Comments (0)

Monday, March 3, 2014

Book Review: Harriman vs. Hill

What happens if short sellers of stock are unable to cover because no one has any shares to sell? That’s one of the many interesting issues in the new book, Harriman vs. Hill: Wall Street’s Great Railroad War, by Larry Haeg (University of Minnesota Press 2013). Haeg details the fight between Edward Henry Harriman, supported by Jacob Schiff of the Kuhn, Loeb firm, and James J. Hill, supported by J.P. Morgan (no biographical detail needed), for control of the Northern Pacific railroad. Harriman controlled the Union Pacific railroad and Hill controlled the Great Northern and Northern Pacific railroads. When Hill and Harriman both became interested in the Burlington Northern system and Burlington Northern refused to deal with Harriman, Harriman raised the stakes a level by pursuing control of Hill’s own Northern Pacific.

I’m embarrassed to admit that I wasn’t aware of either the Northern Pacific affair or the stock market panic it caused. I had heard of the Northern Securities antitrust case that grew out of the affair; I undoubtedly encountered it in my antitrust class in law school. (Everything the late, great antitrust scholar Phil Areeda said in that class is still burned into my brain.)

I’m happy I stumbled across this book, and I think you would enjoy it as well. Harriman vs. Hill has everything needed to interest a Business Law Prof reader: short selling; insider trading; securities fraud; a stock market panic; a hostile takeover; a historical antitrust case; and, of course, J. P. Morgan. This was a hostile takeover before hostile takeovers were cool (and before tender offers even existed, so the fight was pursued solely through market and off-market purchases).

The book does have a couple of shortcomings. One is a polemic at the end of the book against the antitrust prosecution. The antitrust case was clearly a political play by Theodore Roosevelt, and Haeg may be right that the railroads’ actions were economically defensible, but his discussion is a little too one-sided for my taste. Haeg also has a tendency to put thoughts into the characters’ minds (Hill might have been thinking . . .), but he only uses the device to add factual background, so it isn’t terribly offensive. Finally, Haeg occasionally gets the legal terminology wrong. For example, he refers to the railroad holding company “that the U.S. Supreme Court narrowly declared unconstitutional,” when what he means is that the court upheld the law outlawing the holding company. He only makes legal misstatements like that a couple of times, but those errors are very grating on a lawyer reading the book.

Still, in spite of those minor flaws, this is a very good book and I highly recommend it.

March 3, 2014 in Business Associations, Books, C. Steven Bradford, Corporate Governance, Corporations, Financial Markets, Merger & Acquisitions, Securities Regulation | Permalink | Comments (0)

Monday, February 10, 2014

Crowdfunding Problems? Blame Congress, Not the SEC

The SEC is taking some flak from crowdfunding proponents for its crowdfunding rules. Sherwood Neiss, one of the early proponents of a crowdfunding exemption, has taken the SEC to task, as has Representative Sam Graves, the chair of the House Committee on Small Business. See also this article.

These critics point out, correctly, that the crowdfunding exemption is too expensive and restrictive. The problem is that the critics are aiming at the wrong target. I’m no SEC apologist; I have criticized its approach to small business and the structure of its exemptions on a number of occasions. But, in this case, it’s not the SEC that deserves the blame. It’s Congress.

Almost everything the critics are concerned about originates in the statute itself, not in the SEC’s attempt to implement the statute. I pointed out the many problems with the JOBS Act’s crowdfunding exemption almost 18 months ago. The unnecessary cost, complexity, and liability issues the critics are currently complaining about are statutory problems.

Yes, the SEC has some discretion to change some of the objectionable provisions, but one should hardly expect the SEC, with no experience whatsoever with crowdfunding, to overrule the express requirements adopted by Congress. If anything, as I have pointed out here and here, the SEC is to be commended for cleaning up some of the problems created by the statute. 

The crowdfunding exemption is terribly flawed, but it’s not the SEC’s fault. If you’re looking for someone to blame, Congress is the place to start, particularly the Senate, which is responsible for the substitute language that became the final crowdfunding bill. The crowdfunding exemption needs to be fixed, but it’s Congress that will have to fix it.

February 10, 2014 in C. Steven Bradford, Entrepreneurship, Securities Regulation | Permalink | Comments (0)

Thursday, January 23, 2014

Top 5 Legal Mistakes Made by Startups

Aaron George at Under30CEO has a nice post on the top five legal mistakes made by startups. Not much new to those of us who are lawyers, but it's a nice summary of some of the mistakes startups can make.

I could quibble with his list. I think selling securities without complying with securities law ought to be there somewhere, and I think his No. 5--not hiring a lawyer--ought to be No. 1. But his list does include some of the common legal mistakes made by budding entrepreneurs.

January 23, 2014 in Business Associations, C. Steven Bradford, Entrepreneurship | Permalink | Comments (0)

Monday, January 6, 2014

Bainbridge on Academic Conflicts of Interest

Stephen Bainbridge has an excellent post on the need for academics to disclose conflicts of interest--specifically, who's funding their research. I agree with Steve 100%. If someone's paying an academic for research or for consulting related to the research, I want to know about it.

A conflict of interest does not mean the research is unreliable. (I'm sick of both the left and the right dismissing research out of hand because it was funded by the right-wing [Fill-in-the-blank] Foundation or the left wing [Fill-in-the-blank] Institute.) But, if someone's paying an author for the work, I am going to pay much closer attention to the methodology and the analysis, even if the author otherwise has a good reputation.

January 6, 2014 in C. Steven Bradford | Permalink | Comments (1)

Osovsky on Secondary Trading Markets and Investor Protection

Adi Osovsky, an S.J.D. candidate at Harvard Law School, has posted an interesting new article on SSRN, The Curious Case of the Secondary Market with Respect to Investor Protection.

Here's the abstract:

The primary mission of the U.S. Securities and Exchange Commission is to protect investors. However, current securities regulation clearly separates between public markets and private markets with respect to investor protection. While the federal securities laws impose strict and costly disclosure and anti-fraud requirements on issuers that offer their securities to the public, they exempt private offerings from such rigid regime. The liberal approach toward private offerings is based on the assumption that investors in private markets are sophisticated and thus can "fend for themselves".

This Article explores the validity of such traditional dichotomy between the public market and the private market in a relatively new, organized secondary market for ownership interests in private companies with retail investor access (the "Secondary Market"). The Secondary Market provides investors and employees with an opportunity to sell their holdings even before the first exit event. It also allows greater flexibility in capital formation, which may enhance productivity and job growth. However, the Secondary Market raises serious problems with regard to investor protection.

As this Article shows, the rise of the Secondary Market has revealed conspicuous cracks in the wall traditionally separating the public and the private markets and the two markets’ participants – the sophisticated investors versus the unsophisticated investors. This separation was undermined by the penetration of unsophisticated investors to the private market sphere and by the erosion of the assumptions regarding the ability of Secondary Market’s participants to fend for themselves.

The Article suggests that the erosion of the sophistication presumption deems the classic dichotomy between the heavily regulated public market and the lightly regulated private market artificial. It calls for a reexamination of the current regulatory regime with respect to investor protection. Such reexamination is of particular importance in light of the new Jumpstart Our Business Startup (JOBS) Act that would enable private companies to stay private longer, and the Secondary Market to thrive.

I haven't read the article yet, but the issue Osovsky addresses is an important one. Even if accredited investors are able to protect themselves in exempted private offerings, the Internet (in conjunction with the liberalization of Rule 144) now makes it much easier for them to resell those securities to unsophisticated investors.

Secondary purchasers will have access to at least some information about the issuer. Rule 144 protects those resales only if the issuer is a reporting company [Rule 144(b)(1)(i)] or if current public information is available about the issuer [Rule 144(b)(1)(ii) and (b)(2), in conjunction with 144(c)]. But is the information required by Rule 144(c)(2) for non-reporting companies sufficient?

January 6, 2014 in C. Steven Bradford, Securities Regulation | Permalink | Comments (0)

Monday, December 30, 2013

Upcoming Crowdfunding Conference

For those of you interested in crowdfunding and the new federal exemption for crowdfunded securities offerings, the University of Cincinnati College of Law is planning a symposium on crowdfunding, to be held on March 28. I and several leading crowdfunding scholars will be presenting papers, and those papers will eventually be published in the University of Cincinnati Law Review.

I will post more details when the official conference announcement is released.

December 30, 2013 in C. Steven Bradford | Permalink | Comments (0)

Monday, December 16, 2013

Crowdfunding Intermediaries' Duty to Protect Against Fraud

I have been pondering one of the provisions in the SEC's proposed crowdfunding rules, and I have decided that it's extremely dangerous to crowdfunding intermediaries.

Reducing the Risk of Fraud: The Statutory Requirement

Section 4A(a)(5) of the Securities Act, added by the JOBS Act, requires crowdfunding intermediaries (brokers and funding portals) to take steps to reduce the risk of fraud with respect to crowdfunding transactions. The SEC is given rulemaking authority to specify the required steps, although the statute specifically requires "a background and securities enforcement regulatory history check" on crowdfunding issuer's officers and directors and shareholders holding more than 20% of the issuer's outstanding equity.

Proposed Rule 301

Proposed Rule 301 of the crowdfunding regulation implements this requirement.

A couple of the requirements of Rule 301 don't really relate to fraud, even though the section is captioned "Measures to reduce risk of fraud." Rule 301(a) requires the intermediary to have a reasonable basis for believing that the issuer is in compliance with the statutory requirements and the related rules. Rule 301(b) requires the intermediary to have a reasonable basis for believing that the issuer has means to keep accurate records of the holders of the securities it's selling. Neither of these requirements is particularly onerous because, in each case, the intermediary may rely on the issuer's representations unless the intermediary has reason to doubt those representations.

Rule 301(c)(2) enforces the background check requirement, as well as the "bad actor" disqualifications in Rule 503. The intermediary must not allow any issuer to use its crowdfunding platform unless the intermediary has a reasonable basis for believing that the issuer, its officers and directors, and its 20% equity holders are not disqualified by Rule 503.  To satisfy this requirement, the intermediary "must, at a minimum, conduct a background and securities enforcement regulatory history check" on each such person.

The Problematic Provision

The part of Rule 301 that really troubles me is the final requirement, in Rule 301(c)(2). The intermediary must deny issuers access to its platform if the intermediary "[b]elieves that the issuer or the offering presents the potential for fraud or otherwise raises concerns regarding investor protection." If an intermediary becomes aware of such information after its has already granted access to the issuer, the intermediary "must promptly remove the offering from its platform, cancel the offering, and return (or, for funding portals, direct the return of) any funds that have been committed by investors in the offering."

If this was all the regulation said, it would make sense: an intermediary can't let known or suspected bad actors use its platform. But that's not all it says. Rule 301(c)(2) adds this little nugget:

"In satisfying this requirement, an intermediary must deny access if it believes that it is unable to adequately or effectively assess the risk of fraud of the issuer or its potential offering."

It's one thing to say an intermediary should shut down the issuer if it's aware of problems or if there are red flags that should reasonably cause concern. But this last provision requires the intermediary to refuse access to the issuer unless it can affirmatively determine that the issuer poses no risk of fraud. And, of course, the only way to "adequately or effectively assess the risk of fraud" is through a full investigation of the issuer and its principals. The cost of fully investigating every issuer on the platform would be prohibitive, and certainly too much for the returns likely to be generated by hosting offerings of less than $1 million.

Intermediaries should be required to deny their platforms to issuers who they know pose a risk of fraud and intermediaries should be required to pursue any red flags that arise. But that should be it. Crowdfunding intermediaries should not be insurers against fraud, which is what this provision is trying to make them.

December 16, 2013 in C. Steven Bradford, Financial Markets, Securities Regulation | Permalink | Comments (2)

Monday, December 9, 2013

The Everything Store: Jeff Bezos' Lessons for Entrepreneurs

If you have an interest in entrepreneurship and innovation, or if you just want to know more about the company whose boxes are currently appearing on porches across the nation, read Brad Stone’s new book, The Everything Store: Jeff Bezos and the Age of Amazon.

Stone is not a corporate shill; his portrait of Bezos is not always flattering. But the book is well written and entertaining, and a good study of what made Amazon successful. Budding entrepreneurs could derive a number of important lessons from Jeff Bezos.

The Goal of a Business is to Serve Customers

Entrepreneurs often chase the wrong rabbit. The goal of a business is not to create the fanciest technology. The goal of a business is not to get ready to make a public offering. The goal of a business, and the way it makes money, is to serve customers—to fulfill some customer need more effectively than any other company.

It’s clear that customers have been Bezos’ top priority from the beginning, and that’s what has made Amazon successful. The most obvious example of that philosophy? Putting both positive and negative customer reviews on the Amazon web site. We take that for granted now—many online retailers do it—but it was business heresy at one time. I have foregone some purchases because of those negative reviews, but those reviews are also one of the main reasons I keep going back.

Innovation: You Have to Break Eggs to Make an Omelet

Forgive the cliché, but innovation depends on risk-taking. For every success, there are many, many failures. Jeff Bezos has wasted a lot of money going down blind alleys, but once in a while, those ideas have paid off in a major way. Amazon is successful because of its willingness to fail.

“Good Enough” is Not Good Enough

It is clear from The Everything Store that Bezos is driven to succeed. He demands results and he doesn’t tolerate failure. I don’t think I would want to work for Bezos. If Stone’s portrayal is accurate, Bezos can sometimes be an unpleasant person; ridicule is one of his tools. But that drive, that demand for results, is one of the reasons Amazon has become such a giant.

Costs Matter Too

Profitability depends on two things, revenues and expenses. You have to be willing to spend money to make money (Cliché No. 2). But that doesn’t mean you should spend as much money as possible. I read a lot of business history and the level of extravagance at some start-up companies amazes me.
Bezos is, to put it bluntly, cheap. He doesn’t waste money. He may take the idea so far as to make it a fetish, but that’s better than the alternative.

The “Everything” Store

I highly recommend Stone’s book. It’s an entertaining look at how one company went from start-up to behemoth.

December 9, 2013 in Books, C. Steven Bradford | Permalink | Comments (0)

Friday, December 6, 2013

Ten Things Entrepreneurs Should Know Before Raising Venture Capital

There's an interesting slide show available on Forbes, 10 Terms You Must Know Before Raising Venture Capital.

It's interesting, but it overlooks the most important thing entrepreneurs should know before raising venture capital: the need to hire an experienced lawyer. Learning the terminology won't substitute for representation by someone who knows what he or she is doing.

 

December 6, 2013 in Business Associations, C. Steven Bradford, Corporate Governance, Corporations | Permalink | Comments (0)

Monday, November 11, 2013

The Crowdfunding Rules and Other Offerings

The SEC’s crowdfunding proposal offers small, startup businesses a new way to raise capital without triggering the expensive registration requirements of the Securities Act of 1933. But the capital needs of small businesses are often uncertain. They may need to raise money again shortly after an exempted offering. Or they may want to sell securities pursuant to another exemption at the same time they’re using the crowdfunding exemption. How do other offerings affect the crowdfunding exemption? The proposed crowdfunding rules are unexpectedly generous with respect to other offerings, but they still contain pitfalls.

Other Securities Do Not Count Against the $1 Million Crowdfunding Limit

The proposed rules make it clear that the crowdfunding exemption’s $1 million limit is unaffected by securities sold outside the crowdfunding exemption. As I explained in an earlier post, only securities sold pursuant to the section 4(a)(6) crowdfunding exemption count against the limit.

Crowdfunding and the Integration Doctrine

But the integration doctrine, the curse of every securities lawyer, poses problems beyond determining the offering amount.

Briefly, the integration doctrine defines what constitutes a single offering for purposes of the exemptions from registration. The Securities Act exemptions are transactional; to avoid registration, the issuer must fit its entire offering within a single exemption. It cannot separate what is actually a single offering into two or more parts and fit each part into different exemptions.

Unfortunately, the application of the integration doctrine is notoriously uncertain and unpredictable, making it difficult for issuers who do two offerings of securities at or about the same time to know whether or not those offerings qualify for an exemption. (For a critical review of the integration doctrine, see my article here.)

The SEC’s crowdfunding proposal begins with what appears to be absolute protection from integration. The proposal says (p. 18) that “an offering made in reliance on Section 4(a)(6) should not be integrated with another exempt offering made by the issuer, provided that each offering complies with the requirements of the applicable exemption that is being relied on for the particular offering.”

However, the SEC giveth and the SEC taketh away. First, this isn’t really a rule, just a pledge by the SEC. The anti-integration language does not appear anywhere in the rules themselves; it’s only in the release discussing the rules. Other integration safe harbors, such as Rule 251(c) of Regulation A and Rule 502(a) of Regulation D, appear in the rules. It’s not clear why the SEC was unwilling to write an integration provision into the crowdfunding rules, but an actual rule would provide much more comfort to issuers than the SEC’s bare promise.

And, unfortunately, the SEC doesn’t stop with the broad anti-integration pledge. It adds (pp. 18-19) that

An issuer conducting a concurrent exempt offering for which general solicitation is not permitted, however, would need to be satisfied that purchasers in that offering were not solicited by means of the offering made in reliance on Section 4(a)(6). Similarly, any concurrent exempt offering for which general solicitation is permitted could not include an advertisement of the terms of the offering made in reliance on Section 4(a)(6) that would not be permitted under Section 4(a)(6) and the proposed rules.

These qualifications may prove particularly mischievous. Assume, for example, that an issuer is offering securities pursuant to section 4(a)(6) and, around the same time, offering securities pursuant to Rule 506(b), which prohibits general solicitation. The issuer would have to verify that none of the accredited investors in the Rule 506(b) offering saw the offering on the crowdfunding platform. Since crowdfunding platforms are open to the general public, that might be difficult.

As a result of the second sentence quoted above, there’s also a potential problem in the other direction. Assume that an issuer is simultaneously offering the same securities pursuant to both section 4(a)(6) and Rule 506(c). Rule 506(c) allows unlimited general solicitation, but the crowdfunding rules severely limit what an issuer and others may say about the offering outside the crowdfunding platform. The SEC seems to be saying that a public solicitation under Rule 506(c) would bar the issuer from using the crowdfunding exemption to sell the same securities. Since the same securities are involved in both offerings, the 506(c) solicitation would arguably “include an advertisement of the terms of the offering made in reliance on Section 4(a)(6).”

Double-Door Offerings Redux

Before the SEC released the crowdfunding rules, I questioned whether “double-door” offerings using the crowdfunding exemption and the new Rule 506(c) exemption were viable. I posited a single web site that sold the same securities (1) to accredited investors pursuant to Rule 506(c) and (2) to the general public pursuant to the crowdfunding exemption. I concluded that, because of the integration doctrine, such offerings were impossible. The SEC anti-integration promise may change that result, if the SEC really means what it says.

The anti-integration promise doesn’t exclude simultaneous offerings, even if those offerings involve the same securities. And I don’t see anything in the rules governing crowdfunding intermediaries that would prevent both 506(c) and crowdfunding offerings on a single web platform, with accredited investors funneled to a separate closing under Rule 506(c). Funding portals could not host such a double-door platform, because they’re limited to crowdfunded offerings, but brokers could.

However, both the issuer and the broker would have to be careful about off-platform communications. Ordinarily, an issuer in a Rule 506(c) offering may engage in any general solicitation or advertising it wishes, on or off the Internet. But the SEC crowdfunding release, as we saw, warns that “any concurrent exempt offering for which general solicitation is permitted could not include an advertisement of the terms of the offering made in reliance on Section 4(a)(6) that would not be permitted under Section 4(a)(6) and the proposed rules.” To avoid ruining the crowdfunding exemption, any off-platform communications would have to be limited to what the crowdfunding rules allow, and that isn’t much.

November 11, 2013 in C. Steven Bradford, Securities Regulation | Permalink | Comments (0)

Monday, November 4, 2013

Four Things I Like About the Proposed Crowdfunding Rules

I support crowdfunded securities offerings, but I have criticized the crowdfunding exemption in the JOBS Act. I won’t repeat those criticisms here, but, after wading through the 585-page SEC rules proposal, I am happy to report that some (but not all) of the proposed rules would significantly improve the exemption.

1. The proposed rules clear up the statutory ambiguities relating to investment limits and the amount of the offering

Title III of the JOBS Act includes a number of ambiguities relating to the investment limits and the amount of the offering. The proposed rules clear up those ambiguities. I have already discussed this aspect of the proposed rules and won’t repeat that discussion here.

2. Both issuers and intermediaries can rely on information provided by investors to determine if the investment limits are met.

The amount that an investor may invest in a crowdfunded offering depends on that investor’s net worth and annual income and also on how much that investor has already invested in section 4(a)(6) offerings in the last 12 months. I have argued that crowdfunding issuers and intermediaries should not be required to verify these numbers--that investors should be able to self-certify.
I am happy to report that the SEC’s proposal recognizes the substantial burden that verification would impose and allows both issuers and crowdfunding intermediaries to rely on the number furnished by investors.

Proposed Rule 303(b)(1) allows crowdfunding intermediaries to rely on an investor’s representations as to net worth, annual income, and previous investments unless the intermediary has reason to question the reliability of the investor’s representations. And Instruction 3 to proposed Rule 100(a)(2) allows the issuer to rely on the intermediary to ensure that investors don’t violate the limits, unless the issuer knows an investor is exceeding the limit.

3. The proposed rules include a “substantial compliance” rule that preserves the exemption in spite of immaterial violations.

The crowdfunding exemption’s requirements are detailed and extensive, and the availability of the exemption is conditioned on the issuer’s and intermediary’s compliance with all of those requirements. Most crowdfunding issuers will be relatively inexperienced small businesses and often won’t have sophisticated securities counsel, so violations are likely. The exemption could be lost due to a relatively minor technical violation of the exemption’s requirements.

The SEC solved this problem in Regulation D by adding a “substantial compliance” rule, Rule 508, that sometimes preserves the Regulation D exemptions even when issuers are not in full compliance.

The SEC has included a similar rule in the proposed crowdfunding rules. Proposed Rule 502 provides that a failure to comply with a requirement of the exemption will not result in loss of the exemption as to a particular investor if the issuer shows:

(1) The failure to comply was insignificant with respect to the offering as a whole;
(2) The issuer made a good faith and reasonable attempt to comply with all of the exemption’s requirements; and
(3) If it was the intermediary who failed to comply, the issuer was unaware of the noncompliance or the noncompliance was solely in offerings other than the issuer’s.

4. The proposed rules require the intermediary to provide communications channels for issuers and investors.

As I have discussed elsewhere, the statutory exemption

omits a crucial element of crowdfunding—an open, public communications channel allowing potential investors to communicate with the issuer and each other. Openness of this sort would allow crowdfunding sites to take advantage of “the wisdom of crowds,” the idea that “even if most of the people within a group are not especially well-informed or rational . . . [the group] can still reach a collectively wise decision.” Open communication channels can help protect investors from both fraud and poor investment decisions by allowing members of the public to share knowledge about particular entrepreneurs, businesses, or investment risks. Open communication channels also allow investors to monitor the enterprise better after the investment is made. [C. Steven Bradford, The New Federal Crowdfunding Exemption: Promise Unfulfilled, 40 SEC. REG. L. J. 195 (2012)]


(For more on why I think open communications channels are a good idea, see here, at pp. 134-136.)

Proposed Rule 303(c) requires crowdfunding platforms to provide “communication channels by which persons can communicate with one another and with representatives of the issuer about offerings made available on the intermediary’s platform.” Those communications channels must be accessible by the general public, although only investors who have opened an account with the crowdfunding platform may post.

November 4, 2013 in C. Steven Bradford, Securities Regulation | Permalink | Comments (0)