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The Status of Environmental Commodities Under the Commodity Exchange Act

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Matthew F. Kluchenek*

This article examines the role of the Commodity Futures Trading Commission (“CFTC”) in regulating transactions in environmental commodities, such as renewable energy certificates (“RECs”), emissions allowances, carbon offsets and carbon credits. The article examines the general role of the CFTC, the types of products subject to the CFTC’s jurisdiction, the basis for and scope of exclusions to the CFTC’s jurisdiction, and how commodity option transactions could be converted into swaps subject to the CFTC’s jurisdiction.

Ultimately, transactions in environmental commodities may qualify for the forward exclusion from the definition of “swap” under the Commodity Exchange Act[1] (“CEA”)—and thus not be subject to CFTC regulation—if the transactions satisfy certain requirements, the most important of which is the parties’ intent to physically settle each transaction. Such an exemption, however, is relatively narrow, and the active “trading” of an environmental commodity may jeopardize the use of the exemption.

I.         The Role of the Commodity Futures Trading Commission

A.        Jurisdiction and Mission of the CFTC

When Congress created the CFTC in 1974, it conferred upon the CFTC “exclusive jurisdiction” over commodity futures and options thereon.[2] Unless exempted, futures contracts and options thereon must trade on a commodity exchange that has been designated as a contract market—that is, an exchange or market—by the CFTC in order to be legal and enforceable.[3] By contrast, spot and forward transactions—in which the parties intend to make or take delivery of a commodity—are not generally subject to CFTC jurisdiction.[4]

Historically, the CFTC’s regulation of trading in environmental commodities has been relatively limited, but the agency has explored the scope of its boundaries with respect to such commodities. For example, while recognizing that other federal agencies may be better equipped to regulate allocation and recordkeeping requirements associated with the trading of such products, former CFTC Chairman Gary Gensler asserted that oversight by the CFTC of environmental commodities would give it additional experience regulating cash emissions contracts, and claimed that, should Congress seek to regulate cash markets for emission instruments, the CFTC would be well suited to carry out that function. According to Chairman Gensler:

In most respects, emissions contract markets operate no differently than the other commodity markets the CFTC regulates. While each contract – such as sulfur dioxide, soybeans, treasury bills or natural gas – presents its own unique challenges, the regulatory scheme is essentially the same. Carbon markets have similarities to several different markets that fall within our regulatory authority. For example, carbon allowances and offsets are similar to agriculture commodities in that there is a yearly “crop” and important programmatic regulations governing the nature of the product. At the same time, carbon contracts have similarities to financial products. For example, government-issued allowances and offset credits would be similar to Treasury-issued debt instruments. Futures contracts on Treasury debt are among the most actively traded CFTC-regulated products.[5]

Ultimately, Congress did not accept Chairman Gensler’s invitation, but did mandate the formation, via the Dodd-Frank Wall Street Reform and Consumer Protection Act[6] (“Dodd-Frank Act”), of an inter-agency working group to study the oversight of existing and prospective carbon markets.[7]

B.        Dodd-Frank Act

In 2010, Congress enacted the Dodd-Frank Act, which adopted sweeping changes to how the markets in the U.S. for over-the-counter derivatives, and the participants in those markets, are regulated. Many of those changes were implemented by amending the CEA. Through the Dodd-Frank Act, Congress issued a general directive to the CFTC of having as many “swaps” as possible cleared by regulated clearing entities in order to reduce “systemic risk” to the financial markets, and as many “swaps” as possible traded on regulated exchanges, or on or through other regulated entities, in order to increase transparency in the markets.[8] The Dodd-Frank Act thus makes it unlawful for a person[9] to enter into a “swap” without complying with the CEA and the numerous rules promulgated by the CFTC.[10]

The Dodd-Frank Act was important to the environmental commodity market in two respects, both of which are discussed more fully below: 1) it provided and confirmed the basis for excluding environmental commodities from the definition of “swap” and thus from regulation by the CFTC; and 2) it created the inter-agency working group to study the markets.

C.        The Definition of “Swap”

1.         Dodd-Frank Act

The cornerstone of commodity futures trading regulations under the Dodd-Frank Act is the definition of “swap.” Generally, if a transaction involves a swap, regulation follows. The Dodd-Frank Act contains a broad definition of “swap” that encompasses most transactions that transfer financial risk from one party to the other party.[11] The definition of swap specifies several categories, including:

  • Options, including puts, calls, caps, floors and collars;
  • Event contracts;
  • Swap structures in which a fixed payment is exchanged for a floating payment on one or more scheduled dates, with payments linked to the value or level of one or more rates, currencies, commodities, quantitative measures or other financial or economic interests, and which transfers risk associated with a future change in the value or level of the foregoing between the parties without also conveying a current or future ownership interest in an asset; and
  • Instruments that become commonly known to the trade as swaps or by more specific names linked to an underlying commodity or financial measure.[12]

2.         The CFTC’s Further Definition of “Swap”

In July 2011, the CFTC and the SEC adopted joint final rules further defining the term “swap” and other terms in the Dodd-Frank Act (“Product Release”).[13] The Product Release provides important guidance on the classification of various types of derivative instruments. These classifications determine whether the instruments are subject to regulation by the CFTC or the SEC (or both) or whether they fall outside of either agency’s general regulatory authority under the CEA, as amended by the Dodd-Frank Act.[14] As discussed below, the Product Release examines whether environmental commodities may be subject to federal regulation by the CFTC and the basis for any exemption.

II.        The Forward Exclusion

A.        Generally

Since its inception in 1936, the CEA has excluded so-called “forward contracts” from federal regulation. The CEA defines the term “forward contract” by excluding such contracts from the term “future delivery”—i.e., from the definition of futures contracts. The operative provision provides that “‘future delivery’ does not include any sale of any cash commodity for deferred shipment or delivery.”[15] This language provides the basis for the so-called “forward exclusion,” which refers to the exclusion of forward contracts from regulation under the CEA and the jurisdictional auspices of the CFTC.[16]

Notably, the Dodd-Frank Act amended the CEA to add a forward exclusion to the definition of “swap.”[17] The exclusion applies to “any sale of a nonfinancial commodityor security for deferred shipment ordelivery, so long as the transaction isintended to be physically settled.”[18] To fall within the exclusion, a transaction must include the following three components:

  • a nonfinancial commodity,
  • deferred shipment or delivery of the nonfinancial commodity, and
  • an intent to physically deliver the nonfinancial commodity.

The CFTC has stated that it intends to interpret the forward exclusion for nonfinancial commodities in the “swap” definition in a manner consistent with its historical interpretation of the existing forward exclusion with respect to futures contracts.[19] The CFTC’s historical interpretation has been that forward contracts are “commercial merchandising transactions,” the primary purpose of which is to transfer ownership of the commodity and not to transfer solely its price risk.[20]

B.        Nonfinancial Commodities

In the Product Release, the CFTC interpreted the scope of the term “nonfinancial commodity” in the forward exclusion. According to the CFTC, a “nonfinancial commodity” is a “commodity that can be physically delivered and that is an exempt commodity or an agricultural commodity.”[21] Exempt commodities, including energy commodities, metals and agricultural commodities, are nonfinancial by nature.

The requirement that a commodity be able to be physically delivered is designed to prevent market participants from relying on the forward exclusion to enter into swaps based on indexes of exempt or agricultural commodities outside the bounds of the Dodd-Frank Act and settling them in cash, which the CFTC believes would be inconsistent with the historical limitation of the forward exclusion to commercial merchandising transactions.[22]

C.        Intangible Commodities

The CFTC has interpreted the term “intangible commodity” to qualify as a nonfinancial commodity so long as “ownership of the commodity can be conveyed . . . and the commodity can be consumed.”[23] The CFTC has emphasized that, for an intangible commodity to qualify for the forward exclusion, there must be an intent to physically settle the transaction.[24] As discussed in greater detail below, an example of an intangible nonfinancial commodity that qualifies under this interpretation is an environmental commodity that can be physically delivered and consumed (e.g.,by emitting the amount of pollutant specified in the allowance).[25]

D.        Deferred Delivery

An essential element of a forward contract is that the delivery of the nonfinancial commodity is deferred.[26] Delivery is typically deferred for commercial convenience or necessity.[27]

To the extent that a transaction results in immediate or near-immediate delivery of the commodity, the contract is likely to be characterized as a “spot” transaction. The CEA excludes “spot” or “cash” transactions from the CFTC’s jurisdiction.[28] The CFTC staff has defined a spot transaction as one where immediate delivery of and payment for the product are expected on or within a few days of the trade date.[29]

According to the Sixth Circuit, “because the CEA was aimed at manipulation, speculation, and other abuses that could arise from the trading in futures contracts and options, as distinguished from the commodity itself, Congress never purported to regulate ‘spot’ transactions (transactions for the immediate sale and delivery of a commodity) or ‘cash forward’ transactions (in which the commodity is presently sold but its delivery is, by agreement, delayed or deferred).”[30] Accordingly, transactions in environmental commodities on a spot basis would not be subject to the CEA.

E.        Intent to Deliver

Because a forward contract is a commercial merchandising transaction, intent to deliver has been the critical element of the CFTC’s analysis of whether a particular contract is a forward contract.[31] In assessing the parties’ delivery intent, the CFTC has applied a “facts and circumstances” test in which the CFTC “reads the ‘intended to be physically settled’ language . . . to reflect a directive that intent to deliver a physical commodity be a part of the analysis of whether a given contract is a forward contract or a swap, just as it is a part of the CFTC’s analysis of whether a given contract is a forward contract or a futures contract.”[32]

A good example of the line of cases interpreting the intent to deliver requirement is CFTC v. Co Petro Mktg. Group, Inc.[33] In 1982, the Ninth Circuit considered a claim by the CFTC that Co Petro, an operator of retail gasoline outlets and a petroleum broker, was unlawfully selling off-exchange futures contracts, under which Co Petro sold petroleum “at a fixed price for delivery at an agreed future date,” but “did not require its customer to take delivery of the fuel.”[34] As explained by the Ninth Circuit, the customer could designate Co Petro, at a future date, to sell the fuel on its behalf and not take delivery of the fuel. If the cash price rose during the interim period, Co Petro would remit to the customer the difference between the original purchase price and the subsequent sale price. If the cash price decreased, Co Petro would deduct from the customer’s deposit the difference between the purchase price and the subsequent sale price and remit the balance of the deposit to the customer.[35]

The CFTC alleged that these transactions constituted transactions in futures and thus were required to be traded on an exchange subject to CFTC jurisdiction. In response, Co Petro contended that the CFTC did not have jurisdiction over the transactions because they constituted forward contracts and were thus expressly excluded from the CEA.[36]

Based upon the CEA’s legislative history, the Ninth Circuit concluded that Congress intended “that a cash forward contract is one in which the parties contemplate physical transfer of the actual commodity.”[37] In finding that the parties to the Co Petro agreements did not contemplate actual delivery in the future, the court of appeals held that the forward contract “exclusion is unavailable to contracts of sale for commodities which are sold merely for speculative purposes and which are not predicated upon the expectation that delivery of the actual commodity by the seller to the original contracting buyer will occur in the future.”[38]

Importantly, subsequent book-outs or alternative settlement methods generally will not alter the original character of the agreement as a commercial merchandising transaction so long as the original agreement contemplated physical delivery of the commodity.[39] In addition, the presence of certain provisions such as liquidated damages and renewal or evergreen provisions does not necessarily render an agreement ineligible for the forward exclusion.[41]

III.      Environmental Commodities

A.        Interagency Working Group’s Carbon Oversight Study

Prior to the issuance of the Product Release, the Interagency Working Group for the Study on Oversight Carbon Markets (“Interagency Working Group”), led by the CFTC, issued a report on the oversight of existing and prospective carbon markets (“Carbon Report”), fulfilling a requirement established in the Dodd-Frank Act.[41]

In its report, the Interagency Working Group recommended that the following four objectives guide the oversight of existing and prospective carbon markets:

  1. Facilitate and protect price discovery in the carbon markets.[42]
  2. Ensure appropriate levels of carbon market transparency.[43]
  3. Allow for appropriate, broad market participation.[44]
  4. Prevent manipulation, fraud and other market abuses.[45]

Based on its study, the Interagency Working Group issued the following recommendations in its report regarding the oversight of existing and prospective carbon markets:

  • Rely on the existing regulatory oversight program, as enhanced by the Dodd-Frank Act, for both existing and prospective carbon allowance and offset derivatives markets.[46]
  • Ensure that appropriate oversight mechanisms are in place for primary and secondary allowance and offset markets, reflecting the above objectives and the interdependence of primary, secondary and derivative carbon markets and any unique characteristics or circumstances of such markets.[47]

B.        Environmental Commodities Under the Forward Exclusion

Building on the findings and recommendations in the Carbon Report, the CFTC noted in its Product Release that the Carbon Report “suggested that the forward exclusion could apply to agreements, contracts or transactions in environmental commodities” such as emissions allowances, carbon offsets/credits and RECs.[48] The Carbon Report specifically states:

No set of laws currently exist that apply a comprehensive regulatory regime—such as that which exists for derivatives—specifically to secondary market trading of carbon allowances and offsets. Thus, for the most part, absent specific action by Congress, a secondary market for carbon allowances and offsets may operate outside the routine oversight of any market regulator.[49]

Further, in discussing environmental commodities, the CFTC noted in its release that it:

understands that market participants often engage in environmental commodity transactions in order to transfer ownershipof the environmental commodity (and not solely price risk), so that the buyercan consume the commodity in order to comply with the terms of mandatory or voluntary environmental programs.Those two features—ownership transfer and consumption—distinguish such environmental commodity transactions from other types of intangible commodity transactions that cannot be delivered, such as temperatures and interest rates. The ownership transfer and consumption features render such environmental commodity transactions similar to tangible commodity transactions that clearly can be delivered, such as wheat and gold.[50]

As a result, the CFTC found that “environmental commodities can be nonfinancial commodities that can be delivered through electronic settlement or contractual attestation. Therefore, an agreement, contract or transaction in an environmental commodity may qualify for the forward exclusion from the swap definition if the transaction is intended to be physically settled.”[51]

Conversely, as described by an industry participant, to the extent that emissions allowances, carbon offsets/credits and RECs are not physically settled (i.e., consumed), but traded in secondary market fashion like a stock or bond, the forward exclusion would likely not apply to the transaction.[52] Moreover, the CFTC has stated that, if a contract were to include the right to unilaterally terminate an agreement under a pre-arranged contractual provision permitting financial settlement, the forward exclusion would not apply.[53]

Importantly, the CFTC does have authority over forward contracts under the CEA’s anti-manipulation provisions prohibiting manipulation, making false and misleading statements and omissions of material fact to the CFTC, fraud and deceptive practices, and false reporting.[54]

IV.      Commodity Options

A.        Generally

To the extent that an environmental commodity transaction is structured as either a commodity option or is embedded with a commodity option, the contract may be subject to CFTC regulation. Further, commodity option contracts that function as “trade options” are subject to limited CFTC oversight.

B.        CFTC Jurisdiction over Commodity Options

Under the CEA, the CFTC has plenary authority to regulate commodity option transactions.[55] Commodity options are illegal unless and until the CFTC specifically authorizes them.[56] The CEA, as amended by the Dodd-Frank Act, defines the term “swap” to include “a put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of 1 or more . . . commodities.”[57] Options on physical commodities are included in the statutory definition of swap.[58]

Under the CFTC’s part 32 rules, any person is permitted to transact commodity options on or subject to the rules of a designated contract market, while only an eligible contract participant(“ECP”) is permitted to transact commodity options bilaterally or on a swap execution facility.[59]

C.        CFTC Jurisdiction over Trade Options

CFTC Rule 32.3 provides an exemption from certain of the swap regulations for trade options on exempt commodities (such as energy and metal commodities) and agricultural commodities (such as grain and soft commodities) if the parties to, and the characteristics of, the commodity options satisfy certain requirements.[60] In order to be eligible for the trade option exemption, three requirements must be met:

  1. the offeror of a commodity option must be either an ECP or a commercial market participant;
  2. the offeree must be a commercial market participant; and
  3. the commodity option must be intended to be physically settled, so that, if exercised, the option would result in the sale of an exempt or agricultural commodity for immediate or deferred shipment or delivery.[61]

While most of the CFTC’s swap rules do not apply to trade options, some rules do apply to each trade option counterparty.[62]

D.        CFTC Jurisdiction over Forward Contracts with Embedded Volumetric or Price Optionality

Under the CFTC’s interpretations, a forward contract may be considered a swap because it is embedded with optionality—either volumetric or price optionality. According to the CFTC, a transaction with volumetric optionality is a forward contract (i.e., not a swap) if it meets the following seven-part test:

  1. the embedded volumetric optionality does not undermine the overall nature of the agreement as a forward contract;
  2. the predominant feature of the agreement is delivery;
  3. the embedded volumetric optionality cannot be severed and marketed separately;
  4. the seller of the underlying nonfinancial commodity intends to make delivery of the commodity if the option is exercised;
  5. the buyer of the underlying nonfinancial commodity intends to take delivery of the commodity if the option is exercised;
  6. both parties are commercial parties; and
  7. the exercise or non-exercise of the embedded volumetric optionality is based primarily on physical factors or regulatory requirements that are outside the control of the parties.[63]

Further, the CFTC has stated that a contract embedded with price optionality is likely a forward contract (i.e., not a swap) if the option:

  1. may be used to adjust the forward contract price but does not undermine the overall nature of the contract as a forward contract;
  2. does not target delivery terms, so that the predominant feature of the contract is actual delivery; and
  3. cannot be severed and marketed separately from the overall forward contract in which the option is embedded.[64]

A contract with an embedded option that satisfies the applicable test(s) will qualify for the forward exclusion and will not be regulated as a swap. As with other transactions, whether price or volumetric options qualify for the forward contract exclusion will be based on overall facts and circumstances.[65]

Ultimately, to the extent that any contracts are deemed to be swaps because of embedded optionality, the full panoply of the CEA’s swap regulations would be triggered. In such a circumstance, the contract would be subject to the various clearing, execution, reporting and recordkeeping requirements under the CEA, and the parties to the transactions may be subject to registration, business conduct and numerous other requirements.[66]

 

Preferred citation: Matthew F. Kluchenek, The Status of Environmental Commodities Under the Commodity Exchange Act, 5 Harv. Bus. L. Rev. Online 39 (2015), https://journals.law.harvard.edu/hblr//?p=3939.

* Matthew F. Kluchenek is a Partner at Baker & McKenzie LLP, and heads the Firm’s North America Derivatives practice.

[1] Commodity Exchange Act of 1936, Pub. L. No. 74–675, 49 Stat. 1491 (1936) (codified as amended in scattered sections of 7 U.S.C.), replacing the Grain Futures Act of 1922.

[2] Commodity Futures Commission Trading Act of 1974, Pub. L. No. 93-463, 88 Stat. 1389 (1974) (codified as amended in scattered sections of 7 U.S.C.). The CEA does not define the term “futures” or “futures contract,” but such contracts are generally defined as standardized contracts to buy or sell a commodity for a specified price in the future. In a futures contract, only the price and the quantity of the contracts are negotiated; all of the other terms are standardized and not negotiable. Importantly, a futures contract does not involve the sale of a commodity, but the sale of a contract, which permits the purchaser to buy or sell the commodity (unless the contract is cash-settled). From a statutory perspective, Congress refers to “futures contracts” in the CEA as “transactions involving . . . contracts of sale of a commodity for future delivery.” 7 U.S.C. § 2(a)(1)(A) (2012). The CEA defines “contract of sale” broadly to include “sales, agreements of sale, and agreements to sell.” See id. § 1a(13). The term “future delivery” is defined as excluding “any sale of any cash commodity for deferred shipment or delivery.” Id. § 1a(27).

[3] Id. § 6(a).

[4] See Dunn v. CFTC, 519 U.S. 465, 472 (1997) (noting that forward contracts are agreements in which participants “anticipate the actual delivery of a commodity on a specified future date,” while spot contracts are “agreements for purchase and sale of commodities that anticipate near-term delivery”).

[5] Global Warming Legislation: Carbon Markets and Producer Groups Before the S. Comm. on Agriculture, Nutrition, and Forestry, 111th Cong. 3 (2009) (statement of Gary Gensler, Chairman, Commodity Futures Trading Comm’n).

[6] Pub. L. No. 111-203, 124 Stat. 1376 (2010) (codified as amended in scattered sections of 7, 12, and 15 U.S.C.).

[7] See Dodd-Frank Act § 750.

[8] See 7 U.S.C. §§ 2(h)(1)(A), 2(h)(8)(B).

[9] Under 7 U.S.C. § 2(e), each counterparty to a swap transaction that is not executed on or pursuant to the rules of a designated contract market is required to be an “eligible contract participant,” or “ECP.” The definition of ECP is set forth in 7 U.S.C. § 1a(18), and 17 C.F.R. § 1.3(m) (2014).

[10] See, e.g., 7 U.S.C. §§ 2(h), 2(h)(8)(B).

[11] See 7 U.S.C. § 1a(47)(A).

[12] See id.

[13] 77 Fed. Reg. 48,208 (Aug. 13, 2012).

[14] See id.

[15] 7 U.S.C. § 1a(27) (emphasis added).

[16] The “forward exclusion” has a lengthy history, originating in the Futures Trading Act of 1921 (“FTA”), Pub. L. No. 67-66, ch. 86, 42 Stat. 187 (1921) (held unconstitutional by Hill v. Wallace, 259 U.S. 44 (1922)). As proposed by Congress, the FTA sought to impose a tax on futures contracts—a term not defined in the FTA. During the bill’s Congressional hearings, however, farmers expressed concern over the possible taxation of forward transactions, which farmers replied upon as a critical commercial hedging tool. See Hearing on H.R. 5676 Before the S. Comm. on Agriculture and Forestry, 67th Cong. 8-9, 213-14, 431, 462 (1921); CFTC v. Co Petro Mktg. Group, 680 F.2d 573, 577 (9th Cir. 1982). In response, the Senate added a provision to the FTA that excluded from the definition of “future delivery” “any sale of cash grain for deferred shipment or delivery.” See Pub. L. No. 67-66, 42 Stat. 187. According to the Senate report, the “addition was made in order that transactions in cash grain when made for deferred shipment or delivery, would not fall within the provisions for taxing imposed in Section 4 of the bill.” S. Rep. No. 212, at 1 (1921). In discussing the scope of the provision, Senator Capper, the bill’s sponsor, made clear that “the bill does not concern itself at all with the sale or purchase of actual grain, either for present or future delivery. The entire business of buying and selling actual grain, sometimes called ‘cash’ or ‘spot’ business, is expressly excluded. It deals only with the ‘future’ or ‘pit’ transaction, in which the transfer of actual grain is not contemplated.” 61 Cong. Rec. 4762 (1921) (statement of Sen. Capper). The cash forward exclusion was carried forward without change into the Grain Futures Act of 1922, Pub. L. No. 67-331, § 2(a), ch. 369, 42 Stat. 998 (1922), which replaced the FTA, and thereafter was incorporated into the CEA, 7 U.S.C. § 1a(27). The language remains unchanged from inception through today.

[17] See id. § 1a(47)(B).

[18]Id.§ 1a(47)(B)(ii).

[19] See 77 Fed. Reg. at 48,227.

[20] See id. at 48,235 (“[A] transaction entered into by a consumer cannot be a forward transaction.”).

[21] Id. at 48,232. The CEA defines an “exempt commodity” as “a commodity that is not an excluded commodity or an agricultural commodity.” 7 U.S.C. § 1a(20). The CFTC defines the term “agricultural commodity” in Rule 1.3(zz). See 76 Fed. Reg. 41,048, 41,056 (Jul. 13, 2011).

[22] See 77 Fed. Reg. at 48,232.

[23] See id. at 48,233 (emphasis added).

[24] See id.

[25] See id.

[26] See 7 U.S.C. § 1a(27).

[27] See 77 Fed. Reg. at 48,228.

[28] See Commodity Futures Trading Comm’n, Div. of Trading & Markets, CFTC Letter No. 98-73 (Oct. 8, 1998) (stating the CEA “does not provide the Commission with jurisdiction over true ‘spot’ transactions”).

[29] See id. (“In a spot transaction, immediate delivery of the product and immediate payment for the products are expected on or within a few days of the trade date.”).

[30] CFTC v. Erskine, 512 F.3d 309, 321 (6th Cir. 2008).

[31]The CFTC observed in its decision inWright that “it is well-established that the intent tomake or take delivery is the critical factor indetermining whether a contract qualifies as aforward.” Wright, CFTC Docket No. 97–02,2010 WL 4388247 at *3 (Oct. 25, 2010).

[32]Further Definition of “Swap;” “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, Securities Act Release No. 9204,Exchange Act Release No. 64372 [FSLR Transfer Binders—2002 to Current] Fed. Sec. L. Rep. (CCH) ¶ 89,429 (April 29, 2011). See also Andersons, Inc. v. Horton Farms, 166 F.3d 308, 318-17 (6th Cir. 1998) (“The purpose of this ‘cash forward’ exception is to permit those parties who contemplate physical transfer of the commodity to set up contracts that (1) defer shipment but guarantee to sellers that they will have buyers and vice versa, and (2) reduce the risk of price fluctuations.”).

[33]680 F.2d 573, 576 (9th Cir. 1982).

[34]Id.

[35]Id.

[36]Id. at 576-77.

[37]Id. at 578 (emphasis added).

[38]Id. at 579. However, while most courts have adopted the CFTC’s reasoning, in CFTC v. Zelener, 373 F.3d 861, 865 (7th Cir. 2004), the Seventh Circuit (and several lower courts) disregarded any intent or physical delivery consideration. Rather, the Seventh Circuit held that the relevant inquiry was whether the transaction involved “a sale of the commodity,” in which case it would be deemed to be a forward contract, or whether the contract was “a sale of the contract,” in which case it would be considered a futures contract. As a proxy for such an inquiry, the court looked to whether the contract was fungible or, absent fungibility, whether the seller promised to allow the buyer to enter into an offsetting contract on demand. If either condition applied, the contract would be regarded as a futures contract. Id. at 868. Nonetheless, the CFTC has continued to adhere to the intent to deliver requirement, as evidenced in the Product Release and subsequent CFTC enforcement actions.

[39] See 77 Fed. Reg., at 48,227-32.

[40] Id. at 48,240.

[41]See Interagency Working Group for the Study on Oversight of Carbon Markets, Report on the Oversight of Existing and Prospective Carbon Markets (Jan. 2011) [hereinafter Carbon Report], http://www.cftc.gov/ucm/groups/public/@swaps/documents/file/dfstudy_carbon_011811.pdf. The interagency group is composed of the following members: the Chairman of the CFTC, who serves as the group’s Chairman, the Secretary of Agriculture, the Secretary of the Treasury, the Chairman of the Securities and Exchange Commission, the Administrator of the Environmental Protection Agency, the Chairman of the Federal Energy Regulatory Commission, the Chairman of the Federal Trade Commission and the Administrator of the Energy Information Administration.

[42] Id. at 49.

[43] Id. at 50.

[44] Id.

[45] Id.

[46] Id. at 51.

[47] Id.

[48] 77 Fed. Reg. at 48,233 n.277. The CFTC chose not to define the term “environmental commodity” because “any intangible commodity—environmental or otherwise—that satisfies the terms of the interpretation [in the Product Release] is a nonfinancial commodity, and thus an agreement, contract or transaction in such a commodity is eligible for the forward exclusion from the swap definition.” Id. at 48,233. Regarding a REC, for example, the commission reasoned the “forward sale of a REC transfers ownership of the REC from the producing entity to another entity that can use the REC for compliance with an obligation to sell a certain percentage of renewable energy. Many times, this forward sale takes place prior to the construction of a project to enable developers to secure related project financing.” Id. at 48,233 n.285.

[49] Carbon Report, supra note 28, at 42.

[50] 77 Fed. Reg. at 48,233–34 (emphasis added). The CFTC has previously indicated that environmental commodities can be physically settled. Id. at 48,233 n.277.

[51] 77 Fed. Reg. at 48,234 (emphasis added).

[52] See id. at 48,235 n.291 (citing a comment letter explaining that, “unlike a stock or a bond, which can be resold for its cash value, purchasers of environmental commodities intend to take delivery of RECs or carbon offsets for either compliance purposes or in order to make an environmental claim regarding their renewable energy use or carbon footprint”); see generally, 77 Fed. Reg. at 48,233-35.

[53] See id. at 48,235 n.292.

[54] See, e.g., 7 U.S.C. § 12(d) (directing the CFTC to investigate the marketing conditions of commodities and commodity products and byproducts); id. §§ 9, 13b, 13(a)(2), 15 (proscribing any manipulation or attempt to manipulate the price of any commodity in interstate commerce and enabling the CFTC to take action against violators). In particular, the CEA prohibits any person to (i) “use or employ, or attempt to use or employ . . . any manipulative or deceptive device or contrivance”; (ii) “make any false or misleading statement of material fact” to the CFTC or “omit to state in any such statement any material fact that is necessary to make any statement of material fact made not misleading in any material respect”; and (iii) “manipulate or attempt to manipulate the price of any swap, or of any commodity in interstate commerce.” Id. § 9(1)-(3); see also 17 C.F.R. § 180.1(a) (prohibiting manipulation, false or misleading statements or omissions of material fact, fraud or deceptive practices or courses of business, and false reporting in connectionwith any swap, or contract of sale of any commodity in interstate commerce).

[55] See 7 U.S.C. § 6c(b).

[56] See 17 C.F.R. § 32.2.

[57] See id. § 1a(47), amended by the Dodd-Frank Act § 721.

[58] See id.

[59] See 17 C.F.R. § 32.3(a)(1)(i).

[60] 17 C.F.R. § 32.3.

[61] Id. § 32.3(a).

[62]Such applicable regulations include: part 20 (large trader reporting); part 151 (position limits); subpart J of part 23 (duties of swap dealers and major swap participants); sections 23.200 through 23.204 (reporting and recordkeeping requirements for swap dealers and major swap participants); and section 4s(e) of the CEA (capital and margin requirements for swap dealers and major swap participants). Id. § 32.3(c)(1)-(5). Each counterparty to a trade option must comply with recordkeeping and reporting requirements under part 45. Id. § 32.3(b).

[63] Commodity Futures Trading Commission, CFTC Division of Market Oversight Responds to Frequently Asked Questions Regarding Commodity Options—Commodity Options FAQ (Sept. 2013), https://forms.cftc.gov/_layouts/TradeOptions/Docs/TradeOptionsFAQ.pdf; see also 77 Fed. Reg. at 48,238-40.

[64] Id.

[65] Id.  On November 20, 2014, the CFTC published a proposed interpretation that would clarify the CFTC’s views with respect to forwards with embedded volumetric optionality.  See 79 Fed. Reg. 69,073 (Nov. 20, 2014).  The proposal targets the seventh element of the volumetric optionality test.  In this respect, the CFTC would delete the reference to “the exercise or non-exercise” of the option, which would clarify that the focus of this element is on the intent of the parties, rather than the exercise or non-exercise of the option.  The proposal would also delete the requirement that the “physical factors or regulatory requirements” be outside the control of the parties.  Id. at 69,075-76.  Thus, if ultimately approved by the CFTC, the seventh factor would read: “The embedded volumetric optionality is primarily intended, at the time that the parties enter into the agreement, contract, or transaction, to address physical factors or regulatory requirements that reasonably influence demand for, or supply of, the nonfinancial commodity.”  Id. at 69,074.  If enacted, such language would represent a significant improvement over the CFTC’s extant interpretation.

[66] See, e.g., 7 U.S.C. § 2(a) (recordkeeping and reporting requirements); § 2(h) (clearing mandate); § 2(h)(8) (trade execution mandate); § 6s(h) (business conduct requirements); § 6s(e) (margin and capital requirements).

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Inevitable: Sports Gambling, State Regulation, and the Pursuit of Revenue

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Anastasios Kaburakis, Ryan M. Rodenberg, & John T. Holden*

“It’s inevitable that, if all these states are broke . . . there will be legalized betting in more states than Nevada and we will ultimately participate in that.”
– NBA commissioner Adam Silver, September 4, 2014[1]

I.         Introduction

Balancing the protection of private business interests against governmental regulation is one of the most significant legal frictions of the modern era. Over the course of the past twenty-eight months, this conflict has manifested itself through a federal sports gambling lawsuit involving New Jersey. However, the ongoing lawsuit between a plaintiff quintet of the most powerful sports entities in the United States—the National Collegiate Athletic Association (“NCAA”), the National Basketball Association (“NBA”), the National Football League (“NFL”), the National Hockey League (“NHL”), and the Office of the Commissioner of Major League Baseball (“MLB”) (collectively “sports leagues”)—and the Governor of New Jersey over the possibility of regulated sports wagering in the state is not about gambling. It is about control: control of events, control of data, control of marketing opportunities, and control of current and future revenue streams. This is a clash between sports leagues looking to reserve opportunities to monetize sporting events as commodities and cash-strapped states intent to raise tax revenue via regulation of an industry with a massive volume of underground activity.[2]

The sports gambling industry, legal and illegal, is vast. The National Gambling Impact Study Commission estimated that up to $380 billion was wagered illegally in the United States in 1999.[3] The International Centre for Sport Security reports a range of $250–650 billion gambled globally on both U.S. and international sports.[4] The state of New Jersey and in effect forty-eight other states receive no taxable share of such revenue.

Sports betting economic activity in the U.S. is largely constrained by the Professional and Amateur Sports Protection Act (“PASPA”).[5] Nevada is the main exception, and its licensed sports books generated a handle of $3.45 billion in 2012.[6] New Jersey has assumed a key role in challenging PASPA’s effective federal ban on sports betting by attempting to implement Las Vegas-style sports betting at casinos and racetracks.[7] Should New Jersey ultimately prevail in its PASPA challenge, other states may follow in efforts to capture taxable portions of the presently elusive sports betting marketplace.

II.         Background and Current Status of Litigation

The complicated relationship between professional sports leagues and the gambling industry, modulated by government regulation, has recently become increasingly blurred. The global promise of capital generation from the gambling industry has increased the attractiveness of strategic partnerships for the professional sports leagues and gambling purveyors. For example, certain forms of “pay to play” fantasy sports have been exempted from the categorization of gambling under the 2006 Unlawful Internet Gambling Enforcement Act,[8] a statute supported by the plaintiffs in the active New Jersey litigation.[9] Weekly and daily fantasy sports leagues, generating over $245 million in entry fees in 2013,[10] are growing through commercial partnerships with the professional sports leagues and individual teams.[11] The result is a fine line between illegal sports gambling and permissible fantasy sports.[12] As the pursuit of revenue and added value to customers becomes more fruitful, conceivably leading to growth of the professional sports leagues’ fan base and acquisition of new clients for the gambling sector, new avenues for business collaboration are explored. The NFL, NBA, and NHL have also allowed teams to solicit sponsorship revenue from gambling providers.[13]

Congress passed PASPA in 1992 with the express purpose of stopping the spread of state-sanctioned sports gambling.[14] PASPA’s language grants a joint right of enforcement to the Department of Justice (“DOJ”) as well as to professional and amateur sports leagues “whose competitive game” is subject to the statute’s scope. [15] This conferral of power from Congress to sports leagues in particular encompasses a de jure acknowledgment of leagues’ proprietary interest in “their” competitive games and the translation of such interest to standing. Granting the sports leagues ownership rights over the games they organize is also constitutionally suspect under the Constitution’s Intellectual Property Clause.[16] Nonetheless, the sports leagues have successfully undertaken to enforce the statute on three occasions.

The first case arose in 2009, against Governor Jack Markell of Delaware, who had signed legislation instituting single-game sports gambling.[17] District Court Judge Gregory M. Sleet denied plaintiff sports leagues’ motion for a preliminary injunction to halt Delaware’s plans.[18] The Third Circuit reversed and interpreted PASPA to only allow for the same types of gambling as were offered prior to the enactment of PASPA; any new form of gambling was thereby prohibited.[19]

The second instance of a challenge to PASPA came in 2012 when Governor Chris Christie of New Jersey signed a law authorizing New Jersey’s racetracks and casinos to offer sports gambling. [20] In National Collegiate Athletic Association v. Christie (“Christie I”),[21] the sports leagues filed suit challenging the law and were successful in asserting that they had standing, that PASPA was a constitutional exercise of the Commerce Clause, and that PASPA did not run afoul of equal sovereignty and anti-commandeering principles.[22] The Third Circuit affirmed the district court decision, and the Supreme Court denied certiorari on June 23, 2014.[23]

The third case (“Christie II”) focuses on the 2014 New Jersey Sports Wagering Law repeal of state prohibitions on gambling and revolves around certain PASPA interpretations in Christie I, particularly regarding N.J.S.A. 5:12A-1. Therein, the DOJ, the sports leagues, and the Third Circuit posited that, if New Jersey simply repealed laws criminalizing sports gambling, the state would not be in violation of PASPA’s prohibition.[24] On October 17, 2014, Governor Christie signed State Senate Bill S2460 (“S2460”), partially repealing state prohibitions on sports betting as applied to casinos and racetracks.[25] On October 20, 2014, the sports leagues brought suit seeking declaratory and injunctive relief against the Governor’s plan.[26] The complaint includes several counts: (i) defendants are in violation of § 3702 of PASPA;[27] (ii) S2460 violates New Jersey’s own constitution;[28] and (iii) the New Jersey Sports and Exposition Authority (“NJSEA”) and the New Jersey Thoroughbred Horsemen’s Association (“NJTHA”) are violating PASPA § 3702.[29]

After a flurry of briefs filed during a three-day period, on October 24, 2014, District Court Judge Michael A. Shipp granted the plaintiffs a Temporary Restraining Order (“TRO”). Judge Shipp found: (a) a likelihood of success on the merits (“the Court cannot read the Third Circuit’s opinion in Christie I in such a way as to render the purpose of PASPA null”);[30] (b) irreparable harm (“reputational injury may constitute irreparable harm . . . plaintiffs’ association with gambling is stigmatizing”);[31] (c) the balance of equities favored the plaintiffs; and (d) the public interest was served by the issuance of the TRO.[32] Two important procedural clarifications accompanied Judge Shipp’s TRO decision: (a) plaintiffs must post a $1,700,000 bond,[33] and (b) in an addendum correcting prior communication by Judge Shipp to counsel for NJTHA, the TRO’s scope was expanded and “NOT limited to the games sponsored by the plaintiffs’ leagues.”[34] On November 21, 2014, Judge Shipp issued a permanent injunction against New Jersey,[35] agreeing with both the Third Circuit’s majority and Judge Vanaskie’s dissent in Christie I, whereby New Jersey was deemed to be either obligated by PASPA to prohibit all sports gambling in the state, or allowed to completely repeal all prohibitions.[36] Any partial repeal of sports wagering laws, however, as in the case of New Jersey’s S2460, would be preempted by PASPA.[37] As anticipated, immediately upon issuance of Judge Shipp’s opinion, defendants filed an appeal to the Third Circuit.[38]

III.         Standing

In this battle for control of sports wagering’s economic activity between the sports leagues and the state, legal standing remains a pivotal issue. While New Jersey may still be violating PASPA via S2460’s partial repeal of the state’s existing prohibitions on sports gambling, the problem is that the sports leagues are the wrong plaintiffs.[39] The DOJ should be bringing any suit to enforce PASPA, not the sports leagues. While the district court and the Third Circuit in Christie I found the sports leagues to have standing,[40] at least partly because the leagues were the object of the sports wagering law, it could also be extracted by the Third Circuit’s decision that sports leagues need not have a proprietary interest in underlying sporting events for standing purposes.[41] Nonetheless, this matter was not deemed worthy of further analysis by the Third Circuit, as the leagues “do not complain of an invasion of any proprietary interest.”[42] Perhaps they should. Missed opportunities to clarify this crucial issue for ensuing monetization of such proprietary interest, which presumably PASPA grants, may prove detrimental (conceivably in other jurisdictions, as per cases discussed infra adjudicating “rights to games”) for strategic objectives, seeds of which have already been expressed publicly.[43]

The standard test for Article III standing is derived from the Constitution’s “cases” and “controversies” provision.[44] In order for the plaintiffs to establish Article III standing, they must demonstrate: (i) “injury in fact,” (ii) “causation,” and (iii) “redressability.”[45]

The injury in fact requirement for standing has grown out of a number of Supreme Court decisions in the period since the 1970’s to ensure that plaintiffs assert claims based on their own personal rights.[46] The Third Circuit established that harm must be “based in reality,” meaning that there must be some basis for determining that the injury may occur.[47] Christie I held that the “stigmatizing effect of having sporting contents associated with gambling” was sufficient to grant standing.[48] The basis for the court’s decisionrested on the proposition that the 2012 New Jersey Sports Wagering Law is directed at the sports leagues.[49]

Causation is a requirement that must be shown by plaintiffs in order for a court to be able to redress the injury suffered.[50] In addressing causation, Christie I found that reputational harm is sufficient to support a cause-and-effect relationship.[51] In so holding, the Third Circuit accepted the argument that the leagues suffered harm in the form of adverse public perception as a result of gambling.[52] That the leagues may not have a proprietary interest in certain sporting events did not factor in the court’s finding of standing.[53] Thus, the Third Circuit, perhaps unintentionally, has expanded the ability of sports leagues to be granted standing.

Christie I concluded that the sports leagues have standing, by virtue of two findings: “that the Sports Wagering Law makes the Leagues’ games the object of state-licensed gambling and that they will suffer reputational harm if such activity expands.”[54] However, despite the court’s characterization, some uncertainty remains surrounding the issue of ownership rights associated with sporting events. Without an explicit proprietary interest in such games, it is unsettled whether the sports leagues are suffering sufficiently specific harm to support standing. Not only other jurisdictions as discussed below, but another Third Circuit panel itself may assume a different position on the matter of sports wagering stigmatizing the leagues and causing reputational harm, particularly as more professional sports executives publicly question PASPA’s purposes and welcome a federal sports wagering policy.[55] Absent such a federal regulatory solution, however, PASPA will continue deputizing sports leagues, which according to Christie I may enforce the current federal ban on sports wagering.

Further, this grant of standing comes in stark contrast to the DOJ’s position in a September 24, 1991 letter expressing concerns before the Senate Committee on the Judiciary in view of PASPA’s adoption.[56] Next to raising federalism issues and confirming that revenue generation determinations have traditionally been reserved for the states, the DOJ found it “particularly troubling that [PASPA] would permit enforcement of its provisions by sports leagues.”[57] Still, PASPA passed by a wide margin in Congress, deputizing certain sports leagues and associations to bring suit, and granting such entities unprecedented protections, by which they could expand their sphere of control over athletic competitions and any revenue streams resulting therefrom.

IV.         Rights to Games

The root of the friction between the sports leagues and New Jersey over revenue generation rests on the yet-to-be definitively decided issue of whether a sporting event itself can be owned and, if so, by whom.[58] In National Football League v. Governor of Delaware,[59] Judge Stapleton found that NFL schedules and scores are available by public sources, and once disseminated the league may no longer have an expectation of generating revenue. Closely, in National Basketball Association v. Motorola,[60] the Second Circuit found that underlying basketball games do not fall within the subject matter of copyright, as they are not original works of authorship. The “real-time” scores updates and statistics derived from the broadcasts constitute factual information, rather than copyrightable content.[61] Only the broadcasts of the games themselves qualify for copyright protection.[62] The court explained the “fact-expression dichotomy is a bedrock principle of copyright law that limits severely the scope of protection in fact-based works.”[63]

In C.B.C. Distribution & Marketing, Inc. v. Major League Baseball Advanced Media, LP,[64] the Eighth Circuit decided that combinations of names and statistics for commercial purposes were deemed protected by the First Amendment. The court concluded: “the information used in CBC’s fantasy baseball games is all readily available in the public domain, and it would be strange law that a person would not have a first amendment [sic] right to use information that is available to everyone.”[65] More recently, in an amicus brief submitted in American Broadcasting Cos., Inc. v. Aereo, Inc.,[66] the Solicitor General posited, “when a television network broadcasts a live sporting event, no underlying performance precedes the initial transmission—the telecast itself is the only copyrighted work.”[67]

Earlier decisions featured conflicting results. In National Football League v. McBee & Bruno’s, Inc.,[68] the Eighth Circuit concluded that “the game . . . constituted the work of authorship . . . the game, the game action . . . [and] the noncommercial elements of the game [are copyrightable].”[69] The same year, 1986, in Baltimore Orioles, Inc., v. Major League Baseball Players Association.,[70] the Seventh Circuit adjudicated whether players’ performances contained the necessary “modicum of creativity” for copyrightability.[71] The Seventh Circuit ultimately acknowledged competitive games’ copyrightability, as it pertained to the broadcast and recording of a game.[72] To further complicate matters, in a case of first instance, the Eleventh Circuit held that a professional golf association may preempt a media organization from disseminating time-sensitive information such as compilations of golf scores.[73] Nonetheless, the court acknowledged that “facts, such as golf scores, and compilations of facts are generally not a proper subject for copyright protection,”[74] and that, “copyright law does not protect factual information, like golf scores.”[75]

Sports leagues, as evident from the above adjudication of relevant data and key intellectual property issues, likely lack the necessary locus of control over the entire universe of material information, which may be utilized for sport wagering purposes. They maintain ownership of copyrighted broadcasts, may monetize streaming athletic competitions via mobile and tablet devices and ensuing technological means, and may customize the viewing experience.[76] However, sports leagues almost certainly cannot preempt the use of factual information in the public domain (i.e. names, statistics, scores, real-time data)—the exact information state regulators are looking to commodify in the offering of taxable sports wagering options for interested citizens.

V.         Conclusion

The trilogy of PASPA-specific cases brought by the sports leagues have been used as the vehicle to further claims of valuable commercial rights that potentially go far beyond the scope of sports wagering. In this way, the sports leagues’ victories in Markell, Christie I,and the on-going Christie II case may far exceed the ability to restrict sports gambling in Delaware and New Jersey. However, none of these three cases undertook a pointed analysis as to whether sports leagues can monetize aspects of underlying athletic competitions. It bears repeating: these cases are not about gambling—they are about control.

A resolution of this control issue is inevitable.[77] In the monolith that is the sports industry, determining whether leagues possess exploitable rights in the underlying games represents a core issue that will guide future revenue growth for sports leagues operating in the shadow of state regulation over a lucrative sector of consumer spending and interest. NBA commissioner Adam Silver explained the importance in an interview:

If you have a gentleman’s bet or a small wager on any kind of sports contest, it makes you that much more engaged in it. That’s where we’re going to see it pay dividends. If people are watching a game and clicking to bet on their smartphones . . . then it’s much more likely you’re going to stay tuned for a long time.[78]

 

Preferred citation: Anastasios Kaburakis, Ryan M. Rodenberg, & John T. Holden, Inevitable: Sports Gambling, State Regulation, and the Pursuit of Revenue, 5 Harv. Bus. L. Rev. Online 27 (2015), https://journals.law.harvard.edu/hblr//?p=3933.

* Kaburakis is an assistant professor at Saint Louis University. Rodenberg is an assistant professor at Florida State University. Holden is a doctoral student at Florida State University.

[1] See Mason Levinson & Scott Soshnick, NBA’s Silver Says Legal Sports Gambling in U.S. Is Inevitable, Bloomberg (Sept. 4, 2014, 11:06 AM), http://www.bloomberg.com/news/2014-09-04/nba-s-silver-says-legal-sports-gambling-in-u-s-is-inevitable.html.

[2] Indeed, the clash between the NCAA, NFL, NBA, MLB, and NHL and Governor Chris Christie is particularly noteworthy given that counsel for the same five sports leagues penned a July 30, 2007 letter to Congress positing: “whether you think gambling liberalization is a bad idea or a good one, the policy judgments of state legislatures and Congress must be respected.” See 153 Cong. Rec. E1684 (daily ed. Aug. 2, 2007) (statement of Hon. Edolphus Towns of New York).

[3] Nat’l Gambling Impact Study Comm’n, Gambling In The United States, 2-14 (1999), available at http://govinfo.library.unt.edu/ngisc/reports/2.pdf.

[4] International Centre for Sport Security, The Threat to Sport: The Facts at a Glance 1–4 (2014), available at http://www.theicss.org/wp-content/themes/icss-corp/pdf/SIF14/Sorbonne-ICSS%20Report%20-%20Infographic_WEB.pdf.

[5] See 28 U.S.C. §§ 3701–3704 (2012).

[6] Sports Wagering, American Gaming Association, http://www.americangaming.org/industry-resources/research/fact-sheets/sports-wagering (last visited Nov. 11, 2014). PASPA, via a grandfathering clause, exempts the states of Nevada, Delaware, Montana, and Oregon, as they offered varying forms of sports betting prior to PASPA’s enactment. However, PASPA limits the gambling activities to states already offering certain forms of sports wagering. In 1992, only Nevada offered full-scale sports betting and, as a result, has enjoyed a near-monopoly in sports gambling. See John T. Holden, Anastasios Kaburakis & Ryan M. Rodenberg, Sports Gambling Regulation and Your Grandfather (Clause), 26 Stan. L. Pol’y Rev. Online 1 (2014). Relatedly, Art Manteris, one of the foremost authorities in the sports gaming industry and veteran Nevada sports books executive, opined on PASPA: “The two greatest blunders in the history of U.S. gaming were the support of the [PASPA], which helped create the offshore online gaming industry, as well as prohibiting the expansion of legal sports wagering into other states.” See National Museum of Organized Crime & Law Enforcement, Wednesday, January 21: Beating the line: The inside story on sports betting in America, Courtroom Conversation, The Mob Museum (Dec. 14, 2014), http://themobmuseum.org/archives/2014/12/14/wednesday-january-21-getting-a-fix-on-sports-betting/.

[7] See David Purdum, NCAA, NFL seek to stop NJ betting, ESPN.com (Oct. 20, 2014, 11:58 AM), http://espn.go.com/espn/chalk/story/_/id/11733844/ncaa-nfl-file-injunction-prevent-new-jersey-sports-betting.

[8] 31 U.S.C. § 5362(1)(E)(ix).

[9] See H.R. Rep. No. 110-910, at 9 (2008).

[10] See Adam Krejcik, Daily Fantasy Sports: The Future of US Sports Wagering? 18–19, Eilers Research (October 16, 2014), http://eilersresearch.com/downloads/daily-fantasy-sports-the-future-of-us-sports-wagering/.

[11] For a summary of this recent trend marking a policy shift for the professional leagues and the inherent conflicts therein, see generally Brent Schrotenboer, Leagues see real benefits in daily fantasy sports, USA Today (Jan. 1, 2015), http://www.usatoday.com/story/sports/2015/01/01/daily-fantasy-sports-gambling-fanduel-draftkings-nba-nfl-mlb-nhl/21165279/. The NBA and the NHL have recently allowed individual teams to negotiate with daily fantasy providers, with the Brooklyn Nets and the New Jersey Devils signing partnership agreements with FanDuel and Hotbox Sports respectively. John Brennan, Nets, FanDuel Daily Fantasy Sports Company Announce Partnership, NorthJersey.com (Oct. 24, 2014, 10:43 AM), http://blog.northjersey.com/meadowlandsmatters/9918/nets-fanduel-announce-daily-fantasy-sports-partnership/;see also Josh Lombardo & Eric Fisher, With New Funds, FanDuel Looks at NBA Deals, Street & Smith’s Sports Business J. (Sept. 8, 2014), http://www.sportsbusinessdaily.com/Journal/Issues/2014/09/08/Marketing-and-Sponsorship/FanDuel.aspx. Major League Baseball’s official mini fantasy game provider is DraftKings. See Jonathan Bales, Daily Fantasy Game a New Way to Play for Draft Kings, MLB.com (Mar. 24, 2014), http://m.mlb.com/news/article/70013300/daily-fantasy-baseball-a-new-easy-way-to-play-from-draftkings. On October 16, 2014, the New England Patriots became the first NFL team to sign with a daily fantasy sports provider, DraftKings. See Eric Fisher, Fantasyland: Patriots become First NFL Team to Sign Deal with DraftKings, Street & Smith’s Sports Business Daily (Oct. 16, 2014), http://www.sportsbusinessdaily.com/Daily/Issues/2014/10/16/Marketing-and-Sponsorship/DraftKings.aspx?hl=DraftKings&sc=0.

[12] The exemption for fantasy sports is premised, in part, on a finding that certain fantasy sports fall on the legal side of the “skill versus chance” determination. With most states following the “dominant factor” test on this issue, it is possible that the legality of traditional forms of sports wagering may be tested in a way akin to the recent analysis specific to poker in United States v. DiCristina, 726 F.3d 92 (2d Cir. 2013). See generally Anthony N. Cabot, Glenn J. Light & Karl Rutledge, Alex Rodriguez, A Monkey, and the Game of Scrabble: The Hazard of Using Illogic to Define the Legality of Games of Mixed Skill and Chance, 57 Drake L. Rev. 383 (2008–09) (discussing the Court’s treatment of skill versus chance-based games). Indeed, in prior litigation and lobbying, the NFL posited that certain forms of sports wagering were skill-based. See, e.g.,Nat’l Football League v. Gov. of Del., 435 F. Supp. 1372, 1383 (D. Del. 1977); Covington & Burling, Memorandum of Law: The Delaware Constitution Prohibits Sports Gambling (Apr. 29, 2003), available at http://finance.delaware.gov/publications/Gaming/Exhibit_H.pdf.

[13] The New York Rangers have a partnership with WSOP.com, an online poker website that allows real money poker games for New Jersey residents. The New Jersey Devils have a partnership with PartyPoker, an online poker company owned by Bwin.Party Digital Entertainment, one of the largest global providers of online sports gambling. See Mason Levinson, NHL’s Rangers Following Devils in Partnering with Gambling Site, Bloomberg (Mar. 25, 2014, 2:30 PM), http://www.bloomberg.com/news/2014-03-25/nhl-s-rangers-following-devils-in-partnering-with-gambling-site.html.

[14] See Prohibiting State-Sanctioned Sports Gambling: Hearing on S. 473 and S. 474 Before the Subcomm. on Patents, Copyrights & Trademarks of the S. Comm. on the Judiciary, 102d Cong. 1 (1991) (opening statement of Dennis DeConcini, Chairman S. Comm. on Patents, Copyrights & Trademarks); Professional and Amateur Sports Protection Act: Hearing on H.R. 74 Before the Subcomm. on Econ. and Commercial Law of the H. Comm. on the Judiciary, 102d Cong. 74 (1991).

[15] 28 U.S.C. § 3703.

[16] See Ryan M. Rodenberg, Anastasios Kaburakis & John T. Holden, “Whose” Game Is It? Sports-Wagering and the Intellectual Property Clause, 60 Vill. L. Rev. Tolle Lege 1, 2 (2014).

[17] Office of Comm’r of Baseball v. Markell, 579 F.3d 293, 295 (3d Cir. 2009).

[18] Office of Comm’r of Baseball v. Markell, No. 09-538, 2009 U.S. Dist. LEXIS 69816, at *10 (D. Del. Aug. 10, 2009).

[19] Markell, 579F.3d at 304. (“[E]xpanding the very manner in which Delaware conducts gambling activities to new sports or to new forms of gambling—namely single-game betting—beyond ‘the extent’ of what Delaware ‘conducted’ in 1976 would engender the very ills that PASPA sought to combat.”). The Third Circuit’s decision in Markell could leave Gov. Brian Sandoval of Nevada vulnerable to possible action by the same plaintiff quintet, based on Nevada’s move into “real-time” in-game wagering made possible by recent technological advances. See generally Michael Kaplan, Cantor Fitzgerald: The First Wall Street Firm to Become a Bookie in Vegas, Daily Finance(July 3, 2010, 7:53 PM), http://www.dailyfinance.com/2010/06/30/cantor-fitzgerald-the-first-wall-street-firm-to-become-a-bookie/; In-Running Wagering Extended by Cantor Gaming for NFL games, MobileCasinos.Co (Nov. 11, 2014), http://www.mobilecasinos.co/in-running-wagering-extended-by-cantor-gaming-for-nfl-games/.

[20] N.J. Stat. Ann. § 5:12A-1 (West 2012) (repealed 2014).

[21] 926 F. Supp. 2d 551 (D.N.J. 2013).

[22] Id. at 558–76.

[23] Nat’l Collegiate Athletic Ass’n v. Governor of N.J., 730 F.3d 208, 241 (3d Cir. 2013), cert. denied, Christie v. NCAA, 134 S. Ct. 2866 (2014). Footnote 18 in the Third Circuit’s opinion, which states that the purpose of the exemptions is clear from the legislative history, represents some low-hanging fruit for New Jersey in that the footnote is inconsistent with the Supreme Court’s decision in Greater New Orleans Broadcasting Ass’n. v. United States, where Justice Stevens, writing for a unanimous court, found some of PASPA’s exemptions to derive from “obscured congressional purposes.” See 527 U.S. 173, 179–80 (1999).

[24] See Brief for Appellee United States of America at 29, Nat’l Collegiate Athletic Ass’n v. Governor of N.J., 730 F.3d 208 (3d Cir. 2013) (Nos. 13-1713, 13-1714, 13-1715), 2013 WL 2904910 at *29; Nat’l Collegiate Athletic Ass’n, 730 F.3d at 233. During oral arguments before the Third Circuit, the United States also opined that PASPA did not prevent New Jersey from repealing its prohibitions on sports gambling. Transcript of Oral Argument at 67, Nat’l Collegiate Athletic Ass’n v. Governor of N.J., 730 F.3d 208 (3d Cir. 2013) (Nos. 13-1713, 13-1714, 13-1715).

[25] S. 2460, 216th Leg., Reg. Sess. (N.J. 2014) (repealing regulations applying to licensed casinos and racetracks in New Jersey, to wagers placed by persons over twenty-one, excluding collegiate sporting contests taking place in New Jersey or involving New Jersey collegiate athletic teams).

[26] Complaint for Declaratory and Injunctive Relief, Nat’l Collegiate Athletic Ass’n v. Christie, No. 3:14-cv-06450 (MAS)(LHG) (D.N.J. filed Oct. 20, 2014), 2014 WL 5395199. The DOJ did not file suit nor did it intervene in the case. New Jersey made no effort to implead the DOJ either. The DOJ did file a statement of interest supporting the plaintiffs’ argument that S2460 was not compliant with PASPA. See Statement of Interest of the United States, Nat’l Collegiate Athletic Ass’n v. Christie, No. 3:14-cv-06450 (MAS) (LHG) (D.N.J. filed Nov. 19, 2014). The DOJ was also present at oral arguments, though it did not participate with the exception of noting its appearance and offering to answer any questions the court had regarding its statement of interest. The court had none. See Transcript of Oral Argument at 17, Nat’l Collegiate Athletic Ass’n v. Christie, Nos. 3:12-cv-04947 (MAS) (LHG), 3:14-cv-14-06450 (MAS) (LHG) (D.N.J. Nov. 20, 2014).

[27] Id. at 19.

[28] Id. at 19–20.

[29] Id. at 20–22.

[30] Transcript of Oral Decision at 12, Nat’l Collegiate Athletic Ass’n v. Christie, Nos. 3:12-cv-04947 (MAS)(LHG), 3:14-cv-14-06450 (MAS)(LHG) (D.N.J. Oct. 24, 2014).

[31] Id. at 13–15.

[32] Id. at 17.

[33] Id. at 19.

[34] Id. at 21.

[35] Nat’l Collegiate Athletic Ass’n v. Christie, Nos. 12-4947 (MAS)(LHG), 14-6450 (MAS)(LHG) (D.N.J. Nov. 21, 2014).

[36] Id. at 15–20.

[37] Id. at 22–27.

[38] Notice Of Appeal, Nat’l Collegiate Athletic Ass’n v. Christie, No. 3:14-6450 (MAS)(LHG) (D.N.J. Nov. 21, 2014).

[39] It is somewhat ironic to note that S2460 was passed, at least in part, to conform to the legal position advanced by the sports leagues and the DOJ, and adopted by the Third Circuit, in Christie I. The sports leagues noted in their brief opposing the writ of certiorari that a repeal of sports wagering prohibitions did not violate PASPA. See Brief in Opposition at 7, Christie v. Nat’l Collegiate Athletic Ass’n, 134 S. Ct. 2866 (2014) (Nos. 13-967, 13-979, 13-980), 2014 WL 1989124 at *7. Likewise, the DOJ stated: “New Jersey is free to repeal those prohibitions in whole or in part” in reference to New Jersey’s sports gambling prohibitions. Brief for the United States in Opposition at 11, Christie v. Nat’l Collegiate Athletic Ass’n, 134 S. Ct. 2866 (2014) (Nos. 13-967, 13-979, 13-980), 2014 WL 1989100 at *11.

[40] See Nat’l Collegiate Athletic Ass’n v. Christie, No. 12-4947 (MAS)(LHG) (D.N.J. Dec. 21, 2012), 2012 WL 6698684 at *9. Judge Shipp’s decision rested, in part, on: (i) several redacted or sealed depositions of five sports league commissioners; (ii) a number of plaintiff-funded studies sealed subject to a protective order; and (iii) a moderately redacted expert report prepared by Robert Willig on behalf of Gov. Christie. Id. at *6.

[41] See Nat’l Collegiate Athletic Ass’n, 730 F.3d at 220.

[42] Id.

[43] In a New York Times op-ed, NBA commissioner Adam Silver argued for an overhaul of the federal prohibition of sports gambling. Silver advocated for a complex regulatory system that would allow for legalized sports betting provided it protects and ensures the integrity of the game. See Adam Silver, Legalize and Regulate Sports Betting, N.Y. Times (Nov. 14, 2014), http://www.nytimes.com/2014/11/14/opinion/nba-commissioner-adam-silver-legalize-sports-betting.html?_r=0. Mark Cuban, owner of the NBA’s Dallas Mavericks, stated that he envisions a partnership with casinos where “[w]e’ll [the NBA] charge the casinos for information sources [and] video sources.” See Tim MacMahon, Mark Cuban: No Betting ‘Hypocritical’, ESPN.com (Nov. 23, 2014), http://espn.go.com/dallas/nba/story/_/id/11921944/mark-cuban-agrees-adam-silver-sports-betting-legalized-united-states. The Ultimate Fighting Championship (UFC) has similarly come out in favor of legalized sports gambling, noting a hypothesis that legalized sports gambling will actually enhance the integrity and perception of games. See David Pudum, UFC Backs Betting Expansion in U.S., ESPN.com (Oct. 31, 2014), http://espn.go.com/espn/chalk/story/_/id/11792598/ufc-exec-lawrence-epstein-backs-expanded-legalized-sports-betting-us.

[44] See U.S. Const. art. III, § 2, cl. 1.

[45] See Lujan v. Defenders of Wildlife, 504 U.S. 555, 560 (1992).

[46] See F. Andrew Hessick, Standing, Injury in Fact, and Private Rights, 93 Cornell L. Rev. 275, 300 (2008).

[47] See Doe v. Nat’l. Bd. of Medical Examiners, 199 F.3d. 146, 153 (3d Cir. 1999).

[48] Nat’l Collegiate Athletic Ass’n, 730 F.3d at 224.

[49] See id. at 219–220.

[50] See Lujan, 504 U.S. at 562.

[51] Nat’l Collegiate Athletic Ass’n, 730 F.3d at 220.

[52] Id. at 217–224.

[53] Id.

[54] Id. at 219 (emphasis added).

[55] See Silver supra note 46; MacMahon supra note 46; Purdum supra note 46.

[56] See Letter from W. Lee Rawls, Assistant Att’y Gen., Dep’t of Justice, to the Hon. Joseph R. Biden, Jr., Chairman, Comm. on the Judiciary (Sept. 24, 1991).

[57] Id. at 2.

[58] Indeed, in unrelated litigation, Fox Broadcasting Company, a broadcast partner of the MLB and NFL, posited that the dissemination of information related to sporting events is one in the public interest and analogous to “a parade, a natural disaster, a March on Washington, or a government shutdown.” See Brief of Amici Curiae Fox Broadcasting Company and Big Ten Network, LLC in Support of Defendant NCAA’s Motion for Summary Judgment at 18, In re NCAA Student-Athlete Name & Likeness Licensing Litig., No. 09-CV-01967 CW (NC) (N.D. Cal. Sept. 17, 2012), 2012 WL 4111728. Such a position runs counter to one where sporting events are treated as a commercially exploitable commodity. Intriguingly, this position has been espoused by the major media partners of all five Christie II plaintiff sports leagues; ABC, CBS, Fox, and NBC have acknowledged that “sports broadcasts concern matters of public interest.” See Brief of A&E Television Networks, LLC, in Support of Appellant NCAA and Reversal at 6, Edward C. O’Bannon, Jr. v. NCAA, Nos. 14-16601, -17068 (9th Cir. 2014).

[59] 435 F. Supp. 1372 (D. Del. 1977).

[60] 105 F.3d 841 (2d Cir. 1997).

[61] Id. at 847.

[62] Id. at 845.

[63] Id. at 847 (citing Feist Publications, Inc. v. Rural Tel. Service Co., 499 U.S. 340 (1991)).

[64] 505 F.3d 818 (8th Cir. 2007).

[65] Id. at 823.

[66] 134 S. Ct. 2498 (2014).

[67] Brief for the United States as Amicus Curiae Supporting Petitioners at 26, Am. Broad. Cos., Inc. v. Aereo, Inc., 134 S. Ct. 2498 (2014) (No. 13-461), 2014 WL 828079 at *26.

[68] 792 F.2d 726 (8th Cir. 1986).

[69] Id. at 732 (internal quotation marks omitted).

[70] 805 F.2d 663 (7th Cir. 1986).

[71] Id. at 699 n.7.

[72] Id. (“[E]ven if the Players’ performances were not sufficiently creative . . . the cameramen and director contribute creative labor to the telecasts. The work that is the subject of copyright is not merely the Players’ performances, but rather the telecast of the Players’ performances. The creative contribution of the cameramen and director alone suffices for the telecasts to be copyrightable.”).

[73] Morris Commc’ns Corp. v. PGA Tour, Inc., 364 F.3d 1288, 1291 (11th Cir. 2004).

[74] Id. at 1292 n.6.

[75] Id. at 1298 n.15.

[76] See Richard Sandomir, ESPN Will Stream Out-of-Market Games on Web as Part of N.B.A. Deal, N.Y. Times (Oct. 6, 2014), http://www.nytimes.com/2014/10/07/sports/basketball/espn-will-stream-out-of-market-games-on-web-as-part-of-nba-deal-.html?_r=1; Joan E. Solsman, NBA, ESPN deal drafts streaming-only service for cord-cutters, CNET.com (Oct. 6, 2014, 8:44 AM), http://www.cnet.com/news/nba-espn-deal-drafts-streaming-only-service-for-cord-cutters/.

[77] New Jersey State Senator Raymond J. Lesniak apparently sees the inevitable resolution happening soon and has been quoted as saying: “[the sports leagues] want a monopoly – they want to have their gambling through fantasy sports. They are not against us having sports betting, they just want to control it and run it. They are going to fight through the end – and I believe this is the end.” Liz Robbins, Sports Betting in New Jersey Challenged, N.Y. Times (October 21, 2014), http://www.nytimes.com/2014/10/21/nyregion/sports-betting-in-new-jersey-is-challenged.html?_r=0.

[78] Levinson & Soshnick, supra note 1.

Photo Credit: Movie TV Tech Geeks on Flickr (https://www.flickr.com/photos/bestmoviesevernews/)

By

Make-Whole Claims and Bankruptcy Policy

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Douglas P. Bartner and Robert A. Britton*

Loan agreements and bond indentures frequently contain “make-whole” or “yield maintenance” provisions that are designed to give the lender or bond investor the benefit of its interest rate bargain in the event that the obligor repays its debt obligation prior to maturity. Generally, although formula and calculation methodologies vary, upon a prepayment the obligor will be required to pay an additional amount that is calculated to be the interest rate differential between the loan or bond contract rate and the interest rate at which the prepaid funds can be reinvested through maturity. The hypothetical reinvestment rate typically references treasury yields along a curve plus a margin, with a present-value discount. When interest rates have fallen between the time the debt was incurred and the prepayment, the formula often will produce a positive number and the obligor will be required to pay a make-whole claim.

In a bankruptcy of the obligor, a claim for a make-whole payment may be very significant, especially today, when interest rates have fallen to historic lows and may stay at these levels for an extended time. The effect of significant make-whole claims is to dilute the recovery to other creditors; indeed, unsecured creditors that are not entitled to receive a make-whole payment could be viewed as effectively subsidizing a lender or bond investor’s contractual make-whole right.

In this article, we will discuss the state of the law regarding the enforceability in bankruptcy proceedings of make-whole provisions, as well as policy considerations that suggest the beneficiaries of make-wholes may be unfairly enriched at the expense of other creditors. We will begin by focusing on two recent high-profile bankruptcy decisions by the United States Bankruptcy Courts for the Southern District of New York and the District of Delaware, respectively, that have garnered considerable interest from insolvency practitioners and the lending community. The decisions in American Airlines[1]and School Specialty[2] each address the enforceability in bankruptcy of “make-whole” payments, and stand generally for the proposition that courts in these key bankruptcy jurisdictions will honor the strict terms of a make-whole negotiated in good faith between a debtor and its lenders to the extent that such provision is enforceable under applicable state law.[3] The decisions appear to be in line with both the majority of precedential cases from these districts and others. We will then consider these decisions in light of fundamental policy goals of the bankruptcy code, and policy choices that have been made by Congress to achieve those goals.

I.         Make-Whole Provisions in Bankruptcy

Historically, bankruptcy courts have split on whether to allow the payment of make-whole amounts to lenders. A minority of courts has likened the payment of make-whole amounts to the payment of unmatured interest, something that is expressly forbidden by the bankruptcy code.[4][5] Another line of cases relied on the ability to award post-petition reasonable “charges” to oversecured creditors in approving the payment of make-whole amounts in the limited circumstances where make-wholes arise under oversecured creditors’ debt instruments, but only to the extent that the court determined the amount of the make-whole payment to be reasonable.[6]

The majority trend, however, has been to permit the payment of make-whole amounts so long as the relevant make-whole provision is enforceable under applicable state law, in some cases regardless of whether the lender is oversecured.[7] This line of cases holds that prepayment charges are not in the nature of unmatured interest since they fully mature in accordance with the terms of the contract.[8] Courts adhering to this line of reasoning examine the loan agreement or indenture at issue to determine whether any applicable prepayment premium has become payable in accordance with its terms, and if so, analyze whether such premium is permissible under applicable state law. Recently, the courts in American Airlines and School Specialty each took this approach in their review of the enforceability of a debtor’s make-whole obligations and reached different conclusions based on the facts in each case.

In American Airlines, the debtor sought to enter into a postpetition financing arrangement and use the proceeds, in part, to prepay certain of its prepetition debt which carried a significantly higher interest rate.[9] The trustee for the prepetition debt that was proposed to be prepaid objected, arguing that the debtor could not prepay its obligations without also paying a make-whole amount provided for in the prepetition indenture.[10] The American Airlines court analyzed the prepetition indenture, and found that the filing of a voluntary bankruptcy proceeding constituted an event of default that automatically accelerated the maturity of the debt.[11] The indenture also specifically provided that no make-whole payment was due upon such an acceleration.[12] As a result, the court found that under the plain language of the indenture, no make-whole payment was due the debtor’s bondholders in connection with its prepayment of the prepetition debt.[13]

In contrast, the decision in School Specialty upheld a lender’s entitlement to payment of a significant make-whole amount.[14] In that case, the debtor entered into a prepetition credit agreement that provided for an “early payment fee” upon either prepayment or acceleration of the loan.[15] Prior to the petition date, the debtor and its lenders entered into a forbearance agreement that acknowledged an event of default and the acceleration of the debt, and, consequently, fixed the lenders’ right to receive the early payment fee.[16] The debtor’s official committee of unsecured creditors challenged the early payment fee, not under the terms of the contract but rather under applicable state law.[17] The School Specialty court determined that under New York law (as with the law in many jurisdictions), “early termination fees are analyzed under the standards applicable to liquidated damages.”[18]

Under New York state law, contractual liquidated damages provisions are enforceable if, as of the time the parties entered into their agreement, actual potential damages were difficult to determine and the amount of the liquidated damages were not “plainly disproportionate” to potential losses.[19] The School Specialty unsecured creditors’ committee argued that the prepayment calculation, which resulted in a prepayment fee equal to 37% of the principal balance of the loan, failed this test because it provided for a fee that was “grossly disproportionate” to the lenders’ expected loss.[20] Upon examination, however, the School Specialty court determined that the prepayment fee calculation was reasonable at the time the parties negotiated the loan in good faith, and could not be invalidated simply because it ultimately resulted in a significant prepayment fee.[21]

II.         Tension Between Enforcement of Make-Whole Provisions and Bankruptcy Policies

Bankruptcy laws are intended to address numerous public policy considerations that, at times, are in tension with one another. Most fundamentally, bankruptcy is intended to provide a debtor with a fresh economic start, and to provide recoveries for similarly situated creditors fairly vis a vis one another.[22] In addition, the bankruptcy code applies applicable non-bankruptcy law in determining creditor rights, except where exceptions are required to further the policy goals of a fresh start and creditor equality.[23]

In limited circumstances, Congress has determined that certain recoveries by creditors that are otherwise permissible under applicable non-bankruptcy law should be disallowed or capped in bankruptcy. A prime example is claims for damages filed by lessors of non-residential real property where the debtor has rejected the lease.[24] Long-term commercial leases that are rejected by a debtor could give rise to very significant claims for damages. The bankruptcy code caps the amount of such claims to further the goal of equitable recoveries by all creditors.[25] Courts have observed that such claims may be “disproportionate in amount to any actual damage suffered, particularly in the event of a subsequent rise in rental values.”[26] That observation is true as far as it goes, but landlords also may be forced to cover a debtor’s default during a period when real estate demands significantly lower rents than the debtor’s lease rate. In such a scenario, and as a result of the policy decisions reflected in the bankruptcy code, the landlord may not look to the bankruptcy court or the market for full, or even pro rata, compensation for its losses.

In other contexts, claimants are required to mitigate damages. For example, suppliers who are party to a contract with a debtor are entitled to assert a claim for damages that are measured by application of non-bankruptcy law if the debtor rejects the contract. Under applicable law, a non-breaching contract counterparty is entitled to damages, which includes consequential damages or lost profits. The non-breaching party, however, is required to make a good faith effort to mitigate its damages. A supplier of product to the debtor, for example, is required to make a good faith effort to find another buyer for its product and a purchaser of goods from the debtor is required to make good faith efforts to find a replacement source for those goods.[27]

Courts that have found make-whole provisions enforceable in bankruptcy have not required the financial creditor with a make-whole right to mitigate damages by re-investing the proceeds of a prepayment, if possible, to reduce the formulaic make-whole amount. Rather, courts that have upheld make-whole payments have turned to the liquidated damages doctrine to determine whether the formulaic claim amount is permissible under non-bankruptcy law.

III.         Conclusion

Following the decisions in American Airlines and School Specialty, it is clear that financial creditors with a contractual make-whole entitlement have an opportunity to assert a claim in bankruptcy proceedings designed to make such creditors whole; and in certain circumstances may also receive a windfall.[28] Their make-whole claim is not subject to a statutory cap, like lessors of non-residential real property, and there is no requirement to mitigate damages, as there is for most other creditors. Although the payment of make-whole amounts clearly may be enforced under applicable state law in many instances, there appears to be tension between a claim in bankruptcy for such a payment and public policies underlying the bankruptcy code, including maximizing recoveries and the fair treatment of all creditors.

 

Preferred citation: Douglas P. Bartner & Robert A. Britton, Make-Whole Claims and Bankruptcy Policy, 5 Harv. Bus. L. Rev. Online 21 (2014), https://journals.law.harvard.edu/hblr//?p=3926.

* Douglas P. Bartner is a partner in the Financial Restructuring and Insolvency Group of Shearman & Sterling LLP. Robert A. Britton is a senior associate in that group. The authors regularly represent debtors, creditors, and other parties in interest in bankruptcy proceedings and out-of-court restructurings. The authors wish to thank Joshua Rivera, an associate at Shearman & Sterling, for his research assistance in connection with this article.

[1]     U.S. Bank Trust Nat’l Assoc. v. American Airlines Inc. (In re AMR Corporation), 485 B.R. 279 (Bankr. S.D.N.Y. 2013).

[2]     In re Sch. Specialty, Inc., No. 13-10125 (KJC), 2013 WL 1838513 (Bankr. D. Del. April 22, 2013).

[3]     See In re AMR Corporation at 288; In re Sch. Specialty at 15. See also Transcript of Oral Decision on Confirmation of Debtors’ Joint Chapter Plan of Reorganization for Momentive Performance Materials Inc. & its Afilliated Debtors at 44, In re MPM Silicones, L.L.C., No. 14-2503-rdd (Bankr. S.D.N.Y. Aug. 26, 2014) (relying on the American Airlines decision in connection with an analysis of the disallowance of make-whole premiums under New York law).

[4]     See, e.g., In re Ridgewood Apartments of DeKalb Cnty., Ltd., 174 B.R. 712, 720 (Bankr. S.D. Ohio 1994) (“[B]ecause the . . . claim is for interest which is not yet due at the time the bankruptcy was filed . . . it would not be allowed to an undersecured creditor”); In re Doctors Hosp. of Hyde Park, Inc., 508 B.R. 697, 708 (Bankr D. Ill. 2014) (finding that “[t]he Yield Maintenance Premium represents unmatured interest”)

[5]     11 U.S.C. § 502(b)(2) (2012).

[6]     See, e.g.,11 U.S.C. § 506(b) (2012) (“To the extent that an allowed secured claim is secured by property the value of which . . . is greater than the amount of such claim, there shall be allowed to the holder of such claim . . . any reasonable fees, costs, or charges provided for under the agreement . . .”); Premier Entm’t Biloxi LLC v. U.S. Bank Nat’l Assoc. (In re Premier Entm’t Biloxi LLC), 445 B.R. 582, 618 (Bankr. S.D. Miss. 2010) (“In general, a prepayment premium is encompassed under the term ‘charges.’”).

[7]     Section 502(b)(1) of the bankruptcy code forbids the payment of any claim to the extent that “such claim is unenforceable against the debtor and property of the debtor under . . . applicable law.” 11 U.S.C. § 502 (2012); Cf. In re Trico Marine Services, Inc., 450 B.R. 474, 481 (Bankr. D. Del. 2011) (finding that an unsecured creditor held an allowed claim for a make-whole payment).

[8]     E.g., In re Outdoor Sports Headquarters, Inc., 161 B.R. 414, 424 (Bankr. S.D. Ohio 1993) (“Prepayment amounts, although often computed as being interest that would have been received through the life of a loan, do not constitute unmatured interest because they fully mature pursuant to the provisions of the contract.”); In re Trico Marine Services, Inc., 450 B.R. at 481.

[9]     U.S. Bank Trust Nat’l Assoc. v. American Airlines Inc. (In re AMR Corporation), 485 B.R. 279, 283-84 (Bankr. S.D.N.Y. 2013).

[10]    Id.

[11]    Id. at 289.

[12]    Id. at 289-90.

[13]    Id. at 298.

[14]    In re Sch. Specialty, Inc., No. 13-10125 (KJC), 2013 WL 1838513, at *5 (Bankr. D. Del. April 22, 2013).

[15]    Id. at *1.

[16]    Id. at *2.

[17]    Id. at *1.

[18]    Id. at *2.

[19]    Id.

[20]    Id. at *3, *4 n.7.

[21]    Id. at *4.

[22]    See Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934) (“[o]ne of the primary purposes of the Bankruptcy Act is to ‘relieve the honest debtor from the weight of oppressive indebtedness, and permit him to start afresh’”) (quoting Williams v. U.S. Fid. & Guar. Co., 236 U.S. 549, 554-555 (1915)); Sampsell v. Imperial paper & Color Corp., 313 U.S. 215, 219 (1941) (“the theme of the Bankruptcy Act is equality of distribution”).

[23]    See Board of Trade of City of Chicago v. Johnson, 264 U.S. 1, 10 (1924) (“Congress derives its power to enact a bankrupt law from the federal Constitution and the construction of it is a federal question. Of course, where the Bankrupt Law deals with property rights which are regulated by state law, the federal courts in bankruptcy will follow the state courts; but when the language of Congress indicates a policy requiring a broader construction of the statute than the state decisions would give it, federal courts cannot be concluded by them”) (quoting Bd. of Trade v. Weston, 243 F. 332 (7th Cir. 1917)).

[24]    This is not the only example, though. For instance, an employee’s claim for damages arising from the termination of an employment contract is also capped by the bankruptcy code. 11 U.S.C. § 502(b)(7) (2012).

[25]    11 U.S.C. § 502(b)(6) (2012).

[26]    Oldden v. Tonto Realty Corp., 143 F.2d 916, 920 (2d Cir. 1944).

[27]    E.g., In re Orion Refining Corp., 445 B.R. 312, 315 (D. Del. 2011) (upholding a Bankruptcy Court decision that a creditor failed to mitigate damages as required by applicable state law).

[28]    As noted, generally, make-whole formulas are tied to Treasury yields along an applicable curve. Of course, an investment in Treasuries is typically considered “risk-free,” while the obligor’s credit profile likely involved some degree of risk at the time the loan was made or bond was issued. Financial creditors with a make-whole right, therefore, may recover the lion’s share of their anticipated yield, and redeploy that make-whole amount as well as recovered principal in investments with significantly greater yield than Treasuries.

By

Venturenomics: Adjusting for Three Standard Practices May Reduce Venture-Backed Company Pre-Money Valuations by 90%

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Jeff Thomas*

I.         Introduction

Vic is trying to buy some of your pizza. He says, “I’ll give you $3 for three of the ten slices.” His $1 a slice offer infers your entire pizza is worth $10 in its current state. But, what if your pizza really has just eight slices instead of ten? Further, what if the five slices Vic is not buying are inedible until you complete a substantial amount of additional work? Specifically, what if those five remaining slices are currently only 25% complete because they lack toppings and still need to be cooked (even though Vic’s three slices are full of toppings and ready to eat)? Finally, what if each of Vic’s three slices comes with a free beer while the other five slices do not? It would seem absurd if people knew these conditions existed and yet still valued your pizza, today, at $10 simply because of Vic’s $1 per slice offer. If Vic is paying $3 for three edible slices with beer, the five remaining (and currently inedible) slices with no beer must be worth less than $1 per slice and the whole eight-slice pizza, in its current state, is certainly worth much less than $10.

Recent valuations attributed to venture-backed companies are shocking. For example, in 2013, the median “pre-money valuation”[1] of a company raising its first round of venture capital (or, its “Series A” round)[2] was reported at $9.4 million.[3] Some commentators are concerned that there is a venture capital bubble.[4] Make no mistake; this Article does not question the wisdom of venture capitalists or suggest that they are paying too much for stock. While it may be possible that investors are overpaying, this Article illustrates how the valuations causing concern are mathematically unsound and misleading. This is because the “VC Math” used to value venture-backed companies ignores the economic impact of three standard practices.[5] First, VC Math treats a company’s unissued, and even non-existing, stock options as outstanding shares of stock.[6] Second, VC Math ignores the fact that much of a company’s common stock, and options to purchase common stock, have not yet been earned.[7] Third, VC Math values a share of common stock and a share of convertible preferred stock equally, despite the fact a share of convertible preferred stock is worth more.[8] This Article is not the first article to point out that VC Math is broken.[9] However, this Article considers the cumulative effect that these three standard practices have on valuations calculated using VC Math. Moreover, a formula is presented that can be used to adjust VC Math amounts for these practices.[10] Using the formula, and considering quantitative norms for each of the three practices, this Article estimates the pre-money valuation of a typical company raising its Series A round in 2013 to be $981,200 (or, 10.4% of $9.4 million).[11]

II.        VC Math 101

When venture capitalists (VCs) value a company, they consider the amount they will invest in the company as well as the percentage ownership they will receive.[12] “Pre-money valuation” and “post-money valuation” refer to “the valuations put on the company before and after the investment,” respectively.[13] To determine these amounts, VCs use the following formulas[14]:

 

Formula 1: Post-Money Valuation = VC Investment Amount / Ownership % Acquired

 

Formula 2: Pre-Money Valuation = Post-Money Valuation – VC Investment Amount

 

For example, if a VC is going to invest $4,000,000 into New Co, Inc. (New Co) and VC will own 40% of New Co immediately after the financing, Formula 1 indicates that New Co’s post-money valuation is $10,000,000 (or, $4,000,000/40%). Moreover, Formula 2 indicates that New Co’s pre-money valuation is $6,000,000 (or, $10,000,000 – $4,000,000). These items can also be expressed in terms of shares[15]:

 

Formula 3: Post-Money Valuation = New Share Price x Total Shares

 

Formula 4: Pre-Money Valuation = New Share Price x Old Shares

 

For example, if VC will pay $1.00 for each New Co share and there will be 10,000,000 Total Shares immediately after the financing, Formula 3 indicates that New Co’s post-money valuation will be $10,000,000 (or, $1.00 New Share Price * 10,000,000 Total Shares).[16] Moreover, if VC will acquire 40% of New Co, VC will acquire 4,000,000 New Shares (or, 40% * 10,000,000 Total Shares) resulting in 6,000,000 Old Shares (or, 10,000,000 Total Shares – 4,000,000 New Shares). Per Formula 4, New Co’s pre-money valuation is $6,000,000 (or, $1.00 New Share Price * 6,000,000 Old Shares).[17]

VC Math typically uses “fully-diluted” capitalization tables when calculating pre-money and post-money valuations.[18] For a company raising its Series A round, this means that the Total Shares amount is broadly defined to include all: (i) New Shares that VC is acquiring in the current financing;[19] (ii) outstanding shares of common stock; (iii) shares of common stock that can be acquired with options already issued under the company’s option pool (or, “issued options”);[20] (iv) shares of common stock that can be acquired with options still available for future grants under the company’s option pool (or, “unissued options”);[21] and (v) shares of common stock that can be acquired by outstanding warrants (if any).[22] Because the New Shares that VC is acquiring represents the only difference between the Total Shares and Old Shares amounts, the Old Shares include items (ii) through (v).

III.      VC Math Amounts for a Representative 2013 Series A Co

As previously stated, the median pre-money valuation of a company raising its Series A round in 2013 has been reported at $9.4 million.[23] Further, the median investment amount for a Series A financing in 2013 has been reported at $4.2 million.[24] Given these two amounts, VC Math can be used to calculate other amounts for a “Representative 2013 Series A Co.” For example, Formula 2 infers a post-money valuation of $13.6 million (or, $9.4 million + $4.2 million) and Formula 1 can be used to deduce the investing VC acquired 30.88235% (or, $4.2 million/$13.6 million) of the Representative 2013 Series A Co when purchasing New Shares. Therefore, the remaining 69.11765% (or, 100% – 30.88235%) of ownership is attributed to the Old Shares. Using the post-money valuation of $13.6 million, and assuming 10,000,000 Total Shares,[25] Formula 3 can be used to deduce a New Share Price of $1.36 (or, $13.6 million/10,000,000 Total Shares). Because VC acquires 30.88235% of the Total Shares, VC acquires 3,088,235 New Shares (or, 10,000,000 Total Shares * 30.88235%) resulting in 6,911,765 Old Shares (or, 10,000,000 Total Shares – 3,088,235 New Shares). Formula 4 can also be used to deduce a New Share Price of $1.36 (or, $9.4 million/6,911,765 Old Shares).  These amounts are summarized in Table 1.[26]

 

Table 1: Representative 2013 Series A Co – VC Math Amounts

ITEM VC Math Amount
Pre-Money Valuation $9,400,000
VC Investment Amount $4,200,000
Post-Money Valuation $13,600,000
Ownership NOT Acquired by VC 69.11765%
Ownership Acquired by VC 30.88235%
Old Shares 6,911,765
New Shares 3,088,235
Total Shares 10,000,000
New Share Price $1.36

 


IV.       VC Math Does Not Add Up Because It Disregards Three Standard Practices

While venture backed companies may differ from each other in certain ways,[27] they are all likely to follow three well-established practices. First, venture backed companies use option pools to attract, motivate, retain and compensate employees.[28] Second, venture backed companies require founders and other employees to earn their equity ownership through a concept referred to as vesting.[29] Third, venture backed companies leverage a two-class equity system whereby founders and other employees are issued common stock, or options to purchase common stock, while VCs are issued convertible preferred stock.[30] This section provides background information for each of these practices. Relevant quantitative norms for venture backed companies raising their Series A round are also provided for each practice. Further, the Representative 2013 Series Co A is revisited to illustrate how the VC Math amounts provided in Table 1 should be adjusted to account for the economic impact of these practices.

A.     Option Pools

1.      Background Information

At a typical venture backed company, founders are issued common stock upon the company’s formation and subsequent employees are issued options to purchase common stock, instead of common stock itself.[31] Options entitle employees to purchase shares from an “option pool.”[32] Option pools are approved by the venture backed company’s board of directors and stockholders.[33] Options act like a coupon, giving employees the right to purchase shares of the company’s common stock at a set price for a set period of time.[34] That is, options allow employees to share in a company’s increase in value, without requiring them to actually purchase stock from the outset.[35] Thus, options are often used to attract, motivate, retain and compensate employees.[36] VC Math’s Total Shares amount includes shares covered by an option pool’s issued and unissued options.[37] However, it is widely accepted that, by including unissued options in the Total Shares, VCs acquire a larger true ownership percentage of a company resulting in VC Math valuations being overstated.[38] Moreover, VCs routinely condition their investments on companies increasing their amount of unissued options prior to the investment[39] thereby further increasing the true ownership percentage that VCs acquire and further overstating VC Math valuations.[40] In order to determine a company’s true current value, one should back out unissued options as of the date of the financing.

2.      Quantitative Norms for Companies Raising Their Series A Round

For a typical company that just completed its Series A round, the option pool will represent approximately 15% of its fully-diluted capital and approximately 76% of the options in the option pool will be unissued.[41] Thus, immediately after a Series A financing, unissued options will represent approximately 11.4% (or, 15% * 76%) of the Total Shares.[42]

3.      Adjustments to VC Math Amounts for the Representative 2013 Series A Co

Assuming options that have not yet been (and may never be) issued to anyone make up 11.4% of the Representative 2013 Series A Co’s fully diluted capital immediately after the Series A financing, only 88.6% of the VC Math Total Shares (or, 8,860,000 Total Shares) are legitimate when considering the company’s current value. That is, the VC Math Total Shares are overstated by 1,140,000 shares (or, 11.4% * 10,000,000 Total Shares) that might be acquired by options that might be issued in the future to employees but are, nevertheless, currently unissued options. Moreover, none of this overstatement will be reflected in the New Shares amount, since that amount represents shares VC purchases in the financing. Instead, the entire 11.4% reduction to the Total Shares amount must come out of the Old Shares amount. Making this adjustment results in VC really acquiring 34.85593% (or, 3,088,235 New Shares/8,860,000 Total Shares) of the Representative 2013 Series A Co for the $4.2 million investment thereby reducing the company’s post-money and pre-money valuations to $12,049,600 (or, $4.2 million/34.85593%) and $7,849,600 (or, $12,049,600 – $4.2 million), respectively. Further, the percent of ownership not acquired by VC becomes 65.14407% (or, 100% – 34.85593%). These amounts are summarized in the right column of Table 2.

 

Table 2: Representative 2013 Series A Co – VC Math Amounts Including Adjustments for Unissued Options (Unissued Os)

ITEM VC Math
Amount		 Adjusted for:
Unissued Os
Pre-Money Valuation $9,400,000 $7,849,600
VC Investment Amount $4,200,000 $4,200,000
Post-Money Valuation $13,600,000 $12,049,600
Ownership NOT Acquired by VC 69.11765% 65.14407%
Ownership Acquired by VC 30.88235% 34.85593%
Old Shares 6,911,765 5,771,765
New Shares 3,088,235 3,088,235
Total Shares 10,000,000 8,860,000
New Share Price $1.36 $1.36

 

B.     Vesting

1.      Background Information

Through a process referred to as vesting, founders must earn their shares of common stock and other employees must earn their options to purchase shares of common stock.[43] Vesting typically occurs when the individual holding the option or stock continues to be employed by the company over a specific period of time.[44] A typical vesting schedule for an employee option occurs monthly over four years, with the right to purchase the initial 25% of the shares covered by the option vesting when the employee has been employed by the company for 12 months.[45] Most founders will commence vesting the date they start providing services to the company, even if that date is prior to the company’s date of incorporation.[46] Moreover, because a founder acquires common stock, as opposed to an option, vesting is accomplished by the issued stock being subject to a contractual “repurchase option” at cost (which is often a nominal value) in favor of the company.[47] The repurchase option will then lapse, usually monthly over a four-year period, as the founder provides services to the company.[48] VC Math’s Total Shares amount includes all outstanding common stock and issued and unissued options, whether vested or not.[49] However, employees have not yet earned (and thus do not yet truly own) the right to purchase shares covered by their unvested options.[50] Similarly, founders have not yet earned (and thus do not yet truly own) their unvested stock.[51] By including the unvested options and stock in the Total Shares, VCs (again) acquire a larger true ownership percentage of a company resulting in VC Math valuations being (further) overstated. In order to determine a company’s true current value, one should back out unvested options and shares as of the date of the financing.

2.      Quantitative Norms for Companies Raising Their Series A Round

For a typical company that just completed its Series A round, it is unlikely that more than 25% of the company’s issued common stock has vested.[52] It is also unlikely that more than 25% of the issued options have vested at the time of the Series A financing.[53]

3.      Adjustments to VC Math Amounts for the Representative 2013 Series A Co

Because it is unlikely that more than 25% of the Representative 2013 Series A Co’s issued options and common stock have vested at the time of the Series A financing, the Total Shares and Old Shares amounts are likely to be significantly overstated. Specifically, if all of the Representative 2013 Series A Co’s Old Shares are represented by common stock or options to purchase common stock held by founders and other employees, only 25% of the Old Shares amount, after being adjusted for unissued options, is legitimate when considering the company’s current value (since the remaining shares, or the options to purchase them, by definition, have not yet been earned).[54] Thus, the issued and vested Old Shares amount becomes 1,442,941 shares (or, 5,771,765 issued Old Shares * 25% vested) and the Total Shares amount becomes 4,531,176 shares (or, 1,442,941 Old Shares + 3,088,235 New Shares). This means VC really acquires 68.15526% (or, 3,088,235 New Shares /4,531,176 Total Shares) of the Representative 2013 Series A Co for its $4.2 million investment thereby further reducing the company’s post-money and pre-money valuations to $6,162,400 (or, $4.2 million/68.15526%) and $1,962,400 (or, $6,162,400 – $4.2 million), respectively. Moreover, the percent of ownership not acquired by VC becomes 31.84474% (or, 100% – 68.15526%). These amounts are summarized in the right column of Table 3.

 


Table 3: Representative 2013 Series A Co – VC Math Amounts Including Adjustments for Unissued Options (Unissued Os) and Unvested Options and Common Stock (Unvested Os/CS)

    Adjusted for:
ITEM VC Math
Amount		 Unissued Os Unissued Os &
Unvested Os/CS
Pre-Money Valuation $9,400,000 $7,849,600 $1,962,400
VC Investment Amount $4,200,000 $4,200,000 $4,200,000
Post-Money Valuation $13,600,000 $12,049,600 $6,162,400
Ownership NOT Acquired by VC 69.11765% 65.14407% 31.84474%
Ownership Acquired by VC 30.88235% 34.85593% 68.15526%
Old Shares 6,911,765 5,771,765 1,442,941
New Shares 3,088,235 3,088,235 3,088,235
Total Shares 10,000,000 8,860,000 4,531,176
New Share Price $1.36 $1.36 $1.36

 

C.     The Two-Class Equity System

1.      Background Information

While founders and other employees will hold common stock and options to purchase common stock, VCs will hold convertible preferred stock.[55] In fact, convertible preferred stock is “practically the exclusive means of external financing for U.S. venture capital-backed companies.”[56] By holding convertible preferred stock, VCs will have rights and preferences generally not given to holders of common stock.[57] The most popular of these rights and preferences are in respect to the earnings or assets of a company.[58] However, virtually any combination of rights and preferences is possible.[59] In addition to responding to control and other concerns associated with startups, granting unique rights and preferences to convertible preferred stock minimizes the tax on employee incentive compensation.[60] This is because companies are able to sell (i) convertible preferred stock at a relatively high price to VCs and (ii) common stock at a relatively low price to employees.[61] If VCs purchased stock at the same (relatively low) price employees pay, employees would quickly be diluted and would thus lose motivation when companies raise external capital since raising significant funds from VCs would require issuing too many New Shares relative to the number of Old Shares.[62] On the other hand, if employees were required to purchase stock at the same (relatively high) price VCs pay, employees may not be able to afford enough shares to become motivated.[63] Further, issuing identical stock at two different prices, on or around the same date, would create tax issues.[64] Having two classes of stock can address these issues. As one Silicon Valley law firm puts it:

At a minimum, the [convertible] preferred stock gives investors a liquidation preference in the event the company fails or is acquired. In addition, [VCs] usually obtain certain other preferential rights over the holders of common stock. From your company’s point of view, these preferences justify a fair market value differential between the [convertible] preferred stock and common stock. This enables your company to sell common stock to your employees at a lower price than is paid by [VCs].[65]

 

VC Math values Old Shares, which include common stock and options to purchase common stock, at the New Share Price. However, as discussed above, shares of common stock are intentionally worth less than the shares of convertible preferred stock VC acquires at the New Share Price. By valuing common stock at an inflated price, VC Math (further) overstates valuations. In order to determine a company’s true current value, the company’s Old Shares (that are represented by common stock and options to purchase common stock) must be appropriately priced.

2.      Quantitative Norms for Companies Raising Their Series A Round

For a typical company that just completed its Series A round, a share of its common stock will be priced at approximately 10% to 50% of the price of a share of its convertible preferred stock.[66] For years, venture backed companies valued their common stock at 10% of the price of their convertible preferred stock being sold at or around the same time.[67] However, Section 409A of the Internal Revenue Code recently increased the need for diligence when valuing common stock.[68] This is because Section 409A and its regulations require the value of a private company’s stock to “be determined, based on the company’s own facts and circumstances, by the application of a reasonable valuation method.”[69]

3.      Adjustments to VC Math Amounts for the Representative 2013 Series A Co

Even if we assume the high end of the “10% to 50%” range referenced above, the Representative 2013 Series A Co’s common stock is worth $0.68 per share (or, 50% * $1.36 New Share Price) at the time of the Series A financing.[70] Because there are 1,442,941 Old Shares, after adjusting for unissued options and unvested options and common stock, the value of the Old Shares and thus pre-money valuation is $981,200 (or, $0.68 per share * 1,442,941 Old Shares).[71] Further, since VC is investing $4.2 million, the Representative 2013 Series A Co’s post-money valuation is $5,181,200 (or, $981,200 + $4,200,000). Thus, while VC acquires 68.15526% of the Representative 2013 Series A Co’s issued and vested shares (or, 3,088,235 New Shares/4,531,176 Total Shares), VC actually acquires 81.06230% (or, $4,200,000/$5,181,200) of the company’s true current value and thus economic ownership. Again, this is because a share of convertible preferred stock is more valuable than a share of common stock. This also results in 18.93770% (or, 100% – 81.06230%) of the Representative 2013 Series A Co’s true current value (and thus true economic ownership) not being acquired by VC. These amounts are summarized in the right column of Table 4.

 

Table 4: Representative 2013 Series A Co – VC Math Amounts Including Adjustments for Unissued Options (Unissued Os), Unvested Options and Common Stock (Unvested Os/CS) and Mispriced Common Stock (Mispriced CS)

    Adjusted for:
ITEM VC Math
Amount		 Unissued Os Unissued Os &
Unvested Os/CS		 Unissued Os,
Unvested Os/CS
& Mispriced CS
Pre-Money Valuation $9,400,000 $7,849,600 $1,962,400 $981,200
VC Investment Amount $4,200,000 $4,200,000 $4,200,000 $4,200,000
Post-Money Valuation $13,600,000 $12,049,600 $6,162,400 $5,181,200
Ownership NOT Acquired by VC 69.11765% 65.14407% 31.84474% 18.93770%
Ownership Acquired by VC 30.88235% 34.85593% 68.15526% 81.06230%
Old Shares 6,911,765 5,771,765 1,442,941 1,442,941
New Shares 3,088,235 3,088,235 3,088,235 3,088,235
Total Shares 10,000,000 8,860,000 4,531,176 4,531,176
New Share Price $1.36 $1.36 $1.36 $1.36
Old Share Price N/A N/A N/A $0.68

 


V.         Formula to Apply the IVY Adjustments to VC Math Pre-Money Valuations

Companies raising their first round of venture capital can use the following formula to adjust VC Math pre-money valuations for the three standard practices examined above:

 

PreMADJ = PreMVCM    *               I   *   V   *   Y

 

Where:

PreMADJ       is the pre-money valuation adjusted for the three standard practices

PreMVCM     is the pre-money valuation using VC Math

I                    is the percent of Old Shares already issued

V                  is the percent of issued Old Shares already vested

Y                  is the yield (or ratio) of the fair market value of a share of common stock to the New Share Price

Per Section IV, the Representative 2013 Series A Co’s amounts for I, V and Y are as follows[72]:

I    =   83.5063836

V   =  25%

Y   =  50%

Thus, given the Representative 2013 Series A Co’s PreMVCM equals $9.4 million,[73] its PreMADJ equals $981,200. This is calculated as follows[74]:

PreMADJ = PreMVCM          *             I                  *      V       *    Y

PreMADJ = $9.4 million   *   83.5063836%    *    25%   *   50%

PreMADJ = $981,200

To the extent these values for I, V and Y are correct for different companies raising their Series A round, a particular company’s PreMADJ would equal approximately 10% of its PreMVCM.[75] However, as the right column of Table 5 illustrates, the PreMADJ / PreMVCM ratio will change as values for I, V and Y change.

 

Table 5: Ratios of Adjusted Pre-Money Valuations to VC Math Pre-Money Valuations (Where PreMVCM equals $9.4 million and Different Values are Assumed for I, V and Y)

Assuming:  
PreMVCM = I = V = Y = PreMADJ = PreMADJ / PreMVCM =
$9,400,000 80% 10% 10% $75,200 0.80%
$9,400,000 85% 15% 25% $299,625 3.19%
$9,400,000 90% 25% 33% $697,950 7.43%
$9,400,000 100% 33% 50% $1,551,000 16.50%

 

VI.      Considering Series Seed and Other Convertible Preferred Stock

Until now, this Article has assumed that all of the Old Shares are represented by common stock and options for common stock. While this may be the case for some companies raising their first round of venture capital, other companies may have issued “Series Seed” stock to friends, family members, angel investors or “seed round VCs” prior to raising their Series A round.[76] Because Series Seed stock is fully-vested and will typically acquire the same rights and preferences as Series A convertible preferred stock (once the Series A financing occurs),[77] the percentage of Old Shares represented by Series Seed stock should not be adjusted for I, V or Y. Thus, the PreMADJ formula becomes:

 

PreMADJ = (PCS * (PreMVCM * I * V * Y))             +          (PPS * PreMVCM)

 

Where:

PCS     is the percent of Old Shares represented by common stock and options to purchase common stock

PPS     is the percent of Old Shares represented by Series Seed stock (and other stock that will have the same rights as the New Shares)[78]

 

Assuming that a company’s Series Seed stock represents 20% of its Old Shares,[79] and using Section IV’s amounts for I, V and Y (83.5063836%, 25% and 50%, respectively), the company’s PreMADJ equals $2,664,960 (or, 28.35% of the $9.4 million amount). This is calculated as follows:

PreMADJ = (PCS * (PreMVCM * I * V * Y))             +          (PPS * PreMVCM)

PreMADJ  = (80% * ($9,400,000 * 83.5063836% * 25% *50%)) + (20% * $9,400,000)

PreMADJ = (80% * $981,200) + (20% * $9.4 million)

PreMADJ = $2,664,960

VII.     Conclusion

While recent valuations attributed to venture backed companies may be shocking, the VC Math used to calculate the valuations is flawed. This is because VC Math: (i) treats unissued, and even non-existing, stock options as outstanding shares of stock; (ii) ignores the fact that much of the common stock and options to purchase common stock have not yet been earned; and (iii) values common stock and convertible preferred stock equally despite the fact that convertible preferred stock was intentionally created to be worth more. The cumulative effect of disregarding these three standard practices is substantial. As this Article illustrates, pre-money valuations calculated using VC Math may be overstated by 10X for companies raising their first round of venture capital. While this should be surprising, what seems more bizarre is the fact that so many intelligent people use VC Math formulas that ignore the existence and impact of three practices they helped make standard. Perhaps more sophisticated investors are taking advantage of less sophisticated entrepreneurs.[80] Alternatively, perhaps overstated valuations just make everyone feel better. Regardless, this Article encourages and empowers people to adjust VC Math amounts to better reflect the economic impact of these practices.

Preferred citation: Jeff Thomas, Venturenomics: Adjusting for Three Standard Practices May Reduce Venture-Backed Company Pre-Money Valuations by 90%, 5 Harv. Bus. L. Rev. Online 1 (2014), https://journals.law.harvard.edu/hblr//?p=3918.

* Jeff Thomas is the Chair of the School of Business at Johnson & Wales University in Charlotte, NC. He also serves on the Board of Directors of Queen City Forward, an accelerator for social ventures. He has extensive experience in counseling entrepreneurial ventures through law firms and law school clinics in Chicago and Silicon Valley.

[1] A “pre-money valuation” is the value of a company prior to the round of the investment. See infra Section II.

[2] See, e.g.,Explanation of Certain Terms Used in Venture Financing Terms Survey, Fenwick & West LLP (Oct. 4, 2013), http://www.fenwick.com/publications/pages/explanation-of-certain-terms-used-in-venture-financing-terms-survey.aspx (defining “‘Series’ of Preferred Stock” as “[w]hen a company raises venture capital . . . [t]he shares sold in the first financing are usually designated ‘Series A,’ the second ‘Series B’, the third ‘Series C’ and so forth”).

[3] U.S. VC Valuations & Trends: 2014 Annual Report, PitchBook Data, Inc. 7 (last visited Oct. 28, 2014), http://pitchbook.com/2014_Annual_US_VC_Valuations_and_Trends_Report.html [hereinafter PitchBook Annual Report].

[4] See, e.g., Kimberly Weisul, VC Investment Reaches Highs Not Seen Since Dot-Com Bubble, Inc. (Apr. 10, 2014), http://www.inc.com/kimberly-weisul/venture-investment-reaches-highs-not-seen-since-dot-com-bubble.html (“[V]enture capital data is also making it harder to argue that we’re not in some sort of bubble.”).

[5] See infra Section IV.

[6] See infra Section IV.A.

[7] See infra Section IV.B.

[8] See infra Section IV.C.

[9] See, e.g., Michael A. Woronoff & Jonathan A. Rosen, Practitioner Note, Effective vs Nominal Valuations in Venture Capital Investing, 2 N.Y.U. J.L. & Bus. 199, 200 (2005) (“The focus on the nominal pre-money and post-money value and ownership percentage, though common, is misguided.” (footnote omitted)).

[10] See infra Section V.

[11] See id.

[12] See, e.g., Constance E. Bagley & Craig E. Dauchy, The Entrepreneur’s Guide to Business Law 445 (3d ed. 2008).

[13] Id. (emphasis added).

[14] See, e.g., William A. Sahlman, The Basic Venture Capital Formula, Harvard Business School Background Note 9-804-042, at 3 (May 13, 2009).

[15] See id.

[16] Alternatively, if the post-money valuation has already been established, one can back into the New Share Price or Total Shares amount once a value is set for one of those items. For example, if New Co’s post-money valuation and Total Shares amount are $10,000,000 and 10,000,000, respectively, Formula 3 can be used to deduce that the New Share Price is $1.00 (or, $10,000,000/10,000,000 Total Shares).

[17] Alternatively, if the pre-money valuation has already been established, one can back into the New Share Price or Old Shares amount once a value is set for one of those items. For example, if New Co’s pre-money valuation and New Share Price are $6,000,000 and $1.00, respectively, Formula 4 can be used to deduce that New Co has 6,000,000 Old Shares (or, $6,000,000/$1.00 New Share Price).

[18] See, e.g., Term Sheet, National Venture Capital Association 2 (June 2013), http://www.nvca.org/index.php?option=com_docman&task=doc_download&gid=75&Itemid=93 [hereinafter NVCA Term Sheet] (demonstratingthat the New Share Price, pre-money valuation, and post-money valuation are based on a fully-diluted capitalization table and that an option pool will represent a certain percentage of the company’s fully diluted post-money capitalization table).

[19] On a converted to common stock basis (holders of convertible preferred stock have the option of converting their shares to common stock (typically) at an initial ratio of 1:1; however, the ratio is subject to adjustments (i) for stock dividends, splits, combinations and similar events and (ii) pursuant to the anti-dilution provisions granted to the convertible preferred stock. See, e.g., NVCA Term Sheet, supra note 18, at 4).

[20] Note that other phrases such as “granted options” or “options no longer available for grant” or “allocated options” or “allocated shares” may also be used to describe an option pool’s issued options.

[21] Note that other phrases such as “ungranted options” or “options available for grant” or “unallocated options” or “unallocated” may also be used to describe an option pool’s unissued options.

[22] See, e.g., NVCA Term Sheet, supra note 18, at Exhibit A. Moreover, see infra Section VI for consideration of the Old Shares including Series Seed stock, which will typically acquire the same rights as the Series A stock (once the Series A stock is issued).

[23] See PitchBook Annual Report, supra note 3, at 7.

[24] See id. at 5.

[25] For illustrative purposes, this article assumes 10,000,000 Total Shares which results in a New Share Price of $1.36. However, once the pre-money valuation and VC investment amount are known (and thus ownership percentages can be calculated), an infinite combination of Total Shares and New Share Price amounts could be assumed. That is, if we would like to assume a different Total Shares amount, we would simply need to make a corresponding adjustment to the New Share Price (or vice versa). For example, if we assumed 5,000,000 Total Shares (and given the post-money valuation of $13.6 million), Formula 3 deduces a New Share Price of $2.72 (or, $13.6 million/5,000,000 Total Shares). Because VC’s ownership interest is still 30.88235% (or, $4.2 million/$13.6 million), VC would own 1,544,117.5 New Shares (or, 5,000,000 Total Shares * 30.88235%) resulting in 3,455,882.5 Old Shares (or, 5,000,000 Total Shares – 1,544,117.5 New Shares). Using Formula 3, the post-money valuation still equals $13.6 million (or, $2.72 New Share Price * 5,000,000 Total Shares). Further, using Formula 4, the pre-money valuation still equals $9.4 million (or, $2.72 New Share Price * 3,455,882.5 Old Shares).

[26] Formulas 1 through 4 can also be used to illustrate VC Math amounts for the Representative 2013 Series A Co:

Formula 1: Post-Money Valuation = VC Investment Amount / Ownership % Acquired

$13.6 million = $4.2 million/30.88235%

Formula 2: Pre-Money Valuation = Post-Money Valuation – VC Investment Amount

$9.4 million = $13.6 million – $4.2 million

Formula 3: Post-Money Valuation = New Share Price x Total Shares

$13.6 million = $1.36 * 10,000,000 shares

Formula 4: Pre-Money Valuation = New Share Price x Old Shares

$9.4 million = $1.36 * 6,911,765 shares

[27] For example, venture-backed companies may offer different products and services.

[28] See infra Section IV.A.

[29] See infra Section IV.B.

[30] See infra Section IV.C.

[31] See, e.g., Bagley & Dauchy, supra note 12, at 89–90 (“At the formation stage of the business and for some time thereafter, it is usually best to issue stock outright [to founders] rather than to use stock options. . . . As the company matures and the value of the stock increases, stock options are used extensively to allow employees and others the opportunity to participate in the growth of the business without putting up cash . . . .”);Guide to Starting a Corporation, Fenwick & West LLP 6 (Apr. 22, 2009), http://www.fenwick.com/FenwickDocuments/2009_Guide_Starting_Corp.pdf [hereinafter Fenwick Corporation Guide] (“A common initial [capital] structure is to authorize 10 million shares of common stock . . . [with] about 3-5 million shares issued [to founders] and about 1-2 million shares reserved in the [option pool].”).

[32] Note that other phrases such as “equity incentive plan” or “employee stock pool” or “employee plan” or “stock option plan” or “employee stock plan” or “stock plan” may be used to describe an option pool.

[33] Orrick, Herrington & Sutcliffe LLP provides examples of related forms including a: (i) Stock Plan; (ii) Board Approval of Stock Plan; and (iii) Stockholder Approval of Stock Plan. See Start-Up Forms: Equity Compensation, Orrick, Herrington & Sutcliffe LLP,http://www.orrick.com/Practices/Emerging-Companies/Startup-Forms/Pages/Forms-Compensation.aspx (last visited Jun. 22, 2014) [hereinafter Orrick Equity Compensation].

[34] A company’s employees can be granted more favorably taxed incentive stock options which must, among other things, have exercise price of at least 100% of the fair market value of the underlying stock at the date of issuance and a maximum duration of 10 years; however, individuals typically have only one to three months after termination of service to exercise their options. See, e.g., Bagley & Dauchy, supra note 12, at 92, 314.

[35] For example, assume New Co would like to hire a Diane as an employee. To entice Diane to join its team, New Co offers to issue Diane an option to purchase 400,000 shares of New Co’s common stock for $0.11 a share. The $0.11 “exercise price” equals the fair market value of the New Co common stock on the date the option is issued. Thus, once hired, Diane has an economic incentive to work hard and help increase New Co’s stock price. If we assume New Co’s stock price increases to $15.11 per share, and that Diane exercises her option to purchase all 400,000 shares for $44,000 (or, $0.11 per share * 400,000 shares), she would receive economic value of $6,044,000 (or, $15.11 per share * 400,000 shares) and an economic gain of $6,000,000 (or, $6,044,000 of economic value less the $44,000 of exercise price she must pay).

[36] See e.g., Orrick Equity Compensation, supra note 33 (under “Stock Plan,” it reads: “[m]any companies use employee stock options to compensate, retain, and attract employees.”);Meghan Casserly, Understanding Employee Equity: Every Startup’s Secret Weapon, Forbes.com (Mar. 8, 2013, 5:30 PM), http://www.forbes.com/sites/meghancasserly/2013/03/08/understanding-employee-equity-bill-harris-sxsw/

[37] Assume that when New Co initially adopted its option pool, 1,000,000 shares of common stock were “reserved” for option issuances to future employees. After issuing Diane an option for 400,000 shares, New Co would have unissued options for 600,000 shares (or, 1,000,000 total shares reserved – 400,000 shares covered by the option issued to Diane). Even though unissued options for 600,000 shares can be issued to attract and motivate future New Co employees, all 1,000,000 shares reserved under the option pool would be included in the Total Shares.

[38] See, e.g., Fred Wilson, Valuation and Option Pool, AVC (Nov. 6, 2009), https://avc.com/2009/11/valuation-and-option-pool/; Brad Feld, Term Sheet: Price, FeldThoughts (Jan. 3, 2005), http://www.feld.com/wp/archives/2005/01/term-sheet-price.html.

[39] This is done by requiring the companies to increase the size of their option pools. For example, assume that VC would like to invest in New Co but believes New Co needs additional shares in its option pool in order to attract and motivate employees it will need to grow in the coming years. Specifically, assume VC insists New Co’s option pool represent 20% of 10,000,000 Total Shares. Thus, VC will condition its investment in New Co on New Co increasing the size of its option pool to 2,000,000 shares. Assuming VC is acquiring 4,000,000 shares and that New Co’s option pool previously covered 1,000,000 shares, increasing the size of the option pool to 2,000,000 shares gives VC the ability to say VC is only acquiring 40% (or, 4,000,000 New Shares/10,000,000 Total Shares) of New Co instead of 44.44% (or, 4,000,000 New Shares/9,000,000 Total Shares).

[40] See, e.g., Jim Brenner, Option Pools: What’s Market in the “New Normal,” in The Entrepreneurs Report, Private Company Financing Trends (Wilson Sonsini Goodrich & Rosati ), Q4 2012, http://www.wsgr.com/publications/PDFSearch/EntrepreneursReport-Q4-2012.pdf [hereinafter WSGR Report] (“In almost all cases, new investors require a company to increase the size of its option pool as part of the pre-money valuation prior to the financing . . . [the] increase in the option pool effectively reduces the pre-money valuation of the company . . . .”).

[41] See id. at 9. (“The average size of the post-Series A total option pool that we examined was 15.9% of fully diluted capital and the median size was 14.5% . . . . It is also useful to note that immediately following the Series A financing, an average of approximately 24% of the stock options in the plan already had been granted.”). I (conservatively) round down from 15.9% to 15%.

[42] This 11.4% amount is also consistent with the WSGR Report’s average (12.06%) and median (10.56%) percentages of options available for grant following the Series A round. See id. at 11. Moreover, 11.4% is consistent with Fred Wilson’s reported experiences. See Wilson, supra note 38 (“In most of the early stage financings I’ve done in the past few years this work on the option pool has shown a need for around 10% in unissued options. I’ve seen it as big as 15% but that is rare. I’ve also seen it as low as 5%, but that is even more rare.”).

[43] See, e.g., Bo Yaghmaie, Vesting: A Founder’s Need to Earn Equity, Entrepreneur (Jan. 27, 2014), http://www.entrepreneur.com/article/231044 (“Vesting is absolutely standard in venture deals. It is predicated on the notion that the founding and management teams must earn their equity by contributing to value creation through so-called ‘sweat equity,’ or hard work.”).

[44] Bagley & Dauchy, supra note 12, at 94.

[45] See, e.g., John Bautista, What Entrepreneurs Need to Know about Founders’ Stock, Think Big. Move Fast. (Sep. 15, 2008), http://lsvp.com/2008/09/15/what-entrepreneurs-need-to-know-about-founders-stock/ (noting that the first year of vesting is referred to as “cliff vesting”).

[46] See id.

[47] See, e.g., Yaghmaie, supra note 43; Common Stock Purchase Agreement (with Vesting), Orrick, Herrington & Sutcliffe LLP 1, http://www.orrick.com/Events-and-Publications/Documents/1951.pdf (last visited Jun. 23, 2014).

[48] See, e.g., Fenwick Corporation Guide, supra note 31, at 8 (“The corporation typically retains the option to repurchase unvested shares at the initial purchase price at the time of termination of a shareholder’s employment. Vesting usually occurs over 4 years, i.e., if the employee remains employed by the corporation for the entire period, all shares become ‘vested’ and the repurchase option ends.”).

[49] See supra note 22 and accompanying text.

[50] For example, assume Diane is issued an option to purchase 400,000 shares of New Co common stock for $0.11 a share and she will be able to purchase 100,000 shares (or, 25% * 400,000 shares) after her one-year anniversary at New Co and an additional 8,333 and 1/3 shares (or, 100,000 shares/12 months) at the end of each of the next 36 months thereafter. Thus, if Diane leaves New Co immediately after her three-year anniversary, she will be able to purchase 300,000 shares (or, 100,000 shares after the initial 12 months + (8,333 and 1/3 shares per month * 24 additional months)). If the stock is valued at $10.11 a share at the time of her three-year anniversary, Diane would have an economic gain of $3,000,000 (or, $3,033,000 worth of stock – $33,000 of exercise price she must pay). However, by departing New Co immediately after her three-year anniversary, Diane would “lose out” on $1,000,000 of additional appreciation to date (or, $1,011,000 worth of unvested options – the $11,000 exercise price she would have to pay) because her right to purchase the remaining 100,000 shares had not vested prior to her departure.

[51] For example, assume that: (i) Sam is the founder of New Co which was incorporated on January 2, 2013; (ii) Sam started working on New Co-related business on January 2, 2013; (iii) Sam acquired 4,000,000 shares of New Co commons stock for $0.001 per share on January 2, 2013 (for a total of $4,000); (iv) as a condition to investing in October 2013, VC required Sam’s shares to become subject to a repurchase option, at cost, in favor of New Co; (v) the repurchase option will lapse, and thus Sam’s shares will vest monthly over a four-year period commencing as of January 2, 2013; (vi) despite New Co’s success in 2013, Sam quit New Co on January 3, 2014; and (vii) on January 3, 2014, New Co’s stock was valued at $2.00 per share. Upon Sam’s departure, New Co would exercise its repurchase option and buy back Sam’s unvested shares for $3,000 (or, 3,000,000 shares x $0.001 per share) even though those shares would then be worth $6,000,000 (or, 3,000,000 shares x $2.00 per share). Thus, while Sam had purchased all 4,000,000 shares on January 2, 2013, it seems as though he does not truly own 3,000,000 of those shares on January 3, 2014 since he must allow New Co to repurchase those shares at a $5,997,000 discount (from their value) on that date. Instead, it seems as though Sam truly owns only his vested stock (that is, the 1,000,000 shares that are no longer subject to the repurchase option on January 3, 2014).

[52] See, e.g.,Yaghmaie, supra note 43 (“The range of credit that venture investors are willing to give a founder tends to fall somewhere between 10 to 25% . . . .”); Bautista, supra note 45 (“In Orrick’s experience, venture capitalists require that at least 75% of founders’ stock remain subject to vesting over the three or four years following the date of Series A investment.”).

[53] This is because, by definition, founders have been at a company the longest. Thus, subsequent employees (who receive options) would have experienced less vesting.

[54] See infra Section VI for a discussion of when Old Shares are represented by Series Seed stock or other shares that will have the same rights as the New Shares being acquired by VC.

[55] See, e.g., Bagley & Dauchy, supra note 12, at 87.

[56] Ronald J. Gilson & David M. Schizer, Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock, 116 Harv. L. Rev. 874, 879 (2003).

[57] See, e.g., Woronoff & Rosen, supra note 9, at 206.

[58] Id. Also, for an example of the value of such rights and preferences, assume that: (i) Sam and VC are New Co’s two stockholders; (ii) Sam purchased 4,000,000 shares of New Co common stock for $0.001 per share on January 2, 2013 (for a total of $4,000); (iii) all of Sam’s shares have since vested; (iv) VC purchased its 4,000,000 shares of Series A convertible preferred stock in October 2013 for $1.00 per share (for a total of $4,000,000); (v) the Series A convertible preferred stock has a “1x” liquidation preference, entitling VC to recoup “1 times” its original purchase price before any proceeds from a New Co liquidation are distributed to common stockholders; (vi) after selling all of its assets and paying off of its debts, New Co has $5,000,000; and (vii) New Co plans to distribute all of the sale proceeds to its stockholders. Even though Sam owns 50% of New Co’s nominal shares, VC’s 1x liquidation preference entitles VC to $4,000,000 (or, 80% of the sale proceeds) leaving Sam with just $1,000,000 (or, 20% of the sale proceeds). VC’s convertible preferred stock may also have full “participation rights” which entitle VC to share any amounts remaining, after payment of the liquidation preference, with the holders of common stock (as if the VC had converted its stock to common stock). If this was the case, VC would receive 50% of the $1,000,000 remaining after VC’s $4,000,000 liquidation preference is paid. Further, this would result in VC receiving $4,500,000 (or, 90% of the proceeds) and Sam receiving $500,000 (or, 10% of the proceeds).

[59] See, e.g.,NVCA Term Sheet, supra note 18, at 2–12 (providing that rights and preferences granted to the Series A convertible preferred stock may include: (a) a liquidation preference – which may entitle a VC to recoup its entire investment amount (or more), upon the sale or dissolution of a company, before common stockholders receive any of the proceeds from the sale or winding-up process; (b) participation rights – which may entitle a VC to a portion of any amounts remaining after the payment of the liquidation preference, upon the sale or dissolution of a company; (c) control rights – which may entitle a VC to designate board members  and benefit from certain contractual protective provisions (such as certain veto rights); (d) conversion rights – which give a VC the right to convert its convertible preferred stock to common stock, when it is advantageous for VC to do so; (e) anti-dilution protections – which may favorably adjust a VC’s conversion price (the price at which VC’s stock converts to common stock) if shares are subsequently issued for less than the price VC paid for its shares; (f) redemption rights – which may entitle a VC to have its shares repurchased by the company at a multiple of the VC’s original purchase price; (h) registration rights – which may entitle a VC to have its stock registered with the Securities and Exchange Commission, at the company’s expense; (i) management and information rights – which may provide a VC with access to a company’s facilities as well as ongoing financial reports and information; (j) right to participate pro rata in future rounds – which may entitle a VC to participate in subsequent issuances of the company’s securities; (k) right of first refusal – which may entitle a VC to purchase shares of stock the company’s founders are proposing to sell to someone else; (l) right of co-sale (or take-me-along or tag-along rights) – which may entitle a VC to join in on a proposed sale of stock by a founder to someone else; (m) drag along rights – which may allow a VC and the company’s board of directors to force all stockholders to sell their shares of company;  and (n) a preferred dividend – which may entitle a VC to a specific amount of dividends before any dividends are paid to common stockholders (and may increase the amount VC is entitled to upon the liquidation of the company or redemption of VCs shares)).

[60] See e.g., Gilson & Schizer, supra note 56, at 877.

[61] Bagley & Dauchy, supra note 12, 64–65, 87, 89–91 and 149.

[62] See id.

[63] See id.

[64] See id. Also, for an example of how the 2-class system may increase incentive compensation, assume VC purchased 4,000,000 shares of New Co’s Series A convertible preferred stock in October 2013 for $1.00 per share (for a total of $4,000,000). Assume further that Diane was hired by New Co immediately after the Series A financing in October 2013 and granted an incentive stock option to purchase 400,000 shares of New Co’s common stock. If there are no bona fide differences between New Co’s common stock and its Series A convertible preferred stock, the exercise price for Diane’s options must be set at least $1.00 per share since VC’s investment supports a $1.00 per share fair market value at that time. However, if New Co’s convertible preferred stock has unique rights and preferences, it will be more valuable than New Co’s common stock. Thus, by utilizing two classes of stock New Co justifies common stock having a fair market value of less than $1.00 per share at the time Diane’s option is granted. Therefore, the exercise price for Diane’s options could be set at less than $1.00 per share thereby increasing her incentive compensation.

[65] Venture Capital for High Technology Companies, Fenwick & West LLP 13 (2010), http://www.fenwick.com/FenwickDocuments/venture_capital_final_2010.pdf [hereinafter Fenwick VC Guide].

[66] See, e.g., Eric Koester, What Every Engineer Should Know About Starting a High-Tech Business Venture 273 (2009) (“A typical price differential between preferred and common stock for an early stage company would be between approximately 2:1 and 10:1, respectively (this price or value differential is just a rule of thumb and is due to the additional rights provided to the preferred stock, including the liquidation preferences, voting rights, participation rights, and veto powers).”); Fenwick VC Guide, supra note 65, at 2, 16 (“Employees continue to buy common stock at a fraction of the price paid by outside investors [and the convertible preferred stock to common stock] price differential starts at 10 to 1 and then declines as the company nears an IPO or acquisition. . . . It is typical for early stage companies (though not approved by the IRS) to establish a fair market value for common stock for such employee plans with a range of 10 to 20 percent of the most recent value of the preferred stock.”).

[67] See e.g., Gilson & Schizer, supra note 56, at 900 n.86 (referring to the “ten-to-one rule” whereby employees common stock is valued at 10% of the price paid by VCs for convertible preferred stock as a “market practice”).

[68] See, e.g., Fenwick Corporation Guide, supra note 31, at 7.

[69] See, e.g., Yoichiro Taku, How do you set the exercise price of stock options to avoid Section 409A issues? Startup Company Lawyer (Jan. 1, 2009), http://www.startupcompanylawyer.com/2009/01/01/how-do-you-set-the-exercise-price-of-stock-options-to-avoid-section-409a-issues/ (citing the CEO of a boutique valuation company stating that “the fair market value of the common stock of a typical early stage technology company is at least around 25% to 30% of the last round preferred stock price” and stating that “[t]he old rule of thumb that the option exercise price could be 10% of the preferred stock price is not valid”).

[70] Alternatively, if we assume the low end of the “10% to 50%” range, the Representative 2013 Series A Co’s common stock would be worth $0.136 per share (or, 10% * $1.36 New Share Price) at the time of the Series A financing. Because there are 1,442,941 Old Shares, after adjusting for unissued options and unvested options and shares, the value of the Old Shares, and thus the pre-money valuation, would be $196,240 (or, $0.136 per share * 1,442,941 Old Shares).

[71] This assumes all Old Shares are common stock or options to purchase common stock. See infra Section VI for when Old Shares are represented by Series Seed stock or other shares that will have the same rights as the New Shares being acquired by VC.

[72] Per Section IV.A.2, unissued options will represent 11.4% of the 10,000,000 Total Shares. This results in 1,140,000 unissued Old Shares (or, 11.4% * 10,000,000 Total Shares) and 5,771,765 issued Old Shares (or, 6,911,765 total Old Shares – 1,140,000 unissued Old Shares). Moreover, 5,771,765 issued Old Shares equals 83.5063836% of the total Old Shares (or, 5,771,765 issued Old Shares/6,911,765 total Old Shares). See supra Sections IV.B.3 and IV.C.3 for calculation of V and Y.

[73] PitchBook Annual Report, supra note 3.

[74] While currently unissued and unvested Old Shares may become issued and vested shares in the future, the economic rights that may eventually be represented by those shares have not yet materialized. Moreover, the economic value that may eventually be attributed to those shares still needs to be created. In the case of unissued shares, future employee-option holders may still need to be identified, recruited and hired. In the case of unvested shares, future work still needs to be performed. See supra note 43. While improving a team and completing work may increase a company’s economic value, simply designating shares for a future team or future work does not. If it did, merely increasing the size of a company’s option pool would increase the company’s valuation. While VC Math supports such an increase in valuation, this is problematic. See supra note 38. Thus, unissued and unvested Old Shares should not be factored into current valuations.

[75] Specifically, 10.4382979% (or, 83.5063836% x 25% x 50%). However, as a company grows and time passes, one would expect V to increase since founders and employees will have remained longer at the company. Moreover, Y should also increase since companies will be closer to an acquisition or IPO. Seesupra note 66 and accompanying text.

[76] See, e.g., Fenwick VC Guide, supra note 65, at 10 (“Some founding teams with strong track records can raise venture capital without a business plan or a product prototype. Most people, however, find it necessary to seek a small amount of “seed” money from friends, relatives, angels or ‘seed round’ venture capitalists.”). However, while Series Seed (preferred) stock may be used to raise seed capital, many companies will instead issue convertible notes to raise such funds. See, e.g., Paul Graham, Tweet, Twitter (Aug. 27, 2010, 7:29 PM), https://twitter.com/paulg/status/22319113993 (“Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”).

[77] See, e.g., Series Seed – Term Sheet, SeriesSeed.Com 1 (Feb. 25, 2014), http://www.seriesseed.com/files/series-seed—term-sheet-v-3-2.doc(stating under “Future Rights” that “[t]he Series Seed will be given the same rights as the next series of Preferred Stock (with appropriate adjustments for economic terms)” upon conversion).

[78] If a company raises later rounds of venture capital and all of its convertible preferred stock will end up having the same rights and preferences, the company’s convertible preferred stock outstanding immediately prior to the later round would be included in the PSS figure. For example, if a company raises is raising its Series B round and the Series B stock will have the same rights and preferences as its (previously issued) Series A stock, the company’s Series A stock would be included in the PSS figure.  Because the Series A stock would be fully-vested and have the same rights and preferences as the Series B stock (given our assumption), the percentage of Old Shares represented by the Series A stock should not be adjusted for I, V or Y.

[79] This assumption of 20% is consistent with Fenwick & West LLP’s illustrative financing scenarios. See, e.g., Fenwick VC Guide, supra note 65 (providing two scenarios whereby Seed investors hold: (i) 14.2857143% (or, 1,000,000 Series Seed shares) of what would constitute the pre-Series A Old Shares (or, 4,250,000 founder shares + 1,750,000 employee shares + 1,000,000 Series Seed shares) of a company with a highly successful team (see id. at 20); or (ii) 21.0526316% (or, 1,000,000 Series Seed shares) of what would constitute the pre-Series A Old Shares (or, 2,000,000 Founder Shares + 1,750,000 Employee Shares + 1,000,000 Seed Shares) of a company with a less experienced team (see id. at 21)). This assumption of 20% is also consistent with PitchBook data. See PitchBook Annual Report, supra note 3 (stating that, for 2013: (i) $5.1 million was the median pre-money valuation for companies raising their Series Seed round (see id. at 7); and (ii) $1.5 million was the median amount raised in the Series Seed round (see id. at 5)). Using VC Math, Series Seed investors would own 22.727% (or, $1.5 million / ($5.1 million + $1.5 million)) of the median company’s shares immediately after the Series Seed round. However, the 22.727% amount would likely decrease due to VCs conditioning their Series A investment on the company increasing its number of unissued options (and thus its number of Old Shares) prior to the Series A round. See supra note 40 and accompanying text.

[80] See, e.g., Woronoff & Rosen, supra note 9, at 225 (noting that “[e]xperienced venture capitalists are acutely aware of the economic value of the rights and preferences of the stock they agree to buy” (alteration in original) (quotingConstance E. Bagley & Craig E. Dauchy, The Entrepreneur’s Guide to Business Law 472 (2d ed. 2003)) and concluding that “many Founders apparently are not so aware of the economic effects of these non-price terms at the time of the initial investment.”).

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An Evaluation Of The U.S. Regulatory Response to Systemic Risk and Failure Posed by Derivatives

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Kimberly Summe*

Derivatives, understood by few but disparaged by many, are often blamed for the collapse of the United States economy in the wake of Lehman Brothers’ bankruptcy in September 2008.[1] A legislative response to the crisis was inescapable and on July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)[2] was signed into U.S. law. While the Dodd-Frank Act addresses many aspects of the financial markets, this Article will focus on Titles II and VII in order to examine how transacting in derivatives has changed in the aftermath of this legislation and to assess how the bankruptcy of a systemically important financial institution engaged in derivative transactions will be approached.

A Bid to Limit Systemic Risk and Failure

The Dodd-Frank Act has two primary objectives that relate to derivatives: first, to limit the systemic risk of modern finance, in part by changing the locus of trading in derivatives and the conduct of derivatives market participants; second, to limit the damage caused by the failure of a systemically important financial institution.[3] With respect to the first objective, the Dodd-Frank Act’s principal strategy required that certain derivatives be “cleared.” With respect to the second objective, the Dodd-Frank Act singled out the entities most likely to cause systemic problems if they failed and subjected them to a new bankruptcy process. This Article will focus on the second objective of the Dodd-Frank Act and in particular on how the failure of a systematically important financial institution would relate to the treatment of derivatives.

Reducing Systemic Risk

The estimated $632 trillion notional over-the-counter derivatives market[4] is in the early transformational stage of where and how such transactions are executed. Title VII of the Dodd-Frank Act requires that all eligible derivatives be cleared through a central clearinghouse, known colloquially as a “central counterparty” or “CCP.” Unlike an over-the-counter derivative transaction where each of the two parties face the risk that its counterparty might fail to perform its obligations, a cleared derivative transaction mitigates this risk of performance failure by having a third party, the CCP, stand between the two parties and absorb that risk.[5]

Two years after the passage of the Dodd-Frank Act, the Commodity Futures Trading Commission (CFTC) proposed that certain credit default swaps and interest rate swaps be cleared. The CFTC’s decision to focus initially on these two products was a function of their importance in the market and the fact that a significant percentage of those swaps were already being cleared. End users of derivatives, such as corporations, are not, however, required to clear swaps if such entities can demonstrate that the swap is being used to hedge or to mitigate commercial risk, the CFTC (or the Securities and Exchange Commission (SEC)) was notified as to how the end user generally meets the financial obligations associated with entering into uncleared swaps, and the entity’s Board of Directors approved such an approach.

Clearinghouses perform a valuable function in their mitigation of counterparty risk. To sustain this function, the clearinghouse’s financial resources must be sufficiently robust to meet its members’ obligations notwithstanding the default of one of its members. Given that J.P. Morgan Chase Bank, Citibank, Goldman Sachs Bank USA, and Bank of America are the four largest derivative counterparties in the United States, the collapse of any one of those institutions could mean the termination of anywhere between a $42.67 and $71.28 trillion notional derivatives portfolio—roughly seven to eleven percent of global notional derivatives value.[6] In addition to the financial resources marshaled by each clearinghouse, another critical component of the clearing model is the provision requiring collateral. The requirement that the parties post collateral every day underpins the purported safety of the clearing model.

Policymakers were correct to focus on collateralization as a risk-mitigation technique. The collateralization of over-the-counter derivative transactions has existed for twenty years, so the posting of collateral for cleared and uncleared transactions to mitigate exposure is not new. Before the economic crisis began, the International Swaps and Derivatives Association (ISDA) reported in its 2006 Margin Survey that the gross amount of collateral in use for over-the-counter derivative transactions was $1.335 trillion, with fifty-nine percent of mark-to-market credit exposure covered by collateral.[7] Today, large dealers reported that eighty percent of over-the-counter derivatives are subject to collateral arrangements, with ninety-six percent of credit derivatives exposure being collateralized.[8] The type of collateral is important as well. Cash has long been the preferred form of collateral. At the end of 2006, nearly eighty percent of collateral was cash, mostly provided in U.S. dollars, and nearly seven years later, similar percentage is true today.[9]

What shifted under the Dodd-Frank Act is that the CCP’s calculation of required collateral is substituted for the individual counterparty’s assessment of its risks. Counterparties to cleared swaps will be required to post initial (or upfront) collateral to the CCP based on the CCP’s assessment of the risk profile of that transaction.[10] In addition, each day the CCP will set the variation margin associated with each transaction by recalculating the value of the transaction and accordingly calling for or releasing collateral, ensuring that counterparties have neutral risk positions in relation to the value of the underlying asset. In other words, the goal is that the CCP receives margin payments every day from counterparties whose contracts moved against them to ensure that the CCP and those that participate through the CCP always have funds to satisfy their obligations under contracts.

The posting of collateral is closely related to how the derivative transactions of an insolvent clearinghouse member are handled. For example, LCH. Clearnet Group’s contract and related rules state that upon a clearing member’s default, the clearinghouse may close out and terminate the cleared transactions and will not transfer such positions. CME Clearing and ICE Trust, by contrast, allow cleared transactions and associated collateral to be transferred to another consenting clearinghouse member.[11] Had Lehman Brothers been a clearing member of CME Clearing, for example, upon its insolvency its $35 trillion notional derivatives portfolio (and associated collateral) would have been ported to another clearinghouse member. The concern in a marketplace where major participants such as Bank of America, Citibank and Morgan Stanley, among others[12] were vulnerable at that same time means that the portability of Lehman Brothers’ derivatives portfolio may not have allayed counterparty risk to the non-defaulting party population because arguably an equally unstable counterparty was receiving those transactions. Alternatively, a stronger clearing member may have rejected the transactions being proposed for transfer without some sort of government backstop for the unknowable counterparty risk being assumed.

Albeit one of the Dodd-Frank Act’s goals was to reduce systemic risk through clearing and collateralization of derivatives, little has changed in terms of how collateralization operates both before and after Lehman Brothers’ bankruptcy. A clearinghouse will determine the collateral required for cleared trades while for over-the-counter derivatives, the counterparties will agree to the extent of such collateralization. As the OCC Quarterly Reports demonstrate, there have actually been very limited counterparty credit losses incurred from over-the-counter derivatives trading activity by U.S. banks. At the end of June 30, 2013, eighteen U.S. banks (out of 1,400) reported a total of $61 million in charge-offs of over-the-counter derivatives exposures, down from $84 million in the first quarter of 2013.[13] Net current credit exposure or the netted amounts of contracts with positive values against those with negative values was reported as $339 billion at the end of the second quarter of 2013—a figure that peaked at $800 billion at the end of 2008.[14] These figures reflect the importance of collateralization and netting in the over-the-counter context and indicate that a very small fraction of the gross notional outstanding of derivatives held at U.S. banks is subject to net current credit exposure. Even with these high collateralization rates in place, at least as reported by U.S. banks, it should be noted that no consensus has formed as to whether there is sufficient collateral in place to mitigate counterparty loss. Researchers at the International Monetary Fund estimated that under-collateralization of derivatives relative to risks in the financial system may be $2 trillion.[15] The TABB Group contended that interest rate and credit derivative transactions’ migration to a clearinghouse would require an additional $240 billion in collateral.[16]

Dealing with Failure

If the Dodd-Frank Act’s first objective was to limit risk before an institution collapses, the second objective was to limit destruction after a systemically important financial institution has failed or is in danger of failing. To accomplish this second objective, the Dodd-Frank Act introduced a new framework in Title II to facilitate the “orderly liquidation” of systemically important financial institutions.[17] The population of systemically important financial institutions includes bank holding companies that have at least $50 billion in assets and nonbank financial institutions such as investment banks or insurance holding companies that the new Financial Stability Oversight Council (Council) deems to be systemically important.[18] At present, there are eight U.S. banks deemed systemically important, along with three Japanese banks, seventeen European banks, and one Chinese bank. Before the Title II orderly liquidation authority procedures apply, however, it must be demonstrated that the use of the U.S. Bankruptcy Code would not be appropriate in the resolution of the institution without the destabilization of the U.S. financial system or a resort to a taxpayer bailout being likely.

It seems certain that all systemically important financial institutions will transact in derivatives and those transactions are more likely today than in 2008 to be booked with a U.S. commercial bank. U.S. banks dominate as derivatives counterparties. The most recent OCC Quarterly Report on Bank Trading and Derivatives Trading reported that out of the 1,400 U.S. banks engaged in derivatives trading, four U.S. commercial banks hold ninety-three percent of that exposure.[19] The concentration of a small number of financial institutions in the derivatives market has not shifted much in many years, including prior to Lehman Brothers’ bankruptcy.[20] The vast majority of this derivatives trading activity focuses on interest rate swaps: in the OCC’s First Quarter Report in 2008, that figure was seventy-nine percent, whereas in the OCC’s Second Quarter Report in 2013, it was eighty-one percent.[21] Interest rate swaps are perhaps the least complicated derivative instrument, particularly as compared to the challenges historically associated with credit derivatives in terms of credit event triggers and settlement, the complex calculations and dependencies of equity derivatives, and the inherent volatility of commodity derivatives, so presumably there is less risk in trading interest rate swaps than other derivatives. In addition, the OCC reports that fifty-nine percent of the top four commercial banks’ net current credit exposure is to other banks and securities firms, with corporates representing thirty-two percent and hedge funds, the most overly collateralized group at 325 percent, being two percent of net credit exposure.[22]

Thus, our financial landscape is dominated by the world’s largest banks, which in turn are among the world’s largest derivatives counterparties. While these banks will be more closely regulated under Title I of the Dodd-Frank Act, the way in which their insolvency will be handled has shifted.

Banks have historically been excluded from application of the U.S. Bankruptcy Code[23] and instead bank insolvencies were addressed under the Federal Deposit Insurance Act (FDIA). The FDIA provides that the Federal Deposit Insurance Corporation (FDIC) may operate as a conservator to preserve the value of a failing bank and return it to financial health or the FDIC may operate as a receiver in order to liquidate a failed bank.[24] Unlike a proceeding under the U.S. Bankruptcy Code, an FDIC receivership or conservatorship is not subject to direct supervision by the courts.[25] In large part, this policy choice was designed to ensure that bank failures were not subjected to the assumed-to-be lengthy proceedings under Chapter 11 of the U.S. Bankruptcy Code and placed more discretion with the FDIC to act expeditiously.

Under an FDIC regime, upon bankruptcy the FDIC has limited repudiation and avoidance powers with respect to derivatives. For example, regardless of whether the FDIC is acting as a conservator or a receiver, it must either disaffirm or repudiate all or none of the qualified financial contracts (derivatives) between the failed bank and the same counterparty, together with associated credit support or collateral.[26] In addition, the FDIC has the right to transfer qualified financial contracts to creditworthy bridge depository institutions.[27] If the FDIC is acting as receiver, it must provide notice of the transfer by 5:00 p.m. EST on the business day after its appointment as receiver.[28] At that time, the counterparty to the failed bank may elect to terminate the qualified financial contract (that is, the non-defaulting counterparty to the failed bank could follow the termination and close-out provisions in Section 6 of the ISDA Master Agreement for derivative transactions). If the FDIC is acting as conservator, there is no time limit on its right to transfer qualified financial contracts and the counterparty may not terminate the qualified financial contracts unless the conservator defaults to a degree that would permit termination under applicable non-insolvency law.[29]

From available reports, it appears that in every recent case where a large U.S. bank has become subject to a receivership proceeding, all qualified financial contracts and associated collateral of the failed bank were transferred in their entirety to a single bridge bank or third party acquirer. When the assets of Washington Mutual Bank, the largest U.S. bank failure to date, were sold in September 2008 to J.P. Morgan Chase, the FDIC transferred to J.P. Morgan Chase all qualified financial contracts to which Washington Mutual Bank was a party. While that process seemed to go well, Washington Mutual was not exactly a powerhouse derivatives market participant. Thus, it is not known whether the FDIC is resourced effectively to be able to handle a systemically important financial institution’s bankruptcy, a clearinghouse’s bankruptcy or multiple simultaneous bankruptcies. To date, the FDIC has fortunately not had the opportunity to deal with a derivatives portfolio approaching anything even near the size of Lehman Brothers’ derivatives portfolio—and Lehman Brothers was not as significant a derivatives market participant as the four largest U.S. commercial banks that trade derivatives.

While it is impossible to know whether the FDIC could effectively administer the bankruptcy of a systemically important financial institution, it is known that Title II’s orderly liquidation authority shifts away from the legal certainty of the bankruptcy processes under the U.S. Bankruptcy Code by permitting the FDIC to engage in ad hoc interventions under Title II. In addition, Title II allows the FDIC to discriminate among similarly situated secured creditors in a bankruptcy. Under Section 506(a)(1) of the U.S. Bankruptcy Code, a creditor’s secured status is determined when the collateral securing the claim is sold or when the Chapter 11 plan is judicially confirmed.[30] In contrast, under the regulations implementing the Dodd-Frank Act, the collateral securing the debt of the covered financial company is valued as of the date of the receiver’s appointment.[31] If the FDIC is unable to find a third party to purchase the collateral, the FDIC may transfer that collateral to a bridge financial company that the FDIC has organized.[32] While the bankruptcy process under the U.S. Bankruptcy Code mandates that the use or sale of the debtor’s property can only occur after there has been due notice and hearing, thereby ensuring the highest price is paid for such assets, Title II allows the FDIC to be on both sides of the transaction and to determine the consideration paid for the assets, with no court or creditor oversight.

The deficiencies of Title II resulted in the development of a proposed new U.S. Bankruptcy Code Chapter 14.[33] Chapter 14 offers two distinct approaches: either a conventional reorganization or a two entity recapitalization of a holding company. Under the Dodd-Frank Act, the FDIC focused on a two entity recapitalization, with a systemically important financial institution’s holding company being recapitalized through the transfer of its assets and liabilities to a new bridge financial company, and this bridge financial company in turn dealing with its operating subsidiaries. By contrast, Chapter 14 provides that if a motion is approved for the transfer of assets and liabilities in the first forty-eight hours of a bankruptcy, then the systemically important financial institution’s operations and ownership of subsidiaries shifts to a new bridge company that is not in bankruptcy. Qualified financial contracts such as derivatives would be kept intact and transferred to the bridge company. Through the transfer, the new bridge company will be effectively recapitalized by leaving the long-term unsecured debt behind in the bankruptcy proceeding.

Conclusion

It was a foregone conclusion that policymakers would respond to the economic crisis in the aftermath of Lehman Brothers’ bankruptcy and the near-collapse of other financial institutions. While it is arguable that the effort to prevent systemic risk through the mandate of clearing derivatives is a useful step, it is not a prophylactic. It remains entirely possible that a clearinghouse itself is capable of failure, as several have failed in the past, and the concentration of derivatives trading in the largest global financial institutions has exacerbated this possibility. Certainly, having the clearinghouse as the counterparty mitigates counterparty credit risk, but there may be costs involved if we have simply migrated to a more focused nucleus of systemically important financial institutions that could possibly fail. In addition, addressing the potential or eventual failure of a systemically important financial institution could have been addressed in a more judicially sound manner than the ad hoc approach policymakers chose to burden the FDIC with. There are attractive features of Title II, such as coordination with foreign regulators, but not at the expense of due process and judicial review. While the markets have already moved to accommodate the clearing of mandated derivative transaction types, it is hoped that efforts can be made to revise Title II as it relates to how the failure of a systemically important financial institution is handled.

 

Preferred citation: Kimberly Summe, An Evaluation of the U.S. Regulatory Response to Systemic Risk and Failure Posed by Derivatives, 4 Harv. Bus. L. Rev. Online 76 (2014), https://journals.law.harvard.edu/hblr//?p=3779.

[*] Kimberly Summe is the Chief Operating Officer and General Counsel at a multi-billion dollar San Francisco based investment advisor, Partner Fund Management, LP. She previously served as a Managing Director at Lehman Brothers and General Counsel at the International Swaps and Derivatives Association. Ms. Summe is a lecturer in law at the Stanford Law School and is a member of the Resolution Working Group at the Hoover Institution, which focuses on bankruptcy reform.

[1] On April 20, 2010, U.S. Treasury Secretary Timothy Geithner testified to the House of Representatives Financial Services Committee that “the market turmoil following Lehman’s bankruptcy was in part attributable to uncertainty surrounding the exposure of Lehman’s derivatives counterparties.” See Treasury Secretary Tim Geithner Written Testimony before the House Financial Services Committee, U.S. Dept. Treasury, (Apr. 20, 2010) http://www.treasury.gov/press-center/press-releases/Pages/tg645.aspx.

[2] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).

[3] See id at 1376.

[4] Bank for Int’l Settlements, Quarterly Review, Table 19, (June 2013), http://www.bis.org/statistics/dt1920a.pdf. Notional, of course, does not reference the amount that is at risk and does not account for the effect of netting and the provision of collateral.

[5] See Dodd-Frank Act §723(h) at 1676.

[6] See Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013 (2013) available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq213.pdf.

[7] Int’l Swaps and Derivatives Ass’n, ISDA Margin Survey 2007, 4, (Apr. 15, 2007) available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/. The ISDA Margin Survey covers U.S. and non-U.S. market participants. In 2007, for example, twenty-five percent of respondents were based in the United States, while fifty-two percent were based in Europe or South Africa. The OCC Quarterly Reports, by contrast, only cover U.S. national banking associations. Id.

[8] International Swaps and Derivatives Association, ISDA Margin Survey 2013, 2, (Jun. 21, 2013) available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/.

[9] See id at 9; International Swaps and Derivatives Association, ISDA Margin Survey 2006, 4, (Apr. 15, 2006), available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys.

[10] As it relates to uncleared swaps, the Dodd-Frank Act requires swap dealers and major swap participants to notify their uncleared swap counterparties of their right to segregate their initial margin with an independent third-party custodian. See Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, 77 Fed. Reg. 6336-01 (Feb. 7, 2012).

[11] See CME Clearing Financial Safeguards, CME Group, (2012), http://www.cmegroup.com/clearing/files/financialsafeguards.pdf.

[12] Federal Reserve chairman Ben Bernanke testified to the U.S. Financial Crisis Inquiry Commission: “If you look at the firms that came under pressure in that period . . . out of . . . thirteen of the most important financial institutions in the United States, twelve were at risk of failure within a period of a week or two.” See Thomas Russo and Aaron J. Katzel, The 2008 Financial Crisis and Its Aftermath: Addressing the Next Debt Challenge, Group of Thirty 7, 11 (2011).

[13] See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6 at 8.

[14] Id at 6.

[15] Manmohan Singh and James Aitken, Counterparty Risk, Impact on Collateral Flows and Roles for Central Counterparties, (International Monetary Fund, Working Paper 09/173, 2009).

[16] E. Paul Rowady Jr., The Global Risk Transfer Market: Developments in OTC and Exchange Traded Derivatives, TABB Group, 6 (November 2010), http://www.world-exchanges.org/files/statistics/pdf/V08-030%20Global%20Risk%20Transfer%20Market.pdf.

[17] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §204, 123 Stat. 1376 1454 (2010).

[18]  Title II is not limited to financial companies already designated as “systemically important” but can apply to any potentially failing entity the Council determines is systemically important and “in default or in danger of default.”

[19] Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6, at Graph 4.

[20] In the OCC Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, the five largest commercial banks represented ninety-seven percent of the total banking industry notional amount of derivatives trading activity. In order by notional, those institutions were JPMorgan Chase Bank, Bank of America, Citibank, Wachovia Bank, and HSBC Bank USA. In the OCC Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, Table 1, the five largest commercial banks in order by notional were JPMorgan Chase Bank, Citibank, Goldman Sachs Bank USA, Bank of America and HSBC Bank USA. The number of insured U.S. commercial banks engaged in derivatives trading has increased: at the end of the first quarter of 2008 there were 1,003 banks, see Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, 7, (2008) available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq108.pdf, whereas at the end of the second quarter of 2013, there were 1,400. See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6.

[21] See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6, at 1; Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, supra note 20, at 1.

[22] See id. at 7.

[23] See 11 U.S.C. § 109(b)(2) (2010).

[24] See 12 U.S.C. § 1821(c)(1) (2013).

[25] See § 1821(c)(6).

[26] See § 1821(e)(1)-(3).

[27] See § 1821(e)(9), (10)(C).

[28] See § 1821(10)(B)(i)(I).

[29] See § 1821(10)(B)(ii).

[30] See 11 U.S.C. §506(a)(1) (2005).

[31] See 12 C.F.R. § 380.1-380.53 (2011).

[32] See 12 U.S.C. §5390(h)(1) (2010).

[33] The Hoover Institution established a Resolution Project Working Group in 2009 (of which this author is a member) to develop an alternative approach to bankruptcy and related issues.

By

Making Equity Crowdfunding Work for the Unaccredited Crowd

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Jeff Thomas*

I.       Introduction

The idea behind equity crowdfunding is both simple and revolutionary. Entrepreneurs will be able to use the Internet to pitch business ideas to millions of potential investors and allow “anyone with a few dollars to spend [to] become an investor.”[1] While this may seem like an obvious use of the Internet, until now, securities laws have prohibited new ventures from using this approach[2] to raise capital from “average Joes” and other unaccredited investors.[3] However, the Jumpstart Our Business Startups (JOBS) Act[4] creates a new “crowdfunding exemption” that will allow companies to raise up to $1 million every twelve months by selling their stock (or other unregistered securities) to both accredited and unaccredited investors, provided that the sales are made through registered intermediaries.[5] This article summarizes why the crowdfunding exemption is important, explains how its expected costs are problematic, and proposes ways to mitigate those costs without sacrificing investor protection.

II.       Importance of the Crowdfunding Exemption

The crowdfunding exemption is important because it allows for new sources of capital for new ventures. New ventures, and the jobs they create, are significant to our economy.[6] New ventures also often need external capital,[7] but due to securities laws, it is difficult for them to raise that capital.[8] When selling stock and other securities, new ventures (and other issuers) must either register their securities under the Securities Act of 1933[9] (the Securities Act) or satisfy federal and state requirements for an exempt offering.[10]

On average, issuers must pay $2.5 million to initially register their securities under the Securities Act and an additional $1.5 million each year thereafter to comply with ongoing requirements, making registration impractical for most new ventures.[11] Without the crowdfunding exemption, unaccredited investors are limited in their ability to participate in exempt offerings,[12] and, as of 2010, only 7.4% of U.S. households were accredited based on the net worth standard.[13] Additionally, only a small percentage of the accredited households are likely to participate in exempt offerings.[14]

Thus, the crowdfunding exemption is critical because it will provide cash-hungry new ventures with access to a large and currently under-tapped source of capital—unaccredited investors.

III.      Crowdfunding Exemption’s High Expected Costs

In order to protect investors, the JOBS Act[15] and the Securities & Exchange Commission’s (SEC) Proposed Crowdfunding Rules[16] impose several requirements on issuers[17] and intermediaries.[18] Unfortunately, the costs associated with these requirements may threaten the usefulness of the exemption in practice. As one practitioner notes:

To produce an offering disclosure document, enlist a funding portal, run background checks and file an annual report with the SEC year after year might well cost upwards of $100,000. The high expenses compared to the low maximum amounts that can be raised by a company and invested by an individual make public equity crowdfunding one of the costliest forms of (legal) capital raising.[19]

The SEC also provides cost estimates for issuers and intermediaries in the Proposed Crowdfunding Rules. These costs are summarized below.

A.     SEC Estimates of Issuer Costs

The SEC estimates that issuers relying on the crowdfunding exemption would incur the following initial and ongoing annual costs for three different offering amounts[20]:

Offering Amount
$50,000 $300,000 $750,000
Initial Costs:
     Compensation to the intermediary[21] $5,000 $30,000 $75,000
     Cost to prepare and file initial disclosure document[22] $6,000 $6,000 $6,000
     Cost of review or audit of financials[23] N/A $14,350 $28,700
     Other initial costs[24] $460 $460 $460
Total Initial Costs $11,460 $50,810 $110,160
Initial Costs as a % of the Offering Amount 22.92% 16.94% 14.69%
Ongoing Annual Costs:[25]
     Cost to prepare and file annual disclosure document[26] $4,000 $4,000 $4,000
     Cost of review or audit of financials[27] N/A $14,350 $28,700
Total Ongoing Annual Costs $4,000 $18,350 $32,700
Ongoing Annual Costs as a % of the Offering Amount 8.00% 6.12% 4.36%

Thus, considering these estimates, a new venture that sells $50,000 of stock would initially net only $38,540 and it must continue to pay outside professionals an additional $4,000 each year to comply with ongoing reporting requirements. Although these costs already seem high, additional issuer costs, intermediary costs, and other costs must also be factored in.

B.     SEC Estimates of Intermediary Costs

To qualify for the crowdfunding exemption, issuers must use a registered broker or funding portal.[28] The SEC estimates the following initial and ongoing annual costs for three different types of intermediaries[29]:

 

Intermediaries That:

Register as Brokers

Register as Funding Portals

Are Already Registered as Brokers
Initial Costs:
     Registration and Membership Costs[30] $275,000 $100,000 N/A
     Compliance Costs[31] $245,000 $67,000 $45,000
     Platform Development Costs[32] $250,000 $250,000 $250,000
     Total Initial Costs $770,000 $417,000 $295,000
Ongoing Annual Costs:
     Registration and Membership Costs[33] $50,000 $10,000 N/A
     Compliance Costs[34] $180,000 $40,000 $30,000
     Platform Development Costs[35] $40,000 $40,000 $40,000
Total Ongoing Annual Costs $270,000 $90,000 $70,000

 

The SEC also estimates that, on average, intermediaries will generate $200,000 per year in revenue from offerings made under the crowdfunding exemption.[36] Thus, it may be difficult for intermediaries to cover these and additional overhead costs even if they are able to collect 10% of the amounts they help issuers raise.

C.     Other Costs

As mentioned above, the SEC estimates do not reflect all of the costs that issuers will have to bear when using the crowdfunding exemption. Additional issuer costs include an expected return for the investors[37] and the value of issuer time required to prepare and file the initial offering document[38] and ongoing annual disclosures.[39] Moreover, the SEC estimates do not include transactional costs that investors will incur. For instance, reasonable investors will require time to learn about an issuer’s business (for example, the issuer’s current and anticipated products, customers and revenue model) as well as the terms of the offering (such as the rights attached to the shares being offered, the number of shares outstanding, and the rights attached to the outstanding shares). Because some people will be investing only a few hundred dollars (or even just “a few dollars”)[40] it would be easy for an investor’s transaction costs to be a significant percentage of, or even exceed, her total investment amount.[41] Furthermore, costly disputes related to offerings may arise in the future.

IV.    Ways to Mitigate the Exemption’s Costs without Sacrificing Investor Protection

If the issuer, intermediary, and other costs are too high, use of the crowdfunding exemption will be limited. This will leave the large unaccredited investor market under-tapped and new ventures without the funds they need to thrive. There are, however, several ways to mitigate the expected costs without sacrificing investor protection. Five suggestions for mitigating costs are provided below.

A.     Allow Intermediaries to Acquire Equity Interests

Funding portals and other intermediaries should be allowed to take an equity interest in the issuers they service in lieu of at least a portion of the cash fees,[42] provided that intermediaries taking such an interest do so as a standard practice. While the Proposed Crowdfunding Rules prohibit intermediaries from doing this,[43] the JOBS Act itself does not.[44] Furthermore, the JOBS Act’s legislative history in fact supports the idea of allowing intermediaries to invest in issuers using their services in order to protect investors.[45] Granting an intermediary an equity interest would still result in an economic cost to issuers and doing so may not always improve an issuer’s cash position.[46] However, there would be many instances where granting equity in lieu of paying cash to an intermediary would improve an issuer’s cash position.[47] Reserving this additional cash is critical for issuers.[48] Moreover, intermediaries who acquire equity interests in issuers would likely service only those issuers they see unique value in—namely, ventures they believe are currently underpriced. This perceived discount by intermediaries could be shared with issuers in the form of a lower stated fee.[49]

B.     Let Unaccredited Investors Test into Accredited Status

The crowdfunding exemption is important because it gives new ventures bona fide access to unaccredited investors—a large source of potential capital. However, this access could be broadened by amending the accredited investor definition[50] to welcome currently unaccredited investors who demonstrate they are capable of investing in exempt offerings (for example, by passing an appropriate exam). These investors could then participate in “506(c) offerings” which are currently not subject to many of the crowdfunding exemption’s requirements such as: (i) the use of an offering document; (ii) an annual reporting obligations; (iii) the use of a registered intermediary; and, (iv) the $1 million offering amount cap.[51] Thus, changing the accredited investor definition could generate many of the benefits of the crowdfunding exemption, at a much lower cost, for those that pass the exam. Although such an exam would likely have imperfections, amending the accredited investor definition to consider an investor’s knowledge of exempt offerings would make the regulation smarter. Instead of concluding from an individual’s net worth and income levels that she is incapable of investing in exempt offerings, the exam would allow her to prove that she has the knowledge and experience in financial and business matters reasonably necessary to evaluate the risks and merits associated with investments in early stage ventures—and thus eliminate much of the need for costly protections assuming the opposite.[52] Perhaps this is why the SEC has requested comment on the current accredited investor definition.[53]

C.     Use Strategic Templates and Deal Structures

Intermediaries should require issuers to use essentially the same formation and financing documents or templates to organize entities and complete financings. Repeatedly using smart templates and deal structures should reduce transaction costs, promote consistency between documents and among transactions, protect entrepreneurs and investors, and help ensure compliance with laws and regulations.[54] This is why leading accelerator programs and attorneys who regularly represent venture capital-backed companies already use templates to form and finance the ventures they help.[55] Given that crowdfunding investors will typically invest smaller amounts than venture capitalists, and therefore transactions costs are likely to represent a larger percentage of their investment, templates seem even more important in the equity crowdfunding setting. Moreover, intermediaries could strategically design the templates and deal structures to make the most of the unique requirements imposed by the JOBS Act[56] and Proposed Crowdfunding Rules.[57] The JOBS Act’s legislative history[58] and Proposed Crowdfunding Rules[59] support intermediaries taking this approach. However, to further reduce the risk of engaging in the unauthorized practice of law, intermediaries should consider taking precautionary steps such as requiring issuers to use the templates and deal structures, instead of merely advising issuers on what to do. Furthermore, issuers should be encouraged to seek legal counsel.[60]

It is beyond the scope of this article to provide details about how equity crowdfunding templates and deal structures should be structured. However, by way of example, a funding portal could require issuers using its service to:

 

  • Be formed as Delaware C corporations, with the funding portal providing templates for issuers’ Certificate of Incorporation, Bylaws and initial corporate resolutions;[61]
  • Prepare an executive summary, pitch presentation, and business plan to be made available on the funding portal’s website, with the funding portal providing templates designed to ensure that the necessary information is provided in a logical and concise format;[62]
  • Use a two-class equity system whereby inexpensive common stock is granted to or reserved for employees and more expensive preferred stock, with special rights,[63] is sold to outside investors thereby allowing issuers to raise external funds with less demoralizing dilution to the employee-owners than would otherwise occur;[64]
  • Make their common stock subject to “vesting” to help ensure that employees earn their stock over time,[65] with the funding portal providing a template Common Stock Purchase Agreement and related forms;[66]
  • Raise exactly $100,000, thereby eliminating the need for reviewed or audited financial statements;
  • Use standard capitalization tables (for example, a fixed number of shares of common stock could be granted to or reserved for each issuer’s employees thereby allowing employees and investors to more quickly understand what their ownership interests represent and more easily compare valuations of different issuers); and,
  • Reserve the right to redeem their preferred stock at a multiple of the price it was originally issued at, thereby giving issuers a path to escape the ongoing annual costs imposed by the crowdfunding exemption.[67]

 

Repeated use of the same templates and deal structures should lead to familiar standards and even a “one size fits many” model.[68] In addition to significantly reducing transaction costs, such a model would help ensure that parties take necessary and desired steps, thereby increasing issuer compliance, investor protections, and economic value.

D.     Leverage Educational Organizations

Having a “one size fits many” model would give schools exciting new ways to connect their students in the classrooms to real world new ventures. Instead of simply reading about different types of business entities and seed financings, students could complete projects using the same templates used by live issuers relying on the crowdfunding exemption. Among other things, this would empower more students and alumni to launch their own ventures. Schools could even form, or develop a relationship with, funding portals.[69] Reputable entrepreneurship programs at prestigious universities have already undertaken initiatives to help their students and others raise capital for new ventures.[70] A funding portal could revolutionize this process and create new ways to engage students, parents, alumni, and others—and to raise funds to support entrepreneurship education.[71] To the extent that schools and other organizations, such as accelerators, can extract educational value from the equity crowdfunding process, the high costs of the exemption would become more tolerable. That is, the costs would support both the exempt offerings and entrepreneurship education objectives. Further, if alumni and others are motivated to invest in student ventures for both economic and non-economic reasons, expected returns should become more issuer-friendly and participating unaccredited investors would receive an education while experiencing the thrill of being angel investors.

Moreover, expenditures already being made could help reduce the incremental cost of building and running a funding portal. For example, a university’s existing business plan competitions, social networks,[72] and news publications could all be used to help drive potential issuers and investors to funding portals and thus reduce issuer search costs and intermediary marketing costs. Additionally, business plan competitions could adopt rules mirroring the crowdfunding exemption’s requirements, thus reducing future compliance costs for ventures choosing to pursue equity crowdfunding. By way of further example, law school clinics already assisting entrepreneurs[73] could be tapped to provide issuers with affordable assistance. If there is a “one size fits many” model, law students and clinicians could more easily “ramp up” and offer clients a defined and meaningful new service, such as offering entrepreneurial ventures assistance with the crowdfunding exemption process.

E.     Arbitrate Disputes in a Forum Designed for Equity Crowdfunding

Issuers, investors, and intermediaries should agree to arbitrate disputes related to offerings made under the crowdfunding exemption. These parties should also agree to use a forum that specializes in equity crowdfunding and is willing to become familiar with its unique players, rules, templates, deal structures, and repeat issues. The Financial Industry Regulatory Authority  (FINRA) currently operates the largest dispute resolution forum in the securities industry.[74] Given the need to mitigate costs further in the equity crowdfunding setting, and its potential educational nature, perhaps an organization like FINRA could work with law school clinics to develop something that resembles a chain of minor league dispute resolution forums.[75] In addition to respecting the laws and practical issues surrounding equity crowdfunding, such an organization could provide expedient and affordable services to issuers, investors, and intermediaries while also creating unique experiential learning opportunities for students.

V.      Conclusion

New ventures are important to our economy. We can support these ventures by giving them better access to capital. In theory, the crowdfunding exemption will open the door to unaccredited investors—a large and currently under-tapped source of capital. However, the crowdfunding exemption is expected to impose significant costs on issuers, intermediaries, and investors. In order to make equity crowdfunding work for the unaccredited crowd, we must mitigate those costs without compromising investor protection.

 

 

Preferred citation: Jeff Thomas, Making Equity Crowdfunding Work for the Unaccredited Crowd, 4 Harv. Bus. L. Rev. Online 62 (2014), https://journals.law.harvard.edu/hblr//?p=3773.

[*] Jeff Thomas is the Chair of the School of Business at Johnson & Wales University in Charlotte, NC. He also serves on the Board of Directors of Queen City Forward, an accelerator for social ventures. He has extensive experience in counseling entrepreneurial ventures through law firms and law school clinics in Chicago and Silicon Valley.

[1] C. Steven Bradford, Crowdfunding and the Federal Securities Laws, 2012 Colum. Bus. L. Rev. 1, 10 (2012).

[2] See, e.g., Edan Burkett, A Crowdfunding Exemption? Online Investment Crowdfunding and U.S. Securities Regulation, 13 Transactions: Tenn. J. Bus. L. 63, 75 (2011) (“[S]ecurities laws . . . are a formidable barrier to investment crowdfunding in the United States.”).

[3] Unaccredited investors (also referred to as non-accredited investors) are investors who are not within the definition of an “accredited investor.” The term accredited investors includes natural persons: “whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000”; “who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year”; or, who serve as a “director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer.” See 17 C.F.R. § 230.501 (2013).

[4] Jumpstart Our Business Startups (JOBS) Act, Pub. L. No. 112-106, 126 Stat. 306 (2012) (codified at scattered sections of 15 U.S.C.A. (West 2012)).

[5] See JOBS Act §§ 301–05, 15 U.S.C.A. §§ 77–78 (West 2012).

[6] See, e.g., Vision Statement: Can Start-Ups Help Turn the Tide?, Harv. Bus. Rev., Sept. 2012, at 30 (“[N]ew businesses—and the jobs they create—are more important than ever.”). An abstract is available at http://hbr.org/2012/09/can-start-ups-help-turn-the-tide/ar/1.

[7] See, e.g., 2013 State of Entrepreneurship Address, Ewing Marion Kauffman Foundation, Financing Entrepreneurial Growth 2 (2013), http://www.kauffman.org/~/media/kauffman_org/research%20reports%20and%20covers/2013/02/soe%20report_2013pdf.pdf (“For the fast-growing (but mostly small) companies on the 2012 Inc. 500 list . . . one-third said access to external capital had been essential to company growth.”).

[8] See, e.g., Burkett, supra note 2, at 82–92.

[9] 15 U.S.C. §§ 77e–77f (2012).

[10] See Bradford, supra note 1, at 42–47.

[11] See Proposed Crowdfunding Rules, 78 Fed. Reg. 66,428, 66,509 (proposed Nov. 5, 2013) (to be codified at scattered parts of 17 C.F.R.) (citing two surveys).

[12] See id. at 66,510–11.

[13] See Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, 78 Fed. Reg. 44,771, 44,793 (July 24, 2013) (to be codified at 17 C.F.R. pts. 230, 239 & 242) (citing data from the Federal Reserve Board’s Triennial Survey of Consumer Finances 2010).

[14] See id. at 44,794 (citing an analysis by the Securities & Exchange Commission’s (SEC) Division of Economic and Risk Analysis that was based on the stock holdings of retail investors from more than 100 brokerage firms covering more than 33 million accounts during the period June 2010–May 2011).

[15] See §302(b), 15 U.S.C.A. § 77d1(a), (b) (West 2012).

[16] See Proposed Crowdfunding Rules, 78 Fed. Reg. 66,428.

[17] See JOBS Act § 302(b), 15 U.S.C.A. § 77d-1(b) (West 2012). Examples of issuer requirements include: (i) providing the SEC, intermediaries, and investors with a description of issuer’s (a) business, including its anticipated business plan, (b) financial condition (and, in some cases, reviewed or audited financial statements), (c) anticipated use of the offering proceeds, (d) ownership and capital structure, and (e) method for valuing the securities being offered; (ii) not advertising the terms of the offering, although issuers may direct investors to intermediaries; and (iii) reporting the results of operations (and, in some cases, providing reviewed or audited financial statements) each year to the SEC and investors. See id.; see also Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,552–54 (stating proposed regulations regarding these requirements).

[18] See JOBS Act § 302(b), 15 U.S.C.A. § 77d-1(a) (West 2012). Examples of intermediary requirements include: (i) registering with the SEC and a self-regulatory organization; (ii) providing investor-education materials; (iii) ensuring each investor (a) reviews the investor-education materials, (b) affirms she understands that she may lose her entire investment and can bear such a loss, and (c) demonstrates she understands the applicable investment risks; (iv) obtaining background checks on officers, directors and stockholders holding 20% of each issuer; and (v) making each issuer’s information, see supra note 17, available to the SEC and potential investors at least 21 days prior to the sale of issuer’s securities. See id.; see also Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,555–56 (stating proposed regulations regarding these requirements).

[19] Brian Korn, SEC Proposes Crowdfunding Rules, Forbes.com (Oct. 23, 2013, 2:41 PM), http://www.forbes.com/sites/deborahljacobs/2013/10/23/sec-proposes-crowdfunding-rules/.

[20] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,521 & n.918 (midpoints of the offering amount ranges provided by the SEC were used for this section). The SEC used both its ranges and these same midpoints to estimate items. See id.

[21] See id. (compensation to the intermediary is assumed to be 10% of the offering amount, which is the midpoint of the SEC’s estimated range of an intermediary compensation fee of 5–15%).

[22] See id. The Form C would be used to provide the required initial offering information about the issuer and the offering. See id. at 66,524. The SEC estimates it will take 60 hours to prepare and file the Form C and any amendment to disclose material information. See id. at 66,540. The SEC estimates that 75% of that burden, or 45 hours, would be carried by the issuer but that the other 25%, or 15 hours, would be carried by outside professionals charging $400 per hour. Id. Thus, the $6,000 amount reflects only the cost of outside professionals working for 15 hours at $400 an hour—it does not include any cost for the estimated 45 hours of issuer time. If, for example, issuer time was valued at $50 per hour, this would increase estimated costs by $2,250. Total Initial Costs would then be $13,710 for a $50,000 Offering Amount, or 27.42% of the Offering Amount.

[23] See id. at 66,521. For offerings of more than $500,000, the financial statements must be audited; for offerings of more than $100,000, but not more than $500,000, the financial statements must be reviewed by an independent public accountant; and offerings of $100,000 or less require merely that the issuer’s principal executive officer certify that the financial statements are true and complete in all material respects. See JOBS Act § 302(b), 15 U.S.C.A. § 77d-1(b)(1)(D) (West 2012).

[24] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,521 & nn.919–20 (assuming a cost of $60 to obtain an EDGAR access code on Form ID and $400 to prepare and file progress updates on Form C-U).

[25] These costs must be incurred until: (i) “issuer becomes a reporting company required to file reports under Section 13(a) or Section 15(d) of the Exchange Act [of 1934]”; (ii) “issuer or another party repurchases all of the securities issued in reliance on [the crowdfunding exemption]”; or (iii) “issuer liquidates or dissolves its business in accordance with state law.” Id. at 66,554.

[26] See id. at 66,521. The Form C-AR would be filed annually with the SEC, beginning the year after the initial offering. See id. at 66,540–41. It would include information substantially similar to that reported via the Form C. See id. at 66,541. The SEC estimates it will take 40 hours to prepare and file each Form C-AR. See id. The SEC estimates that 75% of that burden, or 30 hours, can be carried by the issuer but that the other 25%, or 10 hours, would be carried by outside professionals charging $400 per hour. See id. Thus, the $4,000 amount reflects only the cost of outside professionals working for 10 hours at $400 an hour—it does not include any cost for the estimated 30 hours of issuer time. If, for example, issuer time was valued at $50 per hour, this would increase estimated costs by $1,500. Total Ongoing Annual Costs would then be $5,500 for a $50,000 Offering Amount, or 11% of the Offering Amount.

[27] See supra text accompanying note 23. Costs to review or audit financial statements may be required in connection with each year’s Form C-AR. See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,554.

[28] See JOBS Act, § 302(a), 15 U.S.C.A. § 77d(a)(6)(C) (West 2012).

[29] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,526–28.

[30] See id. at 66,528. The initial and ongoing costs for an entity to register as a broker would be higher than the initial and ongoing costs for an entity to become a funding portal since the SEC assumes brokers would provide a broader range of services, such as providing investment advice, soliciting investors, and managing customer funds and securities. See id. at 66,527. For intermediaries already registered as brokers, there would be no incremental registration or membership costs. See id. at 66,541. The SEC also estimates it would take an intermediary approximately 220 hours to register as a broker-dealer compared to 110 hours to register as a funding portal, and that it would cost intermediaries $10,000, on average, to register with a national securities association. See id. at 66,542.

[31] See id. at 66,528.

[32] See id. This equals the midpoint of the range provided by the SEC, which varies from $100,000 to $400,000 and depends on whether an intermediary can tailor an existing platform to comply with the JOBS Act or would need to develop a new platform from scratch. See id. at n.987.

[33] See supra note 30.

[34]See supra note 31.

[35] See supra note 32.

[36] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,539, 66,543 (estimating that each offering will average $100,000, that each intermediary will facilitate an average of 20 offerings annually, and that each intermediary will be compensated with 10% of the offering amount).

[37] Early stage investors generally expect large returns given the risk of their early stage investment. See, e.g., Constance E. Bagley & Craig E. Dauchy, The Entrepreneur’s Guide to Business Law 137 (3d ed. 2008) (“Venture capitalists generally are not interested in investing unless the expected return is in the range of 35 to 45% compounded annually.”).

[38] See supra note 22.

[39] See supra note 26.

[40] Bradford, supra note 1.

[41] For example, if X is contemplating an investment of $200 into venture V and X’s time is worth $200 an hour, once X spends just one hour learning about V’s business and the terms of the offering, X’s transactional costs will equal 100% of the contemplated investment amount.

[42] See supra note 21 (estimating that an intermediary’s fee will be 5% to 15% of the offering amount).

[43] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,555–56 (to be codified at 17 C.F.R. pt. 227) (“An intermediary . . . may not have a financial interest in an issuer that is offering or selling securities in reliance on [the crowdfunding exemption] through the intermediary’s platform, or receive a financial interest in an issuer as compensation for services provided to or for the benefit of the issuer in connection with the offer or sale of such securities.”).

[44] See JOBS Act § 302(b), 15 U.S.C.A. § 77d-1(a)(11) (West 2012) (prohibiting an intermediary’s “directors, officers, or partners (or any person occupying a similar status or performing a similar function) from having any financial interest in an issuer using its services” but not prohibiting the intermediary itself from having such an interest).

[45] See 158 Cong. Rec. S2231 (daily ed. Mar. 29, 2012) (statement of Sen. Scott Brown) (“[I]ntermediaries should also be allowed to take an equity stake in offerings. This however, does not mean that intermediaries should be able to choose which offerings to participate in but rather it should be a standard process for any offering that the intermediary facilitates. This will incentivize an intermediary to focus on issuer quality over quantity, providing more vetting for investors and greater alignment of interests.”).

[46] For example, an issuer’s cash position would not improve if: (i) the issuer is selling $1 million of stock; (ii) there is sufficient investor demand; and, (iii) the shares being granted to the intermediary for its services “count” towards the JOBS Act’s $1 million offering cap. See supra text accompanying note 5.

[47] For example, when an issuer grants its stock to an intermediary for services and those shares are in addition to shares the issuer would have otherwise sold to investors. This would be the case if the shares to the intermediary would not cause the offering to exceed the $1 million JOBS Act cap or if the shares would not “count” towards the amount being raised (for example, if the SEC adopts final rules both allowing intermediaries to take equity interests and stating that said equity does not count towards the offering amount). Moreover, the issuance of the additional shares must not trigger incremental costs, such as kicking in the requirement to provide audited financial statements, that would offset the amount of cash saved by not paying the intermediary’s fee in cash.

[48] See, e.g., Guy Kawasaki, Reality Check: The Irreverent Guide to Outsmarting, Outmanaging, and Outmarketing Your Competition 107 (2008) (quoting the great Silicon Valley corporate finance lawyer, Craig Johnson: “The leading cause of failure of startups is death, and death happens when you run out of money.”).

[49] For example, if intermediary Z values venture V’s shares at $1 each while investors are expected to value V’s shares at $0.60 each, Z and V could split the $0.40 per share difference in valuations. That is, if intermediaries typically charge a 10% fee and V is raising $600,000, Z would require only 60,000 shares to equal the $60,000 fee and not 100,000 shares (even though 100,000 shares would need to be sold to investors to bring in a $60,000 cash fee). Further, both V and Z would prefer a transaction with 80,000 V shares to a $60,000 cash fee. When using the investor value, this would suggest V is paying only an 8% fee ($48,000/$600,000) even though Z would value 80,000 shares at as much as a 13.33% cash fee ($80,000/$600,000). While one may argue it is illogical to consider more than one value for the same V’s shares, new ventures are unique. First, as a typical Shark Tank episode illustrates, it is common for people (and Sharks) to disagree about the value of new ventures. Second, whatever the “objective” value is, it is based on assumptions that can quickly change and, when those assumptions change, the impact can be significant. For example, one new client contract could cause a venture to quadruple its total sales. Regardless, if intermediaries are allowed to take an equity stake in issuers, they have an economic incentive to welcome those they see as good bets. The intermediaries thus would serve a vetting role, leading to greater capital flow from more confident investors.

[50] See supra note 3 and accompanying text.

[51] See Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, 78 Fed. Reg. 44,771, 44,804 (July 24, 2013) (to be codified at 17 C.F.R. §230.506(c)). 506(c) offerings also allow issuers to “offer securities through means of general solicitation, provided that . . . all purchasers of the securities [are] accredited investors” and several other requirements are met. See id. at 44,776 (“Issuers relying on Rule 506(c) for their offerings will not be subject to the prohibition against general solicitation found in Rule 502(c).”).

[52] However, to protect against investors losing too much, there could be limits on the amount people may invest in such offerings (for example, limits based on a percentage of an investor’s net worth and/or income levels).

[53] See Amendments to Regulation D, Form D and Rule 156, 78 Fed. Reg. 44,806, 44,830 (proposed Jul. 24, 2013) (request from the SEC for comment on whether the net worth and income tests are “the appropriate tests for determining whether a natural person is an accredited investor” and, if not, “what other criteria should be considered as an appropriate test for investment sophistication”).

[54] See Model Legal Documents, National Venture Capital Association, http://www.nvca.org/index.php?option=com_content&view=article&id=108&Itemid=136 (last visited Mar. 28, 2014) (expressing similar goals with respect to a set of model documents the National Venture Capital Association makes available for venture capital financings: “The model documents aim to: reflect and in a number of instances, guide and establish industry norms; be fair, avoid bias toward the [investor] or the company/entrepreneur; . . . include explanatory commentary where necessary or helpful; anticipate and eliminate traps for the unwary (e.g., unenforceable or unworkable provisions); provide a comprehensive set of internally consistent financing documents; promote consistency among transactions; and reduce transaction costs and time.”).

[55]  See, e.g., Leena Rao, YC-backed Clerky Helps Startups Save Time And Money On Legal Incorporation, Stock Issuance Forms And More, TechCrunch (Mar. 11, 2013), http://techcrunch.com/2013/03/11/yc-backed-clerky-helps-startups-save-time-and-money-on-legal-incorporation-stock-issuance-forms-and-more/. For an example of actual templates for startups, see Open Sourced Model Seed Financing Documents, Techstars.com, http://www.techstars.com/docs/ (last visited Mar. 28, 2014) (publishing templates prepared by Cooley LLP).

[56] See supra notes 17 & 18.

[57]See supra notes 17 & 18.

[58] See 158 Cong. Rec. S2231 (daily ed. Mar. 29, 2012) (statement of Sen. Michael Bennet) (“[F]unding portals should be allowed to engage in due diligence services. This would include providing templates and forms, which will enable issuers to comply with the underlying statute. In crafting this law, it was our intent to allow funding portals to provide such services.”).

[59] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,560 (to be codified at 17 C.F.R. §227.402(b)) (“A funding portal may . . . [a]dvise an issuer about the structure or content of the issuer’s offering, including assisting the issuer in preparing the offering documentation.”).

[60] For example, legal counsel could advise on the risks associated with using the templates and assist with matters not covered by the templates, such as becoming “qualified to do business” in the state where the issuer’s offices are physically located. In this way, attorneys will become familiar with the templates and be able to efficiently provide add-on services.

[61] Orrick, Herrington & Sutcliffe LLP provides examples of such templates. See Start-Up Forms: Corporate Formation, Orrick, Herrington & Sutcliffe LLP, http://www.orrick.com/Practices/Emerging-Companies/Startup-Forms/Pages/Forms-Corporation.aspx (last visited Mar. 28, 2014).

[62] See, e.g., Kawasaki, supra note 48, at chs. 8, 9, & 17 (providing rules of thumb for what should be included in an executive summary, investor pitch, and business plan—as well as how to format such items).

[63] An example of such a right is a “liquidation preference.” A liquidation preference ensures that, if a company is acquired (or otherwise liquidated), any assets remaining after payment of the company’s debts get distributed first to the preferred stock holders—until they receive an amount at least equal to their original investment plus any accrued and unpaid dividends. See e.g., Bagley & Dauchy, supra note 37, at 150; Fenwick & West LLP, Venture Capital for High Technology Companies 13 (2010) [hereinafter Fenwick VC Guide], http://www.fenwick.com/FenwickDocuments/venture_capital_final_2010.pdf.

[64] See, e.g., Bagley & Dauchy, supra note 37, at 64–65; Fenwick VC Guide, supra note 63, at 13.

[65] See, e.g., Bagley & Dauchy, supra note 37, at 93–94; Fenwick VC Guide, supra note 63, at 2.

[66] Orrick, Herrington & Sutcliffe LLP provides such templates, including a Common Stock Purchase Agreement with vesting provisions, an “Assignment of IP and Other Assets” form, and paperwork to help with 83(b) elections. Start-up Forms: Founders’ Stock Purchase, Orrick, Herrington & Sutcliffe LLP, http://www.orrick.com/Practices/Emerging-Companies/Startup-Forms/Pages/Forms-Founders.aspx (last visited Mar. 28, 2014).

[67] See supra note 25.

[68] When items need to differ from the standard, they will be highlighted on a concise schedule of exceptions, thereby making it easy for parties to see what changes are needed for particular deals.

[69] To reduce liability exposure, the funding portals would be set up as separate entities.

[70] See, e.g., U-M Based Student-Led Investment Funds, The Samuel Zell & Robert H. Lurie Institute for Entrepreneurial Studies, http://www.zli.bus.umich.edu/wvf/ (last visited Mar. 28, 2014) (providing summaries for three different “Wolverine/Student Venture Funds”: the Wolverine Venture Fund, the Zell Lurie Commercialization Fund, and the Social Venture Fund); About the Irish Entrepreneurs Network, The Irish Entrepreneurs Network, https://www.business.nd.edu/gigot/irishangels/about_ia.cfm (last visited Mar. 28, 2014) (describing the Irish Entrepreneurs Network as consisting of “a select group of Notre Dame alumni and friends having experience with entrepreneurial endeavors” and having a mission to “serve as a focal point for entrepreneurially-minded members of the Notre Dame family worldwide”).

[71] Instead of itemizing charitable deductions, people who invest in for-profit ventures that fail could take a more favorable ordinary loss deduction. See I.R.C. § 1244 (2012).

[72] Social network ties have been found to be important in non-equity crowdfunding. See, e.g., Ethan Mollick, The Dynamics of Crowdfunding: An Exploratory Study, 29 J. Bus. Venturing 14 (2014).

[73] See e.g., Law School Entrepreneurship Clinics, Ewing Marion Kauffman Foundation, http://www.entrepreneurship.org/entrepreneurship-law/law-school-entrepreneurship-clinics.aspx (last visited Mar. 28, 2014) (listing U.S. law school clinics that provide assistance to entrepreneurs and innovators).

[74] See Arbitration & Mediation, FINRA, http://www.finra.org/ArbitrationAndMediation/index.htm (last visited Mar. 28, 2014).

[75] To avoid potential conflicts, some clinics could help with exempt offerings while others could assist with arbitrating disputes.