Peccadillos In The PPM?: Disclosure Of Personal Information In Private Placement Financing Documents

Carl E. Kaplan, Retired Partner at Fulbright & Jaworski, LLP

9 minutes to read

Those involved in the formation of technology and other start-ups meet founders and entrepreneurs many of whom have idiosyncratic personal traits. [1] Venture capital investors appear, for the most part, to overlook these behaviors in favor of encouraging the genius lying underneath. When, if ever however, do proclivities rise to the level of disclosure in a financing? Are there times when habits or foibles impact, potentially, the affairs and furthering of a fledgling operation to such an extent that the failure to advise investors could give rise to liability?

Posit a founding group, one or more of whom have personal "issues": e.g., mental issues, physical illness, addictions, etc. If a first round investor discovers these tendencies, there is a choice to be made as to whether to proceed. If a second round is attempted, there are at least three groups with "knowledge:" the founders, the company and the existing investor. What disclosure might be made in the new round? Consider that in a worst case situation, key people may be lost (and the entity destroyed) through incapacity or inability to function. In the "doomsday" scenario, the company tanks, the founders have no assets but the venture capital investor or angel does. Lawsuit? Result?

There is little, if any, judicial input directly on what might be termed "intensely personal" information. In the public company arena, mandated disclosure under the Securities Act of 1933 (the "1933 Act") [2] and the Securities Exchange Act of 1934 (the "1934 Act") [3] and rules and regulations thereunder focus, basically, on objective, factual matters in those instances where disclosure is required. For example, Regulation S-K deals with a variety of biographical, financial and relationship information, but not personal or health information about individual officers or directors. [4]

Since, bottom-line, there are no "required" disclosures, it would appear that disclosure, or lack thereof, would be governed by Rule 10b-5 [5] and the principles of "materiality" enunciated in Basic Inc v. Levinson [6] and TSC Industries, Inc. v. Northway, Inc. [7]

Under TSC, "[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote … put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." [8] In Basic, a materiality test for "contingent or speculative" information involved balancing the probability of a future event or condition occurring against the magnitude of the future event or condition. [9]

The TSC/Basic formulation [10] has two alternative "materiality" standards for omissions: (a) if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision or (b) if there is a substantial likelihood that disclosure would have been viewed by that reasonable investor as having significantly altered the "total mix" of available information. [11]

Recent teaching in the Supreme Court and the United States Court of Appeals for the Eleventh Circuit affirms the older Basic principles that "materiality" is contextual and that there are no bright-line tests. [12] In echoing Basic, the Eleventh Circuit stated how the test of 'materiality' … requires the Court to consider all the information available to the hypothetical reasonable investor, which necessarily includes private communications." [13] More recently, in Richman v. Goldman Sachs Group, Inc., the United States District Court for the Southern District of New York, in allowing a class action to proceed based on claims of Goldman's misstatements concerning conflicts of interest in certain derivative transactions, stated:

A complaint, however, "may not properly be dismissed … on the ground that the alleged misstatements or omissions are not material unless they are so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of their importance." [14]

Some commentators have argued against disclosure of personal information on a variety of grounds ranging from the First Amendment, the Fifth Amendment and various privacy rights. [15] Further, it has been urged that "there is no conclusive evidence linking CEO leadership to organizational performance, much less linking a CEO's personal life to her firm's performance." [16] It has even been suggested that there be a bar to any cause of action based on the public behaviors. [17]

While it has been suggested there is a duty of good faith or loyalty, under state law, which could support officer or director liability for omissions involving personal "facts," [18] in Beam v. Stewart, [19] the Delaware Chancery Court rejected a claim that the board of Martha Stewart's company had failed to look into her personal matters, stating that there was no authority "to support this new 'duty' to monitor personal affairs." [20]

Despite arguments to the contrary, it is submitted that personal issues may be material:

[A] court may find that it is substantially likely that a reasonable investor would consider certain personal facts important in making an investment decision relating to the corporation's securities. Moreover, a court may find it substantially likely that a reasonable investor would have viewed disclosure of an omitted personal fact about an executive officer as a significant alteration of the total mix of available information. In this regard, it is important to note that executives' personal facts may be contingent or speculative information, as they relate to the public company in which the executive serves. News of a possible criminal prosecution or a terminal illness, for example, is important not just as a statement of current fact, but also as information that may impact the future of the public company. Accordingly, in those circumstances, Basic's probability/magnitude balancing test presumably would be used in gauging materiality. [21]

While the overall legal analysis is the same for privately financed start-ups and venture capital backed entities, the consequences of liability may be quite different. As "iconic" as Steve Jobs, Martha Stewart, Warren Buffet and others may be, their supposed digressions or undisclosed blemishes are not "bet the company" matters. This is not true, however, if one of the three founders of a tech start up overdoses, embezzles or the like. [22]

It is not clear what an investor should do. Diligence may not reveal proclivities or personal behaviors that prove destructive to an organization. It seems, though, that if an investor knows of personal issues, careful consideration should be given when determining whether to disclose this knowledge to prospective investors. Would a "risk factor" noting the possibility of personal issues clouding an investment's future work as a bar? Standard language involving the fledgling nature of an enterprise and that the risk of loss of key personnel might protect if there were no knowledge of specific issues, but maybe not if something more concrete was known and not revealed in the financing. Does it beg or answer the question if the argument for non-disclosure is that if information is disclosed, investors would walk?

[1] See, for example, the "behaviors" of Steve Jobs in WALTER ISAACSON, STEVE JOBS (Simon & Schuster 2011).

[2] 15 U.S.C. §§ 77a-aa (2006) (originally enacted as Act of May 27, 1933, ch. 38, § 1, 48 Stat. 74).

[3] 15 U.S.C. §§ 78a-nn (2006) (originally enacted as Act of June 6, 1934, ch. 404, §1, 48 Stat. 881).

[4] See 17 C.F.R. § 229 (2012).

[5] Id. § 240.10b-5. For simplicity, only Rule 10b-5 will be considered here. There are other anti-fraud provisions in the securities laws. See, e.g., Sections 11, 12 and 17 of the 1933 Act. Sections 9(a)(4) and 9(f) of the 1934 Act, added by the Dodd-Frank Wall Street Reform and Consumer Protection Act, are new anti-fraud provisions as well. See Pub.L. 111-203 (July 21, 2010).

[6] 485 U.S. 224 (1988).

[7] 426 U.S. 438 (1976).

[8] See id. at 449.

[9] See Basic, 485 U.S. at 232.

[10] The analyses of Rule 10b-5 fill many volumes. For the purposes of this piece, the "standard" Basic/TSC Northway formulation will be presumed. For an excellent recent discussion of the law of materiality under Rule 10b-5, see Allan Horwich, An Inquiry into the Perception of Materiality as an Element of Sciender under SEC Rule 10b-5, 67 BUS. LAW. 1, 9-16 (2011).

[11] For a discussion of the core elements of a 10b-5 claim, see Joan MacLeod Heminway, Martha Stewart Saved! Insider Violations of Rule 10b-5 for Misrepresented or Undisclosed Personal Facts, 65 MD. L. REV. 374, 378-88 (2006) [hereinafter Heminway, Martha Stewart Saved!].

[12] See Matrixx Initiatives Inc. v. Siracusario, 131 S.Ct. 1309 (2011); SEC v. Morgan Keegan & Co. Inc., 678 F.3d 1233 (11th Cir. 2012).

[13] Morgan Keegan, 678 F.3d at 1248 (emphasis in original).

[14] See Richman v. Goldman Sachs Group, Inc., 2012 WL 2362539, at *11 (S.D.N.Y. June 21, 2012) (citing ECA, Local 134 IBEW Joint Pension Trust of Chi. v. JP Morgan Chase Co., 553 F.3d 187, 197 (2d Cir. 2009)).

[15] See, e.g., Patricia Sánchez Abril and Ann M. Olazábal, The Celebrity CEO: Corporate Disclosure at the Intersection of Privacy and Securities Law, 46 Hous. L. REV. 1545, 1604 (2009-10) ("Securities law would be unduly burdened by further mandatory disclosures regarding the lives and idiosyncrasies of CEOs. Its focus should remain on verifiable facts rather than attenuated inferences.").

[16] See id. at 1603.

[17] See, e.g., Heminway, Martha Stewart Saved!, supra note 11, at 424-25.

[18] See Joan MacLeod Heminway, Martha's (and Steve's) Good Faith: An Officer's Duty of Loyalty at the Intersection of Good Faith and Candor, 11 TRANSACTIONS 113 (2009).

[19] 833 A.2d 961 (Del. Ch. 2003), aff'd on other grounds, 845 A.2d 1040 (Del. 2004).

[20] See id. at 971.

[21] Joan MacLeod Heminway, Personal Facts about Executive Officers: A Proposal for Tailored Disclosures to Encourage Reasonable Investor Behavior, 42 WAKE FOREST L. REV. 749, 759 (2007).

[22] See Tom C. W. Lin, Undressing the CEO: Disclosing Private, Material Matters of Public Company Executives, 11 U. PA. J. Bus. L. 383, 386 (2008-2009) ("[T]he issue about what types of material, private information should be disclosed will be of significant concern to academics and regulators, to Wall Street and Main Street, and to corporate titans and average citizens in the present and coming years as the investing marketplace's voracious need for more information confronts the executive's innate human desire to protect.").

Carl E. Kaplan is a retired partner at the international law firm of Fulbright & Jaworski, LLP. His practice included the formation and operation of venture capital and private equity entities as well as all aspects of investment in and financing of portfolio companies, both private and public.

Elizabeth DePonte, a summer associate at Fulbright & Jaworski, LLP, assisted in the preparation of this article.

Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Carl E. Kaplan. This work reflects the law at the time of writing.