Page 32 - Delaware Lawyer - Fall 2022

FEATURE | BURNING THE CANDLE AT BOTH ENDS
Continued from page 32
The Fundamental Nature of Books and Records Inspection Rights
How can they get information on a private firm? Stockholders of Dela- ware corporations can make a demand on the company to inspect books and records pursuant to Section 220 of the Delaware General Corporation Law to (among other reasons) determine the value of their stock. While this ability is potentially valuable for stockholders, it can require the company to disclose information that it may prefer to keep private. Demands, particularly for ex- tensive information, can also impose administrative burdens on the company and its executives.
To deal with the rise in demands and the desire not to disclose material infor- mation about the firm, some startups have adopted new contractual mecha- nisms to curtail stockholder rights. The latest practice compels employees to waive their stockholder inspection rights under Section 220 as a condition to re- ceiving stock options from the company. Perhaps the clearest indication of this new practice is a 2020 amendment to the National Venture Capital Association le- gal forms, which is intended to standard- ize a new contractual waiver — “waiver of statutory inspection rights.” The waiver is designed to contract around traditionalinvestorrights,reservingsuch protections for other investors with more bargaining power.
While Delaware law is clear that stockholders’ inspection right is not without limits, it is less clear to what extent it may be contractually lim- ited. More importantly, it is not clear whether employees, who are not yet stockholders and thus do not yet pos- sess the rights under Section 220, can contract away their information rights entirely. Startup employees normally get stock options rather than outright stock awards. The high-tech industry predominantly relies on the practice of
awarding options to rank-and-file em- ployees to attract, engage and retain them.7 To obtain the rights of a stock- holder, option holders need to first ex- ercise their options and buy the stock. After they become stockholders, they can make a demand on the company to inspect the books and records.
But with the insertion of waivers, they may not be able to make these demands. They may have been forced to give up the right to make such a de- mand in order to have the chance to fulfill the principal requirement: being a shareholder.
Other Potential Information Sources
Of course, information does not solely stem from demands under state law. If Section 220 was the only source of information available to shareholders of companies, the plaintiffs’ bar would be extraordinarily overworked. Federal securities laws provide two layers of protections for shareholders and option holders. Securities and Exchange Com- mission (SEC) Rule 701 requires com- panies that sell more than $10 million in securities in a 12-month period to make audited financial statements available to shareholders. Section 12(g) of the Se- curities Exchange Act of 1934 (and its accompanying rules) also is designed to protect investors, both employees and outsiders, by providing thresholds before mandatory disclosures are re- quired. But are these truly effective?
The disclosures made under Rule 701 are backward-looking. They are restricted to the limitations of a typical Form 10-K or Form 10-Q. They do not necessarily provide expectations or for- ward-looking statements from manage- ment. It is extraordinarily hard to value an equity holding via a set of financial statements alone in the absence of a market and in the absence of knowing the full picture of the capital structure of the company.
Section 12(g) is even more problem- atic. Since the passage of the Jumpstart
Our Business Startups (“JOBS”) Act in 2012, exempt capital formation in the unregulated private market has in- creased dramatically. Companies raise nearly limitless capital from a wide range of sources while remaining out- side of the public reporting regime, leading to worse corporate governance outcomes and a decline in IPO volume and quality. Thanks to the increase in Section 12(g) thresholds and the eas- ing of exempt capital raising restrictions under Regulation D, it is far easier for companies to stay private longer and grow to staggering sizes.8
For these disclosure rules to apply, companies must pass certain thresholds before making disclosures. Originally, the limits were $1 million in assets with 500 shareholders of record per class of equity. In 2012, the JOBS Act raised these limits to $10 million in assets, 2,000 accredited shareholders of record per class of equity, and removed any shareholder of record from the count if they received their equity from an em- ployee compensation plan of some kind.
At the time of the passage of the original Section 12(g) rules in 1964, the SEC and Congress conceded that setting the limits based on shareholders of record was only a “rough, indirect measure of activity.”9 Any other method available to them at the time of measur- ing “market activity” was not feasible, meaningful or workable.10 The SEC fur- ther noted that shareholders of record is “the most direct and simple criterion of public-investor interest.”11
Changing Times, Changing Rights?
Yet since 2012, the investing world has changed dramatically. It has become rare that shareholders are considered to be record shareholders. Most investors hold their shares via brokerage accounts or through institutional investors, who are actually considered to be the re- cord holders. As former SEC Com- missioner Allison Lee noted last year, many longtime public companies do
30 DELAWARE LAWYER FALL 2022