Saturday, September 29, 2018

Can Startup Founders Get Paid in Equity Only?

It is a fact of life: startup founders do not get paid for their endless work day during the initial set up stage of their company.  Even though they have titles such as a CEO or a CTO, they do not see a penny until their startup gets funded and there is enough money to start the payroll.  But is it legal?

The Fair Labor Standards Act (the "FLSA") applies to most employers.  According to the FSLA, employees must be paid at least the minimum hourly wage.  Some employees must also receive overtime if they are nonexempt employees under the FLSA.  New York has its own wage and hour laws that do not quite correspond to the federal laws.

The FLSA has an executive employee exemption for certain business owners that would apply to startup founders.  According to it, the minimum wage law does not apply to those who own at least a bona fide 20% equity interest in the company and are actively involved in its management.  Good news?!

Not for everybody.  New York-based startups also need to qualify with New York's wage and hour laws, which as I mentioned, are somewhat different.  New York does not have a corresponding exemption that would apply to startup founders.  Its executive exemption (check 12 NYCRR 142-2.14) does not include minority business owners.

So, founders in New York beware:  please pay yourselves at least a minimum wage.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Thursday, September 27, 2018

How to Find the Right Lawyer?

This blog post is addressed to startups that are looking for legal counsel.  I was prompted to write it because of the September 24th announcement by NY Attorney General that the AG office reached an agreement with an online legal directory Avvo to reform its attorney ratings and improve disclosures for consumers.

Startup founders have a big task to handle: on one hand, they have a small (or no) budget set aside for legal services, but on the other hand, some understand that a lack of legal review can disadvantage them significantly in the future.  Many startup founders have not even talked to a lawyer before.  So, where and how do they look for a lawyer or a legal team that would be a good fit?

Legal services are mostly a referrals business.  Most matters we handle are our existing clients' new projects or referrals to new clients made by the existing ones.  So, the first thing that startup founders should do is "ask the audience," - i.e., reach out to their networks for referrals.

If this yields no results, then some ask a business accelerator or a VC for names of firms that are active in this space.  Bigger firms may not be well set up to handle small matters, but some give discounts or defer their fees.

Others turn to the Internet.  Recently, we have seen a proliferation of legal platforms or directories that allow users to select a lawyer based on their profile.  Platforms usually add their fee on top of the lawyer's rate.  All financial transactions are handled through the platform.

Being a part of a legal platform is a great way for a beginner solo practitioner with few or no clients to start their own practice.  All they have to do is create a profile and respond to client inquiries.  And here is where there is room for misleading information.

Let's take a look at Avvo, one such legal platform.  It does not vet its attorneys like some other platforms that require recommendations and in-person interviews.  Any attorney can create a profile on Avvo, and then even achieve a superb rating.  According to the NY AG, such rating could have been misleading.

The more information attorneys add to their profile, the better is their rating.  Attaining a high rating is not dissimilar to obtaining a search engine optimization of a website.  It does not necessarily correspond to the experience of that lawyer, but rather to the information that is publicly available about him / her.  As part of the agreement with the NY AG, Avvo will remove the ratings for attorneys who do not actively participate in Avvo's directory and disclose the content and limit of its ratings system to the users.  Also, Avvo agreed to ensure that all legal forms posted to its website for customers' use are first reviewed by a NY attorney with relevant experience.  Further, Avvo agreed to make other clarifying statements to their users, as well as pay a $50,000 fine.

Startup founders (and everyone else for that matter) should do a careful independent investigation of the attorney or the legal team they are about to hire, including viewing the attorney's website, searching other sources of information about the attorney online, and checking if there is any disciplinary information about the attorney with the state bar association.  It is always a good idea to ask for references.

Also, ask your attorney to provide estimates for the projects you give to them.  As a startup, you only have a limited budget for legal fees, and you want to make sure it is well spent.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Friday, September 14, 2018

U.S. vs Zaslavskiy - Cryptocurrency May Be a Security

I have read (and written) about Mr. Zaslavskiy and his entrepreneurial ventures, REcoin and Diamond, before.  Overall, 2.8 million tokens were sold (although none were really issued) to approximately 1,000 retail investors in two scam offerings of tokens that supposedly aimed to invest into real estate and diamonds, respectively.  The SEC order and complaint, dated September 29, 2017, can be found here.  At that time (which is only about a year ago), it was the SEC's first enforcement action against promoters of an ICO.

Now, Mr. Zaslavskiy is facing a criminal trial.  He argues that whatever he offered and sold to the public were not securities and therefore the case should be dismissed.  However, on September 11, 2018, a federal judge in the US District Court for the Eastern District of NY dismissed his motion and held that a reasonable jury could conclude that the cryptocurrency is a security, and that Mr. Zaslavskiy's case will proceed to trial.  This decision supports a long-standing position of the SEC that tokens, or digital assets, may be securities under the US federal and state laws.

Judge Dearie analyzed whether the tokens offered and sold by REcoin and Diamonds could be "investment contracts."

It is not disputed that "investment contracts" fall within the definition of security under Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act.  Even though there is no statutory definition of what an "investment contract" is, there is the Howey test developed by the US Supreme Court in 1946.  According to the test, an investment contract is a "contract, transaction, or scheme whereby a person (i) invests his money in (ii) a common enterprise and is (iii) led to expect profits solely from the efforts of the promoter or third party."  All three prongs of the test must be met in order for there to be an investment contract.

With respect to the first prong, Judge Dearie cited cases that stated that cash was not the only form of "money" and that the investment could take form of goods and services and some other exchange of value.

With respect to the second prong, Judge Dearie said that both RE coin and Diamond could constitute a "common enterprise."  To establish this prong, there must be "commonality" among the investors, which is explained as "the tying of each individual investor's fortunes to the fortunes of other investors by the pooling of assets, usually combined with the pro-rata distribution of profits."  In re J.P. Jeanneret, 769 F. Supp. 2d at 359.  Again, if proven at trial, a reasonable jury could conclude that there was a common enterprise.

As to the third prong, the reasonable jury could conclude from the facts presented that the investors did not expect to derive any profit from their own efforts, but rather from the efforts of Mr. Zaslavskiy and his co-conspirators.  They described REcoin as "an attractive investment opportunity" that "grows in value" and has "some of the highest potential returns."  The Diamond investors were promised 10-15% per year returns.  The promotional materials stated that Mr. Zaslavskiy would use his (and his colleagues') expertise to develop the ventures, invest the funds, and generate profits.

Mr. Zaslavskiy also argued that the tokens were actually currencies, and therefore should be excluded from the definition of securities.  The Judge dismissed this argument by saying that just labeling something a currency does not mean it actually is.  Instead, one should look at the economic realities and apply the investment contract test.

Now, all that is left is to learn the outcome of the trial.  This may be the first, but not the last, time when promoters are sentenced because of conducting illegal ICOs.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Thursday, September 13, 2018

ICO Platforms Beware: You May Be Operating as Unregistered Broker-Dealers

On September 11, 2018, the SEC announced that TokenLot LLC, a so called "ICO Superstore," agreed to settle charges brought by the SEC for operating as an unregistered broker-dealer.  The investigation was conducted by the SEC Cyber Unit.

The ICO Superstore enabled U.S. and foreign retail investors to purchase digital tokens during ICOs and engage in secondary trading.  To be precise: (i) TokenLot advertised and sold tokens issued by others; (ii) solicited investors; (iii) processed funds; (iv) enabled secondary trading in those tokens; and (v) advertised and promoted the sale of tokens in exchange for marketing fees paid by token issuers.  In fact, they handled over 200 different digital tokens for a total of 6,100 investors, receiving $471,000 in compensation.  TokenLot made money by charging a percentage of the ICO proceeds, marketing fees, as well as trading profits.

The Securities Exchange Act of 1934 defines a broker as "any person engaged in the business of effecting transactions in securities for the accounts of others."  Section 15(a) of the Exchange Act prohibits anyone to effect any transactions in securities for others unless such person is registered as a broker or dealer.  There are, of course, exceptions to this rule for certain limited categories of people, such as intrastate broker-dealers (Section 15(a)(1) of the Exchange Act), those dealing in exempted securities only (Section 3(a)(12) of the Exchange Act), foreign broker-dealers (Rule 15a-6 of the Exchange Act), issuers, and associated persons of the issuers (Rule 3a4-1 of the Exchange Act).  Some argue that there is also a so-called "finders exemption" developed through the SEC no-action letters, but even if it exists, it is extremely narrow in scope and highly dependent on particular facts and circumstances.

According to the SEC no-action letters and a helpful Guide to Broker-Dealer Registration published on the SEC website, there are four main questions to ask in determining whether certain activity requires broker-dealer registration:

1 - Does the person receive transaction-based compensation?  This is the key factor.
2 - Does the person engage in solicitation of potential investors?  Here, solicitation is interpreted broadly.
3 - Does the person engage in negotiations, provide advice, assist investors? Does the person facilitate the transaction?
4 - Does the person have previous securities sales experience or a history of disciplinary action?

First, the determination that the tokens were "securities" for the purposes of the Securities Act and the Exchange Act is key to the analysis, since there would be no broker-dealer registration requirement if they were facilitating the sales of something that was not a security (although, as you probably know, the definition of "security" is so broad that it even included citrus groves, warehouse receipts, minks, diamonds, pay phones, and chinchillas). 

Second, activities of TokenLot and its owners provide a positive answer to the first three of the B-D questions: the TokenLot promoters marketed the ICOs and tokens to prospective investors, facilitated transactions by receiving purchase orders and investor funds, and transferring digital tokens to investors and funds to the issuer, and they received a percentage of ICO proceeds as compensation.

Although the SEC order was settled and the matter seems closed now, there are potential other charges and liabilities that could have been brought.  For example, the ICO issuers, in addition to conducting unregistered securities offerings, could face aiding and abetting violations for working with an unregistered broker-dealer).  Also, the investors may have a private right of rescission under the Exchange Act Section 29(b) which provides that any contract made in violation of any provision of the Exchange Act is void.  The investors may also have state rescission claims.

This case should be read closely by multiple online platforms that are facilitating ICOs for others.  The SEC position with respect to regulation of online equity platforms has not changed, whether they are facilitating ICOs or traditional equity private placements.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Wednesday, September 12, 2018

Unpaid Internships at NY For-Profit Businesses: a Wish or a Reality

Unpaid internships are a tricky proposition.  You may recall our blog post in 2013 discussing how difficult, if not impossible, it was for New York for-profit employers to offer unpaid internships.  But “the times they are a changing” because the U.S. Department of Labor (“DOL”) lessened the regulatory burden earlier this year.

On January 5, 2018, the DOL announced that it would replace its old six-part analysis with a new “primary beneficiary test” to determine whether an unpaid intern was in fact an employee and thus subject to the Fair Labor Standards Act (“FLSA”) Thanks, in part, to a case involving Fox Searchlight Pictures Inc. in the U.S. Court of Appeals for the Second Circuit, the new test considers seven factors that analyze who the primary beneficiary of the working relationship is. If the analysis of the seven factors shows the primary beneficiary of the employment relationship is the employer, then the intern is designated as an employee and the relationship is subject to minimum wage laws and overtime pay as provided in the FLSA. If, however, the relationship is for the primary benefit of the intern, then the unpaid relationship will not be subject to minimum wage and employee benefit requirements, at least under the primary beneficiary test.

Pursuant to this new primary beneficiary test, businesses that wish to offer an unpaid internship without being subject to the legal requirements involved in an employer-employee relationship should do the following: (1) refrain from making any promise of, or providing, compensation; (2) provide training similar to an educational environment including hands on training; (3) tie the internship to the intern’s formal education, including the receipt of academic credit for the internship; (4) accommodate the intern’s academic calendar and commitments; (5) limit the internship only to a period during which the intern is beneficially learning; (6) provide the intern with academically beneficial work that complements rather than displaces the work of paid employees; and (7) make clear the understanding that the intern is not entitled to a paid job at the conclusion of the internship.

As those who read our prior blog post will know, the above-mentioned factors do not include a previous requirement that the employer does not derive “immediate advantages from the activities of the trainees.” This factor was removed in the new guidance from the DOL for its lack of clear guidance. The rise of appellate court cases, such as Schumann and Benjamin, that determined the DOL’s prior test was “too rigid” and resulted in an “all-or-nothing determination”, encouraged the DOL to ease the employer’s burden and clarify the test regarding unpaid interns.

Despite its potential applicability, this primary beneficiary test only sets forth the minimum standard at the federal level, which means employers still need to consider the applicable state requirements. Unfortunately, the New York State Department of Labor (“NYDOL”) has yet to adopt similar guidance. Instead, the NYDOL maintains its pre-2018 eleven-factor test (as described in detail in our blog post). Therefore, for-profit employers in New York will still have to comply with the prior regulations, despite the new employer-friendly DOL standards.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors Andrew Silvia.  Mr. Silvia is an associate at Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

SEC States that Tomahawkcoin Bounty Program was an Unregistered Security Offering

With an Order Instituting Administrative Proceedings (“Order”) dated August 14, 2018, and a corresponding press release, the SEC renewed its position that there is no such thing as a “free” offering of securities. While we have previously cautioned here that airdrops and other token giveaways should be structured in a manner compliant with the Securities Act, this enforcement action against Tomahawk Exploration LLC (“Tomahawk”) marks the first public action the SEC has taken against issuers distributing tokens to participants in a company's bounty program.

If you wonder what a typical bounty program is, here is a helpful blog post that summarizes ICO bounty programs.  ICO bounty programs have become ubiquitous in the ICO deals.  Terms vary, but typically participants receive tokens in exchange for reviewing the code, and marketing and promoting the ICO.

The enforcement action against Tomahawk lays a clear groundwork that the SEC may apply when investigating bounty programs in the future. From July through September 2017, Tomahawk, an oil and gas exploration company, and its founder, David Laurance (who had previously served a prison sentence for securities-related fraud), offered and attempted to sell digital assets in the form of “Tomahawkcoins” or "TOMs" in an ICO. They sought to raise $5 million to fund oil drilling in California. Tomahawk’s website and white paper touted the tokens’ potential for substantial long-term profits based on fraudulent estimations of Tomahawk’s anticipated oil production. Promotional materials also represented that investors could trade their tokens for potential profits on a token trading platform, and that they would could convert their tokens into Tomahawk equity at a 1:1 ratio on a future date.

The SEC noted that, although Tomahawk failed to raise money through the ICO, Tomahawk did issue TOMs as part of a “Bounty Program” in exchange for online promotional and marketing services. Tomahawk featured the Bounty Program prominently on the ICO website, offering TOMs in exchange for actions such as (i) listing of TOMs on token trading platforms, (ii) promoting TOMs on blogs and social networking websites, and (iii) creating promotional materials for the offering. Under this program, Tomahawk issued more than 80,000 TOMs to approximately 40 wallet holders on a decentralized platform.  In exchange, Tomahawk received online promotions that targeted potential investors to Tomahawk’s offering materials.

The SEC concluded that the TOMs constituted securities as both “investment contracts” (acquired by investors with expectation of future increase in value) and because the tokens were convertible into equity securities, thereby representing a right to an equity share of the company. Additionally, the SEC concluded that TOMs were "penny stock" because they did not meet any of the exceptions from the definition of "penny stock" found in Section 3(a)(51) of the Exchange Act and Rule 3a51-1 thereunder.  This is the first time that the SEC has concluded that tokens could be "penny stock" (which is interesting given that no TOMs were actually sold in the ICO and none ever traded on an exchange).  Penny stock carries additional risks, such as difficulty to accurately price the stock due to infrequent trading.  Typically, penny stock investments are speculative in nature, and therefore are regulated.

Further, the SEC determined that distributing the coins pursuant to the Bounty Program was a sale under Section 2(a)(3) of the Securities Act despite the lack of monetary consideration.  It is a long-standing SEC position that goes back to the 1999 SEC release that “gifting” securities constitutes a “sale” when the donor receives a “real benefit.” The SEC therefore determined that Tomahawk had "sold" the tokens in exchange for value in the form of online marketing promotion and increased liquidity in the securities of the company.

Although the situation with Tomahawk was a clearly fraudulent 21st century reinterpretation of an oil and gas scheme, issuers conducting bounty programs should heed the warning and ask themselves if they are “giving” away tokens in exchange for “value.”  If the SEC Order is taken at face-value, almost any action that has a benefit for an issuer, no more how marginal, may be construed as “value.”  Careful issuers should make sure that their bounty programs are compliant with an exemption from the registration requirements of the Securities Act or risk the SEC scrutiny.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors Ignacio Celis-Aguirre and Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Friday, September 7, 2018

How to spot a fake private offering?

I recently came across an SEC Investor Alert through another blog posting, which I decided to highlight on my blog as well because of its increased relevance and importance in today's investment environment. I am referring to the Investor Alert: 10 Red Flags That an Unregistered Offering May Be a Scam from August 4, 2014.

This guidance has become particularly important because of the adoption of Rule 506(c) that allows private placements to be conducted using general solicitation and advertisement.  Although all purchasers in such offerings must be "accredited investors," information about such offerings gets widely disseminated and reaches the eyes of the unsophisticated and nonaccredited investors through websites and social media.

Below is a list of some of the red flags discussed by the SEC:

1.  Claims of high returns with little or no risk.  Every private placement memorandum should have a section on risk factors relating to that particular offering.  If you don't find one, assume two things: (i) this PPM is incomplete, and (ii) the risks, even though unstated, still exist (and in abundance).

2.  Unregistered investment professionals.  Always check the bios of the management team, as well as the profiles of the people promoting the offering.  The promoters must always be registered as investment advisers and/or broker-dealers with the SEC.  You can check the promoters' records on the Investment Adviser Public Disclosure website or FINRA's BrokerCheck.  A missing registration is a red flag.  I have written extensively about using unregistered broker-dealers in the past.

3.  Problems with sales documents.  Definitely avoid handshake deals.  Avoid signing agreements that you do not understand.  Read the PPM in its entirely to spot any inconsistencies, mistakes, and typos.  All factual information should have references, and no promises should be made.  When you are thinking of investing, do an Internet search and a search of the company's home state Department of State website to determine whether such business actually exists.

4.  Beware of offerings that are extended to nonaccredited investors.  Most private placement offerings are only available to accredited investors.  Those that are not are probably done in circumvention of applicable federal and state securities laws.  There are, of course, exceptions.  Rule 506(b) private placement can include up to 35 nonaccredited but sophisticated investors, and Title III crowdfunding offerings conducted through registered portals can be extended to an unlimited number of nonaccredited investors.

5.  Where are the lawyers?  A private placement offering is typically done with the assistance of a law firm.  Check whether this is the case.  If not, - participation in such offering is not recommended.  If yes, - read the firm's profile.  Are the involved attorneys experts in the area of securities laws?

These (and other) red flags have become increasingly important in light of numerous initial coin offerings offered through the Internet to retail investors.  Recently, to set an example, the SEC launched a bogus offering of HoweyCoins to illustrate to the investors what a scam ICO could look like. 

However, regardless of the SEC guidances and illustrations, there are many investors who have recently become victims of online investment fraud scams.  Thus, it is important to continuously remind investors how to recognize scam offerings and to avoid them.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.