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Non-Compete Covenants In Crowdfunding And Fintech

Co-Authored By: Adam Gersh & Mark Roderick

Taking a break from securities laws, we’ll take a look at using non-compete covenants in the Crowdfunding and Fintech world.

By “non-compete agreement,” we mean a contract that prohibits an employee from being employed by, or engaging in, a competitive business after she leaves.

EXAMPLE:  Real estate Crowdfunding company ABC requires its non-clerical employees to sign an agreement promising not to work for any other real estate Crowdfunding business for two years after termination of employment.

To be clear, when we say “non-compete agreement” in this post we don’t mean (1) a confidentiality agreement (a contract that prohibits the employee or contractor from using trade secrets or other confidential information), or (2) a non-solicitation agreement (a contract that prohibits the employee or contractor from soliciting customers or employees after she leaves). Confidentiality agreements and non-solicitation agreements are often used in conjunction with non-compete agreements but generally don’t raise the same legal and ethical questions.

Are Non-Compete Agreements Ethical?

Over the last year, I’ve seen a lot of press arguing that non-compete agreements are unethical — a form of human bondage. It’s more complicated, in my opinion.

When the U.S. economy was based on manufacturing, no one thought it was okay for an employee to haul away his employer’s tools when he quit. In today’s knowledge-based economy, where a $65 billion taxi company called Uber owns no taxis, the assets of most companies are intangible, i.e., knowledge and information. If employees can haul away those assets when they leave, there’s a problem.

Most of the time, employers are trying to protect two things:  confidential information and contacts/relationships. If confidentiality agreements and non-solicitation agreements were easy to prove and enforce, we probably wouldn’t need non-compete agreements. The problem is that they’re very difficult to enforce because violations are very difficult to prove – did the former employee solicit the customer, or did the customer solicit her? So, companies use non-compete agreements as a sort of “backstop.”

Here are a few hypotheticals that illustrate the ethical dilemma:

  • Real estate Crowdfunding company ABC hires Jean Smith, who knows nothing about real estate or Crowdfunding. After three years she leaves and starts her own real estate Crowdfunding company, competing with ABC for deals and investors based on the relationships and reputation she developed while on ABC’s payroll.
  • The same facts as above except Jean was fired for embezzlement.
  • The same facts as above except Jean was laid off because her job was replaced by an algorithm.
  • The same facts as above except Jean brought her own personal contacts to ABC as investors.

Are Restrictive Covenants Enforceable?

I can’t count the number of times I’ve been asked “Non-competes aren’t enforceable, right?”

In general, that’s wrong. Properly-drafted non-compete agreements are as enforceable as any other contract in most American jurisdictions. The giant exception to that rule is California, where non-competes for employees are per se unenforceable (with limited exceptions).

Almost everywhere else, a non-compete agreement is enforceable as long as the agreement is “reasonable” to enforce the legitimate interests of the employer. Whether a given non-compete agreement is “reasonable” depends on lots of factors, including the duties of the employee in question (e.g., business development vs. clerical duties), the duration of the restriction, and the geographical limitation. Despite their name, non-compete agreements can’t be used to prohibit competition per se. They can be used only to prohibit competition that is unfair based on the facts and circumstances.

The geographical limitation in particular creates hard questions in Crowdfunding and Fintech, where many businesses are either national or international in scope.

EXAMPLE:  A dental practice in Chicago attracts 80% of its patients from a seven mile radius. It would be unreasonable for the practice to prohibit its employees from working in Texas. But a real estate Crowdfunding business in Chicago, with projects from California to Texas to New York, is a different story. Can that business prohibit its employees from working anywhere?

Then there’s the question of what the company’s business really is. Is it a general dentistry practice or a specialist orthodontic practice? Does the company do all kinds of real estate Crowdfunding or only residential fix-and-flips? With about eight and a half million accredited investors in the U.S. alone, but only a small fraction having signed up at Crowdfunding sites, are Crowdfunding companies – real estate or otherwise – even competing with one another in the traditional sense?

Things are even more complicated in the blockchain world. Are all companies issuing tokens competitors? No. But two companies issuing tokens based on distributed digital storage are probably competitors, even if one is based on New York and the other in Silicon Valley.

Do Non-Compete Agreements Apply Only to Employees?

No, non-compete agreements can be used for contractors and vendors as well as for employees.

Do Non-Compete Agreements Inhibit Innovation and Economic Growth?

We’ll leave that to the economists.

Are Non-Compete Agreements Effective?

In general, yes, they are very effective. Meaning:  an employee who is subject to non-compete agreements generally doesn’t compete.

For one thing, the employee generally wants to comply with her contract, even if the contract seems a little overbearing and a lawyer says it might not be enforceable. So she chooses a new job that doesn’t violate the non-compete agreement, if she can.

But most important, a company that hires an employee subject to a non-compete agreement can also be liable. Once it learns about the non-compete, the new employer usually withdraws its offer, effectively “enforcing” the non-compete on behalf of the former employer and forcing the employee to look for a job elsewhere. Every now and then a new employer wants the employee so much that it takes the risk, but very seldom.

Recommendations

If you’re a company and aren’t located in California, you should have your employees sign non-compete agreements, period. Think about what you’re trying to protect and draft the agreements accordingly.

If you’re an employee think hard before you sign one. It’s probably enforceable, and it might affect your ability to find another job if you leave.

Form of Agreement

Here is a form of an Invention, Non-Disclosure, And Non-Competition Agreement. In addition to a non-compete agreement, this contract includes a confidentiality agreement, a non-solicitation agreement, and a provision that makes the company the owner of any inventions of the employee, useful in most tech companies.

CAUTIONS:

  • Don’t assume this agreement will be right for your company or that it will be enforced as written in your state.
  • This contract was written for a real estate Crowdfunding portal. It can be modified for other Crowdfunding or Fintech companies.

REALCROWD Webinar: An Attorney’s Take on Real Estate Crowdfunding

Listen as Adam Hooper and Mark Roderick discuss crowdfunding for real estate and the legal documents investors sign when investing in a real estate deal.

Mark Roderick is one of the leading attorneys in the Crowdfunding/Fintech industry and speaks at conferences and other events all over the world. If you’re interested in having Mark speak at an event, please contact Molly Grimm,Communications Manager at Flaster Greenberg PC, at 856.382.2211 or via email: molly.grimm@flastergreenberg.com.

SEC Makes Intrastate Crowdfunding A Little Easier

Source: NASAA Intrastate Crowdfunding Update – October 17, 2016

The SEC just adopted rules that should make intrastate Crowdfunding easier, at least if State legislatures do their part.

To understand how the new rules help and how they don’t, start with section 3(a)(11) of the Securities Act of 1933, which has been, until now, the basis for all intrastate Crowdfunding laws. While section 5 of the Securities Act generally provides that all sales of securities must be registered with the SEC, section 3(a)(11) provides for an exemption for:

Any security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.

In 1974 the SEC adopted Rule 147, implementing section 3(a)(11). That was long before the Internet, and as state legislatures have enthusiastically adopted intrastate Crowdfunding laws since the JOBS Act of 2012, some aspects of Rule 147 have proven problematic. The rules just adopted by the SEC fix some of the problems of Rule 147:

  • In its original form, Rule 147 required that offers could be made only to residents of the state in question. The revised Rule 147 says it’s okay as long as the issuer has a “reasonable belief” that offers are made only to residents.
  • In its original form, Rule 147 required issuers to satisfy a multi-part test to show they were “doing business” in the state. Under the revised Rule 147, an issuer will be treated as “doing business” if it satisfies any one of several alternative tests.
  • The revised Rule 147 provides safe harbors to ensure that the intrastate offering is not “integrated” with other offerings.
  • In its original form, Rule 147 provided that securities purchased in the intrastate offering could not be sold except in the state where they were purchased for nine months following the end of the offering. The revised Rule 147 provides, instead, that securities purchased in the intrastate offering may not be sold except in the state where they were purchased, for a period of six months (not six months from the end of the offering).

Those are all good changes. But the SEC didn’t stop there. In addition to changing Rule 147 for the better, the SEC has adopted a brand new Rule 147A. Rule 147A more or less begins where Rule 147 leaves off and adds the following helpful provisions:

  • Most significantly, offers under Rule 147A may be made to anyone. That means the issuer may use general soliciting and advertising – and the Internet in particular – to broadcast its offering to the whole world. Purchasers – the investors who buy the securities – must still be residents of the state, but offers may be made to anybody.
  • The issuer doesn’t have to be incorporated in the state, as long as it has its “principal place of business” there – defined as the state “in which the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the issuer.” Thus, a Delaware limited liability company could conduct an intrastate “offering in Indiana, as long as all the officers and managers live and work in Indiana.

Why did the SEC bother to create a whole new Rule 147A to add these provisions, rather than just adding them to Rule 147?

The answer is that Rule 147 is an implementation of section 3(a)(11) of the Securities Act, and if you look at section 3(a)(11) you’ll see that the additional provisions in Rule 147A – allowing offers to everybody, allowing a non-resident issuer – are prohibited by the statutory language. To add these provisions, the SEC had no choice but to create a new Rule 147A that is entirely independent of section 3(a)(11).

And there’s the rub. Many of the existing intrastate Crowdfunding laws require the issuer to comply with Rule 147 and section 3(a)(11). Texas, for example, says:

Securities offered in reliance on the exemption provided by this section [the Texas intrastate Crowdfunding rule] must also meet the requirements of the federal exemption for intrastate offerings in the Securities Act of 1933, §3(a)(11), 15 U.S.C. §77c(a)(11), and Securities and Exchange Commission Rule 147, 17 CFR §230.147.

This means that issuers in Texas will not be allowed to conduct an offering under the more liberal provisions of Rule 147A until the Texas State Securities Board changes that sentence to read:

Securities offered in reliance on the exemption provided by this section must also meet the requirements of the federal exemption for intrastate offerings in the Securities Act of 1933, §3(a)(11), 15 U.S.C. §77c(a)(11), and Securities and Exchange Commission Rule 147, 17 CFR §230.147, or, alternatively, the requirements of the federal exemption for intrastate offerings in Securities and Exchange Commission Rule 147A, 17 CFR §230.147A.

To those who have spent the last three years pushing intrastate Crowdfunding laws through state legislatures, it might look as if the boulder has rolled back down the hill. But there might also be a silver lining. Almost all the state rules were adopted before Title III became final, and almost all include very modest offering limits. Now that Title III is working as promised, Rule 147A might present an opportunity for legislatures not just to take advantage of the more liberal provisions, but also to raise offering limits and make other adjustments, seeking to make their state rules more competitive with the Federal Title III rules.

In the big picture, the SEC has once again proven itself a fan of Crowdfunding. And that’s good.

Questions? Let me know.

Two Upcoming Events

I’m delighted to participate in two important Crowdfunding events over the next few weeks:

  • The Regulation A Bootcamp in Manhattan this Thursday, November 10th. For more information and to register, click here.
  • The CrowdInvest Summit in Los Angeles on December 7th. For more information and to register, click here. (Use prom code “MARK30” for 30% off your conference pass).

Both these events are going to be terrific, with a roster that reads like a who’s-who in the industry.

(Miss Nevada had planned to attend also, but apparently had a last-minute scheduling conflict when she learned I would be participating.)

I look forward to seeing everyone else there!

MARK

Workshop on Regulation A+

 

On March 4th I had the pleasure of co-presenting a workshop on Regulation A (Title IV Crowdfunding) in Mountain View, California, at an event organized by Crowdfund Beat. My co-presenter, Jillian Sidoti of SyndicationLawyers.com, is a terrific person, an engaging speaker, and one of the country’s leading authorities on Regulation A.

I hope you enjoy our conversation and get a sense of the real-life practicalities of preparing and filing a Regulation A offering.

CrowdFund Beat Media International is an online source of news, information, events and resources for the crowdfunding industry. Currently we cover the USA, Canada, the UK, Italy, Germany, France, and Holland, and soon we’ll be expanding to Spain, Australia, Japan and China. We think of our work as an educational and informative service to the crowdfunding community, and appreciate your suggestions.

Intrastate Crowdfunding After Title III

CF WordclouldOn one hand, the SEC just proposed several changes to Rule 147 that will make intrastate Crowdfunding easier:

  • We used to worry, at least a little, about the language in Rule 147 saying that you couldn’t offer securities to anyone outside the state. How does this work when your offers are made with the Internet, we wondered? The SEC just proposed eliminating that requirement.
  • If you were doing an intrastate offering in Texas, Rule 147 used
    to require using a Texas entity – not Delaware, for example. No more.
  • If you’re doing an intrastate offering in Texas, you have to show you’re doing business in Texas. The new proposals would make that easier.
  • The new proposals would also simplify and rationalize the rules around (1) the “integration” of offerings (combining an intrastate offering with other offerings), (2) verifying that investors are residents of the state, and (3) re-sales of securities purchased in an intrastate offering.

All that is great, and should really help the intrastate Crowdfunding market (although I take to heart Anthony Zeoli’s excellent caveat here.)

On the other hand, the SEC also proposed a $5 million cap on intrastate offerings, which seems very important in light of Title III.

Title III Crowdfunding allows any issuer anywhere to raise up to $1 million from non-accredited investors who live anywhere in the world. With Title III Crowdfunding available, why would an issuer use intrastate Crowdfunding? There are only two possible reasons:

  • You’re allowed to raise more money in the intrastate offering
  • The process of the intrastate offering is faster/cheaper/easier

Once the hi-tech folks get their hands around Title III, I think we’re going to see the process becoming faster, cheaper, and easier than it looks now, making Title III comparable (maybe even superior) to intrastate Crowdfunding from that perspective.

Then it just comes down to how much you can raise. If I am a small issuer – raising less than $1 million, for example – why would I use the intrastate law of my state when I can use Title III instead and appeal to the whole universe of investors? Case in point:  New Jersey enacted an intrastate Crowdfunding law just this week – with a $1 million limit. Why would a New Jersey business use that law, with Title III on the books and the gold and silver of Manhattan right across the Hudson River?

And if I’m a software developer wondering what kind of platform to build, isn’t the scale tipped in favor of Title III?

The scales will tip further that way when Congress increases the limit of Title III from $1 million to something higher. Although the SEC can always raise the limit for intrastate Crowdfunding as well, the future probably belongs to Title III.

Questions? Let me know.

Crowdfunding Legal Resources

I really appreciate the time you spend on my blog. To make the blog more useful, I’ve added a Legal Links button, up there to the right. To start, you’ll find links to:

I plan to add more links in the future and welcome your suggestions.

Questions? Let me know.

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