On August 6, 2021, in its first enforcement action against a “decentralized finance” platform, the U.S. Securities and Exchange Commission announced a $13 million settlement against the founders of DeFi Money Market (DMM) for allegedly selling more than $30 million in securities in unregistered offerings by using smart contracts and “DeFi” technology to sell digital tokens and for misleading investors concerning the operations and profitability of their business.
According to the SEC’s order, founders Gregory Keough and Derek Acree, and their company, Blockchain Credit Partners, offered and sold securities in unregistered offerings through DMM from February 2020 to February 2021. DMM sold two types of tokens: mTokens, which accrued 6.25% interest, and DMG tokens, so-called “governance tokens,” that ostensibly gave the holders certain voting rights, a share of excess profits, and the ability to profit from DMG token resales in the secondary market. DMM claimed they could pay investors 6.25% interest on digital assets because DMM would use investor assets to buy “real world” assets (such as car loans) that would create adequate income to pay the assured interest and produce profits.
However, after publicly unveiling DMM, Keough and Acree purportedly realized that DMM could not operate as promised because the price volatility of the digital assets used to purchase the tokens created risk that the income generated through income-generating assets would be insufficient to cover appreciation of investors’ principal. Rather than notifying investors of this roadblock, they allegedly misrepresented how the company was operating, including by falsely claiming that DMM had acquired profitable income generating assets in the form of car loans without having any such assets in its actual possession. Instead, Keough and Acree used their personal funds and funds from the other company they controlled to make principal and interest payments for mToken redemptions. In February 2021, DMM announced that it was shutting down and voluntarily ceased offering and selling mTokens by disabling the DMM website and redirecting website visitors to a page where they could redeem outstanding mTokens.
As the latest sign of the intensifying regulatory scrutiny for cryptocurrency markets, the SEC found that Keough, Acree, and DMM violated Sections 5(a) and 5(c) of the Securities Act of 1933 by conducting unregistered offers and sales of both types of digital assets. The SEC also found that Keough, Acree, and DMM violated the antifraud provisions of Section 17(a) of the Securities Act and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder given the “deceptive acts concerning DMM’s business operations and profitability.” As part of the settlement, Keough, Acree, and DMM agreed to pay a total of disgorgement of $12,849,354, prejudgment interest of $258,052, and civil money penalties totaling $250,000.
NASDAQ Board Diversity Rules Challenged in Fifth Circuit
On August 9, 2021, the Alliance for Fair Board Recruitment (AFFBR), a nonprofit membership organization incorporated in the state of Texas, filed a Petition for Review in the U.S. Court of Appeals for the Fifth Circuit seeking to have the appellate court review the approval by the U.S. Securities and Exchange Commission of corporate board diversity guidelines proposed by The Nasdaq Stock Market LLC.
Under the Nasdaq guidelines, approved by the SEC on August 6, each Nasdaq-listed company (other than a Foreign Issuer, Smaller Reporting Company, and Companies with Smaller Boards) is required to have, or to explain why it does not have, at least two members of its board of directors who are “Diverse,” including at least one director who self-identifies as female and at least one director who self-identifies as an underrepresented minority or LGBTQ+. Reporting companies are to report their compliance or non-compliance with the diversity requirements using a “Board Diversity Matrix.” Nasdaq also proposed to make available to exchange-listed companies complimentary access to board recruiting services, to provide access to a network of diverse candidates for companies to identify and evaluate.
Following SEC approval, AFFBR filed this petition pursuant to Section 25(a) of the Securities Exchange Act of 1934, which allows a “person aggrieved by a final order” of the SEC to obtain review of the order in the U.S. Court of Appeals for the circuit in which he has his principal place of business by filing, within 60 days, a written petition requesting that the order be modified or set aside in whole or in part.
Although the petition itself does not contain any legal agreements, in prior comments submitted to the SEC in connection with its consideration of the guidelines, AFFBR argued that the diversity rule should be disapproved because it is contrary to law, arbitrary, and unconstitutional because: (1) it fails to advance any legitimate exchange purpose; and (2) Nasdaq’s pretextual interest in improving securities markets does not justify “discriminatory classifications based on sex, race, or sexual orientation” under the Fifth Amendment to the U.S. Constitution.
As the petition has only just been filed, it remains to be seen how it will fare. The group has previously filed legal challenges to other efforts to require companies to diversify their boards. For example, in July, the group filed a suit seeking to challenge California laws that require public companies with their headquarters in California to diversify their boards.
Delaware Court of Chancery Declines to Enforce Contractual Limitations on Liability to Bar Contractual Fraud Claims
On August 12, 2021, in Online Healthnow, Inc. v. CIP OCL Investments LLC, et al., Vice Chancellor Joseph R. Slights III of the Delaware Court of Chancery declined to dismiss fraudulent inducement claims against CIP OCL Investments LLC and its related entities and directors. The court held that provisions in the purchase agreement expressly limiting when and against whom the buyers could assert post-closing claims were unenforceable with respect to plaintiffs’ contractual fraud claims.
The lawsuit arises from Online HealthNow, Inc. and Bertelsmann, Inc.’s purchase of CIP’s subsidiary, OnCourse Learning Corp., in 2018. OHN and Bertelsmann acquired OCL from CIP through a stock purchase agreement that contained various representations and warranties, including, in relevant part, representations that all tax returns had been “duly and timely” filed and were “true and correct in all material aspects,” and that the company had no undisclosed liabilities. The SPA contained limitations on the liabilities of the parties, including (1) an agreement that all representations and warranties “terminate effective as of the Closing and shall not survive the Closing for any purpose,” (the “time limitation” clause) (2) an agreement that any claim arising out of the SPA could only be brought against “the parties and their respective successors and permitted assigns,” (the “nonrecourse provision”) and (3) a requirement that post-closing disputes concerning the closing price be submitted to an independent accountant.
The buyers allege that shortly after the deal closed for approximately $525 million, they discovered millions of dollars in undisclosed tax liability. According to the complaint, CIP and its directors were not only aware of this undisclosed liability, but had discussed the issue with another bidder while actively concealing it from OHN and Bertelsmann. OHN and Bertelsmann filed suit against CIP, its parent company, and the individual directors involved in the deal, alleging fraud, aiding and abetting, civil conspiracy, and unjust enrichment, while also seeking a declaratory judgment that their claims fell outside the scope of the requirement that claims be submitted to an accounting firm. Defendants moved to dismiss, arguing that the contractual limitations on liability barred all of the buyers’ claims.
Vice Chancellor Slights denied the motion to dismiss, holding that under ABRY Partners V, L.P. v. F & W Acquisition LLC and its progeny, the SPA’s limitations on liability could not bar plaintiffs’ fraud claims arising out of statements made within the contract itself. Specifically, the court held that where “an agreement purports to limit liability for a lie made within the contract itself, and parties know of the lie, such parties cannot skirt liability through contractual limits within the very contract they procured by fraud.” The court reasoned that this holding applied equally to the time limitations and nonrecourse provisions in the SPA. Finally, the court held that the parties’ dispute could not be outsourced to an independent accounting firm until the court adjudicates the scope of the contractual fraud.
The decision puts parties on notice that the Court of Chancery’s reasoning in ABRY Partners is not strictly limited to non-reliance provisions. Instead, Vice Chancellor Slights’ decision makes clear that where a plaintiff asserts fraud arising out of misrepresentations made in the contract itself, Delaware courts will not enforce any limitations of liability that purport to completely bar recovery against the alleged fraudsters.