Zuckerberg accused of securities fraud
venturebeat.com
venturebeat.com
1. What is at stake: The original lawsuits filed in Massachusetts in 2004 claimed a theft of IP by Mr. Zuckerberg in starting what is today Facebook. Ergo, there is a massive amount at stake financially if the original case is re-opened and made subject to litigation. Among other things, the ConnectU founders could make a claim on FB's profits almost in perpetuity, could obtain injunctive relief by which they could effectively shut FB down via court order, and could cause the FB founders to be exposed to endless problems with FB's own investors for what would undoubtedly be breaches of reps and warranties made by FB and its founders in the Series A through D & following investment documents (for example, Microsoft might potentially seek to rescind its $240 million investment and demand its money back). Thus, a re-opening of the original case would be a horrific event for FB and its founders. The problem here is this and not any supposed indictment for securities fraud. Of course, with such risks involved, the ConnectU founders have a great motivation to push every angle possible to get the case re-opened because any amount that would be paid to settle the case today would easily dwarf the original settlement amount.
2. Where this is at: The article makes it seem like some dramatic event occurred by which FB and its founders have suddenly been hit with some claim for securities fraud. This is far from accurate. Back in 2005, Facebook responded to the original Massachusetts suit by filing a legal action in California, evidently trying to gain a procedural advantage against both ConnectU and its founders. The ConnectU founders got themselves dismissed from that case on grounds of lack of personal jurisdiction, leaving only their entity in the case. The parties later conducted a private mediation and settled the case over a two-day period. The ConnectU founders did appear in the mediation and got their promised payday. The settlement was documented in the form of a 2-page term sheet and basically involved the grant of a large chunk of FB's common stock to the ConnectU founders. After the mediation was done, the parties attempted to take the 2-pager and put it in the form of definitive documentation and that is where things broke down. Initially, FB apparently tried to accommodate the ConnectU side by preparing complex documentation that would have made the acquisition of ConnectU by FB a tax-free merger (this obviously would have benefited the ConnectU founders, who otherwise would have been taxed on the value of the stock they received as of the date of receipt, leaving them with a multi-million dollar tax hit and no way to liquidate their FB stock to pay for it). When disputes arose about the detailed terms, FB filed a motion with the court to enforce the settlement. In doing so, it asked the court to enforce the terms it had put form in the complex documentation and not as set forth in the 2-pager. The court, on hearing the motion, ordered that the settlement agreement be enforced but did so based on the terms set forth in the 2-pager. The ConnectU parties were then forced to deliver the ConnectU stock to Facebook, which (given that it then controlled the company) promptly fired the attorneys who had been representing ConnectU and its founders. This left the founders scrambling to appeal and to do so under circumstances where the only party with standing to appeal (ConnectU) was controlled by FB as an adverse party. This led to a logistical nightmare, from a litigation perspective, but it eventually got sorted out when the court let the ConnectU founders "intervene" and make their case on appeal. The brief filed before the Ninth Circuit Court of Appeals (discussed in this article) is the opening shot on an appeal seeking to overturn the lower court's order enforcing the settlement.
3. The legal claims on appeal: When it opposed enforcement of the settlement in the lower court, ConnectU raised the legal theory that FB had violated federal securities laws when it allegedly agreed to grant stock to the ConnectU founders in exchange for a release of their claims. The lower court disagreed in electing to enforce the settlement and that is why the issue is being raised on appeal. The other ground of appeal is that the 2-pager that the lower court said constituted an enforceable settlement agreement did not amount to a binding contract because it lacked material terms. Hence, given that the parties were unable to agree on the detailed terms, ConnectU asserts that, at best, the parties only had a "letter of intent" outline of what an agreement would look like, subject to reaching final agreement following the mediation itself. Since no final terms were reached, ConnectU argued to the lower court, and argues now on appeal, that there is no binding agreement and that the Massachusetts litigation by which it seeks the horrific remedies described above should be allowed to proceed (i.e., that FB give back the ConnectU stock, that the original lawyers for ConnectU be brought back into the case, and that the litigation on the merits of the alleged trade secret theft by Mr. Zuckerberg be allowed to proceed to trial).
4. The merits of those claims: This appeal is a testament to what high-priced (and quite excellent) lawyers can do to stir things up when large amounts of money are at stake. I have been involved in countless mediations over the course of a 30-year-plus career and can strongly attest that no one in his right mind (or otherwise) even begins to think that federal securities laws should be taken into account when settling a case by which stock is transferred from one party to another as part of the settlement. Such a mediation usually takes place over a day or two (as it did here) and is conducted under confidential circumstances - that is, there are court rules that affirmatively state that nothing said or done in that process shall be admissible as evidence for any reason in a later proceeding. Who, in that context, would be concerned about making sure that whatever was said by one party or the other constituted truthful representations about the value of what was being transferred to settle the case. Indeed, if anything, parties will try to wildly puff up the value of what is being offered in order to maximize the value of their deal (no one wants to leave "money on the table"). What is more, the other party knows that this is happening. That is the nature of litigation, where you frequently have blowhard lawyers shooting off about this or that with little regard to truth. When a fight is settled in this way, and stock is transferred, the party getting the stock is not making a business investment by which the transferring party needs to figure out if he is, e.g., an accredited investor or, e.g., if he has had full and complete access to the company's books and records. If anyone would even suggest such things in a mediation, he would be laughed out of the room. But, when you have expensive lawyers straining for every possible ground to maximize their client's leverage in a case where huge amounts of money are at stake, you get an approach where no stone is left unturned to gain maximum advantage. Hence, this argument in this appeal.
5. The alleged "fraud" is likely bogus here as well. The theory is that FB did a press release shortly before the settlement touting Microsoft's $240 million investment and suggesting that, based on that investment, FB had a market cap of $15 billion. The claim is that the ConnectU founders relied on that valuation in determining what the value of the common stock was that they received. Later, supposedly, they discovered that FB had in fact done a 409A valuation of the common stock and that such valuation had placed an approximately $8/sh price on the common stock (in contrast to the $35/sh price placed on the preferred at the time of the Microsoft investment). Thus, the ConnectU founders were supposedly defrauded by having been misled about the value of the FB stock they were receiving to settle their claims (that is, as alleged, they thought they were getting stock worth $35/sh when it was in fact worth no more than $8/sh and, presumably, they would not have settled their claims for this supposedly lower amount had they known the true facts about the 409A appraisal, which facts were not disclosed to them at the time of the mediation). That might sound plausible to someone who knows nothing about startups but it is in fact an absurd argument to anyone who knows even the basics of startup financing. Every startup deal-maker knows that startups value preferred stock at 4 to 5 times higher (it used to be more like 10 times higher) than the common stock. This is vital for keeping employee incentives reasonably priced. Anyone who has been through even a single financing with a startup will know this. Therefore, what are the odds that the ConnectU founders, knowing that the $35/sh price was based on a press release discussing Microsoft's preferred stock investment, did not immediately know and understand that a startup of this type would be putting a significantly lower price on the common stock at the same time. Thus, the argument strikes me as entirely artificial. It is a lawyer argument, very likely concocted after the fact. Because of this, too, in my judgment, I believe the argument will be rejected on appeal, just as it was by the lower court. If courts were to hold that no stock could be transferred in a settlement effected through mediation unless the parties stopped to comply with federal securities laws, the result would be utter chaos whenever a party sought to transfer equity as part of resolving a dispute. This is wholly inappropriate to a settlement context because you take a situation where a party is trying its best to "put one over" on the other party (that is how litigation is played) and transform it into a situation where a party can be sued for statements made about value or company circumstances, etc. Rule 10b-5, for example, allows a defrauded investor to sue not only the issuer but also all controlling persons and also all aiders and abetters. Will we now get lawsuits against litigation lawyers who are trying to get the best results for their clients by structuring a settlement with a stock component? Will we now have to create a record of negotiations rather than conduct settlements in a confidential context where parties can feel free to discuss the merits of their case openly without fear of repercussions? When you consider this claim in context, it is actually frivolous, at least when considered as a general rule for whether such laws should apply to a settlement context.
6. Having said all that, I have been involved a number of times with settlements where the deal falls apart before it is fully documented, and courts are generally highly reluctant to enforce a settlement agreement if they are not absolutely convinced that the deal as struck is truly a binding agreement. It is impossible to evaluate this without being able to see the 2-pager itself (which is not in this record). Based on that experience, though (and every litigator will attest to this), it could well be that the ConnectU side has good grounds to get the settlement set aside, and I assume that explains the tremendous effort that has gone into this. Even if they don't ultimately succeed, this puts enormous pressure on FB and Mr. Zuckerberg to settle up at a much higher amount than that of the original settlement, even while the appeal is pending. The lawyers representing FB are undoubtedly sitting their client down and reviewing the parade of horribles in great detail, if nothing else just because they want to cover themselves from liability.
7. I don't know any of the participants here but, from what I have read in news reports, the founders on each side of this do seem to deserve each other - but I can't say that about innocent investors and others who stand to lose and lose big if this goes awry. This is just the sort of royal mess that winds up on law school and bar exams to test the limits of a candidate's knowledge when something gets super-complex with myriad twists and turns. Not a happy situation for anyone really.
Thank-you Grellas.
Of course, once the fight was on, this firing was a pretty nasty move. Since I assume FB was surprised by the fact that this did not settle, I don't think it was planned from inception from that particular angle, however.
I am glad to bring clarity to such items - they really can get confusing if one lacks the legal background and the experience with litigation. I also am a pretty fast writer and so can do this sort of thing pretty quickly (apologies for the wall of text, though).
These two parties were practically made for each other.
I am new to the startup world and do not really understand the finance in the 5th point. Is there an article or something that could elucidate on this as I am not one "who has been through even a single financing with a startup will know this"?
In other words, whether or not ConnectU ultimately has a winning case, the doubt that would be cast by its having a case that might even block FB from doing business down the road would hang over FB like a "cloud on title" does over real property. Such a cloud taints the underlying property because no buyer will touch it until it is cleared. This would affect FB's ability to get future funding and would most certainly mar any IPO it might be contemplating.
That is why FB will fight the battle fiercely at this level. Everything is clean so long as it can make the settlement stick. If not, everything busts wide open. Of course, FB would not allow that to happen and would pay a lot of money to prevent such an outcome. The ConnectU founders know this and are essentially pushing to magnify their payout by bringing that cloud into play.
Actually, that is the major risk here. As to other risks, such as a risk of being found to have committed securities fraud, I just don't see that as a material risk here. The real problem, and it is huge if this gets re-opened, is the threat of a trial over trade secret misappropriation, and that is immediately opened up if the judgment is set aside. The underlying case could drag on for years before getting to trial but the "gumming up" effect of its pendency will mar FB's prospects throughout that entire period.
FB might also face legal action by its investors but the far greater likelihood would be that they would pressure FB to settle this up at whatever cost, perhaps at the expense of some of Mr. Zuckerberg's personal holdings in the company. So he would also be under some substantial and immediate pressure should the judgment be reversed.
On the other hand, I find the Winklevoss brothers revolting: "Oh hey, here's this nerd who can our build vision for us and make us rich! Let's hire and pay him pittance! Oh no, he executed on our unique idea himself?!".
As for most other developers, when approached by "business guys" my typical reaction is to polite say no. Zuckerberg did a much smarter: took their (simple and intrinsically worthless) idea and built a product and a business on it himself.
It's sad that the courts gave the brothers any money (rather than treating the lawsuit as frivolous). Nonetheless, I still hope this will be a sign to "business guy" jocks that this model won't work: it's a lot easier for a nerd to learn business than it is for you to learn programming. Want to build software? Pick up the K&R book, instead of trolling the CS lab.
* Apple II had tons of competitors on the market
* Lisa/Macintosh? Xerox PARC roots
* iPod? Tons of poorly constructed devices before it
* NeXT and OS X? Obj C is not the first "C with objects" language, Mach kernel is from CMU
* iPad/Newton? Tons of prior art (the idea itself belongs to Alan Kay)
I have major problems with Apple (they aren't friendly to hackers who don't work at Apple), but the fact that people forgot the predecessors of Apple's devices is only an example of importance of execution.
If these engineers left with only vague product design ideas in their heads (e.g., use triangulation for location awareness, use an accelerometer for rotating the screen) and built their own iPhone work-alike (which is difficult work), I'd side with them as well.
So if you are a client and you come to me with an idea about a social network for plumbers that has an inbox feature, the max I might agree to is that I won't launch a similar product for his market...but I would be hesitant to even make that promise. I would never give away my right to have an inbox feature on a future venture, lol. Of course, you can totally make me agree that I will not reuse any code or specific modules I program for you will be yours.
Yet this is how many Silicon Valley (back when the valley was actually about Silicon) start-ups began. Generally, however, the pattern was engineer and manager would identify a business need that real customers have. They would attempt to build it as a "pet project", be stiffed by conservative and hunch-driven product organization and would then both quit and take a large chunk of the engineers along with them.
The reason this succeeded is that NDAs and non-competes are unenforceable in California. Law suits would still come (due to alleged theft of IP, which generally never happened) and be settled out of court for only a small proportion of the the equity the "idea" produced.
Personally, I will stand by my words. If you can't build your idea it's worthless (you can't estimate whether others can either). If everyone else can (welcome to web 2.0), it's worthless as well. Sure you may be able to sue somebody over your idea (but you generally have to have something more, like a claim of IP theft), but your lawsuit proceeds will be a fraction of what the person who "stole" your idea has made out of it. That $65mm doesn't change Zuckerberg's life _a single bit_ (not having another $65mm might only make life easier for him, as that's one less bodyguard to hire to protect it).
On the other hand, if you have a genuinely new idea i.e., you have a new CPU architecture you invented but don't have the ability to build the prototype chip _all by yourself_ then one engineer quitting and competing with you won't succeed unless he _actually_ steals your design (this is real IP theft) and even then you'll likely outdo him (as he'll have a bug for bug copy of your design, whereas you actually understand the design choices).
If management wants to be rich, they have to treat engineers with utmost respect. There's difference between engineers mere _coders_ who turn business requirements into code (usually by gluing software others have written together) and engineers. Spot the engineers early on, challenge them, give them autonomy and responsibility. Let them work on pet projects (Google calls it "20% time", but it's merely a codification of something successful companies had been doing before), tune your product vision with their data.
True for employee noncompetes with no other relevant factors; not true for NDAs.
Nonetheless the idea of "social network for X" is not unique and deserves no protection similar to what a chip architecture or a machine learning algorithm may receive. Not that there aren't ambiguous examples e.g., using SVMs to categorize users of a social network or using an emulated RISC architecture to profile the GUI front-end of a web application (such as a social network) but in the cases the idea is not very useful without the engineering chops to put it into use.
So you're right, one lesson to be learned is 'don't hire some schmoe to build your revolutionary product'.
The other lesson to be learned is 'doing flagrantly illegal things with revolutionary products will get you sued for millions of dollars or worse'.
As for most other developers, when approached by "business guys" my typical reaction is to polite say no.
Luckily a lot of people try to make me promise that I will not copy their idea. I tell them upfront "WAIT! Please DON'T share your idea with me because chances are I have probably already had it in the past and may very well work on it in the future."
>Zuckerberg did a much smarter: took their (simple and intrinsically worthless) idea and built a product and a business on it himself.
What's more revolting is that Zuckerberg agrees to do the work for them and then stalls them so he can steal their idea. You call it smart, I call it being a shady douche bag.
There are far more engineers burned by business guys stalling and not paying them then there are business guys burned by shady developers.
To put it another way, I am much more scared of a howitzer than of a derringer: there's very high profile and tragic cases of people being killed by derringers (Abraham Lincoln), but there are much more cases of people being killed by howitzers (that we don't even think twice of them).
This is completely irrelevant. Even Zuckerberg knows that he blatantly ripped them off and stalled them so he could execute it himself. Why else would he settle for ~$65M (Err, I should say ~$35M)? Then to add insult to injury, he misrepresents the value of the stock in the settlement.
I might be singing a different tune if he hadn't agreed to do the work for them.
It happens all the time to me and I'm sure to you as well. Someone suggested I implement an iphone app that scrapes the exchange web interface and gives you calendaring, email and all the other goodies because he was stuck logging into a locked down server blah blah blah. All I had to do was code it all up in a weekend and he'd split the money with me.
So lets say I actually looked at the feasibility of it. Now if I go off and implement a revolutionary email program for android and make a billion dollars do I owe him anything?
These guys seem to be the antithesis of what Silicon Valley claims to be all about. They wield the benefits of a privileged American elite background masterfully, having top-brand lawyers work on their behalf whilst they attend top academic institutions and train for the Olympics. It's a far cry from Silicon Valley's purported do-it-yourself, boostrap-iterate-and-execute meritocracy. (This is not an ad hominem attack, just an account of apparently differing values/ideals.)
Yet, here folks are, on Hacker News, dispassionately contemplating whether they deserve $30 million or $60 million. Most folks working 80+ hour weeks on innovative startups, no matter how talented or even lucky they are, will never earn that kind of money.
If this were not connected to Facebook/Zuckerberg, I suspect that any discussion community like this would be absolutely overflowing with vitriol towards these characters.
I am not a lawyer, but I worked in the securities industry in a regulatory supervisory capacity (series 24, plus a mess of others).
Good general advice: Any time you feel the urge to tell somebody what your stock is worth, avoid the urge unless your legal department is involved.
If FB can buy back that stock at the original valuation, they'll get a good deal.
Here, Facebook tried to pull over a "well at least its stock" deal even though they agreed to $65million.
I wouldn't feel bad for ConnectU as $35million is still fantastic, but wouldn't you go back to court if another 35 was on the table? You'd be an idiot not too.
All that said, this is perfectly in-line with Zucker's character as its been painted as of late.
How likely is that, really? Regardless of whatever anyone thinks of Zuckerberg, that's ridiculous.
"Shrug it off and go build something else, it's not worth the hassle" is for when you miss two weeks of consulting fees on a terrible customer before you cut them off, not $30 million.
I know Mark Zuckerberg is the villain now, but let's be fair. Just because Facebook's default privacy settings aren't private enough for our tastes doesn't mean Zuckerberg is a psychopath or that everyone who has a grudge against him is the hero.
Frankly, I don't care how any lawsuit goes. My personal recommendation would be to take the settlement and cash out while Facebook stock is still worth something. I'm not terribly sanguine about the 1-2 year prospect of the stock. (Not because Facebook will be gone by then, but because the current value of the stock includes a promise of growth that I think will be obviously not going to happen by then.)
Most people don't read full articles. They look at the headlines and make assumptions. Mark's put himself in a position where the assumptions that people make are going to be negative, and that's going to hurt his business, even if it's unfair.
Do you see what I did there? Anyone on the Internet can accuse anyone of anything. And you can do the same in a court document -- when you sue someone, you don't say "I think the person I am suing is a fine and upstanding citizen." You come up with anything that sounds bad and could possibly be true, just in case you're right or the judge buys it.
This is a non-story. Facebook is shady, but there is probably no securities fraud involved.