
Zuckerberg accused of securities fraud - bjonathan
http://venturebeat.com/2010/05/19/facebook-connectu-securities-fraud/?utm_source=twitter&utm_medium=twitter-publisher-author&utm_campaign=twitter
======
grellas
A few observations:

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.

~~~
Bjoern
Grellas, thank you for your time and interesting insight. Despite that
probably your writing is more suitable for a blog post than a comment (over
2000 words).

~~~
ericb
I strongly disagree. Writing and thinking of this caliber is _most welcome_
within the comments, in my eyes. That said, nothing stops you from recycling
it as a blog post too.

Thank-you Grellas.

~~~
scott_s
Since the parent's post has gotten a few downvotes, I think he meant "you're
so good you may want to think about breaking out of our small pond", not "we
don't want you in our small pond."

------
mattmaroon
On the one hand, it's tempting to dismiss all of the negative vibes about
Zuckerberg as just haters latching onto a runaway success. On the other hand,
I don't remember anything like they about the Google guys, or Yahoo. (I
remember it about the MySpace guys, and it turned out to be mostly true.)

~~~
rms
The Google guys seem nice. Zuckerberg does not give off a "nice" vibe. He's
much more like Bill Gates than LarrySergeySchmidt. He is in the game to win
and doesn't pretend to have a benign mission.

------
strlen
I have a very neutral opinion about Facebook and no strong attachment. While I
respect their ability to solve some really interesting scalability challenges,
I don't work there: I ignored them early on thinking they're "just another PHP
website", their recruiters did reach out to me recently but I've already
started a new position. I am not a heavy user of the site: I don't message
other users, don't use any applications and update my status from Twitter.
Essentially, I don't have a bias for or against Facebook.

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.

~~~
_delirium
I dunno, it depends on the circumstances I suppose. If you accept a hired job
from someone and then take the idea private instead of doing it for the person
who hired you, that seems like it legitimately should be illegal. Like if an
Intel manager comes up with an idea and asks an engineer to work up a
prototype, surely it'd be illegal for the engineer to quit and work up that
same prototype for a new chip-design startup instead?

~~~
strlen
> Like if an Intel manager comes up with an idea and asks an engineer to work
> up a prototype, surely it'd be illegal for the engineer to quit and work up
> that same prototype for a new chip-design startup instead?

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.

~~~
dctoedt
> The reason this succeeded is that NDAs and non-competes are unenforceable in
> California.

True for employee noncompetes with no other relevant factors; not true for
NDAs.

~~~
strlen
Thanks for correction. I treat NDAs _as_ enforceable, I stick by my word. Just
to be clear: I am entirely against IP theft (taking actual source code from a
company).

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.

------
mcslee
I'm consistently surprised by how supportive or neutral a position the tech
community (or Silicon Valley tech media) takes towards the Winklevoss brothers
when they provide an avenue to attack Facebook or Zuckerberg.

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.

------
ct4ul4u
I believe this will hinge on the details of how Facebook represented the value
of the securities to ConnectU. Representations of the value of a security are
legally perilous. If Facebook's lawyers at the time were good, I imagine
Zuckerberg will get a pass. If they missed the dots on a few "i"s or the
crosses on a few "t"s, then Zuckerberg could be in for a long ugly ride.

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.

------
byrneseyeview
This looks weak. They knew what they were getting. They agreed to take it. And
now they've changed their minds. The secondary value of that stock is _higher_
than the value at the time of the Microsoft deal
(<http://www.sharespost.com/companies/facebook>), so they're basically suing
because Zuckerberg accidentally gave them a bargain.

If FB can buy back that stock at the original valuation, they'll get a good
deal.

~~~
alttab
The point is they based the stock off the valuation of _preferred_ stock, but
then they actually "received" common stock. It takes a while to get the ball
rolling to accuse Facebook that they got a raw 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.

~~~
pwhelan
I don't feel that bad, considering it seems like Zuckers has been an unethical
solipsist since the start. These 3 perhaps had more than just money taken from
them by Zuckers "jackassery".

------
frisco
"An actual indictment on securities fraud would make it impossible for
Zuckerberg to remain Facebook’s CEO if it were to go public."

How likely is that, really? Regardless of whatever anyone thinks of
Zuckerberg, that's ridiculous.

~~~
neurotech1
This statement is ambiguous anyway. This is a civil suit and not criminal
case. Secondly, from my understanding, only the SEC via a federal court can
"ban" someone from being a director in a public company.

------
raganwald
To those who say that the execution matters more than the idea, I ask why copy
someone else's idea? If it's all in the execution, execute well on an idea you
think up yourself.

~~~
ericd
Most ideas, brilliantly executed, could never be 10% as big as FB. It's most
definitely not all in the execution, except where execution includes "Be ready
to change your idea to a better one".

~~~
DaniFong
But the original idea for Facebook wasn't 10% as big as Facebook. 'Execution'
includes turning your good idea into a great one.

------
mkramlich
This is one of those stories where I cannot feel sympathy for either side.

~~~
tiffani
I feel sorry for the ConnectU guys only because it looks like they'd rather
spend time suing than building something else. Sure, it sucks to get ripped
off, but it sucks worse to drag out that kind of response to having that
happen.

~~~
jerf
What realistic chance do they have of building anything that would make up the
difference of around $30 million?

"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.

~~~
philwelch
About as much chance as they'd have of building anything worth $65 million in
the first place, which doesn't seem like much. These guys are just the
stereotypical "startup idea people" who think "we just need to hire a
programmer to implement our vision".

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.

~~~
jerf
I have no idea nor any opinion about the merits of their case. I am pointing
out the otherwise useful idea of "just shrug it off and build something else"
is good advice only in a certain domain, and this is not in that domain. It is
dangerous to take advice out of the domain it is appropriate for (a broadly
applicable statement), and useful to point out when it is occurring.

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.)

~~~
philwelch
I was actually agreeing with you, in a way--the ConnectU people shouldn't and
can't shrug this off and build something new, because they couldn't build
anything in the first place.

~~~
jerf
Ah. My cynicism was insufficiently deep. Thanks for helping me correct that.

------
WillyF
When I first read the headline, I assumed the story was going to be something
like Zuckerberg looks at Facebook user's private messages and makes trades
based on the private information in those messages. Obviously that's not the
case, but it wouldn't have surprised me with the way he treated user data,
especially early on in Facebook's history.

~~~
philwelch
What good do you think it accomplishes to post this comment? Of course people
assume terrible things about Zuckerberg now that Facebook has passed into the
backlash stage of the hype cycle, but having a vivid imagination about the
crimes someone hasn't actually committed is a reflection on you, not on him.

~~~
WillyF
The point of my comment is that unethical behavior, even when you're early
20s, will cause people to assume the worst with you. Facebook's current
privacy policies and attitudes are alarming enough, but they're far more
alarming when taken into context with Mark Zuckerberg's alleged past behavior.

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.

~~~
philwelch
It's important to recognize that once you've reached the backlash stage of the
hype cycle, the negative rumors and assumptions of bad faith will begin. It's
not important to participate in that process personally, and it's rather below
the level of discourse I'm interested in seeing on Hacker News.

------
jrockway
Zuckerberg slept with my girlfriend!

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.

~~~
adelevie
I'm sure the settlement was well-documented... much more documented than any
supposed rendezvous with your girlfriend.

