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.
As a side-note -- have you considered sending this sort of reply to VentureBeat, TechCrunch, et al and seeing if they'd guest post? It's the most clarity I've seen brought to the situation yet, and I'm sure more than a couple folks here could put you in touch with the appropriate editors.
Thanks for the kind words and for the suggestion (also thanks to all here for the nice comments). I hadn't considered it and am not familiar with the channels for pursuing it.
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).
The clusterfuck with the ConnectU lawyers being fired by Facebook boggles my mind. I understand what happened, thanks to your excellent explanation, but I'm left wondering how usual is that? Was that something the Facebook lawyers were planning on, or is it more like when you happen to find your opponents Queen sitting out in the open and realize "Hey... I can just take it"?
Sometimes in litigation you get dizzy trying to figure who among scheming adversaries is the biggest snake. That said, on this point, I think it was planned but not originally in any sinister way - from the FB standpoint, at the time it assumed this would simply be settled based on the mediation agreement, it would be natural to remove the attorneys from representing the company that you had just acquired (they would then either keep ConnectU as a wholly-owned subsidiary or they would dissolve it).
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.
A post like this makes me wish I could upmod more than once.
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"?
Here might be a good place to start: http://www.startupcompanylawyer.com/2009/01/01/how-do-you-se... (this is a somewhat technical piece but written by a real expert in the field and aimed at the knowledgeable executive or other non-lawyer - the discussion of the old 10 to 1 ratio between preferred and common pricing, and the new ratio used since the enactment of IRC 409A, appears toward the end of the piece).
This is obviously a sordid mess, but as one who does not grasp a fraction of the legalities, the worst-case scenarios seem as probable as any other; if I did a blog post on this, it would likely spell doom and destruction for Facebook. There are a lot of potential implications, but which consequences seem inevitable or at least within close reach?
The biggest risk within close reach is that ConnectU might get the appeals court here to reverse the judgment confirming the settlement, with resulting uncertainty that would prove hugely disruptive to FB.
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.