Sunday, March 21, 2010

What Legal Duties Do Angels Owe Each Other?

Just about four years have passed since the current angel investing surge began, and we now have in our midst perhaps the largest group of active angel investors ever.

With increased investment comes a proportionate increase in disputes, and opportunities for courts to consider the nature of the angel investing relationship.

Earlier this year, the Ontario courts provided guidance on what obligations co-investing angels owe each other. Angel investing has always been done on largely a club basis, with loosely affiliated investors sharing information. How much angels shared with each other has been an unregulated matter.

Now, the Ontario courts have laid out some basic rules in a recent ruling involving angel investor Paul Alofs and his fellow angel investors in Kremeko Inc., the Canadian franchisee for Krispy Kreme donuts. Last June, the Ontario Superior Court ordered Mr. Alofs to reimburse his co-investors a total of $655,000 for failing to tell them that Mr. Alof was exiting his investment in Kremeko. The full judgment was finally published just a few weeks ago and is an important cautionary tale.

You may recognize Mr. Alofs' name, who returned to Ontario in 1999 after a much lauded California success with He was an early investor in Kremeko which raised money for angels and other investors in three tranches over 2001-2003 in order to fund the establishment of Krispy Kreme in Canada.

It was Mr.Alofs who contacted certain other angels about the opportunity. According to the court’s decision, the group agreed to work collaboratively, conducting some due diligence individually and exchange their own views about the opportunity. After the investment, two of the angels continued to collaborate directly – Mr. Alofs would share information packages he received for board meetings with the another angel. Some of them reviewed and discussed other investments with Mr. Alofs as well.

And when the company raised the second tranche of $14.5 million, one of the other angels asked Mr. Alofs for his views, and if there were “any red flags” that they should be aware of. Mr. Alofs reported that he would be doubling up his position (which, unknown to the other angels, he did not do). The angel repeated Mr. Alofs' comments to other angels, and they all participated in the round.

Following the second tranche, Mr. Alofs sold his shares to the some of the other investors and resigned his seat on the board of directors. Before that closing, the court found that Mr. Alofs failed to disclose his sale of shares when asked by the other angels, and did not provide the real detaile for his resignation from the board. When the company went under several months later,the angels sued for deceit and negligent misrepresentation. Had they known that Mr. Alofs was no longer participating, the angels claimed, they would not have further invested.

The court agreed. Given the relationship that one angel had not only with respect to Kremeko but also their ongoing discussions about various other investments” the court reasoned, Mr. Alofs should have known that his statements would be relied upon by other angels in determining whether to invest in the third tranche. The skill and knowledge of the angel did not in the court’s eyes reduce Mr. Alof’s liability: “Because someone is a sophisticated investor does not mean that such person would not listen to others and take their views into account.”

As a lawyer, this ruling has made me re-think the kinds of terms I like to see go into investmet involving groups of angels. It could also be the beginning of increased rules around angel club investing. Stay tuned.