Securities fraud is a serious act that can apply to any company, no matter how large or small. This is why it is important that businesses interested in raising capital ensure legal compliance with required securities disclosures prior to making an offer to investors. What is securities fraud exactly? The Securities and Exchange Act of 1934 (the “1934 Act”) defines fraud and misrepresentation in securities as “any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.” For example, knowingly making false statements, misleading investors, and omitting material information, such as certain investment risks, would constitute fraudulent behavior under the 1934 Act. Essentially, any sort of illegal or unethical behavior that enables one party to make a profit at the expense of another would be considered fraudulent by the Securities Exchange Commission ("SEC")
Recently, three men—Mark Allen Miller, Christopher James Rajkaran and Saeid Jaberian—were charged with 15 criminal counts of securities fraud, conspiracy to commit securities fraud, and wire fraud. These men created what is known as a “pump and dump” scheme. This is where someone uses false information to increase the price of stock and sell it for a profit once it gets to a certain amount. Specifically, the three men, also created fake resignation letters in order to gain control of four shell companies and then used the SEC’s EDGAR system to put out fake press releases that would “pump up” the share prices of these companies. Business owners use the EDGAR system—Electronic Data Gathering, Analysis, and Retrieval—to file registration statements, reports, and other disclosure documents with the SEC.
Other forms of fraudulent activity within securities include Ponzi schemes, pyramid schemes, and trading insider information. Not only does the SEC investigate securities fraud, but so does the FBI. Violators can face criminal penalties such as imprisonment, in addition to civil penalties. The pump and dump scheme mentioned above is just one example of some of the consequences that securities fraud and misrepresentation offenders can experience. Other instances of securities fraud and misrepresentation are not always as obvious as the earlier examples.
Recently, Goldman Sachs was under fire, facing a class action lawsuit for failing to disclose certain conflicts of interest when they created subprime securities prior to the 2008 recession. The investors that were suing also alleged that as a result of a 2010 Goldman Sachs fraud investigation, and resulting $550 million settlement, their stock plummeted.The plaintiffs claim to have lost an upwards of $13 billion. They also argue that Goldman Sachs was dishonest in 2008 when it displayed the following statements on its website: “integrity and honesty are at the heart of our business” and “our clients’ interests always come first.” The investors claim that the foregoing statements kept Goldman Sachs’ stock prices artificially high. The securities implications of Goldman Sachs, if true, shows a pattern of failing to properly disclose material information to investors, resulting in a claim of securities fraud and misrepresentation. As you can see, securities fraud and misrepresentation can come in many forms and Goldman Sachs is one example of how a possible failure to disclose can result in legal action.
Another example of securities fraud resulting from a business issuer failing to disclose risks to investors is the 2019 Facebook case. In 2019, Facebook had to pay the SEC $100 million for misleading investors when it failed to disclose the misuse of user data. In this case, Facebook’s offering disclosures described described the misuse of user data this risk as a hypothetical rather than as a real risk to investors, especially where Facebook of consumer data that had already experienced this real risk in the past.
Facebook’s failure to properly disclose this risk came to light during the 2016 Cambridge Analytica investigation. In 2016, Cambridge Analytica collected 87 million Facebook profiles from an allegedly rogue software developer who worked at Facebook. The data from those users' profiles was then used to target individuals in an attempt to bolster Trump's presidential campaign. This resulted in a complete breach of trust among Facebook, its users and its investors. Although Facebook was aware about its misuse of users' data as early as 2015, it did not make any corrections to update its offering disclosures to investors until two years later. Despite the fact that it had an obligation to its existing investors to disclose its misuse of data because of the potential loss to investors. The Facebook case is yet another example of the legal consequences that can occur if a business fails to disclose pertinent information to its investors.
How can a business owner make sure that it is properly disclosing all of the material risks and other necessary information about an offering to investors so as to avoid a charge of securities fraud and misrepresentation? Here are a few tips: (1) be sure to provide ongoing disclosures; (2) ensure timeliness in disclosures; (3) provide simultaneous and identical disclosures; (4) adhere to State and federal securities disclosure rules; and (5) establish accountability. Firstly, providing ongoing risk disclosures to investors would have saved Facebook a lot of money and could have prevented a legal action. Generally, business issuers have an obligation to disclose any material information that may affect an investor’s investment in the business. This includes periodic disclosures detailing important interim events or developments.
Secondly, timeliness would have also helped Facebook save big on legal costs and delays. As mentioned, Facebook waited two years before making any update to its disclosures for investors. Business issuers must disclose ongoing and updated information to investors in a timely manner. Thirdly, it is imperative that the business issuer ensures that offering disclosures in one State is identical or uniform to those offering disclosures required in other States. Fourthly, it is important that a business issuer adhere to all applicable State and federal rules regarding offering disclosures in order to prevent a successful claim of securities fraud and misrepresentation. Lastly, a business issuer should provide the names and contact information of specific people who are responsible for disseminating material information to investors on behalf of the business. The foregoing are just a few tips that a business can use to help avoid a securities fraud claim when raising capital from investors.
If you are currently raising capital for your business, then you should seek appropriate legal counsel to ensure that you are properly disclosing all pertinent and material information about your offering and business. If you do not currently have legal counsel to help you do this, we will be happy to help.
*with contributions and additions by Elizabeth L. Carter, Esq., Managing Attorney