Compliance with Reg CF: When failure becomes fraud

As previously identified in a CrowdCheck investor alert here, a significant number of companies that have raised funds under Regulation Crowdfunding are no longer in business. That is to be expected. Early stage companies have a high rate of failure, and investors should understand that risk before investing.

It is a general principle that a business failure itself is not fraud. Maybe revenues never grew the way the company thought. Perhaps larger competitors entered the space and out-competed the company. Maybe the company could not effectively scale its operations to bring down its cost of revenue. These, and an almost infinite variety of factors, can lead to business failure without the occurrence of fraud. However, when entrepreneurs of failing companies play fast and loose with their investors, they may have turned that failure event into securities fraud.

In studying events that occurred in the Regulation Crowdfunding space for our investor alert series, we have identified a few instances that seem to indicate securities fraud. Bear in mind, as we have discussed in the past, securities fraud is not just running away with investor money, but misleading statements and omissions during an initial offering or in the required ongoing reporting. The general patterns of some of those instances are discussed below.

Failure to make a material update to the Form C

Oftentimes, companies raising funds under Regulation Crowdfunding are in tenuous financial condition. Their liabilities often exceed their assets and their financial statements contain “going concern” opinions. However, even with such discussion in the initial filing, material changes to the financial condition of the company during the course of an offering, such as a default on an outstanding liability, results in the company being required to file a material amendment disclosing that event. The issuer and the investment portal are required to give all committed investors whose funds have not yet been disbursed to the issuer notice of the material change and an opportunity to reconfirm their interest in the offering. If they don’t reconfirm, their funds must be returned.

We identified instances where such an amendment was filed but not marked as material, or when the issuer did not file any such amendment during the course of the offering and proceeded into bankruptcy proceedings shortly after the close of the Regulation Crowdfunding offering. The absence of a material amendment, or any amendment at all, may be considered an omission of material information. In any case, investors who contributed funds to those companies should have had their funds returned prior to the investment unless they affirmatively chose to continue to invest in the company.

Any funding portal involved in these types of instance may be liable as well for not fulfilling its obligations to protect investors and returning the funds in accordance with the requirements of Regulation Crowdfunding.

Failure to adhere to the terms of the securities sold

The Simple Agreement for Future Equity, or SAFE, is a very popular securities instrument for offerings under Regulation Crowdfunding. While the SEC has expressed concerns about use of SAFEs, and many issuers appear not to have provided sufficient disclosure about the preferred stock into which the SAFE note will convert, thereby failing to comply with the disclosure conditions of Regulation Crowdfunding, it is an effective investment instrument because it defers important decisions about valuation of the company. The SAFE has limited protections for investors if the company never converts the SAFEs and stays in business, but it does include certain terms that require the conversion of the SAFEs into equity upon the instance of a change in control or liquidation of assets so that investors have the right to receive, maybe, pennies on the dollar.

It appears that a few companies that ceased operations did not comply with those provisions or have provided inconsistent information to investors. For instance, it appears that some issuers claimed to have merely closed their doors with no assets remaining for investors. However, publicly reported information indicates that the assets of the company were sold for cash and equity of an acquiring company. That scenario would be a “change in control” under the SAFE, entitling SAFE investors to their portion of the consideration received by the company after the SAFEs automatically convert to common stock. Other companies have just gone silent without any updates to investors, thereby failing to comply with the terms of the SAFE and omitting information required under Regulation Crowdfunding.

These are just a few scenarios we have seen in which failure potentially became fraud. It wasn’t the underlying event that was fraudulent, but the failure to disclose or lack of compliance with the company’s obligations under Regulation Crowdfunding.

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