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SEC and DOJ Charge Startup with Defrauding Investors

 James Blakemore,

 Zachary Fallon,

 Julian Russo,

 Jenny Leung

 

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This week, the Securities Exchange Commission (“SEC”) charged a small, California-based private company (YouPlus, Inc., or “YouPlus”) and its CEO with violating antifraud provisions of the federal securities laws by making false and misleading statements about the company’s finances and sources of revenue. In a parallel action, the U.S. Department of Justice (“DOJ”) announced criminal charges against the CEO for wire fraud and securities fraud following an investigation by the Federal Bureau of Investigation.

“Some degree of puffery and vaporware in early stage tech companies is to be expected, but founders should take note, as these actions could signify a trend by authorities to begin tamping down on the more egregious excesses in the space.”

– Julian Russo, Ketsal Partner, emerging companies and venture capital

Background

YouPlus is a California-based private technology startup founded in 2013 that claims to have developed a machine-learning tool to interpret and deliver customer insights from videos on the internet. According to the complaint, YouPlus raised approximately $17.5 million from 50 investors from 2013 to 2019 through convertible promissory notes. Of the $17.5 million, YouPlus raised $11 million between 2018 and 2019 from about 30 investors.

The SEC alleges that, between 2018 to 2019, YouPlus’s CEO made false claims to investors regarding the company’s annual revenue, number of customers, financial results, and future prospects. According to the complaint, the CEO’s misrepresentations included claims that a prominent venture capital firm had committed to lead YouPlus’s Series A round of financing and that YouPlus had more than 150 customers when, in fact, it had only four paying customers throughout the company’s existence. Adding to the SEC’s allegations, the DOJ alleges that in contrast to what they had told to investors, YouPlus was relying on human intelligence rather than artificial intelligence software to provide market analysis.

The SEC is seeking permanent injunctions, civil money penalties, disgorgement with prejudgment interest, and an order office-and-director barring the CEO from acting as an officer or director of specific reporting companies. The CEO was ordered to appear in federal court, and if convicted, faces up to $5,000,000 in fines and a maximum sentence of 20 years’ imprisonment.

Takeaways

This is a good reminder that the SEC oversees both the private and public securities markets, and that when they see fraud and misrepresentations in private offerings, they will take action. Entrepreneurs and founders are also reminded that they will be held to account for statements made to potential investors in private offerings, even when those investors are purportedly wealthy, sophisticated and able to fend for themselves. Some degree of puffery and vaporware in early stage tech companies is to be expected, but founders should take note, as these actions could signify a trend by authorities to begin tamping down on the more egregious excesses in the space. Additionally, company counsel and counsel for investors are reminded of the importance of due diligence to protect their clients and themselves from liability for misstatements made or missed in their representation.

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