Founder Alert: Is Your Startup AI-Powered, or Are You Just Committing Securities Fraud?
July 19, 2024
The Staff and the DOJ Act Against AI Overstatement
Joonko Diversity Targeted by the SEC and DOJ
On June 11, 2024, the Securities and Exchange Commission (SEC) charged Ilit Raz (Raz), the CEO of Joonko Diversity, Inc. (Joonko), a failed recruitment platform, alleging that Joonko falsely claimed it developed an “automatic recruiting solution” meant to help companies achieve diversity, equity, and inclusion goals by using Artificial Intelligence (AI) to identify diverse and underrepresented candidates. Simultaneously, the U.S. Attorney’s Office for the Southern District of New York announced criminal charges against Raz.
The SEC alleges that Raz falsely claimed that Joonko used seven AI algorithms, AI-based technology to generate automated recruiting solutions, a proprietary algorithm that uses natural language processing and computer vision to scan public data on the candidates that are referred to Joonko, and machine learning to improve the matching process as candidates select the roles they’re interested in, and that the matching of candidates was automated from “end to end.” Moreover, Raz, while fundraising over $27 million, falsely claimed that Joonko had hundreds of customers, including Fortune 500 companies. In reality, Joonko had a few hundred customers — none being Fortune 500. Raz also fabricated testimonials, falsely reported that revenue exceeded $1 million (while it was under $100,000), exaggerated Joonko’s job candidate numbers, provided fake customer lists, falsified bank statements, and forged purchase orders to cover up these deceptions during investors’ due diligence. After Joonko failed to provide investors with access to company documents, Joonko’s board of directors began to investigate Raz’s actions. When confronted by the board, Raz admitted she lied about the number of customers, the amount of revenue, and the amount of money in Joonko’s bank accounts. As a result of these charges, Raz resigned as CEO and Joonko filed for bankruptcy in May 2024.
This Is the Just the Latest Target of ‘AI Washing’
Amid the rapid growth of AI, the Department of Justice (DOJ) and the SEC are increasingly bringing claims against companies that exaggerate or make misleading claims about their use of AI. Since there is an impression — which has yet to be proven in practice — that the integration of AI capabilities into legacy technologies leads to increased productivity and efficiency, AI has become a compelling asset for attracting investments. However, companies must be cautious in the disclosures they make regarding their AI capabilities to avoid heavy legal repercussions associated with overstating AI capabilities.
In March 2024, the SEC settled with investment firms Delphia (USA) Inc. and Global Predictions Inc. for making false and misleading statements about their use of AI. The firms agreed to settle the SEC’s charges and pay $400,000 in total civil penalties. Gurbir S. Grewal, Director of the SEC’s Division of enforcement, stated that, “As more and more investors consider using AI tools in making their investment decisions or deciding to invest in companies claiming to harness its transformational power, we are committed to protecting them against those engaged in ‘AI washing.’” He continued, “As today’s enforcement actions make clear to the investment industry — if you claim to use AI in your investment processes, you need to ensure that your representations are not false or misleading. And public issuers making claims about their AI adoption must also remain vigilant about similar misstatements that may be material to individuals’ investing decisions.”
Watch What You Say and Do What You (Actually) Do
Generally speaking, securities fraud occurs when there is an intentional inducement of investors to purchase or sell securities based on false or misleading information. Securities fraud might take the form of (i) making false or misleading statements; (ii) intentionally omitting material information, the absence of which causes statements to be false or misleading, in order to affect another party’s decision to purchase or sell securities; or (iii) making similar statements (or failing to provide similar omitted information) in order to manipulate the price of securities.
The Exchange Act of 1934 (the Exchange Act) is the source of these foundational investor protections, aiming to prevent fraud and deception in securities transactions. The Exchange Act primarily governs secondary market transactions and grants the SEC extensive authority to establish rules against manipulative or deceptive conduct, including Rule 10b-5. So, for purposes of examining questions of securities fraud, Section 10(b) is the source of the legal framework, and Rule 10b-5 details specific prohibited misconduct.
To successfully defend a securities fraud claim, one of five elements must be successfully challenged: (i) whether there was a material representation or omission that was (ii) made in connection with the purchase or sale of a security that was (iii) known to the speaker as false or misleading that was (iv) relied upon by another party, (v) resulting in (or causing) economic loss or harm.
Material Misstatement or Omission
A securities fraud claim requires that the defendant made a material misstatement or omission. Defenses to a securities fraud claim often include arguments that the defendant did not make a material misstatement or omission, such as asserting that any statements made were accurate and truthful at the time, immaterial to the investor’s decision, or that the defendant lacked the intent to deceive and did not have ultimate authority over the content and communication of the statements. Moreover, in a securities fraud claim, a plaintiff must allege a connection between the misrepresentation or omission and their purchase or sale of a security.
Scienter
Scienter is the key element in a securities fraud claim under Section 10(b) and Rule 10(b)-5. Scienter refers to a mental state embracing an intent to deceive, manipulate, or defraud. To establish scienter, the plaintiff must plead that the defendant acted with the intent to deceive investors or acted with such disregard for the truth that fraud could be presumed. To challenge a scienter allegation, a defendant should challenge whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard.
Reliance
Plaintiffs must show that they relied on the defendant’s misrepresentations or omissions when making their investment decision. Parties litigating over the reliance element generally retain experts, particularly to analyze market efficiency and the purposed impact of the misstatements on the stock price. Further, the plaintiff must demonstrate actual economic loss derived from the defendant’s misrepresentation or omission. To refute the economic loss element, one could argue that the alleged misstatements or omissions were not the cause of the investor’s losses, pointing to other factors or market conditions that were responsible for the decline in value.
Causation
Lastly, loss causation refers to the causal connection between the material misrepresentation and the plaintiff’s subsequent loss. Defense counsel frequently challenge the plaintiff’s ability to establish loss causation, which necessitates proving that the market reacted to the revelation of the alleged misrepresentation or the underlying facts, rather than to other negative information about the company that affected the stock price but was unrelated to the alleged fraud.
The Best Defense Is a Good Offense
A false statement is a directly untrue or misleading statement about important information. Further, statements are also false if they leave out critical information that makes the statement materially misleading (even if the statement itself is technically true). Omissions are also false statements in that they fail to disclose information that a reasonable investor would need in order to make an informed decision on whether to purchase or sell the securities. Disclosing information regarding AI-technology can inadvertently become a false statement. As such, it is critical that companies rely on experienced counsel to avoid making false statements regarding AI capabilities. When fundraising centers around a new asset, especially one as dynamic as AI, it is always best practice to engage with experienced securities lawyers to assist in communication and to avoid unwanted legal repercussions.
Please contact a member of the CFDB team for any inquiries relating to this matter.
David Lopez-Kurtz
Associate
dlopezkurtz@crokefairchild.com
872.224.2940
Cameron Robinson
Partner
crobinson@crokefairchild.com
312.774.4885
Henry Zaransky
Law Clerk
hzaransky@crokefairchild.com