The Five-Letter F-Word: A Primer on Fraud after Theranos and FTX

One million seconds is about 11 ½ days, and one billion seconds is about 31 ½ years. That’s an interesting piece of trivia to keep in mind when reading about the recent collapse of cryptocurrency trading platform FTX and its affiliated crypto fund, Alameda Research. Alameda, which launched in 2017, and FTX, which launched in 2019, together had net carryover losses of about $3.7 billion based on tax returns filed for 2021. This means that for 2022, we don’t yet know the extent of the loss (if any) suffered by FTX, Alameda, and, most importantly, the individual investors who bet on the claims made by FTX’s founder, Sam Bankman-Fried. One thing that seems certain is that the losses will be in the billions, not millions, and such a catastrophic loss of money means many people will be paying attention as the companies are dissolved and wound up. In press interviews nearly up to the week of FTX’s collapse, Bankman-Fried touted the company’s health and prospects for future growth, saying that FTX was profitable last year (2021) and that he expects it to be profitable again for 2022.

The collapse of FTX and Alameda comes on the heels of recent convictions for high-level officers of Theranos Inc. Elizabeth Holmes, CEO, and Ramesh Balwani, COO, received just over 11 years and just shy of 13 years, respectively, for their part in Theranos’ collapse, which also resulted in the loss of billions of dollars in company value and nearly one billion dollars in investment. As of this writing, Bankman-Fried has been arrested in the Bahamas, extradited to the United States, and charged with a host of fraud-related crimes. It’s expected that he will plead not guilty to the charges. Meanwhile, the co-CEO of Alameda research, Caroline Ellison, and FTX cofounder Gary Wang, have pleaded guilty to wire fraud and securities fraud, among several other federal crimes.

What is Securities Fraud?

Simply put, securities fraud is the term used to describe what happens when someone commits fraud in order to sell a security. In order to understand how securities fraud might be used in the context of investment, it’s helpful to know the exact meaning of “security” and “fraud”. The US Supreme Court defines a security as “an investment of money in a common enterprise with profits to come solely from the efforts of others”. The Securities Act of 1933 and the Securities Exchange Act of 1934, the primary laws which regulate the sale of securities, provide a very long list of what a security could be. If you’d like to read that list, you can find it here for the Securities Act and here for the Exchange Act. Simply put, a security is a passive economic ownership interest in a business. That SAFE your company issued last week? That’s a security. The option grant awarded to your company’s most recent employee? Also a security. The security holder could, but doesn’t necessarily, work for the company which issued the security – they simply have a stake in the company’s success or failure. In the world of securities law, the decision whether or not to invest in a company and receive a security in return must be based on an investor’s understanding of how the company operates, as well as the potential risks involved. That brings us to the second definition: what, exactly, is fraud? Legally speaking, fraud is lying or misrepresenting in order to secure a gain or deprive someone of a legal right. The more plain answer is that fraud is when someone lies in order to get money or some other benefit they may not have received without lying.

The Line Between Fact and Fraud

The same law which creates liability for insider trading (a topic for another article) is used to determine whether securities fraud has been committed: Rule 10b-5 was drawn up by the Securities and Exchange Commission to allow the organization to bring enforcement actions against individuals whom it believes are committing securities fraud. In order to be found liable under 10b-5, someone must either: (1) employ any device, scheme, or artifice to defraud, (2) make any untrue statement of a material fact or fail to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (3) engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Numbers 1 and 3 above capture your standard Ponzi scheme and average fraudster – it’s clear that anyone who sets out to defraud someone else in order to sell a security should be charged with a crime. A little less clear is number 2, and specifically the part about failing to state a material fact which makes another statement “not misleading”. The reason securities fraud cases are so complicated, which is also the reason many people have such diverse opinions about what they thought was fraudulent (particularly the founders who are charged with securities fraud themselves) is that, when raising money from investors, there is an obvious temptation by founders to paint a picture of sunny optimism instead of listing the potential downsides of the investment. For fans of Parks and Recreation, a good contrast would be Chris Traeger’s relentless positivity and Ben Wyatt’s gloomy pragmatism.  

Did Sam Bankman-Fried Commit Securities Fraud?

The short answer is that Bankman-Fried will answer for FTX’s failure in court, but more is being discovered by the day about his actions, and there are strong indicators that securities fraud was the reason so many people lost so much money. In late September, during a Bloomberg Crypto interview with Sam Bankman-Fried, an interviewer asked him how much cash FTX has available to weather market volatility. Bankman-Fried replied that the company had raised “a couple billion dollars last year” and then veered off into a description of the various acquisitions FTX made over the preceding months. Analyzing Bankman-Fried’s statement through the lens of 10b-5, we might ask, “Did he mislead investors?” The interviewer asked how much cash the company had, which we would probably assume meant “at the time the question was asked”. Instead, Bankman-Fried touted the billions raised by the company already, without directly answering the question. Even if he wasn’t being entirely forthright with the interviewer, Bankman-Fried might reply in defense of his response that investors weren’t on the call, so he couldn’t have possibly committed securities fraud with his statement. That may be true, but it’s also true that in granting an interview on a financial program, he knew it would be watched by many people who are either interested in investing in cryptocurrency or have holdings in FTX and want to know whether to keep their money where it is. A prosecutor could argue that Bankman-Fried’s statements were designed to not only reach investors but also induce them into making an investment in a company which (prosecutors may further argue) Bankman-Friend knew was on the edge of collapse. In the case of Holmes and Balwani of Theranos, each of them knew that the blood-testing hardware developed by the company did not work as reliably as they told investors it did, and in some instances told “aspirational” lies – things they wanted to be true and which maybe even expected to be true at some point in the future, but which were still false. Before the lies caught up with Holmes and Bulwani, Theranos had reached a valuation of around $9 billion at its highest point. The subsequent crash in value wiped out nearly $1 billion in actual funds raised.

What Can a Founder Say and Not Say to Investors?

Every founder wants his or her company to succeed. That desire to succeed often leads to a dilemma: a company must raise capital and sell its product, and in order to do so must frame things is the most positive light possible, but they can’t be dishonest in doing so. We don’t advise founders to disclose excessive amounts of information in response to every question – investors don’t always care about every detail of a company’s operations, and not everything amounts to a “material” fact which helps them make an investment decision. What is and isn’t material is often a matter of common sense, but if we had to list a few questions for founders to ask themselves, it would be these:

• Does the product mostly work, or is it mired in production difficulties?
• Is the company getting sued, or are there any employee disputes which could lead to bad press?
• Has the company turned a profit, or even generated revenue?
• Does the company have any customers and, if so, how many?

Using the last question as an example, suppose a potential investor asked a founder how many users were on his company’s platform. Let’s assume that there are 100 active users, and another 25 in the pipeline who are in the process of signing up. Let’s also assume that, historically speaking, 100% of people in the sign-up phase ultimately end up becoming active users of the platform. What is the correct answer to provide the investor? Many founders would be inclined to say 125. Others might say only 100. Some may compromise and say “more than 100”. At Peak, our recommendation would be to answer it this way: “There are currently 100 active users, and based on previous user data, we expect that number to grow by roughly 25% in the near future”. The statement is (i) most importantly, true, and (ii) still framed in a positive light.

The list above is a small sample of the many different questions founders will be faced with as they scale their companies. If you’re a founder and you’re facing challenging questions from investors, talk with a lawyer to learn about how best to respond.

This article is for informational purposes only, and may not be considered legal advice.