“Fraudsters often seek to use national crises and periods of uncertainty to lure investors into scams. They may play off investors’ hopes and fears, as well as their charity and kindness, and may try to exploit confusion or rumors in the marketplace.” See Securities and Exchange Commission (SEC), April 10, 2020 press release, available at https://www.sec.gov/oiea/investor-alerts-and-bulletins/ia_frauds.
There is no reason to believe the era of COVID-19 will be different. Indeed, with various government agencies and departments, such as the Department of the Treasury, the Food and Drug Administration (FDA) and the SEC, loosening rules to accommodate businesses and investors and help them weather the storm, the chances of an opportunistic fraudster luring victims by false advertising is only increased.
For example, starting in March, the FDA loosened its normal approval rules to accommodate new businesses in the COVID-19 space by granting temporary authorizations to companies looking to sell antibody tests prior to the tests going through the approval process. This loosening of rules in response to a crisis resulted in numerous over-the-counter penny stock pump-and-dump fraudsters falsely advertising antibody test products or test kits. As of June 26, the SEC had suspended trading in at least 30 such companies. See, e.g., SEC Suspension Orders for Arrayit Corporation, Decision Diagnostics Corp., Predictive Technology Group, Inc.
But it is not just blatant false advertising that will be in the sights of the regulators. With the loosening of rules, confusion can reign, and businesses taking advantage of the looser rules may find themselves on the wrong side of the regulators.
Loosening of Rules to Make Capital Raising Easier for Small Companies Not Traded on the Exchanges
On March 5, in the first few days of the pandemic, SEC Chairman Jay Clayton, in announcing proposed new rules, noted,
Emerging companies—from early-stage start-ups seeking seed capital to companies that are on a path to become a public reporting company—use the exempt offering rules to access critical capital needed to create jobs and scale their businesses. The complexity of the current framework is confusing for many involved in the process, particularly for those smaller companies whose limited resources spent on navigating our overly complex rules are diverted from direct investments in the companies’ growth. These proposals are intended to create a more rational framework that better allows entrepreneurs to access capital while preserving and enhancing important investor protections.
On that same day, the SEC proposed loosening rules to raise capital Under Reg CF, Reg D (504) and Reg A—the alternative financing mechanisms that allow smaller companies to sell stock and raise capital without having to register on a national exchange. These regulations were originally crafted to limit the amount of securities that could be sold to investors other than accredited—essentially, sophisticated rather than mom-and-pop—investors and also to put a limit on, and in some cases prohibit, general advertising and solicitation to protect the main street investor.
The proposed loosened rules risk changing that protection, particularly with respect to loosened rules regarding advertising. They also have raised the prior caps on the amount of money that can be raised, increasing the number of potential exposed investors.
One key aspect of the proposed amendment permits “demo day” and “test the waters” advertising—a new carve-out to the rule that advertising be limited to accredited investors. Although there are restrictions to the timing and circumstances of the advertising, the fact that a significantly greater pool will be exposed to advertising suggests the possibility for mischief is still there.
In addition, on March 26, companies filing under Reg A and Reg CF were given an additional 45 days to file certain disclosure reports, and on May 4, companies seeking to raise capital under Reg CF that have sold pursuant to Reg CF in the past and have been in business for at least six months were provided a shorter disclosure period, and in many cases, allowed to provide investors with financial disclosures without signoff from an independent accountant.
Finally, in August, the SEC adopted a new rule amending the definition of an “accredited investor” to significantly broaden the category of investors who can be approached by entities engaging in alternative financing outside the regulated exchanges. See SEC Release Nos. 33-10824; 34-89669; File No. S7-25-19.
Companies Must Not Make Misleading or Deceptive Marketing Claims to Investors or Consumers
With loosened rules, companies strapped for cash will be tempted to advertise to more vulnerable investors seemingly under one of the available alternative finance emergency carve-outs; however, the risk for enforcement is real, not just from the SEC and the Department of Justice (DOJ), but also from the Federal Trade Commission (FTC).
Historically, advertising private placements beyond accredited investors to more vulnerable investors has resulted in enforcement action. See SEC Investor Alert; Intertech (2018); and SEC v. Kik, Case No. 19-cv-5244 (S.D.N.Y. 2019) (the DOJ’s position is that Kik’s presales of tokens to accredited investors pursuant to Reg D “advertised” the ability for the early investors to resell the tokens to the public, in violation of Reg D). Although Kik is a crypto case, it reinforces the landmines that are created when any offering relying on exemptions has a “public” component.
The FTC, along with the SEC, may bring enforcement actions against companies engaging in false or misleading advertising. The FTC has the authority to regulate misleading business practices of SEC-regulated entities, to ensure that markets are fair. In fact, the Securities Act of 1933 was originally administered by the Securities Division of the FTC.
In the wake of COVID-19, the FTC has been actively monitoring companies making various claims related to COVID-19 and has sent (often jointly with the FDA) warning letters to about 300 companies and individuals concerning unsubstantiated claims that their products or services can treat or prevent the disease. In addition to the health claims, some of these warning letters have also discussed the FTC’s concerns regarding false or misleading claims about potential earnings related to the economic fallout from the pandemic. The FTC uses these letters to alert companies of conduct that is likely unlawful and to warn them that they can face serious legal consequences, such as a federal lawsuit, if they do not stop immediately. Recipients of the warning letters typically have 48 hours to get back to the FTC describing the specific actions they have taken to address the FTC’s concerns.
Joint Enforcement by the SEC and FTC
While we have not found any instances where the FTC and SEC engaged in joint enforcement relating to COVID-19 claims to date, joint enforcement is not outside the realm of possibility. The two agencies have overlapping jurisdiction on advertising, whether such advertising is directed to consumers or potential investors, and the SEC has worked in the past with the DOJ in particularly egregious cases.
The SEC has initiated actions against companies that fail to disclose material information in advertising. In an SEC case concerning paid promotions of stocks that appeared in a news format (known as “native advertising”), a court held that “[t]he ‘advertorial’ label … simply does not convey to the reader that the articles, which appear in a news-item format, were indeed purchased by the subject companies; this label does not provide investors with the material information regarding the publishers’ bias.” See SEC v. Corp. Relations Grp., Inc., No. 6:99-cv-1222, 2003 U.S. Dist. LEXIS 24925 (M.D. Fla. Mar. 28, 2003).
Relatedly, the FTC has actively pursued enforcement actions against companies that fail to disclose material connections—in some instances because company owners are touting their own products and services without adequate disclosures of their ownership interest. For example, the FTC has found that an endorser’s failure to disclose that he was an owner in a company was deceptive and issued a consent order prohibiting the endorser and the company from misrepresenting that any endorser is an independent user or ordinary consumer of a product or service. The order also required clear and conspicuous disclosures of any unexpected material connections with endorsers. See In the Matter of CSCO Lotto, Inc., et al., FTC Dkt. No. C-4632 (Nov. 29, 2017) (consent order).
In another case, the FTC charged a company with making false or misleading claims that the fake reviews reflected the opinions of ordinary users of the products, when in fact, the reviews were written by the company’s founder and her employees. In settling these charges, the FTC issued an order in part prohibiting the company from misrepresenting the status of any endorser or person reviewing a product. This order similarly requires clear and conspicuous disclosures of any unexpected material connections with endorsers or any person affiliated with a product. See In the Matter of Sunday Riley Modern Skincare, LLC, FTC File No. 192-3008 (Oct. 21, 2019).
Moreover, deceptive earnings claims by multilevel marketers may be considered pyramid schemes, which violate the federal securities laws, including laws prohibiting fraud and requiring the registration of securities offerings and broker-dealers. The SEC has gone after alleged operators of large-scale pyramid schemes for violating federal securities laws with deceptive multilevel marketing programs. See S.E.C. v. CKB168 Holdings Ltd., No. 13-CV-5584 RRM, 2015 WL 4872553, at *1 (E.D.N.Y. Jan. 7, 2015), report and recommendation adopted in part, No. 13-CV-5584 RRM RLM, 2015 WL 4872555 (E.D.N.Y. Aug. 12, 2015) (allegedly misrepresenting a multilevel marketing company as legitimate and profitable, when the company in fact had little or no retail consumer sales or sources of revenue other than money received from new investors).
As reflected in the COVID-19 warning letters, the FTC also can pursue enforcement actions for deceptive earnings claims. The FTC has recently obtained a preliminary injunction on a case against a company touting an online investment “training program” with allegedly false or unfounded earnings and related claims. Under the terms of the preliminary injunction, the defendants are prohibited from making false, misleading or unfounded representations to consumers about the program, including earnings claims.
Why It Matters
There are more companies seeking to raise cash to conduct legitimate and important businesses than those who would seek to abuse the loosened regulations. But given the regulators’ focus on any company seeking to raise money in connection with a new business relating to COVID-19, it is important to pay attention to the rules.
To avoid potential actions from the SEC, the DOJ and/or the FTC, companies seeking to take advantage of the current relaxation of SEC rules governing alternative financing should be careful not to engage in false or misleading advertising, including:
- Falsely representing that endorsements reflect the independent opinions and experience of impartial users.
- Failing to disclose material connections between endorsers and marketers of a product, specifically that certain endorsers are paid or reimbursed by, or are employees of, an agency promoting the product.
- Falsely representing that paid advertisements are the independent statements and opinions of impartial publications.
- Making false or misleading claims, either express or implied, that a product treats or prevents COVID-19, since the FTC and the FDA take the position that there is currently no scientific evidence that any products or services can treat or prevent the disease.
- Making false promises, directly or by implication, that an investor will be guaranteed a certain return, or otherwise making false or misleading claims concerning the potential to achieve a wealthy lifestyle, career-level income or significant income.
- Failing to disclose that testimonials from participants, customers or investors reflect atypical outcomes.
- Advertising and marketing to investors outside of the new definition of accredited investors
Further, companies may also want to consider revisiting their compliance programs—due diligence and “Know Your Customer” (KYC) procedures before onboarding investors comes to mind. And in keeping with the DOJ guidance for companies seeking to avoid prosecution, the key is to have sufficient resources assigned to compliance—historically, not a focus for many young companies—and monitor social media and other advertising to make sure the issuer is staying within the regulatory boundaries of the offering exemption as well as ensuring whatever information is disseminated is truthful and accurate.