Whenever entrepreneurs offer equity in their companies to investors, state and federal anti-fraud laws apply (whether they know it or not). Unfortunately, anti-fraud laws are easier to violate than entrepreneurs think, and the consequences can be quite severe. Officers and directors of the offending company can be personally held liable to investors or even go to jail for violating these anti-fraud rules.
The Securities Exchange Commission’s Rule 10-b5 prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. Of special note is clause (b) of the Rule, which states: “(It shall be unlawful for any person)…To make any untrue statement of a material fact or to omit 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.” It is not just what is stated about the company or the investment, but what an entrepreneur omits can result in just as much trouble.
The Rule requires entrepreneurs to state any “material fact” that would be material to an investor making his or her investment decision. Generally, a fact will be deemed “material” if there is a substantial likelihood that a reasonable investor would consider the fact to be important in deciding whether to invest in the company. Entrepreneurs must put themselves in the shoes of a hypothetical reasonable investor and ask themselves, “What facts would I want to know about the company and its prospects (good and bad) to help me make an informed investment decision?”
According to the Supreme Court, a fact is material “…if there is a substantial likelihood that a reasonable shareholder would consider it important…” The following are examples of what may be deemed a material misstatement or omission in a lawsuit against a company and its officers and directors:
• Misstatement of the likelihood of success of a product.
• Misstatement regarding the existence and strength of competitors and the impact of said competitors on projected sales.
• Misstatement that affiliated transactions were at arms-length.
• Misstatement that management had no conflicts of interest.
• Misstatement concerning management’s true compensation and benefits.
• Misstatement regarding the backgrounds and integrity of officers and directors.
• Concealment of an adverse feasibility report.
• Concealment of a change in business plans.
• Concealment of pending legislation that could adversely impact business prospects and the cost of doing business.
• Concealment of a material dispute with employees, independent contractors or customers.
• Concealment of the existence of a pending lawsuit.
• Concealment of company debt or loan defaults.
• Concealment of speculative investments being made by management.
Whenever there is a question about whether a fact is material or not, it is always best to disclose it. Not surprisingly, there is no precise way to determine when one is in danger of violating anti-fraud rules (outside of the obvious intentional deceit). Indeed, materiality is a mixed question of law and fact, which means that it will be based on individual circumstances relevant to the company, its offering, and other factors.
Entrepreneurs should consult with experienced securities counsel to assist in drafting securities offering documents and obtain advice as to which facts constitute “material” facts.
Disclaimer: This article should only be used for informational purposes. It does not constitute legal advice, and it does not create an attorney-client relationship with anyone. If you need legal advice, please feel free to contact me at 404-419-6571 or
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or consult an experienced attorney in your community.
