Startup Litigation Digest #1
UC Center for Business Law San Francisco | Summer 2023
*This post was originally published on Aug 10, 2023, on iContact.
About this Edition
The Startup Litigation Digest attempts to shed light on the opaque world of private company litigation. Though startups may not face as many lawsuits as their public company counterparts, litigation by private parties and regulators is still a key feature of the regulatory environment in which startups operate. In fact, we suspect that both regulators and private litigants will increasingly focus on private markets given their explosive growth in recent years. Yet, little is known about startup litigation because these matters often hide on obscure dockets and rarely result in published opinions or widely read media accounts.
We intend to publish new issues of this digest on at least a quarterly basis. We hope that it becomes an indispensable source for understanding the litigation environment in the innovation economy.
We would love to hear from you. If you have feedback on this digest or know of litigation matters you would like to see highlighted, please email us at cbl@uclawsf.edu
Sincerely,
UC Center for Business Law San Francisco
Summary of Cases
HeadSpin & Manish Lachwani. Alleged fraudulent scheme to propel valuation to over $1 billion by falsely inflating key financial metrics and doctoring internal sales records.
Ozy Media & Carlos Watson. Alleged scheme to defraud investors and lenders by making material misrepresentations, including impersonation of a business partner.
Bolt & Ryan Breslow. Boardroom dispute between investors and founder in high flying unicorn.
Naveen Gupta v Fungible. Employee demand to investigate potential wrongdoing and breaches of fiduciary duties in connection with $190 million sale of the company.
Bitwise, Jake Soberal and Irma Olguin, Jr. Fresno-based job training startup helping underrepresented tech workers goes from raising over $100 million to bankruptcy, federal criminal investigations and fraud claims against its co-founders and co-CEOs.
Katerra & Michael Marks et al. CEO and other insiders sued for breach of fiduciary duties, breach of duty to creditors, waste of corporate assets and unjust enrichment in Silicon Valley startup that raised $3 billion.
Frank & Charlie Javice. Alleged scheme by founder and CEO in connection with the $175 million sale of the company by deceiving acquirer into believing that the company had certain data.
FTX & Samuel Bankman-Fried Multiple charges by the Department of Justice (DOJ), Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC) plus other investor lawsuits in failed $32 billion international crypto exchange.
1. HeadSpin & Manish Lachwani
On August 25, 2021, the DOJ and the SEC charged Manish Lachwani, the co-founder and former CEO of Palo Alto-based tech company HeadSpin, Inc. with securities fraud and wire fraud. The allegations surfaced in the spring of 2020 following an internal investigation.
According to the SEC’s complaint, from at least 2018 through 2020, Lachwani engaged in a fraudulent scheme to propel the valuation of his Silicon Valley technology start-up, HeadSpin, Inc., to over $1 billion by falsely inflating the company’s key financial metrics and doctoring its internal sales records. According to the complaint, Lachwani then used HeadSpin’s inflated valuation and financial numbers to deceive investors into pouring approximately $80 million into the company between 2018 and 2020, and to enrich himself through the offer and sale of approximately $2.5 million of his personal HeadSpin stock. Per the complaint, Lachwani’s fraud unraveled in spring of 2020, following an internal investigation. Lachwani was forced to resign as CEO, and HeadSpin revised its valuation dramatically from the $1.1 billion claimed during the Series C round, down to approximately $300 million.
According to the DOJ complaint, Lachwani reported false revenue and overstated key financial metrics of the company in materials and presentations to potential investors. According to the complaint, Lachwani maintained control over operations, sales, and record-keeping, including invoicing, and was the final decision maker on what revenue was booked and included in the company’s financial records. Multiple examples are alleged in the complaint of Lachwani instructing employees to include revenue from potential customers that inquired but did not engage HeadSpin, from past customers who no longer did business with HeadSpin, and from existing customers whose business was far less than the reported revenue. Among other information, Lachwani allegedly provided investors false information that overstated HeadSpin’s annual recurring revenue (ARR) – a key metric for evaluating the success of companies that provide “software as a service” – by approximately $51 to $55 million.
On January 28, 2022, the SEC settled fraud charges without a penalty against HeadSpin, Inc. "[The company made] significant remedial efforts in the wake of an internal investigation into misconduct by its now former CEO." HeadSpin's remedial actions included hiring new senior management, expanding its board, and instituting processes and procedures designed to ensure transparency and accuracy of deal reporting and associated revenues.
On April 27, 2023, Manish Lachwani pleaded guilty in federal court in San Francisco to wire fraud and securities fraud charges. According to the plea agreement, Lachwani admitted that he provided prospective investors with inflated ARR numbers and overstated revenue numbers.
U.S. District Judge Breyer scheduled Lachwani’s sentencing hearing for September 27, 2023.
An SEC civil enforcement action is currently pending against Lachwani in the Northern District of California.
2. Ozy Media & Carlos Watson
On February 23, 2023, Carlos Watson, the founder of a startup called Ozy Media, Inc. (Ozy), a media and entertainment company headquartered in Mountain View, CA, was arrested by the FBI at a hotel in midtown Manhattan. Watson was charged with conspiracy to commit securities fraud and conspiracy to commit wire fraud in connection with a scheme to defraud Ozy’s investors and lenders by making material misrepresentations about the company’s financial and business assets.
According to the SEC: “We allege that over the course of several years, the defendants raised approximately $50 million from victim investors on the basis of fraudulent documents and repeated misrepresentations, including, at least in one case, falsely impersonating a potential business partner during a meeting with an investment bank,” said Gurbir S. Grewal, the SEC’s Director of Enforcement. “This matter underscores that we will hold anyone accountable, even well-known media personalities, for misrepresentations that impact investors.”
According to the DOJ: “As alleged, Carlos Watson is a con man whose business strategy was based on outright deceit and fraud – he ran Ozy as a criminal organization rather than as a reputable media company,” stated United States Attorney Peace. “Investment fraud undermines confidence in our nation’s markets and investors and makes it harder for honest businesses to compete. Our Office and the Department of Justice have made it clear that prosecuting corporations and their corrupt executives who flagrantly violate the law are top priorities.”
In September of 2021, Ozy unraveled after The New York Times published an article with serious allegations about the company including an impersonation of a YouTube executive in an investment call with Goldman Sachs.
Ozy’s board had launched an outside investigation by law firm Paul Weiss. They asked Samir Rao, the co-founder and COO of Ozy (the impersonator in the call) to step down. The collapse of the company was swift. Kathy Kay, a star journalist who had left the BBC to join Ozy quit, and SV Angel, a top Silicon Valley early-stage investment firm led by Ron Conway took the unusual step to “surrender its shares” to the company.
Other early investors such as Laureen Powell Jobs’ Emerson Collective tried to distance itself from the company by stating that “Emerson was one of Ozy’s first investors in 2013 but it did not participate in Ozy’s latest rounds and did not serve on its board since 2019.”
German publisher Axel Springer, an early Ozy investor, told Axios that it gave up its right to a board seat and voting rights after only investing $300,000 in the Series C round.
On Oct 1, 2022, the company was shut down amid fraud allegations. That same day, Watson resigned from the board of NPR.
3. Bolt & Ryan Breslow
The legal issues involving Ryan Breslow, the Co-Founder, Chairman and former CEO of Bolt Financial, Inc. a tech company headquartered in San Francisco, keep piling up.
On March 4, 2022, Authentic Brands Group (ABG), a retail and brand management company, which owns a portfolio of global media, entertainment, and lifestyle brands, including Lucky, Forever 21 and Brook Brothers, was one of Bolt’s biggest customers, and sued Bolt for having “utterly failed to deliver on the technological capabilities that it held itself out as possessing.”
In May 2022, a New York Times’s investigation titled “Bolt Built $11 Billion Payment Business on Inflated Metrics and Eager Investors” reported that “Bolt’s meteoric rise has been fueled at least in part by a pattern of stretching the truth, according to interviews with over 50 former and current employees, clients, investors and others with whom Bolt discussed partnerships and fund-raising, as well as the lawsuit filed by ABG.”
Bolt disputed these claims, but eventually settled the litigation on June 8, 2022, with ABG becoming a shareholder for an undisclosed percentage.
More recently, the SEC subpoenaed Bolt and sent a notice to Breslow last year over their past statements to current and potential investors, according to reporting by The Information.
New claims have been filed by investors against Breslow involving Bolt’s $355 million Series E financing that valued the company at $11 billion in late 2021, and also as a result of a controversial $30 million personal loan facility to Breslow from JP Morgan Private Bank (JPM), guaranteed by Bolt. The loan was not repaid, and JPM swept Bolt’s $30 million in cash maintained as security for Breslow’s loan. This led to a boardroom battle, where three of the investor representatives on the board (Brian Reinken of WestCap Management, Arjun Sethi of Tribe Capital Management and Steve Sarracino from Activant Capital) were removed and replaced by new directors nominated by Breslow.
Activant Capital filed a complaint against Breslow and current board members of the company for breaches of fiduciary duties in Delaware Court of Chancery.
4. Naveen Gupta v. Fungible
The right of stockholders to seek corporate books and records is a well-established feature of corporate law. Section 220 of the Delaware General Corporation Law allows stockholders to access to corporate books and records for a “proper purpose” ― most commonly to investigate wrongdoing such as a possible breach of fiduciary duty by the board or management.
Here is an example of a Section 220 demand: On January 10, 2023, Naveen Gupta, a stockholder of California-based data processing unit storage company Fungible Inc., sought to inspect corporate books and records of Fungible in order to, among other things, determine the events leading up to Microsoft's acquisition of the company for $190 million, and investigate potential wrongdoing and breaches of fiduciary duties by the directors of the company in connection with the negotiation and approval of the merger.
Gupta, who worked at Fungible for four years and owns Fungible Class A common stock, alleges that through the merger, the Company now seek to cash him out, as well as the rest of the company's employees, "at a grossly unfair price and substantial discount to their stock option exercise price."
The complaint alleges that a few months prior to the merger "when the Company was already in talks with Microsoft", the Company issued convertible and promissory notes to two company insiders [names redacted]. Shortly after, these two insiders presented a term sheet to the Company with a proposed Series D financing, into which the promissory notes would be converted and allowed other preferred shareholders, but not common shareholders, to participate.
The terms of the Series D Preferred Stock were "highly dilutive" and entitled its holders to "significant consideration if the company were to be acquired, providing holders with a 5x liquidation multiple," the complaint says. "[The issuance of the convertible promissory notes and the Series D preferred stock] were designed to essentially divert any merger consideration paid by Microsoft to the two company insiders and other preferred stockholders and insiders. To ensure management support, there was a "management carve-out" of any proceeds distributable to the Company stockholders for "key employees," the complaint says.
Moreover, the board approved a charter amendment to alter the allocation of the merger consideration "in order to give the Company the highest chance of completing the acquisition." "Instead of the Series D preferred stockholder receiving all the $190 million of the merger consideration, the Charter amendment provided that the greater of twenty percent of the proceeds from the merger or $22 million would be allocated to the Company's other stockholders."
The plaintiff alleges that [the amount allocated to common] was "significantly less than the employees such as Plaintiff had paid to exercise options but apparently a bone big enough in the Board's view to ensure no more than 5% of the outstanding shares of the Company demand appraisal (a pre-condition to closing under the merger agreement)."
5. Bitwise, Jake Soberal & Irma Olguin
Bitwise Industries Inc, a Fresno-based job training startup that gained attention locally and nationally due to its focus on closing the justice gap, went from raising over $100 million from big name investors including Goldman Sachs, JPM and Kapor Capital to filing for Chapter 7 bankruptcy protection on June 28, 2023, owing creditors over $500 million, a growing figure as more employees file claims for unpaid wages and expenses. Bitwise and its leaders are also now the target of a federal criminal investigation.
Bitwise was founded in 2013 as a hub for training students in software coding and website design, technology services for local companies, and providing leased space to tech entrepreneurs and other businesses. They specialized in providing technical training to people in what they called "underdog" cities to underserved communities. Even California Governor Gavin Newsom had praised the company.
However, Bitwise furloughed all 900 of its employees on Memorial Day, and the board of Bitwise fired co-founders and co-CEOs Jake Soberal and Irma Olguin Jr on June 2, 2023, while announcing an internal investigation into what led to these current circumstances and events.
The co-CEOs are now accused of committing fraud on a “massive” scale and repeatedly misrepresenting the company’s financial situation to its board before they were fired, two former Bitwise board members allege in a bankruptcy court filing.
There are multiple claims involving this company, its founders and board members, including:
Class actions for the abrupt and wrongful termination of employment: Andre Nunn et al. v. Bitwise Industries Inc. et al., Case No. 23-CV-00867-ADA-SAB and Pedro Garza et al. v. BW Industries et al., Case No. 23CECG02098.
A local investor filed 11 charges against the founders, company and board members including fraud, negligent misrepresentation, breach of contract and breaches of fiduciary duties. Agri Capital Inc. and CA AG LLC v Jake Soberal et al, Case No. 23CECG02240.
Intentional breach of a joint venture agreement and engagement in "self-dealing to the tune of tens of millions of dollars." NICBYTE LLC v. BW Industries Inc., et al., Case No. 23CECG01990
Fraudulent misrepresentations. Catalyst Communications Inc. v. Jake Soberal, BW Industries Inc., Case No. 23CECG02145.
Failure to pay monies owed from a joint venture. Chase Carter et al. v. BW Industries Inc., Case No. 23CECG00649.
6. Katerra & Michael Marks, et al.
Katerra, Inc. was a Silicon-Valley based construction company that developed, manufactured, and marketed products and services in the commercial and residential construction spaces. The company gathered a lot of support from investors, raising close to $3 billion in equity investments in just a few years. One of its investors was Softbank Vision Fund, which invested $2 billion in the company.
Katerra was founded in 2015 by Michael E. Marks, Jim Davidson, and Fritz H. Wolff with a vision that it would “disrupt” the construction industry by implementing end-to-end integration of construction products and related services.
CEO Michael Marks' strategy was aggressive expansion, bringing experience from his time as CEO at Flextronics, an electronics components and device manufacturer. At its height, Katerra was valued at over $4 billion. However, the company's promising future was never realized. Katerra filed for Chapter 11 bankruptcy on June 6, 2021.
On February 28, 2022, Katerra, by and through its Plan Administrator, filed a lawsuit against Marks and other insiders for breach of fiduciary duties, breach of duty to creditors, waste of corporate assets, unjust enrichment, and aiding and abetting breach of fiduciary duties. The plaintiffs seek approximately $1 billion in damages.
According to the lawsuit, Marks, as well as Katerra’s former principals and directors, breached their fiduciary duties through “self-dealing and self-interested transactions” and by failing to “enforce meaningful controls” to rein in spending and the Company’s auditor failed to properly audit the Company during the entire relevant time period.
Among other claims, the lawsuit alleged that "at the very same time that Katerra’s directors and officers ignored the mounting operational problems and escalating financial losses the Company was suffering, they were lining their own pockets in the form of compensation increases, bonuses, unnecessary executive perks, rides on the corporate jet for non-business purposes, and the diversion of Katerra business to their own side entities (and for their own personal gain)."
On June 20, 2023, the Court in Delaware heard oral arguments on subject matter jurisdiction, personal jurisdiction, and other threshold issues, with the remaining issues to be heard in September 27, 2023.
Litigation is on-going under Katerra Inc. v. Marks et al, case no, 22-cv-00271 (CJB) in the U.S. District Court for the District of Delaware (Wilmington).
7. Frank & Charlie Javice
On April 3, 2023, Charlie Javice, the 31-year-old founder of Frank, a college financial planning company, was arrested in New Jersey and charged with falsely and dramatically inflating the number of customers of her company in order to fraudulently induce J.P. Morgan Chase to acquire Frank for $175 million. Javice, who appeared on the Forbes 2019 “30 Under 30” list, stood to gain over $45 million from the fraud.
According to the SEC: “The SEC’s complaint alleges that Javice orchestrated a scheme to deceive JPMC into believing that Frank had access to valuable data on 4.25 million students who used Frank’s service when in reality the number was less than 300,000. The SEC’s complaint alleges that Javice made numerous misrepresentations about Frank’s purported millions of users to entice JPMC. As negotiations progressed, JPMC pressed the Frank executives for the data associated with its customers, and Javice allegedly sought the help of Frank’s director of engineering to generate synthetic data to make it appear as if Frank had 4.25 million customers. When the director refused to comply, Javice allegedly paid a data science professor to manufacture the data required to close the deal with JPMC.”
According to the DOJ: “As alleged, Javice engaged in a brazen scheme to defraud JPMC in the course of a $175 million acquisition deal. She lied directly to JPMC and fabricated data to support those lies — all in order to make over $45 million from the sale of her company. This arrest should warn entrepreneurs who lie to advance their businesses that their lies will catch up to them, and this Office will hold them accountable for putting their greed above the law.”
8. FTX & Sam Bankman-Fried
On December 13, 2022, the DOJ charged Samuel Bankman-Fried ("SBF"), the founder and CEO of FTX, with an eight-count indictment with fraud, money laundering, and campaign finance offenses.
The charges arise from an alleged wide-ranging scheme by SBF to misappropriate billions of dollars of customer funds deposited with FTX, the international cryptocurrency exchange founded by the defendant, and to mislead investors and lenders to FTX and to Alameda Research, LLC, the cryptocurrency hedge fund also founded by the defendant.
Attorney General Merrick B. Garland said: “We allege that the defendant conspired to defraud customers by misappropriating their deposits; to defraud lenders; to commit securities fraud and money laundering; and to violate campaign finance laws. As this indictment demonstrates, the U.S. Department of Justice will aggressively investigate and prosecute alleged criminal wrongdoing in the financial system and violations of federal elections laws. We will continue to work to ensure U.S. capital markets operate honestly and with the integrity that investors, lenders, and the American people are entitled to.”
In tandem with the DOJ, on December 13, 2022, the SEC also charged SBF with orchestrating a scheme to defraud equity investors in FTX,
According to the SEC’s complaint, since at least May 2019, FTX, based in The Bahamas, raised more than $1.8 billion from equity investors, including approximately $1.1 billion from approximately 90 U.S.-based investors. In his representations to investors, Bankman-Fried promoted FTX as a safe, responsible crypto asset trading platform, specifically touting FTX’s sophisticated, automated risk measures to protect customer assets. The complaint alleges that, in reality, Bankman-Fried orchestrated a years-long fraud to conceal from FTX’s investors (1) the undisclosed diversion of FTX customers’ funds to Alameda Research LLC, his privately-held crypto hedge fund; (2) the undisclosed special treatment afforded to Alameda on the FTX platform, including providing Alameda with a virtually unlimited “line of credit” funded by the platform’s customers and exempting Alameda from certain key FTX risk mitigation measures; and (3) undisclosed risk stemming from FTX’s exposure to Alameda’s significant holdings of overvalued, illiquid assets such as FTX-affiliated tokens. The complaint further alleges that SBF used commingled FTX customers’ funds at Alameda to make undisclosed venture investments, lavish real estate purchases, and large political donations.
On the same date, the Commodity Futures Trading Commission also announced the filing of a complaint against SBF, FTX, and Alameda. The complaint charges all three defendants with fraud and material misrepresentations in connection with the sale of digital commodities in interstate commerce. Further, the complaint asserts that defendants’ actions caused the loss of over $8 billion in FTX customer deposits.
On February 8, 2023, the DOJ filed an amended complaint, with an additional 4 charges. And in March, another charge of a $40 million bribe to the Chinese government to unfreeze trading accounts owned by Alameda. As of June 15, 2023, federal prosecutors withdrew 5 of the 13 charges but requested and were granted a second trial for the withdrawn charges, pending the Bahamian court’s review.
On June 20, 2023, Judge Lewis Kaplan denied motions seeking to dismiss 10 of the 13 counts charged against SBF. Three former FTX employees, his previous girlfriend and two other co-founders, have already pleaded guilty and are cooperating with prosecutors.
On July 20, 2023, FTX sued SBF and other former executives of the cryptocurrency exchange, seeking to recoup more than $1 billion they allegedly misappropriated before FTX went bankrupt.
On July 26, 2023, the DOJ dropped its charges on campaign-finance charges, per a new letter from prosecutors. “The Government does not intend to proceed to trial on the campaign contributions count.”
SBF is scheduled to go to trial on Oct. 2, 2023. A second trial on an additional set of charges is tentatively set for next March.
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