Startup Litigation Digest #3
UC Center for Business Law San Francisco | March 2024
*This post was originally published on March 29, 2024, on iContact.
About this Edition
The Startup Litigation Digest aims to illuminate the often unclear realm of litigation involving private companies. While startups might not encounter as many legal challenges as publicly traded companies, lawsuits from individuals, investors and regulatory bodies remain a significant aspect of the legal landscape these enterprises navigate. Given the rapid expansion of private markets, we also believe that there will be a growing focus from both regulators and private parties on these areas. However, the specifics of startup-related lawsuits tend to be less known, as these cases often appear on lesser-known legal dockets and rarely result in publicly disseminated opinions or garner significant media attention.
This edition marks the third release of the digest, which we publish on a quarterly basis. Our goal is for this publication to become a valuable resource for those seeking to understand the litigation backdrop of the tech-driven 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 feel free to reach out directly or email us at cbl@uclawsf.edu
Sincerely,
UC Center for Business Law San Francisco
Summary of Cases
Stimwave Technologies and Laura Tyler Perryman. The former CEO and co-founder of a Florida-based medical device company was convicted of creating and selling a fake component that was implanted into patients. Separately, the SEC charged Laura Perryman with defrauding investors out of approximately $41 million by making false and misleading statements about one of the company's key medical device products.
New Enterprise Associates v. Rich. Two opinions from the Delaware Court of Chancery involving breaches of fiduciary duties and enforceability of covenants not to sue between investors in a private venture-backed company that underwent a recapitalization and was subsequently sold.
Slync and Christopher Kirchner. The founder of Slync, a Texas-based supply-chain management software startup, was convicted of defrauding investors out of at least $25 million. Separately, the SEC charged Christopher Kirchner with fraudulently offering and selling more than $67 million of securities to multiple investors, more than $28 million he allegedly misappropriated for personal benefit.
OneTrust Governance Dispute. A Co-Chairman and early investor in a Georgia-based data security company sued the CEO and co-founder in Delaware Chancery Court for violating the company's LLC agreement with "improper actions" that the CEO allegedly took without board approval. The case was eventually dismissed after a board reshuffle and sale of interests in the company.
United States v. Sean Grusd. A California man was charged with wire fraud in federal court in Chicago for defrauding multiple investors out of more than $23 million as part of a fake investment scheme.
Updates on Cases from Prior Issues
You can revisit the full summary of cases from Issue #1 in this link and Issue #2 in this link.
Samuel Bankman-Fried. On March 28, 2024, Samuel Bankman-Fried of Stanford, California, was sentenced to 25 years in prison, three years of supervised release, and ordered to pay $11 billion in forfeiture for his orchestration of multiple fraudulent schemes.
Bolt & Ryan Breslow. Per The Information, Maju Kuruvilla, Bolt's CEO who took over after co-founder Ryan Breslow stepped down from the position, is leaving the role after the board voted to remove him. The company has been struggling and underwent at least four rounds of layoffs. In February of 2024, it offered to buy back stockholder's equity at a $300 million valuation, 97% lower than its 2022 fundraising when it was valued at $11 billion (Bolt raised ~$1 billion from investors). In addition, Fanatics filed a new lawsuit in California court on March 12th, 2023, claiming that Bolt improperly reneged on its contract and “unjustly enriched itself” by touting their deal in the press and to customers. Fanatics is seeking damages that include any profits Bolt realized from their partnership.
Ozy Media & Carlos Watson. Per Fortune Magazine, Ozy Media's Carlos Watson may be jailed before his fraud trial for disclosing private documents in a separate civil lawsuit against BuzzFeed.
Special Interview: Fiduciary Duties of VC-Backed Startups with Delaware Vice Chancellor Travis Laster
1. Stimwave Technologies and Laura Perryman
On March 6, 2024, Laura Perryman, founder and CEO of Stimwave Technologies, Inc. a medical device startup formerly headquartered in Pompano Beach, FL, was convicted by a jury in New York on two counts of an indictment charging her with conspiracy to commit health care fraud and wire fraud and substantive health care fraud in connection with her company’s creation and sale of a fake medical device component. U.S. District Judge Denise L. Cote presided over the 11-day trial. Prior to the arrest, the DOJ agreed to not criminally prosecute Stimwave for its participation in the scheme in exchange for its full cooperation and remediation. Stimwave reached a settlement of $8.6 million with the DOJ for all criminal charges. However the DOJ charged Stimwave together with Perryman with a civil fraud action to recover false claims for reimbursement to the Federal Government’s Medicare Program. Simultaneously, Perryman has also been charged by the Securities and Exchange Commission (SEC) with committing securities fraud.
According to the DOJ’s civil complaint, Stimwave and Perryman knowingly caused medical providers to submit false claims to Medicare from 2018 to 2020. Perryman personally approved the design, creation, and manufacture of a neurostimulation device which contained a fake non-functional piece of plastic. Stimwave personnel were also allegedly involved, and were aware of the change but failed to test the device according to protocol, resulting in doctors submitting false claims with improperly functioning implants.
The SEC complaint made similar allegations, stating Perryman made materially false statements to doctors and investors about the device. Doctors were unaware the piece was non-functional and unwittingly submitted fraudulent claims for reimbursements ranging from $20,000 to $24,000 for each claim. Further, during the Series D Funding, Perryman misleadingly told investors the device was the only one on the market, that it had been approved by the FDA, and that Stimwave’s business model was viable resulting in a $41 million offering. According to the complaint, Stimwave eventually recalled the products, filed for Chapter 11 bankruptcy protections, and ceased operations.
2. New Enterprise Associates v. Rich
In 2023, Vice-Chancellor Travis Laster of the Delaware Court of Chancery issued two opinions with important consequences for dealmaking in private venture-backed companies. The decisions involve a startup called Fugue, a cloud security and compliance company that underwent a recapitalization and was subsequently sold to another company called Snyk for about $120 million in 2022.
The company was founded in 2012 and it raised about $39 million over multiple rounds of financings, including from VC investors and plaintiffs Core Capital and NEA (the Funds). By 2020, the investors urged the CEO of Fugue to seek a liquidity event, but the effort did not result in a sale of the company.
In 2021, the CEO recommended that the Company engage in a recapitalization since it was “the only option available” and a “market check for other financing sources had not generated any alternatives.” The recapitalization raised approx. $8 million (valuing the company’s pre-transaction equity at $10 million) and it had onerous terms for the incumbent investors: 1) all existing preferred stock became common stock, 2) the new investors received a new class of preferred stock, and 3) significant investors executed a voting agreement that included a drag-along right providing that if the board of the company and the holders of the majority of the preferred stock approved a transaction that met a list of eight criteria, then the signatories had to participate. Critically for this case, the Funds covenanted not to sue the new investors over a drag-along sale, including by asserting claims for breach of fiduciary duty.
After the recapitalization, two directors resigned leaving the board with just three members: the CEO and two directors affiliated with the new investors. Soon thereafter, the board approved the issuance of more equity at the original price, set when the company was in distress (the Funds only learned about this second offering after filing a Section 220 books and records demand). The directors also granted themselves millions of options, with the strike price set at one tenth of the value of the common stock implied by the recapitalization.
The Funds subsequently filed suit alleging that the board members and the lead investor, as a controlling stockholder, had breached their fiduciary duties in connection with the sale of the company by engaging in “obvious instances of self-dealing”.
In the first opinion from March 9, 2023, the court held that the claims adequately alleged a breach of fiduciary duties:
“When the sale transaction closed, the new preferred stockholders received a return of nearly 750%. The option holders received a return of 3,200%. Those gains came at the expense of other company stockholders, who suffered dilution from those equity issuances and therefore received a lesser share of the merger consideration.”
In a second opinion, issued on May 2, 2023, the court reviewed the enforceability of the covenant not to sue. In this case, the covenant was based on language found in the National Venture Capital Association (NVCA) model voting agreement:
“[This] decision grapples with a conflict between two elemental forces of Delaware corporate law: private ordering and fiduciary accountability. Ordinarily, those forces operate harmoniously. Here, they pull in opposite directions.”
The language at issue was the drag-along provision in the voting agreement among the company and stockholders, which provided that if specified board and stockholder approvals were obtained in connection with a sale of control of the corporation, the signatory stockholders agreed to take various actions in support of the transaction, including voting in favor of the transaction. The court found that such covenants not to sue may be enforceable, but that the circumstances in an individual case will matter and such covenants cannot protect boards of directors and other defendants from liability for intentionally harmful conduct. The cases are ongoing.
3. Slync and Christopher Kirchner
On January 25, 2024, Christopher Kirchner, the founder and former CEO of Slync, a Texas-based supply-chain management software startup, was convicted by a jury in Texas of four counts of wire fraud and seven counts of engaging in monetary transactions in property derived from specified unlawful activity after a four day trial.
According to evidence presented at trial, Mr. Kirchner – who served as Slync’s CEO from 2017 until 2022, when he was terminated by the Board of Directors due to allegations of misconduct – converted at least $25 million in investor money to his own personal use.
Mr. Kirchner misappropriated the investor funds in various ways: Between April 2020 and March 2022, Mr. Kirchner initiated nearly 100 wire transfers moving money from Slync’s Silicon Valley Bank account into the company’s account at JPMorgan Chase Bank – an account only he had access to. He then wired much of the money from the Chase account to his personal bank accounts. In addition, Mr. Kirchner wired $20 million directly from Slync’s Silicon Valley Bank account into his personal checking account. He used some of those funds to buy a $16 million private jet and to secure a luxury suite at the stadium of a Dallas-area professional sports team.
When Slync, drained of funds, struggled to make payroll in the spring of 2022, Mr. Kirchner attempted to replace some of the money he had misappropriated by convincing at least four investors to wire approximately $850,000 to Slync as part of a purported Series C investment round. However, Slync’s Board of Directors never authorized a Series C investment round.
The SEC also charged Kirchner for misrepresenting Slync’s financial condition and use of proceeds in multiple rounds of funding; fraudulently inducing investors to purchase stocks; and misusing and misappropriating over $28 million funds for his extravagant lifestyle.
Mr. Kirchner now faces up 20 years in federal prison per count of wire fraud and up to 10 years in prison per count of engaging in monetary transactions in property derived from specified unlawful activity.
4. OneTrust Governance Dispute
On February 6, 2023, Kabir Barday, the founder & CEO of OneTrust, a Georgia-based data security company, was sued by Alan Dabbiere, a Co-Chairman and early investor of the company, for violating OneTrust’s LLC agreement with “improper actions” he allegedly took without board approval.
According to the complaint, Dabbiere and John Marshall (the other Co-Chairman of OneTrust) founded a company called AirWatch that hired Barday, then a recent college graduate, as an early employee of AirWatch, and both Dabbiere and Marshall mentored him. In 2014, Dabbiere and Marshall sold AirWatch for $1.5 billion to VMware. In 2016, Barday started OneTrust (then called ZenTrust) and asked Dabbiere and Marshall to join the Board. The complaint alleges that Barday and OneTrust’s early investors carefully negotiated a Limited Liability Company Agreement (“LLCA”) and from 2016-2020, the Board and Barday worked collaboratively. However, in mid-2021, Barday allegedly began asking the Board to be less involved and sought the ability to act more independently as CEO. The relationship deteriorated to such a point that Dabbiere sought a restraining order to prevent Barday from breaching his fiduciary duties through “improper actions” and making unilateral decisions without the board’s approval, specifically around hiring and firing company officers.
Barday’s counterclaim alleged "tyrannical behavior" and a "scorched earth campaign" to seize control of the company by Dabbiere and others. Further, the complaint also accused Dabbiere of “a series of racist, classist, misogynistic and homophobic comments” to OneTrust employees.
According to Law360, the parties got Delaware Vice Chancellor Will's nod to dismiss the case after Dabbiere agreed to step down from the board and sell the majority of his interests in the company, leaving CEO Kabir Barday as the head of a reorganized board.
5. United States v. Sean Grusd
On April 3, 2023, Sean Grusd, CEO of three different entities formed and controlled by him for the sole purpose of investing in privately owned companies, was charged by the DOJ with wire fraud in federal court in Chicago for defrauding multiple investors out of more than $23 million dollars as part of a fake investment scheme.
Per the information, from February 2021 through December 2022, Grusd misappropriated the victims’ funds, using the money to pay personal expenses and purchase luxury items, including expensive cars, vacations, and real estate.
According to the complaint, Grusd created fraudulent stock certificates, misrepresented his professional experience and graduation from Harvard Law School, and fabricated and forged purchase agreements for hundreds of millions of dollars.
On May 5, 2023, Grusd plead guilty to the wire fraud charges and to misappropriating investor’s money to his personal bank account. Sentencing is scheduled for June 18, 2024 and carries maximum possible penalties of 20 years in prison, a maximum fine of $250,000, and restitution granted by the court to the victims.
More details about this case were reported by the Chicago Sun-Times, portraying Grusd as "a junior Bernie Madoff," including the fact that Grusd’s father also has had legal troubles involving fraud. Dr. Ronald Grusd, 77, a Beverly Hills radiologist, completed a four-year prison term last year in connection with an unrelated healthcare insurance kickback scheme, records show.
About the UC Center for Business Law San Francisco
The UC Center for Business Law San Francisco was founded in 2018 with the mission of bringing together leading scholars, business leaders, practitioners, regulators and students to engage in the study, teaching and practice of business law at UC Law SF (formerly UC Hastings).
Other CBL Programs
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CBL Roundtable on Financial Policy & Regulation, an invite-only program that seeks to assemble diverse perspectives from academics, regulators, operators, practitioners, and investors to expressly identify friction points and, more importantly, pragmatic solutions for everyone involved in the ecosystem.
UC Law SF/UCLA Anderson Forecast Economic Outlook, an annual joint program between UC Law SF and UCLA Anderson Forecast to discuss the economic outlook of San Francisco, the Bay Area, California, and the US, in addition to relevant legal matters of interest to legal practitioners and law students.