In a case reminiscent of last year’s blockbuster government actions against Theranos and its former executives, the U.S. Department of Justice and the U.S. Securities and Exchange Commission have separately charged two former executives of a privately held company for falsely touting the firm’s products. On February 12, 2019, the SEC filed a civil enforcement action in Indiana federal court against two former executives of Lucent Polymers Inc., a plastic manufacturing company, for allegedly making false claims hyping the company’s technology for turning recycled scrap metal into strong plastics. The alleged fraud included false product information, deceptive marketing reports and fraudulent data submitted to auditors. In a parallel action, the two former Lucent Polymers executives were arrested and are being prosecuted criminally by the DOJ.
The government’s aggressive action here is a reminder that securities regulators and law enforcement agencies are increasingly scrutinizing statements made by private companies, especially statements that create investor fervor and lead to inflated share valuations.
The complaint filed by the SEC, SEC v. Kuhnash, alleges that Lucent Polymers’ former Chief Executive Officer Kevin Kuhnash and former Chief Operations Officer Jason Jimerson committed securities fraud in violation of section 10(b) of the Securities and Exchange Act of 1934 and rule 10b-5 promulgated thereunder, and section 17(a) of the Securities Act of 1933. According to the SEC, Lucent Polymers provided manipulated performance testing data in certificates of analysis, and made deceptive responses to customer complaints. Specifically, the SEC alleges that Lucent Polymers performed tests to determine whether their plastics products met a customer’s specifications (e.g. durability and flame retardant specifications), and although these tests were performed and recorded accurately internally, if Lucent Polymers’ products failed a test, the company would provide a false certificate of analysis to the customer claiming that all the customer’s specifications were met. The SEC also alleges that Lucent Polymers manipulated Underwriter Labs tests used to certify its products’ safety by, for instance, repeatedly changing the formulas of its products to evade proper testing.
According to the SEC, Kuhnash and Jimerson did not take any steps to fix the alleged deception and continued to promote their company to potential investors even after being put on notice of the fraud by Lucent Polymers’ Technical Director in September 2013. As Lucent Polymers proceeded through two major acquisitions, first by a private holding company in December 2013 and then by a public company in June 2015, Kuhnash and Jimerson allegedly continued the deception and provided false data to auditors in order to receive approximately $2 million from the sales. The SEC claims that within nine weeks of the June 2015 sale, the public company that purchased Lucent Polymers discovered the manipulation of test data and false certificates of analysis, and sued Kuhnash and Jimerson.
While the SEC and DOJ allegations paint a picture of a long-running fraudulent scheme, the Lucent Polymers action in a broader sense demonstrates the SEC’s continued interest in ensuring that private companies have robust internal controls and governance procedures. Since launching the “Silicon Valley Initiative” in March 2016, the SEC has stressed that private companies, particularly late-stage private companies, must have effective controls. As part of that initiative, the SEC’s enforcement division targeted private companies whose employee equity plans fail to satisfy the safe harbor elements of Rule 701 of the Securities Act. And, as noted above, in March 2018 the SEC filed charges against Silicon Valley private company Theranos and CEO Elizabeth Holmes alleging that they engaged in a years-long fraud designed to dupe investors into believing that the company had a proven breakthrough technology. A few months later, the DOJ filed criminal charges against Holmes and Theranos’ former Chief Operating Officer based on the same alleged misconduct.
Private companies should carefully analyze their procedures and controls for ensuring that their public representations and disclosures are accurate. Statements about a company’s key technology are especially important to potential investors, and consequently, those statements will also be scrutinized by government regulators.