Startup businesses need access to quick, easy cash.
Investors want an easy way to get early access to the next breakout company.
In 2013, technology startup accelerator Y Combinator released its solution to these challenges: the Simple Agreement for Future Equity, or SAFE. With a SAFE, an investor pays for a promise: in exchange for payment of cash, the company promises that it will give the investor a return upon the happening of possible future events. The investor’s return may be a grant of stock, or a payment of cash.
While SAFEs address some of the needs of investors and startups, other issues remain. As has been noted elsewhere, a startup does not owe a SAFE investor the same fiduciary duties that corporations owe to their stockholders. If something goes wrong, the investor may be limited to remedies for breach of contract.
The government has also noticed the risks investors face in SAFEs, and the U.S. Securities and Exchange Commission (“SEC”) has used its time-honored tools to address them: public education and enforcement actions. Private lawsuits vindicate private rights, but also serve to educate the public.
Stockholders Are Owed Fiduciary Duties; Parties to Contracts Are Not
It is all but axiomatic that corporate directors owe fiduciary duties to the corporation and its stockholders. Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939). But that benefit of stock ownership has not been extended to persons who hold a potential or future interest in owning stock of the corporation. See, e.g., Simons v. Cogan, 549 A.2d 300, 303 (Del. 1988) (“[A] convertible debenture represents a contractual entitlement to the repayment of a debt and does not represent an equitable interest in the issuing corporation necessary for the imposition of a trust relationship with concomitant fiduciary duties.”). Similarly, the Delaware Court of Chancery has held that preferred stockholders are not owed fiduciary duties beyond those enjoyed by common stockholders, because the rights and preferences of preferred stock are contractual in nature. In re Trados Inc. Shareholder Litigation, 73 A.3d 17, 38-39 (Del.Ch. 2013). And while creditors may have standing to maintain derivative claims against directors for breaches of fiduciary duties if the corporation is insolvent, fiduciary duties only apply to stockholders while the corporation is solvent. North Am. Cath. Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101-03 (Del. 2007).
We have found no court cases holding that SAFE investors are owed fiduciary duties or have rights beyond those found in their contract. Parties to a SAFE do not own equity in the corporation unless and until a triggering event occurs. In this way, SAFE investors are akin to parties to a traditional convertible debenture.
SEC Public Service Announcements
Although Y Combinator’s SAFE template includes an investor representation that they are an accredited investor for purposes of Rule 501 of Regulation D under the Securities Act (allowing investors to purchase unregistered securities), the advent of SAFEs coincided with the rise of crowdfunding, an exception to securities laws that allows relatively inexperienced investors to make small investments in companies at an early stage. With many new investors off to the races, the SEC published an Investor Bulletin warning the public that SAFEs are not quite an “investment” in the traditional sense because the investor does not immediately receive equity in return. The Bulletin warns the public to carefully consider the terms of the proposed SAFE, including in particular the triggering events that may convert the SAFE investment to equity or a payout. The Bulletin also points out that, if the company never again needs to raise capital and never gets acquired, the conversion of the SAFE may never be triggered, leaving the investor with nothing.
SEC Enforcement Actions
Devoted readers of this page will recall that we first mentioned the legal perils of AI washing (that is, the making of exaggerated or untrue statements about a company's AI capabilities to attract investors and customers) in July 2024, and revisited the topic earlier this year. A recent SEC enforcement action highlights the convergence of AI washing and SAFEs on an unsuspecting public.
On October 10, 2024, the SEC announced charges against Rimar Capital USA, Inc. (“Rimar USA”), Rimar Capital, LLC (“Rimar LLC”), Itai Liptz, and Clifford Boro for making false and misleading statements about Rimar LLC’s purported use of AI to perform automated investment trades for client accounts. The parties settled the SEC charges and agreed to pay $310,000 in total civil penalties.
The SEC’s order details the conduct leading up to the charges. The charged parties used SAFEs to lure their victims into making “investments” in Rimar USA, assuring the investors they would get equity in Rimar USA in the event of any equity financing. Rimar USA raised $3.725 million from 45 investors with this scheme. The charged parties made numerous false and misleading statements to investors during this round, including false statements about Rimar LLC having an artificial intelligence platform for trading stock and crypto assets. In truth, no such platform existed. Some of the investors were even deceived into becoming advisory clients of Rimar LLC.
The Rimar USA case underscores that, despite the novelty of SAFEs as a way for investors to get in on the ground floor of an exciting new venture, this new tool can be abused for garden variety securities fraud.
Private Actions Interpreting SAFE Terms
The good news: that “space propulsion company” you invested millions in with a SAFE is going public! The bad news: did you fill out the paperwork for your shares? Worse news: actually, the SEC has issued a cease-and-desist against the company for making false statements about its space tech, and the shares you should have gotten are now worth substantially less than they were as of the triggering event.
These are the basic facts of Larian as Trustee of Larian Living Trust v. Momentus Inc., an unpublished January 2024 order on a motion for partial summary judgment before the Superior Court of Delaware. No. N22C-07-133 EMD CCLD, 2024 WL 386964 (Del. Jan. 31, 2024). The Trust sued for breach of contract (the SAFE) and fraudulent inducement. Defendant Momentus moved to dismiss the breach of contract claim.
The Trust argued that the October 2020 Momentus IPO was a Liquidity Event as defined in the SAFE, and that the Trust should have received equity upon the company going public. Presumably, the Trust could have sold those shares for a handsome profit long before the SEC’s July 2021 cease and desist order caused the shares to fall well below the value of the Trust’s original $4 million investment.
Momentus countered that it went public by merging with a SPAC, and that SAFE investors were required to execute a Letter of Transmittal to receive their equity (the Trust argued said letter allegedly contained release language that would cover potential claims relating to the SEC’s cease and desist order a few months earlier). Momentus argued the Trust failed to satisfy this condition precedent to receiving its shares, so it was entitled to nothing.
The Trust replied that it was not bound by the terms of the merger agreement, and that the SAFE did not include the clear, unambiguous language that would be required to effect the forfeiture that Momentus was advocating.
The trial court ultimately denied Momentus’s motion, reasoning that there were genuine disputes over the merger agreement’s impact, if any, on the SAFE; whether the Trust forfeited its interest by failing to timely execute the Letter of Transmittal; and whether Momentus prevented the Trust from complying with a possible condition precedent by failing to answer straightforward (but no doubt awkward) questions about the looming SEC cease and desist order while insisting that the Trust sign the Letter of Transmittal.
Conclusion
While SAFEs are a relatively new and novel investment tool, they remain subject to many classic risks. Investors should carefully review the terms of the SAFE to ensure they understand the nature of their investment, and what conditions must be satisfied in order for their payment to convert into equity. And if the new SAFE instrument is paired with outlandish promises about new technologies, the very old adage may apply: caveat emptor (“let the buyer beware”).
For more information regarding Alto Litigation’s litigation practice, please contact one of Alto Litigation’s partners: Bahram Seyedin-Noor, Bryan Ketroser, Joshua Korr, or Kevin O’Brien.
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