Do not believe the hype

A recent ruling that company directors “knowingly” breached continuous disclosure obligations flags the danger in talking up a startup, writes Pamela Hanrahan.

Late last year, Justice Michael Lee found that three directors of GetSwift Ltd had each been “knowingly involved” in continuous disclosure breaches committed by the company during 2017 — see Australian Securities and Investments Commission v GetSwift Ltd [2021] FCA 1384. The case raises uncomfortable questions about our approach to sanctioning those who knowingly mislead the market about a company’s prospects and performance.

GetSwift, a software-as-a-service (SaaS) business that has since relocated its public listing to Canada, was described by Justice Lee as “a former market darling” of the ASX. After listing at an issue price of $0.20 in December 2016, its share price rose to $4.30 a year later, before falling by 90 per cent to $0.52 in December 2018. His Honour said it was “notable” that GetSwift, a tech startup, “was able to generate such significant momentum and interest in its share price... in circumstances where potential investors would have likely faced some difficulties in assessing the true value of GetSwift shares due to the absence of any successful track record and its limited operating history”.

In markets, information is everything. Australia — like all mature markets — has extensive mandatory disclosure laws that apply to capital raisings and while shares can be traded. Disclosure failures undermine the capacity of the market to allocate capital efficiently and open the door for investors to be fleeced by hucksters and charlatans.

The disclosure failures at GetSwift were significant. On 22 occasions, the company contravened the continuous disclosure laws; and on 40 occasions, it engaged in misleading or deceptive conduct, including in relation to client acquisition. Justice Lee concluded that “a close review of the contemporaneous record reveals with clarity to any sentient person what went on at GetSwift... a public-relations-driven approach to corporate disclosure on behalf of those wielding power within the company, motivated by a desire to make regular announcements of successful entry into agreements with a number of national and multinational enterprise clients”. This included announcing agreements before the potential benefits were “secure, quantifiable or measurable” in breach of the company’s published continuous disclosure policy. It also included failing to inform the market of information that materially qualified past ASX announcements, such as terminations and decisions by clients not to extend their relationship with the company beyond initial trials.

Signing up new and significant clients was instrumental in driving up the GetSwift share price, including in the lead-up to a further $75m capital raising that took place late in 2017. The content and timing of the announcements, including their treatment as price-sensitive by ASX, was tightly managed by the board.

Directors’ involvement

ASIC proceedings against directors of companies that breach their continuous disclosure obligations are not unusual. What distinguishes GetSwift is Justice Lee’s finding that three directors — Bane Hunter (executive chair and CEO), Joel Macdonald (managing director) and Brett Eagle (non-executive director and sometime general counsel) — were “knowingly involved” in the company’s contraventions. ASIC argued that “each of the directors had an appreciation of the likely effect of the ASX announcements in reinforcing and engendering investor expectations, as well as the way in which the ASX announcements, if released strategically, could increase GetSwift’s share price”.

Knowing involvement requires more than negligence, or just getting it wrong. In recent disclosure cases involving Sino Australia Oil and Gas Ltd (2016), Vocation Ltd (2019) and Big Star Energy Ltd (2020), courts have held that a director cannot be knowingly involved in a continuous disclosure breach unless they knew of the relevant information; knew that the information was not generally available; and actually knew that the information was information that a reasonable person would have expected, if it were generally available, to have had a material effect on the company’s share price. The requirement to prove actual knowledge, especially where directors do not make admissions or give evidence, is a high hurdle, but one that ASIC was able to overcome. It means, in essence, that directors knew that material information was being withheld from the market.

Late in the trial, the directors complained that ASIC was running its case on the basis that they had “embarked upon a deliberate course of unlawful conduct, which caused GetSwift to make ASX announcements to increase its share price”, which would be a serious allegation, tantamount to an allegation of fraud. ASIC’s counsel rejected the suggestion, not least because that “would almost certainly be a criminal case” and was not open to ASIC given the way it had framed its case. Justice Lee agreed with the directors that “a case mounted in closing submissions that they embarked upon a deliberate course of unlawful conduct causing GetSwift to make announcements to increase its share price” was not open to ASIC given the legal pleadings — that is, the case the defendants had to answer. But the evidence about the directors’ state of mind was relevant “to the logically distinct issues as to: (a) the likely effect of announcements made by GetSwift to the ASX concerning the entry into new agreements with clients on maintaining and increasing the share price; and (b) the likely negative impact if positive announcements concerning entry into new agreements could not be made”.

The legal distinction might be lost on most people, but it reflects ASIC’s decision to bring civil penalty proceedings, rather than seek a criminal prosecution for fraud, against the directors involved.

Criminal consequences

But criminal prosecutions in this space are very rare. This makes the conviction of startup founder Elizabeth Holmes on US fraud charges in California, in January 2022, just weeks after the GetSwift decisions, so noteworthy. Holmes was convicted by a federal court jury in San Jose of four counts of defrauding investors based on false claims about the technology underpinning the med-tech startup Theranos Inc. Significantly, Holmes had settled a separate regulatory action brought by the US Securities and Exchange Commission in 2018. At the time of the settlement, the director of the SEC’s San Francisco regional office Jina Choi said, “The Theranos story is an important lesson for Silicon Valley. Innovators who seek to revolutionise and disrupt an industry must tell investors the truth about what their technology can do today, not just what they hope it might do someday”.

In response to the GetSwift debacle, ASX tightened its disclosure rules in March 2018, saying that, “there have been a number of incidents where the disclosures by listed entities about their contractual arrangements with customers have fallen short of the required standards” including “misrepresenting customer contracts as being ‘material’ or with other superlatives when plainly they are not” and “announcing what appears to be a material customer contract without disclosing that it is subject to a trial period or other conditions and therefore may not proceed”.

Investing in early-stage companies involves risks. Everyone gets that, and Australia desperately needs new and innovative businesses to thrive . But illegally overhyping startups damages capital formation in the whole sector — and those who engage in it should be held properly to account.