Check out our launch on Product Hunt today. Your support and feedback mean a lot to us!

Degoverned - Modern legal platform for technology startups | Product Hunt

Cases

SAFT/SAFE Caselaw at a Glance: Caselaw Surrounding Bad Faith Founders

More recently the tech industry has had to resort to dramatic cost-cutting, with many projects failing outright. In the midst of these developments, many investors are left wondering: do companies that raised money through SAFEs or SAFTs have any obligations at all?

The SAFE and SAFTs were designed to simplify how startups raise money from investors. The “Simple Agreement for Future Equity” or SAFE gives the investor the right to receive equity in the company in the next equity financing round (for a detailed overview of the SAFE, read our article). A “Simple Agreement for Future Tokens” or SAFT was designed for the crypto industry and provides the investor with the right to receive tokens to be issued by the company at a fixed price once its blockchain project is operational (for an overview of the SAFT’s terms, check out our SAFT Legal Checklist).

The SAFE and SAFT were created in a time of plentiful liquidity for companies and are very company-friendly. In essence, the investor under these agreements parts with his money in exchange for the mere possibility of receiving equity or tokens in the future. In an era of low interest rates, this pro-company balance was not a large cause for concern among investors. More recently, however, with rising interest rates the tech industry has had to resort to dramatic cost-cutting, with many projects failing outright. In the midst of these developments, many investors are left wondering: do companies that raised money through SAFEs or SAFTs have any obligations at all?

This is the question we sought to answer when we embarked on our research of case law on the subject, and below is what we’ve found, along with some recommendations for investors using these agreements.

Company Intentionally Avoids Triggering Events

A SAFE investor receives stock in the company through conversion of the SAFE into the company’s shares, which happens automatically upon the company’s closing of an equity round. A SAFE investor also receives his proportional share of the sale proceeds if the company is acquired. But a company can intentionally avoid conversion as the business is developed, potentially leaving its investors with nothing.

This was the issue in the case Crashfund, LLC v. FaZe Clan, Inc. (June 8, 2020). There, investors entered into a SAFE with the defendant company, which avoided conversion of the SAFEs by engaging in a de facto merger with another company. Undergoing a legal merger would have triggered conversion of the SAFEs, so the investors sued the company, claiming that it breached the SAFEs by deliberately choosing the de facto merger route to deprive the investors of the company’s stock.

The court noted that, as with all contracts, the parties entered into an agreement that included the implied covenant of good faith and fair dealing. One requirement of this covenant is that when one party exercises discretion, it is exercised in good faith and not in a manner that unfairly deprives the other party of its contractual rights.

The court found that the company had an obligation under the SAFE to protect the investors’ right to obtain stock. This obligation required that the company not intentionally engineer a way to withhold this right from investors. The court also noted that, if proven, this fact pattern would be enough to state a claim for unjust enrichment.

Founder Commits Fraud

There is an element of elusiveness when proving a founder has acted fraudulently. Founders typically allude to potential gains without explicitly promising profits, and investors are typically aware of the risks involved. Many cases of founder fraud originate from this fine line between investor expectations and company outcomes. The degree of fraud is open to some interpretation, but existing case law provides a gauge.

In the case Rostami v. Open Props, Inc. (Jan. 9, 2023), the court, applying New York law, denied the investor’s right to bring a lawsuit against the defendant company for fraud. The court’s decision provides a great deal of insight into how courts analyze fraud claims related to SAFTs.

In Rostami, the investor and the company entered into a SAFT. However, the defendant company eventually made changes to its platform, resulting in its cryptocurrency becoming worthless. In relevant part, the investors asserted claims for fraudulent inducement, unjust enrichment, and breach of the implied covenant of good faith and fair dealing.

Under New York law, a claim for fraudulent inducement involves the following elements: (1) a misrepresentation or omission of material fact, (2) which the defendant knew to be false, (3) which the defendant made with the intention of inducing reliance, (4) upon which the Plaintiff reasonably relied.

The court addressed the first, second, and fourth elements. When analyzing the first element of fraudulent inducement, the court stated that promissory or “puffery” statements can’t form the basis of a claim for fraudulent inducement. This means that a statement similar to, “This will be the greatest investment you’ve ever made!”, would not be sufficient to bring a claim for fraudulent inducement. The court stated that the investor did not satisfy this element as the defendant company’s statements amounted to mere puffery.

When analyzing the second element of fraudulent inducement, the court noted that in order to argue that the defendant knew the statement was false, the Plaintiff must allege acts and/or omissions that aided in the fraud, such as missed deadlines, a lack of communication, etc. The court stated that the investor did not satisfy this element, as its claim was solely based on speculation and conclusory statements, without a factual basis.

When analyzing the fourth element, the court looked at the complexity and magnitude of the transaction, sophistication of the parties, content of the agreement, and whether the SAFT investor engaged in due diligence prior to investing. The court found that this element was not met, as prior to executing the SAFT the company provided the investor with multiple pieces of information communicating the inherent risk of the SAFT. The court pointed to the language of the SAFT, which provided that “the Purchaser . . . is able to incur a complete loss of such investment without impairing the Purchaser’s financial condition and is able to bear the economic risk of such investment for an indefinite period of time.” The court further deemed the investor to be a sophisticated party that should have been aware of the risks given the language of the agreement and the information provided.

The court also rejected the investor’s claim for unjust enrichment, citing similar cases where a sophisticated investor made the investment despite publicly disclosed risks, and where the company’s inducements were merely “amorphous, unmeasurable promises,” i.e. puffery.

Last, the court rejected the investor’s claim for breach of the implied covenant of good faith and fair dealing. As mentioned previously, in other jurisdictions and under New York law, the covenant of good faith and fair dealing is implicit in all contracts. A party breaches the implied covenant when it “acts in a way that is inconsistent with the justified expectations of the other party,” with the effect of “destroying or injuring the right of the other party to receive the fruits of the contract.” The Court stated that the investor did not have a “justified expectation” of profit from the SAFT given the inherent, publicly disclosed risks.

Company Failing to Provide Required Information

The SAFE, SAFT, and their accompanying documents can contain provisions that require a party to provide certain information, such as financial statements. Failure to provide the required information can provide a basis for an investor’s claim against the company.

The case Seed River, LLC v. AON3D, Inc. (Feb. 6, 2023), provides an example of a clear breach of contract as the investor’s right to information was expressly included in the agreement and withheld by the defendant company. The company and investor entered into a SAFE along with a side letter, under the terms of which the company was to provide the investor with quarterly and yearly financial reports as well as assorted tax documentation. The company did not provide any financial reports or allow the investor to inspect the company’s accounts. The investor sued, seeking an injunction requiring the company to provide the required documents.

The court granted judgment for the investor, but denied injunctive relief, reasoning that the investor was still able to sue for monetary relief, and notably, that both the SAFE and side letter failed to include any entitlement to equitable relief.

Takeaways for Investors

As an investor, the pitfalls of founder fraud, avoidance of a triggering event, not receiving duly requested information, or other matters leading to litigation can be lessened with proper due diligence prior to any investment (for a detailed overview of what this entails, read our article on about due diligence). Beyond that, you can protect your rights as an investor by including express provisions in any SAFE or SAFT you enter into, such as:

  • an explicit obligation of the company to use the raised funds to achieve one of the stated triggering events with periodic progress reports;
  • mechanisms to combat conversion avoidance; and
  • express right to sue for legal and equitable relief if the company breaches these obligations.

These mechanisms not only will make you feel more confident in your investment, but provide added protection in case of litigation. With the drastically changed investment landscape, we expect such terms to become more commonplace.

*
*
*

Crypto Law NewsLetter

Occasionally, we write about the legal aspects of tokens, DAOs, NFTs, and the broader web3/crypto industry. Subscribe to receive updates and gain early access to our reports.

Please note that all fields are required
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.

NewsLetter

Subscribe to stay up to date with our latest publications.

Please note that all fields are required
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.

Contact Lawyers

Evgeny Krasnov

Partner

Robert Lynch

Lawyer

Related Publications

February 13, 2024
This is some text inside of a div block.

Understanding ‘Pig Butchering’ Crypto Scams

Understanding the stages of a pig butchering scam can help identify and prevent them, as well as take measures to mitigate their consequences. Here we summarize common fact patterns reported by victims who sought our assistance.

December 20, 2023
This is some text inside of a div block.

Reclaiming Control of Business Operations from PayPal and YouTube, and Defending Against Libel

The following case studies illustrate potential legal challenges for growing companies and our solutions.

September 7, 2022
This is some text inside of a div block.

Blockchain or Web3 Domains: Technology, Legal Aspects, Trademarks, and Brand Protection

We describe how blockchain domains work and how brand owners and blockchain domain name owners can protect their rights.