While investors may see the CARES Act as a lifeline for their startup portfolio companies, there are certain traps to be aware of.
Under the False Claims Act, the government can seek both civil and criminal penalties against companies obtaining funding under false pretenses. On top of this, individual whistleblowers (with their hungry plaintiffs’ attorneys) also have standing to sue on behalf of the government.
It’s not just the companies that obtain funding that can be liable. Individuals, including directors, have the potential to become liable, as well.
Stimulus funding requirements
Many popular CARES Act funding programs — like the PPP and EIDL programs — require an applicant company to make eligibility certifications. For example, the PPP loans require a certification that “the uncertainty of current economic conditions makes necessary the loan request to support the ongoing operations of the eligible recipient.” The SBA further clarified that “Borrowers must . . . [take] into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business.”
There has obviously been a spate of news stories about well-resourced companies obtaining PPP funding (e.g. Ruth’s Chris, Shake Shack). But in the VC and startup community, clients are questioning whether a VC-backed startup really “needs” the money. This isn’t just a moral question. Given the certification described above and the SBA’s recent guidance, it is an important legal question.
In comes the False Claims Act
What happens if a company makes false certifications to obtain CARES Act stimulus funding? The answer is found under the False Claims Act.
The False Claims Act provides for civil and criminal liability for “knowingly” submitting a false claim to the federal government — including a request for a government loan.
Merely submitting a false claim is not enough. It must be “knowingly” false. But there need not be a specific intent to defraud.
False Claims Act liability arising from the CARES Act is not just a theoretical concern. The Department of Justice has already issued a press release asserting that it will be prioritizing investigations of COVID-19 related fraud. So, attention and resources are being put into ferreting out CARES Act fraud.
The government isn’t the only one that can sue you for a false claim
It’s not only the government that one needs to worry about. A member of the public can stand in the government’s shoes and file a suit under the False Claims Act. This is called a qui tam action.
Why would someone bring a qui tam claim under the False Claims Act? Because it can be worth a lot of money. A private plaintiff in a qui tam action may be able to keep up to 30% of the recovery in the lawsuit, plus an award of attorneys’ fees. The rest of the recovery goes to the government.
The plaintiff’s bar has already started advertising for whistleblowers to come forward for the obvious purpose of bringing a slew of qui tam actions under the CARES Act.
Why investors should care
The False Claims Act doesn’t limit liability to just the applicant company. It can extend to directors as well as investors.
And remember — lots of startups are cash poor. Investors, however, are often not. Thus, VCs and other investors make attractive targets with big pockets for plaintiffs’ lawyers seeking to file qui tam actions.
Let’s focus on two important aspects of False Claims Act liability for VCs and other investors.
First, is the notion of “submitting” a false claim. You might think that given the potential liability an investor faces when a startup seeks CARES Act funding that the best thing to do is to insert yourself in the process. This might not have the desired result.
You are not automatically liable under the False Claims Act just because the company becomes liable. In fact, knowledge of the company submitting a false claim isn’t even enough to impose personal liability. Rather, the individual must have taken some affirmative steps to cause the company to submit the false claim.
This has different implications for VCs themselves vs. directors who may be appointed by a VC.
Investors are not generally expected to have any role in deciding whether to seek government funding. So, from a liability avoidance perspective, there is a strong case to be made to stay out of it.
For investor directors, it is more difficult to close your eyes and let the company do what it wants to do. That can raise fiduciary duty concerns. But the job of a director is to make sure the company has policies and procedures in place for the officers to make decisions on government funding, not to substitute one’s judgment for that of the company’s officers. Staying one step removed from day-to-day decision making — where a director ordinarily should be — is helpful in avoiding liability, while still meeting fiduciary duties.
Second, there is the knowledge element of a False Claims Act claim. The False Claims Act is not a strict liability statute, nor does it seek to punish negligence. To be liable, the government (or a private plaintiff in the government’s shoes) must show that the defendant acted “knowingly.”
As an investor director, you want to make sure you can demonstrate, at a minimum, that you have acted reasonably and in good faith. In that regard, documentation is always recommended.
In addition, make sure you are consulting with legal counsel in ensuring compliance with federal funding requirements. This is a particularly key when dealing with facing potential False Claims Act litigation. Reliance on advice of counsel can be, in itself, a defense to a claim that you violated the False Claims Act provided you made a full disclosure of the facts to your counsel.
Did your portfolio company already take a loan it’s not entitled to?
For many investors, this guidance may be seen as coming too late — their portfolio companies already obtained stimulus loans when perhaps they weren’t really eligible. Thankfully, the SBA has provided a solution.
Any company that has received a PPP loan can return the loan in full by May 7, 2020. This safe harbor will allow companies to avoid liability for having obtained a loan when they were potentially ineligible.
Mital Makadia and David Siegel are partners at Grellas Shah LLP, where they counsel tech startups and investors in general corporate, venture financing, M&A, and other transactional matters.