An AI Epidemic? The SEC takes action against companies for AI washing

We often say in the UK that once the US sneezes, the UK will eventually catch the cold and when looking at potential trends in claims against Directors and Officers and Financial Institutions we often look first to regulatory action and litigation taking place in the US to enable us to consider what might be coming down the track in the UK.

Much has been made in recent times of the use of artificial intelligence (“AI”).  There are a multitude of risks faced by Directors and Officers in relation to the use of AI, its development and deployment by a company.  This also gives rise to risks in regulatory action being taken by various regulatory authorities against Directors and Officers looking to take action against Boards for their use and deployment of AI.  As we have reported previously, the increased regulation and desire by regulatory authorities across the globe to pierce the corporate veil and carry out enforcement actions against individual Directors and Officers is one of the most pervasive themes of recent risks faced by Directors and Officers.

The recent charges levied by the Securities and Exchange Commission (“SEC”) against the CEO of a startup company relating to its purported use of AI technology highlights that investigations into alleged “AI washing” are well underway.

The Facts

Joonko Diversity Inc . (“Joonko”) was a startup company founded in 2016 which purported to use AI technology in order to assist its clients in meeting targets to ensure that diversity, equity and inclusions initiatives were met in relation to their recruitment.

Joonko claimed to carry out the following services on behalf of its clients:

1. Connect with the applicant tracking systems of various companies to identify candidates and recommend them to other Joonko customers;
2. Facilitate candidates who got to the final stage of interview with any Joonko client company but who did not ultimately get the job and recommended them to other Joonko customers; and
3. Target US companies with at least 500 employees and 30 job openings available to gain diverse candidates by increasing Joonko’s customer base.

In 2021 and 2022, Joonko, driven by its CEO, Illit Raz, conducted two rounds of equity fundraising which produced $21 million of investment in the company. During the fundraising campaign, Mr Raz made a number of representations relating to the company’s operating position claiming, for example:

1. That Joonko had over 200 companies including a number of Fortune 500 companies in its customer database;
2. It had 185,000 active candidates per month on its platform for the year 2021; and
3. It projected its revenues to increase from $520,000 to in excess of $2 million in the period 2020-2021 with a further rise to $4.6 million and subsequently $8.5 million by the second half of 2023.

Mr Raz also made representations to investors and potential investors about the technology being used by Joonko.  He represented that Joonko used “AI-based technology” and provided an “automatic recruiting solution” to its customers; he also claimed that Joonko’s technology was based on 7 separate AI algorithms; and finally, he explained that Joonko’s algorithm used language processing and computer vision to scan public data on all candidates which were referred to the company.

The SEC has charged Mr Raz stating that none of the representations he made about Joonko were true.  In fact, the company had many fewer customers than was claimed and the revenue he had advertised to investors in the various prospectuses was significantly overestimated.

In addition, the SEC has alleged that even the algorithmic technology which formed the basis of Joonko’s operations did not, in fact, match the reality of the level of sophistication or automation that had been claimed by Mr Raz.  The SEC alleges that Mr Raz “engaged in old school fraud using new school buzzwords such as artificial intelligence and automation”.  As a result, the SEC charged Mr Raz with violations of Section 17(a) of The Securities Act, as well as Section 10(b) of The Securities Exchange Act and Rule 10b-5 of that Act.  The US Attorney’s Office for the Southern District of New York also announced that it would be pursuing criminal charges against Mr Raz for the representations he made.

It is certainly true to say that the landscape of business and the needs of companies to embrace and deploy rapidly evolving technologies and AI might induce companies and their Boards to overstate a company’s progress in developing and integrating technology into its everyday practices.

A failure accurately to advertise technological advances can create risk in addition to regulatory investigations, in the form of, for example, derivative claims by Shareholders or activist employees.  The charges levied by the SEC against Mr Raz demonstrate that, when promises are made in connection with the sale of securities, the SEC is highly sensitive to, and aware of, those who overpromise and underdeliver on their technological capabilities.

In a panel on AI on 28 May 2024, the SEC panellists highlighted two settled enforcement actions which had been launched earlier in 2024 against companies which falsely represented to investors their AI capabilities. Additionally, on 19 April 2024 the SEC filed securities fraud charges against the founder of another AI technology startup company for alleged misrepresentations about the company’s contract portfolio and revenues made to investors during two rounds of equity funding which generated a total of $2.8 million in investments.

With demand for artificial intelligence booming, the SEC (and other regulators) are actively looking for cases in this area, companies must continue to be careful when considering the marketing of technological advancements and capabilities and any potentially fraudulent misstatements which may arise as a result of overstating those capabilities.

Furthermore, this is a trend which is unlikely to be unique to the US.  UK companies and those in the Middle East, as well as in other areas of the World, also need to take heed of increased regulation in this area and for regulators baring their teeth and seeking to make examples of Directors and Officers who make representations designed to attract funding to their companies. This is yet another example of the increased appetite for regulators around the world seeking to pierce the corporate veil.