Several recent lawsuits, and comments by the U.S. Securities and Exchange Commission (“SEC”) and Federal Trade Commission (“FTC”), underscore the increasing litigation and regulatory scrutiny concerning the use of artificial intelligence (“AI”), and specifically how the use of such technology is disclosed in public filings. Given the continuous increase in the use of AI, we expect to see a substantial increase in the number of AI-based lawsuits and regulatory actions filed in the coming months and years.
Innodata Lawsuit
On February 21, 2024, a plaintiff shareholder sued Innodata Inc., a global data engineering company, in the District of New Jersey, arguing that the company made false and misleading statements and failed to disclose material facts regarding its AI-enabled software platforms.[1] Innodata’s business services included the provision of data preparation and data engineering support, as well as the provision of an industry platform to transform medical records into digital data.
The complaint alleges that in 2019, Innodata began implementing AI and machine learning into its processes due to the decline it had seen in its traditional data annotation business over the past few decades. The company then began marketing itself to the public and investors as an AI company, including by “repeatedly ma[king] positive statements about the Company’s AI expertise and capabilities.”[2]
However, on February 15, 2024, a financial research firm published a report claiming that Innodata overstated the nature of and extent to which the company utilized AI in its business and operations. As a result of this report, the price of Innodata’s shares declined by approximately 30%. The complaint alleges that “[i]nvestors were unaware that humans, not AI, were performing the brunt of Innodata’s work, which was highly labor-intensive, with cheap, offshore workers conducting data entry,”[3] and asserts violations under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 thereunder, as well as Section 20(a) of the Exchange Act.
In re Upstart Holdings, Inc.
The Innodata lawsuit is not the only recent shareholder class action alleging securities law violations due to company misrepresentations regarding their use of AI.
In the class action In re Upstart Holdings, Inc. Securities Litigation, shareholders alleged that Upstart Holdings, Inc. made material misrepresentations regarding its “cloud-based AI lending platform.”[4] Specifically, the complaint alleged that Upstart misled investors concerning the “significant advantage” of their AI model over traditional FICO-based underwriting models, especially with respect to how it performed in the face of macroeconomic changes.[5] In reality, shareholders claimed that Upstart’s AI model was unable to adequately assess credit risk and did not work effectively or quickly to respond to economic changes.[6] Upstart moved to dismiss the case, but in September 2023, the U.S. District Court for the Southern District of Ohio held that the shareholders had adequately alleged that Upstart made various material misstatements, including with respect to the capabilities of their AI model, and thus could proceed with the case.[7]
Jaeger v. Zillow Group Inc.
Additionally, trial has been set for June 2, 2025 in Jaeger v. Zillow Group Inc., et al.[8] In this class action securities fraud lawsuit filed in the U.S. District Court for the Western District of Washington, shareholders claimed that Zillow made misleading statements to investors regarding the abilities of its Zillow Offers tool, which used algorithms and technology to buy and resell homes quickly. With respect to AI, Zillow touted that Zillow Offers’ success and ability to react more quickly to market conditions was because of its use of a neutral network model. Zillow noted that such models are “artificial intelligence systems that imitate how the human brain works. They are able to map hundreds of millions of data points efficiently.”[9] However, contrary to these assertions, Zillow’s shareholders alleged that, in fact, the Zillow Offers tool was unable to accurately forecast home prices, resulting in significant losses for the company and ultimately a complete wind-down of the business. The shareholder class asserted that Zillow violated Section 10(b) and Section 20(a) of the Exchange Act, as well as Rule 10b-5 thereunder.
Regulatory Scrutiny of AI
In addition to civil litigation, there has also been heightened regulatory scrutiny of companies’ representations regarding their use of AI.
As we have written about previously, the Securities Exchange Commission has increasingly raised concerns regarding the significant risks that AI brings. This concern is reflected in the fact that the SEC’s 2024 Examination Priorities included AI as an area that the Division is focused on. However, now there also appears to be heightened scrutiny of how companies communicate regarding the AI-based tools that they utilize.
Notably, the shareholder claims in the Innodata and other civil lawsuits echo recent comments made by SEC Chairman Gary Gensler regarding “AI washing.”[10] This term stems from the SEC’s crackdown on “greenwashing,” which is when a company’s marketing practices are deceptive or misleading regarding how environmentally friendly its operations are.[11] AI washing, therefore, is when companies make unfounded claims regarding the use of AI in their operations. Chair Gensler warned that the traditional securities laws require companies to give “full, fair and truthful disclosures,” and that companies should “talk about the risks” of using AI and “how they manage their risk.” Beyond simply cautioning companies, by comparing AI washing and greenwashing, Gensler’s comments suggest that there may be greater enforcement efforts in the AI space to come.[12] Indeed, a senior SEC enforcement official has confirmed that the SEC has active investigations involving firms that claim a product uses AI when it does not.[13]
The SEC is not the only regulator turning attention to how companies communicate regarding their AI risks. The Federal Trade Commission has likewise warned that it will be focusing attention on how companies advertise their AI-based products. Specifically, the FTC noted that exaggerating what an AI product can do, promising an AI product does something better than a non-AI product, and baseless claims that a product is AI-enabled are statements that the regulator will be looking out for.[14]
These communications from regulators are only the beginning, it is expected that there will be significantly more developments with respect to company communications regarding AI as the use of the technology grows. We will continue to monitor developments, providing updates on the class actions discussed and noteworthy regulatory enforcement actions.
[1] D'Agostino v. Innodata, Inc., et al., No. 24-cv-00971 (D.N.J. Feb 21, 2024).
[2] Complaint, Dkt. No. 1 at 21, D'Agostino v. Innodata, Inc., et al., No. 24-cv-00971 (D.N.J. Feb 21, 2024).
[3] Id. at 22.
[4] Crain v. Upstart Holdings, Inc. et al, No. 2:22-cv-02935 (S.D. Ohio Jul 26, 2022).
[5] Consolidated Amended Complaint, Dkt. No. 45 at 89, Crain v. Upstart Holdings, Inc. et al, No. 2:22-cv-02935 (S.D. Ohio Jul 26, 2022).
[6] Id. at 113.
[7] In re Upstart Holdings, Inc. Sec. Litig., 22-cv-02935 (S.D. Ohio Sept. 29, 2023).
[8] Jaeger v. Zillow Group Inc. et al., 21-cv-01551 (W.D. Wash. Nov. 16, 2021).
[9] Amended Complaint, Dkt. No. 71 at 99, Jaeger v. Zillow Group Inc. et al., 21-cv-01551 (W.D. Wash. Nov. 16, 2021).
[10] The National Law Journal, SEC Chief Gensler Warns of “AI Washing” and Potential Conflicts of Interest, (Jan. 17, 2024), available at https://www.law.com/nationallawjournal/2024/01/17/sec-chief-gensler-warns-of-ai-washing-and-potential-conflicts-of-interest/.
[11] In September 2023, the SEC adopted a new rule which targeted “greenwashing” by investment funds. See U.S. Securities and Exchange Commission, SEC Adopts Rule Enhancements to Prevent Misleading or Deceptive Investment Fund Names, (Sept. 20, 2023), available at https://www.sec.gov/news/press-release/2023-188.
[12] The SEC has brought numerous enforcement actions against “greenwashing,” including against firms for making misstatements and omissions regarding environmental, social, and governance (“ESG”) considerations in making investment decisions and for policy and procedure failures involving funds marketed as ESG investments. See, e.g., U.S. Securities and Exchange Commission, SEC Charges BNY Mellon Investment Adviser for Misstatements and Omissions Concerning ESG Considerations, (May 23, 2022), available at https://www.sec.gov/news/press-release/2022-86; U.S. Securities and Exchange Commission, SEC Charges Goldman Sachs Asset Management for Failing to Follow its Policies and Procedures Involving ESG Investments, (Nov. 22, 2022), available at https://www.sec.gov/news/press-release/2022-209.
[13] The Wall Street Journal, SEC Head Warns Against “AI Washing,” the High-Tech Version of “Greenwashing”, (Dec. 5, 2023), available at https://www.wsj.com/articles/sec-head-warns-against-ai-washing-the-high-tech-version-of-greenwashing-6ff60da9.
[14] Federal Trade Commission, Keep Your AI Claims In Check, (Feb. 27, 2023), available at https://www.ftc.gov/business-guidance/blog/2023/02/keep-your-ai-claims-check.
