As I have previously noted on this blog (most recently here), one of the more distinctive litigation phenomena in recent years has been the rash of securities class action lawsuits involved allegations that the defendant firms’ use of stock promotion firms had resulted in misrepresentations to investors. The difficulty for the plaintiffs in these cases is that under the U.S. Supreme Court’s 2011 Janus Capital Group’s decision (about which refer here), only the “maker” of an allegedly misleading statement can be held liable under Rule 10b-5, and in many of these cases it was the stock promotion firm, not the company itself, that “made” the allegedly misleading statement.
However, in a recent motion to dismiss ruling in one of these stock promotion firm securities class action lawsuit, the plaintiffs’ complaint survived the dismissal motion in part, even though the Court agreed that the company defendants could not be liable for statements “made” by the stock promotion firm. The ruling is interesting in and of itself and also for what it says about theories of liability that apparently survived the U.S. Supreme Court’s Janus ruling.
As discussed below, in a July 13, 2015 ruling, Central District of California Chief Judge George H. King, granted in part and denied in part the defendants’ motions to dismiss the securities class action lawsuit that plaintiff shareholders had filed against CytRx Corporation, certain of its officers, and its offering underwriters. A copy of Judge King’s ruling can be found here.
CytRx is biopharmaceutical company with seventeen employees. The complaint alleges that the company hired a marketing firm called TheDreamTeam Group to promote its stock in a series of fourteen misleading articles between September 2013 and February 2014. The complaint alleges that the company’s executive officers allegedly edited and approved the articles before publication, which were then published under pseudonyms and without disclosure of the payment from or involvement of company management. The complaint alleges that these disclosures had the intended effect of driving up the company’s share price, after which the company completed a secondary offering. Company management also allegedly awarded themselves with “massive amounts of perfectly-timed” stock option grants.
The company’s use of the stock promotion firm came to light through two articles published on the Internet in February and March 2014. As a result of these disclosures, the company’s share price declined and securities class action litigation ensued, which, as discussed here, was one of several securities class action lawsuits filed in 2014 against companies that had used The DreamTeam stock promotion firm. The defendants moved to dismiss.
The July 13 Ruling
In their motion to dismiss, the company defendants argued in reliance on the U.S. Supreme Court’s Janus holding that they could not be held liable for the allegedly misleading article the stock promoters had written and published because they (the defendants) had not “made” the statements. Judge King agreed, even though the individual company defendants allegedly had been involved in editing, reviewing, and approving the statements. He dismissed without prejudice the plaintiffs’ allegations based on the allegedly misleading statements in the DreamTeam articles.
However, Judge King denied the motion to dismiss as to four statements by the company that the plaintiffs claimed were false in the absence of disclosure of the DreamTeam scheme. Thus, for example, Judge King found the plaintiffs has sufficiently alleged that the statement that the company had not “taken, directly or indirectly, any action designed to or that might case or result in stabilization or manipulation of the price of” the company’s shares was false and misleading. Judge King also found that the plaintiffs had sufficiently alleged that the statement that “we also have not timed the release of material nonpublic information for the purpose of affecting the value of stock” options was false and misleading, in part owing to the timing the company’s grant of springloaded stop options just before a significant public disclosure. Similarly, Judge King found that the plaintiffs had adequately alleged statements that the company had “disclosed… any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting” were false and misleading.
Judge King also found that the plaintiffs had adequately alleged scienter as to the company’s CEO and CFO. The individual defendants had tried to argue that the scienter allegations were inadequate because the plaintiffs had not alleged that the two were directly involved in editing and approving the Dream Team articles. Judge King said that there were sufficient allegations that the individuals “knew about the [DreamTeam] scheme.” Among other things, Judge King cited allegations that the CEO was on the board of another company (and former CytRx subsidiary) that also used the DreamTeam’s services. Judge King also noted the fact that CytRx, a small company with only seventeen employees that paid DreamTeam $65,000, raised “the inference that [the CEO] was aware what the company’s employees were doing to promote company stock.” Judge King also cited the timing of the springloaded option grant, one day before what the CEO himself called “clearly the most important news in our Company’s history.” Judge King said that “taken together,” the allegations raised a strong inference of scienter against the CEO and CFO.
Judge King then went on to find that the plaintiffs’ allegations of scheme liability were sufficient to survive the defendants’ motion to dismiss. Significantly, Judge King said that the Rule 10b-5 “maker” limitation under the U.S. Supreme Court’s Janus holding “is inapplicable to scheme liability claims.” Judge King also rejected the defendants’ argument that the plaintiffs were “merely attempting to re-label a ‘misrepresentation’ or ‘omission’ claim as a ‘scheme’ claim.” Judge King said that the plaintiffs’ allegations including conduct well beyond the misleading statements, and include “the hiring of promoters, planning and editing well-timed releases with targeted content to artificially inflate the value of company stock and raise revenue, and covering up the Company’s involvement.” Moreover, Judge King noted, the CEO and CFO were not merely alleged to have been passive participants, “they purportedly actively edited articles and added bullish statements about the Company.”
Judge King’s ruling in this case is in part a reflection of the specific factual allegations involved. In particular the allegations about the individual defendants’ direct involvement in editing the allegedly misleading articles and about the springloaded options grant appeared to weigh significantly in Judge King’s consideration of this case. Nevertheless, Judge King’s ruling may be significant in terms of how the other stock promotion securities class action lawsuits may fare.
First, it is significant that even though, under the U.S. Supreme Court’s holding in Janus, a company cannot be held liable for statements “made” by a stock promotion firm, the company can be held liable for its own statements if those statements are misleading because of the activities of the stock promotion firm.
Second, and perhaps even more significantly, Judge King held that the Janus “maker” requirements may not be a barrier to scheme liability allegations, where, as here, the plaintiffs have sufficiently alleged a scheme beyond merely misleading misrepresentations or omissions. Because many of the stock promotion firm securities class action lawsuits similarly allege that the defendant companies’ use of a stock promotion firm (in some cases, the same stock promotion firm as CytRx used) was part of a “scheme” to inflate the companies’ share prices, the plaintiffs in those case may have bases on which to try to resist the defendants’ dismissal motions, notwithstanding the U.S. Supreme Court’s holding in Janus.
Judge King’s ruling that the “maker” limitations that the U.S. Supreme Court described in Janus are “inapplicable” to scheme liability claims is significant in and of itself and even outside of the immediate context of the stock promotion firm securities class action lawsuits. This proposition suggests a way that plaintiffs may try to plead around the constraints involved with the “maker” requirements in situations where the defendant they want to target did not actually “make” the statement on which the plaintiffs’ liability claims are based.
In any event, this case shows underscores something that no company considering the use of a stock promotion firm can afford to overlook, which is that if the promotion firm engages in activity that can later be alleged to have been calculated to try to drive up the company’s share price, the company and its senior executives potentially can be held liable under the federal securities laws for misleading statements the stock promotion firm makes as part of its activities. This case also highlights how damaging it can be for a company if it comes to light that the company has used a stock promotion firm allegedly to try to drive up its share price.
Special thanks to a loyal reader for sending me a copy of the CytRx opinion.