Short sellers have a complicated relationship to securities class action litigation, as several prior posts on this site have noted (most recently here). Among the more unusual roles short sellers can play in a securities suit is to serve as lead plaintiff. One recent high-profile case where a short seller acted as lead plaintiff is the suit filed against Overstock, its founder and former CEO, Patrick Byrne, and other executives. The short seller alleged, with some plausibility, that Overstock and Byrne had attempted to mount a “short squeeze” targeted at the short sellers. The district court granted the defendants’ motion to dismiss, and in an interesting October 15, 2024, opinion, the Tenth Circuit affirmed the district court. The appellate court’s opinion has several interesting features, as discussed below.

The Tenth Circuit’s opinion can be found here.  The Katten law firm’s November 5, 2024 memo about the appellate court’s decision can be found here.

Background

Overstock is publicly traded e-commerce company that was founded by Patrick Byrne. Prior to the events relevant to the securities suit, Byrne became concerned that short sellers were driving down the price of Overstock’s share price. In 2019, Byrne learned that news of his romantic relationship with a Russian spy was about to become public, which would force him to leave Overstock. He also knew that at that point Overstock had over 17.8 million shares short, representing more than half of the company’s outstanding shares.

According to the plaintiff, the defendants allegedly “concocted a scheme” to squeeze Overstock’s short sellers, inflate Overstock’s share price, and permit Byrne to profitably sell his shares of company stock for millions of dollars. To do this, the company proposed to pay as a dividend to all shareholders an unregistered digital security token. The digital token allegedly was intended to put the short sellers in a bind. The short sellers are contractually obligated to pay all dividends to the investor from whom the short seller borrowed a security. But because the token was unregistered, for six months, it could not be transferred to the lender from whom the short seller borrowed the shares. This would leave the only available route for the short sellers to be to close their short position by buying new Overstock shares. This forced buying was intended to drive up trading volume on Overstock’s shares, creating a “short squeeze” as the dividend’s record date approached.

In August 2019, two weeks after the company announced its 2Q results, Byrne announced his resignation, but before doing so he instructed his staff to sell all of his remaining shares at the peak of the short squeeze. He then left the United States for Indonesia.

As the dividend date approached, short sellers began purchasing Overstock shares to fulfill their contractual obligations. At its peak on September 13, 2019, Overstock’s share price had nearly doubled. From Indonesia, Byrne blogged that the dividend has been “carefully” designed to “put legitimate short sellers in a bind.” Byrne then learned that the SEC planned to intervene and postpone the dividend date, so Byrne ordered his accountant to sell all of his remaining Overstock shares. Between September 16 and 18, Byrne sold 4.7 million shares, yielding $90 million. On September 18, the company announced that it would postpone the dividend amid concerns the SEC had voiced.

On September 23, the company’s share price declined after the company announced disappointing 3Q results. The next day, the company announced that it had filed an S-3 to register the tokens to be used in the dividend after all. Two months later, the SEC subpoenaed the company for documents relating to the dividend.

The plaintiff then filed a securities class action lawsuit against the company, Byrne, and certain executives in the United States District Court for the District of Utah. The plaintiff alleged that the defendants had made false or misleading statements, and that the defendants had manipulated the market through an artificial short squeeze in violation of the securities laws. The defendants filed motions to dismiss, which the district court granted. The plaintiff appealed.

The October 15 Opinion

On October 15, 2024, in an opinion written by Judge Joel M. Carson III for a unanimous three-judge panel, the Tenth Circuit affirmed the district court, noting that the court was called up in its consideration of the case to address issues of first impression for the circuit.

The appellate court first affirmed the district court’s holding that the plaintiff had not plausibly alleged reliance. The plaintiff was attempting to rely on the fraud-on-the-market presumption in order to satisfy the requirement to plead reliance. The appellate court held that the defendant had successfully “rebutted” the presumption “with the statement in Plaintiff’s complaint” showing that its purchases (effected to cover its short positions) was motivated not by any alleged misstatements, but rather by Overstock’s planned dividend of unregistered tokens. The Court observed with respect to the plaintiff’s attempts to argue that the presumption could not be rebutted prior to discovery that the plaintiff cannot “have it both ways” – if the Plaintiff “bought its shares to avoid breaching its lending contracts, it cannot also have bought its shares because of Defendants’ alleged misstatements.”  

The appellate court then turned to the plaintiffs’ market manipulation claims. The plaintiff alleged that the defendants manipulated the market by “issuing an unregistered dividend to force Overstock’s short sellers to cover their position, drive Overstock’s stock price to artificially high levels, and allow Byrne to sell his shares at a massive profit.”

However, the Tenth Circuit observed, in order to state a claim for “manipulation,” the manipulative conduct must be “aimed at deceiving investors as to how other market participants have valued a security.” In light of this requirement, conduct resulting in an artificial price alone is not enough, on its own, to establish either manipulative conduct or manipulative intent. The appellate court described Overstock’s disclosures regarding the upcoming dividend transaction to be “truthful” and gave market participants sufficient “notice that short sellers might buy the Company’s stock to cover their short positions.” Investors had enough information “to form judgments about how Overstock’s dividend would impact Overstock’s share price.” Given these circumstances, the appellate court held, the plaintiff had failed to present allegations sufficient to show that the company “deceived investors as to how other market participants valued a security.”

Discussion

As a threshold matter, I note that this case represents an example of a kind of case I had recently wondered might exist out there. In writing a post about a recent securities suit that had been filed by a short seller, I wondered whether there were other cases in which short sellers had filed securities suits and sought to act as lead plaintiffs. Turns out, there is this case, in which the short sellers sought to hold defendants liable under the securities laws for what the plaintiff sought to characterize as a “short squeeze.”

I don’t think I am going out on a limb here to assert that neither the district court nor the appellate court had much sympathy for the short seller. Which arguably is all the more surprising, because the defendants, and in particular defendant Byrne, do not come off particularly sympathetically, either. Indeed, the court quoted at length from Byrne’s blog posts in which he pretty much admitted that he had deliberately set up the short squeeze. In the same blog post, he also expressly invited the SEC to come and get him. (Those who are interested in knowing more about Byrne’s affair with a Russian spy, as well as many other colorful aspects about him, will want to read the fascinating December 7, 2020, New Yorker article, here. The article contains, among many other things, extensive details about Byrne’s long running war with short sellers)

While the “story” of this case is pretty distracting, there are some important building-block securities law issues involved here as well.

At a minimum, as the Katten law firm puts it in the memo to which I linked above, the Tenth Circuit’s opinion suggests that “securities plaintiffs may not always be entitled to the fraud-on-the-market presumption of reliance even at the pleading stage.” The appellate court’s rulings shows that securities lawsuit defendants may be able to argue, as the defendants did here, that a plaintiff’s investment decisions “were not motivated by the challenged public statements.” Defendants, the law firm memo suggests, may be able to use discovery to establish that “distinct motivations make plaintiff stockholders inadequate class representatives, this widening the scope of defenses issuers may use to oppose class certification.”

The Court’s conclusion that the plaintiff had not sufficiently pled a case for market manipulation is more interesting to me, given that Byrne publicly admitted that he had “carefully” designed the dividend to “put legitimate short sellers in a bind.”

The Tenth Circuit was more concerned with what the pleading standards are for pleading a market manipulation claim than what Byrne may have said about the transaction. Critically, the Tenth Circuit said, in an issue of first impression for the court, that “an open-market transaction may qualify as manipulative conduct, but only if accompanied by plausibly alleged deceit.” Further, the court said, “acting in a manner that results in an artificial price, on its own, is not enough to constitute manipulative conduct.” The court explained that “for market activity to ‘artificially’ affect the price of securities, the manipulative conduct must be ‘aimed at deceiving investors as to how other market participants have valued a security.’”

The appellate court said that in this case, the defendants’ “truthful disclosure of the terms of the upcoming dividend transaction did not deceive investors as to how the market valued Overstock.” In other words, as the law firm memo puts it, “there is no valid claim for market manipulation if the issuer is transparent with the market.”

The Tenth’s Circuit’s opinion, the law firm memo says, “may provide a blueprint for public companies seeking to defend against short-seller activities.” Put more bluntly, the memo observes the appellate court’s decision “creates a pathway for issuers to affect corporate transactions solely for the purpose of creating shorty squeezes” without running afoul of the securities laws “as long as they properly disclose the transaction to stockholders.” [Blogger’s Impertinent Side Query: Did the memo’s authors mean “effect” rather than “affect”?]

At a minimum this case raises the bar for market manipulation claims and also raises the possibility that defendants may be able to rebut the presumption of reliance even at the pleading stage, both of which could prove to be valuable to future securities lawsuit defendants, particularly in cases such as this one brought by a short seller.

Special thanks for a loyal reader for calling this decision to my attention.