Wake Forest Law Review
7Aug

Trust, but Verify

Categories: Current Issues Blog
Comments Off on Trust, but Verify

Maya Pillai

Trust, but verify. This is a common methodology in the audit world and was even mentioned by the SEC Acting Chief Accountant Paul Munter in his statement on “The Auditor’s Responsibility for Fraud Detection.” [1]  He commented, “[T]he mindset of ‘trust but verify’ may represent potential bias if it is anchored in the belief that management is honest and has integrity.” Well, that is bold. We all want to believe that management has nothing but the purest intentions. But, what happens when this spotlight turns on the investor? Does the same principle exist?

Section 3(a)(11) of the Securities Act, known as the “intrastate offerings exemption,” provides small businesses with options to procure financing. [2]  Rule 147, the “safe harbor” rule under § 3(a)(11), lists objective criteria with which companies must comply. [3]  The newly loosened exemption, Rule 147A, permits issuers to make offers to out-of-state residents, as long as sales are only made to in-state residents and allows for a company to be incorporated out-of-state when its principal place of business remains in-state. [4]  (The limited framework of the SEC’s interpretation of § 3(a)(11) precludes issuers under Rule 147A from offering securities to out-of-state residents.) [5]  Deregulation is good, right? Well, it depends. Based on my study of these changes—and the caution given by Munter— the provision permitting issuers to rely on representations by investors to display their in-state status should be reconsidered.

This criterion removes a key due diligence requirement for issuers. That isn’t really that important, right? Let’s look at current events. One of the many reasons for the downfall of Silicon Valley Bank (“SVB”) was the loosening of regulatory requirements. Had SVB still been subject to regular stress tests, portfolio misrepresentation would likely have been noted much earlier. Relying only on an investor’s representation to satisfy the in-state requirement shows the issuer conducts no additional “test” to verify residency. As such, the issuer is more likely to fail. Therefore, additional measures should be put in place under Rule 147A for issuers to confirm the veracity of a purchaser’s residency. Once again, trust, but verify.

Why is due diligence necessary? Especially in the financial sector, institutions can “uncover any potential risk … of doing business with a specific organization or individual by analyzing information from a variety of sources.” [6]  Due diligence takes on many forms and consists of a wide range of processes. Knowing the individual or organization from whom you receive money helps ensure every party complies with the applicable rules and regulations to avoid exposure to liability, such as imprisonment and fines. There is also a non-tangible consequence: reputational risk. Financial institutions, like law firms, rely heavily on their name and reputation. Public perception holds a significant amount of weight (notice who the sponsors are at the next golf tournament or non-profit fundraiser you attend). If a financial institution receives a fine or shuts down for non-compliance, that makes headlines around the world. (And, of course, reactions are evident in the stock markets.) Nonetheless, the big institutions (e.g., Wells Fargo, Bank of America, Charles Schwab, etc.) manage to stay afloat, despite bad press. Maybe the banks took a page from Kanye West when he said, “Bad publicity is still publicity.”

There should be preventative measures from the issuer to prevent investors from making false representations about their in-state status.

Rule 147A’s language currently reads,

Sales of securities pursuant to this section shall be made only to residents of the state or territory in which the issuer is resident, as determined pursuant to paragraph (c) of this section, or who the issuer reasonably believes, at the time of sale, are residents of the state or territory in which the issuer is resident. [7]

There is the word, “reasonably.” Does the SEC provide further guidance on the rule? Yes, at the end of paragraph (d), a note states, “Obtaining a written representation from purchasers of in-state residency status will not, without more, be sufficient to establish a reasonable belief that such purchasers are in-state residents.” [8] 

Once again, with the term “reasonable,” but now we gain a clearer picture. While the investor’s written representation is expected to be truthful, this is not always guaranteed. Perhaps the SEC should revise the guidance note for paragraph (d) to read, “Obtaining a written and truthful representation from purchasers of in-state residency status will not, without more, be sufficient to establish a reasonable belief that such purchasers are in-state residents.”

This feels a little better. However, these changes introduce a new uncertainty when evaluating a generally recognized valid measure to confirm a truthful representation from an investor. Remember, “trust, but verify!” A residency affidavit (which must be notarized) would certainly suffice,

“It has been verified that on the ___ day of _____, 202_, John Smith’s principal residence is at 123 Main St, Charlotte, NC 28204. The following documents have been presented to corroborate John Smith’s residency: [.]”

In addition to one’s driver’s license containing an investor’s current address, the following documents should also be considered in verifying an investor’s principal residence: (1) most recent mortgage statement or lease agreement; (2) most recent utility statement; (3) vehicle insurance card from your most current policy; and (4) most recent property tax receipt. An investor’s most recent credit card statement may not be the best because the statement could be addressed to your billing address, which may differ from your principal residence address. Even a W2 or 1099 from the most recent tax year could list a different address if you moved after those tax documents were created and provided to you.

Although partial to the suggestions above, I would be remiss if I did not also question whether the reasonable belief standard is best suited for the securities industry. [9]  From tort law, a reasonable belief is the belief that an ordinary person would hold under like circumstances as those faced by the person in question. It is worth noting that the SEC does not explicitly define “reasonable belief.” (For this essay, I assume the SEC adopted the tort law definition of this term.) In Rule 147A, reasonable belief is merely supported by obtaining a written representation from the investor regarding their residency. [10]  The individuals at these financial institutions tasked with reviewing the representations from purchasers are not your average teller or loan officer at Chase or Wells Fargo. These due diligence/compliance employees are held to a higher standard by their employers because of their expected understanding of the applicable rules and regulations for intrastate offerings. The fate of an entire company rests in the hands of those tasked with reviewing the necessary documents. If a single investor is not an in-state resident, then the entire offering is no longer in compliance with the exemption under Rule 147A.  [11]

In his concluding remarks, Munter reiterated, “[T]he value of the audit and the related benefits to investors, including investor protections, are diminished if the audit is conducted without the appropriate levels of due professional care and professional skepticism.” [12]  It is clear that the entire offering depends upon the accuracy of the audit. With such high stakes, this should be a more defined process. Trust, but verify.

—————————-

[1] Paul Munter, The Auditor’s Responsibility for Fraud Detection, SEC (Oct. 11, 2022), https://www.sec.gov/news/statement/munter-statement-fraud-detection-101122.

[2] Intrastate offerings, SEC (Apr. 6, 2023), https://www.sec.gov/education/smallbusiness/exemptofferings/intrastateofferings.

[3] Id.

[4] Id.

[5] Joe Green, SEC Adopts New Rules to Facilitate Intrastate Crowdfunding, LinkedIn (Oct. 28, 2016), https://www.linkedin.com/pulse/sec-adopts-new-rules-facilitate-intrastate-joe-green/.

[6] What is Customer Due Diligence (CDD)?, SWIFT, https://www.swift.com/your-needs/financial-crime-cyber-security/know-your-customer-kyc/customer-due-diligence-cdd (last visited Aug. 7, 2023).

[7] Intrastate sales exemption, 17 C.F.R. § 230.147(A) (2021).

[8] Id.

[9] Amanda M. Rose, The “Reasonable Investor” of Federal Securities Law: Insights from Tort Law’s “Reasonable Person” & Suggested Reforms, 43 Iowa 77, 79 (2017) .

[10] Covington & Burling LLP, SEC Enhances Exemptions for Local Offerings, Covington (Dec. 1, 2016), https://www.cov.com/-/media/files/corporate/publications/2016/12/sec_enhances_exemptions_for_local_offerings.pdf.

[11] Alan Palmiter, Securities Regulation, (8th ed. 2021).

[12] Munter, supra note 1.

 

Tags:
3Apr

Silent Treatment: The Increase in Confidential Treatment Redactions in SEC Filings

Categories: Online
Comments Off on Silent Treatment: The Increase in Confidential Treatment Redactions in SEC Filings
Securities and Exchange Logo

Securities and Exchange Commission Logo

13 Wake Forest L. Rev. Online 1

Mark T. Wilhelm[*] & Michael T. Byrne[**]

Publicly traded companies in the United States are required to disclose a significant amount of information to the public in order to comply with applicable securities laws.[1] While at times those disclosure requirements are rather rigid, there are many circumstances in which these companies retain latitude to keep secrets out of the public eye—and notably, out of the reach of their competitors.

Public companies are required to file disclosure documents with the U.S. Securities and Exchange Commission (“SEC”), which are made available to the public pursuant to the Freedom of Information Act (“FOIA”).[2] In particular, Item 601(b)(10) of Regulation S-K requires public companies to file as an exhibit to their disclosure documents copies of certain material contracts into which the company has entered.[3] These exhibits often include sensitive information that companies prefer to keep confidential for competitive or other reasons.

Accordingly, under Rule 406 of the Securities Act of 1933[4] and Rule 24b-2 of the Securities Exchange Act of 1934,[5] the SEC permits public companies to request confidential treatment of certain information contained in these exhibits—meaning a company may redact the sensitive information and shield it from public view. FOIA permits the SEC to grant such requests if the redacted information falls into one of FOIA’s specified exemptions. The most commonly cited FOIA exemption in this context is found in Section 552(b)(4), which protects “trade secrets and commercial or financial information obtained from a person and privileged or confidential.”[6]

Historically, at the time that public companies redacted information from these exhibits, they were required to submit along with the exhibit a formal, hard copy confidential treatment request (“CTR”) with the SEC.[7] Submitting a CTR was a relatively arduous process that involved preparing and mailing a particularly formatted application to the SEC that specified (i) the justifications for redacting each piece of information, (ii) which FOIA exemption applied to each piece of information, and (iii) other pertinent details. The CTR also needed to include an unredacted copy of the exhibit that was the subject of the request. Upon receipt of a CTR, the SEC issued a confidential treatment order (“CT Order”) either granting or denying the CTR.[8] If denied, the company had to publicly refile the exhibit without the proposed redactions.

On March 20, 2019, the SEC announced it had modernized and simplified its rules related to, among other things, confidential treatment of information in filed exhibits.[9] The changes, which went into effect in May 2019, were aimed at bringing the SEC’s disclosure requirements into compliance with the Fixing America’s Surface Transportation Act (“FAST Act”).[10] Initially, following the rule changes, a public company could forgo submitting a formal CTR application if the redacted information was not material and would be competitively harmful if publicly disclosed.[11] However, on November 2, 2020, the SEC adopted amendments to eliminate the competitive harm requirement of CTRs in response to the Supreme Court’s clarification of the definition of “confidential” in Food Marketing Institute v. Argus Leader Media,[12] which stated: “[a]t least where commercial or financial information is both customarily and actually treated as private by its owner and provided to the government under an assurance of privacy, the information is ‘confidential’ within the meaning of [FOIA Section 552(b)(4)].”[13]

Thus, currently, if a public company redacts portions of a filed exhibit without submitting a formal CTR, the company must:

(i) mark the exhibit index to indicate that portions of the exhibit or exhibits have been redacted;

(ii) include a prominent statement on the first page of the redacted exhibit that certain information has been excluded from the exhibit because it is both (1) not material and (2) the type that the company treats as private or confidential; and

(iii) include brackets indicating where the information has been redacted from the filed version of the exhibit.[14]

Notably, public companies retain the option to submit formal CTRs to the SEC, and even after the rule changes, a very limited number of public companies have continued to do so.[15] This continued practice is likely a result of such companies (i) simply being unaware of the rule changes, (ii) failing to adjust their practices to conform with the new, relaxed rules, or (iii) taking what could be aggressive positions on what information is confidential, and proactively seeking SEC guidance on whether such confidential treatment would be granted.

As part of the same rule changes, the SEC also reduced the quantity of materials that public companies must file as exhibits.[16] Previously, and among other things, public companies were required to file as exhibits each material contract (i) entered within the preceding two years, or (ii) which was to be performed in whole or in part at or after the filing of the disclosure document.[17] Following the rule changes, the two-year lookback applies only to newly reporting companies—this means that most public companies must file material contracts meeting only the second requirement above.[18]

And finally, the rule changes also made clear that certain types of personally identifiable information (“PII”) such as social security numbers, home addresses, etc., could be redacted outside of the CTR process.[19] Anecdotally, prior to this rule change, certain practitioners would file CTRs to redact these types of personally identifiable information, while other practitioners would redact the information outside of the CTR process on the basis that it was obviously confidential and that the likelihood of the SEC objecting would be very small.[20]

A. SEC’s Standard of Review of Redacted Information

The SEC has stated it “intend[s] to review registrant filings for compliance with the new rules” as part of its regular filing review process.[21] However, the SEC only selectively reviews filings,[22] which means that some (if not many) redacted exhibits will not undergo a formal review. During the rulemaking process related to the applicable Regulation S-K changes, the SEC admitted that “[o]ne potential cost of the amendments is that information may be redacted that would not otherwise be afforded confidential treatment by the [SEC] staff.”[23] However, the SEC felt that the impact of this potential shortcoming was mitigated by the fact that the SEC very rarely denies CTRs. In fact, from 2014 to 2018, the SEC formally denied only one CTR, and an additional 1% of CTRs were withdrawn by filers after the SEC determined the information in the exhibits was too material to redact.[24] But the SEC also noted that 11% of CTRs from those years were granted only after the SEC required the filer to reduce or modify the requested redactions.[25] Thus, while an overwhelming majority of CTRs were granted as-is, the rule changes will likely result in at least some redacted information that would have been revealed in a traditional CTR review remaining hidden from the public.

Nevertheless, it is important to emphasize that while the SEC’s review process has changed, the standard for what information actually qualifies for confidential treatment remains largely the same (aside from some changes in what verbiage should appear in the filings to mark the redactions and the clarification of the treatment of personally identifiable information).[26] Public companies therefore must still ensure they disclose all material information and redact no more information than necessary. If a public company does redact questionably protectable information and the SEC identifies it, the SEC may require that the company provide additional explanation or documentation regarding why the redacted information should qualify for confidential treatment, as well as unredacted copies of the relevant exhibits—essentially replicating the effort and cost of a traditional CTR.[27] If the explanation and documentation do not sufficiently justify the redactions, the SEC will require the company to publicly file an unredacted copy of the exhibit, which could result in negative publicity for the company.

B. Major Increase in Filing of Redacted Exhibits

This Study utilized the Intelligize® database to search SEC filings and estimate the number of exhibits for which confidential treatment was sought from January 1 to December 31 of each year from 2012 through 2022. Searches were intended to uncover the total number of exhibits seeking confidential treatment during each calendar year, rather than the total number of CT Orders issued by the SEC each year, because the SEC often issues a single CT Order to grant confidential treatment of multiple exhibits for the same public company. Search terms reflected common verbiage used by public companies seeking confidential treatment in each respective year analyzed.[28] For example, since the 2019 rule changes, almost all redacted exhibits use the phrase “not material” in their prominent statements marking the redactions; this phrase was not commonly used prior to the rule changes. Search terms additionally accounted for some companies using outdated verbiage in their prominent statements marking the redactions, likely as a result of failing to recognize or comply with the rule changes.

As shown below in Figure 1, an estimated 4,247 redacted exhibits were filed with the SEC in 2022. This represents an increase of approximately 61% above the estimated average number of redacted exhibits filed in the years analyzed prior to the 2019 changes (an average of 2,635 redacted exhibits per year from 2012-2018). Note that while a vast majority of redacted exhibits are filed as an “Exhibit 10” pursuant to Item 601(b)(10) of Regulation S-K (including over 91% of redacted exhibits filed in 2018),[29] the results of this search include other types of redacted exhibits as well.

Figure 1

When considering these results in light of the SEC’s (i) removal of the two-year lookback period for filing material contracts—which presumably reduced the total number of material contracts required to be filed as exhibits following the rule change, and (ii) clarification of the treatment of personally identifiable information, the increase in redacted exhibits is even more significant than it first appears. In fact, as shown below in Figure 2, the estimated number of aggregate annual Exhibit 10 and Exhibit 2 filings—which constitute the overwhelming majority of redacted exhibits—shows a downward trajectory from 2012 to 2022, despite a temporary spike in Exhibit 10 and Exhibit 2 filings in 2021 and early 2022 that was likely the result of increased merger and acquisition activity in the midst of the COVID-19 pandemic, including a short boom in the use of Special Purpose Acquisition Company (“SPAC”) vehicles.[30]

Figure 2

Despite the unique market factors present in 2021, the rate at which the number of redacted exhibits filed per year has increased following the 2019 rule changes has consistently—and significantly—outpaced the growth in the number of Exhibit 10 and Exhibit 2 filings. This suggests that in addition to filing more total redacted exhibits per year since the rule changes, public companies are also redacting information from a larger percentage of the material contract exhibits they file. The estimates below in Figure 3, which were calculated by dividing the total number of redacted exhibits by the total number of combined Exhibit 10 and Exhibit 2 filings per year, support this conclusion.

Figure 3

Moreover, the increase in redacted exhibits takes on added magnitude when considering the reduction of the number of public companies over the analyzed time period. To estimate the number of public companies per year, this Study again utilized the Intelligize® database to find the total number of required annual reports filed with the SEC—specifically forms 10-K, 10-KT, 1-K, and 20-F—in each year.[31]

As shown below in Figure 4, the total number of public companies gradually decreased from 2012 to 2020, but then jumped back up in 2021 and 2022. The recent rise is (at least in part) a likely result of the aforementioned SPAC boom. Because SPACs are public companies with no business operations, until they go through a de-SPAC process their filings do not typically contain the type of sensitive information that would warrant redactions in their SEC filings. Thus, to allow a clearer picture of how often public companies with actual business operations are redacting portions of their exhibits, Figure 4 also includes the estimated total number of public companies per year when SPACs are removed from the presentation. After removing SPACs, there is a much more consistent downward trend in the number of public companies over the studied period, from an estimated 8,361 in 2012 to an estimated 7,671 in 2022—a decrease of approximately 8%.[32]

Figure 4

The intersection of the generally declining number of public companies and the increase in redacted exhibits following the 2019 rule changes suggests that public companies are now submitting a higher number of redacted exhibits per year. The estimates below in Figure 5A—calculated by dividing the total number of redacted exhibits by the total number of public companies in each respective year—support this inference, as the number of redacted exhibits filed per company has soared since the rule changes. As shown in Figure 5B, the growth in the number of redacted exhibits filed per company becomes slightly more pronounced when excluding SPACs from both data points.

Figure 5A

Figure 5B

Notably, the SPAC expansion also presumably played a major role in the influx of Exhibit 10 (and to a lesser extent, Exhibit 2) filings in 2021 and 2022. Again, when considering that SPAC exhibits are less likely to contain materially sensitive information because SPACs have no business operations prior to undergoing the de-SPACing process, the dramatic increase in the number of redacted exhibits filed per public company following the rule changes becomes all the more noteworthy.

An additional partial explanation of this phenomena may be the corresponding increase in the average size of public companies in recent years.[33] As public companies grow in size, it stands to reason that they may be party to more material contracts that warrant requesting confidential treatment.

More obviously, a significant portion of the increase in redacted exhibits may be attributable to companies seeking cost savings.[34] Public companies (especially smaller companies) that could not afford to or did not feel strongly about redacting certain immaterial information may have previously forgone the CTR process to avoid the expense of doing so.

But in addition to cost savings, it is no secret that public companies generally want to keep as much information private as they are legally allowed, and it appears that many are now testing the limits. In light of what appears to be a de-emphasis from the SEC on the administrative checks surrounding CTR redactions, public companies may be taking more aggressive stances on what information they redact in publicly filed exhibits.

C. Implications

The SEC’s modernization and simplification of its confidential treatment rules in 2019 made it drastically easier for public companies to redact information from their material contract exhibits. The results shown in this report reveal that public companies have already begun redacting information more often—and are thus keeping more sensitive (or purportedly sensitive) information away from their competitors—than before the rule changes. Overall, the rule changes appear to be a positive development for most public companies, as well as the SEC, primarily due to the associated cost savings and relieving administrative burden.

When looking at the impact of these changes on the market as a whole, the analysis of the increase in confidential treatment redactions is more mixed. The SEC’s loosened CTR application standards will undoubtedly increase the amount of redacted information that is actually material—and thus should have been disclosed to the public. The question is, to what degree? Measuring just how much material information is improperly redacted will be all but impossible to quantify, especially in light of the redactions obviously not being made public for study. But if the redactions are more extensive than expected, this could negatively impact competitive activity in a way the rule changes could not have intended. Conceivably, the SEC could further deter public companies from over-redacting by imposing serious penalties for clear violations of the new rules, but this has not yet occurred and does not seem likely.

In the end, assuming the SEC maintains a strong level of oversight, it seems unlikely that the increased volume of redacted exhibits will dramatically affect the investing public or the market in general. Public companies should remain diligent about disclosing all material information and complying with the updated rules to avoid unnecessary costs and compliance and enforcement risks.

———————————————————————————————————-

* Associate, Corporate & Securities, Troutman Pepper Hamilton Sanders LLP, Philadelphia, Pennsylvania; J.D., Villanova University Charles Widger School of Law; B.A., University of Michigan. The views expressed in this Study are only those of the Authors and do not reflect the views of Troutman Pepper Hamilton Sanders LLP or its clients. ↑

** Associate, Corporate & Securities, Troutman Pepper Hamilton Sanders LLP, Berwyn, Pennsylvania; J.D., Villanova University Charles Widger School of Law; B.A., Villanova University. The views expressed in this Study are only those of the Authors and do not reflect the views of Troutman Pepper Hamilton Sanders LLP or its clients. ↑

  1. See Rules and Regulations for the Securities and Exchange Commission and Major Securities Law, U.S. Sec. & Exch. Comm’n, https://www.sec.gov/about/laws/secrulesregs (last visited Apr. 3, 2023). ↑

  2.  5 U.S.C. § 552 (2018). ↑

  3.  17 C.F.R. § 229.601(b)(10) (2022). ↑

  4.  17 C.F.R. § 230.406 (2022). ↑

  5.  17 C.F.R. § 240.24b-2 (2022). ↑

  6.  5 U.S.C. § 552(b)(4) (2018). See FAST Act Modernization and Simplification of Regulation S-K, 84 Fed. Reg. 12,674, 12,680 n.45 (Apr. 2, 2019). ↑

  7. See generally, Securities and Exchange Commission Confidential Treatment Procedure Under Rule 83, U.S. Sec. & Exch. Comm’n, https://www.sec.gov/foia/conftreat (last visited Apr. 3, 2023). ↑

  8. For an example of an order denying confidential treatment, see Order Denying Applications by New York Stock Exchange, LLC, Release No. 34-83760 (Aug 1, 2008), available at https://www.sec.gov/rules/other/2018/34-83760.pdf. ↑

  9.  Press Release, SEC Adopts Rules to Implement FAST Act Mandate to Modernize and Simplify Disclosure, U.S. Sec. & Exch. Comm’n (Mar. 20, 2019), https://www.sec.gov/news/press-release/2019-38. ↑

  10.  Fixing America’s Surface Transportation Act, Pub. L. No. 114-94, § 72002–72003, 129 Stat. 1312 (2015). ↑

  11.  FAST Act Modernization and Simplification of Regulation S-K, 84 Fed. Reg. at 12,680. ↑

  12.  139 S. Ct. 2356 (2019). ↑

  13.  Id. at 2366; Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets, 86 Fed. Reg. 3496, 3530 (Jan. 14, 2021). ↑

  14. Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets, 86 Fed. Reg. at 3530. In addition, confidential treatment secured under the new rules is indefinite rather than having a fixed lifespan as it did in the past. See Div. Corp. Fin, U.S. Sec. & Exch. Comm’n, CF Disclosure Guidance: Topic No. 7, Confidential Treatment Applications Submitted Pursuant to Rules 406 and 24b-2 (Dec. 19, 2019, as amended March 9, 2021), https://www.sec.gov/corpfin/confidential-treatment-applications#options. This means that under the new rules, public companies no longer need to file requests to extend confidential treatment. However, public companies that secured confidential treatment of exhibits prior to the rule changes should confirm the SEC’s instructions for how to handle extensions going forward. Id. ↑

  15. Search for Confidential Treatment Orders, U.S. Sec. & Exch. Comm’n, https://www.sec.gov/edgar/searchedgar/ctorders.htm (last visited December 31, 2022). ↑

  16. FAST Act Modernization and Simplification of Regulation S-K, 84 Fed. Reg. at 12,692. ↑

  17. Id. ↑

  18. Id. ↑

  19. Id. at 12,719. ↑

  20. Id. at 12,691 (“As a matter of practice, the staff generally does not object where a registrant omits PII from exhibits without also submitting a confidential treatment request under Rule 406 or Rule 24b-2. To codify this current staff practice, the Commission proposed new Item 601(a)(6) to allow registrants to omit PII from their required Item 601 exhibits without submitting a confidential treatment request for the information.”). ↑

  21. New Rules and Procedures for Exhibits Containing Immaterial, Competitively Harmful Information, U.S. Sec. & Exch. Comm’n (Apr. 1, 2019), https://www.sec.gov/corpfin/announcement/new-rules-and-procedures-exhibits-containing-immaterial. ↑

  22. See Filing Review Process, U.S. Sec. & Exch. Comm’n, https://www.sec.gov/divisions/corpfin/cffilingreview.htm (last visited December 31, 2022). ↑

  23. FAST Act Modernization and Simplification of Regulation S–K, 84 Fed. Reg. at 12,705–06. ↑

  24. Id. ↑

  25. Id. ↑

  26. See 17 C.F.R. § 229.601(b)(10)(iv) (2022). ↑

  27. See New Rules and Procedures for Exhibits Containing Immaterial, Competitively Harmful Information, supra note 23. ↑

  28. For exhibits filed from 2012-2018 (prior to 2019 rule changes), the following search terms were used: ((omit* OR redact* OR omission*) w/40 (“filed separately” OR “separately filed”)) OR “confidential treatment has been requested”.

    For exhibits filed from 2019-2022 (to account for the 2019 rule changes), the following search terms were used: (((omitted OR omits OR omission* OR redacted OR redacts OR redaction*) w/40 “not material”) OR (“has been excluded” w/20 “not material”)) OR (((omit* OR redact* OR omission*) w/40 (“filed separately” OR “separately filed”)) OR “confidential treatment has been requested”). ↑

  29. FAST Act Modernization and Simplification of Regulation S-K, 84 Fed. Reg. at 12,682 n.69. ↑

  30. See Christine Dobridge, Rebecca John & Berardino Palazzo, The Post-COVID Stock Listing Boom, Bd. Governors Fed. Rsrv. Sys.: FED Notes (June 17, 2022), https://www.federalreserve.gov/econres/notes/feds-notes/the-post-covid-stock-listing-boom-20220617.html#:~:text=Using%20data%20for%20the%20three,increase%20of%20about%2028%20percent; Kristin Broughton, M&A Likely to Remain Strong in 2022 as Covid-19 Looms Over Business Plans, Wall St. J. (Dec. 23, 2021 5:30 AM), https://www.wsj.com/articles/m-a-likely-to-remain-strong-in-2022-as-covid-19-looms-over-business-plans-11640255406. A SPAC is a type of blank check company “with no operations that offers securities for cash and places substantially all the offering proceeds into a trust or escrow account for future use in the acquisition of one or more private operating companies. Following its initial public offering . . . the SPAC will identify acquisition candidates and attempt to complete one or more business combination transactions after which the company will continue the operations of the acquired company or companies . . . as a public company.” Div. Corp. Fin, U.S. Sec. & Exch. Comm’n, CF Disclosure Guidance: Topic No. 11, Special Purpose Acquisition Companies (Dec. 22, 2020), https://www.sec.gov/corpfin/disclosure-special-purpose-acquisition-companies. ↑

  31. The search excluded amended filings, such as 10-K/A, 10-KT/A, 1-K/A, and 20-F/A forms, to avoid duplication. ↑

  32. The decline in the number of public companies extends all the way back to the 1990s. Heightened regulation of public companies, especially via the Sarbanes-Oxley Act of 2002, has incentivized companies to stay private or go private. See Jason M. Thomas, Where Have All the Public Companies Gone?, Wall St. J. (Nov. 16, 2017, 7:10 PM), https://www.wsj.com/articles/where-have-all-the-public-companies-gone-1510869125. The expansion of private equity and venture capital are other driving forces in this movement. See Spencer Israel, The Number Of Companies Publicly Traded In The US Is Shrinking—Or Is It?, MarketWatch (Oct. 30, 2020, 8:53 AM), https://www.marketwatch.com/story/the-number-of-companies-publicly-traded-in-the-us-is-shrinkingor-is-it-2020-10-30?mod=investing. ↑

  33. Where Have All the Public Companies Gone?, Bloomberg (Apr. 9, 2018, 7:00 AM), https://www.bloomberg.com/opinion/articles/2018-04-09/where-have-all-the-u-s-public-companies-gone. ↑

  34. FAST Act Modernization and Simplification of Regulation S-K, 84 Fed. Reg. at 12,705. ↑

Tags:
23Feb

Power to the Traders? A Look at the Reddit-Driven Surge of GameStop and Robinhood’s Subsequent Suspension of Meme Stocks

Categories: Current Issues Blog
Comments Off on Power to the Traders? A Look at the Reddit-Driven Surge of GameStop and Robinhood’s Subsequent Suspension of Meme Stocks

By Elizabeth A. Napps

The end of January 2021 brought a few trending headlines.  We all expected to see stories of President Joe Biden’s inauguration, if not breakout star poet Amanda Gorman.  The unexpected story, however, came the following week when Americans were reminded of the existence of GameStop and learned all about “stonks.”  To the uninitiated, the term “stonks” references a popular meme poking fun at the unpredictability and (in)sanity of the stock market.[1]  Another new household name was the Reddit forum “r/wallstreetbets,” which is self-described as “a community for making money and being amused while doing it.”[2]  Users of the subreddit coordinated to purchase previously unpopular stocks, most notably GameStop, ultimately leading to a “10-day realized volatility [of] 308%” just prior to the market opening on January 26, 2021.[3]  By the close of trading on January 27, 2021, the stock price had increased by 1,915 percent from the beginning of the year.[4]

As GameStop stock surged throughout the week, the Securities and Exchange Commission (the “SEC”) and the White House acknowledged monitoring market volatility to “maintain fair, orderly, and efficient markets . . . .”[5]  In response to the volatility, trading apps including Robinhood Markets, Inc. (“Robinhood”) placed temporary pauses on trading of the affected stocks.[6]  Two days after its first statement, the SEC, without naming any specifics, again acknowledged its close review of the “actions taken by regulated entities that may disadvantage investors or otherwise unduly inhibit their ability to trade certain securities;” pledged to protect investors from “abusive or manipulative trading activity that is prohibited by the federal securities laws;” and cautioned investors against participating in such activity.[7]

There has been extensive fallout and speculation about what actions the SEC may take against individual traders and platforms like Robinhood, but what does it all mean? What is really likely to happen?

Individual Traders

The Securities Exchange Act of 1934 (the “Exchange Act”) was enacted to regulate and control transactions in securities and “insure the maintenance of fair and honest markets in such transactions.”[8]  Although anyone can invest in the stock market, there are some regulations that must be followed.  Primary among them here is the prohibition of market manipulation.  Under Section 9 of the Exchange Act, it is unlawful for a person to effect any transaction in a security to “creat[e] a false or misleading appearance of active trading in any security . . . or a false or misleading appearance with respect to the market for any such security . . . .”[9]  Although the Commodity Futures Trading Commission has separately recognized a four-part test regarding manipulation,[10] the SEC’s definition of “market manipulation” remains in flux to a degree.[11]

Although it may take months or years for the SEC to complete any investigation, enforcement actions, or criminal prosecutions against Reddit investors appear unlikely except in exigent circumstances.[12]  For example, Massachusetts is investigating one high profile Redditor, Keith Gill, for a possible violation of state securities regulations because he has a higher fiduciary duty as a registered broker-dealer and previously worked for MassMutual.[13]  After his identification, Gill became the face of early investors who helped increase the popularity of GameStop stock, with even the House Committee on Financial Services calling him to testify during its hearings about recent market volatility.[14]  Gill testified that his only involvement in the GameStop trading was as an amateur investor sharing his ideas solely for the educational value, not manipulation.[15]

Generally, Redditors were largely transparent about their motives and any charge against them would diverge from a typical SEC case.[16]  Although some have characterized the trading as a “pump and dump scheme,” wherein promoters first “try to [pump up] the price of a stock with false or misleading statements” before “selling their own holdings of the stock [and] dumping shares into the market,”[17] questions linger over whether any false or misleading transactions were ever actually made.[18]  Many later investors were evidently joining the bandwagon of rising stock prices and excited to see if their efforts could disrupt Wall Street.[19]  Considering the high volume of media coverage, the most likely enforcement targets would be early investors and participants in the Reddit forum, like Gill.[20]  Although the SEC would need to match the individual traders to posts on Reddit, this would likely not be an impossible feat.[21]  On the whole, the consensus among observers remains that it would be difficult to prove a case against the typical Reddit investor.[22]

Robinhood and Other Platforms

In the wake of Robinhood and other platforms temporarily freezing trading on the suspect stocks, an immediate uproar resulted in over thirty lawsuits against the company[23] and bipartisan congressional calls to investigate.[24]  For its part, Robinhood said that the “halting of buy orders and leveraged trading” was “entirely about market dynamics and clearinghouse requirements.”[25]  Robinhood CEO Vlad Tenev repeated this refrain while testifying to Congress about the company’s actions.[26]  Indeed, former SEC chief economist Chester Spatt told Yahoo Finance that this action was actually an example of the regulations working, because the firm needed to halt trading in order to make sure the high volume of trades could be covered.[27]

Observers also emphasize that Robinhood’s Customer Agreement (the “Agreement”) with each user allows for this action.[28]  The Agreement includes provisions about the clearance of trades, Robinhood’s right to “prohibit or restrict the trading of securities” at its discretion, and even an arbitration agreement.[29]  Furthermore, the Agreement includes a provision about applicable laws and regulations, which permits Robinhood to not complete “any transaction it believes would violate any federal or state law, rule or regulation or the rules or regulations of any regulatory or self-regulatory organization.”[30]  Based on the SEC’s acknowledgement of market volatility and the suspect nature of the increased trading on the securities at issue, it is plausible that Robinhood could rely on this provision as well.  In an early indication that courts would be likely to side with Robinhood, the Central District of California recently denied a request for a temporary restraining order that would have forced Robinhood “to abstain from any further limitations on trading in any stock . . . .”[31]

Future Impact

Although much of the conversation is centered on what already occurred, there remains a question of what may happen to future investors.  There is already some indication that the SEC is watching social media more closely and may be inclined to take action against future attempts by a subreddit or other congregation of amateur traders to spearhead a pump and dump scheme.  On February 11, 2021, the SEC enacted a two-week trading suspension for SpectraScience, Inc. (“SCIE”) under section 12(k) of the Exchange Act.[32]  Although this action was in part because the corporation is inactive, the SEC further acknowledged that “since late January 2021, certain social media accounts may be engaged in a coordinated attempt to artificially influence SCIE’s share price . . . .”[33]  This suggests a new inclination by the SEC to suspend trading where social media activity may have contributed to market manipulation.[34]  A former SEC senior trial counsel hypothesized that the SEC did not halt trading on GameStop because of an “inability to identify an actionable violation of the federal securities laws . . . .”[35]  Although that may have been true with regards to GameStop and other similarly situated stocks, this was evidently not the case with SCIE.

In addition to the SEC’s seemingly new willingness[36] to suspend trading in part because of social media influence, prospective traders should also be cautious of joining similar Reddit-led stock purchases because it is clear they work.  Certainly, social media-inspired investing seems to be becoming a trend.  Indeed, r/wallstreetbets currently boasts over 9.2 million users[37] and a recent Elon Musk tweet of an investment meme garnered a million likes.[38]  Although famous investors like Musk are at more risk of being investigated for illegal stock touting, it is not inconceivable the SEC would choose to investigate other traders as well.[39]  Continued market volatility of this sort may soon appear to be a premeditated, coordinated plan by Redditors and the like to drive stock prices up in manipulative schemes.  A savvy investor would be wise to avoid jumping on the bandwagon.[40]

[1] Jordan Weissmann, What We Talk About When We Talk About Stonks, Slate (Jan. 28, 2021, 3:53 PM), https://slate.com/business/2021/01/stonks-not-stocks-got-it.html (describing “stonks” as “an exclamation . . . that you don’t take any of this finance stuff too seriously, that you are in it as much for the [laughs] as the opportunity to actually make a buck”).

[2] The WSB FAQ, Reddit, https://www.reddit.com/r/wallstreetbets/wiki/faq (last visited Feb. 22, 2021).  For an inside view about the attitudes of some Redditors, see Caitlin McCabe, A Week Inside the WallStreetBets Forum That Launched the GameStop Frenzy, Wall St. J. (Feb. 13, 2021, 2:41 PM), https://www.wsj.com/articles/a-week-inside-the-wallstreetbets-forum-that-launched-the-gamestop-frenzy-11613212202?mod=hp_lista_pos2.

[3] Matt Levine, GameStop Is Just a Game, Bloomberg (Jan. 26, 2021, 12:14 PM), https://www.bloomberg.com/opinion/articles/2021-01-26/will-wallstreetbets-face-sec-scrutiny-after-gamestop-rally.

[4] Dean Seal, White House, SEC “Monitoring” Volatile GameStop Stock, Law360 (Jan. 27, 2021, 9:07 PM), https://www.law360.com/articles/1349195.

[5] Public Statement, Sec. & Exch. Comm’n, Joint Statement Regarding Ongoing Market Volatility (Jan. 27, 2021), https://www.sec.gov/news/public-statement/joint-statement-ongoing-market-volatility-2021-01-27; see also Seal, supra note 4.

[6] Tucker Higgins, Lawmakers from AOC to Ted Cruz Are Bashing Robinhood Over Its GameStop Trading Freeze, CNBC (Jan. 28, 2021, 5:17 PM), https://www.cnbc.com/2021/01/28/gamestop-cruz-ocasio-cortez-blast-robinhood-over-trade-freeze.html.  Affected stocks on Robinhood included GameStop, American Airlines, AMC, BlackBerry, Bed Bath & Beyond, Castor Maritime, Express, Koss, Nokia, Sundial Growers, Tootsie Roll Industries, and trivago.  Id.

[7] Public Statement, Sec. & Exch. Comm’n, Statement of Acting Chair Lee and Commissions Peirce, Roisman & Crenshaw Regarding Recent Market Volatility (Jan. 29, 2021), https://www.sec.gov/news/public-statement/joint-statement-market-volatility-2021-01-29?source=content_type%3Areact%7Cfirst_level_url%3Anews%7Csection%3Amain_content%7Cbutton%3Abody_link; see also Investor Alert: Thinking About Investing in the Latest Hot Stock?, Sec. & Exch. Comm’n (Jan. 30, 2021), https://www.sec.gov/oiea/investor-alerts-and-bulletins/risks-short-term-trading-based-social-media-investor-alert (cautioning potential investors about the risks of following social media trends).

[8] 15 U.S.C. § 78b, https://www.govinfo.gov/content/pkg/USCODE-2018-title15/pdf/USCODE-2018-title15-chap2B-sec78b.pdf.

[9] 15 U.S.C. § 78i(a), https://www.govinfo.gov/content/pkg/USCODE-2018-title15/pdf/USCODE-2018-title15-chap2B-sec78i.pdf.

[10] Prohibition on Price Manipulation, 76 Fed. Reg. 41,398, 41,407 (July 14, 2011) (to be codified at 17 C.F.R. § 180.2), https://www.govinfo.gov/content/pkg/FR-2011-07-14/pdf/2011-17549.pdf (confirming that the Commission will apply a four-part test developed in case law: “(1) That the accused had the ability to influence market prices; (2) that the accused specifically intended to create or effect a price or price trend that does not reflect legitimate forces of supply and demand; (3) that artificial prices existed; and (4) that the accused caused the artificial prices.”).

[11] See Alexis Keenan, Will the SEC Sue GameStop Traders? The Case Could Pose a ‘Super Weird’ Challenge, Yahoo Fin. (Jan. 28, 2021), https://finance.yahoo.com/news/will-the-sec-sue-gamestop-traders-183845241.html; Levine, supra note 3 (“Nobody knows what this means.”).

[12] Bruce Brumberg, Investigations Into GameStop Trading and Reddit: Former SEC Enforcement Chief Provides Insights, Forbes (Feb. 9, 2021, 10:00 AM), https://www.forbes.com/sites/brucebrumberg/2021/02/09/investigations-into-gamestop-trading-and-reddit-former-sec-enforcement-chief-reveals-insights/ (suggesting that registered financial advisors or those engaging in illegal touting may be targeted by the SEC).

[13] Andy Rosen, Regulators Subpoena Mass. Resident ‘Roaring Kitty’ Regarding GameStop Saga, Bos. Globe (Feb. 9, 2021, 6:06 PM), https://www.bostonglobe.com/2021/02/09/business/mass-regulators-subpoena-local-man-known-roaring-kitty-gamestop-saga/.  Keith Gill was separately named a defendant in a proposed class-action lawsuit for allegedly misleading investors through his YouTube channel, though he maintains his innocence.  Christian Berthelsen, “Roaring Kitty” Sued for Securities Fraud Over GameStop Rise, Bloomberg (Feb. 17, 2021, 12:31 PM), https://www.bloomberg.com/news/articles/2021-02-17/-roaring-kitty-sued-for-securities-fraud-over-gamestop-rise (noting the case is Iovin v. Gill, No. 21-cv-10264, D. Mass. (Springfield)).

[14] See Nathaniel Popper, Reddit’s ‘Roaring Kitty’ Will Speak at GameStop Hearing, N.Y. Times (Feb. 12, 2021), https://www.nytimes.com/2021/02/12/business/gamestop-hearing-roaring-kitty.html.  This is the first of three hearings about market volatility, with the SEC expected to feature in the future.  See @RepMaxineWaters, Twitter (Feb. 19, 2021, 5:48 PM), https://twitter.com/RepMaxineWaters/status/1362896862957756418.

[15] Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide: Hearing Before the H. Comm. on Fin. Servs., 117th Cong. (2021), https://docs.house.gov/meetings/BA/BA00/20210218/111207/HHRG-117-BA00-Wstate-GillK-20210218.pdf (statement of Keith P. Gill).

[16] See Brumberg, supra note 12; see also Keenan, supra note 11 (noting a case could “unravel” because the traders “appear to have acted openly”).

[17] Pump and Dump Schemes, Sec. & Exch. Comm’n, https://www.investor.gov/protect-your-investments/fraud/types-fraud/pump-and-dump-schemes (last visited Feb. 22, 2021) (cautioning that investors lose money once shares flood the market and drive the price per share down).  The volatility in the market led to a “short squeeze,” which occurs when stock prices surge, forcing short sellers, who predicted the price would drop, to purchase the stock to protect themselves from further losses, thus increasing the price even more.  See April Joyner & Saqub Iqbal Ahmed, “GameStop Effect” Could Ripple Further as Wall Street Eyes Short Squeeze Candidates, Reuters (Jan. 28, 2021, 1:30 PM), https://www.reuters.com/article/us-retail-trading-shorts/gamestop-effect-could-ripple-further-as-wall-street-eyes-short-squeeze-candidates-idUSKBN29X2MG.  Except in the most extreme cases of a “short squeeze,” the SEC rarely prosecutes for manipulation.  See Complaint, Sec. & Exch. Comm’n v. Falcone, No. 12 CIV 5027 (S.D.N.Y. June 27, 2012), 2012 WL 2457466 (available at https://www.sec.gov/litigation/complaints/2012/comp-pr2012-122-2.pdf).

[18] See Brumberg, supra note 12; see also Yoel Minkoff, GameStop Rally: Is there a Case for Market Manipulation?, Seeking Alpha (Jan. 31, 2021, 9:09 AM), https://seekingalpha.com/news/3656452-gamestop-rally-is-there-a-case-for-market-manipulation (suggesting that “irrational exuberance” does not equate to “fraud and misinformation”).

[19] See Dave Michaels & Alexander Osipovich, “GameStop Stock Surge Tests Scope of SEC’s Manipulation Rules, Wall St. J. (Jan. 28, 2021, 7:49 AM), https://www.wsj.com/articles/gamestop-surge-tests-scope-of-secs-manipulation-rules-11611838175; see also McCabe, supra note 2 (describing some investors’ views); @elonmusk, Twitter (Jan. 26, 2021, 4:08 PM), https://twitter.com/elonmusk/status/1354174279894642703 (addressing the activity in a more mainstream outlet).

[20] See, e.g., Keenan, supra note 11 (“Regulators may have more success targeting the buying behavior that took place at the very beginning of the effort, [Michigan School of Law professor Gabriel Rauterberg] said.”).

[21] Id.

[22] See Minkoff, supra note 18 (quoting Duke Law Prof. Gina-Gail S. Fletcher as saying, “[t]he statutory provisions and the case law related to [market manipulation] are all over the place and they don’t favor the SEC”); see also Brumberg, supra note 12 (“[I]t could be tough to prove [a] case.”).

[23] Mengqi Sun, Robinhood Faces Civil Lawsuits Over Trading Restrictions, Wall St. J. (Feb. 3, 2021, 3:32 PM), https://www.wsj.com/articles/robinhood-faces-civil-lawsuits-over-trading-restrictions-11612384364?page=1.

[24] Higgins, supra note 6.  

[25] Ethan Wolff-Mann, Robinhood “Didn’t Change the Rules” on Users Amid Market Mayhem, Former SEC Economist Explains, Yahoo Fin. (Jan. 29, 2021), https://www.yahoo.com/lifestyle/robinhood-didnt-change-the-rules-chester-spatt-204321652.html (quoting Robinhood CEO Vlad Tenev).  Clearinghouses serve as intermediaries between buyers and sellers in the transfer of securities, and may ask members to front more money, called margin, in the event of volatile market and risky trades.  See Telis Demos, Why Did Robinhood Ground GameStop? Look at Clearing, Wall St. J. (Jan. 29, 2021, 7:33 PM), https://www.wsj.com/articles/how-clearing-demands-grounded-the-wallstreetbets-stocks-for-a-day-11611966092?mod=article_inline (explaining why a broker like Robinhood would choose to suspend trading in the face of a possible margin call).

[26] Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide: Hearing Before the H. Comm. on Fin. Servs., 117th Cong. 8 (2021), https://financialservices.house.gov/uploadedfiles/hhrg-117-ba00-wstate-tenevv-20210218.pdf (statement of Vladimir Tenev, CEO, Robinhood Markets, Inc.).

[27] Wolff-Mann, supra note 25.

[28] See id.; Jeff John Roberts, Robinhood is Being Sued Over the GameStop Meltdown. Do Investors Have a Case?, Fortune (Jan 28, 2021, 07:44 PM), https://fortune.com/2021/01/28/robinhood-class-action-lawsuit-gamestop-gme-amc-stocks-walstreetbets-halted-purchasing/ (suggesting that the lawsuits may just be a tactic to reach a quick settlement in the face of an “uphill” legal battle).

[29] Robinhood Financial LLC & Robinhood Securities, LLC Customer Agreement, Robinhood 8, 11, 29 (last updated Dec. 30, 2020), https://cdn.robinhood.com/assets/robinhood/legal/Robinhood%20Customer%20Agreement.pdf.

[30] Id. at 9.

[31] Dean Seal, Early Robinhood Ruling Marks Rocky Start for Traders’ Suits, Law360 (Feb. 11, 2021, 8:30 PM), https://www.law360.com/securities/articles/1354013/early-robinhood-ruling-marks-rocky-start-for-traders-suits (noting that Judge Virginia Phillips held that the plaintiff trader “failed to establish a likelihood of success on the merits”).

[32] In re SpectraScience, Inc., File No. 500-1 (Feb. 10, 2021), https://www.sec.gov/litigation/suspensions/2021/34-91101-o.pdf; see also 15 U.S.C. § 78l(k), https://www.govinfo.gov/content/pkg/USCODE-2018-title15/pdf/USCODE-2018-title15-chap2B-sec78l.pdf.

[33] Id.

[34] Seal, supra note 4.

[35] Id. (quoting Nick Morgan).

[36] This is not the first time the SEC has taken a close look at social media and message boards.  See, e.g., Press Release, Sec. & Exch. Comm’n, SEC Brings Fraud Charges in Internet Manipulation Scheme (Sept. 20, 2000), https://www.sec.gov/news/press/2000-135.txt (reaching a settlement with an investor accused of online market manipulation; Nicholas Groom, Whole Foods CEO Sorry for Anonymous Web Posts, Reuters (July 17, 2007, 7:10 PM), https://www.reuters.com/article/us-wholefoods/whole-foods-ceo-sorry-for-anonymous-web-posts-idUSN1725360820070718 (acknowledging an SEC probe into deceptive posts made online).  One difference between the message boards of the 1990s and today is the much larger scale.  See generally Brian Cheung, Before WallStreetBets: A History of Online Message Boards and ‘Stonks’, Yahoo Fin. (Feb. 2, 2021), https://www.yahoo.com/now/before-wall-street-bets-a-history-of-online-message-boards-and-stonks-134818361.html.

[37] See Reddit, supra note 2.

[38] @elonmusk, Twitter (Feb. 4, 2021, 2:57 AM), https://twitter.com/elonmusk/status/1357236825589432322.

[39] 15 U.S.C. § 77q(b); see Brumberg, supra note 12 (cautioning that “stock-promotional efforts” may result in liability under Section 17(b) of the Securities Act of 1933, which is a strict liability statute not requiring a finding of fault).

[40] From a practical perspective, many investors, especially novices, lost significant amounts of money by joining the investment rollercoaster at the apex.  See Drew Harwell, As GameStop Stock Crumbles, Newbie Traders Reckon with Heavy Losses, Wash. Post (Feb. 2, 2021, 5:34 PM), https://www.washingtonpost.com/technology/2021/02/02/gamestop-stock-plunge-losers/.

Tags:
27Feb

Weekly Roundup – 2/26 – 3/2

Categories: 4th Cir. Blog Weekly Roundup
Comments Off on Weekly Roundup – 2/26 – 3/2

Weekly Roundup: 2/26-3/2

By: Cara Katrinak & Raquel Macgregor

Carlton & Harris Chiropractic, Inc. v. PDR Network, LLC

In this civil case, Carlton & Harris Chiropractic appealed the district court’s dismissal of its claim against PDR Network for violating the Telephone Consumer Protection Act (TCPA) by sending an unsolicited advertisement via fax. Carlton & Harris argued that the district court erred by failing to defer to a 2006 rule promulgated by the Federal Communications Commission (FCC) interpreting provisions of the TCPA–specifically, interpreting the term “unsolicited advertisement.” Carlton & Harris further argued that the Hobbs Act required the district court to defer to the FCC’s rule. The Fourth Circuit vacated and remanded the case, holding both that the Hobbs Act deprived the district court of jurisdiction to consider the validity of the FCC rule and the district court’s reading of the FCC rule conflicted with the plain meaning of the rule’s text.  

Singer v. Reali

This appeal and cross-appeal arose from the district court’s dismissal of a securities fraud class action complaint related to the healthcare provider reimbursement practices of defendant TranS1 and four of its officers in connection with TranS1’s AxiaLIF system (the “System”). Named plaintiff Phillip J. Singer alleged that TranS1 and its officers, through the System, enabled surgeons to secure fraudulent reimbursements from health insurers and government-funded healthcare programs. Singer initiated this class action against TranS1 and its officers pursuant to Section 10(b) of the Securities Exchange Act, claiming that TranS1 and its officers concealed the fraudulent reimbursement scheme from the market through false and misleading statements and omissions and that TranS1’s stock price plummeted when the scheme was revealed.

Here, Singer appealed (No. 15-2579) the district court’s dismissal of his complaint for failure to sufficiently plead the material misrepresentation element or the scienter element of his Section 10(b) claim. TranS1 and its officers cross-appealed (No. 16-1019), contending that the district court erred in dismissing their challenge to the loss causation element of Singer’s claim. In reviewing the complaint, the Fourth Circuit held that Singer sufficiently pleaded the misrepresentation and scienter elements because the complaint specified statements made by TranS1 and its officers about its reimbursement practices that support Singer’s claim. In addition, the Court held that Singer also sufficiently pleaded the loss causation element because the complaint alleged losses resulting from “the relevant truth . . . leak[ing] out” about TranS1’s previously concealed fraudulent reimbursement scheme. Accordingly, the Fourth Circuit vacated and remanded No. 15-2579 and affirmed No. 16-1019.

Norfolk Southern Railway Co. v. Sprint Communications Co. L.P.

In this civil case, Sprint Communications appealed the district court’s order granting Norfolk Southern Railway’s motion to confirm an arbitration award. The arbitration arose from a disputed license agreement between the parties. The agreement granted use of Norfolk Southern’s railroad rights of way for Sprint’s fiber optic telecommunications system. The parties disagreed over the amount Sprint owed Norfolk Southern for such continued use and, pursuant to their agreement, hired three appraisers to determine an appropriate amount. On appeal, the parties disputed whether the final decision of the appraisers constituted a “final” arbitration award under the Federal Arbitration Act (FAA). Because the text of the appraisers’ final decision reserved the right to withdraw assent in the future, the award could not be considered “final.” Accordingly, the Fourth Circuit reversed and remanded the case, holding that the arbitration award was not “mutual, final, and definite” as required by the FAA.        

U.S. v. Phillips

In this civil case, claimant Damian Phillips appealed the district court’s holding that he lacked standing to intervene in his brother Byron Phillips’ forfeiture case. Damian sought to intervene after the United States claimed that $200,000 in cash found in a storage unit leased by Byron was subject to forfeiture under 21 U.S.C. § 881(a)(6) for being connected to the “exchange [of] a controlled substance.” Damian claimed that the cash was his life savings and, therefore, was not connected with drugs in violation of the statute. The Fourth Circuit affirmed the district court, holding that–based on the record–Damian lacked the necessary colorable interest in the $200,000 to establish standing.     

Janvey v. Romero

The Fourth Circuit affirmed the District Court of Maryland’s decision denying a motion to dismiss a bankruptcy petition. Appellee, Romero, had originally filed a Chapter 7 bankruptcy petition after he was found liable for a $1.275 million Ponzi scheme. The receiver, Janvey, moved to dismiss the bankruptcy petition due to bad faith under 11 U.S.C. §707(a). The Fourth Circuit was tasked with assessing whether the district court abused its discretion in deciding that Romero’s decision to file bankruptcy had not risen to the level of “bad faith.” The Fourth Circuit emphasized that the purpose of the Bankruptcy Code is to “grant a fresh start to the honest but unfortunate debtor,” and dismissing a bankruptcy petition for cause under bad faith is only warranted “in those egregious cases that entail concealed or misrepresented assets . . . excessive and continued expenditures, [and] lavish life-style.” The Court rejected Appellant’s arguments that filing bankruptcy in response to a single debt or the debtor’s ability to pay the debt constitute bad faith per se. The Court noted that although Romero had $5.348 million in assets, most of these assets were statutorily exempt. Moreover, Romero was supporting his wife’s medical costs, which averaged $12,000 a month for a bacterial brain infection that had left her incapacitated. The Court noted that Romero filed for bankruptcy in part for legitimate reasons, such as the inability to pay his wife’s medical expenses, and Romero was unable to find work after the Ponzi scheme was made public. Thus, the Court found that the district court had not abused its discretion in finding that Romero’s bankruptcy petition had not risen to the level of bad faith.

Hickerson v. Yamaha Motor Corp.

In this case, the Fourth Circuit affirmed the District Court of South Carolina’s decision to exclude the Plaintiff’s expert testimony and enter summary judgment for the Defendant. The Plaintiff had filed suit against Yamaha for a WaveRunner’s (jet ski) inadequate warnings and defective design that resulted in serious internal injuries during a watercraft accident. The WaveRunner itself contained several warnings to wear a swimsuit bottom and to only have three passengers riding the craft at a time. When the accident occurred, a ten-year-old was driving, the Plaintiff was only wearing a bikini bottom, and she was the fourth passenger. The district court excluded the Plaintiff’s expert testimony regarding potential warnings because the expert’s proposals were scientifically untested and thus were unreliable under the Daubert standard. The Fourth Circuit offered little independent analysis regarding the expert testimony exclusion, but the Court agreed with the district court’s reasoning under the abuse of discretion standard of review. Moreover, regarding Plaintiff’s defective design claims, the Court noted that in South Carolina, design defects can be “cured” by adequate product warnings. The Court found that the warnings were adequate as a matter of law, and thus the district court did not err in granting summary judgment on the Plaintiff’s design defect claims.

Elliott v. American States Insurance Co.

This appeal arose from Plaintiff Elliott’s claim against her automobile insurer. In 2013, Elliott was in an automobile accident that left her with serious bodily injuries. As Plaintiff’s insurance coverage through the Defendant was capped at $100,000 and Plaintiff claimed more than $200,000 in damages, her recovery was insufficient to cover her expenses. The Plaintiff then initiated an action to recover damages first against Jones, the other driver in the accident, and then against her insurer. The District Court for the Middle District of North Carolina ultimately denied Plaintiff’s motion to remand the case back to the Superior Court (where she originally filed the case) and granted Defendant’s 12(b)(6) motion for failure to state a claim. On appeal to the Fourth Circuit, the Plaintiff had three claims: (1) that the Defendant’s filing for removal to the district court was untimely, (2) that the district court erred in determining parties were diverse, and thus subject matter jurisdiction did not exist in federal court; and (3) the district court erred in granting Defendant’s motion to dismiss for failure to state a claim. On the Plaintiff’s first claim, the Court concluded that the original service of process was made on a “statutory agent,” not an agent appointed by the defendant. Thus, the thirty-day time period to file the notice of removal did not start until the Defendant actually received a copy of the complaint, not when the service of process was actually delivered. Consequently, the Defendant filed its notice of removal within the allotted time period. As to the second claim, the Court held that the “direct action” variation on diversity jurisdiction from § 1332(c)(1) does not include an insured’s suit against his or her own insurer for breach of the insurance policy terms; thus the parties were diverse. Lastly, the Court rejected the Plaintiff’s claims regarding the Defendant’s motion to dismiss on multiple grounds, including that the Defendant had no obligation to settle the Elliot’s claims until after a judgment was settled against the other motorist, Jones.

Tags:
16Mar

Misleading Statements Sufficient for Trial in 10b-5 Suit

Categories: 4th Cir. Blog
Comments Off on Misleading Statements Sufficient for Trial in 10b-5 Suit

By Dan Menken

Today in the published opinion of Zak v. Chelsea Therapeutics International, the Fourth Circuit vacated the district court’s dismissal of the plaintiffs’ claim that the defendants, Chelsea Therapeutics International, LTD (“Chelsea”) and several corporate officers, violated § 10(b) of the Securities Exchange Act of 1934 (“the Exchange Act”) and remanded the case for further proceedings.

Plaintiffs Claim Chelsea Therapeutics and its Officers Violated § 10(b) of the Exchange Act

The plaintiffs in this class-action suit claim that Chelsea and several of its corporate officers violated § 10(b) of the Exchange Act, 15 U.S.C. § 78j(b), by making materially misleading statements and omissions about the development and likelihood of regulatory approval for a new drug, Northera. The district court dismissed the complaint, holding that the plaintiff’s allegations were insufficient as a matter of law to establish that the defendants acted with the requisite state of mind.

On appeal, plaintiffs contend that the district court committed two errors: (1) the district court’s consideration of exhibits submitted with defendants’ motion to dismiss and (2) the court’s determination that the plaintiffs’ allegations of scienter were legally insufficient.

Misleading Statements Regarding Northera’s Chances for FDA Approval

Northera was designed to treat symptomatic neurogenic orthostatic hypotension, a condition which may cause a dramatic drop in blood pressure when a person stands. During clinical testing, Northera’s efficacy was brought into question—only one study achieved a positive outcome. Following a December 2010 meeting with the FDA where Chelsea was warned that a single positive study typically was not sufficient to support approval of a new drug, Chelsea announced to investors that the FDA had “agreed” that Chelsea’s application for Northera could be submitted based on data from the one successful trial.

During a conference call with Chelsea investors, Chelsea President and Chief Executive Officer along with Chelsea’s Vice President and Chief Medical Officer indicated that the meeting with the FDA represented a “successful outcome” and that Chelsea was “very pleased” with the FDA’s responses to Chelsea’s questions about its application and supporting data. Following these statements, Chelsea’s stock price rose about 28%.

After submitting the drug for approval, Chelsea announced to the public on February 13, 2012 that the FDA’s briefing document indicated questions regarding the drugs efficacy in clinical trials, but it did not disclose that the FDA recommended the drug not be approved. Following the press release, Chelsea’s stock price dropped 37.5%. When the briefing document became public eight days later, Chelsea’s stock price dropped an additional 21%. The FDA made its final decision not to approve Northera on March 28, 2012, and one week later the plaintiffs filed suit.

Defendant’s Motion to Dismiss

Defendants, in their motion to dismiss, attached three documents filed with the Securities and Exchange Commission (“SEC”). One document, a “Definitive Proxy Statement,” listed the amount of Chelsea stock shares held by the company’s officers at the end of February 2012, near the end of the class period. However, it did not reflect whether any of these stock holdings had been acquired or sold during the class period. Defendants represented that none of the Chelsea officers had sold any shares of Chelsea stock during the class period and this fact undermined any inference of scienter. The plaintiffs objected to the court’s consideration of the SEC documents because they did not show whether any individuals purchased or sold stock during the period in question. At the conclusion of the hearing, the district court took judicial notice of the SEC documents, and granted the defendants’ motion to dismiss.

Fourth Circuit Review

The Fourth Circuit reviewed the district court’s dismissal de novo. The court noted that Rule 10b-5 prohibited the making of “any untrue statement of a material fact” or the omitting of “a material fact necessary in order to make the statements made . . . not misleading.” Rule 10b-5(b). Plaintiffs asserting a claim under Rule 10b-5 must establish: “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.” Yates v. Mun. Mortg. & Equity, LLC, 774 F.3d 874, 884 (4th Cir. 2014). To demonstrate scienter, a plaintiff must show that the defendant acted with “a mental state embracing intent to deceive, manipulate, or defraud.” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 319 (2007). Allegations of reckless conduct can satisfy the level of scienter necessary to survive a motion to dismiss. However, the court noted, claims of securities fraud are subject to a heightened pleading standard under the Private Securities Litigation Reform Act. 15 U.S.C. § 78u-4(b)(2).

Regarding the plaintiffs’ assertion regarding the district court’s first error, the Fourth Circuit addressed the fact that, generally, when considering a Rule 12(b)(6) dismissal, courts are limited to considering the sufficiency of the allegations set forth in the complaint and documents attached to the complaint. Because the SEC documents were not explicitly referenced in the plaintiffs’ complaint, the Fourth Circuit believed that the district court should not have considered those documents in reviewing the sufficiency of the plaintiffs’ allegations. Even if the judge had the right to take judicial notice of the documents, he did not have the right to construe it in favor the defendants. The court concluded that the district court’s consideration of the challenged SEC documents was not harmless.

The plaintiffs further asserted that the district court erred in concluding that their allegations of scienter were insufficient as a matter of law. The plaintiffs pointed out that Chelsea was aware of the FDA’s adverse recommendation regarding the approval of Northera, but withheld that information, indicating a strong inference of wrongful intent. The Fourth Circuit pronounced that the defendants’ failure to reveal such information must be viewed in the context of the statements that they affirmatively elected to make. In light of Chelsea’s failure to reveal to investors the FDA’s expectation that Northera needed at least two successful clinical trials to be considered for approval, the Fourth Circuit believed that their affirmative assertions regarding their optimism following the FDA meeting could be construed as misleading. Therefore, the court concluded that the plaintiffs’ allegations were sufficient to support the required inference of scienter.

Vacated and Remanded

Thus, the Fourth Circuit held that the district court erred in taking judicial notice of the challenged documents filed with the SEC, because the documents did not relate to the complaint. This error was not harmless. The court also held that defendants’ failure to disclose critical information about the weaknesses of the new drug application were sufficient to support a strong inference of scienter. The Fourth Circuit thus vacated the district court’s judgment and remanded the case for further proceedings.

Tags:
9Mar

Fourth Circuit Affirms Dismissal of Securities Exchange Act Claim

Categories: 4th Cir. Blog
Comments Off on Fourth Circuit Affirms Dismissal of Securities Exchange Act Claim

By Jordan Crews

Today, in Yates v. Municipal Mortgage & Equity, LLC, the Fourth Circuit affirmed the district court’s dismissal of plaintiffs’ claims under section 10(b) of the Securities Exchange Act of 1934.

One of the defendants, MuniMae, was one of the nation’s largest syndicators of low-income housing tax credits (“LIHTCs”).  Federal tax law provides LIHTCs to developers of low-income rental housing.  MuniMae organized LIHTC investment partnerships (“LIHTC Funds”) to pool and sell the credits to investors.  In 2003, the Financial Accounting Standards Board adopted Interpretation No. 46R (“FIN 46R”), which defined a new category of entities—Variable Interest Entities (“VIEs”).  Under FIN 46R, “a company must consolidate onto its financial statements the assets and liabilities of a VIE if the company is its ‘primary beneficiary,’ that is, if the company absorbs the majority of the risks and rewards associated with the VIE.”  MuniMae began reporting compliance with FIN 46R in the first quarter of 2004.

In September of 2006, MuniMae announced that it was restating its financial statements for fiscal years 2003 through 2005, and for the first quarter of 2006.  MuniMae revealed that this restatement would address accounting errors with respect to FIN 46R, and that the Company would “be required to consolidate substantially all of the low income housing tax credit equity funds it has interests in.”  In a conference call in January of 2008, MuniMae provided details to its investors regarding the restatement.  With respect to FIN 46R, the Company disclosed that it had to consolidate 230 LIHTC Funds, which required it to review 6,000 separate financial statements.  MuniMae had no automated process in place to review the accounting, so the work had to be done manually, which required a great amount of time and effort to fix the accounting mistakes.  The price of MuniMae shares dropped an additional 22.416%, to $7.13 per share.  MuniMae disclosed that it spent $54.1 million to complete the restatement.

Shareholders filed multiple lawsuits against MuniMae, alleging violations of federal securities laws.   The district court dismissed the plaintiffs’ Exchange Act claims, holding that the complaint did not adequately plead scienter.

Under § 10(b) of the Exchange Act, a plaintiff must prove six elements: “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.”  To establish the scienter element, a plaintiff must prove that the defendant acted with “a mental state embracing intent to deceive, manipulate, or defraud.”  At the pleading stage, it is sufficient to allege either intentional or severely reckless conduct.  In the § 10(b) context, a reckless act is one that is “so highly unreasonable and such an extreme departure from the standard of ordinary care as to present a danger of misleading the plaintiff to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.”

The Private Securities Litigation Reform Act (“PSLRA”) imposes a heightened pleading standard on fraud allegations in private securities complaints.  “[T]o the extent a plaintiff alleges corporate fraud, the plaintiff must allege facts that support a strong inference of scienter with respect to at least one authorized agent of the corporation.”

The Fourth Circuit agreed with the district court, holding that the allegations did not support a strong inference of wrongful intent.  The Court acknowledged that the allegations permitted an inference that MuniMae knew that the Company was not in compliance with FIN 46R, and knew, or at least suspected, that consolidating the LIHTC Funds in accordance wit FIN 46R would be a difficult and costly undertaking.  Nevertheless, the allegations did not support a strong inference of wrongful intent.  The plaintiffs set forth evidence that MuniMae’s officers and an outside auditor debated how to account for the LIHTC Funds in light of FIN 46R.  However, the Court held that such evidence “does not compel an inference of wrongful intent.”  The Court noted that a more plausible inference is that there was an honest disagreement over the proper application of this challenging new accounting standard.  This was not enough to support an inference of scienter.

The Court viewed MuniMae’s subsequent disclosures to its investors as negating an inference of fraudulent intent.  The Court noted that MuniMae “(1) announced the hiring of an independent consultant to assist with the work of the second restatement, (2) identified the large number of personnel working on the accounting issues, and (3) expressed uncertainty as to the costs of the effort going forward.”  This, in the Court’s view, gave rise to a more compelling inference that MuniMae was attempting “to keep the investing public informed, while working strenuously to correct the accounting errors they had discovered.”  As such, the Court held that the scienter requirement was not sufficiently pled, and affirmed the district court’s dismissal of the claim.

Tags: