On February 18, 2022, the U.S. Court of Appeals for the Eleventh Circuit reversed the dismissal of an investor class action accusing the now-defunct cryptocurrency marketplace BitConnect and its online promotions team of operating a Ponzi scheme.
The plaintiffs, buyers of the BitConnect coins, alleged that BitConnect’s “promoters” were liable under Section 12 of the Securities Act of 1933 for soliciting the purchase of unregistered securities. Specifically, plaintiffs asserted that BitConnect used a “multilevel marketing” structure to incentivize successive sets of investors to draw in new rounds of recruits. The promoters allegedly informed investors that they could earn outsized returns by buying and holding BitConnect coins, touting BitConnect’s “staking” program where investors could earn up to 10% interest per month just for holding their BitConnect coin in their virtual wallet, and also BitConnect’s “lending” program where investors lent their coins to Bitconnect which would then trade the coins for profit. Investors were promised daily fixed interest earnings through these programs, as well as monthly 40% interest. The promoters then encouraged others to sign up for BitConnect, and some investors became promoters themselves, as “[a] share of each investment would then pass on to the recruit’s promoter, her promoter’s promoter, and so on.”
Plaintiffs alleged that the promoters were integral to the alleged Ponzi scheme’s operation. The promoters allegedly created and posted thousands of videos about investing “that always ended with a pitch for BitConnect.” The promotional videos allegedly received millions of views and resulted in substantial investments in BitConnect which peaked at $10 million per week. The investors alleged that the gains they were promised and the purported “returns” the investors received did not actually reflect growth in BitConnect’s value or the traders’ ability to beat the market in the BitConnect lending program, but instead were simply payments from the proceeds received from new investors who were promised similar gains. This alleged scheme collapsed when state regulators issued cease and desist orders after BitConnect attempted to launch another cryptocurrency, BitConnectx. The value of the BitConnect coin subsequently plummeted to 40 cents – a 99.9% drop in value from the start of the year.
The United States District Court for the Southern District of Florida originally dismissed plaintiffs’ complaint, reasoning that the promoters’ videos did not “directly communicate” with the plaintiffs. The court held that plaintiffs failed to allege the promoters had urged or persuaded them “individually” to purchase BitConnect coins. Because plaintiffs’ complaint was based upon their interactions with the promoters’ “publicly available content,” the district court concluded that their complaint failed to state a Section 12 claim.
On appeal, the Eleventh Circuit disagreed. The court emphasized that the Securities Act prohibits a person from using “any means” to sell an unregistered security, and there was no evidence Congress intended such communications to be personal or individualized. The court further observed that neither historic definitions of the word “solicitation” nor prior case law required solicitation to be targeted to a particular person. Therefore, the court held that although technology has created new means for companies to communicate with potential investors, urging people to buy BitConnect coins in online videos was “merely a new way of doing an old thing,” that is, solicitation through mass communications. Because of the Eleventh Circuit’s decision, the case will proceed in the Southern District of Florida.
Federal Court of Appeals Dismisses Leading Fannie Mae and Freddie Mac Shareholder Lawsuits
On February 22, 2022, the U.S. Court of Appeals for the Federal Circuit affirmed in part and reversed in part a decision from the United States Court of Federal Claims (Federal Claims Court), holding that, although the lower court was correct in dismissing shareholders’ direct claims, it improperly failed to dismiss the remaining derivative claims.
Plaintiffs, shareholders of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), challenged the government’s multibillion-dollar “net worth sweep” of the two mortgage companies in 2012. After the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship in September 2008, the FHFA negotiated preferred stock purchase agreements (PSPAs) with the Department of Treasury (Treasury). Under the terms of the PSPAs, the Treasury agreed to allow Fannie Mae and Freddie Mac to draw up to $100 billion in capital in exchange for: (1) senior preferred non-voting stock having quarterly fixed-rate dividends and an initial liquidation preference of $1 billion; and (2) warrants to purchase up to 79.9% of the common stock of Fannie Mae and Freddie Mac at a nominal price. The FHFA and Treasury subsequently amended the terms of the original PSPAs to replace the fixed-rate dividend formula with a variable formula requiring Fannie Mae and Freddie Mac to make quarterly payments equal to their entire net worth, minus a small capital reserve amount. This “net worth sweep” caused Freddie Mac to transfer most of their equity to the Treasury, allegedly leaving no residual value that could be distributed to shareholders.
The plaintiff-shareholders filed complaints with the Federal Claims Court, alleging: (1) the FHFA violated the Fifth Amendment’s Taking Clause by taking shareholder equity without just compensation; (2) the FHFA breached its fiduciary duties by entering into the net worth sweep; and (3) the FHFA, Fannie Mae and Freddie Mac breached an implied contract (with shareholders as the intended third-party beneficiaries) by agreeing to the net worth sweep. Andrew T. Barrett, an individual shareholder, separately asserted derivative claims on behalf of Fannie Mae and Freddie Mac alleging similar takings, breach of fiduciary duty and breach of contract claims. The Federal Claims Court dismissed the shareholders’ directly pled claims, but did not dismiss the derivatively pled allegations.
The Federal Circuit agreed with the lower court concerning the direct claims, holding that the claims related to injuries to Fannie Mae and Freddie Mac rather than the shareholders individually. The court further affirmed the Federal Claims Court’s dismissal of the breach of duty and contract claims, holding that the FHFA did not owe Fannie Mae or Freddie Mac fiduciary duties because the FHFA is authorized to act in ways that “[are] not designed to benefit” Fannie Mae, Freddie Mac or their shareholders. The court also determined that the FHFA, Fannie Mae and Freddie Mac did not enter into an implied contract to benefit shareholders.
With respect to the derivative claims, the Federal Circuit held that it was erroneous to allow the claims to proceed on collateral estoppel grounds, reasoning that the breach of contract and fiduciary duty derivative claims had been disposed of in two earlier cases. With respect to the Fifth Amendment derivative claim, the Federal Circuit concluded that Congress gave the FHFA “very broad authority, as conservator, to act in ways that are not in the best interests of [Fannie Mae and Freddie Mac],” and investors had “[no] expectation that the FHFA would protect their interests and not dilute their equity.” The Federal Circuit’s decision resolves eight different appeals from the Federal Claims Court concerning the net worth sweep.
NY Seeks Blockchain Analytics to Combat Sanctions Evasion
On March 2, 2022, New York Governor Kathy Hochul announced actions to strengthen the Department of Financial Services’ (DFS) enforcement of sanctions against Russia, including expedited procurement of additional blockchain analytics technology. The tools will enhance DFS’ ability to detect exposure among DFS-licensed virtual currency businesses to Russian individuals, banks and other entities that the Biden Administration has sanctioned. Superintendent of Financial Services Adrienne A. Harris said, “[w]e know that bad actors will try to evade sanctions through the transmission of virtual currency, which is why it is imperative that we have the ability to monitor transactions and exposure in real-time. We continue to coordinate closely with federal and other state regulators and communicate with our regulated entities to ensure the full weight of our regulatory regime is brought to bear in the fight to protect Ukraine.” Cryptocurrency has also been used to raise funds to support Ukraine’s government and its military.
Delaware Chancery Court Allows Cannabis Company Shareholder Class Action to Advance
On February 28, 2022, the Delaware Court of Chancery denied in part a motion to dismiss an investor class action arising out of a January 2021 merger between Left Coast Ventures, Inc. (Left Coast), a cultivator and distributor of cannabis products, and TPCO Holding Corp. (TPCO), a SPAC entity of Subversive Capital, which would combine Left Coast and another cannabis company under the TPCO umbrella.
The plaintiffs, former Left Coast stockholders and optionholders, challenged the fairness of the merger in a March 2021 lawsuit, alleging that defendants Fireman Capital Partners LLC (Fireman Capital), Fireman Capital Partners III, L.P. (Fireman Capital III, and together with Fireman Capital, Fireman), Bassler Co Corp. (Bassler), Crocket Resources S.A. (Crocket), along with individual director defendants (the Directors), diverted material consideration from Left Coast stockholders through improper side transactions. In April 2021, Fireman and the Directors filed motions to dismiss, arguing that plaintiffs lacked standing because all claims were derivative, and in the alternative, that the plaintiffs failed to properly plead their claims.
The court first analyzed whether plaintiffs’ claims were direct or derivative, explaining that a derivative claim is one in which a corporation’s stockholders would recover pro rata in proportion with their ownership of the corporation’s stock (i.e., that the injury was to the corporation), as opposed to a direct claim, in which the duty breached was owed to the individual stockholder. The court also noted that a stockholder does not lose standing to challenge a merger after the merger is complete, if the challenge is based on the fairness of the merger itself. As a rule, for a claim involving a side transaction to be a direct claim: (1) the side transaction must have diverted merger consideration from stockholders, rather than from the acquirer; (2) the diversion must have been improper (i.e., as a result of defendants’ misconduct); and (3) the diversion must have materially affected the merger’s process or price, calling the merger’s fairness or validity into question.
The court first held that plaintiffs’ breach of fiduciary claim was a direct claim, finding the alleged side transactions engaged in by Fireman and the Directors diverted assets the stockholder plaintiffs otherwise would have received, and that those assets were material. The court credited plaintiffs’ allegations that Fireman Capital threatened to block the merger if the Directors did not approve favorable amendments to the deal, which allegedly diverted approximately $40 million of the approximately $120 to $130 million total merger consideration, which the court noted was material. The court likewise concluded that Fireman Capital was a controller, and thus had fiduciary duties to the plaintiffs, because it held debt and a Class B proxy that would have allowed it to exercise 83% of the Company’s outstanding voting power, even though it was technically a creditor, not a traditional stockholder. The court held that Fireman Capital’s procurement of the favorable amendments triggered entire fairness review, and directed the parties to confer on supplemental briefing to address whether the entire fairness review should apply to the whole merger or just to the amendments.
The court likewise concluded that plaintiffs’ tortious interference claim was also a direct claim, reasoning that defendants’ misconduct allegedly rendered options held by optionholders worthless, and the benefit of any recovery would run to individual optionholders rather than the company. The court dismissed this claim, however, holding that the plaintiffs had not alleged the reasonable probability of a business opportunity, as the pleading lacked detailed facts to quantify the expectancy. The court found that a “mere hope” of an upside on option contracts is too uncertain to support reasonable probability of a business opportunity.
The court finally held that both of plaintiffs’ civil conspiracy claims were also direct claims, as they were premised on the direct harm stated in the breach of fiduciary duty and the tortious interference claims. As to the civil conspiracy claim based on the fiduciary duty claim, the court denied the motion to dismiss, holding that plaintiffs adequately pleaded that these entities participated in unlawful acts in furtherance of the conspiracy, causing actual damage. The court also noted that “knowing participation” is not a required element of civil conspiracy and denied the motion to dismiss on this basis as well. The court, however, dismissed the civil conspiracy claim premised on the tortious interference claim, as the plaintiffs failed to adequately plead the underlying claim for tortious interference. The court ordered the parties to submit a stipulated implementing order by March 21, 2022, and to confer on a stipulated briefing schedule as to the scope of Fireman Capital’s entire fairness burden.
SDNY Denies Application for Mootness Fee in Connection with Merger-Disclosure Litigation
On February 7, 2022, the Southern District of New York rejected plaintiff’s counsel’s request for attorney’s fees and expenses in a shareholder litigation in connection with an April 2021 merger between Nuance Communications, Inc. (Nuance) and Microsoft Corporation (Microsoft). The plaintiff, a shareholder of Nuance, filed a complaint on May 26, 2021, alleging violations of Sections 14(a) and 20(a) of the Exchange Act for failure to include material information regarding financial metrics and research analysts’ price targets in a proxy statement’s disclosures. On June 8, 2021, Nuance then filed a Schedule 14A with the Securities and Exchange Commission (the SEC), which clarified a nondisclosure agreement between Nuance and Microsoft, and provided more information about a financial analysis regarding the merger shortly before the merger was approved.
On August 20, 2021, plaintiff’s counsel moved for attorney’s fees and expenses, claiming that even though the claims were now moot in light of Nuance’s disclosure, the litigation had conferred a substantial benefit on Nuance shareholders by causing Nuance to issue supplemental disclosures. The district court concluded that there was a causal connection between the litigation and the supplemental disclosures, but held that there was no substantial benefit conferred on Nuance shareholders via the supplemental disclosures. First, while the supplemental disclosures included underlying valuation metrics, their disclosure is not required by law – investors are entitled only to the “fair summary” of the underlying bases for a financial advisor’s fairness opinion. Second, while the supplemental disclosures included additional price targets, this information was already publicly available and did not alter the “total mix” of information initially available which had provided a fair summary of the analyst’s work even before the supplemental disclosures. For these reasons and due to the mootness of the underlying claims, the court denied plaintiff’s counsel’s motion for attorney’s fees and expenses and dismissed the action.
Lawyers in Goodwin’s Securities and Shareholder Litigation and White Collar Defense practices have extensive experience before U.S. federal and state courts, legislative bodies and regulatory and enforcement agencies. We continually monitor notable developments in these venues to prepare the Securities Snapshot — a bi-weekly compilation of securities litigation news delivered to subscribers via email. This publication summarizes news from the civil and criminal securities law arenas in a succinct, digestible format. Topics covered include litigation and enforcement matters, legislation, rulemaking, and interpretive guidance from regulatory agencies.
Charles A. Brown
Meghan K. Spillane
Charles A. BrownPartner
Meghan K. SpillanePartner
Viktors M. DindzansAssociate