On September 29, 2022, U.S. District Judge Edgardo Ramos of the Southern District of New York dismissed a putative securities class action against Plug Power Inc. and certain of its officers, who were represented by Goodwin in the litigation. Plaintiff brought suit after the company issued a restatement of previously issued financial statements due to errors in accounting. Although a restatement may be viewed as an acknowledgment of a prior material error, the decision confirms that a restatement alone is insufficient to plead securities fraud.
In its complaint, plaintiff alleged that statements about the company’s financials that were restated constituted securities fraud under Sections 10(b) and 20(a) and Rule 10b-5 of the Securities Exchange Act of 1934. Specifically, plaintiff claimed that the company misclassified certain fuel delivery expenses as research and development expenses by an aggregate of $80.7 million between 2016 and 2020, in order to, among other things, raise capital in a secondary offering, attract a particular investment and partnership opportunity, and allow its officers to sell their shares at an inflated price. In a well-reasoned, 39-page decision, the court adopted all of defendants’ arguments why the case must be dismissed because plaintiff failed to meet its burden under the Exchange Act to plead scienter.
The court flatly rejected plaintiff’s theory that defendants had the “motive and opportunity” to commit fraud. First, the court dismissed plaintiff’s allegations that defendants were motivated to misclassify certain expenses to help the company close a financing as it was too generic to state a fraud claim, i.e., the allegations “suggest nothing more than the ordinary motives possessed by virtually all corporate insiders.” Plaintiff’s theory that defendants were motivated to attract a specific investment and partnership opportunity also failed because that claim was not supported by the necessary allegations that the misclassification had any particular impact on the counterparty’s decision to invest in and partner with the company — nor could those allegations ever be made because the counterparty closed the transaction after the company restated the financials to disclose the misclassification error. And the court rejected plaintiff’s claim that the officers’ stock sales established scienter because the trades were not “unusual or suspicious” in amount or timing, nor unusual when compared to the officers’ prior trading, and also because the trades were undertaken pursuant to Rule 10b5-1 plans.
The court also ruled that plaintiff failed to plead that defendants engaged in conscious misconduct, or acted with extreme recklessness, when misclassifying the expenses in their financial statements. It placed significant weight on the company’s explanation of the errors in the restated financials, including that the mistake was identified during an audit, that the misclassification was not the product of any evasion of internal controls or similar misconduct, and that the accounting treatment for the expenses was itself complex and technical and called for substantial judgment under GAAP. The court also rejected plaintiffs’ additional theory that defendants’ failure to provide adjusted EBITDA guidance was further evidence of scienter because the company was not required to disclose that information. Finally, the court brushed aside the remainder of plaintiff’s allegations as simply generic to state any actual fraud claims — including boilerplate allegations that the company “knew or should have known” it had misclassified the expenses given the magnitude of the impact on gross income, that the alleged expenses concerned the company’s “core operations,” and that the top officers — like officers at every public company — signed Sarbanes-Oxley certifications.
SEC Chief Accountant Provides Guidance to Auditors When Conducting Fraud Investigations
On October 11, 2022, SEC Acting Chief Accountant Paul Munter issued a statement emphasizing the role and responsibility of independent auditors in preventing and detecting fraud. Munter reiterated his September 6, 2022 statement, in which he warned issuers and accounting firms to expect investigations and potential enforcement actions if they do not maintain auditing independence. It also comes in the wake of several SEC enforcement actions against auditors this year, including a $1.9 million penalty paid by CohnReznick LLP to resolve SEC charges that the firm’s “auditing deficiencies caused misleading disclosures by two clients prior to their bankruptcies and delistings.”
Munter reminded auditors that under existing Public Company Accounting Oversight Board (“PCAOB”) auditing standards, auditors “have a responsibility to consider fraud and to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by fraud or error.” “When considering materiality, auditors should not assume that even small intentional misstatements in the financial statements are immaterial.” Under the PCAOB standards, auditors are further required to “exercise due professional care,” “avoid exhibiting bias,” and carefully evaluate whether information gathered throughout the audit is suggestive of fraud.
Munter identified three areas where auditors should exercise particular care. First, PCAOB standards require audit firms to “establish a system of quality control,” which includes setting the right tone at the top and having personnel management policies in place that assign the right personnel with the necessary competencies to the job. Second, auditors must exercise “professional skepticism,” i.e., to “be skeptical of evidence provided by management when the timing or manner in which such evidence is produced is questionable,” and to bring in specialists as necessary and appropriate to identify or respond to fraud risks. Munter flagged improper revenue recognition and intentional misstatement of accounting estimates as two areas most frequently related to fraudulent schemes, and warned auditors that “a broad sweeping identified risk of ‘fraudulent revenue recognition’ is most likely insufficient for auditors to be able to design an effective audit response to address the risk.” Finally, Munter included several reminders about good practices for auditors, including comparing publicly-available information against information received from management, thoroughly assessing issuers’ entity-level controls, meaningfully evaluating issuers’ codes of ethics, and considering issuers’ processes for receiving and addressing formal complaints related to accounting and auditing matters.
Founder of Nikola Corp. Found Guilty of Securities Fraud
On October 14, 2022, a federal jury in the Southern District of New York found Trevor Milton, founder and former CEO of electric and hydrogen fuel cell company Nikola Corporation, guilty on one count of securities fraud and two counts of wire fraud. Milton’s conviction, for which he faces a maximum prison sentence of 20 years for the most serious charge, serves as a stark reminder of the potential consequences of making false statements about a company’s product and development to investors. As U.S. Attorney Damian Williams stated after the verdict was released: “Let this case serve as a warning to anyone who plays fast and loose with the truth to get investors to part with their money. It won’t end well.”
As Milton’s indictment alleges, Milton made “false and misleading statements directly to the investing public through social media and television, print, and podcast interviews.” Specifically, Nikola allegedly made false and misleading statements that: (1) the company had early success in creating a “fully functioning” semi-truck prototype when Milton knew the prototype was inoperable; (2) Nikola had engineered and built an electric- and hydrogen-powered pickup truck from the “ground up” using Nikola’s parts and technology, when Milton knew that was not true; (3) Nikola was producing hydrogen and was doing so at a reduced cost, when Milton knew that no hydrogen was being produced at all by Nikola, at any cost; (4) Nikola had developed batteries and other important components in-house, when Milton knew that Nikola was acquiring those parts from third parties; and (5) reservations made for the future delivery of Nikola’s semi-trucks were binding orders representing billions in revenue, when the vast majority of orders could be cancelled at any time and were for a truck Nikola had no intent to produce in the near-term.
Nikola was previously the subject of an SEC investigation into whether it defrauded investors by making misleading statements about its products, technical capacity, and business prospects; the investigation ultimately resulted in a $125 million settlement in December 2021.
Tennessee Court Dismisses Scheme Liability Claims in Terminix Investors Suit
On October 6, 2022, Judge S. Thomas Anderson of the Western District of Tennessee dismissed a putative securities “scheme liability” class action against Terminix Global Holdings, Inc. This dismissal is significant because the court refused to allow plaintiffs to repackage their failed misrepresentation claim as a “scheme” claim without pleading additional facts to establish the scheme. Plaintiffs’ complaint alleged that Terminix and certain of its officers violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 by concealing adverse business facts, including damage claims arising from Terminix’s alleged violations of state consumer protection laws, which were the subject of multiple state termite litigation claims in Alabama stemming from a report by that state’s attorney general on the company’s alleged violations. Plaintiffs alleged that Terminix concealed the increasing Alabama termite litigation claims and the resultant impact on the company’s financial results. In the amended complaint, plaintiffs asserted a misrepresentation theory under Rule 10b-5(b), and a scheme liability theory under Rule 10b-5(a) and (c). The court previously dismissed plaintiffs’ misrepresentation theory under Rule 10b-5(b), holding that, while some of defendants’ statements could plausibly have been misleading, the complaint did not allege a strong inference of scienter.
In its October 6, 2022 opinion, the court again dismissed the misrepresentation claims, and extended its ruling to dismiss the alternative scheme liability theory. The court explained that it already considered the same scienter allegations in connection with plaintiffs’ misrepresentation claims, and “there was no meaningful distinction between [plaintiff’s] misrepresentation theory and the scheme liability theory.” The court noted that while the Sixth Circuit has not yet defined the elements of scheme liability under Rule 10b-5, the Second and Ninth Circuits have made clear that “scheme liability” claims that are based upon alleged misrepresentations may only proceed if the complaint pleads an unlawful scheme separate and apart from the misrepresentations. For this reason, the court again dismissed the complaint because plaintiffs failed to plead any illegal “scheme” distinct from their already-dismissed “misrepresentation” allegations that the issuer failed to fully disclose its contingent regulatory liabilities.
Musk-Twitter Deal to Go Forward Even as New Allegations of Twitter Document Destruction Emerge
Elon Musk’s dispute with Twitter took another twist on October 3, 2022 when Musk (again) publicly offered to purchase Twitter at its original price in a letter to Twitter management and an SEC filing. On the same day, however, Musk’s counsel filed a separate letter with Chancellor Kathleen McCormick. This letter alleged that Twitter ordered its former security chief turned whistleblower, Peiter “Mudge” Zatko, to destroy records related to the security issues Musk cited as the reason for previously calling off his $44 billion deal to acquire Twitter. Twitter responded with an October 6 letter informing the court that Musk still had not produced correspondence related to ongoing federal investigations into his conduct in connection with the proposed Twitter deal.
Amid numerous discovery disputes and Musk’s repeated motions to amend his counterclaims, Musk’s renewed commitment to the deal of course signals a potential cessation in hostilities, leading Chancellor McCormick to stay the epic court case until October 28, 2022 to give the parties some time to close the transaction. Of course, given the history and the continued exchange of hostile lawyer letters, the parties are plainly prepared to resume litigation if the deal does not close — with Musk likely to pursue sanctions against Twitter for its alleged destruction of evidence, and Twitter likely to press its demands for the discovery Musk has withheld.
Meanwhile, Musk has been named in another lawsuit, this one filed by angry Twitter investors who claim that Musk’s on-and-off-again approach to the Twitter deal is itself a calculated ploy to drive down the company’s stock price and allow him to re-trade the deal at a discount. The securities class action complaint in Pampena v. Musk (N.D. Cal., filed Oct. 10, 2022) claims that Musk has already succeeded with this strategy, having tanked Twitter’s stock price such that stockholders sold at depressed prices, while also irreparably diminishing the reputation of the business, and thus its value. The complaint characterizes Musk’s latest commitment to close at the original price as an admission that “he had been bluffing all along.” Unlike Twitter’s lawsuit, which seeks equitable relief in the form of consummation of the acquisition, the plaintiffs in Pampena seek damages incurred by investors as a result of Musk’s alleged misconduct.
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.