Securities Snapshot November 02, 2022

Goodwin Wins Dismissal of Shareholder Derivative Suit for Failure to Allege Demand Was Excused

In This Issue

Goodwin Wins Dismissal of Shareholder Derivative Suit for Failure to Allege Demand Was Excused; District Court of Massachusetts Denies Long-Awaited Motion to Dismiss Securities Class Action; SDNY Denies Motion to Dismiss Indictment of OpenSea’s Former Head of Product; Fifth Circuit Denies Petition for Rehearing of Case Finding That SEC Administrative Proceeding Violated Key Constitutional Rights; SEC Initiates Administrative Proceeding Against Former PwC Audit Partner

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On September 27, 2022, U.S. District Judge Kevin McNulty of the District of New Jersey dismissed a consolidated derivative action allegedly brought on behalf of Cognizant Technology Solutions Corporation against certain current and former Cognizant directors and officers. Plaintiffs asserted claims for breach of fiduciary duty, corporate waste, unjust enrichment, and contribution and indemnification based on Cognizant’s disclosure in 2016 that it had initiated an internal investigation into whether certain payments relating to facilities in India were made improperly and in possible violation of the FCPA, and had voluntarily notified the DOJ and SEC and was cooperating with both agencies.

Plaintiffs filed their lawsuits without first making pre-suit demands on Cognizant’s board of directors, primarily alleging that defendants were liable for breach of fiduciary duty for (1) failing to monitor adequately Cognizant’s FCPA compliance, and (2) acting in bad faith by causing Cognizant to release materially false and misleading public statements that there were no reported incidents of corruption in 2014 and 2015.

After the complaints were consolidated, Cognizant and defendants moved to dismiss the derivative action for, among other things, failing to allege adequately that pre-suit demand on Cognizant’s board was excused. The court agreed with Cognizant and defendants and concluded that plaintiffs failed to allege that any directors faced a substantial likelihood of liability for either failing to monitor adequately Cognizant’s FCPA compliance or acting in bad faith and dismissed the complaint in its entirety.

With respect to plaintiffs’ failure to monitor claim, also known as a Caremark claim, the court found that board materials produced to one of the plaintiffs and incorporated by reference into the complaint showed that the directors “made a good faith effort to implement an oversight system and then monitor it,” satisfying their obligations under Caremark. The court relied in large part on Audit Committee presentations showing that the audit committee regularly received updates on Cognizant’s FCPA compliance and monitoring systems and steps taken by Cognizant management to enhance those systems.

With respect to plaintiffs’ bad faith claim, the court found that all of the directors lacked the requisite scienter because plaintiffs did not adequately allege that any director had learned of any incidents of corruption at the time the allegedly false and misleading public statements were made.

The court also found that plaintiffs failed to allege that any directors faced a substantial likelihood of liability for corporate waste or unjust enrichment. Specifically, the court held that the payment of ordinary compensation to an officer or director only constitutes corporate waste if the officer or director “literally performed no legitimate services,” which the complaint did not allege. Similarly, the court held that plaintiffs’ unjust enrichment claim was duplicative of their breach of fiduciary duty claim and should be dismissed for the same reasons.

District Court of Massachusetts Denies Long-Awaited Motion to Dismiss Securities Class Action

On October 20, 2022, Judge George A. O’Toole of the District of Massachusetts denied Sonus Networks, Inc.’s three-year-pending motion to dismiss allegations that Sonus and certain of its officers violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 by making false statements to investors about the company’s revenue forecast for the first quarter of 2015. The decision to allow this action to proceed comes more than five years after Judge O’Toole dismissed similar allegations against the company, filed on behalf of a different group of investors, in 2017. The current plaintiffs, represented by the same attorneys, were able to get a second bite at the apple by alleging new facts that were not made public until the resolution of an SEC investigation into the same conduct in 2018.

Investors in the current lawsuit filed an amended class action complaint in July 2019, alleging that Sonus made materially false and misleading statements to investors about its expected revenue despite knowing of concerns from its sales team and a $5 million reduction in sales. Specifically, in both a January 8, 2015 and February 18, 2015 press release, Sonus’s CFO Mark Greenquist stated that the company “expected revenue to be approximately $74 million” for the first quarter of 2015, and touted Sonus’s diversified revenue portfolio. Sonus later only reported $50 million in revenue for this quarter, causing Sonus’s stock price to drop by more than 33%. Plaintiffs allege that Sonus knew these statements were false, because they relied on estimated sales forecasts, rather than realistic expected sales.

In 2017, Judge O’Toole dismissed a prior complaint filed by a different group of investors, challenging the same alleged misconduct, for failing to allege facts sufficient to support an inference of scienter, or to demonstrate that the allegedly misleading statements amounted to more than non-actionable puffery. Those deficiencies rendered the earlier complaint “vague as to when the defendants became aware of facts that should have made them aware of the falseness of their optimistic statements.”

By contrast, Judge O’Toole found that the later complaint alleged “specific instances in the months leading up to the February statements that indicate when the defendants became ‘aware of facts that should have made them aware of the falseness of their optimistic statements.’” Plaintiffs were able to sufficiently plead that specific chronology, in large part due to additional facts that were made public as a result of an SEC action involving the same facts, which was resolved by a Commission Order that was entered in 2018. The court also rejected Sonus’s additional argument that the second case was time-barred, noting that nothing in the record suggested that “a reasonably diligent plaintiff, lacking the SEC’s authority and tools, would have discovered the facts later made public in the SEC Order.”

Sonus is a stark reminder that securities litigation often proceeds slowly — and that weak cases (such as the case originally dismissed in 2017) can improve with age as new facts or witnesses surface or, as happened here, the SEC publicly announces a regulatory proceeding involving additional inculpatory allegations that can be readily cut-and-pasted into a long-pending investor action.

SDNY Denies Motion to Dismiss Indictment of OpenSea’s Former Head of Product

On October 21, 2022, Justice Jesse Forman of the Southern District of New York denied non-fungible token (“NFT”) marketplace OpenSea’s former Head of Product, Nathaniel Chastain’s August 19, 2022 motion to dismiss an indictment accusing him of insider trading on OpenSea’s confidential business information. The indictment alleges that Chastain purchased NFTs he had selected to be featured on the website's front page, then sold those NFTs for a profit shortly after they hit the front page and their price went up. Chastain’s indictment is the first-ever insider trading case involving digital assets, exemplifying the government’s continued efforts to apply its securities regulatory framework into the digital space.  

On May 31, 2022, a Grand Jury indicted Chastain on counts of wire fraud and money laundering in connection with this alleged scheme. The government alleged that, as an employee of OpenSea, Chastain used his position to misappropriate OpenSea’s confidential business information, namely, his knowledge of which NFTs were about to be featured on its homepage. The government further alleged that Chastain laundered these purchases and sales through anonymous Ethereum accounts to conceal his involvement in this scheme. Chastain moved to dismiss the indictment on the ground that it failed to allege the requisite elements of these offenses.

With respect to the wire fraud count, Chastain argued that his knowledge of which NFTs he had selected to be on OpenSea’s homepage is not “property” of OpenSea within the meaning of the wire fraud statute because it had no inherent economic value to OpenSea. Chastain also contended that the NFTs are not securities or commodities, and that a wire fraud charge premised on insider trading requires allegations of trading in such assets. Chastain also argued that the indictment failed to allege the concealment element of a money laundering offense because the transactions were conducted on the Ethereum blockchain, which is visible to the public.

In denying his motion to dismiss, the court found the indictment adequately tracked the language of the wire fraud and money laundering statutes, and provided notice of the basics of each charge. The court also rejected Chastain’s argument that there could be no wire fraud because the NFTs he traded were not securities or commodities. Although the government had stated publicly that Chastain was charged with “insider trading,” the court found that the wire fraud statute under which Chastain was charged makes no reference to securities or commodities, unlike section 10(b) of the Securities Exchange Act’s prohibition on insider trading. The court held that at most, “Chastain’s argument suggests that the phrase ‘insider trading’ may be misleading,” but did not warrant dismissal of the indictment. Thus, at least for now, this case will serve as a guide to carve a tunnel in the government’s efforts to curb illegal activity for digital assets.

Fifth Circuit Denies Petition for Rehearing of Case Finding That SEC Administrative Proceeding Violated Key Constitutional Rights

On October 21, 2022, the U.S. Court of Appeals for the Fifth Circuit denied, without opinion, the SEC’s petition for rehearing after the court previously vacated the SEC’s judgment against hedge fund manager George R. Jarkesy Jr. and his adviser company Patriot28 LLC, on the basis that the administrative procedure resulting in the judgment violated the parties’ constitutional rights. By refusing to rehear the previous panel decision, the Fifth Circuit leaves in place recent precedent invalidating an SEC administrative enforcement action as unconstitutional. 

In 2014, the SEC brought an enforcement action against Mr. Jarkesy and Patriot28. The case was presided over by an administrative law judge, who found the evidence sufficient to support the SEC’s allegations of securities fraud, and ordered a civil penalty and disgorgement. Mr. Jarkesy and Patriot28 appealed this decision to the Fifth Circuit, alleging that the administrative hearing conducted by an administrative law judge violated their constitutional right under the Seventh Amendment to a jury trial, and unconstitutionally delegated legislative power to the SEC without sufficient guidance. The Fifth Circuit agreed, and, on May 18, 2022, vacated the SEC’s judgment.

The Fifth Circuit was split ten to six in favor of denying rehearing. Though there was no majority opinion, five justices dissented from the denial of the SEC’s petition for rehearing and argued that (1) Congress permissibly delegated power to the SEC, as it did not delegate any legislative power; and (2) the public rights exception to the seventh amendment’s right to jury trial applied, such that petitioners were not constitutionally guaranteed a right to a jury trial. The dissenting justices expressed concern that “[t]he majority’s decision nullifies provisions Congress determined necessary to enforce the securities laws and calls into question adjudication within the Executive Branch more broadly.”

SEC Initiates Administrative Proceeding Against Former PwC Audit Partner

On October 21, 2022, the SEC announced it was instituting administrative proceedings against Joshua Abrahams, a former PwC Audit Partner, pursuant to Section 4C of the Securities Exchange Act of 1934 and Rule 102(e)(1)(ii) of the SEC’s Rules of Practice, in connection with a material misstatement made by Mattel, Inc. in financial statements reviewed by PwC. Abrahams served as lead engagement partner for Mattel when, in 2019, the company issued a $109 million restatement of its financials and disclosed material weaknesses in internal control over financial reporting that led to the accounting error. It is notable that the SEC is taking issue with the fact that Mattel consulted with its outside audit partner on key hires in the finance group, which consultation is not expressly prohibited by SEC rules. In fact, experienced financial officers typically value feedback from their audit team and thus naturally would consult with their auditors, just like they would solicit feedback from any number of resources, when considering adding talent to the management team.

The SEC alleged that, in connection with his audit work for Mattel, Mr. Abrahams “failed to comply with multiple PCAOB professional standards, including interim review standards, identifying and assessing risks of material misstatement, audit evidence, audit documentation, and due care in the performance of work” when he approved the later restated financials without any discussion of the $109 million valuation error. The SEC also alleged that Mr. Abrahams failed to remain independent and engaged in prohibited human resources services for Mattel, including ranking candidates for management positions. According to the SEC, by providing feedback, the auditor violated AS 1005, which requires an auditor to “maintain an independence in mental attitude.”

Concurrently with the SEC’s proceedings against Abrahams, on October 21, 2022 the SEC also announced that Mattel had agreed to pay $3.5 million to the SEC to settle allegations against the company in connection with its 2019 restatement. According to the SEC, Mattel did not have internal controls related to calculating tax valuation allowance, and the miscalculation was only detected when an anonymous whistleblower tipped the company about accounting errors and the possibility that Mr. Abrahams was not independent. The SEC charged Mattel with violating the negligence-based anti-fraud provisions of the Exchange Act, as well as the reporting, books and records, and internal controls provisions after an internal investigation revealed that the accounting error stemmed from the misclassification of one of the company’s assets that should not have been amortized.


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.

Editorial Board
Jennifer Burns Luz
Jonathan Shapiro

Contributing Authors
Dorothy Hazan
Jordan Benson
Benjamin Halper
Maria Massimo