Second Circuit Vacates In Part Decision To Dismiss Putative Securities Class Action Against Tobacco And Cannabis Company For Alleged Failure To Disclose SEC Investigation
On May 24, 2022, the United States Court of Appeals for the Second Circuit affirmed and vacated in part the district court’s dismissal of claims under Sections 10(b) and 20(a) of the Securities Exchange Act (the “Exchange Act”) and Rule 10b-5 thereunder against a company that genetically engineers tobacco and cannabis products (the “Company”) and two of its former officers. Noto, et al. v. 22nd Century Group Inc. et al., No. 21-347 (2d Cir. May 24, 2022). Plaintiffs alleged the Company engaged in an illegal stock promotion scheme by paying authors to write promotional articles about the Company without revealing that the Company paid for the articles, and further failed to disclose an SEC investigation into the Company’s alleged financial control weaknesses. The Court affirmed the district court’s order granting defendant’s motion to dismiss in part, holding that plaintiffs did not adequately plead a claim that the Company violated the Exchange Act by failing to disclose that it paid for the articles, but vacated the district court’s dismissal of claims related to the SEC investigation and remanded for further proceedings.
The amended complaint (the “Complaint”) alleged that upon appointing a new CEO in 2015, the Company hired a consulting firm to handle its investor relations. Plaintiffs’ Confidential Witness 1 (“CW1”), who was allegedly the CEO’s executive assistant from January 2016 to February 2018, purportedly stated that he observed the CEO approve the Company’s press releases, that the CEO told him he was “working behind the scenes” to prop up the Company’s stock price, and that the Company paid writers to publish positive articles about the prospects for the Company’s stock and that he was “sure” the CEO “reviewed, edited, and/or approved the paid stock promotion articles.”
The Complaint also alleged that the Company disclosed in certain of its 2015 and 2016 SEC filings that its internal controls over financial reporting were “not effective” and that “material weaknesses existed,” but noted that it was undergoing remediation efforts. In its Form 10-Q for the second quarter of 2018, the Company allegedly stated that it had “completed the implementation and testing of a remediation plan.” According to plaintiffs, Confidential Witness 2 (“CW2”), allegedly an accounting manager at the Company, stated that the SEC was investigating the Company when he was hired in 2016, that the investigation continued throughout 2016, and that by the time he left in 2019, he had not seen any statement from the SEC formally closing the investigation. The Complaint further alleged that the CFO met with the SEC in 2016, and allegedly told CW2 that he feared the investigation could cost him his CPA license or lead to imprisonment. On July 16, 2018, the SEC received a non-public Freedom of Information Act (“FOIA”) request seeking all documents related to its investigation of the company from January 1, 2016, through July 16, 2018, which, according to plaintiffs, was denied by a FOIA officer under an exemption that authorized the withholding of records “compiled for law enforcement purposes” if they “could reasonably be expected to interfere with enforcement proceedings.”
According to the Complaint, in February and October 2018, an online commentator posted articles making statements about the alleged paid stock promotion scheme, the FOIA request denial, and the SEC investigation, allegedly causing the Company’s stock price to fall. On October 25, the Company issued a press release saying the articles were “highly deceptive” and that the Company “had not received any notice of, and the Company has no knowledge of, any enforcement proceeding against it.” On July 26, 2019, the Company announced that its CEO had resigned for “personal reasons,” and the Company’s CFO resigned on December 3, 2019. Plaintiff investors filed an amended class action complaint in November 2019, which the district court dismissed in its entirety with prejudice in January 2021.
The Second Circuit rejected plaintiffs’ argument that defendants had a duty to disclose that the Company allegedly paid authors of promotional articles, holding that “only an article’s maker, not its benefactor, has a duty to disclose that it was paid for.” Citing the Supreme Court’s decision in Janus Capital Group v. First Derivative Traders, the Court found that the Complaint merely alleged that the CEO reviewed and approved the Company’s press releases, which were then repeated by the promotional articles, which “[did] not qualify [the CEO] as the ‘maker’ of the separate article’s statements.” The Court further found that even if the CEO had provided some input on the content of the articles, “the complaint made no sufficient factual allegation that the articles were published by anyone except the authors or that the authors lacked sufficient control over the articles’ contents.” The Court similarly noted there was no allegation that the press releases were false or misleading. The Court also affirmed the district court’s holding that plaintiffs failed to allege that the Company violated Rule 10b-5(a) and (c) by illegally manipulating the market through its stock promotion scheme, emphasizing that the Complaint did not allege that the market was manipulated by information in the articles or through payments to the authors.
The Court next turned to plaintiffs’ allegations related to the SEC investigation. The Court agreed with plaintiffs’ argument that defendants had a duty to disclose the investigation because their disclosures of certain financial control weaknesses were rendered misleading by failing to also disclose the ongoing investigation. The Court held that the alleged omission was material because “the fact of the SEC investigation would directly bear on the reasonable investor’s assessment of the severity of the reported accounting weaknesses.” The Court stated that the Company “specifically noted the deficiencies and that they were working on the problem, then stated they had solved the issue,” and added that the Company’s public denial of the SEC investigation further indicated that the nondisclosure was material.