Southern District Of New York Dismisses Putative Class Action Against Cannabis Company For Failure To Allege Scienter
On September 27, 2021, Judge Paul Crotty of the United States District Court for the Southern District of New York dismissed a putative class action asserting claims under the Securities Exchange Act of 1934 against a cannabis company and its CEO and CFO. Kasilingam v. Tilray, Inc., No. 20-CV-03459 (PAC), 2021 WL 4429788 (S.D.N.Y. Sept. 27, 2021). Plaintiffs alleged defendants made material misrepresentations that inflated the company’s stock price ahead of a planned share exchange. The Court held that plaintiffs failed to adequately allege scienter and dismissed the action but granted plaintiffs leave to amend to attempt to cure the deficiencies in their complaint.
The claims arose out of the allegation that the company’s CEO and his investment group had worked to maintain control of the company while structuring an ability to monetize part of their investment. Id. at *2. To do so, they allegedly orchestrated a share exchange and “downstream merger” with the investment group. Id. Plaintiffs alleged that defendants made two types of misrepresentations to prop up the company’s share price in advance of the share exchange. The first concerned the value of a co-marketing agreement with a brand management company, the value of which was eventually impaired and which plaintiffs alleged defendants characterized positively even though they “quickly realized [it] was worth far less than [they] had paid for it.” Id. at *3-4. The second related to misrepresentations that allegedly overvalued inventory and understated labor costs. Id. at *4-5.
The Court first assessed plaintiffs’ claim that their allegations that the CEO was motivated to inflate the company’s stock price to facilitate the share exchange established a strong inference of scienter through “motive and opportunity.” Because plaintiffs had not alleged that the CEO or his investment company sold any stock during the relevant period, however, or otherwise received any direct benefit from the scheme, the Court rejected that claim. Id. at *7. In fact, the Court noted, plaintiffs’ “own pleadings suggest that among those most harmed by the natural and intentional consequences of this purported scheme was the schemer himself,” and that when a “purported fraudster ‘miss[es] the boat this dramatically,’ or in this case, opts to go down with the ship, the fraud inference is weakened.” Id. Ultimately, the Court concluded that the inference of scienter, while plausible, was not strong and was outweighed by other competing inferences suggested by the complaint, including of “errant, but genuine, optimism” or negligence. Id. at *8. The Court also rejected plaintiffs’ allegations of motive for the CFO, who was not alleged to have been part of the CEO’s investment group and instead was alleged in “conclusory fashion” only to have knowledge and intent to deceive “by virtue of his position,” which without more was not enough to plead scienter. Id. at *8‑9.
The Court further rejected plaintiffs’ scienter allegations under a theory of “conscious misbehavior or recklessness.” The Court explained that the allegations relied on “the fundamental premise that [d]efendants either knew or should have known their statements were false,” which plaintiffs failed to establish through factual allegations. Id. at *10. While plaintiffs argued that defendants made misleadingly optimistic statements about the co-marketing agreement despite knowing “almost instantly” that the agreement was “effectively worthless to the company,” the Court emphasized that there were no factual allegations showing that defendants did not sincerely believe that the agreement would be valuable or that favorable regulatory developments might occur in the future to increase the value of the agreement. Id. at *10–11. The Court also rejected plaintiffs’ theory that the company’s eventual decision to recognize an impairment relating to the co-marketing agreement due to regulatory uncertainty showed that earlier optimistic statements were fraudulent or that defendants were reckless in not sufficiently monitoring related information. Id. at *11. The Court held that this theory amounted to impermissible “fraud by hindsight” and that “being wrong—even embarrassingly so—is not the same as being dishonest.” Id.
The Court also held that plaintiffs failed to support an inference of “conscious misbehavior or recklessness” with respect to challenged statements that allegedly overvalued the company’s inventory and understated labor costs. For these assertions, plaintiffs relied on confidential witness allegations that the Court determined to be “vague” and “insufficiently particular” to satisfy the heightened pleading standard of the PSLRA. Id. at *12. The Court observed that the allegation that a former employee objected to how labor costs were accounted for and was overruled by senior management simply amounted to a disagreement among staff about accounting protocols. Similarly, while plaintiffs asserted that the company overvalued inventory based on the “vague and conclusory assertions” of two mid-level employees, the Court observed that these allegations merely amounted to “discord among [company] staff” and there was no allegation that these employees even spoke to one of the individual defendants. Id. at *12. Moreover, the Court emphasized that the inventory-related claims were “built atop the faulty premise that the Amended Complaint establishes that [d]efendants knew, or should have known, that much of their inventory was worthless,” which had not actually been shown, and that the fact that the company later reduced its inventory valuation failed to show that the “failure to do so earlier was fraudulent.” Id. at *13.
Because plaintiffs failed to adequately alleged scienter with respect to the individual defendants and asserted no “specific corporate scienter allegations” independent of their claims against the CEO and CFO, the Court also concluded that plaintiffs failed to allege that the company acted with corporate scienter. Id.