Southern District Of New York Grants Motion To Dismiss Securities Fraud Claims Against Cannabis Company, Holding Plaintiffs Failed To Overcome Jurisdictional Limitations
Securities Litigation
This links to the home page
  • Southern District Of New York Grants Motion To Dismiss Securities Fraud Claims Against Cannabis Company, Holding Plaintiffs Failed To Overcome Jurisdictional Limitations

    On August 30, 2021, Judge Lewis A. Kaplan of the Southern District of New York granted a motion to dismiss a claim under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 thereunder against a cannabis company (“Company”), its senior secured lender (“Financing Company”), and certain executives at both companies.  In re iAnthus Capital Holdings Inc. Securities Litigation, 1:20-cv-03135 (S.D.N.Y. Aug. 30, 2021).  Plaintiffs, in consolidated purported class actions and an individual action brought by a shareholder, alleged the Company failed to disclose the nature of its relationship with the Financing Company, which allegedly obtained approximately half of the equity of the Company after the Company defaulted on its loan.  The Court granted defendants’ motion to dismiss plaintiffs’ first amended class action complaint (“Amended Complaint”), holding that plaintiffs failed to allege their transactions with the Company satisfied the jurisdictional limitations of the Exchange Act established by the Supreme Court in Morrison v. Nat’l Australia Bank Ltd., 561 U.S. 247, 267 (2010).  The Court permitted plaintiffs to move for leave to further amend.

    The Company is a Canadian cannabis corporation whose shares are listed on the Canadian Stock Exchange (“CSE”).  The Company operates cultivation and dispensary facilities in the United States, and its shares trade over-the-counter (“OTC”) in the U.S. on the OTCQX, which is part of the OTC Markets Group.  According to the Amended Complaint, on April 6, 2020, the Company announced that it had defaulted on a debt to the Financial Company, which is the Company’s senior secured lender and largest source of financing.  The Company later announced that its CEO had accepted an interest-free loan from the Financing Company.  Shortly thereafter, the Company allegedly negotiated a restructuring support agreement (the “Restructuring Transaction”) with the Financing Company, which would result in the Financing Company obtaining “almost half of the equity” in the Company in exchange for reducing the Company’s debt and providing additional financing, allegedly leaving other equity holders with “only fractions” of their investments.  The Restructuring Transaction was approved by the Supreme Court of British Colombia in October 2020. 

    Plaintiffs alleged that defendants “fail[ed] to disclose information regarding [the Company’s] relationship with [the Financing Company] and certain terms governing financing provided by [the Financing Company].”  Plaintiffs further alleged that these facts caused the Company to default on its loans to the Financing Company which positioned it to take over the Company following the default.

    Under Morrison, the Exchange Act’s application is limited to “transactions in securities listed on domestic exchanges and domestic transactions in other securities.”  While plaintiffs did not contend that the CSE is “domestic,” they contended the OTCQX qualified as a “domestic exchange.”  The Court disagreed, holding that the SEC’s implementing regulations limit “exchange” to “an organization, association, or group of persons who (1) bring ‘together the orders for securities of multiple buyers and sellers’ and (2) use ‘established, non-discretionary methods . . . under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.’”  In contrast, the OTC markets “are not national securities exchanges within the scope of Morrison,” because the Exchange Act refers to securities exchanges and OTC markets separately, “which suggests that one is not inclusive of the other” and, moreover, the phrase “a national securities exchange” is listed in Section 10(b) to the “exclusion of the OTC markets.”  Separately, the Court rejected plaintiffs’ argument that the Exchange Act applied because the Company’s securities traded through OTC Link, which is registered with the SEC, because OTC link is registered as an “alternative trading system,” which is “separately regulated by the SEC and is specifically exempt from the Exchange Act’s definition of ‘exchange.’”  Therefore, as explained by the Court, because neither the CSE nor the OTCQX qualify as domestic exchanges, the alleged transactions did not qualify under Morrison’s first prong.

    The Court turned next to Morrison’s second “domestic transaction” prong, observing that a transaction is domestic if “the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed within the United States.”  The Court noted that conclusory assertions as to irrevocable liability or passage of title are insufficient, and the location or residency of the parties to the transaction “will not necessarily establish the situs of the transaction.”  Instead, “plaintiffs must allege specific facts ‘including, but not limited to, facts concerning the formation of the contracts, the placement of purchase orders, the passing of title, or the exchange of money.’”  Moreover, the allegations must relate to the “‘transactions themselves’ and not merely the ‘actions needed to carry out the transactions.’”  In analyzing the Amended Complaint’s allegations, the Court determined that there were three different transactions at issue:  (i) lead plaintiff’s purchase of shares of the Company’s common stock, (ii) the Company’s largest shareholder’s conversion of shares of common stock through a transaction between the Company and a biopharmaceutical corporation, and (iii) the same shareholder’s purchase of a convertible debenture from the Company.

    First, with respect to lead plaintiff’s alleged stock purchases, the Court found that plaintiff listed these transactions in a Certification filed with the Court, but “[did] not otherwise indicate where or how any of those transactions were made.”  Although lead plaintiff listed those transactions under the Company’s ticker symbol for the OTCQX market, the Court highlighted that “listing [those] transactions under that symbol . . . [did not mean] that those transactions occurred through the OTCQX market.”  Rather, the Court found that “[a]t most, [plaintiff’s] allegations support an inference that [they] purchased shares that trade also in the United States over-the-counter market,” which is “plainly insufficient to allege a domestic transaction.”  Moreover, even if lead plaintiff purchased the stock through a U.S. OTC market, “the mere assertion that transactions took place in the United States is insufficient to plead a domestic transaction,” because it “does not indicate where the parties to that transaction incurred irrevocable liability or where title passed.”  Instead, lead plaintiff was required to make specific allegations concerning the location of the transactions and the structure of the transactions, including “facts concerning the formation of the contracts, the placement of orders, the passing of title[,] . . . the exchange of money or other detail sufficient to discern . . . the situs of over the counter transactions.”  The Court took note of lead plaintiff’s declaration that he purchased the common stock through his U.S. brokerage account which he had no discretion to revoke or cancel while he was in Louisiana, but found that these facts were not alleged in the Amended Complaint and were not properly before the Court.

    Second, concerning the alleged acquisition by plaintiff shareholder of Company shares through a stock conversion, the Court found that “[g]enerally, the acquisition of shares through a merger of foreign entities is not a domestic transaction.”  Indeed, the pleadings failed to allege “that the parties to the merger incurred irrevocable liability in the United States,” and “the only alleged connection between the transaction and the United States” was plaintiff shareholder’s “assertion that its ownership of [the Company’s] stock was ‘memorialized’ in Direct Registration Certificates sent to [plaintiff] in the United States.”  Accordingly, the Court held that delivery of these certificates to the U.S. was insufficient to establish that the transaction itself or the passage of title occurred in the United States.  Further, the Court disagreed with individual plaintiff’s assertion that its acquisition of the Company’s shares was a domestic transaction because its Conversion Notice was executed in the U.S.  In particular, the Court found that, even assuming that the Conversion Notice was incorporated by reference in the Amended Complaint, “it is not indicative of a domestic transaction,” because “the Conversion Notice does not indicate that it was executed in the United States, and the Court cannot properly rely on [plaintiff’s] assertions in its opposition brief to establish otherwise.”  Moreover, the Court did not find the Conversion Notice to be relevant to individual plaintiff’s stock acquisition because it did not allege “that its execution of the Conversion Notice created irrevocable liability for that transaction nor could it, as the transaction at issue was between” the Company and the biopharmaceutical company, and not individual plaintiff.

    Third, the Court turned to the issue of individual plaintiff’s alleged debenture purchase.  Although the Amended Complaint did not allege where the purchase occurred, plaintiff argued that the debenture was a domestic transaction because its terms indicated that title passed in the United States.  The Court disagreed, finding that the Company’s acknowledgment that it promised to make payments to the shareholder at its U.S. address “merely reflected [the Company’s] agreement to repay the principal on the debenture [at that address],” which was “entirely irrelevant to the passage of title” to the debenture.  Moreover, according to the Court, the fact that the terms and conditions attached to the debenture required individual plaintiff to send any notices or communications to the Company’s office in the United States was “[e]qually unpersuasive,” because it merely “indicate[d] that [the Company] operated in the United States.”  The Court maintained that “a party’s residence or location is not indicative of where a transaction occurs.”  Consequently, the Court dismissed the Exchange Act claims, holding that plaintiffs failed to allege “a transaction in securities traded on a domestic exchange or a domestic transaction.”

    Finally, the Court considered individual plaintiff’s request for the Court to exercise supplemental jurisdiction over its common law claims.  Noting that the balance of factors points toward declining supplemental jurisdiction where all federal-law claims are eliminated before trial, the Court declined to exercise supplemental jurisdiction.  The Court gave weight to the fact that  individual plaintiff had filed a related law suit in Canada and the debenture was governed by Canadian law, and held that adjudicating the common law claims in federal court would be inefficient for the parties and the Court.  The Court, however, permitted plaintiffs to move for leave to file proposed second amended complaints.
    CATEGORIES: Exchange ActJurisdiction