On January 6, 2023, Judge John L. Sinatra, Jr. of the United States District Court for the Western District of New York denied a motion to dismiss claims against a cannabis and tobacco engineering company (the “Company”) alleging that the Company failed to disclose an investigation by the United States Securities and Exchange Commission (“SEC”) in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934.
Noto v. 22nd Century Group Inc., No. 1:19-cv-01285, 2023 WL 122305 (W.D.N.Y. Jan. 6, 2023). Following a January 2021 dismissal of the complaint, and the Second Circuit’s reversal of that decision (in a decision covered
here), the Company again moved to dismiss plaintiffs’ claims. The Court denied the Company’s motion and permitted plaintiffs’ Section 10(b) and 20(a) claims to proceed.
Plaintiffs alleged that the Company and its former executives concealed that the SEC was investigating a material weakness in the Company’s internal accounting practices. Throughout 2016, the Company executed multiple stock offerings to raise cash by diluting the interests of existing shareholders. Around the same time, the Company allegedly acknowledged in SEC filings that issues in the Company’s accounting practices had occurred but had been remedied. Plaintiffs alleged that because none of the SEC filings included information about the investigation, the filings were misleading and designed to inflate stock prices. During this time, the Company allegedly executed multiple stock offerings to raise cash. The Company’s stock prices allegedly dropped when, two years later, short seller reports anonymously authored by the Company’s former CEO revealed the existence of the investigation. In response to these reports, the Company issued two press releases denying knowledge of any SEC enforcement proceedings. These press releases allegedly were false because, according to confidential witnesses who allegedly spoke with senior Company officials, the Company knew about the investigation at the time. The Company argued, among other things, that the complaint should be dismissed on remand from the Second Circuit for failure to allege scienter and loss causation.
To survive dismissal, a complaint must plead facts giving rise to a strong inference of scienter, which a plaintiff can do either by alleging facts showing that defendants had both motive and opportunity to commit fraud or strong circumstantial evidence of conscious misbehavior or recklessness. Plaintiffs acknowledged that the prospect of higher bonus payments for the executive defendants was not a sufficient basis to allege motive to commit fraud and that the parties’ dispute centered on whether “bolster[ing] capital acquisition through a specific stock offering is a concrete benefit sufficient to allege motive.” The Court also acknowledged a prior district court decision that held that these sorts of allegations were not a sufficient basis to allege a motive to commit fraud because “a desire to raise much needed capital” is too generalized to support an inference of scienter. However, the Court found more relevant a Second Circuit decision holding that such allegations might be sufficient when defendants “arguably ‘acted in the belief that they could somewhat reduce the degree of dilution by artificially enhancing the price of the stock.’” As to the Company’s arguments that the disclosures made about the accounting weaknesses evinced a lack of intent, including because the Company executives believed those disclosures were consistent with what was legally required, the Court held that those arguments were better left to summary judgment. Accordingly, the Court held that the complaint sufficiently alleged a motive to commit fraud for alleged misstatements that preceded the stock offerings.
However, the Court held that the complaint did not sufficiently allege motive as to the allegedly misleading denials of an SEC investigation that were made
after the stock offerings. As to those alleged misstatements, the Court held that scienter was sufficiently alleged on theories of recklessness and conscious misbehavior. This is because, according to the Court, the complaint sufficiently alleged that Company executives knew or had access to information indicating the statements were false. The Court also held that the investigation denials were alleged to have been made to “placate the market,” which the Court held further supported an allegation that Company executives consciously disregarded signs that the statements were false. And the Court noted that an inference of scienter was further supported by allegations that the Company knew that the short seller reports had been authored by its former CEO but omitted to disclose this fact to avoid giving the reports more credit.
Finally, the Court found that plaintiffs sufficiently alleged loss causation because reports showed that the Company’s stock fell after the investigation was revealed, not before. In reaching this conclusion, the Court held that it would not take judicial notice of intraday trading information showing that the Company’s stock price declined ahead of the short seller reports because plaintiffs sufficiently raised a dispute about the accuracy of the information. Here again, the Court held that the issue was better left for summary judgment.
