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Tenth Circuit Affirms Dismissal of Short Seller Claims for Failure to Allege Reliance and Clarifies Standard for “Manipulative” Acts Under Exchange Act
October 21, 2024 Download PDF
On October 15, the Tenth Circuit issued an opinion in In re Overstock Securities Litigation, which affirmed dismissal of class action claims by a short seller under the Exchange Act for failure to allege reliance, and, as a matter of first impression in the Circuit, held that a corporate transaction that artificially increases the company’s share price is not “manipulative” under the Act absent evidence that the defendants acted with intent to deceive investors.[1]
Background
Section 10(b) of the Securities Exchange Act broadly prohibits deception in connection with the purchase or sale of securities. SEC Rule 10b-5(b) forbids “making any untrue statement of a material fact.”[2] To state a claim for misstatements under Rule 10b-5(b), a plaintiff must sufficiently allege, among other elements, that the plaintiff relied on the misleading statements and suffered damages because of its reliance.[3] Additionally, Rule 10b-5(a) and (c) prohibit manipulative acts in connection with the purchase or sale of securities.[4]
In this case, a short seller brought a putative class action against Overstock and certain former Overstock executives, alleging that they made false and misleading statements about Overstock’s performance, risk controls, and dividend strategy, and that Overstock manipulated the market by inducing an artificial “short squeeze.”[5] During the relevant period, Overstock had significant short interest, with more than half of shares outstanding sold short.[6] According to the complaint, Overstock’s CEO devised a plan to squeeze those short sellers in order to artificially inflate Overstock’s share price.[7] Specifically, Overstock announced that it would issue a dividend in the form of a blockchain-based digital security token that would not be registered with the SEC.[8] Because the token was unregistered, it could not be transferred for six months after issuance.[9] That was problematic for short sellers who had borrowed Overstock shares to place their short positions, and were contractually obligated to transmit any dividends to the brokers that lent them the shares.[10] The announcement of the unregistered dividend forced the short sellers to buy new Overstock shares and close their short positions before the dividend’s record date in order to avoid breaching their lending contracts.[11] This forced buying increased the share price, enabling the CEO to sell his shares at a significant profit before departing the company.[12] The CEO made various public statements prior to the record date of the dividend explaining that the transaction was “designed . . . carefully” to cause a short squeeze.[13]
The District Court for the District of Utah granted defendants’ motion to dismiss, finding that plaintiffs had failed to plead reliance on the alleged misstatements or that defendants acted with scienter.[14]
The Overstock Decision
Beginning by addressing plaintiff’s Rule 10b-5(b) claim for allegedly false or misleading statements, the Tenth Circuit held that plaintiff failed to plausibly allege the necessary element of reliance.[15] The court explained that an Exchange Act plaintiff may plausibly allege reliance either by showing actual reliance on the defendant’s misrepresentation, or by invoking the “fraud-on-the-market” presumption of reliance under the Supreme Court’s decision in Basic Inc. v. Levinson, 485 U.S. 224 (1988).[16] Although plaintiff in Overstock invoked the Basic presumption to plead reliance, defendants successfully “rebutted the presumption with statements in Plaintiff’s complaint” because “Plaintiff admitted that Overstock’s looming crypto dividend—not the [allegedly false] retail statements or the fairness of Overstock’s market price—caused it to buy its Overstock stock.”[17] The court found that plaintiff’s own allegations conceded that it and the other short sellers would have purchased shares to cover their short positions no matter the price.[18] While plaintiff argued that the “fraud-on-the-market” presumption could not be rebutted prior to discovery, the Tenth Circuit explained that no authority supported that position, and plaintiff’s own binding “judicial admissions” doomed its claim.[19] The court reasoned that “Plaintiff cannot have it both ways: if Plaintiff bought its shares to avoid breaching its lending contracts, it cannot also have bought its shares because of Defendant's alleged misstatements.”[20]
As to plaintiff’s Rule 10b-5(a) and (c) claims for market manipulation, the Tenth Circuit adopted the Second Circuit’s approach in Set Capital LLC v. Credit Suisse Group AG, 996 F.3d 64 (2d Cir. 2021), and held that “an open-market transaction may qualify as manipulative conduct, but only if accompanied by plausibly alleged deception.”[21] The court reasoned that acting in a manner that results in an artificial price is not enough on its own to constitute manipulative conduct.[22] Rather, Section 10(b) only “prohibits practices that are manipulative in the ‘technical sense of artificially affecting market activity in order to mislead investors.’”[23] The Tenth Circuit explained that because defendants made truthful disclosures about the planned dividend transaction in advance of the record date, including that the dividend would be of unregistered securities and thus not available for resale for a period after distribution, the necessary element of deception was missing from plaintiff’s allegations.[24] Based on those disclosures, the court concluded that “the market received notice that short sellers might buy Overstock stock to cover their positions before the dividend’s record date,” and thus investors possessed “sufficient information to form judgments about how Overstock’s dividend would impact Overstock's share price[.]”[25] Accordingly, plaintiff failed to allege that Overstock deceived investors as to the value of its securities.[26]
Implications
This decision has potential implications for securities class actions brought by short sellers and other investors with distinctive motives for transacting in a company’s stock. While securities plaintiffs typically invoke the fraud-on-the-market presumption to plead reliance, the Overstock decision suggests that short sellers may not always be entitled to that presumption. Although the Tenth Circuit made clear that it was not adopting a blanket rule barring short sellers from invoking the presumption,[27] companies defending against securities class actions led by short sellers may succeed in rebutting the presumption at the pleadings stage if the complaint itself alleges that short sellers’ investment decisions were motivated by reasons other than the challenged public statements. And even if the complaint lacks such admissions, defendants may wish to use discovery to establish short seller plaintiffs’ distinct motivations to argue that they are inadequate representatives at the class certification stage.
Likewise, the decision underscores that courts may carefully assess the entirety of investors’ factual allegations to determine whether they constitute binding concessions that negate one of the necessary elements of a securities fraud claim. For example, a plaintiff may plead itself out of court by attributing a share price decline to a particular event that a court determines is not causally related to the alleged fraud, thereby conceding the necessary element of loss causation.
Finally, the Tenth Circuit’s decision provides further clarity on the pleading standards for a market manipulation claim under Rule 10b-5(a) and (c). Surveying market manipulation cases from sister circuits, the Tenth Circuit made clear that a claim for market manipulation is dependent on allegations of deceit. Thus, regardless of whether a transaction is designed to “artificially” inflate a company’s share price, there can be no valid claim of market manipulation if adequate information about a planned transaction is disclosed to the market, such that the market can understand the likely impact of the transaction on the share price.
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[1] In re Overstock Sec. Litig., --- F.4th ----, 2024 WL 4489593 (10th Cir. 2024).
[2] 17 C.F.R. § 240.10b-5(b).
[3] In re Overstock, 2024 WL 4489593 at *6.
[4] Id. at *8; see also 17 C.F.R. § 240.10b-5(a), (c).
[5] In re Overstock, 2024 WL 4489593 at *1–5.
[6] Id. at *3.
[7] Id.
[8] Id.
[9] Id.
[10] Id.
[11] Id.
[12] Id. at *4–5.
[13] Id. at *4.
[14] See In re Overstock Sec. Litig., 2021 WL 4267920, at *6–14 (D. Utah Sept. 20, 2021).
[15] In re Overstock, 2024 WL 4489593 at *6.
[16] Id. at *7.
[17] Id.
[18] Id.
[19] Id.
[20] Id.
[21] Id. at *8.
[22] Id. at *9.
[23] Id. (quoting Santa Fe Indus. v. Green, 430 U.S. 462, 476–77 (1977)).
[24] Id. at *9–10.
[25] Id. at *10.
[26] Id.
[27] Id. at *7 n.21.