Key Takeaways

In this edition of Dechert’s Securities & Derivative Litigation Quarterly Update, we:

• Examine the first criminal insider trading prosecution based on a 10b5-1 trading plan;
• Discuss the recent trend of plaintiff relying on short sellers reports in securities class actions;
• And review Cornerstone Research’s analysis of securities class action settlements.

First Criminal Insider Trading Prosecution Based on 10b5-1 Trading Plan

The Department of Justice brought criminal charges for insider trading based exclusively on use of a Rule 10b5-1 trading plan.¹ Rule 10b5-1 allows insiders of publicly traded companies to establish predetermined plans for buying or selling company stock. Although the Securities & Exchange Commission (SEC) has enforced this provision by imposing civil penalties, an indictment issued in March 2023 signals a new route of enforcement: criminal penalties.²

In the indictment, Terren S. Peizer, the CEO and Board Chairman of Ontrak Inc., a publicly traded healthcare company, was charged with one count of engaging in a securities fraud scheme and two counts of securities fraud for insider trading.³ The same day, on the heels of the SEC’s updated amendments to Rule 10b5-1, the SEC announced it would pursue its own prosecution of Peizer in a parallel civil action.⁴

Peizer is accused of engaging in insider trading through the use of trading plans pursuant to 10b5-1.⁵ The charges arise from his alleged avoidance of more than $12 million dollars in losses by entering into Rule 10b5-1 trading plans while in possession of material, nonpublic information concerning the serious risk that Ontrak’s then-largest customer would terminate its contract.⁶ Despite warnings from two brokers, Peizer allegedly refused to accept any “cooling off” period for refraining from trading in the stock following his entry into the plan and instead allegedly began selling shares on the next trading day after establishing each plan.⁷ Following the indictment, Peizer has resigned.⁸

This prosecution signals increased scrutiny of insider trading and suggests that the stakes for employees of public traded companies may be higher than ever.

The Cautionary Tale of Short-Seller Reports in Securities Fraud Class Actions

Despite the inherent unreliability of short-seller reports, U.S. securities fraud plaintiffs continue to attempt to base securities fraud claims on such reports and the nearly inevitable drop in stock price which follows publication.⁹ However, courts are becoming ever more skeptical of plaintiffs’ reliance on short seller reports, particularly when analyzing whether plaintiffs have adequately alleged loss causation or whether allegations based on anonymous witnesses should be discounted.

For example, in In re Nektar Therapeutics Securities Litigation, the Ninth Circuit wrote that “in relying on self-interested and anonymous short-sellers,” plaintiffs must meet a “high bar” for purposes of establishing loss causation.¹⁰ Plaintiff based his claims on assertions by anonymous short sellers in a report published by Plainview LLC that defendants’ statements regarding the effectiveness of its anti-cancer drug failed to disclose that outlier data was included in the average of positive drug results.¹¹ In analyzing defendants’ motion to dismiss, the Circuit held that the Plainview Report does not establish loss causation for the resulting stock price drop.¹² As the Court explained, for purposes of establishing loss causation, a corrective disclosure must reveal new information not already incorporated into the company’s stock price.¹³ This is a difficult hurdle to clear when a short seller bases the assertions in its report on its interpretation or manipulation of publicly available information. As the Nektar Court explained, pleading loss causation in these circumstances is plausible only if the report derived from publicly available information “required extensive and tedious research involving the analysis of far-flung bits and pieces of data.”¹⁴ Even though the Plainview report was deemed to provide new information to the market by pulling “together disparate sources and connected data in ways that were not plainly obvious,” the Court disfavored the fact that the report was “authored by anonymous short-sellers who had a financial incentive to convince others to sell.” Therefore, the Court concluded that “it is not plausible that the market would perceive the Plainview Report as revealing false statements because the nature of the report means that investors would have taken its contents with a healthy grain of salt.”¹⁵

Similarly, the Court in In re DraftKings Inc. Securities Litigation emphasized that when securities fraud complaints use a short seller report as a source for adverse factual allegations, such allegations “must be considered with caution” because the short seller is “an entity with an economic interest in driving down the company’s stock price.”¹⁶ In DraftKings, a report published by Hindenburg Research LLC alleged that DraftKings through its combination with SBTech secretly operated in “black market” jurisdictions where online gambling was illegal and failed to disclose such violations of law to investors.¹⁷ The Court emphasized that Hindenburg’s claims were attributed to unidentified former SBTech employees without specificity or corroboration.¹⁸ Specifically, the Court wrote: “[w]hen plaintiffs’ counsel has not interacted with the unidentified source—and does not even know the source’s name, position, or other attributes tending to bear on the source’s credibility—and instead extracted and pled as true statements from a report by a short seller attributing adverse facts to unidentified persons, these aspects of the complaint, if not corroborated, are fairly discounted or put aside altogether as ill-pled.”¹⁹ Thus, the Court noted that there was an “overarching methodological deficiency” due to reliance on the short seller report and concluded plaintiffs failed to state a claim that DraftKings made false and misleading representations about the company’s failure to disclose violations of foreign law.²⁰

Although we expect plaintiffs will continue to rely on short seller reports to form the basis of their complaints, courts are becoming increasingly skeptical of the reliability of such reports, providing defendants with additional arguments at the pleading stage.

Cornerstone Research Survey of Securities Class Action Settlements

Each year, Cornerstone Research analyzes securities class action settlements from the prior year. This analysis can provide key insights into current and future trends.²¹

In 2022, the median settlement amount ($13 million) was 34% higher than the prior nine-year median.²² The total number of settlements (105 cases) was exceptionally high in 2022 – a 38% increase from the prior nine-year average and the highest in 15 years.²³ 2022 also had the highest number of mega-settlements (those totaling $100 million or more) since 2016.²⁴ By contrast, the percentage of low value settlements (defined as less than $5 million) was at its lowest in almost a decade (23%). As a result, the median size of 2022’s settlements increased. The Report explains that many securities class action settlements involved large issuers, which may account for the above trends.²⁵

Because the number of securities class action case filings from 2021-2022 was relatively small, the Report predicts fewer settlements in coming years.²⁶ However, securities class action filings relating to certain discrete areas have become more prominent. For example, the Report notes the rise of SPAC-related, COVID-19, and cryptocurrency-related securities class action filings, which comprised a large percentage of all “core federal filings in 2020-2022.” Cornerstone anticipates that these filings will materialize in more settlements down the road. For reference, 70% of 2022’s securities class action settlements were filed between 2018 and 2020. Accordingly, the crypto, SPAC, and COVID-19 cases may hit their settlement-apex in the coming two or three years. Lastly, although the number of settlements with parallel SEC proceedings currently remains low, that trend could reverse given the large number of SEC actions filed in 2022 (up 28% from 2021).²⁷

Footnotes:

1. See Press Release, Department of Justice, Office of Public Affairs, CEO of Publicly Traded Health Care Company Charged for Insider Trading Scheme: First Insider Trading Prosecution Based Exclusively on Use of 10b5-1 Trading Plans (Mar. 1, 2023), https://www.justice.gov/opa/pr/ceo-publicly-traded-health-care-company-charged-insider-trading-scheme.
2. See Indictment, US v. Peizer, No. 2:23-cr-00089-DSF (C.D. Cal. Jan. 2023), ECF No. 1.
3. Id. 1:19-20; 15:1-2..
4. Compl., SEC v. Peizer, No. 2:23-cv-01511 (C.D. Cal. 2023).
5. Id. 13:3-20.
6. Id. 7:21; 13:3-20.
7. Id. 8:16-28; 9:1-4.
8. See Kannaki Deka, Reuters, Ontrak CEO Peizer resigns after being charged for insider trading (Mar. 3, 2023), https://www.reuters.com/business/healthcare-pharmaceuticals/ontrak-ceo-peizer-resigns-after-being-charged-insider-trading-2023-03-03/; See Ord. Modif. Conds. of Release, US v. Peizer, No. 2:23-cr-00089-DSF (C.D. Cal. Jan. 2023), ECF No. 14.
9. For example, the recent Hindenburg-Adani incident not only demonstrates the extent to which short sellers can drastically impact the stock price of companies through the publication of a damaging report, but also reveals that this may happen even if there is still an ongoing debate regarding the veracity of the report’s claims. On January 24, 2023, Hindenburg Research, an activist short selling investment research firm published a report titled “Adani Group How The World’s 3rd Richest Man Is Pulling The Largest Con In Corporate History.” Adani Group: How The World’s 3rd Richest Man Is Pulling The Largest Con In Corporate History, Hindenburg Research (Mar. 31, 2023), https://hindenburgresearch.com/adani/. The findings summarized by Hindenburg after a two-year investigation accused Adani Group, a $218 billion Indian conglomerate of engaging “in a brazen stock manipulation and accounting fraud scheme over the course of decades.” Id. Further, the report alleges that key Adani companies have sky-high valuations and substantial debt. Id. Although the Adani Group denied the veracity of Hindenburg’s allegations, the group’s main seven stocks suffered losses over $65 billion by January 30, 2023 and $100 billion by February 2, 2023. Sakshi Dayal, Adani Group reels after report from U.S. short-seller Hindenburg, Reuters (Feb. 10, 2023) https://www.reuters.com/markets/adani-group-reels-after-report-us-short-seller-hindenburg-2023-02-10/. India’s Supreme Court then “appointed a five-member panel to investigate the allegations” with the report to be provided within a month from now. BBC, Gautam Adani: India Supreme Court sets up panel to probe Adani fraud allegation, BBC NEWS (Mar. 2, 2023), https://www.bbc.com/news/world-asia-india-64820716.
10. In re Nektar Therapeutics Sec. Litig., 34 F.4th 828, 839-40 (9th Cir. 2022).
11. Id. at 834.
12. Id. at 840.
13. Id. at 839.
14. Id. at 839.
15. Id. at 840 (internal quotations and citations omitted).
16. In re DraftKings Inc. Sec. Litig., No. 21 CIV. 5739 (PAE), 2023 WL 145591, at *18 (S.D.N.Y. Jan. 10, 2023).
17. Id. at *19, *22.
18. Id. at *19, *22
19. Id. at *19
20. Id. at *1, *20.
21. Cornerstone Research, Securities Class Action Settlements – 2022 Review and Analysis (the “Report”), available at https://www.cornerstone.com/wp-content/uploads/2022/03/Securities-Class-Action-Settlements-2021-Review-and-Analysis.pdf.
22. Id. at 4.
23. Id. at 6.
24. Id.
25. Id. at 2.
26. Id.
27. Cornerstone Research, SEC Enforcement Activity: Public Companies and Subsidiaries at 1, available at https://www.cornerstone.com/wp-content/uploads/2022/11/SEC-Enforcement-Activity-FY2022-Update.pdf..