Monday, April 12, 2021

Investment bank’s ‘head-scratching’ conflict of interest was most likely oversight, not fraud

By Lene Powell, J.D.

The Ninth Circuit upheld the dismissal of a fraud action against an investment bank, finding a lack of scienter. A three-judge panel found it implausible that the bank knowingly engaged in a conflict of interest that did not earn it higher fees and likely strained its relationship with an issuer client. The more likely explanation for a puzzling turn of events, in which an analyst at the bank issued a recommendation to buy a stock at $7 and the bank announced that evening that it would act as the placing agent for an offering of the same stock at $6, was that the conflict had simply slipped past the bank’s compliance systems (Prodanova v. H.C. Wainwright & Co., April 8, 2021, Lee, K.).

Recommendation and offering. H.C. Wainwright & Co. (HCW) is a specialty investment bank. Under FINRA rules, HCW maintains information barriers between its investment banking and research departments designed to ensure that research analysts are insulated from "review, pressure or oversight" by persons engaged in investment banking services activities. HCW also maintains a compliance department to identify and manage conflicts of interest between the research and investment banking groups.

On October 10, 2017, a strange sequence of events transpired involving the stock of MannKind Corporation, a small but publicly traded biopharmaceuticals company, with which HCW has had a long relationship. Early that morning, an HCW investment analyst released an enthusiastic report about MannKind’s only FDA-approved drug product, including a "buy" recommendation at $7 per share. The stock’s price surged 26 percent that day, with a trading volume of over 48 million shares. Then, at nine o’clock at night, MannKind announced a registered direct offering of over 10 million shares of common stock at $6 per share. MannKind revealed that HCW would serve as the exclusive placement agent for the offering and would receive a cash fee of 5 percent of the offering’s aggregate gross proceeds. The next day, MannKind’s stock price declined 18 percent.

A MannKind stockholder and an investment fund brought securities fraud claims, alleging that HCW, its CEO, and the report’s author had issued the report in order to fraudulently inflate the price of MannKind shares before the offering. The district court dismissed the suit, finding that the plaintiffs had adequately shown falsity but not scienter.

Embarrassing error, not fraud. The Ninth Circuit panel affirmed the decision of the district court, agreeing that scienter was not shown. First, the panel rejected the plaintiffs’ theories of motive as unpersuasive and "divorced from common experience." The plaintiffs had argued that HCW published the positive report to drive up MannKind’s stock price and increase its own compensation, or at least to ensure a profitable offering.

But this didn’t add up, said the panel. MannKind raised almost $61 million in the offering, so HCW earned a little over $3 million, equaling 5 percent of the gross proceeds. The plaintiffs did not explain how issuing the report with a higher share price recommendation would affect the gross proceeds, which in turn affected compensation. In other words, HCW would have received the same compensation for a $61 million offering, no matter if the share price was $6 or $7.

Further, the panel concluded that HCW actually stood to lose, not gain, if it engaged in the alleged fraud. HCW’s apparent snafu in issuing a $7 target price in a report just before a dilutive offering of $6 per share likely strained its longstanding relationship with MannKind. The risk of losing a longtime client and sullying its own reputation far outweighed the benefit of a slightly higher return on one transaction. And there were no facts to show that the offering would not have sold out but for the report, especially given an FDA announcement approving MannKind’s drug just a week before the offering, said the panel.

"Indeed, the only plausible explanation for HCW’s action is that someone there pulled a Bill Buckner and somehow let a glaring conflict pass by. Its conduct is more like an embarrassing Red Sox error than an elaborate Black Sox fraud," wrote the panel.

No individual scienter shown. Moving from the big picture to individual allegations, the panel found that the plaintiffs failed to allege facts with sufficient particularity to support a strong inference of scienter for any defendants. The complaint did not plead that the report’s author knew about the offering when he wrote the report, or that the information barriers between the research and investment banking departments had been breached in some specific way.

The complaint asked the court to conclude that there must have been a breach due to assumed knowledge on the part of the CEO and COO: that because they were the primary contact between the research and investment groups, they must have known about specific information in the report, including the $7 price target and the timing of the MannKind offering. But these generalized allegations did not show that they had direct involvement in writing or publishing the report, said the panel.

The complaint also pointed the finger at the compliance department as a whole, arguing that someone must have approved the report despite knowing about the offering. But the evidence did not show this, and the panel declined to draw this conclusion. Witnesses could only attest that general industry practices existed such as maintaining a "watch list" and that HCW generally adhered to these practices. A standard FINRA disclaimer in the report that HCW would seek compensation from companies in the report within three months did not add to the inference of scienter, especially since there were two companies mentioned in the report.

Finally, the panel rejected arguments under the core operations theory and a failure to correct the report. Neither the Ninth Circuit nor the Supreme Court has recognized a duty to correct, and even if there such a duty, there were no particularized allegations to show any defendant acted with scienter in concealing information. Viewed holistically, there was simply not evidence to add up to a strong inference of scienter, said the panel.

Because the dismissal of the fraud claims was affirmed, the dismissal of control person claims was affirmed as well.

The case is No. 19-56048.