A lawsuit alleging that an underwriter participated in a scheme to subvert Nasdaq’s listing requirements failed to allege scienter. The Second Circuit appeals court agreed with the Southern District of New York that further amendment would be futile because even if the plaintiffs met procedural requirements to bring in new evidence, that evidence did not support a strong inference that the underwriter acted with scienter. Indeed, the plaintiffs’ own allegations that the issuer lied to the underwriter about the shares’ validity gave rise to a competing inference that the underwriter was unaware of the problem (Malik v. Network 1 Financial Securities, Inc., February 15, 2022, per curiam).
Case and posture. The class-action lawsuit alleged that Network 1 Financial Securities, as the lead underwriter for a Reg A+ offering by Longfin Corp., facilitated the transfer of a large number of Longfin shares to insiders, without consideration, in order to meet the one-million-share minimum for listing on Nasdaq. The Southern District of New York initially denied Network 1’s motion to dismiss, finding that while a close question, the first amended complaint had sufficiently alleged scienter. On reconsideration, though, and with the benefit now of a second amended complaint, the court did not think the plaintiffs’ allegations of scienter were as cogent or compelling as the inference that Longfin lied to Network 1. On three separate occasions, Network 1 asked for, and received, assurance that the additional shares had been paid for.
The plaintiffs appealed the district court’s scheduling order that permitted only limited amendment of the complaint, as well as a denial of a subsequent motion for leave to file a third amended complaint, which the plaintiffs said compounded the first error. In denying the request for further amendment, the district court concluded that purported new evidence would not alter its conclusion about scienter.
On appeal, the parties disputed whether the plaintiffs properly requested leave to amend or whether the additional allegations were “newly discovered” or had been available before the deadline for amendment. The Second Circuit did not need to reach these issues, however, because even considering all additional allegations in the proposed third amended complaint, the district court correctly concluded that further amendment would be futile.
Scienter. Network 1 correctly pointed out that the Nasdaq rules impose no separate duty on an underwriter to guarantee a company satisfies the listing criteria. However, when a defendant is an alleged co-participant in a manipulative scheme, it can be held liable for a primary violation of Section 10(b) and Rule 10b-5. This securities fraud claim must state with particularity facts giving rise to a strong inference of scienter, which in the Second Circuit means either motive and opportunity or strong circumstantial evidence of conscious misbehavior or recklessness.
The plaintiffs fell short of meeting these pleading requirements. While financial gain weighs heavily in favor of a scienter inference, it is not sufficient to allege goals shared by virtually all corporate insiders. In the third amended complaint, the plaintiffs added new motive allegations that Network 1 negotiated an increase in fees because it sought larger commissions on the funds Longfin raised in the Reg A+ offering. The appeals court concluded that Network 1’s performance of its duty as underwriter, and negotiation of higher fees for doing so, was insufficient to support scienter through motive.
Having failed to demonstrate motive and opportunity, the plaintiffs only open avenue was to show conscious misbehavior or negligence, but the new motive allegations did not meet this requirement either. As the district court explained, much of the supposed new evidence to support the allegations that Network 1 knew that Longfin did not meet Nasdaq’s listing requirements in fact had no relation to Network 1, such as Longfin’s general ledger and a record of wire transfers to and from a Longfin escrow account.
As to the remaining evidence, the third amended complaint did not allege that Longfin’s Control Log indicated that listed individuals were corporate insiders. The plaintiffs’ assertions that Network 1 should have known those people were insiders because they appeared as “lock-up” parties in the underwriting agreement sounded in negligence, at best. Similarly, although the third amended complaint alleged that the escrow and bank account records showed that none of the additional shares were paid for, it wasn’t clear that these were the same records provided to Network 1 after the underwriter requested documentation.
Furthermore, there were plausible opposing inferences to be drawn from the complaint’s allegations that Network 1 asked for confirmation of payment, received bank statements in response, and was “falsely” told by Longfin’s CEO that the shares had been paid for. As the district court observed, those allegations suggested that Network 1 did not know the shares were issued for no consideration.
The case is No. 20-2948.
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