By John Filar Atwood
A judge in the Southern District of New York has dismissed, with leave to amend, 1934 Act Section 16(b) claims against multiple defendants on the grounds that the plaintiff did not plausibly allege that the defendants constituted a “group” subject to Section 16(b) liability. Among other things, the plaintiff misapplied the safe harbor of Rule 13d-5, and parallel investments made under a typical securities purchase agreement, along with the involvement of a single lead investor, were not sufficient to raise a plausible inference that a group was formed. The judge acknowledged the existence of waiver and consent agreements between the parties but ruled that without additional allegations of cooperation, communication, or meetings about the transactions, the agreements did not give rise to a group (Augenbaum v. Anson Investments Master Fund LP, March 30, 2023, Marrero, V.).
The plaintiff is a shareholder of Genius Brands International, Inc., which in March 2020 entered into a securities purchase agreement with the defendants in order to raise capital. The agreement was negotiated by a single lead investor on behalf of the defendants. Under the agreement, Genius Brands sold $13.75 million of senior convertible notes, which came with warrants to purchase 65.5 million Genuis Brands common shares.
As an inducement for the defendants to enter into the securities purchase agreement, Genius Brands entered into a voting agreement with company shareholders that owned 40 percent of the outstanding common shares, and a lock-up agreement with those shareholders which barred them from selling their common shares for one year and 90 days following the closing date. None of the defendants was a party to either the voting agreement or the lock-up agreement.
In June 2020, each of the defendants separately entered into a conversion agreement with Genius Brands requiring each defendant to pay off the promissory notes and to convert the convertible notes into common shares. It further required Genius Brands to file a registration statement with the SEC covering the resale of the shares issuable upon conversion.
The conversion agreement included a leak-out agreement, which restricted each defendant from selling common shares obtained through conversion or exercise of the warrants for a price below $2.00 per share for a 30-day period. The registration statement that Genius Brands filed with the SEC was declared effective on July 6, 2020, which caused the leak-out agreement to be effective through and including August 5, 2020.
Beginning on May 15, 2020, prior to the June filing of a prospectus with the SEC that registered the common shares owned by the defendants, the defendants sold common shares for more than $1.00 per share through the cashless exercise of warrants. In addition, from July 8, 2020, through July 20, 2020, more than 318 million shares of common shares were traded at prices greater than the $2.00 per share limit contained in the leak-out agreement. The sales followed the release of information from Genius Brands about improvements in its business prospects, including that it might be acquired by Disney or Netflix.
Section 16(b) claims. The plaintiff filed a complaint under Section 16(b) which aims to prevent the unfair use of information by a statutory “insider” to benefit through the purchase and sale of securities. To state a claim under Section 16(b), a plaintiff must allege that there was a purchase and a sale of securities by an officer or director of the issuer or by a shareholder who is the beneficial owner more than 10 percent of any one class of the issuer’s securities within a six-month period. A beneficial owner can include a group that agrees to act together to hold, buy, or sell securities.
The plaintiff alleged that the defendants constitute a “group” for purposes of Section 16(b) liability, but the defendants moved to dismiss on the grounds that he failed to plausibly allege that they are a group within the meaning of Section 13(d)(3). The court agreed that the plaintiff did not plausibly allege the existence of a “group” subject to liability pursuant to Section 16(b).
The plaintiff initially relied on the “safe harbor” of Rule 13d-5(b)(2) to allege that the defendants engaged in group activity because their conduct does not meet the criteria enumerated thereunder to be exempted from being considered a “group.” The court determined that in this instance the safe harbor provision is misapplied.
Contrary to the plaintiff’s contention, the court stated, the safe harbor provision determines whether a collective of specific individuals or entities that constitute a group would otherwise be exempt from being considered a “beneficial owner” and therefore exempt from liability. The provision assumes that a group already exists for the purposes of applying the rule, the court said, thereby rendering immaterial the determination of whether the defendants’ conduct falls within or outside the bounds of the safe harbor.
Parallel investments. The plaintiff also argued that the defendants constitute a group because they purchased securities together pursuant to the securities purchase agreement with one defendant acting as lead investor. Relying on Litzler v. CC Investments, LDC, the defendants argued that allegations that they engaged in parallel conduct with respect to the transaction and appointed a lead draftsperson do not raise a plausible inference of a “group.” The court agreed that the parallel investments made pursuant to a typical securities purchase agreement, along with the involvement of a single lead investor, are not sufficient to raise a plausible inference that a group was formed.
The plaintiff countered by citing Schaffer ex rel. Lasersight Inc. v. CC Investments, LDC, in which the court found a group where the members engaged in “concerted activity... over an extensive period of months and through a number of transactions.” The court said that the amended allegations in Schaffer set forth well-pleaded allegations of concerted activity that would give rise to a group, but that no such allegations of “act[ing] together,” or collective agreement, written or otherwise, can be found in this complaint.
Third-party beneficiaries. As further support for the notion that the defendants constituted a group, the plaintiff alleged that the defendants were the intended third-party beneficiaries of the voting and lock-up agreements. The plaintiff cited Wellman v. Dickinson in arguing that the defendants being non-parties to the agreements does not dismantle the “group” allegation as concerted activity “need not be expressly memorialized in writing.”
However, the court determined that the proposition that concerted activity need not be memorialized in writing suggests that something more is required than merely the plaintiff’s allegations that the defendants were purported third-party beneficiaries of the voting and lock-up agreements. Allegations of express representations, communications, or solicitations between and among the defendants are absent from this case, the court stated, so it was not persuaded that being third-party beneficiaries to an agreement is the kind of unwritten “concerted activity” that was contemplated by the Dickinson court’s discussion.
Moreover, taking as true that the defendants were third-party beneficiaries, the court found that the plaintiff did not allege that any communications or interactions among the defendants took place that would plausibly show concerted or coordinated activity. Accordingly, the plaintiff failed to create a reasonable inference that the defendants combined to become third-party beneficiaries to these agreements for the purpose of acquiring, holding, or disposing of the company’s common stock, the court said.
Lock-up agreement. Regarding the lock-up agreement, the plaintiff relied on Morales v. Quintel Ent., Inc. to argue that lock-up agreements can form a stand-alone basis for alleging a Section 13(d) group, noting that the Morales court held that “it is ‘reasonable to infer’ that being parties to a lock-up agreement ‘may bear upon the continued existence of a concerted agreement[.]’”
The court ruled that the case law relied upon by the plaintiff establishes that while ordinary lock-up agreements on their own may not necessarily give rise to a reasonable inference of a group, if bolstered by supporting allegations a court could find group liability. Such allegations could include that the defendants combined in some way, through communications, representations, discussions, meetings, and other such conduct. The court concluded that as alleged, the plaintiff did not provide the factual support that would raise a reasonable inference of a group to survive a motion to dismiss. Similarly, the court determined that without more allegations of cooperation, communication, or meetings regarding the transactions, the waiver and consent agreements also did not give rise to a group.
Leak-out agreement. Finally, the court stated that it was not persuaded that the leak-out agreement is exceptional to the point that the analysis of the lock-out agreement in Lowinger v. Morgan Stanley & Co. LLC would not apply. The plaintiff did not identify “atypical language” in the agreement or allegations of coordination that would warrant the leak-out agreement to be analyzed with greater scrutiny, the court ruled.
As to plaintiff’s argument that signing parallel copies of the leak-out agreement rather than a master document together does not defeat an allegation of a group, the court disagreed. In the court’s opinion, signing parallel agreements with no facts supporting that the alleged group members interacted in any way is likely not within the range of conduct that could “support the inference of a formal or informal agreement or understanding” of the alleged group.
The case is No. 1:22-cv-00249.