On May 24, 2022, the United States Court of Appeals for the
Second Circuit affirmed and vacated in part the district
court's dismissal of claims under Sections 10(b) and 20(a) of
the Securities Exchange Act (the “Exchange Act”) and
Rule 10b-5 thereunder against a company that genetically engineers
tobacco and cannabis products (the “Company”) and two
of its former officers. Noto, et al. v. 22nd Century Group Inc.
et al., No. 21-347 (2d Cir. May 24, 2022). Plaintiffs alleged
the Company engaged in an illegal stock promotion scheme by paying
authors to write promotional articles about the Company without
revealing that the Company paid for the articles, and further
failed to disclose an SEC investigation into the Company's
alleged financial control weaknesses. The Court affirmed the
district court's order granting defendant's motion to
dismiss in part, holding that plaintiffs did not adequately plead a
claim that the Company violated the Exchange Act by failing to
disclose that it paid for the articles, but vacated the district
court's dismissal of claims related to the SEC investigation
and remanded for further proceedings.
The amended complaint (the “Complaint”) alleged that
upon appointing a new CEO in 2015, the Company hired a consulting
firm to handle its investor relations. Plaintiffs'
Confidential Witness 1 (“CW1”), who was allegedly the
CEO's executive assistant from January 2016 to February 2018,
purportedly stated that he observed the CEO approve the
Company's press releases, that the CEO told him he was
“working behind the scenes” to prop up the
Company's stock price, and that the Company paid writers to
publish positive articles about the prospects for the
Company's stock and that he was “sure” the CEO
“reviewed, edited, and/or approved the paid stock promotion
articles.”
The Complaint also alleged that the Company disclosed in certain of
its 2015 and 2016 SEC filings that its internal controls over
financial reporting were “not effective” and that
“material weaknesses existed,” but noted that it was
undergoing remediation efforts. In its Form 10-Q for the second
quarter of 2018, the Company allegedly stated that it had
“completed the implementation and testing of a remediation
plan.” According to plaintiffs, Confidential Witness 2
(“CW2”), allegedly an accounting manager at the
Company, stated that the SEC was investigating the Company when he
was hired in 2016, that the investigation continued throughout
2016, and that by the time he left in 2019, he had not seen any
statement from the SEC formally closing the investigation. The
Complaint further alleged that the CFO met with the SEC in 2016,
and allegedly told CW2 that he feared the investigation could cost
him his CPA license or lead to imprisonment. On July 16, 2018, the
SEC received a non-public Freedom of Information Act
(“FOIA”) request seeking all documents related to its
investigation of the company from January 1, 2016, through July 16,
2018, which, according to plaintiffs, was denied by a FOIA officer
under an exemption that authorized the withholding of records
“compiled for law enforcement purposes” if they
“could reasonably be expected to interfere with enforcement
proceedings.”
According to the Complaint, in February and October 2018, an online
commentator posted articles making statements about the alleged
paid stock promotion scheme, the FOIA request denial, and the SEC
investigation, allegedly causing the Company's stock price to
fall. On October 25, the Company issued a press release saying the
articles were “highly deceptive” and that the Company
“had not received any notice of, and the Company has no
knowledge of, any enforcement proceeding against it.” On July
26, 2019, the Company announced that its CEO had resigned for
“personal reasons,” and the Company's CFO
resigned on December 3, 2019. Plaintiff investors filed an amended
class action complaint in November 2019, which the district court
dismissed in its entirety with prejudice in January 2021.
The Second Circuit rejected plaintiffs' argument that
defendants had a duty to disclose that the Company allegedly paid
authors of promotional articles, holding that “only an
article's maker, not its benefactor, has a duty to disclose
that it was paid for.” Citing the Supreme Court's
decision in Janus Capital Group v. First Derivative
Traders, the Court found that the Complaint merely alleged
that the CEO reviewed and approved the Company's press
releases, which were then repeated by the promotional articles,
which “[did] not qualify [the CEO] as the ‘maker'
of the separate article's statements.” The Court
further found that even if the CEO had provided some input on the
content of the articles, “the complaint made no sufficient
factual allegation that the articles were published by anyone
except the authors or that the authors lacked sufficient control
over the articles' contents.” The Court similarly noted
there was no allegation that the press releases were false or
misleading. The Court also affirmed the district court's
holding that plaintiffs failed to allege that the Company violated
Rule 10b-5(a) and (c) by illegally manipulating the market through
its stock promotion scheme, emphasizing that the Complaint did not
allege that the market was manipulated by information in the
articles or through payments to the authors.
The Court next turned to plaintiffs' allegations related to
the SEC investigation. The Court agreed with plaintiffs'
argument that defendants had a duty to disclose the investigation
because their disclosures of certain financial control weaknesses
were rendered misleading by failing to also disclose the ongoing
investigation. The Court held that the alleged omission was
material because “the fact of the SEC investigation would
directly bear on the reasonable investor's assessment of the
severity of the reported accounting weaknesses.” The Court
stated that the Company “specifically noted the deficiencies
and that they were working on the problem, then stated they had
solved the issue,” and added that the Company's public
denial of the SEC investigation further indicated that the
nondisclosure was material.
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