Palo Alto – October 15, 2024 – In a precedent-setting decision, the US Court of Appeals for the Tenth Circuit ruled that, in order to establish scheme liability under Section 10(b) of the Securities Exchange Act of 1934, a plaintiff must plausibly allege that investors were deceived. Accordingly, an alleged scheme by Overstock and its officers to create a short squeeze to the detriment of short sellers was beyond the reach of Section 10(b) scheme liability, as the company had fully disclosed the material terms of the transaction.
The Tenth Circuit also found, in one of the few decisions to so hold, that Overstock had successfully rebutted the presumption of reliance under Basic v. Levinson, as the short seller was forced to purchase shares because of its contractual obligation to cover its short positions rather than due to any misrepresentations.
The Cooley team representing Overstock consisted of Tijana Brien, John C. Dwyer, Rebecca Ferrari, and Heather Speers.
Key allegations
Overstock, an online retailer of furniture and other goods, has historically been one of the most highly shorted stocks on the market. In the 2010s, the company began developing a number of blockchain-based businesses in an effort to diversify. In 2019, the company announced the issuance of a unique digital dividend that could only be traded on its own proprietary blockchain-based trading platform. The record date for the dividend was set for September 23, 2019, almost eight weeks after the original announcement.
Importantly, the digital dividend shares would be unregistered and, thus, nontransferable for a period of time. In typical transactions, short sellers borrow shares to short and are contractually obligated to transmit to the lender any dividends received on the borrowed shares. Because the digital dividend shares were unregistered, short sellers were forced to close their short positions before the record date of the dividend. If they did not, they would not be able to meet their contractual obligations to transfer those dividends to their lenders. All the material terms of the dividend were fully disclosed, and, as even the short sellers admitted, the market (as reflected in a number of contemporaneous articles in the financial press) immediately understood the bind in which the short sellers were placed.
Overstock’s share price spiked in the days leading up to the record date as short sellers moved to cover their short positions. One such short seller subsequently sued, alleging that Overstock had “illegally manipulated the market by inducing an artificial short squeeze in violation of” Section 10(b) and US Securities and Exchange Commission (SEC) Rules 10b-5(a) and (c).
Tenth Circuit rejects short seller’s arguments
In affirming the district court’s dismissal of the lawsuit, the Tenth Circuit reached two important holdings.
First, in a matter of first impression in the circuit, the court held that “an open-market transaction may qualify as manipulative conduct, but only if accompanied by plausibly alleged deception.” Because Overstock had fully disclosed how the digital dividend would work and the market, including short sellers, fully understood as much, there was no deception and no liability. As the court held, “Defendants’ truthful disclosure of the terms of the upcoming dividend transaction did not deceive investors as to how the market valued Overstock.”
As for the plaintiff’s complaint that the alleged “short squeeze” forced it to buy shares at inflated prices in order to cover its short positions, the court noted that “Had Plaintiff chosen to cover during the five-week period right before September 3,” when the share price began to climb, “rather than wait until September 6,” when the short squeeze began to drive the share price up, “Plaintiff would have avoided any loss it attributes to the short squeeze.”
Second, the court ruled that Overstock had successfully rebutted the plaintiff’s effort to rely on the “fraud on the market” presumption from Basic v. Levinson to establish reliance in support of their accompanying misrepresentation claim under Rule 10b-5(b). Noting that the presumption can be rebutted by “demonstrating that the plaintiff would have bought or sold the stock ‘even if he was aware that the stock’s price was tainted by fraud,’” the court found that was precisely the case here. Because the short seller plaintiff “admitted that Overstock’s looming crypto dividend – not the retail statements or the fairness of Overstock’s market price – caused it to buy its Overstock stock,” the court agreed that “Plaintiff appears to concede it would have purchased no matter the price.” As a result, the plaintiff could not rely on the Basic presumption and failed to plead reliance. This case is one of the very few in which a court has found the Basic presumption rebutted at the pleading stage.
The case is In re Overstock Securities Litigation.
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