Court Refuses To Vacate Sanctions Order For Frivolous Short Selling Claim

The Second Circuit handed down another opinion in ATSI Communications, Inc., v. The Shaar Fund, Ltd., Case No. 08-1815 (2nd Cir. Oct. 20, 2008), perhaps finally brining this case to an end. This opinion concerned a request as part of a settlement to vacate a sanctions order issued under the PSLRA and Rule 11 against plaintiff for filing a baseless compliant. The court refused.

The claims in the underlying litigation might sound familiar given the recent controversy over the SEC’s new short selling rules and the role some believe that such trading had in the demise of Bear Stearns. The suit was brought by ATSI, the issuer of “floorless preferred,” against the purchasers who acquired the shares in a private placement. Essentially, ATSI claimed that defendant purchasers manipulated the stock by selling short. Those sales, according to plaintiffs, drove the stock into a “death spiral.”

In the initial appeal, plaintiff sought reversal of an order dismissing its third amended complaint. In affirming Judge Kaplan’s ruling, the Circuit Court concluded that the theory of the complaint was not “plausible” under Bell Atlantic Corp., v. Twombly, 137 S. Ct. 1955 (2007). The court also held that plaintiff failed to adequately plead scienter as required by Section 21D(b)(2) and Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007). ATSI Communications, Inc. v. The Shaar Fund, Ltd., 493 F.3d 87 (2nd Cir. 2007).

Subsequently, ATSI settled with each defendant except Knight Capital Markets LLC. Rather than settle, Knight brought filed a motion against ATSI under the PSLRA and Fed. R. Civ. P. 11 for sanctions. The district court granted the motion, concluding that ATSI “lacked any reasonable factual basis …” for the claims it asserted. The court ordered plaintiff to pay Knight’s costs in defending the case which were in excess of $64,000.

During the second appeal, ATSI and Knight settled. The settlement is, however, conditioned on obtaining an order vacating the district court sanction order. Accordingly, the parties jointly requested that the Second Circuit vacate that order.

The Circuit Court began its analysis by acknowledging that under 28 U.S.C. § 2106, a court of appeals has the power to vacate a judgment brought before it for review. However, the Supreme Court’s decision in U.S. Bancorp Mortgage Co. v. Bonner Mall Partnership, 513 U.S. 18 (1994) limits the court’s discretion, requiring that when a party who does not prevail appeals, and then settles, it is not entitled to an order vacating the lower court decision absent a showing of equitable entitlement. In addition, it is in the public interest to permit judicial precedent to stand absent an extraordinary showing by the requesting party according to the Court.

In this case, there are no exceptional circumstances justifying the extraordinary remedy sought here. Accordingly, the district court’s decision, concluding that the “death spiral” claim lacked any factual foundation and its sanction order, will stand and not be vacated.

Hedge Funds And PIPE Offerings — A New Enforcement Position?

The SEC filed another settled enforcement action on Monday involving a hedge fund and a PIPE offering. SEC v. Ladin, Civil Action No. 1:08-CV-01784 (D.D.C. Filed Oct. 20, 2008). The case raises a significant question regarding the SEC’s enforcement position on these types of cases..

The case named Brian Ladin as a defendant. Mr. Ladin is an analyst for Bonanza Capital, Ltd., a Cayman Island hedge fund. Bonanza’s investment advisor is Bonanza Capital, Ltd. of Dallas, Texas.

According to the complaint, Mr. Ladin learned about a PIPE offering involving the unregistered shares of the majority shareholders of Radyne ComStream after agreeing to keep the information confidential. Despite that agreement, Mr. Ladin informed Bonanza about the offering. That same day the fund established a 100,000 share short position in Radyne. The next day, Mr. Ladin, on behalf of Bonanza, signed a stock purchase agreement with Radyne representing that the fund did not have a short position in the shares of that company. After the announcement of the PIPE, the share price of Radyne declined as is typical in such offerings. The Commission’s complaint alleged violations of Sections 10(b) and 17(a).

To resolve the case, Mr. Ladin consented to the entry of a permanent injunction prohibiting future violations of both antifraud provisions. In addition, he consented to the entry of an order requiring him to pay $10,895 in disgorgement along with $2,532 in prejudgment interest and a civil penalty of $317,000. Bonanza and its investment advisor, named as relief defendants, consented to the entry of an order requiring the payment of disgorgement in the amount of $371,429.00 along with prejudgment interest.

This case differs significantly from earlier hedge fund-PIPE cases. Unlike earlier cases, there is no allegation that Section 5 was violated. In prior hedge fund-PIPE cases, the SEC has claimed that covering the pre-PIPE short position with the shares from the PIPE resale registration statement violated Section 5. See, e.g., SEC v. Mangan, Civil Action No. 06-cv-531 (W.D. N.C. April 25, 2006) (court dismissed Section 5 claim); SEC v. Lyon, Civil Action No. 06 CV 14338 (S.D.N.Y. Filed Dec. 12, 2006) (Section 5 claim dismissed); But see SEC v. Friedman, Billings, Ramsey & Co., Civil Action No. 06-cv-02160 (D.D.C. Jan. 4, 2007) (settled hedge fund-PIPE action). In fact, the Commission has lost each Section 5 claim it litigated in these types of cases.

The reason that the complaint does not contain a Section 5 claim is at best unclear. One possibility is that after repeated losses in court the SEC has decided not to pursue such claims.

As second possibility may have to do with the nature of the allegations in Landin which, at best, might be described as insubstantial. Unlike earlier cases, the complaint does not state that the short position was covered with shares from the PIPE. This was a key allegation in earlier hedge fund-PIPE cases. While the complaint does claim that Landin and the fund profited – a fact also reflected by the settlement – it does not say how. Presumably the short position was closed after the price drop and possibly from the PIPE shares but these facts are not pled. Rather, the only statement in the complaint is that “Ladin profited and caused Bonanza to profit as a result of the unlawful conduct described herein … .”

The Ladin complaint also lacks the kind of intentional conduct to cover-up the trading activity alleged in some of the earlier cases. Here, there are no allegations of a cover-up. Rather the key allegations concerning the opening of the short position is simply vague alleging only that Mr. Ladin “presented an investment in Radyne to Bonanza, resulting …” in the short position. There is no indication who Mr. Ladin spoke with, that he had any contact with the trader or that he even knew the trade was placed.

The vagueness of these allegations echoes through the critical claim about the alleged misrepresentation made in connection with purchasing PIPE shares. There the complaint says only that Mr. Ladin signed the representation, “even though he knew, or was reckless or negligent in not knowing …” about the short position. Vagueness and negligence contrast sharply with those in earlier cases.

Landin may in fact signal a change in the Commission’s enforcement position in these cases. At the same time, the case may also reflect little more than a poor factual record. We will have to wait for the next hedge fund-PIPE case to see if the Commission has in fact changed its enforcement position.