Distortion to Static: Key First Circuit Opinion Clarifies Limits for Short Sellers
The U.S. Court of Appeals for the First Circuit on Jan. 3, 2023, ruled against Defendant Gregory "Emmanuel" Lemelson's request for a new trial in SEC v. Lemelson.1 The opinion and the underlying matter are critical reads for public companies and short-sellers alike, as Lemelson is one of the few litigated SEC matters involving "short and distort" allegations. As detailed below, the First Circuit's opinion provides key insights into, among other things, First Amendment application to short-seller allegations and fact-versus-opinion arguments that are critical to determining whether short-seller statements are actionable.
Below, we outline key facts from the underlying action and First Circuit opinion, along with some key takeaways.
In 2018, the SEC filed a civil action against Lemelson and his investment firm Lemelson Capital Management LLC (Firm), alleging that he violated antifraud provisions of the Securities Exchange Act of 1934 (Exchange Act) and the Investment Advisers Act of 1940 (Advisers Act) in connection with some of his statements against Ligand Pharmaceuticals, Inc. (Ligand).2 Lemelson and his Firm advised a hedge fund – for which it made investment decisions – to amass a sizeable short position in Ligand. Thereafter, Lemelson made a series of statements via interviews and written publications about Ligand, its licensing partner Viking Therapeutics (Viking) and Ligand's flagship drug "Promacta." Ligand's stock dropped 16 percent in the days after Lemelson's first report and ultimately fell approximately 34 percent overall. Those losses netted roughly $1.3 million in profit for the hedge fund from the short positions.
The SEC alleged that several of Lemelson's statements were false and misleading and charged him with violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder and violating Section 206 of the Advisers and Rule 206(4)-8 thereunder. 3 On Nov. 5, 2021, the jury found that Lemelson did not violate the Advisers Act, nor did his conduct constitute an overall short-and-distort scheme under subsections (a) and (c) of Rule 10b-5. However, the jury did find that Lemelson intentionally or recklessly made three material misstatements in violation of Rule 10b-5(b):
- Promacta Statement: In June of 2014, Lemelson published a report in Seeking Alpha stating that Ligand "face[d] it[s] biggest existential threat" from "what is likely to be a momentous impairment of its largest royalty generating asset, Promacta," due largely to a competitive threat from a new drug called Sovaldi. Two days later, Lemelson discussed Promacta with Ligand's investor relations representative. The day after that, Lemelson gave a radio interview on Benzinga where Lemelson said:
Promacta accounted for 72 percent of [Ligand's] royalty revenues … [and] is literally going to go away … I mean I had discussions with management just yesterday – excuse me, their [investor relations] firm, and they basically agreed. And they said, look, we understand Promacta is going away.4
- Viking Statements: Two weeks later, Lemelson made two statements respecting Ligand's relationship with another company, Viking Therapeutics. In 2014, Ligand and Viking signed a Master License Agreement in which Ligand would become the owner of 49.8 percent of Viking's common stock when Viking went public. Lemelson made two key statements concerning Viking's relationship with Ligand:
After the jury's verdict, U.S. District Judge Patti Saris imposed a $160,000 penalty against Lemelson and issued a five-year injunction. 7 After Judge Saris denied Lemelson's post-trial motions, Lemelson appealed the verdict and the injunction to the First Circuit. On appeal, Lemelson argued that the jury verdict should be overruled for three reasons: 1) the Viking Statements were statements of opinions and thus protected by the First Amendment; 2) the SEC failed to introduce sufficient evidence to prove that both the Promacta and Viking Statements were material; and 3) that the jury lacked a sufficient basis to find the statements were made with scienter.8
The First Amendment/Fact or Opinion
Under Rule 10b-5, a violation necessarily requires a false or misleading statement of fact.9 Lemelson cited a series of First Circuit defamation cases to argue that the First Amendment precludes liability "when the speaker outlines the facts available to him, thus making it clear that the challenged statements represent his own interpretation of those facts and leave the reader to draw his own conclusions."10 According to Lemelson, his Viking Statements interpreted facts in the Viking S-1 and were protected opinions and, thus, not actionable for purposes of 10b-5. The SEC argued that the precedent was in the context of defamation cases, and the First Circuit has never applied them to securities regulations such as Section 10(b) and Rule 10b-5.11 The Court agreed with the SEC.
The Court found that a jury had ample reasons to find that Lemelson's statements were statements of fact, affirming the precedent that a statement of fact expresses certainty about a thing, whereas a statement of opinion does not. 12 Drawing on the U.S. Supreme Court's opinion in Omnicare, Inc. v. Laborers Dist. Council Constr. Indus. Pension Fund – the seminal case on separating fact from opinion – the First Circuit found that Lemelson's statements were unqualified and expressed certainty about things, such as "financial statements provided on the [Viking S-1] are unaudited."13 Likewise, Lemelson did not communicate any extrapolation, i.e., "A, therefore in my opinion, B," or, as the panel explained, presented his "interpretation of the facts."14 Here, Lemelson was "claiming to be in possession of objectively verifiable facts," not merely "expressing a subjective view" concerning the Viking Statements.15
As to the First Amendment/defamation argument, the First Circuit panel largely sidestepped the issue, finding:
Because we determine the Viking Statements to be statements of fact, we need not decide whether the cases cited by Lemelson reach beyond defamation law. Even were we to consider these cases and apply de novo review, Lemelson's argument fails because the Viking Statements reasonably would be understood to declare or imply provable assertions of fact. Far from presenting interpretation of the facts contained in the Viking S-1, the Viking Statements are flatly inconsistent with those facts.16
Next, Lemelson argued that even if all his statements were untrue statements of fact, no reasonable jury could have concluded that the statements were material. To prove materiality, the SEC must show a substantial likelihood that the statements "would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."17
The Court found that a reasonable jury could find the statements material. Concerning the Promacta Statement, Promacta was critical for Ligand's business and, if it were "going away," that would be a severe blow to the company's revenue. Additionally, Lemelson himself took credit for the decline in Ligand's stock value, emailing his investment adviser that his "multi-month battle with [Ligand]" was "paying off" because Ligand's shares were "down ~40% since [Lemelson] published."18 The Court found that a reasonable jury could infer that Lemelson believed that the Promacta Statement was material to investors.
Regarding the Viking Statements, Lemelson argued that the Viking S-1 provided information that contradicted his statements and detailed Viking's intentions around the preclinical studies, thereby precluding a jury from finding his statements material. The Court disagreed, finding that "[w]e have never held that it cannot be a material misstatement to flatly contradict publicly available facts."19 To hold otherwise, the Court noted, "would risk foreclosing Rule 10b-5 liability for all untrue statements belied by public securities filings."20
Violations of Section 10(b) and Rule 10b-5 require the SEC to establish scienter through "a showing of either conscious intent to defraud or a high degree of recklessness." To establish a high degree of recklessness, the SEC must offer evidence that entails "an extreme departure from the standards of ordinary care" and also "presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious the actor must have been aware of it."21
The Court highlighted several reasons why a jury could have found Lemelson acted with scienter. First, concerning the Promacta Statement, the jury could have found the testimony of the investor relations contact – who disputed Lemelson's version of events – credible. Notably, investor relations personnel emailed Lemelson after he made the Promacta Statement, disputing Lemelson's account. Lemelson never corrected his statement. Second, concerning the Viking Statements, Lemelson held himself out as a sophisticated investor and adviser and claimed he "carefully researched" the Viking S-1. Yet, the plain language of the whole S-1 contradicted his statements about the audited financials and, at a minimum, presented a different light around his statement about the studies. Regardless of whether the jury found Lemelson's Viking Statements intentional misstatements, a rational jury could find that such statements were made with a high degree of recklessness.
Overall, Lemelson offers several key takeaways for both short-sellers and companies.
First, short-sellers will often claim First Amendment protections for their statements. Generally speaking, as the Supreme Court ruled in the doctrinal case Central Hudson, commercial speech is analyzed under a form of intermediate scrutiny.22 As Justice Lewis Powell noted in Central Hudson, for commercial speech to come under First Amendment protection, "it at least must concern lawful activity and not be misleading."23 Therefore, given that short-and-distort theories are premised on allegedly misleading statements of fact, short-sellers cannot avail themselves of First Amendment protections for inaccurate information.
Second, the fact that there may be other information available to investors that contradicts the short-seller's misstatements will not, in and of itself, shield the short-seller from misstatement liability. Although within the First Circuit, it is generally true that it is not a violation of 10b-5(b) to "fail to point out information of which the market is already aware," this does not apply to misstatement liability.
Third, the First Circuit hid a key point in a footnote. Lemelson argued that his statements were rendered "categorically immaterial" by virtue of his self-identification as a short-seller. The Court rejected this contention.24 Although rules exist concerning required disclosures for those promoting or "touting" securities when they have received payment for such touts,25 there are not any rules – whether investors have been paid for such disclosures or not – concerning short-seller disclosure. But, as the First Circuit held, even if a short-seller discloses his or her position as a short-seller, this alone will not immunize the short-seller.
Finally, the SEC's Division of Enforcement has long utilized short-sellers as a mechanism for generating enforcement leads against public company issuers. Yet, the Lemelson case is another data point that evidences the Division of Enforcement's interest in holding short-sellers accountable for misstatements. We expect the SEC to continue to keep a close eye on the short-seller space in coming months, most notably in connection with its unanimous approval last year of proposed rules for public disclosure of some short-sale information.26
The SECond Opinions Blog will continue to monitor the agency's activity in this space and provide further updates. If you need any additional information on this topic – or anything related to SEC enforcement – please contact the authors or another member of Holland & Knight's Securities Enforcement Defense Team.
1 Sec. & Exch. Comm'n v. Lemelson et al, No. 22-1630, 2023 WL 21546 (1st Cir. Jan. 3, 2023).
2 SEC v. Lemelson, No. 1:18-CV-11926 (D. Mass filed Sept. 12, 2018).
3 Sec. & Exch. Comm'n v. Lemelson, 596 F. Supp. 3d 227, 236 (D. Mass. 2022) (Motion to Enter Judgment).
4 Lemelson, 2023 WL 21546 at *2 (1st Cir.).
5 Id. at *2-3 (emphasis removed).
6 Id. (Court's emphasis).
7 See generally SEC v. Lemelson, 596 F. Supp. 3d 227 (D. Mass. 2022). Notably, the district court did not order disgorgement in the matter, finding that the misconduct was not causally connected to any ill-gotten gains. Id. at 228.
8 Lemelson, 2023 WL 21546 at *4 (1st Cir.).
9 Lemelson, 2023 WL 21546 at *4 (1st Cir.).
10 Id. at *5 (quoting McKee v. Cosby, 874 F.3d 54, 61 (1st Cir. 2017)).
12 Id. (quoting Constr. Indus. & Laborers Joint Pension Tr. v. Carbonite, Inc., 22 F. 4th 1, 7 (1st Cir. 2021)).
13 Id. at *5 (quoting Omnicare, Inc. v. Laborers Dist. Council Constr. Indus. Pension Fund, 575 U.S. 175, 183 (2015)).
14 Id. at *5 (emphasis added).
16 Id. (citations removed).
17 Id. at *5-6 (quoting Basic Inc. v. Levinson, 485 U.S. 224, 231-232 (1988)).
18 Id. at *7.
21 Id. at *8.
22 Cent. Hudson Gas & Elec. Corp. v. Pub. Serv. Comm'n of N.Y., 447 U.S. 557 (1980).
23 Id. at 566 (emphasis added).
24 Id. at *7 n.9.
25 See Securities Act of 1933, ch. 38, 48 Stat. 74 (codified as amended at 15 U.S.C.A. Section 77q).
26 Short Position and Short Activity Reporting by Institutional Investment Managers, (Release No. 34-94313; File No. S7-08-22), Feb. 25, 2022; see also Magee, Mascianica & Porter, "Something We Can All Agree On? SEC Unanimously Approves Proposed Short-Seller Disclosure Rules," Holland & Knight SECond Opinions Blog (Mar. 4, 2022).