Securities Snapshot: Court Confirms that Dilution of Shareholders May Constitute Both a Direct and Derivative Harm

Zendesk’s Motion to Dismiss Investor Suit Granted, Finding No Securities Fraud in Revised Pre-Merger Projections

On April 24, 2024, the US District Court for the Northern District of California dismissed a putative securities class action against Zendesk, Inc. (Zendesk), a SaaS provider, and its former directors.

In October 2021 and March 2022, Zendesk prepared two separate sets of financial projections, the first related to a proposed acquisition by Zendesk and the latter related to a proposed acquisition of Zendesk. According to the October 2021 projections, which were disclosed in a later proxy statement, Zendesk was valued at $130 to $197 per share. By March 2022, that valuation had increased and Zendesk projected higher future revenues than those predicted the previous October. Two months later, in May 2022, Zendesk received two successive bids from a consortium of buyers (the Consortium) valuing the company first at $120 per share and then at $96. Believing that Zendesk was being undervalued, the board declined both proposals. In response to these failed transactions, shareholder Jana Capital (Jana) repeatedly threatened Zendesk’s board with a proxy contest. In early June, the board announced it had completed the strategic review process and intended to proceed as a stand-alone company. Jana reiterated its intent to engage in a proxy contest should the board fail to move forward with the acquisition.

On June 17, 2022, allegedly intending to capitalize on this turmoil, the Consortium submitted a renewed bid at $75.50 per share, the details of which Zendesk shared with Jana, which purportedly agreed to drop any threat of proxy contest if the deal were taken. A few days after the Consortium’s best and final offer was presented to the board ($77.50 per share), Zendesk’s board was also presented with revised projections, showing significant reductions relative to both the October 2021 and March 2022 projections. These projections took into account that, in the intervening months, Zendesk’s gross and net bookings had been on a downward trend. The company’s stock price had also followed a similar trend.

On June 24, 2022, Zendesk announced a proposed merger with the Consortium for $77.50 per share. In connection with that transaction, the company’s two financial analysts prepared fairness opinions in which they valued Zendesk at $66 to $116 per share and $58 to $96 per share, respectively. Zendesk’s March 2022 projections, June 2022 projections, and fairness opinions were disclosed in an August 2022 proxy statement.

Shareholder plaintiffs alleged that statements in the August 2022 proxy about the revised projections and fairness opinions were false and misleading under Section 14(a) of the Securities Exchange Act because they significantly undervalued the company in light of the prior valuations in October 2021 and March 2022. The plaintiffs alleged that the board was pressured by Jana to revise projections in June 2022 and to accept a lower valuation as an entrenchment measure. The court found these arguments unavailing because, while both parties agreed that revenue projections and value-per-share determinations were opinions, the plaintiffs failed to allege they were actionable opinions. The plaintiffs failed to allege any contemporaneous facts suggesting both that the defendants’ June 2022 projections were objectively false and that the defendants did not subjectively believe them. The higher March 2022 projections and the existence of Jana’s threatened proxy contest did not render the defendants’ statements about the projections misleading in the context of alleged decreasing year-over-year gross and net bookings and declining stock price in the intervening months, because it was not misleading to update projections in light of changed financial conditions.

This case is a notable reminder that, while revenue projections and value-per-share determinations underlying fairness opinions are statements of opinion, they can still give rise to securities fraud if they are not supported by facts, such as a company’s historical financial performance, business trends, and market conditions.

26 Capital Enjoined From Redeeming Outstanding Shares as Part of Larger Merger Dispute

On April 19, 2024, Delaware Chancery Court Vice Chancellor J. Travis Laster entered an order enjoining 26 Capital Acquisition Corp. (26 Capital), a special purpose acquisition company (SPAC), from taking any further action in redeeming its outstanding shares pursuant to a September 2023 notice.

In October 2021, 26 Capital entered into a merger agreement with Tiger Resorts, Leisure & Entertainment, Inc. (CasinoCo) to merge with Philippines-based Okada Manila Resort & Casino and take it public, but the merger was never consummated, leading 26 Capital to file suit in the Delaware Chancery Court against CasinoCo and related entities (the SPAC Action) in February 2023. The court declined to order specific performance of the merger, and 26 Capital’s board of directors held a meeting in which the board approved a plan to instead redeem outstanding shares using a trust account that held its IPO proceeds. In September 2023, 26 Capital issued a press release announcing it would redeem all outstanding shares at a per share price of $10.95. This redemption was subsequently put on hold by a temporary restraining order in a different but related action. The SPAC Action was ultimately settled in November 2023, pursuant to a confidential settlement agreement (November 2023 Settlement) in which 26 Capital would receive $11 million in cash.

By April 2024, the redemption still had not occurred and 26 Capital shareholder Zama Capital Master Fund, Inc. (Zama) filed two actions against 26 Capital in connection with the SPAC Action: one to enjoin the redemption and one as an intervenor in the SPAC Action, seeking to rescind the November 2023 Settlement. In support of the first, Zama argued that 26 Capital was insolvent at the time it announced the redemption because the trust account was not a company asset and the company was not entitled to any portion of the SPAC Action settlement at the time of the press release in September. Zama claimed that the only assets belonging to 26 Capital were its de minimis cash on hand and its contingent rights in the SPAC Action, which it had never attempted to value. In its intervenor complaint, Zama alleged that 26 Capital’s CEO obstructed the company’s ability to fully prosecute its claims and pressured the board to accept an inadequate cash payment for substantially all of its assets—its contingent rights—in order to secure a release of claims against him personally. Zama’s suit, in turn, led to another 26 Capital shareholder—Fifth Lane Capital LP (Fifth Lane)—moving to intervene in Zama’s suit to argue that even if redemption were unlawful, the SPAC could still separately distribute the money from its trust account to investors.

The court granted Zama’s temporary restraining order on the grounds that the complaint presented a “colorable claim” of insolvency against 26 Capital. In other words, a redemption of the company’s 3.3 million shares was likely to impair the capital of the company in contravention of 8 Del. C. § 154. Vice Chancellor Laster also agreed with Fifth Lane and noted that nothing prevented 26 Capital from distributing the funds in its trust pursuant to its investment agreement without redemption, allowing both shareholders who want their money back to get it and shareholders who want to retain a stake in the SPAC Action to keep their shares.

The court’s order indicates that SPAC shareholders may have an interest in the SPAC that extends to potential recovery in litigation, especially if the SPAC itself is insolvent. However, even if redemption is blocked, SPAC funds can be returned to investors in other ways, such as through distribution from a trust.

In the meantime, the court has yet to rule on Zama’s intervenor complaint, and a motion to dismiss the intervenor complaint is pending before Vice Chancellor Laster.

Fifth Circuit Reverses Judgment on the Pleadings Brought by Six Flags

On April 18, 2024, the US Court of Appeals for the Fifth Circuit reversed and remanded the Northern District of Texas’s decision to, among other things, grant judgment on the pleadings in favor of the defendant, Six Flags Entertainment Corporation (Six Flags), in a securities fraud class action brought by plaintiff Oklahoma Firefighters Pension & Retirement System (Oklahoma Pension). In reversing the lower court, the Fifth Circuit disagreed with the lower court and held that plaintiff Oklahoma Pension did not lack standing to pursue its federal securities claims because it purchased shares in Six Flags before the alleged fraud came to light.

Oklahoma Pension (which became a Six Flags shareholder in October 2019) alleged in its complaint that Six Flags violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 by issuing materially false and misleading statements to investors during the period of April 2018 through February 2020, concerning the progress, timeline for completion, and accounting for Six Flags parks in China. The complaint challenged statements throughout that period touting the parks’ progress and completion schedule.

The lower court granted the defendant’s motion to dismiss in March 2021. Oklahoma Pension appealed, and the Fifth Circuit reversed the lower court’s holding in part, concluding that statements prior to October 2019 were actionable, but statements after October 2019 that concerned the timing for completion had been “tempered” by cautionary language and were not actionable. Because Oklahoma Pension became a Six Flags shareholder after the alleged misleading statements were “tempered,” Six Flags moved for judgment on the pleadings, arguing that Oklahoma Pension lacked Article III standing to pursue its claims because the fraud was fully revealed when it purchased stock in Six Flags. Concurrently, Oklahoma Pension moved to add a new named plaintiff, Key West Police & Fire Pension Fund (Key West), which had purchased and held Six Flags shares since July 2018, and Key West moved to intervene. The district court granted Six Flags’ motion and denied Oklahoma Pension’s and Key West’s motions, leading Oklahoma Pension and Key West to appeal that decision, as well.

The Fifth Circuit reversed and remanded all three decisions, finding Oklahoma Pension did have standing to pursue its claims. In so doing, the Fifth Circuit held that the lower court erred in its interpretation of the Fifth Circuit’s prior ruling: That ruling did not mean that the alleged fraud had been fully revealed by October 2019; it meant only that statements about the timeline for completion were not actionable because Six Flags adequately tempered its previously optimistic language. If the fraud had been fully revealed, the court conceded, then Oklahoma Pension would not have had standing. But here, Oklahoma Pension’s injury could have stemmed from false and misleading statements other than those concerning the timeline for completion. In turn, the lower court also erred in denying Oklahoma Pension’s motion to name Key West as a lead plaintiff and Key West’s motion to intervene because Oklahoma Pension did have Article III standing and Key West was a member of the putative class and filed its motion before class certification had been decided.

This decision reinforces that in order to have standing in securities actions, plaintiffs must have become shareholders of the company before the fraud in question was fully disclosed. Otherwise, the fraud is presumed to have been known to investors and absorbed by the market.

Court Denies Forte Biosciences’ Motion to Dismiss Alleged Director Entrenchment Lawsuit

On April 15, 2024, Delaware Chancery Court Vice Chancellor Morgan T. Zurn denied a motion to dismiss a stockholder suit with both direct and derivative claims against members of the board of directors of Forte Biosciences, Inc. (Forte), a clinical-stage biopharmaceutical company. Although the case is pending settlement, its holding is significant in light of a recent wave of investor lawsuits challenging defensive strategies in response to stockholder activism.

According to the amended complaint, in May 2022, Forte announced that it would pivot its operations to developing a new treatment for autoimmune diseases, a decision that was heavily opposed by certain existing shareholders who began increasing their equity positions in Forte to force board turnover. Allegedly in response to this pressure, the board immediately enacted a number of entrenchment measures to protect itself, including implementing a “poison pill” shareholder rights agreement, appointing two additional directors favorable to the incumbent board, and executing two large private investment in public equity (PIPE) offerings to “friendly” third parties, allegedly for the purpose of diluting unaffiliated voting powers. The plaintiff, a shareholder of Forte, filed this complaint alleging a direct claim for breach of fiduciary duty and a derivative claim for wrongful dilution of the unaffiliated shareholders.

In denying Forte’s motion to dismiss, Vice Chancellor Zurn first confirmed that the plaintiff’s fiduciary duty claim was properly direct, because it complained of the PIPE offering’s direct harm to the plaintiff’s voting rights—a harm distinct from the wrongful dilution of all non-PIPE shareholders. Vice Chancellor Zurn further held that the simultaneous accumulation of stock by activist shareholders and the board’s reactionary appointment of new board members and pursuit of the PIPE investment established at the pleading stage that the board perceived a threat and reacted defensively. In other words, the plaintiff raised reasonable inferences that Forte’s directors engaged in a “pattern of defensive conduct” to keep their positions. In turn, the court analyzed the board’s practices under enhanced scrutiny, in lieu of the business judgment presumption. Under enhanced scrutiny, the burden shifted to the defendants, who were unable to demonstrate that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed, and that their response was proportional to that threat. As part of this analysis, Vice Chancellor Zurn further held that the amended complaint adequately alleged that the stated purpose of the PIPE offering was pretextual because the board had previously indicated that the company would have enough cash to meet its projected needs. The plaintiff’s derivative claim for wrongful dilution survived dismissal for the same reasons.

This adverse ruling for Forte led to a tentative settlement with the plaintiff on June 12, 2024, under which Forte agreed to pay $2 million; expand its board to nine seats, with one incumbent required to resign and two directors to be chosen by the plaintiff from a list of five candidates identified by the company; establish a committee to evaluate strategic alternatives; not renew the shareholder rights agreement; and agree not to adopt a new shareholder rights plan for a period of three years. The settlement has yet to be approved by the court.

This case confirms that dilution of shareholders may constitute both a direct and derivative harm. It also confirms that courts may bypass the business judgment presumption and apply enhanced scrutiny where there are well-pled allegations that a board’s entrenchment measures were motivated by a perceived threat to their control.

Federal Court Approves $1.85M Settlement For Electric Vehicle Company’s SPAC Suit

On April 22, 2024, the US District Court for the District of Colorado granted final approval for a $1.85 million settlement of shareholder derivative claims against the board of directors and certain executive officers of GigCapital3, Inc. (GigCapital3), a SPAC, and Lightning eMotors, Inc. (Lightning), the surviving entity of a de-SPAC transaction between GigCapital3 and Lightning Systems. The shareholder plaintiff alleged that Lightning eMotors directors and officers hid the fact that Lightning was facing supply chain issues and could not rapidly scale its operations to fulfill its promise as a company poised to obtain rapid growth.

The amended complaint alleged that GigCapital3’s proxy statement made various false or misleading representations about Lightning’s sales pipeline, including by touting short-term sales projections its directors and officers knew were unachievable. The alleged truth of these misstatements came to light when Lightning announced it could generate only a small fraction of projected revenues during the first quarter of 2021. In response to the complaint and to numerous other shareholder suits deriving from the same alleged conduct, the parties negotiated an arm’s-length settlement. The settlement provides that defendants will pay $1.85 million. The settlement also requires a number of corporate governance reforms requiring additional prospective review and regular disclosure of financial guidance and the creation of a new management committee to ensure that Lightning’s public statements are reviewed “for accuracy, integrity, and compliance with applicable laws and regulations.” In addition, the company will adopt a written whistleblower policy that encourages the reporting of ethical or legal violations. The court also approved a $500,000 award of attorneys’ fees to the plaintiffs, calculated using a “percentage of the fund” method, and representing a significant premium over the roughly $385,000 lodestar amount.

These types of reforms, if implemented proactively, prior to a de-SPAC transaction, may help reduce the risk of derivative suits, especially if future revenues can often be uncertain.

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee a similar outcome.