Grayscale Investments Petitions D.C. Circuit For Review Of SEC’s Decision To Disapprove Proposed Bitcoin Exchange-Traded Product

On June 29, 2022, Grayscale Investments, LLC petitioned the U.S. Court of Appeals for the District of Columbia for review of the U.S. Securities and Exchange Commission’s June 29, 2022 final order disapproving of an October 19, 2021 proposed rule change to list and trade shares of Grayscale Bitcoin Trust under New York Stock Exchange Arca Rule 8.201-E (Commodity-Based Trust Shares). Grayscale Investments plans to argue that the SEC has failed to apply consistent treatment to Bitcoin investment vehicles.

The proposed rule change, filed by NYSE Arca, Inc. and subsequent amendment, would have allowed Grayscale Investments to convert its existing bitcoin trust into a bitcoin-based exchange-traded product (ETP) in which each share would represent a proportional interest of each of the trust’s assets by reference to an index price. While shares of the bitcoin trust are currently offered to accredited investors, as well as on an over-the-counter marketplace, the proposed rule would open shares up to more investors in response to increased investor demand. NYSE Arca asserted that approval of the proposal would be consistent with Exchange Act Section 6(b)(5)’s requirement that the rules of the exchange be designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest. In particular, NYSE Arca pointed to its own surveillance procedures related to trading, the proposal’s use of an index provider, CoinDesk Indices, Inc., and the ability to obtain information from the Chicago Mercantile Exchange bitcoin futures market. NYSE Arca further asserted that bitcoin markets have novel protections beyond those existing in traditional commodity markets, in part because of trading volume, capitalization, number of active trading venues, and participation by institutional investors, resulting in a strong convergence of pricing across a broad market.

In disapproving the proposed rule change, the SEC concluded that NYSE Arca had not met its burden to demonstrate that the proposal was consistent with the requirements of Exchange Act Section 6(b)(5), including the requirement to design all such proposals to prevent fraudulent and manipulative acts and practices. The SEC further stated that, in every case in which it has approved a commodity-trust ETP for listing and trading, the ETP listing exchange has entered into a surveillance-sharing agreement with, or held Intermarket Surveillance Group membership in common with, at least one significant, regulated market for trading futures on the underlying commodity. 
 
The SEC cited previous orders to support its conclusion that NYSE Arca did not establish “other means” beyond a surveillance-sharing agreement to prevent fraudulent and manipulative acts. The SEC pointed to possible sources of fraud and manipulation in the spot bitcoin market, including: (1) wash trading; (2) investors with a dominant position in bitcoin manipulating bitcoin pricing; (3) hacking of the bitcoin network and trading platforms; (4) malicious control of the bitcoin network; (5) trading based on material, non-public information or based on the dissemination of false and misleading information; (6) manipulative activity involving stablecoins; and (7) fraud and manipulation on bitcoin trading platforms. The SEC also noted that it was not persuaded by NYSE Arca’s assertion that bitcoin’s fungibility, transportability, and exchange tradability, along with its market size, liquidity, market participation, and arbitrage, sufficiently addressed concerns regarding fraud and manipulation. It further concluded that NYSE Arca did not provide evidence that price arbitrage in the bitcoin market was particularly efficient, as price disparities in markets must be measured at the nanosecond mark, rather than by an hour-end measurement.

The SEC also found that the index used by the trust to determine the value of its bitcoin assets did not have sufficient oversight to substitute for a surveillance-sharing agreement between NYSE Arca and a regulated market of significant size related to the underlying bitcoin assets. While the index exclusively uses prices from particular spot bitcoin trading platforms subject to FinCEN’s AML/KYC and/or NYSDFS’s BitLicense, the SEC concluded that those platforms were not comparable to a national securities exchange or futures exchange, in part because of the voluntary nature of its regulations and the lack of SEC or Commodity Futures Trading Commission oversight.

After concluding that NYSE Arca had not demonstrated that “other means” that would be sufficient to prevent fraudulent and manipulative acts and practices, the SEC then considered whether NYSE Arca had entered into a comprehensive surveillance-sharing agreement with a regulated market of significant size related to the underlying bitcoin assets. The SEC concluded that while NYSE Arca had the equivalent of a comprehensive surveillance-sharing agreement with the Chicago Mercantile Exchange, the CME bitcoin futures market was not a “market of significant size” related to spot bitcoin trading. In support of this conclusion, the SEC used a two-prong test, considering: (1) whether there is a reasonable likelihood that a person attempting to manipulate the ETP would have to trade on the CME bitcoin futures market to successfully manipulate the ETP (the SEC concluded there was not); and (2) whether it is unlikely that trading in the proposed ETP would be the predominant influence on prices in the CME bitcoin futures market (the SEC concluded it was not). The SEC further concluded that the proposed spot bitcoin ETP was not comparable to bitcoin futures-based ETFs and ETPs on the CME, in part because the underlying holdings were different, and because spot bitcoin markets are not currently federally regulated.

Delaware Chancery Court Denies Motion To Dismiss To Carvana On Stockholder Allegations Of Breaches Of Fiduciary Duty

On June 30, 2022, the Delaware Court of Chancery denied motions to dismiss a stockholder litigation filed by investors in Carvana Co. against the company and its CEO, President and Chairman Ernest Garcia III. The class action complaint alleged breaches of fiduciary duties arising out of a direct stock offering that plaintiffs allege Garcia III orchestrated to benefit himself an a group of “hand-picked” investors at the expense of the company’s public stockholders, who were not included in the direct offering. The court denied Carvana and Garcia III’s motions to dismiss for failure to plead demand futility and failure to state a claim, finding that stockholder plaintiffs pled particularized facts raising a reasonable doubt as to the independence of the directors. The court also found that plaintiffs stated a claim requiring a fact-intensive entire fairness inquiry, such that dismissal would be inappropriate.

The stockholder plaintiffs’ claims arise out of Carvana’s March 30, 2020 direct offering of common stock at $45 per share to certain investors, but not the public stockholders. Plaintiffs allege that defendants took advantage of the company’s depressed stock price during the beginning of the COVID-19 pandemic to benefit themselves through this direct offering. In the final week of March 2020, the Carvana directors discussed and approved the direct offering. While Garcia III could not vote to approve the direct offering in his role as a board member, resolutions approved by the participating board members delegated to Garcia III, in his role as Carvana’s CEO, the authority to negotiate the terms and provisions of the investment agreements for the direct offering. In a March 31, 2020 prospectus, Carvana stated that it would use the capital raised through the direct offering for “general corporate purposes,” without specifying any particular use. The direct offering resulted in a capital raise totaling $600 million, which included a $50 million purchase by Garcia III and his father, Ernest Garcia II at $45 per share. Shortly thereafter, on May 18, 2020, Carvana announced a public offering of five million Class A shares at a price of $92 per share. Carvana’s stock price continued to rise, and following the end of the short-swing period on September 30, 2020, Garcia II sold millions of shares, continuing to do so throughout 2021.

Following Carvana’s public offering, several stockholders served books and records demands, after which they filed initial complaints between May and August 2020. On January 4, 2021, the court consolidated three plenary actions filed by stockholder plaintiffs, after which plaintiffs filed an amended complaint on August 20, 2021. The amended complaint asserted both a direct claim, later dismissed by stipulation, and a derivative claim for breach of fiduciary duty against the defendants. In response, Carvana and Garcia III each separately moved to dismiss for failure to plead demand futility and for failure to state a claim. The court first considered whether stockholder plaintiffs had adequately pled demand futility under a heightened pleading standard, which require particularized factual statements that are essential to the claim.

The stockholder plaintiffs alleged that three of the six directors were conflicted, including Garcia III, Gregory Sullivan, and Ira Platt. Defendants conceded that Garcia III was conflicted in his role as director. The court first found that plaintiffs sufficiently raised a reasonable doubt as to Sullivan’s independence from the Garcias, based upon Sullivan’s past business dealings with Ernest Garcia II, including (1) Sullivan’s prior employment at Garcia II’s companies, (2) Garcia II’s investment in Sullivan’s travel media company, where Garcia II also served as one of three board members, and (3) that Garcia II “allegedly saved [Sullivan’s] career” after he was censured by the NYSE for actions he took on behalf of Garcia II during a financial scandal. The court found that these allegations collectively demonstrated a heightened strength of relationship, creating reasonable doubt about his ability to objectively consider a demand to pursue litigation against Garcia III.

The court similarly found that plaintiffs sufficiently raised a reasonable doubt as to Platt’s independence from the Garcias, after plaintiffs pointed out numerous instances where Platt and the Garcia’s hired one another’s relatives, and where Garcia II appointed Platt as a director for three Garcia-controlled entities. Because the court concluded that plaintiffs had sufficiently raised a reasonable doubt as to whether at least half of the board was independent and could evaluate a demand, it denied the motion to dismiss for demand futility.

Finally, the court denied Garcia III’s motion to dismiss for failure to state a claim for breach of fiduciary duty, explaining that a director could be held liable for a challenged transaction even if he had abstained from a board vote. The court further found that more factual questions were involved that could not be resolved at the motion to dismiss stage, including questions as to Garcia III’s involvement in the challenged transaction and its negotiations. As the court had already determined that plaintiffs were entitled to a pleading stage inference that the majority of the board was conflicted as to the direct offering, the court determined that the entire fairness standard, requiring a more fact-intensive inquiry than appropriate at the motion to dismiss stage, presumptively applied.

The court will rule separately on a separate motion to dismiss filed by Garcia II for failure to plead demand futility, failure to state a claim, and lack of personal jurisdiction.

Delaware Chancery Court Grants Motion To Dismiss To NiSource Board On Stockholder Plaintiff’s Caremark Claim

On June 30, 2022, the Delaware Court of Chancery dismissed a stockholder complaint against current and former directors of utility company NiSource, Inc. for violations of the Securities Exchange Act and breaches of fiduciary duty. The court held that plaintiffs did not sufficiently plead demand futility.

The case arose out of a September 13, 2018 deadly gas explosion catastrophe that occurred during a pipe replacement project at NiSource’s gas distribution subsidiary, Columbia Gas of Massachusetts (CMA). Following the catastrophe, the National Transportation Safety Board commenced an investigation, during which it issued four urgent safety recommendations directly to NiSource and concluded that certain procedural failures contributed to the explosions, in part due to (1) NiSource’s informal, unstructured approach for documenting the pipe replacement project; and (2) NiSource’s inadequate planning, documentation, and recordkeeping processes. The United States Attorney for the District of Massachusetts separately charged CMA with criminal violations of portions of the Natural Gas Pipeline Safety Act, to which it pled guilty, and entered into a Deferred Prosecution Agreement with NiSource, which required NiSource to divest its interest in CMA with no profit, pay $56 million towards a relief fund, and implement a pipeline safety management system to be reviewed and tracked by an independent monitor.

In April 2020, following a Section 220 books and records inspection, plaintiff filed a derivative suit in the U.S. District Court for the District of Delaware on behalf of NiSource to hold certain current and former NiSource directors liable under Section 14(a) of the Securities Exchange Act and under state fiduciary duty laws under the doctrine from In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), which allows directors to be held accountable for the consequences of a corporate trauma such as the gas explosions at issue. After those claims were dismissed due to lack of subject matter jurisdiction, on April 29, 2021, plaintiff refiled the Caremark claim in the Delaware Court of Chancery. On August 26, 2021, plaintiff filed an amended complaint, which named ten current directors, including NiSource’s CEO and director Joseph Hamrock, and one former director, as defendants. On September 10, 2021, defendants moved to dismiss the amended complaint for failure to plead demand futility. Plaintiff opposed the motion, arguing that the defendants cannot impartially consider a demand because they face a substantial likelihood of liability under Caremark, such that demand is futile.

To adequately allege a Caremark claim, the court noted that plaintiff must allege that directors knew or should have known about the risk leading to the corporate trauma, and with such knowledge then failed to discharge their fiduciary obligations in bad faith. The plaintiff may do so by alleging particularized facts that establish either: (1) the directors utterly failed to implement any reporting or information system or controls; or (2) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention. The court noted that a plaintiff who asserts both prongs typically loses on prong one, as a monitoring system must exist for a board to ignore it.

First, the court considered whether plaintiff pled with particularity that the defendant directors “utterly failed to implement any reporting or information system or controls.” The court found that plaintiff did not meet this high bar, as the board of directors formed an Environmental, Safety and Sustainability Committee, which met five times a year to discuss extensive reports from senior executives and even more frequently reported on safety risks to the full board. In support of its claim, plaintiff alleged that defendant directors monitored risk only generically rather than specifically as to pipeline safety. While the court agreed with plaintiff that pipeline safety was “mission critical” to a pipeline operating company, it concluded that the Environmental, Safety and Sustainability Committee did in fact monitor and actively discuss the specific regulatory risks at issue, including frequent discussions of current and proposed regulations, other companies’ gas safety incidents and proposed responses to those incidents. The court therefore concluded that defendants did not face a substantial likelihood of liability under prong one.

Second, the court found that plaintiff did not plead with particularity that the defendant directors consciously failed to monitor or oversee its own control systems. In support of its claim, plaintiff contended that: (1) the board made repeated business decisions to allow NiSource’s gas subsidiaries to operate in violation of pipeline safety laws; and (2) the board ignored red flags related to their gas subsidiaries’ repeated violation of pipeline safety laws. As to the first contention, the court found that plaintiff did not allege with particularity that NiSource’s gas subsidiaries’ potential regulatory violations were unusually frequent or serious, nor that the board’s decision to slowly roll out implementation of pipeline safety management systems reflected a law-breaking business model. As to the second contention, the court found that plaintiff did not plead with particularity that the board knew of red flags but disregarded them in bad faith, as the connection between discrete gas safety issues at other companies in other states and the eventual gas explosions at issue here were too attenuated to show that the NiSource board disregarded those safety issues in bad faith, proximately causing those explosions. While the court acknowledged that the board knew of the general risks associated with poor recordkeeping practices, and even of specific risks of recordkeeping violations at its other subsidiaries, the court ultimately found that plaintiff did not adequately allege that the board knew of specific risks of poor recordkeeping concerning this particular gas subsidiary, CMA, which eventually caused the explosions. The court concluded that because plaintiff failed to allege with particularity that the defendant directors consciously failed to monitor or oversee its own control systems, defendants did not face a substantial likelihood of liability under prong two. Because the court concluded that plaintiff failed to allege that at least half of the board faced a substantial likelihood of liability under Caremark, the court held that plaintiff failed to establish that a demand on the board would be futile.

Delaware Supreme Court Affirms Dismissal Of El Pollo Loco Insider Trading Case

On June 28, 2022, the Delaware Supreme Court affirmed the Delaware Court of Chancery’s dismissal of a stockholder complaint alleging derivative claims based on insider trading on the part of Trimaran Pollo Partners, L.L.C., an investment firm that had held the majority of El Pollo Loco Holdings, Inc.’s outstanding stock and had multiple representatives on the board. The court held that there were no disputed issues of material fact as to the independence of El Pollo Loco’s board’s special litigation committee, nor to the reasonableness of its investigation and its conclusions with regard to the alleged insider trading activity.

This case arose out of a May 19, 2015 block trade by stockholders including Trimaran, in which Trimaran sold 5,402,500 shares of El Pollo Loco stock for $118,044,625, or $21.85 per share. Under El Pollo Loco’s trading policy, an insider could not trade stock unless the insider (1) was not aware of material non-public information; (2) purchased or sold within a trading window; and (3) had the trade pre-cleared by El Pollo Loco’s chief legal officer. On May 3, 2015, Michael Maselli, managing partner of Trimaran, first reached out to El Pollo Loco management to discuss a potential sale, and on May 18, 2015, El Pollo Loco management informed its chief legal officer that Trimaran planned to participate in a block sale alongside various executives at El Pollo Loco. Nearly three months later, on August 13, 2015, El Pollo Loco disclosed its second quarter 2015 financial results in a press release, noting that it was adjusting its projected Same Store Sales growth from 3–5% down to 3%. The next day, its stock price dropped from $18.04 per share to $14.56 per share.

On August 24, 2015, a stockholder of El Pollo Loco filed a class action in the U.S. District Court for the Central District of California, alleging federal securities violations and naming as defendants El Pollo Loco, various individual defendants, and Trimaran. Two subsequent stockholder suits were brought in the Delaware Court of Chancery, alleging primarily breach of fiduciary duty, including insider trading claims, after which one of those suits was voluntarily dismissed. On December 3, 2016, defendants moved to stay the Delaware Court of Chancery action pending the outcome of the federal action, and in the alternative, to dismiss for failure to state a claim and failure to make a demand. The Delaware Court of Chancery denied the motion to stay on the insider trading claims, and denied the motion to dismiss, holding that as to the motion to dismiss for failure to state a claim, the circumstances surrounding the block trade supported an inference of scienter at the pleading stage, and that as to the motion to dismiss for demand futility, five of nine directors faced a substantial likelihood of liability.

Following the denial of the motions to dismiss, the board of El Pollo Loco formed a special litigation committee consisting of three newly appointed, independent, and disinterested directors to investigate the allegations in the pending lawsuits. The founder of Trimaran’s managing member recommended two of the directors to the special litigation committee, and one of those two directors recommended the third, all of whom were paid for their service. On February 13, 2019, the committee published a report, concluding that litigation based upon the insider trading allegations would not be proper. In support of its conclusion, the committee determined that any non-public pre-block trade information about El Pollo Loco’s declining sales was not material because it was a sample-size estimate, and that other material information was made public through a May 14, 2015 earnings call. The committee also found insufficient evidence of scienter, because the block trade occurred on the first day of the trading window, meaning that it was unlikely that the sale was in response to inside information. The committee concluded that financial disclosures made by Trimaran and El Pollo Loco’s executives were adequate and made in good faith, and that there was no duty to disclose early, potentially unreliable projections. Finally, the committee noted that decisions to settle other insider trading claims were made not because of the allegations’ merit, but because of the significant costs and reputational risks inherent to litigation. On this basis, the special litigation committee filed a motion to terminate the litigation.

The stockholder plaintiff opposed the special litigation committee’s motion, arguing that the committee was not independent because two of the directors were conflicted, that there were material questions of fact as to the committee’s conclusion, and that in the alternative, the Court of Chancery should apply its own business judgment and move litigation forward. The Court of Chancery first considered director independence, concluding that one of the two committee members was a business acquaintance with the founder of Trimaran’s managing member, and the second only a social contact, neither with any further ties that might conflict their judgment. The court further noted that the special litigation committee was represented by independent counsel with no prior relationship to El Pollo Loco, and that the third uncontested committee member agreed with the other two members’ conclusions and submitted the report alongside them. The court also considered plaintiff’s argument that the committee members had discussed the litigation well before joining the committee, but concluded that they had not participated in in-depth discussion leading to prejudgment of the merits of the suit.

Regarding plaintiff’s arguments as to the merits of the insider trading claims, the Court of Chancery determined that there were no disputed issues of material fact as to the reasonableness of the special litigation committee’s investigation and its conclusion, and the Delaware Supreme Court affirmed. In particular, the court held that the committee had considered the one negative sales report in the context of longer-term financial analyses and disclosures in concluding that Trimaran’s beliefs as to sales and pricing were reasonable. The court also held that the committee had reasonable bases to support its conclusion that the financial information that formed the basis for the insider trading claims was immaterial or made public; that there was insufficient evidence of scienter; that widespread knowledge of the intention to sell mitigated the fact that Trimaran did not have the sale approved by counsel; and that the Court of Chancery did not abuse its discretion in determining there was no public policy or corporate interest reason to disagree with the committee’s report.

One justice, dissenting, argued that an issue of fact remained as to the special litigation committee’s independence, because there was a question as to whether two of the committee members had specifically discussed the merits of the insider trading claims at issue in this case before authorizing, as directors, the motion to dismiss for demand futility in late 2016. The dissent concluded that the special litigation committee bears the burden of proving independence when its members have previously authorized a motion to dismiss, and that the committee did not meet its burden, thus creating a factual issue as to director independence.

Lawyers in Goodwin’s Securities and Shareholder Litigation and White Collar Defense practices have extensive experience before U.S. federal and state courts, legislative bodies and regulatory and enforcement agencies. We continually monitor notable developments in these venues to prepare the Securities Snapshot — a bi-weekly compilation of securities litigation news delivered to subscribers via email. This publication summarizes news from the civil and criminal securities law arenas in a succinct, digestible format. Topics covered include litigation and enforcement matters, legislation, rulemaking, and interpretive guidance from regulatory agencies.

Editorial Board
Jennifer Burns Luz
Meghan K. Spillane

Contributing Authors
Anna Wittman