On March 31, 2021, Judge Alfred H. Bennett of the Southern District of Texas denied a motion to dismiss claims under Section 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) against a company that operates live adult entertainment businesses and bar-restaurants (the “Company”) and certain of its executives, as well as members of its audit, compensation, and nominating committees. Hoffman, et al v. RCI Hospitality Holdings, Inc., et al, No. 4:19-cv-01841 (S.D. Tex. Mar. 31, 2021). Plaintiffs alleged defendants made misleading statements or omissions concerning certain related-party transactions (RPTs), executive compensation, and other financial points in several of the Company’s Form 10-K annual reports. The Court denied defendants’ motion to dismiss the amended complaint, holding that plaintiffs sufficiently pled material misstatements and scienter.
The Company announced in early May 2019 that the SEC had launched an informal inquiry into its financial statements after a “series of negative articles” alleged the Company had omitted certain RPTs from its financial disclosures. The Company hired an independent auditor to investigate the matter, and, in July 2019, the Company disclosed in an 8-K that the independent auditor had resigned, citing certain process failures and inappropriate remedial action by the Company. The next day, the Company’s stock fell by 12.5%. Shortly thereafter, the Company filed another 8-K stating that a special audit committee had determined the Company’s annual report needed to be supplemented to include previously undisclosed information. Two weeks later, one of the individual defendants resigned from the board of directors, and the Company later disclosed that the SEC’s inquiry had become a formal investigation.
According to the Amended Complaint, defendants made six allegedly misleading statements or omissions in the Company’s 10-Ks. These pertained to the Company’s alleged failure to disclose certain RPTs—including a salary increase for a family member, payments to companies owned by family members, and construction contracts to companies affiliated with family members—and failing to disclose executive compensation to two of the individual defendants in the form of personal use of Company-owned aircrafts. The Company also allegedly failed to disclose that one of the individual defendants, a “designated financial expert,” had filed two voluntary bankruptcy petitions during his tenure on the Company’s board of directors. The final allegation asserted that the Company “failed to disclose insufficient internal controls over financial reporting of RPTs, executive compensation, and required disclosures as one of [the Company’s] material weaknesses as is required by the Sarbanes-Oxley Act.” Defendants filed a motion to dismiss, arguing the amended complaint failed to allege falsity or scienter for the alleged misrepresentations or omissions.
The Court first held that plaintiffs adequately alleged scienter. In particular, as to defendants’ argument that they did not have the requisite scienter concerning the executive compensation reporting because “they did not perceive these employment and vendor relationships as ‘transactions’ that needed to be disclosed,” the Court held that defendants’ argument was unpersuasive as Item 404 of Regulation S-K defines “transaction” to include the very transactions defendants allegedly failed to disclose. Furthermore, the Court found that since the Company disclosed as an RPT that one defendant was personally guaranteeing all of the Company’s commercial bank indebtedness, the Company’s simultaneous failure to disclose the relationships between the family members and the various companies rendered “[d]efendants’ plea of ignorance . . . unpersuasive.” The Court held “[d]efendants’ disclosure of an encouraging RPT and simultaneous failure to disclose less flattering RPTs [was] sufficient to create a strong inference of scienter.”
Turning to falsity, the Court rejected defendants’ argument that plaintiffs failed to adequately allege material misrepresentations or omissions related to the Company’s construction contracts and internal control failures. With respect to the construction contracts, defendants argued plaintiffs merely stated a legal conclusion that certain of the parties were related. The Court disagreed, finding “these allegations sufficient to plausibly allege that [the Company’s] transactions with [the construction company] should have been disclosed because of [the individual defendants’] indirect material interests in the transactions.” With respect to omissions related to internal controls, the Court held that plaintiffs alleged sufficient facts to plausibly allege that defendants knew of certain material omissions in its disclosures prior to signing those disclosures, noting that, for example, one of the individual defendants “knew that he had used [the Company’s] jet for personal use when he signed the 2017 Proxy Statement stating that ‘[t]he Company does not provide named executive officers with any significant perquisites or other personal benefits except for an automobile for each executive’s business use.’”
After holding that plaintiffs adequately alleged a Section 10(b) claim, the Court similarly allowed plaintiffs’ control person liability claims under Section 20(a) to proceed.