A federal district court dismissed plaintiffs’ claim under §12(a)(2) of the Securities Act of 1933. Plaintiffs, a group of hedge funds, purchased stock of defendant Health Grades, Inc. directly from defendant Essex Woodland Health Ventures, which owned 30% of Health Grade. Principals of Health Grade assisted Essex in its sales efforts. Plaintiffs alleged, among other things, that defendants violated §12(a)(2) by making material omissions and misrepresentations regarding the status of an important contract between Health Grade and a third party in order to induce plaintiffs to purchase the stock.

The Court ruled that §12(a)(2) claims can survive only if the alleged misrepresentations are contained in or relate directly to a prospectus. Although the plaintiffs conceded that the prospectus did not include any misrepresentations, they argued that the alleged oral misrepresentations related to their decision to purchase the stock and, thus, to the Health Grade prospectus provided to them in connection with their purchase of the stock.

The Court rejected the argument on two grounds. First, it found that the alleged misrepresentations solely concerned the status of Health Grade’s contract with the third party and did not relate to the prospectus itself. Second, because the stock sales were made to institutional investors, rather than the public at large, the Court ruled that there was no obligation for defendants to issue a prospectus to plaintiffs in connection with the sale. While noting that Health Grade’s prospectus was included in the sales offering documents provided to plaintiffs, the Court deemed this irrelevant, ruling that plaintiffs did not allege that Essex was obligated to issue a prospectus and that Essex had not issued one. (Gotham Holdings, L.P. v. Health Grades, Inc., 2008 WL 449689 (S.D.N.Y. Feb. 15, 2008))

Court Denies Motion to Dismiss Rule 10b-5 Claim

Plaintiffs, who had entered into a Merger Agreement with defendant, sued defendant for, among other things, violating §10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. Because plaintiffs and defendant operated casinos, the merger was subject to governmental approval. Defendant represented in the Merger Agreement that no government investigations of its business existed and that its directors and owners were complying with all applicable gaming laws. It also agreed to promptly notify plaintiffs if its representations became untrue.

Plaintiffs sought to extend the closing date specified in the Merger Agreement because it did not anticipate receiving the requisite governmental approvals by such date. Defendant agreed to the extension in exchange for plaintiffs’ agreement to immediately pay defendant a $5 million non-refundable deposit.

After defendant refused plaintiffs’ request for a second extension, because the requisite government approvals still had not been received, plaintiffs sued, alleging that defendant deliberately failed to disclose that at the time of the extension the Illinois Gaming Commission was investigating one of defendant’s director-stockholders for, among other things, alleged ties to organized crime.

Defendant moved to dismiss the federal securities law claim, arguing that plaintiffs failed adequately to allege the scienter and causation elements of the claim. The Court disagreed. The Court found that the complaint created the requisite cogent and compelling inference of scienter by alleging that (i) when defendant agreed to extend the closing date it knew of the Illinois Gaming Commission’s investigation, (ii) defendant knew that some of its representations in the Merger Agreement were false at the time of the extension agreement, and (iii) defendant purposely did not correct the earlier, now false, statements in order to induce plaintiff to pay it $5 million and, avoid having plaintiffs “walk away from the faltering deal.” The Court found the “loss causation” element to be sufficiently pled based upon plaintiffs’ allegation that defendant’s failure to disclose the ongoing gambling commission investigation caused plaintiffs to (i) pay the $5 million non-refundable deposit, and (ii) undervalue the risk that governmental approval would not be forthcoming. (CP St. Louis Casino, LLC v. Casino Queen, Inc., 2008 WL 450463 (S.D. Ill. Feb. 15, 2008))