On May 4, 2022, Judge Victor Marrero of the United States District Court for the Southern District of New York denied a motion to dismiss a putative class action alleging, among other things, violations of Sections 10(b) and 20(a) of the Securities Exchange Act (the “Exchange Act”) and Rule 10b-5 thereunder against an investment company (the “Company”), its related entities, and its president and co-founder. Michael Tecku et al. v. YieldStreet Inc. et al., No. 1:20-cv-07327 (S.D.N.Y May 4, 2022). Plaintiffs alleged that the Company “misrepresented material facts about the stability and attractiveness of their investment products in its offering documents” by making misleading statements or omissions in private placement memoranda (“PPMs”) and series notes supplements (“SNSs”). The Court held that, accepting plaintiffs’ allegations as true, plaintiffs sufficiently alleged securities fraud violations for certain alleged misstatements and omissions.
According to the amended complaint, the Company is an investment firm that prescreens investment products and offers them for sale on its online platform. The Company’s portfolio consists mostly of borrower payment dependent notes (“BDPNs”), which comprise debt obligations tied to the performance of specific underlying loans made by a special purpose vehicle (“SPV”) formed by the Company in connection with the debt offering. The SPV raises funds through the Company’s investors and then lends the funds to an undisclosed borrower. Plaintiffs alleged that the Company’s management is solely responsible for making decisions as to which products to offer for sale on the Company’s investment platform, and the Company does not offer investors access to underlying data or risk-assessment analysis. According to plaintiffs, investors instead rely on the Company’s diligence and transparency in presenting any material information in its offering documents.
Plaintiffs—individual investors in the Company’s products—alleged that the Company made false statements in its April 2018 and January 2019 PPMs, including by representing to investors that “none of the investments offered on [the Company’s] online platform had ever lost any principal.” Plaintiffs also alleged that from December 2018 through September 2019, they were induced to make volatile investments in marine vessel deconstruction transactions, which plaintiffs claimed were “particularly volatile” and requir[e]d a “high degree of industry knowledge to successfully navigate.” Plaintiffs alleged that they would not have made these investments absent false or misleading statements in the vessel transaction offering documents about the Company’s three-step diligence process, which they did not know had been subverted in October 2018 when a member of the credit committee “went rogue” and “abandoned the industry standard model for loans . . . in favor of much higher-risk short-term loans” without consulting the multi-party credit committee or the Company’s asset class expert.
The Court first considered the “no principal loss statement,” which plaintiffs alleged was misleading because the president of the Company had previously acknowledged in a June 2017 email to investors that the Company’s offering for a rideshare fund had gone into default and that the fund had “outstanding principal.” The Court held that “outstanding principal on a defaulted loan plausibly constitutes ‘principal loss,’” and that plaintiffs had therefore sufficiently alleged the Company made material misstatements in its April 2018 and January 2019 PPMs.
The Court further held that plaintiffs sufficiently alleged material omissions regarding the Company’s statements concerning its due diligence process, finding that “plaintiffs allegations create a strong inference of a duty to disclose” the intervening due diligence events from October 2018, which “rendered the diligence process in the SNS misleading or false.” The Court disagreed, however, with plaintiffs’ argument that because the offering documents disclosed the Company’s inexperience in certain areas, the Company had a duty to disclose all areas in which it lacked experience, noting that the offering documents did not provide that the Company was only inexperienced in the listed areas, and warned against the “undesirable outcome” of encouraging companies to forgo disclosing any inexperience “to protect against needing to disclose all.”
The Court next held that plaintiffs sufficiently alleged a reasonable inference of scienter as to the “no principal loss statement” and the omissions concerning the Company’s diligence process. According to the Court, plaintiffs sufficiently alleged that defendants knew the “no principal loss statement” was false when made in 2018 and 2019 based on an email from its president in 2017 about one of the funds being in default. As to the alleged diligence omissions, the Court held that plaintiffs sufficiently alleged that defendants knew their statements regarding the Company’s diligence process were rendered misleading after the October 2018 events materially changed that process, and further found that by subverting the due diligence process, defendants realized increased management fees without regard to loan performance.
The Court rejected defendants’ argument that “cautionary disclosures” in the offering documents prevented plaintiffs from alleging reasonable reliance and held that stating past investments are not indicative of future performance does not convey to investors that past investments may be misrepresented within the documents. Moreover, the Company’s warning that it may use other investment strategies did not prevent investors from relying on statements in the December 2018 through September 2019 offering documents which occurred after the due diligence process was already subverted in October 2018. The Court agreed that plaintiffs sufficiently alleged that they reasonably relied on the information in the offering documents, because investors had no “lens into the industry” and would not have purchased the Company’s investment products had they been aware of the omitted information.
Turning to plaintiffs’ Section 20(a) allegations, the Court held that plaintiffs satisfied the first element of a control person claim by sufficiently alleging a predicate violation of Section 10(b), and further held that plaintiffs sufficiently alleged the remaining elements of a control person claim based on allegations that the individual defendant was the president and co-founder of the Company and its subsidiaries and exerted control over those entities.