(I posted this post, and then LexBlog ate it, so I am posting again – hopefully it will not show up twice.)
Misfit toys. Interesting opinion from CA9 in Construction Laborers Pension Trust of Greater St. Louis v. Funko this week. After setting the stage with a surprising bit of pathos (comparing the fate of outdated Funko toys unfavorably to that of the toys in Rudolph the Red-Nosed Reindeer), the court sustained a complaint alleging that Funko’s risk disclosures were misleading, because they suggested that the company could have problems with managing its inventory, when in fact such problems already existed. That alone isn’t surprising; it tracks similar cases against Facebook and Google. What was interesting here was the analysis of scienter, which depended almost entirely on the core operations doctrine. Per the court:
If Funko could not turn its products around quickly, it would be left with dead product in its warehouse that it could not sell. This scenario could cost Funko far more than just the loss accrued from the costs of manufacturing and transporting these unsellable products; dead inventory could clog up limited warehouse space and prevent Funko from properly storing new product, incur additional cost for storage, and lead to a vicious cycle of further losses. Given Funko’s business model, its ability to effectively manage inventory was critical to its business operations. Funko admitted as much. Taking Plaintiffs’ allegations as true, a rational fact finder could find that it would be absurd for Funko’s CEO or CFO not to have closely monitored the company’s management of its inventory, especially in its highly touted Buckeye DC.
Plaintiffs also allege that Funko’s effective use of information technology was key to its ability to manage its inventory effectively, as Funko itself acknowledged in risk disclosure statements. Plaintiffs make many allegations that Funko viewed its information technology system as integral to its success as a business. Funko’s transition to the Oracle ERP was driven by its goal of modernizing and improving its handling of inventory and management of its distribution centers. And the transition to Buckeye DC—Funko’s largest ever distribution center, which would house approximately 80% of its products within the United States—was partly with the aim of moving to a consolidated distribution center built around the new information technology system. Plaintiffs allege that both the Buckeye DC and Oracle projects were viewed as central priorities by Funko’s executive leadership. Plaintiffs allege that Funko’s executive leadership attended bi-weekly “Steering Committee” leadership meetings directly related to the transition to the new information technology system. And beginning in June 2022, COO Sansone began spending between one to two weeks per month at the Buckeye DC to oversee the project and information upgrade personally—demonstrating the importance with which Funko viewed these projects….
The potential damage that could result from Funko failing to manage its inventory effectively was also not hypothetical….in light of the alleged 2019 incident, we infer that a reasonable trier of fact could find that Funko’s senior management would have been aware of the deleterious impact that inventory mismanagement could have and would therefore be particularly attuned to inventory-related issues. Likewise, a reasonable trier of fact could also find it absurd to suggest that Defendants would not have been aware of Funko’s difficulties in managing its inventory given the scale of the chaos at Buckeye DC and that Funko had experienced similar inventory-related issues a mere three years prior, causing losses in the millions….
So, it’s kind of hard to explain why this is surprising if you’re not in the weeds of securities opinions. Courts are usually very reluctant to let core operations (the idea that top officials are likely to be aware of central business matters) – standing alone – serve as a basis for inferring scienter. Usually, those allegations have to be supplemented, typically by identifying reports that were delivered to top officers detailing the problem. And even then, what operations are “core” are often those directly concerning product flaws or sales – not, as in this case, a collateral logistics issue. For example, in Walling v. Generac Holdings, Inc., 2026 WL 280211 (E.D. Wis. Feb. 03, 2026), decided by E.D. Wisconsin one day before Funko, the court explicitly held that the core operations doctrine standing alone cannot demonstrate scienter, and that allegations of inventory piling past the point where it could be stored were not sufficient.
Here, however, CA9 accepted allegations that inventory tracking was particularly important to Funko, which by extension suggested significant problems would be known to top management. And, implicitly accepted – without further allegations of motive – that top executives might try to conceal a problem simply because they don’t want to disappoint the market, and hope they can make it go away before disclosure becomes inevitable.
Which is totally reasonable! Large corporations keep very close track of internal systems, and those are reports that are likely to be seen in the C-Suite (not the point he was making, but Stavros Gadinis described these systems in his recent article, Social Business Judgment). I believe that, in most cases, if a problem is any reasonable kind of size, it is certainly more likely than not that reports detailing it are seen by the CEO (or the CEO is intentionally blinding him/herself). But courts evaluating complaints under PSLRA pleading standards tend to begin with exceptionally strong presumptions of CEO ignorance (I once said that courts evaluating complaints under PSLRA standards ignore all the ordinary ways we infer other people’s states of mind, just as humans living on this planet), which is why Funko stands out.
On the mercy of the court because he is an orphan. I enjoyed the chutzpah on display in CA3’s Abramowski v. Nuvei, involving a rare allegation a tender offeror violated 17 C.F.R. § 240.14d-10(a)(2), the “best price” rule. The best price rule states that in a tender offer, the “consideration paid to any security holder for securities tendered in the tender offer is the highest consideration paid to any other security holder for securities tendered in the tender offer.”
In this case, plaintiffs sponsored a SPAC, Fintech, which was used to take a company called Paya public. As sponsors, they received promote shares in Fintech, which converted into Paya shares in the de-SPAC merger. To ensure that the sponsors remained committed to Paya’s success, the shares were subject to a lockup for some period of time, which included an exception to permit a sale if the company was acquired within the lockup period at a price above $15 per share. If the acquisition occurred at a price below $15 per share, the sponsors’ shares would be forfeit.
Well, Paya found an acquirer, Nuvei, who chose to accomplish the transaction through a friendly tender offer and merger under DGCL 251(h). Except, the price per share was $9.75, which meant the sponsors’ shares would be forfeited. Rather than accept their fate, however, the sponsors sued, claiming that, by refusing the sponsors’ tender on the ground that the offer was only open to shares that were not subject to transfer restrictions, Nuvei violated the best price rule (offering only zero dollars for the sponsors’ shares, which would now be involuntary merged out, instead of $9.75).
Honestly, the most natural claim, to me, would not be that Nuvei violated the “best price” rule, but that it violated the “all holders” rule, which requires that “the tender offer is open to all security holders of the class of securities subject to the tender offer.” 17 C.F.R. § 240.14d-10(a)(1) (the Third Circuit seemed a little baffled too; it made several references to the “all holders” rule, only to note that plaintiffs were not bringing a claim under it). Nonetheless, I’m sure for good reason, that’s not the argument the sponsors made.
Anyhoo, the court held that “it would contort the Best Price Rule beyond recognition to suggest that the Rule requires offerors to purchase every tendered share, even those restricted by the parties’ prior agreements. … By its plain terms, the Rule relates to the consideration that must be paid to tendering shareholders at the completion of a proposed tender offer. But it is silent as to when, if ever, an offeror must purchase tendered shares or whether that offeror may include in the tender offer terms and conditions of acceptance, such as Nuvei’s requirement that the tendered shares be freely transferable ….”
Which, you know, fair, if for no other reason than the statute contemplates not every share tendered will in fact be accepted in a tender offer, 15 U.S.C. §78n(d)(6), with no concern for whether the nontendered shares will eventually be merged out/canceled at some other price.
But also because there was a reason for the lockup and the price floor, which presumably had something to do with SPACs getting a reputation for being pump-and-dumps! It would be a heckuva thing if lockups could be evaded by the simple expedient of merging via 251(h) instead of 251(c).
So, you know. Valiant effort, appellants.
Sanctions. Rule 11 requires that attorneys file nonfrivolous complaints, warranted by the facts and existing law, on pain of sanction. The PSLRA – passed out of concern for frivolous securities complaints – requires a mandatory Rule 11 review at the conclusion of a case. 15 U.S.C. § 78u–4(c)(1).
But the PSLRA also has the lead plaintiff provisions, which state that after a case is filed, the court will select a lead plaintiff to control the case. The lead plaintiff shall be the one “most capable of adequately representing the interests of” the class, and that plaintiff may not be the same plaintiff who filed the original complaint. Since the PSLRA front loads so much of the litigation into the pleading phase – everything stands or falls on whether a complaint runs a very precise pleading gauntlet – it necessarily follows that the lead plaintiff will want to take control of the complaint. Except you can’t appoint a lead plaintiff until there’s already been a complaint!
What to do?
The practice has grown up that, when a case potentially involves securities fraud, plaintiffs (law firms) will file complaints to get the ball rolling. These are necessarily bare bones if for no other reason than, no firm is going to expend the many hours of legal and investigatory resources drafting a complaint if they aren’t going to be appointed lead and be entitled to fees. After these rather sparse complaints are filed, the court consolidates related actions, appoints a lead, and the lead plaintiff files a new, amended complaint – the real complaint, the one that will govern the action and that is intended to surmount the PSLRA’s pleading hurdles, stretching hundreds of pages, often citing confidential witnesses, experts hired to analyze defendants’ documents, and so forth.
In Toft v. Harbor Diversified, No. 24-C-556, E.D. Wisc., the defendants disrupted the system. After the initial, bare bones complaint was filed – before a lead had been appointed – they moved to dismiss. After that, a new lead plaintiff was appointed, and the motion was held in abeyance to allow for an amended complaint by the lead.
The lead plaintiff filed a new complaint, the defendants moved to dismiss that, and won! After which, the lead plaintiff declined to amend again and instead informed the court of an intention to appeal.
Meanwhile, the defendants moved for sanctions against the law firm that filed the original complaint, on the grounds that the original complaint was so sparse that no reasonable attorney could have believed it complied with PSLRA standards.
To be fair – yes! That’s true of every single initial complaint, which is baked into the statutory design (even if that wasn’t exactly what Congress anticipated).
Nonetheless, the district court agreed that the original attorneys had committed sanctionable misconduct, and ordered briefing on amounts due, which would include defendants’ litigation expenses associated with responding to the original complaint.
So I highlight this because it troubles me. Yes, initial complaints are bare bones, and could not – and are not designed to – withstand PSLRA scrutiny. But the system developed this way because there was no other way it could go, given the incentives created by the statute. The expenses defendants’ incurred moving to dismiss the original complaint were entirely avoidable, because any defendant should understand – and certainly can be made to understand – that the original complaint will not be litigated. And if courts get into the habit of sanctioning the case-starters …. Well, I’m sure defendants will be delighted, because it will make it that much harder to start a case – any case, no matter how meritorious.
Authoritarianism. I previously posted the text of a lecture I delivered at Boston University on shareholders’ shrinking rights in corporate governance. Which is why it is timely that the SEC recently followed through on its previously-announced plans to limit shareholders’ ability to file exempt solicitations. These communications – even if there’s been some abuse recently – are actually a valuable mechanism of intra-shareholder communication, so this is another example of a multi-pronged effort to limit shareholder voice.
And then there’s the SpaceX IPO! WSJ reports that SpaceX is trying to gain entry into major stock indices early, which would mean that large institutional investors would be forced to buy the stock right out of the gate. I think we can safely infer that with this IPO, Elon Musk will not make the mistake he made with Tesla, going public with single class shares. He will almost certainly adopt a dual-class share structure, giving himself outsized control, and probably include a shareholder agreement to boot (which would preclude incorporating in Texas, so Nevada seems more likely). In other words, just as WaPo is reporting (in an article written by at least one journalist who has since been laid off) that Musk tweaked xAI to make it more addictive to users by encouraging more sexual interactions (including nonconsensual image generation), America’s retirees may be more or less forced to provide capital, with no governance rights and (assuming incorporation in Texas or Nevada, and even – increasingly – Delaware) virtually no litigation or inspection rights. This is what we call “private ordering” and “efficiency.”
And there is no other thing. No Shareholder Primacy podcast this week, but back soon!
