DraftKings investors can’t rely on short-seller report to prove fraud – NY judge

Jan 11 (Reuters) – US District Judge Paul Engelmayer of Manhattan says courts shouldn’t believe everything they read in shareholder class actions — especially when allegations are based on reports from short sellers.

Short sellers are not unbiased narrators, Engelmayer said in a rulings on Monday in a securities fraud class action against sports betting company DraftKings Inc. When they publish damning revelations about publicly traded companies, the judge noted, it’s usually because they are hoping to drive down the company’s share price so they can cover their bets.

That conflict means courts must be cautious about assessing assertions from short sellers, particularly when the short seller has attributed key information to unnamed informants, Engelmayer wrote. And if shareholder lawyers cannot independently verify the short seller’s accusations, Engelmayer said, courts should be even more wary.

Engelmayer, as you’ve probably guessed, dismissed the class action against DraftKings, concluding that shareholders’ case was fatally flawed because it relied almost entirely on assertions from a 2019 Hindenburg Research LLC report that pushed DraftKings’ share price down about 4.2%.

Shareholder lawyers from Robbins Geller Rudman & Dowd had accused DraftKings of defrauding investors by failing to disclose that a private gaming software company it acquired as part of its deal to go public was secretly operating in overseas markets where gambling is illegal. DraftKings’ lawyers at Sullivan & Cromwell vehemently disputed that the company misled shareholders, insisting in a dismissal motion that the private company, SBTech (Global) Ltd, did not violate any US sanctions or foreign gaming laws.

Draft Kings also argued that Robbins Geller’s assertions to the contrary were based entirely on the Hindenburg report, which cited unnamed former SBTech employees. Robbins Geller never talked to any of these unnamed Hindenburg sources, the dismissal motion said. The shareholder firm could not even get Hindenburg to stand by the assertions from its confidential informants, according to Draft Kings’ brief.

The lead plaintiff “nevertheless thoughtlessly adopts the entirety of the Hindenburg [report] as fact, even though Hindenburg itself does not,” the brief said.

Hindenburg did not respond to my email query. Robbins Geller, which beat out two other plaintiffs firms to be appointed lead counsel in the Draft Kings case in 2021, also did not respond to my email.

Robbins Geller’s brief opposing dismissal defended shareholders’ reliance on the Hindenburg report, pointing to a string of decisions in which judges overseeing securities class actions have credited Hindenburg’s research. Robbins Geller also argued that Hindenburg’s report on DraftKings used publicly available evidence — including US and international regulatory filing, LinkedIn research and “backend web infrastructure at illicit international gaming websites” — to corroborate information it obtained from confidential sources.

The shareholder firm said it had verified Hindenburg’s public-record reporting, contrary to DraftKing’s accusation. “Defendants mischaracterize what it was that plaintiff was unable to confirm with Hindenburg itself,” Robbins Geller told Engelmayer. “They imply that it was everything in the report, but it was only the former employees’ statements.”

That explanation failed to convince Engelmayer. The judge agreed with DraftKings that key allegations in the shareholder complaint were “virtually entirely based on the Hindenburg Report, which in turn was largely based on unsourced or anonymously sourced allegations.”

Robbins Geller, he said, did not know anything about Hindenburg’s purported sources — not their names, job titles or dates of employment — so shareholders had no real way to verify their credibility. In that circumstance, Engelmayer concluded, the complaint’s attachments must be “discounted or put aside altogether as ill-pled.”

Draft Kings counsel Brian Frawley of Sullivan & Cromwell declined to comment on the ruling.

The Draft Kings decision is actually the third recent case in which Engelmayer has been called upon to decide how much credibility to give to a short seller’s report, which makes him one of the most prolific Manhattan judges on the issue. In 2020’s meow v. Fanhua IncEngelmayer dismissed a shareholder class action against a Chinese financial services company because, among other things, investors failed to corroborate accounts from unnamed sources in short sellers’ reports on the company.

Engelmayer rejected Fanhua’s argument that the reports deserved no credence, pointing to “a developing body of case law” in which courts concluded that short seller reports are entitled to the same consideration in shareholder class actions as other allegations from confidential witnesses.

But he said that shareholder lawyers must present “well-pled independent and particularized facts [to] corroborate those attributed to anonymous sources in short-seller reports.” (In one case Engelmayer discussed, the short seller’s anonymous sources were its own investigators, whose credibility was backed by affidavits from three Chinese lawyers.)

In 2021, Engelmayer reiterated those conclusions in Inre Hebron Technology Co Ltd, another class action alleging fraud by a Chinese company that was the subject of a short seller report. The judge said again that a shareholder class action is not deficient on its face merely because it relies on allegations from such a report, but again warned that plaintiffs lawyers must give judges an independent reason to trust short sellers.

“Where there is a basis to view the short seller’s factual allegations as reliable as opposed to fabricated based on self-interest — for example, where facts are cited that tend to substantiate these allegations or reveal the basis for the short-seller’s factual assertions — those attachments are more apt to be viewed as reliable,” Engelmayer wrote, in language Robbins Geller quoted in its brief opposing dismissal of the Draft Kings case.

Engelmayer nevertheless dismissed the Hebron suit, finding that shareholders’ complaint fell short on alleging actionable misrepresentations. Engelmayer has ruled three times in the last few years on dismissal motions in shareholder class actions based on short seller reports. He has tossed all three cases.

The judge, in other words, has left the door open for shareholder claims based on short seller reports — but the opening is narrow indeed.

Read more:

Draftkings shares fall as short-seller Hindenburg bets against firm

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