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.
Hoffman, et al v. RCI Hospitality Holdings, Inc., et al
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