Reflections on the Martin Shkreli case
May 2018 | EXPERT BRIEFING | LITIGATION & DISPUTE RESOLUTION
Martin Shkreli made global news in late 2015 as the man behind the 5000 percent increase in the price of the HIV drug Daraprim. Despite an initially passionate defence, he was publicly pilloried, earning himself the dubious title of ‘most hated man in America’. Even bitter rivals Donald Trump and Hillary Clinton were united in their condemnation of Mr Shkreli’s actions.
In March, he was handed a seven year sentence resulting from his mismanagement of businesses totally unrelated to Daraprim.
Litigation relating to company mismanagement is something the US legal system is well versed in dealing with and such claims are becoming increasingly prevalent in the UK as well.
The charges against Mr Shkreli revolved around his involvement in two hedge funds, MSMB Capital Management LLC and MSMB Healthcare Management LLC, as well as his time as CEO of Retrophin LLC (now Retrophin Inc.).
The key accusations against Mr Shkreli were that he: (i) misappropriated MSMB Capital’s and MSMB Healthcare’s money to pay various unauthorised expenses; (ii) suffered significant losses on his hedge fund trading and created a Ponzi scheme using new investor money to cover those losses; (iii) made material misrepresentations to investors regarding the sums managed by, the performance of and the independent regulation of the funds (he was alleged, for example to have told prospective clients that MSMB Capital had US$35m of assets under management, when the actual figure was less than US$1000 and represented that the funds had returned profits of 35.77 percent when an 18 percent loss had actually been made); and (iv) on behalf of MSMB Capital, short traded a substantial number of shares in an unrelated company. As part of this transaction, he misrepresented to the broker Merrill Lynch his ability to borrow the shares in order to settle the short trades. The failed short caused Merrill Lynch to lose over US$7m, resulting in it commencing proceedings against Mr Shkreli and MSMB Capital. He is said to have used nearly US$1m of MSMB Healthcare investor funds to settle the claim.
After some time, clients started raising questions regarding their investments, including a threat to complain to the US Securities and Exchange Commission (SEC). In order to appease investors, Mr Shkreli arranged for them to receive a settlement in the form of cash from and/or shares in Retrophin. This, it was alleged, was Mr Shkreli looting Retrophin to appease the disgruntled hedge fund stakeholders.
As a result, Mr Shkreli stood accused by the SEC of a total of eight fraud and securities violations.
The defence appeared to accept that a lot of what Mr Shkreli told his clients was not true. Instead, it focused on the financial gains made by a number of them via their replacement investments in Retrophin. For example, the court heard from Susan Hassan whose US$300,000 investment ultimately resulted in her receiving US$400,000 in cash, along with US$900,000 in Retrophin share sale proceeds. Similarly Darren Blanton’s investment of US$1.25m ultimately translated into US$200,000 in cash and US$2.4m in share sale proceeds, in addition to around US$3m worth of shares which he still held at the time of Mr Shkreli’s trial.
After nearly five days of deliberation, the jury found Mr Shkreli guilty of three of the eight charges he faced. He was convicted of two counts of securities fraud and one count of conspiracy to commit securities fraud, but cleared of those relating to the effective looting of Retrophin’s assets.
Following his conviction, Mr Shkreli declared himself “delighted to have been acquitted of the most important charges” relating to Retrophin. He was originally released on bail pending sentencing, but was recalled shortly thereafter following a provocative online post involving Hilary Clinton.
Mr Shkreli was certainly less bullish by the time of his recent sentencing. In a letter to the judge, he outlined his remorse, admitting “It was wrong. I was a fool. I should have known better”, and promising that, if any mercy was shown to him, he would use his skills “for the betterment of humanity”.
His submissions did little to help his cause or outweigh the harm created by his conduct following his arrest. The sentencing judge handed him a seven year sentence and cited offensive messages he had sent about the police while incarcerated as an example of his failure to change. The sentence was nearly midway between the 15 years sought by prosecutors and the defence’s suggestion that 12 to 18 months would be appropriate.
An unusual element of Mr Shkreli’s trial was the positive financial consequences for his hedge fund investors. The vast majority of cases of this nature involve reams of individuals or businesses having lost substantial sums of money. We will obviously never know the full story of what went on in the jury deliberation room, but it seems that they accepted, in part, the ‘no harm has been done’ argument that the defence pushed so hard.
While it seems that Mr Shkreli managed to convince the jury that his investors had suffered no loss, it is less clear whether the same can be said for other shareholders of Retrophin. A class action was filed in October 2014 against (among others) Retrophin and Mr Shkreli, alleging various breaches of the federal securities laws in connection with the shares in Retrophin handed to hedge fund investors. The claim alleged that the acts and omissions of Mr Shkreli, Retrophin and its senior management, by way of misleading statements made in SEC filings, had resulted in “the precipitous decline in the market value of Retrophin securities”. The class action sought relief of US$26-41m and was settled for US$3m, which is said to have been paid by Retrophin’s insurers.
The UK courts are seeing an increasing number of similar cases where shareholders have brought civil proceedings to recover their losses due to inaccurate statements made by management. In circumstances akin to Mr Shkreli’s, investors in English companies may look to section 90A of the Financial Services and Markets Act 2000 (FSMA). To ground a claim on this basis requires a statement issued on a “regulated information service”, such as the London Stock Exchange, which: (i) contained false information or a material omission in respect of a material fact; (ii) was known by a person discharging managerial responsibility to be untrue, that person was reckless as to whether it was true or that individual knew there was a dishonest concealment of a material fact; (iii) was relied on by the investor claimant when buying, selling or holding the shares; and (iv) caused the investor loss.
In such cases, much will self evidently turn on the facts in question, but some of the potential hurdles for an investor to establish liability include the following. First, arguments that the information supplied was not demonstrably false. Certain circumstances would strongly imply the information was incorrect, for example a subsequent accounting write down or a regulatory investigation. In other cases it may not be so clear. Second, if the statement was false, did a person discharging managerial responsibility know of this? The share issuer may try to argue that the conduct in question was deliberately concealed from senior management. Importantly, the fact that the management may have made the statement negligently is not sufficient – they need to have been dishonest or reckless regarding its accuracy. Finally, did the investor rely on the statement? This logically will be closely linked to the importance of the statement to investors – if profits were stated as £100m when they were actually nil, it is highly likely that this would have been relied on. If the statement related to the implementation of a safety report which did not take place, resulting in an accident and losses, this may not have been relied upon. Importantly, if the false statement can be found in a prospectus or listing particulars, the investor can rely on section 90 of the FSMA. Proceeding under section 90 removes the need for the potential claimant to show they relied on the statement when investing.
Once liability is established, further complexities of pursuing such litigation revolve around the calculation of loss that can be said to have been suffered. By their very nature, shares fluctuate in price. While you may have suffered a short-term loss, waiting some time may pull you out of the red. The Retrophin shares, for example, suffered a short-term reduction when the allegations regarding Mr Shkreli’s conduct emerged in September 2014, but they went on to nearly double in value by mid 2015.
It is often difficult to pinpoint the reason for a share’s devaluation as events completely unconnected to any alleged misconduct may equally have caused a reduction in share value. Additional complications may arise when an investor has bought and sold shares during the period in which the falsity of the statement was not known, as it could be argued they benefitted from the misstatement by receiving a higher price for the shares than they would have had the true position been known.
The quantification of such loss is therefore notoriously complex and there is, as yet, no court approved method of valuing such losses. Some of the possible approaches already pleaded in cases going through the courts include the ‘left-in-hand’ approach and the ‘inflation per share’ approach. The former is calculated based on the difference between the price paid for shares and the average share price in the period immediately following the disclosure of the ‘true position’. The latter would assess the difference between the price paid and the ‘true value’, which would be calculated following an economic analysis. The analysis to determine the true value under the inflation per share approach would seek to strip out other factors that may have impacted share performance. For example, the performance over the relevant period of a representative group of shares, such as those of peer companies, could be analysed to calculate what would have happened to the shares irrespective of the false statement.
There is also an important question to resolve in the above scenario where there have been sales and purchases during the period of the misstatement. The court may need to consider whether and how these should be treated to calculate the true loss. Potential options including ‘first in, first out’, with the oldest shares being set off against the first shares sold, or ‘last in, first out’, where the newest shares purchased are set off against the first shares disposed of.
In each of the above, the investor’s remedy would be against the issuing company rather than the directors. However, it is not always the case that compensation for the investor is paid out of the company’s assets. Frequently there is money available to pay some or all of shareholder compensation, as it appears was the case in the 2014 Retrophin class action where the settlement was paid by insurers.
What is clear is that Mr Shkreli’s troubles do not seem to be over quite yet. Retrophin has issued civil proceedings against him in which they are seeking to recover the cash sums it paid to his disgruntled hedge fund investors, along with the current market value attributable to the stocks those investors received. Mr Shkreli is countersuing, claiming wrongful dismissal. His lawyer asserted his confidence in defending the lawsuit following his partial acquittal in the criminal trial. However, one thing does seem very clear – the legal fallout from Mr Shkreli’s conduct does not appear to be coming to an end just yet.
Keith Thomas is a partner and William Towell is a senior associate at Stewarts. Mr Thomas can be contacted on +44 (0)20 7822 8177 or by email: firstname.lastname@example.org. Mr Towell can be contacted on +44 (0)20 7822 8000 or by email: email@example.com.
© Financier Worldwide
Keith Thomas and William Towell