The class action lawsuit brought against DraftKings on behalf of its investors has failed. New York District Judge Paul A. Engelmayer sided with the company in its motion to dismiss.
The suit involved information that the company disclosed – or failed to disclose – around the time that it went public while simultaneously merging with its technology provider SBTech.
DraftKings stock enjoyed a hot streak throughout 2020 until early 2021. It has since plummeted, with share values ending up right around where they began. The plaintiffs who brought the suit blamed a report from short-seller Hindenburg Research, which alleged illegal activities by the new subsidiary SBTech.
The plaintiffs claimed that DraftKings and SBTech leadership had deliberately concealed these purported facts. The class action sought restitution for those who’d lost money as a result of purchasing DraftKings stock prior to the Hindenburg report.
However, Judge Engelmayer’s decision indicates that he found the plaintiff’s arguments unconvincing on several fronts. In particular, he says they relied too heavily on claims made by Hindenburg without independently verifying them.
The DraftKings-SBTech SPAC Deal and Hindenburg Report
DraftKings announced that it would be going public in 2019, at a time when the hype around the still-young US sports betting industry was at a fever pitch. A special acquisitions company, Diamond Eagle Acquisition Company (DEAC), would purchase both DraftKings and SBTech. This would allow them to become a single entity trading on Nasdaq.
The deal closed in Apr 2020.
It’s a strategy that was all the rage in the US online gambling industry in that period. DraftKings itself was an investor darling at the time too. Investors big and small were eager to get in on the action. The stock, which was trading below $15 shortly before the deal became final, more than quadrupled in price over the course of six months.
By spring 2021, the stock (DraftKings 41,47 -0,43%) had already peaked, with an all-time closing high of $71.98 on Mar 19. The Hindenburg report came out three months later, on Jun 15.
Hindenburg’s business model is to profit through the downfall of companies it considers to be overvalued. It will take a short position in such a company – meaning it will gain if the company’s stocks fall – and then attempt to persuade the investing public to agree with its assessment. In DraftKings’ case, it did so by calling attention to the international activities of SBTech.
As a supplier, SBTech does business with other gambling companies around the world. The Hindenburg report alleged that some of these companies were serving countries where online gambling is illegal, including some, like Iran, against which the US also has economic sanctions. That, according to the lawsuit, was what precipitated the fall of DraftKings stock.
The Fall of $DKNG
Recently, DraftKings stock has been trading in the $10-15 range, similar to the price of DEAC just before the deal closed. The Hindenburg report surely didn’t help the company’s value, but there are likely other factors that have contributed to its decline as well.
Massive promotional expenditures in the name of building customer databases and brand visibility were the hallmark of the early years of US sports betting. Investors were initially on board, impressed with large revenue and market share figures. However, in 2021, questions began to swirl about when the market leaders would find profitability, coupled with demands to rein in spending. DraftKings has been among the most stubborn in staying the course, resulting in a loss of investor confidence.
Compounding that has been the larger economic downturn of 2022. Valuations for most industries have dropped, and online gambling has been particularly hard hit. DraftKings hasn’t been alone on that front.
The New York Lawsuit and Motion to Dismiss
The plaintiffs in the case attempted to sue on behalf of all investors who bought shares of DEAC or DraftKings between Dec 23, 2019 – when the SPAC deal was first announced – and Jun 15, 2021 – when Hindenburg released its report.
In a nutshell, the claim was that six defendants – including DraftKings CEO Jason Robins and SBTech founder Shalom Meckenzie – knew that SBTech’s business included illegal activities and that they deliberately avoided disclosing this to potential investors. The plaintiffs further claimed that these facts caused the decline in DraftKings’ share value after Hindenburg released its findings. Finally, they claim that some of the defendants offloaded some of their own stake in the company before the stock lost value.
If they had been proven, those claims taken together would have put the defendants in violation of the Securities Exchange Act.
As is typical in such cases, the defense began with a motion to dismiss. In an 85-page order, Judge Engelmayer agreed with the defense regarding the flaws it pointed out in the plaintiffs’ argument, and granted the dismissal.
Standards for Dismissal
Judge Engelmayer’s order lays out the standards the court must apply in evaluating such a motion. Plainly put, it must determine if the claim is reasonable when taken at face value.
More specifically, that means that the court must make all reasonable assumptions in favor of the plaintiff when it comes to the facts of the case. However, it needn’t do so for the plaintiffs’ assertions about the legal conclusions that follow from those facts.
In this sort of case, the burden of proof is somewhat higher on the plaintiffs than normally. Judge Engelmayer points out that when it comes to alleged falsehoods, simply declaring a statement false is not sufficient for the court to assume it is. The plaintiffs must show how and why it is. Furthermore, the defendants’ mindset matters and there must be some indication of deceptive intent. Finally, there must be reasonable evidence that the deception caused the loss suffered by the plaintiffs.
Motion Granted
DraftKings’ legal team challenged all of these points. However, Judge Engelmeyer didn’t need to consider the arguments about the alleged loss and its causes. In his determination, the plaintiffs had already failed the earlier tests.
The official explanation for granting the motion is long and technical. In part, that is because of the need to apply the legal reasoning individually to each of the plaintiffs’ many separate but similar allegations.
In broad strokes, however, Judge Engelmeyer sided with the defense for two reasons.
Excessive Reliance on the Hindenburg Report
Firstly, and most importantly, he did not find the Hindenburg report credible enough to stand on its own. It had a clear financial motive for leveling accusations at DraftKings and SBTech, and relied in large part on the testimony of anonymous former employees to do so.
Judge Engelmeyer pointed to precedent in refusing to take such claims at face value. He also faulted the plaintiffs for failing to produce their own evidence or direct interviews with the employees in question. One relevant portion of the order reads:
As the case law further reflects, where these two problematic features coincide—when a complaint’s factual attributions to unidentified sources derive not from interviews by plaintiffs’ counsel, but from a short-seller report’s attributions to such sources—there is still greater need for care. The author of such a report is economically motivated to drive the issuer’s stock price down. He or she is not an attorney with professional obligations to the Court, such as that under Federal Rule of Civil Procedure 11(b) to certify that a pleading’s factual averments were the product of an inquiry reasonable under the circumstances.
Without such direct evidence, Judge Engelmeyer was unwilling to take the claims of illegal activity by SBTech at face value.
No Evidence of Intentional Deception
Judge Engelmeyer also found unconvincing the plaintiffs’ arguments that the defendants had deliberately withheld information in order to sell their shares for a higher price. Although three defendants (including Robins and Meckenzie) had sold off some of their holdings, the court deemed these transactions normal and not worthy of suspicion in their own right.
At the same time, the fact that the plaintiffs failed to show that SBTech had been doing anything illegal means they also failed to show that there was anything to hide. Moreover, Judge Engelmeyer ruled that even if one were to take the allegations against SBTech as genuine, the plaintiffs failed to produce any concrete evidence that the defendants would have been aware of the activities and that they were something that would require disclosure.
One portion of the order is particularly scathing in that regard:
Most salient, the SAC—unsurprisingly given its failure to plead black-market operations adequately—makes only conclusory allegations that defendants knew of such operations. It does not “specifically identify the reports or statements containing this information” that were accessible to individual defendants.
The End of the Road
Judge Engelmeyer dismissed the case with prejudice, meaning the plaintiffs can’t simply try again. They had requested leave to file an amended complaint in the event of dismissal. However, the order points out that already had multiple opportunities to amend the claim and failed to produce anything more substantial.
Plaintiffs have already amended the complaint twice—once before and once after a motion to dismiss. And plaintiffs have not identified additional factual allegations—for example, a solid factual basis on which to allege black-market operations by SBTech—that would cure the deficiencies noted in the motion to dismiss, explained how further investigation or diligence would rectify the [claim]’s deficiencies, or otherwise offered any reason for the Court to disregard its earlier warning.
As a result, this is the end of the road for DraftKings’ shareholders hoping for some compensation for their losses. Those still holding their shares can hope for the stock to rally. The price dropped perilously close to $10 shortly after Christmas, but has been recovering since, sitting at $13.48 as of the time of publication.
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