Securities Law Alert
In This Edition:• Tenth Circuit: Rejects Motion to Compel Arbitration of ESOP Claims, Holding That theEffective Vindication Exception Applies• Southern District of New York: Denies Dismissal of Claims Alleging That NFTs Were
Securities Under Howey• Delaware Court of Chancery: Dismisses Derivative Lawsuit on Demand Futility Grounds
March 2023

Tenth Circuit: Rejects Motion
to Compel Arbitration ofESOP Claims, Holding That
the Effective Vindication
Exception Applies
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On February 9, 2023, the Tenth Circuit
affirmed a district court’s denial of a motion
to compel arbitration in a lawsuit brought by
an ESOP (Employee Stock Ownership Plan)
participant, alleging that the plan fiduciaries
breached their fiduciary duties to the planunder ERISA. Harrison v. Envision Mgmt.
Holding, 59 F.4th 1090 (10th Cir. 2023)(Briscoe, J.). The Tenth Circuit held thatenforcing the arbitration provisions in theplan document would prevent plaintiff fromvindicating the statutory causes of action
listed in his complaint, and concluded “thatthe effective vindication exception applies inthis case.”

Background
Plaintiff filed a lawsuit in the district court,
alleging that the plan fiduciaries engaged
in a prohibited transaction in which theSimpson Thacher & Bartlett LLP

company’s founders retained control of
the company while selling their shares of
the company to the ESOP for more thanthey were worth, causing the ESOP to incur
substantial debt. Defendants moved tocompel arbitration based on Section 21 of theplan document entitled ERISA Arbitrationand Class Action Waiver. After the district
court denied defendants’ motion to compel
arbitration based on the effective vindication
exception, defendants appealed.

The Court Sets Out the Effective
Vindication Exception Standard
On appeal, the Tenth Circuit held that thedistrict court properly invoked the effective
vindication exception to invalidate thearbitration provision, explaining that theexception “finds its origin in the desire toprevent prospective waiver of a party’s rightto pursue statutory remedies” (quoting Am.
Express v. Italian Colors Restaurant, 570
U.S. 228 (2013)). The court stated that under
American Express, the “key question iswhether ‘the prospective litigant effectively
may vindicate its statutory cause of action in
the arbitral forum.’” The court explained that,to determine whether the effective vindication

exception applies, it “must first identify thestatutory remedies [plaintiff] is seeking”
and “then determine whether the arbitration
provisions contained in the Plan Document
effectively prevent [plaintiff] from obtaining
those statutory remedies in the arbitralforum.”

The Statutory Remedies
Plaintiff Sought
The court noted that the statutory remedies
plaintiff sought were under ERISA
subsections 502(a)(2) and (a)(3),1 andincluded a declaration that defendants
breached their fiduciary duties under ERISA;
an injunction of further fiduciary duty
violations; the appointment of a new fiduciaryto manage the ESOP; removal of the ESOP
trustee; and an order directing the ESOP
trustee to restore all losses to the plan that
resulted from the fiduciary breaches and todisgorge all profits made through use of theESOP’s assets.

that all defendants breached their fiduciary
duties under ERISA, an order removing thetrustee, and an order enjoining all defendants
from further violations. The court explainedthat these forms of relief would provide
additional benefits to the plan as a whole or to
all of the plan participants and beneficiaries
and would thus be barred by the arbitration
provisions. The court concluded that “Section
21(b) is not problematic because it requires[plaintiff] to arbitrate his claims, but rather
because it purports to foreclose a number ofremedies that were specifically authorized
by Congress in the ERISA provisions citedby [plaintiff].”

The Arbitration Provisions Would
Prevent Vindication of the Statutory
Remedies
As to whether the arbitration provisions
effectively prevented plaintiff fromvindicating the statutory remedies, the court
focused on the language in the plan document
stating that “each arbitration shall be limited
solely to one Claimant’s Covered Claims, andthat Claimant may not seek or receive any
remedy which has the purpose or effect ofproviding additional benefits or monetaryor other relief to any Eligible employee,
Participant or Beneficiary other than theClaimant.” (emphasis in original). The court
found that the “this sentence would clearly
prevent [plaintiff] from obtaining at least
some of the forms of relief that he seeks in hiscomplaint pursuant to [Section 502(a)(2)],”
including, among other things, a declaration
1. Subsection 502(a)(2) provides, in relevant part, that a civil
action may be brought “for appropriate relief under section
1109 of this title.” 29 U.S.C. § 1132(a)(2). Section 1109(a)provides that a fiduciary who breaches their duties shall bepersonally liable to make good any losses resulting from thebreach, to restore any such profits, and shall be subject tosuch other equitable or remedial relief as the court may deem
appropriate. 29 U.S.C. § 1109. Subsection 502(a)(3) provides
that a civil action may be brought “to enjoin any act or practicewhich violates any provision of this subchapter or the termsof the plan, or (B) to obtain other appropriate equitable relief(i) to redress such violations or (ii) to enforce any provisionsof this subchapter or the terms of the plan . . . .” 29 U.S.C.
§ 1132(a)(3).

Southern District of New
York: Denies Dismissal ofClaims Alleging That NFTs
Were Securities Under Howey
On February 22, 2023, in a decision of firstimpression, the Southern District of New
York denied dismissal of a putative classaction alleging that a company violated theSecurities Act by offering for sale to thepublic NFTs (non-fungible tokens) without
filing a registration statement with the SEC,
in violation of Sections 5 and 12(a)(1) of theSecurities Act.2 Friel v. Dapper Labs, 2023
WL 2162747 (S.D.N.Y. 2023) (Marrero, J.).
Looking to SEC v. W.J. Howey Co., 328 U.S.
293 (1946), to analyze whether the NFTs
constituted a security, the court held thatplaintiffs adequately pleaded all three prongsof Howey.
2. Section 5 prohibits persons from offering, selling, or delivering
any security, unless a registration statement is filed with theSEC. 15 U.S.C. § 77e(a), (c). Section 12 creates a private rightof action for any person who purchased a security in violationof Section 5 to recover from the seller the consideration paidfor such security, with interest. 15 U.S.C. § 77l(a).
2Background
The NFTs at issue are digital video clips ofprofessional sports highlights. The defendantcompany may produce multiple copies
of a given highlight, but each copy has aunique serial number. The authenticity andownership of the NFTs is recorded on a
private blockchain—a decentralized digitalledger—that the company developed. The
company also created an application toprovide a platform to sell the NFTs and adigital token to validate transactions on its
private blockchain. The NFTs at issue could
be acquired only when the company sold“packs” of them on its application, or througha secondary marketplace hosted on thecompany’s application.

Whether the NFTs Are Securities
Depends on Whether They Amountto an Investment Contract
The issue before the court was whether
plaintiffs had sufficiently pled that thecompany’s offer and sale of the NFTs
amounted to an offer or sale of a security.
The Securities Act’s definition of a “security”
includes an “investment contract.” The U.S.
Supreme Court defined an “investmentcontract” in SEC v. W.J. Howey Co. as “acontract, transaction or scheme whereby aperson invests their money in a common
enterprise and is led to expect profits solely
from the efforts of the promoter or a thirdparty.” The Southern District of New York
explained that at the motion to dismissstage, plaintiffs “must plead facts adequate
to establish the three prongs of the Howey
test: (1) an investment of money (2) in acommon enterprise (3) with the expectationof profit from the essential entrepreneurial
or managerial efforts of others.” Because theparties did not dispute the first prong, thecourt focused on the second and third prongs.
As to the second prong, the court noted thata common enterprise can be alleged under atheory known as “horizontal commonality,”
which requires “(1) a sharing or pooling of thefunds of investors and (2) that the fortunes ofeach investor in a pool of investors are tied to
one another and to the success of the overallventure.” Revak v. SEC Realty, 18 F.3d 81(2d Cir. 1994). The court explained that“[g]enerally, pooling occurs when the funds
received by the promoter through an offering
are, essentially, reinvested by the promoter
into the business. In turn, such reinvestment
increases the value of the instrument offered”(referencing Milnarik v. M-S Commodities,457 F.2d 274 (7th Cir. 1972)). The Southern
District of New York held that plaintiffs
adequately alleged a pooling of assets because
they alleged that the company’s NFT sales
and the related transaction fees generated
revenue that was used to support and growthe company’s blockchain. The court also
determined that plaintiffs adequately pledthat the fortunes of each investor were tied tothe success of the overall venture because thecompany controlled the enterprise, including
its private blockchain. Further, plaintiffs
plausibly alleged that the continued value of
the NFTs depended on the company’s successbecause the NFTs had no value outside of
the private blockchain that the company
controlled.
The court also determined that plaintiffs
adequately pled the third Howey prong byalleging that the company’s NFT offer camewith “a reasonable expectation of profits
to be derived from the entrepreneurial ormanagerial efforts of others.” The court
found that the company’s public statements
and marketing materials, including tweetspromoting a recent sale or statistics ofrecent sales, objectively led purchasers toexpect profits. Notably, while the court
acknowledged that the word “profit” did notappear in any of the tweets, it concluded thatthe “rocket ship” emoji, “stock chart” emoji,
and “money bags” emoji objectively suggested
a financial return on investment. The court
also determined that plaintiffs plausibly
alleged that the “promise of profits mustalso be derived from the entrepreneurial ormanagerial efforts of others.” The court statedthat the “allegations that [the company]
3created and maintains a private blockchain
is fundamental” to its conclusion. The court
explained that privatizing the blockchain
on which the NFTs’ value depend andrestricting their trade to only its blockchain,forces purchasers to rely on the company’s“expertise and managerial efforts, as well as
its continued success and existence.”

Delaware Court of Chancery:
Dismisses Derivative Lawsuiton Demand Futility Grounds
On March 1, 2023, the Delaware Court ofChancery dismissed two breach of fiduciary
duty claims against the board of a global fastfood company: (i) for failing to take action
to address “red flags” indicating that sexual
harassment and misconduct were occurringat the company; and (ii) in connection withvarious executive employment decisions.
In re McDonald’s S’holder Derivative Litig.,
2023 WL 2293575 (Del. Ch. Mar. 1, 2023)(Laster, V.C.). On the same day, the court also
issued a Rule 23.1 order dismissing—on theground of demand futility—the remainder ofplaintiffs’ derivative lawsuit, which asserted
breach of fiduciary duty claims against thecompany’s former Global Head of HR, related
to the allegations of sexual harassment andmisconduct at the company. Previously, inJanuary 2023, the court had denied dismissalof the breach of fiduciary duty claims3
against the former Global Head of HR, on
the basis of its groundbreaking holding that
officers, in addition to directors, have a dutyof oversight.4
Because plaintiffs had not made a demandon the company’s board before commencing
their lawsuit, the court explained that theirclaims against the former Global Head of HR
were subject to dismissal unless they could
plead demand futility under the three-part
test in UFCW Union & Participating Food
Industry Employers Tri-State Pension Fundv. Zuckerberg, 262 A.3d 1034 (Del. 2021).5
Plaintiffs had asserted that demand on theboard was futile and should be excused
because the board faced a “substantial riskof liability” from plaintiffs’ claims. However,as discussed below, because the court
dismissed these claims on March 1, demandon the board was not excused, and the court
stated in its Rule 23.1 order that “the road toestablishing demand futility that the plaintiffs
sought to travel is closed.”

Plaintiffs Failed to State a “RedFlags” Claim Against the Board
In its March 1 decision, the court held thatplaintiffs failed to state a claim against theboard for breach of the duty of oversightunder the second prong of In re Caremark
International Inc. Derivative Litigation,
698 A.2d 959 (Del. Ch. 1996), for failing totake action to address red flags indicatingthat sexual harassment and misconduct
were occurring at the company. The court
explained that “[a]lthough they have pledfacts supporting an inference that redflags came to the attention of the DirectorDefendants, they have not alleged facts
supporting a reasonable inference thatthe Director Defendants acted in bad faith
in response to those red flags.” The facts
supporting the inference that the board wason notice included, among other things,
a second round of coordinated EEOC
3. Plaintiffs alleged that the former Global Head of HR breached
his fiduciary duties by: (i) consciously ignoring red flags
regarding sexual harassment and misconduct at the company(duty of oversight), and (ii) personally engaging in sexualharassment (duty of loyalty).
4. Please click here to read our discussion of the court’s January2023 decision in In re McDonald’s Stockholder Derivative
Litigation, 2023 WL 387292 (Del. Ch. Jan. 26 2023).
5. Please click here to read our discussion of Tri-State.
4

complaints, a ten-city strike, a Congressional
inquiry, and that the board learned in
December 2018 that the CEO had personallyengaged in two acts of sexual harassment.
However, the court determined that plaintiffs’
allegations fell short regarding the board’s
response to the red flags, noting that at theend of 2018 the board began taking various
responsive steps that included, among otherthings, hiring outside consultants, revising
the company’s policies, implementing new
training programs, providing new levels of
support to franchisees, and setting up anemployee hotline.

each decision. The court applied the businessjudgment rule because “[n]one of theestablished situations in which enhanced
scrutiny applies are present in this case,rendering that standard inapplicable.” Thecourt went on to determine that plaintiffs
failed to plead facts sufficient to rebut any ofthe business judgment rule’s presumptions,which are that “in making a business decision
the directors of a corporation acted on an
informed basis, in good faith and in thehonest belief that the action taken was in thebest interests of the company.” Aronson v.
Lewis, 473 A.2d 805 (Del. 1984).

Plaintiffs Failed to Statea Claim Related to theBoard’s Decision-Making
On March 1, the court also held that plaintiffs
failed to state a claim against the board forbreach of fiduciary duty in connection withthree executive employment decisions6
because the business judgment rule protected
6. Plaintiffs had challenged the board’s decision to: (i) hire theCEO based on his assurance that a consultant with whom he
was in an intimate relationship would be removed from thecompany’s account, (ii) discipline rather than terminate theGlobal Head of HR following a sexual harassment incident,and (iii) terminate the CEO without cause rather than withcause after learning that he had engaged in an inappropriate
relationship with an employee.

This edition of theSecurities Law Alert was edited byJoshua Polster / +1-212-455-2266
joshua.polster@stblaw.com
Karen Porter / +1-202-636-5539
karen.porter@stblaw.com andSimona G. Strauss / +1-650-251-5203
sstrauss@stblaw.com

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