Why CD Projekt can't ignore the threat of U.S. securities class action

UPDATE: The lawsuit was filed on Christmas Eve, alleging securities fraud in violation of Rule 10b-5, as predicted in this article. co-CEO Adam Kiciński, CFO Piotr Nielubowicz and Biz Dev VP Micha? Nowakowski were all named as co-defendants (click here to view the lawsuit).

UPDATE #2: A second lawsuit was filed on Christmas.

The December, 10th release of Cyberpunk 2077 was very likely the most disastrous launch in video gaming history. Between poor last-generation console performance, numerous bugs and glitches, apparently missing features and unfinished game mechanics, and emerging game-breaking code, the massive loss of goodwill and reputation led to a drop of over PLN 12.5 billion ($3.4 bn, €2.8 bn) in CD Projekt's (WSE:CDR) market capitalization between the day prior to release and Friday's closing price.

(This is not to say that the game is unplayable. I personally enjoy it on PC. But last-gen console players got shafted, and many gamers were disappointed by the state of the game. Even mainstream media are mocking it.)

There are many takeaways from this fiasco:

• Design and enforce a communications policy instead of letting devs disclose work in progress; otherwise, your game may become overhyped which will lead to customer dissatisfaction.
• Once you're in crisis and damage-control mode, onboard a competent crisis management team. You want to have them, IR and legal on any emergency investor/analyst calls. Failing to do so can backfire, hard.
• Offering refunds on behalf of your distributors can backfire even harder. We can only speculate what terms Sony will impose to let Cyberpunk back into the PlayStation Store.

But in this piece I want to talk about more boring stuff - legal.

There has already been some coverage of the possible legal action by Polish investors. I generally agree that any such case would be a long shot under Polish law. Here, I want to comment on the possible case in the U.S.

Three U.S. law firms have announced that they were investigating potential securities class actions against CD Projekt (#1, #2, #3). The firms have called on all holders of American Depositary Receipts (ADRs) of CD Projekt who incurred losses to make contact. One might dismiss this as the plaintiff bar fishing for na?ve clients. But let's take a deeper look.

The language of the announcements suggests that the firms are exploring securities fraud lawsuits based primarily on Rule 10b-5. The relevant limb of that rule states that it is unlawful to

make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.

CD Projekt's co-CEO on November, 25th was on record saying that the game performs great on every platform, and that the performance on base last-gen consoles is surprisingly good. I am emphasizing the "base" here because these consoles are the weakest in terms of system specs (think PS4 instead of PS4 Pro).

As evidenced in the video below, both PS4 and PS4 Pro performance was substandard: the game stuttered during scripted missions, with frames per second (FPS) dropping below 20 (skip the video to 08:50):

To make matters worse, during the December, 14th emergency call with analysts, CDR admitted that they were too focused on releasing the game and ignored the signals about the need for additional time to refine the game on the base last-gen consoles. This is difficult to square with the assurances that the game runs "great" and "surprisingly good" on last-gen consoles. These assurances were made just two weeks before release. Sony pulled Cyberpunk from the Playstation Store just 4 days after the emergency call.

What kind of risk are we talking about? Based on the plaintiff law firms' pointed indication to the 15% ADR price drop following Sony's decision to pull Cyberpunk from the PlayStation Store, the lawsuit could claim up to $384 million (PLN 1.4 bn).

Let's dive into the technical legal stuff. Why should U.S. law apply? Would a U.S. court even have jurisdiction in such a case? After all, CDR is listed and incorporated in Poland and it has not, to my knowledge, offered its shares in the U.S.

The thing is, 110,000,000 ADRs (OTC:OTGLY) for CD Projekt's shares are currently traded on U.S. OTC markets. Out of those, 50m were issued by Citibank, 10m by Deutsche Bank, and 50m by The Bank of New York Mellon. According to the opinion of BNY Mellon's legal counsel, the ADRs are "unsponsored", meaning there is no formal agreement concerning the ADR program between CD Projekt and the depositary.

For the decade following the U.S. Supreme Court's decision in Morrison v. National Australia Bank, it has been generally understood that only sponsored ADR programs are subject to U.S. securities law. But unfortunately for CD Projekt, recent case law has brought this legal issue back into play. In Stoyas v. Toshiba (2018), the U.S. Court of Appeals (9th Circuit) held that a foreign issuer can be subject to U.S. securities law, provided that it is "sufficiently connected" to the unsponsored ADR transaction. (Toshiba sought to have this decision reviewed by the U.S. Supreme Court, but was denied certiorari.) In 2020 Toshiba was handed down another ruling in which the trial court agreed with the plaintiffs that a large block of underlying shares being held by the depositary is indicative of "sufficient connection". In Toshiba, the depositary held 1.3% of the shares.

Now let's get back to CD Projekt. Each ADR represents 1/4th of one ordinary share in CDR. This means that the ADRs represent more than 27% of all outstanding stock in CD Projekt, with a market value of PLN 7.5 billion ($2.0 bn) based on the last closing price.

Did the ADR depositaries purchase the underlying shares without CD Projekt's involvement? Did CD Projekt issue letters of non-objection? Was CD Projekt sufficiently connected to the ADRs? I have no idea, but if I were CD Projekt's GC, these questions would be close to the top of my list.

To be sure, everything I have written above must be viewed from the right perspective. We do not know how the Toshiba case will play out. We do not know if any U.S. court in the 9th Circuit will have jurisdiction over the potential CDR case. (UPDATE: The Rosen lawsuit was filed in the 9th Circuit.) With how the rules of precedent work in the U.S. legal system, even an outcome unfavorable for Toshiba may not impact on CDR's case. And most importantly, we do not know what was going on behind the scenes.

But CD Projekt just can't ignore this. It can't keep releasing almost-impromptu announcements. It can't keep letting management wing it during unscripted calls with investors and analysts. This is no longer an exercise in pure marketing and PR.

I'll stay tuned for more.