A recent Third Circuit opinion demonstrates the high bar that plaintiffs face when attempting to plead the falsity of two categories of statements: (1) risk factors alleged to be misleading because the warned-of risk had already materialized, and (2) forward-looking earnings projections. In Williams v. Globus Medical, Inc., — F.3d —, 2017 WL 3611996 (3rd Cir. Aug. 23, 2017), the Third Circuit affirmed a district court ruling dismissing such claims.

Globus Medical is a medical device company that sells implants to medical professionals to be used on their patients. Globus formerly relied on both in-house sales reps and third-party distributors to sell its products. One of those distributors, Vortex Spine, LLC, was Globus’ exclusive distributor in parts of Louisiana and Mississippi. The exclusive deal between Globus and Vortex was set to expire on December 31, 2013, but the plaintiffs alleged that Globus had already decided to terminate its deal with Vortex by that date. Globus intended to take more of its sales operation in-house. Nevertheless, Globus extended the agreement with Vortex through April 2014, and it told Vortex it would use that four-month period to negotiate a new agreement. Instead, plaintiffs alleged, Globus used that time to hire an in-house salesperson to take over Vortex’s territory. Id. at *1-2

In the middle of that four-month period, during a February 26, 2014 earnings call, Globus CFO Richard Baron projected fiscal year sales of $480 million to $486 million, and earnings per share of $0.90 to $0.92. In its March 14, 2014 10-K, Globus included a risk factor cautioning:

If we are unable to maintain and expand our network of direct sales representatives and independent distributors, we may not be able to generate anticipated sales. . . . [I]f any of our independent distributors were to cease to do business with us, our sales could be adversely affected. Some of our independent distributors account for a significant portion of our sales volume, and if any such independent distributor were to cease to distribute our products, our sales could be adversely affected. In such a situation, we may need to seek alternative independent distributors or increase our reliance on our direct sales representatives, which may not prevent our sales from being adversely affected.

Id. On April 18, 2014, Globus met with Vortex and notified it that had hired an in-house sales rep for the Vortex territory. Just ten days later, on a quarterly earnings call, Baron projected the same revenue and earnings figures for the year, and on April 30, 2014, Globus filed its 10-Q that stated there had been no significant changes to its risk factors. Id. at 2.

Finally, on August 5, 2014, Globus issued a press release announcing its second quarter financial results. The press release revised its revenue guidance down by approximately $20 million for the year. In an earnings call that day, Globus COO David Demski explained the change in guidance was due to a decline in sales growth in part because, “early in the quarter we made the decision not to renew our existing contract with a significant U.S. distributor, negatively impacting our sales.” The next day Globus’ stock price dropped nearly 18 percent. When Globus announced its year-end financial results in early 2015, sales were $474.4 million — just 1 percent lower than the original guidance — and earnings per share beat the original guidance by over 5 percent. Id.

Plaintiffs filed a securities class action in the Eastern District of Pennsylvania in September 2015, alleging violations of Exchange Act Sections 10(b) and 20(a), and Rule 10b-5. The amended complaint named the company, Baron, Demski, and two others as defendants. The District Court granted the defendants’ motion to dismiss. The Third Circuit affirmed. Id. at *2-3.

The Third Circuit’s analysis began by separating the challenged statements into historical risk factor statements, and the forward-looking revenue and earnings projection statements. With respect to the historical risk factor statements, plaintiffs alleged that the Globus defendants had a duty to disclose its decision to terminate the relationship with Vortex when that decision was made around December 2013, and that they had a duty to disclose in April 2014 when Globus actually terminated the relationship. Id. at *4.

Of course, Section 10(b) and Rule 10b-5 do not require disclosure of all material information. Disclosure is required “only when necessary ‘to make . . . statements made, in light of the circumstances under which they were made, not misleading.’” Id. (quoting Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 44 (2011)). The plaintiffs in this case alleged that Globus’ failure to disclose its decision to terminate the agreement with Vortex made the existing risk disclosures inaccurate, incomplete and misleading. Globus’ risk factors warned of the potential consequences of losing a distributor when it had already decided to end its relationship with such a distributor. Typically, the Third Circuit explained, “courts are skeptical of companies treating as hypothetical in their disclosures risks that have already materialized.” Id.

“But this is not such a case.” Id. *5. The challenged risk factor was more specific — it warned of the adverse affect on sales of losing a distributor, not just the loss of the distributor. Plaintiffs did not allege that Globus’ sales were adversely affected by the decision to terminate Vortex, or the ultimate termination of Vortex, and nothing in the complaint was sufficient to infer that Globus was aware of an impact on sales prior to the disclosure in August 2014. Likewise, plaintiffs did not plead that a drop in sales was an inevitable consequence of the termination of the deal with Vortex. Indeed, sales at the end of the year were largely in line with the original forecast. Id.

The court next turned to the forward-looking statements at issue. Plaintiffs alleged that the Globus defendants violated Section 10(b) and Rule 10b-5 by issuing revenue projections that did not account for the company’s decision — already made at the time — to terminate the relationship with Vortex. The district court dismissed these claims on two grounds — that the plaintiffs failed to plead the projections were false when made, and that the statements were covered by the Private Securities Litigation Reform Act’s safe harbor for forward-looking statements. The Third Circuit again affirmed the district court ruling. Id. at *6.

Under Third Circuit precedent, when pleading the falsity of a forward-looking statement, plaintiffs must “plead factual allegations that show the projections were ‘made with either (1) an inadequate consideration of the available data or (2) the use of unsound forecasting methodology.’” Id. (quoting In re Burlington coat Factory Sec. Litig., 114 F.3d 1410, 1430 (3d Cir. 1997)). Here, the plaintiffs alleged that the Globus sales forecasts incorporated Vortex’s sales figures. Plaintiffs made that assertion based on “numerous inferences” including that defendant Baron said in the August 2014 earnings call that “the decision not to renew the distributor, and the impact to pricing will affect our top line expectations,” and other similar statements that could demonstrate that the loss of the Vortex sales were a driver in the change in revenue and earnings projections. Those allegations failed to plead the falsity of projections. In particular, the court was critical of the plantiffs’ use of hindsight conjecture rather than contemporaneous information to show that the Vortex sales were a component of the original projections. Id. at *6-7.

Finally, the Third Circuit addressed whether the statements were protected by the Reform Act’s safe harbor, which immunizes forward-looking statements if they are accompanied by meaningful cautionary language, are immaterial, or if the plaintiff fails to show the statement was made with actual knowledge it was false. In this case, the court determined that the plaintiffs did not meet their burden that the revenue and earnings forecasts were made with actual knowledge of their falsity. Plaintiffs could only point to three facts in support of the actual knowledge requirement:

(1) during the August 5, 2014, call explaining the revisions to the sales projections, COO Demski stated that the company “understood the risks to our short-term results” when it terminated its relationship with Vortex []; (2) during that same call, CEO Paul and CFO Baron acknowledged that they recalled Globus’s 2010 experience with “distributor turnover” and the two-year period it took to get the company “back to where [it was],”; and (3) the nature of the market for spinal implant products and the importance of goodwill between salespeople and customers.

Id. at *7. The Third Circuit agreed with the district court that these facts only made it plausible to infer that the defendants should have known that ending the Vortex relationship could have some effect on sales, but that is not the same as actual knowledge that the forecasts were false. Instead, the court found that the more plausible inference was that Globus accounted for the change from Vortex to an in-house sales rep when it made the initial projections. Id. at *7-8.