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.

On July 28, the Ninth Circuit reversed the dismissal of a securities class action, and remanded to the Central District of California. In re Quality Sys., Inc. Sec. Litig., 865 F.3d 1130 (9th Cir. 2017). Quality Systems, which develops and markets electronic health records software, allegedly made false statements about its current and past sales “pipeline,” and used those statements to support public projections about the company’s future performance. Id. at 1135. The court addressed the application of the Private Securities Litigation Reform Act’s Safe Harbor for forward-looking statements—essentially predictions regarding future events or performance. The court announced a bright-line rule for “mixed” statements, which occur “[w]here a forward-looking statement is accompanied by a non-forward-looking factual statement that supports” it. Id. at 1146. The court held that “[i]f the non-forward-looking statement is materially false or misleading, it is likely that no cautionary language—short of an outright admission of the false or misleading nature of the non-forward-looking statement—would be ‘sufficiently meaningful’ to qualify the statement for the safe harbor.” Id. at 1146–47. The court further ruled that for “mixed” statements, whether “the non-forward-looking statements are, or may be, untrue is clearly an ‘important factor’ of which investors should be made aware.” Id. at 1148.

Doug Greene, Peter Hawkes, and I authored an amicus curiae brief on behalf of the Washington Legal Foundation, urging the Ninth Circuit to rehear the case en banc to replace the panel’s unduly constricted approach to the Safe Harbor with a context-driven standard that is consistent with Congress’s judgment in enacting the Safe Harbor. The brief first explains that the Safe Harbor was enacted to encourage companies to offer predictions about their future performance without the fear of crippling securities litigation if their predictions are not borne out by future events. To accomplish that, the Safe Harbor protects false or misleading forward-looking statements if they are identified as forward-looking and accompanied by “meaningful cautionary statements” identifying important risk factors that could affect future performance. The Safe Harbor offers an independent second prong that protects forward-looking statements if the speaker lacks actual knowledge that the statements are false. The brief shows that courts have been reluctant to apply the first prong of the Safe Harbor independently, fearing that it gives companies a “license to defraud.” By announcing an inflexible rule that, for “mixed statements,” cautionary language cannot be “meaningful” absent an admission of the falsity of any inaccurate statements of present or past fact—regardless of whether the company even knows they are false—the Ninth Circuit panel similarly nullifies the Safe Harbor’s first prong by ignoring disclosures of other “important” risk factors and holding companies strictly liable for innocent misstatements.

In a 91-page opinion covering several important securities-litigation issues, the Second Circuit upheld the district court’s partial judgment against Vivendi following a three-month jury trial that resulted in the jury finding Vivendi liable under Section 10(b) and Rule 10b-5.

As I was preparing to summarize the opinion for this blog, I read a summary by Wiley Rein’s David Topol and Jennifer Williams in Kevin LaCroix’s blog, The D&O Diary.  Their post is excellent and comprehensive.  So instead of publishing a separate summary, I obtained their permission to refer readers of this blog to their post:

Vivendi: A Victory for Plaintiffs on the Price Maintenance Theory and on Loss Causation .

In Rand-Heart of New York, Inc. v. Dolan, 812 F.3d 1172 (8th Cir. 2016), the Eighth Circuit Court of Appeals found that the Reform Act’s Safe Harbor did not protect comments made by a CEO during an earnings call, finding that he had actual knowledge that his comments would be misleading when he did not disclose a significant decline in future revenue from a major customer.

The Eighth Circuit reversed a district court’s dismissal of the claims against James Dolan, the CEO of Dolan Company, finding that plaintiffs had adequately alleged that Dolan acted with scienter during an earnings call with analysts, and that he was not protected by the Reform Act’s Safe Harbor, because the company’s cautionary language was not sufficiently meaningful and Dolan had actual knowledge that his statements were misleading. However, the Court ruled in Dolan’s favor on a loss causation issue, holding that the company’s first corrective disclosure was complete, and that plaintiffs therefore could not claim damages from a second large stock price decline two months later.

Factual Background

The litigation relates to Dolan Company’s subsidiary DiscoverReady, a company that performed litigation support services primarily for Bank of America. In spring 2013, Bank of America expressed concern to Dolan and DiscoverReady management regarding Dolan Company’s financial health, suspended discussions of a pending colocation agreement with DiscoverReady, and indicated it would cease sending new work to DiscoverReady until the financial concerns were resolved. Dolan reported this news to Dolan Company’s board, which then authorized the sale of DiscoverReady. Id. at 1174-75.

Approximately two months later, on August 1, 2013, Dolan Company announced its second quarter financial results.  Among other things, it reported 18% revenue growth for DiscoverReady. It also reported on certain cash flow and borrowing issues that could impact its profitability, but nothing specific to DiscoverReady. The same day, James Dolan spoke with stock analysts. He said that Dolan Company expected double-digit growth from DiscoverReady for 2013, but that third quarter revenue would be lower than the previous year. He added: “We make this comment not to dampen enthusiasm about our growth prospects for DiscoverReady, but to set proper expectations for a business that may experience lumpiness on a quarter-to-quarter basis.” When asked to elaborate on the “lumpiness,” Dolan added some additional vague commentary, but refused to elaborate on any specifics. Id. at 1175.

On November 12, 2013, Dolan Company filed its third quarter Form 10-Q, which reported that revenue decline “exceeded our expectations,” largely due to “a reduction in new work from [DiscoverReady’s] largest customer, a reduction that we identified towards the end of the quarter.” Dolan Company’s stock price traded at $2.08 on November 11, and fell to $1.05 on November 12, and to $0.90 on November 13. On January 2, 2014, Dolan Company issued a final press release announcing the appointment of a Chief Restructuring Officer and a Continuing Listing Standards Notice from the NYSE. On that news the company’s stock fell an additional 20%. In March, the company filed for Chapter 11 bankruptcy protection. Id. at 1175-76.

Eighth Circuit’s Scienter Analysis

In analyzing the complaint’s scienter allegations, the Court agreed with the district court that there was no allegation of Dolan’s motive. However, plaintiffs could still survive the motion to dismiss by alleging that Dolan was “severely reckless,” which, under Eighth Circuit precedent, is defined as “highly unreasonable omissions or misrepresentations involving an extreme departure from the standards of ordinary care, and presenting the danger of misleading buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it.” Id. at 1177 (quoting In re K-Tel Intern., 300 F.3d 881, 893 (8th Cir. 2002)).

Applying the “severely reckless” standard, the Court held that plaintiffs had not adequately pleaded that Dolan possessed scienter in failing to disclose that Bank of America had suspended discussions of a co-location agreement with Dolan Company, and had demanded that Dolan Company restructure, finding that the inference of scienter was negated by Dolan’s warnings regarding the company’s precarious financial state during the August 1 analyst call. Id. However, the Court concluded that Dolan was severely reckless in failing to disclose that Bank of America had stopped sending new work to DiscoverReady; the company’s financial instability was, at the least, “so obvious that [Dolan] must have been aware of it.” Id. at 1178. As a result, the Court ruled that plaintiffs had met their burden of pleading Dolan’s scienter.

Court’s Findings on Safe Harbor

Dolan asserted that his August 1 statements about “double-digit” growth and “lumpiness” were protected by the Reform Act’s Safe Harbor, which provides that a forward-looking statement is not actionable if it is accompanied by meaningful cautionary language or the defendant does not have actual knowledge of the statement’s falsity. See 15 U.S. C. § 78u-5(c)(1). The Court found that Dolan’s Safe Harbor defense failed on both grounds. First, the court held that Dolan had actual knowledge that his statements about DiscoverReady’s expected performance were misleading. Rand-Heart of New York, Inc., 812 F.3d at 1178. Second, the cautionary language was not meaningful because it consisted of boilerplate, generally applicable risk factors. For example, one excerpt of cautionary language on which Dolan relied stated: “Our failure to comply with the covenants in our debt instruments could result in an event of default that could adversely affect our financial condition and ability to operate our business as planned if we are not successful in obtaining a waiver of our failure to comply with our covenants.” Id.

Eighth Circuit Opinion on Loss Causation

Finally, the Court addressed plaintiffs’ assertion that the fraud was not fully revealed until the January 2 press release announcing the new restructuring officer, which disclosure was followed by a 20% stock price decline. But the Court found that the January 2 press release merely elaborated on the previous corrective disclosures, and did not serve as a separate corrective disclosure. Id. at 1180. The fact that this disclosure was followed by an additional stock price decline does not necessarily mean that decline was caused by the previous misrepresentation.  The 20% stock price decline in January could have been caused by any number of other market forces. As the Court concluded, “not every bit of bad news that has a negative effect on the price of a security necessarily has a corrective effect for purposes of loss causation.” Id. (quoting Meyer v. Greene, 710 F.3d 1189, 1202 (11th Cir. 2013)).