A California company represented by Schulte Roth & Zabel LLP scored a first-round knockout victory when a federal district judge in Los Angeles dismissed—with prejudice—a class action complaint alleging that it and several of its senior officers and directors had illegally "backdated" stock option grants. The company, Hansen Natural Corporation ("Hansen"), and the individual defendants filed a motion to dismiss the class action complaint on the grounds that the plaintiff failed adequately to plead his claim under federal law. The U.S. District Court for the District of California on Oct. 16 not only granted the motion to dismiss, but also denied plaintiff's request for leave to amend his complaint. Rather than allow the case to linger, with attendant expense and burden to the defendants, the court's ruling thus brings the litigation to a complete and early end.
Beginning in 2006, the practice of "backdating" stock options gained national attention after The Wall Street Journal published a series of articles questioning the timing of stock option grants at several public companies. "Backdating" refers to the selection of a stock option grant date that does not reflect the fair market value of the stock as of the actual date of the grant. Backdating stock options can cause a company to misstate its financials by underreporting its compensation expense, and can also result in tax liabilities. In the wake of these news reports and announcements of investigations by the Securities & Exchange Commission ("SEC") and federal prosecutors, dozens of securities class action suits and derivative actions have been filed by shareholders against public companies. See "Counting the Options Backdating Lawsuits," The D&O Diary, available at http://dandodiary.blogspot.com/2006/07/counting-options-backdating-lawsuits.html.
The plaintiff in the present action filed a consolidated class action complaint alleging that Hansen's financial statements materially overstated the company's income over the course of several years due to understatements of compensation expense resulting from the backdating of stock options awarded to various officers of the company. The plaintiff based his claims on §§10(b) and 20(a) of the Securities Exchange Act of 1934.
The defendants moved to dismiss on the grounds that the complaint failed to meet the heightened pleading requirements of Federal Rule of Civil Procedure 9(b) and the Private Securities Litigation Reform Act ("PSLRA"). In particular, SRZ argued on behalf of the defendants that the complaint failed adequately to allege several elements of a claim for federal securities fraud, including the existence of an actionable misstatement, fraudulent intent (or scienter), materiality and loss causation.
Not only did the court agree with SRZ's arguments on all these points, it denied plaintiff's request for leave to amend his complaint and granted a final judgment in defendant's favor. See In re Hansen Natural Corp. Securities Litigation, No. CV 06-7599-JFW (C.D. Cal. Oct. 16, 2007).
The District Court's decision in Hansen highlights several recent developments in federal securities law that should help defendants obtain early dismissal of options backdating cases and other types of securities class action suits.
First, the court's decision is one of the first rulings applying, in the context of allegations of options backdating, the Supreme Court's recent decision in Tellabs v. Makor Issues & Rights, Ltd. __ U.S. __, 127 S. Ct. 2499 (2007). In Tellabs, which was issued last June, shortly before the Hansen defendants filed their motions to dismiss, the Supreme Court emphasized the high bar for private shareholder plaintiffs seeking to establish scienter under Section 10(b). To plead scienter, the PSLRA requires plaintiffs to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." 15 U.S.C. § 78u- 4(b)(2). Tellabs clarified what constitutes a "strong inference" of scienter, holding that it "must be more than merely plausible or reasonable—it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent." Id. at 2504-05.
The plaintiff in Hansen did not have any statements from witnesses or contemporaneous documents that would demonstrate that backdating took place. Rather, he relied upon an "empirical and statistical analysis" which, he claimed, gave rise to a strong inference of scienter. The essence of plaintiff's claim was that Hansen's stock price tended to increase after each allegedly backdated grant, and that many grants were made in "troughs" after a drop in the stock price, evincing what plaintiff called a "a striking pattern that could not have been the result of chance." In re Hansen at 12. SRZ attacked plaintiff's analysis by noting that it failed to demonstrate any indicia of reliability (e.g., peer review or academic approval), that it was methodologically unsound, and that plaintiff's data could be just as easily explained by facts having nothing to do with backdating, and thus failed to establish a "strong inference" of scienter within the meaning of Tellabs.
The court agreed with SRZ, stating that the plaintiff's analysis was "no analysis at all"; rather, it suffered from a series of deficiencies that cast doubt upon the reliability of his methods and the soundness of his conclusions. Moreover, the court accepted SRZ's argument that the pattern of increases in Hansen's stock price following the grants in question could have been the result of the dramatic increase in the price of the company's stock during the period of the alleged backdating. Accordingly, the court found that the plaintiff pled "no facts" giving rise to a strong inference of scienter. Id.
Second, the court in Hansen found that the plaintiff had failed to plead the element of loss causation by relying on public announcements that the company's stock option granting practices were under investigation. Under the PSLRA, the plaintiff must show that the defendant's alleged act or omission "caused the loss for which the plaintiff seeks to recover damages.” 15 U.S.C. § 78u-4(b)(4). Typically, loss causation is predicated upon a "corrective disclosure" made by the company that reveals the so-called "truth" of its financial condition and that leads to a drop in the share price. In the present case, the plaintiff claimed that he suffered a loss, and that the cause of that loss was a series of "corrective disclosures" by Hansen in late October and November of 2006 that were followed by a 22% decline in Hansen's stock price.
SRZ argued that these disclosures could not have constituted "corrective disclosures" because they did not in fact disclose any wrongdoing. The disclosures that preceded the drop in Hansen's stock price simply stated that the company received an inquiry letter from the SEC, that the company had formed a special committee to conduct an independent investigation of its stock option granting practices, and that, as a result of that investigation, it would be late in filing its Form 10-Q. Since there was no disclosure of wrongdoing, the disclosures cannot be said to have "caused" plaintiff's loss within the meaning of Section 10(b). The court agreed with this argument, finding that "'the mere existence of [an] investigation cannot support any inferences of wrongdoing or fraudulent scienter on the part of [a] company or its senior management.'" In re Hansen at 19 (citation omitted).
Third, the court rejected plaintiff's argument that certain individual defendants could be held liable for making allegedly false and misleading statements under the "group pleading" doctrine. The group-pleading doctrine holds that allegations of false and misleading statements are entitled to the presumption that they are the collective action of all defendants—even those who play no role in the preparation or dissemination of the allegedly false statements. The defendants argued that the group pleading doctrine did not survive the PSLRA, an issue that has divided the lower federal courts and that the Supreme Court has not yet resolved. Joining a number of other district courts in the Ninth Circuit, the Hansen court agreed with the defendants that "the group pleading doctrine can no longer be used in pleading cases under the PSLRA." In re Hansen at 10.
Fourth, in denying leave to amend, the court implicitly rejected the notion that securities plaintiffs should as a matter of course get at least "two bites at the apple." The court noted that the plaintiff had failed to offer any additional facts that could be alleged in an amended complaint, and that this was a "strong indication that the plaintiffs have no additional facts to plead." Leave to amend was particularly inappropriate, the court further found, because plaintiff's allegations had all been based on publicly filed documents, rather than the statements of witnesses, and because plaintiff had already been given an opportunity to plead additional facts in filing his consolidated amended complaint. In re Hansen at 19–20.