On August 23, 2022, the United States Court of Appeals for the Tenth Circuit unanimously reversed the dismissal of a putative securities class action against an online education company (the “Company”), alleging violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), SEC Rule 10b-5, Section 20A of the Exchange Act, and Sections 11, 12(a)(2), and 15 of the Securities Act of 1933 (the “Securities Act”). Plaintiffs alleged that the Company made false and misleading statements about the size and productivity of the Company’s sales force. The district court dismissed the Exchange Act claims because plaintiffs failed to plead a strong inference of scienter and dismissed both the Exchange Act and the Securities Act claims for failure to plead a violation of Item 303 of SEC Regulation S-K. On appeal, the Tenth Circuit reversed and remanded, holding that (i) the Exchange Act allegations “support[ed] an inference of scienter at least as compelling as any nonculpable inference” and (ii) the district court relied on “erroneous reasoning” to dismiss the Exchange Act and Securities Act claims based on the alleged violation of Item 303.

Plaintiffs alleged that the Company, which was not profitable, touted its “billings” growth to attract investors. The Company defined “billings” as “total revenue plus the change in deferred revenue in the period.” Plaintiffs alleged that the Company made assurances about how closely it tracked billings, allegedly calling this a “key business metric.” According to plaintiffs, the Company informed investors and analysts that its sales force—“including both the number of its sales representatives and their productivity”—was the primary driver of the Company’s billings growth. Plaintiffs alleged that the Company artificially inflated its stock price, including in connection with a secondary public offering in March 2019, when it made false and misleading statements about the size and productivity of its sales force. Specifically, plaintiffs alleged that, in January 2019, the Company’s CFO spoke at an annual conference and highlighted the size and effectiveness of the Company’s sales force. During a Q&A session with analysts and investors, the CFO explained that the Company’s sales force had grown from 80 to about 250 “quota-bearing” sales representatives over the course of several years, which allegedly was false because the Company only had around 200. Plaintiffs also challenged statements in the Company’s February 2019 Form 10-K in which the Company stated that it had “a large direct sales force to focus on business sales” and had “been able to drive substantial increases in the productivity and effectiveness of [its] sales personnel.” Plaintiffs also alleged that the Company violated Item 303, which requires the disclosure of “known trends” reasonably likely to have a material impact on net sales, by failing to disclose that the Company “was months behind its sales ramp capacity plan, which was likely to negatively impact its billings.”

In dismissing the Exchange Act claims, the district court held that the CFO’s statement that “today we have about 250” quota-bearing sales representatives was false. This allegedly was false because the Company purportedly only had around 200, but the district court concluded that plaintiffs failed to plead a “strong, cogent inference of scienter” as required by the Private Securities Litigation Reform Act of 1995. In dismissing the Item 303 claims, the district court held that plaintiffs had not adequately alleged that the Company was aware that the alleged capacity gap would materially impact billings growth because the Company experienced “strong billings growth in the first quarter of 2019 despite the alleged sales capacity gap.”

The Tenth Circuit reversed the district court’s holding that the complaint failed to raise a strong inference of scienter. With respect to the statement by the Company’s former CFO that “today we have about 250” quota-bearing sales representatives, the Court noted that plaintiffs’ allegations—including that the CFO admitted he knew about a capacity gap in an earnings call, that the CFO represented he closely monitored the Company’s sales force numbers, and that he emphasized that sales force capacity to generate billings was at the core of the Company’s business model—“strongly support[ed] the inference that [the CFO] knew his January 16, 2019, statement was false or misleading when he made it.” The Court thus concluded that the district court erred in finding there was no strong inference of scienter with respect to this statement.

The Tenth Circuit next held that, on remand, the district court should revisit plaintiffs’ allegations that the Company violated Item 303. The Court explained that, according to the complaint, the Company “relied heavily on deals that took several months to close, and thus quarterly billings primarily reflected deals initiated in a previous quarter.” Accordingly, the Court noted that plaintiffs “plausibly alleged [the Company] knew first quarter billings growth did not mean the sales capacity gap would not affect future billings.” The Court held that the district court’s conclusion—that the failure to disclose the sales capacity gap was not misleading—was “unsupported by the allegations in the complaint” and could not “form the basis for dismissing the Item 303 violation.” On remand, the Court instructed the district court to “consider in the first instance whether two months of being behind an internal sales ramp capacity plan constitutes a ‘trend’ within the meaning of Item 303.”