On February 24, 2017, Judge Edward Chen of the United States District Court for the Northern District of California granted in part and denied in part a motion to dismiss a putative securities class action against Leapfrog Enterprises, its current CEO, and its former CFO. The complaint alleged that Leapfrog violated the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder by falsely representing in its financial disclosures that it did not need to take write-offs related to the value of its goodwill and long-lived assets. In re Leapfrog Enterprise, Inc. Sec. Litig., No. 15-cv-00347-EMC, 2017 WL 732909 (N.D. Cal. Feb. 24, 2017). Considering the difference in the relevant disclosures, the Court dismissed plaintiffs’ claims related to the goodwill write-off, but not the claims related to the write-off of long-lived assets.

Leapfrog develops educational entertainment, including learning tablets, for children. Heading into the summer of 2014, Leapfrog had experienced disappointing sales of its tablets and a delay of a new product launch. Leapfrog ultimately took a $19.5 goodwill impairment adjustment—amounting to 100% of the reported value of its goodwill—in its third fiscal quarter of 2015 (October through December 2014). Plaintiffs alleged Leapfrog should have taken the impairment one quarter earlier, and had falsely stated in its report for its second fiscal quarter (June through September 2014) that no such adjustment was needed. Leapfrog also took a long-lived asset write-down of $36.5 million (96% of the reported value of its long-lived assets) in its fourth fiscal quarter of 2015 (January through March 2015). Plaintiffs alleged that this adjustment also came one quarter too late, and that Leapfrog had falsely represented in its report, for the third fiscal quarter, that its long-lived assets were not impaired.

The Court concluded that plaintiffs failed to adequately plead scienter with respect to the allegation that the goodwill write-off was improperly delayed because, even though Leapfrog did ultimately write-down the value of its goodwill, Leapfrog’s contemporaneous disclosures made it clear that there was no intent to defraud through delay. In particular, the Court noted that Leapfrog had disclosed in its report for the second quarter 2015 that it did not need to conduct a goodwill impairment analysis at that time because its overall financial results would largely depend on the company’s performance during the upcoming holiday season, and that it might need to test for a goodwill impairment if holiday results were weaker than expected. Thus, the subsequent substantial write-down could be explained by “the fact that the holiday season was not the boon anticipated by the Defendants,” and there was no basis to find a “strong inference” of intent for failure to take the write-off earlier. 2017 WL 732909, at *7. The Court also noted in this regard that Leapfrog’s CEO and CFO bought company shares in 2Q2015, which further undermined any allegation of fraudulent intent.

The Court reached the opposite conclusion with respect to Leapfrog’s write-off for long-lived assets. As they had with respect to goodwill, plaintiffs alleged that the need for this impairment was “obvious” a quarter before it was taken. Plaintiffs also alleged that the timing and magnitude of the write-down supported a strong inference of scienter. In this context, the Court agreed with plaintiffs. The Court rejected Leapfrog’s argument that the need for the adjustment only arose from a substantial drop in Leapfrog’s stock price in the fourth quarter, because much of the relevant stock price drop had occurred before Leapfrog issued its report for the third quarter. Thus, Judge Chen found that “in contrast to the analysis of the failure to take a goodwill impairment in F2Q2015” in which the subsequent poor holiday sales accounted for the timing of the write-down, “[n]o such intervening event explains the difference between F3Q15 and F4Q15” with respect to long-lived assets. Id. at *9. The Court further noted that, in contrast to the second quarter’s specific disclosure of the significance of the upcoming holiday season to potential impairments, generalized disclosures in the third quarter that impairment testing might result in write-downs did not undermine any inference of scienter based on a failure to disclose.

The opinion provides an important reminder that the more specific a disclosure can be, the better the protection will be against a subsequent securities fraud claim.

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