One of the recurring issues with which federal district courts wrestle is the right way to assess securities complaint allegations based on confidential issues. Another recurring issue has to do with the assessment of trading in company securities by corporate insiders pursuant to Rule 10b5-1 trading plans. A recent decision by Second Circuit addressed both of these issues. The Second Circuit’s opinion in Employees’ Retirement System of Government of the V.I. v. Blanford, Case No. 14-cv-199 (2d Cir. July 24, 2015), can be found here.
In the following guest post, John E. Clabby and Avi R. Kaufman of the Carlton Fields Jorden Burt law firm review the Second Circuit’s opinion and in particular consider the appellate courts consideration of the confidential witness and Rule 10b5-1 trading plan issues. The authors’ bios appear at the end of the post.
I would like to thanks Jack and Avi for their willingness to publish their article on my site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is Jack and Avi’s guest post.
Late last week, the U.S. Court of Appeals for the Second Circuit reversed the dismissal of a shareholder class action against the makers of Keurig coffeemakers and their ubiquitous “K-Cups.” In so doing, the Second Circuit further described the standard for stating claims for securities fraud based on confidential witnesses and in the face of a 10b5-1 trading plan.
The underlying lawsuit was a putative class action filed in federal court in Vermont against Green Mountain Coffee Roasters, Inc., its CEO, and its CFO under sections 10(b) and 20(a) of the Exchange Act and SEC Rule 10b-5. The complaint alleged that the company executives made false statements during investor conference calls in 2011 about high demand for its products, while at the same time both orchestrating a scheme to hide excess inventory from auditors and selling their own shares at prices inflated by these false statements.
The allegations relied heavily on the statements of 10 confidential witnesses purported to have held positions throughout the company, from the warehouse to management. These confidential witnesses described a company that engaged in systematic excess production and destruction of expired inventory while it fraudulently continued to assure investors that it was straining to meet product demand.
The defendants moved to dismiss under the PSLRA’s and Rule 9(b)’s pleading standards, arguing, first, that plaintiffs failed to allege a false statement or omission of material fact and, second, that plaintiffs failed to plead a strong and compelling inference of scienter, either under a motive to defraud or a “conscious misbehavior or recklessness” theory.
The district court agreed with both arguments. As to failure to allege a false statement, the court explained that the complaint did not allege that the company’s financials failed to disclose the amount of unsold inventory it maintained. And representations regarding the company’s desire to build up inventory reserves were consistent with what the company ultimately did.
The court found that the confidential witnesses’ statements were not sufficiently specific to demonstrate the falsity of management’s representations. The confidential witnesses’ statements were not tied to a specific time period and the confidential witnesses were not in positions to know about companywide inventory, production, or demand, and the complaint did not allege that they had an understanding of how what they observed impacted companywide inventory levels and financial reporting. The confidential witness statements therefore failed to satisfy the standard of Novak v. Kasaks, 216 F.3d 300 (2d Cir. 2000), the court held, requiring that a confidential witness be “described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged.”
The court also found that the plaintiffs failed to adequately plead scienter. Among other things, the court reasoned that, because all but one of the CEO’s and CFO’s trades were made pursuant to a 10b5-1 plan, they did not support an inference of scienter. The court distinguished the case from others in which 10b5-1 plans were entered into strategically to take advantage of inflated stock prices because “there was nothing suspicious or unusual about the timing of the [executives’] 10b5-1 plans in relation to the negative disclosures made toward the end of the Class Period,” spanning over nine months in 2011. To the contrary, the executives were “tak[ing] advantage of a rare trading window after several years of acquisitions that had prevented insiders from diversifying their holdings.”
The Second Circuit reversed in an opinion that – quite unusually – failed entirely to reference or quote the District Court’s reasoned, 43-page opinion. The Second Circuit’s opinion is a reminder that occasionally “de novo” really means “de novo.”
In finding specific statements misleading, the Second Circuit held that the representations to investors that the company “was struggling to meet demand and had no excess inventory” were adequately contradicted by the confidential witnesses’ observations, notwithstanding that those observations were not “linked to specific quarters.” The Second Circuit accorded little weight to the company’s explanation for the alleged inconsistency between its representations regarding supply and demand, and actual supply and demand levels, stating “the explanation of the revenue gap and inventory spike that Green Mountain offers is entitled to little weight at this stage of the litigation.” This last shot of espresso is a reminder to the defense bar that a complaint can apparently state a claim using prolific statements of 10 untested confidential witnesses, but that simple explanations in defense requiring extraneous evidence cannot be aired until summary judgment, and only then after wading through costly discovery.
Further to that point, in relying on the confidential witness statements, the court cited the Novak standard but did not analyze any purported errors in the district court’s order on this point. Nor did the appeals court make specific rulings, as the district court did, as to whether the confidential witnesses were in positions to know about companywide inventory, production, or demand, and whether the complaint had to allege that the witnesses had an understanding of how what they personally observed impacted companywide inventory levels and financial reporting. The appeals court seemed persuaded that one confidential witness could be relied upon as to a particular point simply because another confidential witness “corroborated this story.”
The court also held that the plaintiffs had credibly and cogently alleged scienter for two reasons. First, the court held that Defendants’ “efforts to conceal inventory from auditors” – based, again, on the confidential witnesses’ allegations – demonstrated an intent to defraud.
Second, the court held that the CEO’s and CFO’s “sales of Green Mountain stock at opportune moments throughout the Class Period at significant personal gain” showed an intent to deceive or defraud. The conclusion was despite the executives’ stock sales being through a pre-determined 10b5-1 trading plan. The court held that because the 10b5-1 plans were entered into during the class period, and the executives “knew the dates of their scheduled sales were imminent when they made allegedly misleading statements to investors,” the trading plans were not a defense to the scienter allegations. Unlike the district court, the appeals court did not address the relationship between the timing of this trading and the end of years of restrictions on insider sales due to the company’s acquisition activity.
The Second Circuit’s leeway given to allegations sourced by confidential witnesses and the complaint’s specificity in describing the confidential witnesses’ positions at the company, if not the exact timing of their observations, had significant probative impact on the panel. In this way, a story of possible inventory mismanagement was held by a court to support an inference that the company executives made false statements on specific days with the required scienter.
Employees’ Retirement System of Government of the V.I. v. Blanford, Case No. 14-cv-199 (2d Cir. July 24, 2015)
John E. Clabby is of counsel at Carlton Fields Jorden Burt’s Tampa office, and Avi R. Kaufman is an associate at the firm’s Miami office. Clabby and Kaufman defend companies, executives, and directors across the country in shareholder class actions and derivative suits, government investigations, and other high-stakes litigation alleging corporate and commercial wrongdoing. Clabby is a former federal prosecutor. Clabby can be reached at firstname.lastname@example.org. Kaufman can be reached at email@example.com.
A version of this article previously was published on JD Supra and Carlton Fields Jorden Burt’s website.