As a result of the U.S. Supreme Court’s March 2018 Cyan decision, in which the Court ruled that state courts retain concurrent jurisdiction over ’33 Act liability actions, companies issuing shares now face the risk of having to face parallel securities litigation in state and federal court. Among the many problems this risk poses is the possibility that, due to the differing pleading standards between state and federal court, Securities Act liability suits that would be dismissed in federal court might survive a dismissal motion in state court. New York is among the states where many post-Cyan securities suits are being filed and where differences in pleading standards might lead to a fewer state court lawsuit dismissals relative to the dismissal rate in state court. However, notwithstanding these concerns, a New York state court judge recently entered an order dismissing a post-Cyan securities suit, raising the possibility that defendants may be able to dismiss securities suits filed in New York state court after all.
The July 17, 2019 decision of New York (New York County) Supreme Court, Commercial Division, Judge Andrew Borrok in the Netshoes Securities Litigation can be found here.
Netshoes (Caymen) Limited is a Brazilian online retailer. Netshoes completed its IPO on April 12, 2017. In 2018, plaintiff shareholders filed a securities class action lawsuit against Netshoes, certain of its directors and officers, and its offering underwriters in New York State Court. The complaint alleges that the company’s offering documents contained a materially false and misleading picture of Netshoes’ business, resulting in an artificial inflation of the offering price.
Essentially, the plaintiff shareholders alleged that the offering documents misleadingly touted the company’s “competitive” position, its “high margin” business strategy, and its new vitamin and supplements distribution business. The complaint alleges that in fact the company actually faced intense competitive pressure that would force the company to offer steep discounts, undermining its supposed high margin business model. The plaintiffs also specifically allege that at the time of the IPO the defendants knew or should have known that the company’s 2016 Financial Statements were overstated because they did not reflect substantial write-downs that the company later took because, the complaint alleged, the company must have had a return policy that was not disclosed to investors. The complaint alleged that the defendants’ misrepresentations and omissions violated Sections 11 and 12(a)(2) of the Securities Act of 1933. The defendants moved to dismiss the plaintiffs’ complaint.
The July 11, 2019 Order
In his July 11, 2019 order, Judge Borrok granted the defendants’ motion to dismiss without prejudice. Judge Borrock ruled that none of the supposed misrepresentations or omissions on which the plaintiffs sought to rely are actionable under Sections 11 and 12(a)(2) of the ’33 Act.
First, he ruled that plaintiffs failed to allege that the statement on which plaintiffs sought to rely relating to Netshoes’ customer loyalty and past performance of the vitamin and supplements business were not false or misleading when made, and therefore do not give rise to a securities claim.
Second, he ruled that the statements of belief in Netshoes’ offering documents about the level of competition and its competitive position in Brazil were unactionable opinion. In reaching this conclusion, Judge Borrok specifically cited and relied upon the U.S. Supreme Court’s 2015 opinion in the Omnicare case, in which the Supreme Court held that in order to be actionable, opinion statements must be both false and not honestly believed when made. Judge Borrock also noted that the statements of opinion about competition were counterbalanced by extensive disclosure in the Risk Factor section of the prospectus about competitive risks and uncertainties the company faced. He also emphasized that the alleged falsity of a statement must be viewed at the time that it is made, not in hindsight.
Third, Judge Borrock rejected the plaintiffs’ allegation, made in reliance on the company’s supposedly false 2016 financial statements, that the company hid the poor performance of its vitamins and supplements business. He noted that the company has not in fact restated its 2016 financials but instead has increased its allowance for doubtful accounts. He noted that under the accounting rules relating to this item, a company must exercise judgment as to which accounts are collectable, adding that valuations and write-downs are subjective statements of opinion that are only actionable if they are subjectively disbelieved or not honestly held. Judge Borrock said that the supposed financial statement misrepresentations on which the plaintiffs sought to rely depended on “house of cards” suppositions about a return policy that the company “must have had” are “simply insufficient as a matter of law to give rise to a cause of action under the 1933 Act.”
Fourth, Judge Borrok held that Netshoes’ statements about future growth and long term-strategy are not actionable under the “bespeaks caution” doctrine, and that various other statements on which the plaintiffs sought to rely are inactionable statements of puffery or corporate optimism.
According to Cornerstone Research’s 2018 annual report on securities class action filings, there were a total of 33 state court securities class action lawsuits filed in 2018, of which 13 were filed in New York (refer here, page 19). All 13 of the New York lawsuits were filed after the U.S. Supreme Court’s March 2018 decision in the Cyan case. Only California, with 16 state court securities class action lawsuits, had more post-Cyan securities suit filings in 2018. During the period 2010-2017, there were no state court securities lawsuits filed in New York. (It is probably worth noting that pre-Cyan, securities suits filed in New York state court were removable to federal court, so it may well have been that there were securities suits filed in New York state court during the 2010-2017 period, but any such suits were removed to federal court.)
Pretty clearly, among the practical consequences of the Cyan decision is that some plaintiffs’ lawyers perceive some advantage of filing their clients’ securities suits in New York State court rather than in federal court. To be sure, at least some of these lawsuits also have parallel federal court suits, and it could just be that the plaintiffs’ counsel filing the state court lawsuit was just trying to avoid getting cut out of the action. However, a number of these New York state court lawsuits – including for example the Netshoes lawsuit – are standalone actions. The plaintiffs’ lawyers in these cases, for whatever reason, made a tactical or procedural decision to file in state court rather than federal court.
There are any number of reasons we might speculate as to why the plaintiffs’ lawyers chose to file in state court rather than federal court, but somewhere in there has to be some calculation that the plaintiffs will fare better in state court rather than federal court.
In their paper “State Section 11 Litigation in the Post-Cyan Environment” (here), Stanford Law Professor Michael Klausner and his colleagues from Stanford Securities Litigation Analytics specifically examined the question of whether or not the different pleading standards between state and federal court might lead to fewer dismissals of state court securities suits than there are in federal court. The authors examined the dismissal rate in state and federal securities cases during the period 2011-2018. They found that during the period the dismissal rate in federal court ’33 Act liability actions was 42% but the dismissal rate for state court cases was only 19%. The authors attributed the lower dismissal rate to the differences in pleading standards between state and federal court, noting that the difference suggests that “cases are being filed in state court in anticipation of a lower bar at the dismissal stage.”
Of course, we don’t know why the plaintiffs’ lawyers in the Netshoes case filed their action in state court rather than in federal court. But to the extent that the plaintiffs’ lawyers were motivated to file in state court based on perceived advantages at the motion to dismiss stage, Judge Borrok’s decision represents something of a reality check. Judge Borrok’s opinion is thorough, sure-handed, and shows no discomfort in working with the federal securities laws and relevant case law. (In that regard, Judge Borrok’s reliance on the Omnicare decision underscores the importance of that ruling in opinion cases.) The state court pleading standard does not seem to have been a factor in the ruling. And no one would mistake Judge Borrok’s opinion as plaintiff friendly.
The decision in the Netshoes case is of course just one ruling by one trial court judge. It has no precedential value and may have only limited value as an indicator of how New York state courts generally may deal with the new influx of securities cases. Moreover, Judge Borrok’s dismissal of the Netshoes case was without prejudice; the plaintiffs will have an opportunity to try to cure the shortcomings Judge Borrok noted in his decision. For all we know, the plaintiffs might well succeed in amending their complaint and in surviving the next round of dismissal motions.
However, one can hope that Judge Borrok’s ruling may help send a message that the plaintiffs may need to reconsider whatever perceived advantages they may think they have in proceeding in state court rather than federal court. Ultimately, we can hope that Congress will fix the problem that Cyan created; it makes no sense to have a system that permits parallel or duplicative litigation and that has a multitude of state courts enforcing and applying the federal securities laws. However, unless or until Congress gets around to amending the ’33 Act’s jurisdictional provision, plaintiffs’ lawyers will have the option of filing their suits in state court. One can only hope that decisions like Judge Borrok’s in the Netshoes case will help persuade the plaintiffs’ lawyers to stick with the federal court forum.