California District Court Grants Motion To Dismiss Securities Class Action Against Hearing Aid Company, Finding Plaintiffs Failed To Plead Falsity And Scienter
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  • California District Court Grants Motion To Dismiss Securities Class Action Against Hearing Aid Company, Finding Plaintiffs Failed To Plead Falsity And Scienter
     

    02/28/2023
    On February 14, 2023, Judge Charles R. Breyer of the United States District Court for the Northern District of California granted a motion to dismiss a putative securities class action alleging that a hearing aid company (the “Company”) and its officers, directors, and IPO underwriters falsely or misleadingly inflated the Company’s revenue and growth opportunities and allegedly downplayed an insurance audit, leading to a Department of Justice investigation for insurance fraud.  In re Eargo, Inc. Sec. Litig., No. 21-cv-08597 (N.D. Cal. Feb. 14, 2023).  Plaintiffs alleged violations of Sections 11, 12(a)(2), and 15 of the Securities Act of 1933 (the “Securities Act”) against all defendants, and violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 promulgated thereunder against the Company and its officers.  The Court granted defendants’ motion to dismiss, holding that plaintiffs failed to sufficiently plead falsity and scienter.

    According to the amended complaint (the “Complaint”), the Company makes and directly sells hearing aids to consumers.  Plaintiffs alleged that unlike the traditional hearing aid sales model, which requires customers to make in-person visits to hearing aid professionals who examine the customer, the Company developed a telecare model using an in-house team of individuals licensed in one or more states to advise customers on hearing aid needs.  Plaintiffs alleged that initially the Company primarily sold its products to customers who paid out-of-pocket, but allegedly eventually targeted customers with a Federal Employees Health Benefits Program (“FEHBP”) which provides health benefits through various insurance carriers, such as the Blue Cross Blue Shield Federal Employee Plan (“BCBS FEP”).  Plaintiffs alleged that after targeting FEHBP beneficiaries, the Company’s revenue more than doubled, and by the end of 2020, insured customers comprised approximately 45% of the Company’s total customer base.

    Plaintiffs alleged that between March 15 and April 7, 2021, the Company was notified that it was being audited by BCBS and that the Company would be required to supply supporting documentation with all claims submitted.  On May 12, 2021, in its Q1 2021 SEC Form 10-Q filing, the Company stated that it was “currently subject to a routine audit.”  According to the Amended Complaint, the Company updated investors on August 12, 2021, in its Q2 2021 filing, disclosing that in addition to being subject to the audit, “claims submitted since March 1, 2021 have not been paid.”  The Company also disclosed that “[r]eimbursement claims submitted to another insurance company are also currently undergoing an audit, and … it is possible that they may seek recoupments of previous claims paid and deny any future claims.”  The Company warned that “an unfavorable outcome of the ongoing audits could have a material adverse effect on our future financial results[.]”  On an August 12, 2021 earnings call, the Company’s CFO allegedly stated that “[t]hese kind of audits are—on claims are pretty common, particularly given the growth in our business.”  According to plaintiffs, after the August 12 filing, the Company’s stock price dropped over 24%.  Plaintiffs further alleged that during an August 16 meeting with analysts, the Company’s CEO and CFO stated the audit was “not an issue with the benefit amount, the device delivered, or a dispute denial.”  On September 9, 2021, the CEO allegedly further stated that “audits in the hearing aid industry happen all the time, right.”

    On September 22, 2021, the Company filed an SEC form 8-K notifying shareholders that the DOJ had begun conducting a criminal investigation into the Company’s insurance reimbursement claims.  Following this announcement, the Company’s stock price allegedly dropped approximately 68%.  According to the Complaint, in January 2022, the Company disclosed that the DOJ referred the matter to the Civil Division and that the criminal division was no longer active.  On April 29, 2022, the DOJ purportedly issued a press release announcing a $34.37 million settlement with the Company “to settle common law and False Claims Act allegations of unsupported diagnosis code.”  In the press release, the DOJ noted that “[t]he claims settled by this agreement are allegations only and there has been no determination of liability.”  For its part, the Company denied any wrongdoing.  While the DOJ investigation was ongoing, several investors filed separate suits alleging violations of federal securities law, which were consolidated into a single putative class action.

    The Court first addressed plaintiffs’ Securities Act claims.  As a preliminary matter, the Court agreed with defendants that the heightened pleading standard of Rule 9(b) governed plaintiffs’ Section 11 claims because plaintiffs’ Securities Act allegations generally mirrored their fraud-based allegations under the Exchange Act.  In turn, the Court found that plaintiffs did not adequately plead falsity from statements made in the Company’s offering documents sufficient for violations of Section 11 or Section 12(a)(2).  The Court noted that the challenged statements generally fell into three categories:  (i) unaudited financial results; (ii) statements concerning available insurance coverage; and (iii) risk factors concerning uncertainty surrounding available insurance and the Company’s compliance with law.

    Regarding the Company’s unaudited financial results, plaintiffs alleged that defendants’ statements were inaccurate, misleading, or false because it was unlikely that the Company could collect insurance reimbursements as revenue.  The Court emphasized that satisfying the standard for accounting statements of opinion to be actionable is “no small task,” and found that plaintiffs fell short of meeting the standard because “[t]he Complaint contains no allegations of subjective falsity—that is, Plaintiffs do not allege, with particularity, facts showing that Defendants believed that FEHBP insurance companies would not reimburse the claims.”  The Court found that plaintiffs “merely speculate[d] that Defendants must know, or it was reckless that they did not know, from BCBS’s policy manual that [the Company’s] claims would be rejected for falsehood.”

    Regarding defendants’ allegedly false or misleading statements about the Company’s ability to obtain insurance coverage and its growth opportunities through the insurance market, the Court found that these statements “simply conveyed corporate optimism,” and that plaintiffs did not sufficiently plead that defendants believed that the mechanism for revenue growth through insurance coverage was unattainable.  The Court determined that the alleged statements in the Offering Documents that the Company intended to target customers with eligible insurance coverage fell within the PSLRA safe harbor as forward-looking statements regarding plans and objectives for future operations.  Similarly, the Court found that although plaintiffs “point to a handful of statements containing concrete facts that are quantifiable and verifiable … most of the challenged statements simply convey optimism for business growth,” and were therefore nonactionable puffery.

    Regarding risk factors in the Company’s SEC filings related to the uncertainty surrounding available insurance, its compliance with law, and its business model, the Court noted that “risk factors” are not actionable without further factual allegations indicating that the risks had already “come to fruition,” and found that the Complaint did not contain well-pleaded facts showing that, at the time of the IPO, any insurer audit or regulatory investigation had begun such that it would make the Company’s risk disclosures inaccurate.  The Court, therefore, held that plaintiffs had not pleaded actionable claims under Sections 11 and 12(a)(2) of the Securities Act, and accordingly dismissed their Section 15 claim against a purported “control person” of the Company.

    The Court turned next to plaintiffs’ Exchange Act claims.  At the outset, the Court noted that these claims largely hinged on the same or similar categories as plaintiffs’ Securities Act claim, and were not actionable for the same reasons.  Plaintiffs did include additional misrepresentation allegations in support of their Exchange Act claims, alleging that the Company’s representation that it “validates customer eligibility and reimbursement amounts prior to shipping the product” was false or misleading and that the Company falsely or misleadingly characterized and downplayed the BCBS audit as “routine” and “pretty common.”  The Court, however, found that it need not address whether a reasonable investor would have been misled by the Company’s alleged statement about validating insurance eligibility (nor would it have been equipped to make such a factual determination at the pleadings stage) because plaintiffs did not plead a strong inference of scienter.  The Court also found that plaintiffs did not adequately plead that the Company should have disclosed the BCBS audit in its Q4 2020 SEC Form 10-K because plaintiffs did not allege that the Company received the letter from BCBS in time for the Q4 2020 filing.  Moreover, the Court found that plaintiffs failed to adequately plead that the Company’s officers did not believe the insurance audit was routine or that their characterization of the audit was false or misleading at the time they disclosed it.

    Although the Court did find that plaintiffs adequately pled that the CEO “downplayed the audit” as part of his alleged statements made on September 9, 2021, the Court held that plaintiffs did not adequately plead scienter.  According to the Court, plaintiffs did not allege facts showing that any individual defendants sold Company stock during the Class Period, or that the officers knew or should have known that the Company’s telecare business model would not comport with the publicized insurance requirement that hearing aid benefits meet the criteria for “medical necessity.”  The Court further reasoned that plaintiffs failed to identify any alleged facts suggesting that the officers believed the BCBS audit was anything but routine and failed to offer any particularized allegation of what the Company’s January 2021 “internal review” showed about its billing practices (or that the officers were even aware of such internal review).  The Court similarly rejected plaintiffs’ assertions that the Company’s “rapid and substantial” settlement with the DOJ was evidence of scienter, and rejected plaintiffs’ argument that the “core operations doctrine” established scienter, because “the Complaint cites no particularized facts that [defendants] believed, or they were deliberately reckless in disbelieving, that [the Company’s] insurance submissions were false or improper.”  Therefore, the Court dismissed plaintiffs’ Exchange Act claims, including their Section 20(a) control person claim.  The Court permitted plaintiffs to file a further amended complaint.

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