Shearman & Sterling LLP | Securities Litigation Blog | Central District Of California Dismisses Securities Fraud Claim Against Facebook, Finding Plaintiffs Failed To Sufficiently Allege Scienter <br >  
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  • Central District Of California Dismisses Securities Fraud Claim Against Facebook, Finding Plaintiffs Failed To Sufficiently Allege Scienter 
    On October 4, 2017, United States District Judge Stephen V. Wilson of the United States District Court for the Central District of California dismissed without prejudice a putative class action against Facebook, Inc., and three of its senior executives.  Anshen v. Facebook, No. 2:17-cv-00679-SVW-AGR (C.D. Cal., Oct. 4, 2017).  Plaintiffs alleged that defendants violated Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Rule 10b-5 promulgated thereunder, and Section 20(a) of the Exchange Act by fraudulently inflating Facebook’s “average duration of video view” advertisement efficacy metric, leading to a decrease in expected revenue and a drop in the company’s share price when the inaccuracy of the metric was later disclosed.  The company maintained that it inadvertently had overstated this key metric by 60—80% for two years because only advertisements that were viewed for more than three seconds were included in the calculation.  The Court rejected plaintiffs’ claims, finding that plaintiffs had failed to adequately plead scienter or causation.

    Noting that “in most cases, the most straightforward way to raise an inference of scienter for a corporate defendant will be to plead it for an individual defendant,” the Court first considered whether plaintiffs had adequately pled scienter for the three individual defendants.  Pointing out that plaintiffs’ complaint contained no specific allegations against two of the individual defendants other than that they signed Form 10-Ks, and that the only allegations against the third were that he was “heavily involved in the development of video ads” and wanted the company to be more “video centric,” the Court found that plaintiffs had not met their requirements for pleading scienter for the individual defendants.  The Court emphasized that an individual defendant’s potential motivation to profit does not give rise to an inference of scienter, and was unpersuaded by a confidential witness statement put forth by plaintiffs, finding that the confidential witness did not have personal knowledge that any of the individual defendants reviewed the video metrics.

    The Court additionally evaluated plaintiffs’ “core operations” theory of scienter.  Under that theory, the importance of the corporate information about which management was alleged to have made false or misleading statements may create a strong inference of scienter when made in conjunction with detailed allegations about management’s exposure to factual information within the company.  The Court stated that scienter under the core operations theory is generally supported by allegations of specific admissions by a corporate executive of detailed involvement in the minutia of a company’s operations or witness accounts demonstrating that executives were directly involved in creating false reports.  Noting that plaintiffs did not cite any admissions from Facebook executives and also that the confidential witness’s statement failed to demonstrate that any defendants were involved in the calculation of the metric at issue, the Court found that plaintiffs’ pleadings on the core operations theory failed as a matter of law.  The Court similarly rejected plaintiffs’ “broad theory” to establish corporate scienter on the basis that “Facebook hires smart people, so a mistake of this magnitude can be explained only by intentional fraud.” The Court found that plaintiffs’ theory would “bizarrely” subject companies with more talented employees to greater liability in the securities context, a result the Court deemed “absurd.”

    The Court then turned to plaintiffs’ allegations regarding loss causation.  The Court rejected plaintiffs’ assertions that two separate declines in Facebook’s stock price were caused by the disclosure of the inaccurate video metric, finding that the company had disclosed the discrepancy to the public at least several weeks before the first stock price drop (following the announcement of the discrepancy) and more than two months before the second stock price drop (following an investor earnings call).  The Court also noted that plaintiffs failed to plead any facts that could explain why the market would have taken so long to react to the company’s statement and separately that plaintiffs failed to exclude alternative explanations for the stock price drop. 

    Accordingly, finding that plaintiffs had failed to adequately plead scienter or causation, and remarking that it was “skeptical of the viability of the claim,” the Court dismissed the complaint without prejudice.  The decision highlights the high bar plaintiffs must meet in pleading scienter. Absent allegations of specific admissions by executives that they had detailed involvement in the company’s daily operations or witness statements demonstrating that an executive was directly involved in creating the false statement, courts are unlikely to find scienter under the “core operations” theory. 
    CATEGORIES: Loss CausationScienter