Eastern District Of Virginia Dismisses Putative Securities Fraud Class Action Against Cybersecurity Company For Failure To Allege Falsity Or Scienter
On February 1, 2023, Judge Anthony J. Trenga of the United States District Court for the Eastern District of Virginia dismissed a putative securities fraud action against a cybersecurity company (the “Company”) and several of its executives and directors alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Section 11 of the Securities Act. Firemen’s Retirement System of St. Louis, et al. v. Telos Corp., et al., No. 1:22-cv-00135 (E.D. Va. Feb. 1, 2023). Plaintiffs alleged that defendants misled investors about the status and prospects of key government contracts and falsely certified to having reasonable financial controls. The court dismissed the action without prejudice, holding that plaintiffs failed to allege falsity or scienter.
The Company specializes in cybersecurity and provides, among other products and services, a digital identity services platform to the government, military, and Fortune 500 companies. Prior to conducting an initial public offering in November 2020, the Company announced that it had been selected for significant contracts with the Transportation Services Administration (“TSA”) to provide support for TSA Precheck enrollment services and the Centers for Medicare and Medicaid Services (“CMS”). A few months after the IPO, in April 2021, the Company conducted a secondary offering, during which offering the Company executives were permitted to sell their personal shares to the Company.
In its registration statement filed with the IPO and its earnings calls for the first and second quarters of 2021, the Company stated that it expected to see substantial revenue growth attributed to the TSA and CMS contracts and that they expected the TSA and CMS contracts to be approved by the end of the second and third quarter of 2021, respectively. Plaintiffs alleged that these statements were misleading and false based on subsequent developments that included the delay in the expected launch of the TSA and CMS contracts and, after disclosing material weaknesses in its internal controls and a delay in filing its 2021 10-K, an announcement in March 2022 that the Company had uncovered mistakes in applying Generally Accepted Account Principles (“GAAP”) that had led to errors in calculating the revenues attributable to the TSA and CMS contracts, which plaintiffs claimed were overvalued by as much as 175%.
The Court held that plaintiffs failed to plead falsity with respect to any of the three categories of alleged misstatements. First, the Court held that statements related to the Company’s predictions or expectations about its future revenue or future operational growth, as well as statements related to when the Company expected the TSA and CMS contracts to begin yielding revenue, were all forward-looking statements that were “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially.” Specifically, the Company disclosed risks that: (i) it was “dependent on a few key customer contracts for a significant portion of [its] future revenue,” (ii) these services were vulnerable to interruptions caused by the COVID-19 pandemic and cyberattack threats, and (iii) the Company does “not control the decision-making timeline within TSA.” Second, the Court held that plaintiffs did not adequately allege that the Company chairman’s certification regarding “reasonable financial controls” was false because that certification was accompanied by cautionary and qualifying language that the Company had made “certain estimates and assumptions related to the adoption and interpretation of [the relevant accounting] principles.” Third, the Court held that statements that the Company expected “strong results” and hoped to “meet or exceed” financial guidance and that the sale cycle will “accelerate” were all non-actionable puffery.
The Court also held that plaintiffs failed to adequately plead that defendants acted with actual knowledge of falsity or scienter. First, the Court rejected plaintiffs’ argument that the Company’s statement that it was “in near daily communications with the TSA” or its alleged subsequent admission that the Company failed to conduct an analysis of the relevant accounting principles was sufficient to show knowledge and stated that plaintiffs’ allegations were “nothing more than the fact of what happened—the events themselves,” and “conclusory ‘fraud by hindsight’ allegations.” In a similar vein, the Court took note of the fact that plaintiffs were not alleging that the Company was aware of and failed to correct an accounting mistake. Second, the Court held that stock sales by executives also did not establish scienter. The Court noted that there was no other trading period with which to compare sales to demonstrate that the trades were abnormal, but also that one of the defendants also purchased shares during the class period, another defendant sold his shares pursuant to a Rule 10b-5 trading plan, and the percentage of shares sold by the remaining individual defendants were far below the percentage that the Fourth Circuit has found to be sufficient to infer scienter.
The Court dismissed the Section 11, Section 20(a) and Section 15 claims on the same bases.