Fifth Circuit Affirms Dismissal Of Putative Securities Class Action Against Home Furnishings Retailer For Failure To Adequately Allege Scienter
On August 19, 2019, the United States Court of Appeals for the Fifth Circuit affirmed the dismissal by a Northern District of Texas court of a putative securities class action asserting a Section 10(b) claim under the Securities Exchange Act of 1934 (the “Exchange Act”) against a home furnishings retailer (the “Company”) and two of its senior officers. Municipal Employees’ Retirement System of Michigan v. Pier 1 Imports Inc. et al., No. 18-10998 (5th Cir. Aug. 19, 2019). Plaintiff alleged that defendants failed to disclose that the Company’s inventory was too high and was subject to significant “markdown risk” because it had too much inventory that was too “seasonal” and “subject to changing consumer tastes.” The Court affirmed the district court’s decision that plaintiff’s allegations did not adequately support the required strong inference of scienter.
Plaintiff contended that after the Company’s online service proved unsuccessful, the Company became “severely flooded with excess merchandise” that, according to plaintiff, could only be sold by dramatically reducing prices. Slip op. at 2. Plaintiff further contended that in late 2015, the Company’s stock price dropped significantly after it made a series of corrective disclosures that acknowledged inventory-related issues resulting from “unplanned supply chain expenses,” “inventory-related inefficiencies,” the Company’s need to resort to clearance sales and that the Company would require at least 18 months to reduce inventory to appropriate levels. Id. at 3.
At the outset, the Court rejected plaintiff’s argument that the district court failed to follow the Fifth Circuit’s prior directive in Owens v. Jastrow, 789 F.3d 529 (5th Cir. 2015), that a district court “may best make sense of scienter allegations by first looking to the contribution of each individual allegation to a strong inference of scienter,” and if any “single allegation, standing alone, create[s] a strong inference of scienter,” then the court may stop there without proceeding to a “holistic look at all the scienter allegations.” Id. at 537. The Court determined that the district court’s analysis was fully consistent with Owens because it had in fact considered the scienter allegations individually, and that it was not an error for the district court to separately consider—and reject—the possibility of special circumstances that might permit “a defendant’s corporate title coupled with a severe problem with the company” to establish an inference of scienter. Id. at 6-7.
The Court then addressed in turn plaintiff’s three categories of scienter allegations: (1) allegations of motive; (2) allegations that the officer defendants knew that the Company’s inventory was high and (3) allegations that those officers knew that the Company had significant markdown risk. Id. at 7. The Court determined that each set of allegations fell short of establishing the “strong inference” of scienter required under the Private Securities Litigation Reform Act (“PSLRA”).
Concerning motive, plaintiff alleged that the officer defendants had two distinct motives to mislead: (1) that they “staked their careers” on the Company, which allegedly “drove them to overstate” the Company’s success and (2) that their employment contracts promised them cash bonuses based on the Company’s earnings. The Court held that, particularly in the absence of any allegation that defendants profited from the alleged fraud, an allegation of scienter based on career prospects is insufficient. In particular, the Court cited to its prior precedent holding that “the desire ‘to protect [one’s job in an] executive position  was not the type  of motive that support[s] a strong inference of scienter.’” Id. at 8 (citing Abrams v. Baker Hughes Inc., 292 F.3d 424, 434 (5th Cir. 2002) (alternations in original). Likewise, the Court held that allegations concerning incentive compensation could not support an inference of scienter because “the vast majority of corporate executives receive such compensation,” and there were no allegations in the amended complaint that the potential bonuses of the officers were particularly high. Slip op. at 8-9.
With respect to plaintiff’s allegations relating to alleged high inventory levels, the Court emphasized that plaintiff fundamentally failed to allege that the executives misrepresented the Company’s inventory, and, in fact, the amended complaint itself contained several public disclosures concerning the Company’s problem with high inventory. Id. at 10. In addition, while plaintiff attempted to argue that knowledge of the inventory levels equated to knowledge of the markdown risk, the Court rejected that inference and concluded that “an equally plausible inference is that [the executives] reasonably believed they could fix the excessive inventory problem without resorting to markdowns.” Id. The Court also determined that plaintiff’s other allegations relating to inventory levels failed to meet the PSLRA’s heightened pleading standard, including because they were based on alleged statements about events outside of the putative Class Period, knowledge of information that was in fact publicly disclosed, “vague” and “amorphous” allegations from confidential witnesses or allegations that otherwise were not sufficiently tied to defendants in question. Id. at 10-14. Notably, the Court cited to Fifth Circuit precedent to hold that “‘courts must discount allegations from confidential sources.’” Id. at 12 (citing Ind. Elec. Workers’ Pension Tr. Fund IBEW v. Shaw Grp, Inc., 537 F.3d 535, 543 (5th Cir. 2008)).
Lastly, the Court considered and rejected plaintiff’s theory of scienter based on other allegations regarding high inventory markdown risk. First, while plaintiff argued that the Company was “particularly subject to markdown risk” as a “trend-based fashion retailer,” the Company argued that a large percentage of its products were “long-standing collections” that do well “day in and day out,” and further that the Company kept ordering more inventory which it would not have done if it knew it would be unable to sell its existing inventory. Slip Op. at 16. The Court concluded that plaintiff’s allegations were conclusory or vague, and did not create a “strong inference” that all or most of the inventory was so trend-driven that it “could not be sold without significant markdowns.” Id. Second, the Court rejected as “weak circumstantial evidence” the allegation that defendants should have known about the markdown risk because of certain clearance sales that the Company held after the alleged statements in question. In addition to rejecting plaintiff’s argument because it was only first raised in plaintiff’s reply brief and not alleged in the amended complaint, the Court found that such a “temporal-proximity” argument is “weak circumstantial evidence of fraud.” Id. at 17. Third, the Court declined to assess various alleged “red flags” of a “looming markdown risk,” as they were set out in an expert report attached to the amended complaint that had been stricken from the record by the district court. Id. at 14. Fourth, the Court declined to adopt the theory that Item 303 of Regulation S-K creates a duty under the Exchange Act to disclose “known trends or uncertainties” that a company “reasonably expects will have a material . . . unfavorable impact . . . on revenues.” Id. at 17-18. The Court noted that it had never addressed this issue, while observing that other circuits were split on this issue—the Second Circuit has held that there is a duty to disclose (see Stratte-McClure v. Morgan Stanley, 776 F. 3d 94, 102 (2d Cir. 2015)), while the Ninth Circuit has held that no such duty exists (see In re NVIDIA Corp. Sec. Litig., 768 F.3d 1036, 1056 (9th Cir. 2014)). Moreover, the Court noted that plaintiff failed to allege any independent facts showing that the officer defendants reasonably expected, prior to the time of disclosure, that inventory levels would have a material unfavorable impact on revenues. Slip Op. at 18.