Fifth Circuit Holds That Complaint Based On Confidential Informant’s Allegations Sufficiently Alleged Material Misrepresentation And Omission In Investor Class Action
On January 18, 2023, the United States Court of Appeals for the Fifth Circuit reversed and remanded the district court’s order dismissing the putative securities class action with prejudice, holding that plaintiff sufficiently alleged that a major theme park operator (the “Company”) and two of its executives made material misstatements and omissions in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. Oklahoma Firefighter Pension and Retirement Systems v. Six Flags Entertainment Corporation, No. 21-10865, 2023 WL 228268 (5th Cir. 2023). Largely on information from a former employee (“FE”), the complaint alleged that defendants misled investors by projecting unrealistic or impossible timelines for opening theme parks in China. After significantly discounting the FE’s allegations, the district court dismissed the complaint with prejudice. The Fifth Circuit reversed, holding that the complaint adequately alleged the FE’s personal knowledge of the relevant topics and that the FE’s allegations should be discounted “only minimally.”
The Company, a major U.S. theme park operator, announced that it had partnered with a Chinese real estate developer (the “Developer”) to build 11 theme parks at three different locations in China. According to the complaint, the Company projected that some of the parks would open as early as late 2019, with all 11 opening by 2021, and that these parks would contribute at a minimum $60 million to the Company’s annual EBITDA post-opening. The complaint alleges that, throughout 2018, the Company stated that the China park projects were “progressing nicely towards their anticipated opening dates” as scheduled. The complaint further alleges that, in February 2019, the Company stated that the China parks would be delayed by 6 to 12 months due to macroeconomic events impacting the Developer. After a series of additional statements throughout the year regarding further delays, in January 2020, the Company disclosed that the Developer had defaulted on its payment obligations, which could lead to the termination of all projects in China, and that they expected a negative $1 million revenue adjustment and one-time charges of approximately $10 million. In February 2020, the Company announced that the agreements with the Developer were terminated.
Plaintiff filed suit, alleging that defendants knew that the projected timelines were unrealistic and impossible. The complaint relied primarily on allegations from the FE, a former Director of International Construction and Project Management whose responsibilities included overseeing the construction of the China parks, ensuring that the Developer was building the parks correctly and safely, and reporting on their progress internally at the Company. According to the complaint, the FE believed that it was “obvious” as early as May 2018 that the parks could not open on schedule because the Developer had not funded the theme park rides or commissioned the necessary blueprints, had barely begun construction, and had fallen behind on making licensing payments to the Company. The complaint also alleged that the FE prepared weekly presentations to Company executives regarding the lack of progress at the parks, and that the FE had direct contact with the Developer and knew about its financial conditions. The complaint corroborated the FE’s allegations with a photo of one of the park sites in April 2018 that showed essentially no construction. Finally, the complaint also alleged that the Company improperly recognized revenue on the China parks and misstated its compliance with GAAP, which allowed the Company to recognize certain revenues related to the China parks only if there was “progress toward completion of [the Developer’s] performance obligations.”
The Fifth Circuit held that the complaint sufficiently alleged a securities fraud claim with respect to the majority of the alleged misstatements. As an initial matter, the Court noted that it may rely on assertions from confidential sources if the person is described with sufficient detail and those details “substantiate that the source has the necessary knowledge.” The Court held that the allegations regarding the FE sufficiently detailed his position as one whose responsibilities were “directly relevant to the events at issue” and corroborated by at least one photo, and therefore “should be discounted only minimally for his anonymity and lack of corroborating witnesses.”
With respect to the alleged misstatements, the Court held that statements that “all our parks are progressing nicely towards their anticipated opening dates,” “the timing of the parks remains exactly the same as previously discussed,” and that although the park opening in one location had shifted back a month or two the others were on-time, were not forward-looking statements that fell within the PSLRA’s safe harbor. First, although the deadlines were future projections, the statements related to the Company’s present construction progress. Second, there were no meaningful cautionary statements related to the actual risk at issue—i.e., that the parks might be significantly delayed or fail to ever open. Third, the complaint sufficiently alleged facts supporting its assertions that the statements were misleading, including that certain necessary steps had not taken place on schedule, that the construction sites showed no meaningful progress, and that the Developer was unable to pay the vendors. Notably, the Court rejected defendants’ argument that plaintiff needed to show that timely completion was categorically “impossible,” stating that such a requirement would raise plaintiff’s burden at the pleading stage. Finally, the Court held that the complaint sufficiently alleged scienter based on allegations that (i) the FE prepared weekly presentations about the lack of infrastructure and progress for Company executives, and (ii) defendants were motivated to hide the true nature of the parks’ progress to achieve the target EBITDA that would have entitled the individual defendants to receive equity awards of 300% and 600% of their base salaries.
With respect to the alleged improper revenue recognition, the Court held that it was not unreasonable to infer that defendants overstated the revenue that depended on the projected opening dates. The Court credited plaintiff’s arguments that because the Company’s statements regarding the scheduled opening dates were false, any recognized revenue during those quarters (which plaintiff claimed were allowed only if there was progress in the development) also must have been erroneous, and also that the Company’s one-time downward revenue adjustment in 2018 was an acknowledgment of its overstatement.