Northern District Of California Dismisses Putative Class Action Against Cybersecurity Company Based On Failure To Adequately Allege Misrepresentations And Scienter
On June 14, 2019, Judge William Alsup of the United States District Court for the Northern District of California dismissed a putative class action against a cybersecurity company (the “Company”) and certain of its executives. SEB Inv. Mgmt. AB v. Symantec Corp., No. 18-02902 (N.D. Cal. June 14, 2019). After the Company announced that its audit committee had commenced an internal investigation and had voluntarily contacted the SEC after a former employee raised unspecified concerns, plaintiff, an investor in the Company, alleged that defendants made misrepresentations in connection with the Company’s growth as a result of its acquisition of two security firms, in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 promulgated thereunder. The Court held that plaintiff failed to allege actionable material misrepresentations and/or scienter as to various categories of alleged misstatements, and dismissed the complaint without prejudice.
The complaint alleged that the Company made certain false and misleading statements about (i) its revenue growth, by recognizing revenue improperly in violation of Generally Accepted Account Principles (“GAAP”), (ii) non-GAAP adjustments, by improperly categorizing certain expenditures as transition costs, (iii) its executive compensation policies, (iv) its internal controls, and (v) the reason for the departure of a Company executive.
Revenue Recognition. The Court first ruled that plaintiff failed to adequately allege that defendants made misrepresentations about the Company’s revenue recognition. The complaint alleged that, according to confidential witnesses, the Company “shifted” the way revenue was recorded, such as by recognizing revenue that should have been deferred, recording sales that were not made, and recognizing deals early “to make its numbers.” The Court found that the complaint alleged sufficient facts regarding the reliability and personal knowledge of these confidential witnesses, including based on the details alleged as to their job titles, employment dates, and responsibilities. The Court concluded, however, that plaintiff failed to allege enough facts to determine whether the claimed GAAP violations were “minor or technical in nature, or whether they constituted widespread and significant inflation of revenue” such that they would have been material in light of the Company’s “overall financial situation.”
Transition Costs. Next, the Court turned to plaintiff’s claims that the Company improperly categorized certain expenses related to IT projects and security as transition costs rather than operation costs. Defendants argued that these costs were appropriately categorized because they “concerned long-term strategic planning.” The Court rejected those arguments, finding that the allegations, taken as a whole and crediting plaintiff’s sources, were sufficient to plead false and misleading statements. The Court held, however, that plaintiff failed to adequately allege scienter. The Court found that, at most, plaintiff alleged that the misclassification of expenses resulted from pressure and scrutiny from certain of the individual defendants, but not that the accounting manipulations were directed by them. The Court also found that plaintiff’s general allegations about “leadership” and “unethical behavior” were not sufficiently tied to the executive defendants or the accounting practice at issue to establish scienter.
Executive Compensation. The Court next determined that plaintiff failed to plead sufficient facts establishing that the Company made false and misleading statements about its executive compensation program. The Court rejected plaintiff’s argument that the Company’s disclosures that its compensation program was aligned with the Company’s financial performance were misleading because executives allegedly inflated transition costs to report financial results that would trigger more lucrative compensation packages. The Court found that these claims merely reiterated the allegations regarding the Company’s accounting practices, and that plaintiff had failed to connect the alleged accounting practices with the disclosures.
Internal Controls. The Court found that plaintiff’s claims that the Company made misleading statements concerning its internal controls over revenue recognition and tracking of transition expenses lacked specific factual allegations indicating that the Company knew about its allegedly faulty internal controls when it made such statements and were not just simply “wrong in their assessment.” Accordingly, the Court concluded that plaintiff failed to adequately plead scienter in connection with this claim.
Executive Departure. Turning next to plaintiff’s allegation that the Company issued misleading statements about the departure of one of its executives, the Court found that the witnesses relied upon by plaintiff had not spoken to the executive about his reasons for leaving and plaintiff failed to allege facts describing the witnesses’ personal knowledge about his departure.
Finally, the Court found insufficient a variety of additional allegations of scienter. The Court observed that while executive compensation incentives can be a factor in determining whether a strong inference of scienter exists—especially where compensation can be linked to the alleged fraud—plaintiff’s allegations were insufficient to support a strong inference even when holistically viewed with all the other allegations. Additionally, the Court found that allegations concerning the individual defendants’ stock sales did not support such an inference. The sales made up approximately 4% of one executive’s holdings and approximately 27% of another’s, and the Court observed that the Court of Appeals for the Ninth Circuit has held that more significant sales (including more than 37% of holdings) are typically “necessary to support scienter.” Furthermore, both executives owned more stock at the end of the class period and a third executive sold based on a pre-determined plan, all of which the Court concluded “strongly rebuts an inference of scienter.”
Having determined that plaintiff failed to adequately plead a primary violation under Section 10 of the Exchange Act, the Court dismissed plaintiff’s control person liability claims under Section 20(a) of the Exchange Act, as well as the insider trading liability claims under Section 20A(a). The Court granted defendants’ motions to dismiss, but allowed plaintiff leave to amend to cure the issues raised by the Court’s order.