Northern District Of California Finds Allegations Of Scienter Sufficient Based On “Deliberate Recklessness” Standard
05/09/2017On May 1, 2017, Judge Edward Davila of the United States District Court for the Northern District of California denied a motion to dismiss a putative securities fraud class action against Finisar Corporation and certain executives, in which plaintiffs alleged that the company had falsely denied an inventory build-up of key telecom products by Finisar’s customers, in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (“Exchange Act”). In re Finisar Corp. Sec. Litig., 2017 WL 1549485 (N.D. Cal. May 1, 2017). The Court had previously dismissed the case for failure to allege a material misrepresentation, but the United States Court of Appeals for the Ninth Circuit reversed, holding that plaintiffs had adequately alleged a false statement in that they asserted that defendants had denied knowledge of an inventory build-up by customers in the face of evidence that they knew of the issue. On remand, the District Court found the complaint also adequately alleged scienter and loss causation.
Finisar develops and sells fiber optic subsystems and components for various telecommunications applications. On December 2, 2010, an analyst noted that Finisar’s growth had repeatedly outpaced its industry and suggested that had to be the result of inventory build-up by customers, which would result in subsequent sales declines. The former CEO responded that it did not appear that there was any such build-up. Id. at *2. Approximately three months later, however, the company disclosed that it would have lower revenue than expected, in part because of “the adjustment of inventory levels at some telecom customers” and a slowdown in business in China (where many of Finisar’s customers were located). Id. Finisar’s stock price fell sharply, and plaintiffs filed suit soon thereafter.
Defendants argued that plaintiffs had failed to plead scienter and loss causation. As to scienter, the Court noted that in the Ninth Circuit, scienter can be supported by allegations of either intentional misconduct or “deliberate recklessness,” which includes “turning a ‘blind eye’” to impropriety or having reasonable grounds to believe material facts were misstated but failing to obtain or disclose such facts despite having the ability to do so without “extraordinary effort.” Id. at *6 (citations omitted). In light of the facts that (a) the Ninth Circuit had already held that plaintiffs sufficiently alleged falsity based on defendants’ statements that they were not aware of stock-piling, (b) plaintiffs alleged confidential witnesses had stated that Finisar and the industry in general discussed inventory levels in negotiations with customers and (c) the executives would have had the ability to inquire into such negotiations, the Court held that plaintiffs had established a strong inference of scienter. The Court also rejected defendants’ argument that plaintiffs failed to plead loss causation, holding that the claimed misstatements and the disclosures resulting in the stock drop were sufficiently “relate[d] to the same subject matter”—the buildup of customer inventory—to establish the requisite causal link. Id. at 8.
This case is significant in that it shows how the distinct elements of falsity and scienter can sometimes overlap and serves as a reminder that plaintiffs can sometimes adequately plead scienter without a showing of actual knowledge that a statement was false when made.