Shearman & Sterling LLP | Securities Litigation Blog | Northern District Of California Grants Motion To Dismiss Securities Fraud Claims Against Software Company, Finding That Plaintiffs Did Not Adequately Allege Falsity Or Scienter With Respect To Alleged Material Omissions<br >  
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  • Northern District Of California Grants Motion To Dismiss Securities Fraud Claims Against Software Company, Finding That Plaintiffs Did Not Adequately Allege Falsity Or Scienter With Respect To Alleged Material Omissions

    On March 9, 2020, Judge William H. Orrick of the United States District Court for the Northern District of California granted a motion to dismiss a putative securities class action asserting claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”), and Rule 10b-5 promulgated thereunder, against a software company (the “Company”) and two of its executive officers.  Ryan Scheller, et. al. v. Nutanix, Inc., et. al., No. 19-cv-01651-WHO (N.D. Cal. Mar. 9, 2020).  Plaintiffs alleged—based primarily on statements allegedly made by seven confidential witnesses (the “CWs”)—that defendants made false and misleading statements and omissions concerning, among other things, the Company’s internal operations, business relationships, product quality, and sales performance.  The Court granted defendants’ motion to dismiss, finding that plaintiffs failed to allege that the Company’s public statements were false or misleading, and that plaintiffs failed to sufficiently allege scienter.

    The Company, which specializes in providing enterprise cloud platforms and is allegedly “known for pioneering hyper-converged infrastructure software (“HCI”) that combines data center computing into a single machine[,]” began to transition to providing software-only products and to a subscription-based model in the first quarter of 2018.  According to plaintiffs, defendants made false statements “in SEC filings, press releases, investor conference calls, a blog post, and a public report” during the transition.  Specifically, plaintiffs alleged that defendants made material misstatements and omissions concerning the Company’s “(i) investments in lead generation; (ii) institution of secret hiring freezes of sales personnel; (iii) deteriorating relationship with Dell [its primary business partner]; (iv) declining product quality; and (v) practice of ‘pulling in’ orders in order to conceal its declining sales pipeline.”

    Regarding the Company’s statements concerning its investments in lead generation, plaintiffs alleged that the Company, as part of the “planning process” during its business transition, misled investors that the Company was investing in marketing and lead generation, when it was instead reallocating those funds to engineering.  Plaintiffs further alleged that the Company “acknowledged its inadequate lead spending in February 2019, when it reported ‘inadequate marketing spending for pipeline generation and slower than expected sales hiring’ and ‘some imbalances in [the Company’s] lead generation spending that were beginning to impact [its] sales pipeline.’”  The Court stated that the inquiry was “whether ‘a reasonable investor would have understood statements that [the Company] was ‘increasing’ marketing activities to mean that [the Company] was also increasing the most critical component of marketing—lead generation—when, in fact, this was not true[.]”  The Court held that plaintiffs failed to allege that the Company made false statements about new customer growth and that in fact plaintiffs’ complaint included statements suggesting the public was actually “aware of slowing new customer growth” during the transition.  The Court further determined that plaintiffs “argue[d] that various facially true statements regarding a variety of sales and marketing activities were in fact misleading” due to the Company’s subsequent admission that “it kept ‘lead generation’ flat,” but such allegations were insufficient because the complaint failed to specifically allege false or misleading statements with respect to lead generation.” 

    The Court next considered plaintiffs’ allegations concerning the Company’s statements regarding hiring.  Plaintiffs alleged that defendants made false statements that the Company planned to increase its headcount in the near future during several conference calls, when the Company was in fact experiencing a decrease in sales personnel and had already instituted hiring freezes.  Defendants argued that these statements were not false because the Company did add over 60 new sales teams, and in any event, the Company had disclosed that it had “encountered challenges in its sales hiring.”  The Court agreed with defendants, noting that the Company “in fact increased its headcount, [so] its statements to that effect [were] not rendered false by difficulties in sales turnover” because “[e]mployee retention and new hiring are separate issues, and a company may experience high turnover while still increasing headcount.”  The Court further held that “several of the[] statements, such as ‘we are big on hiring’ and ‘a lot of hiring [is going on],’ are vague and amount non-actionable puffery.”  The Court held that CWs’ alleged statements that the Company had experienced hiring freezes were contradicted by the Company’s disclosures related to increased headcounts, and that the allegations failed to provide specific details about the hiring freezes, and did not adequately plead each CW’s personal knowledge with respect to the Company’s hiring.

    The Court next considered plaintiffs’ allegation that the Company omitted information concerning its purported “deteriorating relationship” with Dell.  Plaintiffs alleged that defendants knew that the relationship with Dell was deteriorating because Dell had begun to sell its own products instead of the Company’s products.  The Court found that these allegations were insufficient to plead a material misstatement or omission, because the Company “did maintain its relationship with Dell throughout the Class Period and continued to receive sales from existing customers from Dell.”  The Court further found that the Company’s alleged failure to disclose “full information about the relationship with Dell is not actionable in and of itself,” and that a majority of the alleged misstatements were in fact “forward-looking, contain[ed] expressions of subjective belief, and [were] accompanied by detailed cautionary language about the risks of the relationship with Dell and changing market conditions,” thus “render[ing] these statements protected by the safe harbor provision of the PLSRA.”

    The Court similarly rejected plaintiffs’ allegations that the Company made false statements regarding its product quality.  The Court found that certain alleged statements that the Company “was aggressively adding new customers” and that the Company was experiencing a “record number of new customers,” did not explicitly relate to product quality, and instead focused on the Company’s increased customer base.  According to the Court, while the statements would “potentially be actionable if they were false,” plaintiffs failed to “specifically allege[] that [the Company] did not add new customers in the Class Period, but merely that the pipeline was ‘drying up.’”  The Court found that a majority of the remaining statements—such as references to a “consumer-grade experience that is unmatched” and “a relentless focus on our customers,” and that “[d]emand for our solutions remains strong”—constituted non-actionable puffery.

    The Court then addressed plaintiffs’ allegations that the Company failed to disclose “that it had instructed salespeople to ‘pull in’ sales from future quarters in order to compensate for ‘[the Company’s] empty pipeline.’”  The Court held that plaintiffs’ “non-specific allegations that are based almost entirely upon the statements of one confidential witness with limited personal knowledge do not adequately allege a fraudulent pull-in scheme under the law of this circuit.”

    Finally, the Court concluded that plaintiffs failed to sufficiently allege scienter.  According to the Court, “defendants’ after-the-fact statements that they decided to re-allocate funding from lead generation to development do not support an allegation that the defendants understood each of their statements was false at the time they made them.”  Additionally, the Court found that the CWs’ purported statements were inadequate to plead scienter because plaintiffs did not sufficiently allege that any of the CWs had the requisite level of involvement or knowledge with respect to falsity of the specific statements at issue or the individual defendants’ awareness of such alleged falsity.  Further, the Court noted that plaintiffs’ complaint did “not contain any allegations that either defendant actually knew that the pipeline was drying up, but provide[d] only vague statements that pipeline was discussed with the defendants.”  The Court further held that the resignation of four non-defendant executive officers, without other facts, could not lead to “an inference, let alone a strong inference, of scienter.”  Finally, the Court held that the allegations concerning defendants’ stock sales did not demonstrate motive or a strong inference of scienter, because the fact that no defendant had ever previously sold the Company’s stock before the class period was not suspicious given that those shares were subject to a 180-day lock-up period that did not expire until less than a year before the class period began. 

    The Court dismissed the claims with leave to amend.