Northern District Of Illinois Dismisses Putative Class Action Against Cosmetics Retailer For Failure To Adequately Allege Falsity And Scienter
On March 30, 2022, the United States District Court for the Northern District of Illinois dismissed, without prejudice, a putative class action asserting claims under the Securities Exchange Act of 1934 against a cosmetics retailer and certain of its executives. Chandler v. Ulta Beauty, Inc., No. 18-CV-1577, 2022 WL 952441, at *1 (N.D. Ill. Mar. 30, 2022). Plaintiffs alleged that the company made various statements that were misleading because they failed to disclose the company’s alleged practice of reselling used returned products. The Court held that plaintiffs failed to identify any actionable misrepresentations and failed to adequately allege scienter, but granted plaintiffs leave to replead.
Plaintiffs alleged that the company’s personnel were instructed to “retouch used and dirty returned products and resell them as new in order to reduce inventory losses.” Id. at *3. Plaintiffs alleged on this basis that the company made misstatements and omissions relating to (i) compliance with the company code of conduct, (ii) the company’s compensation program, (iii) the quality of the company’s products, (iv) the company’s financial results, and (v) the company’s internal controls and reporting. Id. at *7.
The Court held that plaintiffs failed to explain why the challenged statements were false. For example, with respect to the company’s statements about compliance with the company code of conduct—specifically, that employees “must act ethically at all times” and in accordance with the code of conduct, which itself provided that employees “should not deliberately misrepresent information to customers”—the Court concluded that such statements were “immaterial as a matter of law” because they were “too general to cause a reasonable investor to rely upon them” and amounted to “inactionable puffery.” Id. at *9. With respect to statements regarding the company’s “compensation plans, practices and policies,” the Court concluded that plaintiffs did not explain how those statements were false and further observed that the alleged improper reselling practices were “not so closely tied to compensation” that they were required to be disclosed in order to prevent the compensation-related statements from being misleading. Id. at *10. With respect to statements concerning product quality—specifically, that the company had a “pipeline of newness and innovation in merchandising”—the Court found that this statement was referring to new types of products and it was not reasonable to infer that the company was touting the product offerings as “being ‘new’—as opposed to used—because such a statement would only make sense if investors believed that [the company] was selling used products,” something which the complaint alleged was being hidden from the public. Id. at *11.
In addition, the Court held that challenged statements regarding the company’s financial performance were not adequately alleged to be false or misleading, including because plaintiffs never alleged, even in a general sense, “what the correct sales, income, and inventory figures purportedly were that [the company] should have reported.” Id. at *14. Similarly, the Court rejected plaintiffs’ allegations as to statements regarding internal controls and reporting, explaining that plaintiffs failed to allege facts showing how such challenged statements were false or misleading and failed to explain “how [the company’s] internal controls should have been designed differently.” Id. at *21.
The Court then evaluated plaintiffs’ allegations of scienter and concluded that they failed to support a strong inference of scienter as to either the company itself or to the CEO or CFO, who were alleged to have made the challenged statements. The Court rejected plaintiffs’ argument that the CFO’s alleged attendance at committee meetings designed to prevent “shrink”—losses from customer returns of products as well as theft and in-store damage—showed the CFO’s knowledge of the alleged improper reselling, including because there were no allegations that the scheme was discussed at such meetings. Id. at *23. Moreover, with respect to the CEO’s alleged approval of bonuses relating to reduced “shrink,” the Court discounted such allegations as they were attributed to a confidential witness who was four levels of seniority below the CEO, and there was no alleged basis for the confidential witness’s knowledge of the CEO’s alleged approval of the bonuses. Id. at *24. The Court also noted that even if the CEO had approved such bonuses, issues of “shrink” involved a number of different issues and not only issues relating to the alleged reselling practices. Id.
The Court further rejected plaintiffs’ argument that the CFO and CEO must have known about the alleged scheme given their roles and responsibilities. The Court explained that plaintiffs did not allege how many used products were resold or reshelved, or that reselling used products was critical to the company’s operations. Id. at *24-26. While the Court determined that the CEO and CFO were “likely aware of [the company’s] general problem with shrink,” the Court emphasized that “it does not follow that they must have been aware that retail stores were combating it by selling used items,” and plaintiffs failed to “quantify how significant the practice actually was.” Id. at *25. Thus, the Court concluded that, even if the alleged reselling practice was widespread, it did not support a strong inference of scienter as to the CEO and CFO because there was “no alleged connection” between them and the alleged practice. Id. at *26. Similarly, the Court rejected plaintiffs’ contention that the CEO and CFO had access to weekly reports that revealed stores were reselling used products, noting that neither executive was plausibly alleged to have reviewed those reports, and there was no allegation explaining how the reports would have revealed the alleged reselling practices. Id. at *27-28. In addition, the Court rejected plaintiffs’ allegations of scienter based on the CEO’s and CFO’s stock sales. The Court concluded that those sales occurred “shortly after announcements of quarterly results, a pattern that appears benign on its face” and were not close in time to any other significant event. Id. at *28-29.
Finally, the Court rejected plaintiffs’ argument that scienter should be imputed to the company based on the allegation that employees other than the CEO and CFO were “aware of, and even encouraged, the resale of used products.” Id. at *30. The Court explained that those employees’ alleged knowledge could not be imputed to the company because they were “not alleged to have had any role in promulgating the alleged misrepresentations.” Id. The Court concluded that the “most cogent explanation for [the company’s] alleged conduct is that the resale of used product was an unfortunate and unintentional byproduct of [the company’s] focus on reducing shrink,” rather than something known by the executives responsible for the alleged misstatements. Id. at *31.