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Southern District Of New York Declines To Dismiss Claims In Putative Class Action Against Medical Test Manufacturer
02/13/2024On February 5, 2024, Judge Arun Subramanian of the United States District Court for the Southern District of New York largely declined to dismiss a putative class action asserting claims under the Securities Exchange Act of 1934 against a manufacturer of medical tests and certain of its executives. Stadium Capital LLC v. Co-Diagnostics, Inc., 2024 WL 456745 (S.D.N.Y. Feb. 5, 2024). Plaintiff alleged that the company made misrepresentations regarding the prospect of future sales of the company’s medical tests as the COVID-19 pandemic subsided. The Court held that plaintiff plausibly alleged actionable misrepresentations regarding comments made announcing earnings results for the first quarter of 2022, and plausibly alleged that defendants acted with scienter.
Plaintiff alleged that during the COVID-19 pandemic—from the second quarter of 2020 through the first quarter of 2022—the company’s revenue was approximately $20 million per quarter, but that in the second quarter of 2022 the company’s revenue was only $5 million. Id. at *1.
The Court first determined that three challenged statements were actionable: (i) “changes in our operating environment and markets have restricted our near term visibility”; (ii) “[o]ur ability to accurately forecast … COVID-19 test sales through the balance of the year has diminished”; and (iii) “we are experiencing sizable fluctuations in order patterns from our customers … [and] it has become difficult to predict with an expected level of precision the cumulative impact of these and other factors on our future financial results.” Id. at *2. The Court explained that the company’s references to “near term visibility” and “fluctuations” implied it was experiencing current or potential volatility, not that its sales had actually already cratered, as plaintiff alleged, and which was supported by the company’s reported revenue figures. Id. The Court found these statements would have provided “comfort to investors” even though plaintiff alleged that the company knew demand for tests was already in decline. Id. Moreover, the company CFO expressly said in response to a question about whether the company was “already seeing a decline in customer orders” that the company’s statements to this effect were “more about the timing and being able to forecast the timing of orders … not necessarily a demand issue that we’re seeing,” which the Court held reinforced the determination that the challenged statements were plausibly alleged to be misleading. Id. The Court held these statements were not opinions or puffery because they described fluctuations in order patterns and were “determinate, verifiable statements.” Id. The Court also determined that these statements were not forward-looking, and to the extent they were, they were not accompanied by meaningful cautionary statements, since the cautionary language was misleading in light of historical fact, and thus not subject to the safe harbor for forward-looking statements. Id.
In addition, the Court held that plaintiff adequately alleged that the company failed to disclose a trend with respect to its declining sales as required by Item 303 of Regulation S-K by failing to disclose that federal funding it had received for COVID tests had run out. Id. at *4. The Court noted that it was plausible that at least half the company’s revenue was tied to this funding since the company, in opposing the motion to dismiss, had argued that half of the company’s revenue was attributable to other sources. Id. The Court also noted that even though decreased federal funding for COVID testing had been publicized, “the magnitude of the effect” on the company was not. Id.
But the Court held that various statements were not actionable since they did not imply anything about overall demand for the company’s products, and otherwise described historical facts about the company’s performance. Id.
The Court then held that plaintiff adequately alleged scienter. Id. at *5. The Court explained that plaintiff alleged that the company’s executives were reckless in making the challenged statements because the executives had knowledge or access to facts that contradicted those statements, as evidenced by the fact that the executives noted that they were “able to monitor the daily influx of demand for our tests” and “keep a close eye on” distributor inventory “every day” and explained that they saw “falloff” in inventory when they reported their disappointing earnings results. Id. On the basis of these statements about sales monitoring, the Court held that the executives “were likely to know whether demand had fallen substantially for the product that accounted for more than 99% of the company's revenue” and thus scienter was supported by the “core operations doctrine” which “reflects the commonsense assumption that executives are likely to know more about things central to their business.” Id. The Court found that the company’s statements noting “fluctuations” and an “inability to forecast” also suggested they were monitoring sales, knew sales were down and hoped that demand would later rebound. Id. The Court similarly held that scienter was sufficiently alleged with respect to the Item 303 claim, given the importance of federal funding to the company’s revenue. Id.
The Court rejected defendants’ arguments against the inference of scienter. First, the Court held that the individual defendants were linked to the alleged fraud by their statements that they closely monitored sales. Id. at *6. Second, while the individual defendants were not alleged to have reviewed specific sales reports that undermined their statements, the Court explained that in this case plaintiff was not alleging the general existence of sales reports but was instead pointing to the fact that the company’s executives themselves touted that they were monitoring sales at the time they were speaking with investors. Id. Finally, the Court rejected the suggestion the company lacked motive in light of the company’s stock buybacks, noting that the volume of stock buybacks was significantly lower during the period plaintiff contended the company’s stock price was inflated than during the surrounding periods, and the individual executives’ stock holdings increased because options had vested and were sold to cover certain tax obligations. Id. Thus, the Court held that plaintiff adequately alleged the company’s executives knew sales were down and tried to obscure that fact. Id.
