Second Circuit Vacates And Remands Dismissal Of Exchange Act Claims Against Food Manufacturer, Holding The District Court Erred In Its Interpretation Of Exchange Act Claim Requirements
Securities Litigation
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  • Second Circuit Vacates And Remands Dismissal Of Exchange Act Claims Against Food Manufacturer, Holding The District Court Erred In Its Interpretation Of Exchange Act Claim Requirements

    On December 17, 2021, the Court of Appeals for the Second Circuit unanimously vacated and remanded for reconsideration the dismissal by the United States District Court for the Eastern District of New York of a putative securities class action asserting claims under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), and Rule 10b-5(b) promulgated thereunder, against a health food product manufacturing company (the “Company”) and certain of its executives, for alleged misstatements regarding the Company’s sales and internal controls.  In re: The Hain Celestial Group, Inc. Securities Litigation, No. 20-1517 (2d Cir. Dec. 17, 2021).  The late District Judge Arthur Spatt granted defendants’ motion to dismiss, with prejudice, the Second Amended Complaint (the “SAC”), holding that plaintiffs failed to allege a fraudulent scheme or business practice in violation of the terms of Rule 10b-5(a)-(c), and further failed to sufficiently plead scienter.  Plaintiffs appealed the district court’s dismissal with respect to their Rule 10b-5(b) claims.  The Second Circuit vacated the dismissal, holding that the district court erred in finding that plaintiffs’ Rule 10b-5(b) claim relied on plaintiffs’ pleading a fraudulent business scheme or plan.

    According to plaintiffs, defendants allegedly made misleading statements that attributed the Company’s “high sales volume to strong consumer demand” while concealing an alleged channel stuffing scheme.  The alleged scheme—a practice whereby the Company’s customers were offered valuable incentives to purchase more of the Company’s product than needed before the end of each financial quarter—allegedly allowed the Company to report “unsustainably inflated quarterly sales results.”  In dismissing plaintiffs’ Rule 10b-5(a) and (c) claims, the district court held that the alleged channel stuffing conduct did not constitute “inherently fraudulent” conduct.  Finding that the channel stuffing was “legitimate,” the district court dismissed plaintiffs’ Rule 10b-5(b) claim, holding that it similarly failed “because its predicate [was] the illegitimacy of the channel stuffing practices [which] the [district court] already found to be legitimate.”  Accordingly, the district court held that the SAC did not sufficiently plead violations of Rules 10b-5(a)-(c) and scienter and dismissed the SAC with prejudice.

    The Second Circuit first addressed the differences among Rule 10b-5(a), (b), and (c).  Whereas clauses (a) and (c) require allegations of the “use of a fraudulent deceptive device, scheme, artifice, act, or practice,” the Court clarified that Rule 10b-5(b) is “significantly different” because it “focuses not on schemes, devices, or practices, but on statements made.”  The Second Circuit held that the district court’s finding with respect to the legitimacy of the channel stuffing “is not dispositive of [p]laintiffs’ Rule 10b-5(b) claim” because the “conduct underlying a purportedly misleading statement or omission” does not need to be fraudulent itself.  In particular, the SAC alleged the defendants misleadingly stated that the Company’s favorable sales figures were attributable to “strong consumer demand” for its products while failing to disclose that demand for its products was declining and that a significant percentage of sales was in fact attributable to the alleged practice of channel stuffing.  The Second Circuit held that the district court’s reasoning “reflect[ed] a misunderstanding of the requirements of clause (b),” and accordingly vacated the district court’s decision that the SAC “failed to satisfy” the requirements of Rule 10b-5(b).

    Turning next to the issue of scienter, the Second Circuit found that the district court erred in failing to weigh plaintiffs’ scienter allegations “as a whole.”  The Court found that the district court’s “mistaken understanding” of the alleged misstatements and underlying conduct “inevitably affected” its finding that plaintiffs failed to sufficiently plead scienter.  In particular, the Court noted that, although the district court separately considered both the individual defendants’ knowledge of the alleged channel stuffing and their “motive and opportunity to commit fraud,” the district court erred by not considering “the total weight of the circumstantial allegations together with the allegations of motive and opportunity.” (emphasis added). The Second Circuit held that on remand the district court should consider the “cumulative effect of the circumstantial allegations of intent” and the “pleaded facts relating to motive and opportunity.”  However, the Second Circuit “express[ed] no views” as to whether the SAC’s allegation are sufficient to plead scienter.

    Accordingly, the Second Circuit vacated and remanded the dismissal of the SAC to the district court.  Noting that the case must be reassigned to a new judge upon remand, the Court instructed that the newly assigned judge should “consider afresh” whether the SAC sufficiently alleged a violation of Rule 10b-5(b).