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Southern District Of New York Grants In Part And Denies In Part Motion To Dismiss Putative Class Action Complaint Against Software Company For Failing To Disclose A Fake Customer-Review Scheme
03/26/2024On March 5, 2024, Judge John P. Cronan of the United States District Court for the Southern District of New York granted in part, and denied in part, a motion to dismiss a putative shareholders’ class action, alleging that a software company (the “Company”), several of its executives and directors (“Individual Defendants”), and three banks who underwrote the Company’s initial public offering (“IPO”) violated Sections 11 and 15 of the Securities Act of 1933. Lian v. Tuya Inc., 22 Civ. 6792 (JPC) (S.D.N.Y. Mar. 5, 2024). Plaintiff alleged that the Company failed to disclose at the time of its IPO, as required by Items 105 and 303 of Regulation S-K, that its sales and growth could be impacted by the involvement of a significant percentage of its customers in a pervasive and far-reaching fake customer reviews scheme. Furthermore, plaintiff alleged that the Company’s failure to disclose the scheme rendered several statements in the IPO registration statement (“Registration Statement”) false and misleading. The Court dismissed the claims predicated upon Items 105 and 303 but found the Section 11 claims based upon alleged misstatements in the Registration Statement to be sufficiently pled.
The Company is a China-based developer and seller of software, which enable “smart” devices to connect to the internet, communicate and interact with end users, and record and provide information and services. The Company does not manufacture or distribute devices itself; rather, it pairs with manufacturers, operators, and distributors of such devices—the Company’s customers—to provide its proprietary software for a one-time fee per device. According to the complaint, roughly one-third of the Company’s customers are China-based cross-border e-commerce merchants, who sold devices embedded with the Company’s software on e-commerce platforms, including Amazon. In March 2021, the Company launched its IPO and filed the accompanying Registration Statement. Several months later, the Company’s stock fell sharply after a cybersecurity organization published a report, which revealed an allegedly pervasive fake customer-review scheme by China-based e-commerce merchants. Plaintiff alleged that, under this practice, also known as “brushing,” merchants would duplicate the accounts of actual customers and use their names and addresses to send them cheap, lightweight items they did not actually buy. Plaintiff further alleged that the merchants would use the fake accounts to write fraudulent positive customer reviews. In response, Amazon allegedly banned 600 Chinese brands, including several of the Company’s customers, for violating its terms of service.
Plaintiff asserted two categories of claims. First, plaintiff alleged that Item 105, which requires disclosure of material factors that make an investment “speculative or risky,” and Item 303, which requires registrants to disclose any “trends or uncertainties,” obligated the Company to disclose the existence of the fraudulent review scheme. Second, plaintiff alleged that the Company’s failure to disclose that scheme rendered five categories of statements in the Registration Statement false and misleading. Defendants moved to dismiss on the basis that (i) plaintiff failed to allege the Company and the Individual Defendants had actual knowledge of the fake customer-review scheme at the time of the Registration Statement, and (ii) the Registration Statement adequately disclosed the risks posed by that scheme.
The Court granted in part, and denied in part, the motion to dismiss. First, the Court assessed the sufficiency of the claims premised upon Items 105 and 303. Interpreting the plain language of these regulations, the Court sided with the majority view that, to establish violations of either, there must be allegations to support an inference of “actual knowledge” of the undisclosed material trends or risks. The Court concluded that plaintiff’s allegations that there existed public reporting by popular international news sources about the fake customer review scheme fell short of establishing defendants’ actual knowledge. The Court found significant that the complaint lacked factual allegations to support the notion that defendants had reason to know—either through public reporting or targeted communications—about the Company’s customers’ involvement in the fake customer-review scheme. Accordingly, the Court dismissed without prejudice plaintiff’s claims based on Items 105 and 303.
The Court then turned to the five categories of allegedly false and misleading statements in the Registration Statement relating to (i) the Company’s deep relationships with its customers; (ii) its ability to gain new customers and increase adoption of its products; (iii) its statements attributing the Company’s success to reasons other than its customers’ fake-review practices; (iv) statements touting the Company’s marketing efforts; and (v) purported risk warnings describing potential risks of its customers receiving negative product reviews from customers. The Court first disposed of defendants’ argument that they lacked actual knowledge of the scheme, finding that Section 11, unlike Items 105 and 303, does not have such a requirement. Rather, a material fact must simply be “knowable” for liability to extend to its omission under Section 11. The Court concluded that the fake customer-review scheme was, indeed, knowable to defendants prior to the Registration Statement, for plaintiff alleged that the cybersecurity organization that published the May 2021 report into the fake customer-review scheme had begun unearthing it on March 1, 2021.
Although defendants raised several arguments to rebut allegations about the Registration Statement’s falsity, the Court found that only one had been properly and timely raised: defendants’ argument that the Registration Statement’s disclosure that the Company’s success depends on customers’ ability to generate positive reviews and minimize negative ones adequately warned about risks associated with fake customer reviews. The Court found this rebuttal unpersuasive, concluding that the Registration Statement’s risk disclosure related to a different type of risk than fake customer reviews, and that a reasonable risk disclosure relating to the scheme would have been more specific than the generic disclosure contained in the Registration Statement.
Finally, the Court dismissed without prejudice the Section 15 claim against one of the Individual Defendants, who plaintiff alleged exerted control over the Company by virtue of that Defendant’s position as a director. The Court found that such thin factual allegations could not suffice to adequately demonstrate actual control as required by Section 15.
