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Southern District Of New York Largely Denies Motion To Dismiss Putative Class Action Against Dental Product Manufacturer
05/07/2024On May 1, 2024, Judge Arun Subramanian of the United States District Court for the Southern District of New York largely denied a motion to dismiss a putative class action asserting claims under the Securities Exchange Act of 1934 against a manufacturer of dental products and certain of its former executives. San Antonio Fire and Police Pension Fund v. Dentsply Sirona Inc., –—F. Supp. 3d—, 2024 WL 1898512 (S.D.N.Y. May 1, 2024). Plaintiffs alleged the company made misrepresentations regarding its inventory, supply chain, product quality, and overall financial health. The Court held that plaintiffs’ allegations were largely sufficient as to the required elements of falsity, scienter, and loss causation, but the Court dismissed allegations regarding certain alleged misrepresentations and claims against one former executive.
Plaintiffs alleged that from June 2021 through November 2022, the company suffered a sharp drop in demand from dentists for the company’s products, had supply-chain constraints, and had increased numbers of defective products, all of which were either caused or exacerbated by the COVID pandemic. Id. at *1. After the company had previously paid an SEC fine for alleged “channel stuffing”—pushing its product distributors to buy more inventory than they needed, which allowed the company to report inflated sales figures—plaintiffs contended that the company returned to its “channel-stuffing ways” under pressure during the pandemic and did not properly account for this in its financial results. Id. at *2. In May 2022, the company announced that it had been investigating financial reporting matters, including with respect to providing incentives to further sales, and ultimately announced in November 2022 that it would restate its financials, due to issues with sales practices and because of the company’s failure to properly account for product returns and repairs. Id. at *2–3.
The Court began by assessing whether statements the company made were sufficiently specific to be actionable. Id. at *4. The Court explained that various statements only “express a subjective state of mind or feeling,” such as the statements “we’ve been super happy with our dealer partners” and “we’re pretty optimistic that our growth prospects are good,” and were thus “classic opinion” statements and not actionable. Id. at *5. The Court further determined that other statements were non-actionable puffery, such as that the company’s supply-chain team has “done a great job of managing” and “handl[ing]” risks. Id. But the Court observed that when the company’s former CEO made more concrete statements about the company’s performance, such as “[w]e feel very good that we have adequate supply,” these types of statements were actionable because a “reasonable investor plausibly could interpret ‘adequate supply’ to mean the supply necessary to meet demand” and because the statement was otherwise “definite and verifiable.” Id. The Court also found that statements the company made discussing the strength and sustainability of its earnings, demand for products, and whether its inventory levels would rise were also actionable since they would be misleading if the company had, in fact, been engaging in channel stuffing. Id.
The Court then assessed whether the challenged statements were plausibly false or misleading at the time they were made. Id. at *5–6. The Court first found that statements the company made in the second half of 2021, downplaying supply-chain issues, were plausibly misleading in light of plaintiffs’ allegations that supply-chain issues the company faced were getting worse over time, but were already severe by the third quarter of 2021 when the company held weekly inventory calls, and certainly by the fourth quarter when the company knew its distributors had been waiting for months for backordered products. Id. at *6. The Court, however, noted that one statement the company made acknowledging these challenges was entirely consistent with this timeline of alleged events, and thus was not actionable. Id.
With respect to pure omissions that plaintiffs alleged were required to be disclosed under Item 303 of Regulation S-K, the Court applied the Supreme Court’s recent decision in Macquarie Infrastructure Corp. v. Moab Partners, L.P., 144 S. Ct. 885, 892 (2024) (the subject of a prior post), explaining that pure omissions are not actionable under the Exchange Act in the absence of particular statements that are rendered misleading by the omission, and held that plaintiffs would need to amend their complaint to plead such a theory of wrongdoing. 2024 WL 1898512, at *6.
The Court then turned to plaintiffs’ allegations of scienter. The Court explained that certain individual defendants, specifically the former CEO and CFO, were plausibly motivated to make misstatements because the success of the misstatements allowed them to make millions in performance-based pay. Id. at *6–7. The Court also observed that, once the company’s “meddling board” began investigating its financial results, the board reduced the CEO’s and CFO’s pay by millions of dollars as well. Id. at *7.
The Court next explained that plaintiffs sufficiently alleged that the former CEO and CFO possessed actual knowledge of information that contradicted their statements. The Court explained that each executive answered analyst questions suggesting personal knowledge of the company’s inventory and emphasized that plaintiffs alleged that they had orchestrated the channel-stuffing scheme. Id. at *7. The Court also pointed to allegations indicating that the CEO was attuned to the existence of product defects because the CEO had pushed back against a distributor who resisted making purchases because of the company’s product defects, and the CEO also attended meetings where such defects were discussed, received complaints about these defects, and approved product returns. Id. at *8. Collectively, the Court found that the detailed statements the company made supported scienter, or otherwise suggested that the makers of the challenged statements were reckless in making those statements. Id. The Court also agreed with plaintiffs that the magnitude of the company’s restatement, which adjusted each financial account by 3% to 24%, also supported an inference of scienter, as did the importance of various products that were the subject of the company’s sales. Id. And the Court found that the CEO’s and CFO’s execution of SOX certifications lent further support to plaintiffs’ allegations of knowledge. Id. at *9. While the Court agreed that the inference of knowledge-based scienter was weak until the fourth quarter of 2021, since plaintiffs alleged up to that time only that unnamed employes were merely worried about the company’s supply chain, the Court found this failed to significantly refute plaintiffs’ allegations. Id. And the Court explained that the fact that certain statements allegedly showing scienter were made after the class period did not preclude the Court from considering them. Id.
The Court also held that plaintiffs’ allegations that the CEO and CFO set a poor “tone at the top” supported an inference of scienter and plausibly demonstrated that these executives fostered a company culture that led to channel-stuffing, especially because the CEO “set outlandish sales targets, silenced critics, muddied internal controls, and bullied [lower-level employees] into meeting [those sales] targets.” Id. at *9–10. The Court observed that plaintiffs alleged a pattern of wrongdoing by the company and these executives, which bolstered plaintiffs’ allegations that these executives were attuned to the sales issues the company faced, and that if the executives failed to monitor these issues that could have been reckless. Id. at *10.
The Court also held that the fact that various executives were fired or resigned shortly after the company began investigating its financial results supported an inference of scienter, as did the fact that (i) the company’s former CFO was fired from the job he took after his resignation when the company’s investigation was revealed, and (ii) the company’s former CEO never collected the millions in termination payments he was entitled to receive if he was ever terminated without cause. Id. at *10–11. Collectively, the Court found that as to the former CEO and CFO, the inference of scienter was strong, and thus could be imputed to the company. Id. at *11.
But as to the company’s former chief accounting officer, the Court concluded that plaintiffs did not make any specific allegations linking him to any alleged fraud and observed that he resigned from his position many months after the company began its investigation, which did not suggest he had engaged in wrongdoing. Id. at *12. Consequently, the Court held the inference of scienter was not as strong as the competing inference that the former chief accounting officer was merely kept in the dark about the company’s sales practices. Id.
The Court also assessed plaintiffs’ allegations of loss causation. The Court first rejected defendants’ suggestion that the company’s earnings announcements could not be loss-causing events. Id. at *13. While the Court agreed that a company’s failure to simply meet forecasted earnings is not sufficient to establish loss causation, the Court held that an earnings announcement could still amount to a corrective disclosure, so long as the announcement reflected the materialization of a risk that had been concealed by a fraudulent statement. Id. The Court also held that the company’s announcements that it had fired its CEO and was conducting a comprehensive investigation plausibly revealed risks the company faced that had been concealed by the alleged fraudulent statements. Id. at *14.
Finally, the Court held that plaintiffs could pursue control person liability claims against the company’s former CEO and CFO, but not the company’s chief accounting officer, since a claim for control person liability has similar scienter requirements as a traditional fraud claim, which could not be met in this case as to the chief accounting officer. Id.
