Eastern District Of New York Dismisses Exchange Act Claims For Failure To Adequately Allege Falsity Or Scienter

Shearman & Sterling LLP

Shearman & Sterling LLP

On September 30, 2019, Judge Ann M. Donnelly of the United States District Court for the Eastern District of New York dismissed a putative securities class action asserting claims brought under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) against a footwear retailer (the “Company”) and several of its executives.  City of Warren Police and Fire Retirement System v. Foot Locker Inc. et al., 18-cv-01492 (E.D.N.Y. Sept. 30, 2019).  Plaintiffs alleged that the Company and its executives made materially misleading statements and omissions in violation of the Exchange Act concerning its competitive position in the market, the strength of the Company’s relationship with its vendors, and its product allocation and inventory.  The Court dismissed the complaint without prejudice, holding that plaintiffs failed to sufficiently plead falsity and scienter, and granted plaintiffs leave to amend.

According to plaintiffs, the Company did not manufacture products of its own, but instead relied on partner vendors to supply merchandise, which it then sold for a profit at its physical stores and (to a lesser degree) through its online retail channels.  Plaintiffs alleged in their Second Amended Complaint (“SAC”) that the Company misrepresented (i) that it had competitive strength in the market and a “solid position at the center of sneaker culture” despite negative market trends, (ii) the strength of their relationships with vendors, by concealing the fact that its vendors engaged in direct competition, and (iii) that the Company was careful and diligent in “product allocation” and in acquiring inventory, despite the alleged fact that its vendors were requiring the Company to purchase unpopular merchandise as a pre-condition for being permitted to order premium merchandise. 

In May 2017, the Company announced poor financial results for the first quarter of 2017 and “projected that earnings would be in the low-single digits, and would stay ‘relatively flat’ year-over-year.”  Although the Company attributed the disappointing results to delayed tax refunds affecting customer demand, plaintiffs alleged that this concealed the true cause of the poor performance, i.e., according to plaintiffs, deteriorating vendor partnerships and the Company’s loss of competitiveness in the market.  Plaintiffs’ claims allegedly were based in part on statements from confidential witnesses who were former employees of the Company.  Plaintiffs alleged that, according to these confidential witnesses, many of the Company’s vendors were keeping much of their premier products to sell directly themselves rather than selling through the Company, and would only provide premium products to the Company if it also agreed to purchase less desirable inventory, leading to a glut of inventory that had to be marked down in order to be sold.  

The Court first assessed whether plaintiffs had sufficiently alleged material misstatements.  As to the first category of alleged misstatements, concerning the Company’s strong position in the market, Defendants argued that the statements at issue were broad and generalized and mere puffery.  The Court agreed, including because plaintiffs failed to adequately allege that the vendors’ direct sales to customers had a negative effect on the Company’s sales.  As to the second category of alleged misstatements – regarding the Company’s positive relationship with vendors – the Court found that plaintiffs had failed to explain why the statements about working closely with vendors and having “strong” vendor relationships were false.  While plaintiffs relied on alleged statements by confidential witnesses that “vendors were not selling ‘especially popular products’” to the Company, the Court found these allegations unavailing, because the confidential witnesses “did not say that the vendor relationships were not ‘strong’” or “that vendors were refusing to work with [the Company] on product assortment and allocations.”  Finally, as to third category of alleged misstatements—regarding the Company’s inventory and product allocation—the Court found that, although plaintiffs claimed that the Company misstated how carefully it was managing its inventory, the confidential witnesses’ alleged statements about the Company being compelled to purchase undesirable merchandise did not undercut the Company’s statements that it was “trying” to obtain what it believed would be an appropriate amount of inventory and that it was “working to ‘improv[e] allocation.’”

Although the Court held that plaintiffs had failed to adequately allege material misstatements or omissions, it nonetheless proceeded to consider plaintiffs’ allegations of scienter.  Plaintiffs principally relied on stock sales by defendant executives to support a strong inference of scienter.  The Court observed that the sales were not suspicious because they only comprised 5.4% and 10.9% of the two defendant executives’ stock holdings, and some of the sales were made pursuant to a Rule 10b5-1 trading plan that was put in place prior to the putative class period.  Although another sale was made pursuant to a plan that was adopted during the putative class period, the Court found that this failed to raise an inference of scienter, because plaintiffs did not allege any facts that suggested there was strategic trading and manipulative intent involved in the trading plan.  The Court also found that stock sales by the non-defendant executives did not support an inference of scienter as to defendant executives, as plaintiffs did not allege why the defendant executives would have been motivated to engage in fraud to benefit the non-defendant executives.  The Court further found that plaintiffs failed to sufficiently plead that non-defendants’ sales were “suspicious or unusual” because, for the most part, they did not coincide with the dates the alleged misstatements were made. 

The Court further found that plaintiffs did not adequately plead scienter based on allegations of circumstantial evidence.  Plaintiffs alleged that defendants had access to software showing the Company’s sales and inventory and that sales, earnings, and cost trends were discussed regularly.  The Court found these allegations too vague to establish scienter because plaintiffs failed to plead with specificity “that the defendants ‘knew facts or had access to information that their public statements were not accurate.’”  The Court noted that plaintiffs failed to allege that there was any discussion by defendants at any meeting of the Company’s allegedly deteriorating vendor relationships and competing online sales, or that these alleged trends were reflected in the reports to which defendants had access.  The Court also found that the core operations doctrine on which plaintiffs sought to rely could not, on its own, be used to meet the PSLRA’s “demanding” scienter requirement.

The Court declined to address defendants’ alternative argument that plaintiffs have not adequately alleged loss causation, and Court dismissed the Section 20(a) claim because there was no predicate violation of the Exchange Act under which control-person violations could be established.  The Court granted plaintiffs leave to amend. 

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