Northern District Of California Allows Certain Securities Fraud Claims To Proceed Against Cloud Services Company, Holding Plaintiffs Adequately Alleged Falsity And Scienter

Shearman & Sterling LLP

Shearman & Sterling LLPOn September 11, 2020, Judge William H. Orrick of the Northern District of California denied a motion to dismiss a putative securities class action asserting claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”), and Rule 10b-5 promulgated thereunder, against a software company (the “Company”) and two of its executive officers. Scheller v. Nutanix Inc., No. 19-cv-01651 (N.D. Cal. Sept. 11, 2020). This case was previously dismissed with leave to amend by Judge Orrick in March, and was covered in our newsletter. Plaintiffs filed a Second Amended Complaint (“SAC”) in an attempt to cure the prior pleading defects. The Court noted that the SAC “suffers from many of the same deficiencies as [the] prior complaint” and held that certain categories of allegations were insufficient, but the Court allowed certain claims to proceed.

Plaintiffs allege defendants made misleading statements in their regulatory filings, during conference calls, and in press releases regarding the Company’s “(i) investment[s] in ‘lead generation,’ (ii) [a customer] ‘pull-in’ scheme [to allegedly hide its declining pipeline], (iii) [increased] new customer growth, and (iv) [increased] sales hiring and productivity.” The SAC raises much of the same allegations as the prior complaint, though with some additions, including new statements from a number of alleged confidential witnesses.

The Court first considered the statements at issue regarding the Company’s increased spending on sales and marketing that plaintiffs argue were false or misleading concerning the Company’s investment in “lead generation.” The Court noted that while the SAC “persuasively allege[s]” the Company failed to invest enough resources into “lead generation or new customer growth,” plaintiffs’ allegations fail to adequately allege that the Company’s statements were false when made. In particular, the statements “do not mention lead generation specifically” and “do not allege how or why investors would understand that ‘marketing’ included separate components of lead generation, sales, and travel.” To the contrary, the Court noted, public statements indicate the “investors would have understood lead generation to be separate from marketing” and that it was actually a “subset of marketing activities.” The Court concluded that plaintiffs’ allegations with respect to “lead generation” failed to meet the heightened pleading standards required under the PSLRA.

The Court turned next to allegations of misstatements regarding a “pull-in scheme”—i.e., that the Company allegedly “pulled in” existing customers “expected to close in the next quarter” into the current quarter to obscure its pipeline issues. Plaintiffs pointed to confidential witnesses’ statements that the Company “routinely” pulled sales and was “‘significantly behind’ on its revenue goals.” The Court held that such an alleged practice “by itself [did] not support a finding of falsity” concerning the Company’s pipeline statements. The Court also found that plaintiffs did not adequately plead that the Company’s statements regarding its “end-customers” numbers were false, noting that plaintiffs fail to “adequately allege[] that a reasonable investor would have conflated the terms ‘end customers’ and ‘new customers.’” The Court held, however, that related allegations that defendants misrepresented their sales and customer acquisition to obscure pipeline issues were sufficient to plead falsity. In particular, the Court found that the Company’s statements at a March 2018 conference that it “added a record number of new customers and had made a huge contribution to overall mid-market customer acquisition” were misleading “in light of the alleged concerns throughout the company regarding the company’s pipeline of new customers.” The Court also held that plaintiffs sufficiently alleged the Company’s other statements at a May 2018 conference regarding its “renewed focus with the [new customer] channel” were misleading, as it could cause a “reasonable investor to conclude . . . [the] pipeline for new customers was robust when, in fact, it was facing a significant decline.”

Plaintiffs also alleged that defendants’ sales hiring and productivity statements “created the false impression that it was on track to meet its internal sales hiring goals needed to achieve revenue growth forecasts,” when in fact it was actually “experiencing strong attrition in its sales personnel, failing to meet internal revenue goals, and experiencing ‘general disorganization.’” The Court disagreed in part, holding that plaintiffs failed to allege how “a reasonable investor would have been misled” into believing that an increase in sales hiring necessarily meant the Company’s “retention and sales productivity also increased.” However, based on purported statements by confidential witnesses that the Company’s “sales force was experiencing high levels of attrition, sales people were unable to meet quotas, and sales productivity was in fact poor,” the Court held that plaintiffs adequately alleged falsity as to the Company’s statements that “it experienced ‘record sales productivity,’ had executed hiring plans ‘flawlessly,’ ‘had strong success in . . . hiring . . . that position[ed] [it] to deliver on [its] future growth plans,’ and had ‘ramped rep sales productivity.’”

Turning to scienter, the Court held that plaintiffs’ new allegations gave rise to a strong inference of scienter. The Court noted the SAC adequately alleged the CEO was “regularly kept apprised of [the Company’s] pipeline [which was “very important” to the Company] . . . such that he was at least deliberately reckless as to the fact that the pipeline was declining and the statements made regarding customer growth [were] misleading.” This was based in part on statements by the confidential witnesses, one of whom allegedly personally met with the individual defendants “to discuss the status of prospective customers.” Although plaintiffs did not make specific allegations that the pipeline’s problems were discussed in these meetings, the Court found that “this fact can be inferred from the remaining allegations in the SAC, which allege widespread concerns” about it. The Court similarly held that plaintiffs adequately alleged scienter with respect to sales productivity as the pipeline would have been “dependent” on this metric, but held that scienter was not adequately alleged with respect to hiring.

Having concluded that plaintiffs adequately alleged falsity and scienter with respect to defendants’ statements concerning the Company’s new customer growth and sales, the Court denied defendants’ motion to dismiss.

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Scheller v. Nutanix Inc.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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