Northern District Of Illinois Dismisses A Putative Securities Class Action Alleging Failure To Disclose Fraudulent Channel Stuffing In Connection With A Merger Of Two Large Packaged Foods Companies

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Shearman & Sterling LLPOn October 15, 2020, Judge Martha M. Pacold of the United States District Court for the Northern District of Illinois granted a motion to dismiss a putative securities class action asserting violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Sections 11, 12(a)(2), and 15 of the Securities Act of 1933 against a large packaged foods company (the “Company”), as well as certain of its officers and directors, and its underwriters. W. Palm Beach Firefighters’ Pension Fund v. Conagra Brands, Inc., No. 19-cv-101323, 2020 WL 6118605 (N.D. Ill. Oct. 15, 2020). Plaintiffs alleged that, in connection with a secondary public offering (“SPO”) to finance the acquisition of another packaged foods company (the “Acquired Company”), the Company failed to disclose that the Acquired Company had engaged in channel stuffing—a form of accounting fraud—to disguise the fact its key brands were struggling. The Court dismissed these claims in their entirety because, among other reasons, plaintiffs failed to allege adequately that the Acquired Company engaged in fraudulent channel stuffing.

In June 2018, the Company announced its $10.9 billion merger. In subsequent press releases and investor calls, defendants (i) emphasized that the companies were “two of the fastest-growing companies in the consumer packaged foods industry”; (ii) stated that the Acquired Company’s sales were $3.1 billion and that its year-over-year growth rate was $17 million; and (iii) predicted that, after the merger, “top line growth [will] continue at the pace both companies have [previously] delivered.” In October 2018, the deal closed and the Company initiated a $575 million SPO to finance the merger. The offering materials for the SPO included the same sales figures and again touted the Acquired Company’s fast growth rate. Several months later, on a quarterly earnings call, the Company disclosed that the Acquired Company’s sales had fallen $160 million short of the Acquired Company’s pre-merger target. The Company’s CEO attributed $30 million of that shortfall to the Company’s decision to end the Acquired Company’s use of year-end promotions. The CEO stated that the Company terminated these promotions because the Acquired Company had been using these promotions to “chas[e] volume over value.”

Plaintiffs alleged that (i) the Acquired Company engaged in fraudulent channel stuffing by using promotional pricing to shift future sales forward to the period right before the merger to conceal its decelerating sales and provide investors with a false impression of its financial health; and (ii) the Company’s statements about the Acquired Company’s sales and growth were misleading because they were based, in part, on sales generated through fraudulent channel stuffing that the Company had failed to disclose.

The Court rejected these claims. The Court first held that plaintiffs failed to allege a distinctive feature of fraudulent channel stuffing—significant quantities of returned product. In the Seventh Circuit, channel stuffing typically refers to the practice of shipping more products to a distributor than a company knows that distributor can possibly sell. And because channel stuffing can serve legitimate business purposes, the practice is only fraudulent if “it is used . . . to book revenues on the basis of goods shipped but not really sold because the buyer can return them.” As a result, a “huge number of returns” can be evidence of channel stuffing because this shows “the purpose of the stuffing was to conceal the disappointing demand for the product rather than to prod distributors to work harder to attract new customers.”

Plaintiffs argued that they were not required to allege returns because their theory of channel stuffing conformed with the SEC’s definition of channel stuffing as “the pulling forward of revenue from future fiscal periods by inducing customers—through price discounts, extended payment terms, or other concessions—to submit purchase orders in advance of when they would otherwise do so.” The Court, however, held that even if it were to accept that “price discounts without any possibility of returns could constitute fraudulent channel stuffing,” plaintiffs had still failed to show that the Acquired Company “shipped more product to its distributors than it thought it could sell” or offered discounts with the fraudulent purpose of overstating it sales. With respect to the CEO’s post-merger statement that the Acquired Company’s decelerating growth was related to its former strategy of “chasing volume over value,” the Court found that this, at most, showed that defendants believed the Acquired Company “made poor business decisions in the period preceding the merger.”

Although the Court concluded that both plaintiffs’ Exchange Act claims and Securities Act claims were subject to dismissal for failure to adequately allege an actionable misstatement, the Court found independent deficiencies with each set of claims. With respect to the Exchange Act claims, the Court held that plaintiffs had failed to adequately plead scienter because they did not allege that defendants were aware of channel stuffing during the pre-merger diligence process and because the Company’s officers purchased shares in the Company at the allegedly inflated price.

With respect to the Securities Act claims, the Court held that plaintiffs lacked statutory standing because they failed to adequately allege that they purchased shares that were traceable to the SPO. Although plaintiffs emphasized that they purchased shares on the date of the SPO and at the SPO’s offering price, the Court found these allegations to be insufficient. Because “the SPO accounted for only around 4% of the total outstanding . . . stock,” and because plaintiffs’ allegations regarding traceability were conclusory and did not identify the identity of the seller, the Court concluded that plaintiffs’ shares “may or may not have originated in the SPO” and “more likely did not.”

The Court declined to dismiss the complaint with prejudice, observing that the Seventh Circuit has “repeatedly . . . said that a plaintiff whose original complaint has been dismissed under Rule 12(b)(6) should be given at least one opportunity to try to amend [its] complaint” and that “[t]his admonition carries special weight in securities fraud cases because in this technical and demanding corner of the law, the drafting of a cognizable complaint can be a matter of trial and error.”

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W. Palm Beach Firefighters’ Pension Fund v. Conagra Brands, Inc.

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