Sheer Yoga Pants And Over-Stretched Allegations: Court Refuses To Stretch Allegations Of Corporate Mismanagement Into Federal Securities Fraud

by Orrick - Securities Litigation and Regulatory Enforcement Group
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https://jdsupra-html-images.s3-us-west-1.amazonaws.com/bd5e565e-2f51-4441-8762-e2dbd452f1d2-iStock_000018328608XSmall-200x150.jpgA lack of sweaty models trying on yoga pants may be problematic, but does it give rise to securities fraud? Not in the Southern District of New York. In In re lululemon Securities Litigation, decided on April 18, 2014, Judge Katherine B. Forrest dismissed in its entirety a class action complaint against lululemon based on sheer yoga pants alleging violations of Section 10(b) and Section 20(a) of the Exchange Act and SEC Rule 10b-5. As summarized by the court, lead plaintiff alleged, “if only lululemon had someone try on its black luon yoga pants before they shipped, it would have realized they were sheer; similarly, if lulumeon had only had someone exercise in certain athletic wear (enough to produce sweat), it would have realized that the colors bled.” Based on these purported shortcomings, plaintiff alleged that statements touting the high quality of the company’s products were materially false and misleading. The court, however, disagreed: “This narrative requires the Court to stretch allegations of, at most, corporate mismanagement into actionable federal securities fraud. This is not the law.”

The black luon pants were recalled in March 2013 after customers complained that they were transparent. The recall amounted to seventeen percent of the company’s sales. After the recall, customers reported additional problems, including pilling (when small balls of fabric accumulate on the surface of clothes), flawed seams, and continuing sheerness. During this so-called “sheergate” period, the company made the following representative statements:

Statement #1: The Company’s quality level was the “highest in the industry.”

Statement #2: The Company was the “leader in technical fabrics and quality construction.”

Statement #3: “Quality” was the company’s “key differentiating factor” from its peers.

Plaintiff honed in on these statements for its federal securities law claims, claiming that they were “irreconcilable with [l]ululemon’s actual and undisclosed quality control practices, and . . . thus actionable.”

Although quality issues seemingly plagued lululemon, Plaintiff’s Section 10(b) and Rule 10b-5 claims were inadequate. Plaintiff failed to plead that the statements identified above were false because they were taken out of context and, at most, contained either non-actionable statements of opinion or forward-looking language that was not false. The statements about quality were not false where, in context, they actually acknowledged that product defects sometimes occurred or stated the company’s belief that third parties viewed the products favorably. Statement #1 regarding the products’ high quality was tempered by a statement on the same page recognizing that “[b]ecause our products are made for humans, by humans, sometimes products don’t quite turn out the way we imagined. If we made too much or we have products with visual or minor functional defects, we make them available through our factory outlets . . . [or] we work with deBrand to reuse and recycle the product.” This statement implied that defects occurred, and that they did so with such regularity as to require an established policy. Statement #2 regarding the company’s status as a leader did not make any guarantees because it was framed in the passive voice, “We believe that our brand is recognized as premium in our offerings of run and yoga assortment, as well as a leader in technical fabrics and construction.” This was a statement about what third parties believed about the product, and not a guarantee by the company that it was, in fact, the leader. Statement #3 describing “quality” as the products’ “key differentiating factor” was a statement of the company’s “goals or belief” and was qualified by a sentence immediately before it recognizing that defects sometimes occurred.

The remaining elements required for a Section 10(b) and Rule 10b-5 violation were also absent. Plaintiff failed to allege scienter; they made no allegations that defendants did not believe the truth of their statements or that the claimed quality control steps were not in fact taken. Furthermore, there was no showing that the allegedly false and misleading statements caused lead plaintiff’s losses. Even after the recall of lululemon’s signature black luon pants, the company continued to experience growth. Plaintiff made no assertions revealing pervasive quality control issues or that earlier earnings statements were fraudulent. Because there was no underlying primary violation of Section 10(b), the Section 20(a) control person claim also failed. The court’s dismissal confirms that allegations of corporate mismanagement coupled with falling stock prices do not necessarily mean plaintiffs have a viable federal securities claim.

 

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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