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Class Action Defense Cases-In re Spectrum: Georgia Federal Court Grants Defense Motion To Dismiss Securities Fraud Class Action Finding Allegations Fail To Meet Requirements Under Private Securities Litigation Reform Act (PSLRA)

Allegations in Securities Fraud Class Action Complaint Failed to Satisfy Heightened Pleadings Requirements Imposed by PSLRA (Private Securities Litigation Reform Act) But Plaintiffs Are Entitled To Leave To Amend Georgia Court Holds

In September 2005,, plaintiffs filed a putative securities fraud class action under the Securities Exchange Act of 1934 against Spectrum Brands (formerly known as Rayovac) and individual defendants – including its Chief Executive Officer and Chief Financial Officer/Executive Vice President – on behalf of purchasers of persons who purchased Spectrum Brands’s common stock between November 11, 2004, and November 13, 2005 alleging that defendants’ conduct “artificially affected the value of Spectrum Brands’s stock” through the practice of “channel-stuffing.” In re Spectrum Brands, Inc. Sec. Litig., 461 F.Supp.2d 1297, 1300-01 (N.D. Ga. 2006). Plaintiffs amended the complaint in February 2006, and defense attorneys moved to dismiss, id., at 1300. The district court granted the motion, finding that the class action complaint failed to plead securities fraud with sufficient particularity as required by the federal Private Securities Litigation Reform Act (PSLRA).

Channel-stuffing refers to the act of persuading customers to purchase more inventory than they presently require – a practice the Eleventh Circuit recognizes “is not fraudulent per se.” Garfield v. NDC Health Corp., 466 F.3d 1255, 1261 (11th Cir. 2006). The practice, however, causes a company to realize as revenue monies that would otherwise be received later, assuming that the customer did not decide to switch suppliers. In re Spectrum Brands, at 1301. The class action complaint alleged Spectrum “engaged in aggressive channel-stuffing during the fourth quarter of 2004 and the first quarter of 2005, which allowed Spectrum Brands’s performance in the battery market to appear better than it should have and caused an artificial spike in the company’s stock price.” Id. As the district court summarized at page 1301, the class action hinged on the theory that “[company] statements of strong battery sales growth and positive earnings guidances were misleading because Defendants concealed that battery sales reported during the Class Period were generated at the expense of sales in future quarters.” The complaint asserts senior management engaged in channel-stuffing for the purpose of artificially inflating the company’s stock price. Id., at 1301-02.

After summarizing the applicable standard of review, including the pleading requirements imposed by the Private Securities Litigation Reform Act (PSLRA), 15 U.S.C. § 78u-4, the federal court found the allegations of the complaint lacking, explaining at page 1307:

Plaintiffs’ Complaint sets forth, at most, a hypothesis that Defendants engaged in channel-stuffing to inflate artificially short-term quarterly sales revenue, thus boosting temporarily Spectrum Brands’s stock price, for the primary purpose of facilitating Spectrum Brands’s acquisition of United Industries and other companies. Plaintiffs present a number of generalized conclusory allegations, supplement them with a few averments of specific fact, and, from that mix, offer their conclusion that securities fraud occurred. The PSLRA, however, requires more than a reasonable hypothesis drawn mostly from general observations. The PSLRA requires Plaintiffs, at a minimum, to plead specific facts: (i) describing the statements alleged to be materially misleading, (ii) showing why the statements alleged are misleading; (iii) describing the circumstances of the allegedly misleading statements; and (iv) giving rise to a strong inference of scienter as to the Defendants. The Complaint does not meet this standard. Even if the Plaintiffs’ general observations and conclusions appear facially reasonable . . ., Plaintiffs failed to plead their case with the particularity demanded by the statute governing this action.

The district court stressed that under Eleventh Circuit case authority “‘a securities fraud plaintiff must plead scienter with particular facts that give rise to a strong inference that the defendant acted in a severely reckless manner'” and that “‘[s]evere recklessness is limited to those highly unreasonable omissions or misrepresentations that involve not merely simple or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and that present a danger of misleading buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it.'” In re Spectrum Brands, at 1306-07 (citations omitted).

The district court recognized that channel-stuffing “can facilitate fraud if it is used for ‘providing excess supply to distributors in order to create a misleading impression in the market of the company’s financial health,'” In re Spectrum Brands, at 1309 (citation omitted), but concluded that plaintiffs’ allegations failed to adequately allege that this occurred. “To prove the context of the alleged fraud, Plaintiffs must plead with particularity facts sufficient to allege not only that the alleged channel-stuffing occurred, but also that it was not legitimate.” Id. (italics added). Here, plaintiffs’ allegations were conclusory only. As the court explained at page 1310, “Plaintiffs do not allege any specific instances where a particular customer with a high inventory of batteries actually purchased more batteries at the end of a quarter in response to special incentives or pressure from Spectrum Brands.” The court elaborated at pages 1310-11,

Plaintiffs do not allege facts sufficient to show whether the alleged channel-stuffing practices were widespread or anecdotal, whether they involved hundreds rather than millions of dollars worth of product, or how the alleged channel-stuffing transactions at the end of the quarters differed from sales made at other times during the quarter. Without this particularity, Plaintiffs have pled insufficient context for the representations and omissions alleged.

The district court ultimately held that the class action complaint failed to meet the heightened pleading requirements imposed by the PSLRA and failed to adequately plead scienter. It therefore granted the defense motion to dismiss but granted plaintiffs leave to amend.

NOTE: We do not here discuss that portion of the opinion in which the district court analyzed and rejected plaintiffs’ claims that Spectrum Brands improperly recognized revenue in light of its liberal return policy. We note only that after its detailed analysis the district court concluded at page 1314, “Plaintiffs have failed to allege adequately the who, what, when, where, and how of the context of its fraud allegations tied to improper returns and revenue recognition.” We also do not discuss the court’s detailed analysis of scienter, which is well worth reading in full. See id., at 1314-20.

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