On March 22, 2021, Judge Beth Labson Freeman of the United States District Court for the Northern District of California dismissed certain of the claims asserted in a putative class action brought under the Securities Exchange Act of 1934 against a technology company and certain of its executives. City of Sunrise Firefighters' Pension Fund, et al. v. Oracle Corporation, et al., No. 18-cv-04844-BLF, slip op. (N.D. Cal. Mar. 22, 2021). Plaintiffs alleged that the company made misrepresentations regarding its transition from locally installed software to cloud-based products, which plaintiffs alleged was driven through undisclosed “coercive sales practices.” After the Court dismissed an earlier iteration of the complaint without prejudice for failure to allege any actionable misstatements, plaintiffs filed an amended complaint. The Court held that a number of allegations failed to establish falsity or scienter, but permitted some claims to go forward against certain defendants on a limited theory of liability.
Plaintiffs alleged that the company engaged in two strategies to use its legacy business of locally installed software to artificially inflate its numbers for its cloud-based software subscriptions. First, the company allegedly installed features in locally installed software that would cause customers to exceed the limits of their software license, which the company would then allegedly use as a basis to pressure the customer to accept short-term cloud subscriptions. Second, the company allegedly offered significant discounts if the customer agreed to accept a short-term cloud subscription. Plaintiffs alleged that these tactics resulted in deals that were not genuine purchases—because the customers allegedly did not want or intend to use the cloud-based software—and that the company in this way inflated short-term results for its cloud-based subscriptions. Id. at 3.
The Court characterized the alleged misrepresentations as falling into the following categories: (1) statements related to the revenue growth of the company's cloud-based products; (2) statements related to allegedly coercive sales practices; and (3) statements regarding the “technical adequacy or superiority of cloud products.”
The Court held that certain alleged misstatements were non-actionable statements of corporate optimism or were protected by the PSLRA's safe harbor provision for forward-looking statements accompanied by meaningful cautionary language. Specifically, the Court explained that statements that the company's cloud software had a “modern user interface,” was “easy to use,” and could provide “very high performance at a dramatically lower cost” were “subjective and unverifiable” and therefore were not actionable. Id. at 19-20. The Court also noted that statements such as “we think our customers are going to move very, very rapidly to the cloud” and “right now you certainly have a very large [cloud] business growing at a high rate” were non-actionable because they were “made in response to forward-looking questions” or were otherwise accompanied by meaningful cautionary language. Id. 21-22.
The Court then addressed plaintiffs' additional allegations, observing that plaintiffs had “dedicated significant investigative resources in the operative complaint.” Although the Court found many of plaintiffs' purported claims legally deficient, it concluded that, with respect to certain allegations, plaintiffs had adequately alleged “a narrow omission-based theory of fraud” which would be permitted to proceed and be reviewed on a more developed factual record. Id. at 23.
The Court rejected plaintiffs' argument, which they attempted to support with an expert opinion submitted to the Court, that the company's financial reporting violated GAAP because sales resulting from the alleged sales practices were “multiple element arrangements” for which the company was required to disclose the nature of the arrangements and “significant deliverables” within the arrangements. Id. at 23. The Court held this theory of liability was untenable given that the company's Form 10-K complied with the GAAP provision and explained the company's method of accounting for “multiple-element arrangements.” Id. at 26.
Plaintiffs also attempted to bolster allegations regarding the company's allegedly improper sales tactics by adding new allegations from confidential witnesses. The Court observed, however, that the company's “concededly accurate financial reporting and projections [were] a tough hurdle for [plaintiffs] to overcome,” id., and that while the new allegations were sufficient to “fortify allegations about [the company's] pervasive use of the Sales Practices,” plaintiffs still had not established that the company had an independent duty to disclose those practices. Id. at 30. Nor, determined the Court, had plaintiffs sufficiently shown the falsity of challenged statements regarding the quality of the company's cloud offerings. Id. at 33.
However, the Court determined that the company's alleged statements attributing material cloud revenue growth to the “quality and competitiveness of its cloud offering” were potentially misleading because they allegedly failed to disclose the impact of the alleged coercive sales practices on those results. Id. at 31. The Court also held that plaintiffs sufficiently alleged that the company omitted information about the alleged coercive sales practices when it attributed a decline in cloud revenue growth to customers waiting for the next generation of the company's cloud product. Id. at 34. Thus, the Court held that, at the pleadings stage, plaintiffs had sufficiently alleged a “narrow omission theory” based on the fact that the company made affirmative statements regarding the reasons for growth and deceleration in the company's cloud business. Id. at 35-36.
With respect to scienter, the Court held that plaintiffs' “overall fraud theory” was “plausible, cogent and compelling.” Id. at 38. While the Court took a holistic approach and considered alternative theories for alleged misstatements such as corporate optimism, the Court explained that it was plausible to believe both that defendants were optimistic about the eventual success of the cloud products while nevertheless attempting to buy time to facilitate the transition to the cloud by engaging in and concealing improper sales practices. Id.
Considering scienter allegations as to specific executives, the Court held that plaintiffs' confidential witness allegations cured prior deficiencies with respect to the company's co-CEOs, who, the Court determined, were plausibly alleged to have acted with “at least deliberate recklessness.” Id. at 39. While the Court's prior order found that plaintiffs established the CEOs had “approved large sales tied to [the alleged coercive] Sales Practices” but failed to establish when those approvals occurred or how those approvals showed the materiality of the sales practices, plaintiffs' new allegations were sufficient to show the timing of the approvals, the relative magnitude of the deals approved, and that the CEOs received regular briefings on the alleged sales practices before they made the challenged statements. Id. at 40. The Court also determined that scienter was adequately alleged as to the company's Senior Vice President of Investor Relations, who prior to the alleged misstatements acknowledged being aware of the sales practices and attempted to downplay them, and the Chief Technology Officer, who allegedly received a letter from industry participants detailing the alleged sales practices and allegedly “spent the large majority of [his] time on investor calls discussing the cloud.” Id. at 42-44.
The Court also addressed the “core operations” doctrine, which can permit knowledge of facts critical to a company's core operations to be attributed to certain individuals. While the Court's prior order rejected the theory due to a lack of detail as to the revenue generated by the alleged sales practices, the Court held that plaintiffs' new allegations cured that deficiency and sufficiently alleged that certain executives were involved in day-to-day decision-making regarding cloud products. Id. at 50-51. Thus, the Court explained that the core operations allegations, while insufficient alone to raise an inference of scienter, “add[ed] heft to the inference of scienter” for certain executives when considered as part of a holistic review of plaintiffs' allegations. Id.
The Court held, however, that scienter was not adequately alleged as to two other executives, as the allegations respecting those executives focused primarily on alleged product defects, not the challenged sales practices that were central to plaintiffs' claims. Id. at 53.
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