On February 1, 2023, Judge Anthony J. Trenga of the United
States District Court for the Eastern District of Virginia
dismissed a putative securities fraud action against a
cybersecurity company (the "Company") and several of its
executives and directors alleging violations of Sections 10(b) and
20(a) of the Securities Exchange Act of 1934 and Section 11 of the
Securities Act. Firemen's Retirement System of St. Louis,
et al. v. Telos Corp., et al., No. 1:22-cv-00135 (E.D. Va.
Feb. 1, 2023). Plaintiffs alleged that defendants misled investors
about the status and prospects of key government contracts and
falsely certified to having reasonable financial controls. The
court dismissed the action without prejudice, holding that
plaintiffs failed to allege falsity or scienter.
The Company specializes in cybersecurity and provides, among other
products and services, a digital identity services platform to the
government, military, and Fortune 500 companies. Prior to
conducting an initial public offering in November 2020, the Company
announced that it had been selected for significant contracts with
the Transportation Services Administration ("TSA") to
provide support for TSA Precheck enrollment services and the
Centers for Medicare and Medicaid Services ("CMS"). A few
months after the IPO, in April 2021, the Company conducted a
secondary offering, during which offering the Company executives
were permitted to sell their personal shares to the Company.
In its registration statement filed with the IPO and its earnings
calls for the first and second quarters of 2021, the Company stated
that it expected to see substantial revenue growth attributed to
the TSA and CMS contracts and that they expected the TSA and CMS
contracts to be approved by the end of the second and third quarter
of 2021, respectively. Plaintiffs alleged that these statements
were misleading and false based on subsequent developments that
included the delay in the expected launch of the TSA and CMS
contracts and, after disclosing material weaknesses in its internal
controls and a delay in filing its 2021 10-K, an announcement in
March 2022 that the Company had uncovered mistakes in applying
Generally Accepted Account Principles ("GAAP") that had
led to errors in calculating the revenues attributable to the TSA
and CMS contracts, which plaintiffs claimed were overvalued by as
much as 175%.
The Court held that plaintiffs failed to plead falsity with respect
to any of the three categories of alleged misstatements. First, the
Court held that statements related to the Company's predictions
or expectations about its future revenue or future operational
growth, as well as statements related to when the Company expected
the TSA and CMS contracts to begin yielding revenue, were all
forward-looking statements that were "accompanied by
meaningful cautionary statements identifying important factors that
could cause actual results to differ materially."
Specifically, the Company disclosed risks that: (i) it was
"dependent on a few key customer contracts for a significant
portion of [its] future revenue," (ii) these services were
vulnerable to interruptions caused by the COVID-19 pandemic and
cyberattack threats, and (iii) the Company does "not control
the decision-making timeline within TSA." Second, the Court
held that plaintiffs did not adequately allege that the Company
chairman's certification regarding "reasonable financial
controls" was false because that certification was accompanied
by cautionary and qualifying language that the Company had made
"certain estimates and assumptions related to the adoption and
interpretation of [the relevant accounting] principles."
Third, the Court held that statements that the Company expected
"strong results" and hoped to "meet or exceed"
financial guidance and that the sale cycle will
"accelerate" were all non-actionable puffery.
The Court also held that plaintiffs failed to adequately plead that
defendants acted with actual knowledge of falsity or scienter.
First, the Court rejected plaintiffs' argument that the
Company's statement that it was "in near daily
communications with the TSA" or its alleged subsequent
admission that the Company failed to conduct an analysis of the
relevant accounting principles was sufficient to show knowledge and
stated that plaintiffs' allegations were "nothing more
than the fact of what happened—the events themselves,"
and "conclusory 'fraud by hindsight'
allegations." In a similar vein, the Court took note of the
fact that plaintiffs were not alleging that the Company was aware
of and failed to correct an accounting mistake. Second, the Court
held that stock sales by executives also did not establish
scienter. The Court noted that there was no other trading period
with which to compare sales to demonstrate that the trades were
abnormal, but also that one of the defendants also purchased shares
during the class period, another defendant sold his shares pursuant
to a Rule 10b-5 trading plan, and the percentage of shares sold by
the remaining individual defendants were far below the percentage
that the Fourth Circuit has found to be sufficient to infer
scienter.
The Court dismissed the Section 11, Section 20(a) and Section 15
claims on the same bases.
Firemen's Retirement System of St. Louis, et al. v. Telos Corp., et al.
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