Western District Of Washington Dismisses Securities Fraud Claims Against Manufacturer Of Pop Culture Collectibles For Lack Of Falsity And Scienter

Shearman & Sterling LLP


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On May 16, 2024, Judge James L. Robart of the United States District Court for the Western District of Washington granted a motion to dismiss a putative securities...
United States Corporate/Commercial Law
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On May 16, 2024, Judge James L. Robart of the United States District Court for the Western District of Washington granted a motion to dismiss a putative securities class action against a manufacturer of pop culture collectibles (the "Company") and certain of its former executives (the "Individual Defendants"). Studen v. Funko, Inc., No. C23-0824JLR (W.D. Wash. May 16, 2024). The complaint alleged that the Company failed to disclose accurate information regarding the risks associated with its infrastructure projects and inventory in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the "Exchange Act"). Judge Robart dismissed the complaint, holding that plaintiffs did not adequately plead falsity or offer any particularized allegations showing that defendants knew that the risks could or did occur.

The Company designs, produces, and sells consumer pop culture products. The Company uses enterprise resource planning ("ERP") software to track inventory. In 2020, the Company announced that it would improve its ERP to a more sophisticated platform (the "ERP Project"), with a target completion in the second or third quarter of 2022. In addition, in late 2021, the Company entered into a lease for a new "state-of-the-art" distribution center to consolidate all of its warehouses that would operate on the new ERP. The ERP Project fell behind schedule, however, and was not ready for use when the new distribution center opened in April 2022. Plaintiffs alleged that the warehouse opening was premature and that large quantities of "dead" inventory—inventory that could not be sold because the relevant licensing agreement expired or because there was no demand—were sent en masse to the new distribution center with no system to organize, identify, or track items. Plaintiffs further alleged that this caused major disruptions, frequent system errors, and significant delays in order fulfillment. The Company's quarterly financial results in 2022 did not meet the projections made in March 2022, and, on March 1, 2023, the Company announced that it would abandon the ERP Project and take a $32.5 million write-down of associated costs and a $30 million to $36 million write-down in inventory. Plaintiffs alleged that defendants made false and misleading statements regarding the status of the ERP Project, warehouse, and inventory, as well as the Company's financial outlook, and that defendants knew the projects were nowhere near being completed on schedule and that excess inventory would have to be written down.

The Court held that plaintiffs failed to allege falsity with respect to any of the challenged statements, many of which were inactionable statements of opinion or puffery, and some of which were not false when read in context. Still others were statements that were included in the "Risk Factors" section of the Company's SEC filings in 2022, and the Court held that these were forward-looking statements, identified as such, and accompanied by meaningful cautionary language that fell within the PSLRA's safe harbor protection. The Court also rejected plaintiffs' arguments that defendants knew that the stated risks had already transpired or were substantially likely to occur at the time the risks were disclosed as possibilities.

First, plaintiffs challenged the Company's Risk Factor statements that: "Our success depends, in part, on our ability to successfully manage our inventories. . . . If demand or future sales do not reach forecasted levels, we could have excess inventory that we may need to hold for a long period of time, write down, sell at prices lower than expected or discard." Plaintiffs alleged that this was misleading because the risks had already materialized, claiming that "[e]ven a casual observer . . . could tell that the [distribution center] was over capacity and not able to operate with even close to the necessary productivity." Plaintiffs further alleged that the Company COO, who was not a defendant, visited the warehouse and "[u]ndoubtedly . . . reported back" what he saw to the Individual Defendants. The Court held that forward-looking statements are actionable based on claims that the risks already materialized only when a plaintiff sufficiently alleges that the defendant "knew that the risks had materialized." The Court further held that the complaint's allegations failed to "connect the dots" and that the complaint lacked particularized allegations plausibly showing that the Individual Defendants in fact knew that the specific warned of risks had materialized.

Second, plaintiffs challenged statements in the "Risk Factors" of the Company's 2022 Q1 and Q2 Form 10-Q's that: "If the potential upgrades are not successful or result in [further] delays, our business could be disrupted or harmed." (The word "further" appeared only in the Q2 Form 10-Q.) Again, the Court held that plaintiffs were required to plead that defendants knew this risk had already materialized but rejected plaintiffs' argument that the Individual Defendants must have known about the likely delay in the ERP Project at the time of the Q1 Form 10-Q because they attended Steering Committee leadership meetings and received status reports of "ongoing problems" that needed to be resolved prior to the ERP launch. The Court held such allegations were too vague and did not plausibly allege that the Individual Defendants received information about "the specific reasons that made the target launch date impossible or highly improbable." The Court also held that plaintiffs failed to allege that the statement in the Q2 Form 10-Q was false because the Company disclosed that it had decided to delay implementing the ERP software to 2023 on an earnings call held on the same day of that filing and referred to "further" delays in the Form 10-Q.

The Court further held that plaintiffs failed to allege scienter and rejected three main arguments advanced by plaintiffs. First, the Court declined to find scienter through the core operations doctrine, which permits courts to "infer[] that facts critical to a business's 'core operations' or an important transaction are known to a company's key officers." The Court held that allegations regarding the Individual Defendants' "hands-on management style, their interaction with other officers and employees, their attendance at meetings, and their receipt of unspecified weekly or monthly reports" were insufficient to allege scienter under this doctrine and that plaintiffs were required to set forth "detailed and specific allegations" showing how the Individual Defendants were "expos[ed] to factual information with the Company." Second, the Court declined to credit plaintiffs' confidential witness allegations because plaintiffs offered no details about the confidential witness's personal knowledge and because the confidential witness account pre-dated plaintiffs' putative class period. Even setting that aside, however, the Court held that the confidential witness accounts failed to establish scienter because they consisted of "vague allegations of internal disagreement and concern that establish, at most, a serious disconnect between [the Company's] C-Suite and its operations on the ground" and did not establish that the Individual Defendants personally knew of the extent of the alleged issues on the ground. Finally, the Court rejected plaintiffs' attempt to establish scienter by pointing to a prior securities fraud litigation related to the Company's write-down of excess dead inventory in 2019. Plaintiffs argued that the Company's involvement "in securities fraud litigation regarding some of the very same conduct as alleged . . . within six months of the start of the Class Period further supports a strong inference of scienter," but the Court was "not persuaded that separate litigation involving a different period and different, now-settled claims 'should have put the [defendants] on notice that the statements at issue here 'were misleading.'"

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