Securities Regulation Daily Netshoes plaintiffs flunk pleading stage post-Cyan challenge
Tuesday, July 23, 2019

Netshoes plaintiffs flunk pleading stage post-Cyan challenge

By Mark S. Nelson, J.D.

Shareholders who sued Netshoes in state court alleging Securities Act claims will get another chance to make their case after a New York state court dismissed their Securities Act claims.

A New York state trial court dismissed strict liability and negligence claims brought under various sections of the Securities Act by shareholders who challenged an initial public offering by Brazilian company Netshoes (Cayman) Limited. The court, for a variety of reasons, dismissed the case without prejudice, thus granting the plaintiffs another chance to plead an actionable Securities Act violation (In Re Netshoes Securities Litigation, July 17, 2019, Borrok, A.).

Cyan decision applied. The court began by reciting the generalized history of securities claims starting with the Private Securities Litigation Reform Act (PSLRA), which imposed procedural requirements in federal court cases and the later Securities Litigation Uniform Standards Act (SLUSA), which sought to close loop holes discovered after enactment of the PSLRA.

The Supreme Court in Cyan held that SLUSA did not upset the long-standing concurrent federal and state court jurisdiction over Securities Act claims. Specifically, Cyan reiterated that state cases alleging only Securities Act claims may be brought in state court and they cannot be removed to federal court. (In other state court actions, the Class Action Fairness Act has provided an alternative route to federal court where plaintiffs alleged both Securities Act and state claims; CAFA has even ensnared one case that alleged only Securities Act claims but which had been consolidated with other removable cases).

The IPO. Netshoes went public in April 2017 and, at the time, was the first Brazilian company to do so in the U.S. since 2014. As recited by the court, the offering documents detailed a "high margin" business focused on Netshoes’ newer business-to-business distribution of supplements and vitamins and its core e-commerce business centered on sports and lifestyle products.

The plaintiffs alleged that Netshoes’ offering documents were materially false and misleading because they de-emphasized just how stressed the company’s core business was by supposedly offering discounts to customers that were not reflected in the company’s financials, which, in turn, would not have complied with IFRS. Netshoes’ stock went public at $18 per share but, within a year, had fallen to $2.87 per share.

Failure to state a claim. The court began its analysis by rejecting Netshoes’ assertion that a heightened pleading standard applied because the complaint, in actuality, alleged fraud. The court, by contrast, concluded that the complaint alleged strict liability and negligence only.

With respect to claims about Netshoes’ repeat business and exclusive distribution arrangements, the court found that the complaint failed to allege a violation because the company’s statements were mere puffery or statements of corporate optimism. Claims focused on Netshoes’ assertions about competitors also fell short because they were statements of opinion about information that was public at the time; the complaint had alleged that Netshoes had a Latin American competitor and that Amazon also was competitor (the court noted that Amazon did not enter the relevant market until after Netshoes’ IPO).

The court also rejected claims about Netshoes having an undisclosed customer discount program. Here, the court noted that Netshoes did not restate its financials, although it did increase an allowance for "doubtful accounts." Still, the company had to exercise accounting judgment and there could be no IFRS violation unless the plaintiffs could allege that Netshoes subjectively disbelieved its accounting judgments.

Netshoes had countered that its statements about future growth identified by the plaintiffs were protected by the PSLRA safe harbor for forward looking statements, but the court noted that Securities Act Section 27A(b)(2)(D) explicitly provides that the safe harbor is inapplicable to a statement made in connection with an IPO. Nevertheless, the court said the statements were protected "ample cautionary language" under the bespeaks caution doctrine. Moreover, the court found no actionable omissions because Netshoes either disclosed the information allegedly omitted or it had no duty to disclose the information.

Item 303. Item 303 of Regulation S-K requires companies to provide information about known trends or uncertainties in their SEC filings. The court found that regardless of whether the plaintiffs’ claims were evaluated qualitatively or quantitatively they failed to allege a violation of Item 303. Specifically, the court noted that Netshoes’ offering documents disclosed falling gross margins and net sales, and rising "credit risk" and allowance for "doubtful accounts." Claims based on Item 303 are generally difficult to plead, although the U.S. Supreme Court almost examined such claims last year, but that case eventually settled.

With respect to the remaining issues in the case, the court found no basis for the plaintiffs’ controlling person claims because there was no underlying securities law violation. The court also declined to address the question of whether the plaintiffs met the statute of limitations because, having found no viable claims, the question was moot.

The case is No. 157435/2018.

Attorneys: (Scott+Scott LLP) for 1199SEIU United Healthcare. (Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates) and (Sullivan & Cromwell) for Netshoes [Cayman] Ltd.

Companies: 1199SEIU United Healthcare; Netshoes [Cayman] Ltd

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