Take care when settling with the SEC: York County v. HP shows litigation risks may still arise, even years later

Companies often settle Securities and Exchange Commission (SEC) investigations on a neither-admit-nor-deny basis rather than contest the agency’s claims on the merits.  A recent decision from the United States Court of Appeals for the Ninth Circuit, York County ex rel. County Of York Retirement Fund v. HP, Inc., 65 F.4^th 459 (Apr. 11, 2023), highlights the potential risk of such settlements. 

Years after the events at issue, the SEC’s statements in its settled action with the company allowed private plaintiffs to file a securities fraud class action even though the SEC did not charge anyone with intentional fraud and there was no admission that the SEC’s allegations were correct.

The allegations against the company

The company defendant in HP sold printer supplies to “Tier 1” distributors, which in turn sold them to “Tier 2” distributors, which in turn sold them to other resellers or end users.  The company used a metric, Weeks of Supply (WOS), to measure how many weeks it could supply its products if sales continued at the same pace as prior weeks.  WOS ostensibly was the amount of inventory at the distributors divided by average weekly sales but included only inventory at Tier 1 distributors in the numerator.  The company made public statements as to whether its “channel inventory” was within or above its target WOS ranges but did not those targets or how it calculated WOS.

In September 2020, the SEC and the company settled a years-long investigation via a cease-and-desist order.  According to the later Ninth Circuit opinion, the SEC order alleged that in 2015 through 2016, sales managers engaged in “gray market” sales to Tier 1 distributors who sold outside their assigned territories, and “pulled in” sales that otherwise would have been made in later quarters, by offering steep price discounts.  The sales managers undertook these practices so that they could report WOS numbers in line with internal targets, even as the practices caused inventory to build up at Tier 2 distributors.  The practices also allowed the company “to reach quarterly sales targets to the detriment of overall profits.”  The SEC did not claim that the company’s financial statements had not been prepared in accordance with GAAP or that they contained any false numbers.

The SEC asserted that by not disclosing the sales practices and by excluding Tier 2 inventory from WOS, “disclosures about the company’s position relative to the channel inventory ceiling only told part of the story regarding HP’s channel health” and were “incomplete and misleading.”  The SEC, however, did not allege that anyone had knowingly or recklessly violated the antifraud provisions of the securities laws; the order claimed violations only required negligent conduct.  The company neither admitted nor denied the SEC’s claims, and the SEC acknowledged that its findings were not binding on any other person or entity in any other proceeding.  The company paid a $6 million civil penalty to the agency.

The private securities fraud class action and Ninth Circuit decision

The first private class action case asserting securities fraud claims under Exchange Act Section 10(b) and SEC Rule 10b-5 was filed approximately six weeks after the SEC order was announced (November 5, 2020).  The lead plaintiff filed a consolidated complaint on April 21, 2021.  The complaint challenged the company’s public statements between November 6, 2015 and June 2, 2016 based on the SEC’s allegations.

The district court dismissed solely on the basis of the statute of limitations, which requires that private 10b-5 actions be brought within “2 years after the discovery of the facts constituting the violation.”  The statements challenged by the plaintiffs related to practices and events that had occurred by 2016.  The court ruled that a reasonably diligent plaintiff would have discovered these operative facts of the complaint by that time, which was more than four years before both the first plaintiff and the lead plaintiff sued.

The Ninth Circuit reversed.  Under the Supreme Court’s 2010 decision in Merck & Co. v. Reynolds, the “facts constituting the violation” of 10b-5 include the fact that a defendant intended to deceive (i.e., scienter).  Following a Second Circuit case, the Ninth Circuit held that a reasonably diligent plaintiff has not discovered one of the facts constituting a 10b-5 violation until it can plead that fact with sufficient detail and particularity to survive a motion to dismiss.  Crucially, this analysis works retrospectively from the date that is two years prior to when the action is filed (the “critical date”), not prospectively from the date on which a reasonably diligent plaintiff would have known the facts (often called “inquiry notice”).

The Ninth Circuit then created a two-pronged standard for a defendant to prevail on the statute of limitations at the dismissal stage:  it must establish that a complaint “conclusively shows that either (1) the plaintiff could have pleaded an adequate complaint based on facts discovered prior to the critical date and failed to do so, or (2) the complaint does not include any facts needed to plead an adequate complaint that were discovered following the critical date.”

Applying this standard, the court held that plaintiff could not have discovered the facts necessary to plead an adequate claim with sufficient detail to survive a motion to dismiss until the SEC order became public.   Plaintiff claimed it did not have information to plead scienter until the SEC order put the company’s “prior statements in a new context, revealing that ostensibly innocuous statements were actually intentional misrepresentations.”  The court agreed that the SEC order disclosed information about the company’s supply channel health that contradicted its internal data.  According to the court, the disclosure of information which contradicts internal data creates a “strong inference” that the company “knowingly misled” the public.  The SEC’s discretionary decision not to charge any scienter-based claim did not “hurt” the plaintiff’s ability to plead the strong inference of scienter required for a private 10b-5 claim.

Implications

A threshold lesson from HP is that companies should try to forestall a viable securities fraud claim in the first place by avoiding what the SEC and the private plaintiff complained about.  If a company’s public statements refer to a proprietary or unfamiliar metric, it should consider disclosing how the metric is calculated if not also the actual data.  Several securities fraud cases filed after a company reported adverse metrics and its stock price declined have been dismissed for this reason, including by the Ninth Circuit.

The central lesson from HP, however, is that if the SEC is investigating a company’s statements or practices, there can be no assurance that an SEC settlement will not spur private litigation based on long-ago events, even if the company settles on the most favorable terms – with no admissions and no scienter-based claim.  Moreover, the company should not assume that the passage of time provides an easy way to dismiss a private securities case tagging on to an SEC settlement.   Indeed, HP shows that in some ways, the presence of statute of limitations issues can make matters worse.

The retrospective approach to the statute of limitations adopted by the Ninth Circuit in HP clarifies the law and helps parties brief the issue in future cases.  This approach, however, is inherently difficult for defendants to pursue.  Defendants usually move to dismiss a 10b-5 complaint on the grounds that it fails to plead a false or misleading statement and\or scienter.  If the plaintiff borrows allegations from a source of information that appears years after the public statements at issue (as in HP), the defendant will argue that the allegations do not contribute to falsity or scienter.   But if a defendant also wants to raise the statute of limitations, it must argue that the later-disclosed information came too late even if it is probative.  Statute of limitations is a fallback argument, not the lead. 

In HP, the statute of limitations became the lead argument, and that worked to the defendants’ detriment.  In the Ninth Circuit, a corporation can possess scienter only if its senior executives or other persons who make its public statements possess scienter.   Judging by the opinion, however, the SEC did not allege any specific facts indicating that senior officers knew of the alleged sales practices or how they contradicted the company’s public statements – the usual allegations of which scienter is made.  To the contrary, according to the opinion, sales managers, not senior executives, allegedly undertook the questioned sales practices to achieve their internal targets, not to inflate the stock price.  It is not evident why the senior executives would have known about the effect of the sales managers’ practices.  Nor is it evident why the senior executives would have known that what the company disclosed about WOS was false or recklessly disregarded that possibility, as is required for scienter.  The company sold only to Tier 1 distributors, and there is no reason set forth in the opinion why it would have known the amount of inventory held by Tier 2 distributors. A WOS metric based only on Tier 1 distributors aligned with the information known to the company and how the company managed inventory targets internally.

The SEC order buttresses these points.  See In the Matter of HP Inc., File No. 3-20112 (Sept. 30, 2020).  The SEC found that “certain regional managers” in one business unit gave incentives to “pull in” sales “that they otherwise expected to materialize in later quarters.”  Internal presentations defined the pull-ins as “pay[ing] the channel to take additional shipments within a given quarter,” but the order did not allege anything else about the presentations.  The company “had no continuing obligations following the sale to the Tier 1 partner” and “did not receive channel inventory data from all of its Tier 2 channel partners,” which meant that it “only estimated its Tier 2 channel inventory following the end of quarters using incomplete data.”  As to the gray marketing, the SEC found sales managers in one region (Asia Pacific and Japan) sold supplies to distributors known to sell outside their territories, managers in certain countries granted additional discounts to local distributors, and regional sales managers sold supplies to Tier 1 distributors who sold them to Tier 2 distributors immediately. 

The SEC did not allege that any of this information made its way to senior management.  To the contrary, it alleged that the company “lacked sufficient disclosure controls and procedures to ensure that the use of pull-ins and [gray marketing] to meet quarterly sales targets, and their negative impact on margin and potential impact on future quarters, was provided to the HP executives responsible for the company’s disclosures in a timely manner….”  The “principal financial officers and principal executive officers who were responsible for the company’s disclosures learned of the conduct” only “quarters after the actual conduct had taken place.”

Despite these factors, the Ninth Circuit made statements that the complaint included facts supporting a strong inference of scienter as to the company in the context of ruling on the statute of limitations.  Moreover, while the court acknowledged that “other information in the SEC Order could suggest that HP executives lacked scienter,” it claimed those facts were “irrelevant at this stage, where we must accept [lead plaintiff’s] allegation as true.”  In effect, the court applied the point that falsity and scienter are often drawn from the same set of facts, pointed to the allegations about the sales managers, and called it a day.  Its truncated analysis of scienter for the statute of limitations purposes was far short of what courts undertake when considering scienter as a standalone ground for dismissal. 

It will remain to be seen how far the ruling will affect a scienter analysis on remand.  To be sure, the Ninth Circuit cited Tellabs for the proposition that “[t]he inference that the defendant acted with scienter need not be irrefutable … or even the most plausible of competing inferences.”  However, the court’s conclusion (set forth in the paragraph immediately following this statement) was only that the company had failed to show that lead plaintiff discovered the facts constituting its claims more than two years before filing its complaint.  The court explicitly declined to rule on the adequacy of lead plaintiff’s complaint, where defendants had challenged whether it pleaded the elements of a 10b-5 claim. 

As to the element of scienter, there is substantial case law holding that the alleged withholding of adverse information from senior management weighs against inferring scienter and must be considered at the pleading stage under Tellabs.  Some or all the defendants will be able to invoke this principle if the SEC order upon which lead plaintiff and the Ninth Circuit relied for statute of limitations purposes is considered in its whole.

Conclusion

HP does not mean that a company never should settle with the SEC.  What it does mean, however, is the company should assume that any allegation the SEC includes in a settlement decree will be used against it by private plaintiffs, even if there is no scienter-based claim or admission.

If a private lawsuit does ensue, HP counsels caution in asserting the statute of limitations on a motion to dismiss.  It is difficult to “conclusively” show any fact-based argument on the limited record available at that stage.  HP also suggests that defendants should challenge the notion that a private plaintiff may rely on allegations from an SEC decree or complaint.  The Ninth Circuit mentioned this point in a brief footnote, but there is substantial case law holding that a litigant must make an independent investigation of the allegations of a separate complaint before alleging those facts in its own complaint.  Finally, defendants should resist any notion that the mere opinion of someone – even the SEC – that a public statement is false or misleading is a fact a court must accept on a motion to dismiss.

Learn more about the implications of this decision by contacting any of the authors or your DLA Piper relationship attorney.