Securities Litigation Update: Federal Courts Allow Section 10(b) Claims Based On Non-Fraudulent "Channel Stuffing" And Hyped COVID-19 Vaccine Candidate

• Published date: 20 January 2022
• Subject Matter: Accounting and Audit, Corporate/Commercial Law, Criminal Law, Accounting Standards, Corporate and Company Law, Securities, White Collar Crime, Anti-Corruption & Fraud
• Law Firm: Cadwalader, Wickersham & Taft LLP
• Author: Mr Jason Halper, Ellen V. Holloman, Philip S. Khinda, Jonathan Watkins and Adam Magid

Federal courts closed out 2021 with a flurry of securities decisions in the month of December. In this update, we discuss two decisions involving claims under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 based on (i) alleged "channel stuffing"'a company's practice of shipping excessive product to its distributors, and recognizing revenue at the time of and on such shipments, when it believes the distributors will not be able to sell all such product in the particular period'and (ii) an allegedly over-hyped COVID-19 vaccine candidate.

In In re Hain Celestial Group, Inc. Securities Litigation,¹ the U.S. Court of Appeals for the Second Circuit revived Section 10(b) claims based on allegations that a company defrauded investors by making public statements attributing growing sales to strong consumer demand, without disclosing that it achieved its sales through "unsustainable" channel stuffing. The court below dismissed the claims, determining that the channel stuffing was legitimate and non-fraudulent. As the court explained, plaintiffs failed to plead that the company offered distributors an "absolute right" to return products; therefore, the company did not improperly book sales achieved through channel stuffing as revenue. According to the court, the company had no obligation to disclose legal sales incentives simply because plaintiffs alleged that they were unsustainable. The Second Circuit, however, reversed based on a perceived flaw in the district court's reasoning: its failure to consider whether, although there was no actionable allegation of channel stuffing in violation of Rule 10b-5(a) and (c), the company should have disclosed that its high sales volume was achieved in part through unsustainable channel stuffing to avoid rendering statements attributing its sales to strong consumer demand misleading in violation of Rule 10b-5(b). Hain is notable for its exposition of the subsections of Rule 10b-5, as well as the possibility that future plaintiffs may wield the decision to advocate for a broadened duty to disclose "unsustainable" business practices, contrary to prior Second Circuit precedent.

In In re Vaxart, Inc. Securities Litigation,² the U.S. District Court for the Northern District of California allowed Section 10(b) claims to survive a motion to dismiss based on allegations involving two press-release headlines'one about a company's purported selection for Operation Warp Speed; the other about a third party's ability to manufacture and distribute "a billion or more doses" of vaccine. Even though the text of the releases clarified the assertions, the Court concluded that, in light of the "presentation," a reasonable investor would have been misled into believing the company was on the precipice of developing a successful COVID-19 vaccine. The decision illustrates the liability risks that may arise from undue "emphasis" and "gloss" in public statements. Nonetheless, the Court arguably erred in brushing aside the significance of clarifying information and disclaimers contained in the text of the press releases.

I. In re Hain Celestial Group: Second Circuit Revives Section 10(b) Claims Based on Non-Fraudulent "Channel Stuffing"

A. Background

"Channel stuffing" generally refers to a company's practice of "flood[ing] distribution channels by employing incentives to induce customers into purchasing their products in large quantities, creating a short-term bump in revenue and excess supply in the distribution chain."³ Channel stuffing may involve efforts to move sales to an earlier quarter by offering distributors incentives, such as discounts or favorable credit terms, to take on extra inventory.⁴ The practice is not inherently fraudulent or illegal, because "a seller might have a realistic hope that stuffing the channel of distribution would incite his distributors to more vigorous efforts to sell the stuff lest it pile up in inventory."⁵ As some courts have recognized, channel stuffing is fraudulent only when used "to book revenues on the basis of goods shipped but not really sold because the buyer can return them."⁶ In that situation, the sales are effectively "sales on consignment," which accounting rules do not permit to be booked as revenue.⁷

Hain involved alleged channel stuffing at the Hain Celestial Group, Inc., a publicly traded company that manufactures and markets organic and natural products. In the mid-2010s, Hain was struggling to meet revenue targets and Wall Street projections due to increased competition. In response, Hain allegedly sought to ramp up quarterly sales by offering distributors discounts and financial incentives to take on more product, as well as an "absolute right" to return any unsold goods the following quarter. Hain ceased its practices of channel stuffing in mid-2016, after an audit identified it as a potential accounting issue. In August 2016, Hain announced it would be delaying release of its 2016 financial results and not meeting revenue targets, after which its share price fell by 26%. And in November 2016, the company announced that its audit committee had completed an internal review "into concessions with respect to certain distributors in the United States."⁸ Although the review "found no evidence of intentional wrongdoing in connection with [Hain's] financial statements," the company announced it had "begun to implement a remediation plan to strengthen its internal controls and organization."⁹

In the course of these events, Hain investors filed putative class actions alleging securities fraud, which were consolidated before the late Judge Arthur D. Spatt of the U.S. District Court for the Eastern District of New York. On August 4, 2017, lead plaintiffs filed a consolidated amended complaint asserting claims against Hain and its current and former executives under Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5. Among other things, plaintiffs alleged that defendants misled investors by failing to disclose that they were misclassifying inventory forced onto distributors as revenue, and their conduct constituted a "device, scheme, or artifice to defraud" and "act, practice, or course of business which operates . . . as a fraud or deceit" in violation of subsections (a) and (c) of Rule 10b-5. The defendants moved to dismiss. Evaluating the motion, the district court concluded that plaintiffs did not allege sufficient facts, with particularity, to support an inference that Hain offered its distributors an "absolute right" to return the products'a prerequisite for channel stuffing to constitute a fraud.¹⁰ Further, the court found that the value of the returns, if any, was "quite insignificant": Hain's 2016 10-K disclosed that any accounting errors were "immaterial." Therefore, this was not a situation where a material amount of sales were improperly...