Newett v. Leapfrog Enterprises, Inc. et al

Filing 117

ORDER by Judge Edward M. Chen Granting in Part and Denying in Part 100 Defendants' Motion to Dismiss. Case Management Conference set for 4/6/2017 09:30 AM. Joint Case Management Conference Statement due 3/30/2017. (emcsec, COURT STAFF) (Filed on 2/24/2017)

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UNITED STATES DISTRICT COURT

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NORTHERN DISTRICT OF CALIFORNIA

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IN RE LEAPFROG ENTERPRISE, INC.
SECURITIES LITIGATION,
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This Document Relates to:

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All Actions.

ORDER GRANTING IN PART AND
DENYING IN PART DEFENDANTS’
MOTION TO DISMISS
Docket No. 100

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For the Northern District of California

United States District Court

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Case No. 15-cv-00347-EMC

Plaintiffs have filed a securities class action against Defendant Leapfrog Enterprises, Inc.

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(“LF”) and two of its executive officers, John Barbour (CEO) and Raymond L. Arthur. Since

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appointment of lead plaintiff and lead counsel, and their filing of a consolidated class action

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complaint, Defendants have repeatedly challenged the sufficiency of Plaintiffs‟ pleadings. This

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Court previously dismissed the original consolidated class action complaint as well as the first

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amended complaint. See Docket No. 63 (minutes); Docket No. 88 (order). The current operative

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complaint is the second amended consolidated class action complaint (“SAC”). In that pleading,

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Plaintiffs allege that Defendants violated federal securities law, including § 10(b) and related Rule

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10b-5, because they falsely represented that accounting write-offs did not need to be taken when,

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in fact, they did as required by generally accepted accounting principles (“GAAP”). Currently

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pending before the Court is Defendants‟ motion to dismiss the SAC pursuant to Federal Rule of

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Civil Procedure 12(b)(6).
Having considered the parties briefs, as well as their accompanying submissions where

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appropriate,1 the Court hereby GRANTS in part and DENIES in part Defendants‟ motion.

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Defendants have asked the Court to take judicial notice of various documents and KBC has
objected to most of the requests. The Court addresses only those objections that are pertinent to

I.

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FACTUAL & PROCEDURAL BACKGROUND

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In their complaint, Plaintiffs allege as follows.

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LF “is a developer of educational entertainment for children.” SAC ¶ 32. It “has

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developed a number of learning platforms, including the LeapPad learning tablets.” SAC ¶ 32.

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Mr. Barbour was, during the relevant period, LF‟s CEO, and Mr. Arthur was LF‟s CFO. See SAC

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¶¶ 29-30.
For the relevant period, LF‟s fiscal years started in April and ended in March. Thus, for

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fiscal year 2015:
F1Q15 lasted from April 1, 2014, to June 30, 2014;

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F2Q15 lasted from July 1, 2014, to September 30, 2014;

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F3Q15 lasted from October 1, 2014, to December 1, 2014; and

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

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

F4Q15 lasted from January 1, 2015, to March 31, 2015.

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See SAC at 1 n.2. Prior to F1Q15, LF‟s “quarters aligned more closely to the calendar year, with

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1Q ending March 31, 2Q ending June 30, 3Q ending September 30 and 4Q ending December 31.”

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SAC at 1 n.2.
At the end of the 2013 fiscal year, LF had disappointing results, due at least in part to the

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poor sales of the LeapPad tablet. See SAC ¶ 35 (noting that LF was “facing aggressive

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competition in the tablet market from other manufacturers, which forced LeapFrog to cut the price

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of its LeapPad offerings and disappointing 2013 and F4Q13 results”). LF issued what analysts

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considered weak guidance for fiscal year 2014, based in part on a carryover inventory problem

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with the LeapPad product.2 See SAC ¶¶ 37, 40 (stating that, in a press release, Defendants

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“discussed their expectations that LeapPad inventory build, due to poor sales and difficult retail

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conditions, would reduce expectations for net sales throughout 2014”; also stating that, “[a]s a

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result of LeapFrog‟s poor 2013 performance, the Company faced a substantial retail inventory

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resolution of the motion.
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Carryover inventory is a problem because “„[t]he longer [a] product sits in back rooms and on
shelf, the less willing retailers will be to bring in new product, both for space and risk reasons, and
the more they are likely to want in sales allowances.‟” SAC ¶ 116 (quoting analysts at BMO
Capital Markets).
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hangover of LeapPad tablets from 2013 that management knew would impact both margins and

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sales heading into 2014”). “To generate sales in 2014, . . . Defendants sought to move up the

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release of what they described as a „major‟ new product, LeapTV, to a calendar 2014 release.”

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SAC ¶ 40.
Problems, however, persisted in 2014, with LF‟s “results continu[ing] to be affected by a

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informed “investors that LeapTV would not ship until September 2014, with [the product] „hitting

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stores in October.‟ Defendants acknowledged that this would restrict LeapTV sales during the

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quarter ending December 31, 2014 [i.e., F3Q15].” SAC ¶ 44. This is because the “anticipated

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September 2014 shipment date would result in LeapTV hitting shelves at least two months later

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than most competing holiday items.” SAC ¶ 44 (noting that “major retailers like Wal-Mart

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For the Northern District of California

„tough‟ retail market and LeapPad carryover inventory.” SAC ¶ 42. In June 2014, Defendants

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typically put holiday items on their shelves in August and that to do so, the retailers would have to

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receive items at their distribution centers by the end of July”).
F1Q15 (i.e., April through June 2014) continued the downward trend, and, in August 2014,

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LF reduced its fiscal year 2015 guidance. See SAC ¶¶ 45-46, 51. Thus, according to Plaintiffs,

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prior to the end of F2Q15 (i.e., September 30, 2014), Defendants knew that LF

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faced serious problems as a company and . . . even Defendants‟ own
future expectations for the Company were tempered by these
problems, including: (i) the late shipment of LeapTV and limitations
in the ability to sell the product given the late shipment; (ii)
indefinite deferral of its consumer electronics tablet; (iii) carryover
inventory; and (iv) the cannibalizing LeapPad sales and profits.

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SAC ¶ 52.
The gist of the SAC is that, subsequently, Defendants made false statements about LF‟s

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F2Q15 financial results and its F3Q15 financial results – more specifically, those results were

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based on accounting that violated GAAP provisions relating to goodwill and long-lived assets.

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A.

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2Q: No Write-Off for Goodwill Impairment
According to Plaintiffs, Defendants falsely stated that no goodwill impairment testing was

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necessary after the end of F2Q15, when in fact such testing was not only necessary and but also

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such testing would have led to a 100% writedown for goodwill impairment for 2Q.
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“Goodwill represents the excess of the purchase price over the fair value of the net assets

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acquired in a business combination.” SAC ¶ 71. Under GAAP, goodwill “„[i]mpairment is the

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condition that exists when the carrying amount [or book value] of goodwill exceeds its implied

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fair value.‟” SAC ¶ 73.

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Under GAAP, there is a two-step test for goodwill impairment. See SAC ¶ 74. However,

such testing is needed in the first place. That “qualitative assessment” is referred to as “step zero.”

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SAC ¶ 74. “Step zero . . . requires impairment testing for any quarter when certain triggering

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events are present „that would more likely than not reduce the fair value of a reporting unit below

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its carrying amount.‟” SAC ¶ 75. Examples of triggering events include (but are not limited to) a

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negative or declining overall financial performance, a sustained decrease in share price, an

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For the Northern District of California

before a company must engage in that two-step test, it first makes an assessment as to whether

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increased competitive environment, and a change in the market for an entity‟s products or

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services. See SAC ¶ 75.

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According to Plaintiffs, for 2Q (the quarter ending September 30, 2014), there were

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various triggering circumstances that “indicated . . . it was objectively and overwhelmingly more

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likely than not [that] LeapFrog‟s goodwill was impaired,” SAC ¶ 68, such that Defendants should

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have tested for goodwill impairment. Plaintiffs point to, e.g.:

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a decline in overall financial performance, see, e.g., SAC ¶ 80 (alleging that, “[f]or

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five consecutive quarters, from F2Q14 through F2Q15, [LF] reported weak

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financial results or substantially lowered guidance”);

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increased competition and a change in the market for LF‟s products, see, e.g., SAC

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¶ 83 (referring to “a tough retail environment and competition,” including but not

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limited to the carryover inventory problem); and

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a sustained decrease in share price (and corresponding decline in market

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capitalization). See, e.g., SAC ¶ 92 (alleging that LF‟s “stock price decline lasted

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57 days of the [F2Q15] quarter – 62% of F2Q15”).

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Plaintiffs assert that, even though it was obvious that goodwill impairment testing was
necessary (step zero), Defendants falsely claimed, in November 2014 (i.e., shortly after 2Q
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ended), that such testing was not necessary. Most notably, in its 10-Q for 2Q (filed in November

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2014), LF stated:

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As of September 30, 2014 [i.e., the end of 2Q], based on its
assessment of various qualitative factors and projection of future
operating results, the Company does not believe that sufficient
indicators of impairment of its goodwill currently exist that would
require performing step one of the two-step test for goodwill
impairment.

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Defs.‟ RJN, Ex. 16, at 9 (LF‟s 10-Q for 2Q).
Plaintiffs further assert that, if Defendants had conducted goodwill impairment testing for

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2Q (as they should have), then they would have determined that goodwill was in fact impaired

overstated LF‟s financial results for 2Q by not making the necessary deduction for goodwill

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under the GAAP two-step test for impairment. Thus, according to Plaintiffs, Defendants falsely

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impairment.
Plaintiffs admit that, in the next quarter, Q3, Defendants ultimately did make a goodwill

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impairment adjustment – a write-off of approximately $19.5 million (100% of its value). But,

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according to Plaintiffs, this was one quarter too late.

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B.

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3Q: No Write-Off for Long-Lived Asset Impairment
According to Plaintiffs, Defendants also falsely represented that LF‟s long-lived assets

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were not impaired as of F3Q15. See SAC ¶ 158 (alleging that LF‟s “long-lived assets consisted of

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property and equipment, capitalized content costs, and other intangible assets that the Company

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expected to retain for at least a year to generate cash flows”).

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Similar to above, under GAAP, there is a two-step test for impairment to a long-lived

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asset, but, before a company engages in that test, it must first determine (step zero) that such

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testing is necessary. See SAC ¶ 158. At step zero, a long-lived asset is to be tested for impairment

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“„whenever events or changes in circumstances indicate that [the] carrying amount [i.e., book

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value] may not be recoverable.‟” SAC ¶ 158. Events or changes in circumstances indicating

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long-lived asset impairment include: a significant decrease in the market price of a long-lived

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asset; a significant adverse change in the extent or manner in which a long-lived asset is being

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used or in its physical condition; a significant adverse change in legal factors or in the business
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climate that could affect the value of a long-lived asset; and a current-period operating or cash

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flow loss combined with a history of operating or cash flow losses or a projection or forecast that

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demonstrates continuing losses associated with the use of a long-lived asset. See SAC ¶ 159.

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In the instant case, there is no dispute that, for 3Q (ending on December 31, 2014),

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Defendants did conclude that testing for long-lived asset impairment was necessary and did

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conduct such testing. See RJN, Ex. 19, at 9 (LF‟s 10-Q for 3Q) (stating that “the Company

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determined that testing for recoverability of its long-lived assets . . . was required”). In the 10-Q

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for 3Q, Defendants indicated that testing was necessary based on “the Company‟s performance

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during the 2014 holiday season being significantly lower than anticipated,” “the underperformance

trading values of the Company‟s stock and corresponding decline in the Company‟s market

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of products and product lines newly introduced to the market,” and “the continuing decrease in

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capitalization.” Id.

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At step one, however, Defendants went on to find that there was no long-lived asset

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impairment. At step, “one must determine whether the carrying amount of a long-lived asset (or

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asset group) exceeds the sum of the undiscounted cash flows expected to result from the use and

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the eventual disposition of the asset.” SAC ¶ 160. According to Defendants, “its long-lived assets

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were not impaired as of December 31, 2014 [i.e., the end of 3Q]” because “their carrying value did

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not exceed the cumulative undiscounted future cash flows.” Id. (adding that “[t]he principal

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assumptions used in the Company‟s undiscounted cash flow analyses consisted of projections of

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future net cash flows”).

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According to Plaintiffs, Defendants falsely represented that its long-lived assets were not

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impaired as of 3Q. Plaintiffs admit (similar to above) that Defendants ultimately did make an

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adjustment for long-lived asset impairment in the following quarter, i.e., 4Q – more specifically a

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write-down of $36.5 million which constituted 96% of the value of the long-lived assets. But

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Plaintiffs maintain (similar to above) that this adjustment was one quarter too late. Plaintiffs note

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that, when Defendants did find impairment at 4Q, they indicated that this was “primarily due to

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the significant decline of the trading value of the Company‟s Class A common stock and the

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corresponding market capitalization.” Defs.‟ RJN, Ex. 22, at 58-59 (LF‟s 10-K for fiscal year
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2015) (note 9). But, according to Plaintiffs, there already was a significant decline in LF‟s stock

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value as of 3Q – or at least, there was a significant decline by January 23, 2015, when LF‟s stock

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was worth only $2.55, compared to $4.72 at the end of December 31, 2014.3 See SAC ¶ 175; see

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also SAC ¶ 16 (alleging that the average stock price from January 23, 2015, through the end of

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4Q, i.e., March 31, 2015, was $2.44). Thus, according to Plaintiffs, the long-lived asset

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impairment write-off of $36.5 million (96% of its value), which was taken in 4Q, should have

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been taken in 3Q. See SAC ¶ 170 (alleging that “the „weak financial results‟ that necessitated the

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impairment charge of $36.5 million or 96% of the Company‟s long-lived assets [in 4Q] had

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already occurred as of December 31, 2014 [i.e., 3Q]”) (emphasis in original).
II.

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A.

Legal Standard
As the Court has before it a 12(b)(6) motion to dismiss, the Twombly/Iqbal standard is

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DISCUSSION

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applicable. That is, the Court must evaluate the SAC for plausibility. See Ashcroft v. Iqbal, 556

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U.S. 662, 678 (2009) (stating that, “[t]o survive a motion to dismiss, a complaint must contain

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sufficient factual matter, accepted as true, to „state a claim to relief that is plausible on its face‟”)

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(quoting Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)).

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A claim has facial plausibility when the plaintiff pleads factual
content that allows the court to draw the reasonable inference that
the defendant is liable for the misconduct alleged. The plausibility
standard is not akin to a “probability requirement,” but it asks for
more than a sheer possibility that a defendant has acted unlawfully.
Where a complaint pleads facts that are “merely consistent with” a
defendant‟s liability, it “stops short of the line between possibility
and plausibility of „entitlement to relief.‟“

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Iqbal, 556 U.S. at 678 (quoting Twombly, 550 U.S. at 556-57).
However, because Plaintiffs‟ claims are predicated on securities fraud, more than just the

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Twombly/Iqbal standard must be met. More demanding requirements must be satisfied, as

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codified in Federal Rule of Civil Procedure 9(b) and the Private Securities Litigation Reform Act

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Although January 23, 2015, technically falls within 4Q, Plaintiffs point out that LF‟s 10-Q for
3Q was not filed with the SEC until after that date (i.e., on February 9, 2015), and, under GAAP,
Defendants were required to take into account “„subsequent events that provide[d] additional
evidence about conditions that existed [at the end of 3Q, i.e., December 31, 2014].‟” SAC ¶ 178.
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(“PSLRA”).
Under Rule 9(b), “[i]n alleging fraud . . . , a party must state with particularity the

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circumstances constituting fraud.” Fed. R. Civ. P. 9(b); see also Cafasso v. Gen. Dynamics C4

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Sys., 637 F.3d 1047, 1055 (9th Cir. 2011) (stating that “[t]o satisfy Rule 9(b), a pleading must

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identify „the who, what, when, where, and how of the misconduct charged,‟ as well as „what is

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false or misleading about [the purportedly fraudulent] statement, and why it is false‟”).

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The PSLRA has a similar requirement. See Janas v. McCracken (in Re Silicon Graphics

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Sec. Litig.), 183 F.3d 970, 996 (9th Cir. 1999) (noting that, under the PSLRA, “a securities fraud

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complaint shall identify: (1) each statement alleged to have been misleading; (2) the reason or
reasons why the statement is misleading; and (3) all facts on which that belief is formed”; citing

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15 U.S.C. § 78u-4(b)(1)).

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Moreover, the PSLRA has an additional requirement – i.e., that a securities fraud plaintiff

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must “state with particularity facts giving rise to a strong inference that the defendant acted with

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the required state of mind.” 15 U.S.C. § 78u-4(b)(2)(A). For a § 10/Rule 10b-5 claim, “a private

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securities plaintiff proceeding under the PSLRA must plead, in great detail, facts that constitute

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strong circumstantial evidence of deliberately reckless or conscious misconduct.” Silicon

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Graphics, 183 F.3d at 974. “Deliberate recklessness means that the reckless conduct „reflects

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some degree of intentional or conscious misconduct.‟” Reese v. Malone, 747 F.3d 557, 569 (9th

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Cir. 2014). For example, “„[a]n actor is [deliberately] reckless if he had reasonable grounds to

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believe material facts existed that were misstated or omitted, but nonetheless failed to obtain and

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disclose such facts although he could have done so without extraordinary effort.‟” Id.

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To qualify as a “strong inference,” the Supreme Court has held, “an
inference of scienter must be more than merely plausible or
reasonable.” Tellabs, 551 U.S. at 314. When determining whether
there are sufficient allegations of scienter, courts “must consider the
complaint in its entirety . . . [and inquire] whether all of the facts
alleged, taken collectively, give rise to a strong inference of scienter,
not whether any individual allegation, scrutinized in isolation, meets
that standard.” Id. at 322-23. Moreover, courts must take into
account plausible opposing inferences. Id. at 323. A complaint will
survive a motion to dismiss “only if a reasonable person would
deem the inference of scienter cogent and at least as compelling as
any opposing inference one could draw from the facts alleged.” Id.
at 324.
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In re Rigel Pharms., Inc. Secs. Litig., 697 F.3d 869, 882-83 (9th Cir. 2012).

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B.

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2Q: No Write-Off for Goodwill Impairment
Defendants argue that Plaintiffs‟ claims based on the failure to take the goodwill

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impairment in 2Q must be dismissed because (1) Plaintiffs have failed to adequately allege

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scienter and (2) Plaintiffs have failed to adequately allege falsity. As discussed below, the Court

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agrees that allegations on scienter are lacking.

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Plaintiffs contend that they have sufficiently pled scienter largely based on two reasons: (1)

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because the impairment to goodwill was obvious in 2Q, see In re Cardinal Health, Inc. Sec.

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Litigs., 426 F. Supp. 2d 688, 719-20 (S.D. Ohio 2006) (noting that an “inference of knowledge or

and pervasive in nature, and so great in magnitude, that they should have been obvious to a

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recklessness may be drawn from allegations of accounting violations that are so „simple, basic,

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defendant‟”); and (2) because, effectively “overnight” (i.e., from 2Q to 3Q), Defendants wrote off

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100% of goodwill, which amounted to a sizeable $19.5 million. See Dudley v. Haub, No. 2-11-cv-

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05196 (WJM), 2013 U.S. Dist. LEXIS 61386, at *30-31 (D.N.J. Apr. 30, 2013) (noting that “the

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magnitude of the impairment suggests that it should have been recorded earlier[;] [g]oodwill does

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not go from being unimpaired to fully impaired overnight”). Neither argument is convincing,

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particularly in light of Plaintiffs‟ obligation to state with particularity facts giving rise to a strong

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inference of scienter.

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As an initial matter, even if it were obvious that LF had suffered a decline in overall

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financial performance, that there was increased competition and a change in the market for LF‟s

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products, and that there had been a sustained decrease in LF‟s share price – i.e., that certain

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“triggering events” existed – that does not mean that it was obvious that those triggering events

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“„would more likely than not reduce the fair value of a reporting unit below its carrying amount.‟”

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SAC ¶ 75 (emphasis added). This is especially true given that, by the end of 2Q (September 30,

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2014), the holiday season was still upcoming. It is undisputed that the holiday season is a highly

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significant period for LF, a time where a major portion of its annual sales are made. Plaintiffs

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admit as much in their complaint. See, e.g., SAC ¶ 81 (chart reflecting largest sales for the quarter

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ending on December 31). Given that circumstance, even with the triggering events alleged by
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Plaintiffs, it may not have been obvious that goodwill impairment testing was warranted as the end

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of F2Q15 – prior to the big holiday season. See City of Dearborn Heights Act 345 Police & Fire

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Ret. Sys. v. Align Tech., Inc., No. 12-cv-06039-WHO, 2013 U.S. Dist. LEXIS 172841, at *26, 32

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(N.D. Cal. Dec. 9, 2013) (taking into account that “a goodwill evaluation is based on several

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factors present at the time the assessment is made „which are not matters of objective fact‟”;

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adding that “„[a] plaintiff arguing for a quicker write down of goodwill would have to explain

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how, in a given quarter, the company‟s optimism about that market was not just wrong . . . but so

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wholly unfounded that it was fraudulent‟”); City of Omaha v. CBS Corp., No. 08 Civ. 10816

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(PKC), 2010 U.S. Dist. LEXIS 25497, at *30 (S.D.N.Y. Mar. 16, 2010) (noting that “SFAS 142 –

not‟ that that a reporting unit‟s fair value had fallen below its carrying amount, based on, among

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upon which plaintiffs base their fraud theory – requires testing only once it is „more likely than

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other things, adverse changes in market conditions[;] [t]his formulation necessarily involves

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judgment and discretion on the part of a company in deciding whether to undertake an intra-year

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impairment test”), affirmed on appeal in 679 F.3d 64 (2d Cir. 2012); In re Radian Sec. Litig., 612

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F. Supp. 2d 594, 615 (E.D. Pa. 2009) (noting that, “[e]ven if an impairment of [the company‟s]

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investment did occur at some point earlier than [the company] ultimately stated, the plaintiffs do

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not allege facts to show that [the company‟s] decision not to report whatever impairment may

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have existed until July 2007 involved not merely simple, or even inexcusable negligence, but an

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extreme departure from the range of reasonable business treatments permitted under GAAP”); see

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also SEC v. Todd, 642 F.3d 1207, 1216 (9th Cir. 2011) (“recogniz[ing] that GAAP „tolerate[s] a

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range of “reasonable” [accounting] treatments, leaving the choice among alternatives to

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management‟”).

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In fact, in LF‟s 10-Q for 2Q, Defendants expressly pointed to the upcoming holiday season

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in addressing why it was not testing for goodwill impairment at that point in time. See Defs.‟

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RJN, Ex. 16, at 9 (LF‟s 10-Q, filed in November 2014, covering F2Q15) (stating there were

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insufficient indicators to do goodwill impairment testing; noting that “[i]ndicators of impairment

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considered by the Company include . . . overall financial operating results which depend in large

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part on the strength of the Company’s performance during the holiday season”) (emphasis added).
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during the holiday season are weaker than anticipated, the Company may be required to perform

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step one of the two-step test for goodwill impairment.” Id. The fact that Defendants disclosed this

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information to the public and expressly warned of the consequences of a poor holiday season

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further weighs against an inference of scienter. See Iron Workers Local No. 25 Pension Fund v.

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Oshkosh Corp., No. 08-C-797, 2010 U.S. Dist. LEXIS 30693, at *63 (E.D. Wis. Mar. 30, 2010)

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(explaining that, if the defendants intended to defraud, they would likely have used stronger

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language – not just express cautious optimism; defendants would not “have repeatedly warned

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about the possibility of an impairment charge” – defendants “teed up the issue and flagged the

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question of an impairment so that investors could make their own judgments”); see also In re

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NVIDIA Corp. Sec. Litig., 768 F.3d 1046, 1065 (9th Cir. 2014) (finding no strong inference of

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Moreover, in the 10-Q, Defendants went on to warn that, “[t]o the extent the Company‟s results

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scienter based on, inter alia, company‟s warning to investors of possible product flaws and

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“set[ting] aside a reserve to account for costs related to those flaws”). As it turns out, the fact that

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the holiday season was not the boon anticipated by Defendants provides an explanation was to

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why there was the “overnight” decision to do goodwill impairment testing for 3Q and to find a

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sizeable impairment.
Finally, strongly weighing against scienter is the fact that “[Mr.] Barbour and [Mr.] Arthur

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each purchased [LF] stock within days after the challenged November [2014] disclosures

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[regarding goodwill], adding to their significant holdings.” Mot. at 5 (citing Foster Decl. ¶ 26 &

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Exs. 28-29).4 Plaintiffs have objected to judicial notice of the individual defendants‟ stock

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purchases, see Docket No. 106 (Obj. at 3) (arguing that the documents are not relevant), but, in a

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different case, the Court rejected a similar objection.5 See Westley v. Oclaro, Inc., 897 F. Supp. 2d

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See, e.g., Defs.‟ RJN, Ex. 28, at 11 (Mr. Barbour‟s Form 4 regarding November 5, 2014,
transaction) (indicating that Mr. Barbour acquired 20,000 shares of common stock on that date);
RJN, Ex. 28, at 12 (Mr. Barbour‟s Form 4 regarding November 7, 2014, transaction) (indicating
that Mr. Barbour acquired 3,125 shares of common stock on that date); Defs.‟ RJN, Ex. 29, at 7
(Mr. Arthur‟s Form 4 regarding November 10, 2014, transaction) (indicating that Mr. Arthur
acquired 21,000 shares of common stock on that date).
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Plaintiffs argue that, if the Court does take judicial notice of the acquisition of stock, it should
also take judicial notice of an article that criticizes LF management for not buying or holding
stock. See Pls.‟ RJN at 2 (quoting article as stating: “„If they believed in the long run success of
11

1

902, 929 (N.D. Cal. 2012) (noting “obligat[ion] to take a „holistic approach‟ in evaluating

2

scienter” and stating that, as “the Court may take judicial notice of the individual defendants‟

3

Oclaro stock sales (as reflected in the SEC Forms 4 which are public records), the presence or

4

absence of insider trading is a fact that could be considered by the Court as a part of its holistic

5

approach”); cf. In re Rigel Pharms., Inc. Secs. Litig., 697 F.3d 869, 884-85 (9th Cir. 2012) (noting

6

that “the individuals‟ conduct concerning their stock is inconsistent with Plaintiff‟s theory that

7

financial motive establishes scienter here[;] [t]he complaint alleges that individual defendants

8

knew that the value of their stock options would increase if Rigel reported positive results from

9

the clinical trial” but, “because none of the defendants sold stock during the period between the

the period during which they would have benefitted from any allegedly fraudulent statements, the

12
For the Northern District of California

allegedly fraudulent statements and the subsequent public disclosure of the detailed data, which is

11

United States District Court

10

value of the stock and stock options does not support an inference of scienter”). Plaintiffs do not

13

dispute that these stock purchases were in fact made.
Taking into account the above, the Court concludes that, as to Defendants‟ failure to take a

14
15

write-off for goodwill impairment in 2Q, Plaintiffs have failed to plead facts supporting a strong

16

inference of scienter.

17

C.

18

3Q: No Write-Off for Long-Lived Asset Impairment
Similar to above, Defendants argue that Plaintiffs have not sufficiently alleged either

19

scienter or falsity with respect to their claims that Defendants improperly failed to take a write-off

20

in 3Q for long-lived asset impairment. Here, the Court reaches a different conclusion than that

21

reached as to goodwill impairment.

22

As to scienter, the Court acknowledges that Plaintiffs‟ contentions are similar to above –

23

i.e., scienter may reasonably be inferred on the part of Defendants because (1) it was obvious that

24

the impairment for long-lived assets needed to be taken and (2) 96% of LF‟s long-lived assets, for

25
26
27
28

the company as much as I do, they would probably be buying up shares of LF‟”). Plaintiffs‟ point
here seems to be that Mr. Barbour and Mr. Arthur acquired stock in response to this criticism and
not because they truly believed in the value of the stock. But the missing link in Plaintiffs‟
analysis is that, even if the article was in the public realm (and thus judicially noticeable), that
does not mean that Mr. Barbour or Mr. Arthur read or knew about the article, which then
(allegedly) prompted them to purchase LF stock.
12

1

a total of $36.5 million, were effectively written off “overnight” (in F4Q15 as opposed to F3Q15).

2

These arguments have resonance in respect to long-lived asset impairment.
The Court recognizes that Defendants actually tested for long-lived asset impairment (i.e.,

3
4

they concluded step zero was met) and that the long-lived asset impairment determination is

5

somewhat of a subjective assessment. As Plaintiffs expressly admitted in their SAC:

6



“[s]tep one of the long-lived assets determination required Defendants to determine

7

whether the carrying amount of the assets exceeded the sum of the undiscounted cash

8

flows expected to result from the use and eventual disposition of the asset,” SAC ¶ 172;

9

and

10



“[t]he projected changes to current free cash flows is a subjective, speculative factor
involving considerations including: performance year-to-date, trends in free cash flows

12
For the Northern District of California

United States District Court

11

over time, the competitive landscape, management track records, acquisitions, new

13

products and other considerations bearing on a company‟s future performance.” SAC ¶

14

56(c) (emphasis added).

15

To be sure, inferring scienter can be challenging where an alleged GAAP violation is

16

complicated and not obvious. See, e.g., MicroStrategy, Inc. Sec. Litig., 115 F. Supp. 2d 620, 636

17

(E.D. Va. 2000) (noting that, “if the GAAP rules and [company] accounting policies Defendants

18

are alleged to have violated are relatively simple, it is more likely that the Defendants were aware

19

of the violations and consciously or intentionally implemented or supported them, or were reckless

20

in this regard”); see also SEC v. Todd, 642 F.3d 1207, 1216 (9th Cir. 2011) (“recogniz[ing] that

21

GAAP „tolerate[s] a range of “reasonable” [accounting] treatments, leaving the choice among

22

alternatives to management‟”). Nevertheless, Plaintiffs‟ argument that the need to take the

23

impairment was obvious in this case is supported by specific allegations in the complaint.

24

Plaintiffs point out that, when Defendants did make the adjustment for impairment in 4Q (rather

25

than 3Q), they justified it based on a significant stock decline (and not, e.g., on changed cash flow

26

projections). See Defs.‟ RJN, Ex. 22, at 58-59 (LF‟s 10-K for fiscal year 2015) (note 9)

27

(indicating that there was impairment at 4Q “primarily due to the significant decline of the trading

28

value of the Company‟s Class A common stock and the corresponding market capitalization”).
13

1

The bulk of the stock decline, however, had already happened in 3Q or at least by January 23,

2

2015, when the price fell to $2.55 (a 46.3% fall from its price of $4.75 on December 31, 2014).

3

See SAC ¶ 175 (noting that LF‟s stock was worth $4.75 at the end of December 31, 2014, but that

4

it declined to $2.55 by January 23, 2015); SAC ¶ 16 (adding that the average stock price from

5

January 23, 2015, through the end of 4Q (March 31, 2015) was $2.44). After January 23, 2015,

6

the stock fell further by the end of 4Q15, but the bulk of the price reduction during the quarter

7

occurred before January 23, 2015. See SAC ¶ 16 (alleging that the average stock price from

8

January 23, 2015, through March 31, 2015, was $2.44 – i.e., only $0.11 less). Although January

9

23, 2015, technically falls in 4Q rather than 3Q, LF‟s 10-Q for 3Q was filed on February 9, 2015,

GAAP. See SAC ¶ 178 (alleging that, under GAAP, Defendants were required to take into

12
For the Northern District of California

and therefore should have taken into account the January 23, 2015, price drop, as required by

11

United States District Court

10

account “„subsequent events that provide[d] additional evidence about conditions that existed [at

13

the end of 3Q, i.e., December 31, 2014]‟”). In short, as Defendants justified the long-lived

14

impairment write-off in 4Q based on an obvious stock decline, but that stock decline was obvious

15

as of 3Q or shortly thereafter. Accordingly, Plaintiffs‟ obviousness argument in support of

16

scienter has merit.

17

A strong inference of scienter arises because not only are there Plaintiffs‟ obviousness

18

allegations but also their allegations related to the timing and size of the impairment, which further

19

support scienter. As Plaintiffs have alleged, Defendants knew that the LF stock price had dropped

20

to $2.55 by January 23, 2015, but did not claim any impairment to long-lived assets for 3Q; then,

21

just two months later, i.e., March 31, 2015, for the end of 4Q, Defendants claimed an impairment

22

of $36.5 million, which represented 96% of LF‟s long-lived assets. Defendants have failed to

23

explain why, in just two months, they changed their view on long-lived assets from no impairment

24

to a 96% impairment. This is in contrast to the analysis of the failure to take a goodwill

25

impairment in F2Q15; in that case, there was a significant intervening event that could have

26

altered Defendants‟ expectations between F2Q15 and F3Q15 – the disappointing holiday sales.

27

No such intervening event explains the difference between F3Q15 and F4Q15.

28

Defendants point out that they did give a warning about the possibility of an impairment to
14

1

long-lived assets in the 10-K for LF‟s 3Q. See Defs.‟ RJN, Ex. 19, at 28 (LF‟s 10-Q for 3Q)

2

(stating that, “[i]f impairment testing shows that the carrying value of our long-lived assets

3

exceeds their estimated fair values, we would be required to record a non-cash impairment charge,

4

which would decrease the carrying value of our long-lived assets, as the case may be, and our

5

results of operations would be adversely affected”). While this warning is given some

6

consideration, the fact that it is general in nature, i.e., lacking in specifics, particularly in

7

comparison to the specificity of the warning regarding goodwill impairment, renders its impact on

8

scienter of less consequence.

9

At the end of the day, Plaintiffs‟ allegations regarding scienter are more than merely

in light of the lack of any explanation as to why, in just two months, Defendants recognized an

12
For the Northern District of California

plausible; the inference of scienter is at least as compelling as any opposing inference, especially

11

United States District Court

10

impairment of the size claimed despite the absence of a significant intervening change in

13

circumstances.

14

At the hearing, Defendants suggested for the first time that the long-lived impairment may

15

not have been taken at 3Q because, e.g., costs were going to be brought down (which would affect

16

the cash flows of the company). See Defs. RJN, Ex. 18 (LF earnings call for Q3, held on February

17

5, 2015) (stating that “yesterday we announced internally a reduction of 95 full term positions

18

across our business, which represents over 16% of our organization”). While, based on timing,

19

reduction-in-workforce costs may well have been a consideration for 3Q, see SAC ¶ 178 (alleging

20

that, under GAAP, Defendants were required to take into account “„subsequent events that

21

provide[d] additional evidence about conditions that existed [at the end of 3Q, i.e., December 31,

22

2014]‟”), that same consideration, based on timing, should have affected 4Q as well. Thus, as the

23

Court asked at the hearing, the question is what changed between 3Q and 4Q that caused

24

Defendants to take the impairment at 4Q but not 3Q? As nothing has been identified for the

25

Court, it concludes that there is a strong inference of scienter.

26

Defendants protest that, even if the Court is inclined to find sufficient allegations of

27

scienter, Plaintiffs have still failed to allege falsity. According to Defendants, because an

28

assessment of long-lived asset impairment depends on expected cash flows, see SAC ¶ 160
15

1

(alleging that, at step one, “one must determine whether the carrying amount of a long-lived asset

2

(or asset group) exceeds the sum of the undiscounted cash flows expected to result from the use

3

and the eventual disposition of the asset”), and Plaintiffs have not made any allegations about

4

what cash flow analysis Defendants actually did (i.e., what was wrong with that analysis), the

5

falsity allegations are lacking. The Court is not persuaded. Plaintiffs have adequately pled falsity

6

based on the allegations that Defendants justified the long-lived asset impairment determination

7

based on a significant stock decline, but that stock decline had primarily taken place at 3Q (or

8

shortly thereafter, i.e., by January 23, 2015). Plaintiffs have alleged enough to survive the motion

9

to dismiss.
III.

10

For the foregoing reasons, the Court grants in part and denies in part Defendants‟ motion

11
12
For the Northern District of California

United States District Court

CONCLUSION

to dismiss the SAC. The motion is granted to the extent Plaintiffs‟ claims are based on

13

Defendants‟ failure to take a write-off for goodwill impairment in 2Q. The motion is denied to the

14

extent Plaintiffs‟ claims are based on Defendants‟ failure to take a write-off for long-lived asset

15

impairment in 3Q.
Defendants shall file their answer to the SAC, with claims limited by the Court‟s ruling

16
17

herein, within four (4) weeks of the date of this order. The Court will hold a Case Management

18

Conference on April 6, 2017 at 9:30 a.m. to set dates in connection with Plaintiffs‟ motion to

19

certify the class. A Joint Case Management Conference statement shall be filed by March 30,

20

2017.

21

This order disposes of Docket No. 100.

22
23

IT IS SO ORDERED.

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25
26
27

Dated: February 24, 2017
______________________________________
EDWARD M. CHEN
United States District Judge

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