On September 25, 2024, Judge Orelia E. Merchant of the United States District Court for the Eastern District of New York granted in part and denied in part a motion to dismiss a putative securities class action against an online clothing rental company (the “Company”) and the Company’s underwriters and certain officers, directors and other related individuals. Rajat Sharma v. Rent the Runway, Inc., et al. (E.D.N.Y. Sept. 25, 2024).Plaintiffs asserted claims on behalf of a putative class of investors who allegedly purchased shares in the Company’s IPO, alleging violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933, and Items 105 and 303 promulgated thereunder.
According to plaintiffs, the Company’s offering documents in connection with its 2021 IPO were negligently prepared and allegedly contained a total of 25 misrepresentations or omissions of material information related to (1) the demand for the Company’s services, (2) the Company’s shipping costs, and (3) customer and employee theft. In an attempt to bolster these allegations, the consolidated amended complaint incorporated statements from six purported confidential witnesses (“CWs”) who are allegedly former employees of the Company. These CWs allegedly recalled that senior personnel involved in preparing the offering statements understood that the Company was not meeting its enrollment subscriber projections at the time of the IPO; that the Company frequently changed shipping carriers due to cost and reliability issues; and that senior personnel involved in preparing the offering statements understood that customer and employee thefts were a “huge issue” for the Company. Defendants moved to dismiss, and the Court granted the motion with respect to the statements concerning demand, but denied the motion with respect to most of the allegations concerning shipping costs and theft.
As an initial matter, the Court held that Rule 9(b)’s heightened pleading standard did not apply. Defendants argued that the claims under Sections 11 and 12 sounded in fraud because they were littered with fraud “buzzwords.” The Court found that the gravamen of the complaint sounded in negligence, not fraud, because the complaint expressly disclaimed “that any of the Defendants committed intentional or reckless misconduct.” Moreover, the Court found that the complaint tracked the elements of Section 11, and “a plaintiff cannot be held to allege fraud by simply tracking those elements.”
Next, the Court held that the offering statements did not materially misstate consumer demand by referring to “increased demand” and “strong momentum.” The Court credited one of the alleged CW statements regarding the Company leadership having an understanding of customer attrition, but concluded that these alleged statements did not demonstrate that leadership was aware of an alleged downward trend in subscribers that was inconsistent with the offering materials. For example, one CW allegedly stated that “at some point ‘leading up to the IPO’ 100 subscribers a day were canceling or ‘churning,’ their subscription.” But, as plaintiffs conceded, the revenue and subscriber numbers included in the offering materials accurately demonstrated an upward trend. The Court thus found that the alleged CW statement was insufficiently precise as to timing. Similarly, the Court found that alleged CW statements regarding alleged missed subscriber projections were not inconsistent with the disclosed upward trends, and instead showed that the Company was not getting as many subscriptions as it wanted. The Court further found that the offering materials adequately disclosed risk factors related to subscription demand such that the Company was under no obligation to disclose specific details, such as the missed internal projections. Finally, the Court found that the Company’s references to strong momentum were akin to corporate puffery or optimism that could not have misled any reasonable investor. Accordingly, the Court dismissed the claims predicated on the alleged misstatements concerning demand for the Company’s services.
As for the allegations concerning shipping costs and theft, however, the Court found that plaintiffs adequately stated a claim.
With respect to shipping costs, plaintiffs alleged based on purported CW statements that the Company leadership was aware that its shipping company had doubled the Company’s shipping rates causing it to change to a lower-cost shipping company in the months before the IPO, and that the Company made statements in an earnings call the quarter after the IPO suggesting it had anticipated increased shipping costs at the time of the IPO. The Court found that allegedly failing to disclose this rate increase and the switch of shipping companies was plausibly an omission of material information in violation of Section 11 and denied the motion to dismiss with respect to these allegations.
With respect to the issue of theft, plaintiffs alleged claims on the basis of Section 12, Item 303, and Item 105, alleging that the offering materials described theft as a hypothetical future risk, despite this risk having already materialized. The Court rejected defendants’ argument that failure to disclose losses due to theft could not be material where the losses amounted to less than 3% of annual revenue. The Court explained that the Second Circuit has “consistently rejected a formulaic approach to assessing materiality,” and found that because the Company’s entire business model depends on customers returning the clothing they rent, customers’ failure to return the clothing could plausibly be material to a reasonable investor. Thus, the Court held that plaintiffs adequately alleged a Section 12 violation. The Court further found these alleged omissions actionable on the basis of Item 303, because the CWs allegedly demonstrated that the Company failed to disclose a trend that was “both [1] presently known to management and [2] reasonably likely to have material effects on the registrant's financial condition or results of operations.” The Court, however, held that plaintiffs did not adequately allege a claim on the basis of Item 105, because the Company disclosed that it “may incur significant losses from fraud” and “in the past incurred” losses from failure to return rentals.
Having held that plaintiffs adequately alleged violations of Section 11, the Court further held that plaintiffs sufficiently alleged liability under Sections 12(a)(2) and 15. The Court found that control person liability is available under Section 15 with respect to the individual defendants, because they allegedly signed the offering statements.
As for Section 12(a)(2), with respect to each of the individual defendants, the Court explained that “because the Individual Defendants’ conduct involved more than just signing a registration statement—it also included affirmative conduct, including the allegations that the Individual Defendants chose to participate in delivering IPO roadshow presentations,” those individuals could be held liable as statutory sellers. As to the underwriters, the Court held that plaintiffs sufficiently alleged a Section 12(a)(2) claim because the underwriters allegedly participated in roadshows and purportedly drafted and disseminated the offering materials. As to the Company, the Court accepted plaintiffs’ argument at the pleading stage that, based on SEC Rule 159A, the Company’s role as issuer in the IPO was sufficient to qualify as a statutory seller under Section 12(a)(2)—however, courts are not settled on whether companies qualify as statutory sellers under Section 12(a)(2) based on that SEC rule.
Links & Downloads
[View source.]
