On July 17, 2024, Judge Paul A. Engelmayer of the U.S. District Court for the Southern District of New York granted a motion to dismiss a putative securities class action against a cannabis company and three of its officers. In re Canopy Growth Securities Litigation, 23 Civ. 4302 (PAE) (S.D.N.Y. July 17, 2024). Plaintiffs alleged that defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act, and Rule 10b-5 promulgated thereunder, by making false and misleading statements about the financial prospects of the Company’s newly acquired sports drink subsidiary (the “Subsidiary”). The Court granted defendants’ motion to dismiss with prejudice, holding that plaintiffs failed to adequately plead scienter.
Plaintiffs were a putative class of investors who allegedly acquired the Company’s securities between November 5, 2021 and June 22, 2023. According to the first amended complaint (the “Complaint”), the Company specializes in the manufacture and sale of consumer-packaged goods, in particular those derived from cannabis and hemp. Plaintiffs alleged that in October 2019, the Company acquired the Subsidiary, a sports drink company, in an effort to expand beyond its cannabis-related business. Plaintiffs alleged that defendants misled investors as to the Subsidiary’s revenue, distribution, and inventory, and concealed internally known problems such as the Subsidiary’s failure to enter into enforceable contracts with distributors, its excess and aging inventory, and the extreme pressure it faced to meet revenue targets. Specifically, plaintiffs alleged that defendants’ statements about the Subsidiary’s performance were misleading because the Subsidiary’s revenue was allegedly artificially inflated, and the statements did not disclose the Subsidiary’s failure to enter into enforceable distribution contracts and that it had significant unsold inventory with limited shelf-life. Plaintiffs further alleged that statements about the Company’s internal controls were misleading because those controls were ineffective. Plaintiffs’ allegations relied heavily on purported statements from confidential witnesses (“CWs”), who allegedly were former employees of the Company and its Subsidiary.
Plaintiffs contend that the truth emerged in February, May, and June 2023, when the Company made a series of disclosures concerning inventory write-downs, material weaknesses in its internal controls, and significant restatements of its financial results due to improper revenue recognition for the Subsidiary. Plaintiffs alleged that these disclosures caused the Company’s share price to decline significantly.
The Court dismissed the Complaint with prejudice, holding that plaintiffs failed to plead “even a weak inference” of scienter. In so holding, the Court gave little weight to the alleged CW statements, finding that plaintiffs failed to establish (i) the CWs’ basis of knowledge, noting that the CWs were “primarily former lower-level sales and marketing employees, not executives or managers with direct knowledge of the [C]ompany’s financials, accounting, or the individual defendants’ states of mind,” and (ii) that certain CWs attended meetings where the relevant issues were discussed or had actual communications with the individual defendants. The Court noted that five of the six CWs referenced in the Complaint were not alleged to have had any contact at all with the Company’s senior management. The Court further found that the CW allegations were too vague with respect to the alleged inventory and distribution issues because they provided no specifics as to purported inventory buildup or financial impact or the means by which such facts were conveyed to the individual defendants. As a result, the Court concluded that the CW allegations amounted to nothing more than offering the CWs’ “thoughts and opinions” as to various issues experienced by the Company, but these “ruminations” did not establish what specific contradictory information defendants had and the connection between that information and the statements at issue.
The Court similarly rejected plaintiffs’ three alternative theories of scienter based on the individual defendants’ alleged public statements, the Company’s “sudden reversal of fortune,” the “size and scale” of the inventory and internal control problems, and the departures of certain Company executives. The Court found that these theories were overly general and speculative, unsupported by alleged facts, and/or insufficient to show that defendants acted with the requisite intent to deceive or recklessness. In particular, the Court noted that the revenue adjustment in the Company’s restatement was relatively modest and did not support the inference that the individual defendants knew about these issues well before they were disclosed to investors. The Court thus concluded that plaintiffs’ allegations, viewed holistically, did not establish a cogent and compelling inference of scienter that was at least as strong as any opposing inference.
Finding plaintiffs failed to adequately plead a primary violation of Section 10(b), the Court dismissed the derivative control person claims under Section 20(a). In dismissing the Complaint with prejudice, the Court noted that plaintiff had already amended the complaint once and was given another opportunity to amend after defendants filed their motion to dismiss, while being warned that no further opportunities to amend will ordinarily be granted.
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