(Article from Securities Law Alert, June 2016)
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On June 21, 2016, the Southern District of New York dismissed in its entirety a securities fraud action against Alibaba Group Holding Limited. Christine Asia Co. v. Alibaba Group Holding Ltd., 2016 WL _____ (S.D.N.Y. 2016) (McMahon, C.J.).[1] The court held Alibaba had no obligation to disclose in its IPO Registration Statement either the existence or the substance of “informal and non-binding guidance” provided by a Chinese government agency concerning the company’s e-commerce practices.
Background
Alibaba is a Chinese e-commerce company that operates a number of popular e-commerce marketplaces in which “independent third party merchants sell products to wholesale and retail buyers around the world.” Alibaba, like many third-party platform operators, has long faced scrutiny regarding the alleged sale of counterfeit goods by third parties on its marketplaces.
On July 16, 2014, representatives of China’s State Administration for Industry and Commerce (“SAIC”) met with Alibaba to provide the company with administrative guidance concerning compliance with Chinese law, including newly enacted regulations by the SAIC (“the July 16 Meeting”). Among the topics discussed was the sale of counterfeit goods on Alibaba’s marketplaces. Under the Chinese regulatory scheme, administrative guidance is a “non-compulsory” and “informal regulatory tool used by the SAIC to encourage businesses and industries to self-regulate.” Earlier that year, the SAIC had announced the launch of the “Red Shield and Web Sword” program (the “Red Shield Program”), an initiative aimed at reducing counterfeit sales, among other practices.
On September 19, 2014, Alibaba conducted an initial public offering on the New York Stock Exchange.[2] The company’s Registration Statement “contained a litany of disclosures about the pitfalls of e-commerce, the Chinese regulatory environment, and the attendant risks to Alibaba’s business.” The company “disclosed that it had been criticized in the past due to the sale of pirated, counterfeit and illegal products on its sites” and explained that Chinese law “required it to police its marketplaces for unlicensed merchants and counterfeit goods.” The company cautioned that it was subject to new more “stringent” ecommerce laws, it “expect[ed] to face increased scrutiny” from regulators, and that as a result of its business risks, it could be subject to a variety of adverse effects, including increased compliance costs and civil and criminal liabilities. However, the company did not “disclose the existence of the Red Shield Program” or “reveal that it had received administrative guidance from the SAIC.”
On January 28, 2015, a self-described “white paper” appeared on the SAIC’s website purportedly describing the July 16 Meeting. Although the white paper was removed from the SAIC’s website within hours, numerous media outlets reported on the white paper. On January 29, 2015, Alibaba acknowledged in a press release and earnings call that the July 16 Meeting had taken place. Alibaba’s share price fell substantially on January 28 and January 29. Seven class actions followed in various district courts; these actions were centralized in a multi-district litigation in the Southern District of New York.
Plaintiffs alleged Alibaba and several of its officers and directors had “knowingly or recklessly concealed” the July 16 Meeting and the SAIC’s administrative guidance in order to “artificially inflate” the company’s IPO price. Defendants moved to dismiss for failure to state a claim.
Court Holds Alibaba Had No Duty to Disclose the SAIC’s Administrative Guidance Under Section 10(b) and Rule 10b-5
At the outset of its analysis, the court observed that Alibaba’s Registration Statement was “unusually comprehensive.” The court found Alibaba’s disclosures “more than sufficient to warn investors that Alibaba faced continuing risks related to the sale of counterfeit goods in its marketplaces, and that it could face enforcement actions and substantial fines should it fail to properly police its marketplaces for defective and illegal goods.” Moreover, the court determined that Alibaba’s disclosures made it “clear that China’s legal and regulatory environment [rendered] investing in a Chinese company, like Alibaba, risky.”
The court found the key issue was whether: “an offering document that fully discloses all substantive investment risks [is] materially misleading if it fails to disclose that a government agency . . . met with the issuer to underscore the issuer’s obligation to ameliorate those risks?” The court concluded that the answer is “no.” As a general matter, the court explained that “a company is not compelled to disclose every communication it has with a regulator—even where, as here, a regulator has informed a company of deficiencies in its operations.” The court noted that in Acito v. IMCERA Group, 47 F.3d 47 (2d Cir. 1995), for example, the Second Circuit held a health products manufacturer had no duty to disclose Food and Drug Administration (“FDA”) inspections that uncovered deficiencies in the company’s manufacturing operations. The Second Circuit in that case held that no disclosure was required because “the two inspections had not resulted in any adverse action that affected earnings—even though a third inspection ultimately resulted in the company shutting down the facility.” Similarly, the Alibaba court noted that in In re Sanofi Securities Litigation, 87 F. Supp. 3d 510 (S.D.N.Y. 2015), the court held a pharmaceutical company had no duty to disclose FDA concerns regarding the testing methodology for a new pharmaceutical because it determined that such feedback “‘does not express a binding agency decision.’” Id. (quoting Sanofi, 87 F. Supp. 3d 510).
Turning to Alibaba’s disclosures, the court held Alibaba’s failure to disclose the July 16 Meeting and its receipt of “informal and non-binding guidance” from the SAIC did not “render inaccurate any statement about the likelihood of an actual inquiry or investigation taking place.” The court also found it immaterial that “[t]he Registration Statement did not specifically mention the ‘Red Shield’ Program’” because plaintiffs “allege[d] that the program was widely publicized” and “the securities laws do not require disclosure of information that is publicly known.”
The court rejected plaintiffs’ contention that Alibaba’s Registration Statement was materially misleading insofar as the company represented that no inquiry or investigation “has resulted in significant restrictions on [the company’s] business operations.” The court reasoned that plaintiffs had “not alleged facts tending to show that Alibaba actually face[d] a government inquiry or investigation that was likely to result in significant restrictions on Alibaba’s business operations.” Rather, plaintiffs alleged only “that Alibaba attended a meeting with Chinese regulators, at which it received nonbinding administrative guidance aimed at encouraging Alibaba” to self-regulate. The court underscored that “[m]aking Alibaba aware of concerns and prompting it to pay attention to problems it had plainly disclosed is not tantamount to the institution of a formal regulatory proceeding.”
The court also determined that plaintiffs’ reliance on the Second Circuit’s decision in Meyer v. Jinkosolar Holdings Co., 761 F.3d 245 (2d Cir. 2014), was misplaced. In Jinksolar, the defendant allegedly “disclosed that environmental violations generally posed a financial risk to the company, while not cautioning investors that it knew its efforts to comply with Chinese law were failing and could expose it to penalties.” Here, however, the court explained that “Alibaba did not represent that its efforts to comply with the law were particularly effective, let alone foolproof.” The court concluded that Alibaba’s “disclosures were not likely to cause a reasonable investor to make an overly optimistic assessment of that risk.”
Court Further Determines Alibaba Had No Duty to Disclose the SAIC’s Administrative Guidance Under Items 303 or 503
With respect to plaintiffs’ contention that defendants had a duty to disclose the SAIC’s administrative guidance under Items 303 and 503 of Regulation S-K,[3] the court held “[n]either regulation compel[s] disclosure.”
The court found meritless plaintiffs’ argument that under the Second Circuit’s decision in Indiana Public Retirement System v. SAIC, 818 F.3d 85 (2d Cir. 2016), “Item 303 requires disclosures of even potential harm to a company’s business.” The court underscored that “the Second Circuit has never imposed such a sweeping disclosure obligation.”
In Indiana Public Retirement System, the Second Circuit held “a government contractor [had] violated Item 303 by failing to disclose that it had overbilled various New York City agencies by millions of dollars and that the overbilling practices subjected it to monetary and reputational risks.” The Alibaba court explained that “the likelihood of harm in Indiana Public Retirement System was not merely potential—it was probable and, indeed, imminent.” Here, however, the court determined there was “far less reason to believe that the July 16 Meeting ‘might reasonably be expected’ to have a material effect on Alibaba’s business.”
The court similarly found Section 503 did not “compel[ ] disclosure” of the July 16 meeting and the SAIC’s guidance. While the court noted that there is “scant caselaw” on this provision, the court explained that the relevant inquiry for Item 503 purposes is “whether the Offering Documents were accurate and sufficiently candid.” The court found the Registration Statement was “accurate and sufficiently candid” with regard to the SAIC’s crackdown on violations of [Chinese law] on e-commerce sites like Alibaba.” As to plaintiffs’ claim that “Alibaba was obligated to admit that it was engaged in conduct that violated Chinese and American laws and regulations,” the court emphasized that there were no allegations that Alibaba had “ever been charged with such misconduct.” The court held that “in light of Second Circuit case law declining to impose a duty to disclose uncharged conduct under Item 503,” plaintiffs had “failed to state a duty to disclose” pursuant to Item 503. Id. (citing In City of Pontiac Policemen’s and Firemen’s Ret. Sys. v. UBS AG, 752 F.3d 173 (2d Cir. 2014)).
Court Finds Plaintiffs Failed to Allege Scienter
The court held plaintiffs’ Section 10(b) claims “fail[ed] for the additional reason that they [had] not pleaded facts giving rise to a strong inference that either the [i]ndividual [d]efendants or the [c]ompany acted with the requisite scienter.” With respect to plaintiffs’ scienter allegations as to Alibaba, the court found it “well established that a corporation’s desire to raise funds through an IPO and to obtain favorable pricing for a bond offering do not give rise to a strong inference of scienter.” As to the individual defendants, the court acknowledged that their profits from the IPO were “massive sums”; however, the court found plaintiffs’ failure to allege facts showing that the individual defendants’ “insider trading sales were unusual . . . temper[ed] any strong inference of scienter that [could] be raised based on [their] insider sales alone.”
The court dismissed plaintiffs’ claims in their entirety and denied plaintiffs leave to amend their complaint, concluding that the deficiencies in the allegations were “substantive,” rather than inartful pleading. The court reasoned that the “linchpin” of the case was the July 16 Meeting, which could not “be construed as anything more than an informal meeting with regulators.”
[1]
Simpson Thacher represents Alibaba and the individual defendants in this matter.
[2]
Simpson Thacher represented Alibaba in the IPO.
[3]
Pursuant to Item 303 of Regulation S-K, Registration Statements must include a description of “any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.” Item 303 does not apply to foreign corporations, but the SEC has stated that its interpretations of Item 303 apply to the Management Discussion & Analysis disclosures required under Item 5 of Form 20-F, which does apply to foreign corporations.
Item 503 of Regulation S-K mandates that Registration Statements “provide under the caption ‘Risk Factors’ a discussion of the most significant factors that make the offering speculative or risky.”