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(Article from Securities Law Alert, August/September 2019) 

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On August 19, 2019, the Fifth Circuit affirmed the dismissal of a securities fraud action alleging that a home furnishings company and its executives failed to disclose “the risk that [the company] had so much inventory that it could get rid of it only by lowering prices dramatically.” Municipal Emps. Ret. Sys. of Mich. v. Pier 1 Imports, 2019 WL 3886843 (5th Cir. 2019) (Elrod, C.J.). Plaintiffs did not claim that defendants “misrepresented [the company’s] inventory” but instead asserted that defendants “misled the public about [the company’s] ability to offload that excessive inventory without significant markdown risk.” The court held plaintiffs failed to allege scienter because “[k]nowledge of high inventory does not necessarily equate to knowledge of significant markdown risk.”

In Novak v. Kasaks, 216 F.3d 300 (2d Cir. 2000), the Second Circuit found plaintiffs adequately pled scienter by alleging that a women’s apparel retailer failed to mark down the inventory value of out-of-style clothing. Plaintiffs relied on Novak to argue that the company’s “products are particularly subject to markdown risk” because the company “is a trend-based [home] fashion retailer that is subject to the whims of consumer trends.” But the Fifth Circuit found the company “operates largely in the sturdier business of style” rather than the ever-changing business of fashion. The court pointed out that the company does not characterize itself as a “trend-based [home] fashion retailer,” and a substantial percentage of its inventory consists of “rebuy” goods. The court determined that plaintiffs’ allegations therefore did “not create a strong inference that all (or even most) of [the company’s] inventory is so trend driven that it could not be sold without significant markdowns.”

The Fifth Circuit also noted that plaintiffs offered no explanation for why defendants “kept ordering more inventory when they supposedly knew deep down that they would not be able to sell it.” The court found defendants’ “conduct belied any attempt to conceal the impact of that problem: were [defendants] attempting to conceal significant markdown risk, continuing to order inventory would be counterproductive.” Rather than raising a strong inference of scienter [as to a significant markdown risk], the court found it “equally plausible . . . that [defendants] reasonably believed they could fix the excessive inventory problem without resorting to markdowns.”