PANTHER PARTNERS INC., on Behalf of Itself and All Others Similarly Situated, Plaintiff-Appellant, v. IKANOS COMMUNICATIONS, INC., RAJESH VASHIST, DANIEL K. ATLER, DANIAL FAIZULLABHOY, MICHAEL L. GOGUEN, MICHAEL GULETT, PAUL G. HANSEN, GOPAL VENKATESH, CITIGROUP GLOBAL MARKETS INC., Defendants-Appellees, LEHMAN BROTHERS INC., Defendant.
Docket No. 11-63-cv
UNITED STATES COURT OF APPEALS FOR THE SECOND CIRCUIT
August Term, 2011 (Argued: April 17, 2012 Decided: May 25, 2012)
VACATED and REMANDED.
SUSAN K. ALEXANDER, Robbins Geller Rudman & Dowd LLP, San Francisco, CA (Sanford Svetcov, Robins Geller Rudman & Dowd LLP, San Francisco, CA, Samuel H. Rudman, David A. Rosenfeld, Robins Geller Rudman & Dowd LLP, Melville, NY, on the briefs), for Plaintiff-Appellant.
JAMES N. KRAMER (Michael D. Torpey, on the brief), Orrick, Herrington & Sutcliffe LLP, San Francisco, CA, for Defendants-Appellees Ikanos Communications, Inc., Rajesh Vashist, Daniel K. Atler, Danial Faizullabhoy, Michael L. Goguen, Michael Gulett, Paul G. Hansen and Gopal Venkatesh.
DANIEL J. TOAL (Daniel J. Kramer, Farrah R. Berse, Aaron H. Crowell, on the brief), Paul, Weiss, Rifkind, Wharton & Garrison LLP, New York, NY, for Defendant-Appellee Citigroup Global Markets Inc.
BARRINGTON D. PARKER, Circuit Judge:
Plaintiff Panther Partners Inc. (“Panther“) appeals an order of the United States District Court for the Southern District of New York (Crotty, J.), denying leave to amend its complaint alleging violations of §§ 11, 12(a)(2), and 15 of the Securities Act of 1933. See
BACKGROUND1
In this putative securities class action, Panther alleges that Ikanos and various of its officers, directors, and underwriters violated §§ 11, 12(a)(2), and 15 of the Securities Act by failing to disclose known defects in the Company‘s VDSL (very-high-bit-rate digital subscriber line) Version Four chips. Ikanos is a publicly-traded company that develops and markets programmable semiconductors. The semiconductors enable fiber-fast broadband services over telephone companies’ existing copper lines. Ikanos‘s customers are primarily large original equipment manufacturers (“OEMs“) in the communications industry that incorporate Ikanos‘s products into their products, which are then sold to telecommunications carriers. All of Ikanos‘s revenues derive from the sale of semiconductor chip sets.
In 2005, Ikanos sold its VDSL Version Four chips to Sumitomo Electric and NEC, its two largest customers and the source of 72% of its 2005 revenues. Sumitomo Electric and NEC
Ikanos learned in January 2006 that there were quality issues with the chips. In particular, the chips had developed a problem called “Kirkendahl voiding,”2 traceable to a third party assembling company in China to which Ikanos had switched the majority of its assembly work during the third and fourth quarters of fiscal year 2005. In the weeks leading up to the Secondary Offering, the defect issues became more pronounced as Ikanos received an increasing number of complaints from Sumitomo Electric and NEC. The thrust of the complaints was that the chips that had been installed in the NTT network were defective and were causing the network to fail, and that end-users who had subscribed to NTT‘s television, Internet and telephone services were losing signals and access to their subscribed services. According to Ikanos‘s former Director of Quality and Reliability, the defects “were a substantial problem for [Ikanos] to resolve in order to appease Sumitomo Electric and NEC and to retain them as customers,” in part because Ikanos knew it would be unable to determine which of the chip sets it sold to these customers actually contained defective chips. J.A. at 52. Panther alleges that Ikanos‘s Board of Directors met and discussed the defect issue at the time it arose, and Company representatives regularly traveled to Japan to meet with Sumitomo and NEC representatives to evaluate the problem and to discuss possible solutions.
[h]ighly complex products such as those that [Ikanos] offer[s] frequently contain defects and bugs, particularly when they are first introduced or as new versions are released. In the past we have experienced, and may in the future experience, defects and bugs in our products. If any of our products contains defects or bugs, or have reliability, quality or compatibility problems, our reputation may be damaged and our OEM customers may be reluctant to buy our products, which could harm our ability to retain existing customers and attract new customers. In addition, these defects or bugs could interrupt or delay sales or shipment of our products to our customers.
Id. at 54-55, 168.
Some 5.75 million shares of Ikanos stock were sold in the Secondary Offering at $20.75 per share, raising more than $120 million. The individual defendants sold stock valued at $7.3 million.
Ikanos ultimately determined that the chips had an “extremely high” failure rate of 25-30%. Id. at 53. In June 2006, three months after the Secondary Offering, the Company reached an agreement with Sumitomo Electric and NEC to replace at Ikanos‘s expense all of the units sold - not just the units containing observably defective chips. This recall resulted in the return of hundreds of thousands of chip sets whose cost had to be written off.
In July 2006, the Company reported a net loss of $2.2 million for the second quarter, causing the price of its shares to drop over 25% from $13.85 to $10.24. Three months later, in October 2006, it reduced its expected third-quarter revenues from $40-$43 million to $36-37 million, citing “product delays and manufacturing constraints” involving its fourth- and fifth-
The operative complaint on this appeal, from which the facts above are drawn, is the third to have been considered by the district court in this case. The First Amended Complaint (“1AC“) alleged merely that Ikanos learned in January 2006 that its VDSL Version Four chips were failing and causing NTT‘s customers to lose access to their subscribed services; that, some time later, Ikanos was forced to ship replacement products to Sumitomo Electric and NEC at Ikanos‘s expense; and that, at some point, Ikanos determined that the chips had a failure rate of 25-30%. The district court dismissed the 1AC for failure to state a claim, concluding that “[n]o plausibly pleaded fact suggests that Ikanos knew or should have known of the scope or magnitude of the defect problem at the time of the Secondary Offering.” Panther Partners, Inc. v. Ikanos Commc‘ns, Inc., 538 F. Supp. 2d 662, 673 (S.D.N.Y. 2008) (”Panther Partners I“).
Panther moved for reconsideration, providing the court with a proposed amended complaint (the “First Proposed Second Amended Complaint” or “1PSAC“). The 1PSAC added allegations that the defect issue was becoming “more pronounced” in the weeks leading up to the
“silent about the rate at which chips were being returned . . . or the volume of the defect [in the weeks leading up to the Secondary Offering] . . . . Nor do the allegations specify that Ikanos knew exactly what the particular defect was at that time. It is no secret that chips are subject to some percentage of failure (and here there is no pleading as to what a ‘normal’ defect rate is), so the allegation that ‘there were defects’ is meaningless without more. . . . The [p]laintiff must tell the Court what was going on when - and how much the defect experienced actually differed from the norm.”
Panther Partners, Inc. v. Ikanos Commc‘ns, Inc., No. 06 Civ. 12967, 2008 WL 2414047, at *3 (S.D.N.Y. June 12, 2008) (”Panther Partners II“) (quoting Panther Partners I, 538 F. Supp. 2d at 673). The court reiterated its view that no plausibly pleaded fact suggested that Ikanos knew or should have known the magnitude of the defect problem at the time of the Secondary Offering.
Ikanos appealed both decisions. By summary order, we first affirmed the district court‘s dismissal of Panther‘s 1AC. We further held that, while the 1PSAC‘s new allegations “nudged plaintiff‘s claims closer to the line from conceivable to plausible, they were not enough to push the proposed second amended complaint across that line.” Panther Partners Inc. v. Ikanos Commc‘ns, Inc., 347 F. App‘x 617, 621 (2d Cir. 2009) (”Panther Partners III“) (quotation marks and brackets omitted). Specifically, we held, the 1PSAC “failed to allege plausibly that [Ikanos]
On remand, Panther moved for leave to file the 2PSAC, adding the allegations that Sumitomo Electric and NEC were Ikanos‘s two largest customers and that they accounted for 72% of Ikanos‘s revenues in 2005. Panther further alleged that, weeks before the Secondary Offering - when Ikanos was receiving an increasing volume of complaints from these customers - Ikanos knew it would be unable to determine which of the chip sets it sold them contained defective chips. In November 2010, the district court denied Panther‘s motion, again on the grounds of futility, finding that the 2PSAC failed to allege “‘additional facts that Ikanos knew the defect rate was above average before filing the registration statement.‘” Special App. at 4, 5 (”Panther Partners IV“) (quoting Panther Partners III, 347 F. App‘x at 622). Panther‘s new allegations regarding Sumitomo Electric and NEC, the district court reasoned,
have no logical connection to the issue of when Ikanos knew that the defect rate was above average. Although these customer demographics might shed light on whether any defect might potentially be problematic assuming the defect rate turned out to be above average, this does not satisfy the Second Circuit‘s road map - it is simply a detour.
Id. at 4.
STANDARD OF REVIEW
We review a district court‘s denial of leave to amend for abuse of discretion, unless the denial was based on an interpretation of law, such as futility, in which case we review the legal conclusion de novo. Starr v. Sony BMG Music Entm‘t, 592 F.3d 314, 321 (2d Cir. 2010). Futility is a determination, as a matter of law, that proposed amendments would fail to cure prior deficiencies or to state a claim under Rule 12(b)(6) of the Federal Rules of Civil Procedure. See Cortec Indus., Inc. v. Sum Holding L.P., 949 F.2d 42, 50 (2d Cir. 1991). In assessing whether the proposed complaint states a claim, we consider “the proposed amendment[s] . . . along with the remainder of the complaint,” Sony BMG, 592 F.3d at 323 n.3, accept as true all non-conclusory factual allegations therein, and draw all reasonable inferences in plaintiff‘s favor to determine whether the allegations plausibly give rise to an entitlement to relief. Iqbal, 556 U.S. at 678-80.
Sections 11 and 12(a)(2) of the Securities Act impose liability on certain participants in a registered securities offering when the registration statement or prospectus contains material misstatements or omissions.
One of the potential bases for liability under §§ 11 and 12(a)(2) is an omission in contravention of an affirmative legal disclosure obligation. Id. In this case, Item 303 of SEC Regulation S-K provides the basis for Ikanos‘s alleged disclosure obligation. The Regulation, as we have seen, requires registrants to “[d]escribe any known trends or uncertainties . . . that the registrant reasonably expects will have a material . . . unfavorable impact on . . . revenues or income from continuing operations.” Instruction 3 to paragraph 303(a) provides that “[t]he discussion and analysis shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.”
the key information that plaintiffs assert should have been disclosed is whether, and to what extent, the particular known trend, event, or uncertainty might have been reasonably expected to materially affect Blackstone‘s investments. . . . Again, the focus of plaintiffs’ claims is the required disclosures under Item 303 - plaintiffs are not seeking the disclosure of the . . . downward trend in the real estate market . . . . Rather, plaintiffs claim that Blackstone was required to disclose the manner in which th[at] then-known trend[], event[], or uncertaint[y] might reasonably be expected to materially impact Blackstone‘s future revenues.
We hold that the 2PSAC plausibly alleges that the defect issue, and its potential impact on Ikanos‘s business, constituted a known trend or uncertainty that Ikanos reasonably expected would have a material unfavorable impact on revenues or income from continuing operations. Like the 1PSAC, the 2PSAC alleges that, before the Secondary Offering, Ikanos was receiving an increasing number of calls from Sumitomo Electric and NEC alerting Ikanos to the fact that its chips were defective and were causing network failures. The 2PSAC also alleges that the “defect issues,” which were becoming “more pronounced,” were a “substantial problem for
The reasonable and plausible inferences from these allegations are not simply that Ikanos quite possibly would have to replace and write off a large volume of chip sets, but also that it had jeopardized its relationship with clients who at that time accounted for the vast majority of its revenues. It is true that, as alleged, Ikanos did not recall and undertake to replace all the chip sets until June 2006. Nor was the precise 25-30% chip failure rate determined until after the Secondary Offering. But neither of these facts undermines the plausible inference that, at a time when it was receiving an increasing number of calls from these customers and its Board of Directors was discussing the issue, Ikanos was aware of the “uncertainty” that it might have to accept returns of a substantial volume, if not all, of the chips it had delivered to its major customers. It goes without saying that such “known uncertainties” could materially impact revenues. See Litwin, 634 F.3d at 722.
In focusing on whether plaintiff alleged that Ikanos knew the defect rate was “above average” before the Secondary Offering, the district court construed the proposed complaint and our remand order too narrowly. See Panther Partners III, 347 F. App‘x at 622. Item 303‘s disclosure obligations, like materiality under the federal securities laws’ anti-fraud provisions, do not turn on restrictive mechanical or quantitative inquiries. See Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1318-19 (2011) (explaining that the problem with “bright-line” and “categorical” rules is that they “would artificially exclude information that would otherwise be considered significant to the trading decision of a reasonable investor” (brackets and quotation marks omitted)). If nothing else, the allegations pertaining to Sumitomo Electric and NEC altered the relevant inquiry, rendering a narrow focus on defect rates inappropriate. Under the new allegations in the 2PSAC, the defect rate was, in essence, 100% for all chips sold to clients representing 72% of revenues. These circumstances were not simply “potentially problematic” for the Company; they were very bad. Panther Partners III, 347 F. App‘x at 622. We have little difficulty concluding that Panther has adequately alleged that the disclosures concerning a problem of this magnitude were inadequate and failed to comply with Item 303.
The judgment of the district court is vacated, and the case remanded with instructions to grant Panther leave to file the 2PSAC.