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Netflix (NASDAQ:NFLX), the largest SVOD provider in the world with more than 150 million global subscribers has run into legal trouble with a host of its disaffected investors. The fallout has occurred over the dismal results in the second quarter which deviated significantly from the company's guidance in its April 17 note to investors - which forecast roughly 5 million more subscriber additions in the second quarter but only managed 2.7 million and lost 126,000 in the US as revealed in the second-quarter earnings call.
Some investors have lawyered up and are calling this an act of misrepresentation and fraud. A class-action lawsuit has been filed and Rosen Law Firm among others has notified investors to apply as a class member before the 20th of September. Shares of Netflix were down 1.02% on the 30th of August since the announcement of the suit. We bring you the full picture as well as a prognosis of the case as it develops and the likely outcome.
So far this present case has the makings of a frivolous suit or the actions of particularly disgruntled investors seeking a remedy without a cause of action (a legal right accruing or for whose violation remedy is available in the court of law). If the investors were to succeed in their action, it would set a very ugly precedent where companies are made liable for speculation as to their future performance. This would have catastrophic implications for the whole of the modern economy. For the detail on the legal basis they are filing under, see below.
Netflix's Tussle with the Law - Explained
Fundamentally Netflix's legal liability in the current context is governed by a trio of U.S. federal legislations - The Securities Act of 1933, The Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995. The first two acts were part of Roosevelt's "New Deal", which established federal regulatory oversight over the sale and purchase of securities in the primary market - where they are issued for the first time (previously the domain of state "blue sky" laws) , the second act following a year later was enacted to extend the provisions and regulatory principles of the act of 1933 to secondary capital markets - where the securities are traded as a standardized instrument.
The third act significantly overhauled the procedural rules regarding the anti-fraud provisions in the acts of 1933 and 1934. The former two acts - forming the backbone of securities regulation in the US - inter-alia provide for disclosure of relevant and material information by entities offering securities for sale for the benefit and protection of the investor and scrutiny of the regulatory authority - the Securities Exchange Commission - established by the act of 1934 for the secondary capital markets as well as offer a legal remedy against fraudulent practices by such entities.
The act of 1933 requires that a registration statement (which includes the prospectus of the company) be filed at the time of floating any security in the primary market as well as near strict (liable as a rule with almost no exceptions, merely on proving material misrepresentation in the statement) personal civil liability of the auditors, issuers, underwriters, officers of the company and the accountants.
However it is important to understand that this is not what the current case is about - the shareholders are suing under section 10b and 20 of the act of '34, specifically the liability which arises under rule 10b-5. Said rule provides individual investors a private right to sue for having been defrauded by the company. The company becomes liable when the following has been alleged and proven :
- The company has indulged in material misrepresentation or fraud;
- The Company had the intent or the knowledge to commit such fraud;
- "in connection with the purchase or sale of security";
- The victimized party relied upon the fraudulent representation;
- Suffering economic loss as a consequence.
Now it is of the essence to notice that to file a complaint and obtain discovery (the written documentation and depositions of witnesses as evidence) from the defendant the court would need to find the facts contained in it to be sufficient for the conditions under 10b-5. Prior to the passing of the third act, the PSLRA,'95, the question of what the standard for dismissal should be for the application to survive and proceed further to discovery had been very heavily litigated in the courts.
The defendant would file a motion to dismiss stating that even if the facts were to be assumed to be true, no liability would arise as a consequence. This question was settled by congress by passing the act of '95 which provides for inter-alia the standard necessary for the complaint to survive the motion to dismiss - the pleading standard - which would play a big part in determining whether the case against Netflix proceeds further and whether the court approves the class certification.
Misleading The Court?
On considering the requirements under the act of '95 and the complaint filed by Rosen Law Firm (counsel for plaintiff), it is hard to see any viable case for damages. The PSLRA requires that :
False statements pleaded particularly and specifically - the statements alleged to have been fraudulent have to be specifically identified and the reasons leading to the belief that they are fraudulent to have to be mentioned. The complaint as available fails to provide any reason as to why it is believed the statements from the letter dated April 17 are fraudulent - only that supposedly the alleged wrongdoers knew beforehand that the targets would not be met. This is a claim made without adducing any manner of evidence as to why Netflix's CEO or CFO would have had definitive knowledge about a prospective matter.
The pleading must create a strong sense of "Scienter" or "Mens Rea" - These terms refer to intention or knowledge as to the act purported to be fraudulent. Essentially that the alleged wrongdoers knowingly and with intent failed to disclose material information or made fraudulent representation. Again the complaint as filed does not disclose any reasons as to why the executives would have known and how the Plaintiff's (the party bringing the suit) now know that material knowledge about the future was deliberately concealed (or indeed how "knowledge" about a future forecasted event could be alleged to have been concealed). It simply alleged that on June 17 ( a month after the April 17 guidance) the second-quarter earnings supposedly "revealed the truth". Implying that this information had been kept from the investors in the April letter - which seems fairly implausible considering this was simply the result of moving forward in time and obtaining the actual market data as it happened.
The plaintiff must prove loss causation - The party seeking damages and the legal remedy must prove that the loss was specifically caused by the particular deceptive representations made by the defendant, in this case, Netflix. Again the complaint does allege that investors who purchased shares of Netflix between April 17 and June 17 have been defrauded but forward-looking statements made by companies are protected under PSLRA and are marked by the use of words like "project", "believe", and other such words indicating a future projection which is subject to change and not guaranteed to occur as forecast. The April 17 note as issued by Netflix does make use of forward-looking terminology.
Ultimately the act of '95 was passed precisely to curb excessive and frivolous filing of suits without any merit merely to force discovery of the defendant and to hope that something falls through the cracks and comes to light which aids the plaintiff in making a quick buck. The costs associated with such proceedings also might force the defendant company to simply settle out of court than to fight and win.
Stay tuned as Wccftech brings to you the details of the case as it develops.