Bass, Berry & Sims attorney Chris Lazarini provided insight on the Sixth Circuit’s affirmation of a lower court’s dismissal of a shareholder class action. The Court found that claims of corporate mismanagement are not covered by §10(b) of the Securities Exchange Act of 1934. The Court further found that while Plaintiffs alleged that Defendants had motive and opportunity to commit securities fraud, the allegations did not sufficiently allege scienter. Chris provided the analysis for Securities Litigation Commentator (SLC). The full text of the analysis is below and used with permission from the publication. If you would like to receive additional content from the SLC, please visit the SLC website to sign up for the newsletter.

Bondali vs. Yum! Brands, Inc., No. 15-5064 (6th Cir., 8/20/15) 

*Claims of corporate mismanagement are not covered by §10(b).

**Allegations of motive and opportunity to commit securities fraud alone are not sufficient to create a strong inference of knowing or reckless activity necessary to establish scienter. 

Defendant owns Taco Bell and KFC restaurants. Between 2010 and 2011, Defendant learned that chicken from one of its Chinese KFC suppliers tested positive for drug and antibiotic residues prohibited under Chinese law. Defendant terminated its relationship with the supplier and its parent entity, but did not disclose the test results or the supplier terminations to the public or regulators. In late 2012, Chinese media reported that Defendant was facing food safety issues with multiple suppliers. In the wake of the reports, Defendant’s stock price fell 17%, and Defendant, admitting that it had lost consumer confidence, stated that it no longer expected to achieve earnings per share growth in 2013. The district court dismissed the consolidated class action that followed, finding that Plaintiffs failed to allege a material misstatement or omission and failed to allege a strong inference of scienter. The Court agrees and affirms.

Plaintiffs alleged that Defendant’s regulatory filings were misleading because they portrayed food safety issues as potential risks, without disclosing the known testing results. The Court finds the risk disclosures not actionable because their purpose, by definition, is to warn investors about what may happen to their investment and not to educate investors on harms currently affecting the company. In addition, the Court finds that Plaintiffs failed to allege facts suggesting that the supplier issues were so widespread or severe that they would have resulted in a financial loss to Defendant. The Court notes that, while it must construe the allegations in the light most favorable to Plaintiffs, it does not have to speculate about facts not alleged.

Plaintiffs also alleged that the regulatory filings and Defendant’s statements following the media reports were misleading because Defendant described its safety protocols as “strict” when they were “woefully inadequate.” The Court finds Defendant’s description of its safety protocols not actionable because it was reasonably grounded in objective fact. That a few suppliers did not adhere to the protocols does not mean they did not exist, and the Court declines to interpret Defendant’s characterization of its protocols as anything more than an aspirational statement, and not a guarantee that all suppliers would, in all instances, abide by the protocols. At best, the Court concludes, Plaintiffs have raised a claim of corporate mismanagement regarding the efficiency of the protocols, not investor deception. Such a claim is not covered by §10(b) and Rule 10b-5.

Finally, the Court notes that a strong inference of scienter was not sufficiently alleged. While the complaint alleged that Defendant had the motive and opportunity to commit securities fraud, it failed to allege that senior officers or other agents knew or should have known that Defendant’s statements discussing investment risks or touting safety protocols were false or misleading. Absent a primary violation, the Court also affirms the dismissal of the control person claims.