Tuesday, January 04, 2022

First Circuit gives shareholders a second bite at Carbonite

By Rodney F. Tonkovic, J.D.

A First Circuit panel has reversed and remanded the dismissal of a fraud complaint against Carbonite, Inc. In this case, company executives spoke highly of a new backup product while allegedly knowing that it did not work; the product was withdrawn from the market after less than one year. The district court found that the complaint failed to plead scienter, but the panel disagreed, reversing the dismissal after finding that the complaint showed that Carbonite's CEO and CFO made material misrepresentations with scienter (Construction Industry and Laborers Joint Pension Trust v. Carbonite, Inc., December 22, 2021, Kayatta, W.).

Buggy back up. In October 2018, Carbonite launched a new data-backup product called "Server VM Edition" ("VME"). For several months after the launch, Carbonite executives, including its CEO and CFO, publicly promoted VME as a strong product that would make Carbonite competitive in the market for backing up virtual environments. According to the complaint, however, VME simply never worked: there were no successful backups during prerelease testing and there were no successful backups of customer data. Following the launch, the complaint avers, Carbonite set up an internal team focused on fixing VME, and a large patch and "hundreds" of bug fixes were released. By the summer of 2019, Carbonite had internally decided to stop selling VME.

On July 25, 2019, Carbonite announced that VME was being withdrawn from the market. At the same time, Carbonite announced its results and projections, and also disclosed that the CEO had resigned, effective immediately. A stock price drop followed, and this suit was filed soon after, seeking recovery under the antifraud provisions of the Exchange Act. The district court dismissed the complaint with prejudice, finding that the complaint never successfully alleged that, at the time they made their statements, the CEO and CFO did not reasonably believe that VME's problems could be fixed.

Reversed and remanded. On appeal, the shareholders argued that 12 statements made by the CEO and CFO were materially false and misleading, and the panel agreed. The appeal focused most prominently on statements made on November 1 and 15 by the CEO and CFO, respectively, stating that VME was a strong and competitive backup product. The court first explained that the CEO's statement implied that VME offered better performance for backing up virtual environments and could thus be taken as a statement of fact—one that was false in light of the claim that VME could not back up virtual environments at the time. The CFO's statement, on the other hand, was presented as a belief: "we think" VME is competitive and a strong product. The court said that this statement still conveyed the facts that the CFO believed that VME was "strong" and "competitive," which was at odds with the actual state of the product. The court added that these statements were material because VME was, as the officers themselves said, an important product for Carbonite.

The panel also disagreed with the district court's finding that the complaint failed to plead a strong inference of scienter. The crux of the shareholder's argument was that Carbonite must have known that VME did not work because of its importance to the company. The panel pointed out that Carbonite thought VME was important enough to warrant specific plugs from top management, creating a "very strong" inference that the executives would have been paying close attention to the product's status. And, the complaint showed that the CEO and CFO could not have been in the dark about VME's status since employees had reported internally that the product was far from ready for the market.

The court accordingly found that the complaint sufficiently alleged that the statements of the CEO and CFO were material misrepresentations made with scienter. The judgment of the district court granting the motion to dismiss was reversed and remanded for further proceedings.

The case is No. 20-2110.