District Of New Jersey Discounts Confidential Witness Allegations And Grants Education Company’s Motion To Dismiss In Securities Class Action
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  • District Of New Jersey Discounts Confidential Witness Allegations And Grants Education Company’s Motion To Dismiss In Securities Class Action

    On February 24, 2023, Judge Esther Salas of the United States District Court for the District of New Jersey granted a motion to dismiss a putative class action against a Beijing-based education company (the “Company”) and its CEO and CFO (the “Individual Defendants”).  The lawsuit alleged that the Company misled investors about its student enrollment figures in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5.  Wu v. GSX Techedu Inc., No. 20-cv-04457, 2023 WL 2207422 (D.N.J. Feb. 24, 2023).  Specifically, plaintiffs alleged that the Company artificially inflated its enrollment figures by creating fake student accounts.  In dismissing the action, the Court discounted the import of several purported confidential witness statements, demonstrating the rigor courts apply to such allegations, and held that the complaint failed to allege facts sufficient to give rise to a strong inference of scienter.

    The Company, based in China, specializes in online coursework and tutoring for students in grades K–12.  Plaintiffs alleged that the Company devised a scheme to overstate the size and growth of its enrollment and revenue using “bots,” “that is, fake internet personalities used to boost … enrollment figures.”  Plaintiffs additionally alleged that the Company misstated its teachers’ qualifications, its process for hiring teachers, the compensation structure for its teachers, and the reasons for differences between its filings with the Securities Exchange Commission (“SEC”) and China’s State Administration for Industry and Commerce (“SAIC”).  Plaintiffs also alleged that the Company failed to disclose that it contracted with related parties to hire employees to falsify student enrollment figures through the use of bots and fake identities.  Finally, plaintiffs alleged that the Company falsely denied reports published by a number of short-sellers (the “Short-Seller Reports”) that suggested the Company was failing to comply with legal and regulatory requirements.

    The Court first held that certain categories of misstatements were not actionable for failure to plead falsity, mainly on the grounds that several confidential witnesses were not alleged to have been in a position to know of the supposed untruths.  The Court first held that alleged misstatements about the Company’s teacher compensation and hiring process were not supported because the confidential witnesses were not in a position to know about the Company’s compensation structure and hiring process, either because of the positions they held or the dates of their employment.  As to one of the confidential witnesses, for example, the Court observed that the complaint did not allege any dates of employment.  The Court also held that certain other confidential witnesses did not provide statements that supported plaintiffs’ allegations or were not employed during the relevant period.

    With respect to the claim that the Company entered into related-party transactions with companies that hired employees to falsify data, the Court held that plaintiffs did not plead with particularity facts supporting the allegation that the new hires were contracted to falsify student enrollment figures through the use of bots and fake identities.  For example, plaintiffs alleged that one of the alleged related parties was using a fake business address because job postings by the company used the Company’s address, while another company that was hired shared an IP address with the Company.  The Court held that the complaint nevertheless failed to allege how these alleged related parties were connected to enrollment figures.  The Court also held that plaintiffs’ claims based on alleged discrepancies between the Company’s SEC and SAIC filings and the Company’s statements regarding its compliance with legal and regulatory requirements in response to the Short-Seller reports were deficient because the allegations were conclusory and, as to the differences between the different regulatory filings, did not address defendants’ arguments based on accounting differences that were required in each of the filings.

    With respect to the remaining alleged misrepresentations, the Court held that plaintiffs failed to “plead with particularity circumstantial evidence supporting an inference of scienter.”  Plaintiffs argued that the Individual Defendants’ denials of the fraudulent scheme in response to the Short-Seller Reports supported a strong inference of scienter, citing the Third Circuit’s decision in Institutional Investors Group v. Avaya, Inc., 564 F.3d 242, 253 (3d Cir. 2009).  According to plaintiffs, Avaya held that scienter could be alleged sufficiently by showing specific denials of a fraudulent scheme by a defendant who holds a senior position if warranted by the alleged state of the business.  The Court disagreed, noting that Avaya “did not state that direct denials of fraudulent conduct on their own constitute strong evidence of scienter.”  Rather, the “direct denials” in Avaya “strongly supported scienter in light of the particularized facts alleged in that case, which provided circumstantial evidence supporting how the defendant would have or should have been apprised of the alleged fraudulent scheme and the risk that his confident, unhedged denials … would mislead investors.”  The Court noted that (i) the Individual Defendants’ denials were not “unqualified” or “unhedged” and “included specific reasons why they believed the alleged fraudulent conduct was not happening,” and (ii) plaintiffs failed to allege “particularized circumstantial evidence that the Individual Defendants knew or should have known that those direct denials were false.”

    The Court dismissed the action without prejudice and granted plaintiffs leave to file an amended complaint.

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