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Mitzner v. Hastings

January 14, 2005

MILES L. MITZNER, PLAINTIFF,
v.
REED HASTINGS, W. BARRY MCCARTHY, JR., JAY C. HOAG, A. ROBERT PISANO, MICHAEL RAMSAY AND TIMOTHY HALEY, DEFENDANTS, AND NETFLIX, INC. NOMINAL DEFENDANT.



ORDER ON NOMINAL DEFENDANT'S AND INDIVIDUAL DEFENDANTS' MOTIONS TO DISMISS

INTRODUCTION

Plaintiff Miles Mitzner ("Mitzner") filed a shareholder derivative action on behalf of nominal defendant Netflix, Inc. ("Netflix" or "the Company") against its CEO, CFO, and four outside directors (the "Individual Defendants"). The Company has filed a motion to dismiss under Federal Rule of Civil Procedure 12(b)(6) for failure to comply with the "demand" requirement of Federal Rule of Civil Procedure 23.1. The Individual Defendants have filed a motion to dismiss under Rule 12(b)(6) for failure to state a claim for breach of fiduciary duty, insider trading based on material confidential information, and contribution and indemnification. Having considered the pleadings and relevant authority, the Court GRANTS the Company's Motion to Dismiss and dismisses the Individual Defendants' Motion to Dismiss as moot.

BACKGROUND

Netflix, a Delaware corporation with its principal place of business in Los Gatos, California, is an online movie rental subscription service. Individual Defendants, citizens and residents of California, include the CEO and CFO of Netflix as well as four outside directors of Netflix. Plaintiff Mitzner is a citizen and resident of Oklahoma and a shareholder of Netflix. Mitzner claims that the Individual Defendants caused the Company's shares to trade at artificially inflated levels by issuing false and misleading statements in the time period between October 1, 2003 and July 15, 2004 (the "Relevant Period"). The allegedly false and misleading statements concerned the Company's business prospects and financial condition, and more specifically, the Company's rate of "churn," a metric relating to loss of subscribers.

During the Relevant Period, Netflix issued financial results for the third quarter of 2003, the fourth quarter of 2003, the first quarter of 2004, and the second quarter of 2004. The reports contained the following information, in relevant part:

On October 15, 2003, the Company reported that it ended the third quarter of 2003 with a total of 1,291,000 subscribers, increasing from a total of 1,147,000 subscribers at the end of the second quarter of 2003. The Company also reported that it had acquired 282,000 new trial customers and that the churn rate was 5.2%.

On January 21, 2004, the Company reported that it ended the fourth quarter of 2003 with a total of 1,487,000 subscribers. The Company also reported that it had acquired 444,000 new trial customers and that the churn rate was 4.8%.

On April 15, 2004, the Company reported that it ended the first quarter of 2004 with a total of 1,932,000 subscribers. The Company also reported that it had acquired 760,000 new trial customers and that the churn rate was 4.7%.

On July 15, 2004, the Company reported that it ended the second quarter of 2004 with a total of 2,093,000 subscribers. The Company also reported that it had acquired 583,000 new trial customers and that the churn rate was 5.6%. In this report, the Company also provided data about subscriber cancellations that had not been provided in other reports. It reported 424,000 subscriber cancellations in the second quarter of 2004; 315,000 subscriber cancellations in the first quarter of 2004; and 232,000 subscriber cancellations in the second quarter of 2003.

On July 16, 2004, the day after the company issued its financial results for the second quarter of 2004, the share price of Netflix fell $8.98 per share, or 28.6%, to close at $23.02 per share. Subsequent to the July 15, 1004 announcement and the July 16, 2004 share price decline, various Netflix shareholder filed securities class action lawsuits alleging that Netflix and a number of its executives violated federal securities laws by failing to disclose the potential adverse effects of subscriber cancellations and by manipulating the calculation of customer churn. These actions (C-04-2978 FMS, C-04-3204 FMS, C-04-3233 FMS, C-04-3329 FMS, C-04-3770 FMS, C-04-3801 FMS, and C-04-3021 FMS) (the "Federal Class Actions") are currently pending before this Court.

In the present action, Mitzner claims that the Company and Individual Defendants improperly failed to provide information about subscriber cancellations in the financial reports submitted in the Relevant Period prior to July 15, 2004. Mitzner also alleges that the manner in which Netflix calculated churn was improper. Whereas Netflix calculated churn by dividing subscriber cancellations by the sum of subscribers at the beginning of the quarter plus new subscriber additions during the quarter, Mitzner contends that "actual churn" is calculated by dividing subscriber cancellations by the average number of customers during the quarter (beginning plus ending subscribers divided by two). Mitzner further claims that statements related to the rates of churn and the overall performance of the company made in these financial reports were false or misleading. For example, in the April 15, 2004 report, defendant Reed Hastings, CEO of Netflix, stated "Our strategy is paying off in terms of increased satisfaction, reduced churn, and faster growth."

Defendants contend that there were no false or misleading statements with respect to churn and subscriber cancellations. It states that the method of calculating churn was explained in a footnote on each quarterly report. Netflix also argues that while the number of subscriber cancellations was not included in the financial reports before July 15, 2004, this number could be calculated for each quarter using the numbers that were included in that quarter's financial reports (the number of subscribers at the beginning and end of each quarter, new subscriber additions, and the churn rate).

Mitzner's complaint asserts the following causes of action against the named officers and directors of Netflix: (1) breach of fiduciary duty by "failing in their oversight responsibilities" and "by making and/or permitting to be made material false and misleading statements"; (2) insider trading based on confidential information in violation of California Corporation Code ยง 25402 and Delaware Law; and (3) ...


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