United States District Court, N.D. California
November 18, 2005.
IN RE NETFLIX, INC. SECURITIES LITIGATION.
The opinion of the court was delivered by: WILLIAM ALSUP, District Judge
In this securities-fraud case, defendants move for dismissal of
plaintiffs' first amended consolidated complaint (hereinafter
"complaint") and for judicial notice of certain documents. The
request for judicial notice is unopposed and is GRANTED.
Because plaintiffs have failed to allege any false statements or
material omissions, the motion to dismiss for failure to state a
claim is GRANTED. Leave to amend previously being allowed, the
case is over at the district court. This time the dismissal is
without leave to amend.
Lead plaintiffs are four investors who purchased publicly
traded shares of securities in Netflix, Inc., a corporation based
in Los Gatos, California, that sold monthly subscriptions
allowing people to order DVDs on the Internet and to receive them
They allege that they purchased shares at prices that were
inflated by fraud committed by Netflix and three of its officers:
Reed Hastings, chief executive officer and board of directors chairman, Barry McCarthy, chief financial officer and
secretary, and Leslie Kilgore, chief marketing officer and
marketing vice president.
Lead plaintiffs claim that from April 17, 2003, to October 14,
2004, defendants made false and misleading statements, and failed
to disclose material facts required to make their other
statements not misleading. They allege such statements came in
press releases issued on wire services, in Securities and
Exchange Commission filings, in public presentations and in
telephone conference calls with investors and analysts. They
charge defendants with using a misleading calculation of the
average subscriber cancellation rate, also called "churn." That
metric was in turn used to calculate other financial measures.
Plaintiffs allege that investors relied upon these measures in
overvaluing the securities. Defendants do not contest that the
measures are material. The contested measures made Netflix appear
to be viable. In fact, say plaintiffs, the company's business
model was broken.
1. JUDICIAL NOTICE.
Defendants have asked for judicial notice of certain SEC
filings, calculations based upon information in those filings,
Netflix press releases and a publication on churn published by
the audit firm KPMG and referenced in the complaint (Defs.' Req.
for Judicial Notice).
A court must take judicial notice of adjudicative facts if a
party requests that it do so, supplies the necessary information
to decide the request and the facts are "not subject to
reasonable dispute" because they are "capable of accurate and
ready determination by resort to sources whose accuracy cannot
reasonably be questioned." FRE 201 (a), (b), (d).
The time has passed for plaintiffs to raise objections to
defendants' request. They have not done so. Defendants have met
the FRE 201 requirements. The documents are relevant to the
complaint. This order therefore takes notice of those facts.
2. PUBLIC STATEMENTS BEFORE THE CLASS PERIOD.
As Netflix was preparing to make its initial public offering of
securities, it notified the SEC on April 16, 2002, that "an
average of approximately 8% of  total subscribers cancelled
their subscriptions each month" in the twelve-month period that
had ended March 21. It repeated that statement to the SEC on May
6. Two weeks later, the company reported a similar cancellation rate for calendar year 2001. It further stated that
for the first quarter of 2002, the cancellation rate per month
was about seven percent, down from about ten percent in the first
quarter of 2001. Netflix repeated most of these statements in its
IPO Prospectus filed May 23, 2002 (Compl. ¶¶ 92, 94, 95). In
these statements, the corporation provided no definition of
On July 24, 2002, the company released a statement that churn
had declined to 6.7 percent. In an endnote linked to the first
mention of churn, the term was defined as "a monthly percentage
determined by subtracting from one, a quotient, the numerator of
which is the ending subscribers for the current quarter and the
denominator of which is the sum of the previous quarter's ending
subscribers plus the current quarter's new trial subscribers and
then dividing this resulting number by 3, which is the number of
months in the quarter." That formula was repeated in the
corporation's quarterly SEC filings for the second and third
quarters of 2002 (Hoffman Decl., Exhs. A, B, G).
3. ALLEGED FRAUD DURING THE CLASS PERIOD.
The first allegedly false statement made during the class
period came April 17, 2003, when the company announced that its
first quarter 2003 churn rate was a "record low" of 5.8 percent,
down from 7.2 percent a year earlier (Hoffman Decl., Exh. H). The
release also stated that "implied subscriber lifetime" the
average duration of subscriptions was defined as the inverse of
the reported churn rate.[fn*] The release's tabular material
containing the churn rate purportedly was "unaccompanied by, and
was not preceded by, any definition of how the churn rate was
calculated" (Compl. ¶¶ 104-05). That claim is untenable. The July
24, 2002, press release and the quarterly reports for the second
and third quarters of 2002 each disclosed how churn was
determined. This order takes judicial notice of those documents.
Also on April 17, Hastings and McCarthy spoke by conference
call with analysts. Hastings touted the company's "lowest churn
rate in [its] history," repeated the churn statistics for the
quarter, stated that the decrease was related to improving
customer satisfaction and credited the low churn rate with playing a central role in
"enabling [Netflix] to build a bigger and more profitable
business." He also stated that customer retention "is the just
the numeric inverse on churn." McCarthy stated that the churn
rate was one of the "trinity of metrics" guiding Netflix to
financial success (Compl. ¶ 106).
This news propelled average share price twenty percent higher
over the next two days, to $24.63, on volume five times its
normal level (Compl. ¶ 112).
Hastings repeated the churn-rate figures in a public
presentation at the Wharton School of Business at the University
of Pennsylvania on May 1, 2003, and three days later by Netflix
in its first-quarter SEC report. Tabular material in that filing
included a line listing the churn rate followed, on the next
line, by the average number of paid subscribers during the
quarter. The latter line was indented so that it appeared to be a
sub-component of the churn rate. No definition of churn was given
(Compl. ¶¶ 115, 117).
On July 17, 2003, Netflix announced that its churn rate was 5.6
percent in the second quarter. The term "churn" was followed by a
superscript numeral that led readers to an endnote definition
identical to earlier ones. Again, Hastings and McCarthy spoke by
conference call with analysts and touted the importance of
declining churn (Compl. ¶¶ 119, 120, 122).
On October 15, 2003, Netflix announced another churn-rate
decline, to 5.2 percent, and again defined the term. This time,
it was defined "as customer cancellations in the quarter divided
by the sum of beginning subscribers and gross subscriber
additions, divided by three months." This definition is
functionally identical to the more formal one given earlier.
Hastings and McCarthy hailed the results in a quarterly
conference call. Hastings said good service drove churn down.
McCarthy called churn a "primary driver" of financial
performance," and partly attributed its decline to an increase in
the number of movies Netflix's offered for rental (Compl. ¶¶ 124,
In an interview October 23, 2003, Hastings was asked by The
Motley Fool magazine how long the "median customer is maintaining
his Netflix membership?" Hastings responded by stating that the
"mean customer life" was "roughly one divided by the churn," a
definition identical to that previously applied to "implied
subscriber lifetime" (Compl. ¶ 129). On January 21, 2004, the company announced the churn had fallen
to 4.8 percent in the fourth quarter of 2003. It repeated the
definition of churn (Hoffman Decl., Exh. J). This achievement was
trumpeted in a conference call to analysts. On March 1, the
company repeated these results and the churn definition in SEC
filings. It ascribed the lower rate to an increase in the
proportion of longer term subscribers to new subscribers, and to
service improvements (Compl. ¶¶ 138-39, 143).
On March 29, the stock price bounced almost ten percent, to
$31.87 per share (Compl. ¶ 145).
On April 15, 2004, Netflix released another quarter's results.
"Record low churn" was at 4.7 percent. Netflix again defined the
term. At the same time, however, it raised monthly subscriptions
from $19.95 to $21.99 (Compl. ¶ 146). That same day, Hastings
told analysts that the churn rate was Netflix's best indicator of
customer satisfaction, and predicted that it would dip below four
percent in 2005 (Compl. ¶¶ 146-47).
The following day, Netflix's share price stumbled, falling
$6.27, to $30.75. In a television interview that day, Hastings
predicted that churn would increase slightly in the next quarter,
followed by a steep drop. On May 3, 2004, Netflix reported these
results to the SEC (Compl. ¶¶ 150-52).
On July 15, 2004, Netflix released second-quarter results.
Churn had sprung up to 5.6 percent. Netflix directly disclosed
the number of customer cancellations in the second quarter of
2003, and the first two quarters of 2004. Investors had
previously been able determine such figures only by algebraic
equation. Share price tanked after this announcement, falling
from $32 to $20 over the next two days (Compl. ¶¶ 158, 160). The
5.6 percent churn figure was reported to the SEC on July 30.
On October 14, 2004, the last day of the class period, Netflix
announced that it was delaying plans to expand into the United
Kingdom, downgraded its earnings forecast from $80 million to
zero and retreated from its higher prices, dropping basic service
to $17.99 per month. Churn had stayed at 5.6 percent in the
previous quarter. Netflix defined the term yet again. On October 15, 2004, Netflix stock cratered, falling to $10.30 per
share and losing forty-one percent of its value.
4. PROCEDURAL HISTORY.
The first securities-fraud action in this case was filed July
22, 2004. A consolidated complaint came six months later. Judge
Fern Smith dismissed that complaint June 23 for failure to state
a claim, ruling that Netflix's churn rate was not false and that
investors were able to calculate the rates preferred by
plaintiffs using numbers Netflix provided during the class
period. She also stated that plaintiffs had not alleged a strong
inference of scienter. The complaint was dismissed with leave to
amend (Order Granting Defendants' Mot. To Dismiss 8-9, 11-12, 13,
hereinafter "Smith Order"). A new, amended complaint was filed
entitled "First Amended Consolidated Complaint." Defendants
responded with the instant motion to dismiss pursuant to Federal
Rule of Civil Procedure 12(b)(6).
Section 10(b) of the Securities Exchange Act of 1934 provides,
in part, that it is unlawful "[t]o use or employ, in connection
with the purchase or sale of any security . . . any manipulative
or deceptive device or contrivance in contravention of such rules
and regulations as the [Securities and Exchange] Commission may
prescribe." 15 U.S.C. 78j(b).
SEC Rule 10b-5 bars any person from using interstate commerce
to (1) employ "any device, scheme, or artifice to defraud, (2)
make any untrue statement of a material fact or to omit to state
a material fact necessary in order to make the statements made,
in light of the circumstances under which they were made, not
misleading, or (3) to engage in any act, practice, or course of
business which operates or would operate as a fraud or deceit
upon any person, in connection with the purchase or sale of any
security." 17 C.F.R. 240.10b-5.
A party can only be held liable under Section 10(b) and Rule
10b-5 for a false statement or omission if there is "(1) a
misstatement or omission (2) of material fact (3) made with
scienter (4) on which [plaintiffs] relied (5) which proximately
caused their injury." DSAM Global Value Fund v. Altris Software,
Inc., 288 F.3d 385, 388 (9th Cir. 2002). Section 20(a) of the Securities Exchange Act of 1934 allows
imposition of joint and several liability on persons who directly
or indirectly control a violator of the securities laws.
15 U.S.C. 78t(a). Plaintiffs claiming that someone is a "controlling
person" must allege that (1) he or she had the power to control
or influence the company, (2) he or she was a culpable
participant in the allegedly illegal activity, and (3) the
company violated federal securities laws. See Durham v. Kelly,
810 F.2d 1500, 1503-04 (9th Cir. 1987).
Securities-fraud plaintiffs must meet demanding pleading
requirements. The Private Securities Litigation Reform Act
requires them to specify each misleading statement, why the
statement was misleading and, if an allegation is made on
information and belief, all facts upon which that belief is
formed. 15 U.S.C. 78u-4(b)(1). The complaint must also state with
particularity facts giving rise to a "strong inference" that the
defendant knowingly or with deliberate recklessness made false
statements or omitted a material fact. 15 U.S.C. 78u-4(b)(2); In
re Silicon Graphics Securities Litig., 183 F.3d 970, 977
(9th Cir. 1999).
These PSLRA requirements are in "inevitable tension [with] . . .
the customary latitude granted the plaintiff on a motion to
dismiss under Fed.R.Civ.P. 12(b)(6)." Gompper v. VISX, Inc.,
298 F.3d 893, 896 (9th Cir. 2002). In considering whether to
dismiss a securities-fraud claim, a court is not required to draw
all reasonable inferences in the plaintiffs' favor, as it is for
most 12(b)(6) motions. See Usher v. City of L.A., 828 F.2d 556,
561 (9th Cir. 1987) (stating 12(b)(6) standard). The court
instead must consider all reasonable inferences, whether
unfavorable or favorable to the plaintiffs. Gompper,
298 F.3d at 896. The court is not required, however, "to accept legal
conclusions cast in the form of factual allegations if those
conclusions cannot reasonably be drawn from the facts alleged."
Clegg v. Cult Awareness Network, 18 F.3d 752, 754-55 (9th
Cir. 1994). Rule 12(b)(6) requires dismissal when it appears
beyond doubt that plaintiff can prove no set of facts to support
a claim entitling him to relief under a cognizable legal theory.
Conley v. Gibson, 355 U.S. 41, 46 (1957); Balistreri v.
Pacifica Police Dept., 901 F.2d 696, 699 (9th Cir. 1990).
When the claim alleges false statements and is subject to the
PSLRA, it must appear beyond doubt that plaintiff cannot prove a
strong inference that defendants knowingly made false statements, or made them with
reckless disregard for the truth.
1. PLAINTIFFS' ALLEGATIONS.
Plaintiffs claim that defendants' statements about churn, and
defendants' failure to provide certain other information related
to churn, were false or misleading for several reasons.
First, plaintiffs claim defendants did not disclose that
Netflix's churn calculation and derivative financial measures
were "inaccurate . . . illogical . . . and . . . unconventional."
Instead, defendants allegedly led investors to believe that the
churn rate was one of the more commonly used methods discussed
below. The measures derived from the churn rate were the average
duration of subscriptions ("average subscriber lifetime") and the
average amount of money earned per subscriber ("subscriber
lifetime value," equivalent to the "average subscriber lifetime"
in months multiplied by the average monthly subscription cost)
(Compl. ¶¶ 24, 107).
Second, Hastings attributed the decrease in churn to Netflix's
"strategic focus on improving the Netflix user experience." He
thus drew an allegedly false causal connection between increased
customer satisfaction and lower churn, when in fact the lower
churn was due in part to Netflix's unique method of computing
churn (Compl. ¶ 108).
Third, defendants computed "average subscriber lifetime" as the
inverse of the reported churn rate. Plaintiffs claim that this
was false because the usual measure of "average subscriber
lifetime" bears no such relationship to Netflix's method. In
drawing the analogy between the two rates here, defendants
allegedly misled the market into believing that its financial
measures were identical to those commonly used by other
subscription businesses (Compl. ¶ 110). Furthermore, plaintiffs
allege that although the inverse of its "true churn" rate
(described below) is a fair estimate of "average subscriber
lifetime", the inverse of Netflix's churn rate is a less accurate
estimate, and thus misled investors (Compl. App. A at 14).
Fourth, defendants used "average subscriber lifetime" to
calculate revenue, operating income, and earnings before
interest, taxes, depreciation and amortization (EBITDA).
Plaintiffs reason that, because the "average subscriber lifetime"
figure was misleading, these further measures based on it were
also misleading (Compl. ¶ 111). Fifth, plaintiffs allege that defendants "buried" their churn
definition in press releases and SEC filings, and sometimes
obscured it by not stating it in "plain-English" (Compl. ¶ 121).
In short, "having cleverly redefined commonly-understood
financial measures [defendants] nevertheless stated and discussed
those measures in a manner designed to suggest that their
definitions accorded with the commonly-understood definitions"
(Compl. ¶ 118).
Plaintiffs assert that defendants should have calculated churn
in one of two ways:
1. The number of cancellations in the month divided
by the number of subscribers at the month's start.
This is the method described by KPMG.
2. The number of cancellations in the month divided
by the average number of subscribers at any one point
during the month. Plaintiffs call this "true churn."
Instead, Netflix determined monthly churn as the number of
cancellations during the quarter divided by the sum of
subscribers at the beginning of the month and gross subscriber
additions, with the result divided by three.
Plaintiffs assert that their preferred methods are the industry
standards. They claim that Netflix's redefinition of those terms
was false and misleading because the new churn calculation did
not reasonably express the relative propensity of subscribers to
terminate their service. They also claim that Netflix's failure
to disclose the proper rates was a material omission that made
its other statements misleading (Compl. ¶¶ 49, 70, 161, 201; Opp.
4). Plaintiffs concede that there is no generally accepted
accounting principle (GAAP) for churn rates (see, e.g., Compl ¶
In addition, plaintiffs allege that Netflix's calculation
yielded lower (i.e., better) churn rates than did the "true
churn" method, and thus created a false impression of success.
During the class period, the Netflix method produced rates that
were 1.94 percentage points to 1.19 percentage points lower than
"true churn." These differences produced a discrepancy in
"average subscriber lifetimes" between the two methods. The
"average subscriber lifetime" calculated using Netflix's churn
rate was 3.6 months to 5.1 months longer (i.e., better) than
that derived from "true churn." For example, it was 21.4 months
under the Netflix method and 16.3 months under "true churn" during the first quarter of 2004. The
degree by which the Netflix method produced a lower churn rate
increased in periods when the company added many new subscribers.
This was significant because, during the class period, Netflix
was acquiring as many as 760,000 new subscribers per quarter
(compared with 1.5 million at the beginning of that particular
period). Furthermore, during one quarter of the class period, the
Netflix method produced a decline in the churn rate while the
"true churn" method above produced an increase (Compl. ¶¶ 46, 60,
Plaintiffs also claim that defendants "never once gave notice
to investors that their reported measures of `average subscriber
lifetime' and subscriber lifetime value were derived from their
novel `churn rate.'" This, however, is contradicted within the
complaint, where plaintiffs reproduce a table in Netflix's April
17, 2003, press release, defining "implied subscriber lifetime
(months)" as the "reciprocal of reported churn" and, in turn,
describing the calculation method for implied lifetime revenue as
"implied subscriber life multiplied by monthly subscription
charge" (Compl. ¶¶ 80, 105; Hoffman Decl., Exh. H at 9) (emphasis
Plaintiffs claim that despite using a novel churn-rate method,
defendants discussed it and its derivative measures as if they
were the calculations commonly used in the industry. They note
1. Netflix's Form 10-Q report to the SEC for the first quarter
of 2003 included a line of tabular data for "[a]verage paid
subscribers during period" immediately below a line on
"[s]ubscriber churn (monthly)." This lower line was indented, as
if it were a sub-component of subscriber churn (see Compl. ¶
117). It looked like this:
Three months ended
March 31, 2002 March 31, 2003
Subscriber churn (monthly) ......................................7.2%............5.8%
Average paid subscribers during period ............481 .............903
Average paid subscribers year to year change.......78% .............88%
In fact, the average number of paid subscribers was not an
input to the churn calculation. That calculation depended instead
on the number of subscribers at the beginning of the quarter,
plus gross additions during the quarter. 2. Although defendants knew the mean duration of a
subscription, they instead presented the inverse of the churn
rate as the "average subscriber lifetime" in conversations with
analysts, as on April 17, 2003 (Compl. ¶ 110).
3. When apparently discussing churn, Hastings talked about
"retention" going to an all-time high, thus allegedly invoking
the more common definition of that term as the inverse of the
"true churn" rate. McCarthy did the same (Compl. ¶¶ 125, 139).
4. When discussing the churn rate during the third quarter of
2003 in a call with analysts, Hastings described the significance
of the quarter's decline in churn from 5.6 percent to 5.2
percent. He stated: "[P]lus or minus . . . 0.2 [percentage
points] is statistical noise. . . . [Y]ou're talking about 3,000
or 4,000 people out of 1.3 million staying or not staying gets
you 0.2 [percentage point differences in the churn rate]. So
factoring that in, it still is a statistically significant
difference going from 5.6 [percent churn] to 5.2 [percent
churn]." At the end of the third quarter of 2003, 1.3 million
subscribers remained with Netflix. That figure, however, was not
an input in Netflix's churn calculation. Plaintiffs claim
Hastings nevertheless was discussing the figure so as to suggest
subtly that Netflix's churn calculation was based in part that
1.3-million figure, as the "true churn" rate would have been
(Compl. ¶¶ 126).
5. An interviewer apparently misunderstood how Netflix
calculated the churn rate yet Hastings did not correct him
(Compl. ¶¶ 126, 130-31).
In addition to alleging that Netflix's statements were false,
plaintiffs also allege that defendants' purported decision to
deceive investors was an "act, practice, or course of business
which operates or would operate as a fraud or deceit upon any
person, in connection with the purchase or sale of any security,"
barred by 17 C.F.R. 240.10b-5.
All analysts covering Netflix during the class period appear to
have adopted defendants' churn rates in making their own
calculations of "average subscriber lifetime" and average
subscriber lifetime values (Compl. ¶¶ 82, 83, 133).
2. NO FALSE STATEMENT, MATERIAL OMISSION OR FRAUDULENT
At the beginning of the class period, defendants' definition of
churn already had been properly disclosed (see Hoffman Decl.,
Exhs. A (second quarter 2002 SEC report), B (third quarter 2002 SEC report) and G (July 24, 2002, press release)).
This definition was repeated during the class period on July 17,
2003 (Netflix press release), October 15, 2003 (press release),
January 21, 2004 (press release), March 1, 2004 (SEC fourth
quarter 2003 results), April 15, 2004 (press release), July 30,
2004 (SEC filing) and October 14, 2004 (press release). In short,
it was reported every quarter. Given Netflix's regular disclosure
of the calculation method in its nationally distributed press
releases and in SEC filings, defendants cannot be said to have
failed to disclose this material information.
Furthermore, the raw data that would have allowed investors and
analysts to calculate churn using the methods preferred by
plaintiffs were disclosed by Netflix (e.g., Hoffman Decl. Exhs.
J, K (containing number of subscribers at beginning and at end of
first quarter 2004, and new subscribers acquired during period)).
See Werner v. Werner, 267 F.3d 288, 299 (3d Cir. 2001)
(affirming dismissal of 10b-5 claim where "the shareholders had
access to all the information necessary to calculate the exact
amount of the benefit management incurred" in the challenged
transaction.); Acme Propane, Inc. v. Tenexco, Inc.,
844 F.2d 1317, 1323 (7th Cir. 1988) (no fraud where defendant
disclosed the relevant numbers and the necessary calculation to
produce the ratio at issue).
Plaintiffs do not allege that defendants' used bogus figures to
calculate the Netflix churn rate nor that the calculations were
done improperly. Their complaint is that other, more common
methods would have been more predictive, descriptive and
consistent. They claim that the other methods are so superior and
the Netflix methods so deeply flawed that using them amounts to
This is not a case in which defendants used one calculation
method when another is mandated by industry practice, generally
accepted accounting principles or federal securities regulations.
As noted above, plaintiffs concede that there is no GAAP for
churn rates. Plaintiffs themselves suggest that no method is
generally accepted as superior, citing a study that found that,
among the companies taking in ninety percent of U.S. wireless
telephone revenue, forty-one percent of them used the KPMG
formula and fifty-nine percent used the "true churn" method (Compl. ¶ 50). Plaintiffs cite no statute or
SEC regulation barring Netflix from reporting its type of churn
It is true, of course, that a public release, filing or
prospectus can be misleading even though every sentence therein
is literally true. SEC v. C.R. Richmond & Co., 565 F.2d 1101,
1106-07 (9th Cir. 1977). But here the critical key to
understanding defendants' methodology was adequately and
repeatedly disclosed. They did not need to repeat this
information in telephone calls with analysts because the
information already was available in press releases and filings
with the SEC.
The company's Form 10-Q for the first quarter of 2003 could
have been indented differently to reflect more clearly the
independence of subscriber churn rates and the number of average
paid subscribers during the period. The failure to be that clear
does not rise, however, to the level of being false and
misleading. No reasonable investor would have concluded that
Netflix's churn rate was dependent on the average number of
paid subscribers because a major and prominent part of
Netflix's business was free trial subscriptions (see Compl. ¶
31). Defendants prominently disclosed that churn included free
trial subscriptions (Netflix press release, April 17, 2003,
Hoffman Decl., Exh. H at 1, ¶ 3 ("Churn includes free trial
subscribers as well as paying subscribers who elect not to renew
their monthly subscription service during the quarter."); see
also Compl. ¶ 104 (quoting from release)).
Defendants did not estimate mean subscription length in the
most common way, by the inverse of one of the more common churn
rates. Instead, they used the inverse of the Netflix-calculated
churn rate. The use of a unique measure in and of itself does not
render their reports false and misleading. Plaintiffs claim that
such unique definitions are false and misleading because
"[a]verage subscriber lifetime . . . ha[s] a plain-English
meaning" that is different from the inverse of Netflix's churn
rate (Compl. ¶ 79). Not so. There are no plain-English
definitions of these financial measures. They are, like all
statistics, artificial constructs. Emphasis is placed on the
word "constructs" because it signifies that the financial terms
are built and therefore defined by their builders. In this
situation, Netflix was the builder of the financial measure
"average subscriber lifetime" and it fully disclosed what it had
built by defining the term in its many public statements. It therefore
made no false statement. If anyone ever thought that the measure
was more accurate than it actually was, it was not because
defendants made any false or misleading statement.
Hastings's and McCarthy's discussions of "retention" did not
suggest the more traditional churn methodology in light of the
fact that they repeatedly and clearly explained that their own
method of determining retention. Confusion over Hastings's
remarks concerning the churn attributable to 1.3 million people
is possible but too uncertain to form the basis of any jury
finding that such a statement was false. Failure to correct an
interviewer's false statement is not a false statement in itself.
Hastings had no duty to police the media.
Plaintiffs' allegations fail insofar as they allege that
defendants' made a decision to deceive investors and that such a
decision constitutes an "act, practice, or course of business
which operates or would operate as a fraud or deceit upon any
person, in connection with the purchase or sale of any security,"
17 C.F.R. 240.10b-5. Any decision to deceive is a scienter
allegation, not one of an act, practice, or course of business
that operates as a fraud. This allegation therefore fails.
3. NO VIOLATION OF REGULATIONS G, S-K OR S-B, OR OF ITEM 12,
Plaintiffs allege that defendants violated SEC regulations G,
S-K and S-B, and rules governing Item 12 of Form 8-K (Compl. ¶¶
189-90). Regulation G bars securities issuers from disclosing a
non-GAAP financial measure that, taken together with accompanying
information and discussion, is untrue or omits to state a
material fact necessary to make that presentation not misleading.
17 C.F.R. 244.100(b). Netflix's churn rate and related measures
were not prepared in accordance with generally accepted
accounting principles because there is no GAAP for such measures.
As stated above, the information was not untrue nor did it omit
to state a material fact. Netflix, therefore, did not violate
this aspect of Regulation G.
Regulation G also requires issuers who disclose non-GAAP
information to produce the "most directly comparable" GAAP
measure and reconcile it with the non-GAAP measures.
17 C.F.R. 244.100(a). Plaintiffs accuse defendants of misleading investors
by using Netflix's churn rate and its inverse, "average
subscriber lifetime," to calculate EBITDA (Compl. ¶ 111). Defendants reconciled EBITDA with earnings calculated according
to GAAP, adding back in stock-based compensation, depreciation
and amortization (Hoffman Decl., Exh. H at 9-10). Plaintiffs
claim that this reconciliation violated Regulation G because its
EBITDA figure was distorted by the inclusion of the allegedly
misleading churn rate and "average subscriber lifetime" figure
(ibid., Opp. at 13-14). There was nothing misleading about the
reconciliation. It contained explicit definitions of churn and
average subscriber lifetime and made it clear that EBITDA
incorporated those figures (Hoffman Decl., Exh. H at 9-10). In
short, all the inputs into this reconciliation were fully and
clearly disclosed. Defendants did not violate Regulation G.
Plaintiffs allege that defendants violated Regulation S-K, Item
10, which requires an issuer disclosing non-GAAP information to
state why that information is useful to investors.
17 C.F.R. 229.10(e)(1)(i)(C). Plaintiffs concede, however, that such
disclosure was made. They claim that there nevertheless was a
violation of Regulation S-K because that information allegedly
furthered defendants' fraud (Compl. ¶ 192). This claim is
unavailing because, as discussed above, there was no false
statement or material omission. Plaintiffs allege that Netflix
also violated an almost identical requirement under Regulation
S-B, Item 10, that is applicable only to small-business
securities issuers. 17 C.F.R. 228.10(h)(1)(i)(C). Netflix was not
subject to Regulation S-B because it was not a small-business
issuer during the class period. See 17 C.F.R. 228.10(a)(1)(i)
(defining small-business issuer as one with $25 million or less
in annual revenues); see also, e.g., Compl. ¶ 119 (listing
quarterly revenues of $63 million). Netflix therefore could not
have violated Regulation S-B, Item 10.
Plaintiffs also allege that defendants violated disclosure
rules related to Item 12 of Form 8-K. Plaintiffs concede,
however, that defendants were exempt from the disclosure
requirements of Item 12 because they disclosed the relevant
information on the Netflix web site. They claim, however, that
defendants removed the material from the web site too early. The
only authority they cite for a requirement to maintain the
information for a minimum period of time is an SEC statement that
actually states that there is no such minimum period: "Item 12
does not state how long a company must keep this information
available on its web site." The SEC statement expresses mere "encouragement" to companies to keep
it up for twelve months. Plaintiffs therefore allege only that
Netflix acted contrary to SEC guidance (Compl. ¶¶ 193-95). This
is not sufficient to allege a violation of Section 10(b).
4. NO CONTROL PERSON LIABILITY.
No Section 20(a) claim can stand without an underlying
violation by the company of securities laws. In this case, there
was none. The Section 20(a) claim of control-person liability is
Because no defendant made a false statement actionable under
federal securities law, plaintiffs have failed to state a valid
claim and there is no need to consider other elements of a valid
10(b) claim, such as scienter. The complaint is DISMISSED
WITHOUT LEAVE TO AMEND for the reasons stated above. The Clerk
is directed to close the case.
IT IS SO ORDERED.
[fn*] For example, if the churn rate per month were 0.05, then
the "average subscriber lifetime" would be 1/0.05 months = 20
months (Compl., App. A at 3).
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