In re LeapFrog Enterprise, Inc. Securities Litigation

          ORDER GRANTING DEFENDANTS’ MOTION TO DISMISS DOCKET NO. 72

          EDWARD M. CHEN UNITED STATES DISTRICT JUDGE

         I. INTRODUCTION

         Plaintiffs have filed a class action against LeapFrog Enterprises Inc., and two of its officers, John Barbour (“Barbour”) and Raymond L. Arthur (“Arthur”), for violations of federal securities laws. Defendants' motion to dismiss Plaintiffs' First Amended Consolidated Class Action Complaint (“FAC”) focuses on the allegedly false and misleading statements about LeapFrog's inventory, the roll out of LeapTV, LeapFrog's financial guidance, and accounting. For the reasons stated below, the Court GRANTS Defendants' motion to dismiss.

         II. REQUESTS FOR JUDICIAL NOTICE

         A. Defendants' Request

         Defendants ask the Court to take judicial notice over nine categories of documents or to consider them under the doctrine of incorporation by reference: (1) LeapFrog's press releases filed with the SEC as attachments to Forms 8-K (Exs. 1, 4, 8, 14, 16); (2) LeapFrog's earnings and conference call transcripts (Exs. 2, 5, 7, 9, 11, 12, 15); (3) LeapFrog's Forms 10-Q filed with the SEC (Exs. 13, 17); (4) LeapFrog's Forms 10-K filed with the SEC (Exs. 3, 19); (5) LeapFrog's Forms DEF 14A filed with the SEC (Exs. 20, 21); (6) LeapFrog's press releases published through PRNewswire (Exs. 6, 18); (7) SunTrust Robinson Humphrey's Report about LeapFrog's 1Q15 results (Ex. 10); (8) a Microsoft Excel Spreadsheet with the data about LeapFrog's daily stock price for the period of January 1, 2014 to July 17, 2015 (Ex. 22); and (9) copies of Defendants' Form 4 (Exs. 23, 24). See Docket No. 73, (“Foster Decl.”), Docket No. 74 (“D's RJN”).

         Plaintiffs object to the Court's consideration of three of the items. Docket No. 76 (“Response to D's RJN”). Plaintiffs object to (1) Exhibit 21 - copies of LeapFrog's Form DEF 14A filed with the SEC on July 2, 2015 (“Proxy Statement”) and (2) Exhibits 23 and 24 - copies of Defendants' Forms 4, which show that Defendants exercised LeapFrog stock options.^[1]Defendants respond that Exhibits 21, 23, and 24 are public filings with the SEC and thus subject to judicial notice. Docket No. 81 at 4 (“D's Reply to P's RJN”). Because these exhibits are not necessary to this decision, the Court declines to take judicial notice.

         Plaintiffs also ask the Court to strike all factual assertions and arguments derived from Exhibits 3, 15, and 19, (LeapFrog's 10-K filed March 14, 2014; a transcript of an earnings call held February 5, 2015; and LeapFrog's 10-K filed June 15, 2015) asserting that Defendants improperly rely on these exhibits for the truth of these factual assertions:

• Exhibit 3: “LeapFrog's business depends on being able to predict highly changeable trends and consumer preferences, which is no easy task, especially in the toy market.” Docket No. 53 at 2; (“MTD”) (citing Ex. 3 at 9); “LeapFrog's products help teach children things like phonics, reading, writing, math, sciences, social studies, creativity, and life skills.” MTD at 2 (citing Ex. 3 at 1; ¶ 21); “LeapFrog's business is highly seasonal, and its overall success depends on sales relating to a brief, but critical, holiday season.” MTD at 2-3 (citing Ex. 3 at 11).

• Exhibit 15: “Worldwide sales of children's tablets ' shrunk for the first time since 2010, ' causing 'significant sales declines' industrywide.” MTD at 6 (citing Ex. 15 at 3).

• Exhibit 19: “Its products include, among others, the LeapPad learning tablets and, since the fall of 2014, the LeapTV educational video game system.” MTD at 2 (citing Exh. 19 at 1; ¶ 21); “Over 70% of LeapFrog's sales come in the second half of the calendar year, with 40% in the period between October and December.” MTD at 3 (citing Ex. 19 at 7).

         Defendants respond that the contents of Exhibits 3, 5, and 19 must be considered for the truth of the facts asserted therein because these exhibits are incorporated by reference into the FAC. Docket No. 81 at 1 (“D's RJN Reply”).

         Under the incorporation by reference doctrine, if a document is referenced in a complaint, a court may “properly consider the [document] in its entirety.” In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046, 1058 n.10 (9th Cir. 2014) (“Once a document is deemed incorporated by reference, the entire document is assumed to be true for purposes of a motion to dismiss, and both parties -and the Court - are free to refer to any of its contents.”). Specifically, courts may take into account “documents whose contents are alleged in a complaint and whose authenticity no party questions, but which are not physically attached to the [plaintiffs] pleading.” Knievel v. ESPN, 393 F.3d 1068, 1076 (9th Cir. 2005). A court “may treat such a document as part of the complaint, and thus may assume that its contents are true for purposes of a motion to dismiss under Rule 12(b)(6).” United States v. Ritchie, 342 F.3d 903, 908 (9th Cir. 2003). Here, Plaintiffs expressly referred to these exhibits in the FAC, and relied on them as sources of the allegedly fraudulent statements. See, e.g., FAC ¶¶ 55, 24, 176. Therefore, the Court DECLINES to strike all factual assertions and arguments derived from Exhibits 3, 15, and 19.

         B. Plaintiffs' Request

         Plaintiffs filed a conditional request to take judicial notice of a November 5, 2014 analyst article entitled “LeapFrog Continues To Offer Rare And Compelling Value Going Into The Holidays, ” published by Seeking Alpha. Docket No. 78, Exhibit 1 (“Article”). “If the Court takes judicial notice of the extrinsic evidence (Defendants' Exhibits 21, 23, and 24) on which Defendants base their factual assertions concerning Barbour's and Arthur's stock ownership and does not strike the assertions, Plaintiff respectfully requests that it also take judicial notice of Exhibit 1.” Docket No. 77 at 1 (“P's RJN”). Since the Court is not taking notice of Exhibits 21, 23, and 24, Plaintiffs request is denied. In any event, judicial notice is not proper. Plaintiffs must allege sufficient facts, not wait to see what Defendants challenge and then seek to add facts at the briefing stage. Because Plaintiffs attach the Article in an improper attempt to introduce new facts at briefing, and because the Court is not taking judicial notice of Defendants' Exhibits 21, 23, and 24, the Court DENIES judicial notice of Plaintiffs' Exhibit 1.

         III. BACKGROUND

         A. The Parties and Claims

         Defendant LeapFrog creates electronic learning toys and content. FAC ¶ 5. The putative class consists of all persons or entities who purchased shares of LeapFrog common stock during the Class Period. Id. ¶ 1. The Class Period is between May 5, 2014 and June 11, 2015. Id. During the Class Period, Barbour was LeapFrog's director and CEO; id. ¶ 38; Arthur was LeapFrog's CFO. Id. ¶ 39. Plaintiffs allege that from May 2014 to June 2015 Defendants made false statements about: (1) LeapFrog's carryover inventory and development delays with Leap TV; and (2) LeapFrog's financial guidance and accounting.

         B. Roll Out of LeapTV

         Plaintiffs allege that Defendants claimed that LeapTV would help LeapFrog to deliver growth. Id. ¶ 9. In January 2014, the management decided to move up the release of LeapTV to a calendar 2014 release. Id. ¶ 6. Because the product had not been slated for such an early release, the decision placed a tight timeline for development and production of the new product. Id. Plaintiffs allege that Defendants misled investors by representing on June 11, 2014 that LeapTV would be shipping at the end of September, id. ¶ 81, and would be “hitting stores in October.” Id. ¶ 72. However, LeapTV did not ship until mid-October meaning that LeapTV was not on store shelves until November as the result of the typical lag time between shipment and arrival of the product in stores of weeks. Id. ¶ 77. Plaintiffs contend that because Defendants knew about development delays of LeapTV, they lacked any basis for telling investors that it would ship at the end of September. Id. ¶ 100. Finally, Plaintiffs allege that Defendants misled investors during the November 3, 2014 conference call that “LeapTV [was] off to a very strong start.” Id. ¶ 105. This was supposedly misleading because the late launch caused Target to relegate LeapTV to end-cap space and important retailers to drop LeapTV from sales. Id. ¶ 112(c).

         C. Inventory

         Plaintiffs allege that LeapFrog “faced a substantial retail inventory hangover of LeapPads from 2013 that management knew would impact both margins and sales heading into 2014.” Id. ¶¶ 6, 77. Plaintiffs allege that defendants made false and misleading statements on May 5, 2014 that “[i]inventories at retail have come down from where they were at year end by a fair amount . . . . []The important fact is that isn't across the board . . . . We don't have higher inventories across the board. We have some pockets of inventory.” Id. ¶ 45. Plaintiffs allege that the above statements were false and misleading because in fact “there remained a massive volume of carryover inventory at retailers that required discounts to sell.” Id. Plaintiffs further allege that Defendants “deliberate[ly] conceal[ed] the nature and impact of the carryover inventory” when referring to inventory hangover as a “one-off situation” and stating that the bulk of the inventory will be gone by Thanksgiving. Id. ¶¶ 88, 97.

         D. Guidance

         1. May 5, 2014

         On May 5, 2014 (the first day of the proposed class period), LeapFrog issued a press release announcing LeapFrog's financial guidance for the rest of 2014. Id. ¶ 41. The company reported expected sales for the 2014 year of $554-$580 million, or $0.18-$0.25 per diluted share. Id. ¶ 42. Defendants are quoted in the press release as stating that “[their] line-up of major new product introductions will begin shipping in late summer and fall.” Id. ¶ 41.

         The same day Defendants held a 1Q14 earnings conference call to review LeapFrog's results for the first quarter ended March 31, 2014. Id. ¶ 41; Ex.5 at 3. Arthur projected net sales for the second quarter of $48-$52 million. Id. ¶ 43; Ex.5 at 7. Arthur announced that LeapFrog expected “net sales and earnings growth in the second half of the year, largely due to new product introductions.” Id. Arthur noted that “[w]ithin the second half of this year, [LeapFrog's] results will be much more back-end-loaded with some new products shipping for the first time in September.” Id. In response to questions about inventory allowances for the next quarter, Arthur asserted that possible clearance costs are not going to be “incredibly significant.” Id. ¶ 46; Ex.5 at 10. Following these announcements, the price of the company's stock increased from $6.83 to $7.29 per share, or approximately 6%. Id. ¶ 47.

         Plaintiffs contend that there was no reasonable basis for these projections. They cite the August 4, 2014 press release stating that for the full fiscal year ending March 31, 2015 the company expected net sales to be $480-$505 million as opposed to $554-$580 million and net income (loss) per basic and diluted share to be in the range of a loss per share of $0.04-$0.10 as opposed to a loss of $0.18-$0.25. Id. ¶ 197; Ex.8 at 3. Plaintiffs emphasize that Defendants explained the reduction in guidance to be due “elevated beginning retail inventory levels, a challenging market environment and POS trends as well as the timing of new product shipments.” Id. Moreover, Plaintiffs assert that on May 5, 2014 the shipment date of “as-yet undeveloped and untested” LeapTV was in question. Id. ¶ 68.

         2. August 4, 2014

         On August 4, 2014, LeapFrog issued a press release announcing its financial results for the quarter ended June 30, 2014 and lowering its earning guidance for the 2015 fiscal year ending March 31, 2015. Id. ¶ 80; Ex. 8. The company noted that the new guidance will be offset by “a very back-end loaded year with Leap TV shipping at the end of September, ” and “the introduction of new products that we expect to perform very well in the market place in fiscal 2015 and beyond.” Id. ¶ 81. The press release stated that LeapFrog would experience a “strong holiday season” and a “solid net sales growth in both the December and March quarters, led largely by sales of new releases including LeapTV, LeapBand, LeapPad3, LeapPad Ultra XDi and related content.” Id. ¶ 82; Ex. 8 at 1, 3.

         On August 4, 2014, Defendants held a 1Q15 conference call to review LeapFrog's results for the first fiscal quarter, ended June 30, 2014. Id. ¶ 83; Ex. 9. Barbour stated that LeapFrog expected “double-digit sales growth in the December and March quarters.” Id. ¶ 83; Ex. 9 at 3. Barbour also stated: “We expect this growth to be driven by shipments of our exciting new product introductions for the year . . . .” Id. ¶ 84; Ex. 9 at 3. Arthur added that LeapFrog expected “solid growth in [its] third and fourth fiscal quarters” and that it was “well positioned for a strong holiday season with a new lineup of tablets, fantastic new products in LeapTV and LeapBand set to enter the market . . . .” Id. ¶ 85; Ex. 9 at 8. Arthur stated that the company expected net sales in the second quarter to be in the range of $125-$130 million. Id. ¶ 86; Ex. 9 at 7. When asked how to reconcile an old guidance with the new guidance, ^[2] Arthur said: “Definitely the third quarter of our fiscal year is a big quarter for us, bigger than it has been for a long time. I think that's primarily the result of LeapTV starting to ship at the end of September, so most of the channel fill is going to occur in Q3.” Id. ¶ 90; Ex. 9.

         Plaintiffs contend that the projections offered during this period were false and misleading, given that three months later Defendants reported a loss of $0.13 to $0.25 per share and net sales of $450-$470 million (as opposed to expected EPS of $0.04 to $0.10 and net sales of $480-$505 million). Id. ¶ 95. In a November 3, 2014 press release, Defendants explained that “slippage of first shipments of LeapTV” was the primary reason for reduced guidance. Id. ¶ 95; Ex. 12 at 1.

         3. November 3, 2014

         On November 3, 2014, LeapFrog issued a press release announcing financial results for the quarter ended September 30, 2014. Id. ¶ 103; Ex. 12. Defendants are quoted in the press release as stating that LeapFrog was “well-positioned for the all-important holiday season” and that the company expected “financial results in . . . fiscal third quarter ending December 31, 2014 to improve year-over-year given the launch of LeapTV, two new LeapPad tablets . . . .” Id. ¶ 103; Ex. 12 at 2. Defendants stated that “for the full fiscal year ending March 31, 2015, [LeapFrog] expected net sales to be in the range of $450 million to $470 million compared to $528 million for the twelfth-month period ended March 31, 2014.” Id. ¶ 104; Ex. 12 at 3. Plaintiffs contend this was misleading, as Defendants “knew” that reaching even this lowered sales guidance “would be impossible due to their awareness of adverse facts and circumstances . . . .” FAC ¶ 110. For the third fiscal quarter ending December 31, 2014, LeapFrog expected “net sales to be in the range of $220 million to $240 million, up 18% to 28%, compared to $187 million for the quarter ended December 31, 2013.” Id.

         On November 3, 2014, defendants held a conference call to review results for the second fiscal quarter ended September 30, 2014. Id. ¶ 105; Ex. 11. Barbour emphasized that “[t]he second half of fiscal 2015 will be much brighter and [LeapFrog] expected double-digit sales growth in the December and March quarters.” Id. ¶ 105; Ex. 11 at 3. Barbour stated that this growth will be driven “by shipments of [LeapFrog's] exciting new product introductions for the year.” Id. Finally, Barbour reported that LeapFrog “started shipping [LeapTV] units to retailers a few weeks ago and . . . LeapTV [was] off to a very strong start.” Id. ¶ 105; Ex. 11 at 4. Arthur reiterated: “[w]e expect sales to increase for the balance of our fiscal year versus the same period of last year as we are well positioned for the holidays with our best product lineup ever and strong support from significant retail, trade, and advertising campaigns, as well as off-shelf promotions.” Looking forward to the full-year outlook, Arthur stated: “[w]hile our reported results through the second fiscal quarter of 2015 reflect sales and earnings reductions versus the same periods in the prior year, we expect to see improved results for the remaining two quarters of the year versus the same periods a year ago.” Id. ¶ 106; Ex. 11 at 6. When asked if LeapFrog would make up for the second quarter shortfall of LeapTV sales in the fiscal third quarter, Barbour responded: “We would hope that we would make up most of it, yes . . . .” Id. ¶ 107; Ex. 11 at 9. Barbour added: “if you take the carryforward tablet from last year out of the equation, our inventory is actually quite tight in the marketplace at the moment. So I think it may be more than normalized at the moment, and that is why we are looking at growth . . . for the third quarter and into the fourth quarter.” Id. ¶ 108; Ex. 11 at 11.

         Plaintiffs assert that Defendants' forecasts during this period were materially false and misleading because Defendants knew that to achieve this guidance, the company “had to have holiday 2014 sales that surpassed those of its successful launch of LeapPad in 2011, and knew that this would be impossible due to their awareness of adverse facts and circumstances at the time.” Id. ¶ 110. Plaintiffs contend given that “LeapTV had shipped to retailers late, in mid-October” Defendants “knew that LeapTV could not drive the 3Q15 and FY 2015 guidance they issued.” Id. ¶ 111. Plaintiffs also allege that Defendants “deliberate[ly] conceal[ed] the nature and impact of the carryover inventory, ” in telling investors that the carryover was “a 'one-off situation'” and “build-up would be gone by Thanksgiving.” FAC ¶ 97. Specifically, Plaintiffs allege that a “shocking amount” of carryover inventory remained, which would require “further discounts” and “cannibalizing of new tablet sales.” Id.

         4. February and May 2015

         On February 5, 2015, Defendants held a conference call to review results for the third fiscal quarter ended December 31, 2014. Id. ¶ 154; Ex. 15. Barbour stated that financial results for the third quarter of fiscal 2015 “were very disappointing.” Id. ¶ 154; Ex. 15 at 2. Barbour explained: “[b]ased on these factors, and our own experiences with consumers playing with LeapTV, we believe this platform will deliver, but understand that financial performance did not live up to expectations for this past holiday season.” Ex. 15 at 4.

         Arthur announced that LeapFrog “will not be providing guidance for fiscal fourth quarter or full year beyond indicating that we believe sales for our fiscal fourth quarter will be below that of the prior year period.” Ex. 15 at 6. Arthur stated:

We are very disappointed that our performance in the third fiscal quarter of 2015 was significantly below our expectations. . . . In our projections for the third quarter we planned for a decline in retail sales of LeapPad tablets. However, we are surprised by the magnitude of the actual decline across the tablet business and our key competitors during the holiday season, which was significantly in excess of our expectations.

FAC ¶ 155. Plaintiffs contend that Defendants materially misled investors regarding their surprise about across the tablet business sales declines because, in part, Defendants already knew that leading up to Black Friday 2014 LeapTV sales were off-trend and that the carryover inventory would not allow LeapFrog to achieve its guidance forecasts. Id. ¶ 163.

         E. Accounting

         1. November 3, 2014

         On November 3, 2014, defendants held a conference call to review results for the second fiscal quarter ended September 30, 2014. Id. ¶ 122; Ex. 11. The company reported a net income loss of $2, 026 and EPS of negative $0.03. Id. ¶ 122. Plaintiffs assert that if LeapFrog had properly recorded goodwill impairment charges of $19.5 million in 2Q15, then the company should have reported a net income loss of $17, 442 and EPS of negative $0.25. Id. ¶ 125.

         On November 10, 2014, LeapFrog filed its 2Q15 form 10-Q with the SEC, which reported that “[a]s of September 30, 2014, based on [company's] assessment of various qualitative factors and projection of future operating results, the Company does not believe that sufficient indicators of impairment of its goodwill currently exist that would require performing step one of the two-step test for goodwill impairment.” Id. ¶ 123; Ex. 13 at 9.

         2. February 5, 2015

         On February 9, 2015, LeapFrog filed its 3Q15 form 10-Q with the SEC. Id. ¶ 167. The company reported a net income loss of $124, 212 and EPS of $1.77 with negative $0.22, accounting for goodwill. Id. Plaintiffs assert that if LeapFrog had properly recorded goodwill impairment charges of $36.5 million in 3Q15, then the company should have reported a net income loss of $145, 233 and EPS of $2.07. Id. ¶ 170. The company concluded that its long-lived assets were not impaired as of December 31, 2014. Id. ¶ 168; Ex.17 at 9.

         3. GAAP Violation

         Plaintiffs claim that LeapFrog fraudulently inflated its financial results for the second and third quarters of 2015. See FAC ¶¶ 17, 24. Plaintiffs first allege “that a $19.5 million goodwill impairment that LeapFrog took after its disappointing holiday season for the quarter ended December 31 should have been taken in the second quarter ended September 30, 2014.” MTD at 15-16. Second, Plaintiffs allege that “the 36.5 million long-lived asset ...