On June 25, 2024, Judge Michael E. Farbiarz of the United States
District Court for the District of New Jersey denied in large part
a motion to dismiss a putative securities class action against an
internet-based educational platform that sells online classes and
certain of its senior officers.Zequi Wu, et al. v. GSX Techedu
Inc., et al., No. 20-4457 (MEF) (JRA) (D.N.J. June 25,
2024).Plaintiff alleged that defendants violated Sections 10(b) and
20(a) of the Securities Exchange Act of 1934 and Rule 10b-5
promulgated thereunder by making false statements that misled
investors about defendants' inclusion of fake "bot"
students in enrollment numbers to inflate the company's
revenue.The Court in large part denied defendants' motion to
dismiss, finding that plaintiff sufficiently alleged numerous false
statements and scienter.
Plaintiff, representing a putative class of investors who held the
company's securities during the relevant period, alleged that
the company paid for a large number of "bots" to pose as
bona fide students as part of a fraudulent scheme to inflate the
company's enrollment and revenue metrics.Plaintiff alleged that
as part of this fraudulent scheme, defendants made misstatements in
2019 and 2020 in the company's initial public offering
materials, press filings, SEC filings, and during earnings
calls.These statements allegedly provided a "fairly specific
recounting of the number of students enrolled" in company
classes, "including statements as to enrollment
growth."Plaintiff also included allegations based on purported
confidential witnesses, including a teacher and student who
allegedly witnessed "sham" transactions by fake students,
employees of the company who allegedly witnessed or were involved
in the enrollment of fake students, and employees of a third party
"brushing" firm that was allegedly hired by the company
to create fake student accounts.Plaintiff also cited a published
short-seller report that concluded that more than 70% of the
company's students were sham accounts.As a result of these
alleged misstatements regarding student enrollment, plaintiff
alleged that defendants made misstatements regarding the
corresponding revenue attributed to the company's student
enrollment.
The Court rejected defendants' argument that there were
insufficient allegations that a substantial percentage of the
company's enrollment numbers were based on "bot"
enrollments, finding that "[b]y and large, the confidential
witness allegations do not need to be discounted," and taken
together, they "paint[ed] an unmistakable picture of allegedly
systematic and large-scale use of bots" by the company
"to generate fake student enrollments."The Court also
declined to discount the short-seller report, finding that, even
under the "hard look" approach sometimes taken by courts
analyzing short-seller reports, the report was sufficiently
detailed, had corroborating sources, and relied on a sufficiently
large data set to reach its conclusions.The Court further found
that plaintiff sufficiently alleged misstatements by defendants
related to the company's revenue, noting the "strong
inference that all-but inescapably runs from (a) allegedly
systematic and large overstatements of student enrollment numbers
to (b) overstatements of revenue numbers," which inference was
"propped up" by additional confidential witness
allegations and another third-party report corroborating that bot
enrollments were being counted as revenue.The Court also rejected
defendants' contention that the alleged revenue statements were
immaterial given the "very large scale" of the alleged
misrepresentations.
Turning to scienter, the Court concluded that plaintiff alleged a
"strong enough" inference at the pleading stage, finding
that there were "ample allegations" that company leaders,
including the CEO and CFO, were directly aware of some of the
reports cited by plaintiff, and that defendants made statements,
"the gist" of which were that no systematic revenue or
student enrollment inflation was taking place even though they had
been provided with "detailed information that directly
suggested precisely the opposite conclusion."The Court further
found that the alleged misstatements as to revenue and student
enrollment were within the individual defendants'
"workplace bailiwick" given their position in the
company, and were of sufficient importance to the company because
revenue and student enrollments were plainly among the
company's "most fundamental metrics."
Finally, the Court rejected defendants' challenge to
plaintiff's allegations regarding loss causation, finding that
the information and analysis in the alleged corrective disclosures
was "more detailed, more systematic, more rigorous, and closer
to first-hand" by "leaps and bounds" than the
information and analysis in the short-seller report that defendants
argued previously disclosed the alleged corrective information.The
Court further emphasized that it could not be said that the alleged
corrective disclosures "added too little incremental
information to the mix ... such that by the time these reports were
released, the information in them was old hat as a matter of law,
and had already been impounded into" the company's stock
price.
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