The US Court of Appeals for the Sixth Circuit recently affirmed an Ohio district court’s decision to dismiss a securities fraud putative class action accusing Defendant Zoo Entertainment, Inc. (Zoo), a video game software company, of publishing financial statements with reckless disregard of their falsity. The court found that the allegations did not support the strong inference of scienter required under the Private Securities Litigation Reform Act. 

The complaint concerned financial statements Zoo issued during 2010, the year  the company went public. After claiming record revenues in its 2010 Securities and Exchange Commission filings, Zoo issued a press release in April 2011 stating that a year-end audit revealed errors in recording certain transactions and that its 10-Q statements for the first three quarters of 2010 should no longer be relied upon. Zoo lowered its 2010 quarterly revenues, causing its stock value to plummet. Plaintiff shareholder Bruce E. Ricker (Ricker) sued, relying, in part, on information allegedly from a confidential witness, a former employee in Zoo’s accounting department. It was alleged that the confidential witness had informed Zoo’s CEO and CFO of payment problems with Zoo’s most significant customer account, which prevented the accountant from accurately projecting cash flow. Ricker also alleged that, despite knowing about these problems, the CEO and CFO took no action. Ricker additionally alleged that Zoo’s awareness of its weak internal controls and the departure of high-ranking Zoo officials following the restatement further supported a strong inference of scienter. 

After applying a “holistic analysis” of the shareholder’s amended complaint, the district court dismissed the complaint finding that Ricker had not presented information tying the confidential witness’s allegations to the need to restate revenue. Even assuming Zoo knew about problems with its largest account, the district court held that did not support a strong inference that the company should have known its financial statements were false. The Sixth Circuit agreed, holding that Ricker failed to meet the pleading standard of alleging “unreasonable conduct that was an extreme departure from the standards of ordinary care.” The court recognized its duty to consider the whole of the complaint and opposing plausible inferences, and found that the inference that Zoo recklessly disregarded internal revenue recognition problems with its largest account was not as strong as the opposing plausible inference: that Zoo is a small company with an understaffed and unsophisticated accounting department that simply miscalculated revenues. Further, despite a “long list of alleged errors,” the court found that Zoo failed to allege the “multiple, obvious red flags” the court typically requires to infer recklessness. 

Ricker v. Zoo Entm’t Inc. et al., No. 12-3951 (6th Cir. Aug. 27, 2013).