Davis v. Skullcandy, Inc.: Defendant’s Motion to Dismiss Securities Fraud Claim Granted

In Davis v. Skullcandy, Inc., No. 2:16-cv-00121-RJS-PMW, 2018 BL 96655 (D. Utah Mar. 21, 2018), the United States District Court for the District of Utah Central Division granted Skullcandy, Inc. (“Skullcandy”), CEO Seth Darling ("Darling"), CFO Jason Hodell ("Hodell"), and board member Richard Allen’s ("Allen") (collectively the “Defendants”) motion to dismiss shareholder Melanie Davis’s (“Plaintiff”) securities fraud claim alleging Defendants mislead shareholders about Skullcandy's performance. The court held Plaintiff did not allege with particularity a violation of Section 10(b) or Section 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”).

Plaintiff alleges that starting in the first quarter of 2015, Defendants misled shareholders by attributing company growth to increased sales in China. Plaintiff also alleges that Defendants engaged in a “channel-stuffing” scheme in an attempt to inflate sales numbers by sending extra inventory to its only distributor in China, despite Defendant’s knowledge that the market in China was poor and the distributor would not be able to sell the product. Plaintiff argues that Defendants Darling and Hodell knew of the scheme from their participation in the weekly internal sales calls that would have informed Defendants that the market in China was strained. Plaintiff also argues that Defendant Alden's sale of Skullcandy stock indicated his knowledge or his reckless disregard of the alleged channel-stuffing scheme. To support the allegations that the sales in China were not legitimate, Plaintiff offers statements from six former employees.

The Private Securities Litigation Reform Act ("PSLRA") requires a plaintiff alleging securities fraud to meet rigorous pleading requirements. The statements alleged to be misleading must be specified with the reasons for why the statement is misleading. 15 U.S.C. § 78u—4(b)(1). The plaintiff’s pleading of scienter must meet a more stringent standard by stating facts with particularity to give rise to a strong inference that the defendant acted with the required state of mind. The inference must be clear, logical, and convincing, and at minimum, as compelling as any opposing inference of non-fraudulent intent in order to meet the threshold of “strong” inference of scienter.

Following precedent from the Tenth Circuit, the court found Plaintiff’s allegations to be weak and insufficient to support an inference of scienter. Plaintiff’s presentation of statements from six former employees to show Defendants’ knew the market in China was volatile were too general to prove knowledge or recklessness. The former employees were either not alleged to have worked closely with Defendants, or the former employees left Skullcandy before key events in the complaint occurred. Additionally, the court determined that Plaintiff did not offer any supporting facts to connect Defendants to the alleged channel-stuffing scheme. Without Plaintiff’s showing of either an agreement between Skullcandy and the distributor in China, a showing of how and when the plan was formed, or a showing of who knew about or recklessly disregarded the plan, the court was unable to draw an inference that Defendants acted with scienter rather than a mere misunderstanding of the China market.

The court also held that Defendant Alden’s sale of Skullcandy stock did not support an inference of scienter because the sale of stock was made under an automatic trading plan. Plaintiff’s claim against Skullcandy itself must also fail because Plaintiff’s claim is based on the liability of Skullcandy’s executives and Plaintiff has failed to allege that any of the individual Defendants acted with scienter.

Plaintiff’s failure to successfully allege a 10(b) claim renders her 20(a) claim invalid.

For the above reason, the court granted Defendants’ motion to dismiss.

The primary materials for this case may be found on the DU Corporate Governance website.