Altayyar v. Etsy, Inc.

Citations: 242 F. Supp. 3d 161; 2017 WL 1157193Docket: 15-cv-2785 (AMD) (RER)

Court: District Court, E.D. New York; March 16, 2017; Federal District Court

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On May 13, 2015, a class action lawsuit was filed against Etsy, Inc., its CEO Chad Dickerson, CFO Kristina Salen, and several directors, along with underwriter firms Goldman Sachs, Morgan Stanley, Allen & Company, Loop Capital Markets, and The Williams Capital Group. The plaintiffs, representing themselves and others, alleged that the defendants made misleading statements that artificially inflated Etsy's stock price, resulting in financial losses when the truth emerged. The revised amended complaint cited violations of the Exchange Act (Sections 10(b) and 20(a)) and the Securities Act (Sections 11, 12(a)(2), and 15). The defendants sought dismissal on the grounds that the complaint lacked the necessary specificity required by Federal Rule of Civil Procedure 9(b) and the Private Securities Litigation Reform Act of 1995. The court granted the defendants’ motion to dismiss with prejudice, indicating that the claims were not sufficiently substantiated. The plaintiffs, who purchased Etsy securities from the IPO date (April 16, 2015) to August 4, 2015, argued that Etsy’s market performance relied heavily on active seller and buyer engagement. Key financial details included significant stock acquisitions by the defendants and their firms, notably from Accel Partners and Union Square Ventures.

Underwriter defendants earned $19.9 million from the IPO's underwriter discount. Etsy's Prospectus and Registration Statement emphasized its commitment to ethical manufacturing and methods to prevent counterfeit goods, utilizing machine learning and community flags for policy enforcement. Etsy's Terms of Use prohibited illegal and counterfeit sales, and it reserved the right to remove infringing materials. The Board, including defendants Burns, Klein, and Wilson, was responsible for risk management, with the Audit Committee overseeing financial compliance.

On May 11, 2015, Wedbush Securities downgraded Etsy to "Underperform," citing research that indicated up to 2 million items (5% of merchandise) may be counterfeit, which could hinder growth. Following this report, Etsy's stock price dropped to $1.86. On May 19, Etsy disclosed its first-quarter earnings, revealing gross merchandise sales of $531.9 million, a stagnant active seller base, and a revenue decline, leading to an 18.1% stock price decrease after adverse market reactions from Wedbush and Morgan Stanley.

In its second-quarter earnings report on August 4, Etsy announced gross merchandise sales of $546.2 million, a slight increase. However, Wedbush noted that increased marketing did not translate to growth, suggesting brand dilution due to counterfeits as sellers shifted to competitors. Etsy's stock price declined again. Plaintiffs claim that six confidential witnesses support allegations that Etsy's management was aware of compliance issues prior to the IPO.

CWs (confidential witnesses) who worked at Etsy between September 2013 and May 2015 provided insights into the company's operations regarding counter-infringement policies. CWs 1 and 2 were part of the Integrity Team from October 2013 to January 2015, focusing on enforcing these policies. CW 3, a member advisor from September 2013 to August 2014, noted that Etsy depended on rights-holders to report infringement and required them to navigate a complex process for product removal. The Integrity Team, comprising 8 to 75 employees, managed a high volume of complaints. Even after a counterfeit item was reported, it could remain listed if it passed Etsy’s “handmade inquiry” and no complaint was filed.

Rights-holders had to provide proof of infringement and item numbers, and if sellers reposted items under new numbers, rights-holders had to restart the complaint process. CW 1 highlighted inefficiencies in the internal reporting system and a quota system that pressured team members to initiate a set number of investigations daily, discouraging thorough examinations. Popular sellers were often shielded from scrutiny, with CW 1 recalling directives to avoid actions against a well-known seller of factory-made clothing. 

Concerns about compliance were acknowledged by managers, but resources for the Integrity Team were inadequate. Fraud reports were prepared for management, yet the team was instructed to refrain from discussing fraudulent behavior. CW 2 indicated that while a vetting process for sellers was considered, it was ultimately not implemented. CW 2 expressed dissatisfaction with Etsy's handling of infringement issues, leading to their termination, which they perceived as retaliation for raising concerns. The plaintiffs argue that these accounts, along with notes from Wedbush and Morgan Stanley, support claims that Etsy's Prospectus and Registration Statement contained false and misleading information regarding its operations and performance metrics.

The Prospectus emphasized that handmade goods are central to Etsy’s marketplace, highlighting the company's commitment to supporting small businesses and ethical practices, such as humane working conditions and sustainability. It claimed that Etsy actively ensured compliance with these ethical standards among its sellers. However, plaintiffs allege that Etsy misrepresented its dedication to artisans and small manufacturers, asserting that a significant portion of its marketplace consisted of mass-produced counterfeit goods, with Etsy failing to adequately enforce its stated policies. They argue that the Prospectus misrepresented the number of active sellers and sales figures while underreporting costs and losses. Additionally, they claim that Etsy's leadership made misleading statements regarding the company's compliance efforts during investor calls, asserting that these inaccuracies inflated Etsy's stock price prior to a decline following negative reports from Wedbush and Morgan Stanley. The plaintiffs contend that these misstatements led to their economic losses. The legal standard for the case requires that the complaint presents sufficient facts to support a plausible claim of relief, incorporating relevant documents and disclosures as necessary.

A plaintiff alleging securities fraud must adhere to heightened pleading standards under Rule 9(b) and the Private Securities Litigation Reform Act (PSLRA). Specifically, Rule 9(b) mandates that the plaintiff must articulate the circumstances of the fraud with particularity, which includes identifying the fraudulent statements, the speaker, the time and place of the statements, and the reasons the statements are deemed fraudulent. The PSLRA further requires plaintiffs to specify each misleading statement, explain why it is misleading, and provide particular facts that establish a strong inference of the defendant's intent.

The Exchange Act delineates “primary liability” under Section 10(b) and “secondary liability” under Section 20(a). Plaintiffs allege violations of Section 10(b) and its implementing Rule 10b-5 by Etsy and individual defendants, asserting that these parties made material misstatements or omissions with scienter in connection with securities transactions. To succeed under Section 10(b), a plaintiff must demonstrate misstatements or omissions of material fact, reliance on those statements, and that such reliance was the proximate cause of their injury. 

Section 20(a) holds individuals who control those directly liable under the Exchange Act accountable as well. While a party cannot be held both primarily and secondarily liable, a plaintiff may present both claims as alternative theories at the pleading stage. The plaintiffs argue Etsy's Prospectus and Registration Statement contained false and misleading statements regarding its values, policies, and performance metrics, while defendants counter that these statements were neither false nor material, with the determination of falsity hinging on whether the statements were indeed incorrect.

Omissions can constitute false statements if they lead to misleading information presented by the defendant, as established in Kleinman v. Elan Corp. A plaintiff asserting misrepresentations of opinion must demonstrate that the statement was both objectively false and disbelieved by the defendant at the time it was made, per Fait v. Regions Fin. Corp. Materiality is defined by whether a reasonable investor would find the information significant for investment decisions, as noted in Ganino v. Citizens Utilities Co. Courts must conduct a detailed inquiry to assess if disclosing omitted facts would likely alter the "total mix" of information available to an investor, following the precedent set in ECA, Local 134 IBEW Joint Pension Trust of Chicago v. JP Morgan Chase Co. Materiality is a mixed question of law and fact, leading the Second Circuit to stipulate that a 12(b)(6) motion to dismiss based on non-materiality should not be granted unless the misstatements or omissions are evidently trivial to a reasonable investor.

The plaintiffs allege that Etsy made material misstatements or omissions regarding its "values," citing claims about the significance of handmade goods in its marketplace, the nature of its community, and its commitment to authenticity and transparency. They argue these statements misrepresented the authenticity and trustworthiness of Etsy's marketplace, which they claim is a critical strength contributing to Etsy's growth.

No reasonable investor would interpret the contested statements as anything but aspirational and vague, categorizing them as "puffery" that is not actionable under the Exchange Act, as established in ECA, Local 134 IBEW v. JP Morgan Chase Co. and Footbridge Ltd. v. Countrywide Home Loans, Inc. Statements regarding corporate culture and integrity are generally considered inactionable, with descriptors like “mindful,” “humane,” and “authentic” being subjective opinions rather than factual claims. The Supreme Court in Omnicare, Inc. v. Laborers Dist. Council distinguished between statements of opinion and fact, asserting that a sincere opinion cannot be deemed an untrue statement of material fact. Allegations of "fraud by hindsight" are insufficient, as such assessments are only identifiable post-factum. The Court emphasized the necessity of contextual interpretation of issuer statements; an opinion is not misleading simply because the issuer knows of contrary facts, as reasonable investors consider opinions in conjunction with surrounding information. Plaintiffs may indicate imperfections in Etsy's compliance practices but fail to demonstrate that the challenged value statements were false or disbelieved at the time they were made. The cited cases do not support the plaintiffs' assertions that the statements exceed mere puffery, highlighting distinctions where statements about financial stability were deemed actionable due to specific misleading contexts and allegations.

A chief risk officer was dismissed after questioning the prudence of the company's investment strategy, which involved using intra-day transfers from multiple MF Global accounts, including customer funds, to meet liquidity demands. In Freudenberg v. E*Trade Fin. Corp., claims were made that E*TRADE's statements about strong growth and positioning were misleading, given allegations of significant loan purchases from dubious lenders and internal distress, including an executive's acknowledgment of expected profit declines. The plaintiffs pointed to Wedbush's estimate that over five percent of items on Etsy were counterfeit, arguing that this undermined Etsy's claims of authenticity. However, it was noted that valuing authenticity and believing in it—even with some non-compliant items—was not unreasonable. Disagreement with the defendants' views did not equate to falsehood. Section 10(b) does not address corporate mismanagement or non-deceptive conduct. Courts have determined that broad statements about compliance are not misleading even when specific unethical practices are alleged. Etsy's statements regarding its policies were upheld as not false, with assurances made about the nature of goods sold and the enforcement of compliance through automated systems and human review. The context surrounding vague statements about authenticity included more concrete compliance practices and acknowledgment of limitations in preventing counterfeiting. Overall, the plaintiffs did not successfully demonstrate that Etsy's value statements were misleading.

Etsy does not own or create items listed by its sellers but receives complaints about potential infringements on intellectual property rights, such as copyrights and trademarks. To address these concerns, Etsy has established complaint and takedown procedures, which are deemed essential for fostering confidence in its marketplace. These procedures involve reviewing complaints and determining appropriate actions, including removing infringing items and potentially shutting down shops of repeat offenders. The majority of Etsy sellers operate as individual artisans, and there is apprehension within the community about preserving the platform's handmade ethos while allowing partnerships with responsible manufacturers. Etsy aims to promote a model where artisans can maintain craftsmanship while collaborating with small manufacturers.

Etsy’s compliance practices align with its Prospectus, which details how users can flag items and how the Integrity Team proactively detects fraud. If a seller violates trademark policies three times, they may be expelled. Etsy adheres to the Digital Millennium Copyright Act, and while plaintiffs challenge the strength of Etsy's compliance representation in the Prospectus, the statements are not deemed misleading when taken in context. The Prospectus indicates that Etsy aims to act in its interests and allows management discretion in decision-making. The language used, such as "strive" and "not afraid," does not guarantee outcomes but reflects Etsy’s intentions. The Prospectus acknowledges the imperfection of its compliance practices and recognizes that sellers may not always adhere to guidelines.

Etsy's Prospectus highlights its inability to control sellers, indicating potential harm to its reputation from sellers engaging in illegal or unethical practices. It acknowledges that its fraud detection methods may not always be effective and that its complaint and takedown processes might not fully mitigate liability. The document asserts that a reasonable investor would not be misled by the language challenged by the plaintiffs, referencing a case where disclosures about complaints did not mislead investors.

The plaintiffs argue that the Prospectus misrepresented the alignment of Etsy's platform with its vision of an authentic marketplace, specifically contesting statements about Etsy sellers and their diversity, the company's commitment to responsible manufacturing, and the employees’ community engagement. However, the contested statements are described as vague and not misleading, lacking contradictory numerical data. The Prospectus does not claim that all sellers conform to its ideal standards but expresses a commitment to this vision and encourages compliance from sellers.

Companies are expected to maintain a positive outlook about their future performance, relying on current data, as established in case law (Rombach v. Chang; Shields v. Citytrust Bancorp). The description of Etsy sellers in the Prospectus serves as illustrative rather than exhaustive, allowing defendants to showcase sellers that align with the brand (ECA v. JP Morgan Chase; Kleinman v. Elan Corp). Under Rule 10b-5, disclosure of material information is only required to prevent previous statements from being misleading, as clarified in Matrixx Initiatives v. Siracusano.

The plaintiffs challenge Etsy's reported performance metrics, claiming they were misleading. They specifically contest claims regarding Etsy's membership growth, active seller numbers, gross merchandise sales (GMS), and total revenue for 2014, which showed significant year-over-year increases. Etsy reported 54 million members, 1.4 million active sellers, GMS of $1.93 billion, and total revenues of $195.6 million. The company attributed growth in marketplace and seller services revenues to increased transaction fees and new seller listings. Etsy’s costs and marketing expenses also rose significantly, with a net loss reported for the year. The plaintiffs do not dispute the accuracy of these figures but argue they are misleading due to the presence of counterfeiters and property rights infringements on the platform.

Etsy's reported financial metrics, including the number of active sellers and various revenue figures, were significantly overstated, with actual performance reflecting a greater net loss than disclosed. Under Second Circuit precedent, specifically Boca Raton Firefighters v. Bahash, the court found plaintiffs' claims regarding misleading statements to be unfounded. The plaintiffs alleged that McGraw-Hill's financial reports were misleading due to overly positive descriptions that concealed unsustainable business practices. The court dismissed these claims, stating that the responsibility to avoid half-truths does not apply to straightforward corporate earnings reporting. The plaintiffs argued that Etsy's defendants should have employed a specific method for financial calculations without offering an alternative method. Even if accounting for infringement was feasible, the defendants’ approach was deemed reasonable, as they provided necessary information for evaluating reported results. The Etsy Prospectus clarified that complaints regarding infringement led to the removal of offending products and sellers, and defined "active sellers" based on recent charges incurred, noting the importance of active sellers for assessing brand awareness and potential growth. The Prospectus did not indicate any adjustments to seller numbers or financial metrics for infringement, making it clear to investors that some reported sellers could be infringing.

Plaintiffs lack evidence to support claims that defendants intentionally misled investors regarding financial metrics related to infringement, asserting that accurate historical data disclosures do not constitute violations of federal securities law. Challenges to defendant Dickerson’s claims of Etsy’s transparency hinge on previously failed assertions of misleading conduct, which do not establish a lack of transparency due to insufficient allegations of false statements. The defendants acknowledged compliance issues and the presence of counterfeit goods, warning investors about risks associated with maintaining marketplace authenticity. Liability cannot arise from a failure to disclose information already made public. Plaintiffs allege that Dickerson made misleading statements during a May 20, 2015 investor call, asserting Etsy's commitment to best practices in managing intellectual property rights, addressing infringement through partnerships with major brands, and employing legal measures to remove infringing content. Dickerson’s statements emphasized cooperation with brand owners and adherence to relevant laws, asserting that Etsy’s practices are effective in balancing seller interests and intellectual property rights.

Etsy collaborates with major brands to combat infringing articles, facing criticism for being overly aggressive in removing listings and closing shops. The company continually updates its technology to address evolving tactics of infringers, although security concerns prevent detailed disclosure of their systems. Sellers have expressed grievances about Etsy's enforcement practices, claiming excessive removals. The statements regarding Etsy's actions align with prior reports and are deemed non-actionable, as there is insufficient evidence to suggest that Etsy's compliance system was misrepresented by defendant Dickerson. 

To assert a claim under Section 10(b) or Rule 10b-5, plaintiffs must demonstrate that defendants acted with scienter, defined as an intent to deceive, manipulate, or defraud. To establish scienter, plaintiffs must show either the motive and opportunity for fraud or strong circumstantial evidence of reckless behavior. When the defendant is a corporation, intent must be attributed to a person whose intent can be imputed to the corporation. 

The plaintiffs failed to adequately plead scienter, lacking allegations of recklessness or motive. They claim that defendants Etsy, Dickerson, and Salen acted with conscious recklessness due to awareness of infringement issues and their potential impact on performance metrics. However, proving recklessness requires demonstrating an extreme deviation from ordinary care, which must have been known or obvious to the defendants. Courts typically require specific contradictory information to be presented to the defendants at the time misleading statements were made.

Plaintiffs assert that Etsy's top managers were aware of infringement issues yet chose not to close shops selling non-handmade goods, retaliated against an employee for raising concerns, instructed the Integrity Team to conceal fraud reports, and considered but ultimately rejected a vetting process to reduce infringing items. While these actions suggest managerial knowledge of the infringement problems, they do not demonstrate awareness of potential impacts on financial results, leading to insufficient circumstantial evidence of conscious misconduct or recklessness.

In terms of motive, plaintiffs argue that defendants had a financial incentive to mislead due to profits from Etsy's IPO. Motive can be established by showing concrete benefits from misleading statements, particularly when insiders misrepresent material facts to maintain an inflated stock price for personal gain. However, general motivations, such as maintaining a high credit rating or the appearance of profitability, are insufficient for establishing motive. The court emphasizes that if a mere interest in profitability were enough to imply motive, nearly all companies experiencing stock price declines could face securities fraud claims.

The plaintiffs reference a previous case, In re Silvercorp Metals, Inc. Sec. Litig., to support their claim that a stock offering can imply motive for fraud. However, the court distinguishes this case, noting that the Silvercorp plaintiffs provided extensive circumstantial evidence of misconduct, which strengthened their motive inference. In contrast, the current allegations lack similar robust support.

An individual was interrogated and held without charge, had personal property confiscated, and paid an unofficial bail of $32,000, only to be re-imprisoned. The plaintiffs' allegations do not meet the factual sufficiency established in Silvercorp, lacking any wrongdoing that could transform their weak inferences into strong ones. Consequently, they have failed to adequately plead scienter against defendants Etsy, Dickerson, Salen, Burns, Klein, and outside directors Breyer and Wilson. The plaintiffs’ claims regarding the outside directors are based solely on their stock ownership, which, without specific circumstances relating to stock sales, does not provide a strong inference of deceit. Routine stock sales by early investors and promoters do not imply fraud. As a result, the plaintiffs cannot establish scienter for any defendant. 

Regarding the Exchange Act claims, the failure to identify any actionable misstatements or adequately allege scienter precludes establishing reliance or loss causation. Control person liability under Section 20(a) hinges on a primary violation of Section 10(b), which the plaintiffs do not allege, thus failing their control person claims. 

For the Securities Act claims under Sections 11 and 12(a)(2), the plaintiffs assert that all defendants violated these sections. Liability under these sections concerns material misrepresentations and omissions in registration statements and prospectuses, respectively, where only negligence needs to be shown. Claims under these sections generally follow the permissive Rule 8 pleading standard unless they are fraud-based, which would invoke the heightened standards of Rule 9(b). The plaintiffs argue that their claims are based on negligence and thus do not require the heightened standard; however, the Second Circuit's ruling in Rombach indicates that allegations against corporate officers can be classified as sounding in fraud if framed in such a manner.

The complaint alleged that the offering statements were "inaccurate and misleading," containing "untrue statements of material facts." Under Rombach, if a Securities Act claim uses language associated with fraud and does not specify a basis for a non-fraud claim, then Rule 9(b) applies. However, plaintiffs can distinguish their Securities Act claims from fraud claims by clearly separating them in the complaint. The current complaint lacks a clear structure and does not explicitly mention negligence, but does use language suggesting a duty of care, such as the defendants' obligation to conduct reasonable diligence and make accurate disclosures.

To establish liability under Sections 11 and 12(a)(2), a plaintiff must demonstrate either a material misrepresentation, a material omission against disclosure obligations, or a material omission that renders existing disclosures misleading. The standard for materiality aligns with that under Section 10(b) of the Exchange Act, focusing on whether a reasonable investor would be misled by the defendants' representations. Despite the liberal pleading standards of Rule 8, the plaintiffs failed to adequately plead material misstatements or omissions, as previous cases showed that the statements in question were merely "aspirational puffery." Thus, the claims were dismissed for not meeting the necessary legal thresholds.

Investors were warned of the risks that the plaintiffs claim were undisclosed, and the district court did not determine if the plaintiffs met the 9(b) pleading standard. The plaintiffs allege violations of Section 15 of the Securities Act, which pertains to 'control person' liability, but this claim hinges on proving primary liability under Sections 11 and 12. Since the plaintiffs failed to establish a primary violation of these sections, their Section 15 claim also fails. The court granted the defendants' motion to dismiss the complaint with prejudice.

The complaint includes excerpts from the Prospectus, but only highlighted portions are reproduced for efficiency. The plaintiffs challenge the sincerity of the defendants' opinions, yet their allegations are considered insufficient. They reference Item 303 of Regulation S-K, which requires disclosure of known trends affecting financial performance, but do not identify any undisclosed trends that would materially impact Etsy's projections. The Prospectus adequately disclosed the risk related to infringement, which the plaintiffs cite as a concern.

In cases of false statements of opinion, the requirements for falsity and scienter are closely linked, as a material misstatement of opinion reflects a false belief of the defendant rather than an objective fact. The plaintiffs failed to allege sufficient scienter regarding all opinion statements. They claimed that Etsy managers instructed team members not to shut down profitable counterfeit sellers, but the supporting statement did not substantiate those allegations. The court noted that while the defendants had the opportunity to lie, they argued that the individual defendants were not "statutory sellers" of Etsy securities, making the Section 12(a)(2) claims against them dismissible. However, since the Securities Act claims were dismissed entirely, the court chose not to address this issue further.