Godinez v. Alere Inc.

Citation: 272 F. Supp. 3d 201Docket: Civil Action No. 16-10766-PBS

Court: District Court, D. Massachusetts; August 23, 2017; Federal District Court

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Plaintiffs have filed a lawsuit against Alere and three corporate officers, alleging violations of Section 10(b) of the Exchange Act and SEC Rule 10b-5, along with derivative claims under Section 20(a) of the Exchange Act. The motion to dismiss the supplemental and amended consolidated class action complaint is evaluated under Federal Rules of Civil Procedure 9(b) and 12(b)(6) and the PSLRA, focusing on whether the complaint satisfies the heightened pleading standard for scienter. The Court has partially allowed and denied the motion.

Alere, a Delaware corporation based in Waltham, Massachusetts, specializes in diagnostic testing and operates globally. Key allegations of securities fraud include: (1) undisclosed material weaknesses in internal controls over revenue recognition; (2) failure to disclose product recalls for IN-Ratio devices; (3) billing improprieties in its divisions; and (4) undisclosed violations of the Foreign Corrupt Practices Act by foreign offices.

Plaintiffs support their scienter claims by citing the executives' decision to sell the company and the substantial change-of-control payments of $29 million that Nawana and Hinrichs would receive if an acquisition occurred. In defense, the defendants argue that Nawana and Hinrichs increased their stock holdings during the class period, which counters the inference of fraudulent intent. Nawana was promoted to CEO in October 2014, and Hinrichs became CFO in April 2015, with both having significant financial incentives tied to a potential company sale.

In February 2015, Alere implemented a new executive compensation plan featuring a short-term incentive based on performance metrics. By mid-2014, Alere executives had started exploring options to sell the company, culminating in an August 4, 2014, announcement to refocus on core operations. Former CEO Ron Zwanziger expressed interest in acquiring Alere for $46 per share, which was publicly noted in a September 15, 2014, press release where J.P. Morgan was identified as the financial advisor for potential transactions. Although Alere rejected Zwanziger's offer, it proceeded to sell subsidiaries in October 2014 and January 2015 as part of its refocusing strategy.

In December 2015, Abbott Laboratories expressed interest in acquiring Alere, prompting the Alere board to authorize J.P. Morgan to reach out to other potential buyers. During a January 11, 2016, healthcare conference, Alere reported financial results for the first three quarters of 2015 that were later revised downward, and discussed the INRatio2 medical device, which was subsequently recalled.

Regarding internal controls, Alere's March 5, 2015, 2014 Annual Report disclosed a material weakness in accounting for deferred tax assets following the sale of its health management business. Subsequent amendments revealed errors in income tax accounting linked to 2014 divestitures, requiring revisions to financial statements from 2012 to 2014. An internal control issue was noted in a November 2015 SEC filing, highlighting a lack of adequate accounting resources for income taxes. A former Alere Senior Accountant indicated that the company’s expansive structure hindered accurate financial reporting, with reliance on basic spreadsheet software for reconciliations.

Additional confidential witnesses reported deficiencies in revenue recognition practices, including premature revenue claims before the transfer of risk, and a strategy of "stuffing" distribution channels with discounted sales at quarter-end to inflate sales figures.

Confidential witnesses do not have contact with senior management, and some left Alere before Nawana and Hinrichs assumed executive positions. Alere's SEC filings (10-K and 10-Q), including amended versions, contained Sarbanes-Oxley Act certifications, with Nawana and Hinrichs affirming the effectiveness of internal and disclosure controls. Plaintiffs argue that Alere was aware for years of significant deficiencies in its INRatio blood clotting measurement tool, which likely warranted a recall. A 2007 comment from then-CEO Zwanziger described the device as “crude,” and customer complaints were often attributed to “user error.” A confidential witness from Quality Assurance noted persistent complaints about the device’s performance and reported that Alere had to significantly increase its quality assurance staff to manage the influx of complaints. Plaintiffs claim Alere was aware of INRatio issues as early as May 2014, following a partial recall of the device’s test strips, which was mentioned in the 2014 10-K filing. In late 2015, an investigation into the INRatio's impact on Xarelto study results was underway, and the FDA later advised Alere that a proposed software improvement for INRatio was ineffective, recommending a voluntary market withdrawal. This was not disclosed until Alere's July 2016 announcement of the INRatio recall. Additionally, it is alleged that in early 2016, Alere became aware of further adverse information regarding INRatio, coinciding with negative media coverage about the device's reliability and safety. Regarding billing practices, Alere's Toxicology Division faced allegations of fraudulent billing practices, starting with a complaint from Horizon Blue Cross and Blue Shield in August 2013, claiming at least $36 million in fraudulent insurance claims for unnecessary drug tests.

A former Medicaid Accounts Resolutions Specialist and a former Toxicology Billing and Pricing Supervisor at Alere provided confidential testimonies indicating that Alere engaged in unnecessary toxicology screenings and faced audits revealing problematic billing practices. Alere's subsidiary, Arriva, which sells diabetes testing supplies, reportedly had a history of Medicare billing violations and was under multiple government investigations, including a Civil Investigative Demand from the U.S. Attorney for the Middle District of Tennessee regarding improper claims. Plaintiffs allege that Alere was aware of these issues, particularly after Arriva's acquisition of AmMed Direct, LLC, which was previously involved in a Federal False Claims Act suit.

In addition, a confidential witness, who served as the National Sales Manager in India, indicated that Alere was notified of potential Foreign Corrupt Practices Act (FCPA) violations by at least fall 2013, citing a Deloitte investigation into corrupt bidding practices involving Alere distributors and government officials in India.

On February 1, 2016, Abbott announced its intention to acquire Alere for $56 per share, potentially yielding $29 million in change-of-control payments for certain executives. Alere filed a Form 8-K with the SEC, asserting compliance with securities laws and that all relevant disclosures were accurate, including the absence of any material adverse legal proceedings. However, subsequent events throughout 2016 revealed further details of the alleged fraud, contradicting the assurances made in the merger agreement.

On February 26, 2016, Alere announced a delay in filing its 2015 Annual Report (10-K) due to an ongoing analysis of revenue recognition issues in Africa and China, which could impact internal financial controls. The company also revealed it received a SEC subpoena related to a formal investigation into its sales practices in Africa. By March 15, further delays in filing the 10-K were disclosed, alongside a grand jury subpoena from the DOJ regarding sales practices and FCPA compliance in multiple regions, leading to an eight percent drop in Alere’s stock price. Analysts reacted negatively, with BTIG downgrading the company.

On April 20, during Abbott's earnings call, the CEO did not confirm the commitment to acquire Alere, resulting in a twelve percent decline in Alere’s stock. Alere’s response on April 28 indicated that Abbott had raised concerns about Alere's representations in the merger agreement and sought a termination of the merger in exchange for $30 to $50 million.

In May 2016, lawsuits were filed regarding INRatio product defects, and a subpoena was issued by the U.S. Attorney for documents related to Alere's FDA interactions and product performance. On July 11, Alere announced the recall of INRatio products due to inaccurate blood clotting time results, expecting $70 to $90 million in related charges, which caused a three percent drop in stock price.

On July 14, Alere disclosed in a press release and Form 8-K that it identified material weaknesses in its internal controls over financial reporting, which had led to improper revenue recognition in previous fiscal years.

On July 1, 2016, Alere received a subpoena from the DOJ’s Criminal Fraud Unit regarding billing records related to Medicare, Medicaid, and Tricare patients, which led to a 29% drop in stock value on July 27, 2016. On August 8, 2016, Alere filed its delayed 2015 Form 10-K, revealing revenue performance below prior estimates, with a significant revision of income from continuing operations for the first nine months of 2015 from $18.2 million to $6 million. The report indicated material weaknesses in internal controls over financial reporting, confirmed by PwC, and outlined corrective measures, including staff hiring and operational reorganization. Additionally, the withdrawal of INRatio products was expected to adversely affect fourth quarter results, with a $38 million charge noted for the recall and projected charges of $70 to $90 million for 2016.

On August 25, 2016, Alere initiated a lawsuit against Abbott in Delaware Chancery Court to enforce their merger agreement, which led to Abbott counter-suing on November 3, 2016, for breach of contract due to inadequate information access. The breach of contract claim was settled on November 15, 2016, but Abbott later sought to terminate the merger agreement on December 7, 2016. On November 4, 2016, Alere disclosed in its Third Quarter 2016 10-Q that Medicare revoked the enrollment of its subsidiary Arriva for improper billing practices involving deceased patients, highlighting the potential for severe revenue impacts, as Arriva contributed $88 million in revenue in the first nine months of 2016.

Plaintiffs assert that Arriva has had compliance issues since at least March 2012, linked to its acquisition of AmMed, which faced false claims allegations regarding Medicare diabetes testing supplies. They claim Arriva made several materially false and misleading statements, including improper revenue recognition in SEC filings for fiscal year 2014 and the first three quarters of 2015, deficiencies in internal controls over financial reporting, failure to disclose a loss contingency for INRatio products, and misleading SOX certifications. Plaintiffs also allege that Arriva’s risk disclosures lacked material facts and that the Alere-Abbott merger agreement was misleading and omitted significant information. 

To establish loss causation, plaintiffs cite stock price declines following the disclosures of these issues, asserting reliance on the fraud-on-the-market theory. For the legal standards, to withstand a Rule 12(b)(6) motion to dismiss, plaintiffs must present sufficiently substantial factual allegations to suggest a plausible claim for relief. Allegations under Section 10(b) require proof of material misrepresentation or omission, scienter, a connection to securities transactions, reliance, economic loss, and loss causation. The PSLRA mandates specificity in identifying misleading statements and the reasons they are misleading, as well as a "strong inference" of fraudulent intent or high recklessness. Ordinary negligence does not meet the threshold for recklessness in this context, and claims of fraud cannot merely reflect hindsight, contrasting prior optimism with negative outcomes.

The excerpt outlines the legal standard for establishing a strong inference of scienter in securities fraud cases. A mere reasonable inference is inadequate to withstand a motion to dismiss; instead, the inference must be compelling compared to any opposing inferences. The First Circuit has confirmed that clear allegations of admissions, internal records, or discussions indicating that defendant officers were aware of withholding critical information can satisfy this stringent requirement.

In addressing the plaintiffs' claims regarding materially false or misleading statements related to revenue recognition in 2013 and 2014, the defendants contend that the allegations do not present particularized facts indicating a conscious intent to defraud or substantial recklessness. While the defendants acknowledge that the original statements violated GAAP standards, they argue that these standards are complex, and thus, the plaintiffs' claims do not meet the scienter threshold. Conversely, the plaintiffs assert that the clarity of GAAP principles supports their argument for scienter.

The complaint lacks specific allegations showing that senior officers of Alere were aware of the revenue recognition errors before February 2016. To adequately plead scienter, the plaintiffs must demonstrate GAAP violations alongside fraudulent intent. Although there are references to issues with internal controls from confidential witnesses, the complaint fails to establish that the defendants or the company had prior knowledge of the revenue recognition issues. The plaintiffs attempt to argue that the defendants were aware of internal control problems in other accounting areas, which they claim should have indicated potential issues with revenue recognition, thereby supporting a stronger inference of scienter.

The argument regarding scienter is weakened by the fact that previous internal control issues at Alere related to corporate taxation rather than revenue recognition, distinguishing it from past cases like Varghese, which involved uncollected trade receivables. Plaintiffs fail to demonstrate that problems in one accounting area indicate widespread internal control issues across all accounting functions. Furthermore, the revenue recognized prematurely was genuine, undermining claims of fraudulent intent. The plaintiffs' assertion that the acknowledgment of internal control issues closely followed the merger announcement suggests potential falsity in the merger agreement's warranty of financial statement accuracy. However, the inference of fraudulent intent is weak because Alere’s revenue recognition issues were not based on fictitious revenue, and temporal proximity alone does not suffice to infer scienter. 

A timeline of events related to the INRatio recalls highlights that Alere began recalling INRatio testing strips in May 2014 and issued warnings by December 2014. Despite submitting a software enhancement to the FDA in late 2015, the FDA later indicated that the enhancements were ineffective and advised Alere to plan for a voluntary market withdrawal. Alere officially withdrew INRatio products on July 11, 2016, and recorded a $38 million loss in its 2015 10-K due to issues existing as of December 31, 2015. Reports of INRatio malfunctions and injuries surfaced in early 2016, and the FDA began investigating the product's reliability in clinical trials. Defendants argue that there was no basis for plaintiffs to claim that Alere should have anticipated the need to disclose a loss contingency for the INRatio recall prior to July 2016, noting that while Alere attempted to address INRatio issues, these efforts did not guarantee an eventual recall.

Accounting standards require an entity to accrue a loss contingency when it is probable that a liability has been incurred and the amount can be reasonably estimated, as outlined in ASC 450-20-25-2. Disclosure is mandated when the likelihood of a loss is "more than remote but less than likely." Alere contends that knowledge of a necessary recall in 2015 would have deterred its investment in product fixes, challenging the inference of scienter. Defendants characterize the plaintiffs' claims regarding INRatio as "fraud by hindsight," which is insufficient for establishing scienter.

Several points weaken the defendants' position on not needing to disclose or accrue a loss contingency. Firstly, Alere recorded part of the claimed loss in July 2016 against a reserve created in 2015, acknowledging that the circumstances necessitating the withdrawal were present as of December 31, 2015. Plaintiffs argue this indicates that loss recording facts were known well before the July 2016 disclosure. Secondly, between the FDA's late 2015 software update submission and the July 2016 recall, the FDA informed Alere that the enhancements were inadequate, suggesting a voluntary removal of INRatio from the market. Thirdly, confidential witness statements regarding increased quality assurance hiring for INRatio complaints, along with reports of numerous complaints to the FDA, imply that Defendants were aware of ongoing issues.

Additionally, a statement made by Nawana at a January 2016 industry conference about improving conditions for INRatio products adds to the plaintiffs' case. Collectively, these facts suggest that Defendants knew or should have known by mid-2015 that a recall was likely, warranting accrual or disclosure under accounting standards. The potential withholding of this adverse information until after the merger announcement with Abbott raises further questions of scienter. Defendants' claim that the loss was recorded in the fourth quarter of fiscal 2015 due to accounting timelines is unconvincing.

Aere failed to disclose critical information regarding the INRatio product recall in its early 2016 Form 8-K filings, despite the existence of circumstances warranting a recall as of December 31, 2015. The company had previously acknowledged risks associated with INRatio in its 2014 10-K, indicating that product issues could lead to recalls. However, this disclosure did not adequately inform the market about the severity of the product's failure rate that prompted the FDA's recommendation for a voluntary recall. The court considers confidential witness statements regarding numerous complaints and increased quality assurance efforts in 2015 as factual support for the allegations against Aere. While defendants argue that Aere was unaware of the likelihood of a recall until July 2016, the ongoing consumer issues hinted at an impending recall, which could impact the company's merger with Abbott. The court suggests that the combination of prior recalls, high complaint volumes, and the timing of merger discussions creates a strong inference that Aere's management knew or recklessly concealed the need for a loss reserve related to the INRatio recall to ensure the merger proceeded smoothly. The potential for significant personal financial gain for executives further supports this inference. The court will seek a summary judgment record to evaluate whether Aere intentionally hid these facts from the market.

Plaintiffs must plead facts that create an inference of scienter, which must be at least as likely as any opposing inference. Materiality is determined by whether a reasonable investor would find that the disclosure of omitted facts significantly alters the information available. In the case at hand, defendants argue that the recall of INRatio products was immaterial due to their minimal contribution (less than two percent) to net revenue and the relatively small financial charge ($0.38 million) in the fourth quarter of 2015. Conversely, plaintiffs contend that the recall was significant as it involved substantial charges ($70-$90 million) and led to a notable decrease (3.2% to 8%) in gross profits. The materiality of the recall is supported by Alere's filing of a Form S-K to inform the market; however, the court finds that materiality cannot be resolved as a matter of law at this stage.

Regarding the Toxicology Unit's billing practices, defendants claim that the existence of a 2016 regulatory investigation does not sufficiently indicate scienter in the context of securities fraud. The mere existence of an investigative subpoena lacks probative value without allegations of prior disclosure to senior management. Confidential witness statements do not support an inference of scienter at the senior management level since the witnesses did not hold senior positions and lacked communication with upper management. Additionally, a DOJ notification that it was closing its investigation without action further weakens the plaintiffs' position. Allegations concerning a lawsuit from Horizon Blue Cross Blue Shield do not provide strong evidence of senior management's scienter either, as they pertain to a predecessor corporation and lack further substantiation.

No strong inference of scienter was found in the allegations against the defendants, as the claims were linked to a predecessor corporation, Avee Laboratories, and the lawsuit had not been adjudicated. The defendants argued that FCPA allegations failed to adequately plead scienter, noting that a government investigation alone does not imply senior management's knowledge of unlawful conduct. The plaintiffs referenced statements from a National Sales Manager regarding a "highly corrupted" bidding process and a Deloitte investigation, but the timing and results were vague, lacking evidence of senior management's awareness.

Furthermore, the existence of a DOJ subpoena related to FCPA compliance was deemed insufficient to establish a strong inference of scienter. In contrast to prior cases, where more substantial allegations were present, the only evidence presented was the subpoena itself. Regarding Arriva’s Medicare claims, while defendants acknowledged billing for deceased patients, they contended there was no evidence to suggest senior management knew of specific false claims. The plaintiffs pointed to prior compliance issues and disclosures in Alere’s 10-K but failed to demonstrate that the parent company was aware of the subsidiary's submission of claims for deceased individuals.

Lastly, Alere’s filing of a Form 8-K on February 1, 2016, indicated its agreement to be acquired by Abbott, asserting compliance with SEC regulations and maintaining adequate internal controls, which further complicates allegations of wrongdoing. The court found that the allegations did not adequately support an inference of scienter against senior management.

Plaintiffs allege that Abbott's claims in the Delaware Chancery Court indicate that representations and warranties in the merger agreement with Alere were materially false and misleading. They assert that Abbott's accusations of Alere's failure to disclose critical information under the merger agreement imply a strong inference of scienter under securities law. However, Abbott's focus in Delaware was primarily on contractual violations, such as Alere's refusal to provide necessary financial and business information, rather than on securities law breaches. Although some representations by Alere were proven untrue, the allegations from the Delaware litigation, except for one, do not sufficiently demonstrate that senior management knew or recklessly disregarded the misleading nature of the merger agreement statements at the time they were made.

One notable allegation from Abbott claims that Alere India’s Director of Finance was placed on "long leave" and suspended with pay, preventing Abbott from interviewing him during due diligence. This claim is vague regarding whether it was directed by Alere India management or the parent company’s senior management and does not establish that the Director possessed information that needed to be disclosed under securities law. Ultimately, Alere and Abbott completed the merger at a reduced price of $51 per share on April 14, 2017, coinciding with Abbott’s dismissal of all claims in Delaware.

Plaintiffs argue for a holistic examination of all alleged facts to assess the inference of scienter, rather than evaluating each allegation in isolation. They contend that the multitude of allegations reflects a systemic failure in internal controls across various aspects of the corporation's reporting structure, which includes accounting errors and FCPA violations. They also note that while a single government investigation may not indicate scienter, the presence of multiple investigations across different departments contributes to a stronger inference. The year following the merger announcement was notably difficult for Alere, marked by consistent negative information disclosed to the market.

Internal control issues primarily stemmed from diverse international operations and varying government regulations affecting subsidiaries. Aside from INRatio-related concerns, there is insufficient evidence of senior management's prior knowledge of the alleged issues, leading to a weak inference of scienter. Under Section 20(a) of the Exchange Act, which holds controlling persons liable for securities law violations, the claims are dependent on an underlying violation. Consequently, the court dismissed the section 20(a) claims except for those related to INRatio, as the underlying claims under Rule 10b-5 were also dismissed. The court denied the motion to dismiss regarding materially false statements linked to INRatio but granted the motion for all other allegations. Carla Flakne was dismissed from all claims due to the lack of pursued individual liability. The court noted that the specific date when the FDA advised Alere about a voluntary recall remains unclear but occurred between a software enhancement submission and the July 11, 2016 recall announcement. Alere reported part of the loss in Q4 2015, indicating that the circumstances for the recall existed then. The plaintiffs lacked evidence showing that Alere's senior management was aware of Medicare's restriction on Arriva's access to the HETS billing system in 2015, nor was there a clear link between this restriction and improper billing for deceased patients, especially given that CMS's decision suggested limited access was not Arriva's fault.