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February 14, 2013

Nexflix Pricing Plan Securities Fraud Suit Tossed

By Mark S. Nelson, J.D.

The federal court in San Francisco has dismissed a securities fraud suit against Netflix, Inc., but the lead plaintiffs may file an amended complaint (In re Netflix, Inc., Securities Litigation, February 13, 2013, Conti, S.). The case arose after Netflix altered its service plans, changed subscriber pricing options, and disclosed previously undifferentiated business segment results. Lead plaintiffs Arkansas Teacher Retirement System and State-Boston Retirement System alleged securities fraud under Exchange Act Section 10(b) resulting from an alleged total stock price drop of 67 percent. The district court dismissed both the fraud claims and related controlling person claims.

Background. Netflix is a public company that offers subscription-based entertainment services via Internet streaming or mail-order DVDs. Initially, Netflix offered only DVD services (1999–2007), but later offered a hybrid plan for $9.99/month that combined streaming and DVDs (2007). In 2010, Netflix offered a separate streaming-only plan for $7.99/month.

However, in order to achieve what Netflix described as the "virtuous cycle," it again revamped subscriber choices in 2011 to offer separate streaming-only and DVD-only plans ($7.99/month each; combined $15.98/month versus the old hybrid plan at $9.99/month). These plan changes offended Netflix subscribers, who allegedly left in droves (Netflix's first net subscriber loss in many years). Netflix also had spun off its DVD business into a subsidiary and began to report separate operating results for its DVD and streaming plans.

As a result, plaintiffs alleged that Netflix experienced two major stock price drops: first when Netflix announced subscriber losses due to the cancelled hybrid plan (September 15, 2011), and again when Netflix announced new segment results showing contribution margins of 8 percent for streaming plans and 50 percent–plus for DVDs, albeit with even more lost subscribers (October 25, 2011). According to plaintiffs, these stock price drops were the result of securities fraud.

Accounting fraud. The plaintiffs alleged that Netflix ran afoul of ASC 280, which requires reporting of discrete business segments, such as Netflix's DVD and streaming lines. The plaintiffs said Netflix should have been reporting these segments separately prior to Q4 2011. The court, however, said Netflix's DVD and streaming segments were not discrete during the period alleged and thus Netflix's alleged failure to differentiate these segments in its financial reports could not support fraud allegations.

The plaintiffs also alleged fraud based on Netflix's supposed violation of Item 303 of Regulation S-K. The court rejected this claim because rule violations generally are not predicates for securities fraud. The court said that, in any event, Netflix had not withheld information about any known trends or uncertainties.

Content and pricing model. Netflix had adopted the "virtuous cycle" approach to splitting its business into DVD-only and streaming-only subscriber plans. The plaintiffs alleged that Netflix must have known that this model was likely to be unprofitable. However, the court found that Netflix had accurately portrayed its new business model. The court also declined to address the question of whether Netflix's statements on this point were forward-looking because the court had already found these statements were not false or misleading.

Moreover, the plaintiffs alleged that Netflix withheld data showing how unprofitable its new business model was based on Netflix's SEC filings and its executives' conference calls. The court found these claims flawed. The court observed that the Supreme Court's Matrixx and the Ninth Circuit's Brody opinions would not find fraud just because the speaker's words could have been more expansive.

The plaintiffs also alleged that Netflix was bleeding cash and that the new pricing model for DVD-only and streaming-only plans was just a scheme to buoy the firm's liquidity. Netflix said this was wrong because in June 2011 the firm had liquid assets of $375 million. The court found that the plaintiff's allegations were conclusory and thus did not support a finding that Netflix misled investors.

Staff comment letters. The plaintiffs alleged that comment letter correspondence between Netflix and SEC staff revealed fraud. Here, the plaintiffs claimed that Netflix failed to respond to staff requests that it provide greater detail about its business model. The plaintiffs also claimed that Netflix had provided some additional disclosures in reply to staff comments, but omitted some of these disclosures from its later SEC filings. Netflix noted that comment letters are public documents. The court found that Netflix's comment letter replies were not misleading because SEC staff never asked Netflix for detailed segment information.

The case is No. 12-00225 SC.

Attorneys: Michael Walter Stocker (Labaton Sucharow, LLP) and Shawn A. Williams (Robbins Geller Rudman & Dowd, LLP) for City of Royal Oak Retirement System, Duane Labbee and Frank J. Fish. Keith E. Eggleton (Wilson Sonsini Goodrich & Rosati) for Netflix, Inc., Reed Hastings, David B. Wells, Theodore A. Sarandos, Leslie J. Kilgore, Neil D. Hunt and Barry McCarthy.

Companies: Netflix, Inc.; Arkansas Teacher Retirement System; State-Boston Retirement System

LititgationEnforcement: CaliforniaNews FraudManipulation AccountingAuditing CorporateFinance

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