Securities Litigation Against NutriSystem Is Thrown Out

Shannon P. Duffy

10-28-2009

The team of lawyers from Morgan Lewis who defended NutriSystem Inc. in a spate of securities fraud suits can claim a complete victory now that a federal judge has dismissed a pair of derivative suits.

U.S. District Judge Mary A. McLaughlin's 56-page opinion in In re NutriSystem Inc. Derivative Litigation comes less than two months after the same judge tossed out a class action shareholders suit against the company.

McLaughlin's 41-page opinion in In re NutriSystem Inc. Securities Litigation rejected allegations that top executives made false and misleading statements about the company's financial health.

The suit alleged that NutriSystem was aware that its sales were threatened by the competition from Alli, an over-the-counter anti-obesity drug produced by GlaxoSmithKline, but that the company continued to tout its future earnings prospects.

But Nutrisystem's lawyers -- Marc J. Sonnenfeld and Karen Pieslak Pohlmann of Morgan Lewis & Bockius -- argued that the case should be dismissed because the plaintiffs had failed to establish "scienter," meaning there was insufficient evidence that any public statements were knowingly false.

McLaughlin agreed, saying in her August opinion that "the most plausible inference from the facts as alleged is that the defendants were aware of the threat posed by an over-the-counter weight loss pill, and by Alli specifically, but genuinely believed any effect on NutriSystem sales would be short-lived."

The theory of the suit was fatally flawed, McLaughlin found, because the plaintiffs failed to allege how the NutriSystem executives would have been aware of Alli's sales figures in any way other than GSK's press releases.

Lead plaintiffs attorney David C. Katz of Weiss & Lurie in New York urged McLaughlin to green-light the case on the "core business" theory, which allows for scienter to be pleaded through the combination of an officer's position with the company and fraud allegations related to the company's core business.

McLaughlin refused, saying the theory failed because it was "unclear what knowledge the plaintiff seeks to impute to which defendant on this theory; the complaint does not make such specific allegations of scienter."

The Private Securities Litigation Reform Act abandoned the group pleading doctrine, McLaughlin noted, and the law now requires the plaintiff "to establish a culpable state of mind on the part of each defendant."

Now, in a second opinion, McLaughlin has dismissed a pair of derivative actions that accused NutriSystem top executives and board members of fraud, waste and breach of their fiduciary duties.

Named as defendants in the suit were four executives -- CEO Michael J. Hagan, Chief Financial Officer James D. Brown, Chief Marketing Officer Thomas F. Connerty and Chief Information Officer Bruce Blair -- as well as six members of NutriSystem's board of directors.

Sonnenfeld and Pohlmann, in moving for dismissal of the derivative suit, argued that the plaintiffs had failed to adequately allege that making a demand on NutriSystem's board would be futile because the complaint does not contain sufficient particularized factual allegations to overcome the presumption that the board would act impartially on the demand.

McLaughlin agreed, saying individual shareholder plaintiffs who seek to bring a derivative suit have a threshold burden of showing that it would have been futile to ask the company's current board to bring the suit.

The plaintiffs fell short of satisfying that test, McLaughlin found, because the facts alleged "do not create a reasonable doubt as to whether the specific actions taken by the board are the product of the valid exercise of business judgment or whether the directors are disinterested and independent."

Plaintiffs attorneys Marc M. Umeda, Craig W. Smith and George C. Aguilar of Robbins Umeda & Fink in San Diego argued that the NutriSystem board committed waste by approving stock buyback programs in August 2006, February 2007 and October 2007 -- times when, they argued, the price of NutriSystem's stock was "artificially inflated" -- without properly considering the competitive effects of Alli upon NutriSystem's business.

McLaughlin flatly rejected that argument, saying "none of these allegations, however, is supported by particularized facts in the complaint showing that NutriSystem's stock price was artificially inflated at the time of the buybacks or that the directors knew or should have known of Alli's eventual impact."

The plaintiffs also failed to cast any reasonable doubt on whether any of the board members were "both disinterested and independent" at the time the derivative suit was filed.

As for the board members who were also company insiders, McLaughlin found there was insufficient specificity to support allegations that they possessed material non-public information at the time they made their trades.

The outside directors were also free from any reasonable doubt, McLaughlin found, because the plaintiffs' own allegations were admittedly premised on the "extensive public knowledge" of Alli's progression to FDA approval.

"This public information was equally available to the market as a whole and does not support an inference that the outside directors knew material non-public information that they deliberately failed to disclose," McLaughlin wrote.

Katz said he is pursuing an appeal of McLaughlin's August decision and that he believes recent decisions from the 3rd U.S. Circuit Court of Appeals do not support her rulings on the scienter issues.

Umeda could not be reached for comment on the ruling in the derivative suit.