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A federal appeals court has reinstated a shareholders’ lawsuit that charges Scholastic Corporation misrepresented its financial condition to investors as a top executive cashed in the majority of his shares. The 2nd U.S. Circuit Court of Appeals overturned a lower court’s dismissal of the class action, which alleges that the company buried information about a sharp increase in the number of unsold books returned to Scholastic by retailers. The ruling came in the case of Hollin v. Scholastic Corp., 00-7517, which had been dismissed by senior federal Judge John Keenan of the U.S. District Court for the Southern District of New York. The allegations concern Scholastic’s popular children’s series “Goosebumps,” and the company’s expansion of its distribution of the series beyond traditional retailers to mass merchandisers and nontraditional retailers in 1996. Plaintiffs claimed that although the expansion was well-received by the investing public, the company did not reveal that it had a liberal return policy for unsold books, and made numerous misrepresentations about the number of returns in late 1996 and early 1997. The complaint charged that when compared with the book publishing industry as a whole, Scholastic had enjoyed a relatively low return rate. But the same was not true for “Goosebumps,” and when company officials met with an analyst for Merrill Lynch in 1996, plaintiffs claimed, it persuaded the analyst to issue a report saying the company’s “return rates remain among the lowest in the industry at less than 20 percent, which might suggest that Goosebumps has been somewhat underdistributed.” After talking with company officials a second time and being reassured that no meaningful increase in book returns had occurred, Merrill Lynch issued another report in January 1997, raising its rating on the company — a report that caused the company’s stock to rise. But shareholder anger was unleashed in February 1997, when Scholastic, having previously announced it would probably earn between 64 and 73 cents per share for the previous quarter, issued a press release saying it expected a third-quarter loss of between 70 to 80 cents per share. The release also noted the company was planning to take a $13 million pretax special charge for additional book returns. As a result of the release, the company’s stock plunged 40 percent. The suit, filed under the Securities Exchange Act of 1934 and Rule 10b-5, charged that the company disseminated false information, was silent as to damaging truthful information about the company and failed to update prior public statements that had become misleading. The suit also charged that the company’s vice president for finance and investor relations, Raymond Marchuk, sold 80 percent of his stock in the company before the damaging news was released. Scholastic and Marchuk moved to dismiss the case, arguing that the complaint failed to state a claim and failed to plead fraud with particularity, as required by the Federal Rules of Civil Procedure and the Private Securities Litigation Reform Act. Judge Keenan found some allegations regarding the December returns “too vague,” and criticized the plaintiffs for using information in its pleadings from the “pre-class” period. ‘AGGRESSIVE TACTICS’ But on the appeal from that dismissal, Senior 2nd Circuit Judge Richard J. Cardamone said that “any information that sheds light on whether class period statements were false or materially misleading is relevant.” And the lower court, he said, “failed to take into account” that the plaintiffs had alleged that Scholastic reviewed point-of-sale data from some retailers on a daily basis and employed “aggressive tactics,” such as altering its return policy and encouraging distributors to keep unsold books rather than return them. “In this way, plaintiffs claim, defendants staved off or delayed disclosure of the huge amount of book returns to its inventory and delayed having to set up adequate reserves for the income it had reported, but due to huge returns would never receive,” he said. These allegations, in spite of Scholastic’s claim that the widely varying quarterly results reflected the cyclical nature of the book business, were enough for plaintiffs to survive the pleading stage, he said. “Defendants maintain, in effect, that there are no allegations in the complaint that would support proofs of either false statements or a fraudulent intent,” Judge Cardamone said. “To the contrary, we think plaintiffs sufficiently allege an unusual business model which, if proven, ignored alarmingly high returns that function as an obvious straw to show which way the wind was blowing in this book business.” As to Marchuk, assuming the allegations were true for purposes of a motion to dismiss, Cardamone said, “For a spokesperson to cash in his own stock can in appropriate circumstances be like a ship’s captain exiting into the safety of a lifeboat while assuring the passengers all is well.” “Marchuk was primarily responsible for Scholastic’s communications with investors and industry analysts,” Cardamone said. “He was involved in the drafting, producing, reviewing and/or disseminating of the false and misleading statements issued by Scholastic during the class period.” Judge Guido Calabresi and Southern District Senior Judge Charles S. Haight Jr., sitting by designation, joined in the opinion. Jeffrey A. Klafter of Bernstein Litowitz Berger & Grossman, along with Stephen A. Whinston and Douglas M. Risen of Berger & Montague, represented the plaintiffs. Michael J. Chepiga and Felecia L. Stern of Simpson Thacher & Bartlett represented Scholastic Corporation and Raymond Marchuk.

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