ATTORNEY: Michael J. Wernke
POMERANTZ MONITOR January/February 2016
Judge Allen of the Eastern District of Virginia recently denied defendants’ motion to dismiss our class action complaint against Lumber Liquidators Holdings, Inc. During the class period, the company, which sells hardwood and laminate flooring, reported record gross margins that were substantially higher than its major competitors’. Defendants represented that the major driver of these high margins was legitimate “sourcing initiatives” in China that supposedly reduced the cost of goods and cut out middlemen. In truth, however, the company’s high margins were due to importing cheap flooring made from illegally harvested wood and laminate that was contaminated with high levels of formaldehyde. When the truth emerged in a series of disclosures and events – including news of federal criminal charges for violations of the Lacey Act and the well-substantiated, televised broadcast by 60 Minutes of extensive wrongdoing -- the stock price plunged by 68%. In the aftermath, the board suspended the sale of Chinese laminate products, the CEO, CFO and the company’s “Head of Sourcing” abruptly resigned, and the company replaced its compliance officer.
The court held that the complaint adequately alleged that defendants’ statements were false: its increased margins were not due to legitimate “sourcing initiatives,” or to the company’s efforts to work with mills to produce flooring that meets their “high quality standard,” or to policies to ensure regulatory compliance, as the company had said. In fact, the company later admitted that its Chinese suppliers failed to adhere to regulations and that it did not build a compliance team in China until December 2014.
The court also held that the complaint raised a strong inference of scienter, because defendants had access to non-public information suggesting that their statements were false; third parties easily discovered the regulatory violations; defendants repeatedly discussed analyst calls regarding their personal involvement in the sourcing initiatives in China that were driving their margins higher; and defendants sold a majority of their stock during the class period. The court found that, given the importance and focus of the sourcing initiatives in China, it was part of the “core operations” of the business, another factor that supported the conclusion that management must have known the truth. Finally, the court imputed to management, and to the company, the knowledge of its head of sourcing.
Finally, the court found that the complaint adequately pleaded loss causation because the partial disclosures, when “taken together.... revealed the widespread scope of defendants’ allegedly fraudulent scheme.”