Tile Shop Can’t Chip Away at Disclosure Duty

On March 4, 2015, Judge Ann D. Montgomery of the United States District Court for the District of Minnesota (located in the Eighth Circuit) sustained securities fraud and other claims against Tile Shop Holdings Inc. and its President, CEO and founder, Robert Rucker.  In doing so, Judge Montgomery navigated a Circuit split and followed Second Circuit authority – developed, in large part, by Robbins Geller – to find that Item 303 of SEC Regulation S-K, which requires the disclosure of known trends that could have a material effect on an issuer’s business, imposed a disclosure duty that these defendants violated.

Tile Shop is a manufacturer and retailer of tile.  The complaint alleges that during the class period (August 22, 2012 to January 28, 2014), Tile Shop emphasized the success of its business model and the strength of its business and supplier relationships.  Capitalizing on these statements, Tile Shop completed two secondary public offerings that generated proceeds of nearly $70 million for several insiders, including Rucker.  Unbeknownst to investors, however, Tile Shop had cultivated an extensive business relationship with foreign supplier Beijing Pingxiu (“BP”), which was owned by Rucker’s brother-in-law, who was also employed as Tile Shop’s purchasing supervisor.  As of fiscal year 2011, 8.3% of Tile Shop product sold was purchased from BP.  By fiscal year 2013, that figure had skyrocketed to 32.2%. 

On November 14, 2013, a securities research report exposed BP’s relationship with Tile Shop and Rucker and alleged that Tile Shop had engaged in various accounting improprieties by, among other things, overstating inventory and gross profits and understating the cost of sales.  In response, Tile Shop announced that it had engaged outside counsel to conduct an investigation.  But the damage was done, and Tile Shop’s stock price plummeted by almost 39%.  On January 27, 2014, Tile Shop claimed that it found no basis to believe that Rucker knew about his brother-in-law’s ownership of BP or that accounting improprieties took place, but disclosed additional facts concerning BP and related matters.  In response, the stock price declined by nearly another 7%. 

A core issue at the motion to dismiss stage was whether Item 303 – which requires the disclosure of known trends – required Tile Shop to disclose its increasing dependency on BP.  In considering this issue, Judge Montgomery was confronted with a dearth of authority in the Eighth Circuit and conflicting authorities from the Second and Ninth Circuits, which had most recently addressed whether Item 303 could provide a basis for liability in a securities fraud case.  As Judge Montgomery recognized, while the Ninth Circuit questioned whether Item 303 could provide a basis for liability, “the Second Circuit held that Item 303 disclosure can be actionable . . . if certain conditions are met.”  Notably, the Second Circuit’s decision was based, in part, on an earlier Second Circuit decision in a case in which Robbins Geller was co-lead counsel.  

Finding the Second Circuit’s reasoning “persuasive,” Judge Montgomery concluded that “Tile Shop was required to disclose the trend of its increasing reliance on BP” under Item 303, reasoning that “a disruption in this relationship would be reasonably likely to impact Tile Shop’s future performance.”  Judge Montgomery further held that “Tile Shop management knew, or had access to information, about BP’s growing importance.”  Judge Montgomery also held that Tile Shop’s positive statements regarding its business were actionable in the absence of disclosure of its relationship with BP and upheld other securities claims against Tile Shop, Rucker, and other defendants. 

Commenting on this decision, Samuel H. Rudman stated: “We have always recognized the importance to investors of material trends in a company’s business and are gratified by the court’s well-reasoned decision in this case.  We pride ourselves on facilitating the development of law that makes the markets safer for investors.”

Robbins Geller attorneys litigating this action are Samuel H. Rudman and Joseph Russello.  The Firm is co-lead counsel in this case, and the Firm’s client is co-lead plaintiff Luc De Wulf, an individual investor. 

Beaver County Employees’ Retirement Fund, et al. v. Tile Shop Holdings, Inc., et al., No. 14-cv-00786-ADM-TNL, Memorandum Opinion and Order (D. Minn. Mar. 4, 2015).