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Zhang v. Lifevantage Corp.

United States District Court, D. Utah

September 18, 2017

JUN ZHANG, Individually and On behalf of All Others Similarly Situated, Plaintiffs,



         This matter is before the Court on Plaintiffs' Motion for Leave to File Second Amended Class Action Complaint. For the reasons discussed below, the Court will deny the Motion as Plaintiffs' proposed Second Amended Complaint fails to meet the Private Securities Litigation Reform Act's (“PSLRA”) heightened pleading requirements and filing the Complaint would be futile.

         I. BACKGROUND

         LifeVantage Corporation (“LifeVantage”) is a network marketing company incorporated in Colorado and headquartered in Utah. LifeVantage sells dietary supplements, skin care products, energy drink mixes, pet supplements, and other products. LifeVantage sells products in the United States, Japan, Hong Kong, Australia, Canada, Philippines, Mexico, and Thailand.

         Beginning in 2009, LifeVantage adopted a business model known as Multi-Level Marketing, or “MLM.” Instead of selling its products in retail stores, LifeVantage relies on “independent distributors”[1] to sell its products and to recruit additional distributors. MLMs are subject to regulatory constraints in most countries and are banned in others.

         After adopting the MLM model, LifeVantage grew rapidly. The company's revenue roughly tripled annually for three consecutive years, surging from $4.14 million to $126.18 million. Revenue rose again in 2013 to $208.18 million before plateauing and beginning to decline in 2014.

         On February 4, 2015, LifeVantage's Board stated that a new CEO was necessary because LifeVantage's growth was not progressing in line with its business model. Another reason the company gave for hiring a new CEO was to “successfully manage the complexities of international product distribution and finance.”[2] In 2015, nearly all of LifeVantage's top management resigned, including the President and CEO, Chief Financial Officer, Chief Sales Officer, Chief Science Officer, and General Counsel. Around the same time, LifeVantage eliminated the position of General Counsel, appointed a new Chief Marketing Officer, and changed auditors.

         In September 2015, LifeVantage's new CEO, Darren Jensen (“Jensen”), announced new initiatives to enhance the business. These included rewards for the recruitment of new distributors and incentives for newly enrolled distributors to purchase more product. Jensen also promoted global expansion by “targeting certain gateway markets which in turn opens up opportunities in more and more markets.”[3] On October 19, 2015, LifeVantage's stock prices fell below $1 and LifeVantage affected a 7:1 stock split in order to conform to NASDAQ trading requirements.

         SEC rules require management to evaluate a company's internal controls and disclose every material weakness of which they are aware.[4] A material weakness is defined as “a deficiency, or a combination of deficiencies, in internal controls over financial reporting such that there is a reasonable possibility that a material misstatement of the registrant's annual or interim financial statements will not be prevented or detected on a timely basis.”[5] In a 2015 10-K and in four 10-Q Forms, Defendants represented that LifeVantage's internal controls over financial reporting did not contain material weaknesses.[6] In various statements, Defendants touted the adequacy of LifeVantage's internal controls, distributor oversight, and LifeVantage's compliance department.

         In 2016, LifeVantage employees raised concerns about LifeVantage's international policies, and an employee submitted a formal Sarbanes-Oxley (“SOX”) complaint. In June 2016, the company initiated an independent audit and discovered several improper sales practices dating as far back as mid-2015. In connection with this news, the investigation, and subsequent remedial efforts, the market value of LifeVantage securities fell precipitously.

         On January 27, 2017, Plaintiffs filed their First Amended Complaint (“FAC”) against Jensen, CFO Mark Jaggi, and LifeVantage, claiming that Defendants violated sections 10(b) and 20(a) of the Securities Exchange Act by making representations regarding the adequacy of LifeVantage's internal controls that were allegedly false and made recklessly or with the intent to mislead investors. The Court, in its Memorandum Decision and Order Granting Defendants' Motion to Dismiss (“the Order”), [7] filed June 15, 2017, found that Plaintiffs adequately pleaded the falsity and materiality of a number of Defendants' statements. However, the Court found that Plaintiffs failed to sufficiently plead facts giving rise to a strong inference that Defendants acted with scienter. Therefore, the Court granted Defendants' Motion to Dismiss, but allowed Plaintiffs to file a motion to amend. That Motion is now before the Court.


         Federal Rule of Civil Procedure 15(a)(2) dictates that “a party may amend its pleading only with the opposing party's written consent or the court's leave.”[8] The Rule specifies that “[t]he court should freely give leave when justice so requires.”[9] “The purpose of the Rule is to provide litigants ‘the maximum opportunity for each claim to be decided on its merits rather than on procedural niceties.'”[10]

         The Court may refuse to grant leave to amend where it finds evidence of “undue delay, bad faith or dilatory motive on the part of the movant, repeated failure to cure deficiencies by amendments previously allowed, undue prejudice to the opposing party by virtue of allowance of the amendment, [or] futility of amendment.”[11] “A proposed amendment is futile if the complaint, as amended, would be subject to dismissal.”[12]


         Section 10(b) of the Securities Exchange Act prohibits the “use or employ[ment], in connection with the purchase or sale of any security . . . [of] any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe . . . .”[13] SEC Rule 10b-5 implements Section 10(b) by making it unlawful to “make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made . . . not misleading . . . in connection with the purchase or sale of any security.”[14] Section 10(b) “affords a right of action to purchasers or sellers of securities injured by its violation.”[15]

         “A plaintiff suing under section 10(b) . . . bears a heavy burden at the pleading stage.”[16] To properly state a claim for securities fraud, a complaint must allege facts supporting the following:

(1) the defendant made an untrue or misleading statement of material fact, or failed to state a material fact necessary to make statements not misleading; (2) the statement complained of was made in connection with the purchase or sale of securities; (3) the defendant acted with scienter, that is, with intent to defraud or recklessness; (4) the plaintiff relied on the misleading statements; and (5) the plaintiff suffered damages as a result of his reliance.[17]

         Federal securities fraud claims are subject to the pleading requirements of Federal Rule of Civil Procedure 9(b), which states that “[i]n alleging fraud or mistake, a party must state with particularity the circumstances constituting fraud or mistake.”[18] The Tenth Circuit requires a plaintiff pleading fraud to “set forth the time, place and contents of the false representation, the identity of the party making the false statements and the consequences thereof.”[19]

         In an effort to meet the heightened pleading requirements, Plaintiffs' proposed Second Amended Complaint (“SAC”) re-alleges the facts contained in the FAC and adds: (1) information alleging a standard of ordinary care which Jensen allegedly deviated from; (2) statements from two more former LifeVantage employees which detail an improper sales scheme in Thailand and allege that Jensen was informed of the scheme as early as January 2016; and (3) more information regarding LifeVantage's financial history and public statements. The SAC also extends the class period to May 10, 2017, five months beyond the class period set out in the FAC.[20]

         The SAC does not include additional information affecting the three challenged statements in the FAC that were found to be immaterial or lacked facts supporting falsity. Further, allegations regarding Defendants' motive and opportunity, LifeVantage's imposition of new restrictions on Jensen's incentive compensation, the allegedly false SOX certifications, and the application of the core operations theory remain essentially the same in the SAC. Therefore, the Court will assign the same weight to those allegations as provided in the Order and will focus its discussion on whether the standard of ordinary care and former employee statements in the SAC create a strong inference of scienter.

         The PSLRA states that “the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”[21] This requirement, known as scienter, is an essential element and “consists of ‘a mental state embracing intent to deceive, manipulate, or defraud, or recklessness.'”[22] “Recklessness is ‘conduct that is an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.'”[23]

         To make this determination, “courts must look to the totality of the pleadings to determine whether the plaintiffs' allegations permit a strong inference of fraudulent intent.”[24]

[W]e may recognize the possibility of negative inferences that may be drawn against the plaintiff . . . not in a preclusive manner, but in an evaluative manner. That is to say, we consider the inference suggested by the plaintiff while acknowledging other possible inferences, and determine whether plaintiff's suggested inference is ‘strong' in light of its overall context.[25]

         Plaintiffs must show an inference of scienter that is “more than merely plausible or reasonable- it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.”[26]

         1. Standard of Ordinary Care

         In the FAC, Plaintiffs failed to provide the standard of ordinary care Defendants were held to and instead relied on statements from former LifeVantage employees to allege Defendants' deviating acts. These statements alleged that distributors purchased product ostensibly for personal use, but in quantities too large to be used by a single person. Plaintiffs concluded that Defendants' failure to more closely monitor product purchased for personal use and failure to enact adequate internal controls was an extreme departure from the standards of ordinary care. The Court found, however, that the FAC did not set out a standard of ordinary care for the situation. Moreover, there were few allegations concerning what Defendants knew about the improper sales and material weaknesses in LifeVantage's internal controls. Therefore, the mere fact that Jensen worked in the industry before and did not strengthen controls at LifeVantage was not enough to show scienter.

         The SAC renews those allegations and adds that in the 2015 and 2016 10-Ks, Jensen assured investors that LifeVantage was a member of the United States Direct Selling Association (“DSA”) and therefore subject to the ethical business practices and consumer service standards required by DSA's Code of Ethics.[27] The DSA Code of Ethics addresses, among other things, inventory loading:

A member company shall not require or encourage an independent salesperson to purchase inventory in an amount which unreasonably exceeds that which can be expected to be resold and/or consumed by the independent salesperson within a reasonable period of time. Member companies shall take clear and reasonable steps to ensure that independent salespeople are consuming, using or reselling the products and services purchased.[28]

         DSA member companies are also required to “provide adequate training to enable independent salespeople to operate ethically, ” and to “prohibit their independent salespeople from marketing or requiring the purchase by others of any materials that are inconsistent with the member company's policies and procedures.”[29] Finally, when a complaint is made that an

independent salesperson . . . of a member company has engaged in any improper course of conduct pertaining to the sales presentation of its goods or services, the member company shall promptly investigate the complaint and shall take such steps as it may find appropriate and necessary under the circumstances to cause the redress of any wrongs that its investigation discloses to have been committed.[30]

         In addition to the DSA Code of Ethics, SEC regulations require certain internal controls.[31] The internal controls designed by management must “[p]rovide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the issuer's assets that could have a material effect on the financial statements.”[32]

         Plaintiffs allege that Jensen, as CEO, was responsible for following these standards, but failed because (1) LifeVantage did not have documented, country-specific policies for distributor enrollment requirements, distributor payment and collection policies, and shipping, order fulfillment, and customs import policies; (2) there were inadequate controls over certain international practices, including a lack of training monitoring and oversight of personnel who were involved in or managed its international business operations; and (3) Jensen instituted bonus pools and other incentives which encouraged purchasing of inventory beyond what an individual could sell or use.

         Despite these alleged issues, Jensen assured investors on January 12, 2016, and February 12, 2016, that he was aware of the evolving regulatory environment within direct selling and that the company had “proactively taken steps” to ensure that they were fully in compliance with this ever changing regulatory landscape.[33] Plaintiffs claim that deficiencies were an extreme departure from the standard of ordinary care. Defendants' response argues that Jensen complied with the standard of ordinary care and, only months after allegedly learning of inadequate internal controls and improper sales practices, initiated an independent investigation.[34]

         The allegations do suggest that Jensen, at some level, deviated from the standards of ordinary care by providing incentives that encouraged inventory loading, failing to make sure LifeVantage's internal controls were adequate for the international expansion the company was attempting to accomplish, and assuring investors that controls were in place. These allegations provide some support for an inference of scienter. However, the Thailand scheme, discussed below, began before Jensen announced the initiatives that allegedly encouraged inventory loading. This, combined with the mere fact that Jensen did not strengthen controls within his first few months as CEO, is not enough to show extreme deviation from the standard of ordinary care. Further, when Jensen allegedly discovered the improper sales practices, he followed the standard of care and initiated an internal investigation into the complaints. Therefore, Plaintiffs' allegations may support a finding that Jensen deviated from the standard of ordinary care, but the Court finds that any deviations that occurred did not rise to the level of extreme deviations and are insufficient to independently support a strong inference of scienter.

         2. Former Employees

         The FAC included statements from former LifeVantage employees which Plaintiffs used to support allegations that Jensen put policies in place that encouraged inventory loading and improper sales practices. The Court found that, while some upper management may have known about improper sales practices, the former employees' statements did not include any allegation that supported an inference that Jensen was made aware of improper distributor enrollments or sales during the class period. Without this link, the FAC did little to support a strong inference of scienter.

         The SAC contains the same statements from the first four former employees and adds statements from two other former employees, Former Employee 5 (“FE5”) and Former Employee 6 (“FE6”), detailing an illegal sales scheme that allegedly occurred in Thailand. FE5:

served as Director of Supply Chains from February 2009 to March 2017. He managed approximately nine people in three departments: inventory, logistics, and purchasing. He oversaw 10 markets for the Company and performed quality control audits in the United States, Japan, and India. He reported to COO Robert Urban until Urban's termination in December 2016, and ...

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