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Shah v. Zimmer Biomet Holdings, Inc.

United States District Court, N.D. Indiana, South Bend Division

September 27, 2018

RAJESH M. SHAH, et al Plaintiffs,



         Plaintiffs Rajesh M. Shah, Matt Brierley, Eric Levy and UFCW Local 1500, which I'll refer to in this opinion as either “Shah” or “plaintiffs”, bring this putative securities fraud class action on behalf of themselves and all other similarly situated individuals who bought shares in Zimmer Biomet Holdings, Inc. (“ZBH”) during a specified period. ZBH is a publicly traded company that manufactures medical devices, based in Warsaw, Indiana. The case concerns alleged materially false statements relating to the financial performance of ZBH during the summer and fall of 2016. Four separate but overlapping motions to dismiss on behalf of four subsets of the defendants are presently before me. They all argue that Shah has failed to sufficiently allege any actionable claims. [DE 94, 96, 98, and 99.] But because Shah's allegations paint a convincing story that, if proven true, would constitute fraud in violation of the securities laws, I cannot dismiss this suit in its entirety. But as explained below, the complaint is not without deficiencies, and thus some claims must be dismissed.


          Before analyzing the sufficiency of the claims before me, I will summarize the factual allegations. Given the procedural posture of the case, the following summation comes from the complaint and certain incorporated exhibits, all of which I must assume to be true. It's difficult to tell the players without a scorecard so I'll start with a roster of defendants for fear that the underlying factual allegations would be incomprehensible without one.

         I. The Cast of Defendants.

         ZBH is the main defendant here. ZBH is a relatively recently formed entity, coming into existence as a result of a $13.4 billion mega-merger between Zimmer Holdings, Inc. and Biomet, Inc., that closed in June 2015. [DE 60 ¶ 4.] Prior to the Merger, Zimmer and Biomet were two of the major players in the medical device manufacturing industry and both were headquartered in the small town of Warsaw, Indiana. [Id.] But the crosstown rivals now operate as one; ZBH remains headquartered in Warsaw, has a presence in more than 100 countries, and employs more than 18, 000 individuals. [Id.]

         Plaintiffs have also sued several ZBH C-suite executives and corporate officers who they allege played a central role in the perpetuation of the wrongs at issue, including the individuals who made the allegedly misleading statements concerning ZBH's financial performance. These include: David C. Dvorak, ZBH's CEO, President and one its directors; Daniel P. Florin, ZBH's Senior Vice President and CFO; Robert J.

         Marshall, Jr., ZBH's Vice President of Investor Relations and Treasurer; and Tony W. Collins, ZBH's Vice President and Corporate Controller and Chief Accounting Officer. [DE at ¶¶ 52-56.] I will refer to these defendants by their last names individually and collectively as the “ZBH Management.” Plaintiffs have further named additional members of ZBH's Board of Directors as culpable parties. This subset includes the aforementioned Dvorak, as well as Larry Glasscock, the Chairman of ZBH's Board of Directors, and ten additional directors: Christopher B. Begley; Betsy J. Bernard; Paul M. Bisaro; Gail K. Boudreux; Michael J. Farrell; Robert A. Hagemann; Arthur J. Higgins; Michael W. Michelson; Cecil B. Pickett; and Jeffrey K. Rhodes. [DE 60 ¶¶ 57-68.] I will refer to these defendants by their last names individually and collectively as the “ZBH Directors.” There are also the eighteen private equity funds named as defendants. These entities previously owned Biomet stock and acquired a 15% stake in ZBH as part of the merger. [DE 60 ¶ 5.] These defendants then later sold their stakes in ZBH after the merger was consummated. This subset of defendants can further be categorized by the three private equity firms with whom these funds were affiliated. First, there are the funds affiliated with Kohlberg Kravis Roberts & Co. LP (the “KKR Funds”); second, the funds affiliated with TPG Global, LLC (the “TPG Funds”); and third, the funds affiliated with Goldman Sachs Capital Partners (the “Goldman Funds”). [Id.] To the extent it is necessary to discuss these defendants collectively, I will refer to them as the Private Equity Defendants.

         II. Plaintiffs' Substantive Allegations

         Having defined the cast of relevant players, we now come to the main action, namely the conduct which Shah has alleged transpired and how he says that conduct amounts to fraud within the meaning of the federal securities laws. Shah's 185 page complaint is a blunderbuss that paints a picture of ZBH, the ZBH Management and the ZBH Directors knowingly sitting on a proverbial ticking time bomb of a factory known as North Campus. Shah tells me that the Private Equity Defendants were allowed to make an immensely profitable escape before the clock reached zero and news of the problem first reached ZBH's regulator, the Food and Drug Administration, and, more important for present purposes, the investing public.

         Here are the details, according to Shah. By 2016 the North Campus was a facility which needed a complete overhaul in order to be compliant with federal regulations. But North Campus was also a facility which needed to be running at full capacity to realize the ambitious revenue and sales growth goals that ZBH had touted. These two needs were mutually-exclusive and plaintiffs allege that defendants kept the need for remediation on temporary hold, and hidden, in favor of trying to meet their growth goals. In effect, plaintiffs allege that ZBH took a gamble that it could in the long run accomplish both of these needs which were diametrically opposed to one another in the short term. Of course, this lawsuit would likely not exist if the gamble had worked. But instead, ZBH was forced to reveal the issues at North Campus that were previously concealed and, as a consequence, that it would miss its revenue and growth goals, sending its stock price down by approximately 20% in the span of a week.

         While analysts may have been shocked by this development, Shah alleges that defendants were anything but taken aback. According to Shah, the company's challenging situation would have come as no surprise at all had ZBH not misled investors as to the cause of the issues and made materially misleading statements in the process. Shah alleges that all of the causes of the lower-than-anticipated third quarter growth, downward projection in fourth quarter growth and attendant supply shortages were the result of substantial issues at North Campus which ZBH and its co-defendants are alleged to have known about and appreciated for months.

         A. Problems Identified at North Campus Throughout 2016.

         Key to plaintiffs's theory that defendants' knowingly concealed their manufacturing problems is the fact that defendants engaged in a series of audits of ZBH's North Campus facility in the spring of 2016. The audits of North Campus were begun in response to problems which ZBH had identified at its other main facility in Indiana, known as “West Campus.” [DE 60 ¶ 15.] The prior year, the FDA began an inspection of this separate West Campus facility and issued a letter to ZBH regarding deficiencies observed in West Campus. [Id. At ¶ 14.] ZBH later acknowledged the “systemic issues” the FDA pointed out at West Campus in a series of letters with the FDA and agreed to remediate the problems.

         It was against this backdrop that Shah alleges that ZBH decided to conduct audits of North Campus and its quality systems. [Id. at ¶ 137.] The audit reports were issued on March 31, 2016, April 13, 2016, and June 7, 2016 (the final date marking the beginning of the class period). While plaintiffs do not allege the full scope of these audit reports or their findings (as it seems they have not yet had the chance to review them via discovery), they allege that they identified significant quality system problems at North Campus. In other words, ZBH learned that its quality systems issues (and thus its FDA non-compliance) were not isolated to West Campus, which had already undergone a full FDA review, but instead were present in two of the company's main manufacturing facilities.

         While the complaint itself focuses on the temporal connection between the West Campus inspection by the FDA and subsequent internal audits of North Campus, plaintiffs, in opposing the present motions, put forth that the problems identified at North Campus in the audits would likely not have been surprising to ZBH and its upper management. This is because Zimmer, prior to the merger with Biomet, had a long and troubled history with” keeping its facilities in compliance with FDA regulations. [DE 108 at 8.] This history primarily relates to “Project Trident, ” a $250 million remediation project engaged in by Zimmer prior to the merger beginning in 2012 and continuing into 2016. [Id.][1] Plaintiffs point to ZBH's (or rather its precursor Zimmer's) experience with costly remediation of a manufacturing plant as proof that, at the time the audit reports were issued, ZBH would have appreciated the scope of the problem at North Campus and known that extensive (and expensive) remediation was a foregone conclusion.

         ZBH planned a complete overhaul of the policies and procedures at North Campus in order to bring it up to snuff. But instead of starting the overhaul immediately in the spring of 2016, it kicked the can down the road to November 2016. Plaintiffs allege that this timing is a key aspect of defendants efforts to keep ZBH stock artificially inflated. Plaintiffs allege that had ZBH began to remediate North Campus to bring it into fully regulatory compliance, the company would have had to effectively shut the plant down, bringing production at this major facility to a halt. And without a steady supply of product, ZBH could not hit its sales targets for the third quarter.

         Instead, ZBH engaged in some more minor remediation at North Campus in the immediate aftermath of the audits, something plaintiffs allege was akin to applying a tourniquet to slow down the bleeding, but putting off actually closing the wound at North Campus. Plaintiffs allege that ZBH likely hoped that beginning remediation would stave off any painful sanctions from the FDA and keep supply lines open so that ZBH could hit the third quarter and annual revenue growth projections it continued to tout.

         B. Regulatory Inspection at North Campus.

         The FDA's inspection of North Campus began on September 12, 2016. [DE 60 ¶ 161.] In all likelihood, ZBH would have had five days notice of the inspection. [DE 60 at 58, n. 7]. The FDA immediately began to identify deficiencies in the quality systems and internal controls at the facility, especially as they related to the sterilization of final product to be shipped out from North Campus. [Id. at ¶ 162.] Those problems were so bad that roughly two weeks later, on September 29, 2016, ZBH voluntarily issued a complete hold on all products coming out of the North Campus facility. [Id. at ¶ 163.] According to plaintiffs, this embargo out of the North Campus facility at the very end of the third quarter “devastated” ZBH's supply of products as well as third quarter revenue. [Id. at ¶ 164.]

         But the problems did not stop there. The FDA inspection continued throughout October and continued to cause additional disruptions in ZBH's supply of product and thus its financial performance in the fourth quarter. [Id. At ¶ 165.] And the company's “safety stock” (i.e. product reserves) was insufficient to meet demand, and so sales were not realized.

         C. Alleged Coverup By ZBH Senior Management.

         In the midst of the FDA's 2016 inspection, ZBH's third fiscal quarter came to a close at the end of September 2016. On October 31, 2016, during an investor call, ZBH announced its third quarter financial results and reported a drop in growth that quarter, reduced projected revenue guidance for the fourth quarter, and revised its total growth for 2016 to reflect no improvement for the entire year. [DE 60 ¶ 151.] These financial reports and projections were surprising to many and stood in contrast to statements made by ZBH in the months leading up to the close of the third quarter-but more on that later. During the October 31st call, Dvorak, ZBH's CEO, stated that the lower revenue, both past and projected, were related, in part, to “unanticipated supply constraints, related to our transitioning supply chain infrastructure” as well as “[efforts to] harmonize and optimize [ZBH's] sourcing, manufacturing and quality management systems.” [Id. at ¶ 153.]

         According to plaintiffs, this explanation for the third quarter miss was complete hogwash. It wasn't a case of mistaken information or carelessness by ZBH's management in learning the truth, but instead an intentional effort to conceal the true cause of the company's woes. To support this coverup theory, Plaintiffs rely heavily on allegations and facts relating to Robin Barney, a former senior vice president at ZBH and member of ZBH's executive leadership team.

         In a separate lawsuit pending in this district, Ms. Barney has alleged that she was effectively fired from her job at ZBH around the same time and that she was forced to resign for refusing to go along with ZBH's scheme to conceal the problems at North Campus. She has alleged that ZBH Management, specifically defendants Florin and Dvorak, instructed her to “commit securities fraud” and help “concoct a story” relating to North Campus and the company's third quarter miss. [Id. at ¶¶ 219-220.] As part of this alleged coverup, Barney was to pretextually fire individuals at North Campus, an allegation that is further found in (and corroborate by) allegations of yet another lawsuit filed by another ex-employee named Terry Martin. [Id. at ¶ 234] Martin was the Senior Director of Facility and Maintenance for ZBH. [Id. at ¶¶ 236-237.] Barney alleges that she refused to follow the order to terminate certain employees, and consequently was forced to resign. [Id. at ¶ 221.] Nevertheless, according to plaintiffs, ZBH went ahead with the plan, and they posit that the reasons given on the October 31, 2016 conference call for the company's unexpected revenue miss were materially misleading, because ZBH's Management was by then fully aware as to what the real cause of its problems were - the same problems the company had been alerted to months earlier via its own internal audit of North Campus.

         D. ZBH's Stock's Plummets in October and November 2016.

         After the announcement on October 31, 2016, things began to fall apart. Investors reacted immediately to the news of ZBH's under performance and began unloading ZBH's stock. The stock plummeted by $17.15 per share that day and closed at $105.40 - a 14% drop. [Id. at 154.] This resulted in the sudden evaporation of approximately $3.4 billion in ZBH's market capitalization. [Id. at ¶ 154.] As one investment analyst at Suntrust stated, ZBH's announcement “blindsided investors” by reporting that organic sales growth declined to 1.6% thus wiping out all of the projected revenue gains for 2016. [Id. at ¶ 151.]

         Speculation loomed large as to what caused this seemingly unexpected turn at ZBH, with some analysts questioning the reasons given by ZBH on the October 31st call. That same day, analysts at BMO Capital Markets issued a report expressing disbelief that supply chain issues could have been such an unexpected surprise for ZBH Management, or in their words, “to say this was a surprise is an understatement.” [Id. at ¶ 227.] J.P. Morgan likewise questioned “why didn't [ZBH management] see this coming and how could management have been so bullish on 3Q as late as the September investor conferences and an NDR [non-deal roadshow] in Boston on September 28th?” [Id. at ¶ 229.]

         Then, Northcoast Research downgraded its recommendation of ZBH's stock from “buy” to “neutral” based upon “conversations with industry contacts” stating that ZBH had been experiencing problems at its Warsaw, Indiana facilities, i.e., North Campus. [Id. at ¶ 156-157.] Analysts at Northcoast noted that while they were “initially willing to give ZBH the benefit of the doubt regarding its explanation behind unanticipated product supply issues on its 3Q16 earnings call . . . following our conversations with industry contacts, we are concerned there is more to the story.” [Id. at ¶ 156.] Specifically, Northcoast “worr[ied] future acknowledgment of manufacturing issues at [North Campus] (either by the company or in FDA Form 483 observations) could lead to additional investor concern and limit upside potential for the stock.” [Id.] According to plaintiffs, Northcoast's report effectively “foiled” the coverup and supply chain story that ZBH Management had attempted to sell to investors. [Id. at ¶ 232.]

         On November 8, 2016, ZBH made additional disclosures through its quarterly From 10-Q filed with the SEC and a press release. Through the 10-Q and press release, ZBH disclosed “(i) that the true cause of the supply shortages in Q3'16 was the disruption being caused by a disastrous FDA inspection of the North Campus; (ii) that there were regulatory deficiencies with the [quality systems] at the North Campus; and (iii) that ZBH lacked the ability to meet demand for its products while remediating the regulatory deficiencies at the North Campus.” [DE 60 at ¶ 159.] These revelations caused another significant drop in ZBH's stock price; it fell by another $2.62 which represented a drop of approximately $500 million in market capitalization. [Id. at ¶ 160.]. While this information was all new to investors, plaintiffs allege that this information, and the reasons why ZBH missed (and would miss) its third quarter revenue goals, were long known to ZBH, as it would later admit to the FDA.

         E. FDA Inspection Concludes With a 483 Warning Letter.

         The FDA concluded its inspection of North Campus on November 22, 2016. [DE 60 ¶ 166.] The results were stark. Through a 57-page Form 483 Warning Letter the FDA listed out its numerous findings and deficiencies at North Campus. These included 14 observations of process and procedure deficiencies at North Campus. Specifically, the FDA noted:

(1) A process whose results cannot be fully verified by subsequent inspection and test has not been adequately validated according to established procedures;
(2) Procedures to control environmental conditions have not been adequately established;
(3) Procedures have not been adequately established to control product that does not conform to specified requirements;
(4) Procedures for design control have not been established;
(5) Procedures for corrective and preventative action have not been adequately established;
(5) Process control procedures that describe any process controls necessary to ensure conformance to specifications have not been adequately established;
(7) Procedures for monitoring and control of process parameters for a validated process have not been adequately established;
(9) Procedures for acceptance activities have not been adequately established;
(10) Buildings are not of suitable design to perform necessary operations;
(11) Sampling plans are not based on valid statistical rationale;
(12) Procedures for rework of nonconforming products have not been adequately established;
(13) Procedures to ensure that all purchased or otherwise received product and services conform to specified requirements have not been adequately established; and
(14) Document control procedures have not been adequately established.

[Id. at ¶ 167.] In other words, the FDA's audit revealed severe deficiencies at North Campus across a wide variety of compliance areas which required large-scale remediation at North Campus.

         In response to the FDA's letter, ZBH acknowledged the deficiencies the FDA had identified via a letter to the FDA on December 21, 2016. [Id. at ¶179.] In this letter, ZBH admitted that “corporate management” was aware of “systemic issues” at North Campus as a result of the internal audits. [Id.] Specifically these “systematic issues” included “self-identified major compliance-related issues in areas such as design controls, sterile packaging, complaint handling, nonconforming material, and CAMAS.” [Id. at ¶ 180.] According to plaintiffs, the problems identified by the FDA “effectively mirrored the issues” which had been identified in the internal audits from months earlier, with ZBH acknowledging in its December letter that its audits had identified issues relating to 7 of the 14 observations noted in the FDA's Form 483 letter. [Id. at ¶ 181.] Plaintiffs say these statements are proof of ZBH's scheme throughout 2016 to conceal issues at North Campus in the hopes of beating the clock and keeping its revenue growth in line with expectations before having to engage in full-scale remediation at North Campus.

         F. Alleged Misrepresentations Throughout ...

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