Myriad multi-year accounting errors across numerous accounting categories which resulted in significant income restatements, even when accompanied by allegations of inaccurate SOX certifications, management changes, admissions of multiple material internal control weaknesses and suspicions of insider trading, were as plausibly the result of corporate mismanagement as they were indicative of fraud and the strong inference of scienter needed to make such a claim under the PSLRA.
Hertz Global Holdings Inc. Sheet Metal Workers Local Union 80 Pension Trust Fund, In Re, No. 17-2200 (3rd Cir., 9/20/18).
The Case Below
Pension Trust Funds, Plaintiffs in this accounting restatement putative securities class action for violations of §§10(b) and 20(a) of the 1934 Act and Rule 10b-5, promulgated thereunder, appealed the district court’s dismissal of their fourth amended complaint for failure to plead the strong inference of scienter required by the PSLRA. Plaintiffs’ claims against defendant Hertz and four of its senior officers related to accounting irregularities, income adjustments and revised projections, which culminated in a multi-year restatement of income. The restatement extended over three years’ financials and revealed cumulative pre-tax and net income overstatements of $215 million and $132 million, respectively.
No Strong Inference Here
Appellants argued on appeal that the dismissal deviated from established Tellabs scienter pleading standards by (1) failing to draw inferences favorable to them; (2) requiring “smoking gun” evidence of scienter; and (3) failing to consider the scienter allegations holistically. As to the first of plaintiffs’ arguments, the Appellate Court emphasizes that, because Tellabs requires a comparative analysis of the inferences at issue, the district court could not limit itself only to those favoring plaintiffs. As to the second, stressing that causation is not the same as awareness or reckless disregard, which plaintiffs on their fourth try could not plead, the Court finds no “smoking gun” requirement in the district court’s conclusions. Turning to the defendants’ third argument, and the five factors actually evaluated by the district court – size and scope of the income restatements, deficient internal controls, materially false SOX certifications, replacement of upper management and the claims of insider trading – the Appellate Court analyzes the specifics pled as to each and concludes that none, in isolation or taken together, justifies a strong inference of scienter.
More Likely Mismanagement than Misconduct
Absent particularized allegations of fraudulent intent, the restatements, though significant, were “not sufficiently drastic or so obvious that the Individual Defendants must have known about them,” and any inference of scienter was further “circumscribed by” the fact that they were spread across myriad accounting categories and a lengthy class period. Similarly, the accounting control weaknesses, inaccurate SOX certifications and management changes designed to address an “inappropriate tone at the top” are, in the Court’s view, more plausibly consistent with mismanagement than misconduct. Even when viewed “holistically,” the Court concludes, these factors do not give rise to a cogent inference that defendants knew or consciously disregarded that their “tone” was causing the accounting errors.
Insider Trading Analyzed
And though the Appellate Court agrees that financial gain from insider trading, which in this case was both unusual and economically substantial in comparison to the sellers’ annual salaries, can be a factor indicative of motive and an inference of scienter, sales like those alleged--over a lengthy class period and in amounts (24.7% and 62.3%, respectively) which at least for this court “[did] not materially move the scienter needle,” add only minimal weight to the inference here. Finally, without accepting or rejecting the doctrine of corporate scienter, the Court concludes that the allegations at issue “would not give rise to corporate scienter under any recognized theory of that doctrine.” The appeal fails and the Court affirms.
(D. Franceski: Perhaps the Court was simply unimpressed that plaintiffs would not do better after four tries, but one would think the smoke of significant multi-year accounting errors in the context of admittedly deficient internal controls, meaningless SOX certifications, an “inappropriate tone at the top,” and significantly profitable insider sales, would suggest some fire worth exploring beyond the pleadings stage, at least on a theory of reckless disregard by the Court, or in another time, the SEC.)
(SOLA Ref. No. 2018-42-03)
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