Opinion ID: 2972410
Heading Depth: 3
Heading Rank: 2

Heading: analysis

Text: We find that “storm warnings” were certainly present by February 23, 1999, as the restatements announced at that time wiped out $16.7 million in earnings, based on the “review of certain judgmental accounting matters,” the bulk of which were attributed to recognition of asset impairments, adjustments to valuation allowances, and correction of improperly recognized revenue. Other storm warnings preceded that announcement, however, including: the collapse of the Symbol deal following a due diligence review of Telxon’s books; the December 11, 1998 restatement of earnings; the shareholder class actions filed that day alleging misrepresentations in the financial statements; delays in the release of financial results because the review of certain judgmental accounting matters had not been completed; and the SEC’s commencement of a formal investigation covering Telxon’s accounting practices. WPMC argues that it could not have known from the restatements announced on February 23, 1999, of facts supporting a claim that PwC participated in the scheme to falsely inflate Telxon’s financial results. First, WPMC claims that at that point Telxon was apparently still content with PwC’s services since the restatements were made “with the concurrence of PwC.” On the contrary, PwC’s “concurrence” in no way negates PwC’s alleged participation in the fraudulent scheme. In fact, WPMC alleges that the Telxon defendants and PwC acted together to falsely inflate the company’s financial results. PwC’s concurrence in the restatements indicated its agreement that the financial statements over a three-and-a-half year period had materially misrepresented the company’s financial condition. WPMC also relies on the fact that the February 1999 restatements did not include all of the transactions that were ultimately restated in August 1999. While that is true, the question is when the plaintiff should have discovered the facts underlying PwC’s participation in the fraud. The newly disclosed items were of the same nature as those that had been previously disclosed and told nothing new about PwC’s involvement in the scheme. With the additional items, the restatements for the entire period wiped out about $18 million in net earnings (as opposed to the $16.2 million announced on February 23, 1999). With the March 10, 1999 disclosures, Telxon revealed some detail concerning the restatements that suggested the nature of the accounting manipulations and that they were not “small mistakes” that could have been overlooked. Without repeating all the items, we note that they included the outright reversal of more than $20 million in product revenues and financing because the “criteria for revenue recognition had not been recognized”; an increase in product return reserves by $4.725 million for a six-month period; and a $6.5 million adjustment to receivables to account for bad debts owed by a single retailer. A week later, Telxon also fired Brick and Haver. These disclosures added to the texture of the information available to WPMC in evaluating the earlier storm warnings, the February restatements, and the facts underlying PwC’s alleged participation in the fraud. Finally, WPMC urges us to find that it could not have known the facts underlying its claims against PwC until May 2001, when Telxon filed its third-party complaint and the class plaintiffs filed their own action against PwC. The crux of this argument is that WPMC could not successfully establish scienter without direct evidence from a participant in the fraud or access to PwC’s internal No. 04-3240 Wyser-Pratte Mgmt. Co. v. Telxon Corp., et al. Page 11 work papers. First, we agree with the district court that WPMC was not required to plead scienter with the level of specificity required by the PSLRA. Second, even if it were, we find that WPMC may not delay the commencement of the statute of limitations until after it has secured direct evidence of PwC’s culpability. This court rejected a similar argument in New England, which was also a securities fraud claim brought against an outside auditor. New England filed an earlier action against the company, Fruit of the Loom, alleging the same accounting manipulations that formed the basis of the claims against the auditor. New England argued that it could not have known whether the accountant’s certification of the financial statements were knowingly or recklessly false until after the accountant’s workpapers were obtained in the earlier action. Rejecting this argument, the court explained that: We agree that scienter on the part of corporate insiders—which New England plainly alleged in the Fruit complaint—does not necessarily imply scienter on the part of outside auditors. At the same time, however, direct evidence of scienter is not necessary to a determination of fraud. See, e.g., Herman & MacLean v. Huddleston, 459 U.S. 375, 390 n.30 [] (1983) (noting that scienter may be proved with circumstantial evidence). In this case, we believe, the facts alleged in the Fruit complaint strongly suggest that Fruit’s auditors were at least reckless. For one thing, the alleged fraud relates primarily to departures from GAAP contained in audited financial statements—the “same issues,” New England has said, that are addressed in the Ernst complaint—and not to representations that were neither scrutinized nor approved by the auditors. Moreover, the scope of the alleged fraud—involving overvaluation of fixed assets and inventory by more than $400 million, premature recognition of more than $50 million in sales, and failure to accrue liabilities and charges totaling $89 million—is such that any reasonable investor would question the auditors’ oversight. As New England says in its brief, the fraud “does not involve little mistakes that the auditors might have overlooked.” In the light of the particular allegations against Fruit, we are at a loss to understand why New England should not have determined, by July 1, 1998, that Ernst knowingly or recklessly participated in the alleged fraud. New England, 336 F.3d at 502. Seeking to distinguish New England, WPMC argues that it was New England that filed the earlier action against the company as well as the later action against the auditor. The relevance of the prior action was not that New England had filed it, but was that the facts alleged in the earlier complaint provided inquiry notice sufficient to start the limitations period on claims that the auditors participated in the fraud. Likewise, we may consider the facts that were known or should have been known to WPMC at the time the original class action suits were filed against Telxon. This case is more like New England than it is different. In denying the motion to dismiss the class claims against the Telxon defendants, the district court provided this characterization of the accounting manipulations at issue: Plaintiffs allege over three years of pervasive and escalating accounting manipulations. Plaintiffs allege that defendants (1) improperly recognized revenue, (2) understated its charges, [3] improperly valued accounts receivable, [4] improperly recorded charges, and [5] understated its bad debt expenses. While some of these alleged accounting manipulations, by themselves, would appear to be entirely discretionary, such as in which quarter bad debt should be recognized, others nearly create a strong inference of, at least, recklessness even when considered in No. 04-3240 Wyser-Pratte Mgmt. Co. v. Telxon Corp., et al. Page 12 isolation. . . . These accounting decisions are not of the type that are generally within any range of “reasonable treatments”; they are, instead, the kind of accounting entries which, at least on their face, would seem to put reasonable men, particularly those with the training, background and access to information available to Brick and Haver, on notice that they were improper and would lead to a serious misstatement of revenue. This is particularly true, moreover, when one considers the number of accounting errors, the many quarters over which they occurred, and the fortuity of their timing—i.e., resulting in revenue increases at times when Telxon foretold that it would return to profitability, or when Telxon needed to show profits to justify rejecting Symbol’s offer and to win its proxy battle with Wyser-Pratte. In re Telxon, 133 F. Supp.2d at 1030. As in New England, the alleged fraud by PwC is based on the same accounting manipulations and misleading financial statements as the fraud claims against the Telxon defendants and are such that any reasonable investor would question the oversight of the auditor. In its reply brief, WPMC points to the following allegations as having been first disclosed by the May 2001 complaints against PwC: PwC violated GAAS by failing to adequately plan and supervise the work of its staff or establish and carry out procedures reasonably designed to search for and detect the existence of material misstatements, and by substituting client representations for audit procedures; PwC recklessly assigned new and inexperienced auditors to the Telxon account, limited the time and experience devoted to the Telxon account in order to increase PwC’s profit margin, and completely ignored serious concerns raised by Telxon as early as April 1997 as to the service being provided by PwC; PwC consciously and recklessly disregarded the risk that Telxon’s financial statements might contain material errors, particularly relating to certain transactions occurring at the end of the second quarter of 1999, by failing to test and evaluate Telxon’s internal control structure in order to verify that Telxon had appropriate policies, practices and personnel in place to ensure that non-standard, unusual and significant transactions were properly account[ed] for; PwC coerced Telxon to restate its financial statements in order to conceal PwC’s own reckless audits and reviews of the financial reporting periods in question; and PwC concealed that it was insisting on Telxon’s restatements in order to obviate the appearance of fraud by PwC and limit PwC’s exposure to liability. Telxon also alleged that PwC’s audit plans identified certain audit risks, but recklessly disregarded them in conducting the audits and certifying the financial statements. Comparison of the allegations of fraud against Telxon and PwC show that the “facts” WPMC contends were first disclosed in the allegations made against PwC in the May 2001 complaints do not reveal that anything materially different was discovered about PwC’s participation in the fraud. The essence of WPMC’s argument is, as it was in New England, that it was entitled to discover direct evidence of PwC’s recklessness before the statute of limitations began to run. Given the less stringent pleading requirements for scienter applicable to WPMC’s state law fraud claims, we find that WPMC knew or should have known in the exercise of reasonable diligence of the facts underlying the claim that PwC participated in the alleged fraud no later than the end of March 1999. Thus, WPMC’s complaint filed on June 11, 2002, was not filed within two No. 04-3240 Wyser-Pratte Mgmt. Co. v. Telxon Corp., et al. Page 13 years of commencement of the statute of limitations and, in the absence of class action tolling, is time barred.