Opinion ID: 4301416
Heading Depth: 4
Heading Rank: 2

Heading: “Tone at the Top”

Text: The Fund also contends that we can infer Kirk and McHenry’s scienter from the Committee’s conclusion that those two set an “inappropriate tone at the top” by emphasizing their desire to achieve financial targets. The only court of appeals to have addressed similar allegations concluded that they did not support an inference of scienter. 52 In that case, the Fourth Circuit explained that such admissions “fail to suggest that defendants intentionally created an environment conducive to accounting fraud; the company simply admits that such an environment existed.” 53 Some district courts have inferred scienter from a company’s admissions of an inappropriate tone at the top. In Luna v. Marvell Technology Group, the plaintiff alleged that the inappropriate tone at the top “applied pressure to meet revenue targets not only on sales personnel (who, presumably, could work harder to generate more revenue), but also on finance personnel (who could only work with the transactions they were given).” 54 But the Luna court also relied on the fact that the company terminated its CEO shortly after 50 Southland, 365 F.3d at 365. 51 Cf. Owens, 789 F.3d at 538 n.4 (“These allegations [common to more than one defendant] do not constitute group pleading because they are sufficiently particularized.”). 52 Matrix Capital Mgmt. Fund, LP v. BearingPoint, Inc., 576 F.3d 172, 183 (4th Cir. 2009). 53 Id.; see also In re Hertz Glob. Holdings, Inc. Sec. Litig., No. 13-7050, 2017 WL 1536223, at  (D.N.J. Apr. 27, 2017) (describing a company’s restatement admitting there was an inappropriate tone at the top and concluding “although the Restatement admits to mismanagement and admits that the mismanagement impacted company accounting decisions, that by itself is not actionable”). Matrix also rejected the same argument that the Fund raises here, that “tone at the top” is a term of art critical to strong internal controls. See Matrix, 576 F.3d at 183. Even if that is true, it does not suggest that McHenry and Kirk intended to create that tone or were consciously doing so. 54 No. C 15-05447 WHA, 2017 WL 2171273, at  (N.D. Cal. May 17, 2017). 15 Case: 17-50162 Document: 00514587918 Page: 16 Date Filed: 08/06/2018 No. 17-50162 commencing the internal investigation, without terminating any senior or lower-level employees, which further supported an inference of the CEO’s misconduct in creating the “tone.” 55 Another district court determined that a company’s disclosure that it had “concerns about tone at the top,” made it “more plausible . . . that the fraud flowed from the top[ ]down.” 56 We conclude that the instant allegations based on the Audit Committee’s finding of an inappropriate tone at the top do not strongly support an inference of scienter. The allegation that Kirk and McHenry set an inappropriate tone at the top gives no information about how they did so. The Fund must plead the requisite scienter “with respect to each act or omission.” 57 Without knowing what Kirk and McHenry said or did, it is equally credible that they realized that the tone at the top was inappropriate only with hindsight. 58 All we know about this tone is that Kirk and McHenry emphasized “meeting or beating consensus EPS and achieving certain financial targets.” This court has declined to find a strong inference of scienter in goals that “virtually all corporate insiders share.” 59 These allegations also contrast with Luna in two key ways. First, there is no indication that Kirk and McHenry applied direct pressure to finance personnel. The Audit Committee concludes only that their emphasis on financial targets “may have” resulted in inappropriate accounting decisions. Second, it is undisputed in this case that a former lower-level employee orchestrated a large part of the fraud. This makes even more likely the 55 See id. at . 56 Fresno Cty. Emps.’ Ret. Ass’n v. comScore, Inc., 268 F. Supp. 3d 526, 551–52 (S.D.N.Y. 2017). 57 15 U.S.C. § 78u-4(b)(2)(A). 58 Much like accounting errors and restatements “can easily arise from negligence, oversight or simple mismanagement,” Abrams, 292 F.3d at 433, so too can “tones” become “inappropriate” through negligence. 59 Owens, 789 F.3d at 539. 16 Case: 17-50162 Document: 00514587918 Page: 17 Date Filed: 08/06/2018 No. 17-50162 alternative that the fraud flowed from the “bottom[ ]up” than from the “top[ ]down.” 60 These details also make it less probable that the corporate officers directed the fraud or acted with severe recklessness. We emphasize, however, that we are not saying that allegations based on a company’s finding of an “inappropriate tone at the top” can never support a strong inference of scienter. Rather, we conclude only that the instant allegations contribute minimally to that inference. c. “Inappropriate Historical Accounting Practices” The complaint also alleges, based on the June 8-K, that McHenry and at least one other person “engaged in inappropriate historical accounting practices relating to management estimates and certain accruals.” This accounting related to (1) inventory valuation, (2) adjustments to estimates and accruals “without timely or appropriate analysis,” 61 and (3) accrual and release of a contingency reserve in a manner inconsistent with Generally Accepted Accounting Principles (GAAP). The Audit Committee also concluded that these practices “were undertaken for the purpose of enhancing the Company’s reported financial results.” The Audit Committee’s report states that a group (including McHenry) engaged in the improper accounting, and that a subgroup (perhaps as large as the whole group) did so with the requisite scienter. Two aspects of these allegations dampen an inference of McHenry’s scienter. First, the June 8-K does not identify McHenry’s particular inappropriate practices, stating only that he engaged in inappropriate accounting “in some instances.” Second, the report is replete with passive voice: It makes no reference to McHenry’s objective, only that “particular adjustments to particular management 60 Cf. comScore, 268 F. Supp. 3d at 552. 61 Specifically, recording adjustments before analysis was complete, or modifying analysis to obtain a desired result. 17 Case: 17-50162 Document: 00514587918 Page: 18 Date Filed: 08/06/2018 No. 17-50162 estimates were undertaken” for improper purposes. Nevertheless, these allegations support the inference that McHenry shared the objectives of improperly enhancing Hanger’s financial results, or that he at least knew that others were doing so. The Audit Committee’s report contributes to an inference of scienter. 62