Opinion ID: 62908
Heading Depth: 2
Heading Rank: 1

Heading: Accounting Irregularities

Text: The vast bulk of allegations in a very bulky complaint relate to Shaw's alleged abuse of or failure to follow GAAP. The accounting irregularities are of two types: those relating to the way in which Shaw treated its acquisition of two large companies from bankruptcy proceedings; and those relating to the percentage of completion method of recognizing revenue from Shaw's performance of long-term contracts. Plaintiffs' bottom line assertion is that these irregularities allowed Shaw artificially to inflate its earnings by hundreds of millions of dollars during the class period. This court follows the general rule [3] and has stated repeatedly that [t]he mere publication of inaccurate accounting figures, or a failure to follow GAAP, without more, does not establish scienter. Barrie v. Intervoice-Brite, Inc., 397 F.3d 249, 264 (5th Cir.), modified and reh'g denied, 409 F.3d 653 (5th Cir.2005) (quoting Fine v. Am. Solar King Corp., 919 F.2d 290, 297 (5th Cir.1990)); see also Fin. Acquisition Partners LP v. Blackwell, 440 F.3d 278, 290 (5th Cir.2006) ([F]ailure to follow accounting standards, without more, does not establish scienter.). To plead scienter adequately, plaintiffs must state with particularity facts giving rise to a strong inference that the party [knew] that it [was] publishing materially false information, or the party [was] severely reckless in publishing such information. Barrie, 397 F.3d at 264 (quoting Fine, 919 F.2d at 297).
Plaintiffs allege that Shaw misused the purchase method of accounting for the acquisitions of the assets of two large companies, Stone & Webster and the IT Group, out of their respective bankruptcy proceedings in July 2000 and May 2002. Shaw portrayed the acquisitions as critical to consolidating the company's market position and to its diversification efforts. Shaw fully disclosed its application of the relevant accounting principles. The plaintiffs assert, however, that Shaw artificially inflated the recorded reserves and goodwill associated with the purchase method and thereafter used such accounts to pad Shaw's earnings. Shaw also established reserves for pending contracts acquired from these companies that, according to the plaintiffs, bore no reasonable relationship to the fair market value of the acquired assets, and were used as cookie jar reserves to inflate its reported earnings. Plaintiffs finally allege irregularities in Shaw's accounting for adjustments to the fair value of the acquired assets; its failure to disclose the basis for pre-acquisition contingencies bearing on such adjustments; and its failure to write off impaired goodwill. (Plaintiffs' Consolidated Amended Complaint (Compl.) 98.) All of these allegations are tied to the statements in Shaw's periodic financial reports during the class period, and voluminous citations to accounting rules are included. No direct allegations of fraudulent conduct or intent on the part of Bernhard or Belk are alleged. Instead, plaintiffs rely, as they are permitted to do, on circumstantial allegations. They assert that the individual defendants must have known of the irregularities because of their executive positions in the company, and they emphasize Bernhard's hands-on management style, and the magnitude and extent of the accounting standards violations. None of these assertions withstands analysis. First, this court's caselaw makes clear that pleading[s] of scienter may not rest on the inference that defendants must have been aware of the misstatement based on their positions with the company. Abrams, 292 F.3d at 432. [4] Second, Bernhard's management style, coupled with his alleged boast that there is nothing in this company that I don't know, are insufficient to support a strong inference of scienter. See Goldstein v. MCI WorldCom, 340 F.3d 238, 251 (5th Cir.2003). Such statements lack specificity about what Bernhard may have known or, for that matter, was reckless not to have known, about the details of the company's accounting practices. That these allegations derive from confidential sources further detracts from their weight in the scienter analysis. Following Tellabs, courts must discount allegations from confidential sources. Higginbotham v. Baxter Int'l Inc., 495 F.3d 753, 756-57 (7th Cir. 2007). Such sources afford no basis for drawing the plausible competing inferences required by Tellabs. Id. at 757 ( Tellabs requires judges to weigh the strength of plaintiffs' favored inference in comparison to other possible inferences; anonymity frustrates that process.). At the very least, such sources must be described with sufficient particularity to support the probability that a person in the position occupied by the source ... would possess the information pleaded.... ABC Arbitrage Plaintiffs Group v. Tchuruk, 291 F.3d 336, 353 (5th Cir.2002); see also Central Laborers', 497 F.3d at 552 (same). The final assertion, that Bernhard, Belk and through them, Shaw must have known of the alleged accounting irregularities because they are so massive, disproves itself. This case is quite unlike most securities fraud cases, which are precipitated when the company announces such revelations as a restatement in earnings due to accounting mistakes or the discovery and correction of material errors or misdeeds in a subsidiary. Here, there was no mea culpa from the company in the form of acknowledged wrongdoing or restated financial reports, nor was there any auditor qualification to those aspects of the reports made the basis of this complaint, nor any publicly expressed reservations by the auditors to the financials. There is no single event or fact that the executives can be alleged to have known and concealed from the public. In Central Laborers, by contrast, the company disclosed material weaknesses in its internal controls that eventually required restatement of two and a half fiscal years of financial results. 497 F.3d at 549. This court concluded that the defendant's public statements and subsequent restatement due to GAAP violations provide[d] some basis to infer scienter. Id. at 552. But that is lacking here. Moreover, while plaintiffs strenuously argue that the cookie jar reserves and other devices enabled Shaw to pad its earnings massively, they make no attempt to estimate by how much the earnings were inflated. There is no standard of comparison to what the correct numbers would have been. Valuations of assets, especially contracts and assets acquired from bankrupt companies, as well as the application of sophisticated accounting standards like fair value, leave broad scope for judgment and informed estimation; this is another way of saying that determinations on such matters can differ reasonably and sizably. See Greebel v. FTP Software, Inc., 194 F.3d 185, 205 (1st Cir.1999) (`Generally accepted accounting principles' ... tolerate a range of `reasonable' treatments, leaving the choice among alternatives to management. (quoting Thor Power Tool Co. v. Comm'r of Internal Revenue, 439 U.S. 522, 544, 99 S.Ct. 773, 787, 58 L.Ed.2d 785 (1979))). Plaintiffs cannot transform inherently nuanced conclusions into fraudulent misstatements or omissions simply by saying that there were abuses or misuses of the GAAP rules. See DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th Cir.1990) (At one time the firm bathes itself in a favorable light. Later the firm discloses that things are less rosy. The plaintiff contends that the difference must be attributable to fraud. `Must be' is the critical phrase, for the complaint offers no information other than the differences between the two statements of the firm's condition.). Likewise, plaintiffs cannot make allegations that strongly support the defendants' guilty knowledge of securities fraud, on the issues of acquisition accounting here raised, by throwing out large numbers with no factual basis for ascertaining what the truth was. See In re Stone & Webster, Inc., Sec. Litig., 414 F.3d 187, 199 (1st Cir.2005) (holding that alleged overstatement of financial results did not contribute to an inference of scienter because complaint gave no indication whatsoever what the size of the alleged overstatement of current profits was). For all these reasons, we cannot derive a strong inference of scienter against Bernhard, Belk and Shaw. Plaintiffs have failed to allege a sufficient basis for defendants' knowledge or severe recklessness as to the accuracy of the accounting standards for the Stone & Webster and IT Group acquisitions.
Plaintiffs allege that Shaw inflated its earnings by prematurely recognizing revenue on long-term contracts. A substantial portion of the company's business derives from the performance of long-term engineering, procurement and construction contracts, each of which is, by plaintiffs' admission, unique and complicated. The preferred accounting standard for such contracts is the percentage of completion method, used and disclosed by Shaw in its financial reports, whereby a company records revenue as it performs work on a contract. The company first estimates the total cost of contract performance and then compares the estimate with actual costs over the life of the contract. As work proceeds, the company records the corresponding percent of the revenue that should be recorded on the company's books. When, however, reasonably dependable estimates cannot be made or inherent hazards relating to contract conditions make profit predictions unreliable, the completed-contract method becomes preferable; it recognizes revenue and expenses incurred on a contract only in the year of completion. In re Stone & Webster, 414 F.3d at 196-97. Shaw allegedly prematurely recognized revenue on long-term contracts in violation of GAAP. Shaw's management pressured, coerced and if necessary, forced employees to inflate the percentage of completion of their projects and accelerate earnings recognition. (Compl.98.) Second, Shaw lacked the internal controls necessary to estimate the percentage of completion accurately because its proprietary software program for project tracking, Shaw-Trac, did not work. [5] Because Shaw could not make reasonably dependable estimates, the plaintiffs contend that it should have used the completed contract method and deferred recognizing revenue until the contracts were completed. Overriding the specific allegations, which will be discussed below, are systematic deficiencies and an inherent contradiction in the pleadings. The plaintiffs rely heavily on confidential sources for their allegations. But they generally fail to provide sufficient details about their sources to credit their statements and fail to tie those statements to the large scale accounting fraud that allegedly took place. Further, the fact that the company's internal accounting controls did not work properly does not necessarily lead to the conclusion that revenues were consistently overstated on the company's financial reports. Because errors could bias the figures down as well as up, the inference that such errors demonstrate an intent to defraud is weak. Finally, as with the company's acquisition accounting, Shaw has never corrected, repudiated or recalculated its use of the percentage of completion method on its long-term contracts. To support the allegations of scienter on the part of Bernhard and Belk, plaintiffs contend that Shaw pressured employees to inflate the percentage of completion numbers; that Bernhard and Belk knew about Shaw-Trac's deficiencies; that they had access to allegedly incriminating internal reports; and that they must have known about the alleged overstatement of contract revenues. Each of these subjects requires discussion. The only pleadings that connect either of these defendants to pressuring of employees are two statements attributed to Bernhard. It is asserted that Bernhard told several Shaw executives during a dinner conversation that, We have got to show more progress, on Shaw's construction projects. (Compl.8). Plaintiffs would draw the inference that he was advising the others to report higher completion rates on the construction projects than had actually been achieved. Second, in or about June 2002, a former confidential insider heard Bernhard scream at a company financial analyst named Scott Roussell because Shaw's revenue numbers were too low and he needed to do something to fix that. (Compl.280.) After this incident, the confidential source claims to have heard Roussell call various operations centers in order to get them to increase their percentages of completion on Shaw's projects to `help with the numbers.' (Compl.280.) The dinner table remark is insufficient to support an inference of scienter on Bernhard's part. Initially, plaintiffs offer no source, documentary or personal, for this comment. See ABC Arbitrage, 291 F.3d at 358. Plaintiffs fail to allege with particularity when this comment was made. See Southland, 365 F.3d at 376-77. But even if Bernhard made the statement, a more likely, nonculpable inference, absent any other details, is that Bernhard was commenting on the need to improve the company's business performance. Bernhard's do something to fix that statement suffers from similar deficiencies. The confidential source is not identified sufficiently by his title, work location, or dates of employment to reassure the reader that he heard and understood the meaning of the remark. See Central Laborers, 497 F.3d at 552. Further, the statement cannot contribute to a strong inference of scienter because it is susceptible to many interpretations, including innocent ones. In re Integrated Elec. Servs., Inc., No. 4:04-CV-3342, 2006 WL 54021, at  (S.D.Tex. Jan. 10, 2006) (unpublished) (holding that comment by corporate manager to employee was too ambiguous to support strong inference of scienter), aff'd, Central Laborers, 497 F.3d 546 (5th Cir. 2007). Bernhard may have simply been pointing out an error that needed to be corrected. Bernhard and Belk allegedly knew about Shaw-Trac's malfunction in several ways. The complaint alleges that in May 2002, a letter detailing problems with Shaw-Trac was sent to senior Shaw insiders responsible for Shaw-Trac's development. (Compl.71.) Whether Bernhard and Belk were among the recipients or how they may have learned of its contents, however, is not stated, nor does the complaint allege who wrote the letter or just what it said. This allegation is too vague to allow an inference of scienter. More pointedly, plaintiffs allege that Bernhard knew that Shaw-Trac was not functional when Shaw began using the program in mid-2001. They claim that Bernhard insisted on rolling out Shaw-Trac because he wanted to use it as a marketing tool with potential customers. By 2003, it is alleged, Shaw began to move away from the program because it did not work, and Bernhard then directed the company IT department to develop Shaw-Trac Lite, a simplified new program that also failed to work. (Compl.74.) Plaintiffs do not, however, supply documentary or personal sources for the majority of these allegations. [6] This court has explained that general allegations and conclusory statements, such as stating [defendants] knew... adverse material do not contribute to a strong inference of scienter. See Blackwell, 440 F.3d at 289-90. Because there is no factual support for the allegation that Bernhard knew that Shaw-Trac was dysfunctional when it was rolled out, the allegation fails to support a strong inference of scienter. [7] Compare In re Stone & Webster, 414 F.3d at 205 (holding allegations of communications from customer to defendant were too vague to support a strong inference that defendants were aware of them or, if so, were reckless in failing to take them seriously). Further, the allegation of Shaw-Trac's problems may indicate corporate mismanagement, but the securities laws do not protect investors against negligence. See Tuchman v. DSC Commc'ns Corp., 14 F.3d 1061, 1070 (5th Cir.1994) ([C]orporate mismanagement does not, standing alone, give rise to a 10b-5 claim . ...); Acito v. IMCERA Group, Inc., 47 F.3d 47, 53 (2d Cir.1995) (same). [8] Plaintiffs do not state facts that support an inference that Bernhard rolled out Shaw-Trac with intent to deceive or with severe disregard of its potential to mislead investors. Belk is alleged to have been informed, in great detail, by a former Baton Rouge project controls manager, of all the problems associated with the use of Shaw-Trac. (Compl.73.) In Southland, this court found wanting a similar scienter allegation. 365 F.3d at 375-76. There, securities fraud plaintiffs alleged that corporate insiders, including named individual defendants, were repeatedly told by programmers and developers that one of the company's technology products would not work as represented. Id. The court held this allegation insufficient because it fail[ed] to state when, where or on what occasion or occasions this occurred, fail[ed] to in any way identify the [company's] programmers and developers involved, and [did] not indicate whether their statements were oral or written or give[] any meaningful particulars as to what was stated. Id. at 376. In this case, plaintiffs' allegation also lacks particularity concerning when, how and what the confidential source told Belk, and it lacks sufficient detail to support the probability that the source was in a position to know about all of the problems related to Shaw-Trac or that these problems pervaded the company. See ABC Arbitrage, 291 F.3d at 353; see also Cal. Pub. Employees' Ret. Sys. v. Chubb Corp., 394 F.3d 126, 155 (3d Cir. 2004) (rejecting use of statements from local branch office employees to substantiate allegations about nationwide company practices). Finally, plaintiffs allege that the defendants knew or were severely reckless in not knowing about Shaw-Trac's problems because, according to numerous confidential sources, the problems were widely known throughout the company. (Compl.26, 72.) The defendants must have known allegation was rejected by this court in Abrams, 292 F.3d at 432, as too vague to support a strong inference of scienter. Turning to more general allegations that the executive defendants knew or should have known that Shaw was prematurely recognizing revenue from its long-term contracts, plaintiffs first point to their receipt of monthly reports on the progress of contracts, which were discussed at meetings. (Compl.24-29.) The complaint does not, however, allege that the reports or the meetings included information at odds with Shaw's public statements. See Abrams, 292 F.3d at 433. [9] In fact, the complaint alleges that the reports were already inaccurate when prepared because they contained allegedly unreliable data derived from Shaw-Trac. [10] Thus, these allegations do not substantiate an inference that Bernhard and Belk knew they contained false information, nor does the mere fact that they received the reports imply that they knew of any inaccuracy. Plaintiffs also assert that the magnitude and egregiousness of Shaw's premature revenue recognition create an inference of scienter by Bernhard and Belk. According to their brief, Shaw improperly recognized millions of dollars of revenue on every single one of its EPC contracts, and because of their size, even minimal percentage increases caused material overstatement[s] of Shaw's income. Such bold statements cannot substitute for factual assertions connecting the corporate executives to specific contracts or accounting or management practices that led to the alleged overstatements. Yet particularized assertions are lacking here. [11] Moreover, a single confidential source identified as a former independent contractor for [Stone & Webster] and then Shaw contributed these allegations, but the complaint does not state how long the contractor worked for Shaw, when he learned the information alleged, or how he was in a position to know the practices of every superintendent on every Shaw project. See ABC Arbitrage, 291 F.3d at 353. Without such details, we cannot credit these allegations as a basis for a strong inference of scienter. The only specific observation by this source is that he saw a construction superintendent incorrectly record that 200 feet of pipe had been installed when, in fact, only 120 feet had been. (Compl.277.) And even the location and date of this allegation are not pinpointed. After considering plaintiffs' scienter allegations together, we conclude they do not state with particularity facts giving rise to a strong inference that the defendants knew or were severely reckless in not knowing that Shaw was prematurely recognizing revenue on its long-term contracts.