Opinion ID: 785790
Heading Depth: 5
Heading Rank: 1

Heading: Accounting Improprieties

Text: 48 Plaintiffs contend that the Complaint's allegations of Intrenet's improper accounting practices and internal control deficiencies comprise circumstantial evidence supporting a strong inference of the Individual Defendants' scienter. Plaintiffs suggest that none of these accounting maneuvers had any facially valid purpose and, therefore, they support the inference that the Individual Defendants harbored an intent to artificially inflate the Company's operating results. The alleged accounting improprieties include: failure to reconcile inter-company transactions; understatement of day-to-day operating expenses; accounting for uncollectible receivables and understatement of Intrenet's accounts receivable reserve; failure to record an impairment in the value of assets; failure to disclose significant risks and uncertainties; arbitrarily applying cash receipts against the oldest outstanding receivable; and recording journal entries in violation of the Foreign Corrupt Practices Act, without support or backup documentation. According to Plaintiffs, the nature and magnitude of the obvious, pervasive accounting problems at Intrenet support a strong inference that the Individual Defendants knew of or recklessly disregarded these problems when making statements to the investing public. 49 In Comshare, we held that [t]he failure to follow GAAP is, by itself, insufficient to state a securities fraud claim. 183 F.3d at 553 (internal citations omitted). A complaint alleging accounting irregularities fails to raise a strong inference of scienter if it allege[s] no facts to show that Defendants knew or could have known of the errors, or that their regular procedures should have alerted them to the errors sooner than they actually did. Id. We noted in Comshare that a strong inference of scienter cannot be drawn from speculative and conclusory allegations of GAAP violations. Id. However, as discussed below, some courts have recognized that an inference of knowledge or recklessness may be drawn from allegations of accounting violations that are so simple, basic, and pervasive in nature, and so great in magnitude, that they should have been obvious to a defendant. 50 Courts have described the type and scope of accounting errors that, in combination with other factors, support a strong inference of scienter. For example, Plaintiffs cite In re MicroStrategy, Incorporated Securities Litigation, 115 F.Supp.2d 620 (E.D.Va.2000) for the proposition that violations of simple accounting rules are obvious, and an inference of scienter becomes more probable as the violations become more obvious. The complaint in MicroStrategy alleged that accounting violations caused the company to report aggregate record net income of $18.9 million over three years, when in fact the company incurred a net loss for those years of more than $36 million. Id. at 636. In addition, the company overstated its revenues over the same period by a total of $66 million. Id. After reiterating the maxim that allegations of accounting violations standing alone can never lead to a strong inference of scienter, MicroStrategy nevertheless intimated that the nature of the misapplication of accounting principles — in terms of number, size, timing, frequency, and context — is relevant circumstantial evidence of a defendant's state of mind. Id. at 635. Turning to the facts before it, the court concluded that the magnitude, pervasiveness, and repetitiveness of the company's violations of simpl[e] accounting principles serve[d] to amplify the inference of scienter. Id. at 636. The court explained: 51 Indeed, common sense and logic dictate that the greater the magnitude of a restatement or violation of GAAP, the more likely it is that such a restatement or violation was made consciously or recklessly. This, of course, is a matter of degree, but it cannot be gainsaid that some violations of GAAP and some restatements of financials are so significant that they, at the very least, support the inference that conscious fraud or recklessness as to the danger of misleading the investing public was present. Cf. In re Oxford Health Plans, Inc. Sec. Litig., 51 F.Supp.2d 290, 294 (S.D.N.Y.1999) ([P]laintiffs allege `in your face facts,' that cry out, `how could [defendants] not have known that the financial statements were false.') In this case, the alleged GAAP violations and the subsequent restatements are of such a great magnitude — amounting to a night-and-day difference with regard to MicroStrategy's representations of profitability — as to compel an inference that fraud or recklessness was afoot. 52 Id. at 636-37 (footnotes omitted). 53 Other cases likewise indicate the drastic nature and magnitude necessary for accounting violations to support a strong inference of scienter. In Telxon, the court distinguished the far more egregious facts before it from those alleged in Comshare, where we held that the alleged accounting errors did not support a strong inference of scienter. 133 F.Supp.2d at 1031. Telxon, allegedly, overstated its revenues for years, did so by over $20 million in a single quarter and reported profits when it should have been reporting losses over several different quarters. Id. (italics in original) In addition, the accounting errors appeared to be fortuitously timed, resulting in revenue increases at times when the company foretold that it would return to profitability, or when the company needed to show profits to justify rejecting a takeover bid and to win a proxy battle. Id. The Telxon court also noted the defendants' training, background, and access to information. Thus, the nature and number of the alleged accounting manipulations, coupled with the magnitude of the difference between the originally reported financial disclosures and their restatements, and the fact that the misstatements escalated dramatically in the face of the [competing offer and proxy battle], taken in conjunction with the remaining allegations in the complaint, convinced the court that the plaintiffs had adequately alleged scienter. Id. 54 In contrast to the aforementioned cases, the accounting irregularities Plaintiffs allege in this case are significantly less egregious in nature and magnitude and thus do not support a strong inference that nondisclosure of the correct numbers was the product of a deliberate or reckless effort by the Individual Defendants to defraud investors. Alleged inaccuracies stemming from GAAP violations at Intrenet include: (1) unreconciled and uneliminated inter-company transactions totaling $600,000 by the end of 1999 that, had they been properly accounted for, would have reduced Intrenet's 1999 pre-tax operating income of $750,000 to $150,000; (2) at least $200,000 in unrecorded expenses resulting from the ADS subsidiary's failure to record normal day-to-day operating expenses as they occurred; (3) $600,000 in underreported expenses due to failure to adequately reserve for uncollectible accounts receivable resulting in an amplified accounts receivable balance (e.g., during the year ending December 31, 1999, Intrenet's net accounts receivable increased by approximately $4.4 million, or 14%, but its operating revenues increased by only 8%); and (4) failure to record an impairment loss in the carrying value of machinery and equipment assets valued at $340,000 but in reality worth nowhere near the recorded amount. The Complaint notes the October 18, 2000, press release reporting a possible restatement to the tune of $1.3 million in unrecorded expenses at ADS and alleges that improper accounting practices caused Intrenet to report a pre-tax 1999 operating income of $750,000 when in fact it should have reported an operating loss of approximately $50,000. 55 These alleged accounting and reporting problems do not resemble the pervasive and egregious manipulations found to support a strong inference of scienter in other cases. Intrenet operated one of the largest trucking fleets in the country, with over $280 million in revenue and $75 million in total assets in 1999. Moreover, the Company did disclose that it lost over $4.8 million in 1999, compared with a gain of $2.8 million in 1998, and that its operating income fell from over $6.3 million in 1998 to less than $1 million in 1999 on higher revenues. Intrenet's press release announced a possible downward restatement of income of approximately $1.3 million, and Plaintiffs allege that the Company's accounting irregularities turned the Company's 1999 operating loss of $50,000 into a $750,000 profit. In the face of these figures, the errors Plaintiffs allege are not especially dramatic. Accepting Plaintiffs' allegations as true, Intrenet represented itself as a barely profitable company, when in fact it was a barely unprofitable company. It simply cannot be said that Intrenet's accounting improprieties, by virtue of their type and size, should have been obvious, Comshare, 183 F.3d at 554, to the Individual Defendants. These are not in your face facts that cry out scienter. Therefore, the alleged GAAP violations, standing alone, are insufficient to state a securities fraud claim, and when viewed in combination with the other allegations only weakly support an inference of scienter, if at all. 56