Opinion ID: 62908
Heading Depth: 3
Heading Rank: 2

Heading: Percentage of Completion Accounting

Text: 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.