Opinion ID: 201697
Heading Depth: 3
Heading Rank: 2

Heading: The TPPI Project and Phantom Revenue

Text: 55 The second group of claims of fraud relates to the TPPI contract for construction in Indonesia, which was ultimately cancelled for lack of funding. The Complaint alleges that S & W, with the knowledge of Smith and Langford, reported expected future payments as current revenues, even though the project was indefinitely suspended and defendants knew it was unlikely to ever be resumed. The Complaint alleges that S & W overstated its current revenues and concealed an expected loss, which according to GAAP principles should have been recognized. 56 The allegations are essentially as follows: In 1996, TPPI awarded to S & W a $710-million contract in connection with the construction of a $2.3-billion chemical complex in Indonesia. ¶ 63. S & W procured and transported to Indonesia approximately $332 million worth of materials and equipment to perform the project. ¶ 64. Under its agreements, S & W assumed responsibility for cancellation costs with respect to equipment purchase orders and subcontract work. ¶¶ 64-65. 57 In 1997, TPPI suspended work on the project because its funding arrangements were exhausted. ¶ 65. The Complaint alleges that TPPI suggested to S & W [in 1997] that it try to get out of its contracts with its vendors due to the suspension. Id. By August 1998, S & W obtained permission from TPPI to resell project materials and equipment, and it began selling equipment, according to Daniel Martino, a former senior accountant at S & W, for pennies on the dollar. ¶¶ 58, 73. 58 By January 1999, it was clear that the project would not restart, and TPPI had told S & W that the slight prospect that had existed during 1998 that they would find an investor to fund the project had fallen through. ¶ 74. In January 1999, a special meeting of the Company's Board of Directors was held to discuss TPPI, and by the end of the meeting it was evident to the Board that the TPPI project had already caused S & W serious financial problems and that it was unlikely the project would ever restart. ¶ 77. 59 The Complaint asserts that because the Company had incurred substantial costs without corresponding revenue, the suspension of the project 60 should have had a significant negative effect on S & W's financial statements. According to CS-1 [an informant who had been an assistant comptroller at S & W], to avoid that negative effect, beginning with the first quarter of 1998, S & W created phantom revenue and receivables from the TPPI project to cover S & W's project related costs by recording revenue equal to the amount of those costs. 61 ¶ 67. S & W booked $86.9 million of such phantom revenue in connection with TPPI in 1998 and $53 million in 1999. ¶ 68. The use of this allegedly fraudulent accounting changed the Company's results in 1998 from a loss of $108.7 million to a reported loss of $49.3 million, and in 1999 from a loss of $11.3 million to reported net income of $20.5 million. Id. Furthermore, because S & W knew the project was cancelled, it was obligated under FAS 5 to immediately recognize the entire expected loss either as a charge or as a loss contingency. See ¶ 76. 62 While the notes to the financial statements did refer to a loss contingency based on TPPI, the Complaint alleges that the references were false in two respects. First, the notes stated that the Company believes it unlikely that the project will be cancelled, or otherwise gave the impression of a likely restart, see ¶¶ 209, 224, 296, while the apparent circumstances showed it was highly likely the contract would be cancelled. Second, the amount of the loss estimated to result from the cancellation was substantially understated given the immense investment the Company had made in the TPPI project and the high probability the entire investment would be lost if TPPI failed to reinstate the project. 63 In substance, the Complaint describes two separate, though related, accounting abuses in violation of GAAP principles: First, it alleges the overstatement of revenues (phantom revenues) and concealment of loss by inappropriate use of percentage-of-completion accounting (assuming a zero-profit margin) to report current revenues not yet received, when the buyer could not be expected to satisfy [its] obligations under the contract. See SOP 81-1 ¶ .23. The offsetting of the actual current losses with projected revenues that were not expected ever to be received allegedly concealed large current losses on the project. Second, the Complaint alleges concealment of an expected loss by failure to acknowledge it appropriately, either as a charge to income, or as an accurately described loss contingency. See FAS 5 ¶¶ 8, 10. The Complaint alleges that as a result of these accounting decisions, S & W's financial results published in the Company's 10-K and 10-Q filings, as well as in other public announcements, were materially overstated. 64 In addition, the Complaint alleges that S & W misled investors by carrying the TPPI project in its backlog, see, e.g., ¶ 221, failing to acknowledge that the project was terminated or at least unlikely to restart, see, e.g., ¶¶ 166, 193, 209, 217, 224, 296, and reporting a materially understated estimate of the Company's losses when disclosing the charge S & W would take in the event the project were to be cancelled, see, e.g., ¶¶ 209, 224, 296. 65 (a) The PSLRA's requirement of clarity and basis. In our view, the allegations of exaggerated revenues and failure to report an expected loss are sufficiently detailed and supported to satisfy the PSLRA's clarity-and-basis requirement. 66 These allegations are quite detailed and clear in setting forth what are the allegedly false and misleading statements and in explaining why they are false and misleading. The GAAP documents cited by the Complaint specify that the propriety of reporting unreceived payments as current revenue, matched with currently incurred costs, depends on a reasonable expectation that the buyer will satisfy the obligation to make the payments. See SOP 81-1 ¶ .23. The Complaint adequately explains that in these circumstances, TPPI, which had lost its source of funding and had indefinitely suspended all work on the project, could not be expected to satisfy its contractual obligation to make payment. 67 It also seems clear from the GAAP documents that as soon as current estimates of total contract revenue and contract cost indicate a loss, a provision for the entire loss on the contract should be made. See SOP 81-1 ¶ .85; see also ARB 45 ¶¶ 6, 11. A probable loss should be accrued by a charge to income when the amount of loss can be reasonably estimated. FAS 5 ¶ 8. A reasonable possibility of loss should be properly described and declared as a loss contingency. Id. ¶ 10. The Complaint clearly states its theory that TPPI's expected failure to pay would result in very substantial losses to S & W, which it did not take as a charge against earnings. To the extent the probable loss is described in the contingency notes of S & W's statements, the Complaint alleges with clarity that the notes are misleading in describing the possibility that TPPI might cancel as unlikely, ¶ 209, and in understating the size of the loss that would result in the event of that contingency. Furthermore, drawing all reasonable inferences in plaintiffs' favor, the Complaint adequately asserts that the amount of loss could have been reasonably estimated. 68 We find that, as in Aldridge, 284 F.3d at 82, and In re Cabletron Systems, Inc., 311 F.3d at 39, these allegations are sufficiently detailed and clear to satisfy the clarity-and-basis requirements of the PSLRA and Rule 9(b). 69 On the other hand, claims of fraud based on the mere inclusion of the TPPI contract in S & W's backlog must be dismissed. We affirm the district court's dismissal of these aspects of the Complaint for substantially the same reasons in our discussion of the inclusion of the allegedly underbid contracts in the backlog. As defined by the Complaint, S & W's backlog consisted of the accumulated amount of the Company's committed, but unexpended, contractual work. ¶ 38. Even if the TPPI project was unlikely to restart, it still constituted, under the terms of the Complaint, committed, but unexpended, contractual work. S & W's statements as to backlog cannot be considered false or misleading just because they included the TPPI contract. Thus, these statements cannot give rise to liability under Rule 10b-5, § 20(a), or § 18. 70 (b) Strong inference of scienter. As noted above, where the plaintiff's recovery depends on proof that the defendant acted with a particular state of mind, the Complaint must set forth facts giving rise to a strong inference that the defendants acted with the required state of mind. See 15 U.S.C. § 78u-4(b)(2). 71 (i) Claims under 10b-5. The claims relating to TPPI, to the extent pleaded under 10b-5, must be supported by facts giving rise to a strong inference of scienter. We find that the allegations as to Smith and Langford's involvement with TPPI fail that test. 72 The principal theory of the Complaint as to TPPI is that defendants reported phantom revenue and failed to make appropriate disclosure of an expected loss. Even drawing all reasonable inferences in plaintiffs' favor, as we must, the Complaint fails to support a strong inference of scienter as to Smith and Langford. The factual allegations, which satisfy the clarity-and-basis requirements as to the use of misleading accounting, lack sufficiently compelling and clear factual allegations concerning the culpable involvement of Smith and Langford to support a strong inference of scienter on their part. 73 Despite the Complaint's rhetorical flourish, accusing defendants of reporting phantom revenue, the booking of revenues before their receipt does not necessarily involve any impropriety whatsoever. As described earlier, such anticipatory booking of revenues is integral to percentage-of-completion accounting (including with a zero-profit margin), according to the GAAP documents plaintiffs cite in the Complaint. In fact, for construction businesses engaged in S & W's type of work, such percentage-of-completion accounting with anticipatory recognition of revenue is described as preferable in most circumstances. See SOP 81-1 ¶ .25. The question raised by the Complaint is the more subtle one of whether in the particular circumstances presented it was appropriate to use percentage-of-completion accounting, which depended primarily on whether the purchaser of S & W's services (TPPI) was expected to fulfill its obligations. 74 Thus, the allegations of scienter concerning both the reporting of phantom revenue from the TPPI project and the failure to reflect the expected loss depend largely on whether the Complaint alleges facts supporting a strong inference that Smith and Langford did not expect TPPI to fulfill its commitments. The Complaint speaks vaguely of communications from TPPI to S & W expressing doubt as to TPPI's resumption of the project and suggesting that S & W get out of its contracts with vendors. These allegations are simply too vague to support a strong inference that Smith and Langford were aware of them or, if so, were reckless in failing to take them seriously. 75 Again, without attribution, the Complaint alleges that S & W obtained TPPI's permission to sell project materials. A former senior accountant is quoted for the proposition that the materials were sold for pennies on the dollar. This allegation is too sketchy and vague. There is no indication how broadly materials were sold or that senior management was aware of the circumstances. 76 We recognize the Complaint alleges that Smith and Langford knew the equipment sent to Indonesia for the project was being sold for pennies on the dollar and that the project would not be restarted. ¶ 75. It also alleges that it was evident to the Board [of Directors] ... that it was unlikely the project would ever restart. ¶ 77. Such conclusory allegations as to the existence of knowledge are insufficient to provide the factual basis, supporting a strong inference of scienter, required by the PSLRA. They are simply conclusory assertions of the facts for which a showing supporting a strong inference of scienter must be pleaded. Where the state of mind in question is the defendant's knowledge of the fraudulent nature of the Company's financial reports, and the PSLRA requires that facts be stated with particularity giving rise to a strong inference that the defendant acted with that state of mind, the requirement is not satisfied by a pleading which simply asserts that the defendant knew of the falsity. 77 We therefore affirm the district court's dismissal of the claims regarding TPPI brought under Rule 10b-5 against Smith and Langford. 78 (ii) Claims under §§ 20(a) and 18. Our rulings on the claims brought under §§ 20(a) and 18 with respect to TPPI mirror our treatment of the claims brought under §§ 20(a) and 18 with respect to the alleged policy of underbidding. Because the PSLRA's strong-inference requirement does not apply to the claims brought under §§ 20(a) 12 and 18, (1) we reject the reasons given by the district court for dismissing the claims, and (2) note that the reasons which support our order of dismissal of the similar claim under Rule 10b-5 have no application to these claims. Accordingly, we vacate the judgment dismissing them. We remand these claims to the district court for whatever further proceedings are appropriate. 79