Opinion ID: 201697
Heading Depth: 3
Heading Rank: 1

Heading: Underbid Projects

Text: 33 The first category of plaintiffs' claims principally relates to the allegation that S & W underbid various projects and fraudulently reported expected profits from these projects when, in fact, the projects were expected to produce losses. The district court dismissed all of these claims on the ground that the pleading failed to satisfy the PSLRA's requirement of clarity and basis. We conclude that at least with respect to some of the claims, the clarity-and-basis requirement was satisfied. 34 (a) PSLRA's requirement of clarity and basis. In our view, this pleading is not the kind of vague prelude to a fishing expedition that Congress sought to bar by imposing the clarity-and-basis requirement of the PSLRA. Citing sources within the company, the Complaint alleges that S & W developed a strategy of bidding a number of projects at a loss. ¶¶ 52-53. The Complaint expressly names ten contracts, aggregating over $1.4 billion, which allegedly were underbid by margins between 10% and 40% and were expected to produce losses. ¶¶ 58-61. The Complaint alleges that the Company accounted for these projects using percentage-of-completion accounting, recognizing a proration of anticipated future profits in the current profit and loss statements, notwithstanding that losses, rather than profits, were expected to result from these contracts. ¶¶ 43, 47, 168. The Complaint refers to SOP 81-1, which forbids the use of the percentage-of-completion method to prorate anticipated future profits into current operating results unless future profits are in fact anticipated, see SOP 81-1 ¶¶ .24-.25, as well as FAS 5, which requires immediate recognition of expected losses, as soon as they are anticipated, see FAS 5 ¶ 8; SOP 81-1, ¶¶.24, .85. The Complaint identifies with precision statements alleged to be false, including S & W's periodic current earnings figures in its sequential profit and loss statements during the period of the alleged fraud. 35 With respect to clarity, the Complaint sets forth a clear and precise statement of what the alleged fraud consisted of. With respect to basis, while the sources of information on which the Complaint relies for these allegations are not overwhelmingly impressive, they include sources within the Company who might well have access to the kind of information for which they are cited. Furthermore, the allegations are not merely conclusory, but are rather supported by details that provide factual support for plaintiffs' allegations of fraud. 36 We find that these pleadings complied sufficiently with PSLRA's requirement of clarity and basis, as well as with the preexisting requirements of Rule 9(b). See Fed.R.Civ.P. 9(b). We have previously stated that PSLRA does not require the plaintiff to plead evidence. See In re Cabletron Systems, Inc., 311 F.3d at 33. As we understand, it was not Congress's intention to bar all suits as to which the plaintiff could not yet prove a prima facie case at the time of the complaint, but rather to prevent suits based on a guess that fraud may be found, without reasonable basis or a clear understanding as to what the fraud consisted of, but in the hope of finding something in the course of discovery. Cf. In re Cabletron Systems, Inc., 311 F.3d at 30 (observing that the statute was designed to erect barriers to frivolous strike suits, but not to make meritorious claims impossible to bring). 37 To the extent that the district court dismissed these claims on the grounds that they failed to satisfy the clarity-and-basis requirement of PSLRA, we respectfully disagree. It does not necessarily follow, however, that the dismissal of all of those claims should be vacated. We believe some of the claims relating to the underbidding of contracts were fatally flawed for other reasons and thus affirm the dismissal as to some of them. 38 (b) Strong inference of scienter. As noted, the PSLRA imposes an additional hurdle: The Complaint must allege facts supporting a strong inference of whatever state of mind on the part of the defendant must be proved as an element of the claim. 39 (i) Claims under 10b-5. To the extent these claims are asserted under Rule 10b-5, the plaintiffs must prove that the defendants acted with scienter in order to establish their right of recovery. Accordingly, under the PSLRA, the Complaint must state with particularity facts giving rise to a strong inference that the defendants acted with either knowing, intentional falsity or reckless disregard for the truthfulness of the statements. 40 We find the Complaint deficient in this respect. First, the Complaint provides nothing supporting the inference that either Smith or Langford was directly involved in the detailed accounting for these ten particular contracts, or had knowledge of the alleged falsity. One could draw the inference that Langford, as the Chief Financial Officer, had some supervisory involvement with the accounting. But no strong inference necessarily follows that the Chief Financial Officer, much less the Chief Executive Officer, was aware of the improper proration of future profits on any particular underbid contract. 41 This weakness is accentuated by another. The larger the distortion of the company's accounting figures, the more likely it might be that such distortion could not be accomplished without either complicity, or reckless irresponsibility, of top officers. The Complaint, however, gives no indication whatsoever what the size of the alleged overstatement of current profits was. Such an overstatement, in the circumstances alleged, would result primarily from two variables — the size of the expected future loss which should have been taken as a charge against current earnings, see FAS 5 ¶ 8, and the size of the improperly anticipated future profits prorated into the current profit and loss statement. The Complaint says nothing of the size of either component. 42 Indeed, the Complaint at times does not even assert that a loss was expected from these underbid contracts. Its description of the underbidding policy asserts that Smith planned the selling [of] fixed-price jobs either at a loss or with such small margin for error that the slightest adverse change in a project's economics would cause S & W to lose money on the job. ¶ 53 (emphasis added). According to this description, the contracts were bid near the expected break-even point, or with the expectation of a small and unreliable profit, rather than with expectation of a loss. 43 We recognize that in assessing a motion to dismiss for insufficient pleading, we must read the Complaint in the manner most favorable to the plaintiff, drawing reasonable inferences in the plaintiff's favor, see Aldridge, 284 F.3d at 79, and that inconsistent pleading does not deprive the pleader of the right to have the complaint read, as between the inconsistencies, in the manner that supports the adequacy of the pleading. The PSLRA's strong-inference requirement does not change this rule. 8 Because the Complaint elsewhere asserts that the ten projects were bid at a loss, ¶ 58, we credit the Complaint as asserting that the projects were indeed bid at a loss, rather than at the break-even point or at a slight profit. Nonetheless, the Complaint in no way suggests that the losses anticipated from these contracts were large. 44 At one point, the Complaint asserts that [a]ccording to ... former S & W insiders, S & W's underbidding [of those contracts] ranged from 10% to 40%. ¶ 61. But it says nothing about how much loss would be expected to result from underbidding by 10% to 40%. That would depend on the anticipated profit margins of a normal bid, not affected by the underbidding strategy, and the Complaint includes no allegation about that. Nor does the Complaint allege what percentage of the Company's net operating figures were attributable to the ten contracts. 45 In short, the Complaint tells no more than that, in the accounting for ten contracts, a profit of unspecified size was recognized in current earnings when, according to GAAP principles, those contracts should have been booked either as a loss of unspecified size or using a zero-profit-margin assumption coupled with a note describing a loss contingency. As anything above the break-even point represents profit, and anything below the break-even point represents loss, the difference between profit and loss can on a particular contract be tiny. Nothing in the Complaint suggests that correct accounting for these contracts would have involved significantly different overall numbers from those produced by the allegedly incorrect accounting. And if the accounting for those contracts had no significant effect on the Company's overall results, there is little reason to assume that the Company's CEO and CFO must have known about the failure to follow accepted accounting practices. Irregular financial statements which overstate estimated results to only a small degree do not support a strong inference that the Chief Executive Office or the Chief Financial Officer of the company acted with intent to defraud, or with reckless disregard for the truth of the statements. 46 A third significant weakness in the alleged basis of scienter is that in such accounting, the question whether to recognize profit or loss depends not on concrete facts but an estimation or prediction of whether in the end the project will net a profit or a loss. The Complaint fails to allege particularized facts supporting the inference that a reasonable assessment of the facts relating to those underbid contracts could support a prediction only of loss. 9 47 Accordingly, we determine that the claims of fraud for improper proration of future profits on these ten allegedly underbid contracts, to the extent asserted under Rule 10b-5, as to which the plaintiff may recover money damages only on proof that the defendant acted with [scienter], fail the requirement of the PSLRA that the complaint ... state with particularity facts giving rise to a strong inference that the defendant acted with [scienter]. 15 U.S.C. § 78u-4(b)(2). As to those 10b-5 claims, we affirm the judgment of the district court dismissing them. 48 We reach a different result, however, where those claims are asserted under §§ 20(a) and 18. 49 (ii) Claims under §§ 20(a) and 18. As explained above, the PSLRA's strong-inference requirement does not apply to claims under § 20(a), because this statute does not require proof of the defendant's state of mind. 10 50 We recognize that a plaintiff must show under § 20(a) that the controlled entity committed a violation of the securities laws. If that violation was, for example, a violation of Rule 10b-5, which requires a proof of scienter, then the plaintiff under § 20(a) must prove that the controlled entity acted with a particular state of mind. Nonetheless, if the statute is read literally, the strong-inference requirement of the PSLRA does not apply. The statute states that the strong-inference requirement applies only where the plaintiff's recovery depends on proof that  the defendant acted with a particular state of mind (emphasis added). See 15 U.S.C. § 78u-4(b)(2). The obligation to prove that the controlled corporation acted with scienter does not involve an obligation to prove that the defendant acted with a particular state of mind. 11 51 Section 18 similarly imposes no burden on plaintiff to prove the defendant's state of mind, shifting the burden to the defendant to show that he acted in good faith and had no knowledge that such statement was false or misleading. See 15 U.S.C. § 78r(a). Accordingly, the strong-inference requirement of the PSLRA has no application to § 18. 52 With respect to the claims under §§ 20(a) and 18 based on improper recognition of anticipated profits on underbid contracts, (1) we reject the reasons given by the district court for dismissing these claims, and (2) we conclude 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. As to whether one or both of those claims is subject to possible dismissal for other reasons, we express no view. We remand the claims under §§ 20(a) and 18 to the district court for whatever further proceedings are appropriate. 53 (c) Backlog. In addition to alleging that the policy of underbidding resulted in materially overstated earnings, the Complaint also alleges that it was misleading of defendants to include the underbid contracts in S & W's backlog. See, e.g., ¶¶ 228, 248-49, 251, 254, 284, 313-15. As to these claims, brought under Rule 10b-5, § 20(a), and § 18, we sustain the district court's dismissal. Plaintiffs have simply failed to plead a false statement with respect to the backlog allegations, and so their claims must be dismissed under Federal Rule of Civil Procedure 12(b)(6). As defined by the Complaint, S & W's backlog consisted of the accumulated amount of the Company's committed, but unexpended, contractual work. ¶ 38. These contracts represented committed, but unexpended, contractual work. The statements resulting from the inclusion of the contracts in the backlog were neither false nor misleading. 54