Opinion ID: 4301416
Heading Depth: 3
Heading Rank: 3

Heading: Audit Committee Findings

Text: 37 497 F.3d at 554. 38 Id. 39 Id.; see also Ind. Elec., 537 F.3d at 543 (finding it “quite plausible” that a defendant would sell stock days after the expiration of a “lock-up” agreement to not sell shares for a period of time). 40 ArthroCare, 726 F. Supp. 2d at 723 (noting a Fourth Circuit case that “labeled a class period of 46 months ‘exceedingly long’ and declared ‘such a lengthy class period weakens any inference of scienter that could be drawn from the timing of defendants’ trades.’” (quoting Teachers’ Ret. Sys. of La. v. Hunter, 477 F.3d 162, 185 (4th Cir. 2007))). 41 The parties also cite to several cases in which courts held that different percentages of the stock sold did or did not significantly contribute to a strong inference of scienter. But these percentages contribute to a strong inference of scienter only in a holistic context of the allegations in those cases, so particular percentages do not help us. 11 Case: 17-50162 Document: 00514587918 Page: 12 Date Filed: 08/06/2018 No. 17-50162 Perhaps the most important of the scienter allegations are those concerning the Audit Committee findings as reported in the June 8-K. 42 The TAC relies primarily on two of the Audit Committee’s conclusions. 43 The first specifically identifies Kirk and McHenry: [T]he former Chief Executive Officer [Kirk], former Chief Financial Officer [McHenry], and former Chief Accounting Officer (but not any current executive officers) set an inappropriate “tone at the top.” Specifically, emphasis placed by former executive management on meeting or beating consensus EPS and achieving certain financial targets, may have resulted in certain inappropriate accounting decisions and entries. The second major conclusion also identifies McHenry: “[I]t is more likely than not that former employees and officers, including in some instances the former Chief Financial Officer [McHenry] and former Chief Accounting Officer, engaged in inappropriate historical accounting practices relating to management estimates and certain accruals.” The Form 8-K discusses these inappropriate accounting practices and concludes that whoever made particular accounting decisions did so for the purpose of achieving financial targets. But these findings are written in the passive voice and do not identify who made those adjustments with such intent: For example, “management’s estimate of quarterly cost of materials was inappropriately reduced with the objective of attaining financial targets for those periods[.]” Also, the section describing the accounting practices concludes: The evidence of the actual purpose of these adjustments of management estimates and other accruals was neither direct nor 42 The February 8-K contains some of the same conclusions as the June 8-K, but its conclusions are more general: It identifies only “former officers and employees,” as opposed to the officers identified by title in the June 8-K. The June 8-K is essentially a more detailed version of the February 8-K, and this analysis is therefore confined to the June 8-K. 43 As noted above, the Audit Committee also concluded that a former employee had intentionally fabricated records. There is no allegation, however, that any defendant knew about this fabrication. 12 Case: 17-50162 Document: 00514587918 Page: 13 Date Filed: 08/06/2018 No. 17-50162 conclusive. Nor did witnesses interviewed by the Investigative Team acknowledge having made these adjustments for an improper purpose. Nevertheless, based on the evidence uncovered in the Investigation, the Audit Committee has determined that it is more likely than not that in certain interim fiscal periods of 2011 particular adjustments to particular management estimates were undertaken for the purpose of enhancing the Company’s reported financial results. Based on the evidence uncovered in the Investigation, the Audit Committee has also determined that it is more likely than not that in the years 2010 through 2012, the accrual and release of the “contingency reserve” was undertaken for the purpose of inappropriately enhancing the Company’s reported financial results. The question, then, is whether the June 8-K constitutes particular facts supporting a strong inference of scienter.
As an initial matter, both major findings implicate more than one person. The defendants insist that these allegations are thus “group pleading.” “[T]he ‘group pleading’ doctrine in its broadest form allows unattributed corporate statements [such as press releases] to be charged to one or more individual defendants based solely on their corporate titles.” 44 This court does not consider group pleading allegations. 45 The Audit Committee-based allegations against Asar are that he must have known about the issues identified in the report and allowed them to continue. These allegations are based on his role as CEO, but the Audit Committee report specifically states that it makes no finding as to his role in the accounting problems. These allegations thus do not support Asar’s scienter. Kirk and McHenry are identified by title in the Audit Committee report. These allegations are not group pleading, however, because the report concerns 44 Southland, 365 F.3d at 363. 45 See id. at 365. 13 Case: 17-50162 Document: 00514587918 Page: 14 Date Filed: 08/06/2018 No. 17-50162 only statements about the state of mind of McHenry, Kirk, and others. These allegations do not concern the allegedly false statements made by these two defendants, nor do they attribute Hanger’s statements in the Audit Committee report to them. 46 In fact, the Fund describes Kirk’s and McHenry’s allegedly false statements individually in the complaint. 47 As we understand it, the defendants contend that these allegations are group pleading because they are general allegations of scienter, and they are not linked to specific statements in the complaint. A plaintiff must allege a connection between a defendant’s scienter and the allegedly false statements, 48 but we have never required different sets of scienter allegations for each statement. 49 The Audit Committee allegations make this connection by providing a basis (the strength of which we discuss below) for inferring Kirk’s and McHenry’s scienter with respect to their accounting decisions, which logically connects to their statements about those accounting decisions. These are not allegations that “fail[] to specify” which statements are “attributable to 46 Cf., e.g., Fin. Acquisition Partners LP v. Blackwell, 440 F.3d 278, 287 (5th Cir. 2006) (rejecting allegations as group pleading when “Plaintiffs fail . . . to allege which Individual Defendant made which statement at that meeting” (emphasis added)); Barrie v. IntervoiceBrite, Inc., 397 F.3d 249, 261 (5th Cir.), opinion modified on denial of reh’g, 409 F.3d 653 (5th Cir. 2005) (upholding dismissal when plaintiff attributed statements to “management,” but not individuals). McHenry cites various district court cases, but does not explain why our case law requires more of a connection than the June 8-K provides. 47 To the extent that the Audit Committee report states that “officers” or “management” made certain statements, allegations based on those statements would indeed be group pleading. But we consider the Audit Committee report only in the context of whether the defendants have adequately pleaded scienter with respect to the specifically pleaded false statements elsewhere in the complaint. 48 Southland, 365 F.3d at 364 (“[S]cienter [must] be pleaded with regard to ‘each act or omission’ sufficient to give ‘rise to a strong inference that the defendant acted with the required state of mind.’” (quoting 15 U.S.C. § 78u-4(b))); cf. id. at 365 (“[W]e do not construe allegations contained in the Complaint against the ‘defendants’ as a group as properly imputable to any particular individual defendant unless the connection between the individual defendant and the allegedly fraudulent statement is specifically pleaded.”). 49 See, e.g., Diodes, 810 F.3d at 957–61; Owens, 789 F.3d at 538–46. 14 Case: 17-50162 Document: 00514587918 Page: 15 Date Filed: 08/06/2018 No. 17-50162 each individual defendant.” 50 The fact that these allegations pertain to more than one person does not make them group pleading. 51 The allegations against Kirk and McHenry are not categorically barred as group pleading.
The Fund also contends that we can infer Kirk and McHenry’s scienter from the Committee’s conclusion that those two set an “inappropriate tone at the top” by emphasizing their desire to achieve financial targets. The only court of appeals to have addressed similar allegations concluded that they did not support an inference of scienter. 52 In that case, the Fourth Circuit explained that such admissions “fail to suggest that defendants intentionally created an environment conducive to accounting fraud; the company simply admits that such an environment existed.” 53 Some district courts have inferred scienter from a company’s admissions of an inappropriate tone at the top. In Luna v. Marvell Technology Group, the plaintiff alleged that the inappropriate tone at the top “applied pressure to meet revenue targets not only on sales personnel (who, presumably, could work harder to generate more revenue), but also on finance personnel (who could only work with the transactions they were given).” 54 But the Luna court also relied on the fact that the company terminated its CEO shortly after 50 Southland, 365 F.3d at 365. 51 Cf. Owens, 789 F.3d at 538 n.4 (“These allegations [common to more than one defendant] do not constitute group pleading because they are sufficiently particularized.”). 52 Matrix Capital Mgmt. Fund, LP v. BearingPoint, Inc., 576 F.3d 172, 183 (4th Cir. 2009). 53 Id.; see also In re Hertz Glob. Holdings, Inc. Sec. Litig., No. 13-7050, 2017 WL 1536223, at  (D.N.J. Apr. 27, 2017) (describing a company’s restatement admitting there was an inappropriate tone at the top and concluding “although the Restatement admits to mismanagement and admits that the mismanagement impacted company accounting decisions, that by itself is not actionable”). Matrix also rejected the same argument that the Fund raises here, that “tone at the top” is a term of art critical to strong internal controls. See Matrix, 576 F.3d at 183. Even if that is true, it does not suggest that McHenry and Kirk intended to create that tone or were consciously doing so. 54 No. C 15-05447 WHA, 2017 WL 2171273, at  (N.D. Cal. May 17, 2017). 15 Case: 17-50162 Document: 00514587918 Page: 16 Date Filed: 08/06/2018 No. 17-50162 commencing the internal investigation, without terminating any senior or lower-level employees, which further supported an inference of the CEO’s misconduct in creating the “tone.” 55 Another district court determined that a company’s disclosure that it had “concerns about tone at the top,” made it “more plausible . . . that the fraud flowed from the top[ ]down.” 56 We conclude that the instant allegations based on the Audit Committee’s finding of an inappropriate tone at the top do not strongly support an inference of scienter. The allegation that Kirk and McHenry set an inappropriate tone at the top gives no information about how they did so. The Fund must plead the requisite scienter “with respect to each act or omission.” 57 Without knowing what Kirk and McHenry said or did, it is equally credible that they realized that the tone at the top was inappropriate only with hindsight. 58 All we know about this tone is that Kirk and McHenry emphasized “meeting or beating consensus EPS and achieving certain financial targets.” This court has declined to find a strong inference of scienter in goals that “virtually all corporate insiders share.” 59 These allegations also contrast with Luna in two key ways. First, there is no indication that Kirk and McHenry applied direct pressure to finance personnel. The Audit Committee concludes only that their emphasis on financial targets “may have” resulted in inappropriate accounting decisions. Second, it is undisputed in this case that a former lower-level employee orchestrated a large part of the fraud. This makes even more likely the 55 See id. at . 56 Fresno Cty. Emps.’ Ret. Ass’n v. comScore, Inc., 268 F. Supp. 3d 526, 551–52 (S.D.N.Y. 2017). 57 15 U.S.C. § 78u-4(b)(2)(A). 58 Much like accounting errors and restatements “can easily arise from negligence, oversight or simple mismanagement,” Abrams, 292 F.3d at 433, so too can “tones” become “inappropriate” through negligence. 59 Owens, 789 F.3d at 539. 16 Case: 17-50162 Document: 00514587918 Page: 17 Date Filed: 08/06/2018 No. 17-50162 alternative that the fraud flowed from the “bottom[ ]up” than from the “top[ ]down.” 60 These details also make it less probable that the corporate officers directed the fraud or acted with severe recklessness. We emphasize, however, that we are not saying that allegations based on a company’s finding of an “inappropriate tone at the top” can never support a strong inference of scienter. Rather, we conclude only that the instant allegations contribute minimally to that inference. c. “Inappropriate Historical Accounting Practices” The complaint also alleges, based on the June 8-K, that McHenry and at least one other person “engaged in inappropriate historical accounting practices relating to management estimates and certain accruals.” This accounting related to (1) inventory valuation, (2) adjustments to estimates and accruals “without timely or appropriate analysis,” 61 and (3) accrual and release of a contingency reserve in a manner inconsistent with Generally Accepted Accounting Principles (GAAP). The Audit Committee also concluded that these practices “were undertaken for the purpose of enhancing the Company’s reported financial results.” The Audit Committee’s report states that a group (including McHenry) engaged in the improper accounting, and that a subgroup (perhaps as large as the whole group) did so with the requisite scienter. Two aspects of these allegations dampen an inference of McHenry’s scienter. First, the June 8-K does not identify McHenry’s particular inappropriate practices, stating only that he engaged in inappropriate accounting “in some instances.” Second, the report is replete with passive voice: It makes no reference to McHenry’s objective, only that “particular adjustments to particular management 60 Cf. comScore, 268 F. Supp. 3d at 552. 61 Specifically, recording adjustments before analysis was complete, or modifying analysis to obtain a desired result. 17 Case: 17-50162 Document: 00514587918 Page: 18 Date Filed: 08/06/2018 No. 17-50162 estimates were undertaken” for improper purposes. Nevertheless, these allegations support the inference that McHenry shared the objectives of improperly enhancing Hanger’s financial results, or that he at least knew that others were doing so. The Audit Committee’s report contributes to an inference of scienter. 62