Abrams v. Baker Hughes Inc.

292 F.3d 424, 53 Fed. R. Serv. 3d 1, 28 Employee Benefits Cas. (BNA) 1963, 2002 U.S. App. LEXIS 9565, 2002 WL 1018944

• Court: Court of Appeals for the Fifth Circuit
• Decided: May 21, 2002
• Docket: 01-20514
• Status: Published

Opinions

W. EUGENE DAVIS, Circuit Judge:

The plaintiffs appeal from a dismissal under F.R.C.P. 12(b)(6) of their securities fraud class action under §§ 10(b) and 20(a) of the Exchange Act. The district court dismissed the case based on its conclusion that the plaintiffs failed to adequately allege particularized facts to establish the necessary element of scienter. Finding no error, we affirm.

I.

This securities fraud class action is brought on behalf of all investors who purchased common stock of Baker Hughes from February 1, 1999 through December 8, 1999 (the “Class Period”). Baker Hughes is a diversified oil and gas services company headquartered in Houston, Texas, whose stock trades on the New York Stock Exchange under the symbol “BHI.” Defendant Lukens was Baker Hughes’ president, chairman and chief operating officer. Defendant George Finley was its chief financial officer. The plaintiffs contend generally that the defendants’ Class Period press releases and SEC filings contained false and misleading statements and omissions. Specifically, the plaintiffs allege that the defendants deceived the investing public regarding the adequacy of Baker Hughes’ internal financial controls, the fiscal discipline with which the company operated and the company’s financial condition. They contend that these misstatements artificially inflated the price of the company’s common stock during the Class Period. Thus, they allege that they were harmed when they purchased Baker Hughes stock at artificially high prices.

The Complaint

The complaint contains the following chronology of events and allegations regarding scienter. The complaint alleges that in 1998, Baker Hughes’ revenues and earnings were suffering. Years of growth through mergers and acquisitions had left Baker Hughes’ accounting systems in disarray, with no unified accounting system and a lack of proper internal controls. The primary problems.were in the INTEQ division, located in Venezuela which produced approximately 20% of company revenues. During 1999, Baker Hughes initiated Project Renaissance. The purpose of the project was to cut costs and streamline internal control systems. The project was built around a new information system called SAP which was designed to unify all accounting and data management systems at the company.

Problems were encountered in the implementation of the new system which the defendants allegedly kept quiet so as not to jeopardize their incentive compensation or the success of a scheduled $200 million debt offering. During the Class Period internal controls were inadequate and unreliable but the defendants repeatedly touted the adequacy of the company’s internal controls.. The lack of internal controls caused Baker Hughes to issue false and misleading financial reports throughout the Class Period. Based on the company’s reported financial results and the apparent success of the implementation of SAP, the price of Baker Hughes’ stock increased throughout the Class Period and analysts upgraded their ratings of the stock.

For example, in March 1999, the company filed its 1998 Form 10-K with the SEC. The report included a letter from the defendants that indicated that the company had in place an extensive system of internal controls to prevent material errors or irregularities in the reports. In May 1999, Baker Hughes announced favorable first quarter results and the stock price rose from $29,785 per share on April 30,1998 to $31.83 per share on May 3, 1999. Also in May, Schroder & Co., Inc. issued a report raising its rating for Baker Hughes in reliance on a conversation with Baker Hughes management that SAP was on track to produce significantly improved returns. The next day, defendant Finley sold 21,574 shares of Baker Hughes stock at $30.88 per share. Finley was largely responsible for the implementation of SAP. Two weeks later, Finley was appointed chief financial officer and senior vice president of finance and administration.

On May 21, 1999, the former senior vice president and chief financial officer as well as the controller resigned. Baker Hughes stated that these officials left “to pursue other interests.” Platt’s Oxigram News reported that the CFO left because of cost overruns and operations glitches associated with the SAP conversion. The resignations raised concerns in the investment community. On the same day Merrill Lynch issued a favorable report on Baker Hughes based on conversations with management. The report noted the resignations but assured that there are “no accounting issues” at the company. Baker Hughes stock price rose to $31,125 per share. In June 1999, Schroder & Co. issued another favorable report after meetings with defendant Lukens. Baker Hughes price rose $1 per share to $34.5625. On September 27, 1999, Baker filed a shelf registration for the future issuance of debt and equity securities totaling one billion dollars. The plaintiffs claim that it was critical for Baker to raise capital to cover fixed charges that could not be covered by earnings.

The alleged deceptions were brought to fight beginning in December, 1999. On December 1, 1999, Baker Hughes announced that results for the 4th quarter would be poor and the company would record a $130 million pre-tax charge to dispose of assets and equipment due to adverse market conditions. On December 8, 1999, the company announced the existence of accounting irregularities at IN-TEQ, one of its major subsidiaries, that would adversely affect the company’s financial statements by $40 to $50 million pre tax. The company canceled the previously announced note offering. On December 9, 1999, Baker Hughes stock closed at $19.25 per share. During the Class Period the stock traded as high as $36.125 per share.

On December 16, 1999, the president of INTEQ resigned. On January 24, 2000, the company’s general counsel resigned. On January 31, 2000, Baker Hughes announced that it had fired defendant Luk-ens from his position as Chairman and Chief executive officer. Also on that day, the company announced that the head of the company’s Western Geophysical, Baker Atlas and INTEQ divisions resigned.

On February 17, 2000, the company announced that it would restate previously filed financial reports for periods dating back to December 31, 1997. The restatement reduced profit by $31 million, $24.2 million of which was related to INTEQ. The writeoffs related to uncollectible accounts receivable, inventory write downs and unrecorded employee compensation. More details regarding the writeoffs were disclosed on March 16, 2000 when Baker Hughes filed its 1999 10-K. The report noted that the misstatements “were primarily the result of noncompliance with the Company’s accounting and operating procedures and that such noncompliance was isolated primarily to INTEQ’s operations in Venezuela.” On April 10, 2000, Baker Hughes filed amended quarterly reports for 1999.

The District Court’s Decision

The defendants filed a motion to dismiss the case on the grounds that the plaintiffs failed to adequately allege particularized facts as to defendants’ scienter and that the plaintiffs faded to show that the alleged misleading public statements were material. Without the benefit of the Zo-nagen decision, discussed later in this opinion, the district court analyzed case law from this and other circuits and concluded, properly that a strong inference of scienter is not raised where a plaintiff merely alleges facts of a defendants’ motive and opportunity to commit fraud. Rather, the plaintiffs must plead specific facts constituting strong circumstantial evidence of conscious misbehavior or recklessness and motive and opportunity may be considered as a factor in determining whether a strong inference has been raised.

The district court proceeded to analyze the three claims raised by the plaintiffs: (1) the defendants had the motive and opportunity to commit fraud based on the need to raise capital, incentive compensation contingent on the successful implementation of SAP and Finley’s insider stock sales; (2) the defendants engaged, in conscious misbehavior or were reckless as-to their public representations because Lukens and Finley were intimately familiar with the company’s inadequate internal controls, and (3) the defendants violated generally accepted accounting principles. The district court concluded that the “totality of the Plaintiffs’ facts has failed to raise a strong inference of scienter.” The court went on to say that although the facts were insufficient in the aggregate, it was not error for the court to compartmentalize the allegations and “wipe the slate clean after considering each component.” The district court accordingly dismissed the plaintiffs 10(b) and 10b-5 claims. Because the plaintiffs failed to raise a strong inference of scienter, it declined to reach the issue of materiality. Although not sought by the parties, the district court further held that dismissal of the 10(b) and 10b-5. claims required dismissal of the 20(a) claim.

The plaintiffs appeal.

II.

This Court reviews a district court’s dismissal under Rule 12(b)(6) de novo. In doing so, we will accept the facts alleged in the complaint as true and construe the allegations in the light most favorable to the plaintiffs.²

To state a claim- under § 10(b) of the Exchange Act, a plaintiff must show: “(1) a misstatement or omission (2) of a material fact (3) made with scienter (4) on which the plaintiff relied (5) that proximately caused his injury.”³ The scienter, or state of mind element of a § 10(b) claim is a “mental state embracing intent to deceive, manipulate, or defraud.”⁴ A § 10b-5 claim is subject to both Federal Rule of Civil Procedure 9(b)’s requirement that fraud be pled “with particularity” and the requirements of the requirements of the Private Securities Litigation Reform Act (the “PSLRA”). Under the PSLRA, to allege scienter:

the complaint shall, with respect to act or omission alleged to violate this chapter', state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.⁵

In addition,

the complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts upon which that belief is formed.⁶

This court’s recent decision in Nathenson v. Zonagen Inc. sets the standard of pleading required after the enactment of the PSLRA.⁷ That case, which first applied the PSLRA in this circuit, held that “in order to survive a motion to dismiss, a plaintiff alleging a section 10(b)/ Rule 10b-5 claim must now plead specific facts giving rise to a ‘strong inference’ of scienter.”⁸ As it did before the enactment of the PSLRA, severe recklessness can supply the scienter required to prove securities fraud.⁹ Severe recklessness is “limited to those highly unreasonable omissions or misrepresentations that involve not merely simple or even inexcusable negligence, but an extreme departure from the standard of ordinary care, and that present a danger of misleading buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it.”¹⁰ Allegations of motive and opportunity, standing alone, are no longer sufficient to plead a strong inference of scienter, although appropriate allegations of motive and opportunity may enhance other allegations of scienter.¹¹ Circumstantial evidence can support a strong inference of scienter.¹² Zonagen also establishes that the effect of the PSLRA “at a minimum, incorporates the standard for pleading fraud under Fed. R.Civ.P. 9(b).”¹³ This circuit interprets Rule 9(b) strictly, requiring the plaintiff “to specify the statements contended to be fraudulent, identify the speaker, state when and where the statements were made, and explain why the statements were fraudulent.”¹⁴

Finally, Zonagen suggests that the allegations should not be read in isolation, but taken together as a whole to see if they raise the necessary strong inference of scienter. In analyzing whether the complaint adequately alleged scienter, the court in Zonagen reacted negatively to the district court’s consideration of certain statements in isolation.¹⁵ The appropriate analysis, under Zonagen is to consider whether all facts and circumstances “taken together” are sufficient to support the necessary strong inference of scienter on the part of the plaintiffs.¹⁶

III.

Plaintiffs complain first that the district court erred by failing to analyze their scienter allegations based on the totality of the circumstances alleged as required by Zonagen. The district court stated in its opinion that it was not error for the court to compartmentalize the allegations and “wipe the slate clean after considering each component,” citing Coates v. Heartland Wireless Communications, Inc., 55 F.Supp.2d 628 (N.D.Tex.1999)(“C'oaies IF’). However, in its conclusion, the district court also stated that the facts in the complaint were insufficient when viewed in the aggregate. The district court concluded that the “totality of the Plaintiffs’ facts has failed to raise a strong inference of scienter.” The district court’s clear statement that it considered the allegations insufficient in the aggregate, although without analysis, is difficult for us to contradict. We need not do so as we conclude, based on our independent review, that the complaint taken as a whole fails to sufficiently plead scienter and agree with the result reached by the district court.

IV.

We turn now to our analysis of the plaintiffs’ complaint. The false and misleading statements alleged in the com-, plaint relate to Baker Hughes’ internal accounting and financial controls. Specifically, during the Class Period, the plaintiffs allege that the defendants issued positive representations to the investing community that the disclosures in the company’s financial reports were sufficient to make them reasonably accurate. Plaintiffs focus on statements defendants made in the wake of the resignation of two top financial officers, that there were “no accounting issues” at the company. The plaintiffs contend that these statements were false when made as revealed by statements issued by the company beginning in December 1999. They further contend that the defendants knew the statements were false or were severely reckless in making them based on the following circumstantial evidence. First, the individual defendants were senior level executives of Baker Hughes who were intimately familiar with the inner workings of the company, including the inadequacies of its internal controls. Both allegedly received unidentified daily, weekly and monthly financial reports that apprized them of the company’s true financial status and had the power and influence to cause Baker Hughes to issue the false- statements. The defendants knew that the SAP program was being implemented because the company lacked a single uniform accounting system and thus knew that the company’s internal controls lacked cohesiveness. Accounting irregularities discovered mainly at IN-TEQ necessitated restatement of several previously issued reports. The restatement announced in 2000 was stated to be the result of noncompliance with the company’s accounting and operating procedures. Second, the defendants’ violations of generally accepted accounting principles (“GAAP”) in combination with other allegations raise a strong inference of scienter. Third, the allegations of the defendants’ motive and opportunity to commit fraud enhance the strong inference of scienter. The allegations of motive 'include the need to raise additional capital, a desire to protect their incentive compensation, and insider stock sales.

Based on case law in this and other circuits, these allegations fail to reach the required standard. Plaintiffs point to no allegations that the defendants knew about the internal control problems, only that they should have known or that their lack of knowledge based on their corporate positions demonstrates recklessness. A pleading of scienter may not rest on the inference that defendants must have been aware of the misstatement based on their positions within the company.¹⁷

The plaintiffs’ allegations regarding non-specific internal reports are also inadequate. An unsupported general claim about the existence of confidential corporate reports that reveal information contrary to reported accounts is insufficient to survive a motion to dismiss.¹⁸ Such allegations must have corroborating details regarding the contents of allegedly contrary reports, their authors and recipients.¹⁹ Also, the mere publication of inaccurate accounting figures or failure to follow GAAP, without more, does not establish scienter. The party must know that it is publishing materially false information, or must be severely reckless in publishing such information.²⁰ The plaintiffs point to no specific internal or external report available at the time of the alleged misstatements that would contradict them.

■ As an example of the type of allegations that survive a motion to dismiss, see No-vak v. Kasaks.²¹ In that -case the complaint alleged that the defendants knew that the company had serious inventory problems that they sought to disguise by adopting a cover up scheme. The defendants acted intentionally and deliberately to artificially inflate the company’s financial results in ways that violated the company’s internal policies; The complaint in Novak alleged that the defendants “discussed the need to mark down inventory but refused to do so because that would damage the Company’s financial prospects.”²² Further the Novak defendants approved an inventory management practice that violated the company’s own markdown policy as it was stated in the company’s public filings.²³ Also, despite their knowledge that the inventory practice they adopted in violation of stated company policy was the reason for growth in inventory, the defendants in Novak gave false explanations for its growth.²⁴ We have no such allegations of actual knowledge or intentional or deliberate behavior in this case. Rather the nature of the accounting problems at Baker Hughes that lead to the restatement, i.e. uncollectible accounts re-, ceivable, inventory write downs and unrecorded employee compensation, can easily arise from negligence, oversight or simple mismanagement, none of which rise to the standard necessary to support a securities fraud action.

This case is more like Melder v. Morris.25 In Melder, the complaint alleged that “the true adverse facts about UR-CARCO’s financial condition ... were known to or recklessly disregarded by defendants” and “[bjecause of their board membership and/or their executive and managerial positions with URCARCO, defendants ... knew or had access to information concerning the adverse non-public information about URCARCO’s adverse financial outlook.”²⁶ In that case this court concluded that the plaintiffs failed to plead scienter adequately.

In our case, the plaintiffs have not pointed to any particular reports or information — available to defendants before the announced financial restatements — that are contrary to the restatements. The fact that Baker Hughes was overhauling its accounting system via Project Renaissance and the SAP program does not command an inference that company officials should have anticipated finding a problem or assumed that financial data reported under old system was inaccurate. We can just as easily infer that the implementation of SAP was driven by a need to better coordinate the accounting systems in place in various companies Baker Hughes hadmerged with' over the years. '- A planned improvement or upgrade does not mean that the prior system was necessarily producing bad data. A perfectly reasonable explanation for implementing Project Renaissance was to improve efficiency and lower costs. In discussing the standard for reckless conduct, the court in Novak noted that company officials should not be held responsible for failure to foresee future events. Also, as long as public statements are reasonably consistent with reasonably available data, corporate officials need not present an overly gloomy or cautious picture of the company’s current performance.²⁷ The cases relied on by the plaintiffs in this regard involve actual knowledge of the falsity of the published reports, which is not alleged in this case. See Meadows v. SEC, 119 F.3d 1219, 1226 (5th Cir.1997)(Meadows told investors that certain companies were low-risk investments that were virtually certain to yield a high return without disclosing that he was an officer and director of one of the companies, had been temporarily denied after-hours access to the Companies’ books; he had never conducted a background investigation into the principals, any of their assertions, or the Companies! purported successes and that therefore, he had no basis for recommending the investments. Further Meadows was aware one principal of the company had recently been accused of misappropriation; he was aware that a recommendation that they- maintain separate bank accounts for each drilling program was not being followed; and he had been forced out of the Companies by certain principals, who also paid him to be silent about the Companies’ financial situation.); Serabian v. Amoskeag Bank Shares, 24 F.3d 357, 365 (1st Cir.1994)(General statement that bank’s existing loan review function was not operating timely and of other failures to follow internal policy does not support conclusion that defendants knew loans were.deteriorating in creditworthiness. However, bank’s statement that loss reserves were adequate, conservative and cautious directly contrary, to identified internal reports was sufficient to state a claim.).

Plaintiffs imply that the resignation of key accounting officials from the company in May 1999 should have served as a warning that problems existed within that department and that .the defendants were reckless for failing to investigate, especially given their statement that there were “no accounting issues” at the company. However, nothing in the complaint points to any information that would indicate that either the resigning officials, their replacements or other defendants knew of any accounting irregularities or that such irregularities were the reason for their resignations. According to the complaint, Baker Hughes reported that these officials resigned to “pursue other interests.” Platt’s Oilgram News reported that the CFO resigned because of cost overruns and operational glitches associated with the implementation of SAP. Neither reason has any scienter implications.²⁸

V.

In addition, although we acknowledge that allegations of motive and opportunity to commit fraud may enhance an inference of scienter, the .motives alleged in the complaint are not the types of motive that support a strong inference of scienter. The plaintiffs allege that the defendants were motivated to commit fraud by the need to raise capital, the desire for enhanced incentive compensation and the desire to sell stock at inflated prices. This court has held that similar allegations were insufficient to support an inference of scienter. In Melder v. URCARGO, the plaintiffs claimed that the defendants engaged in a conspiracy to commit securities fraud in order to inflate the price of the company’s stock to allow for successful stock offerings, to protect their executive positions and to enhance the value of their personal stock holdings in the company.²⁹ Absent an allegation that the defendants profited from the inflated stock value or the offerings, such allegations fail. Similar claims were rejected in Tuchman v. DSC Communications Corp.30 In Tuchman, this court stated:

Incentive compensation can hardly be the basis on which an allegation of fraud is predicated. On a practical level, were the opposite true, the executives of virtually every corporation in the United States would be. subject to fraud allegations. It does not follow that because executives have components of their compensation keyed to performance, one can infer fraudulent intent.³¹

As to the alleged insider stock sales, only-one defendant sold only a portion of his shares in the company. Finley exercised and sold 21,574 of 92,405 stock options and sold none of his other 34,980 shares. Only insider trading in suspicious amounts or at suspicious times is probative of scienter.³² Plaintiffs make no allegations that these sales are out of line with prior trading practices or at times calculated to maximize personal profit.³³ Further, even unusual sales by one insider do not give rise to a strong inference of scienter when other defendants do not sell some or all of their shares during the Class Period.³⁴

VI.

In summary, based on our complete review of the plaintiffs’ complaint, we conclude that it fails to adequately plead facts that raise a strong inference of scienter. Accordingly, the district court correctly dismissed plaintiffs’ action. AFFIRMED.

2 . Nathenson v. Zonagen Inc., 267 F.3d 400 (5th Cir.2001).

3 . Shushany v. Allwaste, Inc., 992 F.2d 517, 520-21 (5th Cir.1993) (quoting Cyrak v. Lemon, 919 F.2d 320, 325 (5th Cir.1990)).

4 . Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193, n. 12, 96 S.Ct. 1375, 47 L.Ed.2d 668 (19.76).

5 . 15 U.S.C. § 78u-4(b)(2)(Supp.V.1999).

6 . Id.

7 . 267 F.3d 400 (5th Cir.2001).

8 . Id. at 407.

9 . Id. at 408-409.

10 . Id. at 408, citing Broad v. Rockwell International Corp., 642 F.2d 929, 961-62 (5th Cir.1981)(en banc).

11 -. Id. at 410-12.

12 . Id. at 410.

13 . Id. at 412.

¹⁴

15 . Id. at 424.

16 . Id. at 425.

17 . In re Advanta Corp. Sec. Litig., 180 F.3d 525, 539 (3d Cir.1999).

18 . San Leandro Emergency Medical Group Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801, 812 (2d Cir.1996).

19 . Janas v. McCracken (In re Silicon Graphics Sec. Litig.), 183 F.3d 970, 985 (9th Cir.1999).

20 . Fine v. American Solar King Corp., 919 F.2d 290 (5th Cir.1990).

21 . 216 F.3d 300 (2d Cir.2000).

22 . 216 F.3d at 311.

²³

24 . Id. at 311-312.

25 . 27 F.3d 1097 (5th Cir.1994).

26 . Id. at 1103.

27 . Novak, 216 F.3d at 309.

28 .Branca v. Paymentech, Inc. [2000 Transfer Binder] Fed.Sec. L. Rep. (CCH) ¶ 90,911, at 93,855-56 (N.D. Tex. Feb. 8 2000) (Scienter may not be inferred from resignation of company officials "for personal reasons.”)

29 . 27 F.3d 1097, 1102, (5th Cir.1994).

30 . 14 F.3d 1061, 1068 (5th Cir.1994).

31 . Id. at 1068-69.

32 . In re Silicon Graphics, 183 F.3d at 987.

³³

34 .San Leandro, 75 F.3d 801, 814 (2d Cir. 1996).