On August 21, 2007, there was a significant court decision made possibly impacting future Sarbanes-Oxley Act decisions in “CENTRAL LABORERS‚Äô PENSION FUND v.INTEGRATED ELECTRICAL SERVICES INC; HERBERT ALLEN; WILLIAM W REYNOLDS; JEFFREY PUGH”
Even though the corporate officers signed their SOX certificates, generally indicating they had been reviewed and were accurate, and placing accountability on the corporate officers, the officers were found not guilty of intending to defraud the company.
Why not? It appears that the SOX reports had some errors, and the judge determined that the officers could not reasonably know about the errors, at least with the evidence provided…along with many other complex and varied considerations.
This is something that many officers within SOX-covered entities commonly fear; that they will sign the SOX reports/certifications and then later find out there were some errors that they didn’t catch, and that the officers will then be held accountable and subsequently be fined and/or put in jail. This decision will likely make many officers breath a little easier knowing that their is some forgiveness for errors if they can show it was reasonable for them to not be aware of them.
When you cut through the legelese, it is a pretty interesting read! Allegations of insider trading, millions of dollars of personal profit, eavesdropping on conversations, officers supposedly wanting to claim ignorance, divorce settlements, and other issues often considered and talked/gossiped about.
Here is an excerpt of the discussion of the decision-making reasoning:
“III. DISCUSSION
A. Motion to dismiss for failure to plead scienter with sufficient particularity CLPF contends that it pleaded scienter with sufficient particularity to avoid dismissal based on a holistic examination of the various allegations taken in the light most favorable to it. CLPF alleged insider trading, GAAP violations, failure to fix an accounting error, the making of false statements about internal controls, and pervasive knowledge of accounting problems throughout IES. This court must examine these allegations in toto when determining whether CLPF adequately pleaded scienter. Barrie, 397 F.3d at 260.
(1) GAAP violations, public statements, and restatement of financials The CAC describes IES’s alleged GAAP violations in detail. CLPF urges that its assertions in the CAC regarding the accounting errors and internal controls at IES serve as strong circumstantial evidence of, at a minimum, recklessness as to senior management’s ignorance of the problems at IES. See, e.g., Barrie, 397 F.3d at 263‚Äì64; In re: McKesson HBOC, Inc. Sec. Litig., 126 F.
Supp. 2d 1248, 1273 (N.D. Cal. 2000) (“[W]hen significant GAAP violations are described with particularity in the complaint, they may provide powerful indirect evidence of scienter. After all, books do not cook themselves.”). However, GAAP violations, without more, do not establish scienter. Barrie, 397 F.3d at 263–64. The public statements and subsequent restatement due to GAAP violations provide some basis to infer scienter.
(2) Confidential sources In the CAC, CLPF also points to statements by confidential sources. Confidential source statements are a permissible basis on which to make an inference of scienter. Tchuruk, 291 F.3d at 353. There are two specific, direct allegations in the CAC suggesting that the defendants ignored the accounting problems at IES. First, a former IES network technician claimed that he overheard comments at headquarters about the company’s accounting practices indicating that IES lacked the internal controls it repeatedly lauded and embraced a culture of financial manipulation that favored hitting financial numbers rather than accurate accounting. Second, a former senior vice president stated that Allen said that he did not want to know the details of a revenue issue so that he would not be liable. The CAC includes various other confidential witness accounts containing fewer details. IES suggests that these confidential source statements are of no scienter value because they lack specific details, such as particular job descriptions, individual responsibilities, and specific employment dates for the witnesses, and that without such information there is an insufficient basis on which to evaluate the presented information. CLPF essentially retorts that these sort of details go to the weight accorded the statements rather than the validity of considering them in ruling on the motion to dismiss. See Tchuruk, 291 F.3d at 354 (noting that the court considers ‚Äúeach allegation for its particularization‚Äù value). We hold that CLPF’s confidential source statements lack sufficient detail to credit them as bases for a strong inference of scienter with respect to the particular allegations of fraud in the CAC.
(3) IES officers’ trading
CLPF also alleges that IES’s officers‚Äô trading of IES stock permits a strong inference of scienter on the part of the officers. More specifically, CLPF argues that a strong inference of scienter is raised by the amount, timing, profit, and profits ratio to ordinary compensation of the stock sales. Insider trading can be a strong indicator of scienter if the trading occurs at suspicious times or in suspicious amounts. See Rubinstein v. Collins, 20 F.3d 160, 169 (5th Cir. 1994). ‚ÄúSuspicious‚Äù in this context generally means that the ‚Äúsales are out of line with prior trading practices or at times calculated to maximize personal profit.‚Äù Abrams v. Baker Hughes Inc., 292 F.3d 424, 435 (5th Cir. 2002). Insider trading alone cannot create a strong inference of scienter, but it ‚Äúmay meaningfully enhance the strength of the inference of scienter.‚Äù Southland Sec. Corp. v. INSpire Ins. Solutions, Inc., 365 F.3d 353, 368 (5th Cir. 2004) (internal quotation omitted). CLPF points to trading by Allen, Reynolds, and non-defendants. IES contends that the sale assertions are insufficient because the CAC lacks information about the sellers‚Äô trading history, including prior sales patterns. In other words, IES’s position is that the information regarding sales by Allen and Reynolds is meaningless unless it is placed in context with previous trades. See Ronconi v. Larkin, 253 F.3d 423, 435‚Äì37 (9th Cir. 2001) (stating that plaintiffs ‚Äúmust allege sufficient context of insider trading for us to determine whether the level of trading is ‚Äòdramatically out of line with prior trading practices‚Äô‚Äù). In this circuit, officer trading may give rise to an inference of scienter if it is unusual in timing or scope. Nathenson, 267 F.3d at 421. In other words, prior trading history does not need to be pleaded as a per se matter; instead, the court looks at the information that is pleaded and determines whether the timing or scope is unusual. In doing so, the court must consider plausible nonculpable
explanations for such officer trading, as well as inferences that favor CLPF. Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499, 2510 (2007).
(a) Allen
During the class period, on March 4, 2004, Allen made a one-time sale of 30,000 IES shares for a profit of more than $225,000. Allen owned 734,400 shares prior to this sale and thereafter retained 704,400 shares. CLPF points out that the profit on this sale represented 43% of Allen’s 2004 salary and argues that such a figure provides a strong inference of scienter. See In re: Suprema Specialties, Inc. Sec. Litig., 438 F.3d 256, 277 (3d Cir. 2006) (noting that one relevant factor to the scope and timing of a sale is ‚Äúwhether the profits were substantial relative to the seller’s ordinary compensation‚Äù). IES responds that Allen only sold 4% of his shares during the class period and urges that Allen’s continued ownership of a large amount of stock compels an inference that he was not involved in a fraud scheme. In other words, the fact that Allen retained over 700,000 shares of IES stock indicates that he did not possess scienter regarding the alleged fraud, because otherwise he would have sold these shares before the price fell. In addition, in Suprema the sale at issue increased the defendants‚Äô incomes far more substantially than Allen’s sale did. See id. at 278. The skeletal insider trading allegations against Allen do not contribute to an inference of scienter.
(b) Reynolds
During the class period, Reynolds exercised 351,335 options for a profit of approximately $1.44 million. Reynolds left the company in March 2004 and retained only 19,781 options as of April 2004. CLPF contends that these sales were suspicious in scope. IES offers innocent explanations for the sales. First, Reynolds resigned from IES in March 2004, near the end of the period when his relevant stock sales occurred. IES asserts that it is not unusual for a corporate officer to sell his stock shortly before resigning. Second, IES urges that financial obligations created by a divorce decree, of which IES asks the court to take judicial notice, provide a non-suspicious explanation for the stock sales. Third, IES contends that Reynolds sold much of the stock pursuant to a 10b5-1 plan, rendering the sales non-suspicious. CLPF makes four arguments in response. First, it asserts that Reynolds’s retirement near the time of sale is suspicious rather than non-suspicious. See Suprema, 438 F.3d at 278 (‚ÄúThe timing of the sales was also suspect in that they occurred just six weeks before [the defendants] resigned.‚Äù). We conclude that this argument does not cut deeply in favor of either position. Second, CLPF contends that the divorce decree should not have been considered, as Fifth Circuit precedent permits admission of public documents only to prove the existence of their written contents, not the truth of those contents. Cf. Lovelace v. Software Spectrum Inc., 78 F.3d 1015, 1017‚Äì18 (5th Cir. 1996) (discussing admission of publicly-available documents filed with the SEC). Here, however, the document’s written terms themselves indicate the reason Reynolds had for selling the shares. The ‚Äútruth‚Äù of the document is not at issue, as might be the case if the terms of the divorce were in dispute. The divorce decree was properly considered. Third, CLPF points out that the divorce decree awarded substantial property to Reynolds, including real estate, a sports car, and a motorcycle. Accordingly, CLPF asserts that it is unclear whether the divorce decree actually created any financial obligations. The implications of the divorce decree are equivocal; they do not counsel a conclusion that it renders the sale nonsuspicious. Fourth, CLPF convincingly suggests that the attempt to use the 10b5-1 Plan as a non-suspicious explanation is flawed because, inter alia, Reynolds entered into the Plan during the Class Period. IES fails to provide a direct
response to this assertion. Accordingly, the insider trading allegations contribute to an inference of scienter on the part of Reynolds.
(4) Sarbanes-Oxley certifications
CLPF also points to the Sarbanes-Oxley certifications signed by Allen and Reynolds as indicative of scienter. Reynolds and Allen both signed certifications that were attached to the company’s 10-K. The Sarbanes-Oxley Act states that signing officers must certify that they are responsible for establishing and maintaining internal controls [and] have designed such internal controls to ensure that material information relating to the [company] and its consolidated
subsidiaries is made known to such officers by others within those entities, particularly during the period in which the period reports are being prepared. 15 U.S.C. § 7241(a)(4). IES argues that these certifications are irrelevant to scienter because they are merely statements of opinion. Other courts have viewed such certifications as indicative of scienter. See In re: Lattice Semiconductor Corp. Sec. Litig., No. CV 04-1255-AA, 2006 WL 538756, at *18 (D. Or. Jan. 3, 2006) (“The Sarbanes-Oxley certifications, [combined with other allegations], are sufficient to create a strong inference of actual knowledge or of deliberate recklessness.”); cf. In re: Michaels Stores, Inc. Sec. Litig., No. 3:03-CV-0246, 2004 WL 2851782, at *12 & n.11 (N.D. Tex. Dec. 10, 2004) rejecting use of Sarbanes-Oxley certifications as a basis for drawing a strong inference of scienter because the statements in the particular certification were not sufficiently related to the alleged misstatements in the complaint). The Eleventh Circuit recently addressed the interaction of Sarbanes-Oxley and the scienter requirement for securities fraud claims in Garfield v. NDC. The CAC contains various other allegations that arguably permit an inference of scienter. We conclude that these other allegations do not contribute to a strong inference of scienter. Health Corp., 466 F.3d 1255, 1266 (11th Cir. 2006). The court rejected a reading that would permit a strong inference of scienter from the certification alone. “If we were to accept [this] proffered interpretation of Sarbanes-Oxley, scienter would be established in every case where there was an accounting error or auditing mistake made by a publicly traded company, thereby eviscerating the pleading requirements for scienter set forth in the PSLRA.” Id. The court, however, went on to hold that such an inference was proper “if the person signing the certification had reason to know, or should have suspected, due to the presence of glaring accounting irregularities or other ‘red flags,’ that the financial statements contained material misstatements or omissions.” Id. This interpretation of the statute is plausible. CLPFdoes not clearly explain the link between these statements about the internal controls and the actual accounting and reporting problems that arose. IES urges that there is not an allegation that on the particular date the certifications were made, the internal controls at IES were inadequate. We hold that the Sarbanes-Oxley certifications at issue here do not permit an inference of scienter.
(5) Collective impact
The tension between the parties, unsurprisingly, is over how specifically the allegations in the CAC must be pleaded in order to avoid dismissal. The flaw in CLPF’s argument is its failure to link the misstatements with the bases for inferring scienter. CLPF’s allegations read in toto do not permit a strong inference of scienter. Therefore, we conclude that the CAC fails to meet the pleading requirements of the PSLRA and must be dismissed.”
Tags: awareness and training, CENTRAL LABORERS’ PENSION FUND, HERBERT ALLEN, Information Security, INTEGRATED ELECTRICAL SERVICES INC, IT compliance, JEFFREY PUGH, policies and procedures, privacy, risk management, Sarbanes Oxley, SOX, WILLIAM REYNOLDS