In an unpublished opinion in The Hemmer Group v. Southwest Water Company, No. 11-56154, slip op. at 7-8 (9th Cir. Jun. 7, 2013), the U.S. Court of Appeals for the Ninth Circuit partially revived a securities class action lawsuit arising from the restatement of the corporate defendant's financial statements for a three-year period. The restatement stemmed from accounting errors that resulted in a significant downward adjustment to operating income. The accounting problems arose from various material weaknesses in internal controls and involved a wide range of errors, including: capitalization of costs that should have been expensed; reporting of intercompany profits; under-appreciation of assets; improper revenue recognition; failure to recognize liabilities; and improper application of purchase accounting. Perrin v. Southwest Water Company, No.2:08-cv-7844-JHN-AGRx, slip op. at 4 (N.D. Cal. Jun. 30, 2011).

The alleged class action asserted claims under Sections 11 and 15 of the Securities Act of 1933, as amended (the "Securities Act"), and Sections 10(b) and 20(a) of the Exchange Act. The district court dismissed the action in its entirety with prejudice. The Ninth Circuit reversed the dismissal of claims under Sections 11 and 15 of the Securities Act, but affirmed the dismissal of claims under Sections 10(b) and 20(a) of the Exchange Act.

The Ninth Circuit refused to revive the Section 10(b) fraud claim, finding that the complaint had failed to adequately plead scienter under the balancing standard articulated in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 324 (2007). The plaintiff argued a strong inference of scienter was established by the enormity of the restatement, the simplicity of the underlying accounting rules, the sheer number of errors, the lack of internal controls, the fact that nearly all errors favored the company, red flags that included letters from the SEC questioning the company's accounting, the accounts of confidential witnesses, the importance of the transactions, the individual defendants' positions within the company and the company's incentive compensation. Southwest Water Company, No.2:08-cv-7844-JHN-AGRx, slip op. at 14. In agreeing with the district court's dismissal for lack of scienter, the Ninth Circuit found that the most likely inference was that the defendants were at most negligent in failing to maintain proper internal controls. In particular, the Ninth Circuit relied upon facts that were only consistent with a non-fraudulent inference. Those facts included disclosures of potential problems in the accounting system during the class period, confidential witness testimony that the corporate defendants attempted to improve systems, and the distinct geographic origin of the accounting errors.

In reversing the Section 11 dismissal, the court applied the Rule 9(b) heightened pleading standard because the allegations sounded in fraud. The complaint satisfied the heightened standard because the restatement constituted an admission that the financial statements were false when made. The misstatements were material because they revised net income between 33 and 100 percent.

A copy of the district court opinion can be accessed at http://cdn.ca9.uscourts.gov/datastore/memoranda/2013/06/07/11-56154.pdf.

A copy of the Ninth Circuit opinion can be accessed at http://securities.stanford.edu/1041/SWWC_01/2011630_r01x_0807844.pdf.