On September 11, 2018, Judge Barbara M. G. Lynn of the United States District Court for the Northern District of Texas dismissed with prejudice a third amended putative class action complaint against Global Power Equipment Group, Inc. and certain of its former officers asserting claims under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder based on allegations that defendants filed false and misleading financial statements. Budde v. Global Power Equip. Grp., Inc., No. 3:15-CV-1679-M, 2018 WL 4335670 (N.D. Tex. Sept. 11, 2018). Global Power issued restated financials and acknowledged that it had recognized certain revenues and expenses in the wrong period for its Electrical Solutions (“ES”) Segment, had deficiencies in internal controls over financial reporting, and incorrectly accounted for goodwill upon the sale of a subsidiary. Nevertheless, the Court held that plaintiffs failed to adequately allege scienter with respect to any individual defendant and dismissed the complaint with prejudice.
Plaintiffs relied on confidential witness statements to allege that Global Power’s former CFO and CEO were made aware of problems with the ES Segment’s financial results and with respect to internal controls, yet did nothing to correct the issues. The Court first rejected defendants’ argument that the confidential witness allegations were not sufficiently detailed to be given any weight in the scienter analysis. The Court emphasized that the complaint provided each witness’s job description, period of employment, and the bases of the witness’s knowledge, which was sufficient under Fifth Circuit precedent to support the conclusion that the witness would possess the information pleaded. Id. at *6-7. The Court noted that, while confidential witness allegations should be discounted to some extent, nothing prohibits the use of such allegations in supporting an inference of scienter. Id. at *7.
The Court next considered scienter. The Court observed that the confidential witness allegations—for example, statements that the CFO and CEO were told that a “couple of million dollars in total revenue” had been prematurely recognized and thus the ES Segment results contained errors—were sufficient to support the conclusion that they knew they were publishing false information. Crucially, however, these allegations did not establish that they knew they were publishing “materially” false information. Id. at *6. Indeed, the Court emphasized that merely because a material change was made to Global Power’s financial results did not mean that the accounting errors impacting the ES Segment were themselves material. For example, knowledge of the difference of a “couple of million dollars” in revenue affecting the ES Segment was not knowledge that the financial statements were materially false, given that Global Power reported nearly $500 million in revenue. Id. In this regard, the Court noted that the restatement in Global Power’s 2013 financial results attributable to the ES Segment’s accounting errors at issue was 2.36% (for total revenue) or 0.0001% (for total cost), and concluded that no reasonable investor would consider such information important in making a decision to invest. Id. at *6 n.12. Moreover, knowledge of errors relating to the ES Segment did not support scienter with respect to other parts of Global Power. Thus, the Court concluded that the “compelling inference” was that the CFO and CEO knew of “immaterial errors limited to the ES Segment.” Id.
The Court also rejected plaintiffs’ other attempts to support a strong inference of scienter. For example, plaintiffs alleged that the CFO and CEO knew of or recklessly disregarded the lack of internal controls. However, the complaint also alleged that they hired consultants from outside staffing agencies to handle internal accounting-related work, creating an inference that defendants in fact addressed accounting concerns by hiring the consultants. Id. at *7. The Court also emphasized that while the magnitude of the restated financials was significant, this could not alone establish scienter because “courts do not recognize allegations of fraud by hindsight.” Id.
This decision highlights that, even in the case of a material restatement, scienter is adequately alleged only if specific facts are pleaded demonstrating a defendant’s knowledge of accounting errors that were themselves material, independent of the restatement as a whole.