On July 12, 2018, the United States Court of Appeals for the Seventh Circuit affirmed the dismissal of a putative class action brought against Kohl’s Corporation and certain of its executives asserting claims pursuant to Sections 10(b) and 20(a) of the Securities Exchange Act. Pension Tr. Fund for Operating Eng’rs v. Kohl's Corp., —F.3d—, 2018 WL 3385278 (7th Cir. July 12, 2018). Plaintiffs alleged that defendants made false and misleading statements prior to an announcement that Kohl’s would be correcting several years of financial statements due to lease accounting errors. The Court, affirming the district court’s dismissal with prejudice, held that plaintiffs’ complaint failed to adequately allege scienter under the Private Securities Litigation Reform Act (PSLRA) and that plaintiffs were not entitled to an opportunity to replead because they had not provided any basis to infer they could plead a viable claim.
In 2011, Kohl’s restated its financials to account for its large book of store leases as capital leases, rather than operating leases. Plaintiffs’ suit followed, alleging that Kohl’s accounting errors were purposeful or reckless primarily because (i) Kohl’s had made earlier adjustments to its lease accounting practices in 2005 and 2010, and (ii) certain executives had sold company stock during the class period.
The Court found plaintiffs’ allegations unavailing. While the complaint contained an “exhaustive account of the facts of Kohl’s accounting mishaps,” it contained very few factual allegations pointing either toward or away from scienter—a “lack of connective tissue” that the Court found determinative. Id. at *4. Importantly, the Court found that although the accounting errors identified in 2005 and 2011 were both significant, they were not as similar as plaintiffs argued. Specifically, the adjustments in 2005 related to how Kohl’s calculated the start and end date of lease terms, whereas the 2011 adjustments related to the classification of leases as operating or capital leases. Id. Further, although one error from 2005 recurred in 2010, the 2010 corrections led to a relatively minor restatement affecting only a single quarter. Id. The Court therefore found no allegations in the complaint supporting a theory of recklessness, but instead found that the complaint itself provided an “innocent explanation” that was more likely—that the 2011 errors were discovered as part of a comprehensive review of Kohl’s financial statements in connection with a credit agreement Kohl’s had just secured. Id.
The Court also rejected the argument that executives’ stock sales supported a compelling inference of scienter. Plaintiffs alleged the date of sale, number of shares, and sale price for each trade, and argued that stock sales in 2009 and 2010 were suspicious given that the executives made no sales in 2008 or 2011. The Court found these allegations insufficient, particularly in light of the information not contained in the complaint: whether the sales were a high percentage of each individual’s holdings, whether each individual sold more shares than typical, whether they bought more shares to offset their sales, what the total typical trading volume was of Kohl’s shares, and how much Kohl’s stock price fluctuated around the time of these sales. Id. at *5. Moreover, the Court emphasized that the “probative value of stock sales depends greatly on timing,” and the alleged sales occurring 14 months before the 2010 corrections and 23 months before the 2011 corrections were “more than long enough” in advance of the corrections for “any inference of suspicion to dissipate, at least in the absence of concrete facts suggesting otherwise.” Id.
With respect to the lower court’s dismissal with prejudice, the Court emphasized that plaintiffs should be given “at least one opportunity to try to amend,” particularly in securities fraud cases where “the drafting of a cognizable complaint can be a matter of trial and error.” Id. While questioning the lower court’s reasoning for denying leave to amend, the Court nevertheless found reversal inappropriate. In this regard, the Court noted that although plaintiffs did not have an opportunity to show what they could add before the district court dismissed with prejudice, they had had several opportunities since, including moving under FRCP 59(e) or 60(b) for another opportunity in the district court, or telling the Court in their appellate briefing what more they would plead. Indeed, despite being asked during oral argument, plaintiffs failed to identify how they could cure the defects in the complaint on amendment. The Court therefore affirmed the dismissal with prejudice. Id. at *6.
This decision illustrates that even seriatim accounting errors, standing alone, may not support a cogent and compelling inference of scienter.