Thursday, July 21, 2016

In absence of scienter, Crocs auditor walks away

By Rodney F. Tonkovic, J.D.

A Tenth Circuit panel has affirmed a district court judgment giving the boot to a complaint against the auditor for Crocs, Inc. The complaint, which the district court dismissed for failure to state a claim, alleged that Crocs's reports fraudulently represented the value of its inventory and the adequacy of its internal controls over financial reporting, and that the auditor was complicit in the fraud. While Crocs' inventory was problematic, the complaint failed to show that the auditor knew of, or refused to see, any warning signs, and the more compelling inference was one of negligence (Sanchez v. Crocs, Inc., July 19, 2016, Holmes, J.)

According to the complaint, shoe-maker Crocs experienced rapid growth between its formation in 2002 and 2006. Despite this, Crocs did not use modern inventory control software or procedures, causing a host of problems with its inventory. As a result of unreliable data, the company had in its inventory too many poor-sellers and too few best-sellers, and retailers were frequently sent the wrong orders. The investors alleged further that one of the company's overseas manufacturers was producing poor quality goods, resulting in a rise in returns.

By 2008, Crocs's inventory had ballooned. While management recognized that demand was decreasing, it believed that demand would rebound, and the company sustained its high production. Despite these issues, Crocs valued its inventory at cost in its 2006 and 2007 Form 10-Ks, and Deloitte & Touche, the company's auditor, issued unqualified audit opinions in both years. In April 2008, Crocs announced a three-month inventory increase of between 5 and 10 percent in three months, resulting in a 45 percent drop in its stock's price. In November 2008, Crocs wrote down the value of its inventory by over seventy million dollars.

Procedural history. Even before the write-down, several plaintiffs had filed securities fraud class action lawsuits against Crocs. The complaints were consolidated and the lead plaintiff, the Sanchez Group, filed the complaint at issue in this case. According to the complaint, Crocs knew that the bulk of its inventory was unsalable, but materially overstated the value of the inventory in its Forms 10-K. Deloitte, as Croc's auditor was complicit in the fraud, and knew of, or recklessly disregarded, various warning signs.

In February 2011, the district court dismissed the complaint for failure to state a claim. The plaintiffs then appealed, but, in the interim, a settlement was reached with the Crocs defendants.

The only remaining defendant on appeal is Deloitte. The district court found that the complaint failed to allege to allege that Deloitte acted with scienter and, at most, established negligence. According to the court, the allegations that Deloitte had access to confidential material and was aware of red flags were too general. On appeal, the investors argued that the complaint adequately set forth Deloitte's false and misleading statements and that the allegations gave rise to a strong inference of scienter.

Mere negligence. The panel concluded that the complaint failed to allege a strong inference that Deloitte acted recklessly in auditing Crocs's finances and internal controls. The complaint alleged that Deloitte knew of, or recklessly disregarded, obvious red flags, including Croc's "primitive" inventory system and the inventory build-up. According to the panel, the complaint insufficiently demonstrated that Deloitte knew about the red flags. The complaint failed to identify any particular document or statement that would have alerted Deloitte to Croc's error-prone inventory.

The complaint also failed to show that any warning signs were so obviously indicative of fraud that Deloitte's failure to see them constituted willful blindness. Neither the flawed inventory system nor the inventory build-up would have ineluctably led to the conclusion that the value of Crocs's entire inventory should have been written down, and far more blatant misconduct would be necessary to infer that Deloitte refused to see the obvious, the panel said. In sum, the more compelling inference was one of negligence on Deloitte's part.

The case is No. 11-1116.

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