Monday, July 24, 2017

Knowing accounting rules is not the same as knowing they are being followed

By Rodney F. Tonkovic, J.D.

A securities fraud action alleging that Kohl's Corporation misrepresented its accounting for lease agreements has been dismissed by a federal court. The complaint alleged that the retailer made a number of misrepresentations and nondisclosures concerning its improper lease accounting practices and the impact of those practices. The court found that the complaint failed to show that Kohl's and the officer defendants either knew information that contradicted their public statements or that they were motivated to keep stock prices artificially high while they sold their own shares (Pension Trust Fund for Operating Engineers v. Kohl's Corporation, July 20, 2017, Stadtmueller, J.P.).

Procedural history. This action was filed nearly four years ago. Kohl's first motion to dismiss was denied without prejudice in 2014, and a second motion was filed in mid-2015. In May 2017, the case was reassigned following the retirement of the judge to whom it was originally assigned. At the time, the second motion to dismiss had been pending unresolved for nearly two years, a situation the court described as "inexplicable and unacceptable." The court then requested supplemental briefing on any relevant case law from the previous two years.

Accounting for leases. Approximately 65 percent of Kohl's 1127 stores are leased. In February 2005, Kohl's disclosed that its lease accounting practices did not conform with GAAP, requiring a restatement of its financial results from 1998 through the first three quarters of 2004. In early 2009, Kohl's filed its Form 10-K representing that its financial statements were in conformity with GAAP and fairly presented the company's financial condition.

In November 2010, Kohl's announced that it had reviewed its historical accounting for leased properties and noted various corrections. These corrections were not material to its previous financial statements, Kohl's said, and were recorded in that quarter through adjustments to depreciation, interest, and rent expense totaling up to $25 million. Similar statements were made in subsequent filings. In August 2011, Kohl's indicated that investors should no longer rely on the financial statements included in its 2010 Form 10-K and 2011 first-quarter Form 10-Q as a result of errors related to its accounting for leases.

In September 2011, Kohl's issued restatements covering 2006 through 2010, plus the first two quarters of 2011. The restated figures showed that Kohl’s had significantly understated its total assets while overstating net income and capitalization. Kohl’s also disclosed material weaknesses in its disclosure and internal controls.

According to the complaint, however, the improper lease accounting caused Kohl's reported liabilities and debt to be materially understated and its reported equity to be materially overstated. Kohl's should have known that its representations that the corrections were not material were false because the company had made a detailed review of its accounting several years earlier, the complaint said. The complaint alleged further that Kohl's disregarded its improper lease accounting practices in order to facilitate insider sales. Finally, the allegedly false and misleading statements and omissions caused investors to purchase Kohl's common stock at artificially inflated prices.

No scienter. The court dismissed the action with prejudice after finding that the complaint failed to meet the pleading standards for fraud cases. The complaint first asserted that Kohl's had access to information demonstrating the falsity of the financial statements it distributed publicly and therefore must have provided the false information either intentionally or recklessly. Kohl's knew and understood the applicable accounting rules, the complaint explained, as a result of its 2005 restatement.

The court concluded that the complaint failed to allege with the required particularity that the officer defendants knew that Kohl's accounting personnel and auditor were committing any errors or that the officers' failure to recognize these errors was an extreme departure from the standards of ordinary care. Knowing an accounting rule and knowing that it is not being followed are two different things, the court remarked. There were no allegations, the court said, tying any individual defendant to information or knowledge that would contradict their statements. At best, Kohl's CEO and CFO were negligent.

Next, the complaint alleged that Kohl's CEO, CFO, and other executives were motivated to provide false information that would keep the price of Kohl’s stock artificially high at the time they sold a significant amount of their own shares. The complaint set forth dates, numbers, and value of the shares sold for nine executives, but gave the court no context to consider the import of the trades, such as the percentage of the officers' total holdings. There was also insufficient information to determine whether the sales represented any kind of pattern, let alone an unusual one.

In short, the complaint failed to plead with particularity facts giving rise to a strong inference of scienter. In dismissing the case with prejudice, the court noted that the originally-assigned judge had put the plaintiffs on notice of weaknesses in the complaint, but they chose to stand on the amended complaint as filed, despite several opportunities.

The case is No. 13-cv-1159.

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