(Article from Securities Law Alert, July 2016)
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On July 6, 2016, the Tenth Circuit affirmed dismissal of a securities fraud action against Spirit AeroSystems Holdings and several of its executives for allegedly misrepresenting cost overruns and production delays. Anderson v. Spirit Aerosystems Holdings, 2016 WL 3607032 (10th Cir. 2016) (Bacharach, J.). The Tenth Circuit found plaintiffs’ allegations failed to raise a strong inference of scienter. The court determined it was “more probable that the Spirit executives were overly optimistic and failed to give adequate weight to financial red flags.”
Background
Spirit Aerosystems “agreed to supply parts for three types of aircraft,” including the Boeing 787. The company “managed production of the parts through three projects,” each of which “encountered production delays and cost overruns.” In periodic public reports in 2011 and 2012 concerning the progress of these projects, “Spirit acknowledged risks but expressed confidence about its ability to meet production deadlines and ultimately break even on the projects.” However, on October 25, 2012, Spirit disclosed “that it expected to lose hundreds of millions of dollars on the three projects.” Following the announcement, Spirit’s share price fell approximately thirty percent.
Spirit’s shareholders brought suit in the District of Kansas alleging that Spirit and several of its executives knew long before the October 2012 announcement that “the three projects were behind schedule and were generating so much in additional costs that a loss would be inevitable.” The district court dismissed plaintiffs’ complaint for failure to allege facts showing scienter, among other grounds. Plaintiffs appealed.
Tenth Circuit Finds Plaintiffs’ Allegations Insufficient to Raise a Strong Inference of Scienter
On appeal, the Tenth Circuit observed that “Spirit’s executives [allegedly] knew that Spirit had encountered problems in containing costs and meeting production deadlines.” The court also “assume[d] (without deciding) that Spirit did not adequately communicate these problems to the public.” The Tenth Circuit found that the key question here was why. The court noted at the outset that plaintiffs did not allege that “defendants had a particularized motive for committing securities fraud.” While the court explained that this was not dispositive, the court found “the absence of a motive allegation . . . relevant” to the scienter analysis.
The court found plaintiffs had “suppl[ied] little reason to suspect malevolence rather than benign optimism.” The court held plaintiffs’ allegations inadequate to “create a cogent, compelling inference of scienter.”
Testimony of Lower-Level Employees Does Not Support High-Level Executives’ Scienter
The Tenth Circuit deemed insufficient plaintiffs’ “generalized descriptions of internal meetings, cost reports, delays, and mismanagement” bolstered by the allegations of “ten corroborating witnesses.” The court found the corroborating witnesses “were too far removed” in the corporate hierarchy from the four Spirit executives named as defendants, and these witnesses “did not provide sufficiently particularized accounts of what the Spirit executives must have known.”
Plaintiffs also alleged that one of the Spirit executives “had a culpable intent.” However, the court found plaintiffs did “not tie [his] potentially culpable state of mind to any public disclosures.”
“Core Operations” Theory Is Not Sufficient, Standing Alone, to Allege Scienter
The Tenth Circuit rejected plaintiffs’ effort to allege scienter based on the executives’ alleged involvement in monitoring and overseeing the company’s “core operations.” The court explained that it could not “infer scienter based only on a defendant’s position in a company or involvement with a particular project.” Similarly, the court stated that “mere attendance at meetings does not contribute to an inference of scienter.” The Tenth Circuit held that it could infer from plaintiffs’ “core operations” allegations “only that the four executives were overly optimistic about Spirit’s ability to achieve the forecasted production schedules and cost reductions.” The court found plaintiffs did not “provide[ ] a good reason to believe that the executives knew that the projects were unlikely to meet forecasts.”
Company’s Implementation of a Project “Recovery Plan” Does Not Establish Scienter
The Tenth Circuit also found meritless plaintiffs’ efforts to allege scienter based on a “recovery plan” adopted in July 2012 to put the Boeing 787 project back on schedule. Plaintiffs’ asserted that “the existence of this plan show[ed] that Spirit executives knew that their subsequent representations about the Boeing 787 project were false or misleading.” However, the court found plaintiffs’ allegations did not “support [the] logical leap” that “Spirit executives knew that the recovery plan could not accomplish the plan’s stated objectives.” The Tenth Circuit acknowledged that the company’s “eventual announcement of a forward loss suggest[ed] that Spirit had placed too much confidence in the recovery plan.” But the court explained that “the same [could] always be said when a company delays announcement of a forward loss based on remedial efforts to increase profitability or production.”
The Tenth Circuit noted that it had “addressed an analogous issue in In re Zagg, Inc. Sec. Litig., 797 F.3d 1194 (10th Cir. 2015).”[1] There, a company “adopted a corrective policy restricting executives’ pledges of corporate shares” after the company “allegedly failed to disclose that [its] chief executive officer had pledged approximately half of his shares in the corporation as collateral in a personal margin account.” Spirit Aerosystems, 2016 WL 3607032 (discussing In re Zagg, 797 F.3d 1194). The In re Zagg court rejected plaintiffs’ contention that “adoption of the policy showed that the corporation had a fraudulent intent.” Id. Rather, the In re Zagg court determined that “the new policy showed only that the corporation had ‘identified a better way of doing things moving forward.’” Id. (quoting In re Zagg, 797 F.3d 1194).
Finding In re Zagg “instructive,” the Tenth Circuit stated that Spirit’s implementation of a recovery plan indicated that the company had “identified an interim step to reduce costs and expedite production on the Boeing 787 project.” The court determined that rather than inferring scienter, “[t]he stronger inference is that the Spirit executives thought they had ‘identified a better way of doing things.’” Id. (quoting In re Zagg, 797 F.3d 1194).
Disclosure of Project-Related Risks Does Not Indicate Scienter
With respect to defendants’ disclosure of project-related risks, plaintiffs claimed that “these warnings suggest[ed] a culpable mental state because the four executives must have known that the risks had already materialized.” Plaintiffs asserted that “the more a defendant speaks about a topic, the likelier it is that [the defendant] knows about the topic.” The Tenth Circuit “disagree[d],” and explained that “[o]rdinarily, a defendant’s warnings weaken an inference of scienter.”
CEO’s After-the-Fact Explanation Suggested an Honest Mistake, Not Scienter
After Spirit announced a forward loss, the company’s CEO publicly explained why the loss had occurred. Among other factors, the CEO “acknowledged that Spirit had mistakenly projected Spirit’s ability to improve efficiency and that Spirit ultimately learned that it could not meet projections.” Plaintiffs contended that the CEO’s “statements show[ed] that Spirit [had] recklessly ignored production delays and cost overruns.” However, the Tenth Circuit found the CEO’s statements only “suggest[ed] an honest mistake in predicting Spirit’s future production and costs, not an inference of scienter.”
Size of Forward Loss Does Not Support an Inference of Scienter
The Tenth Circuit also rejected plaintiffs’ contention that “because the forward loss was so large, the executives must have known long before October 2012 that Spirit would incur a loss.” The court stated that “[t]he loss of $434.6 million was undoubtedly significant,” but found that “[t]he size of the loss does not suggest that the four executives knew or recklessly disregarded the risks that Spirit was eventually going to lose money on the three projects.”
Judge Lucero, Dissenting in Part, Opines Plaintiffs Adequately Pled Scienter as to Statements Concerning Then-Present Facts
Judge Lucero concurred with the majority opinion with respect to “statements regarding Spirit’s projected ability to meet cost targets.” However, he “part[ed] ways with the majority with respect to the portion of plaintiffs’ claim based on false statements . . . regarding the then-current performance of Spirit’s 787 project” which did “not rely on any prediction as to future costs.”
Judge Lucero observed that according to plaintiffs, “defendants stated both ‘we will be on budget’ and ‘we are on budget.’” He noted that although “[t]hese two statements differ markedly for purposes of a securities fraud claim . . . the majority opinion focuse[d] its scienter analysis exclusively on the former.”
[1] Please click here to read our prior discussion of the In re Zagg decision.