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Knurr v. Orbital ATK Inc.

United States District Court, E.D. Virginia, Alexandria Division

September 28, 2017

STEVEN KNURR, et al., Plaintiffs,
ORBITAL ATK INC., et al., Defendants.



         Plaintiffs in this federal securities class action allege claims under (i) § 10(b) and Rule 10b-5; (ii) § 14(a) and Rule 14a-9; and (iii) § 20(a) of the Securities Exchange Act of 1934 (“Exchange Act”). Defendants seek threshold dismissal of claims under all three provisions, and a separate memorandum opinion addresses the § 14(a) and related § 20(a) claims. This memorandum opinion addresses the questions presented under § 10(b) and the related § 20(a) claims, which are as follows:

(1) whether plaintiffs have alleged facts in the Complaint[1] that warrant, as the Private Securities Litigation Reform Act (“PSLRA”) requires, a “strong inference” of scienter with respect to their claim under § 10(b) of the Exchange Act that defendants, a publicly traded aerospace and defense company and four of its high-level officers, intentionally concealed or recklessly ignored significant losses on a government contract; and
(2) whether under § 20(a) of the Exchange Act, the Complaint adequately alleges that the defendants had control over any person liable under § 10(b) of the Exchange Act.

         Parties have fully briefed and argued these questions, and they are ripe for disposition.


         Before reciting the pertinent facts, it is important to identify the proper source of those facts. First, as the parties agree and as settled precedent requires, the facts recited here are taken chiefly from the Complaint's factual allegations, which must be accepted as true at this stage. Cozzarelli v. Inspire Pharm. Inc., 549 F.3d 618, 625 (4th Cir. 2008) (noting that at the motion to dismiss stage, “we must accept plaintiffs' factual allegations as true”). Defendants have also sought to have additional facts considered by attaching various exhibits to the motion to dismiss.[2] Only certain of these documents are appropriately considered at this stage.

         Settled circuit authority permits courts to consider external documents in a motion to dismiss when they “are integral to and explicitly relied on in the complaint, and when the plaintiffs do not challenge the document's authenticity.” Zak v. Chelsea Therapeutics Int'l, Ltd., 780 F.3d 597, 606-07 (4th Cir. 2015) (quotation marks and brackets omitted). The SEC filings attached to defendants' dismissal motion, the transcripts of the August 10, 2016, November 8, 2016, and March 8, 2017 Orbital ATK conference calls, and the Wells Fargo and Barclays analyst reports are integral to or explicitly referenced in the Complaint, and plaintiffs do not challenge their authenticity. Accordingly, these documents are appropriately considered at this stage. Similarly, because the Fourth Circuit permits courts to take “judicial notice of published stock prices without converting a motion to dismiss into a motion for summary judgment, ” it is also appropriate to consider the chart summarizing Orbital ATK's historical stock prices. Greenhouse v. MCG Capital Corp., 392 F.3d 650, 655 (4th Cir. 2004). By contrast, Alliant's August 1, 2013 conference call is not referenced in the Complaint, nor does the Complaint cite the KeyBank analyst report, so it is inappropriate to consider these documents at the motion to dismiss stage.


         Corporate defendant, Orbital ATK, is an aerospace and defense company headquartered in Dulles, Virginia. The company's stock trades on the New York Stock Exchange under the ticker symbol “OA.” Orbital ATK was formed out of the February 2015 merger between two companies-Orbital Sciences Corporation (“Orbital Sciences”) and Alliant Techsystems, Inc. (“Alliant”).

         In addition to the corporate defendant, the Complaint names the following four individual defendants:

(1) David D. Thompson;
(2) Garrett E. Pierce;
(3) Blake E. Larson; and
(4) Mark DeYoung.

         Defendant Thompson has been the Chief Executive Officer and President of Orbital ATK since the merger; before the merger, he was the Chairman of the Board, CEO, and President of Orbital Sciences. Defendant Pierce is currently Orbital ATK's Chief Financial Officer; before the merger he was Vice Chairman of the Board and CFO of Orbital Sciences. Defendant Larson is the Chief Operating Officer of Orbital ATK; before the merger he was the Senior Vice President of Alliant and President of Alliant's Aerospace Group. Finally, defendant DeYoung was a Director of Orbital ATK from the merger until March 2016; before the merger he served as the CEO and President of Alliant.

         Plaintiffs allege that Thompson, Pierce, and Larson made a number of false and misleading statements with respect to the financial success of Orbital ATK after the merger of Orbital ATK's predecessor companies, Orbital Sciences and Alliant. In particular, plaintiffs focus on Thompson, Pierce, DeYoung and Larson's failure to disclose for over a year that a major ammunition contract with the United States Army-the Lake City Contract-was costing Orbital ATK hundreds of millions of dollars. Under Orbital ATK's own accounting policy and Generally Accepted Principles of Accounting (“GAAP”), gross estimated losses on long-term contracts such as the Lake City Contract must be disclosed and recorded as soon as such losses become evident. On August 10, 2016, Thompson, Pierce, and Larson announced that they would be restating several of Orbital ATK's financial statements to reflect nearly $400 million in losses on the Army ammunition contract, and also announced that the losses from this contract should have been recorded earlier pursuant to the accounting policy and GAAP. Defendants' alleged cover-up of the losses on the ammunition contract form the basis of plaintiffs' claims under § 10(b) of the Exchange Act.

         Prior to their merger, Orbital Sciences and Alliant were both publicly traded aerospace and defense companies headquartered in Virginia and both sold products such as rockets and satellites to NASA and the United States military. Alliant was also a leading ammunition producer for the United States military; Orbital Sciences did not manufacture or sell ammunition. Both companies relied heavily on government contracts, which were 70% of Alliant's sales and 80% of Orbital Sciences' sales. At the same time, the Complaint alleges that heading into the merger, Alliant was under pressure to renew a major ammunition contract, and Orbital Sciences was dealing with a series of financial missteps. The Complaint alleges that these pressures set the stage for defendants' fraudulent and misleading statements with respect to Orbital ATK's post-merger financial performance.

         With respect to Alliant, plaintiffs' claims focus on the Lake City Contract between Alliant and the United States Army, which Alliant originally entered into in 2000. Alliant manufactured billions of rounds of small caliber ammunition under this contract at the Lake City Plant in Independence, Missouri, and the contract accounted for 13% of Alliant's total revenues in fiscal year 2010; no other contract contributed more than 10% of the company's sales. In fiscal year 2010, Alliant received a four-year renewal on the Lake City Contract. In August 2012, Alliant submitted a bid to the Army to retain the Lake City Contract beyond 2013. The Complaint alleges that Alliant, at this time, was under pressure to retain the Lake City Contract because Alliant had recently lost a bid to renew another major multi-year ammunition Army contract to Alliant's competitor, BAE Systems PLC. To make matters worse for Alliant, BAE Systems was also seeking the Lake City Contract. Accordingly, plaintiffs allege that Alliant and DeYoung “aggressively bid” on the Lake City Contract renewal with a “low-ball bid.” (Compl. ¶¶ 47, 38). Alliant and DeYoung's plan apparently worked, as Alliant won the renewal of the Lake City Contract on September 28, 2012; the contract had a seven-year term with a three-year extension option, and production under the contract would begin on October 1, 2013.

         Plaintiffs allege that making a profit on the new Lake City Contract would be more difficult compared to the old contract owing to the lower production volume, given that overhead costs had to be spread over the total cost of production. Alliant assured investors that it would monitor costs carefully to account for these reductions in volume, but also made clear that Alliant would face some pressure with respect to the profit margins on the Lake City Contract. For instance, on various conference calls, DeYoung acknowledged that Alliant won the Lake City Contract on an “aggressive bid” and that winning that bid would require “price reductions which could impact margins in the early years of winning the recompete.” (Compl. ¶ 43). After Alliant won the contract, DeYoung reiterated that it was an “aggressive contract” and that the company would experience an “initial period of margin pressure” and “some reduced revenue” as a result. Id. ¶ 44. DeYoung also informed investors on October 30, 2014 that Alliant was taking a number of steps to reduce costs and boost profitability on the Lake City Contract, including (i) reducing staff and work force; and (ii) offering commercial ammunition out of the Lake City Plant.

         As for Orbital Sciences, the Complaint also alleges that this company was facing its own problems in the year before the merger, namely: (i) lower than expected revenues for each quarter of 2014; (ii) two reductions in revenue guidance for 2014; and (iii) a failed rocket launch in October 2014, which jeopardized a multi-year contract with NASA. The Complaint alleges that these failures raised the stakes for a successful proposed merger between Orbital Sciences and Alliant.

         On April 29, 2014, Orbital Sciences and Alliant announced that they planned to merge to form Orbital ATK. Orbital Sciences shareholders would receive .449 shares of Orbital ATK stock in exchange for each share of Orbital Sciences stock held, Alliant shareholders would retain their Alliant stock, and Alliant would be renamed Orbital ATK. Thompson would serve as CEO of Orbital ATK, while Pierce would serve as the CFO. DeYoung would become CEO and Chairman of a new company, Vista, which would be a spin-off of Alliant's sporting segment. Even though Vista would manufacture ammunition, Vista and DeYoung did not take the Lake City Contract; that contract remained with Orbital ATK.

         After conducting due diligence, Alliant and Orbital Sciences, on December 17, 2014, filed a joint proxy statement (“Joint Proxy Statement”) with the SEC concerning the merger. Shortly thereafter, both companies held special stockholders meetings on January 27, 2015 to vote on the merger. The shareholders from each company approved the merger, which was announced on February 9, 2015.

         Following the merger, Orbital ATK transitioned from Alliant's fiscal year, which ended March 31, 2015, to a fiscal year ending on December 31. The Class Period begins on May 28, 2015, when Orbital ATK reported its first financial results after the merger. The Complaint alleges that defendants began making a series of statements on May 28, 2015 about Orbital ATK's post-merger financial performance. In particular, the Complaint identifies four categories of false and misleading statements as the basis for the § 10(b) claim:

(1) statements regarding merger synergies;
(2) statements regarding the Lake City Contract's performance;
(3) statements regarding financial results; and
(4) statements regarding internal controls.

         Because defendants, at this stage, do not contest the materiality or falsity of the statements, a brief summary of the statements suffices.

         Statements Regarding Merger Synergies

         On May 28, 2015, the beginning of the Class Period, Orbital ATK announced its financial results from the first transition period quarter ending on March 31, 2015. Orbital ATK also filed these results with the SEC on Form 8-K. Between May 28, 2015 and May 11, 2016, Thompson, Larson, and Pierce made a number of public statements in financial releases, [3]conference calls, [4] and investor meetings[5] concerning Orbital ATK's success in achieving merger synergies. Specifically, defendants touted the benefits of and synergies associated with the merger and described the related cost savings and improved profit margins.

         The Complaint alleges all of these statements were false and misleading for the following reasons: (i) the positive statements regarding the benefits, cost reductions, and synergies omitted to disclose that such savings and synergies were outweighed by the $375 million loss on the Lake City Contract; (ii) the various statements regarding the benefits of the merger, cost savings, and improved profit margins did not disclose that the Lake City Contract losses negatively impacted Orbital ATK's profit margins; (iii) the Lake City Contract was priced millions of dollars below cost, and, in violation of GAAP and Orbital ATK's accounting policy, defendants failed to record the $375 million loss on the contract when it became evident; and (iv) defendants did not disclose that their efforts to reduce the costs on the Lake City Contract had failed to make the contract profitable.

         Statements Regarding the Lake City Contract's Performance

         The next category of allegedly false and misleading statements ranges from May 28, 2015 to May 11, 2016 and involves the financial performance of the Lake City Contract. Again, these statements appeared in financial releases[6] and SEC forms.[7] Moreover, defendants made various statements on conference calls[8] and at conferences.[9] Generally, these statements described the continued success of the Lake City Contract and its high rates of production.

         The Complaint alleges that these statements were false and misleading because, in fact, the company was losing money on the Lake City Contract by selling the bullets at a significant loss. In particular, the statements concerning the Lake City Contract's profit margins were false because the contract was in fact operating at negative margins, which resulted in substantial losses. Likewise, statements concerning the profit rate of the Lake City Contract were also false because Orbital ATK was, in fact, losing money on the contract.

         Statements Regarding Financial Results

         The Complaint alleges that between June 1, 2015 and May 9, 2016, defendants made a number of false and misleading statements concerning Orbital ATK's financial results in releases[10] and SEC filings.[11] The Complaint alleges that these figures and statements concerning Orbital ATK's financial condition were false and misleading for the same reason-the Lake City Contract had been priced hundreds of millions of dollars below cost, and defendants, in violation of GAAP and the company's accounting policy, did not record this $375 million forward loss on the contract. As a result of defendants' failure to record the loss properly, all of the financial figures reported in these releases and statements were erroneous. For instance, the Complaint alleges that with respect to the figures stated in the 2016 release and Form 10-Q, the total current liabilities were understated by $264 million (22%), the retained earnings were overstated by $255 million (23%), the net receivables were overstated by $119 million (6%), and total equity reported was overstated by $255 million (15%).

         Statements Regarding Internal Controls

         Finally, between May 28, 2015 and May 9, 2016, the Complaint alleges that defendants made a number of false statements in SEC forms[12] and conference calls[13] concerning Orbital ATK's internal financial controls.

         The Complaint alleges that these statements were false and misleading because, in fact, Orbital ATK had not integrated the accounting systems of its predecessor companies, and as such, Orbital ATK could not generate accurate financial reporting. Furthermore, the Complaint alleges that Orbital ATK's financial controls at the time suffered from several material weaknesses, particularly with respect to the failure to maintain an effective financial control environment at the company's Defense Systems Group and Small Caliber Systems Division. These statements were false according to the Complaint because defendants continued to conceal the large losses stemming from the Lake City Contract.

         After more than a year of positive statements concerning the merger and analysts' corresponding expectations for Orbital ATK, [14] events took a turn for the worse on August 10, 2016. Before the market opened that day, Orbital ATK made the following announcements: (i) that the company would not be able to file its quarterly report for second quarter 2016 on time; (ii) that the company's previously issued quarterly and annual financial statements in fiscal year 2015, transition period 2015, and first quarter 2016 were no longer reliable; (iii) that the company would have to restate its financial statements because of material misstatements related to the Lake City Contract; and (iv) that the company's internal financial controls were ineffective and weak.

         Also on August 10, 2016, Orbital ATK filed a Form 8-K report, which provided further detail about the misstatements relating to the Lake City Contract. Specifically, the Form 8-K explained that:

Under generally accepted accounting principles, the Company is required to record the entire anticipated forward loss provision for a contract in the period in which the loss becomes evidence. The Company believes that a forward loss provision should have been recorded for the Contract in fiscal 2015, which was the first year of large-scale production under the Contract.

         With respect to the cause of these misstatements, the Form 8-K stated that there were “one or more material weaknesses in [the company's] internal control over financial reporting and disclosure controls and procedures during the Restated Periods.” As for the losses caused by the misstatements, Orbital ATK estimated that the forward loss charge would reduce previously reported pre-tax operating income by about $400 million to $450 million and after-tax net income by about $250 million to $280 million. Orbital ATK also estimated that the misstatements resulted in revenues being overstated by $100 million to $150 million, primarily for fiscal year 2015. Finally, the Form 8-K stated that Orbital ATK expected to file an amended Form 10-K for the 2015 transition period, and its quarterly report on Form 10-Q for the quarter ending April 3, 2006 “as soon as reasonably practicable, ” but that the company had obtained an extension from its lenders to file the reports by November 14, 2016.

         Thompson, Pierce, and Larson also held a conference call that day to discuss Orbital ATK's announcement that Orbital ATK's earnings would have to be restated. The transcript from the August 10, 2016 conference call shows that Thompson stated that Orbital ATK's review of its financial processes and controls “ultimately determined that [the Lake City Contract] had in fact[] been in a substantial loss position since 2014, rather than the roughly breakeven profit level that had been previously recorded.” Pierce stated that the Lake City Contract “moved into high-rate production” in fiscal year 2015, and that “[d]espite vigorous and sustained efforts to achieve productivity improvements, and despite realizing substantial cost efficiencies, [the] Lake City team was unable to reduce the production costs far enough for the contract to be profitable.” The Complaint also notes Pierce's statement that the Lake City Contract involved a simple product with fixed material costs, so “the latitude that [the company has] is labor costs and overheads and the like, so there's not a lot of room to move on that.” Finally, Larson stated that the Lake City Contract team had “achieved more than one-half, to one-half to two-thirds of the objective cost reduction that the bid anticipated.”

         After these disclosures, Orbital ATK's stock price dropped more than 20%, from a close of $89 per share on August 9, 2016 to a close of $71 per share on August 10, 2016. Analysts from Wells Fargo, Barclays, and Jefferies all lowered their ratings for Orbital ATK, and Wells Fargo analysts noted the surprising magnitude of the revision. In another report issued on August 23, 2016, Wells Fargo reiterated its opinion concerning the substantial size of the earnings restatement.

         Three months later, Orbital ATK filed another Form 8-K with the SEC on November 1, 2016. The Form 8-K stated that the company had preliminarily determined, after a multi-month review, that “the majority of the [Lake City Contract] loss provision should be recorded at the inception of the Contract which occurred in fiscal 2013, ” instead of the August position that the loss should have been recorded in fiscal 2015.[15] Orbital ATK also stated, however, that the preliminary estimate of the loss amount was lower than previously announced, as the estimated reduction in pre-tax operating income would be $350 million, instead of the original estimate of $400 to $450 million, and the estimated reduction in after-tax net income would be about $220 million, instead of the original estimate of $250 million to $280 million.

         Orbital ATK ultimately filed its Amended Form 10-K for the nine-month transition period ending December 31, 2015 on February 24, 2017. The Amended Form 10-K restated the company's financial statements for the first quarter of 2016, the transition period ending on December 31, 2015, fiscal year 2015, fiscal year 2014, and fiscal year 2013 (except for the first quarter); the Amended Form 10-K also confirmed that the previous financial statements for these fiscal years, as well as the associated quarterly reports, should no longer be relied on due to the misstatements concerning the Lake City Contract. With respect to the Lake City Contract, the Amended Form 10-K confirmed that Alliant had submitted a significantly low bid for the contract on the basis that it would reduce operating costs substantially over the life of the contract. Although the Amended Form 10-K noted that Orbital ATK achieved “significant cost reductions, ” those reductions “were not sufficient to achieve profitability over the life of the Lake City Contract.” As for the misstatements, the Amended Form 10-K confirmed that senior management identified the misstatements in 2016 as part of a company-wide effort to enhance accounting controls and oversight. Once the misstatements were corrected, it became clear that the costs of the Lake City Contract would exceed its revenues over the life of the contract, which meant that the entire anticipated forward loss should have been recorded in 2013 when the loss became evident. Specifically, the Complaint notes that Orbital ATK determined that $32 million of the loss should have been evident when the contract was signed in the second quarter of fiscal 2013, and $342 million should have been evident in the second quarter of fiscal 2014.

         The Amended Form 10-K also provided information as to the reasons the misstatements occurred in the first place. The internal investigation revealed that certain personnel in the Small Caliber Systems Division and the Defense Systems Group failed to adhere to company standards with respect to the Lake City Contract. In particular, (i) there was likely a “bias toward maintaining a targeted profit rate;” (ii) there was, in some cases, apparently an “inappropriate use of management reserves to maintain the targeted profit rate;” (iii) “some members of the Small Caliber Systems Division finance staff failed to follow up and inquire further into indications that cost overruns were occurring;” and (iv) “negative information was suppressed, and concerns at the Small Caliber Systems Division about cost overruns were not escalated appropriately” to higher-level company management and finance staff, the Audit Committee, the Board of Directors, or the independent accounting firm.

         Finally, Orbital ATK also revealed in the Amended Form 10-K that Orbital ATK was the subject of a non-public SEC investigation, and noted that the restatement could result in government enforcement actions or adverse litigation.

         After Orbital ATK filed its Amended Form 10-K, plaintiffs filed the operative Complaint in this matter on April 24, 2017, asserting claims against the defendants. Plaintiffs bring four claims against defendants based on the post-merger statements, as well as defendants' alleged negligence in preparing, reviewing, and disseminating the Joint Proxy Statement issued before the merger: (i) a violation of § 10(b) of the Exchange Act and Rule 10b-5 against all defendants, (ii) a violation of § 20(a) of the Exchange Act against Thompson, Pierce, and Larson, (iii) a violation of § 14(a) of the Exchange Act and Rule 14a-9 against Thompson, Pierce, DeYoung, and Orbital ATK (the “Joint Proxy Defendants”), and (iv) a violation of § 20(a) of the Exchange Act against DeYoung, Thompson, and Pierce.

         Defendants then filed a joint motion to dismiss all claims in the Complaint pursuant to Rule 12(b)(6), Fed. R. Civ. P and under the PSLRA. With respect to the § 10(b) and related § 20(a) claims, defendants argue that the Complaint does not allege facts that warrant a strong inference of scienter, and plaintiffs contend that the Complaint satisfies the PSLRA ...

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