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Knurr v. Orbital ATK Inc.

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

March 2, 2018

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

          MEMORANDUM OPINION

          T. S. ELLIS, III UNITED STATES DISTRICT JUDGE.

         This is the second chapter in this federal securities fraud saga. The first chapter ended with the dismissal in part of the original complaint (“OC”). Specifically, the § 10(b) claim in the OC was dismissed with leave to amend because the facts alleged therein did not give rise to the statutorily required “strong inference” of scienter. Knurr v. Orbital ATK (“Knurr I”), 272 F.Supp.3d 784, 813 (E.D. Va. 2017) (granting motion to dismiss with respect to § 10(b) claims). The § 14(a) claim, however, passed threshold muster. Knurr v. Orbital ATK (“Knurr II”), 276 F.Supp.3d 527, 544 (E.D. Va. 2017) (denying motion to dismiss with respect to § 14(a) claims).

         Plaintiffs then filed an amended complaint (“AC”), alleging essentially the same facts as alleged in the OC, but adding an additional individual defendant and adding some allegations relating to this new individual defendant. Defendants now seek dismissal of the AC, arguing that the AC fails to remedy the OC's fatal flaw inasmuch as the AC still does not allege facts that give rise to a “strong inference” of scienter, as required by the Private Securities Litigation Reform Act (“PLSRA”).[1] These issues have been fully briefed and argued and are now ripe for disposition.

         I.[2]

         The facts recited here are derived from the AC, and as required, these facts are assumed to be true for purposes of this motion. 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”). Because most of the facts in the AC are facts contained in the OC and set forth in some detail in Knurr I, they are only briefly summarized here. More detail is provided here with respect to the additional allegations in the AC relating to the new individual defendant.

         Plaintiffs filed the OC in this matter on April 24, 2017, asserting claims pursuant to §§ 10(b), 14(a), and 20(a) of the Securities and Exchange Act of 1934 (“Exchange Act”) against corporate defendant Orbital ATK and several individual defendants, including David Thompson, Garrett Pierce, Blake Larson, and Mark DeYoung. Corporate defendant, Orbital ATK, is an aerospace and defense company headquartered in Dulles, Virginia. Orbital ATK was formed as a result of the February 2015 merger between two companies-Orbital Sciences Corporation (“Orbital Sciences”) and Alliant Techsystems, Inc. (“Alliant”). The aforementioned individual defendants were corporate officers of Alliant, Orbital Sciences, and Orbital ATK. The OC alleged that the individual defendants, and by extension Orbital ATK, made a series of false and misleading statements in various SEC filings, conference calls, and investor meetings with respect to merger synergies, the performance of a major ammunition contract with the United States Army (the “Lake City Contract”), [3] Orbital ATK's overall financial performance, and Orbital ATK's internal controls. Specifically, the OC focused on the defendants' failure to disclose substantial cost overruns on the Lake City Contract and the defendants' corresponding failure to record estimated contract losses as soon as those losses became evident. These overruns and losses eventually led Orbital ATK to issue two restatements of earnings which revealed that, in contrast to the defendants' statements, Orbital ATK had suffered a $375 million loss on the Lake City Contract. The restatements also disclosed two causes of the misstatements: (1) a flawed accounting methodology that excluded general and administrative costs from forward loss measurements; and (2) weaknesses in Orbital ATK's internal controls, which allowed lower-level management to suppress information related to overruns from higher-level corporate officers.[4]

         The OC also alleged that the individual defendants and Orbital ATK made these misleading statements with the requisite scienter. Specifically, the OC pointed to several indicia as establishing the required strong inference of scienter:

(1) defendants' senior positions with Orbital ATK and corresponding awareness of, responsibility for and control over the Lake City Contract and other subjects of the misleading statements;
(2) multiple “red flags” indicating that the Lake City Contract was operating at a loss;
(3) the simplicity of the “percentage-of-completion” accounting method for the Lake City Contract and defendants' years of experience in using this method for long-term government contracts;
(4) the sheer magnitude of the restatement;
(5) the departure of key employees, particularly DeYoung, government investigations, and defendants' false SOX certifications; and
(6) defendants' motives, namely defendants' profit from incentive compensation or stock sales and desire to complete the merger and make it appear successful.

         On May 30, 2017, defendants filed a motion to dismiss the OC, arguing that the facts alleged therein did not give rise to the “strong inference” of scienter required by the PSLRA. An Order and two Memorandum Opinions issued on September 26, 2017, granting in part and denying in part the motion to dismiss. Specifically, the motion to dismiss the § 10(b) claim was granted and that claim was dismissed with leave to plaintiffs to amend while the motion to dismiss the § 14(a) claim was denied.[5]

         Shortly thereafter, plaintiffs filed the AC at issue here, realleging the § 10(b) claims and adding a new individual defendant, Hollis Thompson. Defendant Hollis Thompson (“Hollis Thompson”) is a Certified Public Accountant (“CPA”) with a bachelor's degree in accounting. Before joining Orbital Sciences, Hollis Thompson worked as an audit manager at Arthur Andersen & Co. At Orbital Sciences, Hollis Thompson worked as Controller from 1998 until 2003 and then served as Principal Accounting Officer (“PAO”) from 2003 until the merger in 2015. After the merger, Hollis Thompson served as Vice President of Financial Reporting and PAO of Orbital ATK. In this role, Hollis Thompson approved Orbital ATK's accounting practices and oversaw all financial reporting and controls. In particular, the AC alleges that Hollis Thompson approved the accounting methodology that excluded general and administrative costs from Orbital ATK's loss calculations, and in so doing, contributed to Orbital ATK's failure to record forward losses on the Lake City Contract when those losses became evident.

         The AC also alleges that Hollis Thompson made several false and misleading statements with respect to the financial success of Orbital ATK after the merger. Specifically, the AC alleges that Hollis Thompson signed Orbital ATK's 2015 Form 10-K and Orbital ATK's Form 10-KT for the transition period from April 1, 2015 to December 31, 2015 (“2015 Form 10-KT”), both of which allegedly contained material misrepresentations regarding the performance of the Lake City Contract, Orbital ATK's overall financial performance, and Orbital ATK's internal controls. On February 27, 2017, one day after Orbital ATK issued its Amended 2015 Form 10-KT, defendant was replaced as PAO.[6]

         On October 24, 2017, defendants filed the motion to dismiss the AC at issue here, arguing that the AC, like the OC, fails to allege facts that warrant a strong inference of scienter with respect to Hollis Thompson and that the § 10(b) claim against Orbital ATK cannot survive without a claim against an individual defendant. In response, plaintiffs contend that the AC satisfies the PSLRA requirement to allege facts to establish a strong inference of scienter as to Hollis Thompson and that even assuming plaintiffs cannot state a claim against Hollis Thompson, the § 10(b) claim against Orbital ATK survives because lower-level employees in the Small Caliber Systems Division intentionally concealed the Lake City Contract cost overruns. As such, there are two questions presented by defendants' motion to dismiss the AC:

(1) whether plaintiffs have alleged facts in the AC that warrant, as the PSLRA requires, a “strong inference” of scienter that Hollis Thompson intentionally concealed or recklessly ignored significant losses on a government contract; and
(2) whether plaintiffs can state a § 10(b) claim against a corporate defendant based on the scienter of lower-level employees who did not make the misleading statement, but merely furnished inaccurate information to higher-level employees who signed the 10-Ks.

         These questions have been fully briefed and argued and are now ripe for disposition.

         II.

         Section 10(b) of the Exchange Act prohibits the use of “any manipulative or deceptive device or contrivance” in connection with the sale of securities “in contravention of [the] rules and regulations” prescribed by the SEC. 15 U.S.C. § 78j(b). The elements of a § 10(b) claim are well-established: “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase of a sale or security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.” Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 552 U.S. 148, 157 (2008).

         Defendants' motion to dismiss the § 10(b) claim against Hollis Thompson focuses exclusively on the second element, namely the required “strong inference” of scienter. Fourth Circuit precedent makes clear that “to establish scienter, a plaintiff must prove defendant acted with ‘a mental state embracing intent to deceive, manipulate, or defraud.'” Yates v. Mun. Mortg. & Equity, LLC, 744 F.3d 874, 884 (4th Cir. 2014) (quoting Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 319 (2007)). As such, at the pleading stage, the plaintiff must allege that defendants “either knowingly or recklessly defrauded investors[.]” Id.at 885.[7] At the same time, because the PSLRA “imposes a heightened pleading standard on fraud allegations in private securities complaints, ” general allegations of scienter are not sufficient. Id. at 885.[8]Instead, the complaint must “state with particularity facts giving rise to a strong inference that the defendant acted with [the requisite scienter].” 15 U.S.C. § 78u-4(b)(1)(B), (2)(A) (emphasis added). In this regard, the Supreme Court has made clear that “in determining whether the pleaded facts give rise to a ‘strong' inference of scienter, [a] court must take into account plausible opposing inferences.” Tellabs, Inc, 551 U.S. at 323. A complaint survives a dismissal motion “only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.” Id. at 324.

         The AC realleges the same facts and indicia of fraud contained in the OC in an attempt to establish a strong inference that defendant Hollis Thompson, and by extension Orbital ATK, acted with the requisite scienter in making the aforementioned misleading statements. The AC also alleges additional indicia unique to Hollis Thompson, including: (1) that in his role as Orbital ATK's PAO, defendant developed and approved what proved to be a flawed accounting practice that contributed to the Lake City Contract errors; (2) that in his role as PAO, defendant was responsible for overseeing all financial reporting and accounting practices; and (3) that defendant was replaced as PAO immediately following the restatement of earnings in February 2017. Because Knurr I held that the previously alleged indicia were not sufficient to warrant a strong inference of scienter as to the other individual defendants, [9] the central question is whether these three additional indicia, viewed individually or together with all of the other indicia, establish the requisite strong inference of scienter with respect to Hollis Thompson.

         To answer this question, these three allegations are evaluated first in light of “context and common sense” to determine whether they give “rise to an inference of scienter and, if so, the strength of that inference.” Yates, 744 F.3d at 885. From there, Fourth Circuit precedent requires consideration of “whether a reasonable person would regard the inference that defendant[] knowingly or recklessly misstated or omitted material information at least as strong as the inference that [the defendant] [was] merely negligent with respect to those statements.” Id. at 893 (quoting Matrix Capital Mgmt. Fund, LP v. BearingPoint, Inc., 576 F.3d 172, 187 (4th Cir. 2009)). In this respect, the AC is “evaluate[d] . . . holistically, recognizing that allegations of scienter that would not independently create a strong inference of scienter might [complement] each other to create an inference of sufficient strength to satisfy the PSLRA.” Id. (quotation marks omitted).

         A.

         The AC's first allegation arises out of Hollis Thompson's role as Orbital ATK's PAO and his responsibility in this role for accounting practices within the company. Specifically, the AC alleges that Hollis Thompson knowingly developed and approved an accounting methodology that violated Generally Accepted Accounting Principles (“GAAP”) and contributed to the Lake City Contract accounting errors. Plaintiffs argue that given Hollis Thompson's background as a CPA and his experience with Orbital ATK, he knew or recklessly disregarded the fact that the accounting practice he approved-which excluded general and administrative costs from forward loss measurements-violated GAAP. Based on this inference, the AC further alleges that Hollis Thompson knew the costs on the Lake City Contract were vastly understated and consequently that Orbital ATK's SEC filings were false and misleading.

         This allegation fails to establish any inference of scienter, let alone the strong inference required under the PSLRA, for two primary reasons: (1) Orbital ATK publicly disclosed this accounting practice in all of its SEC filings; and (2) the AC fails to allege ...


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