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From Securities Regulation Daily, August 7, 2018

Ex-CFO’s scienter can arise from audit committee report, but case against other execs falters

By Mark S. Nelson, J.D.

A divided Fifth Circuit held that allegations made by a pension fund could support a strong inference of scienter regarding Hanger, Inc.’s former CFO, reversing the district court, but the majority upheld the remainder of the district court’s opinion because the complaint failed to alleged scienter regarding Hanger’s ex-CEO and current CEO/president. The majority also held that a series of corrective releases could allege loss causation. As a result, the case can go forward, but the district court also will need to conduct further proceedings on related controlling persons claims, which were not fully briefed. Meanwhile, Judge Ho dissented because he would have required the pension fund’s scienter allegations to have demonstrated a higher degree of particularity (Alaska Electrical Pension Fund v. Asar, August 6, 2018, Wiener, J.).

Audit committee report. The crux of the case is whether Hanger, a major provider of orthotic and prosthetic services, made false and misleading statements about its financials, including regarding its Medicare reimbursement and appeals practices. The court noted that Alaska Electrical Pension Fund made 93 discrete allegations of securities fraud, which the majority distilled into four categories: (1) Hanger’s boasts about robust same-store sales; (2) Hanger’s Medicare practices; (3) Hanger’s internal controls; and (4) Hanger’s allegedly understated financial restatement.

The preliminary and final results of an investigation by Hanger’s audit committee revealed that a former employee fabricated inventory records and that the company’s former CEO and CFO created an "inappropriate ‘tone at the top’" that may have put pressure on employees to meet financial goals. With respect to the fabrication allegation, the court observed in footnote 43 that the pension fund did not allege that the executive defendants knew of the fabrication. The district court had dismissed the case in its entirety, but the appeals court would reverse with respect to Hanger’s former CFO.

Scienter alleged as to ex-CFO. The majority examined the pension fund’s scienter allegations individually and holistically. To this end, the majority extensively analyzed the conclusions of an audit committee report. First, in some instances where the audit committee report implied action by numerous persons and only identified Hanger’s current CEO and two former executives, the majority rejected the allegations in the complaint as group pleading. However, similar allegations against the company’s former CEO and CFO did not amount to group pleading even if the allegations referred to multiple persons.

Second, with respect to allegations of inappropriate tone at the top, the majority noted a Fourth Circuit case finding that such allegations did not imply scienter; the majority also distinguished a district court case that did find scienter in a similar situation by observing that in the Hanger case there was no showing of direct pressure by executives and it was undisputed that a lower-level employee was responsible for much of the alleged fraud. Moreover, there was no allegation of how Hanger’s executives set the allegedly improper tone; thus, it was equally possible that the executives would have found their tone inappropriate in hindsight only. Still, the majority refused to conclude that tone at the top can never lead to a strong inference of scienter, just that tone was a "minimal" component in this case.

Third, the majority examined the pension fund’s allegations that scienter could be inferred from Hanger’s historical accounting practices. Despite the audit committee report’s failure to identify Hanger’s former CFO or to refer to the CFO’s objective, the pension fund’s allegations did support an inference of scienter because the CFO shared the goal of improperly boosting financial results, or he knew others sought to improperly enhance Hanger’s financials.

The majority also examined four other aspects of the pension fund’s scienter allegations. For one, the majority found that allegations regarding the magnitude of the alleged fraud ($87 million) and timing ("significant" time frame) of Hanger’s accounting problems, on their own, could not support scienter. Stock sales by Hanger executives pursuant to Exchange Act Rule 10b5-1 plans also could not by themselves imply scienter, although they raised a "slight" inference. Nor could allegations about Sarbanes-Oxley Act certifications support an inference of scienter because it was insufficiently alleged that the executive defendants knew of red flags. Likewise, allegations about Hanger’s Medicare practices and its rollout of clinical management software could only "slightly" bear on the scienter question.

Loss causation and controlling persons claims. Loss causation is the link between an allegedly material misrepresentation and the loss incurred by an investor. The majority cited the Fifth Circuit’s decision in Amedisys (the Supreme Court declined to hear that case) for the proposition that partial corrective releases can produce a cumulative effect, especially where there is a stock drop in close proximity to the corrective releases. In the case of Hanger, the pension fund had alleged three corrective disclosures: (1) an announced decline in same-store sales due to Medicare issues and a software rollout resulting in a 25 percent stock drop; (2) an 18 percent stock drop following an announcement that the release of the company’s financials would be delayed due to ongoing accounting reviews and internal controls assessments; and (3) an 80 percent stock drop after the company released the audit committee’s preliminary findings. As a result, the majority concluded that the pension fund alleged loss causation.

As for the pension fund’s controlling person claims, the majority concluded that the allegations against Hanger’s former CFO were sufficient to state a claim against Hanger such that Hanger’s executives could be liable as controlling persons. That catch here is that the possible imputation of liability extends only to the former CFO’s allegedly false statements. The controlling persons claims, however, were not fully briefed and the case will have to be remanded so the district court can mull whether to allow them to proceed.

Dissent. Judge Ho disagreed with the majority’s conclusion because the complaint failed to cite specific facts showing how any of Hanger’s executives acted with scienter. Judge Ho noted that the majority conceded that the former CFO’s specific actions that might indicate scienter cannot be gleaned from the generalizations made by the Hanger audit committee report. Judge Ho also posited that the former CFO’s "shared" improper objective would be insufficient to allege scienter.

The case is No. 17-50162.

Attorneys: Andrew Love (Robbins Geller Rudman & Dowd LLP) for Alaska Electrical Pension Fund. Paul R. Bessette (King & Spalding LLP) for Vinit K. Asar and Hanger, Inc.

Companies: Alaska Electrical Pension Fund; Hanger, Inc.

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