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From Securities Regulation Daily, February 8, 2019

Data behind statements was flawed, but company didn't know it

By Rodney F. Tonkovic, J.D.

What a company said about data used in marketing and sales later turned out to be wrong, but that was more likely the result of simple negligence than fraud.

A Fifth Circuit panel has affirmed the dismissal of a fraud complaint for failing to adequately plead scienter. The complaint suggested that a company made misrepresentations that exaggerated the usefulness of its flagship product. The court concluded that in context, the statements did not conflict with later revelations that the underlying data was flawed (Alaska Electrical Pension Fund v. Flotek Industries, Incorporated, February 7, 2019, Dennis, J.).

Software error. Flotek Industries, Inc. sells products known as "Complex nano-Fluid technologies" (CnF), which are used to improve the productivity of oil and gas wells. To help market its products, the company developed a software product called "FracMax" which allowed comparison of the productivity of wells using CnF with those that do not. Flotek and its CEO, in particular, promoted FracMax as a key component of its sales and marketing strategies and represented that use of the software led to a substantial increase in sales.

In late 2015, an online financial publication claimed that Flotek's CEO had used data in a presentation at an investor conference that had been altered to make CnF look more effective. Flotek admitted that the report was correct, but ascribed the error to inaccurate data provided by a third party. Later yet, the company said that an internal investigation showed that the error was in the software and was the likely result of the accidental inclusion of test code by a developer.

The lawsuit alleged that Flotek was reckless in making, and continuing to make, statements contrary to information that should have been obvious to it. The investors pointed to several alleged misrepresentations that gave rise to an inference of scienter: the use of the term "conclusive" as tantamount to an assurance that the FracMax data was irrefutable; describing the FracMax data as "unadjusted" when it in fact was; the reliance on incorrect data; and the CEO's representation that the FracMax data was back-checked and validated. The district court dismissed the complaint, finding that the investors failed to sufficiently plead scienter.

No scienter. On appeal, the panel concluded that the alleged misrepresentations failed to raise a strong inference of scienter, either standing alone or taken collectively. The panel first found that, in context, the use of the term "conclusive" may have been innocent and not inconsistent with a lack of internal controls over third-party data. It may have been unwise to rely completely on third-party data while referring to the product using it as "conclusive," the court said, but it was not reckless to do so when there was no allegation that Flotek should have known that the data was unreliable or that there were internal control problems before the issue was made public.

The investors also asserted that Flotek's CEO spoke falsely when he said that the FracMax data was unadjusted because the software used an "allocation algorithm." There was, however, no specific allegation that the CEO knew when he made the statement that FracMax used an algorithm. And, while the CEO said that the FracMax data had been checked and validated, there was no allegation that he knew, or should have known, at the time that there was no quality control in place to validate the data.

In sum, the panel found that none of Flotek's earlier statements were directly contradicted by the later revelations about the data's accuracy and the lack of internal controls. At most, the allegations pointed to simple, even inexcusable, negligence, but not to scienter.

The case is No. 17-20308.

Attorneys: Steven Francis Hubachek (Robbins Geller Rudman & Dowd LLP) for Alaska Electrical Pension Fund. Gerard Pecht (Norton Rose Fulbright LLP) for Flotek Industries, Inc.

Companies: Alaska Electrical Pension Fund; Flotek Industries, Inc.

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