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From Securities Regulation Daily, September 7, 2016

IBM’s accounting of failed microelectronics venture didn’t amount to fraud

By Anne Sherry, J.D.

The Southern District of New York dismissed two cases alleging that IBM defrauded shareholders by failing to write down the value of its microelectronics business segment. In 2014 IBM paid GlobalFoundries $1.5 billion to take over the business and recorded a $2.4 billion write-down, whereupon its share price fell 17 percent. Although the plaintiffs sufficiently alleged that the business could constitute a distinct asset group for purposes of GAAP impairment testing, they failed to establish that a failure to take the write-down earlier amounted to fraud (International Association of Heat and Frost Insulators and Asbestos Workers Local #6 Pension Fund v. International Business Machines Corporation, September 7, 2016, Pauley, W.).

Decline of microelectronics segment. The plaintiffs alleged that IBM failed to update its microchip plants to be competitive in the market. The microelectronics unit lost nearly $1.4 billion between 2012 and 2013, leading IBM to divest itself of the business segment. A competing microchip manufacture, GlobalFoundries, agreed to take over the business if IBM paid it to do so. The companies settled on a $1.5 billion payment, with the agreement that GlobalFoundries would become the exclusive supplier of semiconductors to IBM for the next decade. The deal’s announcement coincided with disappointing quarterly financial results, and IBM’s stock dropped more than 17 percent from its high during the class period.

Alleged misrepresentations. Throughout the class period, the complaint alleged, the defendants consistently misrepresented that their assets were tested for impairment, there were no material impairments of non-financial assets, and IBM was on track to reach $20 earnings per share. The defendants countered, however, that the plaintiffs’ assertion that the write-down should have been recorded earlier rested on a misapplication of GAAP.

Plausible inference of GAAP violation. Taking the complaint’s allegations as true, the court concluded, the plaintiffs had a point about GAAP. The relevant FASB Accounting Standards Codification turns on whether microelectronics constituted an "asset group" for purposes of impairment testing. The ASC directs that assets be grouped "at the lowest level for which identifiable cash flows are largely independent of other assets and liabilities," a determination that "requires considerable judgment." IBM’s own disclosures demonstrated that it tracked the revenues of the microelectronics segment and designated it as a "component of an entity." This permitted a reasonable inference that microelectronics could have been construed as an independent asset group for purposes of impairment testing.

Furthermore, FASB provides a non-exhaustive list of factors that should indicate to an entity that the carrying value of an asset or asset group may not be recoverable. Although the plaintiffs failed to raise an inference as to several of the relevant factors (a significant adverse change in use or physical condition, or a current expectation that the asset would be sold earlier than previously estimated), the allegations of microelectronics’ losses were indicators that impairment testing was necessary. This impairment indicator was interconnected with the pleadings about asset grouping: because the plaintiffs pleaded that microelectronics could be construed as a standalone asset group, it was plausible that the segment’s losses, combined with the allegations that the plants’ value was significantly depreciated, constituted GAAP impairment indicators.

Plaintiffs failed to plead scienter. Although the complaint pleaded the existence of impairment indicators under GAAP, violations of GAAP without corresponding fraudulent intent do not constitute securities fraud. GAAP tolerates a range of reasonable treatments, and specifically recognizes that decisions about asset grouping require "considerable judgment." Even in the context of the plaintiffs’ allegations, it may have been entirely reasonable for microelectronics to be grouped within the larger asset group, thereby not requiring a write-down or triggering impairment indicators until it was held for sale. The complaint failed to raise a strong inference that the need for a write-down was so apparent that a failure to take action earlier was fraud.

With respect to the alleged misrepresentations about earnings-per-share projections, the scienter hurdle was even higher because those statements fell within the PSLRA’s safe harbor for forward-looking statements. Recklessness would not be enough; the plaintiffs would have to show knowing falsity. The plaintiffs failed to explain how the potential GAAP violation supported an inference of actual knowledge that the EPS projections lacked a reasonable basis when made. If anything, the court wrote, the most reasonable inference was that the defendants’ attempt to divest the microelectronics segment was an effort to meet those projections.

ERISA action dismissed. The court also dismissed a separate ERISA action brought on behalf of participants in IBM’s 401(k) plan who invested in company stock. The ERISA action had lower pleading standards, and the plaintiffs plausibly pleaded that the microelectronics unit was impaired and that the retirement plan fiduciaries were aware of its impairment. However, they failed to plead that IBM was a plan fiduciary. They also failed to meet the high standard established by the Supreme Court in Dudenhoeffer for breach-of-duty cases. The court did grant leave to file an amended complaint to allow for further due diligence that would flesh out the plaintiffs’ allegations.

The case is No. 15cv 2492.

Attorneys: Edward H. Glenn, Jr.(Zamansky LLC) for Larry W. Jander. Lawrence Jay Portnoy (Davis Polk & Wardwell LLP) for International Business Machines Corp. and Retirement Plans Committee of IBM.

Companies: International Business Machines Corp.

MainStory: TopStory AccountingAuditing FiduciaryDuties FraudManipulation NewYorkNews

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