On July 20, 2017, Judge J.P. Stadtmueller of the United States District Court for the Eastern District of Wisconsin dismissed claims brought by shareholders of Kohl’s Corporation (“Kohl’s”) against the company and two of its officers.  Pension Trust Fund for Operating Engineers et al. v. Kohl's Corp. et al., Case No. 2:13-cv-01159 (E.D. Wisc. July 20, 2017).  Plaintiffs alleged that defendants’ financial disclosures during the class period materially misrepresented and failed to disclose the extent of accounting errors related to Kohl’s leasing agreements.  Plaintiffs brought claims under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 thereunder, as well as control person claims under Section 20(a) of the Exchange Act.  The Court granted defendants’ motion to dismiss with prejudice, holding that plaintiffs failed to establish that any of the defendants acted with the requisite scienter to support a securities fraud claim.

Plaintiffs alleged that due to longstanding errors in defendants’ accounting of its lease agreements — which included erroneously underestimating the possession date in determining the commencement of lease terms, improperly accounting for and reporting certain asset depreciations, and improperly accounting for and reporting landlord reimbursements of construction-related costs — the company materially understated its liabilities and debt and materially overstated its equity.  Plaintiffs further alleged that defendants’ statements during the class period that the accounting errors were not material were “false and misleading because Defendants knew or should have known the scope of the errors and the figures that had to be restated” because “Defendants had previously engaged in a detailed review of the Company’s lease accounting practices several years earlier, which also resulted in restatements.”

Plaintiffs attempted to plead scienter in two ways:  (i) by alleging that defendants had access to information demonstrating the falsity of the financial statements and therefore must have provided the false information either intentionally or recklessly and (ii) by alleging that the company’s executives were “motivated to provide false information that would keep the price of Kohl’s stock artificially high at the time they sold a significant amount of their shares.” 

The Court first found that “[t]hough the plaintiffs’ lengthy amended complaint alleges with particularity the accounting errors that Kohl’s made during the Class Period and ultimately disclosed publicly, it does not allege with the required particularity that the defendants knew that Kohl’s accounting personnel and the company’s outside auditor were committing such errors.”  Indeed, the Court emphasized that “knowing an accounting rule and knowing that it is not being followed by your company’s accountants are two different things.”  Significantly, the Court found that “[t]he accounting rules the plaintiffs allege were violated are complex and technical, and the plaintiffs have not alleged with sufficient particularity why or how senior executives at Kohl’s would have been so familiar with those rules so as to see a problem in the company’s accounting before their auditors did.”  The Court emphasized the fact that the company’s auditors had not sounded the alarm:  “the plaintiffs’ failure to allege that the company’s auditor expressed concern undermines an inference of fraudulent intent.”  Finally, the Court noted that, in any event, whether the individual defendants “should have known” about the misrepresentations “is not the state of mind required for fraud.”

Turning to the individual defendants’ stock sales — which, according to plaintiffs, garnered proceeds of over $7 million and $500,000, respectively over the class period — the Court held that those facts alone were “insufficient to demonstrate scienter because they include no context in which the Court could consider the import of the trades.”  For example, the Court could not determine whether the sales represented a significant percentage of defendants’ total portfolio or if they were later offset by purchases of shares.  Moreover, plaintiffs’ argument that the individual defendants did not make similar sales before or after the class period were insufficient to assess whether the class period trading was “unusual or suspicious,” and thus did not plead scienter with particularity.

This case demonstrates that courts will not expect directors and officers to be completely familiar with the highly technical rules employed by accountants and auditors and are reluctant to allow securities fraud claims to proceed when the underlying misstatements involve technical errors in complex financial disclosures, absent direct evidence that defendants were aware of the extent of the error or were reckless in not discovering it.