U.S. Sec. & Exch. Comm'n v. Winemaster

• Decision Date: 29 March 2021
• Docket Number: No. 19-cv-04843,19-cv-04843
• Citation: 529 F.Supp.3d 880
• Parties: UNITED STATES SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. Gary WINEMASTER, et al., Defendants.
• Court: U.S. District Court — Northern District of Illinois

529 F.Supp.3d 880

UNITED STATES SECURITIES AND EXCHANGE COMMISSION, Plaintiff,

v.Gary WINEMASTER, et al., Defendants.

No. 19-cv-04843

United States District Court, N.D. Illinois, Eastern Division.

Signed March 29, 2021

Daniel J. Hayes, Steven Lee Klawans, Michael Mueller, United States Securities and Exchange Commission, Senior Trial Counsel/Enforcement Division, Chicago, IL, for Plaintiff.

John J. Sikora, Jr., Eric Robert Swibel, Heather A. Waller, Jack Mitchell McNeily, Sean M. Berkowitz, Adam L. Rosenbloom, Latham & Watkins LLP, Chicago, IL, for Defendant Gary S. Winemaster.

Vincent Dominick Pinelli, Burke, Burns & Pinelli, Ltd., Chicago, IL, for Defendant Craig Davis.

Alexander Martin Madrid, Pro Hac Vice, McGuireWoods LLP, Pittsburgh, PA, Christina M. Egan, Vinu George Joseph, McGuire Woods LLP, Chicago, IL, Edward Andrew Southerling, Pro Hac Vice, Nathan Pittman, Pro Hac Vice, McGuireWoods LLP, Washington, DC, Molly M. White, Pro Hac Vice, McGuireWoods LLP, Los Angeles, CA, for Defendant James F. Needham.

MEMORANDUM OPINION AND ORDER

Andrea R. Wood, United States District Judge

Power Solutions International, Inc. ("PSI") is a publicly traded company that manufactures and sells engines. Between the fourth quarter of 2014 and the fourth quarter of 2015, PSI encountered difficulties meeting its revenue targets. While PSI aggressively tried to solicit additional sales from its customers, it found a lack of demand for its products during that period. According to Plaintiff United States Securities and Exchange Commission ("SEC"), this led PSI to inflate artificially its revenue numbers by fraudulently accounting for several transactions. In total, PSI overstated its revenues by about $25 million. As a result of this alleged fraud, the SEC has brought the present action against PSI's Chief Executive Officer ("CEO"), Defendant Gary Winemaster; its Vice President of Sales, Defendant Craig Davis; and its General Manager for Industrial, Heavy Duty Products, Defendant James Needham. The SEC's 11-count complaint sets out several securities law claims against Defendants, including for violations of § 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder. Now before the Court are two motions to dismiss the complaint pursuant to Federal Rule of Civil Procedure 12(b)(6) filed by Winemaster (Dkt. No. 34) and Needham (Dkt. No. 30). For the reasons that follow, both motions are denied.

BACKGROUND

For the purposes of the motions to dismiss, the Court accepts all well-pleaded facts in the complaint as true and views those facts in the light most favorable to the SEC as the non-moving party. Killingsworth v. HSBC Bank Nev., N.A. , 507 F.3d 614, 618 (7th Cir. 2007). The complaint alleges as follows.

PSI is a publicly traded company that manufactures and sells engines to industrial equipment manufacturers and transportation companies. (Compl. ¶¶ 1, 17–18, Dkt. No. 1.) As a publicly traded company, PSI must file various periodic reports with the SEC, including annual reports on Form 10-K and quarterly reports on Form 10-Q. (Id. ¶ 19.) In those reports, PSI is required to include financial statements that accurately and fairly reflect PSI's financial condition. (Id. ) Moreover, any financial statements in those reports must be prepared in accordance with Generally Accepted Accounting Principles ("GAAP"). (Id. )

At all times relevant to this action, Winemaster served as PSI's CEO, President, and Chairman of the Board of Directors. (Id. ¶¶ 1, 14.) As PSI's CEO, Winemaster was responsible for reviewing and approving PSI's consolidated financial statements and reviewing, approving, signing, and certifying PSI's periodic public reports, including its Forms 10-K and 10-Q. (Id. ¶¶ 14, 24.) Among the representations Winemaster made when signing each of PSI's periodic public reports was that each report did not include any material misstatements or omissions and fairly presented, in all material respects, PSI's financial condition for the reporting period. (Id. ¶ 24.) In addition, Winemaster was responsible for establishing and maintaining PSI's system of internal financial reporting controls and was aware of and responsible for PSI's system of internal accounting controls. (Id. ¶¶ 24, 143)

Reporting directly to Winemaster was Needham, who served as PSI's General Manager for Industrial, Heavy Duty Products. (Id. ¶¶ 1, 16, 26.) Needham's position made him responsible for selling PSI's products to customers serving the oil and gas industry. As PSI's Vice President of Sales, Davis was in charge of PSI's sales department. (Id. ¶¶ 1, 15, 25.) While Davis oversaw most of PSI's sales personnel and approved all sales incentives offered to PSI customers, he did not have oversight authority over Needham. (Id. ¶ 25.) Davis also reported directly to Winemaster, who exercised close oversight of the sales department and maintained close contact with several PSI customers. (Id. ¶¶ 16, 25.)

I. Improper Recognition of Revenue

Each quarter, PSI would provide the public with revenue guidance predicting the company's revenue for the upcoming quarter. (Id. ¶ 30.) Similarly, PSI provided revenue guidance for the full year. (Id. ) Winemaster determined the revenue guidance provided to the public. (Id. ) Stock analysts would review such guidance, along with PSI's periodic reports, to develop recommendations for investors and make projections for a number of PSI's financial metrics, including anticipated net revenue. (Id. ¶ 29.) Various financial firms and media outlets would then combine analysts’ projections for PSI's quarterly net revenue and produce a publicly available consensus net revenue estimate for the time period. (Id. ) Consensus net revenue estimates are important because when a company falls short of its projection, the company usually experiences a negative reaction from investors and a decrease in stock price. (Id. ) Consequently, PSI management used quarterly analyst estimates as a benchmark for its internal quarterly revenue targets. (Id. ¶ 30.) Winemaster had ultimate authority for determining PSI's revenue targets. (Id. )

PSI's accounting department recorded PSI's revenue through an enterprise resource planning system known as EPICOR.

(Id. ¶ 27.) When processing sales, the accounting department relied on the sales department to communicate whether there were any non-standard or atypical terms associated with a particular sale. (Id. ) That is because the accounting department did not review customer purchase orders or shipping documents for customer orders before recording revenue. (Id. ¶ 28.) Thus, if a customer was given terms different from PSI's standard sales terms, those terms would not be accurately reflected in what the accounting department inputted into EPICOR. (Id. ¶¶ 27–28.) Sales department personnel, including Needham, knew that they needed to communicate to the accounting department any non-standard terms associated with a particular sale. (Id. ¶ 27.)

It was important for the accounting department to know any non-standard terms associated with a particular sale because such terms could affect how it recorded revenue from that sale. (Id. ¶¶ 21, 27.) Under the GAAP standard set forth at Accounting Standards Codification ("ASC")¹ 605-10-25-1, revenue may be recognized when it is realized, realizable, and earned. (Id. ¶ 20.) Consistent with ASC 605-10-25-1, PSI stated in its SEC filings that its policy was to recognize revenue "upon transfer of title and risk of loss to the customer, which is typically when products are shipped, provided there is persuasive evidence of an arrangement, the sales price is fixed or determinable and management believes collectability is reasonably assured." (Id. ¶ 21.) Further, PSI stated that

[i]n certain circumstances, [PSI] recognizes revenue before delivery has occurred. In such circumstances, among other things, risk of ownership has passed to the buyer, the buyer has made a written fixed commitment to purchase the finished goods, the buyer has requested the finished goods be held for future delivery as scheduled and designated by them, and no additional performance obligations exist by [PSI].

(Id. ) Thus, certain non-standard terms or side arrangements associated with a particular sale could affect PSI's ability to recognize revenue associated with that sale consistent with GAAP and PSI's own revenue recognition policies or the timing of when such revenue can be recognized. (Id. ¶¶ 2–4, 27–28, 32.)

Beginning in the fourth quarter of 2014, PSI encountered difficulties meeting its revenue targets. (Id. ¶¶ 32, 35.) Those difficulties were exacerbated in 2015 due to a decline in the price of oil. (Id. ¶ 32.) Because many of PSI's largest customers purchased engines to be used in the oil and gas industry, demand for a significant portion of PSI's products was tied to the price of oil. (Id. ¶ 18.) Thus, when the price of oil decreased, demand for many PSI products also decreased. (Id. ) During this time, Winemaster, Needham, and Davis undertook efforts to encourage its customers to agree to purchases that would help PSI meet its revenue targets. (Id. ¶¶ 32–35.) In furtherance of those efforts, one or more Defendants would offer certain incentives or side arrangements to PSI customers to encourage them to make purchases prior to the end of the quarter, even when the customer did not have an immediate need for the products it purchased. (Id. ) As a result of Defendants’ conduct, PSI improperly recognized revenue for several transactions, causing the company to materially misstate the financial statements in its periodic filings for every period from the fourth quarter of 2014 through the fourth quarter of 2015. (Id. ¶¶ 1, 35.) The transactions at issue in the present action are presented according to the quarter in which the associated revenue was recognized and are summarized as follows.

A. Fourth Quarter 2014

In the fourth...