Pension Trust Fund for Operating Eng'rs v. Kohl’s Corp.

• Decision Date: 12 July 2018
• Docket Number: No. 17-2697,17-2697
• Citation: Pension Trust Fund for Operating Eng'rs v. Kohl’s Corp., 895 F.3d 933 (7th Cir. 2018)
• Parties: PENSION TRUST FUND FOR OPERATING ENGINEERS, et al., Plaintiffs-Appellants, v. KOHL’S CORPORATION, et al., Defendants-Appellees.
• Court: U.S. Court of Appeals — Seventh Circuit

895 F.3d 933

PENSION TRUST FUND FOR OPERATING ENGINEERS, et al., Plaintiffs-Appellants,

v.KOHL’S CORPORATION, et al., Defendants-Appellees.

No. 17-2697

United States Court of Appeals, Seventh Circuit.

Argued January 16, 2018

Decided July 12, 2018

Amended July 16, 2018

Joseph D. Daley, Attorney, ROBBINS GELLER RUDMAN & DOWD LLP, San Diego, CA, Joseph Russello, Attorney, ROBBINS GELLER RUDMAN & DOWD LLP, Melville, NY, for Plaintiffs–Appellants.

Robert J. Giuffra, Jr., Maya Krugman, Matthew Alexander Schwartz, Attorneys, SULLIVAN & CROMWELL LLP, New York, NY, John L. Kirtley, Howard A. Pollack, Attorneys, GODFREY & KAHN S.C., Milwaukee, WI, for Defendants–Appellees.

Before Wood, Chief Judge, and Rovner and Hamilton, Circuit Judges.

Wood, Chief Judge.

In September 2011, Kohl’s Corporation announced that it was correcting several years of its financial filings because of multiple lease accounting errors.Hard on the heels of that announcement came a putative class action complaint.The plaintiffs, led by the Pension Trust Fund for Operating Engineers, allege that Kohl’s and two of its executives defrauded investors by publishing false and misleading information in the lead-up to the corrections.(For ease of exposition, we refer to the putative class as the Pension Fund.)The Pension Fund took the position that one can infer that the defendants knew that these statements were false or recklessly disregarded that possibility at the time they were made, because Kohl’s recently had made similar lease accounting errors.Despite those earlier errors, it was pursuing aggressive investments in its leased properties, and at the same time, company insiders sold considerable amounts of stock.

The district court dismissed the complaint for failure to meet the enhanced pleading requirements for scienter imposed by the Private Securities Litigation Reform Act (PSLRA).The court entered that dismissal with prejudice, declining to give the Pension Fund even one opportunity to amend to cure the defects.The Pension Fund now appeals both the dismissal of the complaint and the district court’s decision to enter it with prejudice.Because the first complaint fell short and the Pension Fund has not been able to suggest how an amendment might help, we affirm.

I

Kohl’s runs over one thousand department stores across the United States.About 65 percent of those stores are leased—a fact that makes lease obligations a significant component of Kohl’s financial picture.The treatment of those leases has caused Kohl’s accountants and external auditors some trouble in recent years.The company was forced to adjust its accounting practices three times—in 2005, 2010, and 2011—to bring its books in line with generally accepted accounting principles ("GAAP").The first and third of these corrections were material and required the restatement of several years’ worth of financial statements.The second was comparatively minor and required an adjustment to income in one quarter.The Pension Fund asserts that these recurring lease accounting errors show that Kohl’s, its CEO Kevin Mansell, and its CFO Wesley McDonald were at least reckless in overseeing the company’s lease accounting practices by the time of the second and third corrections.Specifically, the Pension Fund contends that purchasers of Kohl’s stock from February 26, 2009, to September 13, 2011(the "class period"), were defrauded by knowing or reckless false statements in Kohl’s financial reports.

The Pension Fund advanced two theories of liability in the district court: securities fraud in violation of section 10(b) of the Securities Exchange Act of 1934,15 U.S.C. § 78j(b), andSEC Rule 10b-5,17 C.F.R. § 240.10b-5, against all defendants, and "controlling person" liability under section 20(a) of the Securities Exchange Act,15 U.S.C. § 78t(a), against Mansell and McDonald.We can limit our discussion to section 10(b)andRule 10b-5, because a violation of those provisions is necessary to support a violation of section 20(a).Pugh v. Tribune Co. , 521 F.3d 686, 693(7th Cir.2008).

To state a claim under section 10(b), a plaintiff must plead "(1) a material misrepresentation or omission by the defendant; (2)scienter ; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation."Id.We can narrow our focus even further, for the scienter element is the only point of dispute between the parties.We review the sufficiency of scienter pleadings de novo .Id. at 692.

Scienter pleadings in securities fraud class actions must satisfy a heightened standard of plausibility.Through the PSLRA, Congress requires that plaintiffs"state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind."15 U.S.C. § 78u-4(b)(2)(A)(emphasis added).For a case under section 10(b), that state of mind is "an intent to deceive, demonstrated by knowledge of the statement’s falsity or reckless disregard of a substantial risk that the statement is false."Higginbotham v. Baxter Int’l, Inc. , 495 F.3d 753, 756(7th Cir.2007).

The Supreme Court has told us that a complaint gives rise to a strong inference of scienter"only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged."Tellabs, Inc. v. Makor Issues & Rights, Ltd. , 551 U.S. 308, 324, 127 S.Ct. 2499, 168 L.Ed.2d 179(2007).In making this determination, the allegations in the complaint "are accepted as true and taken collectively."Id. at 326, 127 S.Ct. 2499.We must consider the relative probability of whether, taken as a whole, the false statements alleged here were "the result of merely careless mistakes at the management level based on false information fed it from below" or reflect "an intent to deceive or a reckless indifference to whether the statements were misleading."Makor Issues & Rights, Ltd. v. Tellabs Inc. , 513 F.3d 702, 709(7th Cir.2008).If the latter inference is not at least as compelling as the former, dismissal is appropriate.

II

Most of the Pension Fund’s complaint recounts the details of the accounting errors and Kohl’s financial restatements, but both sides argue that we need not wade too deeply into those details.The Pension Fund insists that because Kohl’s repeatedly made lease accounting errors, something is up—where there’s smoke, there’s fire.But this inference depends on how (dis)similar the errors are.Kohl’s counters that technical accounting errors such as these are well below the pay grade of its executives.But leases are a significant part of Kohl’s financial picture that cannot be expected to evade executive knowledge altogether.SeeS. Ferry LP, No. 2 v. Killinger , 542 F.3d 776, 784(9th Cir.2008)(concluding that a "core-operations inference" can support scienter after Tellabs).We decline to take either simplistic approach.Tellabs ’s repeated emphasis on looking at the facts "holistically" tells us that we must do more.551 U.S. at 326, 127 S.Ct. 2499.To apply the PSLRA meaningfully, we must dig deeper into the accounting and other allegations the Pension Fund has raised.After we have done this, we step back to look at what inferences can be drawn from the evidence as a whole.

A

As detailed in the complaint, all three sets of errors were announced through SEC filings accompanied by press releases and on at least one occasion, an investor conference call.The first restatement came on February 22, 2005.Kohl’s announced that it was adjusting the period over which its lease obligations were reported.GAAP does not allow firms simply to record lease obligations when they are paid; rather, firms must record start and end dates that reflect the economic reality of the lease.As part of the restatement, Kohl’s adjusted how it calculated both the start and the end of lease terms.Previously, Kohl’s had fixed the start of each lease term as the date when it began making payments; as revised, it would set the start as the earlier of the date of first payment or first possession of the building.Similarly, Kohl’s formerly set the end of the term at the conclusion of the initial non-cancelable lease term; as revised, it would recognize the lease through the expected term, including some cancelable option periods.These changes required Kohl’s to restate its financial statements from 1998 through the third quarter of 2004.

Kohl’s next set of accounting adjustments came in the fall of 2010.The company first identified the errors in November, before publicizing its final adjustments in December.These adjustments concerned (again) the start dates of the lease terms.It seems that Kohl’s may have overcorrected in 2005.Kohl’s had used the date of first possession as the start date for some leases even though the obligation to pay rent began earlier, contrary to its 2005 disclosures.Additionally, Kohl’s adjusted depreciation expenses across the terms of some leases and corrected miscategorized incentive payments from landlords.Together, these changes were not material to past financial statements, but they resulted in a $50 million adjustment to income in the third quarter of 2010.

Finally, in August 2011 Kohl’s announced that it had discovered another round of accounting errors.These errors were of a different type.This time, Kohl’s had failed to reclassify many of its operating leases as capital leases after making significant investments in the affected stores.Operating leases have no impact on the balance sheet.Rental payments are expensed, the rented property is not counted as an asset, and future rent payments are not recognized as liability.By contrast, capital leases have a significant effect on the balance sheet.The leased property is recognized as an asset and future rent obligations as liabilities.Rental payments are treated...