Securities Fraud Is No Joking Matter

Published on this site March 2001

Three federal courts have drawn inferences of securities fraud from humorous, nonresponsive, or hypothetical speaking regarding the sensitive topic of accounting rules. In contrast, another court refused to infer scienter from a serious comment that could have been troublesome had it been made in a more colorful manner. The moral of these cases is that corporate officers should be careful about what they say, or don't say, whenever this topic arises.

No Joking

The first lesson is that it does not benefit a CEO to joke about accounting fraud.

In In re Premiere Technologies, Incorporated, Securities Litigation, No. 1:98-CV-1804-JOF, 2000 U.S. Dist. LEXIS 19207 (N.D. Ga. Dec. 8, 2000), a district court judge denied (in substantial part) a motion to dismiss a complaint alleging '33 Act and '34 Act claims against communications company. The complaint asserted misrepresentations regarding the progress of two mergers, as well as violations of GAAP in accounting for the mergers (including the improper booking of SG&A as restructuring costs, the improper use of pooling, and the failure to book A/R reserves). While it was not the only factor motivating the judge's decision, in finding that scienter had been pleaded, the court cited plaintiffs' allegation that Premiere Technologies' CEO "joked that continuing acquisitions was a good way to keep reported costs down by rolling operating expenses into acquisition accounting."

It is impossible to determine from the text whether the alleged joke was just that - a joke - or whether the CEO betrayed his actual thinking. On that uncertainty alone, some courts would have ruled that plaintiffs had not met their burden to plead scienter. It is also possible that the CEO may have intended to use improper merger accounting, yet in the end the accounting was proper. Regardless of these possibilities, the risk of negative inferences from "humorous" comments is to great to justify feeble attempts at humor.

Not No Means Yes

The second lesson is that if you mean to say no, say no, because not saying no may be construed as saying yes.

In United States v. Henke, 222 F.3d 633, 642 (9th Cir. Aug. 25, 2000), an appellate court reversed the criminal securities fraud and insider trading convictions of the former CEO and CFO of California Micro Devices, on the basis that a conflict of interest prevented their counsel from cross-examining a key government witness who had attended joint defense meetings. In preparing for a possible retrial, the appellate court also considered whether the district court judge had properly admitted the CEO's out-of-court response - "next question please" - to an accusation in a press conference that the defendants were "cooking the books." The district court had found that the response was not unduly prejudicial and that, under the circumstances, the natural response to such an accusation would be to address or deny it. It therefore admitted the statement as an adoptive admission. The appellate court agreed the district court acted within its discretion.

Henke does not stand for the proposition that a non-denial automatically constitutes an admission. Nevertheless, at least one court thought that it did, albeit in the extreme circumstance of an admitted revenue recognition fraud by a company. This may raise problems for the honest executive. One can imagine that a harried or indignant CEO may snap, "next question please," under the belief that it is a denial of impropriety.

No Ethical Thinking

Even if the CEOs in Premiere Technologies and Henke deserved the treatment they received for their flip comments, it is hard to understand the sanction given to a third CEO who allegedly committed the "offense" of giving voice to ethical thinking about the accounting rules. The lesson of this case, unfortunate as it may be, is that it does not pay to express yourself in this manner.

In In re Microstrategy, Incorporated Securities Litigation, 115 F. Supp. 2d 620 (E.D. Va. Sept. 15, 2000), a district court judge considered a motion to dismiss a case filed after a company's large restatement. As the pertinent federal circuit (the Fourth) had not yet interpreted the Reform Act, the judge analyzed other Circuits' law, and found "none of the . . . approaches . . . wholly persuasive." The judge thus delved into an exegesis of the word "inference" and talked about the "logic, common sense, and human experience" used to assign probative weight to pleaded facts. In the end, the judge found that the complaint went "well beyond alleging that [the company] misapplied accounting principles": the complaint alleged "in some detail" the "breathtaking" magnitude of the restatement, the "pervasiveness and repetitiveness of . . . GAAP violations; the simplicity of the accounting principles violated . . .; and the importance of the contracts involved." The court also found stock sales and a desire to maintain a credit agreement probative of scienter.

Other district courts may or may not have drawn a similar conclusion from these allegations; at the least, the stock sale and credit agreement allegations alone would not have been a sufficient basis for most courts to infer scienter. What is interesting in this case is that, according to the judge, the following portions of an interview with Microstrategy's CEO "contribute[d] significant weight to a inference of scienter in this case":

  1. In the public world there's a difference between 11:59 and 12:01, the last day of March . . . One of them is, you go to jail if the thing gets signed at 12:01 . . . One of them is, the stock is up $500 million. And the other one is, you've just torched the life and livelihood of a thousand families. "Would you sacrifice a thousand people's lives for one minute of integrity, or would you, like, put the clock back?" It was a dilemma he [the CEO] now had to "deal with . . . every quarter."

Surely the court drew the wrong inference. Unlike the CEOs in Premiere Technologies and Henke, the Microstrategy CEO did not admit, suggest, or fail to deny that he had acted improperly. On a simple level, the CEO, at least according to this interview, recognized that he faced the ethical choices in deciding whether to follow the law. On a deeper level, the fact that a CEO would recognize that he faced choices with serious consequences, and give voice to this realization, suggests respect for the law more than it does fraud.

Be Serious about Serious Matters

In re e.spire Communications, Inc. Sec. Litig., No. CIV. H-00-1140, 2001 WL 85167, ___ F. Supp. 2d ___ (D. Md. Jan. 29, 2001), illustrates how one should discuss the serious matter of compliance with the law. In this case, the Court granted a motion to dismiss with prejudice in a lawsuit alleging GAAP violations by a telecommunications company. After rejecting several arguments presented by plaintiffs, the Court asked whether the complaint was saved by a statement from the company's new CEO "[t]here's absolutely zero tolerance for any lying, cheating, or stealing in any way, shape, or form here." The Court decided that this statement would give rise to at most a "strained and tenuous" inference of fraud, not the strong inference required under the Reform Act, as it did not discuss or refer to prior practices or management.

It is possible to imagine that had the new CEO been more colorful or effusive on this topic, he could have led his company into trouble. That the CEO did not do so illustrates the benefits of serious language for serious subjects.