11-7-2012 Sdny Case Scienter Swipe

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Case 1:11-cv-01646-LAK Document 103 Filed 11/07/12 Page 1 of 44

UNITED STATES DISTRICT COURTSOUTHERN DISTRICT OF NEW YORK- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - xMIKE DOBINA,Plaintiff,

-against- 11 Civ. 1646 (LAK)

WEAT HERFORD INTERNATIONAL L TD., et al.,Defendants.- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - x

MEMORANDUM OPINION

Appearances:

Curtis Victor Trinko, Esq.Eli R. GreensteinErik D. PetersonRamzi AbadouStacey M. KaplanKESSLER TOPAZ M ELTZER & C HECK, LLPAttorneys for Lead P laintiff AmericanFederation for Musicians and EmployersPension Fund

Robert J. MalionekKevin H. MetzPeter A. WaldSarah A. G reenfieldLATHAM & WATKINS, LLPAttorneys for Defendants WeatherfordInternational Ltd., Bernard J. Duroc-Danner,Andrew P. Becnel, Jessica Abarca, andCharles E. Geer, Jr.

Stanley J. ParzenMAYER BROWN LLPAttorneys for Defendant Ernst & Young LL P


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LEWIS A. K APLAN , District Judge.This action arises out of statements regarding the internal controls and accounting

practices of Weatherford International Ltd. (Weatherford or the Comp any), after Weatherfordannounced in 20 11 that it had understated its tax expenses from 2007 through 2 010 by over $5 00million. Lead plaintiff American Federation of M usicians and Employers Pension Fund (AFM E)alleges that Weatherford and certain of its officers, as well as its auditor Ernst & Young LLP (Ernst& Young or E & Y ), violated Sections 10(b) and 20(a) of the Securities Exchange A ct of 1934(the Exchange Act) 1 and Rule 10b-5 thereunder 2 by knowingly issuing materially false statementsregarding the Companys tax accounting for the relevant time period and omitting to state factsnecessary to make the statements that were made n ot misleading.

This matter is now before the Court on defendants motions to dismiss the com plaintfor failure to state a claim and on AFM Es motion for leave to supplement the amended complaint(the AC)

FactsI.artiesA.ead PlaintiffAFM E is one of the largest pension funds in the entertainment industry, with over

Se e 15 U.S.C. 78j(b), 78t.Se e 17 C.F.R. 240.10b5.


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2$1 billion dollars in assets under management. 3 It purchased Weatherford common stock duringthe class period. 4

B.efendantsThe defendants are the Com pany, Ernst & Young, and several individuals associatedwith the Com pany (the Individual Defendants). 5Weatherford is an international provider of equipment and services used in thedrilling, completion and production of oil and natural gas wells. 6 Ernst & Young is a certifiedpublic accounting firm that Weatherford hired to provide independent audits, accounting andmanagem ent consulting services, tax services, and review of W eatherfords SEC filings. 7

The Individual Defendants are Ms. Jessica Abarca and Messrs. Bernard Duroc-Danner, Andrew Becnel, and Charles Geer, Jr. 8 Duroc-Danner is Weatherfords chief executive

3DI 12, at 8.

4Se e AC 38. The class period is defined as April 25, 2007 (when the Companys firstquarter 2007 financial results were released) through March 1, 2011. See DI 12, at 2.

5Weatherford and the Ind ividual Defendants are referred to collectively as the WeatherfordDefendants.

6AC 39.

7Id . 40.

8See id. 1.


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3officer, president, and chairman. 9 Becnel was the Companys senior vice president and chieffinancial officer. 1 0 Geer was Weatherfords vice president and principal accounting officer. 1 1Abarca w as the Companys chief accounting officer and vice president of accounting. 1 2

II .he Amended Com plaintThe AC focuses on Weatherfords alleged understatement of tax expenses in itsfinancial statements for the years 200 7, 2008, 2009, and the first three quarters of 2010. 1 3 It allegesthat, through a simp le and crude tax accounting fraud, the Comp anys effective tax rate dropped

See id. 42. Duroc-Danner has been chief executive officer, president, and chairman since1998. See id. He signed Weatherfords 2007, 2008, and 2009 Form 10-Ks, as well as itsfirst, second and third quarter Form 10-Qs for 2007, its first, second, and third quarter Form10-Qs for 2008, its first, second, and third quarter Form 10-Qs for 2009, and its first,second, and third quarter Form 10-Qs for 2010. See id. 43. He signed also a June 9, 2009Form 8-K, and participated in every earnings c onference call with analysts during the C lassPeriod. Id.

10See id. 44. Becnel became vice president of finance in 2005, and chief financial officerin 2006. See id. He signed W eatherfords 2007, 2008, and 2009 Form 10-Ks, a 2009 Form10-K/A, a March 1, 2011 Form 12b-25, Forms 10-Q for ever quarter covered by theRestatement, and Current Reports on Forms 8-K covered by the R estatement. Id. 45 .He is alleged also to have participated on every conference call with analysts during theClass Period. Id .

11See id. 46. His alleged sudden departure from the Company was announced on March16, 2011. Id . 1. He signed Weatherfords second quarter Form 10-Q for 2010, as wellas a Form 10-Q/A for this same quarter in 2010, and its third quarter Form 10-Q for 2010.Id. 46. Geer also participated in the Companys March 2, 2011 material weaknessconference call with analysts. Id .See id. 47. Abarca signed Weatherfords 2007, 2008, and 2009 Form 10-Ks, as well asits first, second, and third quarter Form 10-Qs for 2007, its first, second, and third quarterForm 10-Qs for 2008, its first, second, and third quarter Form 10-Qs for 2009, and its firstquarter 10-Q for 2010. See id.See id. 24.

12

13


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4sharply in 2007 and that the Company reported artificially low and rapidly declining effectivetax rates one of the lowes t, if not the lowest, in the industry through the rest of the class period. 1 4

According to the AC, the lower rate was of particular interest to analysts andinvestors. The Weatherford Defendants are alleged to have closely monitored Weatherfordseffective income tax rate, and specifically touted it in numerous SEC filings and analyst conferencecalls. 1 5 For example, when asked during an April 2007 call about the surprisingly low tax rate,Becnel stated [y]es, that was good work from our tax group in terms of planning. 1 6 TheCompanys 2008 and 2009 annual reports stated that the decreases in the Companys effective taxrates were due to benefits realized from the refinement of our international tax structure andchanges in our geographic earnings m ix. 1 7 As a result of the lower tax rates, a num ber of analystsupgraded their earnings estimates for W eatherford, with one July 2007 report stating that its higherestimates were primarily a func tion of a low er effective tax rate. 1 8

This apparently lower rate proved illusory. On March 1, 2011, the Companyannounc ed that it would restate its earnings for 2007 thro ugh the third quarter of 2010. It stated thatit had identified in February 2011 a material weakness in internal control over financial reporting

14Id . 57.

15Id . 8; see id. 7376.

16Id .

17Id . 17.

18Id . 10; see id. 7376.


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5for income taxes. 1 9 In particular, it said that the Com panys processes, procedures, and controlsrelated to financial reporting were not effective to ensure that amounts related to current taxespayable, certain deferred tax assets and liabilities, reserves for un certain tax positions, the currentand deferred income tax expense and related footnote disclosures were accurate. 2 0

According to the statement, the Company conducted additional testing afteridentifying the m aterial weakness and, in the process, identified tax receivable balances for w hich,as the Company later explained to the SEC, documentary support was not available. 2 1 TheCom pany stated that it subsequently determined that those receivables had been recorded in errordue to a tax benefit incorrectly being applied to the elimination of intercompany dividends. 2 2 Itsaid that the error manifested itself in 2007 and went und etected in that year and each subsequentyear. 2 3 It clarified that it had not erred in its actual cash paym ent of taxes to the Internal Reven ueService, but rather in its accounting for tax expense in its financial statements. 2 4 The Company

19 Id . 135. As the Company explained elsewhere, [m]aterial weakness is a term of art. Itis a deficiency or combination of deficiencies in internal control over financial reportingsuch that there is a reasonable possibility that a material misstatement of the financialstatements would not be prevented or detected on a timely basis. Id . 136 (alterationsomitted).

20Id . 134.

21DI 68, Ex. 8 at 2.

22Id . ; see AC 137 (quoting Becnels statements on March 2, 2011 conference call that theerror arose from tax-affecting an inter-company transaction at a 35% level rather thanat a 0% effective tax rate, thereby leading to the creation of a substantial tax asset).

23DI 68, Ex. 9 at 2.

24See id.


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6ultimately concluded that it had understated its 20072010 tax expense by approximately $500million$460 million due to these intercompany transactions and $40 million relating to foreigntax assets. 2 5 Thus, the Com panys tax expense actually was $1.2 billion rather than the previously-reported $700 million. 2 6 A M arch 8, 2011 annual report provided restated financial information andincluded an opinion by Ernst & Young, which stated that Weatherford had not maintainedeffective internal control over financial reporting as of December 31, 2010. 2 7 The AC alleges thatWeatherfords stock price declined nearly 11 percent on the day following the announcement,thereby eliminating $1.8 billion from W eatherfords market capitalization. 2 8

The AC asserts claims under Sections 10(b) and 20(a) of the Exchange A ct and Rule10b5 thereunder. It alleges that the Weatherford Defendants com mitted securities fraud throughfalse statements and om issions falling into tw o principal categories: (1) those arising directly fromthe understatement of tax expense and (2) those pertaining to Weatherfords maintenance of internalcontrols over its financial reporting. In addition, the AC alleges that Ernst & Young committedsecurities fraud w hen it provided, throughout the class period, (1) its unqualified opinion regardingthe fair presentation of Weatherfords financial position and its compliance with generally acceptedaccounting principles (GAAP) (2) its unqualified opinion regarding the effectiveness ofWeatherfords internal controls and (3) its statements that it complied with generally accepted

25See id.

26DI 68, Ex. 9 at 5.

27AC 140.

28See id. 24 .


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7auditing standards (GAAS) in reaching these conc lusions.

DiscussionI.egal StandardIn deciding a m otion to dismiss under Rule 12(b)(6), a court m ust accept all factualallegations in the co mplaint as true and draw all reasonable inferences in the plaintiffs favor. 2 9 Inorder to survive such a m otion, the complaint must contain sufficient factual matter, accepted astrue, to state a claim to relief that is plausible on its face. 3 0 A claim is facially plausible when theplaintiff pleads factual content that allows the court to draw the reasonable inference that thedefendant is liable for the miscond uct alleged. 3 1

To state a claim und er Section 10(b) of the Exchan ge A ct, a plaintiff must allege factssufficient to establish that the defend ant, in connection w ith the purchase or sale of securities, madea materially false statement or omitted a material fact, with scienter, and that the plaintiffs relianceon the defendan ts action caused injury to the plaintiff. 3 2

A com plaint asserting a Section 10(b) claim m ust satisfy also the heightened pleadingstandards of Rule 9(b) and the Private Securities Litigation Reform Act of 1995 (PSLRA). 3 3

29See Anschutz Corp. v. Merrill Lynch & Co. , 690 F.3d 98, 107 (2d Cir. 2012).

30Id . (quoting Ashcroft v. Iqbal , 556 U.S. 662, 678 (2009)).

31Iqbal, 556 U.S. at 678.

32ECA & Local 134 IBEW Joint Pension Trust of Chi. v. JP Morgan Chase Co. , 553 F.3d187, 197 (2d Cir. 2009) [hereinafter EC A ] (internal quotation marks omitted).

33Se e FED . R. C IV . P. 9(b); 15 U.S.C. 78u4(b).


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Under R ule 9(b), averments of fraud [must] be stated w ith particularity and a plaintiff must (1)specify the statements that the plaintiff contends were fraudulent, (2) identify the sp eaker, (3) statewhere and when the statements were m ade, and (4) explain why the statements were fraudulent. 3 4

In addition, the PSLRA requires a complaint to state with particularity facts givingrise to a strong inference that the defendant a cted w ith the requisite state of m ind. 3 5 The requisitestate of mind is an intent to deceive, manipulate, or defraud. 3 6 In this circuit, allegations ofrecklessness an extreme departure from the standards of ordinary care to the extent that thedanger w as either known to the defendant or so obvious that the defendant must have been aw areof it are sufficient. 3 7

In evaluating whether a com plaint alleges facts giving rise to a strong inference ofscienter, courts must c onsider all the facts alleged, inferences favoring p laintiffs rationally draw nfrom the facts, and plausible, nonculpable explanations for the defendants conduct. 3 8 Theinference of scienter must be more than merely plausible or reasonableit must be cogent and

34Anschutz , 690 F.3d at 108 (internal quotation marks and alterations omitted); see also 15U.S.C. 78u4(b)(1) (providing that the complaint shall specify each statement allegedto have been misleading, the reason or reasons why the statement is misleading, and, if anallegation regarding the statement or omission is made on information and belief, thecomplaint shall state with particularity all facts on which that belief is formed).

3515 U .S.C. 78u4(b)(2)(A); accord Tellabs, Inc. v. Makor Issues & Rights, Ltd. , 551 U.S.308, 314 (2007).

36EC A , 553 F.3d at 198 (quoting Tellabs , 551 U.S. at 313).

37Id . (internal quotation marks and alterations omitted).

38Tellabs , 551 U.S. at 324.


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9at least as compelling as any opp osing inference of nonfraudulent intent. 3 9 Generally, the plaintiffsmust allege facts sufficient to show that each defendant personally knew of, or participated in, thefraud. 4 0 That is, the plaintiff must allege that each defendant had the requisite scienter . 4 1

A com plaint may satisfy the scienter requirement by alleging facts to show either(1) that defendants had the motive and opportunity to commit the fraud, or (2) strong circumstantialevidence of conscious m isbehavior or recklessness. 4 2

In order sufficiently to allege motive and opportunity, plaintiffs must allege thatdefendants benefitted in some concrete and personal way from the purported fraud. 4 3 Our Circuithas made clear that goals possessed by virtually all corporate insiders are insufficient to allegemotive for Section 10(b) purposes. 4 4 Such common goals include the desire to maintain a highcredit rating for the corporation or otherwise sustain the appearance of corporate profitability or thesuccess of an investment, or the desire to maintain a high stock price in order to increase executivecompensation. 4 5

39EC A , 553 F.3d at 198 (quoting Tellabs , 551 U.S. at 314).

40Mills v. Polar Molecular Corp. , 12 F.3d 1170, 1175 (2d Cir. 1993) (emphasis omitted).

41See In re BISYS Sec. Litig. , 397 F. Supp. 2d 430, 440 (S.D.N.Y. 2005) (hereinafterBISYS ).

42EC A , 553 F.3d at 198.

43Id . (internal quotation marks omitted).

44South Cherry Street, LLC v. Hennessee Grp. LLC , 573 F.3d 98, 109 (2d Cir. 2009) (internalquotation marks om itted).

45Id .


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10If plaintiffs have not alleged motive and opportunity sufficiently, they may rely upon

the strong circumstantial evidence prong, thoug h the strength of the circumstantial allegationsmust be correspondingly greater if there is no motive. 4 6 A com plaint alleges strong circumstantialevidence of scienter when it alleges that defendants (1) benefitted in a concrete and personal w ayfrom the purported fraud, (2) engaged in deliberately illegal behavior, (3) knew facts or hadaccess to information suggesting that their public statements were not accurate, or (4) failed tocheck information they had a duty to m onitor. 4 7

II .nalysisA.eatherford Defendants1 .otive and OpportunityAFM E contends that the AC adequately pleads that the Weatherford Defendants hadboth a motive and the opportunity to commit fraud. The contention is unavailing.The AC points first to the Individual Defendants discretionary bonuses tied to

performance targets and their large compensation packages. 4 8 Such motives, however, arepossessed by virtually all corporate insiders and thus are insufficient to give rise to the requisitestrong inference of scienter. 4 9 Similarly unavailing are the ACs allegations that the fraud helped

46EC A , 553 F.3d at 199 (internal quotation marks omitted).

47Id . ; Novak v. Kasaks , 216 F.3d 300, 311 (2d C ir. 2000); see Teamsters Local 445 FreightDivision Pension Fund v. Dynex C apital, Inc. , 531 F.3d 190, 194 (2d Cir. 2008) [hereinafter( Teamsters )].

48Se e AC 2223, 15158.

49South Cherry Street, 573 F.3d at 109 (internal quotation marks omitted).


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1 1the Com pany m eet earnings targets or sustain the appearance of profitability. 5 0

The Second Circuit has recognized that individual stock sales by corporate insiderswill provide the requisite motive. 5 1 But the AC fails to allege that any such sales occurred here. Itstates only that certain of the individual defendants Duroc-Dann er and Becnel delivered tensof thousands of their personally-held W eatherford shares back to W eatherford one day before theCompany announced that it would be issuing the financial restatement. 5 2 It noticeably does notstate, however, that either Duroc-Danner or Becnel actually sold stock at that time. The inadequacyof the pleading is highlighted by the defendants assertion that these were shareholder-approved[]tax withholding transactions in which the executives surrendered a portion of their stock grants (butretained [and acquired] a much larger part) on the dates those g rants vested in order to cover theirwithholding ob ligations. 5 3 AFM Es briefing does not earnestly contest defendants assertion andstates only that resolving this argument would be improvident at this early stage. 5 4 But the Courtneed not determine whether defendants proffered explanation is correct or accurate. The basicpoint is that plaintiff has failed adequately to allege that these deliveries were sales of stock, thatthey resulted in profits or avoided losses, or even that they h ad the net effect of reducing defen dantsoverall holdings in Weatherford stock. The lack of such allegations precludes any strong inference

50Se e AC 10, 11, 28; South Cherry S treet, 573 F.3d at 109.

51See ECA , 553 F.3d at 198.

52AC 23; s ee id. 158.

53DI 69, at 9 n.9.

54DI 71, at 25.


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12of scienter based on these deliveries.

In light of the inadequacy of these grounds for motive, AFME focuses principally onits theory that the fraud inflated Weatherfords stock price and thus permitted it to fund itsaggressive growth strategy while avoiding becoming an acquisition target in its own right. 5 5 TheAC points to a sampling of seven acquisitions Weatherford conducted from 2007 through 200 9and further refers to Weatherfords 2009 an nual report, which stated that the Comp any funded its2008 and 20 09 acquisitions through the issuance of $287 m illion in stock. 5 6

The theory is rejected easily with regard to the Individual Defendants becauseplaintiff now here allege[s] that defendants engaged in these transactions to secure personal gainas opposed to c arrying out their financial responsibilities to the Company. 5 7 Moreover, [e]venif the complaint is read to say that defendants artificially inflated [Weatherfords] stock price toincrease their personal compensation (by undertaking the cited transactions or otherwise), thecomplaint would still fail to allege the requisite motive because such an incentive is common to

55AC 67 (internal quotation marks omitted); see id. 30 n.6, 6870, 16364.

56Id . 164.

57Rombach v. Chang , 355 F.3d 16 4, 177 (2d C ir. 2004) (internal quotation marks omitted).The only allegations in the AC coming close to such a charge are those of a confidentialwitness, CW 1, who purportedly stated that in order to earn brownie points, Becnel bentaccounting rules when Weatherford went on an acquisition spree. AC 56 (internalquotation marks omitted). In the absence of other facts supporting the relevant point, acomplaint must describe confidential witnesses with sufficient particularity to support theprobability that a person in the position occupied by the source would possess theinformation alleged. Novak , 216 F.3d at 314. The c omplaints description of CW1 simplyas a Senior Financial Executive, AC 54, provides an insufficient basis to conclude thatCW1 would be privy to Becnels inner motivations. See BISYS , 397 F. Supp. 2d at 442(deeming inadequate similarly general descriptions of various confidential witnesses).


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13all insiders. 5 8

More challenging is the question of whether the corporate defendantW eatherforditselfmay be inferred to have had the requisite motive due to its interest in acquiring othercompanies. While artificial inflation of stock prices in order to acquire another company . . . insome circum stances [may] be sufficient for scienter, 5 9 the desire to achieve the most lucrativeacquisition proposal can be attributed to virtually every company seeking to be acquired or toacquire another and therefore generally is insufficient. 6 0 Whether an interest in acquisitions issufficient is an extremely c ontextual inquiry that demands an allegation of a unique connectionbetween the fraud an d the acquisition. 6 1

The Circuit has provided little guidance as to what this unique connection must be,but has sugg ested that it is sufficient wh en the misstatem ents directly relat[e] to the acquisition. 6 2The Court concludes that this requirement demands more than alleging simply that the Company

58Rombach , 355 F.3d at 177; see BISYS, 397 F. Supp. 2d at 446 (rejecting motive based onacquisition spree as to individual defendants for same reason).

59EC A , 553 F.3d at 201 n.6 (quoting Rothman v. Gregor , 220 F.3d 81, 9294 (2d Cir. 2000)).

60Id . at 201 (internal quotation marks omitted) (citing Kalnit v. Eichler , 264 F.3d 131, 141(2d Cir. 2001)).

61Id . at 201 n.6 (internal quotation marks omitted).

62See id. (citing Cohen v. Koenig , 25 F.3d 1168, 117071, 117374 (2d Cir. 1994)); see alsoRothman , 220 F.3d at 93 (relying on In re Time Warner Inc. Sec. Litig. , 9 F.3d 259, 262,270 (2d Cir. 1993), in which our Circuit addressed misstatement that directly concernedcompanys search for strategic partners and its nondisclosure of its consideration ofalternative stock offering).


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14acquired comp anies during the class period with the use of stock. 6 3

There is an important reason to apply exacting scrutiny to any claim of motivethrough company acquisitions. A plaintiff who alleges motive and opportunity necessarily hassatisfied the pleading requirements for scienter, even without any allegation that a statement thatlater proved to have been false was made w ith an indication of know ledge or recklessness. 6 4 Thishelps explain why our Circuit refuses to consider allegations of even lavish executive compensationas sufficiently alleging motive despite the fact that one certainly could imagine that a number ofexecutives might com mit fraud in o rder to ma intain their positions and therefore their considerableannual pay packages. The point is not whether such pay packages provide, in at least some senseof the wo rd, motive to comm it fraud, but rather, whether the m ere fact that an executive is paidwell provides a motive sufficient to permit a case to go to discovery without any further allegationsthat would support an inference of scienter. Our Circuit has concluded, and the PSLRA has

63The Court recognizes that in Rothman v. Gregor , 220 F.3d 81, our Circuit obse rved that astock-based acquisition contemporaneous w ith, but apparently otherwise unrelated to, themisstatements reenforce[d] the adequacy of the com plaints allegation of scienter. Id . at94. But Rothman already had concluded that the scienter element was alleged adequatelythrough sufficient circumstantial evidence of recklessness. Moreover, Rothman now mustbe read in the context of EC A , which emphasizes the importance of the unique connectionbetween the fraud and the acquisition.EC A undermines also plaintiffs reliance on a prior decision, In re Interpublic SecuritiesLitigation , No. 02 Civ 6527, 2003 WL 21250682 (S.D.N.Y. May 29, 2003), for theproposition that a sustained growth-by-acquisition strategy not otherwise connected to analleged fraud provides sufficient motive.

64See ECA , 553 F.3d at 198 (recognizing that the requisite scienter can be alleged with factsshowing either (1) that defendants had the motive and opportunity to commit fraud, or (2)strong circumstantial evidence of conscious misbehavior or recklessness (emphasisadded)).


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15reinforced, that relying on su ch m otives possessed by virtually all corporate insiders 6 5 would beimproper because it would require virtually every company in the United States that experiencesa dow nturn in stock price . . . to defend securities fraud actions. 6 6

Likewise, while an acquisition program funded by stock issuances in a certain sensemight p rovide a m otive to inflate the stock price, it is not sufficient to allege scienter. AcceptingAFMEs position would allow a plaintiff to proceed to discovery whenever it can allege that acompa ny that is growing through the issuance of equity made a statement that ultimately proved tohave been materially false but helped to raise the companys share price. That conclusion isinconsistent with the PSLR A and our Circuits requirements of a unique connection between thefraud and the acquisition, and this Court declines to accept it. 6 7

65South Cherry Street , 573 F.3d at 109 (internal quotation marks omitted).

66EC A , 553 F.3d at 201 (internal quotation marks omitted).

67The Court notes a potential further ground for finding motive insufficient here any suchmotive to raise the stock price in order to fund acquisitions more cheaply w ould inure to thebenefit of all shareholders, and thus w ould not dem onstrate intent to defraud W eatherfordshareholders. See Kalnit , 264 F.3d at 141 (observing, in case in which comp any was targetof acquisition, that any intent to defraud [the acquirer] cannot be conflated with an intentto defraud the shareholders because achieving a superior merger benefitted allshareholders); cf. ECA , 553 F.3d at 203 (Even if [defendant] was actively engaged induping other institutions for the purposes of gaining at the expense of those institutions, itwould not constitute a motive for [the defendant] to defraud its own investors.).Kalnit an d EC A appear to be in some tension w ith Rothman on this point, because it wouldseem that any time an inflated stock price permits cheaper acquisition proposals, the lowerprice paid would inure to the benefit of all shareholders. Because the allegations areinsufficient for other reasons, the Court need not resolve any apparent tension among thesecases.


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162.ircumstantial Evidence of R ecklessnessAs discussed ab ove, plaintiff alleges two different kinds of false statements by the

Weatherford Defendants: (1) those relating to the quality of Weatherfords internal controls and (2)those relating to the understated tax expense. 6 8

a.nternal ControlsIn every Form 10-Q and 10-K filed during the class period, certain defendants madestatements regarding the effectiveness of Weatherfords internal controls. In particular, Duroc-Danner and Becnel individually certified that they were responsible for establishing andmaintaining disclosure controls and procedures . . . and internal control for financial reporting forWeatherford and have, among other things, [d]esigned such internal control over financialreporting, or caused such internal control over financial reporting to be designed under oursupervision, to provide reasonable assurance regarding the reliability of financial reporting a nd thepreparation of financial statements for external purposes in accordance with generally acceptedaccounting principles and disclosed, based on our most recent evaluation of internal control overfinancial reporting, to the registrants auditors and the audit comm ittee of the registrants board of

68The AC and plaintiffs briefing leaves somewhat unclear whether plaintiff alleges a thirdcategory of false statements regarding the Companys projected capital expenditures(capex). Compare AC 18 (alleging that [a]nother adverse consequence ofWeatherfords lack of internal controls related to the Companys capital expenditures . . .which far exceeded its stated budgets and alleging that the Company repeatedly revisedits capex projections) with DI 71, at 24 n.21 (plaintiffs opposition brief contending that ithas not abandoned its capex allegations). The Court does not understand the ACs fewparagraphs discussing capex statements to set forth an independent Section 10(b) claim onthis ground. In any event, the Court agrees with the W eatherford Defendants that any suchclaim should be dismissed because plaintiff fails to allege the false statements withparticularity and fails to raise any inference that the projections were made with therequisite scienter.


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17directors . . . [a]ll significant deficiencies and material weaknesses in the design or operation ofinternal control over financial reporting which are reasonably likely to adversely affect theregistrants ability to record, process, summarize and report financial information. 6 9 Theseattestations continued quarterly as late as November 1, 2010, in Weatherfords 10-Q for the thirdquarter of 2010 . 7 0

By contrast, the Companys March 2011 restatement identifying the materialweakn ess detailed significant gaps in its internal controls as follows:

The Companys processes, procedures and controls related to financial reportingwere not effective to ensure that amounts related to current taxes payable, certaindeferred tax assets an d liabilities, reserves for uncertain tax positions, the current anddeferred income tax expense and related footnote disclosures were accurate.Specifically, our processes and procedures were not designed to provide for adequateand timely identification and review of various income tax calculations,reconciliations, and related supporting documentation required to apply ouraccounting policies for incom e taxes in accordance w ith US GAAP .The principal factors contributing to the material weakness were: 1) inadequate

AC 142. The C ompany itself made statements also in each report about the effectivenessof its internal controls, relying on the certifications of Duroc-Danner and Becnel. Inparticular, it stated, [W]e carried out an evaluation, under the supervision and with the participation ofmanagement, including [Becnel] and [Duroc-Danner], of the effectiveness of our disclosurecontrols and procedures . . . . Based upon that evaluation, our CEO and CFO haveconcluded our disclosure controls and procedures are effective as of the end of the periodcovered by this report to ensure that information required to be disclosed by us in thereports we file or submit under the Exchange A ct is recorded, processed, summarized andreported within the time periods specified in the Securities and Exchange Commissionsrules and forms and that information relating to us . . . required to be disclosed isaccumulated and communicated to management, including the CEO and CFO, to allowtimely decisions regarding required disclosure.DI 65, Ex. 15 at 39.Se e DI 65, Ex. 17.

69

70


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18staffing and technical expertise w ithin the compan y related to taxes, 2) ineffectivereview and approval practices relating to taxes, 3) inadequate processes to effectivelyreconcile income tax accounts and 4) inadequate controls over the preparation ofquarterly tax provisions.

7 1

Although the March 2011 restatement specifically stated only that Weatherfordsinternal control over financial reporting for income taxes was not effective as of December 31,2010 7 2 (i.e., the end of that particular reporting period), in light of the Companys attestationsthrough the class period that its internal controls had not changed 7 3 and the fact that the $500 milliontax expense understatement persisted from 2007 through 2010, one reasonably may infer thatWeatherfords internal controls in fact were inadequate throughou t the class period.

The question, of course, is wh ether the AC adequately pleads that Becn el and Duroc-Danner m ade their certifications either knowing they were false or w ith reckless disregard for theirtruth. 7 4 The Court is mindful of the fact that the certifications involve a certain amount ofsubjectivity, e.g., regarding whether Weatherfords internal controls provide reasonableassurance a bout the reliability of financial reporting. 7 5 This Court previously has recognized howthe subjectivity of statements in the securities fraud context bears on w hether a plaintiff adequately

71DI 68, Ex. 4.

72Id .

73See, e.g. , DI 65, Ex. 15 at 39.

74See South Cherry Street , 573 F.3d at 109.

75AC 142.


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19has alleged scienter . 7 6 But subjectivity will not completely immunize a statement from reviewunder Section 10(b). Indeed, a plaintiff can plead a claim adequately based even on a statement ofopinion if it alleges facts sufficient to perm it a conclusion that [the defen dant] either did not in facthold that opinion or knew that it had no reasonable basis for it. 7 7

The Court concludes that AFME has alleged scienter adequately with regard toBecnels statements about internal controls. In reaching this conclusion, the Court relies on severalkey factors.

First, the personal participation of Becnel in designing and evaluating the internalcontrols is relevant to the inquiry. The certifications state that Becnel, along with Duroc-Danner,was responsible for establishing and maintaining those controls and designed or caused suchcontrols to be designed under his supervision. 7 8 Moreover, Becnel participated in and supervisedeach of the Co mpanys q uarterly evaluations of its internal controls. 7 9 Where a statement is maderepeatedly regarding an issue of specific personal interest to the officers, the allegations w ill morereadily give rise to the requisite strong inference of scienter . 8 0

76See In re Lehman Bros. Sec. and ERISA Litig. , 799 F. Supp. 2d 258, 30003 (S.D.N.Y.2011) [hereinafter Lehman ].

77Id . at 302.

78

AC 142.79

See, e.g.. , DI 65, Ex. 15 at 39.80

See Plymouth Cnty..Ret. Assn v. Schroeder , 576 F. Supp. 2d 360, 38283 (E.D.N.Y. 2008)(supporting finding of scienter with allegations that directors were personally involved intransactions at issue); Buxbaum v. Deutsch Bank A.G. , No. 98 Civ. 8460, 2000 WL33912712, *1 9 (S.D.N.Y. Mar. 7, 2000) (similar).


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20Second, the discrepancies between the adm issions of the March 2011 restatement and

the repeated certifications that continued from the beginning of the class period until as late asNovember 2010 are stark. In March 2011, the Company admitted inadequate staffing and technicalexpertise, ineffective review and approval practices, inadequate processes to effectivelyreconcile income tax accounts and inadequate controls over the preparation of quarterly taxprovisions. 8 1 Given Becnels personal participation in designing and evaluating the internalcontrols, he presumably had extensive know ledge about precisely these matters. The inference thathe lacked a reasonable basis for his certifications is plausible in the circumstances.

Third, the AC alleges that Becnel was aw are of at least some problems w ith internalcontrols in the tax department during the class period. The A C refers to CW 2, a senior-level auditexecutive who worked in Weatherfords internal audit department from approximately 2000 to2010. 8 2 CW2 allegedly states that taxes were always an area of concern and a constant issue.CW 2 reported that taxes were the only department with unexplained audit delays that genuinelyconcerned CW2. He or she allegedly informed Abarca and Becnel about these delays, but theyare said to have believed that is just the nature of taxes and the Tax Department. Moreover,[a]ccording to CW2, on several occasions, Tax Department audits turned up multiple controldeficiencies, including at least one significant deficiency in 2009, that were exp ressly raised with

81DI 68, Ex. 4.

82AC 57. The Court is not persuaded by defendants contention that the AC insufficientlydescribes CW2 in order for these allegations to be considered. The complaints descriptionof CW2 as a s enior-level executive in the internal audit department during most of the classperiod and its allegation that CW 2 attended recurring quarterly A udit Comm ittee meetingssupports the probability that he or she would have been aware of problems regardingWeatherfords internal controls in taxation. See BISYS , 397 F. Supp. 2d at 442 (holdingadequate similarly specific descriptions of various confidential witnesses).


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21Becnel, Abarca, and the Audit Com mittee. 8 3 All deficiencies were entered into Exception Log swhich were summarized and presented in Audit Committee meetings that Becnel and Abarcaregularly attended. 8 4 CW2 stated that one of the reasons for his/her departure from Weatherford wasincreasing concern that the Tax Department issues were not being addressed, and CW 2 was no tsurprised to learn of Weatherfords Restatement. 8 5

Finally, to the extent the Tax Depa rtment posed unique issues, the fact that taxes werekey to measuring [W eatherfords] financial performance and [were] a subject about which investorsand analysts often inquired further reinforces the inference o f scienter. 8 6

Defendants ope ning brief paid almost no attention to the internal controls statements,contending principally that the alleged statements of CW2 regarding internal audit delays are notrelevant. The Court is unpersuaded. Given that part of Weatherfords challenged statementsregarded the effectiveness of internal controls to allow timely 8 7 decisions regarding disclosure andthat part of the ultimately revealed problem was that Weatherfords processes and procedures werenot designed to provide for adequate and timely identification and review, 8 8 one reasonably may

83AC 58.

84Id .

85Id . 59.

86New Orleans Emps. Ret. Sys. v. Celestica, Inc. , 455 F. Appx 10, 14 (2d Cir. 2012)(summary order).

87DI 65, Ex. 15 at 39.

88DI 68, Ex. 4.


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22infer that Becnels certifications were recklessly made in light of the audit delays raised by CW2and dismissed by Becnel. Moreover, the defendants awareness of delays that might have beenindicative of the inadequate staffing and technical expertise and dismissal of issues that pertainedsolely to the Tax Departmen t may be also indicative of recklessness.

Defendants challenge also C W2's alleged statements about con trol deficiencies onthe ground that the AC does not allege that those deficiencies related in any way to the $500 millionrestatement. But that is entirely beside the point when determining whether Becnels generalstatements regarding internal controlswhich were separate from its understatement of taxexpensewere made recklessly. The ACs allegations permit the conclusion that Becnel knewabout but failed to resolve meaningful control deficiencies at times when Becnel was certifying thatthe internal controls were effective. While discovery ultimately may undermine the probative valueof the supposed deficiencies referenced by CW2, the complaint is sufficient in this respect to survivea motion to dismiss.

In short, in light of the personal involvement of B ecnel in designing and evaluatingWe atherfords internal controls, the stark realities about the inadequacies of the internal controls thatwere revealed in the March 2011 restatement, the audit delays and control deficiencies expresslyraised to him during the class period, and the fact that the Tax Department uniquely wasexperiencing problems even while he knew that its functions were of specific importance to theCom pany, the AC sufficiently alleges scienter with regard to his statements. 8 9 The inference thathis certifications were made with reckless disregard for the truth is at least as compelling as any

89See In re Scottish Re Group Sec. Litig. , 524 F. Supp. 2d 370 39295 (S.D.N.Y. 2007)(concluding that complaint adequately alleged scienter with respect to comp anys internalcontrols certifications).


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23opposing, nonculpable inference. 9 0

The Court conc ludes further that the AC adequ ately alleges scienter with regard toWeatherford. 9 1 While the above allegations are sufficient to give rise to the requisite stronginference of scienter as to Becnel, the Court concludes that the AC does not sufficiently allegescienter with respect to any of the other individual defendants. Although A barca was present alsoat the Audit Committee meetings, the AC does not allege with particularity her role in designing theinternal controls. The AC is insufficient also with respect to Duroc-Danner because it fails to allegethat he was aware of any issues with internal controls at all during the class period. The AC containsno allegations about Geer on this issue whatsoever.

b.nderstatement of Tax ExpenseNext, the AC alleges false statements that relate specifically to the understatementof tax expense, including the Companys reports on Forms 10-K and 10-Q. It alleges that these90

The authorities relied on by defendants in its reply do not undermine this conclusion. InCoronel v. Quanta Capital Holdings, No. 07 Civ. 1405, 2009 WL 174656 (S.D.N.Y. Jan.26, 2009), the court rejected only the plaintiffs use of internal control weakness as a basisfor inferring scienter regarding the filing of false earnings statements, not as anindependently actionable securities fraud claim. Moreover, it relied on the fact that thecompanys control weaknesses did not lead to any financial restatements. That is not thiscase.Similarly unavailing is In re Interpublic Securities Litigation , 2003 WL 21250682. Inconcluding that the plaintiffs did not adequately plead scienter, the court relied on the factthat the company had never admitted that it failed to have the proper procedures in place,a far cry from this case. Nor was there any indication that executives in Interpublic hadreceived any information about internal control problems while the company was certifyingthat the controls were adequate.

91See Teamsters , 531 F.3d at 195 ([T]he most straightforward way to raise [a stronginference of scienter] for a corporate defendant will be to plead it for an individualdefendant.).


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24reports materially overstated the Companys net income, net earnings, effective income tax rate andpurported growth. 9 2 Relatedly, because the companys accounting for the tax receivables, whichresulted in the understatement of tax expense, did not conform to GAAP, the AC alleges that theWeatherford defendants falsely asserted that the Companys financial results were prepared inaccordance with GAA P. 9 3 This category of false statements finally includes numerous statementsmade in conference calls by the Weatherford defendants indicating that their positive financialresults were due to successful strategies and competitive tax advantages rather than impropermanipulation of the Companys incom e tax expense. 9 4

To the extent plaintiff appears to allege an intentional scheme w hereby defendantscrudely manipulated the Companys effective tax rate expense by a few percentage points eachquarter and fiscal year to generate enough earnings to meet or beat the Companys targets in keyperiods, its allegations are insufficient. 9 5 The complaint is entirely devoid of factual allegationsthat could m ake plausible, let alone compelling, the inference that defendants actively manipulatedthe tax receivable asset in order to beat Wall Street estimates or otherwise inflate earnings by adesired amount. Nor d oes the AC provide a sufficient basis to support even its allegations that thefictitious tax asset was intentionally introduced by defendants on to Weatherfords book s. 9 6

92AC 77.

93See id.

94Id .

95Id 65.

96Id . 5 (alleging that the Insider Defendants devised a com petitive edge that its rivals couldnot match, a simple and crude tax accounting fraud designed to inflate Weatherfords net


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25But that is not the end of the story. Plaintiff need not make such grandiose

allegations to plead scienter adequately. Rather, plaintiff needs to allege facts p lausibly giving riseto an inference of recklessness, an extreme departure from the standards of ordinary care to theextent that the danger w as either known to the defendant or so obvious that the defendant must havebeen aw are of it. 9 7

Plaintiff puts forward several bases on which to found such an inference ofrecklessness, including (1) the magnitude of the restatement, (2) the focus of defendants andinvestors on the effective tax rate, (3) the quality of internal controls, and (4) access to information. 9 8

The Court is not persuaded by the ACs attempt to allege scienter regarding theunderstatement of tax expense based on an access to information theory. 9 9 Our Circuit has held thatwhere plaintiffs contend defendants h ad access to contrary facts, they mu st specifically identifythe reports or statements containing this information. 1 0 0 The allegations of the AC do not gobeyond a broad reference to raw data that the Circuit has concluded is insufficient to allege accessto information as a basis for scienter . 1 0 1 Although AFME points to the assertions of CW3 that

income and net [earnings per share] to create an overall false facade of financial successduring an otherwise very difficult period for the Company).97

EC A , 553 F.3d at 198 (internal quotation marks and alterations omitted).98

To the extent plaintiff relies on CW 1 from the A C for another basis to allege scienter, seeAC 5456, this Court above has already concluded CW1 was not sufficiently describedto be deemed credible.99

AC 4853.100

Teamsters , 531 F.3d at 196 (quoting Novak , 216 F.3d at 309) (alterations omitted).101

Id .


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26Weatherford maintained a mo nthly spreadsheet detailing intercompany receivables and payables,the AC notably stops short of actually alleging that the spreadsheet contained sufficient informationto demonstrate that the tax expenses were in error. 1 0 2 Nor does the AC allege that any of thedefendants actually were provided this spreadsheet. 1 0 3

Similarly unpersuasive is the alleged lack of internal controls. While Weatherfordspoor internal controls may give rise to liability with respect to the defendants statements aboutinternal controls, the weak internal controls provide little if any circumstantial support that thestatements that the understated tax expense were made with scienter. Simply put, [w]eakaccounting controls may pave the way for fraud. They do not themselves constitute fraud. 1 0 4

This leaves plaintiffs central points that the magn itude of the understatement andthe defendants and investors considerable focus on Weatherfords tax rates demon strate that thedefendants were at least reckless w ith regard to the truth of their statements.

The Second Circuit has held that the magnitude, at least in certain circumstances, canbe relevant to the scienter inquiry. 1 0 5 To the extent that the invalid tax assets created a largefootprint on Weatherfords finances without any supporting documentation, the size of the error may

102AC 60.

103Id .

104BISYS , 397 F. Supp. 2d at 450.

105See Rothman , 220 F.3d at 92 (invoking magnitude of write-off to render less credibleinference advanced by defendants and thus to conclude that plaintiff adequately allegedscienter); In re Scholastic Corp. Securities Litigation , 252 F.3d 63, 7677 (2d Cir. 2001)(similar); see also Defer LP v. Raymond James Financial, Inc. , 654 F. Supp. 2d 204, 219(S.D.N.Y. 2009) (recognizing that the magnitude of the alleged fraud does provide somecircumstantial evidence of scienter (internal quotation marks omitted)).


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27provide some support for scienter . 1 0 6 Moreover, these assets reduced Weatherfords stated taxexpense enormouslyW eatherfords stated expense from 20072010 w as 21 percent, but after therestatement it proved actually to have been 34 percent. 1 0 7 How substantial that understatement wasto Weatherfords prospects and outlook is highlighted by the m any analyst conference calls and SECfilings in which defendants touted their lower tax rates. As the AC alleges, analysts showedconsiderable interest to defendants in even a few percentage point change in the effective tax rate. 1 0 8Moreover, the defendants often provided specific guidance about the effective tax rate they expectedto achieve, down to the percentage point, in analyst calls along with their reasons behind that belief,generally owing to tax planning and the Com panys geographic earnings mix. 1 0 9 The AC

106When the magnitude of an error is relevant to scienter depends on the circumstances. Forexample, if a widget m anufacturer announces that it will be writing off significant inventoryassets due to a previously undisclosed defect in a particular model of widgets, the size ofthe restatement may say very little, if anything, about scienter regarding the failure todisclose the defect earlier. The probability that corporate officers would have discoveredthe defect earlier might be unaffected by whether the inventory was worth $10 million or$100 m illion.Conversely, if a widget manufacturer states repeatedly that it had annual sales of $100million when in actuality its sales were only $1 0 million, the magnitude of that error shouldprovide some support for an inference of scienter, because such a significant discrepancywould be unlikely to go unnoticed.AC 5.Id . 74 (analyst noting he was surprised by the lower rate of 24% versus an expected 27%,and Becnel stating [y]es, that was good work from our tax group in terms of planning.We had some benefits that rolled in that will appreciate over the that we will recognizeover the rest of the year in terms of those planning implementations. And also it willdepend . . . on where we are making our money. But we feel very good about that.).

109Id . 88; see id. 107 (when asked about the reasons for a lower 15.5 percent ratew hichultimately proved to be a 32 percent rate after the restatementBecnel stating That wecan answ er. If you look at distribution of earnings by geographic segm ent and the d ifferentrates both what I would call the statutory versus effective rates that we have been able toachieve and incremental tax planning that we undertook during the quarter in connection

107

108


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28further notes that the difference between the repo rted tax rate and the actual tax rate w ould often beeven more significant in specific quarters. For exam ple, in the third quarter of 2010, the Com panyreported a 5 percent tax rate, which ultimately was restated to 35 percent. 1 1 0 Other quarters sawsignificant tax benefits, when the restated tax rate was a meaningful net co st. 1 1 1

Nevertheless, it is clear that the size of the fraud alone d oes not create an inferenceof scienter, 1 1 2 and wh at is noticeably missing from the A C is any allegation that the Weatherforddefendants had any contemporaneous basis to believe that the information they related was incorrectthat wo uld be sufficient to allege the requisite conscious recklessness. 1 1 3 In an attempt to bridgethe gap in this regard, plaintiff relies considerably on the core operations theory adopted byseveral courts in this district. That theory states that [k]nowledge of the falsity of a company'sfinancial statements can b e imputed to key officers who should h ave know n of facts relating to thecore operations of their company that would have led them to the realization that the company'sfinancial statements w ere false when issued. 1 1 4 The theory finds its roots in Cosma s v. Hassett , a

with our mov e to Geneva, all of those helped. Obviously w e feel a lot more confident aboutputting our thumb on exactly where we w ill be by the end of the year in terms of earningsgiven the prognosis that [Duroc-Danner] just went through, and so I feel a lot moreconfident in that [tax] rate than where w e w ere heading into Q1).

110See id. 127.

111See id. 116, 122.

112BISYS , 397 F. Supp. 2d at 447 (internal quotation marks omitted).

113South Cherry Street , 573 F.3d at 109 (internal quotation marks omitted).

114In re Atlas Air Worldwide Holdings, Inc. Sec. Litig ., 324 F. Supp. 2d 474, 490 (S.D.N.Y.2004).


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29case in which know ledge about new Chinese import restrictions was imp uted to corporate officerswhen sales to China constituted a significant part of [the com panys] business. 1 1 5 As a numberof courts have noted, however, it remains an open question whether the theory has survived thepassage of the PSLRA. 1 1 6

That debate need n ot be settled here. The C ourt assumes, in light of the importanceof tax rates to Weatherfords financials, that the proper determination of these rates constituted coreoperations that would have permitted a plausible inference that the defendants knew about thefalsity or knew facts that made the risk of such falsity obvious.

But the fact that the Court may make such an inference does not mean that such aninference necessarily would be the most compelling under Tellabs . The Court is required toconsider plausible, nonculpable explanations for the defendant's conduct and , in order to sustainthe complaint, must conclude that the inference of scienter is at least as compelling as any opp osinginference one could draw from the facts alleged. 1 1 7 Here, the allegations of the AC support theplausible inference that the Company made an error in its tax accounting treatment in 2007 thatpersisted on its books, compounding over time, and leading to incorrect financial reporting thatpropagated up to management. That is, it is a plausible inference that managements statements

115886 F.2d 8, 13 (2d Cir. 1989).

116See B d. of Trustees of City of Ft. Lauderdale Gen. Emps. Ret. Sys. v. Mechel OAO , 811 F.Supp. 2d 853, 871 (S.D.N.Y. 2011) (surveying caselaw in the district) affd Frederick v.Mechel OAO , 475 F. Appx 353, 356 (2d Cir. 2012) (summary order) ( Cosmas wasdecided prior to the enactment of the PSLRA, and we have not yet expressly addressedwhether, and in what form, the core operations doctrine survives as a viable theory ofscienter).

117Tellabs , 551 U.S. at 324.


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31opinions about W eatherfords internal controls 1 2 1 and GAAP compliance. 1 2 2

With regard to the third category, E & Y s statements about GAA S com pliance, theAC points to several General Standards (GS), interpretive Statements on Auditing Standards(AU), and Standards of Fieldwork that allegedly are part of GAAS and that E & Y allegedlyviolated. 1 2 3 AFME focuses particularly on GAAS standards regarding the gathering of sufficientevidential matter. In particular, AU Section 3 26 provides that the auditor should be thoroug h inhis or her search for evidential matter, 1 2 4 and A U Section 110 states that [s]ufficient competentevidential matter is to be obtained through inspection, observation, inquiries, and confirmations toafford a reasonable basis for an opinion regarding the financial statements under aud it. 1 2 5

121See, e.g. , id. at 39 (We conducted our audit in accordance w ith the standards of the PublicCompany Accounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether effective internalcontrol over financial reporting was maintained in all material respects. Our audit includedobtaining an understanding of internal control over financial reporting, assessing the riskthat a material weakness exists, testing and evaluating the design and operatingeffectiveness of internal control based on the assessed risk, and performing such otherprocedures as we considered necessary in the circumstances. We believe that our auditprovides a reasonable basis for our opinion.).See, e.g. , id. at 40 (We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements. An audit alsoincludes assessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.).Se e AC 202 n.15 (indicating allegations of violations of GS Nos. 13 and Standards ofField Work Nos. 23).Id . 206.

Id . 207.

122

123

124

125


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32AFM E contends that each of these three categories of statements was false and that

E & Y m ade such false statements with the requisite scienter .

1 .otive and OpportunityPlaintiff first posits that it sufficiently has alleged facts giving rise to a stronginference of scienter under the motive and opportunity approach on three types of allegations. Thefirst regard the fees that Ernst & Young received from Weatherford. 1 2 6 The second are based onsupposed close ties between the tw o entities the A C focuses particularly on former em ployees ofErnst & Y oung w ho later worked for Weatherford, including individual defendant Abarca. 1 2 7 Thethird set of allegations focus on ad ministrative sanctions and d iscipline that Ernst & Young and itsemployees have faced in other, independent circumstances. 1 2 8 None of these allegations suffices.

The AC alleges only that Ernst & Youn g generated over $30 million in aggregatefees from Weatherford during the class period. 1 2 9 It nowhere alleges that these fees were notcommensurate with work performed or otherwise were paid inappropriately. This does notsufficiently allege motive, as [i]t would defy common sense to hold that the motive element . . .would be satisfied m erely by alleging the receipt of normal comp ensation for professional services

126See id. 201, 218, 220.

127See id. 22026.

128See id. 22728.

129Id . 218.


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33rendered. 1 3 0

The revolving door a llegations are similarly unsuccessful. The Court assumes forpresent purposes that there was, in fact, a steady stream of Weatherford employees and executiveswith close personal ties to Ernst & Young. 1 3 1 Even so, the AC fails to allege why this gave Ernst& Young a motive to commit the alleged fraud. The Weatherford employees whose departure datesfrom Ernst & Young a re given are alleged to have left the auditor in 1996 and 2000,132 some sevenyears before the class period. In any event, the AC fails to allege why the fact that certainWeatherford employees onc e worked for Ernst & Young h as any bearing on either partys motiveor opportunity to commit the fraud alleged in this case. Simply listing commo n employees of bothcompan ies, without more, is not enough. 1 3 3

Finally, the AC provides two paragraphs of allegations of prior wrongs it assertsErnst & Young com mitted. 1 3 4 These prior sanctions and disciplinary measures which occurred incircumstances entirely independent of the circumstances of this caseha ve no bearing on w hetherErnst & Young had a motive to perpetuate fraud in this case.

130Friedman v. A riz. World Nurseries , 730 F. Supp. 521, 532 (S.D.N.Y. 1990), affd 927 F.2d594 (2d Cir. 1991); see Ganino v. Citizen Utilities Co. , 228 F.3d 154, 170 (2d Cir. 2000)(General allegations that the defendants acted in their economic self-interest are notenough.).

131AC 220.

132See id. 221, 222.

133See Vogel v. Sands Bros. & Co. , 126 F. Supp. 2d 730, 743 (S.D.N.Y. 2001) (holding thatalleging a close relationship without more did not allow the court to infer scienter).

134Se e AC 227, 228.


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34

2.ircumstantial Evidence of R ecklessnessAlternatively, AFME contends that it has alleged the requisite scienter through

sufficient circumstantial evidence of con scious misbehavior or recklessness.In conducting this inquiry, the Court is mindful of the deman ding standard im posed

by this Circuit to plead a uditor scienter in a securities fraud case. 1 3 5 In particular, for recklessnesson the part of a non-fiduc iary accoun tant to satisfy securities fraud scienter, such recklessness mustbe conduct that is highly unreasonable, representing an extreme departure from the standards ofordinary care and approximat[ing] an actual intent to aid in the fraud being perpetrated by theaudited company. 1 3 6 Moreover, our Circuit has said that the failure of a non-fiduciary accountingfirm to identify problems with the defendant-com panys internal controls and a ccounting practicesdoes not c onstitute reckless conduct sufficient for 10 (b) liability. 1 3 7

135Lehman , 799 F. Supp. 2d at 302 (internal quotation marks omitted).

136Rothman , 220 F.3d at 98 (internal quotation marks omitted); accord South Cherry Street,573 F.3d at 110. This said, auditor scienter can be established by a showing of shoddyaccounting practices amounting at best to a pretended audit, or of grounds supporting arepresentation so flimsy as to lead to the conclusion that there was no genuine belief backof it. Rothman , 220 F.3d at 98 (quoting McLean v. Alexander , 599 F.2d 1190, 1198 (3dCir. 1979)). This is because, although the Circuit requires approximate intent, theplaintiff need not allege that the aud itor actually wa nted the fraud to happ en; rather, it issufficient to consider what could the defendant reasonably foresee as a potential result ofhis action. AUSA Life Ins. Co. v. Ernst & Young , 206 F.3d 202, 221 (2d Cir. 2000)(internal quotation marks omitted). Thus, because E & Y is not an accounting dilettanteand knows well that its opinions and certifications are afforded great weight . . . . it issufficient for a plaintiff to allege and prove that a defendant could have foreseen theconsequences of his action but forged ahead nonetheless. Id . ; accord Gould v. WinstarComm unications, Inc. , 692 F.3d 148, 158 (2d Cir. 2012).

137Novak , 216 F.3d at 309; see Gould, 692 F.3d at 159 (suggesting at summary judgment stagethat mere failure to uncover the accounting fraud is insufficient).


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35Typically, auditor scienter in this Circuit turns on alleging that the auditor

repeatedly failed to scrutinize serious signs of fraud. 1 3 8 Such allegations of red flags, whencoupled with allegations of accounting violations, may permit a complaint to survive a motion todismiss. 1 3 9 But an unseen red flag cannot be heeded and flags are not red merely because theplaintiff calls them red. 1 4 0 Rather, the red flags, taken collectively, must demonstrate obvioussigns of fraud, or that the danger of fraud was so obvious that [the defendant] must have been awareof it. 1 4 1

Moreover, where, as here, statements by an auditor are couched as opinions, thisCourt has previously recog nized that the bar is raised even higher to allege the requisite scienter.In particular, to allege that an opinion is false (and a fortiori, to allege that it is false with scienter),the com plaint must set forth facts sufficient to warrant a finding that the auditor did not ac tuallyhold the opinion it expressed or that it knew that it had no reasonable basis for holding it. 1 4 2

The Court takes each category of alleged m isstatements in turn.

138Gould, 692 F.3d at 160.

139Stephenson v. PricewaterhouseCoopers, LLP , 768 F. Supp. 2d 5 62, 573 (S.D.N.Y. 2011).

140

Id .141

South Cherry Street , 573 F.3d at 112; see Tellabs , 551 U.S. at 32223 (The inquiry . . .is whether all of the facts alleged, taken collectively, give rise to a strong inference ofscienter, not whether any individual allegation, scrutinized in isolation, meets thatstandard (emphasis in original)).

142Lehman , 799 F. Supp. 2d at 303.


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36a.AAP ComplianceAFME relies on what it characterizes as nine red flags to support an inference of

scienter regarding E & Ys opinions about Weatherfords GAAP comp liance: (1) the sudden dropin Weatherford s tax rate in 2007, (2) the magnitud e of the error as ultimately revealed in 2010, (3)the frequency and consistency of the tax en tries, (4) the fact that Weatherfords appa rent tax rate wasmuch lower than that of its rivals and permitted Weatherford to beat earnings forecasts, (5) the factthat E & Y received fees for non-U.S. tax compliance, planning and U.S./non-U.S. tax relatedconsultation, (6) Weatherfords prior history of accounting improprieties, (7) the discrepancybetween Weatherfords cash tax rate and reported tax rate, (8) E & Ys access to a spreadsheetcontaining intercompan y reconciliations and (9) the discrepancy between E & Ys representationsabout internal controls and Weatherfords March 2011 adm issions. 1 4 3 The Court is not persuadedthat these allegations are sufficient to satisfy the demanding standard for pleading scienter as againstan auditor.

First, several of these were not red flags at all. That E & Y received fees fromWeatherford for U.S. tax related consultation says substantially nothing about w hat E & Y w ouldhave know n from 20072010 about this particular aspect of Weatherfords taxes beyond its generalrole as auditor. Nor is Weatherfords Ma rch 2011 revelation of its poor internal controls a red flagthat would have been seen by E & Y in 20072010.

Second, at least one of these purported red flags is insufficiently connected to E &Y. The AC fails to allege that E & Y knew ab out Weatherfords com petitors tax rates or that thetax rates were responsible for beating earnings forecasts.

143AC 213.


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37Third, some of these red flags just are not sufficiently colorful. As discussed

previously, the AC fails to explain with particularity whether and how the spreadsheet providingintercompany reconciliations w ould have revealed the understatement of tax expense. 1 4 4 Nor doesWeatherfords general history of one-time accounting charges provide any m eaningful grounds tocontend that E & Y w as reckless for failing to uncover this particular misstatement.

Finally, to the extent that the suppos ed red flag m erely constituted better performanceby W eatherford, the Circuit has rejected the notion that a rapid increase in profitability is a sign offraud sufficient to plead scienter . 1 4 5

The remaining purported red flags amount not so much to any meaningfulcontemporaneous knowledge that E & Y had show ing the existence of any misstatements, but ratherthat the size and nature of the fraud was such that E & Y should have found it. That is, the AC isreplete with allegations that [E & Y] would have learned the truth as to those aspects of[Weatherfords taxes] if [E & Y] had performed the due diligence it promised. 1 4 6 This is notenough.

144The AC contains also many more general statements about E & Ys access due to itslongstanding role as an auditor of Weatherford since 2001, non-audit work, frequentconversations with management, etc. See AC 209. None of these allegations showsanything more than that [E & Y] was [Weatherfords] auditor, a fact which is whollyinsufficient to show [E & Ys] scienter. In re Doral Fin Corp. Sec. Litig. , 563 F. Supp.2d 461, 466 (S.D.N.Y. 2008).

145See Chill v. Gen. Elec. Co. , 101 F.3d 263, 26970 (2d Cir.1996)

146South Cherry Street , 573 F.3d at 112 (internal quotation marks omitted). Moreover, E &Ys opinion letter makes clear that its audit operates on a test basis and therefore did notanalyze every single transaction. DI 68, Ex. 7 at 40. Thus, AFMEs allegation that E & Yfailed to uncover the error is insufficient to allege that the audit was im properly conduc ted.


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38b.nternal ControlsThe allegations reg arding internal controls fare no better. The only purported red flag

that AFME alleges regarding internal controls is the tension between E & Ys opinion that theinternal controls were effective and Weatherfords subsequen t conclusion that they were not. Butthat is not a red flag because Weatherfords conclusion was made known only after E & Ysrepresentations. Unlike in the case of B ecnel, the AC con tains no allegations suggesting that E &Y ever had been m ade aware of issues w ith internal tax controls.

AFM Es stronger argum ent is that, in light of the considerable deficiencies in internalcontrols revealed by the Com pany, any reasonable audit following the criteria that E & Y affirmedthat it had used would have revealed the deficiencies. But the ACs allegations in this regard areonly conclusory, providing no factual detail as to how application of the criteria would necessarilyhave uncovered the problems with internal controls. 1 4 7 The Court thus concludes that the morecompelling inference is that the audit was no more than negligent, if indeed it was that, in failingto identify the problems. 1 4 8

147Se e AC 216 (The C OSO criteria provide a detailed roadmap for auditors, including theidentification of red flags, appropriate policies and procedures and comprehensive auditplanning and review of internal controls necessary for reliable financial reporting.Accordingly, if Ernst & Young conducted the audit it claimed it had pursuant to CO SO, ithad actual knowledge that the Company had virtually no internal controls over financialreporting for taxes, as Weatherford admitted in the Restatement. If Ernst & Young did notconduct a C OSO audit, as it represented to investors that it had during the Class P eriod, itscertifications were knowingly false.)

148The Court further recognizes that the Circuit has said that the failure of a non-fiduciaryaccounting firm to identify problems with the defendant-companys internal controls andaccounting practices does not constitute reckless conduct sufficient for 10(b) liability.Novak , 216 F.3d at 309 (citing Decker v. Massey-Ferguson, Ltd. , 681 F.2d 111, 120 (2d Cir.1982)). Plaintiff contends that the principle is inapposite since the passage of the Sarbanes-Oxley A ct w hich mandates specific reviews and certifications regarding internal controls.The Court need n ot rely on the broad principle enunciated by Novak and Decker to conclude


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c .AAS ComplianceFinally, E & Ys statements regarding its compliance with GAAS is disposed easily.

Whether in alleging that E & Y violated its duties of due professional care, professionalskepticism, or gathe ring sufficient evidential matter, or otherwise, the claims fall for essentially thesame reasons as described above. Indeed, the burden is doubly high in this context; not only mustAFME allege that E & Y failed to do an adequate audit, but it must allege also that E & Y was atleast reckless in believing that its audit was adequate. There is nothing in the A C that even beg insto suggest anything about E & Ys state of mind with regard to how it conducted the audit, and thusthe claim fails.

C.ection 20(a)Section 20(a) of the Exchange Act makes liable those who directly or indirectly

control a person w ho is liable for a primary violation of the statute. 1 4 9 As this Court previously hasheld, a plaintiff need not plead culpable participation by the control person in order to state a legallysufficient claim. 1 5 0 Nor need the allegations of control be pleaded with particularity. 1 5 1

The Court concludes that in addition to stating a claim against Becnel and

that plaintiff has failed to allege any reckless conduct here.149

Se e 15 U.S.C. 78t(a).150

See In re Parmalat Sec. Litig. , 497 F. Supp. 2d 526, 532 n.42 (S.D.N.Y. 2007); BISYS ,397 F. Supp. 2d at 450.151

Id .


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40Weatherford as primary violators, the AC states a claim against Duroc -Danner, Abarca, and Geerunder Section 20(a). As ch ief executive officer, Duroc-Danner clearly had the pow er to direct orcause the direction of the management and policies of Weatherford. 1 5 2 The same is true for Abarcaand Geer, who were Weatherfords chief accounting officer and principal accounting officer,respectively, and signed some o f the statements at issue. 1 5 3

D.otion to SupplementAFME moves to supplement the complaint to add factual content that purportedly

came to light only after the filing of the amended complaint.A m otion to supplement a complaint pursuant to Rule 15(d) is governed by the same

standard as a m otion to amend under Rule 15(a). 1 5 4 It differs only in that it refers to a request to addallegations about an event or events that occurred after the original pleading was filed, as comparedto a motion to amend, which covers events that occurred before the filing of the pleading but whichwere not included in the com plaint. 1 5 5

A m otion to supplement generally should be permitted w hen the supplemental facts

152S.E.C. v. First Jersey Sec. Inc. , 101 F.3d 1450, 147273 (2d Cir. 1996) (internalquotation marks om itted).

153

Se e AC 4647.154

See Quaratino v. Tiffany & C o. , 71 F.3d 58, 66 (2d Cir. 1995); Instinet Inc. v. Ariel (UK)Ltd. , No. 08 Civ. 7141, 2011 WL 4444086, at *2 n.1 (S.D.N.Y. Sept. 26, 2011).

155Se e F ED . R. C IV . P. 15(d) (On motion and reasonable notice, the court may, on just terms,permit a party to serve a supplemental pleading setting out any transaction, occurrence, orevent that happened after the date of the p leading to be supplemented.).


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41connect it to the original pleading. 1 5 6 Such a motion should not be granted, however, where itwould cause undue delay, . . . undue prejudice to the party to be served with the proposed pleading,or [w ould be] futil[e]. 1 5 7

At a hearing before this Court on January 17, 2012, counsel for lead plaintiff AFMEindicated that they preferred to go forward 1 5 8 with the am ended com plaint as drafted, and declinedthe opportunity offered by this Court to amend their complaint. Lead Plaintiff has tw ice attemptedto add to the allegations of the AC since this date, first requesting to amend an d then filing a motionto supplement it, both in spite of the fact that they are seeking to alter the very comp laint on whichthey unequivocally elected to stand. 1 5 9

Be that as it may, AFM E asserts that its present motion to supplement the AC shouldbe granted because events have occu rred after the date the AC w as filed that add substantively tothe allegations asserted therein. 1 6 0 AFME seeks to supplement with allegations regarding (1) theremov[al] of Becnel, as well as the Companys vice president of tax, (2) a U.S. Department ofJustice investigation that was announced on March 15, 2012, and which the motion asserts islooking into the facts alleged in the [AC], and (3) a second financial restatement issued by the

156Quaratino, 71 F.3d at 66.

157Id .

158DI 83, at 2.

159Se e DI 86; DI 89 .

160As certain of the defendants note, it appears that plaintiffs supplemental amendedcomplaint contains also changes that are not simply alterations reflecting events thathappened after the AC w as filed. See DI 94, at 6 n.2.


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42Company in 2012, which admitted tax misstatements . . . [of] another $185 million. 1 6 1 In addition,AFM E asks the C ourt to take judicial notice of related materials.

The motion is denied as futile. None of the proposed additions in any way affectsthe resolution of this case. First, that Becnel and a nother executive were removed well over a yearafter a restatement in which the C ompany w as forced to acknowledge, at a minimum, a $500 millionmistake, is not probative of scienter . 1 6 2 Second, while the existence of government investigationsmay som etimes be probative ofscienter with regard to post-investigation conduct, there is no basisto conclude that a DOJ investigation initiated over a year after the even ts in question is probativeof anything. 1 6 3 Finally, the 2012 restatement appears to have increased the size of the losses, butchanges nothing o f substance with regard to the claims in this case.

ConclusionAccordingly, Ernst & Youngs motion to dismiss the AC [DI 63] is granted. The

Weatherford Defendan ts motion to dismiss the AC [DI 67] is granted in all respects, except that itis denied with respect to (1) the Section 10(b) claims against Becnel and Weatherford regardingstatements about the quality of internal controls and (2) corresponding Section 20(a) claims against

161DI 90, at 4, 8.

162See Glaser v. The9, Ltd. , 772 F. Supp. 2d 573, 598 (S.D.N.Y. 2011) (finding that officerresignations did not support inference of scienter absent highly unusual or suspiciouscircumstances). It would hardly be unusual or suspicious that two executives would beremoved as a result of this significant restatement, even assuming it was an hones t mistake.

163See Teamsters Allied Benefit Funds v. McGraw , No. 09 Civ 140, 2010 W L 882883, at *11(S.D.N.Y. Mar. 11, 2010) (noting that government investigations only allege scienter formisconduct occurring after the investigation).


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43Duroc-Dan ner, Abarca, and Geer. AFM Es motion for leave to supplement the complaint [DI 90]is denied, and its requests for judicial notice [DI 90; DI 101] are denied as m oot.

SO ORDERED.Dated:ovember 7, 2012

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11-7-2012 Sdny Case Scienter Swipe