Pension Trust Fund for Operati v. Kohl's Corporaton ( 2018 )

In the
United States Court of Appeals
For the Seventh Circuit
____________________
No. 17-2697
PENSION TRUST FUND FOR OPERATING ENGINEERS, et al.,
Plaintiffs-Appellants,
v.
KOHL’S CORPORATION, et al.,
Defendants-Appellees.
____________________
Appeal from the United States District Court for the
Eastern District of Wisconsin.
No. 13-CV-1159 — J. P. Stadtmueller, Judge.
____________________
ARGUED JANUARY 16, 2018 — DECIDED JULY 12, 2018
____________________
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 execu-
tives defrauded investors by publishing false and misleading
2 No. 17-2697
information in the lead-up to the corrections. (For ease of ex-
position, 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 reck-
lessly disregarded that possibility at the time they were made,
because Kohl’s recently had made similar lease accounting er-
rors. 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 im-
posed by the Private Securities Litigation Reform Act
(PSLRA). The court entered that dismissal with prejudice, de-
clining 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 de-
cision 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 com-
ponent 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 ad-
just its accounting practices three times—in 2005, 2010, and
2011—to bring its books in line with generally accepted ac-
counting principles (“GAAP”). The first and third of these
corrections were material and required the restatement of sev-
No. 17-2697 3
eral years’ worth of financial statements. The second was com-
paratively 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 Man-
sell, 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 Pen-
sion Fund contends that purchasers of Kohl’s stock from Feb-
ruary 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), and
SEC 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)
and Rule 10b-5, because a violation of those provisions is nec-
essary 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 defend-
ant; (2) scienter; (3) a connection between the misrepresenta-
tion or omission and the purchase or sale of a security; (4) re-
liance 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.
4 No. 17-2697
Scienter pleadings in securities fraud class actions must
satisfy a heightened standard of plausibility. Through the
PSLRA, Congress requires that plaintiffs “state with particu-
larity 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 (2007). In making this determination, the allega-
tions in the complaint “are accepted as true and taken collec-
tively.” Id. at 326. 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 manage-
ment 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
No. 17-2697 5
details. The Pension Fund insists that because Kohl’s repeat-
edly 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 ac-
counting errors such as these are well below the pay grade of
its executives. But leases are a significant part of Kohl’s finan-
cial picture that cannot be expected to evade executive
knowledge altogether. See S. Ferry LP, No. 2 v. Killinger, 542
F.3d 776, 784 (9th Cir. 2008) (concluding that a “core-opera-
tions 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. 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 evi-
dence as a whole.
A
As detailed in the complaint, all three sets of errors were
announced through SEC filings accompanied by press re-
leases and on at least one occasion, an investor conference call.
The first restatement came on February 22, 2005. Kohl’s an-
nounced 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 re-
ality 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
6 No. 17-2697
the start as the earlier of the date of first payment or first pos-
session 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 ex-
pected 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 adjust-
ment to income in the third quarter of 2010.
Finally, in August 2011 Kohl’s announced that it had dis-
covered another round of accounting errors. These errors
were of a different type. This time, Kohl’s had failed to reclas-
sify 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 ex-
pensed, the rented property is not counted as an asset, and
future rent payments are not recognized as liability. By con-
trast, 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 not
No. 17-2697 7
as a rental expense, but instead as a combination of deprecia-
tion expense and interest expense.
These changes were significant—indeed, firms will often
go to great lengths to keep their financial obligations off the
balance sheet. See Paul B.W. Miller & Paul R. Bahnson, Off-
Balance-Sheet Financing: Holy Grail or Holey Pail?, ACCT.
TODAY (Oct. 11, 2010), https://www.accountingto-
day.com/news/off-balance-sheet-financing-holy-grail-or-
holey-pail-AT55794 (“Managers strive after [off-balance-sheet
financing] like the Holy Grail … .”); but see Tom Petruno, Why
Corporate Leasing Practices Deserve More Respect, UCLA
ANDERSON REV. (Apr. 4, 2018), https://www.ander-
son.ucla.edu/faculty-and-research/anderson-review/leasing
(arguing that reforms to operating lease rules “may be target-
ing an accounting abuse that is more imagined than real”).
Whatever the firm’s preference, GAAP requires leases to be
categorized as capital when the economic reality of the ar-
rangement makes the lessee more like the owner.
Simplifying the requirements somewhat, capital-lease
treatment is required if ownership transfers to the tenant at
the end of the term, if the tenant has the right to purchase the
property well below its value, or if the term of the lease or
lease payments amount to a significant portion of the prop-
erty’s value. In Kohl’s case, McDonald suggested that Kohl’s
“strategies in negotiating leases and in renovating and con-
structing stores” created “ongoing financial interest[s]” in the
leased buildings that warranted capital-lease treatment. “Ma-
terial weaknesses” in its financial reporting “controls and pro-
cedures,” however, allowed these misclassifications to go un-
noticed. The next month, Kohl’s restated its financial disclo-
sures from 2006 through the second quarter of 2011, with
8 No. 17-2697
large effects on Kohl’s balance sheet, but relatively minor ef-
fects elsewhere. According to the Pension Fund, Kohl’s had
understated its liabilities from about 26 to 39 percent annually
and its assets from about 9 to 12 percent annually as a result
of these errors.
The complaint supplements this chronology of accounting
mistakes and corrections with some additional allegations
supporting scienter. First, it alleges that Kohl’s leasing
strategies should have put its executives on alert for potential
lease accounting issues. By aggressively “renovating and
constructing stores,” Kohl’s should have known that capital-
lease treatment was appropriate earlier on. Second, the
Pension Fund finds highly suspicious a number of stock sales
by Mansell, McDonald, and other company insiders. Mansell
sold 138,000 shares for $7,676,400 in September 2009.
McDonald sold 7,000 shares for $412,000 in September and
October 2009, and 2,000 shares for $112,500 in November
2010. Seven other insiders also sold significant numbers of
shares during the class period. The Pension Fund argues that
these sales underscore that Mansell and McDonald knew that
Kohl’s financial statements were false or misleading when
they were published.
B
Taking these facts together, the Pension Fund has made a
strong case that many of Kohl’s disclosures regarding its lease
accounting practices turned out to be false. But that is not
enough. The facts must also give rise to a strong inference of
scienter. The complaint fails in this regard if it is more likely
that the errors resulted from “careless mistakes at the man-
agement level” than from “an intent to deceive or a reckless
No. 17-2697 9
indifference to whether the statements were misleading.” Ma-
kor Issues & Rights, 513 F.3d at 709. In contrast with the com-
plaint’s exhaustive account of the facts of Kohl’s accounting
mishaps, the Pension Fund gives us very few facts that would
point either toward or away from scienter. This lack of connec-
tive tissue is determinative in this case. See Tellabs, 551 U.S. at
326 (noting that “omissions and ambiguities count against in-
ferring scienter”).
The Pension Fund argues that its strongest evidence of sci-
enter is that Kohl’s made similar and significant accounting
errors in 2005, 2010, and 2011 related to a core part of its busi-
ness. But these errors are not as similar as the Pension Fund
suggests. True, one error from 2005 recurred in 2010 (misstat-
ing the start date of the lease), but that error led to a relatively
minor restatement. The errors leading to major restatements
in 2011 were wholly unrelated to the problems of 2005. The
classification of leases and the length of lease terms implicate
different lease accounting rules and affect firms’ financial
statements in very different ways. Shifting start or end dates
moves expenses from one period to another, affecting net in-
come across periods. The classification of leases, meanwhile,
has its primary effect on the balance sheet. The impact and
considerations are quite different, even if both involve leases.
The Pension Fund tries to overcome the differences be-
tween the 2005 and 2011 restatements by arguing that the 2010
and 2011 restatements should be taken as one. The represen-
tations in October and November 2010 that the changes
would not be material are false, they say, because the 2011
problems were already known. The problem with this theory
is that not only is the complaint devoid of evidence to support
it—there is actually evidence in the complaint undermining
10 No. 17-2697
it. On June 28, 2011, just over a month before the 2011 lease
accounting errors were discovered, Kohl’s announced that it
had secured a $1 billion credit agreement requiring a compre-
hensive review of its books. Without allegations of facts sug-
gesting otherwise, the temporal proximity of these events
suggests that an innocent explanation is more likely: the ac-
counting errors were discovered during the comprehensive
review mandated by contract. To the extent that making the
same error again and again suggests recklessness, rather than
negligence, the Pension Fund has failed to tell us why these
errors are so alike as to make the recklessness inference at
least as compelling as any other.
That the defendants were employing aggressive invest-
ment strategies in their leased properties is similarly of no
help to the Pension Fund. Perhaps a reasonable person should
have realized that the number of capital leases on Kohl’s bal-
ance sheet should have increased as these investments were
made. But the allegations do nothing to show why it was reck-
less, rather than just negligent, that Kohl’s executives did not
realize that something was amiss. Perhaps the executives had
a motive to pretend nothing was amiss (though even that does
not seem beyond dispute, as they might equally have wanted
the most accurate financial picture possible), but a general-
ized motive common to all corporate executives is not enough
to establish scienter. Otherwise, “virtually every company in
the United States that experiences a downturn in stock price
could be forced to defend securities fraud actions.” Zucco
Partners, LLC v. Digimarc Corp., 552 F.3d 981, 1005 (9th Cir.
2009) (quoting Lipton v. Pathogenesis Corp., 284 F.3d 1027, 1038
(9th Cir. 2002)). It is quite possible that Kohl’s accountants or
external auditors knew they were pushing the boundaries of
GAAP to keep leases off the balance sheet, but their
No. 17-2697 11
knowledge is immaterial to the scienter of those making the
statements. See Makor Issues & Rights, 513 F.3d at 708–09.
Without more, we cannot say that Kohl’s pursuit of aggressive
leasehold improvements counsels for or against scienter.
Perhaps suspicious stock sales could tip the balance, but
the insider trading allegations in this case do not. “[B]ecause
executives sell stock all the time, stock sales must generally be
unusual or suspicious to constitute circumstantial evidence of
scienter.” Pugh, 521 F.3d at 695. The plaintiffs argue that the
sales in this case are suspicious because Mansell and McDon-
ald made no sales at all in the year before the class period or
in 2011. But that the individual defendants made sales in 2009
and 2010 but not in 2008 or 2011 is not enough to render the
sales unusual. See Teachers’ Ret. Sys. of La. v. Hunter, 477 F.3d
162, 185 (4th Cir. 2007) (“[T]he complaint does not provide de-
fendants’ trading patterns outside the class period to permit
comparison with their trades within the class period.”); Ron-
coni v. Larkin, 253 F.3d 423, 435 (9th Cir. 2001) (finding graphs
showing trading seven months before and twelve months af-
ter the class period insufficient to show trades were suspi-
cious or unusual). Once again, the Pension Fund has given us
little to go on. The complaint tells us the date of sale, number
of shares, and sale price for each trade, but nothing else. We
do not know whether these sales were a high percentage of
the individual defendants’ holding; we do not know whether
the individual defendants sold more shares than they typi-
cally would; we do not know if they bought more shares to
offset their sales; we have no sense of the typical trading vol-
ume of Kohl’s shares; and we do not know how Kohl’s stock
price fluctuated around these sales.
12 No. 17-2697
Perhaps we could overlook the complaint’s lack of context
if the stock sales resembled a smoking gun, but the probative
value of stock sales depends greatly on timing. The most sig-
nificant insider sales in this case were made in September
2009, 14 months before the 2010 corrections were announced
and 23 months before the 2011 corrections were announced.
These periods are more than long enough for any inference of
suspicion to dissipate, at least in the absence of concrete facts
suggesting otherwise. See In re Harley-Davidson, Inc. Sec. Litig.,
660 F. Supp. 2d 969, 1002 (E.D. Wis. 2009); In re Party City Sec.
Litig., 147 F. Supp. 2d 282, 313 (D.N.J. 2001) (“A broad tem-
poral distance between stock sales and a disclosure of bad
news defeats any inference of scienter.”). With nothing to in-
dicate that these stock sales were unusual or suspicious, they
cannot support an inference of scienter.
We have addressed these issues with the complaint one at
a time, but we recognize that we need to look at the allega-
tions as a whole. Unfortunately for the Pension Fund, this
does not help. Each allegation in the complaint is advanced
without any sense of how the dots connect. Tellabs requires
that a complaint give rise to a “cogent and compelling” infer-
ence of scienter. 551 U.S. at 324. The Pension Fund tells us that
Kohl’s made similar, but not identical, lease accounting errors;
that it did so while management was pursuing an aggressive
store-improvement strategy; and that insiders sold stock dur-
ing the same period. This could suggest wrongdoing, but it
more plausibly suggests negligent oversight of overzealous
accounting staff or some other breakdown lower in the corpo-
rate hierarchy. The Pension Fund has not taken the extra step
to show why these allegations give rise to a strong inference
of scienter, even considered collectively.
No. 17-2697 13
III
Although we agree with the district court that the com-
plaint fell short of the PSLRA’s requirements, that court was
so unimpressed that it entered a dismissal with prejudice
without further ado and refused to entertain an amended
complaint. We repeatedly have said that “a plaintiff whose
original complaint has been dismissed under Rule 12(b)(6)
should be given at least one opportunity to try to amend her
complaint before the entire action is dismissed.” Runnion ex
rel. Runnion v. Girl Scouts of Greater Chi. & Nw. Ind., 786 F.3d
510, 519 (7th Cir. 2015). This admonition carries special weight
in securities fraud cases because “[i]n this technical and de-
manding corner of the law, the drafting of a cognizable com-
plaint can be a matter of trial and error.” Eminence Capital, LLC
v. Aspeon, Inc., 316 F.3d 1048, 1052 (9th Cir. 2003). Our final
task is to determine whether the district court abused its dis-
cretion through its unusual departure from the standard pro-
cedure. Foster v. DeLuca, 545 F.3d 582, 583 (7th Cir. 2008).
The district court justified dismissal with prejudice be-
cause it thought that the court’s prior rulings “put the plain-
tiffs on notice of weaknesses in the amended complaint … .”
The district court was right that its prior rulings (which were
issued by a different presiding judge) identified weaknesses
with the complaint, but those weaknesses were unrelated to
the reasons for which the complaint was later dismissed. In
its order denying the defendants’ first motion to dismiss with-
out prejudice for relying too heavily on exhibits, the district
court noted “ongoing concerns about the prolixity of the
Amended Complaint—sixty-one pages, with 173 numbered
paragraphs.” Whatever the merits of the district court’s criti-
14 No. 17-2697
cism, concerns about the complaint’s length could not possi-
bly alert the plaintiffs to problems with their scienter allega-
tions. If anything, they reasonably might have thought that
more length was necessary to meet the PSLRA’s demanding
standards for pleading scienter. The district court’s earlier crit-
icism thus does not help support the abrupt end of the case.
The defendants argue that the Pension Fund could not
have been taken by surprise, because defendants had alerted
the plaintiffs to the weaknesses of the complaint. This argu-
ment is a non-starter. If briefing in opposition to a motion to
dismiss were sufficient basis to deny leave to amend after that
motion were granted, there would be little left to the general
rule we have just discussed. The only case the defendants cite
to the contrary involved denial of leave to amend for the fifth
time, when the defects had been identified by the motion to
dismiss the second amended complaint. Huon v. Denton, 841
F.3d 733, 745–46 (7th Cir. 2016). In other words, the plaintiffs
in Huon had already amended twice with full knowledge of
what the defendants would argue. In the usual case, we look
only to decisions of the court to determine whether the plain-
tiffs knew of faults with their complaint. See Gonzalez-Koeneke
v. West, 791 F.3d 801, 806 (7th Cir. 2015) (pointing to “the defi-
ciencies identified in the court’s order granting the motion to
dismiss”); Bausch v. Stryker Corp., 630 F.3d 546, 562 (7th Cir.
2010) (“But a formal motion for leave to amend was not nec-
essary at the Rule 12(b)(6) stage, and the plaintiff was entitled
to wait and see if any pleading problems the court might find
could be corrected.”). A litigant need not take the opposing
side’s legal position as gospel; indeed, it frequently would be
unwise to do so.
No. 17-2697 15
Although there are problems with the district court’s deci-
sion, and better practice might have been to allow one amend-
ment, we find no reversible error here. At bottom, the district
court was concerned that amendment would be futile, and the
plaintiffs have done nothing before this court to dispel that
notion. “[A] district court does not abuse its discretion by
denying a motion for leave to amend when the plaintiff fails
to establish that the proposed amendment would cure the de-
ficiencies identified in the earlier complaint.” Gonzalez-
Koeneke, 791 F.3d at 807. While the plaintiffs did not have the
opportunity to show what they would add before the district
court dismissed with prejudice, they have had several oppor-
tunities since. They could have moved under Federal Rule of
Civil Procedure 59(e) or 60(b) for another opportunity in the
district court, see Runnion, 786 F.3d at 521, or they could have
told us what more they would plead in their briefing. They
took neither step. We asked at oral argument what the plain-
tiffs hoped to add if given the opportunity. Again, we were
given no indication of what new material the plaintiffs could
provide. Reversal is inappropriate if the plaintiff cannot iden-
tify how it would cure defects in its complaint. Arlin-Golf, LLC
v. Vill. of Arlington Heights, 631 F.3d 818, 823 (7th Cir. 2011).
The Pension Fund made no such showing in the district court
or on appeal and is not entitled to another chance to do so.
IV
The Pension Fund failed adequately to plead scienter and
has not suggested how it would amend its pleadings to cure
this defect. As a result, the judgment of the district court is
AFFIRMED.