Thursday, November 10, 2005

Multiple Restatements Not Enough

By the third restatement, and a 46% drop in the value of their shares, investors in once high-flying Stonepath Group, Inc., had been battered and bruised. So they sued, alleging that the company and its executives portrayed “Stonepath as an increasingly profitable company positioned to expand and continue earnings growth through strategic acquisitions," when in reality it "was plagued by internal control deficiencies that caused the Company to consistently understate its most significant operating cost."

Well, it all came down to scienter, with a lot hinging on whether the three seemingly unrelated restatements by the company would be enough. Judge Stewart R. Dalzell (E.D. Pa.) held that “since the restatements addressed such unrelated problems, it cannot be said that the mere fact that there were three restatements shows defendants acted recklessly.” He also held that it was “significant” that “Plaintiffs do not allege that either internal or external auditors or any participant in the comprehensive review process alerted defendants to the problems leading to the third restatement.”

Getting nowhere with recklessness, Plaintiffs tired to prove that Defendants had motive and opportunity to commit the fraud. In doing so, “Plaintiffs rely primarily on two alleged motivations: (1) to inflate Stonepath stock to use it in various acquisitions, and (2) to inflate EBITDA to comply with Stonepath's debt covenants.” The Court rejected both, finding that “Plaintiffs rely mainly on one acquisition to establish motive,” and this can “hardly” be a “concrete and personal benefit." As for the “the need to comply with debt covenants,” he held that “at most,” this “can be a contributing motive to commit securities fraud, but standing alone even severe cash flow problems are insufficient to establish motive.”

Result: Case dismissed with leave to amend, as long as Plaintiffs “can do so conformably with the foregoing analysis and with Fed. R. Civ. P. 11.”

You can read In re Stonepath, issued October 27, 2005, at 2005 U.S. Dist. LEXIS 25250.

Nugget: “The magnitude of the restatement is undeniably large, and therefore relevant, but alone it does not establish recklessness.”

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