Deceptive Accounting Practices Can Constitute Both Material Misrepresentations And Scienter For 10b-5 Claims

In securities fraud litigation it can be difficult to identify the material misrepresentation sometimes without careful scrutiny because typically companies try to be sly about it. This is what happened with Gateway, Inc. in a case recently, where the company tried to use deceptive accounting practices to misrepresent to investors the health of its quarterly sales. Turns out that these deceptive accounting practices constituted both the material misrepresentation, and because the deception made it look like Gateway was trying to hide something it also constituted the scienter element necessary for the case.

In the case styled Securities And Exchange Commission v. Todd, decided by the Ninth Circuit on June 23, 2011 the SEC brought a securities fraud claim against Gateway Inc. and several of its corporate officers under the Securities Exchange Act of 1934, section 10(b) and Rule 10b-5. The allegations in the complaint dealt with three unusual transactions during the year 2000 where Gateway had unusual large sales to other corporations and reported them in a deceptive way through its accounting practices to make it look like they had better normal quarterly sales than they really did.

The case actually went all the way to a jury trial, where the jury found the former Gateway financial executives liable on all claims by the SEC. Thereafter, the defendants brought motions for judgment as a matter of law, which the district court granted, basically nullifying the jury’s decision. The SEC then appealed to the Ninth Circuit, which after review of the evidence determined that at least some of the district court’s orders should be reversed and the jury’s verdict reinstated for the 10b-5 claims.

Specifically, the Court of Appeals reviewed the evidence supporting the viability of the SEC’s 10b-5 claim. Liability under 10b-5 requires evidence of (1) a material misrepresentation, (2) in connection with the purchase or sale of security, (3) with scienter, (4) by means of interstate commerce. In reviewing the jury verdict of the Plaintiffs’ 10b-5 claim the court acknowledged that the standard of review for such considerations was that “a jury’s verdict must be maintained if it is supported by substantial evidence.” In light of the facts, the majority of the court’s attention focused on whether or not the SEC had provided enough evidence to support the jury’s verdict on the misrepresentation and scienter elements of their claims. The court concluded that the deceptive accounting and reporting of these incidents by Gateway was enough evidence to support the jury’s verdict in regard to the misrepresentation and scienter elements of the 10b-5 claims.

The Gateway decision illiterates one of the basic protections afforded by securities

fraud litigation. While not involved in a blatant Ponzi scheme or similar activity the corporate officers of Gateway were riding the line of accurate account and report
practices in an effort to maximize the company’s profits and live up to the market
forecasters’ expectations of their quarterly revenue growth. Feeling the weight of a
more competitive and shrinking personal PC market in 2000 Gateway felt pressure to
preserve its perception of corporate health through suspect accounting. This type of
misrepresentation is no less harmful to investors and the case is a way of sending a message to companies not to engage in these deceptive accounting practices in the future.