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


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  •                                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
    AMENDED JULY 16, 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
    2                                                  No. 17-2697
    Operating Engineers, allege that Kohl’s and two of its execu-
    tives defrauded investors by publishing false and misleading
    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
    No. 17-2697                                                    3
    corrections were material and required the restatement of sev-
    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.
    16                                                 No. 17-2697
    HAMILTON, Circuit Judge, concurring. I join the court’s
    opinion in all respects. I write separately to highlight the in-
    terplay of Rule of Professional Conduct 4.2 and the demand-
    ing pleading standards adopted in the Private Securities Liti-
    gation Reform Act, and in particular the role of “confidential
    sources” in pleading a securities fraud case. The arguments in
    this case highlight the need for courts to avoid restricting or
    punishing plaintiffs’ attorneys and investigators from contact-
    ing a wide range of current or former employees of a com-
    pany they are considering suing.
    This case arose in Wisconsin, where Kohl’s has its head-
    quarters. As adopted by the Wisconsin Supreme Court, Rule
    of Professional Conduct 4.2(a) provides:
    In representing a client, a lawyer shall not com-
    municate about the subject of the representation
    with a person the lawyer knows to be repre-
    sented by another lawyer in the matter, unless
    the lawyer has the consent of the other lawyer
    or is authorized to do so by law or a court order.
    When a lawyer’s client is adverse to an organization, such as
    a corporation like Kohl’s, Rule 4.2(a) governs that lawyer’s ef-
    forts to obtain information directly from current employees,
    officers, or directors of the adverse organization, without in-
    volving or obtaining consent from counsel for the organiza-
    tion. For those issues, however, the text of the rule does not
    offer much guidance. Comment 7 addresses that problem:
    In the case of a represented organization, this
    Rule prohibits communications with a constitu-
    ent of the organization who supervises, directs or
    regularly consults with the organization’s lawyer
    No. 17-2697                                                        17
    concerning the matter or has authority to obligate
    the organization with respect to the matter or whose
    act or omission in connection with the matter may be
    imputed to the organization for purposes of civil or
    criminal liability. Consent of the organization’s
    lawyer is not required for communication with
    a former constituent. If a constituent of the or-
    ganization is represented in the matter by his or
    her own counsel, the consent by that counsel to
    a communication will be sufficient for purposes
    of this Rule. Compare Rule 3.4(f). In communi-
    cating with a current or former constituent of an
    organization, a lawyer must not use methods of
    obtaining evidence that violate the legal rights
    of the organization. See Rule 4.4. (Emphasis
    added.)
    Rule 4.2(a) and comment 7 can be central to plaintiffs’ abil-
    ity to plead a viable claim for securities fraud under the
    PSLRA. As a practical matter, the PSLRA requires plaintiffs’
    lawyers to conduct extensive pre-complaint investigations.
    They must investigate without the help of formal discovery
    tools. As a result, information provided voluntarily by current
    or former employees may be helpful or even essential for
    plaintiffs trying to allege fraud, and especially fraudulent sci-
    enter, with sufficient particularity. See, e.g., Makor Issues &
    Rights, Ltd. v. Tellabs Inc., 
    513 F.3d 702
    , 711 (7th Cir. 2008); In re
    Daou Systems, Inc., 
    411 F.3d 1006
    , 1015–16 (9th Cir. 2005) (re-
    versing in part dismissal where plaintiffs relied on confiden-
    tial information from current employees and provided suffi-
    cient detail); Novak v. Kasaks, 
    216 F.3d 300
    , 313–14 (2d Cir.
    18                                                            No. 17-2697
    2000) (plaintiffs did not need to identify confidential sources
    in complaint).1
    Before filing a complaint, plaintiffs’ lawyers have no way
    to compel testimony from the prospective defendant’s em-
    ployees, current or former. Subject to Rule 4.2(a), however,
    they can reach out to former and current employees and seek
    information from those willing to provide it voluntarily. Such
    information can sometimes be critical in defeating a motion to
    dismiss a complaint. See 
    Tellabs, 513 F.3d at 711
    –12 (reversing
    dismissal).
    On the other hand, when the plaintiffs’ lawyers have not
    obtained information from the defendant’s current or former
    employees, courts can expect the defendant to highlight that
    point. Kohl’s has done just that here, in its brief (pages 3 and
    23) and in oral argument.
    Fair enough. Plaintiffs are not required to plead infor-
    mation from confidential sources, but they can certainly help
    build a case, as defense counsel understand very well.
    What prompts this concurrence are the problems that can
    arise when aggressive lawyers for the corporation or other or-
    ganization try to stretch the coverage of Rule 4.2(a) and its
    comment 7 to deter or prohibit plaintiff’s counsel from con-
    tacting broad groups of current employees in search of such
    1As the cited cases indicate, such current or former employees often
    ask for confidentiality, at least as long as it can be maintained legally. The
    securities laws provide employees with protection against retaliation for
    providing information about suspected securities fraud, see 18 U.S.C.
    § 1514A(a), but the statute is relatively narrow. Also, the prospect of a
    right to file a lawsuit offers only limited comfort to employees who might
    risk their jobs by helping others pursue a lawsuit against their employer.
    No. 17-2697                                                               19
    supporting information. Cf. Weibrecht v. Southern Illinois Trans-
    fer, Inc., 
    241 F.3d 875
    , 881 (7th Cir. 2001) (analyzing pre-
    amendment version of Rule 4.2, affirming district court find-
    ing that plaintiff’s counsel violated rule by contacting captain
    of defendant’s tugboat, but vacating sanction of dismissal
    with prejudice). It is not my purpose to provide a treatise on
    this subject, and results may vary from state to state. Nor do
    we have any indication of such overreach in this case.
    Given the potential importance of such information from
    current or former employees more generally, my purpose is
    simply to caution courts and lawyers that Rule 4.2(a) and
    comment 7 were amended in 2002 to allow lawyers to contact
    directly broader categories of employees or other constituents
    of adverse organizations. These considerations can apply in a
    wide range of cases, of course. Parties often have trouble pay-
    ing for formal depositions of potential witnesses. Such access
    may be especially important in cases covered by the PSLRA.
    Proof of scienter focuses on the most senior officers of the de-
    fendant, but many lower-level employees are likely to have
    relevant information in cases with viable claims for fraud. Un-
    due restriction of access to those employees or other constitu-
    ents can also lead to reversal of favorable judgments. See, e.g.,
    Palmer v. Pioneer Inn Assoc., Ltd., 
    338 F.3d 981
    (9th Cir. 2003)
    (ordering new trial in employment discrimination case).2
    2 Other courts and authorities have addressed these problems in more
    depth. See, e.g., Goswami v. DePaul University, 
    8 F. Supp. 3d 1004
    (N.D. Ill.
    2014); Snider v. Superior Court, 
    7 Cal. Rptr. 3d 119
    (Cal. App. 2003) (grant-
    ing writ of mandamus to vacate sanctions impose for permissible contacts
    with adverse corporation’s current employees); Wagner v. City of Holyoke,
    
    183 F. Supp. 2d 289
    (D. Mass. 2001) (applying rule before amendment of
    comment); Burt & Cook, Ethical Considerations concerning Contacts by Coun-
    sel or Investigators with Present and Former Employees of an Opposing Party,
    20                                                            No. 17-2697
    38 St. Mary’s L. J. 963 (2007); Wis. Ethics Opinion E–07–01 (see particularly
    the helpful discussion of reasons for 2002 amendments to comment).
    

Document Info

Docket Number: 17-2697

Judges: Wood

Filed Date: 7/16/2018

Precedential Status: Precedential

Modified Date: 7/17/2018

Authorities (20)

carol-novak-robert-nieman-joseph-desena-on-behalf-of-themselves-and-all , 216 F.3d 300 ( 2000 )

teachers-retirement-system-of-louisiana-and-barry-schoenfeld , 477 F.3d 162 ( 2007 )

Arlin-Golf, LLC v. Village of Arlington Heights , 631 F.3d 818 ( 2011 )

Foster v. DeLuca , 545 F.3d 582 ( 2008 )

Bausch v. Stryker Corp. , 630 F.3d 546 ( 2010 )

Pugh v. Tribune Co. , 521 F.3d 686 ( 2008 )

Dena Palmer v. Pioneer Inn Associates, Ltd., a Limited ... , 338 F.3d 981 ( 2003 )

Shane Weibrecht v. Southern Illinois Transfer, Inc. , 241 F.3d 875 ( 2001 )

in-re-daou-systems-inc-securities-litigation-greg-sparling-eugene , 411 F.3d 1006 ( 2005 )

Makor Issues & Rights, Ltd. v. Tellabs Inc. , 513 F.3d 702 ( 2008 )

South Ferry LP, No. 2 v. Killinger , 542 F.3d 776 ( 2008 )

Higginbotham v. Baxter International Inc. , 495 F.3d 753 ( 2007 )

Eminence Capital, Llc, and Jay Spechler v. Aspeon, Inc. ... , 316 F.3d 1048 ( 2003 )

Zucco Partners, LLC v. Digimarc Corp. , 552 F.3d 981 ( 2009 )

alfred-ronconi-james-v-biglan-jean-mullin-v-c-raymond-larkin-jr , 253 F.3d 423 ( 2001 )

david-s-lipton-on-his-own-behalf-and-on-behalf-of-those-similarly , 284 F.3d 1027 ( 2002 )

Tellabs, Inc. v. Makor Issues & Rights, Ltd. , 127 S. Ct. 2499 ( 2007 )

In Re Harley Davidson, Inc., Securities Litigation , 660 F. Supp. 2d 969 ( 2009 )

Wagner v. City of Holyoke , 183 F. Supp. 2d 289 ( 2001 )

In Re Party City Securities Litigation , 147 F. Supp. 2d 282 ( 2001 )

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