In Re Hutchinson Technology Inc. Securities Lit.

Citations: 502 F. Supp. 2d 884; 2007 U.S. Dist. LEXIS 40622; 2007 WL 1620805Docket: 05-CV-2095 (PJS/JJG)

Court: District Court, D. Minnesota; June 4, 2007; Federal District Court

SummaryOriginalCytator Case TreatmentBackward CitatorAnalysis

EnglishEspañolSimplified EnglishEspañol Fácil

Plaintiffs, represented by the NECA-IBEW Pension Fund, filed a securities fraud lawsuit against Hutchinson Technology, Inc. and its executives, alleging a fraudulent scheme that inflated the company's stock price from October 4, 2004, to August 29, 2005. The plaintiffs claim that Hutchinson concealed the production of defective products and its inability to meet customer demand, starting with an optimistic announcement in October 2004 about exceeding earnings guidance. This narrative unraveled in mid-2005 as Hutchinson disclosed capacity constraints and declining customer demand, leading to a significant drop in stock value.

The plaintiffs assert violations of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, alongside controlling-person liability claims under Section 20 of the Act. The court reviewed the defendants' motion to dismiss for failure to state a claim and ultimately granted the motion, dismissing the consolidated class-action complaint with prejudice.

Hutchinson, a major manufacturer of suspension assemblies for hard disk drives, generates over 90% of its revenue from this product line. The company's public statements during the class period included optimistic forecasts that led to an increase in stock price, specifically noting an EPS alignment with predictions following its fourth-quarter 2004 results.

In July 2004, Hutchinson forecasted an earnings per share (EPS) of 0.10 but experienced a decline in stock price to about $30.00 per share, despite CEO Fortun's optimistic remarks about an upward trend in suspension assembly demands during a conference call. Following further declines in stock price, several executives, including Fortun, Ingleman, Graczyk, Schaefer, and Penn, sold a total of 137,750 shares for nearly $6 million. The company filed its FY04 Form 10-K with the SEC on December 9, 2004, disclosing increased allowances for sales returns totaling $5,124,000 for 4Q04 and FY04, which were smaller than previous years. The Form 10-K included signed Sarbanes-Oxley certifications from Fortun and Ingleman.

In January 2005, Hutchinson announced it had exceeded its 1Q05 shipment guidance, with Fortun noting stronger-than-anticipated demand. Following this, Graczyk and Schaefer sold another 26,820 shares for almost $1 million. The 1Q05 Form 10-Q, filed on February 3, 2005, reported a smaller increase in return allowance of $745,000 compared to the previous year. By March 31, 2005, demand continued to rise, prompting plans to increase production capacity and capital spending. The 2Q05 financial results released on April 21, 2005, showed continued demand growth, forecasting shipments of 190 to 200 million units and net sales of $175 to $185 million. Fortun indicated difficulties in maintaining inventory levels. Following the announcement, Hutchinson's stock price rose to $36.93, and Graczyk sold another 19,670 shares for approximately $750,000.

On April 27, 2005, the 2Q05 Form 10-Q reported an increase in return allowance of $824,000, surpassing the previous year's increase. However, by July 21, 2005, Hutchinson disclosed it had missed its 3Q05 shipment projections due to "capacity constraints" and only met net income projections because of a tax refund, revealing potential issues in financial forecasting and management.

Hutchinson faced inefficiencies affecting its gross margin due to peak capacity operations and higher costs linked to expedited production and shipping. Despite reporting increased shipments and sales prices compared to previous periods, the company anticipated stronger sales in 4Q05. Following this, Hutchinson's stock price fell from $37.90 to $32.99. Shortly thereafter, insiders sold 154,300 shares for over $5 million as the market absorbed negative news. On August 30, 2005, Hutchinson revised its 4Q05 projections downward, citing weak demand and a shift toward newer, less profitable products, resulting in a further stock price drop from $31.51 to $26.16.

Allegations emerged that by October 2004, Hutchinson was operating at peak capacity with an increasing defect rate. Plaintiffs asserted that customer demand for newer, costlier suspension assemblies contributed to reduced profit margins. Five confidential witnesses supported claims of rising product defect rates and customer returns during this period. One witness, a manufacturing supervisor, noted a significant rise in defects starting May 2005, with approximately one million units returned weekly and a 75% increase in returns in the six months before May. Another witness reported that despite adding production capacity, the defect rate escalated from 8% to 15%. Weekly reports detailing production and quality issues were created and shared among plant managers, indicating widespread production problems, including one major customer returning half a million units weekly in fall 2004. Weekly conference calls involving key executives highlighted ongoing production discussions and issues, further underscoring the operational challenges faced by Hutchinson.

The report distributed to conference-call participants indicated that Hutchinson experienced a 22.5% increase in product-defect rates for every 10% increase in production capacity, suggesting that the defendants were aware of Hutchinson's production issues during the class period. A human resource generalist confirmed an 'obvious' rise in defects at Hutchinson's Eau Claire plant. The plaintiffs allege securities fraud under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, as well as controlling-person liability under Section 20. To establish their claims, plaintiffs must prove misrepresentations or omissions of material facts, causation, scienter, and economic harm. If they fail to substantiate their securities-fraud claims, their controlling-person liability claims also fail. The standard of review for motions to dismiss under Rule 12(b)(6) requires courts to accept factual allegations as true and draw reasonable inferences in favor of the claimant, but the Private Securities Litigation Reform Act imposes additional requirements. Specifically, plaintiffs must detail misleading statements and the reasons they are misleading, as well as provide strong evidence of the defendants' required state of mind. This requires a "strong inference" of scienter, surpassing mere plausibility.

The court applies the Reform Act's requirements, dismissing complaints lacking particularity. Plaintiffs allege two categories of materially false or misleading statements by defendants during the class period. First, they claim Hutchinson's reported financial results were misleading due to insufficient return allowances. They argue Hutchinson should have recorded higher return allowances, violating generally accepted accounting principles (GAAP), specifically Financial Accounting Standard No. 5 (FAS No. 5). Plaintiffs assert Hutchinson's return allowances in 4Q04, 1Q05, and 2Q05 were significantly lower than necessary, leading to overstated earnings. 

FAS No. 5 mandates accruing estimated losses from contingencies when it's probable that an asset is impaired or a liability incurred, and the loss can be reasonably estimated. Plaintiffs contend that return-allowance increases during the class period were inadequate compared to rising customer-return and product-defect rates. However, their argument is weakened by their admission that the 2Q05 return allowance increase exceeded that of 2Q04, contradicting their claim that it was the most understated. The plaintiffs fail to provide factual support for this assertion. Furthermore, the allegations regarding 4Q04 and 1Q05 return allowances lack sufficient historical context, rendering them anecdotal and insufficient under the Reform Act's standards.

Hutchinson's product-defect rate increased by 22.5% for every 10% rise in production capacity, leading to an overall increase from 8% to 15% during the class period. However, plaintiffs failed to contextualize these increases or provide evidence showing they were abnormal compared to Hutchinson's historical data when adding production capacity. Additionally, there is no evidence linking the defect rate to heightened customer returns. The only specific claim regarding returns comes from CW1, a manufacturing supervisor at the Sioux Falls plant, who stated returns rose 75% from late 2004 to May 2005. However, the complaint lacks details on CW1's knowledge of company-wide return rates and does not indicate that CW1 had access to relevant reports or meetings. The complaint does not assert that return allowances were inadequate relative to actual returns, nor does it establish that returns materially exceeded allowances. Plaintiffs rely on confidential witnesses for their claims but do not provide sufficient particulars on how the return allowances were calculated. They suggest that return allowances should have increased by varying percentages in three quarters but fail to explain their methodology. The Court notes that a claimed $300,000 discrepancy in return allowance for 4Q04, amidst net sales of over $122 million, may not be material, and plaintiffs have not substantiated this figure. Overall, without adequate allegations regarding the proper return allowances, plaintiffs cannot demonstrate that the reported figures were materially false or misleading. Furthermore, the complaint references public statements from Fortun and Ingleman in press releases and conference calls, with some quotations emphasized, but the context of these statements is not sufficiently detailed.

Plaintiffs do not assert that all highlighted statements made by Fortun or Ingleman are false, particularly those regarding the growing demand for suspension assemblies, which they actually rely on to support their fraud claims. They also quote statements about Hutchinson's production capacity expansion but do not allege any of these are false. When pressed to identify core false statements, plaintiffs highlight Fortun's April 21, 2005 statement about being "well-positioned" for new disk drive programs, claiming it is misleading due to Fortun's knowledge of Hutchinson's peak capacity and production issues. However, the plaintiffs concede that Hutchinson was transparent about operating at full capacity. Fortun acknowledged production challenges during the same call, stating the company was struggling to meet demand. This clarity undermines the claim that Fortun's general statement misled investors. Plaintiffs also express concern over Hutchinson’s defect rate but fail to cite specific misleading statements from defendants regarding this issue. The court agrees with defendants that Fortun’s statement lacks materiality. Additionally, Hutchinson's actual financial results largely met or exceeded its projections throughout the class period, indicating that the company accounted for its capacity issues. The plaintiffs do not provide sufficient evidence to meet the Reform Act's pleading requirements, failing to demonstrate that any defendant made materially false or misleading statements.

Scienter refers to the intent to deceive, manipulate, or defraud, with negligence alone—regardless of severity—being inadequate to establish this intent. Severe recklessness may suffice but requires evidence of extreme departures from ordinary care that present clear risks of misleading buyers or sellers, which the defendant must either know or be obviously aware of. Under the Reform Act, plaintiffs must specifically allege facts that create a strong inference of the defendant's state of mind. This can be achieved by demonstrating that defendants either knew of materially inaccurate statements or had the motive and opportunity to commit fraud. However, mere allegations of a desire to increase stock prices are insufficient; specific personal benefits from the fraud must be shown, such as unusual insider trading activity.

In the case at hand, plaintiffs argue that defendants had access to information indicating their public statements were false and that unusual insider trading occurred during the class period. They assert that defendants' performance-based compensation packages strengthen the inference of scienter. The plaintiffs claim the false statements include Hutchinson's reported financial results and Fortun's statement about the company's positioning on new disk drive programs. However, even if customer-return and product-defect rates were rising, these do not directly contradict the defendants' public statements. Specifically, the plaintiffs fail to provide evidence that Fortun was aware of any issues contradicting his April 21 statement regarding the company's prospects. Hutchinson reportedly met its financial projections and was actively increasing production capacity, with no undisclosed facts suggesting negligence in addressing defect rates. Consequently, the allegations do not meet the strong inference standard required for scienter under the Reform Act.

Plaintiffs contend that individual defendants sold significant stock amounts during the class period, contrasting with their minimal sales in the two years prior. However, an analysis of these sales reveals they do not strongly suggest scienter. The first notable sales by Fortun, Ingleman, Graczyk, Schaefer, and Penn occurred from November 3 to November 5, 2004, totaling 137,750 shares for nearly $6 million, shortly after Hutchinson's announcement of its 4Q04 financial results. Following this announcement, Hutchinson's stock price fell, and the subsequent sales largely occurred during and after this decline. Fortun and Ingleman sold stock again in late July 2005, following Hutchinson's announcement of failing to meet 3Q05 shipment projections, with stock prices again declining sharply. Green, the board chairman, also sold stock during this period, marking his sole class-period sale, which also happened after negative news. Notably, Fortun, Ingleman, and Green did not sell any shares at or near the peak stock price of the class period. This timing contradicts the plaintiffs' assertion that these defendants withheld information from the market. Plaintiffs attempt to support their insider trading claims by linking the timing of sales to a subsequent announcement about decreased demand and lowered 4Q05 projections. However, they fail to provide evidence that Fortun, Ingleman, and Green were aware of this negative information prior to their sales. Overall, the sales patterns do not substantiate claims of insider trading or deception.

The excerpt addresses the actions of three defendants—Fortun, Ingleman, and Green—who sold stock before disclosing negative information in August, prior to the end of the fourth quarter. Their timely disclosure undermines any suspicion regarding the stock sales, as they could have delayed the announcement to avoid raising red flags about their sales. Additionally, any stock sales by Graczyk and Schaefer that occurred in January and April 2005 also happened before the stock reached its class-period high, further weakening inferences of intent to deceive (scienter). The plaintiffs argue that Graczyk and Schaefer should be held accountable for allegedly misleading statements based on the "group-pleading" doctrine, which allows collective attribution of statements to individuals involved in company operations. However, the court finds this doctrine inconsistent with the Reform Act's requirement for specificity regarding the state of mind of each defendant. The excerpt emphasizes that without specific allegations of each defendant's responsibility for misleading statements, the claims against them lack sufficient basis, aligning with recent case law that critiques the applicability of the group-pleading doctrine post-Reform Act.

The Court considers the application of the group-pleading doctrine to Graczyk and Schaefer, asserting that their job titles do not inherently indicate responsibility for corporate financial statements. The precedent set in *City of Monroe Employees Ret. Sys. v. Bridgestone Corp.* is cited, where mere corporate titles and meeting attendance were deemed insufficient for establishing liability under this doctrine. 

Plaintiffs claim that all individual defendants, except Green, received bonuses linked to Hutchinson's reported financial results. However, the Court notes that simply alleging a connection between bonuses and corporate performance does not establish fraudulent intent. In comparison to *Green Tree*, where substantial bonuses were timed with financial misrepresentations, plaintiffs fail to show anything unusual regarding the bonuses received by the defendants. As such, the allegations do not satisfy the heightened scienter requirements of the Reform Act.

Additionally, the plaintiffs allege liability for individual defendants as controlling persons under Section 20 of the 1934 Act, which is contingent upon an underlying violation of the Act. Since the plaintiffs have not established a claim under Section 78j(b), the Section 20 claim is dismissed.

Lastly, while plaintiffs request leave to amend their complaint, they do not specify potential amendments that could rectify the identified deficiencies. The additional materials submitted post-argument concerning Hutchinson’s return allowances suggest that estimates were inadequate, but the implications of this information on their claims remain unclear.

Plaintiffs presented Hutchinson's 2Q06 and 3Q06 Form 10-Qs, which reported increases in the "allowance related to warranties issued," and a November 2, 2006 Form 8-K, which disclosed adjustments to revenues recorded in 2004 and 2005. Additionally, Hutchinson's FY06 Form 10-K and 2Q07 Form 10-Q revealed an SEC investigation concerning some allegations in this lawsuit. However, the 2Q06 and 3Q06 reports fall outside the class period. Plaintiffs acknowledged uncertainty regarding whether these allowances corrected class-period understatements, which is insufficient under the Reform Act, as it requires concrete facts for a strong inference of scienter. The mere occurrence of an incorrect estimate does not imply fraud. Moreover, plaintiffs provided no substantial evidence linking the adjustments in the November 2 Form 8-K to fraudulent activity; the adjustments related to revenue recognition, not the return allowance calculations central to their claims. The SEC's investigation does not imply the truth of the allegations or enhance the inference of scienter. Consequently, the court denied the plaintiffs' request to amend their complaint, ruling that doing so would be futile. The court granted the defendants' motion to dismiss, resulting in the dismissal of the plaintiffs' consolidated complaint with prejudice.

Under Sections 302 and 906 of the Sarbanes-Oxley Act, companies must have their principal executive and financial officers certify the accuracy of their financial reports filed with the SEC, ensuring no misleading statements or omissions exist. The complaint asserts that Hutchinson inaccurately reported a $79,000 increase in return allowance for 2Q05, later corrected to $824,000, leading to a percentage difference of 191%, contrary to the initially claimed 3100%. Plaintiffs' comparison of allowance increases for FY03 and FY04 lacks reliance on overall FY04 results. Additional materials submitted by plaintiffs suggest Hutchinson's return allowances were inadequate, to be discussed with their request to amend the complaint. Allegations against Fortun's and Ingleman's statements reflecting Hutchinson's financial results are deemed insufficient, mirroring deficiencies in the broader financial statement claims. In August 2005, Hutchinson revised its 4Q05 guidance due to reduced demand; plaintiffs argue this contradicts their claim that demand was consistently unmet, lacking supporting facts for their theory. The timing of Penn's stock sale, occurring at a low point, shows no signs of fraud. Lastly, a Form 8-K must be filed for specific triggering events, such as disclosing material non-public information regarding fiscal periods.