Earning Less than Expected does not Constitute Securities Fraud: Material Yard Workers Local 1175 Benefit Funds v. Men’s Wearhouse Inc.

In Material Yard Workers Local 1175 Benefit Funds v. Men’s Wearhouse Inc., No. H-09-3265, 2011 WL 3059229 (S.D. Tex. July 22, 2011), the court dismissed an action alleging that a men’s suit retailer and the company’s officers were guilty of securities fraud.  Material Yard Workers Local 1175 Benefit Funds accused Men’s Wearhouse, CEO George Zimmer, and CFO Neill Davis of inflating the company’s 2007 earnings expectations.

Zimmer’s estimates of first and second quarter earnings were slightly below actual earnings.  The company’s estimated third quarter earnings were slightly above actual earnings.  Men’s Wearhouse predicted in November of 2007 that its fourth-quarter earnings would total between $0.43 and $0.48 and earnings for the year would be between $2.87 and $2.92.  During a call later in the quarter with analysts, Davis “admitted that the fourth-quarter would be challenging and require modest changes to promotions.”  As a result, Men’s Wearhouse stock decreased by 16%.

At the beginning of 2008, the company lowered its mid-fourth quarter earnings to between $0.16 and $0.18 and its 2007 earnings prediction to between $2.60 and $2.62.  Following the announcement, shares fell another 30%.  The actual fourth quarter earnings were $0.28 and the actual 2007 fiscal-year earnings were $2.73.

The fund alleged that Men’s Wearhouse and its officers made statements in 2007 that were materially misleading.  The fund relied upon the allegations of four “confidential witnesses,” each of whom was employed by Men’s Wearhouse or one of its subsidiaries.  The witnesses asserted that the company was aware of facts suggesting that the forecasts would not be met.  The opinion described one witness as alleging that the company

• knew that (a) its largely urban customers were susceptible to economic downturns and (b) the slowing economy that began in 2006 would be quickly reflected in 2007 sales.  He opines that it became apparent in the second quarter of 2007 that K&G would suffer a 20% decrease in revenue for that quarter and the remaining year.  This signaled a need to revise the earnings guidance.

The court stated that “[f]or a company to be responsible for an investor’s losses, the investor must show that (a) the company omitted or misstated a material fact knowingly, (b) the investor relied on that fact, and (c) his reliance directly caused his loss.”  15 U.S.C. § 78j(b).  A company or its officers has not issued misleading predictions if they are “(a) presented as predictions and (b) uttered without actual knowledge of their falsity.”  15 U.S.C. § 78u-5.

The court held that plaintiffs had not sufficiently alleged that Men’s Wearhouse had deliberately made false projections.  The various conference calls to analysts contained disclaimers that uncertainties could alter the predictions and warned that “its results were dependent on the slowing economy’s effect on the demand for tailored clothing.” The mere fact that a projection proved to be wrong was not enough to establish fraud.

The court severely criticized the plaintiffs’ use of confidential witnesses.  The trial judge described one of the witnesses as a “person without the courage of his convictions."  Under a section titled “office gossip,” he also noted that “[a] party who presents the stories of unnamed people is neither giving the court nor the defendant a plain statement of the facts” and described the practice as “dissembling.”  Likewise, “[a] secret witness is not far above a false witness.”

As for the suit itself, the court had this to say:

• The fund has lawyer friends. They talk. The fund decides to let them initiate a securities case. If the fund is wrong, it walks away with no responsibility for having wasted the company's owners' wealth. This lack of reciprocity creates what economists call a perverse incentive.

Since “[t]he fund simply equate[d] a dropped stock price to fraud,” the court dismissed the securities fraud litigation brought against Men’s Wearhouse.

The primary materials for this case may be found at the DU Corporate Governance website.