Lowinger v. Oberhelman

924 F.3d 360

Robert LOWINGER, et al., Plaintiffs-Appellants,

v.Douglas R. OBERHELMAN, et al., Defendants-Appellees.

No. 18-1863

United States Court of Appeals, Seventh Circuit.

Argued November 1, 2018

Decided May 9, 2019

Jeffrey S. Abraham, Todd Kammerman, Attorneys, ABRAHAM, FRUCHTER & TWERSKY, LLP, New York, NY, for Plaintiffs-Appellants.

Walter C. Carlson, James W. Ducayet, Robert N. Hochman, Nilofer I. Umar, Attorney, SIDLEY AUSTIN LLP, Chicago, IL, for Defendants-Appellees.

Before Wood, Chief Judge, and Manion and Rovner, Circuit Judges.

Wood, Chief Judge.

In the fall of 2011 Caterpillar Inc. began making serious inquiries about the possible acquisition of a Chinese mining company, ERA Mining Machinery Ltd., and its wholly-owned subsidiary, Zhengzhou Siwei Mechanical & Electrical Equipment Manufacturing Co., Ltd. (We refer to the two companies as "Siwei" for simplicity.) Caterpillar completed that acquisition in June 2012. Only after the closing did Caterpillar gain access to Siwei’s physical inventory. What it found was unsettling. An inspection of the inventory revealed that Siwei had overstated its profits and improperly recognized revenue. As a result, Caterpillar took a $580 million goodwill impairment charge just months after the acquisition was completed. Plaintiffs Robert Lowinger and Issek Fuchs, both Caterpillar shareholders, now bring this shareholder derivative suit alleging that several former Caterpillar officers breached their fiduciary duties by failing to conduct an adequate investigation of the Siwei acquisition. (We call them the Lowinger Plaintiffs.) That failure, they contend, caused Caterpillar’s loss. The Lowinger Plaintiffs made a demand that the Caterpillar Board bring this litigation; the Board refused; and in this lawsuit, they argue that the Board’s refusal was improper.

The district court granted the Officers’ motion to dismiss the complaint for failure adequately to allege that the Board wrongfully refused to pursue the Lowinger Plaintiffs’ claim, FED. R. CIV. P . 23.1(b)(3) ; it then denied plaintiffs’ motion for leave to amend. We affirm.

I

A

In 2010 Caterpillar, a construction and mining equipment manufacturer, was hoping to gain a greater foothold in the Chinese market. According to the Lowinger Plaintiffs—whose well pleaded allegations we must accept as true at this stage—in August of that year defendant Douglas Oberhelman, Caterpillar’s then-CEO, told investors that Caterpillar was "stepping up big time" in the Chinese market and that "[W]e’re going to win. We will win in China." Following this proclamation, defendants Edward Rapp, Caterpillar’s CFO, and Steven Wunning, Caterpillar’s Group President, began to advocate for Caterpillar to purchase Siwei, a Chinese mining company that manufactures hydraulic mining roof supports. (We refer to the defendants collectively as the Officers unless the context requires otherwise.)

Caterpillar began its investigation of the Siwei acquisition in October 2011. To perform the necessary financial analysis, Caterpillar hired the accounting firm Ernst & Young ("E&Y"). E&Y’s inquiry was limited, however, because Siwei’s auditors refused to allow E&Y to review their audit work papers. Instead E&Y was forced to rely on oral statements from those auditors, along with Siwei’s publicly reported financial statements. Despite the limited scope of its review, E&Y’s report raised several financial red flags: Siwei’s declining gross profit margins; long-aged accounts receivable; and working capital and cash flow problems. In its report, E&Y recommended that Caterpillar undertake additional investigation, but Caterpillar never did so. In addition to the issues identified by E&Y, an examination performed by a recently acquired Caterpillar subsidiary, Bucyrus International, Inc., suggested reasons for concern. Bucyrus’s research, of which Caterpillar was aware, suggested that Siwei might be plagued by a host of potential fraud and anti-corruption problems. At least in part for those reasons, Bucyrus had scuttled its own attempted purchase of Siwei.

As the acquisition process continued, other headaches emerged. Caterpillar discovered that Siwei needed an immediate $50 million loan; that Siwei’s customers were not paying their bills on time; and that Siwei had engaged in several suspicious transactions with closely related parties, including its parent company’s directors and its former CEO.

Notwithstanding these alerts, Caterpillar entered into an acquisition agreement with Siwei in November 2011. Bad news was not far behind. In March 2012, before the acquisition was completed, Siwei informed Caterpillar that instead of the $16 million profit it was expected to report in 2011, it would record a $2 million loss. In its 2011 Annual Report, Siwei disclosed not only this loss, but numerous other troubles. For example, its accounts receivable had grown from 320 to 371 days outstanding, its "allowances for bad and doubtful debts" had increased over 450%, and its debt had ballooned. Siwei explained many of these issues as results of its aggressive attempts to gain market share at the expense of other metrics. Despite everything, on June 6, 2012, Caterpillar completed its tender offer to acquire Siwei for approximately $690 million.

With the acquisition complete, Caterpillar gained access to Siwei’s physical inventory. Only then did Caterpillar realize that discrepancies existed between Siwei’s physical inventory and the inventories it recorded in its accounting records. The resulting investigation uncovered inappropriate accounting practices that led to overstated profit and early or unsupported revenue recognition. As a result, Caterpillar determined that it would have to recognize a $580 million loss in the form of a goodwill impairment charge. It announced this step publicly in January 2013. At the same time, Caterpillar’s Board approved the departure of Luis de Leon, Caterpillar’s mining product vice president, at least in part because of his role in the Siwei acquisition.

After recording the $580 million goodwill impairment charge, Caterpillar retained the law firm Sidley Austin LLP to investigate the Siwei acquisition. In July 2013, Sidley provided a report to Caterpillar’s board and audit committee detailing its findings. The Board then imposed financial penalties on some Caterpillar executives, including Oberhelman. Neither the amount nor the existence of these penalties, however, was ever disclosed in Caterpillar’s public filings.

Shortly after this, several major corporate news outlets, including Forbes , Reuters , and the Financial Times , ran articles detailing the story of the acquisition and chiding Caterpillar and its board for what those outlets viewed as insufficient investigation and oversight. Several months after these stories ran, Caterpillar settled with Siwei’s former directors and controlling shareholders, releasing them from claims in exchange for a settlement that benefitted Caterpillar by $135 million for its 2013 second quarter results.

B

Litigation soon followed. First, a group of shareholders brought a derivative action based on a theory that the Board was conflicted and so it was futile to ask the Board to sue Caterpillar’s officers and directors (the "Demand Futility Action"). On June 25, 2014, while the Demand Futility Action was pending, the Lowinger Plaintiffs made a demand on the Board. They called on the Board to begin litigation against the Officers, or any other responsible party, with respect to the losses Caterpillar suffered because of the acquisition. The Board declined to respond formally to this demand, because if the Demand Futility Action was successful, shareholders would not need first to make a demand on the Board to bring litigation. It reasoned that any time or resources spent responding to the Lowinger Plaintiffs’ demand would in that case have been wasted. Also during this period, the Board declined to enter into any tolling agreements to suspend applicable statutes of limitation, as its counsel believed the Demand Futility Action tolled the relevant limitations periods.

The Board sought to stay this case while the Demand Futility Action remained pending, but the district court denied that request on March 28, 2016. At that point, the Board retained the law firm Jones Day to investigate the allegations in the Lowinger Plaintiffs’ demand. On November 1, 2016, Caterpillar provided the Lowinger Plaintiffs with a redacted version of Jones Day’s report. That report, based on interviews with 17 current and former Caterpillar employees and a consultation with a Jones Day partner with expertise in Chinese acquisitions, detailed Jones Day’s investigation into the Siwei acquisition. The report also contained analyses of the competing benefits and risks of bringing litigation, including the chance of success of a lawsuit against any Caterpillar officers or external advisors involved in the Siwei acquisition.

Jones Day ultimately concluded that the likelihood of success in litigation was slim, and that any potential success was likely to be undercut by Caterpillar’s duty to indemnify its former officers in most scenarios, as well as by business considerations (such as the hit to corporate morale that litigation might cause). Based on Jones Day’s report and recommendation, the Board refused the Lowinger Plaintiffs’ demand. The Lowinger Plaintiffs filed their complaint against the Officers in March 2015.

Rather than amending their complaint to reflect that refusal, the Lowinger Plaintiffs continued to argue that the Board’s initial delay in responding to their demand was sufficient by itself to allow them to pursue this litigation. The district court granted the Officers’ motion to dismiss that complaint, holding that the Board’s decision to delay was protected by the business judgment rule, but it gave the Lowinger Plaintiffs leave to amend. They did so, this time alleging that the Board’s refusal to accede to their demand was wrongful...