Originally published on Forbes.com.
There are not many stories that hinge on an accountant being the key to the story behind the story. Even rarer, perhaps sui generis, is a story in which the income tax disclosures in financial statements are a critical piece. All this makes Société G é nérale Securities Services, GbmH v. Caterpillar, Inc irresistible. To me anyway. It was a class-action suit on behalf of people who purchased shares in Caterpillar from February 19, 2013, to March 1, 2017. The start date is based on the release of Caterpillar’s 2012 10-K. Besides Caterpillar, the defendants were Caterpillar executives James Umpleby III, Douglas R. Oberhelman, Bradley M. Halverson, James B. Buda, and Jananne A. Copeland. Here is a little background.
The Accountant At The Heart Of The Matter
Daniel Schlicksup is the accountant behind this drama. According to this story in Bloomberg – The Whistleblower Behind Caterpillar’s Massive Tax Headache Could Make $600 Million – he followed a pretty conventional path working for Arthur Andersen (RIP), then moving to PwC, where he worked on the Caterpillar account and then he went to work for Caterpillar’s tax department. That sent him the Europe where he helped establish Caterpillar’s international tax office and then back to Peoria where according to Bloomberg, he was appointed global tax strategy manager in 2005. That is when the relationship between Caterpillar and Mr. Schlicksup became strained, which led to litigation – Schlicksup v Caterpillar. You can get the flavor from Mr. Schlicksup’s deposition:
Mr. Burritt was very well aware of my capabilities.. He knew I was the only person not currently working in the tax department who was capable of understanding what had been going in the tax department in the previous number of years. So Mr. Burritt asked me to come back and help him control risks. I accepted the opportunity and I accepted it with the full understanding that Mr. Burritt wanted to hear about those risks.
In the fall of – at some point in 2005 I started to explain risks to Mr. Burritt that were significant to Caterpillar shareholders. There were risks related to misleading the investing public. There were risks related to lack of independence on the part of Price Waterhouse. There were risks related to misleading the board. There were risks related to misleading the executive office. There were significant risks. I reported them to Mr. Burritt and he retaliated specifically and quickly.
I reported Mr. Burritt to the Office of Business Practice.
Reading the deposition I see a bit of myself in Mr. Schlicksup. Only I am not as self-confident, courageous, or stubborn. After telling my immediate boss about the matter and being told that the PwC and the tax attorneys have blessed the arrangement, I probably would have figured “Not my circus. Not my monkeys.” And becoming an IRS whistleblower? That is extremely distasteful. Just saying.
At any rate that part about “misleading the investing public” has to do with tax disclosures.
Tax Provision
Sometimes I feel like I am the only person who ever reads the income tax disclosure footnotes in 10-Ks. A lot of work goes into them. It takes a special kind of geek to really engage in that area. You have to be immersed in both GAAP (generally accepted accounting principles) and corporate income tax at its most arcane. It is like the CPA equivalent of being both a cleric and a wizard. When FIN 48 came out, I studied it intensively with the hope that I would be able to join the Fellowship of the Tax Provision, but the managing partner ruled that I should stay in the high net worth group, so it seemed like it was for naught. Regardless, whenever I write about a tax decision concerning a public company, I will see how it is discussed in the income tax notes of the 10-K. And I will occasionally rant about journalists who confuse the income tax provision with the amount paid.
Anyway here is something from the discussion of business risks in the 2012 10-K:
We are also subject to the continuous examination of our income tax returns by the U.S. Internal Revenue Service and other tax authorities. The results of audit and examination of previously filed tax returns and continuing assessments of our tax exposures may have an adverse effect on the company’s provision for income taxes and cash tax liability.
There is a good bit of detail in the Income Tax note to the financial statements. For example:
The provision for income taxes for 2012 included a $300 million benefit for adjusting prior year taxes and interest primarily to reflect a settlement reached with the U.S. Internal Revenue Service (IRS) for tax years 2000 to 2006. The largest drivers of the settlement benefit were a $188 million benefit to remeasure and recognize previously unrecognized tax benefits and a $96 million benefit to adjust related interest and penalties, net of tax. This benefit was offset by a negative impact from nondeductible goodwill of $203 million related to the ERA Mining Machinery Limited (Siwei) goodwill impairment and $115 million related to the divestiture of portions of the Bucyrus distribution business. See Note 10 and Note 25 for more information.
There was nothing about Mr. Schkicksup’s concern that the PwC scheme to assign spare parts income to Switzerland, where there was a lower rate, was kind of sketchy. So when Caterpillar headquarters was raided on March 2, 2017, it was bad for the stock price. That story was covered on Forbes.com by Nathan Vardi and Antoine Gara.
The Complaint
The complaint by the plaintiffs states:
Throughout the Class Period, Defendants made materially false and misleading statements regarding the Company’s business, operational and compliance policies. Specifically, Defendants made false and/or misleading statements and/or failed to disclose that: (i) Caterpillar unlawfully used foreign subsidiaries to avoid paying billions of dollars in U.S. taxes; (ii) discovery of the foregoing conduct would subject the Company to heightened regulatory scrutiny and potential criminal sanctions; and (iii) as a result of the foregoing, Caterpillar’s public statements were materially false and misleading at all relevant times.
When you think about it, it is a little odd. You really can’t have a note in your financial statements that you are unlawfully using foreign subsidiaries to avoid paying billions in taxes, without accruing the taxes. At least that is my understanding of Fin 48. Of course, I never learned the secret handshake or got the decoder ring, so I can’t be sure.
When the nasty news broke Caterpillar’s stock fell by over 4%. That’s their beef although they go on about the perceived inadequacy of disclosure in years subsequent to 2013.
The Decision
The Court was having none of it and responded favorably to a motion to dismiss, although it was without prejudice. Here are some of the high points.
Citing the grand jury subpoena and execution of search warrants, Sociét é Gén é rale essentially argues that Caterpillar should have admitted a securities or tax law violation while the investigations were ongoing and the failure to do so was both a material omission and a misstatement. This Court finds such a position untenable. If every investigation or executed search warrant was evidence of wrongdoing then what purpose do hearings and trials have. As previously stated, securities laws generally do not impose such a duty upon publicly traded corporations to confess to uncharged, unadjudicated claims of wrongdoing. ….
Société G é nérale further claims that Caterpillar’s statements, regarding its compliance with the tax laws and its cooperation with the investigation, were false based on a report from an accounting professor, Dr. Robinson, that was prepared for the Senate Subcommittee hearings and was excerpted in the New York Times on March 7, 2017. Société G é nérale also points to a Wall Street Journal (“WSJ”) article from July 3, 2017. …..
Neither these reports nor the retirement or resignation of two senior executives suggests that Caterpillar did not believe that it complied with tax laws and was cooperating with the investigation. …
Even if Société G é nérale had sufficiently alleged false statements or omissions, the allegations supporting scienter fall short. To maintain a claim for securities fraud, Soci é té G é nérale must also allege with particularity facts giving rise to a strong inference that Caterpillar acted with the required state of mind. “For a case under section 10(b), that state of mind is ‘intent to deceive, demonstrated by knowledge of the statement’s falsity or reckless disregard of a substantial risk that the statement is false.’ ….
Under Section 20(a) of the Securities Exchange Act, Soci é té G é nérale must allege (1) a primary violation of securities law; (2) that each individual defendant exercised general control over the primary violator’s operations; and (3) that each individual defendant “possessed the power or ability to control the specific transaction or activity which the primary violation was predicated, whether or not that power was exercised. DH2, Inc. v. Athanassiades, 359 F. Supp. 2d 708, 719-20 (N.D. Ill. 2005) (citing Harrison v. Dean Witter Reynolds, Inc. , 974 F.2d 873, 881 (7th Cir.1992)). Because this Court has found no primary violation of securities laws, Société G é nérale cannot state a claim for control person liability under Section 20(a).
Too bad, it would have been interesting if it had kept going, particularly if there was featured testimony from someone who actually works on tax provisions.
Other Coverage
Wayne Grayson had a summary of the decision in Equipment World. Jonathan Stempel wrote – Caterpillar wins dismissal in U.S. of post-raid lawsuit tied to tax probes for Reuters. Jack Townsend on Federal Tax Crimes had Caterpillar Shareholder Suit For Fraudulent Disclosures from Tax Civil and Criminal Investigation Dismissed (9/28/18). Jack refers to the larger drama as the “Caterpillar kerfuffle”. Jack pulled some more of the high points out of the decision. Jack had covered the search in 2017 and also had something on the whistleblower story.
Referring to the Bloomberg article Jack writes:
The article identifies the whistleblower as Daniel Schlicksup, a Caterpillar accountant, and summarizes his saga from company curmudgeon trying to get the attention of superiors on the matter to finally whistleblower. A very good read.
Schlicksup’s journey is consistent with my experience with whistleblowers or persons considering becoming whistleblowers. All too often the company is just not interested in listening before the problems get out of hand. The wizards in the company buttressed by their outside professional enablers will not listen to naysayers , and often the internal mechanisms to elevate problems can be thwarted by power structures in the firm. That is not the way it is supposed to work, particularly for public companies, but unfortunately that is the way it sometimes works