Securities Regulation Daily Wrap Up, FRAUD AND MANIPULATION—DNJ: Shareholders Show That A&P Misrepresented Goodwill Impairment and Concealed Liquidity Problems, (May 1, 2013)

By Rodney F. Tonkovic, J.D.

A motion to dismiss a fraud action brought against The Great Atlantic & Pacific Tea Company (A&P) was granted in part. The action was brought by A&P shareholders against A&P, several current or former officers and directors, and The Yucaipa Companies LLC (Yucaipa), a Los Angeles-based private equity firm. The fraud allegations centered around a goodwill impairment, A&P’s turnaround efforts, and A&P’s relationship with Yucaipa (Dudley v. Haub, April 30, 2013, Martini, W.).

Goodwill impairment. In 2007, A&P acquired Pathmark Stores, Inc. (Pathmark), a discount supermarket chain in which Yucaipa had been the majority shareholder. According to the complaint, while Pathmark represented a significant percentage of A&P’s business, A&P struggled to integrate the acquisition after discovering that it had numerous hidden liabilities that were not discovered during the due-diligence process. Following the acquisition, A&P’s stock losses ballooned; this was mostly attributable to Pathmark.

Yucaipa agreed to invest in A&P, conditioned on a notes offering and in exchange for an ownership interest. Following the announcement of the investment, A&P’s stock price rose. The investors alleged that A&P was able to conduct the notes offering on favorable terms because it materially misstated its income and assets. According to the investors, by the summer of 2009 there were numerous indicators that Pathmark’s goodwill was impaired, but no impairment was taken until January 2010. Following the announcement of the impairment, A&P’s stock price dropped by 21 percent.

Goodwill: misrepresentations. The court found that the shareholders plausibly alleged that A&P, and the CEOs and CFO during the relevant period, made material misrepresentations with respect to the goodwill impairment charge taken for Pathmark. There were numerous indicators of impairment by the summer of 2009, including enormous operating losses and price competition, and the magnitude of the impairment suggested that it should have been recorded earlier, the court stated. The court concluded that the allegations, taken as a whole, showed that the CEOs and CFO knew that Pathmark’s goodwill had been overvalued in the relevant quarters.

Goodwill: scienter. The court also found that the complaint sufficiently alleged scienter with respect to the goodwill impairments. The allegations of the indicators of impairment, when taken as a whole, gave rise to the strong inference that the impairment was consciously delayed so that A&P could secure desperately needed capital.

Turnaround efforts. The shareholders claimed that, during the class period, A&P made false statements about the progress it was making in implementing its turnaround initiatives, which included “building sustainable profitability” and improving operations. In reality, the shareholders asserted, A&P’s operational and financial conditions were deteriorating rapidly, and the turnaround efforts were being thwarted by high-cash burn and worsening liquidity. The shareholders maintained that the defendants knew that A&P’s poor credit rating, combined with tight global credit markets, meant that securing the financing necessary to maintain liquidity was unlikely and that its filing Chapter 11 in late 2010 was unavoidable.

Turnaround plan: misrepresentations. The complaint alleged that A&P failed to disclose that the Pathmark acquisition was a “complete disaster” and that there was no reasonable basis for the company’s positive statements. The court found that the majority of the alleged misrepresentations and omissions were non-actionable forward-looking statements. The statements were “vague projections of future performance” or merely conveyed managements; objectives and were accompanied by meaningful cautionary language. Most of the remaining statements were non-actionable statements of corporate optimism.

Two statements made during analyst calls, however, were found to be misleading. The court concluded that A&P’s CEO made false statements about its relationship with its vendors, which the CEO characterized as “supportive.” The court found it plausible that the omitted information, that the suppliers were seriously concerned about A&P’s creditworthiness, would have been considered material by a reasonable investor. Next, A&P’s Chief Administrative Officer made false statements about A&P defaulting on leases for closed stores. The court stated that this conduct was a possible early indicator of insolvency and would have been considered material.

The court also found that the complaint sufficient alleged scienter as to these statements to analysts. According to the court, the allegations gave rise to a strong inference that the executives consciously omitted negative information so that analysts and investors would not know the full extent of A&P’s liquidity crisis.

Relationship with Yucaipa. Throughout the class period, A&P made statements about its partnership with Yucaipa, representing that the firm was helping in turning around A&P’s fortunes and creating value for the shareholders. The shareholders, however, alleged that rather than being a partner, Yucaipa was planning to take over A&P run it as a private company after a Chapter 11 reorganization. When A&P emerged from bankruptcy in March 2012, Yucaipa had a minority interest in the newly privatized A&P, and its CEO became chairman of the board of directors.

Yucaipa: scienter. The court found that the shareholders failed to plead scienter with respect to the Yucaipa relationship. The allegations only gave rise to the inference that A&P had no knowledge of Yucaipa’s takeover plan. In fact, the court stated, the defendants “had every financial and professional incentive to keep A&P out of bankruptcy.” The complaint similarly failed to plead that the Yucaipa defendants acted with scienter. The court concluded that the more compelling inference was that Yucaipa sought to assist A&P’s turnaround efforts by investing substantial capital, but A&P still became insolvent.

Loss causation. The court then found that the complaint adequately alleged loss causation as to the goodwill impairment and the analyst statements. According to the court, the January 2010 announcement of the impairment was a corrective disclosure due to the significant drop in stock prices following the announcement. The statements in the analyst calls concealed A&P’s liquidity problems from the market, the court determined. When the liquidity problems were disclosed upon filing for bankruptcy, the effect on A&P stock was “devastating.”

The case is Civ. No. 2:11-cv-05196 (WJM).

Attorneys: Erin Whitney Boardman (Robbins Geller Rudman & Dowd, LLP) for City of New Haven Employees’ Retirement System and Plumbers and Pipefitters Locals 502 & 633 Pension Trust Fund. Peter S. Pearlman (Cohn, Lifland, Pearlman, Herrmann & Knopf, LLP) for Ricky Dudley. Lawrence M. Rolnick (Lowestein Sandler, PC) for Christian W.E. Haub. Michael S. Gordon (Katten, Muchin, Zavis & Rosenman) for Eric Claus. Allen W. Burton (O’Melveny & Myers, LLP) for Brenda M. Galgano. James L. Brochin (Paul, Weiss, Rifkind, Wharton, & Garrison, LLP) for Frederic F Brace.

Companies: Pathmark Stores, Inc.; The Great Atlantic & Pacific Tea Company; The Yucaipa Companies LLC

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