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Vitellone v. Evans

United States District Court, Fifth Circuit

December 20, 2013



EWING WERLEIN, Jr., District Judge.

Pending is Defendants' Motion to Dismiss (Document No. 13). After carefully considering the motion, response, reply, and applicable law, the Court concludes as follows.

I. Background

Plaintiff Joseph Vitellone, [1] derivatively on behalf of Magnum Hunter Resources Corporation ("Magnum Hunter" or the "Company"), brings this action against Defendants Gary C. Evans, Ronald D. Ormand, Fred J. Smith, Jr., H.C. Ferguson, III, James W. Denny, III, J. Raleigh Bailes, Sr., Brad Bynum, Stephen C. Hurley, Joe L. McClaugherty, Victor G. Carrillo, Steven A. Pfeifer, Jeff Swanson, and David S. Kreuger (collectively, "Defendants"), and nominal Defendant Magnum Hunter, a publicly-traded energy company incorporated in Delaware, for violation of Section 14(a) of the Exchange Act, breach of fiduciary duty, waste of corporate assets, and unjust enrichment.[2] Plaintiff's claims arise out of the alleged failure of Defendants, who are past or present officers and directors of Magnum Hunter, to ensure adequate financial controls during a period of rapid growth from 2010 to 2012 when, with a series of about a half dozen acquisitions in 2011 and 2012, Magnum Hunter's assets grew from $249 million to $2.19 billion.[3]

According to Plaintiff's Complaint, current management took control of a much smaller Magnum Hunter in 2009. Defendant Gary C. Evans became Magnum Hunter's Chief Executive Officer, Chairman of the Board, and a director in May 2009, and since then has continuously held those offices. Magnum Hunter's new management initially obtained its financial and internal accounting services from GreenHunter Energy, Inc. ("GreenHunter"), another energy company of which Defendant Evans was the founder, majority shareholder, Chairman, and CEO. Magnum Hunter's new management in 2009 also retained Hein & Associates, LLP ("Hein") as Magnum Hunter's external auditor.

In November 2010, Magnum Hunter announced plans to evaluate a number of joint venture and acquisition opportunities, and by February, 2011, the Company told investors that it anticipated substantial growth in 2011. The Complaint alleges that with the Company's new acquisitions its revenues and capital expenditures significantly increased in 2011. Indeed, the Complaint describes the Company as growing at a "breakneck pace" in 2011, which continued in 2012. By October 1, 2011, Magnum Hunter began using its own internal accounting and financial services and ceased to rely on GreenHunter for those services. What Plaintiff describes as the Company's "explosive growth" continued, and by June 1, 2012, Magnum Hunter disclosed in its Current Report on Form 8-K that although the audit committee initially selected Hein as the Company's independent auditor for fiscal 2012, Magnum Hunter had "concluded that it would be in the Company's best interest for the Company to engage a new independent registered public accounting firm for 2012 with a greater depth of resources...."[4] Magnum Hunter replaced Hein with Pricewaterhouse Coopers LLP ("PwC") as its external auditor.

PwC discovered previously unreported material weaknesses at Magnum Hunter, and on November 14, 2012, Magnum Hunter restated its second quarter 2012 Form 10-Q/A financial results, which increased its quarterly loss and disclosed certain accounting errors and material weaknesses in its internal controls over financial reporting. In portions of its November 14, 2012 restated Form 10-Q/A quoted in the Complaint, Magnum Hunter described multiple remediation actions, including that it had on October 23, 2012, hired a new Chief Accounting Officer who had the appropriate knowledge and experience to establish and maintain a desired control environment, was implementing more formalized processes and controls, was expanding its accounting department to respond to the Company's growth, and added an Assistant Controller, a Division Controller, an Internal Audit Manager, and other accounting personnel, all hired between July and November, 2012.

On November 15, 2012, according to the Complaint, Magnum Hunter filed with the SEC its Quarterly Report on Form 10-Q for the third quarter ending September 30, 2012. The Company acknowledged that as of September 30, 2012, the Company had material weaknesses in its disclosure controls and procedures, and that management was making changes to establish an environment necessary to prevent or detect potential deficiencies as also detailed in the restated second quarter 2012 Form 10-Q/A filed the previous day.

The Complaint alleges that the New York Stock Exchange ("NYSE") on October 16, 2012, notified Magnum Hunter that if it did not hold its 2012 annual shareholder meeting on the scheduled delayed date of January 17, 2013, the Company would risk violating the NYSE's listing standards. Magnum Hunter did hold its annual shareholder meeting on January 17, 2013, and the Company remained listed. On February 28, 2013, Magnum Hunter filed with the SEC a notification that its 2012 Form 10-K would be filed late, no later than March 18, 2013. The notice of late filing recalled previous filings by the Company disclosing material weaknesses in the Company's internal controls over financial reporting, lack of sufficient qualified personnel, etc., and the Company's implementation of numerous measures to address those weaknesses. The Company reported that its change of independent auditors from Hein to PwC, which occurred in July, 2012, had resulted in additional significant review of certain financial matters by the new auditors. Before the anticipated 2012 Form 10K late-filing date of March 18, 2013, however, Plaintiff alleges that PwC presented Magnum Hunter with a list of additional material weaknesses, which presumably required further delay in the Company's filing of its Form 10-K.

On March 18, 2013, Magnum Hunter issued a press release stating that it had had trouble keeping up with the accounting and operational challenges resulting from its rapid growth over the past two years, and that it continued to work diligently with PwC, its independent auditors, and was not aware of any disagreements with its auditors concerning the Company's fiscal 2012 financial statements. The press release disclosed that the Company's revenues had increased during 2012 by 141%, and that oil and gas production had increased 139%.

The Complaint alleges, however, that on April 16, 2013, Magnum Hunter filed with the SEC a Current Report on Form 8-K, disclosing that on April 10, 2013, at the direction of the audit committee, Magnum Hunter dismissed PwC as the Company's independent registered public accounting firm for the fiscal year ended December 31, 2012, effective immediately, and that the Board unanimously ratified and approved the decision. That April 16, 2013 Report, among other things, acknowledged that PwC had identified various material weaknesses at Magnum Hunter related to (1) the valuation of the Company's oil and gas properties; (2) the calculation of the Company's oil and gas reserves; (3) the Company's position with respect to certain tax matters; (4) the Company's accounting of its acquisition of NGAS Resources, Inc.; and (5) the Company's compliance with certain debt covenants. Two days after that filing, PwC informed Magnum Hunter and the SEC that it disagreed with a portion of Magnum Hunter's April 16, 2013 public statement, and that information had come to the attention of PwC that it concluded "materially impacts the fairness or reliability of the Company's consolidated financial statements and this issue was not resolved [to PwC's] satisfaction prior to [PwC's] dismissal." PwC also stated that it had advised the Company of PwC's belief that "the Company needs to evaluate the impact of the tone at the top' on the control environment." On this news, Magnum Hunter's stock took a plunge, "erasing more than $142.8 million in market capitalization in a few days."

Magnum Hunter replaced PwC with BDO USA, LLP ("BDO") as its external auditor, and two months later on June 14, 2013, the Company was able to file its delayed 2012 Form 10-K with the SEC. BDO-like PwC-found material weaknesses in Magnum Hunter's financial reporting, leasehold property costs, complex accounting issues, and income taxes. BDO's audit also found that Magnum Hunter lacked adequate internal controls over financial reporting, and the 2012 Form 10-K revealed that the SEC had inquired concerning Magnum Hunter's changes in its outside auditors, internal controls, and public statements to investors.

Plaintiff alleges that Defendants "repeatedly and inaccurately reported that the Company had sufficient internal controls and procedures relating to accounting systems, " caused Magnum Hunter to file multiple corrections to its SEC filings, required it to take an untimely $65 million impairment charge, and subjected the Company to at least six federal securities class action lawsuits on behalf of investors. Defendants' misconduct allegedly "wiped out more than $571.3 million in market capitalization, or 57.54%, from the Company's recent high of $993 million on February 22, 2012, " and "devastated the Company's market capitalization and reputation."[5]

Plaintiff contends that Defendants breached their duty of loyalty and good faith by causing or allowing Magnum Hunter to operate without adequate internal and financial controls, and breached their duty of loyalty by causing or allowing "the dissemination of SEC filings and public statements which they knew or were reckless in not knowing contained improper statements and omissions, including with respect to the Company's financial controls and business prospects." Plaintiff further alleges that Defendants Bailes, Bynum, Hurley and McClaugherty (collectively, the "Audit Committee Defendants"), had additional duties as members of Magnum Hunter's Audit Committee to review the effectiveness of the independent audit effort and to oversee the integrity of Magnum ...

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