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Alaska Electrical Pension Fund v. Flotek Industries

United States Court of Appeals, Fifth Circuit

February 7, 2019

ALASKA ELECTRICAL PENSION FUND, Lead Plaintiff, Plaintiff-Appellant
v.
FLOTEK INDUSTRIES, INCORPORATED; JOHN W. CHISHOLM; H. RICHARD WALTON; ROBERT M. SCHMITZ, Defendants - Appellees

          Appeal from the United States District Court for the Southern District of Texas

          Before DENNIS, CLEMENT, and ENGELHARDT, Circuit Judges.

          JAMES L. ENNIS, CIRCUIT JUDGE.

         This appeal arises out of a putative class action filed on behalf of purchasers of Flotek Industries, Inc. common stock. Plaintiffs allege that defendants, Flotek and three of its officers, exaggerated the usefulness of its products. They allege misrepresentations relating to a proprietary software Flotek developed to help market these products. The district court dismissed the complaint, holding that plaintiffs had failed to plead facts giving rise to a strong inference of fraudulent scienter. We AFFIRM.

         I

         Plaintiffs filed this putative securities class action on behalf of investors who purchased Flotek common stock between October 23, 2014, and November 9, 2015. Defendants are Flotek Industries, Inc. and three of its officers: Chief Executive Officer (CEO) and President John W. Chisholm and Chief Financial Officers H. Richard Walton and Robert M. Schmitz. Flotek sells oilfield products called "Complex nano-Fluid technologies" (CnF), which are supposed to improve the productivity of oil and gas wells. According to the complaint, CnF is Flotek's "hallmark" product, and "[b]y the beginning of the Class Period, the Energy Chemistry Technologies segment [of Flotek] represented over 50% of the Company's revenue due to sales of its CnF products." This lawsuit concerns representations made about a software application Flotek developed to help market CnF to exploration and production companies. The software, called "FracMax," analyzes and presents data concerning hydraulically fractured wells to allow comparison of the productivity of oil and gas wells that use CnF with those that do not.

         Flotek introduced FracMax to investors at a June 2014 investor conference. Over the next sixteen months, "[D]efendants attended at least 21 conferences, including Flotek's earning conference calls, analyst-hosted conferences and [c]ompany-hosted investor conferences, where they focused on and praised FracMax and its ability to conclusively validate the efficacy and economic benefits of Flotek's CnF products." Defendants promoted FracMax as an integral component of Flotek's sales strategy and as "key to 'materially broaden[ing] the reach of Flotek's marketing efforts' for its CnF products." "[D]efendants reported that the FracMax database included production data from 80, 000 wells across key U.S. basins and that based on this data, Flotek's sales force could demonstrate to potential customers that the use of Flotek CnF chemistries added at least an estimated $8 billion in aggregate value for operators when compared to those operators that had not adopted Flotek's CnF products." In a 2015 press release, Chisholm, Flotek's President and CEO, stated, "Our FracMax software technology provides conclusive evidence that our [CnF] suite of completion chemistries provides compelling economic benefits to production companies." Flotek also represented in a quarterly earnings press release that sales of CnFs increased substantially because of FracMax.

         Although their complaint largely refers to Defendants generically, Plaintiffs' references to specific representations, to the extent they specify, primarily relate to statements made by Chisholm, who at various times emphasized FracMax's empirical validity. During several conference calls with investors, Chisholm explained that FracMax used publicly available data that companies self-reported to state agencies to compare production from wells that used CnF and wells that did not, suggesting this made FracMax's output more reliable. In September 2015, Chisholm gave a presentation at an investor conference in which he explained that FracMax used data reported to the Texas Railroad Commission, a state agency, and he suggested that the data was "back check[ed] and validate[d]." In his PowerPoint presentation, Chisholm presented an "About FracMax" slide stating that the data was "sourced from operator-provided completion data." This slide further stated that the data was "un-adjusted, providing for comparison and analysis of operators' self-reported data sets." Chisholm also presented images of the FracMax interface in order to compare the productivity of four Texas wells, one that used CnF and three that did not, again emphasizing the difference in production levels.

         On November 9, 2015, online financial publication Bronte Capital released a blog post (the Bronte Report) contending that the data in Chisholm's presentation was wrong and suggesting that the data had been intentionally altered to make CnF look significantly more effective. Specifically, the Bronte Report alleged that, as compared with the numbers reported by the Texas Railroad Commission, "Flotek had reduced the production data for the [three] non-CnF wells by 40% to 50% . . ., while leaving the production data for the CnF well unchanged." After release of the Bronte Report, Flotek shares declined.

         The next day, Flotek issued a press release conceding that Bronte Capital's analysis was correct, [1] and ascribing the error to data provided by a third party, Drillinginfo, that "caused FracMax to identify the three non-CnF wells as contained in units with multiple wells (as opposed to single well units), which required FracMax to incorrectly apply an allocation algorithm to the production for the non-CnF wells." According to Flotek, because Texas reports oil and gas production by lease, rather than by well, FracMax used an algorithm to apportion production within multiple-well lease units, leading to unwarranted adjustments of the non-CnF wells discussed at the September conference. Flotek also held a conference call, during which "Chisholm admitted that the Company's internal controls 'did not catch'" the errors, and "that the Company had no internal controls in place to check the accuracy of the third-party data from Drillinginfo." He explained that they did not cross-reference the third-party data against the underlying state-agency data and that the company "had, several months ago, evolved to a different allocation program" that would provide greater accuracy.

         According to Plaintiffs, a report issued by Iberia Capital Partners that same day "stated that the four wells presented at the September 11, 2015 investor conference were designated by Drillinginfo as being single well leases, not multiple leases, therefore the Texas Railroad Commission data for those wells did not require adjustment," and Flotek shares fell further as a result. Contrary to its earlier statements following the Bronte Report, Flotek then reported that an internal investigation concluded that the error originated in the software, not the data set, as Chisholm had stated earlier, and "most likely resulted from the accidental inclusion of test code by the third-party software developer . . . . who was hired to write code for FracMax."

         Plaintiffs filed this lawsuit, alleging violations of Section 10(b) of the Securities Exchange Act, 15 U.S.C. § 78j(b); Securities and Exchange Commission Rule 10b-5, 17 C.F.R. § 240.10b-5; and control person liability for the individual defendants under Section 20(a) of the Securities Exchange Act, 15 U.S.C. § 78t. Defendants filed a motion to dismiss the complaint for failure to state a claim. The district court dismissed the complaint, concluding that Plaintiffs had failed to sufficiently plead scienter. Plaintiffs timely appealed.

         II

         This court reviews the sufficiency of a complaint de novo. Ind. Elec. Workers' Pension Tr. Fund IBEW v. Shaw Grp., Inc., 537 F.3d 527, 533 (5th Cir. 2008). Plaintiffs' "well-pleaded facts are to be accepted as true and viewed in the light most favorable to [them]." Daugherty v. Convergent Outsourcing, Inc., 836 F.3d 507, 510 (5th Cir. 2016). "[C]onclusory allegations, unwarranted deductions, or legal conclusions" are not "well-pleaded facts" for purposes of evaluating a complaint. Southland Sec. Corp. v. INSpire Ins. Sols. Inc., 365 F.3d 353, 361 (5th Cir. 2004). Where fraud is alleged, Federal "Rule [of Civil Procedure] 9(b) creates a heightened pleading requirement that 'the circumstances constituting fraud or mistake shall be stated with particularity.'" U.S. ex rel. Rafizadeh v. Cont'l Common, Inc., 553 F.3d 869, 872 (5th Cir. 2008) ...


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