A Formula for Errors: Deferred maintenance, outsourcing, and stock fraud

A Formula For Errors

Deferred maintenance, outsourcing, and stock fraud

Stephen P. Prentice
Stephen P. Prentice

You might wonder why or how deferred maintenance and outsourcing has anything to do with stock fraud. Well, in this case it does. Read on . . .

The lawsuit
On March 3, 1999, long before Enron and similar cases came on the scene, the Teamster Joint Council Trust Fund (mechanics union) filed an action in the U.S. District Court of Arizona against an airline, its major shareholders, and some of its officers and directors. The Teamsters Trust Fund owned shares along with mechanics and others in this airline. The case alleged that the company made misleading statements to artificially inflate the value of its stock at the same time that controling shareholders engaged in "insider trading" making millions of dollars of profit, that is, they "bailed out" at the top. This is called a securities fraud class action case. The allegations were that the federal laws governing insider trading were violated. You may recall from recent news events following the Enron case that this is a hot topic now. The law also provides criminal sanctions where appropriate. As noted, this civil case was filed long before Enron and the other current cases involving corporate malfeasance surfaced.

Some history
In 1994 the airline filed for bankruptcy protection and during the reorganization efforts the investors who helped the airline back to solvency were given many shares of stock for their cash investments. The number of shares allowed these shareholders to have a controling interest in the airline. What you must remember at this point is this: When a company goes bankrupt shares become virtually worthless and all the shareholders usually lose their investment. In order to regain investors' confidence during reorganization the company must try to make it possible in some cases for the same losing investors and new ones to hang onto and enhance their investment, one way or the other.

Investors usually control a company by their ability to appoint directors and hire officers of the corporation. Directors also have a lot to do with the promotion, salaries, and bonuses handed out to officers. This is how it works.

New management - outsourcing
The Teamsters alleged in the complaint that the level and quality of maintenance on the airlines' aircraft had dangerously deteriorated during the term of a new executive officer. They alleged that during his term the rule was "don't gold plate the plane." This was further alleged to mean that mechanics were only to do the minimum required to get the job done. Open door and self-disclosure policies had been established with the Federal Aviation Administration (FAA), by the former chief executive. The former executive had maintained a cooperative environment with the FAA inspectors and he was highly praised by both FAA and his employees for his management and airline expertise. Alas, he was removed and replaced by the new director. The new man was alleged to be somewhat uninformed and uncooperative in regard to Federal Air Regulations (FARs) regarding outsourced maintenance and his responsibilities for quality control.

To those of us in the air carrier business self-disclosure is a well-known and frequently used program that allows a company to disclose violations of the FARs that it finds by itself. Reporting these violations before the FAA finds them can avoid fines or other sanctions, with certain restrictions (Advisory Circular 00-58). However, the program does open the door for further investigation of maintenance practices by the FAA inspectors charged with the duty to protect the public.

In addition, during this time the new executive fired half of the maintenance work force and maintenance was outsourced to a large third-party maintenance facility. The employees were fired and work was outsourced, it was alleged, so that costs could be further reduced.

The thrust of the complaint was that outsourced maintenance did not follow airline standards and therefore should have required intensive oversight by the airline. Little if any oversight existed in this case. The FAA found this to be true, in its opinion, and it pointed out that the airline was responsible for all the maintenance (FAR 121.363b), something that management failed to understand. Incredibly, the new executive was alleged to have stated that the responsibility for maintenance quality was in the hands of the third-party repair facility not his! FAA took strong enforcement action against the airline because of its poor maintenance record. The result was a $5 million settlement of the FAA enforcement cases. This was the largest fine ever imposed on an air carrier by the FAA.

Case theory and deferred maintenance
The plaintiffs in this case were required under the law to show that the company was involved in a continuing effort to reduce direct operating costs so that it could drive up operating profits. This would hopefully raise the stock price to a level where insiders could sell at a substantial profit.

The complaint alleged that a combination of things including firing 375 mechanics, deferring maintenance on the aircraft as long as possible, outsourcing maintenance, not performing required inspections (AD's), and some routine maintenance items, all contributed to driving down operating costs and raising operating income, thus making management look good, and raising the stock price.

Bottom line
In summary, the Teamsters-Mechanics Trust Fund was saying that this scheme to raise the stock price in fact succeeded by overstating the operating income of the company, outsourcing maintenance, ignoring or deferring maintenance, and firing mechanics. This, it was alleged, raised the stock price allowing insiders to sell their stock at a handsome profit because of what they knew.

Needless to say, a vigorous and detailed defense was included in a motion by the company and other defendants to dismiss the complaint for insufficiency of the evidence.

The outcome in the trial court
The District Court Judge in June of 2001, decided that the Teamsters had not presented sufficient evidence to support their case under the law and therefore dismissed the case on the motion by the defendants. The plaintiff's lost at this point!

The appeal - the plaintiffs turn it around!
The Teamsters and shareholders appealed the decision stating that the District Court erred in dismissing the complaint.

On Valentine's Day Feb. 14, 2003, the Appellate Court after reviewing all the facts presented, reversed the lower court decision, remanding the case back to the lower court for further proceedings. This usually means that the case will go to trial, or it could settle. The fat lady had sung!

The effect of current events
When this case was filed there was no Enron, or the other bankrupt companies that have come to light where corporate executives ran away from their responsibilities much to the detriment of employees and other stockholders. Maybe the quiet business climate of the time had something to do with the lower court dismissing the case. In June of 2001 the court found that the evidence did not support the position of the plaintiffs even though the airline management's conduct was suspect at that time.

One must remember that statements in a complaint are only "claims" and "allegations" that are designed to support the case for violation of the law, thus allowing the lawsuit to be filed. Everything in a civil case has to be proved by a preponderance of the evidence presented to a jury. Even though the allegations sounded onerous, the shares of stock sold, and profits made, the first court found that this was not enough to violate the federal law on the subject. One has to wonder that if Enron and its progeny had not occurred whether or not an appellate court would have reversed this decision.

Present climate
At this point in time there is little sympathy for companies, their executives, and controlling shareholders, who sell their stock at a profit and in essence bail out on their duties. We are all familiar with the plight of former employees of Enron and others who have lost their savings. Perhaps, when this appellate court looked at this case they found little sympathy for the defendants because of what has taken place since the case was dismissed in June of 2001. We'll never know for sure.

Today the business climate has changed dramatically for corporate officers and directors. They are being held to a much higher standard than in the past due to recent events. New legislation out of Congress (Sarbanes-Oxley) has enacted reforms in financial reporting, stock trading, retention of audit records (no more shredding), and other requirements designed to put pressure on management for ethical corporate conduct. One of the more important reforms still pending is the requirement that a firm have a majority of "outside" directors on its boards providing stronger oversight and making it harder for management to play games with the books.

The result
We have to keep in mind that this decision is simply a procedural decision that sends the case back to the first judge for trial by a jury. A jury will hear the evidence and decide on the merits of the case. The language of the appellate decision, however, tends to support the theory of the plaintiffs and gives them a leg up for settlement discussions.

Mechanics should have an interest in the outcome of this case so lets watch and see what happens when it gets back to the District Court in Arizona. The evidence and the testimony will involve many aspects of air carrier maintenance and procedures that you are all familiar with. If you have any comments or questions on this case or can add some details please forward them to the writer at aerolaw@att.net. Stand by for Part II!

Stephen P. Prentice is an attorney whose practice involves FAA-NTSB issues. He has an Airframe and Powerplant certificate and is an ATP rated pilot.