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Lowinger v. Oberhelman

United States Court of Appeals, Seventh Circuit

May 9, 2019

Robert Lowinger, et al., Plaintiffs-Appellants,
Douglas R. Oberhelman, et al., Defendants-Appellees. v.

          Argued November 1, 2018

          Appeal from the United States District Court for the Central District of Illinois. No. l:15-cv-01109-SLD-JEH - SaraL. Darrow, Chief Judge.

          Before WOOD, Chief Judge, and Manion and ROVNER, Circuit Judges.

          WOOD, CHIEF JUDGE.

         In the fall of 2011 Caterpillar Inc. began making serious inquiries about the possible acquisition of a Chinese mining company, ERA Mining Machinery Ltd., and its wholly-owned subsidiary, Zhengzhou Siwei Mechanical & Electrical Equipment Manufacturing Co., Ltd. (We refer to the two companies as "Siwei" for simplicity.) Caterpillar completed that acquisition in June 2012. Only after the closing did Caterpillar gain access to Siwei's physical inventory. What it found was unsettling. An inspection of the inventory revealed that Siwei had overstated its profits and improperly recognized revenue. As a result, Caterpillar took a $580 million goodwill impairment charge just months after the acquisition was completed. Plaintiffs Robert Lowinger and Issek Fuchs, both Caterpillar shareholders, now bring this shareholder derivative suit alleging that several former Caterpillar officers breached their fiduciary duties by failing to conduct an adequate investigation of the Siwei acquisition. (We call them the Lowinger Plaintiffs.) That failure, they contend, caused Caterpillar's loss. The Lowinger Plaintiffs made a demand that the Caterpillar Board bring this litigation; the Board refused; and in this lawsuit, they argue that the Board's refusal was improper.

         The district court granted the Officers' motion to dismiss the complaint for failure adequately to allege that the Board wrongfully refused to pursue the Lowinger Plaintiffs' claim, Fed. R. Crv. P. 23.1(b)(3); it then denied plaintiffs' motion for leave to amend. We affirm.



         In 2010 Caterpillar, a construction and mining equipment manufacturer, was hoping to gain a greater foothold in the Chinese market. According to the Lowinger Plaintiffs- whose well pleaded allegations we must accept as true at this stage-in August of that year defendant Douglas Ober-helman, Caterpillar's then-CEO, told investors that Caterpillar was "stepping up big time" in the Chinese market and that "[W]e're going to win. We will win in China." Following this proclamation, defendants Edward Rapp, Caterpillar's CFO, and Steven Wunning, Caterpillar's Group President, began to advocate for Caterpillar to purchase Siwei, a Chinese mining company that manufactures hydraulic mining roof supports. (We refer to the defendants collectively as the Officers unless the context requires otherwise.)

         Caterpillar began its investigation of the Siwei acquisition in October 2011. To perform the necessary financial analysis, Caterpillar hired the accounting firm Ernst & Young ("E&Y"). E&Y's inquiry was limited, however, because Siwei's auditors refused to allow E&Y to review their audit work papers. Instead E&Y was forced to rely on oral statements from those auditors, along with Siwei's publicly reported financial statements. Despite the limited scope of its review, E&Y's report raised several financial red flags: Siwei's declining gross profit margins; long-aged accounts receivable; and working capital and cash flow problems. In its report, E&Y recommended that Caterpillar undertake additional investigation, but Caterpillar never did so. In addition to the issues identified by E&Y, an examination performed by a recently acquired Caterpillar subsidiary, Bucyrus International, Inc., suggested reasons for concern. Bucyrus's research, of which Caterpillar was aware, suggested that Siwei might be plagued by a host of potential fraud and anti-corruption problems. At least in part for those reasons, Bucyrus had scuttled its own attempted purchase of Siwei.

         As the acquisition process continued, other headaches emerged. Caterpillar discovered that Siwei needed an immediate $50 million loan; that Siwei's customers were not paying their bills on time; and that Siwei had engaged in several suspicious transactions with closely related parties, including its parent company's directors and its former CEO.

         Notwithstanding these alerts, Caterpillar entered into an acquisition agreement with Siwei in November 2011. Bad news was not far behind. In March 2012, before the acquisition was completed, Siwei informed Caterpillar that instead of the $16 million profit it was expected to report in 2011, it would record a $2 million loss. In its 2011 Annual Report, Siwei disclosed not only this loss, but numerous other troubles. For example, its accounts receivable had grown from 320 to 371 days outstanding, its "allowances for bad and doubtful debts" had increased over 450%, and its debt had ballooned. Siwei explained many of these issues as results of its aggressive attempts to gain market share at the expense of other metrics. Despite everything, on June 6, 2012, Caterpillar completed its tender offer to acquire Siwei for approximately $690 million.

         With the acquisition complete, Caterpillar gained access to Siwei's physical inventory. Only then did Caterpillar realize that discrepancies existed between Siwei's physical inventory and the inventories it recorded in its accounting records. The resulting investigation uncovered inappropriate accounting practices that led to overstated profit and early or unsupported revenue recognition. As a result, Caterpillar determined that it would have to recognize a $580 million loss in the form of a goodwill impairment charge. It announced this step publicly in January 2013. At the same time, Caterpillar's Board approved the departure of Luis de Leon, Caterpillar's mining product vice president, at least in part because of his role in the Siwei acquisition.

         After recording the $580 million goodwill impairment charge, Caterpillar retained the law firm Sidley Austin LLP to investigate the Siwei acquisition. In July 2013, Sidley provided a report to Caterpillar's board and audit committee detailing its findings. The Board then imposed financial penalties on some Caterpillar executives, including Oberhelman. Neither the amount ...

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