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In re Heckmann Corporation Securities Litigation

United States District Court, Third Circuit

June 6, 2013

IN RE HECKMANN CORPORATION SECURITIES LITIGATION.

REPORT AND RECOMMENDATIONS

MARY PAT THYNGE, Magistrate Judge.

I. INTRODUCTION

Lead plaintiff Matthew Haberkorn ("Haberkorn") and defendants[1] dispute over a shareholder-approved merger between the Heckmann Corporation ("Company") and China Water and Drinks, Inc. ("China Water").[2] The amended complaint, filed on October 8, 2010, asserts claims under ยงยง 10(b), 14(a), 20(a), and Rule 10b-5 of the Securities Exchange Act of 1934 ("Securities Exchange Act") on behalf of all shareholders who held stock in the Company as of September 15, 2008, and were entitled to vote on the merger, and on behalf of investors who acquired securities in the Company during the class period, May 20, 2008 to May 8, 2009.[3] The allegations are of fraud, recklessness, and materially false and misleading statements.[4]

Prior to the filing of the amended complaint, defendants moved to transfer to the Central District of California, [5] which this court denied.[6] On November 12, 2010, Haberkorn moved for partial modification of the Private Securities Litigation Reform Act ("PSLRA") discovery stay, [7] which this court also denied.[8] Defendants moved to dismiss pursuant to the Federal Rules of Civil Procedure 8(a), 9(b), 12(b)(2) and 12(b)(6); this motion was denied.[9]

On October 19, 2012, plaintiff filed a motion to certify the class.[10] Defendants filed its answer brief in opposition of the motion on January 1, 2013.[11] Further, defendants filed a motion to exclude the declaration of plaintiff's expert witness Zachary Nye, Ph.D.[12] Both of these issues are now before the court.

II. BACKGROUND

A. The Merger and Events Leading Thereto

The Company is a publicly traded, "blank check company" that acquires or obtains control of operating entities through various business combinations, such as stock acquisitions and mergers.[13] It is incorporated under Delaware law with its principle office in Palm Desert, California.[14] In this particular instance, the Company raised funds from public investors through an initial public offering ("IPO") promising to acquire a "qualifying" operating company using the IPO proceeds, which were held in escrow.[15] The certificate of incorporation required the Company be dissolved and the IPO proceeds returned to the shareholders if it failed to accomplish a business combination with an entity whose fair value was equal to at least 80% of the Company's net assets (a qualifying business combination) within twenty-four months of the IPO.[16] The founders of the Company, i.e., defendants, were not to receive any of the proceeds upon the Company's dissolution.[17]

The IPO was completed on November 16, 2007, raising approximately $432.9 million through the issuance of 54.1 million units at $8.00 per unit.[18] Each unit consisted of one share and one warrant, allowing the holder to purchase one share for $6.00.[19] The founders awarded themselves 14, 375, 000 units, or 20% of the Company, at $0.005 per unit, for a total investment of $71, 875.[20] The founders also agreed to invest $7 million in exchange for 7, 000, 000 warrants.[21] These funds were placed in escrow to be paid to shareholders if the Company failed to complete a qualifying business combination.[22] By October 30, 2008, the date of the shareholder vote, defendants would personally lose more than $287 million if the Company failed to acquire a qualifying business.[23]

On May 20, 2008, the Company publicized a merger agreement to acquire China Water and filed the agreement with the Securities and Exchange Commission ("SEC").[24] China Water, now incorporated under Delaware law, manufactures and distributes bottled water products in China.[25] The agreement contained statements, representations, and warranties regarding China Water's operations and financial condition, expressing, inter alia, that its financial statements did not contain any materially false or misleading statements or omissions.[26] It also stated that China Water possessed no undisclosed liabilities, paid all required taxes, and was in compliance with all applicable laws.[27] The purchase price was $625 million; $455 million in the Company's common stock and $170 million in cash.[28]

The Company praised China Water and the merger, stating that it was a "compelling" and "special opportunity."[29] Defendant Richard Heckmann, Chairman and CEO of the Company, projected $220 million in revenues and $70 million in net income for fiscal year 2008.[30] The merger agreement required the Company to hold in escrow 90% of the Company's shares given to Xu Hong Bin ("Xu"), CEO and president of China Water and a director of the Company, in exchange for his China Water shares.[31] The Company agreed to release 80% of Xu's escrowed shares on March 31, 2010, approximately eighteen months after the merger closing, and the remaining shares two years after the merger closing.[32]

On June 16, 2008, the Company filed a Form S-4 registration statement for the proposed merger with the SEC.[33] The Form disclosed several risk factors that included China Water's failure to: (1) maintain effective internal controls over its internal audit function because it lacked sufficient qualified personnel; (2) maintain effective internal controls over the financial closing process to ensure the accurate and timely preparation of local financial statements and financial data due to an insufficient number of qualified financial and accounting staff; and (3) adequately design and operate internal controls to support the requirements of the financial reporting and period-end closing process.[34]

The Form also described the due diligence conducted by Credit Suisse, one of the Company's financial advisors, which involved weeks of meetings in China and inspections of China Water's plants.[35] The Form acknowledged that even though extensive due diligence was performed, it could not assure that such diligence identified all material issues possibly existing in China Water or its business, or that factors outside of China Water's control would not later arise.[36] If such an issue arose, the Form noted it may result in losses, and the Company "may be forced to write-down or write-off assets, restructure operations, or incur impairment or other charges."[37]

The Form also stated the acquisition of China Water may negatively effect market perceptions of the Company or its common stock, and potentially cause violations of net worth requirements or other covenants due to post-combination debt financing.[38] These disclosures were repeated in amendments to the Form filed on July 25, August 22, September 30, and October 1, 2008, and the Form S-1 registration statement of October 23, 2008, and an amendment filed on November 5, 2008.

The merger was renegotiated allegedly due to market instability, resulting in the September 29, 2008 purchase price reduction to slightly over $400 million with $120 million less in cash consideration.[39] In addition, Xu agreed to reduce the cash proceeds he was to receive from the merger from $5.00 per share to $2.77 per share for his 5.4 million shares of China Water.[40] To induce China Water shareholders to do the same, Xu agreed to transfer 7.6 million of his China Water shares to its shareholders.[41]

On October 2, 2008, the Company issued the joint proxy and filed it with the SEC, recommending its shareholders to approve the merger.[42] The joint proxy included, inter alia, the merger agreement, a registration statement filed with the SEC, and the financial statements of China Water and the Company.[43] The proxy listed risk factors and deficiencies in China Water's internal controls, and stated its historical operating results may not provide a meaningful basis for evaluating its business, financial performance, and future prospects.[44] It also advised it was more than a remote likelihood that a material misstatement of the financial statement would not be prevented or detected on a timely basis by employees in their normal course of work.[45] The proxy restated the risk factors and the due diligence results described in Form S-4.[46] The proxy showed China Water had a net loss of $36.55 million in 2007 and a projected loss of $22.01 million for the first six months ending June 30, 2008.[47]

The Company nevertheless reassured investors in the proxy that it was comfortable with the stated deficiencies, that it expected China Water to achieve record results, [48] and that China Water's operations and value would exceed the qualifying business combination requirement.[49] Based on these and other reasons, the board of directors encouraged shareholders to vote in favor of the merger, and to amend the certificate of incorporation to provide for the Company's perpetual existence.[50] The change in the certificate would absolve the requirement that the Company dissolve and return the IPO funds if it failed to complete a qualifying business combination within twenty-four months of the IPO.[51] After soliciting votes through a joint Proxy/Prospectus, the merger was secured on October 30, 2008 at a special stockholder meeting, where the required majority voted to approve the merger and amend the certificate of incorporation.[52] The merger closed the same day.[53]

B. Post-Merger

Approximately five months after the merger, Xu resigned as president and CEO of China Water and from the Company's board of directors.[54] The agreement between Xu and the Company provided for the release of Xu's 3, 500, 000 shares in the Company and the Company's $14 million payment to Xu.[55]

On May 8, 2009, the Company issued its financial results for the first quarter following the merger.[56] It disclosed financial results inconsistent with China Water's historical and projected financial data, and China Water's value was written down by $184 million.[57] The Company revealed that China Water's prior management misrepresented the strength of its business, and may have diverted corporate assets.[58] It also advised 15, 527, 900 common shares and approximately 1.5 million shares underlying warrants issued to former China Water management and insiders were cancelled.[59]

The market reacted negatively to these disclosures by decreasing the price of the Company's common shares by 13.2%; $4.99 on May 7, 2009, to $4.33 the next day.[60] The price of the Company's warrants fell 25.5%, from $0.90 to $0.7075 during the same time frame.[61] By the third quarter after the merger, China Water's goodwill had been written down from $384.72 million, the date of the joint proxy, to $6.3 million.[62] On February 23, 2010, China Water's total value had been written down to $21 million, a 96% reduction from its $625 million initial price.

III. STANDARD FOR EXPERT TESTIMONY

The admissibility of expert testimony is governed by Federal Rule of Evidence ("FED. R. EVID.") 702, which states in pertinent part:

If scientific, technical or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training or education, may testify thereto in the form of an opinion or otherwise, if (1) the testimony is based upon sufficient facts or data, (2) the testimony is the product of reliable principles and methods, and (3) the witness has applied the principles and methods reliably to the facts of the case.[63] In Daubert v. Merrell Dow Pharmaceuticals, Inc., the Supreme Court interpreted

FED. R. EVID. 702 "confides to the judges some gatekeeping responsibility in deciding questions of the admissibility of proffered expert testimony."[64] The Third Circuit has analyzed Rule 702 as "embodying three distinct substantive restrictions on the admission of expert testimony: qualifications, reliability, and fit."[65] Important facts to consider in evaluating the reliability of a particular scientific or technical methodology include:

(1) whether a method consists of a testable hypothesis; (2) whether the method has been subject to peer review; (3) known or potential rate of error; (4) the existence and maintenance of standards controlling the technique's operation; (5) whether the method is generally accepted; (6) the relationship of the technique to methods which have been established to be reliable; (7) the qualifications of the expert witness testifying based on the methodology; and (8) the non-judicial uses to which the method has been put.[66]

"In Paoli, [the Third Circuit] explained that even if the judge believes there are better grounds for some alternative conclusion, ' and that there are some flaws in the scientist methods, if there are good grounds' for the expert's conclusions, it should be admitted."[67] The question of whether an expert's testimony is admissible based on his qualifications, reliability, and fit is committed to the court's discretion.[68]

The trial judge has broad latitude in determining whether the Daubert factors are reasonable measures of reliability.[69] In Paoli, the Third Circuit found that proffers of expert testimony do not have to "demonstrate... by a preponderance of evidence that the assessments of their experts are correct, they [need] only... demonstrate by a preponderance of evidence that their opinions are reliable."[70] Daubert recognized "vigorous cross examination, presentation of contrary evidence, and careful instruction on the burden of proof are the traditional and appropriate means of attacking shaky but admissible evidence."[71] Daubert emphasized the trial court must "focus" solely on principles and methodology, and not on the conclusions generated.[72] A trial judge, however, is to scrutinize whether such methods have been properly applied to the facts of the case.[73]

As previously stated, the determination of whether to exclude expert evidence is at the court's discretion.[74] The Third Circuit has noted, however:

While evidentiary rulings are generally subject to a particularly high level of deference because the trial court has a superior vantage point to assess the evidence..., evaluating the reliability of scientific methodologies and data does not generally involve assessing the truthfulness of the expert witness and thus is often not significantly more difficult on a cold record. Moreover, here there are factors that counsel in favor of a hard look at (more stringent review of) the district court's exercise of discretion. For example, because the reliability standard of 702 and 703 is somewhat amorphous, there is significant risk that district judges will set the threshold too high and will in fact force plaintiffs to prove their case twice. Reducing this risk is particularly important because the Federal Rules of Evidence display a preference for admissibility.[75]

The Third Circuit has identified several factors for the court to consider in determining whether to exclude expert testimony:[76]

(1) the prejudice or surprise in fact of the party against whom the excluded witness would have testified, (2) the ability of the party to cure the prejudice, (3) the extent to which waiver of the rule against calling unlisted witnesses would disrupt the orderly and efficient trial of the case or of other cases in the court, and ...

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