Brody v. RAM Trust Services

United States Court of Appeals
For the First Circuit

No. 03-2429

IN RE STONE & WEBSTER, INC., SECURITIES LITIGATION

ADELE BRODY, on behalf of herself and all others similarly
situated; FRED DUBOIS, JR., individually and on behalf of all
others similarly situated; ALBERT A. BLANK, on behalf of himself
and all others similarly situated; DAVID B. EVERSON, on behalf of
himself and all others similarly situated; FANNY MANDELBAUM, on
behalf of herself and all others similarly situated; MARK HANSON,
on behalf of himself and all others similarly situated,

Plaintiffs,

RAM TRUST SERVICES, INC., LENS INVESTMENT MANAGEMENT LLC,

Plaintiffs, Appellants,

v.

STONE & WEBSTER, INC., H. KERNER SMITH, THOMAS LANGFORD,
PRICEWATERHOUSECOOPERS, LLP,

Defendants, Appellees.

APPEAL FROM THE UNITED STATES DISTRICT COURT

FOR THE DISTRICT OF MASSACHUSETTS

[Hon. Reginald C. Lindsay, U.S. District Judge]

Before

Boudin, Chief Judge, Leval, Senior Circuit Judge,*
and Harrington, Senior District Judge.**

*
Of the Second Circuit, sitting by designation.
**
Of the District of Massachusetts, sitting by designation.
 Jay A. Eisenhofer, with whom Sidney S. Liebesman, P.
Bradford DeLeeuw, Grant & Eisenhofer, P.A., Norman M. Berman,
Bryan A. Wood, and Berman, Devalerio, Pease, Tabacco, Burt &
Pucillo were on brief for appellant.
Jordan D. Hershman, with whom Inez H. Friedman-Boyce, Anita
B. Bapooji, Meredith A. Wilson, and Testa, Hurwitz & Thibeault,
LLP were on brief for appellee Smith.
Peter M. Casey, with whom Christian M. Hoffman, Matthew E.
Miller, and Foley Hoag LLP were on brief for appellee
PricewaterhouseCoopers, LLP.
John D. Donovan, with whom Richard D. Batchelder, Jr. and
Ropes & Gray were on brief for appellee Langford.

July 14, 2005

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 LEVAL, Senior Circuit Judge. This appeal concerns primarily

the sufficiency of a complaint alleging securities fraud under the

standards of the Private Securities Litigation Reform Act

(“PSLRA”), 15 U.S.C. § 78u-4. With respect to most of the claims,

the United States District Court for the District of Massachusetts

granted the defendants’ motion to dismiss, based principally on the

court’s conclusion that the allegations were insufficient to

satisfy the PSLRA’s required pleading standards. On the remaining

claims, the district court granted summary judgment for defendants

and then entered a final judgment. We affirm the judgment as to

some of the claims and vacate as to others.

I. Background

The lead plaintiffs, Ram Trust Services, Inc. and Lens

Investment Management, LLC, are stockholders of Stone & Webster

Inc. (“S&W” or the “Company”), and purport to represent a class of

all purchasers of securities of S&W between January 22, 1998, and

May 8, 2000. They brought this consolidated securities-fraud class

action against S&W; its chairman, president, and chief executive

officer, H. Kerner Smith; its executive vice president and chief

financial officer, Thomas Langford; and its auditor,

PricewaterhouseCoopers, LLP (“PwC”). The claims against the

Company were stayed at the outset because it had filed for

protection under the bankruptcy laws. See 11 U.S.C. § 362. The

action proceeded against Smith, Langford, and PwC.

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 The very lengthy Amended Complaint (the “Complaint”) alleges

essentially that S&W, with the complicity of the other defendants,

issued fraudulent financial statements and press releases, designed

to conceal S&W’s rapidly worsening financial condition. It asserts

that S&W, a 111-year-old “global leader” in construction,

engineering, and consulting services, with consolidated gross

revenues in 1999 exceeding $1.2 billion, ¶ 14, began in 1998 to

experience rapid deterioration of its financial condition, which

Smith and Langford aimed to conceal while they sought a purchaser

for the Company. It alleges that PwC also concealed the Company’s

misleading accounting by making false statements to the effect that

S&W’s financial statements were prepared in accordance with

Generally Accepted Accounting Principles (“GAAP”), and that in

auditing and certifying S&W’s statements, PwC followed Generally

Accepted Accounting Standards (“GAAS”).

The Complaint’s strongest factual allegations fall into three

main categories, which will be explored in greater detail below.

They are, first, that S&W deliberately underbid on more than a

billion dollars of contracts, which at the contract price could be

performed only at a loss, and fraudulently reported anticipatory

profits on these loss contracts, so as to overstate earnings;

second, that S&W fraudulently concealed its loss on a huge contract

in Indonesia with Trans Pacific Petrochemical Indotama (“TPPI”) by

concealing the cancellation of the contract and thus reported

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unreceived revenues, inflating the Company’s profits or diminishing

its losses; and finally, that S&W made public statements, which

concealed and misrepresented its shortage of liquid reserves and

its impending bankruptcy, as its finances slid into shambles.

Based chiefly on these allegations, the defendants are alleged

to have violated § 10(b) of the Securities Exchange Act of 1934

(“Exchange Act” or “1934 Act”), 15 U.S.C. § 78j(b), and Rule 10b-5

promulgated thereunder, 17 C.F.R. § 240.10b-5, as well as § 18 of

the Exchange Act, 15 U.S.C. § 78r. In addition, Smith and Langford

are alleged to have violated § 20(a) of the Exchange Act, 15 U.S.C.

§ 78t(a), as persons in control of S&W.

II. Procedural History

In a memorandum and order dated March 28, 2003, the district

court dismissed all claims against PwC and nearly all claims

against Smith and Langford, finding that the Complaint failed to

satisfy the pleading requirements imposed by the PSLRA and Federal

Rule of Civil Procedure 9(b) for securities fraud claims. See In

re Stone & Webster, Inc., Sec. Litig., 253 F. Supp. 2d 102, 136 (D.

Mass. 2003). On August 25, 2003, the district court denied

plaintiffs’ motion for leave to amend its complaint, on the grounds

of undue delay. See In re Stone & Webster Inc., Sec. Litig., 217

F.R.D. 96 (D. Mass. 2003). On September 23, 2003, the court

granted summary judgment in favor of Smith and Langford as to the

remaining claims against them, and on September 24, 2003, entered

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final judgment.

III. Pertinent Elements of Plaintiffs’ Claims

The three different statutory bases of the claims under the

Exchange Act – § 10(b) and Rule 10b-5 promulgated thereunder

(“Rule 10b-5”), § 20(a), and § 18 – rest on slightly different

theories and thus have different elements, especially with respect

to a plaintiff’s need to plead and prove that the defendant acted

with a specified state of mind. These differences have a

significant effect on this appeal. A summary of the elements of

these three claims, to the extent pertinent to this dispute, is as

follows.

The Supreme Court has described the “basic elements” of a

claim under Rule 10b-5 as including: (1) “a material

misrepresentation (or omission)”; (2) “scienter, i.e., a wrongful

state of mind”; (3) “a connection with the purchase or sale of a

security”; (4) “reliance”; (5) “economic loss”; and (6) “loss

causation.” See Dura Pharm., Inc. v. Broudo, 125 S. Ct. 1627, 1631

(2005) (emphasis removed); see also Wortley v. Camplin, 333 F.3d

284, 294 (1st Cir. 2003); Geffon v. Micrion Corp., 249 F.3d 29, 34

(1st Cir. 2001). To prove scienter, a plaintiff “must show either

that the defendant[] consciously intended to defraud, or that they

acted with a high degree of recklessness.” Aldridge v. A.T. Cross

Corp., 284 F.3d 72, 82 (1st Cir. 2002).

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 To succeed on a claim under § 18,1 that statute appears to

require a plaintiff to plead and prove that (i) the defendant made

a false or misleading statement, (ii) the statement was contained

in a document “filed” pursuant to the Exchange Act or any rule or

regulation thereunder, (iii) reliance on the false statement, and

(iv) resulting loss to the plaintiff.2 Under this statute, unlike

1
Section 18 provides, in relevant part:

Any person who shall make or cause to be made any
statement in any application, report, or document filed
pursuant to this chapter or any rule or regulation
thereunder . . . which statement was at the time and in
the light of the circumstances under which it was made
false or misleading with respect to any material fact,
shall be liable to any person (not knowing that such
statement was false or misleading) who, in reliance upon
such statement, shall have purchased or sold a security
at a price which was affected by such statement, for
damages caused by such reliance, unless the person sued
shall prove that he acted in good faith and had no
knowledge that such statement was false or misleading. .
. .

15 U.S.C. § 78r(a).
2
With respect to the instant case, the district court ruled
that under § 18 plaintiffs must show specific reliance on an
allegedly misleading statement, and cannot rely on a presumption of
fraud on the market as in Rule 10b-5 cases. See In re Stone &
Webster, Inc., Sec. Litig., 253 F. Supp. 2d at 135 (citing Linder
Dividend Fund, Inc. v. Ernst & Young, 880 F. Supp. 49, 56-57 (D.
Mass. 1995)); see also Basic Inc. v. Levinson, 485 U.S. 224, 247
(1988). No party directly challenges that ruling in this appeal,
and so we have no reason to review it here. The district court
also read the Complaint as alleging reliance only by the named
plaintiffs and failing to allege reliance by the class plaintiffs,
thus permitting only the named plaintiffs to pursue § 18 claims.
See In re Stone & Webster, Inc., Sec. Litig., 253 F. Supp. 2d at
135. We are skeptical of this reading of the Complaint, especially
given the obligation to construe the Complaint in the light most
favorable to plaintiffs. However, we refrain from expressing

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Rule 10b-5, a plaintiff bears no burden of proving that the

defendant acted with any particular state of mind. See Magna

Invest. Corp. v. John Does One Through Two Hundred, 931 F.2d 38,

39-40 (11th Cir. 1991). The state of mind with which the defendant

acted enters the case instead as a defense. The statute provides

that the defendant can rebut liability by proving “that he acted in

good faith and had no knowledge that such statement was false or

misleading. . . .” See 15 U.S.C. § 78r(a).

Section 20(a) asserts the liability of persons exercising

control for violations of law by a controlled entity.3 Smith and

Langford are alleged to have exercised control over S&W, and

further views, as this finding by the district court was not
directly raised as part of the appeal, and we anticipate that it
will be subject to litigation on remand.
In addition, as among the array of documents alleged by
plaintiffs in their Complaint to contain false statements, only the
statements made in S&W’s annual (“10-K”) filings with the
Securities and Exchange Commission (“SEC”) are deemed “filed” for
the purposes of § 18. Again, the district court so ruled, id., and
no party challenges that determination in this appeal.

3
Section 20(a) provides:

Every person who, directly or indirectly, controls any
person liable under any provision of this chapter or of
any rule or regulation thereunder shall also be liable
jointly and severally with and to the same extent as such
controlled person to any person to whom such controlled
person is liable, unless the controlling person acted in
good faith and did not directly or indirectly induce the
act or acts constituting the violation or cause of
action.

15 U.S.C. 78t(a).

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therefore to share liability for S&W’s violations of Rule 10b-5.

The elements of § 20(a) are generally stated to be (i) an

underlying violation of the same chapter of the securities laws by

the controlled entity, here S&W; and (ii) control of the primary

violator by the defendant. See 15 U.S.C. § 78t(a); see also

Aldridge, 284 F.3d at 84-85.

As with § 18, and once again unlike Rule 10b-5, § 20(a) does

not on its face obligate the plaintiff to plead or prove scienter

(or any other state of mind) on the part of the controlling persons

named as a defendant.4 Instead, the burden is shifted. The

defendant can rebut liability by proving that he or she “acted in

good faith and did not directly or indirectly induce the act or

acts constituting the violation or cause of action.” See 15 U.S.C.

§ 78t(a).

IV. Standards Imposed by the PSLRA and Rule 9(b)

Three provisions of the PSLRA are of significance for this

appeal. The first is a pleading requirement, which specifies that

4
Some courts have indicated that the plaintiff must prove
“culpable participation” on the part of the controlling person.
See S.E.C. v. First Jersey Sec., Inc., 101 F.3d 1450, 1472 (2d Cir.
1996) (citing Gordon v. Burr, 506 F.2d 1080, 1085 (2d Cir. 1974));
Rochez Bros., Inc. v. Rhoades, 527 F.2d 880, 890 (3d Cir. 1975).
This Circuit has taken no position on the question. See Aldridge,
284 F.3d at 85. The district court in the instant case did not
rule on the question, see In re Stone & Webster, Inc., Sec. Litig.,
253 F. Supp. 2d at 135, and the parties did not brief it. We
therefore again take no position in this decision on whether
“culpable participation” is required, or on what it means.

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a complaint alleging securities fraud must “specify each statement

alleged to have been misleading, the reason or reasons why the

statement is misleading, and, if an allegation regarding the

statement or omission is made on information and belief, the

complaint shall state with particularity all facts on which that

belief is formed.” 15 U.S.C. § 78u-4(b)(1).5 In the body of this

opinion, we will refer to this provision of § 78u-4(b)(1) as the

PSLRA’s “clarity-and-basis” requirement. There is no dispute that

it applies to every claim alleged in the Complaint.

We have explained previously that to satisfy this provision,

a complaint “must provide factual support for the claim that the

statements or omissions were fraudulent, that is, facts that show

exactly why the statements or omissions were misleading.”

Aldridge, 284 F.3d at 78; see also Greebel v. FTP Software, Inc.,

194 F.3d 185, 193-94 (1st Cir. 1999). The plaintiff need not,

5
The full text of this provision reads:

In any private action arising under this chapter in which
the plaintiff alleges that the defendant--
(A) made an untrue statement of a material fact; or
(B) omitted to state a material fact necessary in order
to make the statements made, in the light of the
circumstances in which they were made, not misleading;

the complaint shall specify each statement alleged to
have been misleading, the reason or reasons why the
statement is misleading, and, if an allegation regarding
the statement or omission is made on information and
belief, the complaint shall state with particularity all
facts on which that belief is formed.

15 U.S.C. § 78u-4(b)(1).

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however, go so far as to “plead evidence.” See In re Cabletron

Sys., Inc., 311 F.3d 11, 33 (1st Cir. 2002).

The PSLRA’s clarity-and-basis requirement is closely related

to the requirement of Federal Rule of Civil Procedure 9(b) that in

“all averments of fraud or mistake, the circumstances constituting

fraud or mistake shall be stated with particularity.” We have

observed that the PSLRA’s pleading standard is “congruent and

consistent” with pre-existing Rule 9(b) pleading standards in this

Circuit. See Greebel, 194 F.3d at 193.

The second relevant PSLRA provision, also a pleading

requirement, provides,

in any private action arising under this chapter in which
the plaintiff may recover money damages only on proof
that the defendant acted with a particular state of mind,
the complaint shall, with respect to each act or omission
alleged to violate this chapter, state with particularity
facts giving rise to a strong inference that the
defendant acted with the required state of mind.

15 U.S.C. § 78u-4(b)(2). We have interpreted this provision as

demanding a recitation of facts supporting a “highly likely”

inference that the defendant acted with the required state of mind.

Aldridge, 284 F.3d at 82. We have explained, that “[u]nder the

PSLRA, the complaint must state with particularity facts that give

rise to a ‘strong inference’ of [the required state of mind],

rather than merely a reasonable inference. . . . The inference .

. . must be reasonable and strong, but need not be irrefutable.”

In re Cabletron Systems, Inc., 311 F.3d at 38 (quoting 15 U.S.C. §

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78u-4(b)(2)); see also Aldridge, 284 F.3d at 82. In this opinion,

we will refer to this provision of §78u-4(b)(2) as the “strong-

inference” requirement of the PSLRA.

In addition to these two pleading requirements, the PSLRA also

carves out a statutory safe-harbor for many “forward-looking”

statements. See 15 U.S.C. § 78u-5. “Forward-looking” statements

are, generally speaking, statements that speak predictively of the

future. See 15 U.S.C. § 78u-5(i)(1) (defining “forward-looking

statement”). Under the safe harbor provisions, fraudulent forward-

looking statements cannot give rise to liability in certain

circumstances, including where the statement at issue is

“identified as a forward-looking statement, and is accompanied by

meaningful cautionary statements identifying important factors that

could cause actual results to differ materially from those in the

forward-looking statement.” See 15 U.S.C. § 78u-5(c)(1).

The clarity-and-basis requirement of the PSLRA and its limited

safe harbor for forward-looking statements seem to apply equally to

claims under Rule 10b-5, § 18, and § 20(a). However, because Rule

10b-5, § 18, and § 20(a) differ as to whether the plaintiff must

prove that the defendant acted with a particular state of mind, the

PSLRA’s strong-inference requirement applies differently as among

the three theories.

By the terms of the PSLRA, the strong-inference requirement

applies only to private actions “in which the plaintiff may recover

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money damages only on proof that the defendant acted with a

particular state of mind.” A claim under Rule 10b-5 falls within

those parameters. Under 10b-5 the plaintiff must prove that the

defendant acted with scienter. Thus, the PSLRA requires that the

Complaint allege with particularity facts giving rise to a strong

inference of scienter. In contrast, §§ 18 and 20(a) do not, at

least on their face, require that the plaintiff prove that the

defendant acted with any particular state of mind. The strong-

inference requirement of the PSLRA therefore has no application to

claims under these statutes.6

V. Applicable Accounting Standards

Before turning to the precise allegations of the Complaint, we

6
As noted above in footnote four, this Circuit has taken no
position on the question whether a plaintiff must prove “culpable
participation” on the part of the defendant in order to prevail
under § 20(a). See Aldridge, 284 F.3d at 85. “Culpable
participation” would seem to imply a culpable state of mind. If
that is an element of a claim under § 20(a), the PSLRA’s strong-
inference requirement would appear to apply, as well.
Because defendants have not argued on appeal that “culpable
participation” in an element of plaintiffs’ case under § 20(a), we
will assume throughout this opinion that it is not an element and
that the strong-inference requirement of the PSLRA accordingly has
no application to a claim under § 20(a). It is not our intention,
however, to foreclose that question. As we are remanding several
claims under § 20(a), we leave it to the district court to
determine, in the first instance, if the issue is raised, whether
“culpable participation” applies. Should the district court
determine that “culpable participation” is an element of a claim
under § 20(a) and that the strong-inference requirement of the
PSLRA therefore applies, this may require the dismissal of claims
we have remanded. Because of the commonality of elements of claims
under §§ 20(a) and 18, rulings one way or another in the district
court as to § 18 may well moot the question whether § 20(a)
requires “culpable participation.”

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pause to discuss briefly certain accounting standards for long-term

construction contracts, which are integral to an understanding of

the Complaint.

Long-term construction contracts can characteristically

involve early periods during which the contractor’s expenditures

far exceed its revenues and later periods during which its revenues

far exceed expenditures. Depending how the revenues and

expenditures are accounted for, the profit and loss statements of

contractors engaged in such long-term construction projects might

present the appearance of drastic gyrations, beginning with large

losses and later shifting to large profits, even though on a

sophisticated analysis, the company’s experience would reflect a

predictable, orderly progress toward a predictable result.

To counteract such misleading appearances of unpredictable

gyrations, and present a more realistic picture of the stability of

operating results, the accounting profession has developed, as part

of GAAP, two accounting methods designed in proper circumstances to

smooth out the reported operating results of such businesses. The

Complaint points to, and quotes extensively from, three accounting

documents, which provide guidance: American Institute of Certified

Public Accountants Statement of Position 81-1: Accounting for

Performance of Construction-Type and Certain Production-Type

Contracts (1981) (“SOP 81-1”), see ¶ 40, Accounting Research

Bulletin 45: Long-Term Construction-Type Contracts (1955) (“ARB

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45”), see id., and Financial Accounting Standards Board Statement

of Financial Accounting Standards No. 5 (“FAS 5"), see, e.g., ¶¶

44, 76.

According to SOP 81-1 and ARB 45, as we understand them, the

most favored method for a contractor to account for long-term

construction contracts, in appropriate circumstances, is

“percentage-of-completion” accounting. Under this approach, the

contractor recognizes revenues expected to be received in the

future, as well as net profits expected to be realized, as work on

a contract progresses, notwithstanding that the contractor may not

yet have received payment. In appropriate circumstances, this

accounting method is thought to best reflect the actual “economic

substance” of a contractor’s transactions and therefore to be

preferable. SOP 81-1 ¶¶ .22, .25. Under percentage-of-completion

accounting, generally speaking, regardless of whether revenues have

been received, a company recognizes as current revenue on its

profit and loss statement that percentage of total expected

revenue, which reflects the percentage that the costs incurred in

the period bear to total estimated costs on the project. ARB 45 ¶

4. Various conditions must be present to justify the use of this

method, such as the expectation that the buyer will satisfy its

obligations under the contract, and “the ability to make reasonably

dependable estimates,” including “estimates of the extent of

progress toward completion, contract revenues, and contract costs.”

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SOP 81-1 ¶ .23. The current recognition of expected future profit,

furthermore, presupposes that the contract be expected to yield a

profit. See id. ¶¶ .25, .85.

The second generally accepted method of accounting for such

contracts is called the completed-contract method. See generally

id. ¶¶ .04, .30-.33. Under this method, “income is recognized only

when a contract is completed or substantially completed.“ Id. ¶

.30. Until that point, for the duration of contract performance,

“billings and costs are accumulated on the balance sheet, but no

profit or income is recorded.” Id. The completed-contract method

is viewed as preferable when reasonably dependable estimates cannot

be made or “inherent hazards” relating to contract conditions make

profit predictions unreliable. See id. ¶ .32. A recognized

weakness of the completed-contract method is that it “does not

reflect current performance when the period of a contract extends

beyond one accounting period,” and “may result in irregular

recognition of income.” See id. ¶ .30.

Third, in circumstances where “estimating the final outcome

may be impractical except to assure that no loss will be incurred,”

percentage-of-completion accounting, with a zero estimate of

profit, may be utilized. See id. ¶ .25. In doing so, a company

recognizes revenues (even though not yet received) equal to its

costs incurred in the period “until results can be estimated more

precisely.” Id.

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 This zero-profit-margin approach resembles the completed-

contract method in some respects and resembles percentage-of-

completion in others. The similarity to completed-contract lies in

the fact that, under both methods, no estimated future profit is

recognized on a current basis as the job progresses. Profit is

recognized only upon substantial completion. Its greater

resemblance to percentage-of-completion lies in the fact that

current costs, matched by equal amounts of anticipated revenue, are

recognized in the current profit and loss statement, while under

the completed-contract method, neither costs nor revenues from the

project are reflected in the current profit and loss statement

until substantial completion of the project.7 See id. ¶ .33.

Thus, the zero-profit-margin approach provides an indication in

the income statement of the “volume of a company’s business”

activity while the completed-contract approach does not. Id.

Regardless of the method employed, however, anticipated losses

are accounted for differently from anticipated profits. “[W]hen

7
SOP 81-1 states:

Under the zero profit margin approach to applying the
percentage-of-completion method, equal amounts of revenue
and cost, measured on the basis of performance during the
period, are presented in the income statement; whereas,
under the completed-contract method, performance for a
period is not reflected in the income statement, and no
amount is presented in the income statement until the
contract is completed.

SOP 81-1 ¶ .33.

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the current estimates of total contract revenue and contract cost

indicate a loss, a provision for the entire loss on the contract

should be made.” Id. ¶ .85; see also ARB 45 ¶¶ 6, 11. Such

provision for losses should be made “in the period in which they

become evident.” SOP 81-1 ¶ .85.

The full amount of a “probable” loss should be taken as a

charge against income if the amount of the loss “can be reasonably

estimated,” according to FAS 5. See FAS 5 ¶ 8. If the amount of

the loss cannot be reasonably estimated, “disclosure of the

contingency shall [instead] be made . . . indicat[ing] the nature

of the contingency and . . . giv[ing] an estimate of the possible

loss or range of loss” where possible. Id. ¶ 10. Likewise, if

there is only a “reasonable possibility” of a loss instead of a

“probable” loss, disclosure instead of accrual is appropriate. Id.

“Probable” is defined by FAS 5 to mean “likely to occur.” Id. ¶ 3.

VI. Discussion

A. Allegations of the Complaint as to Smith and Langford

Against this background of pertinent legal rules and

accounting principles, we turn to the central allegations in the

Complaint, which as noted earlier, can be grouped into three

general categories.

1. Underbid Projects

The first category of plaintiffs’ claims principally relates

to the allegation that S&W underbid various projects and

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fraudulently reported expected profits from these projects when, in

fact, the projects were expected to produce losses. The district

court dismissed all of these claims on the ground that the pleading

failed to satisfy the PSLRA’s requirement of clarity and basis. We

conclude that at least with respect to some of the claims, the

clarity-and-basis requirement was satisfied.

(a) PSLRA’s requirement of clarity and basis. In our view,

this pleading is not the kind of vague prelude to a fishing

expedition that Congress sought to bar by imposing the clarity-and-

basis requirement of the PSLRA. Citing sources within the company,

the Complaint alleges that S&W developed a strategy of bidding a

number of projects at a loss. ¶¶ 52-53. The Complaint expressly

names ten contracts, aggregating over $1.4 billion, which allegedly

were underbid by margins between 10% and 40% and were expected to

produce losses. ¶¶ 58-61. The Complaint alleges that the Company

accounted for these projects using percentage-of-completion

accounting, recognizing a proration of anticipated future profits

in the current profit and loss statements, notwithstanding that

losses, rather than profits, were expected to result from these

contracts. ¶¶ 43, 47, 168. The Complaint refers to SOP 81-1,

which forbids the use of the percentage-of-completion method to

prorate anticipated future profits into current operating results

unless future profits are in fact anticipated, see SOP 81-1 ¶¶ .24-

.25, as well as FAS 5, which requires immediate recognition of

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expected losses, as soon as they are anticipated, see FAS 5 ¶ 8;

SOP 81-1, ¶¶ .24, .85. The Complaint identifies with precision

statements alleged to be false, including S&W’s periodic current

earnings figures in its sequential profit and loss statements

during the period of the alleged fraud.

With respect to clarity, the Complaint sets forth a clear and

precise statement of what the alleged fraud consisted of. With

respect to basis, while the sources of information on which the

Complaint relies for these allegations are not overwhelmingly

impressive, they include sources within the Company who might well

have access to the kind of information for which they are cited.

Furthermore, the allegations are not merely conclusory, but are

rather supported by details that provide factual support for

plaintiffs’ allegations of fraud.

We find that these pleadings complied sufficiently with

PSLRA’s requirement of clarity and basis, as well as with the

preexisting requirements of Rule 9(b). See Fed. R. Civ. P. 9(b).

We have previously stated that PSLRA does not require the plaintiff

to “plead evidence.” See In re Cabletron Systems, Inc., 311 F.3d

at 33. As we understand, it was not Congress’s intention to bar

all suits as to which the plaintiff could not yet prove a prima

facie case at the time of the complaint, but rather to prevent

suits based on a guess that fraud may be found, without reasonable

basis or a clear understanding as to what the fraud consisted of,

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but in the hope of finding something in the course of discovery.

Cf. In re Cabletron Systems, Inc., 311 F.3d at 30 (observing that

the “statute was designed to erect barriers to frivolous strike

suits, but not to make meritorious claims impossible to bring”).

To the extent that the district court dismissed these claims

on the grounds that they failed to satisfy the clarity-and-basis

requirement of PSLRA, we respectfully disagree. It does not

necessarily follow, however, that the dismissal of all of those

claims should be vacated. We believe some of the claims relating

to the underbidding of contracts were fatally flawed for other

reasons and thus affirm the dismissal as to some of them.

(b) Strong inference of scienter. As noted, the PSLRA

imposes an additional hurdle: The Complaint must allege facts

supporting a strong inference of whatever state of mind on the part

of the defendant must be proved as an element of the claim.

(i) Claims under 10b-5. To the extent these claims are

asserted under Rule 10b-5, the plaintiffs must prove that the

defendants acted with scienter in order to establish their right of

recovery. Accordingly, under the PSLRA, the Complaint must state

with particularity facts giving rise to a strong inference that the

defendants acted with either knowing, intentional falsity or

reckless disregard for the truthfulness of the statements.

We find the Complaint deficient in this respect. First, the

Complaint provides nothing supporting the inference that either

-21-
Smith or Langford was directly involved in the detailed accounting

for these ten particular contracts, or had knowledge of the alleged

falsity. One could draw the inference that Langford, as the Chief

Financial Officer, had some supervisory involvement with the

accounting. But no strong inference necessarily follows that the

Chief Financial Officer, much less the Chief Executive Officer, was

aware of the improper proration of future profits on any particular

underbid contract.

This weakness is accentuated by another. The larger the

distortion of the company’s accounting figures, the more likely it

might be that such distortion could not be accomplished without

either complicity, or reckless irresponsibility, of top officers.

The Complaint, however, gives no indication whatsoever what the

size of the alleged overstatement of current profits was. Such an

overstatement, in the circumstances alleged, would result primarily

from two variables – the size of the expected future loss which

should have been taken as a charge against current earnings, see

FAS 5 ¶ 8, and the size of the improperly anticipated future

profits prorated into the current profit and loss statement. The

Complaint says nothing of the size of either component.

Indeed, the Complaint at times does not even assert that a

loss was expected from these underbid contracts. Its description

of the “underbidding policy” asserts that Smith planned the

“selling [of] fixed-price jobs either at a loss or with such small

-22-
margin for error that the slightest adverse change in a project’s

economics would cause S&W to lose money on the job.” ¶ 53

(emphasis added). According to this description, the contracts

were bid near the expected break-even point, or with the

expectation of a small and unreliable profit, rather than with

expectation of a loss.

We recognize that in assessing a motion to dismiss for

insufficient pleading, we must read the Complaint in the manner

most favorable to the plaintiff, drawing reasonable inferences in

the plaintiff’s favor, see Aldridge, 284 F.3d at 79, and that

inconsistent pleading does not deprive the pleader of the right to

have the complaint read, as between the inconsistencies, in the

manner that supports the adequacy of the pleading. The PSLRA’s

strong-inference requirement does not change this rule.8 Because

8
One difficulty we find with the district court’s decision is
that in several instances, in ruling on defendants’ motion to
dismiss under Federal Rule of Civil Procedure 12(b)(6), the court
failed to read the Complaint in the light most favorable to the
plaintiff and failed to give the plaintiff the benefit of
inferences that could reasonably be drawn. For example, where the
court found “internal inconsisten[cies]” in the allegations, it
concluded that the conflicting allegations “undermine[d] the
sufficiency of [the] claim.” See In re Stone & Webster, Inc., Sec.
Litig., 253 F. Supp. 2d at 120-21.
A plaintiff has the right to plead in the alternative, and the
plaintiff’s doing so does not undermine the validity of the
complaint. The stronger of the conflicting allegations must be
accepted as if the conflicting alternative allegation had not been
included. Nor is this changed by the PSLRA’s strong-inference
requirement. In assessing whether the pleading satisfies the
strong-inference requirement, a court must draw all reasonable
inferences in the plaintiff’s favor, and then weigh whether they
satisfy the statutorily mandated “strong inference.” See Aldridge,

-23-
the Complaint elsewhere asserts that the ten projects were bid “at

a loss,” ¶ 58, we credit the Complaint as asserting that the

projects were indeed bid at a loss, rather than at the break-even

point or at a slight profit. Nonetheless, the Complaint in no way

suggests that the losses anticipated from these contracts were

large.

At one point, the Complaint asserts that “[a]ccording to . .

. former S&W insiders, S&W’s underbidding [of those contracts]

ranged from 10% to 40%.” ¶ 61. But it says nothing about how much

loss would be expected to result from underbidding by 10% to 40%.

That would depend on the anticipated profit margins of a normal

bid, not affected by the underbidding strategy, and the Complaint

includes no allegation about that. Nor does the Complaint allege

what percentage of the Company’s net operating figures were

attributable to the ten contracts.

In short, the Complaint tells no more than that, in the

accounting for ten contracts, a profit of unspecified size was

recognized in current earnings when, according to GAAP principles,

those contracts should have been booked either as a loss of

unspecified size or using a zero-profit-margin assumption coupled

with a note describing a loss contingency. As anything above the

break-even point represents profit, and anything below the break-

even point represents loss, the difference between profit and loss

284 F.3d at 78; Greebel, 194 F.3d at 201.

-24-
can on a particular contract be tiny. Nothing in the Complaint

suggests that correct accounting for these contracts would have

involved significantly different overall numbers from those

produced by the allegedly incorrect accounting. And if the

accounting for those contracts had no significant effect on the

Company’s overall results, there is little reason to assume that

the Company’s CEO and CFO must have known about the failure to

follow accepted accounting practices. Irregular financial

statements which overstate estimated results to only a small degree

do not support a strong inference that the Chief Executive Office

or the Chief Financial Officer of the company acted with intent to

defraud, or with reckless disregard for the truth of the

statements.

A third significant weakness in the alleged basis of scienter

is that in such accounting, the question whether to recognize

profit or loss depends not on concrete facts but an estimation or

prediction of whether in the end the project will net a profit or

a loss. The Complaint fails to allege particularized facts

supporting the inference that a reasonable assessment of the facts

relating to those underbid contracts could support a prediction

only of loss.9

9
In addition, we agree with the district court that Smith and
Langford’s change-in-control agreements did not provide a strong
motive to engage in fraud. See In re Stone & Webster, Inc., Sec.
Litig., 253 F. Supp. 2d at 127-28.

-25-
 Accordingly, we determine that the claims of fraud for

improper proration of future profits on these ten allegedly

underbid contracts, to the extent asserted under Rule 10b-5, as to

which “the plaintiff may recover money damages only on proof that

the defendant acted with [scienter],” fail the requirement of the

PSLRA that “the complaint . . . state with particularity facts

giving rise to a strong inference that the defendant acted with

[scienter].” 15 U.S.C. § 78u-4(b)(2). As to those 10b-5 claims,

we affirm the judgment of the district court dismissing them.

We reach a different result, however, where those claims are

asserted under §§ 20(a) and 18.

(ii) Claims under §§ 20(a) and 18. As explained above,

the PSLRA’s strong-inference requirement does not apply to claims

under § 20(a), because this statute does not require proof of the

defendant’s state of mind.10

We recognize that a plaintiff must show under § 20(a) that the

controlled entity committed a violation of the securities laws. If

that violation was, for example, a violation of Rule 10b-5, which

requires a proof of scienter, then the plaintiff under § 20(a) must

prove that the controlled entity acted with “a particular state of

mind.” Nonetheless, if the statute is read literally, the strong-

inference requirement of the PSLRA does not apply. The statute

states that the strong-inference requirement applies only where the

10
See, though, supra note 6.

-26-
plaintiff’s recovery depends on proof that “the defendant acted

with a particular state of mind” (emphasis added). See 15 U.S.C.

§ 78u-4(b)(2). The obligation to prove that the controlled

corporation acted with scienter does not involve an obligation to

prove “that the defendant acted with a particular state of mind.”11

Section 18 similarly imposes no burden on plaintiff to prove

the defendant’s state of mind, shifting the burden to the defendant

to show “that he acted in good faith and had no knowledge that such

statement was false or misleading.” See 15 U.S.C. § 78r(a).

Accordingly, the strong-inference requirement of the PSLRA has no

application to § 18.

With respect to the claims under §§ 20(a) and 18 based on

improper recognition of anticipated profits on underbid contracts,

(1) we reject the reasons given by the district court for

dismissing these claims, and (2) we conclude that the reasons which

support our order of dismissal of the similar claim under Rule 10b-

5 have no application to these claims. Accordingly we vacate the

judgment dismissing them. As to whether one or both of those

claims is subject to possible dismissal for other reasons, we

11
We recognize that this plain language reading of the PSLRA
allows the secondary liability claims to go forward where claims of
primary liability have been dismissed. There may be policy
arguments counseling for a broader reading of the PSLRA. As to
this case, however, such arguments have not been made and we
therefore do not consider them. For purposes of this case, we read
the PSLRA as written, leaving the question whether the statute
should be interpreted more broadly to be addressed if and when such
argument is advanced.

-27-
express no view. We remand the claims under §§ 20(a) and 18 to the

district court for whatever further proceedings are appropriate.

(c) Backlog. In addition to alleging that the policy of

underbidding resulted in materially overstated earnings, the

Complaint also alleges that it was misleading of defendants to

include the underbid contracts in S&W’s “backlog.” See, e.g., ¶¶

228, 248-49, 251, 254, 284, 313-15. As to these claims, brought

under Rule 10b-5, § 20(a), and § 18, we sustain the district

court’s dismissal. Plaintiffs have simply failed to plead a false

statement with respect to the “backlog” allegations, and so their

claims must be dismissed under Federal Rule of Civil Procedure

12(b)(6). As defined by the Complaint, S&W’s backlog consisted of

“the accumulated amount of the Company’s committed, but unexpended,

contractual work.” ¶ 38. These contracts represented “committed,

but unexpended, contractual work.” The statements resulting from

the inclusion of the contracts in the backlog were neither false

nor misleading.

2. The TPPI Project and “Phantom Revenue”

The second group of claims of fraud relates to the TPPI

contract for construction in Indonesia, which was ultimately

cancelled for lack of funding. The Complaint alleges that S&W,

with the knowledge of Smith and Langford, reported expected future

payments as current revenues, even though the project was

indefinitely suspended and defendants knew it was unlikely to ever

-28-
be resumed. The Complaint alleges that S&W overstated its current

revenues and concealed an expected loss, which according to GAAP

principles should have been recognized.

The allegations are essentially as follows: In 1996, TPPI

awarded to S&W a $710-million contract in connection with the

construction of a $2.3-billion chemical complex in Indonesia. ¶

63. S&W procured and transported to Indonesia approximately $332

million worth of materials and equipment to perform the project.

¶ 64. Under its agreements, S&W assumed responsibility for

cancellation costs with respect to equipment purchase orders and

subcontract work. ¶¶ 64-65.

In 1997, TPPI suspended work on the project because its

funding arrangements were exhausted. ¶ 65. The Complaint alleges

that “TPPI suggested to S&W [in 1997] that it try to get out of its

contracts with its vendors due to the suspension.” Id. By August

1998, S&W obtained permission from TPPI to resell project materials

and equipment, and it began selling equipment, according to Daniel

Martino, a former senior accountant at S&W, “for pennies on the

dollar.” ¶¶ 58, 73.

By January 1999, “it was clear that the project would not

restart,” and “TPPI had told S&W that the slight prospect that had

existed during 1998 that they would find an investor to fund the

project had fallen through.” ¶ 74. In January 1999, a special

meeting of the Company’s Board of Directors was held to discuss

-29-
TPPI, and by the end of the meeting “it was evident to the Board

that the TPPI project had already caused S&W serious financial

problems and that it was unlikely the project would ever restart.”

¶ 77.

The Complaint asserts that because the Company had incurred

substantial costs without corresponding revenue, the suspension of

the project

should have had a significant negative effect on S&W’s
financial statements. According to CS-1 [an informant
who had been an assistant comptroller at S&W], to avoid
that negative effect, beginning with the first quarter of
1998, S&W created phantom revenue and receivables from
the TPPI project to cover S&W’s project related costs by
recording revenue equal to the amount of those costs.

¶ 67. S&W booked $86.9 million of such “phantom revenue” in

connection with TPPI in 1998 and $53 million in 1999. ¶ 68. The

use of this allegedly fraudulent accounting changed the Company’s

results in 1998 from a loss of $108.7 million to a reported loss of

$49.3 million, and in 1999 from a loss of $11.3 million to reported

net income of $20.5 million. Id. Furthermore, because S&W knew

the project was cancelled, it was obligated under FAS 5 to

immediately recognize the entire expected loss either as a charge

or as a loss contingency. See ¶ 76.

While the notes to the financial statements did refer to a

loss contingency based on TPPI, the Complaint alleges that the

references were false in two respects. First, the notes stated

that the Company “believes it unlikely that the project will be

-30-
cancelled,” or otherwise gave the impression of a likely restart,

see ¶¶ 209, 224, 296, while the apparent circumstances showed it

was highly likely the contract would be cancelled. Second, the

amount of the loss estimated to result from the cancellation was

substantially understated given the immense investment the Company

had made in the TPPI project and the high probability the entire

investment would be lost if TPPI failed to reinstate the project.

In substance, the Complaint describes two separate, though

related, accounting abuses in violation of GAAP principles: First,

it alleges the overstatement of revenues (“phantom revenues”) and

concealment of loss by inappropriate use of percentage-of-

completion accounting (assuming a zero-profit margin) to report

current revenues not yet received, when the buyer could not “be

expected to satisfy [its] obligations under the contract.” See SOP

81-1 ¶ .23. The offsetting of the actual current losses with

projected revenues that were not expected ever to be received

allegedly concealed large current losses on the project. Second,

the Complaint alleges concealment of an expected loss by failure to

acknowledge it appropriately, either as a charge to income, or as

an accurately described loss contingency. See FAS 5 ¶¶ 8, 10. The

Complaint alleges that as a result of these accounting decisions,

S&W’s financial results published in the Company’s 10-K and 10-Q

filings, as well as in other public announcements, were materially

overstated.

-31-
 In addition, the Complaint alleges that S&W misled investors

by carrying the TPPI project in its backlog, see, e.g., ¶ 221,

failing to acknowledge that the project was terminated or at least

unlikely to restart, see, e.g., ¶¶ 166, 193, 209, 217, 224, 296,

and reporting a materially understated estimate of the Company’s

losses when disclosing the “charge” S&W would take in the event the

project were to be cancelled, see, e.g., ¶¶ 209, 224, 296.

(a) The PSLRA’s requirement of clarity and basis. In our

view, the allegations of exaggerated revenues and failure to report

an expected loss are sufficiently detailed and supported to satisfy

the PSLRA’s clarity-and-basis requirement.

These allegations are quite detailed and clear in setting

forth what are the allegedly false and misleading statements and in

explaining why they are false and misleading. The GAAP documents

cited by the Complaint specify that the propriety of reporting

unreceived payments as current revenue, matched with currently

incurred costs, depends on a reasonable expectation that the buyer

will satisfy the obligation to make the payments. See SOP 81-1 ¶

.23. The Complaint adequately explains that in these

circumstances, TPPI, which had lost its source of funding and had

indefinitely suspended all work on the project, could not be

expected to satisfy its contractual obligation to make payment.

It also seems clear from the GAAP documents that as soon as

“current estimates of total contract revenue and contract cost

-32-
indicate a loss, a provision for the entire loss on the contract

should be made.” See SOP 81-1 ¶ .85; see also ARB 45 ¶¶ 6, 11. A

probable loss should be “accrued by a charge to income” when “the

amount of loss can be reasonably estimated.” FAS 5 ¶ 8. A

“reasonable possibility” of loss should be properly described and

declared as a loss contingency. Id. ¶ 10. The Complaint clearly

states its theory that TPPI’s expected failure to pay would result

in very substantial losses to S&W, which it did not take as a

charge against earnings. To the extent the probable loss is

described in the contingency notes of S&W’s statements, the

Complaint alleges with clarity that the notes are misleading in

describing the possibility that TPPI might cancel as “unlikely,” ¶

209, and in understating the size of the loss that would result in

the event of that contingency. Furthermore, drawing all reasonable

inferences in plaintiffs’ favor, the Complaint adequately asserts

that the amount of loss could have been reasonably estimated.

We find that, as in Aldridge, 284 F.3d at 82, and In re

Cabletron Systems, Inc., 311 F.3d at 39, these allegations are

sufficiently detailed and clear to satisfy the clarity-and-basis

requirements of the PSLRA and Rule 9(b).

On the other hand, claims of fraud based on the mere inclusion

of the TPPI contract in S&W’s “backlog” must be dismissed. We

affirm the district court’s dismissal of these aspects of the

Complaint for substantially the same reasons in our discussion of

-33-
the inclusion of the allegedly underbid contracts in the backlog.

As defined by the Complaint, S&W’s backlog consisted of “the

accumulated amount of the Company’s committed, but unexpended,

contractual work.” ¶ 38. Even if the TPPI project was unlikely to

restart, it still constituted, under the terms of the Complaint,

“committed, but unexpended, contractual work.” S&W’s statements as

to backlog cannot be considered false or misleading just because

they included the TPPI contract. Thus, these statements cannot

give rise to liability under Rule 10b-5, § 20(a), or § 18.

(b) Strong inference of scienter. As noted above, where the

plaintiff’s recovery depends on proof that the defendant acted with

a particular state of mind, the Complaint must set forth facts

giving rise to a “strong inference” that the defendants acted with

the required state of mind. See 15 U.S.C. § 78u-4(b)(2).

(i) Claims under 10b-5. The claims relating to TPPI, to

the extent pleaded under 10b-5, must be supported by facts giving

rise to a strong inference of scienter. We find that the

allegations as to Smith and Langford’s involvement with TPPI fail

that test.

The principal theory of the Complaint as to TPPI is that

defendants reported “phantom revenue” and failed to make

appropriate disclosure of an expected loss. Even drawing all

reasonable inferences in plaintiffs’ favor, as we must, the

Complaint fails to support a “strong inference” of scienter as to

-34-
Smith and Langford. The factual allegations, which satisfy the

clarity-and-basis requirements as to the use of misleading

accounting, lack sufficiently compelling and clear factual

allegations concerning the culpable involvement of Smith and

Langford to support a “strong inference” of scienter on their part.

Despite the Complaint’s rhetorical flourish, accusing

defendants of reporting “phantom revenue,” the booking of revenues

before their receipt does not necessarily involve any impropriety

whatsoever. As described earlier, such anticipatory booking of

revenues is integral to percentage-of-completion accounting

(including with a zero-profit margin), according to the GAAP

documents plaintiffs cite in the Complaint. In fact, for

construction businesses engaged in S&W’s type of work, such

percentage-of-completion accounting with anticipatory recognition

of revenue is described as “preferable in most circumstances.” See

SOP 81-1 ¶ .25. The question raised by the Complaint is the more

subtle one of whether in the particular circumstances presented it

was appropriate to use percentage-of-completion accounting, which

depended primarily on whether the purchaser of S&W’s services

(TPPI) was expected to fulfill its obligations.

Thus, the allegations of scienter concerning both the

reporting of “phantom revenue” from the TPPI project and the

failure to reflect the expected loss depend largely on whether the

Complaint alleges facts supporting a strong inference that Smith

-35-
and Langford did not expect TPPI to fulfill its commitments. The

Complaint speaks vaguely of communications from TPPI to S&W

expressing doubt as to TPPI’s resumption of the project and

suggesting that S&W get out of its contracts with vendors. These

allegations are simply too vague to support a strong inference that

Smith and Langford were aware of them or, if so, were reckless in

failing to take them seriously.

Again, without attribution, the Complaint alleges that S&W

obtained TPPI’s permission to sell project materials. A former

senior accountant is quoted for the proposition that the materials

were sold “for pennies on the dollar.” This allegation is too

sketchy and vague. There is no indication how broadly materials

were sold or that senior management was aware of the circumstances.

We recognize the Complaint alleges that Smith and Langford

knew the equipment sent to Indonesia for the project was being sold

for pennies on the dollar and that the project would not be

restarted. ¶ 75. It also alleges that “it was evident to the

Board [of Directors] . . . that it was unlikely the project would

ever restart.” ¶ 77. Such conclusory allegations as to the

existence of knowledge are insufficient to provide the factual

basis, supporting a strong inference of scienter, required by the

PSLRA. They are simply conclusory assertions of the facts for

which a showing supporting a strong inference of scienter must be

pleaded. Where the state of mind in question is the defendant’s

-36-
knowledge of the fraudulent nature of the Company’s financial

reports, and the PSLRA requires that facts be stated with

particularity giving rise to a strong inference that the defendant

acted with that state of mind, the requirement is not satisfied by

a pleading which simply asserts that the defendant knew of the

falsity.

We therefore affirm the district court’s dismissal of the

claims regarding TPPI brought under Rule 10b-5 against Smith and

Langford.

(ii) Claims under §§ 20(a) and 18. Our rulings on the

claims brought under §§ 20(a) and 18 with respect to TPPI mirror

our treatment of the claims brought under §§ 20(a) and 18 with

respect to the alleged policy of underbidding. Because the PSLRA’s

strong-inference requirement does not apply to the claims brought

under §§ 20(a)12 and 18, (1) we reject the reasons given by the

district court for dismissing the claims, and (2) note that the

reasons which support our order of dismissal of the similar claim

under Rule 10b-5 have no application to these claims. Accordingly,

we vacate the judgment dismissing them. We remand these claims to

the district court for whatever further proceedings are

appropriate.

12
See, though, supra note 6.

-37-
3. Concealment of Illiquidity, Inability to Pay Debts, and

Impending Bankruptcy

The Complaint’s final major area of focus is on statements

allegedly concealing S&W’s financial deterioration. The Complaint

contends that S&W issued false and misleading statements reassuring

investors of S&W’s financial viability and its access to sufficient

cash to meet its needs, even as its finances fell into shambles,

and eventually into bankruptcy.

The allegations of financial deterioration are set forth in

the Complaint at length and with specificity. According to a

former controller for S&W’s industrial division, by the middle of

1998, “S&W knew that the Company was ‘starting to get strapped for

cash.’” ¶ 70. The Company began having problems paying its

vendors on the Tiverton project in the summer of 1998, leading some

unpaid vendors to stop delivering materials to the project site.

¶ 71. Meanwhile, throughout 1998,

comprehensive internal financial reports, distributed to
approximately twenty S&W division heads and top
executives, that included financials broken out for all
divisions, with details of personnel costs, sales, income
and working capital and which also measured S&W’s
performance against its plan for the year, showed a
materially worse financial situation and outlook [than
the disclosed financial results].

¶ 72. A confidential source, identified as the “head of S&W’s

Development Corporation” said:

Anyone who had access to the monthly financials could see
that it was not what was being said publicly. You could
read them and compare them with the quarterlies he

-38-
 [Smith] was reporting and ask what he was smoking.
Knowing what we knew inside and seeing the quarterlies —
they just did not jibe.

Id.

The financial problems continued to mount through 1999.

Unpaid vendors threatened to place liens on the Tiverton project,

¶ 78; the Company began using credit cards to purchase materials

for the project, ¶ 79; the Company faced calls seeking payment on

various projects, ¶ 83; the Company’s “treasurer regularly sent e-

mails to internal staff advising that the Company had no money to

pay the vendors’ bills and to not bother submitting requests for

payment,” id.; and the Company found that it was increasingly

difficult to get vendors to bid on S&W projects, ¶ 84. Some

vendors and subcontractors called Smith directly to complain about

not being paid, and “those who called Smith regularly to collect

money and threaten to walk off a project were usually the first to

get paid.” ¶ 85.

By summer of 1999, a list of overdue accounts payable was

created and regularly delivered to Smith, Langford, and S&W’s

comptroller. ¶ 87. Some accounts payable were 600-700 days

overdue, and consequently vendors and subcontractors were stopping

work, engaging in slow-downs, or filing liens. Id. The Company

succeeded in obtaining a credit agreement in July 1999, but was

already in material default by the time the agreement was made

because of the failure to pay vendors and subcontractors as

-39-
required. ¶ 92.

In October, needing cash to placate lenders, S&W announced it

was selling its headquarters building and cold storage business,

but knew in December that the sale of its building would not

alleviate its problems, and even had to “obtain an emergency

adjustment in its lending arrangements so it could survive long

enough to complete the sale.” ¶¶ 117, 119. In November, S&W was

told that it was in material breach of a $250-million contract

because it had failed to pay subcontractors and suppliers, leading

senior executives to embark on a “desperate effort” to stop the

project from being terminated. ¶¶ 108, 110. In December, in a bid

to generate cash, Smith and Langford caused the S&W Employee

Retirement Plan Trust to purchase 1 million shares of S&W common

stock, raising over $15 million. ¶ 121. By the end of the year,

“Smith’s gasoline credit card was discontinued and newspaper

delivery to S&W’s building was halted,” ¶ 126, while at the

Tiverton project site, “trash was building up . . . and spilling

out of the dumpsters because S&W had not paid the bills of the

trash hauler,” ¶ 131.

In 2000, the Complaint alleges, the owner of the Tiverton

project notified S&W of defaults on its contract because of liens

placed on the Tiverton site, and S&W was unable to cure the

defaults. ¶¶ 98, 138. Cost overruns on the project at that time

soared to over $27 million. ¶ 140. S&W eventually filed for

-40-
bankruptcy in June 2000. ¶ 155.

In the face of these events, the Complaint alleges, S&W issued

false and misleading statements principally in press releases and

filings with the SEC, falsely asserting or implying that the

Company had sufficient cash, see, e.g., ¶¶ 172, 192, 199, and

inadequately disclosing the extent of the Company’s financial

problems, see, e.g., ¶¶ 283-84, 286-88, 293-94, 298-304, 305-06,

307-10. For example, in the context of these events, the Company

repeatedly announced in its SEC filings that it “believes that the

types of businesses in which it is engaged require that it maintain

a strong financial condition,” and that it “has on hand and has

access to sufficient sources of funds to meet its anticipated

operating, dividend and capital expenditure needs.” The Company

included words to that effect in at least its March 1998 10-Q

(filed in May 1998), ¶ 192, September 1998 10-Q (filed in November

1998), ¶ 223, 1998 10-K (filed in March 1999), ¶ 242, March 1999

10-Q (filed in May 1999), ¶ 264, and June 1999 10-Q (filed in

August 1999), ¶ 278. As discussed below, the Company made notable

disclosures about its financial difficulties in later filings, most

especially in the fall of 1999. Plaintiffs acknowledge these

disclosures, but argue that they did not go far enough in revealing

the “financial collapse” that was upon S&W. ¶ 283.

This group of allegations raises four primary questions: (1)

Did disclosures made by S&W in the fall of 1999, prior to the first

-41-
purchase of S&W stock by the named plaintiffs, adequately apprise

investors of the financial problems facing the Company, rendering

previous misleading statements immaterial as a matter of law, for

purposes of this suit? (2) If not, do the Complaint’s allegations

meet the clarity-and-basis requirements of the PSLRA and Rule 9(b)?

(3) Does the Complaint satisfy the PSLRA’s required “strong

inference” of scienter with respect to Smith and Langford to

support claims under Rule 10b-5? (4) As to some of the allegedly

misleading statements made in quarterly and annual filings with the

SEC, were they “forward-looking” statements, protected from suit by

the PSLRA’s safe harbor?

(a) Falsity and materiality. The district court first ruled,

upon the defendants’ motion to dismiss, that while some of the

Company’s statements made prior to the autumn of 1999 might be

actionable, none of S&W’s statements made after that time were

actionable because by then S&W had made full disclosure of its

financial woes. See In re Stone & Webster, Inc. Sec. Litig., 253

F. Supp. 2d at 126. On that basis, the court granted summary

judgment on all outstanding claims. Although the judgment was not

explained, it was apparently based on the following reasoning: (1)

None of the named plaintiffs purchased securities in S&W prior to

that time; (2) Any materially false statements made prior to that

time had been cured, as a matter of law, by the Company’s more

revelatory statements made during autumn of 1999; and (3) Because

-42-
the named plaintiffs could not assert claims on their own behalf

based on statements made prior to autumn of 1999, they could not do

so on behalf of class plaintiffs.13

The first question we must consider is whether disclosures

made by S&W in the fall of 1999 so completely disclosed the alleged

financial problems of the Company that they either corrected, or

rendered immaterial as a matter of law, any misleading statements

made before that point. We must determine whether S&W sufficiently

disclosed the state of affairs at S&W, such that the totality of

information offered to investors purchasing after that time could

not be considered false or materially misleading.

We find that they did not. Assuming, as we must, the truth of

the Complaint’s allegations as to the Company’s financial condition

in the fall of 1999, we find that the Company’s statements made at

that time, although more revealing than some earlier statements,

were not so informative as to correct earlier false statements, or

render them immaterial as a matter of law. A jury could reasonably

find that the cumulative sum of information provided to investors

by that point was still materially misleading.

In their argument that any prior falsity of statements had

been cured by the autumn 1999 statements, defendants rely primarily

13
Plaintiffs do not challenge the district court’s assumption
that summary judgment would be proper if the autumn 1999 statements
adequately apprised investors of the state of S&W’s finances.
Thus, we do not consider that question.

-43-
on a Company press release dated October 27, 1999, and on the

quarterly 10-Q filed with the SEC on November 15, 1999.14 The

October 27, 1999, press release announced that the Company intended

to sell its corporate headquarters and its cold storage business in

order to “enhance liquidity and focus on its core competencies.”

The document stated that the Company was “not in compliance” with

its “principal credit agreement” and stated that it had “requested

waivers from its bank group regarding certain covenants” in that

agreement. It acknowledged also that S&W could not “continue

normal operations” unless it obtained “additional short-term

funding.” Finally, it stated that “[i]n light of the Company’s

current liquidity needs,” the Board of Directors decided to omit

the Company’s normal quarterly dividend, and that S&W had retained

financial advisors “to assist the Company in arranging and

restructuring interim and long-term financing and with asset sales

authorized by the board of directors.”

In its November 15, 1999, 10-Q filing with the SEC, the

Company noted that “losses incurred in the past 24 months have

negatively impacted the Company’s cash position,” and explained:

As of the end of the third quarter of 1999, the Company
had fully drawn the cash available to it under its
current credit facility and the amount of the Company’s
past due trade payables had increased, as reflected in
accounts payable on the Consolidated Balance Sheets, with
certain of the Company’s vendors and subcontractors
having delayed work to be performed by them.

14
The Company made prior disclosures, but not to the same
extent.

-44-
 The falsity of a statement and the materiality of a false

statement are questions for the jury. See TSC Industries, Inc. v.

Northway, Inc., 426 U.S. 438, 450 (1976); see also In re Cabletron

Systems, Inc, 311 F.3d at 34. Cf. United States v. Gaudin, 515

U.S. 506 (1995). A court is thus free to find, as a matter of law,

that a statement was not false, or not materially false, only if a

jury could not reasonably find falsity or materiality on the

evidence presented. See TSC Industries, Inc., 426 U.S. at 450. We

cannot agree that as a matter of law these disclosures sufficiently

apprised investors of all material information regarding the

Company’s alleged financial condition and corrected or rendered

immaterial the falsity of previous statements.

A potential investor after the autumn 1999 statements would

likely examine not only the Company’s very most recent statements,

but also the statements made by the Company in the recent preceding

periods. If prior to autumn 1999 the Company had issued false

statements, describing its financial condition in misleadingly

benign terms, those statements might continue to influence an

investor’s decision unless they had been retracted, had ceased to

be relevant, or their misleading message had been adequately

corrected by subsequent revelations or statements. In our view,

although the autumn 1999 statements revealed more about the

deterioration of the Company’s financial conditions than prior

statements, we cannot agree that, as a matter of law, a jury could

-45-
not reasonably find that after their issuance the totality of the

Company’s statements continued to be materially misleading as to

the Company’s financial situation. For one thing, a company which

has long maintained a strong financial position but recently fallen

into a liquidity crunch may be considered a safer investment than

a company with an identical present balance sheet which has been

struggling with underfunding for some time. The former may be seen

as coping with a sudden temporary reversal, likely to be cured by

the good management practices which have long dominated, while in

the latter case the current difficulty may appear the inevitable

consequence of a continuous history of bad management, which is

destined to result in eventual failure. The Company’s autumn 1999

statements certainly made significant disclosures, but they did not

sufficiently dispel the allegedly misleading picture of a Company

which, up to that point, had maintained a strong position.

For example, as we noted above, S&W filings with the SEC made

at least through August 1999 contained reassuring assertions

informing investors that the Company “has on hand and access to

sufficient sources of funds,” and even arguably implying that it

“maintain[ed] a strong financial condition.” See, e.g., ¶ 278. If

the Company’s financial situation was in fact as dire as alleged by

the Complaint, such statements could reasonably be found to be

materially misleading. The Complaint portrays S&W as a company in

financial distress, spiraling toward bankruptcy — out of cash,

-46-
unable to keep up with payments, and with vendors and

subcontractors halting work and deliveries and threatening liens.

In our view, the information released by the Company in autumn

1999 did not so clearly correct the alleged falsity of the earlier

statements. Rather, a jury could reasonably find that the “‘total

mix’” of information available to an investor in the fall of 1999

– that is, the totality of new disclosures, read in the context of

previous statements by the Company – still was materially

misleading, by virtue of both false statements and material

omissions. See TSC Industries, Inc., 426 U.S. at 449.

(b) The PSLRA’s requirement of clarity and basis. Finding

that the dismissal of these claims cannot be supported on the basis

of the autumn 1999 disclosures, we must next consider whether the

allegations meet the requirements of the PSLRA. We have no doubt

that these allegations pass the clarity-and-basis requirements.

The Complaint paints a detailed account of the deteriorated

financial conditions at S&W, replete with factual support and

citations to sources likely to have knowledge of the matter. The

Complaint also identifies with specificity the statements alleged

to be false and misleading and explains in what respect they were

misleading.

(c) Strong inference of required state of mind. In addition

to passing the clarity-and-basis test, we find that these

allegations also survive the PSLRA’s strong-inference requirement.

-47-
 (i) Claims under 10b-5. Claims under Rule 10b-5 require

proof of scienter. The Company statements alleged to be false

concealments of its liquidity crunch were made at various times

from 1997 to 2000. In order to plead a valid claim against Smith

and Langford as to any of these statements, the Complaint must

assert facts supporting a strong inference that they acted with

scienter at the time the statement was made. We find that the

Complaint alleges facts sufficient to support a strong inference of

scienter on the parts of both Smith and Langford starting as early

as January 1999.

The Complaint alleges that during the summer of 1999 an

accounts payable list showing accounts overdue by 600-700 days was

being prepared on a regular basis for review by Smith and Langford

and that the Company was so strapped for cash that no subcontractor

was allowed to be paid without the personal approval of Smith or

Langford. ¶ 87. The Complaint further alleges that in the spring

of 1999 Smith received calls from vendors and subcontractors

demanding payment and threatening to walk off their projects. Id.

These allegations are clearly sufficient to support a strong

inference of scienter for the periods to which they pertain.

The allegations relating to the early part of 1999, which rely

more heavily on circumstantial evidence, are nonetheless sufficient

in our view, when taken together with the entire mix of alleged

facts, to support a strong inference of at least recklessness with

-48-
respect to the falsity, if not actual knowledge of the falsity.

The financial strength of the Company was undoubtedly a matter of

principal concern to its Chief Executive Officer and Chief

Financial Officer. The Company’s public statements repeatedly

stressed the importance of financial strength for a company engaged

in S&W’s business, before going on to give assurance of S&W’s

access to ample funds.

The Complaint alleges furthermore that throughout 1998

comprehensive internal financial reports of the Company’s current

condition were regularly distributed to the Company’s top

executives. Id. Although the contents of the reports are not

described, we can fairly infer that they described what they

purported to describe – the Company’s current financial condition.

According to the allegations of the Complaint, the condition that

would have been reflected in those internal reports was becoming

desperate, so that already the Company had slowed payments to

vendors and subcontractors. If by the summer of 1999 such accounts

were 600-700 days overdue, it follows that by January 1999, those

accounts were 400-500 days overdue, and this was regularly revealed

in internal reports distributed to Smith and Langford. An unnamed

confidential source, the executive described as the head of S&W’s

Development Corporation, is quoted in the Complaint as saying that

a comparison of the Company’s periodic internal reports distributed

to the Company’s executives with the statements signed by Smith in

-49-
the Company’s quarterly public reports would lead one to ask “what

[Smith] was smoking.” ¶ 72.

Those allegations of particularized facts support a strong

inference that by January 1999, both Smith and Langford were either

aware of the misleading nature of the Company’s reassuring reports,

or were at least reckless with respect to their truthfulness on

matters of enormous importance. We therefore vacate the district

court’s judgment relating to claims under Rule 10b-5 against Smith

and Langford for false statements as early as January 1999 and

thereafter relating to the Company’s liquidity and financial

condition.

(ii) Claims under §§ 20(a) and 18. With respect to claims

asserted against Smith and Langford under §§ 20(a) and 18 for

statements concealing illiquidity and the deterioration of S&W’s

financial condition, we vacate the judgment and remand for further

proceedings for the same reasons as given above relating to claims

under §§ 20(a) and 18.15

(d) Safe harbor for forward-looking statements. As for some

of the statements which we ruled could serve as the basis for

claims of misleading statements relating to the Company’s liquidity

and financial condition, the district court ruled in considering

the defendant’s motion to dismiss that these were within the

PSLRA’s safe harbor for “forward-looking” statements. See In re

15
See, though, supra note 6.

-50-
Stone & Webster, Inc. Sec. Litig., 253 F. Supp. 2d at 125, 130.

While the exact wording of these statements varied slightly, they

effectively asserted that the Company “has on hand and has access

to sufficient sources of funds to meet its anticipated operating,

dividend and capital expenditure needs.” See ¶ 192; see also ¶¶

172, 208, 223, 242. We do not agree with the district court that

this statement is necessarily protected by the PSLRA’s safe harbor

rule.

The statute generally provides, with specified limitations,

that issuers and underwriters of securities shall not be liable in

any private action based on an untrue or misleading statement of a

material fact “with respect to any forward-looking statement” if

the forward-looking statement is

identified as a forward-looking statement, and is
accompanied by meaningful cautionary statements
identifying important factors that could cause actual
results to differ materially from those in the forward-
looking statement, . . . or . . . the plaintiff fails to
prove that the forward-looking statement . . . [if made
on behalf of a business entity by or with the approval of
an executive officer was] made . . . with actual
knowledge by that officer that the statement was false or
misleading.

See 15 U.S.C. § 78u-5(c)(1). The statute thus seems to provide a

surprising rule that the maker of knowingly false and wilfully

fraudulent forward-looking statements, designed to deceive

investors, escapes liability for the fraud if the statement is

“identified as a forward-looking statement and [was] accompanied by

meaningful cautionary statements identifying important factors that

-51-
could cause actual results to differ materially from those in the

forward-looking statement.” See id. § 78u-5(c)(1)(A)(i).

The statute goes on to define “forward-looking” statements as

including: “(A) a statement containing a projection of revenues,

income . . . earnings (including earnings loss) per share, . . .

capital expenditures, dividends, . . . or other financial items;

(B) a statement of the plans and objectives of management for

future operations . . . ; (C) a statement of future economic

performance . . . ; (D) any statement of the assumptions underlying

or relating to [any of the above].” Id. § 78u-5(i)(1).

The statement in question asserted essentially that the

Company “has on hand . . . sufficient sources of funds to meet its

anticipated [needs].” Because the statement includes a reference

to anticipated future needs for funds, the district court found it

to be “forward-looking,” apparently concluding that the statement

came within the protection granted for “a projection of . . .

capital expenditures, dividends, . . . or other financial items.”

We think that the meaning of this curious statute, which grants

(within limits) a license to defraud, must be somewhat more complex

and restricted.

By reason of the emphasis on “projection[s],” “plans,” and

“statement[s] of future economic performance,” we understand the

statute to intend to protect issuers and underwriters from

liability for projections and predictions of future economic

-52-
performance, which are later shown to have been inaccurate. See

Webster’s Third New International Dictionary 1814, def. 12b (1976)

(defining “projection” as “an estimate of future possibilities

based on a current trend”). The legislative history confirms this

understanding. The House Conference Report explains that the bill

was intended “to enhance market efficiency by encouraging companies

to disclose forward looking information” that otherwise might be

“muzzled” out of fear that making predictions could later spawn

burdensome securities fraud actions. See H.R. Conf. Rep. No. 104-

369 (1995), 1995 U.S.C.C.A.N. 730, 742.

The problem in applying this statute to the statement in

question is that the statement is composed of elements that refer

to estimates of future possibilities and elements that refer to

present facts. Essentially the statement asserts that the Company

has present access to funds sufficient to meet anticipated future

needs. The part of the statement that speaks of the quantity of

cash on hand speaks of a present fact. The part that speaks of the

amount of “anticipated operating, dividend and capital expenditure

needs” speaks of a projection of future economic performance. The

claim of fraud, however, does not involve a contention that the

defendants were underestimating the amount of their future cash

needs. The claim is rather that the defendants were lying about

the Company’s present access to funds. The Company was, according

to the allegations of the Complaint, in an extreme liquidity

-53-
crunch.

We believe that in order to determine whether a statement

falls within the safe harbor, a court must examine which aspects of

the statement are alleged to be false. The mere fact that a

statement contains some reference to a projection of future events

cannot sensibly bring the statement within the safe harbor if the

allegation of falsehood relates to non-forward-looking aspects of

the statement. The safe harbor, we believe, is intended to apply

only to allegations of falsehood as to the forward-looking aspects

of the statement. Cf. Shaw v. Digital Equip. Corp., 82 F.3d 1194,

1213 (1st Cir. 1996) (examining, in the context of the bespeaks

caution doctrine, a statement that “has both a forward-looking

aspect and an aspect that encompasses a representation of present

fact” and concluding that the doctrine was inapplicable to the

extent the statement “encompasses the latter representation of

present fact”), superceded by statute on other grounds, as noted in

Greebel, 194 F.3d at 197.

To illustrate the distinction we draw, assume as hypothetical

facts that an issuer of securities relating to a business venture

carrying an obvious risk of liability (say, the operation of an

amusement park) issues a public statement that it has procured

liability insurance in amounts sufficient to cover the maximum

liability that can be anticipated based on comparable experience.

Assume that in the suit, the aspect of the statement alleged to be

-54-
fraudulent lies not in the estimate of likely liabilities, but in

the fact that the issuer was lying in stating that it had obtained

insurance. It in fact had no insurance policy. The accusation of

falsity, in other words, lay not in the accuracy of the projection

of future financial events, but rather in the representation of a

present fact. Notwithstanding that the allegedly false statement

“contain[s] a projection of [future] financial items,” we do not

think Congress intended to grant safe harbor protection for such a

statement whose falsity consists of a lie about a present fact.

While our case is not precisely like the hypothetical example,

we think the example illustrates that where the falsehood relates

to a representation of present fact in the statement, it will not

necessarily come within the statute’s safe harbor, even though the

statement might also contain a projection of future financial

experience.

In this case, the alleged falsehood was in the fact that the

statement claimed that the Company had access to ample cash at a

time when the Company was suffering a dire cash shortage. The

claim was not that the Company was understating its future cash

needs. In our view, the safe harbor of the PSLRA does not confer

a carte blanche to lie in such representations of current fact. We

reject the district court’s conclusion that the statements assuring

that the Company had access to sufficient cash to cover anticipated

needs were within the safe harbor.

-55-
B. Claims Against PwC

Against PwC, the auditor of S&W’s accounts, the Complaint

asserts claims under Rule 10b-5 and § 18 relating to PwC’s

unqualified audit opinions on the Company’s 1997, 1998, and 1999

financial statements contained in its annual 10-K filings. See ¶¶

343-45. These opinions are alleged to have been false and

misleading in two principal respects: They stated, first, that

S&W’s financial statements were prepared in conformity with GAAP,

and second, that PWC’s audits were performed in accordance with

Generally Accepted Auditing Standards (“GAAS”).

1. The PSLRA’s Requirement of Clarity and Basis

We first consider whether these claims against PwC meet the

PSLRA’s requirements for clarity and basis.

The claims that PwC falsely asserted compliance with GAAP

focuses on the accounting for the allegedly underbid contracts and

for the TPPI project. We have already considered substantially the

same allegations made against Smith and Langford and found that

they pass the PSLRA test for clarity and basis. Because the

allegations against PwC are substantially the same for purposes of

the clarity-and-basis test, we reach the same conclusion – that the

claims against PwC also pass the clarity-and-basis test.

The second set of claims against PwC concerns its statements

that its audits were performed in accordance with GAAS. To the

extent that these claims relate to its failure to discover the

-56-
alleged deviations from GAAP in the accounting for the underbid

contracts and TPPI, we find that they pass the clarity-and-basis

test. The other GAAS claims, however, rest on nothing more than a

litany of conclusory allegations of failure to conform to various

GAAS standards. The Complaint asserts also that PwC missed various

“red flag” warning signs but lacks concreteness as to how the

conduct of the audit related to the missed warning signs. See ¶¶

341, 351. With the exception of the GAAS claims relating to the

alleged GAAP violations for TPPI and the underbid contracts, we

find the GAAS claims insufficient to pass the clarity-and-basis

test of PSLRA.

2. Strong Inference of State of Mind

Even while some allegations survive the clarity-and-basis

test, they still must meet the strong-inference requirement with

respect to any claim demanding proof of scienter.

(a) Claims under Rule 10b-5. As for the claims under Rule

10b-5, which requires proof of scienter, the claims based on both

GAAP and GAAS fail completely to allege particularized facts

supporting a strong inference of scienter on PwC’s part.

Plaintiffs point to four types of allegations which they contend

are sufficient to pass the test. We disagree.

First, the Complaint makes the conclusory assertion that PwC

auditors were “aware of the true facts,” which were inaccurately

presented in S&W’s financials. ¶ 341. As noted above, a plaintiff

-57-
does not satisfy the PSLRA’s requirement of particularized facts

supporting a strong inference of scienter by a conclusory assertion

that the defendant knew the true facts, or knew that the challenged

statement was false. What is needed is the allegation of

particularized facts which give strong support to that conclusion.

Second, the Complaint alleges that PwC missed “red flags.” ¶¶

341, 351. However, the mere fact that an auditor missed what a

plaintiff labels warning signs gives little support on its own to

the conclusion that an auditor was reckless, much less wilfully

blind, with respect to the falsity of information in a financial

statement. Here the so-called “red flags” were so described

without particularized allegations supporting the recklessness of

PwC in missing them when conducting its audits.

Third, plaintiffs point to allegations relating to the

improper use of percentage-of-completion accounting on the TPPI

project. See, e.g., ¶ 67. But, as noted above, the alleged

impropriety under GAAP of using the percentage-of-completion

method, with a zero profit assumption, depends on the perception

that the project was terminated, as opposed to delayed, and that it

would result in a loss. We noted above that these allegations were

insufficient to support a strong inference of scienter on the part

of Smith and Langford. The case with respect to PwC is a fortiori,

as PwC had less reason than Smith and Langford to know that TPPI

would fail to obtain financing to continue the project.

-58-
 The final allegations on which plaintiffs rely is PwC’s

motivation to overlook S&W’s concealment of losses in order to

protect its own source of lucrative accounting and consulting fees.

We do not doubt that such a profit motive could contribute to an

auditor’s decision to “turn[] a bind eye,” see ¶ 347, to a

corporation’s misleading accounting. See generally Sarbanes-Oxley

Act of 2002, tit. II, Pub. L. No. 107-204, 116 Stat. 745 (codified

in various sections of 15 U.S.C.) (addressing concerns raised about

auditor independence). Such allegations can thus strengthen an

inference of scienter predicated on other facts, possibly adding

sufficient strength to satisfy the strong-inference requirement of

PSLRA. On the other hand, absent truly extraordinary

circumstances, an auditor’s motivation to continue a profitable

business relationship is not sufficient by itself to support a

strong inference of scienter. And here there was virtually nothing

else.

We affirm the district court’s dismissal of the Rule 10b-5

claims against PwC. The allegations of the Complaint, whether

viewed separately or cumulatively, do not rest on particularized

facts supporting a strong inference of scienter.

(b) Claims under § 18. Because the PSLRA’s strong-inference

requirement does not apply to claims under § 18, we vacate the

district court’s judgment dismissing the claims under § 18 alleging

that PwC falsely asserted conformity with GAAP in the accounting

-59-
for TPPI and the allegedly underbid projects and with GAAS in PwC’s

audits relating to that accounting. Once again, we express no view

as to whether these claims may be subject to dismissal on other

grounds on which the district court did not rule.

C. Motion for Leave to Amend

Plaintiffs also appeal from the district court’s denial of

their motion for leave to amend the Complaint. Such a ruling is

reviewed for abuse of discretion. See Larocca v. Borden, Inc., 276

F.3d 22, 32 (1st Cir. 2002). The district court denied the motion

on the basis of undue delay in making the motion. We find no abuse

of discretion in that ruling.

However, given that we hereby vacate the judgment terminating

the action and remand for further proceedings, plaintiffs may well

reassert a motion for leave to amend the Complaint, and the

district court may conclude that in the context of a continuing

action, the equities affecting such a motion have changed. We

express no view on the question of the appropriate disposition of

a renewed motion for leave to amend in the continuing action, but

leave that to the district court’s good judgment.

Conclusion

The judgment is affirmed in part and vacated in part. The

case is remanded for further proceedings in the district court.16

16
We do not purport to have ruled on each of the numerous
fraudulent statements alleged in the Complaint. To the extent an
allegation of fraud is not discussed in this opinion, the district

-60-
Costs are awarded to the appellants.

court should rule again on defendants’ motion to dismiss, in a
manner consistent with the discussions herein. We deny appellees’
motion for leave to file a supplemental memorandum. Particularly
in light of the Supreme Court’s recent decision in Dura
Pharmaceuticals, Inc., 125 S. Ct. at 1631-35, we believe appellees’
arguments as to loss causation should in the first instance be
addressed by the district court. All other pending motions are
denied as moot.

-61-