Key Equity Investors Inc. v. Sel-Leb Marketing Inc.

Opinions of the United
2007 Decisions States Court of Appeals
for the Third Circuit

9-6-2007

Key Equity Inv Inc v. Sel Lab Marketing
Precedential or Non-Precedential: Non-Precedential

Docket No. 06-1052

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 NOT PRECEDENTIAL

UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT

No. 06-1052

KEY EQUITY INVESTORS INC.,

Appellant

v.

SEL-LEB MARKETING INC.; HAL MARKOWITZ; JACK KOEGEL;
PAUL SHARP; GEORGE FISCHER; JH COHN LLP,

On Appeal from the United States District Court
for the District of New Jersey
(04-cv-01675)
District Judge: Honorable Dennis M. Cavanaugh

Submitted pursuant to Third Circuit LAR 34.1(a)
June 28, 2007

Before: BARRY, FUENTES and GARTH, Circuit Judges.

(Filed: September 6, 2007)
 OPINION OF THE COURT

FUENTES, Circuit Judge.

In this securities appeal, we review the District Court’s decision to dismiss the

complaint of Key Equity Investors, Inc. (“Key Equity”) for failure to satisfy the pleading

requirements of the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u-4

et seq. (“PSLRA”). Appellant, Key Equity, alleged that defendants issued materially

false and misleading statements about the financial health of a company called Sel-Leb

Marketing, Inc. (“Sel-Leb”). For the reasons that follow, we will affirm.

I. Factual and Procedural Background

A. Factual Background1

Sel-Leb is a New York corporation that distributes and markets consumer

merchandise to retailers. At all relevant times, Harold Markowitz, Paul Sharp, Jack

Koegel, and George Fischer were company directors, and J.H. Cohn, LLP was a company

auditor. In the period between April 5, 2002 and February 25, 2004 (the putative class

period), during which Key Equity purchased company stock, Sel-Leb made numerous

statements relevant to this appeal.

1
On review of a motion to dismiss, we “accept all well-pled allegations in the
complaint as true and draw all reasonable inferences in favor of the non-moving party.”
Brown v. Card Service Center, 464 F.3d 450, 452 (3d Cir. 2006). Our review is limited
to the contents of the complaint and any attached exhibits. Yarris v. County of Delaware,
465 F.3d 129, 134 (3d Cir. 2006).

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 Two of the statements concerned the past financial performance of the company.

First, on April 5, 2002, Sel-Leb filed a form with the Securities and Exchange

Commission (“SEC”) reporting a net income of $443,669 for fiscal year 2001. In the

disclosure, J.H. Cohn stated that it audited the company’s financial statements and that

they conformed with generally accepted accounting principles (“GAAP”). Second, Sel-

Leb issued a press release on August 15, 2002 announcing $418,370 in pre-tax earnings

for the first six months of 2002.

In contrast to these statements of prior earnings, many of Sel-Leb’s other

statements expressed its “glowingly optimistic expectations for fiscal year 2002.” (A50)

For instance, in April 2002, the company said it was “slated to begin to generate strong

revenue and earnings growth in 2002.” (A51 (internal quotation marks omitted)) In May,

the company “anticipate[d] . . . report[ing] record revenues for its fiscal year end[ing]

December 31, 2002.” (A51) In August and September, it reiterated its optimism about

2002. And in November, although recognizing the financial difficulties of “several of our

major customers,” Sel-Leb predicted “a significant increase in the sales and earnings” for

the fourth quarter of 2002. (A52) Notably, in November the company also stated that it

had renegotiated and renewed the terms of a $3.8 million “credit facility” with Merrill

Lynch Business Financial Services, Inc. (“Merrill Lynch”). (A53)

In late 2002, Sel-Leb’s expectations about its financial health “began to dim.”

(A53) On December 24, 2002, it issued a press release indicating that “sales for the

fourth quarter of 2002 will be substantially lower than the revised projection previously

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issued by the Company.” (A53) The company cited “generally weak economic

conditions,” and “production problems” with a third-party manufacturer that had “caused

the Company to miss shipping orders during the fourth quarter.” (A53) Moreover,

throughout early 2003, the company was unable to make required financial disclosures

“due to unforeseen difficulties in obtaining information essential to these estimates.”

(A54) Specifically, Sel-Leb had been unable to obtain information “from an independent

third party, which is an integral and important part of the Company’s operations.” (A54)

As a result, Sel-Leb announced that it would be “delisted from the Nasdaq SmallCap

Market with the opening of business on Friday, May 23, 2003.” (A54)

Sel-Leb later disclosed, on July 24, 2003, that it was “not in compliance with

certain net worth and cash flow covenants of its Merrill Lynch credit facility,” and on

October 15, 2003, revealed that the credit facility had been terminated. (A54) On

February 24, 2004, the company indicated that its operations had been significantly

curtailed due to decreased sales and lack of funding. Finally, it stated that it had incurred

a pre-tax loss of $3.8 million for fiscal year 2002, and also had to revise downward by

$1.8 million its pre-tax income for fiscal year 2001.

According to the complaint, although Sel-Leb’s stock had traded as high as $4.00

per share, its disclosures about financial health had rendered the company’s shares

worthless.2

2
We may take judicial notice under Federal Rule of Evidence 201of facts not
found by the district court, even when reviewing its ruling on a motion to dismiss.

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 B. District Court Opinion

On April 9, 2004, Key Equity filed a class action complaint in the United States

District Court for the District of New Jersey. Based on the foregoing facts, Key Equity

alleged that Sel-Leb, and its directors and accountant, (collectively, “defendants”) had

made materially false and misleading statements in violation of section 10(b) of the

Securities Exchange Act of 1934.3 In particular, Key Equity alleged that Sel-Leb had

“failed to disclose” that: (1) pre-tax earnings for fiscal year 2001 were overstated by

approximately $1.8 million; (2) the company incurred a pre-tax loss of approximately

$3.8 million for fiscal year 2002; (3) the company was in default on the terms of its credit

facility with Merrill Lynch; and (4) the company’s financial statements were not prepared

in accordance with GAAP.

According to the complaint, defendants concealed information about the “true state

of the Company’s deteriorating affairs” in order to “maintain the credit facility with

Merrill Lynch.” (A57) In Key Equity’s view, “[h]ad Merrill Lynch discovered the

adverse information about the Company earlier, it would have called for termination of

the credit facility immediately.” (A57)

On defendants’ motion, the District Court dismissed Key Equity’s complaint for

3
In a separate count, Key Equity alleged a violation of section 20(a) of the
Exchange Act on the part of Sel-Leb’s directors. Section 20(a) “imposes joint and several
liability on any person who ‘controls a person liable under any provision of the
[Exchange Act].’” In re Alpharma Inc. Sec. Litig., 372 F.3d 137, 153 (3d Cir. 2004)
(quoting Shapiro v. UJB Financial Corp., 964 F.2d 272, 279 (3d Cir. 1992)). As we
affirm dismissal of the § 10(b) claim, we likewise affirm the dismissal of this claim. Id.

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failure to state a claim on which relief could be granted, under Federal Rule of Civil

Procedure 12(b)(6), and failure to plead facts with particularity, under Rule 9(b) and the

PSLRA. The Court reached the following conclusions. Regarding the allegation that the

company’s financial statements did not conform to GAAP, Key Equity had not “alleged

with any detail what principles . . . were violated by Defendants.” (A16) Regarding the

allegation that the company renegotiated its credit line because of financial trouble, Key

Equity had relied merely on “information and belief,” and thus did not plead with

particularity. (A17) Regarding the allegations that the company had misstated its 2001

and 2002 earnings, Key Equity failed to plead with particularity facts giving rise to a

“strong inference” of scienter. (A17-20) Finally, the Court concluded that all of the

statements concerning the company’s future financial health were “forward looking” and,

therefore, did not give rise to liability. (A20-21)

On December 29, 2005, Key Equity filed a Notice of Appeal. We have

jurisdiction pursuant to 28 U.S.C. § 1291, and exercise plenary review over the District

Court’s order granting the defendants’ motion to dismiss. Cal. Pub. Employees’ Ret. Sys.

v. Chubb Corp., 394 F.3d 126, 143 (3d Cir. 2004).

II. Legal Background

“Section 10(b) of the Securities Exchange Act of 1934 forbids the ‘use or employ,

in connection with the purchase or sale of any security . . ., [of] any manipulative or

deceptive device or contrivance in contravention of such rules and regulations as the

[SEC] may prescribe . . . .’” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct.

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2499, 2507 (June 21, 2007) (quoting 15 U.S.C. § 78j(b)). “Pursuant to this statutory

authority, the [SEC has] promulgated Rule 10b-5, which creates a private cause of action

for investors harmed by materially false or misleading statements.” In re Suprema

Specialties, Inc. Sec. Litig., 438 F.3d 256, 275 (3d Cir. 2006).4

To state a claim for a violation of section 10(b), a plaintiff must plead the

following elements: “(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, often referred to in cases involving public securities markets

(fraud-on-the-market cases) as ‘transaction causation;’ (5) economic loss; and (6) ‘loss

causation,’ i.e., a causal connection between the material misrepresentation and the loss.”

Id. (quoting Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 341 (2005)). In assessing the

sufficiency of § 10(b) pleadings, we “accept all factual allegations in the complaint as

true,” and “consider the complaint in its entirety, as well as . . . sources courts ordinarily

examine when ruling on Rule 12(b)(6) motions to dismiss.” Tellabs, 127 S. Ct. at 2509.

More importantly, in assessing the sufficiency of a § 10(b) claim, we also observe

the heightened pleading requirements of Federal Rule of Civil Procedure 9(b) and the

4
The rule makes it unlawful “for any person ‘[t]o make any untrue statement of a
material fact or to omit to state a material fact necessary to make the statements made[,]
in light of the circumstances under which they were made, not misleading . . . in
connection with the purchase or sale of any security.’” Id. (quoting 17 C.F.R. §
240.10b-5(b)).

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PSLRA.5 Under these requirements, a plaintiff 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, [a

plaintiff must] state with particularity all facts on which that belief is formed.” In re

Alpharma Inc. Sec. Litig., 372 F.3d 137, 147 (3d Cir. 2004) (quoting 15 U.S.C. §

78u-4(b)(1)(B)). In other words, the complaint should set out the “who, what, when,

where and how” of the events at issue. DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th

Cir. 1990) (quoted in In re Advanta Corp. Sec. Litig., 180 F.3d 525, 534 (3d Cir. 1999)).

Regarding allegations of scienter, a plaintiff must “state with particularity facts

giving rise to a strong inference that the defendant acted with the required state of mind.”

In re Alpharma, 372 F.3d at 148 (quoting 15 U.S.C. § 78u-4(b)(2) (emphasis added)). To

do so, the complaint may allege (1) “facts to show that defendants had both motive and

opportunity to commit fraud,” or (2) “facts that constitute strong circumstantial evidence

of conscious misbehavior or recklessness.” Id. (quoting In re Burlington Coat Factory

Sec. Litig., 114 F.3d 1410, 1418 (3d Cir. 1997)). As the Supreme Court has made clear, a

complaint gives rise to a “strong inference” of scienter “only if a reasonable person would

5
The purpose of Rule 9(b) is to “give defendants notice of the claims against them,
provide an increased measure of protection for their reputations, and reduce[ ] the number
of frivolous suits brought solely to extract settlements.” In re Suprema Specialties, 438
F.3d at 270 (internal quotation marks omitted). The purpose of the PSLRA is “to restrict
abuses in securities class-action litigation.” In re Advanta Corp. Sec. Litig., 180 F.3d 525,
531 (3d Cir. 1999). To the extent that Rule 9(b) conflicts with the PSLRA, the statute
supersedes it. Id. at 531 n.5.

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deem the inference of scienter cogent and at least as compelling as any opposing

inference one could draw from the facts alleged.” Tellabs, 127 S. Ct. at 2510.

“Stated in another way, unless plaintiffs in securities fraud actions allege facts

supporting their contentions of fraud with the requisite particularity mandated by Rule

9(b) and the [PSLRA], they may not benefit from inferences flowing from vague or

unspecific allegations—inferences that may arguably have been justified under a

traditional Rule 12(b)(6) analysis.” In re Rockefeller Center Properties, Inc. Sec. Litig.,

311 F.3d 198, 224 (3d Cir. 2002). If a complaint fails to meet the stringent pleadings

requirements for sustaining a § 10(b) claim, the “appropriate sanction . . . is dismissal.”

In re Alpharma, 372 F.3d at 148; In re Rockefeller, 311 F.3d at 224 (citing 15 U.S.C. §

78u-4(b)(3)(A)).

III. Discussion

On appeal, Key Equity offers four reasons for us to vacate the order of the District

Court and reinstate its complaint. First, Key Equity argues that it did not have to plead

with particularity “which provisions of GAAP had been violated in order to satisfy the

pleading requirements of the PSLRA and Rule 9(b).” Br. at 9. Second, it argues that it

“pleaded with particularity that defendants were in default of the $3.8 million credit

facility with Merrill Lynch.” Br. at 11. Third, it contends that its complaint sufficiently

alleged “motive and opportunity” to satisfy the pleading requirements for scienter. Br. at

13. Finally, it contends that “defendants’ press releases and financial statements” were

not “forward looking” and were “thus not entitled to the PSLRA’s safe harbor

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protection.” Br. at 15.

We reject these contentions and conclude that Key Equity’s complaint fails to

satisfy the heightened pleading requirements of Rule 9(b) and the PSLRA.6 We agree

with the decision of the District Court primarily for two reasons.7 First, almost all the

statements identified by Key Equity were projections about the company’s financial

growth, or expressions of general optimism about its financial health. Such positive

portrayals of the company, however, are not actionable under § 10(b). As we stated in In

re Advanta, “vague and general statements of optimism ‘constitute no more than ‘puffery’

and are understood by reasonable investors as such.’” 180 F.3d at 538 (quoting In re

Burlington Coat, 114 F.3d at 1428 n.14). Accordingly, the company’s optimistic

statements that it was, for example, “slated to begin to generate strong revenue and

earnings growth in 2002,” do not give rise to liability under § 10(b).8

6
For the purposes of brevity, we do not distinguish between defendants in our
discussion of the issues. Notably, Key Equity does not do so on appeal. Its failure to
specify which facts support a claim against which defendants—i.e., which defendants said
and knew what at what time—supports our conclusion that the complaint is not pleaded
with sufficient particularity.
7
J.H. Cohn also points out that Key Equity failed to adequately plead “loss
causation,” i.e., that “the drop in the value of a security is related to the alleged
misrepresentation.” Berckeley Inv. Group, Ltd. v. Colkitt, 455 F.3d 195, 223 (3d Cir.
2006). Although it appears that no facts establish a causal connection between the
misstatements and the decline in the value of the stock, we, like the District Court, need
not reach this issue.
8
To the extent these statements could be considered materially misleading to a
reasonable investor, they were “identified as . . . forward-looking” and “accompanied by
meaningful cautionary statements identifying important factors that could cause actual
results to differ materially from those in the forward-looking statement.” 15 U.S.C. §

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 Second, although the District Court concluded that the complaint adequately

identified Sel-Leb’s earnings statements for 2001 and the first half of 2002 as materially

misleading,9 it concluded that Key Equity had failed to accompany these statements with

sufficient allegations of scienter. In order to establish scienter, Key Equity relies on the

defendants’ “motive and opportunity” to commit fraud. Presumably, the inference we are

to draw is that defendants had a motive to fraudulently misstate earnings because Sel-Leb

needed the Merrill Lynch line of credit to operate. Because the company could not meet

the requirements for sustaining this line of credit, defendants decided to overstate Sel-

Leb’s 2001 and 2002 earnings. Moreover, by stating that it was only “renewing” the

credit line, the defendants attempted to disguise the company’s deteriorating financial

condition from investors.

We conclude that these allegations have been pleaded with insufficient

particularity to meet the heightened pleading requirements of Rule 9(b) and the PSLRA.

Specifically, the facts allegedly supporting a strong inference of scienter have not been

adequately pled.10 As the Supreme Court recently stated, “omissions and ambiguities

78u-5(c)(1)(A)(i).
9
We observe that, arguably, the complaint fails to adequately plead that the
earnings statement for the first six months of 2002 was misleading. A $3.8 million loss
for the year as a whole is not necessarily inconsistent with gains in the first half of that
year. In fact, the press releases indicate that in the latter portion of 2002 a large number
of orders could not be filled, leading to financial difficulties. (A43)
10
We also note that the complaint sets out nothing more than an ordinary business
motive, which is typically insufficient to support a strong inference of fraud. See GSC
Partners CDO Fund v. Washington, 368 F.3d 228, 237 (3d Cir. 2004) (“Motives that are

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count against inferring scienter, for plaintiffs must ‘state with particularity facts giving

rise to a strong inference that the defendant acted with the required state of mind.’”

Tellabs, 127 S. Ct. at 2511 (quoting 15 U.S.C. § 78u-4(b)(2)).

In this case, although Key Equity alleges that Sel-Leb falsified its earnings to

maintain its credit line, its complaint is bereft of any facts or details supporting this

conclusion. We are therefore left to speculate about what particular information was

hidden, what financial figures were manipulated, and when any of the defendants knew of

or implemented such fraudulent devices. Cf. In re Burlington Coat, 114 F.3d at 1417-18

(“[W]here plaintiffs allege that defendants distorted certain data disclosed to the public by

using unreasonable accounting practices, we have required plaintiffs to state what the

unreasonable practices were and how they distorted the disclosed data.”). Inferring

scienter in these circumstances would impermissibly provide Key Equity the “benefit [of]

inferences flowing from vague or unspecific allegations.” In re Rockefeller, 311 F.3d at

224. In other words, because of the complaint’s omissions, it fails to set out the “who,

what, when, where and how” of the events at issue. DiLeo, 901 F.2d at 627.11

generally possessed by most corporate directors and officers do not suffice; instead,
plaintiffs must assert a concrete and personal benefit to the individual defendants
resulting from this fraud.”) (internal quotation marks omitted).
11
Our dissenting colleague relies on the tightening of Merrill Lynch’s credit line
as a motive to commit fraud. The complaint states only that, on information and belief,
Sel-Leb had to renegotiate its credit line because it could not repay certain obligations to
Merrill Lynch. (A53) With this allegation alone, an inference that defendants
renegotiated Sel-Leb’s credit line in the ordinary course of business (when it was up for
renewal) is more likely than an inference of scienter. See Tellabs, 127 S.Ct. at 2513.

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 Furthermore, we conclude that the complaint fails to adequately plead facts “that

constitute strong circumstantial evidence of conscious misbehavior or recklessness.” In

re Alpharma, 372 F.3d at 148. To do so, Key Equity would have to allege “an extreme

departure from the standards of ordinary care [that] presents a danger of misleading

buyers or sellers that is either known to the defendant or is so obvious that the actor must

have been aware of it.” In re Advanta, 180 F.3d at 535 (quoting McLean v. Alexander,

599 F.2d 1190, 1197 (3d Cir. 1979)). Although Key Equity does not appear to pursue a

recklessness theory on appeal, its complaint nonetheless fails to satisfy the requirements

for doing so. The mere fact of a misstatement is not evidence of recklessness, and Key

Equity provides no detail to support a stronger conclusion than: there must have been

fraud. We have previously rejected such conclusory pleading as precisely what the

PSLRA was intended to weed out. GSC Partners CDO Fund v. Washington, 368 F.3d

228, 239 (3d Cir. 2004) (“Of course, it is not enough for plaintiffs to merely allege that

defendants ‘knew’ their statements were fraudulent or that defendants ‘must have known’

their statements were false.”); In re Advanta, 180 F.3d at 539 (rejecting as inadequate

allegation that defendants “must have been aware of impending losses”).12

12
Our dissenting colleague would infer scienter from what he believes to be a
400% overstatement of Sel-Leb’s 2001 earnings. We disagree with his calculations. As
the record reveals, the original 2001 net earnings of $443,669 resulted from gross income
of $21,451,140 and expenses (including taxes) of $21,007,471. The revised figure for
that year reflected a reduction of about $1.8 million in pre-tax earnings. Assuming this
$1.8 million is a reduction in Sel-Leb’s gross income of over $21 million, the
misstatement reflects an error of less than 10%. Cf. PR Diamonds, Inc. v. Chandler, 364
F.3d 671, 686 (6th Cir. 2004) (“Accepting Plaintiffs’ allegations as true, Intrenet

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 IV. Conclusion

For the foregoing reasons, we conclude that Key Equity’s complaint failed to meet

the heightened pleading requirements applicable to a securities fraud claim under § 10(b).

We therefore affirm.

represented itself as a barely profitable company, when in fact it was a barely unprofitable
company. It simply cannot be said that Intrenet’s accounting improprieties, by virtue of
their type and size, should have been obvious.”). In any event, the complaint provides
insufficient details from which to determine what errors the misstatement resulted from,
or whether any “red flags” had warned any of the defendants about them.

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GARTH, Circuit Judge, dissenting:

I find it difficult to understand how the majority opinion can overlook the magnitude

of Sel-Leb’s overstatement of earnings ($1.8 million) which was 400% below its reported

income in 2001. Moreover, I find it even more difficult to understand how the majority

opinion can overlook Sel-Leb’s failure to disclose Merrill Lynch’s significant modifications

to Sel-Leb’s credit agreement because of Sel-Leb’s precarious financial condition. The

majority opinion does so by characterizing Sel-Leb’s rosy projections about its financial

health and future growth as “puffery.” I cannot join in the majority’s “puffery” analysis and

I therefore respectfully dissent.

I.

The facts alleged in the complaint, taken together with Sel-Leb’s SEC filings which

we are permitted to consider on a motion under Rule 12(b)(6),13 are more than sufficient to

13
See Oran v. Stafford., F.3d 275, 289 (3d Cir 2000) (adopting the reasoning of
“[a] number of our sister circuits [that] . . . in deciding a motion for judgment on the
pleadings [we may] take judicial notice of properly-authenticated public disclosure
documents filed with the SEC); see also Kramer v. Time Warner, Inc., 937 F.2d 767, 774
(2d Cir. 1991).

Moreover, I emphasize that this is a Fed. R. Civ. P. 12(b)(6) proceeding. In reviewing a
dismissal for failure to state a claim, a judge must accept as true all of the factual
allegations contained in the complaint and may take judicial notice of SEC documents.
See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499, 2509 (2007). As the

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plead and satisfy a “strong inference” that the director defendants acted fraudulently and with

scienter as required under the Private Securities Litigation Reform Act of 1995 (“PSLRA”).14

First, Merrill Lynch’s repeated material modifications of Sel-Leb’s loan agreements

in mid-2002 strongly point to the fact that Merrill Lynch was seriously concerned about Sel-

Leb’s financial position.15 I find it rather quixotic that in its effort to minimize Sel-Leb’s

intent to commit fraud, the majority opinion recites in its footnote 11 – and without the

context, language, and facts found in paragraph 30 of the complaint – that Sel-Leb’s

renegotiation of its credit line was no more than in the “ordinary course of business.” The

majority opinion’s footnote 11 states:

Supreme Court recently noted, “[t]he inquiry . . . is whether all of the facts alleged, taken
collectively, give rise to a strong inference of scienter, not whether any individual
allegation, scrutinized in isolation, meets that standard.” Id. (emphasis in original).
14
I concur with the majority that the complaint was properly dismissed as to J.H.
Cohn, Sel-Leb’s auditor, on the grounds that it stood to gain no “concrete and personal
benefit” from such misstatements. GSC Partners CDO Fund v. Washington, 368 F.3d
228, 237 (3d Cir. 2004); see also Rothman v. Gregor, 220 F.3d 81, 98 (2d Cir. 2000)
(holding that an auditor may be found liable for recklessness in certifying financial
misstatements only if its conduct was “highly unreasonable, representing an extreme
departure from the standards of ordinary care [and] must, in fact, approximate an actual
intent to aid in the fraud being perpetrated by the audited company”).
15
It is convenient for the majority opinion to infer that Sel-Leb’s credit line was
renegotiated only in the ordinary course of business. See maj op. n. 11. This is the same
litany that Sel-Leb would have us believe. However, as I point out, what Sel-Leb did was
bury its “renewal” to disguise the true purpose and effect of renegotiating its credit with
Merrill Lynch. One need only take a cursory look at the modifications made by Merrill
Lynch – which critically tightened Sel-Leb’s credit (and were instituted not only once, but
twice, in a span of four months) – to understand that this was no mere “ordinary course of
business.” This was financial desperation!

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 . . . The complaint states only that, on information

and belief, Sel-Leb had to renegotiate its credit

line because it could not repay certain obligations

to Merrill Lynch. (A53) With this allegation

alone, an inference that defendants renegotiated

Sel-Leb’s credit line in the ordinary course of

business (when it was up for renewal) is more

likely than an inference of scienter. See Tellabs,

127 S.Ct. at 2513.

However, paragraph 30 of the complaint in which the majority opinion finds comfort

– in full alleges not just the last sentence cited by the majority – but rather those facts and

details giving rise to the renegotiation of the credit agreement. Paragraph 30 of the complaint

alleges that:

This disclosure [that fourth quarter 2002 sales

would be substantially lower than projected]

occurred shortly after defendants filed their

quarterly report for the third quarter of 2002.

Buried in the quarterly report was the disclosure

that Sel-Leb had been required to renegotiate the

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 terms of a $3.8 million credit facility with Merrill

Lynch Business Financial Services, Inc. (“Merrill

Lynch”) and to postpone its obligation to repay

the $3,717,249 outstanding balance on the credit

facility from October 31, 2002 to October 31,

2003. Upon information and belief, the Company

had to renegotiate the terms of the credit facility

with Merrill Lynch because it could not make the

payment as required on October 31, 2002.

These concerns obviously caused Merrill Lynch problems. Despite these troubling

concerns of Sel-Leb’s principal lender, the director defendants reported in a November 18,

2002 press release that Sel-Leb was merely “pleased to announce” that it was “renewing

[not renegotiating] our Operating Line of Credit.” A42 (emphasis added). From the entire

allegations (not just the last sentence) contained in paragraph 30 of the complaint, it appears

that the director defendants had actual knowledge, to a far greater degree than they

disclosed, of Sel-Leb’s troubled financial position.

Second, the sheer size of Sel-Leb’s overstatements – over 400% of earnings in fiscal

year 2001 alone – are indicative of fraudulent intent. The complaint alleges that without

these enormous overstatements of earnings (which actually were losses, not positive

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income), Sel-Leb would have breached and defaulted on the terms of its credit agreement,

causing Merrill Lynch to terminate its credit at once and “exercis[e] remedies available to

it as a secured lender.” Comp. ¶¶ 44-45. Would reasonable investors truly regard a

misstatement of over 400% of reported income as mere “puffery?” Nor is it an answer to

say that the 400% overstatement of earnings have been miscalculated as the majority claims

in its footnote 12.

The majority opinion’s hypothesis (evaluating the extent of revenues and expenses)

as to the source of the misstatement – “a decrease of about 10%” of revenues – is nothing

more than pure speculation since neither the record nor the SEC filings state the reason for

the 400% overstatement of earnings.16 All the record and the SEC filings reveal is that Sel-

Leb turned from a profitable venture into a bankrupt company because, in part, its 2001

earnings were overstated by 400%. See A50; Sel-Leb Form 8-K, filed Feb. 24, 2004. To

a reasonable investor, it is inconsequential whether such a significant misstatement of

earnings retained by shareholders arises from an overstatement of revenues and/or an

understatement of expenses.

The SEC documents and reports, which the majority opinion has taken pains not to

16
The majority opinion could have attempted to further dilute the size of the 400%
earnings misstatement by speculating that it resulted from a 4.2% overstatement of
revenues and a 4.3% understatement of expenses (both percentages equaling in total to
about $1.8 million of the misstated net earnings).

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address, disclose that Sel-Leb was not a “barely unprofitable company” (see maj. op. n. 12)

but was rather in deep financial trouble – trouble which it chose not to disclose to its

investors or to Merrill Lynch. Moreover, by affirming the erroneous dismissal of Key

Equity’s complaint the majority has now precluded Key Equity from providing by proofs

the further facts and details as to Sel-Leb’s losses and its fraud.

Finally, the need to falsify Sel-Leb’s asset statements in order to prevent a default

leading to an end of its crucial credit line constitutes a motive to commit fraud that is

probative of scienter. In this regard, the complaint alleges that “[d]efendants were

motivated to issue materially false statements . . . in large part to maintain the credit facility

with Merrill Lynch. Had Merrill Lynch discovered the adverse information about the

Company earlier, it would have called for termination of the credit facility immediately.”

Comp. ¶ 45. Such motivation provides further probative support for plaintiffs’ assertion that

the director defendants acted with fraudulent intent.

These allegations, separately and particularly in combination, adequately plead a

“strong inference” of scienter as required by the PSLRA.

II.

The majority opinion states that Key Equity’s allegations in its complaint have not

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been adequately pled and are “bereft of any facts or details supporting” the conclusion that

Sel-Leb concealed its financial condition to maintain its credit line. Maj. op. p. 12. Let’s

examine what Key Equity really and factually charged.

Sel-Leb’s Failure to Disclose Modifications of its Credit Agreement

Sel-Leb’s Form 10-KSB contained, as an attachment, a loan agreement dated

November 8, 1999, under which Merrill Lynch agreed to provide a revolving line of credit

to Sel-Leb. One of the covenants contained in this loan agreement, under the heading

“Minimum Tangible Net Worth,” required that “Customer’s ‘tangible net worth’ shall at all

times exceed $6,500,000.00.” A27. In 2002, amidst Sel-Leb’s now evident catastrophic

losses, Merrill Lynch modified the loan agreement two times. On June 6, 2002, Merrill

Lynch increased the tangible net worth requirement to $8 million. A28. Just four months

later, on October 18, 2002, the tangible net worth requirement was further increased to $8.5

million. A29.

Sel-Leb did not report either of these modifications in its subsequent August 15,

2002 or September 13, 2002 press releases that accompanied its second quarter 2002 or third

quarter 2002 financial reports. Finally, in a November 18, 2002 press release, Sel-Leb

cheerfully reported that it was “pleased to announce that we have signed an agreement with

our major lending institution, renewing our Operating Line of Credit through October 31,

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2003.” A42 (emphasis added). This announcement made no mention of nor did it contain

any indication of the changes to Sel-Leb’s loan agreement. Moreover, the very term

“renewing” used by Sel-Leb to characterize the modifications to its loan agreement was

itself misleading and fraudulent. The complaint alleges that this was not a renewal but at

best a significant renegotiation. Comp. ¶ 30. (Puffery?).

The November 18, 2002 press release also reported positive earnings for the nine

months ended September 30, 2002, and stated “we expect to continue to show growth in

both sales and earnings for the fiscal year 2002.” Id. It was only later that Sel-Leb

disclosed that it had sustained a $3.8 million loss for fiscal year 2002. Comp. ¶¶ 39-40.

The allegations containing and referring to these facts demonstrate that the director

defendants had actual knowledge or at the very least behaved recklessly with respect to Sel-

Leb’s deteriorating financial condition. Merrill Lynch’s fears – as expressed by its

decisions to twice modify Sel-Leb’s loan covenants – were obvious warnings putting the

director defendants on notice of Sel-Leb’s seriously unstable financial condition. Even

more revealing of the director defendants’ state of mind, however, is the misleading manner

by which Sel-Leb reported the extension of its credit facility – i.e., that it was “pleased” to

be “renewing” the facility – without so much as a hint that in fact Merrill Lynch had twice

within the last five months materially tightened the terms of Sel-Leb’s credit. Comp. ¶¶ 30,

36, 45, 54. These allegations and facts are alone sufficient to create a strong inference of

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scienter permitting this case to go forward.

The director defendants argue that “the reason why Sel-Leb had to renegotiate the

terms of the credit facility on October 31, 2002 . . . was because October 31st was the annual

date for renewal of the credit facility.” Def. Br. at 23. This still fails to explain why the

materially adverse renegotiated terms were not disclosed. Instead, the director defendants

whitewashed those changes with a report that Sel-Leb’s credit facility had merely been

“renew[ed].” Comp. ¶ 30. In any event, the issue whether the October 31, 2002 extension

was simply an annual renewal or, as Key Equity maintains, “a renegotia[tion] . . . because

[Sel-Leb] could not make the payment as required on October 31, 2002” is a matter for

discovery, not resolution on a motion under Rule 12(b)(6). Id. The allegations amply reveal

that the actions of the director defendants were not the result of unfortunate business

conditions, but were rather fraudulent efforts to disguise Sel-Leb’s failing enterprise.

III.

Size of Misstatements and Errors in Financial Reports

The inference of scienter here is further heightened by the sizable magnitude of the

overstatements in Sel-Leb’s 2001 and 2002 financial statements. According to the

complaint, Sel-Leb’s pre-tax earnings for fiscal year 2001 were overstated by $1.8 million,

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and were thus actually over 400% below Sel-Leb’s $443,669 reported 2001 income. Comp.

¶¶ 41, 44. And, while reporting positive pre-tax income of $339,000 for first quarter 2002

and positive, though declining, pre-tax income of $418,370, and $132,276 for the six and

nine month periods ending June 30, 2002 and September 30, 2002, Sel-Leb later admitted

no income for those periods but rather a $3.8 million loss for fiscal year 2002. Comp. ¶¶ 24,

26, 40, 44. These facts can hardly be called “puffery” or a vague and general statement of

optimism (maj. op. p. 10-11) or forward-looking (maj. op. n. 8).

The magnitude of the overstatements in corporate financial statements has repeatedly

been held to constitute corroborating circumstances of fraudulent intent. See Gen. Elec.

Capital Corp. v. Acosta (In re Acosta), 406 F.3d 367, 372 (5th Cir. 2005) (“An intent to

deceive may be inferred from “reckless disregard for the truth or falsity of a statement

combined with the sheer magnitude of the resultant misrepresentation.”) (emphasis added);

PR Diamonds, Inc. v. Chandler, 364 F.3d 671, 684 (6th Cir. 2004) (“[A]n inference of

knowledge or recklessness may be drawn from allegations of accounting violations that are

so simple, basic, and pervasive in nature, and so great in magnitude, that they should have

been obvious to a defendant.”) (emphasis added); In re MicroStrategy, Inc. Sec. Litig., 115

F. Supp. 2d 620, 637 (D. Va. 2000) (“[T]he . . . restatements are of such a great magnitude

– amounting to a night-and-day difference with regard to MicroStrategy's representations

of profitability – as to compel an inference that fraud or recklessness was afoot.”) (emphasis

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added).17

Here, Sel-Leb overstated its earnings by over 400% in 2001 and reported hundreds

of thousands of dollars in earnings in 2002 while in reality sustaining a massive $3.8 million

loss. The enormity of these overstatements, taken together with the serious consequences

the director defendants knew would result from a disclosure that Sel-Leb breached the

covenants in its credit facility, are prime indicia of scienter under the PSLRA and Rule 9(b).

IV.

17
See also Rothman v. Gregor, 220 F.3d 81, 92 (2d. Cir. 2000) (agreeing that the
magnitude of write-offs involved “renders less credible” defendants’ argument that they
acted without scienter); In re Baan Co. Sec. Litig., 103 F. Supp. 2d 1, 21 (D.D.C. 2000)
(observing that “the magnitude of the error can play a role” in inferring scienter); In re
Ancor Communiations, Inc., 22 F. Supp. 2d 999, 1005 (D. Minn. 1998) (finding support
for a strong inference of conscious behavior from a company’s substantial overstatements
of revenues); In re First Merchants Acceptance Corp. Sec. Litig., No. 97-C-2715, 1998
U.S. Dist. LEXIS 17760, at *30-*31 (N.D. Ill. Nov. 4, 1998) (“Other circumstances
suggesting fraudulent intent can include . . . the magnitude of the fraud alleged.”); Carley
Capital Group v. Deloitte & Touche, L.L.P., 27 F. Supp. 2d 1324, 1339 (N.D. Ga. 1998)
(holding that a misapplication of GAAP “when combined with a drastic overstatement of
financial results can give rise to a strong inference of scienter”); Rehm v. Eagle Fin.
Corp., 954 F. Supp. 1246, 1255 (D. Ill. 1997) (citing the defendants’ 91% overstatement
of revenues as an “egregious miscalculation of credit losses” indicative of fraudulent
intent); Marksman Partners, L.P. v. Chantal Pharm. Corp., 927 F. Supp. 1297, 1314 (D.
Cal. 1996) (“The facts that the allegedly overstated revenues constituted such a
significant portion of Chantal's total revenues . . . tend[s] to support the conclusion that
the defendants acted with scienter.”).

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 We have held that scienter may be adequately pleaded either (1) by “alleging facts

establishing a motive and an opportunity to commit fraud;” or (2) by “setting forth facts that

constitute circumstantial evidence of either reckless or conscious behavior.” In re Advanta

Corp. Sec. Litig., 180 F.3d 525, 534-35 (3d Cir. 1999). As discussed above, the plaintiffs

here have alleged “conscious behavior” in that the director defendants knew of Merrill

Lynch’s concerns and concealed those concerns by reporting merely that Sel-Leb’s credit

facility had been “renew[ed].” But the complaint also alleges that the director defendants

had the “motive and opportunity” to commit fraud. In particular, the complaint asserts that

the director “[d]efendants were motivated to issue materially false statements . . . in large

part to maintain the credit facility with Merrill Lynch.” Comp ¶ 45. Such motivations are

highly probative of an intent to defraud. Allegations that a company’s life hinges upon a

credit facility, and that its lender is growing concerned about the company’s financial state

– coupled, as here, with severely overstated financials – present a starkly different scenario

than the sort of generalized and commonplace motivations that the majority opinion finds

to warrant dismissal under Rule 12(b)(6). The present complaint alleges that (1) absent

financial overstatements, a corporation would default on a credit facility necessary to its

survival; and (2) anxious lenders are repeatedly stiffening the terms of loan covenants,

suggest a more specific and less common motivation and, therefore, are more probative of

fraudulent intent.

Several courts have found such allegations probative of scienter. In Howard v.

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Everex Sys., 228 F.3d 1057 (9th Cir. 2000), the court found scienter had been sufficiently

established through plaintiffs’ evidence that “Everex had a motivation to overstate its net

value so as not to violate loan covenants with its principal lender CIT.” Id. at 1064.

Everex’s lender had required it to maintain a net worth of $90 million and at the end of

fiscal year 1991, Everex had a net worth of $92.1 million. The court stated that, given

Everex’s “projected possible first quarter FY1992 losses of $2.1 million, resulting in a net

worth of exactly $90 million,” the defendant director and CEO had the incentive to overstate

Everex's value.” Id. The court concluded that “the demonstration of [the defendant’s]

possible motive, combined with the red flags of Everex's financial condition, are sufficient

to withstand a motion for JMOL.” Id.18

Similarly, in PR Diamonds, Inc. v. Chandler, 364 F.3d 671 (6th Cir. 2004), the court

found significant the plaintiffs’ allegations that the defendants used improper accounting

practices to forestall the company’s impending default under certain financial covenants of

its bank loan agreement:

[T]he allegations that the Individual Defendants

18
Howard arose in the context of a motion for judgment as a matter of law rather
than on a motion to dismiss, in which context the Ninth Circuit has interpreted the
PSLRA to discount allegations of motive and opportunity as a means of establishing
scienter. See Fischer v. Vantive Corp.(In Re Vantive Corp. Secs. Litig.), 283 F.3d 1079,
1097 (9th Cir. 2002).

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 were motivated to engage in fraud in order to

forestall Intrenet's default of its bank loan

agreement and to preserve the Company's ability

to borrow pursuant to its credit facility warrant

closer scrutiny. These more particularized sorts

of motive allegations are more probative of

scienter. For example, as part of the mix of

factors contributing to an inference of scienter,

the Ninth Circuit has considered a defendant's

motivation to overstate a company's reported net

value so as not to violate loan covenants with its

lender and to improve the prospects of

increasing its credit line. Howard v. Everex

Sys., Inc., 228 F.3d 1057, 1064 (9th Cir. 2000).

We view the motive allegations concerning the

bank loan and credit facility as suggestive of

scienter, although standing alone they do not

establish a strong inference.

Id. at 690 (emphasis added).

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 In the present case, the complaint’s allegations that the director defendants were

motivated to avoid defaulting on Sel-Leb’s credit facility do not stand alone. Read together

with Sel-Leb’s SEC filings, the pleadings show that Merrill Lynch twice within a four-

month period tightened Sel-Leb’s loan covenants, the most plausible explanation for which

is Merrill Lynch’s concern about Sel-Leb’s financial situation. The director defendants

knew of these concerns but did not disclose them; in fact, the complaint alleges that the

director defendants hid or “buried” those concerns, see Comp. ¶ 30 (supra n. 3), behind the

pretense that the facility was being “renew[ed].” A42.

The question for us is not whether there are benign and “puffery” ways of

interpreting these events; there may be many. Rather, the issue is whether plaintiffs have

pled facts “rendering an inference of scienter at least as likely as any plausible opposing

inference.” Tellabs, 127 S.Ct. 2499, 2513 (2007) (emphasis in original). I would hold that

they have met this burden, and have therefore properly and adequately pled the “strong

inference” of scienter required under the PSLRA.

I therefore respectfully dissent from the majority’s judgment, which upholds the

district court’s dismissal of plaintiffs’ complaint pursuant to Fed. R. Civ. P. 12(b)(6) and

thus precludes plaintiffs from proving the fraud and intent of the defendant directors –

which plaintiffs have abundantly and appropriately alleged in the complaint.

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