Robert Garfield v. NDCHealth Corporation

[PUBLISH]

IN THE UNITED STATES COURT OF APPEALS

FOR THE ELEVENTH CIRCUIT FILED
________________________ U.S. COURT OF APPEALS
ELEVENTH CIRCUIT
OCTOBER 12, 2006
No. 05-14765
THOMAS K. KAHN
________________________
CLERK

D. C. Docket No. 04-00970-CV-WSD-1

ROBERT GARFIELD, individually
and on behalf of all others similarly situated,
THE DEKALB COUNTY PENSION PLAN,

Plaintiffs-Appellants,

versus

NDC HEALTH CORPORATION,
WALTER M. HOFF,
RANDOLPH L.M. HUTTO,
CHARLES W. MILLER,
DAVID H. SHENK,
JAMES W. FITZGIBBONS,
LEE ADREAN,
ERNST & YOUNG, LLP,

Defendants-Appellees.

________________________

Appeal from the United States District Court
for the Northern District of Georgia
_________________________

(October 12, 2006)
Before EDMONDSON, Chief Judge, BIRCH and ALARCÓN,* Circuit Judges.

ALARCÓN, Circuit Judge:

Lead Plaintiff DeKalb County Pension Fund (“DeKalb”) appeals from the

District Court’s Order dismissing its Second Amended Complaint for failure to

meet the heightened requirements of Rule 9(b) and the Private Securities

Litigation Reform Act (“PSLRA”), 15 U.S.C. § 77z-1, 78u. We affirm the District

Court’s Order dismissing the Second Amended Complaint and hold that DeKalb

waived its right to further amendment of its Complaint by taking the instant

appeal.

I

On April 07, 2004 Dekalb brought a claim in the United States District

Court for the Northern District of Georgia for securities fraud as a putative class

action against NDCHealth Corporation (“NDC”), several of its officers

(“Individual Defendants”), and the accounting firm Ernst and Young LLP

(“E&Y”). DeKalb set forth two causes of action in its Second Amended

Complaint: (1) securities fraud pursuant to Section 10(b), 15 U.S.C. §78j(b) and

Rule 10b-5, 17 CFR § 240.10b-5; and (2) violation of Section 20(a) of the

*
Honorable Arthur L. Alarcón, United States Circuit Judge for the Ninth Circuit, sitting
by designation.

2
Exchange Act, 15 U.S.C. 78t.

The gravamen of the Second Amended Complaint is that during the class

period of August 21, 2002 through August 9, 2004, NDC “engaged in a variety of

undisclosed accounting manipulations and business practices which caused the

Company’s financial results to be materially overstated.” DeKalb alleges that

NDC engaged in channel stuffing;1 prematurely recognized sales revenue; did not

follow Generally Accepted Accounting Principles; and materially misstated the

value of a failed investment in a company known as MedUnite. E&Y is being

sued because it served as NDC’s independent auditor and issued audit opinions on

the Company’s 2003 and 2004 financial statements.

NDC and E&Y filed motions to dismiss DeKalb’s Second Amended

Complaint on October 13, 2004. After the opposition and reply papers were filed,

on January 5, 2005, NDC filed a Form 8-K and a Form 12b-25 document with the

SEC disclosing that it would restate its accounts for the prior period “beginning

with its fiscal year ended May 31, 2002 through the first quarter of fiscal year

1
Channel stuffing is a practice whereby a company floods distribution channels by
employing incentives to induce customers into purchasing their products in large quantities,
creating a short-term bump in revenue and excess supply in the distribution chain. See e.g. In re
Scientific-Atlanta Inc., Securities Litigation, 239 F. Supp. 2d 1351, 1355 (N.D. Ga. 2002)
(“‘channel stuffing’ has the effect of shifting earnings into earlier quarters to the detriment of
earnings in later quarters.”).

3
2005 ended August 27, 2004.” The District Court took judicial notice of these

documents.2 The Second Amended Complaint contains no allegation regarding

the restatement of accounts.

The District Court dismissed Appellant’s Second Amended Complaint on

July 27, 2005 with leave to amend. The order states: “Plaintiff shall file its Third

Amended Complaint within thirty (30) days of entry of this Order, and Defendants

shall file their motions to dismiss within thirty (30) days of the filing of the Third

Amendment.” In re NDC Health Corp. Inc., No. 1:04-cv-0970, slip op. at 53 (N.D.

Ga. July 27, 2005). Instead of filing a third amended complaint, DeKalb filed a

Notice of Appeal on August 26, 2005, the last day of the period allotted for filing

an amended complaint.

2
On a motion to dismiss for failure to state a claim upon which relief can be granted, if
“matters outside the pleading are presented to and not excluded by the court, the motion shall be
treated as one for summary judgment and disposed of as provided in Rule 56, and all parties shall
be given reasonable opportunity to present all material made pertinent to such a motion by Rule
56.” Fed. R. Civ. P. Rule 12(b). Normally, “once the court decides to accept matters outside the
pleading, it must convert the motion to dismiss into one for summary judgment.” Property
Mgmt. & Inv., Inc., v. Lewis, 752 F.2d 599, 604 (11th Cir. 1985) (citing Carter v. Stanton, 405
U.S. 669, 671 (1972)). However, in the context of securities fraud, “SEC documents [may be
treated] as public records capable of being judicially noticed at the motion to dismiss stage.”
Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1280 (11th Cir. 1999). By taking judicial notice of
SEC documents, the District Court did not transform Defendants’ motions to dismiss into a
motion for summary judgment. Id.

4
 II

On September 13, 2005, this Court inquired nostra sponte whether the

District Court’s Order of July 27, 2005 constitutes a final appealable order. In

response, the parties agreed that “[g]enerally, an order dismissing a complaint is

not final and appealable unless the order holds that it dismisses the entire action or

that the complaint cannot be saved by amendment.” Van Poyck v. Singletary, 11

F.3d 146, 148 (11th Cir. 1994) (citing Czeremcha v. Int'l Ass'n of Machinists and

Aerospace Workers, AFL-CIO, 724 F.2d 1552, 1554-55 (11th Cir. 1984)).

“[W]here an order dismisses a complaint with leave to amend within a

specified period, the order becomes final (and therefore appealable) when the time

period allowed for amendment expires.” Briehler v. Miami, 926 F.2d 1001, 1002

(11th Cir. 1991). However, “the plaintiff need not wait until the expiration of the

stated time in order to treat the dismissal as final, but may appeal prior to the

expiration of the stated time period.” Schuurman v. Motor Vessel “Betty K V,”

798 F.2d 442, 445 (11th Cir. 1986). Accordingly, this Court has jurisdiction over

this timely filed appeal pursuant to 28 U.S.C. § 1291. By filing an appeal in this

manner, however, DeKalb elected to stand on its Second Amended Complaint and

waived its right to further amendment. Schuurman, 798 F.2d at 445 (“Once the

plaintiff chooses to appeal before the expiration of time allowed for amendment,

5
however, the plaintiff waives the right to later amend the complaint, even if the

time to amend has not yet expired.”).

III

DeKalb argues the District Court erred in dismissing its Second Amended

Complaint because, in determining that DeKalb did not plead facts sufficient to

give rise to a strong inference of scienter, “[t]he District Court failed to consider

all of the facts pled and also failed to view the allegations in a light most favorable

to Appellant.” (Appellant’s Br. 34.) DeKalb also argues that “the District Court

erred in determining that Appellant failed to plead the reasons for the falsity of the

alleged misstatements and omissions with requisite specificity.” Finally, Dekalb

assigns error to the District Court for “improperly impos[ing] conditions on

Appellant’s right to amend its complaint.”

“At the motion to dismiss stage, all well-pleaded facts are accepted as true,

and the reasonable inferences therefrom are construed in the light most favorable

to the plaintiff.” Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1273 n.1 (11th Cir.

1999). The “court reviews de novo the dismissal of a complaint pursuant to Rule

12(b)(6).” Oxford Asset Mgmt. v. Jaharis, 297 F.3d 1182, 1187 (11th Cir. 2002).

Section 10(b) and Rule10b-5 make it unlawful for any individual to employ

a manipulative or deceptive device in connection with the purchase or sale of any

6
security.3 “To allege securities fraud under Rule 10b-5, a plaintiff must show: 1) a

misstatement or omission, 2) of a material fact, 3) made with scienter, 4) on which

plaintiff relied, 5) that proximately caused his injury.” Bryant, 187 F.3d at 1281.

Section 20(a) of the Exchange Act provides for liability of “controlling

persons” who aid and abet “any person liable under any provision of this chapter

or of any rule or regulation thereunder.” 15 U.S.C. 78t. Dekalb’s claims under

3
Section 10(b), 15 U.S.C.S. § 78j, provides:

To use or employ, in connection with the purchase or sale of any
security registered on a national securities exchange or any security
not so registered, or any securities-based swap agreement (as defined
in section 206B of the Gramm-Leach-Bliley Act [15 USCS § 78c
note]), any manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the Commission may
prescribe as necessary or appropriate in the public interest or for the
protection of investors.

Rule 10b-5, 17 C.F.R. § 240.10b-5, was promulgated under Section 10(b) and
provides:

It shall be unlawful for any person, directly or indirectly, by the use of
any means or instrumentality of interstate commerce, or of the mails
or of any facility of any national securities exchange, (a) To employ
any device, scheme, or artifice to defraud, (b) To make any untrue
statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the
circumstances under which they were made, not misleading, or (c) To
engage in any act, practice, or course of business which operates or
would operate as a fraud or deceit upon any person, in connection
with the purchase or sale of any security.

7
Section 20(a) are alleged against the Individual Defendants, and predicated upon

the same alleged unlawful conduct relevant to its claims under Section 10b.

(Compl. ¶ 186.) Accordingly, the success of DeKalb’s section 20(a) claim turns

on the resolution of its claims under Section 10b and Rule 10b-5.

A

Channel stuffing is not fraudulent per se. Greebel v. FTP Software, Inc.,

194 F.3d 185, 202 (1st Cir. 1999) (“There is nothing inherently improper in

pressing for sales to be made earlier than in the normal course.”). In Greebel, the

First Circuit commented that in the context of alleged improper revenue

recognition, “channel stuffing evidence has some probative value. But that value

is weak.” Id. at 203; but see In re Cabletron Sys., 311 F.3d 11, 26 (1st Cir. 2002)

(allegations of improper revenue recognition, including fictitious sales, and

channel stuffing, were supported by averments of testimonial evidence from

insiders and pled with adequate specificity to survive a motion to dismiss). The

Seventh Circuit determined in Makor Issues & Rights, Ltd., et al., v. Tellabs, Inc.,

437 F.3d 588 (7th Cir. 2006) that “[w]hile there may be legitimate reasons for

attempting to achieve sales earlier via channel stuffing, providing excess supply to

distributors in order to create a misleading impression in the market of the

company’s financial health is not one of them.” Id. at 598. We agree with the

8
Seventh Circuit that channel stuffing may amount to fraudulent conduct when it is

done to mislead investors, but the allegations of channel stuffing in the instant

case were not pled with sufficient detail to overcome the PSLRA’s scienter hurdle.

Rule 9(b) provides that “[i]n all averments of fraud or mistake, the

circumstances constituting fraud or mistake shall be stated with particularity.”4

Fed. R. Civ. P. Rule 9(b). “Rule 9(b) is satisfied if the complaint sets forth ‘(1)

precisely what statements were made in what documents or oral representations or

what omissions were made, and (2) the time and place of each such statement and

the person responsible for making (or, in the case of omissions, not making) same,

and (3) the content of such statements and the manner in which they misled the

plaintiff, and (4) what the defendants obtained as a consequence of the fraud.’”

Ziemba v. Cascade Int'l, Inc., 256 F.3d 1194, 1202 (11th Cir. 2001) (quoting

Brooks v. Blue Cross and Blue Shield of Florida, Inc., 116 F.3d 1364, 1371 (11th

Cir. 1997)). “A sufficient level of factual support for a [10b] claim may be found

where the circumstances of the fraud are pled in detail. ‘This means the who,

what, when where, and how: the first paragraph of any newspaper story.’” Gross

v. Medaphis Corp., 977 F. Supp. 1463, 1470 (N.D. Ga. 1997) (quoting DiLeo v.

4
Rule 9(b) states: “In all averments of fraud or mistake, the circumstances constituting
fraud or mistake shall be stated with particularity. Malice, intent, knowledge, and other condition
of mind of a person may be averred generally.” Fed. R. Civ. P. Rule 9(b).

9
Ernst & Young, 901 F.2d 624, 627 (7th Cir. 1990)).

For claims brought under the Exchange Act, including Appellants’ claims

under Section 10b and Section 20a, the complaint 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

DeKalb argues that it set forth a claim satisfying the requirements of Rule

9(b) and the PSLRA when it alleged that NDC understated expenses in violation

of GAAP in three ways: “(1) it began to capitalize costs well before its

development projects reached ‘technological feasibility;’ (2) it amortized costs

over periods much greater than the economic life of its software assets; and (3) it

applied an excessive burden factor to its capitalized costs, thereby expensing less

5
Section 77u-4(b) provides:
(1) Misleading statements and omissions
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.

10
than necessary in the present term.” In discounting this argument, the District

Court stated “Plaintiff’s allegations are thin, and are based almost entirely on

statements by an undisclosed former executive in the Physician Services Group.”

In Re NDC Health Corp. Inc., No. 1:04-cv-0970, slip op. at 44.

The District Court did not err because Dekalb’s allegations regarding

amortization and capitalization are vague and difficult to evaluate. For example,

the Second Amended Complaint does not specify when the improper accounting

occurred. It also fails to allege how and what products were improperly

capitalized or amortized.

DeKalb also argues that the District Court erred in holding that DeKalb’s

allegations regarding material misstatement in NDC’s financial statements were

overly speculative and amount to nothing more than “non-actionable corporate

mismanagement.” The District Court determined that “the financial reporting was

itself accurate” and the reports “accurately reflected the performance of the

Company.” At the time the District Court issued its opinion, NDC had already

declared its intention to restate its accounts. On January 05, 2005, NDC filed a

disclosure with the SEC stating that it “identified certain practices regarding the

exchange of physician software inventory held by the Company’s value-added

resellers that were inconsistent with Company policies.” Accordingly, NDC

11
announced that “after discussion with the Company’s independent accountants, on

January 4, 2005, the Audit Committee of the Board of Directors determined it is

appropriate to restate prior-period results beginning with its fiscal year ended May

32, 2002 through the first quarter of fiscal year 2005 ended August 27, 2004.”

NDC also noted that “[t]he restatement will also include other identified

adjustments from prior periods.” It follows that NDCs prior financial reporting

may not have been accurate and may not have reflected the performance of the

company.

DeKalb elected to stand on its Second Amended Complaint. NDC’s

intention to restate its accounts is not alleged in the Second Amended Complaint.

Because DeKalb waived its right to file a third amended complaint, we limited our

review to the facts set forth in the Second Amended Complaint instead of

speculating whether DeKalb could have filed a third amended complaint that

would have met the pleading requirements of the PSLRA and Rule 9(b).

Turning to the allegations set forth in the Second Amended Complaint,

DeKalb maintains that it alleged improper revenue recognition with adequate

specificity by stating that in March of 2004, “a management level employee in the

Physician Services unit” notified E&Y of a “dire situation facing that business

segment – that accounts receivable were very high as a result of aggressive

12
channel-stuffing practices, which rendered the unit’s reported revenues highly

suspect.” (Compl. ¶ 61.) According to DeKalb, NDC “determined that

approximately $25 million of inventory was in the channel as of March 31, 2004.”

(Id. at ¶ 63.) The Second Amended Complaint goes on to state that, after

management learned of this information, NDC decided to “delay its earning

release pending a review of its revenue recognition practices in the Physician

Services Unit.” (Id.) In sum, DeKalb alleged that NDC issued erroneous financial

statements that contained substantial misstatements due to the improper

recognition of revenue and channel stuffing in the Physician Services Unit.

DeKalb also alleged that “Defendants sought to conceal their improper

revenue recognition by increasing reserves and taking large, year-end charges for

uncollected receivables, without explanation.” Absent from these allegations are

any detailed allegations of scienter with respect to the alleged misrepresentations.

B

DeKalb argues it was plain error for the District Court to conclude “that the

Complaint does not contain allegations sufficient to give rise to a strong inference

of scienter with respect to Appellees[.]” A complaint must “state with

particularity facts giving rise to a strong inference that the defendant acted with

13
the required state of mind.” 15 U.S.C. § 78u-4(b)(2).6 “This [statutory]

requirement alters the usual contours of a Rule 12(b)(6) ruling because, while a

court continues to give all reasonable inferences to plaintiffs, those inferences

supporting scienter must be strong ones.” In re Cabletron Sys., 311 F.3d at 28

(citing Greebel, 194 F.3d 185, 201 (1st Cir. 1999)). “[F]actual allegations may be

aggregated to infer scienter and must be inferred for each defendant with respect

to each violation.” Phillips v. Scientific-Atlanta, Inc., 374 F.3d 1015, 1016 (11th

Cir. 2004).

Dekalb contends “the District Court fail[ed] to properly consider all scienter

allegations in the aggregate, [and] the Court patently failed to interpret the

allegations in a light most favorable to Appellant.” “[A] securities fraud plaintiff

must plead scienter with particular facts that give rise to a strong inference that the

defendant acted in a severely reckless manner.” Bryant, 187 F.3d at 1287.

“‘Severe recklessness is limited to those highly unreasonable omissions or

misrepresentations that involve not merely simple or even inexcusable negligence,

6
Section 77u-4(b)(2) provides:
(2) Required state of mind
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.

14
but an extreme departure from the standards of ordinary care, and that present a

danger of misleading buyers or sellers which is either known to the defendant or is

so obvious that the defendant must have been aware of it.’” Id. at 1282 n.18

(quoting McDonald v. Alan Bush Brokerage Co., 863 F.2d 809, 814 (11th Cir.

1989)).

Turning to the salient allegations of scienter set forth in the Second

Amended Complaint, DeKalb alleged that Defendants Hoff and Miller attended

monthly operations meetings in Arizona and “every aspect of the Physician

Services business was discussed in detail, including the aggressive channel

stuffing and mounting problems with accounts recevable (sic).” (Compl. ¶ 56.) In

the Second Amended Complaint, DeKalb alleged that testimonial evidence

provided by a “former senior executive” would show Defendants Miller and Hoff

knew there was a problem with “mounting accounts receivable” but decided to

continue with “aggressive discounting and credit terms” because the company had

to “make its numbers.”7

7
In its Second Amended Complaint, DeKalb avers:

According to the former senior executive, Defendants Miller and Hoff often
discussed the difficult tension between the rising accounts receivable and the
aggressive discounting and extended credit terms being given to VARs on the one
hand, and the need for the Company to “make its numbers,” on the other. The
senior executive related that Hoff and Miller remarked that the Company was

15
 Absent from these allegations are any particularized averments of fraud or

scienter. In Theoharous v. Fong, 256 F.3d 1219 (11th Cir. 2001), this Court held

that scienter was not pled with adequate specificity “because the plaintiffs did not

allege the context in which Fong made this statement, [and] it does not appear

from the face of the complaint that Fong must have known that the statement

presented a danger of misleading buyers or sellers.” Id. at 1225. As in Fong,

DeKalb’s broad claim of testimonial evidence is not set forth with requisite detail

because DeKalb failed to allege what was said at the meeting, to whom it was said,

or in what context. Accordingly, the averment lacks the requisite particularity. It

is well established that “claims of securities fraud cannot rest ‘on speculation and

conclusory allegations.’” Hoffman v. Comshare, Inc. (In re Comshare Inc. Sec.

Litig.), 183 F.3d 542, 553 (6th Cir. 1999) (quoting San Leandro Emergency Med.

Plan v. Philip Morris Co., 75 F.3d 801, 813 (2d Cir. 1996). A general allegation

that Individual Defendants promoted channel stuffing at a series of meetings does

‘quarter driven,’ and that the need to sustain reported revenue growth outweighed
the need to properly address the mounting accounts receivable and the attendant
questionable revenue recognition. Instead of addressing growing concerns of
managers in the unit that the aggressive discounting, channel-stuffing, and
extended credit terms. . . were creating serious realizability (sic) concerns . . .
Defendants Hoff and Miller directed the unit to forge ahead and continue to
aggressively stuff the channel in order to give the appearance of robust revenue
growth.

(Compl. ¶ 57.)

16
not establish scienter.

DeKalb also avers that the Individual Defendants, Mssrs. Hoff, Hutto and

Miller, made a PowerPoint presentation in Atlanta on March 1, 2004 that

“contained several statements identifying problems with the VAR channel.” The

presentation included discussion of the following topics: “Heavy promotion

discounting to drive VAR sales,” and “Change ordering/buying behavior of Vars

from Q/E promotion discount buying to pull through demand buying and add

additional VARs”. DeKalb also alleges: “Identified as ‘Conditions for

Success/Risks’ (sic) were ‘VAR accounts receivable collections’ and ‘Visibility

into VAR inventory levels and outbound programs/assistance to move inventory

physician practices (pull through sales).’” DeKalb maintains that these allegations

establish a strong inference of scienter on the part of the individual defendants.

We disagree.

Viewing these confusing statements in the best possible light, it is possible

to surmise that the Individual Defendants might have been aware of improper

revenue recognition in the VAR channel and also knew that they needed to

increase actual sales rather than “promot[e] discount buying.” But that conclusion

is based on multiple inferences and drawn from somewhat baffling language.

DeKalb failed to allege what was actually discussed at the meeting. Accordingly,

17
the allegation regarding the meeting of March 1, 2004, does not give rise to a

strong inference of scienter.

DeKalb also argues that the personal certifications required by the

Sarbanes-Oxley Act and signed by senior executives “are indicia of Defendants’

scienter.” Dekalb contends that by signing the certification, Defendants

represented to the general public that: “(1) they reviewed the filing being certified;

(2) the report did not contain any untrue statement of material fact . . . ; (3) the

report fairly presented the financial condition of the company; and (4) they

designed the disclosure controls and procedures to ensure that material

information relating to the Company was disclosed to them for the period in

question.”

The plain meaning of the language contained in Sarbanes-Oxley, 18 U.S.C.

§ 1350, does not indicate any intent to change the requirements for pleading

scienter set forth in the PSLRA, 15 U.S.C. § 78u-4(2). Sarbanes-Oxley requires

that the chief executive officer and chief financial officer certify “[e]ach periodic

report containing financial statements filed by an issuer with the Securities and

Exchange Commission . . .” 18 U.S.C. § 1350(a). The statute also provides for

imprisonment of up to 10 years or a fine of $1,000,000 for any person who

“certifies a periodic financial statement . . . knowing that the periodic report

18
accompanying the statement does not comport with all the requirements set forth

in [section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C.

78m(a) or 78o(d))] . . .” 18 U.S.C. § 1350(c). An individual who “willfully

certifies” such a statement is subject to a prison term of 20 years and a fine of up

to $5,000,000. Nowhere in the statute is there any mention of civil liability or

pleading requirements for scienter in civil actions brought for securities fraud.

“A fundamental canon of statutory construction is that, unless otherwise

defined, words will be interpreted as taking their ordinary, contemporary, common

meaning.” Perrin v. United States, 444 U.S. 37, 42 (1979) (citing Burns v. Alcala,

420 U.S. 575, 580-81 (1975)). When construing the meaning of a statute, “the

beginning point must be the language of the statute, and when a statute speaks

with clarity to an issue judicial inquiry into the statute's meaning, in all but the

most extraordinary circumstance, is finished.” Estate of Cowart v. Nicklos

Drilling Co., 505 U.S. 469, 475 (1992) (citing Demarest v. Manspeaker, 498 U.S.

184, 190 (1991)). In the instant case, the statute does not speak to the issue of

pleading scienter. The plain language of Sarbanes-Oxley evidences no

congressional intent to alter the pleading requirements set forth in the PSLRA. 18

U.S.C. § 1350.

DeKalb’s interpretation of Sarbanes-Oxley conflicts with the plain language

19
of the PSLRA. “‘[W]hen two statutes are capable of coexistence, it is the duty of

the courts, absent a clearly expressed congressional intention to the contrary, to

regard each as effective.’” J.E.M. Ag Supply v. Pioneer Hi-Bred Int'l, 534 U.S.

124, 143-44 (2001) (quoting Morton v. Mancari, 417 U.S. 535, 551 (1974)). If we

were to accept DeKalb’s proffered interpretation of Sarbanes-Oxley, scienter

would be established in every case where there was an accounting error or

auditing mistake made by a publicly traded company, thereby eviscerating the

pleading requirements for scienter set forth in the PSLRA. We decline to adopt

such an interpretation.

Instead, we hold that a Sarbanes-Oxley certification is only probative of

scienter if the person signing the certification was severely reckless in certifying

the accuracy of the financial statements. This requirement is satisfied if the person

signing the certification had reason to know, or should have suspected, due to the

presence of glaring accounting irregularities or other “red flags,” that the financial

statements contained material misstatements or omissions. In the instant case,

there are no allegations in the Second Amended Complaint that indicate the

presence of such “red flags” in the company’s financial statements.

The Second Amended Complaint states that “the Physician Services

accounts receivable grew from $200,000 to almost $11 million in approximately

20
eighteen months beginning in late 2002.” By way of comparison, NDC

announced that its revenue for the third quarter of 2003 was $116.1 million and

net income was only $9.3 million. DeKalb alleged that “[i]n the fourth quarter

(ended May 30, 2003 . . . ), NDC increased its allowance for doubtful accounts by

$4.26 million, nearly seven times the average for the three previous quarters.”

(Compl. ¶ 68.) Those numbers are somewhat alarming because they indicate a

relatively large amount of revenue that might never be realized. But those

statements themselves do not appear to be untrue or misleading.

Viewing the allegations individually and in aggregate, the facts set forth in

the Second Amended Complaint do not create a “strong inference” of scienter.

See 15 U.S.C. § 78u-4(b)(2) (mandating “strong inference that the defendant acted

with the required state of mind.”) Accordingly, the District Court did not err in

dismissing DeKalb’s Second Amended Complaint.

C

NDC argues that Dekalb did not have standing to bring a claim regarding

the stated value of MedUnite because DeKalb did not purchase any stock until

after the alleged fraudulent conduct occurred. Dekalb alleged that the impact of

the sale of MedUnite was realized on March 19, 2003. (Compl. ¶ 75.) But Dekalb

21
did not buy stock until March 10 and 11, 2004. Accordingly Dekalb did not have

standing to bring this claim because they did not buy the stock until long after the

impact of the sale was realized. See Marsh v. Armada Corp., 533 F.2d 978, 981-

82 (6th Cir. 1976) (“Standing is established by allegations that plaintiffs bought or

sold shares of the stock in question within a reasonable period of time after the

allegedly fraudulent conduct occurred to support an inference of reliance.”); see

also Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 730 (1975) (holding

that “the plaintiff class for purposes of a private damage action under § 10(b) and

Rule 10b-5 [i]s limited to actual purchasers and sellers of securities.”).

IV

DeKalb argues that the District Court erred in dismissing its Complaint

against E&Y because E&Y certified NDC’s financial accounts even though their

practices did not comport with Generally Accepted Acounting Principles

(“GAAP”) and Generally Accepted Auditing Standards (“GAAS”).8 DeKalb

alleged that E&Y ignored “red flags” when it issued unqualified audits and

8
Generally Accepted Accounting Principles ("GAAP") are the “basic postulates and broad
principles” that guide business accounting. SEC v. Price Waterhouse, 797 F. Supp. 1217,
1222-23 n17 (S.D.N.Y. 1992) (cited in Ziemba, 256 F.3d at 1200. GAAP is approved by the
Auditing Standards Board of the American Institute of Certified Public Accountants ("AICPA").
Id. Generally Accepted Auditing Standards ("GAAS") are the standards prescribed by the
AICPA for the conduct of auditors in the performance of an examination. Id. GAAP and GAAS
establish guidelines for measuring, recording, and classifying a business entity's transactions. Id.

22
financial statements in 2003 and 2004. (Compl. ¶¶ 151-54.)

A

DeKalb argues that anomalous increases in NDC’s reserve for doubtful

accounts put E&Y “on notice of the other Defendant’s fraudulent scheme.”

Drastic overstatement of accounts, or other red flags, combined with alleged

violations of GAAS or GAAP may be enough to establish the requisite level

scienter. In re Eagle Bldg. Tech. Inc., Sec. Litig., 319 F. Supp. 2d 1318, 1328

(S.D. Fla. 2004) (finding sufficient particularity where fraudulent contracts made

up 74% of the company’s business, financial statements had 60 out of 75 line

items restated, and red flags included inter alia, purchase order discrepancies in

the hundreds of thousands, delivery discrepancies of 50% of goods, and post-dated

license agreements); see also In re Friedman’s, Inc., Sec. Litig., 385 F. Supp. 2d

1345, 1365-66 (N.D. Ga. 2005) (finding a strong inference of scienter where

auditing firm “had continuous arguments” with company management over

allowance for uncollected accounts, the firm “knew that” the company was under-

reserved, the firm discussed doubtful accounts every quarter, and the firm

committed numerous GAAP and GAAS violations); In re Hamilton Bankcorp.,

Inc., Sec. Litig., 194 F. Supp. 2d 1353 (S.D. Fla. 2002) (finding sufficient

particularity where auditing firm committed numerous GAAP and GAAS

23
violations and ignored an investigation by the Office of the Comptroller of the

Currency, the simultaneous sale and purchase of overpriced loans or securities to

avoid write down on its books, and the corporation’s failure to adhere to SEC

requirements).

Red flags are “those facts which come to the attention of an auditor which

would place a reasonable auditor on notice that the audited company was engaged

in wrongdoing to the detriment of its investors.” In re Sunterra Corp. Sec. Litig.,

199 F. Supp. 2d 1308, 1334 (M.D. Fla 2002). “It is established, however, that the

purported red flags cannot simply ‘re-hash’ the alleged GAAP violations.” In re

Spear & Jackson Sec. Litig., 399 F. Supp. 2d 1350, 1363 (S.D. Fla. 2005) (citing

Holmes v. Baker, 166 F. Supp. 2d 1362, 1379 (S.D. Fla. 2001)).

DeKalb alleged that E&Y was put on notice of fraudulent activity by NDC’s

increased allowance for “doubtful accounts” in the fourth quarter of 2003 and

2004. (Compl. ¶ 67). DeKalb also claimed that “[a]n analysis of NDC’s reserve

for doubtful accounts and related charge-offs and recoveries for fiscal year 2003

and fiscal year 2004 reveals a pattern strongly suggesting that Defendants

concealed overstated revenues for fiscal year 2003 and 2004 by increasing NDC’s

provision in the fourth quarter of both years and taking a large, anomalous charge

for uncollectible accounts receivable. . . .” (Id.) The Complaint alleged

24
 the first three quarters of fiscal year 2003 NDC provisioned at a
modest rate and actually reported net recoveries on accounts
receivable previously written off . . . [but] in the fourth quarter (ended
May 30, 2003, and incidentally, the quarter in which NDC’s
independent auditors began to review the Company’s financials in
preparation for the filing of the Form 10-K), NDC increased its
allowance for doubtful accounts by $4.26 million, nearly seven times
the average for the three previous quarters.

(Compl. ¶ 68.) DeKalb also alleged that “NDC charged-off over $6.1 million in

uncollectible accounts receivable.” (Id.) The Second Amended Complaint states

that “[i]n fiscal, 2004, in spite of NDC’s special review of its revenue recognition

practices and reserves prior to the issuance of its third quarter results, the

Company once again took an anomalous charge against its reserve of

approximately $6.7 million, or 78% of its reserve [and] failed to give any

explanation for these year-end results[.]” (Id.) DeKalb alleged that this charge

was “highly irregular given that NDC had purportedly experienced net recoveries

for the first three quarters of fiscal year 2003 and modest provisioning and charge

offs for the first three quarters of fiscal 2004.” (Id.)

DeKalb has not alleged any facts that show E&Y was actually aware or

should have known that NDC recklessly “concealed overstated revenues.” See

Bryant, 187 F.3d at 1287 (adopting the recklessness standard). DeKalb does not

allege facts that show that such increased allowances were so irregular as to put an

25
auditing company on notice for fraud. See Ziemba, 256 F.3d at 1210 (dismissing a

complaint where auditing firm was not “tipped off”). The Second Amended

Complaint states NDC chose the fourth quarter to start increasing the allowances

for doubtful accounts “incidentally” at the same time E&Y “began to review the

Company’s financials.” Since DeKalb has not alleged that E&Y knew about the

alleged reason for the increased “irregular” allowance for doubtful accounts, or

should have known about NDC’s improper revenue recognition, DeKalb failed to

plead facts giving rise to a strong inference of scienter.

B

DeKalb alleged that “during March 2004, E&Y was notified by a

management level employee in the Physician Services unit of the dire situation

facing that business segment – that accounts receivable were very high as a result

of aggressive channel-stuffing practices, which rendered the unit’s reported

revenues highly suspect.” (Compl. ¶ 61.) As a result of this notification, “the

Company and Defendants were forced to begin addressing the problem.” (Id.)

The Second Amended Complaint does not assert that E&Y had knowledge of

wrongdoing before March of 2004 and does not allege facts demonstrating that

E&Y acted with reckless disregard after E&Y was informed of the problem. On

the contrary, DeKalb alleged that when E&Y was “notified” of a “dire situation,”

26
E&Y took action. DeKalb has not pled facts that indicate E&Y’s response to the

notice was highly unreasonable or an extreme departure from the standards of

ordinary care.

C

DeKalb’s remaining allegations pertain to violations of GAAP or GAAS.

“Allegations of GAAS or GAAP, standing alone, do not satisfy the particularity

requirement of Rule 9(b).” Ziemba, 256 F.3d at 1208. Such allegations do not

create a strong inference of recklessness because “[t]hey merely suggest that either

management or the accountant missed something, and may have failed to prepare

or review the financial statements in accordance with an accepted standard of

reasonable care.” Reiger v. Price Waterhouse Coopers LLP, 117 F. Supp. 2d

1003, 1010 (S.D. Cal. 2000), aff’d sub nom. DSAM Global Value Fund v. Altris

Software, Inc., 288 F.3d 385 (9th Cir. 2002).

In the Second Amended Complaint, DeKalb alleged that E&Y’s audit report

of July 21, 2003 “falsely represented that E&Y had conducted its audit for NDC’s

year end 2003 financial statements in accordance with GAAS, and that NDC’s

financial statements conformed with GAAP.” (Compl. ¶ 151.) DeKalb alleged

that E&Y violated GAAS by failing exercise due professional care, failing to

design proper audit procedures, and by “failing to expand or otherwise properly

27
conduct its audit to detect the understatement in the allowance for doubtful

accounts. . . .” (Compl. ¶¶ 156, 165, 168.) DeKalb also alleged that “E&Y failed

to obtain sufficient competent evidential matter” with regards to write-offs,

software capitalization, and improper revenue recognition. (Compl. ¶ 166.)

DeKalb goes on to allege that these GAAS violations were caused by “E&Y’s

failure to qualify, modify or abstain from issuing its audit opinions, when it knew

or recklessly turned a blind eye to NDC’s accounting manipulations. . . .” (Compl.

¶ 158.)

While the DeKalb broadly claims that E&Y failed to design and implement

proper auditing procedures, DeKalb never describes how E&Y failed to do so.

For example, DeKalb refers to the American Institute of Certified Public

Accountants’ Codification of Statement on Auditing Standards, but DeKalb does

not allege how E&Y violated each section. DeKalb alleged that if E&Y had not

violated GAAP and GAAS the supposed fraud would not have taken place.

(Compl. ¶ 158) However, DeKalb may not “establish scienter by alleging that the

auditor would have discovered the fraud had it not violated GAAS.” In re Spear

& Jackson Sec. Litig., 399 F. Supp. 2d at 1363 (citing In re Eagle Bldg. Tech. Inc.,

Sec. Litig., 319 F. Supp. 2d at 1328). This is merely an allegation of negligence.

DeKalb states that E&Y “recklessly turned a blind eye” to the problems at

28
NDC. But merely alleging scienter in general, conclusory terms does not meet the

particularity requirement. 15 U.S.C. § 78u-4(b)(2). The District Court did not err

in granting E&Y’s motion to dismiss.

V

DeKalb waived its right to file a third amended complaint by filing the

instant appeal. But that does not moot the issue because a question remains as to

whether the restrictions on further amendment were overly burdensome. Federal

Rule of Civil Procedure Rule 15(a) states that leave to amend “shall be freely

given when justice so requires.”9 Denial of leave to amend is reviewed for abuse

of discretion. Baez v. Banc One Leasing Corp., 348 F.3d 972, 973 (11th Cir.

2003). In Foman v. Davis, 371 U.S. 178 (1962) the Supreme Court declared that

trial courts have broad discretion in permitting or refusing to grant leave to amend.

Id. at 182. “In the absence of any apparent or declared reason -- such as undue

delay, bad faith or dilatory motive on the part of the movant, repeated failure to

9
Rule 15(a) provides, in pertinent part:
A party may amend the party’s pleading once as a matter of course at any time
before a responsive pleading is served, or, if the pleading is one to which no
responsive pleading is permitted and the action has not been placed upon the trial
calendar, the party may so amend it at any time within 20 days after it is served.
Otherwise a party may amend the party’s pleading only by leave of court or by
written consent of the adverse party; and leave shall be given freely when justice
so requires.

29
cure deficiencies by amendments previously allowed, undue prejudice to the

opposing party by virtue of allowance of the amendment, futility of amendment,

etc. -- the leave sought should, as the rules require, be ‘freely given.’” Id.

DeKalb argues the District Court erred in placing restrictions upon its right

to further amend its Complaint because the District Court incorrectly premised the

restrictions on “the interest of fairness and to manage this litigation effectively.”

DeKalb also argues that the District Court did not adhere to the factors in Foman

v. Davis, 371 U.S. 178, 182 (1962). DeKalb’s argument lacks merit because the

District Court did not deny DeKalb leave to amend. The District Court explicitly

considered at least two of the Foman factors in fashioning the restrictions placed

on DeKalb’s right to further amendment of its Complaint.

In discussing the issue of leave to amend, the District Court made the

following comments: “The Eleventh Circuit requires leave to amend be granted

where a more carefully drafted complaint might state a claim. Here, the Court was

inclined to deny Plaintiff’s request for leave to amend the Second Amended

Complaint.” In re NDCHealth Corp., Inc. Securities Litigation, No. 1:04-cv-0970,

slip op. at 50. The District Court noted that “Plaintiff previously has amended its

complaint twice.”

The District Court gave DeKalb leave to amend because NDC’s notice to

30
the SEC regarding the restatement of its accounts “may at least be germane to the

claims asserted.” In re NDCHealth Corp., Inc. Securities Litigation, No. 1:04-cv-

0970, slip op. at 51 n.23. However, the District Court placed restrictions on

Appellant’s right to amend: “Plaintiff may amend its complaint but the amendment

is limited to allegations (i) based on information not available to Plaintiff when the

Second Amended Complaint was filed and (ii) which bear only on claims already

asserted.” Id. at 52.

“[I]n the exercise of sound discretion, the granting of leave to amend can be

conditioned in order to avoid prejudice to the opposing party.” Allied Indus.

Workers v. Gen. Elec. Co., 471 F.2d 751, 756 (6th Cir.) (quoting Strickler v.

Pfister Assoc. Growers, Inc., 319 F.2d 788, 791 (6th Cir. 1963)), cert denied, 414

U.S. 822 (1973). But the conditions placed on a plaintiff’s right to amend its

Complaint must be reasonable. See id. (holding the “requirement that the

amendment be filed by a specified date or that the party amending bear a portion

of the additional cost to the opposing party would, in proper circumstances, be

reasonable conditions.”); see also Anderberg v. Masonite Corp., 176 F.R.D. 682,

687 (N.D. Ga. 1997) (“the court may under Rule 15(a), impose costs as a condition

of granting leave to amend in order to compensate Defendant and avoid any

prejudice caused by the amendment.”); Gen. Signal v. MCI Telecomm. Corp., 66

31
F.3d 1500, 1514 (9th Cir. 1995) (same); Chicago Pneumatic Tool Co. v. Hughes

Tool Co., 192 F.2d 620, 631 (10th Cir. 1951) (holding “it lay well within the range

of sound judicial discretion of the court to allow the amendment in toto, to deny it

altogether, or to permit it with reasonable conditions and limitations.”).

In the instant case, the conditions placed upon DeKalb’s right to amend

were relatively modest. The District Court merely required that DeKalb limit its

amendment to the legal theories already asserted, and permitted DeKalb to assert

any new facts to state a claim. DeKalb has failed to demonstrate that these

restrictions were unreasonable. Because DeKalb already had ample opportunity to

file an amended complaint that meets the heightened pleading requirements of

Rule 9(b) and the PSLRA, the District Court did not abuse its discretion by

placing those restrictions on DeKalb’s right to further amendment.

AFFIRMED.

32