United States Court of Appeals
For the First Circuit
____________________
No. 01-1989
MICHAEL ALDRIDGE, individually and on behalf of
all others similarly situated,
Plaintiff, Appellant,
v.
A.T. CROSS CORPORATION, BRADFORD R. BOSS, RUSSELL A. BOSS, W.
RUSSELL BOSS JR. TRUST A, W. RUSSELL BOSS JR. TRUST B, W. RUSSELL
BOSS JR. TRUST C, JOHN E. BUCKLEY, and JOHN T. RUGGIERI,
Defendants, Appellees.
____________________
APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF RHODE ISLAND
[Hon. Mary M. Lisi, U.S. District Judge]
____________________
Before
Torruella, Circuit Judge,
Stahl, Senior Circuit Judge,
and Lynch, Circuit Judge.
____________________
Lawrence Deutsch with whom Shanon J. Carson, Berger &
Montague, P.C., Matthew F. Medeiros, and Little, Bulman, Medeiros
& Whitney, P.C. were on brief for appellant.
John F. Sylvia with whom R. Robert Popeo, Stephen T. Murray,
Justin S. Kudler, and Mintz, Levin, Cohn, Ferris, Glovsky and
Popeo, P.C. were on brief for appellees A.T. Cross Company,
Bradford R. Boss, Russell A. Boss, John E. Buckley, and John T.
Ruggieri.
William R. Grimm with whom Charles D. Blackman and Hinckley,
Allen & Snyder LLP were on brief for appellees W. Russell Boss Jr.
Trust A, W. Russell Boss Jr. Trust B, and W. Russell Boss Jr. Trust
C.
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March 20, 2002
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LYNCH, Circuit Judge. In early 1998 the A.T. Cross
Corporation, a venerable New England maker of fine pens and
pencils, entered the personal electronic devices market by offering
pen-based computing products through its Pen Computing Group (PCG).
The stars of its new line were the CrossPad and its later-
introduced smaller cousin, the CrossPad XP. Cross had high hopes
for its new product line and expressed those hopes publicly in
September 1997 by saying it expected to report a minimum of $25
million in profitable sales for PCG in 1998. Indeed, one of
Cross's officers compared its fledgling product to the highly
successful Palm Pilot.
Reality did not keep pace with these projections. By
late 1999 Cross had discontinued the product line and suffered
losses that year of $24.3 million, which essentially eliminated
profits from the $24.8 million in sales on the PCG products in
1998.
Michael Aldridge brought this securities action in April
2000 as a putative class action on behalf of those who purchased
Cross common stock between September 17, 1997 and April 22, 1999
(the class period). An amended complaint asserts claims against
the company, four officers of the company, and certain trusts which
own part of Cross. The complaint alleges violations of section
10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. §
78j(b) (2000), and Rule 10b-5 under that Act, 17 C.F.R. § 240.10b-5
(2001), against the company, the individual defendants, and the
trusts. It also alleges a section 20(a) claim against the
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individual and trust defendants as "controlling person[s]."1 15
U.S.C. § 78t(a) (2000).
On a Rule 12(b)(6) motion by the defendants, the district
court dismissed the action. Aldridge v. A.T. Cross Corp., No. 00-
203ML (D.R.I. June 4, 2001). The court did not reach the question
of whether to certify a class.
We reverse the dismissal of the claims against the
individual defendants and the company. We find that there is
sufficient factual support for the allegations of fraud and a
strong inference of scienter to survive a motion to dismiss under
the Private Securities Litigation Reform Act (PSLRA). We affirm
the dismissal of the section 20(a) claim against the trust
defendants on different grounds; on these pleadings, the trust
defendants cannot be considered "controlling persons" for the
purpose of section 20(a) liability.
I.
Because this is an appeal from a motion to dismiss, we
describe the facts in the case in the light most favorable to
Aldridge, the plaintiff and nonmoving party. Doe v. Walker, 193
F.3d 42, 42 (1st Cir. 1999).
1
The individual defendants were members of the Cross
management team during the class period: Bradford Boss, Chairman of
Cross's board; Russell Boss, President and CEO of Cross; John
Buckley, Executive Vice President and COO; and John T. Ruggieri,
Senior Vice President and CFO. The trust defendants are: the W.
Russell Boss Jr. Trust A; the W. Russell Boss Jr. Trust B; and the
W. Russell Boss Jr. Trust C. For purposes of all but the section
20(a) analysis, we refer to all of the defendants as the company.
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Cross is a publicly traded company on the American Stock
Exchange. For over a century, Cross has been producing traditional
high-end writing instruments. By the mid 1990s, sales of these
products were dropping off, and the company's stock price had
decreased significantly since 1990. In July 1996, Cross
established a new division it called the Pen Computing Group (PCG)
in an effort to "bridge . . . the worlds of traditional and
electronic paper," to expand the company's traditional product
base, and "to return Cross to acceptable margins and earnings."
One of these PCG products was the CrossPad, unveiled in
November 1997, and first shipped in March 1998. The CrossPad XP,
a smaller model, was introduced to the market in October 1998. The
CrossPads were electronic note pads with digital pens, with which
a user wrote on a note pad atop a battery powered unit. The pens
wrote on the paper in the traditional way and also recorded the pen
strokes for later connection to a computer. Once the information
was stored in a computer, it could be viewed, searched, and
otherwise used.
There was a great deal of optimism about the CrossPads
and their positive impact on Cross as a whole. On September 17,
1997, even before unveiling the CrossPad, Cross issued a press
release announcing that the company expected at least $25 million
in profitable sales from PCG in 1998. On March 23, 1998, Cross
filed a 10-K report with the SEC for the fiscal year 1997, which
stated: "We look at 1998 as a year where . . . our Pen Computing
Group will provide its first year of significant sales and
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earnings." The bulk of PCG's business was the CrossPad product
line. In an April 1998 article in Value Line, an investment
publication, Cross's management said that sales of the CrossPad
would drive PCG's growth, and predicted sales of $200 million in
the year 2000. In a June 1998 article in Barron's, another
investment publication, management predicted that CrossPad could
triple the size of the company. On June 30, 1998, the Cross share
price peaked for the class period at $14.25.
In Cross's 1998 filings with the SEC, the company
continued to report significant sales growth for PCG products. In
a business article dated February 4, 1999, the Providence Journal
quoted Brian Mullins, the Director of Marketing for PCG, as saying
that PCG's "sales for all of 1998 did meet the Company's goal of
$25 million in sales."
Despite the earlier optimism, Cross began to lower the
market's expectations beginning in early 1999. The same February
4 Providence Journal article discusses Mullins's comments on the
recently announced price reductions for both the CrossPad and the
CrossPad XP. He stated that the price cuts were not related to the
sales of the products but were "planned . . . from the get go" and
were expected by the retailers. The article paraphrases Mullins as
saying that "even with the price cuts, the company will still make
a profit." He also said that more price cuts were expected later
in the year. On March 23, 1999, the company filed its 10-K report
with the SEC. The report stated the success of the CrossPad sales
in 1998, but it also acknowledged the price reductions and "greater
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marketing support and technical development [than] planned, which
resulted in a loss for Pen Computing operations."
On April 22, 1999, Cross announced in a press release
that the company's sales had dropped dramatically from $9 million
in the first quarter of 1998 to $1.1 million in the first quarter
of 1999. It also expressed its expectation that revenues from PCG
would be a great deal lower in 1999 than they were in 1998.
On the same day, Cross's management held a conference
call with securities analysts and investors to discuss the
company's results for the first quarter of 1999. During the call,
Russell Boss, President and CEO of Cross, explained that PCG sales
had decreased in the first quarter "because of price protections."
He also mentioned "take backs" from customers. Robert Byrnes,
President and CEO of PCG also spoke about "price protection," and
said that the price reductions were part of the company's original
sales strategy. John Buckley, Cross's Executive Vice President and
Chief Operating Officer, also acknowledged the company's price
protection practices. Cross did not disclose any price protection
plans or take back agreements in its public financial disclosures
in 1998.
Also on April 22, Russell Boss and Bradford Boss
announced that they were stepping down from their positions as CEO
and executive Chairman respectively, and stepping into the
positions of non-executive Chairman, and non-executive Chairman
Emeritus. Immediately after the end of the class period, on April
22, 1999, the share price for Cross fell below $4.
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PCG sales continued to decline in 1999. On May 13, 1999,
the company filed a 10-Q report for the first quarter of the year,
and revealed for the first time in a SEC filing a "rebate" program
it had with its customers. In a 10-Q report issued on August 13,
1999, the company reported over $8 million in losses for PCG in the
second quarter of 1999, and an 85% decline in PCG sales compared to
the same quarter the previous year. The company pointed to the
excess inventory its customers had as a reason for the decrease in
sales.
Finally, the CrossPad product line was discontinued at
the end of 1999 because of poor performance in the market. In a
Form 10-K filed on March 23, 2000, Cross's new President and CEO
discussed PCG's decline in 1999. He stated:
Early in the year [1999] it became clear that our
investment[] in the Pen Computing Group . . . w[as] a
significant drain on the Company's financial and human
resources. As a result, in the fourth quarter, the
Company discontinued the CrossPad product line . . . .
The company also described a revenue recognition policy not
disclosed earlier, which stated: "Revenue from sales is recognized
upon shipment or delivery of goods. Provision is made at the time
the related revenue is recognized for estimated product returns,
term discounts and rebates."
Aldridge, the plaintiff, brought a claim under section
10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. §
78j(b) (2000), and Rule 10b-5, 17 C.F.R. § 240.10b-5 (2001), for
fraud against Cross, members of its top management team, and three
trusts that own a large number of shares in the company. He argues
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that the statements made by the company and its management during
the class period were misleading in light of the company's sales
and accounting practices. Specifically, Aldridge says that the
company employed sales strategies, such as price protection, take
backs, and channel stuffing, without disclosing them to the
shareholders, or reserving for them in financial statements, as
they were obligated to do. Aldridge also brought a claim under
section 20(a) of the Securities and Exchange Act of 1934, 15 U.S.C.
§ 78t(a) (2000), against the individual defendants and the trust
defendants as "controlling persons" of the corporation. Aldridge
argues that the trust defendants, "[b]y reason of their ownership
and ability to select two-thirds of the Board," and the individual
defendants influenced and steered the company to engage in
fraudulent conduct.
The district court dismissed the action on a Rule
12(b)(6) motion under the standards of the Private Securities
Litigation Reform Act of 1995 (PSLRA), 15 U.S.C. § 78u-4 (2000),
finding Aldridge had neither provided sufficient factual support
for the allegations of fraud nor raised a strong inference of
scienter. Aldridge v. A.T. Cross Corp., No. 00-203ML, slip. op. at
10-15 (D.R.I. June 4, 2001). The district court, without reaching
the details of the controlling person issue, also dismissed the
section 20(a) claim against the individual defendants and the trust
defendants because it was derivative of the dismissed section 10(b)
claim. Id. at 15-16. The court did not reach the question of
whether to certify a class.
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II.
Our review of the allowance of a motion to dismiss is de
novo. Serabian v. Amoskeag Bank Shares, Inc., 24 F.3d 357, 361
(1st Cir. 1994). The pleading standards for violations of section
10(b) and Rule 10b-5 are found in the PSLRA, 15 U.S.C. §78u-4.2
This circuit's seminal case on the pleading standards under the
PSLRA is Greebel v. FTP Software, Inc., 194 F.3d 185, 193-94 (1st
Cir. 1999). In Greebel, we held that the PSLRA did not alter this
circuit's rigorous reading of the standards for pleading fraud.
The plaintiff in a securities fraud action must "specify each
2
The statute provides, in relevant part:
(b) Requirements for securities fraud actions
(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.
(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.
15 U.S.C. §§ 78u-4(b)(1)-(2).
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allegedly misleading statement or omission" including its time,
place and content. Id. at 193. The plaintiff must provide factual
support for the claim that the statements or omissions were
fraudulent, that is, facts that show exactly why the statements or
omissions were misleading. Id. at 193-94. If the plaintiff brings
his claims on information and belief, he must "set forth the source
of the information and the reasons for the belief." Id. at 194
(quoting Romani v. Shearson Lehman Hutton, 929 F.2d 875, 878 (1st
Cir. 1991)) (internal quotation marks omitted). The plaintiff must
also show that the inferences of scienter "are both reasonable and
'strong.'" Id. at 195-96.
Although the pleading requirements under the PSLRA are
strict, id. at 194, they do not change the standard of review for
a motion to dismiss. Even under the PSLRA, the district court, on
a motion to dismiss, must draw all reasonable inferences from the
particular allegations in the plaintiff’s favor, while at the same
time requiring the plaintiff to show a strong inference of
scienter. Id. at 201; accord Helwig v. Vencor, Inc., 251 F.3d 540,
553 (6th Cir. 2001) (en banc), petition for cert. filed, 70
U.S.L.W. 3269 (Sept. 27, 2001) (No. 01-538).
A. Fraud Allegations
The district court correctly found that Aldridge had met
the specificity requirements as to "time, place and content" of the
statements said to be misleading. Aldridge, slip. op. at 10. The
district court faulted the complaint, however, for failing to
provide factual support for the allegations of fraud. Id. at 10-
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11. The district court concluded that even if Cross made false
statements or material omissions, there is no support for the
proposition that the defendants knew these statements or omissions
were misleading at the time they were made. It also relied on the
absence of specific figures regarding which transactions were
misstated and by what amounts. It was here that the court erred.
The district court did not "giv[e] plaintiff[] the benefit of all
reasonable inferences" as it should have on a motion to dismiss,
Greebel, 194 F.3d at 201, but appears to have drawn its inferences
in the defendants' favor. We take the plaintiff’s allegations to
be true and draw inferences in the plaintiff’s favor.
Aldridge's core claim is that the reported revenues and
earnings in A.T. Cross’s financial statements were artificially
inflated, and that the statements contained omissions of material
facts. Aldridge alleges that under generally accepted accounting
principles (GAAP), with which Cross purported to comply, Cross was
required to estimate a loss or range of loss and set a reserve with
respect to all contingent sales that were made, including sales for
which the buyer had the right to receive a credit or allowance if
the price of the CrossPad declined before the buyer could resell
the product (i.e., price protection). If Cross was unable to
establish a reserve or estimate the loss, it was required to
disclose the practices that gave rise to the contingent revenues
and earnings. Aldridge alleges that the defendants knew that Cross
had not sufficiently reserved for the losses that inevitably would
occur when Cross was forced to honor its price protection
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commitments, and that their failure to disclose this to the public
violated federal regulations (specifically Item 303 of the SEC's
Regulation S-K) and accounting standards. See 17 C.F.R. §
229.303(a) (2001) (requiring that SEC filings "provide . . .
information that the registrant believes to be necessary to an
understanding of its financial condition"); Accounting for
Contingencies, Statement of Financial Accounting Standards No. 5,
¶ 10 (Financial Accounting Standards Bd. 1975); Revenue Recognition
When Right of Return Exists, Statement of Financial Accounting
Standards No. 48, ¶ 7 (Financial Accounting Standards Bd. 1981)
("FAS 48"). Cross has not argued that the information that was not
provided in the financial statements was not material.
The district court’s holding hinged on a key issue:
whether, from the statements made by company officials in 1999, it
could be reasonably inferred that Cross had engaged in undisclosed
price protection earlier, in 1998. The district court thought not.
If there was no price protection or similar practice in 1998, the
district court concluded, then the company's financial statements
did not contain misleading omissions. Our view is to the contrary:
it is an extremely reasonable inference, from the defendants'
statements in 1999, that the company had offered its customers
price protection guarantees in 1998, likely to induce them to carry
the new CrossPad product lines. From this, it may easily be
inferred that the statements were misleading and that the
defendants knew that they were misleading.
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There were several statements in 1999 that support the
inferences. First, in February 1999, the prices of the CrossPad
products were discounted by up to 30%. A February 4 business
article in the Providence Journal reported the price reductions and
cited Mullins, the Director of Marketing, as saying that the
company would make a profit on the CrossPads even with the price
cuts.3 The article also reported (obviously relying on company
sources and most likely on Mullins) that price cuts "had been
planned since the products were introduced." Mullins was quoted as
saying that "the price cuts were not related to how well the units
were selling." Mullins said "[w]e actually had planned it from the
get go. We told the retailers to expect it."
In this context, "from the get go" is easily read to mean
from the introduction of the new product to the market in 1998. If
the price cuts were planned from early 1998, it is entirely
reasonable to think that price protection for the stores selling
the product was also discussed and agreed on at that time, to
insulate the retailers from the inevitable price reductions.
The price reductions were also discussed at Cross's April
22, 1999 conference call with analysts and investors. During that
conference call Byrnes, the head of PCG, said that the price
reductions were in line with the company’s original strategy, but
3
At oral argument Cross argued that Mullins, the Director
of Marketing, lacked authority to make admissions. See Fed. R.
Evid. 801(d)(2). That seems improbable; but we need not decide it
as an evidentiary matter as we take inferences in the plaintiff’s
favor, and there is a strong inference that a Director of Marketing
had authority to make such statements.
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were not put into place until February 1999. President Russell
Boss said that "PCG business was down" in the first quarter of 1999
"because of price protections [Cross] gave retailers." Two other
corporate officers, including Byrnes, mentioned that there was a
price protection program.
There is a possibility that the Cross officers used the
term "price protection" in some specialized narrow sense for a
right to reimbursement offered by the company to the retailers once
the CrossPads had already been on the store shelves for some
months. However, on this record it is just as likely, if not more
likely, that Aldridge's more common definition of price protection
is what was meant: "Price protection is a retailer’s or
distributor’s right to reimbursement in the event of post-sale
price reductions." As Aldridge argues, "[t]hat price protection is
a right implies that it is bargained for at the time the
retailer/distributor contracts to buy product from the
manufacturer," not once the product has been on the shelves for
several months.
Aldridge also argues that under accounting rules, booking
sales subject to price protection requires adequate accounting
reserves at the time of sale to offset the effects of such price
protection. Otherwise, such sales should not be recognized as
revenue. If a reserve is not set up -- because, for example, the
size of the contingencies was impossible to estimate -- disclosure
should be made. See Greebel, 194 F.3d at 203 (discussing FAS 48).
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In dismissing the case, the district court referred to a
statement in Greebel that the absence of specific identifying
information as to the amount and nature of contingent sales
transactions was indicative of the generality of the allegations of
violations of GAAP standards such as FAS 48, and thus insufficient
by itself to infer scienter. Aldridge, slip op. at 11 (citing
Greebel, 194 F.3d at 203-04). However, in Greebel, there was no
evidence of statements by management indicating material
undisclosed contingencies, while here there was such evidence.
Further, it is reasonable to infer that in this case all customers
were offered price protection as a matter of company policy. Cross
itself attributed losses in early 1999 in part to its price
protection program. There was therefore little need for the type
of specificity discussed in Greebel. In Greebel, the argument that
contingent sales were not properly accounted for under FAS 48 was
made largely in service of more direct claims of warehousing and
whiting out, claims which, even after discovery, lacked any factual
support. Here, in contrast, there is a reasonable inference of a
pattern of price protection. Further, the evidence that contingent
sales were not accounted for as they should have been under FAS 48
was offered in Greebel as indirect evidence of scienter, and there
was discounted, in the absence of particulars and other evidence of
scienter. Greebel did not hold that a plaintiff, before discovery,
must in every case allege the amount of overstatement of revenues
and earnings in order to state a claim that undisclosed price
protection schemes were fraudulent. 194 F.3d at 204 (relying on
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"complete absence" of particulars but refusing to hold that such
information must appear in a complaint).
Aldridge also attempts to support the inference that a
price protection program was entered into in 1998 but not disclosed
at the time with allegations of two corollary practices: take
backs and channel stuffing. A "take back" is a promise to take
back goods from customers who have been unable to sell them. In
the April 22, 1999 conference call, Russell Boss specifically used
the phrase "take back." Again, it is reasonable to infer that a
take back guarantee for the retailers of CrossPads was agreed to in
1998, because a take back agreement, just like price protection, is
likely to have been part of the original bargain between Cross and
its customers. No take back agreements were disclosed in the
company’s 1998 public statements and filings. The take back
allegations therefore support Aldridge's claim that Cross engaged
in undisclosed price protection.
Channel stuffing, in turn, was defined in Greebel:
"Channel stuffing" means inducing purchasers to increase
substantially their purchases before they would, in the
normal course, otherwise purchase products from the
company. It has the result of shifting earnings into
earlier quarters, quite likely to the detriment of
earnings in later quarters.
194 F.3d at 202. Aldridge's allegation is that 50% of the store
placements for the CrossPad took place in the last four months of
1998 and that 36% of PCG sales occurred in the last three months of
1998. These figures might well be explained by holiday season
sales. Beyond that, the second quarter 1999 Form 10-Q report
stated that the 85% reduction in sales from the prior year was
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attributable to retailers having significantly reduced their
purchases as they reduced their current inventory levels. Also,
the company’s expenses were higher as it administered a rebate
promotion "to reduce channel inventory at the retail level." This
information may or may not suggest that more inventory was in the
hands of the retailers than commercially warranted. "There is
nothing inherently improper in pressing for sales to be made
earlier than in the normal course," id. at 202, and in this case,
the channel stuffing allegations at present are neutral. After
discovery, however, they may play a supporting role in buttressing
the price protection inferences.
The company says this is a garden variety "fraud by
hindsight" case, occasioned by the large drop in sales of CrossPad
products after 1998. That characterization is off the mark. Fraud
by hindsight occurs when a plaintiff "simply contrast[s] a
defendant's past optimism with less favorable actual results, and
then 'contend[s] that the difference must be attributable to
fraud.'" Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1223 (1st
Cir. 1996) (quoting DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th
Cir. 1990)). In this case, on the other hand, Aldridge complains
that the company failed to disclose certain known material
information as to the contingent nature of the sales, and that
Cross essentially admitted to the 1998 contingencies in 1999.
The allegations of fraud in the complaint have sufficient
factual support to survive a motion to dismiss. A closer question
is whether the allegations of scienter are sufficient.
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B. Scienter
Scienter, which is a requirement for liability under
section 10(b) and Rule 10b-5, is "a mental state embracing intent
to deceive, manipulate, or defraud." Ernst & Ernst v. Hochfelder,
425 U.S. 185, 193 n.12 (1976). To win a section 10(b) case, the
plaintiff must show either that the defendants consciously intended
to defraud, or that they acted with a high degree of recklessness.
Greebel, 194 F.3d at 198-201.
In Greebel, we held that the PSLRA did not mandate a
particular test to determine scienter and that this court would
continue to use its case by case fact-specific approach; "we . . .
analyze[] the particular facts alleged in each individual case to
determine whether the allegations were sufficient to support
scienter." 194 F.3d at 196; accord City of Philadelphia v. Fleming
Cos., 264 F.3d 1245, 1262-63 (10th Cir. 2001) (adopting Greebel's
fact-specific approach); Helwig, 251 F.3d at 551 (same). Thus, the
plaintiff may combine various facts and circumstances indicating
fraudulent intent to show a strong inference of scienter. As part
of the mix of facts, the plaintiff may allege that the defendants
had the motive ("concrete benefits that could be realized by . . .
the false statements and wrongful nondisclosures") and opportunity
("the means and likely prospect of achieving concrete benefits by
the means alleged") to commit the fraud. Novak v. Kasaks, 216 F.3d
300, 307 (2d Cir.) (quoting Shields v. Citytrust Bancorp, Inc., 25
F.3d 1124, 1130 (2d Cir. 1994)), cert denied, 531 U.S. 1012 (2000).
However, as we stated in Greebel, while mere allegations of motive
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and opportunity alone may be insufficient, together with additional
factual support, evidence of motive and opportunity may establish
a strong inference of scienter. 194 F.3d at 197.
In evaluating whether the inferences of scienter are
strong, we agree with the Sixth Circuit’s language that:
"Inferences must be reasonable and strong -- but not irrefutable.
. . . Plaintiffs need not foreclose all other characterizations of
fact, as the task of weighing contrary accounts is reserved for the
fact finder." Helwig, 251 F.3d at 553. The plaintiff must show
that his characterization of the events and circumstances as
showing scienter is highly likely.
Taking all the facts and circumstances into
consideration, the complaint survives the requirement that its
pleadings raise a strong inference of scienter. First, strong
inferences can be made that the company offered price protection
and take back arrangements in 1998.4 These arrangements, if they
existed, were not disclosed, and that nondisclosure could hardly
have been inadvertent. The company only disclosed the price
protection and take back agreements in an April 1999 conference
call with industry analysts and investors. Full public disclosure
of the agreements only occurred in the Form 10-Q report filed on
May 13, 1999. Although the company officials referred to "price
protection" during the conference call, the report used the term
4
Aldridge could have buttressed his case by obtaining
information, if available absent discovery, from Cross's customers
on the price protection and take back allegations. In another case
the failure to make that effort might prove fatal. Here it is not.
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"rebates," which may suggest an attempt to recharacterize the
events. Of course, more than mere proof that the defendants made
a particular false or misleading statement is required to show
scienter. Geffon v. Micrion Corp., 249 F.3d 29, 36 (1st Cir.
2001). However, the fact that the defendants published statements
when they knew facts suggesting the statements were inaccurate or
misleadingly incomplete is classic evidence of scienter. Fl. State
Bd. of Admin. v. Green Tree Fin. Corp., 270 F.3d 645, 665 (8th Cir.
2001) (collecting cases from various circuit courts).
Second, building on the reasonable inference that either
or both the price protection or take back guarantees were in place
in 1998, it may also be inferred that accounting standards required
that a reserve be established or at least that Cross disclose the
sales practices in its financial statements. This is also evidence
of scienter. See Geffon, 249 F.3d at 35 (noting that "accounting
shenanigans" may be evidence of scienter). There is evidence that
the defendants acted with knowledge and intent when they did not
account for the sales practices in the company's reports in 1998.
In the Form 10-K filed by the company on March 23, 2000, after a
new company president was installed, Cross disclosed for the first
time after the dramatic PCG losses, a revenue recognition policy:
"Revenue from sales is recognized upon shipment or delivery of
goods. Provision is made at the time the related revenue is
recognized for product returns, term discounts and rebates."
The company argues that because it has never restated any
of its financials or otherwise indicated any error in the 1998
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financial statements, and because its financial statements were
audited by an independent accounting firm, no inference of
accounting error, and so no inference of scienter, can be drawn.
We disagree. Had the 1998 financials been restated, that might
well have been useful to Aldridge. However, the fact that the
financial statements for the year in question were not restated
does not end Aldridge's case when he has otherwise met the pleading
requirements of the PSLRA. To hold otherwise would shift to
accountants the responsibility that belongs to the courts. It
would also allow officers and directors of corporations to exercise
an unwarranted degree of control over whether they are sued,
because they must agree to a restatement of the financial
statements.
Third, the Cross corporate officers had some particular
financial incentives to load sales and earnings into 1998. Their
compensation depended on the company’s earnings; as Cross correctly
notes, that fact alone is not and cannot be enough to establish
scienter. Green Tree, 270 F.3d at 661; Fleming Cos., 264 F.3d at
1269-70; Novak, 216 F.3d at 307. What makes this case different
are the inferences that corporate officers understood in 1997 and
1998 that the success of the new products, and of taking the old
line company into a new world, was important to their own survival
and that of the company. Indeed, the complaint alleges that
Russell said, "If I can’t turn the company around in one year, I
won’t be here." This gave incentive to maximize 1998 earnings in
particular. When financial incentives to exaggerate earnings go
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far beyond the usual arrangements of compensation based on the
company's earnings, they may be considered among other facts to
show scienter. See, e.g., Green Tree, 270 F.3d at 661 (reversing
trial court decision based on lack of scienter where it was
reasonable to infer that defendant officer maximized his
compensation by overstating earnings before his contract ran out).
More specifically, the individual defendants were the
ones who set the target sales goal of $25 million, and their jobs
were in jeopardy if the goals were not met. Moreover, the CrossPad
product line was very important to Cross. In April 1998 the
defendants were quoted as stating that the CrossPad would be the
primary driver of PCG’s growth. In a September 30, 1998 press
release, Cross stated that the sales of PCG products made up 34% of
the company’s total domestic revenue. That being so, there was
incentive to maximize profits in 1998 by various means. See
Greebel, 194 F.3d at 196 (stating that "self-interested motivation
of defendants in the form of saving their salaries or jobs" may be
evidence of scienter). As it turned out, the company President,
Russell Boss, and Chairman, Bradford Boss, did resign after the
disastrous first quarter 1999 results were made public.
Playing lesser but supporting roles in the factual
analysis, there were the additional financial incentives to
management to overstate 1998 profits. The exercise price of the
individual defendants' stock options was lowered in 1997, just
before the introduction of the new product line. The exercise
price was lowered again to match the market price in December 1998.
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There is no evidence that the defendants exercised their options;
Aldridge's point is rather that the adjustment in price created
incentives to "boost A.T. Cross share price." The adjustments in
the exercise price of the defendants' stock options alone are not
enough to create a strong inference of scienter. But this fact is
not alone here. While this case does not involve trading while in
possession of material nonpublic information, which in some
circumstances may be taken to support allegations of motive, see,
e.g., Acito v. IMCERA Grp., 47 F.3d 47, 54 (2d Cir. 1995), there
were sufficient other sources of financial motive that make the
absence of such evidence less important here.
Our conclusion that Aldridge's section 10(b) and Rule
10b-5 claim survives a motion to dismiss is only that. The
defendants may yet prevail once the facts of the case are further
developed.5
C. Section 20(a) Claim
The district court’s dismissal of the section 20(a) claim
was derivative of its dismissal of the section 10(b) claim. See
Suna v. Bailey Corp., 107 F.3d 64, 72 (1st Cir. 1997). Because
there must be a primary violation for liability under section
20(a), the district court did not independently evaluate whether
the claim otherwise failed. Nonetheless, we "may affirm a district
court's judgment on any grounds supported by the record."
Greenless v. Almond, 277 F.3d 601, 605 (1st Cir. 2002).
5
We leave to the district court on remand Aldridge’s
argument that there is a sub-class of the 1999 investors.
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As to the trust defendants only, the matter is plain
enough to affirm the dismissal of the section 20(a) claim against
them. Section 20(a) provides:
Every person who, directly or indirectly, controls
any person liable under any provision of this chapter or
of any rule or regulation thereunder shall also be liable
jointly and severally with and to the same extent as
such controlled person . . . unless the controlling
person acted in good faith and did not directly or
indirectly induce the act or acts constituting the
violation or cause of action.
15 U.S.C. § 78t(a) (2000).
The trust defendants argue that this court should adopt
a three part test for controlling person liability, under which the
plaintiff must allege and prove: (1) an underlying violation by a
controlled person or entity; (2) the defendants control the
violator; and (3) the defendants are in a meaningful sense culpable
participants in the fraud in question. See SEC v. First Jersey
Secs. Inc., 101 F.3d 1450, 1472 (2d Cir. 1996). They correctly
described a split among the circuits on whether an element of
section 20(a) liability is "culpable participation."6 We do not
reach that question, but rest on the "control" element.
To meet the control element, the alleged controlling
person must not only have the general power to control the company,
but must also actually exercise control over the company. See
6
Whether culpable participation is a required element of
liability under section 20(a) has generated a great deal of
discussion. Compare First Jersey Secs., 101 F.3d at 1472-73
(applying such a requirement), with Hollinger v. Titan Capital
Corp., 914 F.2d 1564, 1575 (9th Cir. 1990) (en banc) (rejecting
such a requirement); see generally 3C H. Bloomenthal & S. Wolff,
Securities and Federal Corporate Law § 14.9 (2d ed. 1999)
(discussing the culpable participant requirement).
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Sheinkopf v. Stone, 927 F.2d 1259, 1270 (1st Cir. 1991) ("For [the
defendant] to be liable . . . there must be 'significantly
probative' evidence that the [defendant] exercised, directly or
indirectly, meaningful hegemony over the . . . venture . . . .")
(internal citation omitted); see also Harrison v. Dean Witter
Reynolds, Inc., 974 F.2d 873, 880-881 (7th Cir. 1992) (describing
a similar requirement). In this case, the trust defendants have
the power to elect two-thirds of the directors. But they have no
direct control over the management and operations of the company.
At most the evidence pled is that the trust defendants are
controlling shareholders. This indicates some potential ability to
control. In the absence of some indicia of the exercise of control
over the entity primarily liable, however, that status alone is not
enough. Although controlling shareholders own the majority of the
shares in a company, they, like any other shareholders, should have
the ability to be passive, leaving the management to the directors
and officers. See L. Carson, The Liability of Controlling Persons
Under the Federal Securities Acts, 72 Notre Dame L. Rev. 263, 318-
19 (1997). Unless there are facts that indicate that the
controlling shareholders were actively participating in the
decisionmaking processes of the corporation, no controlling person
liability can be imposed. In this case, no facts are pled
permitting an inference that the trust defendants actually
exercised control over Cross.
III.
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The case will be reinstated as to the company and the
individual defendants. The district court may wish to consider
limiting discovery initially to key issues. Nothing in this
opinion, of course, predicts any outcome if a postdiscovery summary
judgment motion is filed or the matter goes to trial. Where there
is smoke, there is not always fire.
Accordingly, we reverse the dismissal of the section
10(b) claim and the section 20(a) claim against the company and the
individual defendants; we affirm, on different grounds, the
dismissal of the section 20(a) claim against the trust defendants.
No costs are awarded.
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Aldridge v. A.T. Cross Corp.
Court: Court of Appeals for the First Circuit
Date filed: 2002-03-20
Citations: 284 F.3d 72
Copy CitationsCombined Opinion