United States Court of Appeals
For the First Circuit
No. 01-2622
JAMES R. YOUNG, AS TRUSTEE OF THE NUTRAMAX LITIGATION TRUST,
Plaintiff, Appellant,
v.
DONALD E. LEPONE ET AL.,
Defendants, Appellees.
APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF MASSACHUSETTS
[Hon. Richard G. Stearns, U.S. District Judge]
Before
Boudin, Chief Judge,
Selya, Circuit Judge,
and Greenberg,* Senior Circuit Judge.
David C. Frederick, with whom Mark C. Hansen, Silvija A.
Strikis, Leo R. Tsao, Kellogg, Huber, Hansen, Todd & Evans,
P.L.L.C., Robert M. Thomas, Jr., and Thomas & Associates were on
brief, for appellant.
Thomas J. Dougherty, with whom David S. Clancy, Kara E. Fay,
and Skadden, Arps, Slate, Meagher & Flom LLP were on brief, for
appellee Deloitte & Touche LLP.
September 10, 2002
_______________
*Of the Third Circuit, sitting by designation.
SELYA, Circuit Judge. We confront here two intricate
variations on a standard theme — the invocation of a limitations
defense to federal securities claims. The general scenario is
distressingly familiar: shareholders of a publicly-held company
allege that the corporate officers systematically inflated
earnings, concealed losses, and treated the company's books as
works of fiction. The shareholders further allege that their
natural guardians — the company's outside accountants — perpetuated
this massive fraud through perfunctory audits and certified
financial statements that they knew (or consciously avoided
knowing) were materially false and misleading.
The district court ruled that all the federal securities
claims were barred by the applicable one-year statute of
limitations. See Cape Ann Investors, LLC v. Lepone, 171 F. Supp.
2d 22 (D. Mass. 2001). We conclude that this ruling is partially
correct and partially incorrect. As to the federal securities
claim asserted by the original plaintiff, the primary issue is
whether management letters from the accounting firm effectively
placed this plaintiff (an investor who held a seat on the company's
board of directors and the audit committee) on inquiry notice of
possible fraud. Given our inability to resolve that highly nuanced
issue based solely on the face of the amended complaint, we vacate
the lower court's order of dismissal in pertinent part and remand
for further proceedings. As to the later-filed claims asserted by
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the remaining shareholders, we reach a different result. Because
those plaintiffs (and their claims) lacked a sufficient identity of
interest with the original complainant (and its claims), Federal
Rule of Civil Procedure 15(c)(3) does not apply; the claims are not
entitled to relate back to the date when the suit was first filed;
and, accordingly, the claims are time-barred. We therefore affirm
that portion of the district court's ukase.
I. BACKGROUND
We glean the facts from the amended complaint, stripped
of any rhetorical gloss. Aulson v. Blanchard, 83 F.3d 1, 3 (1st
Cir. 1996). We then trace the travel of the case and offer a
roadmap for our exploration of the instant appeal.
A. The Facts.
At the times relevant hereto, NutraMax Products, Inc.
("NutraMax" or "the company") was a Delaware corporation that
maintained its principal offices in Gloucester, Massachusetts. The
company's shares were traded on the NASDAQ stock exchange. Donald
E. Lepone served as its chief executive officer, Robert F. Burns as
its chief financial officer, and Noreen Gottfredsen as its
controller.
NutraMax's fiscal year ran from October 1 through
September 30. Like all publicly-held corporations, it issued
annual financial statements within ninety days after the close of
each fiscal year. For each of the years here in question – 1996,
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1997, and 1998 – it represented that these financial statements
were prepared in accordance with generally accepted accounting
principles ("GAAP").1 The company's independent auditor, Deloitte
& Touche LLP ("Deloitte"), placed its imprimatur on each of these
financial statements. In so doing, Deloitte expressly certified
that: (1) it had conducted its audit in accordance with generally
accepted auditing standards ("GAAS");2 (2) NutraMax's financial
statements had been prepared in accordance with GAAP and fairly
presented the company's financial position and operational results
in all material respects; and (3) Deloitte could provide reasonable
assurances, based on its audits, that the financial statements
contained no material misrepresentations.
In connection with its presentation of audited financial
statements, Deloitte wrote an annual "management letter" to the
audit committee designated by NutraMax's board of directors. Those
letters contained comments that Deloitte deemed pertinent to
management's assessment of the financial condition of the company
1
The GAAP rules embody the prevailing principles, conventions,
and procedures defined by the accounting industry from time to
time. See Sanders v. Jackson, 209 F.3d 998, 1001 n.3 (7th Cir.
2000) (citing American Institute of Certified Public Accountants,
Statement of Auditing Standards No. 69, ¶ 69.02 (1992)).
2
The GAAS compilation consists of general criteria relating to
the inquiry undertaken, and the judgments exercised, by the auditor
in the performance of its examination and the issuance of its
report. In Deloitte's own words, these standards "require that
[the auditor] plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of
material misstatement."
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and the reliability of its accounting systems. In the management
letter submitted under date of November 28, 1997, Deloitte
concluded that certain deficiencies in the company's internal
control structure constituted "reportable conditions."3
Specifically, that letter highlighted a number of weaknesses in
NutraMax's inventory control and valuation procedures, identified
a $291,000 variance in an inventory account, pointed out under-
accruals of various expenses, and noted that the company had failed
to earmark adequate reserves for bad debts. Deloitte nonetheless
certified the 1997 financial statements without any substantial
qualification. Much the same pas de deux occurred the following
year. On November 24, 1998, Deloitte wrote to NutraMax's audit
committee identifying reportable conditions involving inventory
control and valuation, but proceeded to certify the company's
financial statements for fiscal 1998 without substantial
3
A reportable condition is generally regarded as a weakness in
the design or operation of the internal control structure that, in
the auditor's judgment, reflects a significant shortcoming that
"could adversely affect the organization's ability to record,
process, summarize, and report financial data consistent with the
assertions of management in the financial statements." Monroe v.
Hughes, 31 F.3d 772, 774 (9th Cir. 1994) (quoting American
Institute of Certified Professional Accountants, Professional
Standards (CCH), AU § 325.02). This squares with Deloitte's 1997
and 1998 management letters, each of which states that
"[r]eportable conditions involve matters coming to our attention
relating to significant deficiencies in the design or operation of
the internal control structure that, in our judgment, could
adversely affect the Company's ability to record, process,
summarize, and report financial data consistent with the assertions
of management in the consolidated financial statements."
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qualification. On both occasions, Deloitte's representatives
assured the audit committee that the reportable conditions did not
denote material weaknesses in NutraMax's reporting systems (and,
therefore, did not pose a significant risk of skewing the company's
financial statements). Moreover, Deloitte assured the audit
committee that, "as required by GAAS," its audit for each of these
years "would provide reasonable assurance of detecting
irregularities or illegal acts by NutraMax management and
employees."
In 1999, NutraMax's board of directors installed a new
chief operating officer ("COO"). It did not take him long to note
glaring inadequacies in the company's accounting procedures and
internal controls. Suspecting that the books and records contained
serious irregularities, the COO recommended that the board engage
outside counsel to conduct a full investigation into the company's
accounting records, systems, and procedures. The board complied,
and the law firm designated by the board engaged a team of forensic
accountants. In the spring or summer of 1999 – the amended
complaint is vague as to the exact timing – the investigators
concluded that NutraMax's management had failed to write down
worthless inventory, improperly accrued expenses, booked bogus
journal entries, and incorrectly adjusted the accrual dates on
various receivables. As a result, a myriad of accounts required
multimillion dollar adjustments.
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The denouement occurred on August 18, 1999, when NutraMax
publicly announced that it had (1) ousted Lepone and Burns, (2)
delayed the release of an earnings report for the third quarter,
and (3) decided that it would be necessary to restate its
financials for certain previous years. In the wake of this
announcement, the price of NutraMax's common stock plummeted.
NutraMax subsequently wrote down its assets by over $75,000,000 and
restated its net worth from a positive figure of $21,200,000 to a
negative figure of $46,600,000. On October 15, 1999, NASDAQ
delisted the company. On November 12, 1999, Deloitte withdrew its
audit reports for the 1996, 1997, and 1998 fiscal years.4 Less
than six months later, NutraMax filed for bankruptcy protection
under Chapter 11. See 11 U.S.C. §§ 1101-1174.
B. The Proceedings Below.
On August 1, 2000, Cape Ann Investors, LLC ("Cape Ann"),
a major NutraMax shareholder, sued Lepone, Burns, Gottfredsen, and
Deloitte in the United States District Court for the District of
Massachusetts. Cape Ann's complaint charged that the three former
officers had systematically falsified NutraMax's financial
statements by inflating earnings, refusing to write off outdated
inventory, and manipulating the company's accounting records to
misrepresent its financial performance and condition. The
4
Although the amended complaint is inexplicit as to the date
when NutraMax and Deloitte parted company, it is apparent that the
separation occurred prior to this date.
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complaint further charged that Deloitte had facilitated the former
officers' fraudulent misconduct by conducting perfunctory audits of
the company's finances — audits that fell far short of GAAS. Cape
Ann alleged that the defendants' malfeasance violated both federal
securities law, see Securities Exchange Act of 1934, 15 U.S.C. §
78j; SEC Rule 10b-5, 17 C.F.R. § 240.10b-5, and state law.
At this point, we shift our focus momentarily to
NutraMax's Chapter 11 reorganization. In the course of that
proceeding — which is pending in Delaware — the bankruptcy court
established the NutraMax Litigation Trust ("the Trust"). The Trust
became the assignee of several sets of claims. Only one such set
is of interest here: all claims by persons who held NutraMax
common stock prior to the bankruptcy filing and who either voted to
approve the reorganization plan or elected thereafter to assign
their claims to the Trust. By voting in favor of the
reorganization plan, Cape Ann became a participant in the Trust.
Since Cape Ann's position is distinct from that of the other
shareholders who have assigned their rights to the Trust, we
emulate the district court, see Cape Ann, 171 F. Supp. 2d at 23-24,
and refer to Cape Ann by name while referring to the other electing
shareholders as the "new plaintiffs."
On March 9, 2001, the Trust filed an amended complaint
that, inter alia, sought to substitute the Trust for Cape Ann as
the named plaintiff in the securities fraud action and to add
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claims assigned to it by the new plaintiffs.5 Deloitte moved to
dismiss the amended complaint, asserting, inter alia, that the
federal securities claims were time-barred by the applicable one-
year statute of limitations. Following briefing and oral argument,
the district court granted the motion. Id. at 27-28.
The district court's decision sets the stage for our
discussion of the issues on appeal. To begin with, the court
recognized that Cape Ann's claims and the new plaintiffs' claims
had to be analyzed differently. Turning first to Cape Ann, the
court emphasized that, unlike an ordinary investor, it had a
presence on the company's board of directors and audit committee
during 1997 and 1998. On this basis, the court concluded that a
reasonable director in Cape Ann's shoes (i.e., a director who had
received Deloitte's 1997 and 1998 management letters) would have
realized the need for an immediate investigation "if not in 1997,
certainly by 1998." Id. at 27. Based on this conclusion, the
court ruled that Cape Ann (which had not brought suit until August
1, 2000) had missed the one-year statute of limitations vis-à-vis
its federal securities claim. Id. at 28.
Turning to the federal securities claims brought by the
new plaintiffs, the district court rejected the Trust's argument
5
These included various state-law claims that have no bearing
on this appeal. We refrain from any discussion of those claims.
We likewise refrain from any mention of other persons (e.g.,
creditors) who assigned claims to the Trust.
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that those claims related back to the date on which Cape Ann had
filed the original complaint. Id. at 28-30. Apparently concluding
that the limitations period for the new plaintiffs began to run no
later than November 12, 1999 (the date on which Deloitte withdrew
its audit reports), the court determined that these claims, first
asserted on March 9, 2001, had emerged too late. Id. at 30.
Having found all the federal claims time-barred, the court declined
to exercise supplemental jurisdiction over the remaining state-law
claims, see supra note 5, and dismissed those claims without
prejudice to their renewal in an appropriate forum. This timely
appeal ensued.
C. The Anatomy of the Appeal.
Although this appeal originally encompassed all the
federal securities claims, the former officers recently bought
their peace, and we approved a stipulation dismissing the case as
to them. See Fed. R. App. P. 42(b). Consequently, the appeal
proceeds only with respect to the remaining defendant (Deloitte).
In the pages that follow, we examine whether the district
court erred in assessing the timeliness of the plaintiffs' federal
securities claims against Deloitte. Because the district court
dismissed the claims pursuant to Rule 12(b)(6) of the Federal Rules
of Civil Procedure, we afford plenary review, giving credence to
all well-pleaded factual averments limned in the amended complaint
and indulging all reasonable inferences therefrom in the
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plaintiffs' favor. Aulson, 83 F.3d at 3. "If the facts contained
in the complaint, viewed in this favorable light, justify recovery
under any applicable legal theory, we must set aside the order of
dismissal." SEC v. SG Ltd., 265 F.3d 42, 46 (1st Cir. 2001).
Where, as here, an order of dismissal is predicated on the statute
of limitations, we will affirm only if "the pleader's allegations
leave no doubt that an asserted claim is time-barred." LaChappelle
v. Berkshire Life Ins. Co., 142 F.3d 507, 509 (1st Cir. 1998).
II. THE LEGAL LANDSCAPE
Rule 10b-5 claims "must be commenced within one year
after the discovery of the facts constituting the violation and
within three years after such violation." Lampf, Pleva, Lipkind,
Prupis & Petigrow v. Gilbertson, 501 U.S. 350, 364 (1991). In this
case, Deloitte concedes that suit was brought within three years of
the alleged violation. Our focus, then, is on the date of
discovery.
With respect to a Rule 10b-5 violation that involves
fraudulent concealment, the one-year interval does not begin to run
"until the time when the plaintiff in the exercise of reasonable
diligence discovered or should have discovered the fraud of which
he complains." Cooperativa de Ahorro y Credito Aguada v. Kidder,
Peabody & Co., 129 F.3d 222, 224 (1st Cir. 1997) (citations and
internal quotation marks omitted). This formulation is not self-
executing, and the circumstances of each case must be explored
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independently. When telltale warning signs augur that fraud is
afoot, however, such signs, if sufficiently portentous, may as a
matter of law be deemed to alert a reasonable investor to the
possibility of fraudulent conduct. See Mathews v. Kidder, Peabody
& Co., 260 F.3d 239, 251 n.15 (3d Cir. 2001) (collecting cases).
We have dubbed such signs "storm warnings," and have
established a two-part process for handling a defendant's claim
that such precursors should have sufficed to put investors on
inquiry notice. Maggio v. Gerard Freezer & Ice Co., 824 F.2d 123,
128 (1st Cir. 1987). The first step in the pavane requires a
reviewing court to ascertain whether, when, and to what extent,
storm warnings actually existed in a given situation. Because
sufficient storm warnings would lead a reasonable investor to check
carefully into the possibility of fraud, this step necessarily
entails a determination as to whether a harbinger, or series of
harbingers, should have alerted a similarly situated investor that
fraud was in the wind. Id. The next step requires the court to
assay whether, once sufficient storm warnings were apparent, the
investor probed the matter in a reasonably diligent manner. Id.
This issue lends itself to a more individualized inquiry — an
inquiry that focuses on the particulars of each investor's
situation. See id.
When the defendant in a securities fraud case pleads the
statute of limitations as an affirmative defense, the plaintiff
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normally has the burden of pleading and proving facts demonstrating
the timeliness of her action. See Gen. Builders Supply Co. v.
River Hill Coal Venture, 796 F.2d 8, 11-12 (1st Cir. 1986); Cook v.
Avien, 573 F.2d 685, 695 (1st Cir. 1978). If, however, a defendant
seeks to truncate the limitations period by claiming that the
plaintiff had advance notice of the fraud through the incidence of
storm warnings, then the defendant bears the initial burden of
establishing the existence of such warnings. Mathews, 260 F.3d at
252. Only if the defendant succeeds in this endeavor must the
plaintiff counter with a showing that she fulfilled her
corresponding duty of making a reasonably diligent inquiry into the
possibility of fraudulent activity. Maggio, 824 F.2d at 128.
As this discussion makes plain, the existence vel non of
storm warnings has important ramifications for determining when the
statute of limitations in a Rule 10b-5 case begins to run. The
multifaceted question of whether storm warnings were apparent
involves issues of fact. Id. In the archetypical case, therefore,
it is for the factfinder to determine whether a particular
collection of data was sufficiently aposematic to place an investor
on inquiry notice. Marks v. CDW Computer Ctrs., Inc., 122 F.3d
363, 368-69 (7th Cir. 1997); see also Gen. Builders, 796 F.2d at 12
(emphasizing that this sort of factual question may be determined
as a matter of law only when the underlying facts are either
admitted or undisputed). So too the related question of whether a
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particular plaintiff exercised reasonable diligence in the face of
such warnings. Maggio, 824 F.2d at 128; Kennedy v. Josephthal &
Co., 814 F.2d 798, 803 (1st Cir. 1987).
There is one lingering question. In Cooperativa, we left
open the question of whether the statute of limitations begins to
accrue on the date that sufficient storm warnings first appear or
the later date on which an investor, alerted by storm warnings and
thereafter exercising reasonable diligence, would have discovered
the fraud. 129 F.3d at 225. In the case at hand, this difference
is potentially meaningful. We turn, then, to that question.
A number of considerations drive us to choose the latter
answer. First, we believe that the purpose of the discovery rule
is to afford a suitable degree of protection to plaintiffs who have
exercised reasonable diligence consistent with the information
available to them. Depending on the individual circumstances, a
reasonably diligent investigation following the receipt of storm
warnings may consume as little as a few days or as much as a few
years to get to the bottom of the matter. Given the wide range of
possibilities, we think it is fair that the one-year limitations
period begin to accrue only at the point when the Rule 10b-5
violation reasonably could have been discovered.
Second, and perhaps more importantly, we look to the
principles underlying the one-year limitations period. As the
Tenth Circuit noted in Sterlin v. Biomune Sys., Inc., 154 F.3d
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1191, 1202 (10th Cir. 1998), the proper administration of a
discovery rule must strike a delicate balance between the staunch
federal interest in requiring plaintiffs to bring suit promptly
once they have been apprised of their claims (thus securing repose
for deserving defendants) and the equally strong interest in not
driving plaintiffs to bring suit prematurely, that is, before they
are able, in the exercise of reasonable diligence, to discover the
facts necessary to support their claims. It makes no more sense to
reconcile this balance in a way that causes the one-year
limitations period to begin to run before a reasonably diligent
investor has had an adequate opportunity to discover the facts
underlying the alleged fraud than it would to reconcile it in a way
that allows an investor to dawdle endlessly after sufficient storm
warnings are apparent. In the end, a limitations period that
begins when a plaintiff reasonably should have discovered the fraud
treats both plaintiffs and defendants even-handedly.
This interpretation of the limitations standard has
metamorphosed into the majority view. See, e.g., Rothman v.
Gregor, 220 F.3d 81, 97-98 (2d Cir. 2000); Morton's Mkt. Inc. v.
Gustafson's Dairy, Inc., 198 F.3d 823, 836 (11th Cir. 1999);
Sterlin, 154 F.3d at 1201; Marks, 122 F.3d at 368; Byelick v.
Vivadelli, 79 F. Supp. 2d 610, 619 (E.D. Va. 1999); see also Berry
v. Valence Tech., Inc., 175 F.3d 699, 704 (9th Cir. 1999)
(predicting that the Ninth Circuit, were it to adopt the inquiry
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notice rule, would subscribe to the Sterlin court's approach).6
This consensus has become particularly evident since Lampf. In
etching the bounds of the one-year limitations period, the Lampf
Court explained that equitable tolling is both "unnecessary" and
"fundamentally inconsistent" with the one-year limit because this
period, "by its terms, begins after discovery of the facts
constituting the violation." 501 U.S. at 363. From this, we can
extrapolate a standard that starts the limitations clock only when
a plaintiff, in the exercise of reasonable diligence, should have
discovered her cause of action. Accord Sterlin, 154 F.3d at 1202.
We hold, therefore, that following the receipt of sufficient storm
warnings, a plaintiff's cause of action is deemed to accrue on the
date when, exercising reasonable diligence, she would have
unearthed the fraud.
III. THE ORIGINAL CLAIM
We now determine where Cape Ann's federal securities
claim falls in this taxonomy. The critical date is August 1, 1999
— one year before Cape Ann brought suit. The question, then, is
6
Even though we declined in Cooperativa to discrepate between
the date that storm warnings first appeared and the date that a
reasonably diligent investor would have discovered the fraud, 129
F.3d at 225, we wrote in Maggio that "storm warnings of the
possibility of fraud trigger a plaintiff's duty to investigate in
a reasonably diligent manner . . . and his cause of action is
deemed to accrue on the date when he should have discovered the
alleged fraud." 824 F.2d at 128 (emphasis in original; citation
and internal quotation marks omitted). That dictum correctly
anticipated the rule that we adopt today.
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whether it can be said, as a matter of law, that Cape Ann should
have discovered the fraud before that date.
The district court apparently concluded — we say
"apparently" because the court's opinion is not explicit on this
point — that the sequential 1997 and 1998 management letters
amounted to sufficient storm warnings, and, therefore, put Cape Ann
on inquiry notice of the alleged fraud no later than November of
1998. Cape Ann, 171 F. Supp. 2d at 27-28. Noting that the
management letters were directed to the audit committee of the
NutraMax board, and that a Cape Ann representative held a seat on
that committee, the court reasoned that those letters should have
led Cape Ann, as a fiduciary of NutraMax, to recognize the need for
an immediate investigation (which, the court surmised, would have
uncovered the fraudulent scheme). Id. We test this hypothesis.
Distilled to bare essence, Deloitte can prevail at this
procedural stage only if the trial court properly concluded that
the management letters amounted to storm warnings for a shareholder
who (like Cape Ann) held a seat on the company's board of directors
and audit committee; that Cape Ann failed to exercise reasonable
diligence in the face of those portents; and that, had Cape Ann
investigated, it would have discovered the fraud prior to August 1,
1999.
The fate of a motion to dismiss under Rule 12(b)(6)
ordinarily depends on the allegations contained within the four
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corners of the plaintiff's complaint. Here, however, the
management letters were neither attached to the amended complaint
nor incorporated by reference therein. We nonetheless conclude
that it was proper for the trial court to consider those letters in
ruling on Deloitte's motion to dismiss.
The key fact is that the amended complaint contained
extensive excerpts from, and references to, these letters. When
the factual allegations of a complaint revolve around a document
whose authenticity is unchallenged, "that document effectively
merges into the pleadings and the trial court can review it in
deciding a motion to dismiss under Rule 12(b)(6)." Beddall v.
State St. Bank & Trust Co., 137 F.3d 12, 17 (1st Cir. 1998); see
also 2 James Wm. Moore et al., Moore's Federal Practice ¶ 12.34[2]
(3d ed. 1997) (explaining that courts may consider "[u]ndisputed
documents alleged or referenced in the complaint" in deciding a
motion to dismiss). Both sides agree that this principle is
controlling here.
The significance of this ruling is readily apparent. It
is undisputed that Cape Ann held a seat on NutraMax's audit
committee, and that Deloitte addressed the management letters to
that committee. On that basis, the district court correctly
assumed, for the purposes of its Rule 12(b)(6) analysis, that Cape
Ann knew or should have known about this correspondence. It
follows logically that the substance of those missives may be
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incorporated into the objective prong of the Maggio test. Cf.
Constructora Maza, Inc. v. Banco de Ponce, 616 F.2d 573, 578-79
(1st Cir. 1980) (incorporating facts known to or ascertainable by
creditor into resolution of objective "prudent business person"
standard). This leaves us with the following legal question:
Would Deloitte's management letters necessarily have placed a
reasonable investor on inquiry notice concerning the possibility of
fraud?
For present purposes, the import of the management
letters lies in the reportable conditions identified therein, but
those references cannot be considered in a vacuum. There are
countervailing considerations here. In the first place, the
letters themselves contained specific reassurances that the
reportable conditions did not represent material weaknesses in the
company's reporting systems. In the second place, Deloitte gave
NutraMax a clean bill of financial health notwithstanding the
contents of the management letters: it certified NutraMax's 1997
and 1998 consolidated financial statements without any significant
qualification. And, finally, the amended complaint alleges that
Deloitte provided Cape Ann with independent assurances that tended
to palliate the import of the reportable conditions. For example,
the amended complaint alleges that Deloitte offered reassurances
that it had adjusted each of its audits "to respond to the risks"
posed by the problems it had discovered in NutraMax's internal
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controls. Moreover, Deloitte represented that, in addition to
providing reasonable assurances of detecting irregularities and
illegal acts, its audits had "focus[ed] on areas that were material
to NutraMax's consolidated financial statements, even if those
areas were not considered to be high risk." The complaint further
alleges that after Deloitte issued its 1998 management letter, Cape
Ann's representative asked Deloitte point-blank whether the letter
raised any cause for concern and was assured that it did not.
Given this steady stream of comforting words, we are not persuaded
that the management letters necessarily placed Cape Ann on inquiry
notice of the possibility that fraud was afoot.
It is, of course, true that Cape Ann, qua fiduciary,
received other unsettling information between November of 1998 and
August of 1999 (e.g., the COO's discoveries and the board's
decision to engage outside counsel and authorize a forensic audit).
But on the present record, we are unable to say with the requisite
level of certainty that the newly appointed COO had discovered the
fraud and so advised the board by the end of July 1999 (even though
the amended complaint acknowledges that the fraud had been
uncovered by mid-1999). And, moreover, to the extent that these
developments may have comprised storm warnings, they simultaneously
put Cape Ann on notice that a thorough investigation was in
progress. Cape Ann hardly can be faulted, as a matter of law, for
awaiting the results of that investigation before jumping to the
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conclusion that management was cooking the books. Cf. Jarrett v.
Kassel, 972 F.2d 1415, 1424-28 (6th Cir. 1992) (allowing plaintiffs
benefit of reasonably diligent investigation conducted on behalf of
another); Jensen v. Snellings, 841 F.2d 600, 608 (5th Cir. 1988)
(suggesting that limitations period did not begin to accrue until
plaintiffs received results of investigation). In short, the
complaint, on its face, permits the inference that NutraMax's board
neither knew of nor fully appreciated the true state of NutraMax's
finances, much less Deloitte's role in the situation, until after
August 1, 1999.
We also reject the district court's conclusion that, as
a matter of law, Cape Ann failed to exercise reasonable diligence.
While the fact that an investor is a director and a member of the
company's audit committee is plainly relevant to an evaluation of
the investor's diligence, fiduciary status, in and of itself, is
not dispositive of the reasonable diligence issue:
While the existence of a fiduciary
relationship is one factor which a court
should consider in determining whether the
plaintiff has exerted due diligence, a mere
allegation that such a fiduciary relationship
existed is not necessarily determinative. We
must also consider other factors, including
the nature of the fraud alleged, the
opportunity to discover the fraud, and the
subsequent actions of the defendants.
Gen. Builders, 796 F.2d at 12; accord Rowe v. Marietta Corp., 955
F. Supp. 836, 842-43 (W.D. Tenn. 1997) (rejecting summary judgment
predicated, in part, on plaintiff's status as a director and his
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receipt of storm warnings in that capacity). We hold, therefore,
that Cape Ann's status as a fiduciary does not justify an
irresistible inference that it acted in willful disregard of a
known risk. From the information contained in the amended
complaint, it is a jury question as to whether Cape Ann acted with
reasonable diligence.7
Drawing all reasonable inferences in Cape Ann's favor, we
do not think that a court could conclude, on the bare bones of the
amended complaint, either that the management letters amounted to
storm warnings or that those communications inexorably placed Cape
Ann on inquiry notice. By like token, it cannot be said, as a
matter of law, that Cape Ann failed to exercise diligence
commensurate with its knowledge. Given these conclusions, we must
vacate the order of dismissal insofar as that order pertains to
Cape Ann's Rule 10b-5 claim.8 See, e.g., Rothman, 220 F.3d at 96-
98; Marks, 122 F.3d at 368-69; Olcott v. Del. Flood Co., 76 F.3d
1538, 1549 (10th Cir. 1996). We fully appreciate that this is a
7
We recognize that pretrial discovery, not yet conducted, may
change the picture. Consequently, we express no opinion as to
whether summary judgment may be in order on a better-developed
record.
8
In reaching a contrary conclusion, the district court relied
heavily on Hathaway v. Huntley, 188 N.E. 616 (Mass. 1933).
Hathaway, however, arose in a markedly different procedural
posture: the case had been referred to a master, who made
extensive factual findings. Id. at 617. The Hathaway court relied
on those findings in concluding that the defendant-director had
failed to exercise reasonable diligence. Id.
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close case on the facts, but we review a Rule 12(b)(6) disposition
de novo — and in this instance we do not think that the amended
complaint itself offers a sufficient basis for dismissal.
We add two brief observations designed to assist the
district court on remand. First, we note that Deloitte has
questioned whether Cape Ann's federal securities claim should be
dismissed on the ground that the allegations set forth in the
amended complaint were insufficiently specific. The district court
did not address this asseveration, and we take no view of it.
We also note that courts generally refer to the law of
the state of incorporation, rather than the law of the forum state,
to determine the duties of corporate directors. 1 William E.
Knepper & Dan A. Bailey, Liability of Corporate Officers &
Directors § 1-5, at 16 (6th ed. 1998). In light of this tenet, we
encourage the district court to take a closer look at whether
Delaware law, rather than Massachusetts law, should be applied to
ascertain the scope of Cape Ann's fiduciary duty for purposes of a
Maggio analysis. We leave open the possibility, however, that a
formal choice-of-law ruling will prove unnecessary. See, e.g.,
Royal Bus. Group, Inc. v. Realist, Inc., 933 F.2d 1056, 1064-65
(1st Cir. 1991) (declining to make such a ruling when choice of law
will not affect the outcome).
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IV. THE ADDED CLAIMS
We turn next to the new plaintiffs' federal securities
claims. Although the viability of this set of claims also hinges
on temporal considerations, our evaluation traverses a much
different analytical path.
The new plaintiffs first asserted their claims in the
amended complaint, filed March 9, 2001. They did not argue in the
district court that the one-year limitations period was still open
on that date.9 By failing to advance such a theory below, they
have forfeited the right to raise it on appeal. See Teamsters
Union Local No. 59 v. Superline Transp. Co., 953 F.2d 17, 21 (1st
Cir. 1992) ("If any principle is settled in this circuit, it is
that, absent the most extraordinary circumstances, legal theories
not squarely raised in the lower court cannot be broached for the
first time on appeal."); McCoy v. MIT, 950 F.2d 13, 22 (1st Cir.
1991) (similar).
This leaves the new plaintiffs with the argument that
they urged below. That argument depends upon Rule 15(c)(3) of the
Civil Rules, which states in pertinent part:
9
This hardly seems surprising. The date of suit — March 9,
2001 — was more than one year after (1) NutraMax's blockbuster
announcement of August 18, 1999 and the resultant 40% drop in the
price of the company's stock, (2) NASDAQ's delisting of the
company's shares, and (3) Deloitte's withdrawal of its audit
reports. It strains credulity to maintain either that these
events, collectively, did not amount to sufficient storm warnings
or that the fraud was not readily discoverable by March of 2000.
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An amendment of a pleading relates back to the
date of the original pleading when . . . the
amendment changes the party or the naming of
the party against whom a claim is asserted if
. . . the party to be brought in by amendment
(A) has received such notice of the
institution of the action that the party will
not be prejudiced in maintaining a defense on
the merits, and (B) knew or should have known
that, but for a mistake concerning the
identity of the proper party, the action would
have been brought against the party.
Fed. R. Civ. P. 15(c)(3). The new plaintiffs take the position
that, under this rule, their federal securities claims relate back
to August 1, 2000 — the date on which Cape Ann filed its original
complaint – and, thus, come within the one-year prescriptive
period. We find this argument unpersuasive.
At the outset, we acknowledge that the new plaintiffs'
argument is theoretically available. Although the text of Rule
15(c)(3) seems to contemplate changes in the identity of
defendants, we have recognized that the rule can be applied to
amendments that change the identity of plaintiffs. See Allied
Int'l, Inc. v. Int'l Longshoremen's Ass'n, 814 F.2d 32, 35 (1st
Cir. 1987) (discussing potential applicability of the rule to an
amendment "substituting a fresh plaintiff for the original one");
see also Fed. R. Civ. P. advisory committee note (1966)
(emphasizing that Rule 15(c)(3) "extends by analogy to amendments
changing plaintiffs"). In theory, then, the benefits of Rule
15(c)(3) are within the reach of new plaintiffs.
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In practice, however, relation back is far from
automatic. Rule 15(c)(3) is not an open invitation to every
plaintiff whose claim otherwise would be time-barred to salvage it
by joining an earlier-filed action. Rather, the rule strikes a
carefully calibrated balance. Properly construed, it allows some
claims that otherwise might be dismissed on the basis of procedural
technicalities to prosper while at the same time keeping the door
closed to other claims that have been allowed to wither on the
vine. See Nelson v. County of Allegheny, 60 F.3d 1010, 1014 (3d
Cir. 1995); see also 3 Moore's Federal Practice, supra, ¶
15.19[3][a]. To separate wheat from chaff, we have laid down three
separate requirements applicable to plaintiffs who seek succor
under Rule 15(c)(3):
[T]he amended complaint must arise out of the
conduct, transaction, or occurrence set forth
or attempted to be set forth in the original
pleading; there must be a sufficient identity
of interest between the new plaintiff, the old
plaintiff, and their respective claims so that
the defendants can be said to have been given
fair notice of the latecomer's claim against
them; and undue prejudice must be absent.
Allied Int'l, 814 F.2d at 35-36.
We ordinarily review a trial court's decision to grant or
deny motions under Rule 15(c)(3) for abuse of discretion. E.g.,
id. at 37. It is, however, settled beyond peradventure that an
error of law constitutes an abuse of discretion. See United States
v. Keene, 287 F.3d 229, 233 (1st Cir. 2002); In re Grand Jury
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Subpoena, 138 F.3d 442, 444 (1st Cir. 1998). Here, the district
court rejected the new plaintiffs' claim that they were eligible
for "relation back" principally on the ground that they and their
claims lacked a sufficient identity of interest with the original
plaintiff and its claims. Cape Ann, 171 F. Supp. 2d at 30. This
was a quintessentially legal determination, made on undisputed
facts, and thus engenders de novo review.
The guideposts for evaluating whether two parties possess
a sufficient identity of interest to permit relation back are not
well-defined. As to defendants, identity of interest typically
means that parties are "so closely related in their business
operations or other activities that the institution of an action
against one serves to provide notice of the litigation to the
other." Singletary v. Pa. Dep't of Corr., 266 F.3d 186, 197 (3d
Cir. 2001) (citing 6A Charles A. Wright et al., Federal Practice
and Procedure § 1499, at 146 (2d ed. 1990)). "The substitution of
such parties after the applicable statute of limitations may have
run is not significant when the change is merely formal and in no
way alters the known facts and issues on which the action is
based." Staren v. Am. Nat'l Bank & Trust Co., 529 F.2d 1257, 1263
(7th Cir. 1976). The identity of interest requirement reflects
this line of thought; it "ensures that the old and new plaintiffs
are sufficiently related so that the new plaintiff was in effect
involved in [the proceedings] unofficially from an early stage."
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Leachman v. Beech Aircraft Corp., 694 F.2d 1301, 1309 (D.C. Cir.
1982) (citation and internal quotation marks omitted).
That formulation is not readily transferrable to
plaintiffs. Nevertheless, it suggests that when a new plaintiff
attempts to enter a pending action under the aegis of Rule
15(c)(3), courts should require substantial structural and
corporate overlap to ensure that the defendant is not called upon
to defend against new facts and issues. This, then, should be the
focal point of the identity of interest requirement vis-à-vis a new
plaintiff.
The case law runs along these lines. See 3 Moore's
Federal Practice, supra, ¶ 15.19[3][c] (collecting cases). Some
concrete examples may prove helpful. Courts have found a
sufficient identity of interest when the original and added
plaintiffs are a parent corporation and a wholly-owned subsidiary.
Hernandez Jimenez v. Calero Toledo, 604 F.2d 99, 103 (1st Cir.
1979). So too when they are "related corporations whose officers,
directors, or shareholders are substantially identical and who have
similar names or share office space, past and present forms of the
same enterprise." Id. Similarly, in Raynor Bros. v. Am. Cyanimid
Co., 695 F.2d 382, 384-85 (9th Cir. 1982), the court sanctioned the
substitution of a family partnership for a family-owned corporate
plaintiff upon a showing that each partner also was a major
shareholder in the corporation. And in Staren, 529 F.2d at 1263,
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the court permitted the substitution of a corporation in lieu of
two individuals (the president of the corporation and his business
associate) to head off a claim that the corporation, rather than
the individuals, was the purchaser in a particular transaction.
These cases sound a common theme. To use an old-
fashioned word, they require a fairly advanced degree of privity to
ground the substitution or addition of new plaintiffs under Rule
15(c)(3). Our decision in Allied International fits such a mold.
There, we allowed the substitution, under Rule 15(c)(3), of a
corporation that had purchased all the assets of the original
complainant (and, afterwards, continued to operate the acquired
business). 814 F.2d at 35-38.
The case at hand presents a variation on this theme: the
question is whether stockholders in a publicly-held corporation,
not related to each other except by that status, share a sufficient
identity of interest to meet the requirements of Rule 15(c)(3). We
answer that question in the negative. Persons who are identified
with each other only by their ownership of stock in the same
publicly-traded corporation share some of the same rights, but that
fact, standing alone, does not place them in the kind of proximity
needed to invoke Rule 15(c)(3).
In so holding, we repudiate the conceit that an action
filed by one plaintiff gives a defendant notice of the impending
joinder of any or all similarly situated plaintiffs. Such a rule
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would undermine applicable statutes of limitations and make a
mockery of the promise of repose. We, like other courts, flatly
reject the proposition that relation back is available merely
because a new plaintiff's claims arise from the same transaction or
occurrence as the original plaintiff's claims. See In re Syntex
Corp. Sec. Litig., 95 F.3d 922, 935 (9th Cir. 1996) (disallowing
relation back for newly proposed investor plaintiffs who bought
stock at different values and after different disclosures and
statements than original plaintiffs); Page v. Pension Ben. Guar.
Corp., 130 F.R.D. 510, 513 (D.D.C. 1990) (similar). This means,
then, that the happenstance that individuals have invested in the
same publicly-traded stock, without more, cannot suffice to confer
identity of interest.
It is readily apparent, then, that the new plaintiffs in
this case are facing an uphill climb — and the raw facts make the
slope even steeper. The new plaintiffs' underlying Rule 10b-5
claims differ from Cape Ann's in significant respects. The
pleadings reveal that Cape Ann invested in NutraMax stock with the
avowed intention of becoming a "strategic partner" in the ownership
and management of a third company whose later acquisition Cape Ann
funded. Pursuant to this transaction and a subsequent private
placement, Cape Ann acquired its NutraMax stock at negotiated
prices and proceeded to take an active role in the company's
affairs. In contrast, the new plaintiffs purchased their shares on
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the open market at a much wider range of times and prices, and
thereafter were purely passive investors. Clearly, Cape Ann and
the new plaintiffs had different vantage points from which to
observe how NutraMax was being run. By the same token, they had
different incentives and opportunities to investigate the ongoing
fraud.
Given this broad disparity, we find it difficult to
credit the new plaintiffs' blithe assertion that the filing of suit
by Cape Ann gave Deloitte notice that the new plaintiffs also would
sue. Cape Ann's complaint was not couched as a class action — and
on these facts, Deloitte had no reason to believe that Cape Ann was
speaking on behalf, or acting to the behoof, of other shareholders.
In fact, as the district court noted, Cape Ann, 171 F. Supp. 2d at
29-30, Cape Ann has no beneficial interest whatever in the claims
of the new plaintiffs. Similarly, the new plaintiffs harbor no
beneficial interest in Cape Ann's claims, save for their desire to
ride piggyback on Cape Ann's filing date.7 And the parties'
injuries, although arising out of the same set of occurrences, are
completely separate and distinct. Accordingly, Deloitte could not
have had notice that the injuries of the one were in any way
dependent upon the existence of the other. Cf. Williams v. United
States, 405 F.2d 234, 239 (5th Cir. 1968) (holding that since
7
Far from being beneficially interested in one another's
claims, the two groups of plaintiffs, as shareholders in a bankrupt
corporation, may have adverse interests.
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mother's derivative loss-of-services claim predictably arose from
tortious injury to son, defendant was put on notice because the
"circumstances of these individuals was such as would reasonably
indicate a likelihood that the parent would incur losses of a
recoverable kind").
The short of the matter is that the amended complaint
does not allege any facts showing that Cape Ann and the new
plaintiffs were linked through any preexisting relationship. This
is a decisive consideration because the absence of a sufficient
identity of interest between Cape Ann and the new plaintiffs
resulted in a lack of fair notice to Deloitte. The Supreme Court
has emphasized that "notice within the limitations period" is the
linchpin of a Rule 15(c) analysis. Schiavone v. Fortune, 477 U.S.
21, 31 (1986). In our view, lack of notice and unfair prejudice go
hand in hand. Thus, while Cape Ann's original complaint may have
given Deloitte reason to fear that other shareholders might pursue
similar claims, such minimal notice hardly suffices to avert undue
prejudice to Deloitte within the meaning of Rule 15(c)(3) should we
permit relation back. That prejudice is obvious: it is the
prejudice "suffered by one who, for lack of timely notice that a
suit has been instituted, must set about assembling evidence and
constructing a defense when the case is already stale." Nelson, 60
F.3d at 1014-15.
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To say more on this point would be supererogatory.
Where, as here, real issues of fact still hover as to what
representations and reassurances were proffered and who owed what
duties to whom, the accession of new plaintiffs and claims will
likely entail new legal theories and tactics against which Deloitte
must defend and a geometric increase in its potential liability.
When this occurs long after the statute of limitations has run,
prejudice is manifest. The Third Circuit summed it up well:
Statutes of limitations ensure that defendants
are protected against the prejudice of having
to defend against stale claims . . . . In
order to preserve this protection, the
relation-back rule requires plaintiffs to show
that the already commenced action sufficiently
embraces the amended complaint so that
defendants are not unfairly prejudiced by
these late-coming plaintiffs and that
plaintiffs have not slept on their rights.
Id. at 1014 (citation and internal quotation marks omitted); see
also Leachman, 694 F.2d at 1309 (emphasizing that defendants are
entitled to "have notice of who their adversaries are").
The fact that the new plaintiffs have assigned their
claims to the Trust does not alter the decisional calculus. An
assignee ordinarily stands in the shoes of the assignor. E.g., In
re SPM Mfg. Corp., 984 F.2d 1305, 1318 (1st Cir. 1993); R.I. Hosp.
Trust Nat'l Bank v. Ohio Cas. Ins. Co., 789 F.2d 74, 81 (1st Cir.
1986). Consequently, an assignee cannot maintain a claim in the
face of a limitations defense that would have trumped the same
claim had it been brought by the assignor. See Ass'n of
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Commonwealth Claimants v. Moylan, 71 F.3d 1398, 1402 (8th Cir.
1995); Fox-Greenwald Sheet Metal Co. v. Markowitz Bros., Inc., 452
F.2d 1346, 1357 n.69 (D.C. Cir. 1970). That is as it should be.
Were the law otherwise, the efficacy of a limitations defense could
be destroyed by the simple expedient of assigning the claim in
question to a party who already had sued the defendant.
To summarize, we hold, based upon the lack of a
sufficient identity of interest between Cape Ann and the new
plaintiffs, that the latter are precluded from invoking Rule
15(c)(3) in order to salvage their time-barred federal securities
claims. Because this holding forecloses the only available route
to recovery, we affirm the district court's dismissal of those
claims.
V. CONCLUSION
We need go no further. To recapitulate, we reverse the
district court's dismissal of Cape Ann's Rule 10b-5 claim because
it cannot be said, as a matter of law, that the statute of
limitations expired before Cape Ann sued. Conversely, we uphold
the district court's refusal to permit the new plaintiffs to hitch
their wagon to Cape Ann's star because the new plaintiffs do not
share a sufficient identity of interest with Cape Ann. We direct
the district court, on remand, to reconsider the dismissal of the
supplemental state-law claims, but we take no view as to whether
the court should exercise supplemental jurisdiction over those
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claims. See Carnegie-Mellon Univ. v. Cohill, 484 U.S. 343, 350
(1988) (emphasizing that exercise of pendent jurisdiction is at the
district court's discretion); Rodriguez v. Doral Mortg. Corp., 57
F.3d 1168, 1176 (1st Cir. 1995) (similar).
Affirmed in part, reversed in part, and remanded for further
proceedings consistent with this opinion. All parties shall bear
their own costs.
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