United States Court of Appeals
For the First Circuit
No. 01-1965
In Re: CABLETRON SYSTEMS, INC.
CHARLES MESKO, STEVEN GOLDMAN, BGC INVESTMENT CLUB, MALCOLM R.
BRAID, LINDA LEE BRAID, JO BRIDGEFORD, JAMES E. CHESNEY, STEVEN
M. CROSS, CHARLES C. CULLERS, THOMAS D'AMBROSIO, LISA D'AMBROSIO,
ROBERT J. DATSKO, KATHY O. DATSKO, BRET M. DAVIS, WILLIAM DENEEN,
FRED V. GAKSTATTER, LARRY M. GIESEN, ROBERT GLAMB, DEBORAH GLAMB,
DONALD F. GODWIN, NATALIE GREENBERG, JOHN HALICKS, PATRICIA
HALICKS, SIMON X. HE, INTREPID INVESTORS, ASHVIN KAPADIA, IRWIN
KRAMER, MARK F. KULIGOWSKI, GARY W. KURTZ, SUZANNE KURTZ, PAUL
LAWSON, EDMUND E. LEBLANC, TERRY LENMARK, CRAIG LUKEMIRE, BRET J.
MAY, DAVID L. MAYES, TIMOTHY M. MCMAHON, WALTER C. MEYER, EDITH
L. MEYER, ED NEUBERT, WILLIAM KENT NICHOLS, MARTIN PALKOVIC,
RICHARD W. PENOZA, FRED PERLMAN, ROY PHILEMON, DAVID PHILLIPS,
JOSIE PHILLIPS, GREGORY PINTO, GREGORY PIRO, WILLIAM CARL PORTER,
DENIS A. PRATT, ANDREW ROBINTON, TRACY ROBINTON, BARBARA
ROBINTON, ALI ROBINTON, MICHAEL R. SCHARF, ROMILDO J. SCOLARI,
WOLFGANG U. SPENDEL, LEE STEIN, PETER SWANSON, JAMES F. SWEENEY,
TITAN INVESTORS, JOHN R. TONSAGER, CARYL TRAUGOTT, ROBERT F.
WHITE JR., ROBERT C. WHITE, JAMES W. WHITMER, JOHN ROBINTON,
JAMES WONG, BERNARD YAMNER, NANCY ZORNER, PATRICIA J. ZUMPFE,
BERNARD ROBINSON, MARC LINSKY, MALA BALASUBRAMANIAN, MATTHEW J.
DECKER, RON GRYNKIEWICZ, RON KNECHT, VINCENT LUONGO, RICHARD
NADZIEJA, THAI NGUYEN, CHANI PANGALI, ROBERT RANDO, RUSSELL
RUFFINO, BABETTE SPATZ, KAREN BORIC, RICHARD DURA, JAMES G. PADS,
KENNETH M. WILLIAMS, and PHILIP ADLER,
Plaintiffs, Appellants,
GEORGE R. BIELSKI, HENRY BRENER, BYSG CAPITAL, JOHN CAMPBELL,
FRANK CHARAMITARO, ED DUNN, LESLIE C. HALE, CHARLES HAMMOND,
CAROLE KOPS, LARRY MORRISON, LOU ANN MURPHY, MURIEL ROBINSON, JIM
SPENCER, PATRICIA STACK, ALBERT SHAPIRO,
PETER SAMEK AS TRUSTEE OF ROBERT AND JOANNE SAMEK LIVING TRUST,
and NATHAN SCHLESSINGER,
Plaintiffs,
v.
CABLETRON SYSTEMS, INC., ROBERT LEVINE, CRAIG R. BENSON, PAUL R.
DUNCAN, DAVID J. KIRKPATRICK, DONALD F. MCGUINNESS, MICHAEL D.
MYEROW, and CHRISTOPHER J. OLIVER
Defendants, Appellees.
APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF NEW HAMPSHIRE
[Hon. Mary M. Lisi, U.S. District Judge*]
Before
Lynch, Circuit Judge,
Coffin and Cyr, Senior Circuit Judges.
Sanford P. Dumain with whom William C. Fredericks, Bruce
D. Bernstein, Milberg Weiss Bershad Hynes & Lerach LLP, Herbert E.
Milstein, Mark S. Willis, Cohen, Milstein, Hausfeld & Toll,
P.L.L.C., Jules Brody, Mark Levine, and Stull Stull & Brody were on
briefs for appellants.
Harvey J. Wolkoff with whom Robert G. Jones, David C.
Potter, Ropes & Gray, Wilbur A. Glahn III, and McLane, Graf,
Raulerson & Middleton were on brief for appellees.
November 12, 2002
*
Of the District of Rhode Island, sitting by designation.
LYNCH, Circuit Judge. This case requires us to apply the
pleading standards for private securities fraud litigation under
the Private Securities Litigation Reform Act of 1995 ("PSLRA"), 15
U.S.C. § 78u-4(b) (2000), and raises several issues of first
impression for this court. The district court, acting under Fed.
R. Civ. P. 12(b)(6), dismissed the complaint. We differ with the
district court concerning certain tests to be applied in assessing
securities fraud claims and in construction of our precedent. We
conclude that the complaint as a whole complies with the PSLRA in
sufficient part, and we reverse the dismissal and remand the case
for further proceedings, with the exception that we affirm
dismissal of one of the two claims against defendant Christopher J.
Oliver. Our ruling does not mean that plaintiffs' claims have any
merit. It means only that the claims are not to be dismissed at
this very early stage. Nothing has been proven yet.
Charles Mesko and other investors filed a class action
suit against Cabletron Systems, Inc. and seven individuals who
served as executives or directors of Cabletron.1 Mesko alleged
1
We will refer to the plaintiffs collectively as "Mesko."
The individual defendants, along with the offices they held during
the relevant period, are: S. Robert Levine, who served as
president, chief executive officer, and a member of the board of
directors until his retirement on or about August 6, 1997, in the
middle of the class period; Craig Benson, the chairman of the board
of directors, chief operating officer, and treasurer; David J.
Kirkpatrick, the director of finance and chief financial officer;
Christopher J. Oliver, the director of engineering and
manufacturing; and three members of the board of directors who were
not officers of Cabletron: Paul R. Duncan, Donald F. McGuinness,
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violations of sections 10(b) and 20(a) of the Securities Exchange
Act of 1934, 15 U.S.C. §§ 78j(b), 78t(a), and Rule 10b-5
promulgated by the Securities and Exchange Commission (SEC), 17
C.F.R. § 240.10b-5 (2002). Plaintiffs purchased Cabletron stock,
or bought call options or sold put options for Cabletron stock,
between March 3, 1997 and December 2, 1997 (the "class period").
The first consolidated amended complaint was rejected for failing
to meet the standards of the PSLRA, but Mesko was granted leave to
amend it. He did, and the district court then ruled that this
second consolidated amended complaint (the "complaint") satisfied
the requirements of the PSLRA. After the judge who issued this
ruling died, the defendants renewed their motion to dismiss.
Contrary to the first district judge's ruling, a
successor district judge granted defendants' motion to dismiss the
complaint. This dismissal occurred before discovery was conducted
or any class was certified. The district court held that the
complaint fails the particularity test for pleading fraud, that it
fails to allege facts supporting a belief that the misstatements
were material, and that the pleadings do not raise a strong
inference of scienter. We disagree on all three points.
As to the particularity ruling, it is unclear if the
district court held that any pleading based upon confidential
sources would fail the PSLRA's pleading requirements, thus adopting
and Michael D. Myerow.
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the rule from a case it cited, In re Silicon Graphics Securities
Litigation, 970 F. Supp. 746, 763-64 (N.D. Cal. 1997), aff'd, 183
F.3d 970, 985 (9th Cir. 1999). Alternatively, the court may have
utilized a rule that allows confidential sources if there are other
specific facts alleged, but then determined that this complaint
lacked such facts. We reject the Silicon Graphics per se test
forbidding PSLRA pleadings based on confidential sources, and
instead adopt a test similar to the Second Circuit's test in Novak
v. Kasaks, 216 F.3d 300, 314 (2nd Cir. 2000). Applying that test,
we find there was sufficient detail in the allegations, including
those made by confidential sources, to permit the complaint to go
forward. We also hold, contrary to the district court, that the
complaint provides adequate information concerning internal company
documents on which it relies.
As to materially misleading statements, the district
court erred in the overly restrictive test it applied to statements
made by third parties -- in this instance mostly market analysts --
which were in turn based on statements made by company officials.
We reject the district court's determination that the defendants
must have either "controlled" the content of the third party
statements or adopted them. Instead we join the majority of courts
in applying the "entanglement" test first articulated in Elkind v.
Liggett & Myers, Inc., 635 F.2d 156, 163 (2d Cir. 1980).
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As to both materiality and scienter, we conclude that the
pertinent portions of the complaint sufficiently meet pleading
requirements at this stage of the case.
While some of the allegations are stronger than others,
and those against the defendant outside directors present a close
call, we conclude that the complaint as a whole states a claim
against Cabletron and against all but one of the individual
defendants. As to that defendant, Oliver, the director of
engineering and manufacturing, we affirm dismissal of the section
10(b) claim against him but not dismissal of the section 20(a)
claim. We reverse the remainder of the district court decision and
remand.
In addition to appealing the dismissal of the complaint,
Mesko asks this court to remand the case to a district judge who
had previously recused himself, on the basis that his
disqualification was improper. We deny this request.
I.
Mesko filed his original complaint in the U.S. District
Court for the District of New Hampshire, where the case was
assigned to the late Judge Shane Devine. On December 23, 1998, in
response to defendants' motion to dismiss, Judge Devine ruled that
Mesko's first consolidated amended complaint lacked enough detail
concerning statements made "on information and belief" to survive
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heightened pleading standards under the PSLRA, but granted Mesko
leave to amend.
Mesko amended the complaint by adding sources for the
allegations pled, particularly "more than a half dozen former
Cabletron employees who worked at the Company during the Class
Period." Judge Devine accepted these changes in a one-page order
on February 4, 1999, writing, "The court has reviewed the complaint
and is satisfied that it meets the PSLRA's requirements relative to
pleadings based on information and belief." His order invited
defendants to either renew their motion to dismiss or file an
answer.2 Shortly after Judge Devine passed away on February 22,
1999, the defendants renewed their motion to dismiss.
2
Mesko suggests that this ruling by Judge Devine
foreclosed later consideration in the district court of the
defendants' subsequently renewed motion to dismiss, under the
"law of the case" doctrine. That is incorrect. The law of
the case is a discretionary doctrine, especially as applied to
interlocutory orders such as this one. See Perez-Ruiz v.
Crespo-Guillen, 25 F.3d 40, 42 (1st Cir. 1994) ("Interlocutory
orders, including denials of motions to dismiss, remain open
to trial court reconsideration, and do not constitute the law
of the case."). As Justice Holmes expressed it, "[T]he
phrase, law of the case, as applied to the effect of previous
orders on the later action of the court rendering them in the
same case, merely expresses the practice of courts generally
to refuse to reopen what has been decided, not a limit to
their power." Messenger v. Anderson, 225 U.S. 436, 444
(1912). Reconsideration is also appropriate because
defendants filed a motion to strike the complaint hours before
Judge Devine issued his sua sponte order, so that he did not
have their arguments before him.
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The case was then reassigned several times as the result
of recusals. First it went before Judge Joseph A. DiClerico Jr.,
who recused himself from the case because he owned stock in
companies that were defendants in other securities class actions
brought by plaintiffs' counsel or their firms. One of defendants'
attorneys was on the recusal lists of the two other federal
district judges in the District of New Hampshire. Therefore, the
case was transferred to the District of Rhode Island for assignment
to a judge there, sitting by designation in the District of New
Hampshire, which retained jurisdiction. The case was then assigned
to Chief Judge Ernest C. Torres, but, like Judge DiClerico, he
owned stock in several corporations against which counsel in this
case had brought securities litigation, and he too disqualified
himself. The case was finally reassigned once more, to Judge Mary
M. Lisi. Neither party objected to any of these recusals at the
time they occurred.3
Judge Lisi heard oral argument on the defendants' motion
to dismiss on November 7, 2000. During oral argument, she asked
Mesko to provide a list of those paragraphs in the complaint that
are based on information and belief. Mesko did so on November 13,
3
Before his decision to recuse himself, Judge DiClerico
first ordered counsel to supply lists identifying all federal and
state securities class action suits in which their firms appeared.
At that point, Mesko did file a motion seeking a status conference
and asking that these lists be submitted in camera or under seal.
Once this motion was denied, Mesko's attorneys produced the lists
without further objection to the recusals until this appeal.
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indicating that four of the 126 paragraphs are based on information
and belief; he attributed most of the others to either a document
or a witness who had spoken to counsel.4 On May 23, 2001, Judge
Lisi granted the motion to dismiss, determining that the complaint
failed to meet the heightened pleading requirements of the PSLRA.
This appeal followed.
II.
Where the dismissal is grounded in Rule 12(b)(6), the
facts pled in the complaint are taken in the light most favorable
to the plaintiff. See Aldridge v. A.T. Cross Corp., 284 F.3d 72,
75 (1st Cir. 2002) (citing Doe v. Walker, 193 F.3d 42, 42 (1st Cir.
1999)) (applying standard in PSLRA case). We describe the facts in
the complaint.
Cabletron, now renamed, was a publicly-traded corporation
registered in Delaware with its principal place of business in New
Hampshire.5 In 1997, at the beginning of the class period,
Cabletron was among the nation's leading manufacturers and vendors
4
The district court seems to have used inconsistent
definitions of "information and belief." The court first said at
oral argument that, if the confidential sources based their
allegations on personal knowledge, then their statements were not
made "on information and belief." Its written opinion later seemed
to reverse this position and interpret information and belief
claims as any made without plaintiffs' direct personal knowledge.
Mesko's submission rested on the first of these definitions.
5
Cabletron reorganized itself after the events at issue in
this litigation; Cabletron's core business is now carried on under
a new corporate name, Enterasys Networks, Inc.
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of equipment for large enterprise computer networks, such as local
area network and wide area network switches, as well as related
hardware, software, and consulting services. Its customers
included sizable corporations, universities, and government
entities. For the quarter ending on February 28, 1997, immediately
before the class period, Cabletron reported strong financial
performance, including a twenty-six percent increase in net sales.
In a company press release, S. Robert Levine, the president and
chief executive officer, said these results represented Cabletron's
"thirty-second quarter of consecutive record growth, the strongest
and steadiest earnings growth rate among all S&P 500 companies."
These impressive numbers did not last. After the market
closed on June 2, 1997, Cabletron announced that its earnings for
the March-May 1997 quarter were less than those in the prior
quarter. The earnings, at $0.37 per share, were also well below
stock analysts' previous expectations of about $0.49 per share.
When the market opened the following day, June 3, the price of
Cabletron common stock fell from $45.75 to $30.35 per share. This
was a one-day decline of approximately one-third of its value.
Reported results for the June-August quarter were in line with
expectations. However, on December 2, Cabletron reported earnings
of $0.08 to $0.12 per share for the September-November quarter,
again falling short of expectations. In the same announcement,
Cabletron declared that it would take a charge against earnings of
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between $25 million and $30 million. Investors responded with
another one-day sell-off on December 2, when the price per share
fell from $23.1875 to $15.6875 in heavy trading. Over the class
period as a whole, the price of Cabletron stock declined from a per
share high of $46.50 to $15.6875, a total drop of almost 67
percent.
Mesko filed this lawsuit soon thereafter. The complaint
alleges that a variety of problems, well known to the leadership of
the company, seriously threatened Cabletron's business at the time
of the class period. Again, for the purposes of the motion to
dismiss, we assume the allegations to be true. The company's
ballyhooed new products, the SmartSwitch 6000 and SmartSwitch 2200,
encountered two serious problems that greatly slowed their
manufacture. The resulting delay in their commercial availability
was a blow to a company relying on the SmartSwitch to fuel
continued growth. The European sales force, which had contributed
about twenty percent of revenues in the fiscal year that ended just
before the class period, was being run by inexperienced managers
who were in over their heads and unable to meet their goals.
Cabletron's pricing became grossly out of line with its
competitors. The company knowingly shipped products that still had
unresolved defects. Market saturation, increased selling cycles,
and the cancellation of Cabletron's cooperative relationship with
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its dominant market rival, Cisco Systems, also contributed to these
woes.
In the face of these "adverse factors," the complaint
alleges, the company's public statements were unremittingly
optimistic, especially concerning its European operations and the
SmartSwitch. Even when the company announced the surprising bad
news about its quarterly earnings on June 2, management maintained
its unjustifiable bright optimism and disclosed only part of the
troubles facing Cabletron. The failure to disclose and the
positive statements in the face of contrary knowledge were
themselves securities law violations, the complaint alleges.
Even worse, Mesko alleges, the defendants tried to hide
this downward spiral by fraudulently inflating the company's
quarterly net revenue with a number of techniques, some blatant and
some more subtle. These included booking entirely fictitious
sales; making shipments late in one quarter, which had the effect
of bumping up that quarter's revenue, while knowing that the goods
would be returned during the next quarter; and setting aside newly
received raw materials and booking them in a later quarter so that
they would not appear as liabilities in the quarter when they
actually arrived. The complaint supports these allegations by
reference to one or more of a half dozen anonymous former Cabletron
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employees who say they have personal knowledge of the practices
they describe.6
As a result of this frantic end-of-quarter fraud, the
complaint alleges, thirty percent of shipments in the last weeks of
a quarter were returned early in the following quarter, compared to
a typical return rate of one to three percent at other times. In
turn, the receiving department was "probably the busiest department
in the Company" in the early days of a quarter, as employees logged
numerous pallets of computer equipment, with total values between
$160,000 and $1.2 million, back into the warehouse as returned
merchandise. It is a reasonable inference that the timing of this
disproportionate surge in returns was no coincidence, but was
caused by attempts to inflate revenue in one quarter, albeit at the
expense of the next one.
The complaint states that improperly recognized revenue
from the different schemes totaled tens of millions of dollars
during each of the fiscal quarters at issue. It derives this
figure from estimates of two of its former employee sources, one
who estimates that Cabletron improperly recognized revenue of
between $20 million and $30 million per quarter, and another who
6
The complaint repeatedly refers to its anonymous sources
as "former employees with personal knowledge of the relevant facts"
or some similar phrase. In the interest of simplicity, we will use
less wordy formulations, while recognizing that the complaint does
reiterate the personal basis for its anonymous sources' knowledge
each time.
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estimates that the company processed as much as $100 million in
"phony" orders during the quarter that ended just before the class
period. The falsely inflated earnings figures that resulted from
these improper practices were then used in Cabletron's filings with
the SEC during the class period and in company press releases
announcing quarterly results.
The picture that emerges from the pleading as a whole
portrays a frenzied effort by a troubled company to conceal its
difficulties for as long as possible. Mesko's complaint suggests
as scienter for this fraud that defendants wanted to keep the house
of cards standing (perhaps expecting salvation from the SmartSwitch
or other developments). The complaint also offers allegations of
significant stock sales by corporate insiders taking their profits
before the worst of the news was out.
It is not difficult to conclude that such practices, if
they went on, certainly add up to fraudulent and material
misstatement. The question at this stage is not whether the
practices occurred -- defendants deny them and actual proof, not
just allegations in a complaint, would be required before any
conclusion about that question could be reached -- but whether the
pleadings accusing defendants of these practices meet the
requirements of the PSLRA. Our holding that the complaint is
sufficient returns the case to the district court, which ultimately
will resolve the broader issues of culpability.
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We elaborate on several categories of Mesko's allegations
here, without reciting every claim in the 79-page complaint; we
will add some details later when they become relevant to our
analysis.
A. Fictitious Sales
The most egregious examples of fraud alleged in the
complaint accuse Cabletron of booking entirely fictitious sales.
Each of these allegations is supported by reference to the
anonymous former employees.
According to the complaint, the company wrote purchase
orders for nonexistent sales of merchandise late in one quarter,
and then logged the merchandise back in as if it had been returned
after the next quarter began, when in fact the merchandise had
never left the company's possession. These supposedly-sold items
were held in various locations before being returned to inventory.
Some were loaded onto as many as eight tractor-trailers that
remained in the factory yard. Some were stored at selected
employees' homes; the complaint provides the name and address of
one employee who allegedly accepted such goods "at the behest of"
defendant Craig Benson, the chairman of the board and chief
operating officer. Some simply "sat on the shelves or lay in the
corridors" of Cabletron's warehouse until after the quarter ended.
This scheme allegedly extended, at the close of one quarter, to
removing equipment from employees' desks and unfinished product
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from the company's labs, running it through this sold-and-returned
routine, and then, after the quarter had ended, returning the same
equipment -- with identical serial numbers -- to the offices and
labs where they had originated.
Employees had to move this material and to log it back in
when it was "returned." Cabletron used a computer system called
"Intrepid" to track orders and returns, and the fictitious sales
and returns were logged into this system. The broader inference
from all of these alleged activities is that, in order to inflate
revenue, Cabletron used a variety of techniques to create the
appearance of sales where no sales ever occurred.
B. Inventory Parking and Channel-Stuffing
Other merchandise left Cabletron's factories and
warehouses but, the complaint alleges, it was still fraudulent for
the company to count it as sold either because the sales were not
bona fide, or because the customers had an unlimited right of
return and those return rights were not disclosed to investors.
The complaint alleges "inventory parking" arrangements
with certain Cabletron customers, distributors, and resellers.
Under these arrangements, they agreed to receive shipments of
Cabletron products which they had not really ordered and would not
really buy. One of the former employee sources named two locations
in New Hampshire where inventory was parked: a "warehouse near
Brock's Lumber in Rochester" and the grounds of a particular
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company in Somersworth. The complaint also reports rumors about
inventory parking at other locations, including St. Louis and New
York City.7
Cabletron also allegedly engaged in "channel stuffing,"
the practice of inducing distributors or wholesalers to buy
Cabletron products in excess of their projected needs by promising
them that the products could be returned "at any time and for any
reason if they were not sold." This allowed the company to "dump
excess inventories of Cabletron products for which there was no
present demand" and thereby convert the liability of unsold goods
into the revenue of supposed sales. The complaint names five
distributors who apparently participated in the practice. To
support the channel stuffing allegation, the complaint cites former
employees with personal knowledge of Cabletron's sales practices.
C. Defective and Premature Shipments
In other instances, Cabletron allegedly inflated revenue
toward the end of a quarter by making shipments of products sold
while knowing that they would not be accepted or would be returned.
One variation of this theme involved shipping orders in
quarters much earlier than the requested delivery dates. A former
employee said the company sent the University of North Carolina a
7
Mesko identified these less-substantiated rumors to Judge
Lisi among the few allegations made on narrowly-defined information
and belief, and did not attribute them to the former employees with
personal knowledge cited elsewhere in the complaint.
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shipment worth $75 million to $80 million very early on three
different occasions, each one just before the end of a quarter. A
second employee agreed that the company "regularly" made such early
shipments.
Similarly, according to several former employees,
Cabletron "regularly" sold computer equipment late in the quarter
that still had unresolved bugs. Like the early shipments,
Cabletron knew that this merchandise would be returned. One former
employee specified AT&T as a customer that had received such
defective merchandise on several occasions.
D. Artificially Reduced Costs
Cabletron also overstated its net quarterly revenues by
artificially reducing its costs, according to two employees cited
in the complaint. Raw materials were held in trailers or on
loading docks for weeks after they arrived rather than being booked
in and transferred into storage immediately. These supplies were
then moved in and booked as received on the first day of the next
quarter, although they had actually been received during the prior
quarter. This delay removed the expense of these purchases from
the quarter when they would otherwise have appeared, thus inflating
net revenue.
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E. SmartSwitch Problems
Most of the "adverse factors" noted earlier need little
further explanation, but the company's difficulties with its new
SmartSwitch products require some additional context.
Cabletron unveiled the SmartSwitch line on March 3, 1997,
the first day of the class period, with a glowing press release
stating that the products "set a new standard for price and
performance." The complaint's quotes from various market analyst
reports make it clear that investors considered the SmartSwitch an
important aspect of Cabletron's future growth.
Unfortunately for Cabletron, SmartSwitch production
immediately encountered two serious problems. First, supplies of
two essential components for the SmartSwitch, one provided by
Lucent Technologies and the other by LSI Logic, proved unreliable.
Second, those units the company did manufacture were plagued by
glitches involving their wiring. These wiring flaws were so
widespread that the complaint alleges, citing two employees of whom
at least one was personally familiar with the facts, that
"virtually every SmartSwitch manufactured from April to at least
September 1997 was subject to individualized re-wiring by hand."
The complaint alleges that these problems delayed the
availability of the SmartSwitch during much of the class period,
and that these delays damaged the company. Information about the
problems was widely known within the company and was addressed
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extensively at weekly quality control meetings. The problems were
also described in two internal Cabletron databases that were
routinely circulated in hard copy to managers, including to
defendants Levine, Benson, and Oliver. According to a former
employee alleged to have personal knowledge, Benson directed that
these reports should not be provided to salespersons "in order to
insulate them (and the Company's customers) from knowledge of
problems relating to SmartSwitches."
F. Insider Stock Sales
Finally, the complaint points to stock sales by several
of the individual defendants, during and after the class period, as
evidence of scienter. These sales totaled over $180 million during
the class period. Almost all of this amount was attributable to
sales by Levine, who stepped down from his positions as president
and chief executive officer and resigned his seat on the board of
directors on or about August 6, 1997, midway through the class
period. Between March 26, 1997 and the date of his resignation in
August, Levine sold almost three million shares for a total of just
over $89 million. Levine also sold another 2.7 million shares
between September 24 and October 7, 1997, after he had left his
executive positions, earning $88.7 million.
Aside from Levine, the complaint documents smaller stock
sales by four other individual defendants during the class period.
One sale was made by the chief financial officer, David J.
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Kirkpatrick, on September 24, 1997; the proceeds were $474,320.
The remaining sales were made by the three defendants who served as
outside directors on Cabletron's board: Paul R. Duncan, Donald F.
McGuinness, and Michael D. Myerow. The sales by these three
outside directors totaled $2.6 million. Duncan sold almost $1.6
million worth of stock on March 28, 1997. Also on March 28,
McGuinness sold $66,000 worth of stock; he also sold $152,200 worth
of stock on July 9, 1997. All the sales Myerow made during the
class period were after the June disclosures by Cabletron; they
added up to $796,570.
The parties disagree about how to calculate the
percentage of the defendants' stock liquidated during the class
period, but Mesko alleges that Levine, McGuinness, and Myerow each
sold approximately one third of their Cabletron holdings, while
Kirkpatrick and Duncan each sold over 90 percent of theirs. The
complaint does not document any stock sales during the class period
by either Benson or Oliver, the remaining individual defendants.
It does note stock sales by Oliver in the four months prior to the
class period, as well as by Levine, Kirkpatrick, Myerow, and
McGuinness.
III.
Under the PSLRA, a securities fraud complaint must
"specify each statement alleged to have been misleading, the reason
or reasons why the statement is misleading, and, if an allegation
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regarding the statement is made on information and belief, the
complaint shall state with particularity all facts on which that
belief is formed." 15 U.S.C. § 78u-4(b)(1). Furthermore, in order
to state a claim of securities fraud, the statements alleged to be
misleading must be misleading to a material degree. See Serabian
v. Amoskeag Bank Shares, Inc., 24 F.3d 357, 361 (1st Cir. 1994).
Finally, the PSLRA requires the complaint to state with
particularity facts that give rise to a "strong inference" of
scienter rather than merely a reasonable inference. 15 U.S.C.
§ 78u-4(b)(2); Greebel v. FTP Software, Inc., 194 F.3d 185, 196-97
(1st Cir. 1999). This last requirement alters the usual contours
of a Rule 12(b)(6) ruling because, while a court continues to give
all reasonable inferences to plaintiffs, those inferences
supporting scienter must be strong ones. Greebel, 194 F.3d at 201.
The PSLRA did not, however, change significantly this circuit's
previous underlying substantive standards for adequately pleaded
securities fraud, which were already strict. Id. at 193-94.
A. Particularity of Fraud Pleadings
The district court found the complaint lacked the
particularity required by the PSLRA in several ways, especially in
its descriptions of confidential sources and its reliance on
internal company reports. In addition, defendants argue that the
total amount of detail provided in the complaint falls short of
what is necessary to satisfy the particularity requirement.
-22-
1. Use of Confidential Sources
The complaint details numerous statements which were made
to Mesko's counsel by unnamed former Cabletron employees, and which
are said to be based on the personal knowledge of these former
employees. Many of its allegations are supported by reference to
these anonymous statements.
The parties dispute whether such statements are made "on
information and belief" and the district court, as noted above,
defined the concept inconsistently. This inconsistency mirrors the
conflict in the caselaw. Compare ABC Arbitrage Plaintiffs Group v.
Tchuruk, 291 F.3d 336, 351 & n.70 (5th Cir. 2002) (defining
"information and belief" in securities fraud pleading as any
allegation made without plaintiffs' personal knowledge), with In re
Honeywell Int'l Sec. Litig., 182 F. Supp. 2d 414, 426 (D.N.J. 2002)
(stating that some allegations made without plaintiffs' personal
knowledge are not made on "information and belief").
The point is pertinent because of the especially
heightened pleading standards that the PSLRA established for claims
based on information and belief. See 15 U.S.C. § 78u-4(b)(1); ABC
Arbitrage, 291 F.3d at 350 ("[F]or allegations made on information
and belief, the plaintiff must . . . state with particularity all
facts on which that belief is formed, i.e., set forth a factual
basis for such belief."). This circuit imposed a strict
requirement on such claims under Rule 9(b) before enactment of the
-23-
PSLRA. Romani v. Shearson Lehman Hutton, 929 F.2d 875, 878 (1st
Cir. 1991) ("Where allegations of fraud are . . . based only on
information and belief, the complaint must set forth the source of
the information and the reasons for the belief.").
Without deciding the more general issue of whether
confidential source pleadings in other contexts are made "on
information and belief," we hold that in the context of the PSLRA
such confidential source allegations must comply with the standard
described below, drawn from the Second Circuit's Novak decision.8
We further hold that compliance with that standard constitutes
compliance with the "information and belief" particularity
requirements of section 78u-4(b)(1).
This court has never interpreted the heightened pleading
requirement for information and belief, either before the PSLRA or
after it, as a per se rule that anonymous sources must be named at
the pleading stage. The defendants suggest that we adopt such a
per se rule, and cite the Ninth Circuit's decision in Janas v.
8
Under this test, some allegations based on anonymous
sources will not, on their face, be adequate. See ABC Arbitrage,
291 F.3d at 353-54. Many securities fraud complaints rely on
unnamed sources accompanied by only the vaguest detail. For
example, a complaint may include a boilerplate paragraph at its
beginning or end stating that its allegations as a whole are
supported by investigation of counsel, sometimes including
interviews with unnamed sources such as former employees. See
generally 2 H.S. Bloomenthal, Securities Law Handbook § 29.10
(2002 ed.). A general statement that unspecified sources support
the complaint's allegations as a whole usually will not suffice.
-24-
McCracken (In re Silicon Graphics Securities Litigation), 183 F.3d
970, 985 (9th Cir. 1999), as authority for doing so.9
In Novak, the Second Circuit took a more moderate view of
section 78u-4(b)(1), rejecting
any notion that confidential sources must be named as a
general matter. In our view, notwithstanding the use of
the word "all," [section 78u-4(b)(1)] does not require
that plaintiffs plead with particularity every single
fact upon which their beliefs concerning false or
misleading statements are based. Rather, plaintiffs need
only plead with particularity sufficient facts to support
those beliefs.
Novak, 216 F.3d at 313-14; accord ABC Arbitrage, 291 F.3d at 353;
cf. Fla. State Bd. of Admin. v. Green Tree Fin. Corp., 270 F.3d
645, 667-68 (8th Cir. 2001) (citing Novak analysis favorably).
We reject a per se rule such as the Silicon Graphics
test, and think the two approaches described in Novak are useful
guides for evaluating whether confidential source material meets
the PSLRA particularity requirement:
[W]here plaintiffs rely on confidential personal sources
but also on other facts, they need not name their sources
as long as the latter facts provide an adequate basis for
believing that the defendants' statements were false.
Moreover, even if personal sources must be identified,
there is no requirement that they be named, provided they
9
In fact, it is not the Ninth Circuit decision but the
Silicon Graphics district court opinion, 970 F. Supp. at 763-64,
that sets out a strong per se rule. The district court in the
present case cites that opinion rather than the Ninth Circuit's, as
does Novak, 216 F.3d at 313. While not entirely clear, the Ninth
Circuit's opinion can be read as stopping short of endorsing the
district court's per se rule. See Silicon Graphics, 183 F.3d at
985.
-25-
are described in the complaint with sufficient
particularity to support the probability that a person in
the position occupied by the source would possess the
information alleged. In both of these situations, the
plaintiffs will have pleaded enough facts to support
their belief, even though some arguably relevant facts
have been left out.
Novak, 216 F.3d at 314; accord ABC Arbitrage, 291 F.3d at 352-53
(adopting Novak-type test); see also Fitzer v. Sec. Dynamics
Techs., Inc., 119 F. Supp. 2d 12, 21-22 (D. Mass. 2000) (following
Novak test). The approach we take, similar to Novak, is to look at
all of the facts alleged to see if they "provide an adequate basis
for believing that the defendants' statements were false." Novak,
216 F.3d at 314. This involves an evaluation, inter alia, of the
level of detail provided by the confidential sources, the
corroborative nature of the other facts alleged (including from
other sources), the coherence and plausibility of the allegations,
the number of sources, the reliability of the sources, and similar
indicia.
This approach, we think, better strikes the balance
Congress intended in the PSLRA. The statute was designed to erect
barriers to frivolous strike suits, but not to make meritorious
claims impossible to bring. See S. Rep. No. 104-98, at 4 (1995),
reprinted in 1995 U.S.C.C.A.N. 679, 683 (stating that intent of
PSLRA is "combatting . . . abuses, while maintaining the incentive
for bringing meritorious actions"); ABC Arbitrage, 291 F.3d at 354
(noting that PSLRA "was not enacted to raise the pleading burdens
-26-
. . . to such a level that facially valid claims, which are not
brought for nuisance value or as leverage to obtain a favorable or
inflated settlement, must be routinely dismissed"). A blanket ban
on unnamed sources presents obvious policy problems. Employees or
others in possession of important information about corporate
malfeasance may be discouraged from stepping forward if they must
be identified at the earliest stage of a lawsuit. See Novak, 216
F.3d at 314. While we recognize that a case-by-case approach may
provide less concrete guidance to district courts, the tension
inherent in balancing the two congressional goals cannot be evaded
by adopting an unnecessarily broad per se rule which may prevent
pursuit of legitimate cases.
We also support our conclusion with a helpful analogy
from an entirely different field of law: courts' consideration of
government requests for search warrants based on tips from
confidential informants. Courts frequently allow such anonymously-
provided information, if properly supported, to justify an
otherwise problematic search. They examine carefully a variety of
factors before doing so, including the basis offered for the
informant's knowledge, the existence of other information
corroborating the informant's allegations, and the amount of self-
verifying detail provided in the allegations themselves. E.g.,
United States v. Barnard, 299 F.3d 90, 93 (1st Cir. 2002); United
States v. Zayas-Diaz, 95 F.3d 105, 111 (1st Cir. 1996). None of
-27-
these factors is dispositive, and all are weighed in the context of
the "'totality of the circumstances.'" United States v.
Khounsavanh, 113 F.3d 279, 283 (1st Cir. 1997) (citing Illinois v.
Gates, 462 U.S. 213, 238 (1983)). The overlap between these
considerations and those articulated in Novak further reinforces
our view that courts can competently make a careful evaluation of
securities fraud pleadings based on anonymous sources, and separate
frivolous complaints from those with potential merit.
When these standards are applied to the complaint's
allegations supported by anonymous sources, we find that they
satisfy the test. Overall, the accumulated amount of detail the
sources provide tends to be self-verifying; these are not
conclusory allegations of fraud, but specific descriptions of the
precise means through which it occurred, provided by persons said
to have personal knowledge of them. In addition, the number of
different sources helps the complaint meet the standard. Their
consistent accounts reinforce one another and undermine any
argument that the complaint relies unduly on the stories of just
one or two former employees, possibly disgruntled. Furthermore, as
employees who were familiar with the activities discussed -- and
the complaint notes specifically when there are exceptions to this
characterization -- the sources have a strong basis of knowledge
for the claims they make. Finally, the sources also point to the
startlingly large number of returns, which they had the experience
-28-
to judge based on the level of activity in the warehouse and the
number of returns employees entered into Intrepid. This unusual
increase independently suggests suspicious activity of the kind
they allege: a tenfold jump in return rates for products shipped
late in the quarter, with pallets full of as many as forty pieces
of expensive equipment coming back into inventory early in the
following quarter, permits a strong inference that something was at
least significantly different about sales booked late in the
quarter.
The level of specific detail about the fictitious sales
is significant. Far from resting on mere assertions, the anonymous
sources describe tractor-trailers in the factory yard, equipment
"borrowed" from employees' desks to be fraudulently processed, and
the unusual activity in the warehouse as products were shuttled
back and forth. The sources provide the name and address of one
employee who is said to have stashed goods in the garage of his
home, and say that Benson told him to do so. There are multiple
sources for many of the fictitious sales claims.
There are other categories of allegations with similar
detail. The principal source for the inventory parking allegations
names two particular locations where the parking is said to have
occurred. The complaint names five distributors alleged to have
participated in channel stuffing, and the allegations of channel
stuffing rely on two sources with knowledge about sales practices
-29-
in particular. As to the premature or defective shipments, the
complaint cites four different employees, three with direct
knowledge. Between them, they describe the widespread nature of
the problem and also name specific customers (the University of
North Carolina, AT&T) who were affected. Two employees supply the
information that the raw materials were not entered as received
when they should have been, and note that they were entered on the
first day of the following quarter, underscoring the likelihood
that the purpose of the delay was inflation of quarterly net
revenue.
In sum, the complaint provides enough particular details
to meet the standards of the test we have adopted and justify the
omission of sources' names at the pleading stage. These details
amply supply "facts on which that belief is formed" as the PSLRA
(and our precedent) require.
2. Internal Company Reporting Systems
The district court determined that the complaint provided
too little detail about internal company documents to which it
referred. Presumably, the court had in mind the complaint's
references to the Intrepid order-processing system that would
provide evidence about returns, the quality-control databases that
informed individual defendants about SmartSwitch problems, or both.
It is true that merely stating the existence of efficient
internal reporting systems in a conclusory fashion will not do much
-30-
to increase the particularity of a securities fraud pleading. See
Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1224 n.38 (1st Cir.
1996). Here, the complaint does more than that.
The pleadings about the Intrepid system show that former
employees had to physically input returns; this is probative of the
basis that anonymous sources had for recognizing the spike in
returns early in the quarter. The quality-control databases serve
a more important function, as discussed further below, because they
help demonstrate knowledge of SmartSwitch problems on the part of
Levine, Benson, and Oliver. The complaint also provides more
substance about the contents of these systems. Unlike in Shaw,
where we found that a plaintiff failed to provide any "indication
of the specific factual content of any single report generated by
the alleged reporting system," id. (emphasis removed), the
complaint here says that the two quality control databases (the
"Product Support Call Tracking Database" and the "Phone Support
Database") reported customer service problems related to the
defective SmartSwitches. Thus, these databases serve as supporting
evidence of Mesko's allegations.
3. Level of Particularity as a Whole
Defendants argue that, even if the allegations supported
by anonymous sources and internal documents are accepted, the
complaint still leaves too many other unanswered questions -- such
as the precise dates of transactions, the names used for phony
-31-
customers, the identities of corporate personnel involved, the
specific products warehoused, or the exact dollar amounts of
individual fraudulently recorded sales. As a result, defendants
argue, the complaint does not satisfy the PSLRA's particularity
requirements as interpreted in this circuit, particularly in
Greebel. Their argument misapplies Greebel and our other caselaw.
The defendants list factors found lacking in the
complaint in Greebel, 194 F.3d at 203-04, as if they constituted a
checklist for securities fraud complaints. We explicitly disavowed
this interpretation in Greebel itself. 194 F.3d at 204 ("We do not
say that each of these particulars must appear in a complaint, but
their complete absence in this case is indicative of the excessive
generality of these allegations."). We have since repeated this
clarification. See Aldridge, 284 F.3d at 80-81.
In response to the PSLRA, this circuit has adopted a
fact-specific individual case analysis in preference to a list of
factors required to be pled. See Greebel, 194 F.3d at 196, 204.
Here, the complaint does include some of the factors missing in
Greebel; the absence of others is not decisive. Each securities
fraud complaint must be analyzed on its own facts; there is no one-
size-fits-all template. Sufficient evidence of one type might
reduce or eliminate the need for evidence in other categories,
without thwarting the legislative intent behind the PSLRA. As the
Sixth Circuit put it, "In enacting the PSLRA, Congress was
-32-
concerned with the quantum, not type, of proof." Helwig v. Vencor,
Inc., 251 F.3d 540, 551 (6th Cir. 2001) (en banc) (adopting "fact-
specific approach" from Greebel). Because a categorical approach
is not appropriate, courts will allow private securities fraud
complaints to advance past the pleadings stage when some questions
remained unanswered, provided the complaint as a whole is
sufficiently particular to pass muster under the PSLRA. See, e.g.,
Aldridge, 284 F.3d at 79-82 (failure of complaint to document
precise amounts of overstatements of revenue not fatal); Hollin v.
Scholastic Corp. (In re Scholastic Corp. Sec. Litig.), 252 F.3d 63,
72-74 (2d Cir. 2001) (allegations of longer-term trends adequate to
plead inferences about activity during particular month); Rothman
v. Gregor, 220 F.3d 81, 91 (2d Cir. 2000) (complaint need not "fix
the exact date and time that [defendants] became aware" of
information that rendered their accounting practices misleading,
because it adequately alleged awareness within necessary time
frame); In Re No. Nine Visual Tech. Corp. Sec. Litig., 51 F. Supp.
2d 1, 26-27 (D. Mass. 1999) (complaint survives PSLRA scrutiny
despite failure of complaint to document precise amount of
overstatement of inventory or to tie knowledge of inventory
problems to specific defendants). In contrast, in many cases where
we have upheld dismissal of securities fraud pleadings, we have
described the allegations they made as very general or even
conclusory. See, e.g., Maldonado v. Dominguez, 137 F.3d 1, 10 (1st
-33-
Cir. 1998) ("When we examine these pleadings carefully, we find
that there are no specific allegations [of scienter]."); Suna v.
Bailey Corp., 107 F.3d 64, 71 (1st Cir. 1997) ("Appellants offer no
factual support for their conclusory allegations . . . ."); Gross
v. Summa Four, Inc., 93 F.3d 987, 996 (1st Cir. 1996) ("In this
case, Gross has failed to allege any particulars to support his
general allegation of inflated earnings through the use of improper
accounting methods.").
Another difference between Greebel and the result in this
case is the amount of discovery that had been completed on
particular fraud allegations when the complaint was evaluated. The
district court in Greebel had already permitted limited discovery
before granting a motion to dismiss. See Greebel, 194 F.3d at 188.
The complaint had originally relied on a source to support an
allegation that the defendant company fraudulently altered its
books. The district court did not dismiss the complaint at that
juncture. It did so only after limited discovery revealed that
plaintiffs could not offer this source as a witness capable of
testifying about the allegation at trial, and after they failed to
produce adequate additional evidence. In Greebel, we said that
both the original denial of a motion to dismiss (before discovery)
and the subsequent dismissal (after some limited discovery) were
correct. Id. at 207. Similarly, in Gross, the district court had
granted the plaintiff limited discovery and even an opportunity to
-34-
amend his complaint afterward. 93 F.3d at 990. The company then
moved to dismiss, the district court granted the motion, and this
court affirmed, noting key details that were still lacking in the
complaint even after the focused discovery.
To be sure, the particularity requirements apply before
any discovery has been conducted -- indeed, the PSLRA itself stays
all discovery, with certain narrow exceptions, during the pendency
of any motion to dismiss. 15 U.S.C. § 78u-4(b)(3)(B). But the
difference in discovery is relevant to a court's evaluation of
sufficient particularity. In short, under our circuit law, the
procedural posture of the case matters, and we will scrutinize a
post-discovery motion to dismiss even more stringently than a pre-
discovery motion. See Cooperman v. Individual Inc., 171 F.3d 43,
48-49 & n.8 (1st Cir. 1999); see also Aldridge, 284 F.3d at 81
(distinguishing Greebel on basis of difference in amount of
discovery); Maldonado, 137 F.3d at 9 (noting limit on expectations
of securities fraud pleadings when discovery is incomplete);
Glassman v. Computervision Corp., 90 F.3d 617, 630 (1st Cir. 1996)
(collecting cases in various areas of law where courts considered
amount of discovery completed when evaluating motion to dismiss).
As to this complaint, this court has said repeatedly that
the rigorous standards for pleading securities fraud do not require
a plaintiff to plead evidence. See Cooperman, 171 F.3d at 48-49;
Shaw, 82 F.3d at 1225. Defendants' argument that even more detail
-35-
be required, before there is any discovery, here amounts to
requiring plaintiffs to plead evidence. The fraud allegations
advanced in this complaint, with their consistent details provided
from at least half a dozen different sources across various alleged
schemes, reinforce each other and suggest reliability of the
information reported. The complaint satisfies the PSLRA's
particularity requirements.
B. Identification of Materially Misleading Statements
Having jumped the first hurdle by pleading fraud with
particularity, Mesko must identify the specific statements rendered
materially misleading by the fraud he has pleaded. A fact is
material if it is substantially likely "that the disclosure of the
omitted fact would have been viewed by the reasonable investor as
having significantly altered the 'total mix' of information made
available." Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988)
(quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449
(1976)). Information which "would have assumed actual significance
in the deliberations of a reasonable shareholder" is material. TSC
Indus., 426 U.S. at 449. In general, the materiality of a
statement or omission is a question of fact that should normally be
left to a jury rather than resolved by the court on a motion to
dismiss. See Lucia v. Prospect St. High Income Portfolio, Inc., 36
F.3d 170, 176 (1st Cir. 1994). Thus, we review the complaint only
-36-
to determine that it pleads the existence of such statements and
presents a plausible jury question of materiality.
The complaint describes three categories of statements
that it alleges were materially misleading: (1) Cabletron's
financial report filings with the SEC; (2) direct statements made
by Cabletron officials, either in press releases or in direct
quotes in the media; and (3) statements made by stock analysts and
journalists, allegedly echoing statements made to them by
defendants. According to the district court, the complaint listed
three statements in the first category, eight statements in the
second, and twenty-five statements in the third.
1. SEC Filings
Cabletron made its required filings with the SEC during
the class period: its Form 10-K for the fiscal year that ended on
February 28, 1997, its Form 10-Q for the March-May 1997 quarter,
and its Form 10-Q for the June-August 1997 quarter. The Form 10-K
was signed by all of the individual defendants except for Oliver,
while each Form 10-Q was signed by Benson and Kirkpatrick.
Mesko asserts that, because of the fraudulent revenue
recognition practices discussed in Part II.A of this opinion, these
SEC filings did not reflect Cabletron's true earnings, rendering
them materially misleading.10 More specifically, Mesko alleges that
10
Mesko also alleges that disclosure of adverse factors was
required in some of the SEC filings, and that failure to so
disclose independently rendered them materially misleading. We
-37-
the practices violated the Generally Accepted Accounting Principles
(GAAP), which "embody the prevailing principles, conventions, and
procedures defined by the accounting industry from time to time."
Young v. Lepone, 305 F.3d 1, 5 n.1 (1st Cir. 2002); see generally
Migliaccio v. K-Tel Int'l, Inc. (In re K-Tel Int'l, Inc. Sec.
Litig.), 300 F.3d 881, 889-90 (8th Cir. 2002) (elaborating on
multiple and potentially conflicting sources of GAAP). Under SEC
regulations, Mesko notes, filings that do not comply with GAAP
"will be presumed to be misleading and inaccurate." 17 C.F.R. §
210.4-01(a)(1). As a result, Mesko says, Cabletron's SEC filings
during the class period were unlawfully false and misleading.
Merely stating in conclusory fashion that a company's
books are out of compliance with GAAP would not in itself
demonstrate liability under section 10(b) or Rule 10b-5. See
Serabian, 24 F.3d at 362. Indeed, some techniques that result in
early booking of sales, such as channel stuffing, might prove to be
entirely legitimate, depending on the specific facts. See Greebel,
194 F.3d at 202.
In this case, however, Mesko alleges that Cabletron's
revenue was fraudulently inflated by tens of millions of dollars
per quarter. Given that Cabletron's quarterly revenue ranged from
$371 million to $381 million during the class period, reasonable
handle this claim as we do other direct statements alleged to be
misleading because of failure to disclose the adverse factors; we
consider those statements in the next subsection.
-38-
investors unquestionably might consider a difference of such
magnitude material. Accurate earnings figures are vital aspects of
the "total mix of information" which investors would consult when
evaluating Cabletron's stock. Furthermore, the nature of much of
the alleged inaccuracy in earnings derives from systematic fraud,
described in detail, that extends to completely fictitious sales.
This distinguishes it from cases where the alleged GAAP violation
consisted merely of questionable bookkeeping practices. Cf., e.g.,
Gross, 93 F.3d at 995-96 (recognition of revenue at time of order
rather than at time of shipment, allegedly in violation of GAAP,
held insufficient where plaintiff "failed to allege any particulars
to support his general allegation"); Serabian, 24 F.3d at 362
(allocation of losses to wrong fiscal quarters, absent other
pleadings of fraud, fails to state claim even if in violation of
GAAP). Mesko has adequately pled that the fraudulent revenue
recognition rendered Cabletron's SEC filings materially misleading.
2. Other Direct Public Statements
In addition to SEC filings, Cabletron and its executives
made other direct statements to the public during the class period
that the complaint alleges were materially misleading. This court
has previously attributed direct quotes of company officials in the
news media to the company, see Aldridge, 284 F.3d at 79-80, and
does so again here. The direct statements catalogued in the
complaint include: press releases announcing earnings, public
-39-
statements about the availability of the SmartSwitch, and general
optimistic statements about Cabletron's health.
First, Cabletron issued press releases during the class
period to announce earnings figures for each quarter. The
complaint alleges that these press releases were misleading for the
same reason as the SEC filings: they announced figures that
reflected fraudulently inflated revenue, and thereby misstated
Cabletron's true earnings for each of these quarters. The same
analysis we applied to the SEC filings demonstrates the materiality
of these alleged misstatements.
Second, the complaint alleges that public statements
about the SmartSwitch were materially misleading because they gave
the impression that production and distribution of this important
new product were "ramping up" smoothly when this was not so.
However, it specifically identifies only a small number of such
statements attributable to Cabletron directly (as opposed to third-
party statements, which we discuss below).11 These are: a press
release issued when Cabletron unveiled the SmartSwitch on March 3,
1997, the first day of the class period; direct quotes in a trade
publication article on March 17, 1997 suggesting that the product
11
The complaint also includes a catch-all assertion about
other unspecified "press releases and other disseminations and
communications about these new SmartSwitch products." Section
10(b) and Rule 10b-5 require that the specific statements alleged
to be materially misleading must be identified, and we accordingly
disregard this catch-all assertion.
-40-
was then available; and a media interview with Benson on July 14,
1997 in which he predicted that SmartSwitch problems would be
resolved by September.
Mesko has not shown why any of these three statements
were materially misleading when they were made. The complaint
fails to demonstrate that the problems which later plagued the
SmartSwitch were known to the individual defendants by mid-March,
when the first two statements were made.12 The supply delays might
or might not have been visible to defendants by then, but in any
event it may also have been reasonable to believe they would soon
be resolved. Even Mesko's own sources state that the manual
rewiring to resolve mechanical flaws began in April, not March.
The third statement, made by Benson in July, was simply an
optimistic forward-looking prediction about the timeline for
resolving SmartSwitch problems, and Mesko does not even allege that
this timeline was not met.
If, however, Cabletron's direct statements created the
impression that the SmartSwitch was already commercially available
on a large scale, the company may then have had a duty to revise
12
The complaint does allege that certain other company
personnel knew of the SmartSwitch problems in March, including
public relations and quality assurance personnel. If Mesko can
demonstrate at a later time that the individual defendants are
therefore liable as control persons, or that this information made
its way to the individual defendants so that they have primary
liability, then this information could provide further basis for a
jury to find that defendants' statements were materially
misleading.
-41-
that impression if later developments substantially undermined the
accuracy of the earlier statements. See Gross, 93 F.3d at 992
(citing Roeder v. Alpha Indus., Inc., 814 F.2d 22, 26-27 (1st Cir.
1987)). While a company need not reveal every piece of information
that affects anything said before, it must disclose facts, "if any,
that are needed so that what was revealed [before] would not be 'so
incomplete as to mislead.'" Backman v. Polaroid Corp., 910 F.2d
10, 16 (1st Cir. 1990) (en banc) (quoting SEC v. Tex. Gulf Sulphur
Co., 401 F.2d 833, 862 (2d Cir. 1968)). Seen in this light, the
complaint establishes a reasonable inference of a material omission
which, if borne out by evidence, would present a question of fact
for a jury. On remand, these allegations should be allowed to
proceed on that more limited basis, that is, not as statements
misleading when made, but as statements potentially requiring
revision in light of subsequent developments. See generally G.S.
Porter, What Did You Know and When Did You Know It?: Public Company
Disclosure and the Mythical Duties to Correct and Update, 68
Fordham L. Rev. 2199, 2228-30 (2000) (expressing general skepticism
about duty to correct but envisioning scenario similar to this one
in which it might rightfully apply).
Finally, the complaint alleges that other direct
statements by Cabletron were unduly optimistic in light of the
mounting difficulties facing the company. Mesko argues that
adverse factors other than the SmartSwitch delays should have been
-42-
disclosed earlier or more fully. For example, the complaint calls
the June 2, 1997 press release that made partial disclosures of
Cabletron's problems materially misleading, because it failed to
disclose the full extent of those problems.
The defendants accurately argue that Cabletron was under
no obligation to disclose information on industry-wide trends that
was available to the public. Some of the complaint's adverse
factors, such as the split with Cisco Systems and the increased
market saturation, fall into this category. More fundamentally,
the complaint lacks the level of detail in these allegations that
it provides elsewhere, and fails to plead with sufficient
particularity that the adverse factors were known to Cabletron but
were contemporaneously concealed from the public. Rather, the
adverse factors are gleaned from the company's disclosures, which
are then alleged to be too little, too late. "[P]laintiffs may not
simply seize upon disclosures made later and allege that they
should have been made earlier." Berliner v. Lotus Dev. Corp., 783
F. Supp. 708, 710 (D. Mass. 1992). Standing alone, such circular
assertions represent little more than the type of "fraud by
hindsight" pleading that we have long rejected. See, e.g., Gross,
93 F.3d at 991; Greenstone v. Cambex Corp., 975 F.2d 22, 25 (1st
Cir. 1992).
As noted previously, however, the complaint also relies
on these adverse factors to supply a reason for the revenue-padding
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at the heart of plaintiffs' case, and as context for understanding
it, rather than as independent grounds for pleading fraud. As the
rationale for the other fraudulent actions, these adverse factors
help support scienter, and should be considered as such on remand.
Cf. No. Nine, 51 F. Supp. 2d at 26 (using allegations advanced in
complaint primarily to show scienter as means to support
particularity holding).
3. Third-Party Statements
The complaint catalogues many statements about Cabletron
in reports published by market analysts. It also cites a few
business news stories about Cabletron. Mesko alleges that the
third parties who made these statements -- market analysts or
journalists -- based them on statements that had been made to them
by defendants or by other agents of Cabletron, so that the latter
are responsible for their materially misleading content.
Defendants respond that they have no liability for statements made
by third parties.
The district court appears to have utilized a two-prong
test to analyze these statements, requiring that defendants either
"controlled" the third party's statements or that they "adopted"
the statements after they were made. The court then found that the
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complaint had not satisfied either of these conditions.13 We reject
the district court's rule.
A majority of courts has analyzed third-party statements
by applying the "entanglement" test developed by the Second
Circuit. Elkind, 635 F.2d at 163. See generally 2 H.S.
Bloomenthal, Securities Law Handbook § 27.10(4) (2002 ed.)
(collecting cases). District courts in this circuit have also
employed this test, while recognizing that we have not yet embraced
it. See, e.g., Carney v. Cambridge Tech. Partners, Inc., 135 F.
Supp. 2d 235, 248 & n.7 (D. Mass. 2001); No. Nine, 51 F. Supp. 2d
at 30-31; Schaffer v. Timberland Co., 924 F. Supp. 1298, 1310
(D.N.H. 1996).
We now hold that the entanglement test is the correct
approach.14 This test requires the plaintiff to demonstrate the
defendants' involvement with third-party statements:
[L]iability may attach to an analyst's statements where
the defendants have expressly or impliedly adopted the
statements, placed their imprimatur on the statements, or
13
The district court also suggested that some of the
statements on which the analysts and journalists based their
reporting were unactionably vague "puffing," but failed to specify
which of the statements fell into this category or why.
14
In the past, we had expressly reserved the question of
whether statements in a third-party source such as an analyst's
report may be attributable to a securities fraud defendant when it
is not explicit that they are the defendant's direct statements.
Suna, 107 F.3d at 73. At least one recent case came close to doing
so but did not need to reach the overarching question. See
Aldridge, 284 F.3d at 79-80.
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have otherwise entangled themselves with the analysts to
a significant degree. . . . [T]he court will determine
whether the complaint contains allegations which,
favorably construed and viewed in the context of the
entire pleading, could establish a significant and
specific, not merely a casual or speculative,
entanglement between the defendants and the analysts with
respect to the statements at issue.
Schaffer, 924 F. Supp. at 1310. Entanglement also includes
situations where company officials "intentionally foster a mistaken
belief concerning a material fact." Elkind, 635 F.2d at 163-64.
As this articulation of the test makes clear, the district court
erred when it required that defendants "controlled" third-party
statements. Nonetheless, an entanglement claim will be rejected if
it merely suggests or assumes that company insiders provided the
information on which analysts or other outsiders based their
reports. See Suna, 107 F.3d at 73-74; No. Nine, 51 F. Supp. 2d at
31.
Some of the third-party statements cited in the complaint
do satisfy the entanglement test. To give examples of two such
statements, without reaching the further question of whether they
were misleading, the complaint alleges that an analyst report
issued on March 25, 1997 stated, on the basis of information from
Levine and other Cabletron executives, that the SmartSwitch 6000
would "ship in volume in the second week of April." Further, a May
13 analyst report, based on a presentation by a named Cabletron
official responsible for investor relations, stated that the
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SmartSwitch products were "ramping according to plan," which by
mid-May seems clearly not to have been so.
The entanglement test separates mere salesmanship from
fraudulent misrepresentation.15 A test that required "control"
would give company officials too much leeway to commit fraud on the
market by using analysts as their mouthpieces. Elkind and its
progeny set a better boundary. On remand, the district court
should evaluate each of the third-party statements under the
correct test.
C. Scienter
Liability under section 10(b) and Rule 10b-5 also
requires scienter, "a mental state embracing intent to deceive,
manipulate, or defraud." Ernst & Ernst v. Hochfelder, 425 U.S.
185, 193 n.12 (1976). Under the PSLRA, the complaint must state
with particularity facts that give rise to a "strong inference" of
scienter, rather than merely a reasonable inference. 15 U.S.C. §
78u-4(b)(2); Greebel, 194 F.3d at 195-96.
The inference of scienter must be reasonable and strong,
but need not be irrefutable. Aldridge, 284 F.3d at 82. Scienter
may be demonstrated by indirect evidence, Greebel, 194 F.3d at 196-
15
We note, in addition, that new SEC regulations concerning
disclosure of communications between companies and analysts may
help to resolve some of these issues in the future. See Regulation
FD, 17 C.F.R. § § 243.100-243.103 (requiring disclosure to public
of information provided to analysts simultaneously or soon
thereafter). See generally Bloomenthal, supra, § 33.10 (discussing
Regulation FD).
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97, and may extend to a form of extreme recklessness that "is
closer to a lesser form of intent," id. at 198-99. Furthermore,
this circuit has rejected any rigid formula for pleading scienter,
preferring to rely on a "fact-specific approach" that proceeds case
by case. Aldridge, 284 F.3d at 82; see Greebel, 194 F.3d at 196.
We have specifically rejected the contention that "facts
showing motive and opportunity can never be enough to permit the
drawing of a strong inference of scienter." Greebel, 194 F.3d at
197. "[T]he plaintiff may combine various facts and circumstances
indicating fraudulent intent" -- including those demonstrating
motive and opportunity -- to satisfy the scienter requirement.
Aldridge, 284 F.3d at 82. However, "catch-all allegations" which
merely assert motive and opportunity, without something more, fail
to satisfy the PSLRA. Greebel, 194 F.3d at 197 (quoting In re
Advanta Corp. Sec. Litig., 180 F.3d 525, 535 (3rd Cir. 1999)); see
also Green Tree, 270 F.3d at 660.
Applying these standards, we conclude that the complaint
adequately demonstrates scienter.
We look first to the evidence of conscious wrongdoing,
which may provide the "something more" necessary to prove scienter.
See Greebel, 194 F.3d at 201; A. Morales Olazabal, The Search for
"Middle Ground": Towards A Harmonized Interpretation of The Private
Securities Litigation Reform Act's New Pleading Standard, 6 Stan.
J.L. Bus. & Fin. 153, 187-88 (2001) ("[T]he obvious should not go
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unstated, and that is that allegations of intentionally fraudulent
conduct also will permit the drawing of a strong inference of
scienter."). Accusations of warehousing of the sort plaintiffs
make here are "very serious." Greebel, 194 F.3d at 202.
Significant GAAP violations also "could provide evidence of
scienter." Id. at 203. "[A]ccounting shenanigans" are among the
characteristic types of circumstances which may demonstrate
scienter for securities fraud. See Geffon v. Micrion Corp., 249
F.3d 29, 36 (1st Cir. 2001).
Mesko's complaint makes adequate particularized
allegations of large-scale fraudulent practices over time. In such
circumstances, these and similar cases make it difficult to escape
a strong inference of the type of recklessness concerning
wrongdoing that amounts to scienter.
Other allegations also add to a strong inference of
scienter. The complaint alleges that Benson specifically directed
some of the fraudulent warehousing activities at the heart of the
complaint. Again, he may have done no such thing, but we must take
the allegations in the complaint as true. It also alleges that
many people within the company -- including Levine, Benson, and
Oliver -- received regular information about the SmartSwitch
problems which they should have realized contradicted the company's
public statements about the rollout of the product.
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In addition, the complaint identifies concealment of the
serious and worsening deterioration of Cabletron's financial health
as a significant motive for the alleged fraud. Cf. Aldridge, 284
F.3d at 83 (scienter supported by corporate officers' understanding
that rollout of new product was "important to their own survival
and that of the company"); Nathenson v. Zonagen, Inc., 267 F.3d
400, 425 (5th Cir. 2001) (scienter for misstatements about patent
supported by fact that company's future depended on patent).
Indeed, it appears that Levine, a cofounder of the company, was
forced out of management as the magnitude of Cabletron's problems
began to come to light, thus confirming that these motivating fears
were realistic. This is more than the usual concern by executives
to improve financial results; the executives' careers and the very
survival of the company were on the line.
And if these interrelated facts and circumstances still
were not enough to give rise to a strong inference of scienter, the
complaint adds its allegations of insider trading. Stock sales by
insiders can supply evidence of scienter. "The vitality of the
inference to be drawn depends on the facts, and can range from
marginal to strong." Greebel, 194 F.3d at 197-98 (citations
omitted). Here, the insider trading allegations add some weight to
the other evidence of scienter, and we need not determine whether
alone they would suffice. Levine made the overwhelming majority of
the sales, and his resignation provides a plausible innocent
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explanation for large stock sales. Id. at 206 ("It is not unusual
for individuals leaving a company . . . to sell shares."). Still,
the approximately $177 million he gained from stock sales can be a
powerful incentive. It is also true, as defendants point out, that
many of the sales, by both Levine and others, occurred after
Cabletron's disclosures in early June 1997, even though the share
price was significantly higher before this time. The insider
trading allegations nonetheless provide additional ballast to
Mesko's argument for scienter. They suggest further motive for
securities fraud, and they combine with other aspects of the
complaint to produce a strong inference of scienter overall. See
Shaw, 82 F.3d at 1224 (although allegations of smaller-scale
insider trading did not show scienter on their own, they "provide
some support").
Taking the allegations of the complaint as a whole -- and
as true -- we find that it is not only a reasonable inference but
a strong one that defendants possessed a state of mind giving rise
to a securities fraud claim, if fraud was committed. Each
individual fact about scienter may provide only a brushstroke, but
the resulting portrait satisfies the requirement for a strong
inference of scienter under the PSLRA.
D. Pleading of Individual Defendants' Liability
Finally, we analyze here how the section 10(b) claim in
the complaint survives, with one exception, against each individual
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defendant. Again, we do not state that the allegations are true,
nor do we imply anything about those allegations we do not name in
this summary; we merely show why the complaint is sufficient as to
each defendant to survive a motion to dismiss.
The complaint asserts that, under the so-called group
pleading presumption, the court need not consider the liability of
each individual defendant, but may attribute all the statements to
all the defendants as "collective actions." This circuit has
recognized a very limited version of the group pleading doctrine
for securities fraud. See Serabian, 24 F.3d at 367-68 (dismissal
inappropriate where defendants signed annual report and allegedly
had access to contrary information). There is presently great
debate about the doctrine's continued existence after enactment of
the PSLRA. See generally In re Raytheon Sec. Litig., 157 F. Supp.
2d 131, 152-53 (D. Mass. 2001) (collecting cases and concluding
that presumption survives); W.O. Fisher, Don't Call Me a Securities
Law Groupie: The Rise and Possible Demise of the "Group Pleading"
Protocol in 10b-5 Cases, 56 Bus. Law. 991 (2001) (reviewing cases
and arguing that PSLRA undermines doctrine). For purposes of this
opinion, we will set the issue aside without deciding it, because
we determine without reference to the group pleading presumption
whether the complaint states a claim against each defendant.
Cabletron itself is the clearest. Most of the
potentially actionable statements in the complaint, including the
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SEC filings and the press releases, were company documents. The
scienter alleged against the company's agents is enough to plead
scienter for the company. Mesko has thereby stated a claim against
Cabletron that survives the PSLRA's pleading requirements.
Levine and Kirkpatrick, officers of the company, are
both alleged to have had access to information contrary to the
company's public statements, to have participated in a number of
the statements (including signing both the Form 10-K and the two
Forms 10-Q) and to have made significant stock sales. Benson, also
an officer, did not sell stock or sign the 10-Q, but was alleged to
have directed some of the fraudulent practices surrounding
fictitious sales and also to have ordered negative information
about the SmartSwitch withheld from sales personnel. The complaint
against each of them also survives.
The case against the three outside directors -- Duncan,
McGuinness, and Myerow -- presents a closer call, but on balance we
believe the complaint also suffices in its claims against them.
Each signed the Form 10-K and accepted responsibility for its
contents. See Howard v. Everex Sys., Inc., 228 F.3d 1057, 1061-62
(9th Cir. 2000) (holding outside directors responsible for SEC
filings they signed). Each is alleged to have made stock sales
that contribute to a strong inference of scienter against them.
Given the pre-discovery posture of this case, the overall
complaint's survival under the PSLRA, and the possibility that
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these three defendants also face control person liability under
section 20(a), as explained below, we reverse the dismissal of the
case against them.
Finally, unlike the outside director defendants, Oliver
did not sign the Form 10-K or trade Cabletron stock during the
class period. Oliver did receive reports from the quality control
databases. Unlike the other officers, however, the complaint fails
to connect him specifically to any of the materially misleading
statements that we have found survive the PSLRA pleading
requirements.16 Consequently, we affirm the dismissal of the
section 10(b) claim against Oliver.
The parties did not brief the question of how the section
20(a) claims of control person liability17 against each of the
individual defendants should be resolved if this court reversed
dismissal of the section 10(b) claims, as we have done; in such
circumstances we think the best course is to remand those section
16
Under the group pleading presumption, if we had applied
it, the result would likely be the same, because the complaint did
not allege Oliver's participation in the production of any group-
published documents such as SEC filings.
17
That provision, 15 U.S.C. § 78t(a), states:
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 . . . .
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20(a) claims as well. See Scholastic, 252 F.3d at 77-78 (remanding
section 20(a) claims when reversing dismissal of primary liability
claims, because district court had based section 20(a) dismissal on
primary liability dismissal); Nathenson, 267 F.3d at 426 n.29
(same).
Control is a question of fact that "will not ordinarily
be resolved summarily at the pleading stage." 2 T.L. Hazen,
Treatise on the Law of Securities Regulation § 12.24(1) (4th ed.
2002). The issue raises a number of complexities that should not
be resolved on such an underdeveloped record. Since the section
20(a) claims involve most of the same defendants who remain in the
case by virtue of our section 10(b) ruling, the practical effect of
reinstating them at this stage is small. There is a reasonable
inference in the complaint that Oliver may have controlled persons
responsible for promulgating misleading information about the
SmartSwitch, so we remand the section 20(a) claim against him as
well. On remand, those individual defendants who wish to challenge
their liability under section 20(a) may, of course, do so
explicitly. Likewise, Mesko may augment his argument for control
person liability against the defendants, and particularly against
the outside directors and Oliver.
IV.
Mesko objects to the recusals by Judge DiClerico and
Chief Judge Torres and asks that this case be remanded to Judge
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DiClerico because his recusal was inappropriate. Mesko failed to
raise concerns about these recusals at the time they occurred.
This court will decide issues that were not argued before the
district court only rarely, and we decline to set aside the recusal
decisions here.
"If any principle is settled in this circuit, it is that,
absent the most extraordinary circumstances, legal theories not
raised squarely in the lower court cannot be broached for the first
time on appeal." Teamsters Union, Local No. 59 v. Superline
Transp. Co., 953 F.2d 17, 21 (1st Cir 1992). The circumstances
here were hardly extraordinary. As first one judge and then the
other considered recusal, Mesko "made not a murmur." Toscano v.
Chandris, S.A., 934 F.2d 383, 384 (1st Cir. 1991).
Even under normal circumstances, with an objection
preserved, a district court judge's decision to disqualify himself
or herself is reviewed under the same abuse of discretion standard
used to evaluate refusals to recuse. United States v. Snyder, 235
F.3d 42, 46 (1st Cir. 2000) ("The appellate court, therefore, must
ask itself not whether it would have decided as did the trial
court, but whether that decision cannot be defended as a rational
conclusion supported by [a] reasonable reading of the record.")
(quoting In re United States, 158 F.3d 26, 30 (1st Cir. 1998)).
The standard is deferential in part because these sensitive
decisions often require a complex balancing of multiple factors.
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Judge DiClerico and Chief Judge Torres both gave thorough
consideration to their recusal decisions. Chief Judge Torres
specifically weighed the advice of the Committee on Codes of
Conduct of the Judicial Conference of the United States, which has
issued a helpful advisory opinion about recusal decisions in a
class action context. See Comm. on Codes of Conduct, Adv. Op. No.
99 (July 12, 2000), at http://www.uscourts.gov/guide/vol2/99.html.
We will not overturn the decisions these judges made, especially
given Mesko's failure to argue the point to them directly.
V.
This decision does not suggest that Mesko's allegations
against Cabletron or the individual defendants are true, or that
plaintiffs would prevail at trial. By reinstating the case and
returning it to the district court, we hold only that the complaint
presents a sufficient pleading of fraud to avoid dismissal at this
stage. "Where there is smoke, there is not always fire."
Aldridge, 284 F.3d at 85; see Serabian, 24 F.3d at 365-66 ("Despite
our conclusion that certain allegations survive threshold
consideration, we note that plaintiffs remain a great distance from
actually proving securities fraud.").
On remand, the district court may, in its discretion,
limit or structure discovery so that potentially dispositive issues
are addressed first. See Aldridge, 284 F.3d at 85. This technique
has been used in other securities fraud cases where, despite a
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complaint's survival of the initial motion to dismiss, plaintiffs
were ultimately unable to provide allegations strong enough to go
to trial. See Greebel, 194 F.3d at 207; Gross, 93 F.3d at 990.
The district court order granting the motion to dismiss
is reversed, except that dismissal of the section 10(b) claim
against Oliver is affirmed, and the case is remanded for further
proceedings consistent with this opinion. Plaintiffs' request that
the case be remanded to a previously recused judge is denied.
So ordered.
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Mesko v. Cabletron System, Inc.
Court: Court of Appeals for the First Circuit
Date filed: 2002-11-12
Citations: 311 F.3d 11
Copy CitationsCombined Opinion