[PUBLISH]
IN THE UNITED STATES COURT OF APPEALS
FOR THE ELEVENTH CIRCUIT FILED
________________________ U.S. COURT OF APPEALS
ELEVENTH CIRCUIT
OCTOBER 12, 2006
No. 05-14765
THOMAS K. KAHN
________________________
CLERK
D. C. Docket No. 04-00970-CV-WSD-1
ROBERT GARFIELD, individually
and on behalf of all others similarly situated,
THE DEKALB COUNTY PENSION PLAN,
Plaintiffs-Appellants,
versus
NDC HEALTH CORPORATION,
WALTER M. HOFF,
RANDOLPH L.M. HUTTO,
CHARLES W. MILLER,
DAVID H. SHENK,
JAMES W. FITZGIBBONS,
LEE ADREAN,
ERNST & YOUNG, LLP,
Defendants-Appellees.
________________________
Appeal from the United States District Court
for the Northern District of Georgia
_________________________
(October 12, 2006)
Before EDMONDSON, Chief Judge, BIRCH and ALARCÓN,* Circuit Judges.
ALARCÓN, Circuit Judge:
Lead Plaintiff DeKalb County Pension Fund (“DeKalb”) appeals from the
District Court’s Order dismissing its Second Amended Complaint for failure to
meet the heightened requirements of Rule 9(b) and the Private Securities
Litigation Reform Act (“PSLRA”), 15 U.S.C. § 77z-1, 78u. We affirm the District
Court’s Order dismissing the Second Amended Complaint and hold that DeKalb
waived its right to further amendment of its Complaint by taking the instant
appeal.
I
On April 07, 2004 Dekalb brought a claim in the United States District
Court for the Northern District of Georgia for securities fraud as a putative class
action against NDCHealth Corporation (“NDC”), several of its officers
(“Individual Defendants”), and the accounting firm Ernst and Young LLP
(“E&Y”). DeKalb set forth two causes of action in its Second Amended
Complaint: (1) securities fraud pursuant to Section 10(b), 15 U.S.C. §78j(b) and
Rule 10b-5, 17 CFR § 240.10b-5; and (2) violation of Section 20(a) of the
*
Honorable Arthur L. Alarcón, United States Circuit Judge for the Ninth Circuit, sitting
by designation.
2
Exchange Act, 15 U.S.C. 78t.
The gravamen of the Second Amended Complaint is that during the class
period of August 21, 2002 through August 9, 2004, NDC “engaged in a variety of
undisclosed accounting manipulations and business practices which caused the
Company’s financial results to be materially overstated.” DeKalb alleges that
NDC engaged in channel stuffing;1 prematurely recognized sales revenue; did not
follow Generally Accepted Accounting Principles; and materially misstated the
value of a failed investment in a company known as MedUnite. E&Y is being
sued because it served as NDC’s independent auditor and issued audit opinions on
the Company’s 2003 and 2004 financial statements.
NDC and E&Y filed motions to dismiss DeKalb’s Second Amended
Complaint on October 13, 2004. After the opposition and reply papers were filed,
on January 5, 2005, NDC filed a Form 8-K and a Form 12b-25 document with the
SEC disclosing that it would restate its accounts for the prior period “beginning
with its fiscal year ended May 31, 2002 through the first quarter of fiscal year
1
Channel stuffing is a practice whereby a company floods distribution channels by
employing incentives to induce customers into purchasing their products in large quantities,
creating a short-term bump in revenue and excess supply in the distribution chain. See e.g. In re
Scientific-Atlanta Inc., Securities Litigation, 239 F. Supp. 2d 1351, 1355 (N.D. Ga. 2002)
(“‘channel stuffing’ has the effect of shifting earnings into earlier quarters to the detriment of
earnings in later quarters.”).
3
2005 ended August 27, 2004.” The District Court took judicial notice of these
documents.2 The Second Amended Complaint contains no allegation regarding
the restatement of accounts.
The District Court dismissed Appellant’s Second Amended Complaint on
July 27, 2005 with leave to amend. The order states: “Plaintiff shall file its Third
Amended Complaint within thirty (30) days of entry of this Order, and Defendants
shall file their motions to dismiss within thirty (30) days of the filing of the Third
Amendment.” In re NDC Health Corp. Inc., No. 1:04-cv-0970, slip op. at 53 (N.D.
Ga. July 27, 2005). Instead of filing a third amended complaint, DeKalb filed a
Notice of Appeal on August 26, 2005, the last day of the period allotted for filing
an amended complaint.
2
On a motion to dismiss for failure to state a claim upon which relief can be granted, if
“matters outside the pleading are presented to and not excluded by the court, the motion shall be
treated as one for summary judgment and disposed of as provided in Rule 56, and all parties shall
be given reasonable opportunity to present all material made pertinent to such a motion by Rule
56.” Fed. R. Civ. P. Rule 12(b). Normally, “once the court decides to accept matters outside the
pleading, it must convert the motion to dismiss into one for summary judgment.” Property
Mgmt. & Inv., Inc., v. Lewis, 752 F.2d 599, 604 (11th Cir. 1985) (citing Carter v. Stanton, 405
U.S. 669, 671 (1972)). However, in the context of securities fraud, “SEC documents [may be
treated] as public records capable of being judicially noticed at the motion to dismiss stage.”
Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1280 (11th Cir. 1999). By taking judicial notice of
SEC documents, the District Court did not transform Defendants’ motions to dismiss into a
motion for summary judgment. Id.
4
II
On September 13, 2005, this Court inquired nostra sponte whether the
District Court’s Order of July 27, 2005 constitutes a final appealable order. In
response, the parties agreed that “[g]enerally, an order dismissing a complaint is
not final and appealable unless the order holds that it dismisses the entire action or
that the complaint cannot be saved by amendment.” Van Poyck v. Singletary, 11
F.3d 146, 148 (11th Cir. 1994) (citing Czeremcha v. Int'l Ass'n of Machinists and
Aerospace Workers, AFL-CIO, 724 F.2d 1552, 1554-55 (11th Cir. 1984)).
“[W]here an order dismisses a complaint with leave to amend within a
specified period, the order becomes final (and therefore appealable) when the time
period allowed for amendment expires.” Briehler v. Miami, 926 F.2d 1001, 1002
(11th Cir. 1991). However, “the plaintiff need not wait until the expiration of the
stated time in order to treat the dismissal as final, but may appeal prior to the
expiration of the stated time period.” Schuurman v. Motor Vessel “Betty K V,”
798 F.2d 442, 445 (11th Cir. 1986). Accordingly, this Court has jurisdiction over
this timely filed appeal pursuant to 28 U.S.C. § 1291. By filing an appeal in this
manner, however, DeKalb elected to stand on its Second Amended Complaint and
waived its right to further amendment. Schuurman, 798 F.2d at 445 (“Once the
plaintiff chooses to appeal before the expiration of time allowed for amendment,
5
however, the plaintiff waives the right to later amend the complaint, even if the
time to amend has not yet expired.”).
III
DeKalb argues the District Court erred in dismissing its Second Amended
Complaint because, in determining that DeKalb did not plead facts sufficient to
give rise to a strong inference of scienter, “[t]he District Court failed to consider
all of the facts pled and also failed to view the allegations in a light most favorable
to Appellant.” (Appellant’s Br. 34.) DeKalb also argues that “the District Court
erred in determining that Appellant failed to plead the reasons for the falsity of the
alleged misstatements and omissions with requisite specificity.” Finally, Dekalb
assigns error to the District Court for “improperly impos[ing] conditions on
Appellant’s right to amend its complaint.”
“At the motion to dismiss stage, all well-pleaded facts are accepted as true,
and the reasonable inferences therefrom are construed in the light most favorable
to the plaintiff.” Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1273 n.1 (11th Cir.
1999). The “court reviews de novo the dismissal of a complaint pursuant to Rule
12(b)(6).” Oxford Asset Mgmt. v. Jaharis, 297 F.3d 1182, 1187 (11th Cir. 2002).
Section 10(b) and Rule10b-5 make it unlawful for any individual to employ
a manipulative or deceptive device in connection with the purchase or sale of any
6
security.3 “To allege securities fraud under Rule 10b-5, a plaintiff must show: 1) a
misstatement or omission, 2) of a material fact, 3) made with scienter, 4) on which
plaintiff relied, 5) that proximately caused his injury.” Bryant, 187 F.3d at 1281.
Section 20(a) of the Exchange Act provides for liability of “controlling
persons” who aid and abet “any person liable under any provision of this chapter
or of any rule or regulation thereunder.” 15 U.S.C. 78t. Dekalb’s claims under
3
Section 10(b), 15 U.S.C.S. § 78j, provides:
To use or employ, in connection with the purchase or sale of any
security registered on a national securities exchange or any security
not so registered, or any securities-based swap agreement (as defined
in section 206B of the Gramm-Leach-Bliley Act [15 USCS § 78c
note]), any manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the Commission may
prescribe as necessary or appropriate in the public interest or for the
protection of investors.
Rule 10b-5, 17 C.F.R. § 240.10b-5, was promulgated under Section 10(b) and
provides:
It shall be unlawful for any person, directly or indirectly, by the use of
any means or instrumentality of interstate commerce, or of the mails
or of any facility of any national securities exchange, (a) To employ
any device, scheme, or artifice to defraud, (b) To make any untrue
statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the
circumstances under which they were made, not misleading, or (c) To
engage in any act, practice, or course of business which operates or
would operate as a fraud or deceit upon any person, in connection
with the purchase or sale of any security.
7
Section 20(a) are alleged against the Individual Defendants, and predicated upon
the same alleged unlawful conduct relevant to its claims under Section 10b.
(Compl. ¶ 186.) Accordingly, the success of DeKalb’s section 20(a) claim turns
on the resolution of its claims under Section 10b and Rule 10b-5.
A
Channel stuffing is not fraudulent per se. Greebel v. FTP Software, Inc.,
194 F.3d 185, 202 (1st Cir. 1999) (“There is nothing inherently improper in
pressing for sales to be made earlier than in the normal course.”). In Greebel, the
First Circuit commented that in the context of alleged improper revenue
recognition, “channel stuffing evidence has some probative value. But that value
is weak.” Id. at 203; but see In re Cabletron Sys., 311 F.3d 11, 26 (1st Cir. 2002)
(allegations of improper revenue recognition, including fictitious sales, and
channel stuffing, were supported by averments of testimonial evidence from
insiders and pled with adequate specificity to survive a motion to dismiss). The
Seventh Circuit determined in Makor Issues & Rights, Ltd., et al., v. Tellabs, Inc.,
437 F.3d 588 (7th Cir. 2006) that “[w]hile there may be legitimate reasons for
attempting to achieve sales earlier via channel stuffing, providing excess supply to
distributors in order to create a misleading impression in the market of the
company’s financial health is not one of them.” Id. at 598. We agree with the
8
Seventh Circuit that channel stuffing may amount to fraudulent conduct when it is
done to mislead investors, but the allegations of channel stuffing in the instant
case were not pled with sufficient detail to overcome the PSLRA’s scienter hurdle.
Rule 9(b) provides that “[i]n all averments of fraud or mistake, the
circumstances constituting fraud or mistake shall be stated with particularity.”4
Fed. R. Civ. P. Rule 9(b). “Rule 9(b) is satisfied if the complaint sets forth ‘(1)
precisely what statements were made in what documents or oral representations or
what omissions were made, and (2) the time and place of each such statement and
the person responsible for making (or, in the case of omissions, not making) same,
and (3) the content of such statements and the manner in which they misled the
plaintiff, and (4) what the defendants obtained as a consequence of the fraud.’”
Ziemba v. Cascade Int'l, Inc., 256 F.3d 1194, 1202 (11th Cir. 2001) (quoting
Brooks v. Blue Cross and Blue Shield of Florida, Inc., 116 F.3d 1364, 1371 (11th
Cir. 1997)). “A sufficient level of factual support for a [10b] claim may be found
where the circumstances of the fraud are pled in detail. ‘This means the who,
what, when where, and how: the first paragraph of any newspaper story.’” Gross
v. Medaphis Corp., 977 F. Supp. 1463, 1470 (N.D. Ga. 1997) (quoting DiLeo v.
4
Rule 9(b) states: “In all averments of fraud or mistake, the circumstances constituting
fraud or mistake shall be stated with particularity. Malice, intent, knowledge, and other condition
of mind of a person may be averred generally.” Fed. R. Civ. P. Rule 9(b).
9
Ernst & Young, 901 F.2d 624, 627 (7th Cir. 1990)).
For claims brought under the Exchange Act, including Appellants’ claims
under Section 10b and Section 20a, the complaint must “specify each statement
alleged to have been misleading, the reason or reasons why the statement is
misleading, and, if an allegation regarding the statement or omission is made on
information and belief, the complaint shall state with particularity all facts on
which that belief is formed.” 15 U.S.C. § 78u-4(b)(1).5
DeKalb argues that it set forth a claim satisfying the requirements of Rule
9(b) and the PSLRA when it alleged that NDC understated expenses in violation
of GAAP in three ways: “(1) it began to capitalize costs well before its
development projects reached ‘technological feasibility;’ (2) it amortized costs
over periods much greater than the economic life of its software assets; and (3) it
applied an excessive burden factor to its capitalized costs, thereby expensing less
5
Section 77u-4(b) provides:
(1) Misleading statements and omissions
In any private action arising under this chapter in which the plaintiff alleges that
the defendant--
(A) made an untrue statement of a material fact; or
(B) omitted to state a material fact necessary in order to make the statements
made, in the light of the circumstances in which they were made, not misleading;
the complaint shall specify each statement alleged to have been misleading, the
reason or reasons why the statement is misleading, and, if an allegation regarding
the statement or omission is made on information and belief, the complaint shall
state with particularity all facts on which that belief is formed.
10
than necessary in the present term.” In discounting this argument, the District
Court stated “Plaintiff’s allegations are thin, and are based almost entirely on
statements by an undisclosed former executive in the Physician Services Group.”
In Re NDC Health Corp. Inc., No. 1:04-cv-0970, slip op. at 44.
The District Court did not err because Dekalb’s allegations regarding
amortization and capitalization are vague and difficult to evaluate. For example,
the Second Amended Complaint does not specify when the improper accounting
occurred. It also fails to allege how and what products were improperly
capitalized or amortized.
DeKalb also argues that the District Court erred in holding that DeKalb’s
allegations regarding material misstatement in NDC’s financial statements were
overly speculative and amount to nothing more than “non-actionable corporate
mismanagement.” The District Court determined that “the financial reporting was
itself accurate” and the reports “accurately reflected the performance of the
Company.” At the time the District Court issued its opinion, NDC had already
declared its intention to restate its accounts. On January 05, 2005, NDC filed a
disclosure with the SEC stating that it “identified certain practices regarding the
exchange of physician software inventory held by the Company’s value-added
resellers that were inconsistent with Company policies.” Accordingly, NDC
11
announced that “after discussion with the Company’s independent accountants, on
January 4, 2005, the Audit Committee of the Board of Directors determined it is
appropriate to restate prior-period results beginning with its fiscal year ended May
32, 2002 through the first quarter of fiscal year 2005 ended August 27, 2004.”
NDC also noted that “[t]he restatement will also include other identified
adjustments from prior periods.” It follows that NDCs prior financial reporting
may not have been accurate and may not have reflected the performance of the
company.
DeKalb elected to stand on its Second Amended Complaint. NDC’s
intention to restate its accounts is not alleged in the Second Amended Complaint.
Because DeKalb waived its right to file a third amended complaint, we limited our
review to the facts set forth in the Second Amended Complaint instead of
speculating whether DeKalb could have filed a third amended complaint that
would have met the pleading requirements of the PSLRA and Rule 9(b).
Turning to the allegations set forth in the Second Amended Complaint,
DeKalb maintains that it alleged improper revenue recognition with adequate
specificity by stating that in March of 2004, “a management level employee in the
Physician Services unit” notified E&Y of a “dire situation facing that business
segment – that accounts receivable were very high as a result of aggressive
12
channel-stuffing practices, which rendered the unit’s reported revenues highly
suspect.” (Compl. ¶ 61.) According to DeKalb, NDC “determined that
approximately $25 million of inventory was in the channel as of March 31, 2004.”
(Id. at ¶ 63.) The Second Amended Complaint goes on to state that, after
management learned of this information, NDC decided to “delay its earning
release pending a review of its revenue recognition practices in the Physician
Services Unit.” (Id.) In sum, DeKalb alleged that NDC issued erroneous financial
statements that contained substantial misstatements due to the improper
recognition of revenue and channel stuffing in the Physician Services Unit.
DeKalb also alleged that “Defendants sought to conceal their improper
revenue recognition by increasing reserves and taking large, year-end charges for
uncollected receivables, without explanation.” Absent from these allegations are
any detailed allegations of scienter with respect to the alleged misrepresentations.
B
DeKalb argues it was plain error for the District Court to conclude “that the
Complaint does not contain allegations sufficient to give rise to a strong inference
of scienter with respect to Appellees[.]” A complaint must “state with
particularity facts giving rise to a strong inference that the defendant acted with
13
the required state of mind.” 15 U.S.C. § 78u-4(b)(2).6 “This [statutory]
requirement alters the usual contours of a Rule 12(b)(6) ruling because, while a
court continues to give all reasonable inferences to plaintiffs, those inferences
supporting scienter must be strong ones.” In re Cabletron Sys., 311 F.3d at 28
(citing Greebel, 194 F.3d 185, 201 (1st Cir. 1999)). “[F]actual allegations may be
aggregated to infer scienter and must be inferred for each defendant with respect
to each violation.” Phillips v. Scientific-Atlanta, Inc., 374 F.3d 1015, 1016 (11th
Cir. 2004).
Dekalb contends “the District Court fail[ed] to properly consider all scienter
allegations in the aggregate, [and] the Court patently failed to interpret the
allegations in a light most favorable to Appellant.” “[A] securities fraud plaintiff
must plead scienter with particular facts that give rise to a strong inference that the
defendant acted in a severely reckless manner.” Bryant, 187 F.3d at 1287.
“‘Severe recklessness is limited to those highly unreasonable omissions or
misrepresentations that involve not merely simple or even inexcusable negligence,
6
Section 77u-4(b)(2) provides:
(2) Required state of mind
In any private action arising under this chapter in which the plaintiff may recover
money damages only on proof that the defendant acted with a particular state of
mind, the complaint shall, with respect to each act or omission alleged to violate
this chapter, state with particularity facts giving rise to a strong inference that the
defendant acted with the required state of mind.
14
but an extreme departure from the standards of ordinary care, and that present a
danger of misleading buyers or sellers which is either known to the defendant or is
so obvious that the defendant must have been aware of it.’” Id. at 1282 n.18
(quoting McDonald v. Alan Bush Brokerage Co., 863 F.2d 809, 814 (11th Cir.
1989)).
Turning to the salient allegations of scienter set forth in the Second
Amended Complaint, DeKalb alleged that Defendants Hoff and Miller attended
monthly operations meetings in Arizona and “every aspect of the Physician
Services business was discussed in detail, including the aggressive channel
stuffing and mounting problems with accounts recevable (sic).” (Compl. ¶ 56.) In
the Second Amended Complaint, DeKalb alleged that testimonial evidence
provided by a “former senior executive” would show Defendants Miller and Hoff
knew there was a problem with “mounting accounts receivable” but decided to
continue with “aggressive discounting and credit terms” because the company had
to “make its numbers.”7
7
In its Second Amended Complaint, DeKalb avers:
According to the former senior executive, Defendants Miller and Hoff often
discussed the difficult tension between the rising accounts receivable and the
aggressive discounting and extended credit terms being given to VARs on the one
hand, and the need for the Company to “make its numbers,” on the other. The
senior executive related that Hoff and Miller remarked that the Company was
15
Absent from these allegations are any particularized averments of fraud or
scienter. In Theoharous v. Fong, 256 F.3d 1219 (11th Cir. 2001), this Court held
that scienter was not pled with adequate specificity “because the plaintiffs did not
allege the context in which Fong made this statement, [and] it does not appear
from the face of the complaint that Fong must have known that the statement
presented a danger of misleading buyers or sellers.” Id. at 1225. As in Fong,
DeKalb’s broad claim of testimonial evidence is not set forth with requisite detail
because DeKalb failed to allege what was said at the meeting, to whom it was said,
or in what context. Accordingly, the averment lacks the requisite particularity. It
is well established that “claims of securities fraud cannot rest ‘on speculation and
conclusory allegations.’” Hoffman v. Comshare, Inc. (In re Comshare Inc. Sec.
Litig.), 183 F.3d 542, 553 (6th Cir. 1999) (quoting San Leandro Emergency Med.
Plan v. Philip Morris Co., 75 F.3d 801, 813 (2d Cir. 1996). A general allegation
that Individual Defendants promoted channel stuffing at a series of meetings does
‘quarter driven,’ and that the need to sustain reported revenue growth outweighed
the need to properly address the mounting accounts receivable and the attendant
questionable revenue recognition. Instead of addressing growing concerns of
managers in the unit that the aggressive discounting, channel-stuffing, and
extended credit terms. . . were creating serious realizability (sic) concerns . . .
Defendants Hoff and Miller directed the unit to forge ahead and continue to
aggressively stuff the channel in order to give the appearance of robust revenue
growth.
(Compl. ¶ 57.)
16
not establish scienter.
DeKalb also avers that the Individual Defendants, Mssrs. Hoff, Hutto and
Miller, made a PowerPoint presentation in Atlanta on March 1, 2004 that
“contained several statements identifying problems with the VAR channel.” The
presentation included discussion of the following topics: “Heavy promotion
discounting to drive VAR sales,” and “Change ordering/buying behavior of Vars
from Q/E promotion discount buying to pull through demand buying and add
additional VARs”. DeKalb also alleges: “Identified as ‘Conditions for
Success/Risks’ (sic) were ‘VAR accounts receivable collections’ and ‘Visibility
into VAR inventory levels and outbound programs/assistance to move inventory
physician practices (pull through sales).’” DeKalb maintains that these allegations
establish a strong inference of scienter on the part of the individual defendants.
We disagree.
Viewing these confusing statements in the best possible light, it is possible
to surmise that the Individual Defendants might have been aware of improper
revenue recognition in the VAR channel and also knew that they needed to
increase actual sales rather than “promot[e] discount buying.” But that conclusion
is based on multiple inferences and drawn from somewhat baffling language.
DeKalb failed to allege what was actually discussed at the meeting. Accordingly,
17
the allegation regarding the meeting of March 1, 2004, does not give rise to a
strong inference of scienter.
DeKalb also argues that the personal certifications required by the
Sarbanes-Oxley Act and signed by senior executives “are indicia of Defendants’
scienter.” Dekalb contends that by signing the certification, Defendants
represented to the general public that: “(1) they reviewed the filing being certified;
(2) the report did not contain any untrue statement of material fact . . . ; (3) the
report fairly presented the financial condition of the company; and (4) they
designed the disclosure controls and procedures to ensure that material
information relating to the Company was disclosed to them for the period in
question.”
The plain meaning of the language contained in Sarbanes-Oxley, 18 U.S.C.
§ 1350, does not indicate any intent to change the requirements for pleading
scienter set forth in the PSLRA, 15 U.S.C. § 78u-4(2). Sarbanes-Oxley requires
that the chief executive officer and chief financial officer certify “[e]ach periodic
report containing financial statements filed by an issuer with the Securities and
Exchange Commission . . .” 18 U.S.C. § 1350(a). The statute also provides for
imprisonment of up to 10 years or a fine of $1,000,000 for any person who
“certifies a periodic financial statement . . . knowing that the periodic report
18
accompanying the statement does not comport with all the requirements set forth
in [section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C.
78m(a) or 78o(d))] . . .” 18 U.S.C. § 1350(c). An individual who “willfully
certifies” such a statement is subject to a prison term of 20 years and a fine of up
to $5,000,000. Nowhere in the statute is there any mention of civil liability or
pleading requirements for scienter in civil actions brought for securities fraud.
“A fundamental canon of statutory construction is that, unless otherwise
defined, words will be interpreted as taking their ordinary, contemporary, common
meaning.” Perrin v. United States, 444 U.S. 37, 42 (1979) (citing Burns v. Alcala,
420 U.S. 575, 580-81 (1975)). When construing the meaning of a statute, “the
beginning point must be the language of the statute, and when a statute speaks
with clarity to an issue judicial inquiry into the statute's meaning, in all but the
most extraordinary circumstance, is finished.” Estate of Cowart v. Nicklos
Drilling Co., 505 U.S. 469, 475 (1992) (citing Demarest v. Manspeaker, 498 U.S.
184, 190 (1991)). In the instant case, the statute does not speak to the issue of
pleading scienter. The plain language of Sarbanes-Oxley evidences no
congressional intent to alter the pleading requirements set forth in the PSLRA. 18
U.S.C. § 1350.
DeKalb’s interpretation of Sarbanes-Oxley conflicts with the plain language
19
of the PSLRA. “‘[W]hen two statutes are capable of coexistence, it is the duty of
the courts, absent a clearly expressed congressional intention to the contrary, to
regard each as effective.’” J.E.M. Ag Supply v. Pioneer Hi-Bred Int'l, 534 U.S.
124, 143-44 (2001) (quoting Morton v. Mancari, 417 U.S. 535, 551 (1974)). If we
were to accept DeKalb’s proffered interpretation of Sarbanes-Oxley, scienter
would be established in every case where there was an accounting error or
auditing mistake made by a publicly traded company, thereby eviscerating the
pleading requirements for scienter set forth in the PSLRA. We decline to adopt
such an interpretation.
Instead, we hold that a Sarbanes-Oxley certification is only probative of
scienter if the person signing the certification was severely reckless in certifying
the accuracy of the financial statements. This requirement is satisfied if the person
signing the certification had reason to know, or should have suspected, due to the
presence of glaring accounting irregularities or other “red flags,” that the financial
statements contained material misstatements or omissions. In the instant case,
there are no allegations in the Second Amended Complaint that indicate the
presence of such “red flags” in the company’s financial statements.
The Second Amended Complaint states that “the Physician Services
accounts receivable grew from $200,000 to almost $11 million in approximately
20
eighteen months beginning in late 2002.” By way of comparison, NDC
announced that its revenue for the third quarter of 2003 was $116.1 million and
net income was only $9.3 million. DeKalb alleged that “[i]n the fourth quarter
(ended May 30, 2003 . . . ), NDC increased its allowance for doubtful accounts by
$4.26 million, nearly seven times the average for the three previous quarters.”
(Compl. ¶ 68.) Those numbers are somewhat alarming because they indicate a
relatively large amount of revenue that might never be realized. But those
statements themselves do not appear to be untrue or misleading.
Viewing the allegations individually and in aggregate, the facts set forth in
the Second Amended Complaint do not create a “strong inference” of scienter.
See 15 U.S.C. § 78u-4(b)(2) (mandating “strong inference that the defendant acted
with the required state of mind.”) Accordingly, the District Court did not err in
dismissing DeKalb’s Second Amended Complaint.
C
NDC argues that Dekalb did not have standing to bring a claim regarding
the stated value of MedUnite because DeKalb did not purchase any stock until
after the alleged fraudulent conduct occurred. Dekalb alleged that the impact of
the sale of MedUnite was realized on March 19, 2003. (Compl. ¶ 75.) But Dekalb
21
did not buy stock until March 10 and 11, 2004. Accordingly Dekalb did not have
standing to bring this claim because they did not buy the stock until long after the
impact of the sale was realized. See Marsh v. Armada Corp., 533 F.2d 978, 981-
82 (6th Cir. 1976) (“Standing is established by allegations that plaintiffs bought or
sold shares of the stock in question within a reasonable period of time after the
allegedly fraudulent conduct occurred to support an inference of reliance.”); see
also Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 730 (1975) (holding
that “the plaintiff class for purposes of a private damage action under § 10(b) and
Rule 10b-5 [i]s limited to actual purchasers and sellers of securities.”).
IV
DeKalb argues that the District Court erred in dismissing its Complaint
against E&Y because E&Y certified NDC’s financial accounts even though their
practices did not comport with Generally Accepted Acounting Principles
(“GAAP”) and Generally Accepted Auditing Standards (“GAAS”).8 DeKalb
alleged that E&Y ignored “red flags” when it issued unqualified audits and
8
Generally Accepted Accounting Principles ("GAAP") are the “basic postulates and broad
principles” that guide business accounting. SEC v. Price Waterhouse, 797 F. Supp. 1217,
1222-23 n17 (S.D.N.Y. 1992) (cited in Ziemba, 256 F.3d at 1200. GAAP is approved by the
Auditing Standards Board of the American Institute of Certified Public Accountants ("AICPA").
Id. Generally Accepted Auditing Standards ("GAAS") are the standards prescribed by the
AICPA for the conduct of auditors in the performance of an examination. Id. GAAP and GAAS
establish guidelines for measuring, recording, and classifying a business entity's transactions. Id.
22
financial statements in 2003 and 2004. (Compl. ¶¶ 151-54.)
A
DeKalb argues that anomalous increases in NDC’s reserve for doubtful
accounts put E&Y “on notice of the other Defendant’s fraudulent scheme.”
Drastic overstatement of accounts, or other red flags, combined with alleged
violations of GAAS or GAAP may be enough to establish the requisite level
scienter. In re Eagle Bldg. Tech. Inc., Sec. Litig., 319 F. Supp. 2d 1318, 1328
(S.D. Fla. 2004) (finding sufficient particularity where fraudulent contracts made
up 74% of the company’s business, financial statements had 60 out of 75 line
items restated, and red flags included inter alia, purchase order discrepancies in
the hundreds of thousands, delivery discrepancies of 50% of goods, and post-dated
license agreements); see also In re Friedman’s, Inc., Sec. Litig., 385 F. Supp. 2d
1345, 1365-66 (N.D. Ga. 2005) (finding a strong inference of scienter where
auditing firm “had continuous arguments” with company management over
allowance for uncollected accounts, the firm “knew that” the company was under-
reserved, the firm discussed doubtful accounts every quarter, and the firm
committed numerous GAAP and GAAS violations); In re Hamilton Bankcorp.,
Inc., Sec. Litig., 194 F. Supp. 2d 1353 (S.D. Fla. 2002) (finding sufficient
particularity where auditing firm committed numerous GAAP and GAAS
23
violations and ignored an investigation by the Office of the Comptroller of the
Currency, the simultaneous sale and purchase of overpriced loans or securities to
avoid write down on its books, and the corporation’s failure to adhere to SEC
requirements).
Red flags are “those facts which come to the attention of an auditor which
would place a reasonable auditor on notice that the audited company was engaged
in wrongdoing to the detriment of its investors.” In re Sunterra Corp. Sec. Litig.,
199 F. Supp. 2d 1308, 1334 (M.D. Fla 2002). “It is established, however, that the
purported red flags cannot simply ‘re-hash’ the alleged GAAP violations.” In re
Spear & Jackson Sec. Litig., 399 F. Supp. 2d 1350, 1363 (S.D. Fla. 2005) (citing
Holmes v. Baker, 166 F. Supp. 2d 1362, 1379 (S.D. Fla. 2001)).
DeKalb alleged that E&Y was put on notice of fraudulent activity by NDC’s
increased allowance for “doubtful accounts” in the fourth quarter of 2003 and
2004. (Compl. ¶ 67). DeKalb also claimed that “[a]n analysis of NDC’s reserve
for doubtful accounts and related charge-offs and recoveries for fiscal year 2003
and fiscal year 2004 reveals a pattern strongly suggesting that Defendants
concealed overstated revenues for fiscal year 2003 and 2004 by increasing NDC’s
provision in the fourth quarter of both years and taking a large, anomalous charge
for uncollectible accounts receivable. . . .” (Id.) The Complaint alleged
24
the first three quarters of fiscal year 2003 NDC provisioned at a
modest rate and actually reported net recoveries on accounts
receivable previously written off . . . [but] in the fourth quarter (ended
May 30, 2003, and incidentally, the quarter in which NDC’s
independent auditors began to review the Company’s financials in
preparation for the filing of the Form 10-K), NDC increased its
allowance for doubtful accounts by $4.26 million, nearly seven times
the average for the three previous quarters.
(Compl. ¶ 68.) DeKalb also alleged that “NDC charged-off over $6.1 million in
uncollectible accounts receivable.” (Id.) The Second Amended Complaint states
that “[i]n fiscal, 2004, in spite of NDC’s special review of its revenue recognition
practices and reserves prior to the issuance of its third quarter results, the
Company once again took an anomalous charge against its reserve of
approximately $6.7 million, or 78% of its reserve [and] failed to give any
explanation for these year-end results[.]” (Id.) DeKalb alleged that this charge
was “highly irregular given that NDC had purportedly experienced net recoveries
for the first three quarters of fiscal year 2003 and modest provisioning and charge
offs for the first three quarters of fiscal 2004.” (Id.)
DeKalb has not alleged any facts that show E&Y was actually aware or
should have known that NDC recklessly “concealed overstated revenues.” See
Bryant, 187 F.3d at 1287 (adopting the recklessness standard). DeKalb does not
allege facts that show that such increased allowances were so irregular as to put an
25
auditing company on notice for fraud. See Ziemba, 256 F.3d at 1210 (dismissing a
complaint where auditing firm was not “tipped off”). The Second Amended
Complaint states NDC chose the fourth quarter to start increasing the allowances
for doubtful accounts “incidentally” at the same time E&Y “began to review the
Company’s financials.” Since DeKalb has not alleged that E&Y knew about the
alleged reason for the increased “irregular” allowance for doubtful accounts, or
should have known about NDC’s improper revenue recognition, DeKalb failed to
plead facts giving rise to a strong inference of scienter.
B
DeKalb alleged that “during March 2004, E&Y was notified by a
management level employee in the Physician Services unit of the dire situation
facing that business segment – that accounts receivable were very high as a result
of aggressive channel-stuffing practices, which rendered the unit’s reported
revenues highly suspect.” (Compl. ¶ 61.) As a result of this notification, “the
Company and Defendants were forced to begin addressing the problem.” (Id.)
The Second Amended Complaint does not assert that E&Y had knowledge of
wrongdoing before March of 2004 and does not allege facts demonstrating that
E&Y acted with reckless disregard after E&Y was informed of the problem. On
the contrary, DeKalb alleged that when E&Y was “notified” of a “dire situation,”
26
E&Y took action. DeKalb has not pled facts that indicate E&Y’s response to the
notice was highly unreasonable or an extreme departure from the standards of
ordinary care.
C
DeKalb’s remaining allegations pertain to violations of GAAP or GAAS.
“Allegations of GAAS or GAAP, standing alone, do not satisfy the particularity
requirement of Rule 9(b).” Ziemba, 256 F.3d at 1208. Such allegations do not
create a strong inference of recklessness because “[t]hey merely suggest that either
management or the accountant missed something, and may have failed to prepare
or review the financial statements in accordance with an accepted standard of
reasonable care.” Reiger v. Price Waterhouse Coopers LLP, 117 F. Supp. 2d
1003, 1010 (S.D. Cal. 2000), aff’d sub nom. DSAM Global Value Fund v. Altris
Software, Inc., 288 F.3d 385 (9th Cir. 2002).
In the Second Amended Complaint, DeKalb alleged that E&Y’s audit report
of July 21, 2003 “falsely represented that E&Y had conducted its audit for NDC’s
year end 2003 financial statements in accordance with GAAS, and that NDC’s
financial statements conformed with GAAP.” (Compl. ¶ 151.) DeKalb alleged
that E&Y violated GAAS by failing exercise due professional care, failing to
design proper audit procedures, and by “failing to expand or otherwise properly
27
conduct its audit to detect the understatement in the allowance for doubtful
accounts. . . .” (Compl. ¶¶ 156, 165, 168.) DeKalb also alleged that “E&Y failed
to obtain sufficient competent evidential matter” with regards to write-offs,
software capitalization, and improper revenue recognition. (Compl. ¶ 166.)
DeKalb goes on to allege that these GAAS violations were caused by “E&Y’s
failure to qualify, modify or abstain from issuing its audit opinions, when it knew
or recklessly turned a blind eye to NDC’s accounting manipulations. . . .” (Compl.
¶ 158.)
While the DeKalb broadly claims that E&Y failed to design and implement
proper auditing procedures, DeKalb never describes how E&Y failed to do so.
For example, DeKalb refers to the American Institute of Certified Public
Accountants’ Codification of Statement on Auditing Standards, but DeKalb does
not allege how E&Y violated each section. DeKalb alleged that if E&Y had not
violated GAAP and GAAS the supposed fraud would not have taken place.
(Compl. ¶ 158) However, DeKalb may not “establish scienter by alleging that the
auditor would have discovered the fraud had it not violated GAAS.” In re Spear
& Jackson Sec. Litig., 399 F. Supp. 2d at 1363 (citing In re Eagle Bldg. Tech. Inc.,
Sec. Litig., 319 F. Supp. 2d at 1328). This is merely an allegation of negligence.
DeKalb states that E&Y “recklessly turned a blind eye” to the problems at
28
NDC. But merely alleging scienter in general, conclusory terms does not meet the
particularity requirement. 15 U.S.C. § 78u-4(b)(2). The District Court did not err
in granting E&Y’s motion to dismiss.
V
DeKalb waived its right to file a third amended complaint by filing the
instant appeal. But that does not moot the issue because a question remains as to
whether the restrictions on further amendment were overly burdensome. Federal
Rule of Civil Procedure Rule 15(a) states that leave to amend “shall be freely
given when justice so requires.”9 Denial of leave to amend is reviewed for abuse
of discretion. Baez v. Banc One Leasing Corp., 348 F.3d 972, 973 (11th Cir.
2003). In Foman v. Davis, 371 U.S. 178 (1962) the Supreme Court declared that
trial courts have broad discretion in permitting or refusing to grant leave to amend.
Id. at 182. “In the absence of any apparent or declared reason -- such as undue
delay, bad faith or dilatory motive on the part of the movant, repeated failure to
9
Rule 15(a) provides, in pertinent part:
A party may amend the party’s pleading once as a matter of course at any time
before a responsive pleading is served, or, if the pleading is one to which no
responsive pleading is permitted and the action has not been placed upon the trial
calendar, the party may so amend it at any time within 20 days after it is served.
Otherwise a party may amend the party’s pleading only by leave of court or by
written consent of the adverse party; and leave shall be given freely when justice
so requires.
29
cure deficiencies by amendments previously allowed, undue prejudice to the
opposing party by virtue of allowance of the amendment, futility of amendment,
etc. -- the leave sought should, as the rules require, be ‘freely given.’” Id.
DeKalb argues the District Court erred in placing restrictions upon its right
to further amend its Complaint because the District Court incorrectly premised the
restrictions on “the interest of fairness and to manage this litigation effectively.”
DeKalb also argues that the District Court did not adhere to the factors in Foman
v. Davis, 371 U.S. 178, 182 (1962). DeKalb’s argument lacks merit because the
District Court did not deny DeKalb leave to amend. The District Court explicitly
considered at least two of the Foman factors in fashioning the restrictions placed
on DeKalb’s right to further amendment of its Complaint.
In discussing the issue of leave to amend, the District Court made the
following comments: “The Eleventh Circuit requires leave to amend be granted
where a more carefully drafted complaint might state a claim. Here, the Court was
inclined to deny Plaintiff’s request for leave to amend the Second Amended
Complaint.” In re NDCHealth Corp., Inc. Securities Litigation, No. 1:04-cv-0970,
slip op. at 50. The District Court noted that “Plaintiff previously has amended its
complaint twice.”
The District Court gave DeKalb leave to amend because NDC’s notice to
30
the SEC regarding the restatement of its accounts “may at least be germane to the
claims asserted.” In re NDCHealth Corp., Inc. Securities Litigation, No. 1:04-cv-
0970, slip op. at 51 n.23. However, the District Court placed restrictions on
Appellant’s right to amend: “Plaintiff may amend its complaint but the amendment
is limited to allegations (i) based on information not available to Plaintiff when the
Second Amended Complaint was filed and (ii) which bear only on claims already
asserted.” Id. at 52.
“[I]n the exercise of sound discretion, the granting of leave to amend can be
conditioned in order to avoid prejudice to the opposing party.” Allied Indus.
Workers v. Gen. Elec. Co., 471 F.2d 751, 756 (6th Cir.) (quoting Strickler v.
Pfister Assoc. Growers, Inc., 319 F.2d 788, 791 (6th Cir. 1963)), cert denied, 414
U.S. 822 (1973). But the conditions placed on a plaintiff’s right to amend its
Complaint must be reasonable. See id. (holding the “requirement that the
amendment be filed by a specified date or that the party amending bear a portion
of the additional cost to the opposing party would, in proper circumstances, be
reasonable conditions.”); see also Anderberg v. Masonite Corp., 176 F.R.D. 682,
687 (N.D. Ga. 1997) (“the court may under Rule 15(a), impose costs as a condition
of granting leave to amend in order to compensate Defendant and avoid any
prejudice caused by the amendment.”); Gen. Signal v. MCI Telecomm. Corp., 66
31
F.3d 1500, 1514 (9th Cir. 1995) (same); Chicago Pneumatic Tool Co. v. Hughes
Tool Co., 192 F.2d 620, 631 (10th Cir. 1951) (holding “it lay well within the range
of sound judicial discretion of the court to allow the amendment in toto, to deny it
altogether, or to permit it with reasonable conditions and limitations.”).
In the instant case, the conditions placed upon DeKalb’s right to amend
were relatively modest. The District Court merely required that DeKalb limit its
amendment to the legal theories already asserted, and permitted DeKalb to assert
any new facts to state a claim. DeKalb has failed to demonstrate that these
restrictions were unreasonable. Because DeKalb already had ample opportunity to
file an amended complaint that meets the heightened pleading requirements of
Rule 9(b) and the PSLRA, the District Court did not abuse its discretion by
placing those restrictions on DeKalb’s right to further amendment.
AFFIRMED.
32
Robert Garfield v. NDCHealth Corporation
Court: Court of Appeals for the Eleventh Circuit
Date filed: 2006-10-12
Citations: 466 F.3d 1255, 2006 U.S. App. LEXIS 25435, 2006 WL 2883238
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