MILBERG WEISS BERSHAD
  HYNES & LERACH LLP
WILLIAM S. LERACH (68581)
HELEN J. HODGES (131674)
ARTHUR C. LEAHY (149135)
600 West Broadway, Suite 1800
San Diego, CA 92101
Telephone: 619/231-1058
     - and -
ALISON M. TATTERSALL (149607)
222 Kearny Street, 10th Floor
San Francisco, CA 94108
Telephone: 415/288-4545

BARRACK, RODOS & BACINE
EDWARD M. GERGOSIAN (105679)
KRISTI A. SHELTON (179400)
600 West Broadway, Suite 1700
San Diego, CA 92101
Telephone: 619/230-0800

BERGER & MONTAGUE, P.C.
SHERRIE R. SAVETT
GARY E. CANTOR
1622 Locust Street
Philadelphia, PA 19103
Telephone: 215/875-3000

Co-Lead Counsel for Plaintiffs
 
 

II. STATEMENT OF FACTS

III. THE COMPLAINT ADEQUATELY PLEADS FRAUD UNDER §10(b) AND RULE 9(b)

IV. PLAINTIFFS' ALLEGATIONS ARE ADEQUATELY PARTICULAR

A. Plaintiffs' Allegations Of False Financial Statements State Federal Securities Laws Claims
1. Fritz's False Financial Statements Are Adequately Pled

2. The Restatement Confirms Material Errors In The Original Financial Statements When Issued

B. Misstatements Concerning The Success Of The Intertrans Merger

C. Defendants' Misstatements Concerning Fritz's Other Acquisitions

VI. PLAINTIFFS HAVE SATISFIED THE PSLRA'S PLEADING REQUIREMENT FOR SCIENTER

A. Motive And Opportunity Are Adequately Pled
1. The May 1996 $75 Million Debenture Offering Was Completed After Fritz's False Financial Statements Were Issued

2. Defendants Benefitted From The Fraud

3. Defendants Used Artificially Inflated Fritz Stock To Acquire Other Companies

B. Circumstantial Evidence Of Conscious Misbehavior Or Recklessness Has Been Adequately Pled
1. Defendants' Control Of Fritz And Fritz's False And Misleading Statements Are Circumstantial Evidence Of Scienter

2. Defendants' Admitted GAAP Violations Are Circumstantial Evidence Of Scienter

3. The Annual Audit Cannot "Refute" Defendants' Scienter

I. INTRODUCTION

Defendants admitted that Fritz's Class Period financial statements were overstated by millions of dollars because of (1) serious problems known to company management from before the Class Period; (2) defendants' decision to recognize revenue from acquisitions before those deals were completed, in violation of Generally Accepted Accounting Principles ("GAAP") (correcting this violation alone reversed $26 million in revenue in Fritz's third quarter 1996, ¶81);⁽²⁾ and (3) defendants' reliance on a variety of improper accounting practices to increase earnings, including defendants' failure to reserve for doubtful accounts, refusal to properly account for Fritz's operating expenses and improper capitalization of software costs. ¶¶95-114.

Having admitted that these practices materially impacted the Company's financial statements, defendants devote much of their brief to claiming the Complaint does not adequately plead their knowing or reckless participation in the alleged fraud. Defendants urge that they -- the Company's top officers, including the CEO and CFO -- knew nothing of Fritz's improper accounting and revenue recognition practices, and that their professed lack of knowledge about the Company's most important affairs, including its revenues, earnings and growth by acquisitions, was not reckless. Defendants' Motion to Dismiss and Supporting Memorandum of Points and Authorities ("Defs' Brf.") at 16-24. Defendants argue that they could not possibly have known of or recklessly disregarded these facts because to do so would be economically "irrational." Defendants simultaneously ask the Court to give them too much credit and too little, claiming they would never be so foolish as to put short term goals, such as the temporary appearance of strong earnings growth, over the long term health of the Company and management's credibility, while gamely protesting they had no idea Fritz's financial statements were inflated by tens of millions of dollars. Defendants also misrepresent plaintiffs' access to discovery -- plaintiffs received only a smattering of the requested KPMG Peat Marwick ("Peat") workpapers. See Declaration of Arthur C. Leahy in Opposition to Defendants' Motion to Dismiss ("Leahy Decl."), ¶¶6-8. Notably, defendants themselves have not produced a single piece of paper relating to plaintiffs' allegations. Undaunted, defendants forge ahead and actually present "evidence," as if this were a trial, urging the Court to draw improper factual inferences in their favor.

The Complaint presents specific and very detailed allegations of defendants' material misrepresentations and omissions, their knowing or deliberately reckless conduct, their admissions about Fritz's materially overstated revenues and earnings, the specific GAAP that were violated and the actual dollar amount of the overstatements. While defendants hope this Court will interpret the Private Securities Litigation Reform Act of 1995 ("PSLRA") as eliminating liability for securities fraud, in fact this is the very type of accounting fraud that the PSLRA was intended to remedy. Defendants' motion to dismiss should be denied. 

II. STATEMENT OF FACTS

Defendants nonetheless repeatedly assured the public of the synergistic benefits of Fritz's growth through acquisitions, and in particular, that Fritz had successfully merged Intertrans into its operations, which was increasing Fritz's margins and earnings. ¶¶4, 36, 44, 51, 55-62, 68, 76. So effective was defendants' dissemination of false information that Fritz's stock price soared as high as $43 during the Class Period. Taking advantage of the inflated stock price, defendant Carsten Andersen sold over 166,000 shares of his Fritz common stock for over $6 million, and Fritz completed a $75 million private debt placement which could not have taken place without the successful scheme. ¶¶8-9, 27, 73.

On July 24, 1996, just two months after the $75 million debt offering, defendants shocked the market by admitting that, due to accounting "irregularities," Fritz's earnings for the third quarter ending February 29, 1996 had been restated downward from $10.3 million to just $3.1 million, and that, for the fourth quarter ended May 31, 1996, Fritz would report a loss of $3.4 million, or $0.10 per share. ¶¶6, 77, 78. Defendants disclosed that, of the $22.5 million total charges taken in the third and fourth quarters, approximately $14.5 million was for additional merger costs and approximately $8 million related to other costs approximately 60 to 70 percent ($5-6 million) of which was uncollectible receivables. Defendants also revealed that the Company reversed $33 million of phantom revenue, which defendants claimed arose from the Intertrans accounting system problems. Defendants finally admitted they knew from the beginning of problems with the Intertrans accounting system and its lack of integration with Fritz's operations system, and stated that costly enhancements, attempted since before the Class Period, were only 80% complete. These admissions cut the price of Fritz stock in half -- it dropped over 55% that day, from $27.50 to $12.25, on extremely heavy volume. ¶¶6, 78-80.⁽³⁾

Defendants thus admit they knew contemporaneous adverse facts which rendered Fritz's publicly reported financial results and defendants' statements about Fritz and its growth materially false and misleading (¶¶77-78, 81, 84-85), including that:

1. The $29.995 million Intertrans merger charge, recorded as of May 31, 1995, significantly underestimated the actual costs of the merger.

2. At least $4.7 million of pre-merger bad debt, an ordinary operating expense, was improperly recorded in this one-time Intertrans acquisition charge.

3. Fritz improperly recognized over $26 million in revenue from acquisitions of other companies before those deals were completed.

4. Fritz improperly recognized approximately $10 million in revenue for sales with inadequate documentation to show a sale was actually made.

5. Fritz improperly capitalized over $5 million in software development and EDP Systems integration costs.

6. Fritz's financial statements for the third quarter, ended February 29, 1996, at the time they were issued, materially overstated Fritz's earnings by 200% -- by at least $7.2 million.

7. Although Fritz began several expensive corrections to the Intertrans system, a year after the merger only about 80% of those enhancements were completed, and they were ineffective -- the system was still unable to accurately account for both companies' air and ocean freight.

III. THE COMPLAINT ADEQUATELY PLEADS FRAUD UNDER §10(b) AND RULE 9(b)

In Fecht v. Price Co., 70 F.3d 1078, 1083 (9th Cir. 1995), cert. denied, ___ U.S. ___, 116 S. Ct. 1422 (1996), the Ninth Circuit upheld a complaint alleging "facts that reveal that the statements failed to reflect the Company's true condition at the time the statements were made."⁽⁶⁾ Plaintiffs in Fecht had alleged that "the positive statements about [a retail chain's] expansion program were false when made because, in truth, the new stores were losing money and the program overall was doing so poorly that it would have to be curtailed or abandoned." 70 F.3d at 1083. Finding these allegations sufficient, the court said that "[a] plaintiff may 'draw on contemporaneous statements or conditions' to demonstrate why statements were false when made." Id. (citation omitted).⁽⁷⁾

The purpose of Rule 9(b) is to provide defendants adequate notice of the claims against them. Where, as here, there is direct evidence of fraud -- for example, contemporaneous inconsistent facts that are later revealed -- "a plaintiff may simply set forth these facts . . . and satisfy Rule 9(b)." Id. at 1082-83. "A plaintiff may also satisfy Rule 9(b) with allegations of circumstantial evidence if the circumstantial evidence alleged explains how and why the statement was misleading when made." Id. at 1083. Plaintiffs have pled the specific content of defendants' false or misleading statements and allege, based in part on defendants' admissions, why those statements were false when made. ¶78.⁽⁸⁾ No more is required. 

IV. PLAINTIFFS' ALLEGATIONS ARE ADEQUATELY PARTICULAR

A. Plaintiffs' Allegations Of False Financial Statements State Federal Securities Laws Claims

1. Fritz's False Financial Statements Are Adequately Pled

Plaintiffs plead specific facts -- many admitted by defendants -- explaining why the financial statements were false and misleading:

Fritz failed to record at least $10 million of acquisition costs, and inflated earnings by at least $6.6 million, or approximately $.40 per share, for the five months ended May 31, 1995 and each subsequent quarter. ¶¶99, 101.

Fritz's May 31, 1995 financial statements disguised at least $1.3 million of Intertrans ordinary bad debt as a merger-related cost. ¶103.⁽¹²⁾

Fritz fraudulently recorded $26 million of potential merger candidates' pre-acquisition revenues as its own, before the mergers took place, and recorded $7 million in revenues from sales defendants admit did not exist. ¶¶106, 107.

Fritz improperly recapitalized $2.1 million in software development costs during the third quarter ended February 29, 1996, which were previously written off as merger costs. ¶108.

Fritz failed to account for uncollectible accounts receivable, including $4.7 million of Intertrans' accounts receivable over one year old, and another $5 million of other receivables. ¶¶110-11.

2. The Restatement Confirms Material Errors In The Original Financial Statements When Issued

Defendants claim that "restatement does not (as a matter of law or logic) establish that these original estimates were 'false when made.'" Defs' Brf. at 12. But the reasons for the restatement are powerful evidence of falsity: improper recognition of phantom and unsupported revenue, ordinary business expenses disguised as merger costs, improper capitalization of software costs and improper recognition of $26 million of other companies' revenue as if earned by Fritz, before those deals were completed. ¶¶99-114. While a restatement of financial statements is not a per se admission of securities fraud, it is an admission that the originally issued financial statements contained material errors when issued.⁽¹⁵⁾ ¶100. Defendants suggest the $10 million third quarter 1996 retroactive restatement to include additional merger costs reflected an honest change in its previous, good faith "accounting estimate" after "new information" came to light. But the Complaint alleges in great detail that defendants deliberately or recklessly violated GAAP in the first instance and restated their third quarter only at Peat's insistence. ¶¶95-114. GAAP draws a clear distinction between accounting for an error and accounting for a simple change in estimate, and mandates different treatment:

A change in an [accounting] estimate should not be accounted for by restating amounts reported in financial statements of prior periods or by reporting pro forma amounts for prior periods.

Conversely, to correct an error or irregularity, GAAP and GAAS require restatements (as alleged in the Complaint, ¶100, and by the very accounting standard cited by defendants):

A major distinguishing feature of a correction of an error [as opposed to change in estimate] is that the financial statements of the affected prior period, when originally issued, should have reflected the adjustment . . . . The Board concluded that a correction of an error, as defined above, should continue to be reflected by restating the financial statements of the affected prior period.

Under GAAP, the need to restate previously reported financial statements thus arises only from facts known or knowable at the time they were issued and does not arise from a "change in estimate." By restating its prior financial statements, Fritz has conceded that the failure to recognize the $10 million in merger costs, the $2.1 million in software costs and the improper recognition of $33 million in revenue was not merely a "change in estimate," but rather a "material error or irregularity."⁽¹⁶⁾

B. Misstatements Concerning The Success Of The Intertrans Merger

Defendants feebly assert that "plaintiffs fail to identify any statement by defendants that the integration of [Fritz and Intertrans] was 'complete' or that the Intertrans accounting system had been successfully adopted." Defs' Brf. at 9. In fact, plaintiffs identify several such statements. See ¶¶51, 55, 76. For example, in his letter to shareholders issued on October 16, 1995, defendant Lynn Fritz writes:

The first quarter of our new fiscal year -- which now ends on May 31, 1996 -- was an important period of growth and integration for Fritz Companies, as we successfully merged Intertrans Corporation into our global operations.

C. Defendants' Misstatements Concerning Fritz's Other Acquisitions

that defendants misrepresented acquisition profits and the costs of the acquisition program; that Fritz used acquisition charges to hide Fritz's payable amounts, bad debt, software costs, freight charges and other ordinary operating expenses enabling Fritz to disguise its deteriorating financial condition and failure to properly accrue for ordinary business expenses.

V. THE BASES FOR PLAINTIFFS' CLAIMS ARE PROPERLY SET FORTH

Even if plaintiffs' statement that some allegations are based on counsel's investigation is deemed "pleading on information and belief" (which plaintiffs do not concede), plaintiffs have provided all of the appropriate "facts on which that belief is formed" pursuant to 15 U.S.C. §78u-4(b)(1). Plaintiffs allege defendants' control of Fritz' corporate reports and filings, ¶25; defendants' restatement of Fritz's third quarter fiscal 1996 financial statements and reversal of $33 million in revenue, ¶¶95-114; defendants' due diligence examination of Intertrans in advance of the acquisition, during which defendants learned about the problems with the Intertrans system, ¶¶34, 40; defendants' July 24, 1996 admissions in the press release and conference call with analysts, that defendants had known from the beginning of the problems with the merger and Fritz's accounting system, ¶78; the information in the restated 10-QA, ¶81; and the Peat workpapers plaintiffs obtained, ¶¶91-93.⁽¹⁹⁾

Before the PSLRA, the Ninth Circuit permitted pleading "information and belief" pleading if it was accompanied by the facts upon which the belief is based, which is the same standard adopted by Congress. Wool, 818 F.2d at 1439; Moore v. Kayport Package Express, Inc., 885 F.2d 531, 540 (9th Cir. 1989). See 15 U.S.C. §78u-4(b)(1). Ninth Circuit precedents interpreting this standard in securities fraud cases still govern,⁽²⁰⁾ and those standards are more than met here. Furthermore, whether a complaint adequately alleges the facts underlying the pleader's information and belief is inseparable from whether the complaint satisfies Rule 9(b). No Ninth Circuit decision has ever held a §10(b) information-and-belief complaint satisfied Rule 9(b)'s particularity requirement but failed to adequately plead the facts upon which the information and belief was based.

Defendants would require plaintiffs to divulge plaintiffs' counsel's work product.⁽²¹⁾ Neither pre-existing case law nor the PSLRA, which merely codified the existing rule, require plaintiffs to plead with reference to sources or specific documentary evidence. See 15 U.S.C. §78u-4(b)(1); Powers v. Eichen, No. 96-1431-B(AJB), 1997 U.S. Dist. LEXIS 10881, at *5 (S.D. Cal. May 23, 1997) (rejecting argument that plaintiffs must plead "evidentiary facts" under PSLRA (citing Fecht, 70 F.3d at 1082)); GlenFed, 42 F.3d at 1548; Warshaw, 74 F.3d at 960; see also Wool, 818 at 1440 (pre-PSLRA case) (a plaintiff only needs to allege facts to meet information and belief standard).⁽²²⁾ Plaintiffs have met the pleading standard and are not required to reveal their counsel's work product. 

VI. PLAINTIFFS HAVE SATISFIED THE PSLRA'S PLEADING REQUIREMENT FOR SCIENTER

A. Motive And Opportunity Are Adequately Pled

1. The May 1996 $75 Million Debenture Offering Was Completed After Fritz's False Financial Statements Were Issued

[T]he timing of the changes in accounting policy and the charge back following the issue [of stock] also constitutes circumstantial evidence of knowledge of the misleading impression made by the changes.

2. Defendants Benefitted From The Fraud

Swept away by their own rhetoric, defendants claim that no matter how egregious their fraud, a lack of insider trading negates their scienter -- that scienter can never be shown absent substantial insider trading by the fraud's participants. But in McGann v. Ernst & Young, 102 F.3d 390 (9th Cir. 1996), cert. denied, ___ U.S. ___, 117 S. Ct. 1460 (1997) the Ninth Circuit reversed a judgment on the pleadings and expressly rejected a "traders only" rule:

The traders-only rule proposed by E&Y . . . would exempt from the remedial breadth of §10(b) a broad range of misinformation and market manipulation, so long as the perpetrators did not buy or sell securities . . . . Yet a party that introduces fraudulent information into the securities markets does no less damage to the public because that party did not trade stocks.

3. Defendants Used Artificially Inflated Fritz Stock To Acquire Other Companies

Plaintiffs make well-pled allegations of motive. They allege that all of the defendants gained heavily from an artificially inflated stock price during the class period: the insiders through sizable sales of their personal stock holdings; and the company through an important stock-financed acquisition.

B. Circumstantial Evidence Of Conscious Misbehavior Or Recklessness Has Been Adequately Pled

1. Defendants' Control Of Fritz And Fritz's False And Misleading Statements Are Circumstantial Evidence Of Scienter

In Cosmas v. Hassett, 886 F.2d 8, 12-13 (2d Cir. 1989), plaintiffs contended that a company's optimistic sales and revenue projections were misleading because of import restrictions imposed by the People's Republic of China ("PRC"). The Second Circuit held plaintiffs pled "facts which give rise to a strong inference that the defendants possessed the requisite fraudulent intent," simply by "alleg[ing] facts from which one can reasonably infer that sales to the PRC were to represent a significant part of [the company's] business." Id. at 13.

These facts give rise to a strong inference that the defendants, who the amended complaint alleges were directors of [the company], had knowledge of the PRC import restrictions, since the restrictions apparently eliminated a potentially significant source of income for the company.

Id.⁽³³⁾

In Provenz, 102 F.3d at 1491, the Ninth Circuit reversed summary judgment, stating that despite a lack of insider trading, a material fact nonetheless existed as to a particular defendant's scienter, because "Ludvigson made many of the allegedly false and misleading statements to the analysts during the . . . conference calls," and "was personally involved in and approved each decision to record revenue for the licensing agreements . . . ." Plaintiffs' allegations of control and involvement more than meet these standards.⁽³⁴⁾

2. Defendants' Admitted GAAP Violations Are Circumstantial Evidence Of Scienter

Moreover, the enormous size of the restatement -- a $22.5 million charge and a reversal of $33 million in revenue, and its cause -- defendants' decision to prematurely recognize millions in revenue from the companies Fritz acquired before the effective date of those acquisitions, improperly capitalize Fritz's software development costs and improperly reserve for its receivables and merger costs, all in violation of then-existing GAAP principles -- also support an inference that defendants knew of or recklessly disregarded that Fritz was overstating its earnings.⁽³⁵⁾ In Rehm, 954 F. Supp. 1246, the court held:

[T]he magnitude of reporting errors may lend weight to allegations of recklessness where defendants were in a position to detect the errors. In re Leslie Fay Companies, Inc. Sec. Litig., 835 F. Supp. 167, 175 (S.D.N.Y. 1993)(rejecting independent auditor's motion to dismiss where allegations of large accounting errors gave rise to inference of scienter). The more serious the error, the less believable are defendants protests that they were completely unaware of Eagle's true financial status and the stronger is the inference that defendants must have known about the discrepancy.

While defendants desperately downplay the significance of Fritz's multimillion dollar restatement and virtually ignore the $33 million dollar revenue reversal, as set forth in §IV.A.2. above, defendants' restatement is an admission those financial statements contained material errors and did not conform to GAAP when issued. ¶¶100-101.⁽³⁶⁾ "A violation of [GAAP] may be used to show that a company overstated its income, which may be used to show the scienter for a violation of Section 10(b) and Rule 10b-5," and "[w]hen combined with other circumstances suggesting fraudulent intent . . . allegations of improper accounting may support a strong inference of scienter." Marksman, 927 F. Supp. at 1313 (citation omitted).⁽³⁷⁾

Likewise, defendants' statements (and subsequent contradictory admissions)⁽³⁸⁾ to the effect that the Intertrans merger was completed, was increasing Fritz's margins and contributing to strong earnings growth also constitute circumstantial evidence defendants acted with scienter.⁽³⁹⁾ Moreover, the timing of the announcement of the restatement and additional charges on July 24, 1997, close on the heels of defendants' May 9, 1997 $75 million private debt placement and without any intervening industry-wide event, is also circumstantial evidence of defendants' scienter. Fecht, 70 F.3d at 1083; Flecker, ¶99,436, at 96,859 (proximity of bad news to public offering circumstantial evidence of scienter); Powers v. Eichen, No. 96-1431-B(AJB), slip. op. at 11 (S.D. Cal. Mar. 13, 1997) (proximity of bad news to the dates defendants made optimistic statements supported strong inference of scienter) (Hodges Decl., Ex. E). These allegations are entitled to greater weight because the false financial statements allowed Fritz's private debt placement to go forward, obtaining $75 million for the Company. Fecht, 70 F.3d at 1084 (citing GlenFed, 42 F.3d at 1550). The Complaint thus alleges specific facts which raise a strong inference of defendants' actual knowledge or reckless disregard that there was no reasonable basis for their improper accounting, GAAP violations or public statements of a successful merger and strong growth -- meeting the "conscious misbehavior" test. 

3. The Annual Audit Cannot "Refute" Defendants' Scienter

Moreover, the Ninth Circuit rejected this very argument in the context of a motion for summary judgment in Provenz, 102 F.3d at 1491. In Provenz -- a case where there was no restatement -- the district court agreed that defendants' good faith was evidenced by defendants' allowing their accountant to audit the defendant Company's practices and to review each quarter defendants' revenue recognition for specific transactions. The Ninth Circuit reversed, stating that, if "defendants withheld material information from their accountants, defendants will not be able to rely on their accountant's advice as proof of good faith." Id. at 1491. Whether defendants here withheld material information from their auditor is a factual question not appropriately resolved on this motion.⁽⁴¹⁾ See Plaintiffs' Motion to Strike. 

VII. CONCLUSION

FRITZ\JMI03540.BRF

1. Defendants are Fritz Companies, Inc. ("Fritz"), and its highest senior executives: (1) Lynn C. Fritz ("Lynn Fritz"), Chairman, President and CEO; (2) John H. Johung ("Johung"), Executive Vice President and CFO; (3) Dennis L. Pelino ("Pelino"), Executive Vice President, Chief Operating Officer and a Director; (4) Stephen M. Mattessich ("Mattessich"), Vice President and Controller; and (5) Carsten S. Andersen ("Andersen"), Executive Vice President, Director and Managing Director of Fritz's air freight operations -- the former Intertrans Corporation ("Intertrans") operations. ¶¶21, 22.

2. Paragraph references are to the Complaint.

3. The Company also terminated its controller and reassigned its CFO (defendants Mattessich and Johung). The stock has never recovered, nor was the full extent of the Fritz's financial fraud revealed in July 1996. In February 1997, Fritz began to leak additional negative information about operational weakness and receivables problems. On April 9, 1997, Fritz announced a $17 million receivable reserves increase and a $16.831 million net loss for the quarter ended February 28, 1997. ¶¶7, 83, 86-90.

4. This Court recently recognized that the standard for pleading false and misleading statements in securities fraud cases is the same as before the PSLRA, and that pre-PSLRA Ninth Circuit case law is still applicable. Hockey v. Medhekar, [Current Binder] Fed. Sec. L. Rep. (CCH) ¶99,465, at 97,080 (N.D. Cal. 1997). The Court must assume all factual allegations in the Complaint to be true and must construe all reasonable inferences to be drawn from these allegations in a light most favorable to plaintiffs. See North Star Int'l v. Arizona Corp. Com., 720 F.2d 578, 580 (9th Cir. 1983). Dismissal is appropriate only where it "`appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief.'" See Levine v. Diamanthuset, Inc., 950 F.2d 1478, 1482 (9th Cir. 1991) (quoting Conley v. Gibson, 355 U.S. 41, 45-46 (1957)).

5. Here, as elsewhere, emphasis has been added unless otherwise noted.

6. The Ninth Circuit in Warshaw v. Xoma Corp., 74 F.3d 955, 960 (9th Cir. 1996) stated:

Plaintiffs bought stock in Xoma Corporation. Xoma assured them that their principal product, E5, was in perfect shape with respect to safety and FDA approval. But E5 turned out to be useless and never approved by the FDA. Xoma stock lost most of its value. These assurances took place between March 2 and June 4, 1992, and the defendants knew they were largely untrue. Just on this skeletal analysis, we have no trouble deciding that the Complaint meets the Rule 9(b) standards set forth in GlenFed.

8. Several recent district court cases are instructive. See Fugman v. Aprogenex, Inc., 961 F. Supp. 1190, 1194 (N.D. Ill. 1997) (applying PSLRA, motion denied where each misstatement included a brief explanation why it was misleading); Friedberg v. Discreet Logic, 959 F. Supp. 42 (D. Mass. 1997) (motion rejected where, as here, the complaint set forth the actionable statements and why each was false and misleading); Page v. Derrickson, No. 96-842-CIV-T-17C, 1997 U.S. Dist. LEXIS 3673, at *26 (M.D. Fla. Mar. 24, 1997) (applying PSLRA, court ruled "'allegations which provide a reasonable delineation of the underlying acts and transactions allegedly constituting the fraud are sufficient'") (citation omitted); Freedman v. Louisiana-Pacific Corp., 922 F. Supp. 377, 388 (D. Or. 1996) ("'whether a public statement is misleading . . . is a mixed question to be decided by the trier of fact'") (quoting Fecht, 70 F.3d at 1080-81) (citing Durning v. First Boston Corp., 815 F.2d 1265, 1268 (9th Cir. 1987)).

9. Defendants' claim that the market knew of their financial fraud defies common sense. To avoid liability, a purportedly true disclosure must be made with a "degree of intensity and credibility sufficient to effectively counterbalance any misleading impression created by the [defendants'] one-sided representations." In re Apple Computer Sec. Litig., 886 F.2d 1109, 1116 (9th Cir. 1989). The market will only be presumed to have complete and accurate information where "both the 'true' and the 'false' information are transmitted to the market with 'roughly equal intensity and credibility.'" Marksman Partners, L.P. v. Chantal Pharm. Corp., 927 F. Supp. 1297, 1306 (C.D. Cal. 1996) (citation omitted). The Court, therefore, must weigh the impact on the market of defendants' discreet few sentences in a one hundred plus page proxy statement "warning" that merger expenses may increase and that future success is not guaranteed -- against defendants' multiple subsequent misleading press releases, public filings and a letter to shareholders during the Class Period. See Marksman, 927 F. Supp. 1297 (C.D. Cal. 1996) (rejecting defendants' claim that statement in appendix to Form 10-K adequately disclosed adverse information); Knapp v. Gomez, [1993 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶97,645, at 96,966 (S.D. Cal. 1993) (sustaining jury's verdict against individual defendants and auditor on scienter grounds, despite auditor's claim that a press release disclosing the huge reduction in the IPO was adequate to warn investors, because defendants were aware "the scaled back offering would dramatically impact ATV's liquidity"). Id.

10. Declaration of Helen J. Hodges in Opposition to Defendants' Motion to Dismiss and in Support of Cross-Motion to Strike ("Hodges Decl."), Ex. A is a chart setting out each alleged misstatement, the form of the misstatement, the date it was issued, the speaker, the substance and paragraph references to the Complaint's allegations explaining how the misstatement was false.

11. See, e.g., Provenz v. Miller, 102 F.3d 1478, 1484-86 (9th Cir. 1996), petition for cert. filed (May 5, 1997) (improper revenue recognition); In re Wells Fargo Sec. Litig., 12 F.3d 922, 926-27 (9th Cir. 1993) (inadequate reserves); Wool v. Tandem Computers, Inc., 818 F.2d 1433, 1435 (9th Cir. 1987) (incomplete sales); Blake v. Dierdorff, 856 F.2d 1365, 1370 (9th Cir. 1988) (savings and loan falsely portrayed its financial condition); Marksman, 927 F. Supp. at 1305 (violation of SFAS 48); In re Wall Data Sec. Litig., [1996-1997 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶99,292, at 95,745 (W.D. Wash. 1996) (accounting allegations upheld); In re Discovery Zone Sec. Litig., 943 F. Supp. 924, 934 (N.D. Ill. 1996) (improper accounting for pre-opening costs); Flecker v. Hollywood Entertainment Corp., [Current Binder] Fed. Sec. L. Rep. (CCH) ¶99,436, at 96,859 (D. Ore. 1997) (violations of GAAP). See also Blackie v. Barrack, 524 F.2d 891, 904 (9th Cir. 1975) ("Failure . . . to recognize that a portion of the accounts receivable . . . are uncollectible, and to create or adjust a reserve, will have the effect of inflating the balance sheet . . . and overstating the income . . . .").

12. Defendants respond by citing part of a Peat document relating to the May 31, 1996 financial statements (plaintiffs' allegation relates to 1995), which is neither cited in the Complaint nor a source of plaintiffs' allegation. See Plaintiffs' Motion to Strike, filed concurrently herewith. Importantly, defendants ignore that in this document, Peat acknowledged that bad debt "is not one of the direct costs contemplated by the applicable literature . . . ." Herrera Decl., Ex. J, at 8.

13. Wells Fargo, like defendants here, falsely represented in its SEC filings that it included all adjustments and provisions necessary for fair presentation of its results in conformity with GAAP. The Ninth Circuit held this was actionable: "Where a defendant affirmatively characterizes management practices as 'adequate' or loans as 'substantially secured,' 'a defendant declares the subject of its representation to be material to the reasonable shareholder, and thus is bound to speak truthfully.'" Wells Fargo, 12 F.3d at 930 (citation omitted). See ¶¶63, 69, 96. In Wall Data, ¶99,292, at 95,744, the court upheld accounting allegations identifying the specific customers, transactions, and amounts that were each improperly recorded, and explaining why the revenue was improperly booked. Id.

14. Fritz represented to Peat that its management closely monitored receivables, and conducted pre-merger due diligence and post-merger conversations about receivables with employees, during which plaintiffs allege defendants learned of the problems with Fritz's receivables. ¶¶91-93, 109-112.

15. Defendants' reliance on In re Cirrus Logic Sec. Litig., 946 F. Supp. 1446 (N.D. Cal. 1996) is baffling, as that case fully supports plaintiffs' financial fraud claims here. While defendants claim that Judge Orrick rejected "fraud claims that followed defendants' restatement of reported earnings, which led to a 30% stock price drop," Defs' Brf. at 13, in fact Judge Orrick upheld plaintiffs' restatement-based claims on summary judgment and after full opportunity for discovery. Cirrus, 946 F. Supp. at 1476-77.

16. Defendants rely upon Myles v. Midcom Comm., Inc., No. C96-614D (W.D. Wash. Nov. 19, 1996), Defs' Index, Ex. 10. While defendants aver "the Midcom court concluded that the company's subsequent restatement of its earnings was `irrelevant' to the issue of whether the initial statement was actionable," (Defs' Brf. at 15) the opinion actually says "such evidence is irrelevant in order to adequately plead securities fraud." Defs' Index, Ex. 10, at 18. The difference is significant. While the mere fact of a restatement may or may not be sufficient under the GlenFed analysis (42 F.2d at 1549) to show the original financial statements were false and misleading, the reasons for the restatement and its size, taken with other facts like defendants' admissions here, can be sufficient to plead securities fraud.

17. Defendants also made false statements about the success of the Intertrans merger before the Class Period, which plaintiffs allege artificially inflated the price class members paid for Fritz stock. See ¶¶36-38, 41, 42. See Defs' Brf. at 5-8. Defendants' invitation to strike statements outside the proposed Class Period should be declined, as they are admissions and provide context for plaintiffs' allegations. Defendants rely on In re Clearly Canadian Sec. Litig., 875 F. Supp. 1410 (N.D. Cal. 1995), a securities fraud case where the court denied defendants' motion to dismiss -- but there the court reached the unusual conclusion that because Rule 8 requires nothing more than a short plain statement of the alleged fraud, anything more than a short plain statement was improper.

18. Rule 11(b)(3) provides that the attorney who signs a pleading is "certifying that to the best of [his or her] knowledge, information, and belief, formed after an inquiry reasonable under the circumstances, the allegations and other factual contentions have evidentiary support or, if specifically so identified, are likely to have evidentiary support after a reasonable opportunity for further investigation or discovery."

19. Hodges Decl., Ex. B is a chart mapping the paragraphs in the Complaint where the bases for plaintiffs' allegations appear.

20. Wool states that "`in cases of corporate fraud, the plaintiffs cannot be expected to have personal knowledge of the facts constituting the wrongdoing.'" Wool, 818 F.2d at 1439 (citation omitted). Thus, a plaintiff may plead securities fraud on information and belief "if the allegations are accompanied by a statement of the facts upon which the belief is founded." Id. In such cases, "the allegations should include the misrepresentations . . . with particularity and, where possible, the roles of the individual defendants in the misrepresentations." Moore, 885 F.2d at 540. Section 21D(b)(1) tracks Wool's language requiring a complaint to state the "facts upon which that belief is founded." Under this standard, information-and-belief allegations are adequate if "[e]ach alleged misstatement is identified by content, date, and the document or announcement in which it appeared," and "the manner in which such representations were false and misleading." Wool, 818 F.2d at 1439-40. This tracks the Rule 9(b) requirement. Fecht, 70 F.3d at 1082-83; Warshaw, 74 F.3d at 960.

21. To require disclosure of counsel's work product or sources would be inconsistent with the New Act's requirement that §10(b) complaints must satisfy Rule 11. The Advisory Committee Notes to the 1983 Amendment to Rule 11 state:

The rule does not require a party or an attorney to disclose privileged communications or work product in order to show that the signing of the pleading, motion, or other paper is substantially justified.

23. See also Fugman, 961 F. Supp. at 1195; Page, 1997 U.S. Dist LEXIS 3673, at *27; Myles v. Midcom, (Defs' Index, Ex. 10); STI Classic Fund v. Bollinger Indus., No. CA 3:96-CV-0823-R, Report and Recommendation of United States Magistrate Judge at 2 (N.D. Tex. Oct. 25, 1996), adopted as a finding of the court, STI Classic Fund v. Bollinger Indus., Inc., No. CA 3:96-CV-0823-R, 1996 U.S. Dist. LEXIS 21082 (N.D. Tex. Nov. 12, 1996) (Hodges Decl., Ex. C); Fischler v. AmSouth Bancorp., No. 96-1567-CIV-T-17A, 1996 U.S. Dist. LEXIS 17670 (M.D. Fla. Nov. 14, 1996); In re Baesa Sec. Litig., 96 Civ. 7423, 1997 U.S. Dist. LEXIS 9663 (S.D.N.Y. July 9, 1997); In re Health Management, Inc. Sec. Litig., CV96-889(ADS), 1997 U.S. Dist. LEXIS 10665 (E.D.N.Y. July 21, 1997). See also Williams v. WMX Technologies, Inc., 112 F.3d 175, 178 (5th Cir. 1997); Sloane Overseas Fund v. Sapiens Int'l Corp., 941 F. Supp. 1369, 1377 (S.D.N.Y. 1996); Shahzad v. H.J. Meyers & Co., No. 95 Civ. 6196(DAB), 1997 U.S. Dist. LEXIS 1128, at *19-20 & n.6 (S.D.N.Y. Feb. 4, 1997).

24. Financial statements are expressly exempt from the PSLRA safe harbor. 15 U.S.C. §77z-2(b)(2)(A) (excluding forward looking statements contained in a financial statement prepared in accordance with GAAP). Compare Hockey, ¶99,465 at 97,079 (plaintiffs acknowledged all defendants' alleged false or misleading statements were forward looking). While defendants strive to portray reserves as forward looking, implying that an "actual knowledge" standard applies, plaintiffs allege that defendants then knew or recklessly disregarded that their improper accounting practices, including their reserve for the Intertrans merger, overstated Fritz's revenues and earnings and understated its reserves and expenses. ¶¶99-101. See, e.g., Wells Fargo, 12 F.3d at 926 (inadequate reserves stated a claim). In Shaw v. Digital Equipment Corp., 82 F.3d 1194, 1213 (1st Cir. 1996), the First Circuit rejected defendants' bespeaks caution argument, because the adequacy of a restructuring reserve "has both a forward-looking aspect and an aspect that encompasses a representation of present fact." In any event, the PSLRA does not apply retroactively to defendants' pre-December 22, 1995 conduct. See ¶¶44-61. In Hughes Aircraft Co. v. United States ex rel. Schumer, No. 95-1340, 1997 U.S. LEXIS 3719 (June 16, 1997), a unanimous Supreme Court held that because the 1986 amendment to the False Claims Act, which would have permitted the suit in question, did not expressly apply retroactively to pre-enactment conduct, qui tam suits regarding allegedly false claims submitted prior to the 1986 amendment had to be dismissed as required by the pre-1986 version of the False Claims Act.

25. As Fritz's top officers, who controlled Fritz's statements to analysts and the press, defendants' opportunity to commit the fraud cannot be subject to serious question. ¶¶22-23, 25. Rehm, 954 F. Supp. at 1249; Time Warner, 9 F.3d at 269.

26. In re Kidder Peabody Sec. Litig., [1995-1996 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶99,030, at 94,098 (S.D.N.Y. 1995) ("Kidder badly needed bank financing and the only way to get that financing was to show profitability."); Friedberg, 959 F. Supp. at 50-51 (proximity of time of secondary offering to negative announcements months later supported a strong inference of scienter).

27. In fiscal 1996 defendant Lynn Fritz obtained incentive compensation worth over $800,000; defendant Pelino over $759,000; and defendant Johung over $2.1 million. ¶26(d). Defendants' derision notwithstanding, courts have upheld similar allegations, in conjunction with other facts suggesting a motive, as probative of defendants' scienter. Defendants' reliance on Ferber v. Travelers Corp., 785 F. Supp. 1101, 1107 (D. Conn. 1991), is misplaced as there plaintiffs pled little more than the bare conclusion that defendants would benefit under the incentive plan. Even Acito v. IMCERA Group, 47 F.3d 47, 54 (2d Cir. 1995), relied upon by defendants, does not hold that defendants' compensation should never be considered; rather the court held that, "without more," incentive compensation was not enough to raise a strong inference of scienter. Marksman, 927 F. Supp. at 1312 (same); Freedman v. Value Health, 958 F. Supp. 745, 759 (D. Conn. 1997) ("plaintiffs' allegations transcend mere 'compensation for professional services,'" where portion of fee was contingent on completion of merger) (citation omitted).

28. See also Blake, 856 F.2d at 1369-70 (allegation defendants wanted to "'protect their executive and/or directorship positions and the substantial compensation and/or prestige they obtained thereby [and] obtain extra and or bonus compensation'" pled specific intent to commit fraud).

29. In Gross v. Medaphis Corp., No. 96-CV-2088-FMH (N.D. Ga. May 27, 1997) (Hodges Decl., Ex. D), a case with no insider trading, the court upheld allegations that defendants violated GAAP and inflated the company's stock price to use the inflated stock to acquire other companies. Id. at 16; Harvey M. Jasper Retirement Trust v. Ivax Corp., 920 F. Supp. 1260, 1264 (S.D. Fla. 1995) (complaint upheld where false statements by Ivax were alleged because "Ivax planned to acquire McGaw . . . [and] the higher Ivax's stock price was, the fewer Ivax shares would have to be issued").

30. Defendants' cases do not compel a different conclusion. Defendants rely on In re Ross Systems Sec. Litig., [1994 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶98,363 (N.D. Cal. July 21, 1994), but plaintiffs have met the Ross standard: a subsequent Ross decision, No. C-94-0017-DLJ, 1994 U.S. Dist. LEXIS 20385, at *8 (N.D. Cal. Dec. 5, 1994) stated an allegation that "identifies a particular transaction and what about it was erroneous" was sufficient, and noted "a plaintiff need not specify the exact dollar amount of each financial error," id. at *7, although plaintiffs have done so here. In Lovelace v. Software Spectrum, 78 F.3d 1015, 1020 (5th Cir. 1996) the court held that, in light of the language in the prospectus, plaintiffs merely claimed that "although Defendants disclosed reliance on rebates generally, Defendants did not specifically disclose reliance on rebates based on sales goals." Far more is alleged here. Glickman v. Alexander & Alexander Servs., [1995-1996 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶99,101 (S.D.N.Y. 1996), involved allegations of fraud against the parent company based on restatement of the subsidiary's financial statements and generalized motives of "increasing capital and preserving executive benefits." Id. at 94,639. The court noted these were implausible as the alleged fraud in the subsidiary only allowed the parent to record a "minute" reduction in losses. Id. Similarly, in Chill v. GE, 101 F.3d 263, 267 (2d Cir. 1996), the court dismissed plaintiff's case against GE, the corporate parent, based on a single trader's fraud at Kidder, Peabody, the separately operated subsidiary. Importantly, defendants repeatedly cite Chill but omit that in the related case, Kidder Peabody, ¶99,030, at 94,098, the court upheld plaintiffs' complaint in its entirety.

31. The Complaint also alleges that each of the individual defendants knew that Fritz had for a long time relied on improper accounting practices to inflate Fritz's revenues and earnings. ¶¶28-29, 33-34, 91.

32. Defendants assured their auditor that Fritz management closely monitored receivables. ¶¶92-93.

33. Similarly, in Cohen v. Koenig, 25 F.3d 1168, 1174 (2d Cir. 1994), the Second Circuit upheld "allegations that the [individual defendants] were officers, directors, and majority shareholders of the Koenig Group, that they 'were hands on managers active in [its] day to day operations,' and they were 'fully familiar with all aspects of [its] businesses and financial conditions and operations,'" as raising a strong inference. See also Beck v. Manufacturers Hanover Trust Co., 820 F.2d 46, 50 (2d Cir. 1987).

34. Likewise, in Wellcare, 964 F. Supp. at 639-40, the court found plaintiffs sufficiently alleged defendants' conscious or reckless behavior because plaintiffs alleged defendants knew of or encouraged the deliberate overstatement of earnings and understatement of reserves, in violation of GAAP. Courts routinely recognize that top executives are well aware of such material accounting abuses. See, e.g., STI Classic Fund, Hodges Decl., Ex. C, at 4 ("Based upon [defendants'] positions with the company, a strong inference may be drawn that they were knowledgeable about the methods and billing practices . . . which led to the over-stated sales and revenues reported in SEC filings signed by them."); Health Management, 1997 U.S. Dist. LEXIS 10665, at *31 (size of accounting fraud and defendants' personal involvement supported strong inference of scienter); Nationwide Cellular Service, Inc. v. American Mobile Communications, Inc., [1991-1992 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶96,435, at 91,889 (S.D.N.Y. 1991) (knowledge and control of the operations and books and records, and participation in allegedly fraudulent agreement held sufficient); In re Network Equipment Tech. Inc. Litig., 762 F. Supp. 1359, 1362 (N.D. Cal. 1991) (conduct alleged "'presents a danger of misleading investors -- who commonly rely on revenue figures -- that "is so obvious that the [Defendants] must have been aware of it"'") (citation omitted); In re Genentech, Inc. Sec. Litig., [1989-1990 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶94,960, at 95,372 (N.D. Cal. 1989) (finding a "strong inference of . . . scienter" where Genentech was "overstating revenue through the use of misleading accounting practices [and] [t]his material inside information remained unknown to other stockholders").

35. Defendants' reliance on Mathews v. Centex Telemanagement, Inc., [1994-1995 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶98,440 (N.D. Cal. 1994), is misplaced, as that case involved a motion for summary judgment and the court expressly noted the same arguments had been overruled at the pleading stage. Id. at 91,034. The court nonetheless recognized that accounting estimates are fraudulent "'if, when they were established, the responsible parties knew or should have known that they were derived in a manner inconsistent with reasonable accounting practices,'" which is exactly what plaintiffs allege here. Id. at 91,037 (citation omitted).

36. Marksman, 927 F. Supp. at 1315 n.14 ("Although not perfectly coextensive, the Financial Accounting Standards of GAAP and the anti fraud rules promulgated pursuant to §10(b) of the 1934 Securities Act serve similar purposes, and some courts have treated violations of the former as indicative that the latter were also violated.").

37. Here, as in Marksman, the individual defendants "controlled and approved the issuance of accounting and financial statements" for Fritz, and had "direct access to information concerning" the Company's financial condition and operations. Id. at 1314. ¶¶22-23, 25. Flecker, ¶99,436, at 96,859 ("violations of GAAP are also relevant to show scienter").

38. During the Class Period defendants falsely stated that "[t]he Company attributes its continued rapid growth to aggressive expansion . . . as well as a margin expansion resulting from its merger with Intertrans Corporation . . ." ¶51; "we successfully merged Intertrans into our global operations. This acquisition -- the largest in our history -- contributed significantly to our strong first quarter revenue and earnings growth, and will continue to yield operating benefits in the months and years ahead" ¶55; "'Following the very successful integration of Intertrans Corporation into the Fritz global network over the last year, my mission is complete.'" ¶76. In July 1996 they admitted the costly problems with the merger which started before the Class Period. ¶¶77, 78, 81.

39. Fugman, 961 F. Supp. at 1195 (defendants' statements insisting that system was "marketable," component was "adequate," and "commercially viable" when system was not operable held sufficient to plead scienter); see also Rehm, 954 F. Supp. at 1256 ("defendants' attempts to mollify public doubt about [their] financial health by putting an optimistic and reassuring 'spin' on otherwise damaging . . . reports, shows that defendants acted with knowledge of [their] deteriorating earnings").

40. Were defendants' view the law, financial fraud could never be pled against a publicly held company whose auditor negligently approves or fails to discover the underlying fraud. "Even compliance with GAAP will not immunize one who chooses not to disclose on a financial statement a known material fact." SEC v. Arthur Young & Co., 590 F.2d 785, 788 (9th Cir. 1979); Marksman, 927 F. Supp. at 1314 n.13 ("The fact that Chantal's independent auditor may have approved the accounting methods will not shield Chantal from liability for deception such methods may have caused."); In re Chambers Dev. Litig., 848 F. Supp. 602, 611-13, 619-21 (W.D. Pa. 1994); Siemens Information Systems, Inc. v. TPI Enterprises, Inc., [1991-1992 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶96,573, at 92,662 (S.D.N.Y. 1992) (denying motion to dismiss 10(b) claims despite arbitrator's finding defendants complied with GAAP: "Touche's compliance with GAAP does not resolve the issue of its fraud liability . . . .").

41. Moreover, Peat's conclusion that Fritz was "capable" of producing accurate reports does not respond to plaintiffs' allegations that Fritz intentionally violated GAAP to overstate revenues and earnings. ¶¶95-114.

1. That declarant is and was, at all times herein mentioned, a citizen of the United States and a resident of the County of San Diego, over the age of 18 years, and not a party to or interested in the within action; that declarant's business address is 600 West Broadway, Suite 1800, San Diego, California 92101.

2. That on August 5, 1997, declarant served the PLAINTIFFS' OPPOSITION TO DEFENDANTS' MOTION TO DISMISS AND MEMORANDUM OF POINTS AND AUTHORITIES IN SUPPORT THEREOF by depositing a true copy thereof in a United States mailbox at San Diego, California in a sealed envelope with postage thereon fully prepaid and addressed to the parties listed on the attached Service List and that this document was forwarded to the following designated Internet site at:

http://securities.milberg.com

I declare under penalty of perjury that the foregoing is true and correct. Executed this 5th day of August, 1997, at San Diego, California.

______________________________ DANELLE L. McNERTNEY

 

12 Oct 1997
Source: Milberg Weiss web file