Fritz Companies, Inc. - DEFENDANTS' REPLY MEMORANDUM IN SUPPORT OF MOTION TO DISMISS

Stanford University Law School - Securities Class Action Clearinghouse

WILLIAM F. ALDERMAN (State Bar No. 47381)
JOHN H. KANBERG (State Bar No. 113156)
TANYA HERRERA (State Bar No. 177790)
ORRICK, HERRINGTON & SUTCLIFFE LLP
Old Federal Reserve Bank Building
400 Sansome Street
San Francisco, CA 94111
Telephone: (415) 392-1122

TOWER C. SNOW, JR. (State Bar No. 58342)
DAVID M. FURBUSH (State Bar No. 83447)
BROBECK, PHLEGER & HARRISON LLP
Spear Street Tower, One Market
San Francisco, CA 94105
Telephone: (415) 442-0900

Attorneys for Defendants
Lynn C. Fritz, John H. Johung,
Dennis L. Pelino, Stephen M.
Mattessich, Carsten S. Andersen
and Fritz Companies, Inc.

UNITED STATES DISTRICT COURT

NORTHERN DISTRICT OF CALIFORNIA

SUSAN POLK, Trustee for the F. Felix
Polk, a Psychological Corporation Profit
Sharing Plan, SAMUEL WEISS, VIC
SHACKELFORD, E.M. LAWRENCE
LIMITED FROZEN RETIREMENT
TRUST dated September 1, 1992,
GEORGE LEVENSON, and IRVING
ROSENZWEIG, On Behalf of Themselves
and All Others Similarly Situated,

Plaintiffs,

vs.

LYNN C. FRITZ, JOHN H. JOHUNG,
DENNIS L. PELINO, STEPHEN M.
MATTESSICH, CARSTEN S.
ANDERSEN and FRITZ COMPANIES, INC.,

Defendants.

________________________________________

In re FRITZ COMPANIES SECURITIES
LITIGATION

________________________________________

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Master File No. C 96-2712 MHP

DEFENDANTS' REPLY
MEMORANDUM IN SUPPORT OF
MOTION TO DISMISS

Date: September 12, 1997
Time: 10:30 a.m.
Courtroom: 11, The Honorable
Marilyn Hall Patel

I. INTRODUCTION

II. PLAINTIFFS' OPPOSITION CONFIRMS THAT THEIR COMPLAINT DOES NOT EXPLAIN HOW ANY STATEMENT WAS ALLEGEDLY FALSE WHEN MADE

A. Plaintiffs Cannot Base Securities Fraud Claims On A Hindsight Challenge of the Intertrans Merger Accounting
B. Plaintiffs Fail to Identify any Misstatement Concerning Integration of the Intertrans Operations
C. Plaintiffs State No Cognizable Claim Based Upon The Announcement of Other Fritz Acquisitions

III. FRITZ'S RESTATEMENT DOES NOT ESTABLISH EITHER AN ACTIONABLE MISSTATEMENT OR ANY INFERENCE OF SCIENTER

IV. PLAINTIFFS' OPPOSITION CONFIRMS THEIR FAILURE TO ESTABLISH A "STRONG INFERENCE" OF SCIENTER UNDER ANY STANDARD

A. Plaintiffs Have Confirmed that Their Fraud Allegations Are Primarily Based Upon Forward-Looking Statements or Omissions
B. Plaintiffs' New Arguments Still Fail to Suggest any Conceivable Motive That Might Support A "Strong Inference" of Scienter
C. Plaintiffs Conspicuously Fail to Address KPMG's Unqualified Audit and the Supportive Management Letters that put the Lie to Their Fraud Allegations

TABLE OF AUTHORITIES

CASES

In re Cirrus Logic Sec. Litig.,
946 F.Supp. 1446 (N.D. Cal. 1996)

In re Convergent Tech. Sec. Litig.,
948 F.2d 507 (9th Cir. 1991)

In re Glenfed, Inc. Sec. Litig.,
42 F.3d 1541 (9th Cir. 1994)(en banc)

Hollinger v. Titan,
914 F. 2d 1564 (9th Cir. 1990)(en banc)
cert. denied, 499 U.S. 976 (1991)

Kaplan v. Rose,
49 F.3d 1363 (9th Cir. 1994),
cert. denied, 116 S.Ct. 58 (1995)

Leonard v. NetFRAME Systems, Inc.,
[1995 Tr. Binder] Fed. Sec. L. Rep.
(CCH) ¶ 98,793 (N.D. Cal. Aug. 8, 1995)

In re Lotus Dev. Corp. Sec. Litig.,
875 F.Supp. 48 (D.Mass. 1995)

Lovelace v. Software Spectrum, Inc.,
78 F.3d 1015 (5th Cir. 1991)

Matthew v. Centex Telemanagement, Inc.,
[1994-95 Tr. Binder] Fed. Sec. L. Rep.
(CCH) ¶ 98,440 (N.D. Cal. June 8, 1994)

In re Oak Technology Sec. Litig.,
1997 WL 448168 (N.D. Cal. August 1, 1997)

In re Silicon Graphics, Inc. Sec. Litig.,
[Current Tr. Binder] Fed. Sec. L. Rep.
(CCH) ¶ 99, 468 (N.D. Cal. May 23, 1997)

In re Software Toolworks, Inc. Sec. Litig.,
50 F.3d 615 (9th Cir. 1994), cert. denied sub nom.,
Montgomery Securities v. Dannenberg,
116 U.S. 274 (1995)

In re Valence Technology Sec. Litig.,
[1995 Tr. Binder] Fed. Sec. L. Rep.
(CCH) ¶ 98,793 (N.D. Cal. May 8, 1995)

In re Verifone Sec. Litig.,
11 F.3d 865 (9th Cir. 1993)

In re Wells Fargo Sec. Litig.,
12 F.3d 922 (9th Cir. 1993),
cert. denied, 513 U.S. 917 (1994)

In re Worlds of Wonder Sec. Litig.,
35 F.3d 1407 (9th Cir. 1994),
cert. denied, 116 S. Ct. 185 (1995)

Zeid v. Kimberley,
930 F.Supp. 431 (N.D. Cal. 1996)

STATUTES AND RULES

Private Securities Litigation Reform Act of 1995,
15 U.S.C. §§78a, et seq.

§ 21E(b)(2)(A)
§ 21E(c)(1)(B)
§ 21E(i)(1)(A)
§ 21E(i)(1)(C)

Fed. R. Civ. Proc. 9(b)

MISCELLANEOUS

Accounting Changes, Accounting Principles
Board Opinions No. 20 (1971)

I. INTRODUCTION

In May 1995, when Fritz shareholders approved the Company's merger with Intertrans Corporation, they were cautioned that a "potentially negative factor" of this transaction was the "cost of integrating the business and transaction expenses arising from the merger which will have an adverse effect on operating results." Proxy p. 13. The Company further apprised investors that this business combination "will present difficult challenges" and that "[t]here can be no assurance that integration will be accomplished smoothly or successfully." Id. p. 22. With respect to the potential costs of this merger, Fritz specifically warned that integration expenses -- which were "expected to include the estimated costs associated with workforce reductions" -- "cannot be determined at this time" and "there can be no assurance that Fritz will not incur additional charges in subsequent quarters to reflect costs associated with the Merger." Id.

As forewarned, Fritz announced on July 24, 1996 that it was recording $10 million in merger expenses for the just-completed fourth quarter, and was restating its third quarter expenses to reflect additional merger costs of $4.6 million. The Company explained -- in words that remain unchallenged by plaintiffs -- that "we underestimated final costs related to the full integration of the two companies" and that these costs had increased due to "the Company's decision to reduce headcount by approximately 200 more people than was originally anticipated." Herrera Decl. Ex A. In a candid self-assessment that plaintiffs now mistake for "contemporaneous adverse facts," Fritz concluded that it had "erred in adopting the Intertrans accounting system, as it has proven inadequate, especially given our rapid growth." Id.

Based solely on a stock price drop that followed this adverse development, plaintiffs have concluded that there must somehow be a securities fraud claim hidden somewhere behind the Company's announcement of this "disappointing surprise." Id. Yet after many months, numerous opportunities and undeserved discovery, the basis for plaintiffs' imagined fraud claim remains a mystery. Because the Ninth Circuit requires particularized factual allegations that explain how any alleged misstatement was false when made, plaintiffs cannot simply rely on hindsight allegations that "an allegedly fraudulent statement and a later statement are different." In re Glenfed, Inc. Sec. Litig., 42 F.3d 1541, 1549 (9th Cir. 1994) (en banc) (holding that a plaintiff is "generally required to elaborate circumstances contrary to the alleged false statement to explain how and why the statement was misleading when made"). Moreover, because the Reform Act further requires particularized factual allegations that establish a "strong inference" of scienter, plaintiffs cannot ignore the assurances provided by Fritz's independent auditors and rely solely on irrational speculation that these defendants purposefully adopted a defective accounting system in pursuit of a "get poor quick" scheme.

Nor can plaintiffs survive the absence of adverse contemporaneous facts by simply repeating, but never supporting the claim that these defendants somehow "admitted" wrongdoing. Plaintiffs summarily claim that Fritz "admitted" it: (a) "knew from the beginning of the problems with the Intertrans accounting system," Oppos. p. 4; (b) violated GAAP, id.; and (c) "knew contemporaneous facts which rendered Fritz's [public statements] materially false and misleading." Id. p. 4. In reality, nothing in plaintiffs' Complaint supports this desperate mischaracterization and -- as plaintiffs elsewhere concede, Oppos. pp. 10 and 11 n. 16 -- Fritz's restatement of certain third quarter revenues and expenses does not imply that any prior accounting treatment was "false when made."¹

Significantly, while plaintiffs plainly have failed to satisfy either the Glenfed or the Reform Act standards, they cling to the argument that these pleading requirements can be bypassed with the faint hope that "evidentiary support will likely exist for these claims." Compl. ¶ 125. As a matter of law, however, plaintiffs cannot simply point to Fritz's voluntary restatement and conclude that prior representations were actionable or that any defendant acted with scienter. Because plaintiffs' Opposition now confirms that their allegations are no more than a superficial exercise in second-guessing every statement made by Fritz during (as well as before and after) the class period -- and because the only "strong inference" in this case refutes scienter -- the present Complaint cannot serve as the predicate for a federal securities class action.

II. PLAINTIFFS' OPPOSITION CONFIRMS THAT THEIR COMPLAINT DOES NOT EXPLAIN HOW ANY STATEMENT WAS ALLEGEDLY FALSE WHEN MADE

Plaintiffs now contend that they have satisfied all pleading requirements because "[t]he Complaint presents specific and very detailed allegations of defendants' material misrepresentations and omissions." Oppos. p. 2. However, the point of Glenfed and the Reform Act clearly is not that fraud claims must be buried beneath pages of meaningless detail. See In re Oak Technology Sec. Litig., 1997 WL 448168 (N.D.Cal. August 1, 1997)(rejecting complaint that "sets forth numerous 'adverse material facts' but contains only conclusory allegations that the 'adverse material facts' were in existence or known by defendants at the time the allegedly misleading statements were made"). While the plaintiffs must, as a threshold matter, "state precisely the time, place, and the nature of the misleading statements," Kaplan v. Rose, 49 F.3d 1363, 1370 (9th Cir. 1994), cert. denied, 116 S.Ct. 58 (1995), this could easily have been done by simply attaching the documents upon which they purportedly rely. Because Glenfed makes clear that the essence of Rule 9(b) is the requirement that plaintiffs identify particularized facts "which constitute the fraud," 42 F.3d at 1548 (emphasis original), plaintiffs cannot, as they have attempted here, "mistake quantity for particularity" and substitute detailed recitals of the Company's own announcements for particularized factual allegations that demonstrate how any statement was false when made. Oak Technology *3.

Ironically, plaintiffs have highlighted several of their pleading failures by now offering a chart (Hodges Ex. A) that -- for the first time -- purportedly informs the defendants of "each alleged misstatement, the form of the misstatement, the date it was issued, the speaker, the substance and paragraph references to the complaints' allegations explaining how the misstatement was false." Oppos. p. 7 n. 10 (emphasis original). This chart is not only far "too little too late," it reveals that plaintiffs rely on just eight (8) boilerplate paragraphs to provide the Glenfed-mandated explanation as to how every alleged misstatement was false when made. (Indeed, because these paragraphs are largely duplicative, see Compl. ¶¶ 50, 61, 67, 75 and 45, 56, 64, 70, plaintiffs' claims are actually premised on just two (2) paragraphs from this 77-page pleading.) As shown below, plaintiffs' belated acknowledgment of the flimsy basis for their fraud claims now compels their dismissal.

A. Plaintiffs Cannot Base Securities Fraud Claims On A Hindsight Challenge of the Intertrans Merger Accounting

In arguing that their Complaint adequately explains why Fritz financial statements when issued were false, see Oppos. p. 8-10, plaintiffs cite a series of paragraphs that are not even identified in the Hodges Chart. Compl. ¶¶ 99, 101, 103, 106, 107, 108, 110-111. However, this confusion cannot hide the fact that nowhere in the Complaint do plaintiffs allege any "circumstances contemporary to the alleged false statements to explain how and why the statement was misleading when made." Glenfed, 42 F.3d at 1549. Rather than the "admissions" and "explanations" that are touted in plaintiffs' Opposition, their Complaint rests on the following bare conclusions:

Compl. ¶ 99, cited at Oppos. p. 6.:

"Fritz improperly failed to record at least $10 million of costs and expenses associated with recent acquisitions and mergers. . . . Defendants knew, or were reckless in not knowing, that these costs would be incurred at the time of the merger, yet did not disclose this to investors until late July 1996. . . ."

Plaintiffs do not suggest what costs or expenses should have been recognized, or when, or in connection with which "recent acquisition [or] merger." There is absolutely no factual allegation to support even the existence, at the beginning of the alleged class period, of merger expenses that were incurred at the end of this period.² Instead, plaintiffs simply conclude that Fritz "knew" -- at some unspecified time, for entirely unspecified reasons, and despite the unqualified audit of KPMG -- of $10 million in merger expenses "incurred at the time of the [May 1995] merger" solely because the Company later announced a $10 million merger charge for the fourth quarter ending May 31, 1996. As the Ninth Circuit and the Northern District Courts have observed, "[t]o adequately state a claim for accounting fraud, plaintiff must . . . identify particular transactions underlying defendants' alleged accounting deficiencies. In re Wells Fargo Sec. Litig., 12 F.3d 922, 926-27 (9th Cir. 1993), cert. denied 513 U.S. 917 (1994)." Oak Technology *7.

Compl. ¶ 103, cited at Oppos. p. 8:

"[I]n the May 31, 1995 financial statements, Fritz buried at least $1.3 million of Intertrans bad debt as merger/restructuring costs, when the bad debt costs were ordinary business costs. . . . Fritz knew that these receivables were uncollectible long before the merger, as it had identified them during its due diligence."

Contrary to the very cases now relied upon by plaintiffs, this allegation does not identify why any particular debt, from any account, should have been written off as uncollectible at any given time.³
Moreover, despite KPMG's audit of these financial statements, plaintiffs provide no explanation as to how any costs were improperly categorized. On its face, this claim simply presumes clairvoyance ("Fritz knew that these [unidentified] receivables were uncollectible") and is unsupported by contemporaneous facts supporting plaintiff's conclusion. As courts throughout the Ninth Circuit have concluded, Glenfed does not permit securities fraud claims based upon summary allegations that unidentified defendants must have discovered unspecified adverse facts during an undescribed due diligence investigation. See In re Valence Technology Sec. Litig., [1995 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,793 at 92,795 (N.D.Cal. 1995)(rejecting generalized allegations that defendants "became aware of" adverse information during a due diligence investigation as "conclusory allegations [that] lack the necessary specificity to satisfy Rule 9(b)").

Oppos. p. 9 citing Compl. ¶¶ 106, 107:

"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."

Plaintiffs rely entirely upon sleight of hand with these hindsight claims selectively recasting portions of Fritz's own third quarter restatement.⁴ While plaintiffs repeatedly claim that Fritz's restatement "admitted" a $26 million error, it is clear that the determination of "effective control" for purposes of revenue recognition is inherently a case-specific accounting judgment. Moreover, while plaintiffs have breathlessly claimed that "the enormous size of the restatement" supports an inference of fraud, Oppos. p. 22, it is undisputed that Fritz's adjustment of the date of recognition of "acquisition" revenues also reduced associated expenses by more than $25 million. Thus, while plaintiffs portray this adjustment as a $26 million issue, it actually had just an $8 million impact on net revenue and barely a $500,000 impact on net income for the quarter. As demonstrated by a glance at Fritz's unchallenged Form 10Q/A, this restatement reduced Fritz's originally-stated quarterly net revenue by less than 7% and its net income by less than 6%. The impact of this restatement on annual net revenue and income was less than 2%. See Supplemental Herrera Decl. Ex. A and In re Convergent Tech. Sec. Litig., 948 F.2d 507, 514 (9th Cir. 1991)(holding that a revenue shortfall of 10% was not material).

Likewise, plaintiffs' fleeting reference to $7 million in allegedly "non-existent" revenues is revealing for what it does not allege. The Complaint does not identify any particular sale, to any particular customer, that was allegedly improperly recognized as revenue. This failure is not surprising because, in reality, Fritz simply determined that these sales were most appropriately recognized in a subsequent period. Despite their misleading rhetoric, plaintiffs can plead no facts to support the suggestion that any Fritz revenues were "non-existent," that these payments (which were undeniably received by the Company) were not "reasonably assured" at any particular time, or that any accounting judgment by the Company (and its independent auditors) was "false when made." See Oak Technology *7 ("To adequately plead financial fraud based on improper revenue recognition, plaintiffs must allege, at a minimum, some particular transactions where revenues were improperly recorded, including the names of the customers, the terms of the specific transactions, where the transactions occurred, and [not] merely . . . estimating the net effect of the alleged improper revenue recognition").

Compl. ¶¶ 110-111, cited at Oppos. p. 9:

"Fritz knew, or was reckless in not knowing, that collection of certain Intertrans accounts receivables was doubtful based an [sic] information acquired during its pre-merger due diligence and post-merger conversations with ex-Intertrans, now Fritz employees.... Additionally, Fritz knew that its allowance for uncollectible receivables was wholly inadequate to cover anticipated bad debt."

While plaintiffs now contend that this allegation is adequate because it pleads "that defendants knew specific amounts of receivables related to prior periods," Oppos. p. 9, this argument simply highlights the hindsight nature of their pleading. The only "specific amounts" identified by plaintiffs are the charges that Fritz subsequently took for bad debt. See Zeid v. Kimberley, 930 F.Supp. 431, 436 (N.D.Cal. 1996)("[W]ithout contemporaneous facts, the only possible basis for plaintiffs' assertions is the [defendants'] disclosure. . . . As such, plaintiffs' allegations of false and misleading company statements are no more than 'fraud by hindsight' and are therefore insufficient under Rule 9(b)"). There is no attempt to identify the "certain Intertrans accounts receivable" in question, why any such accounts should have been considered "doubtful" at any prior date, or who allegedly said what to whom in any conversation concerning this subject.

Likewise, the only support offered for plaintiffs' claim that "Fritz knew" it had recorded inadequate bad debt reserves is the hindsight observation that the Company subsequently absorbed an additional charge for uncollectible receivables. Plaintiffs have conspicuously ignored KPMG's contemporaneous assurance that, considering the debt collection history of Fritz and Intertrans, the Company's reserves were adequate. See Herrera Ex. J, p. KPM 001860. Instead, plaintiffs resort to a misleading and meaningless chart (Complaint Ex. A) that says nothing about the adequacy of Fritz's debt reserve, but simply demonstrates that an unchanged amount of reserve will modestly decrease as a percentage of accounts receivable if there is an increase in such accounts. As the Zeid court observed when facing a similar pleading, "the Complaint is devoid of any contemporaneous facts which tend to show that the allegedly misleading statements were false when made." Zeid, 930 F.Supp. at 436.

B. Plaintiffs Fail to Identify any Misstatement Concerning Integration of the Intertrans Operations

Plaintiffs' Opposition claims reliance upon four statements concerning the Intertrans merger, each of which is allegedly followed by "a descriptive paragraph describing how the representation was false and misleading when made." Oppos. p. 11; but see Hodges Ex. A and Compl. ¶ 76 (no allegation suggesting how any statement was misleading). These statements, on their face, fail to support the following fraud theories that are offered by plaintiffs:

Compl. ¶ 56(b): "The Intertrans accounting system, which Fritz adopted for its air freight forwarding and ocean freight forwarding businesses, was not integrated with Fritz's operations system."
Compl. ¶ 56(c): "The Intertrans accounting system required substantial accounting assumptions and estimates and subsequent reconciliations, and when combined with Fritz's inadequate system of internal controls and termination of many key Intertrans employees, prevented Fritz from timely and accurately preparing its financial statements."
Compl. ¶ 56(d): "The claimed integration of Fritz and Intertrans was not complete by the time these statements were made, as the Company's attempts to use the Intertrans accounting system . . . were unsuccessful throughout the class period due to Fritz's faulty implementation plan, inadequate internal controls and the decision to terminate many key Intertrans employees."

These purported "explanations" are both devoid of factual support and fail to identify any actionable misstatement by these defendants. For example, the only reference to the Intertrans merger in Compl. ¶ 44 is the Company's statement that it was taking a $30 million acquisition charge "relating to combining the operations." Although plaintiffs have now second-guessed the size of this merger charge, there is no explanation offered as to how this estimate (which was contained in the financial statements audited by KPMG) was "false when made." See Leonard v. NetFRAME, 1995 WL 798923*6 (N.D.Cal. 1995)(rejecting conclusory allegations that "are not specific facts indicating that the first statement was false; these are simply statements that the opposite was true without any supporting facts or circumstances").

Similarly, the only reference to the Intertrans merger in Compl. ¶ 51 (referencing the Company's significant -- and unchallenged -- increase in revenues, income and earnings per share for the first quarter ended August 31, 1995) is the Company's mention of "margin expansion resulting from its merger with Intertrans Corporation." Although plaintiffs have attempted to premise their fraud claim on allegations that Fritz somehow knew that the Intertrans accounting system would prove inadequate, they cannot challenge the fact that the merger initially expanded margins for the combined Company.⁵ While plaintiffs have tirelessly recited every public reference to the Intertrans merger, there remains no connection between these undeniably truthful statements and any proffered fraud theory.

Plaintiffs' failure is aggravated by their insistence that Fritz stated the Intertrans integration process was "complete" and, specifically, that the Intertrans accounting system had been successfully adopted. Oppos. p. 11. In truth, the actual statements cited in the Complaint establish that Fritz never suggested that the integration process was complete (and, in fact, never used the word "complete"), and never referred to the Intertrans accounting system. To the contrary, the statements cited by plaintiffs specifically referenced the merger of Intertrans into Fritz's "global operations" -- without mention of "accounting systems." Despite plaintiffs' tortuous mischaracterization, these statements remain undeniably accurate descriptions of the Company's very significant revenue increases throughout the class period.

C. Plaintiffs State No Cognizable Claim Based Upon The Announcement of Other Fritz Acquisitions

Plaintiffs' laundry list of alleged misstatements is comprised, in large part, of the announcements by Fritz of its acquisition of various small logistics providers. See Oppos. p. 12. Revealingly, plaintiffs now contend that "nothing more is required" than the following 'catch-all' paragraph that purportedly sets forth the mandated specific factual explanation as to why each press release was false when made:

"That defendants misrepresented acquisition profits and the costs of the acquisition program; that Fritz used acquisition charges to hide Fritz's payable accounts, 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."

Oppos. p. 12. As a threshold matter, plaintiffs never even identify whether they are attempting to allege an actionable omission or a misrepresentation. In either event, there is no clue provided as to what "acquisition profits" or "costs" were allegedly misrepresented, or how, with respect to any acquisition. (Indeed, in light of the fact that no charges were recorded for any acquisition other than the Intertrans merger, plaintiffs can never establish the necessary factual foundation for this claim.) While this fact-free allegation provides no support for any fraud claim, plaintiffs' unstinting reliance on it confirms their misunderstanding of the requirements of Glenfed and the Reform Act. See also In re Verifone Sec. Litig., 11 F.3d 865, 868 (9th Cir. 1993)("Conclusory allegations of law and unwarranted inferences are insufficient to defeat a motion to dismiss for failure to state a claim").

III. FRITZ'S RESTATEMENT DOES NOT ESTABLISH EITHER AN ACTIONABLE MISSTATEMENT OR ANY INFERENCE OF SCIENTER

Despite plaintiffs' repeated mischaracterization of Fritz's restatement as an "admission," as a matter of law this amendment cannot establish a claim for fraud. As plaintiffs elsewhere concede, a restatement of reported financial results does not imply that any prior statement was false or misleading. See Oppos. pp. 10 and 11 n. 16. Furthermore, a change in the application of accounting principles -- which requires a restatement -- does not give rise to an inference that prior financial statements were prepared improperly (much less recklessly or deceptively.)⁶

Plaintiffs employ faulty logic when they argue that because GAAP requires a restatement in the event of an accounting irregularity or error, a restatement necessarily implies the existence of such an error or irregularity. In reality, it is widely recognized that "[a] corporation does not admit that previous SEC filings are misleading every time that it amends or updates language in new filings." Lovelace v. Software Spectrum, Inc., 78 F.3d 1015, 1019 (5th Cir. 1991). Indeed, the very GAAP provisions now cited (but not provided) by plaintiffs make clear that "financial statements prepared for prior periods in current reports should be restated if a reporting entity changes an accounting principle," which by definition includes the "methods of applying" any such accounting principle.⁷

Significantly, plaintiffs elsewhere concede that a claim of accounting fraud requires specific allegations that "the responsible parties knew or should have known that [originally reported statements] were derived in a manner inconsistent with reasonable accounting practices." Matthew v. Centex Telemanagement, Inc. [1994-95 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,440 at 91,037 (N.D.Cal. June 8, 1994), cited at Oppos. p. 22 n. 35. Nonetheless, this Complaint merely concludes that "earlier, cheerier" statements were false "without setting forth how [defendants] violated the rules which are cited." Glenfed, 42 F.3d at 1553. While plaintiffs have chosen to ignore the Ninth Circuit's definitive ruling in Glenfed, it is inescapable that "[i]n order to allege the circumstances constituting fraud, plaintiff must set forth facts explaining why the difference between the earlier and later statements is not merely the difference between two permissible judgments, but rather the result of a falsehood." Id. at 1549.⁸

Contrary to plaintiffs' apparent belief that allegations of accounting fraud are somehow exempt from Glenfed's pleading requirements, it is precisely because of the range of "permissible judgments" that they must plead specific factual allegations that establish a statement was false when made. See Oak Technology Sec. Litig. *8, citing Cirrus Logic Sec. Litig. 946 F.Supp. at 1457 ("GAAP is not a set of rules ensuring identical treatment of identical transactions; rather, it tolerates a range of reasonable treatments, leaving the choice among alternatives to management"). Moreover, it is well-established that even a material misstatement of financial results, or an avowed failure to follow GAAP, does not establish scienter. In re Software Toolworks, Inc. Sec. Litig. 50 F.3d 615, 627 (9th Cir. 1994), cert. denied, 116 U.S. 274 (1995); In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir. 1994). Because the Complaint in this case does nothing more than reference Fritz's restatement and assume a cause of action, it does not begin to satisfy the Ninth Circuit or Reform Act requirements for pleading fraud with particularity.

IV. PLAINTIFFS' OPPOSITION CONFIRMS THEIR FAILURE TO ESTABLISH A "STRONG INFERENCE" OF SCIENTER UNDER ANY STANDARD

The theme of plaintiffs' case is that "Fritz adopted the Intertrans accounting system for much of Fritz's business despite knowing that when combined with Fritz's inadequate internal controls and its decision to terminate many key Intertrans employees, the Intertrans accounting system would not provide accounting information that was sufficiently reliable for Fritz's financial reporting purposes." Compl. ¶ 34. But because there was no profiteering by any member of the Fritz management team during the alleged class period, there obviously was no "motive" for these defendants to adopt an accounting system that they allegedly "knew" was doomed to failure. Similarly, because KPMG provided the Company with multiple assurances that its internal controls were not inadequate, there is no basis for concluding that Fritz acted recklessly. As the defendants' Opening Brief established, the only "strong inference" raised by these pleadings affirmatively refutes an inference of scienter under any standard. As plaintiffs' Opposition now acknowledges, the appropriate standard for most of the allegations in their Complaint is "actual knowledge" that the defendants' forward-looking statements were false or misleading -- a standard that plaintiffs do not pretend to satisfy.

A. Plaintiffs Have Confirmed that Their Fraud Allegations Are Primarily Based Upon Forward-Looking Statements

Under the Reform Act's broad definition of "forward-looking statements" that require "actual knowledge" of falsity, SRA § 21E(c)(1)(B), each of the following alleged misstatements is either "a statement containing a projection of . . . financial items," SRA § 21E(i)(1)(A); "a statement of future economic performance," id., § 21E(i)1)(C); or a "statement of the assumptions underlying or relating to" a forward-looking statement. Id., § 21E(i)(1)(D):

the alleged omission of a prediction by the defendants that "the Intertrans accounting system would not be integrated with Fritz's operating system." Compl. ¶ 45(a)
the alleged understatement of merger costs, "including what it would cost Fritz to integrate Intertrans into its operations." Compl. ¶¶ 45(e), 56(e), 64(e) and 70(e)
the alleged failure to identify, at the time of the Intertrans merger, "at least $4.7 million in necessary bad debt reserves." Compl. ¶¶ 45(f), 56(f), 64(f) and 70(f)

While the statutory Safe Harbor is not available for "forward-looking statement[s] that [are] included in a financial statement prepared in accordance with generally accepted accounting principles," SRA § 21E(b)(2)(A), according to plaintiffs' own allegations this exception is inapplicable. The Hodges Ex. A Chart, which claims to identify all alleged misstatements, refers only to Company disclosures in various press releases or in its protected "analysis of financial condition" in quarterly filings. Id., § 21E(i)(1)(C). Moreover, other than Fritz's audited financial statements prepared in connection with the August 1995 Form 10-K, each of the Company's referenced quarterly reports expressly stated that "certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted for the purposes of the condensed consolidated interim financial statements." See Herrera Decl. Ex. F. Thus, plaintiffs have not only failed to establish a "strong inference" of conscious or reckless wrongdoing, they have not even attempted to supply factual allegations that could support the heightened "knowing misstatement" standard that governs these allegations.

B. Plaintiffs' New Arguments Still Fail to Suggest any Conceivable Motive That Might Support A "Strong Inference" of Scienter

Not surprisingly, plaintiffs have abandoned their principal "motive" allegations (and their self-refuting stock price chart) in light of the inescapable fact that the Fritz management team did not sell a single share during the 11-month period when they are alleged to have manipulated the Company's stock price.⁹ However, it is also predictable that plaintiffs would now attempt to revive other "motive" allegations because it is always possible to fabricate some theory that management acted to increase a company's stock price. Because the generic and irrational allegations relied upon by plaintiffs in this case do not approach the "strong inference" standard defined by this Court and others, they cannot serve as the prerequisite for any fraud claim.

For example, plaintiffs now claim that Fritz adopted a defective accounting system in the May 1995 Intertrans merger in order to "complete the [$75 million] private placement [in May 1996] and thereafter at year end restate its financial statement." Oppos. p. 17. There is absolutely no suggestion as to why any defendant would decimate his own stock holdings, without any personal gain, to complete a routine corporate debt offering 12 months later. Moreover, plaintiffs stretch the term "motive" beyond recognition with their contention that Lynn Fritz -- alleged "mastermind" of this scheme to sabotage his eponymous company -- somehow had an incentive to generate unreliable financial results in order to complete a $75 million debt offering while he personally suffered losses many times greater.

Likewise, plaintiffs' own allegations refute any inference of scienter premised on the claim that "Fritz's top executives received bonuses based on Fritz's operating results compared to the Company's [unspecified] internal budget." Oppos. p. 17. As plaintiffs now concede, no bonuses were paid as a result of any increase in Fritz's stock price. Moreover, the 1996 performance bonuses cited by plaintiffs were undeniably based on the Company's unchallenged year-end financial results -- not the interim results that plaintiffs claim were overstated. Thus, plaintiffs' theory of "motive" is not only irrational, it is also inapplicable.

Finally, the authorities now relied upon by plaintiffs conclusively negate any inference of scienter based upon Fritz's partial use of stock in the purchase of two small logistics businesses. As plaintiffs have recognized, Fritz's aggressive business strategy included the purchase of more than 30 such companies over a two-year period. Oppos. p. 3. Unlike the cases cited by plaintiff, e.g., In re Lotus Dev. Corp. Sec. Litig., 875 F.Supp. 48 (D.Mass. 1995), no Fritz acquisition involved any stock sales by any individual. Most critically (and unlike any case cited by plaintiffs), the conspicuous pattern of Fritz's numerous acquisitions is that almost none involved any stock component. Plaintiffs' contention that Fritz was motivated to fraudulently inflate its stock price in order to reduce the cost of its corporate acquisitions is nonsensical in light of the uncontested fact that 28 of Fritz's 30 acquisitions were exclusively cash transactions (and the remaining two purchases included only a small stock component).

C. Plaintiffs Conspicuously Fail to Address KPMG's Unqualified Audit and the Supportive Management Letters that put the Lie to Their Fraud Allegations.

Plaintiffs' Opposition urges this Court to find a "strong inference" of scienter based upon their unsupported allegation that the defendants "had long known of problems with Fritz's accounting system." Oppos. p. 20. While plaintiffs rely on the most conclusory of allegations, see, e.g., Compl. ¶ 91 ("since at least 1994, Fritz management was aware of the Company's inadequate internal accounting and control systems"), they have conspicuously ignored the conclusions of Fritz's independent auditors. It is undisputed that KPMG's November 1995 management letter -- which plaintiffs reference in their Complaint -- assured the defendants that the Company's internal controls had "no material weaknesses" and that its financial statements required no material corrections.

These unconditional endorsements preclude the necessary "substantial factual basis to support a 'strong inference' that the defendant[s] acted with the required state of mind." Oak Technology *3. Even under the most lenient scienter standard, plaintiffs' fraud claims require specific factual allegations which establish that a misstatement was "either known to the defendant[s] or so obvious that [they] must have been aware of it." Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569 (9th Cir. 1990). In this case, plaintiffs' own allegations establish that the outside accounting experts who assessed Fritz's financial controls repeatedly assured these defendants -- contrary to plaintiffs' conclusory fraud theory -- that there was no cause for concern with respect to Fritz's accounting systems. Because the Reform Act requires that "plaintiffs must do more than speculate as to defendants' motives or make conclusory allegations of scienter; plaintiffs must allege specific facts," Silicon Graphics, Inc. Sec. Litig., their Complaint in this case cannot survive.

Dated: August 27, 1997 WILLIAM F. ALDERMAN
JOHN H. KANBERG
TANYA HERRERA
ORRICK, HERRINGTON & SUTCLIFFE LLP

___________________________________
John H. Kanberg
Attorneys for Defendants
Lynn C. Fritz, John H. Johung,
Dennis L Pelino, Stephen M. Mattessich,
Carsten S. Andersen and Fritz Companies, Inc.

¹ Similarly, plaintiffs cannot create admissions by the misleading use of quotation marks. While their Opposition states that Fritz admitted to accounting "irregularities," Oppos. p. 3, that phrase is entirely plaintiffs' invention.

² In their fervor to transform Fritz's voluntary restatement of its third quarter merger costs into a fraud claim, plaintiffs have also misstated the undisputed facts. On July 24, 1996, Fritz announced a $10 million charge for merger expenses incurred during the fourth quarter, and added $4.6 million in merger costs to its third quarter results. See Herrera Ex. A. Plaintiffs now argue that "[b]y restating its prior financial statements, Fritz has conceded that the failure to recognize the $10 million in merger costs. . . [was] a 'material error or irregularity'." Oppos. p. 11; see also, id. at p. 10 (referring to "the $10 million third quarter 1996 retroactive restatement to include additional merger costs . . . ") Plaintiffs are not only wrong as a matter of law, see below, they have also misrepresented Fritz's actual statement of $4.6 million -- and not $10 million -- in additional third quarter merger expenses.

³ While plaintiffs simply conclude that "bad debt" expenses were mischaracterized as "merger expenses," the fact that Fritz terminated nearly 400 employees following the merger (and 200 more than had been anticipated) readily explains why the Company was unable to collect certain accounts receivable. As KPMG agreed, payments that historically had been recovered by both companies became uncollectible after the agents responsible for these accounts were terminated. See Herrera Ex. J., p. KPM 001860.

⁴ These claims are also wholly conclusory and provide -- as the only support for their claim that Fritz "fraudulently inflated revenues" -- plaintiffs' own threadbare conclusion. There is absolutely no explanation (other than the revised judgment of Fritz and its auditors as to the most appropriate date for determining "effective control") as to why it was an inappropriate practice for Fritz to recognize the revenues of these acquired companies as of the effective date of their acquisition. As the Ninth Circuit noted in rejecting similar claims, "[w]hat those [accounting] practices were and how they were departed from is nowhere set forth." Glenfed, 42 F.3d at 1549 n. 10.

⁵ Indeed, while the Intertrans accounting system ultimately proved to be inadequate, it is undisputed that the merger of these two multi-national logistics providers resulted in greatly enhanced revenues and market share throughout the class period.

⁶ Indeed, APB 20 (¶ 7) makes clear that "[a] characteristic of a change in accounting principles is that it concerns a choice from among two or more Generally Accepted Accounting Principles."

⁷ GAAP provides that "[t]he term 'accounting principle' includes not only accounting principles and practices but also the method of applying them." Accounting Changes, Accounting Principles Board Opinions No. 20, ¶ 7 (Accounting Principles Bd. 1971)("APB20"). See Supplemental Herrera Decl. Ex. B.

⁸ Similarly, plaintiffs' labored effort to distinguish between an accounting "error" and a "change in estimates" both misses the point and is refuted by the very authorities upon which they rely. As explained by APB 20 (¶ 11), "[t]he effect of the change in accounting principle is inseparable from the effect of the change in accounting estimate." Moreover, the dispositive question for purposes of the present motion is not whether a restatement was required or merely permitted, but rather whether plaintiffs have pled particularized facts which establish that any accounting treatment lacked a reasonable basis. See, e.g., In re Cirrus Logic Sec. Litig., 946 F.Supp. 1446, 1457 (N.D.Cal. 1996).

⁹ Plaintiffs have also apparently abandoned the original centerpiece of their Intertrans allegations, i.e., that Fritz failed to report the impact of a "program to grow revenues to over $1 billion by acquisition," and had reported "success in profitably integrating the companies." Compl. ¶¶ 50, 61, 67, 75. As pointed out in the defendants' Opening Brief, these claims are refuted by the very corporate announcements relied upon by plaintiffs.

10 Sep 1997

Dated: August 27, 1997	WILLIAM F. ALDERMAN JOHN H. KANBERG TANYA HERRERA ORRICK, HERRINGTON & SUTCLIFFE LLP
	___________________________________ John H. Kanberg Attorneys for Defendants Lynn C. Fritz, John H. Johung, Dennis L Pelino, Stephen M. Mattessich, Carsten S. Andersen and Fritz Companies, Inc.

TABLE OF CONTENTS

TABLE OF AUTHORITIES

CASES

STATUTES AND RULES

MISCELLANEOUS

I. INTRODUCTION

II. PLAINTIFFS' OPPOSITION CONFIRMS THAT THEIR COMPLAINT DOES NOT EXPLAIN HOW ANY STATEMENT WAS ALLEGEDLY FALSE WHEN MADE

A. Plaintiffs Cannot Base Securities Fraud Claims On A Hindsight Challenge of the Intertrans Merger Accounting

Compl. ¶ 99, cited at Oppos. p. 6.:

Compl. ¶ 103, cited at Oppos. p. 8:

Oppos. p. 9 citing Compl. ¶¶ 106, 107:

Compl. ¶¶ 110-111, cited at Oppos. p. 9:

B. Plaintiffs Fail to Identify any Misstatement Concerning Integration of the Intertrans Operations

C. Plaintiffs State No Cognizable Claim Based Upon The Announcement of Other Fritz Acquisitions

III. FRITZ'S RESTATEMENT DOES NOT ESTABLISH EITHER AN ACTIONABLE MISSTATEMENT OR ANY INFERENCE OF SCIENTER

IV. PLAINTIFFS' OPPOSITION CONFIRMS THEIR FAILURE TO ESTABLISH A "STRONG INFERENCE" OF SCIENTER UNDER ANY STANDARD

A. Plaintiffs Have Confirmed that Their Fraud Allegations Are Primarily Based Upon Forward-Looking Statements

B. Plaintiffs' New Arguments Still Fail to Suggest any Conceivable Motive That Might Support A "Strong Inference" of Scienter

C. Plaintiffs Conspicuously Fail to Address KPMG's Unqualified Audit and the Supportive Management Letters that put the Lie to Their Fraud Allegations.