MILBERG WEISS BERSHAD
HYNES & LERACH LLP
WILLIAM S. LERACH (68581)
ALAN SCHULMAN (128661)
600 West Broadway, Suite 1800
San Diego, CA 92101
Telephone: 619/231-1058
- and -
JEFFREY W. LAWRENCE (166806)
LISA C. ATKINSON (163320)
DAVID R. STICKNEY (188574)
222 Kearny Street, 10th Floor
San Francisco, CA 94108
Telephone: 415/288-4545
LAW OFFICES OF JAMES V.
BASHIAN, P.C.
JAMES V. BASHIAN
500 Fifth Avenue
Suite 2700
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Telephone: 212/921-4110
WOLF POPPER LLP
STEPHEN D. OESTREICH
PATRICIA I. AVERY
845 Third Avenue
New York, NY 10022
Telephone: 212/759-4600
UNITED STATES DISTRICT COURT
NORTHERN DISTRICT OF CALIFORNIA
OAKLAND DIVISION
|
ALBERT J. COPPERSTONE, et al., On Behalf Plaintiffs, vs. TCSI CORPORATION, et al.,
Defendants. |
No.
C-97-3495-SBA CLASS ACTION DATE: May 12, 1998 |
I. INTRODUCTION
III. PLAINTIFFS ALLEGE ACTIONABLE FALSE AND MISLEADING STATEMENTS WITH THE REQUIRED PARTICULARITY
A. The Complaint Explains How TCSI's Financial Statements Were False And Misleading
IV. THE SAFE HARBOR AND "BESPEAKS CAUTION" DOCTRINE DO NOT IMMUNIZE DEFENDANTS' FALSE STATEMENTS
A. Defendants' Conscious Misbehavior And Actual Knowledge
B. The Complaint Pleads Facts Showing Motive And Opportunity
VII. THE TCSI INSIDERS ARE LIABLE FOR STATEMENTS IN ANALYSTS' REPORTS
VIII. PLAINTIFFS PLEAD CONTROLLING PERSON LIABILITY AGAINST WAGNER, STRAUCH AND TCSI
IX. THE COMPLAINT PROPERLY ALLEGES RELIANCE AND DAMAGES
X. CONCLUSION
Throughout the Class Period (October 11, 1995 through September 25, 1996), the price of TCSI Corporation ("TCSI" or the "Company") stock was artificially inflated, reaching a high of $29-3/4 per share, because TCSI and nine of its top executives misrepresented its business and financial performance.(1) In particular, defendants misled the public about TCSI's bookings and orders, repeatedly telling investors demand for its product was strong and its business was growing, when in truth its products were not selling and its competitors were taking its market share. To conceal the ongoing deterioration in its business, defendants falsified TCSI's reported financial results for the fourth quarter of 1995 and the first two quarters of 1996 by not recording and reporting write-downs related to a cancelled contract with major customer United Parcel Service ("UPS") and by prematurely recognizing revenue on software licensing agreements transactions with its customers. ¶¶89-105.(2) Their motive is clear: Defendants' fraud enabled the Company and the nine executives to sell off over $105 million of TCSI stock during the Class Period, including a secondary offering in March 1996. ¶¶1, 107.
Defendants challenge these allegations, contending plaintiffs fail to allege falsity or scienter as required by the Private Securities Litigation Reform Act ("PSLRA"). In fact, the Complaint meets the PSLRA's pleading requirements. Plaintiffs allege each of defendants' false statements, ¶¶7-11, 40-48, 51-55, 57, 59-60, 63-73, 75-83, 85-86, and the reasons why each was false, ¶¶3-4, 9, 11, 14, 32, 50, 58, 74, 84, 87. They plead facts raising a strong inference that defendants knew or recklessly disregarded that their statements were false or misleading. ¶¶1, 4-6, 11-13, 15-16, 22-26, 28-30, 32-34, 62, 67, 88, 89-107.
Defendants contend they cannot be liable for causing securities analysts to issue misleading statements unless plaintiffs show a two-way flow of information in which defendants "placed their imprimatur" on the analysts' misleading statements. The Ninth Circuit flatly rejected the same argument in Cooper v. Pickett, No. 95-55657, 1997 U.S. App. LEXIS 39330 at **15-23 (9th Cir. Feb. 2, 1998). Defendants are liable because they made false statements to analysts with the intention that the information be communicated to the market. Id. That is what is alleged here. Moreover, defendants explicitly endorsed analyst reports. E.g., ¶70.
Defendants cannot immunize their fraud as a matter of law under the statutory "safe harbor" or the "bespeaks caution doctrine." Neither applies where false forward-looking statements are not identified as such and accompanied by meaningful cautions. Defendants cannot rely on warnings in other documents, that did not accompany the misrepresentations at issue. The Company's annual report, quarterly reports to shareholders, and two press releases at issue fail to satisfy either the "safe harbor" or the "bespeaks caution" doctrine in any event because the false and misleading statements dealt with present conditions, not forward-looking statements.
Purported "warnings" in TCSI's SEC filings of problems which "could" occur if customers reduced demand or cancelled contracts were worse than meaningless boilerplate -- they were positively deceitful, for they concealed the actual adverse impact which the Complaint alleges was already being suffered by TCSI due to the difficulties it was then encountering with demand and specific contracts. As the Ninth Circuit succinctly put it, "[t]o warn that the untoward may occur when the event is contingent is prudent; to caution that it is only possible for the unfavorable events to happen when they have already occurred is deceit." In re Convergent Tech. Sec. Litig., 948 F.2d 507, 515 (9th Cir. 1991) (citation omitted). Any company will experience fluctuations in revenues and operating results if its customers fail to buy its products. That is why defendants' representations that orders were in fact strong -- and improving TCSI's financial results -- mattered so much to investors.
This Court must accept the Complaint's allegations as true and draw every reasonable inference in favor of sustaining plaintiffs' case. Scheuer v. Rhodes, 416 U.S. 232, 236 (1974); Gila River Indian Community v. Waddell, 967 F.2d 1404, 1413 (9th Cir. 1992). Accepting the facts alleged, the Complaint clearly sets out a claim for securities fraud.
TCSI, which sells object-oriented software to companies in the telecommunications industries, ¶¶2, 31, reported consistent net income and earnings per share ("EPS") growth on a quarterly and annual basis during fiscal 1993, 1994 and 1995. Id. By the fall of 1995, however, TCSI's insiders realized that TCSI's business had peaked, that new competitors (including Objective Systems Integrators) and competitive products were making significant in-roads into TCSI's business. TCSI's competitive position was eroding and the strength of demand for TCSI's products was diminishing. ¶¶3, 32. At the same time, TCSI's customers told defendants they would no longer fund the Company's research and development expenditures, which would further hurt TCSI's revenue and earnings. ¶3.
In addition, TCSI was also having problems with a large object imaging contract it had with UPS, which was a major source of TCSI's revenue and earnings. ¶¶3, 98-102. By early 1996, defendants knew that the Company was unable to profitably complete the UPS contract, ¶¶3, 91, Generally Accepted Accounting Principles ("GAAP") required the contract to be written off, and that, of course, would reduce TCSI's revenue and earnings still further, resulting in a large quarterly loss. ¶98.
Defendants were all top officers and directors of TCSI, intimately familiar with its business, who knew that these problems would devastate TCSI's business and stock price. ¶4. Wagner and the other TCSI insiders wanted to sell off as much of their ownership of TCSI stock as possible before TCSI's declining competitive position and prospects became publicly known. ¶¶4, 33. TCSI's insiders also wanted to have TCSI sell new shares to the public to raise millions in additional capital to stave off the decline in TCSI's business. ¶¶3, 33.
As part of the scheme to artificially inflate the price of TCSI stock defendants falsified the Company's financial statements, overstating revenues and earnings by millions of dollars. See, e.g., ¶¶86-95. Defendants also falsely stated that demand for TCSI's products continued to be strong. ¶¶40, 43, 53. They repeatedly represented that TCSI's "business was doing better than forecast," ¶¶48, 52; that TCSI was "ahead of the competition," ¶42; and was uniquely positioned to take advantage of the growing telecom market. ¶83. Defendants told investors that TCSI was "straining to keep up with customer requests," ¶76, and "expected to close" a major contract in the third quarter with an RBOC. ¶85. As late as August 29, 1996, only weeks before the Company announced its dismal performance for third quarter 1996, Strauch and Farmer boldly and falsely forecast that TCSI expected to achieve "third and fourth quarter EPS of $.14 and $.15 per share and $.54 per share for the year." ¶¶9, 86.
In contrast to these highly positive statements, defendants actually knew and recklessly disregarded that demand for TCSI's products was declining as a result of superior products offered by its competitors. ¶¶47-48, 50(a), (g). Because its customers would no longer fund TCSI's research and development, the Company would have to expend millions of dollars a year of its own on research and development (which would adversely impact TCSI's earnings going forward). ¶¶50(c), 84(c). Moreover, defendants actually knew and recklessly disregarded that TCSI's UPS contract should have to be written off in the first quarter of 1996, resulting in a substantial loss for the Company, ¶50, and that TCSI would not likely obtain a contract from a major RBOC in the third quarter of 1996. ¶87(c). For these reasons defendants had no reasonable basis for their repeated forecasts of strong earnings and growth. ¶87(h).
In order to cover up the problems with TCSI's sales and reduced demand for its products, defendants falsified TCSI's financial statements for December 1995 and the first and second quarters of 1996 by causing the Company to change its revenue recognition policy in order to overstate millions of dollars in revenues and operating income and improperly failing to timely recognize the loss on the UPS contract. ¶¶89-90, 94-96. The financial statements were false because TCSI improperly recorded as revenue millions of dollars of contingent "sales" to its largest customers (including Lucent, NEC, Bell South, Bell Atlantic, PTT Telecom Netherlands, Intel, Motorola and OSC Communications), which should not have been recorded as revenue until the products were accepted, the other contingencies were removed, and collectibility was assured. ¶¶95-96. The Company also boosted its revenue by failing to recognize its loss on the UPS contract when it knew the contract could not profitability be completed in late 1995-early 1996. ¶91. By this violation of GAAP, the Company was able to overstate its earnings in the fourth quarter of 1995 and the first two quarter of 1996. Id.
Absent these accounting improprieties, TCSI would have reported significantly lower net income -- 30% lower -- for each of the quarters ended December 31, 1995, March 31, 1996, and June 30, 1996. ¶104. Due to these improprieties, and the positive statements concerning the Company's overall business and prospects, TCSI's common stock began its price rise through the Class Period. The chart at ¶17 (reprinted at Appendix A hereto) shows this change in TCSI's stock price throughout the Class Period.
The surge in TCSI's stock price enabled TCSI to complete a huge secondary public offering in March 1996, in which TCSI and its founder and long-time Chairman Wagner sold 1.5 million and 3.675 million shares of TCSI stock, respectively, at $18-5/8 per share, pocketing $26.6 million and $65.1 million, respectively, ¶¶1, 15-16, 62, and allowed TCSI's insiders (including Wagner) to sell approximately 800,000 more shares of their TCSI stock into the open market at artificially inflated prices as high as $26 per share, pocketing an additional $15 million. ¶¶1, 67, 83. In trading radically different than their previous practices, ¶¶34-35, Wagner unloaded 81% of his TCSI holdings, three other top officers of TCSI sold 100% of their holdings, and two other insiders sold 78%-79% of their holdings. ¶¶1, 15, 22, 25, 106. By continuing to disseminate false and misleading information after the offering and throughout the Class Period, defendants maintained the artificially inflated stock price so that they could unload even more stock at the expiration of the post-offering lock-up period. ¶83. In the three-weeks following the July 26, 1996 expiration of the lock-up, these insiders sold another 96,000 shares for proceeds of over $2.3 million. Id.
On September 24, 1996, the fraud began to unravel. TCSI stock traded as high as $23 per share during the day before falling in late trading to close at $20-3/4 per share when rumors of an earnings shortfall for TCSI's third quarter first circulated. ¶¶13, 88. On Sept. 25, 1996, TCSI stock fell by $6-11/16 per share, trading as low as $14-1/16 on rumors that TCSI would report third quarter results well below the forecasted substantial growth in revenues, net income and EPS. Id. After the close of trading on September 25, 1996, TCSI admitted that third quarter 1996 revenues would decline from the prior quarter and TCSI would suffer a loss. Id. On October 17, 1996, TCSI reported third quarter 1996 revenues were only $9.8 million, a 55% decline from second quarter 1996 revenues of $21.8 million and a 31% decline from $14 million in revenues for third quarter 1995. Id. TCSI finally took the overdue write-off on the terminated UPS contract, resulting in a huge third quarter loss of $6.5 million, or $0.31 per share that wiped out all of the profits that TCSI supposedly earned during the first half of 1996! Id. TCSI stock collapsed to as low as $5-3/4 per share, an 81% decline from the Class Period high of $29-3/4 in late June 1996. Id. Since then, TCSI has continued to report reduced revenues and losses, and Strauch, its Chairman and CEO, has resigned. Id.
Section 21D(b)(1) of the PSLRA requires plaintiffs to "specify each statement alleged to have been misleading, [and] the reason or reasons why the statement is misleading." 15 U.S.C. §78u-4(b)(1). In this respect, the PSLRA effectively adopted Ninth Circuit law, which has long required plaintiffs alleging securities fraud to identify the false statements and explain why they were false. In re GlenFed, Inc. Sec. Litig., 42 F.3d 1541, 1548 (9th Cir. 1994) (en banc). Though defendants insist that the PSLRA did not adopt "any aspect of the prior Ninth Circuit law," TCSI Defs' Mem. at 12, the Conference Report clearly states "the standard also is specifically written to conform the language to Rule 9(b)'s notion of pleading with "'particularity.'" Kendrick Decl., Ex. D (citation omitted).(3) The Ninth Circuit's decisions applying Rule 9(b) have "consistently required that circumstances indicating falseness be set forth." GlenFed, 42 F.3d at 1548. For this reason, courts continue to apply Ninth Circuit decisions interpreting Rule 9(b).(4)
Defendants' contention that plaintiffs fail to plead falsity ignores a string of Ninth Circuit decisions approving allegations that are either similar to or less specific than those here.(5) The Ninth Circuit consistently holds that "allegations of specific problems undermining a defendant's optimistic claims suffice to explain how the claims are false." Fecht, 70 F.3d at 1083; see Warshaw, 74 F.3d at 960.
The most recent and most pertinent Ninth Circuit opinion on pleading falsity is Cooper, 1997 U.S. App. LEXIS 39330 at **39-40. In Cooper, as here, plaintiffs alleged that a company misrepresented its finances and the health of its business in order to try to facilitate a securities transaction. Id. at **3-9. As explained below, allegations strikingly similar to those here were more than enough to allege falsity.
While the TCSI defendants relegate plaintiffs' improper revenue recognition allegations to a footnote, TCSI Defs' Mem. at 15 n.21, and Wagner ignores them altogether, plaintiffs' accounting allegations meet the particularity requirements of Cooper and the PSLRA by, "point[ing] to specific quarters and specific customers, and provid[ing] dollar figures for each quarter." Cooper, 1997 U.S. App. LEXIS 39330 at *30. Plaintiffs allege that TCSI prematurely recognized revenue before customers were obligated to pay, and on sales that had cancellation privileges and acceptance contingencies, such that the revenue was not yet earned. In addition, defendants, knowing TCSI could not profitably complete its contract with UPS, did not record a loss until the third quarter of 1996 -- after TCSI's March offering and defendants' stock sales -- in order to inflate the Company's operating income and earnings in the fourth quarter of 1995 and the first and second quarters of fiscal 1996.
Accounting fraud and improper revenue recognition are classic §10(b) violations. See Cooper, 1997 U.S. App. LEXIS 39330 at **26-27 (improper revenue recognition); Provenz v. Miller, 102 F.3d 1478, 1484-86 (9th Cir. 1996), cert. denied, 118 S. Ct. 48 (1997) (improper revenue recognition); Wool, 818 F.2d at 1435 (revenues recognized from incomplete sales); Marksman Partners, 927 F. Supp. at 1305 (violation of SFAS 48); Gross v. Medaphis Corp., 977 F. Supp. 1463 (N.D. Ga. 1997) (improper revenue recognition); In re Wellcare Management Group Sec. Litig., 964 F. Supp. 632 (N.D.N.Y. 1997) (sustaining accounting allegations).(6) "[R]evenue must be earned before it can be recognized," and, under GAAP, "the earnings process must be substantially completed and an exchange must have occurred before revenues can be recognized." Provenz, 102 F.3d at 1484; see Wool, 818 F.2d at 1435. A fundamental concept of GAAP is that revenue must be collectible prior to recognition.(7)
The Complaint identifies specific customers and explains how TCSI's financial results were inflated by specific accounting tricks in each quarter. As alleged in ¶89, defendants thought it important to report revenues and earnings growth consistent with their public forecasts. Thus, when TCSI's business began to weaken in 1995, they changed TCSI's revenue recognition policy so that they could prematurely recognize revenue from later periods, inflating TCSI's reported results and covering up the deterioration of its business. Id. Until 1995, TCSI's revenue recognition had been constrained by the following phrase: "[No] revenue is recognized for unpaid license fees unless collection is assured." ¶90. In 1995 defendants removed this constraint from the policy so that TCSI could recognize revenue on software license transactions even when collection was not assured, thus improperly boosting TCSI's reported financial results. ¶¶11, 90.
TCSI's customers (including Lucent, NEC, BellSouth, Bell Atlantic, PTT Telecom Netherlands, Italtel, Motorola and DSC Communications) would not sign contracts without cancellation privileges and acceptance contingencies. ¶95. And they would not accept an obligation to pay until services and licenses were completed. As a result of these explicit and implicit terms, TCSI could not even bill its customers when license agreements were executed or when software was delivered. Id. Thus, although defendants publicly represented TCSI's financial statements were prepared in accordance with GAAP, ¶¶93-94, in fact that was false. In order to report growth in revenue and earnings, TCSI recognized millions of dollars in revenues where payment was not assured due to acceptance and other contingencies. ¶95. They violated §10(b) when, like the defendants in Provenz, they "recognized revenue before binding agreements existed and before contract requirements were completed." 102 F.3d at 1485.
The amounts are set out as well. Unbilled receivables which represent the difference between the amount of revenue TCSI had recognized and the amount it was permitted to bill its customers under the terms of its contracts, skyrocketed from $1.6 million (or less than 25% of total receivables) at December 31, 1994 to $9.1 million (55% of total receivables) at December 31, 1995, and to $12.2 million (55% of total receivables) at June 30, 1996. ¶96. Ultimately, TCSI had to write off (recognize losses on) receivables associated with its software license and service contract revenues when customers refused to pay, because they did not believe they were obligated to. ¶97. Moreover, in the Company's 1996 Form 10-K, management falsely attributed the significant decrease in unbilled receivables (from $9.1 million at Dec. 31, 1995, to $2.5 million at Dec. 31, 1996) to a divestment of its transportation and wireless product lines. Id.
These allegations of accounting fraud -- which defendants simply ignore -- are more than sufficient. In Cooper, the Ninth Circuit "decline[d] to require that a complaint must allege specific shipments to specific customers at specific times with a specific dollar amount of improperly recognized revenue." 1997 U.S. App. LEXIS 39330 at *31. "It is not fatal to the complaint that it does not describe in detail a single specific transaction (i.e., shipment) in which Merisel transgressed as [alleged] by customer, amount, and precise method." Id. at *30. It is enough that "the complaint points to specific quarters and specific customers, and provides dollar figures for each quarter." Id. "This," said the Ninth Circuit, "is more than fraud by hindsight." Id. at *29. The accounting fraud allegations here are, if anything, more specific than those in Cooper.
The Complaint likewise properly alleges accounting fraud in connection with the UPS contract. Plaintiffs allege that by mid-1995, TCSI realized that it could not profitably complete its agreement with UPS due to the substantial reworking to its technology and systems. During early 1996, as TCSI began shipping equipment to UPS and performing more work on the contract, it was even more clear to defendants that this contract would probably result in a loss to TCSI. ¶98. TCSI has no alternative use for this technology. Id. Despite the fact that TCSI had recognized millions of dollars of revenue in 1995 on this contract and although it was publicly representing that it would recognize millions more in 1996, ¶¶66, 80, TCSI's insiders knew that the contract would result in a loss to TCSI. ¶¶91, 98, 100, 103.
Though required by GAAP to do so, TCSI did not record the loss in order to report the growth in net income and EPS necessary to support its positive statements regarding its business. As a result, TCSI's reported earnings for the fourth quarter 1995 (included in the secondary offering Prospectus) and for the first and second quarters of 1996 were materially overstated, ¶¶100, 103-104, allowing defendants to sell millions of shares of TCSI stock at inflated prices. Thus, defendants' claim that the Complaint does not specifically allege when the problems with this contract arose is simply wrong. TCSI Defs' Mem. at 14.
Ultimately, when UPS formally terminated its contract with TCSI in the third quarter, the Company revealed that it would take a $3.3 million charge relating to this contract -- exceeding all operating income TCSI had recognized on the UPS contract in the first two quarters of 1996 -- and that the Company had incurred a $6.5 million loss (or $0.31 per share) for the third quarter. ¶101. Moreover, TCSI was stuck with at least $1.5 million in equipment it had purchased for UPS which UPS would not accept. Id.
That defendants knew that the contract was not profitable in the fall of 1995 was revealed in a striking admission during the October 18, 1996 conference call with analysts. Strauch acknowledged that TCSI knew the UPS contract did not "make sense" to TCSI as soon as TCSI began deploying the system.(8) ¶¶98-102. Thus, the substantial decline in TCSI's reported revenues after the second quarter 1996 was due in part to the fact that TCSI's revenues in prior quarters had been improperly inflated. ¶103. Absent these accounting improprieties, TCSI would have reported much lower net income; lower by at least $850,000, or 30%, in each of the quarters ended December 31, 1995, March 31, 1996, and June 30, 1996, unquestionably material amounts. ¶¶104-105.
As the Complaint alleges TCSI's accounting manipulations in detail, setting forth the improper methods of accounting, ¶¶89-100, the dollar amounts involved, ¶¶96-97, 101, 104, TCSI's top officers as the individuals who orchestrated the wrongdoing, ¶¶11, 22-24, 26-27, 29-30(c), the customers, ¶¶91, 95, and the amounts by which TCSI's revenue and income were overstated, ¶¶103-104, nothing more can reasonably be required. Cooper, 1997 U.S. App. LEXIS 39330 at **27-34; Wells Fargo, 12 F.3d at 926-27. A complaint sufficiently pleads falsity if it "'"identifies the circumstances of the alleged fraud so that defendants can prepare an adequate answer."'" Cooper, 1997 U.S. App. LEXIS 39330 at *31 (quoting Warshaw, 74 F.3d at 960). Defendants can answer these specific allegations.(9)
During the Class Period, defendants consistently forecasted 1996 EPS of well over $0.50 for TCSI, ¶¶48, 53, 56, 72, 80, 85, with further revenue and earnings growth in 1997. Defendants also made false statements of current fact about TCSI's business and products -- all alleged with particularity in the Complaint. On October 11, 1995, Strauch represented, based on "growing demand" and "current customers," "TCSI's Object Software Group has seen a nearly 70% increase in revenues," "this is only the beginning," ¶40, and later Strauch and Farmer stated, "we're already having significant market penetration" resulting in "an unprecedented number of customer references." ¶41. In December 1995, Strauch told analysts that demand for TCSI's products was "very strong," backlog remained strong," and "business was doing better than forecast." ¶48. On January 25, 1996, Wagner and Strauch confirmed that, while TCSI would be funding virtually all of its research and development expenses in the future, this would not adversely impact TCSI's EPS. ¶53. On April 18, 1996, Strauch and Farmer represented that "orders for the second quarter already looked good with much stronger bookings than the first quarter," ¶66, while on June 3, 1996, Strauch, Banin and Farmer stated that, the interest of RBOCs and other telecommunications companies in TCSI's products was "soaring," TCSI was "straining to keep up with demand," and the Company had a number of "highly profitable deals pending." ¶72.
Later in July 1996, Strauch and Farmer represented that TCSI's July bookings alone would equal the bookings during its entire second quarter, that TCSI was "in the midst" of the UPS contract which would generate $4 million in additional revenue during the second half of 1996, and that TCSI was instituting revised business procedures to improve quarterly linearity. ¶80. As late as August 29, Strauch and Farmer told analysts that business was "on track," TCSI "expected to close" a major contract in the third quarter with an RBOC and another major contract in the fourth quarter, that third quarter bookings were "strong" and still expected to run twice second quarter levels, looking "strong" into the fourth quarter. ¶85. Barely three weeks later, TCSI's stock began its collapse, plunging 81% in September upon the news of TCSI's horrible third quarter results.(10) ¶88.
Defendants argue that plaintiffs fail to allege "specific facts" demonstrating that the defendants "knew" their statements were false, but plaintiffs specify what is required by the PSLRA, Cooper and Fecht: the adverse internal "conditions" or "problems" or "facts" which rendered defendants' statements about TCSI false when made. TCSI's competitive position was being eroded by competitors offering superior and/or lower priced products, causing TCSI's orders or bookings to decline. ¶¶14(a)-(b), 32, 50(a)-(b), 58(a)-(b), 74(a)-(b), 84(a)-(b), 87(a)-(b). TCSI's declining orders during the first quarter of 1996 was not a "seasonal" or "temporary situation" but rather a major and permanent decline in TCSI's business. ¶¶14(e)-(f), (i)-(j), 50(f)-(g), 58(f), 74(e)-(f), 84(e)-(f), 87(c)-(d). TCSI's customers were now unwilling to fund TCSI's research and development expenditures, requiring the Company to spend millions of dollars annually on research and development, adversely impacting TCSI's earnings. ¶¶14(c), 32, 50(c), 58(c), 74(c), 84(c). As a result, TCSI knew that the likelihood of future contracts with existing customers had dropped significantly. ¶¶14(d), 50(d), 58(d), 74(d). TCSI had been informed by UPS that UPS would likely terminate its contract during 1996, leaving TCSI holding millions of dollars worth of custom-designed equipment. ¶¶14(h), 32, 50(e), 58(e), 74(g), 84(h), 87(f). Finally, a major RBOC customer told TCSI it likely would not place an order during the third quarter of 1996 but rather in 1997 at the earliest. ¶¶14(g), 84(g), 87(e).
For these reasons, as the Complaint alleges, defendants knew TCSI could not achieve sequential revenue, net income and EPS growth throughout 1996 and, in fact, TCSI's revenues would stagnate or likely decline in 1996. ¶¶14(k)-(l), 32, 50(h)-(i), 58(g)-(h), 74(j)-(k), 84(k)-(l), 87(g)-(h). Defendants consciously created the illusion of growth by means of accounting manipulations as described in ¶¶14(i)-(j), 50(f)-(g), 58(f), 74(h)-(i), 84(i)-(j), 89-105. Because the reported financial results were fraudulent, so too were representations that TCSI was performing well, and was "on track" for strong third and fourth quarter earnings. Such contemporaneous adverse conditions inside TCSI are plainly inconsistent with defendants' public statements. They are, if anything, more specific than the conditions alleged in Cooper, that "[d]emand was softening, the profitability of the company's core business was under severe pressure from price-cutters, the European operations were still weak, international operations continued to lose money, and the Computerland acquisition would hurt Merisel's 1994 earnings." 1997 U.S. App. LEXIS 39330 at *6. See also Fecht, 70 F.3d at 1083 ("specific problems with the expansion program: unsatisfactory initial sales volumes at the new stores and losses at specifically identified stores") (footnotes omitted).
On this motion, plaintiffs' allegations must be accepted as true. The Ninth Circuit in Cooper and Fecht did not require plaintiffs, in alleging falsity, to identify specific internal documents or percipient witnesses to prove these allegations, nor are plaintiffs required to plead defendants' inconsistent contemporaneous statements -- although plaintiffs here do plead defendants' admissions confirming they knew during the Class Period TCSI could not profitably complete the UPS contract. ¶102. "A plaintiff may 'draw on contemporaneous statements or conditions' to demonstrate why statements were false when made." Fecht, 70 F.3d at 1083 (quoting GlenFed, 42 F.3d at 1549); "[A]llegations of specific problems undermining a defendant's optimistic claims suffice to explain how the claims are false." Fecht, 70 F.3d at 1083. See Powers, 977 F. Supp. at 1038 ("Plaintiffs have indicated each alleged misstatement [and] have given the reasons why the statement was misleading when made. Therefore, Defendants' contention that Plaintiffs have not alleged that the statement[s] were false when made as required by the PSLRA fails."); accord Gross, 977 F. Supp. 1463. Ignoring the Complaint's allegations of problems and conditions, defendants instead demand citation of evidentiary documents in a complaint. But, as the Ninth Circuit just reaffirmed in Coopers, 1997 U.S. App. LEXIS 39330 at *31, "'[w]e do not test the evidence at this stage.'" (Quoting GlenFed, 42 F.3d at 1550.) Under Cooper and the other controlling precedents, there can be no question -- falsity is adequately alleged.
Defendants also suggest that certain of their representations are either "vague expressions of optimism" or "historical facts" which could not mislead investors, specifically attacking the statement, "we are well positioned for future growth" as "immaterial puffery." TCSI Defs' Mem. at 15. Defendants' argument rests on decisions which pre-date such Ninth Circuit authorities as Cooper, Provenz, Fecht, Warshaw and Gray, and conflicts with Ninth Circuit precedent by, inter alia, ignoring the statements' context, and the sharp decline in TCSI's stock price upon the September disclosures.(11) Such statements as "[d]emand for TCSI's object-oriented software continues to be quite strong . . . TCSI's Object Software Group has seen a nearly 70% increase in revenues and we believe this is only the beginning," ¶40, that TCSI had "an unprecedented number of customer references," ¶41, projecting revenue and EPS growth of 25-35% year over year, ¶¶41, 48, and assurances that business was "better than forecast" and 1996 EPS expected to exceed $.50, ¶¶43, 48, are material.(12) Nor can specific statements about the strength of TCSI's bookings, such as "orders for the second quarter already look good with much stronger bookings than the first quarter," ¶66, and "bookings in July alone will equal the bookings during the entire second quarter," ¶80, possibly constitute "soft" statements which no reasonable investor would rely on in making investment decisions. Indeed, as this Court found in Parnes v. Harris, et al., Case No. C-95-2715 SBA, Order at 16 (N.D. Mar. 31, 1997), "[s]tatements concerning the actual reliability of Purus' products, their current market acceptance and customer satisfaction, and the acceleration of purchase orders are not vague statements of optimism. Rather, they are actionable representations of existing fact." Lawrence Decl., Ex. B. Moreover, defendants' statements of optimistic earnings of "25-35%" are also actionable, since, as alleged in the Complaint, there was no basis for defendants to believe them. "'[G]eneral expressions of optimism may be actionable under the federal securities laws,'" Hanon v. Dataproducts Corp., 976 F.2d 497, 501 (9th Cir. 1992) (quoting In re Apple Computer Sec. Litig., 886 F.2d 1109, 1113 (9th Cir. 1989)), "if not genuinely and reasonably believed, or if the speaker is aware of undisclosed facts that tend seriously to undermine the statement's accuracy." Cooper, 1997 U.S. App. LEXIS 39330 at *37; see Warshaw, 74 F.3d at 958-59. "Present, known information that strongly implies an important future outcome is not immune from mandatory disclosure merely because it does not foreordain any particular outcome." Shaw v. Digital Equipment Corp., 82 F.3d 1194, 1210 (1st Cir. 1996).
Shareholders pay close attention to opinions of corporate insiders because they know that insiders "usually have knowledge and expertness far exceeding the normal investor's resources." Virginia Bankshares v. Sandberg, 501 U.S. 1083, 1091 (1991). Even conclusory expressions of insiders "are reasonably understood to rest on a factual basis that justifies them as accurate, the absence of which renders them misleading." Id. at 1093. The Ninth Circuit has held many statements similar to those alleged here to be actionable.(13) No allegedly false statement in this case may be discarded as "too vague" at the pleading stage.
Plaintiffs' allegations satisfy the PSLRA's pleading requirements, including §21D(b)(1)'s requirements regarding allegations based upon "information and belief." To begin with, the Complaint does not contain allegations based upon "information and belief allegations," but rather is based upon investigation of counsel.(14) Where "[p]laintiffs' allegations are based on the investigation of their counsel, not on information and belief . . . [t]he heightened standard [of §21D(b)(1)] does not apply here." Cherednichenko, Case No. CV-97-4320-GHK(CWx), Minute Order at n.3. Lawrence Decl., Ex. A. Second, defendants' insistence that plaintiffs must allege particular documents or identify a percipient witness in the Complaint to demonstrate that defendants "knew" their statements were false is wholly misplaced and at odds with the statute. By its terms, §21D(b)(1)'s provision on information and belief allegations does not apply to scienter allegations but only to the pleading of false or misleading statements or omissions. Compare 15 U.S.C. §78u-4(b)(1) with 15 U.S.C. §78-4(b)(2).
Moreover, even if §21D(b)(1) applied here, it merely codifies Ninth Circuit decisional law. For example, in Wool, the court held a plaintiff may plead on information and belief "if the allegations are accompanied by a statement of the facts upon which the belief is founded." Wool, 818 F.2d at 1439; see Moore v. Kayport Package Express, Inc., 885 F.2d 531, 540 (9th Cir. 1989). In such cases, the allegations should include the misrepresentations themselves with particularity and, "where possible the roles of the individual defendants in the misrepresentations." Wool, 818 F.2d at 1440. Section 21D(b)(1) similarly provides that only "if an allegation regarding [a] statement or omission is made on information and belief," must the complaint state "with particularity all facts on which that belief is formed." 15 U.S.C. §78u-4(b)(1). Second Circuit law on this point -- even if it applies -- is fully consistent.
When the PSLRA was enacted, the Second Circuit applied substantially the same standard as the Ninth Circuit did in Wool and Moore -- that the plaintiff set forth facts upon which the belief that fraud was committed are based.(15) The Second Circuit requires plaintiffs to allege facts -- not evidence or confidential sources -- in order to explain how the challenged statements are false and misleading.
When Congress selects words with an accepted meaning in case law, it presumably intends the words to have that meaning. See Cottage Sav. Ass'n v. Commissioner, 499 U.S. 554, 561-62 (1991); Lorillard Div. of Loew's Theatres, Inc. v. Pons, 434 U.S. 575, 580-81 (1978). At the time of the PSLRA, the Ninth Circuit's decision in Wool and the Second Circuit's decision in Schlick provided a standard nearly identical to the words selected by Congress -- and thus the law in this Circuit has not changed on this issue. As the Ninth Circuit explained in Wool, 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 complaint specifies the amount of alleged accounting overstatements and "the manner in which such representations were false and misleading."(16) The Complaint satisfies this information and belief pleading standard by identifying with particularity each misstatement, its content, where and when it was issued, and the manner in which the representation was false and misleading.
Moreover, nothing in the requirement to plead all "facts" even remotely suggests that plaintiffs are required to disclose the identity of percipient witnesses or identify specific internal corporate documents "proving" those facts. Facts and sources are two very different things, and Congress knew how to use the word "source" when it wanted to. When Congress required the consideration or disclosure of "sources," it said so quite clearly.(17) For example, in 15 U.S.C. §772(b), Congress required "identification of all data and projections as to source." But in §21D(b)(1), Congress required only pleading of the "facts" on which a belief was formed, not the "source" of those facts. 15 U.S.C. §78u-4(b)(1). In re Silicon Graphics Sec. Litig., 970 F. Supp. 746, 763-64 (N.D. Cal. 1997), is simply wrong on this point, as the district court erred in its analysis of legislative history, misconstruing a portion of the history to change the statute's plain meaning.
In Silicon Graphics, the district court concluded that "facts" meant "sources" because two Congressmen in opposing a different information and belief pleading provision in an earlier version of the PSLRA, indicated they feared that that provision could mean that plaintiff had to identify "any whistle-blower . . . 'employees, competitors . . . and others who have provided information leading to the filing of the case.'" 970 F. Supp. at 763-64 (citation omitted). However, when Reps. Bryant and Dingell made those claims they were opposing a very different information and belief provision -- one that did apply to "scienter" allegations and was broader than the information and belief provision that was enacted in the PSLRA. The provision then at issue stated: "Requirement for Explicit Pleading of Scienter. . . . If an allegation is made on information and belief, the complaint shall set forth with specificity all information on which that belief is formed." 141 Cong. Rec. H2769 (daily ed. Mar. 7, 1995) (see Lawrence Decl., Ex. C). The PSLRA's information and belief provision is narrower, stating: "[I]f an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed." 15 U.S.C. §78u-4(b)(1). Requiring that "facts" be disclosed is far narrower than disclosing all "information." If anything, deletion of the "all information" language that Reps. Bryant and Dingell objected to in H.R. 1058 in favor of the narrower "all facts" language in the final PSLRA -- language which had an accepted meaning under existing decisional law -- supports the view that Congress did not intend to require the disclosure of whistle-blowers or sources as opponents of H.R. 1058 feared the broader "all information" language in H.R. 1058 might require. Because "'Congress does not intend sub silentio to enact statutory language that it has earlier discarded in favor of other language,'" INS v. Cardoza-Fonseca, 480 U.S. 421, 442-43 (1987) (citation omitted), the Silicon Graphics holding that "plaintiffs must plead the sort of information described by Reps. Bryant and Dingell," 970 F. Supp. at 763-64, is mistaken. Where an allegation is based upon information and belief, the plaintiff need only state the facts upon which the belief is formed.
The PSLRA, as enacted, is consistent with long-established decisional law and preserves the work product and other privileges which generally protects counsel from having to reveal confidential informants and witnesses they interviewed as protected opinion work product.(18) Requiring plaintiffs to plead confidential sources in a complaint would prevent counsel from even attempting to invoke the work product protections under Rule 26. The PSLRA requires district courts to determine if §10(b) complaints satisfy Rule 11, requiring allegations to be well grounded, but the Advisory Committee Notes to the 1983 Amendment emphasize that:
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. The provisions of Rule 26(c), including appropriate orders after in camera inspection by the court, remain available to protect a party claiming privilege or work product protection.
The Complaint sets out defendants' false and misleading statements, the reasons they were false, and defendants' attempt to require that plaintiffs comply with a different statutory requirement must be rejected.
The defendants variously claim that every statement they uttered is protected from liability by a statutory "safe harbor" for forward-looking statements accompanied by meaningful cautionary statements, or by the judicially created "bespeaks caution" doctrine. But analysis of statements in the Complaint reveal that the safe harbor and "bespeaks caution" doctrine do not protect any defendant from liability.
None of the Class Period statements alleged in the Complaint is immunized by the safe harbor. Statements alleged at ¶¶40-48 all pre-date the PSLRA. None of these oral or written statements is "identified as forward looking," nor do they contain the "meaningful cautionary" statements required by the safe harbor, "identifying important factors that could cause actual results to differ materially from those in the forward-looking statement." 15 U.S.C. §78u-5(c)(1)(A). TCSI's false and misleading financial statements, alleged at ¶¶51, 52, 60, 65 and 79, disseminated false financial statements that are expressly excluded from safe harbor immunity. 15 U.S.C. §78u-5(b)(2)(A). Statements in analyst reports, see ¶¶49, 51, 54-56, 63-64, 67-69, 70,73, 75-77, 81-82 and 86, also are excluded from the safe harbor. Most are statements of historical or current fact and disseminate false and misleading financial results that the safe harbor does not immunize, for Congress specifically intended to preclude inappropriate application of the safe harbor to non-forward-looking statements.(19) To the extent that these allegations include any forward-looking statements, none was identified as forward-looking and the reports omitted the cautionary language required by the statute.
Oral statements made by defendants in conference calls to analysts and market professionals, ¶¶53, 66, 71, 72, 80, 85, are not immunized, either. The special "safe harbor" for oral statements requires that a particular oral statement be "accompanied by an oral statement that additional information . . . is contained in a readily available document, or portion thereof," and the document is specifically identified. 15 U.S.C. §78u-5(c)(2)(B)(i). None of the oral statements in this case were so identified. Nothing in the Complaint, or in defendants' papers, suggests that any "particular" oral statement was identified as a forward-looking statement or that the required safe harbor caution was given. And their statements are not forward-looking: They are affirmative statements of current fact, such as the Company "enjoyed strong orders in July," ¶80, TCSI "is in the midst of" the large UPS contract, id., or TCSI is "straining to keep up with demand." ¶72.
The TCSI defendants do not even contend the safe harbor applies to their misleading oral statements, ¶¶41, 43, 48, 53, 66, 71-72, 80, 85, or to statements made to analysts and subsequently published in analyst reports, ¶¶44-47, 49, 54-55, 63-64, 67-70, 73, 75-77, 81-82, 86, including projections of future revenue and earnings. They limit their argument to the April 17 and July 18, 1996 press releases, ¶¶65, 78, submitting certain SEC filings -- the Forms 10-K and 10-Q, for which no forward-looking statements are challenged in the Complaint. The Complaint challenges the annual and quarterly reports to shareholders (which did not contain the "cautions" in the SEC filings) and the Prospectus for disseminating false financial results, ¶¶52, 57, 60, 83. But defendants cannot immunize a statement "that is included in a financial statement prepared in accordance with [GAAP]." §21E(b)(2)(A). Any cautionary statements in these documents are irrelevant.
Because the "safe harbor" does not apply to defendants' written statements unless the cautionary language accompanies the statement, 15 U.S.C. §78u-5(c)(1)(A), defendants cannot rely on TCSI's SEC filings and Prospectus to immunize statements in other documents, like the press releases.(20) Thus, defendants cannot inoculate their written statements by reference to the "most recent" Form 10-K and Form 10-Q, published prior to the press releases. Because these warnings did not accompany the statements in the press releases, they are not immunized by the safe harbor. Only oral forward-looking statements may gain safe harbor protection by referring to other documents -- and then only when the document is identified and it complies with the safe harbor requirement of 15 U.S.C. §78u-5(c)(1)(A). 15 U.S.C. §78u-5(c)(2)(B)(ii)-(iii).(21) In any event, the purported "cautionary" statements loaded into these SEC filings are not "meaningful" but merely boilerplate routinely rejected by the courts, as explained below.
Finally, statements alleged at ¶¶51, 65, 78, 79 and 83 are not forward-looking statements. In addition to containing false financial results excluded from the safe harbor, these representations contain only statements of historical or present fact to which the safe harbor does not apply. Thus, none of the statements challenged as false and misleading in the Complaint qualifies for immunity under the statutory safe harbor.
Like the statutory safe harbor, the "bespeaks caution" doctrine from which it was derived, Conference Report at 68, Kendrick Decl., Ex. D, applies only to forward-looking statements, and has never been applied to immunize the falsification of financial statements.(22) Even with respect to forward-looking statements, the doctrine rarely justifies granting a motion to dismiss because the materiality of a misstatement or omission is an inherently factual determination. Fecht, 70 F.3d at 1082; Warshaw, 74 F.3d at 959-60. See Virginia Bankshares, 501 U.S. at 1097 ("a misleading statement will not always lose its deceptive edge simply by joinder with others that are true"); Mayer v. Mylod, 988 F.2d 635, 638-39 (6th Cir. 1993).
Like the safe harbor, "bespeaks caution" requires that cautionary language must appear "in the document" itself. Provenz, 102 F.3d at 1493; Fecht, 70 F.3d 1078; Warshaw, 74 F.3d 955; and Gray, 82 F.3d at 884 (holding that cautionary language included in filings with the SEC does not negate misleading statements made elsewhere).(23) The doctrine does not apply to any documents that do not include such language, for "'[o]ne cannot simultaneously bespeak caution on a subject and not address it.'" WOW, 35 F.3d at 1413 n.2 (citation omitted).
Unlike WOW and In re Stac Elecs. Sec. Litig., 89 F.3d 1399 (9th Cir. 1996), cert. denied, 117 S. Ct. 1105 (1997), where the forward-looking statement was in a prospectus, i.e., the document that itself contained explicit warnings directly related to the allegedly misrepresented matter, all of the statements in this case involve false statements made in press releases, interviews and analyst reports not accompanied by cautionary language. Courts have long held that, where cautionary statements were scattered throughout several documents, it cannot be found as a matter of law that those statements adequately cautioned investors. Provenz, 102 F.3d at 1493 ("judgment based on the 'bespeaks caution' doctrine is only appropriate 'when reasonable minds could not disagree as to whether the mix of information in the document is misleading'") (citation omitted). Thus, defendants' statements are not shielded by the safe harbor or bespeaks caution doctrine. See, e.g., Powers, 977 F. Supp. at 1042 ("although cautionary language was used in the applicable [SEC] filings, the mix of information contained in the public documents issued by the Company do not clearly preclude reasonable minds from differing on the question of whether the optimistic statements were misleading").
Moreover, the Ninth Circuit has adopted a narrow or measured application of the bespeaks caution doctrine, as an "overbroad application would encourage management to conceal deliberate misrepresentations beneath broad cautionary language." WOW, 35 F.3d at 1414. That is precisely the case here. To say the Company generically experiences "significant fluctuations in revenues and operating results on an annual or quarterly basis," "as a result of many factors," including "the cancellation . . . of license or maintenance agreements," says nothing about what defendants knew about impediments to an existing contract such as UPS. What the SEC filings contained were meaningless documents loaded with page upon page of the type of standard boilerplate "cautions" rejected by courts under the "bespeaks caution" doctrine.(24) For example, while the problems affecting TCSI's business changed for the worse over time, the generalized cautionary language in TCSI's SEC filings during the Class Period never changed in any meaningful way. See Appendix B hereto. True cautionary language must truthfully address specific risks, and must exhaust the capacity of the positive statements to mislead investors. See Provenz, 102 F.3d 1478; Gray, 82 F.3d at 885-86; Kaplan, 49 F.3d at 1373-74. Neither is present here. Courts have repeatedly rejected such cautionary language.(25) This Court must do so as well.
At most, by trying to rely on cautions in other documents, defendants allude to the affirmative defense of "truth-on-the-market," that information withheld or misrepresented in specific documents was elsewhere "'"transmitted to the public with a degree of intensity and credibility sufficient to effectively counterbalance any misleading impression created by insider's one-sided representations."'" Provenz, 102 F.3d at 1492-93 (citations omitted). But whether the truth has "credibly entered the market and dissipated the effects of the misstatements," is a question of fact that requires evidence of the total mix of information in the market. Basic, Inc. v. Levinson, 485 U.S. 224, 249 & n.29 (1988); Kaplan, 49 F.3d at 1378 n.3 (reversing summary judgment because "the ultimate resolution of this question is an issue for trial"); Hanon, 976 F.2d at 503-04 (same). Such fact finding is inappropriate in a motion to dismiss. In Provenz, the Ninth Circuit drew a sharp distinction between the two doctrines, and explained that defendants who invoke the truth-on-the-market defense must carry "a heavy burden of proof." 102 F.3d at 1493. Presumably, if the market were "cautioned" by TCSI's boilerplate disclosures, this would be reflected in the stock price. Yet, upon the September disclosures, the stock plummeted. This precipitous decline is evidence of the materiality of the information that had been misrepresented and concealed during the Class Period.
Section 21D(b)(2) of the PSLRA requires securities plaintiffs to plead facts "giving rise to a strong inference" that defendants acted with "the required state of mind," 15 U.S.C. §78u-4(b)(2), thereby modifying holdings (such as GlenFed) that although falsity must be alleged with particularity, scienter may be generally averred. See Marksman Partners, 927 F. Supp. at 1309-10. While Congress did not specifically define the "required state of mind," it did not legislate in a vacuum. Epstein v. Itron, Case No. CS-97-214-RHW, 1998 U.S. Dist. LEXIS 659 (E.D. Wash. Jan. 22, 1998). When the PSLRA was enacted, the required state of mind for a §10(b) violation would be established by a showing recklessness. See, e.g., Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-70 (9th Cir. 1990) (en banc). Thus, when Congress enacted the PSLRA and to have chosen not to modify this standard, it can be presumed to have been aware of the standard and chose not to alter the standard for liability for false and misleading statements under the PSLRA. Lorillard, 434 U.S. 575; Itron, 1998 U.S. Dist. LEXIS 659 at **13-16. Congress knew how to modify the scienter requirement when it wanted to, as it did by requiring "actual knowledge for imposing liability for false and misleading forward-looking statements." Id. at **10-13.
Moreover, the "strong inference" standard of §21D(b)(2), is drawn from Second Circuit precedents, which use that very language and uniformly hold that a §10(b) plaintiff may raise a "strong inference" of scienter either by pleading facts showing motive and opportunity for committing fraud, or by pleading facts that constitute circumstantial evidence of reckless or conscious behavior.(26)
Not surprisingly, most courts hold that the PSLRA means what it says: recklessness still suffices as the "required state of mind" (except for certain forward-looking statements) and the Second Circuit "strong inference" pleading standard now governs.(27) Thus, despite the assertion by some of defendants that actual knowledge is required, for most §10(b) violations "the required state of mind" remains knowledge or recklessness. See Hollinger, 914 F.2d at 1568-70. Marksman Partners, 927 F. Supp. at 1309 n.9; Itron, 1998 U.S. Dist. LEXIS 659. For certain specifically defined and limited forward-looking projections -- and subject to many specified exceptions -- the PSLRA raised "the required state of mind" for §10(b) liability to actual knowledge. 15 U.S.C. §78u-5(c). Indeed, accounting fraud of the kind alleged here is specifically excluded from the safe harbor. 15 U.S.C §78u-5(b)(2)(A). Thus, plaintiffs' allegations at ¶¶89-105 alleging accounting fraud must be sustained if the Complaint raises a strong inference that defendants acted recklessly in making the materially false and misleading statements. Similarly, plaintiffs' allegations that defendants misled the market concerning TCSI's then current market conditions and revenues are not forward-looking statements and are likewise not shielded by the actual knowledge requirement of the statutory safe harbor. Thus, for example, defendants' statements to the market that "demand for TCSI's object-oriented software continues to be strong," ¶40, that "TCSI was on target with its business model," and its "business was doing better than forecast," ¶48, and the Company "was straining to keep up with demand," ¶72, are non-forward-looking statements outside the safe harbor and must be upheld if the facts alleged lead to a strong inference that they were only made recklessly, which they clearly do. E.g., Marksman Partners, 927 F. Supp. at 1310-11. Here, however, the facts pleaded do create an inference of actual knowledge of falsity. The Complaint not only alleges each of the false and misleading statements and sets forth the reasons each was false and misleading, but sets out the defendants' motive in undertaking the scheme as well. Defendants sought to raise and maintain TCSI's stock price so that they could reap nearly $105 million in proceeds from sales of their stock and the completion of a secondary offering in March 1996. These allegations raise an inference, not merely of recklessness, but defendants' conscious behavior in committing fraud. Powers, 977 F. Supp. at 1039 (stock sales are evidence of conscious misbehavior in constituting fraud); Voit, 977 F. Supp at 374 ("conscious behavior" standard met when defendants sold $4.6 million in stock while in possession of material non-public information); Friedberg v. Discreet Logic, 959 F. Supp. 42, 51 (D. Mass. 1997) (sales of 12%, 33% and 50% of defendants' holdings sufficient to plead scienter under the "conscious behavior" standard; allegations of motive and opportunity raise an inference not just of recklessness, but specific intent to commit fraud). Wells Fargo, 12 F.3d at 931 (citing Blake, 856 F.2d at 1369-70); Gross, 977 F. Supp. 1463. Thus, the facts alleged here raise a strong inference of defendants' knowledgeable participation in the false and misleading statements, and the Complaint should be sustained under either standard.
Allegations of financial fraud by public companies and their executives have been found to raise a strong inference of scienter. Wellcare Management, 964 F. Supp. at 640 (allegations that corporate executive "had knowledge of, condoned and/or encouraged [] the deliberate overstatement of earnings by a number of means," sufficient to plead intent); Marksman Partners, 927 F. Supp. at 1314 ("The facts that the allegedly overstated revenues constituted such a significant portion of Chantal's total revenues and that the allegedly misleading financial and other public statements bore defendants' imprimatur tend to support the conclusion that the defendants acted with scienter."); Page v. Derrickson, Case No. 96-842-CIV-T-17C, 1997 U.S. Dist. LEXIS 3673 at *14 (M.D. Fla. Mar. 25, 1997) (scheme employed to materially misstate company's liabilities and revenues sufficient to plead scienter); Health Management, 970 F. Supp. at 204 (allegations that corporate insiders approved of plans of financial fraud, and directed fraud to be put into effect, satisfy this test); Gross, 977 F. Supp. at 1472 (allegations that corporate insiders engaged in a pervasive accounting fraud sufficiently alleged scienter); Rehm, 954 F. Supp. 1246 (accounting fraud alleged, complaint sustained).
These recent PSLRA decisions have held that allegations of financial fraud by top corporate executives constitute strong circumstantial evidence of conscious misbehavior. Powers, 977 F. Supp. at 1039; Voit, 977 F. Supp. at 374. Furthermore, a strong inference of actual knowledge is recognized in such circumstances, because corporate books do not "cook" themselves! Accounting manipulations of the extensive sort alleged here are, of necessity, the product of conscious behavior by high level executives. Moreover, the inference of conscious behavior by the defendants is further strengthened upon consideration of their motive for the fraud.
Additionally, conscious misbehavior may be inferred from defendants' positions and their access to adverse information that they ignored or concealed. See, e.g., Cohen, 25 F.3d at 1174; Breard, 941 F.2d at 143 & n.3; Cosmas, 886 F.2d at 12-13; Itron, 1998 U.S. Dist. LEXIS 659. In Cohen, the Second Circuit held that a plaintiff raised a strong inference of scienter by pleading facts suggesting that defendants likely knew that their financial representations about the Koenig Group were false. 25 F.3d at 1174. The fact that the defendants "were officers, directors and majority shareholders of the Koenig Group [and were active managers and thus] 'fully familiar with all aspects of [its] business and financial conditions and operations,'" meant that the defendants likely knew their representations were false. Id. Wechsler v. Steinberg, 733 F.2d 1054, 1059 (2d Cir. 1984) (nondisclosure of information and attempts by choice of accounting methods to artificially increase financial statements and price of stock held "to support an inference . . . that defendants deliberately omitted material information from their annual reports with the intent to deceive investors").
For example, in Cosmas, the Second Circuit held that plaintiffs raised a strong inference of scienter through their allegations of material falsity because corporate directors most likely would know of adverse facts seriously affecting an important segment of their company's business. 886 F.2d at 13. The Cosmas complaint alleged that Inflight Corporation's optimistic statements about revenues and projected sales were false or misleading because the People's Republic of China ("PRC") had imposed new import restrictions -- restrictions that would adversely affect the company's sales. Id. at 10-12. It raised a strong inference of scienter because the "amended complaint alleges facts from which one can reasonably infer that sales to the PRC were to represent a significant part of Inflight's business." Id. at 13. "These facts," the Court explained, "give rise to a strong inference that the defendants, who the amended complaint alleges were directors of Inflight, had knowledge of the PRC import restrictions, since the restrictions apparently eliminated a potentially significant source of income for the company. In light of the strong inference that the defendants, at the time the allegedly fraudulent statements were made, had knowledge of the PRC import restrictions, we conclude that the amended complaint alleges sufficient facts from which it can be inferred that the defendants had the requisite fraudulent intent." Id.
The Complaint in this case similarly pleads facts from which it may be inferred that software licensing fees, and the UPS contract, accounted for a large portion of TCSI's sales, and that much of its revenues during the Class Period were generated by fraudulent accounting perpetrated at the Individual Defendants' direction. ¶¶23(b), 25. The Complaint not only alleges that the Individual Defendants were top officers and directors of TCSI who together owned well over four million shares of its stock, ¶¶22, 107, but that they were active managers, fully familiar with TCSI's business and financial conditions. Banin was an Executive Vice President and General manager of the Object Software Group, the very group at the heart of the fraud. ¶22(f). Banin sold 100% of his stock during the Class Period, 67% of which was sold on February 13, 1996. Rao, who also worked in the same group sold 100% of his TCSI stock within the same day -- right at the period when the UPS contract should have been written off. Defendants Bolger and Hasler were directors and members of TCSI's Audit Committee, ¶22(e), (g), which had responsibility over the financial statement irregularities and the removal of the constraint against improper recognition of revenue on software license transactions where collection was not assured. Banin, Rao, Farmer and Wagner served as members of TCSI's executive committee. ¶23(a). They would know, then, about recent developments important enough to "eliminate[] a potentially significant source of income for the company." Cosmas, 886 F.2d at 12-13. In addition, defendants Wagner, Strauch, Miller, Rao, Bolger, Banin, Hasler, Messerschmitt and Farmer each were aware of and approved the false statements issued by or on behalf of TCSI during the Class Period. ¶¶22, 23(c). Thus, the facts alleged here raise a strong inference that defendants knew their statements were false or misleading when made. As in Ouaknine -- where defendants allegedly made false promises and projections and concealed adverse financial data -- "[i]t is difficult to imagine how such events could have occurred if the defendants who controlled them had not actually intended to defraud." 897 F.2d at 81.
Based on their reference to and receipt of regularly internally prepared and regularly disseminated operating plans, budgets and forecasts and reports of the Company's actual operations to the Company forecasts, see, e.g., ¶¶22-26, 28-29, defendants actually knew:
These facts, necessarily accepted as true on this motion, clearly allege that defendants knew at the time they were making positive statements that those statements were false. The allegations of deliberate misconduct in this case are thus far more detailed, and raise a much stronger inference of scienter than those in Cosmas and Cohen, where the fact that the defendants "were officers, directors, and majority shareholders of the Koenig Group," and as active managers, were "'fully familiar with all aspects of [Koenig Group's] businesses and financial conditions and operations," meant they likely knew their company's financial statements and other representations were false. Cohen, 25 F.3d at 1174 (citation omitted). In this case, the defendants were directly involved in the dissemination of the false and misleading statements.(28)
Finally, the proximity between the revelations of the bad news (here September 24, 1996) and the last of the positive statements (here August 30, 1996) "is circumstantial evidence that the Defendants knew that their optimistic statements were false." Powers, 977 F. Supp. at 1039 (three week time period); Friedberg, 959 F. Supp. at 51 (proximity between a false statement and the bad news can provide circumstantial facts in support of scienter). In re Grand Casinos, Inc. Sec. Litig., Case No. 4-96-980, 1997 U.S. Dist. LEXIS 19916 at **37-38 (D. Minn. Dec. 9, 1997). In short, the Complaint more than adequately alleges defendants' actual knowledge of conditions making their statements false and misleading.
Motive entails concrete benefits that could be realized by one or more of the false statements and wrongful nondisclosures alleged. Opportunity entails the means and likely prospect of achieving concrete benefits by the means alleged. Shields v. Citytrust Bancorp., Inc., 25 F.3d 1124, 1129-30 (2d Cir. 1994). In cases where defendants' motive has provided a strong inference of defendants' intent to deceive, defendants have received an actual benefit from the fraudulent conduct. Thus, for example, motive is sufficiently alleged where insider defendants are alleged to have profited by significant stock sales based upon false and misleading bullish statements. Goldman v. Belden, 754 F.2d 1059 (2d Cir. 1985); accord Marksman Partners, 927 F. Supp. 1297; Wellcare Management, 964 F. Supp. 632. Motive is sufficiently alleged where defendants sought to conduct a stock offering, In re Time Warner Sec. Litig., 9 F.3d 259 (2d. Cir. 1993), or artificially inflated the company's stock price in order to finance acquisitions of other companies. Gross, 977 F. Supp. 1463. Moreover, such allegations have been held as circumstantial evidence to establish that defendants who are alleged to have made false and misleading statements, did so with actual knowledge of their falsity. E.g., Powers, 977 F. Supp. 1031; Voit, 977 F. Supp. 363 (strong inference of conscious misbehavior where three executives sold 72%, 14.9% and 10.6% of their holdings (129,570 shares for $4.6 million) and the company used its stock at artificially inflated prices for an acquisition).
Here, motive is clearly alleged. All defendants benefited by artificially inflating TCSI's stock price to sell their stock at huge gains and to complete the March 1996 secondary offering. The Complaint alleges how the defendants, knowing TCSI's business had been and was rapidly deteriorating, sought to inflate its stock price to complete a huge secondary offering in March 1996. That offering directly benefited both the Company and Wagner, who were able to sell millions of shares of TCSI stock for over $80 million. The remaining defendants obtained a concrete benefit from their fraud as well. Throughout the Class Period, the Individual Defendants sold over 800,000 shares of TCSI stock at prices artificially inflated by their false and misleading statements. All of the defendants were able to sell and sold a large percentage of their TCSI stock -- in the case of Banin, Farmer and Rao, 100% -- at huge gains. ¶¶22(a)-(i), 107.
The Complaint identifies specific stock sales by specific insiders that totaled over $105 million. ¶106. These massive sales provide more than "motive and opportunity," they are also strong circumstantial evidence of wrongdoing: "Insider trading in suspicious amounts or at suspicious times is probative of bad faith and scienter." Kaplan, 49 F.3d at 1379; accord Provenz, 102 F.3d at 1491. The Complaint alleges that once the stock price had increased, and before the truth leaked out, all defendants sold a total of 5.4 million shares of stock for over $105 million. During the 11 month Class Period, the Individual Defendants sold 4.48 million shares. Prior to the Class Period defendants' sales were insignificant, and in the 11 months following the Class Period, these same individuals sold only 30,000 shares (15,000 of them were sold by Strauch after he resigned). ¶¶34-35. The timing of these sales, the amount of the sales and the fact that, contrary to their prior trading practices, ¶34, all of the defendants sold huge quantities of their stock within the Class Period, provide a strong inference of scienter. Marksman Partners, 927 F. Supp. at 1311; Powers, 977 F. Supp. at 1039 (inference that defendants knew of false statements when defendant insiders made sales of 100%, 41%, 30% of their stock during Class Period is circumstantial evidence that defendants knew the stock price would drop when problems were revealed).
Moreover, compensation for the executive officers -- Strauch, Farmer, Banin and Rao -- was tied to increases in earnings. ¶30(u)-(c). Receiving substantial salary increases and bonuses, coupled with the proceeds from their massive insider sales, provides more than sufficient "concrete benefits" to establish motive. Wellcare Management, 964 F. Supp. 632 (increased compensation coupled with other factors establish defendants' motive). Thus, despite defendants' characterization, the Complaint in this case does far more than allege simply that defendants sought to increase the stock price merely because it would have an effect on their compensation or that only one defendant sold a small percentage of his stock, as in Acito v. IMCERA Group, 47 F.3d 47, 54 (2d Cir. 1995). Rather, all the defendants here are alleged to have actually received concrete, substantial benefits from their fraud. See Wellcare Management, 964 F. Supp. 632; Cohen, 25 F.3d at 1174.
Opportunity in this case is also clear. Defendants controlled the dissemination of information about TCSI. They were the Company's top officers and directors and spoke on its behalf to analysts and the market. They ran the Company and were responsible for the generation and reporting of its financial results. ¶¶22(a)-(i), 23, 24-25, 26-27. They had the opportunity, given their positions, to manipulate the recording of revenue. ¶25. Under such circumstances, "no one doubts that the defendants therefore had the opportunity, if they wished, to manipulate the price of [the Company's] stock." Time Warner, 9 F.3d at 269; Cohen, 25 F.3d at 1174; Wellcare Management, 964 F. Supp. at 639; Marksman Partners, 927 F. Supp. at 1312.
Moreover, defendants' opportunity to commit the fraud when they did is also clear. Defendants knew, by the end of 1995 that the Company's growth had come to an end. Competitors were taking their market share, their customers would no longer be funding their research and development and a major imaging contract with UPS would have to be written off in first quarter 1996 -- all dramatically reducing TCSI's profits. Knowing there was only a small window before the truth would have to be revealed, defendants sought to prop up TCSI's stock price through 1996. They did it by not only repeatedly misleading the market with positive statements concerning TCSI's growth and product demand, ¶¶40-55, but (1) by changing their revenue recognition policy in violation of GAAP on software licenses to increase revenues, ¶¶94-97, and (2) delaying the write-off of the UPS contract from the first quarter of 1996 when they knew the contract would not be completed, also in violation of GAAP. ¶¶98-103. These accounting improprieties had the purpose and effect of allowing the defendants to continue to report revenue growth and thus maintain and increase TCSI's stock price. Indeed, defendants took advantage of the opportunity they created and sold over four million shares of their stock from October 1995 through September 1996, including a secondary offering in March 1996. Defendants had the opportunity to profit by their knowledge of undisclosed adverse information and they took it.
In response, defendants argue that scienter is not properly pleaded because motive is not properly alleged. Defendants do not dispute the unusual trading patterns or the amount of stock sales alleged. Rather, they assert that "they had significant holdings of TCSI stock and options through the end of the class period," which proves that they did not act with scienter, submitting TCSI's 1996 and 1997 Proxy Statements, TCSI Defs' Mem. at 18, Wagner Mem. at 16 and Rao Mem. at 15-16 (citing Silicon Graphics). Defendants cannot, on a motion to dismiss, counter the Complaint's allegations by arguing "that they sold only a small fraction of their holdings." Gupta, 900 F. Supp. at 1231-32; accord Voit, 977 F. Supp. 363. Defendants ask this Court to discredit plaintiffs' well-pleaded allegations regarding their insider sales and draw an inference adverse to plaintiffs by improperly having the Court (a) consider matters outside the pleadings (defendants' SEC filings), (b) accept defendants' statements in those SEC filings for the truth of the matters asserted, and then (c) draw the inference, based on defendants' presentation of their option holdings four months after the Class Period, rebutting the Complaint's allegations of defendants' motive in selling their stock during the Class Period.
Defendants ask the Court to take judicial notice of their 1996 and 1997 Proxy Statements to determine their holdings and rule on the issue of scienter. A court ordinarily may not consider material beyond the pleadings or material not referred to in the complaint in ruling on a motion to dismiss. Cooper, 1997 U.S. App. LEXIS 39330 at **11-15; Branch v. Tunnell, 14 F.3d 449, 453-54 (9th Cir. 1994); Bonilla v. Oakland Scavenger Co., 697 F.2d 1297, 1301 (9th Cir. 1982). Under Cooper, these documents may not be considered.
Even if SEC filings could be considered on a motion to dismiss -- which they cannot -- the filings show only that defendants had "exercisable" options, not that they bought stock or that it should be included in their "holdings." Exercisable options are far different from stock or exercised options, for that matter. Take for example, Rao.
Rao claims that he held 71,625 exercisable options on January 15, 1997, which supposedly proves he did not sell 100% of his stock on February 13, 1996 as alleged in the Complaint. ¶107. However, all the TCSI Proxy Statement shows is that Rao was granted 55,000 options at an exercise price of $11.17 per share during 1996. 1997 Proxy Statement at 7 (Kendrick Decl., Ex. L). It cannot be determined when during the year these options were granted although it is clear that they were not among those exercised or sold in February (see ¶106, exercise price of Rao's options was between $1.77 and $6.40 per share). The Proxy Statement only reveals that TCSI stock closed on December 31, 1996 at $6.25. 1997 Proxy Statement at 7 (Kendrick Decl., Ex. L). Rao's holding of an exercisable option for $11.17 on January 17, 1997, when the price of the stock was $6.25, proves hardly surprising. Thus, it is misleading to imply that Rao's failure to exercise these options is anything other than his desire to avoid losing money.
Moreover, by holding the options without exercising them, he, as well as the other defendants, can wait for the Company to reprice them -- as TCSI has already done in the last two years. See 1996 Proxy Statement at 7 (repricing Banin's options) (Kendrick Decl., Ex. K); 1997 Proxy Statement at 7 (repricing Banin and Farmer's options) (Kendrick Decl., Ex. L); see also E.S. Browning & Laura Jereski, In the Money: Firms With Sagging Stocks Set New 'Repricings' of Executive Options, Wall St. J., June 11, 1997, at 1 (Lawrence Decl., Ex. J). In short, for defendants to rebut the inference of scienter, a factual record must be developed -- including evidence of the option exercise price relative to market price, the likelihood that defendants would reprice the options later (providing an even better opportunity for insiders to profit), and the risks of defendants getting caught if they sold too much. At this stage, however, where the Complaint's allegations are deemed to be true, defendants may not do so.
Indeed, defendants' treatment of their "stock and options" together as their "holdings" is also improper and misleading. The reporting services covering insider selling do not treat options as stock for purposes of computing an "insiders 'total holdings' of stock." At bottom, insiders' stock options do not carry the same economic risk as actual stock ownership. In particular, executives do not face the same risk of loss in stock options as they do with common stock -- because they do not pay for the options, and because the company can always lower the exercise price of the options if the value of the stock falls:
Directors simply lower the options' exercise prices to the stock's current price level. Presto! The options can soon be back in the money again. It doesn't matter if the stock ever returns to the levels where the options were originally issued.
Browning & Jereski, supra at 1 (Lawrence Decl., Ex. J). Indeed, that is precisely what has been done; the Company has repriced options three times in the last two years. 1996 Proxy Statements at 7 (Kendrick Decl., Ex. K); 1997 Proxy Statements at 7 (Kendrick Decl., Ex. L). In fact, TCSI's August 1997 Proxy Statement (not submitted by defendants) reflects a repricing of an additional 30,000 options for Strauch. See Lawrence Decl., Ex. I.
Prior to Judge Smith's decision in Silicon Graphics, no court had ever engaged in the type of stock-option analysis defendants seek here on a motion to dismiss. For example, in Fecht, the Ninth Circuit did not consider how many vested stock options the insiders held when it determined that their stock sales were probative -- even though the insiders had many vested stock options.(29) The reason is obvious: A motion to dismiss challenges the allegations of the complaint not whether a fact-finder might reach another conclusion and believe a defendant's explanation of why he exercised only a certain percentage of his options. See Kaplan, 49 F.3d at 1379 (summary judgment denied, defendants' explanation regarding reasons for stock sales is a fact question for a jury). To hold otherwise would give corporate insiders license to trade on inside information with immunity -- for corporate insiders virtually always can argue that they could have sold more stock than they did by exercising options.
Even if defendants were correct about the percentages of stock they sold, it still would not rebut the inference of scienter. See Friedberg, 959 F. Supp. at 48-49 (five defendants sold 12%, two sold 33% and 50% -- sufficient to infer scienter). As the Ninth Circuit explained only three years ago:
Of course, an insider may not always trade all his shares in the company for which he possesses the inside information; the trader may hold on to a portion of his shares to hedge against the unforeseen or to obscure the insider trading from the SEC.
WOW, 35 F.3d at 1427. Similarly, in San Leandro, the Second Circuit sustained allegations of unlawful insider trading where an executive sold some of his stock at a $2 million profit shortly before public disclosures caused the stock's market price to fall -- even though he "retained a large holding in the company, and actually acquired more shares by the conclusion of [his class-period] transactions than he had sold." 75 F.3d at 814. At the pleading stage, "the allegation that [an insider] realized a profit of over $2 million from his pre-announcement transactions gives rise to an inference that he engaged in insider trading," notwithstanding this retention of "a large holding." Id. at 814-15.
In short, these allegations meet the PSLRA scienter pleading standard. Defendants' knowledge of TCSI's business problems, the employment of accounting chicanery and massive insider selling all mandate the conclusion that they knowingly engaged in the securities fraud alleged. As the court observed in Powers, "[p]laintiffs allege Defendants were selling high because they 'knew' that the stock would fall as soon as the 'problems'" were revealed. 977 F. Supp. at 1039. That is precisely the situation here.
Rao and Wagner contend that they cannot be liable unless they made the statements at issue. Not so. Under the group-published information doctrine, the Ninth Circuit holds "'[i]n cases of corporate fraud where the false and misleading information is conveyed in prospectuses, registration statements, annual reports, press releases, or other 'group-published information,' it is reasonable to presume that these are the collective actions of the officers.'" In re GlenFed, Inc. Sec. Litig., 60 F.3d 591, 593 (9th Cir. 1995) ("GlenFed II") (quoting Wool, 818 F.2d at 1440).(30) Contrary to defendants' contentions, TCSI Defs' Mem. at 21-22, Rao Mem. at 8-11, Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994), did not eliminate the group-pleading presumption.
Rao contends that §21D(b)(2) abolished the "group publication" doctrine because §21(d)(b)(2) requires plaintiffs to allege "facts giving rise to a 'strong inference' that the defendant acted with the required state of mind." Rao Mem. at 12. Plainly, the statutory text addresses only scienter and does not address group publication. Nor can Rao muster even the slightest hint in the extensive legislative history of Congressional intent to affect the group-publication presumption. There is simply no tension between the PSLRA and the group-publication precedents. Valujet, ¶99,579, at 97,885-86; Health Management, 970 F. Supp. at 209. Defendants thus jointly "made" the false and misleading statements contained in TCSI's public reports, financial statements, the October 11, 1995 press release, ¶40, the October 19, 1995 report of third quarter results, ¶42, the 1995 annual report to shareholders, ¶57, the excerpt from the June 1996 "Buyside," ¶70, the July 17, 1996 press release, ¶78, and the quarterly report for TCSI's second quarter. ¶83.
Rao further contends that the group-publication presumption should not attach to him because he was too remote from the alleged fraud. Rao conceals that he was the Senior Vice President of the Object Software Group, ¶22(d), the division at the center of the fraud. During the Class Period, object software was exalted as the cornerstone of TCSI's purported success, ¶¶40-41, 43, 48, 70. Lastly, Rao received huge cash awards for the group's purported contribution to TCSI's bottom line. ¶30(b), (c). Thus, Rao was in a pivotal position with respect to both the UPS contract and TCSI's object software business. Consistent with the allegations of the Complaint, Rao sold 100% of his stock on February 13, 1996, ¶107 -- in the middle of the first quarter of 1996 and at the time that plaintiffs allege that TCSI knew the UPS contract should be written off. ¶98. His liability for "group published" information is clearly pled.
Defendants are also liable for false statements which they did not personally issue, because they participated in a scheme to defraud.(31) ¶27. The Ninth Circuit, in Cooper, held that Central Bank, which precludes aiding-and-abetting liability, does not foreclose primary liability based on a scheme to defraud. Cooper, 1997 U.S. App. LEXIS 39330 at **20-22. In an attempt to end-run the Ninth Circuit's holding in Cooper, the defendants claim repeatedly that the "Complaint alleges that the defendants were part of a 'conspiracy.'" TCSI Defs' Mem. at 22. The Complaint, however, neither contains the term "conspiracy" nor alleges conspiracy liability. More to the point, the Ninth Circuit rejected an identical attempt by defendants to redraft a complaint in Cooper. The court stated:
The complaint does not allege a conspiracy . . . . Instead, it alleges a "scheme," in which [the defendants] directly participated, tracking the language of Rule 10b-5(a) . . . .
Central Bank does not preclude liability based on allegations that a group of defendants acted together to violate the securities laws, as long as each defendant committed a manipulative or deceptive act in furtherance of the scheme.
Id. at *21; accord Health Management, 970 F. Supp. at 209. Thus, participating in a fraudulent scheme is a primary violation of Rule 10b-5. As Central Bank stated, "[i]n any complex securities fraud, moreover, there are likely to be multiple violators." 511 U.S. at 191.
Contrary to defendants' contentions, it is well-settled that a defendant may commit a "deceptive act," for the purposes of §10(b), even if he does not speak. In Affiliated Ute Citizens v. United States, 406 U.S. 128 (1972), the Supreme Court stated that "the second subparagraph of the rule specifies the making of an untrue statement of a material fact and the omission to state a material fact," but held that since "[t]he first and third subparagraphs are not so restricted," defendants violated 10b-5 by participating in "a 'course of business' or a 'device, scheme or artifice' that operated as a fraud" -- even though these defendants had never themselves said anything that was false or misleading. Id. at 152-53. In re Software Toolworks Sec. Litig., 50 F.3d 615, 628 n.31, 629 (9th Cir. 1995) (accountant who participated in letter that was a part of a fraudulent scheme primarily liable); Shores v. Sklar, 647 F.2d 462 (5th Cir. 1981) (en banc) (a defendant who did not issue statements could be held primarily liable as a participant in a scheme to defraud). See also Adam v. Silicon Valley Bancshares, 884 F. Supp. 1398, 1401 (N.D. Cal. 1995) (recognizing validity of Software Toolworks). The Second Circuit recently affirmed §10(b) liability of an executive who made no false statements, but participated in a scheme to defraud investors:
Primary liability may be imposed "not only on persons who made fraudulent misrepresentations but also on those who had knowledge of the fraud and assisted in its perpetration." Azrielli v. Cohen Law Offices, 21 F.3d 512, 517 (2d Cir. 1994).
The evidence presented at trial sufficed to establish that [the executive] had knowledge of [the corporation's] frauds and participated in the fraudulent scheme.
SEC v. First Jersey Secs., 101 F.3d 1450, 1471 (2d Cir. 1996), cert. denied, 118 S. Ct. 57 (1997).
Insiders commit a deceptive act in furtherance of a scheme when, as here, they trade stock based on non-public information. The Supreme Court holds that "§10(b) and Rule 10b-5 are violated when a corporate insider trades on the basis of material, non-public information. Trading on such information qualifies as a 'deceptive device' under §10(b)." United States v. O'Hagan, ___ U.S. ___, 117 S. Ct. 2199, 2207 (1997) (citation omitted). Put differently, the practice of trading on inside information violates the "abstain-or-disclose" doctrine and is manipulative act:
There is no doubt that an individual corporate insider in possession of material nonpublic information is prohibited by the federal securities laws from trading on that information unless he makes public disclosure. He must disclose or abstain from trading.
Shaw, 82 F.3d at 1203; see Chiarella v. United States, 445 U.S. 222, 226-29 (1980); Dirks v. SEC, 463 U.S. 646, 654 (1983). In the present case, the insiders all engaged in massive insider selling knowing undisclosed material information about TCSI's declining business. ¶106. Such insider trading violates the abstain-or-disclose doctrine, qualifies as a "deceptive act," and therefore results in liability under §10(b) for participation in a larger scheme to defraud.
Defendants made false statements to the market on specific dates through the identified analysts, via both conference calls and private communications with the analysts. ¶¶44-47, 49, 54-55, 63-64, 67-69, 70, 73, 75-77, 81-82, 86.
Citing In re Syntex Corp. Sec. Litig., 95 F.3d 922, 934 (9th Cir. 1996), and Stac, 89 F.3d at 1410, defendants insist that they cannot be liable unless they "adopted" the analysts' reports, or "put their imprimatur, express or implied, on the [analysts'] projections." TCSI Defs' Mem. at 20. Neither case is so broad. The Ninth Circuit held in Cooper that this "argument fails, as we have held that corporate defendants may be directly liable under 10b-5 for providing false or misleading information to third-party securities analysts." 1997 U.S. App. LEXIS 39330 at *18. The Ninth Circuit explained:
[O]ur decisions in Stac and Syntex did not consider whether corporate defendants could be directly liable for misrepresentations to securities analysts. See In re Cirrus Logic Sec. Litig., 946 F. Supp. 1446, 1467 n.13 (N.D. Cal. 1996). Instead, the issue in Stac and Syntex was whether corporate defendants could be held liable for analysts' interpretations of defendants' truthful statements. See id. Our decisions in Stac and Syntex do not preclude plaintiffs' claims that [defendants] made false and misleading statements to securities analysts with the intent that the analysts communicate those statements to the market.
Id. at **19-20. That is precisely what is alleged here. Defendants are liable for statements made to analysts where "[t]he Complaint asserts that [the Company] intentionally used these third parties to disseminate false information to the investing public." Warshaw, 74 F.3d at 959. See Fecht, 70 F.3d at 1080; Cirrus, 946 F. Supp. at 1467; In re DSP Group Sec. Litig., Case No. C-95-4025-CAL, 1997 U.S. Dist. LEXIS 11942 at *19 (N.D. Cal. Mar. 5, 1997) (defendants may be liable for misleading statements made to analysts "even if the company did not adopt the analysts' subsequent reports"). The Complaint here is replete with particularized allegations of false and misleading statements made directly to analysts, with plaintiffs setting forth additional instances of defendants' reviewing, copying and distributing analysts' reports. See ¶¶44-47, 49, 54-55, 63-64, 67-69, 73, 75-77, 81-82, 86.
Moreover, plaintiffs here have alleged both entanglement and adoption by the TCSI defendants. For example, in ¶¶47 and 49, among others, plaintiffs allege that defendants communicated false information to the analysts, and later reviewed and approved the resultant reports. That is entanglement for which they can be held liable. Cirrus, 946 F. Supp. at 1467. Plaintiffs allege that defendants adopted specifically-described analysts' reports by reproducing and distributing the erroneous reports. ¶¶63-64. Indeed, in May 1996 TCSI reproduced and publicly distributed excerpts from specific analyst reports, labeled "sponsored by TCSI Corporation." ¶70. Still other allegations demonstrate both entanglement and adoption, with defendants speaking directly to analysts on certain dates, with the resultant analysts' reports reviewed by defendants, then copied and distributed by them. ¶¶47, 49, 75-76.
The SEC recently confirmed that
under certain circumstances an issuer that disseminates false third party reports may adopt the contents of those reports and be fully liable for the misstatements contained in them, even if it had no role whatsoever in the preparation of the report.
See In the Matter of Order Instituting Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934 Against Presstek, Inc., SEC Release Nos. 39472, 997 (Dec. 22, 1997) (Lawrence Decl., Ex. K). "Entanglement," requires only that plaintiffs show "some evidence" of pre-publication involvement with a report that contains misstatements. Id. "Once an analyst's statement is imputed to the defendants, they may be found liable 'as if they made the statement themselves.'" Id. (citation omitted). Defendants' liability for analysts' statements is properly pled.
Defendants also insist that the analysts' reports cannot be a basis for liability unless plaintiffs allege "that defendants actually knew that the analysts' forecasts were false" when made. TCSI Defs' Mem. at 20. Defendants are wrong for two reasons. First, those statements are not immunized by the safe harbor for the reasons set out in §IV, above. Second, because much of the analysts' reports describe existing conditions they would not come within the safe harbor ever if made on defendants' behalf. See, e.g., ¶47 ("TCSI is well positioned to benefit" and its OSG "is growing at well above a 50% annual rate"); ¶54 (Company enjoying "strong bookings and continued strong backlog" and "is able to maintain its backlog at such a high level while continuing to generate revenue growth"); ¶73 ("interest in TCSI's . . . software solutions is soaring" and "software strategy picking up steam"). Because these misstatements are non-forward-looking, plaintiffs need only allege facts leading to a strong inference they were made recklessly. Marksman Partners, 927 F. Supp. at 1310-11.
Finally, the reports at issue are evidentiary facts demonstrating that defendants' false statements of financial results and current facts were misleading, for they show how those statements operated to mislead analysts and the market. In Durning, 815 F.2d 1265, the Ninth Circuit held that plaintiffs may use statements of securities analysts or other financial professionals to show how defendants' statements were misleading. Id. at 1266, 1269. Analysts' interpretations of defendants' statements are particularly relevant in fraud-on-the-market cases, as "market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices." Basic, 485 U.S. at 246 n.24; see also Harvey M. Jasper Retirement Trust v. Ivax Corp., 920 F. Supp. 1260, 1267 (S.D. Fla. 1995); In re Synergen, Inc. Sec. Litig., 863 F. Supp. 1409, 1418 (D. Colo. 1994) (summary judgment foreclosed by analyst's report demonstrating misunderstanding of pharmaceutical test data).
Wagner claims that in order to state a claim for liability on a "control person" under §20(a) of the Exchange Act, plaintiffs must allege that he was a culpable participant in the wrongful conduct.(32) Wagner Mem. at 24-25. Wagner is wrong both on the law and on the facts.
First, defendant is wrong in the law. In Hollinger, the Ninth Circuit expressly held that the plaintiff is not required to have "culpable participation" to establish "control person" liability, overruling the cases relied upon by Wagner. Rather, the Hollinger court held,
Section 20(a) provides that a "controlling person" is liable "unless [he] acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action." 15 U.S.C. §78t(a). Thus, the statute premises liability solely on the control relationship, subject to the good faith defense. According to the statutory language, once the plaintiff establishes that the defendant is a "controlling person," then the defendant bears the burden of proof to show his good faith.
914 F.2d at 1574 (citation omitted, footnote omitted). To state a claim for controlling person liability, plaintiffs may allege a primary violation of the federal securities laws and "'control' by the alleged controlling person." Id. The term "control," as used in §15, 15 U.S.C. §77o, and §20(a), 15 U.S.C. §78t(a), includes the "possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise." 17 C.F.R. §230.405. See also Hollinger, 914 F.2d at 1572 n.16; Safeway Portland Employees' Fed. Credit Union v. C.H. Wagner & Co., 501 F.2d 1120 (9th Cir. 1974).
Since Hollinger the controlling precedent has uniformly rejected the "culpable participant" requirement. E.g., Arthur Children's Trust v. Keim, 994 F.2d 1390, 1398 (9th Cir. 1993); Powers, 977 F. Supp. at 1044-45. Moreover, because liability under §20(a) is based solely on the control relationship without culpable participation in the circumstances constituting fraud, control is not among the "circumstances constituting fraud" that Rule 9(b) requires to be pleaded with particularity. Rule 9(b) requires particularity only where liability rests upon the circumstances of fraud. Leatherman v. Tarrant County Narcotics Intelligence & Coordination Unit, 507 U.S. 163, 167-68 (1993); GlenFed, 42 F.3d at 1546. In order to hold Wagner liable under §20(a), the Complaint need only allege that Wagner had power or influence over the Company. Powers, 977 F. Supp. at 1044-45. Clearly, it does.
Plaintiffs allege that Wagner, one of the Company's founders, "by reason of [his] executive positions and membership on the Board of Directors of TCSI, [was a] controlling person[] of TCSI and had the power and influence, and exercised the same, to cause TCSI to engage in the conduct complained of herein." ¶¶20, 22. See also ¶115. This identical allegation was found "sufficient to satisfy the pleading standard for a §20(a) violation. . . . [and assuming a §10(b) claim is stated] withstands the Defendants' motion to dismiss." Powers, 977 F. Supp. at 1044-45. See also Health Management, 970 F. Supp. at 205-06. Moreover, Wagner's sale of 3,675,000 shares of his TCSI stock in the March 1996 offering, indeed, the very fact of that offering, demonstrates his power and influence at TCSI. Finally, plaintiffs also allege that Wagner and the Individual Defendants participated in the particular drafting, approval, and issuance of numerous other materially false and misleading statements issued by the Company. Thus, even if Fed. R. Civ. P. 9(b) applied, these allegations more than sufficiently allege Wagner's power to direct and control TCSI. E.g., Powers, 977 F. Supp. at 1044-45; Health Management, 970 F. Supp. 205-06; see also Marksman Partners, 927 F. Supp. at 1315; ValuJet, ¶99,579, at 97,885-86. Accordingly, Wagner is properly charged with "control person" liability under §20(a).
Wagner's claims that plaintiffs have failed to plead reliance and damages must be rejected. Plaintiffs have alleged that the price of TCSI's stock was artificially inflated throughout the Class Period by defendants' false and misleading statements, e.g., ¶¶1, 5, 15, and that they and the other class members relied on these statements by purchasing stock during the Class Period, and were damaged thereby. ¶20(a). Under the fraud-on-the-market theory plaintiffs have adequately pled reliance. "Because most publicly available information is reflected in market price, an investor's reliance on any public material misrepresentations, therefore, may be presumed for purposes of a Rule 10b-5 action." Basic, 485 U.S. at 247; Kaplan, 49 F.3d at 1376. Page, 1997 U.S. Dist. LEXIS 3673 at *16. The allegations that defendants' misrepresentations caused the artificially inflated price and induced the purchase clearly allege the requisite damage. ¶113. Blackie, 524 F.2d 891; Page, 1997 U.S. Dist. LEXIS 3673 at **15-17; Galaxy Inv. Fund v. Fenchurch Capital Management, Case No. 96-C-8098, 1997 U.S. Dist. LEXIS 13207 at **41-42 (N.D. Ill. Aug. 29, 1997). Nothing more is required.
For all of the foregoing reasons, defendants' motions to dismiss the Complaint should be denied.
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DATED: February 19, 1998 |
Respectfully submitted, MILBERG WEISS BERSHAD MILBERG WEISS BERSHAD ______________________________ 222 Kearny Street, 10th Floor LAW OFFICES OF JAMES V. WOLF POPPER LLP Attorneys for Plaintiffs and the Class |
TCSI\JMI03850.BRF
1. TCSI and the nine top executives -- TCSI, Harvey E. Wagner, Harish S. Rao, Roger A. Strauch, Daniel H. Miller, John C. Bolger, Ram A. Banin, William A. Hasler, David G. Messerschmitt and Paul A. Farmer -- are referred to herein as "defendants."
2. All "¶__" references are to plaintiffs' Complaint for Violation of the Securities Exchange Act of 1934, filed September 24, 1997 ("Complaint"), unless otherwise indicated.
3. Here, as elsewhere, emphasis has been added unless otherwise indicated.
4. E.g., Marksman Partners, L.P. v. Chantal Pharm. Corp., 927 F. Supp. 1297 (C.D. Cal. 1996); Powers v. Eichen, 977 F. Supp. 1031 (S.D. Cal. 1997); Cherednichenko, et al. v. Quarterdeck Corp., et al., Case No. CV-97-4320-GHK(CWx), Minute Order (C.D. Cal. Nov. 26, 1997) (Lawrence Decl., Ex. A). See also Rehm v. Eagle Fin. Corp., 954 F. Supp. 1246, 1251 n.1 (N.D. Ill. 1997) ("[I]nsofar as the pleading standard set forth in the [PSLRA] 15 U.S.C. §78u-4(b)(2), is based upon the judicial interpretation of Rule 9(b)'s particularity standard, Rule 9(b) is very relevant to our discussion of the adequacy of the complaint on this motion.") (citation omitted).
5. See, e.g., Warshaw v. Xoma Corp., 74 F.3d 955, 960 (9th Cir. 1996); Fecht v. Price Co., 70 F.3d at 1078, 1082-84 (9th Cir. 1995), cert. denied, 116 S. Ct. 1422 (1996); GlenFed, 42 F.3d at 1550-51; In re Wells Fargo Sec. Litig., 12 F.3d 922, 926-28 (9th Cir. 1993); Wool v. Tandem Computers, Inc., 818 F.2d 1433, 1435-36 & 1439 (9th Cir. 1987); Blake v. Dierdorff, 856 F.2d 1365, 1368-70 (9th Cir. 1988).
6. See also Rehm, 954 F. Supp. 1246 (understated credit losses and overstated earnings); STI Classic Fund v. Bollinger Indus., [1997 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶99,539 (N.D. Tex. 1996) (financial results materially inflated); Cherednichenko, Case No. CV-97-4320-GHK(CWx), Minute Order (improper revenue recognition) (Lawrence Decl., Ex. A); 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); Flecker v. Hollywood Entertainment Corp., [1997 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶99,436, at 96,859 (D. Or. 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 . . . .").
7. AICPA Statement of Position ("SOP") 91-1 (Software Revenue Recognition) states that revenue should not be recognized on software licenses unless "collectibility is probable." SOP 91-1; ¶34c, see ¶94. In addition to the credit worthiness of customers, other aspects of collectibility are also important, including customer cancellation privileges and payment terms. SOP 91-1, ¶¶47-57, see ¶94.
8. Thus, unlike Shuster v. Symmetricon, Inc., [1997 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶99,437 (N.D. Cal. 1997), plaintiffs here do plead a "later statement by defendant[s] along the lines of 'I knew it all along'" which demonstrates they knew their financial statements were false. GlenFed, 42 F.3d at 1549 n.9; see ¶102.
9. In Michaels Bldg. Co. v. Ameritrust Co., N.A., 848 F.2d 674, 681 (6th Cir. 1988), the court reversed dismissal of a complaint because plaintiffs could not name every person involved in the scheme alleged. "We will not demand clairvoyance from pleaders," the appellate court explained. Id. "Corporate entities who jealously guard the names of their clients or other information" would never lose a motion to dismiss if courts demanded such specificity. Id.; see In re Bausch & Lomb Sec. Litig., 941 F. Supp. 1352, 1361 (W.D.N.Y. 1996).
10. In Cooper, the fact that optimistic statements were still being made only three weeks before adverse revelations was "circumstantial evidence" of falsity, strengthened by the fact that the company was attempting to complete a stock offering. 1997 U.S. App. LEXIS 39330 at **23-26; see also Powers, 977 F. Supp. at 1039-40. In Fecht, where adverse disclosures came ten weeks after the last optimistic statements, this "shortness of time" was held to be "circumstantial evidence that the optimistic statements were false when made." 70 F.3d at 1083.
11. See San Leandro Emergency Med. Group Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801, 809 (2d Cir. 1996) ("a significant decline in the price of the company's stock" evidences the materiality of newly disclosed information); see also Rubinstein v. Collins, 20 F.3d 160, 169-70 (5th Cir. 1994) (information is presumptively material given the allegation that within one day of disclosure the stock price fell substantially).
12. Statements like these made in connection with specific earnings projections are, as Cooper holds, more than "mere optimism." 1997 U.S. App. LEXIS 39330 at *37. "What might be innocuous 'puffery' or mere statement of opinion standing alone may be actionable as an integral part of a representation of material fact when used to emphasize and induce reliance upon such a representation." Casella v. Webb, 883 F.2d 805, 808 (9th Cir. 1989) (quoting G & M, Inc. v. Newbern, 488 F.2d 742, 745-46 (9th Cir. 1973)); accord Metromedia Co. v. Fugazy, 983 F.2d 350, 361-62 (2d Cir. 1992) (following Casella); see also Marx v. Computer Sciences Corp., 507 F.2d 485, 489-90 (9th Cir. 1974).
13. See Cooper, 1997 U.S. App. LEXIS 39330 at **5-6 ("business was strong . . . [recent] acquisition . . . would increase . . . earnings per share . . . demand was strong . . . international operations were stabilizing and could be expected to be profitable in [current year]"); Provenz, 102 F.3d at 1487, 1489 ("MIPS expected . . . 'higher technology revenue performance . . . for the total year,'" there was "'pretty significant demand'" for a new product and "shipment levels would increase in the third quarter of 1991"); Warshaw, 74 F.3d at 957-58 ("'everything [was] going fine'" with a new product, which "'shows positive forward progress'"); Fecht, 70 F.3d at 1081 (company "'anticipates a continuation of its accelerated expansion schedule,'" representing that it "'feel[s] a little more optimistic about our near-term future than [it] did at the end of the last quarter,'" predicting "'overall improvement in the sales trend'"); Kaplan v. Rose, 49 F.3d 1363, 1375-76 (9th Cir. 1994) (company's competitive position was "'strong,'" "'[p]rogress is excellent,'" "'our outlook is bright'" and "'we see increased sales activity'" as the "'market is responding favorably'" to a new product); and Gray v. First Winthrop Corp., 82 F.3d 877, 880 (9th Cir. 1996) (company was "progressing 'smoothly'" due to "'successful'" marketing program, "surge in leasing activity" and was "'well-positioned for [the] future'").
14. The Complaint's statements that plaintiffs' allegations are likely to have evidentiary support after reasonable opportunity for further investigation or discovery simply tracks the language of Rule 11(b)(3) and does not invoke information and belief. ¶24. The PSLRA requires that securities complaints satisfy Rule 11. 15 U.S.C. §78u-4(c).
15. See Ouaknine v. MacFarlane, 897 F.2d 75, 81 (2d Cir. 1990) (plaintiffs adequately supported their belief that a fraud was committed by including the specific facts that they contended made the statements false); DiVittorio v. Equidyne Extractive Indus., 822 F.2d 1242, 1247-48 (2d Cir. 1987) ("allegations regarding the Equidyne defendants . . . framed entirely upon information and belief" passed muster where plaintiff included facts showing why he believed defendants' statements were false); Luce v. Edelstein, 802 F.2d 49, 54 n.1 (2d Cir. 1986) (information and belief allegations regarding an offering memorandum survived because plaintiff's belief that the memorandum was misleading was based on specified facts); Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 379 (2d Cir. 1974) ("While all of [the] allegations are stated on information and belief . . . the particularity requirement may be satisfied if, as here, the allegations are accompanied by a statement of the facts upon which the belief is founded."). San Leandro, 75 F.3d 801, is not contrary. There, the Second Circuit rejected allegations that a company failed to disclose a change in its marketing strategy, in the absence of allegations that Philip Morris had made any statements or predictions foreclosing the possibility of adopting alternative marketing strategies. Here, plaintiffs allege affirmative misstatements and how and why they were contradicted by facts known to defendants.
16. 818 F.2d at 1439-40; see, e.g., Flashman v. Singleton, [1990-1991 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶95,872, at 93,313 (N.D. Cal. 1991); Wegbreit v. Marley Orchards Corp., 793 F. Supp. 957, 962 (E.D. Wash. 1991); Rolex Employees Retirement Trust v. Mentor Graphics Corp., 749 F. Supp. 1042, 1047 (D. Or. 1990); In re ZZZZ Best Sec. Litig., [1989 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶94,485, at 93,095 (C.D. Cal. 1989);