Monday, July 18, 2005

First Circuit Reverses PSLRA Dismissal, Establishes New Clarity and Basis Test, and Restricts Safe Harbor Protections

File your appeal in the First Circuit, and a Second Circuit Judge authors the opinion? That’s what happened in Friday’s Stone & Webster decision, authored by Second Circuit veteran Judge Pierre Nelson Leval. Also serving on the Panel were District Judge Edward Francis Harrington (from the District of Massachusetts) and the First Circuit’s sole representative Judge Michael Boudin. Interestingly, Judges Boudin and Leval studied at Harvard together, and were both law clerks in the early 60’s for the Second Circuit’s legendary late pragmatic jurist Henry J. Friendly (also a Harvard alumnus). Of additional interest, of the seven First Circuit PSLRA decisions issued to date, this is the first one that was not written by First Circuit Judges Juan R. Torruella or Sandra Lea Lynch.

The Panel started its unanimous decision by noting that "the Complaint's strongest factual allegations fall into three main categories." "First, that S&W deliberately underbid on more than a billion dollars of contracts, which at the contract price could be performed only at a loss, and fraudulently reported anticipatory profits on these loss contracts, so as to overstate earnings; second, that S&W fraudulently concealed its loss on a huge contract in Indonesia with Trans Pacific Petrochemical Indotama ("TPPI") by concealing the cancellation of the contract and thus reported unreceived revenues, inflating the Company's profits or diminishing its losses; and finally, that S&W made public statements, which concealed and misrepresented its shortage of liquid reserves and its impending bankruptcy, as its finances slid into shambles."

From there, the Panel proceeded to evaluate Plaintiffs’ argument that Judge Reginald Lindsay (yes more Crimson here too) (D. Mass.) was wrong to dismiss their claims (on 12(b)(6) and later on summary judgment) that in committing these acts, Defendants (CEO & CFO Smith and Langford and PwC) violated § 10(b), § 18, and § 20(a) of the 1934 Exchange Act.

The Panel coined a new phrase they call the "clarity-and-basis" requirement. Basically, this is a simplified method for analyzing 15 U.S.C. § 78u-4(b)(1)’s specificity, reasons for falsity, and particularity prerequisites, and the Panel says that it is "closely related to the requirement of Federal Rule of Civil Procedure 9(b)" and that "the PSLRA's pleading standard is congruent and consistent with pre-existing Rule 9(b) pleading standards in this Circuit."

"The central allegations in the Complaint" "can be grouped into three general categories." "The first category of plaintiffs' claims principally relates to the allegation that S&W underbid various projects and fraudulently reported expected profits from these projects when, in fact, the projects were expected to produce losses." Noting the specificity of Plaintiff’s claims in this respect, the Panel said "in our view, this pleading is not the kind of vague prelude to a fishing expedition that Congress sought to bar by imposing the clarity-and-basis requirement of the PSLRA." In addition, "with respect to clarity, the Complaint sets forth a clear and precise statement of what the alleged fraud consisted of. With respect to basis, while the sources of information on which the Complaint relies for these allegations are not overwhelmingly impressive, they include sources within the Company who might well have access to the kind of information for which they are cited."

However, the Panel found "the Complaint deficient" with respect to these claims, because Plaintiffs provided "nothing supporting the inference that either Smith or Langford was directly involved in the detailed accounting for these ten particular contracts, or had knowledge of the alleged falsity." In sum, "irregular financial statements which overstate estimated results to only a small degree do not support a strong inference that the Chief Executive Office or the Chief Financial Officer of the company acted with intent to defraud, or with reckless disregard for the truth of the statements." Accordingly, the Panel affirmed the dismissal of these 10b-5 claims, but reached "a different result, however, where those claims are asserted under §§ 20(a) and 18," because those claims do not require proof of scienter, and the Panel "vacate[d] the judgment dismissing them."

"The second group of claims of fraud relates to the TPPI contract for construction in Indonesia, which was ultimately cancelled for lack of funding." The Panel held that "the allegations of exaggerated revenues and failure to report an expected loss are sufficiently detailed and supported to satisfy the PSLRA's clarity-and-basis requirement," because "the GAAP documents cited by the Complaint specify that the propriety of reporting unreceived payments as current revenue, matched with currently incurred costs, depends on a reasonable expectation that the buyer will satisfy the obligation to make the payments" and "the Complaint clearly states its theory that TPPI's expected failure to pay would result in very substantial losses to S&W, which it did not take as a charge against earnings."

However, the Panel found that the Complaint again failed the strong inference test as to the CEO and CFO because the complaint lacks "sufficiently compelling and clear factual allegations concerning the culpable involvement of Smith and Langford to support a strong inference of scienter on their part," and because "despite the Complaint's rhetorical flourish, accusing defendants of reporting 'phantom revenue,' the booking of revenues before their receipt does not necessarily involve any impropriety whatsoever."

"The Complaint's final major area of focus is on statements allegedly concealing S&W's financial deterioration. The Complaint contends that S&W issued false and misleading statements reassuring investors of S&W's financial viability and its access to sufficient cash to meet its needs, even as its finances fell into shambles, and eventually into bankruptcy." To this, the Panel found that "the allegations of financial deterioration are set forth in the Complaint at length and with specificity," and that "a jury could reasonably find that the cumulative sum of information provided to investors by that point was still materially misleading."
As for clarity and basis, the Panel said that "we have no doubt that these allegations pass the" test, because the "complaint paints a detailed account of the deteriorated financial conditions at S&W, replete with factual support and citations to sources likely to have knowledge of the matter."

Turning to the Defendants’ "safe harbor" defense, the Panel observed that the statute "seems to provide a surprising rule that the maker of knowingly false and willfully fraudulent forward-looking statements, designed to deceive investors, escapes liability for the fraud if the statement is identified as a forward-looking statement and [was] accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement." To that, the Panel said "we think that the meaning of this curious statute, which grants (within limits) a license to defraud, must be somewhat more complex and restricted." "By reason of the emphasis on "projections," "plans," and "statements of future economic performance," we understand the statute to intend to protect issuers and underwriters from liability for projections and predictions of future economic performance, which are later shown to have been inaccurate." "We believe that in order to determine whether a statement falls within the safe harbor, a court must examine which aspects of the statement are alleged to be false. The mere fact that a statement contains some reference to a projection of future events cannot sensibly bring the statement within the safe harbor if the allegation of falsehood relates to non-forward-looking aspects of the statement. The safe harbor, we believe, is intended to apply only to allegations of falsehood as to the forward-looking aspects of the statement," and "we do not think Congress intended to grant safe harbor protection for [statements] whose falsity consists of a lie about a present fact."

In applying this framework to the Company’s statements that it "has on hand and has access to sufficient sources of funds to meet its anticipated operating, dividend and capital expenditure needs," the Panel held that "we do not agree with the district court that this statement is necessarily protected by the PSLRA's safe harbor rule," and "we reject the district court's conclusion that the statements assuring that the Company had access to sufficient cash to cover anticipated needs were within the safe harbor."

In remanding the action back to the District Court, the Panel noted that "we do not purport to have ruled on each of the numerous fraudulent statements alleged in the Complaint. To the extent an allegation of fraud is not discussed in this opinion, the district court should rule again on defendants' motion to dismiss, in a manner consistent with the discussions herein."

You can read the decision at 2005 U.S. App. LEXIS 14325.

Nugget: "The falsity of a statement and the materiality of a false statement are questions for the jury," and "a court is thus free to find, as a matter of law, that a statement was not false, or not materially false, only if a jury could not reasonably find falsity or materiality on the evidence presented."

Nugget: "As we understand, it was not Congress's intention to bar all suits as to which the plaintiff could not yet prove a prima facie case at the time of the complaint, but rather to prevent suits based on a guess that fraud may be found, without reasonable basis or a clear understanding as to what the fraud consisted of, but in the hope of finding something in the course of discovery."

Nugget: "In our view, the safe harbor of the PSLRA does not confer a carte blanche to lie in such representations of current fact."

Nugget: "One difficulty we find with the district court's decision is that in several instances, in ruling on defendants' motion to dismiss under Federal Rule of Civil Procedure 12(b)(6), the court failed to read the Complaint in the light most favorable to the plaintiff and failed to give the plaintiff the benefit of inferences that could reasonably be drawn."

Nugget: "A plaintiff has the right to plead in the alternative, and the plaintiff's doing so does not undermine the validity of the complaint. The stronger of the conflicting allegations must be accepted as if the conflicting alternative allegation had not been included. Nor is this changed by the PSLRA's strong-inference requirement. In assessing whether the pleading satisfies the strong-inference requirement, a court must draw all reasonable inferences in the plaintiff's favor, and then weigh whether they satisfy the statutorily mandated strong inference."

Nugget: "We recognize that a plaintiff must show under § 20(a) that the controlled entity committed a violation of the securities laws. If that violation was, for example, a violation of Rule 10b-5, which requires a proof of scienter, then the plaintiff under § 20(a) must prove that the controlled entity acted with "a particular state of mind." Nonetheless, if the statute is read literally, the strong-inference requirement of the PSLRA does not apply"

Nugget: "Where the state of mind in question is the defendant's knowledge of the fraudulent nature of the Company's financial reports, and the PSLRA requires that facts be stated with particularity giving rise to a strong inference that the defendant acted with that state of mind, the requirement is not satisfied by a pleading which simply asserts that the defendant knew of the falsity."

Nugget: "The Complaint alleges furthermore that throughout 1998 comprehensive internal financial reports of the Company's current condition were regularly distributed to the Company's top executives. Id. Although the contents of the reports are not described, we can fairly infer that they described what they purported to describe - the Company's current financial condition."

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