New England Health v. Ernst & Young ( 2003 )

RECOMMENDED FOR FULL-TEXT PUBLICATION
Pursuant to Sixth Circuit Rule 206 2 New England Health No. 01-6523
ELECTRONIC CITATION: 2003 FED App. 0226P (6th Cir.) Care v. Ernst & Young
File Name: 03a0226p.06
_________________
UNITED STATES COURT OF APPEALS COUNSEL
FOR THE SIXTH CIRCUIT ARGUED: Eric A. Isaacson, MILBERG, WEISS,
_________________ BERSHAD, HYNES & LERACH, San Diego, California, for
Appellant. Stanley J. Parzen, MAYER, BROWN, ROWE &
NEW ENGLAND HEALTH CARE X
MAW, Chicago, Illinois, for Appellee. ON BRIEF: Eric A.
-
Isaacson, Joseph D. Daley, MILBERG, WEISS, BERSHAD,
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EMPLOYEES PENSION FUND, HYNES & LERACH, San Diego, California, for Appellant.
-
On Behalf of Itself and All Stanley J. Parzen, Jeffrey W. Sarles, MAYER, BROWN,
-
No. 01-6523 ROWE & MAW, Chicago, Illinois, Frank P. Doheny, Jr.,
Others Similarly Situated, DINSMORE & SHOHL, Louisville, Kentucky, Lora S.
,
Plaintiff-Appellant, > Morris, MUSE & MORRIS, Louisville, Kentucky, for
- Appellee.
v. -
- _________________
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Defendant-Appellee. -
ERNST & YOUNG, LLP, OPINION
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_________________
N DAVID A. NELSON, Circuit Judge. Private lawsuits
Appeal from the United States District Court impliedly authorized under § 10(b) of the 1934 Securities
for the Western District of Kentucky at Bowling Green. Exchange Act, the Supreme Court held in Lampf, Pleva,
No. 00-00124—Joseph H. McKinley, Jr., District Judge. Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350(1991), are subject to the statutory limitations provision
Argued: May 1, 2003 established in § 9(e) of the Act. Private securities fraud
actions must thus be “brought within one year after discovery
Decided and Filed: July 9, 2003 of the facts constituting the violation and within three years
after such violation.” See 15 U.S.C. § 78i(e).
Before: NELSON and COLE, Circuit Judges; ROSEN,
District Judge.* The present action, a § 10(b) securities fraud case brought
by an investor against an accounting firm, is barred by the
one-year statute of limitations if the word “discovery,” as
used in the statute, extends to constructive discovery as well
as actual discovery. The plaintiff investor having been put on
“inquiry notice” of the alleged fraud more than one year
*
The Honorable Gerald E. Rosen, United States District Judge for the
Eastern District of Michigan, sitting by designation.
1
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Care v. Ernst & Young Care v. Ernst & Young
before the filing of the complaint, in other words, the question generally accepted accounting principles.” The report stated
is whether such notice suffices to bar the action. further that Ernst had conducted its audit of Fruit’s statements
“in accordance with generally accepted auditing standards”
Like a number of our sister circuits, we believe that inquiry (“GAAS”).
notice is sufficient to trigger the running of the one-year
limitations period. The district court dismissed this case on In March of 1997, Fruit filed its Form 10-K – which
grounds that involved the three-year statutory period, among included the 1996 financial statements and Ernst’s
other things, but we shall affirm the dismissal under the one- February 12 audit report – with the Securities and Exchange
year provision without reaching the grounds found persuasive Commission (“SEC”). The next month, Fruit distributed the
by the district court. financial statements and Ernst’s certification to its
shareholders as part of an annual report. Also in April, Fruit
I reported its results for the first quarter of 1997 – results that
were down from the first quarter of 1996 and that fueled a
This case has its origins in financial difficulties decline in the value of Fruit stock. Fruit reported its second-
experienced by clothing manufacturer Fruit of the Loom, Inc. quarter results, which were again below 1996 levels, in July.
(“Fruit”) in the 1990s. According to the plaintiff, Fruit’s The plaintiff contends that Fruit’s first and second quarter
stock “collapse[d]” in November of 1995 as a result of market financial statements, which were reviewed by Ernst, departed
changes and poor management. Fruit took steps to improve from GAAP.
performance in 1996, but it became clear by the fourth
quarter that Fruit would not meet its financial goals for the On July 9, 1997, Fruit filed a registration statement with
year. Therefore, the plaintiff has alleged, Fruit’s management the SEC in connection with a public offering of securities.
instituted a “pull-forward” program of early shipments, which The registration statement included Fruit’s financial
was designed to accelerate recognition of 1997 revenues into statements for 1996 and the first two quarters of 1997,
the fourth quarter of 1996. Fruit ended up reporting financial incorporated Ernst’s February 12 audit report by reference,
results for 1996 that were much higher than expected, and and included a letter in which Ernst consented to the use of its
Fruit’s stock rebounded. report. On August 6, 1997, Fruit filed an amendment to the
July 9 registration statement. The amendment, like the
Fruit’s 1996 financial statements were audited by Ernst & original registration statement, incorporated Ernst’s audit
Young, LLP (“Ernst”), the defendant herein. According to report and included Ernst’s consent to the use of that report.
the plaintiff, the statements violated generally accepted
accounting principles (“GAAP”) by failing to write down For the third and fourth quarters of 1997, Fruit reported
overvalued inventory and fixed assets and failing to accrue large losses. In January of 1998, the value of Fruit’s stock
certain liabilities, as well as by improperly recognizing 1997 dropped to slightly more than half of what it had been in
revenue in 1996. In a report dated February 12, 1997, March of 1997.
however, Ernst certified that Fruit’s 1996 financial statements
“present fairly, in all material respects, the consolidated On July 1, 1998, New England Health Care Employees
financial position of [Fruit] . . . and the consolidated results Pension Fund (“New England”), undertaking to act on behalf
of [its] operations and [its] cash flows . . . in conformity with of itself and other purchasers of Fruit stock, sued Fruit and
No. 01-6523 New England Health 5 6 New England Health No. 01-6523
Care v. Ernst & Young Care v. Ernst & Young
several of its directors and officers for securities fraud. New Act of 1995, 15 U.S.C. § 78u-4(b)(2). The district court
England alleged that the defendants intentionally overstated rejected Ernst’s argument that the action was barred by the
earnings on Fruit’s financial statements for 1996 and the first one-year statute of limitations, see 15 U.S.C. § 78i(e), holding
two quarters of 1997, and that the defendants made additional that it was not necessarily true that New England knew or
public statements about Fruit’s performance and prospects should have known of Ernst’s alleged fraud before June 28,
that were intentionally false (including representations that 1999.
the financial statements adhered to GAAP). Ernst was not
named as a defendant. The dismissal being without prejudice, New England filed
an amended complaint against Ernst in March of 2001. Ernst
While that case was pending, Fruit entered bankruptcy. again moved to dismiss the complaint, and the district court
Then, on June 28, 2000 – nearly two years after the filing of again granted the motion. The court rejected New England’s
the suit against Fruit – New England brought the present argument that Ernst’s consent letters constituted new
action against Ernst. New England’s complaint, which misrepresentations – made within the three-year period of
substantially repeated the earlier allegations of fraud by Fruit repose – that were materially different from the
and its directors and officers, alleged that Ernst participated misrepresentations allegedly contained in the February 12
in the fraud by certifying the 1996 financial statements as audit report. The court also held that New England still had
consistent with GAAP, stating that it audited the statements not pleaded sufficient facts showing scienter. The complaint
in accordance with GAAS, and consenting to the use of its was dismissed with prejudice, and this timely appeal
audit report in Fruit’s offering documents. According to New followed.
England, Ernst’s statements and letters of consent were
fraudulent because Ernst was aware of evidence contradicting II
Fruit’s reported results for 1996 and the first two quarters of
1997. We review the dismissal of New England’s complaint de
novo. See, e.g., In re Comshare, Inc. Securities Litigation,
Ernst moved for dismissal under Rule 12(b)(6), Fed. R. 183 F.3d 542, 547 (6th Cir. 1999). In doing so, we may
Civ. P., arguing that the action was time-barred and that New affirm the judgment of the district court on any ground
England had failed to allege particular facts supporting an supported by the record. See id. at 547-48.
inference of scienter, i.e., an inference that Ernst either knew
its statements to be false or was reckless in assessing their A
truth. The district court granted the motion. The court noted
that Ernst’s audit report of February 12, 1997, was made Securities fraud litigation under § 10(b) of the Securities
more than three years before the filing of suit, and it held that Exchange Act of 1934, 15 U.S.C. § 78j(b), and Securities and
Ernst’s consent letters of July 9 and August 6, 1997, did not Exchange Commission Rule 10b-5, 17 C.F.R. § 240.10b-5,
re-start the three-year repose period prescribed by 15 U.S.C. must be commenced, as we have seen, “within one year after
§ 78i(e). The court further held that New England had not the discovery of the facts constituting the violation . . . .” 15
pleaded “with particularity facts giving rise to a strong U.S.C. § 78i(e); see Lampf, 501 U.S. at 364, where the
inference that [Ernst] acted with the required state of mind” Supreme Court borrowed the limitations provisions of § 9(e)
in accordance with the Private Securities Litigation Reform
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Care v. Ernst & Young Care v. Ernst & Young
of the 1934 Act, 15 U.S.C. § 78i(e), for actions brought under stock recovered, reap investment profits if it did, and sue for
§ 10(b) and Rule 10b-5. damages if it did not. Tregenza v. Great American
Communications Co., 12 F.3d 717, 722 (7th Cir. 1993), cert.
Reading the language of § 9(e), narrowly, New England denied, 511 U.S. 1085 (1994).1 “This tactic is discouraged by
argues that only actual discovery of fraud can start the one- the doctrine of inquiry notice . . . .” Id.year limitations period. Ernst counters that the period begins
to run upon “inquiry notice” of fraud – meaning, under one The fact that Congress expressly provided for inquiry
interpretation, the point at which the plaintiff should have notice in § 13 of the 1933 Act, without doing so in § 9(e),
discovered the fraud through reasonably diligent inquiry. does not persuade us that “discovery” must be read as “actual
discovery.” As the Seventh Circuit has pointed out, Congress
New England is correct, of course, that § 9(e) refers only to could not have guessed in 1934 that § 9(e) would be applied
“discovery” as the trigger of the limitations period. Unlike to claims of fraud brought under § 10(b) – claims more
some other federal statutes of limitations – notably, § 13 of closely resembling “false statement” claims under §§ 11 and
the Securities Act of 1933, which allows actions based on 12 of the 1933 Act, 15 U.S.C. §§ 77k and 77l, than “market
false offering documents to be brought “within one year after manipulation” claims under § 9 of the 1934 Act, id. § 78i.
the discovery” of the false statement “or after such discovery See Tregenza, 12 F.3d at 721-22. Section 9(e)’s failure to use
should have been made by the exercise of reasonable “inquiry notice” language, therefore, cannot support an
diligence,” 15 U.S.C. § 77m (emphasis added) – § 9(e) does inference that Congress intended the narrowest possible
not expressly provide for inquiry notice. discovery standard to apply in actions arising under § 10(b).
See id. Congress never focused on the question, because
That does not necessarily mean, however, that § 9(e) Congress never chose any statute of limitations for § 10(b)
requires actual discovery of fraud before the limitations actions – actions that are, after all, creatures of the courts and
period will begin to run. The term “discovery,” when used in not of the legislature. See Lampf, 501 U.S. at 358-59.
a statute of limitations, can be broader than “actual
discovery.” See, e.g., J. Geils Band Employee Benefit Plan The Supreme Court, on the other hand, did choose a statute
v. Smith Barney Shearson, Inc., 76 F.3d 1245, 1254 (1st Cir.) of limitations for § 10(b) actions, and it explicitly chose §
(holding that “discovery,” as used in a statute of limitations 9(e) over § 13 and other one-year/three-year limitations
within the Employee Retirement Income Security Act, periods set out in the 1933 and 1934 Acts. See id. at 364 n.9.
“encompasses both actual and constructive discovery”), cert. But while acknowledging that “slight[]” differences in
denied, 519 U.S. 823 (1996). And there is good reason to terminology could someday “prove significant,” id., the Court
interpret § 9(e)’s “discovery” as “includ[ing] constructive or characterized the various limitations provisions as essentially
inquiry notice, as well as actual notice.” Menowitz v. Brown, the same: “Although not identical in language, all these
991 F.2d 36, 41 (2d Cir. 1993). If actual discovery were
required, investors could extend the time for filing suit simply
by refusing to investigate possible fraud. Thus, an actual
1
discovery standard would encourage “the opportunistic use of Investors’ ability to hedge against risk in this manner would be
federal securities laws to protect investors against market circumscribed by the three-year period of repose contained in § 9(e), see
risk;” investors could wait to see whether a poorly performing 15 U.S.C. § 78i(e), but, in the words of the Seventh Circuit, “[t]hree years
is an age in the stock market.” Tregenza, 12 F.3d at 722.
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Care v. Ernst & Young Care v. Ernst & Young
relate to one year after discovery and to three years after sister circuits, so far as we know, has held that constructive
violation.” Id. at 355 n.2. Finding no indication that the discovery cannot suffice to start the one-year clock running.4
Court believed § 9(e) to be meaningfully different from § 13
– or, more to the point, that the Court considered the absence Before we turn to the application of § 9(e) to the facts of
of an express reference to inquiry notice in § 9(e) to be this case, we need to consider when the limitations period
significant – we do not think the Court’s choice of § 9(e) begins to run under an “inquiry notice” standard. Ernst
forecloses an interpretation of “discovery” that includes suggests that the limitations period is triggered when the
inquiry notice.2 plaintiff learns facts that would cause a reasonable investor to
investigate the possibility of fraud. Some cases support that
We therefore join the courts of appeals of at least seven suggestion. See, e.g., Theoharous, 256 F.3d at 1228. The
other circuits in holding that inquiry notice is sufficient to majority view, however, is that knowledge of suspicious facts
trigger the one-year limitations period for actions brought – “storm warnings,” they are frequently called – merely
under § 10(b). See LC Capital Partners v. Frontier triggers a duty to investigate, and that the limitation period
Insurance Group, 318 F.3d 148, 154 (2d Cir. 2003); In re begins to run only when a reasonably diligent investigation
NAHC, Inc. Securities Litigation, 306 F.3d 1314, 1324-25 (3d would have discovered the fraud. See, e.g., Young, 305 F.3d
Cir. 2002); Young v. Lepone, 305 F.3d 1, 8 (1st Cir. 2002); at 9-10; Rothman v. Gregor, 220 F.3d 81, 97 (2d Cir. 2000);
Theoharous v. Fong, 256 F.3d 1219, 1228 (11th Cir. 2001); Sterlin, 154 F.3d at 1201-02 ; Marks v. CDW Computer
Sterlin v. Biomune Systems, 154 F.3d 1191, 1196 (10th Cir. Centers, Inc., 122 F.3d 363, 367-68 (7th Cir. 1997). This
1998); Kauthar SDN BHD v. Sternberg, 149 F.3d 659, 670 view, we believe, reflects an appropriate balance between
(7th Cir. 1998), cert. denied, 525 U.S. 1114 (1999); Howard “the staunch federal interest in requiring plaintiffs to bring
v. Haddad, 962 F.2d 328, 330 (4th Cir. 1992).3 None of our suit promptly . . . and the equally strong interest in not driving
plaintiffs to bring suit . . . before they are able, in the exercise
of reasonable diligence, to discover the facts necessary to
2
In reaching this conclusion, we considered the SEC’s brief as amicus
curiae in Lampf, as well as the other materials that New England
submitted for judicial notice. Ernst’s motion to strike the request for discovered” into Lampf’s literal holding – was not essential to our decision
judicial notice is denied. in Ockerman, as the sufficiency of inquiry notice was not at issue in that
case. We thus agree with New England that Ockerman does not control
3 the case at bar.
Ernst suggests that this circuit endorsed the inquiry notice standard
for § 10(b) actions in Ockerman v. May Zima & Co., 27 F.3d 1151, 1155 4
(6th Cir. 1994). The passage that Ernst quotes, however, merely The Ninth Circuit has indicated – in dictum – an inclination toward
characterizes the holding of Lampf: the actual discovery standard. See Berry v. Valence Technology, Inc., 175
F.3d 699, 703-04 & n.6 (9th Cir.), cert. denied, 528 U.S. 1019 (1999). For
“In Lampf, the Supreme Court held that all actions under section the reasons given above, we are not persuaded by the Ninth Circuit’s
10(b) and Rule 10b-5 must be brought within one year from the analysis.
time the fraud was discovered or should have been discovered,
but no more than three years from the transaction giving rise to The Third Circuit’s position on this issue has not always been clear,
the claim.” 27 F.3d at 1155. but in 2002, answering what it termed “an open question in this court,”
that circuit applied the inquiry notice standard under § 9(e). See NAHC,
This gloss on Lampf – i.e., the insertion of the phrase “or should have been 306 F.3d at 1325.
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support their claims.” Young, 305 F.3d at 9 (citing Sterlin, New England argues that it could not have known whether
154 F.3d at 1202). We conclude, in accordance with the Ernst’s certification was knowingly or recklessly false until it
majority view, that the § 9(e) limitations period begins to run obtained Ernst’s workpapers through discovery in the Fruit
when a plaintiff should have discovered, by exercising litigation. We agree that scienter on the part of corporate
reasonable diligence, the facts underlying the alleged fraud. insiders – which New England plainly alleged in the Fruit
complaint – does not necessarily imply scienter on the part of
B outside auditors. At the same time, however, direct evidence
of scienter is not necessary to a determination of fraud. See,
Like other Rule 12(b)(6) motions to dismiss, a motion to e.g., Herman & MacLean v. Huddleston, 459 U.S. 375, 390
dismiss on statute of limitations grounds should be granted n.30 (1983) (noting that scienter may be proved with
“when the statement of the claim affirmatively shows that the circumstantial evidence). In this case, we believe, the facts
plaintiff can prove no set of facts that would entitle him to alleged in the Fruit complaint strongly suggest that Fruit’s
relief.” Ott v. Midland-Ross Corp., 523 F.2d 1367, 1369 (6th auditors were at least reckless.
Cir. 1975), quoted in Duncan v. Leeds, 742 F.2d 989, 991
(6th Cir. 1984). A court that is ruling on a Rule 12(b)(6) For one thing, the alleged fraud relates primarily to
motion may consider materials in addition to the complaint if departures from GAAP contained in audited financial
such materials are public records or are otherwise appropriate statements – the “same issues,” New England has said, that
for the taking of judicial notice. See, e.g., Jackson v. City of are addressed in the Ernst complaint – and not to
Columbus, 194 F.3d 737, 745 (6th Cir. 1999), abrogated on representations that were neither scrutinized nor approved by
other grounds, Swierkiewicz v. Sorema N.A., 534 U.S. 506 the auditors. Moreover, the scope of the alleged fraud –
(2002). New England’s complaint against Fruit, therefore, is involving overvaluation of fixed assets and inventory by more
properly a part of the record before us. than $400 million, premature recognition of more than $50
million in sales, and failure to accrue liabilities and charges
Reading New England’s amended complaint against Ernst totaling $89 million – is such that any reasonable investor
in conjunction with New England’s earlier complaint against would question the auditors’ oversight. As New England
Ernst’s client, Fruit of the Loom, we believe that New says in its brief, the fraud “does not involve little mistakes
England can prove no set of facts showing that it failed to that the auditors might have easily overlooked.” In the light
discover Ernst’s alleged fraud, either actually or of the particular allegations against Fruit, we are at a loss to
constructively, before June 28, 1999. No later than July 1, understand why New England should not have determined, by
1998, when it filed the complaint against Fruit, New England July 1, 1998, that Ernst knowingly or recklessly participated
was aware that Fruit’s financial statements for 1996 (and the in the alleged fraud.
first two quarters of 1997) did not adhere to GAAP. New
England also knew, or could have learned through minimal At the very least, New England should have made that
investigation of public records, that Ernst had audited Fruit’s determination during the 12 months that elapsed between
1996 statements and declared them to be in conformity with July 1, 1998, and June 28, 1999 – ample time, it seems to us,
GAAP. New England obviously knew enough by for a diligent investigation to establish Ernst’s close
July 1,1998, to conclude that Ernst’s certification was false. involvement with Fruit’s business. In sum, we are satisfied
No. 01-6523 New England Health 13
Care v. Ernst & Young
that New England can prove no set of facts showing that it
lacked inquiry notice before June 28, 1999.
III
Having concluded that New England’s complaint is
untimely under the statute of limitations, we need not address
the complaint’s timeliness under the three-year statute of
repose or the sufficiency of the allegations of scienter. Our
conclusion also compels a determination that the district court
did not err in dismissing the amended complaint with
prejudice. Because of the time bar, further amendment of the
complaint would be futile. See, e.g., Deutsch v. Turner
Corp., 317 F.3d 1005, 1029 n.20 (9th Cir. 2003).
AFFIRMED.