Key Equity Inv Inc v. Sel Lab Marketing

Opinions of the United
2007 Decisions States Court of Appeals
for the Third Circuit
9-6-2007
Key Equity Inv Inc v. Sel Lab Marketing
Precedential or Non-Precedential: Non-Precedential
Docket No. 06-1052
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NOT PRECEDENTIAL
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
No. 06-1052
KEY EQUITY INVESTORS INC.,
Appellant
v.
SEL-LEB MARKETING INC.; HAL MARKOWITZ; JACK KOEGEL;
PAUL SHARP; GEORGE FISCHER; JH COHN LLP,
On Appeal from the United States District Court
for the District of New Jersey
(04-cv-01675)
District Judge: Honorable Dennis M. Cavanaugh
Submitted pursuant to Third Circuit LAR 34.1(a)
June 28, 2007
Before: BARRY, FUENTES and GARTH, Circuit Judges.
(Filed: September 6, 2007)
OPINION OF THE COURT
FUENTES, Circuit Judge.
In this securities appeal, we review the District Court’s decision to dismiss the
complaint of Key Equity Investors, Inc. (“Key Equity”) for failure to satisfy the pleading
requirements of the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u-4
et seq. (“PSLRA”). Appellant, Key Equity, alleged that defendants issued materially
false and misleading statements about the financial health of a company called Sel-Leb
Marketing, Inc. (“Sel-Leb”). For the reasons that follow, we will affirm.
I. Factual and Procedural Background
A. Factual Background1
Sel-Leb is a New York corporation that distributes and markets consumer
merchandise to retailers. At all relevant times, Harold Markowitz, Paul Sharp, Jack
Koegel, and George Fischer were company directors, and J.H. Cohn, LLP was a company
auditor. In the period between April 5, 2002 and February 25, 2004 (the putative class
period), during which Key Equity purchased company stock, Sel-Leb made numerous
statements relevant to this appeal.
1
On review of a motion to dismiss, we “accept all well-pled allegations in the
complaint as true and draw all reasonable inferences in favor of the non-moving party.”
Brown v. Card Service Center, 464 F.3d 450, 452 (3d Cir. 2006). Our review is limited
to the contents of the complaint and any attached exhibits. Yarris v. County of Delaware,
465 F.3d 129, 134 (3d Cir. 2006).
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Two of the statements concerned the past financial performance of the company.
First, on April 5, 2002, Sel-Leb filed a form with the Securities and Exchange
Commission (“SEC”) reporting a net income of $443,669 for fiscal year 2001. In the
disclosure, J.H. Cohn stated that it audited the company’s financial statements and that
they conformed with generally accepted accounting principles (“GAAP”). Second, Sel-
Leb issued a press release on August 15, 2002 announcing $418,370 in pre-tax earnings
for the first six months of 2002.
In contrast to these statements of prior earnings, many of Sel-Leb’s other
statements expressed its “glowingly optimistic expectations for fiscal year 2002.” (A50)
For instance, in April 2002, the company said it was “slated to begin to generate strong
revenue and earnings growth in 2002.” (A51 (internal quotation marks omitted)) In May,
the company “anticipate[d] . . . report[ing] record revenues for its fiscal year end[ing]
December 31, 2002.” (A51) In August and September, it reiterated its optimism about
2002. And in November, although recognizing the financial difficulties of “several of our
major customers,” Sel-Leb predicted “a significant increase in the sales and earnings” for
the fourth quarter of 2002. (A52) Notably, in November the company also stated that it
had renegotiated and renewed the terms of a $3.8 million “credit facility” with Merrill
Lynch Business Financial Services, Inc. (“Merrill Lynch”). (A53)
In late 2002, Sel-Leb’s expectations about its financial health “began to dim.”
(A53) On December 24, 2002, it issued a press release indicating that “sales for the
fourth quarter of 2002 will be substantially lower than the revised projection previously
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issued by the Company.” (A53) The company cited “generally weak economic
conditions,” and “production problems” with a third-party manufacturer that had “caused
the Company to miss shipping orders during the fourth quarter.” (A53) Moreover,
throughout early 2003, the company was unable to make required financial disclosures
“due to unforeseen difficulties in obtaining information essential to these estimates.”
(A54) Specifically, Sel-Leb had been unable to obtain information “from an independent
third party, which is an integral and important part of the Company’s operations.” (A54)
As a result, Sel-Leb announced that it would be “delisted from the Nasdaq SmallCap
Market with the opening of business on Friday, May 23, 2003.” (A54)
Sel-Leb later disclosed, on July 24, 2003, that it was “not in compliance with
certain net worth and cash flow covenants of its Merrill Lynch credit facility,” and on
October 15, 2003, revealed that the credit facility had been terminated. (A54) On
February 24, 2004, the company indicated that its operations had been significantly
curtailed due to decreased sales and lack of funding. Finally, it stated that it had incurred
a pre-tax loss of $3.8 million for fiscal year 2002, and also had to revise downward by
$1.8 million its pre-tax income for fiscal year 2001.
According to the complaint, although Sel-Leb’s stock had traded as high as $4.00
per share, its disclosures about financial health had rendered the company’s shares
worthless.2
2
We may take judicial notice under Federal Rule of Evidence 201of facts not
found by the district court, even when reviewing its ruling on a motion to dismiss.
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B. District Court Opinion
On April 9, 2004, Key Equity filed a class action complaint in the United States
District Court for the District of New Jersey. Based on the foregoing facts, Key Equity
alleged that Sel-Leb, and its directors and accountant, (collectively, “defendants”) had
made materially false and misleading statements in violation of section 10(b) of the
Securities Exchange Act of 1934.3 In particular, Key Equity alleged that Sel-Leb had
“failed to disclose” that: (1) pre-tax earnings for fiscal year 2001 were overstated by
approximately $1.8 million; (2) the company incurred a pre-tax loss of approximately
$3.8 million for fiscal year 2002; (3) the company was in default on the terms of its credit
facility with Merrill Lynch; and (4) the company’s financial statements were not prepared
in accordance with GAAP.
According to the complaint, defendants concealed information about the “true state
of the Company’s deteriorating affairs” in order to “maintain the credit facility with
Merrill Lynch.” (A57) In Key Equity’s view, “[h]ad Merrill Lynch discovered the
adverse information about the Company earlier, it would have called for termination of
the credit facility immediately.” (A57)
On defendants’ motion, the District Court dismissed Key Equity’s complaint for
3
In a separate count, Key Equity alleged a violation of section 20(a) of the
Exchange Act on the part of Sel-Leb’s directors. Section 20(a) “imposes joint and several
liability on any person who ‘controls a person liable under any provision of the
[Exchange Act].’” In re Alpharma Inc. Sec. Litig., 372 F.3d 137, 153 (3d Cir. 2004)
(quoting Shapiro v. UJB Financial Corp., 964 F.2d 272, 279 (3d Cir. 1992)). As we
affirm dismissal of the § 10(b) claim, we likewise affirm the dismissal of this claim. Id.
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failure to state a claim on which relief could be granted, under Federal Rule of Civil
Procedure 12(b)(6), and failure to plead facts with particularity, under Rule 9(b) and the
PSLRA. The Court reached the following conclusions. Regarding the allegation that the
company’s financial statements did not conform to GAAP, Key Equity had not “alleged
with any detail what principles . . . were violated by Defendants.” (A16) Regarding the
allegation that the company renegotiated its credit line because of financial trouble, Key
Equity had relied merely on “information and belief,” and thus did not plead with
particularity. (A17) Regarding the allegations that the company had misstated its 2001
and 2002 earnings, Key Equity failed to plead with particularity facts giving rise to a
“strong inference” of scienter. (A17-20) Finally, the Court concluded that all of the
statements concerning the company’s future financial health were “forward looking” and,
therefore, did not give rise to liability. (A20-21)
On December 29, 2005, Key Equity filed a Notice of Appeal. We have
jurisdiction pursuant to 28 U.S.C. § 1291, and exercise plenary review over the District
Court’s order granting the defendants’ motion to dismiss. Cal. Pub. Employees’ Ret. Sys.
v. Chubb Corp., 394 F.3d 126, 143 (3d Cir. 2004).
II. Legal Background
“Section 10(b) of the Securities Exchange Act of 1934 forbids the ‘use or employ,
in connection with the purchase or sale of any security . . ., [of] any manipulative or
deceptive device or contrivance in contravention of such rules and regulations as the
[SEC] may prescribe . . . .’” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct.
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2499, 2507 (June 21, 2007) (quoting 15 U.S.C. § 78j(b)). “Pursuant to this statutory
authority, the [SEC has] promulgated Rule 10b-5, which creates a private cause of action
for investors harmed by materially false or misleading statements.” In re Suprema
Specialties, Inc. Sec. Litig., 438 F.3d 256, 275 (3d Cir. 2006).4
To state a claim for a violation of section 10(b), a plaintiff must plead the
following elements: “(1) a material misrepresentation (or omission); (2) scienter, i.e., a
wrongful state of mind; (3) a connection with the purchase or sale of a security; (4)
reliance, often referred to in cases involving public securities markets
(fraud-on-the-market cases) as ‘transaction causation;’ (5) economic loss; and (6) ‘loss
causation,’ i.e., a causal connection between the material misrepresentation and the loss.”
Id. (quoting Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 341 (2005)). In assessing the
sufficiency of § 10(b) pleadings, we “accept all factual allegations in the complaint as
true,” and “consider the complaint in its entirety, as well as . . . sources courts ordinarily
examine when ruling on Rule 12(b)(6) motions to dismiss.” Tellabs, 127 S. Ct. at 2509.
More importantly, in assessing the sufficiency of a § 10(b) claim, we also observe
the heightened pleading requirements of Federal Rule of Civil Procedure 9(b) and the
4
The rule makes it unlawful “for any person ‘[t]o make any untrue statement of a
material fact or to omit to state a material fact necessary to make the statements made[,]
in light of the circumstances under which they were made, not misleading . . . in
connection with the purchase or sale of any security.’” Id. (quoting 17 C.F.R. §
240.10b-5(b)).
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PSLRA.5 Under these requirements, a plaintiff must “specify each statement alleged to
have been misleading, the reason or reasons why the statement is misleading, and, if an
allegation regarding the statement or omission is made on information and belief, [a
plaintiff must] state with particularity all facts on which that belief is formed.” In re
Alpharma Inc. Sec. Litig., 372 F.3d 137, 147 (3d Cir. 2004) (quoting 15 U.S.C. §
78u-4(b)(1)(B)). In other words, the complaint should set out the “who, what, when,
where and how” of the events at issue. DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th
Cir. 1990) (quoted in In re Advanta Corp. Sec. Litig., 180 F.3d 525, 534 (3d Cir. 1999)).
Regarding allegations of scienter, a plaintiff must “state with particularity facts
giving rise to a strong inference that the defendant acted with the required state of mind.”
In re Alpharma, 372 F.3d at 148 (quoting 15 U.S.C. § 78u-4(b)(2) (emphasis added)). To
do so, the complaint may allege (1) “facts to show that defendants had both motive and
opportunity to commit fraud,” or (2) “facts that constitute strong circumstantial evidence
of conscious misbehavior or recklessness.” Id. (quoting In re Burlington Coat Factory
Sec. Litig., 114 F.3d 1410, 1418 (3d Cir. 1997)). As the Supreme Court has made clear, a
complaint gives rise to a “strong inference” of scienter “only if a reasonable person would
5
The purpose of Rule 9(b) is to “give defendants notice of the claims against them,
provide an increased measure of protection for their reputations, and reduce[ ] the number
of frivolous suits brought solely to extract settlements.” In re Suprema Specialties, 438
F.3d at 270 (internal quotation marks omitted). The purpose of the PSLRA is “to restrict
abuses in securities class-action litigation.” In re Advanta Corp. Sec. Litig., 180 F.3d 525,
531 (3d Cir. 1999). To the extent that Rule 9(b) conflicts with the PSLRA, the statute
supersedes it. Id. at 531 n.5.
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deem the inference of scienter cogent and at least as compelling as any opposing
inference one could draw from the facts alleged.” Tellabs, 127 S. Ct. at 2510.
“Stated in another way, unless plaintiffs in securities fraud actions allege facts
supporting their contentions of fraud with the requisite particularity mandated by Rule
9(b) and the [PSLRA], they may not benefit from inferences flowing from vague or
unspecific allegations—inferences that may arguably have been justified under a
traditional Rule 12(b)(6) analysis.” In re Rockefeller Center Properties, Inc. Sec. Litig.,
311 F.3d 198, 224 (3d Cir. 2002). If a complaint fails to meet the stringent pleadings
requirements for sustaining a § 10(b) claim, the “appropriate sanction . . . is dismissal.”
In re Alpharma, 372 F.3d at 148; In re Rockefeller, 311 F.3d at 224 (citing 15 U.S.C. §
78u-4(b)(3)(A)).
III. Discussion
On appeal, Key Equity offers four reasons for us to vacate the order of the District
Court and reinstate its complaint. First, Key Equity argues that it did not have to plead
with particularity “which provisions of GAAP had been violated in order to satisfy the
pleading requirements of the PSLRA and Rule 9(b).” Br. at 9. Second, it argues that it
“pleaded with particularity that defendants were in default of the $3.8 million credit
facility with Merrill Lynch.” Br. at 11. Third, it contends that its complaint sufficiently
alleged “motive and opportunity” to satisfy the pleading requirements for scienter. Br. at
13. Finally, it contends that “defendants’ press releases and financial statements” were
not “forward looking” and were “thus not entitled to the PSLRA’s safe harbor
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protection.” Br. at 15.
We reject these contentions and conclude that Key Equity’s complaint fails to
satisfy the heightened pleading requirements of Rule 9(b) and the PSLRA.6 We agree
with the decision of the District Court primarily for two reasons.7 First, almost all the
statements identified by Key Equity were projections about the company’s financial
growth, or expressions of general optimism about its financial health. Such positive
portrayals of the company, however, are not actionable under § 10(b). As we stated in In
re Advanta, “vague and general statements of optimism ‘constitute no more than ‘puffery’
and are understood by reasonable investors as such.’” 180 F.3d at 538 (quoting In re
Burlington Coat, 114 F.3d at 1428 n.14). Accordingly, the company’s optimistic
statements that it was, for example, “slated to begin to generate strong revenue and
earnings growth in 2002,” do not give rise to liability under § 10(b).8
6
For the purposes of brevity, we do not distinguish between defendants in our
discussion of the issues. Notably, Key Equity does not do so on appeal. Its failure to
specify which facts support a claim against which defendants—i.e., which defendants said
and knew what at what time—supports our conclusion that the complaint is not pleaded
with sufficient particularity.
7
J.H. Cohn also points out that Key Equity failed to adequately plead “loss
causation,” i.e., that “the drop in the value of a security is related to the alleged
misrepresentation.” Berckeley Inv. Group, Ltd. v. Colkitt, 455 F.3d 195, 223 (3d Cir.
2006). Although it appears that no facts establish a causal connection between the
misstatements and the decline in the value of the stock, we, like the District Court, need
not reach this issue.
8
To the extent these statements could be considered materially misleading to a
reasonable investor, they were “identified as . . . forward-looking” and “accompanied by
meaningful cautionary statements identifying important factors that could cause actual
results to differ materially from those in the forward-looking statement.” 15 U.S.C. §
-10-
Second, although the District Court concluded that the complaint adequately
identified Sel-Leb’s earnings statements for 2001 and the first half of 2002 as materially
misleading,9 it concluded that Key Equity had failed to accompany these statements with
sufficient allegations of scienter. In order to establish scienter, Key Equity relies on the
defendants’ “motive and opportunity” to commit fraud. Presumably, the inference we are
to draw is that defendants had a motive to fraudulently misstate earnings because Sel-Leb
needed the Merrill Lynch line of credit to operate. Because the company could not meet
the requirements for sustaining this line of credit, defendants decided to overstate Sel-
Leb’s 2001 and 2002 earnings. Moreover, by stating that it was only “renewing” the
credit line, the defendants attempted to disguise the company’s deteriorating financial
condition from investors.
We conclude that these allegations have been pleaded with insufficient
particularity to meet the heightened pleading requirements of Rule 9(b) and the PSLRA.
Specifically, the facts allegedly supporting a strong inference of scienter have not been
adequately pled.10 As the Supreme Court recently stated, “omissions and ambiguities
78u-5(c)(1)(A)(i).
9
We observe that, arguably, the complaint fails to adequately plead that the
earnings statement for the first six months of 2002 was misleading. A $3.8 million loss
for the year as a whole is not necessarily inconsistent with gains in the first half of that
year. In fact, the press releases indicate that in the latter portion of 2002 a large number
of orders could not be filled, leading to financial difficulties. (A43)
10
We also note that the complaint sets out nothing more than an ordinary business
motive, which is typically insufficient to support a strong inference of fraud. See GSC
Partners CDO Fund v. Washington, 368 F.3d 228, 237 (3d Cir. 2004) (“Motives that are
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count against inferring scienter, for plaintiffs must ‘state with particularity facts giving
rise to a strong inference that the defendant acted with the required state of mind.’”
Tellabs, 127 S. Ct. at 2511 (quoting 15 U.S.C. § 78u-4(b)(2)).
In this case, although Key Equity alleges that Sel-Leb falsified its earnings to
maintain its credit line, its complaint is bereft of any facts or details supporting this
conclusion. We are therefore left to speculate about what particular information was
hidden, what financial figures were manipulated, and when any of the defendants knew of
or implemented such fraudulent devices. Cf. In re Burlington Coat, 114 F.3d at 1417-18(“[W]here plaintiffs allege that defendants distorted certain data disclosed to the public by
using unreasonable accounting practices, we have required plaintiffs to state what the
unreasonable practices were and how they distorted the disclosed data.”). Inferring
scienter in these circumstances would impermissibly provide Key Equity the “benefit [of]
inferences flowing from vague or unspecific allegations.” In re Rockefeller, 311 F.3d at
224. In other words, because of the complaint’s omissions, it fails to set out the “who,
what, when, where and how” of the events at issue. DiLeo, 901 F.2d at 627.11
generally possessed by most corporate directors and officers do not suffice; instead,
plaintiffs must assert a concrete and personal benefit to the individual defendants
resulting from this fraud.”) (internal quotation marks omitted).
11
Our dissenting colleague relies on the tightening of Merrill Lynch’s credit line
as a motive to commit fraud. The complaint states only that, on information and belief,
Sel-Leb had to renegotiate its credit line because it could not repay certain obligations to
Merrill Lynch. (A53) With this allegation alone, an inference that defendants
renegotiated Sel-Leb’s credit line in the ordinary course of business (when it was up for
renewal) is more likely than an inference of scienter. See Tellabs, 127 S.Ct. at 2513.
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Furthermore, we conclude that the complaint fails to adequately plead facts “that
constitute strong circumstantial evidence of conscious misbehavior or recklessness.” In
re Alpharma, 372 F.3d at 148. To do so, Key Equity would have to allege “an extreme
departure from the standards of ordinary care [that] presents a danger of misleading
buyers or sellers that is either known to the defendant or is so obvious that the actor must
have been aware of it.” In re Advanta, 180 F.3d at 535 (quoting McLean v. Alexander,
599 F.2d 1190, 1197 (3d Cir. 1979)). Although Key Equity does not appear to pursue a
recklessness theory on appeal, its complaint nonetheless fails to satisfy the requirements
for doing so. The mere fact of a misstatement is not evidence of recklessness, and Key
Equity provides no detail to support a stronger conclusion than: there must have been
fraud. We have previously rejected such conclusory pleading as precisely what the
PSLRA was intended to weed out. GSC Partners CDO Fund v. Washington, 368 F.3d
228, 239 (3d Cir. 2004) (“Of course, it is not enough for plaintiffs to merely allege that
defendants ‘knew’ their statements were fraudulent or that defendants ‘must have known’
their statements were false.”); In re Advanta, 180 F.3d at 539 (rejecting as inadequate
allegation that defendants “must have been aware of impending losses”).12
12
Our dissenting colleague would infer scienter from what he believes to be a
400% overstatement of Sel-Leb’s 2001 earnings. We disagree with his calculations. As
the record reveals, the original 2001 net earnings of $443,669 resulted from gross income
of $21,451,140 and expenses (including taxes) of $21,007,471. The revised figure for
that year reflected a reduction of about $1.8 million in pre-tax earnings. Assuming this
$1.8 million is a reduction in Sel-Leb’s gross income of over $21 million, the
misstatement reflects an error of less than 10%. Cf. PR Diamonds, Inc. v. Chandler, 364
F.3d 671, 686 (6th Cir. 2004) (“Accepting Plaintiffs’ allegations as true, Intrenet
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IV. Conclusion
For the foregoing reasons, we conclude that Key Equity’s complaint failed to meet
the heightened pleading requirements applicable to a securities fraud claim under § 10(b).
We therefore affirm.
represented itself as a barely profitable company, when in fact it was a barely unprofitable
company. It simply cannot be said that Intrenet’s accounting improprieties, by virtue of
their type and size, should have been obvious.”). In any event, the complaint provides
insufficient details from which to determine what errors the misstatement resulted from,
or whether any “red flags” had warned any of the defendants about them.
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GARTH, Circuit Judge, dissenting:
I find it difficult to understand how the majority opinion can overlook the magnitude
of Sel-Leb’s overstatement of earnings ($1.8 million) which was 400% below its reported
income in 2001. Moreover, I find it even more difficult to understand how the majority
opinion can overlook Sel-Leb’s failure to disclose Merrill Lynch’s significant modifications
to Sel-Leb’s credit agreement because of Sel-Leb’s precarious financial condition. The
majority opinion does so by characterizing Sel-Leb’s rosy projections about its financial
health and future growth as “puffery.” I cannot join in the majority’s “puffery” analysis and
I therefore respectfully dissent.
I.
The facts alleged in the complaint, taken together with Sel-Leb’s SEC filings which
we are permitted to consider on a motion under Rule 12(b)(6),13 are more than sufficient to
13
See Oran v. Stafford., F.3d 275, 289 (3d Cir 2000) (adopting the reasoning of
“[a] number of our sister circuits [that] . . . in deciding a motion for judgment on the
pleadings [we may] take judicial notice of properly-authenticated public disclosure
documents filed with the SEC); see also Kramer v. Time Warner, Inc., 937 F.2d 767, 774
(2d Cir. 1991).
Moreover, I emphasize that this is a Fed. R. Civ. P. 12(b)(6) proceeding. In reviewing a
dismissal for failure to state a claim, a judge must accept as true all of the factual
allegations contained in the complaint and may take judicial notice of SEC documents.
See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499, 2509 (2007). As the
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plead and satisfy a “strong inference” that the director defendants acted fraudulently and with
scienter as required under the Private Securities Litigation Reform Act of 1995 (“PSLRA”).14
First, Merrill Lynch’s repeated material modifications of Sel-Leb’s loan agreements
in mid-2002 strongly point to the fact that Merrill Lynch was seriously concerned about Sel-
Leb’s financial position.15 I find it rather quixotic that in its effort to minimize Sel-Leb’s
intent to commit fraud, the majority opinion recites in its footnote 11 – and without the
context, language, and facts found in paragraph 30 of the complaint – that Sel-Leb’s
renegotiation of its credit line was no more than in the “ordinary course of business.” The
majority opinion’s footnote 11 states:
Supreme Court recently noted, “[t]he inquiry . . . is whether all of the facts alleged, taken
collectively, give rise to a strong inference of scienter, not whether any individual
allegation, scrutinized in isolation, meets that standard.” Id. (emphasis in original).
14
I concur with the majority that the complaint was properly dismissed as to J.H.
Cohn, Sel-Leb’s auditor, on the grounds that it stood to gain no “concrete and personal
benefit” from such misstatements. GSC Partners CDO Fund v. Washington, 368 F.3d
228, 237 (3d Cir. 2004); see also Rothman v. Gregor, 220 F.3d 81, 98 (2d Cir. 2000)
(holding that an auditor may be found liable for recklessness in certifying financial
misstatements only if its conduct was “highly unreasonable, representing an extreme
departure from the standards of ordinary care [and] must, in fact, approximate an actual
intent to aid in the fraud being perpetrated by the audited company”).
15
It is convenient for the majority opinion to infer that Sel-Leb’s credit line was
renegotiated only in the ordinary course of business. See maj op. n. 11. This is the same
litany that Sel-Leb would have us believe. However, as I point out, what Sel-Leb did was
bury its “renewal” to disguise the true purpose and effect of renegotiating its credit with
Merrill Lynch. One need only take a cursory look at the modifications made by Merrill
Lynch – which critically tightened Sel-Leb’s credit (and were instituted not only once, but
twice, in a span of four months) – to understand that this was no mere “ordinary course of
business.” This was financial desperation!
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. . . The complaint states only that, on information
and belief, Sel-Leb had to renegotiate its credit
line because it could not repay certain obligations
to Merrill Lynch. (A53) With this allegation
alone, an inference that defendants renegotiated
Sel-Leb’s credit line in the ordinary course of
business (when it was up for renewal) is more
likely than an inference of scienter. See Tellabs,
127 S.Ct. at 2513.
However, paragraph 30 of the complaint in which the majority opinion finds comfort
– in full alleges not just the last sentence cited by the majority – but rather those facts and
details giving rise to the renegotiation of the credit agreement. Paragraph 30 of the complaint
alleges that:
This disclosure [that fourth quarter 2002 sales
would be substantially lower than projected]
occurred shortly after defendants filed their
quarterly report for the third quarter of 2002.
Buried in the quarterly report was the disclosure
that Sel-Leb had been required to renegotiate the
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terms of a $3.8 million credit facility with Merrill
Lynch Business Financial Services, Inc. (“Merrill
Lynch”) and to postpone its obligation to repay
the $3,717,249 outstanding balance on the credit
facility from October 31, 2002 to October 31,
2003. Upon information and belief, the Company
had to renegotiate the terms of the credit facility
with Merrill Lynch because it could not make the
payment as required on October 31, 2002.
These concerns obviously caused Merrill Lynch problems. Despite these troubling
concerns of Sel-Leb’s principal lender, the director defendants reported in a November 18,
2002 press release that Sel-Leb was merely “pleased to announce” that it was “renewing
[not renegotiating] our Operating Line of Credit.” A42 (emphasis added). From the entire
allegations (not just the last sentence) contained in paragraph 30 of the complaint, it appears
that the director defendants had actual knowledge, to a far greater degree than they
disclosed, of Sel-Leb’s troubled financial position.
Second, the sheer size of Sel-Leb’s overstatements – over 400% of earnings in fiscal
year 2001 alone – are indicative of fraudulent intent. The complaint alleges that without
these enormous overstatements of earnings (which actually were losses, not positive
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income), Sel-Leb would have breached and defaulted on the terms of its credit agreement,
causing Merrill Lynch to terminate its credit at once and “exercis[e] remedies available to
it as a secured lender.” Comp. ¶¶ 44-45. Would reasonable investors truly regard a
misstatement of over 400% of reported income as mere “puffery?” Nor is it an answer to
say that the 400% overstatement of earnings have been miscalculated as the majority claims
in its footnote 12.
The majority opinion’s hypothesis (evaluating the extent of revenues and expenses)
as to the source of the misstatement – “a decrease of about 10%” of revenues – is nothing
more than pure speculation since neither the record nor the SEC filings state the reason for
the 400% overstatement of earnings.16 All the record and the SEC filings reveal is that Sel-
Leb turned from a profitable venture into a bankrupt company because, in part, its 2001
earnings were overstated by 400%. See A50; Sel-Leb Form 8-K, filed Feb. 24, 2004. To
a reasonable investor, it is inconsequential whether such a significant misstatement of
earnings retained by shareholders arises from an overstatement of revenues and/or an
understatement of expenses.
The SEC documents and reports, which the majority opinion has taken pains not to
16
The majority opinion could have attempted to further dilute the size of the 400%
earnings misstatement by speculating that it resulted from a 4.2% overstatement of
revenues and a 4.3% understatement of expenses (both percentages equaling in total to
about $1.8 million of the misstated net earnings).
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address, disclose that Sel-Leb was not a “barely unprofitable company” (see maj. op. n. 12)
but was rather in deep financial trouble – trouble which it chose not to disclose to its
investors or to Merrill Lynch. Moreover, by affirming the erroneous dismissal of Key
Equity’s complaint the majority has now precluded Key Equity from providing by proofs
the further facts and details as to Sel-Leb’s losses and its fraud.
Finally, the need to falsify Sel-Leb’s asset statements in order to prevent a default
leading to an end of its crucial credit line constitutes a motive to commit fraud that is
probative of scienter. In this regard, the complaint alleges that “[d]efendants were
motivated to issue materially false statements . . . in large part to maintain the credit facility
with Merrill Lynch. Had Merrill Lynch discovered the adverse information about the
Company earlier, it would have called for termination of the credit facility immediately.”
Comp. ¶ 45. Such motivation provides further probative support for plaintiffs’ assertion that
the director defendants acted with fraudulent intent.
These allegations, separately and particularly in combination, adequately plead a
“strong inference” of scienter as required by the PSLRA.
II.
The majority opinion states that Key Equity’s allegations in its complaint have not
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been adequately pled and are “bereft of any facts or details supporting” the conclusion that
Sel-Leb concealed its financial condition to maintain its credit line. Maj. op. p. 12. Let’s
examine what Key Equity really and factually charged.
Sel-Leb’s Failure to Disclose Modifications of its Credit Agreement
Sel-Leb’s Form 10-KSB contained, as an attachment, a loan agreement dated
November 8, 1999, under which Merrill Lynch agreed to provide a revolving line of credit
to Sel-Leb. One of the covenants contained in this loan agreement, under the heading
“Minimum Tangible Net Worth,” required that “Customer’s ‘tangible net worth’ shall at all
times exceed $6,500,000.00.” A27. In 2002, amidst Sel-Leb’s now evident catastrophic
losses, Merrill Lynch modified the loan agreement two times. On June 6, 2002, Merrill
Lynch increased the tangible net worth requirement to $8 million. A28. Just four months
later, on October 18, 2002, the tangible net worth requirement was further increased to $8.5
million. A29.
Sel-Leb did not report either of these modifications in its subsequent August 15,
2002 or September 13, 2002 press releases that accompanied its second quarter 2002 or third
quarter 2002 financial reports. Finally, in a November 18, 2002 press release, Sel-Leb
cheerfully reported that it was “pleased to announce that we have signed an agreement with
our major lending institution, renewing our Operating Line of Credit through October 31,
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2003.” A42 (emphasis added). This announcement made no mention of nor did it contain
any indication of the changes to Sel-Leb’s loan agreement. Moreover, the very term
“renewing” used by Sel-Leb to characterize the modifications to its loan agreement was
itself misleading and fraudulent. The complaint alleges that this was not a renewal but at
best a significant renegotiation. Comp. ¶ 30. (Puffery?).
The November 18, 2002 press release also reported positive earnings for the nine
months ended September 30, 2002, and stated “we expect to continue to show growth in
both sales and earnings for the fiscal year 2002.” Id. It was only later that Sel-Leb
disclosed that it had sustained a $3.8 million loss for fiscal year 2002. Comp. ¶¶ 39-40.
The allegations containing and referring to these facts demonstrate that the director
defendants had actual knowledge or at the very least behaved recklessly with respect to Sel-
Leb’s deteriorating financial condition. Merrill Lynch’s fears – as expressed by its
decisions to twice modify Sel-Leb’s loan covenants – were obvious warnings putting the
director defendants on notice of Sel-Leb’s seriously unstable financial condition. Even
more revealing of the director defendants’ state of mind, however, is the misleading manner
by which Sel-Leb reported the extension of its credit facility – i.e., that it was “pleased” to
be “renewing” the facility – without so much as a hint that in fact Merrill Lynch had twice
within the last five months materially tightened the terms of Sel-Leb’s credit. Comp. ¶¶ 30,
36, 45, 54. These allegations and facts are alone sufficient to create a strong inference of
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scienter permitting this case to go forward.
The director defendants argue that “the reason why Sel-Leb had to renegotiate the
terms of the credit facility on October 31, 2002 . . . was because October 31st was the annual
date for renewal of the credit facility.” Def. Br. at 23. This still fails to explain why the
materially adverse renegotiated terms were not disclosed. Instead, the director defendants
whitewashed those changes with a report that Sel-Leb’s credit facility had merely been
“renew[ed].” Comp. ¶ 30. In any event, the issue whether the October 31, 2002 extension
was simply an annual renewal or, as Key Equity maintains, “a renegotia[tion] . . . because
[Sel-Leb] could not make the payment as required on October 31, 2002” is a matter for
discovery, not resolution on a motion under Rule 12(b)(6). Id. The allegations amply reveal
that the actions of the director defendants were not the result of unfortunate business
conditions, but were rather fraudulent efforts to disguise Sel-Leb’s failing enterprise.
III.
Size of Misstatements and Errors in Financial Reports
The inference of scienter here is further heightened by the sizable magnitude of the
overstatements in Sel-Leb’s 2001 and 2002 financial statements. According to the
complaint, Sel-Leb’s pre-tax earnings for fiscal year 2001 were overstated by $1.8 million,
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and were thus actually over 400% below Sel-Leb’s $443,669 reported 2001 income. Comp.
¶¶ 41, 44. And, while reporting positive pre-tax income of $339,000 for first quarter 2002
and positive, though declining, pre-tax income of $418,370, and $132,276 for the six and
nine month periods ending June 30, 2002 and September 30, 2002, Sel-Leb later admitted
no income for those periods but rather a $3.8 million loss for fiscal year 2002. Comp. ¶¶ 24,
26, 40, 44. These facts can hardly be called “puffery” or a vague and general statement of
optimism (maj. op. p. 10-11) or forward-looking (maj. op. n. 8).
The magnitude of the overstatements in corporate financial statements has repeatedly
been held to constitute corroborating circumstances of fraudulent intent. See Gen. Elec.
Capital Corp. v. Acosta (In re Acosta), 406 F.3d 367, 372 (5th Cir. 2005) (“An intent to
deceive may be inferred from “reckless disregard for the truth or falsity of a statement
combined with the sheer magnitude of the resultant misrepresentation.”) (emphasis added);
PR Diamonds, Inc. v. Chandler, 364 F.3d 671, 684 (6th Cir. 2004) (“[A]n inference of
knowledge or recklessness may be drawn from allegations of accounting violations that are
so simple, basic, and pervasive in nature, and so great in magnitude, that they should have
been obvious to a defendant.”) (emphasis added); In re MicroStrategy, Inc. Sec. Litig., 115
F. Supp. 2d 620, 637 (D. Va. 2000) (“[T]he . . . restatements are of such a great magnitude
– amounting to a night-and-day difference with regard to MicroStrategy's representations
of profitability – as to compel an inference that fraud or recklessness was afoot.”) (emphasis
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added).17
Here, Sel-Leb overstated its earnings by over 400% in 2001 and reported hundreds
of thousands of dollars in earnings in 2002 while in reality sustaining a massive $3.8 million
loss. The enormity of these overstatements, taken together with the serious consequences
the director defendants knew would result from a disclosure that Sel-Leb breached the
covenants in its credit facility, are prime indicia of scienter under the PSLRA and Rule 9(b).
IV.
17
See also Rothman v. Gregor, 220 F.3d 81, 92 (2d. Cir. 2000) (agreeing that the
magnitude of write-offs involved “renders less credible” defendants’ argument that they
acted without scienter); In re Baan Co. Sec. Litig., 103 F. Supp. 2d 1, 21 (D.D.C. 2000)
(observing that “the magnitude of the error can play a role” in inferring scienter); In re
Ancor Communiations, Inc., 22 F. Supp. 2d 999, 1005 (D. Minn. 1998) (finding support
for a strong inference of conscious behavior from a company’s substantial overstatements
of revenues); In re First Merchants Acceptance Corp. Sec. Litig., No. 97-C-2715, 1998
U.S. Dist. LEXIS 17760, at *30-*31 (N.D. Ill. Nov. 4, 1998) (“Other circumstances
suggesting fraudulent intent can include . . . the magnitude of the fraud alleged.”); Carley
Capital Group v. Deloitte & Touche, L.L.P., 27 F. Supp. 2d 1324, 1339 (N.D. Ga. 1998)
(holding that a misapplication of GAAP “when combined with a drastic overstatement of
financial results can give rise to a strong inference of scienter”); Rehm v. Eagle Fin.
Corp., 954 F. Supp. 1246, 1255 (D. Ill. 1997) (citing the defendants’ 91% overstatement
of revenues as an “egregious miscalculation of credit losses” indicative of fraudulent
intent); Marksman Partners, L.P. v. Chantal Pharm. Corp., 927 F. Supp. 1297, 1314 (D.
Cal. 1996) (“The facts that the allegedly overstated revenues constituted such a
significant portion of Chantal's total revenues . . . tend[s] to support the conclusion that
the defendants acted with scienter.”).
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We have held that scienter may be adequately pleaded either (1) by “alleging facts
establishing a motive and an opportunity to commit fraud;” or (2) by “setting forth facts that
constitute circumstantial evidence of either reckless or conscious behavior.” In re Advanta
Corp. Sec. Litig., 180 F.3d 525, 534-35 (3d Cir. 1999). As discussed above, the plaintiffs
here have alleged “conscious behavior” in that the director defendants knew of Merrill
Lynch’s concerns and concealed those concerns by reporting merely that Sel-Leb’s credit
facility had been “renew[ed].” But the complaint also alleges that the director defendants
had the “motive and opportunity” to commit fraud. In particular, the complaint asserts that
the director “[d]efendants were motivated to issue materially false statements . . . in large
part to maintain the credit facility with Merrill Lynch.” Comp ¶ 45. Such motivations are
highly probative of an intent to defraud. Allegations that a company’s life hinges upon a
credit facility, and that its lender is growing concerned about the company’s financial state
– coupled, as here, with severely overstated financials – present a starkly different scenario
than the sort of generalized and commonplace motivations that the majority opinion finds
to warrant dismissal under Rule 12(b)(6). The present complaint alleges that (1) absent
financial overstatements, a corporation would default on a credit facility necessary to its
survival; and (2) anxious lenders are repeatedly stiffening the terms of loan covenants,
suggest a more specific and less common motivation and, therefore, are more probative of
fraudulent intent.
Several courts have found such allegations probative of scienter. In Howard v.
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Everex Sys., 228 F.3d 1057 (9th Cir. 2000), the court found scienter had been sufficiently
established through plaintiffs’ evidence that “Everex had a motivation to overstate its net
value so as not to violate loan covenants with its principal lender CIT.” Id. at 1064.
Everex’s lender had required it to maintain a net worth of $90 million and at the end of
fiscal year 1991, Everex had a net worth of $92.1 million. The court stated that, given
Everex’s “projected possible first quarter FY1992 losses of $2.1 million, resulting in a net
worth of exactly $90 million,” the defendant director and CEO had the incentive to overstate
Everex's value.” Id. The court concluded that “the demonstration of [the defendant’s]
possible motive, combined with the red flags of Everex's financial condition, are sufficient
to withstand a motion for JMOL.” Id.18
Similarly, in PR Diamonds, Inc. v. Chandler, 364 F.3d 671 (6th Cir. 2004), the court
found significant the plaintiffs’ allegations that the defendants used improper accounting
practices to forestall the company’s impending default under certain financial covenants of
its bank loan agreement:
[T]he allegations that the Individual Defendants
18
Howard arose in the context of a motion for judgment as a matter of law rather
than on a motion to dismiss, in which context the Ninth Circuit has interpreted the
PSLRA to discount allegations of motive and opportunity as a means of establishing
scienter. See Fischer v. Vantive Corp.(In Re Vantive Corp. Secs. Litig.), 283 F.3d 1079,
1097 (9th Cir. 2002).
-27-
were motivated to engage in fraud in order to
forestall Intrenet's default of its bank loan
agreement and to preserve the Company's ability
to borrow pursuant to its credit facility warrant
closer scrutiny. These more particularized sorts
of motive allegations are more probative of
scienter. For example, as part of the mix of
factors contributing to an inference of scienter,
the Ninth Circuit has considered a defendant's
motivation to overstate a company's reported net
value so as not to violate loan covenants with its
lender and to improve the prospects of
increasing its credit line. Howard v. Everex
Sys., Inc., 228 F.3d 1057, 1064 (9th Cir. 2000).
We view the motive allegations concerning the
bank loan and credit facility as suggestive of
scienter, although standing alone they do not
establish a strong inference.
Id. at 690 (emphasis added).
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In the present case, the complaint’s allegations that the director defendants were
motivated to avoid defaulting on Sel-Leb’s credit facility do not stand alone. Read together
with Sel-Leb’s SEC filings, the pleadings show that Merrill Lynch twice within a four-
month period tightened Sel-Leb’s loan covenants, the most plausible explanation for which
is Merrill Lynch’s concern about Sel-Leb’s financial situation. The director defendants
knew of these concerns but did not disclose them; in fact, the complaint alleges that the
director defendants hid or “buried” those concerns, see Comp. ¶ 30 (supra n. 3), behind the
pretense that the facility was being “renew[ed].” A42.
The question for us is not whether there are benign and “puffery” ways of
interpreting these events; there may be many. Rather, the issue is whether plaintiffs have
pled facts “rendering an inference of scienter at least as likely as any plausible opposing
inference.” Tellabs, 127 S.Ct. 2499, 2513 (2007) (emphasis in original). I would hold that
they have met this burden, and have therefore properly and adequately pled the “strong
inference” of scienter required under the PSLRA.
I therefore respectfully dissent from the majority’s judgment, which upholds the
district court’s dismissal of plaintiffs’ complaint pursuant to Fed. R. Civ. P. 12(b)(6) and
thus precludes plaintiffs from proving the fraud and intent of the defendant directors –
which plaintiffs have abundantly and appropriately alleged in the complaint.
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