Catogas v. Cyberonics, Inc.

IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT United States Court of Appeals
Fifth Circuit
FILED
September 8, 2008
No. 07-20787 Charles R. Fulbruge III
Clerk
JOHN E. CATOGAS; CECILIA CATOGAS; BLANCA RODRIGUEZ;
MOHAMED BAKRY; CYBERONICS INVESTOR GROUP; EFCAT, INC.
Plaintiffs-Appellants
v.
CYBERONICS, INC.; ROBERT P. CUMMINS; RICHARD L. RUDOLPH;
ALAN TOTAH; PAMELA B. WESTBROOK; MICHAEL A. CHENEY; W.
STEVEN JENNINGS
Defendants-Appellees
Appeal from the United States District Court
for the Southern District of Texas
USDC No. 4:06-CV-2121
Before HIGGINBOTHAM, DAVIS, and BARKSDALE, Circuit Judges.
PER CURIAM:*
At issue in this putative securities-fraud class action is the dismissal, with
prejudice, of plaintiffs’ complaint, pursuant to Federal Rule of Civil Procedure
12(b)(6) and the Private Securities Litigation Reform Act of 1995 (PSLRA), 15
U.S.C. § 78u-4. Plaintiffs, who purchased Cyberonics, Inc., stock during the
class period (5 February 2004 to 1 August 2006), challenge that dismissal for
*
Pursuant to 5TH CIR. R. 47.5, the court has determined that this opinion should not
be published and is not precedent except under the limited circumstances set forth in 5TH CIR.
R. 47.5.4.
No. 07-20787
only one of the dismissed claims: that Cyberonics and certain of its directors and
officers defrauded investors by backdating and repricing executive stock options
without reporting the stock-based compensation as an expense on Cyberonics’
financial statements. We hold plaintiffs failed to plead loss causation with the
requisite particularity. AFFIRMED.
I.
Cyberonics is a manufacturer and seller of implantable medical devices for
the treatment of epilepsy and other neurological disorders. Its principal product
is the Vagus Nerve Stimulation Therapy System (VNS Device): a small pulse
generator implanted beneath the skin and connected to the vagus nerve in the
neck.
Plaintiffs filed this action in November 2005, claiming defendants violated
§§ 10(b) and 20(a) of the Securities Exchange Act of 1934 (Exchange Act), as well
as Securities and Exchange Commission (SEC) Rule 10b-5, by making false or
misleading statements regarding: the likelihood that the FDA would approve
the VNS Device for the treatment of depression; the marketability of the device;
and its safety and efficacy.
Defendants moved to dismiss in January 2006. That July, the district
court dismissed the action, ruling plaintiffs failed to plead with the specificity
required by Federal Rule of Civil Procedure 9(b) and PSLRA §§ 78u-(b)(1)-(2).
Contemporaneously, however, the court granted the lead plaintiff, Cyberonics
Investor Group (CIG), leave to amend the complaint.
On 17 August 2006, CIG filed its First Amended Complaint (FAC), which
expanded both the class period and the claims. The new claims alleged:
defendants misrepresented the prospects for payer approval, i.e., insurance
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company authorization of the VNS Device for depression treatment; and
Cyberonics improperly accounted for stock options granted to its CEO.
Defendants again moved to dismiss; but, before the district court ruled on
that motion, plaintiffs moved for leave to amend their complaint again. In April
2007, the district court denied plaintiffs’ motion and stayed the action, pending
the Supreme Court’s disposition of Tellabs, Inc. v. Makor Issues and Rights, Ltd.,
127 S. Ct. 2499 (2007).
After Tellabs was rendered, the district court lifted the stay and
authorized plaintiffs to supplement their FAC. Plaintiffs filed their almost 200-
page Supplemented First Amended Complaint (SFAC) in July 2007. The SFAC
restated the claims in the FAC and added new claims regarding Cyberonics’
stock-option practices. Most of the SFAC concerned the VNS Device.
Defendants again moved to dismiss on 8 August 2007.
Regarding the challenged stock-option practices, related public activity
had taken place over a year before the SFAC was filed. First, an investment
analyst had published a report on 8 June 2006, raising questions about certain
stock options granted by Cyberonics. (As discussed, the original complaint,
which did not contest those practices, had been filed in November 2005.) The
next day, 9 June, the SEC had initiated an informal inquiry into the matter.
And, on 26 June, the United States Attorney for the Southern District of New
York had subpoenaed documents relating to Cyberonics’ stock-option grants. On
the same day as those subpoenas were issued, Cyberonics announced it had
designated its Audit Committee to conduct an internal investigation into the
matter.
This internal investigation caused Cyberonics to delay filing its SEC Form
10-K (annual report) for fiscal year 2006 (FY06 10-K). On 11 July 2006, a year
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before the SFAC was filed, Cyberonics had issued a press release, announcing:
it would delay filing its FY06 10-K in the light of its internal investigation; and
it had so notified NASDAQ. On 1 August 2006 (the last day of the class period),
Cyberonics issued a second press release, which stated, inter alia: its internal
investigation was ongoing; and its FY06 10-K filing would be further delayed.
That second press release also stated that Cyberonics had received a NASDAQ
Staff Determination Letter the day before, 31 July, informing Cyberonics that
it was subject to delisting from the exchange if it did not file its Form 10-K. The
price of Cyberonics’ common stock fell from its 31 July close of $21.43 to $15.89
on 1 August, a decline of approximately 25%. (As noted, part of the stock-option-
practices claim had first been raised in the 17 August 2006 FAC.)
On 20 November 2006, in a SEC Form 8-K, Cyberonics announced: it had
improperly accounted for its stock-option grants; and a restatement of past
financial results would be forthcoming. That restatement came in Cyberonics’
belatedly-filed FY06 10-K, which was filed with the SEC on 5 January 2007.
Cyberonics restated its prior financial statements to reflect approximately $18.4
million in additional compensation expense relating to stock-option grants for
the 12-year period FY 1994 through FY 2005. The FY06 10-K also made several
admissions, which, in plaintiffs’ view, demonstrate that defendants engaged in
a scheme to purposely manipulate and falsify the stock-option dates and pricing.
In October 2007, for the claims concerning the VNS Device, the district
court ruled that the SFAC “fail[ed] to cure any of the deficiencies from which
their original complaint suffered with regard to the particularity required for
pleading misstatements, omissions, scienter, and loss causation”. The court also
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dismissed the stock-option claims, ruling that plaintiffs did not plead sufficient
facts to raise a “strong inference of scienter”, as required by the PSLRA.
II.
The Rule 12(b)(6) dismissal of the SFAC is reviewed de novo. E.g., Cent.
Laborers’ Pension Fund v. Integrated Elec. Servs., Inc., 497 F.3d 546, 550 (5th
Cir. 2007) (citing Nathenson v. Zonagen, Inc., 267 F.3d 400, 406 (5th Cir. 2001)).
For doing so, we must “consider the complaint in its entirety, as well as . . .
documents incorporated into the complaint by reference, and matters of which
the court may take judicial notice”. Tellabs, 127 S. Ct. at 2509. The allegations
are construed in the light most favorable to the plaintiff, accepting all well-
pleaded factual allegations as true. Id. We may not, however, “accept as true
conclusory allegations, unwarranted factual inferences, or legal conclusions”.
Cent. Laborers’ Pension Fund, 497 F.3d at 550 (quoting Plotkin v. IP Axess, Inc.,
407 F.3d 690, 696 (5th Cir. 2005)) (internal quotation marks omitted). Finally,
we may affirm the Rule 12(b)(6) dismissal of the SFAC on any basis supported
by the record. R2 Invs. Ltd. v. Phillips, 401 F.3d 638, 642 (5th Cir. 2005).
“To state a claim under [Exchange Act] § 10(b) and [SEC] Rule 10b-5, a
plaintiff must allege, in connection with the purchase or sale of securities[:] (1)
a misstatement or an omission (2) of material fact (3) made with scienter (4) on
which plaintiff relied (5) that proximately [injured him; i.e., loss causation].”
Fin. Acquisition Partners, L.P. v. Blackwell, 440 F.3d 278, 286 (5th Cir. 2006)
(citation and internal quotation marks omitted). As noted, the district court
dismissed the SFAC based upon finding plaintiffs had not pleaded scienter
adequately.
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Plaintiffs do not appeal the dismissal concerning the VNS Device. In other
words, the only claim-dismissal contested here concerns the stock options. In
addition to responding to plaintiffs’ contentions regarding scienter, defendants
also present an alternative basis for affirming the dismissal of the SFAC: the
failure to plead loss causation adequately. (Because the dismissal is upheld on
that basis, we need not address whether a “strong inference” of scienter was
adequately pleaded under the PSLRA. See Tellabs, 127 S. Ct. at 2499.)
The PSLRA requires plaintiffs to plead loss causation, “i.e., a causal
connection between the material misrepresentation and the loss”. Dura Pharm.,
Inc. v. Broudo, 544 U.S. 336, 342 (2005); see 15 U.S.C. § 78u-4(b)(4) (“[T]he
plaintiff shall have the burden of proving that the act or omission of the
defendant alleged to violate this chapter caused the loss for which the plaintiff
seeks to recover damages”.). Dura made clear that there must be sufficient
allegations that the misrepresentations caused plaintiffs’ loss; it is insufficient
to simply allege that the misrepresentation “‘touches upon’ a later economic
loss”. Dura, 544 U.S. at 343 (emphasis added). Plaintiffs must allege, therefore,
that the market reacted negatively to a corrective disclosure, which revealed the
falsity of Cyberonics’ previous representations regarding the accounting for its
stock options. Id. at 347 (“The complaint’s failure to claim that Dura’s share
price fell significantly after the truth became known suggests that the plaintiffs
considered the allegation of purchase price inflation alone sufficient.”); see also
Glaser v. Enzo Biochem, Inc., 464 F.3d 474, 477 (4th Cir. 2006) (“Dura requires
plaintiffs to plead loss causation by alleging that the stock price fell after the
truth of a misrepresentation about the stocks was revealed”); Lentell v. Merrill
Lynch & Co., 396 F.3d 161, 175 (2d Cir. 2005). Moreover, because publicly
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disseminated information is reflected in the price of a stock traded on an
efficient market, confirmatory information—that information already known to
the market—may not constitute such a corrective disclosure. See Greenberg v.
Crossroads Sys., Inc., 364 F.3d 657, 663 (5th Cir. 2004); Nathenson, 267 F.3d at
415.
In their reply brief, responding to Cyberonics’ alternative loss-causation
assertion, plaintiffs contend that Cyberonics’ 1 August 2006 press release
constitutes such a corrective disclosure because the release was “the first time
that the market learned the full ramifications of the backdating and repricing
scheme – i.e., before the August 1, 2006 press release, the investing public did
not know and was never told that the illegal scheme could eventually lead
Cyberonics’ market to stop trading on the Nasdaq exchange”. (Emphasis added.)
Again, 1 August 2006, the date of the press release, is the last day of the class
period.
That press release, entitled “Cyberonics Revises Guidance for FY07 And
Confirms Receipt of NASDAQ Staff Determination Letter”, states, in relevant
part:
Financial results and the Form 10-Q for the quarter ended July 28,
2006, as well as the Annual Report on Form 10-K for the year ended
April 28, 2006 will be issued and filed upon completion of the
previously announced internal review being conducted by the Audit
Committee of the Company’s Board of Directors regarding option
grants and resolution of any disclosure and accounting issues that
may arise from the results of the review. . . .
....
. . . As anticipated in the Company’s Form 8-K filed with the
[SEC] on July 27, 2006, Cyberonics received a Nasdaq Staff
Determination Letter on July 31, 2006 indicating that the Company
fails to comply with the filing requirement for continued listing set
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No. 07-20787
forth in Marketplace Rule 4310(c)(14), and that its securities are,
therefore, subject to delisting from the Nasdaq Global Market.
(Emphasis added.) The remainder of the press release is irrelevant to the stock-
option practices; it concerned Cyberonics’ 2007 earnings guidance. Specifically,
the release stated that Cyberonics did not see a return to profitability until it
achieved broader third-party coverage for the VNS Device.
Although the 1 August 2006 press release (as stated, it concerned both the
stock-option matter and the VNS Device) disclosed news that negatively
impacted Cyberonics’ stock price (as stated, it dropped approximately 25% from
the previous day’s close), such news did not reveal anything regarding the
accounting of options that had not already been disclosed to the investing public.
It had been made aware of potential problems with Cyberonics stock-option
accounting by the June 2006 investment-analyst report, as well as by a
Cyberonics 26 June 2006 SEC Form 8-K, which confirmed: the SEC
investigation; the subpoenas from the United States Attorney; and its own
internal investigation. Moreover, the investing public had also been made aware
on 11 July 2006 that Cyberonics would be late in filing its FY06 10-K. As
discussed, under our precedent, confirmatory information cannot cause a change
in stock price. Greenberg, 364 F.3d at 665-66.
For the stock-option issue, the only information in the 1 August 2006 press
release not previously disclosed to the market—potential delistment—did
nothing to reveal previous misstatements with respect to Cyberonics’ stock-
option accounting. Cyberonics’ being subject to delistment was the result of its
delayed FY06 10-K filing. (Indeed, had Cyberonics concluded its internal
investigation earlier in order to be able to restate its earnings in a more timely
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No. 07-20787
fashion, it would not have been subject to NASDAQ delistment pursuant to the
above-referenced Marketplace Rule 4310(c)(14) (requiring issuers listed on
NASDAQ to file documents required by the SEC with the exchange).) It is true
that the FY06 10-K was delayed due to the internal investigation into stock-
option accounting, but such a relationship merely “touches upon” the earlier
allegedly fraudulent financial statements; it does nothing to correct the
inaccuracy of such statements or bring to light any of the alleged fraud by
defendants.
On the other hand, Cyberonics’ statements that did suggest inaccuracies
in stock-option accounting during the class period did not significantly impact
the stock price. For example, on 8 June 2006, the date the analyst released a
report questioning Cyberonics’ stock-option accounting, its stock closed at
$23.59, down $0.20 from the previous day’s close of $23.79. (We can, of course,
take judicial notice of stock prices. See In re Merck & Co. Sec. Litig., 432 F.3d
261, 265 n.3 (3d Cir. 2005); see also Tellabs, 127 S. Ct. at 2509.) Furthermore,
when Cyberonics filed its Form 8-K on 26 June 2006, disclosing the SEC and
Department of Justice investigations, as well as its own internal investigation,
the stock closed at $21.15, down $0.46 from the previous close of $21.61. On 20
November 2006, when the company announced the result of its internal
investigation in another Form 8-K, the stock closed at $24.17, down $0.41 from
its previous close of $21.58. And, when Cyberonics restated its past financial
results on 5 January 2007, with the filing of the FY06 10-K, the stock price
closed at $20.97, $0.95 higher than its previous close of $20.02.
As with the rest of the SFAC, most of its loss-causation section discussed
events surrounding the FDA and the VNS Device. With respect to the stock-
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No. 07-20787
option practices, the only loss-causation allegations concerned the 1 August 2006
press release. The SFAC’s “loss causation” section provides in full:
182. On August 11, 2004, with FDA issuance of the
Company’s “Not Approvable Letter”, the market learned that,
contrary to defendants’ earlier representations, that the FDA
scientists were not satisfied with the Company’s scientific evidence
of safety and effectiveness, and that the advisory board’s
recommendation was not the only substantive hurdle to the
approval of the TRD indication for the VNS Device. As a result of
the shocking news of the “Not Approvable Letter,” on August 12,
2004, the value of the Company’s shares plunged over 40 percent,
losing $9.59 from the previous closing price of $23.95 on August 11,
2004, to close on August 12, 2004 at $14.36, on heavy volume of over
27 million shares.
183. Nevertheless, the Company immediately went to work
to reverse the deservedly devastating effect that the “Not
Approvable Letter” had on the market, creating a second wave of
stock inflation based on defendants’ new misrepresentations.
Defendants’ efforts to again artificially inflate the price of the
Company’s stock succeeded, the result of unfounded and objectively
unreasonable claims directed towards “confirmation” of a lucrative
marketing opportunity for the Company’s TRD treatment option.
184. In addition to this, for the ten year period of 1994
through 2005, defendants manipulated the dates of the approvals of
the executive stock option awards to reduce the options’ exercise
prices, thereby increasing their own compensation, and
understating the compensation expense reported for these options
on Cyberonics’ financial statements, including those publicly filed
during the Class Period. Because of the misstatement of Cyberonics
compensation expense, each of these financial statements violated
GAAP, and the statements included in Cyberonics public filings,
that the financial statements were fairly represented in accordance
with GAPP were false. Not surprisingly, when the investment
community learned that the SEC, the U.S. Attorney’s Office and
NASDAQ were all looking [sic] defendants’ misconduct and the false
financial reports, the disclosure of this combined and aggressive
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regulatory action caused Cyberonics stock to drop in price and
investors’ losses to be realized.
185. As a result of the shocking news regarding the severely
limited marketability of the VNS Device for TRD, in combination
with the issues leading to the governmental investigations and a
possible delisting of the Company’s stock, on August 1, 2006, the
value of the Company’s shares plummeted again, falling $5.54 from
the previous closing price of $21.43 on July 31, 2006, for a loss of
over 25.8%, to close at $15.89, on heavy volume of over 5.4 million
shares.
186. The almost 40% decline in Cyberonics stock on August
12, 2004, and the 25.8% decline in Cyberonics’ stock price on August
1, 2006, at the end of the Class Period were the direct result of the
unraveling of the nature and extent of defendants’ fraud finally
being revealed to investors and the market. The timing and
magnitude of Cyberonics stock price decline negate any inference
that the loss suffered by plaintiff and other [putative] Class
members was caused by changed market conditions, macroeconomic
or industry factors or Company-specific facts unrelated to the
defendants’ fraudulent conduct.
187. On the days in which Cyberonics stock price fell almost
40% and 25.8% as a result of defendants’ fraud being revealed, the
Standard & Poor’s 500 securities index was flat. The economic loss,
i.e., damages, suffered by plaintiff and other members of the Class
was a direct result of defendants’ fraudulent scheme to artificially
inflate Cyberonics stock price and the subsequent decline in the
value of Cyberonics stock when the defendants’ prior
misrepresentations and other fraudulent conduct was revealed.
(Emphasis in original.)
In sum, plaintiffs did not allege that any of the above-discussed non-
August 2006 statements constituted a corrective disclosure—perhaps because
the stock price did not drop significantly on any of those dates. Although the
stock price dropped dramatically on the day of the 1 August 2006 press release,
no new facts concerning Cyberonics’ stock-option accounting were disclosed in
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No. 07-20787
that release which demonstrated that the “truth became known” about
Cyberonics’ challenged financial statements. Dura, 544 U.S. at 347. Therefore,
“a causal connection between the material misrepresentation and the loss” was
not adequately pled. Id. at 342 (emphasis added).
III.
For the foregoing reasons, the judgment is AFFIRMED.
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