Financial Fraud Lawsuits: The Case For Stricter Judicial Scrutiny

Originally published August 2001 by the Washingon Legal Foundation, later reprinted at 7 No. 5 ANSLRR 15 (Andrews Securities Litigation and Regulation Reporter)

Co-authored by SHIRLI FABBRI WEISS

Introduction

The securities class action plaintiffs' bar has long touted cases based on allegations of financial fraud. Asserting that a company "cooked the books" by improperly recognizing revenue, deferring expenses, or using other accounting "tricks" has a patina of legitimacy absent from cases brought simply because a company missed Wall Street estimates. The apparent attractiveness of these cases to plaintiffs has increased because financial statements are not covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 (the "Reform Act"), which allow companies to protect most forward‑ looking statements (such as earnings projections) from liability.[1].  The plaintiffs' bar also has cited a few well‑publicized cases such as Cendant [2] to assert that financial fraud is on the upswing.

The seduction of financial fraud cases will wane if courts devote the same careful, strict scrutiny to this type of case as they often do to other types of securities fraud cases. The Ninth Circuit's recent affirmance of dismissal in Zeid v. Kimberley, No. 00‑16089, 2001 WL 357526 (9th Cir. Apr. 19, 2001) (hereinafter "Firefox") demonstrates that financial fraud allegations, like other securities fraud allegations, must be dismissed if they are not pleaded with factual particularity or if plaintiffs do not plead all facts underlying their allegations.

While Firefox (to the authors' knowledge) is the first appellate court decision to affirm the dismissal of financial fraud allegations on these grounds, its approach is not unique: district courts have dismissed financial fraud allegations, particularly (but not exclusively) where no "restatement" ‑‑ alteration and republication of the company's financial statement ‑‑ is involved. The Firefox experience should serve as a model to all courts, as the Reform Act requires judges to apply this type of strict scrutiny to all securities cases.

I. The Firefox Case (Zeid v. Kimberley)

A. The Initial Complaint is Dismissed

Firefox Communications, Inc. was a manufacturer of internetworking connectivity and communications software. (It was later acquired by FTP Software, which in turn was acquired by NetManage Inc.) On January 2, 1996, Firefox pre‑announced that it expected to lose money in the recently concluded quarter. The stock price declined, and the company and its officers were hit by a securities class action lawsuit filed in the United States District Court for the Northern District of California.This case was among the very first securities fraud class actions filed following passage of the Reform Act. Plaintiffs' initial complaint contained routine allegations that Firefox had made falsely optimistic statements about its business prospects. It also contained vague financial fraud allegations that Firefox had engaged in contingent sales and had taken inadequate reserves.

Firefox moved to dismiss on a variety of grounds. The district court  (Judge Spencer Williams) granted the motion. Zeid v. Kimberley, 930 F. Supp. 2d 431 (N.D. Cal. 1996) ("Firefox I"). Judge Williams found that the complaint failed to plead any details of the revenue recognition allegations, id. at 437; and that even under a motive and opportunity approach to pleading scienter (i.e. intent), the complaint failed to set forth sufficient facts to allow for a strong inference of scienter with respect to that claim or the allegation of inadequate reserves. Id. at 437, 438.

B. The First Amended Complaint is Dismissed

At the hearing of the initial motion to dismiss, plaintiffs asserted that they could add facts sufficient to state a claim. Judge Williams thus allowed leave to amend.  Id. at 438. Plaintiffs came back with an amended complaint. Superficially, this complaint appeared to contain specific financial fraud allegations. It alleged that in order to cover up its allegedly poor products and results while it tried to sell itself to FTP Software, Firefox had sold two of its main customers, whichwere identified by their names, over $750,000 each in products without purchase orders and with representations that they did not have to pay if they did not resell the products. It also alleged that in order to implement this plan, the company's vice president of national sales, also identified by name, had persuaded a "friend," a "product reseller on the east coast" named "Manny," to generate a fictitious invoice worth "$200,000 to $300,000." It further alleged that the company had engaged in similar tactics to generate "at least" $1.6 million in false sales in the subsequent quarter.

Firefox faced difficult choices in responding to the amended complaint. To its knowledge, the plaintiffs allegations had no basis in reality: there had been no contingent sales and there was no such person as "Manny." However, the allegations had a superficial specificity that may have been enough to sustain them under pre‑Reform Act law. In the end, Firefox decided to move to dismiss, on the basis (among others) that plaintiffs had not fulfilled their Reform Act obligation to set forth all facts underlying their financial fraud (and other) allegations, which the defendant contended were pleaded oninformation and belief.[3]

Judge Williams granted the motion. Zeid v. Kimberley, 973 F. Supp. 910  (N.D. Cal. 1997) ("Firefox II"). As is typical, the plaintiffs tried to avoid their obligation to plead all facts underlying their allegations by purporting to plead on a(nonexistent) category called "investigation of counsel." The defendant argued that there was no separate category, that allegations were either made on personal knowledge or on information and belief. In his ruling, Judge Williams called plaintiffs' bluff: he ruled that he would assume that plaintiffs' allegations were pleaded on actual knowledge, and hence would not allow plaintiffs the leniency in pleading conferred in pre‑Reform Act cases. Id. at 915. The judge then applied strict scrutiny to analyze the factual particulars ‑‑ more accurately, the lack thereof ‑‑ of the financial fraud allegations. He noted that the complaint did not plead a single transaction involving delayed shipping or unauthorized delivery, id. at 922; that while the complaint alleged contingent sales to identified customers, it did not plead who told the customers they could return products, or that any supposedly contingently‑sold products had been returned, id. at 923; and that the allegations regarding "Manny" were "clouded by a thick fog of ambiguity," with several unanswered questions. Id.

Judge Williams also rejected plaintiffs' scienter allegations, both as a matter of law and for lack of factual support. The plaintiffs had been unable to allege insider selling during the class period as the motive for "fraud;" there was none. Judge Williams rejected plaintiffs' contention that the company was motivated to inflate earnings in order to entice the FTP Software merger. This theory did not make sense because the merger was not completed until after Firefox had released the adverse information at the end of the class period. Id. at 924. In recognition of this flaw, the plaintiffs alleged that Firefox had tried to inflate its financials to support earlier merger negotiations. According to plaintiffs, a draft merger agreement had been signed and FTP Software had started due diligence on Firefox; the talks then broke down, and Firefox was forced to reveal the fraud in the subsequent year‑end audit. Judge Williams responded that this theory was defective because a merger "involves a due diligence process" and plaintiffs "fail to explain how a year‑end audit would reveal 'true' information while the due diligence process would not." Id. As explained below, two district courts have taken this argument further to dismiss implausible securities fraud claims.

Judge Williams held that as a result of these defects and others, the complaint was insufficient under Federal Rule of Civil Procedure 9(b) and the Reform Act. This time, he dismissed the case without leave to amend. Id. at 925. This was apparently the first securities class action case dismissed with prejudice under the Reform Act.

C. The Ninth Circuit Affirms the Dismissal

The plaintiffs appealed the district court's dismissal. While that appeal was pending, the Ninth Circuit decided the appeal of a securities case involving allegedly false forecasts that had been dismissed after Firefox. In In re Silicon Graphics Securities Litigation, 183 F.3d 970 (9th Cir. 1999), the court held that in order to comply with the Reform Act, "a plaintiff must provide a list of all relevant circumstances in great detail" and provide, "in great detail, all the relevant factsforming the basisof her belief." Id. at 984, 985. The court also rejected plaintiffs' contention that their so‑called "investigation of counsel" allegations excused them from the Reform Act's requirements to plead all facts on which their allegations were based. The Ninth Circuit vacated Firefox II and remanded for reconsideration in light of Silicon Graphics.[4] Judge Williams again dismissed the case,and the plaintiffs again appealed.

In an unpublished opinion, the Ninth Circuit affirmed dismissal. Zeid v. Kimberley, No. 00‑16089, 2001 WL 357526 (9th Cir. Apr. 19, 2001) ("Firefox III"). The court reiterated that Silicon Graphics had found that a complaint failed to meet Reform Act standards "because it did not specify enough details about, or the sources of, the information that formed the basis of the plaintiffs' allegations, other than to state that the information was contained in internal reports and was discovered through the investigation of counsel." Id. at *1.  Among the information that was lacking was "the sources of [plaintiff's] information with respect to the reports, how she learned of the reports, who drafted them, ... which officers received them," and the contents of the reports. Id.  The court applied this standard to the Firefox complaint and found that it, too, "alleges that Defendants made statements that they knew were misleading because of 'their access to internal corporate data,' 'internal corporate information,' and 'private corporate information' ‑‑ reports about which the required detail is lacking." Id.  Thus, the court found "no principled basis on which to distinguish Silicon Graphics with respect to the required level of particularity." Id.

II. The Firefox Approach in the District Courts

Firefox III applied the Reform Act's particularity standards to a financial fraud case, and the Firefox experience as a whole demonstrates that defendants can contest financial fraud allegations at the pleading stage. Firefox III may be the first appellate case to dismiss such allegations for lack of particularity under the Reform Act,[5] but it is not alone. District courts have carefully scrutinized financial fraud allegations, demanding that plaintiffs plead the particulars of the alleged underlying misconduct and/or the bases of their allegations.

A. Strict Scrutiny Where There Is No Restatement: Vantive and Other Cases

District courts have been most active in applying strict scrutiny to financial fraud allegations where, as in Firefox, the defendant company did not restate ‑‑ that is, change and republish its previously issued financial statements. A good example is In re Vantive Corporation Securities Litigation, 110 F. Supp. 2d 1209 (N.D. Cal. 2000), which is currently on appeal to the Ninth Circuit. The complaint alleged both false forecasts and financial fraud; "specifically," that the company had engaged in unspecified contingent sales with unidentified customers in unspecified amounts, and that a projected $19 million contract had been signed with an identified customer with the description of the services in the contract written in as "to be determined." The district court (per Judge William Orrick) dismissed all allegations for lack of particularity, and for the lack of pleading of all facts forming the basis of information and belief allegations. In connection with this ruling, the court explained that the statutory requirement to plead all facts:

  1. is the [Reform Act]'s single most important weapon against t pleading fraud by hindsight because it forces plaintiffs to reveal whether they base their allegations on an inference of earlier knowledge drawn from later disclosures orfrom contemporaneous documents or other facts.

Id. at 1216.[6] With respect to the financial fraud allegations, the court held that the "to be determined" allegation lacked sufficient particularity (including the amount, if any, of the projected $19 million that ultimately was not recognized); that the complaint did not plead sufficient details of the other allegedly improper transactions; and that the complaint did not plead any facts indicating that any defendant knew that revenue had been improperly recognized. Id. at 1217.

Other district courts have concurred with Firefox and Vantive in dismissing for lack of particularity where there was no restatement of company financials.[7] Indeed, one court consciously recognized the significance of the lack of a restatement: it dismissed no‑restatement financial fraud claims for lack of particularity, and distinguished other cases in which courts had found that scienter had been pleaded on the basis that those cases had involved restatements. In re K‑Tel Int'l, Inc. Sec. Litig., 107 F. Supp. 2d 994, 1004 (D. Minn. 2000). Another good example of the approach in a no‑restatement case is In re Galileo Corporation Shareholders Litigation, 127 F. Supp. 2d 251 (D. Mass. 2001). The court found the allegation that the company improperly booked $900,000 in sales to a financially distressed customer lacked specificity as to the contacts with the customer that would have alerted defendants to this condition, especially as the issue of whether the company had the reasonable assurance of collection required for recognition "was a fluid and subjective concept, dependent on the knowledge the defendants had at the time." Id. at 262‑64. The court also found the allegation that the company improperly recognized sales to a customer that later returned $800,000 in defective products lacked details such as the nature of the defect, the costs of repairingor replacing the product, when the product would be repaired or replaced, and the amount of the reserve that should have established. Id. at 266‑69.[8]

The absence of particularity is not the only flaw that district courts have found when they have applied strict scrutiny to no‑restatement financial fraud allegations. Courts have rejected assertions that contemporaneous accounting metrics indicated improper revenue recognition. In one case, for example, the court dismissed a challenge to the company's reported revenues based solely on the increases in the company's reserves and accounts receivable balances.[9] Another court rejected a financial fraud case predicated on after‑ the‑fact disclosures or changes in accounting policy ‑‑ the financial fraud equivalent to the traditional "fraud by hindsight" case alleging that a company "must have known" that its forecasts were false because they did not come to pass. In Sakhrani v. Brightpoint, Inc., No. IP99‑0870‑C‑H/G, 2001 WL 395752 (S.D. Ind. Mar. 29, 2001), a court rejected for lack of particularity the allegation that a company had improperly recognized revenue on sales to uncreditworthy accounts. The court reached this conclusion notwithstanding allegations that the company later filed a lawsuit to collect a $17 million unpaid bill and disclosed that it was tightening credit policies. The court sensibly held that these later events did not signify that previous credit extension policies had been reckless. Id. at *28.[10]  District courts also have rejected financial fraud claims for the failure to plead other elements of 10b‑5 liability.[11]

Finally, district courts have rejected any theory of fraud, be it financial fraud or another type of claim, predicated (as plaintiffs alleged in Firefox) on the alleged motive to complete a merger. As noted above, Judge Williams explained in Firefox II that it did not make sense to conclude that a company would be able to hide a financial fraud during merger due diligence. Two other district courts have taken this insight one step further, reasoning that if a company was intent on concealing the truth, the least likely thing it would do would be to expose itself to merger due diligence. In re CDnow, Inc. Sec. Litig., 138 F. Supp. 2d 624, 642 (E.D. Pa. 2001) (scienter not pleaded under theory that officers tried to hide company's poor condition to attract merger candidate because officers would know that any candidate would conduct due diligence and discover the true conditions); Coates v. Heartland Wireless Communications, Inc., 55 F. Supp. 2d 628, 643 (N.D. Tex. 1999) (same, for financial fraud allegations).

B. Strict Scrutiny In Restatement Cases: Where's The Intent?

It is more difficult to defend a financial fraud case involving a restatement. A restatement commonly is regarded as an admission that the original financial statements were false ‑‑ although that understanding is not correct.[12] Under such an assumption, the usual battleground becomes whether a complaint's allegations plead a strong inference of scienter, or intent to defraud.

Astute district courts have applied the Firefox approach to demand particularity in scienter allegations even when there has been a restatement. In In re Baker Hughes Securities Litigation, 136 F. Supp. 2d 630 (S.D. Tex. 2001), for example, a company announced that its internal audit department had discovered "accounting issues" in a division, and later restated $31 million in revenues from that division over a five year period. The court rejected plaintiffs' scienter allegations, all of which were non‑specific, notwithstanding the alleged Generally Accepted Accounting Practices ("GAAP") violation. Likewise, in In re Galileo, which dismissed financial fraud allegations relating to transactions that were not restated, the court dismissed a separate allegation that the company booked $390,000 in sales that were restated because the complaint did not identify the transactions or how GAAP violations had occurred. 127 F. Supp. 2d at 269‑70.[13]

Some courts have expanded the scope of the Firefox particularity analysis by requiring plaintiffs to plead factsat the outset that refute circumstances indicating that defendants did not act with scienter notwithstanding a restatement. The common thread in these cases is that the allegations of the complaint itself, sometimes accompanied by other judicially noticeable facts, are contrary to a plausible theory of scienter, and hence the required strong inference of scienter. This approach may become increasingly important in restatement cases.

One circumstance that negates an inference of scienter exists when a restatement is based on a new accounting rule. It does not make sense to infer that a company or its officers knowingly or recklessly issued false financial statements when they had prepared those statements under the accounting rules then in effect.

In recognition of this fact, the court in Sakhrani v. Brightpoint, Inc. dismissed a claim based on a company's cumulative charge arising from the application of a new accounting policy, SOP 98‑5; plaintiffs did not allege that the policy had been in effect prior to the charge, and the company had disclosed that it was evaluating the effect the new policy would have. 2001 WL 395752 at *28. Likewise, in Mortensen v. Americredit Corp., 123 F. Supp. 2d 1018 (N.D. Tex. 2000), aff'd, 240 F.3d 1073 (5th Cir. 2000), plaintiffs alleged that a company restated financial results using cash‑out method under FASB 125 after SEC clarified that cash‑in method was not acceptable. The court dismissed the complaint because an accounting fellow at the SEC had stated that the clarifying release had been issued in response to uncertainty on the topic undercut the notion that the company knew that its prior accounting method was wrong.[14]

A second circumstance that negates an inference of scienter applies when a company's accounting judgments decrease reported earnings during the class period. A company would not sensibly choose to do this if it supposedly was intent on "cooking its books" in order to inflate earnings, even if turned out to be the case that the additional reserves did not turn out to be adequate. Thus, in In re Segue Software, Inc. Securities Litigation,106 F. Supp. 2d 161, 169 (D. Mass. 2000), the court dismissed claims alleging that a company booked inadequate returns for reserves, even though the company later restated its revenues, where the pleadings themselves indicated that the company historically had provided a sufficient reserve for returns, and because the fact that the reserve was substantially higher in the quarter challenged by plaintiffs as compared to the three previous years "by itself tends to negate an inference of fraudulent intent."

A third situation in which it does not make sense to infer scienter occurs when a company relies on the opinions or representations of others. Thus, one court dismissed financial fraud allegations on the basis (among others) that plaintiffs had not pleaded facts undermining the auditors' clean opinions issued during the class period. In re First Union, 128 F. Supp. 2d at 894. In another case that was settled during the pendency of a motion to dismiss,a company restated due to complex revenue recognition improprieties at a foreign subsidiary. In re Sybase II Sec. Litig., No. C‑98‑0252‑CAL (filed Jan. 27, 1998). The defendants publicly disclosed the text of a voice mail message from the subsidiary's CEO explaining how he had given the company's management and auditors false information that concealed the improprieties. Plaintiffs set forth the message in their complaint.Defendants moved to dismiss on the basis that scienter could not be the pleaded where the alleged facts showed how the CEO's representations had led the company to conclude that there were no financial improprieties.

Finally, it makes no sense to infer that an individual knowingly or recklessly engaged in financial fraud when that person actually attempted to correct alleged improprieties. In In re Informix Corp. Securities Litigation, No. C 97‑1289 CRB, slip op. (N.D. Cal. Oct. 27, 1998), plaintiffs sued several officers of a company that restated revenues. One defendant was an officer who became the controller near the end of the class period and then became the company's highest‑ranking finance officer upon the CFO's resignation. The chronology set forth in the complaint showed that it was during the latter period that the company and its auditors conducted a massive investigation of revenue recognition practices. In other words, once the Controller became involved with the company's accounting policies and financial statements, the company made enormous efforts to correct any prior errors and irregularities. The court agreed scienter was not pleaded under these circumstances, and dismissed the complaint as to the officer.[15]

III. Why Firefox Makes Sense

In a recent article, Stanford University professor Joseph Grundfest opined that plaintiffs know that filing complaints with accounting fraud allegations "maximizes the [chance] courts will find a strong inference of scienter." Columbia University professor John Coffee, Jr. agreed that "[c]ourts interpret the pleading requirements a little more liberally when dealing with accounting restatements."[16] Plaintiffs have expressed their attitude towards this type of case in a different form: they have argued for leniency in pleading because "corporate books do not cook themselves."

As demonstrated in this Working Paper, not all courts share these assessments of financial fraud cases. Rather, under the approach of Firefox and the other cases cited here, courts have applied strict scrutiny to financial fraud allegations and dismissed complaints lacking the requisite particularity. Any court inclined to follow a different approach should reconsider. There is no reason not to apply the same healthy skepticism to financial fraud allegations as applied to any other securities fraud allegation. Congress enacted the Reform Act in recognition of the fact that "[n]aming a party in a civil suit for fraud is a serious matter. Unwarranted fraud claims can lead to serious injury to reputation for which our legal system effectively offers no redress."[17] The Reform Act's particularity standards seek to prevent this type of injury. Those standards do not distinguish between types of allegations: they require plaintiffs to plead with particularity and to come forward with all facts forming the bases of their allegations.

If plaintiffs do not come forward with support for their financial fraud claims, allowing a lawsuit to proceed would circumvent the statute and impose the injury Congress sought to prevent. Indeed, given the alleged increase in accounting malfeasance, if there is any type of claim that courts should take particular care in screening out at the outset, it is the unsupported, and hence unwarranted, financial fraud allegation. (In contrast, given plaintiffs' recent rhetoric, if they have a genuine basis for accusing each defendant of financial fraud, then they should have the motive and opportunity to come forward with all factual bases of those allegations each time they bring suit.) Corporate books may not cook themselves, but a complaint cannot pass muster if it does not explain with particularity who the chefs were and what ingredients they had used.

It also is important that courts continue to apply the extensions of the Firefox approach to dismiss financial fraud allegations, even in restatement cases, where the complaint does not refute facts negating the scienter of some or all defendants. If (as in Sahkrani, Mortenson, Segue Software, and Informix) the facts within a court's purview tend to negate rather than support scienter, then how can a complaint possibly meet the Reform Act requirement that it plead not just any inference, but a strong inference, of scienter? Any argument to the contrary would require that courts waste their time on cases that cannot possibly go forward, abandon common sense,and/or turn a blind eye to the type of judicially noticeable facts that courts traditionally consider at the pleading stage.

Notes

[1] The safe harbor provides absolute protection from liability if a statement  "is identified as a forward‑looking statement and is accompanied by meaningful cautionary language that could cause actual results to differ materially from those inthe forward‑looking statement." 15 U.S.C. Sec. 78u‑5(c)(1)(A). Even if a forward‑looking statement does not qualify for this absolute protection, a complaint must set forth with particularity the specific facts giving rise to a strong inference that an executive officer of the company had actual knowledge that a forward‑looking statement was false or misleading. Id. Secs. 78u‑ 4(b)(2), 78u‑5(c)(1)(B)(i) & (ii).

[2] Cendant involved the merger of two companies, CUC and HFS. Prior to the merger, CUC had recorded $500 million in improper revenue over a three year period via fictitious transactions and improper adjustments to reserves. The improprieties were discovered after the merger when the former HFS management assumed control of the new combined company, Cendant. The main securities case settled for over $3 billion.  See In re Cendant Corp. Sec. Litig., 139 F. Supp. 2d 585 (D.N.J. 2001) (later opinion on cross‑claims by Cendant against CUC's former auditors.) There also remains an ancillary case brought by the shareholders of another company that Cendant had planned to purchase between the time the merger occurred and the time Cendant discovered and announced the improprieties. See Semerenko v. Cendant Corp., 223 F.3d 165 (3rd Cir. 2000).

[3] 115 U.S.C. Sec. 78u‑4(b)(1)(B) ("if an allegation regarding the  [allegedly false or misleading] statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.").

[4] Zeid v. Kimberley, 201 F.3d 446 (9th Cir. 1999).

[5] Earlier, the Sixth Circuit in In re Comshare, Inc. Sec. Litig., 183 F.3d 542 (6th Cir. 1999), affirmed the dismissal of a securities case based on financial fraud allegations. In Comshare, however, there was no dispute that financial improprieties had occurred: a foreign subsidiary of the defendant company had entered into approximately $4 million in contracts with known contingencies. The district court dismissed the complaint, and the appellate court affirmed that dismissal, due tothe absence of pleaded facts allowing plaintiffs toattribute scienter from the subsidiary to the corporate parent. Comshare is consistent with other decisions that refused to impute scienter from a subsidiary to a parent. Chill v. General Elec. Co., 101 F.3d 263 (2d Cir. 1996) (pre‑Reform Act law);In re Baesa Sec. Litig., 969 F. Supp. 238 (S.D.N.Y. 1997); Glickman v. Alexander & Alexander Servs., Inc., No. 93 Civ. 7594 (LAP), 1996 WL 88570 (S.D.N.Y. Feb. 29, 1996) (pre‑Reform Act law).

[6] See also Carney v. Cambridge Tech. Partners, Inc., 135 F. Supp. 2d 235, 247 (D. Me. 2001) ("It appears then, from the legislative history of the [Reform Act], that a securities fraud action brought on the basis of an 'investigation of counsel' ‑‑ with its implications of lawyer‑directed and motivated litigation ‑‑ was precisely the kind of case Congress found most troubling.").

[7] Some courts have found the absence of particularity so acute as to render financial fraud allegations incomprehensible. See Caprin v. Simon Transp. Serv., 112 F. Supp. 2d 1251, 1257 (D. Utah 2000) (certain financial fraud allegations dismissed as inconsistent and conclusory); Zishka v. American Pad & Paper Co., No. 3:98‑CV‑0660‑M, 2000 WL 1310529, *4 (N.D. Tex. Sept. 13, 2000)(allegation that company understated LIFO reserve was so "confusing and vague" that it required repleading); In re Oakwood Homes Corp., Inc. Sec. Litig., No. 1:98 CV 1013, slip op. at 29‑30 (M.D.N.C. June 27, 2000) (adopted Oct. 23, 2000) (complaint's confused structure, failure to name sources, and failure to provide details about the frequency and magnitude of alleged practicesdisclosed by alleged sources, rendered it impossible to determine when any defendant knew of the supposed falsity of statements).

[8] See also Goldberg v. Primax Elecs., Ltd., No. C‑00‑2525 PJH, slip op. at 7‑8 (N.D. Cal. Feb. 2, 2001) (court dismissed complaint alleging that company recognized sales with rights of return while understating its returns for reserves because it did not allege facts sufficient to support strong inference of fraudulent intent); In re Oakwood Homes Corp., slip op. at 27‑28 (court conducted what it characterized as a "searching review" of the complaint and found that it "lack[ed] particularity precisely where such particularity is absolutely necessary," namely the details and magnitude of the alleged improper accounting practices and how the defendants knew about them); In re Secure Computing, 120 F. Supp. 2d. 810, 820‑21 (N.D. Cal. 2000) (court dismissed financial fraud allegations where plaintiffs did not adequately explain why recognition of revenue was in improper and did not plead any facts upon which allegations were based); Caprin, 112 F. Supp. 2d at 1256 (complaint alleging GAAP violations by trucking company's failure to disclose and accrue for accident claims, driver problems, and other factors dismissed; plaintiffs had not pled facts demonstrating impermissible accounting judgments); Employer‑ Teamsters Joint Council No. 84 Pension Trust Fund v. America West Holdings Corp., Civ. 99‑0399‑PHX‑EHC (OMP) et al., slip op. at 10‑11 (D. Ariz. Oct. 31, 2000) (complaint alleging that airline inflated earnings by reducing maintenance spending to far below FAA minimums with the knowledge that it would have to spend this money later dismissed; while complaint was extremely detailed and noted that the FAA had fined the company a record $5 million, the alleged charts and graphs in the complaint "are not supported by reference to the sources of information relied on," had unexplained significance, and were not accompanied by explanations of "who prepared the report, what the contents of the report are, who received the report, how plaintiffs obtained this information."); In re Versant Object Tech. Corp. Sec. Litig., No. C 98‑00299 CW, slip op. at 22 (N.D. Cal. 2000) (although financial fraud allegations "superficially" resembled those found sufficient under pre‑Reform Act law, complaint did not provide specific factual detail as to why accounting was fraudulent); Ree v. Pinckert, No. C‑99‑0262 MMC, slip op. at 12 (N.D. Cal. Mar. 28, 2000) (court dismissed complaint alleging financial fraud and other claims dismissed for failure to plead falsity with specificity, notwithstanding plaintiffs' submission of alleged internal company document in a declaration).

[9] In re Versant, No. C 98‑00299 CW, slip op. at 24; see also Wilson v. CKS Group, Inc., No. C‑98‑4229 MMC, slip op. at 14 (N.D. Cal. Mar. 21, 2000) (rejecting argument that increases in company's Days Sales Outstanding and accounts receivable balance signified financial fraud).

[10] See also In re First Union Sec. Litig., 128 F. Supp. 2d 871, 894  (W.D.N.C. 2001) ("The mere fact that accounting adjustments were made in one period does not support an inference that they should have been made in another period as well.").

[11] See In re First Union, 128 F. Supp. 2d at 895 (complaint dismissed where alleged misstatement concerned an immaterial 2.1% of operating earnings and 2.8% of earnings after charges); In re Newell Rubbermaid Inc. Sec. Litig., No. 99 C 6853, 2000 WL 1705279 (N.D. Ill. Nov. 14, 2000) (dismissing for lack of materiality allegation that company improperly recorded "piddling amount of expenses" and an even smaller amount of revenue); accord, In re Miller Indus., Inc. Sec. Litig., 120 F. Supp. 2d 1371, 1381 (N.D. Ga. 2000) (summary judgment granted in suit alleging failure to "gross up" the reported sales figures of an acquired; failure was immaterial in view of market's disregard of the subject category of sales, as proven by the way those sales were treated in analyst reports); In re Polaroid Corp. Sec. Litig., 134 F. Supp. 2d 176 (D. Mass. 2001) (rejecting financial fraud claims where the complaint did not plead the specifics of any allegedly improperly recognized transaction save one, and as to that transaction the complaint did not allege loss causation).

[12] For example, a company could prepare its financial statements based on its best current estimates of the cost of future obligations, but decide to restate later when actual costs materially varied from its estimates. See Polk v. Fritz, No. C 96‑2712 MHP, slip op. at 10 (N.D. Cal. Mar. 5, 1998) ("The fact that defendant may have, through its restatement, corrected its prior assessment, does not establish that the earlier accounting judgment was false when made."), subsequent opinion vacated in light of Silicon Graphics sub nom. In re Fritz Cos. Sec. Litig., 201 F.3d 444 (9th Cir. 1999).

[13] See also In re Evans Sys., Inc. Sec. Litig., No. H‑99‑2182, slip op.  (S.D. Tex. May 31, 2000) (alleged failure to follow GAAP, which resulted in "relatively minor" overstatements of revenue in some quarters and understatements in others; and vague allegation that a potential merger partner abandoned discussions because it discovered "suspect accounting practices" at the company; did not plead scienter).

[14] 1123 F. Supp. 2d at 1027; see also In re e.spire Communications, Inc. Sec. Litig., 127 F. Supp. 2d 734, 746‑47 (D. Md. 2001) (complaint alleging that company restated revenues by $12.3 million "in order to comply with prevailing industry accounting practices" in accordance with newly issued FASB Interpretation 43 dismissed; the Interpretation indicated that there was debate within the literature, not that the FASB was restating existing rules, and relative size of restatement was small); accord, Coates v. Heartland Wireless Communications, Inc., 100 F. Supp. 2d 417, 425 (N.D. Tex. 2000) (dismissing allegation in no‑restatement case that wireless cable company misstated financials by inaccurately counting subscriber reports where counting method appeared to be consistent with company policy and there were no particularized allegations that policy was motivated by intent to defraud); In re Miller Indus., 120 F. Supp. 2d at 1382‑83 (summary judgment granted in suit alleging failure to "gross up" revenues under APB Opinion 16; issue involved a judgment call on which reasonable accountants could disagree and the Opinion states that it is not intended to apply in all circumstances); cf. In re Allied Products Corp., Inc. Sec. Litig., No. 99 C 3597, 2000 WL 1721042 (N.D. Ill. Nov. 15, 2000) (where company restated financials to recognize (1) cost escalation that had been deferred under the "reallocation method" variant of contract accounting and (2) additional compensation expenses, court rejected claim based on second category of adjustments, but sustained allegations based on the former theory given size of the restatement and plaintiffs' allegation that the "reallocation method" had been expressly prohibited for over a decade).

[15] The case settled during the pendency of the motion to dismiss the amended complaint.

[16] David E. Rovella, Securities Reform Spawns Discord, Natl. Law J. (July 18, 2001) (printed from http://www.law.com).

[17] This statement is taken from the Conference Committee report on the Reform Act as enacted, which is the definitive source for the statute's legislative history. H.R. Conf. Rep. No. 104‑369, 104th Cong., 1st Sess. 31, 43 (Nov. 28, 1995); see also 141 Cong. R. S17982 (Dec. 5. 1995) (Sen. Burns) ("Many times, securities class action suits are characterized by the 'sue them all and let the judge sort it out' mentality.

© David Priebe 2016