The opinion of the court was delivered by: SPATT
This action arises from a consolidated amended complaint (the "complaint") by the plaintiffs on behalf of all persons who purchased the common stock of Health Management, Inc. ("Health Management") from August 25, 1994 through February 26, 1996 (the "Class Period"), alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b), 78t(a) ("Section 10(b)" and "Section 20(a)", respectively), and Rule 10b-5 promulgated thereunder by the Securities and Exchange Commission, 15 C.F.R. 240.10b-5 ("Rule 10b-5"), against Health Management, certain of its officers and/or directors - specifically, Irwin Hirsh ("Hirsh"), Lloyd N. Myers ("Myers"), Clifford E. Hotte ("Hotte"), Drew W. Bergman ("Bergman"), and Virginia Belloise ("Belloise") (collectively, the "Individual Defendants"), and its outside auditor, BDO Seidman, LLP ("BDO").
By a Final Judgment and Order of Partial Dismissal of Action dated June 9, 1997, this action was dismissed as to Health Management. Presently before the Court are: (1) BDO's motion pursuant to Fed. R. Civ. P. 12(b)(6), to dismiss for failure to state a claim upon which relief can be granted; (2) Hotte's motion pursuant to Fed. R. Civ. P. 12(b)(6), to dismiss for failure to state a claim upon which relief can be granted; (3) Belloise's motion pursuant to Fed. R. Civ. P. 12(b)(6), to dismiss for failure to state a claim upon which relief can be granted; and (4) Hirsh and Myers' motion pursuant to Fed. R. Civ. P. 12(e) and 9(b), for a more definitive statement.
According to the eighty-nine page complaint, the defendant Health Management is engaged in the business of providing integrated health management services to individuals suffering from chronic medical conditions, and to various health care professionals, drug manufacturers, and third-party payers involved in the care of such patients. Health Management has purportedly grown rapidly since its shift in 1989 from the general home healthcare market to the specialized field of chronic disease management. The plaintiffs allege that converting increasing revenues and earnings to cash proved to be a daunting task for Health Management and as a result, prior to the commencement of the Class Period, Health Management began to experience increasing difficulty collecting payment for its enhanced services, which resulted in ballooning accounts receivable and days sales outstanding ("DSO"), the average number of days that a receivable remains outstanding prior to collection. Faced with these pressing concerns, Health Management embarked upon an aggressive acquisition strategy designed to improve Health Management's balance sheet by acquiring complimentary companies with lower DSO levels in order to generate cash flow. The plaintiffs allege that because Health Management lacked resources to acquire these businesses, it was forced to use its common stock to fund many of these acquisitions. Health Management soon recognized that its acquisition strategy would fail unless it was able to support the value of its stock.
The cast of characters in the alleged fraudulent scheme include the Individual Defendants and BDO, Health Management's outside auditor. Set forth in the complaint is each defendant's relationship to Health Management, which are as follows.
Hotte, the founder of Health Management in 1986, was the President and Chairman of the Board of Directors of Health Management. He was the second largest shareholder of Health Management. As of September 20, 1995, Hotte owned or controlled in excess of 1.1 million shares of Health Management common stock, which is approximately 11.4% of the outstanding common stock, including shares held in the name of his wife, co-defendant Belloise, and shares subject to exercisable options. Hotte is alleged to have signed: (1) Health Management's Form 10-Q for the first three quarters of Fiscal 1995; (2) the statement in the letter to shareholders dated December 18, 1994; (3) the statement contained in the 1995 Form 10-K; (4) the statement contained in Health Management's letter to shareholders dated August 5, 1995; and (5) Health Management's Form 10-Q for the first two quarters of Fiscal 1996.
Belloise was a member of Health Management's Board of Directors and also served as its Secretary from March 1988 to December 1993. Belloise is alleged to have signed the 1995 Form 10-K.
Bergman was Corporate Development Officer, Treasurer and Secretary of Health Management, as well as a member of Health Management's Board of Directors. From approximately June 1995 through December 21, 1995, Bergman served as Chief Financial Officer and Principal Accounting Officer of Health Management. As of September 20, 1995, Bergman owned or controlled 25,667 shares of Health Management common stock, including shares subject to exercisable options. Bergman is alleged to have signed: (1) Health Management's Form 10-Q for the first three quarters of Fiscal 1995; (2) the statement contained in the 1995 Form 10-K; and (3) Health Management's Form 10-Q for the first two quarters of Fiscal 1996.
Myers served as Vice President and principal of both Murray Pharmacy, Inc., and Murray Pharmacy Too, Inc. (collectively, the "Murray Group"). On or about April 1, 1994, Health Management acquired substantially all of the net assets of the Murray Group. By virtue of this transaction, and subsequent to July 24, 1995, Myers became Vice President for Sales and Marketing of Health Management. In addition, since March 1994, Myers served as Vice President for Program Development of Health Management's wholly owned subsidiary, HMI Pennsylvania. Further, as a result of the acquisition, by September 20, 1995, Myers owned or controlled over 3.3% of Health Management's outstanding common stock.
Hirsh served with Myers as principal of the Murray Group. After Health Management's acquisition of the Murray Group, Hirsh became Vice President for Purchasing and Managed Care Contracts of HMI Pennsylvania. In addition, by September 20, 1995, Hirsh exercised control or ownership of more than approximately 3.3% of Health Management's outstanding common stock.
The complaint alleges that the individual defendants engaged in the following culpable conduct:
Each of the defendants...reviewed or was aware of the materially false and misleading SEC filings, press releases, and other statements complained of herein at or about the time they were issued or circulated, knew or recklessly disregarded their materially false and misleading nature, and were in a position to control or influence their contents or otherwise cause corrective or accurate disclosures to have been made. Defendants engaged in the common course of conduct complained of herein from at least August 25, 1994 -- the day that the Company announced its earnings for the first quarter of Fiscal 1995 -- the purpose of which was to artificially inflate the market price of Health Management common stock, through the issuance of materially false and misleading statements to the public, all as particularized herein.
In addition, the complaint alleges that the individual defendants were "controlling" persons of Health Management within the meaning of Section 20(a) of the Securities Exchange Act of 1934, 15 U.S.C. § 78t(a),
by reason of their management positions in Health Management, their membership on the Company's Board, their extensive equity interest in the Company, and/or their direct and necessary participation in the fraudulent acts alleged herein. Because of their positions in the company, and/or their stock ownership, the Individual Defendants had the power and influence to Cause Health Management to engage in the unlawful acts and conduct alleged herein. The Individual Defendants participated in this wrongful conduct to inflate the price of the Company's common stock and to conceal the adverse facts concerning the Company's business and financial condition, so that they could (i) enhance the value of their extensive Health Management securities holdings; (ii) allow the Company to conclude various acquisitions by using the inflated value of its stock as merger consideration; and (iii) obtain financing on behalf of the Company to pursue various business acquisitions.
Finally, BDO is an accounting firm with its principal office located in New York, New York, and a regional office located in Mitchel Field, New York. Commencing as early as April 30, 1989, BDO served as Health Management's auditor. The plaintiffs allege that BDO issued an opinion included in Health Management's Form 10-K for Fiscal 1995, certifying that it had audited Health Management's financial statements in accordance with generally accepted auditing standards ("GAAS"). In addition, the plaintiffs allege that Bergman's wife was the Office Manager and Marketing Coordinator for BDO Seidman's Mitchel Field office.
C. The alleged fraudulent scheme
The complaint sets forth the plaintiffs' claims under the federal securities laws for materially false and misleading statements and omissions disseminated by the individual defendants during the Class Period. These alleged materially false and misleading statements caused the price of Health Management common stock to be artificially inflated during the Class Period, allowing Health Management to complete a number of business acquisitions and for the individual defendants to profit from the artificially inflated value of their personal holdings of Health Management common stock.
Specifically, the Individual Defendants are alleged to have performed the following acts, among others, to artificially inflate Health Management's financial reports:
1) the inclusion of severely delinquent, uncollectible and, in some cases, fictitious accounts receivables on Health Management's financial statements throughout the Class Period;
2) the inclusion of fictitious "in-transit" inventory on Health Management's balance sheet for its fiscal year ending April 30, 1995 ("Fiscal 1995"), thereby inflating Health Management's Fiscal 1995 earnings by decreasing its cost of goods sold during the applicable reporting period;
3) the inclusion of inventory on Health Management's balance sheet for the second fiscal quarter of the fiscal year ending April 30, 1996 ("Fiscal 1996"), for which invoices were received but not recorded as accrued payables until after the applicable reporting period, which inflated Health Management's earning's by decreasing its cost of goods sold during the applicable reporting period; and
4) the inclusion of cash received after the end of Fiscal 1995 and the first two quarters of Fiscal 1996, as if these sums had been received during the applicable reporting periods, thereby artificially inflating Health Management's cash balances and artificially decreasing levels of DSO.
The alleged fraudulent scheme, according to the complaint, continued through the first two quarters of Fiscal 1996, during which time the net income was overstated by more than 116%. The investment community reacted positively to these optimistic financial results. However, the alleged fraudulent scheme began to unravel on February 23, 1996 when Health Management announced that it had "discovered certain accounting irregularities" and that a restatement was possible. By March 1996, BDO withdrew its opinion of Health Management's financial results for Fiscal 1995. Consequently, Health Management restated its results for each quarter of Fiscal 1995 and the first two quarters of Fiscal 1996.
A. Fed. R. Civ. P. 12(b)(6) standard
On a motion to dismiss for failure to state a claim, "the court should not dismiss the complaint pursuant to Rule 12(b)(6) unless it appears 'beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief'". Goldman v. Belden, 754 F.2d 1059, 1065 (2d Cir. 1985)(quoting Conley v. Gibson, 355 U.S. 41, 45-46, 2 L. Ed. 2d 80, 78 S. Ct. 99 (1957)); see also IUE AFL-CIO Pension Fund v. Herrmann, 9 F.3d 1049, 1052-53 (2d Cir. 1993), cert. denied, 513 U.S. 822, 115 S. Ct. 86, 130 L. Ed. 2d 38 (1994). The Second Circuit stated that in deciding a Rule 12(b)(6) motion, a court may consider "only the facts alleged in the pleadings, documents attached as exhibits or incorporated by reference in the pleadings and matters of which judicial notice may be taken." Samuels v. Air Transport Local 504, 992 F.2d 12, 15 (2d Cir. 1993); see also Paulemon v. Tobin, 30 F.3d 307, 308-09 (2d Cir. 1994); Rent Stabilization Ass'n of the City of New York v. Dinkins, 5 F.3d 591, 593-94 (2d Cir. 1993) (citing Samuels, 992 F.2d at 15).
It is not the Court's function to weigh the evidence that might be presented at a trial; the Court must merely determine whether the complaint itself is legally sufficient, see Goldman, 754 F.2d at 1067, and in doing so, it is well settled that the Court must accept the allegations of the complaint as true, see Leeds v. Meltz, 85 F.3d 51 (2d Cir. 1996); LaBounty v. Adler, 933 F.2d 121, 123 (2d Cir. 1991); Procter & Gamble Co. v. Big Apple Indus. Bldgs, Inc., 879 F.2d 10, 14 (2d Cir. 1989), cert. denied, 493 U.S. 1022, 110 S. Ct. 723, 107 L. Ed. 2d 743 (1990), and construe all reasonable inferences in favor of the plaintiff. See Scheuer v. Rhodes, 416 U.S. 232, 236, 94 S. Ct. 1683, 40 L. Ed. 2d 90 (1974); Leeds, supra, 85 F.3d at 51; Bankers Trust Co. v. Rhoades, 859 F.2d 1096, 1099 (2d Cir. 1988), cert. denied, 490 U.S. 1007, 109 S. Ct. 1642, 104 L. Ed. 2d 158 (1989).
The Court is mindful that under the modern rules of pleading, a plaintiff need only provide "a short and plain statement of the claim showing that the pleader is entitled to relief", Fed. R. Civ. P. 8(a)(2), and that "all pleadings shall be so construed as to do substantial justice," Fed. R. Civ. P. 8(f).
The issue before the Court on a Rule 12(b)(6) motion "is not whether a plaintiff will ultimately prevail, but whether the claimant is entitled to offer evidence to support the claim." Villager Pond, Inc. v. Town of Darien, 56 F.3d 375, 378 (2d Cir. 1995) (citing Scheuer, supra, 416 U.S. at 235-36). Recovery may appear remote and unlikely on the face of the pleading, but that is not the test for dismissal under Rule 12(b)(6). Gant v. Wallingford Bd. of Educ., 69 F.3d 669, 673 (2d Cir. 1995) (citing Scheuer, supra, 416 U.S. at 236).
It is within this framework that the Court addresses the present motions to dismiss.
B. Pleading scienter pursuant to the Private Securities Litigation Reform Act