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IN RE APPLIED CAPITAL CORPORATION SECURITIES LITIGATION

April 21, 2003

IN RE ALLIED CAPITAL CORPORATION SECURITIES LITIGATION.


The opinion of the court was delivered by: Gerard E. Lynch, United States District Judge

OPINION AND ORDER

This securities class action was brought by persons who purchased common stock of Allied Capital Corporation ("Allied") between November 14, 2001, and May 16, 2002 (the "Class Period"), against Allied and two members of its senior management. The Consolidated Amended Class Action Complaint ("Complaint" or "Compl.") alleges that defendants violated section 10(b) of the Securities and Exchange Act of 1934 ("Exchange Act") and Rule 10b-5 promulgated thereunder, and section 20(a) of the Exchange Act. Defendants move to dismiss pursuant to Rules 12(b)(6) and 9(b) of the Federal Rules of Civil Procedure and the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u-4(b) ("PSLRA"). For the reasons stated below, the motion is granted.

BACKGROUND

Allied is a Business Development Company ("BDC") that invests in roughly 130 public and private companies through debt, equity, and mezzanine financial instruments. (Defs. Mem. at 1.) During the Class Period, defendant William Walton served as its Chief Executive Officer and defendant Penni Roll was its Chief Financial Officer. (Compl. ¶ 3.) Allied in turn issues securities to the public, which trade at prices determined in the marketplace by buyers and sellers of the stock, just as with any other publicly traded company. (Defs. Mem. at 1.)

As an investment company, Allied is regulated by the Investment Company Act of 1940, 15 U.S.C. § 80a-1 et seq., which requires it to disclose the identity cost basis, and updated carrying value of its investments in its quarterly filings with the SEC. (Pl. Mem. at 2; Defs. Mem. at 1.) The Act provides that BDCs must value their investments at market value, if market quotations are available, and if no market for the securities exists, at "fair value as determined in good faith by the board of directors." 15 U.S.C. § 80a-2(a)(41)(A). Since many of Allied's investments are composed of illiquid securities for which no market exists, and which Allied does not intend to trade in the near future, it must use the "fair value" method of valuation with many of its holdings.

There is no one authoritative method of determining fair value, since valuing securities for which no current market exists involves the exercise of judgment. and is inherently imprecise. The SEC has provided some guidance to BDCs, in the form of Accounting Series Release 118 ("ASR 118"), which explicates the SEC's interpretation of the Act's fair value requirement: "No single standard for determining `fair value' . . . can be laid down, since fair value depends upon the circumstances of each individual case. As a general principle, the fair value of restricted securities [is] the amount which the owner might reasonably expect to receive for them upon their current sale." SEC Release No. AS-118, 1970 WL 5621, at *4 (Dec. 30, 1970). Allied values its illiquid securities pursuant to written valuation policies tailored to the type of security at issue, which it discloses each quarter in its Form 10-Q, and again in its annual Form 10-K. (See, e.g., Davies Decl. Ex. 2 at 22.) Allied also describes its overall policy in general terms in each filing:

The Company's investments are generally subject to restrictions on resale and generally have no established trading market. The Company values its securities at fair value as determined in good faith by the Company's Board of Directors in accordance with the Company's valuation policy. The Company determines fair value to be the amount for which the investment could be exchanged in an orderly disposition over a reasonable period of time between willing parties other than in a forced or liquidation sale. . . . The Company's valuation policy considers the fact that privately negotiated securities increase in value over a long period of time, that the Company does not intend to trade the securities, and that no ready market exists.
(Davies Decl. Ex. 1 at 8-9.) Allied goes on to briefly describe its valuation policy with respect to different types of securities; for instance, "[e]quity interests in portfolio companies for which there is no liquid public market are valued based on various factors, including cash flow from operations and other pertinent factors such as recent offers to purchase a portfolio company's securities or other liquidation events. The determined values are generally discounted to account for liquidity issues and minority control positions." (Id. Ex. 2 at 22-23.)

Plaintiffs contend that Allied's stated valuation policy contravenes ASR 118 and generally accepted accounting principles ("GAAP"),*fn1 because it fails adequately to account for changes in companies' circumstances and market conditions that can affect the value of their debt or equity, and consequently does not value investments at their current sale value. (Compl. ¶¶ 52-56.) Plaintiffs allege that Allied's flawed valuation policy caused it to over-value its investments in nine companies, and to materially misstate these values on its Third Quarter 2001 Form 10-Q (id. ¶ 27), its 2001 Annual Report (Form 10-K) (id. ¶ 30), its April 2002 Prospectus and Prospectus Supplement (id. ¶¶ 37-38), and its First Quarter 2002 Form 10-Q (id. ¶ 40). All of these filings were signed by either Walton or Roll. (Compl. ¶¶ 15-16.) According to plaintiffs, the values that Allied assigned to its investments in the nine companies were "unrealistically and misleadingly high." (Id. ¶ 41(a).) For instance. Allied valued its investment in BLX at five times net worth (id ¶ 41(b)(1)); it valued its investment in NETtel at 40% of cost, even though NETtel had filed for bankruptcy (id. ¶ 41(b)(3)); and it continued to place value on debt securities held in Schwinn, even though Schwinn had filed for bankruptcy (id. ¶ 41(b)(5)).

On May 16, 2002, the last day of the Class Period, David Einhorn, a hedge fund manager, publicly questioned Allied's accounting practices, stating that Allied was carrying its investment in Velocita, Inc., at par value, even though Cisco Systems had recently devalued its position in Velocita; and that Allied should have written down its investment in The Loewen Group more substantially than it had, since Loewen's stock had recently been delisted from the OTC Bulletin Board. (Id. ¶ 5.) On that day, Allied's stock price fell from $25.99 to $23.20. (Id.) The share price recovered quickly, however, increasing to $24.00 on May 17, and rebounding to $25.30 by June 10, even as the market as a whole was declining. (Defs. Mem. at 19 n. 20; The New York Times, Company Research: Allied Cap Corp. New, available at http://marketwatch.nytimescom (April 14, 2003).)

On May 17, 2002, plaintiffs filed the first of these consolidated actions, alleging that defendants made materially misleading statements in their financial filings, and are therefore liable for primary violations of § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, as well as control person violations of § 20(a) of the Exchange Act.

DISCUSSION

On a motion to dismiss under Fed.R.Civ.P. 12(b)(6), the Court must accept "as true the facts alleged in the complaint," Jackson Nat'l Life Ins. Co. v. Merrill Lynch & Co., Inc., 32 F.3d 697, 699-700 (2d Cir. 1994), and may grant the motion only if "it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Thomas v. City of New York, 143 F.3d 31, 36 (2d Cir. 1998) (citations omitted); see also Bernheim v. Litt, 79 F.3d 318, 321 (2d Cir. 1996) (stating that when adjudicating motion to dismiss under Fed.R.Civ.P. 12(b)(6), the "issue is not whether a plaintiff will ultimately prevail but whether the claimant is entitled to offer evidence to support the claims" (internal quotation marks and citations omitted)). When deciding such a motion, the Court may consider documents attached to the complaint as exhibits or incorporated in it by reference. Brass v. American Film Techs., Inc., 987 F.2d 142, 150 (2d Cir. 1993). In addition to facts alleged in the complaint, the Court may take judicial notice of public disclosure documents filed with the SEC. Kramer v. Time Warner Inc., 937 F.2d 767, 774 (2d Cir. 1991), as well as "well-publicized stock prices," Ganino v. Citizens Utils. Co., 228 F.3d 154, 167 n. 8 (2d Cir. 2000). All reasonable inferences are to be drawn in the plaintiffs' favor, which often makes it "difficult to resolve [certain questions] as a matter of law." In re Independent Energy Holdings PLC, 154 F. Supp.2d 741, 748 (S.D.N.Y. 2001).

I. Section 10(b) ...


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