United States District Court, S.D. New York
May 19, 2004.
IN RE PHILIP SERVICES CORP. SECURITIES LITIGATION; THIS DOCUMENT RELATES TO: ALL ACTIONS
The opinion of the court was delivered by: MICHAEL MUKASEY, Chief Judge, District
OPINION AND ORDER
This opinion and order treats two motions to dismiss a consolidated
class action. The action arises out of an announcement of losses and
restatement of earnings by Philip Services Corporation ("Philip"), a
Canadian metal processing company.
Plaintiffs represent an uncertified class of investors who purchased
Philip stock or call options during the proposed class period, or
former shareholders of companies whose stock was exchanged for Philip
stock. The gravamen of their complaint is that Philip perpetrated a
massive fraud upon its shareholders by making various fraudulent
misrepresentations concerning the income and value of the company during
a three-year period between 1995 and 1998. Plaintiffs have sued, among
others, Philip's outside auditor Deloitte & Touche LLP ("Deloitte"),
alleging violations of Section 10(b) of the Securities Exchange Act of
1934 (the "Exchange Act"), 15 U.S.C. § 78j(b) (2000), and Rule 10b-5
promulgated thereunder, and Section 11 of the Securities Act of 1933 (the
"Securities Act"), 15 U.S.C. § 77k (2000); and Philip directors William
Haynes and Robert Knauss, alleging violations of Section 20(a) of the
Exchange Act, 15 U.S.C. § 78t(a) (2000), Section 11 of the Securities
Act, and Section 15 of the Securities Act, 15 U.S.C. § 77o (2000).
All of the defendants named in the action previously moved to dismiss
on forum non conveniens grounds. In addition, Deloitte, Haynes and Knauss moved to dismiss the claims asserted against
them under Fed.R.Civ.P. 12(b)(6) for failure to state a claim. By
previous order, I dismissed the action on forum non conveniens grounds.
See In re Philip Servs. Corp. Sec. Litig., 49 F. Supp.2d 629 (S.D.N.Y.
1999). On appeal, the Court of Appeals reversed and remanded for
consideration of the motions to dismiss for failure to state a claim.
This opinion resolves those motions.
For the reasons set forth below, the motions to dismiss are denied as
to all claims, except that Haynes' and Knauss' motion to dismiss the
Section 20(a) claim is granted in part.
Many of the facts underlying this action are set forth in prior
opinions issued by the Second Circuit and this court. See DiRienzo v.
Philip Servs. Corp., 294 F.3d 21 (2d Cir. 2002); DiRienzo v. Philip
Servs. Corp., 232 F.3d 49 (2d Cir. 2000); In re Philip Servs. Corp. Sec.
Litig., 49 F. Supp.2d 629 (S.D.N.Y. 1999). Familiarity with those
opinions is assumed for current purposes, and what follows are only those
facts relevant to the motions presently under consideration.*fn1 The
facts are either undisputed or presented in the light most favorable to
plaintiffs. Between 1992 and 1997, Philip sought to expand its revenue base, range
of services and network of facilities throughout North America. To the
extent relevant here, Philip's expansion effort assumed two forms.
First, in July 1997, Philip acquired two companies Allwaste, Inc.
("Allwaste") and Serv-Tech, Inc. ("Serv-Tech") in stock-for-stock deals
worth approximately $560 million. Second, in November 1997, Philip placed
secondary stock offerings in the U.S. and Canada (the "November 1997
public offerings"), raising from investors approximately $380 million.
On January 26, 1998, Philip announced it would take charges to earnings
for fiscal year 1997 of between $250 and $275 million. Over the next
several months, this figure was increased to over $381 million. In
addition, Philip restated its financial statements for fiscal years 1995,
1996, and 1997. The restatements showed that Philip had overstated its
1995 earnings by $22.5 million and its 1996 earnings by $48.3 million.
After these announcements, Philip's share price dropped from $13 1/8 on
January 16, 1998 to $2 9/16 in July 1998, a loss of approximately 80
Philip's announcements and the drop in its share price loosed a torrent
of litigation in the United States and Canada. In the United States, more
than 20 class action lawsuits were commenced in various jurisdictions.
The Judicial Panel on Multi-District Litigation transferred the cases to this court for coordinated pre-trial
proceedings.*fn2 Plaintiffs filed a 157-page, 453-paragraph Consolidated
and Amended Class Action Complaint ("Complaint"), alleging numerous
fraudulent misrepresentations regarding Philip's financial condition and
financial results. The Complaint names as defendants, among others,
Deloitte, Haynes and Knauss.
Claims Against Deloitte
Deloitte is a member of Deloitte Touche Tohmatsu, a federation of
affiliated accountants headquartered in New York City. Deloitte served as
Philip's outside auditor beginning in 1990 and for the entirety of the
proposed class period. (Compl. ¶¶ 83, 282) It staffed and performed the
audit of Philip's financial statements from its Mississauga, Ontario,
Canada office. (Id. ¶ 284) According to the Complaint, the Philip audit
engagement was "one of the largest accounts (if not the largest account)
handled by the Mississauga office of Deloitte." (Id. ¶ 291)
Deloitte issued unqualified or "clean" audit opinions on Philip's
financial statements for fiscal years 1995 and 1996. (Id. ¶ 286) In both
opinions, Deloitte stated that it had conducted the audit "in accordance
with auditing standards generally accepted in Canada" and that, in Deloitte's opinion, the
financial statements "present fairly, in all material respects, the
financial position of the Company" as at year-end, "in accordance with
accounting principles generally accepted in Canada." (Id. ¶¶ 287, 288;
1995 Philip Annual Report, Serio Decl. Ex. A ("1995 Report"), at 36; 1996
Philip Annual Report, Serio Decl. Ex. B ("1996 Report"), at 38) Philip
included the audit opinions in its Form 40-Fs annual reports that
certain Canadian issuers file with the Securities and Exchange Commission
("SEC") pursuant to Section 13(b) or 15(d) of the Exchange Act of 1934
for fiscal years 1995 and 1996. (Compl. ¶¶ 100, 287, 288; 1995 Report at
36; 1996 Report at 38) Moreover, Deloitte agreed to the inclusion of its
1996 audit opinion in the registration statements accompanying the
Allwaste and Serv-Tech mergers and the November 1997 public offerings.*fn3
(Id. ¶¶ 125, 286, 386, 411, 433) In connection with the November
1997-registration statement, Deloitte updated its 1996 audit opinion to
reflect Philip's compliance, in all material respects, with accounting
principles generally accepted in the United States, and confirmed this information as of a week before the November 1997 public offerings.
(Id. ¶ 289)
The Complaint alleges that the 1995 and 1996 audit opinions were false
and misleading because, contrary to its representations, Deloitte
knowingly or recklessly failed to disclose Philip's multiple violations
of U.S. and Canadian Generally Accepted Accounting Principles ("GAAP")
and, in preparing the audit opinions, failed to comply with U.S. and
Canadian Generally Accepted Accounting Standards ("GAAS").*fn4 (Id. ¶¶
4, 167, 230, 270-336) The Complaint asserts claims against Deloitte
pursuant to Section 10(b) of the Exchange Act, and Rule 10b-5 promulgated
thereunder, and Section 11 of the Securities Act of 1933.
Claims Against Haynes and Knauss
Haynes and Knauss were directors of Allwaste before its acquisition by
Philip in July 1997, and were appointed directors of Philip on August 6,
1997. (Id. ¶¶ 60, 61) Knauss was appointed Chairman of Philip's Board on
May 6, 1998. (Id. ¶ 60) The Complaint alleges that Haynes and Knauss
attended a board of directors meeting at which the participants discussed Philip's improperly
recorded earnings for the third quarter of 1997, and then signed the
November 1997 registration statement, which made no disclosure that the
earnings therein reported were fraudulent. (Id. ¶¶ 60-61, 236-238) The
Complaint asserts claims against Haynes and Knauss pursuant to Section
20(a) of the Exchange Act and Sections 11 and 15 of the Securities Act.
For purposes of a motion to dismiss, the court must accept as true all
allegations in the complaint and draw all reasonable inferences in the
plaintiffs' favor. Press v. Chem. Inv. Servs. Corp., 166 F.3d 529, 534 (2d
Cir. 1999). Also, for purposes of a Rule 12(b)(6) motion in a securities
case, a complaint is deemed to include any statements or documents
incorporated in it by reference, as well as publicly disclosed documents
required by law to be, and that actually have been, filed with the SEC,
and documents the plaintiffs either possessed or knew about and upon
which they relied in bringing suit. Rothman v. Gregor, 220 F.3d 81, 88
(2d Cir. 2000) (citations omitted). III.
As described above, the Complaint alleges multiple claims against
Deloitte, Haynes and Knauss under various provisions of the federal
securities laws. Each claim will be addressed in turn.
A. Section 10(b) of the Exchange Act
The first claim in the Complaint alleges that Deloitte committed
securities fraud in violation of Section 10(b) and Rule 10b-5 promulgated
thereunder. Section 10(b) makes it unlawful "[t]o use or employ, in
connection with the purchase or sale of any security . . ., any
manipulative or deceptive device or contrivance in contravention of such
rules and regulations as the Commission may prescribe as necessary or
appropriate in the public interest or for the protection of investors."
15 U.S.C. § 78j(b). Rule 10b-5 lists the following among the acts
proscribed by Section 10(b): "To make any untrue statement of a material
fact or to omit to state a material fact necessary in order to make the
statements made, in the light of the circumstances under which they were
made, not misleading." 17 C.F.R. § 240.10b-5(b). The Second Circuit has
held that to state a claim under Section 10(b) and Rule 10b-5, a
plaintiff must allege that the defendant: "(1) made misstatements or
omissions of material fact; (2) with scienter; (3) in connection with the
purchase or sale of securities; (4) upon which plaintiffs relied; and (5) that plaintiffs'
reliance was the proximate cause of their injury." In re IBM Corp. Sec.
Litig., 163 F.3d 102, 106 (2d Cir. 1998) (citations omitted).
Deloitte moves to dismiss the Section 10(b) claim on the grounds that
the Complaint (1) fails sufficiently to allege scienter; and (2) fails to
allege fraud with sufficient particularity.
1. Pleading Scienter
In order to state a Section 10(b) claim, a plaintiff must allege that
defendants acted with scienter, i.e., fraudulent intent. See Ernst &
Ernst v. Hochfelder, 425 U.S. 185, 193 (1976) (finding that the Exchange
Act "clearly connotes intentional misconduct" and thus a plaintiff must
plead scienter). The Private Securities Litigation Reform Act of 1995
("PSLRA") codified the scienter requirement and established a pleading
standard. Pursuant to that statute, a complaint alleging a Section 10(b)
claim must "state with particularity facts giving rise to a strong
inference that the defendant acted with the required state of mind."
15 U.S.C. § 78u-4(b)(2).
Even before passage of the PSLRA, the Second Circuit interpreted Fed.
R. Civ. P. 9(b), which governs fraud claims generally, to require
securities fraud plaintiffs to allege facts giving rise to "a strong inference of fraudulent intent." See, e.g.,
Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1127-28 (2d Cir.
1994). See also Sec. & Exch. Comm'n v. KPMG LLP, 03 Civ. 671 (DLC), 2003
U.S. Dist. LEXIS 14521, at *10-11 (S.D.N.Y. Aug. 22, 2003) (noting that
securities fraud plaintiffs have "long been required to state with
particularity `facts that give rise to a strong inference of fraudulent
intent.'") (quoting Acito v. IMCERA Group, Inc., 47 F.3d 47, 52 (2d Cir.
1995.)). Accordingly, the Second Circuit has ruled that the PSLRA
heightened the nationwide pleading standard to the level already used by
the Second Circuit. See Levitt v. Bear Stearns & Co., 340 F.3d 94, 104
(2d Cir. 2003); Kalnit v. Eichler, 264 F.3d 131, 138 (2d Cir. 2001).
Because the PSLRA effectively codified the existing Second Circuit
pleading standard for scienter, I may look to the Circuit's pre-PSLRA body
of case law to determine whether plaintiffs sufficiently allege scienter
in this case. See Novak v. Kasaks, 216 F.3d 300, 311 (2d Cir. 2000)
("[W]e hold that the PSLRA adopted our "strong inference' standard. . . .
Therefore, in applying this standard, district courts should look to
the cases and factors . . ." already established by the Circuit.); Hart
v. Internet Wire, Inc., 145 F. Supp.2d 360, 366 (S.D.N.Y. 2001) (noting
that "we may apply the standards for scienter that have been developed in
this Circuit" in weighing sufficiency of scienter allegations). In the Second Circuit, a plaintiff can generate the requisite "`strong
inference" of scienter by alleging either of two categories of fact: (1)
facts showing that defendants had motive and opportunity to commit
fraud; or (b) facts constituting strong circumstantial evidence of
conscious misbehavior or recklessness. See Chill v. Gen. Elec. Co.,
101 F.3d 263, 267 (2d Cir. 1996) (citations omitted). Either will
suffice. Stevelman v. Alias Research, Inc., 174 F.3d 79, 84 (2d Cir.
1999) (citation omitted).
a. Motive and opportunity
Motive is properly alleged by stating "concrete benefits that could be
realized by one or more of the false statements'" identified in the
complaint. Shields, 25 F.3d at 1130. Here, the Complaint can be read as
alleging two possible motives for Deloitte to commit fraud: (1)
Deloitte's desire to receive auditing fees from Philip; and (2) the
possibility that certain Deloitte employees would obtain employment with
Philip. Neither of these motives, as pleaded, is sufficient to suggest
Plaintiffs' first theory of motive is that Deloitte made fraudulent
misstatements in its 1995 and 1996 audit opinions because it received
substantial compensation from serving as Philip's auditor and wished to
maintain this profitable relationship. (Plaintiffs' Memorandum of Law in
Opposition to Deloitte's Motion to Dismiss ("Pls.' Mem. in Opp'n to Deloitte's Mot. to
Dismiss") at 23-26; Plaintiffs' Supplemental Memorandum of Law in
Opposition to Deloitte's Motion to Dismiss ("Pls.' Supp. Mem. in Opp'n to
Deloitte's Mot. to Dismiss") at 12-13). However, a generalized economic
interest in professional fees is insufficient to establish an accounting
firm's motive to commit fraud. See id. at 1130; ICD Hldgs. S.A. v.
Frankel, 976 F. Supp. 234, 245 n.51 (S.D.N.Y. 1997) (citing cases).
Notwithstanding the financial importance of the Philip account to
Deloitte's Mississauga office, it strains reason that Deloitte would
jeopardize its reputation, subject itself to civil and/or criminal
liability, and risk substantial financial penalties simply because it
wanted to keep Philip as a client. See In re Health Mgmt., Inc. Sec.
Litig., 970 F. Supp. 192, 202 (E.D.N.Y. 1997) (it was not in auditor's
economic self-interest to willingly condone fraud to preserve a fee
that, though large account in field office, was "minute" relative to all
of auditor's accounts); Duncan v. Pencer, 94 Civ. 0321 (LAP), 1996 U.S.
Dist. LEXIS 401, at *32-33 (S.D.N.Y. Jan. 18, 1996) (finding
"economically irrational" the claim that a large accounting firm "would
condone a client's fraud in order to preserve a fee that, at best, is an
infinitesimal percentage of its annual revenues and, by doing so,
jeopardize its reputation and license, as well as subject itself to
potential damages literally tens of thousands of times as large as its fee"). Absent specific facts
warranting a departure from the assumption that Deloitte was acting in
its economic self-interest, I decline to infer fraudulent intent merely
from its desire to keep a client.
Plaintiffs argue that, even if Deloitte's interest in earning future
revenues from Philip were an insufficient motive, its interest in
collecting approximately $1 million in outstanding fees from Philip at
the time the November 1997 registration statement was issued is "entirely
another" kind of motivation. (Pls.' Mem. in Opp'n to Deloitte's Mot. to
Dismiss at 26) But collecting past fees as opposed to maximizing future
revenues does not present a meaningful distinction in the scienter
analysis. Plaintiffs cite no authority making that distinction, nor can I
think of any reason why Deloitte would be more inclined to commit fraud
to collect past fees than it would to collect future fees. In short, the
desire to collect fees, whether prospective or past, can be attributed to
practically every professional services firm, and "[s]uch generalized
desires do not establish scienter." Kalnit, 264 F.3d at 141 (citing San
Leandro Emergency Med. Group Profit Sharing Plan v. Philip Morris Cos.,
Inc., 75 F.3d 801, 814 (2d Cir. 1996)).
Plaintiffs next contend that Deloitte's individual employees might be
found to have had the requisite motive even if the firm did not: "[W]hile
as a matter of organizational behavior theory Deloitte might not want to jeopardize its so-called `priceless
reputation' for a fee, at the individual level, an inference has been
created that the temptation was too great for the individual auditor to
place Deloitte's informed economic self-interest above his or her own."
(Pls.' Mem. in Opp'n to Deloitte's Mot. to Dismiss at 24 n.11) However,
an auditor's participation in a client's fraud is perhaps even more
economically irrational at the individual level because of the asymmetry
of risks involved: the individual auditor shares relatively little of the
financial gain from the fraud, but he subjects himself to substantial
professional and financial risk. See Dileo v. Ernst & Young, 901 F.2d 624,
629 (7th Cir. 1990) ("[C]overing up fraud and imposing large damages on
the partnership will bring a halt to the most promising career. [The
auditor's] partners shared none of the gain from any fraud and were
exposed to a large fraction of the loss. It would have been irrational
for any of them to have joined cause with [the client].").
Plaintiffs' second theory of motive is that Deloitte issued fraudulent
audit opinions because, in exchange for doing so, some of its employees
were offered and accepted higher-paying jobs from Philip. (Pls.' Mem. in
Opp'n to Deloitte's Mot. to Dismiss at 26; Pls.' Supp. Mem. in Opp'n to
Deloitte's Mot. to Dismiss at 12) Even presuming an individual auditor's
interest in future employment with a client by itself is enough to establish
motive, this allegation fails because the Complaint fails to state with
any reasonable specificity when Philip made the alleged job offers to
Deloitte's employees. Notably, Deloitte was the outside auditor for
Philip since 1990 (Compl. ¶ 83), but its 1995 and 1996 audit opinions
are the only ones at issue in the present litigation. The Complaint
alleges merely that Deloitte employees received job offers "during the
audits of Philip," (Id. ¶ 336) (emphasis in original) but does not
specify which, if any, of the disputed audits in the present action were
involved, or what the role was of particular employees in such audits.
Such vague allegations cannot establish that receipt of concrete benefits
(the individual auditors' employment with Philip) was linked to alleged
false statements (the misstatements in the 1995 and 1996 audit
opinions). Accordingly, such allegations cannot support an inference of
b. Circumstantial evidence of conscious misbehavior or recklessness
Although the Complaint fails sufficiently to allege Deloitte's motive
to commit fraud, I must consider whether it alleges strong circumstantial
evidence of conscious misbehavior or recklessness. Where, as here,
plaintiffs fail sufficiently to allege a fraudulent motive, "it is still
possible to plead scienter by identifying circumstances indicating
conscious misbehavior by the defendant, though the strength of the circumstantial allegations must be correspondingly greater." Kalnit, 264
F.3d at 142 (internal quotation marks and citation omitted). Assuming the
truth of the allegations, and granting plaintiffs all reasonable
inferences, the Complaint sufficiently alleges Deloitte's fraudulent
intent under both the conscious misbehavior and recklessness prongs.
(i) Conscious misbehavior
Conscious misbehavior "is easily identified since it encompasses
deliberate illegal behavior." Novak, 216 F.3d at 308. The Complaint
alleges at least three specific instances of Deloitte's conscious
(1) In 1996, Philip incurred approximately $8 million
in losses as a result of its acquisition of the
Petrochem S.C. facility in Rockville, South
Carolina. While conducting the 1996 audit, Noel
Woodsford, the Deloitte audit partner, advised
Marvin Boughton, Philip's Executive
Vice-President and Chief Financial Officer, and
John Woodcroft, Philip's Vice President of
Operations, that if Philip characterized the
losses as "training expenses," they could be
capitalized under GAAP. Boughton and Woodcroft
agreed to this suggestion and Woodsford agreed to
sign off on the audit. Deloitte was aware that
the Petrochem losses were actual losses, and that
Philip had not undertaken any training activities
at the Petrochem facility. Deloitte did not have
any documentation supporting the characterization
of the Petrochem losses as training expenses.
(Compl. ¶¶ 227-230, 306-310)
(2) In late January or early February 1997, Ronald
McNeill, Deloitte's Group Managing Partner,
expressed concern about certain "corporate
adjustments" made by Philip's accounting office.
According to the Complaint, Boughton and
Woodcroft would instruct Philip's accounting
office to manipulate the financial statements of
certain Philip subsidiaries, e.g., by deleting recorded
liabilities, such that the company's consolidated
results would meet Wall Street analysts'
expectations. McNeill informed certain Philip
officers that "just because they tell you make an
entry does not mean you have to make it." (Id. ¶¶
(3) While conducting the 1996 audit, Deloitte became
aware of Philip's practice of recording the
revenue of companies it was in the process of
acquiring as of the date Philip agreed to the
acquisition rather than the closing date. Under
U.S. GAAP, the revenues and earnings of acquired
companies cannot be consolidated until the date
of closing. Nonetheless, Philip's financial
statements represented that they were in material
compliance with U.S. GAAP. Although Deloitte knew
that Philip's method of revenue recognition
violated U.S. GAAP, and advised Boughton and
Woodcroft that Philip should discontinue the
practice, it did not require the company to
correct previous entries on its financial
statements. (Id. ¶¶ 316-317)
The Complaint alleges that Deloitte, notwithstanding its awareness of
these instances of accounting fraud, issued an unqualified opinion on
Philip's 1996 financial statements. (Id. ¶ 318)
These allegations show that Deloitte not only had knowledge of, but
actively facilitated, Philip's accounting fraud.*fn5 Such express
allegations of deliberate misconduct easily satisfy the standard for pleading scienter. See Suez Equity Investors,
L.P. v. Toronto-Dominion Bank, 250 F.3d 87, 100 (2d Cir. 2001); Hudson
Venture Partners, L.P. v. Patriot Aviation Group, Inc., 98 Civ. 4132
(DLC), 1999 U.S. Dist. LEXIS 1518, at *10-11 (S.D.N.Y. Feb. 16, 1997).
Deloitte argues that the above allegations omit critical facts
necessary to create a strong inference of scienter. (Deloitte's
Memorandum of Law in Support of its Motion to Dismiss ("Deloitte's Mem.")
at 34-35; Deloitte's Reply Memorandum in Further Support of its Motion to
Dismiss ("Deloitte's Reply Mem.") at 34-36; Deloitte's Supplemental
Memorandum of Law in Support of its Motion to Dismiss ("Deloitte's Supp.
Mem.") at 5-6) To the contrary, the allegations specify instances of
accounting fraud at Philip of which Deloitte became aware, when Deloitte
learned of those practices, which persons at Deloitte became aware of
them (excepting the allegation of premature revenue recognition), and how
Deloitte participated in the fraud. The scienter allegations are not as precise or descriptively exhaustive as might satisfy
Deloitte, and may be dismissed at a later stage in the proceedings, but
they are not so vague and conclusory as to justify dismissal at the
pleading stage. See Ganino v. Citizens Utils. Co., 228 F.3d 154, 169 (2d
Cir. 2000) (noting that although "speculation and conclusory allegations
will not suffice, . . . `great specificity'" is not required "provided
the plaintiff alleges enough facts to support a "strong inference of
fraudulent intent.'") (quoting Stevelman, 174 F.3d at 84); Cohen v.
Koenig, 25 F.3d 1168, 1173 (2d Cir. 1994) (holding that "`great
specificity [is] not required with respect to . . . allegations of . . .
scienter' . . . because `a plaintiff realistically cannot be expected to
plead a defendant's actual state of mind'") (quoting Conn. Nat'l Bank v.
Fluor Corp., 808 F.2d 957, 962 (2d Cir. 1987)).
The scienter allegations here go well beyond those that Second Circuit
courts have dismissed for lack of particularity. See, e.g., Shields, 25
F.3d at 1129 (allegations "that Defendants "knew but concealed' some
things, or "knew or were reckless in not knowing' other things" were "so
broad and conclusory as to be meaningless") (citation omitted); Vogel v.
Sands Bros. & Co., 126 F. Supp.2d 730, 741 (S.D.N.Y. 2001)
("[C]onclusory and speculative allegations stating that [defendant] must
have known of the violations due to its role as . . . investment banker" were insufficient to allege scienter); Zucker v. Sasaki, 963 F. Supp. 301,
309 (S.D.N.Y. 1997) (dismissing securities fraud claim where scienter
allegations were premised "solely on [the defendant's] status as an
auditor"; plaintiff "profer[red] no specific facts as to how or when [the
auditor] learned of or recklessly disregarded [its client's] problems and
the negative consequences that would ensue from the acquisition [,]. . .
never state [d] what alleged information was revealed to [the auditor],"
in what form the information was provided, at what point [the auditor]
became aware of it, and from whom [the auditor] received this
information"). Cf. In re Complete Mgmt. Inc. Sec. Litig.,
153 F. Supp.2d 314, 334-35 (S.D.N.Y. 2001) (rejecting defendant auditor's
argument that "the complaint fails to allege how it is that [the auditor]
would have been aware" of allegedly illicit practices at client's largest
account; "[s]uch specificity is more than Rule 9(b) and the PSLRA demand
at this stage in the litigation") (emphasis in original); In re Health
Mgmt., 970 F. Supp. at 204 (rejecting defendant's objections that
"plaintiffs do not allege that [defendant] had actual knowledge of the
implications of the alleged [fraudulent] scheme on particular statements
made in [defendant's] filings, that he had actual knowledge of the scope
of the scheme, or that he was informed the scheme had been carried out";
"the Court is unaware of any legal precedents requiring that these particulars are necessary to plead
scienter under Sections 10(b) and 10b-5").
Deloitte argues that the allegations of conscious misbehavior are
insufficient because they can be read in an innocent way. Deloitte
contends, for example, that the allegations concerning the Petrochem
facility losses "are no less susceptible to an innocent interpretation,
in which Woodsford gave Philip an explanation and/or examples of the
kinds of situations in which losses could legitimately be deferred."
(Deloitte's Mem. at 36) Likewise, with respect to the allegations of
improper corporate adjustments, Deloitte argues that "all that plaintiffs
have alleged . . . is that [Deloitte] knew of proposed adjustments" and
that, "to the extent that any adjustments were improper," the allegations
in fact suggest that Deloitte caused Philip to remedy its accounting.
(Id. at 33, 33 n.17) Such characterizations either contradict the plain
meaning of the allegations in the Complaint or rely on convoluted
inferences favoring Deloitte. Granting plaintiffs the reasonable
inferences to which they are entitled at the pleading stage,*fn6 the allegations are sufficient to establish Deloitte's conscious
misbehavior. See In re Initial Public Offering Sec. Litig.,
241 F. Supp.2d 281, 332-33 (S.D.N.Y. 2003) (rejecting defendants' efforts
to "rewrit[e] the Complaints in a way that they believe favors
dismissal"; "[d]efendants must take the Complaints as they are
written").*fn7 (ii) Recklessness
Although recklessness is harder to identify than conscious
misbehavior, the Second Circuit has observed that "securities fraud
claims typically have sufficed to state a claim based on recklessness
when they have specifically alleged defendants' knowledge of facts or
access to information contradicting their public statements." Novak, 216
F.3d at 308. For an accountant to be found to have acted recklessly
during an audit, its alleged misconduct must "`approximate an actual
intent to aid in the fraud being perpetrated by the audited company.'"
Rothman, 220 F.3d at 98 (citation omitted). This standard requires more
than the auditor's "mere publication of inaccurate accounting figures, or
a failure to follow GAAP." Vladimir v. Deloitte & Touche LLP, 95 Civ.
10319 (RPP), 1997 U.S. Dist. LEXIS 3823, at * 10 (S.D.N.Y. Mar. 31, 1997)
(citing In re Worlds of Wonder Sec. Litiq., 35 F.3d 1407, 1426 (9th Cir.
A plaintiff must prove that . . . `[t]he accounting
practices were so deficient that the audit amounted to
no audit at all, or an egregious refusal to see the
obvious, or to investigate the doubtful, or that the
accounting judgments which were made were such that no
reasonable accountant would have made the same
decisions if confronted with the same facts.'
In re Complete Mgmt., 153 F. Supp.2d at 333-34 (quoting Price
Waterhouse, 797 F. Supp. at 1240).
The Complaint alleges that Deloitte recklessly disregarded various "red
flags" indicating Philip's accounting fraud, including: (1) a "highly suspicious" and "massive" increase of
Philip's copper inventories during a period of backwardation*fn8 in the
copper markets (Id. ¶ 320-323); (2) a qualified opinion issued by a
former auditor of a Philip subsidiary indicating the difficulty of
verifying inventory levels at the subsidiary (Id. ¶ 325); (3) a letter
written by a former Philip employee in 1995 alleging "questionable
business practices and material accounting misstatements". at Philip
prior to 1994 (id. ¶¶ 327-330); (4) Philip's lack of an adequate financial
reporting system that would allow it to track financial transactions
properly (id. ¶ 332); (5) the existence of material unrecorded
liabilities that plainly were reflected in certain inventory repurchase
contracts entered into by Philip (id. ¶ 333); and (6) the "obvious
simplicity" of Philip's alleged fraudulent practices, (id. ¶ 334).
These multiple allegations of "red flags," considered in the aggregate,
support an inference of fraudulent intent adequate to survive a motion to
dismiss. "[B]ecause the `red flags' would be clearly evident to any
auditor performing its duties, one could reasonably conclude that
[Deloitte] must have noticed the `red flags,' but deliberately chose to
disregard them to avoid antagonizing [Philip] and incidentally frustrating its
fraudulent scheme." In re Leslie Fay Cos. Sec. Litig., 871 F. Supp. 686,
699 (S.D.N.Y. 1995). See also In re Complete Mgmt., 153 F. Supp.2d at
334; In re Health Mgmt., 970 F. Supp. 192, 203 (E.D.N.Y. 1997) (both
finding scienter allegations sufficient where auditor ignored multiple
red flags). The enormity of the fraud attributed to Philip makes this
finding particularly appropriate. See In re Leslie Fay Cos. Sec. Litig.,
835 F. Supp; 167, 175 (S.D.N.Y. 1993) ("Alleged fraud of this magnitude,
coupled with plaintiffs' other allegations, creates an implication of
recklessness, on the face of the pleading, which compels us to deny
Deloitte argues that the recklessness allegations too lack enough
specificity to support an inference of fraudulent intent. (Deloitte's
Mem. at 38-39; Deloitte's Reply Mem. at 36; Deloitte's Supp. Mem. at 6-7)
Here, Deloitte takes two different approaches. First, it singles out
certain paragraphs in the Complaint that summarize the more precise
allegations described above, and contends that these "general
allegations" are insufficiently particularized. However, "[i]t is
elementary that, on a motion to dismiss, the Complaint must be read as a
whole," Yoder v. Orthomolecular Nutrition Inst., Inc., 751 F.2d 555, 562
(2d Cir. 1985) (citing Conley v. Gibson, 355 U.S. 41, 47-48 (1957)), and
Deloitte cannot secure dismissal by cherry-picking only those allegations susceptible to rebuttal and disregarding the
remainder. See Manavazian v. ATEC Group, Inc., 160 F. Supp.2d 468, 479-80
(E.D.N.Y. 2001) (rejecting "with dispatch" argument whereby "[d]efendants
simply [found] fault with paragraphs of the complaint that purport to do
no more than summarize more specific allegations found elsewhere").
Second, Deloitte contends that the recklessness allegations fail to
state what audit procedures Deloitte used, why the procedures were
inadequate, and what audit procedures Deloitte should have used in
response to the alleged "red flags." However, such facts are peculiarly
within Deloitte's knowledge, and thus are not required at the pleading
stage. See In re Leslie Fay, 835 F. Supp. at 174 ("[T]he specifics of
BDO's auditing procedures strike us as the type of facts which are
particularly within defendants' knowledge and therefore, need not be
included in the complaint.") (citing DiVittorio v. Equidyne Extractive
Indus., Inc., 822 F.2d 1242, 1247 (2d Cir. 1987)); Liberty Ridge LLC v.
RealTech Sys. Corp., 173 F. Supp.2d 129, 137 (S.D.N.Y. 2001) ("[C]ourts
should not demand a level of specificity in fraud pleadings that can only
be achieved through discovery.") (citations omitted). Cf. Vladimir, 1997
U.S. Dist. LEXIS 3823, at *24-25 (failure to particularize facts
concerning auditor's misconduct was "inexcusable . . . in light of the
fact that plaintiffs' counsel has been in possession of defendant's work papers for
three years and has conducted extensive discovery").*fn9
In sum, the allegations in the Complaint create a strong inference of
Deloitte's conscious misbehavior and recklessness, and do so with
sufficient particularity to withstand dismissal. Although plaintiffs "may
have a long road ahead to substantiate their allegations" of fraudulent
intent, In re Leslie Fay, 871 F. Supp. at 699, the allegations reasonably
support the requisite strong inference at this stage in the litigation.
2. Pleading Fraud With Particularity
A securities fraud complaint must also plead with particularity the
circumstances constituting the alleged fraud. The Second Circuit has
interpreted Rule 9(b) to require that a securities fraud complaint: "(1)
specify the statements that the plaintiff contends were fraudulent, (2) identify the speaker, (3) state
where and when the statements were made, and (4) explain why the
statements were fraudulent." Mills v. Polar Molecular Corp., 12 F.3d 1170,
1175 (2d Cir. 1993) (citing Cosmas v. Haslett, 886 F.2d 8, 11 (2d Cir.
1989)). Likewise, the PSLRA requires that a complaint "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, the complaint shall state
with particularity all facts on which that belief is formed."
15 U.S.C. § 78u-4(b)(1) (hereinafter, "paragraph (b)(1)") (emphasis
Deloitte argued in its initial motion papers that, because the
Complaint relies exclusively on information and belief, plaintiffs'
failure to name certain "relevant witnesses" they interviewed in
preparing the Complaint is an additional ground for dismissing the
Section 10(b) claim. (Deloitte's Mem. at 41-43; Deloitte's Reply Mem. at
37-38) In essence, Deloitte contended that the phrase "all facts" in
paragraph (b)(1) described above requires a securities fraud complaint to
name the sources of allegations based on information and belief. In a
later submission to the court, Deloitte's counsel conceded that, after
its initial motion papers were filed, the Second Circuit considered and
rejected that argument in Novak v. Kasaks, 216 F.3d 300 (2d Cir. 2000). (2/13/04 King Letter) However, Deloitte
insists that the Complaint fails in other respects to satisfy the
pleading standard for fraud allegations outlined in Novak and required
under the PSLRA. (Id.; Deloitte's Second Supplemental Memorandum of Law
in Further Support of its Motion to Dismiss, Addressing the Impact of
Novak v. Kasaks, passim; Deloitte's Reply Memorandum of Law Addressing
the Impact of Novak v. Kasaks, passim)
In Novak, the plaintiffs, shareholders in a public corporation, alleged
that the corporation and some of its officers had artificially inflated
the price of the corporation's stock. The district court found the
pleadings insufficiently particularized, in large part because the
plaintiffs failed to name the sources of some of their critical
allegations. On appeal, the Second Circuit vacated the district court's
decision, noting that, "notwithstanding the use of the word `all,'
paragraph (b)(1) does not require that plaintiffs plead with particularity
every single fact upon which their beliefs concerning false or misleading
statements are based." Novak, 216 F.3d at 313, The Court explained the
"illogical results" of reading the word "all" in paragraph (b)(1)
[I]t would allow complaints to survive dismissal
where "all" the facts supporting the plaintiff's
information and belief were pled, but those facts
were patently insufficient to support that belief.
Equally peculiarly, it would require dismissal
where the complaint pled facts fully sufficient to support a
convincing inference if any known facts were omitted.
Id. at 314 n.1. It noted also that neither Second Circuit precedent nor
the language of the PSLRA requires plaintiffs to reveal anonymous sources
at the pleading stage, and observed that the purpose underlying paragraph
(b)(1) to afford a defendant fair notice of the plaintiff's claim and
the factual ground on which it is based "can be served without
requiring plaintiffs to name their confidential sources as long they
supply sufficient facts to support their allegations." Id. at 314.
Accordingly, the Court announced the following method for evaluating
whether confidential source material meets the PSLRA particularity
Where plaintiffs rely on confidential personal
sources but also on other facts, they need not
name their sources as long as the latter facts
provide an adequate basis for believing that the
defendants' statements were false. Moreover, even
if personal sources must be identified, there is
no requirement that they be named, provided they
are described in the complaint with sufficient
particularity to support the probability that a
person in the position occupied by the source
would possess the information alleged. In both of
these situations, the plaintiffs will have pleaded
enough facts to support their belief, even though
some arguably relevant facts have been left out.
Id. at 314. The Court then observed that "a complaint can meet the new
pleading requirement imposed by paragraph (b)(1) by providing documentary
evidence and/or a sufficient general description of the personal sources of the plaintiffs' beliefs."
While Novak categorically rejected the notion that securities fraud
complaints must name confidential sources as a general matter, it was
rather less precise about what types of "other facts" may satisfy the
particularity requirement of paragraph (b)(1). Several district courts in
the Second Circuit have interpreted Novak narrowly to hold that, although
plaintiffs need not name their confidential sources, they nevertheless
must provide a description of the sources, either documentary or
personal, of their information and beliefs allegations to survive
dismissal. See, e.g., In re MSC Indus. Direct Co., Inc. Sec. Litig.,
283 F. Supp.2d 838, 847 (E.D.N.Y. 2003); Fadem v. Ford Motor Co., 02
Civ. 0686 (CSH), 2003 U.S. Dist. LEXIS 16898, at *23 (S.D.N.Y. Sept. 24,
2003); In re Globalstar Sec. Litig., 01 Civ. 1748 (SHS), 2003 U.S. Dist.
LEXIS 22496, at *19-20 (S.D.N.Y. Dec. 12, 2003).
I decline to read Novak that narrowly for several reasons. First, as
the Second Circuit itself acknowledged in Novak, paragraph (b)(1)
"requires plaintiffs to plead only facts and makes no mention of the
sources of these facts." 216 F.3d at 313. Moreover, the opinion states
that a complaint "can" satisfy the PSLRA's particularity requirement by
identifying documentary or personal sources; it does not require that a
complaint do so. Novak. 216 F.3d at 314. Indeed, as the Second Circuit noted, the purposes
of paragraph (b)(1) "can be served as long as [plaintiffs] supply
sufficient facts to support their allegations." Id. For example, the
level of factual specificity or the corroborative nature of other facts
alleged in a securities fraud complaint might be enough to place
defendants on notice of the misconduct alleged and permit them to defend
against the charge. See Adams v. Kinder-Morgan, Inc., 340 F.3d 1083,
1101-02 (10th Cir. 2003). Last, requiring plaintiffs to identify the
sources of their factual allegations would, in effect, compel them to
plead evidence in their complaint, thereby undoing the principle of notice
pleading that underlies the Federal Rules of Civil Procedure. See id. at
1101 (noting that although the PSLRA requires securities fraud plaintiffs
to allege certain facts with greater precision, it Mid not . . . purport
to move up the trial to the pleadings stage"); In re Cephalon Sec.
Litiq., 96 Civ. 0633, 1997 U.S. Dist. LEXIS 13840, at *2 (E.D. Pa. Aug.
29, 1997) ("Clearly, the [PSLRA] requires some precision in alleging
facts, however, it does not require pleading all of the evidence and
proof thereunder supporting a plaintiff's claim."). Had the Second Circuit
chosen to interpret the PSLRA as importing an evidentiary requirement
into securities fraud complaints, it would have done so more explicitly.
See Kinder-Morgan, 340 F.3d at 1101. For the above reasons, I believe Novak should not be read to require
that securities fraud complaints identify documentary or personal
sources. Instead, I join a handful of courts that read Novak as endorsing
a broader approach to the particularity requirement of paragraph (b)(1).
See, e.g., In re Cabletron Sys., Inc., 311 F.3d 11, 29-30 (1st Cir.
2002); In re Initial Public Offering, 241 F. Supp.2d at 358-59. See also
Kinder-Morgan, 340 F.3d at 1101-03 (declining to adopt position,
attributed to Novak, that PSLRA requires securities fraud complaint to
identify sources of allegations based on information and belief).*fn10
Under this approach, the court looks to whether the factual allegations,
considered in the whole, "provide an adequate basis for believing that
the defendants' statements were false," Novak, 216 F.3d at 314, without
adding the requirement that the complaint identify the source of the
factual allegations. This interpretation of Novak recognizes, as I
believe the Second Circuit did, that requiring disclosure of sources in
all securities fraud complaints is too restrictive a response to the
PSLRA's particularity requirement. In re Cabletron Systems, one of the cases cited above that adopts a
broader reading of Novak, addressed what types of "other facts" might
satisfy the particularity requirement of paragraph (b)(1). In that case,
the First Circuit endorsed the following approach for resolving whether
fraud allegations satisfy the particularity requirement of paragraph
The approach we take, similar to Novak, is to look at
all of the facts alleged to see if they `provide an
adequate basis for believing that the defendants'
statements were false.' Novak, 216 F.3d at 314. This
involves an evaluation, inter alia, of the level of
detail provided by the confidential sources, the
corroborative nature of the other facts alleged
(including from other sources), the coherence and
plausibility of the allegations, the number of
sources, the reliability of the sources, and similar
In re Cabletron, 311 F.3d at 29-30. See also Kinder-Morgan. 340 F.3d at
1102-03 (recommending that courts consider, inter alia, coherence,
plausibility and specificity of the allegations, whether sources are
disclosed and reliability of those sources, and "any other factors that
might affect how strongly the facts alleged support a reasonable belief
that the defendant's statements were false or misleading"). Thus, while
the disclosure of sources may strengthen a complaint pleaded on
information and belief, it is not necessary if the facts otherwise
support a reasonable belief that the alleged fraud occurred. In short,
"[w]hat facts and what level of particularity are sufficient to support a
plaintiff's beliefs will vary from case to case. . . . The critical threshold is that the
allegations must be made in a way that satisfies the court that
plaintiff's charge of fraud is not `unwarranted.'" In re Initial Public
Offering, 241 F. Supp.2d at 359.
In the present case, the factual allegations describing Deloitte's role
in the alleged fraud are sufficiently numerous and detailed to meet the
particularity requirement of paragraph (b)(1). To take one example, the
allegations concerning the Petrochem losses specify the division of
Philip at which the improper accounting occurred (the Petrochem
facility), people at Deloitte and Philip complicit in the fraud
(Woodsford, Boughton, and Woodcroft), and the amount of the losses at
issue ($8 million). "Overall, the accumulated amount of detail the
[Complaint] provides tends to be self-verifying; these are not conclusory
allegations of fraud, but specific descriptions of the precise means
through which it occurred. . . ." In re Cabletron Sys., 311 F.3d at 30.
Such particularized allegations "provide an adequate basis for believing
that [Deloitte's] statements were false," and make it unnecessary for
plaintiffs to disclose the sources of their beliefs at the pleading
In sum, the Complaint alleges sufficient facts on which plaintiffs'
beliefs are formed to satisfy the PSLRA's particularity requirement.
Viewed in their entirety, the allegations put Deloitte on fair notice of
plaintiffs' claims and their factual basis. Accordingly, the Complaint is "not frivolous
or conclusory and deserves to proceed to the next stage of litigation."
Kinder-Morgan, 340 F.3d at 1105.
B. Section 11 of the Securities Act
The third, sixth, and ninth claims are asserted against Deloitte,
Haynes and Knauss under Section 11 of the Securities Act. Section 11
permits an action by any person who acquired a security in reliance on a
registration statement that contained a material misstatement, as
against, among others,
(1) every person who signed the registration
(2) every person who was a director of (or person
performing similar functions) or partner in, the
issuer at the time of the filing of the part of
the registration statement with respect to which
his liability is asserted;
(4) every accountant . . . who has with his consent
been named as having prepared or certified any
part of the registration statement, or as having
prepared or certified any report or valuation
which is used in connection with the registration
statement, with respect to the statement in such
registration statement, report, or valuation,
which purports to have been prepared or certified
by him. . . .
15 U.S.C. § 77k(a).
Because intent to defraud is not an element of a Section 11 claim,
"`only a material misstatement or omission [in a registration statement]
need be shown to establish a prima facie case. . . .'" In re Initial
Public Offering, 241 F. Supp.2d at 343 (citation omitted). See also In re CINAR Corp. Sec. Litiq.,
186 F. Supp.2d 279, 306 (E.D.N.Y. 2002) (" [A] plaintiff does not need to
allege the manner in which a material misstatement on a securities filing
was made innocently, negligently, fraudulently or otherwise because
Section 11 provides for strict liability.") (citation omitted). However,
the Second Circuit has ruled recently that, where Section 11 (or Section
12(a)(2)) claims are based on underlying allegations of" fraud, the
complaint must satisfy the heightened pleading requirements of Rule
9(b). See Rombach v. Chang, 355 F.3d 164, 171 (2d Cir. 2004).
In Rombach, the Second Circuit noted that although fraud "is not an
element or a requisite to a claim under Section 11 or Section 12(a)(2),"
those claims "may be and often are predicated on fraud," and that the
allegations underlying Section 10(b) claims and Section 11 claims are
often the same. Id.*fn11 The Court observed that the considerations for
applying Rule 9(b) to a conventional fraud claim "apply with equal force"
to Section 11 (or Section 12(a)(2)) claims sounding in fraud. Id.
(citation omitted). Accordingly, it held that the heightened pleading standards of Rule 9(b) apply to Section 11 (or Section 12(a)(2)) claims
insofar as such claims as premised on underlying allegations of fraud.
Id. As discussed above, the Second Circuit has interpreted Rule 9(b) to
require that a securities fraud complaint allege, inter alia, facts
giving rise to "a strong inference of fraudulent intent" and state with
particularity the facts constituting the alleged fraudulent conduct.
Applying Rombach, I must consider whether plaintiffs' Section 11 claims
sound in fraud and, if so, whether the underlying allegations of fraud
satisfy the pleading requirements of Rule 9(b). I examine the claims
against Deloitte, and Haynes and Knauss separately, because the facts
underlying those claims vary significantly.
The Complaint asserts Section 11 claims against Deloitte based on its
consent to the republication of the "false and misleading" 1996 audit
opinion in the November 1997, Allwaste, and Serv-Tech Registration
Statements. Deloitte seeks dismissal of the Section 11 claims on the
ground that they are premised on fraud allegations and fail to satisfy
Rule 9(b)'s heightened pleading requirements. (Deloitte's Supp. Mem. at
7-9; Deloitte's Supplemental Memorandum of Law in Further Support of its Motion to Dismiss, dated 1/20/04, passim; Deloitte's Reply Memorandum
of Law Concerning the Impact of Rombach v. Chang, passim)
Plaintiffs argue at the threshold that Deloitte waived any objections
to the Section 11 claims because (1) Deloitte conceded the sufficiency of
the Section 11 claims in its initial set of motion papers and raised its
objections for the first time in a supplemental memorandum that the
parties had agreed was meant only to address recent case law with respect
to pleading standards under the PSLRA; and (2) Deloitte should not be
permitted to circumvent Fed.R.Civ.P. 12(g), which bars a party from
submitting more than one pre-answer motion to dismiss under Rule 12(b).
(Plaintiffs' Reply to Deloitte's Supplemental Memorandum of Law in
Support of its Motion to Dismiss at 1-3; Plaintiffs' Second Supplemental
Memorandum of Law in Opposition to the Motions of Deloitte, Haynes and
Knauss ("Pls.' 2d Supp. Mem. in Opp'n to the Motions of Deloitte, Haynes
and Knauss") at 4-5) Neither argument has merit. First, I am not bound by
the terms of a stipulation between parties to a dispute. See United
States ex rel. Terry v. H enderson, 462 F.2d 1125, 1131 n.13 (2d Cir.
1972); Am. Fed. of State, County and Municipal Employees, AFL-CIO v. New
York, 599 F. Supp. 916, 919 n.1 (S.D.N.Y. 1984). Second, because I have
not yet ruled on that part of Deloitte's motion to dismiss based on
failure to state a claim, Deloitte's "newly-raised" objections as to the Section 11 claims cannot properly be
characterized as a second pre-answer motion to dismiss. Accordingly, this
court has jurisdiction to consider Deloitte's objections to the Section
Turning to the merits of Deloitte's objections, it is plain that the
Section 11 claims asserted against it sound in fraud: not only do
allegations of Deloitte's fraud permeate the Complaint, but also the
claims asserted under Section 11 are premised on the allegations
supporting the Section 10(b) claim against Deloitte. (See, e.g., Compl.
¶ 386 ("Deloitte consented to the inclusion of its auditor's opinions in
the Registration Statement. Deloitte's audit opinions with respect to
Philip's 1995 and 1996 financial statements were false and misleading
when the November 1997 Registration Statement was declared effective by
the SEC.")) Accordingly, Rule 9(b) applies. See Rombach, 355 F.3d at 172
(applying Rule 9(b) where "the wording and imputations of the complaint
are classically associated with fraud"); In re Ultrafem, Inc. Sec.
Litig., 91 F. Supp.2d 678, 690 (S.D.N.Y. 2000) (applying Rule 9(b) where
"plaintiffs [made] little, if any, effort to differentiate their asserted
negligence claims from the fraud claims which permeate the Complaint").
However, because I have already found, in connection with the Section
10(b) claim, that those underlying allegations are sufficiently pleaded
to satisfy Rule 9(b) and the PSLRA, Deloitte's motion to dismiss the Section 11 claims on this ground
Deloitte argues as a fallback position that it cannot be held liable
under Section 11 for misstatements in the registration statements
attributable to parties other than Deloitte. (Deloitte's Mem. at 43-44) I
do not read the Complaint to assert Section 11 claims against Deloitte
for misstatements made by other parties, and plaintiffs have verified in
their papers that they will pursue Section 11 claims against Deloitte
only for misstatements that it prepared or certified. (Pls.' Mem. in
Opp'n to Deloitte's Mot. to Dismiss at 38) Nevertheless, to the extent
Deloitte seeks assurance that it cannot be held liable under Section 11
for information in the registration statements it did not prepare or
certify, the terms of the statute provides ample guidance: an accountant
may be held liable only for statements that "purport . . . to have been
prepared or certified by him." 15 U.S.C. § 77(k)(a)(4). See also Herman
& Maclean v. Huddleston, 459 U.S. 375, 386 n.22 (1983) (holding that
accountants "cannot be reached by a Section 11 action . . . with respect
to parts of registration statement which they are not named as having
prepared or certified"). 2. Haynes and Knauss
The Section 11 claim against Haynes and Knauss is based on their having
signed the November 1997 registration statement in their capacity as
Philip directors. According to the Complaint, Haynes and Knauss, among
others, attended a board of directors meeting at which the participants
discussed Philip's improperly recorded earnings for the 1997 third
quarter amounting to $24.2 million. (Compl. ¶¶ 236-238) Nevertheless,
Haynes and Knauss later signed the November 1997 registration statement,
which did not disclose the fraudulent nature of the earnings. (Id. ¶¶
60-61, 238) Plaintiffs concede that their Section 11 claim against Haynes
and Knauss sounds in fraud, but argue that the underlying allegations
satisfy the heightened pleading requirements of Rule 9(b). (Pls.' 2d
Supp. Mem. in Opp'n to the Motions of Deloitte, Haynes and Knauss,
passim; Plaintiff's Reply Memorandum of Law in Further Opposition to the
Motions to Dismiss of Haynes and Knauss, passim)
Haynes' and Knauss' principal objection is that the Complaint does not
sufficiently allege their participation in making the fraudulent
statements in the November 1997 registration statement, and thus fails to
plead fraud with sufficient particularity under Rule 9(b). (Haynes' and
Knauss' Memorandum of Law in Support of their Motion to Dismiss ("Haynes'
and Knauss' Mem.") at 18-19; Haynes' and Knauss' Supplemental Memorandum of Law in Support of their Motion to Dismiss ("Haynes' and
Knauss' Supp. Mem.") at 13-14; Haynes' and Knauss' Second Supplemental
Memorandum of Law in Support of their Motion to Dismiss ("Haynes' and
Knauss' 2d Supp. Mem.") at 3) The Second Circuit has held that, in order
to satisfy the fraud particularity requirement of Rule 9(b), a complaint
must "inform each defendant of the nature of his or her alleged
participation in the fraud." DiVittorio, 822 F.2d at 1247 (citation
omitted)." However, plaintiffs here are relieved of the burden of having
to identify the specific roles of Haynes and Knauss in the alleged fraud
under the so-called "group pleading doctrine." That doctrine applies
where, as here, the directors or officers of a company participate in the
preparation and dissemination of group-published documents, such as
registration statements. See In re Oxford Health Plans. Inc. Sec.
Litig., 187 F.R.D. 133, 142 (S.D.N.Y. 1999) (noting that "group-pleading
doctrine allows plaintiffs to "rely on a presumption that statements in
prospectuses, registration statements, annual reports, press releases, or
other group-published information, are the collective work of those
individuals with direct involvement in the everyday business of the
company'") (citation omitted); Geiger v. Solomon-Page Group, Ltd.,
933 F. Supp. 1180, 1188 n.7 (S.D.N.Y. 1996) ("The defendants . . .
protest that the Amended Complaint fails to specify the particular
omission attributable to each of the Individual Defendants. When an alleged fraudulent
omission occurs in an offering memorandum filed with the SEC signed by
each of the Individual Defendants, however, there is no requirement that
the complaint be any more particular to comply with Rule 9(b) in this
respect.") (citing DiVittorio, 822 F.2d at 1247).
That Haynes and Knauss were outside directors of Philip and were
appointed to the company's board only three months before issuance of the
November 1997 registration statement is of no consequence because, as the
Complaint alleges, they had access to insider information concerning
Philip's improperly recorded earnings for the 1997 third quarter. See
Sperber Adams Assocs. v. JEM Mgmt. Assocs. Corp., 90 Civ. 7405 (JSM), 1992
U.S. Dist. LEXIS 8301, at *5 (S.D.N.Y. June 4, 1992) (outside director
who prepared and distributed offering materials is insider for purposes
of Rule 9(b) particularity inquiry); Schnall v. Annuity and Life Re
(Holdings). Ltd., 3:02 Civ. 2133 (GLG), 2004 U.S. Dist. LEXIS 1601, at
*11 (D. Conn. Feb. 4, 2004) ("[O]utside directors, although almost by
definition excluded from the day-to-day management of a corporation, can
fall within the group pleading presumption when, by virtue of their
status or a special relationship with the corporation, they have access
to information more akin to a corporate insider.") (citing In re XOMA
Corp. Sec. Litig., C-912252, 1991 U.S. Dist. LEXUS 20051, at *6) (N.D. Cal. Dec. 21, 19, 91). Notwithstanding Haynes' and Knauss'
assertion to the contrary, the enactment of the PSLRA did not undermine
the group pleading doctrine in the Second Circuit. See In re Complete
Mgmt., 153 `F. Supp.2d at 326 n.7 (citing In re American Bank Note
Holographics, Inc. Sec. Litig., 93 F. Supp.2d 424, 442 (S.D.N.Y. 2000));
In re Oxford Health Plans, 187 F.R.D. at 142.
Haynes and Knauss argue that the Section 11 claim should be dismissed
also because the Complaint fails to allege facts creating a strong
inference of their fraudulent intent. (Haynes' and Knauss' Mem. at 18;
Haynes' and Knauss' 2d Supp. Mem. at 3) However, the Complaint alleges
that Haynes and Knauss attended a board meeting at which the participants
were told about Philip's improperly recorded earnings for the 1997 third
quarter, but they nevertheless executed the November 1997 registration
statement. Such allegations are enough to sustain a strong inference at
the pleading stage that Haynes and Knauss knowingly committed securities
fraud by signing that registration statement.
Haynes and Knauss ask the court in the alternative to strike from the
Complaint any claim against them of joint and several liability because,
they argue, the PSLRA requires plaintiffs asserting joint and several
liability claims under Section 11 to allege defendants' knowing violation
of the securities laws, and plaintiffs fail to do so here. (Haynes' and Knauss'
2d Supp. Mem. at 3-5) This argument fails on two grounds. First, the
statute that Haynes and Knauss cite in support of this argument concerns
the level of scienter that the "trier of fact" must find in order for a
defendant to incur joint and several liability; it has no bearing on
plaintiffs' minimum pleading requirements. See 15 U.S.C. § 78u-4(f)(3)(A)
("Any covered person against whom a final judgment is entered in a
private action shall be liable for damages jointly and severally only if
the trier of fact specifically determines that such covered person
knowingly committed a violation of the securities laws.") Second, even
presuming the statute were applicable at this stage in the litigation, for
the reasons discussed above, the Complaint sufficiently alleges facts
creating a strong inference that Haynes and Knauss knowingly committed
C. Section 20(a) of the Exchange Act and Section 15 of the Securities
The second and fifth claims assert "control person" liability claims
against Haynes and Knauss under Section 20(a) of the Exchange Act and
Section 15 of the Securities Act. In effect, the Complaint alleges that
Haynes and Knauss, as Philip directors, held power and influence over the company's actions and,
therefore, are liable for its fraudulent misrepresentations.
Section 20(a) of the Exchange Act
Section 20(a) imposes liability on "every person who, directly or
indirectly, controls any person liable under any provision of this
chapter or of any rule or regulation thereunder . . ., unless the
controlling person acted in good faith and did not . . . induce the . . .
violation." 15 U.S.C. § 78t(a). In order to state a prima facie claim
under Section 20(a), a plaintiff must show: "(1) a primary violation by a
controlled person, (2) control of the primary violator by the defendant,
and (3) `that the controlling person was in some meaningful sense a
culpable participant' in the primary violation." Boguslavsky v. Kaplan,
159 F.3d 715, 720 (2d Cir. 1998) (quoting Sec. & Exch. Comm'n v. First
Jersey Securities, Inc., 101 F.3d 1450, 1472 (2d Cir. 1996)).
Plaintiffs' allegations in furtherance of the Section 20(a) claim,
though sparse, are sufficient to avoid dismissal. The first element is
satisfied with the allegation that Philip committed multiple violations
of Section 10(b) of the Exchange Act. (Compl. ¶¶ 369-376) Because no
party has challenged the sufficiency of that allegation, I assume that
plaintiffs have adequately pleaded a primary violation. See In re Scholastic Corp. Sec.
Litig., 252 F.3d 63, 77-78 (2d Cir.), cert. denied, 534 U.S. 1071 (2001)
(primary violation element of a Section 20(a) claim was satisfied where
plaintiffs adequately pleaded Section 10(b) claim).*fn12
To establish the second element control a plaintiff must show that
the defendant "possessed `the power to direct or cause the direction of
the management and policies of a person, whether through the ownership of
voting securities, by contract, or otherwise.'" First Jersey Securities,
101 F.3d at 1472-73 (quoting 17 C.F.R. § 240.12b-2). "A short, plain
statement that gives the defendant fair notice of the claim that the
defendant was a control person and the ground on which [that claim] rests
. . . is all that is required." Schnall, 2004 U.S. Dist. LEXIS 1601, at
*25 (citing Swierkiewicz v. Sorema, N.A., 534 U.S. 506, 512 (2002) and In re Initial Public Offering, 241 F.
Supp.2d at 352).
Haynes' and Knauss' status as directors, standing alone, is
insufficient to establish their control over Philip. See Food & Allied
Service Trades Dep't, AFL-CIO v. Millfield Trading Co., 841 F. Supp. 1386,
1391 (S.D.N.Y. 1994) ("While courts in this circuit have not always
agreed on just how much beyond status as a director must be alleged to
plead a Section 20(a) claim, . . . they have agreed that a bare allegation
of director status, without more, is insufficient."); In re CINAR, 186
F. Supp.2d at 309 ("It is well accepted that merely alleging that a
particular defendant is a director or an officer of a company is not
sufficient to allege control.") (citations omitted). However, the
Complaint alleges not only that Haynes and Knauss were directors of
Philip, but also that they signed the November 1997 registration
statement. (Compl. ¶¶ 60-61) While there is case law suggesting that a
defendant's execution of a fraudulent SEC filing is insufficient by
itself to establish control, see Jacobs, 1999 U.S. Dist. LEXIS 2102, at
*51 (S.D.N.Y. Feb. 26, 1999) (citing cases), I share the view that it
"comport[s] with common sense to presume that a person who signs his name
to a report has some measure of control over those who write the report."
Id. See also In re Indep. Energy Holdings PLC Sec. Litig.,
154 F. Supp.2d 741, 772 (S.D.N.Y. 2001) (allegations that defendants were directors, held substantial equity
stake in company and signed prospectus were sufficient to establish
control); In re Quintel Entm't Sec. Litig., 72 F. Supp.2d 283, 298
(S.D.N.Y. 1999) (allegations that defendants had "access to [the
company's] internal reports, press releases, public filings, and had the
ability to prevent the issuance or correct the statements" were
sufficient to establish control). That Haynes and Knauss were required by
law to sign the November 1997 registration statement, far from absolving
them of responsibility for the misstatements therein, "charges [them]
with power over the document and represents to the corporation, its
shareholders, and the public that [they have] performed [their] role with
sufficient diligence that [they are] willing and able to stand behind the
information contained in [the] document." In re Worldcom, Inc. Sec.
Litig., 294 F. Supp.2d 392, 420 (S.D.N.Y. 2003). See also In re Livent,
151 F. Supp.2d 371, 437 (S.D.N.Y. 2001) ("An outside director and audit
committee member who is in a position to approve a corporation's
financial statements can be presumed to have "the power to direct or
cause the direction of the management and policies of the corporation, at
least insofar as the `management and policies' referred to relate to
ensuring a measure of accuracy in the contents of company reports and SEC
registrations that they actually sign.") (quoting 17 C.F.R. § 240.12b-2). The Second Circuit has not defined the phrase "culpable participation"
the third element other than to say that "a determination of section
20(a) liability requires an individual determination of a . . .
defendant's particular culpability." Boguslavsky, 159 F.3d at 720, and
district courts in the Circuit are split as to what exactly the phrase
means. Some district courts assume that "culpable participation" requires
proof of state of mind, and thus conclude that plaintiffs must allege the
controlling person's scienter to state a prima facie Section 20(a)
claim. See, e.g., In re Oxford Health Plans, 187 F.R.D. at 143; In re
Deutsche Telekom AG Sec. Litig., 00 Civ. 9475 (SHS), 2002 U.S. Dist.
LEXIS 2627, at *17-18 (S.D.N.Y. Feb. 20, 2002); Mishkin v. Ageloff, 97
Civ. 2690 (LAP), 1998 U.S. Dist. LEXIS 14890, at *67-72 (S.D.N.Y. Sept.
23, 1998). Other district courts have reasoned that there is no basis for
equating "culpable participation" with scienter, so that plaintiffs
asserting a Section 20(a) claim need allege only an underlying primary
violation and control person status. See, e.g., In re Initial Public
Offering, 241 F. Supp.2d at 394 n. 182 (noting that culpable conduct "can
be blameworthy though it was done unintentionally or unknowingly" and
that "the scienter-free definition of `culpable' is particularly
appropriate when it modifies `participation,' which means `to take part in
something (as an enterprise or activity) usually in common with
others.'") (citations omitted).*fn13 I need not resolve this debate because,
even assuming "culpable participation" entails scienter, plaintiffs have
pleaded it here.
If scienter is an element of a Section 20(a) claim, the PSLRA's
pleading requirements apply, and plaintiffs must plead with particularity
facts giving rise to a strong inference that the control person knew or
should have known that the primary violator was engaging in fraudulent
conduct. See Cromer Finance " Ltd, v. Berger, 137 F. Supp.2d 452, 484
(S.D.N.Y. 2001); In re Deutsche Telekom, 2002 U.S. Dist. LEXIS 2627, at
*22 (citations omitted). Here, the Complaint sufficiently alleges Haynes'
and Knauss' scienter by asserting that (1) they attended a board meeting
at which participants discussed Philip's improperly recorded earnings for
the third quarter of 1997, and (2) they later signed the November 1997
registration statement that reported the false earnings. (Compl. ¶¶ 236-238) Haynes and Knauss may
prefer a more particularized description of what was discussed at the
board meeting and their states of mind with respect to those
discussions, but such facts are peculiarly within Haynes' and Knauss' own
knowledge, and plaintiffs should not be expected to plead them in the
Haynes and Knauss next contend that the Section 20(a) claim should be
dismissed because plaintiffs seek to hold them jointly and severally
liable to class members who purchased Philip's stock before Haynes and
Knauss became associated with the company, and thus before they had the
requisite control status for Section 11 liability. (Haynes' and Knauss'
Supp. Mem. at 12) I agree that Haynes and Knauss cannot be held liable
under Section 20(a) for Philip's misconduct during that part of the class
period before they acquired control status, see Whirlpool Fin. Corp. v. GN
Holdings, Inc., 873 F. Supp. Ill, 120 (N.D. Ill. 1995) ("[C]ontrol person
liability attaches only to a person who was in control at the time that
the liability of the controlled person accrued, not to someone who later
takes control.") (citing 9 Louis Loss & Joel Seligman, Securities
Regulation 4472 (3d ed. 1992)); Adair v. Hunt Int'l Resources Corp., 79
Civ. 4206, 1982 U.S. Dist. LEXIS 11045, at *10-11 (N.D. Ill. Feb. 22,
1982) (declining to ascribe control person status to defendants who
acquired ownership interests in company after complained-of transactions occurred), but plaintiffs' failure to
particularize in the Complaint Haynes' and Knauss' proportional liability
does not warrant dismissal of the entire Section 20(a) claim.*fn14
Instead, that claim is dismissed only insofar as it is premised on
Haynes' and Knauss' liability for Philip's fraudulent conduct before
August 7, 1997, the date on which they became directors of the
company.*fn15 Haynes' and Knauss' motion to dismiss the Section 20(a)
claim is otherwise denied.
Section 15 of the Securities Act
Section 15 of the Securities Act attaches liability to "every person
who, by or through stock ownership, agency, or otherwise, . . ., controls
any person liable under Section 11, or 12, . . ., unless the controlling
person had no knowledge of or reasonable ground to believe in the
existence of the facts by reason of which the liability of the controlled person is alleged to
exist." 15 U.S.C. § 77o. Plaintiffs asserting a Section 15 claim must
plead an underlying primary violation of Section 11 (or Section 12(a)(2))
of the Securities Act and control over the primary violator by the
targeted defendant. See In re Initial Public Offering, 241 F. Supp.2d at
352 (citation omitted). However, as with control person liability claims
under Section 20(a) of the Exchange Act, district courts in the Second
Circuit-are split over whether plaintiffs asserting Section 15 claims
must plead scienter (what courts generally refer to as "culpable
participation"). See In re Asia Pulp & Paper Sec. Litig.,
293 F. Supp.2d 391, 395-96 (S.D.N.Y. 2003); In re CINAR, 186 F. Supp.2d
at 309-10; Dorchester Investors v. Peak Trends Trust, 99 Civ. 4696
(LMM)(FM), 2003 U.S. Dist. LEXIS 1446, at *10-11 (S.D.N.Y. Feb. 3, 2003)
(all citing cases).*fn16 Again, I need not resolve the intra-circuit debate because, even if scienter is required, all
three elements of a Section 15 claim are sufficiently pleaded here. The
Complaint alleges that Philip committed violations of section 11 of the
Securities Act in relation to the November 1997 public offerings (Compl.
¶¶ 382-391), and no party has challenged the sufficiency of those
allegations. Moreover, as discussed above in connection with the Section
20(a) claim, plaintiffs have sufficiently alleged Haynes' and Knauss'
control status and their "culpable participation" in Philip's fraud.
Accordingly, Haynes' and Knauss' motion to dismiss the Section 15 claim
is denied. For the reasons stated above, Deloitte's motion to dismiss is denied as
to all claims. Haynes' and Knauss' motion to dismiss is denied as to all
claims except that their motion to dismiss the Section 20(a) claim is
granted insofar as the claim is based on their liability for underlying
primary violations occurring before August 7, 1997.