The opinion of the court was delivered by: John G. Koeltl, District Judge:
The plaintiff, Plumbers and Pipefitters Local Union No. 719 Pension Trust Fund, brought this securities class action against Conseco, Inc. ("Conseco") and seven of its current and former officers. The plaintiff alleges violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 ("the Exchange Act"), as amended by the Private Securities Litigation Reform Act of 1995 ("PSLRA"), 15 U.S.C. §§ 78j(b), 78t, 78u-4, and Securities and Exchange Commission Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5. The putative class consists of persons who purchased Conseco common stock between August 4, 2005, and March 17, 2008.*fn1 Compl. ¶ 29.
On January 12, 2010, the plaintiff filed an amended complaint, and on June 2, 2010, pursuant to a stipulation between the parties, it filed a second amended complaint ("the Complaint"). See Corrected Second Amended Complaint for Violation of the Federal Securities Laws, Plumbers v. Conseco, 09 Civ. 6966 (S.D.N.Y. June 2, 2010). The defendants have now moved to dismiss the Complaint pursuant to Rules 9(b) and 12(b)(6) of the Federal Rules of Civil Procedure, primarily on the ground that the plaintiff has failed to allege facts supporting a strong inference of scienter.
On a motion to dismiss pursuant to Federal Rule of Civil Procedure 12(b)(6), the allegations in the Complaint are accepted as true. Grandon v. Merrill Lynch & Co., 147 F.3d 184, 188 (2d Cir. 1998). In deciding a motion to dismiss, all reasonable inferences must be drawn in the plaintiff's favor. Gant v. Wallingford Bd. of Educ., 69 F.3d 669, 673 (2d Cir. 1995); Cosmas v. Hassett, 886 F.2d 8, 11 (2d Cir. 1989). The Court's function on a motion to dismiss is "not to weigh the evidence that might be presented at a trial but merely to determine whether the complaint itself is legally sufficient." Goldman v. Belden, 754 F.2d 1059, 1067 (2d Cir. 1985). The Court should not dismiss the Complaint if the plaintiff has stated "enough facts to state a claim to relief that is plausible on its face." Twombly v. Bell Atl. Corp., 550 U.S. 544 (2007). A claim has facial plausibility when the plaintiff pleads factual content that allows the Court to draw the reasonable inference that the defendant is liable for the misconduct alleged. Ashcroft v. Iqbal, 129 S.Ct. 1937, 1949 (2009); see also Hart v. Rick's Cabaret Int'l, Inc., No. 09 Civ. 3043, 2010 WL 5297221, at *2 (S.D.N.Y. Dec. 20, 2010).
Moreover, allegations of securities fraud under Section 10(b) and Rule 10b-5 are subject to Federal Rule of Civil Procedure 9(b) and the PSLRA's requirements regarding scienter. See 15 U.S.C. § 78u-4(b)(2); Chill v. General Elec. Co., 101 F.3d 263, 266 (2d Cir. 1996); Acito v. IMCERA Grp., Inc., 47 F.3d 47, 52 (2d Cir. 1995); Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1127-28 (2d Cir. 1994). Under the PSLRA, plaintiffs "must state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind," namely, the intent to "deceive, manipulate, defraud, or knowing misconduct." Press v. Chem. Inv. Servs. Corp., 166 F.3d 529, 537-38 (2d Cir. 1999) (internal quotation marks omitted); see also ECA, Local 134 IBEW Joint Pension Trust of Chicago v. JP Morgan Chase Co., 553 F.3d 187, 198 (2d Cir. 2009). The inference that the defendant acted with scienter must be "at least as compelling as any opposing inference one could draw from the facts alleged." Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 324 (2007).
In deciding the motion, "the Court may consider documents that are referenced in the complaint, documents that the plaintiff relied on in bringing suit and that are either in the plaintiffs' possession or the plaintiffs knew of when bringing suit, or matters of which judicial notice may be taken." In re Loral Space & Commc'ns Ltd. Sec. Litig., No. 01 Civ. 4388, 2004 WL 376442, at *2 (S.D.N.Y. Feb. 27, 2004) (citing Chambers v. Time Warner, Inc., 282 F.3d 147, 153 (2d Cir. 2002)); see also LC Capital Partners, LP v. Frontier Ins. Grp., Inc., 318 F.3d 148, 153-55 (2d Cir. 2003). Such "matters" include public disclosure documents that are required by law to be filed with the Securities and Exchange Commission. See Kramer v. Time Warner, Inc., 937 F.2d 767, 773-74 (2d Cir. 1991). This includes not only documents that contain the allegedly inadequate or misleading statements, but "related documents that bear on the adequacy of the disclosure[s]," provided that the documents are "public disclosure documents required by law to be filed." Id. at 774. "[W]hen a plaintiff chooses not to attach to the complaint or incorporate by reference a document upon which it solely relies and which is integral to the complaint, the court may nevertheless take the document into consideration in deciding the defendant[s'] motion to dismiss, without converting the proceeding to one for summary judgment." Int'l Audiotext Network, Inc. v. AT&T Co., 62 F.3d 69, 72 (2d Cir. 1995) (internal quotation marks and citation omitted).
Conseco engages in the development, marketing, and administration of supplemental health insurance, individual life insurance and annuities, and other insurance products for the senior and middle-income insurance markets in the United States. Compl. ¶¶ 2, 41. During the class period, the company's business was organized into three primary operating segments (Bankers Life and Casualty Company, Conseco Insurance Group, and Colonial Penn), a closed block of "run-off" business from prior acquisitions, and corporate operations. Compl. ¶¶ 8, 42, 82. Conseco managed and received premiums on the "long-term care" ("LTC") policies that are the focus of this action as part of its closed block. See Compl. ¶ 82.
The individual defendants were all officers of Conseco during some portion of the class period. Defendant William Kirsh served as President and Chief Executive Officer ("CEO") of Conseco from August 2004 until May 2006. Compl. ¶ 22(a). Defendant Eugene Bullis served as Executive Vice President and Chief Financial Officer ("CFO") of Conseco from November 2002 until May 2007. Compl. ¶ 22(b). Defendant Michael Dubes served as President of Conseco Insurance Group from May 2005 until December 2007. Compl. ¶ 22(c). Defendant James Hohmann served as Executive Vice President and Chief Administrative Officer of Conseco from December 2004 until September 2006, during which time he oversaw Conseco's LTC business. From May 2006 to September 2006, Hohmann was also Interim CEO of Conseco, and from September 2006 to December 2006, he was President and Chief Operating Officer of the company. Compl. ¶ 22(d). Defendant Jim Prieur became CEO of Conseco in September 2006, and remained in that position at the time of the filing of the Complaint. Compl. ¶ 22(e). Defendant Ed Bonach became Executive Vice President and CFO in May 2007, and remained in that position at the time of the filing of the Complaint. Compl. ¶ 22(f). Defendant John Wells became Senior Vice President of the LTC group in December 2006. Compl. ¶ 22(g).
From 1997 to 2000, several long-term care insurance companies merged into or were acquired by Conseco. Compl. ¶ 47. Those companies used different operating procedures, practices, policy provisions, and computer systems. Compl. ¶¶ 48, 85. As a result, during the class period, the company used as many as nineteen different computer systems, which created difficulties with compiling, organizing, and computing data. Compl. ¶¶ 98, 100-01. Because the company lacked a central repository for individual policies, Conseco could not electronically access the policy or coverage information of particular policyholders. Compl. ¶¶ 89, 91, 94. Because of these deficiencies, Conseco was often unable to determine whether policy limits had been reached or exceeded, and regularly paid claims in excess of the benefit maximums. Compl. ¶¶ 5, 54, 96-97.
According to the plaintiff, this absence of reliable computerized information made it impossible for the company to evaluate accurately the financial health of its LTC business, which meant that it could not reliably set "reserves" for its LTC claims. Compl. ¶ 3. Securities and Exchange Commission ("SEC") accounting regulations require that financial statements account for and disclose existing uncertainties as to probable losses. Compl. ¶ 280. Because insurance companies regularly pay claims after the end of the accounting period in which they accrue, they are required to establish a balance sheet liability to account for insurance claim costs incurred but unpaid. Compl. ¶ 281. Such companies are required to establish reserves both for claims that have been reported but not paid ("RBNP") and those that have been incurred but not reported ("IBNR"). Compl. ¶ 281. According to the plaintiff, as a result of Conseco's failure to integrate satisfactorily the LTC businesses of the companies it acquired, in addition to other mismanagement discussed below, Conseco's actuaries were not able to set reserves accurately. Compl. ¶¶ 283-91.
The Complaint alleges that Conseco had various problems in the recording and payment of claims, particularly in its LTC business. In 2005, Conseco sought to reduce the number of platforms and systems the company used by initiating a "health system simplification" project, using an application from Genelco Software Solutions ("Genelco"). Compl. ¶ 102. The Genelco project was a computer program that would automate Conseco's claims handling and claims payments and the setting of reserves for claims across all its business lines. Compl. ¶ 102. The defendants, however, cancelled the project because of "cost issues." Compl. ¶ 106.
After the termination of the Genelco project, Conseco tried to implement a lower-cost alternative called the "Groomer system" to determine the company's claims exposure and set reserves. Compl. ¶¶ 107-08. The Groomer system was, however, less sophisticated than the Genelco system, and did not aggregate certain important information, which allegedly prevented it from reliably setting reserves. Compl. ¶ 108.
According to the plaintiff, the company also took affirmative steps to hide its claims exposure, so as to under-represent its liabilities. It improperly delayed and eliminated claims made under its policies through the "no letter close" ("NL Close") process. Compl. ¶¶ 64-75. This process was intended to eliminate redundant claims that would otherwise be included in the reserves calculation. Compl. ¶ 65. However, Conseco abused the process across its lines of business to eliminate legitimate, non-redundant claims. Compl. ¶ 66. A claim that was eliminated through the NL Close process would not result in any notification to the policyholder, and would create no record at the company, so the claim would have to be resubmitted, provided that the policyholder noticed the error at all. Compl. ¶¶ 69-70. This practice artificially deflated the number of claims to be included in the company's actuarial assumptions, resulting in lower reserves. Compl. ¶ 72.
Conseco also allegedly engaged in a process known as "bundling." Compl. ¶ 79. Customers often submitted individual claims on different dates within a specified time period. When claims were "bundled," multiple claims submitted by a customer on different dates would be counted as a single claim and paid at once. Compl. ¶ 79. Bundling multiple claims in this manner reduced the total number of claims in a given period, because several individual claims were treated as a single claim. Compl. ¶ 79. Conseco took advantage of this process to bundle or unbundle claims to achieve the claims volume and denial rate it deemed most advantageous to the company. Compl. ¶ 80. During the class period, the company held quarterly meetings to decide whether to bundle or unbundle claims to achieve the desired statistical effects. Compl. ¶ 80.
The Complaint also alleges that non-defendant Ali Inanilan, the head of the LTC business, pressured employees to eliminate claims and, in violation of state insurance regulations, rewarded them for doing so. Compl. ¶ 76. He allegedly implemented a program to reward LTC claims adjusters with televisions, gift cards, and other perquisites based upon the number of claims the adjuster denied. Compl. ¶ 77. Inanilan directed employees to deny claims "whenever and however possible." Compl. ¶ 78.
In April 2007, forty state regulators began an investigation into improper business practices at Conseco. Compl. ¶ 148. The investigation, which was formally conducted between July 9, 2007, and October 19, 2007, was intended to determine whether Conseco had maintained and was maintaining appropriate business practices, particularly with respect to its LTC insurance lines. The investigation covered the time period between January 1, 2005, and April 30, 2007. Compl. ¶ 149. Conseco disclosed the investigation in its Form 10-Q covering the second quarter of 2007, which was filed shortly after the investigation officially began. Declaration of Andrew W. Stern in Support of the Defendants' Motion to Dismiss the Corrected Second Amended Complaint ("Stern Decl.") Ex. U at 28, Plumbers v. Conseco, No. 09 Civ. 6966 (S.D.N.Y. Aug. 2, 2010). On May 7, 2008, the National Association of Insurance Commissioners announced a settlement between the state regulators and Conseco as a result of the investigation. Conseco agreed to pay a $2.3 million fine, and to make $26 million in improvements to its claims handling procedures. Compl. ¶ 151.
In 2007, the House Committee on Energy and Commerce of the United States House of Representatives began an investigation and requested that the company provide it with "anything in writing" that indicated Conseco encouraged employees to deny claims. Compl. ¶ 161. This request was also disclosed in Conseco's 10-Q for the second quarter of 2007. Stern Decl. Ex. U at 28. The Complaint alleges that Conseco employees prepared approximately 40 bankers boxes of materials, including manuals and descriptions of internal controls, but that a non-defendant executive asked Conseco employees "whether it was possible to not turn over some of the materials," and "indicated that materials should be destroyed as opposed to turning them over." Compl. ¶ 163. The documents were, however, in fact turned over to Conseco's attorneys. Compl. ¶ 163.
The Complaint alleges that the defendants made several statements during the class period that were, in light of the circumstances described above, materially misleading. The Complaint is exceedingly prolix. It contains lengthy quotes from numerous public disclosure documents and then, often without citing specific alleged misstatements, claims that the passages are "false and misleading" because they failed to disclose the plaintiff's pejorative characterization of the state of Conseco's reserves, record keeping, and claims payment process.
On August 4, 2005, Conseco issued a press release announcing its financial results for the second quarter of 2005. Compl. ¶ 164. The release contained a statement by defendant Kirsch that "During the past 12 months, . . . [w]e have fundamentally strengthened our balance sheet, expense management, operations, product offerings, distribution systems, internal controls and, most importantly, our management team." Compl. ¶ 164. During an accompanying conference call, Kirsch told analysts that the company was "continu[ing] to make progress improving our operating platform." Compl. ¶ 166. Kirsch made similar statements with respect to corporate progress and, in particular, system improvements, in a November 3, 2005 press release and analyst call accompanying Conseco's announcement of its third-quarter financial results, Compl. ¶¶ 175, 179, and a February 27, 2006 press release announcing Conseco's fourth-quarter and year-end results for 2005, Compl. ¶ 182.
Conseco's Form 10-Q, filed with the SEC on August 8, 2005, reiterated that Conseco's "efforts include[d] . . . significant system conversions, such as the elimination of multiple systems for similar lines of business," and noted that "[d]uring the first six months of 2005, [Conseco] implemented new administrative systems for certain life and long-term care products." Compl. ¶ 172.
Despite the notes of progress, Conseco did not hide the problems it faced with its LTC business. In other portions of the Form 10-Q, not cited in the Complaint, Conseco made clear that it faced significant problems with the business, and specifically in its ability to set sufficient reserves:
This segment includes long-term care insurance inforce, substantially all of which was issued through independent agents by certain subsidiaries prior to their acquisitions by Conseco . . . . The loss experience on the products has been worse than we originally expected. Although we anticipated a higher level of benefits to be paid on these products as the policies aged, the paid claims have exceeded our expectations. . . . This adverse experience is reflected in our high benefit ratios.
Stern Decl. Ex. D at 50. Conseco also disclosed that it had previously been required to increase substantially claim reserves for the LTC business:
We have incurred significant losses beyond our estimates as a result of actual claim costs and persistency of our long-term care business included in the other business in run-off segment. For example, we increased claim reserves by $130 million during 2002 and $85 million during the eight months ended August 31, 2003, as a result of adverse developments and changes in our estimates of ultimate claims for these products.
Stern Decl. Ex. D at 32. Conseco also noted that the LTC business faced serious challenges: "Many of our initiatives address issues resulting from the substantial number of acquisitions of our predecessor. . . . These initiatives may result in unforeseen expenses, complications or delays, and may be inadequate to address all issues." Stern Decl. Ex. D at 29. Conseco noted as a specific risk factor for the company: "Our results of operations may be negatively impacted if we are unable to achieve the goals of our initiatives to restructure our principal insurance businesses." Id.
The Form 10-Q also discussed the difficulties the company faced in setting claims reserves for the LTC business:
The limited historical claims experience on our long-term care products could negatively impact our operations if our estimates prove wrong and we have not adequately set premium rates.
In setting premium rates, we consider historical claims information and other factors, but we cannot predict future claims with certainty. This is particularly applicable to our long-term care insurance products, for which we have relatively limited historical claims experience. Long-term care products tend to have fewer claims than other health products such as Medicare supplement, but when claims are incurred, they tend to be much higher in dollar amount. Also, long-term care products have a much longer tail, meaning that claims are incurred much later in the life of the policy than most other supplemental health products. As a result of these traits, longer historical experience is necessary to appropriately price products. . . .
The long-term care insurance businesses included in the other business in run-off segment were acquired through acquisitions . . . . The experience on these acquired blocks has generally been worse than the acquired companies' original pricing expectations. . . . If future claims experience proves to be worse than anticipated as our long-term care blocks continue to age, our financial results would be adversely affected.
Notwithstanding these disclosures, and indeed without even referring to them, according to the plaintiff, the statements in Conseco's Form 10-Q and press releases were materially false and misleading when made because they failed to disclose that Conseco lacked the internal controls necessary to report properly its liabilities and reserves; that Conseco's financial statements were not prepared in accordance with GAAP; that it "lacked the actuarial science necessary to calculate reserves"; that it had abused the NL Close and bundling processes; that it rewarded employees for denying claims; that it did not maintain a central, integrated database of policy information, and did not have access to the detailed claims data necessary for accurate calculation of reserves; and that, as a result of these issues, the "[d]efendants lacked a reasonable basis for their positive statements about the Company, its corporate governance practices, its financial results, its prospects and earnings growth." Compl. ¶ 165.*fn2
On March 15, 2006, Conseco filed its Form 10-K with the SEC. Compl. ¶ 184. It contained a statement that "[b]ased on our assessment we have concluded, as of December 31, 2005, the Company's internal control over financial reporting was effective based on those criteria." Compl. ¶ 185. It also contained statements identical to those described above. Compl. ¶ 185. According to the plaintiff, these statements were materially false and misleading when made because they failed to disclose the true internal state of affairs at Conseco, as described in paragraph 165 of the Complaint. Compl. ¶ 186. Defendants Kirsch and Bullis certified that the Form 10-K had been prepared in accordance with GAAP. Compl. ¶ 187. The plaintiff alleges that this certification was materially false and misleading because the company's financial statements failed to conform to GAAP disclosure requirements. Compl. ¶ 188.
On May 4, 2006, Conseco announced its financial results for the first quarter of 2006. Compl. ¶ 189. On May 8, 2006, the company filed its Form 10-Q, which stated:
During the first quarter of 2006, we upgraded the prior version of the valuation system used to determine reserves for the long-term care block of business in run-off. The new version includes enhancements to more precisely estimate insurance liabilities for policies with return of premium benefits. The effect of this refinement and certain other reserve adjustments resulted in decreases to our insurance liabilities of approximately $14 million in the first quarter of 2006.
Compl. ¶ 191. This language also appeared in Conseco's second-quarter Form 10-Q, which it filed with the SEC on August 8, 2006. Compl. ¶¶ 199, 201. According to the plaintiff, the language was false and misleading because because Conseco "was unable to 'precisely estimate insurance liabilities' and any small changes Conseco may have made did not change this fact." Compl. ¶¶ 192, 201.
On August 2, 2006, Conseco issued a press release announcing its financial results for the second quarter of 2006. Compl. ¶ 193. The Complaint does not allege that any of the specific figures were inaccurate, but faults the disclosure for not including the plaintiff's characterization in paragraph 165. Compl. ¶ 194. The Complaint also refers to a statement by Hohmann quoted in the press release: "We are making significant strides on many fronts as we establish Conseco as a leading provider of financial security for the life, health and retirement needs of middle market America." Compl. ¶ 193. This statement is also alleged to be false and misleading for not including the plaintiff's characterization in paragraph 165. However, the Complaint ignores the following paragraph in the press release, in which Hohmann specifically discussed the problems in the LTC business and its effect on earnings:
Notwithstanding this progress, second quarter was a difficult quarter in certain of our health businesses, with incurred claims exceeding expectations in the Bankers' long-term care block, specified disease and in particular, the run-off long-term care block. Although we are responding to these challenges with increased claims management focus and pricing initiatives where appropriate, based on our results in the first half of 2006 and our expectations for the balance of the year, we are lowering our outlook for 2006 operating earnings to between $1.65 and $1.75 of operating income per share, excluding the after-tax litigation charges recorded in the first half of 2006. Stern Decl. Ex. I at 2.
On August 3, 2006, Conseco held a conference call with investors to discuss the quarterly results. Compl. ¶ 195. During the call, defendant Hohmann discussed changes within the LTC business:
Bankers [Life and Casualty Company] has already completed an LTC claim leakage study and implemented the findings. We are performing a similar analysis on the closed block. We expect improvements in the closed block beginning in 2007.
Compliance is and has been a focal point. While not an explicit revenue generator, it is part of the Conseco value system and a necessary component of any claims management initiative. We have embedded a legal and compliance function within our closed block and we have conducted an external review of our procedures. We have established a compliance oversight committee that meets regularly and monitors business compliance.
Compl. ¶ 195. As the defendants point out, the Complaint fails to point out that Hohmann prefaced these comments by saying:
One of the more challenging parts of this assessment is the significant amount of recent activity surrounding our long-term care book . . . . [W]ith so many moving parts, it is challenging to determine the extent to which slight timing or method differences influence ratios or the extent to which underlying premium and claim developments are fluctuations or trends.
As a result, we believe there is some noise in the ratios for the second quarter which complicate our assessment of the remainder of the year. However, it is true that initial claims and claims paid were up in the second quarter. Accordingly, in evaluating for the remainder of the year, we have anticipated a higher level of claims and we have ...