The opinion of the court was delivered by: Robert P. Patterson, Jr., U.S.D.J.
On September 19, 2010, Plaintiffs, a proposed class composed of stockholders of CRM Holdings, Ltd. ("CRMH" or the "Company"), filed a Consolidated Amended Complaint ("CAC") against Defendant CRMH, as well as several officers (and one board member) of the company, namely Daniel G. Hickey, Jr., Daniel G. Hickey, Sr., Martin D. Rakoff, and James J. Scardino (collectively, the "Individual Defendants"), alleging violations of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. § 78 et seq.
On January 7, 2011, Defendants filed a motion to dismiss the CAC. On February 22, 2011, Plaintiffs filed a memorandum in opposition to Defendants' motion, and on March 29, 2011, Defendants filed a reply. On September 7, 2011 the Court held oral argument in this matter. At the outset of the argument, counsel for Defendants informed the Court that Defendant CRMH has filed for bankruptcy court protection. (Tr. of Sept. 7, 2011 Oral Argument ("Tr.") at 2.) Accordingly, the entire action with respect to CRMH is stayed, and this decision is confined to the claims levied against the Individual Defendants in this matter.*fn1
Lead Plaintiffs Brett Brandes and Beverly L. Munter represent a proposed class of stockholders, including Plaintiff B&B Investors, LP (collectively, "Plaintiffs"), who purchased the common stock of CRMH between December 21, 2005, the date of the Company's Initial Public Offering ("IPO"), and November 5, 2008 (the "Class Period"). (CAC ¶¶ 1, 28-29.) Plaintiffs allege that they "suffered damages as a result of the federal securities law violations and false and/or misleading statements and/or material omissions" made by the Individual Defendants. (Id. ¶¶ 28-29.)
Defendant CRMH*fn2 is a Bermuda corporation and a provider of workers compensation insurance products. Its main activities are (1) underwriting primary workers' compensation policies, reinsurance, and excess insurance policies and (2) providing fee-based management services for group workers' compensation self insurance trusts ("GSITS") in New York and California. (Id. ¶¶ 2, 30.) Individual Defendants were officers and/or board members of the Company during the Class Period.
Defendant Daniel G. Hickey, Jr. ("Mr. Hickey, Jr.") was a co-founder of CRMH, and co-Chief Executive Officer ("co-CEO") of CRMH at all relevant times until December 28, 2006. (Id. ¶ 31.) He was the sole CEO from December 28, 2006 until his resignation on March 13, 2009. (Id.) At all relevant times until March 13, 2009, he was also Chairman of the Board of Directors of CRMH, Chairman of the Board of Twin Bridges (a CRMH subsidiary and reinsurance provider), and President of Compensation Risk Managers, LLC ("CRM," a CRMH subsidiary), CRM CA (a California CRMH subsidiary), and Eimar, LLC (a CRM affiliate that provided medical claims services for the GSITs that CRM administered). (Id. ¶¶ 3, 31, 47, 51.)
Defendant Martin D. Rakoff ("Mr. Rakoff") co-founded CRMH with Mr. Hickey, Jr., and was co-CEO of CRMH at all relevant times until his resignation from the Company on December 28, 2006. Until that time, he was also CEO of CRM, CRM CA, and Eimar, as well as Deputy Chairman of the Board of Twin Bridges. (Id. ¶ 32.)
Defendant James J. Scardino ("Mr. Scardino") was Chief Financial Officer ("CFO") of CRMH at all relevant times. (Id. ¶ 33.) He also served as CFO of CRM, CRM CA, and Eimar from August 2005 to May 2009. (Id.) From July 2007 to May 2009, Mr. Scardino also served as Executive Vice President, CFO of Majestic Insurance Company (a CRMH subsidiary). (Id. ¶¶ 33, 145.)
Defendant Daniel G. Hickey, Sr. ("Mr. Hickey, Sr.") is Defendant Mr. Hickey, Jr.'s father, and was a member of the Board of Directors of CRMH at all relevant times. (Id. ¶ 34.) Mr. Hickey, Sr. has been a member of the Board of Directors of Majestic since 2006 and was, at all relevant times, a director of Twin Bridges. (Id.) He was a member of the Board of Managers of CRM, CRM CA and Eimar until December 2005. (Id.)
B. Plaintiffs' Claims and Relief Sought
The 115-page CAC alleges three claims against Defendants. The first claim charges all the Defendants with violations of Section 10(b) of the Exchange Act ("Section 10(b)"), 15 U.S.C. § 78j(b), and SEC Rule 10b-5, 17 C.F.R. § 240.10b-5. (Id. ¶¶ 210-20.) 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). SEC Rule 10b-5, promulgated under authority of Section 10(b), states:
It shall be unlawful . . . by the use of . . . any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(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 . . . not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
Plaintiffs' second claim asserts violations of the same statute and rule -- Section 10(b) and SEC Rule 10b-5 -- against Defendants Mr. Hickey, Jr., Mr. Hickey, Sr. and Mr. Rakoff (but not Mr. Scardino), for insider trading of CRMH stock. (Id. ¶¶ 221-28.)
The third claim is lodged against all four Individual Defendants pursuant to Section 20(a) of the Exchange Act ("Section 20(a)"), 15 U.S.C. § 78t(a). (Id. ¶¶ 229-32.) Section 20 is entitled "Liability of controlling persons and persons who aid and abet violations" and provides in pertinent part:
Every person who, directly or indirectly, controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable (including to the Commission in any action brought under paragraph (1) or (3) of section 78u(d) of this title), unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.
15 U.S.C. § 78t(a). In this claim, Plaintiffs allege that,
[b]y virtue of their high-level positions, and their ownership and contractual rights, participation in and/or awareness of the Company's operations and/or intimate knowledge of the false financial statements filed by the Company with the SEC and disseminated to the investing public, the Individual Defendants had the power to influence and control and did influence and control, directly or indirectly, the decision-making of the Company, including the content and dissemination of the various statements which Plaintiffs contend are false and misleading.
Plaintiffs seek damages for their losses "in an amount to be proven at trial," and legal expenses. (Id. ¶ 233.)
Defendants move to dismiss the CAC on two grounds. First, Defendants move to dismiss pursuant to the particularity requirement articulated in both the Private Securities Litigation Reform Act of 1995 ("PSLRA") and Rule 9(b) of the Federal Rules of Civil Procedure ("Fed. R. Civ. P."). Second, Defendants move to dismiss pursuant to Fed. R. Civ. P. 12(b)(6), arguing that the CAC fails to state a claim under Section 10(b). Defendants allege that Plaintiffs have not adequately pleaded (1) loss causation; (2) scienter; and (3) misrepresentation or omission of material facts. Defendants also argue that the Section 20(a) claims should be dismissed because the CAC does not make sufficient allegations to extend "control person liability" to the Individual Defendants.
The Court finds that the CAC does not contain an adequate showing of loss causation or scienter with respect to the Individual Defendants, and thus it must be dismissed pursuant to Fed. R. Civ. P. 12(b)(6) and 9(b) for failure to state a claim upon which relief can be granted and for failure to plead fraud with particularity.
A. New York State Workers' Compensation Laws and the Workers Compensation Board
New York State employers are required to provide workers' compensation coverage for their employees pursuant to the New York Workers' Compensation Law ("WCL"). (CAC ¶ 36.) There are three ways an employer can do this: (1) by subscribing for such coverage by the State Insurance Fund pursuant to WCL § 50.1; (2) by subscribing for such coverage by an insurance carrier authorized in New York pursuant to WCL § 50.2; or (3) by becoming a self-insurer pursuant to WCL § 50.3. N.Y. Workers' Comp. Law § 50 (McKinney 2011). An employer that wishes to self-insure, but lacks the financial ability to do so alone, may join with other employers in a related field to form a GSIT.*fn4 See id.
GSITs are regulated pursuant to Title 12 of the New York Codes, Rules and Regulations ("N.Y.C.R.R.") § 317, and are overseen by the New York State Workers' Compensation Board ("WCB"), a governmental agency created by the WCL, charged with administration of the WCL, and having all the powers and duties set forth in WCL § 142. (CAC ¶ 41.) One purpose of the regulations is to ensure adequate financial strength of the GSIT, and minimize the risk of an interruption in the flow of benefits to injured workers. (Id. ¶ 41.) The WCB regulations require each GSIT to submit financial reports, including independently certified audited financial statements and actuarial reports, to the WCB within 120 days of the close of each fiscal year.*fn5
12 N.Y.C.R.R. § 317.19(a). The WCB uses this information to make a "final determination" concerning the trust's regulatory asset-to-liability ratio. (CAC ¶ 41.) In making this determination, the WCB applies its own regulatory criteria, which differ from those that are part of generally accepted accounting principles ("GAAP"). (See Declaration of Marjorie E. Sheldon, Esq. dated Jan. 7, 2011 ("Sheldon Decl."), Ex. F at 1.) Thus, "a [GSIT's] regulatory funding position may differ, in some cases significantly, from the financial statements prepared in accordance with GAAP" and submitted to the WCB pursuant to 12 N.Y.C.R.R. § 317.19(a)(2). (Id.)
The WCB permits GSITs to grow memberships and use appropriate discounts if their audited financial statements show a trust equity ratio of 90% or more. (CAC ¶ 39.) If the WCB determines that the asset-to-liability ratio is less than 90%, the trust is deemed to be "underfunded," and, pursuant to 12 N.Y.C.R.R. § 317.9(b), the WCB has discretion to subject the GSIT to any or all of seven codified provisions. (Id. ¶ 41.) The provisions are methods of varying intrusiveness by which the WCB attempts to restore the GSIT to health.*fn6 (Id.) If the WCB determines that an underfunded trust "cannot be restored in a timely and appropriate manner," then pursuant to § 317.9(c) the WCB can terminate the GSIT. (Id. ¶ 42.)
The board of trustees of a GSIT has responsibility for ensuring that the GSIT adheres to the WCL and all applicable rules and regulations. (Sheldon Decl., Ex. L at 15.) The trustees must coordinate and oversee the services of any parties providing services to the group. (Id.) A GSIT may hire licensed third-party administrators ("TPAs"), group administers, and various professionals to help the GSIT to carry out its program and to comply with the WCB regulations. The TPA "is responsible for the administration and defense of workers' compensation claims of members of a[ GSIT]." 12 N.Y.C.R.R. § 317.2(d). The group administrator "is responsible for ensuring compliance with the provisions of these rules and the coordination of outside services including but not limited to claims processing, loss control and legal, accounting, and actuarial services." 12 N.Y.C.R.R. § 317.2(g) (definition of "group administrator").
B. CRMH's Business and Business Practices
CRMH was a provider of workers' compensation insurance products, operating two main lines of business: one fee-based, and one risk-based. In the risk-based business, subsidiaries of CRMH -- like Twin Bridges -- underwrote workers' compensation insurance policies. (Id. ¶ 51.) However, this lawsuit focuses primarily on the "fee-based" side of CRMH's business in New York, a business that CRMH has since left.
CRM provided a broad range of fee-based services to the GSITs CRMH administered.*fn7
"These services included, among others, general management, underwriting, risk assessment, medical bill review and case management, general recordkeeping, regulatory compliance . . . and claims management services." (Id. ¶ 48.) By 2002, CRM was providing fee-based TPA and group administration services to eight GSITs in New York, covering a variety of industries.*fn8 (Id. ¶¶ 3, 46.)
The fee-based business was very important to CRMH. (Id. ¶ 49.) For example, in the first nine months of 2005, fees for management-based services accounted for approximately 83% of CRMH's total revenues and approximately 74% of its net income. (Id.) Furthermore, one trust, the Healthcare Industry Trust of New York ("HITNY"), accounted for about half of CRMH's New York trust administration business. (Id. ¶ 8.) The fees from two other trusts -- the Elite Contractors Trust of New York ("ECTNY") and the Transportation Industry Workers' Compensation Trust ("TRIWCT") -- provided a significant portion of the balance of CRMH's net income, so that a large amount of CRMH's business was dependent on these three trusts. (Id. ¶ 50.)
CRMH did not perform all of the services that each GSIT needed. Independent of CRM, as required by 12 N.Y.C.R.R. § 317.19(a)(3), actuary Charles Gruber ("Gruber") of the actuarial firm SGRisk, LLC ("SGRisk") performed actuarial services for each of the trusts. (Id. ¶¶ 7, 52.) Upon notification and examination of the injury claims filed by the trusts' members, CRM did establish initial loss reserve amounts. (Id. ¶ 52.) These initial loss reserve amounts were relied upon by the trusts' independent actuary in estimating the trusts' future claim liability. (Id.) In addition, by virtue of its administrative role for the GSITs, CRM was responsible for coordinating the preparation of each trust's financial statements and corresponding financial footnotes, which were audited by an independent certified public accountant. See 12 N.Y.C.R.R. §§ 317.2 & 317.19(a)(2). UHY LLP ("UHY") acted as an independent accountant for the trusts administered by CRM. (Id. ¶¶ 7, 52.) It was UHY's responsibility to ensure that the claims liability/expense amounts reported by CRM were accurate.*fn9 (Id. ¶ 53.)
C. Significant Events Before, During, and After the Class Period
1. Events Before the Class Period
In December of 2002 the WCB reached a determination that HITNY was
"under-funded." (Sheldon Decl., Ex. C at 9.)
On January 29, 2003 PriceWaterhouseCoopers ("PwC") issued a report on
GSIT HITNY that had been commissioned by the WCB. (Sheldon Decl., Ex. Q.) The report found that the "loss and loss expense reserves
reported by HITNY as of September 30, 2002 are inadequate by
$4,912,943." (Id. at 3.) The CAC alleges that, in response to the PwC
report, Mr. Hickey, Jr. hired Jeffrey Kadison of Practical Actuarial
Solutions to perform an audit on HITNY that would discredit PwC's
audit, and indicated to Kadison that he wanted to "make sure that the
door didn't close" on HITNY. (CAC ¶¶ 87(b),
187; Sheldon Decl., Ex. C at 9.) Still, CRMH worked with the WCB to
cure the problem, and in June 2003, HITNY agreed to a Consent Order
and Consent Agreement with the WCB that placed certain restrictions on
HITNY for an eleven-month period ending on March 31, 2004. (Sheldon
Decl., Ex. C at 10.) HITNY ended its 2004 fiscal year ("FY") with a
95% asset-to-liability ratio. (CAC ¶ 54.)
At the September 27, 2005 HITNY Board of Trustees meeting, attended by Mr. Scardino, internal statements were distributed from August 31, 2005 showing an 87.4% asset ratio in the trust. (Sheldon Decl., Ex. D.*fn10 ) At the meeting, Gruber stated that "[o]n older claims, the incurred losses are higher than had been previously calculated. However there have been other improvements in the underwriting process and newer claims appear to be developing and closing at decreased amounts than previous claims." (Id.) Additionally, "CRM admitted that the assurances made in years past that '[CRM's] development factors would be better than New York State averages' were incorrect." (Id.; CAC ¶ 87(d).) On motion, the board of HITNY approved an 8% member assessment for the 2004-2005 fiscal year. (Sheldon Decl., Ex. D.)
At the November 1, 2005 HITNY Board of Trustees meeting, attended by Mr. Scardino, CRM distributed preliminary year-end statements to the HITNY Board of Trustees which indicated that HITNY had a funding level of 83.4% including the 8% assessment proposed to members for the fiscal year. (Id.) "It was noted that the board expressed their concern at the drastic decrease of the funding status from the immediate past period interim financial statements as presented by CRM." (Sheldon Decl., Ex. D.)
2. The December 21, 2005 CRMH IPO
On December 21, 2005 -- the first day of the putative Class Period -- CRMH became a public company, selling 8,850,000 shares of common stock in their Initial Public Offering ("IPO"). (CAC ¶ 31.) The stock sold at $13.00 per share and returned a gross of $115,050,000. (Id.) Three of the Individual Defendants sold a significant amount of stock at the December IPO: Mr. Hickey, Jr. sold 509,000 shares for proceeds of $6.617 million, (id. ¶ 180); Mr. Hickey, Sr. sold 630,000 shares for proceeds of $8.19 million, (id. ¶ 183); and Mr. Rakoff sold 509,000 shares for proceeds of over $6.6 million, (id. ¶ 182).
The IPO Registration Statement, which the Individual Defendants signed, included CRMH's financial results*fn11 for FYs 2000-2004, and the first nine months of FY 2005. (Id. ¶ 81.) In the IPO Underwriting Agreement, which was attached to the Registration Statement, CRMH stated that none of the GSITs except PETNY "is currently deemed 'underfunded' as determined by the [WCB]." (Id. ¶ 86.)
The Registration Statement highlighted the extent to which CRMH's business was dependent on HITNY, ECTNY, and TRIWCT, and noted the potential harm if the Company were to lose one of these trusts or if the Company were to underestimate liabilities. (Id. ¶¶ 83, 85.) Specifically, it stated: To the extent the loss reserves for any of our managed groups is insufficient to cover such group's actual losses and loss adjustment expenses, the group will have to adjust its loss reserves and it may incur charges to its earnings, which could have a material adverse effect on its financial condition and cash flows and could require the group to assess its members. This could expose us to liability for our management of the group, have a negative impact on our future management of the group, and adversely affect our reputation as a manager.
(Id. ¶ 85.) In addition, CRMH cited its practice of "individually analyzing the appropriate premium for each member of a group . . . [in] attempts to determine premiums that are sufficient to cover the expected losses . . . ." (Id. ¶ 63.) CRMH also represented that, "[w]e attempt to make contact with the injured worker, treating physician and employer with 24 hours after receiving a claim [so as to] mitigate claims and loss adjustment expenses and identify potential fraud," (id. ¶ 75), and stated that that it provided "Independent Medical Examinations . . . for verification of the medical diagnosis and treatment plan for injured workers" (id. ¶ 79).
3. Events Preceding the February 8, 2007 CRMH SPO
At the January 10, 2006 HITNY Board of Trustees Meeting the board of HITNY agreed by common consent to do a complete review of actuarial services for HITNY.*fn12 (Sheldon Decl., Ex. D.)
On or about March 17, 2006 New York Marine and General Insurance Co. and Midlands Claim Administrators, Inc. performed an audit on CRM for HITNY and two other CRM GSIT accounts. (CAC ¶ 94.) It found that (1) after the initial reserve, many reserves were changed in small amounts (stair-stepping) as the file progressed*fn13 ; (2) CRM had a practice of reserving claims in which non-scheduled permanent disability is anticipated for two years of disability benefits, which delayed the setting of proper permanent disability reserves; (3) there was little evidence that the adjusters were making a decision regarding the final reserves necessary early in the claim files; and (4) in most of the claim files, the loss reserve at 180 days was inadequate. (Id.)
On March 27, 2006, CRMH issued a press release announcing its fourth quarter ("Q4") 2005 and FY 2005 financial results. Therein, Mr. Hickey stated that "[w]e could not be more excited about our future prospects given the market opportunities in front of us and the strong financial condition in which we have placed ourselves." (Id. ¶ 88.)
On March 29, 2006, CRMH filed its 2005 10-K form with the SEC, which was signed by each of the Individual Defendants. (Id. ¶ 89.) The 10-K once again highlighted the fact that a significant amount of the Company's existing business was dependent on a relatively small number of GSITs, including HITNY, (id. ¶ 90), and noted the potential harm to the Company if it were to underestimate GSIT liabilities (id. ¶ 91). A copy of the IPO Underwriting Agreement for the December 2005 IPO was attached to the 10-K, and was signed by Mr. Hickey, Jr., Mr. Hickey, Sr., and Mr. Rakoff. (Id. ¶ 93.) It repeated the assertion that none of the trusts except PETNY "is currently deemed 'underfunded' as determined by the [WCB]." (Id. ¶¶ 86, 93.)
On April 13, 2006, the WCB sent a letter to CRM stating its final determination with respect to HITNY's 2005 GAAP financial statements. (Sheldon Decl., Ex. F.) The WCB found that with regulatory adjustments, the trust's final ratio was 81.6%, and as a result, deemed the trust underfunded. (Id.; CAC ¶ 87(e)) Worker's Compensation, The University of Wisconsin System, http://www.wisconsin.edu/oslp/wc/polpro/ wcguide1.htm (last visited May 2, 2012) (emphasis added).
At the April 26, 2006 HITNY Board of Trustees meeting, attended by Mr. Scardino, the Trustees discussed with CRM the possibility of changing actuarial services, by replacing SGRisk with Milliman, Inc. ("Milliman"). (CAC ¶ 99; Sheldon Decl., Ex. D.) They also discussed the WCB's determination that HITNY was underfunded. (Sheldon Decl., Ex. D.)
On May 9, 2006, CRMH issued a press release announcing its Q1 2006 financial results. (CAC ¶ 95.) Therein, Mr. Rakoff stated, "[i]n the first quarter of 2006, our fee-based workers' compensation businesses in both New York and California grew more slowly than anticipated." Mr. Hickey, Jr. added that, "[t]hus far 2006 has presented some challenges to the growth of our fee-based business. Nonetheless, the fundamentals of our business model remain sound and we believe the longer term prospects remain similar to those we envisioned at the start of the year . . . ." (Id.) On the same day, CRMH held a conference call with industry analysts to discuss the Company's Q1 2006 financial results. (Id. ¶ 96.) Defendants Mr. Hickey, Jr., Mr. Rakoff, and Mr. Scardino were present. (Id.) During the call, Mr. Hickey, Jr. described underwriting as one of the Company's "core disciplines," (id. ¶ 65(a)), and stated, "[w]e have the utmost confidence in the fundamentals of our [business] model and recognize that the key to successful and profitable growth is increasing both the number of programs and the number of brokers." (Id. ¶ 97.)
On May 12, 2006, CRMH filed its Q1 2006 10-Q form with the SEC, which was signed by Mr. Hickey, Jr., Mr. Rakoff, and Mr. Scardino. (Id. ¶ 98.) Therein, the Company, in relevant part, stated that "New York is in the process of reevaluating regulations relating to the formation of new [GSITs]. This has led to a temporary moratorium on the formation of new groups." (Id.) It went on to state, "[w]e believe growth in our New York business will occur as a result of increases in the number of members in our existing groups and recently approved manual rate increases" by the WCB averaging 5%, effective October 2005. (Id.) In addition, "manual rates across the industries in which we have formed self-insured groups will increase by approximately 8% on average ...