Greebel v. FTP Software, Inc.
Case Date: 10/08/1999
Court: United States Court of Appeals
Docket No: 98-2194
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For the First Circuit No. 98-2194 LAWRENCE M. GREEBEL, RICHARD CRANE, BRIAN D. ROBINSON, and JOHN and ANN SOMERS on behalf of themselves and all others similarly situated, Appellants, v. FTP SOFTWARE, INC.; ROBERT W. GOODNOW, Jr.; PENNY C. LEAVY; DOUGLAS F. FLOOD; JONATHAN RODIN; CHARLOTTE H. EVANS; and DAVID H. ZIRKLE, Appellees. APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF MASSACHUSETTS [Hon. Joseph L. Tauro, U.S. District Judge] Before Torruella, Chief Judge, Noonan and Lynch, Circuit Judges. Stephen Moulton, with whom Nancy Freeman Gans and Moulton & Gans, LLP, and Sanford P. Dumain, with whom Samuel H. Rudman and Milberg Weiss Bershad Hynes & Lerach LLP, were on brief, for appellants. Bruce G. Vanyo, with whom Jerome F. Birn, Jr., Rebecca A. Mitchells, and Wilson Sonsini Goodrich & Rosati, were on brief for appellee FTP Software, Inc. Jeffrey B. Rudman, with whom Peter J. Macdonald and Hale and Dorr LLP, were on brief, for individual appellees. Harvey J. Goldschmid, General Counsel, Jacob H. Stillman, Solicitor, Eric Summergrad, Deputy Solicitor, and Luis de la Torre, Attorney, on brief for amicus curiae Securities and Exchange Commission. October 8, 1999 LYNCH, Circuit Judge. This case requires us for the first time to interpret the provisions of the Private Securities Litigation Reform Act of 1995, 15 U.S.C. 78u-4. Plaintiffs, purchasers of FTP Software stock from July 14, 1995 to January 3, 1996, brought suit under sections 10(b) and 20(a) of the Securities Exchange Act of 1934, 15 U.S.C. 78j(b), 78t(a). During the period of plaintiffs' purchases, the stock reached a high of $38.875 per share. On January 4, 1996, the company announced that sales growth had declined and that it would have lower earnings. That same day, the stock price fell 52% on heavy trading, from $25.25 to $11.875 per share. By August 9, 1996, the stock price was $8 per share. Plaintiffs' suit was filed on March 3, 1996. It was dismissed on September 24, 1998. See Greebel v. FTP Software, Inc., 182 F.R.D. 370, 376 (D. Mass. 1998). We affirm the dismissal of the complaint under the standards we now adopt: 1. The PSLRA imposes requirements for pleading with particularity that are consistent with this circuit's prior rigorous requirements for pleading fraud with particularity under Fed. R. Civ. P. 9(b). 2. The PSLRA mandates neither the adoption nor the rejection of particular patterns of evidence to prove fraud and scienter, and thus does not alter this circuit's prior law on these points. 3. The PSLRA does, significantly, impose a requirement that pleadings raise a "strong" inference of scienter rather than a merely "reasonable" inference of scienter. 4. The PSLRA does not alter the previous definition of scienter, one that in this circuit includes a narrowly defined concept of recklessness which does not include ordinary negligence, but is closer to being a lesser form of intent. I The district court denied defendants' first motion to dismiss largely on the basis of the complaint's allegations that defendants had routinely "whited out" the contingency terms inserted by customers into purchase orders; this was allegedly done in furtherance of a scheme to inflate revenues by improperly booking contingent transactions as final sales. After limited discovery, the district court concluded that plaintiffs could not prove the white-out claims and entered judgment on those claims. The defendants renewed their motion to dismiss the complaint, and the plaintiffs, in response, sought to make their allegations of fraud more specific by referring to discovered documents, but did not formally move to amend. The district court dismissed the complaint with prejudice, thus effectively denying the plaintiffs an opportunity to amend their complaint. The court did so without deciding whether, in light of the new evidence and allegations, the complaint was adequate to survive. Plaintiffs appeal saying that summary judgment on the white-out allegations was inappropriate; that they are given refuge by Rule 56(f); that the dismissal of the remaining allegations was improper; and that they were entitled to amend their complaint. II The complaint alleges the following. FTP Software, Inc. develops, markets, and supports Internet and Intranet software for personal computers and networks. By the beginning of the Class Period (from July 14, 1995 to January 3, 1996), the demand for FTP's software was diminishing because many of FTP's clients were either developing the technology themselves or acquiring competing systems from other manufacturers, such as Microsoft and Netscape. Microsoft, for example, was incorporating networking capabilities into its new Windows 95 software, free of additional charge. In addition, FTP was struggling to keep pace with "revolutionary" technological developments that threatened to render its software obsolete. In response, FTP and several of its directors and officers through fraudulent schemes inflated FTP's stock price and then made various false statements and material omissions. Plaintiffs allege that FTP failed to disclose the threats to its continued success, as well as several "questionable" sales practices. These included the making of "warehouse shipments" -- that is, booking a fictitious sale of a product to a non-existent buyer, shipping that product to a warehouse for storage, and then eventually returning it to FTP. According to plaintiffs, one FTP employee who complained about these shipments, and who refused (in at least one instance) to sign for the product return, was dismissed as a result of his protest, all before the Class Period. Other objectionable sales practices included excessively discounted sales (as high as 90%) and "channel stuffing" activity that compressed sales and orders into the final weeks of a fiscal quarter, with the intention of "cosmetically" improving the reported results for that quarter. Finally, plaintiffs say that FTP failed to disclose its practice of inducing distributors to purchase more product than they needed by promising that the distributors could return the unsold product. Distributors would send their orders to FTP with a notation that they were entitled to return any unsold product. FTP then booked these sales as revenue, but because FTP understood that recognizing such sales as revenue was improper (because of a right of return existed), it allegedly instructed the sales force to white-out these right-of-return notations on the distributors' order forms. FTP also made several statements that the plaintiffs characterize as false or materially misleading. On July 14, 1995, the first day of the Class Period, David Zirkle, FTP's President and Chief Executive Officer, reported FTP's financial performance results for the second fiscal quarter of 1995. Zirkle declared: "We are pleased with our performance for the second quarter. Sales continue to be strong in both our U.S. and international channels." Zirkle also touted the release of several new products, stating that "[t]hese products should help us achieve our revenue objective for the second half of 1995." Plaintiffs argue that these comments "falsely convey[ed] the impression that sales were, and would continue to be, healthy and strong" and that this false impression was deliberately aided by FTP's failure to disclose that in or around January 1995, the French Post Office canceled its planned purchase of $10 million of FTP products "due to the impending release of 'Windows '95.'" On the same day, Zirkle discussed FTP's impending corporate "reconfiguration" into two business units. He predicted that "FTP Software [would] lead the market in providing applications and support that make it possible to share information and access resources across workgroups, LAN's, enterprise networks and the global Internet." After this announcement, FTP's stock fell from $31.75 to $28.25. Zirkle dismissed this decline as merely "a 'knee-jerk' reaction to the short-term impact of the restructuring on earnings," and on the next trading day, the stock recovered, closing at $30.875. Plaintiffs argue that these comments were misleading because Zirkle did not disclose that FTP's costly investments in its reorganization would have to be continued over the long term. FTP's management team next met with "the investment community and with securities analysts" to promote the company's products and stock. One securities firm rated FTP as a "long-term buy." Plaintiffs assert that this report "and the estimates contained therein were based upon communications with the management of FTP and were of a nature that could only have been provided (or be based on specific information provided) by [FTP] and its management." Meanwhile, several of the individual defendants sold some of their FTP stock. In total, the six individual defendants sold over $23 million in stock during the Class Period. Zirkle made another false statement, plaintiffs say, on October 25, 1995, when he reported FTP's financial results for the third quarter of fiscal year 1995: This was another excellent quarter for FTP. Sales continue to grow both in our U.S. and international channels . . . . Our new ventures are also off to a good start with revenues of $2.7 million. . . . These new products have been well received by our channel partners and customers and will help us in our efforts to achieve fourth quarter revenue objectives. Plaintiffs assert that the "new ventures" Zirkle referred to were failing to generate the expected new business. On November 15, 1995, FTP filed its Form 10-Q report for the third quarter of 1995 with the SEC. The report revealed a dramatic increase in accounts receivable for the fiscal year ending on December 31, 1994. FTP explained that: Such an increase is primarily attributable to increased unit sales and a relative increase, during the third quarter of 1995, in the number of units shipped during the last month of such quarter compared to prior quarters. The Company believes that it may continue to experience such a relative increase as it continues to grow, as is typical in the software industry. Plaintiffs claim that the 10-Q report, and these statements, were false and misleading because the increased unit sales were subject to the purchasers' right to return unsold merchandise and were not the result of FTP's growth. FTP continued the "drumbeat" of misleading positive statements, according to plaintiffs, when Zirkle, speaking in an interview published in the November 27 - December 3, 1995 issue of Mass High Tech, said that "[t]he networking business (TCP/IP) is a cash cow that is feeding the development of other businesses, which are feeding back new technology that makes the core business even better." In December 1995, two other securities firms issued positive reports on FTP; after these statements, FTP's stock rose. Finally, the complaint alleges, the "truth [began] to emerge" on January 4, 1996, when FTP announced that its earnings for the fourth fiscal quarter of 1995 would be less than the same period in 1994. FTP stated that this decline reflected, in part, the company's investment in its New Ventures Business Unit, but, nonetheless, the company's stock fell $13.375 per share to close at $11.875 per share (a one-day decline of 52%). Plaintiffs emphasize that this decline represented a $27 drop in market value (an approximately 70% decrease) from a Class Period high of $38.875 per share. III On March 3, 1996, plaintiffs brought suit against FTP and the individual defendants for violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The defendants moved to dismiss. The procedural history was recited above. The district court ultimately granted summary judgment on the white-out allegations because plaintiffs' only witness, Ms. Trudy Nichols, was unavailable and her testimony was potentially inadmissible (as hearsay). Furthermore, the plaintiffs did not establish that the defendants had ordered the alteration of any documents. The district court also granted the defendants' renewed motion to dismiss. The court found that the complaint failed to plead the circumstances of fraud with specificity, and could not even meet the pleading standards required to establish scienter under Fed. R. Civ. P. 9(b). IV Interpretation of the PSLRA The enactment of the PSLRA in 1995 marked a bipartisan effort to curb abuse in private securities lawsuits, particularly the filing of strike suits. See H.R. Conf. Rep. No. 104-369, at 32 (1995), reprinted in 1995 U.S.C.C.A.N. 730, 731. The PSLRA restated the requirements for securities fraud actions at subsections 21D(b)(1) and (2), codified at 15 U.S.C. 78u-4(b)(1)-(2). Those provisions, involved here, read as follows: (b) Requirements for securities fraud actions (1) Misleading statements and omissions In any private action arising under this chapter in which the plaintiff alleges that the defendant - (A) made an untrue statement of a material fact; or (B) omitted to state a material fact necessary in order to make the statements made, in the light of the circumstances in which they were made, not misleading; the complaint shall 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. (2) Required state of mind In any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this chapter, 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)(1)-(2). The parties and the SEC as amicus have framed different possible interpretations of these provisions. Essentially, these questions are raised: First, did the PSLRA alter the standards for pleading fraud with particularity previously adhered to by this circuit? Second, did the PSLRA restrict the characteristic patterns of facts that may be pleaded in order to establish a "strong inference" of scienter? Specifically, are the two methods of showing scienter endorsed earlier by the Second Circuit -- motive and opportunity or circumstantial evidence of reckless or conscious behavior sufficient to raise a "'strong inference' of fraudulent intent," see, e.g., In re Time Warner Inc. Sec. Litig., 9 F.3d 259, 268-69 (2d Cir. 1993) (quoting O'Brien v. National Property Analysts Partners, 936 F.2d 674, 676 (2d Cir. 1991) (internal quotation marks omitted)) -- now available? Third, did the PSLRA alter the scienter requirement for actions under section 10(b) and Rule 10b-5, 17 C.F.R. 240.10b-5? Specifically, is some form of recklessness sufficient to satisfy the scienter requirement? The parties and amicus all rely heavily on competing excerpts from the congressional history of the Act and on the pre- Act case law from the Second Circuit. The words of the statute are the first guide to any interpretation of the meaning of the statute. The usual maxim is that courts do not go beyond the text of the statute if the meaning is plain. See United Food & Commercial Workers Union, Local 328 v. Almac's Inc., 90 F.3d 1, 5 (1st Cir. 1996). But that maxim has inherent flexibility. Even seemingly straightforward text should be informed by the purpose and context of the statute. See Stafford v. Briggs, 444 U.S. 527, 535 (1980); Puerto Rico Tel. Co. v. Telecommunications Regulatory Bd., No. 98-2228, 1999 WL 618061, at *6 (1st Cir. Aug. 19, 1999). Both this court and the Supreme Court have checked a sense of a statute's plain meaning against undisputed legislative history as a guard against judicial error. See, e.g., Bob Jones Univ. v. United States, 461 U.S. 574, 586 (1983) ("It is a well-established canon of statutory construction that a court should go beyond the literal language of a statute if reliance on that language would defeat the plain purpose of the statute . . . ."); Cablevision of Boston v. Public Improvement Comm'n, 184 F.3d 88, 101 (1st Cir. 1999). If the meaning is not plain from the words of the statute, then resort to legislative history is required. See Akins v. Penobscot Nation, 130 F.3d 482, 488 (1st Cir. 1997). On some of the points neither text nor history is indisputably clear. The legislative history is irretrievably conflicted as to the second issue -- which characteristic patterns of facts may be pleaded in order to establish a "strong inference" of scienter -- with all sides finding some support for their positions. About all that can be said with confidence on that issue is that Congress agreed on the need to curb abuses, that it attempted to do so in the guise of what are articulated as procedural requirements, and that there was agreement on the words of the statute and on little else. And so we return to the text of the statute and its purpose. A. Pleading Standards for Fraud Allegations The text of the Act requires now that any complaint alleging that a statement or omission is misleading must: 1. specify each statement alleged to have been misleading, 2. [specify] the reason or reasons why the statement is misleading, 3. and, if an allegation regarding the statement or omission is made on information and belief, . . . state with particularity all facts on which that belief is formed. 15 U.S.C. 78u-4(b)(1). The effect of this is to embody in the Act itself at least the standards of Rule 9(b), Fed. R. Civ. P. Before the PSLRA, a securities fraud claim had to meet the standards set by Rule 9(b). See Simcox v. San Juan Shipyard, Inc., 754 F.2d 430, 439 (1st Cir. 1985). Rule 9(b) provides that "[i]n all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity. Malice, intent, knowledge, and other condition of mind of a person may be averred generally." Fed. R. Civ. P. 9(b). This circuit has interpreted Rule 9(b) to require "specification of the time, place, and content of an alleged false representation." McGinty v. Beranger Volkswagen, Inc., 633 F.2d 226, 228 (1st Cir. 1980). "Even where allegations are based on information and belief, supporting facts on which the belief is founded must be set forth in the complaint. And this holds true even when the fraud relates to matters peculiarly within the knowledge of the opposing party." Hayduk v. Lanna, 775 F.2d 441, 444 (1st Cir. 1985) (internal quotation marks and citations omitted). The PSLRA's pleading standard is congruent and consistent with the pre-existing standards of this circuit. This circuit has been notably strict and rigorous in applying the Rule 9(b) standard in securities fraud actions. See Maldonado v. Dom |