Wilensky v. Digital
Case Date: 05/07/1996
Court: United States Court of Appeals
Docket No: 95-1995
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United States Court of Appeals For the First Circuit ____________________ No. 95-1995 MERRY LOU SHAW, ET AL., Plaintiffs, Appellants, v. DIGITAL EQUIPMENT CORP., ET AL., Defendants, Appellees. ____________________ No. 95-1996 LEONARD WILENSKY, ET AL., Plaintiffs, Appellants, v. DIGITAL EQUIPMENT CORP., ET AL., Defendants, Appellees. ____________________ APPEALS FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF MASSACHUSETTS [Hon. Joseph L. Tauro, U.S. District Judge] ___________________ ____________________ Before Torruella, Chief Judge, ___________ Cyr and Lynch, Circuit Judges. ______________ ____________________ Sanford P. Dumain, with whom David J. Bershad, James P. __________________ _________________ _________ Bonner, Milberg, Weiss, Bershad, Hynes & Lerach, Glen DeValerio, ______ ________________________________________ ______________ Kathleen Donovan-Maher, Berman, DeValerio & Pease, Richard _______________________ _____________________________ _______ Schiffrin, Schiffrin & Craig, Ltd., Joseph D. Ament, and Much, _________ ________________________ _______________ _____ Shelist, Freed, Denenberg, Ament, Bell & Rubenstein, P.C., were ___________________________________________________________ on brief, for the Shaw appellants. ____ Thomas G. Shapiro, with whom Edward F. Haber, Shapiro, ___________________ ________________ ________ Grace, Haber & Urmy, Glen DeValerio, Kathleen Donovan-Maher, _____________________ _______________ _______________________ Berman, DeValerio & Pease, Fred Taylor Isquith, Peter C. Harrar, _________________________ ___________________ _______________ Wolf, Haldenstein, Adler, Freeman & Herz, L.L.P., Richard _______________________________________________________ _______ Bemporad, and Lowey, Dannenberg, Bemporad & Selinger, P.C., were ________ _____________________________________________ on brief, for the Wilensky appellants. ________ Edmund C. Case, with whom Jordan D. Hershman, Deborah S. _______________ ___________________ ___________ Birnbach, Testa, Hurwitz & Thibeault, John D. Donovan, Jr., ________ ____________________________ ______________________ Randall W. Bodner, Daniel J. Klau, and Ropes & Gray were on __________________ _______________ _____________ brief, for the Shaw appellees. ____ Edmund C. Case, with whom Jordan D. Hershman, Deborah S. _______________ ___________________ __________ Birnbach, Testa, Hurwitz & Thibeault, John D. Donovan, Jr., ________ ____________________________ ______________________ Randall W. Bodner, Daniel J. Klau, Ropes & Gray, Gerald F. Rath, _________________ ______________ _____________ ______________ Robert A. Buhlman, Bingham, Dana & Gould, Michael J. Chepiga, _________________ ______________________ ___________________ Daniel A. Shacknai, and Simpson, Thacher & Bartlett were on ___________________ _____________________________ brief, for the Wilensky appellees. ________ ____________________ May 7, 1996 ____________________ LYNCH, Circuit Judge. Plaintiffs, purchasers of the _____________ securities of Digital Equipment Corp., appeal from the district court's dismissal of two consolidated class actions alleging violations of the federal securities laws. Both complaints assert that there were misleading statements and nondisclosures in the registration statement and prospectus prepared in connection with a public offering of stock. That offering commenced on March 21, 1994, just 11 days prior to the close of the quarter then in progress, and about three weeks prior to the company's announcement of an unexpectedly negative earnings report for that quarter. One of the complaints further alleges that defendants made fraudulently optimistic statements to the public in the period leading up to the offering. The district court found that neither complaint identified any statements or omissions actionable under the securities laws and dismissed both for failure to state a claim. We agree that many of the alleged misstatements and omissions do not provide a legally cognizable basis for the plaintiffs' claims, but we also conclude that a limited set of allegations in both complaints relating to the registration statement and prospectus for the March 1994 offering does state a claim. We further find that the surviving portions of the complaints satisfy the pleading requirements of Fed. R. Civ. P. 9(b). Accordingly, we affirm the district court's decision in part, reverse in part, and remand for further proceedings. -3- I. Background __________ Digital Equipment Corporation ("DEC") is one of the world's largest suppliers of computer hardware, software and services. Founded in 1957, it first became a publicly held company in 1966. By the early 1990's, the company's success had burgeoned into $14 billion in yearly revenues. The company's success story, however, would not last forever. By 1992, the company had fallen on hard times. In January 1992 it reported its first-ever quarterly operating loss of $138.3 million. Faced in the ensuing months with operating losses in the range of $30 million to $311 million per quarter, the company decided to engage in radical surgery, cutting loose some 35,000 employees over the course of 15 months in the process, including its founder and CEO. To cover the costs of these actions, the company accumulated "restructuring" charges totalling close to $3.2 billion in fiscal years 1990-1992 combined. In the midst of its financial woes, however, the company took some steps to restore its health. In February 1992, DEC had introduced a new product, the "Alpha" chip. The Alpha chip was hailed as a technological advance that could potentially restore the company's fortunes. In mid-1992, the company installed a new CEO, Robert B. Palmer. He took the helm in the fall of that year, as the company continued to implement strategies to help its Alpha technology gain acceptance in the -4- marketplace and to bring the company back to financial vitality. At the time Palmer took over, the company had absorbed over $3 billion in losses for the prior three years and had been losing money at the rate of approximately $3 million per day. Under the new management, it appeared that the company's financial hemorrhaging had finally begun to slow. On January 14, 1993, DEC reported a loss for the second quarter of fiscal year 1993 that was far smaller than had been anticipated by analysts. That promising result was followed by another quarter of losses, but within Wall Street's expectations. Then, on July 28, 1993, the company announced its first profitable quarter since before the 1992 fiscal year, reporting a net profit of $113.2 million for the fourth quarter of fiscal year 1993. That result was slightly below analysts' expectations, but a stark improvement over the operating loss of $188.1 million (and overall loss of $2 billion) reported for the comparable quarter in the prior year. Still, on October 20, 1993, DEC announced a loss of $83.1 million for the first quarter of 1994, an improvement over the $260.5 million loss for the same quarter the prior year, but worse than analysts had been predicting. On January 19, 1994, the company announced another setback, reporting losses for the second quarter of fiscal year 1994, ending January 1, 1994, of $72 million. The loss was worse than analysts had expected and was virtually identical to the losses for that period the prior year. -5- It was against this backdrop that DEC, on January 21, 1994, filed with the SEC a "shelf" registration statement giving the company the option to issue up to $1 billion in various classes of debt and equity securities. Two months later, DEC through its underwriters conducted an offering of $400 million in depositary shares of preferred stock, pursuant to the "shelf" registration, a prospectus dated March 11, 1994, and a prospectus supplement dated March 21, 1994. The offering commenced on the date of the prospectus supplement and closed one week later on March 28, 1994, four days before the end of the third fiscal quarter. All 16 million depositary shares of preferred stock were sold, at an offering price of $25. DEC raised a badly needed $387.4 million.1 Less than three weeks later, on April 15, 1994, DEC announced an operating loss of over $183 million for the quarter that had ended on April 2, 1994. This third quarter loss was far greater than analysts had been expecting, and the largest that the company had reported since the first quarter of fiscal 1993. It bucked the positive trend of reduced losses under the company's new management. The announcement sent the price of the newly distributed preferred stock tumbling from the offering price of $25 to $20.875 by the close of trading on April 15. The common stock fell from $28.875 to $23 during the ____________________ 1. Because the offering was conducted pursuant to a "firm commitment" underwriting arrangement, DEC sold all of the offered shares to the underwriters at a discount, who then in turn sold the shares to the public. Thus, DEC's proceeds were less than the total offering amount. -6- same period, and to $21.125 by the close of the next trading day. In its April 15 announcement, the company also disclosed that it had decided to "accelerate [its] on-going restructuring efforts" and "also consider further restructuring." This was despite a representation in the March 21 prospectus supplement that "[t]he Corporation believes that the remaining restructuring reserve of $443 million is adequate to cover presently planned restructuring actions." Eventually, following the close of fiscal year 1994, DEC announced on July 14, 1994 that it would cut almost one-fourth of its remaining workforce and take an additional charge of $1.2 billion for fiscal year 1994 (beyond the $443 million remaining in reserve as of March 21) to cover the costs of additional restructuring activities. II. Description of the Actions __________________________ These two lawsuits were filed on Tuesday, April 19, 1994, two business days after the company's announcement of April 15, 1994. One, the Wilensky action, brought on behalf of ________ all persons who purchased shares in the March 1994 public offering, asserts claims under Sections 11, 12(2), and 15 of the Securities Act of 1933 ("Securities Act") against DEC, its Chief Executive Officer (Robert B. Palmer), its Chief Financial Officer (William Steul), and seven underwriting or investment banking firms, representing a purported defendant class of 65 -7- underwriters who participated in the offering. The second, the Shaw action, advances claims under Sections 10(b) and 20(a) of ____ the Securities Exchange Act of 1934 ("Exchange Act") and Rule 10b-5, and a pendent claim of common law negligent misrepresentation, on behalf of all purchasers of DEC common stock between January 19 and April 15, 1994 (the "Class Period"). At the heart of both complaints are two sets of claims. First, plaintiffs assert that DEC management had knowledge of material facts concerning the large losses developing during the third fiscal quarter of 1994, and that the defendants were under a duty to disclose such material information to the market in connection with the public offering conducted on March 21, 1994. Second, both the Wilensky and Shaw plaintiffs ________ ____ contend that the representation made in the March 21 prospectus supplement concerning the "adequacy" of the then-remaining "restructuring reserve" was materially misleading. The Shaw ____ plaintiffs allege, additionally, that throughout the Class Period, the defendants made fraudulently optimistic statements to the public concerning DEC's future prospects in order artificially to inflate the market value of DEC shares, and that these statements were actionably false or misleading. The defendants filed motions to dismiss under Fed. R. Civ. P. 9(b) and 12(b)(6). The district court consolidated the cases, stayed all discovery, and then dismissed both actions. The district court ruled, inter alia, that defendants had -8- violated no duty to disclose and that the defendants' statements were not misleading, bespoke caution, or were otherwise not actionable as a matter of law. The court granted the defendants' motions to dismiss under Rule 12(b)(6), without reaching whether the complaints satisfied the pleading requirements of Rule 9(b). These appeals followed. We affirm in part and reverse in part. For clarity, we discuss each of the two actions in turn. III. The Section 11 and 12(2) Claims _______________________________ (Wilensky Action) ________ Sections 11 and 12(2) are enforcement mechanisms for the mandatory disclosure requirements of the Securities Act of 1933. Section 11 imposes liability on signers of a registration statement, and on underwriters, if the registration statement "contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading." 15 U.S.C. 77k. Section 12(2) provides that any person who "offers or sells" a security by means of a prospectus or oral communication containing a materially false statement or that "omits to state a material fact necessary to make the statements, in the light of the circumstances under which they were made, not misleading," shall be liable to any "person purchasing such security from him." 15 U.S.C. 77l(2). -9- The Wilensky plaintiffs assert claims under Sections 11, ________ 12(2), and 15,2 alleging that the registration statement and prospectus filed in connection with the March 1994 public offering contained materially false statements and omitted to state material information required to be provided therein. The thrust of the Wilensky complaint is that defendants knew as ________ of the March 21 date of the 1994 public offering, of material facts portending the unexpectedly large losses for the third quarter of fiscal 1994 that were announced later, and that failure to disclose these material facts in the registration statement and prospectus violated Section 11. Additionally, the Wilensky plaintiffs contend that the statement in the ________ registration statement and prospectus characterizing as "adequate" the company's then-remaining "restructuring reserve" of $443 million was materially false and misleading, in violation of both Sections 11 and 12. The defendants parry by attempting to reduce plaintiffs' claims to an argument that the company was required to disclose its internal forecasts about the outcome of the third quarter. _________ They argue that the plaintiffs' position is untenable because the securities laws impose no duty upon a company to disclose internal projections, estimates of quarterly results, or other forward-looking information. They also say that the statement concerning the adequacy of the company's restructuring reserves ____________________ 2. Section 15 imposes derivative liability upon persons who "control" those liable under Section 11 or 12. See 15 U.S.C. ___ 77o. -10- is not actionably misleading when considered in context. Finally, defendants contend that the complaint fails to allege sufficient facts establishing that DEC and the underwriter defendants were statutory "sellers" subject to liability under Section 12(2). We evaluate each set of arguments separately. A. Actionability of Alleged Nondisclosures Under Section 11 __ ________________________________________________________ The proposition that silence, absent a duty to disclose, cannot be actionably misleading, is a fixture in federal securities law. See, e.g., Backman v. Polaroid Corp., 910 F.2d ___ ____ _______ ______________ 10, 13 (1st Cir. 1990) (en banc). Equally settled is that accurate reports of past successes do not themselves give rise to a duty to inform the market whenever present circumstances suggest that the future may bring a turn for the worse. See ___ Serabian v. Amoskeag Bank Shares, Inc., 24 F.3d 357, 361 (1st ________ ___________________________ Cir. 1994); Capri Optics Profit Sharing v. Digital Equip. _____________________________ _______________ Corp., 950 F.2d 5, 7-8 (1st Cir. 1991). In short, the mere _____ possession of material nonpublic information does not create a duty to disclose it. See Roeder v. Alpha Indus., Inc., 814 ___ ______ ___________________ F.2d 22, 26 (1st Cir. 1987) (citing Chiarella v. United States, _________ _____________ 445 U.S. 222, 235 (1980)). To focus here on a duty to disclose in the abstract, however, would be to miss the obvious in favor of the obscure. This action arises out of an allegedly defective registration statement and prospectus filed in connection with a public stock offering. The obligations that attend the preparation of those filings embody nothing if not an affirmative duty to -11- disclose a broad range of material information. Cf. Herman & ___ ________ MacLean v. Huddleston, 459 U.S. 375, 381-82 (1983). Indeed, in _______ __________ the context of a public offering, there is a strong affirmative duty of disclosure.3 See Ernst & Ernst v. Hochfelder, 425 ___ ______________ __________ U.S. 185, 195 (1976) (the Securities Act "was designed to provide investors with full disclosure of material information concerning public offerings"). The question here is not whether defendants were under an abstract duty to disclose information -- clearly, they were. The issue, rather, is whether the defendants had a specific obligation to disclose information of the type that the plaintiffs complain was omitted from the registration statement and prospectus. The task of deciding whether particular information is subject to mandatory disclosure is not easily separable from normative judgments about the kinds of information that the securities laws should require to be ______ disclosed, which depend, in essence, on conceptions of materiality. See generally Victor Brudney, A Note On ______________ ___________ ____________________ 3. In Roeder, this court alluded to three situations that ______ could give rise to a duty to disclose material facts: (i) when an insider trades in the company's securities on the basis of material nonpublic information; (ii) when a statute or regulation requires disclosure; and (iii) when the company has previously made a statement of material fact that is false, inaccurate, incomplete, or misleading in light of the undisclosed information. Roeder, 814 F.2d at 27; see also In ______ _________ __ re Time Warner, Inc. Sec. Litig., 9 F.3d 259, 267 (2d Cir. __________________________________ 1993), cert. denied, 114 S. Ct. 1397 (1994); Backman, 910 F.2d _____ ______ _______ at 12-13; Greenfield v. Heublein, Inc., 742 F.2d 751, 758 (3d __________ ______________ Cir. 1984), cert. denied, 469 U.S. 1215 (1985). We do not ____________ decide here whether these three situations are the only ones that could trigger a duty of disclosure, or whether they necessarily would do so in every case. -12- Materiality and Soft Information Under the Federal Securities _______________________________________________________________ Laws, 75 Va. L. Rev. 723, 728 (1989). For our purposes, it ____ suffices to say that the determination of whether the alleged nondisclosures in this case provide a legally sufficient basis for the plaintiffs' claims cannot be severed from consideration of the basic policies underlying the disclosure obligations of the applicable statutes and regulations. We conclude that we cannot say that DEC was not required to disclose material information concerning its performance in the quarter in progress at the time of the March 21, 1994 public offering. Nor can we conclude, as a matter of law and on these pleadings, that DEC was not in possession of such material nonpublic information at the time of the offering. 1. The Insider Trading Analogy __ ___________________________ In understanding the nature of the disclosure requirements attending a public offering of stock, it is helpful to conceptualize DEC (the corporate issuer) as an individual insider transacting in the company's securities, and to examine the disclosure obligations that would then arise. There is no doubt that an individual corporate insider in possession of material nonpublic information is prohibited by the federal securities laws from trading on that information unless he makes public disclosure. He must disclose or abstain from trading. See SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, ___ ___ ______________________ 848 (2d Cir. 1968) (en banc), cert. denied, 394 U.S. 976 _____________ (1969); see also SEC v. MacDonald, 699 F.2d 47, 50 (1st Cir. ________ ___ _________ -13- 1983) (en banc). A central justification for the "disclose or abstain" rule is to deny corporate insiders the opportunity to profit from the inherent trading advantage they have over the rest of the contemporaneously trading market by reason of their superior access to information. See Shapiro v. Merrill Lynch, ___ _______ ______________ Pierce, Fenner & Smith, Inc., 495 F.2d 228, 235 (2d Cir. 1974); ____________________________ SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848 (2d Cir. 1968) ___ ______________________ (en banc).4 The rule eliminates both the incentives that insiders would otherwise have to delay the disclosure of material information, and minimizes any efficiency losses associated with the diversion of resources by insiders to "beating the market." See Robert C. Clark, Corporate Law ___ ______________ 8.2, at 273-75 (1986); Frank H. Easterbrook & Daniel R. Fischel, The Economic Structure of Corporate Law 288 (1991) _________________________________________ ("The lure of trading profits may induce people to spend a lot of effort and other resources "beating the market"; . . . [T]he prompt disclosure of information by the affected firm will extinguish the trading opportunity. When everyone knows the truth, no one can speculate on it."5). ____________________ 4. See also Brudney, supra, at 735 (noting that the other _________ _____ major justification for requiring trading insiders to disclose is to increase the quality and quantity of information available to investors, thereby facilitating efficiency in the allocation of capital). 5. Judge Easterbrook and Professor Fischel ultimately reject this beating-the-market concern as a justification for mandatory disclosure. They argue that companies normally will _________ voluntarily disclose material bad news, because, among other reasons, if a company consistently fails to make such disclosure, the market will discount the value of the company's securities by the increased probability that it is in -14- The policy rationale for the "disclose or abstain" rule carries over to contexts where a corporate issuer, as opposed to an individual, is the party contemplating a stock transaction. Courts, including this one, have treated a corporation trading in its own securities as an "insider" for purposes of the "disclose or abstain" rule. See, e.g., ___ ____ McCormick v. Fund American Cos., Inc., 26 F.3d 869, 876 (9th _________ _________________________ Cir. 1994) (collecting cases) ("[T]he corporate issuer in possession of material nonpublic information, must, like other insiders in the same situation, disclose that information to its shareholders or refrain from trading with them."); Rogen v. _____ Ilikon Corp., 361 F.2d 260, 268 (1st Cir. 1966); Kohler v. _____________ ______ Kohler Co., 319 F.2d 634, 638 (7th Cir. 1963); Green v. ___________ _____ Hamilton Int'l Corp., 437 F. Supp. 723, 728-29 (S.D.N.Y. 1977); ____________________ VII Louis Loss & Joel Seligman, Securities Regulation 1505 (3d _____________________ ed. 1991) ("When the issuer itself wants to buy or sell its own securities, it has a choice: desist or disclose."); 18 Donald C. Langevoort, Insider Trading: Regulation, Enforcement & ______________________________________________ Prevention 3.02[1][d], at 5 (3d rel. 1994) ("Issuers __________ themselves may buy or sell their own securities, and have long ____________________ possession of undisclosed material negative information, thereby increasing the company's long-run costs of raising capital. Id. at 288-89. However, as the authors also ___ recognize, the argument for voluntary disclosure becomes considerably weaker in contexts where the short-term interests of the company's managers differ from its long-term interests, for example, where management is under pressure to engineer a rapid turnaround in the company's financial performance. See ___ id. at 169 (discussing the "agency" problem in the context of ___ tender offers). -15- been held to an obligation of full disclosure . . . . Conceptually, extending the insider trading prohibition to instances of issuer insider trading makes perfect sense."). Just as an individual insider with material nonpublic information about pending merger or license negotiations could not purchase his company's securities without making disclosure, the company itself may not engage in such a purchase of its own stock, if it is in possession of such ________ undisclosed information. See, e.g., Rogen, 361 F.2d at 268. ___ ____ _____ By extension, a comparable rule should apply to issuers engaged in a stock offering. Otherwise, a corporate issuer selling its ________ own securities would be left free to exploit its informational trading advantage, at the expense of investors, by delaying disclosure of material nonpublic negative news until after completion of the offering. Cf. Ian Ayres, Back to Basics: ___ ________________ Regulating How Corporations Speak to the Market, 77 Va. L. Rev. _______________________________________________ 945, 959-60 (1991) (describing the argument that securities laws impose needed discipline, because companies do not always internalize the costs of failing to provide the market with accurate information that would lower stock prices). 2. The Statutory and Regulatory Scheme ___________________________________ Analogizing a corporate issuer to an individual insider subject to the "disclose or abstain" rule of insider trading law illustrates the policy reasons supporting a comparably strong disclosure mechanism in the context of a public offering. We look to the explicit statutory and regulatory -16- framework to determine whether the Securities Act provides such a mechanism, and whether the Wilensky complaint states a ________ legally cognizable claim for nondisclosure under Section 11. Section 11 by its terms provides for the imposition of liability if a registration statement, as of its effective date: (1) "contained an untrue statement of material fact"; (2) "omitted to state a material fact required to be stated therein"; or (3) omitted to state a material fact "necessary to make the statements therein not misleading." 15 U.S.C. 77k(a). The plaintiffs' claim of nondisclosure relies on the second of these three bases of liability. That predicate is unique to Section 11; neither Section 12(2) of the Securities Act nor Section 10(b) or Rule 10b-5 under the Exchange Act contains comparable language. It is intended to ensure that issuers, under pain of civil liability, not cut corners in preparing registration statements and that they disclose all material information required by the applicable statutes and regulations. See Huddleston, 459 U.S. at 381-82; Harold S. ___ __________ Bloomenthal et al., Securities Law Handbook 14.08, at 663 ________________________ (1996 ed.) ("Congress . . . devised Section 11 of the Securities Act as an in terrorem remedy that would . . . encourage careful preparation of the registration statement and prospectus."). The information "required to be stated" in a registration statement is spelled out both in Schedule A to Section 7(a)of the Securities Act, 15 U.S.C. 77g(a), 77aa, -17- and in various regulations promulgated by the SEC pursuant to its statutory authority.6 Those rules and regulations are no less essential to the statutory scheme than the general outlines of the statute itself. Cf. Touche Ross & Co. v. SEC, ___ __________________ ___ 609 F.2d 570, 580 (2d Cir. 1979). In this case, DEC conducted its March 1994 public offering pursuant to a registration statement on SEC Form S-3. Item 11(a) of the instructions to Form S-37 requires that the issuer (registrant) describe in the portion of the registration statement comprising the prospectus: any and all material changes in the registrant's _________________________________________________ affairs which have occurred since the end of the _______ latest fiscal year for which certified financial statements were included in the latest annual report to security holders and which have not been described in a report on Form 10-Q or Form 8-K filed under the Exchange Act. Instructions to Form S-3, Item 11(a) (emphasis added). To understand the scope of the "material changes" disclosure requirement, it is helpful to understand the nature ____________________ 6. Section 7(a) of the Securities Act provides that the "registration statement shall contain such other information, and be accompanied by such other documents, as the Commission may by rules or regulations require as being necessary or appropriate in the public interest or for the protection of investors." 15 U.S.C. 77g(a); see also 15 U.S.C. 77j(d) ________ (granting SEC similar authority with respect to prospectuses); 15 U.S.C. 77s(a) (granting SEC broad authority to "make, amend, and rescind such rules and regulations as may be necessary to carry out the provisions of this [Act], including rules and regulations governing registration statements and prospectuses"). 7. The provisions of the registration forms prescribed by the SEC constitute an integral part of the regulatory disclosure framework. See 17 C.F.R. 230.400, 230.401, 239.0-1 et seq. ___ _______ -18- of Form S-3. Form S-3 is a streamlined registration form available only to certain well-capitalized and widely followed issuers about which a significant amount of public information is already available.8 A registrant on Form S-3 accomplishes disclosure in part by incorporating in the prospectus by reference its most recent Form 10-K and Forms 10-Q filed pursuant to the Exchange Act. See Instructions to Form S-3, ___ Item 12(a). Unlike registrants on more broadly available forms (such as S-1), a Form S-3 registrant is not required separately to furnish in the prospectus the information required by Item 303(a) of Regulation S-K, 17 C.F.R. 229.303(a) ("Management's discussion and analysis of financial condition and results of operations"),9 because that information is presumed to be contained in the Exchange Act filings that Form S-3 incorporates by reference, which are themselves subject to the requirements of Regulation S-K.10 The primary purpose of the ____________________ 8. To be eligible to register on Form S-3, an issuer must have been subject to public reporting requirements for at least one year, filed all reports required under the Exchange Act (such as Forms 10-Q and 10-K) timely during the past year, and must meet certain other requirements relating to financial strength and stability. See 17 C.F.R. 239.13; see also Bloomenthal et ___ ________ al., supra, 5.05[1][b], at 212-13. _____ 9. Item 303(a) requires the disclosure, among other information, of "any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations." 17 C.F.R. 229.303(a)(3)(ii). 10. By contrast, a registrant on Form S-1 (which does not permit incorporation by reference) must independently furnish in the prospectus the information required by Item 303 of Regulation S-K. See Instructions to Form S-1, Item 11(h). ___ -19- "material changes" disclosure requirement of Item 11(a), then, is to ensure that the prospectus provides investors with an update of the information required to be disclosed in the ______ incorporated Exchange Act filings, including the information provided in those filings concerning "known trends and uncertainties" with respect to "net sales or revenues or income from continuing operations." 17 C.F.R. 229.303(a)(3)(ii). In this case, the date of the final prospectus for the March 1994 offering and the effective date of the registration statement was March 21, 1994.11 Prior to that date, the end of DEC's latest fiscal year was July 3, 1993 (fiscal year 1993), and the last Form 10-Q filed by the company was for the quarter that had ended on January 1, 1994 (DEC's second fiscal quarter). The question, then, is whether the complaint contains sufficient allegations that defendants failed to disclose in the registration statement any information regarding "material changes" in DEC's "affairs" as of March 21, 1994, that had occurred since July 3, 1993 and had not been reported in the Form 10-Q filed for the second quarter of fiscal year 1994. If the Wilensky complaint adequately so ________ alleges, then the complaint sets forth a cognizable claim of nondisclosure under Section 11, namely, that defendants failed ____________________ 11. The effective date of the registration statement for purposes of Securities Act liability is the "speaking date" of the final prospectus. See Bloomenthal et al., supra, ___ _____ 5.05[2][f] at 216. The parties do not dispute that March 21, 1994 was the effective date of the registration statement. -20- to include in the registration statement information "required to be stated therein." 3. The Alleged Nondisclosures __ __________________________ Plaintiffs argue that defendants failed to comply with Item 11(a) by omitting three categories of information from the registration statement and prospectus. First, plaintiffs contend that defendants failed to disclose that DEC had embarked on a risky marketing strategy that involved slashing prices and sacrificing profit margins in the hopes of increasing "market penetration" of the company's Alpha chip products. Second, plaintiffs assert that defendants failed to disclose that under the company's compensation scheme, its sales representatives were being paid "double commissions," again to the detriment of the company's profit margins. Third, and most centrally, plaintiffs allege that, by the date of the March 21 offering, defendants were in possession of, yet failed to disclose, material knowledge of facts indicating that the third fiscal quarter would be an unexpectedly disastrous one. We dispose of the first two claims of nondisclosure, and then focus our discussion on the third. a. Marketing Strategy __ __________________ The defendants provide a decisive rejoinder to the plaintiffs' claim of nondisclosure concerning the "marketing strategy": the relevant aspects and consequences of the strategy were in fact prominently disclosed, both in the text -21- of the prospectus and in documents incorporated by reference.12 For example, in its Form 10-Q filing for the quarter ending October 2, 1993 (the first quarter of fiscal year 1994), the company explained its reported decline in gross profit margins as follows:13 The decline in product gross margin resulted from the decrease in product sales, a continued shift in the mix of product sales toward low-end systems which typically carry lower margins, competitive pricing pressures and unfavorable currency fluctuations, partially offset by manufacturing cost efficiencies. The Corporation has adopted an aggressive, competitive price structure for its Alpha AXP systems. Given this pricing, as well as the factors described in the preceding paragraph, the Corporation expects to experience continued downward pressure on product gross margins. This statement, in conjunction with related disclosures found elsewhere in the prospectus and incorporated filings relating to "competitive pricing pressures," declining gross profit margins, "competitive pricing actions taken by the Corporation," an "industry trend toward lower product gross ____________________ 12. As required by Item 12 of the instructions to Form S-3, the March 11, 1994 prospectus specifically incorporated by reference the company's Form 10-K filing for fiscal year 1993 (as amended by Form 10-K/A dated March 11, 1994), and its Form 10-Q filings for the quarterly periods that ended on October 2, 1993 and January 1, 1994. 13. Since the complaint alleges nondisclosures in the registration statement and prospectus, the court may look to the text of those materials and the incorporated SEC filings to determine whether the plaintiffs' allegations are well founded. See Kramer v. Time Warner, Inc., 937 F.2d 767, 774 (2d Cir. ___ ______ __________________ 1991). We discuss more fully later the circumstances in which a court may look outside the four corners of a complaint in deciding a motion to dismiss. -22- margins," and "persistent intense pricing competition," together obviate the plaintiffs' claim that defendants failed to disclose the company's adoption of a price-cutting strategy to boost the "market penetration" of its Alpha-based systems. b. "Double Commissions" __ ____________________ The plaintiffs' claim of a failure to disclose "double commissions" also fails to make out a Section 11 violation. To the extent that the claim comprises allegations of mismanagement,14 it is not cognizable under the securities laws. See Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 477-80 ___ _____________________ _____ (1977); In re Craftmatic Sec. Litig., 890 F.2d 628, 638-39 (3d ____________________________ Cir. 1989) (stating that plaintiffs cannot circumvent Santa Fe ________ by simply pleading a mismanagement claim as a failure to disclose management practices); see also Hayes v. Gross, 982 _________ _____ _____ F.2d 104, 106 (3d Cir. 1992). Otherwise, the claim fails for lack of any allegations establishing a plausible theory of materiality. The complaint does not allege that "double commissions" have some intrinsic significance to investors. Plaintiffs complain, rather, that DEC failed to tell the market that the commission-based compensation scheme, instead of boosting sales as it was supposed to do, was contributing to the company's losses. This argument is problematic. As the complaint itself acknowledges, DEC publicly announced the switch from a salary- ____________________ 14. The complaint's assertion that "DEC implemented its commission program and set sales quotas without careful evaluation" is an example of such an allegation. -23- based compensation scheme to the incentive-based model that produced the double commissions. Furthermore, according to the complaint, the switch was made not during the third fiscal ___ quarter of 1994, but some two years earlier, in 1992. The ____ plaintiffs do not allege that any material changes to the compensation scheme were implemented after that time. Whatever the bearing of DEC's incentive-based compensation scheme on the company's expenses in relation to its revenues, the investing public had at least a year's worth of hard financial data (through the second quarter of fiscal 1994) to evaluate whether the commission system was working to increase gross margins,15 or instead, as plaintiffs allege, to shrink them. Plaintiffs do not allege that there were any material changes in the payment of commissions between the time of the March public offering and the last prior Form 10-Q filed by the company (for the second fiscal quarter of 1994), and so on their own theory the claim that DEC failed to disclose the payment of "double commissions" amounts to naught. c. Operating Results Prior to End of Quarter __ _________________________________________ We turn to the complaint's central, overarching claim that defendants failed, in connection with the March public offering, to disclose material factual developments foreboding disastrous quarter-end results. In evaluating this claim, we ____________________ 15. The payments made to sales representatives constituted a component of the company's quarterly expenses, and the aggregate effect of such payments could have been determined by examining the company's quarterly earnings data, as disclosed in the required SEC filings. -24- accept arguendo the complaint's allegations16 that DEC had in ________ its possession as of the March 21 offering date nonpublic information concerning the company's ongoing quarter-to-date performance, indicating that the company would suffer unexpectedly large losses for that quarter. We ask, then, whether there was a duty to disclose such information in the registration statement and prospectus under the rubric of "material changes" under Item 11(a) of Form S-3. We focus upon the defendants' primary legal arguments on this point: that DEC was under no duty to disclose "intra-quarterly" results or any other information concerning its third quarter performance until after the quarter ended; and that defendants had no duty as of March 21, 1994 to disclose any internal projections or predictions concerning the expected outcome of the quarter. A central goal underlying the disclosure provisions of the securities laws is to promote fairness and efficiency in the securities markets. See Central Bank of Denver, N.A. v. ___ _____________________________ First Interstate Bank of Denver, N.A., 114 S. Ct. 1439, 1445 _______________________________________ (1994) ("Toget |