On November 8, 2004, upon stipulation of the parties 1

and pursuant to Fed. R. Civ. P. 42(a), we consolidated Civil

Action Numbers 04-4515, 04-4634, 04-4646, 04-4650, 04-4666, 04-

4670, and 04-4674 under the above civil action number. Two weeks

later, we further consolidated Civil Action Nos. 04-4515 and 04-

5390. We appointed Globis Capital Partners, L.P. as lead

plaintiff in this case and approved its selection of lead class

counsel on January 18, 2005. Because Globis represents all

plaintiffs who have been consolidated into this action, we use

"plaintiffs" when referring to Globis's contentions in the motion

considered here.

 The Court may grant a motion to dismiss under Rule 2

12(b)(6) "only if, accepting all well pleaded allegations in the

complaint as true, and viewing them in the light most favorable

to plaintiff, plaintiff is not entitled to relief." In re

(continued...)

IN THE UNITED STATES DISTRICT COURT 

FOR THE EASTERN DISTRICT OF PENNSYLVANIA

IN RE STONEPATH GROUP, INC. : CIVIL ACTION

SECURITIES LITIGATION :

:

:

: NO. 04-4515

MEMORANDUM

Dalzell, J. April 3, 2006

This consolidated litigation is a putative class action

brought on behalf of those who purchased Stonepath Group, Inc.

securities between March 29, 2002 and September 20, 2004 (the

claimed "Class Period"). Lead plaintiff Globis Capital Partners,

L.P., here sues nominal defendant Stonepath and three of its 1

current and former officers, Dennis L. Pelino (also a director),

Bohn H. Crain and Thomas L. Scully (collectively the "Individual

Defendants") for violations of the Securities Exchange Act of

1934. Before us now is defendants' motion to dismiss plaintiffs'

second amended consolidated class action complaint, which largely

challenges whether plaintiffs have sufficiently pleaded the

requisite scienter.2

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 1 of 39
(...continued) 2

Burlington Coat Factory Sec. Litig., 114 F.3d 1410, 1420 (3d Cir.

1997). "The issue is not whether a plaintiff will ultimately

prevail but whether the claimant is entitled to offer evidence to

support the claims." Scheuer v. Rhodes, 416 U.S. 232, 236

(1974). In other words, we will not grant such a motion "unless

it appears beyond doubt that the plaintiff can prove no set of

facts in support of his claim which would entitle him to relief." 

Conley v. Gibson, 355 U.S. 41, 45-46 (1957); see also Semerenko

v. Cendant Corp., 223 F.3d 165, 173 (3d Cir. 2000) (permitting

dismissal "only if it appears that the [plaintiffs] could prove

no set of facts that would entitle [them] to relief"). "The

complaint will be deemed to have alleged sufficient facts if it

adequately put the defendants on notice of the essential elements

of the plaintiffs' cause of action." Nami v. Fauver, 82 F.3d 63,

65 (3d Cir. 1996). We shall review factual background for

plaintiffs' claims with these principles in mind.

 Our task in identifying the differences was greatly 3

simplified by the red-lined version of the second amended

complaint that plaintiffs submitted. We are most grateful for

this professional courtesy, which was of considerable help as we

reviewed the 132-page second amended complaint.

2

I. Factual Background

On October 27, 2005, we dismissed plaintiffs' first

amended consolidated class action complaint and permitted them to

file a second amended complaint, which they did on November 15,

2005. See In re Stonepath Group, Inc. Sec. Litig., 397 F.Supp.2d

575, 578-80 (E.D. Pa. 2005). While many of the alleged facts

remain unchanged, plaintiffs have added some new allegations, the

most relevant being those concerning Stonepath's subsidiary,

Stonepath Logistics Domestic Services, Inc., that subsidiary's

CEO, Gary Koch, and its Air Plus division. We therefore revisit 3

the events giving rise to this action and incorporate the new

allegations.

Stonepath is a Delaware corporation with a principal

place of business in Pennsylvania. Second Am. Consol. Class

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 2 of 39
 Stonepath explained in its Form 10-Q for the period 4

ended September 30, 2002 that "the 2003 installment will be based

on pre-tax income of $6.0 million achieved during the 15 month

(continued...)

3

Action Compl. ("Second Am. Compl.") ¶ 38. In early 2001,

Stonepath changed from a company focused on "developing earlystage technology businesses with significant Internet features"

to one that "deliver[ed] non-asset based third-party logistics

services." Id. ¶ 2. To effectuate this transition, Stonepath

bought "numerous" operating businesses in the transportation and

logistics sector, beginning in the second quarter of 2001. Id.

¶¶ 3, 58.

A. The Acquisitions

Plaintiffs allege that Stonepath's "most significant

acquisition[]" took place on October 5, 2001, when it acquired a

group of Minneapolis-based privately held companies -- M.G.R.,

Inc. (d/b/a Air Plus Limited), Distribution Services, Inc., and

Contract Air, Inc. (collectively "Air Plus"). Id. ¶¶ 58, 60. 

Air Plus was a "platform acquisition," that is, an acquisition

"that creates a significant new capability for the Company, or

entry into a new global geography." Id. ¶ 3. According to

Stonepath's Form 10-K for the year ended December 31, 2001,

Stonepath paid $17.5 million in cash at closing and agreed to a

$17 million "four-year earn-out arrangement based on the future

financial performance of Air Plus." Id. ¶ 59. Stonepath stated

that it:

agreed to pay the former Air Plus

shareholders installments of $3.0 million in

2003, $5.0 million in 2004, $5.0 million in 4

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 3 of 39
(...continued) 4

period from October 1, 2001 through December 31, 2002." Second

Am. Compl. ¶ 326.

4

2005 and $4.0 million in 2006, each

installment payable in full if Air Plus

achieves pre-tax net income of $6.0 million

in each of the years preceding the year of

payment. In the event there is a shortfall in

pre-tax net income, the earn-out payment will

be reduced on a dollar-for-dollar basis to

the extent of the shortfall. Shortfalls may

be carried over or carried back to the extent

that pre-tax net income in any other pay-out

year exceeds the $6.0 million level.

Id. (footnote added). Stonepath's October 5, 2001 Form 8-K

stated that the earn-out payments went only to MGR shareholders,

and it identified Gary A. Koch as a majority shareholder of MGR

and Contract Air, Inc., as well as the sole shareholder of

Distribution Services, Inc. Id. ¶ 60. After the acquisition,

Koch became the CEO of Air Plus and of Stonepath's domestic

operation, Stonepath Logistics Domestic Services, Inc. ("Domestic

Services"). Id. ¶¶ 3, 61. 

Plaintiffs, drawing from Stonepath's public filings

with the Securities and Exchange Commission, allege that Air

Plus's earnings were key to Stonepath's profitability. We have

consolidated plaintiffs' data in a table:

Stonepath's reported

financial results for

continuing operations

without Air Plus earnings

Air Plus

earnings

Stonepath's reported

financial results for

continuing operations

with Air Plus earnings

2001 ($ 4,694,000) $ 1,700,000 ($ 2,994,000)

2002 ($ 1,034,000) $ 4,600,000 $ 3,566,000 

2003 $ 902,000 $ 6,500,000 $ 7,402,000 

Id. ¶¶ 322-32.

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 4 of 39
 Plaintiffs actually state "transportation costs on 5

2005 guidance." Id. ¶ 318 (emphasis added). However, earlier in

the second amended complaint, they allege that during an August

5, 2004 conference call, Pelino stated that:

Over the near-term, we're seeing more cost

and revenues that will initially project

about 2004. It is this dynamic, which leads

us to re-express our 2004 EBITDA guidance in

(continued...)

5

By reporting earnings of $6.3 million from October 1,

2001 through December 31, 2002 and of $6.5 million in 2003, Air

Plus met the earnings targets that triggered full payment of the

first two of the four possible earn-out payments. Accordingly,

its former shareholders, including its majority shareholder,

Koch, were entitled to receive $3 million in 2003 and $5 million

in 2004.

On May 30, 2002, Stonepath augmented Domestic Services

by acquiring American United, "a Detroit-based privately held

provider of expedited transportation services." Id. ¶ 64. It

paid $5.1 million in cash at closing, and $11 million to "the

former United American shareholder" in a "four-year earn-out

arrangement based upon the future financial performance of United

American." Id. 

Plaintiffs give some context for understanding Domestic

Services' role within Stonepath. Allegedly, "at the end of the

Class Period, Defendant Pelino responded to an analyst's question

concerning the effect of the misstated transportation costs on

[2004] guidance" by stating that "within our existing guidance of

$9 to $11 million, domestic's contribution to that was

approximately 5 million." Id. ¶ 318. Thus, it seems that 5

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 5 of 39
(...continued) 5

the range of $9m to a $11m. . . .

As we've represented in our press release, we

have also established preliminary earnings

targets for '05 in the $14m to $16m EBITDA

range and expected total revenue of $375m.

Id. ¶ 269 (emphasis added). While plaintiffs offer conflicting

allegations as to what Pelino said about 2005 earnings guidance,

only their earlier allegation provides a particular date and

context for the alleged comment. We therefore credit the former

for purposes of determining the date. In other words, we assume

that Domestic Services' contribution to the 2004 earnings

guidance of $9-11 million was about $5 million.

 For confidential witnesses, the "underlying 6

prerequisite [is] that each source is described sufficiently to

support the probability that the source possesses the information

(continued...)

6

Domestic Services was expected to be responsible for about half

of Stonepath's projected 2004 earnings. 

Stonepath's acquired companies had disparate preexisting, or legacy, information systems, as well as their own

operating policies and procedures. Id. ¶ 66. Stonepath stated

that it was evaluating "technologies obtained through our

acquisition strategy" and "commercially available supply chain

technologies" to create its own "best-of-breed" solution, called

Technology in Logistics or Tech-LogisTM. Id. But while

developing Tech-LogisTM and working toward an "ultimate migration"

of the acquired companies' information systems, Stonepath

permitted these companies to continue using "their existing

policies and procedures to foster a 'decentralized

entrepreneurial environment,'" id. ¶ 65, 66. 

Using information said to have been provided by

Confidential Witnesses 2-8, the second amended complaint details 6

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 6 of 39
(...continued) 6

alleged." Cal. Pub. Employees' Ret. Sys. v. Chubb Corp., 394

F.3d 126, 155 (3d Cir. 2004).

7

various problems with these legacy systems and accounting

programs. Because these allegations are unaltered from their

previous iteration, we incorporate them by reference as detailed

in our prior decision. See Stonepath, 397 F.Supp.2d at 578-80.

Stonepath did not limit its acquisitions to domestic

companies. It also expanded into international transportation

through its International Services segment. Second Am. Compl. ¶

3. However, at least in 2002 and 2003, domestic operations

outperformed international operations in terms of external

customer revenue: Domestic Services generated $129,474,000 in

2002 and $78,319,000 in 2003, while International Services

generated $90,610,000 in 2002 and $44,469,000 in 2003. Id. ¶¶ 5,

22, 317. Therefore, assuming no other sources generated revenue

from external customers for Stonepath, Domestic Services

accounted for 59% of that revenue in 2002 and 64% in 2003. 

B. The Restatements

During the Class Period, Stonepath issued three

restatements that revised figures the company had previously

reported to the SEC. 

1. The First Restatement

On July 17, 2003, Stonepath issued a press release

stating that it was discussing with the SEC the allocation of the

purchase price for certain acquired companies -- Air Plus, United

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 7 of 39
 The press release quoted Crain as stating: 7

Through the integration process, review of internal controls

and centralization of the financial reporting process the

Company has recently determined that the revenues and costs

of transportation for its International Services division

were overstated in like amounts because certain intercompany

transactions representing the buying and selling of

transportation services were not being appropriately

eliminated in consolidation within the division’s legacy

accounting system.

Id. ¶ 98.

8

American, and Global Transportation. Id. ¶ 94. Then, on August

28, 2003, Stonepath made its first Class Period restatement when

it filed with the SEC an amended interim financial report on a

Form 10-Q/A. Id. ¶ 97. This restated its consolidated financial

statements for the periods ended June 30, 2003 and March 31,

2003, and for the years ended December 31, 2001 and December 31,

2002, by "(i) allocating more value to the customer relationship

intangible assets for the Company's acquisitions and (ii)

revising the amortization method and life used for such assets." 

Id. The "consolidated statements of cash flows for net cash used

in operating activities, net cash used in investing activities

[and] net cash provided by (used in) financing activities in any

of the restated periods" were not affected. Id. 

2. The Second Restatement

On December 29, 2003, Stonepath issued a press release

announcing its second Class Period restatement, the result of a

problem in the legacy accounting process of the International

Services division. Id. ¶ 98. Revenues and transportation costs 7

had been overstated in offsetting amounts, about $26.8 million

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 8 of 39
9

for the nine months ended September 30, 2003, and $16.9 million

for the year ended December 31, 2002. Id. There was no impact

on net revenues, net earnings, or earnings before interest,

taxes, depreciation and amortization ("EBITDA"). Id. 

During a December 31, 2003 conference call held to

discuss the restatement and to answer questions from analysts and

investors, Pelino said: 

The duplication of gross revenues at our

international division should not have

happened in a perfect world but it did. We

discovered it and we corrected it. We have

also taken steps to ensure that this never

happens again by working closely with our

external and internal auditors to improve

their due diligence and field testing

methodologies.

Id. ¶ 99. 

Crain explained:

As part of our normal business process, we

have audits done for all material

transactions. As part of our public reporting

process, we have our auditors do field work

on a quarterly basis at each of our material

business locations. Today that means we have

people in the field every quarter in

Minneapolis, Detroit, Seattle, and here in

Philadelphia to make sure we’re rolling up

the right numbers. Also, as part of our

public reporting process and the 302

certifications under Sarbanes-Oxley, we hold

quarterly calls with the leadership of each

of the business units and go through a

rigorous series of questions to try to ferret

out any areas of concern or weakness in our

financial reporting processes. We also meet

regularly with the leadership of management

of the business units to review business

results.

Id. ¶ 101.

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 9 of 39
10

Responding to a question by Andrew Ponzo, a private

investor, about financial reporting by the acquired companies'

senior management, Crain said that "a local senior financial

executive reports in to the local CEO. So specifically, Jim

Hilgert reports to Jason Totah in Seattle, and Tim Anderson

report[s] in to Joe DiGiacomo and Gary Koch in Minneapolis with a

dotted line responsibility back to me." Id. ¶ 102. Pelino said: 

With respect to kind of the formality of the

reporting, I think at the end of the day,

people will have different views about where

the dotted and solid line should be, but as

long as the communication remains open and we

have good candid conversations taking place,

I think that can be made to work, and I do

have the utmost confidence in the Jim

Hilgert's and Tim Anderson's out there and

their ability to do a good job for us.

Id.

Andrew Ponzo then stated his belief that the same type

of incident would not occur again, but asked, "without having

direct reporting into you or complete control over that, are

there other instances that can happen, and if not [sic], how do

we control that?" Id. ¶ 103. Pelino responded:

[A]s I’m sure you’re aware, Andrew, under

Sarbanes-Oxley we’re right now effectively

identifying every material business process

that exists across the business organization

and will be going out and effectively

benchmarking those practices against what are

deemed to be best practices under general

standards out there, and making sure that we

have state-of-the-art internal controls

across the entire organization. So through

this process to the extent that there are any

weaknesses they will be identified, and we’ll

either change them or put other mitigating

processes in places to make sure that we

cover our basis [sic]. So I think we can all

take some comfort in getting our arms around

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 10 of 39
11

the universe of potential gotcha’s and make

sure that we’re focused on them.

Id.

On January 20, 2004, Stonepath filed a Form 10-K/A and

three Forms 10-Q/A. These Forms restated Stonepath's financial

results by decreasing revenue and costs in like amounts for the

year ended December 31, 2002 and for the quarters ended March 31,

2003, June 30, 2003, and September 30, 2003. Id. ¶ 105. 

3. The Third Restatement

On September 20, 2004, Stonepath announced the need for

a third Class Period restatement to revise its financial

statements for fiscal year 2003 and for the first and second

quarters of 2004. Id. ¶ 279. An internal review of Domestic

Services revealed that its accrual process did not account for

the differences between estimated and actual purchased

transportation costs. Id. The under-accrual of actual costs was

estimated to be from $4 to $6 million for 2003 and from $500,000

to $1 million for the first six months of 2004. Id. Stonepath

stated that its reported EBITDA would be reduced to the range of

$2.6 - $4.6 million for 2003 and $200,000 - $700,000 for the

first six months of 2004. Id. 

Stonepath's press release described the need for the

restatement:

In using its legacy operating system, to be

replaced by Tech-Logis later this year,

Domestic Services relied on trend analysis to

estimate its costs of purchased

transportation. In reviewing the process by

which Domestic Services maintained the

accrual for its costs of purchased

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 11 of 39
12

transportation, the Company has concluded

that the process did not accurately account

for the differences between the estimates and

the actual freight costs incurred. This

allowed for the accumulation of previously

unidentified costs of purchased

transportation and an under reported

liability for the accrued costs of purchased

transportation.

Id. ¶ 280.

Furthermore, Pelino announced changes in management. 

Jason Totah, the CEO of international operations, would also

become the CEO at Domestic Services, putting "all of our

logistics operations under one proven leader." Id. ¶ 281. 

Pelino also described restructuring of financial and accounting

processes. He mentioned that "senior financial staff of [the]

Domestic Services and International Services operations [would]

report directly to Bohn Crain, the Company's Executive Vice

President and Chief Financial Officer." Id.

The day of these disclosures, Stonepath's common stock

closed at $0.86 per share, down 46% from the prior closing price

of $1.59, on volume of over 4.8 million shares. Id. ¶ 282. The

next day, and a day after the Class Period ended, Stonepath held

a conference call in which Pelino and Crain participated. Id. ¶

283. Plaintiffs allege that when asked about Stonepath's

discovery of the understatement of transportation costs, "Crain

stated that it would be fair to say that the Company discovered

the issue in the last 30 days." Id. ¶ 285.

On January 6, 2005, Stonepath issued a press release

concerning its financial results for the third quarter of 2004. 

Id. ¶ 289. In that release, Stonepath also stated that the

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 12 of 39
13

estimated restatement figures announced in September would be

increased, and would now extend back to 2001 and 2002:

The Company expects to report an aggregate

reduction in the previously reported net

income for 2001 through the first six months

of 2004 of approximately $16.3 million. Net

income for 2001, 2002, 2003 and the first six

months of 2004 is expected to be reduced by

$0.4 million, $2.0 million, $7.8 million and

$6.1 million, respectively.

Id. ¶ 289. As a result, the earlier reported 2003 profit of

$7.13 million became a loss of $670,000. Id. For the first six

months of 2004, the previously reported net loss of $785,000

would be $6.1 million worse. Id.

Also on January 6, 2005, Stonepath filed its quarterly

report for the third quarter of 2004 on SEC Form 10-K. Id. ¶

290. It disclosed that the restatement announced on September

20, 2004 "resulted in technical default of certain financial

covenants of [its credit] Facility." Id. However, the defaults

were "waived" and Stonepath entered into an amended credit

facility which, inter alia, reduced the credit available from $25

million to $22.5 million, established new minimum quarterly

EBITDA targets, precluded acquisitions, and eliminated LIBORbased borrowing. Id.

On February 11, 2005, Stonepath finally filed the

restatement it had promised the previous September and then

reiterated in January 2005. Id. ¶ 293. On a Form 10-K/A,

Stonepath restated its financial results for fiscal years 2001

through 2003. Id. The Form 10-K/A stated that since the

September 21, 2004 announcement, Stonepath had analyzed its costs

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 13 of 39
14

of purchased transportation and revenue transactions. Id. It

found that:

These errors resulted in an overstatement of

revenues by $0.2 million in 2003, an

understatement in purchased transportation

costs by $4.4 million in 2003, $1.6 million

in 2002, and $0.3 million in 2001 and an

understatement of income tax expense of $2.0

million in 2003, $0.3 million in 2002 and

$0.1 million in 2001. These restatements

also reduced goodwill by $4.3 million at

December 31, 2003 and $1.3 million at

December 31, 2002. Net income was reduced by

$7.9 million, including a reserve of $1.3

million related to excess earn-out payments

in 2003, $1.9 million in 2002 and $0.3

million in 2001.

Id. This restatement did not change net income for the first and

second quarters of 2004, which, according to the January 6, 2005

press release, was expected to be reduced by $6.1 million. 

During a conference call ten days earlier, Stonepath's

newly appointed President, Bob Arovis, had repeated that "the

restatements were caused by Stonepath's lack of understanding of

its accrued purchase transportation liability and related costs

for purchase transportation." Arovis added these details about

the restatement:

The aggregate adjustment of 16.3 million is

made up of three major components. The first

part is the adjustments to net revenues in

purchased transportation of 8.3 million. The

remaining two parts were consequential

effects of the first part, namely income tax

effects of 3.6 million and issues with

respect to earn-out payments for certain

selling shareholders of 4.4 million.

Specifically what I mean by consequential

effects is that the Company’s previously

filed reports did not improperly record

either the earn-out payments made, nor the

taxes reflected in those filings. However,

once we had to restate the earnings,

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 14 of 39
15

obviously, it impacted income taxes and

certainly impacted the process on which the

earn-outs were made.

Id. ¶ 292.

"Management's Report on Internal Control over Financial

Reporting," included in Stonepath's 2004 Form 10-K, filed on

April 1, 2005, rehearsed much of what Stonepath had already

publicly acknowledged: (1) changes had to be made to disparate

operating systems, financial systems, and financial policies and

procedures; (2) Stonepath had inadequate controls for assessing

the effectiveness of its internal control over financial

reporting and its consolidation process; and (3) controls related

to accounting for purchased transportation were inadequate,

resulting in selling shareholders receiving earn-out payments

greater than what they were actually owed, and creating the need

to restate public filings for fiscal years 2002 and 2003, as well

as for the first and second quarters of fiscal year 2004. Id. ¶

297. Regarding the earn-outs, the reduction of Air Plus's

previously reported cumulative earnings from $12.7 to $8.1

million meant that Stonepath paid about $3.9 million more to Air

Plus's selling shareholders that it should have. Id. ¶¶ 298,

333. It had also given the selling shareholder of United

American about $0.5 million in excess payments. Id. ¶ 299. In

both cases, Stonepath reclassified those excess payments "from

goodwill to advances due from shareholders." Id. ¶¶ 298-99, 333.

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 15 of 39
16

C. The Lawsuit

On September 24, 2004, four days after Stonepath

announced its third restatement, lead plaintiff Globis filed this

lawsuit against nominal defendant Stonepath and Dennis L. Pelino,

Bohn H. Crain, and Thomas L. Scully. Pelino is the Chairman of

the Board of Directors and served as Chief Executive Officer of

Stonepath from June 21, 2001 through October of 2004. Id. ¶ 39. 

Crain was the Chief Financial Officer from January 10, 2002, and

Treasurer from May 30, 2002 through the end of the Class Period. 

Id. ¶ 40. Scully is a certified public accountant who served as

Vice-President and Controller throughout the Class Period. Id. ¶

41. 

The second amended consolidated class action complaint

states two counts. In Count I, Globis sues all defendants for

violations of Section 10(b) of the Exchange Act and Rule 10b-5

promulgated thereunder. In Count II, it sues the Individual

Defendants for violation of Section 20(a) of the Exchange Act. 

Before us now is defendants' motion to dismiss the

second amended complaint. Like the previous motion to dismiss,

this motion contends that plaintiffs have failed to sufficiently

plead scienter. In the prior complaint, plaintiffs relied on

both a recklessness theory and a motive and opportunity theory to

establish scienter, but they have now removed all references to

the latter theory and rest on a recklessness theory. 

Accordingly, we analyze the scienter allegations under the legal

standard for pleading recklessness.

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 16 of 39
17

II. Legal Standard

As noted, Count I of the second amended complaint

alleges that defendants violated Section 10(b) of the Act and

Rule 10b-5 promulgated thereunder. Section 10(b) makes it

illegal "[t]o use or employ, in connection with the purchase or

sale of any security registered on a national securities exchange

. . . any manipulative or deceptive device or contrivance . . .

." 15 U.S.C. § 78j(b) (2003). Rule 10b-5 provides an

enforcement mechanism for Section 10(b) by creating "a private

cause of action for investors harmed by materially false or

misleading statements." In re Alpharma Inc. Sec. Litig., 372

F.3d 137, 147 (3d Cir. 2004). Rule 10b-5 "makes it unlawful for

any person '[t]o make any untrue statement of a material fact or

to omit to state a material fact necessary to make the statements

made in the light of the circumstances under which they were

made, not misleading . . . in connection with the purchase or

sale of any security.'" In re IKON Office Solutions, Inc., 277

F.3d 658, 666 (3d Cir. 2002) (quoting 17 C.F.R. § 240.10b-5(b)). 

To state a valid claim for a violation of Section 10(b)

and Rule 10b-5, a plaintiff must show that "the defendant (1)

made a misstatement or an omission of a material fact (2) with

scienter (3) in connection with the purchase or the sale of a

security (4) upon which the plaintiff reasonably relied and (5)

that the plaintiff's reliance was the proximate cause of his or

her injury." Id.; see also Sowell v. Butcher & Singer, Inc., 926

F.2d 289, 296 (3d Cir. 1991) (collapsing the first and third

elements). 

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 17 of 39
18

Plaintiffs' securities fraud claim is subject to the

heightened pleading requirements of Federal Rule of Civil

Procedure 9(b) and to the Private Securities Litigation Reform

Act of 1995 ("PSLRA") § 101(b), Pub. L. No. 104-67, 109 Stat.

737, 743 (codified at 15 U.S.C. § 78u-4 (2004)). Rule 9(b)

requires that "[i]n all averments of fraud or mistake, the

circumstances constituting fraud or mistake shall be stated with

particularity." See also In re Westinghouse Sec. Litig., 90 F.3d

696, 710 (3d Cir. 1996) (explaining that Section 10(b) claims

must comply with Rule 9(b)). Our Court of Appeals has explained

that "Rule 9(b) requires, at a minimum, that plaintiffs support

their allegations of securities fraud with all of the essential

factual background that would accompany 'the first paragraph of

any newspaper story'--that is, the 'who, what, when, where and

how' of the events at issue." In re Rockefeller Ctr. Props.,

Inc. Sec. Litig., 311 F.3d 198, 217 (3d Cir. 2002) (quoting In re

Burlington Coat Factory Sec. Litig., 114 F.3d 1410, 1422 (3d Cir.

1997)).

The PSLRA imposes an additional "layer of factual

particularity" for pleadings. Rockefeller Ctr., 311 F.3d at 217. 

It requires a plaintiff who alleges that a defendant made an

untrue statement of material fact to "specify each statement

alleged to have been misleading [and] the reason or reasons why

the statement is misleading." 15 U.S.C. § 78u-4(b)(1) (2004). 

Moreover, when the plaintiff must prove that the defendant acted

with a particular state of mind, the complaint must "state with

particularity facts giving rise to a strong inference that the

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 18 of 39
19

defendant acted with the required state of mind." 15 U.S.C. §

78u-4(b)(2) (2004); see In re Advanta Corp. Sec. Litig., 180 F.3d

525, 530-35 (3d Cir. 1999) (discussing how PSLRA modified

pleading requirements in securities fraud cases). 

Plaintiffs must sufficiently plead scienter if the

second amended complaint is to survive a motion to dismiss. See

Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193, 96 S. Ct. 1375,

1381 (1976). Scienter, in the context of securities fraud, is: 

a mental state embracing intent to deceive,

manipulate or defraud, or, at a minimum,

highly unreasonable (conduct), involving not

merely simple, or even inexcusable

negligence, but an extreme departure from the

standards of ordinary care, . . . which

presents a danger of misleading buyers or

sellers that is either known to the defendant

or is so obvious that the actor must have

been aware of it. 

IKON, 277 F.3d at 667 (citations and internal quotations

omitted).

Conclusory allegations will not do under this

jurisprudence. "[A]llegations that a securities-fraud defendant,

because of his position within the company, 'must have known' a

statement was false or misleading are 'precisely the types of

inferences which [courts], on numerous occasions, have determined

to be inadequate to withstand Rule 9(b) scrutiny.'" In re

Advanta Corp. Sec. Litig., 180 F.3d at 539 (quoting Maldonado v.

Dominguez, 137 F.3d 1, 10 (1st Cir. 1998)); cf. In re Aetna Inc.

Sec. Litig., 34 F.Supp.2d at 953 (distinguishing Advanta on the

ground that it did not address scienter in context of

corporation's core business activities). Rather to the point

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 19 of 39
20

here, "claims essentially grounded on corporate mismanagement are

not cognizable under federal law." Advanta, 180 F.3d at 540

(quoting In re Craftmatic Sec. Litig., 890 F.2d 628, 638-39 (3d

Cir. 1989)). 

It is not enough for plaintiffs to "allege generally

that defendants knew or recklessly disregarded each of the false

and misleading statements for which [they were] sued," because

"plaintiffs must allege facts that could give rise to a 'strong'

inference of scienter." In re Burlington Coat Factory Sec.

Litig., 114 F.3d at 1422 (citation and internal quotation

omitted). Interpreting the "strong inference" requirement, our

Court of Appeals has explained that "[p]laintiffs must either (1)

identify circumstances indicating conscious or reckless behavior

by defendants or (2) allege facts showing both a motive and a

clear opportunity for committing the fraud." Id.; see also

Advanta, 180 F.3d at 534-35 (discussing standards for pleading

scienter in light of PSLRA). Allowing scienter to be established

through recklessness "promotes the policy objectives of

discouraging deliberate ignorance and preventing defendants from

escaping liability solely because of the difficulty of proving

conscious intent to commit fraud." Advanta, 180 F.3d at 535. 

Because plaintiffs here have now chosen to proceed solely under a

recklessness theory, see Pls.' Mem. Opp'n Defs.' Mot. ("Pls.'

Mem.) 14, we set forth the legal standard for that theory only.

A reckless statement involves "not merely simple, or

even inexcusable negligence, but an extreme departure from the

standards of ordinary care, and which presents a danger of

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 20 of 39
21

misleading buyers or sellers that is either known to the

defendant or is so obvious that the actor must have been aware of

it." Advanta, 180 F.3d at 535 (quoting McLean v. Alexander, 599

F.2d 1190, 1197 (3d Cir. 1979)). Thus, scienter "requires 'a

misrepresentation so recklessly made that the culpability

attaching to such reckless conduct closely approaches that which

attaches to conscious deception.'" In re Digital Island

Securities Litigation, 357 F.3d 322, 332 (3d Cir. 2004) (quoting

McLean v. Alexander, 599 F.2d at 1197 (3d Cir. 1979)).

III. Analysis

Plaintiffs allege that "Defendants portrayed Stonepath

as an increasingly profitable company positioned to expand and

continue earnings growth through strategic acquisitions," despite

the fact that they "knew, or recklessly disregarded, that

Stonepath was plagued by internal control deficiencies,

especially at Air Plus, the core component of the Company's most

important subsidiary, Domestic Services." Id. ¶ 6. Air Plus's

control deficiencies allegedly caused it to consistently

understate transportation expenses -- its largest operating cost

-- which resulted in materially inflated Class Period earnings. 

Id. These cost understatements are also said to have caused

Stonepath to overpay millions of dollars to former Air Plus

shareholders, who, under the terms of the acquisition agreement,

were entitled to earn-out payments when Air Plus met certain

earnings targets. Id. Finally, the understatements are also

said to have caused defendants to overstate important financial

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 21 of 39
22

benchmarks and earnings estimates. Id. ¶ 7. When Stonepath

issued its three restatements, plaintiffs allege that "the truth

emerged . . . that far from being a profitable growth company,

Stonepath was, in fact, a company with a greater than reported

loss for 2001, minimal earnings for 2002, and no earnings for

2002 through the first six months of 2004." Id.

In moving to dismiss the second amended consolidated

complaint, defendants contend that plaintiffs have failed to

sufficiently plead scienter. Plaintiffs respond that their

latest complaint pleads the requisite scienter under a

recklessness theory. 

B. Section 10(b) and Rule 10b-5

Plaintiffs advance two main arguments in support of

their recklessness theory. First, they contend that defendants'

conduct constitutes an extreme departure from the standards of

ordinary care, largely because they failed adequately to monitor

transportation costs at the core business, Domestic Services. 

Second, they assert that Koch's financial interest in Domestic

Services' performance gave rise to defendants' heightened duty to

monitor transportation costs at Air Plus.

Before addressing the parties' contentions, we note

that we will not rehash findings from our earlier decision that

the parties have not called into question by presenting relevant

new facts or arguments. In particular, we reiterate that the

third restatement's magnitude was "undeniably large, and

therefore relevant, but alone it does not establish

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 22 of 39
23

recklessness," In re Stonepath Group, Inc. Sec. Litig., 397

F.Supp.2d at 588, and that "transportation revenues are central

to Stonepath's business," id. at 590-91. With that foundation in

mind, we turn to plaintiffs' arguments.

Plaintiffs first argue that defendants' conduct

constitutes an extreme departure from the standards of ordinary

care. They contend that they have satisfied our previous

directive to "show that Domestic Services' transportation costs

are at the core of Stonepath's business," id. at 591, and that

defendants therefore had a duty to monitor the accuracy and

integrity of its process for reporting of transportation costs. 

Because Stonepath is said to publicly report transportation costs

on a consolidated basis, plaintiffs are unable to provide precise

figures on the transportation costs of Domestic Services and its

various divisions. See Pls.' Mem. 16. These figures are

exclusively within defendants' control, so we shall not penalize

plaintiffs for not producing them. See In re Burlington Coat

Factory Sec. Litig., 114 F.3d at 1418 (relaxing Rule 9(b)'s

requirements "where the factual information is peculiarly within

the defendant's knowledge or control," but affirming that even in

such cases "boilerplate and conclusory allegations will not

suffice" and "[p]laintiffs must accompany their legal theory with

factual allegations that make their theoretically viable claim

plausible."). 

In fact, the figures that plaintiffs provide are

sufficient to show that Domestic Services was indeed the dominant

subsidiary, at least in 2002 and 2003. As already detailed,

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 23 of 39
24

Domestic Services generated 59% of Stonepath's external customer

revenue in 2002 and 64% in 2003. Moreover, earnings from Air

Plus were critical to Stonepath's profitability from at least

2001 through 2003. By 2004, it seems the domestic and

international operations may have been of roughly equal

importance in terms of EBITDA, given Pelino's statement that

Domestic Services was responsible for about half of Stonepath's

projected 2004 earnings. However, drawing all reasonable

inferences in plaintiffs' favor, we find that they have

adequately pled that Domestic Services was the dominant

subsidiary for most of the Class Period, so Domestic Services'

transportation revenues had greater financial import for

Stonepath than International Services' transportation revenues. 

Accepting that as true, we must consider whether we can

impute knowledge of Air Plus's accounting deficiencies to the

Individual Defendants. Plaintiffs do not challenge our previous

finding -- based on the figures reported in Stonepath's Form 10-K

and the third restatement -- that Stonepath's transportation

costs were $153,718,000 in 2003 and $84,478,000 in 2002, and that

transportation costs were understated by $4.4 million for 2003

and $1.6 million for 2002, i.e., less than 2.9% of transportation

costs for 2003 and 1.9% in 2002. We found before, and reaffirm

today, that variances of 2.9% and 1.9% were not of such magnitude

that defendants could be deemed to have known about, or been

suspicious of, accounting improprieties. 

In reaching that decision, we relied on In re Alpharma

Inc. Securities Litigation, 372 F.3d 137 (3d Cir. 2004). In that

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 24 of 39
25

securities fraud case, improper accounting methods used at a

Brazilian subsidiary affected Alpharma's net income. The Court

of Appeals found that plaintiffs did not adequately plead that

defendants knew about the accounting irregularities. The panel

noted the complaint was "devoid of any allegations" that AHD's

Brazil division was "so central to Alpharma's business" that

company executives should have noticed the Brazil division's

increased reported revenues. Id. at 151. It further observed

that "the Brazil division's total revenue accounted for only

slightly more than one half of one percent of the company's total

revenue in 1999." Id. (emphasis in original). 

Plaintiffs contrast those small numbers with Domestic

Services' demonstrated importance to Stonepath's profitability. 

Despite Domestic Services' significance, we must still consider

whether the relatively small variances should have warned the

Individual Defendants of accounting problems. Indeed, even if we

assume that Domestic Services was only responsible for half of

Stonepath's transportation costs (i.e., $76,859,000 in 2003 and

$42,239,000 in 2002), Domestic Services then understated its

transportation costs by 5.7% in 2003 and less than 3.8% in 2002. 

Given these relatively small margins, we look to when other

courts in this jurisdiction imputed knowledge to defendants in

securities cases.

Of course, knowledge that a statement was false or

misleading cannot be imputed to a defendant simply because he or

she held a certain position within a company. See Advanta, 180

F.3d at 539. Our courts have repeatedly held, however, that

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 25 of 39
26

knowledge of core activities of a business may be imputed to its

highest officials in some circumstances. For instance, courts

have found that allegations were sufficiently pled that director

and officer defendants knew or should have known they were making

misstatements where a defendant personally and often solely

negotiated some transactions and participated in many others that

were "a significant part" of a company's business and which the

Court found "involved misstatements," In re Tel-Save Sec. Litig.,

C.A. No. 98-3145, 1999 WL 999427, at *5 (E.D. Pa. Oct. 19, 1999);

where defendants participated in discussions about improper

company practices during which others expressed reservations

about those practices and even called for them to stop, see In re

Campbell Soup Co. Sec. Litig., 145 F.Supp.2d 574, 599 (D.N.J.

2001); and where defendants occupied the top corporate positions

during an $8.9 billion merger that was plagued with "widespread

integration problems," In re Aetna Inc. Sec. Litig., 34 F.Supp.2d

935, 953 (E.D. Pa. 1999). Even where a company's "premier

product" is at issue, "this fact alone does not warrant imputing

to the Individual Defendants knowledge of subtleties discernable

only through detailed study of monthly and quarterly . . . data." 

In re Bio-Technology General Corp., 380 F.Supp.2d 574, 597

(D.N.J. 2005); but cf. In re Viropharma, Inc., Sec. Litig., No.

02-1627, 2003 WL 1824914, at *9 (E.D. Pa. Apr. 7, 2003) (imputing

knowledge where pharmaceutical company's "highest ranking

members" alleged to have misstated information about the

company's leading drug product undisputedly had access to

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 26 of 39
27

clinical trial reports questioning the efficacy and safety of

that drug).

While none of these courts expressly held that

imputable information had to be easily discoverable, the Courts

plainly did not impute knowledge absent particularized

allegations showing that defendants had ample reason to know of

the falsity of their statements. Thus, while courts will impute

knowledge of core activities in some cases, they do so

cautiously. Given our Court of Appeals's recent reminder that

"'[g]eneralized imputations of knowledge' do not satisfy the

scienter requirement 'regardless of the defendants' positions

within the company,'" Alpharma, 372 F.3d at 149 (quoting Advanta,

180 F.3d at 539), caution is not simply prudent, it is required. 

Indeed, we have further reason to tread carefully in

this area when we consider the cases that the court in Alpharma

approvingly cited. See 372 F.3d at 151. In Kushner v. Beverly

Enterprises, Inc., 317 F.3d 820 (8th Cir.2003), the court noted

that "'the failure of a parent company to interpret

extraordinarily positive performance by its subsidiary . . . as a

sign of problems and thus to investigate further does not amount

to recklessness under the securities laws'." Id. at 829 (quoting

Novak v. Kasaks, 216 F.3d 300, 309 (2d Cir. 2000)). In Chill v.

General Electric Co., 101 F.3d 263 (2d Cir. 1996), the Second

Circuit held that "[g]iven the significant burden on the

plaintiff in stating a fraud claim based on recklessness, the

success, even the extraordinary success, of a subsidiary will not

suffice in itself to state a claim that the parent was reckless

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 27 of 39
28

in failing to further investigate[, and] [f]raud cannot be

inferred simply because [the parent corporation] might have been

more curious or concerned about the activity at [its

subsidiary]." Id. at 270. Lastly, Alpharma cited In re

Comshare, Inc. Securities Litigation, 183 F.3d 542 (6th Cir.

1999), where the Sixth Circuit cited Chill for the proposition

that courts "should not presume recklessness or intentional

misconduct from a parent corporation's reliance on its

subsidiary's internal controls." Id. at 554. 

Thus, even though we accept that Domestic Services was

the more important of Stonepath's two subsidiaries and that Air

Plus's earnings were key to Stonepath's profitability from 2001

to 2003, the relevant jurisprudence prevents us from reflexively

imputing to the Individual Defendants knowledge of a subsidiary's

under-reporting of transportation costs. We cannot do so absent

strong indications that those defendants had sufficient reason to

know of, or be suspicious about, the defective accounting system. 

See also Novak v. Kasaks, 216 F.3d 300, 309 (2d Cir. 2000)

("Where plaintiffs contend defendants had access to contrary

facts, they must specifically identify the reports or statements

containing this information."). 

Notably, plaintiffs have not alleged that Domestic

Services' financial reports were unusual or out of line with

expectations. They have not alleged that Air Plus's earning

targets of $6 million were unrealistic, and that the Individual

Defendants therefore should have been suspicious when Air Plus

realized those goals. While plaintiffs have adequately pled that

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 28 of 39
 Under Oran v. Stafford, 226 F.3d 275, 289 (3d Cir. 8

2000), we can take judicial notice of public disclosure documents

filed with the SEC. See also Advanta, 180 F.3d at 540 (drawing

information from Form 4s filed with the SEC and attached to

defendants' motion to dismiss). Accordingly, we take notice of

the SEC filings that defendants cite to establish their stock

purchases, which they attached to their first motion to dismiss

as Exhibits C, D, E and F.

 See Pelino's Form 4, Feb. 27, 2003, available at 9

http://www.sec.gov/Archives/edgar/data/1093546/000095011603001846

/form4.htm. 

 See Pelino's Form 4, Mar. 10, 2004, available at 10

http://www.sec.gov/Archives/edgar/data/1093546/000095011604001480

/xslF345X02/p331876_ex.xml.

 Id. 11

29

some people in field offices knew of Air Plus's accounting

systems deficiencies, they still have not pled "particularized

facts showing that the information about under-accrual -- or, for

that matter, any of the alleged accounting and financial

reporting problems described by their confidential witnesses --

reached defendants well before Stonepath's restatements." 

Stonepath, 397 F.Supp.2d at 589. 

We also find it telling that throughout the Class

Period, while the Individual Defendants were allegedly

artificially inflating stock prices with their fraudulent

misrepresentations, they were simultaneously buying Stonepath

stock. Pelino bought 100,000 shares on February 27, 2003 and 8 9

25,000 shares on May 7, 2004. As of the latter date, he was 10

the beneficial owner of 431,222 shares. In March of 2003, 11

Pelino accepted shares instead of a minimum cash bonus of

$360,000 that he was otherwise entitled to under his employment

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 29 of 39
 See Stonepath's Form 14-A at 24, Apr. 8, 2004, 12

available at http://www.sec.gov/Archives/edgar/data/1093546

/000095011604001173/def14a.txt.

 Id. 13

 See Crain's Form 4, May 10, 2004, available at 14

http://www.sec.gov/Archives/edgar/data/1093546/000095011604002066

/xslF345X02/p332920_ex.xml, and Form 4, July 2, 2004, available

at http://www.sec.gov/Archives/edgar/data/1093546/000095011604001

479/xslF345X02/p331877_ex.xml.

 See Scully's Form 4, July 2, 2004, available at 15

http://www.sec.gov/Archives/edgar/data/1093546/000095011604002069

/xslF345X02/p332919_ex.xml.

30

agreement, and for his 2003 bonus, Pelino accepted options to 12

buy 675,600 shares instead of a $1,080,000 cash bonus. Crain 13

and Scully also purchased Stonepath stock during this time. 

Crain bought 79,897 shares between May 7, 2004 and June 30, 2004,

and beneficially owned 97,497 shares as of June 30, 2004.14

Scully bought 879 shares on June 30, 2004, and beneficially owned

7,779 shares. 

15

Plaintiffs do not challenge that, rather than selling

stock during the Class Period, the Individual Defendants were

actually buying more. Nor do plaintiffs offer any theory that

would reconcile their allegations with these defendants' actions. 

The Individual Defendants' investment actions negate an inference

that they were aware of or recklessly disregarded financial

reporting problems. See Advanta, 180 F.3d at 540-41 ("Far from

supporting a 'strong inference' that [two] defendants had a

motive to capitalize on artificially inflated stock prices,"

their sales of 7 percent and 5 percent of their holdings, plus

one's continued ownership of a "sizable percentage of Advanta's

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 30 of 39
31

outstanding stock" in fact suggested "they had every incentive to

keep Advanta profitable").

Plaintiffs have failed to plead facts showing that the

Individual Defendants were presented with suspicious earnings

figures or information that would call into question otherwise

reasonable earnings reports. We therefore cannot impute

knowledge to those defendants of the deficiencies of an

accounting program used by a subsidiary, albeit an important one.

Perhaps recognizing that Domestic Services' reported

earnings would not alert the Individual Defendants to accounting

problems, plaintiffs introduce another theory regarding the

relevance of the understated costs. They contend that the underreported transportation costs should be measured by reference to

their impact on net income and earnings. In other words, they

ask us to assess the Individual Defendants' scienter based on the

impact that the under-reporting had on Stonepath's net income and

earnings, and not on whether the transportation costs Domestic

Services actually reported should have appeared suspect to the

senior corporate officers. 

To establish the validity of this theory, plaintiffs

rely on four district court cases, Carley Capital Group v.

Deloitte & Touche, 27 F.Supp.2d 1324 (N.D. Ga. 1998); In re

Wellcare Management Group, Inc. Securities Litigation, 964

F.Supp. 632, 636, 638-40 (N.D.N.Y. 1997) (finding scienter

adequately pled under two theories -- motive and opportunity and

conscious and reckless behavior -- where earnings per share fell

by 50% and 75% for the two years preceding a restatement); In re

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 31 of 39
32

Miller Industries, Inc. Securities Litigation, 120 F.Supp.2d

1371, 1382 (N.D. Ga. 2000) (citing Carley for the proposition

that "alleged GAAP violation must be combined with other factors,

such as a drastic overstatement of financial results, to give

rise to a strong inference of scienter"); and Chu v. Sabratek

Corp., 100 F.Supp.2d 827 (N.D. Ill. 2000) (denying in part motion

to dismiss because the facts alleged raised strong inference of

intentional or reckless false statements where some defendants

had reason to know of improper accounting). A review of these

cases shows that the particularized facts those plaintiffs

alleged gave reason to find that the defendants knew of, or had

reason to be suspicious about, allegedly improper accounting

practices. Moreover, the holdings do not support the theory that

plaintiffs advance. 

In Carley Capital Group v. Deloitte & Touche, the

plaintiffs sued an accounting firm "heavily involved" in the

management of a company. 27 F.Supp.2d at 1339. The defendant

allegedly "specifically direct[ed] the inclusion of $12.5 million

of revenues and income" in violation of the Generally Accepted

Accounting Principles ("GAAP") and of the company's own revenue

recognition policy, and issued an unqualified audit opinion that

the financial statements conformed with the GAAP. The accounting

firm did all this despite having advised the company that it was

understating expenses and overstating income. Id. at 1330-31. 

The court did not find sufficient allegations of reckless

behavior based only on the misstatements' impact on the company's

profitability. 

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 32 of 39
33

The court in Wellcare found that plaintiffs alleged

"facts tending to show negligence that is tantamount to intent"

where a company's president and CFO/Vice-President of Finance

were alleged to have "had knowledge of, condoned, and/or

encouraged" deliberate earnings overstatement, demands for

unwarranted checks, demand for, and receipt of, checks for

nonexistent deficits, misstatement of assets, improper treatment

of an acquisition as a purchase rather than a consolidation, and

recognition of a license fee without having received payment or

assurance of payment. 964 F.Supp. at 635-36, 640. The court's

analysis does not suggest that its holding was grounded on the

earnings overstatements' effect on earnings per share. 

In Chu, the court held that plaintiffs alleged

"specific facts" concerning an alleged mischaracterization of $39

million in research and development expenses as intangible assets

rather than expenses, and "[f]or this reason" it did not dismiss

the claims against certain defendants. 100 F.Supp.2d at 840.

Again, the court's decision did not rely on how the allegedly

improper accounting affected reported earnings.

In short, plaintiffs have not pointed to any authority

that would permit us to find scienter simply because a

misstatement materially impacted net income and earnings. We

therefore will not adopt such a theory. Instead, we analyze the

scienter allegations under the established jurisprudence as we

have described it.

Plaintiffs also ask us to apply the materiality

analysis from Ganino v. Citizens Utilities Co., 228 F.3d 154,

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 33 of 39
34

163-65 (2d Cir. 2000). But defendants here are challenging the

sufficiency of the allegations as they concern scienter, not

materiality, and these are two distinct elements under a Section

10(b) analysis. See In re IKON Office Solutions, Inc., 277 F.3d

658, 666 (3d Cir. 2002) (stating five elements for claim brought

under Section 10(b) and Rule 10b-5). Plaintiffs have cited no

authority in our Circuit or any other that would permit us to

take the novel approach of conflating the legal standards for

these two elements. Because only scienter is at issue here, we

apply, as we must, the well-developed legal standards for this

particular element of a Section 10(b) claim.

In sum, plaintiffs have failed to plead facts showing

that Domestic Services' inaccurate transportation cost accounting

was known to, or should have been obvious to, defendants at any

point significantly prior to Stonepath's restatement

announcements. Thus, plaintiffs' theories and alleged facts in

support of their first argument fail to give rise to the

requisite strong inference of scienter.

Plaintiffs' second argument is that the earn-out

arrangements used to purchase Air Plus and United American -- and

particularly Koch's dual position as a beneficiary of the Air

Plus earn-out payments and as the CEO of Domestic Services and

Air Plus -- created for defendants a "heightened duty to monitor

the accuracy of the data underlying the financial results

reported by Air Plus." Second Am. Compl. ¶ 71. As a majority

shareholder in Air Plus, Koch, along with other former Air Plus

shareholders, was entitled to, and did in fact receive, earn-out

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 34 of 39
35

payments when Air Plus met certain earnings targets. Plaintiffs

allege that his financial interest as a seller is a

distinguishing factor, and they reject defendants' argument that

Koch's interest is akin to any executive who might have a

generalized motive to maximize his or her company's earnings to

receive bonuses, stock options, and promotions.

To establish the existence of this heightened duty,

plaintiffs cite SEC v. Aqua-Sonic Products Corp., 524 F. Supp.

866, 880 (S.D.N.Y. 1981), aff'd, 687 F.2d 577 (2d Cir. 1982), and

Larami Corp. v. Amron, No. 91-6145, 1995 WL 128022 (E.D. Pa. Mar.

23, 1995), aff'd, 91 F.3d 166 (Fed. Cir. Apr. 19, 1996). Neither

of these cases supports plaintiffs' proposition. 

We first note that SEC v. Aqua-Sonic Products Corp. is

a Second Circuit pre-PSLRA case, so it was not decided under the

jurisprudence to which we are now bound. Putting aside that

crucial difference for the moment, Aqua-Sonic bears no

resemblance to this litigation. There, a trial revealed that

defendants, partners in an enterprise and attorneys themselves,

had twice been advised by outside law firms that their enterprise

might be covered by the securities laws. 524 F. Supp. at 880. 

After an employee researched the matter and the partners

discussed it, they concluded that this advice was incorrect and

therefore chose not to comply with the securities laws. Id. The

court found that the failure to obtain another outside opinion

and reliance on the opinion of attorneys with a financial

interest in the enterprise was reckless. Id. By contrast,

plaintiffs here offer no particularized allegations that the

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 35 of 39
 On such a hypothesis, DiGiacomo and Anderson would 16

be in the same scienter shoes as the officers in our Court of

Appeals's recent In re Suprema Specialties, Inc. Securities

Litigation, 438 F.3d 256, 279-80 (3d Cir. 2006) (finding

"specific knowledge" where officers "signed millions of dollars

in company checks during the class period" and "controlled all of

the bookkeeping connected with the accounts" at issue).

36

Individual Defendants ignored advice from auditors or legal

counsel that Air Plus's accounting system might be deficient.

Plaintiffs' second citation, Larami Corp. v. Amron, is

neither a securities case nor a PSLRA litigation. It is a case

arising out of alleged patent and trademark infringement of toy

water guns, and plaintiffs' citation to that court's discussion

of a commercial disparagement claim has no relevance to this

post-PSLRA case.

Thus, neither of plaintiffs' citations supports the

proposition that defendants had a "heightened" duty to monitor

Air Plus's accounting because of Koch's earn-out payments. 

Moreover, Domestic Services had its own CFO, Joe DiGiacomo, and

Controller, Jim Anderson. Even if, as plaintiffs allege, Messrs.

DiGiacomo and Anderson knew of the accounting problems, nothing 16

alleged suggests that those officers had a particularized motive

to inflate their subsidiaries' reported earnings, or that

defendants were reckless in relying on their underlings' work.

Plaintiffs also suggest that Koch's resignation, and

the defendants' alleged failure to elaborate on its

circumstances, is telling for purposes of scienter. Koch's

departure, by itself, tells us nothing about the Individual

Case 2:04-cv-04515-SD Document 61 Filed 04/03/06 Page 36 of 39
37

Defendants' mental state when they were reviewing Domestic

Services' earning reports.

To recapitulate, the second amended complaint details

three restatements, each concerning a different financial

reporting problem within Stonepath. The final restatement, which

materially affected Stonepath's profitability during the Class

Period, was necessary because an accounting program used within

an important division of Stonepath's dominant subsidiary failed

to accurately record the difference between estimated and actual

transportation costs. Plaintiffs allege that the Individual

Defendants, who later admitted to a "lack of understanding" of

this process, were reckless in failing adequately to monitor

Domestic Services' transportation costs both because it was a

core business and because its CEO was a former Air Plus

shareholder who received earn-out payments when Air Plus achieved

certain benchmarks. 

Despite Domestic Services' importance, we hold, for the

reasons discussed at length herein, that plaintiffs have failed

to plead particularized facts demonstrating that the Individual

Defendants, who continued to invest in Stonepath stock during the

Class Period, acted with the requisite level of scienter. 

B. Section 20(a)

In Count II, the second amended complaint alleges that

the defendants violated Section 20(a) of the Act, 15 U.S.C. §

78t(a) (2004). That section imposes joint and several liability

on one who controls a corporation that violates federal

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securities laws. The defendants suggest that we should dismiss

this claim because plaintiffs fail to plead their other federal

claim adequately and a Section 20(a) claim will not lie when

there are no actionable independent underlying violations of the

Act. See In re Advanta Corp. Sec. Litig., 180 F.3d at 541; see

also In re Rockefeller Center Properties, Inc., 311 F.3d 198, 211

(3d Cir. 2002) ("[I]t is well-settled that controlling person

liability is premised on an independent violation of the federal

securities laws."). 

Because we read the allegations in the latest complaint

as insufficient to state a claim for violation of Section 10(b)

of the Act for purposes of this motion to dismiss, we shall

dismiss the Section 20(a) claim.

IV. Conclusion

Plaintiffs have again failed to allege particularized

facts that create a strong inference that defendants acted with

the scienter that the law requires. We therefore grant

defendants' motion to dismiss and bring this litigation to a

close before us.

BY THE COURT:

/s/ Stewart Dalzell, J. 

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