Opinion ID: 201697
Heading Depth: 3
Heading Rank: 3

Heading: Concealment of Illiquidity, Inability to Pay Debts, and Impending Bankruptcy

Text: 80 The Complaint's final major area of focus is on statements allegedly concealing S & W's financial deterioration. The Complaint contends that S & W issued false and misleading statements reassuring investors of S & W's financial viability and its access to sufficient cash to meet its needs, even as its finances fell into shambles, and eventually into bankruptcy. 81 The allegations of financial deterioration are set forth in the Complaint at length and with specificity. According to a former controller for S & W's industrial division, by the middle of 1998, S & W knew that the Company was `starting to get strapped for cash.' ¶ 70. The Company began having problems paying its vendors on the Tiverton project in the summer of 1998, leading some unpaid vendors to stop delivering materials to the project site. ¶ 71. Meanwhile, throughout 1998, 82 comprehensive internal financial reports, distributed to approximately twenty S & W division heads and top executives, that included financials broken out for all divisions, with details of personnel costs, sales, income and working capital and which also measured S & W's performance against its plan for the year, showed a materially worse financial situation and outlook [than the disclosed financial results]. 83 ¶ 72. A confidential source, identified as the head of S & W's Development Corporation said: 84 Anyone who had access to the monthly financials could see that it was not what was being said publicly. You could read them and compare them with the quarterlies he [Smith] was reporting and ask what he was smoking. Knowing what we knew inside and seeing the quarterlies-they just did not jibe. 85 Id. 86 The financial problems continued to mount through 1999. Unpaid vendors threatened to place liens on the Tiverton project, ¶ 78; the Company began using credit cards to purchase materials for the project, ¶ 79; the Company faced calls seeking payment on various projects, ¶ 83; the Company's treasurer regularly sent e-mails to internal staff advising that the Company had no money to pay the vendors' bills and to not bother submitting requests for payment, id. ; and the Company found that it was increasingly difficult to get vendors to bid on S & W projects, ¶ 84. Some vendors and subcontractors called Smith directly to complain about not being paid, and those who called Smith regularly to collect money and threaten to walk off a project were usually the first to get paid. ¶ 85. 87 By summer of 1999, a list of overdue accounts payable was created and regularly delivered to Smith, Langford, and S & W's comptroller. ¶ 87. Some accounts payable were 600-700 days overdue, and consequently vendors and subcontractors were stopping work, engaging in slow-downs, or filing liens. Id. The Company succeeded in obtaining a credit agreement in July 1999, but was already in material default by the time the agreement was made because of the failure to pay vendors and subcontractors as required. ¶ 92. 88 In October, needing cash to placate lenders, S & W announced it was selling its headquarters building and cold storage business, but knew in December that the sale of its building would not alleviate its problems, and even had to obtain an emergency adjustment in its lending arrangements so it could survive long enough to complete the sale. ¶¶ 117, 119. In November, S & W was told that it was in material breach of a $250-million contract because it had failed to pay subcontractors and suppliers, leading senior executives to embark on a desperate effort to stop the project from being terminated. ¶¶ 108, 110. In December, in a bid to generate cash, Smith and Langford caused the S & W Employee Retirement Plan Trust to purchase 1 million shares of S & W common stock, raising over $15 million. ¶ 121. By the end of the year, Smith's gasoline credit card was discontinued and newspaper delivery to S & W's building was halted, ¶ 126, while at the Tiverton project site, trash was building up ... and spilling out of the dumpsters because S & W had not paid the bills of the trash hauler, ¶ 131. 89 In 2000, the Complaint alleges, the owner of the Tiverton project notified S & W of defaults on its contract because of liens placed on the Tiverton site, and S & W was unable to cure the defaults. ¶¶ 98, 138. Cost overruns on the project at that time soared to over $27 million. ¶ 140. S & W eventually filed for bankruptcy in June 2000. ¶ 155. 90 In the face of these events, the Complaint alleges, S & W issued false and misleading statements principally in press releases and filings with the SEC, falsely asserting or implying that the Company had sufficient cash, see, e.g., ¶¶ 172, 192, 199, and inadequately disclosing the extent of the Company's financial problems, see, e.g., ¶¶ 283-84, 286-88, 293-94, 298-304, 305-06, 307-10. For example, in the context of these events, the Company repeatedly announced in its SEC filings that it believes that the types of businesses in which it is engaged require that it maintain a strong financial condition, and that it has on hand and has access to sufficient sources of funds to meet its anticipated operating, dividend and capital expenditure needs. The Company included words to that effect in at least its March 1998 10-Q (filed in May 1998), ¶ 192, September 1998 10-Q (filed in November 1998), ¶ 223, 1998 10-K (filed in March 1999), ¶ 242, March 1999 10-Q (filed in May 1999), ¶ 264, and June 1999 10-Q (filed in August 1999), ¶ 278. As discussed below, the Company made notable disclosures about its financial difficulties in later filings, most especially in the fall of 1999. Plaintiffs acknowledge these disclosures, but argue that they did not go far enough in revealing the financial collapse that was upon S & W. ¶ 283. 91 This group of allegations raises four primary questions: (1) Did disclosures made by S & W in the fall of 1999, prior to the first purchase of S & W stock by the named plaintiffs, adequately apprise investors of the financial problems facing the Company, rendering previous misleading statements immaterial as a matter of law, for purposes of this suit? (2) If not, do the Complaint's allegations meet the clarity-and-basis requirements of the PSLRA and Rule 9(b)? (3) Does the Complaint satisfy the PSLRA's required strong inference of scienter with respect to Smith and Langford to support claims under Rule 10b-5? (4) As to some of the allegedly misleading statements made in quarterly and annual filings with the SEC, were they forward-looking statements, protected from suit by the PSLRA's safe harbor? 92 (a) Falsity and materiality. The district court first ruled, upon the defendants' motion to dismiss, that while some of the Company's statements made prior to the autumn of 1999 might be actionable, none of S & W's statements made after that time were actionable because by then S & W had made full disclosure of its financial woes. See In re Stone & Webster, Inc. Sec. Litig., 253 F.Supp.2d at 126. On that basis, the court granted summary judgment on all outstanding claims. Although the judgment was not explained, it was apparently based on the following reasoning: (1) None of the named plaintiffs purchased securities in S & W prior to that time; (2) Any materially false statements made prior to that time had been cured, as a matter of law, by the Company's more revelatory statements made during autumn of 1999; and (3) Because the named plaintiffs could not assert claims on their own behalf based on statements made prior to autumn of 1999, they could not do so on behalf of class plaintiffs. 13 93 The first question we must consider is whether disclosures made by S & W in the fall of 1999 so completely disclosed the alleged financial problems of the Company that they either corrected, or rendered immaterial as a matter of law, any misleading statements made before that point. We must determine whether S & W sufficiently disclosed the state of affairs at S & W, such that the totality of information offered to investors purchasing after that time could not be considered false or materially misleading. 94 We find that they did not. Assuming, as we must, the truth of the Complaint's allegations as to the Company's financial condition in the fall of 1999, we find that the Company's statements made at that time, although more revealing than some earlier statements, were not so informative as to correct earlier false statements, or render them immaterial as a matter of law. A jury could reasonably find that the cumulative sum of information provided to investors by that point was still materially misleading. 95 In their argument that any prior falsity of statements had been cured by the autumn 1999 statements, defendants rely primarily on a Company press release dated October 27, 1999, and on the quarterly 10-Q filed with the SEC on November 15, 1999. 14 The October 27, 1999, press release announced that the Company intended to sell its corporate headquarters and its cold storage business in order to enhance liquidity and focus on its core competencies. The document stated that the Company was not in compliance with its principal credit agreement and stated that it had requested waivers from its bank group regarding certain covenants in that agreement. It acknowledged also that S & W could not continue normal operations unless it obtained additional short-term funding. Finally, it stated that [i]n light of the Company's current liquidity needs, the Board of Directors decided to omit the Company's normal quarterly dividend, and that S & W had retained financial advisors to assist the Company in arranging and restructuring interim and long-term financing and with asset sales authorized by the board of directors. 96 In its November 15, 1999, 10-Q filing with the SEC, the Company noted that losses incurred in the past 24 months have negatively impacted the Company's cash position, and explained: 97 As of the end of the third quarter of 1999, the Company had fully drawn the cash available to it under its current credit facility and the amount of the Company's past due trade payables had increased, as reflected in accounts payable on the Consolidated Balance Sheets, with certain of the Company's vendors and subcontractors having delayed work to be performed by them. 98 The falsity of a statement and the materiality of a false statement are questions for the jury. See TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 450, 96 S.Ct. 2126, 48 L.Ed.2d 757 (1976); see also In re Cabletron Systems, Inc., 311 F.3d at 34. Cf. United States v. Gaudin, 515 U.S. 506, 115 S.Ct. 2310, 132 L.Ed.2d 444 (1995). A court is thus free to find, as a matter of law, that a statement was not false, or not materially false, only if a jury could not reasonably find falsity or materiality on the evidence presented. See TSC Industries, Inc., 426 U.S. at 450, 96 S.Ct. 2126. We cannot agree that as a matter of law these disclosures sufficiently apprised investors of all material information regarding the Company's alleged financial condition and corrected or rendered immaterial the falsity of previous statements. 99 A potential investor after the autumn 1999 statements would likely examine not only the Company's very most recent statements, but also the statements made by the Company in the recent preceding periods. If prior to autumn 1999 the Company had issued false statements, describing its financial condition in misleadingly benign terms, those statements might continue to influence an investor's decision unless they had been retracted, had ceased to be relevant, or their misleading message had been adequately corrected by subsequent revelations or statements. In our view, although the autumn 1999 statements revealed more about the deterioration of the Company's financial conditions than prior statements, we cannot agree that, as a matter of law, a jury could not reasonably find that after their issuance the totality of the Company's statements continued to be materially misleading as to the Company's financial situation. For one thing, a company which has long maintained a strong financial position but recently fallen into a liquidity crunch may be considered a safer investment than a company with an identical present balance sheet which has been struggling with underfunding for some time. The former may be seen as coping with a sudden temporary reversal, likely to be cured by the good management practices which have long dominated, while in the latter case the current difficulty may appear the inevitable consequence of a continuous history of bad management, which is destined to result in eventual failure. The Company's autumn 1999 statements certainly made significant disclosures, but they did not sufficiently dispel the allegedly misleading picture of a Company which, up to that point, had maintained a strong position. 100 For example, as we noted above, S & W filings with the SEC made at least through August 1999 contained reassuring assertions informing investors that the Company has on hand and access to sufficient sources of funds, and even arguably implying that it maintain[ed] a strong financial condition. See, e.g., ¶ 278. If the Company's financial situation was in fact as dire as alleged by the Complaint, such statements could reasonably be found to be materially misleading. The Complaint portrays S & W as a company in financial distress, spiraling toward bankruptcy — out of cash, unable to keep up with payments, and with vendors and subcontractors halting work and deliveries and threatening liens. 101 In our view, the information released by the Company in autumn 1999 did not so clearly correct the alleged falsity of the earlier statements. Rather, a jury could reasonably find that the `total mix' of information available to an investor in the fall of 1999-that is, the totality of new disclosures, read in the context of previous statements by the Company — still was materially misleading, by virtue of both false statements and material omissions. See TSC Industries, Inc., 426 U.S. at 449, 96 S.Ct. 2126. 102 (b) The PSLRA's requirement of clarity and basis. Finding that the dismissal of these claims cannot be supported on the basis of the autumn 1999 disclosures, we must next consider whether the allegations meet the requirements of the PSLRA. We have no doubt that these allegations pass the clarity-and-basis requirements. The Complaint paints a detailed account of the deteriorated financial conditions at S & W, replete with factual support and citations to sources likely to have knowledge of the matter. The Complaint also identifies with specificity the statements alleged to be false and misleading and explains in what respect they were misleading. 103 (c) Strong inference of required state of mind. In addition to passing the clarity-and-basis test, we find that these allegations also survive the PSLRA's strong-inference requirement. 104 (i) Claims under 10b-5. Claims under Rule 10b-5 require proof of scienter. The Company statements alleged to be false concealments of its liquidity crunch were made at various times from 1997 to 2000. In order to plead a valid claim against Smith and Langford as to any of these statements, the Complaint must assert facts supporting a strong inference that they acted with scienter at the time the statement was made. We find that the Complaint alleges facts sufficient to support a strong inference of scienter on the parts of both Smith and Langford starting as early as January 1999. 105 The Complaint alleges that during the summer of 1999 an accounts payable list showing accounts overdue by 600-700 days was being prepared on a regular basis for review by Smith and Langford and that the Company was so strapped for cash that no subcontractor was allowed to be paid without the personal approval of Smith or Langford. ¶ 87. The Complaint further alleges that in the spring of 1999 Smith received calls from vendors and subcontractors demanding payment and threatening to walk off their projects. Id. These allegations are clearly sufficient to support a strong inference of scienter for the periods to which they pertain. 106 The allegations relating to the early part of 1999, which rely more heavily on circumstantial evidence, are nonetheless sufficient in our view, when taken together with the entire mix of alleged facts, to support a strong inference of at least recklessness with respect to the falsity, if not actual knowledge of the falsity. The financial strength of the Company was undoubtedly a matter of principal concern to its Chief Executive Officer and Chief Financial Officer. The Company's public statements repeatedly stressed the importance of financial strength for a company engaged in S & W's business, before going on to give assurance of S & W's access to ample funds. 107 The Complaint alleges furthermore that throughout 1998 comprehensive internal financial reports of the Company's current condition were regularly distributed to the Company's top executives. Id. Although the contents of the reports are not described, we can fairly infer that they described what they purported to describe — the Company's current financial condition. According to the allegations of the Complaint, the condition that would have been reflected in those internal reports was becoming desperate, so that already the Company had slowed payments to vendors and subcontractors. If by the summer of 1999 such accounts were 600-700 days overdue, it follows that by January 1999, those accounts were 400-500 days overdue, and this was regularly revealed in internal reports distributed to Smith and Langford. An unnamed confidential source, the executive described as the head of S & W's Development Corporation, is quoted in the Complaint as saying that a comparison of the Company's periodic internal reports distributed to the Company's executives with the statements signed by Smith in the Company's quarterly public reports would lead one to ask what [Smith] was smoking. ¶ 72. 108 Those allegations of particularized facts support a strong inference that by January 1999, both Smith and Langford were either aware of the misleading nature of the Company's reassuring reports, or were at least reckless with respect to their truthfulness on matters of enormous importance. We therefore vacate the district court's judgment relating to claims under Rule 10b-5 against Smith and Langford for false statements as early as January 1999 and thereafter relating to the Company's liquidity and financial condition. 109 (ii) Claims under §§ 20(a) and 18. With respect to claims asserted against Smith and Langford under §§ 20(a) and 18 for statements concealing illiquidity and the deterioration of S & W's financial condition, we vacate the judgment and remand for further proceedings for the same reasons as given above relating to claims under §§ 20(a) and 18. 15 110 (d) Safe harbor for forward-looking statements. As for some of the statements which we ruled could serve as the basis for claims of misleading statements relating to the Company's liquidity and financial condition, the district court ruled in considering the defendant's motion to dismiss that these were within the PSLRA's safe harbor for forward-looking statements. See In re Stone & Webster, Inc. Sec. Litig., 253 F.Supp.2d at 125, 130. While the exact wording of these statements varied slightly, they effectively asserted that the Company has on hand and has access to sufficient sources of funds to meet its anticipated operating, dividend and capital expenditure needs. See ¶ 192; see also ¶¶ 172, 208, 223, 242. We do not agree with the district court that this statement is necessarily protected by the PSLRA's safe harbor rule. 111 The statute generally provides, with specified limitations, that issuers and underwriters of securities shall not be liable in any private action based on an untrue or misleading statement of a material fact with respect to any forward-looking statement if the forward-looking statement is 112 identified as a forward-looking statement, and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement, ... or ... the plaintiff fails to prove that the forward-looking statement ... [if made on behalf of a business entity by or with the approval of an executive officer was] made ... with actual knowledge by that officer that the statement was false or misleading. 113 See 15 U.S.C. § 78u-5(c)(1). The statute thus seems to provide a surprising rule that the maker of knowingly false and wilfully fraudulent forward-looking statements, designed to deceive investors, escapes liability for the fraud if the statement is identified as a forward-looking statement and [was] accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement. See id. § 78u-5(c)(1)(A)(i). 114 The statute goes on to define forward-looking statements as including: (A) a statement containing a projection of revenues, income ... earnings (including earnings loss) per share, ... capital expenditures, dividends, ... or other financial items; (B) a statement of the plans and objectives of management for future operations ...; (C) a statement of future economic performance ...; (D) any statement of the assumptions underlying or relating to [any of the above]. Id. § 78u-5(i)(1). 115 The statement in question asserted essentially that the Company has on hand ... sufficient sources of funds to meet its anticipated [needs]. Because the statement includes a reference to anticipated future needs for funds, the district court found it to be forward-looking, apparently concluding that the statement came within the protection granted for a projection of ... capital expenditures, dividends, ... or other financial items. We think that the meaning of this curious statute, which grants (within limits) a license to defraud, must be somewhat more complex and restricted. 116 By reason of the emphasis on projection[s], plans, and statement[s] of future economic performance, we understand the statute to intend to protect issuers and underwriters from liability for projections and predictions of future economic performance, which are later shown to have been inaccurate. See Webster's Third New International Dictionary 1814, def. 12b (1976) (defining projection as an estimate of future possibilities based on a current trend). The legislative history confirms this understanding. The House Conference Report explains that the bill was intended to enhance market efficiency by encouraging companies to disclose forward looking information that otherwise might be muzzled out of fear that making predictions could later spawn burdensome securities fraud actions. See H.R. Conf. Rep. No. 104-369 (1995), 1995 U.S.C.C.A.N. 730, 742. 117 The problem in applying this statute to the statement in question is that the statement is composed of elements that refer to estimates of future possibilities and elements that refer to present facts. Essentially the statement asserts that the Company has present access to funds sufficient to meet anticipated future needs. The part of the statement that speaks of the quantity of cash on hand speaks of a present fact. The part that speaks of the amount of anticipated operating, dividend and capital expenditure needs speaks of a projection of future economic performance. The claim of fraud, however, does not involve a contention that the defendants were underestimating the amount of their future cash needs. The claim is rather that the defendants were lying about the Company's present access to funds. The Company was, according to the allegations of the Complaint, in an extreme liquidity crunch. 118 We believe that in order to determine whether a statement falls within the safe harbor, a court must examine which aspects of the statement are alleged to be false. The mere fact that a statement contains some reference to a projection of future events cannot sensibly bring the statement within the safe harbor if the allegation of falsehood relates to non-forward-looking aspects of the statement. The safe harbor, we believe, is intended to apply only to allegations of falsehood as to the forward-looking aspects of the statement. Cf. Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1213 (1st Cir.1996) (examining, in the context of the bespeaks caution doctrine, a statement that has both a forward-looking aspect and an aspect that encompasses a representation of present fact and concluding that the doctrine was inapplicable to the extent the statement encompasses the latter representation of present fact ), superceded by statute on other grounds, as noted in Greebel, 194 F.3d at 197. 119 To illustrate the distinction we draw, assume as hypothetical facts that an issuer of securities relating to a business venture carrying an obvious risk of liability (say, the operation of an amusement park) issues a public statement that it has procured liability insurance in amounts sufficient to cover the maximum liability that can be anticipated based on comparable experience. Assume that in the suit, the aspect of the statement alleged to be fraudulent lies not in the estimate of likely liabilities, but in the fact that the issuer was lying in stating that it had obtained insurance. It in fact had no insurance policy. The accusation of falsity, in other words, lay not in the accuracy of the projection of future financial events, but rather in the representation of a present fact. Notwithstanding that the allegedly false statement contain[s] a projection of [future] financial items, we do not think Congress intended to grant safe harbor protection for such a statement whose falsity consists of a lie about a present fact. 120 While our case is not precisely like the hypothetical example, we think the example illustrates that where the falsehood relates to a representation of present fact in the statement, it will not necessarily come within the statute's safe harbor, even though the statement might also contain a projection of future financial experience. 121 In this case, the alleged falsehood was in the fact that the statement claimed that the Company had access to ample cash at a time when the Company was suffering a dire cash shortage. The claim was not that the Company was understating its future cash needs. In our view, the safe harbor of the PSLRA does not confer a carte blanche to lie in such representations of current fact. We reject the district court's conclusion that the statements assuring that the Company had access to sufficient cash to cover anticipated needs were within the safe harbor.