Opinion ID: 729940
Heading Depth: 3
Heading Rank: 2

Heading: Circumstantial Evidence of Recklessness

Text: 25 A plaintiff in a fraud action may also plead scienter by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness. Acito, 47 F.3d at 52 (quotation omitted). The plaintiffs argue that GE's financial reporting was reckless in two respects. First, they contend that GE was reckless in its failure to heed the red warning flags coming from Kidder that signaled Kidder's falsification of profits. Second, they argue that GE was reckless in relying on Kidder to monitor its own financial reporting. The district court found plaintiffs' factual allegations insufficient to infer the requisite recklessness. 7 We agree. 26 In Rolf v. Blyth, Eastman Dillon & Co., we stated that [r]eckless conduct is, at the least, conduct which is highly unreasonable and which represents an extreme departure from the standards of ordinary care ... to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it. 570 F.2d 38, 47 (2d Cir.1978) (alteration in original and quotation omitted), op. am., Nos. 77-7104, 77-7124, 1978 WL 4098 (2d Cir. May 22, 1978), cert. denied, 439 U.S. 1039, 99 S.Ct. 642, 58 L.Ed.2d 698 (1978). An egregious refusal to see the obvious, or to investigate the doubtful, may in some cases give rise to an inference of ... recklessness. Goldman v. McMahan, Brafman, Morgan & Co., 706 F.Supp. 256, 259 (S.D.N.Y.1989); see Breard v. Sachnoff & Weaver, Ltd., 941 F.2d 142, 144 (2d Cir.1991). 27 The facts alleged to support recklessness must be strong circumstantial evidence of that recklessness. Acito, 47 F.3d at 52. This showing of recklessness must be such that it gives rise to a strong inference of fraudulent intent. Shields, 25 F.3d at 1128; see also Decker v. Massey-Ferguson, Ltd., 681 F.2d 111, 121 (2d Cir.1982) (recklessness must, in fact, approximate an actual intent to aid in the fraud being perpetrated); In re Leslie Fay Cos. Sec. Litig., 835 F.Supp. 167, 173 (S.D.N.Y.1993) (recklessness must be shown to such an extent that a reasonable finder of fact could actually infer fraudulent intent from it). 28 Plaintiffs' first and central recklessness claim is based on GE having made ... false statements recklessly, disregarding obvious indications the supposed earnings and profits were not--and could not have been--the result of the STRIPs trading activities to which they were attributed. Plaintiffs make several allegations designed to support their contention that the district court erred in rejecting their claim that GE was reckless in disregarding red flags coming from Kidder. 8 29 The plaintiffs argue that they have identified three distinct sources of specific facts--Kidder financial documents reviewed by GE, the Dammerman memoranda, and the history of GE's investment in its Kidder subsidiary--which together establish compelling circumstantial evidence of GE's recklessness. As regards the Kidder financial documents, the plaintiffs allege that [d]uring the Class Period GE had before it financial information from Kidder that contained a host of red warning flags about the legitimacy of Kidder's supposed record results. According to the plaintiffs, these red flags included: (1) the huge increase in the dollar volume of trading at Kidder's government bonds trading desk in less than three years; (2) the large increase in reported profits from the first quarter of 1992 to March of 1994; (3) the lack of records of any cash being realized from these trades; and (4) the multi-billion dollar daily fluctuations in Kidder's balance sheet assets. 30 In addition to these red flags, the plaintiffs contend that GE should have been alerted to possible wrongdoing by monthly memoranda sent from Richard W. O'Donnell, Kidder's Chief Financial Officer, to Dennis D. Dammerman, the Chief Financial Officer at GE (the Dammerman memoranda). The plaintiffs argue that GE disregarded specific information about unprecedented and dramatically increasing profitability of STRIPs trading at Kidder contained in these memoranda. For instance, it was reported that, by the end of April of 1993, Kidder's government bond trading desk had already exceeded its 1992 net income of $18.2 [million], with Treasury STRIPs trading being the principal driver of current profitability, and that by the end of December of 1993, net income from STRIPs trading for 1993 had reached $71.8 million, which was 26 percent of the total 1993 annual net income of Kidder's Fixed Income operations. 31 The plaintiffs contend that a comparison of the historical profits and the current profits of Kidder should have served as a warning to GE. The plaintiffs also contend that [t]he magnitude and unprecedented increase in purported profits from STRIPs trading at Kidder ... were inexplicable given the fact, known throughout the financial investing industry, that by its very nature STRIPs trading typically generated no more than marginal profits at best. They argue that these [a]dditional facts about Kidder, all of which were known to GE, provide a context that further supports the inference of GE's recklessness. The plaintiffs conclude that all of these facts mean that GE blinded itself to numerous obvious signs that hundreds of millions of dollars of Kidder's profits were not the result of legitimate trading activities. 32 However, the facts alleged, if true, do not add up to circumstantial evidence of conscious misbehavior or recklessness. The plaintiffs' claim of deliberate blindness is not supported by their allegations. The plaintiffs do not demonstrate how the increased level of activity at Kidder, as reflected in GE's consolidated financial records, would necessarily have indicated to GE that there was misconduct. The fact that GE did not automatically equate record profits with misconduct cannot be said to be reckless. As GE points out, successfully managed enterprises can earn record (and therefore 'extraordinary') profits at any given point in time and a well managed business that is growing should post 'record' profits on a regular basis. Furthermore, the fact that financial documents showed larger positions in these market securities would support GE's acceptance of the larger profits. The fact that cash was not realized from these trades is equally ambiguous in import. There is no evidence that GE would normally expect to see more than accounting, or paper, profits from its third-tier subsidiaries. The Dammerman memoranda simply show that the STRIPs trading was very successful. The plaintiffs do not show that the memoranda raised compliance concerns or other potential problems. 33 Given 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 in failing to further investigate. Fraud cannot be inferred simply because GE might have been more curious or concerned about the activity at Kidder. See Shields, 25 F.3d at 1129 (allegations strongly suggest[ ] that the defendants should have been more alert and more skeptical, but nothing alleged indicates that management was promoting a fraud); see also Serabian v. Amoskeag Bank Shares, Inc., 24 F.3d 357, 362 (1st Cir.1994) (The fact that the company was in violation of federal law by its ownership of the financial institution stock may reflect poorly on its management, but in no way demonstrates a 10b-5 violation.). In sum, the plaintiffs fail to allege facts to support a finding that GE was faced with sufficient information such that its failure to further investigate Kidder's STRIPs trading practices constituted recklessness. 34 Plaintiffs also contend that GE acted recklessly in relying on Kidder to monitor the accuracy of its own financial reporting. They refer to GAAP provisions and SEC regulations that required GE to accurately report Kidder's financial information. 9 However, the plaintiffs do not provide legal support for their contention that violations of these provisions are adequate proof of recklessness. Allegations of a violation of GAAP provisions or SEC regulations, without corresponding fraudulent intent, are not sufficient to state a securities fraud claim. See, e.g., Decker, 681 F.2d at 120-21; SEC v. Price Waterhouse, 797 F.Supp. 1217, 1240 (S.D.N.Y.1992) (stating that the recklessness standard in a securities fraud action requires more than a misapplication of accounting principles). 35 In fact, this precise claim was raised in a case where plaintiffs pointed to the fact that the parent corporation publicly recognized that it had adopted financial statements from [the subsidiary] based on erroneous accounting practices and restated its financials. Glickman v. Alexander & Alexander Servs., Inc., No. 93 Civ. 7594(LAP), 1996 WL 88570, at  15 (S.D.N.Y. Feb. 29, 1996). The district court stated that [i]ntentional misconduct or recklessness cannot be presumed from a parent's reliance on its subsidiary's internal controls. Id. We agree with the statement of the district court and conclude that the plaintiffs have failed to meet the standard. 36 In sum, we affirm the district court's finding that the plaintiffs did not allege facts that showed strong circumstantial evidence of recklessness on the part of GE. Accordingly, the district court properly determined that the plaintiffs failed to state a securities fraud claim in connection with the allegedly false financial statements issued by GE. 37