Opinion ID: 729940
Heading Depth: 2
Heading Rank: 1

Heading: Failure to Allege Scienter on the Part of GE

Text: 14 In order to state a cause of action under section 10(b) and Rule 10b-5, a plaintiff must plead that in connection with the purchase or sale of securities, the defendant, acting with scienter, made a false material representation or omitted to disclose material information and that plaintiff's reliance on defendant's action caused [plaintiff] injury. Acito v. IMCERA Group, Inc., 47 F.3d 47, 52 (2d Cir.1995) (alteration in original and quotation omitted). The plaintiffs argue that the district court erred in finding that they failed to allege facts sufficient to satisfy the scienter element of a section 10(b) cause of action. We disagree. 15 We review de novo the district court's dismissal of an action pursuant to Fed.R.Civ.P. 12(b)(6), and accept as true the facts alleged in the complaint. First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763, 765 (2d Cir.1994), cert. denied, 513 U.S. 1079, 115 S.Ct. 728, 130 L.Ed.2d 632 (1995); see Acito, 47 F.3d at 51. Generally, we will uphold a district court's dismissal of a claim only if it appears that the plaintiff can prove no set of facts upon which relief may be granted. Acito, 47 F.3d at 51 (quotation omitted). 16 When the complaint contains allegations of fraud, Fed.R.Civ.P. 9(b) requires that the circumstances constituting fraud ... be stated with particularity. Malice, intent, knowledge, and other condition of mind of a person may be averred generally. (Emphasis added.) Therefore, the actual fraudulent statements or conduct and the fraud alleged must be stated with particularity, see Gold v. Morrison-Knudsen Co., 68 F.3d 1475, 1476-77 (2d Cir.1995), cert. denied, --- U.S. ----, 116 S.Ct. 1836, 134 L.Ed.2d 939 (1996); Acito, 47 F.3d at 51, whereas the requisite intent of the alleged speaker of the fraud need not be alleged with great specificity, see Cohen v. Koenig, 25 F.3d 1168, 1173 (2d Cir.1994). We apply the more general standard to scienter for the simple reason that a plaintiff realistically cannot be expected to plead a defendant's actual state of mind. Connecticut Nat'l Bank v. Fluor Corp., 808 F.2d 957, 962 (2d Cir.1987). 17 Despite Rule 9(b)'s lower standard for scienter, this Court has stated that we must not mistake the relaxation of Rule 9(b)'s specificity requirement regarding condition of mind for a 'license to base claims of fraud on speculation and conclusory allegations.'  Acito, 47 F.3d at 52 (quoting Wexner v. First Manhattan Co., 902 F.2d 169, 172 (2d Cir.1990)). Plaintiffs still have the  'burden of pleading circumstances that provide at least a minimal factual basis for their conclusory allegations of scienter.'  Cohen, 25 F.3d at 1173 (quoting Fluor, 808 F.2d at 962). Accordingly, we have held that plaintiffs must allege facts that give rise to a strong inference of fraudulent intent. Acito, 47 F.3d at 52 (emphasis added); see S.Q.K.F.C., Inc. v. Bell Atl. Tricon Leasing Corp., 84 F.3d 629, 634 (2d Cir.1996); In re Time Warner Inc. Sec. Litig., 9 F.3d 259, 268 (2d Cir.1993), cert. denied, --- U.S. ----, 114 S.Ct. 1397, 128 L.Ed.2d 70 (1994). 18 A plaintiff can establish a strong inference of fraudulent intent in two ways: either (a) by alleging facts to show that defendants had both motive and opportunity to commit fraud, or (b) by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness. Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1128 (2d Cir.1994); see S.Q.K.F.C., 84 F.3d at 634; San Leandro Emergency Med. Group Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801, 813 (2d Cir.1996); Acito, 47 F.3d at 52. Plaintiffs make allegations under each alternative. We hold that under both approaches, plaintiffs fail to allege facts sufficient for us to infer the requisite scienter.
19 The first method of pleading scienter is to allege facts that show both motive and opportunity to commit fraud. See Acito, 47 F.3d at 52. It is not disputed that GE had the opportunity to defraud plaintiffs as they allege. 4 See, e.g., Philip Morris, 75 F.3d at 813 (indisputable that key directors and officers have ability to manipulate their company's stock price); In re Time Warner, 9 F.3d at 269 (same). 20 Plaintiffs allege that GE's interest in justifying to its shareholders its over $1 billion investment in Kidder gave GE a motive to willfully blind itself to facts casting doubt on Kidder's purported profitability. However, GE's motive in justifying its substantial investment in Kidder is not adequate to establish GE's scienter. 21 We have stated that [m]otive would entail concrete benefits that could be realized by one or more of the false statements and wrongful nondisclosures alleged. Shields, 25 F.3d at 1130. The motive to maintain the appearance of corporate profitability, or of the success of an investment, will naturally involve benefit to a corporation, but does not entail concrete benefits. See, e.g., Philip Morris, 75 F.3d at 813-14 (alleging that the defendants were motivated by a desire to maintain the company's credit rating); Acito, 47 F.3d at 54 (alleging that defendants were motivated to defraud the public because an inflated stock price would increase their compensation). In both Acito and Philip Morris we held that, [i]f scienter could be pleaded on that basis alone, virtually every company in the United States that experiences a downturn in stock price could be forced to defend securities fraud actions. Acito, 47 F.3d at 54; see Philip Morris, 75 F.3d at 814; see also In re Crystal Brands Sec. Litig., 862 F.Supp. 745, 749 (D.Conn.1994) (finding that allegations of a company's motive to maintain good relations with suppliers, retailers and lenders are flawed because they pertain to virtually any company that manufactures and distributes goods). 22 In this case, GE obviously would want to justify its investment in Kidder and have that investment appear profitable, but such a generalized motive, one which could be imputed to any publicly-owned, for-profit endeavor, is not sufficiently concrete for purposes of inferring scienter. 5 Thus, we agree with the district court that such a generalized motive does not support a strong inference of fraudulent intent. 6 23 The plaintiffs also claim that the district court's determination that they failed to sufficiently allege a motive on the part of GE is inconsistent with the court's finding that the plaintiffs' motive theories were sufficient in their action against the Kidder defendants. However, in In re Kidder Peabody Securities Litigation, the district court simply stated that Kidder arguably had a motive to either hide Jett's trading scheme or to recklessly disregard the warning signs of that scheme. No. 94 Civ. 3954(JFK), 1995 WL 590624, at  5 (S.D.N.Y. Oct. 4, 1995). In each instance, the district court's determination that the Kidder defendants arguably had a motive does not necessarily mean that the parent company, GE, had any motive. Ultimately, whether Kidder defrauded plaintiffs and whether its parent, GE, defrauded plaintiffs are different questions. 24 Accordingly, we hold that the district court properly determined that the plaintiffs failed to allege facts sufficient to show motive and opportunity to commit fraud.
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