Opinion ID: 1253901
Heading Depth: 2
Heading Rank: 2

Heading: Application of the Law to Plaintiffs' Allegations

Text: On appeal, Plaintiffs contend that JPMC made false and misleading statements or omissions that were material by (1) failing to report the Mahonia transactions as related-party transactions, and (2) reporting the Mahonia transactions as trading assets rather than loans. Plaintiffs' complaint pled that JPMC's financial reports were false and misleading with regard to the Mahonia transactions because JPMC did not report them as related-party transactions. [3] SAC ¶¶ 242-54. Specifically, the complaint pled that the failure to identify the Mahonia transactions as related-party transactions violated GAAP because SFAS No. 57 required JPMC to disclose related-party transactions. Id. Plaintiffs contend that the GAAP violation renders the financial statements presumptively misleading. In addition, Plaintiff's complaint pled that JPMC's accounting of disguised loans as trading activities rather than as loans constitutes a false statement. SAC ¶¶ 450-52. Again, the complaint refers to the failure to conform to GAAP and Plaintiffs note that the violation renders the misstatement presumptively misleading. Id.
Plaintiffs' essential claim with regard to the failure to disclose Mahonia as a related party is that JPMC violated SFAS 57, which requires that [f]inancial statements shall include disclosures of material related party transactions. [4] Related Party Disclosures, SFAS No. 57 ¶ 2 (Fin. Accounting Standards Bd.1982). The district court held that Plaintiffs adequately pled a false or misleading statement because they alleged that JPMC created, controlled, and made decisions on behalf of Mahonia. JP Morgan Chase II, 2007 WL 950132, at . We agree that Plaintiffs alleged with particularity that Mahonia was a related party. We also agree with the district court that Plaintiffs failed to allege scienter. [5] Id. [A]llegations of GAAP violations or accounting irregularities, standing alone, are insufficient to state a securities fraud claim.... Only where such allegations are coupled with evidence of corresponding fraudulent intent might they be sufficient. Novak, 216 F.3d at 309 (internal quotation marks omitted). Even if there was a GAAP violation, that corresponding evidence is missing here.
Plaintiffs advance several allegations which, they argue, demonstrate an adequate motive. First, Plaintiffs argue that JPMC was motivated by a desire to secure above-market interest rates and fees from Enron. SAC ¶¶ 702-24. JPMC allegedly charged an interest rate that was three percent higher than its normal rate and earned excessive fees from other transactions with Enron. SAC ¶¶ 706-09. Second, Plaintiffs suggest that there was motive to defraud because The Chase Manhattan Corporation was inflating its stock in anticipation of acquiring JP Morgan in the merger that ultimately resulted in the creation of JPMC. SAC ¶¶ 673-75. Plaintiffs argue that the allegedly artificially inflated stock allowed it to complete the merger without issuing as many shares as it would have had to issue otherwise. Third, Plaintiffs suggest that the individual defendants in the case, Mr. Harrison and Mr. Shapiro, had motive to defraud because they sought to increase their compensation and bonuses. Plaintiffs allege that the individual defendants secured significant performance-based compensation benefits based on Chase's bargain purchase of JP Morgan and based on JPMC's Enron transactions. SAC ¶¶ 696-98. Each of Plaintiffs' arguments fails. First, the desire to maximize the corporation's profits does not strengthen the inference of an intent to defraud because earning excessive fees in a competitive marketplace (for as long as it lasts)far from defrauding the shareholdersactually benefits the shareholders. Earning profits for the shareholders is the essence of the duty of loyalty, and therefore it would be an unusual case where accomplishment of this objective constitutes the requisite motive to defraud the shareholders. This is not such a case. Plaintiff's argument to the contrary, based on In re Livent, Inc. Noteholders Sec. Litig., 174 F.Supp.2d 144 (S.D.N.Y.2001), is unavailing. In that case, while the court did find that the excessive fees the investment bank received provided a strong inference of intent to defraud, the bank's shareholders did not bring the suit; rather, the shareholders of the company being charged excessive fees brought the suit. Id. at 151-53. Therefore, the case is inapposite; while it supports the contention that excessive fees show motive to defraud another company's shareholders, it does not support the argument that excessive fees show motive to defraud a company's own shareholders. Second, in alleging that Chase inflated its stock price in order to reduce the cost of acquiring JP Morgan, Plaintiffs failed to allege a connection between the Enron dealings and the acquisition. While Plaintiffs rely on Cohen v. Koenig, 25 F.3d 1168, 1170-71, 1173-74 (2d Cir.1994), that case is inapplicable because it involved misstatements directly relating to the acquisition of another company. Here, the fact that the alleged misstatements began eight years before the acquisition and ended years afterward renders any connection between the events dubious at best. At most, Plaintiffs allege a generalized desire to achieve a lucrative acquisition proposal. Such generalized desires fail to establish the requisite scienter because the desire to achieve the most lucrative acquisition proposal can be attributed to virtually every company seeking to be acquired, Kalnit, 264 F.3d at 141, or to acquire another. In this case, the link between the acquisition and the alleged misconduct simply is not close enough to strengthen the inference of an intent to defraud. [6] Finally, the allegation that Mr. Harrison and Mr. Shapiro had the requisite motive because they received bonuses based on corporate earnings and higher stock prices does not strengthen the inference of fraudulent intent. See Kalnit, 264 F.3d at 139; Novak, 216 F.3d at 307-08. Again, Plaintiffs do not make the particularized showing that existed in the case on which they rely. In Fla. State Bd. of Admin. v. Green Tree Fin. Corp., 270 F.3d 645, 661-62 (8th Cir.2001), the plaintiffs made a showing of a direct link between the compensation package and the fraudulent statements because of the magnitude of the compensation and the defendants' motive to sweep problems under the rug given one defendant's expiring contract. Here, the complaint is much more generalized and appears to present the type of allegation that Kalnit dismissed as insufficient. If scienter could be pleaded solely on the basis that defendants were motivated because an inflated stock price or improved corporate performance would increase their compensation, virtually every company in the United States that experiences a downturn in stock price could be forced to defend securities fraud actions. `[I]ncentive compensation can hardly be the basis on which an allegation of fraud is predicated.' Acito v. IMCERA Group, Inc., 47 F.3d 47, 54 (2d Cir.1995) (quoting Ferber v. Travelers Corp., 785 F.Supp. 1101, 1107 (D.Conn.1991)). Therefore, even taking the allegations as a whole, as Tellabs requires, Plaintiffs have failed to create a strong inference of scienter based on motive and opportunity.
Plaintiffs contend that JPMC and the individual defendants knew or had access to information that Mahonia was a related party, yet violated GAAP by failing to disclose the Mahonia transactions as related-party transactions. Plaintiffs argue that they sufficiently alleged JPMC's knowledge because JPMC had created and controlled Mahonia. Furthermore, Plaintiffs argue that SFAS 57 clearly required reporting these transactions as related-party transactions. Because JPMC knew that Mahonia was related but did not report it as such, Plaintiffs contend, the allegations in the complaint give rise to a strong inference of scienter. [7] However, Plaintiffs fail to allege sufficient facts to support an inference that JPMC knew that the failure to report Mahonia as a related party was inaccurate. In order to support this inference, Plaintiffs would have to allege facts showing that JPMC's transactions with Mahonia were material, because the disclosure requirements of SFAS 57 only relate to material related-party transactions. See Related Party Disclosures, SFAS No. 57 ¶ 2 (Fin. Accounting Standards Bd.1982); see also Am. Inst. of Certified Pub. Accountants, Codification of Statements on Auditing Standards AU § 334.11 (2008) (Related Parties); Alvin A. Arens et al., Auditing and Assurance Services 216. However, Plaintiffs did not do so. As discussed more fully below in relation to JPMC's accounting for the Mahonia transactions as trading assets rather than as loans, Plaintiffs failed to plead materiality adequately. Here, the prepay transactions through Mahonia were, as the district court noted, a minute fraction of assets on JPMC's balance sheet. JP Morgan Chase I, 363 F.Supp.2d at 630-31. As important, if JPMC had disclosed that Mahonia was a related party, it would only mean that it would have disclosed (1) the nature of the relationship between JPMC and Mahonia; (2) that JPMC engaged in prepay transactions with Mahonia; (3) the dollar amount of the transactions with Mahonia; and (4) the amount of outstanding obligations. See SAC ¶ 245; JP Morgan Chase II, 2007 WL 950132, at . These disclosures would not have materially altered the total mix of information available to investors. Basic, 485 U.S. at 231-32, 108 S.Ct. 978. While the SAC pleaded that disclosure of these transactions as related-party transactions would have revealed JPMC's alleged duplicity with respect to Enron, Plaintiffs fail to plead this allegation with any particularity. Proof of the facts alleged would not give a fact-finder a basis on which it could find that such a chain reaction would have occurred. Because Plaintiffs have not adequately pleaded that the related-party transactions with Mahonia were material, they did not adequately plead that JPMC knowingly or recklessly failed to comply with SFAS 57. Given that they failed to plead the materiality of the Mahonia transactions, [8] Plaintiffs certainly did not plead that defendants had knowledge of the transactions' materiality. Moreover, Plaintiffs failed to plead recklessness. To plead recklessness through circumstantial evidence, Plaintiffs would have to show, `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.' Kalnit, 264 F.3d at 142 (quoting In re Carter-Wallace, 220 F.3d at 39 (other internal quotation marks omitted)). Plaintiffs have not done so here. Finally, we note that Plaintiffs' arguments regarding scienterat least those that rely on JPMC's alleged intent to defraudsuffer from a basic problem concerning plausibility. Plaintiffs fail to show an intent to defraud JPMC's shareholders rather than Enron's shareholders. Even if the alleged violation of SFAS 57 could give rise to an inference of intent to defraud Enron's shareholders (on the remote assumption that the JPMC statements might have helped conceal Enron's financial quandary), such an intent would not necessarily relate to JPMC's shareholders. Indeed, Plaintiffs have argued that JPMC concealed its transactions with Enron in return for excessive fees (which, as discussed, actually inured to Plaintiffs' benefit). It seems implausible to have both an intent to earn excessive fees for the corporation and also an intent to defraud Plaintiffs by losing vast sums of money. See Atl. Gypsum Co. v. Lloyds Int'l Corp., 753 F.Supp. 505, 514 (S.D.N.Y.1990) (Plaintiffs' view of the facts defies economic reason, and therefore does not yield a reasonable inference of fraudulent intent.). As the district court noted, Plaintiffs fail to allege facts explaining why, if it was aware of Enron's problems, [JPMC] would have continued to lend Enron billions of dollars. JP Morgan Chase I, 363 F.Supp.2d at 621. Even if JPMC was actively engaged in duping other institutions for the purposes of gaining at the expense of those institutions, it would not constitute a motive for JPMC to defraud its own investors. See Kalnit, 264 F.3d at 141.
Plaintiffs contend that JPMC's accounting of disguised loans as trading activities rather than as loans constitutes a false statement. The district court found that the Mahonia transactions were indeed mischaracterized on JPMC's financial disclosures, JP Morgan Chase I, 363 F.Supp.2d at 626. However, the district court also held that treating the prepaid transactions as trades rather than as loans was immaterial. Id. at 630. Plaintiffs allege that the misclassification of the loans was material in light of the qualitative factors set out in SAB No. 99. First, according to the complaint, this accounting and reporting misstatement concealed an unlawful transaction because it hid JPMC's collaboration with Enron's illegal activities. Allegedly, the disclosure of the true nature of the prepay transactions would have exposed JPMC's role in the Enron accounting debacle. SAC ¶¶ 249-54. Accordingly, the misstatement was material because its purpose was to deceive investors and conceal misconduct. SAC ¶¶ 249, 254. Second, according to the complaint, the misstatement was material because, after JPMC's actions became public, JPMC stock immediately fell nearly nineteen percent. SAC ¶¶ 251, 588, 603, 606. Third, the complaint alleges that the misstatement was material because it related to JPMC's relationship with Enron, a relationship which Plaintiffs argue constituted a significant aspect of JPMC's operations and profitability because Enron was JPMC's single largest client. SAC ¶¶ 51, 54, 702-19, 726. Accordingly, Plaintiffs contend that three of SAB No. 99's qualitative factors point to the materiality of the alleged misstatement. However, the classification of the loans as trading assets was immaterial in this case. Under the legal standard set forth in Ganino, both quantitative and qualitative factors must be considered in determining materiality. Here, the quantitative factor strongly supports JPMC's argument that the classification error, if it was one, was immaterial. Although $2 billion in prepay transactions may sound staggering, the number must be placed in context reclassifying $2 billion out of one category of trading assets (derivative receivables) totalling $76 billion into another category (loan assets) totalling $212 billion does not alter JPMC's total assets of $715 billion. J.App. 406 (JMPC Annual Report 2000). Moreover, the underlying assets in either classification carry some default risk. As the district court said about this same information, [c]hanging the accounting treatment of approximately 0.3% of JPM Chase's total assets from trades to loans would not have been material to investors. JP Morgan Chase I, 363 F.Supp.2d at 631. While Ganino held that bright-line numerical tests for materiality are inappropriate, it did not exclude analysis based on, or even emphasis of, quantitative considerations. Ganino, 228 F.3d at 164. According to Ganino, an alleged misrepresentation relating to less than two percent of defendant's assets, when taken in context, could be immaterial as a matter of law. Id.; see also Parnes v. Gateway 2000, Inc., 122 F.3d 539, 547 (8th Cir.1997) (finding alleged misrepresentations with regard to two percent of total assets were immaterial as a matter of law); In re Westinghouse Sec. Litig., 90 F.3d 696, 715 (3d Cir.1996) (stating that a misstatement was immaterial where only one percent of assets was allegedly misclassified). And as the SEC stated in SAB No. 99, [t]he use of a percentage as a numerical threshold, such as 5%, may provide the basis for a preliminary assumption that ... a deviation of less than the specified percentage with respect to a particular item on the registrant's financial statements is unlikely to be material. SEC Staff Accounting Bulletin No. 99, 64 Fed.Reg. at 45,151. Here, the five percent numerical threshold is a good starting place for assessing the materiality of the alleged misstatement. In this case, the alleged misrepresentation does not even come close to that threshold. An accounting classification decision that affects less than one-third of a percent of total assets does not suggest materiality. However, this preliminary inquiry under the quantitative factor must be supplemented. See Ganino, 228 F.3d at 163. We go on to consider qualitative factors that might contribute to a finding of materiality. Contrary to Plaintiffs' assertions, however, the qualitative factors do not adequately demonstrate the materiality of the decision to classify the prepay transactions as loans. On appeal, Plaintiffs point to three factors set forth in SAB No. 99 as supporting their argument of materiality. The first qualitative factor is whether the misstatement concealed an unlawful transaction. Plaintiffs have not shown that this factor is present. Although they allege that the transaction should have been described differently, see, e.g., SAC ¶ 261, there is no allegation that the transaction itself was illegal. The second qualitative factor, the misstatements' relation to a significant aspect of JPMC's operations, also favors JPMC. While Plaintiffs allege that Enron is a key client of JPMC, it appears clear that JPMC's transactions with Enron were not a significant aspect of JPMC's operations, considering the fact that JPMC earned less than .1% of its revenues from Enron-related transactions each year. See SAC ¶ 54 and J.App. 405 (showing that while JPMC earned $30.1 million and $29.8 million in relationship revenues from Enron in 1999 and 2000 respectively, it earned $29.484 billion and $31.557 billion in total net revenues in those years). Finally, the third qualitative factor that Plaintiffs rely on is the market reaction to the public disclosures of JPMC's role in the Enron collapse. SAB No. 99, while alluding to market reactions as a valid consideration in analyzing materiality, warned that market volatility alone is too blunt an instrument to be depended on in considering whether a fact is material. SEC Staff Accounting Bulletin No. 99, 64 Fed.Reg. at 45,152 (internal quotation marks omitted). Indeed, SAB No. 99 limits the usefulness of this factor to instances where management expects that a known misstatement may result in a significant positive or negative market reaction. Id. Plaintiffs have not alleged facts that would permit the inference that JPMC expected that the alleged misclassification of the loans might result in a significant market reaction. For this reason, the market reaction to Enron's collapse and JPMC's involvement in this collapse does not point towards qualitative materiality under SAB No. 99. These qualitative factors are intended to allow for a finding of materiality if the quantitative size of the misstatement is small, but the effect of the misstatement is large. See Ganino, 228 F.3d at 163. Here, Plaintiffs have failed to allege properly that despite the relatively small size of the allegedly misstated transactions, reporting these transactions as loans instead of trades would have made a qualitative difference in JPMC's financial statements. To be sure, misclassification of assets does matter (as Plaintiffs point out, it has implications for ratio analysis), but the tenor of the SAC is that JPMC knew that the prepays were worthless all alongan argument that is not only implausible, but also counter-intuitive. Plaintiffs also argue that, had the transactions been reported properly, the subterfuge that JPMC and Enron created would have been exposed, leading to the public becoming aware of JPMC's involvement with Enron's misdeeds. See SAC ¶¶ 249, 254. As set forth in the complaint, this allegation is wholly conclusory. While Plaintiffs make the assertion that the proper accounting would have revealed JPMC's collusion with Enron, that hardly suggests how the whole arrangement with Enron would have come to light. [9] And, given that assets in either category carry some default risk, we cannot reasonably infer that there was a substantial likelihood that JPMC's reporting of the transactions as loans rather than as trades would have been viewed by a reasonable investor as having significantly altered the total mix of information made available.
Plaintiffs allege that JPMC made numerous misrepresentations regarding its highly disciplined risk management and its standard-setting reputation for integrity. SAC ¶ 3 (internal quotation marks omitted). Plaintiffs point to statements such as the assertion that JPMC had `risk management processes [that] are highly disciplined and designed to preserve the integrity of the risk management process,' id.; that it `set the standard' for `integrity,' id.; and that it would `continue to reposition and strengthen [its] franchises with a focus on financial discipline,' id. ¶ 391 (emphasis omitted). See also id. ¶¶ 336, 354, 380, 400, 472, 474, 479, 481. These statements, according to Plaintiffs, were misleading because JPMC's poor financial discipline led to liability in the WorldCom litigation and involvement in the Enron scandal. Id. at ¶¶ 188-240, 636-39. Furthermore, Plaintiffs argue that the statements were material because they related to the integrity and risk-management practices of an investment bank. According to Plaintiffs, the significance of a bank's reputation is undeniable. Therefore, because the misleading statements at issue related to the bank's reputation, Plaintiffs conclude that the statements would necessarily be relied upon by a reasonable investor and qualify per se as material. The statements highlighted by Plaintiffs are no more than puffery which does not give rise to securities violations. See Lasker v. N.Y. State Elec. & Gas Corp., 85 F.3d 55, 59 (2d Cir.1996). The statements are too general to cause a reasonable investor to rely upon them. As in Lasker, these statements did not, and could not, amount to a guarantee that its choices would prevent failures in its risk management practices. See id. at 58 (The Company could not guarantee and did not guarantee ... that its investment choices would yield increased future earnings. (internal quotation marks omitted)). JPMC's statements were merely generalizations regarding JPMC's business practices. Such generalizations are precisely the type of `puffery' that this and other circuits have consistently held to be inactionable. Lasker, 85 F.3d at 59; see also San Leandro, 75 F.3d at 811 (stating that such puffery cannot have misled a reasonable investor). Plaintiffs conflate the importance of a bank's reputation for integrity with the materiality of a bank's statements regarding its reputation. While a bank's reputation is undeniably important, that does not render a particular statement by a bank regarding its integrity per se material. In Lasker, it was undisputed that the financial integrity of the utility was important to its investors; but we still found that the broad, general statements regarding the utility's financial integrity could not reasonably be relied upon as a guarantee that the company's actions would in no way impact [its] finances. Lasker, 85 F.3d at 59 (internal quotation marks omitted). Here also, JPMC's statement that it `set the standard for best practices in risk management techniques,' SAC ¶ 336, like its other similar statementsis so general that a reasonable investor would not depend on it as a guarantee that JPMC would never take a step that might adversely affect its reputation. No investor would take such statements seriously in assessing a potential investment, for the simple fact that almost every investment bank makes these statements. See Lasker, 85 F.3d at 58. Finding that JPMC's statements constitute a material misrepresentation would bring within the sweep of federal securities laws many routine representations made by investment institutions. We decline to broaden the scope of securities laws in that manner.
Because we have concluded that Plaintiffs failed to allege any misstatements or omissions by JPMC that could be found to be material, Plaintiffs' claims under section 14(a) of the Exchange Act and section 11 of the Securities Act must also fail. See Koppel v. 4987 Corp., 167 F.3d 125, 131-32 (2d Cir.1999) (section 14(a) claim); McMahan & Co. v. Wherehouse Entm't, Inc., 65 F.3d 1044, 1047-48 (2d Cir.1995) (section 11 claim). Moreover, having found that Plaintiffs failed to state a claim under sections 10(b) and 14(a) of the Exchange Act and section 11 of the Securities Act, their control person liability claim pursuant to section 15 of the Securities Act and section 20 of the Exchange Act must also fail for want of a primary violation. See SEC v. First Jersey Sec., Inc., 101 F.3d 1450, 1472 (2d Cir.1996) (In order to establish a prima facie case of controlling-person liability, a plaintiff must show a primary violation by the controlled person.); Demarco v. Edens, 390 F.2d 836, 841 (2d Cir.1968).