Opinion ID: 769627
Heading Depth: 2
Heading Rank: 1

Heading: Claims Against GT and Its Officers

Text: 35 The Appellants contend that GT and its officers rendered its reported earnings and its accounting policy regarding royalty advances misleading by omitting the fact that they refused to expense royalty advances for a particular software title even after concluding that royalty advances for that title were unlikely to be recouped by future sales of the title. The Appellants argue that GT's failure to expense was so perverse that the royalty advances for the most poorly selling titles were the ones that remained capitalized. GT only expensed advances when such amounts could be charged against sales of the software title. If a title did not generate sufficient sales, the royalty advances remained in the asset column and were not expensed. Brief for Appellants at 9 (citations omitted). 36 To survive a motion to dismiss, Appellants' complaint must state with particularity all facts on which they formed this belief. 15 U.S.C. 78u-4(b)(1). Using GT's public financial statements, the Appellants sufficiently allege facts supporting the inference that GT did not expense any prior royalty advances during the first nine months of 1996 and the first nine months of 1997. According to GT's Form 10-K for the fiscal year ended December 31, 1996, GT recorded as assets royalty advances in the amount of $ 29,577,000, as of December 31, 1995. According to the Complaint, by the third quarter of 1996, GT had capitalized $ 57,357,000 in royalty advances. The Appellants argue that GT did not expense any prior royalty advances during the first nine months of 1996; this is an inference from the fact that the increase in the total amount of royalty advances treated as assets by the end of that period ($ 27,780,000) equaled the amount GT spent on royalty advances during that period ($ 27.8 million). If some of the previously capitalized royalties had been expensed, the increase in the total of capitalized royalties should have been somewhat less than the amount of newly advanced royalties. 37 Similarly, according to GT's Form 10-Q for the quarter ending on September 30, 1997, GT had recorded $ 69,202,000 in total royalty advances as assets as of December 31, 1996, and had recorded $ 87,542,000 in total royalty advances as assets as of September 30, 1997. According to the same Form 10-Q, however, during the first nine months of 1997, GT spent $ 18.3 million for royalty advances. The Appellants argue that GT did not expense any prior royalty advances during the first nine months of 1997, because the increase in the amount of total royalty advances treated as assets by the end of that period ($ 18,340,000) equaled the amount GT spent on royalty advances during that period ($ 18.3 million). 38 However, the Appellants must also sufficiently allege facts to support their belief that GT and its officers failed to expense royalty advances after concluding that they would be not be recouped through future sales. The Appellants base this belief on: (1) poor sales of most of GT's software titles during the GT Class Period, in comparison with the amount of royalties advanced; (2) GT's allegations in lawsuits seeking to recover royalty advances from particular software developers for failing to deliver technologically or commercially viable products; and (3) GT's $ 73.8 million write-off for the fourth quarter of 1997. This aspect of the Appellant's claim essentially combines the misrepresentation and scienter inquiries. In this respect, if the Appellants have sufficiently pled facts to support scienter, they have also met the pleading requirements for false representation or omission.
39 For a securities fraud claim, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. 15 U.S.C. 78u-4(b)(2). By enacting this pleading requirement, Congress did not change the basic pleading standard for scienter in this circuit (except by the addition of the words 'with particularity'). Novak v. Kasaks, 216 F.3d 300, 310, (2d Cir. 2000). We have held that to plead scienter in a securities fraud claim, a complaint may (1) allege facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness, or (2) allege facts to show that defendants had both motive and opportunity to commit fraud. See Stevelman v. Alias Research, Inc., 174 F.3d 79, 84 (2d Cir. 1999); Shields v. Citytrust Bancorp., Inc., 25 F.3d 1124, 1128 (2d Cir. 1994). As Novak explains, what is required when endeavoring to plead facts supporting a strong inference of scienter by showing motive and opportunity is not a bare invocation of magic words such as 'motive and opportunity' but an allegation of facts showing the type of particular circumstances that our case law has recognized will render motive and opportunity probative of a strong inference of scienter. Novak, 216 F.3d at 311, 2000 WL 796300, at . 40
41 To qualify as reckless conduct, the decision not to expense royalty advances must have been highly unreasonable, representing 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. Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978) (internal quotation marks omitted). The Appellants contend that they pled facts constituting strong circumstantial evidence of GT's intentional or reckless failure to expense royalty advances unlikely to be recouped through future sales, i.e., (1) poor sales of most of GT's software titles during the GT Class Period, (2) pleadings filed in GT's lawsuits against software developers indicating that certain software titles were not commercially viable, and (3) the $ 73.8 million write-off of royalty advances that GT took for the fourth quarter of 1997. 42 First, the Appellants argue that GT acted recklessly by not expensing royalty advances for poorly selling software titles. Generally, poor business judgment is not actionable under section 10(b) and Rule 10b-5. See Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 479, 51 L. Ed. 2d 480, 97 S. Ct. 1292 (1977). The fact that management's optimism about a prosperous future turned out to be unwarranted is not circumstantial evidence of conscious fraudulent behavior or recklessness: People in charge of an enterprise are not required to take a gloomy, fearful or defeatist view of the future; subject to what current data indicates, they can be expected to be confident about their stewardship and the prospects of the business that they manage. Shields, 25 F.3d at 1129. 43 The Appellants' argument, however, turns not on GT's overly optimistic predictions of sales before the fact, but on its failure to expense royalty advances after poor sales during the Class Periods were known. In Novak, we upheld the sufficiency of a complaint alleging that a company's refusal to mark down inventory known to be worthless artificially inflated the company's reported financial results and rendered the company's markdown policy misleading in that the disclosed policy no longer reflected actual practice. Novak, 216 F.3d at 311. The facts of the pending claim are not quite as strong as in Novak, but present somewhat similar allegations of a reckless failure to follow an announced policy of expensing royalty advances, thereby artificially inflating financial results. 44 We assume to be true, as we must on a motion to dismiss, the allegation that most of GT's sales of a software product are realized during the first year of that product's release, and that GT knew of this fact. Although the Appellants do not have to fix the exact date and time that GT and its officers became aware that recovering royalty payments through future sales would be unlikely, they must supply some factual basis for the allegation that the defendants had reached this conclusion at some point during the time period alleged. Posner v. Coopers & Lybrand, 92 F.R.D. 765, 769 (S.D.N.Y. 1981) (dismissing for insufficient pleading a securities fraud action alleging that between 1972 and 1975 defendants become aware that company's product was not economically viable), aff'd, 697 F.2d 296 (2d Cir. 1982) (table); see Ross v. A.H. Robins Co., 607 F.2d 545, 558 (2d Cir. 1979) (Fed. R. Civ. P. 9(b) required plaintiff's pleading to allege facts concerning when defendants knew about their product's major safety problems). In this case, GT and its officers do not dispute that they assessed quarterly the probability that they would recoup royalty advances for a particular software title through future sales. Therefore, allowing for awaiting a full year of sales after a product's release in late 1995, GT's refusal to expense royalty advances could rise to the level of recklessness sometime after the beginning of the first quarter of 1997. 45 Secondly, the Appellants point to the pleadings in separate lawsuits filed by GT against Scavenger, Smith Engineering, and Technology Marketing Partners. The Appellants argue that GT failed to expense royalty advances to these software developers even though, according to GT's lawsuit pleadings, these software developers had failed to perform their obligations under their development agreements with GT. The Appellants conclude that GT's pleadings in these lawsuits indicate that GT did not consider the software titles at issue to be commercially viable. 46 Notably, GT does not dispute that it failed to expense the royalty advances to Scavenger, Smith, and Technology Marketing Partners during the Class Periods. Instead, GT argues that these facts do not support a strong inference of fraudulent intent, because it would not have been appropriate to expense the royalty advances sought to be recovered through these lawsuits unless it became apparent that GT would not be able to do so. This argument, however, appears to concede the Appellants' point: GT sued to recover royalty payments, because it had concluded that for these software titles it could not recover its royalty advances through sales of the related product. According to GT's accounting policy, that conclusion required expensing the unrecoverable royalties (subject perhaps to a footnote indicating the possibility of a non-recurring income item in the future if the lawsuit succeeded in recouping the advanced royalties). GT advanced approximately $ 3.4 million in royalties to Smith, Technology Marketing, and Scavenger alone. 47 The Appellants also ask this Court to take judicial notice of a breach of contract suit filed in January 1999 in New York Supreme Court by GT against Midway Games Inc. and other co-defendants. In its complaint against Midway, GT alleges that, starting in 1994, GT advanced $ 35 million in royalties to the defendant software developers. Midway and the other defendants, however, failed to satisfy their contractual obligations, including failing to deliver technically acceptable, 'bug'-free master game disks and advertising materials. 48 The Appellants explain that the Second Amended Complaint does not refer to the Midway lawsuit because the Midway complaint was filed after the Appellants had submitted their proposed second amended complaint in the instant action in connection with their January 22, 1999, application to amend the complaint and name Andersen as a defendant. The Appellants submitted a copy of the Midway complaint to the District Court in their papers in opposition to the motion to dismiss. GT and its officers do not dispute the authenticity of the Midway complaint and further agree that the Midway complaint was filed on or after January 22, 1999. Pursuant to Fed. R. Evid. 201(b), we take judicial notice of the Midway complaint as a public record. See, e.g., 5-Star Management, Inc. v. Rogers, 940 F. Supp. 512, 518 (E.D.N.Y. 1996) (taking judicial notice of pleadings in other lawsuits attached to defendants' motion to dismiss). 49 GT and its officers argue that the Midway complaint is not relevant because it was filed thirteen months after the GT Class Period ended and eleven months after GT announced its change in accounting policy. The allegations in the Midway complaint, however, refer to the failure of software developers to meet their contractual obligations during the Class Periods. For example, the Midway complaint alleges that sometime after 1994, the Midway Group failed to deliver technically acceptable master disks for at least thirty games on a timely basis, causing material delays in GT's exploitation of the games, and resulting in substantial financial losses. Although the Midway complaint does not specify when this alleged breach of contract occurred, it is reasonable to draw the inference favorable to the Appellants that some aspect of it occurred during the GT Class Periods. Together, in the four lawsuits, GT sought to recover approximately $ 38.4 million in royalty advances, or almost 44 percent of the $ 87.5 million in royalty advances that GT had capitalized by the third quarter of 1997. 50 Finally, we deem significant the amount of the write-off GT eventually did take for the final quarter of 1997. In its February 17, 1998, press release, GT stated that it had written off, in the fourth quarter of 1997, $ 73.8 million in royalty advances for products currently in development or on sale, because the increase in technological change, competitiveness for shelf space, and buyer selectivity, coupled with a shorter product life cycle, had made it increasingly difficult to evaluate the likelihood that an individual product would succeed. GT further stated that it had decided to change its accounting policy and prospectively expense royalty advances in a manner comparable with internal software development costs, which are expensed as incurred, until technological feasibility is confirmed. The Appellants argue that GT's $ 73.8 million write-off supports its claim of fraudulent intent. They argue that the magnitude of this write-off renders less credible the proposition that during the Class Period, GT believed it likely that it could recover those royalty advances through future sales. We agree. The write-off suggests something remarkable: prior to the fourth quarter of 1997, GT was unable to appreciate that the poor performance of its products after a disappointing first year sales required substantial expensing of royalty advances each quarter but suddenly realized that $ 73.8 million of $ 87.5 million in royalty advances, i.e., over 84 percent of the total royalty advances it had capitalized by the end of the third quarter of 1997 needed to be expensed. Taken together with the allegations of poor sales and the pleadings in various lawsuits filed by GT, the Appellants have alleged sufficient facts to support a strong inference of recklessness. 51
52 (a)Acquisitions. The Appellants also seek to plead facts supporting a strong inference of scienter by alleging facts to show motive and opportunity. It is undisputed that Defendants-Appellees GT, Chaimowitz, Cayre, and Gregor had the opportunity to commit fraud. The key question is motive, namely whether the Appellants adequately alleged concrete benefits that could be realized by one or more of the false statements and wrongful disclosures alleged. Shields, 25 F.3d at 1130. The motive alleged must be sufficiently particularized. See, e.g., Chill, 101 F.3d at 268 (generalized motive to justify investment and have it appear profitable, one which could be imputed to any publicly-owned, for-profit endeavor, is not sufficiently concrete for purposes of inferring scienter) (footnote omitted); San Leandro Emergency Medical Group Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801, 814 (2d Cir. 1996) (company's desire to maintain high bond or credit rating, and thereby maximize marketability of and minimize interest rate on debt securities, does not qualify as sufficient motive for fraud); Acito v. Imcera Group, Inc., 47 F.3d 47, 54 (2d Cir. 1995) (scienter cannot be adequately pleaded based only on existence of executive compensation dependent upon stock value). 53 The Appellants argue that GT, Chaimowitz, Cayre, and Gregor had the requisite motive because they would concretely benefit from an artificially inflated GT stock price, caused by their alleged material omissions, by using less GT stock as consideration to acquire four companies: two in June 1996, another in July 1996, and another in October 1997. This Court has ruled that, in some circumstances, the artificial inflation of stock price in the acquisition context may be sufficient for securities fraud scienter. See In re Time Warner Inc. Securities Litigation, 9 F.3d 259, 270 (2d Cir. 1993) (sufficient pleading of motive that company allowed prior statements to become misleading by material nondisclosure of company's active consideration of rights offering in order to maintain high stock price before announcing new rights offering in order to lessen dilutive effect of that announcement on stock price); cf. Sirota v. Solitron Devices, Inc., 673 F.2d 566, 573 & n.2 (2d Cir. 1982) (sufficient evidence to support jury finding of defendants' fraudulent intent to overstate inventory, including, among other evidence, that company benefitted from overstated inventory because stock price followed rising reported earnings, enabling [the company] to make numerous acquisitions after a five-for-one split) (footnote omitted). 54 San Leandro does not support the argument advanced by GT that the desire to consummate any corporate transaction cannot ever be a motive for securities fraud. In San Leandro, we simply ruled that a company's desire to maintain a high bond or credit rating, and thereby maximize the marketability of, and minimize the interest rate on, debt securities, does not qualify as a sufficient motive for fraud because 'if 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.' 75 F.3d at 814 (alteration in original). Although virtually every company may have the desire to maintain a high bond or credit rating, as San Leandro reasoned, not every company has the desire to use its stock to acquire another company. 55 GT's acquisitions that occurred in 1996, however, cannot support motive to commit fraud, because in mid-1996, the allegedly poor selling products had either not then been introduced or had not been on sale long enough to reveal the need to expense advanced royalties. The Complaint alleges sales data for software released in late 1995 at the earliest. The Appellants further alleged that most of GT's sales of a software product were realized during the first year it was commercially available. Therefore, under the Appellants' theory, GT was entitled to wait at least a year, until late 1996, to become aware that the sales of products released in late 1995 would not recoup the royalty advances for that product. 56 Accordingly, only GT's October 1997 acquisition of SingleTrac Entertainment Tech could support a motive to commit fraud and thereby contribute to a finding of scienter. At oral argument, counsel for GT argued that this acquisition alone could not support a strong inference of fraudulent intent (based on maintenance of a high share price) because the acquisition was largely a cash deal. The Complaint, however, states that GT acquired SingleTrac for $ 5.4 million in cash and 700,000 shares of stock valued at $ 7.2 million. Based on this allegation, it is strongly inferable that GT and its officers improperly refused to expense royalty advances in order to artificially inflate its stock price with an eye toward using its stock to acquire SingleTrac. This conduct, in combination with the other allegations of the Complaint, reenforces the adequacy of the complaint's allegation of scienter. Whether sufficient motive could be shown solely by an allegation of a high stock price artificially maintained in the context one impending acquisition might well depend on the particular circumstances of the case, and, in any event, is not the issue before us. 57 (b) Insider Sales. The Appellants also allege that Cayre and Chaimowitz had a motive to inflate GT's stock price because they sold many shares of GT stock to their financial benefit. We have recognized that unusual insider trading activity during the class period may permit an inference of bad faith and scienter. Acito, 47 F.3d at 54. In connection with GT's IPO, Cayre sold 1,494,720 shares of the 16,094,07 shares he beneficially owned at the time for $ 20 million. Chaimowitz beneficially owned 804,582 shares at the time of the IPO, and allegedly sold at least 70,000 shares during the Class Periods for $ 1,615,000. 58 The District Court did not consider these sales to be unusual, however, because Cayre sold only approximately 9.3 percent of the stock he beneficially owned in December 1995, and because Chaimowitz's sales involved only 9.9 percent of the shares he owned outright and 7.8 percent of the total shares and stock options he held at the time of sale. See Herzog, 1999 WL 1072500, at . The District Court also noted that in February 1997, Chaimowitz bought 6,000 shares and held those shares through the end of the Class Period: Taking into account Defendant Chaimowitz's vested options, he held more shares at the end of the GT Class Period than at the beginning. Id. 59 The Appellants argue that the District Court erred by focusing on the percentage of stockholdings sold, not on the considerable dollar amounts received by Cayre and Chaimowitz for selling their shares. Insider sales have been found unusual based on a variety of factors, including the amount of profit from sales, see In re Oxford Health Plans, Inc. Securities Litigation, 187 F.R.D. 133, 140 (S.D.N.Y. 1999) ($ 78 million profit from sale of 1.2 million shares during the class period is massive by any measure), and the portion of stockholdings sold, see Stevelman, 174 F.3d at 85 (president and CEO of company sold 40 percent of his stock holdings in company while making optimistic statements about company's financial position), the change in volume of insider sales, see In re Quintel Entertainment Inc. Securities Litigation, 72 F. Supp. 2d 283, 296 (S.D.N.Y. 1999) (sales by corporate insiders represented 156 percent increase over total insider sales for fourteen months prior to start of class period), and the number of insiders selling, see San Leandro, 75 F.3d at 814 (company officer's $ 2 million profit from company stock sales did not suffice to prove motive, because no other company executives sold their shares during the relevant period). 60 In light of the $ 2 million profit in San Leandro, which in that case was not by itself enough to establish the sales as unusual, Chaimowitz's alleged $ 1.6 million profit is not unusual even if we look only to the absolute amount of profit, and certainly not if we consider the fact that Chaimowitz sold only 9.9 percent of his GT stock during the class period, see Acito, 47 F.3d at 54 (insufficient facts to support inference of scienter where only one corporateinsider sold 11 percent of his stock in the company). 61 Although Cayre's sales in December 1995 resulted in a $ 20 million return, a more significant amount, several circumstances surrounding his sales weaken the inference of fraudulent intent. First, it is undisputed that his sales in connection with the IPO represented only about 9.3 percent of the GT stock he beneficially owned. See In re Oxford, 187 F.R.D. at 140 (Large volume trades may be suspicious but where a corporate insider sells only a small fraction of his or her shares in the corporation, the inference of scienter is weakened. ). Second, as with the 1996 acquisitions, Cayre's 1995 sales do not support motive, because he was entitled to wait at least a year, until early 1997, to become aware that the sales of products released in late 1995 would not recoup the royalty advances for those products. See Acito, 47 F.3d at 54 (sales by outside director occurring before alleged misrepresentation or omission fail to provide an inference of an intent to deceive the public).
62 In a securities fraud action, the plaintiff shall have the burden of proving that the act or omission of the defendant alleged to violate this chapter caused the loss for which the plaintiff seeks to recover damages. 15 U.S.C. 78u-4(b)(4). To establish causation, a plaintiff must prove that the economic harm that it suffered occurred as a result of the alleged misrepresentations and that the damage suffered was a foreseeable consequence of the misrepresentation. Citibank, N.A. v. K-H Corp., 968 F.2d 1489, 1495 (2d Cir. 1992) (citation omitted). 63 The District Court rejected the sufficiency of the claim of loss causation because of the absence of a suggestion that GT's practice of capitalizing royalty advances caused the drop in GT's stock price, and because GT fully disclosed its accounting policy. Neither reason defeats the claim of loss causation. The Appellants allege that the stock price fell, not because the royalty advances were initially capitalized, but because the market became aware of an impending writedown attributable to GT's reckless failure to expense appropriate portions of the advances, once it became evident that they would not be recouped through sales. And, although the accounting policy was disclosed, the Appellants' claim is that it was not followed, with a consequent overstatement of income and a decline in share price when the market became aware that a massive writedown was imminent. 64 The Appellants focus on the December 9 newspaper articles on the failed merger with MicroPose and the December 12 report issued by BancAmerica as the causes of the drop in GT's stock price. The Appellees respond that GT had already announced in its November 1997 Form 10-Q that it might expense some or all of its $ 87.5 million in royalty advances. Although the precise duration of the GT class period and the amount of recoverable damages might ultimately turn on the extent and timing of the market's awareness of GT's impending writedown of royalty advances, the Complaint adequately alleges that awareness of such a likely writedown was a cause of the decline in share price. Of course, to show loss causation, the Appellants will have to show that but for GT's failure to expense royalty advances for a title even after concluding that they would not be recouped through future sales of that title, GT would never have had $ 87.5 million in royalty advances to potentially write off all at once. If the Appellants can prove this, they can also prove that GT could reasonably foresee that its fraudulent failure to expense would lead to a drop in GT's stock price whenever the market became aware of the impending writedown, because GT's quarterly earnings might well have been quarterly losses had GT expensed more royalty advances than it did during the Class Periods. We think the Complaint permits the required showing to be made.