Opinion ID: 1253901
Heading Depth: 4
Heading Rank: 1

Heading: Failure to Report Mahonia as a Related Party

Text: 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.