Court Opinion

ID: 2966024
Source: CourtListenerOpinion
Date Created: 2015-09-21 21:47:51.126052+00
Date Added: 2024-06-11T11:43:08.476026
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<pre>                 United States Court of Appeals <br>                     For the First Circuit <br> <br> <br> <br> <br> <br>No. 98-2194 <br> <br>               LAWRENCE M. GREEBEL, RICHARD CRANE,  <br>           BRIAN D. ROBINSON, and JOHN and ANN SOMERS <br>                   on behalf of themselves and  <br>                  all others similarly situated, <br> <br>                           Appellants, <br> <br>                                v. <br> <br>          FTP SOFTWARE, INC.; ROBERT W. GOODNOW, Jr.; <br>       PENNY C. LEAVY; DOUGLAS F. FLOOD; JONATHAN RODIN; <br>            CHARLOTTE H. EVANS; and DAVID H. ZIRKLE, <br> <br>                            Appellees. <br> <br> <br> <br>           APPEAL FROM THE UNITED STATES DISTRICT COURT <br> <br>                FOR THE DISTRICT OF MASSACHUSETTS <br> <br>           [Hon. Joseph L. Tauro, U.S. District Judge] <br> <br> <br> <br>                              Before <br> <br>                     Torruella, Chief Judge, <br>               Noonan and Lynch, Circuit Judges. <br>                                 <br>                                 <br>                                 <br>                                 <br>     Stephen Moulton, with whom Nancy Freeman Gans and Moulton & <br>Gans, LLP, and Sanford P. Dumain, with whom Samuel H. Rudman and <br>Milberg Weiss Bershad Hynes & Lerach LLP, were on brief, for <br>appellants. <br>     Bruce G. Vanyo, with whom Jerome F. Birn, Jr., Rebecca A. <br>Mitchells, and Wilson Sonsini Goodrich & Rosati, were on brief for <br>appellee FTP Software, Inc. <br>     Jeffrey B. Rudman, with whom Peter J. Macdonald and Hale and <br>Dorr LLP, were on brief, for individual appellees. <br>     Harvey J. Goldschmid, General Counsel, Jacob H. Stillman, <br>Solicitor, Eric Summergrad, Deputy Solicitor, and Luis de la Torre, <br>Attorney, on brief for amicus curiae Securities and Exchange <br>Commission. <br> <br> <br> <br> <br> <br>October 8, 1999 <br> <br> <br> <br> <br>

  LYNCH, Circuit Judge.  This case requires us for the <br>first time to interpret the provisions of the Private Securities <br>Litigation Reform Act of 1995, 15 U.S.C.  78u-4.  Plaintiffs, <br>purchasers of FTP Software stock from July 14, 1995 to January 3, <br>1996, brought suit under sections 10(b) and 20(a) of the Securities <br>Exchange Act of 1934, 15 U.S.C.  78j(b), 78t(a).  During the <br>period of plaintiffs' purchases, the stock reached a high of <br>$38.875 per share.  On January 4, 1996, the company announced that <br>sales growth had declined and that it would have lower earnings.  <br>That same day, the stock price fell 52% on heavy trading, from <br>$25.25 to $11.875 per share.  By August 9, 1996, the stock price <br>was $8 per share.  Plaintiffs' suit was filed on March 3, 1996.  It <br>was dismissed on September 24, 1998.  See Greebel v. FTP Software, <br>Inc., 182 F.R.D. 370, 376 (D. Mass. 1998). <br>  We affirm the dismissal of the complaint under the <br>standards we now adopt: <br>1. The PSLRA imposes requirements for pleading with particularity <br>that are consistent with this circuit's prior rigorous requirements <br>for pleading fraud with particularity under Fed. R. Civ. P. 9(b). <br>2. The PSLRA mandates neither the adoption nor the rejection of <br>particular patterns of evidence to prove fraud and scienter, and <br>thus does not alter this circuit's prior law on these points. <br>3. The PSLRA does, significantly, impose a requirement that <br>pleadings raise a "strong" inference of scienter rather than a <br>merely "reasonable" inference of scienter. <br>4. The PSLRA does not alter the previous definition of scienter, <br>one that in this circuit includes a narrowly defined concept of <br>recklessness which does not include ordinary negligence, but is <br>closer to being a lesser form of intent. <br>                                I <br>  The district court denied defendants' first motion to <br>dismiss largely on the basis of the complaint's allegations that <br>defendants had routinely "whited out" the contingency terms <br>inserted by customers into purchase orders; this was allegedly done <br>in furtherance of a scheme to inflate revenues by improperly <br>booking contingent transactions as final sales.  After limited <br>discovery, the district court concluded that plaintiffs could not <br>prove the white-out claims and entered judgment on those claims.  <br>The defendants renewed their motion to dismiss the complaint, and <br>the plaintiffs, in response, sought to make their allegations of <br>fraud more specific by referring to discovered documents, but did <br>not formally move to amend.  The district court dismissed the <br>complaint with prejudice, thus effectively denying the plaintiffs <br>an opportunity to amend their complaint.  The court did so without <br>deciding whether, in light of the new evidence and allegations, the <br>complaint was adequate to survive. <br>  Plaintiffs appeal saying that summary judgment on the <br>white-out allegations was inappropriate; that they are given refuge <br>by Rule 56(f); that the dismissal of the remaining allegations was <br>improper; and that they were entitled to amend their complaint. <br>                                II <br>   The complaint alleges the following.  FTP Software, Inc. <br>develops, markets, and supports Internet and Intranet software for <br>personal computers and networks.  By the beginning of the Class <br>Period (from July 14, 1995 to January 3, 1996), the demand for <br>FTP's software was diminishing because many of FTP's clients were <br>either developing the technology themselves or acquiring competing <br>systems from other manufacturers, such as Microsoft and Netscape.  <br>Microsoft, for example, was incorporating networking capabilities <br>into its new Windows 95 software, free of additional charge.  In <br>addition, FTP was struggling to keep pace with "revolutionary" <br>technological developments that threatened to render its software <br>obsolete.  In response, FTP and several of its directors and <br>officers through fraudulent schemes inflated FTP's stock price and <br>then made various false statements and material omissions.   <br>  Plaintiffs allege that FTP failed to disclose the threats <br>to its continued success, as well as several "questionable" sales <br>practices.  These included the making of "warehouse shipments" -- <br>that is, booking a fictitious sale of a product to a non-existent <br>buyer, shipping that product to a warehouse for storage, and then <br>eventually returning it to FTP.  According to plaintiffs, one FTP <br>employee who complained about these shipments, and who refused (in <br>at least one instance) to sign for the product return, was <br>dismissed as a result of his protest, all before the Class Period.  <br>Other objectionable sales practices included excessively discounted <br>sales (as high as 90%) and "channel stuffing" activity that <br>compressed sales and orders into the final weeks of a fiscal <br>quarter, with the intention of "cosmetically" improving the <br>reported results for that quarter.  Finally, plaintiffs say that <br>FTP failed to disclose its practice of inducing distributors to <br>purchase more product than they needed by promising that the <br>distributors could return the unsold product.  Distributors would <br>send their orders to FTP with a notation that they were entitled to <br>return any unsold product.  FTP then booked these sales as revenue, <br>but because FTP understood that recognizing such sales as revenue <br>was improper (because of a right of return existed), it allegedly <br>instructed the sales force to white-out these right-of-return <br>notations on the distributors' order forms.  <br>  FTP also made several statements that the plaintiffs <br>characterize as false or materially misleading.  On July 14, 1995, <br>the first day of the Class Period, David Zirkle, FTP's President <br>and Chief Executive Officer, reported FTP's financial performance <br>results for the second fiscal quarter of 1995.  Zirkle declared: <br>"We are pleased with our performance for the second quarter.  Sales <br>continue to be strong in both our U.S. and international channels."  <br>Zirkle also touted the release of several new products, stating <br>that "[t]hese products should help us achieve our revenue objective <br>for the second half of 1995."  Plaintiffs argue that these comments <br>"falsely convey[ed] the impression that sales were, and would <br>continue to be, healthy and strong" and that this false impression <br>was deliberately aided by FTP's failure to disclose that in or <br>around January 1995, the French Post Office canceled its planned <br>purchase of $10 million of FTP products "due to the impending <br>release of 'Windows '95.'" <br>  On the same day, Zirkle discussed FTP's impending <br>corporate "reconfiguration" into two business units.  He predicted <br>that "FTP Software [would] lead the market in providing <br>applications and support that make it possible to share information <br>and access resources across workgroups, LAN's, enterprise networks <br>and the global Internet."   After this announcement, FTP's stock <br>fell from $31.75 to $28.25.  Zirkle dismissed this decline as <br>merely "a 'knee-jerk' reaction to the short-term impact of the <br>restructuring on earnings," and on the next trading day, the stock <br>recovered, closing at $30.875.  Plaintiffs argue that these <br>comments were misleading because Zirkle did not disclose that FTP's <br>costly investments in its reorganization would have to be continued <br>over the long term. <br>  FTP's management team next met with "the investment <br>community and with securities analysts" to promote the company's <br>products and stock.  One securities firm rated FTP as a "long-term <br>buy."  Plaintiffs assert that this report "and the estimates <br>contained therein were based upon communications with the <br>management of FTP and were of a nature that could only have been <br>provided (or be based on specific information provided) by [FTP] <br>and its management." <br>  Meanwhile, several of the individual defendants sold some <br>of their FTP stock.  In total, the six individual defendants sold <br>over $23 million in stock during the Class Period.   <br>  Zirkle made another false statement, plaintiffs say, on <br>October 25, 1995, when he reported FTP's financial results for the <br>third quarter of fiscal year 1995: <br>    This was another excellent quarter for FTP.  Sales <br>  continue to grow both in our U.S. and international <br>  channels . . . .  Our new ventures are also off to a good <br>  start with revenues of $2.7 million. . . .  These new <br>  products have been well received by our channel partners <br>  and customers and will help us in our efforts to achieve <br>  fourth quarter revenue objectives. <br> <br>Plaintiffs assert that the "new ventures" Zirkle referred to were <br>failing to generate the expected new business. <br>  On November 15, 1995, FTP filed its Form 10-Q report for <br>the third quarter of 1995 with the SEC.  The report revealed a <br>dramatic increase in accounts receivable for the fiscal year ending <br>on December 31, 1994.  FTP explained that: <br>    Such an increase is primarily attributable to increased <br>  unit sales and a relative increase, during the third <br>  quarter of 1995, in the number of units shipped during <br>  the last month of such quarter compared to prior <br>  quarters.  The Company believes that it may continue to <br>  experience such a relative increase as it continues to <br>  grow, as is typical in the software industry. <br> <br>Plaintiffs claim that the 10-Q report, and these statements, were <br>false and misleading because the increased unit sales were subject <br>to the purchasers' right to return unsold merchandise and were not <br>the result of FTP's growth.  <br>  FTP continued the "drumbeat" of misleading positive <br>statements, according to plaintiffs, when Zirkle, speaking in an <br>interview published in the November 27 - December 3, 1995 issue of <br>Mass High Tech, said that "[t]he networking business (TCP/IP) is a <br>cash cow that is feeding the development of other businesses, which <br>are feeding back new technology that makes the core business even <br>better."  In December 1995, two other securities firms issued <br>positive reports on FTP; after these statements, FTP's stock rose. <br>  Finally, the complaint alleges, the "truth [began] to <br>emerge" on January 4, 1996, when FTP announced that its earnings <br>for the fourth fiscal quarter of 1995 would be less than the same <br>period in 1994.  FTP stated that this decline reflected, in part, <br>the company's investment in its New Ventures Business Unit, but, <br>nonetheless, the company's stock fell $13.375 per share to close at <br>$11.875 per share (a one-day decline of 52%).  Plaintiffs emphasize <br>that this decline represented a $27 drop in market value (an <br>approximately 70% decrease) from a Class Period high of $38.875 per <br>share. <br>                               III <br>  On March 3, 1996, plaintiffs brought suit against FTP and <br>the individual defendants for violations of sections 10(b) and <br>20(a) of the Securities Exchange Act of 1934.  The defendants moved <br>to dismiss.  The procedural history was recited above.  The <br>district court ultimately granted summary judgment on the white-out <br>allegations because plaintiffs' only witness, Ms. Trudy Nichols, <br>was unavailable and her testimony was potentially inadmissible (as <br>hearsay).  Furthermore, the plaintiffs did not establish that the <br>defendants had ordered the alteration of any documents. <br>  The district court also granted the defendants' renewed <br>motion to dismiss.  The court found that the complaint failed to <br>plead the circumstances of fraud with specificity, and could not <br>even meet the pleading standards required to establish scienter <br>under Fed. R. Civ. P. 9(b). <br>                                IV <br>                  Interpretation of the PSLRA <br>  The enactment of the PSLRA in 1995 marked a bipartisan <br>effort to curb abuse in private securities lawsuits, particularly <br>the filing of strike suits.  See H.R. Conf. Rep. No. 104-369, at <br>32 (1995), reprinted in 1995 U.S.C.C.A.N. 730, 731. <br>  The PSLRA restated the requirements for securities fraud <br>actions at subsections 21D(b)(1) and (2), codified at 15 U.S.C.  <br>78u-4(b)(1)-(2).  Those provisions, involved here, read as follows: <br>    (b) Requirements for securities fraud actions <br>    (1) Misleading statements and omissions <br>      In any private action arising under this chapter in <br>  which the plaintiff alleges that the defendant  - <br> <br>        (A) made an untrue statement of a material fact; or <br> <br>        (B) omitted to state a material fact necessary in <br>      order to make the statements made, in the light of <br>      the circumstances in which they were made, not <br>      misleading; <br> <br>    the complaint shall specify each statement alleged to <br>  have been misleading, the reason or reasons why the <br>  statement is misleading, and, if an allegation regarding <br>  the statement or omission is made on information and <br>  belief, the complaint shall state with particularity all <br>  facts on which that belief is formed. <br> <br>    (2)  Required state of mind <br> <br>      In any private action arising under this chapter in <br>  which the plaintiff may recover money damages only on <br>  proof that the defendant acted with a particular state of <br>  mind, the complaint shall, with respect to each act or <br>  omission alleged to violate this chapter, state with <br>  particularity facts giving rise to a strong inference <br>  that the defendant acted with the required state of mind. <br>     <br> <br>15 U.S.C.  78u-4(b)(1)-(2). <br>  The parties and the SEC as amicus have framed different <br>possible interpretations of these provisions.  Essentially, these <br>questions are raised: <br>First, did the PSLRA alter the standards for pleading fraud with <br>particularity previously adhered to by this circuit? <br>Second, did the PSLRA restrict the characteristic patterns of facts <br>that may be pleaded in order to establish a "strong inference" of <br>scienter?  Specifically, are the two methods of showing scienter <br>endorsed earlier by the Second Circuit -- motive and opportunity or <br>circumstantial evidence of reckless or conscious behavior <br>sufficient to raise a "'strong inference' of fraudulent intent," <br>see, e.g., In re Time Warner Inc. Sec. Litig., 9 F.3d 259, 268-69 <br>(2d Cir. 1993) (quoting  O'Brien v. National Property Analysts <br>Partners, 936 F.2d 674, 676 (2d Cir. 1991) (internal quotation <br>marks omitted)) -- now available?   <br>Third, did the PSLRA alter the scienter requirement for actions <br>under section 10(b) and Rule 10b-5, 17 C.F.R.  240.10b-5?  <br>Specifically, is some form of recklessness sufficient to satisfy <br>the scienter requirement?  <br>  The parties and amicus all rely heavily on competing <br>excerpts from the congressional history of the Act and on the pre- <br>Act case law from the Second Circuit. <br>  The words of the statute are the first guide to any <br>interpretation of the meaning of the statute.  The usual maxim is <br>that courts do not go beyond the text of the statute if the meaning <br>is plain.  See United Food & Commercial Workers Union, Local 328 v. <br>Almac's Inc., 90 F.3d 1, 5 (1st Cir. 1996).  But that maxim has <br>inherent flexibility.  Even seemingly straightforward text should <br>be informed by the purpose and context of the statute.  See <br>Stafford v. Briggs, 444 U.S. 527, 535 (1980); Puerto Rico Tel. Co. <br>v. Telecommunications Regulatory Bd., No. 98-2228, 1999 WL 618061, <br>at *6 (1st Cir. Aug. 19, 1999).  Both this court and the Supreme <br>Court have checked a sense of a statute's plain meaning against <br>undisputed legislative history as a guard against judicial error.  <br>See, e.g., Bob Jones Univ. v. United States, 461 U.S. 574, 586 <br>(1983) ("It is a well-established canon of statutory construction <br>that a court should go beyond the literal language of a statute if <br>reliance on that language would defeat the plain purpose of the <br>statute . . . ."); Cablevision of Boston v. Public Improvement <br>Comm'n, 184 F.3d 88, 101 (1st Cir. 1999).  If the meaning is not <br>plain from the words of the statute, then resort to legislative <br>history is required.  See Akins v. Penobscot Nation, 130 F.3d 482, <br>488 (1st Cir. 1997). <br>  On some of the points neither text nor history is <br>indisputably clear.  The legislative history is irretrievably <br>conflicted as to the second issue -- which characteristic patterns <br>of facts may be pleaded in order to establish a "strong inference" <br>of scienter -- with all sides finding some support for their <br>positions.  About all that can be said with confidence on that <br>issue is that Congress agreed on the need to curb abuses, that it <br>attempted to do so in the guise of what are articulated as <br>procedural requirements, and that there was agreement on the words <br>of the statute and on little else.  And so we return to the text of <br>the statute and its purpose. <br>A.  Pleading Standards for Fraud Allegations <br>  The text of the Act requires now that any complaint <br>alleging that a statement or omission is misleading must: <br>           1.     specify each statement alleged to have been <br>         misleading, <br>           2.     [specify] the reason or reasons why the statement <br>         is misleading, <br>           3.     and, if an allegation regarding the statement or <br>         omission is made on information and belief, . . . <br>         state with particularity all facts on which that <br>         belief is formed.  <br> <br>15 U.S.C.  78u-4(b)(1).  The effect of this is to embody in the <br>Act itself at least the standards of Rule 9(b), Fed. R. Civ. P. <br>  Before the PSLRA, a securities fraud claim had to meet <br>the standards set by Rule 9(b).  See Simcox v. San Juan Shipyard, <br>Inc., 754 F.2d 430, 439 (1st Cir. 1985).  Rule 9(b) provides that <br>"[i]n all averments of fraud or mistake, the circumstances <br>constituting fraud or mistake shall be stated with particularity.  <br>Malice, intent, knowledge, and other condition of mind of a person <br>may be averred generally."  Fed. R. Civ. P. 9(b).  This circuit has <br>interpreted Rule 9(b) to require "specification of the time, place, <br>and content of an alleged false representation."  McGinty v. <br>Beranger Volkswagen, Inc., 633 F.2d 226, 228 (1st Cir. 1980).  <br>"Even where allegations are based on information and belief, <br>supporting facts on which the belief is founded must be set forth <br>in the complaint.  And this holds true even when the fraud relates <br>to matters peculiarly within the knowledge of the opposing party."  <br>Hayduk v. Lanna, 775 F.2d 441, 444 (1st Cir. 1985) (internal <br>quotation marks and citations omitted). <br>  The PSLRA's pleading standard is congruent and consistent <br>with the pre-existing standards of this circuit.  This circuit has <br>been notably strict and rigorous in applying the Rule 9(b) standard <br>in securities fraud actions.  See Maldonado v. Domnguez, 137 F.3d <br>1, 9 (1st Cir. 1998) ("This court has been especially rigorous in <br>applying Rule 9(b) in securities fraud actions . . . .") (quotation <br>marks omitted); Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1223 <br>(1st Cir. 1996) (similar); Romani v. Shearson Lehman Hutton, 929 <br>F.2d 875, 878 (1st Cir. 1991) ("We have been especially rigorous in <br>demanding . . . factual support in the securities context . . . <br>."). <br>  The requirements of the PSLRA's new pleading standard in <br> 78u-4(b)(1) were largely imposed under First Circuit law, <br>although this court has not used the same precise terminology.  <br>First, this court had already required a fraud plaintiff to specify <br>each allegedly misleading statement or omission.  See, e.g., <br>Romani, 929 F.2d at 878 (plaintiffs' isolation of the offering <br>materials as the source of the alleged fraud was "sufficient to <br>identify the time and place of the alleged misrepresentations"); <br>New England Data Servs., 829 F.2d at 292 (rejecting plaintiffs' <br>claims as merely "conclusory allegations of mail and wire fraud . <br>. . with no description of any time, place or content of the <br>communication"). <br>  Second, this court has required a securities fraud <br>plaintiff to explain why the challenged statement or omission is <br>misleading by requiring that "the complaint . . . provide some <br>factual support for the allegations of fraud."  Romani, 929 F.2d at <br>878 (citation omitted).  This means that the plaintiff must not <br>only allege the time, place, and content of the alleged <br>misrepresentations with specificity, but also the "factual <br>allegations that would support a reasonable inference that adverse <br>circumstances existed at the time of the offering, and were known <br>and deliberately or recklessly disregarded by defendants."  Id. <br>  Finally, this court has required plaintiffs who bring <br>their claims on information and belief to "set forth the source of <br>the information and the reasons for the belief."  Romani, 929 F.2d <br>at 878; see also New England Data Servs., 829 F.2d at 288; Hayduk, <br>775 F.2d at 444-45; Wayne Inv., Inc. v. Gulf Oil Corp., 739 F.2d <br>11, 13 (1st Cir. 1984). <br>  Our previous strict pleading requirements under Rule 9(b) <br>are, in our view, consistent with the PSLRA.  See Maldonado, 137 <br>F.3d at 10 n.6. <br>

B.  Pleading Required State of Mind: Characteristic Fact Patterns <br>  Where a plaintiff can recover money damages on proof that <br>a defendant acted with a particular state of mind, the PSLRA now <br>requires a complaint to "state with particularity facts giving rise <br>to a strong inference that the defendant acted with the required <br>state of mind."  15 U.S.C.  78u-4(b)(2).  The "required state of <br>mind" for liability under section 10(b) and Rule 10b-5 is referred <br>to as scienter, which the Supreme Court has defined as "a mental <br>state embracing intent to deceive, manipulate, or defraud."  Ernst <br>& Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). <br>  The debate between the plaintiffs and the defendants is <br>largely over whether Congress intended to embody, as the SEC says, <br>the prior Second Circuit methods for proving scienter (i.e., by <br>showing motive and opportunity or evidence of reckless or conscious <br>behavior sufficient to raise a strong inference) or, as the <br>defendants say, to prohibit use of at least the motive and <br>opportunity method.  This focus of the parties is not surprising, <br>as there was much debate in Congress on these points. <br>  The plaintiffs and the SEC argue that the PSLRA does not <br>prohibit use of the Second Circuit's methods for proving scienter.  <br>They refer to the bill reported out of the Senate Committee on <br>Banking, Housing, and Urban Affairs, see S. 240, 104th Cong.  <br>104(b) (1995), reprinted in 141 Cong. Rec. S9222 (daily ed. June <br>28, 1995), and to the Senate Report, which states, in part, that: <br>    The Committee does not adopt a new and untested pleading <br>  standard that would generate additional litigation.  <br>  Instead, the Committee chose a uniform standard modeled <br>  upon the pleading standard of the Second Circuit. . . . <br>  [T]he Second Circuit requires that the plaintiff plead <br>  facts that give rise to a "strong inference" of <br>  defendant's fraudulent intent.  The Committee does not <br>  intend to codify the Second Circuit's caselaw <br>  interpreting this pleading standard, although courts may <br>  find this body of law instructive. <br> <br>S. Res. 98, 104th Cong., at 15 (1995), reprinted in 1995 <br>U.S.C.C.A.N. 679, 694 (footnotes omitted).  They also rely on the <br>comments of Senator Dodd, co-sponsor of the PSLRA, explaining that <br>Congress intended to codify the Second Circuit's "pleading <br>standards."  141 Cong. Rec. S17960 (daily ed. Dec. 5, 1995).  <br>Finally, they argue that their position is bolstered by the <br>Statement of Managers of the Securities Litigation Uniform <br>Standards Act of 1998, Pub. L. No. 105-353, 112 Stat. 3227, which <br>declared that "the managers again emphasize that the clear intent <br>in 1995 and our continuing intent in this legislation is that <br>neither the Reform Act nor [the Standards Act] in any way alters <br>the scienter standard in Federal securities fraud suits."  Joint <br>Explanatory Statement of the Committee of Conference, Conference <br>Report to Accompany S. 1260, H.R. Conf. Rep. No. 105-803 ("1998 <br>Conf. Rep."), at 15 (1998). <br>  The defendants argue that allegations of the existence of <br>motive and opportunity to commit fraud (or simple recklessness) do <br>not satisfy the scienter requirement.  To support their view, they <br>note Congress' statement that "[t]he Conference Committee language <br>is based in part on the pleading standard of the Second Circuit," <br>(emphasis added) and that "[b]ecause the Conference Committee <br>intends to strengthen existing pleading requirements, it does not <br>intend to codify the Second Circuit's case law interpreting this <br>pleading standard."  H.R. Conf. Rep. 104-369, at 41 (1995), <br>reprinted in 1995 U.S.C.C.A.N. 730, 740.  Defendants also rely <br>heavily on the footnote associated with this sentence, which <br>states: "For this reason, the Conference Report chose not to <br>include in the pleading standard certain language relating to <br>motive, opportunity, or recklessness."  Id. at 41 n.23, reprinted <br>in 1995 U.S.C.C.A.N. at 747.  Further, the defendants emphasize <br>that although the Senate Bill (S. 240) included an amendment that <br>would codify Second Circuit law, the Conference Committee <br>eliminated that amendment.  See Amend. 1485, S. 240, 104th Cong., <br>1st Sess. (1995), 141 Cong. Rec. S9170 (daily ed. June 27, 1995).  <br>  Finally, the defendants place considerable weight on <br>Congress' decision to override President Clinton's veto, in light <br>of the President's statement that in the Act Congress "intended to <br>'strengthen' the existing pleading requirements of the Second <br>Circuit . . . [and] to erect a higher barrier to bringing suit than <br>any now existing[.]"  H.R. Doc. No. 104-150, 104th Cong., 1st Sess. <br>(1995), 141 Cong. Rec. H15214 (Dec. 20, 1995).  Counsel for <br>defendant FTP candidly admitted before the district court that the <br>legislative history standing alone could be read either way, but <br>argued that the President's veto -- based on his reading of the Act <br>as overruling the Second Circuit motive and opportunity test -- <br>administered the coup de grace.  While the President's view of what <br>Congress meant has some informational value, we give that view <br>little weight: the real issue is what the intent was of the <br>Congress, not the President.  <br>  The legislative history is inconclusive on whether the <br>Act was meant to either embody or to reject the Second Circuit's <br>pleading standards.  As the Third Circuit has noted, "[t]he Reform <br>Act's legislative history on this point is ambiguous and even <br>contradictory."  In re Advanta Corp. Sec. Litig., 180 F.3d 525, 531 <br>(3d Cir. 1999).  The history and text show no agreement to restrict <br>the types of evidence which may be used to show a strong inference <br>of scienter.  Indeed, it would be unusual for Congress to legislate <br>on what fact patterns could or could not prove fraud or scienter.  <br>At best, there appears to have been an agreement to disagree on the <br>issue of Second Circuit standards (other than the strong inference <br>standard), and perhaps, as is common, to leave such matters for <br>courts to resolve.  See, e.g., Burlington Indus., Inc. v. Ellerth, <br>118 S. Ct. 2257, 2264 (1998). <br>  From the words of the Act, certain conclusions can be <br>drawn.  First, Congress plainly contemplated that scienter could be <br>proven by inference, thus acknowledging the role of indirect and <br>circumstantial evidence.  See 15 U.S.C.  78u-4(b)(2) (requiring <br>that "the complaint . . . state with particularity facts giving <br>rise to a strong inference that the defendant acted with the <br>required state of mind") (emphasis added).  Second, the words of <br>the Act neither mandate nor prohibit the use of any particular <br>method to establish an inference of scienter.  Third, Congress has <br>effectively mandated a special standard for measuring whether <br>allegations of scienter survive a motion to dismiss.  While under <br>Rule 12(b)(6) all inferences must be drawn in plaintiffs' favor, <br>inferences of scienter do not survive if they are merely <br>reasonable, as is true when pleadings for other causes of action <br>are tested by motion to dismiss under Rule 12(b)(6).  See Conley v. <br>Gibson, 355 U.S. 41, 45-46 (1957).  Rather, inferences of scienter <br>survive a motion to dismiss only if they are both reasonable and <br>"strong" inferences. <br>  Indeed, the debate about adoption or rejection of prior <br>Second Circuit standards strikes us as somewhat beside the point.  <br>The categorization of patterns of facts as acceptable or <br>unacceptable to prove scienter or to prove fraud has never been the <br>approach this circuit has taken to securities fraud.  As stated in <br>Maldonado, 137 F.3d at 10 n.6, this court has never adopted the <br>Second Circuit test.  Instead we have analyzed the particular facts <br>alleged in each individual case to determine whether the <br>allegations were sufficient to support scienter.  See, e.g., Shaw <br>v. Digital Equip. Corp., 82 F.3d 1194, 1209 (1st Cir. 1996).  In <br>this, the approach of this circuit has been like that taken by the <br>Supreme Court as to the issue of materiality in Basic Inc. v. <br>Levinson, 485 U.S. 224 (1988).   <br>  This court has considered many different types of <br>evidence as relevant to show scienter.  Examples include: insider <br>trading (discussed below); divergence between internal reports and <br>external statements on the same subject (see Serabian  v. Amoskeag <br>Bank Shares, Inc., 24 F.3d 357, 361 (1st Cir. 1994)); closeness in <br>time of an allegedly fraudulent statement or omission and the later <br>disclosure of inconsistent information (see Shaw, 82 F.3d at 1224- <br>25); evidence of bribery by a top company official (see Greenstone <br>v. Cambex Corp., 975 F.2d 22, 26 (1st Cir. 1992)); existence of an <br>ancillary lawsuit charging fraud by a company and the company's <br>quick settlement of that suit (see id.); disregard of the most <br>current factual information before making statements (see Glassman <br>v. Computervision Corp., 90 F.3d 617, 627 (1st Cir. 1996)); <br>disclosure of accrual basis information in a way which could only <br>be understood by a sophisticated person with a high degree of <br>accounting skill (see Holmes v. Bateson, 583 F.2d 542, 552 (1st <br>Cir. 1978)); the personal interest of certain directors in not <br>informing disinterested directors of impending sale of stock (see <br>Estate of Soler v. Rodrguez, 63 F.3d 45, 54 (1st Cir. 1995)); and <br>the self-interested motivation of defendants in the form of saving <br>their salaries or jobs (see Serabian, 24 F.3d at 368).  While a <br>number of these cases could be thought of as falling into motive <br>and opportunity patterns, this court continues to prefer a more <br>fact-specific inquiry.  See, e.g., Glassman, 90 F.3d at 624 (fact <br>that lead underwriter may have had incentive to inflate the <br>offering price was significant, but overall, complaint failed to <br>state a claim on which relief could be granted). <br>  The most salient feature of the PSLRA is that whatever <br>the characteristic pattern of the facts alleged, those facts must <br>now present a strong inference of scienter.  A mere reasonable <br>inference is insufficient to survive a motion to dismiss.  Our pre- <br>Act case law had used both the language of "strong" inference and <br>of "reasonable" inference in various contexts.  For example, <br>"strong inference" is used in Maldonado, 137 F.3d at 9 and Suna v. <br>Bailey Corp., 107 F.3d 64, 68 (1st Cir. 1997).  "Reasonable <br>inference" language was used in Gross v. Summa Four Inc., 93 F.3d <br>987, 996 (1st Cir. 1996); Shaw, 82 F.3d at 1224; Serabian, 24 F.3d <br>at 368; Greenstone, 975 F.2d at 25; and Romani, 929 F.2d at 878.  <br>It is clear that scienter allegations now must be judged under the <br>"strong inference" standard at the motion to dismiss stage. <br>  Our view of the Act is thus close to that articulated by <br>the Sixth Circuit.  That court held that a plaintiff could survive <br>a motion to dismiss by "pleading facts that give rise to a strong <br>inference of [scienter]."  In re Comshare, Inc. Sec. Litig., 183 <br>F.3d 542, 550 (6th Cir. 1999) (internal quotation marks omitted).  <br>The Sixth Circuit found that evidence of motive and opportunity to <br>commit fraud did not, of itself, constitute scienter for purposes <br>of section 10(b) and Rule 10b-5.  See id. at 551.  "Indeed, those <br>courts addressing motive and opportunity in Securities Act cases <br>have held only that facts showing a motive and opportunity may <br>adequately allege scienter, not that the existence of motive and <br>opportunity may support, as scienter itself, liability under  10b <br>or Rule 10b-5."  Id.  The court held that evidence of motive and <br>opportunity was "relevant" to pleading facts that could establish <br>scienter, and, on occasion, could "rise to the level of creating a <br>strong inference of reckless or knowing conduct."  Id.  <br>Nevertheless, such evidence, standing alone, could not "constitute <br>the pleading of a strong inference of scienter."  Id.; accord <br>Bryant v. Avado Brands, Inc., No. 98-9253, 1999 WL 688050, at *8 <br>(11th Cir. Sept. 3, 1999). <br>  Without adopting any pleading litany of motive and <br>opportunity, we reject defendants' argument that facts showing <br>motive and opportunity can never be enough to permit the drawing of <br>a strong inference of scienter.  But, as we cautioned in Maldonado, <br>137 F.3d at 10 n.6, merely pleading motive and opportunity, <br>regardless of the strength of the inferences to be drawn of <br>scienter, is not enough.  Three circuits have interpreted the PSLRA <br>as permitting use of motive and opportunity type pleading if it <br>raises a strong inference.  See In re Advanta Corp. Sec. Litig., <br>180 F.3d 525, 534-35 (3d Cir. 1999); Press v. Chemical Inv. Servs. <br>Corp., 166 F.3d 529, 537-38 (2d Cir. 1999); Williams v. WMX Techs., <br>Inc., 112 F.3d 175, 178 (5th Cir. 1997) (dicta).  Like the Third <br>Circuit, we caution that "catch-all allegations that defendants <br>stood to benefit from wrongdoing and had the opportunity to <br>implement a fraudulent scheme are [not] sufficient."  In re Advanta <br>Corp., 180 F.3d at 535. <br>  Similarly, the PSLRA neither prohibits nor endorses the <br>pleading of insider trading as evidence of scienter, but requires <br>that the evidence meet the "strong inference" standard.  Unusual <br>trading or trading at suspicious times or in suspicious amounts by <br>corporate insiders has long been recognized as probative of <br>scienter.  See Shaw, 82 F.3d at 1204; Rubinstein v. Collins, 20 <br>F.3d 160, 169-70 (5th Cir. 1994); Greenstone, 975 F.2d at 26.  The <br>vitality of the inference to be drawn depends on the facts, and can <br>range from marginal, see Shaw, 82 F.3d at 1204, to strong, see <br>Rubinstein, 20 F.3d at 169-70.  This continues to be true in <br>litigation after the effective date of the PSLRA.  Indeed, in <br>Greenstone we noted, and still think today, that allegations of <br>unusual insider trading by a defendant with access to material non- <br>public information can support a strong inference of scienter.  See <br>Greenstone, 975 F.2d at 26.  We similarly caution that mere <br>pleading of insider trading, without regard to either context or <br>the strength of the inferences to be drawn, is not enough.  See <br>Maldonado, 137 F.3d at 9-10.  At a minimum, the trading must be in <br>a context where defendants have incentives to withhold material, <br>non-public information, and it must be unusual, well beyond the <br>normal patterns of trading by those defendants. <br>C.  Substantive Scienter Standards <br>  The parties disagree about the effect, if any, of the <br>PSLRA on the substantive standard for proving scienter.  We start <br>with the state of the law in this circuit before the enactment of <br>the PSLRA. <br>  The Supreme Court has defined scienter as "a mental state <br>embracing intent to deceive, manipulate, or defraud."  Ernst & <br>Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976).  The Court <br>explicitly reserved the issue of whether recklessness sufficed, <br>saying "[i]n certain areas of the law recklessness is considered to  <br>be a form of intentional conduct for purposes of imposing liability <br>for some act."  Id.  Before enactment of the PSLRA, most circuits <br>had held that scienter in civil securities fraud actions could be <br>shown by showing recklessness.  It is accepted that recklessness <br>may establish intent to defraud in criminal prosecutions under  <br>17(a)(1) of the Exchange Act and under the mail and wire fraud <br>statutes.  See 8 L. Loss and J. Seligman, Securities Regulation <br>3656-57 (3d ed. 1991).  The question became whether the standard <br>for criminal liability should also apply to civil liability.  That, <br>in turn, raised the question of what was meant by recklessness. <br>  We have used a definition of recklessness articulated by <br>the Seventh Circuit: <br>    [R]eckless conduct may be defined as a highly <br>  unreasonable omission, involving not merely simple, or <br>  even inexcusable, negligence, but an extreme departure <br>  from the standards of ordinary care, and which presents <br>  a danger of misleading buyers or sellers that is either <br>  known to the defendant or is so obvious the actor must <br>  have been aware of it. <br> <br>Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. <br>1977) (quoting Franke v. Midwestern Okla. Dev. Auth., 428 F. Supp. <br>719, 725 (W.D. Okla. 1976)).  Without at first explicitly adopting <br>that standard, this court assumed that it applied and cited it with <br>approval in Cook v. Avien, Inc., 573 F.2d 685, 692 (1st Cir. 1978).  <br>In Hoffman v. Estabrook & Co., 587 F.2d 509, 515-16 (1st Cir. <br>1978), this court again assumed that recklessness could ground a <br>Rule 10b-5 action and, again, quoted with approval a Seventh <br>Circuit definition: <br>      In view of the Supreme Court's analysis in <br>  Hochfelder of the statutory scheme of implied private <br>  remedies and express remedies, the definition of <br>  "reckless behavior" should not be a liberal one lest any <br>  discernible distinction between "scienter" and <br>  "negligence" be obliterated for these purposes.  We <br>  believe "reckless" in these circumstances comes closer to <br>  being a lesser form of intent than merely a greater <br>  degree of ordinary negligence.  We perceive it to be not <br>  just a difference in degree, but also in kind. <br>   <br>Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977).  <br>This court explicitly rejected a formulation of recklessness as <br>mere negligence, finding it had to come closer to being a lesser <br>form of intent than merely a greater degree of ordinary negligence.  <br>See Hoffman, 587 F.2d at 516 & n.10.  <br>  In Serabian this court held that it was error to dismiss <br>a securities fraud complaint that alleged sufficient facts to draw <br>"an inference that the [defendant] knew, or should have known, that <br>its public statements were inconsistent with the actual conditions <br>then being reported to [it]."  Serabian, 24 F.3d at 365 (emphasis <br>added and original emphasis omitted).  We understand Serabian to <br>have used "should have known" in the reckless disregard sense used <br>in Cook and Hoffman.  This court has explicitly tested factual <br>allegations to see whether they supported an inference that <br>defendants acted with reckless disregard.  See Romani, 929 F.2d at <br>878.  Since then, there have been encapsulated references to this <br>rule in dicta in other cases.  See, e.g., Maldonado, 137 F.3d at 9 <br>n.4.  The rule in this circuit has been to accept recklessness, as <br>narrowly defined in the two Seventh Circuit cases (Sundstrand and <br>Sanders), as a method of proving scienter.  See Serabian, 24 F.3d <br>at 365.  That definition of recklessness does not encompass <br>ordinary negligence and is closer to a lesser form of intent.  <br>  The effect of the PSLRA on the standard for scienter has <br>been much disputed.  The Act itself is silent on the general <br>scienter requirements for 10b-5 actions, referring only to scienter <br>as "the required state of mind."  15 U.S.C.  78u-4(b)(2).   <br>Plaintiffs and the SEC maintain that the PSLRA did not intend or <br>purport to change whatever the preexisting standard was, and that <br>standard included some form of recklessness.  The defendants say <br>that only the most heightened recklessness standard should be used, <br>and that the SEC's views are not entitled to any weight. <br>  The circuit courts have reached different results.  A <br>panel in the Ninth Circuit has held that the PSLRA elevated the <br>standard to one of "deliberate recklessness," In re Silicon <br>Graphics Inc. Sec. Litig., 183 F.3d 970, 974 (9th Cir.  1999).  One <br>district court within this circuit has concluded that recklessness <br>is insufficient and that only conscious conduct would suffice under <br>the Act.  See Friedberg v. Discreet Logic Inc., 959 F. Supp. 42, 48 <br>(D. Mass. 1997). <br>  In contrast, the Sixth Circuit has concluded that the <br>PSLRA did not alter the state of mind requirement and thus a <br>complaint pleading facts that give rise to a "'strong inference of <br>recklessness' of the kind required for securities fraud liability" <br>suffices.  In re Comshare, Inc. Sec. Litig., 183 F.3d 542, 552-53 <br>(6th Cir. 1999).  The Sixth Circuit had previously adopted, as had <br>this circuit, the Sundstrand definition of recklessness, see id. at <br>550, and concluded that same standard applied after the PSLRA was <br>enacted.  The Eleventh Circuit has expressed its "basic agreement" <br>with the Sixth Circuit, Bryant v. Avado Brands, Inc., No. 98-9253, <br>1999 WL 688050, at *8 (11th Cir. Sept. 3, 1999), holding that the <br>PSLRA did not "substantively change the actionable level of <br>scienter," id. at *10.  The Third Circuit has concluded that <br>"[a]lthough the Reform Act established a uniform pleading standard, <br>it did not purport to alter the substantive contours of scienter," <br>In re Advanta Corp. Sec. Litig., 180 F.3d 525, 534 (3d Cir. 1999), <br>and reiterated its prior law that recklessness, as defined in <br>Sundstrand, suffices, see id.  Without much discussion of the <br>issue, the Second Circuit has adhered to its previous acceptance of <br>recklessness.  See Press v. Chemical Inv. Servs. Corp., 166 F.3d <br>529, 537-38 (2d Cir. 1999).  The Fourth Circuit has also concluded <br>that the PSLRA did not change the pre-existing scienter standard.  <br>See Phillips v. LCI Int'l, Inc., No. 98-2572, 1999 WL 717253, at <br>*11 (4th Cir. Sept. 15, 1999) ("[T]o establish scienter, a <br>plaintiff must still prove that the defendant acted intentionally, <br>which may perhaps be shown by recklessness.").  Two district courts <br>in this circuit have reached the conclusion that some form of <br>recklessness is available.  See In re PLC Sys., Inc. Sec. Litig., <br>41 F.Supp.2d 106, 115 (D. Mass 1999); Lirette v. Shiva Corp., 27 <br>F.Supp.2d 268, 282 (D. Mass. 1998). <br>  We agree with those courts that hold that the PSLRA did <br>not address the substantive definition of scienter.  The <br>legislative history shows no such intent and the language of the <br>Act itself does not address the topic.  See generally Dunn, Note, <br>Pleading Scienter After the Private Securities Litigation Reform <br>Act, 84 Cornell L. Rev. 193 (1998).  The opinions of the Sixth and <br>Third Circuits discuss these points ably and there is no reason to <br>repeat the discussion here.  <br>  We add additional reasons that buttress this conclusion.  <br>The PSLRA does in fact discuss the role of "knowing" violations, <br>and thus an aspect of scienter, in two different respects.  The <br>first concerns contribution; the second, "safe harbors" for <br>defendants.  As to contribution, the Act, through a new  21D(g), <br>added a section "to preserve joint and several liability for <br>persons who knowingly commit securities fraud, but otherwise to <br>proportionately limit liability to the 'portion of the judgment <br>that corresponds to the percentage of responsibility of that <br>covered person.'"  10 Loss & Seligman, at 4687 (quoting 15 U.S.C. <br> 78u-4(f)(2)(B)(i)).  The PSLRA specifies that: <br>    [a]ny covered person against whom a final judgment is <br>  entered in a private action shall be liable for damages <br>  jointly and severally only if the trier of fact <br>  specifically determines that such covered person <br>  knowingly committed a violation of the securities laws. <br> <br>15 U.S.C.  78u-4(f)(2)(A).  In turn "knowingly commits a violation <br>of the securities laws" is defined (for 10b-5 purposes) as <br>requiring "actual knowledge" that a representation is false or an <br>omission renders a representation false.  Id.  78u-4(f)(10)(A).  <br>The definition specifically excludes "reckless conduct" as a basis <br>for construing a knowing commission of a violation.  Id.  78- <br>u(f)(10)(B). <br>  These special contribution provisions lead to several <br>conclusions.  Congress, having explicitly eliminated recklessness <br>as a basis for imposing joint and several liability, should not be <br>taken as implicitly having eliminated recklessness as a basis for <br>any liability.  See In re Silicon Graphics, 183 F.3d at 995 <br>(Browning, J., concurring in part and dissenting in part).  Because <br>joint and several liability is more onerous than individual <br>liability, the exclusion of recklessness as the basis for imposing <br>joint and several liability constitutes a recognition that some <br>form of recklessness may suffice for individual liability.  <br>Furthermore, Congress took great care to insure that the actual <br>knowledge requirement was restricted to the joint and several <br>liability provisions of the Act.  Section 78u-4(f)(1) provides that <br>"nothing in this subsection shall be construed to create, affect, <br>or in any manner modify, the standard for liability associated with <br>any action arising under the securities laws."  15 U.S.C.  78- <br>u(f)(1).  Including this language would not make sense if Congress <br>had altered the general scienter requirement to restrict it to <br>actual knowledge. <br>  The "safe harbor" provisions of the Act similarly <br>buttress the conclusion that the Act did not alter pre-existing law <br>defining scienter.  The PSLRA adopted a statutory "safe harbor" by <br>adding a new section 27A to the 1933 Act, 15 U.S.C.  77z-2, and a <br>new section 21E to the 1934 Act, 15 U.S.C.  78u-5.  The safe <br>harbor has two alternative inlets: the first shelters forward- <br>looking statements that are accompanied by meaningful cautionary <br>statements.  See 15 U.S.C.  78u-5(c)(1)(A)(i).  The second inlet <br>is of importance here.  It focuses on the state of mind of the <br>defendant and precludes liability for a forward-looking statement <br>unless the maker of the statement had actual knowledge it was false <br>or misleading.  See  78u-5(c)(1)(B); H.R. Conf. Rep. No. 104-369 <br>(1995), reprinted in 1995 U.S.C.C.A.N. 730, 743.  Again, this new <br>section 21E to the 1934 Act is explicit, in contrast with the lack <br>of such language in the definition of scienter in  21D(b)(2).  See <br>Bryant, 1999 WL 688050, at *10; In re Silicon Graphics, 183 F.3d at <br>995 (Browning, J., concurring in part and dissenting in part). <br>  Concluding that the Act does not alter the pre-existing <br>definition of scienter adopted by this circuit, we accordingly test <br>the complaint against that definition. <br>                                V <br>       Application of Standards to Plaintiffs' Complaint <br>  We review the dismissal of plaintiffs' complaint de novo, <br>giving plaintiffs the benefit of all reasonable inferences, but <br>holding plaintiffs to the standard of showing a strong inference of <br>scienter.  See Gross v. Summa Four, Inc., 93 F.3d 987, 991 (1st <br>Cir. 1996).  We think the claims are either insufficiently <br>particularized or, where particularized, do not permit a strong <br>inference of scienter. <br>  At the heart of plaintiffs' case is the allegation that <br>defendants consistently overstated the earnings of the company by <br>improperly booking as revenue (and inadequately reserving) "sales" <br>that were actually contingent transactions.  This was improper, <br>plaintiffs say, under generally accepted accounting principles <br>("GAAP"), specifically Statement of Financial Accounting Standards <br>No. 48 ("FAS 48").  Plaintiffs claim that the sales were contingent <br>because there were unlimited return rights.  Plaintiffs say that <br>they have evidence both tending directly to show conscious <br>wrongdoing on the part of defendants and circumstantial evidence <br>from which such wrongdoing may be inferred, including that the <br>defendants had both motive and opportunity. <br>A.  Direct Evidence of Scienter <br>  Two types of allegations tend to show conscious <br>wrongdoing: the "white-out" and the warehousing allegations. <br>1.  The "White-Out" Allegations and the Rule 56(f) Motion <br>  The "white-out" allegations claimed that FTP personnel <br>"whited out" (in a manner undetectable to company auditors) the <br>customers' additions to standard purchase orders; those additions <br>made orders contingent on the customers' unlimited right to return <br>the goods to FTP.  The white-out allegations were powerful, as the <br>district court recognized in initially denying the motion to <br>dismiss.  If adequately supported, claims that management <br>deliberately altered company records to hide material information <br>from company auditors could well create strong inferences of <br>scienter.  But, as the district court correctly ruled on summary <br>judgment, plaintiffs could not produce admissible evidence to <br>support the white-out allegations, and so we disregard these <br>allegations. <br>2. The Warehousing Allegations <br>  The warehousing allegations remain.  In essence, the <br>complaint asserts that at some time before the Class Period, the <br>company made a phony sale or sales and caused to be booked as goods <br>sold certain product that was shipped to a warehouse and not to <br>customers; the company then recognized the revenue from such phony <br>sales.  After a period, the product was sent back from the <br>warehouse as "returned" goods.  The allegations state that Robert <br>Casa, an employee who refused to sign for the "returned" product <br>and complained about the practice, was fired.  If true, such <br>practices by a company are very serious.  See United States v. <br>Bradstreet, 135 F.3d 46, 48 (1st Cir. 1998) (affirming a criminal <br>conviction for, inter alia, "knowingly falsifying [a company's] <br>books and records in an attempt to conceal [securities] fraud"). <br>  The complaint is deficient in not identifying when this <br>took place.  The complaint is specific only in saying this occurred <br>before the Class Period.  The complaint alleges, on information and <br>belief, that the practice continued into the Class Period but <br>provides no specifics about why the practice is thought to have <br>occurred during the Class Period or why it caused harm to <br>plaintiffs.  The defendants say the temporal lag means the <br>allegations are irrelevant and should be disregarded.  The <br>allegations are not irrelevant -- evidence of past practice may <br>indeed be probative of present practice.  But there is scant else <br>from which to infer that this was the company's practice at any <br>pertinent time, and the allegations are not enough to support a <br>strong inference of scienter.  See Lefkowitz v. Smith Barney, <br>Harris Upham & Co., 804 F.2d 154, 155-56 (1st Cir. 1986). <br>B. Indirect Evidence of Scienter <br>  There is also indirect evidence from which plaintiffs say <br>scienter can be inferred.  Defendants, or so the complaint alleges, <br>knew the company was in trouble because they knew that Microsoft <br>would have, as an integral part of its Windows 95 package, a <br>product that would compete with FTP's wares.  Purchasers of Windows <br>95 would therefore have no reason to purchase FTP's product. Before <br>and during the Class Period (July 14, 1995, to January 3, 1996), <br>FTP engineers repeatedly warned management of this competitive <br>threat.   Indeed, certain large orders, such as a $10 million order <br>by the French Post Office, were cancelled.  Plaintiffs allege that <br>FTP's management responded through two strategies, "channel <br>stuffing" and contingent sales, which artificially inflated the <br>company's revenues. <br>1. Channel Stuffing <br>  "Channel stuffing" means inducing purchasers to increase <br>substantially their purchases before they would, in the normal <br>course, otherwise purchase products from the company.  It has the <br>result of shifting earnings into earlier quarters, quite likely to <br>the detriment of earnings in later quarters.  There is nothing <br>inherently improper in pressing for sales to be made earlier than <br>in the normal course, and we do not understand plaintiffs' <br>complaint to make any such claim.  Plaintiffs make use of the <br>channel stuffing allegations in a different way.  They say evidence <br>of channel stuffing supports their contention that management knew <br>that revenues during the Class Period would be low and attempted to <br>hide that fact by shifting income through channel stuffing (which <br>remained undisclosed) and by artificially inflating income through <br>improper revenue recognition.  In this context, the channel <br>stuffing evidence has some probative value.  But that value is <br>weak.  Unlike altering company documents, there may be any number <br>of legitimate reasons for attempting to achieve sales earlier.  <br>Thus, it does not support a strong inference of scienter. <br>2.  Contingent Sales <br>  Plaintiffs allege that the financial statements included <br>in FTP's Form 10-Q report for the third quarter of 1995 were <br>prepared in violation of GAAP and contained improperly inflated <br>revenues and earnings.  Specifically, plaintiffs claim that FTP <br>recognized revenues from sales that included a right of return, <br>which did not meet the requirements for revenue recognition set <br>forth in FAS 48.  When a buyer has the right to return a product, <br>FAS 48 prohibits the seller from recognizing income from the sale <br>unless six conditions are met.  See Statement of Financial <br>Accounting Standards No. 48,  6 (Fin. Accounting Standards Bd., <br>June 1981).   <br>  Plaintiffs focus on three of the six FAS 48 conditions:  <br>that the buyer's obligation to pay the seller is not contingent on <br>resale of the product; that the seller does not have significant <br>obligations for future performance directly to bring about resale <br>of the product by the buyer; and that the amount of future returns <br>can be reasonably estimated.  See id.  If any of the conditions are <br>not met at the time of the sale, sales revenue cannot be <br>immediately recognized.  See id. <br>  Plaintiffs allege that during the Class Period FTP <br>recorded as "sales" transactions including a right of return that <br>violated all three of the above conditions.  Plaintiffs claim FTP <br>"induc[ed] distributors to purchase more product than they needed <br>with the promise that they could return the product if it were <br>unsold . . . . [S]ubsequently, a material portion of these 'sales' <br>were either returned in the fourth fiscal quarter of 1995 or <br>remained with distributors, but were unpaid for."  Plaintiffs <br>contend that "[u]nder certain circumstances, the distributor could <br>defer payment until FTP's or its own sales force had booked a sale <br>to an ultimate customer for the products.  FTP, however, would not <br>receive payment until the distributor was in a position to book the <br>sale and ship the product and receive payment from the end user . <br>. . ."  Furthermore, "due to the constantly changing competitive <br>environment and the release of Microsoft's 'Windows '95', FTP had <br>no way to reasonably estimate returns."  Finally, even if all the <br>conditions for immediate revenue recognition are met, FAS 48 <br>requires that the seller reduce sales revenue and cost of sales <br>reported in the income statement to reflect estimated returns.  See <br>id.  7.  Plaintiffs allege that FTP violated this by failing to <br>adequately reserve for returns. <br>  Violations of GAAP standards such as FAS 48 could provide <br>evidence of scienter.  See Malone v. Microdyne Corp., 26 F.3d 471, <br>478-79 (4th Cir. 1994).   To support even a reasonable inference of <br>scienter, however, the complaint must describe the violations with <br>sufficient particularity; "a general allegation that the practices <br>at issue resulted in a false report of company earnings is not a <br>sufficiently particular claim of misrepresentation."  Gross v. <br>Summa Four, Inc., 93 F.3d 987, 996 (1st Cir. 1996) (quoting <br>Serabian v. Amoskeag Bank Shares, Inc., 24 F.3d 357, 362 n.5 (1st <br>Cir. 1994)).  Here, as the district court correctly concluded, the <br>complaint clearly falls short.  The  allegations in the complaint <br>do not include such basic details as the approximate amount by <br>which revenues and earnings were overstated, see Gross, 93 F.3d at <br>996; the products involved in the contingent transactions, cf. <br>Malone, 26 F.3d at 476-77 (products that were "sold" with rights of <br>return specifically identified); the dates of any of the <br>transactions; or the identities of any of the customers or FTP <br>employees involved in the transactions.  We do not say that each of <br>these particulars must appear in a complaint, but their complete <br>absence in this case is indicative of the excessive generality of <br>these allegations. <br>  As part of their opposition to defendants' renewed motion <br>to dismiss, plaintiffs attempted to introduce evidence of four <br>alleged contingent transactions drawn from defendants' automatic <br>disclosure.  The district court, however, refused to take this new <br>evidence into consideration in its ruling.  The court reasoned that <br>there would have been no disclosure but for the white-out <br>allegations, because the complaint would have been dismissed at the <br>outset; the white-out allegations proved insubstantial, even with <br>the benefit of disclosure; and therefore the remainder of the <br>complaint should be judged without the additional evidence obtained <br>through disclosure.  We need not decide whether the district <br>court's refusal to consider the additional evidence was correct, <br>because we believe that plaintiffs' additional evidence would not <br>have sufficed to prevent dismissal. <br>  Plaintiffs identify four sets of transactions from the <br>third quarter of 1995 that allegedly involve improperly booked <br>revenue.  Plaintiffs present invoices, purchase orders, and other <br>documentation that show, they contend: (a) a set of transactions <br>totaling $678,000 with a distributor, Merisel, in which Merisel was <br>not obliged to pay for the product; (b) a $705,250 transaction with <br>reseller CC-OPS in which CC-OPS was given an unlimited right to <br>return the product; (c) a $1.14 million transaction with reseller <br>Afina Sistemas that involved the "sale" of an FTP product that did <br>not yet exist; and (d) a $416,325 transaction with reseller Force <br>3 that was contingent upon Force 3 receiving a government contract. <br>a. The Merisel Transactions <br>  The Merisel allegations involve one $130,078 transaction <br>in August 1995 and two transactions in late September 1995 totaling <br>$548,192.  Plaintiffs claim that the August transaction, for which <br>FTP issued an invoice, was not a true sale but a "stock rotation," <br>in which FTP replaced outdated products in Merisel's inventory at <br>no charge.  Plaintiffs point to a credit issued to Merisel by FTP <br>in mid-October for the full amount.  Less detail is provided <br>concerning the September transactions.  To support their contention <br>that those transactions were improperly booked contingent sales, <br>plaintiffs proffer three items: the $548,192 posted to accounts <br>receivable on September 29; the fact that $494,872 remained unpaid <br>as of December 31; and the agreement between Merisel and FTP, which <br>states that Merisel will pay FTP for all copies of FTP's products <br>sub-licensed by Merisel and its dealers.   <br>  A possible -- though far from necessary -- conclusion is <br>that the August transaction was an exchange of new products for old <br>improperly booked as a sale, as the original Merisel purchase order <br>contains the notation "[o]ffsetting order f. stockrotation" (sic).  <br>The September transactions, on the other hand, are described in <br>insufficient detail to support plaintiffs' allegations.  The mere <br>existence of an overdue receivable does not support an inference <br>that the original transaction was booked as a sale in violation of <br>GAAP. <br>b. The CC-OPS Transaction  <br>  The CC-OPS allegation concerns a September 29 order for <br>$705,250 of FTP products, which FTP immediately booked as a sale.  <br>A letter from FTP's sales director for the Americas apparently <br>accompanied the invoice.  The letter stated that it was FTP's <br>"policy" to "allow[] large or frequent customers to return product <br>without contingency within 60 days of receipt of order."  Large <br>customers were defined as those generating over $100,000 per year.  <br>A copy of the original letter is not present in the invoice file.  <br>On November 27, CC-OPS faxed a copy of the letter back to FTP, and <br>FTP extended the right of return from 60 to 90 days.  This revised <br>letter is present in the file.  Shortly after the return period was <br>lengthened, FTP issued a credit for the full amount of the invoice <br>and authorized the return of the product. On the original invoice <br>is written: "Credit per Jack Geraghty.  Not recognizable revenue." <br>  Plaintiffs charge that the initial booking of revenue <br>from this transaction violated GAAP; that the letter indicates that <br>FTP had a policy of granting unlimited return rights to its <br>customers; and that the absence of the original September 29 letter <br>from the file indicates that FTP was attempting to conceal the <br>existence of return rights.  However, FAS 48 permits sellers to <br>recognize sales that include a right of return, so long as the <br>required conditions are met and the seller establishes a reasonable <br>reserve for returns.  The granting of a right of return in a <br>particular transaction, or even a general policy of granting return <br>rights, does not per se mean that revenue cannot be recognized at <br>the time of sale.  Plaintiffs merely make an allegation that FTP <br>failed to adequately reserve and materially overstated FTP's <br>revenues.  Without any information on FTP's experience with past <br>return rates, the size of its reserve for returns, or how the <br>reserve changed over time, it is difficult to infer that FTP's <br>revenue recognition decisions were unreasonable enough to violate <br>GAAP, or that they give rise to a strong inference of scienter.   <br>"'Generally accepted accounting principles,' . . . tolerate a range <br>of 'reasonable' treatments, leaving the choice among alternatives <br>to management."  Thor Power Tool Co. v. Commissioner of Internal <br>Revenue, 439 U.S. 522, 544 (1979). <br>c. The Afina Sistemas Transaction <br>  The Afina Sistemas ("Afina") allegation involves two <br>purchase orders totaling $1.14 million issued on September 28.  The <br>orders were for 200,000 copies of FTP's Internet browser, custom <br>made for an Afina client.  FTP booked the entire amount as revenue <br>on September 29 and carried the amount as an account receivable <br>throughout the fourth quarter.  Plaintiffs claim that this revenue <br>was improperly booked because the version of the browser ordered by <br>Afina was then still under development.  An internal FTP document <br>indicates that the test version of the Spanish edition of the <br>browser was not scheduled to be completed until late October.  <br>Plaintiffs also point to notations reading "DO NOT SHIP PRODUCTS" <br>on documents attached to each invoice. <br>  This transaction is difficult to classify.  This appears <br>to be one part of a larger undertaking (the "Telefonica project" <br>referred to on the Afina purchase order) about which plaintiffs <br>present only fragmentary information.  It is not clear that the <br>custom version of FTP's browser referred to in Afina's purchase <br>order is the same as the Spanish version listed on FTP's <br>development schedule.  Furthermore, marking "DO NOT SHIP" <br>prominently on documents seems an odd way to conceal an improperly <br>booked sale from auditors.  Finally, the fact that an overseas <br>customer with 90 days to pay has not paid after 94 days is not <br>highly suspicious.  It is possible to infer, however -- at least <br>tentatively -- that this transaction should not have been booked as <br>a sale in September.  It is a leap from there to a strong inference <br>of scienter. <br>d. The Force 3 Transaction <br>  The Force 3 allegations concern a purchase order for <br>$416,325 issued on September 30, which stated on its face that it <br>was contingent on Force 3's receipt of a government contract.  FTP <br>nonetheless immediately recorded the entire amount as an account <br>receivable.  On December 29, FTP issued Force 3 a credit for the <br>full amount.  The same day, Force 3 sent FTP a new purchase order <br>for the same products it ordered on September 30, but this purchase <br>order did not refer to any contingency.  FTP issued a new invoice <br>and again booked the amount as a sale.  The original booking of <br>this sale in September appears to have violated the requirement in <br>FAS 48 that the buyer's obligation to pay the seller is not <br>contingent on resale of the product.   <br>  At best, plaintiffs' additional evidence supports an <br>inference that FTP improperly recognized from $416,000 to $1.55 <br>million in revenue in the third quarter of 1995.  Because FTP <br>reported overall revenue during the quarter of $37.1 million, these <br>transactions do not support a strong inference of scienter.  It <br>is equally possible to conclude that FTP made some incorrect <br>accounting decisions regarding a limited number of transactions.  <br>Seeing fraud, however, requires too great of an inferential leap.  <br>In short, even when viewed in combination with plaintiffs' other <br>allegations, plaintiffs' additional evidence does not support a <br>strong inference of scienter, and thus the district court's <br>decision not to consider the evidence could not have affected the <br>outcome of the motion to dismiss. <br>3.  Insider Trading <br>  The allegations of insider trading do not, either alone <br>or together with the other allegations, suffice.  The individual <br>defendants sold FTP common stock during the Class Period.  For <br>example, Zirkle sold 40,000 shares on July 21, 1995 at a price of <br>$26.27 per share, for total proceeds of $1,050,800.  Goodnow sold <br>40,000 shares on July 27 at a price of $29.00 per share, for a <br>total price of $1,160,000.  Last, on August 2, 1995, Charlotte <br>Evans sold 200 shares at $28.50 per share, for a total of $57,000.  <br>All three defendants sold stock later in the Class Period as well. <br>  We first look at context.  The timing does not appear <br>very suspicious.  None of these three key players sold at the high <br>points of the stock price.  Each waited to sell until after FTP <br>announced a corporate reorganization on July 14, an announcement <br>which caused the price of the stock to fall.  Each sold some stock <br>before an allegedly manipulated analyst's report from Brookehill <br>Equities recommended FTP stock as a long-term buy on August 3, <br>1995, and before a favorable Cowen & Co. report on December 1, <br>1995. <br>  The total sum of sales involved -- over $23 million <br>during a six month period -- could be suspicious, but a closer look <br>provides ready explanations.  Goodnow, as plaintiffs allege, <br>retired on October 26, 1995, from his position as vice president, <br>CFO, and treasurer.  His sale of stock in July occurred not long <br>before he left the company.  He also sold a considerable number of <br>shares after he left the company -- 690,000 shares  accounting for <br>$19 million out of his total of almost $20.2 million in sales <br>during the Class Period.  The vast majority of the $23 million in <br>sales by the individual defendants, more than $20 million worth, <br>were by one individual who was leaving the company, and more than <br>$19 million was after that individual had left the company.  It is <br>not unusual for individuals leaving a company, like Goodnow, to <br>sell shares.  Indeed, they often have a limited period of time to <br>exercise their company stock options.  As to the others, the sales <br>do not reflect either unusual sales or sales made before a big <br>"event" unknown to the public.  Selling after delivering news that <br>causes a company's stock price to go down is not suggestive of <br>withholding information.  But that is what happened here.  <br>Plaintiffs provided no information on sales by corporate insiders <br>at times outside the Class Period, so there is no comparison point.  <br>  Although the total sum involved was large, the district <br>court correctly concluded that plaintiffs produced no evidence that <br>the trading was out of the ordinary or suspicious.  Absent <br>additional evidence, it is not possible to draw a strong inference <br>of scienter based on improper trading on material, non-public <br>information.  <br>C.  Other Alleged False Statements and Material Omissions <br>1.  Zirkle's Statements <br>  Zirkle's upbeat statements of optimism and puffing about <br>the company's prospects, described earlier, have each been reviewed <br>and we conclude that they are not actionable.  See Glassman, 90 <br>F.3d at 635-36; Shaw, 82 F.3d at 1217-19.   <br>2.  Form 10-Q Report for Third Quarter 1995 <br>  The 10-Q Report stated there was an increase in accounts <br>receivable and attributed it to increased sales.  Plaintiffs do not <br>say this statement was false; only that it was misleading because <br>it did not say the increased sales were subject to return rights.  <br>As an independent ground, this is too slight; as a ground in <br>service of the contingent sales/improper booking argument, it fails <br>for the same reasons that argument fails. <br>D.  Individual Defendants <br>  Because the dismissal of the complaint is upheld, we do <br>not reach the arguments of the individual defendants that the facts <br>alleged do not make out a claim against them. <br>E. Section 20(a) Claim <br>  Plaintiffs also assert claims against the individual <br>defendants under Section 20(a) of the Exchange Act, which provides <br>for derivative liability of persons who "control" others found to <br>be primarily liable under the Exchange Act.  See 15 U.S.C.  <br>78t(a).  Because plaintiffs' complaint does not adequately allege <br>an underlying violation of the securities laws, the district court <br>was correct to dismiss the Section 20(a) claim.  See Suna v. Bailey <br>Corp., 107 F.3d 64, 72 (1st Cir. 1997). <br>                               VI <br>  The district court correctly refused to dismiss the <br>complaint originally and was well within its discretion in limiting <br>the discovery it afforded.  The difficult and different balance the <br>Act now requires -- testing allegations before little or no <br>discovery, but holding plaintiffs to a strong inference of scienter <br>standard -- has been honored in this case.  Plaintiffs did not have <br>enough weight on their side of the balance to meet the requirements <br>of the Act, and so we affirm the dismissal.  Costs to appellants.</pre>

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