Opinion
Civil Action No. 01-B-2050 (PAC).
March 25, 2003
ORDER
Plaintiffs J. Roger Gregg, Anthony Chiarenza, and Jerry V. Steinberg (collectively "Plaintiffs") bring a purported class action suit against Defendants Sport-Haley, Inc., Robert G. Tomlinson, Kevin M. Tomlinson and Robert W. Haley (collectively "Defendants"). Plaintiffs allege violations of § §§ 10(b) and 20(a) of the Exchange Act. Defendants move to dismiss the Plaintiffs' first amended complaint. The motion is adequately briefed and hearing would not materially aid its resolution. For the reasons set forth below, I deny the motion.
I. Facts
The following facts are alleged in the Plaintiffs' complaint. Denver-based Sport-Haley, Inc. ("Sport-Haley") designs, markets, and contracts for the manufacture of golf apparel. The company's stock trades on the NASDAQ stock exchange under the symbol "SPOR." Defendants Robert G. Tomlinson, Kevin M. Tomlinson and Robert W. Haley (collectively "Individual Defendants") were all senior officers and directors of the Company. Robert G. Tomlinson served as Chairman and Chief Executive Officer. Kevin M. Tomlinson was Vice President of Operations, Chief Operations Officer, and Vice President and Director of a Sport-Haley subsidiary. Robert W. Haley was President and a Director of the company.
On October 16, 2000, Sport-Haley publicly disclosed that its previous financial statements contained accounting irregularities and GAAP violations. The errors Sport-Haley uncovered included incorrect valuation of work in progress; improper recording of assets; erroneous accounting for the acquisition of the company's subsidiary; inaccurate accounting relating to the minority interest loss in the subsidiary; and incorrect recording of losses on discontinued operations. In response to that disclosure, NASDAQ suspended trading of Sport-Haley's securities until the company satisfied NASDAQ's request for additional information.
On November 6, 2000, Sport-Haley disclosed that its financial statements for fiscal years 1996 through 1999 required adjustment, including an adjustment of earnings for 1998 and 1999. Pursuant to that disclosure, Sport-Haley restated its 1998 net income from $4.3 million to $2.5 million. The company also restated its 1999 net income from $814,000 to $147,000.
In a letter dated November 7, 2000, the SEC informed Sport-Haley and the Individual Defendants that it would conduct an informal investigation into possible violations of federal securities laws related to Sport-Haley's financial restatements. In that letter, the SEC requested certain documents and testimony from Sport-Haley and its employees. Upon reviewing Sport-Haley's documents and considering its testimony, the SEC initiated a formal investigation of the company.
On November 14, 2001, Sport-Haley publicly announced that its former independent auditor — Levine, Hughes Mithuen Inc. — expressed that it might initiate legal proceedings against Sport-Haley relating to the 1998 and 1999 restatements. Then, in December 2001, the SEC announced that it planned to recommend an enforcement action against defendants Sport-Haley and Robert Tomlinson. On March 19, 2002, the Company announced that Robert Tomlinson had resigned.
Plaintiffs are investors who purchased Sport-Haley common stock between September 4, 1996 and October 16, 2000. They claim an estimated total of $786,503.00 in losses due to a decline in the value of Sport-Haley stock.
II. Motion to Dismiss
Defendants move to dismiss Plaintiffs' Section 10(b) claims under Fed.R.Civ.P. 12(b)(6). Rule 12(b)(6) states that a court may dismiss a complaint for "failure to state a claim upon which relief can be granted." The complaint should not be dismissed under Rule 12(b)(6) "unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief" Conley v. Gibson, 355 U.S. 41, 45-46 (1957). In reviewing the sufficiency of the complaint, a court must presume that the plaintiff's factual allegations are true and construe them in a light most favorable to the plaintiff Scheuer v. Rhodes, 416 U.S. 232 (1974). Securities claims should be dismissed pursuant to Rule 12(b)(6) where the alleged misstatements or omissions are plainly immaterial, or where the complaint fails to satisfy the pleading requirements of 15 U.S.C. § 78u-4(b)(1) (2).
A. Section 10(b) of the Securities and Exchange Act
Section 10(b) of the Securities and Exchange Act makes it unlawful for any person "[t]o use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission [SEC] may prescribe as necessary or appropriate in the public interest or for the protection of investors." 15 U.S.C. § 78j(b). Rule 10b-5, prescribed by the SEC under Section 78j(b), declares it unlawful for a person "to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading." 17 C.F.R. § 240.10b-5 (1997). To state a claim under Rule 10b-5, a plaintiff must allege: (1) a misleading statement or omission of a material fact; (2) made in connection with the purchase or sale of securities; (3) with intent to defraud or recklessness; (4) reliance; and (5) damages. In re Ribozyme Pharmaceuticals, Inc., 119 F. Supp.2d 1156, 1161 (D.Colo. 2000); Grossman v. Novell, Inc., 120 F.3d 1112, 1118 (10th Cir. 1997).
The Private Securities Litigation Reform Act of 1995 ("PSLRA") amended the Securities Exchange Act to deter the perceived rise in abusive private securities fraud suits by enhancing the standard for pleading securities fraud claims. Now, to adequately plead a Rule 10b-5 claim, a plaintiff not only must plead with particularity the facts constituting fraud, see 15 U.S.C. § 78u-4(b)(2), but also facts permitting a strong inference that the respective defendant acted with the requisite state of mind. 15 U.S.C. § 78u-4(b)(2). Consequently, defendants moving to dismiss can now challenge the particularity of allegations regarding the elements of Rule 10b-5 or the defendant's alleged state of mind. In re Ribozyme Pharmaceuticals, Inc., 119 F. Supp.2d at 1162. Defendants advance numerous arguments against the Plaintiffs' first amended complaint. I consider their arguments in turn.
A. Strong Inference of Scienter
First, the Defendants contend that the Plaintiffs have failed to plead facts that give rise to a strong inference of scienter. I disagree.
The PSLRA requires plaintiffs to "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). The appropriate level of scienter in securities fraud cases is "a mental state embracing intent to deceive, manipulate, or defraud." Ernst Ernst, 425 U.S. 185, 193 n. 12 (1976). The standard includes recklessness. City of Philadelphia v. Fleming Cos., 264 F.3d 1245, 1259 (10th Cir. 2001). Recklessness is defined in the Tenth Circuit as "conduct that is an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it." Id. at 1260 (citing Anixter v. Home-Stake Prod. Co., 77 F.3d 1215, 1232 (10th Cir. 1996)).
A court must look to the totality of the pleadings to determine whether the plaintiffs' allegations permit a strong inference of fraudulent intent. City of Philadelphia, 264 F.3d at 1262. Allegations of motive and opportunity may be considered, but are typically not sufficient in themselves to establish a "strong inference" of scienter. Id.
Plaintiffs allege that Defendants misstated their net income by 72 percent in 1998 and 454 percent in 1999. The corresponding reductions in profit for those years were from $4.3 million to $2.5 million and from $814,000 to $147,000 respectively. Plaintiffs further allege that Defendants incorrectly valued their work in process; improperly recorded assets; erroneously accounted the acquisition of the company's subsidiary; inaccurately accounted relating to the minority interest loss in the subsidiary; and incorrectly recorded losses on discontinued operations. They allege that Defendants publicly commented on their ability to control costs and signed filings with the SEC that were later shown to be false.
Additionally, Plaintiffs allege that the SEC has formally investigated Sport-Haley and announced a planned recommendation of enforcement action against Sport-Haley and Robert Tomlinson. They also allege that the company's independent auditor has threatened Sport-Haley with legal action in relation to the 1998 and 1999 restatements.
At its least, the alleged overstatement of profit is the type of disclosure that creates a "danger of misleading buyers or sellers that is . . . so obvious that the actor must have been aware of it." City of Philadelphia, 264 F.3d at 1259. Plaintiffs have satisfied their burden to plead a strong inference of scienter.
B. The Specificity of the Alleged Misstatements and Reasons Why They are Misleading
Defendants next contend that the Plaintiffs fail to specify the allegedly fraudulent statements. Again I disagree.
The PSLRA requires complaints to "specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding a statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed." 15 U.S.C. § 78u-4(b)(1).
Plaintiffs allege that Defendants released incorrect press releases and SEC filings regarding Sport-Haley's net income and earnings per share for fiscal years 1996 through 1999. For instance, the Plaintiffs allege that on September 4, 1996, Defendants issued a press release stating that the company's fiscal year 1996 income was $2.47 million with earnings per share at 66 cents. Plaintiffs also identify an October 1996 release reporting the company's income at $797,000 for the first quarter of 1996.
Plaintiffs allege that those figures are misleading by relying upon the Defendants' subsequent press release that sought to correct those previous statements. Subsequent corrections for fiscal years 1998 and 1999 noted a 72 percent and 454 percent correction in previous years' net income reports. Plaintiffs have thus alleged specific statements that they contend are false and the reason that those statements were misleading. I decline to dismiss the Plaintiffs' complaint on this basis as well.
C. Group Published Documents
Defendants next contend that Plaintiffs have not properly pleaded individual liability under the "group published documents" exception. Under that exception, "identifying the individual sources of statements is unnecessary when the fraud allegations arise from misstatements or omissions in group-published documents . . . which presumably involve the collective actions of corporate directors or officers." Ribozyme Pharmaceuticals, 119 F. Supp.2d at 1165. In Ribozyme, I noted that the Tenth Circuit has adopted the doctrine in Schwartz v. Celestial Seasonings, Inc., 124 F.3d 1246, 1254 (10th Cir. 1997), and held that press releases were among the type of documents for which the doctrine applies.
Plaintiffs allege that Defendants have filed misleading and fraudulent SEC filings and issued fraudulent press releases. Both types of documents are "group published documents." See Schwartz, 124 F.3d at 1254. Plaintiffs have further alleged that each individual defendant was a high-level corporate officer or director during the period at-issue. Thus, the doctrine applies, and there is no need to identify the individual sources of those statements. Defendants' motion to dismiss on this basis is likewise denied.
D. Allegations of Reliance
Defendants next argue that the Plaintiffs have failed to allege reliance. Again I disagree.
The "fraud on the market" doctrine recognizes that in an open, efficient, and developed market, investors must rely on the market to perform a valuation process which incorporates all publicly available information, including misinformation. In re Ribozyme Pharm. Sec. Litig., 119 F. Supp.2d at 1164 ( citing Basic Inc. v. Levinson, 485 U.S. 224, 241-42 (1988)). Consequently, the reliance of individual plaintiffs on the integrity of a price in such a market, and implicitly the misinformation that contributed to that price, may be presumed. Id. In order to take advantage of the doctrine, however, a plaintiff must plead, and ultimately prove, that the market on which the security is traded is efficient. Id. The factors which identify an efficient market are (1) a large weekly trading volume; (2) a significant number of securities analysts following and reporting on the stock; (3) eligibility of the issuer to file a Form S-3 registration statement; (4) whether the stock has market makers and arbitrageurs; and (5) whether there are empirical facts showing a cause and effect relationship between unexpected corporate events or financial releases and an immediate response in the stock. Id.
Plaintiffs allege that the average weekly trading volume of Sport-Haley's stock on the NASDAQ was at least 200,000 shares, amounting to 5 percent of its total outstanding shares. Plaintiffs also allege that Sport-Haley's stock was followed by three separate securities analysts; that the Defendants' stock was traded on NASDAQ; that Sport-Haley filed a Form S-3A on January 15, 1997; and that the company's stock price immediately declined after Sport-Haley announced unexpected decreases in net income for fiscal years 1998 and 1999. Plaintiffs have met each factor to allege that the Defendants' stock was traded on an efficient market. They have therefore provided sufficient allegations for the "fraud on the market" theory of reliance. Defendants' motion on this basis is also denied.
E. Control Person Liability
Finally, Defendants argue that Plaintiffs have failed to plead control person liability against the Individual Defendants. To state control person liability, Plaintiffs must plead (i) a primary violation of the securities laws and (ii) "control" over the primary violator by the alleged controlling person. City of Philadelphia, 264 F.3d at 1270-71.
As noted above, Plaintiffs have plead a primary violation of securities law. Plaintiffs also allege that each individual defendant held a high-level position at Sport-Haley. They allege that Robert Tomlinson was Chairman and Chief Executive Officer; Kevin Tomlinson was Chief Operations Officer, Executive Vice President and Director of Sport-Haley's subsidiary; and Mr. Haley was President and Director. The Plaintiffs have adequately plead control person liability.
The Defendants' motion to dismiss is denied.
Accordingly, IT IS ORDERED that:
1. Defendants' motion to dismiss the first amended class action complaint is DENIED.
BY THE COURT:
ORDER OF REFERENCE TO UNITED STATES MAGISTRATE JUDGE
Pursuant to 28 U.S.C. § 636(b)(1)(A) and (B) and Fed.R.Civ.P. 72(a) and (b), United States Magistrate Judge Patricia A. Coan is designated to conduct proceedings in this civil action as follows:
(X) Convene a scheduling conference under Fed.R.Civ.P. 16(b) and enter a scheduling order meeting the requirements of D.C.COLO.LCivR 16.2.
(X) Conduct such status conferences and issue such orders necessary for compliance with the scheduling order, including amendments or modifications of the scheduling order upon a showing of good cause.
(X) Convene such settlement conferences and direct related procedures as may facilitate resolution of this case.
(X) Hear and determine pretrial matters, including discovery and other non-dispositive motions.
() Conduct hearings, including evidentiary hearings, and submit proposed findings of fact and recommendations for rulings on dispositive motions.
(X) Conduct a pretrial conference and enter a pretrial order.
IT IS ORDERED that this civil action is referred to the named magistrate judge to proceed according to the designations marked (X) above.
BY THE COURT: