Opinion
Civil Action No. 01-0949 c/w 01-1509, 01-1510, 01-1801, Section "N"
October 24, 2002
ORDER AND REASONS
Before the Court is the Defendants' Motion to Dismiss Plaintiffs' Consolidated Amended Class Action Complaint. For the reasons that follow, the motion is GRANTED.
I. BACKGROUND
Orthodontic Centers of America, Inc. ("OCA") manages the financial, administrative, marketing, and business operations of orthodontic practices pursuant to service agreements or consulting agreements with affiliated orthodontists. Pursuant to these agreements, OCA provides capital, facilities, staff, and equipment; purchases inventory and supplies; implements patient scheduling systems; maintains files; and bills and collects patient fees. As payment for these services, affiliated orthodontists assign their accounts receivables to OCA. The company's stock is publicly traded on the New York Stock Exchange.
These background facts are drawn from the Consolidated Amended Class Action Complaint.
Before 2001, OCA used the percentage-of-completion method of recognizing revenue. Using this method, OCA recognized twenty-four to thirty-three percent of service-fee revenue in the first month of patient services. Also, for newly developed orthodontic centers, the revenue retained by the affiliated orthodontist was reduced by the orthodontist's share of operating losses due to start-up expenses. This amount was added to OCA's fee and recognized as income in the period during which the losses were incurred.
On December 3, 1999, the Securities Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101 ("SAB 101"), emphasizing that revenue should not be recognized until services have been rendered, the price is determinable, and collectibility is reasonably assured. In its quarterly filings with the SEC for 2000, OCA stated that it was in the process of evaluating the impact of SAB 101 on OCA's results. In a Form 8-K, filed January 18, 2001, OCA announced the conclusion it had reached, based on a review internally and with its independent auditors: OCA's revenue recognition policy complied with SAB 101.
The SEC staff, however, did not arrive at the same conclusion. On March 16, 2001, OCA issued a press release announcing that the SEC staff disagreed with the company's position; accordingly, OCA would change its revenue recognition policy to a straight-line basis, effective January 1, 2000, and would no longer recognize affiliated orthodontists' share of operating losses during a given period as part of net revenue recognized for that period. OCA' s stock closed that day at $21.50 per share, down $1.70 from the previous day's close.
Three weeks later, plaintiff Joanne Bay filed this securities fraud putative class action against OCA and three of its officers: (1) Bartholomew Palmisano, Sr., president and CEO; (2) Bartholomew Palmisano, Jr., chief financial officer; and (3) Gasper Lazzara, Jr., a founder of OCA, who had retired as CEO in August 2000 and retired as chairman of the board in June 2001. Seeking damages under sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 of the SEC, Bay alleged that these defendants had knowingly or recklessly: (1) overstated OCA's financial condition prior to 2001 by improperly recognizing 24% to 33% of fee revenues from service agreements in the first month of patient services; (2) overstated OCA's financial condition by recognizing as part of net revenue for a given period the share of operating losses attributable to affiliated orthodontists in that period; and (3) misrepresented that OCA's accounting and reporting policies conformed with Generally Accepted Accounting Principles ("GAAP").
In the ensuing weeks, plaintiffs Daowei Ma, Warren Walton, and Delmer Nimz each filed a separate action nearly identical to Bay's. On June 19, 2001, Delmer Nimz and five other putative class members moved to be appointed lead plaintiffs. Judge G. Thomas Porteous, Jr. of this Court consolidated the cases and, on December 18, 2001, granted the motion by Nimz and his co-movants (the "plaintiffs"), appointing them lead plaintiffs. On February 25, 2002, the plaintiffs filed their Consolidated Amended Class Action Complaint (the "Amended Complaint").
The Amended Complaint reiterates the allegations contained in the original complaints regarding OCA's pre-2001 revenue recognition policies. In addition, plaintiffs allege that defendants again violated the Exchange Act and Rule 10b-5 after the original complaints were filed. They allege that, starting in May 2001, defendants made statements about OCA's upcoming merger with its competitor, OrthAlliance, Inc. ("OrthAlliance"), that omitted material facts. According to plaintiffs, defendants' statements about the merger were false and misleading because they failed to disclose that: (1) an increasing number of orthodontists were suing to get out of their contracts with OrthAlliance and ceasing payments to OrthAlliance; and (2) defendants themselves believed the OrthAlliance contracts to be voidable under state laws prohibiting dentists from splitting fees with non-licensed persons. The merger closed on November 9, 2001.
The Amended Complaint adds a fifth defendant, W. Dennis Summers, the former chairman and CEO of OrthAlliance, who joined OCA's board of directors in December 2001, just after the merger. In addition, the Amended Complaint extends the proposed class period beyond that proposed in the original complaints (April 27, 2000 to March 15, 2001), expanding the proposed class definition to include those who bought OCA stock during the period from April 27, 2000 to February 7, 2002.
II. LAW AND ANALYSIS
Defendants move to dismiss the Amended Complaint pursuant to Rule 12(b)(6). For purposes of this motion, the Court must accept the facts alleged as true and must construe the allegations in the light most favorable to the plaintiffs. Nathenson v. Zonagen Inc., 267 F.3d 400, 406 (5th Cir. 2001).
To state a claim under section 10(b) of the Exchange Act and Rule 10b-5, a plaintiff must allege the following in connection with a purchase or sale of securities:" `(1) a misstatement or an omission (2) of material fact (3) made with scienter (4) on which plaintiff relied (5) that proximately caused [the plaintiffs'] injury.'" Nathenson, 267 F.3d at 406-07 (quoting Tuchman v. DSC Communications Corp., 14 F.3d 1061, 1067 (5th Cir. 1994).
Defendants argue that the Amended Complaint must be dismissed because it fails to satisfy the heightened pleading requirements of the Private Securities Litigation Reform Act of 1995 ("PSLRA"). See 15 U.S.C. § 78u-4(b). The Court agrees.
A. The Private Securities Litigation Reform Act of 1995 ("PSLRA"):
The PSLRA enhanced the pleading requirements for section 10(b) claims in two respects. First, with respect to the misstatement element, the PSLRA requires that the complaint specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the 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). Second, the PSLRA requires that the complaint, "with respect to each act or omission. . ., 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). Defendants argue that the Amended Complaint fails to satisfy either of these requirements.
1. Pleading Sufficient Facts to Support a Reasonable Inference of Falsity:
The PSLRA reiterates the requirements under Rule 9(b) jurisprudence that the complaint "specify each statement alleged to have been misleading" and "the reason or reasons why the statement is misleading." 15 U.S.C. § 78u-4(b)(1); see ABC Arbitrage Plaintiff's Group v. Tchuruk, 291 F.3d 336, 350 (5th Cir. 2002). To these, the PSLRA added the requirement that, where any allegation regarding the allegedly misleading statement 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). For an allegation to be subject to this heightened pleading requirement, it need not be labeled as having been made "on information and belief." Allegations "made on "investigation of counsel' are equivalent to those made on "information and belief "for purposes of the PSLRA. ABC Arbitrage, 291 F.3d at 351 n. 69. Indeed, any allegations that "are not based on Plaintiffs' personal knowledge" are "necessarily pleaded on "information and belief, ' although not labeled as such." Id. at 351. Plaintiffs here allege personal knowledge only "as to themselves and their own acts." As to "all other matters," their allegations are made "upon the investigation made by and through their counsel." See Amended Complaint ("CAC") at p. 1. Thus, all of plaintiffs' allegations regarding statements and omissions by the defendants are subject to this PSLRA requirement.
To satisfy the requirement, plaintiffs must plead with particularity, with respect to each allegedly misleading statement or omission, facts that "are sufficient to support a reasonable belief as to the misleading nature of the statement or omission." ABC Arbitrage, 291 F.3d at 3-52. In other words, plaintiffs must allege specific facts, such as "documentary evidence or personal sources," that support a reasonable inference that the statement in question was false when made. Id. at 352-53, 358.
2. Pleading Specific Facts that Support a Strong Inference of Scienter:
The state of mind or "scienter" required for a section 10(b) claim is a "`mental state embracing intent to deceive, manipulate, or defraud.'" Abrams v. Baker Hughes Inc., 292 F.3d 424, 430 (5th Cir. 2002) (quoting Ernst Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12 (1976)). Under the PSLRA, "[a]llegations of motive and opportunity, standing alone, are no longer sufficient to plead a strong inference of scienter." Abrams, 292 F.3d at 430. However, plaintiffs need not plead facts showing actual knowledge of falsity or intent to deceive on the part of the defendants. A strong inference of "severe recklessness" will suffice. Id; Nathenson, 267 F.3d at 407.
The "severe recklessness" threshold is not met by simple negligence "or even inexcusable negligence." Abrams, 292 F.3d at 430. Rather, it is satisfied only by "those highly unreasonable omissions or misrepresentations [1] that involve . . . an extreme departure from the standard of ordinary care, and [2] that present a danger of misleading buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it." Id. (emphasis added).
B. Plaintiffs' Allegations of Fraud:
Plaintiffs allege that defendants made fraudulent statements concerning two matters: 1) OCA's revenue recognition policy; and 2) the merger with OrthAlliance.
1. Statements Regarding OCA's Revenue Recognition Policy:
Plaintiffs do not allege that defendants misstated the method by which OCA recognized revenue. Rather, plaintiffs allege that the method violated GAAP and, thus, that the following characterizations of OCA's accounting policies and reports of OCA's financial results were false.
a. Quarterly and Year-End Results for 2000: For the year 2000, OCA announced first quarter results in an April 27, 2000 press release, second quarter results in a July 27, 2000 press release, third quarter results in an October 26, 2000 press release, and fourth-quarter/year-end results in a January 25, 2001 press release. CAC ¶¶ 82, 91, 98, 109. Each announced an increase in revenue and net income over the results for the same period in 1999. Id. In the April 2000, July 2000, and January 2001 press releases, management described the company's performance as "superlative," touting the company's "superior internal growth" and successful strategy." CAC ¶¶ 84, 91, 109. OCA's Form 10-Q for the first quarter of 2000, filed May 15, 2000, reported the same numbers as the April 2000 press release; its Form 10-Q for the second quarter, filed August 14, 2000, contained the same numbers as the July 2000 press release; and its Form 10-Q for the third quarter, filed November 14, 2000, contained the same numbers as the October 2000 press release. CAC ¶¶ 87, 94, 101. All three Form 10-Qs mentioned above stated that the financial statements they presented had been prepared in accordance with GAAP. CAC ¶¶ 87, 95, 102.
OCA announced: Net revenue increased 34.1 percent to $65.8 million, compared with $49.0 million for the same quarter in 1999; net income totaled $14.0 million, 38.1 percent above the $10.1 million recorded for the first quarter of 1999; the Company earned $.29 net income per share, 38.1 percent above the $.21 recorded for the first quarter of 1999. CAC ¶ 82.
OCA announced: Net revenue increased 29.5 percent to $71.8 million, compared with $55.4 million for the same quarter in 1999; net income totaled $15.3 million, 32.6 percent above the $11.5 million recorded for the second quarter of 1999; the Company earned $.31 net income per share, 29.2 percent above the $.24 recorded for the second quarter of 1999. CAC ¶ 91.
OCA announced: Net revenue increased 29.7 percent to $77.5 million, compared with $59.8 million for the same quarter in 1999; net income totaled $16.3 million, 34.9 percent above the $12.1 million recorded for the third quarter of 1999; the Company earned $.33 net income per share, 32.0 percent above the $.25 recorded for the third quarter of 1999. CAC ¶ 98.
OCA announced: Net revenue increased 28.8 percent to $80.1 million, compared with $62.1 million for the same quarter in 1999; net income totaled $17.3 million, 36.1 percent above the $12.7 million recorded for the fourth quarter of 1999; the Company earned $.35 net income per share, 34.6 percent above the $.26 recorded for the fourth quarter of 1999. CAC ¶ 109. For the year ended December 31, 2000, OCA reported: Net revenue increased 30.4 percent to $295.1 million, compared with $226.3 million for the same period in 1999; net income totaled $63.0 million, 35.4 percent above the $46.5 million recorded for the same period in 1999; the Company earned $1.27 net income per share, 32.3 percent above the $96 recorded for the same period in 1999. Id.
The April 2000 and July 2000 statements are attributed to Gasper Lazzara, Jr. CAC ¶¶ 84, 91. The January 2001 statements are attributed to Bart Palmisano, Sr. CAC ¶ 109.
* * *
[Question] 2. A recent "short" report asserts that OCA's "accounting is neither proper not is it in accordance with GAAP." What is OCA's response to that?
We emphatically disagree with that assertion. The authors of that report either misunderstood or misrepresented OCA's business, service fee arrangements, financial statements and accounting policies, as well as relevant accounting principles. The report even falsely claims that its authors were told information by OCA's Chief Financial Officer, when, in fact, they have never met or spoken with him.
Our accounting policies have also been reviewed from time to time by various analysts and other third parties. In many cases, our accounting policies have been characterized as excessively conservative given the environment in which we operate.
In sum, we are extremely confident that our accounting policies are appropriate and that our financial statements comply with GAAP in every circumstance.
According to plaintiffs, the above statements were false because: (1) OCA's revenue recognition policy violated GAAP (by failing to recognize service fees on a straight-line basis and by recognizing as revenue affiliated orthodontists' share of operating losses); and (2) as a result of the asserted GAAP violations, the reported "superlative" revenues and net income were overstated. CAC ¶¶ 83, 85, 88, 92, 94, 96, 99, 101, 105, 110. In addition, there is some suggestion in the Amended Complaint that OCA's financial statements were rendered false by the "questionable legality" of OCA's service agreements. CAC ¶ 57.
b. Statements Regarding SAB 101: The Form 10-Q's filed for the first, second, and third quarters of 2000 each contained the following statement about SAB 101: "implementation of SAB 101 is required in the second quarter of 2000. The Company is currently in the process of evaluating the impact, if any, of SAB 101 will have on its consolidated financial position or results of operations." CAC ¶¶ 89, 95, 102. In a Current Report on Form 8-K, filed with the SEC on January 18, 2001, OCA made the following statement about SAB 101 in its responses to selected inquiries:
[Question] 3. What is the impact, if any, on OCA of the new accounting rules proposed by FASB with regard to SAB 101 and revenue recognition policies?
In light of the SEC's issuance of [SAB 101], we have reviewed our revenue recognition policies internally and with our independent auditors, Ernst Young LLP. Based on that review, we believe that our existing revenue recognition policies comply with SAB 101, and that SAB 101 will not have a material impact on our results of operations.
CAC ¶ 106.
Plaintiffs allege that these statements were false because, according to plaintiffs, SAB 101 was simply a reaffirmation of existing GAAP and did not require changes to OCA's accounting method. CAC ¶¶ 90, 96, 103, 107.
c. April 17, 2001 Filing of the 2000 Form 10-K:
On April 17, 2001, after this action had commenced, OCA filed its Form 10-K annual report for the year ended December 31, 2000. The 10-K reported that the cumulative pretax effect of the accounting change was $50,576,000. CAC ¶¶ 118, 119. The 10-K also stated that pro forma net income, calculated as if the accounting change had been in effect throughout 1999 and 2000, increased to $47.7 million for 2000, up 47.7 percent from $32.3 million for 1999. CAC ¶ 119. Defendants repeated these pro forma numbers during an April 18, 2001 conference call with market analysts. CAC ¶ 120. A week later, OCA filed an amended Form 10-K, reporting a miscalculation in the pro forma comparison: the increase in net income from 1999 to 2000 was 44.5 percent, not 47.7 percent as reported one week earlier. CAC ¶ 123.
2. Statements Concerning the Merger with OrthAlliance:
Plaintiffs allege that on May 16, 2001, the boards of directors of OCA and OrthAlliance approved a merger agreement whereby OrthAlliance shareholders would receive an amount of OCA stock based on a ratio (ranging from 0.09214 to 0.16585 of OCA stock per share of OrthAlliance stock), to be fixed according to the percentage of OrthAlliance's affiliated orthodontists who agreed to make the transition to OCA (by amending their contracts to adopt OCA's system and stay with OCA for at least three years). CAC ¶¶ 126, 127. If less than thirty percent of the orthodontists agreed to made the transition, OCA could walk away by paying a break-up fee. CAC ¶ 128. Between May 16, 2001 and the merger closing on November 9, 2001, the defendants issued several statements about the merger's progress, which plaintiffs claim were false.
a. May 17, 2001 Press Release:
OCA announced the merger agreement in a May, 17, 2001 press release. Plaintiffs_claim_the press release was false because it failed to state that: (1) a number of orthodontists were suing to get out of their contracts with OrthAlliance; and (2) defendants themselves believed the OrthAlliance contracts to be voidable under state laws prohibiting dentists from splitting fees with non-licensed persons. CAC ¶ 129.
b. June 28, 2001 Press Release:
OCA and OrthAlliance issued a joint press release on June 28, 2001, announcing that they had received amendments from enough orthodontists to satisfy the minimum threshold specified as a condition to OCA's obligation to close the merger. CAC ¶ 130. The press release quoted Dennis Summers (then chairman and CEO of OrthAlliance) as stating: "We are not surprised to have so many amendments this quickly, and we expect to continue the brisk pace of OrthAlliance allied professionals willing to amend their applicable agreements in accordance with terms described in the merger agreement." Id. Plaintiffs claim this press release was false because it failed to state that: (1) an increasing number of orthodontists were suing to get out of their contracts with OrthAlliance; and (2) defendants themselves believed the OrthAlliance contracts to be voidable under state laws prohibiting dentists from splitting fees with non-licensed persons. CAC ¶ 131.
c. July 26, 2001 Press Release:
OCA again discussed the merger in a July 26, 2001 press release announcing second quarter earnings. The press release quoted Bartholomew Palmisano, Sr. as stating: "We focused diligently during the second quarter on meeting with the majority of OrthAlliance's outstanding affiliated orthodontists. . . . We look forward to welcoming [them] to our organization . . . [The merger] presents an unprecedented strategic opportunity for us. . . . We are excited about our prospects for growth and our continued ability to build shareholder value." CAC ¶ 132. According to plaintiffs, this press release was false because it failed to state that: (1) an increasing number of orthodontists were suing to get out of their contracts with OrthAlliance and ceasing payments to OrthAlliance; and (2) defendants themselves believed the OrthAlliance contracts to be voidable under state laws prohibiting dentists from splitting fees with non-licensed persons. CAC ¶ 133.
d. August 7, 2001 Form S-4:
On August 7, 2001, defendants filed a Form S-4, containing pro forma financial statements reflecting the merger. The S-4 stated that the number of lawsuits by affiliated orthodontists had increased. Nevertheless, plaintiffs claim that the S-4 was false because it failed to state that: (1) most of the orthodontists who had sued OrthAlliance had also ceased making payments to OrthAlliance under their contracts; and (2) defendants themselves believed the OrthAlliance contracts to be voidable under state laws prohibiting dentists from splitting fees with non-licensed persons. CAC ¶ 137. Plaintiffs also contend that the S-4 was false because the pro forma statements valued management contracts, advances, property, and notes receivable at amounts which were not adjusted downward (as was done after the merger closed) to reflect uncertainty in the recoverability of these assets due to litigation with affiliated orthodontists. CAC ¶¶ 135, 136.
OCA filed an amended S-4 on October 5, 2001. Plaintiffs claim that it was false for the same reasons that the original S-4 was false. See CAC ¶¶ 143, 145.
e. Second Quarter 2001 Form 10-Q:
On August 14, 2001, OCA filed a Form 10-Q reporting OCA's second quarter results. Plaintiffs allege that the 10-Q contained the following statement about the merger: "The transaction . . . is currently anticipated to close in the third quarter of 2001. . . . OrthAlliance is a leading provider of practice management and consulting services to orthodontic and pediatric practices in the United States." CAC ¶ 138. Plaintiffs claim that the statement was false because, once again, it failed to state that: (1) an increasing number of orthodontists were suing to get out of their contracts with OrthAlliance and ceasing payments to OrthAlliance; and (2) defendants themselves believed the OrthAlliance contracts to be voidable under state laws prohibiting dentists from splitting fees with non-licensed persons. CAC ¶ 139.
f. October 25, 2001 Press Release:
OCA again discussed the merger in an October 25, 2001 press release announcing third quarter earnings. ed filed an amendment to the Form S-4 filed on August 7, 2001. Like the June 28, 2001 press release, the October 25 release quoted Bartholomew Palmisano, Sr. as stating: "[The merger] presents an unprecedented strategic opportunity for us. . . . We are excited about our prospects for growth and our continued ability to build shareholder value." CAC ¶¶ 132, 146. The release also stated that "[a]s of June 30, 2001, OrthAlliance was affiliated with 226 orthodontists and pediatric dentists practicing in 397 centers." CAC ¶ 146. Plaintiffs claim that this press release was false because it failed to state that: (1) an increasing number of orthodontists were suing to get out of their contracts with OrthAlliance and ceasing payments to OrthAlliance; (2) defendants themselves believed the OrthAlliance contracts to be voidable under state laws prohibiting dentists from splitting fees with non-licensed persons; (3) only forty percent of the OrthAlliance doctors had agreed to amend their contracts and implement OCA's systems; and (4) none of the OrthAlliance doctors had agreed to a 60/40 profit split. CAC ¶¶ 147, 148.
g. Third Quarter 2001 Form 10-0:
On November 2, 2001, OCA filed a Form 10-Q reporting OCA's third quarter results. Plaintiffs allege that the 10-Q referenced the merger and stated: "OrthAlliance is a leading provider of practice management and consulting services to orthodontic and pediatric dental practices in the United States." CAC ¶ 150. Plaintiffs claim that this statement was false because it failed to state that: (1) an increasing number of orthodontists were suing to get out of their contracts with OrthAlliance and ceasing payments to OrthAlliance; and (2) defendants themselves believed the OrthAlliance contracts to be voidable under state laws prohibiting dentists from splitting fees with non-licensed persons. CAC ¶ 151.
The 10-Q also discussed a lawsuit brought by one Dr. Callender against OCA, which had been dismissed during the third quarter 2001, after Dr. Callender transferred his practice to another Affiliated Orthodontist. CAC ¶ 150. Plaintiffs claim that this statement was false because it failed to state that Dr. Callender, while his lawsuit was pending, had attacked his agreement with OCA as illegal and voidable. CAC ¶ 151. Plaintiffs claim that the 2000 Form 10-K also should have contained this information. CAC ¶ 124.
h. November 9, 2001 Press Release:
On November 9, 2001, OCA and OrthAlliance issued a press release announcing completion of the merger. The press release quoted Bartholomew Palmisano, Sr. as calling the merger a "strategic milestone," which extended OCA's "breadth of integrated business services by an order of magnitude to orthodontic and pediatric dental practices nationwide." CAC ¶ 152. The release quoted Dennis Summers as stating: "We are extremely pleased to have completed our merger successfully. . . ." Id. Plaintiffs claim that the release was false because it failed to state that: (1) only forty percent of the OrthAlliance doctors had agreed to amend their contracts and implement OCA's systems; (2) none of the OrthAlliance doctors had agreed to a 60/40 profit split; (3) a majority of the OrthAlliance doctors who had sued to get out of their contracts had also ceased making payments to OrthAlliance; and (4) defendants themselves believed the OrthAlliance contracts to be voidable under state laws prohibiting dentists from splitting fees with non-licensed persons. CAC ¶ 153.
C. Sufficiency of the Allegations under the PSLRA:
To determine whether the plaintiffs' allegations survive scrutiny under the PSLRA, the Court must ascertain, with respect to each allegedly misleading statement, whether plaintiffs have alleged: (1) with particularity sufficient facts ( e.g., documentary evidence or personal sources) to support a reasonable belief that the statements were false when made; and (2) specific facts that, taken as a whole, support a strong inference of intent to deceive or severe recklessness on the part of the defendants. ABC Arbitrage, 291 F.3d at 352; Abrams, 292 F.3d at 430.
1. Sufficient Facts to Support a Reasonable Inference of Falsity:
a. Statements Relating to Revenue Recognition: The "facts" that plaintiffs allege to support the alleged falsity of defendants' statements regarding revenue recognition are citations to accounting publications that, according to plaintiffs, support a reasonable inference that OCA's revenue recognition policies were inconsistent with GAAP. Plaintiffs contend that this conclusion on their part ends the inquiry and that the Court may not examine the actual accounting publications without impermissibly converting the motion into one for summary judgment. Opp. Memo at pp. 10-12. They argue that the existence of GAAP violations is the "domain of experts" and should not be decided on the pleadings. Id.
Defendants, on the other hand, argue that the Court cannot perform its gatekeeping duty under the PSLRA without considering, at a minimum, the accounting publications the plaintiffs have cited by name in their Amended Complaint and those publications cited in (and therefore necessary to understand) the named publications. Reply Memo at p. 6. They argue that when these pronouncements are read in context, they are not sufficient to support a reasonable inference that OCA's revenue recognition policies were inconsistent with GAAP. Orig. Memo at pp. 10-13; Reply at pp. 18-20. Alternatively, defendants argue that plaintiffs' allegations fail to support a reasonable inference of falsity even if the Court accepts plaintiffs' assertion that OCA's revenue recognition methods deviated from GAAP. Orig. Memo at pp. 14-15 n. 26; Reply at pp. 14-17.
As defendants correctly point out, GAAP is "far from being a canonical set of rules that will ensure identical accounting treatment of identical transactions." Thor Power Tool Co. v. C.I.R., 439 U.S. 522, 544 (1979). "`Generally accepted accounting principles,' rather, tolerate a range of `reasonable' treatments, leaving the choice among alternatives to management." Id.
The Court need not determine whether OCA's revenue recognition methods deviated from GAAP, for it agrees with defendants' alternative argument. OCA repeatedly and precisely disclosed to investors its method for recognizing revenue, including the two aspects that, according to plaintiffs, violated GAAP. OCA consistently disclosed that: (1) it recognized as revenue "approximately 24% of new patient contract balances in the first month of new contracts;" and (2) it recognized as revenue certain affiliated orthodontists' shares of operating losses in the period during which the operating losses were incurred. OCA also disclosed the risk that OCA's contracts might encounter legal challenges under state laws regulating dental practices. Thus, even if the Court accepts plaintiffs' assertion that OCA's accounting methods violated GAAP, plaintiffs have failed to allege sufficient facts to support a reasonable belief that OCA's financial statements were false and misleading.
See 1st Qtr. 2000 10-Q, Request for Judicial Notice ("RJN"), Exh. 3 at. p. 7; 2d Qtr. 2000 10-Q, RJN, Exh. 5 at. p. 8; 3d Qtr. 2000 10-Q, RJN, Exh. 6 at. p. 7; see also 1999 Form 10-K, RJN, Exh. 2 at p. 13; Form 8-K, 1/18/01, RJN, Exh. 7 at p. 3. As to these enumerated SEC filings, the Court grants defendants' request for judicial notice. See Lovelace v. Software Spectrum Inc., 78 F.3d 1015, 1018 (5th Cir. 1996) ("[W]e adopt the following rule: When deciding a motion to dismiss a claim for securities fraud on the pleadings, a court may consider the contents of relevant public disclosure documents which (1) are required to be filed with the SEC, and (2) are actually filed with the SEC."). The Court further notes that plaintiffs cited each of these documents in the Amended Complaint.
See 1999 Form 10-K, RJN, Exh. 2 at p. 20 ("Amounts retained by an Affiliated Orthodontist who operates a newly developed Orthodontic Center are typically reduced by operating losses on a cash basis because of start-up expenses. An Affiliated Orthodontist's share of these operating losses is added to the Company's fee in the period during which the operating losses are incurred, with such fees aggregating approximately $4.0 million."); 2000 Form 10-K, RJN, Exh. 10 at p. 23. As to these SEC filings, the Court grants defendants' request for judicial notice. See Lovelace, 78 F.3d at 1018. The Court notes, in addition, that plaintiffs cited both of these documents in the Amended Complaint.
See OCA 1999 Form 10-K, RJN, Exh. 2 at p. 14 ("The laws of many states prohibit orthodontists from splitting fees with non-orthodontists and prohibit non-orthodontic entities (such as the Company) from . . . employing orthodontists or, in certain circumstances, orthodontic assistants. . . . A number of states limit the ability of a . . . non-orthodontist to own or control equipment or offices used in an orthodontic practice. . . . Management believes . . . that the Company's current and planned activities do not violate these statutes and regulations. There can be no assurance, however, that future interpretations of such laws . . . will not require . . . modifications. . . . [and] there can be no assurance that its arrangements will not be successfully challenged or that required changes may not have a material adverse effect on operations or profitability.").
b. Statements Concerning the Merger with OrthAlliance:
Plaintiffs contend that defendants' statements about the merger were false because they failed to disclose that (1) an increasing number of orthodontists were suing to get out of their contracts with OrthAlliance and ceasing payments to OrthAlliance, (2) only forty percent of the OrthAlliance doctors agreed to amend their contracts and implement OCA's systems, and (3) defendants themselves believed the OrthAlliance contracts to be voidable under state laws prohibiting dentists from splitting fees with non-licensed persons. However, the SEC filings show that OCA and OrthAlliance specifically disclosed: (1) that orthodontists and dentists affiliated with OrthAlliance had filed notices of default and had sued to get out of their contracts, including on the bases of unenforceability and illegality; and (2) that the number of such suits had increased since the date of the merger agreement. The risk that these suits would increase was evident. OrthAlliance's management disclosed that one of its reasons for supporting the merger was OrthAlliance's deteriorating relationship with several of its affiliated practitioners. Indeed, under the merger agreement, OCA's obligation to close hinged on at least thirty percent of OrthAlliance's practitioners remaining with OCA, and even the price of the acquisition depended on the percentage of OrthAlliance affiliates retained by OrthAlliance. See CAC ¶¶ 126, 128.
See OCA/OrthAlliance Registration Stmt. on Form S-4, filed 8/7/01, RJN, Exh. 14 at F-29 ("Legal proceedings with Allied Practitioners have increased since the announcement of the Company's merger agreement with OCA. Certain Allied Practitioners have sent notices of default to, or commenced litigation against, the Company alleging that the Company has failed to provide certain services under the Management Agreements. Other litigation alleges that certain provisions of the Management Agreements may be unenforceable, among other claims. The Company vigorously defends against such claims and believes that such claims area without merit."). As to this SEC filing, the Court grants defendants' request for judicial notice. See Lovelace, 78 F.3d at 1018. The Court also notes that this document is cited in the Amended Complaint.
See OCA/OrthAlliance Registration Stmt. on Form S-4, filed 8/7/01, RJN, Exh. 14 at 37.
Nor have plaintiffs alleged any facts showing that the pro forma estimates regarding the merger were false when made. OCA and OrthAlliance disclosed the risk that later led OCA to assign a lower value to the OrthAlliance assets ( i.e., litigation with affiliated practitioners). The mere fact that OCA did not estimate the value of these assets after the merger closed exactly as it had before the merger closed does not support an inference that the pro forma estimates were false when made. The Court concludes that plaintiffs have failed to allege sufficient facts to support a reasonable belief that any of the challenged statements were false or misleading when made.
2. Specific Facts to Support a Strong Inference of Scienter:
Even if plaintiffs had alleged sufficient facts to support a reasonable inference of falsity, their Amended Complaint fails for the additional reason that plaintiffs have failed to allege specific facts that, taken as a whole, support a strong inference of intent to deceive or severe recklessness on the part of any defendant.
a. Statements Relating to Revenue Recognition:
Under Fifth Circuit law, "the mere publication of inaccurate accounting figures or failure to follow GAAP, without more, does not establish scienter." Abrams, 292 F.3d at 432. Nor may a pleading of scienter "rest on the inference that defendants must have been aware of the misstatement based on their positions within the company." Id. Rather, to satisfy the PSLRA, plaintiffs must allege specific facts supporting a strong inference that the defendant in question either "kn[ew] that it [was] publishing materially false information, or [was] severely reckless in publishing such information." Id. Plaintiffs have not identified any such facts.
In their opposition memorandum, plaintiffs allege that certain analysts had a conversation with Bartholomew Palmisano, Jr., which led these analysts to conclude that OCA's accounting was not in accordance with GAAP. Opp. Memo at p. 17. According to the Amended Complaint, these analysts published their conclusion in a "short" report, and OCA openly disagreed with the analysts in a Form 8-K filed January 18, 2001. CAC ¶ 104. These facts do nothing to support an inference of scienter, on the part of Palmisano or any other defendant.
Instead, plaintiffs rely on "motive and opportunity" allegations, which fail to support the requisite strong inference. For example, plaintiffs try to make a case for insider trading. However, only one defendant — Gasper Lazzara — sold any OCA stock during the class period. He did so shortly before and shortly after he retired as CEO in August 2000. CAC ¶ 24. These trades were not suspicious in either timing or amount. Dr. Lazzara had made public his intent, in connection with his retirement, estate planning, and diversification goals, to sell approximately forty percent of his stake in OCA in an orderly manner over the course of four years. Moreover, any inference that might be drawn from Dr. Lazzara's sales is undermined by the fact that no other defendant sold stock during the class period. See Abrams, 292 F.3d at 435 ("even unusual sales by one insider do not give rise to a strong inference of scienter when other defendants do not sell some or all of their shares during the Class Period"); Nathenson, 267 F.3d at 421 ("fact that the other defendants did not sell their shares during the relevant class period undermines plaintiffs' claim").
Form 8-K, 1/18/01, RJN, Exh. 7 at p. 5.
Plaintiffs have alleged that Bartholomew Palmisano, Sr. and his son registered stock to sell in 2000, but withdrew the registration. However, plaintiffs have alleged no facts to raise suspicion with respect to this registration. If any inference relevant to scienter can be drawn from these registrations (withdrawn at a time when OCA's stock price was allegedly falsely inflated), it is that the Palmisanos lacked scienter. Certainly, the registrations do not support a strong inference of scienter.
Plaintiffs' remaining motive allegations are that defendants had a motive to inflate the stock price because a high price would help them obtain incentive compensation, secure bank financing, and fund the acquisition of OrthAlliance. Such motivations are far too commonplace to support an inference of scienter. See Abrams, 292 F.3d at 434; Nathenson, 267 F.3d at 420 ("[A]llegations that corporate officers and directors would benefit from enhancing the value of their stock and/or stock options and that the corporation would benefit by receiving more for its shares to be issued in [an upcoming] public offering are . . . insufficient to support a strong inference of scienter."); see also Tuchman v. DSC Communications Corp., 14 F.3d 1061, 1068-69 (5th Cir. 1994) ("Incentive compensation can hardly be the basis on which an allegation of fraud is predicated. . . . [W]ere the opposite true, the executives of virtually every corporation . . . would be subject to fraud allegations. It does not follow that because executives have components of their compensation keyed to performance, one can infer fraudulent intent."); Tarica v. McDermott Int'l, Inc., 2000 WL 1346895 *10 (E.D. La. 2000) (Vance, J.) (corporate acquisitions do not provide legally sufficient bases for scienter; they "are routine corporate events, and the "courts reject motive theories that would almost universally permit an inference of fraud' "). Certainly, they do not support an inference of scienter under the facts alleged here.
The same holds true for plaintiffs' argument that the timing and magnitude of the January 2002 downward adjustment support an inference of scienter. The temporal proximity between the adjustment and the earlier pro forma estimates (several eventful months) is not suspicious. The adjustment was sizeable, which might help strengthen a reasonable but weak inference of scienter. However, the facts alleged here do not support any such inference, and the size of the adjustment does not alone support an inference of scienter. It simply does not follow that because OCA made a large downward adjustment in January 2002's pro forma and did not make the adjustment in earlier pro formas, one or more defendants must have acted with severe recklessness (negligence — even inexcusable negligence — is not enough) or an intent to deceive.
b. Statements Concerning the Merger with OrthAlliance:
With regard to the challenged statements concerning the merger, plaintiffs make the same deficient allegations of scienter discussed above. In addition, plaintiffs point to an email from Dr. Lazzara to an orthodontist, suggesting that the orthodontist could void his contract with OrthAlliance in Florida on the basis that it was fee-splitting, given that OrthAlliance did not provide any structured services. CAC, Exh. A. Even when construed strongly in plaintiffs' favor, the email supports only a very narrow inference: that Dr. Lazzara viewed OrthAlliance's contracts as voidable under Florida law in cases where OrthAlliance provided no structured services to the affiliated practitioner. Given the explicit disclosures by OCA and OrthAlliance concerning the challenges to OrthAlliance's contracts with its affiliated practitioners, the fact that Dr. Lazzara held such a view does not support an inference that Dr. Lazzara (or any other defendant) acted with severe recklessness or intent to deceive in making the statements about the merger set forth in the Amended Complaint.C. Leave to Amend:
The PSLRA states that "[i]n any private action arising under this chapter, the court shall, on the motion of any defendant, dismiss the complaint if the requirements of paragraphs (1) and (2) are not met." 15 U.S.C. § 78u-4(b)(3)(A). However, "nothing in this language . . . restricts the Court's discretion whether to grant leave to amend." Tarica, 2000 WL 1346895 at *12. This determination remains within "the sound discretion of the Court." Id; see also Norman v. Apache Corp., 19 F.3d 1017, 1021 (5th Cir. 1994). In exercising this discretion, the Court considers judicial economy, undue delay, undue prejudice, prior opportunities to amend, and the futility of amendment. Id; see also Chitimacha Tribe of Louisiana v. Harry L. Laws Co., Inc., 690 F.2d 1157, 1163 (5th Cir. 1982), cert. denied, 464 U.S. 814 (1983). This Court has considered these factors, and like the court in Tarica, "finds that further amendment would be futile." Tarica, 2000 WL 1346895 at *12. As in Tarica, the plaintiffs here "have already had more than one bite at the apple." Id. Here, as there, the plaintiffs "originally filed four different complaints [01-949, 01-1509, 01-1510, and 01-1801], which this Court consolidated." Id. "After consolidating these cases, the Court ordered plaintiffs to file a consolidated amended compliant, which afforded them a second bite at the apple." Id. "[P]laintiffs have not presented or suggested in their pleadings or at oral argument that there are any additional facts that they have not pled that would cure the defects that the Court has analyzed." Id. Therefore, the Court dismisses plaintiffs' Amended Complaint with prejudice because "another pleading attempt would be an inefficient use of the parties' and the Court's resources, would cause unnecessary and undue delay, and would be futile." Id.
At oral argument, plaintiffs' counsel described a conference call, during which one or more defendants made statements suggesting that they knew before the merger closed about the high number of OrthAlliance's affiliated practitioners who were trying to get out of their contracts. The Court has considered this allegation as though it had been pled. For the reasons discussed supra at pages 18 and 22, this alleged fact would not alter this Court's conclusions regarding falsity or scienter. Thus, amending to add the allegation would be a futile exercise.