Opinion
Civil No. 02-4893 (PAM/RLE)
January 9, 2004
MEMORANDUM AND ORDER
This matter is before the Court on Defendants' Motions to Dismiss. For the following reasons, the Motions are granted. Plaintiffs are ordered to replead within thirty (30) days of this Order.
This is a putative class action on behalf of all persons who purchased or otherwise obligated themselves to purchase the publicly traded equity securities of Rural Cellular Corporation ("RCC") between May 7, 2001, and November 12, 2002 (the "class period"). Plaintiffs allege violations of §§ 10(b) and 20, and Rule 10b-5, of the Securities and Exchange Act of 1934 ("Exchange Act"), arising from Defendants' issuance of alleged false financial statements and other alleged false and misleading statements about RCC's operating performance.
BACKGROUND
A. The Parties
1. Rural Cellular Corporation
RCC is a wireless communications service provider headquartered in Alexandria, Minnesota. RCC focuses on rural markets within the United States. RCC's cellular networks cover a total population of nearly six million people and serve approximately 667,000 voice customers, as of December 31, 2002. Throughout most of the class period, RCC's stock was traded on the NASDAQ National Market System. In November 2002, RCC restated its intangible assets, goodwill, interest expenses and some preferred dividends for 2001 and the first two quarters of 2002. Plaintiffs claim that RCC made false and misleading statements throughout this period about its financial performance, damaging them.
2. Individual Defendants
The individual Defendants are RCC's CEO, CFO, Vice President of Finance and Accounting, and four outside directors. Plaintiffs aver that these individuals are liable based on their positions within the RCC, because of their knowledge of the "adverse, non-public information" about RCC's business and finances, and because of their direct involvement in RCC's release of false or misleading information.
3. Arthur Andersen, L.L.P.
Arthur Andersen, L.L.P. ("Arthur Andersen") is a firm of certified public accountants that RCC hired to provide both auditing and independent consulting services. Plaintiffs claim that as a result of the services provided to RCC, Arthur Andersen personnel were present at RCC headquarters throughout the class period with access to RCC's confidential corporate financial and business information. Plaintiffs further claim that Arthur Andersen substantially participated in the issuance of false and misleading statements by RCC.
4. Class Plaintiffs
Plaintiffs are a class of persons who purchased or otherwise obligated themselves to purchase RCC's publicly traded equity and debt securities between May 7, 2001, and November 12, 2002, including those who acquired RCC's 9.75% Notes pursuant and traceable to the Form S-4 Prospectus, issued on April 16, 2002. As of November 2002, RCC had more than 11,900,000 shares of stock outstanding.
B. Facts
On November 12, 2002, RCC restated its financial statements for 2001 and the first two quarters of 2002. The restatement involved two accounting issues: (1) RCC's treatment of certain derivatives and hedge instruments under Statement of Financial Accounting Standards ("SFAS") No. 133; and (2) impairment charges to goodwill and licenses that RCC recorded pursuant to SFAS No. 142. The restatement also recalculated RCC's preferred stock dividends. Overall, RCC's financial statements were overstated by $16 million in 2001 and $417 million in 2002. Plaintiffs claim that they were damaged because RCC knowingly and/or recklessly failed to disclose these errors until November 2002.
1. Derivative Instruments and Hedging Activities
RCC used derivative instruments and hedging activities, which are interest rate management tools, to allow it to change from a variable interest rate to a lower fixed interest rate. SFAS No. 133 required that RCC show either a gain or a loss on its financial statements as a result of these interest rate swaps. In August 2002, RCC determined that it had not properly followed SFAS No. 133 in its accounting treatment of its 9.58% Senior Subordinated Notes. As a result, RCC revised its interest expense and net loss numbers for 2001 and the first quarter of 2002. RCC further determined that the dividends on its preferred stock needed recalculation. Overall, these revisions amounted to $16 million for 2001.
2. Goodwill and Licenses
RCC recorded both its goodwill and other intangible assets as assets on its balance sheet. In July 2001, the accounting standards for goodwill and intangible assets changed pursuant to the issuance of SFAS No. 142. (Thoresen Aff. Ex. F.) This change required entities to annually evaluate such assets for impairment, rather than amortiye them. (Id.) Once an entity adopts SFAS No. 142, it has six months to perform an assessment of whether its goodwill assets are impaired, (Id. ¶ 55.) If an impairment to goodwill exists, then the entity must perform a second test to measure the amount of the impairment. (Id.) This impairment analysis must be completed by December 31 of the year in which the entity adopts SFAS No. 142. With respect to intangible assets such as licenses, SFAS No. 142 requires that the adopting entity reassess its intangible asset value during the "first interim period" of the fiscal year in which the standard is adopted. (Id. ¶ 53.)
RCC adopted SFAS No. 142 in January 2002. During the second quarter of 2002, RCC completed its initial assessment, and in its August 2002 Form 10-Q announced that "the carrying value of the South Region exceeds that unit's fair value." (Id. at Ex. D at 8.) RCC had not yet completed the second phase of its impairment evaluation. (Id.) In this same 10-Q, RCC announced that it would record a "non-cash charge of approximately $400-$450 million as the cumulative effect of a change in accounting principle." (Id.) RCC completed the impairment evaluation in the third quarter of 2002, and recorded a $5 million impairment charge to goodwill and a $412 million impairment charge to its licenses. These charges were applied retroactively to the first quarter 2002. RCC reported these charges in its 10-Q Form in November 2002. (Id. at Ex. E.) Plaintiffs claim that RCC failed to record these changes in the "first interim period" of the fiscal year, as required by the SFAS No. 142.
3. Allegedly False or Misleading Statements or Omissions
Plaintiffs allege that Defendant RCC made six false or misleading statements. Essentially, Plaintiffs assert that RCC failed to disclose its accounting errors in a timely manner and that the November 2002 financial restatement was too late. Plaintiffs further allege that Defendant Arthur Andersen made one false or misleading statement, but substantially participated in the issuance of all of the allegedly false or misleading statements because it failed to disclose that RCC's financial statements were not in accordance with required standards.
The allegedly false and misleading statements are specifically identified in the Complaint. (See Am. Compl. ¶¶ 24, 25, 26, 28, 30, 32, 34.) Plaintiffs claim that statements RCC made from May 7, 2001 to November 5, 2001, were false and misleading because the statements failed to account for RCC's understatements of net interest expense, preferred stock dividends, and net losses. See Am Compl. ¶¶ 24-26.) Plaintiffs claim that RCC knew that these statements were false or misleading based on its review of "internal Rural Cellular data." (Id. ¶ 27.) Plaintiffs claim that RCC's and Arthur Andersen's statements made from February 25, 2002, to May 6, 2002, were false and misleading because they failed to account for the overvalue of RCC's licenses and goodwill. (See Id. ¶ 28, 30, 32, 34.) Plaintiffs contend that RCC knew that its licenses and goodwill were overstated by $417 million, based on its review of "internal Rural Cellular data." (Id. ¶ 35.)
DISCUSSION
A. Standard of Review
Generally, a Rule 12(b)(6) motion requires the court to assume all factual allegations in the complaint as true, and grant plaintiffs all reasonable inferences that may be drawn from the complaint. Fed.R.Civ.P. 12(b)(6); In re Navarre Corp. Sec. Litig., 299 F.3d 735, 741 (8th Cir. 2002). However, when Congress adopted the Private Securities Litigation Reform Act ("PSLRA"), it raised the pleading standards for securities fraud class action claims pursuant to Rule 12(b)(6).Navarre, 299 F.3d at 741; See 15. U.S.C. § 78j, 78t(a); 17 C.F.R. § 240.10b-5. The PSLRA was designed to encompass at the very least the heightened pleading standards of Rule 9(b).Kushner v. Beverly Enter., Inc., 317 F.3d 820, 826 (8th Cir. 2003).
In order to proceed on claims brought under § 10(b) and Rule 10b-5, Plaintiffs must allege four elements: (1) misrepresentations or omissions of material fact or acts that operated as fraud or deceit in violation of the Rule; (2) causation, often analyzed in terms of materiality and reliance; (3) science; and (4) economic harm caused by the fraudulent activity occurring in connection with the purchase and sale of a security. In re K-Tel Intel. Inc. Sec. Litig., 300 F.3d 881, 888 (8th Cir. 2002). The complaint must specify each misleading statement or omission and specify why the statement or omission was misleading. 15 U.S.C. § 78u-4(b)(1); Kushner, 317 F.3d at 826. It must also "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); Navarre, 299 F.3d at 741 ("[I]nferences of science survive a motion to dismiss only if they are both reasonable and `strong' inferences"). The ultimate issue before the Court is not whether Plaintiffs will prevail at trial, but rather whether Plaintiffs are entitled to proceed with their claims. In re DIBI Intel. Inc. Sec. Litig., 6 F. Supp.2d 1089, 1095 (D. Minn. 1998) (Tunheim, J.).
B. RCC
RCC and the individual Defendants claim that Plaintiffs have failed to plead with specificity their allegations of falsity, science, and reliance. The Court finds fault only with the allegations as to RCC's science. Plaintiffs must set forth facts that give a strong reason to believe that there was reckless or intentional wrongdoing.Navarre, 299 F.3d at 745. Science may be established by: (1) facts demonstrating a conscious intent to deceive, manipulate, or defraud; (2) allegations of severe recklessness; or (3) allegations of opportunity or motive. In re Pemstar, No. 02-1821, slip op. at 6 (D. Minn. Aug. 15, 2003) (Frank, J.); K-Tel, 300 F.3d at 893. Allegations of motivation or opportunity alone are insufficient to establish science, but coupled with actual knowledge or recklessness, they bolster a plaintiffs showing of science. See Pemstar, No. 02-1821, slip op. at 7.
Plaintiffs argue that RCC knowingly or recklessly published false statements regarding the value of RCC's goodwill and licenses, and knowingly and recklessly published false preferred dividend, net interest expense, and net loss numbers. Plaintiffs further claim that an inference of science is bolstered by RCC's motives, which included: (1) enabling RCC to comply with its then newly amended loan covenant ratio; (2) attracting initial purchasers to buy Company Notes through a private placement; (3) facilitating the exchange of Notes on the NASDAQ PORTAL market; and (4) permitting defendants Eckstrand and Shultz to profit personally through incentive-based compensation plans linked to RCC performance.
Plaintiffs assert that RCC knew that its statements were false and misleading because RCC had access to internal Rural Cellular data and that it disregarded that data when making its public statements. (Am. Compl. ¶¶ 27, 35.) Plaintiffs further assert that RCC knew that its intangible assets were overstated, based on its knowledge that: (1) telecom subscriber growth rates were slowing; (2) roaming revenues for RCC were significantly lower because of the increase in competing networks; and (3) Defendant Eckstrand admitted in January 2002 that RCC experienced significant disappointing results in the fourth quarter of 2001. (Id. ¶ 35().) Plaintiffs contend that RCC intentionally or recklessly disregarded these known facts when issuing statements between February 2002 and May 2002.
Taken as a whole, these allegations merely indicate an inference of science, rather than support a strong inference of science. Although Plaintiffs have generally alleged that RCC either knowingly or recklessly disregarded known facts, Plaintiffs fail to actually assert what specific facts RCC knew or recklessly disregarded. The allegation that RCC had "access" to internal data is insufficient to constitute a strong inference of science. Moreover, the allegations that RCC recklessly disregarded the status of the telecom industry are too general to satisfy the standards of the PSLRA. A strong inference of science is established if the plaintiff alleges that the defendant "knew facts or had access to information suggesting that [its] public statements were materially inaccurate." Florida State Bd. of Admin, v. Green Tree Fin. Corp., 270 F.3d 645, 665 (8th Cir. 2001). Plaintiffs have failed to allege what underlying information RCC knew or had access to at the time it issued its public statements. Plaintiffs must replead to assert specific facts that raise a strong inference of fraud.
C. Arthur Andersen
1. Primary Liability
Plaintiffs claim that Arthur Andersen issued a false or misleading audit opinion for the 2001 financial year. (Am. Comp. ¶¶ 32, 57.) In a separate section of the Amended Complaint entitled `The Role of Arthur Andersen," Plaintiffs allege that Arthur Andersen falsely represented that RCC's 2001 financial statements were accurate and in accord with Generally Accepted Accounting Principles ("GAAP"), and that these financial statements had been audited by Arthur Andersen in conformance with Generally Accepted Auditing Standards ("GAAS"). (Am. Compl. ¶¶ 53-66.) Plaintiffs contend that Arthur Andersen knew that RCC's 2001 financial statements were inaccurate and in violation of GAAP. To support this allegation of actual knowledge and/or recklessness, Plaintiffs allege that Arthur Andersen "had continual access to and knowledge of Rural Cellular's private and confidential corporate financial and business information," because Arthur Andersen was "present at Rural Cellular's headquarters" during 2001. (Id. ¶ 56.) Finally, Plaintiffs contend that Arthur Andersen was financially motivated to release false or misleading statements, in order to: (1) to retain RCC as a client and thus maintain a competitive position as to the other large accounting firms in the U.S.; (2) protect the fees it received from RCC; and (3) maintain and increase its market share for auditing and accounting services in Minnesota's telecommunications industry. (Id. ¶ 54.) Arthur Andersen asserts that these allegations are insufficient to establish the requisite state of mind for securities fraud.
Plaintiffs maintain that Arthur Andersen certified RCC's 2001 financial statement, and represented that these statements were in accord with GAAS. Plaintiffs assert that Arthur Andersen knew or recklessly disregarded that its 2001 audits were not compliant with GAAS. (Id. ¶ 64.) Plaintiffs contend that Arthur Andersen had a duty to comply with GAAS, and that it breached that duty in a variety of ways. (Id. ¶¶ 64(a)-(f), 65.) Plaintiffs assert that an auditor "is deemed to have acted recklessly where . . . there was `an egregious refusal to See the obvious, or to investigate the doubtful.'" (Pls.' Opp'n. Mem. to Def. Arthur Andersen at 22 (quotingIn re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir. 1994)).) Even so, Plaintiffs have failed to demonstrate that Arthur Andersen knew or had access to such "obvious" or "doubtful" facts, or even what these facts were. Moreover, Plaintiffs' allegations that Arthur Andersen failed to conform with certain standards or principles are insufficient because they are unaccompanied by any allegation of fraud or recklessness.
Plaintiffs alternatively assert that the "magnitude" of the restatement indicates that Arthur Andersen knew, or recklessly disregarded, that RCC's original statements were erroneous. Plaintiffs contend that Arthur Andersen's alleged GAAS violations, which allegedly resulted in a $16 million restatement in 2001 and a $417 million restatement in 2002, are alone sufficient to establish the requisite state of mind. The Court declines to accept the bald assertion that magnitude alone is sufficient for science purposes. Although the size of these restatements are large, Plaintiffs fail to put the restatements in perspective to RCC's overall operations and how those restatements impacted RCC's financial results.
The Court orders that Plaintiffs replead to assert specific facts that raise a strong inference of fraud as to Arthur Andersen. Absent more specified allegations of what Arthur Andersen actually knew or recklessly disregarded, Plaintiffs' claims against Arthur Andersen will fail.See Ferris, Baker Watts, Inc. v. Ernst Young, LLP. No. 03-3339 (D. Minn. November 24, 2003) (Kyle, J.) (dismissing claims against auditor because allegations of GAAS and GAAP violations alone are insufficient for securities fraud).
2. Primary Liability as a Secondary Actor
Plaintiffs alternatively assert that Arthur Andersen is liable for the remaining allegedly false and misleading statements based on the substantial participation doctrine. Arthur Andersen asserts that as a matter of law, it cannot be liable for alleged misstatements contained in unaudited company disclosures. Moreover, Arthur Andersen asserts that the "bright line" test precludes liability for statements that it did not make.
Plaintiffs urge this court to adopt the minority "substantial participation test," in order to impose secondary liability on Defendant Arthur Andersen for the remaining allegedly fraudulent statements made by RCC. According to Plaintiffs, "if a defendant played a `significant role' in preparing a false statement actually uttered by another, primary liability will lie." (Pl's Opp'n. Mem. to Def. Arthur Andersen at 27);See McNamara v. Bre-X Minerals Ltd., 57 F. Supp.2d 396, 429 (E.D. Tex. 1999). Plaintiffs maintain that Arthur Andersen performed audits and reviews of RCC's 2002 financial statements, to ensure that those statements were accurate for stockholders, stock purchasers, government agencies, the investing public, and other members of the financial community. In performing these tasks, Plaintiffs argue that Arthur Andersen is liable because it knowingly or recklessly ratified RCC's false statements and/or agreed with RCC's false statements. Plaintiffs contend that Arthur Andersen had access to RCC's financial and business information, and knew or recklessly disregarded the true facts of RCC's financial problems.
Conversely, Arthur Andersen urges this Court to adopt the majority rule, more commonly known as the "bright line" doctrine. In Central Bank of Denver v. First Interstate Bank of Denver, the U.S. Supreme Court abolished auditor liability based on theories of aiding and abetting, and emphasized that "we again conclude that the statute prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act." 511 U.S. 164, 177 (1994) (emphasis added). According to the Second Circuit:
[I]f Central bank is to have any real meaning, a defendant must actually make a false or misleading statement in order to be held liable under Section 10(b). Anything short of such conduct is merely aiding and abetting, and no matter how substantial that aid may be, it is not enough to trigger liability under Section 10(b).Wright v. Ernst Young, L.L.P., 152 F.3d 169, 175 (2d. Cir. 1998) (internal citations omitted); See also Anixter v. Home-Stake Prod. Co., 77 F.3d 1215, 1226 n. 10 (10th Cir. 1996) ("To the extent these cases allow liability to attach without requiring a representation to be made by defendant, and reformulate the `substantial assistance' element of aiding and abetting liability into primary liability, they do not comport with Central Bank of Denver"):Ziemba v. Cascade Intel. Inc., 256 F.3d 1194, 1205 (11th Cir. 2001) ("[W]e conclude that, in light of Central Bank, in order for the [secondary] defendant to be primarily liable under 10(b) and Rule 1 Ob-5, the alleged misstatement or omission upon which a plaintiff relied must have been publicly attributable to the defendant."); In re Ikon Office Solutions, Inc. Sec. Litig., 131 F. Supp.2d 680, 685 n. 5 (E.D. Pa. 2001) (although accounting firm approved press release, press release failed to refer to accounting firm, and thus Central Bank compelled dismissal); Great Neck Capital Appreciation Inv. P'ship. L.P. v. PricewaterhouseCoopers, L.L.P., 137 F. Supp.2d 1114, 1121 (E.D. Wis. 2001) (auditor's assistance with press release by reviewing it and advising that it conformed with GAAP insufficient for primary liability; auditor did not draft, publicly adopt, or allow its name to be associated with release and therefore auditor's actions more closely conformed to "aiding and abetting," and thus liability was inconsistent with Central Bank). Although the Eighth Circuit has not yet determined this issue, this Court concludes that substantial participation is insufficient to impose primary liability on a secondary actor. Therefore, Arthur Andersen can only be liable for the allegedly false or misleading statements that it actually made.
CONCLUSION
Plaintiffs' allegations do not satisfy the requirements of the PSLRA. Therefore, the Court will grant the Motions to Dismiss. The Court will, however, allow Plaintiffs the chance to re-plead their allegations of science as to all Defendants. The Court reminds Plaintiffs that they must set forth specific facts demonstrating what RCC and Arthur Andersen knew or recklessly disregarded in issuing the allegedly false or misleading statements. The facts must support a strong inference that RCC and Arthur Andersen's actions were fraudulent. If Plaintiffs amend their Amended Complaint, Defendants may renew their Motions to Dismiss. Finally, Plaintiffs should bear in mind that Arthur Andersen may only be liable for any statements it actually made. Any claims against Arthur Andersen predicated on its role as a secondary actor will fail as a matter of law.
The Court notes that permitting Plaintiffs to replead may not ultimately save this litigation. Although Plaintiffs allege that Defendants' actions resulted in damages, there is a strong possibility that Plaintiffs will be unable to demonstrate that Defendants' actions actually caused Plaintiffs' loss.
Accordingly, based on the all the files, records and proceedings herein, IT IS HEREBY ORDERED that:
1. Defendant Rural Cellular Corporation's Motion to Dismiss (Clerk Doc. No. 21) is GRANTED;
2. Defendant Arthur Andersen L.L.P.'s Motion to Dismiss (Clerk Doc. No. 27) is GRANTED; and
3. Plaintiffs must file a second amended complaint within thirty (30) days of this Order that pleads science in compliance with Rules 9(b) and 12(b)(6) and the PSLRA. Failure to comply with the Court's Order will result in dismissal of this action with prejudice.