Opinion
Case No. O1-8346-CIV-HURLEY
June 8, 2002
ORDER DENYING SENSORMATIC DEFENDANTS MOTION TO DISMISS GRANTING OUTSIDE DIRECTORS MOTION TO DISMISS WITHOUT PREJUDICE
THIS CAUSE is before the court upon the defendants' motions to dismiss plaintiffs' complaint for failure to state a claim under Fed.R.Civ.P. 12(b)(6), raising issue as to whether the complaint in this securities fraud class action states a claim under the heightened pleading requirements of the Private Securities Litigation Reform Act of 1995 ("PSLRA"), 15 U.S.C. § 78u-4(b)(1), (2).
I. BACKGROUND
Defendant Sensormatic Electronics Corporation designs, manufactures and sells electronic security products for retail outlets. Individual defendants Per-Olof Loof, Gregory C. Thompson, Ronald G. Assaf, Jerry T. Kendall, Kenneth W. Chmiel, Walter A. Engdahl, Stephan Cannellos, and William J. Bufe, are former officers and/or directors of Sensormatic during the relevant time period, while individual defendants Timothy Hartman and Thomas Buffett are outside directors. [The corporate defendant and individual insiders shall be cumulatively referred to in this order as the "Sensormatic defendants." Hartman and Buffet shall be referred to as the "outside directors."]
Plaintiffs are an uncertified class composed of all individuals who purchased Sensormatic's common stock during the class period of August 8, 2000 through April 9, 2001. In their amended consolidated class action complaint, plaintiffs allege that defendants violated § 10(b) and 20(a) of the Securities and Exchange Act of 1934 and Securities and Exchange Commission (SEC) Rule 10b-5 by illegally causing the Sensormatic stock price to rise through false and misleading statements regarding Sensormatic's financial condition beginning in August, 2000.
More specifically, plaintiffs assert that defendants caused Sensormatic to manipulate and falsify its publicly reported financial results by prematurely recognizing revenue on incomplete sales contracts with customers accepting delivery of the product on a trial basis under the company's "try-buy" program, in violation of Generally Accepted Accounting Principles (GAAP), resulting in overstatement of Sensormatic's financial results for year-end 2000 and for the third quarter of fiscal year 2001. Plaintiffs also allege that defendants made false and misleading statements in press releases and earnings announcements to analysts and investors about the growth of Sensormatic's sales and falsely forecast increased revenues for fiscal 2001. Plaintiffs allege that these false and misleading statements caused the stock price to rise through the early part of March, 2001, and then to drop precipitously by 31% following public announcement on April 10, 2001 of slumping third quarter profits.
According to the plaintiffs' complaint, defendants knew that business was weakening at the time they made the false statements regarding Sensormatic's sales growth, but falsified the company's financial condition in the hopes of securing a buyer for Sensormatic, appreciating that a sale would allow the inside officers and directors to cash in their options and receive huge cash bonuses. Failing an immediate sale, the individual defendants then sold up to 95% of their Sensormatic stock at the class period near high, over a five week period spanning February 5, 2001 through March 13, 2001 — just weeks before the April 10, 2001 "bad news" announcement, reaping nearly eight million ($8,000,000.00) dollars in insider trading proceeds.
Most of the allegations in the amended complaint relate to the collective knowledge of all of the individual defendants, with certain allegations directed toward one or more of the individual defendants with regard to dissemination of a particular statement, or access to specific internal information. In their responsive memorandum, plaintiffs argue that they have raised a strong inference of scienter as to each individual defendant through these cumulative allegations regarding (1) timing, coordination and amount of the defendants' insider stock sales; (2) GAAP violations; (3) defendants' knowledge of the GAAP violations; (4) defendant's receipt or access to internal dissemination of adverse sales trends and forecasts through marketing reports, quarterly sales reports, weekly and monthly sales forecasts, and annual product forum meetings; (5) defendants' publication of inconsistent sales performance data and projections.
In moving to dismiss the complaint, the Sensormatic defendants urge that plaintiffs have failed to plead allegations of false and misleading statements and scienter with the particularity required by the PSLRA. The outside directors join in the motion, urging as an additional pleading deficiency, unique to them, that the complaint fails to allege any facts suggesting a premise upon which the outsiders knew, or should have known, of the alleged accounting improprieties or the negative internal sales information forming the predicate of the fraud allegations.
II. PLEADING STANDARDS
Section 10(b) of the Securities Exchange Act of 1934 makes it unlawful for any person to "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 [SEC] may prescribe." 15 U.S.C. § 78j(b). To state a claim under Section 10(b), plaintiff must allege:
(1) a misrepresentation or omission of material fact; (2) made with scienter; (3) upon which plaintiff relied and (4) which proximately caused plaintiff's damages. Theoharous v. Fong, 256 F.3d 1219 (11th Cir. 2001).
In the context of a motion to dismiss directed to a securities fraud complaint, the court must limit its consideration to the pleadings and written instruments attached as exhibits to the pleadings. It may also consider relevant documents legally required by and publicly filed with the Securities Exchange Commission. Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1276-1281 (11th Cir. 1999).
In this case, there is a dispute as to the date of the 2001 Sensormatic Products Forum meeting in Boca Raton Florida, at which time marketing employees allegedly disseminated negative hardgoods and softgoods sales performance data. Plaintiffs allege that this meeting began February 27 — 28 and concluded March 1st, just one day prior to heaviest stock dumping during the suspicious insider stock trade wave. Defendants allege that this meeting occurred later, after the insider stock sales, thereby defeating any suggestion that a "strong inference" of scienter is available from the timing of these sales. Recognizing that the alternative date proposed contradicts the allegations of the complaint, defendants urge the court to take judicial notice of the later date on the basis of a copy of a document which counsel purports to reflect the cover page of the meeting agenda for the 2001 Products Forum Meeting. The court rejects the notion that the disputed date of the meeting may be resolved through the process of judicial notice on the basis of this unverified filing. Thus, for purposes of determining the instant motion, the court will assume the accuracy of the date of this meeting alleged in the complaint, observing, at the same time, that establishment of the alternative date proposed by defendant would not alter the disposition of the motion.
Further, the complaint must be measured against the enhanced pleading requirements imposed for securities fraud by Fed.R.Civ. 9(b) which requires that "in all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity," and those imposed by the Private Securities Litigation Reform Act of 1995 [PSLRA]. This Act requires first, that the complaint must specify each statement alleged to have been misleading, and the reason or reasons why the statement is misleading. § 78u-4(b)(1) Second, as to allegations made upon information and belief, the complaint must state with particularity all facts on which the belief is formed. § 78u-4(b)(1). Further, as to allegations of scienter, the complaint must plead specific facts giving rise to the "strong inference" that the defendant acted with the required state of mind. § 78u-4(b)(2).
However, even under these heightened pleading requirements, a court ruling on a motion to dismiss must draw all reasonable inferences from the particular allegations in the plaintiff's favor, while at the same time requiring plaintiff to show strong inference of scienter. Romani v. Shearson Lehman Hutton, 929 F.2d 875, 878 (1st Cir. 1991).
III. Sufficiency of the Consolidated Class Action Complaint A. Fraud Allegations
Defendants contend that the complaint is fatally deficient under the PSLRA and Rule 9(b) for failure to allege sufficient facts demonstrating how the alleged misrepresentations were false at the time made, and how each of the misrepresentations alleged are attributable to each individual defendant.
1. Specific Statements — Contrary Information
Divided by section, the complaint identifies the following statements as false or misleading, followed by a separate sub-section describing contradictory facts then known to the defendants:
a. August 8, 2000 press release: Announced fiscal 2000 earnings surge by 123%, hailed as "strong earnings improvement" attributable to "improving margins across all sales regions and product divisions," followed by 21% jump in stock price with analyst endorsements [§§ 66-70].
(i) fraud allegation: Financial results artificially inflated by improper revenue recognition tactics on contingent sales in violation of General Accepted Accounting Principles (¶¶ 71-75) and Sensormatic practice of deeply discounting products at end of quarter in order to meet quarterly sales numbers (¶ 76). Defendants later published statements indicating intent to adopt provisions of SAB 101, delaying revenue recognition until after product, falsely representing that GAAP previously allowed recognition of revenue for equipment sales upon shipment. (¶ 74). Defendants previously warned that sales would be significantly lower at Annual Product Forum Meeting in 2000 due to saturation of market with existing Sensormatic products. (¶ 77).
b Annual 10K report filed Sept 28, 2000 (for fiscal year ending June 30, 2000): Reported 8.1% increase in revenues for fiscal 2000, attributed to strong growth in company's Americas business unit (¶ 80), without disclosing declining sales trend and quarter end deep discounting practice.
(i) fraud allegation: Financial results overstated by approximately ten million dollars as result of improper revenue recognition practices, as later acknowledged in 10-K. for fiscal year ending June 30, 2001, and April 26, 2001 press release. Contrary information in control of defendants includes Softgoods Sales Report issued September 5, 2000 by former marketing manager, reporting decrease in Softgoods sales by 16% in fiscal year 2000; decrease in department store gross revenues of 41% in fiscal year 2000; decline in CCTV, Ultra-Max and Microwave sales; and declining sales to top ten customers; (¶¶ 81-83). Softgoods report circulated to Sensormatic executives and sales personnel, including defendant Kendall, who reported directly to defendant Loof (¶ 84).
c First Quarter Fiscal 2001 — October 19, 2000 press release reported earnings per share (EPS) for 1Q2001 of 100%, attributed to increased revenue and higher margins (§ 85-86), and November 14, 2000 10-Q for quarter ending September 30, 2000 (signed by defendant Gregory Thompson).
(i) fraud allegation: Neither statement disclosed improper revenue recognition practices or declining sales trend documented in September, 2000 Softgoods Sales Report. In addition, contrary internal information alleged to be accessible through sales tracking performed on daily and weekly basis by Sensormatic employees who reported to Chris Davell and Jerry Kendall, who held conference calls with field people and reported up to Per-Olof Loof.
d. Second Quarter Fiscal 2001 — — January 12, 2001 press release projecting increased revenue growth for second half of fiscal 2001, noting anticipated shortfall in second quarter growth attributed to Euro weakness, but still projecting 20% increase in BPS in light of "overall" healthy business;
— January 12, 2001 conference call for investing public and analysts, recognizing "sluggish" retail sales, while reassuring investors that BPS earnings projections of 35% remain the same;
— January 25, 2001 press release announcing seventh consecutive quarter of improved results for BPS, and quoting Loof as being optimistic about aggressive pricing and product innovations heralded as keeping company "on track" to meet 35% earnings growth projection;
— Feb 12, 2001 1OQ form filed signed by Thompson reporting significant reduction in manufacturing costs which would allow company to maintain gross margin level at its 45% target for remainder of fiscal year.
(i) fraud allegations: Defendants knowledgeable about accounting improprieties and adverse sales trend as identified above.
These detailed allegations, describing the content of the allegedly false or misleading statements, when and where they were issued, and the ways in which Sensormatic violated GAAP, sufficiently pleads fraud with particularity under Rule 9(b) and the PSLRA. Although each statement is not directly linked to each individual defendant, under the "group pleading" doctrine, a securities fraud plaintiff may impute false and misleading statements appearing in annual reports, quarterly and yearly financial statements, press releases, or other "group published" information to to all inside corporate officers and directors, who are presumed to have knowledge of and involvement in the day to day affairs of the company. In re Smith-Gardner Securities Litigation, 2002 WL 925365 (S.D. Fla., March 19, 2002); Holmes v. Baker, 166 F. Supp.2d 1362 (S.D. Fla. 2001).
The defendants urge that with the advent of the PSLRA, the group pleading doctrine is no longer viable as a means of establishing scienter in securities fraud cases, but the court is not persuaded by the logic of this proposition. Noting that the Eleventh Circuit has not yet addressed the question, this court agrees with the multiple other courts which have held that the group pleading doctrine remains viable even in PSLRA cases. See In re Theragenics Corp Sec. Litig, 105 F. Supp.2d 1342, 1357 (N.D.Ga. 2000) and cases collected infra; see also Ramp Networks, Inc. Securities Litigation, 2002 WL 862956 (N.D. Cal. March 1, 2002); In re CINAR Corporation Securities Litigation, 186 F. Supp.2d 279 (E.D. N.Y. 2002); In re JDN Realty Corp. Securities Litigation, 182 F. Supp.2d 1230 (N.D. Ga. 2002); In re Sunbeam Securities Litig., 89 F. Supp.2d 1326, 1340-41 (S.D. Fla. 1999).
Applying the concept here, the court concludes that the plaintiffs' complaint sufficiently alleges scienter as to the inside defendant officers and directors on the basis of the group published information described in the complaint, data which is presumed to represent the collective knowledge of these defendants.
C. Outside Directors — Hartman and Buffett
As to the outside directors, Timothy Hartman and Thomas Buffett, plaintiffs cannot rely on the group published information exception to Rule 9(b) because the complaint contains no allegations that the outside directors either participated in the day-to-day operations of Sensoramtic, or had some special relationship with it, such as preparation or communication of Sensormatic group published information at a particular time. Glen Fed Inc. Securities Litigation, 60 F.3d 591(9th Cir. 1995); Polar International Brokerage Corp. v. Reeve, 108 F. Supp.2d 225 (S.D.N.Y. 2000); In Re Ross Systems Securities Litigation, 1994 WL 583114 *6 (N.D. Cal. 1994).
The bare allegation that one of the directors, Hartman, participated on the Sensormatic audit committee and signed the company's annual Form 10-K with the SEC does not create such a special circumstance which might justify invocation of the group published information presumption. See In re Silicon Graphics, Inc. Sec. Litigation, 183 F.3d 970, 987-88 (9th Cir. 1999); In re Livent, Inc Noteholders Securities Litigation, 151 F. Supp.2d 371, 433 (S.D.N.Y. 2001); Cheney v. Cyberguard Corp., 2000 WL 1140306 *7 (S.D. Fla. 2000); In re Sunbeam Securities Litigation, 89 F. Supp.2d 1326, 1341 (S.D. Fla. 1999).
Nor is the alleged participation of these outside directors in the suspiciously timed insider trades sufficient, standing alone, to trigger the presumption. The timing and coordination of the Hartman and Buffett trades is highly suspicious, particularly as to Hartmann who sold 58.8% of his shares, in a first time Sensormatic stock sale, between March 9 through March 13, 2001, for a profit of $1,579,312.00 [Buffett in contrast sold 25.5% in first time trades over January 26, 2001, and March 8-March 9, 2001, for a cumulative $418,906.00 return]. However, unlinked, as they are, to any suggestion that Hartman or Buffet were involved in the company accounting practices, had day-to-day involvement in the operations of the corporation, or participated in, were recipients of or had access to the negative internal communications regarding the company's accounting problems or adverse sales trends, the insider trader allegations as to these outside directors are insufficient to establish scienter. See In Re Sunterra Corporation Securities Litigation, 2002 WL 480620 (M.D. Fla., March 12, 2002); Zishka v. American Pad Paper Co., 2001 WL 1748741 (N.D. Tex. 2001); In re Theragenics Corp. Securities Litigation, 105 F. Supp. 1342, 1361 (N.D. Cal. 2000). The plaintiffs' complaint will therefore be dismissed without prejudice as to these outside directors.
B. Scienter Allegations
Scienter is a "mental state embracing an intent to deceive, manipulate, or defraud. " Ernst Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976). In a 10-b case, the element of scienter is established either by evidence that the defendant consciously intended to defraud (actual fraud), or acted with "severe recklessness" to the truth, the latter of which is defined to mean "those highly unreasonable omissions or misrepresentations that involve not merely simple or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and 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." McDonald v. Alan Bush Brokerage Co., 863 F.2d 809 (11th Cir. 1989). This "severe recklessness" standard has been reaffirmed post-PSRA in this Circuit. See Bryant v. Avado Brands, Inc., 187 F.3d at 1282 n. 18. (11th Cir. 1999).
Although motive and opportunity are not enough, standing alone, to establish this element, see Bryant, 187 F.3d at 1285-86, these concepts remain relevant considerations in all cases in the determination of this highly fact specific inquiry, properly approached on an ad hoc basis. See Aldridge v. A.T Cross, 284 F.3d 72 (1st Cir. 2002); City of Philadelphia v. Fleming Co., 264 F.3d 1245, 1262-63 (10th Cir. 2001).
Considering the unique combination of facts and circumstances alleged here, the court concludes that plaintiffs in this case have pled adequate facts to establish the requisite "strong inference" of scienter. Where a defendant publishes a statement at a time he is in possession of or has access to facts suggesting that the statement is inaccurate, misleadingly, or incomplete — as is alleged here — a classic fact pattern giving rise to a strong inference of scienter appears. See Florida Board of Administrators v. Green Tree Financial Corp., 270 F.3d 645, 665 (8th Cir. 2001). In addition, the allegations of this complaint are susceptible to inference that established accounting standards required revenue recognition to hinge on final acceptance of product and completion of sale, and that the Sensormatic "try-buy" sales practice was abused to artificially inflate revenue recognition in violation of those standards or GAAP. Failure to account for this sales practice in the Sensormatic 2000 financial reports is some evidence that defendants acted with knowledge and intent, especially when viewed in combination with the fact that Sensormatic did not disclose its revenue recognition policy variances until April 26, 2001 — a few weeks after the dramatic April 10, 2001 losses. Third, the complaint alleges strong financial incentive on the part of the corporate officers to overstate sales revenues in order to attract a buyer for Sensormatic, and in order to simultaneously artificially inflate the stock price so as to maximize their own personal financial gain in a massive insider trading maneuver which occurred just prior to the April 10, 2001 bad news announcement.
Insider trading is suspicious when it is "dramatically out of line with prior trading practices at times calculated to maximize the personal benefit from undisclosed inside information." Silicon Graphics, 183 F.3d at 986. This case presents such an instance of "out of line" insider trading practices which support a strong inference of scienter: Toward the end of the class period, between February 5, 2001 and March 13, 2001, defendants sold a total of $7,980,151.00 of stock. The lion's share of that stock was sold by defendants Kendall and Assaf who reaped a $1,898.093 and $2,002,500 profit, respectively. None of the defendants sold a single share of Sensormatic stock during 1999 or 2000, and only defendant Asaf, who sold 200,000 in 1998, and defendant Engdahl, who sold 855 shares in 1997, had any prior Sensormatic trades at all.
Further, the proportionate amount of shares sold is significant: It is alleged that the insider sales constituted from 14.9% (Assaf) to 95.5% (Bufe) of the individual defendants' stock holdings, with the bulk of sales made almost immediately after dissemination of adverse sales trends at the 2001 Product Forum Meeting in Boca Raton, and just weeks before the "bad news" announcement on April 10, 2001 which led to the precipitous stock price drop. The timing and coordination of these primarily first-time insider sales — viewed in juxtaposition to Loofs recent public assurances in January 2001 to investors and analysts that Sensormatic remained "on track" to meet its projected 35% earnings growth — renders them highly suspicious.
Combined with the insider defendants' alleged failure to disclose known material information as to the contingent nature of 2000 sales, false reports of sales growth in the face of actual adverse sales trends, this allegation of massive insider stock dumping shortly before the bad news announcement is sufficient to create the" strong inference" of scienter needed to satisfy the PSRA and Rule 9(b) for the Sensormatic defendants. See In re Secure Computing Corp Securities Litigation, 184 F. Supp.2d 980 (N.D. Cal. 2001) ("unique and suspicious" insider trading sufficient to support an inference of deliberate recklessness given the timing of the sales (almost immediately after chief officers made statement at analyst conference that Secure was "on track" to meet its 1Q1999 and 1999 financial goals, and just before it released the adverse financial information that led to a stock price drop), the magnitude of the sales (between 83% and 100% of the individual defendants' stock holdings) and the history of the insiders' trading (stock dump represented first stock sales for all defendants)). Accordingly, the court shall deny the motion to dismiss as to the Sensormatic defendants.
For the foregoing reasons, it is
ORDERED AND ADJUDGED:
1. The Sensormatic defendants' motion to dismiss [DE# 21] is DENIED.
2. The outside directors motion to dismiss [DE# 17] is GRANTED WITHOUT PREJUDICE.
DONE AND ORDERED in Chambers at West Palm Beach, Florida this 8th day of June, 2002.