Opinion
Civil Action No. 3:02-CV-0323-N
March 26, 2003
ORDER
Before the Court are Defendants John D. Phillips, Bryan D. Yokley, Martin D. Kidder, W. Tod Chmar, Walter J. Burmeister, Kirby J. Campbell, Bryan Cipoletti, Stephen J. Clearman, John P. Imlay, Jr., Massimo Prelez Oltramonti, John P. Rigas, Carl E. Sanders, Dru A. Sedwick, Lawrence C. Tucker, Michael F. Mies, and Henry C. Lyon's ("Individual Defendants") Motion to Dismiss Plaintiff's First Amended Complaint and Ernst Young LLP and Ernst Young U.S. LLP's ("E Y") Motion to Dismiss Plaintiff's Second Amended Complaint. The Individual Defendants' Motion to Dismiss is GRANTED IN PART; R2 shall have 30 days from the date of this Order to file an amended complaint in compliance with this Order. Additionally, for the reasons stated below E Y's Motion to Dismiss is also GRANTED, and R2's case against E Y is DISMISSED WITH PREJUDICE.
I. FACTUAL BACKGROUND
R2, an investment company, purchased over $52 million worth of World Access, Inc.'s ("World Access") bonds ("Senior Notes") between October 12, 2000 and February 13, 2001. The indenture for the Senior Notes required World Access to make a tender offer to purchase back some or all of the Senior Notes on a pro rata basis on or before January 2, 2001 using the proceeds of a sale of certain business equipment and assets, including the assets of Telco Systems, Inc. ("Telco"). World Access represented in several SEC filings filed between May and December 2000 that it would redeem $160 million worth of the Senior Notes after the Telco sale. The Individual Defendants, each of whom are officers or directors of World Access, signed the SEC filings that included statements discussing World Access's obligation to redeem $160 million of the Senior Notes after the Telco sale. In addition, E Y assented to the inclusion of an unqualified 1999 audit letter and its designation as an expert in the same SEC filings.R2 began purchasing Senior Notes in October of 2000. By the end of the month, R2 owned close to $ 7 million worth of Senior Notes. The Telco sale occurred in April of 2000. On January 2, 2001, World Access made a tender offer to repurchase $ 160 million worth of the Senior Notes as required under the bond indenture. Between January 9 and February 13 2001, R2 purchased an additional $45 million worth of Senior Notes. Only days after R2's last purchase, World Access announced that because of a cash deficiency, the company reached an agreement with certain Senior Note holders that it would redeem only $70.6 million of the Senior Notes. R2 would not agree to the decreased tender offer. World Access gave R2 the opportunity to perform a forensic investigation of its financial records. During that investigation, R2 found information indicating that World Access knew on January 2, 2001, when it made its initial tender offer, that it would not have the cash to follow through with it. Ultimately, World Access filed bankruptcy, and R2 lost its entire investment, other than anything it may recover through the bankruptcy.
In its complaint, R2 urges that the Individual Defendants and E Y violated federal and state securities laws by signing and/or assenting to SEC filings which included the description of World Access's $160 million obligation to purchase the Senior Notes when they knew that World Access did not have the resources to go through with the tender offer. R2 argues that it relied on the SEC filings and the January 2, 2001 tender offer when making the decision to purchase Senior Notes. In addition, R2 asserts state law fraud, civil conspiracy and negligent misrepresentation claims against both the Individual Defendants and EY.
II. THE INDIVIDUAL DEFENDANTS' MOTION TO DISMISS
This securities fraud case is governed by the Private Securities Litigation Reform Act ("PSLRA"), which imposes increased pleading requirements for plaintiffs. 15. U.S.C. § 78u-4(b)(1) (1995). The PSLRA codifies a ban on group pleading. Coates v. Heartland Wireless Communications, Inc., 26 F. Supp.2d 910, 916 (N.D. Tex. 1998); 15. U.S.C. § 78u-4(b)(1) (1995). Because the PSLRA allows plaintiffs to plead on information and belief and requires a certain level of scienter for each defendant, group pleading is not allowed in securities fraud cases. Coates, 26 F. Supp.2d at 916. The PSLRA requires plaintiffs' complaints to distinguish among the defendants and inform each defendant of his or her particular role in the alleged fraud. Schiller v. Physicians Res. Group, 2002 WL 318441, at * 5 (N.D. Tex. Feb. 26, 2002).
In this case, R2's complaint repeatedly refers to the "Individual Defendants'" behavior rather than the specific individuals involved. See R2's Complaint, ¶¶ 28, 45, 52, 65 73. The complaint fails to inform each of the Individual Defendants what R2 claims were his or her specific roles in the alleged fraud, and it violates the pleading requirements of the PSLRA. Accordingly, the Individual Defendants' Motion to Dismiss is GRANTED IN PART, and R2 has thirty days from the date of this order to amend its complaint in compliance with this Order. The Court declines to address the Individual Defendants' other grounds for dismissal until R2 has had an opportunity to address this group pleading problem.
III. E Y'S MOTION TO DISMISS A. 12(b)(6) 9(b) Standards
A complaint should not be dismissed for failure to state a claim under Federal Rule of Civil Procedure 12(b)(6) "unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Conley v. Gibson, 355 U.S. 41, 45-46 (1957). Generally, courts must accept a plaintiffs factual allegations as true. Kaiser Aluminum Chem. Sales, Inc. v. Avondale Shipyards, Inc., 677 F.2d 1045, 1050 (5th Cir. 1982). However, to avoid dismissal, the plaintiff "must come forward with specific supporting factual allegations, not mere conclusory allegations or mischaracterizations of defendants' actual statements." Alcina v. Pcorder.Com, Inc., 230 F. Supp.2d 732, 736 (W.D. Tex. 2002). When portions of a statement are discussed in a complaint, the court can consider the statement in its entirety when deciding a motion to dismiss. See Melder v. Morris, 27 F.3d 1097, 1100-1101 (5th Cir. 1994). In addition, the court may take judicial notice of documents of public record, such as documents filed with the SEC. In re Sec. Litig. BMC Software, Inc., 183 F. Supp.2d 860 (S.D. Tex. 2001). Courts can consider matters of which they take judicial notice. Lovelace v. Software Spectrum Inc., 78 F.3d 1015, 1017-1018 (5th Cir. 1996).
Because R2 asserts fraud claims under the Securities Exchange Act of 1934 ("Exchange Act") Rule 10(b), it must also satisfy the heightened pleading requirements imposed by Federal Rule of Civil Procedure 9(b) and the PSLRA to avoid dismissal. Rule 9(b) requires certain minimum allegations to be pled in securities fraud cases including the specific place, time and content of the false representations as well as the identity of the individual making the false representations and what that person gained from making the representations. Shushany v. Allwaste, Inc., 992 F.2d 517, 521 (5th Cir. 1993). Additionally, the PSLRA requires complaints in security fraud cases to "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) (1995).
The PSLRA also requires plaintiffs to allege facts demonstrating scienter. Lovelace, 78 F.3d at 1018. Scienter is defined as a "mental state embracing an intent to deceive, manipulate or defraud." Id. The PSLRA requires complaints to state with particularity facts giving rise to a strong inference of scienter. U.S.C. § 78u — 4(b)(2) (1995); Nathenson v. Zonagen Inc., 267 F.3d 400, 407 (5th Cir. 2001). Negligence alone is insufficient to support liability; however, severe recklessness suffices. Nathenson, 267 F.3d at 408-409. The defendant's motive and opportunity to commit fraud, alone, does not support a strong inference of scienter. Id. at 410-411. If the complaint does not plead scienter as required by the PSLRA, then the case must be dismissed. 15 U.S.C. § 78u-4(b)(3)(A) (1995); Coates v. Heartland Wireless Communications, Inc., 55 F. Supp.2d 628, 634 (N.D.Tex. 1999).
B. 10b-5 Claim 1. Elements of 10b-5
Section 10b-5 of the Exchange Act ("10b-5") makes it unlawful for any person "to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading . . . in connection with the purchase or sale of any security." 17 C.F.R. § 240.10b-5 (2002). To state a claim under 10b-5, a plaintiff must allege the following in connection with the sale or purchase of securities: (1) an omission or misstatement, (2) of a material fact, (3) made with scienter, (4) on which plaintiff relied, (5) that proximately caused the plaintiff's injury. Nathenson v. Zonagen, Inc., 267 F.3d 400, 407 (5th Cir. 2001). As discussed previously, plaintiffs must also state with particularity facts giving rise to a strong inference of scienter, specifically identify the alleged misleading omissions or misrepresentations, and discuss the reasons why the statement or omission is misleading. Id. at 412.
2. Alleged Misstatement
In this case, R2 argues that E Y made an actionable misstatement under 10b-5 when it consented to the inclusion of its audit opinion in SEC filings that state "that World Access would go through with the tender offer," when, at the time of the SEC filing, World Access knew it would not go through. See R2 Comp. ¶¶ 32, 63. E Y's behavior does not constitute a misstatement under 10b-5. The statements in the SEC filings do not promise that World Access will actually perform the Senior Note tender offer, rather the filings say that "the Company [World Access] is currently obligated to tender to approximately $ 160 million of its 13.25% Senior Notes by January 2, 2001." See R2 Comp. ¶ 35 (emphasis added). Unfortunately, companies are not always able to meet their financial obligations, hence the fact that Chapter 7 and Chapter 11 bankruptcies occur often. Accordingly, stating that a company has a financial obligation is not equivalent to guaranteeing that the company will pay the debt. The Court is not required to accept R2's mischaracterization of the statements in World Access's SEC filings. See Associated Builders, Inc. v. Alabama Power Co., 505 F.2d 97 (5th Cir. 1974). The Court holds that the statements regarding the Senior Notes tender obligation did not guarantee that World Access would complete the tender offer; therefore, they are not misstatements under Rule 10b-5.
Even if the statements in World Access's SEC filings regarding its financial condition after the E Y audits constitute misstatements by World Access, those cannot be attributed to E Y. E Y did not complete an audit of World Access during the time frame at issue in this case, the year 2000. It performed audits on World Access in 1998 and 1999, which covered the financial information through December 31, 1999. All the events R2 says it relied upon in making its decision to purchase the Senior Bonds occurred after the time period covered in E Y's audits of World Access. Also, the fact that E Y's audit opinions are included in later SEC filings does not somehow make the opinions themselves cover a later time period. Because E Y did not audit World Access during the relevant time period in this case, it cannot be liable for any alleged misstatements by World Access.
Finally, E Y cannot be liable for misstatements under 10b-5 in this case because for an accountant's misrepresentations to be actionable under Rule 10b-5, the accountants themselves "must make a false or misleading statement (or omission) that they know or should know will reach potential investors." Anixter v. Home-Stake Prod. Co., 77 F.3d 1215, 1226 (10th Cir. 1996). In this case, R2 does not allege that any of E Y's audit opinions contain any false or misleading information. Because R2 failed to plead any facts supporting the proposition that E Y personally made any misstatements, R2's 10b-5 claim against E Y for misstatements fails as a matter of law.
3. Alleged Omission
Along with misstatements, R2 claims that E Y violated 10b-5 when it omitted certain important information regarding World Access's ability to complete the tender offer. Rule 10b-5 imposed no duty on E Y to disclose this information. Rule 10b-5 requires disclosure only when silence would make other statements misleading or false. Taylor v. First Union Corp. of S. Carolina, 857 F.2d 240, 243 (4th Cir. 1988). Additionally, auditors are required to disclose subsequent events only if they "cast doubt on the reliability of the certified figures with respect to the period covered by the audit." Igenito v. Bermec Corp., 441 F. Supp. 525, 549 (S.D.N.Y. 1977).E Y did not violate 10b-5 by omitting important information for several reasons. First, as mentioned previously, the information that R2 argues that E Y was obligated to publicly disclose involved the year 2000, which is after the time frame during which E Y audited World Access. Also, the description of the tender offer obligation did not constitute a promise that the tender offer would go through. The fact that World Access may not be able to complete the tender offer on time does make the statement that World Access has an obligation to repurchase the Senior Notes untrue or misleading. Therefore, E Y's silence did not make other World Access or E Y statements regarding the tender offer false or misleading. Accordingly, E Y had no duty to report that World Access could not pay the whole debt on time. Thus R2's 10b-5 claim against E Y for omissions also fails as a matter of law.
4. Necessary Scienter
In an abundance of caution, the Court will analyze whether the complaint alleges adequate facts regarding scienter. Assuming that R2 adequately pled a misstatement, it must also plead specific facts giving rise to a "strong inference" of scienter to avoid dismissal. Abrams v. Baker Hughes, Inc., 292 F.3d 424, 430 (5th Cir. 2002). Severe recklessness, which supplies the scienter required to prove a 10b-5 claim, is defined as "highly unreasonable omissions or misrepresentations that involve not merely simple or even inexcusable evidence, but an extreme departure from the standard 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." Id. (citing Nathenson v. Zonagen Inc., 267 F.3d 400, 408 (5th Cir. 2001)). Circumstantial evidence can support a strong inference of scienter. Id. at 431. Finally, the allegations should not be considered in isolation, but should be read together as a whole to determine whether they rise to the required strong inference of scienter. Id.
In this case, R2 alleges that E Y committed fraud because it knew or recklessly disregarded that World Access's financial statements did not comply with GAAP because "they failed to provide accurate information regarding World Access's ability to satisfy its obligations on the Senior Notes tender offer," and because E Y knew that World Access could not go through with the tender offer when it issued it's audit letter. See R2 Comp. ¶ 66. Even assuming that R2's factual allegations are true, the mere misapplication of accounting principles does not establish 10b-5 scienter. In re MicroStrategy, Inc. Sec. Litig., 115 F. Supp.2d 620, 651 (E.D. Va. 2000). The PSLRA also requires the plaintiff to allege facts tending to show that "the accounting practices are so deficient that the audit amounted to no audit at all or that no reasonable accountant would have made the same decisions if confronted with the same facts." Id. (citing Zucker v. Sasaki, 963 F. Supp. 301, 307 (S.D.N.Y. 1997)). R2 fails to meet this burden. As mentioned before, R2 does not complain about the quality or veracity of E Y's 1998 or 1999 audits. R2 does not plead any facts supporting the proposition that E Y's audit was so deficient that it amounted to no audit at all. Therefore, R2 fails to adequately plead scienter on this ground.
Next, R2 claims it can prove scienter because E Y had access to World Access's books during 2000 and that E Y must have known that World Access could not honor its tender obligations, and it failed to make this information public. See R2 Comp. ¶ 63. This assertion is problematic. The mere fact that an accountant had access to a company's books does not mean that the accountant is automatically aware of GAAP violations, just as a person who reads one chapter in a textbook cannot be expected to know the contents of the entire book. See Reiger v. Price Waterhouse Coopers LLP, 117 F. Supp.2d 1003, 1012 (S.D. Cal. 2000).
Also, when motive is not alleged and the plaintiff relies entirely on allegations of recklessness, the evidence of scienter must be strong. Zucker v. Saski, 963 F. Supp. 301, 309 (S.D.N.Y. 1997). In this case, R2 fails to allege a motive for E Y's failure to report the information that R2 alleges it must have learned by examining World Access's books. R2's allegations of recklessness involve GAAP violations which, as previously discussed, alone do not provide the necessary recklessness. Because R2 fails to adequately plead that E Y acted reckless, R2 failed to allege the necessary scienter required for a 10b-5 violation. Accordingly, R2's 10b-5 claim against E Y must also be dismissed on the alternate ground of failure to plead scienter.
C. Section 20(a) Claim
Along with the 10b-5 claim, R2 alleges that E Y violated section 20(a) of the Exchange Act. 15 U.S.C. § 78t(a) (2002). Section 20(a) discusses control person liability stating "[e]very person who, directly or indirectly, controls any person liable under any provision of this chapter . . . shall also be liable jointly and severally with and to the extent as such controlled person. . . ." Id. To establish liability under section 20(a), R2 must demonstrate in its pleadings that E Y possessed the power to control the specific transaction or activity upon which the primary violation is predicated." Abbot v. Equity Group, Inc., 2 F.3d 613, 620 (5th Cir. 1993). Outside accountants are not controlling persons unless they have influence over the daily operations of the company. Morin v. Trupin, 809 F. Supp. 1081, 1087 (S.D.N.Y. 1993). R2's complaint does not allege that E Y controls the daily operations of World Access or that it controlled World Access during the time that each SEC filing at issue in this case was filed. Accordingly, R2 failed to adequately plead that E Y was a "control person" liable under section 20(a) for any of World Access's potential 10b-5 violations. Therefore, R2's section 20(a) claim against E Y is dismissed.
D. Fraud Claim
In its complaint, R2 argues that E Y committed fraud under Texas law when it allowed its audit opinion to be attached to World Access's SEC filings at issue in the case and when it failed to report possible GAAP violations regarding World Access's ability to make the $160 million tender offer. Most of the fraud analysis mirrors the 10b-5 analysis addressed in Section III, Part B of this Order. Texas fraud claims include liability for affirmative fraudulent representations, which are discussed in the 10b-5 analysis above, as well as liability for failure to disclose important information. A duty to disclose arises when a representation is made and new information makes the earlier representation misleading or untrue. Hoggett v. Brown, 971 S.W.2d 472, 487 (Tex.App.-Houston [1st Dist] 1997, pet. denied). In the instant case, E Y had no duty to disclose the fact that World Access may not be able to follow through with the $160 million tender offer because its earlier representation did not say that World Access would go through with the tender offer. As discussed previously, World Access's SEC filings at issue in the case merely stated World Access's tender offer obligation; it did not contain a guarantee that World Access would actually make and complete the tender offer. Accordingly, E Y had no duty to disclose any information it may have received that World Access could not complete the tender offer. Because R2 failed to plead that E Y made any fraudulent representations or failed to disclose any important information, R2's state fraud claim must be dismissed.E. Texas Securities Act Claim
Along with the federal securities law and state fraud claims, R2 argues that E Y violated the Texas Securities Act when it assented to the inclusion of its audit reports in World Access SEC filings and when it failed to make public that World Access did not have the funds to go through with the Senior Notes $160 million tender offer. Like the federal claims discussed previously, R2's Texas Securities Act claim fails because the pleadings do not allege that E Y made any untrue statements or omitted any material facts. The Texas Securities Act prohibits false statements and material omissions in the sale of securities and imposes liability upon sellers, aiders and control persons who offer or sell securities "by means of an untrue statement of a material fact or omission." TEX. Civ. STAT. ANN. art. 581-33 (2002). As discussed in the 10b-5 section, R2 failed to identify any false statements or material omissions by E Y. Therefore, R2's Texas Securities Act claim fails.Even assuming R2 adequately pled an untrue statement or material omission, E Y is not liable under the Texas Securities Act because it is not a seller, control person or aider as defined by the Act. R2 did not allege that E Y is a seller, and as discussed previously, R2 did not adequately plead that E Y controlled the daily workings of World Access or the SEC filings at issue in the case. To establish aider and abettor liability R2 must demonstrate: (1) a primary violation of securities law, (2) the aider had a general awareness of its role in the violation, (3) the aider substantially assisted in the violation, (4) the aider intended to deceive the plaintiff or the aider acted with reckless disregard for the truth regarding the representations made by the primary party. Crescendo Invs., Inc. v. Brice, 61 S.W.3d 465, 472 (Tex.App.-San Antonio 2001, pet. denied). In this case, R2 did not plead evidence of any of the elements required for aider and abettor liability. First, R2 did not plead sufficient facts to establish a violation of securities law. Also, R2 plead no evidence indicating that E Y knew about a violation or that E Y substantially assisted in any such violation. Accordingly, R2's Texas Securities Act claim must be dismissed.
F. Civil Conspiracy
R2 alleges that E Y conspired with World Access to defraud R2 and other potential investors by failing to report that World Access did not have the funds to go through with the $160 million tender offer and by allowing its audit letter to be included in SEC filings that discuss the tender obligation. A civil conspiracy is defined as "a combination of two or more persons to accomplish an unlawful purpose, or to accomplish a lawful purpose by unlawful means." Carroll v. Timmers Chevrolet, Inc., 592 S.W.2d 922, 925 (Tex. 1979). A person without knowledge of the purpose or object of the conspiracy cannot be a co-conspirator because he cannot agree to the commission of a wrong that he does not know about. Schlumberger Well Surveying Corp. v. Nortex Oil Gas Corp., 435 S.W.2d 854, 857 (Tex. 1969). A meeting of the minds between co-conspirators is required for a conspiracy. Id. In this case, R2 did not plead any facts indicating a meeting of the minds between World Access and E Y regarding the alleged fraud. Therefore, R2's civil conspiracy claim must be dismissed.
G. Negligent Misrepresentation Claim
R2 urges in its complaint that E Y negligently misrepresented World Access's financial situation when it failed to make public World Access's GAAP violations and the fact that World Access did not have enough cash to go through with the tender offer. To prevail on a negligent misrepresentation claim, R2 must show: (1) that E Y made a representation to R2 in the course of E Y's business; (2) that E Y supplied false information for the guidance of others; (3) that E Y failed to exercise reasonable care or competence when obtaining or communicating the information; (4) that R2 justifiably relied on the representation; and (5) that E Y's negligent representation proximately caused R2's injury. McCamish, Martin, Brown Loeffler v. F.E. Appling Interests, 991 S.W.2d 787, 791 (Tex. 1999).In this case, R2's complaint does not allege that E Y supplied any false information to the public or to R2 specifically. Rather, it asserts tangentially that E Y's audit letter was attached to SEC filings that spelled out World Access's $ 160 million tender offer obligation on the Senior Notes. As established above, these statements did not guarantee that World Access would perform the tender offer, rather they merely stated World Access's obligation regarding the offer. Therefore, the SEC filings at issue did not contain false statements, and E Y's involvement with the filings did not constitute a false statement. Without a false statement, R2's negligent misrepresentation claim against E Y fails.