Ezra Charitable Trust v. Tyco International, Ltd. , 466 F.3d 1 ( 2006 )

United States Court of Appeals
For the First Circuit
No. 05-2762
EZRA CHARITABLE TRUST, MIRROR MANAGEMENT, LTD., ROBERT BOVIT,
Plaintiffs, Appellants,
v.
TYCO INTERNATIONAL, LTD., EDWARD D. BREEN,
DAVID J. FITZPATRICK, PRICEWATERHOUSECOOPERS, LLP.,
Defendants, Appellees.
APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF NEW HAMPSHIRE
[Hon. Paul J. Barbadoro, U.S. District Judge]
Before
Selya, Lipez, and Howard, Circuit Judges.
Kenneth J. Vianale, with whom Vianale & Vianale LLP, Biron L.
Bedard and Cook & Molan, P.A. were on brief, for appellants.
Francis P. Barron, with whom Stephen S. Madsen, Cravath,
Swaine & Moore LLP, Edward A. Haffer and Sheehan, Phinney, Bass &
Green, were on brief for appellees, Tyco International LTD., Edward
D. Breen and David J. Fitzpatrick.
Michael P. Carroll, with whom Michael S. Flynn, Davis Polk &
Wardwell, Arnold Rosenblatt, Cook, Little, Rosenblatt & Manson,
P.L.L.C., Christian M. Hoffman, Lisa C. Wood and Foley Hoag LLP
were on brief, for appellee PricewaterhouseCoopers LLP.
September 27, 2006
HOWARD, Circuit Judge. Plaintiffs Ezra Charitable Trust,
Mirror Management, Ltd., and Robert Bovit brought this action
pursuant to Sections 10(b) and 20(a) of the Securities Exchange Act
of 1934, 15 U.S.C. §§ 78j(b) and 78t(a), against defendants Tyco
International, Ltd., Edward R. Breen (Tyco's chief executive
office), David J. Fitzpatrick (Tyco's chief financial officer), and
PricewaterhouseCoopers, LLP (Tyco's auditor)("PwC"). The district
court dismissed the action as to all defendants on the ground that
the amended class action complaint did not adequately allege
scienter under the Private Securities Litigation Reform Act
("PSLRA"), 15 U.S.C. § 78u-4(b), and plaintiffs appealed. We
affirm.
I.
We present the facts as set forth in the amended class
action complaint and the SEC filings relied upon in the complaint.
See Gross v. Summa Four, Inc., 93 F.3d 987, 991 & 994 n. 6 (1st
Cir. 1996).
The context of this action -- viz., the travails of Tyco
-- is well-known. Plaintiffs recount at some length the reported
abuses of Tyco's past officers and directors, notably chief
executive officer Dennis Kozlowski, chief financial officer Mark
Swartz, chief corporate counsel Mark Belnick, and director Frank
Walsh. In 2002, as revelations of misconduct surfaced, there was
a major shake up at Tyco. Tyco commissioned a massive internal
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investigation led by the law firm of Boies Schiller & Flexner,
which was aided by various accounting firms. All told, over 15,000
attorney hours and 50,000 accountant hours were invested.1 As a
consequence, Tyco disclosed the alleged misconduct of its prior
management and made necessary accounting adjustments. The changes
were costly, as Tyco's Form 10-K report for fiscal 2002 showed a
net loss of over nine billion dollars, a stark contrast from its
nearly four billion dollars of profit in fiscal year 2001, and over
four and a half billion dollars profit in fiscal year 2000. As
part of Tyco's clean-up, new senior officers and directors were
appointed. Breen was made the chief executive officer in July
2002, and Fitzpatrick was made the chief financial officer in
September 2002.
Plaintiffs' action focuses on the initial results of the
clean-up, spanning the period between December 30, 2002 and March
12, 2003.2 Plaintiffs allege that the clean-up fell well short of
sanitizing Tyco's books, and that new management perpetuated a
fraud in the accounting for ADT, one of Tyco's largest
subsidiaries.
1
The scope of the investigation was broad, and included the
integrity of the company's financial statements, the possible
existence of systemic fraud, and corporate governance issues. The
investigation yielded numerous recommendations regarding Tyco's
accounting and corporate governance practices.
2
The misconduct during the prior period is the subject of other,
ongoing class-action law suits.
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Plaintiffs allege that ADT, a provider of security
systems, purchased customer contracts from its authorized dealers
and accounted for the transactions in the following improper
manner. First, ADT would ostensibly agree to purchase a customer
contract from a dealer for $1000. Second, the dealer would
ostensibly agree to pay ADT $200 as reimbursement for ADT's
expenses in connection with acquiring the contract (the "connection
fee"). Third, ADT would remit the $800 net amount to the dealer
(the only cash that changed hands), record the acquisition of the
contract at the full price of $1000, and record a $200 expense
offset (income). Significantly, ADT's actual expenses related to
each contract were de minimis - $5 for a credit check - and ADT
recorded the difference ($195) as income. Plaintiffs allege that
this was "Alice in Wonderland" accounting because Generally
Accepted Accounting Principles ("GAAP") require that intangible
assets such as these contracts be recorded at their actual cost
(here $805), and because no income is to be recognized under such
circumstances. Thus, according to plaintiffs, these transactions
permitted Tyco/ADT to fraudulently overstate ADT's income and
assets.
Plaintiffs allege that the defendants made actionable
misrepresentations in connection with these transactions. First,
in its 12/30/02 Form 8-K filed with the SEC, Tyco's management
disclosed the results of the internal investigation and stated that
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Tyco was "not aware of any systemic or significant fraud related to
the Company's financial statements or of any clear accounting
errors that would materially adversely affect the Company's
reported earnings or cash flow from operations for the year 2003
and thereafter." The Form 8-K also purported to correct ADT's
accounting, noting that to the extent the connection fee exceeded
actual costs, it "should be deferred and amortized over the
estimated useful life of an acquired customer relationship" (ten
years). As a consequence, the Form 8-K reported that 2002 earnings
would be reduced by $135 million, and that a $185.9 million charge
to earnings would be taken to adjust income improperly recognized
in fiscal years 1999 to 2001 (a $320.9 million adjustment in all).
Tyco's Form 10-K, filed on 12/30/02, largely echoed the Form 8-K's
representations. Notably, it stated that "new senior management
has no reason to believe that the financial statements included in
this report are not fairly stated in all material respects." As to
ADT's contract acquisitions, the Form 10-K noted that fees received
from dealers, in excess of actual costs incurred, would be
amortized over ten years as a "deferred credit." The 10-K also
included PwC's audit opinion, dated December 23, 2002, which
stated:
In our opinion, the accompanying
consolidated balance sheets and related
consolidated statements of operations, of
shareholders' equity and of cash flows present
fairly, in all material respects, the
financial position of Tyco International, Ltd.
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and its subsidiaries at September 30, 2002 and
2001, and the results of their operations and
their cash flows for each of the three years
in the period ended September 30, 2002, in
conformity with accounting principles
generally accepted in the United States of
America . . . . We conducted our audits of
these statements in accordance with auditing
standards generally accepted in the United
States of America . . . .
Plaintiffs assert that these releases contained four
fraudulent misstatements by the Tyco defendants: (1) that Tyco's
accounting had been corrected; (2) that the financial statements
fairly presented Tyco's status; (3) that all material accounting
issues, particularly those involving ADT, had been corrected; and
(4) that ADT would receive a $320.9 million revenue stream over the
next ten years. Plaintiffs maintain that these representations
were false because there were still major problems in ADT's books,
notably that the income recognized from dealer "connection fees" to
ADT was "imaginary," and that the contracts acquired were being
recorded at an artificially inflated cost. Plaintiffs assert that
the defendants corrected only a technical, inconsequential error --
that the "imaginary" income was being recognized too quickly
(immediately rather than over the life of the contract) -- in their
initial restatement, but knowingly permitted more significant
errors -- the improper recognition of income and the inflation of
asset value -- to remain unaltered. Plaintiffs also allege that
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PwC, knowing of the errors in ADT's books, nonetheless wrongfully
issued a "clean" audit opinion.
Plaintiffs allege that the fraud was brought to light in
March 2003, when Tyco essentially admitted the fraud in a press
release and subsequent Form 10-Q. In a March 12, 2003 press
release, Tyco stated that, pursuant to ongoing discussions with the
SEC, it expected "to take non-cash, pre-tax charges between $265
million and $325 million for issues identified primarily in [ADT]."
Tyco also announced that the president of ADT, Jerry Boggess, and
other senior ADT managers, had been fired. Tyco stock dropped
significantly on the news. Plaintiffs say that defendants
acknowledged in their 3/31/03 Form 10-Q that they had been in
ongoing discussions with the SEC about their accounting for the
dealer fees and were changing their accounting for the non-
refundable dealer charges to treat them properly as a reduction in
ADT's costs in acquiring the contracts.3
Plaintiffs also allege that Tyco falsely attributed the
March 2003 accounting corrections to a then-recently issued
accounting requirement from the Financial Accounting Standards
Board's Emerging Issues Task Force ("EITF") -- EITF 02-16 -- which
had nothing to do with the relevant accounting issue. Plaintiffs
3
Plaintiffs also note that the Form 10-Q announced over $900
million in additional charges to earnings to correct various
accounting problems unearthed by "intensified . . . internal audits
and detailed controls and operating reviews . . . ."
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assert that the proper accounting principle is and was located in
Accounting Research Bulletin ("ARB") 43, which has been in effect
since 1953.
Plaintiffs also emphasize the actions of PwC's audit
engagement partner for Tyco, Richard Scalzo. The SEC, in an
Accounting and Auditing Enforcement Action dated August 13, 2003,
barred Scalzo from practicing accounting before it based on its
finding that Scalzo had violated Section 10(b) and Rule 10b-5 and
committed improper professional conduct in connection with his
audits of Tyco for fiscal years 1997-2001. See 2003 WL 21938985(SEC Release No. 1839). Essentially, the SEC concluded that Scalzo
was on notice of prior management's misconduct, failed to take the
necessary steps required by Generally Accepted Auditing Standards
("GAAS"), and recklessly permitted PwC to issue audit reports
stating that Tyco's books had been audited according to GAAS.
Plaintiffs assert that the Tyco defendants had two basic
motivations for the alleged fraud. First, they wished to keep Tyco
viable as a going concern. Plaintiffs allege that Tyco had over
four billion dollars in debt coming due in early 2003, and faced
imminent bankruptcy if it failed to meet these obligations. Their
theory is that management misstated ADT's accounting to give the
false impression that Tyco had a $320.9 million revenue stream,
-8-
which permitted Tyco to obtain crucial financing.4 Second, they
wanted to preserve their own lucrative positions, which included
large salaries, bonuses, and stock options. Plaintiffs allege that
the Tyco defendants highlighted their deceit by providing false
explanations for the belated correction.
As to PwC, plaintiffs allege that PwC's audit opinion was
fraudulent because PwC knowingly failed to comply with GAAS and was
aware that Tyco's accounting was not in compliance with GAAP.
Plaintiffs state that PwC's motive was straightforward. PwC looked
the other way on Tyco's new fraud, just as it allegedly had with
past frauds, to preserve its lucrative business relationship with
Tyco.
The district court dismissed the complaint, concluding
that scienter was inadequately alleged. As to Breen and
Fitzpatrick, the court concluded that their financial stake in
Tyco's continued viability was inadequate, standing alone, to
create a strong inference of scienter, and that the balance of the
allegations amounted to nothing more than "fraud by hindsight," as
there was no basis for concluding that Breen and Fitzgerald knew
the disputed representations were false when made. The court also
held that, because Tyco's liability was solely derivative of
4
Plaintiffs note that the Tyco defendants did not fully correct
ADT's accounting until after Tyco had successfully placed an over
four billion dollar bond offering and obtained a one and a half
billion dollar line of credit.
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Breen's and Fitzpatrick's, the claims against the corporate entity
should be dismissed. Finally, the court concluded that PwC's
financial stake in its continued business relationship with Tyco
was inadequate to create a strong inference of scienter, and that
the remaining allegations were either too vague or pertained only
to conduct outside the class period.
II.
Plaintiffs argue that the district court erred in
evaluating in isolation their allegations of scienter on the part
of the Tyco defendants rather than assessing the collective
picture. They further contend that the court erred in failing to
appreciate the import of the alleged GAAP and GAAS violations that
PwC countenanced, as well as the relevance of PwC's past misconduct
in auditing Tyco.
We review the allowance of the defendants' motions to
dismiss de novo. Aldridge v. A.T. Cross Corp., 284 F.3d 72, 78
(1st Cir. 2002). In reviewing a motion to dismiss, we take as true
all well-pleaded allegations and draw all reasonable inferences in
the plaintiff's favor; however, we are free to "disregard bald
assertions, unsupportable conclusions, and opprobrious epithets."
In re Credit Suisse First Boston Corp., 431 F.3d 36, 45 (1st Cir.
2005). Moreover, we "may affirm on any independently sufficient
ground." Badillo-Santiago v. Naveira-Merly, 378 F.3d 1, 5 (1st
Cir. 2004).
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In general, a securities fraud claim has six elements:
(1) a material misrepresentation or omission; (2) scienter; (3)
connection with the purchase or sale of a security; (4) reliance;
(5) economic loss; and (6) loss causation. Dura Pharma., Inc. v.
Broudo, 544 U.S. 336, 341-42 (2005). Our focus here is on the
adequacy of plaintiffs' allegations of scienter. Scienter is
defined as "a mental state embracing intent to deceive, manipulate,
or defraud," and a plaintiff must allege that "defendants
consciously intended to defraud, or that they acted with a high
degree of recklessness." Aldridge, 284 F.3d at 82.
Under the PSLRA, the complaint must first provide
detailed pleading about each of the statements challenged,
including factual allegations illustrating precisely why the
challenged statement is misleading. Greebel v. FTP Software, Inc.,
194 F.3d 185, 193-94 (1st Cir. 1999).5 The PSLRA also requires the
complaint to plead particular facts that give rise to a strong
(rather than merely reasonable) inference of scienter.6 This
5
The PSLRA provides:
[T]he complaint shall specify each statement alleged to
have been misleading, the reason or reasons why the
statement is misleading, and, if an allegation 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).
6
As to scienter, the PSLRA states:
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alters the usual Rule 12(b)(6) standard, in that while the "court
continues to give all reasonable inferences to plaintiffs, those
inferences supporting scienter must be strong ones." In re
Cabletron Sys., Inc., 311 F.3d 11, 28 (1st Cir. 2002).
"We have interpreted [the PSLRA scienter] provision as
demanding a recitation of facts supporting a 'highly likely'
inference that the defendant acted with the required state of
mind." In re Stone & Webster, Inc., Sec. Litig., 414 F.3d 187, 195
(1st Cir. 2005). In making this assessment, we have eschewed any
reliance on a rigid pleading formula, instead "preferring to rely
on a 'fact-specific approach' that proceeds case by case."
Cabletron, 311 F.3d at 38. "Scienter allegations do not pass the
'strong inference' test when, viewed in light of the complaint as
a whole, there are legitimate explanations for the behavior that
are equally convincing." Credit Suisse, 431 F.3d at 49; see also
Aldridge, 284 F.3d at 82 ("The plaintiff must show that his
characterization of the events and circumstances as showing
scienter is highly likely."). Pleading "fraud by hindsight,"
essentially making general allegations "that defendants knew
In any private action arising under this chapter in which
the plaintiff may recover money damages only on proof
that defendant acted with a particular state of mind, the
complaint shall, with respect to each act or omission
alleged to violate this chapter, 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).
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earlier what later turned out badly," is not sufficient. Gross,
93 F.3d at 991 (internal citation and quotation omitted).
A. Tyco defendants
As to the Tyco defendants, the plaintiffs argue that
several factors which, taken together, establish scienter: (1) the
significant GAAP violation in ADT's accounting; (2) defendants'
false exculpatory statement that the March restatement was mandated
by EITF 02-16; (3) the close proximity between the March
restatement and the purported December 2002 correction; (4)
defendants' knowledge of Kozlowski's relationship with Boggess and
ADT; and (5) defendants' desire to save Tyco and maintain their
lucrative positions. We conclude that the district court correctly
dismissed the claims.
We begin with context. The plaintiffs assert that the
district court failed to view their allegations in their entirety.
But we think it is the plaintiffs who are being myopic. Plaintiffs
pay too little heed to the circumstances in which the alleged fraud
was taking place: Tyco had new management, was in the midst of a
massive clean-up of fraud, and had disclosed the wrongdoing of
prior management. We think that it is important to bear this
context in mind as we evaluate plaintiffs' claims.
Tyco's statements were not nearly so absolute as
plaintiffs present them. For example, the statement in the Form 8-
K that management was currently unaware of systemic fraud was made
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in the context the Form 8-K's recounting of the investigation,
prior management's transgressions, and the impossibility of
correcting all errors:
Few, if any, major companies have ever
been subjected to the corporate governance and
accounting scrutiny entailed in Phase 2 of the
Boies Firm's work. However, despite the
extent of the Boies Firm's work, the Company
has not sought to go back and identify every
accounting decision and every corporate act
over a multi-year period that was wrong or
questionable, or whether there was a
preferable accounting treatment among the
alternative treatments available under [GAAP].
Given the size and scope of the Company's
operations, such a task, or anything
approaching it, would have been impossible
within any plausible time-frame. Moreover, in
part because of the passage of time,
documentation was not always available; the
documentation that was available was often
dispersed; and neither the Boies Firm nor the
Company had the benefit of information from
prior senior management of Tyco because the
former Chief Executive Officer, Chief
Financial Officer, and Chief Corporate Counsel
have all been under criminal indictment during
the course of this review and analysis. All
of these factors, as well as the Company's
past failure to document many decisions
contemporaneously, would have limited the
conclusions that could have been drawn
concerning individual accounting treatments in
any event. Nonetheless, for the actual
purposes of the work, as discussed above, the
Company believes that the scope and detail of
the review, and the documentation and
information available, was sufficient to reach
the conclusions discussed below.
The Company is not aware of any
systemic or significant fraud related to the
Company's financial statements or of any clear
accounting errors that would materially
adversely affect the Company's reported
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earnings or cash flow from operations for the
year 2003 and thereafter. However, as
discussed below, certain instances of
erroneous accounting entries have been
identified and corrected. In addition,
current management has concluded that, in the
past, the Company in general suffered from
poor documentation; inadequate policies and
procedures to prevent the misconduct of senior
executives that occurred; inadequate
procedures for proper corporate
authorizations; inadequate approval procedures
and documentation; a lack of oversight by
senior management at the corporate level; a
pattern of using aggressive accounting that,
even when not erroneous, was undertaken with
the purpose and effect of increasing reported
results above what they would have been if
more conservative accounting were used;
pressure on, and inducements to, segment and
unit managers to increase current earnings,
including by decisions as to what accounting
treatment to employ; and a lack of stated and
demonstrable commitment by former senior
corporate management to set appropriate
standards of ethics, integrity, accounting,
and corporate governance. . . .
Similarly, the Form 10-K's representation that new
management believed the financial statements were fairly stated
included the caveat:
There can be no assurances, however, that new
problems will not be found in the future. We
expect to continue to improve our controls
with each passing quarter. It will take some
time, however, before we have in place the
rigorous controls that our Board of Directors
and new senior management desire and our
shareholders deserve.
The Form 10-K sounded other cautionary notes as well.
Under "risk factors," in addition to cautioning that continuing
negative publicity and pending litigation could have a substantial
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negative impact on Tyco, the Form 10-K warned that more bad news
could be on the horizon:
We and others have received various
subpoenas and requests from the SEC, the
District Attorney of New York, and the U.S.
Attorney for the District of New Hampshire and
others seeking the production of voluminous
documents in connection with various
investigations into our governance,
management, operations, accounting and related
controls. We cannot predict when these
investigations will be completed, nor can we
predict what the results of these
investigations may be. It is possible that we
will be required to pay material fines,
consent to injunctions on future conduct, lose
the ability to conduct business with
government instrumentalities or suffer other
penalties, each of which could have a material
adverse effect on our business....
Perhaps most significantly, the Form 10-K also
specifically cautioned about on-going review by the SEC:
As of the filing date of this Form 10-
K, we continue to be engaged in a dialogue
with the SEC's Division of Corporation
Finance, as part of a routine review of our
periodic filings. While we believe that we
have resolved the material accounting issues
prior to filings there can be no assurance
that the resolution of the remaining comments
issued by the Staff will not necessitate one
or more amendments to this or prior periodic
reports.
Essentially, the warned-of hazard came to pass regarding ADT's
contract accounting. See Financial Acquisition Partners LP v.
Blackwell, 440 F.3d 278, 288-89 (5th Cir. 2006) ("what [the
company] warned might happen, did indeed happen"). All told, these
cautionary statements are far more concrete, in light of Tyco's
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circumstances, than vague "boilerplate" warnings. Compare Plotkin
v. IP Axess Inc., 407 F.3d 690, 697 (5th Cir. 2005). Moreover,
attempts to provide investors with warnings of risks generally
weaken the inference of scienter. See Geffon v. Micrion Corp., 249
F.3d 29, 37 (1st Cir. 2001). From this context, we proceed to
plaintiffs' specific allegations.
As to GAAP violations, there is nothing in the complaint
supporting an inference that Breen or Fitzgerald were directly
involved in these detailed accounting matters or had knowledge of
their alleged falsity. See Stone & Webster, 414 F.3d at 199
(nothing supporting inference that senior officers were involved in
details of accounting). While Fitzgerald, as chief financial
officer, might be expected to have some general supervisory role
over the accounting issues, he appeared on the scene only weeks
before the Form 8-K was prepared, and there is no indication that
he was aware of any impropriety. See id. Moreover, the
representations in Tyco's filings were, in essence, estimations of
whether the books still contained significant errors. Plaintiffs'
allegations fall short of establishing that these estimations were
unreasonable in light of the massive internal investigation. See
id. at 201. In sum, there are no alleged facts that strongly
suggest that the defendants knew any of the challenged statements
were false when made. See Credit Suisse, 431 F.3d at 49-50; see
also Blackwell, 440 F.3d at 289 (no factual allegations supporting
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inference that individual defendants knew true value of assets or
that discount rate or credit-loss assumption was improper).
Plaintiffs' reliance on the defendants' allegedly false
attribution of the restatement to EITF 02-16 is similarly flawed.
Obviously, evidence of conscious wrongdoing may be shown by facts
demonstrating concealment. See generally Cabletron, 311 F.3d at
39. But the allegations fall short again here. There is simply no
basis for concluding that the individual defendants were involved
in or had personal knowledge of this detailed accounting issue.
See Stone & Webster, 414 F.3d at 199.
Plaintiffs are correct that a short time period between
an alleged misstatement and a later disclosure of inconsistent
information may be relevant to the question of scienter. See Shaw
v. Digital Equip. Corp., 82 F.3d 1194, 1225 (1st Cir. 1996). In
this case, however, the timing of the correction has limited
probative value, as the change appears to have been prompted by
SEC's Division of Corporation Finance.7 The simple fact of a
7
Plaintiffs have moved the court to take judicial notice of the
SEC's 2006 complaint against Tyco in the United States District
Court for the Southern District of New York, the subsequent consent
decree, and the final judgment entered against Tyco (collectively
the "Consent Decree"). In the Consent Decree, Tyco agreed to pay a
50 million dollar civil fine and not to contest, inter alia, that
ADT's contract accounting was wrongful. We grant the motion.
We note that the SEC describes ADT's accounting practices
somewhat differently than do the plaintiffs. According to the SEC,
in 1997, Tyco began charging dealers a $200 connection fee when ADT
purchased their contracts while simultaneously increasing the price
ADT paid to the dealers by $200 (from $800 to $1000). Tyco then
classified this premium "paid" to the dealers a "growth bonus."
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correction is also not particularly probative; "[p]laintiffs may
not simply seize upon disclosures made later and allege that they
should have been made earlier." Cabletron, 311 F.3d at 37.
That the defendants were generally aware of Kozlowski's
relationship with Boggess also does not suffice. It is ordinarily
not sufficient to conclusorily allege "an overarching fraudulent
scheme or corrupt environment." Credit Suisse, 431 F.3d at 49.
Similarly, that there had been issues with ADT is not enough.
"Fraud cannot be inferred simply because [a parent corporation]
might have been more curious or concerned about the activity at [a
subsidiary]." Chill v. Gen. Elec. Co., 101 F.3d 263, 270 (2d Cir.
1996). Moreover, plaintiffs fail to account for both Breen's and
Fitzgerald's general unfamiliarity with Tyco.8 Indeed, the fact of
The $200 connection fee was immediately recognized as income, but
the offsetting $200 growth bonus was amortized over 10 years.
Because the connection fee and growth bonus cancelled each other
out, they did not alter the economic substance of the contract
acquisition, should not have been recognized under GAAP, and
significantly inflated Tyco's income and cash flow. The SEC noted
that Tyco terminated the connection fee and restated its operating
income and cash flow in 2003 as a result of a review by the SEC's
Division of Corporation Finance.
Plaintiffs assert that the SEC action validates their claims,
as the SEC found the same conduct that plaintiffs challenge to be
wrongful under the securities laws. However, the Consent Decree,
in addition to being three years after the fact, is of very limited
relevance. That the SEC concluded that an ADT accounting practice,
adopted in 1997 by past Tyco officers, was wrongful, adds little to
creating a strong inference of scienter on the part of current Tyco
officers.
8
Interestingly, Tyco noted the presence of new management
unfamiliar with Tyco in the midst of a clean up as a "Risk Factor"
in its Form 10-K:
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Breen's and Fitzpatrick's recent arrivals, and consequent lack of
involvement in past dubious decisions, undermines most of
plaintiffs' allegations.
This brings us to plaintiffs' allegations of motive and
opportunity. "'[C]atch-all allegations' which merely assert motive
and opportunity, without something more, fail to satisfy the
PSLRA." Cabletron, 311 F.3d at 39. The question becomes whether
plaintiffs have alleged "more than the usual concern by executives
to improve financial results." Id.
The key motivation alleged is Breen's and Fitzgerald's
desperation to save Tyco from bankruptcy. Plaintiffs rely on three
In the past few months, we have replaced our senior
management with entirely new members and our entire board
of directors determined not to stand for reelection at
our next annual general meeting of shareholders. It will
take some time for our new management team and our new
board of directors to learn our various businesses and to
develop strong working relationships with our cadre of
operating managers at our various subsidiary companies.
Our new senior management team's ability to complete this
process is hindered by their need to spend significant
time and effort dealing with internal and external
investigations, developing effective corporate governance
procedures, strengthening reporting lines and reviewing
internal controls. During this period and in order to
complete the process, our new executives will be in part
dependent on advisors, including certain former
directors. We cannot assure you that this major
restructuring of our board of directors and senior
management team will not adversely affect our results of
operations, at least in the near term, especially in
light of the significant attention they are required to
devote to such other matters.
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factual allegations to support the inference that Tyco faced
imminent bankruptcy: (1) that Tyco had to repay or refinance nearly
four billion dollars in debt in February 2003; (2) that Breen
acknowledged that Tyco faced a liquidity gap in 2003 if it failed
to obtain a one and a half billion dollar line of credit; and (3)
that some suppliers had requested letters of credit from Tyco.
These allegations are rather limited and conclusory, particularly
when set against Tyco's enormous assets (well over sixty billion
dollars worth, per the Form 10-K), significant shareholder equity
(over twenty-five billion dollars), and substantial going-concern
value (despite significant continued write-downs, Tyco earned
approximately a billion dollars in 2003 and its earnings have
climbed steadily since then). This collection of facts does not
support a strong inference of imminent bankruptcy. Cf. Baron v.
Smith, 380 F.3d 49, 57 (1st Cir. 2004)(an event of default is
different from an actual default).
Further, this case is different from those relied upon by
the plaintiffs. Here, the defendants were not acting to conceal
their own errors or justify their past strategic decisions.
Compare Cabletron, 311 F.3d at 38-39; Aldridge, 284 F.3d at 83-84.
In addition, the defendants' compensation appears to be largely
"up-front" or otherwise guaranteed, perhaps as an acknowledgment of
risk. As to their stock options, it is not at all clear why
defendants would prefer postponing profit reducing and stock price
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reducing write-downs to future years (when their options would have
vested) to swallowing the entire bitter pill in 2002.
The dueling inferences, taken as wholes, break down as
follows. Did the defendants, brought in to clean up a massive and
well-publicized fraud and actively scrutinized by the SEC,
financial media, and bar, fraudulently commit an accounting
violation (and fully document their fraud in Tyco's SEC filings) to
briefly delay recognition of an additional write-down in the ADT
books and present the illusion of a limited9 additional revenue
stream to obtain needed financing, only to reveal their wrongdoing
to all concerned (including their new creditors) in a subsequent
filing to the SEC shortly thereafter? Or did the new management,
having been advised by an internal investigation of errors in ADT's
accounting that required a 320 million dollar adjustment, believe
their job was done as to that subsidiary (one of approximately
2300), only to subsequently discover (with the SEC's assistance)
that ADT's books had more mischief to address than first realized?
Under all the facts and circumstances alleged, the second inference
is at least as strong as the first and thus dooms plaintiffs'
claims. See Credit Suisse, 431 F.3d at 49.
9
A 320 million dollar income stream to be recognized over ten
years (or 32 million dollars a year) would appear to be of limited
consequence in obtaining over four billion dollars in loans and
over an additional billion and a half dollars in credit, while
simultaneously recognizing a nine billion dollar loss.
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B. PwC
Plaintiffs emphasize the following allegations as
demonstrating PwC's scienter: (1) that the initial restatement of
the ADT books in 2002 was an "obvious" GAAP violation that resulted
in a significant second restatement less than three months later;
(2) that PwC committed a host of GAAS violations in connection with
its 2002 audit; (3) that Scalzo was intimately involved in the
creation of the 2002 financial statements; (4) that PwC was well
aware of prior bad acts by Tyco's former management and ignored the
numerous "red flags" implicated by those acts; and (5) that PwC had
an enormous financial incentive to keep Tyco as a client.
Plaintiffs stress that PwC specifically reaffirmed the validity of
the 2001 financial statements in its 2002 audit opinion, rendering
the prior misconduct relevant to the instant action. We again
conclude that the district court reached the correct result.
We first note, as did the district court, that plaintiffs
attempt to muddy the waters with their emphasis on 2001. The only
representations made by PwC challenged by plaintiffs in this action
are contained within PwC's 2002 audit opinion letter. While the
2002 audit opinion makes a passing reference to 2001, the fact
remains that plaintiffs' action targets representations, made at
the close of 2002, regarding ADT's contract acquisition accounting.
Plaintiffs have shown no connection between their current action
and any representations in the 2001 financial statements.
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Moreover, the prior misconduct relating to prior years' financial
statements had been disclosed in Tyco's 2002 filings. As before,
plaintiffs have overlooked the most important circumstances of the
case: that new management had been appointed and Tyco was
attempting to clean up its operations.
For that reason, plaintiffs' reliance on Scalzo's conduct
is unavailing. Indeed, the SEC's ruling banning Scalzo from
practicing accountancy before it specifically refers to his
wrongful conduct in the 1997 through 2001 fiscal years. While
plaintiffs assert that Scalzo was still assigned to Tyco in 2002,
the climate had changed. Given the internal investigation, new
management, massive restatements, and public scrutiny, it is not a
likely inference, based upon the factual allegations, that Scalzo
(to whatever extent that he remained involved) was still engaged in
the same wrongful conduct. And in any event, plaintiffs fail to
provide any specific allegations regarding Scalzo's involvement in
the 2002 financial statements. Furthermore, plaintiffs'
allegations that PwC disregarded various "red flags," based upon
its detailed knowledge of past misdeeds, is unavailing. Correcting
the past misstatements was the focus of the new management and the
internal investigation. Significantly, the SEC's ruling banning
Scalzo does not mention the dealer accounting issue at ADT (or
anything like it), making it questionable whether PwC would have
been aware of difficulties there. The presence of "red flags" not
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acted upon by an auditor is not sufficient to raise a strong
inference of scienter if there are no facts showing that the
auditor knew (or willfully blinded itself to the knowledge) that
the underlying facts, if properly accounted for, would result in
significant changes to audited financial statements. See Fidel v.
Farley, 392 F.3d 220, 229 (6th Cir. 2005).
Having cleared the underbrush, we now examine the
plaintiffs' remaining allegations against PwC. We start with the
alleged GAAP violation. "Merely stating in conclusory fashion that
a company's books are out of compliance with GAAP would not itself
demonstrate liability under section 10(b) or Rule 10b-5."
Cabletron, 311 F.3d at 34. Moreover, the circumstances are more
complex than plaintiffs indicate -- that intangible assets like the
contracts are recorded at actual cost pursuant to ARB 43. One
complication, as plaintiffs concede, is that "ARB 43" has no
relevance to this issue, as it was superceded long ago by
Accounting Principles Board Opinion 17 and Financial Accounting
Standards Board Opinion 147 (although plaintiffs maintain that the
underlying principle has remained the same). Another is that the
ADT contract acquisitions also included a connection fee (and a
growth bonus in the SEC's description). These additional
transactions make the accounting issue more complex, as ADT's
records create the impression that ADT in fact received cash from
a vendor, a circumstance that PwC notes is specifically dealt with
-25-
in EITF 02-16. See generally Greebel, 194 F.3d at 205 (GAAP can
tolerate a range of reasonable approaches). Plaintiffs presume
that it should have been obvious to PwC that the connection fee and
growth bonus were bogus entries that essentially netted out of the
contract price.10 However, there do not appear to be any facts
supporting this presumption.11 Simply pleading that the defendant
knew of the falsity, without providing any factual basis for that
knowledge, does not suffice. Stone & Webster, 414 F.3d at 205-06.
Further, that ADT's accounting was ultimately restated in
March 2003 does not raise a significant inference of scienter.
"[T]hat a speaker changes his or her mind and decides after the
fact that an earlier opinion was ill-advised is insufficient to
support an averment of subjective falsity." Credit Suisse, 431
F.3d at 49. Moreover, as noted above, Tyco was in ongoing
discussions with the SEC regarding its accounting practices, so
neither the change nor its timing adds to the scienter equation.
10
Even if one deemed PwC's failure to discover the problem
negligent, or perhaps inexcusably negligent, that is well short of
the conscious misconduct or extreme recklessness necessary to
allege scienter. See Geffon v. Micrion Corp., 249 F.3d 29, 35-36
(1st Cir. 2001). Alleging a poor audit is not equivalent to
alleging an intent to deceive. See Ferris Baker Watts, Inc. v.
Ernst & Young, LLP, 395 F.3d 851, 856 (8th Cir. 2005).
11
In their opening brief, plaintiffs state that prior "management
was corrupt, systematically bilking Tyco, and concealing its fraud
from public scrutiny." (Emphasis added). The disclosure statements
also note prior management's propensity towards making false
booking entries and failing to record material events that should
have been recorded.
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Similarly, the conclusorily presented "laundry list" of alleged
GAAS violations, which lack any specific ties to the alleged fraud
at issue, do not get plaintiffs far in creating a strong inference
of scienter. See Stone & Webster, 414 F.3d at 214.
Lastly, we come to allegations of PwC's financial motive.
"[A]bsent truly extraordinary circumstances, an auditor's
motivation to continue a profitable business relationship is not
sufficient by itself to support a strong inference of scienter."
Id. at 215. Because the balance of plaintiffs' allegations have
washed out, the less than extraordinary financial ties between PwC
and Tyco do not suffice.12
III.
For the reasons stated above, we affirm the judgment of
the district court.
12
As to the remaining claims, a Rule 10b-5 violation by the
controlled entity is an essential element of a § 20(a) controlling
person claim. See In Re Stone & Webster, Inc. Sec. Litig., 424 F.3d
24, 27 (1st Cir. 2005). Our rejection of the § 10(b) claims
therefore dooms the plaintiffs' claims against the defendants under
§ 20(a). See Credit Suisse, 431 F.3d at 53.
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