D.E. & J v. Conaway , 133 F. App'x 994 ( 2005 )

NOT RECOMMENDED FOR FULL-TEXT PUBLICATION
File Name: 05a0488n.06
Filed: June 10, 2005
Nos. 03-2334, 03-2417
UNITED STATES COURT OF APPEALS
FOR THE SIXTH CIRCUIT
D.E. & J. LIMITED PARTNERSHIP, )
Individually, and on behalf of All Others )
Similarly Situated, )
)
Plaintiffs-Appellants, )
)
v. ) ON APPEAL FROM THE UNITED
) STATES DISTRICT COURT FOR THE
CHARLES CONAWAY, JEFFREY BOYER, ) EASTERN DISTRICT OF MICHIGAN
MARK S. SCHWARTZ, MATTHEW F. )
HILZINGER, MARTIN E. WELCH and )
PRICEWATERHOUSECOOPERS LLP, )
)
Defendants-Appellees. )
Before: KENNEDY, DAUGHTREY, and SUTTON, Circuit Judges.
SUTTON, Circuit Judge. On January 22, 2002, Kmart Corporation, one of the most familiar
brands in discount retailing and one of the largest—operating through approximately 1,900 stores
with approximately 234,000 employees—filed for bankruptcy. Kmart’s bankruptcy announcement
was followed by a predictable drop in its stock price, by the restatement of some of its interim
financial reports and by this securities fraud lawsuit.
On February 21, 2002, D.E. & J. Limited Partnership filed this lawsuit on behalf of a class
of Kmart stockholders who purchased their stock from March 13, 2001, to May 15, 2002, against
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several of Kmart’s senior executives and its auditor, PricewaterhouseCoopers (PwC). The district
court dismissed D.E. & J.’s complaint with prejudice for failing to meet the pleading standards of
the Private Securities Litigation Reform Act (PSLRA). As the plaintiffs have failed adequately to
plead “loss causation” under 15 U.S.C. § 78u-4(b)(4) and Dura Pharmaceuticals, Inc. v. Broudo,
125 S. Ct. 1627 (2005), we affirm.
I.
Kmart is a Delaware Corporation. Its principal place of business is Troy, Michigan, where
it was first incorporated as the successor to the business developed by its founder, S.S. Kresge.
In May of 2000, Kmart hired Charles Conaway and gave him a mandate to revitalize the
discount-retail chain. During his tenure as Kmart’s Chairman and Chief Executive Officer from
May 2000 until his resignation in March of 2002, Conaway replaced much of Kmart’s existing
management. Two of the individual defendants in this case were among the officers that Conaway
hired or promoted during this period: Mark Schwartz, who was Kmart’s President and Chief
Operating Officer from March 14, 2001, until November 9, 2001; and Jeffrey Boyer, who was
Kmart’s Chief Financial Officer from May 4, 2001, until November 9, 2001. The other two named
individual defendants were among those officers whom Conaway replaced at the very beginning of
the class period: Matthew Hilzinger, who was Kmart’s Vice President and Controller until July
2001; and Martin Welch, who was Kmart’s Executive Vice President and Chief Financial Officer
until May of 2001.
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In order to compete more effectively with Kmart’s two principal rivals, Wal-Mart Stores and
Target Corporation, Conaway implemented several projects intended to strengthen Kmart’s
inventory controls, customer service and price competitiveness. These initiatives achieved initial
success, with Kmart reporting improved sales and gross margins and an improving inventory
situation. The price of Kmart stock, as a result, rose from $9.19 per share on March 13, 2001, to
$13.16 per share on August 7, 2001, an increase of 43% at a time when the stock market was
generally stagnant or declining.
Kmart’s brief financial success during this period, D.E. & J. alleges, was the result of
accounting fraud. According to D.E. & J., senior executives at Kmart represented that Kmart was
experiencing a financial turnaround while concealing the extent of Kmart’s financial difficulties in
several ways. First, Kmart allegedly tried to mask losses by using interim financial statements that
reported rebates that it hoped to earn from its vendors at the end of the year. By reporting vendor
rebates as a reduction of expenses in interim statements and by basing its interim statements on
aggressive forecasts, Kmart ran the risk that it would not ultimately obtain all of the rebates and that
its interim statements would reflect unrealistically high projections of future sales. Second, Kmart’s
outdated internal control system failed to track and monitor inventory effectively, (1) reporting an
item as “in-stock” even if the company had only one piece of inventory, (2) causing stores to
accumulate obsolete merchandise and (3) ultimately misstating inventory ledgers. Third, Kmart’s
aggressive efforts to obtain discounts and other benefits from its vendors damaged the company’s
long-term relationships with its vendors. Fourth, Kmart’s expansion of its “Bluelight Special”
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discount program to a “Bluelight Always” program failed, because the company’s competitors
responded by cutting their prices as well. JA 0140.
By late 2001, whether as a result of fraud or not, it was clear that Conaway’s initiatives were
not succeeding. In October of 2001, the company disclosed that its sales had been flat during
September, and in November and December the company disclosed a decline in sales.
On January 22, 2002, Kmart filed for bankruptcy. In a press release, the company attributed
its bankruptcy filing to a “combination of factors, including a rapid decline in its liquidity resulting
from Kmart’s below-plan sales and earnings performance in the fourth quarter.” JA 0155. The price
of Kmart’s stock subsequently dropped from $1.74 to $0.70 per share.
On January 25, 2002, Kmart disclosed that it had received an anonymous “whistleblower”
letter expressing serious concerns about the Company’s accounting methods and financial results.
The anonymous author of the letter stated that he or she had “kept copies of transactions [he or she]
consider[ed] to be inaccurate” and “recorded conversations during which distortions and
misstatement[s] of records were discussed.” JA 0128. The letter directly implicated Schwartz and
PwC. See JA 0128 (reporting that Schwartz told a “superior to not be surprised if Kmart shares were
trading at four or five dollars per share by the end of the year”); id. (“Resident auditors from
PricewaterhouseCoopers are hesitant to pursue these issues or even question obvious changes in
revenue and expense patterns.”). Kmart announced that it would conduct an internal investigation
to look into the allegations. Three similar letters followed.
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On February 21, 2002, D.E. & J. brought this securities fraud lawsuit on behalf of purchasers
of Kmart securities between May 17, 2001, and January 22, 2002. The lawsuit initially named only
Conaway as a defendant.
On May 15, 2002, Kmart, in its Form 10-K disclosure for fiscal year 2001, reported a loss
of $2.42 billion for the year. In addition to adjusting for a single vendor transaction in 2001 and
moving a $167 million loss contingency from the fourth quarter to the third quarter (matters not at
issue here), Kmart announced that, due to the bankruptcy and resulting inability to estimate vendor
purchases and associated allowances, it had changed its policy of estimating and recording vendor
allowances on an interim basis. It then restated its financial statements to lower its vendor rebates
for the first three quarters of fiscal year 2001 (which until then had not been audited) by $311, $211
and $32 million respectively. In the disclosure, Kmart attributed its bankruptcy filing to a “rapid
decline in our liquidity resulting from our below-plan sales and earnings performance in the fourth
quarter, the evaporation of the surety bond market and erosion of supplier confidence,” and stated
that “[o]ther factors includ[ing] intense competition in the discount retailing industry, unsuccessful
sales and marketing initiatives, the continuing recession, and recent capital market volatility” played
a role as well. JA 0205. Following this announcement, Kmart’s common stock dropped five cents,
from $1.22 to $1.17 per share.
On June 14, 2002, Kmart announced a $1.45 billion loss during the first fiscal quarter of
2002. The company recorded a charge of $758 million to “write-down inventory in 283 stores that
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were closed in May and June, and inventory transferred from the remaining stores to the closing
stores.” JA 0158.
On August 15, 2002, D.E. & J. filed an amended complaint naming Boyer, Schwartz,
Hilzinger, Welch and PwC as defendants; attaching the whistleblower letters; and expanding the
class period to March 13, 2001, through May 15, 2002, five months longer than the period in the
original complaint. On November 1, 2002, D.E. & J. filed its “corrected consolidated amended
complaint,” declaring that its counsel had conducted interviews with “[f]ormer employees of Kmart,
who worked at the Company during the relevant time” and “[f]ormer employees of certain vendors
of Kmart,” both of whom, the complaint claimed, were “knowledgeable with respect to the matters
referred to herein.” JA 0125–26. Any remaining information, the complaint continued, was “within
the possession and control of defendants and other Kmart insiders, thus preventing plaintiffs from
further detailing defendants’ misconduct at this time.” JA 0126. The complaint reiterated the
expanded class period of March 13, 2001, to May 15, 2002.
On September 19, 2003, the district court dismissed all of the claims with prejudice. In
doing so, it determined that D.E. & J. had failed to meet the PSLRA’s pleading requirements for
scienter and misrepresentation for all defendants except Conaway and Schwartz. The court
dismissed the complaint in its entirety, however, because D.E. & J. had failed to plead the necessary
element of “loss causation” for any of its allegations. Because D.E. & J. had failed to plead primary
violations of § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), by any of the
defendants, the district court also found that it had failed to plead that they were “controlling
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persons” liable under § 20(a) of the Act, 15 U.S.C. § 78t(a). And the district court denied D.E. &
J. leave to amend its complaint, first and foremost because, instead of filing a motion for leave to
amend, it had merely requested in its brief that “if the Court concludes that any aspect of plaintiffs’
claims are inadequately pled . . . [the plaintiffs] be granted leave to replead and cure any
deficiencies.” D. Ct. Op. at 58.
II.
D.E. & J. appeals the dismissal of its § 10(b) claims against all parties save for Boyer,
Hilzinger and Welch and appeals the dismissal of its § 20(a) claims against all parties. We review
the district court’s dismissal of the complaint de novo. Helwig v. Vencor, Inc., 251 F.3d 540, 553
(6th Cir. 2001).
A.
Section 10(b) of the Securities Exchange Act of 1934 forbids (1) the “use or employ[ment]”
of any “deceptive device,” (2) “in connection with the purchase or sale of any security,” and (3) “in
contravention of” Securities and Exchange Commission “rules and regulations.” 15 U.S.C. § 78j(b).
Promulgated under this statute by the Securities and Exchange Commission, Rule 10b-5 forbids the
making of any “untrue statement of material fact” or the omission of any material fact “necessary
in order to make the statements made . . . not misleading.” 17 C.F.R. § 240.10b-5(b).
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On the basis of this statute and this rule, individuals may bring a private damages action
resembling the common-law tort actions for deceit and misrepresentation. See, e.g., Blue Chip
Stamps v. Manor Drug Stores, 421 U.S. 723, 730, 744 (1975); Ernst & Ernst v. Hochfelder, 425 U.S.
185, 196 (1976). With the passage of the PSLRA, however, Congress has imposed additional
statutory requirements on this private action, including the heightened pleading requirements that
a plaintiff (1) specify “each statement alleged to have been misleading [and] the reason or reasons
why the statement is misleading” and (2) allege “facts giving rise to a strong inference that the
defendant acted with the required state of mind.” 15 U.S.C. § 78u-4(b)(1)–(2).
Under § 78u-4(b)(4) of the PSLRA, private plaintiffs also must prove that a defendant’s
securities fraud caused their economic loss. In relevant part, the statute says the following:
Loss causation. In any private action arising under this chapter, the plaintiff shall
have the burden of proving that the act or omission of the defendant alleged to
violate this chapter caused the loss for which the plaintiff seeks to recover damages.
15 U.S.C. § 78u-4(b)(4).
Construing this causation provision, Dura Pharmaceuticals v. Broudo recently held that a
plaintiff could not satisfy it merely by alleging (and later establishing) that the price of the security
on the date of the purchase was inflated because of the misrepresentation. 125 S. Ct. at 1631. In
Dura, the plaintiff represented a class of individuals who bought stock in Dura Pharmaceuticals on
the public market between April 15, 1997, and February 24, 1998. See id. at 1629. During that
period, the plaintiffs alleged, Dura (or its officials) made false statements concerning its profits and
the prospects for future approval by the Food and Drug Administration (FDA) of its products. Upon
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disclosure of the news on February 24, 1998, that its earnings would be lower than previously
expected (principally due to slow drug sales), Dura’s shares lost almost half of their value, falling
from $39 per share to about $21 per share. See id. at 1630. In November of 1998, Dura announced
that the FDA would not approve its new product, prompting a further drop in its share price. See
id. The plaintiffs argued that, “[i]n reliance on the integrity of the market, [they] . . . paid artificially
inflated prices for Dura securities and . . . suffered damage[s] thereby.” Id. (quotations and emphasis
omitted).
This type of allegation, the Supreme Court concluded, did not adequately plead loss
causation under the PSLRA. Because a purchaser may sell the “shares quickly before the relevant
truth begins to leak out,” id. at 1631, a seller’s misrepresentation (and its associated inflated price)
does not inevitably lead to a loss, but rather “might mean a later loss,” id. at 1632. Even if the
purchaser later resells those shares at a lower price, “that lower price may reflect, not the earlier
misrepresentation, but changed economic circumstances, changed investor expectations, new
industry-specific or firm-specific facts, conditions, or other events, which taken separately or
together account for some or all of that lower price.” Id. “[A]t the moment the transaction takes
place,” therefore, “the plaintiff has suffered no loss,” id. at 1631, and the most than can be said “is
that the higher purchase price will sometimes play a role in bringing about a future loss,” id. at 1632.
Drawing on this insight and on the observation that securities-fraud actions resemble
common-law fraud actions that have long required a showing that an individual suffered actual
economic loss, the Court held that private securities-fraud plaintiffs may recover damages only when
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they “adequately allege and prove the traditional elements of causation and loss.” Id. at 1633. And
although the Federal Rules of Civil Procedure require only “a short and plain statement of the claim
showing that the pleader is entitled to relief,” see Fed. R. Civ. P. 8(a)(2), the mere allegation that the
plaintiff class purchased their shares at an artificially inflated price did not serve to place the
defendants on “fair notice of what the plaintiff’s claim is and the grounds upon which it rests.” Id.
at 1634 (quoting Conley v. Gibson, 355 U.S. 41, 47 (1957)). The Dura complaint (1) failed “to
claim that Dura’s share price fell significantly after the truth became known,” (2) failed to specify
“the relevant economic loss,” and (3) failed to describe “the causal connection . . . between [the] loss
and the misrepresentation.” Id. Without the requirement that a plaintiff “provide a defendant with
some indication of the loss and the causal connection that the plaintiff has in mind,” the Court
concluded, the securities laws would become nothing more than “a partial downside insurance
policy.” Id.
D.E. & J.’s complaint here does not differ in any material respect from Broudo’s. Like
Broudo, D.E. & J. did not plead that the alleged fraud became known to the market on any particular
day, did not estimate the damages that the alleged fraud caused, and did not connect the alleged
fraud with the ultimate disclosure and loss. Rather, the heart of D.E. & J.’s causation theory looks
remarkably like Broudo’s allegations in his complaint:
Plaintiffs and the Class have suffered damages in that, in reliance on the integrity of
the market, they paid artificially inflated prices for Kmart publicly traded securities.
Plaintiffs and the Class would not have purchased Kmart publicly traded securities
at the prices they paid, or at all, if they had been aware that the market prices had
been artificially and falsely inflated by defendants’ misleading statements.
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As a direct and proximate result of defendants’ wrongful conduct, plaintiffs and the
other members of the Class suffered damages in connection with their purchases of
Kmart publicly traded securities during the class period.
JA 0189–90 (emphasis added). The recitation of D.E. & J.’s belief that the “defendants’ wrongful
conduct” “direct[ly] and proximate[ly]” caused the plaintiffs’ losses does not change matters. For
if these allegations would suffice here, the mere inclusion of boilerplate language would suffice
everywhere and would defeat the requirement that a plaintiff explain how the loss occurred.
In D.E. & J.’s view, two other facets of this case distinguish it from the pleading failings that
doomed the complaint in Dura. First, D.E. & J. claims that the complaint’s observation that the
price of Kmart stock dropped from $1.74 per share to $0.70 per share on January 22, 2002,
following the company’s disclosure that it had filed for reorganization under Chapter 11, suffices
to plead that Kmart caused the investors’ losses. See JA 0155. And second, D.E. & J. asserts that
its observation on appeal that “Kmart’s stock did drop more than 4%” on the day that Kmart
announced its restatements (May 15, 2002) suffices to meet the statutory requirement. See D.E. &
J. Br. at 36–37; id. at 28 (“[T]he price of Kmart’s stock did decline after the Company announced
its massive restatement.”).
Neither of these observations (one in the complaint, the other on appeal) “provide[d] the
defendants with notice of what the relevant economic loss might be or of what the causal connection
might be between the loss and the misrepresentation.” Dura, 125 S. Ct. at 1634. As to the
bankruptcy filing, D.E. & J. never alleged that Kmart’s bankruptcy announcement disclosed any
prior misrepresentations to the market. See JA 0155 (observing only that “[a]ccording to [Kmart’s]
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press release, the Company’s decision to seek ‘judicial reorganization’ was based on a ‘combination
of factors, including a rapid decline in its liquidity resulting from Kmart’s below-plan sales and
earnings performance in the fourth quarter’” and that “[f]ollowing this announcement, the price of
Kmart common stock dropped”). And, of course, the filing of a bankruptcy petition by itself does
not a security fraud allegation make. Cf. Lentell v. Merrill Lynch & Co., 396 F.3d 161, 175 n.4 (2d
Cir. 2005) (explaining that defendant Merrill Lynch’s downgrades in its stock
recommendations—from “accumulate” to “neutral” and from “buy” to “accumulate”—did “not
amount to a corrective disclosure . . . because they do not reveal to the market the falsity of the prior
recommendations”). Here, D.E. & J. has done nothing more than note that a stock price dropped
after a bankruptcy announcement, never alleging that the market’s acknowledgment of prior
misrepresentations caused that drop. But the observation that a stock price dropped on a particular
day, whether as a result of a bankruptcy or not, is not the same as an allegation that a defendant’s
fraud caused the loss.
As to the stock price drop following Kmart’s restatements, D.E. & J. never mentioned in its
complaint the five cent drop in Kmart’s stock prices on May 15, 2002, the day Kmart announced its
restatements. By failing even to note that Kmart’s stock dropped in price after the company restated
its financial records and by failing to present this argument to the district court, D.E. & J. simply
never pleaded that the defendants’ alleged misrepresentations caused economic losses on May 15,
2002. Ultimately, as in Dura, D.E. & J. has said “the following (and nothing significantly more than
the following) about economic losses attributable to the . . . misstatement,” 125 S. Ct. at 1630:
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“Plaintiffs and the Class have suffered damages in that, in reliance on the integrity of the market,
they paid artificially inflated prices for Kmart publicly traded securities.” JA 0189. And ultimately,
as in Dura, that pleading does not satisfy the PSLRA’s loss causation requirement.
B.
D.E. & J. also seeks to hold each of the individual defendants liable as “controlling persons”
of Kmart under § 20(a) of the Exchange Act. That provision extends liability to
Every person who, directly or indirectly, controls any person liable under any
provision of this chapter or of any rule or regulation thereunder . . . unless the
controlling person acted in good faith and did not directly induce the act or acts
constituting the violation or cause of action.
15 U.S.C. § 78t(a); see also 17 C.F.R. § 240.12b-2 (defining “control” as “the power to direct or
cause the direction of the management and policies of a [company], whether through the ownership
of voting securities, by contract, or otherwise”).
Because “controlling person” liability is derivative, however, a plaintiff may hold a
defendant liable under this theory only if the defendant controlled an entity that violated the
Securities Act. D.E. & J. has not charged Kmart with a violation of the Securities Act, and
accordingly it may not bring a claim for recovery under this theory. See PR Diamonds, Inc. v.
Chandler, 364 F.3d 671, 696–98 (6th Cir. 2004); In re Comshare Inc. Sec. Litig., 183 F.3d 542, 554
n.11 (6th Cir. 1999); Moss v. Morgan Stanley, Inc., 719 F.2d 5, 17 (2d Cir. 1983). The district court
properly rejected this claim on the pleadings.
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III.
Lastly, we do not believe that the district court abused its discretion in denying D.E. & J. an
opportunity to file what would have amounted to a fourth complaint. See Miller v. Champion
Enters., Inc., 346 F.3d 660, 671 (6th Cir. 2003); Parry v. Mohawk Motors of Michigan, Inc., 236
F.3d 299, 306 (6th Cir. 2000). D.E. & J. did not file a formal motion for leave to amend in this case
and did not submit a proposed amended complaint to the district court, in contravention of local
rules. See E.D. Mich. Local R. 15.1 (“A party who moves to amend a pleading shall attach the
proposed amended pleading to the motion.”). The sole way in which D.E. & J. indicated that it
wished to amend its complaint was by “request[ing], almost as an aside in their brief opposing
Defendants’ motions to dismiss, that ‘if the Court concludes that any aspect of the plaintiffs’ claims
are inadequately pled . . . that they be granted leave to replead and cure any deficiencies identified
by the Court.’” D. Ct. Op. at 58. See JA 0847 (requesting “an opportunity to amend” the complaint
“if the Court deems the claims [ ] insufficiently pleaded”). The district court did not abuse its
discretion in choosing not to credit this statement in a brief as a motion to amend where D.E. & J.
previously had been given two opportunities to amend its complaint. See PR Diamonds, 364 F.3d
at 698–700 (upholding the district court’s denial of leave to amend where the plaintiffs made the
following request in a brief opposing the defendants’ motions to dismiss: “Alternatively, in the event
the Court grants any part of the Defendants’ motions to dismiss, plaintiffs respectfully request leave
to amend their Complaint”); Begala v. PNC Bank, Ohio, Nat’l Ass’n, 214 F.3d 776, 784 (6th Cir.
2000) (affirming denial of leave to amend because “[w]hat plaintiffs may have stated, almost as an
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aside, to the district court in a memorandum in opposition to the defendant’s motion to dismiss is
[ ] not a motion to amend”); see also id. (plaintiffs cannot expect “an advisory opinion from the
Court informing them of the deficiencies of the complaint and then an opportunity to cure those
deficiencies”) (emphasis omitted); Parry, 236 F.3d at 306 (“[A] party requesting leave to amend
must ‘act with due diligence if it wants to take advantage of the Rule’s liberality.’”) (quotations and
citation omitted).
IV.
For these reasons, we affirm.
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