The opinion of the court was delivered by: LECHNER, JR.
ALFRED J. LECHNER, JR., UNITED STATES DISTRICT JUDGE
This is an action brought by holders of common stock of Coated Sales, Inc. ("Coated Sales" or the "Company"). The individual defendants include Bruce M. Bloom, Richard Bober, Ernest Glantz, Michael S. Weinstein, Dennis Lustig, and Philip I. Kagan ("Kagan"). These individuals are or were high level officers of Coated Sales and, in the case of Kagan, an outside director and attorney for the Company. Other defendants include Coated Sales, now in bankruptcy proceedings, and Peat Marwick Main & Co. ("PMM"), the former independent auditors for Coated Sales. Separate motions have been filed by PMM and Kagan attacking the sufficiency of plaintiffs' Consolidated Amended Class Action Complaint (the "Amended Complaint").
Count I of the Amended Complaint is asserted pursuant to Sections 10(b) and 20(a)
of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. §§ 78j(b) (1982) and 78t(a) (1982), and Rule 10b-5 promulgated under Section 10(b). Count II of the Amended Complaint alleges common law fraud and deceit under the law of the State of New Jersey. Count III of the Amended Complaint asserts a claim of negligent misrepresentation, again based upon New Jersey law.
PMM's motion requests a dismissal of Count I pursuant to Fed. R. Civ. P. 12(b)(6) (for failure to allege necessary elements, or adequate substitutes therefor, of the securities fraud claims) and Fed. R. Civ. P. 9(b) (for failure to allege fraud as to PMM's reports with particularity). PMM's motion requests a dismissal of Counts II and III on the grounds that, if Count I is dismissed, there will exist no independent basis for federal jurisdiction, and, as well, pursuant to Fed. R. Civ. P. 9(b); 12(b)(1) and 12(b)(6).
Coated Sales, incorporated under the laws of the State of New Jersey in 1974, develops and sells specially treated fabrics to industry and government. Coated Sales became a public company in 1984 when it offered shares of common stock registered on Form S-1 under the Securities Act of 1933 (the "Securities Act"), 15 U.S.C. § 77a et seq., the Securities and Exchange Commission ("SEC") form which relatively new and unseasoned corporate issuers are required to use for securities offerings.
The Company's publicly held securities are not listed on a national exchange, but instead are traded in the "over-the-counter" market (a reporting network in which transactions in securities are reported to the National Association of Securities Dealers for publication) and listed on the NASDAQ automated national quotation system ("NASDAQ"). According to the Amended Complaint, during the class period
Coated Sales had approximately 19,000,000 shares of stock outstanding which were held by approximately 1200 holders. Amended Complaint para. 10. The Amended Complaint contains no other factual allegations indicating the degree to which the Company's stock was traded or followed by investors and analysts; it does not allege in plain words or otherwise the market for Coated Sales stock was efficient or well-developed.
As is sometimes the case with new "growth companies," Coated Sales found itself in a bankruptcy situation (Chapter 11 filing made on June 16, 1988) after learning from PMM that the Company's financial well being had been overstated in the last two years. PMM had been the independent public auditor for Coated Sales until it resigned, as announced by the Board of Directors of the Company on May 23, 1988. Although not overly critical to most aspects of the present motions, a short summary of the Company's troubles is useful.
In addition, the Amended Complaint alleges Company officers perpetrated a significant fraud beginning in the Fall of 1987 in connection with a phony equipment acquisition. These officers stated an equipment manufacturer received $ 6,000,000 from Coated Sales as a deposit on the machinery; this amount was capitalized and classified on the balance sheet as part of the current assets. It is asserted that on May 6, 1988, PMM learned the $ 6,000,000 deposit for machinery was a sham transaction and reported this to the Company's Board of Directors at its May 20, 1988 meeting. On May 23, 1988 Coated Sales announced PMM had resigned as the Company's auditors because it was dissatisfied with representations regarding the alleged $ 6,000,000 payment for machinery in October, 1987 and determined it could not rely on the representations of management.
In response to PMM's resignation, the Board appointed an outside director to investigate the $ 6,000,000 transaction. As a result of the investigation, Coated Sales conceded on May 31, 1988 that the $ 6,000,000 "deposit" on machinery reportedly made in October, 1987 and the $ 6,000,000 "receipt" by the supposed equipment manufacturer in May 1988 of a deposit never took place. The Company conceded the net assets reported as of November 30, 1987 and May 17, 1988 were overstated by $ 6,000,000. The Company also conceded that "material irregularities in the booking of accounts receivable were discovered" and stated that "many of the individual defendants were being terminated from their senior management positions." Amended Complaint para. 34(a).
On May 31, 1988 a press release was issued concerning the foregoing events. Following the announcement on May 31, 1988 the market price of Coated Sales common stock dropped 2 1/8 points per share. During the Class Period, the stock reached a high of $ 12 per share. Amended Complaint para. 35. It is not clear from the Amended Complaint how quickly the 2 1/8 point per share drop occurred. Furthermore, while it appears from this allegation that Coated Sales stock declined during the Class Period, it is not possible to determine from the Amended Complaint to what extent various changes in the price occurred in response to specific information released by the Company during the period.
The vast majority of the allegations contained in the Amended Complaint, and indeed all of the allegations relating to the culpable acts referred to above, are made against individual defendants Weinstein, Bober, Bloom, Glantz and Lustig, the top management of Coated Sales. As to PMM, the Amended Complaint alleges Coated Sales' 1987 fiscal year and financial statements were fraudulent and PMM nonetheless issued its unqualified opinion that the financial statements had been audited by PMM in accordance with generally accepted auditing standards ("GAAS") and fairly represented the financial position of Coated Sales under generally accepted accounting principles ("GAAP").
The Amended Complaint recites in detail what auditing steps should have been taken, and what accounting treatment should have occurred, under GAAS and GAAP and further states how various accounting principles and standards were violated in this case. For example, the Amended Complaint alleges PMM violated GAAP by permitting Coated Sales to book material amounts of revenue in fiscal 1987 from the fictitious "bill and hold" transactions. PMM was allegedly required under GAAS to take greater than usual care in auditing these transactions because GAAP does not allow such revenues to be recorded prior to shipment, absent a compelling business purpose, and because of the unusual legend contained on the invoices: "Do Not Call." In addition, the Amended Complaint alleges PMM delayed unreasonably in bringing the financial irregularities to the attention of the Company's Board of Directors at its regular meeting on May 20, 1988, some two weeks after PMM discovered them.
The financial statements, along with PMM's opinion, were contained in Coated Sales' 1987 Annual Report and 10-K Report.
PMM's present motion centers on the issue of reliance which, as discussed below, is a necessary element to a securities fraud lawsuit. It is not clearly alleged in the Amended Complaint, however, any of the plaintiffs directly relied on the annual reports in purchasing their shares of Coated Sales stock. The Amended Complaint is ambiguous on this issue.
It appears the issue of individual reliance was never taken seriously by plaintiffs in this litigation until very recently in the latest of several rounds of briefing. Although they appeared to rely primarily on the fraud on the market theory (as a substitute for individual reliance)
in their "early round submissions," plaintiffs, responding to a recent suggestion that this issue be promptly investigated, belatedly made testimonial and legal submissions which, at least as to some named plaintiffs, purportedly demonstrate direct and indirect reliance on the PMM 1987 audit report.
As discussed later, PMM's motion will be treated under Rule 56 and factual assertions contained in the recent submissions will be taken into account.
At the Hearing, plaintiffs' counsel summarized the reliance situation in this litigation as follows: some plaintiffs directly relied upon the PMM report; some plaintiffs relied upon the PMM report, but indirectly through the advice of third parties such as brokers or family members who themselves read it; some plaintiffs relied on the "efficiency of the market" to reflect the content of the PMM report and other data released by the Company in the price of the Coated Sales stock; and some plaintiffs assert a combination of the foregoing forms of reliance. It was suggested at the Hearing multiple classes may well be sought to be certified, perhaps with certain stipulations to be entered into between the parties. It was represented by plaintiffs' counsel at the Hearing that there existed a sufficient number of plaintiffs who directly relied upon the PMM report, so that the numerosity prerequisite to such a class certification could be met.
To the extent direct reliance is deemed to have been asserted (by at least some plaintiffs), PMM's motion to dismiss on summary grounds must clearly be denied. The strong impression created in this lawsuit, however, is that, of the several investors who purchased Coated Sales stock during the Class Period, most of them will depend on the availability of the fraud on the market presumption of reliance.
If it is available, of course, all plaintiffs can assert fraud on the market and obviate the need to prove individual reliance (at least as to the federal securities law claims).
While there may ultimately exist other issues concerning reliance in this case (some of which may be legal), PMM's motion is treated as a Rule 56 motion to dismiss the fraud on the market theory in this case because it contends, as a matter of law, Coated Sales stock traded in an inefficient market. PMM's motion to dismiss the state law claims, which require direct reliance, is also treated under rule 56.
The Amended Complaint alleges Kagan was Assistant Secretary and Director of the Company. In addition, Kagan derived personal income from Coated Sales as counsel to the company during the Class Period.
On June 29, 1987, Kagan sold 2,000 shares of Coated Sales common stock. During the period between April 13, 1988 and April 18, 1988, Kagan sold an additional 10,000 shares of common stock of Coated Sales which yielded approximately $ 125,000. Amended Complaint at para. 6(f). In addition, as part of its allegations against "all defendants," the Complaint basically alleges Kagan had readily available to him the underlying facts concerning the financial misstatements and he either knowingly or wrecklessly participated in the Coated Sales fraud. Complaint para. 50.
I. Fraud on the Market Theory
Plaintiffs have alleged PMM audited Coated Sales' financial statements for fiscal year 1987 and that PMM issued an unqualified opinion on those financials. Section 10 of the Exchange Act provides that:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange -
(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
15 U.S.C. § 78j. Subsequent to passage of the Exchange Act, the SEC promulgated Rule 10b-5, providing that:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) to employ any device, scheme, or artifice to defraud,
(b) 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, or
17 C.F.R. § 240.10b-5. To prevail in an action brought under Rule 10b-5, a plaintiff must establish six elements: (1) a false representation of (2) a material (3) fact; (4) defendant's knowledge of its falsity and his intention that plaintiff rely on it; (5) the plaintiff's reasonable reliance thereon; and (6) his resultant loss. See Peil v. Speiser, 806 F.2d 1154, 1160 (3d Cir. 1986); 3 Loss, Securities Regulation 1431 (1961). While there is little dispute plaintiffs asserting § 10(b) claims must generally satisfy all of these requirements, only the reliance requirement is of concern here.
It is settled a plaintiff asserting a claim under Rule 10b-5 can satisfy the reliance element by asserting, in appropriate cases, the fraud on the market theory rather than alleging direct reliance on a defendant's misrepresentations. See Basic v. Levinson, 485 U.S. 224, 108 S. Ct. 978, 989-91, 99 L. Ed. 2d 194 (1988); Peil v. Speiser, 806 F.2d at 1160-1161; Blackie v. Barrack, 524 F.2d 891, 907 (9th Cir. 1975), cert. denied, 429 U.S. 816, 50 L. Ed. 2d 75, 97 S. Ct. 57 (1976). As the Supreme Court succinctly explained in Basic :
"The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company's stock is determined by the available material information regarding the company and its business. . . . Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements. . . . The causal connection between the defendants' fraud and the plaintiffs' purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations."
108 S. Ct. at 988-89 (citations omitted). A specific holding in the Third Circuit's Peil decision was that "plaintiffs who purchase in an open and developed market need not prove direct reliance on defendants' [material] misrepresentations" -- only that defendants made such misrepresentations. 806 F.2d at 1161.
Although Peil makes it clear "the fraud on the market theory rests on the assumption that there is a nearly perfect market of information," id. at 1161 n. 10, the Third Circuit affirmatively declined to specifically define the term "open and developed market."
It stated that "as the case at bar involves a widely traded and established stock, we need not consider whether we would apply the fraud on the market theory in other instances." Id. This unanswered question in Peil goes to the heart of PMM's motion.
PMM does not question the validity of the fraud on the market theory in general, but argues it has no application here, because plaintiffs have failed to allege (and cannot prove as a matter of fact) Coated Sales stock trades actively in an "open and developed" securities market, such as the New York or American Stock Exchanges. PMM also points out Coated Sales was not such a seasoned company that it was entitled to register new securities using SEC Form S-3.
As indicated above, the Company's stock traded in the "over-the-counter" market. Although some may concur with PMM's suggestion -- which was doubtless unintended -- that companies listed on national stock exchanges
or companies entitled to issue new securities using SEC Form S-3 would almost by definition involve stocks trading in an "open and developed" market, it is less clear that companies without these distinctions necessarily trade outside of an "open and developed" market.
Plaintiffs have cited in their briefs cases in which the fraud on the market theory was allowed where the stock in question was traded in the over-the-counter market. E.g., Finkel v. Docutel/Olivetti Corp., 817 F.2d 356 (5th Cir. 1987), cert. denied, 485 U.S. 959, 99 L. Ed. 2d 421, 108 S. Ct. 1220 (1988); Teichler v. DSC Communications Corp., 1988 U.S. Dist. LEXIS 16448, No. CA3-85-2005-T (N.D.Tex. Apr. 26, 1988); In re Electro-Catheter Secs. Lit., 1987 U.S. Dist. LEXIS 13500 [1987-88]Fed.Sec.L.Rep. (CCH) Para. 93,643 1987 WL 47375 (D.N.J. Dec. 3, 1987); Gavron v. Blinder Robinson & Co., Inc., 115 F.R.D. 318 (E.D.Pa. 1987); Klein v. A.G. Becker Paribas, Inc., 109 F.R.D. 646 (S.D.N.Y. 1986); Mottoros v. Abrams, 524 F. Supp. 254 (N.D.Ill. 1981). In none of these cases, however, was the question of whether the over-the-counter stock traded in an efficient or developed market squarely addressed.
PMM, on the other hand, has referred in its briefs to at least two cases which contain language suggesting that stocks trading over-the-counter are not ripe for application of the fraud-on-the-market theory. See Epstein v. American Reserve Corp., No. 79 C 4767, (N.D.Ill. 1988); In re Data Access Systems Securities Litigation, 103 F.R.D. 130, 138 (D.N.J. 1984) (dicta), rev'd on other grounds, 843 F.2d 1537 (3d Cir. 1988). These cases, however, do not provide any analysis of why over-the-counter stocks do not qualify for fraud-on-the-market treatment. They simply conclude such stocks do not trade in "open and developed" markets.
The question of whether the fraud on the market theory can substitute for direct reliance in any given case is both a legal and a factual one: is the market in which a particular company's stock trades efficient and well-developed. See generally Fleming, Securities Fraud -- Third Circuit adopts Fraud-On-The-Market Theory of Causation In 10b-5 Actions, 32 Vill. L. Rev. 913, 936 N. 85 (1987) (hereinafter "Fleming") ("term 'developed markets' generally refers to large impersonal, actively traded markets. . . . Such markets can be contrasted with 'undeveloped markets', such as thin markets and markets for new offerings and restricted resale securities" (citing cases)). There must, then, be a factual inquiry
made into whether Coated Sales stock was traded on a "thin market."
Before discussing the kinds of facts which suggest the existence of an efficient ("open and developed") market, it is important to address two points. First, it is necessary to state why the Rule 56 standard rather than the Rule 12(b)(6) standard is applied to PMM's motion. Second, it is important to address two bright-line tests for efficiency of the market offered by PMM. In short, PMM submits that listing on a national stock exchange or status as an issuer eligible to register securities on SEC Form S-3 should be considered prerequisites to an efficient market. PMM argues that, because Coated Sales stock fails to meet either of the two bright-line tests, the court should conclude the market in question is inefficient as a matter of law.
As indicated, PMM and Kagan have brought their motions as motions to dismiss under Rule 12(b)(6). If PMM's fraud on the market motion were to be treated under Fed. R. Civ. P. 12(b)(6), the question would be whether plaintiffs have alleged in the Amended Complaint that the Company's stock traded in an efficient or "open and developed market," Peil, supra, 806 F.2d at 1161, or whether any of the facts alleged give rise to such an inference. As the Supreme Court stated in Conley v. Gibson, 355 U.S. 41, 45-46, 2 L. Ed. 2d 80, 78 S. Ct. 99 (1957):
In appraising the sufficiency of the complaint we follow, of course, the accepted rule that a complaint should not be dismissed for failure to state a claim 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.
Accord, Cruz v. Beto, 405 U.S. 319, 321, 31 L. Ed. 2d 263, 92 S. Ct. 1079 (1972); Angelastro v. Prudential-Bache Securities, 764 F.2d 939 (3d Cir. 1985), cert. denied, 474 U.S. 935, 106 S. Ct. 267, 88 L. Ed. 2d 274 (1985). Indeed, the Supreme Court has stated that a Rule 12 motion should not succeed unless the complaint is found to be "wholly frivolous." Radovich v. National Football League, 352 U.S. 445, 453, 1 L. Ed. 2d 456, 77 S. Ct. 390 (1957). As articulated in this Circuit, the standard to be applied in a motion under Fed. R. Civ. P. 12(b)(6) is whether, after construing the pleading in the light most favorable to the plaintiff, and resolving every doubt in his favor, the pleading states any valid claim for relief. Mortensen v. First Federal Savings and Loan Ass'n, 549 F.2d 884, 891 (3d Cir. 1977).
The Amended Complaint, however, does not contain any specific allegations that Coated Sales stock traded in an efficient or "open and developed" market. Nor does it allege the kinds of facts, discussed below, from which it can be inferred Coated Sales traded in such a market.
Plaintiffs' counsel, Milberg Weiss, submitted an amicus brief to the Supreme Court in the Basic litigation on these very issues and are keenly aware of the pleading requirements to invoke the fraud on the market theory.
While the Amended Complaint -- which is the product of twenty-nine capable law firms collaborating on essentially the eighteenth draft -- is void of facts which would support the invocation of the fraud on the market theory, plaintiffs have belatedly submitted the Poser Affidavit and numerous other submissions which, they argue, amply demonstrate the efficiency of the market. Furthermore, plaintiffs have requested leave to amend the Amended Complaint yet another time to assert the additional facts contained in the Poser Affidavit should it be determined the Amended Complaint, as currently drafted, is insufficient. Plaintiffs' Third Brief, p. 10.
PMM, on the other hand, previously argued plaintiffs have already filed eighteen complaints and "enough is enough." PMM contended "while leave to amend is freely granted" under Fed. R. Civ. P. 15, it should not be granted here where, even considering the contents contained in plaintiffs' new submissions, plaintiffs cannot prove Coated Sales (trading in the over-the-counter market) trades in an efficient market. PMM's Third Brief, pp. 46-47. The Amended Complaint, as currently drafted, is woefully deficient as far as the "fraud on the market theory" is concerned (and plaintiffs have had more than ample opportunity to perfect the pleadings); however, it appears genuine factual issues concerning the "character of the market" have been raised by plaintiffs' recent submissions. Plaintiffs' request for leave to further amend the Amended Complaint to set forth the facts, detail and allegation as set forth in the Finkle & Ross Complaint is granted. See discussion at footnote 10.
Although leave has been granted to allow plaintiffs to further amend the Amended Complaint, for present purposes consideration will be given to the contents of the Poser Affidavit (along with other recent submissions) and PMM's Rule 12(b)(6) motion will be treated as a motion for summary judgment under Rule 56.
The Federal Rules of Civil Procedure provide that a Rule 12(b)(6) motion to dismiss for failure to state a claim shall be converted to a motion for summary judgment under Rule 56 whenever matters submitted outside the pleading are considered by the court. Fed. R. Civ. P. 12(b).
Because of the review and consideration of matters outside the pleading in this case which are sufficient to require a determination of the motion on summary judgment, the summary judgment standard under Fed. R. Civ. P. 56 will be applied.
To prevail on a motion for summary judgment, the moving party must establish "there is no genuine issue as to any material fact and that [it] is entitled to judgment as a matter of law." Fed. R. Civ. P. 56(c). The district court's task is to determine whether disputed issues of fact exist, but the court cannot resolve factual disputes in a motion for summary judgment. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 249-50, 91 L. Ed. 2d 202, 106 S. Ct. 2505 (1986). All evidence submitted must be viewed in a light most favorable to the party opposing the motion. See Matsushita Elec. Industrial Co., Ltd. v. Zenith Radio Corp., 475 U.S. 574, 587, 89 L. Ed. 2d 538, 106 S. Ct. 1348 (1986).
Although the summary judgment hurdle is a difficult one to overcome, it is by no means insurmountable. As the Supreme Court has stated, once the party seeking summary judgment has pointed out to the court the absence of a fact issue,
its opponent must do more than simply show that there is some metaphysical doubt as to the material facts. . . . In the language of the Rule, the non-moving party must come forward with 'specific facts showing that there is a genuine issue for trial.' . . . Where the record taken as a whole could not lead a rational trier ...