The opinion of the court was delivered by: HAROLD A. ACKERMAN
This matter involves allegations of securities fraud against a corporation and its outside auditor, and a vigorous argument by the defendant corporation and auditor that they, as well as other financial institutions, are being scapegoated for the current economic decline in the country. Defendants' argument takes the form of a motion to dismiss the complaint for failure to state a claim upon which relief can be granted, and for failure to plead fraud with the particularity required under Federal Rule 9.
For the following reasons, the motion is denied.
I. Standard for Motion to dismiss
When assessing a motion to dismiss under Rule 12(b)(6), "the court must accept as true all factual allegations in the complaint and view them in a light most favorable to plaintiff." DP Enterprises, Inc. v. Bucks County Community College, 725 F.2d 943, 944 (3rd. Cir. 1984); Walck v. American Stock Exchange, Inc., 687 F.2d 778, 780 (3rd Cir. 1982). The court may dismiss the complaint only if "it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Conley v. Gibson, 355 U.S. 41, 45-56, 2 L. Ed. 2d 80, 78 S. Ct. 99 (1957).
The saga, and class period, began on December 20, 1989, when Richard Kelley, Citizens' Chairman of the Board, announced that Citizens' dividends on common stock were increasing from $ .60 per share to $ .72 per share annually. Kelley assured potential shareholders that Citizens was experiencing a record year for profits. On January 17, 1990, Citizens announced that it had achieved a net income of $ 9,459,000, or $ .44 a share, for the fourth quarter of the 1989 fiscal year. For the full fiscal year, Citizens reported a net income of $ 37,190,000, or $ 1.73 per share. This reflected an 18.2% increase over the equivalent time period in 1988. Nonetheless, on February 1, 1990, Citizens announced a plan to repurchase 500,000 shares of its own common stock on the open market, informing shareholders that the market price of Citizens stock was undervalued.
On March 30, 1990, Citizens filed with the Securities and Exchange Commission its Form 10-K and Annual Report for fiscal year 1989. Citizens disclosed that for each quarter of 1989, the number of nonperforming loans issued by Citizens had increased from 2.35% to 3.60% of its total outstanding loans. Still, Citizens announced that it had created provisions for loan losses of only $ 1,650,000 (an aggregate for the year of $ 6,600,000), a figure essentially unchanged from the previous year despite the increase of nonperforming loans. Citizens defended this decision by informing shareholders that "a substantial portion of these loans are collateralized by real estate, as well as by the personal guarantees of the principals." Citizens also informed shareholders of its internal procedures for setting the loan loss reserve:
The allowance for loan losses is generated through the charges to earnings. Loan losses (loans charged off net of recoveries) are charged against the allowance for loan losses. If, as a result of loans charged off or increases in the size or risk characteristics of the loan portfolio, the allowance is below the level considered by management to be adequate to absorb future loan losses, the provision for loan losses is increased to the level considered necessary to provide an adequate allowance.
Citizens went on to assure shareholders that "as a result of the increase in nonperforming loans, it is possible that additional chargeoffs may occur in the future. However, management believes that the allowance for loan losses is sufficient to absorb these possible additional chargeoffs. . . . In the opinion of management, the allowance for loan losses is adequate to absorb both current and future losses."
The Annual Report for 1989 contained a Letter To Shareholders from Kelley and defendant Rodney T. Verblaauw, President and director of Citizens, detailing to investors the secure state of Citizens' loan loss reserves:
REAL ESTATE LOANS ARE MANAGEABLE
There has been a great deal of press coverage regarding nonperforming real estate loans in the nation and in New Jersey. At year-end, our nonperforming loans amounted to $ 77.7 million, up from $ 45.6 million at year-end 1988. Loan losses for 1989, net of recoveries, were $ 5.3 million, compared with $ 2.4 million in net losses in 1988. Although we are obviously not insulated from the problem, this total is at a manageable level. Each problem loan has been identified, and a plan has been implemented to work toward an orderly reduction of the debt. We believe that there are adequate reserves in our loan loss allowance to cover all present and future problems.
Lest investors think Citizens could wind up being victims of the economic downturn, Kelley and Verblaauw also assured investors of Citizens' sound management procedures:
We continue to evaluate our loan portfolio by using early warning signals to classify loans where signs point to deteriorating quality. All classified loans were previously identified, and no additions have been made by regulatory examinations or outside audit reviews. We are following our traditional conservative lending practices to minimize future risk. Almost all of the commercial properties we finance are owner occupied or substantially leased. Residential construction loans to builders are limited to two homes ahead of sale, and borrowers must have a strong net worth.
In the "Management's Discussion and Analysis of Financial condition and Results of Operations", Citizens again detailed its internal control procedures:
On a monthly basis, management reviews loans delinquent 30 days or more, nonaccrual loans, and other loans identified as needing additional review. In addition, management considers loans identified in the most recent examination by the Comptroller of the Currency and the external auditors. Loans or portions thereof that are determined to be uncollectible are either reserved for or charged off. Loans 90 days past due are placed on a nonaccrual basis unless they are secured and in the process of collection. The evaluation of loans in these categories takes into consideration the risk of the prospective loss presented by such loans and potential sources of repayment, including collateral security. An estimate of losses existing in the portfolio is also made with consideration given to historical data, negative trends in overall delinquencies, concentration of loans by industry, current and anticipated economic conditions that might result in increased delinquencies and new loan types as well as the area served and other relevant factors. . . . Nonperforming classification does not mean nonearning, but rather, that the probability exists that the interest owed will not be received in full and within the contractual term.
On March 19, 1990, Citizens filed with the SEC, and distributed to shareholders, a Proxy Statement that assured investors that on the recommendation of Citizens' internal Audit Committee, defendant accounting firm Coopers & Lybrand had been retained as independent certified accountants to audit Citizens' 1989 financial statements. In the 10-K form filed with the SEC, and in the Annual Report for 1989, Coopers represented to Citizens' shareholders and the SEC that:
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Citizens First Bancorp, Inc. and Subsidiary at December 31, 1989 and 1988, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1989, in conformity with generally accepted accounting principles.
On April 16, 1990 Citizens announced that it had achieved a net income of $ 6,530,000, or $ .30 a share, for the first quarter of 1990. This was down from $ 9,283,000, or $ .43 a share for the similar period in 1989. This decline apparently was due to the fact that Citizens had increased the quarterly provision for loan losses from $ 1.65 million to $ 5 million for the first quarter of 1990, and was planning to make a similar provision for the second quarter. Nevertheless, defendants assured shareholders that the increased provisions reflected Citizens' philosophy of caution, sound management and fiscal conservatism. According to the PR Newswire, "Kelly stated that Citizens is a very conservative institution and has a philosophy of dealing with circumstances before they become a problem. The action taken today is a continuation of this philosophy."
In a Form 10-Q, filed with the SEC on May 14, 1990, Citizens continued to assure investors of the adequacy of its loan loss reserves. Particularly, the Form stated that "the nonperforming classification does not mean nonearning; but rather that the probability exists that the interest owed will not be received within the contractual term . . . . [A] substantial portion of these [nonperforming] loans are collateralized by real estate, as well as by the personal guarantees of the principals." The Form represented that "in management's opinion, the current provision for loan losses reflects the amount deemed appropriate to produce an allowance for loan losses adequate to meet the present and foreseeable risk characteristics of the loan portfolio."
On July 27, 1990, Citizens disclosed that it would report a loss of $ 34,488,000, or $ 1.47 a share, for the second quarter of 1990, due to its increase in loan loss reserves to $ 70 million. This provision was fourteen times greater than the provision for the first quarter of 1990, and forty-two times greater than the provision for each of the quarters of 1989. Subsequently, a director of Citizens disclosed that $ 20 million of the $ 70 million addition to reserves was needed because bank examiners had found that files documenting Citizens' loans lacked current appraisals and financial statements.
Citizens' second quarter 10-Q reported an increase in nonperforming assets from $ 77,085,000 at the end of 1989 to $ 192,075,000 at June 30, 1990. For the first time, this 10-Q reflected the classification of non-performing assets, consisting of nonaccrual loans, troubled debt restructuring, and foreclosed real estate. Until this time, Citizens had not included "foreclosed real estate" as an aspect of nonperforming loans and had no classification of "nonperforming assets". Of the increase, $ 101,602,000 was due to foreclosed real estate, though Citizens stated on the form that foreclosed real estate had been just $ 713,000 on December 31, 1989.
On August 28, 1990, Citizens reported that Robert Iamuzzo, a Coopers auditor who had acted in a secondary review capacity on Citizens's 1989 audit, was in default to Citizens on a substantial amount in loans issued him by Citizens.
During the time Citizens was portraying itself as a profitable firm, different than the rest, Citizens' common stock reached over $ 12 per share. On July 18, 1990, the end of the Class period, Citizens stock had fallen by more than 44%, to $ 7 per share.
On September 6, 1990, plaintiffs filed this complaint, alleging that defendants -- consisting of Citizens, Coopers, and several named officers of Citizens and Coopers -- intentionally committed a fraud that resulted in the artificial inflation of the price of Citizens' common stock during the Class period.
Specifically plaintiffs alleged that the price remained inflated because Citizens failed to provide sufficient reserves to cover loan losses. This failure to provide adequate loan loss reserves allegedly enabled Citizens to represent that its profits were increasing, and hence attract investors. Plaintiffs also contend that Citizens misrepresented the adequacy of its internal control procedures, its lending policy, and the secured nature of nonperforming loans. Plaintiffs further contend that defendant Coopers committed fraud by misrepresenting that its 1989 audit of Citizens complied with generally accepted accounting principles.
Citizens and its representative named in the suit (the "Citizens defendants") originally moved to dismiss two particular clauses of the complaint, arguing that those clauses alleged unactionable mismanagement rather than fraud. Coopers, though, moved for a complete dismissal of the complaint, for failure to plead fraud with particularity and for alleging mismanagement rather than fraud. In February, 1992, however, Citizens defendant Kelley, later joined by all Citizens and Coopers defendants, made a supplemental motion to dismiss the entire complaint. In this opinion, I address the adequacy of the complaint with respect to all these arguments.
Plaintiffs' cause of action involves two separate categories of claims: (1) Securities fraud against Citizens and Coopers, under section 10(b) of the Exchange Act; and (2) common law claims under New Jersey law. The Citizens defendants contest only the federal claims; Coopers contests both the federal and state claims.
A. Federal securities laws
Because the issues raised in this case have been the focus of much discussion in federal courts, a word about the purpose of the securities fraud laws and the courts' interpretations of them is in order.
Under Section 10(b) of the Exchange Act of 1934, and the Securities and Exchange Commission's Rule 10b-5 (the "Exchange Act") misrepresenting or omitting material information in connection with the purchase or sale of securities is unlawful. When claiming a violation of these sections, a plaintiff not only has to satisfy Fed.R.Civ.P. 12(b)(6)'s mandate to state a claim upon which relief can be granted, a plaintiff also must satisfy Federal Rule of Procedure 9(b), which provides a minimum standard for pleading fraud. Rule 9(b) states, in relevant part:
In all averments of fraud . . . the circumstances constituting fraud . . . shall be stated with particularity. Malice, intent, knowledge, and other condition of mind of a person may be averred generally.
Over the past several years, allegations of securities fraud against financial organizations have increased with the decline in the American economy. As such cases have increased in number, courts across the country have struggled over the correct application of the federal rules on pleading to the Exchange Act. Underlying this problem are two apparently conflicting policies. On the one hand, firms must be protected against claims arising only from hindsight and from a desire to scapegoat certain institutions for the economic downturn of recent years. Describing the complaint in another case, the Seventh Circuit summed up this policy:
The story in this complaint is familiar in securities litigation. At one time the firm bathes itself in a favorable light. Later the firm discloses that things are less rosy. The plaintiff contends that the difference must be attributable to fraud.
DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th Cir.), cert denied, 112 L. Ed. 2d 312, 1 ...