The opinion of the court was delivered by: Irenas, District Judge
In In re Campbell Soup Company Securities Litigation, No. Civ. A 00-152 (JEI), this Court found that a class of plaintiffs consisting of certain current and former shareholders in the Campbell Soup Company (hereinafter "Campbell" or "the Company") had adequately stated a cause of action against Campbell, and a number of its directors and officers, for violations of §§ 10(b) and 20(a) of the Securities Exchange Act of 1934 ("Exchange Act"). See Campbell, 145 F.Supp.2d 574 (D.N.J. 2001). The action presently before the Court is a related case against Pricewaterhouse Coopers LLP (hereinafter "Pricewaterhouse" or "PwC"), arising from that company's alleged participation in Campbell's alleged fraud. Specifically, the plaintiffs in this case, also a number of current and former Campbell shareholders, assert that Pricewaterhouse, which had been hired to conduct an audit of Campbell's financial statements for the 1998 fiscal year, violated the provisions of the Exchange Act, and its accompanying regulations, by knowingly or recklessly certifying that Campbell's fraudulent financials accurately reflected the health of the Company. However, as is discussed below, because the facts alleged against PwC do not support a "strong inference" that that firm acted with scienter in certifying Campbell's statements, Plaintiffs' action must be dismissed for failure to state a claim upon which relief may be granted.
By all accounts, the years leading up to 1997 were banner ones for the Campbell Soup Company, the world's largest manufacturer and marketer of soup products. As the Court noted in Campbell, in those years, "Campbell experienced great success, with increasing sales, gross margins, and profits, and a consequent increase in its stock price." Campbell, 145 F.Supp.2d at 580. However, according to the complaints filed in both Campbell and this litigation, those successes were the illusory result of a number of fraudulent "aggressive trade practices" and improper accounting procedures adopted by high-ranking officials within the Company. More specifically, the plaintiffs in these suits allege that Campbell, aided by the recklessness, if not active assistance, of PwC, engaged in a scheme to prematurely recognize revenue, thereby inflating the Company's margins and, consequently, stock price. Because these alleged practices are at the heart of this case, as well as the action against Campbell itself, it is appropriate that they be recited in some detail here.
According to the Plaintiffs, who comprise a putative class of all persons who purchased Campbell's common stock between October 9, 1998 and January 8, 1999 (other than certain high-level Campbell employees and related individuals), much of Campbell's successes during the class period were the result of its alleged practice of "trade loading". (See Compl. at ¶¶ 25-27). According to Plaintiffs, in order to satisfy the quarterly earnings projections of stock market analysts, Campbell maintained a practice of offering steep discounts (often as much as fifteen to twenty percent) to its customers at each quarter's end, in order to increase sales. Id.; see also, Campbell, 145 F.Supp.2d at 580-81. While Plaintiffs concede that such "loading" is not itself fraudulent, they contend that the practice was accompanied by numerous accounting misstatements and improprieties. (Compl. at ¶ 37h).
According to Plaintiffs, Campbell traditionally offered its customers small price reductions (generally two to three percent), in return for the customer's participation in certain promotional activities involving Campbell products. (Compl. at ¶ 26). These discounts were then accounted for as "sales, general and administrative expenses" ("SG&A") rather than as deductions from gross revenue. This treatment, Plaintiffs state, was proper under generally accepted accounting principles ("GAAP"), which Campbell was obligated to follow. (Compl. at ¶ 26). However, Plaintiffs contend that Campbell treated the larger, loading discounts in the same manner, which was improper under GAAP and which resulted in artificially inflated statements of gross revenue. (Id. at ¶ 26, 37h (citing Accounting Principles Board Opinion No. 22)).
Despite these efforts, Plaintiffs contend, earnings expectations still could not be met. Accordingly, with most customers unable to accept more Campbell's product, management resorted to a number of further practices to continue sales. For instance, Plaintiffs allege, Campbell began conducting "bill-and-hold" transactions and "shipping to the yard", in which Campbell would "sell", but not ship, product to its customers, instead storing the product at off-site warehouses or loading it onto trucks parked at Campbell's facilities. (Compl. ¶¶ 27-30). Treating these transactions as completed sales, as Campbell allegedly did, resulted, Plaintiffs contend, in the recognition of revenue well before it was earned, in clear violation of GAAP. (Compl. at ¶ 37c).
A further illegitimate practice for overstating revenue, Plaintiffs allege, was Campbell's recognition of revenue from so-called "guaranteed" sales, that is, those in which a customer was provided a right of return. According to GAAP, Plaintiffs state, revenue from sales in which a customer retains a right of return may only be recognized where certain conditions are met, such as where the seller maintains an adequate reserve for returned product. (Compl. at ¶ 37d (quoting Financial Accounting Standards Board Statement No. 48)). Campbell, however, allegedly maintained no such reserve, despite the fact that product was being returned in such great quantities that the company's head of marketing, William Toler, instituted a policy requiring that all sales with a right of return be personally approved by him. (See Compl. at ¶ 31; Aff. of Stuart J. Guber, Ex. 2).
In October, 1998, Campbell submitted its fiscal 1998 Form 10-K to the Securities and Exchange Commission. Included in this filing was PwC's Audit Report of Campbell's financial statements, which provided an unqualified opinion that those statements
present fairly, in all material respects, the financial position of Campbell Soup Company and its subsidiaries at August 2, 1998 and August 3, 1997, and the results of their operations and their cash flows for each of the three years in the period ended August 2, 1998, in conformity with generally accepted accounting principles. (Compl. at ¶ 38).
On January 11, 1999, however, Campbell announced that its fiscal 1998 earnings would fall short of analysts' estimates by eighteen to twenty-three cents per share. (Compl. at ¶ 8). The reasons for this shortfall, Campbell allegedly stated, were "inefficiencies in the supply chain" and "unseasonably warm weather". (Id.). Plaintiffs, however, assert that the real reasons for the failure were Campbell's loading and other aggressive sales practices. (Id.).
As noted, in Campbell, this Court held that the facts alleged above were sufficient to state claim for securities fraud against Campbell and its officers. In connection with their litigation against Campbell, Plaintiffs sought leave to take discovery to determine whether they might have a claim against Pricewaterhouse related to its audit of Campbell's finances. This Court granted Plaintiffs' request in June 2001 and, on October 4, 2001, Plaintiffs filed the instant action against PwC.
As will be discussed in detail below, in order to maintain its independent claims against Pricewaterhouse, Plaintiffs must demonstrate that PwC knowingly or recklessly participated in Campbell's alleged fraud. In connection with their claims, therefore, Plaintiffs offer a number of additional allegations designed to demonstrate PwC's knowledge, or reckless disregard, of the practices and improprieties described above. In attempting to draw connections between Campbell's alleged fraud and PwC's audit, Plaintiffs rely on a number of documents allegedly created or reviewed by PwC in connection with its fiscal 1998 audit. *fn1
In September, 1998, PwC's Bryan M. Reasons prepared a memorandum (the "Reasons Memo") addressing potential problems arising from Campbell's year-end revenue recognition policies. Specifically, the problem identified in the memorandum was related to Campbell's practice of treating all domestic sales as "FOB shipping point," meaning that revenue on such sales would be recognized as soon as the product left Campbell's shipping docks. (See Reasons Memo, attached as Ex. 4 to Aff. of William R. Maguire). However, the memo noted, some of the sales treated in this fashion were, in fact, "FOB destination", meaning that the risk of loss did not pass to the buyer until the product was received. This, the memo observed, created a risk that revenue from certain sales made at the end of one fiscal year, but not received by the buyer until the next, would be recognized prematurely. According to Plaintiffs, the Reasons memo "establishes that PwC had actual knowledge of Campbell's improper revenue recognition practice in connection with products `shipped' to the `yard' or to Campbell warehouses." (Pl. Br. at 16). In addition, Plaintiffs contend that the Reasons Memo, which makes reference to Campbell's "historical shipping practices, which generally involve heavy shipments at quarter ends," and to "incremental marketing spending" in connection with those shipments, establishes PwC's knowledge of the Company's improper loading practices. (Pl. Br. at 7-8).
In connection with their allegations regarding PwC's participation in Campbell's loading practices, Plaintiffs also point to a 1998 "Procedure Standard Report" which, in discussing a review of Campbell's promotional spending practices, made reference to "load dollars." (Ex. 5 to Maguire Aff.). This reference, Plaintiffs contend, permits an inference of "PwC's actual knowledge of the Company's practice of `loading' - and its treatment of `loading' discounts as SG&A rather than as a reduction of revenue." (Pl. Br. at 8).
Also relied upon in connection with their loading allegations is an August 26, 1998 PwC document entitled "Notes of Year End Audit Meeting." (See Ex. 6 to Maguire Aff.). In discussing the "level and timing" of Campbell's fourth quarter sales, this document refers to statements made by Campbell's employees regarding "additional trade spending to assist the late order pattern driven by Campbell's customer base." (Id.). According to Plaintiffs, in addition to establishing knowledge of Campbell's trade loading, because Campbell's quarter-end loading clearly was the result of the Company's calculated practices and not the demand of its customers, this statement raised, as will be discussed below, a "red flag" which should have given PwC reason to suspect Campbell's fraud and which is further evidence of PwC's complicity in Campbell's schemes.
The final document offered by Plaintiffs to establish PwC's knowledge of Campbell's loading practices is a "Work Paper" produced in connection with PwC's fiscal 1999 audit of Campbell's financial statements. (Ex. 7 to Maguire Aff.). In this document, PwC noted that during fiscal 1999, Campbell modified some of its "supply chain processes" and "historical shipping practices" to eliminate some of the heavy quarter-end shipments that were present in previous years. (Id.). This recognized modification, Plaintiffs contend, demonstrates PwC's knowledge of Campbell's earlier loading practices. (Pl. Br. at 10).
As noted above, Plaintiffs allege that an essential element of Campbell's fraud was the improper treatment of the heavy discounts offered in connection with its quarter-end sales as general marketing expenses rather than as a reduction in sales price. In attempting to connect PwC with these alleged accounting improprieties, Plaintiffs refer in their Complaint to a number of additional documents. (See Compl. at ¶ 44). First, Plaintiffs refer to two internal Campbell memoranda: a 1992 memo, from Campbell employee Garth Cooper, regarding "Accounting for World-wide Marketing Expenditures" (the "Cooper Memo", attached as Ex. 1 to Maguire Aff.) and a 1997 memo from Gerald S. Lord entitled "Modifications to Accounting Policies for Marketing/Advertising Costs" ("Lord Memo", Ex. 2 to Maguire Aff.). In these documents, Cooper and Lord explain that, under GAAP, discounts offered to customers should only be recorded as SG&A where some return "performance" is required of the customer. (Id.). According to Plaintiffs, the existence of these memoranda should be regarded as indicating to PwC that Campbell was experiencing serious problems with improper accounting in connection with its trade loading.
Finally, Plaintiffs' Complaint refers to a July 6, 1998 memo from PwC auditor Jennifer John, regarding "MIP Accrual", as further evidence of PwC's awareness of Campbell's improper accounting. Specifically, Plaintiffs contend that the "John Memo" (attached as Ex. 3 to Maguire Aff.), which states that Campbell's "promotional spending also includes incremental offerings... offered to customers as additional incentive to purchase the company's products", demonstrates PwC's knowledge ...