On Appeal from the United States District Court for the District of New Jersey (D.C. Nos. 02-cv-00168, 02-cv-03099) District Judge: Honorable William H. Walls.
The opinion of the court was delivered by: Sloviter, Circuit Judge
Argued September 14, 2005
Before: SLOVITER, BARRY, and SMITH, Circuit Judges.
I. A. The Rise and Fall of Suprema
B. The Secondary Offerings
II. A. Section 11 and Section 12(a)(2) Claims
a) Motive and Opportunity
b) Circumstantial Evidence of Misconduct
4. The 2000 and 2001 Underwriters
D. Section 15 and Section 20(a) Claims
E. Pendent State law claims
At the center of this securities fraud action is Suprema Specialties, Inc. ("Suprema"), a now-defunct company that presented itself as a producer and distributor of all natural gourmet Italian cheeses. Over a two-year period, Suprema reported wildly successful growth in its sales and receivables, thereby enticing lenders to increase its credit line and luring investors to the purchase of its stock. In truth, Suprema had fabricated millions of dollars in cheese sales and engaged in other fraudulent schemes that ultimately led to the company's dissolution in bankruptcy. Government investigations resulted in four individuals connected to Suprema's schemes pleading guilty to federal charges of, inter alia, conspiracy to commit securities fraud. Those individuals have admitted that a number of Suprema's public statements regarding its finances and the nature of its business were untrue.
The plaintiffs-appellants here are two institutional investors, Special Situations Fund, III, L.P., and Special Situations Fund Cayman, L.P. (collectively, the "SSF Plaintiffs"), and the Teachers' Retirement System of Louisiana (referred to as "Lead Class Plaintiff" because it held that status in the consolidated class actions before the District Court). SSF Plaintiffs and Lead Class Plaintiff brought separate actions for damages against Suprema's former officers and directors, its auditor, and several investment firms that served as underwriters in two public stock offerings through which plaintiffs claim to have acquired Suprema stock. Plaintiffs asserted claims for relief under Sections 11, 12(a)(2), and 15 of the Securities Act of 1933 (the "Securities Act"), and Sections 10(b), 18, and 20 of the Securities and Exchange Act of 1934 (the "Exchange Act"), along with fraud and misrepresentation claims under state law. On defendants' motions, the United States District Court for the District of New Jersey dismissed all claims pursuant to Rules 9(b) and 12(b)(6) of the Federal Rules of Civil Procedure, as well as provisions of the Private Securities Litigation Reform Act ("PSLRA"). Among the important issues presented on appeal is whether the District Court properly applied the "sounds in fraud" doctrine in dismissing the claims asserted under Section 11 and Section 12(a)(2) despite plaintiffs' efforts to ground their Securities Act claims in negligence and to plead them separately in the complaints from their fraud-based claims. We will reverse the District Court's orders dismissing the claims under Sections 11, 12(a)(2), and 15 of the Securities Act and Section 10(b) of the Exchange Act as to some of the defendants, and we will affirm as to the dismissal of the remaining counts. We will remand as to the state law claims.
In setting forth the underlying facts, we accept as true the well-pleaded allegations in plaintiffs' second amended complaints and consider the documents incorporated by reference therein. See Cal. Pub. Employees Ret. Sys. v. Chubb Corp., 394 F.3d 126, 134 (3d Cir. 2004) (hereinafter "CALPERS").
A. The Rise and Fall of Suprema
Suprema was founded as a New York non-public corporation in 1983. It became a publicly traded company in 1991 and was listed on the NASDAQ (trading under the symbol "CHEZ") in 1993. Suprema had its corporate headquarters, along with a processing plant, in Paterson, New Jersey, and it operated three wholly-owned subsidiaries, at which it manufactured and processed cheese, in Manteca, California; Ogdensburg, New York; and Blackfoot, Idaho. Suprema's business was divided between two product lines: "hard cheese," which included imported and domestically produced parmesan and romano, and "soft-cheese," which included domestically produced mozzarella, ricotta, and provolone.
Defendant-Appellee Mark Cocchiola was a founder of Suprema and acted as the company's Executive Vice-President, CEO, and Chairman of the Board of Directors. Defendant-Appellee Steven Venechanos was the company's CFO and Secretary, and also a member of the Board of Directors during the Class Period. (Cocchiola and Venechanos will be referred to collectively as the "Officers.") Defendants-Appellees Marco Cocchiola (Mark Cocchiola's father), Rudolph Acosta, Jr., Paul DeSocio, and Barry Rutcofsky (collectively, the "Outside Directors") were members of the Board of Directors. (We will refer to Mark Cocchiola simply as "Cocchiola" and to Marco Cocchiola by his full name.) Marco Cocchiola was also Suprema's Operations Manager. Acosta, DeSocio, and Rutcofsky were members of the Board's Audit Committee. Defendant-Appellee BDO Seidman, LLP ("BDO") was Suprema's auditor throughout the class period.
In 2000 and 2001, Suprema reported dramatic growth in sales and receivables, which it attributed primarily to growth in sales of its domestically manufactured hard cheeses. Suprema's net sales for fiscal year 2000 increased to $278.4 million, reflecting a 58% increase over fiscal year 1999, and for fiscal year 2001, increased to $420.3 million, or 51% over fiscal year 2000. In its hard cheese business alone, Suprema reported 400% growth in revenue between fiscal year 1999 and the end of fiscal year 2001. Its receivables were reported to have grown from $36 million at the end of fiscal year 1999 to $101.8 million by the end of fiscal year 2001. During this same period, industry-wide growth in sales was only approximately 9% per year. In September 2001, FORTUNE MAGAZINE named Suprema the twenty-third fastest growing small company in the United States, and shortly thereafter FORBES MAGAZINE ranked it as the twenty-second best small company. Between the fourth quarter of 1998 and the fourth quarter of 2000, the company's average share price more than doubled.
State and federal investigations subsequently revealed that Suprema's explosive growth was an illusion-- the product of a fraudulent scheme involving so-called round-trip sales or circular transactions associated with the hard cheese side of its business. The round-trip sales scheme was one in which Suprema purportedly sold hard cheese products to entities posing as customers, which then sold the fictitious products to entities posing as suppliers. The "suppliers," in turn, sold the products back to Suprema. In most cases, the customer and the supplier in these sales shared a common owner who would reap commissions on the fictitious transactions. According to a civil complaint filed by the Securities and Exchange Commission ("SEC") in 2004, fictitious sales accounted for approximately 30%, 65%, 85% and 87% of Suprema's accounts receivable for fiscal years 1998, 1999, 2000, and 2001.
Millions of dollars in company checks-- some signed by Cocchiola, some by Venechanos, and some by both-- were issued to ostensible "suppliers" during 2001. The apparent increase in net sales and accounts receivable brought increases in the company's line of credit. Suprema's credit line increased from $35 million in 1998 to $140 million in 2001. The increased credit line led to an expansion in the volume and value of fictitious round-trip sales, which in turn led to further increases in accounts receivable, thereby fueling the increased line of credit. The ever-widening cycle produced the appearance, on paper, of phenomenal growth.
The invoices issued in connection with the circular scheme generally did not correspond to any actual shipments. Some of the "ship to" locations identified in invoices for huge quantities of cheese were nothing more than postal boxes, storefronts, or single-family residences. The shipments that were actually made contained mislabeled or adulterated cheese products that were generally unfit for human consumption. Suprema purchased imitation cheeses and other non-cheese products and relabeled them as higher-priced premium cheeses, and it adulterated its "all natural" cheeses with fillers to reduce costs and increase sales. Inventory impounded by the government in connection with its investigations turned out to have been grossly overvalued and was actually worth less than $2 million, though Suprema had represented it in December 2001 as worth more than $60 million.
On December 21, 2001, just six weeks after Suprema conducted a substantial public stock offering (discussed below), Venechanos and Suprema's controller, Arthur Christensen, resigned, and the company announced that it had initiated an internal investigation into its previously reported financial results. In response to this announcement, NASDAQ suspended trading of Suprema's stock. On January 25, 2002, the company announced that it had engaged Deloitte & Touche, LLP to continue the investigation.
From that point, Suprema and the fraudulent scheme upon which its apparent success had been founded unraveled quickly. On February 4, 2002, federal authorities executed a search warrant at Suprema's headquarters and seized financial and manufacturing records. Thereafter, Suprema revealed that it was being criminally investigated by the FBI, the FDA, the SEC, and the New Jersey Department of Agriculture. On February 18, 2002, BDO resigned as Suprema's auditor, citing, among other reasons, an inability to determine whether the company had adequate internal controls necessary to develop reliable financial statements, whether Suprema's prior financial statements contained material inaccuracies, and whether it could rely on management's representations.
On February 24, 2002, Suprema filed for Chapter 11 bankruptcy protection. On the same day, it announced that Cocchiola had resigned as CEO and that NASDAQ would be de-listing its stock as of March 1, 2002. On March 20, 2002, the company's Chapter 11 reorganization was converted into a Chapter 7 liquidation, and a liquidation trustee was appointed.
On January 7, 2004, four individuals associated with the company-- the former Operations Manager of the Paterson plant, John Van Sickell,*fn1 and the principals of three companies that had been Suprema's ostensible customers or suppliers, Lawrence Fransen, George Vieira, and Robert Quattrone-- pled guilty to federal charges of, inter alia, conspiracy to commit securities fraud, bank fraud, and mail fraud in connection with the round-trip sales scheme. In their plea allocutions, all four individuals admitted that their criminal actions, including participation in the invoicing scheme and adulteration of products, were undertaken at the direction and under the supervision of, or with the knowledge of and in conjunction with, Suprema's management. The criminal informations filed by the United States Attorney in the case alleged that $700 million of Suprema's $1.2 billion in net sales between 1996 and 2002 (87% of all sales made to the companies controlled by Fransen, Vieira, and Quattrone) were entirely fictitious.*fn2
B. The Secondary Offerings
Suprema conducted two public stock offerings relevant to this action: the first was in August 2000 (the "2000 Offering"), and the second was in November 2001 (the "2001 Offering"). The 2000 Offering was for 1.2 million shares of common stock. It was underwritten by, inter alia, defendants-appellees Oberweis.net; Paulson Investment Co.; Westminster Securities Corp.; and Westport Resources (collectively, the "2000 Underwriters").*fn3 On May 10, 2000, Suprema filed a registration statement and prospectus on Form S-2 with the SEC announcing the offering. Cocchiola, Venechanos, Marco Cocchiola, Acosta, and DeSocio signed the Form S-2. The Form S-2 incorporated by reference Suprema's annual report on Form 10-K filed on June 30, 1999, its quarterly reports on Form 10-Q filed on September 30 and December 31, 1999, and its proxy statement filed on October 22, 1999.
The 2001 Offering was for 4.05 million shares of common stock. It was underwritten by defendants-appellees Janney Montgomery Scott, LLC; Pacific Growth Equities, Inc.; and Roth Capital Partners, LLC (collectively, the "2001 Underwriters"). Cocchiola, Venechanos, Marco Cocchiola, Acosta, DeSocio, and Rutcofsky signed the Form S-2 filed with the SEC in connection with the offering. The Form S-2 incorporated by reference Suprema's annual report on Form 10-K filed on September 28, 2001. By the close of the 2001 Offering, Suprema had sold 3.5 million shares for proceeds of $41.5 million.
BDO issued unqualified audit opinions in August 1999 and August 2001 regarding Suprema's consolidated financial statements for fiscal years 1999, 2000, and 2001. The audit opinions were incorporated into the Form S-2s that Suprema filed for the 2000 and 2001 Offerings. BDO stated that it had performed its audits in ...