The opinion of the court was delivered by: Brown, Chief Judge
This matter is before the Court on Defendants' motions (collectively "Motions") to dismiss the Plaintiffs' Third Amended Consolidated Class Action Complaint ("Complaint") pursuant to Federal Rules of Civil Procedure 9(b) and 12(b)(6), and the Private Securities Litigation Reform Act of 1995 ("Reform Act" or "PSLRA"), 15 U.S.C. §§ 78u-4, et seq. For the reasons discussed below, Defendants' Motions are GRANTED, and Plaintiffs' Complaint is DISMISSED WITH PREJUDICE.
I. PROCEDURAL BACKGROUND. .......................................... 7
II. FACTUAL BACKGROUND. .............................................. 8
III. JUDICIAL NOTICE. ..................................................... 9
IV. PLEADING REQUIREMENTS OF A 10b-5 CLAIM. . . . . . . . . . . . . . . . . . . . . . . . . . . 12
A. Elements of a 10b-5 Claim. ......................................... 12
1. Elements Subject to Heightened Pleading Requirements. . . . . . . . . . . . . 13
2. Elements Subject to Rule 8 Pleading Requirements. . . . . . . . . . . . . . . . . 17
B. Pleading a Class 10b-5 Claim. ....................................... 20
C. Pleading a Derivative Claim Against Controlling Persons. . . . . . . . . . . . . . . . . . 22 V. PLEADING SPECIFIC ELEMENTS OF A 10b-5 CLAIM. . . . . . . . . . . . . . . . . . . . . . . 23
A. Pleading the "False and Misleading Statement" Element. . . . . . . . . . . . . . . . . . . 23
1. Pleading an Affirmative Misrepresentation. . . . . . . . . . . . . . . . . . . . . . . . 23
2. Pleading Misrepresentation Based on Failure to Disclose.. . . . . . . . . . . . 24
B. Pleading the "Scienter" Element. ..................................... 26
1. Pleading Intentional or Recklessness State of Mind. . . . . . . . . . . . . . . . . 26
2. Pleading Scienter by Inference.................................. 27
a. Inferring Scienter from Defendant's "Motive and Opportunity". . 28
b. Inferring Scienter from Circumstantial Evidence. . . . . . . . . . . . . 30
i. Inferring Scienter from GAAP Violations. . . . . . . . . . . . . 30
ii. Inferring Scienter from SOX Certifications.. . . . . . . . . . . 34
3. Pleading Scienter by Relying on Confidential Information. . . . . . . . . . . . 39
C. Pleading the "Materiality" Element .................................. 40
D. Pleading the "Reliance" Element...................................... 41
1. Two Methods to Plead Reliance. ............................... 42
2. Pleading Reliance on Inferred Technical Facts. . . . . . . . . . . . . . . . . . . . . 44
E. Pleading the "Causation" Element..................................... 47
VI. DISCUSSION. ......................................................... 52
A. Transactional Causation............................................. 52
1. Deficiencies Contained in Plaintiffs' Second Complaint . . . . . . . . . . . . . 52
2. "Fraud-on-the-market" Allegations Based on Intelligroup's Financials . .58
3. 2001 Period . ............................................... 59
4. 2004 Period. ............................................... 63
5. Periods Reflected in the Table. ................................. 65
a. Plaintiffs' Allegations . ................................. 65
b. Legal Precedents Examining Financial Matters.. . . . . . . . . . . . . . 66
i. IPO Cases...................................... 67
Levinson. ............................... 72
iii. Other District Court Cases. . . . . . . . . . . . . . . . . . . . . . . . . 73
c. Financial Theories and Calculations. . . . . . . . . . . . . . . . . . . . . . 75
6. Alternative Allegations of Reliance.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
B. Loss Causation. ................................................... 87
1. Relevant Facts. ............................................. 87
a. Intelligroup's Publications. .............................. 88
b. Chart of Intelligroup's Stock Price. . . . . . . . . . . . . . . . . . . . . . . . . 89
2. Deficiencies Contained in Plaintiffs' Second Complaint . . . . . . . . . . . . . 92
3. Plaintiffs' Instant Allegations . ................................. 94
a. Interrelation-Among-the-Press-Release-Announcements Claim . 94
b. Lack-of-Interrelation-Among-the-Announcements Claim. . . . 101
i. Marsden v. Select Med. Corp.. .................... 102
ii. Other District Court Cases. . . . . . . . . . . . . . . . . . . . . . . . 104
c. Miscellaneous Claims. ................................ 112
i. Contentions About Implied Disclosure .. . . . . . . . . . . . . 113
ii. Contentions About the Post-Release Recovery. . . . . . . . 118
C. Scienter. ....................................................... 123
1. Motive and Opportunity...................................... 124
2. Circumstantial Evidence . ................................... 127
a. Resignations as Evidence of Scienter. . . . . . . . . . . . . . . . . . . . 128
i. Resignations of Defendants Valluri and Visco. . . . . . . . 129
ii. Resignation of Intelligroup's Auditor.. . . . . . . . . . . . . . . 135
b. Violations of GAAP as Evidence of Scienter. . . . . . . . . . . . . . . 137
c. SOX Certifications as Evidence of Scienter . . . . . . . . . . . . . . . 142
i. Impact of the Statements Made in the Restatement.. . . . 143
ii. The Fact of SOX Certifications. . . . . . . . . . . . . . . . . . . . 147
iii. The Language of SOX Certifications.. . . . . . . . . . . . . . 150
d. Undisclosed Witnesses................................. 153
i. UW-1 ........................................ 154
ii. UW-2 ........................................ 157
iii. UW-3 ....................................... 158
iv. UW-4 ........................................ 160
v. UW-5 ........................................ 166
vi. UW-6........................................ 167
e. Internet Posting by an Anonymous Witness. . . . . . . . . . . . . . . . 168
3. Totality of Evidence Analysis. ............................... 173
4. SeraNova Allegations. ...................................... 177
a. Allegations Based on Intelligroup's 10-K. . . . . . . . . . . . . . . . . . 181
b. Allegations Based on the Fact of Non-collectability. . . . . . . . . . 183
D. Derivative Liability of Visco and Valluri. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
E. Leave to Amend. ................................................. 186
1. General Rule. ............................................. 187
2. Entry of Binding Precedent Clarifying Applicable Pleading Standard. . 188
3. Repeated Failure to Cure Deficiencies and Futility of Amendment . . . . 193
VII. CONCLUSION. ....................................................... 195
Plaintiffs, investors who purchased the common stock of Defendant Intelligroup ("Intelligroup" or "Company," or "Issuer") during forty months between May 1, 2001, through and including September 24, 2004 ("Class Period"), brought this securities fraud class action alleging that Defendants defrauded them by artificially inflating the value of the stock through false and misleading statements disseminated into the investing community. See Compl. (Docket Entry No. 53) at 1.
The litigation was initiated on October 12, 2004, see Docket Entry No. 1, when the first of six class action complaints was filed with the Court. On August 10, 2005, all six actions were consolidated into the instant action. See Docket Entry No. 24. On October 10, 2005, Plaintiffs filed their joint Amended Complaint ("Original Complaint") against the Issuer and four former officers of the Issuer, two of whom were Defendants Valluripalli ("Valluri") and Visco ("Visco"). See Docket Entry No. 31. On December 5, 2005, certain Defendants filed their motion to dismiss Plaintiffs' Original Complaint. See Docket Entry No. 3. On February 10, 2006, Plaintiffs' Second (Amended) Complaint ("Second Complaint") was filed against the Issuer and Defendants Valluri and Visco, with all claims against the other two officers being dismissed. See Docket Entry No. 39. On March 27, 2006, Defendants filed their motions to dismiss the Second Complaint, see Docket Entries Nos. 40 and 42, and Plaintiffs filed their brief in Opposition to the Motions on May 11, 2006. See Docket Entry No. 43. On November 2, 2006, this matter was transferred to the undersigned. See Docket Entry No. 50.
On December 20, 2006, this Court issued an Order and accompanying Opinion ("December Opinion") dismissing the Second Complaint without prejudice. See Docket Entries Nos. 51 and 52.
On January 25, 2007, Plaintiffs filed the instant Third Amended Complaint. See Docket Entry No. 53. On March 5, 2007, Defendants filed their Motions to dismiss the Complaint. See Docket Entries Nos. 64 and 65. On April 13, 2007, Plaintiffs filed their Opposition to Defendants' Motions ("Opposition"). See Docket Entry No. 68. On May 3, 2007, Defendants filed their replies to Plaintiffs' Opposition ("Replies"), see Docket Entries Nos. 69 and 70, and supplemented the Replies by a letter filed on May 23, 2007 ("Letter"). See Docket Entry No. 71.
Except for the instant Motions, no other applications are currently pending in this action.
Intelligroup is a publicly traded company incorporated in the State of New Jersey with its principal office at 499 Thornall Street, Edison, New Jersey. See Compl. ¶ 28. "Intelligroup assists a variety of companies with setting up and maintaining various kinds of software for e-commerce." Id. Much of Intelligroup's work is sent offshore to the Company's subsidiary in India. See id. Intelligroup's stock was traded on the National Association of Securities Dealers Automated Quotation System ("NASDAQ"). See Opposition at 13.
Defendant Valluri served as the Company's CEO, President and Chairman of the Board during the Class Period, and Defendant Visco served as the Company's CFO from November of 2000 to November of 2003. See Compl. ¶ 5.
On September 24, 2004, Intelligroup issued a press release ("Press Release") announcing, inter alia, that Intelligroup was expecting to restate its financial statements issued and filed with the United States Securities and Exchange Commission ("SEC") during 2001, 2002, 2003 and the first quarter of 2004 ("Statements"). See id. ¶ 5. In the same Press Release, the Company made two other announcements, one about Intelligroup's anticipated private placement and another about Intelligroup's default on--and potential loss of--revolving credit. See Opposition at 30-31. On September 27, 2004, the first day after the Press Release, the stock began falling and fell $0.52 per share.*fn1 See Compl. ¶ 4. The restatement of the Company's financials ("Restatement") was made on October 24, 2005, more than one year after the issuance of the Press Release. See id.. ¶ 13.
Plaintiffs now assert that Defendants' issuance of the Statements containing a host of accounting errors inflated the market value of Intelligroup securities and amounted to a violation of (a) Section 10(b) of the Securities Exchange Act of 1934 ("'34 Act"), 15 U.S.C. §§ 78a-78kk (1994 & Supp. IV 1998), and (b) Rule 10b-5 ensuing from the '34 Act. See id. ¶ 14. In addition, Plaintiffs maintain Defendants Valluri and Visco are liable for Plaintiffs' injuries as controlling persons, since these Defendants knew about or recklessly disregarded the falsity of accounting data contained in Intelligroup's Statements. Id. ¶ 129.
Defendants' Motions are accompanied by Defendants' request for judicial notice of the following documents: (a) the Press Release; (b) Intelligroup's Form 8-K dated January 28, 2005, filed which was with the SEC and announced that the SEC had commenced a formal investigation into the matters related to the Restatement ("SEC Investigation Notice"); (c) a letter from SEC Assistant Director to Intelligroup's counsel, dated January 31, 2006, notifying the counsel that the investigation by the SEC was terminated and no enforcement action was recommended by the SEC ("SEC No-action Letter"); (d) Plaintiffs' Original and Second Complaints; (e) transcript of Intelligroup's "Second Quarter 2004 Update" Conference Call of October 5, 2004 ("10/05/04 Transcript"); and (f) a financial stock chart published by Yahoo!Finance and showing the adjusted closing price of Intelligroup's stock during the Class Period ("Stock Chart"). See Docket Entries Nos. 65-3 and 65-5 to 65-6-12. Although Plaintiffs' Opposition to Defendants' Motions is effectuated through a memorandum of law titled "Lead Plaintiffs' Memorandum of Law in Opposition to Motions to Dismiss Third Amended Complaint and in Partial Opposition to Request for Judicial Notice," see Docket Entry No. 68, neither the Table of Contents nor the body of the Opposition clearly identify or even suggest the nature of Plaintiffs' partial opposition to Defendants' request for judicial notice. See generally, id.
Rule 201(b), Federal Rules of Evidence permits a district court to take judicial notice of facts that are "not subject to reasonable dispute in that [they are] either (1) generally known within the territorial jurisdiction of the trial court or (2) capable of accurate and ready determination by resort to sources whose accuracy cannot reasonably be questioned." Rule 201(b). Under Rule 201(d), Federal Rules of Evidence, a district court must take judicial notice "if requested by a party and supplied with the necessary information." Rule 201(d).
In re NAHC, Inc. Sec. Litig., 306 F.3d 1314, 1331 (3d Cir. 2002) (finding that judicial notice was properly taken with respect to "three different categories of documents [which] included: (1) documents relied upon in the Complaint ([including] Company['s] press releases); (2) documents filed with the SEC; and (3) stock price data compiled by [a reliable financial] news service"). Since Plaintiffs' Complaint relies on the statements made in the Press Release, the 10/05/04 Transcript and Intelligroup's Restatement and 10-K 2004 Form, plus the SEC Investigation Notice was duly filed by Intelligroup with the SEC, and, in as much as the a stock price chart compiled by Yahoo!Finance appears to provide this Court with stock price data compiled by a reliable financial news service, this Court takes judicial notice of items (a), (b), (e) and (f) listed supra, as well as of Intelligroup's Restatement and 10-K 2004 Form. In addition, the Court takes limited judicial notice of the statements made by Plaintiffs in their Original and Second Complaint, that is, item (d) listed supra, solely for the purpose of examining whether Plaintiffs' factual assertions in the instant Complaint contradict those made in Plaintiffs' earlier pleadings. See Jackson v. Broad. Music, Inc., 2006 U.S. Dist. LEXIS 3960, at *18 (S.D.N.Y. Jan. 31, 2006) ("the court may take judicial notice of public records and of 'admissions in pleadings and other documents in the public record filed by a party in other judicial proceedings that contradict the party's factual assertions in a subsequent action' without converting the motion into one for summary judgment") (quoting Harris v. New York State Dep't of Health, 202 F. Supp.2d 143, 173 (S.D.N.Y. 2002), and citing Munno v. Town of Orangetown, 391 F. Supp. 2d 263, 268 (S.D.N.Y. 2005)), compare Young v. Dreiblatt, 2000 U.S. App. LEXIS 21704, at *2 (9th Cir. Aug. 17, 2000) (amended complaint supersedes previous complaint in the sense that it constitutes waiver of claims in previous complaint). Finally, since this Court may take judicial notice of a fact "capable of accurate and ready determination by resort to sources whose accuracy cannot reasonably be questioned," Rule 201(b), the Court "'may take judicial notice of records and reports of administrative bodies,' such as notices and opinion letters." Wible v. Aetna Life Ins. Co., 375 F. Supp.2d 956, 965 (C.D. Cal. 2005) (taking judicial notice of a notice and opinion letter issued by the Department of Justice and citing, inter alia, Interstate Natural Gas Co. v. Southern California Gas Co., 209 F.2d 380, 385 (9th Cir. 1953)); see also Toth v. Automobile Club of California Long Term Disability Plan, 2005 U.S. Dist. LEXIS 40746 (C.D. Cal. 2005) (same). Therefore, this Court takes judicial notice of the SEC No-action Letter for the limited purpose of acknowledging that the SEC investigation of the matters related to Intelligroup's Restatement was terminated without any enforcement action by the Commission or by a government agency having the power to instigate a prosecutorial action against Intelligroup upon the SEC's referral.*fn2
IV. PLEADING REQUIREMENTS OFA10B-5CLAIM
A. ELEMENTS OF A 10B-5CLAIM
Congress passed the '34 Act, 15 U.S.C. §§ 78a-78kk, to assure the disclosure of full and fair information to the investing public. See H.R. Rep. No. 73-1383, at 1-2 (1934) (describing the legislation's purposes). In relevant part, Section 10(b) of the '34 Act proscribed the "use or employ[ment], in connection with the purchase or sale of any security, . . . [of] any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe." 15 U.S.C. § 78j(b). The ensuing Rule 10b-5, 17 C.F.R. § 240.10b-5, emerged in 1943. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 737 (1975). Like Section 10(b), Rule 10b-5 prohibits "any act . . . which operates or would operate as a fraud or deceit upon any person" and makes it illegal "[t]o 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 . . . in connection with the purchase or sale of any security."
17 C.F.R. § 240.10b-5(b). Under this Rule, "the basic elements [of a private federal securities fraud action] include: (1) a material misrepresentation . . . ; (2) scienter, i.e., [defendant's] wrongful state of mind; (3) a connection with the purchase or sale of a security; (4) reliance, often referred to . . . as 'transactional causation'; (5) economic loss; and (6) loss causation, i.e., a causal connection between the material misrepresentation and the loss." Dura Pharm., Inc. v. Broudo ("Dura"), 544 U.S. 336, 341 (2005) (citing 15 U.S.C. § 78u-4(b)(4); Basic Inc. v. Levinson, 485 U.S. 224, 231-232, 248-249 (1988); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 197, 199 (1976); Blue Chip, 421 U.S. at 730-731; Thomas Lee Hazen, Law of Securities Regulation, ¶¶ 12.11,  (5th ed. 2002)). Plaintiff's pleading requirements, however, are different with respect to different elements of a 10b-5 claim.
1. Elements Subject to Heightened Pleading Requirements
The general standard of review triggered by a defendant's motion to dismiss under Rule 12(b)(6) is well-settled, i.e., the court must accept all well-pleaded allegations in the complaint as true and draw all reasonable inferences in favor of the non-moving party. See Scheuer v. Rhodes, 416 U.S. 232, 236 (1974), overruled on other grounds, Harlow v. Fitzgerald, 457 U.S. 800 (1982); Allegheny Gen. Hosp. v. Philip Morris, Inc., 228 F.3d 429, 434-35 (3d Cir. 2000). The Rule 12(b)(6) standard of review is, however, altered by Rule 9(b), which imposes a heightened pleading requirement of factual particularity with respect to allegations of fraud. Rule 9(b) states: "In all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity." Fed. R. Civ. P. 9(b). "This particularity requirement has been rigorously applied in securities fraud cases." Burlington Coat Fact. Sec. Litig., 114 F.3d 1410, 1417 (3d Cir. 1997) (citations omitted). Therefore, a plaintiff averring securities fraud claims must specify "'the who, what, when, where, and how: the first paragraph of any newspaper story.'" Advanta Corp. Sec. Litig., 180 F.3d 525, 534 (3d Cir. 1999) (quoting DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th Cir. 1990)). The Court of Appeals for the Third Circuit clarified:
[a]lthough Rule 9(b) falls short of requiring every material detail of the fraud such as date, location, and time, plaintiffs must use "alternative means of injecting precision and some measure of substantiation into their allegations of fraud." Rockefeller Ctr. Props. Sec. Litig., 311 F.3d 198, 216 (3d Cir. 2002) (quoting Nice Sys., Ltd. Sec. Litig., 135 F. Supp. 2d 551, 577 (D.N.J. 2001)). Moreover, a "stringent" reading of the requirements set forth in Rule 9(b) is expressly applicable to two elements of a securities fraud claim, i.e., scienter and material misrepresentation, because of the analogous heightened pleading requirements contained in the Reform Act.*fn3 See 15 U.S.C. § 78u-4(b)(1) and (b)(2).
Therefore, when stating "falsity," i.e., "material misrepresentation" element of his/her 10b-5 claim, a securities fraud plaintiff must "specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed." 15 U.S.C. § 78u-4(b)(1), (2). Similarly, with respect to the scienter element of the plaintiff's10b-5 claim, the Reform Act requires that "the complaint shall . . . state with particularity [all] facts giving rise to a strong inference that the defendant acted with the required state of mind." 15 U.S.C. § 78u-4(b)(2); Winer Family Trust v. Queen, 2007 U.S. App. LEXIS 22620, at *13 (3d Cir. Sept. 24, 2007) (noting that "[t]he Supreme Court has mandated a uniform construction of the strong inference standard in light of the objectives of the PSLRA" and citing Key Equity Investors, Inc. v. Sel-Leb Marketing, Inc., 2007 U.S. App. LEXIS 21392 (3d Cir. Sept. 6, 2007), and Globis Capital Partners, L.P. v. Stonepath Group, Inc., 2007 U.S. App. LEXIS 16353 (3d Cir. July 10, 2007), in support of the conclusion that "[the] scienter pleading requirement is a significant bar to litigation"); see also Higginbotham v. Baxter Int'l, Inc., 495 F.3d 753, at 756-57 (7th Cir. 2007). In sum, Rule 9(b) and the Reform Act modified the traditional Rule 12(b)(6) analysis for the purposes of pleading "misrepresentation" and "scienter" elements. See id.; see also Digital Island Sec. Litig., 357 F.3d 322, 328 (3d Cir. 2004) ("The Reform Act requires a 'strong inference' of scienter, and accordingly, alters the normal operation of inferences under Rule 12(b)(6)"); Rockefeller, 311 F.3d at 224 (noting that "'whereas under Rule 12(b)(6), [the court] must assume all factual allegations in the complaint are true, . . . under the Reform Act, [the court would] disregard 'catch-all' or 'blanket' assertions that do not live up to the particularity requirements of the statute," quoting Florida State Bd. of Admin. v. Green Tree Fin. Corp., 270 F.3d 345, 660 (8th Cir. 2001)); Advanta, 180 F.3d at 531 (unambiguously explaining that a securities plaintiff's failure to meet the heightened pleading requirements would result in dismissal of the complaint); accord Greebel v. FTP Software, Inc., 194 F.3d 185, 196 (1st Cir. 1999) ("A mere reasonable inference is insufficient to survive a motion to dismiss").
In its recent decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007), the Supreme Court elaborated on the issue of what factual allegations satisfy plaintiff's obligation to plead "strong inference" of fraud. The majority opinion stated that, to qualify as a "strong" inference, the facts alleged "must be cogent and compelling, thus strong in light of other explanations. A complaint will survive . . . only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged." Id. at 2510. Moreover, the Supreme Court expressly guided that the district court shall dismiss as insufficient those factual allegations "from which an inference of scienter [only] could be drawn." Id. (emphasis in original). Rather, the court should consider all facts alleged and "must take into account [all] plausible opposing inferences." Id. at 2509-10. Although a sufficient fraudulent inference need not be "irrefutable," nor need it be the "most plausible of competing inferences," it must be at least as strong as any other inferences that could be drawn in favor of defendants. Id. at 2510 (defining "strong" as "[p]ersuasive, effective, and cogent [and p]owerful to demonstrate or convince," and defining "inference" as "a conclusion [drawn] from known or assumed facts or statements" or "reasoning from something known or assumed to something else which follows from it") (citations omitted). The Court of Appeals for the Third Circuit emphasized this requerement. See Winer Family Trust, 2007 U.S. App. LEXIS 22620, at *21-22 and n.3 (collecting relevant decisions by various courts of appeals and citing Higginbotham,495 F.3d at 755, for the proposition that a plaintiff's factual pleading of scienter must yield an inference at least as compelling as any competing inference, Cent. Laborers' Pension Fund v. Integrated Elec. Servs., 497 F.3d 546, 550 (5th Cir. 2007), in order to stress that the courts must consider both culpable and non-culpable explanations, ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 104 (2d Cir. 2007), to observe that , where a plausible non-culpable explanation is more likely than any guilty inference, the court must find that plaintiffs failed to establish scienter, and Belizan v. Hershon, 495 F.3d 686, 670 (D.C. Cir.2007), to state that a district court's failure to conduct a comparison of alleged culpable and plausible non-culpable explanation warrants remand of the case).
2. Elements Subject to Rule 8 Pleading Requirements
It appears that the heightened pleading requirements of PSLRA are inapplicable to the remaining elements of a 10b-5 claim. See Dura, 544 U.S. at 346 ("[The Court] assume[s], at least for argument's sake, that neither the Rules nor the securities statutes impose any special further requirement in respect to the pleading of proximate causation or economic loss"). In view of the fact that only the first two Subsections of 15 U.S.C. § 78u-4(b) require investors to specify falsity and plead facts supporting a strong inference of scienter, while the remaining Subsections appear to applyonly after the heightened pleading standards of 15 U.S.C. § 78u-4(b)(1) and (2) have been met, this Court presumes that the remaining elements of any 10b-5 claim are subject to ordinary notice-pleading standards set forth in Rule 8. See 15 U.S.C. 78u-4(b)(3); accord Dura, 544 U.S. at 346 ("[T]he Federal Rules of Civil Procedure require only 'a short and plain statement of the claim showing that the pleader is entitled to relief'") (quoting Fed. R. Civ. P. 8(a)(2)).
But, even so, the "short and plain statement" must provide the defendant with "fair notice of what the plaintiff's claim is and the grounds upon which it rests." Conley v. Gibson, 355 U.S. 41, 47 (1957). [The Court recognizes] that ordinary pleading rules are not meant to impose a great burden upon a plaintiff. [See] Swierkiewicz v. Sorema N. A., 534 U.S. 506, 513-15 (2002). But it should not prove burdensome for a plaintiff . . . to provide a defendant with some indication of the [facts] that the plaintiff has in mind. . . . [A]llowing a plaintiff to forgo giving any indication of the [facts] that the plaintiff has in mind would bring about harm of the very sort the [Reform Act] seek[s] to avoid. Cf. H.R. Conf. Rep. No. 104-369, p. 31 (1995) (criticizing "abusive" practices including "the routine filing of lawsuits . . . with only a faint hope that the discovery process might lead eventually to some plausible cause of action"). It would permit a plaintiff "with a largely groundless claim to simply take up the time of a number of other people, with the right to do so representing an in terrorem increment of the settlement value, rather than a reasonably founded hope that the [discovery] process will reveal relevant evidence." Blue Chip, 421 U.S. at 741. Such a rule would tend to transform a private securities action into a partial downside insurance policy. See H. R. Conf. Rep. No. 104-369, at 31; see also Basic, 485 U.S. at 252 . . . .
Dura, 544 U.S. at 588-89; accord Burlington, 114 F.3d at 1429 (courts are not required to credit bald assertions or legal conclusions improperly alleged in the complaint); Nice, 135 F. Supp. 2d at 565 (legal conclusions draped in the guise of factual allegations may not benefit from the presumption of truthfulness).
Recently, the Supreme Court further elaborated on the requirements associated with the relaxed notice-pleading standard of Rule 8. See Bell Atlantic Corp. v. Twombly, 127 S.Ct. 1955 (2007). In this seven-to-two opinion, the Court explained that Rule 8 pleadings must provide "enough factual matter" to suggest that the alleged event took place. See id. at 1965. While the Supreme Court left it to the district courts to determine, on a case-by-case basis, how much factual matter is "enough," the Court unambiguously indicated that represented litigants alleging wrongs other that violations of their civil rights cannot satisfy Rule 8 pleading requirements by invoking the overly lenient regime of "pure notice" originated in Conley, 355 U.S. 41, a case decided half a century ago.*fn4 In fact, the Court explicitly disavowed the oft-quoted statement in Conley of "'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'" stating that the "no set of facts" language "has earned retirement" and "is best forgotten." Bell Atlantic, 127 S.Ct. at 1968-69 (quoting Conley, 355 U.S. at 45-46).
Moreover, the Court, using a variety of phrases, indicated that more than notice of a claim is needed to allege a commercial violation. For example, the Court required "enough facts to raise a reasonable expectation that discovery will reveal evidence of [the alleged claim]," "facts that are suggestive enough to render [plaintiff's allegations] plausible," "allegations plausibly suggesting (not merely consistent with) [plaintiff's allegations]," a "plain statement" with "enough heft" to show entitlement to relief, and "enough facts to state a claim to relief that is plausible on its face." Id. at 1969-74. Finally, the Court refused to entertain a plaintiff's far-fetched flights of fancy by unambiguously stating that the line "between the factually neutral and the factually suggestive . . . must be crossed [by allegations made in plaintiff's pleadings] to enter the realm of plausible liability," id. at 1966 n.5, and stated that no "reassurances of plaintiffs' counsel" that discovery would soon flesh out plaintiff's claim, which is currently pled so that it is "just shy of a plausible entitlement," can prevent Rule 12(b)(6) dismissal. Id. at 1967 and n.6 (referring to id. at 1975 (Stevens, J., dissenting)). In sum, while a securities plaintiff setting forth allegations of those 10b-5 elements that are subject to Rule 8 pleading requirements need not state with particularity all facts giving rise to a strong inference that the elements are present, plaintiff's complaint will survive dismissal only if it contains "enough [factual] heft" rather than plaintiff's conjecture and self-serving interpretations of actual events.*fn5 See Bell Atlantic, 127 S.Ct. at 1965-69; Dura, 544 U.S. at 588-89.
B. PLEADING A CLASS 10B-5CLAIM
In order for Plaintiffs' action to remain viable as a class action, Plaintiffs must continuously comply with the four prerequisites of Rule 23(a), that is, numerosity, commonality, typicality and adequacy, and must also satisfy the requirements of Rule 23(b)(3).*fn6 See Baby Neal v. Casey, 43 F.3d 48 (3d Cir. 1994). Commonality does not require an identity of claims or facts among class members. See Newton v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 259 F.3d 154, 183 (3d Cir. 2001) (citing Prudential Ins. Co. Am. Sales Practice Litig. Agent Actions, 148 F.3d 283, 310 (3d Cir. 1998), and Baby Neal, 43 F.3d at 56). "Commonality under Rule 23(a)(2) is met where, notwithstanding some factual differences, the class action claims are based on a 'common course of conduct' of misrepresentations, omissions, or other wrongdoing affecting all class members in the same manner." Yadlosky v. Grant Thornton L.L.P., 197 F.R.D. 292, 298 ( E.D. Mich. 2000) (citing Computer Memories Sec. Litig., 111 F.R.D. 675, 684 (N.D. Calif. 1986)). Within the setting of a securities action, a plaintiff alleging a certain source of stock price inflation has to allege that the source of inflation was common to every purchaser. See Blackie v. Barrack, 524 F.2d 891 (9th Cir. 1975), cert. denied, 429 U.S. 946 (1980). By contrast, the pleading of such plaintiff are insufficient if the pleading indicate that either the plaintiff or other members of the class purchased fairly priced or price-deflated stock, or bought stock inflated by another source. Cf. Shamrock Assocs. v. Moraga Corp., 557 F. Supp. 198, 206 (D. Del. 1983). Similarly, with respect to typicality, "factual differences will not render a claim atypical if the claim arises from the same event or practice or course of conduct that gives rise to the claims of the class members." Newton, 259 F.3d at 183. However, within the realm of securities law, a plaintiff alleging that statements of defendants caused the market price of a corporation's stock to be inflated above its true value through a class action must state facts indicating that the price inflation was present at every point throughout period, see Aboudi v. Daroff, 65 F.R.D. 388, 391 (S.D.N.Y. 1974), and cannot satisfy the pleading requirements by alleging inflation of the stock price during only certain parts of the class period rather than the entire span of time.*fn7 See Richland v. Cheatham, 272 F. Supp. 148 (S.D.N.Y.1967).
C. PLEADING A DERIVATIVE CLAIM AGAINSTCONTROLLINGPERSONS
Section 20(a) of the 1934 Act, 15 U.S.C. § 78(a), states that "[e]very person who, directly or indirectly, controls any person liable [for securities fraud] shall also be liable jointly and severally with and to same extent as such controlled person." 15 U.S.C. § 78t(a). Thus, for a controlling person to be liable, the person over whom control was exercised must have committed a primary violation of the securities laws. See Merck & Co. Sec. Litig., 432 F.3d 261 (3d Cir. 2005); Digital Island, 357 F.3d at 337; Shapiro v. UJB Fin. Corp., 964 F.2d 272, 279 (3d Cir. 1992). To establish a prima facie case that the defendant was a controlling person, the plaintiff must show that: (1) the defendant had actual power or influence over the controlled person; and (2) the defendant actually participated in the alleged illegal activity.*fn8 See Kersh v. General Council of the Assemblies of God, 804 F.2d 546, 548 (9th Cir. 1986); Rochez Bros., Inc. v. Rhoades, 527 F.2d 880, 885 (3d Cir. 1975); Mobile Media Secs. Litig., 28 F. Supp. 2d 901, 940 (D.N.J. 1998); Klein v. Boyd, 949 F. Supp. 280 (E.D. Pa. 1996), aff'd in part, rev's on other grounds, 1998 U.S. App. LEXIS 2004 (3d Cir. Feb. 12, 1998); Gordon v. Diagnostek, Inc., 812 F. Supp. 57 (E.D. Pa. 1993).
V. PLEADING SPECIFIC ELEMENTSOFA10B-5CLAIM
A. PLEADING THE "FALSE AND MISLEADING STATEMENT"ELEMENT
1. Pleading an Affirmative Misrepresentation
When a securities plaintiff challenges a statement made by a defendant, plaintiff's mere usage of catchwords or bold assertions that defendant's statement was false or misleading because the defendant knew or must have known it to be false or misleading cannot lend support to plaintiff's claim. See, e.g., GSC Partners CDO Fund v. Washington, 368 F.3d 228, 239 (3d Cir. 2004) ("[I]t is not enough for plaintiffs to merely allege that defendants 'knew' their statements were fraudulent or that defendants 'must have known' their statements were false"); accord Tellabs, 127 S.Ct. at 2509-10. "[Plaintiff's] mere second-guessing of [defendant's] calculations will not suffice; [the plaintiff] must show that [the defendant's] judgment--at the moment exercised--was sufficiently egregious such that a reasonable [person] reviewing the facts and figures should have concluded that [these facts or figures] were misstated and [in addition,] that . . . the public was likely to be misled. [Securities] 'law does not expect clairvoyance.'" IKON Office Solutions, Inc., 277 F.3d 658, 673 (3d Cir. 2002) (quoting Denny v. Barber, 576 F.2d 465, 470 (2d Cir. 1978)); see also DiLeo, 901 F.2d at 627) ("[P]roffer[ing a] different financial statement [is not sufficient.] Investors must point to some facts suggesting that the difference is attributable to fraud"); Suprema Specialties, Inc. Sec. Litig. ("Suprema-District"), 334 F. Supp. 2d 637, 647 (D.N.J. 2004) ("Allegations that a company's later financial difficulties imply that earlier financial statements were untrue or misleading are 'fraud by hindsight' and do not state a claim") (citations omitted), rev'd on other grounds, Suprema Specialties, Inc. Sec. Litig. ("Suprema-Appellate"), 438 F.3d 256 (3d Cir. 2006).
2. Pleading Misrepresentation Based on Failure to Disclose
"When an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak [since a] duty to disclose under § 10(b) does not arise from the mere possession of nonpublic market information." Chiarella v. United States, 445 U.S. 222, 235 (1980). As the Third Circuit explained,
"Silence, absent a duty to disclose, is not misleading under Rule 10b-5." Basic, 485 U.S. [at] 239 n.17 . . . ; see also Burlington, 114 F.3d at 1432 ("Except for specific periodic reporting requirements . . . there is no general duty on the part of a company to provide the public with all material information"). Such a duty to disclose may arise [only] when there is [an incident of] insider trading, [or presence of] a statute requiring disclosure, or [there was] an inaccurate, incomplete or misleading prior disclosure [requiring a corrective statement]. See Glazer v. Formica Corp., 964 F.2d 149, 157 (2d Cir. 1992); Backman v. Polaroid Corp., 910 F.2d 10, 12 (1st Cir. 1990) (en banc); General Motors Class E Stock Buyout Sec. Litig., 694 F. Supp. 1119, 1129 (D. Del. 1988).
Oran v. Stafford, 226 F.3d 275, 286-87 (3d Cir. 2000) (emphasis supplied); see also Galati v. Commerce Bancorp, Inc., 2007 U.S. App. LEXIS 7315 (3d Cir. Mar. 29, 2007) (reiterating the standard and dismissing plaintiffs' allegations that "[d]efendants made several . . . false and misleading [statements] by virtue of their failure to speak fully and accurately about the illegal bid-rigging and kick-back scheme" in view of defendants lack of duty to disclose those facts, which plaintiffs qualified as indicators of "illegal schemes"). Explaining the rationale for the rule, the Court of Appeals for the Sixth Circuit noted that this set of requirements preserves the healthy limits on a public corporation's "duty to disclose all information . . ." because corporations might otherwise "face potential second-guessing in a subsequent disclosure suit," a regime that would threaten to "deluge investors with marginally useful information, and would damage corporations' legitimate needs to keep some information non-public."
City of Monroe Emples. Ret. Sys. v. Bridgestone Corp., 399 F.3d 651, 669 (6th Cir. 2005) (quoting Digital Island, 357 F.3d at 329 n.10); see also, Burlington, 114 F.3d at 1432 ("[Management's] possession of material nonpublic information alone does not create a duty to disclose it") (quoting Time Warner Sec. Litig., 9 F.3d 259, 267 (2d Cir. 1993), and citing Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1202 (1st Cir. 1996), and Roeder v. Alpha Indus., Inc., 814 F.2d 22, 26 (1st Cir. 1987)); Milton v. Van Dorn Co., 961 F.2d 965 (1st Cir. 1992) (where plaintiffs bought the stock of a subsidiary company of the parent corporation and, after the sale was completed, another of the parent corporation's subsidiaries announced plans to produce a competing product, nondisclosure of the other subsidiary's production plans was immaterial).
B. PLEADING THE "SCIENTER"ELEMENT
1. Pleading Intentional or Recklessness State of Mind
The term "scienter" means "a mental state [of] intent to deceive, manipulate or defraud." (quoting Ernst, 425 U.S. at 193 n.12). To successfully plead scienter, a securities plaintiff must plead "conscious misbehavior or recklessness." GSC, 368 F.3d at 236; see also SEC v. Infinity Group Co., 212 F.3d 180, 192 (3d Cir. 2000), cert. denied, 532 U.S. 905 (2001). The requirement to allege defendants' intentional state of mind, that is, defendants' "conscious misbehavior," sets forth a very high pleading standard. See IKON, 277 F.3d at 667. Moreover, in securities matters, the term "recklessness" is not interpreted lightly. The Court of Appeals instructed that the term "recklessness" means a "highly unreasonable (conduct), involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care,. . . which presents a danger of misleading [the parties to the transaction] that is either known to the defendant or is so obvious that the actor must have been aware of it."
Id. (quoting Ernst, 425 U.S. at 193 n.12); see also Advanta, 180 F.3d at 535. Therefore, when assessing the sufficiency of plaintiff's pleading alleging a reckless violation of Rule 10b-5, courts are expected to be mindful of the fact that, in securities matters, "recklessness is a lesser form of intent rather than a greater degree of negligence . . . . Reckless conduct may be defined as a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care."
2. Pleading Scienter by Inference
Since scienter is based on the defendant's state of mind and, as such, may be difficult to prove with direct evidence, courts are willing to permit an inference that the defendant acted with the requisite scienter. See, e.g., Fine v. Am. Solar King Corp., 919 F.2d 290 (5th Cir. 1990), cert. dismissed, 502 U.S. 976 (1991). However, such inferences are not to be made lightly. See, e.g., Rothman v. Gregor, 220 F.3d 81 (2d Cir. 2000) ($1.6 million dollar profit from inside trading was not sufficiently unusual to provide an inference of scienter). To withstand the scrutiny imposed by the Reform Act, the inference of scienter must be both strong and based on the facts with particularity. See 15 U.S.C. § 78u-4(b)(1) and (2) (the plaintiff shall state "particular facts giving rise to a strong inference that the defendant acted with the required state of mind"); Tellabs, 127 S.Ct. at 2510 ("A complaint will survive . . . only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged"); see also Higginbotham, 495 F.3d 753 (affirming dismissal of the complaint for failure to properly allege scienter with respect to restatement of a corporation's earnings during the preceding three years); Alpharma Sec. Litig., 372 F.3d 137, 150 (3d Cir. 2004); The End of the Unbearable Lightness of Pleading, 48 UCLA L. Rev. 973 (2001).
A plaintiff may establish the requisite strong inference of fraudulent intent in one of two ways: (1) by alleging facts "establishing a motive and an opportunity to commit fraud"; or (2) "by setting forth facts that constitute circumstantial evidence of either recklessness or conscious behavior." Advanta, 180 F.3d at 534; see also Burlington, 114 F.3d at 1418. Both methods are equally acceptable and, "[w]hile it is true that motive can be a relevant consideration, and personal financial gain may weigh heavily in favor of a scienter inference," the Supreme Court has said that "the absence of a motive allegation is not fatal." Tellabs, 127 S.Ct. at 2511.
a. Inferring Scienter from Defendant's "Motive and Opportunity"
If the plaintiff desires to employ the "motive and opportunity" method, the plaintiff should demonstrate a logical connection between the alleged fraud and motive in order to establish a reasonable inference of fraud: plaintiffs' allegations as to defendants' motive to defraud investors with respect to a certain matter cannot be matched with plaintiffs' facts that defendants committed fraud with respect to another matter. See Glickman v. Alexander & Alexander Servs., 1996 U.S. Dist. LEXIS 2325, at *36 (S.D.N.Y. Feb. 27, 1996) ("[There should be a] coherent nexus between the alleged fraudulent conduct and its alleged purpose"); cf. Glessner v. Kenny, 952 F.2d 702, 714 (3d Cir. 1991) (pleading a "complaint is not a mix and match game"). Furthermore, there must be more than conclusory allegations of motive and opportunity, see, e,g., Mortensen v. AmeriCredit Corp., 123 F. Supp. 2d 1018 (N.D. Tex. 2000); Livent, Inc. Sec. Litig., 78 F. Supp. 2d 194 (S.D.N.Y. 1999), or a mere set of assertions "from which an inference of [motive and opportunity] rationally could be drawn." Tellabs, 127 S.Ct. at 2510 (emphasis in original). Rather, a strong inference of motive and opportunity may arise only if the complaint sufficiently alleges that the defendants: (1) "benefitted in a concrete and personal way from the purported fraud"; (2) "engaged in deliberately illegal behavior"; (3) "knew facts or had access to information suggesting that their public statements were not accurate"; or (4) "failed to check information they had a duty to monitor." Novak v. Kasaks, 216 F.3d 300, 311 (2d Cir. 2000); see Wilson v. Bernstock, 195 F. Supp. 2d 619, 633 (D.N.J. 2002) ("Motive entails allegations that the individual corporate defendants stood to gain in a concrete and personal way from one or more of the allegedly false or misleading statements and wrongful nondisclosures. . . . [M]otive and opportunity 'like all other allegations of scienter must now be supported by facts stated with particularity and must give rise to a strong inference of scienter'") (quoting Advanta, 180 F.3d at 535); Cybershop.com Sec. Litig., 189 F. Supp. 2d 214 (D.N.J. 2002).
Under this pleading standard, a plaintiff may not rely on facts indicating that the defendant had certain goals or aspirations (or sought to engage in the industry practices) common to the law-abiding business community , since such goals or practices cannot amount to a valid motive for the purposes of showing scienter. See GSC, 368 F.3d at 237 ("'Motives that are generally possessed by most corporate directors and officers do not suffice'") (quoting Kalnit v. Eichler, 264 F.3d 131, 139 (2d Cir. 2001)) (lack of capitalization restored); San Leandro Emergency Med. Group Profit Sharing Plan v. Phillip Morris Cos., Inc., 75 F.3d 801, 814 (2d Cir. 1996) ("[A] company's desire to maintain a high bond or credit rating" is an insufficient motive for fraud because such motive could be imputed to any company. If scienter could be pleaded on that basis alone, virtually every company in the United States that experiences a downturn in stock price could be forced to defend securities fraud actions"); Tuchman v. DSC Communications Corp., 14 F.3d 1061, 1068 (5th Cir.1994) ("[I]ncentive compensation can hardly be the basis on which an allegation of fraud is predicated") (citation omitted); Nice, 135 F. Supp. 2d at 584 ("[T]he allegation that [d]efendants made false and misleading statements to secure market share is . . . insufficient to demonstrate that
[d]efendants had a motive to commit fraud"); Boeing Sec. Litig., 40 F. Supp. 2d 1160, 1175 (W.D. Wash. 1998) ("[T]he desire to remain profitabl[e] is a generic motive that fails to satisfy the heightened pleading standards for scienter under the PSLRA").
b. Inferring Scienter from Circumstantial Evidence
If the plaintiffs choose to use the other method of establishing scienter, that is, by asserting circumstantial evidence of intent or recklessness, "the strength of the circumstantial allegations must be [even] greater." Kalnit, 264 F.3d at 142; see Oran, 226 F.3d at 288-89. In that situation, the plaintiffs must support their allegations by detailing, with particularity, "the who, what, when, where and how" of the events at issue and present clear facts verifying plaintiff's deductions with respect to defendant's state of mind. Burlington, 114 F.3d at 1422 (citing DiLeo, 901 F.2d at 627); see also Ronconi v. Larkin, 253 F.3d 423, 437 (9th Cir. 2001) (finding that a temporal proximity of events is insufficient circumstantial evidence). Moreover, the totality of circumstantial facts alleged must give rise to inference of scienter "at least as compelling as any opposing inference one could draw from the facts." Tellabs, from which an inference of at 2510.
i. Inferring Scienter from GAAP Violations
The seminal case addressing the issue of inferring scienter from violations of Generally Accepted Accounting Principles ("GAAP") is the Third Circuit's decision examining so-called "positive portrayals," that is, public statements that were alleged to have been inaccurate. See Advanta, 180 F.3d 525. The complaint in Advanta alleged that defendants had publicly made certain "positive portrayals" of the corporation that were materially misleading. See id. at 538 (Since Advanta's annual report included the following statement regarding the quality of the company's credit portfolio: "While we added substantially to our account base, our credit quality remained excellent," Advanta plaintiffs alleged that this and similar statements were materially false "because they failed to disclose the deterioration in [Advanta's] credit" during the time when Advanta "implemented policies relaxing its underwriting and monitoring procedures"). With respect to the scienter element, plaintiffs made "conclusory assertions that the defendants acted 'knowingly' [or] must have been aware of the [true facts] by virtue of their positions within the company." Id. at 539. Affirming the dismissal of the complaint, the Third Circuit explained that scienter must "not rest on a bare inference that a defendant 'must have had' knowledge of the facts." Id. (citing Maldonado v. Dominguez, 137 F.3d 1, 10 (1st Cir. 1998); Greenstone v. Cambex Corp., 975 F.2d 22, 26 (1st Cir. 1992)). In other words, knowledge of the falsity of publicly made statements generally will not be imputed to defendants, absent particular factual allegations supporting a strong inference that they knew or must have known of the falsity of their statements at the time they were made.*fn9
To explain its rationale, the Third Circuit distinguished Advanta from a district court case, Ancor Communs., Inc. Sec. Litig., 22 F. Supp. 2d 999 (D. Minn. 1998), in which the company had announced a $30 million supply contract for one of its products, resulting in a dramatic increase in the price of its stock. Later, the contract was cancelled due to product incompatibility, causing the company's share price to plummet. As in Advanta, the Ancor complaint alleged that defendants were (or should have been) aware that the product would likely prove incompatible as of the time the company entered into the supply contract at issue and, therefore, the public announcement was false or misleading when made. See Ancor, 22 F. Supp. 2d at 1004-05. But, unlike in Advanta, two salient facts permitted the "unusually strong inference" to be drawn in the Ancor case: (1) the complaint alleged that the supply contract was by far the most significant contract in Ancor's history and, therefore, Ancor defendants should have been intimately aware of its provisions, and (2) the complaint pointed to some other extrinsic evidence of the defendants' knowledge, such as discussions among officers regarding the incompatibility problem, and the fact that there was an escape clause in the contract governing possible incompatibility. See Advanta, 180 F.3d at 539. As neither of these types of facts was alleged in Advanta, the Court of Appeals would not make the inferential leap that Advanta plaintiffs there invited, namely, that Advanta defendants "must have known" their statements were false when made. The Court of Appeals ruled that, without some persuasive particulars to support this allegation, the Advanta complaint failed to allege a strong inference of the necessary scienter under the PSLRA. See id. at 539.
The differences between Advanta and Ancor illustrate an important point about the substantive meaning of recklessness in the securities fraud context, namely, that--in a case involving inaccurate public statements--simply alleging that defendants "knew or should have known" is not enough and, "where plaintiffs contend defendants had access to contrary facts, they must specifically identify the reports or statements containing this information." Novak, 216 F.3d at 309 (citing San Leandro, 75 F.3d at 805).
Since cases involving allegations that defendants violated GAAP present nothing but a subgroup of the inaccurate public statement category of securities cases, the courts have uniformly held that allegations of scienter based on GAAP violations do not create the requisite strong inference of scienter unless plaintiffs' complaint alleges "more." See Wyser-Pratte Mgt. Co. v. Telxon Corp., 413 F.3d 553, 563 (6th Cir. 2005); Ferris, Baker Watts, Inc. v. Ernst & Young, L.L.P., 395 F.3d 851, 855 (8th Cir. 2005); Saxton, Inc. Sec. Litig., 156 Fed. App. 917, 920 (9th Cir. 2005); PR Diamonds, Inc. v. Chandler, 364 F.3d 671, 694 (6th Cir. 2004); Kushner v. Beverly Enter., 317 F.3d 820, 831 (8th Cir. 2003); Pirraglia v. Novell, Inc., 339 F.3d 1182, 1192 (10th Cir. 2003); Abrams v. Baker Hughes, Inc., 292 F.3d 424, 432 (5th Cir. 2002); Navarre Corp. Sec. Litig., 299 F.3d 735, 745 (8th Cir. 2002); DSAM Global Value Fund v. Altris Software, Inc., 288 F.3d 385, 390 (9th Cir. 2002); City of Philadelphia v. Fleming Cos., 264 F.3d 1245, 1261 (10th Cir. 2001); Ziemba v. Cascade Int'l, Inc., 256 F.3d 1194, 1208 (11th Cir. 2001); Novak, 216 F.3d at 309; Greebel, 194 F.3d at 203-04; Comshare, Inc. Sec. Litig., 183 F.3d 542, 553 (6th Cir. 1999); Stevelman v. Alias Research, Inc., 174 F.3d 79, 84-85 (2d Cir. 1999); Carter-Wallace, Inc. v. Hoyt, 150 F.3d 153 (2d Cir. 1998); Chill v. GE., 101 F.3d 263, 270 (2d Cir. 1996); Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir. 1994); Malone v. Microdyne Corp., 26 F.3d 471, 479 (4th Cir. 1994); Fine, 919 F.2d at 297. The decisions rendered in this Circuit are no exception. See Alpharma, 372 F.3d 137; Advanta, 180 F.3d 525; Westinghouse Sec. Litig., 90 F.3d 696 (3d Cir. 1996).
Although the decisions which held that GAAP violations or restated financials, without more, do not create the requisite strong inference of scienter do not provide an exhaustive list of the "more" that satisfies the pleading requirements (and have left the matter to be assessed on a case-by-case basis), it appears that the "more" envisioned by the courts consists of the panoply of such facts which could sufficiently indicate that defendants had clear reasons to doubt the validity of the issuer's financials but, nonetheless, kept turning a blind eye to all such factual "red flags." See Rothman, 220 F.3d 81 (plaintiffs did not adequately plead scienter where the complaint alleged that defendants' policy of expensing prepaid royalties was contrary to GAAP, resulting in nearly $74 million in royalties continuing to be reported as assets long after they should have been expensed); Comshare, 183 F.3d at 553 (plaintiffs failed to plead scienter properly--although plaintiffs' allegations combined both GAAP violations and claims of failure to adequately monitor relevant information--since plaintiffs did not allege specific facts to show that defendants knew or could have known about the accounting errors, "or that their regular procedures should have alerted them to the errors sooner than they did"); compare Novak, 216 F.3d at 312 (discussing Cosmas v. Hassett, 886 F.2d 8 (2d Cir. 1989), and Goldman v. Belden, 754 F.2d 1059 (2d Cir. 1985), two pre-PSLRA cases involving inaccurate public statements that the Novak court selected as examples of cases in which defendants "knew facts or had access to information suggesting that their public statements were not accurate." In Cosmas, just as in Ancor, the plaintiffs alleged that the sales to China promised by defendants were not viable under the then-existing trade restrictions of which defendants were actually aware, and in Goldman plaintiffs alleged that defendants were actually informed about the facts making their statements untrue but elected to ignore the unfavorable information); accord Health Mgt. Sec. Litig., 970 F. Supp. 192 (E.D.N.Y. 1997) (a strong inference of recklessness is sufficiently pled where the complaint alleges that defendant was actually advised of but ignored "red flags").
ii. Inferring Scienter from SOX Certifications
Section 302 of the Sarbanes-Oxley Act ("SOX") required the SEC to implement rules under which principal executive and financial officers of public companies certify to the general truthfulness of the company's quarterly and annual reports. See 15 U.S.C. § 78m, 78o(d); 17 C.F.R. § 240.13a-14(b)(2). The certification requirement obligates officers to state that, based on their knowledge, the report does not contain any material misrepresentations or omit any material fact otherwise necessary to make the other disclosures not misleading. See 116 Stat. at 777; 17 C.F.R. § 240.13a-14(b)(2). Additionally, the report has to identify the officer's basis for making the certification and each officer must certify that he or she and other officers are "responsible for establishing and maintaining" disclosure controls and procedures. See 116 Stat. at 777; 17 C.F.R. § 240.13a-14(b)(4). Moreover, the certifying officers must also certify to having "evaluated the effectiveness of the issuer's internal controls" and procedures within the previous ninety days and have "presented in the report their conclusions about the effectiveness" of the disclosure controls and procedures. See id.
However, since neither Section 302 nor its implementing regulations make any reference to the creation of a private cause of action or indicate an intent to modify securities fraud pleading requirements under the PSLRA, including the requirement to plead strong inference of scienter, see Kogan v. Robinson, 432 F. Supp. 2d 1075, 1076 (S.D. Cal. 2006); Neer v. Pelino, 389 F. Supp. 2d 648, 657 (E.D. Pa. 2005); BiSys Group, Inc. Derivative Action, 396 F. Supp. 2d 463, 464 (S.D.N.Y. 2005); Whitehall Jewelers, Inc. S'holder Derivative Litig., No. 05-C-1050, 2006 WL 468012, at 7 (N.D. Ill. Feb. 27, 2006); Harold S. Bloomenthal, Sarbanes-Oxley Act in Perspective § 74 (2002), it appears that the test applicable to erroneous SOX certifications mirrors that coined for public statements in general and for GAAP violations in particular, i.e., (a) erroneous SOX certifications automatically encompassing all above-listed requirements cannot, without "more," create the requisite strong inference of scienter; and (b) plaintiffs must allege facts indicating that certifying defendants had clear reasons to doubt the validity of financials being certified but kept turning their blind eye to all "red flags." See WatchGuard Sec. Litig. ("WatchGuard II"), 2006 U.S. Dist. LEXIS 74269 (W.D. Wash. Oct. 12, 2006); InVision Techs., Inc. Sec. Litig., 2006 WL 538752 (N.D. Cal. Feb. 27, 2006). Both cases are quite instructive.
In WatchGuard, plaintiffs brought their 10b-5 claim in the wake of WatchGuard's financial restatement, which: (a) implicitly admitted errors in applying GAAP; (b) expressly admitted errors in income classification, revenue recognition and calculation of liabilities ensuing from customer-rebate obligations; and (c) revealed the falsity of all Sarbanes-Oxley certifications containing assurances that the stated financial results were adequate, and that the certifying officers had designed adequate financial controls, evaluated those controls, and disclosed any material weaknesses. See WatchGuard II, 2006 U.S. Dist. LEXIS 74269, at *3. Assessing plaintiffs' challenges based on violations of GAAP and erroneous SOX certifications, the WatchGuard court reminded plaintiffs of the "truism" that "[f]alse statements are an insufficient basis for a securities fraud claim, [and] culpability arises only when a defendant makes a false statement with scienter," and dismissed the complaint reasoning as follows:
[p]laintiffs must show that the Sarbanes-Oxley certifications accompanying [the erroneous] results were culpably false. . . . The court assumes for present purposes that better "controls" would have revealed the ground-level problems at issue. This assumption is not without controversy. Although WatchGuard admitted to material weaknesses in its controls when it issued the . . . restatement, it did not reveal which controls were inadequate. Under these circumstances, it is not obvious what "controls" would have ameliorated the problems that [p]laintiffs identify. It appears that [d]efendants should have had better awareness of the sales practices and returns processing practices at issue, but there is no indication that "controls" would have provided that awareness. The court shelves those concerns, however, and assumes that better controls would have, at the very least, led WatchGuard to discover these problems sooner.
Even under the assumption that WatchGuard's misstated earnings are the result of shoddy controls, the court finds no strong inference of scienter as to [d]efendants' inaccurate Sarbanes-Oxley certifications. For many of the reasons that the court has already discussed [in its previous opinion], there are no allegations that create a strong inference that [d]efendants knew WatchGuard's controls were inadequate, or were deliberately reckless regarding those controls. Plaintiffs' allegations suggest that WatchGuard took steps to assess its controls during the class period, and acted to improve its controls when it discovered those problems. They do not raise a strong inference that any [d]efendant acted culpably in designing those controls, assessing them, or certifying them under the Sarbanes-Oxley Act. That the controls were inadequate is perhaps an indication of incompetence, but incompetence, even gross incompetence, is no basis for a securities fraud claim.
Id. at *32-33; see also WatchGuard Sec. Litig. ("WatchGuard I"), 2006 U.S. Dist. LEXIS 27217, at *29-31 (W.D. Wash. Apr. 21, 2006) (the opinion dismissing the original complaint of the WatchGuard plaintiffs, which noted that, in view of WatchGuard's previous errors necessitating the financial restatement, any SOX certification of WatchGuard's officers as to the correctness of original financial data or as to adequacy of reporting controls would be, by definition, untrue, since--had these certifications been true--plaintiffs would have no case, but not every erroneous SOX certification is a culpable one).
The court in InVision reached the same conclusion. In InVision, plaintiffs challenged InVision's merger announcement stating that "acquisition [was] subject to normal closing conditions including customary regulatory approval," even though InVision was undergoing investigations by the United States Department of Justice and the SEC with respect to InVision's possible violations of the Foreign Corrupt Practices Act. See InVision, 2006 WL 538752, at *1. The InVision plaintiffs alleged that defendants acted with requisite scienter in view of defendants' SOX certification stating that InVision's officers designed, established, maintained and evaluated the effectiveness of InVision's internal control over financial reporting and related control procedures. See id. at *2. Dismissing plaintiffs' complaint, the court in InVision: (a) observed that defendants' certification merely stated that defendants crafted the control system defendants believed to be adequate and disclosed all weaknesses or lack thereof that defendants were aware of at the time of certification, (b) refused to interpret the sole fact that defendants' beliefs were erroneous or knowledge was limited as an indication that defendants were either aware of these shortcomings or intentionally overlooked them, and (c) directed plaintiffs to plead the facts indicating actual culpability--rather than mere ignorance--on the part of defendants at the time of SOX certification. See id. at *6-7.
Notably, both the WatchGuard and InVision courts contrasted the facts of their cases with the case where plaintiffs properly alleged SOX violation together with "more" evidence, i.e., that defendants improperly changed accounting journal entries in order to artificially inflate revenue and then executed a SOX certification while being well aware of the impropriety of the change. See WatchGuard II, 2006 U.S. Dist. LEXIS 74269, at *32 (discussing Lattice Semiconductor Corp. Sec. Litig., 2006 U.S. Dist. LEXIS 262 (D. Or. Jan. 3, 2006), a case presenting "markedly different circumstances" in view of the fact that the SOX certification in Lattice was made after the Lattice defendants "cooked the books"); InVision, 2006 WL 538752, at *7 n.3 (making the same observations as to the fact pattern in Lattice and making the distinctions analogous to the ones noted in WatchGuard).
In sum, while the issue of what impact a Sarbanes-Oxley certification has on a 10b-5 claim is a relatively novel question, the above-discussed holdings indicate that--as with allegations that defendants violated GAAP--allegations based on defendants' erroneous SOX certification cannot establish the requisite strong inference of scienter unless the complaint asserts facts indicating that, at the time of certification, defendants knew or consciously avoided any meaningful exposure to the information that was rendering their SOX certification erroneous.*fn10
3. Pleading Scienter by Relying on Confidential Information
Even though all allegations relating to the falsity of a defendant's statement must be pled with particularity, see 15 U.S.C. § 78u-4(b)(1) and (2), a plaintiff in securities fraud actions can support a complaint by reliance on information attributed to confidential sources. See Novak, 216 F.3d at 313-14 (holding that, while the PSLRA "may compel revelation of confidential sources under certain circumstances," there was no per se requirement of disclosure if the plaintiff states sufficient facts to support plaintiff's allegations). However, statements from undisclosed confidential sources can be used only in two situations: (1) if the complaint sets forth other factual allegations, such as documentary evidence, which are sufficient alone to support a fraud allegation, see id. at 314; Royal Dutch/Shell Transp. Sec. Litig., 380 F. Supp. 2d 509 (D.N.J. 2005) (finding sufficient corroboration in specific notes, memoranda, emails and presentation materials); compare Barnum v. Millbrook Care Ltd. Partnership, 850 F. Supp. 1227, 1232-33 (S.D.N.Y. 1994) (if the allegations are contradicted by the documents, the documents control), aff'd, 43 F.3d 1458 (2d Cir. 1994); or (2) when the confidential sources are described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the [confidential] source would possess the information alleged. See Royal Dutch, 380 F. Supp. 2d 509.
Elaborating on the latter scenario, the Court of Appeals explained that the complaint must disclose: (1) the time period that the confidential source worked at the defendant-company, (2) the dates on which the relevant information was acquired, and (3) the facts detailing how the source obtained access to the information. See Cal. Pub. Emples'. Ret. Sys. v. Chubb Corp., 394 F.3d 126,146 (3d Cir. 2004); Freed v. Universal Health Servs., 2005 U.S. Dist. LEXIS 7789 (E.D. Pa. May 3, 2005); Portal Software, Inc. Secs. Litig., 2005 U.S. Dist. LEXIS 20214, at *28 (N.D. Cal. Aug. 10, 2005) ("[P]laintiffs must describe the job title, job description, duties, and dates of employment for the controller's sources before this information can be deemed reliable"). Moreover, in Chubb, the Court of Appeals held that allegations attributed to the information obtained from a confidential source must contain specific details regarding the basis for the source's personal knowledge and describe supporting events in detail. See id.; see also Northpoint Communs. Group, Inc., Sec. Litig., 184 F. Supp. 2d 991, 999-1000 (N.D. Cal. 2001); U.S. Aggregates, Inc. Sec. Litig., 235 F. Supp. 2d 1063, 1074 (N.D. Cal. 2002); Ramp Networks, Inc., 201 F. Supp. 2d 1051, 1067 (N.D. Cal. 2002). Failure to meet these requirements with respect to each and every confidential source the plaintiff relies upon, renders that source irrelevant for the purposes of plaintiff's allegations. See Chubb, 394 F.3d at 146. "The sheer volume of confidential sources cited cannot compensate for these inadequacies. . . . Cobbling together a litany of inadequate allegations does not render those allegations particularized in accordance with Rule 9(b) or the PSLRA." Id. at155; see also Am. Bus. Fin. Servs., Inc. Sec. Litig., 413 F. Supp. 2d 378, 391-92 (E.D. Pa. 2005) (finding statements from five insufficiently identified confidential sources inadequate).
C. PLEADING THE "MATERIALITY"ELEMENT
The test of materiality depends not upon the literal truth of statements but upon the ability of reasonable investors to become accurately informed. See McMahan & Co. v. Warehouse Entertainment, Inc., 900 F.2d 576, 579 (2d Cir. 1990), cert. denied, 501 U.S. 1249 (1991). This is sometimes referred to as the mosaic representation thesis. See TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976); Genentech, Inc. Sec. Litig., 1989 WL 137189 (C.D. Cal. 1989). Thus, a finding of materiality is based on the total mix of information available, see Ieradi v. Mylan Labs., Inc., 230 F.3d 594 (3d Cir. 2000), and the concept of materiality cannot be distilled into a bright-line test, see Basic, 485 U.S. 224, see also Shapiro, 964 F.2d at 281; Ganino v. Citizens Util. Co., 228 F.3d 154 (2d Cir. 2000), short of stating that an alleged misrepresentation cannot be deemed material to an investor if the general public has access to correct information. See Basic, 485 U.S. at 231-32; Wallace v. Systems & Computer Tech. Corp., 1997 U.S. Dist. LEXIS 14677, at *42-44 (E.D. Pa. Sept. 22, 1997).
Since materiality is determined in context, a purchaser or seller of securities is not necessarily entitled to all information relating to each of the circumstances surrounding the transaction. See Acito v. IMCERA Group, 47 F.3d 47 (2d Cir. 1995) (deficiencies found by FDA inspectors at one of many business locations were not material); Wilensky v. Digital Equip. Corp., 903 F. Supp. 173 (D. Mass. 1995), aff'd in part, rev'd in part on other grounds, 82 F.3d 1194 (1st Cir. 1996) (failure to disclose details of new marketing strategy was immaterial); accord Press v. Quick & Reilly, Inc., 218 F.3d 121 (2d Cir. 2000) (intermediary's conflict of interest is immaterial). Therefore, it is not sufficient to show that a shareholder might have found the information to be of interest: the plaintiff has to establish importance of the particular piece of information to a reasonable investor in order to plead a material misstatement. See Burlington, 114 F.3d at 1432 ("'[A] corporation is not required to disclose a fact merely because a reasonable investor would very much like to know that fact") (quotation omitted).
D. PLEADING THE "RELIANCE"ELEMENT
A securities plaintiff must plead both "transactional" and "loss causation," where the former is an assertion that the plaintiff relied on defendant's false or misleading statement to purchase the stock in question. See Emergent Capital Inv. Mgmt. v. Stonepath Group, Inc., 343 F.3d 189, 197 (2d Cir. 2003). The "transactional causation" requirement, also known as the "reliance" element, is a corollary of materiality. See Semerenko v. Cendant Corp., 233 F.3d 165, 180 (3d Cir. 2000). As under common law, the reliance requirement applies in securities fraud cases, and reliance is an element of a private claim under Rule 10b-5. See List v. Fashion Park, Inc., 340 F.2d 457, 452 (2d Cir. 1965), cert. denied, 382 U.S. 811, reh'g denied, 382 U.S. 933 (1965). Thus, if a duty to disclose is established, and the misrepresentation is deemed material, the plaintiff must still demonstrate reliance by showing a causal link between the misrepresentation and the plaintiff's entry into the transaction which eventually harmed the plaintiff.*fn11 See Basic, 485 U.S. at 243. "There is, however, more than one way to demonstrate the causal connection." Id.
1. Two Methods to Plead Reliance
"In face-to-face transactions, [an] inquiry into an investor's reliance . . . is [the inquiry] into the subjective pricing . . . by that investor." Basic, 485 U.S. at 244 (quoting LTV Sec. Litig., 88 F. R. D. 134, 143 (N.D. Tex. 1980)). In a face-to-face transaction, an investor has no reason to rely on the integrity of an offered price because the price may not reflect available information. See Gariety v. Grant Thornton, LLP, 368 F.3d 356, 367 (4th Cir. 2004) (citing Basic, 485 U.S. at 243-44). For face-to-face transactions, the reliance requirement serves to ensure that the plaintiffs who would not have acted differently if the true information were known cannot recover. The requirement guarantees, in other words, that information that does not affect a buyer's or seller's view of the merits of a transaction cannot form the basis of a cause of action.
Id. (citations omitted). Therefore, a securities plaintiff asserting individualized, that is, direct actual reliance is required to plead that the plaintiff was actually aware of and misled by an alleged misrepresentation. See Semerenko, 223 F.3d at 178 (citing Peil v. Speiser, 806 F.2d 1154, 1160 (3d Cir. 1986), for discussion of various theories of reliance).
Since proving reliance could be hard in view of the nature of modern securities markets, federal courts fashioned a "fraud-on-the-market" presumption for proving reliance based on the Efficient Capital Market Hypothesis, i.e., the premise that, if the market is efficient, the information disclosed by issuers, issuers' agents and analysts is both available to and ...