FLORIDA STATE BOARD OF ADMINISTRATION, Plaintiff-Appellant, v. GREEN TREE FINANCIAL CORPORATION; Lawrence M. Coss; Robert D. Potts; Edward L. Finn, Defendants-Appellees. Securities and Exchange Commission, Amicus on Behalf of Appellant. In re: Green Tree Financial Corporation, Stock Litigation, Vivian Chill, on behalf of herself and others similarly situated, Plaintiffs-Appellants, v. Green Tree Financial Corporation; Lawrence M. Coss; Robert D. Potts; Richard G. Evans; Edward L. Finn; Joel H. Gottesman, Defendants-Appellees. In re: Green Tree Financial Corporation: Options Litigation, June Shapiro, on behalf of herself and others similarly situated, Plaintiffs-Appellants, v. Green Tree Financial Corporation; Lawrence M. Coss; Robert D. Potts; Robley D. Evans; Edward L. Finn; Joel H. Gottesman, Defendants-Appellees.
Nos. 99-3536, 99-3586 and 99-3587
United States Court of Appeals, Eighth Circuit
Submitted: Dec. 11, 2000. Filed: Oct. 25, 2001.
Rehearing and Rehearing En Banc Denied: Nov. 29, 2001.*
270 F.3d 645
* Judge LOKEN did not participate in the consideration or decision of this case.
Samuel D. Heins, Minneapolis, MN, argued, for Appellant Vivian Chill.
Luis de la Torre, Washington, D.C., argued, Patrick V. Dahlstrom, Chicago, IL, for Amicus USA.
Gregory P. Joseph, New York, NY, argued, for appellee.
Before McMILLIAN and JOHN R. GIBSON, Circuit Judges, and LAUGHREY,1 District Judge.
JOHN R. GIBSON, Circuit Judge.
In this case we must assess the sufficiency of three complaints under the new pleading standards made applicable to securities fraud cases by the Private Securities Litigation Reform Act of 1995,
I.
For the purpose of a motion to dismiss, we take the facts from the complaints. Green Tree is a financial services corporation that originally specialized in lending money on house trailers, referred to as “manufactured housing,” although it later diversified into other kinds of lending. Because manufactured housing loans are classified as “sub-prime,” the interest rates are very high—as much as 200 to 400 basis points (two to four percentage points) above residential mortgage rates. Green Tree rose to prominence by pioneering the securitization of manufactured housing loans, which means that it pooled large numbers of these loans and put them into a trust, which sold securities for which the loans served as collateral. The securities
As it securitized each loan pool, Green Tree booked a current gain on the transaction, even though the expected profits would not actually come into its coffers until much later and even though the amount of those profits would fluctuate with Green Tree‘s success in collecting the loan payments. This “gain-on-sale revenue” was the force that drove Green Tree‘s reported earnings during the periods covered by the complaints. Gain-on-sale receivables made up 63.8% of the net revenue that Green Tree originally reported for 1996. In addition to the income, Green Tree also recorded the present value of the securitizations as balance sheet assets called “Excess Servicing Rights Receivable” or “Interest Only Securities.” In 1996 “Excess Servicing Rights Receivable” was the greatest single asset on Green Tree‘s balance sheet.
In order to estimate the present value of the securitizations, Green Tree had to assume three things: (1) the discount rate (reflecting the lesser value of a dollar to be paid in the future than a dollar paid today); (2) the loan default rate; and (3) the loan prepayment rate. The numbers chosen for these assumptions played a crucial role in deciding the amount Green Tree would report as earnings on the securitizations and as the value of the Excess Servicing Rights Receivable. Choosing a figure for prepayment rate was especially difficult because if interest rates fell substantially or if other lenders competed aggressively, borrowers would be likely to refinance in large numbers. If that happened, the loans and consequently, the expected profit on them, would simply disappear. A discrepancy between assumed prepayment rates and actual prepayment experience could have a serious effect on Green Tree‘s earnings and balance sheet.
The crux of this suit is the investors’ allegation that Green Tree used “unrealistic and unreasonable” assumptions in its gain-on-sale accounting, thus overvaluing its assets and overstating its earnings. In particular, the investors allege that the actual prepayment experience from 1995 to 1997 varied so much from the prepayment rate Green Tree assumed in its gain-on-sale accounting for 1994 and 1995 securitizations that Green Tree‘s financials and other publicly filed reports during the 1995-1997 period were materially false. The investors concede that Green Tree publicly disclosed its actual prepayment experience. However, they allege the defendants refused to disclose what prepayment assumptions Green Tree had used in its gain-on-sale accounting and that this constituted omission of a material fact necessary to prevent its financial reports from being misleading. Green Tree stated in its public filings with the SEC that its management regularly reevaluated Green Tree‘s prepayment assumptions in light of actual experience. According to the complaints, the defendants either knew that
In any event, Green Tree‘s assumptions about prepayment rates turned out to be seriously inadequate. Green Tree announced on November 13, 1997, that it planned to increase the prepayment reserve in its 1997 financials by an estimated $125-150 million because of higher than expected prepayment rates on manufactured housing loans. This announcement caused a precipitous decline in Green Tree‘s stock price, from $42 to $30.75. The day after the announcement, in a conference call with industry analysts, CEO Coss disclosed the prepayment assumptions Green Tree had been using for the 1994 and 1995 pools.4 He assured analysts, “I don‘t see any set of circumstances that would cause us to [write down the 1994-1995 loan pools] again. And if we thought there was any set of circumstances that would, we would have provided more.” He also stated that a revision of prior earnings was not appropriate.
On January 27, 1998, Green Tree took an addition to its reserves of $190 million, rather than the $125-150 million addition to reserves anticipated in the November announcement. At the same time, it took a $200 million reduction of its previously reported 1996 earnings. In the press release accompanying the financials, Green Tree explained the decision to make larger adjustments than it had announced before; in reviewing its financial modeling, it “determined it had not fully considered the effect upon its interest only securities of partial prepayments (principal curtailments) and the impact that higher prepayments have on projected future interest due to investors on a weighted average basis.” Green Tree‘s stock fell as low as $18.
On April 7, 1998, about two months after the close of the class periods, Green Tree announced that it would be acquired by Conseco, Inc., in a merger. On July 6, 1998, Conseco took charges totaling $350 million to write down the carrying value of Green Tree‘s interest-only securities, reflecting adjustment to assumptions for prepayment rates, discount rates, and default rates.
The investors allege that several motives prompted the defendants to spread misleading financial information through the market. First, they allege that the compensation of defendant Coss and other Green Tree executives was tied to Green Tree‘s financial results, which made the defendants want to maximize Green Tree‘s reported earnings. In particular, CEO Coss had a remarkable contract awarding him 2.5% of Green Tree‘s pre-tax income (minus other executives’ bonuses). Coss‘s contract was to expire December 31, 1996. Accordingly, it was in Coss‘s personal interest to report as much income as possible before the expiration of his lucrative contract. Other motives alleged are: (1) the defendants’ desire to maintain a high corporate credit rating to maximize the selling price of the loan pools; and (2) Green Tree‘s need to demonstrate exemplary financial results in order to fend off a pending derivative suit alleging that the company wasted corporate assets by paying excessive executive compensation.
II.
The stock purchasers’ class, the option traders’ class and the Florida State Board of Administration each filed a complaint alleging that Green Tree and the defendant officers of Green Tree violated
The defendants moved to dismiss the complaints for failure to state a claim under
Applying
The district court then turned to the central issue in this case—whether the complaints met the Reform Act‘s requirements for pleading scienter,
Considering the allegations that the defendants were motivated to exaggerate Green Tree‘s financial performance in order to increase the performance-based compensation of Green Tree‘s executives, the court held that performance-based compensation alone does not give rise to a strong inference of scienter. Id. at 873 (citing Acito v. IMCERA Group, Inc., 47 F.3d 47, 54 (2d Cir.1995), and Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1130 (2d Cir.1994)). The unusual size of Coss‘s performance incentives, while “clearly shocking,” id., did not provide the extra ingredient necessary to establish scienter. Id. Moreover, the court held that the complaints did not even show that the misrepresentations increased Coss‘s compensation, since he had to give back a proportional amount of his 1996 compensation after Green Tree restated its 1996 financial results in 1998. Id. The 1995 results were not restated, so the district court held that there was no showing that they were misstated. Id. Coss and the other executives’ 1997 compensation was based on year-end results, which were figured after the revelation of the prepayment problems. Id. The investors argued that even though the defendants may not have actually profited from the misstatements, they could have hoped to do so, and this would supply the motive for fraud. The court responded that any such hope would have been so irrational that it could not be regarded as a motive. Id. at 874. Finally, any possible showing of motive to misrepresent would be rebutted by the fact that defendants Potts, Finn, and Gottesman bought Green Tree stock on the open market during the time period of the alleged fraud. Id. The court rejected the investors’ other theories of motive as well. Id.
The district court then considered whether the complaints contained facts that, in the absence of a showing of motive, nevertheless amounted to strong circumstantial evidence of scienter. The complaints allege that defendants monitored actual prepayment rates as they occurred throughout the periods covered in the complaints. Id. at 875. The investors’ theory was that once the defendants knew the actual prepayments for the 1994 and 1995 pools exceeded their assumed rates, their continued publication of financial statements based on assumptions they knew to be inadequate demonstrates intentional or reckless misrepresentation. Id. The district court held that the complexity of the accounting issue precluded this inference. Id. Amending the assumptions for pools that had already been sold was only one possible response to the problem; other responses would be to increase the assumed prepayment rate for future pools, which the defendants did beginning in 1996, and to increase prepayment reserves, which Green Tree did throughout the relevant period. Id. at 876. Therefore, the district court held that knowledge of the disparity between the prepayment assumptions and actual experience for the 1994 and 1995 pools would not satisfy the statutory pleading requirements without some additional evidence of wrongdoing. Id. at 877.
The investors sought to supply that additional evidence in three ways: (1) by pointing to the restatement of 1996 financial results as an admission that Green Tree knew those results were misleading when published; (2) by alleging that Green Tree‘s accounting practices violated generally accepted accounting practices (GAAP) in various respects; and (3) by juxtaposing Green Tree‘s publicized estimate of $125-150 million in charge-offs in November 1997 with its actual adjustments of $390
The district court concluded that the complaints did not adequately allege scienter and therefore dismissed them with prejudice. Id. at 878.
III.
for any person directly or indirectly, by use of any means or instrumentality or interstate commerce, or of the mails or any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.
Our Circuit has adopted a definition of recklessness
limited to those highly unreasonable omissions or misrepresentations that involve not merely simple or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and that present a danger of misleading buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it.
Camp v. Dema, 948 F.2d 455, 461 (8th Cir.1991) (stating requirements for establishing aider and abetter liability under
The question before us is whether the facts pleaded in the complaints adequately plead scienter. At the outset we must determine what pleading standard the investors have to satisfy. Complaints brought under
There is disagreement in the various circuits about the meaning of the strong-inference-of-scienter pleading standard. Our circuit has not yet decided the question, and the district court declined to decide it because the court concluded the investors had not framed an adequate complaint under any of the possible standards. 61 F.Supp.2d at 870. The investors contend that to establish a strong inference of scienter, they have only to plead either (1) facts showing the defendants had the motive and opportunity to commit fraud or (2) facts constituting strong circumstantial evidence of scienter. The defendants contend that a complaint cannot survive under the Reform Act based on allegations showing motive and opportunity alone. Additionally, the defendants contend that the investors have not pleaded facts showing motive and opportunity, or any other theory adequate to raise a strong inference of scienter.
Where the statutory language is susceptible of competing interpretations, we resort to legislative history to help determine congressional intent. Arkansas AFL-CIO v. F.C.C., 11 F.3d 1430, 1440 (8th Cir.1993) (en banc); Dubois v. Thomas, 820 F.2d 943, 949 (8th Cir.1987).
The strong inference standard has its genesis in case law antedating the Reform Act. Since its adoption in 1937,
In particular, the Second Circuit began to require plaintiffs in fraud cases to plead facts that “give rise to a ‘strong inference’ that the defendants possessed the requisite fraudulent intent.” Beck v. Manufacturers Hanover Trust Co., 820 F.2d 46, 50 (2d Cir.1987). In Beck, Judge Newman elaborated in a discussion that became the black-letter law of the Second Circuit:
A common method for establishing a strong inference of scienter is to allege facts showing a motive for committing fraud and a clear opportunity for doing so. See e.g., Goldman v. Belden, 754 F.2d 1059, 1070 (2d Cir.1985). Where motive is not apparent, it is still possible to plead scienter by identifying circumstances indicating conscious behavior by the defendant, though the strength of the circumstantial allegations must be correspondingly greater.
Id. (citations omitted and emphasis added).
From this discussion in Beck, it is not apparent that Judge Newman meant to say that pleading facts that show a motive and opportunity to commit fraud would, alone, satisfy
The rule that pleading motive and opportunity alone would give rise to a strong inference of scienter was remarkable for two reasons. First, having the motive and opportunity to do wrong are certainly not the same as having the intent to do it. See In re Comshare, Inc. Sec. Litig., 183 F.3d 542, 551 (6th Cir.1999) (quoted with approval in Greebel v. FTP Software, Inc., 194 F.3d 185, 197 (1st Cir.1999)). The rule, taken literally, presumes that anyone who has the chance to profit by wrongdoing is likely to do so. This is a large leap.
The second remarkable thing about the assertion that pleading motive and opportunity alone gives rise to a strong inference of fraud is the size of the breach it would leave in a pleading standard that was said to be stringent and tough. Nearly every highly ranked executive of a company could be said to have the motive and the opportunity to profit by misstatements. “Greed is a ubiquitous motive, and corporate insiders and upper management always have the opportunity to lie and manipulate.” Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1286 (11th Cir.1999) (quoting Carley Capital Group v. Deloitte & Touche, L.L.P., 27 F.Supp.2d 1324, 1339 (N.D.Ga.1998)).
If motive could be pleaded by alleging the defendant‘s desire for continued employment, and opportunity by alleging the defendant‘s authority to speak for the company, the required showing of motive and opportunity would be no realistic check on aspersions of fraud, and mere misguided optimism would become actionable under the securities laws.
Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1130 (2d Cir.1994). Nor would it constitute a pleading of “motive” to allege that the defendant wanted to maintain his or her company‘s profitability or credit rating, either for its own sake or to increase thereby the defendant‘s own compensation, see Chill v. Gen. Elec. Co., 101 F.3d 263, 268 (2d Cir.1996); Acito v. IMCERA Group, Inc., 47 F.3d 47, 54 (2d Cir. 1995), even though common sense would suggest that these may be the very motives that prompt many cases of deceptive misstatements. Instead, the Second Circuit came to interpret “motive and opportunity” as requiring allegations that the “defendants benefitted in some concrete and personal way from the purported fraud,” Novak v. Kasaks, 216 F.3d 300, 307 (2d Cir.), cert. denied, 531 U.S. 1012, 121 S.Ct. 567, 148 L.Ed.2d 486 (2000), with the prototypic case being insider trading. Id. (“[I]n the ordinary case, adequate motive arose from the desire to profit from extensive insider sales.“). But see Press v. Chem. Inv. Serv. Corp., 166 F.3d 529, 538 (2d Cir.1999) (in case against three corporations, sufficient allegation of motive to aver that defendants would benefit from four-day “float” on a $100,000 T-bill). Yet, the difference between a case in which the defendant allegedly lied to increase his or her performance-driven compensation and one in which he or she allegedly lied to profit from insider trading is not so much a difference in the type of motive as a difference in the evidence that the defendant intended to capitalize on the opportunity. In either case, the defendant stands to make money (how much money depends entirely on the facts of the cases). But in the insider trading case, trading at a particular time is circumstantial evidence that the insider knew the best time to trade because he or she had inside information not shared by the public. This in turn is circumstantial evidence that he or she kept the information from the public in order to trade on the unfair advantage. See e.g., Stevelman v. Alias Research Inc., 174 F.3d 79, 85 (2d Cir.1999) (holding that allegation that officers sold off large portions of stockholdings during period of alleged misrepresentations “supports the inference that [CEO] withheld disclosures that would depress his stock until he had profitably sold his shares“); Greebel, 194 F.3d at 197 & n. 10. In contrast, in the executive compensation case, there is no telltale action (other than the false statement) to suggest guilty knowledge or purpose.
Whatever the difficulties in applying the Second Circuit‘s strong-inference-of-scienter standard, when Congress decided to reform securities litigation to eliminate strike suits, it regarded the Second Circuit standard as the “most stringent pleading standard” in the country.
The subsequent legislative history shows a great deal of confusion about whether the strong-inference-of-fraud standard was the same standard with the motive-and-opportunity test as without it. Senator Specter clearly thought it was not. He introduced an amendment to add the motive-and-opportunity language into the text of the bill. 141 Cong. Rec. 17,286 (1995).8 He reasoned that without this caveat, the strong-inference-of-scienter standard posed an impossible task for plaintiffs. “How do you get into somebody else‘s head?” he asked. 141 Cong. Rec. 17,424 (1995). It is not clear, however, if Senator Specter‘s objection was that the standard
was simply so vague that it might be interpreted unevenly or whether he believed the motive-and-opportunity language was a substantive relaxation of the strong-inference standard.9
The Specter amendment passed on the Senate floor, 141 Cong. Rec. 17,425 (1995), only to be deleted in the Conference Committee. The Conference Report stated: “Because the Conference Committee intends to strengthen existing pleading requirements, it does not intend to codify the Second Circuit‘s case law interpreting this pleading standard.”
Although the import of the Conference Report seems to be that any reference to the motive-and-opportunity test applied in the Second Circuit was disapproved, the legislative history does not support that reading. Admittedly, the opponents of the bill, including President Clinton, characterized the deletion of the Specter amendment as a decision to raise the pleading standard above the Second Circuit standard.10 E.g., 141 Cong. Rec. at 38,194
In sum, the legislative history provides nothing but uncertainty about whether the motive-and-opportunity test is an inherent part of the strong inference standard or whether it modifies and relaxes that standard. Ultimately, the Act as passed does not resolve this question.11
The Circuits that have interpreted the Reform Act have fallen into (at least) three camps. The Ninth Circuit inferred from the deletion of the Specter amendment by the Conference Committee that Congress expressly rejected the Second Circuit‘s “two-pronged test” and raised the pleading standard to a level beyond that in the Second Circuit. In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 978-79 (9th Cir. 1999).
At the other end of the spectrum, the Second and Third Circuits have held that in using the “strong inference” language, the Reform Act adopted a pleading standard “approximately equal in stringency to that of the Second Circuit,” In re Advanta Corp. Sec. Litig., 180 F.3d 525, 534 (3d Cir.1999); Novak v. Kasaks, 216 F.3d 300, 310 (2d Cir.2000), including the motive-and-opportunity formulation, Advanta, 180 F.3d at 534-35; Ganino v. Citizens Util. Co., 228 F.3d 154, 168-70 (2d Cir.2000). The Second Circuit qualified its conclusion by stating that “Congress‘s failure to include language about motive and opportunity suggests that we need not be wedded to these concepts in articulating the prevailing standard,” Novak, 216 F.3d at 310, but that courts should nevertheless be guided by the motive-and-opportunity
Occupying the middle ground, the First, Fifth, Sixth, Tenth, and Eleventh Circuits have held that the primary effect of the Reform Act is to require a pleading to state facts giving rise to a “strong inference of scienter.” Allegations of motive and opportunity may or may not rise to that level in a particular case. See Nathenson v. Zonagen Inc., 267 F.3d 400, 409-11 (5th Cir.2001); City of Philadelphia v. Fleming Cos., 264 F.3d 1245, 1261-63 (10th Cir.2001); Helwig v. Vencor, Inc., 251 F.3d 540, 551 (6th Cir.2001) (en banc); Greebel v. FTP Software, Inc., 194 F.3d 185, 197 (1st Cir.1999); Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1282-83 (11th Cir.1999). “While it is true that motive and opportunity are not substitutes for a showing of recklessness, they can be catalysts to fraud and so serve as external markers to the required state of mind... ‘[M]otive’ and ‘opportunity’ are simply recurring patterns of evidence.” Helwig, 251 F.3d at 550.
Putting aside the Ninth Circuit standard, which gives the deletion of the Specter amendment a more pointed reading than it will bear, the split in the other Circuits is more apparent than real. As we discussed above, supra at 656, the Second Circuit has dramatically constricted the types of “motive and opportunity” that it will recognize as sufficient to plead scienter. It will not allow plaintiffs to proceed based on widely held motives such as “(1) the desire to maintain a high corporate credit rating or otherwise sustain ‘the appearance of corporate profitability, or of the success of an investment, [or] (2) the desire to maintain a high stock price in order to increase executive compensation or prolong the benefits of holding corporate office.‘” Novak, 216 F.3d at 307 (internal citations omitted). Even complaints based on insider trading must allege more than that the defendant benefitted from trading because of a false statement or misleading omission; the insider trades have to be “unusual,” either in the amount of profit made, the amount of stock traded, the portion of stockholdings sold, or the number of insiders involved, before they will give rise to the required inference of scienter. See Rothman v. Gregor, 220 F.3d 81, 94 (2d Cir.2000); In re Advanta, 180 F.3d at 540-541; Oran v. Stafford, 226 F.3d 275, 290 (3d Cir.2000). This is the same kind of inquiry undertaken by courts that do not adhere to the motive-and-opportunity formulation. See Nathenson, 267 F.3d at 420; Helwig, 251 F.3d at 552; Greebel, 194 F.3d at 198. The search in the Second Circuit line of cases, as well as in the other circuits, is for facts that give a strong reason to believe that there was reckless or intentional wrongdoing. See Greebel, 194 F.3d at 197 (facts must support strong inference of scienter, rather than merely reasonable inference). Taken as a whole, the cases simply do not substantiate the fear that courts applying the motive-and-opportunity formulation will permit pleadings to go forward without facts strongly suggesting wrongdoing.
The Reform Act itself adopted only the strong-inference-of-scienter standard,
Therefore, we can say three things about motive and opportunity allegations. First, motive and opportunity are generally relevant to a fraud case, and a showing of unusual or heightened motive will often form an important part of a complaint that meets the Reform Act standard. Second, in some cases the same circumstantial allegations that establish motive and opportunity also give additional reason to believe the defendant‘s misrepresentation was knowing or reckless. For instance, in insider trading cases, the timing of trades shows motive and opportunity, but it may also provide additional circumstantial evidence that the defendant knew of an advantage. Such allegations may meet the Reform Act standard, but if so it is because they give rise to a strong inference of scienter, not merely because they establish motive and opportunity. Third, when the complaint does not show motive and opportunity of any sort—either the unusual, heightened motive highlighted in the Second Circuit cases, or even an everyday motive such as keeping one‘s job—then other allegations tending to show scienter would have to be particularly strong in order to meet the Reform Act standard. Cf. Matsushita Elec. Indus. Co. v. Zenith Radio Corp., 475 U.S. 574, 587, 106 S.Ct. 1348, 89 L.Ed.2d 538 (1986) (in Sherman Act context, where there appeared to be no rational motive to break the law, a plaintiff would have to adduce a particularly strong case in order to survive summary judgment).
IV.
This case was decided under both the Federal Rules of Civil Procedure and the Reform Act. The Reform Act modifies the ordinary
Second, under
Congress has effectively mandated a special standard for measuring whether allegations of scienter survive a motion to dismiss. While under
We review de novo the district court‘s dismissal of complaints pursuant to
V.
We must evaluate the cogency of the investors’ allegations against the strong inference standard. The investors argue that Coss and the other executives’ performance-based compensation gave the defendants a motive not to disclose the prepayment problems.13 The stock purchasers class, for example, alleged:
In 1995 and 1996, Green Tree had the highest paid business executive in the entire United States. In 1995 and 1996, defendant Coss was paid, in cash and deeply discounted stock, $65 million and $102 million, respectively. Under the terms of his 1991 employment agreement, which was in effect until the end of 1996, Coss was paid 2.5% of the Company‘s pre-tax income, in addition to a base salary of over $430,000. After Green Tree restated its 1996 earnings, Coss was required to repay $25.9 million of his 1996 bonus.
. . .
As a result of the approaching expiration of the 1991 employment agreement, Coss knew that 1996 would be the last year for which he would receive bonus compensation valued in the tens of mil-
lions of dollars.... Coss‘s 1997 compensation was valued at approximately $4.8 million, about $97 million less than the value of his original 1996 compensation.
Even in the Second Circuit, pleading that a defendant‘s compensation depends on corporate value or earnings does not, by itself, establish motive to fraudulently misrepresent corporate value or earnings. Novak, 216 F.3d at 307; Acito, 47 F.3d at 54. Here, the investors allege that Coss‘s arrangement established a legally significant motive because the amount of his compensation was based on a percentage of Green Tree‘s pre-tax earnings, and his contract was set to expire at the end of 1996, making it urgent for Coss to maximize Green Tree‘s earnings for that year. Green Tree originally booked earnings for 1996 that allowed Coss to earn $102 million. Roughly a year later, Green Tree found it necessary to revise its 1996 earnings retrospectively.
We conclude that the magnitude of Coss‘s compensation package, together with the timing coincidence of an overstatement of earnings at just the right time to benefit Coss, provides an unusual, heightened showing of motive to commit fraud. The motive and opportunity allegations regarding Coss are therefore an important part of a circumstantial case against him and consequently, against Green Tree, which was subject to Coss‘s control.
The defendants contend that Coss‘s compensation is irrelevant because Coss wound up giving back a proportional amount of his 1996 compensation after the 1996 earnings were restated in January 1998. But Coss did not necessarily know at the time of the alleged misrepresenta-
The district court held that, even without such hindsight, such a gamble was so unlikely to succeed that the court would not infer that Coss tried it:
[T]here is no allegation in the pleadings from which it can be inferred that defendants could have concealed (forever) a significant gap between projected and actual earnings, even if prepayment speeds eventually had slowed. Furthermore, this alleged motive is premised on mere hope: even assuming that defendants knew that the company‘s earnings were inflated and that a later turnaround could have been used to conceal past poor performance, plaintiffs allege no facts which suggest that defendants had reason to believe that economic forces beyond their control would change dramatically enough to correct the alleged earnings woes.
61 F.Supp.2d at 873-74. To the contrary, the allegations provide powerful support for the idea that defendants hoped that the prepayment problem would come out in the wash—why else would they have waited until 1998 to reveal and remedy the problem? The complaints plead that defendants knew their assumed prepayment rate and they knew their actual rates as those rates were unfolding. This amounts to knowledge of the prepayment discrepancy. If the valuation of the interest-only securities turned out to be significantly wrong, there can be no question that it would be material to the accuracy of Green Tree‘s financials. Assuming the defendants knew of the prepayment discrepancy, if we deprive them of the expectation that this discrepancy would be offset by other factors or later experience, we deprive them of an innocent explanation for their failure to correct their financials. Indeed, the defendants’ theory of this case is that they failed to correct the financials because the accounting was sufficiently complex that they reasonably believed the financials were fairly stated despite the prepayment discrepancy. Somewhere in between the defendants’ theory that the assumptions were still reasonable and the district court‘s theory that the defendants could not have hoped to conceal the inadequacy of the assumptions, lies the investors’ theory. The investors allege that the defendants knew facts that showed the assumptions were materially inadequate, but the defendants recklessly attempted to sweep the problem under the rug hoping a change in the economy would ameliorate the problem. We cannot conclude that this is a case in which the motive theory is too irrational to add to the weight of other circumstantial allegations, and we therefore must disagree with the district court‘s determination to the contrary.
Notably, the complaints do not allege that the executives sold their stock during the class periods.14 Indeed, the defen-
dants point to documents filed with the S.E.C. indicating that the executive defendants owned more Green Tree stock at the end of the class period than at the beginning. Defendants Finn, Gottesman, and Potts bought more than $870,000 in Green Tree stock during the stock and option class period. Apparently, only Richard Evans sold stock during the class period. The defendants argue that these purchases are so inconsistent with the idea that defendants intentionally inflated the value of Green Tree stock that they “defeat” the investors’ pleading of motive.
The shareholders respond that the executives’ stock transactions are outside the four corners of the complaints and are therefore not to be considered on a motion to dismiss. The executives’ stock transactions are documented in public filings required to be filed with the SEC, which other circuits have considered on a motion to dismiss. See Rothman v. Gregor, 220 F.3d 81, 88 (2d Cir.2000); Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1275-81 (11th Cir.1999) (taking judicial notice under
But whether or not the documents detailing defendants’ trading history can be considered on motion to dismiss, they do not neutralize the motive allegations because they do not directly contradict them. In cases in which plaintiffs sought to use stock transactions as evidence of motive, the Second Circuit has held that certain defendants’ abstention from trading stock so undercut the investors’ allegations of motive that the complaints failed to state a claim. Acito, 47 F.3d at 54; San Leandro Emerg. Med. Plan v. Philip Morris Cos., 75 F.3d 801, 814 (2d Cir.1996); accord Advanta, 180 F.3d at 539-40; see also Nathenson, 267 F.3d at 420; Ronconi v. Larkin, 253 F.3d 423, 436 (9th Cir.2001); Helwig, 251 F.3d at 571-72 (Kennedy, J., dissenting). In this case, however, the investors do not rely on allegations of inside transactions, but on other motives, such as the hope of huge bonuses, that are not directly undermined by their abstention from trading.
Coss argues that since his bonus was in the form of stock, not cash, he would have only benefitted from the fraud by selling his stock. This argument wounds but does not defeat the investors’ theory of Coss‘s motive, since the investors allege that Coss‘s bonus was in cash as well as stock. We cannot resolve a factual dispute on a motion to dismiss. Furthermore, getting the stock bonus would have been a first step in Coss‘s plan to benefit from manipulating Green Tree‘s earnings. We may not dismiss the investors’ complaint merely because the alleged plan did not come to fruition. The defendants may well make effective use at trial of the fact that they held their stock, but this fact does not neutralize the investors’ other motive allegations for purposes of the motion to dismiss.
The other executives besides Coss object that they did not share Coss‘s lucrative employment contract and that it is not plausible that they would commit fraud to enrich someone else. The compensation allegations against the other executives are obviously weaker evidence of motive than
The investors also allege that the defendants were motivated by the desire to maintain a high credit rating for Green Tree so that its securitizations would continue to sell at good prices. The desire to maintain a high credit rating is universally held among corporations and their executives and consequently does not contribute significantly to an inference of scienter. Novak, 216 F.3d at 307; San Leandro, 75 F.3d at 814.
The investors claim that defendants were motivated during the class period to show exemplary performance by Green Tree to enhance their defense of a derivative suit for corporate waste that was not filed until January 23, 1997, a year and a half into the class period alleged by the stockholders’ and option traders’ classes. The investors seem to concede that defense of a non-existent suit cannot supply a motive for the first year and a half of the alleged misrepresentation. Moreover, the defendants made their November 1997 and January 1998 revelations while the state suit was pending. While the pendency of a derivative suit could supply an important motive in some circumstances, we cannot say that it automatically satisfies the scienter requirement. The inference to be drawn depends on the facts of the case, and the timing issues in this case undermine the notion that the derivative suit played an important role in the events at issue.
The options traders’ class and the shareholders’ class also argue in their briefs that the defendants were motivated to overstate Green Tree‘s financial results in order to make it more attractive to a potential buyer. They did not plead any such facts. The district court said that even if they had pleaded this theory, it would have been too implausible to suggest that Green Tree hoped a buyer would purchase the company without performing its own examination of Green Tree‘s financial status. 61 F.Supp.2d at 874. Another problem with the theory is that the only merger on the horizon was the merger with Conseco, Inc., a transaction announced April 7, 1988—months after the November 1997 and January 1998 revelations. This is too thin a reed on which to hang an inference of scienter existing during the class period. Cf. Rothman, 220 F.3d at 94 (whether motive to inflate stock sufficiently pleaded by alleging impending acquisition “might well depend on the particular circumstances of the case“).
While this is not the kind of case in which the facts showing motive and opportunity alone create a strong inference of scienter, nevertheless, Coss‘s extraordinary compensation package, on the very eve of expiring, created a powerful incentive to see to it that Green Tree made plenty of money before his contract expired. For Coss and for Green Tree, this factor is an important part of the overall picture of scienter. It appears that the investors’ motive allegations against the other executives are basically derivative from their case against Coss. They argue that “Coss was the dominant force at Green Tree” and that the Green Tree board of directors lacked independence
VI.
In addition to the motive-and-opportunity allegations, the complaints contain other facts that give rise to a strong inference of fraud. In broad outline, the investors pleaded with particularity that defendants knew the prepayment assumptions on which their gain-on-sale accounting for the 1994 and 1995 pools were based, they knew that actual experience in 1995, 1996 and the first three quarters of 1997 deviated from those premises greatly, and they issued financials that did not take account of the disparity between the assumptions and actual experience. Specifically, Green Tree‘s gain-on-sale accounting assumed that the 1994 and 1995 pools would experience prepayment at a rate referred to as “100 MHP,”15 meaning roughly that after twenty-four months the borrowers would be prepaying the loans at the rate of 6% per annum. In fact, the loans were being prepaid at a much faster rate, with the majority of the pools running well above the 6% per annum rate at ten months. “At 24 months, the loans were being prepaid at a rate of between 9.0% and 16.30%.” The shareholders have appended to their complaint a chart indi-
cating that the problem was pronounced as early as July 1995. The complaints alleged that the defendants were informed of the actual prepayment rates “on at least a monthly basis.” Green Tree‘s SEC filings stated: “Actual default and prepayment experience are reviewed quarterly.” In the November 14, 1997 conference call with industry analysts, Coss stated that Green Tree had been taking additional reserves in connection with this prepayment problem since the fourth quarter of 1996. There is no dispute that the prepayment problem led to Green Tree‘s $390 million write-down in January 1998.
One of the classic fact patterns giving rise to a strong inference of scienter is that defendants published statements when they knew facts or had access to information suggesting that their public statements were materially inaccurate. See Novak, 216 F.3d at 311; Hollin v. Scholastic Corp. (In re Scholastic Corp. Sec. Litig.), 252 F.3d 63, 76 (2d Cir.2001), petition for cert. filed, 70 U.S.L.W. 3164 (U.S. Aug. 30, 2001) (No. 01-397); Howard v. Everex Sys. Inc., 228 F.3d 1057, 1064 (9th Cir.2000); City of Philadelphia v. Fleming Cos., 264 F.3d 1245, 1260-61 (10th Cir.2001) (in case of omissions, scienter proved by knowledge of omitted fact plus knowledge that omission likely to mislead). Here, the investors alleged that defendants published statements with knowledge of facts indicating crucial information in the statements was based on discredited assumptions. These allegations give rise to a strong inference of scienter. See Rothman v. Gregor, 220 F.3d 81, 91 (2d Cir.2000) (where defendants regularly assessed likelihood of recouping investment in asset, failure to ex-
The defendants respond that this is too simplistic a view of a case involving sophisticated financial transactions in which the accounting decisions were difficult and even very large mistakes could fall within the realm of good faith. The defendants contend:
[T]he securities that Green Tree issues are complex, with multiple layers (tranches) of debt at varying rates, making all of Green Tree‘s valuation calculations complex. For example, with respect to the ‘weighted average’ interest rate issue [which Green Tree cited as causing greater write-downs than anticipated in November 1997], prepayments cause high priority tranches of the securities (which bear lower interest rates) to pay down more quickly, so the weighted average interest rate to be paid out to investors in the future increases.
Undoubtedly, the accounting issues are complex; whether they were handled within the parameters of good faith decision-making or whether the decisions amounted to recklessness will surely be the focus of any trial of this case. We will not prejudge that issue. But neither the district court, nor we, can conduct a battle of experts on a motion to dismiss. Rather, we must assume the truth of the allegations pleaded with particularity in the complaint. The strong-inference pleading standard does not license us to resolve disputed facts at this stage of the case.
The defendants contend that they did respond to the discrepancy between actual and assumed prepayment rates by adding to their reserves.16 This response does not rob the investors’ allegations of their effect. First, although adding to reserves could correct the discrepancy, in light of the $390 million write-down announced in January 1998, it is clear that whatever response defendants took was not adequate. It was, after all, necessary to amend the 1996 financials retrospectively in 1998 to reduce reported earnings by $200 million. Moreover, in the November 14, 1997 conference call, Coss said that Green Tree had begun increasing reserves in response to the prepayment problem in the third quarter of 1996. This supports the inference that Green Tree did not begin responding to the prepayment problem until the end of 1996, whereas the investors have alleged that the problem was apparent by July 1995. Coss also characterized those additions to reserves as “relatively modest.” Whether defendants could have believed during the class period that the reserves were an adequate response is a question of fact that cannot render the complaints inadequate, lest the heightened pleading requirements of the Reform Act replace the function of a trial.
The investors have pleaded that during the various class periods, the defendants had in their possession facts that rendered their financial results materially false
VII.
Finally, the shareholders take issue with the district court‘s holding that paragraph 178 of their complaint lacks the particularity required by the Reform Act. 61 F.Supp.2d at 871-72 (citing
[T]hroughout the Class Period, defendants knew or recklessly disregarded that Green Tree‘s revenue, income and earnings per share were materially overstated and that critical assumptions used in calculating gain-on-sale revenue were unreasonable and contradicted by actual experience. For example, in or around January, 1998, defendant Coss had a telephone conversation with a money manager, in which Coss admitted that Green Tree had been aware of the Company‘s prepayment problem for some time but had delayed making any sort of disclosure until November, 1997 because he had hoped that the problem would go away. In the same telephone call, Coss also admitted that defendants only decided to disclose the prepayment problem to the investing public when it became apparent that the situation was getting worse.
Contrary to the district court‘s and the shareholders’ assumption, it is clear that this allegation goes to scienter, not to the making of a misrepresentation, and therefore is governed by
Whether pleading with particularity requires the identification of the speaker
However, the part of paragraph 178 at issue here is not explicitly pleaded on information and belief about facts peculiarly within the defendants’ control, nor does it state that the allegation is contingent on further discovery. Cf. Lirette v. Shiva, 999 F.Supp. 164, 165 (D.Mass.1998) (distinguishing between allegations based on information and belief and those “supported by some document or statement on personal knowledge by a potential witness“), quoted in Bloomenthal & Wolf at § 16:25:10. Paragraph 178 of the shareholders’ complaint recites details of a particular conversation with a particular person. If the shareholders’ attorneys do not have a factual basis for this allegation, they will be subject to
Though we conclude that the allegation about the unknown money manager is adequately particular, it is not an especially valuable addition to the shareholders’ showing of scienter. They have already alleged that Coss knew the prepayment
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We reverse the district court‘s dismissal of the investors’ complaints and remand for further proceedings consistent with this opinion.