OPINION AND ORDER
INDEX
I. INTRODUCTION AND SUMMARY.........................................697
II. BACKGROUND...........................................................698
A. Defendants................................. 698
B. Plaintiffs’ Allegations...................................................702
C. The Parties’ Dispute............................................’........709
III. STANDARD OF REVIEW .................................................711
IV. ANALYSIS ...............................................................711
I.Plaintiffs’ Motion to Strike Defendants’ Appendices & Any Arguments Arising Therefrom.......................................................711
II. Cardinal Defendants ’ Motion to Dismiss.....................................715
A. Section 10(b) and Rule 10b-5 Claims......................................715
1. Whether the Complaint Sufficiently Alleges Facts Establishing a “Strong Inference” of Scienter.........'............................717
a. Scienter Under the PSLRA........._.............................717
b. Applying the Scienter Standard..................................719
c. Conclusion.....................................................741
2. Particularity of Fraud Allegations....................................741
a.. Particularity of Fraud Allegations with Respect To Each Defendant...................................................742
b. Whether Plaintiffs Pled Cardinal’s Accounting Misstatements With Particularity............................................744
c. Cardinal’s Forward-Looking Statements..........................746
3. Whether the Complaint Fails to Plead Loss Causation as to Any of the “Improprieties” Enumerated in the Complaint....................758
4. Conclusion.........................................................761
B. Control Person Claims Under Section 20(a)................................762
III. Defendant E & Y’s Motion to Dismiss.......................................763
A. Plaintiffs’ Section 10(b) and Rule 10b-5 Claims......................'.......763
1. Red Flags.........................................................765
2. Ignoring Audit Evidence Gathered from FY 2002 Through FY 2004.....766
a. Cardinal’s Classification of Operating Revenue.....................768
b. Premature Recognition of the Vitamin Litigation Settlement.........768
d. Balance Sheet Reserves and Accrual Adjustments............. .770
e. Recognition of Cash Discounts.............................. .771
f. Special Charges........................................... .772
g. Off-Balance Sheet Transactions............................. .774
h. October 2004 Restatement.................'................. .775
3. Alleged Non-Compliance with GAAS Principles................... .777
4. E & Y’s Motivation to Keep Cardinal’s Business................... .778
5. Other Fraud Claims Brought Against E&Y...................... .778
6. Conclusion.................................................... .779
Y. CONCLUSION 780
I. INTRODUCTION AND SUMMARY
Plaintiffs, investors in Cardinal Health, Inc. (“Cardinal” or “the Company”) bring securities fraud actions against Cardinal, Cardinal executives, Robert D. Walter, George L. Fotiades, Richard J. Miller, James F. Millar, Gary S. Jensen, and Mark Parrish (collectively, the “Individual Defendants” 1 ), and Cardinal’s independent auditor, accounting firm Ernst & Young (“E & Y”). Plaintiffs allege that from 1998 through 2002, while Cardinal’s pharmaceutical distribution unit underwent a reorganization, the corporation engaged in an elaborate accounting scheme designed to artificially inflate its earnings and conceal debt. Further, Plaintiffs allege that E & Y, hired as the Company’s independent auditor in 2002, aided Cardinal in perpetuating its fraudulent accounting.
Cardinal and the Individual Defendants filed a joint motion to dismiss Plaintiffs’ Complaint under Federal Rules of Civil Procedure 12(b)(6) and 9(b) and the Private Securities Litigation Reform Act of 1995 (“PSLRA”), alleging that Plaintiffs failed to state a claim upon which relief can be granted. Defendants Miller, Mil-lar, and Jensen, and E&Y also filed separate motions dismiss Plaintiffs’ Complaint under Rules 12(b)(6) and 9(b) and the PSLRA. Plaintiffs filed a Motion to Strike Defendants’ Appendixes ## 58-60, 64-65, and 70, as well as any and all arguments relying on these Appendixes in Defendants’ various motions to dismiss.
This Court holds that: (1) Plaintiffs allegations of Defendants’ accounting fraud, insider trading, motive, and opportunity were sufficient to state a § 10(b) claim against the Corporation and all of the various Individual Defendants except Defendant Jensen, and Defendants failed to show they were entitled to the protection of the statutory safe harbor for certain allegedly fraudulent forward-looking statements upon which Plaintiffs relied; (2) Plaintiffs stated § 20(a) claims against the Corporation and all of the Individual Defendants- except Defendant Jensen; (3) Plaintiffs’ failed to state a § 10(b) claim against Defendant E&Y because their allegations that E&Y had intimate knowledge of Cardinal’s fraudulent activities and that E&Y had failed to adhere to GAAP and GAAS rules did not establish the necessary inference of scienter required under the law.
Defendants’ motions are GRANTED in part and DENIED in part. The following motions are GRANTED: (1) Cardinal Defendants’ Motion to Dismiss as to Defendant Jensen; (2) Defendant E & Y’s Mo
II. BACKGROUND 3
This case involves a securities class action lawsuit brought on behalf of all persons and entities who purchased Cardinal’s publicly traded securities between October 24, 2000 and July 26, 2004, inclusive (the “Class Period”). 4 The Complaint alleges that all Defendants knowingly or recklessly disregarded errors in Cardinal’s methods of revenue recognition, and that, through their public misrepresentations about the Company’s Operating Revenue, Defendants fraudulently induced Plaintiffs to purchase Cardinal stock at artificially inflated prices in violation of Section 10(b) of the Exchange Act, 15 U.S.C. §§ 78j(b) and 78t(a), and the rules and regulations promulgated thereunder by the Securities Exchange Commission (“SEC”), including Rule 10b-5, 17 C.F.R. § 240.10b-5. The Complaint further alleges that the Individual Defendants are liable as “controlling persons” of Cardinal, under Section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a). 5
A. Defendants
The Complaint asserts causes of action against numerous defendants. The defendants have been grouped together based on their roles and the claims asserted against them. The first such group, which is collectively referred to as “the Cardinal Defendants,” includes Cardinal and the following six individuals who were either Cardinal directors or members of the Company’s senior management during the Class Period: Robert D. Walter, George L. Fo-tiades, Richard J. Miller, James F. Millar, Gary S. Jensen, and Mark Parrish. 6 The roles and responsibilities of each of these six individuals during the Class Period, as alleged in the Complaint, are described below.
1. Robert Walter
Defendant Robert D. Walter (‘Walter”) founded Cardinal, and served, at all relevant times, as the Chairman and Chief Executive Officer (“CEO”) of the Company. During the Class Period, Walter pre
2. George L. Fotiades
During the Class Period, Defendant George L. Fotiades (“Fotiades”) served as the President and CEO of Cardinal’s Life Science Products and Services division, overseeing Cardinal’s Pharmaceutical Technologies and Services segment. In February 2004, Fotiades was promoted to Executive Vice President and Chief Operating Officer (“COO”) of Cardinal. Further, throughout the Class Period, Fo-tiades was a member of the Executive Operating Committee (the “EOC”), a committee led by Walter, which met monthly to discuss Cardinal’s business, operations and finance. Fotiades participated in the preparation of the Company’s SEC filings and press releases, and took part in the Company’s conference calls with analysts and investors. During the Class Period, Fotiades received $48,984,750 in total compensation. Further, during the Class Period, Fotiades sold 65,960 shares of his personal Cardinal stock for proceeds of $4.68 million and obtained bonuses and option awards worth more than $46 million.
3. Richard J. Miller
Defendant Richard J. Miller (“Miller”) served as Cardinal’s Executive Vice President, Chief Financial Officer (“CFO”) and Principal Accounting Officer from March 1999 through July 2004. Prior to that time, Miller had served as Cardinal’s acting CFO since August 1998, and as a Controller and Vice President from August 1995 through March 1999. Before joining Cardinal, Miller had been a partner with Deloitte & Touche with over thirteen years of financial and accounting experience; he is a certified public accountant (“CPA”) and holds a bachelor’s degree in accounting from Ohio State University. Miller prepared and signed the Company’s SEC filings, issued statements in press releases and participated in the Company’s conference calls with analysts and investors. Like Walter, in conjunction with each of Cardinal’s public financial statements filed with the SEC beginning in the Company’s September 30, 2002, Form 10-K for FY 2002, Walter signed a certification pursuant to § 302 of the Sarbanes-Oxley Act. Defendant Miller left Cardinal in July 2004. Upon his resignation, Miller admitted that “[cjertain financial reporting practices and judgments that occurred during
4. James F. Millar
Defendant James F. Millar (“Millar”) served as the Executive Vice President and President and COO of Cardinal’s Pharmaceutical Distribution segment from the beginning of the Class Period through December 2002, at which time Millar was promoted to President and CEO of the Company’s Healthcare Products Segment. In February 2004, Millar was again promoted, this time to the position of Executive Director, Strategic Initiatives. Moreover, throughout the Class Period, Millar was a member of Cardinal’s EOC. Miller participated in the preparation of the Company’s SEC filings and press releases, and participated in the Company’s conference calls with analysts and investors, representing himself as one of the primary persons with knowledge about Cardinal’s pharmaceutical distribution business, financial reports and outlook and business practices. During the Class Period, Millar received $43,657,910 in total compensation. Further, during the Class Period, Millar sold 86,043 shares of his personal Cardinal stock for proceeds of $5.15 million and obtained incentive-based bonuses and option awards worth more than $41.76. million.
5. Gary S. Jensen
Defendant Gary S. Jensen served as the Senior Vice President of Audit and Financial Services, Corporate Controller and Principal Accounting Officer for fiscal years 2003 and 2004, throughout the Class Period, and until February 2005, at which point he was asked to resign following Cardinal’s internal review in connection with investigations of the Company’s accounting practices by both the SEC and the U.S. Attorney’s Office. Though Plaintiffs contend that a Cardinal spokesperson acknowledged that Jensen’s resignation was “tied to the audit over how the company classifies revenue from its pharmaceutical distribution business,” the Cardinal Defendants counter that Jensen’s resignation was, in fact, voluntary. During the Class Period, Jensen sold 10,357 shares of his personal Cardinal stock for proceeds of $743,984.
6.Mark Parrish
Defendant Mark Parrish (“Parrish”) was promoted to Chairman and CEO of Cardinal’s Pharmaceutical Distribution business in August 2004. Prior to that time, Parrish had served as the Executive Vice President and Group President of the Pharmaceutical Distribution businesses in which he was responsible for Cardinal’s pharmaceutical and specialty distribution businesses and reported directly to Defendant Millar. Further, in fiscal year 2003, Parrish became a member of Cardinal’s EOC. Parrish participated in the preparation of the Company’s SEC filings and press releases, and participated in the Company’s conference calls with analysts and investors. During the Class Period, Parrish sold 16,032 shares of his personal Cardinal stock for proceeds of $972,835.
7.Cardinal
Defendant Cardinal is generally recognized as one of the three largest distributors of pharmaceutical products in the United States. Headquartered in Dublin, Ohio, Cardinal employs more than 55,000 people on six continents and produces annual revenue of nearly $75 billion. Cardinal divides its business into four reporting units: (1) Pharmaceutical Distribution and Provider Services; (2) Medical Products and Services; (3) Pharmaceutical Technologies and Services; and (4) Clinical Tech
8. Ernst & Young
Plaintiffs, however, do not place the blame solely on Cardinal and the Individual Defendants; they also allege that E & Y, serving as Cardinal’s independent auditor, assisted the Company “in orchestrating or profiting from [its alleged] fraud.” On May 8, 2002, E & Y received $2.31 million from Cardinal for pre-engagement services, and took on Cardinal’s multi-mil-lion dollar account after Arthur Anderson (“AA”), Cardinal’s previous long-term auditor, imploded under the weight of its involvement in massive alleged accounting frauds. 8
A large portion of E & Y’s services related to work that fell outside the scope of financial statements audits. In fact, in addition to auditing, during the Class Period, E & Y provided Cardinal with the following services: (1) due diligence services related to mergers and acquisitions, audit-related research and assistance and employee benefit plan audits; (2) tax advice and planning services; and (3) other services related to matters such as litigation assistance and internal audit services. 9
E & Y made no public statement relating to Cardinal until September 30, 2002 when Cardinal filed its 10-K for FY 2002, containing its audited financial statement. E & Y certified Cardinal’s FY 2002 financial results, previously audited by AA. The only other public statement E & Y made during the Class Period was its audit opinion with respect to Cardinal’s financial statements for FY 2003, which was published in Cardinal’s 2003 10-K filed on September 29, 2003.
10
Over the course of
B. Plaintiffs’ Allegations
1. Cardinal’s Operating Model-Shifting from B + H to FFS
The timing of the instant litigation is significant as the Class Period coincides with a monumental shift in the pharmaceutical distribution business’ operating model. As such, background information on this transition period is integral to the parties’ dispute.
At the start of the Class Period, Cardinal and its major pharmaceutical distribution competitors operated through a “buy- and-hold” (B + H) model. Under a B + H model, pharmaceutical distributors “buy” pharmaceuticals from manufacturers and “hold” those products for a period of time before re-selling them to retailers. 11 Through successful B + H acquisitions, Cardinal expanded its regional markets and customer base. Cardinal took advantage of the rapidly rising drug prices in the 1990s, and, accordingly, from the early 1990s through the year 2002, Cardinal regularly reported annual growth exceeding 20%. 12
Nevertheless, Cardinal’s ability to continue such significant growth was sharply curtailed in FY 2001. By that time, the pharmaceutical distribution market was effectively divided between three major companies: Cardinal, McKesson Corporation, and AmerisourceBergen Corporation. In fact, when Cardinal made a $2.2 billion acquisition of Bindley Western Industries, Inc. in February 2001, and AmeriSource Health Corporation made a $2.4 billion merger with Bergen Brunswig Corporation in March 2001, the top three distributors effectively controlled 90% of the entire pharmaceutical distribution business. Investors realized that Cardinal’s distribution business would soon face increasing pressure on its profit margins as the top three distribution companies battled each other for the same market. 13
Cardinal was one of the first to recognize this changing dynamic, advising investors in February 2003 that the market was beginning to transition to Inventory Management Agreements (“IMAs”) under which wholesalers would be compensated not through investment in an inflationary product, but rather through negotiated fees for inventory management and distribution services — a “fee-for-service” (FFS) model. 14 Under the FFS model manufacturers pay a negotiated fee to Cardinal for the Company to distribute their products. Accordingly, manufacturers sell and ship their products to Cardinal and other pharmaceutical distributors only when there is a corresponding retail request. Thus, instead of making bulk shipments to the distributors without regard for demand, Cardinal began to make shipments only when they had an order to fill — “just-in-time” (JIT) shipments. 15
Though Cardinal was considered to be a “pioneer” in the B + H to FFS business-model migration,
16
analysts were skeptical about whether the Company would be able to continue to generate returns. Facing increasingly intense competition and mar
2. Corporate Acquisitions and Note Offerings
At the same time that Cardinal underwent a switch from a B + H to an FFS model, the Company also began to expand its other business segments through both acquisition efforts and internal growth, making pharmaceutical distribution a smaller part of Cardinal’s overall revenues and earnings. In fact, during the four years covered by the putative class period, Cardinal acquired twenty-four companies, and the percentage of Cardinal’s earnings that came from pharmaceutical distribution declined from 52% to 46%. Further, to finance these acquisitions, Cardinal exchanged over 36 million shares of Cardinal stock (valued at over $3.0 billion) and expended more than $656 million in cash.
During the Class Period, Cardinal also completed three separate note offerings, raising $1.3 billion. These note offerings “were necessary and used, in part, to repay Cardinal’s indebtedness (as of December 31, 2001, Cardinal had an outstanding debt of approximately $1.96 billion, and Cardinal’s subsidiaries had an outstanding debt of $611.20 million).” Plaintiffs allege that “Cardinal’s acquisition spree would not have been possible without the cash infusions” from the note offerings.
Cardinal’s ’ acquisitions and note offerings allowed the Company’s stock to continue to trade at high levels. As such, over the course of the Class Period, Cardinal achieved and maintained investment grade commercial ratings. By achieving investment grade ratings, Cardinal was eligible to gain access to commercial paper, 17 and Cardinal’s participation in the commercial paper program provided for issuance of up to $1.5 billion in credit facilities by June 30, 2001. That $1.5 billion was pursuant to unsecured bank facilities, $750 million of which were set to expire on March 27, 2003, and the other $750 million of which were set to expire on March 31, 2004. In FY 2003, because of Cardinal’s high stock value, the expiration dates were extended to March 26, 2004 and March 27, 2008. During a December 13, 2004 conference call, the Company’s then CFO, Mike Losh, 18 said,
We are definitely committed to maintaining investment grade ratings ... One, when you get to be noninvestment-grade, not only are there the costs of money costs, but we think there are certain hidden costs that you have to deal with that we do not think that is appropriate for us to ever put ourselves in that position. Also we want to regain access to the commercial paper market.So on a longer-term basis, we are targeting the return to an A-debt rating level.
Complaint ¶249. By FY 2004, however, Cardinal’s stock price dropped, and Cardinal’s debt and commercial paper ratings were downgraded far below the A-level.
3. Bulk Deliveries and Operating Revenue
The parties’ dispute centers on Plaintiffs’ allegations of Cardinal’s fraudulent or misstated accounting. Plaintiffs’ allege that over the four-year Class Period, Cardinal’s numerous accounting misstatements allowed the Company to overstate its revenues by approximately $26 billion. 19 See Complaint ¶¶ 56-58, 63-66, 72-76, 80-85, 88-95, 97-105, 108-14, 118-28, 132-38, 141-46, 150-51, 153-59, 163-68, 171-78, 181-87, 191-95, 199-223. To provide the necessary background, a brief discussion of Cardinal’s basic accounting policies follows.
Cardinal’s Pharmaceutical and Distribution and Provider Services (“Pharmaceutical Distribution”) primarily sells pharmaceutical products to its customers through “direct store door” (“DSD”) sales. 20 Not all of Cardinal’s sales, however, are made in small shipments directly to retailers’ store doors. Customers who operate their own warehouses sometimes order products in bulk. On some occasions, Cardinal receives these bulk orders and fills them from the company’s own inventory. On other occasions, however, Cardinal receives bulk orders under terms that its customers have previously negotiated with manufacturers. For these orders, while Cardinal does not bear the risk of the transaction, Cardinal also has no significant opportunities to derive a profit from it. In 1998, to account for these non-DSD sales, Cardinal began to report its revenue in two separate categories: (1) “Operating Revenue”; and (2) “Bulk Deliveries to Customer Warehouses and Other” (“Bulk Deliveries”). 21
The Individual Defendants touted Cardinal’s reported Operating Revenue as “the main driver” of the Company’s growth rate. Further, investors and analysts considered Operating Revenues to be crucial in ascertaining the success of Cardinal’s conversion to an FFS model. Over the course of the Class Period, in their SEC filings and press releases, Defendants highlighted their steady Operating Revenue as a strong indicator that Cardinal was successfully increasing its market, expanding its customer base, migrating sales from no margin Bulk Deliveries to profitable direct-store business, and, most importantly, adapting well to the shifting drug distribution market.
Unlike Operating Revenue, Cardinal’s Bulk Deliveries were unpredictable and provided little or no margin. Hence, most investment analysts did not consider them to be good indicators of Cardinal’s growth. Further, the market interpreted escalating Bulk Deliveries as a sign that Cardinal was not successfully converting pharmaceutical manufacturers from a B + H to an FFS model because, with most Bulk Deliveries, the large pharmaceutical retailers used Cardinal only as an intermediary, significantly limiting the Company’s earnings potential.
4. SEC Inquiries Begin
From FY 2000 through FY 2003, Cardinal’s press releases and SEC filings made it appear to be a thriving company. Considering its burgeoning Operating Revenue, which increased at least 10 percent each quarter, Cardinal seemed to be making an easy transition to an FFS model. In actuality, however, Cardinal was not as successful as its numbers suggested, and on October 9, 2003, Cardinal disclosed that the SEC had opened an informal inquiry into its accounting practices. 23 Primarily, the SEC sought information about the Company’s accounting treatment of $22 million that it had received in settling antitrust litigation with various vitamin manufacturers (the “Vitamin Litigation”).
5. Vitamin Litigation Settlement
The Vitamin Litigation began in May 2000, when Scherer, a company acquired by Cardinal in 1998, filed a civil antitrust lawsuit against a group of vitamin manufacturers alleging that certain of its raw material suppliers and others had unlawfully conspired to fix wholesale vitamin prices. During the Class Period, Scherer entered into a series of multi-tiered settlement agreements with the various vitamin manufacturers under which Cardinal re
Six months later, critics began to question Cardinal’s accounting treatment of the first $22 million of the Vitamin Litigation settlement. On April 2, 2003, The Wall Street Journal published a “Heard on the Street” column challenging Cardinal’s decision to recognize those anticipated recoveries before an actual settlement agreement had been reached. 25 Though the article acknowledged that Cardinal had subsequently entered into binding settlement agreements and had received payments in the amount of $35.5 million by the end of FY 2002, the article suggested that Cardinal had recognized the $22 million prematurely to avoid falling short of analysts’ quarterly earnings estimates.
As established above, the SEC was also concerned that Cardinal may have prematurely recognized that $22 million in order to meet analyst estimates, in violation of Generally Accepted'Accounting Principles (“GAAP”).
26
The Audit Committee of
Nonetheless, Cardinal’s problems did not end with SEC and Audit Committee investigations. On June 21, 2004, as part of the SEC formal investigation, Cardinal received a subpoena, including a request for the production of documents relating to its revenue classification policies, and specifically those policies used in the Company’s pharmaceutical distribution segment. 27 Further, the State Attorney General of New York, Eliot Spitzer, commenced an inquiry allegedly relating to the Company’s revenue classification. On July 30, 2004, Cardinal announced both the subpoena and the Spitzer inquiry to the public.
6. The October 2004 Restatement
On September 13, 2004, due to its discussions with the SEC and the Spitzer investigation, Cardinal announced its plans to restate its financial statements for FY 2001 through FY 2003 and the first three quarters of FY 2004. The Company reversed its previous recognition of estimated recoveries from the Vitamin Litigation and recognized the income from such recoveries as a “special item” in the period it received the cash from the manufacturers. Moreover, Cardinal decided to delay its announcement of its FY 2004 financial re-suits until it had both completed its restatement and changed its accounting policies.
On October 26, 2004, more than three months after the end of the Class Period, Cardinal issued its delayed 4Q and FY 2004 results and filed a Form 10-K (the “Restatement”) in which the Company restated certain items to correct past errors and announced changes in other accounting policies on a prospective basis, without restating past results. In the Restatement, Cardinal announced its decision to change its accounting policies to abandon the distinction between “Operating Revenues” (which included bulk sales out of Cardinal’s inventory) and “Bulk Deliveries to Customer Warehouses.” From the fourth quarter of FY 2004 forward, Cardinal classified all sales of pharmaceutical products as “Operating Revenue.” For FY 2002 through FY 2004, Cardinal reclassified all of the revenues it had previously reported and consolidated them in a single revenue line. Cardinal stated, “[t]he re-classifications have no effect on previously reported total revenue, related cost of products sold, net earnings or earnings per share,” and assured analysts that the “only impact of the reclassification” was on “previously reported growth rates.”
Also on October 26, 2004, during a conference call with investors and analysts, Mike Losh, admitted that the Company had misclassified $23.5 billion over three years. He also revealed, among other things, that the Audit Committee had concluded that over the past few years, Cardinal had based its revenue classifications on its 24-hour rule, and that, at certain, specifically identified times, the Company had intentionally held Bulk Deliveries for more than 24 hours so as to label them high
Moreover, Cardinal restated its FY 2001 and FY 2002 financials to shift its recognition of the Vitamin Litigation settlement into later quarters, in particular, adding $22 million to the cost of goods sold in the relevant quarters in 2001 and 2002 and recording the $22 million as an income item in its fourth quarter 2004 results.
C. The Parties’ Dispute
On April 22, 2005, Lead Plaintiff, PFG, filed a Consolidated Amended Complaint (the “Complaint”) alleging that, during the Class Period, Defendants engaged in a scheme to defraud Plaintiffs by knowingly or recklessly disregarding errors in revenue recognition, and, through their public misrepresentations about Cardinal’s Operating Revenue, fraudulently induced Plaintiffs to purchase Cardinal’s stock at artificially inflated prices.
In summary, Plaintiffs’ Complaint alleges the following: (1) Defendants materially misrepresented Cardinal’s revenues and earnings in violation of GAAP as evidenced by the Company’s press releases and SEC filings concerning revenues and earnings from FY 2000 through FY 2004, and Individual Defendants’ statements that routinely highlighted “increased revenues” over consecutive periods; (2) though Cardinal represented that its financial statements were prepared in compliance with GAAP, they were not: (a) Cardinal’s financial statements mis-characterized Operating Revenues and made inadequate disclosures regarding revenue classification procedures; (b) Cardinal improperly and prematurely recognized $22 million of expected lawsuit settlement proceeds prior to a settlement being reached in the Vitamin Litigation; (c) Cardinal used improper reserve accounting and improper accrual adjustments to overstate the Company’s net income by $64.2 million in violation of GAAP;
28
(d) Cardinal failed to disclose the Company’s recognition of cash discounts earned from suppliers for prompt payment;
29
(e) Cardinal improperly recog
The Plaintiffs’ Complaint identifies all of Cardinal Defendants’ allegedly false and misleading statements occurring over the course of the Class Period in 105 pages. See Complaint 55-238. The Plaintiffs allege that Cardinal Defendants made these misleading ■ statements in forward-looking statements, press releases, conference calls, and corporate documents, and they aver that analysts relied on these statements in their reports to the market. The Plaintiffs’ Complaint is meticulously detailed.
On August 22, 2005, the Individual Defendants, and Defendant Cardinal, jointly brought a Motion to Dismiss the Complaint under Federal Rule of Civil Procedure 12(b)(6), staying all discovery pursuant to 15 U.S.C. § 78u-4(b)(3)(B).
32
Also
III. STANDARD OF REVIEW
It is settled law that a court may not grant a defendant’s Rule 12(b)(6) motion to dismiss unless it appears beyond doubt that the claimant can prove no set of facts supporting its claim which would entitle it to relief.
See H.J. Inc. v. Northwestern Bell Tel. Co.,
In considering a Rule 12(b)(6) motion to dismiss, the Court must assume as true all well-pleaded facts, and must draw all reasonable inferences in favor of the nonmovant.
Murphy v. Sofamor Danek Group, Inc.,
IV. ANALYSIS
I. Plaintiffs’ Motion to Strike Defendants’ Appendices and Any Arguments Arising Therefrom
The parties are not in agreement as to what materials outside the Complaint the Court may properly consider in ruling on Cardinal Defendants’ motion to dismiss. Cardinal Defendants have attached 70 appendices to their brief in support of their Motion to Dismiss. In response, Plaintiffs have filed a Motion to Strike certain of these documents arguing that they are not properly subject to judicial notice.
33
Because these matters relate to the general
A. Standard for Motion to Strike
Rule 12(f) permits the court to strike from a pleading “any insufficient defense or any redundant, immaterial, impertinent, or scandalous matter.” Fed. Civ. R. Proc. 12(f).
34
The Sixth Circuit has held that “because of the practical difficulty of deciding cases without a factual record it is well-established that the action of striking a pleading should be sparingly used by the courts. It is a drastic remedy to be resorted to only when required for the purposes of justice.”
35
Brown & Williamson Tobacco Corp. v. United States,
1. Judicial Notice of Public Documents
When considering a motion to dismiss, courts should generally not consider matters outside the pleadings.
Weiner v. Klais & Co.,
Whether a document is considered integral is within the court’s discretion and is guided by Federal Rule of Evidence 201.
36
In re Unumprovident Corp. Sec. Litig.,
2. Appendices ## 58, 59, 60, 64, 65, 70
The Court agrees that Plaintiffs do not reference the contents of Cardinal Defendants’ Appendices ## 58, 59, 60, 64, 65, and 70 in the Complaint. Therefore, this Court may take judicial notice of these documents
only
if it finds: (1) that they are public documents integral to the parties’ dispute; and (2) that the documents do not ask the Court to adopt disputed facts as true.
See Keithley Instruments,
Appendixes ## 58, 59, and 60 consist of the annual reports and Form 10-K’s of AmerisourceBergen (“AmBerg”), and McKesson Corporation for certain years within the Class Period. See supra note 33. Appendixes ## 64, and 65 are certain Baird analysts’ reports on McKesson Corporation (“McKesson”). See id. Cardinal Defendants submit the Appendixes as evidence of widespread financial problems faced by the drug distribution business during the Class Period. AmBerg and McKesson are Cardinal’s two top competitors; therefore, Cardinal asserts that the companies’ financial situations, as presented in their annual reports and 10-K’s, provide support for Cardinal Defendants’ theory that a general market downturn, not fraudulent misstatements, caused Cardinal’s stock price to drop.
Courts may consider the full text of SEC filings, prospectuses, and analysts’ reports regardless of whether they are attached to a plaintiffs complaint (in part or in whole) as long as they are
integral
to statements within the complaint.
See Albert Fadem,
Appendix # 70 is a Business Week Online article from July 2, 2004. Among other things, the article cites the industry switch from a B + H model to a JIT model as being responsible for the drop in Cardinal’s stock price, as well as the downward trend of both AmBerg and McKesson’s stock prices. The article reads:
Beginning in late 2003, the [drug distribution] industry pushed to change the payment system for distributing medical products (drugs, devices, and other supplies) to customers (hospitals, doctors’ offices, etc.). Wholesalers essentially want “fee-for-service” deals with manufacturers that would create less volatility in profit margins. However, the switchover to such contracts could remain problematic. The dramatic hit to Cardinal suggests other wholesalers are pretty deep in the woods, ... Cardinal had expected many customers to have agreed to [the] new contracts by now.Instead, the majority are still in negotiations.
See Amy Tsao, “A Common Cold for Drug Distributors? News of Cardinal Health’s poor earnings surprised the Street, which fears rivals McKesson and AmBerg may not be immune,” Business Week Online, July 2, 2004.
In the context of a motion to dismiss, a court may not accept an otherwise reliable public document to decide facts that are in dispute.
See Firstenergy Corp.,
3. Appendices ## 61, 62, 66, 67
Appendices ## 61, 62, 66, and 67 are various analysts’ reports regarding the financial outlook of Cardinal.
See supra
note 33. In considering a motion to dismiss, a court may not “assume the truth of the statements cited by defendants [in Appendices], or accept the inferences asserted by defendants ... based on [those statements].”
See Firstenergy Corp.,
Plaintiffs argued that Cardinal’s fraud was the impetus for the Company’s significant drop in stock price. Cardinal Defendants cite the analysts’ reports to counter that “financial analysts long have lauded Cardinal’s management team and Cardinal’s strong market positions.” Plaintiffs aver that this statement directly contradicts Plaintiffs’ allegations that Cardinal Defendants’ malfeasance stunned investors and materially impacted the Company’s earnings. Nevertheless, because Plaintiffs cited to the Appendixes in their Complaint, and because the dispute over the effect of Cardinal’s fraud is certainly integral to the instant litigation, the Court DENIES Plaintiffs’ motion to strike these appendixes and any arguments related thereto.
4. Jensen Motion at 8-9
In addition to the Plaintiffs’ motion to strike the foregoing appendixes, Plaintiffs also ask the Court to strike Cardinal Defendants’ argument in Defendant Jensen’s Motion to Dismiss asserting that Defendant Jensen voluntarily resigned from Cardinal. In their Complaint, Plaintiffs allege that a source informed them that Jensen was forced to resign from Cardinal as a result of his involvement in the Company’s accounting fraud.
After Congress’ enactment of the PSLRA, in assessing whether a plaintiff has offered “facts giving rise to a
strong inference
” of defendants’
scienter,
“plaintiffs are entitled only to the most plausible of competing inferences.”
Id.; see Miller v. Champion Enter. Inc.,
II. Cardinal Defendants’ Motion to Dismiss
A. Section 10(b) and Rule 10b-5 Claims
Cardinal Defendants first contend that the Court must dismiss Plaintiffs’ claims pursuant to Section 10(b) of the Exchange Act on the following grounds: (1) Plaintiffs’ fail to plead that any Defendant possessed scienter, particularly in light of the heightened pleading standard mandated by the PSLRA, 15 U.S.C. § 78u-4 and controlling Sixth Circuit law; (2) the Complaint does not state a claim based upon any of Cardinal’s alleged accounting misstatements; (3) the Complaint fails to plead loss causation as to any of the seven “improprieties” they enumerate in the Complaint; and (4) the Complaint does not allege particularized facts sufficient to state a claim based upon Cardinal’s transition to a new business model.
Section 10(b)
38
of the Exchange Act and Rule 10b-5 promulgated thereunder prohibit “[fjraudulent, material misstatements or omissions in connection with the sale or purchase of a security.”
See PR Diamonds v. Chandler,
Prior to the enactment of the PSLRA, the pleading requirements for stating a claim under Section 10(b) were governed by Federal Rule of Civil Procedure 9(b).
See In re Telxon Sec. Litig.,
Originally, the Rule 9(b) heightened pleading requirement (requiring a plaintiff to plead fraud with particularity) was meant to curb any possible vexatious litigation under Rule 10b-5.
See Comshare,
Adding to the Rule 9(b) requirement that plaintiffs state them fraud allegations with particularity, the PSLRA requires a plaintiffs to, “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, or made on information and belief, ... [to] state with particularity all facts on which that belief is formed.” 15 U.S.C. § 78u-4(b)(l).
1. Whether the Complaint Sufficiently Alleges Facts Establishing a “Strong Inference” of Scienter
Courts consider scienter the most difficult element of a 10(b) and 10b-5 claim for plaintiffs to plead under the PSLRA; therefore, should the Court find that Plaintiffs’ Complaint does not adequately plead the scienter element of their Section 10(b) and Rule 10b-5 claims, it must grant Cardinal Defendants’ motion to dismiss.
See PR Diamonds,
a. “Scienter” under the PSLRA
The Supreme Court has defined “scienter” as “a mental state embracing intent to deceive, manipulate, or defraud.”
Ernst & Ernst,
Next, the Court must examine the special requirements for pleading scienter in federal securities fraud claims such as this. As with all fraud claims, Federal Rule of Civil Procedure 9(b) applies to pleading a defendant’s state of mind, allowing that “[m]alice, intent, knowledge, and other condition of mind of a person may be averred generally.”
PR Diamonds,
As the foregoing authorities make clear, a plaintiff may survive a motion to dismiss by pleading with particularity facts giving rise to a strong inference that the defendant acted with knowledge or recklessness.
See PR Diamonds,
Inferences must be reasonable and strong but not irrefutable. “Strong inferences” nonetheless involve deductive reasoning; their strength depends on how closely a conclusion of misconduct follows from a plaintiffs proposition of fact. Plaintiffs need not foreclose all other characterizations of fact, as the task of weighing contrary accounts is reserved for the fact finder. Rather, the “strong inference” requirement means that plaintiffs are entitled only to the most plausible of competing inferences.
Moreover, the Helwig Court enumerated factors which, though not exhaustive, may be probative of scienter in securities fraud actions:
(1) insider trading at a suspicious time or in an unusual amount;
(2) divergence between internal reports and external statements on the same subject;
(3) closeness in time of an allegedly fraudulent statement or omission and the later disclosure of inconsistent information;
(4) evidence of bribery by a top company official;
(5) existence of an ancillary lawsuit charging fraud by a company and the company’s quick settlement of that suit;
(6) disregard of the most current factual information before making statements;
(7) disclosure of accounting information in such a way that its negative implications could only be understood by someone with a high degree of sophistication;
(8) the personal interest of certain directors in not informing disinterested directors of an impending sale of stock; and
(9) the self-interested motivation of defendants in the form of saving their salaries or jobs.
The Sixth Circuit employs a “totality of the circumstances analysis” whereby the facts argued
collectively
must give rise to a strong inference of at least recklessness.
See PR Diamonds,
Plaintiffs maintain that the Complaint in its entirety, establishes a strong inference that, throughout the Class Period, the Cardinal Defendants either knew or were at least reckless in disregarding serious accounting improprieties at Cardinal and the effect that such improprieties had on the Company’s financial condition. Specifically, Plaintiffs argue that, when considering the following factors in their totality, a strong inference of the Defendants’ scien-ter arises: (1) the nature and magnitude of the accounting improprieties at Cardinal; (2) the Individual Defendants’ access to Cardinal’s financial information by virtue of their positions at the Company; (3) the fact that the accounting improprieties occurred in “key areas of focus”; (4) the Individual Defendants’ motives and opportunities to commit fraud; and (5) other red flags potentially signaling Cardinal’s accounting errors.
Accordingly, in the following discussion, this Court examines each of Plaintiffs’ scienter allegations.
See PR Diamonds,
i. Accounting Improprieties
Plaintiffs contend that their allegations of Cardinal’s improper accounting practices and internal control deficiencies comprise circumstantial evidence supporting a strong inference of the Defendants’ scien-ter. The alleged accounting improprieties include: (1) the mis-classification of bulk deliveries as operating revenue in FY 2001 through FY 2003; (2) the premature recognition of $22 million gained from the Vitamin Litigation settlement in FY 2002; (3) the decision to change Cardinal’s revenue recognition policy for its Pyxis business in FY 2002; (4) balance sheet reserve and accrual adjustments in the Company’s 2004 10-K; (5) as announced in the 2004 10-K, the Company’s decision to change its method of accounting for cash discounts received from vendors for prompt payment; (6) the mis-classification of an unidentified amount of expenses as “special charges” related to mergers and acquisitions; and (7) improper off-balance sheet transactions.
In
Comshare,
the Sixth Circuit held that GAAP violations are, by themselves, insufficient to establish scienter for a securities fraud claim.
First, Cardinal Defendants contend that despite the trend signaled by PR Diamonds, Telxon, and its progeny, GAAP violations alone do not constitute scienter. Nevertheless, Cardinal Defendants argue that should this Court consider the Cardinal Defendants’ GAAP violations in its scienter analysis, many of Plaintiffs’ allegations do not even amount to actual GAAP errors, altogether negating any inference of scienter. 44 Plaintiffs, counter, however, that Cardinal’s GAAP misstatements were so egregious in terms of “number, size, timing, frequency and context,” that they are more than sufficient to create a strong inference of scienter.
Although
Comshare
sets forth the prevailing view in this Circuit that GAAP violations do not ipso facto establish scien-ter, as it is factually inapposite,
Comshare
does not control here.
See id.
at 542.
Comshare
was a consolidated securities fraud action arising from the company’s restatement of certain financial statements after it had acknowledged that its original financial statements had contained a num
The plaintiff-shareholders brought claims of securities fraud under 10(b) based on Comshare’s accountings errors in addition to bare allegations demonstrating the company’s motive and opportunity to commit fraud. See id. The district court, however, granted the defendants’ motion to dismiss, finding that the plaintiff-shareholders had failed to plead facts establishing that the subsidiary’s GAAP violations constituted “knowing misrepresentation” by the defendants. Id. at 554. The court of appeals affirmed the district court’s ruling, holding, “[plaintiffs have failed to plead facts that show that the revenue recognition errors at Comshare’s UK subsidiary should have been obvious to Coms-hare or that Comshare consciously disregarded ‘red flags’ that would have revealed the errors prior to their inclusion in public statements.” Id.
In this case, Plaintiffs’ allegations arise from Cardinal’s own GAAP violations, as opposed to a recently acquired subsidiary’s violations, like those alleged in
Comshare.
The Plaintiffs’ allegations are parallel to those of plaintiffs in
SmarTalk.
The court held that the plaintiffs “adequately alleged widespread and varied accounting errors that led to a drastic overstatement of SmarTalk’s financial success,” supporting an inference of scienter.
Id.
at 540;
see, e.g. Rehm,
As in SmarTalk, Plaintiffs here make a number of detailed violations based on Cardinal’s accounting misstatements. 48 Moreover, like the SmarTalk plaintiffs, Plaintiffs in this case do not end their allegations with GAAP violations; they also allege that, when considered together, the Individual Defendants’ insider trading, the presence of red flags evidencing overinflated revenues, and the sheer magnitude of the actual fraud point to a strong inference of scienter. See id.
Hence, this Court finds Plaintiffs’ allegations to be at least as “widespread and varied” as those of the
SmarTalk
plaintiffs.
See id.
Further, though Cardinal Defendants counter that Plaintiffs’ allegations are not even
actual
GAAP violations, just as in
SmarTalk,
the substance of the errors strengthens the inference of scien-ter, and accounting errors of the type here have been held to be sufficient to establish scienter.
See id.
at 540;
see also PR Diamonds,
ii. Access to Information
To buttress their argument that the Individual Defendants’ knew of or recklessly disregarded adverse information about Cardinal when making representations about the Company to the public, Plaintiffs point to the Individual Defendants’ high-level positions in the Company. Plaintiffs state, “Defendants Walter, Miller, Fo-tiades, Millar and Parrish also routinely communicated with analysts and investors during the Class Period and represented that they were informed of and knowledge
Courts may presume that high-level executives are aware of matters related to their business’ operation where the misrepresentations or omissions pertain to “central, day-to-day operational matters.”
See In re Complete Mgmt. Inc. Sec. Litig.,
In this case, Cardinal Defendants argue, and this Court agrees, that Plaintiffs’ allegations appear to be no more than conclusory allegations based on the Individual Defendants’ high-level positions.
See Comshare,
Rather than repeat each of the Plaintiffs’ allegations verbatim, this Court finds that Plaintiffs’ allegations are too broad and conclusory to establish scienter. The Second Circuit has held that “allegations that defendants should have anticipated future events and made certain disclosures earlier than they actually did do not suffice to make out a claim of securities fraud” and that “as long as the public statements are consistent with reasonably available data, corporate officials need not present an overly gloomy or cautious picture of current performance and future prospects
iii. Areas of Focus
Plaintiffs seek to draw additional support for a strong inference of the Cardinal Defendants’ scienter by claiming that Cardinal’s accounting improprieties occurred in areas of the business that the Company had specifically identified as targets of intense focus for the Company — areas in which the Company felt pressure to show continued growth.
In this case, Plaintiffs contend that, to showcase Cardinal’s successful to transition from a B + H to an FFS model, the Company improperly booked zero-margin sales as Operating Revenue “to give investors the false and misleading impression Cardinal was achieving revenue growth.” See Complaint 285. Plaintiffs allege that because Cardinal Defendants had consistently highlighted “Operating Revenue” as the “main driver of its growth,” 51 Cardinal Defendants’ inflation of this area of focus for both analysts and investors implies scienter. See id. 293-99.
Plaintiffs’ allegations resemble those of plaintiffs in
Telxon. See
This Court has already found that Plaintiffs sufficiently alleged that Cardinal Defendants’ GAAP violations, particularly its overstatement of Operating Revenue,
iv. Motive & Opportunity
Next, Plaintiffs argue that the Complaint alleges that Cardinal Defendants had motives and opportunities to defraud investors. These allegations, Plaintiffs maintain, when considered together with the other allegations in the Complaint, support a strong inference of knowledge or reckless disregard on the part of Cardinal Defendants.
“[T]he bare pleading of motive and opportunity does not,
standing alone,
constitute the pleading of a strong inference of scienter.”
See PR Diamonds,
Opportunity to commit fraud “entail[s] the means and likely prospect of achieving concrete benefits by the means alleged.”
PR Diamonds,
In order to demonstrate motive, a plaintiff must show “concrete benefits that could be realized by one or more of the false statements and wrongful nondisclosures alleged.”
Id.
(citing
Phillips v. LCI Int'l, Inc.,
1) Insider Sales 52
In addition to considering them to be a Helwig “red flag,” courts also consider a plaintiffs allegations that the individual defendants engaged in insider trading to be a motive to commit fraud. By trading on inside information, executives stand to profit from what may turn out to be other shareholders’ losses.
The Complaint alleges that the Individual Defendants were motivated to commit the alleged fraud, in part, because they were able to benefit from the resulting inflation of Cardinal’s stock price. Plaintiffs allege that during the Class Period, the Individual Defendants sold at least 774,156 shares of Cardinal stock, for proceeds of $49.7 million; they argue that the magnitude and timing of these sales of stock — independent of any sales in the context of an offering-by themselves raise a strong inference of scienter.
Indeed, “[i]nsider trading at a suspicious time or in an unusual amount comprises one of the ‘fixed constellations of facts’ that courts have found probative of securities fraud.”
See Helwig,
Nevertheless, if the executive officers’ stock sales were “unusual in scope or timing,” they may support an inference of scienter.
See Burlington Coat Factory,
There is no bright line test, however, as to the amount or percentage of stock that must be sold to constitute a “suspicious amount” — nor should there be, for, in the end, the determination of whether insider sales were “suspicious” is highly context-specific and depends on the other allegations offered in the Complaint.
53
Courts have classified stock sales as unusual or suspicious based on a variety of factors, which include “the amount of profit from sales,” “the portion of stockholdings sold,” “the change in volume of insider sales,” “and the number of insiders selling.”
See Rothman v. Gregor,
I) Defendant Walter
Plaintiffs allege that Defendant Walter personally sold 539,910 shares of Cardinal stock for insider trader proceeds of $38.19 million during the Class Period. Walter’s reported insider trading during the Class Period is detailed below.
Transaction Date Shares Sold Price Proceeds
12/13/2000_ 22,500 $63.42 $ 1,426,949
03/01/2001_ 32.100 $67.33 $ 2,161,292
03/01/2001_ 7.500 $65.88 $ 494,100
03/01/2001 7.500 $67.66 $ 507,450
03/01/2001_ 7.500 $67.83 $ 508,725
03/01/2001_ 3,750 $67.43 $ 252,863
03/01/2001_ 9,150 $66.72 $ 610,488
03/02/2001_ 7.500 $66.68 $ 500,100
03/02/2001_ 15.000 $67.53 $ 1,012,949
03/09/2001_ 03/13/2001_ 7.500 7.500 $66.23 $66.66 $ 496,725 $ 499,950
03/13/2001 34,900 $66.50 $ 2,320,850
05/08/2001 22.100 $66.70 $ 1,474,070
05/08/2001_ 9,800 $66.80 $ 654,640
05/08/2001_ 5.000 $66.90 $ 334,500
05/08/2001_ 1,600 $66.55 $ 106,480
05/08/2001_ _900. $66.52 $ 59,868
05/08/2001 _400. $66.53 $ 26,612
05/08/2001_ _200 $66.84 $ 13,368
05/08/2001_ 100 $66.75 $ 6,675
05/08/2001 30.000 $66.57 $ 1,997,100
01/28/2002_ 10.000 $65.07 $ 650,700
01/30/2002 10,000 $65.81 $ 658,100
01/31/2002_ 7,720 $65.71 $ 507,281
01/31/2002 _500 $65.91 $ 32,955
03/07/2002_ 50.000 $65.95 $ 3,297,500
03/07/2002 18,700 $65.45 $ 1,223,915
03/07/2002 15.000 $66.00 $ 990,000
03/07/2002 10.000 $65.97 $ 659,700
03/07/2002_ 5.000 $65.20 $ 326,000
03/07/2002_ 1,300 $65.30 $ 84,890
09/12/2002_ 100,000 $65.80 $ 6,580,000
01/29/2003 133,190 $57.90 $ 7,711,701
593,910 $38,188,496 Total
This Court agrees that most courts do not view an executive’s decision to exercise bas stock options before they expire as evidence of fraudulent insider trading. 54 Nonetheless, in their Motion to Dismiss, Cardinal Defendants confirm that Walter made approximately 31% of his sales during the Class Period through exercising stock options set to expire in 2002 and 2004. That leaves 69% of his other sales activity to be unrelated to exercising his stock options, and all 69% of these sales, if inconsistent with Walter’s past trading activity, could be considered suspicious.
Moreover, Cardinal Defendants argue that Plaintiffs’ chart fails to account for Walter’s stock purchases during the Class Period. They contend that any “fair analysis” would more properly measure the net proceeds from trading activity during the relevant period, accounting for the significant portion of the sale proceeds that were offset by the amounts Walter paid during the same period for acquired shares, including open-market purchases, “option exercises and relevant payroll taxes associated with his option purchases.” Def.’s Motion to Dismiss at 46. Cardinal Defendants, however, cite no authority for this technical dispute. 55
Further, Cardinal Defendants argue that the fact that Walter actually
purchased
40,000 shares during the Class Period, augurs against an inference of scien-
The Court agrees with the Ninth Circuit that, in some cases, a broad temporal distance between stock sales and a disclosure of bad news defeats any inference of scien-ter; however, the Court does not believe the principle applies to the case sub judice.
See Vantive Corp.,
Finally, Cardinal Defendants argue that, irrespective of whether the Court accepts Cardinal Defendants’ arguments concerning stock options and stock purchases, Walter’s trading activity is still not unusual or suspicious because Walter’s “sales
Cardinal Defendants also declare that Plaintiffs’ incorrectly compare Walter’s four years of Class Period trading to his trading in his two years of pre-Class Period trading, and that, in fact, Plaintiffs should have looked at
four
years of pre-Class Period trading.
56
They argue that “Plaintiffs compound their error by comparing, without adjustment, sales during the 45-month Class Period with sales during the preceding 24-month period,” and that “the numbers Plaintiffs derive from comparisons drawn between these two dissimilar periods are meaningless.” Defs Motion to Dismiss at 43. To the contrary, the Court considers it compelling that Walter’s proceeds during the Class Period exceeded his pre-Class Period sales proceeds by more than 600 percent. In
Quintel Entertainment,
the court drew an inference of scienter when sales by corporate insiders were 156 percent greater than insider sales in the 14 month pre-Class Period.
See
ii) Defendant Fotiades
Plaintiffs allege that Defendant Fotiades personally sold 67,814 shares of Cardinal stock for insider trader proceeds of $4,678,158 during the Class Period. Fotiades’ reported insider trading during the Class Period is detailed below.
12/13/2000 5,561 $63.45 352,909
05/30/2001 17,300 $71.10 $1,247,330
05/30/2001 808 $72.38 58,483
04/29/2002 4,144 $68.59 284,237
04/30/2002 40,000 $68.38 $2,735,200
Total 67,814 $4,678,159
Cardinal Defendants contend that Fo-tiades’ trading is neither unusual nor suspicious because, like Walter, he did not sell stock in the last 27 months of the Class Period. Nonetheless, just as such claims failed to negate an inference of scienter as to Defendant Walter, so too do they fail to negate such an inference as to Defendant Fotiades.
Next, Cardinal Defendants argue that because the only shares Fotiades sold in the Class Period were made while he was with Cardinal’s Life Sciences segment, before he became Cardinal’s COO, they do not infer scienter. This Court disagrees; a sale by a high-level officer is still a sale, regardless of whether that officer had not yet risen to the highest echelons of the company. 57
Finally, Cardinal Defendants argue that Fotiades sold more than twice the number of shares he sold during the Class Period on November 10, 2004, four months after the end of the Class Period, and “after every alleged ‘misrepresentation’ Plaintiffs alleged had already been disclosed.” See Def.’s Motion to Dismiss at 48. They aver that, “[i]f Fotiades really were participating in an artificial inflation of Cardinal’s price, one would imagine, he would sell his shares while the inflation was effect.” Id. Plaintiffs counter that Cardinal Defendants’ failure to cite any authority for their proposition that post-Class Period sales negate scienter nullifies their argument. The Court finds that if such sales negated scienter, a defendant in an insider trading case could simply re-sell the options he had acquired cheaply as a means to evade liability.
Hi) Defendant Jensen
Plaintiffs allege that Defendant Jensen personally sold 10,357 shares of Cardinal stock for insider trader proceeds of $743,984 during the Class Period. Jensen’s reported insider trading during the Class Period is detailed below.
Transaction Date_ Shares Sold__Price_Proceeds
03/08/2004_2j638_$67.45_ $177,933
03/08/2004_1¿00_$67.42_ $ 74,162
03/08/2004_600_ $67.44_$ 40,464
05/03/2004_6j019_$75.00_$451,425
Total_._10,357_$743,984
Plaintiffs state that during the Class
iv) Defendant Parrish
Plaintiffs allege that Defendant Parrish personally sold 16,032 shares of Cardinal stock for insider trader proceeds of $972,835 during the Class Period. Parrish’s reported insider trading during the Class Period is detailed below.
Transaction Date_Shares Sold_Price_Proceeds
05/12/2003_18,000_$67.14_ $475,571
01/26/2004_4,097_$63.80_$261,389
01/26/2004_3^700_$63,75_$235,875
Total_16,032_$972,835
Plaintiffs allege that based on Defendant Parrish’s Forms 4 filed with the SEC, as of Parrish’s final Class Period trade, he had sold 90.9% of his Cardinal stock holdings.
59
Even so, Plaintiffs fail to set forth any facts showing that Parrish’s pre-Class
v) Defendant Millar
Plaintiffs allege that Defendant Millar personally sold 86,043 shares of Cardinal stock for insider trader proceeds of $5,152,292 during the Class Period. Millar’s reported insider trading during the Class Period is detailed below.
Transaction Date Shares Sold Price Proceeds
03/01/2001_ 18,000 $67.14 $1,208,519
05/16/2001_ 7,900 $69.05 $ 545,495
05/16/2001_ _297 $69.25 $ 20,567
02/11/2002_ 15.200 $65.60 $ 997,120
02/11/2002 _411 $65.61 $ 26,966
04/28/2003_ 31.200 $53.20 $1,659,840
04/28/2003_ 7,700 $53.21 $ 409,717
04/28/2003_ 5,035 $53.25 $ 268,114
04/28/2003_ _300 $53.18 $ 15,954
Total 86,043 $5,152,292
Plaintiffs argue that, during the Class Period, Millar sold 43.9% of his Cardinal stock trading, none of which was part of any general or specific pre-planned pattern of stock sales. They assert that, when compared to Defendant Millar’s two years of pre-Class trading, in which he sold-17% of his stock shares, the approximately 27% jump in sales should be viewed as suspicious.. Cardinal Defendants counter that, in fact, Defendant Millar’s sales during the Class Period were derived almost entirely from exercising options due to expire in 2002, 2003, and 2004. Further, they contend that when Defendant Millar exercised his options in April 2003, he actually retained 31,000 shares rather than selling them, making him a net acquirer of shares at the end of the Class Period
Other courts have held that a defendant’s retention of his stock holdings significantly undermines plaintiffs’ assertion of scienter.
See Wilson v. Bemstock,
vi) Defendant Miller
Though Plaintiffs and Cardinal Defendants agree that Defendant Miller sold
no shares
of stock during the Class Period, they are in dispute as to whether Miller’s failure to sell a single share of
In the end, without considering the impact of the technical disputes between the parties regarding the timing, amounts, and other minute details of the Individual Defendants’ trading activities, the Court finds that, Plaintiffs’ allegations against Defendants Walter, Fotiades, Jensen, and Miller, raise a strong inference of scienter and, therefore, survive Cardinal Defendants’ Motion to Dismiss. Though the insider trading allegations Plaintiffs raise against Defendants Parrish and Millar do not raise a strong inference of scienter, the Plaintiffs’ allegations do not rest on insider trading alone. Thus, before the Court can dismiss Plaintiffs’ claims against Parrish and Millar as too weak to establish the strong inference of scienter required by the PSLRA, it must first consider the strength of Plaintiffs’ other allegations.
2) Executive Compensation
Pursuant to Cardinal’s FY 2000 Proxy dated September 18, 2000, the Board of Directors established fixed guidelines relating to executive compensation, and among the guiding principles was that executives would receive “pay-for-performance” and be rewarded for positive “corporate business unit, and individual performance.” Plaintiffs allege that Cardinal Defendants were motivated to recklessly over-inflate Cardinal’s stock price because the terms of their employment agreements tied them compensation directly to Cardinal’s reported financial results and the performance of the Company’s stock. Plaintiffs allege that based on the reported performance of Cardinal during the Class Period, the Individual Defendants each received the maximum possible incentive compensation through salary, cash bonuses, and options. 60 Plaintiffs argue that because, in total, Defendants Walter, Miller, Fotiades, and Millar collected more than $245 million in incentive-based executive compensation while perpetrating their fraud on the investing public, their compensation package points to their scienter. 61
A careful reading of
PR Diamonds
reveals that Cardinal Defendants’ interpretation is inaccurate. The
PR Diamonds
court actually held that
“bare allegations
of motive and opportunity, without more, are insufficient to establish scienter.”
See
3) Meeting Analysts’ Expectations
Finally, Plaintiffs also allege that Cardinal was motivated to engage in fraud to meet analysts’ expectations as to its performance, particularly during its transition from a B + H model to an FFS model. Courts have found that this type of “general allegation, though relevant, adds little by itself to the scienter calculus, because these are motives ‘possessed, to a certain degree’, by every corporate officer.”
See MicroStrategy,
115 Fed. Supp.2d at 648;
see also, In re Stratosphere Corp. Sec. Litig.,
v. Red Flags
Finally, Plaintiffs contend that the Cardinal Defendants knowingly or recklessly disregarded numerous red flags indicating Cardinal’s improper accounting practices, GAAP violations, and internal control deficiencies. “Specific factual allegations that a defendant ignored red flags, or warning signs that would have revealed the accounting errors prior to their inclusion in public statements may support a strong inference of scienter.”
See Comshare,
Red flags in this case would be “circumstances that would have put the [defendants on notice that [Cardinal’s] financial statements and press releases contained material misstatements or omissions, or at
(1) insider trading at a suspicious time or in an unusual amount;
(2) divergence between internal reports and external statements on the same subject;
(3) closeness in time of an allegedly fraudulent statement or omission and the later disclosure of inconsistent information;
(4) evidence of bribery by a top company official;
(5) existence of an ancillary lawsuit charging fraud by a company and the company’s quick settlement of that suit;
(6) disregard of the most current factual information before making statements;
(7) disclosure of accounting information in such a way that its negative implications could only be understood by someone with a high degree of sophistication;
(8) the personal interest of certain directors in not informing disinterested directors of an impending sale of stock; and
(9) the self-interested motivation of defendants in the form of saving their salaries or jobs.
Cardinal Defendants argue that Plaintiffs suggestion that “the Court brush aside the absence of a
Helwig
factor is ... nonsense.”
See
Def.’s Reply to Motion to Dismiss at 19; see
Helwig,
Four of the nine
Helwig
factors are altogether inapplicable to this case: (1) Plaintiffs concede that there was no bribery of top Cardinal officials; (2) Plaintiffs do not allege the “overly-sophisticated disclosure of information”; (3) Plaintiff do not point to the quick settlement of ancillary lawsuits; and (4) Plaintiffs identify no conflicts of interest among directors. Cardinal Defendants ask the Court to regard the absence of these factors as pointing
against
an inference of scienter.
1) Insider Trading
Plaintiffs allege that each of the Individual Defendants engaged in suspicious or unusual trading activity over the course of the Class Period and that their trading, considered in its totality, establishes an inference of scienter except with respect to Defendants Parrish and Millar. See supra Part IV.II.A.l.b.iv.1). Thus, the Court must also consider the Individual Defendant’s alleged insider trading in its analysis of whether the Helwig factors imply scienter.
2) Divergence Between Internal Reports and External Statements on the Same Subject
Plaintiffs attempt to satisfy the second
Helwig
factor by suggesting that the Indi
Cardinal Defendants argue, and this Court agrees, that the Plaintiffs may not rest on such conclusory allegations to establish a “divergence” between external reports and internal statements. In total, Plaintiffs allege a $26 billion difference between Cardinal’s reported financials and their actual financials. 64 Though it has yet to be proven whether or not this figure is in fact accurate, the Court need not decide this issue on a motion to dismiss. This Court, therefore, finds that the alleged divergence between the Company’s reported and actual financials resulting from the misstatements implies scienter.
3)Closeness in Time of the Allegedly Fraudulent Statement or Omission and the Later Disclosure of Inconsistent Information
Plaintiffs allege that Cardinal Defendants disregarded current information before issuing their allegedly fraudulent statements. Cardinal Defendants, however, argue that Plaintiffs’ Complaint pleads the issue in a “conclusory fashion without providing supporting numbers or identifying specific items of information supposedly disregarded.” Def.’s Motion to Dismiss at 53. In
Comshare,
Plaintiffs alleged that Cardinal Defendants “were aware of, or were recklessly indifferent to” the revenue recognition errors.
See
4)Disregarding Current Factual Information Before Making Statements
Plaintiffs aver that Cardinal Defendants disregarded current information before issuing their allegedly fraudulent statements. Again, the Cardinal Defendants counter, and the Court agrees, that Plaintiffs’ allegations are merely conclusory, accompanied by no factual support.
5)Defendants’ Self-Interested Motivation to Save Their Salaries or Jobs
As established above, the Court finds that Plaintiffs sufficiently alleged that Cardinal Defendants had a motive to artificially inflate the purchase price of Cardinal’s stock, in part, because of their ineen-
c. Conclusion
As Plaintiffs stated during oral argument, the scienter analysis in these types of securities fraud cases is akin to looking at a painting. Though one or two brush strokes may be more powerful up close, to fully appreciate the painting, the viewer must step back to take in the “big picture.” Applying this analogy to the facts in this case, the Complaint viewed in toto the conclusion that Plaintiffs have met their burden under the PSLRA, pleading sufficient facts to raise a strong inference that the Cardinal Defendants acted with the requisite scienter. Specifically, the Complaint’s allegations as to: (1) Cardinal’s GAAP violations; (2) the Individual Defendants’ various motives to commit fraud, in particular, their insider trading, and incentive-based executive compensation packages; (3) Plaintiffs’ allegations highlighting Operating Revenues as an area of focus for Cardinal which Cardinal Defendants had overstated by approximately $26 billion; and (4) Plaintiffs’ sufficient allegations of a number of Helwig factors cumulatively raise a strong inference that the Cardinal Defendants acted intentionally, consciously, or, at the very least, recklessly, in violation of the securities laws.
Because the Court finds that the Plaintiffs have alleged scienter, the Court must now analyze whether Plaintiffs have established the other elements of a prima facie case of securities fraud.
See Comshare,
2. Particularity of Fraud Allegations
Cardinal Defendants argue that Plaintiffs’ Complaint must be dismissed under Rule 12(b)(6) for failing to allege false or misleading statements or material omissions made by Defendants with the particularity required by both Rule 9(b) and the PSLRA. Def.’s Motion to Dismiss at 28. The Plaintiffs must plead fraud with particularity under Rule 9(b) while also establishing facts demonstrating each
Plaintiffs’ Complaint devotes 105 pages, 66 to presenting a detailed description of Cardinal Defendants’ allegedly false statements or omissions of material fact. In their Motion to Dismiss, Cardinal Defendants argue the following: (1) Plaintiffs’ Complaint has not sufficiently pled fraud allegations with respect to each Individual Defendant; (2) Plaintiffs’ Complaint does not state a claim based upon any of Cardinal’s alleged accounting misstatements; and (3) Plaintiffs’ Complaint does not allege particularized facts sufficient to state a claim based on Cardinal’s transition from a B + H to an FFS business model.
a. Particularity of Fraud Allegations with Respect to Each Defendant
Cardinal Defendants argue that Plaintiffs’ allegations fail as a matter of law because Plaintiffs do not specify their allegations with respect to each Individual Defendant. They contend that a plaintiff “is required to meet the Rule 9(b) and PSLRA standards as to
each
defendant against whom securities fraud is alleged” and that the Fifth Circuit has “explained the PSLRA’s prohibition on clumping in some detail.”
See
Def.’s Motion to Dismiss at 61;
see Southland Sec. Corp. v. Inspire Ins. Solutions, Inc.,
The Plaintiffs, however, contend that they have adequately pled fraud
Cardinal Defendants argue that a plaintiffs vague allegations
must
fail if the plaintiff fails to attribute them to specific directors, grouping directors together as “Defendants” instead.
See Mills v. Polar Molecular Corp.,
Though Defendants’ prudential argument may have appeal, it has been specifically rejected by courts within the Sixth Circuit.
See Century Bus.,
Defendants Walter, Fotiades, Miller, Millar, and Parrish were all high-level executives, responsible for day-to-day operations and issues relating to Cardinal’s financial performance. See supra PartJLA. They also signed off on Cardinal’s corporate disclosure statements or participated in conference calls with analysts and investors. Id. Though Plaintiffs have alleged facts showing that Defendant Jensen was a high-level executive, they have not shown that he had any involvement in certifying corporate documents to the extent of the other Individual Defendants. Also, Plaintiffs have not pled facts showing that Jensen ever participated in conference calls with analysts and investors. Moreover, at oral argument, counsel for Defendant Jensen further convinced the Court that there were not enough facts alleged to link Jensen to Cardinal’s corporate misstatements to the extent of his co-Defendants. And although the Court still finds that Plaintiffs’ allegations about Defendant Jensen’s insider trading provide some indications of scienter, in their totality, Plaintiffs’ Complaint fails to establish that Defendant Jensen should be found responsible for Cardinal’s alleged misstatements or omissions. Accordingly, the Court GRANTS Defendant Jensen’s Motion to Dismiss.
b. Whether Plaintiffs Pled Cardinal’s Accounting Misstatements with Particularity
Cardinal Defendants emphasize that Plaintiffs have failed to allege GAAP violations because they have not indicated any true “misstatements” or “omissions” by Cardinal Defendants.
See
Def.’s Motion to Dismiss 58-87. Cardinal Defendants’ arguments fall short, in part, however, because this Court has already found
In
Montalvo v. Tripos, Inc.,
plaintiffs, purchasers of stock in a corporation, sued defendants — the corporation, certain corporate officials, and the corporation’s outside auditor' — alleging that defendants had made false and misleading financial misstatements which, when discovered, led to a significant drop in the company’s stock value.
See
The Montalvo court held that the purchasers had sufficiently alleged that defendants acted with the requisite scienter, properly identified misleading statements and the circumstances under which the statements were made, and adequately pled fraud in connection with defendants’ accounting irregularities. Id. The court reasoned that where plaintiffs had alleged both far-reaching GAAP violations as well as facts showing the evidence of defendants’ fraudulent intent, they had met the PSLRA’s standards of pleading with particularity. Id. The Montalvo court concluded:
Here the plaintiffs have alleged not only egregious GAAP violations, but also “evidence of corresponding fraudulent intent.” They have set out with particularity the material misstatements in the public statements which omitted, among other things, the on-going problems with the software consulting business, and have set forth GAAP violations which defendants do not deny as evidenced by their restatements. Essentially, the amended complaint alleges that defendants knew that certain company assets were impaired and that losses were certain, but that recognizing these losses (during the Class Period) would have lowered the company’s stock price and threatened the ability to market and sell its products ... It is [also] alleged that the “strategic non-disclosures” kept [the defendant company’s] stock artificially high, attracting more investors, until the restatements were issued, causing a drastic stock price fall. The plaintiffs have identified specific documents and statements within those documents attributable to the defendants that allegedly artificially inflated [the defendant company’s] earnings and net tangible assets by deliberately hiding specific losses that were also identified.
See id.
at
Just as the
Montalvo
plaintiffs’ complaint identified a number of examples of allegedly inaccurate statements meant to defraud investors, so too does Plaintiffs’ Complaint detail 105 pages of detailed errors. Thus, the Court finds that while the Cardinal Defendants spend considerable time and effort explaining how and why
c. Cardinal’s Forward-Looking Statements
Cardinal Defendants also argue that Plaintiffs’ allegations fail to satisfy the standards of the PSLRA because they are protected by the statutory safe-harbor as “immaterial” forward-looking statements. During the Class Period, Plaintiffs allege that Defendant Cardinal made numerous statements concerning the Company’s shift from the B + H to the FFS distribution market, and its effect on Cardinal’s business. Cardinal Defendants aver that its statements concerning the Company’s changing distribution model constitute in-actionable “forward-looking statements” protected by the PSLRA’s safe-harbor provision. Def.’s Motion to Dismiss at 83-85;
see
15 U.S.C. §§ 78u-5(c)(l)(A), 77z-2(c)(1)(A), 78u-5(c)(l)(A);
see Southland,
A “forward-looking statement,” which can be either written or oral, is defined as:
(A)a statement containing a projection of revenues, income (including income loss), earnings (including earnings loss) per share, capital expenditures, dividends, capital structure or other financial items;
(B) a statement of the plans and objectives of management for future operations, including plans or objectives relating to the products or services of the issuer;
(C) a statement of future economic performance, including any statement contained in a discussion and analysts of financial condition by the management or in the results of operations included pursuant to the rules and regulations of the Commission....
15 U.S.C. § 77z-2(i)(l);
see Southland,
The safe harbor has two independent prongs: one focusing on the defendant’s cautionary statements, and the other on the defendant’s state of mind. 15 U.S.C. §§ 77z-2(c)(l)(A), 78u-5(c)(l)(A) (1996); 15 U.S.C. §§ 77z-2(e)(l)(B), 77u-5(c)(l)(B) (1996);
Southland,
Cardinal Defendants are liable only if the statements were “material” and Cardinal Defendants had “actual knowledge” that they were false or misleading, or if the statements were not identified as “forward-looking” and/or lacked meaningful cautionary language. See 15 U.S.C. § 78u-5(c)(l). The Court will now analyze whether any of the following statements are protected by statutory safe harbor.
I. Materiality
First, Cardinal Defendants would dismiss their optimistic projections and internal estimates as “soft, puffing statements” that are immaterial as a matter of law. Def.’s Motion to Dismiss at 83-85;
see San Leandro,
Under the federal securities laws, a statement is
material
if there is a “substantial likelihood that [it] would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”
See TSC Indus., Inc.,
The Supreme Court endorses a fact-intensive test of materiality in securities fraud cases.
Helwig,
In
Helwig,
Defendants also argued that because their economic projections amounted to puffery, they were not actionable under the securities laws.
See
[I]t cannot be said that Vencor’s preliminary appraisals and internal assessments of the Balanced Budget Act were material solely by virtue of their omission ... [P]laintiffs have alleged facts to produce a strong inference that defendants knew that the Budge Act could adversely affect their operations. Yet defendants simply rested on their disavowals of knowledge while continuing to make favorable earnings predictions. We concluded that there is a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”
Id.
There are also instances in which courts have found that a defendant’s omissions or misstatements were inactionable because they were “too general.”
See In re Ford Motor Company Sec. Litig.,
Plaintiffs’ theory of liability is premised on Ford’s omission of material information which allegedly transformed seemingly innocuous and accurate statements into misleading statements ... By omitting information about this contingent liability, plaintiffs argue, Ford’s accurate statements about sales of Explorers and its bolstering statements regarding corporate responsibility became misleading to investors.
Id.
at 630. The court found that plaintiffs had failed to state a claim under Section 10(b) and Rule 10b-5 because “Ford’s statements were
general, ...
[and] did not
Moreover, relying on
In re Ford,
this Court determined in
Albert Fadem
that plaintiffs’ allegations were, similarly, too general to substantiate plaintiffs’ claims.
See
This Court finds the instant case more similar to Hehvig than to In re Ford and Albert Fadem. Just as plaintiffs in Hel-wig pled detailed facts that could not be considered puffery, in this case, Plaintiffs have alleged 105 pages of specific facts, each of which implies that although Defendants knew that Cardinal’s attempted business model transition could adversely affect the Company’s financial standing, they recklessly reported accounting misstatements in their SEC filings, their statements to the market, and their statements during conference calls with analysts and investors. See Complaint ¶¶ 56-58, 63-66, 72-76, 80-85, 88-95, 97-105, 108-14, 118-28, 132-38, 141-46, 150-51, 153-59, 163-68, 171-78, 181-87, 191-95, 199-223. As such, the Court finds that Cardinal Defendants’ statements regarding the Company’s transition from a B + H to an FFS distribution model were not immaterial puffery.
ii. Meaningful Cautionary Language
Though the Court has determined that Cardinal’s statements about its shifting distribution model were not puffery, they may still be protected by the safe harbor if they constitute forward-looking statements accompanied by “meaningful cautionary language.” Cardinal Defendants argue that each of their alleged “misstatements” related to the future of the Company in the face of the distribution shift and were forward-looking. The issue, then, is whether the statements were “accompanied by meaningful cautionary language.”
The requirement for “meaningful cautionary language” calls for “substantive” company specific warnings based on a realistic description of the risks applicable to the particular circumstances, not merely a boilerplate litany of generally applicable risk factors.
Southland,
365
In
Firstenergy,
the court found that, though some of defendants’ forward-looking statements were protected by cautionary statements, the cautionary language was “insufficient to bring them within the safe harbor provision.”
See
This News Release includes forward-looking statements based on information currently available to management. Such statements are subject to certain risks and uncertainties. These statements typically contain, but are not limited to, the terms ‘anticipate,’ ‘expect,’ ‘believe,’ ‘estimate,’ and similar words. Actual results may differ materially due to a number of factors including, but not limited to, the speed and nature of regulatory approvals.
Id.
n. 9. The court reasoned that, considering the facts of the plaintiffs’ complaint suggesting that defendants had “actual knowledge” of the problems at the defendant Company, the above “vague and insipid cautionary language is insufficient to afford the statements protection under [the] PSLRA’s safe harbor provision.”
Id.
(citing
In re Prudential Sec. Litig.,
1) Cardinal’s January 23, 2003 Conference Call
Plaintiffs cite Defendant Walter’s statement in Cardinal’s January 2003 conference call as being a fraudulent misstatement about whether Cardinal was successfully shifting from a B + H to an FFS distribution model.
[D]uring the call, Defendant Walter stated:
I’m happy to report to you another strong quarter for Cardinal overall where we met our goals and market expectations. We positioned ourselves for a second half of fiscal 2003 that will allow us to deliver on a commitment of 20% earnings per share growth with the solid improvement and return on sales and capital and strong cash flow and— cash flow in excess of $1 billion____
I was very pleased with the quarter. Revenue and earnings were in line with expectations but cash flow in return and committed capital was substantially better than I expected. I will explain what is driving that in each of our segments.... The pharmaceutical distribution and provider service segment continued with above-industry revenue growth driven predominantly by a favorable mix towards change, up 17%, and alternate site up 20%. ...
I already mentioned that fiscal 2004 revenues will be strong. Earnings in the second half for the segment will grow a little slower than the first half, but with favorable revenue and expense trends, earning growth rates for FY04 will pick up over the second half of FY03. Return on sales, capital and cash flow will be very strong. Now, let me shift to the medical products and service area. I really like what I see happening here. Ron [Labrum] and his team have really stepped up the momentum, and you will see it in our second half. First, there is a new leadership in the distribution business segment and a strong determination to grow our distribution volume. And we are winning in the marketplace with some very important new contract
The fact is our models are changing a bit, frankly for the better and we want you to understand it ... Cardinal continued to enter into inventory management agreements with manufacturers, whereby we are compensated on incentive basis to help manufacturers better match their shipments with market demand.
See Complaint ¶ 142.
Cardinal Defendants argue that Walter’s statements are not actionable because he accompanied them with meaningful cautionary language that protected them under the statutory safe harbor.
See
Def.’s Reply at 62-65. They contend that, Plaintiffs conceded as such by remaining silent on the issue their Opposition Motion.
See
Def.’s Reply at 64. Further, Cardinal Defendants contend that Plaintiffs have strategically crafted their Complaint, misquoting Walter’s statements to give the impression that he had knowingly “misrepresented” the number of customers who had signed new IMA contracts and the actual success of Cardinal’s transition.
See
Def.’s Reply at 62; Pl.’s Opposition at 50. Cardinal Defendants argue that such manipulative pleadings make Plaintiffs’ allegations immaterial.
71
See Royal Appliance,
1995 WL
This Court does not agree that this situation is akin to
Royal Appliance, Kaufman, Field
or
Fudge. See
2) Cardinal’s May 2003 Investor
The Plaintiffs cite the May 2003 issue of The Cardinal Health Investor as including a number of actionable misstatements. 72 This issue of the Investor identified several “Hot Topics,” one of which was the Company’s [IMAs] with manufacturers, writing:
IMAs — Our critical role
We’ve been getting questions about our relationships with' pharmaceutical manufacturers lately, particularly in light of “channel stuffing” activities being repotted. Manufacturers are looking to better align productivity with health care providers’ product demand and, because of this, are offering less inventory for sale into the channel, which you all are aware has had an impact on our trading company business this year.
[IMAs] ... are an attempt to balance manufacturing production with actual prescription demand by retailers and consumers. IMAs, which often contain provisions limiting the distributor’s inventory investment, are an important part of doing business as a pharmaceutical distributor. The channel can operate more efficiently, and costs to eventual patients can be contained.
We look to structure IMAs to achieve similar levels of profitability and improve our return on capital by reducingthe capital that is needed for investment in inventory. That frees up capital for reinvestment either in this business or in other areas of the company. With the diversity of our businesses and attractive investment alternatives, we will deploy the capital returned from these agreements into new opportunities.
Evolution occurring in the marketplace over the past several years can be a positive development for the industry, but also one in which we have to remain diligent in understanding how the structure of these agreements will impart our profit over the next several years. We will continue to utilize our experience and competitive expertise to negotiate individually with manufacturers, but we will always weight the economic value of every product we carry to ensure it is consistent with our profit targets and the value we bring to manufacturers.
We are confident that we can work with manufacturers to meet them needs and also preserve our profit consistent with the influential role we play in the pharmaceutical channel.
See Complaint ¶ 156.
Again, Cardinal Defendants argue that Plaintiffs’ silence as to whether the above statement is accompanied by meaningful cautionary language makes it inactionable. See Def.’s Reply at 65. Further, Cardinal Defendants argue that the above statement merely “confirms that the market is in ‘[e]volution’ and that Cardinal recognizes the need to ‘remain diligent’ in the face of new challenges.” See id. Nevertheless, the Court finds that this brief sentence of cautionary language is not specific enough to allow the entire statement the protection of the statutory safe-harbor.
3) Cardinal’s July 31, 2003 Conference Call
In Cardinal’s July 31, 2003 conference call with analysts and investors, Cardinal Defendants “repeated and addressed information previously made public in the [Company’s] July 31, 2003 press release.” Complaint ¶ 164. During that call, Defendant Miller stated:
As expected, Cardinal Health’s 4th quarter financial results' capped off the year that delivered on the financial commitment that we made to our shareholders at the beginning of the year. Strong revenue growth across all of our business segments drove continued expansion and operating earnings....
Now, let me comment on just a few matters of importance in our various operating segments, beginning with the Pharmaceutical Distribution and Provider Services segment. Strong revenue growth of 14 percent was driven by 42 percent growth from alternate site customers and 11 percent growth from chain customers during the 4th quarter. Incremental revenue from previously announced new customer wins had a positive impact during the quarter and served to offset the expected dampening effect of a slow down in our wholesaler-to-wholesaler trading revenues.
Id. Further, Defendant Walter allegedly provided:
Our solid 4th quarter performance capped another strong year for our company. The financial results for the year were outstanding and we did deliver on our commitments....
... In our analyst meeting last August, we forecasted 14 to 17 percent revenue growth and 20 to 22 percent earnings per share growth for Cardinal Health, and our performance was right on target. ...
Now for some of the highlights from the 4th quarter in fiscal 2003, from my perspective, strong revenue growth acrossthe company, and each segment delivers at or above our expectations ...
In our Pharmaceutical Distribution business ... [r]evenue growth was strong with some important new relationships being established that provides us more from a supplier that moves us more from a supplier of products to a solutions provider ...
First, we are confident that revenues in each of our segment will continue to be strong. An I’ve already given you some of the reasons for that. Revenue growth for the corporation should be in the mid-teens. So there is a lot of confidence in sales....
[I’m] convinced, after extensive conversations with many of our manufacturing partners, that they are not seeking to pull margins from the distribution partners ....
And this has led to the statements I made on the call in April, led to more active conversations at the high level with other manufacturers and I am very pleased with those conversations and met with the CEOs of some of the major pharmaceutical manufacturers to talk about and make sure they know about distribution and make sure they understand how moving to what I call a closer — a model that has sales in production and closer to demand of the patient.
Id.
Cardinal Defendants argue that “[neither excerpt purports to identify manufacturers who have entered new contracts. The complete transcript makes clear that with the first sentence Walter is cautioning investors about the diminishing margin opportunities that led to the transition.” See Def.’s Reply at 66. Defendants aver that Walter began his statement by saying,
First we have concluded that it’s prudent to be more cautious about vendor margins in this environment ... .we expect strong revenue ... but as we pulled our budget together for the fiscal year and reviewed recent activity, we came to the conclusion vendor margins will be down when compared to a relatively strong '02 in first half of '03. Some manufacturers are seeking a distribution relationship that pulls inventory out of the channel when compared to fiscal '02 and fiscal '03. Their goal is to match production in sales more closely to script demand at the patient level. Keep in mind, I said some, but not all. I want to accommodate their needs as we view them as our upstream customer. And [I’m] convinced, after extensive conversations with many of our manufacturing partners, that they are not seeking to pull margins from the distribution partners.
Id.
Cardinal Defendants argue that Walter reiterated his warnings in response to analyst questions, and that Plaintiffs intentionally omitted some of Walter’s cautionary language in their pleadings.
See
Def.’s Reply at 68. Specifically, they aver that in response to an analyst question about the Company’s management of the IMA model, Defendant Walter responded by stating, “... Let’s put this in perspective, in my conversation I said that the less optimism on buying margin, vendor margin for the next six months affected the overall growth rate of Cardinal’s operating earnings by 2-3%----”
Id.
They declare that, considering Walter’s statements
in context,
Cardinal clearly disclosed “the difficulties that lay both in the past and the future” and also offered “what Cardinal hoped would be ‘perspective’ ” —amounting to “sound management, not deception.”
See
Def.’s Reply at 68. The Court does not find that these tidbits of “perspective” amount to meaningful cautionary language sufficient to warn an investor that, despite Cardinal’s seemingly successful operating
4) Cardinal’s February 19, 2004 Conference Call
On February 19, 2004, Cardinal hosted its Semi-Annual Investor Update Conference during which Defendant Parrish allegedly stated:
We have seen tremendous organic growth in the business and we’re not looking forward maybe projections of winning through large agreement and having to sort of hit one over the fence, if you will, in order to make our numbers ....
Our revenue growth is dependable and sustainable. We’re going to grow slightly faster than the marketplace because of our mix of mail-order business and alternate-care business....
Now finally, as we have been informing you over the last three quarters, our manufacturers’ needs have shifted. It is our inventory management model, with inventory levels that match demand, production efficiencies and increase the safety and security of the U.S. distribution channel.
Finally, as we move through fiscal year 2005, our results will begin to resemble the traditional model for the distribution company, in which earnings grow faster than revenues, the model that you’re used to seeing from Cardinal Distribution....
And we’re making significant progress with our branded manufacturer customers at this point....
And currently, we have in process 47 manufacturers, representing about 80% of our volume in these negotiations in some phase of these five-step processes.
See Complaint ¶ 187.
Cardinal Defendants argue that, in his statements, Parrish neither “misrepresented” the “number of customers” who had signed IMA contracts nor “the actual status of the transition.” See Def.’s Reply at 74. They opine that, when Parrish mentioned 47 manufacturers “in some phase of these five-step processes” he was not claiming that Cardinal had actually completed new FFS agreements with each manufacturer, and they contend that Plaintiffs intentionally left out the following clarifying statements made by Parrish:
This enabled us to enter into the discussions with the manufacturers armed with documentation and supporting evidence to support the process. Working through this discussion was really a five-stage process involving first establishing awareness of the services that we provide. Then we have to educate our partners on the changes that are going on in the marketplace. We then define the terms of the new agreements, which we’re calling distribution service agreements, or DSAs. We go through the implementation process of those agreements, and then there’s an ongoing refinement.
See id. As such, Cardinal Defendants argue that “rather than misstating the transition, Parrish was explaining what [the transition] might entail.” Id. (emphasis added). Nevertheless, the Court does not find that Parrish’s side note that the development of IMAs was a long-term “process” amounts to meaningful cautionary language sufficient to protect Cardinal Defendants’ statements under the statutory safe-harbor.
5) Cardinal’s April 22, 2004 Conference Call
On April 22, 2004, Cardinal Defendants hosted another conference call with ana
Another important measure of our progress to the just in time business model as seen in our day’s inventory on hand, which declined a significant seven days versus the year-ago period, driven largely by distribution....
So I think these discussions are now moving into a much more informed kind of discussion because, you know, they now know it’s real. They’re starting to do their own work and it’s making good progress ... We have agreements with everybody today and those agreements are going to continue to get refined and we’ll continue to see improvements in our business as a result.
See Complaint ¶ 192. The Court is not persuaded that Fotiades one-line statement that the IMAs in development would continue to be refined constitutes meaningful cautionary language to protect Cardinal Defendants’ statements under the statutory safe-harbor.
iii. Actual Knowledge of Misleading Nature of Forward-Looking Statements
The Cardinal Defendants may also be protected by the statutory safe harbor for material statements as long as the Plaintiffs have not adequately alleged Cardinal Defendants’ “actual knowledge” of the misleading or false nature of their statements.
See Helwig,
A defendant who asserts a fact as of his own knowledge or so positively as to imply that he has knowledge, under the circumstances when he is aware that he will be so understood when he knows that he does not in fact know whether what he says is true, is found to have intent to deceive, not so much as to the fact itself, but rather as the extent of his information.
See id. (citing Prosser and Keaton on Torts 741-42 (5th ed.1984) (citations omitted)).
Nonetheless, in
Mayer v. Mylod,
the Sixth Circuit held that the truth or falsity of a defendant’s misstatements “is not an issue to be decided under Rule 12(b)(6).”
iv. Liability for Third-Party Statements
Cardinal Defendants also contend that they cannot be held liable for analysts’ and reporters’ statements regarding Cardinal. See Def.’s Reply at 68-70. Specifically, Cardinal Defendants argue that Plaintiffs have pointed to no actionable misstatements in their allegations regarding the October 23, 2003 Morgan Stanley Report or the January 22, 2004 Dow Jones News Service Article Regarding Cardinal. See id.; see Complaint ¶¶ 175,183.
Cardinal Defendants assert that, to state a viable securities fraud claim with respect to analysts’ statements, the plaintiffs must plead facts demonstrating that the defendants adopted or
entangled
themselves with the statements.
See Albert Fadem,
In
Albert Fadem,
Plaintiffs attempted to attribute the forecasts and statements of analysts to the defendants in making out their securities fraud claim.
In this case, in addition to the Morgan Stanley and the Dow Jones Reports, Plaintiffs’ Complaint presents a number of different analyst and reporter statements regarding Cardinal as fraudulent misstatements for which Cardinal should incur liability. Complaint ¶¶ 89-90, 93, 99, 101, 114, 120, 122-23, 134, 143, 175, 183, 209-12, 215-16, 218. Though Plaintiffs set forth each statement in detail, like the
3. Whether the Complaint Fails to Plead Loss Causation as to any of the “Improprieties” Enumerated in the Complaint
Plaintiffs argue that Cardinal Defendants’ alleged fraud caused Cardinal’s stock to be artificially inflated and that Defendants’ alleged misstatements created Plaintiffs’ false confidence in Cardinal’s performance. Plaintiffs also argue that Cardinal Defendants’ fraud proximately caused their losses because when the Company revealed the truth about its financial struggles and Cardinal’s stock price plummeted, Plaintiffs faced billions of dollars in losses. Cardinal Defendants counter that none of Plaintiffs’ allegations adequately establishes a causal connection between an “act or omission” of any Defendant and the “loss for which the Plaintiffs now seek damages,” and Defendants argue that “this failure is dispositive as to all of Plaintiffs claims.” See Def.’s Motion to Dismiss at 29.
Under § 78u-4(b)(4) of the PSLRA, private plaintiffs must prove that a defendant’s securities fraud caused their economic loss. In relevant part, the statute provides, “[i]n any private action arising under this chapter, the plaintiff shall have the burden of proving that the act or omission of the defendant alleged to violate this chapter caused the loss for which the plaintiff seeks to recover damages.” 15 U.S.C. § 78u-4(b)(4). For loss causation claims, the Federal Rules require only “a short and plain statement of the claim showing that the pleader is entitled to relief.”
See
Fed. Rule Crv. Pro. 8(a)(2). Essentially, a plaintiff needs to allege a drop in stock price; establish a causal connection; and connect the alleged fraud with the ultimate disclosure and loss.
See DE & J Ltd. P’ship. v. Conaway,
The Supreme Court recently interpreted the securities laws’ causation requirement in
Dura Pharmals., Inc. v. Broudo,
a case determining that the 9th Circuit’s loss causation pleading standard was insufficient under the PSLRA.
See
The
Dura
plaintiffs argued that, “[i]n reliance on the integrity of the market, [they] ... paid artificially inflated prices for Dura securities and ... suffered damage[s] thereby.”
Id.
(quotations and emphasis omitted). Nonetheless, the Supreme Court concluded that this interpretation of loss causation, if applied, would do more harm than good.
Id.
at 1631. First, the Court found that “at the moment the transaction takes place,” the plaintiff must have suffered a loss to be able to establish a securities loss causation claim.
Id.
The most that can be said is that a higher purchase price can
sometimes
contribute to bringing about a future loss.
Id.
at 1632. The
Dim
Court held that a plaintiff cannot satisfy the PSLRA’s loss causation requirement merely by alleging (and later establishing) that the price of the security on the date of the purchase was artificially inflated because of defendant’s misrepresentation.
See id.
The Court reasoned, “[t]o ‘touch upon’ a loss is not to
cause
a loss, and it is the latter that the law requires,” and continued, “it should not prove burdensome for a plaintiff who has suffered an economic loss to provide a defendant with some indication of the loss and causal connection that the plaintiff has in mind. At the same time, allowing a plaintiff to forgo giving any indication of the economic loss and proximate cause that the plaintiff has in mind would bring about” the strike suits the statutes seek to avoid.
See Dura,
Cardinal Defendants aver that Plaintiffs have failed to plead “loss causation” under
Dura,
arguing that Plaintiffs do no more than allege that they relied on an artificially inflated stock price that caused their loss.
See
Def.’s Motion to Dismiss at 31-37. They declare that though Plaintiffs set forth a number of allegedly fraudulent misstatements, because they failed to plead facts showing that Cardinal’s subsequent truthful disclosures led to the Company’s falling stock price, they have not established the necessary causal link between the alleged misstatements and the price decrease required by
Dura. See id.
at 29-31;
Plaintiffs counter that the case sub judi-ce differs from the foregoing cases because, in this case, Plaintiffs have not just
In this case, Plaintiffs’ Complaint consists of over 200 pages of allegations regarding, among other things, Cardinal Defendants’ fraudulent misstatements, accounting violations, and insider trading. Plaintiffs allege a four-year long fraud in which Defendants, increasingly desperate to improve the outlook of Cardinal’s transition from a B + H to an FFS distribution model, overinflated the Company’s stock price by falsely reporting its operating revenues to misrepresent the Company’s progress. Cardinal Defendants note that the Company did not reveal the truth about the Company’s accounting violations until issuing its October 26, 2004 Restatement, after the Class Period had ended. Nonetheless, this Court is convinced that this issue of timing alone is not enough to defeat Plaintiffs’ allegations of loss causation where they have clearly specified causal connections between Cardinal Defendants’ misstatements over the four-year Class Period and their resulting damages.
4. Conclusion
As established above, the following allegations, taken together, raise the requisite inference of scienter necessary under the PSLRA: (1) Defendants’ alleged accounting improprieties; (2) Defendants’ alleged manipulation of areas of focus; (3) alleged insider sales by Defendants Walter, Fo-tiades, Jensen, Miller, Millar; (4) the Indi
Hence, the Court GRANTS in part and DENIES in part Cardinal Defendants’ Motion to Dismiss and DENIES the Motions to Dismiss by Defendants Miller and Millar. The Court GRANTS Cardinal Defendants’ Motion to Dismiss as to Defendant Jensen. As Senior Vice President of Audit and Financial Services, Corporate Controller and Principal Accounting Officer for Cardinal from 2003 through 2005, Jensen was employed by Cardinal after the bulk of the alleged accounting fraud occurred. Thus, Jensen was not involved in the alleged accounting allegations upon which Plaintiffs rest their Complaint, and the Court finds it appropriate to GRANT Cardinal Defendants’ Motion to Dismiss as to Defendant Jensen. The Court, however, DENIES the'motion as to Defendants Walter, Fotiades, and Parrish.
B. Control Person Claims Under Section 20(a)
In their Complaint, Plaintiffs also allege claims against the each of the Individual Defendants and Defendant Cardinal for violations of Section 20(a) of the Exchange Act.
See
15 U.S.C. § 78t. Section 20(a) imposes secondary liability on those persons who “control” the violators of Sections 10(b).
Id; see, e.g. Albert Fadem,
This Court had concluded that Plaintiffs have, in fact, sufficiently pled securities fraud as to all Cardinal Defendants, except Defendant Jensen.
See supra
Part
IV.II.A.2.a.
Plaintiffs also adequately allege that each of the Individual Defendants had direct and supervisory involvement in the day-to-day operations of Cardinal. Moreover, Plaintiffs maintain that, excluding Defendant Jensen, these Individual Defendants were provided with or had unlimited access to copies of the Company’s press releases, public filings, and other statements alleged to be misleading.
See supra
Part
IV.II.AI.
In light of these pleadings, the Court determines that Plaintiffs have sufficiently pled a § 20(a) claim.
See id.
Accordingly, the Court DENIES Cardinal Defendants’ Motion to Dismiss Plaintiffs’ § 20(a) claims as to Defendants Walter, Fotiades, Miller, Millar, and Parrish.
See Firstenergy Corp.,
A. Plaintiffs’ Section 10(b) and Rule 10b-5 Claims
Unlike their broader allegations against the Cardinal Defendant, Plaintiffs’ claims against E & Y focus on the alleged GAAP violations in Cardinal’s accounting for FY 2002 through FY 2004. Essentially, Plaintiffs contend that, since being hired as Cardinal’s outside auditor in 2002, E & Y consistently performed audits that did not comply with GAAS. Plaintiffs argue that E & Y’s non-compliant audits raise a strong inference that E & Y either knew or recklessly disregarded the fact that Cardinal’s materially misleading financial statements enabled the Company to artificially inflate its stock price. See Complaint ¶¶ 367-403.
The same PSLRA pleading standard applicable to the Section 10(b) and Rule 10b-5 allegations against the Defendants applies to Plaintiffs’ allegations against E
&
Y.
See PR Diamonds,
There is no accountanf/client privilege analogous to that accorded to lawyers.
See In re Enron,
In summary, “[w]hen the standard of recklessness for an auditor is overlaid with the pleading requirements of the PSLRA, a simple rule emerges: to allege that an independent accountant or auditor acted with scienter, the complaint must allege specific facts showing that the deficiencies in the audit were so severe that they strongly suggest that the auditor must have been aware of the corporation’s fraud.”
See PR Diamonds,
Once again, the Court must examine Plaintiffs’ allegations collectively to determine whether the Plaintiffs’ allegations, when viewed in totality, create a strong inference of Defendant E & Y’s scienter.
See PR Diamonds,
The class members point to a number of red flags that they should have alerted E & Y to likely improprieties at Cardinal and conveyed the need for it to engage in a more exacting audit of the Company’s books. A red flag creating a strong inference of scienter consists of “[a]n egregious refusal to see the obvious, or to investigate the doubtful.”
PR Diamonds,
In
Fidel,
plaintiff, class members, sued Fruit of the Loom (FOTL), individual officers of FOTL, and E & Y, FOTL’s outside auditor, for securities fraud, and when the district court granted E & Y’s motion to dismiss, the plaintiffs appealed.
See
In the case sub judice, Plaintiffs’ allegations are nearly identical to those of the plaintiffs’ in
Fidel.
The
Fidel
court found that the above red flags “[did] not create the inference, much less a strong inference, that [E
&
Y], in preparing an audit report of 1998 financial results, acted with scienter”.
Id.
at 229;
see
15 U.S.C. § 78u-4(b)(2) (requiring facts “giving rise to a strong inference that the defendant acted with the required state of mind”).
80
Further, in
Fidel,
the Sixth Circuit found that the fact that E & Y served as a consultant to FOTL and had access to “both confidential documents and upper- and lower-level management” did not, without more, lend credence to plaintiffs’ allegation that E & Y acted with scienter.
See
Against the backdrop of Fidel, the class members in this case have not pled with the requisite particularity any facts showing that E & Y knew of or recklessly disregarded these red flags in conducting its audit. Because “claims of securities fraud cannot rest ‘on speculation and con-clusory allegations’ ” alone, Plaintiffs’ alleged red flags do not create an inference that E & Y acted with scienter.
2. Ignoring Audit Evidence Gathered from FY 2002 through FY 2004 83
The Plaintiffs also contend that by consistently ignoring GAAS principles while
Plaintiffs argue that Cardinal engaged in the following acts of fraudulent accounting, which E & Y ignored: (1) the mis-classification of bulk deliveries as operating revenue in FY 2001 through FY 2003; (2) the premature recognition of $22 million gained in the Vitamin Litigation settlement in FY 2002; (3) the decision to change Cardinal’s revenue recognition policy for its Pyxis business in FY 2002; (4) balance sheet reserve and accrual adjustments in Cardinal’s 2004 10-K; (5) as announced in Cardinal’s 2004 10-K, the decision to change the Company’s method of accounting for cash discounts received from vendors for prompt payment; (6) the mis-classification of an unidentified amount of expenses as “special charges” related to mergers and acquisitions to understate Cardinal’s regular expenses; (7) improper
a. Cardinal’s Classification of Operating Revenue
Plaintiffs attack the method Cardinal used to differentiate between its high-margin Operating Revenues and its low-margin Bulk Deliveries — the 24-hour rule — in its FY 2002 and FY 2003 statements. Plaintiffs argue that Cardinal should have applied the classification guidelines it adopted in the FY 2004 Restatement during the Class Period, and they claim that Cardinal’s failure to do so caused it to significantly overstate its “Operating Revenue,” giving investors a false impression of the success of the Company’s growth in the face of the shifting pharmaceutical distribution market. Thus, Plaintiffs contend that the fact that Defendant E & Y failed to discover Cardinal’s “mis-classifications” of revenue in its FY 2002 and FY 2003 audits raises an inference of Defendant E & Y’s scienter.
First, though Plaintiffs argue that Cardinal’s internal bulk order policy did not comply with GAAP, this Court is not convinced that the “24-hour rule” violates fundamental principles of accounting. Plaintiffs cite various pronouncements 85 which they argue tend to show Cardinal’s recklessly or intentionally inaccurate reporting of “Operating Revenue” in violation of the SEC’s assertions that financial reporting should be both “accurate” and “reliable.” As Defendant E & Y correctly notes, however, these authorities do not provide guid- ame as to how sales from bulk deliveries should be distinguished from operating revenues, if at all.
Further, from FY 1998, when Cardinal began separating its revenues into two different line items, to FY 2004, when Cardinal issued its Restatement, classifying all revenue as a single line item, Cardinal was at all times forthcoming about its treatment of “Bulk Deliveries” and “Operating Revenues.” Hence, it was Defendant Cardinal’s use of the “24-hour rule” to manipulate the sales classifying as high-margin “Operating Revenue” that led to investors’ false confidence in the Company’s growth, not the fact that the 24-hour rule violated GAAP in and of itself. The facts alleged do not show that E
&
Y could have known that the Company’s use of the 24-hour rule during FY 2002 and FY 2003 had artificially inflated Cardinal’s “Operating Revenue.” Moreover, though Plaintiffs correctly argue that Cardinal’s later restated mis-classifications of revenue provides evidence of the
Cardinal
Defendants’ scienter, a claim based on “alleged accounting irregularities fails to raise a strong inference of scienter if it alleges no facts to show that Defendants[,
outside
auditors,] knew or could have known of the errors, or that their regular accounting procedures should have alerted them to the errors sooner than they actually did.”
Fidel,
b. Premature Recognition of the Vitamin Litigation Settlement
Plaintiffs assert that Cardinal’s premature recognition of $22 million in settle
Defendant E & Y counters that Plaintiffs have not alleged any basis for their assertion that E & Y acted with scienter. Defendant argues that even assuming the timing of Cardinal’s original recognition of the $22 million in revenue violated GAAP, one GAAP violation alone, does not give rise to an inference that E
&
Y knew that its certification of Cardinal’s financial statements (which had already been approved by AA) violated GAAP. Further, they argue that though Plaintiffs rely upon various GAAP rules to show that a company should not recognize a substantial gain until it can be
certain
that that particular gain will be realized, Cardinal had considered the $22 million in proceeds to be a virtual certainty.
86
Finally, Defendant E & Y argues that the fact that Cardinal had fully explained its accounting treatment of the $22 million in its SEC filings, undermines Plaintiffs’ fraud allegations.
87
See Ziemba v. Cascade Int’l, Inc.,
The GAAP rules are designed to ensure that public companies, like Cardinal, are truthful in their financial statements, only recognizing income that they are certain to obtain. In that vein, Cardinal’s premature recording of the $22 million can be considered a significant breach of GAAP principles. Nonetheless, it is uncontroverted that Cardinal was at all times truthful about its treatment of the Vitamin Litigation settlement. Moreover, once The Wall Street Journal article had revealed Cardinal’s methods of accounting to the public, Cardinal further explained its reason for treating the settlement proceeds as it did. In addition to Cardinal’s thorough explanations defending the Company’s accounting procedures, Plaintiffs have pled no facts alleging that E & Y certified Cardinal’s financial statements knowing or recklessly disregarding the fact that they were fraught with glaring errors. Therefore, E & Y’s certification of Cardinal’s premature income recognition does not create a strong inference of E & Y’s scienter.
Cardinal’s Automation and Information Services segment offers a mix of products and services for use by hospitals and other health care facilities. It develops, manufactures, leases, sells and services point-of-use systems that automate the distribution and management of medications and supplies. This segment includes Pyxis Corporation (“Pyxis”) which leases point-of-use systems that automate the distribution management and control of medications.
Beginning in FY 2002, Cardinal changed its revenue recognition for Pyxis so that revenue would not be recognized until all of the Company’s installation obligations were complete, the equipmeht was functioning properly, and the customer had accepted it. In the course of its Audit Committee’s internal investigation, however, Cardinal discovered that customers had sometimes been persuaded by Pyxis salespeople to execute equipment confirmations before the equipment had been fully installed.
In its 2004 10-K, Cardinal acknowledged that certain revenue from the sale of Pyxis machines had been prematurely recognized during the Class Period. The Company was unable to determine precisely how much revenue it had prematurely recognized from improper customer confirmations, but it estimated that in FY 2002, $8.3 million of revenue should have been deterred to a later period, resulting in $5.3 million of operating earnings, and that in FY 2003, the total estimated revenue impact was $1.3 million of revenue and $800,000 of operating earnings.
Plaintiffs argue that the fact that Cardinal had prematurely recognized its Pyxis revenue supports their assertion that Defendant E & Y acted with scienter. They aver that, if it had correctly performed its duties, E & Y would have undoubtedly discovered Cardinal's fraudulent treatment of Pyxis revenues. Defendants, however, counter that Plaintiffs fail to plead any allegations explaining how E & Y would have become aware of any manipulation. Defendants argue that if E & Y had reviewed the improper Pyxis transactions, it would have seen that there were third-party confirmations that the company’s installation was complete, and, therefore, that E & Y would have not had a reason to question Pyxis’ decision to recognize revenue when it did. See SAS No. 99, Consideration of Fraud in Financial Statement Audit (2002) (stating that collusion “such as a false confirmation from a third party that is in collusion with management,” may cause an “auditor who has properly performed the audit” to conclude that there is persuasive evidence that a particular transaction was properly recorded when, in fact, it was not). Because E & Y’s review of Cardinal’s treatment of Pyxis revenues would not, on its face, have revealed any accounting misconduct on the part of Cardinal, Plaintiff have failed to plead facts showing that E & Y had scien-ter in certifying Pyxis’ premature revenue recognition.
d. Balance Sheet Reserves and Accrual Adjustments
In its 2004 10-K, Cardinal restated the Company’s balance sheet reserves and accrual adjustments. Cardinal Defendants acknowledged that in connection with the Company’s balance sheet reserves and accrual adjustments, there were various situations prior to and throughout the Class Period in which Cardinal could not substantiate either the amount of its reserves or the timing of its reserve adjustments. In the end, Cardinal’s restatement due to these various reserve and accrual adjustments decreased the Company’s reported
Plaintiffs allege that E & Y was reckless in not discovering the above GAAP errors that were later identified and corrected by Cardinal in its October 2004 Restatement. Defendants respond that Plaintiffs fail to allege how E & Y could have known of the existence of these “relatively minor errors” during the course of the firm’s audit work. Essentially, Defendants allege that the magnitude of these items was so small that E & Y’s failure to discover them does not give rise to a strong inference of scienter. First, they allege that because the 2004 Restatement revealed that Cardinal’s 2002 net earnings had been understated by $14.5 million, these net earnings could not provide a basis for Plaintiffs’ claim that they had been defrauded by artificially inflated financial statements. Second, they argue that, in 2003, the restatement caused a relatively small impact on Cardinal’s net earnings, making a 2.2% drop from $1.405 billion to $1.375 billion.
“[T]he magnitude of an erroneous financial statement caused by allegedly fraudulent representations, without more, cannot sustain a finding that an auditor acted with scienter.”
See SCB Computer Tech.,
e. Recognition of Cash Discounts
In prior reporting periods, Cardinal treated cash discounts received from vendors for prompt payment as a reduction of the cost of the products sold, recognizing the discount immediately. 88 Beginning in FY 2004, however, Cardinal announced that it had decided to change its classification of these cash discounts, to treat them as components of inventory cost, rather than as reductions in the cost of products sold. Thus, Cardinal was able to postpone its recognition of the discount until the Company actually sold the associated products.
Cardinal did not retroactively restate its financials prior to FY 2004 because it believed that it had simply switched from “one acceptable accounting method” to another, more preferable, but also acceptable, method. E & Y concurred in Cardinal’s judgment, providing a letter that was attached as an exhibit to Cardinal’s 10-K that agreed that Cardinal had changed “to an acceptable alternative method, which, based on [Cardinal’s] business judgment to make this change and for the stated reason [in the 10-K, was] preferable” in Cardinal’s circumstances. Plaintiffs allege
The Court, however, finds that Plaintiffs have failed to allege that Cardinal’s old method violated GAAP, and, even if it did, that Plaintiffs have inadequately alleged that E & Y knowingly certified a Cardinal GAAP violation. The Supreme Court has acknowledged that accounting rules are subject to a range of reasonable judgments:
Accountants have long recognized that [GAAP] are far from being a canonical set of rules that will ensure identical accounting treatment of identical transactions. [GAAP] rather, tolerate a range of reasonable treatments, leaving the choice among alternatives to management. As a result, “an ethical, reasonably diligent accountant may choose to apply any of a variety of acceptable accounting procedures” when that accountant prepares a financial statement.
Godchaux v. Conveying Techniques, Inc.,
The Court further finds that Plaintiffs have failed to cite accounting literature, which suggests that Cardinal should have restated its recognition of cash discounts before FY 2004. The Court finds that even if Plaintiffs had properly alleged a GAAP violation, they do not set forth any facts suggesting that E & Y could have known the accounting treatment was incorrect.
f. Special Charges
In FY 2001 and FY 2002, Cardinal recorded “special charges” of $149.9 million and $141.4 million respectively for merger-related and restructuring costs. Plaintiffs argue that Cardinal inflated its “special charges”
89
to enable the Company to understate its normal recurring expenses ei
Plaintiffs posit that, consequently, since 1996, Cardinal “has taken ‘special’ charges for activities that are similar in nature and thereby does not meet the definition of ‘unusual in nature’ and ‘infrequency in occurrence’ ” under APB No. 30, ¶¶ 21-22. Plaintiffs contend that “special charges also create a serious potential for abuse by permitting a company to manipulate its financial statements by shifting ‘normal’ operating expenses that otherwise would have been recorded in future periods into the current period.” Pl.’s Opposition at 29. 92 They argue that Cardinal’s financials strongly indicate “that Cardinal improperly overstated its special charges in order to understate its normal recurring charges either in the same quarter that Cardinal overstated its special charges or in subsequent quarters.” Id. at 30. Defendant E & Y retorts, and the Court agrees, that Plaintiffs’ broad allegations do not rise to the necessary of level specificity required by the PSLRA. Essentially, Plaintiffs have provided no facts that show that E & Y knew that these special charges were Cardinal’s efforts at fraudulent “big bath” accounting.
Plaintiffs also argue that during the Class Period, the Cardinal Defendants irii-properly accounted for a securitization 93 of the Company’s Pyxis receivables in IQ 2002 as an off-balance sheet transaction, causing Cardinal’s account receivables and its outstanding debt to be understated in violation of GAAP. Plaintiffs contend that in connection with the change in revenue recognition related to Pyxis, Cardinal Defendants engaged in a securitization transaction in FY 2002 involving its sale-lease portfolio that does not qualify as a “true sale” under SFAS standards. See supra note 94. Plaintiffs argue that to sell Pyxis receivables, Cardinal created a wholly-owned special purpose vehicle (“SPV”), Pyxis Funding LLC and that through that SPV, Cardinal sold approximately $150 million in Pyxis sales-type lease receivables during IQ 2002, all of which were sold with recourse, 94 Plaintiffs allege that because the risk of non-collection remained with Cardinal, in the form of Pyxis Funding LLP (a Cardinal subsidiary), proper conservative accounting treatment required Cardinal to treat the transaction as a “secured borrowing,” accounting for it on the Company’s balance sheet. Plaintiffs aver that Cardinal’s accounting for the sale of the Pyxis receivables as an off-balance sheet transaction, Defendant Cardinal violated GAAP, and understated the Company’s accounts receivables and outstanding debt.
Defendant E & Y contends that Plaintiffs fail to plead facts showing that E
&
Y should be liable for the understated receivables related to Cardinal’s Pyxis subsidiary. E & Y asserts that, “Plaintiffs’ allegations fail to demonstrate that Cardinal should have treated the securitization of the Pyxis receivables as a loan instead of a sale” because they “offer no factual basis for their allegation that the transaction was not reported in accordance with GAAP”, and because in notes to its FY 2002 statements, Cardinal provided investors with a lengthy explanation of its Pyxis securitization program that does
not
suggest purchasers had general rights of recourse against Pyxis Funding LLC. Defen
Plaintiffs’ allegations resemble those made by the lead plaintiffs in the landmark
Enron
litigation.
See
In this case, Plaintiffs’ allegations concerning Cardinal’s sales of Pyxis receivables do not rise to the level of specificity of those in
Enron.
h. Cardinal’s October 2004 Restatement
Finally, Plaintiffs allege that, by issuing an October 2004 Restatement of their FY 2002, and 2003 financials, Cardinal conceded that its accounting was materially false and misleading.
See
Pl.’s Opposition at 13. Plaintiffs opine, that Cardinal’s Oc
Defendant E & Y counters that, despite Plaintiffs’ allegations, Cardinal’s October Restatement never conceded that the classification standards Cardinal used in FY 2002 and 2003 to distinguish between operating revenue and bulk revenue were materially improper. See Def.’s Reply at 5. Furthermore, Defendant E & Y contends that “there is no GAAP guidance alleged-nor does any exist — the prohibits a company from restating if it chooses to do so to correct even immaterial errors.” See Def.’s Reply at 13.
Whether there is such a GAAP guidance, the Court agrees with Defendant E & Y that Plaintiffs’ claims as to the 2004 Restatement fail to infer scienter because, in their Opposition Motion, Plaintiffs do not “respond to E & Y’s argument that they have failed to allege any factual basis for inferring that E & Y was aware, at the time it issued its audit opinions, that Cardinal’s FY 2002 and FY 2003 financial statements contained material errors.” Id. As Plaintiffs have not pled sufficient facts suggesting that Cardinal’s alleged errors were discovered during the course of the 2004 investigation, came to E & Y’s attention during the course of its FY 2002 or 2003 audits, or were so obviously material that it was reckless for E & Y to issue an unqualified opinion unless those errors were corrected, Cardinal’s October 2004 Restatement does not imply that Defendant E & Y acted with scienter.
Plaintiffs acknowledge that the above accounting issues may not, on their own, establish a strong inference of E
&
Y’s scienter. Nevertheless, they argue that the fact that E & Y certified Cardinal’s FY 2002 and FY 2003
97
financial statements
3. Alleged Non-Compliance with GAAS Principles 98
Next, Plaintiffs contend that E & Y made false and misleading statements by representing that it performed its audits in a manner consistent with GAAS. In support of this claim, Plaintiffs note that for its FY 2002 and FY 2003 audits of Cardinal, E & Y had represented that the Company’s financial statements were fair and accurate and comported with GAAP when in fact, they were riddled with red flags. Plaintiffs allege that E & Y’s failure to “adequately perform its audit procedures to identify [Cardinal’s] improprieties,” enabled those improprieties to continue over a period of four years, leading to inaccurate financial statements, and, eventually, a rapidly dropping stock price. Plaintiffs specifically allege that E
&
Y failed to adhere to a number of specific GAAS principles, listing and describing
4. E & Y’s Motivation to Keep Cardinal’s Business
Plaintiffs also allege that E & Y committed fraud in order to maintain its lucrative Cardinal account. Though Plaintiffs have established Cardinal was clearly a profitable client for E & Y, such claims have failed in the past.
See Fidel,
5. Other Fraud Claims Brought Against E & Y
Finally, Plaintiffs allege that the fact that E & Y has been “sanctioned in administrative proceedings before the SEC” for failing to comply with auditor independence rules and improper professional conduct in the past, [makes it] more likely that E & Y had scienter in this case. Complaint ¶ 399-400.
100
Plaintiffs claim
The Court finds that Plaintiffs’ claims regarding E & Y’s “pattern of bad behavior” do not create an inference of scienter. In
Fidel,
the court noted that plaintiffs relied on settlements that E
& Y
had made in a case arising from its audits of Cendant Corporation as evidence that it had engaged in fraud while auditing the financial statements of FOTL.
6. Conclusion
Plaintiffs rest on nothing more than broad conclusory allegations to assert that E & Y acted with scienter in preparing its audit reports. In
Fidel,
the Sixth Circuit explained that such vague allegations, even when viewed in their totality, “do not create the inference, much less a
strong
inference, that [an auditor] acted with the required state of mind.”
See
Because Plaintiffs’ claims do not create a strong inference of Defendant E & Y’s scienter, Plaintiffs cannot establish all the elements of their Section 10(b) prima facie case. Thus, the Court GRANTS Defendant E & Y’s Motion to Dismiss.
Y. CONCLUSION
Based on the foregoing discussion, the Court DENIES Plaintiffs’ Motion to Strike Appendices ## 58, 59, 60, 61, 62, 64, 65, 66, 67, and Jensen’s Motion at 8-9 and GRANTS Plaintiffs’ Motion to Strike Appendix # 70 and any arguments related thereto. Further, the Court DENIES the following: (1) Cardinal Defendants’ Motion to Dismiss both Plaintiffs’ § 10(b) and Rule 10b-5 claims and Plaintiffs’ § 20(a) control person claims; (2) Defendant James F. Millar’s Motion to Dismiss both Plaintiffs’ § 10(b) and Rule 10b-5 claims and Plaintiffs’ § 20(a) control person claims; and (3) Defendant Richard J. Miller’s Motion to Dismiss both Plaintiffs’ § 10(b) and Rule 10b-5 claims and Plaintiffs’ § 20(a) control person claims. The Court GRANTS the following: (1) Defendant Gary S. Jensen’s Motion to Dismiss both Plaintiffs’ § 10(b) and Rule 10b-5 claims and Plaintiffs’ § 20(a) control person claims; and (2) Defendant E & Y’s Motion to Dismiss Plaintiffs’ § 10(b) and Rule 10b-5 claims.
IT IS SO ORDERED.
Notes
. Plaintiffs allege that the Individual Defendants, Cardinal’s Senior Executives, "directed and approved” Cardinal's alleged fraud, culminating in the artificial inflation of Cardinal’s stock price.
. Because the Defendants' various motions to dismiss rely on a common basis of underlying factual allegations and because the Defendants have raised common arguments in support of dismissal of the consolidated amended complaint, the Court will consolidate its ruling on each of the various motions to dismiss in this single opinion.
. These facts were primarily drawn from the Plaintiffs’ Complaint, along with undisputed facts offered by the Defendants in their Motions to Dismiss, where appropriate, to present a true, accurate and more comprehensive accounting of the factual background relevant to these motions.
. Lead Plaintiff, Pension Fund Group ("PFG”), purchased Cardinal common stock during the Class Period, as set forth in its certification previously filed with the Court, and allegedly suffered damages. Though ten different Plaintiffs moved to be appointed Lead Plaintiff in the instant litigation, the Court appointed PFG Lead Plaintiff on January 26, 2005.
See In re Cardinal Health, Inc. Sec. Litig.,
. At all relevant times, Cardinal's fiscal year ran from July 1 to June 30. Hereinafter, fiscal year will be abbreviated FY (i.e., FY 2001 for fiscal year 2001) and fiscal quarter will be abbreviated Q (i.e. IQ 2002 for first quarter of fiscal year 2002).
. As noted above, these six individuals are referred to collectively herein as the "Individual Defendants.”
. Walter's annual compensation also included a $511,525 set-aside in FY 2001-FY 2004 for taxes to cover his, his family, and his associates' personal use of the Company airplane, as well as $333,711 in insurance premiums paid by the Company to benefit a trust for Walter's family. See Complaint ¶ 272.
. Prior to retaining E & Y, Cardinal’s auditors were from the now defunct firm of Arthur Andersen ("AA”). AA’s "accounting frauds” included, among others, the highly publicized frauds in the WorldCom and Enron cases.
See In re MCI Worldcom, Inc. Sec. Litig.,
. In FY 2002 and FY 2003, $2.6 million of the $4.9 million in total fees E & Y received from Cardinal, and $5.1 million out of the $8.9 million in total fees E & Y received from Cardinal, respectively, related to the firm’s performance of various non-audit services.
.In its audit opinions for both FY 2002 and FY 2003, E & Y explained the roles of the Company and its auditors, noting that the financial statements were "[t]he responsibility of the Company's management.” E & Y averred that it had conducted an audit of Cardinal’s year-end financial statements in accordance with GAAS and believed that those financial statements "presented] fairly, in all material respects, the consolidated financial position of Cardinal Health, Inc." at the respective audit dates (June 30, 2002 and June 30, 2003). Further, E & Y explained that the Company’s fiscal 2000 and 2001 statements were audited by AA, and that E & Y had performed certain limited procedures with respect to those statements "but had not been engaged to audit, review, or apply any [other] procedures to the Company’s financial statements” and did not "express an opinion or any other form of assurance” on those financial statements taken as a whole.
.In its 2003 Form 8-K, Cardinal explained the B + H model in detail and discussed the ways in which the buy-and-hold model allowed drug distributors, like Cardinal, such successful growth. Cardinal representatives wrote:
[Under the buy-and-hold model, mjargins were earned by distributors based largely on the amount of inventory bought and held, and to a lesser extent, on fees collected for the unique distribution requirements of the individual pharmaceutical products. In an environment where inventory was appreciating at a rate greater than the cost of carrying, distributors were encouraged to carry more and more inventory. Large inventory stocks drove margins through price appreciation and manufacturer incentives, with the resulting profitability more than covering distribution costs for all products. With knowledge of distributors' willingness to buy and hold inventory, manufacturers also periodically offered deals or incentives to carry even more inventory, exacerbating the large supplies of inventory in the channel.
. Cardinal mainly profited from the inflation in pharmaceutical prices between the date the products were purchased from manufacturers and the date the same products were sold to retailers.
. The consolidation of the distributor market was matched by a consolidation in the retail pharmacy market in which mass retailers like
. In the May 2003 issue of The Cardinal Health Investor, the Company characterized IMAs writing, "IMAs, which are agreements negotiated between pharmaceutical manufacturers and distributors, are an attempt to balance manufacturing production with actual prescription demand by retailers and consumers. IMAs, which often contain provisions limiting the distributor's inventory investments, are an important part of doing business as a pharmaceutical distributor. The channel can operate more efficiently, and costs to eventual patients can be contained.” See Complaint ¶ 156.
. Defendants argue that what Plaintiffs refer to as "JIT” transactions are more properly labeled "anticipatory ordering.” Nevertheless, the system described is the same under both Plaintiffs' and Defendants' classifications. This system is one in which Cardinal uses its electronic ordering and inventory systems to anticipate when customers will need additional product, then order that product so as to have it available in Cardinal's inventory. As with product that Cardinal sold as Bulk from Stock, product that Cardinal used for anticipatory ordering is considered to be a part of Cardinal’s inventory.
.Cardinal, however, was not the only pharmaceutical distributor to shift from a B + H to an FFS model. Defendants mention that McKesson and AmerisourceBergen, like Cardinal, changed their business models during the Class Period to respond to manufacturers’ efforts to control the distribution channel. Defendants note that McKesson’s stock dropped from $34.33/share on June 30, 2004 to $30.27/share on July 6, 2004 (11.8% drop), and that AmerisourceBergen's stock declined from $59.78/share on June 30, 2004 to $54.00/share on July 6, 2004 (9.7% drop).
. The "commercial paper market” is composed of unsecured, short-term loans issued by corporations, typically for financing accounts receivables and inventories. Such loans — or commercial paper — are usually issued at a discount reflecting prevailing market interest rates. To trade on this market, however, "Cardinal needed to present itself as financially sound.” See Complaint ¶ 249.
. Mike Losh replaced Defendant Miller as Cardinal's CFO in 2004.
. At oral argument on February 6, 2006, Plaintiffs explained that the $26 billion consisted of 3 separate components: (1) $21 billion was bulk from stock sales; (2) $3.8 billion was derived from the 24-hour rule; and (3) $1:8 billion came out of the interception of orders from just-in-time inventory. Plaintiff explained, "it's our position that [Cardinal] restated all that money.” The Court must construe the facts in the light most favorable to the Plaintiffs at this stage of this litigation. As such, though the Cardinal Defendants dispute the accuracy of the foregoing numbers, the Court shall adopt them in analyzing the Defendants’ various motions to dismiss.
. In a DSD sale, Cardinal receives a shipment from a manufacturer in bulk, takes that shipment into its own inventory, and holds that inventory until products are ordered by and delivered to a retailer or some other customer.
. In this type of transaction, Cardinal acted as an "intermediary” instead of selling products out of its own inventory. In its FY 1998 10-K Cardinal explained,
Along with other companies in its industry, the Company has begun reporting as revenue bulk deliveries made to customers' warehouses, whereby the Company acts as an intermediary in the ordering and subsequent delivery of pharmaceutical products. All years presented have been reclassified to include these bulk deliveries as revenue (previously only the service fees related to such bulk deliveries were reported as revenue; such service fees were not significant in any period presented). Fluctuations in bulk deliveries result largely from circumstances that are beyond the control of the Company, including consolidation within the chain drugstore industry, decisions by chains to either begin or discontinue warehousing activities, and changes in policy by manufacturers related to selling directly to chain drugstore customers. Due to the insignificant margins generated through bulk deliveries, fluctuations in their amount have no significant impact on operating earnings.
See Def.'s Motion to Dismiss at 9.
. Both Plaintiffs and Defendants refer to Cardinal's decision to classify its revenue based on this 24-hour cut-off period as the "24-hour rule.”
. Cardinal’s release stated:
Cardinal Health, Inc. announced today that it has received a request for information from the [SEC] in connection with an informal inquiry. The request seeks historical financial and related information, including information pertaining to the accounting treatment of $22 million recovered from vitamin manufacturers who were found to have overcharged the company. The company is highly confident in its accounting and financial disclosure practices, and intends to cooperate fully and provide all information required to satisfy the request.
See Complaint ¶ 171.
.Cardinal wrote:
During the fourth quarter of fiscal 2002, the Company recorded income from net litigation settlements of $11.3 million. These settlements included a $13.3 million special item resulting from the recovery of antitrust claims against certain vitamin manufacturers for amounts overcharged in prior years. The recovery totaled $35.3 million, of which $22 million had previously been recorded ($10.0 million in the second quarter of fiscal 2001 and $12.0 million in the first quarter of fiscal 2002). The amounts previously recorded were reflected as a reduction of cost of goods sold, which is consistent with the classification of the original overcharge, and were based on the minimum amounts estimated to be recoverable based on the facts and circumstances available at the time they were recorded. While the Company still has pending claims against other manufacturers, the amount of any future recovery is not currently estimable. Any future recoveries will be recorded as a special item in the period when a settlement is reached.
Cardinal recorded "[t]hese pricing adjustments ... as a reduction of cost of goods sold, consistent with the classification of the original overcharge,” during the second quarter of FT 2001 and IQ 2002. Cardinal's total recovery from vitamin manufacturers resulting from the Vitamin Litigation was $144.7 million. See Def.’s Motion to Dismiss at 22.
. The article’s lead paragraph suggested that Cardinal had prematurely recognized the settlement proceeds. Jonathon Weil, Cardinal Health’s Accounting Raises Some Questions, Wall St. J., Apr. 2, 2003, at Cl. ("Don’t count your chickens before they hatch. Yet new disclosures in Cardinal Health, Inc.’s latest annual report suggest that is what the drug wholesaler has done not just once, by twice, independent accounting specialists say.”).
. GAAP rules are the "basic postulates and broad principles of accounting pertaining to business enterprises, approved by the Financial Accounting Standards Board of the American Institute of Certified Public Accountants (AICPA).”
See Sec. & Exchange Comm’n v. Price Waterhouse,
. The SEC's subpoena specifically requested information about Cardinal’s classification of "Operating Revenue” and "Bulk Deliveries to Customer Warehouses and Other.”
. In its October 2004 10-K, Cardinal restated the Company's balance sheet reserves and accrual adjustments. Cardinal Defendants acknowledged that in connection with the Company’s balance sheet reserves and accrual adjustments, there were various situations prior to and throughout the Class Period where the amount and timing of its reserves as well as the timing of its reserve adjustments could not be substantiated. In the end, Cardinal’s restatement due to these various reserve and accrual adjustments decreased the Company’s reported net income for FY 2000-3Q 2004 by $64.2 million. See Complaint ¶¶ 219-22.
. In prior reporting periods, Cardinal treated its cash discounts received from vendors for prompt payment as a "Reduction of the Cost of Goods Sold,” recognizing the discount immediately. Beginning in FY 2004, however, Cardinal announced it would change its treatment of its cash discounts, considering them a component of inventory cost rather than reductions in the cost of products sold. As such, Cardinal postponed its recognition of the cash discounts until the Company had sold the associated products.
Plaintiffs allege that Cardinal should have always used the latter method of recognizing cash discounts, and that its failure to do so until 2004 constituted a GAAP violation. Nonetheless, Cardinal did not restate fiscal periods prior to FY 2004 because it believed that it was simply switching from “one acceptable accounting method” to another, more preferable, but also acceptable, accounting method. E & Y concurred in Cardinal’s judgment, providing a letter that was attached as an exhibit to Cardinal's 10-K agreeing that
. In FY 2001 and FY 2002, Cardinal recorded "special charges” of $149.9 million and $141.4 million respectively for merger-related and restructuring costs. Plaintiffs argue that Cardinal inflated its "special charges” to enable the Company to understate its normal recurring expenses either in the same quarters Cardinal overstated its special charges, or in subsequent quarters, thereby reporting inflated Operating Earnings.
In support of its Complaint about these "special charges,” Plaintiffs cite: (1) a 1998 speech made by the SEC’s Chairman explaining how merger and restructuring services could be abused, and (2) a 2003 analyst report observing that restructuring charges are "clearly a factor” in analyzing a company as "acquisitive as Cardinal Health had been in recent years” and suggesting that "this needs to be monitored closely.”
. Finally, Plaintiffs argue that during the Class Period, the Cardinal Defendants improperly accounted for a securitization of the Company's Pyxis receivables in IQ 2002 as an off-balance sheet transaction, causing an understatement of Cardinal's account receivables and its outstanding debt in violation of GAAP.
Plaintiffs contend that in connection with the change in revenue recognition related to Pyxis, Cardinal Defendants engaged in a secu-ritization transaction in FY 2002 involving its sale-lease portfolio that is not a "true sale” under SFAS standards. See supra note 94. Plaintiffs argue that to sell Pyxis receivables, Cardinal created a wholly-owned special purpose vehicle ("SPV”), Pyxis Funding LLC, and that through that SPV, Cardinal sold approximately $150 million in Pyxis sales-type lease receivables during IQ 2002, all of which were sold with recourse. Plaintiffs allege that because the risk of non-collection remained with Cardinal, in the form of Pyxis Funding LLC (a Cardinal subsidiary), the proper conservative accounting treatment required Cardinal to treat the transaction as a "secured borrowing,” accounted for on the Company’s balance sheet. Further, Plaintiffs aver that Cardinal’s classification of the sale of the Pyx-is receivables as an off-balance sheet transaction violated GAAP and allowed Cardinal to fraudulently understate both its accounts receivables and outstanding debt.
.The rule reads, "(B) In any private action arising under this chapter, all discovery and other proceedings shall be stayed during the pendency of any motion to dismiss, unless the court finds upon the motion of any party that particularized discovery is necessary to preserve evidence or to prevent undue prejudice to that party.” See 15 U.S.C. § 78 — 4(b)(3)(B).
. Plaintiffs have moved to strike the following exhibits and any references Defendants make to them: (1) Appendix # 58: December 28, 2001 Form 10-K of AmerisourceBergen; (2) Appendix # 59: 2003 AmerisourceBergen Annual Report; (3) Appendix # 60: June 10, 2004 Form 10-K of McKesson Corporation; (4) Appendix # 61: August 17, 2001 WR Hambrecht & Co. analyst report; (5) Appendix # 62: August 20, 2001 Credit Suisse/First Boston analyst report; (6) Appendix # 66: July 1, 2004 Baird analyst report; (7) Appendix # 64: October 24, 2003 Baird analyst report on McKesson; (8) Appendix # 65: January 23, 2004 Baird analyst report on McKes-son; (9) Appendix #67: September 14, 2004 A.G. Edwards analyst report; (10) Appendix # 70: Amy Tsao, "A Common Cold for Drug Distributors? News of Cardinal Health’s poor earnings surprised the Street, which fears rivals McKesson and AmerisourceBer-
. Rule 12(f) states:
Upon motion made by a party before responding to a pleading or, if no responsive pleading is permitted by these rules, upon motion made by a party within 20 days after the service of the pleading upon the party or upon the court's own initiative at any time, the court may order stricken from any pleading any insufficient defense or any redundant, immaterial, impertinent, or scandalous matter.
Fed. Rule Civ Pro. 12(f).
. Courts interpret "the interests of justice” to "include such concerns as ensuring speedy trials, trying related litigation together, and having a judge who is familiar with the applicable law try the case.”
See Heller Fin., Inc. v. Midwhey Powder Co., Inc.,
.Federal Rule of Evidence 201 permits the 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.” Fed. Rule Evid. 201(b). A district court must take judicial notice "if requested by a party and supplied with the necessary information.” Id. at 201(d). A court may take such notice "at any stage of the proceeding.” Id. at 201(f).
. The Court also notes that, though Sixth Circuit precedent on the issue is unclear, both the Third and the Fifth Circuit have found that resignations of key officers from defendant corporations are insufficient to show that those officers acted with the requisite scienter to commit the alleged securities fraud.
See In re Great Atl. & Pac. Tea Co. Inc. Sec. Litig.,
. According to the Supreme Court, "the basic aim of the antifraud provisions [in Section 10(b) ] is to 'prevent rigging of the market and to permit operation of the natural law of supply and demand.'''
See Ernst & Ernst,
. Section 10 of the Exchange Act provides:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange ... (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or. for the protection of investors.
15 U.S.C. § 78j.
.Rule 1 Ob-5, prescribed by the SEC under Section 10(b) of the Exchange Act, provides:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of 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 the 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.
17 C.F.R. § 240.10b-5. The scope of Rule 10b-5 is "coextensive” with the coverage of Section 10(b). See United States v. O’Hagan, 521 U.S. 642 , 651,117 S.Ct. 2199 ,138 L.Ed.2d 724 (1997). By enacting these rules, "Congress tried to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry.' ” See Affiliated Ute Citizens of Utah v. United States,406 U.S. 128 ,92 S.Ct. 1456 ,31 L.Ed.2d 741 (1972). Further, the Supreme Court has indicated that the statute should be "construed ‘not technically and restrictively, but flexibly to effectuate its remedial purposes.’ ” See id. at 151,92 S.Ct. 1456 .
. "Congress echoed the concerns expressed by the Supreme Court in
Blue Chip Stamps [v. Manor Drug Stores,
. The PSLRA states, in relevant part:
(b) Requirements for securities fraud actions
(1) Misleading statements and omissions.
In any private action arising under this chapter in which the plaintiff alleges that the defendant -
(A) made an untrue statement of a material fact; or
(B) omitted to state a material fact necessary in order to make the statements made, in the light of the circumstances in which they were made, not misleading; the complaint shall 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.
(2) Required state of mind.
In any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state ofmind, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.
15 U.S.C. § 78u-4(b) (2005). Further, the PSLRA provides that if a plaintiff fails to meet the above requirements, a court may, on any defendant's motion, dismiss the complaint. See Id. § 78u-4(b)(3).
. While the Sixth Circuit qualified that it found this list “while not exhaustive, at least helpful in guiding securities fraud pleading,” it acknowledged that a plaintiff seeking to
. For instance, Cardinal Defendants contend that Cardinal's decision to classify its revenues as Bulk Deliveries or Operating Revenue based on the ''24-hour” rule was not a GAAP violation, but merely the misapplication of a valid GAAP method. As such, they argue that the market was not misled as to whether Cardinal followed GAAP.
. After reviewing the subsidiary's audit, Comshare disclosed that "it initiated a detailed review 'after discovery of letters setting forth conditions to certain orders in the United Kingdom, which the Company had not been made aware of at the time the revenue was recognized,' " and that it was now aware of approximately $4 million in such orders.
Comshare,
. Though
MicroStrategy
is a non-binding Eastern District of Virginia case, because the magnitude of the accounting errors alleged are comparable to those in this case, this Court is persuaded by the
MicroStrategy
court’s analysis..
See
. In summary, plaintiff-shareholders alleged the following accounting errors: (1) improper categorization of at least $88.9 million of intangible assets purchased during Cardinal’s acquisition efforts; (2) "big bath” accounting that allowed SmarTalk to inflate later period earnings by improperly transferring expenses incurred in these later periods back into the charge previously recorded as capital expenses rather than operating expenses; (3) accounting for acquisitions in 1997 involving the issuance of SmarTalk shares by improperly using the share price on the day of the announcement, rather than the three-day average of the share prices spanning the announcement of the transaction resulting in a lower acquisition cost to SmarTalk' — thereby reducing amortized goodwill expenses by $7 million; (4) improperly reporting as capital expenses at least $10.9 million in marketing expenses paid to manufacturers and retailers to carry SmarTalk’s product thereby spreading the expense associated with .these items over a number of years rather than properly incurring those expenses in FY 1997 and the first and second quarters of FY 1998; (5) improperly recognizing the deferred revenues and breakage revenues of the companies SmarTalk acquired in 1997; (6) failing to write off impaired or uncollectible accounts receivable; (7) creating a sham sale of Smar-Talk’s money-losing call center operations at a price of $20 million to a related party that had no prior material operations or assets and thus lacking in any ability to pay. Plaintiffs alleged that because of these accounting errors, SmarTalk’s stock prices were significantly overinflated.
SmarTalk,
. In summary, Plaintiffs allege that: (1) Cardinal's financial statements mis-characterized Operating Revenues and made inadequate disclosures regarding revenue classification procedures; (2) Cardinal improperly and prematurely recognized $22 million of expected lawsuit settlement proceeds prior to a settlement being reached in the Vitamin Litigation; (3) Cardinal used improper reserve accounting and improper accrual adjustments to overstate the Company’s net income by $64.2 million in violation of GAAP; (4) Cardinal failed to disclose the Company’s recognition of cash discounts earned from suppliers for prompt payment; (5) Cardinal improperly recognize Bulk Deliveries as Operating Revenue by manipulating its use of the 24-hour rule; (6) Cardinal made excessive special charges; (7) Cardinal understated its receivables through securitization of Pyxis receivables; and (8) Cardinal violated SEC regulations due to its inadequate internal controls.
. Cardinal Defendants also argue that the Sixth Circuit holds that the magnitude of financial fraud does not contribute to an inference of scienter.
See Fidel v. Farley,
. Though Plaintiffs cite
Xerox Corp.,
the case does not support Plaintiffs' argument that the Individual Defendants' positions analyzed against the backdrop of their misstatements rises to the level of scienter.
. As noted above, Cardinal’s Bulk Deliveries has "very little financial impact on Cardinal’s Operating Earnings — the transactions were generally pass-through with zero or immaterial margin — and as the amount of Bulk Deliveries could fluctuate widely from quarter to quarter through circumstances the Company could not control, Bulk Deliveries revenue was not a reliable or accurate barometer of Cardinal's true revenue growth.” See Complaint ¶ 296.
. In Plaintiffs' Opposition Motion, Plaintiffs raise an argument that the Individual Defendants’ sales are also an “independent basis for liability” under Rule 10b-5. They cite
SEC v. Zandford,
for the proposition that "neither the SEC nor this Court has ever held that there must be a misrepresentation ... in order to run afoul of the [1934] Act.”
See
. Compare the following cases:
Provenz v. Miller,
. This stock options issue is somewhat complex. Essentially, Cardinal Defendants argue that Plaintiffs lump the Individual Defendants' decision to exercise their stock options as akin to regular trading activity, when, in fact, there is nothing fraudulent about exercising one's stock option before it expires. Cardinal Defendants are correct in arguing that the market does not ask executives to buy and hold stock options indefinitely. If an executive buys an option at $10.00 per share which expires one year later at $56.00 per share, he should certainly be allowed to profit from the sale of that option before its expiration. Nonetheless, should the executive strategically arrange to sell its option long before its expiration because he knows inside information that would lead him to believe that his company’s stock price would drop before he had a chance to exercise his option, courts might consider that somewhat suspicious — a “pump and dump" scheme.
. In total, Cardinal Defendants argue that Plaintiffs failed to account for approximately $12.2 million of shares Defendant Walter acquired during the Class Period.
. Cardinal Defendants also claim that Plaintiffs omitted the sale of 26,097 shares on January 1, 1999 from Walter’s pre-Class Period total. See Def.’s Motion to Dismiss at 43. However, Plaintiffs counter that, "in accordance with Walter’s SEC filing for the sale, [P]laintiffs did not include the transaction because it was for the 'payment of exercise price or tax liability’ by delivering or withholding securities incident to the receipt, exercise or vesting of a security issued in accordance with Rule 16b-3.’’ See PL’s Opposition to Motion to Dismiss at 69-70 n. 25. Plaintiffs also contend that they were “consistent in not including these transactions as sales,” and posit that Cardinal "Defendants’ own analysis, at least when it came to asserting that Miller had no stock sales, did not include these types of transactions as sales when they were made during the Class Period.” Id. Regardless of which party’s construction of the facts is correct, the Court need not resolve the parties' technical dispute at this stage of the proceedings.
. Before Fotiades became Cardinal’s COO in February 2004, he was a senior executive at Cardinal.
. Defendant Jensen argues that the Court may, at this stage of the litigation, take judicial notice of Jensen’s 10b5-l plan because "its existence was disclosed in a publicly filed document, specifically Cardinal's Form 4 from March 10, 2004.”
See New England Health Care Employees Pension Fund v. Ernst & Young, LLP,
. Though Plaintiffs and Cardinal Defendants disagree as to the number of Parrish's shares, the Court need not and will not resolve this technical issue at this early stage of the litigation.
. Plaintiffs created charts that detail the executive compensation, earned during the Class Period by Defendants Walter, Miller, Fo-tiades, and Millar. See Complaint ¶ 271-74.
. Plaintiffs contend that “Cardinal did not publicly report salary or bonus information for defendants Jensen or Parrish, however, given the Company's reported approach to compensation, it is likely that these [D]efen-
. Cardinal Defendants also contend that "Plaintiffs' factual recitations are lacking.” They argue that Plaintiffs allege, for example, that Walter was awarded 486,009 options in • fiscal year 2003 that had a value of $36,600,000, and that Plaintiffs state that their pleaded value represents that “median of the potential realizable value as reported by Cardinal in the Company's corresponding Proxy statements.” See Complaint ¶271, n. 14. However, Defendants aver that "Plaintiffs are playing with the numbers” and that Cardinal’s proxy statement for 2003 shows that Walter was awarded options with a strike price of $67.90. They argue that the proxy then shows the value of those options under three scenarios: (1) a 0% stock price appreciation for the option term; (2) a 5% stock price appreciation for the option term; and (3) a 10% stock price appreciation for the option term. They contend that Plaintiffs arrived at their "median” by dropping the low number and averaging the larger two, "which is neither sound mathematics nor sound pleading.” See Def.'s Motion to Dismiss at 55 n. 5. Nonetheless, it is unnecessary to get to the heart of these complex mathematical issues at this stage of the proceedings. As such, the Court considers the Plaintiffs’ allegations as evidence, though not dispositive evidence, of scienter. The parties’ dispute over the specific facts should be dealt with at trial.
. Plaintiffs also allege that Cardinal Defendants were motivated, in part, by a desire to maintain a high credit rating, however, most courts hold that allegations pertaining to "a company’s desire to maintain a high bond or credit rating [does not] qualif[y] as a sufficient motive for fraud ... because 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.”
See MicroStrategy,
. See supra note 19 (discussing Plaintiffs’ analysis of their allegation that Cardinal’s accounting errors amounted to $26 billion).
. Looking at Cardinal Defendants' Motion to Dismiss as well as their Reply, Plaintiffs' Opposition correctly asserts that, through their silence, Cardinal Defendants' concede that Plaintiffs adequately pled both
reliance
and
economic loss (damages).
To plead reliance, a plaintiff need only allege that, "but for the fraud, the plaintiff would not have engaged in the transaction at issue.”
In re Daou Sys., Inc., Sec. Litig.,
. Complaint 55-237 describe, in detail, Cardinal Defendants' allegedly false statements or omissions of material fact.
. In Century Bus., the court stated:
Plaintiffs note that, while the Sixth Circuit has not addressed the applicability of the Doctrine after the passage of the PSLRA, a plethora of district court decisions from within [the Sixth Circuit] supports the plaintiffs’ position. See, e.g. SmarTalk,124 F.Supp.2d at 545 ; Benedict v. Cooperstock,23 F.Supp.2d 754 , 762 (E.D.Mich.1998) (accepting group-published information doctrine). Moreover, the vast majority of cases decided nationwide also have recognized the [D]octrine. See, e.g., In re Baan Co. Sec. Litig.,103 F.Supp.2d 1 , 17 (D.D.C.2000); In re Oxford Health Plans,187 F.R.D. at 142 ; In re Sunbeam Sec. Litig.,89 F.Supp.2d 1326 , 1340-41 (S.D.Fla.1999); In re Livent, Inc.,78 F.Supp.2d 194 , 219(S.D.N.Y.1999); In re BankAmerica Corp., 78 F.Supp.2d 976 , 987 (E.D.Mo.1999); Robertson v. Strassner,32 F.Supp.2d 443 , 446 (S.D.Tex.1998); In re Digi Int’l, Inc. Sec. Litig.,6 F.Supp.2d 1089 (D.Minn.1998); Zuc kerman v. Foxmeyer Health Corp., 4 F.Supp.2d 618, 627 n. 4 (N.D.Tex.1998); In re Stratosphere Corp. Sec. Litig.,1 F.Supp.2d 1096 , 1108 (D.Nev.1998); In re Health Mgmt., Inc. Sec. Litig.,970 F.Supp. 192 , 208 (E.D.N.Y.1997).
See
.
See also In re Federal-Mogul Corp. Sec. Litig., 166
F.Supp.2d 559, 562-63 (E.D.Mich.2001) (following
Royal Appliances
in holding that “vague, optimistic statements” are not material);
Picard Chem., Inc. v. Perrigo Co.,
.
Basic Inc. v. Levinson
involved a company’s denials of preliminaiy merger negotiations, which were, in fact, on-going. A panel of the Sixth Circuit reversed summary judgment for the defendant company, holding that “once a statement is made denying the existence of any discussions, even discussions that might not have been made material in the absence of the denial are material because they make the statement untrue.”
See Levinson v. Basic Inc.,
. Following the devastating corporate scandals occurring in the past decade, most courts now consider statements of corporate optimism with more hesitation.
See Brumbaugh, et al. v. Wave Sys. Corp., et al.,
. In their Reply Motion, Cardinal Defendants write,
Plaintiffs' Opposition cites, but does not quote, Walter’s statement in a January 2003 conference call that:
The fact is our models are changing a bit, frankly for the better and we want you to understand it ... Cardinal continued to enter into inventory management agreements with manufacturers, whereby we are compensated on an incentive basis to help manufacturers better match their shipments with market demand....
The first sentence about "ongoing changes in the business market” in fact does not relate to Cardinal’s distribution model at all. Instead, as the full text of the transcript makes clear, Walter was discussing Cardinal's general business plans across all four business segments:
The fact is our models are changing a bit, frankly for the better and we want you to understand it. First, I want to restate our business model because it’s working. First, a total focus on health care. The very big and rapidly growing market with plenty of opportunities so we don't feel a need to wander around.
Second, delivers superior execution that drives scale and strong market positions and superior productivity. Third innovate to differentiate ...
The second sentence Plaintiffs highlight, meanwhile, was part of a larger conversation in which Cardinal explained that IMAs included many concepts, none of which (yet) were identified as fee for service.... The conversation explained that Cardinal was reducing its inventories over time. It did not point to fee-for-service as a goal or even a possibility, though — much less represent how many manufacturers entered fee-for-service contracts ... Given this context, Plaintiffs’ assertion that Cardinal in January 2003 was misrepresenting anything at all about fee-for-service makes little sense, and Plaintiffs cannot ignore the full text to pretend that it is so.
See Def.’s Reply at 63.
. Plaintiffs cite to the inaugural edition of The Cardinal Health Investor, which was distributed to investors, potential investors, and analysts. See Complaint ¶ 155. Cardinal wrote, ”[w]ith The Cardinal Health Investor we are looking to create a tool that will be of interest and use to you as you consider your investment decisions. As always, we invite your comments and look forward to your input as this publication evolves over time.” See id.
. Additionally, courts have determined that, “[pleople in charge of an enterprise are not required to take a gloomy, fearful or defeatist view of the future; subject to what current data indicates, they can be expected to be confident about their stewardship and the prospects of the business that they manage.”
Albert Fadem,
. At oral argument, Plaintiffs’ Counsel, Tor Gronborg, laid out the distinguishing factors between the issues in Cardinal and those in DE & J, Ltd. He stated,
[H]ere is what the plaintiffs [in DE & J, Ltd.] failed to do. First, they never alleged that the fraud became known to the market at any time ... They said, "we bought stock at an inflated price.” They did not estimate what the damages of the alleged fraud were, and they didn’t connect the alleged fraud to any disclosure or loss. Again, the focus was on whether the fraud itself got disclosed at any time ... Now let's compare that to what is pled here, the fact is this complaint was written after Dura. We had Dura’s insight, and again it’s short, and clear, so it was not hard to comply with ... We plead that the fraud was revealed ... [w]e do identify damages ... Finally, in the chart we provide in the complaint, we say why each of these drops was linked to the fraud ... we certainly say here is how each of these drops was connected to the fraud.
See Oral Arg. Tr. at 105-06.
. At oral argument, Plaintiffs submitted a number of recent cases to further support their argument that they have successfully pled loss causation under
Dura. See Brumbaugh,
Defendants recently submitted a response to these supplemental authorities first cited by the Plaintiffs at oral argument. In this response, they argue that the Plaintiffs' use of the Iridium opinion, offers "only ipse dixit assertions of a tie-in between the contents of [Cardinal’s releases] and the multiple discrete accounting shortcomings they charge were later revealed.” See Def.'s Response to Supp. Authorities at 2. Nonetheless, though Iridium is distinguishable from this case in that it discussed Dura on plaintiffs' motion for class certification, not on a motion to dismiss, its analysis of Dura's requirements is insightful.
. See supra Part IV.II.A.2-4.
. Courts have rationalized this higher standard for independent auditors noting that,
[T]he lack of a rational of economic incentive for an independent accountant to participate in fraud, the client’s central role in providing information to the accountant, and the complex professional judgment required to perform an audit, make it exceedingly difficult for a securities plaintiff to plead facts suggesting that an independent accountant acted with the deliberate state of mind now required to withstand a motion to dismiss.
See SCB Computer Tech.,
. If an accountant finds an illegal act has taken place, and that it is "of consequence,” he must "as soon as 'practicable' inform the appropriate management personnel of the issuer and 'assure' its audit committee or, if there is no audit committee, its board of directors of its conclusions.” See 15 U.S.C. § 78j-l(b)(l)(B). That committee or board must notify the SEC within one day and send a copy of the notice to the accountant. See 15 U.S.C. § 78j — 1(b)(3).
. In their Complaint, Plaintiffs also allege that E & Y’s failure to identify material weaknesses in internal controls provides an inference of E & Y’s scienter. Complaint ¶ 389-98. Under auditing standards "the auditor should obtain an understanding of internal controls sufficient to plan the audit by per
. First the court reasoned that the timing of the red flags pointed against scienter; at least
. At oral argument, when asked to reveal what Defendant E & Y actually knew of Cardinal's fraud, Counsel for Plaintiffs, David Ro-sen, repeatedly evaded the question.
. For instance, Cardinal notes that, in 2003, a large portion of E & Y’s fees were derived from providing Cardinal with due diligence services related to its acquisitions. In FY 2003, E & Y provided Cardinal with $3.2 million — or 36% of its total fees — in "audit-related services.” Audit-related services are fees for "due diligence services related to mergers and acquisitions, audit-related research and assistance and employee benefit plan audits.” See Complaint ¶ 385.
.In their Complaint, Plaintiffs also sought to hold E & Y liable for all of the interim, unaudited financial statements issued by Cardinal on a quarterly basis after E & Y was retained by Cardinal in May 2002. Plaintiffs try to forge a link between E & Y and Cardinal's interim financial statements by alleging that "E & Y signed off on and approved Cardinal's quarterly financial results prior to their issuance to the public during the Class Period.” Complaint ¶ 376; PL's Opposition at 15. In support of that allegation, however, Plaintiffs fail to cite any public statements by E & Y offering an opinion with respect to the material accuracy of Cardinal’s quarterly financial statements. Instead, they cite a description of E & Y's work that appears in Cardinal's proxy statements, stating simply
Defendant E & Y counters, and the Court agrees that, according to
Fidel,
investors cannot state a claim against outside auditors based on
unaudited
financial statements, and, as such, are limited to claims based on audit opinions actually communicated to the market.
. Though, in their pleadings, Plaintiffs and Defendants dispute whether the Court may consider the magnitude of alleged accounting errors in its analysis,
Fidel
clearly establishes the Sixth Circuit's decision declining "to follow the cases that hold that the magnitude of financial fraud contributes to an inference of scienter on the part of the defendant.”
See
. Plaintiffs cite Financial Accounting Standards Board ("FASB”) Statement of Concepts No. 1, providing that one of the fundamental objectives of financial reporting is that it provides accurate and reliable information concerning an entity's financial performance during the period presented. Further, Plaintiffs cite GAAP Accounting Principles Board ("APB”) Opinion No. 22, Disclosure of Accounting Policies, to assert that the usefulness of financial statements in making economic decisions depends significantly on accounting policies followed by a company and that information about the accounting policies adopted by a reporting company is "essential” to financial statement users. See Complaint ¶¶ 353-66
. E & Y Defendants cite Cardinal's press release following The Wall Street Journal article lambasting the Company’s accounting procedures. The release reads, in part,
Cardinal Health takes pride in properly accounting for all transactions. The vitamin overcharge recovery was no different. The transaction was fully approved by Arthur Andersen, LLP, who were our auditors at the time, and was subsequently approved by our current auditors, [E & Y] ... The recording of this item was not a contingent litigation gain. It was the recognition of an asset related to expected recoveries for vendor overcharges in prior periods. Our assessment of the certainty of a minimum recovery, accepted by our independent auditor and supported by independent legal opinions, was sound and fundamentally conservative.
See Complaint ¶ 151.
. E & Y Defendants also contend that The Wall Street Journal article announced Cardinal’s treatment of the $22 million settlement proceeds to the public long before the Plaintiffs filed their Complaint. They argue that the public’s awareness of Cardinal's accounting clearly negated the possibility of fraud.
. In FY 2002, this practice of immediately recognizing cash discounts decreased Cardinal’s net earnings by $3.3 million. In FY 2003, however, the same practice benefited net earnings by $8.8 million.
. Plaintiffs' Complaint defines a "special charge” as "a charge for an event that is either unusual in nature or infrequent in occurrence.” "Unusual in nature” and "Infrequency of Occurrence” are defined as follows:
Unusual Nature. The specific characteristics of the entity, such as type and scope of operations, lines of business, and operating policies should be considered in determining ordinary and typical activities of an entity. The environment in which an entity operates is a primary consideration in determining whether an underlying event or transaction is abnormal and significantly different from the ordinary and typical activities of the entity. The environment of an entity includes such factors as the characteristics of the industry or industries in which it operates, the geographical location of its operations, and the nature and extent of governmental regulation. Thus, an event or transaction may be unusual in nature forone entity but not for another because of differences in their respective environments. Unusual nature is not established by the fact that an event or transaction is beyond the control of management.
Infrequency of Occurrence. For purposes of this Opinion, an event or transaction of a type not reasonably expected to recur in the foreseeable future is considered to occur infrequently. Determining the probability of recurrence of a particular even or transaction in the foreseeable future should take into account the environment in which an entity operates. Accordingly, a specific transaction of one entity might mean that criterion and a similar transaction of another entity might not be because of different probabilities of recurrence. The past occurrence of an event or transaction for a particular entity provides evidence to assess the probability of recurrence of that type of event or transaction to the foreseeable future.
See Complaint ¶ 346.
.On September 28, 1998, SEC Chairman, Arthur Levitt stated in his speech: "Problems arise, however, when we see large charges associated with companies restructuring. These charges help companies 'clean up' their balance sheet-giving them a so-called ‘big bath.’ ... And if these charges are conservatively estimated with a little extra cushioning, that so-called conservative estimate is miraculously reborn as income when estimates or future earnings fall short.” See Complaint ¶ 349.
. The May 28, 2003 report, written by an analyst with Citigroup Smith Barney, commented about a possible boost to current and future earnings caused by numerous special ■ charges, remarking, "We believe that this is a valid concern. Restructuring charges are clearly a factor when analyzing the financials of any company that has been as acquisitive as Cardinal has been in recent years ... and we believe that this needs to be monitored closely going forward.” See Complaint V 352.
. Plaintiffs declare, " 'big bath' behavior takes place when a company is having a bad year a the company decides to restructure to clean up its balance sheet. Accordingly, the company will take a large restructuring charge. As a result, companies may include an additional cushion into the special charge. This extra cushion can then be reversed in future periods when a company’s earnings will fall short of estimates in order to meet those estimates.” Pl.’s Opposition at 29.
. The Complaint provides a good discussion of the basics of "secured transactions” that is helpful to discussing this element of the parties' dispute:
Securitization is the process by which financial assets are transformed into negotiable securities. A company will aggregate or pool a group of similar assets such as loans or mortgages ... and place them in a trust. Thereafter, the trust then sells the negotiable securities for which the loans or leases serve as collateral. Only if structured correctly can the assets and liabilities associated with the securitization transaction be removed from a company's balance sheet. A company may enter into a securitization agreement as opposed to entering into a secured financing arrangement only if certain conditions are met. In a secured financing arrangement, a company borrows funds and the loans or leases serve as collateral (it is similar to a mortgage where the mortgage is secured by the house). In order for a transaction to be considered a secn-ritization arrangement, it must reflect a “True sale" as opposed to a financing arrangement. A securitization transaction may only be considered for off-balance sheet treatment if the company has swrendered control, effectively, as well as legally, over the assets, and the assets have been isolated from the company and its creditors, even in the even of bankmptcy. If any of the above are not met, then the company must account for transaction as secured bonowing.
SFAS No. 140, Accounting for Transfers and Serving of Financial Assets and Extinguishment of Liabilities. See Complaint ¶¶ 354-55.
. When a receivable is sold "with recourse,” it means that the selling party agrees to make good any receivables not collectible and the risk of non-collection remains with the seller, as if the receivables had remained on its books. See SFAS No. 140 113; Complaint ¶ 355.
. Enron used off-balance sheet deals to obscure the amount of debt the company owed.
. SFAS No. 123 permits accounting for transfers of financial assets as sales to the extent that consideration other than beneficial interests is received in exchange, when the transferor has surrendered control over the assets, if the following three conditions are met:
(1) The transferred assets have been isolated from the transferor, i.e., they are beyond the reach of the transferor and its creditors.
(2) One of the following is met:
(a) The transferee obtains the unconditional right to pledge or exchange the transferred assets.
(b) The transferee is a qualifying special-purpose entity and the holders of beneficial interests in that entity have the unconditional right to pledge or exchange those interests.
(3)The transferor does not maintain effective control over the transferred assets either through an Offering that obligates the transferor to repurchase or redeem the assets before their maturity or through an Offering that entitles the transferor to repurchase or redeem transferred assets that are not readily obtainable.
See SFAS No. 125.
. With respect to Cardinal’s financial statements for FY 2002, E & Y represented, in a report dated August 6, 2002, and included in the Company's FY 2002 Form 10-K, that:
We conducted our audit in accordance with [GAAS], Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the fiscal 2002 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Cardinal Health, Inc. and [its] subsidiaries as of June 30, 2002, and the consolidated results of their operations and their cash flows for the year then ended in conformity with [GAAP], Also, in our opinion, the related fiscal 2002 financial statements schedule, when considered in relation to the basic consolidated financial statements taken as a whole presents fairly, in all material respects, the information set forth therein.
See Complaint ¶ 374. With respect to Cardinal's financial statements for FY 2003, E & Y issued another, almost identical, audit report dated July 30, 2003, and included in the Company’s FY 2003 Form 10-K. The audit report reads:
We conducted our audit in accordance with [GAAS]. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the fiscal 2003 and 2002 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of June 30, 2003 and 2002, and the consolidated results of their operations and their cash flows for the years then ended in conformity with [GAAP], Also, in our opinion, the related fiscal 2003 and 2002 financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
See Complaint ¶ 375.
. The relationship between GAAP and GAAS so far as an auditor is concerned is as follows:
[SEC] regulations stipulate that ... financial reports must be audited by an independent certified public accountant in accordance with generally accepted auditing standards [GAAS], By examining the corporation's books and records, the independent auditor determines whether the financial reports of the corporation have been prepared in accordance with [GAAP]. The auditor than issues an opinion as to whether the financial statements, taken as a whole, fairly present the financial position and operations of the corporation for the relevant period.
See MicroStrategy,115 F.Supp.2d at 650 n. 60 (citing Arthur Young,465 U.S. at 810 ,104 S.Ct. 1495 ). Because E & Y's alleged GAAS violations include its alleged participation in and approval of Cardinal’s recognition practices in violation of GAAP, references to E & Y's GAAS violations also include any and all alleged violations of GAAP. See id.
. Plaintiffs allege that E & Y violated the following GAAS standards: (1) audits should be performed by persons having adequate technical training and proficiency as auditors; (2) auditors should maintain an independence in mental attitude in all matters relating to the engagement; (3) due professional care is to be exercised in the performance of the audit and preparation of the report; (4) an audit must be adequately planned and that assistants should be properly supervised; (5) auditors should obtain a sufficient understanding of a company's internal controls so as to plan the audit and determine the nature, timing and extent of tests to be performed; (6) sufficient, competent, evidential matter must be obtained to afford a reasonable basis for an auditor's opinion on the financial statements subject to audit; (7) an audit report must state whether the financial statements are presented in accordance with GAAP; (8) an audit report shall identify circumstances in which GAAP has not been consistently observed; (9) informative disclosures are regarded as reasonably adequate unless otherwise stated in the report; and (10) an audit report shall contain an expression of auditors' opinions or the reason why such opinions cannot be expressed. Complaint ¶¶ 399-400.
. Plaintiffs state that on April 16, 2004, in connection with E & Y’s audit of PeopleSoft, Inc., Chief Administrative Law Judge ("ALJ”), Brenda P. Murray found the following, among other things: "[E & Y] had no procedures in place that could reasonably be expected to deter violations and assure compliance with” GAAS standards; E & Y relied on
. "The class members allege in their amended complaint that [E & Y] paid $335 million to settle a securities fraud action arising out of its audits of Cendant Corporation and $34 million to compensate investors of Informix."
Fidel,