MEMORANDUM OF DECISION AND ORDER ON DEFENDANT’S MOTION TO DISMISS
This is a class action for securities law and state common law violations brought by certain shareholders of Ferrofluidics, Inc., against Ferrofluidics’ auditor, Coopers & Lybrand, arising out of alleged accounting improprieties in Ferrofluidics’ financial statements for fiscal year 1992 (“FY 92”). Defendant moves to dismiss the complaint, mainly on the grounds that it inadequately pleads the element of scienter essential to a claim under section 10(b) of the Securities Exchange Act of 1934,15 U.S.C. § 78j(b) (“section 10(b)”). After reviewing the nationwide case law involving securities suits against auditors, this court concludes that the primary section 10(b) claim is adequately pled. The court agrees with defendant, however,
BACKGROUND
In ruling on a motion to dismiss for failure to state a claim, the court of course takes all well-pled allegations as true, drawing all reasonable inferences in the plaintiffs favor.
See, e.g., Feinstein v. RTC,
Ferrofluidies is a Massachusetts corporation which applies magnetic fluid technology to a variety of processes, including the manufacture of stereo speakers and hard disk drives. Ferrofluidies did not have a formal written revenue recognition policy and recognized revenue upon “delivery” of its systems to its customers. It improperly recognized revenue from two sales on or about June 27, 1992. The first sale involved four crystal growing systems valued at $4.33 million, designed for Poseo Huís Co., Ltd., and for a firm hired by Poseo Huís to provide additional technology, MEMC Electronic Material, Inc. One unit was delivered to MEMC’s site in May, 1992. After installation of the first unit, Poseo Huls/MEMC requested a laundry list of engineering changes involving all units. The second sale involved crystal growing equipment valued at $570,000, designed for Toshiba, Inc.
Concerned about the propriety of recognizing revenue from these transactions, the auditor urged Ferrofluidies to obtain statements from the customers that the systems were “accepted,” but being held at the Ferro-fluidies facility at their request. MEMC obliged with the following statement, in a letter dated August 21, four days after the date of the contested audit opinion.
[The systems] were complete at Ferro-fluidies location for purposes of invoicing.... This in no way, however, affects the payment terms for said systems as detailed in the purchase contract.... Due to [the] complex nature of the systems and need to minimize the need to rework them for subsequent design changes once they are installed at our facility, it was in the best interest of all parties to keep the systems at Ferrofluidies’ plant until all technical discussions and training are completed.
Compl. ¶ 39. The Performance Cancellation Clause in the Poseo Huls/MEMC purchase order provides: “By 3/3/92 or 30 days after delivery of the first unit, if a unit does not operate per specification [at MEMC], Ferro-fluidies will refund 100% of the payment.... to date.” The first unit had been delivered by May, 1992.
For its part, Toshiba refused to provide any statement remotely suggesting that its purchase had been “accepted.”' Furthermore, at the end of FY 92 or the beginning of FY 93, Toshiba inspected its ordered equipment at the Ferrofluidies facility and requested design changes. Ferrofluidies’ Chief Financial Officer discussed these requested changes with the auditor.
Plaintiffs allege that the company violated accepted accounting practices in two respects. First, Ferrofluidies violated Accounting Practice Board (“APB”) Opinion 22, in neglecting to disclose in the notes to its financial statements its policy for determining earned revenue. (Compl. ¶ 43).
Second, the company failed to satisfy the criteria for revenue recognition under any of the three methods conceivably acceptable under the circumstances: the method of Financial Accounting Standard Board Statement No. 48, used when the contract establishes a right of return; the “bill and hold” method; and the “completed-contract” method of APB Opinion 10. Compl. ¶¶ 25-28). None of these methods could be satisfied, because the sales were “either subject to financial, performance, acceptance or other contingencies that were not satisfied, and/or the equipment was not substantially complete at the time Ferrofluidies recorded the sale.” (Compl. ¶ 29).
Nonetheless, Coopers
&
Lybrand wrote an unqualified audit opinion, dated August 17, 1992, and filed with the SEC on September 28, 1992, certifying that, after conducting an audit in compliance with Generally Accepted Accounting Standards (“GAAS”), it had a reasonable basis for the opinion that Ferro-fluidies’ financial statements for FY 92 com
During the following year, an SEC investigation focusing on the Poseo Huls/MEMC and Toshiba sales led, in turn, to the publication of revised financial statements for FY 92, a severe market correction, and the departure of Ferrofluidics’ two top executives. In its audit opinion for FY 93, Coopers withdrew its opinion for FY 92, stating that in light of the executives’ departures, “we believe we can no longer rely on their representations nor can we be certain that we have been provided with all appropriate documentation relevant to the transactions which they initiated or for which they were responsible.”
DISCUSSION
A. Violations of Section 10(b)
To state a claim for a direct violation of section 10(b), a plaintiff must allege (1) a misrepresentation or omission of a material fact in connection with the purchase or sale of a security; (2) scienter; (3) reliance/causation; and (4) damages.
See, e.g., Basic v. Levinson,
1. Scienter
Defendant maintains that plaintiffs-have failed to meet the stringent pleading requirement of Fed.R.Civ.P. 9(b). The implications of Rule 9(b) for the pleading of scien-ter has been stated by the First Circuit as follows: “[GJeneral averments of the defendants’ knowledge of material falsity will not suffice_ Consistent with Fed.R.Civ.P. 9(b), the complaint must set forth ‘specific facts that make it reasonable to believe that defendant
knew
that a statement was materially false or misleading.’ ”
Serabian v. Amoskeag Bank Shares, Inc.,
a. Case Law
Nearly twenty years ago, the Supreme Court left open the question whether the scienter requirement of section 10(b) can be satisfied by a showing of recklessness.
See Ernst & Ernst v. Hochfelder,
A useful recitation of the recklessness standard in the present context is the following:
“ ‘Recklessness’ in a securities fraud action against an accountant is defined as ‘highly unreasonable [conduct], involving not merely simple, or even excusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.’ That standard requires more than a misapplication of accounting principles. The [plaintiff] must prove that the accounting practices were so deficient that the audit amounted to no audit at all, or ‘an egregious refusal to see the obvious, or to investigate the doubtful,’ or that the accounting judgments which were made were such that no reasonable accountant would have made the same decision if confronted with the same facts.”
SEC v. Price Waterhouse,
The notion that “an egregious refusal to see the obvious, or to investigate the doubtful” gives rise to inference of recklessness is a recurrent refrain in the case law.
See, e.g., In re Software Toolworks, Inc.,
One generality that emerges from a study of the treatment of similar motions to dismiss is that a well-pled section 10(b) claim against an auditor will specify the improper transactions, the standards violated, and the manner of violation. Compare Adam v. Silicon Valley Bancshares, Fed.Sec.L.Rep. (OCR) 11 98,525, at 91,561,
b. Red Flags
Plaintiffs point to the following five "red flags" that they say should have sig-nalled to the auditor-at the time of the FY 92 audit-that the Posco Huls/MEMC and Toshiba deals were out of the ordinary. (1) Revenue from the two deals was recognized three days before the end of the fiscal year, and the revenue was substantial-spelling the difference between a six cent per share loss and an 83 cent per share gain, for that year. (2) The equipment from these transactions remained visibly present on Ferrofluid-ics' manufacturing floor during the audit. (3) Recognition of the revenue from these deals before delivery violated Ferrofluidics' own (undeclared) revenue recognition policy. (4) The letter of "acceptance" obtained from MEMO was at best equivocal-with its reaffirmation of the contract terms (including the "performance cancellation payment" clause), and its implication that the ordered systems were not yet complete. (5) Toshiba refused altogether to provide a letter confirming "acceptance" of the goods ordered.
Plaintiffs accurately observe that a complaint will usually survive a motion to dismiss if plaintiffs have alleged the existence of "red flags" sufficiently attention-grabbing to have alerted a reasonable auditor to the audited
Defendant attempts to put a different spin on the facts by pointing out that the auditor reviewed the two questionable transactions and discussed them with Ferrofluidics’ executives, and the complaint is devoid of allegations that Coopers was given any specific information that would lead it to believe that revenue was improperly recognized. Defendant also gives a more benign interpretation to the MEMO letter of August 21, and argues that, given the conditions of the “performance cancellation clause,” the auditor would have had no reason to believe that the clause might be triggered. To be sure, a negative inference could be drawn from the fact that the complaint does not make certain allegations that would make the inference of scien-ter much easier; and both the MEMO letter and the “performance cancellation clause” are subject to interpretation. But defendant forgets that, at this stage in the proceedings, the court is obligated to construe the facts in the light most favorable to the plaintiffs. See, e.g., Feinstein, supra. Which party’s view of the facts would be vindicated by a complete examination of the record remains an open question.
Defendant does make three legitimate points that go directly to what this courts sees as the crux of the matter — the contextual determination of “recklessness.” First, defendant points out that the two questionable transactions
were
eventually completed. As another court put it, “[T]he fact that income was fully realized from the transactions for which plaintiffs claim revenue was recognized early negates an inference of scienter. The deals were ‘real deals’ — the transaction closed and [the company] was paid.”
Provenz v. Miller,
Second, defendant argues that its after-the-fact retraction of its unqualified audit opinion tends to indicate that it had no guilty knowledge at the time the opinion was issued.
See Griffin v. McNiff,
Defendant's final argument is that scienter has not been adequately pled because plaintiffs can point to no conceivable motive for its alleged approval of Ferrofluidics' slipshod accounting. As its chief supports, defendant cites one case from the Seventh Circuit and one from the Fifth Circuit. The Seventh Circuit stated in sweeping terms: "`The plaintiff must [offer] some reason to conclude that the defendant has thrown in his lot with the primary violators.'" DiLeo v. Ernst & Young,
The Fifth Circuit applied DiLeo `s motive analysis in the course of granting an auditor's motion to dismiss a section 10(b) claim. Melder v. Morris,
The First Circuit has not adopted a rule either outright requiring a showing of motive in order to plead scienter, or raising the pleading standard in the absence of a showing of motive. See Serabian v. Amoskeag Bank Shares, Inc.,
Plaintiffs' allegations amply specify the flawed deals, the accounting norms violated, and the maimer of violation. Of equal importance, plaintiffs have identified a number of "red flags" which-taken together, on the facts of this case-satisfy this court that a reasonable auditor would have become aware that the disputed transactions demanded special inquiry. The court concludes that plaintiffs have pled the scienter element of their section 10(b) claim with sufficient specificity to satisfy the strictures of Fed.R.Civ.P. 9(b).
2. Causation
The other element of a section 10(b) violation over which the parties skirmish is causation. Defendant dwells on the fact the value of Ferrofluidics' stock did not decline immediately upon the heels of the corrective disclosures concerning FY 92 on November 24, 1993. Plaintiff responds that the precipitous market drop in reaction to the September 3 and 7 announcements relating to Fer-
B. Secondary Violations of Section 10(b)
In Para. 77 of the complaint, plaintiffs allege that "Coopers also conspired with Fer-rofluidics to defraud plaintiffs and the Class through the issuance of materially false and misleading financial statements." To the extent that this constitutes a distinct claim for conspiracy to violate the securities laws, defendant is correct that this claim is barred by Central Bank of Denver, N.A. v. First Interstate Bank, N.A., - U.S. -,
Central Bank held that there is no cause of action for aiding and abetting a securities violation. Id. at -,
Plaintiffs make scant effort to salvage their apparent claim for conspiracy. Their principal point in rebuttal is that Central Bank does not preclude securities claims against secondary parties (such as accountants), so long as those parties have committed primary violations. See, e.g., In re Software Toolworks,
C. State Law Claims
In addition to securities violations (Count I), the complaint alleges claims for common law fraud and deceit (Count II), and for negligent misrepresentation (Count III). Defendant correctly points out that the state law claims are inadequately pled.
A claim for fraud and deceit in Massachusetts should ordinarily be dismissed unless it pleads actual reliance by the named plaintiffs, because the "fraud on the market" presumption of reliance, though adopted in federal law by Basic, Inc. v. Levinson,
ORDER
For the foregoing reasons, Defendant’s Motion to Dismiss (Docket #9) is ALLOWED with respect to Counts II and III, and so much of Count I as asserts liability based on a conspiracy theory.