recognized revenues on sales of one of its products earlier than GAAP permitted. Id. at 1304. These "stellar sales figures" in turn fueled a stock price increase. Id. at 1302. After the company's CEO sold 20% of her stock and the plaintiff purchased his shares at these inflated prices, a financial journal publicly questioned the company's accounting procedures, prompting a quick decline in stock value. Id. at 1303, 1313.
The court held that the company's overstated revenues tainted by GAAP violations amounted to a false or misleading statement of material fact necessary to establish a Rule 10b-5 violation. Id. at 1305. The complaint alleged that GAAP required the company to wait until it could "reasonably estimate future returns" on sales of this particular product before recognizing revenues. Id. The plaintiff set forth a number of reasons explaining why the company could not, in fact, reasonably estimate future returns. Id. Since these allegations fit the GAAP criteria, the company's financial statements issued in contravention of those criteria were false and misleading. Id.
Like the Marksman plaintiff, plaintiffs here point to a specific alleged GAAP, whose violation inflated earnings, and set forth allegations that meet GAAP criteria.
FASB CON No. 6
permits amortizing pre-opening costs only when their expenditure is reasonably expected to produce a "probable future economic benefit." Given DZ's short operating history, plaintiffs contend that defendants could not possibly predict whether spending this money would probably benefit DZ in the future. For all defendants knew, the FunCenters could have (and arguably did) turn out to be a financial flop. Moreover, the alleged GAAP itself explicitly characterizes the gains from pre-opening expenditures as "especially uncertain." FASB CON No. 6 app. B. Accepting plaintiffs' allegations as true on this point, the Court finds that they fit the criteria of the relevant GAAP. As such, plaintiffs have sufficiently pled that the 1993 10-K and 10-Qs for the first two quarters of 1994, which presented earnings calculated in violation of those criteria, were misleading.
The defendants misled not only by way of financial statements hiding losses through accounting manipulations, but also through inaccurate public statements about the health of the company. Both Flynn and Mitchum openly stated in interviews, press releases and public documents that DZ was profitable in 1993 and the first two quarters of 1994, and attributed the company's success to expansion. But the plaintiffs allege that DZ was not actually profitable during this period, and the reason it appeared to be was not growth, but rather improper accounting. Consequently, Mitchum's interview with Reuters, Flynn's April letter to DZ shareholders, and the reports on 1994 first quarter earnings are all sufficiently pled as misleading.
Plaintiffs also identify misleading statements made after DZ announced its decision to expense pre-opening costs. While the press release reporting third quarter earnings issued on November 9, 1994 included a provision for the change in accounting procedure, it failed to disclose the dramatic adverse effect on future income. Nor did the company explain that earlier financial statements, prepared under the amortization method, would be rendered useless because they were impossible to compare with statements implementing the new practice. Incomplete disclosures implicate a duty to disclose any additional information needed to rectify the misleading statements. Schlifke, 866 F.2d at 944. Even though the release's acknowledgement that DZ had decided to expense pre-opening costs was literally true, the plaintiffs claim that it continued to mislead investors by concealing the resulting negative impact. See McMahan & Co. v. Wherehouse Entertainment, Inc., 900 F.2d 576, 579 (2d Cir. 1990) ("Some statements, although literally accurate, can become, through their context and manner of presentation, devices which mislead investors."), cert. denied, 501 U.S. 1249, 115 L. Ed. 2d 1052, 111 S. Ct. 2887 (1991). Not until DZ filed its 10-K annual report for 1994 on March 31, 1995 did defendants reveal the accounting change's full impact by restating earnings reported under the original procedure.
B. Plaintiffs Have Pled Scienter
Scienter, or the intent to defraud, is an essential element of every 10b-5 claim. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 47 L. Ed. 2d 668, 96 S. Ct. 1375 (1976). It is sufficiently pled if the complaint "afford[s] a basis for believing that plaintiffs could prove scienter." DiLeo, 901 F.2d at 629. Unlike the factual circumstances constituting the fraud, a defendant's fraudulent intent may be averred generally. Fed. R. Civ. P. 9(b); Reshal, 754 F. Supp. at 1235.
Defendants contend that their timing and selection of accounting methods was a product of business judgment, not fraudulent intent. They cite DiLeo v. Ernst & Young for the proposition that "if all that is involved is a dispute about the timing of the [adjustment], we do not have fraud; we may not even have negligence." 901 F.2d at 627. This is to ignore two critical allegations: (1) that defendants violated GAAP; and (2) that defendants took advantage of the violation by selling their own stock at the resulting inflated prices. Both statements provide a basis for inferring that defendants possessed fraudulent intent.
Scienter can be inferred from an allegation that the defendants sold or intended to sell stock from their personal reserves during the class period. Marksman, 927 F. Supp. at 1312. For example, in Marksman, the court found that the defendant's overstatement of revenues, the consequent rise in stock price, and the CEO's sale of over 20% of her shares at this price raised a "strong inference of scienter." 927 F. Supp. at 1313. In the case before this Court, plaintiffs have similarly alleged that four of the five defendants sold huge amounts of stock (in Mitchum and Casini's case, over 95% of their holdings) when DZ share prices were among their highest, just before DZ disclosed its decision to change accounting methods. The extent of insider selling alleged here easily "afford[s] a basis for believing that plaintiffs could prove scienter." DiLeo, 901 F.2d at 629.
Moreover, DiLeo, the only Seventh Circuit case on which defendants rely to support their business judgment theory, did not involve charges of insider trading. The plaintiffs in that case "offered no information other than the differences between the two statements of the firm's condition," and did not point to any facts suggesting that the difference was attributable to fraud. Id. at 627-28. Here, in contrast, we are faced with clear allegations that the defendants committed fraud by taking advantage of inflated earnings fueled by a GAAP violation, knowing that a downturn was imminent given the earlier decision to change practices.
Finally, the alleged GAAP violations alone support an inference of fraudulent intent. Marksman, 927 F. Supp. at 1313; Chambers, 848 F. Supp. at 619-20. Like the defendants in this case, the Chambers defendants had allegedly used improper accounting methods to "artificially enhance Chambers' profits, its financial picture and financial projections." Id. at 619. Although an intent to defraud was "not the only inference that [could] be drawn from the complaint," it was certainly a permissible one. Id. at 620 (internal quotations and citation omitted). Under these circumstances, the complaint "quite plainly alleged the requisite scienter." Id. at 619.
We find that, based on charges that the defendants committed GAAP violations having the effect of overstating DZ's earnings, and that the defendants profited from this practice by engaging in insider trading, plaintiffs have adequately pled scienter.
C. Plaintiffs Have Satisfied Rule 9(b)
Defendants assert that plaintiffs do not delineate the alleged accounting fraud with particularity, that is, the "who, what, where, when, and how" necessary to plead a 10b-5 violation.
DiLeo, 901 F.2d at 627. Specifically, defendants criticize plaintiffs for not identifying who at DZ knew that amortizing pre-opening costs violated GAAP, how the conclusion was reached, or when it was made.
Once again, defendants pursue the wrong analysis. Rule 9(b) requires articulation of the time, place and contents of the misrepresentation, the identities of the persons responsible for it, and the manner in which it was made. Sears, 912 F.2d at 893; Reshal, 754 F. Supp. at 1230. It does not demand details on how the defendants came to their decision to commit fraud.
Under the correct reading of 9(b), plaintiffs have met their pleading burden for the accounting claims. They identify public records containing the misleading statements: press releases and specific annual and quarterly reports. They describe the misrepresentations by quoting the relevant language from these documents. They put dates on all the alleged misrepresentations. And they identify the communicators: Mitchum, in an interview with Reuters and in signing off on SEC filings; and Flynn, in press releases and a letter to DZ shareholders. Finally, by explaining the GAAP violation and demonstrating its impact on earnings, plaintiffs show how defendants brought about the fraud. See, e.g., Ross v. A.H. Robins Co., 607 F.2d 545, 558 (2d Cir. 1979), cert. denied, 446 U.S. 946, 64 L. Ed. 2d 802, 100 S. Ct. 2175 (1980) (Rule 9(b) met by referring to specific dated documents, such as Form 10-K, press releases, and annual reports, that were claimed to be misleading); Marksman, 927 F. Supp. at 1308 (highlighting the precise dates, manner, content and nature of allegedly misleading statements satisfied 9(b)).
Keeping in mind the purposes behind Rule 9(b) -- to afford defendants fair notice of the claims against them and to prevent conclusory complaints from hiding frivolous suits -- we conclude that plaintiffs have satisfied their burden of pleading fraud with particularity. The court in Reshal Associates v. Long Grove Trading Co. adopted the same practical approach in response to the argument that plaintiffs failed to link specific misrepresentations to specific defendants:
This is not a case, however, where plaintiffs' failure to be more specific implicates Rule 9(b)'s purposes to any substantial extent. Plaintiffs have provided several concrete examples of alleged misrepresentations, contained in documents attached to the complaint, and one reason for the lack of further specificity may be a desire to avoid overwhelming the complaint with impenetrable and complex details that could be more easily shared during discovery. Although plaintiffs refer to an ongoing pattern of misrepresentations over the course of several years, the number of defendants involved is very limited. Plaintiffs' allegations are not inconsistent or confusing. They do not leave the reader without any basis for inferring that the defendants were involved in the alleged wrongs.