MEMORANDUM AND ORDER
Plaintiff Alfred Rehm (Rehm), on behalf of all persons who purchased or acquired the common stock of Eagle Finance Corporation (Eagle) during the period from May 12, 1995 to April 15, 1996 (class period), brought this class action suit alleging that defendant Eagle and its executive officers materially misrepresented Eagle's known credit losses and net income for the fiscal year 1995 in violation of § 10(b) and § 20(a) of the Securities Exchange Act of 1934 (SEA), 15 U.S.C. § 78j(b) and § 78t(a), and Rule 10b-5, 17 C.F.R. § 240.10b-5 (1996). Defendants now move to dismiss the complaint pursuant to Fed. R. Civ. P. 12(b)(6), arguing that plaintiffs have failed to allege facts sufficient to show a strong inference of scienter as required by the Private Securities Litigation and Reform Act of 1995 (PSLRA). 15 U.S.C. § 78u-4(b)(2). For the reasons set forth below, defendants' motion is denied.
In considering a motion to dismiss under Rule 12(b)(6) for failure to state a claim, we accept all well pled factual allegations in the complaint as true and draw all reasonable inferences from these facts in favor of the plaintiff. Travel All Over the World, Inc. v. The Kingdom of Saudi Arabia, 73 F.3d 1423, 1429 (7th Cir. 1996). Read in this light, the facts are as follows.
Eagle is a Delaware corporation headquartered in Gurnee, Illinois which operates as a specialized financial services company engaged primarily in the acquisition and service of automobile and retail installment sales contracts by "sub-prime" consumers. At all relevant times, Charles F. Wonderlic (Wonderlic) was Chairman of the Board and Chief Executive Officer of Eagle. Robert J. Braasch (Braasch) was Eagle's Chief Financial Officer, Senior Vice President, and Treasurer. Ronald B. Clonts (Clonts) was President and a Director of Eagle.
During the class period, Eagle issued four separate press releases which reported quarterly and cumulative financial information for fiscal year 1995. The veracity of the contents of these press releases, along with the SEC filings which accompanied them, is the crux of the issue in this case. Specifically, plaintiff contends that during the class period, Eagle issued statements which materially understated its credit losses, overstated its earnings, and artificially inflated stock prices.
The first press release was issued May 12, 1995. First quarter net income was reported at $ 1.240 million or $ .30 per share. On approximately May 15, 1996, Eagle filed Form 10-Q for the first quarter which reiterated the financial information disclosed in the May 12 report. The May 15 10-Q was signed by defendant Braasch. It stated that Eagle's provision for credit losses during the first quarter was $ 13,000. In May 1995, Eagle's stock traded at approximately $ 14 - $ 15 per share. In June 1995, the stock traded at approximately $ 17 - $ 18 per share.
On August 7, 1995, Eagle issued its second press release. Reported net income for the second quarter and first six months of fiscal year 1995 was stated at $ 1.315 million and $ 2.555 million, respectively, which represented earnings of $ .31 and $ .61 per share, respectively. Eagle reported that as of June 30, Eagle's allowance for credit losses and nonrefundable acquisition discount totaled $ 16.892 million, or 13.3% of net receivables. On approximately August 14, 1995, defendants filed Form 10-Q for the second quarter which reiterated the financial information disclosed in its press release. The second quarter 10-Q was signed by Braasch. It stated that Eagle's provision for credit losses during the second quarter was $ 46,000. In August and September of 1995, Eagle's stock traded in the price range of $ 20 - $ 24 per share.
In August of 1995, at the time when Eagle stock traded near the highest price in its history, defendant Clonts sold 35,000 shares on the open market, for which he received over $ 720,000 in proceeds. These sales by Clonts were the only public sales of Eagle stock he ever made.
On November 6, 1995 Eagle issued its third quarter press release which reported third quarter net income at $ 1.429 million or $ .33 per share. Net income for the nine month period was reported at $ 3.983 million or $ .93 per share. Eagle's total allowance for credit losses was reported at $ 17.029 million, or 12.5% of its net receivables. The press release indicated that as of September 30, 1995, 8.8% of accounts were delinquent. In the press release, defendant Wonderlic stated that although delinquency rates had been unacceptable in the previous two quarters due to an inadequate collection staff, that trend had been reversed and delinquency was declining. (Compl. at 10 - 11.) Wonderlic described Eagle's first half credit loss experience as an "interim 'hiccup.'" (Compl. at 11.) Wonderlic conceded that Eagle could not at that time state with specificity what the appropriate level of credit loss allowance would be required at the year's end to cover the outstanding delinquencies. Id. However, he stated "with some confidence" that Eagle would be profitable in the fourth quarter and would show record earnings growth. Id.
The information in the November 6 press release was restated in Eagle's third quarter Form 10-Q which was filed on approximately November 15, 1995 and signed by Braasch. During the third quarter, Eagle made no provision for credit losses. Eagle's stock traded throughout November in the range of approximately $ 14 3/4 to $ 16 1/8 per share.
Eagle issued its fourth quarter press release on March 13, 1996. A net loss of $ 348,000 or $ .08 per share was reported for the quarter. Full-year results were stated at $ 3.530 million or $ .82 per share. Total loss reserves were increased to $ 22.639 million, representing 14.8% of Eagle's net receivables. Installment contract delinquency was reported at 8.2%.
Eagle's fourth quarter provision for credit losses was reported at $ 2,194,000, a sharp increase over previously reported levels. Total credit losses for fiscal year 1995 were reported at $ 2,253,000. In the March 13 press release, Wonderlic explained the fourth quarter increase in loss reserves as follows:
The fourth quarter charge was based on a stringent, comprehensive review of the credit performance of each loan pool, economic uncertainty and changes in evaluating the reserve adequacy of discounted loan purchases. We have conservatively built our reserves to stay ahead of the loss curve and the standard we applied in the process exacted the cost of eliminating fourth quarter profitability and a record profitability for 1995 as a whole.
(Compl. at 15.) Wonderlic reassured the public that the reserve adjustments were a one-time revision to cover unexpected losses and that the company looked forward to resuming its long-term growth. (Compl. at 15.)
Following the March 13 press release, several market analysts lowered their ratings of Eagle's stock due to its inadequate reserve accounting. On March 18, 1995, Eagle issued another press release in which Braasch stated that "the analysts' viewpoint isn't educated by what we believe are the relevant facts of the matter. . .As to the level of reserves, it is our considered judgment, which is supported by our independent outside auditors, that the level of reserves taken against this portfolio is adequate." (Compl. at 16.)
However, on April 2, 1996, Eagle announced that it had been "unexpectedly" advised by its accountants, KPMG Peat Marwick LLP, that in connection with their year-end audit, the accountants would require the company to make a substantial addition to its allowance for credit losses as of December 31, 1995, resulting in a drastic reduction of previously reported earnings. After the April 2 announcement, Eagle's stock fell to close at $ 7 1/4.
On April 15, 1996, Eagle announced its restated results for fiscal year 1995. Actual earnings were reported at $ 325,000 or $ .08 per share, which represented a 91% decrease from previously reported earnings of $ 3.530 million or $ .82 per share. Eagle also reported an additional $ 7.3 million provision for credit losses, an increase of approximately 300% over the $ 2.3 million previously reported by Eagle. On April 15, 1996, the market price of Eagle stock closed on the NASDAQ at $ 7 5/16.
On April 25, 1996, plaintiff Rehm filed the instant class action complaint alleging that defendants, both as direct participants under § 10(b) and as controlling persons under § 20(a) of the SEA, committed securities fraud by failing to report the proper amount of its credit losses in accordance with generally accepted accounting principles, thereby overstating its 1995 reported income.
I. Rule 12(b)(6) Standard
In order to have a claim dismissed under Rule 12(b)(6) the moving party must show that plaintiff's complaint fails to state a claim upon which relief can be granted." Fed.R.Civ.P. 12(b)(6). The purpose of a motion to dismiss is to test the sufficiency of a complaint, not its merits. Triad Ass'n Inc. v. Chicago Housing Authority, 892 F.2d 583, 586 (7th Cir. 1989), cert. denied, 498 U.S. 845, 112 L. Ed. 2d 97, 111 S. Ct. 129 (1990). A complaint should not be dismissed for failure to state a claim "unless it appears beyond a reasonable doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Conley v. Gibson, 355 U.S. 41, 45-46, 2 L. Ed. 2d 80, 78 S. Ct. 99 (1957). In order to withstand a motion to dismiss a complaint must allege facts sufficiently setting forth the essential elements of the cause of action. Gray v. County of Dane, 854 F.2d 179, 182 (7th Cir. 1988).
II. Standard for Pleading Scienter Under the Private Securities Litigation Reform Act of 1995
Section 10(b) makes it unlawful for any person "to use or employ, in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe." 15 U.S.C. § 78j(b). One such rule is Rule 10b-5 which prohibits the making of any untrue statement of material fact or the omission of a material fact that would render statements made misleading in connection with the purchase or sale of any security. 17 C.F.R. § 240.10b-5. To state a valid Rule 10b-5 claim, "a plaintiff must allege that the defendant: 1) made a misstatement or omission, 2) of material fact, 3) with scienter, 4) in connection with the purchase or sale of securities, 5) upon which the plaintiff relied, and 6) that reliance proximately caused the plaintiff's injury." Stransky v. Cummins Engine Co., 51 F.3d 1329, 1331 (7th Cir. 1995). Allegations of fraud under Rule 10b-5 must satisfy the requirements of Federal Rule of Civil Procedure 9(b) to survive a motion to dismiss. Rule 9(b) requires that "the circumstances constituting fraud ... be stated with particularity." Fed.R.Civ.P. 9(b).
The Seventh Circuit has established that a sufficient level of factual support for a 10b-5 claim may be found where the circumstances of the fraud are pled "in detail." DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th Cir. 1990), cert. denied, 498 U.S. 941, 112 L. Ed. 2d 312, 111 S. Ct. 347 (1990). "This means the who, what, when, where, and how: the first paragraph of any newspaper story." Id.
In this case, defendants contend that plaintiff Rehm has failed to adequately plead the scienter requirement for 10b-5 claims. Scienter is defined as a "mental state embracing intent to deceive, manipulate, or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 n. 12, 47 L. Ed. 2d 668, 96 S. Ct. 1375 (1976). As defendants point out, under the recently enacted Private Securities Litigation and Reform Act of 1995 (PSLRA), which amends the Securities Exchange Act of 1934, the pleading standard for scienter in securities fraud cases has been made more rigorous, beyond mere Rule 9(b) requirements. 15 U.S.C. § 78u-4(b)(2). Pursuant to the PSLRA, in order to sufficiently allege scienter, the complaint must "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)(2). If the complaint fails to do so, dismissal is required. 15 U.S.C. § 78u-4(b)(3)(A).
Although the parties do not contest the fact that the PLRSA applies to the present action, they dispute the stringency of the pleading standard that § 78u-4(b)(2) adopts. Prior to the enactment of § 78u-4(b)(2), plaintiffs were only required to plead scienter in accordance with Rule 9(b)'s more lenient particularity requirement. However, this broad standard created disuniformity among the various circuits as courts of appeals interpreted Rule 9(b) in conflicting ways. See, e.g., Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1128 (2d Cir. 1994); DiLeo, 901 F.2d at 629; In re GlenFed, Inc. Securities Lit., 42 F.3d 1541, (9th Cir. 1994). Of these conflicting standards, the Second Circuit's rule requiring plaintiffs to allege facts "that give rise to a strong inference of fraudulent intent," Shields, 25 F.3d at 1128, was clearly the most rigorous. In an effort to eliminate circuit conflicts and curtail the filing of meritless fraud claims, Congress adopted the "strong inference" pleading standard modeled after the Second Circuit approach. H.R. Conf. Rep. No. 104-369, 104th Cong., 1st Sess. 41 (1995) (Conf. Rep.); see also, In re Silicon Graphics, Inc. Securities Litigation, 1996 U.S. Dist. LEXIS 16989, Fed. Sec. L. Rep. (CCH) P 99,325, at 95,961 (N.D.Cal. Sept. 25, 1996).
However, Congress did not simply codify the Second Circuit case law interpreting its pleading standard. In re Silicon Graphics, 1996 U.S. Dist. LEXIS 16989, Fed. Sec. L. Rep. (CCH) P 99,325, at 95,961. Instead, Congress specifically declined to make the Second Circuit's case law an explicit part of the statute. Id. at 95,962. As a result, defendants argue that the enactment of § 78u-4(b)(2) creates a heightened pleading standard that is even more stringent than that enunciated by the Second Circuit. Defendants point to the Conference Committee Report which emphasized that the PSLRA strengthened existing pleading requirements and therefore did not incorporate the Second Circuit's case law interpreting the scienter pleading standard.
According to defendants, the Conference Report, when viewed alongside the President's veto message,
clearly demonstrates Congress' intent to raise the pleading standard for scienter even beyond the existing Second Circuit level.
As this is an issue of first impression in this circuit, we draw upon the case law of other jurisdictions for guidance. Despite conflicting judicial views on this issue, see STI Classic Fund v. Bollinger Industries, Inc., 1996 U.S. Dist. LEXIS 21082, No. 3:96-CV-0823-R, (N.D.Tex. Nov. 12, 1996); In re Silicon Graphics, 1996 U.S. Dist. LEXIS 16989, Fed. Sec. L. Rep. (CCH) P 99,325, at 95,961; Marksman Partners, L.P. v. Chantal Pharmaceutical Corp., 927 F. Supp. 1297, 1308, 1996 WL 277415, at *11 (C.D.Cal 1996), and ambivalent language in the legislative history, we agree with plaintiff that § 78u-4(b)(2) does not impose a more rigorous pleading requirement than that enunciated by the Second Circuit.
Specifically, we find that § 78u-4(b)(2) adopts the Second Circuit standard but declines to bind courts to the Second Circuit's interpretation of its standard. Three factors militate in favor of this conclusion. First, "the language used by the PSLRA to articulate its scienter pleading standard, i.e. 'strong inference,' mirrors the language traditionally employed by the Second Circuit in its application of Rule 9(b) to scienter pleadings." Marksman, 927 F. Supp. at 1310, 1996 WL 277415, at *11. That Congress chose to incorporate verbatim the language of the Second Circuit Rule 9(b) standard is a strong indication of its intent to enact in § 78u-4(b)(2) a pleading standard of approximately the same specificity. Second, as the plaintiff notes, the legislative history supports a reading of the PSLRA consistent with this view. The Conference Report indicates that the "strong inference" language is based explicitly on the Second Circuit standard. Conf. Rep. at 41. That Congress chose not to codify Second Circuit case law does not mean that it specifically chose to disapprove the Second Circuit test. Marksman, 927 F. Supp. at 1311, 1996 WL 277415, at *12. In its report on the passage of the PSLRA, the Senate Banking, Housing, and Urban Affairs Committee articulated this position:
The Committee does not adopt a new and untested pleading standard that would generate additional litigation. Instead, the Committee chose a uniform standard modelled upon the pleading standard of the Second Circuit. ...The Committee does not intend to codify the Second Circuit's caselaw interpreting this pleading standard, although courts may find this body of law instructive.