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In Cross v. 21st Century Holding Co., No. 00 CIV. 4333 AGS, 2002 WL 31158901, at *6-7 (S.D.N.Y. Sept. 27, 2002), the court held that the presumption of reliance afforded by the fraud-on-the-market theory was not rebutted by the fact that share prices did not decline for several days after the defendant company announced that it was restating earnings.
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00 Civ. 4333 (AGS)
September 26, 2002
OPINION ORDER
I. Introduction
Plaintiffs bring this purported class action pursuant to sections 11 and 15 of the Securities Act of 1933, as amended, 15 U.S.C. § 77k, 77o, and sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, 15 U.S.C. § 78j(b), 78t(a). Plaintiffs filed their action on June 12, 2000. Defendants moved to dismiss the complaint pursuant to FED. R. Civ. P. 12(b)(6) (failure to state a claim upon which relief can be granted). On August 6, 2001, the Court issued a Memorandum Order granting the motion in part and denying it in part, and granting plaintiffs leave to file an amended complaint. See Cross v. 21st Century Holding Co., No. 00 Civ. 4333 (AGS), 2001 U.S. Dist. LEXIS 11189 (S.D.N.Y. Aug. 6, 2001). On September 5, 2001, plaintiffs filed an amended complaint. Defendants again move to dismiss the amended complaint pursuant to FED. R. Civ. P. 12(b)(6). For the reasons set forth below, defendants' motion is denied.
II. Factual Background
The facts in this case are set forth in detail in Cross v. 21st Century Holding Co., No. 00 Civ. 4333 (AGS), 2001 U.S. Dist. LEXIS 11189 (S.D.N.Y. Aug. 6, 2001) (" Cross I"). Familiarity with that decision is assumed and the factual details of this case need not be repeated at length here. The action is purportedly being brought on behalf of purchasers of stock of the 21st Century Holding Company ("21st Century" or "the Company") between November 5, 1998, the date of the Company's initial public offering, and August 13, 1999 (the "class period"). 21st Century is an insurance holding company that engages in insurance underwriting, distribution, and claims processing through various subsidiaries. See First Amended Class Action Complaint ("Amended Complaint"), at ¶ 11. Its primary product is "nonstandard" personal automobile insurance, offered to those who are unable to obtain standard insurance coverage because of their payment history or driving record. See id. at ¶ 11. 21st Century reinsures a portion of its insurance risks, paying for this protection based upon the premiums received. The Company cedes a portion of its exposure to the reinsurer in return for a quota share of the premium. The reinsurer in turn pays 21st Century a ceding commission based on the amount of insurance ceded. See id. at ¶ 12.
Defendant Edward J. Lawson is a co-founder of 21st Century and has at all times since its formation served as its President, Chief Executive Officer, and Chairman of the Board. See id. at ¶ 13. Defendant Michele V. Lawson, incorrectly referred to in the Amended Complaint's caption as Michelle V. Larson, is a co-founder of 21st Century and has at all times since its formation served as its Vice President-Agency Operations and Treasurer. See id. at ¶ 14. Defendant Ronald A. Raymond has at all relevant times served as a director of 21st Century and as president of one of its subsidiaries. See id. at ¶ 15. Defendant Patrick D. Doyle has at all relevant times served as a director and as Secretary of 21st Century. See id. at ¶ 16. Defendants Joseph A. Epstein, Carla L. Leonard, and Bruce Simberg each served as a director of 21st Century during the class period. See id., at ¶¶ 17-19. Mr. Lawson, Ms. Lawson, Mr. Raymond, Mr. Doyle, Mr. Epstein, Ms. Leonard, and Mr. Simberg are collectively referred to as the "Individual Defendants." The Individual Defendants and 21st Century are collectively referred to as the "Section 10(b) Defendants." Defendants Gilford Securities, Inc., Brean Murray Company, First of Michigan Corporation, Hobbes Melville Securities, Inc., Hoefer Arnett, Inc., Ormes Capital Markets, Pennsylvania Merchant Group, Prime Charter Ltd., Redwine Company, Sands Brothers Company, and Van Kasper Company are all corporations that served as underwriters of 21st Century's initial public offering. See id. at ¶¶ 25-35. These defendants are collectively referred to as the "Underwriter Defendants." The Underwriter Defendants, the Individual Defendants, and 21st Century are collectively referred to as the "IPO Defendants."
21st Century filed its Initial Registration Statement on September 17, 1998, and an Amended Registration Statement on November 4, 1998. See Cross I, at *4. The Amended Registration Statement included financial information for, inter alia, the six-month periods ending June 30, 1997 and 1998, and for the years ending December 31, 1996 and 1997. See id. at *4-*5. The Amended Registration Statement also stated that "[c]omission income is earned on a pro rata basis over the life of the policies." Amended Complaint, at ¶ 50. 21st Century's initial public offering took place on November 5, 1998 and provided the Company with $9,000,000 in proceeds after expenses. See Cross I, at *5.
On December 2, 1998, 21st Century issued a press release, which was published in Business Wire, announcing its financial results for the three — and nine-month periods ending September 30, 1998, and comparing those results to the results for the comparable periods in 1997. See id. at *5. On December 22, 1998, 21st Century filed a Notification of Late Filing with the Securities and Exchange Commission ("SEC"). The Notification stated that the Company could not timely file its Form 10-QSB for the quarter ending September 30, 1998 because "a change needed to be made in the manner in which the Company recognized certain ceding commission income." Amended Complaint, at ¶ 69. On December 28, 1998, 21st Century filed its form 10-QSB with the SEC for the quarter ending September 30, 1998. The 10-QSB included financial results for the nine-month period ending September 30, 1998, and also stated that the Company's financial results for 1997 had to be restated "to reflect the effect of recording unearned ceding commissions for ceded premiums. Previously the Company had earned the ceding commissions on a written basis." Amended Complaint, at 70. In the Amended Complaint, plaintiffs allege that the December 28, 1998 Form 10-QSB listed a net income for the nine months ending September 30, 1997 that was six percent higher than the previously-reported net income. See id. at ¶ 63. On that basis, plaintiffs claim that a reasonable investor of ordinary intelligence would have understood that the restatement disclosed in the December 28, 1998 Form 10-QSB had a "positive or benign effect on the Company's financial performance." Id. at ¶ 64. On January 14, 1999, Mr. Lawson appeared in an interview on "Capital Ideas," a program on the CNNfn financial news television station. On the program he allegedly stated that "for the last three years, we've had [a] 100 percent growth rate with the company." Amended Complaint, at ¶ 77. Finally, on March 30, 1999, 21st Century filed its Form 10-KSB with the SEC, and on May 1, 1999, it filed its Form 10-KSB/A. Both filings stated that "[c]omission income is earned on a pro rata basis over the life of the policies" and that ceding commissions are recognized "based on the current loss experience for the policy year premiums." Amended Complaint, at ¶ 78.
On August II, 1999, 21st Century issued a press release, published in PR Newswire, announcing the results for the second quarter and six months ending June 30, 1999. Without disclosing the reasons for the variance, net income and earnings per share for the comparison period ending June 30, 1998 were reported as $963,565 and $0.46 per share, respectively. See Amended Complaint, at ¶ 81. Net income and earnings per share for the period ending June 30, 1998 had been reported in the Company's Form SB-2/A, however, as $1,111,738 and $0.53 per share, respectively. See Amended Complaint, at ¶ 81. On August 13, 1999, the last day of the class period, 21st Century filed its Form 10-QSB with the SEC. In this filing, the Company revealed that its financial statements for the first and second quarters of fiscal year 1998 also required restatement for the same reasons the 1997 financials had been restated earlier; namely, that the Company had recognized ceding commissions on a written basis. See Amended Complaint, at ¶ 81.
Plaintiffs filed this action on June 12, 2000, pursuant to sections 11 and 15 of the Securities Act of 1933 ("Securities Act"), as amended, 15 U.S.C. § 77k, 77o, and sections 10(b) and 20(a) of the Securities Exchange Act of 1934 ("Exchange Act"), as amended, 15 U.S.C. § 78j(b), 78t(a). Plaintiffs, who move for class certification, seek compensatory damages, pre-and post-judgment interest, attorneys fees, expert witness fees, and costs. Defendants moved to dismiss the complaint pursuant to FED. R. Civ. P. 12(b)(6), and on August 6, 2001, the Court issued a Memorandum Order granting the motion in part and denying it in part, and granting plaintiffs leave to file an amended complaint. See Cross v. 21st Century Holding Co., No. 00 Civ. 4333 (AGS), 2001 U.S. Dist. LEXIS 11189 (S.D.N.Y. Aug. 6, 2001). On September 5, 2001, plaintiffs filed an amended complaint.
III. Legal Standard
Defendants move to dismiss the Amended Complaint pursuant to FED. R. Civ. P.12(b)(6). In considering a motion for dismissal for failure to state a claim upon which relief can be granted, a court must assume as true factual allegations in the complaint and construe the complaint in the light most favorable to the plaintiff. See, e.g., York v. Association of Bar of City of New York, 286 F.3d 122, 125 (2d Cir. 2002); Shipping Fin. Servs. Corp. v. Drakos, 140 F.3d 129, 131 (2d Cir. 1998). The question on a motion to dismiss is "not whether a plaintiff will ultimately prevail but whether the claimant is entitled to offer evidence to support the claims." York, 286 F.3d at 125 (quoting Scheuer v. Rhodes, 416 U.S. 232, 236 (1974)). However, to survive a motion to dismiss, the complaint must allege facts which "assumed to be true, confer a judicially cognizable right of action." York, at 286 F.3d at 125.
IV. Legal Analysis
A. Count I is Not Barred by the Statute of Limitations
Defendants argue that Count I of the Amended Complaint, against the IPO Defendants for violations of section 11 of the Securities Act, is time-barred. A cause of action under section 11 is governed by the statute of limitations set forth in section 13 of the Securities Act:
No action shall be maintained to enforce any liability created under section 77k or 771(2) of this title unless brought within one year after the discovery of the untrue statement or the omission, or after such discovery should have been made by the exercise of reasonable diligence, or, if the action is to enforce a liability created under section 771(1) of this title, unless brought within one year after the violation upon which it is based. In no event shall any such action be brought to enforce a liability created under section 77k or 771(2) of this title more than three years after the sale.15 U.S.C. § 77m (emphasis added). In Cross I, the Court held that plaintiffs' section II claim was barred by the statute of limitations. The Court's finding was based on the contents of the December 28, 1998 Form 10-QSB form:
The December 28, 1998 Form 10-QSB expressly restated the 1997 financial results, and explained that the Company had to restate those results because ceding commission income had been recognized on a written basis. By their terms, these express statements contradict the Amended Registration Statement, which presented different 1997 financial results and stated that all commission income was recognized on a pro rata basis. That is sufficient to suggest a probability of fraud or misstatement.Cross I, at * 15-* 16. The Court held that as of December 28, 1998, plaintiffs were put on inquiry notice as to the probability of fraud or misstatement, even if they did not have notice of the full extent of the fraud at that time. See id. at *16-*17. Thus, in order to be timely, a complaint would have had to have been filed by December 28, 1999. The Court thus held that the original complaint, filed on June 12, 2000, was barred by the statute of limitations. See id. at *18.
In the Amended Complaint, plaintiffs have added language alleging that the December 28, 1998 Form 10-QSB restated the Company's income as six percent higher than was previously reported. See Amended Complaint, at ¶ 63. Plaintiffs contend that because this restatement was "positive or benign," the statute of limitations was not triggered. See Plaintiffs' Memorandum of Law in Opposition to Defendants' Motion to Dismiss the First Amended Class Action Complaint ("Opposition Brief"), at 6. According to plaintiffs, a reasonable investor would not inquire into the truthfulness of a registration statement where later filings indicated a higher net income. See id. at 6. Moreover, because of the misleading information on the Form 10-QSB, plaintiffs claim they had no way of knowing that the Company's net income was in fact lower than previously reported. Defendants argue that plaintiffs are on notice of a potential section 11 claim as soon as they know or should know that the Registration Statement contains false or misleading information, whether the misstatement is positive (by overstating the company's net income) or negative (by understating it). See Defendants' Reply Memorandum of Law in Support of their Motion to Dismiss the First Amended Class Action Complaint ("Reply Brief"), at 2-3.
Plaintiffs' claims in Count I are not time-barred for two separate reasons. First, the touchstone of section 11's statute of limitations is reasonableness. Section 13 states that actions under section 11 must be brought within one year after the discovery of the untrue statement or omission, or "after such discovery should have been made by the exercise of reasonable diligence [ . . . ]." 15 U.S.C. § 77m. The Second Circuit has held that "when the circumstances would suggest to an investor of ordinary intelligence the probability that she has been defrauded, a duty of inquiry arises, and knowledge will be imputed to the investor who does not make such an inquiry." Dodds v. Cigna Sec., Inc., 12 F.3d 346, 350 (2d Cir. 1993) (citation omitted). Such circumstances are often analogized to "storm warnings." Id. at 350. In light of the new allegations made in the Amended Complaint, specifically paragraphs 58 through 66, plaintiffs have demonstrated that given the positive or benign overstatement of net income in the December 28, 1998 Form 10-QSB, it would not be reasonable to find that plaintiffs were on inquiry notice from that date. Defendants claim that this argument is unsupported by law. However, defendants provide no legal support for the claim that reasonable investors should be presumed to be on inquiry notice when they receive positive or benign net income adjustments. According to defendants, reasonable investors could have a duty to inquire, if not initiate litigation, when a company issues unexpectedly good results. In effect, defendants posit the existence of a "storm warning" on a sunny, cloudless afternoon. Neither the wording of section 13, nor logic, permits such an incongruous result.
The second independent reason why defendants' statute of limitations defense must be rejected is because the Amended Complaint appears to allege that defendants concealed the underlying misstatements in the Amended Registration Statement by misstating, or failing fully to disclose, the effect of recording unearned ceding commissions for ceded premiums. Such concealment of a prior misrepresentation serves to toll the one-year statute of limitations provision in section 13. See, e.g., Dodds, 12 F.3d at 350 (holding that equitable tolling is available where plaintiff has exercised reasonable care and diligence); P. Stolz Family P'Ship, L.P. v. Daum, 166 F. Supp.2d 871, 874 n. 3 (S.D.N.Y. 2001) (noting that the doctrine of equitable tolling is applicable to section 13 ( 15 U.S.C. § 77m)); Butala v. Agashiwala, No. 95 Civ. 936 (JGK), 1997 WL 79845, at *6 (S.D.N.Y. Feb. 24, 1997) ("Under the doctrine of fraudulent concealment, the statute of limitations will be tolled if the plaintiff pleads, with particularity, either active concealment or passive concealment."). The newly-added language in the Amended Complaint constitutes at least a prima facie statement of passive, if not active, concealment. Whether or not such concealment in fact occurred is a factual question which cannot be determined on a motion pursuant to FED. R. CIV. P. 12(b)(6).
Concealment does not toll the three-year statute of limitations provision in section 13. See, e.g., Gilbert Family Partnership v. Nido Corp., 679 F. Supp. 679 (E.D. Mich. 1988). However, there is no dispute that plaintiffs acted timely under the three-year provision.
B. Count III Adequately Pleads Reliance
Defendants move to dismiss Count III, based on violations of section 10(b) of the Securities Exchange Act of 1934 (as amended) and Rule 10b-5 promulgated thereunder on the grounds that plaintiffs fail to plead reliance. According to defendants, plaintiffs rely solely on a "fraud-on-the-market" theory to plead reliance. Defendants claim that the market fraud theory is inapposite here because the price of 21st Century stock did not increase immediately following each of the alleged misrepresentations (i.e., the December 2, 1998 press release, the December 28, 1998 Form 10-QSB, the January 14, 1999 interview, the March 30-31, 1999 Form 10-KSB, and the May 1, 1999 Form 10-KSB/A). See Defendants' Memorandum of Law in Support of Their Motion to Dismiss the First Amended Class Action Complaint ("Motion Brief"), at 16. Moreover, defendants contend that the price of 21st Century stock did not decline in the days immediately following the filing of the August 13, 1999 Form 10-QSB in which the Company revealed that its financial statements for the first and second quarters of fiscal year 1998 also required restatement for the same reason the 1997 financials had been restated earlier. See id. at 17. For support, defendants rely on Nathenson v. Zonagen Inc., 267 F.3d 400 (5th Cir. 2001). In Nathenson, the Fifth Circuit held that "the presumption of reliance may be rebutted by `[a]ny statement that severs the link between the alleged misrepresentation and . . . the price received (or paid) by the plaintiff.'" Id. at 414 (quoting Basic Inc. v. Levinson, 485 U.S. 224, 108 S.Ct. 978, 992 (1988)). The court went on to hold that "a fraud-on-the-market theory may not be the basis for recovery in respect [sic] to an alleged misrepresentation which does not affect the market price of the security in question." Id. at 414 (emphasis in original).
The Second Circuit does not appear to have adopted the Nathenson court's reasoning, nor has Nathenson ever been cited by either the Second Circuit or a Southern District court. Regardless, however, unlike in Nathenson, plaintiffs here specifically allege that 21st Century's stock price "decreased by more than 22%" as a result of the August 13, 1999 restatement. Thus, Nathenson's reasoning is inapplicable because, according to plaintiffs, the alleged misrepresentation did affect the market price of the security in question. The data furnished by defendants adds credence to this argument. Defendants claim that the price of 21st Century's stock was unchanged for each of the seven days after the August 13, 1999 restatement. See Motion Brief, at 17. However, this argument is misleading because 21st Century shares were only apparently traded during four of those seven days. Indeed, the share price of 21st Century stock on the seventh day of trading was lower than it was on August 13, 1999. Regardless, as plaintiffs note and as defendants' data corroborate, 21st Century's stock price declined from August 13, 1999 through the end of the year.
Defendants argue that in an efficient market, "information important to reasonable investors . . . is immediately incorporated into the stock price." Oran v. Stafford, 226 F.3d 275, 282 (3d Cir. 2000). However, the Supreme Court, in Basic Inc. v. Levinson, 485 U.S. 224, 248 n. 28 (1988), upon which Nathenson was based, held that it did "not intend conclusively to adopt any particular theory of how quickly and completely publicly available information is reflected in market price." Nothing in Nathenson suggests that a fraud-on-the-market theory must fail where a relatively brief period of price stability follows a public disclosure, especially where the few days of price stability is followed by a relatively steady decline in share price.
C. Count III Adequately Alleges Scienter
The pleading requirements for allegations of scienter are set forth in the Private Securities Litigation Reform Act ("Reform Act"), 15 U.S.C. § 78u-4(b)(2):
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 of mind, 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.
Defendants allege that with respect to Count III, plaintiffs have failed to plead facts giving rise to a "strong inference" as to defendants' state of mind. Under the statute, plaintiffs can plead scienter by (1) "alleging facts demonstrating that defendants had both motive and an opportunity to commit fraud"; or (2) "otherwise alleging facts to show strong circumstantial evidence of defendants' conscious misbehavior or recklessness." In re Scholastic Corp. Securities Litigation, 252 F.3d 63, 74 (2d Cir. 2001). Defendants contend that the Amended Complaint is devoid of allegations that defendants had a motive and opportunity to perpetrate fraud. For example, defendants note in italicized bold print that "Plaintiffs have not, and cannot, allege that any of the Section 10(b) Defendants sold a single share of 21st Century stock during the Class Period." Motion Brief, at 19.
In its August 6, 2001 Memorandum Order, the Court determined that the original complaint adequately pleaded scienter in Count III. This determination was based on the fact that, inter alia, "[t]he complaint alleges that the Section 10(b) Defendants had access to information suggesting that their statements were inaccurate. This is sufficient to allege recklessness." Cross I, 2001 U.S. Dist. LEXIS 11189, at *37 (citing In re Scholastic, 252 F.3d at 76-78). The Court's prior analysis was based on the theory of recklessness, rather than motive and opportunity. Thus, defendants' argument that the Section 10(b) Defendants did not sell their shares during the class period is irrelevant. Having reviewed defendants' analysis, the Court sees no reason to depart from its prior conclusion in Cross I that plaintiffs adequately allege scienter.
D. Counts II and IV Should Not be Dismissed
Finally, defendants argue that Counts II and IV, which seek to impose "control person" liability under section 15 of the Securities Act and section 20(a) of the Exchange Act, respectively, should be dismissed. Defendants' sole argument is that in order to assert these claims, plaintiffs must first establish a primary violation of the Securities Act or Exchange Act. Because the Court finds that plaintiffs' claims under section 11 of the Securities Act and under 10(b) of the Exchange Act are sufficient, this argument fails. Therefore, defendants' motion with regard to Counts II and IV is denied.
V. Conclusion
In light of the foregoing, defendants' motion to dismiss the Amended Complaint is DENIED.