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finding allegations of motive to attract a buyer "before the company fell apart entirely," while not sufficient to support an inference of scienter on their own, "still probative to the inquiry"
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CV 98-8842 SVW, AND RELATED CASES.
February 23, 2000
ORDER DENYING DEFENDANTS' MOTION TO DISMISS
I. Introduction
This is a class action on behalf of all persons who purchased securities of Imperial Credit Industries, Inc. ("ICI") from January 27, 1998 through October 1, 1998. The complaint alleges violations of Sections 10(b) and 20(a) of the Exchange Act. Named as defendants are ICI and its officers/directors, H. Wayne Snavely, Kevin Villani, Brad Plantiko, and Steven Shugerman. Defendants move to dismiss the complaint on numerous grounds, including the failure to plead fraud with sufficient particularity. For the reasons stated below, Defendants' motion is hereby DENIED.
II. Background
ICI owned approximately 47% of the stock in Southern Pacific Funding Corporation ("SPF"). It controlled a majority of SPF's board. ICI's chairman, Wayne Snavely, was chairman of SPF's board of directors. Steven Shugerman was a director of both corporations. ICI's stake in SPF was a material portion of its business. On May 15, 1998, ICI reported that its share of SPF's net income for the first quarter amounted to $6 million. This represented 12% of ICI's quarterly income. On July 31, 1998, ICI reported that its share of SPF's net income for the second quarter was $6.8 million. This represented 12.4% of ICI's quarterly income. In addition, ICI's holdings in SPF had (at one time) a market value of $150 million.
SPF originates or purchases mortgage loans which it securitizes. To assess the "gain-on-sale" from these securitizations, SPF makes assumptions based on the rate of prepayment of the loans, credit loss, and delinquencies. The rate of prepayment has a big impact on the gain-on-sale. When interest rates decline, borrowers refinance and pay off their existing mortgages, causing lenders like SPF to lose much of the interest they expected to collect. To accurately estimate the gain-on-sale, SPF thus had to accurately estimate the prepayment rate.
The class period was preceded by a drop in interest rates. This drop led to an increase in prepayment, causing many if not all of SPF's competitor mortgage lenders to suffer huge losses. In this time, SPF sought to distinguish itself from its competitors. SPF continuously represented that it was updating its prepayment assumptions to reflect actual prepayment experience, and that it did not expect excessive prepayment because many of its loans had prepayment penalties. SPF predicted that it would not be required to take any write-downs as had its competitors.
SPF continued to paint a rosy picture of its financial status until September 14, 1998, when it revealed that it was considering a write down in the value of its residual assets because earnings were falling well below published expectations. Two days later, SPF announced that it was increasing its prepayment and loss assumptions, and would have to take a one-time charge of $60-70 million. On October 1, 1998, SPF announced that it was filing bankruptcy.
SPF's financial woes had a tremendous impact on ICI. On October 1, it announced that it would take a loss of $85-95 million for the third quarter. ICI's announcement was quickly followed by a precipitous drop in its stock price.
III. Discussion
During the class period, SPF represented that its prepayment assumptions reflected actual prepayment, and that it did not expect to take any write-downs given its financial stability. During the same period, ICI represented in numerous press releases and SEC filings that it had significant unrealized gain in its SPF investment. In an April 28, 1998 news release, for example, ICI stated that its unrealized gain in SPF totaled $79.7 million.
Plaintiffs contend that Defendants knew at the time that these representations were materially false or misleading. Plaintiffs argue that SPF, ICI, and their directors were aware that SPF was experiencing prepayment and delinquency that far exceeded its published assumptions. Defendants were also aware, Plaintiffs argue, that SPF's financial status was in dire straits because of high delinquency rates, high prepayment rates, and serious cash flow problems that prevented it from originating new loans. Plaintiffs assert that Defendants knew SPF's residuals were overvalued, and knew that ICI's statements about unrealized gain in its SPF investment were inaccurate and misleading.
Plaintiffs argue that Defendants had a specific motive to misrepresent SPF's market value: ICI was shopping SPF for a buyer. Plaintiffs contend that Defendants inflated SPF's financial status to attractive prospective buyers and garner a higher purchase price.
A. Plaintiffs Plead Scienter with Sufficient Particularity
Defendants argue that the complaint fails to plead scienter with the particularity required by the Private Securities Litigation Reform Act of 1995 ("PSLRA"). Congress enacted the PSLRA to address and eliminate abusive securities litigation by "erecting procedural barriers to prevent plaintiffs from asserting baseless securities fraud claims.". See In Re Silicon Graphics Inc. Securities Litig., 183 F. 3d 970, 977 (9th Cir. 1999). Pursuant to the PSLRA, plaintiffs in private securities actions 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).
The Ninth Circuit recently set forth the standard for evaluating pleadings under the PSLRA: a plaintiff in a private securities action "is required to state with particularity all facts giving rise to a `strong inference' of the required state of mind." Silicon Graphics, 183 F. 3d at 983, quoting 15 U.S.C. § 78u-4(b)(1), (2). "In order to plead `with particularity,' [the plaintiff] must provide all the facts forming the basis for her belief in great detail." Id. (emphasis added). Under this standard, "mere boilerplate pleadings will rarely, if ever, raise a strong inference of deliberate recklessness or otherwise satisfy the PSLRA's particularity requirement." Id. at 984.
The Court finds that Plaintiffs have plead scienter with sufficient particularity. Plaintiffs first allege a long list of press releases and SEC filings in which SPF represented that it was not experiencing excessive prepayment, that its prepayment assumptions reflected actual prepayment experience, and that it did not expect to take any write-downs. Plaintiffs also allege numerous representations by ICI, both in press releases and SEC filings, indicating that it had unrealized gain in SPF of approximately $80 million. Plaintiffs then point to numerous e-mails and internal reports that raise a strong inference that Defendants knew these statements were false or misleading at the time they were made.
E-mails between Defendants Snavely, Shugerman, and Villani establish that they knew SPF was experiencing serious financial hardship, including a crippling cash flow problem. A June 10 e-mail from Villani to Snavely demonstrates that Defendants were even considering putting SPF out of business. Plaintiffs allege that Bruce Horowitz, Vice President of Risk Management of ICI, prepared a report that indicated SPF's residual assets were extremely overvalued, and that SPF's prepayment assumptions were well below its actual prepayment experience. Horowitz's report was presented to ICI's board at an August 10, 1998 meeting.
If proven, the Horowitz report and e-mails could establish that Defendants knew SPF's prepayment assumptions did not reflect actual prepayment experience, that its residual assets were overvalued, and that SPF was on the verge of bankruptcy. The Horowitz report and e-mails thus raise a strong inference that Defendants knew SPF's statements about its financial status, and ICI's continued representations about unrealized gain in its SPF investment, were inaccurate and misleading to investors.
During the hearing on this motion, Defendants asserted that Plaintiffs do not accurately describe the e-mails and reports identified in the complaint, and that a more accurate description of the documents would preclude an inference of falsity or scienter. As the Court stated during the hearing on this motion, Defendants' arguments are not appropriate at this stage. They are more properly raised in a motion for summary judgment.
The inference of scienter is additionally supported by Plaintiffs' allegations of motive. Defendants had a strong incentive to inflate SPF's financial status because they were shopping SPF for a buyer and sought to attract a large bid. The facts suggest that is exactly what SPF and Defendants did. For example, just weeks before SPF took a huge one-time loss to its earnings and was forced to file bankruptcy, its CEO stated that he felt SPF wasunder-valued, and that the market was not rewarding SPF for its success. Through e-mail, some of the individual defendants discussed an "interim" solution to SPF's problems. Defendants were perhaps referring to a temporary solution that would allow ICI to sell its investment in SPF before the company fell apart entirely.
These allegations of motive support Plaintiffs' claims that Defendants knowingly misrepresented SPF's value. Although evidence of motive is not sufficient to support an inference of scienter under Silicon Graphics, it is still probative to the inquiry.
B. Representations by and Concerning SPF were Made in Connection with the Trading of ICI Securities
Plaintiffs base their complaint on alleged misrepresentations by SPF as well as ICI. It appears Plaintiffs have two theories of liability premised on the statements made by SPF: (1) Snavely and Shugerman are responsible for SPF's false or misleading representations as directors or officers of the corporation; (2) ICI is responsible for SPF's false or misleading representations as a control person. Defendants argue that both theories of liability are barred because SPF's statements about its own financial status were not made "in connection with" the trading of ICI securities.
The Court rejects Defendants' argument. They cite no authority indicating that misrepresentations by and concerning a subsidiary are not actionable by purchasers of the parent corporation's stock, and the Court finds no reason to make such a categorical distinction. It seems clear here that the misrepresentations about SPF were made "in connection with" the sale of ICI securities. SPF accounted for a large portion of ICI's net income and assets, a fact which ICI continuously represented in press releases and SEC filings. Statements as to SPF's status, therefore, had a significant impact on ICI's stock price, and were unquestionably material to purchasers of ICI securities.
In addition, Plaintiffs allege that SPF's statements about its financial status were part of ICI's scheme to sell SPF at an inflated price — a transaction that would have a substantial affect on ICI's stock price, and on the trading of ICI securities. Assuming these allegations of motive true, it can certainly be said that SPF's statements were made in connection with the sale of ICI securities.
C. Plaintiffs' Claims against Shugerman are Not Barred by the Statute of Limitations
Plaintiffs filed their claim against Defendant Shugerman on October 4, 1999. Mr. Shugerman claims that Plaintiffs were on inquiry notice prior to October 4, 1998, such that the one-year statute of limitations ran before he was joined as a defendant.
In its own research, this Court has discovered an apparent split among courts as to when the statute of limitations begins to run for inquiry notice. Some courts have suggested that the statute begins running the instant facts are available that would lead a reasonable investor to investigate for fraud. See, e.g.,Tregenza v. Great American Communications Co., 12 F. 3d 717, 720 (7th Cir. 1993); Jackson v. Speer, 974 F. 2d 676, 679 (5th Cir. 1992) (holding that statute begins to run when investor has knowledge of fraud, and "[k]nowledge of facts that would lead a reasonably prudent person to make inquiry which would lead to a discovery of the fraud is knowledge of the fraud itself"). The majority of courts hold, however, that the statute of limitations does not begin to run until an investor, exercising reasonable diligence, would have discovered the fraud. See, e.g., Brumbaugh v. Princeton Partners, 985 F. 2d 157, 162 (4th Cir. 1993). This distinction was made clear in Sterlin v. Biomune Sys., 154 F. 3d 1191 (10th Cir. 1998). There, the Tenth Circuit found that an article in Barron's magazine would have led a reasonable investor to begin investigating for fraud. In other words, "the article put Plaintiff on inquiry notice, triggering the duty to exercise reasonable diligence." Id. at 1204. However, the court recognized that the statute of limitations does not (necessarily) begin running on that same date. It noted that the district court assumed the statute began running on the day the Barron's article was published. Id. at 1205. The court of appeals remanded the case so that the district court could consider the more operative question: "whether . . . Plaintiff should have discovered the facts underlying the alleged fraudulent activity prior to October 12, 1994, one year before he filed suit." Id. (emphasis added).
In Berry v. Valence Technology, Inc., 175 F. 3d 699 (9th Cir. 1999), the Ninth Circuit made it exceedingly clear that it would adopt the latter of the two tests. In fact, the court explicitly referred to Sterlin, and held that, to the extent it adopts the inquiry notice standard, it "would agree with the Tenth Circuit's formulation of that standard." Id. at 704. The following passage could not more clearly demonstrate that the statute begins running, not on the date of inquiry notice, but on the date an investor should have discovered the facts underlying the fraud:
In Sterlin's formulation, `inquiry notice . . . triggers an investor's duty to exercise reasonable diligence and . . . the one-year statute of limitations period begins to run once the investor, in the exercise of reasonable diligence, should have discovered the facts underlying the alleged fraud.' 154 F. 3d at 1201. Were we to apply the Sterlin test to this case, we would face two questions. First, did the Forbes article raise sufficient suspicion of fraud to cause a reasonable investor to investigate the matter further? Second, when should a reasonably diligent investor have discovered the facts underlying the alleged fraudulent activity? If the answer to the first question were yes, the answer to the second question would determine when the statute of limitations began to run.Berry, 175 F. 3d at 704 (emphasis added).
As in Berry, the Court here must ask two questions: (1) when were investors put on notice of fraud such that a reasonable investor would have investigated the matter further, and (2) when would a reasonably diligent investor have discovered the facts underlying the alleged fraudulent activity, thus starting the statute of limitations period. Defendants argue that ICI investors were put on inquiry notice on September 14 or 15, 1998, when SPF first announced that it was considering considerable write-downs in the value of its residual assets. The Court agrees. SPF had touted its ability to withstand the decline in interest rates for months. It had repeatedly assured investors that it was not experiencing excessive prepayment. SPF then suddenly announced that it was being forced to take major losses because prepayment rates far exceeded assumptions. Any reasonable investor would have been led to investigate the matter further.
However, the Court simply cannot find that a reasonably diligent investor would have discovered the facts underlying Defendants' alleged fraudulent activity by October 4, 1998. The PSLRA requires plaintiffs plead facts supporting an inference of fraud in great detail. Many of these facts — particularly those supporting a showing of scienter — are incredibly difficult to discover because they are within the corporate defendants' exclusive control. The Court sees no way Plaintiffs could have discovered the facts underlying this alleged scheme in just over two weeks. Plaintiffs' claims against Shugerman are therefore not time-barred, and the motion to dismiss Shugerman as a defendant is denied.
D. Snavely and Shugerman May be Held Liable for SPF's Filings
Fed.R.Civ.P. 9(b) requires a plaintiff attribute fraudulent acts or statements to a particular defendant. Under the "group pleading doctrine," however, allegations of securities fraud based on false or misleading statements in "prospectuses, registration statements, annual reports, press releases or other group published information," are presumed to be the collective actions of the corporation's officers and directors. Wool v. Tandem Computers, 818 F. 2d 1433, 1440 (9th Cir. 1987). When a plaintiff seeks to invoke the presumption as to a defendant who is an outside director of a corporation, the plaintiff must allege that the "outside director either participated in the day-to-day corporate activities, or had a special relationship with the corporation." In re Glenfed, Inc., 60 F. 3d 591, 593 (9th Cir. 1995).
Plaintiffs here seek to hold Defendants Snavely and Shugerman liable for the press releases and filings of SPF as directors of that corporation. Because Snavely and Shugerman are outside directors, Plaintiffs must allege with particularity that they either participated in the day-to-day corporate activities, or had a special relationship with the corporation.
Plaintiff provides insufficient allegations to support a finding that Defendants participated in the day-to-day activities of SPF. Plaintiff simply alleges that on a few occasions, Snavely and Shugerman requested reports from SPF concerning prepayment rates and other data. This does not demonstrate, in the Court's opinion, that Snavely and Shugerman were so involved in the management of the corporation' day-to-day affairs that SPF's statements should be attributed to them under the group published information presumption.
However, Plaintiff has adequately alleged that Snavely and Shugerman had a special relationship with SPF. ICI owned approximately 47% of SPF's stock. SPF stated in its 1997 Form 10-K filed with the SEC that "[a]ltough the percentage ownership by ICII is less than 50%, ICII will continue to be able to control the election of at least a majority of the members of [SPF's] Board of Directors and to determine all corporate actions for the foreseeable future." Compl. ¶ 2. Through its control of SPF, ICI was able to elect its chairman, Wayne Snavely, as chairman of SPF's Board of Directors, to elect its directors, Steven Shugerman, to SPF's board. Presumably, ICI intended that Snavely and Shugerman would give it a means for exercising control over SPF. In the Court's opinion, the sum of these factors (i.e., ICI's control over SPF and its placement of ICI directors on the SPF board as a means of control) is that Snavely and Shugerman had a special relationship with SPF exceeding that of a typical outside director. As a result, Snavely and Shugerman are subject to the group published information doctrine for statements made by SPF.
E. Control Person Liability
Plaintiffs' complaint raises various allegations of control person liability. Section 20(a) of the Securities Exchange Act of 1934 imposes joint and several liability upon anyone who "controls a person liable under any provision" of the Act. 15 U.S.C. § 78t(a). To maintain a claim of control person liability, a plaintiff must establish (1) an underlying violation by a controlled person or entity, (2) that the defendants were controlling persons, and (3) that the defendants were culpable participants in the fraud. See Wool, 818 F. 2d at 1440.
Plaintiffs' allegations of control person liability based on statements made by SPF are problematic. As a prerequisite to such a claim, Plaintiffs must establish that SPF is liable as a primary entity for securities fraud. See Paracor Finance, Inc. v. General Elec. Capital Corp., 96 F. 3d 1151 (9th Cir. 1996) (holding that primary violation is a prerequisite to control person liability). The Court questions whether SPF had any duty of disclosure to Plaintiffs, who were purchasers of ICI securities, and whether it could be primarily liable for securities fraud in this action. If the Court's inclinations are correct, Plaintiffs may not be able to base control person claims on representations made by SPF.
Neither party addressed this issue in its papers, so the Court will reserve any decision until summary judgment. If the parties choose to argue this issue at summary judgment, the following two questions should be addressed. First, does a subsidiary like SPF owe a duty to the shareholders of a parent corporation, such that it may be held liable to these shareholders for securities fraud? Second, does the requirement of primary liability under Section 20(a) require that the primary entity be liable in this particular action, to these particular plaintiffs, or would it be sufficient to show that the primary entity is liable generally for securities fraud. In other words, can Plaintiffs here base a claim of control person liability upon SPF's liability for securities fraud to its own shareholders? In researching this issue, the parties may want to consider Lindblom v. Mobile Telecomm. Tech., 985 F. Supp. 161, 163 (D.D.C. 1997) (noting that a "subsidiary owes no duty of disclosure to the shareholders of the parent whose own stock is the only stock being offered for purchase or sale.").
IV. Conclusion
For the reasons stated above, Defendants' motion to dismiss is DENIED.
IT IS SO ORDERED.