Opinion
02 Civ. 6912 (HB).
June 30, 2003.
OPINION AND ORDER
Defendants Goldman, Sachs Co. ("Goldman Sachs"), Credit Suisse First Boston Corporation ("Credit Suisse"), and Morgan Stanley Dean Witter Co. ("Morgan Stanley") (collectively "Defendants") move, pursuant to Federal Rules of Civil Procedure 12(b)(6) and 9(b), to dismiss the Amended Complaint in the putative securities-fraud class-action suit against them. Additionally, Defendants argue that the Plaintiffs claims are time-barred. For the following reasons, Defendants' motion is granted.
I. BACKGROUND
Joseph Pontrello, an intern in my Chambers during the summer of 2003 and a second-year law student at Brooklyn Law School, provided substantial assistance in the research and drafting of this opinion.
Plaintiffs Milton Pfeiffer and Eli Weinstein ("Plaintiffs") sue on behalf of themselves and a class of other investors who purchased common stock in Covad Communications Company ("Covad") between January 27, 1999, and December 18, 2000 (the "class period"). Plaintiffs claim that Defendants violated Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder by the Securities Exchange Commission, 17 C.F.R. § 240.10b-5, because 1) Defendants' research analysts issued positive recommendations about Covad when there was no rational economic basis for doing so, and 2) these positive recommendations were issued to attract business to their investment banking departments, a conflict of interest which they failed to disclose. Plaintiffs allege that they were influenced to purchase and/or hold shares of Covad based on Defendants' favorable recommendations as the value of the stock became inflated and then collapsed. See Am. Compl. ¶¶ 86, 90-95.
Milton Pfeiffer filed a lawsuit on behalf of himself and those similarly situated on August 30, 2002; this case was docketed as 02 Civ. 6912. Eli Weinstein filed a nearly identical lawsuit on October 17, 2002, which was docketed as 02 Civ. 8272. By order of December 17, 2002, the two cases were consolidated, with case number 02 Civ. 6912 designated as the lead case and 02 Civ. 8272 closed.
January 27, 1999, is when the first of the three defendants (Goldman Sachs) first started "covering" Covad, and December 18, 2000, is when Goldman Sachs reduced its rating to Market Perform.
On December 26, 2002, Defendants moved to dismiss the original Complaint for failure to plead securities fraud with the requisite particularity and because the action was filed after the statute of limitations had run. Following oral arguments on February 6, 2003, I granted Defendants' motion to dismiss but with leave to replead within 30 days. Plaintiffs filed the instant Amended Complaint ("Amended Complaint") on April 9, 2003, and again Defendants moved to dismiss arguing that the Amended Complaint suffers from the same deficiencies as the original Complaint: The Plaintiffs fail to plead fraud with particularity — i.e., they do not allege particularized facts to show the falsity of the statements at issue, scienter, or loss causation — and that in any event the action is time-barred.
Plaintiffs subsequently requested and were granted additional time to file the Amended Complaint.
Plaintiffs point to the following facts in support of their allegations:
Goldman Sachs participated in Covad's initial public offering on January 22, 1999 of 7.8 million shares for which Goldman Sachs earned approximately $1.6 million. See Am. Compl. ¶¶ 34-35. Five days later, on January 27, 1999, Goldman Sachs rated Covad stock Market Outperform and made this rating available to the investing public on numerous Internet web sites. See Am. Compl. ¶¶ 49, 51. Goldman Sachs categorizes stocks into four categories, of which Market Outperform is its second-highest rating. See Am. Compl. ¶¶ 46. Goldman Sachs reiterated this rating through 1999 and 2000 and placed Covad on a "Recommended List" of stocks for 2000, before finally reducing its rating to Market Perform, its third-highest rating, on December 18, 2000, when the stock was trading at $1.80, down from its high of $66. See Am. Compl. ¶¶ 56, 62.
Goldman Sachs uses the following terms to rate stocks: Trading Buy, Market Outperformer, Market Performer, and Market Underperformer. See Am. Compl. ¶ 46.
After its initial public offering, Covad had two more equity offerings during the class period. The first of these was on or about June 18, 1999, in which Credit Suisse and Morgan Stanley served as co-managing underwriters for the sale of 7.8 million shares of common stock with total proceeds of $271 million and with underwriting commissions and discounts of $14.25 million.See Am. Compl. ¶¶ 37-38. On June 30, 1999, approximately two weeks after this equity offering, Morgan Stanley initiated coverage and rated Covad as Outperform, its second-highest rating. See Am. Compl. 1 52. This rating remained in place until October 18, 2000, when Morgan Stanley reduced its rating on Covad to Neutral, its third-highest rating. See Am. Compl. ¶ 56. On July 16, 1999, approximately one month after this equity offering, Credit Suisse initiated coverage and rated Covad a Buy, which was its second-highest category. See Am. Compl. ¶ 53. In January 2000, Credit Suisse reiterated its Buy rating, but reduced its rating to Hold on October 18, 2000. See Am. Compl. ¶ 56. Covad's second equity offering, in which all three defendants served as co-managing underwriters, was on or about November 5, 1999, for the sale of 13 million shares of common stock worth $559 million; the underwriting commissions and discounts from this offering were $16.77 million. See Am. Compl. ¶¶ 39-40. The Amended Complaint alleges that there were four debt offerings during the class period but apparently only one of these four involved the defendants named here. Morgan Stanley served as a co-managing underwriter of a $425-million debt offering on January 21, 2000.See Am. Compl. ¶¶ 41-42.
Morgan Stanley uses the following terms to rate stocks: Strong Buy, Outperform, Neutral, and Underperform. See Am. Compl. ¶ 48.
CSFB uses the following terms to rate stocks: Strong Buy, Buy, Hold, and Sell. See Am. Compl. ¶ 47.
As in the original Complaint, plaintiffs allege in the Amended Complaint that Defendants issued and maintained these positive recommendations despite Covad's "dubious financial history." For example, plaintiffs allege that Covad "was operating on a highly risky and entirely unproven business model," that it had "extremely limited operating history," and that after the IPO it "sustained substantial losses" and "failed to post a profit" during the class period. See Am. Compl. ¶¶ 23-28, 30-33. Covad posted a net loss of $195 million in 1999 and $1.4 billion in 2000. See Am. Compl. ¶ 31. Moreover, many of its business partners were telecommunications companies and Internet start-ups that by the end of 2000 were insolvent or nearly so.See Am. Compl. ¶ 32.
The foregoing factual allegations are identical or nearly identical to allegations contained in the original Complaint. The difference between the pleadings is that the Amended Complaint provides specific facts about the conflict of interest within the industry and the dominance by Wall Street firms' investment banking departments over their research analysts, whereas the original Complaint described this situation only in general terms. Compare Compl. ¶¶ 22-28 with Am. Compl. ¶¶ 67-73. For example, the Amended Complaint refers to several e-mail messages by CSFB analysts that were discovered during an investigation by the Massachusetts Securities Division and that were attached to an administrative complaint that it filed against CSFB. See Am. Compl. ¶¶ 67-73. In one of these e-mail messages, a CSFB research analyst complained of CSFB's "unwritten rules" that hindered his ability to express his true opinions about the companies he covered, and he stated that he was pressured to issue positive reports on several companies.See Am. Compl. ¶ 69-71. In a second message, a CSFB analyst who wanted to give companies that CSFB had helped take public a low rating "wondered how to approach this based on banking sensitivities;" another analyst suggested "the `Agilent Two-Step.' That's where in writing you have a buy rating (like we do on CHRT [one of the companies that the analyst was concerned about], and thank God it's not a strong buy) but verbally everyone knows your position." See Am. Compl. ¶ 73. There is no allegation that this message targeted Covad stock.
The Amended Complaint alleges for the first time that a former analyst at Morgan Stanley has stated that Morgan Stanley's investment banking department had absolute veto power over any recommendations to be issued by its research analysts. See Am. Compl. ¶ 74. The Amended Complaint also refers to several articles from USA Today that describe the conflicts of interest in the industry and how the research analysts' pay is tied to the fees earned by their investment banking colleagues.See Am. Compl. ¶¶ 76-79. Finally, the Amended Complaint notes that the three defendants were among the Wall Street investment banking firms that recently settled with state regulatory agencies for $1.5 billion — with CSFB agreeing to pay $200 million, Morgan Stanley $125 million, and Goldman Sachs $110 million. See Am. Compl. ¶¶ 80-81.
In their Memorandum of Law in Opposition to the Motion to Dismiss, Plaintiffs add a new allegation not in their Amended Complaint that MSDW paid $2.7 million to "other underwriters so they would issue positive ratings on Morgan Stanley's investment banking clients." See Pl. Mem. at 13-14.
II. DISCUSSION
Defendants argue that Plaintiffs' claim is time-barred and that the Amended Complaint lacks sufficient particularity. Plaintiff avers that its claim is not time-barred and that the pleading is sufficient and should be sustained, but, in the alternative, they requests leave to amend.A. Time-bar
Section 10(b) provides that "[n]o action shall be maintained to enforce any liability created under this section, unless brought within one year after the discovery of the facts constituting the violation and within three years after such violation." 15 U.S.C § 78i(e); Lampf, Pleva, Lipkind, Prupis Petigrow v. Gilbertson, 501 U.S. 350, 364 (1991). "Discovery of facts for the purposes of this statute of limitations `includes constructive or inquiry notice, as well as actual notice.'"Rothman v. Greor, F.3d 81, 96 (2d Cir. 2002) (quotingMenowitz v. Brown, 991 F.2d 36, 41-42 (2d Cir. 1993)). The statute of limitations is triggered "when, after obtaining inquiry notice . . ., the [plaintiffs], in the exercise of reasonable diligence, should have discovered the facts underlying the alleged fraud. . . ." Rothman, 220 F.3d at 97;see also Dodds v. Cigna Securities Inc., 12 F.3d 346, 350 (2d Cir. 1993) (fraud deemed to have been discovered for purposes of triggering the statute of limitations when a reasonable investor of ordinary intelligence would have discovered the existence of the fraud).
Plaintiffs concede that they were on inquiry notice of the Defendants' fraud no later than June 2001 when Milton Pfeiffer, represented by Beatie Osborn, filed a very similar lawsuit against Morgan Stanley and Credit Suisse in the Supreme Court of the State of New York. Korsinsky v. Credit Suisse First Boston Corp., No. 112752-2001 (N.Y.Sup.Ct. filed June 29, 2001) (hereinafter "Korsinsky"). Plaintiffs argue, as I understand it, that because they had conducted a reasonably diligent inquiry into the possibility of Defendants' fraud and that took time, the one-year statute of limitations only started to run when they obtained actual knowledge and that did not happen until December 2002, when several Wall Street firms, including the three Defendants here, announced a $1.5-billion settlement with the regulatory agencies of several states. Thus, they opine that the statute of limitations for them began on April 10, 2002, when Attorney General Eliot Spitzer announced an investigation of several investment banking firms. Having filed their Complaint on August 30, 2002, the statute of limitations does not bar their lawsuit.
Plaintiffs admit that they may have been on inquiry notice as early as December 2000, when USA Today published an article, which they cite, that stated: "Analysts at several of the large investment banks, including Goldman Sachs, Merrill Lynch, Morgan Stanley Dean Witter and Credit Suisse First Boston, can't even change their ratings without first alerting their investment banking departments." See Am. Compl. ¶ 76. But see In re Sterling Foster Co., Inc Litig., 222 F. Supp.2d 216, 258-59 (E.D.N.Y. 2002) (article in Wall Street Journal and Bloomberg Newswire about fraudulent scheme with respect to IPOs by defendant put plaintiffs on inquiry notice of possibility of fraud with respect to their IPO, but did not trigger the statute of limitations).
Defendants removed the action to federal court where it was subsequently dismissed pursuant to the Securities Litigation Uniform Standards Act. See Pub.L. No. 105-353, 112 Stat. 3227 (codified as amended at 15 U.S.C. § 77p and 78bb(f). SLUSA provides that "no covered class action based upon the statutory or common law of any State or subdivision thereof may be maintained in any State or Federal court by any private party alleging . . . an untrue statement or omission of a material fact in connection with the purchase or sale of a covered security. . . ." 15 U.S.C. § 77 p(b); id. § 77 bb(f). SLUSA was enacted in 1998 to close a loophole in the PSLRA whereby "many class action plaintiffs avoided the stringent procedural hurdles erected by PSLRA by bringing suit in state rather than federal court." Lander v. Hartford Life Annuity Ins. Co., 251 F.3d 101, 107-108 (2d Cir. 2001).
Defendants assert that plaintiffs were on actual notice of the facts underlying the alleged fraud in June 2001 — fourteen months prior to filing of the original Complaint in this action — when they filed the Korsinsky summons and complaint. They point out for example that plaintiffs in Korsinsky alleged that "The glowing recommendations issued by defendants' research departments were essential to defendants' ability to attract investment banking business from Covad and other companies. . . ." See Korsinsky Compl. ¶ 51. Plaintiffs there identified as a common question whether "defendants know or should defendants have known that Covad's business was deteriorating and did defendants willfully and recklessly issue favorable recommendations on [Covad] in order to collect investment banking fees . . ." Id. ¶ 61(c). "Analysts rarely issue a "Sell" recommendation because such a recommendation will drive down the price of a stock and compromise a firm's relationship with the issuer." Id. ¶ 29. "Defendants continued recommending Covad's stock despite the fact that every quarter, Covad posted negative earnings and showed losses in the hundreds of millions of dollars." Id. ¶ 48. "[D]efendants issued favorable recommendations and maintained positive endorsements on Covad stock when in fact Covad's business and prospects were significantly deteriorating. Defendants did this in order to reap millions of dollars in investment banking fees from Covad and to show prospective clients that defendants would consistently support their stock." Id. ¶ 58.
Plaintiffs' argument that they were not on actual notice for purpose of the statute when the Korsinsky complaint was filed in state court is unpersuasive. The Amended Complaint and theKorsinsky complaint contain markedly similar allegations. The inclusion of the e-mails from CSFB analysts does not change the fact that the plaintiffs in June 2001, fourteen months before filing here, knew enough to allege that fraud permeated Defendants' transactions with brokers and triggered the statute of limitations. While the statute of limitations provides grounds that require dismissal, others are also available.
B. Misrepresentation and scienter
Congress has created a tall hurdle for a plaintiff to state a claim for securities fraud. A plaintiff alleging securities fraud must allege particular facts for each of the elements of the claim, which include that 1) Defendants made a false statement and 2) did so with scienter, and that 3) this misrepresentation caused plaintiffs' loss. See Kalnit v. Eichler, 264 F.3d 131, 138 (2d Cir. 2001) (quoting San Leandro Emergency Med. Group Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801, 808 (2d Cir. 1996)); Rothman v. Gregor, 220 F.3d 81, 89 (2d Cir. 2000); In re Initial Public Offering Sec. Litig., 241 F. Supp.2d 281, 328 (S.D.N.Y. 2003).
1. Misrepresentation
The plaintiff must specify each allegedly false statement — i.e., state the date, location and maker of the statement — and why the statement was false. See 15 U.S.C § 78u-4(b)(1);Acito v. IMCERA Group. Inc., 47 F.3d 47, 51 (2d Cir. 1995). Plaintiffs contend that they have pled misrepresentation with sufficient particularity. They claim that the misrepresentations were the 1- or 2-word ratings that each of the Defendants issued about Covad and that these ratings were false because there was no rational basis for such positive ratings when Covad was in such poor financial condition throughout this period. Moreover, the ratings were false because they were designed to attract business to Defendants' investment bankers, a fact which Defendants failed to disclose. Defendants contend that Plaintiffs only allege "impermissible generalities that cannot satisfy the pleading requirements of the PSLRA and Rule 9(b)."See Def. Br. at 9.
The fatal flaw of the pleadings is that nowhere does the Amended Complaint adequately state why the recommendations were fraudulent or misleading. Although plaintiffs have provided facts that show that the firms' investment bankers have a very strong influence over their research analysts, plaintiffs provide no facts to show that the Defendants' research analysts actually had a less-optimistic view of Covad and that the Defendants' bankers pressured them to issue false ratings on Covad. However suspicious it may be that each Defendant maintained their second-highest ratings even as the stock price plummeted, the fact that Covad was in tenuous financial condition at the time and eventually went bankrupt does not mean that there was no rational basis for each's positive recommendations; plaintiffs' conclusion to the contrary is grounded more in hindsight than fact. See Stevelman v. Alias Res. Inc., 174 F.3d 79, 85 (2d Cir. 1999) ("[A]ccounting irregularities and overly optimistic disclosures . . . amount to allegations of `fraud by hindsight,' which this Court has rejected as a basis for a securities fraud complaint."). Lacking is any specific allegation that the ratings were false, as opposed to overly optimistic or unwise — i.e., that the Defendants' analysts actually regarded Covad as a very poor investment. Given the inherent subjectivity of these recommendations and the existence of many variables especially the market's seemingly boundless infatuation with internet technology stocks at that time, plaintiffs' present conclusory allegations of falsity fail the particularity requirement of the PLSRA. 2. Scienter
In cases such as Novak, 216 F.3d at 313, and In re Initial Public Offering Sec. Litig., 241 F. Supp.2d at 354, the plaintiffs were able to point to specific documentary evidence that showed other statements to be false.
Under the PSLRA, plaintiffs are required to "state with particularity facts giving rise to the strong inference that the defendant acted with [an intent to deceive, manipulate or defraud]." 15 U.S.C. § 78u-4(b)(2); Ganino v. Citizen Utils. Co., 228 F.3d 154, 168 (2d Cir. 2000) (quoting Ernst Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12 (1976)). In the Second Circuit, the strong inference of fraudulent intent can be "established either (a) by alleging facts to show that the defendants had motive and opportunity to commit fraud, or (b) by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness." Novak, 216 F.3d at 307, 310 (quoting Acito, 47 F.3d at 52).
Plaintiffs point to "several red flags" which they contend demonstrate Defendants' scienter under either theory — i.e., motive and opportunity or conscious misbehavior or recklessness. For example, plaintiffs emphasize the "more than coincidental" timing of these allegedly false recommendations — specifically, Goldman Sachs issued its first rating on Covad five days after it handled the company's IPO, while Morgan Stanley and Credit Suisse each initiated coverage with their second-highest ratings within weeks of their participation in a $271-million equity offering. They also describe how the payment and bonuses that analysts received was connected to the amount of income their investment banking brethren earned, how analysts were often present or even participated in pitches to potential clients of the investment bankers, and how the ratings issued by the analysts required the approval of the investment bankers.
As with the element of misrepresentation, the weakness of the Amended Complaint is the lack of any specificity with respect to Covad. Given the "irrational exuberance" of the stock market at the time, especially with respect to technology stocks, the plaintiffs' allegations about a general industry-wide conflict of interest fails to plead scienter with sufficient particularity.
III. CONCLUSION
Because plaintiffs knew of the basic underlying fact pattern alleged in the Amended Complaint in June 2001 and to this day have unearthed no new facts, repleading on this ground would be futile. Accordingly the action is dismissed with prejudice, and the Clerk of the Court is instructed to close this case and any open motions and remove them from my docket.