the analysts with the information upon which the predictions were based; (2) met with the analysts on a regular basis; (3) the analysts gave Defendants an opportunity to comment on the forecasts; (4) "it was Caere's practice to have . . . Defendants . . . meet or speak with securities analysts on a regular basis to discuss . . . anticipated sales and earnings and to provide detailed guidance to such analysts with respect to [Caere's] business and projected revenue and earnings;" and (5) that "defendants stated, indicated and confirmed [during meetings with analysts] that [Caere] would continue to experience strong growth in revenues and earnings during the first quarter of its 1993 fiscal year and thereafter." PP 19, 38-42, 48-49.
In order to hold a corporate insider liable under Rule 10b-5 for forecasts made by outside securities analysts or market makers, a plaintiff must demonstrate (1) that the insider adopted the forecast, see Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 163 (2d Cir. 1980), and (2) that the insider knew that the analysts' forecasts were unreasonable when made and failed to disclose their unreasonableness to investors. See Wielgos v. Commonwealth Edison, 892 F.2d 509, 516 (7th Cir. 1989); In re Verifone Securities Litigation, 784 F. Supp. 1471, 1486-87 (N.D. Cal. 1992). The second requirement must be met in order to satisfy Rule 10b-5's scienter requirement. Marx v. Computer Sciences Corp., 507 F.2d 485, 490 (9th Cir. 1974); Verifone, 784 F. Supp. at 1486-87.
A defendant has not adopted an analyst's forecast unless he has "sufficiently entangled [himself] with the analysts' forecasts to render those predictions attributable to [him]." Elkind, 635 F.2d at 163; Verifone, 784 F. Supp. at 1486; Alfus v. Pyramid Technology Corp., 764 F. Supp. 598, 603 (N.D. Cal. 1991). A defendant is sufficiently entangled, for example, when he has reviewed the analysts' forecasts, and "by [his] activity, made an implied representation that the information . . . is true or at least in accordance with the company's views." Elkind, 635 F.2d at 163. Merely providing analysts with historical information and correcting factual inaccuracies is not sufficient. Id.
There are sound reasons for a court to construe the entanglement requirement strictly. In today's complex and highly competitive financial markets, countless analysts, investment managers, market makers and investment banking firms issue earnings and revenue forecasts on virtually every publicly-traded corporation. Forecasts may vary a great deal. If corporate insiders are held liable under Rule 10b-5 every time one of these forecasts proves to be incorrect, they would likely spend more time in court than running their companies.
Also, if a loose and capricious entanglement standard is allowed to develop, it will be very difficult for corporate insiders to know how to regulate their behavior in such a way as to adopt only with those forecasts which they have carefully examined and have determined to be reasonably accurate. Corporate insiders should not be exposed to Rule 10b-5 liability for an analyst's forecast unless it is clear, based on the insider's conduct, that he could have reasonably foreseen that he would be held liable if the forecast turned out to be unreasonable when made and materially misleading to the investing public.
Furthermore, since the allegation of entanglement is central to the overall allegation of securities fraud, plaintiffs seeking to hold a corporate insider liable for an analyst's forecast should plead entanglement with the degree of specificity required under Federal Rule of Civil Procedure 9(b). Pleadings should at least (1) identify specific forecasts and name the insider who adopted them; (2) point to specific interactions between the insider and the analyst which gave rise to the entanglement; and (3) state the dates on which the acts which allegedly gave rise to the entanglement occurred. Accord In re GlenFed Sec. Litig., 93 Daily Journal DAR. 14408, 14410 (9th Cir. Nov. 15, 1993); Wool v. Tandem Computers, Inc., 818 F.2d 1433, 1439 (9th Cir. 1987); Verifone, 784 F. Supp. at 1487. Of course, plaintiffs are not required to plead facts which are "in the exclusive possession of the defendants." Deutsch v. Flannery, 823 F.2d 1361, 1365 (9th Cir. 1987), cert. denied, 498 U.S. 818, 112 L. Ed. 2d 37, 111 S. Ct. 62 (1988); see also Wool, 818 F.2d at 1439. However, much of the required information can be acquired from the analysts who made the allegedly misleading forecasts rather than from the defendants.
This heightened pleading requirement serves the policy goals of Federal Rule of Civil Procedure 11: First, it discourages plaintiffs and their attorneys from filing marginal or baseless complaints, since it is very unlikely that such complaints will survive a motion to dismiss. See Cooter & Gell v. Hartmarx Corp., 496 U.S. 384, 393, 398, 110 L. Ed. 2d 359, 110 S. Ct. 2447 (1990) (Central purpose of Rule 11 is to deter baseless filings, which "put the machinery of justice in motion, burdening courts and individuals alike with needless expense and delay"); accord ABA Model Rules of Professional Conduct Rule 3.1 (1983) ("A lawyer shall not bring . . . a proceeding . . . unless there is a basis for doing so that is not frivolous."); see also Verifone, 784 F. Supp. at 1485-86 (noting that "the costs imposed by [baseless securities actions], while not precisely measurable, become a deadweight loss for society."). Second, it forces plaintiff's attorneys to fulfill their responsibility to conduct a reasonable inquiry into the legal and factual basis for their allegations, since it is impossible to construct a viable complaint without having done so. See Fed. R. Civ. P. 11 Advisory Committee Note to 1983 Amendments (1983 Amendment stressed importance of attorney's affirmative duty to investigate facts and law); William W. Schwarzer, Rule 11 Revisited, 101 Harv. L. Rev. 1013, 1023 (1988) (discussing the value of an adequate pre-filing investigation). Third, it discourages claims designed only to harass defendants or extort settlements, since such claims will either never be filed or will be dismissed before they cause any serious harm. See Fed. R. Civ. P. 11 Advisory Committee Note to 1983 Amendments (1983 Amendment designed to give district courts more power to punish dilatory and abusive tactics); accord ABA Model Rules of Professional Conduct Rule 3.1 (1983); ABA Code of Professional Responsibility DR 7-102(A)(a)(1) (1981); see also GlenFed, 93 Daily Journal D.A.R. at 14410 (heightened pleading requirement for securities fraud allegations "assures at least a colorable factual basis for proceeding with the lawsuit," "protect[s] defendants from the reputational harm associated with fraud claims" and "deter[s] suits pursued for their settlement value.")
Plaintiffs' allegations regarding entanglement are conclusory and inadequate. The only specific statements alleged in the Amended Complaint which suggest an entanglement are Caere's Chief Financial Officer's March 15, 1993, comments regarding analysts' forecasts, indicating that Caere did not have "sufficient information" upon which to base a comment, that "the first quarter is typically slower, reflecting seasonality in Caere's business," and that "as a result, results for the [first] quarter are always difficult to predict." P 49. It strains the intellect to imagine how this statement could constitute an entanglement. Caere's Chief Financial Officer was not embracing the analysts' forecasts when she made this statement. To the contrary, she was suggesting that the analysts' forecasts might be overly optimistic.
Plaintiffs have also failed to demonstrate that Defendants knew that the analysts' forecasts were unreasonable when they were issued. See Wielgos v. Commonwealth Edison, 892 F.2d 509, 516 (7th Cir. 1989); Verifone, 784 F. Supp. at 1487. An analyst's forecast is unreasonable only if there was no reasonable basis for it at the time in which it was made. Wielgos, 892 F.2d at 516; Verifone, 784 F. Supp. at 1487. It is not enough that the forecast merely turned out to be incorrect. Marx v. Computer Sciences Corp., 507 F.2d 485, 490 (9th Cir. 1974); Verifone, 784 F. Supp. at 1486. A forecast can have a reasonable basis even if other, more negative information was available at the time it was issued. Wielgos, 892 F.2d at 516; Verifone, 784 F. Supp. at 1487. Furthermore, because the unreasonableness of the forecasts is central to the allegation of scienter, see Verifone, 784 F. Supp. at 1486-87, the facts supporting unreasonableness must "provide a basis for a strong inference of fraudulent intent." GlenFed, 93 Daily Journal D.A.R. at 14410.
Just like the entanglement requirement, the requirement that a forecast be unreasonable when made should be construed strictly. Modern American corporations are highly complex. A large corporation may create a significant number of internal reports, analyses and statistical compilations over a relatively short period of time. These reports may be contradictory -- one may suggest a positive outlook, another may not. Where a corporation has compiled two forecasts, one positive and one negative, its insiders should not be punished under Rule 10b-5 for choosing to publish the wrong one unless they knew at the time of publication that the report chosen was unreasonable.
Here, Plaintiffs have merely (1) shown that information was available which contradicted the analysts' forecasts and (2) made a conclusory allegation that Defendants knew of and failed to disclose this information in order to further some fraudulent scheme to inflate Caere's share price. Such allegations are inadequate. See Verifone, 784 F. Supp. at 1486-87.
Because Plaintiffs have failed to adequately plead either entanglement or unreasonableness, the allegations relating to the analysts' forecasts are DISMISSED. It appears highly unlikely that Plaintiffs will be able to state a claim if allowed to amend. However, it is the general rule that leave to amend should be granted liberally. See, e.g., Bodine Produce, Inc. v. United Farm Workers Org. Com., 494 F.2d 541, 556 (9th Cir. 1974); In re Genentech Inc. Sec. Litig., [1989 Tr. Binder], Fed. Sec. L. Rep. (CCH) P 94,544 at 93,479 (N.D. Cal. July 7, 1989), modified on other grounds, [1989-90 Tr. Binder],Fed. Sec. L. Rep. (CCH) P 94,813 (N.D. Cal. Sept. 15, 1989). Accordingly, Plaintiffs shall have 30 days to amend their allegations regarding the analysts' forecasts. However, Plaintiffs are hereby advised that if their Second Amended Complaint is as conclusory and ostensibly frivolous as the Amended Complaint, the Court will not hesitate to use the power granted to it under Rule 11 of the Federal Rules of Civil Procedure.
C. Defendants' Insider Trading Claim Is Wholly Without Merit
Plaintiffs have attempted to conjure up an independent insider trading claim under SEC v. Texas Gulf Sulfur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 404 U.S. 1005 (1972), and other government insider trading cases on the theory that Defendants had a duty to disclose the following information or refrain from trading: (1) Caere had oversupplied its distributors in 1992, and therefore Caere's first quarter 1993 earnings and revenues would be depressed, since the distributors would be able to fill orders from inventory purchased in 1992 rather than ordering new products from Caere in 1993; (2) product shipments would decline significantly during the first quarter of 1993 because of softening demand for Caere's key products; (3) Caere was offering "incentives" to its distributors that would adversely affect first quarter 1993 earnings; (4) Caere had committed to significant fixed overhead in order to support substantial sales, maintenance and manufacturing operations; (5) Caere's marketing expenditures had increased significantly; and (6) Caere's systems for determining and forecasting its financial performance were inadequate. PP 1, 55.
In essence, Plaintiffs' claim is that (1) Defendants should have realized based on this information that Caere's first quarter 1993 results would be depressed, and (2) Defendants should have disclosed this projection to the investing public. The very case upon which Plaintiffs rely, Texas Gulf Sulfur, reveals the fallacy of this argument: "An insider [is not] obligated to confer upon outside investors the benefit of his superior financial or other expert analysis by disclosing his educated guesses or predictions." Texas Gulf Sulfur, 401 F.2d at 848.
Accordingly, Plaintiffs' insider trading claim is DISMISSED WITHOUT LEAVE TO AMEND.
D. State Law Claims
Plaintiffs' state law negligent misrepresentation claim is DISMISSED WITHOUT LEAVE TO AMEND, since all of the statements which Plaintiffs allege were misleading were made in routine SEC filings, press releases, or shareholder reports. See Moskowitz v. Vitalink Communications Corp., 751 F. Supp. 155, 160-61 (N.D. Cal. 1990).
Plaintiffs' remaining state law claims are DISMISSED WITH LEAVE TO AMEND because they have failed to plead reliance with the degree of specificity required under Mirkin v. Wasserman, 5 Cal. 4th 1082, 858 P.2d 568 (1993). Plaintiffs shall have 30 days to amend.
IT IS SO ORDERED.