The opinion of the court was delivered by: Marilyn Hall Patel United States District Court Judge
Plaintiffs, a consolidated class, brought this action against defendants CornerStone Propane Partners L.P. ("CornerStone") and several of its top executives and directors ("individual defendants"), alleging that defendants violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The action against CornerStone has been stayed pending bankruptcy proceedings. The class consists of purchasers of CornerStone common units during the period July 29, 1998 through and including February 11, 2003 (the "class period"). Now before the court is the individual defendants' motion to dismiss for failure to state a claim. Having considered the arguments of the parties and for the reasons set forth below, the court enters the following memorandum and order.
CornerStone, a publically-traded limited partnership organized under the laws of Delaware, is the country's sixth largest national wholesale and retail marketer of propane, serving over 440,000 customers in more than 30 states. On February 11, 2003, CornerStone admitted in its Form 8-K securities filing that it would have to restate its financial results for fiscal years 2000 and 2001 due to reporting errors during those years. Plaintiffs have alleged that during the class period, CornerStone engaged in fraudulent manipulation of the securities markets by making false and misleading public statements that artificially inflated the value of CornerStone's common units. CornerStone's common units had traded as high as $22 per share during this period of time; by February, 2003, when news of this apparent deception had reached the market, share price had declined to $0.35. Plaintiffs allege that the market capitalizations lost during this period amounted to over $360 million.
Eight plaintiffs filed class-action lawsuits against CornerStone on behalf of themselves and other similarly-situated investors, charging that they purchased CornerStone stock during the class period in reliance on CornerStone's fraudulent misrepresentations and suffered financial losses as a result. Five parties filed motions seeking to consolidate these eight class action lawsuits and to have themselves named lead plaintiff. On October 3, 2003, this court granted Gilbert H. Lamphere's motion for consolidation and appointed him as lead plaintiff for the class. A Consolidated Amended Class Action Complaint was filed on October 27, 2003; a Corrected Consolidated Amended Class Action Complaint was filed on March 2, 2004.
The complaint names CornerStone, as well as several of its individual executives and directors,*fn2 as defendants and controlling persons. CornerStone filed a Suggestion of Bankruptcy on June 15, 2004, notifying this court of its voluntary petition in the United States Bankruptcy Court for the Southern District of New York seeking relief under chapter 11 of the United States Bankruptcy Code, 11 U.S.C. section 101 et seq. Accordingly, the bankruptcy court entered an automatic stay of proceedings against Cornerstone Partners or its property pursuant to 11 U.S.C. section 362(a).
CornerStone is a Master Limited Partnership that was created in 1996 by NorthWestern Corporation ("NorthWestern"). The Partnership is composed of CornerStone G.P., Inc. (the Managing General Partner) and SYN, Inc. (the Special General Partner). NorthWestern was the majority unit-holder during the class period and parent of the CornerStone partnership's Managing General Partner. The original iterations of the complaint named NorthWestern Corporation as a defendant, but the company has subsequently filed for bankruptcy and is no longer named as a party to this action.
The sequence of events described in the complaint begins with CornerStone's initial public offering in December, 1996. The complaint alleges that CornerStone was especially attractive to investors due to its quarterly distribution of "available cash," defined as the cash available at the end of each quarter less the amount of cash reserves established by the Managing General Partner's reasonable discretion. The partnership's stated intent was to ensure sufficient available cash to make a minimum quarterly distribution ("MQD") of at least $0.54 per common unit per quarter.
The partnership established earnings before income taxes, depreciation, and amortization ("EBITDA") as an indicator of CornerStone's strength and ability to make MQDs. According to the complaint, the use of the EBITDA indicator became fertile terrain for manipulating expenses to give a false impression of healthy cash flows. In addition, the partnership established the Annual Operating Performance Incentive Plan, a program which paid annual incentive bonuses marked to budget. The bonus pool for top executives amounted to as much as 10% of the excess of EBITDA over budget.
A second prong of the company's business strategy consisted of an aggressive acquisitions policy intended to control for the highly seasonal, weather-dependent price volatility of the propane market. Between 1997 and 2000, the Partnership acquired a total of 43 businesses. An Acquisition Incentive Plan in place between 1997 and 2002 fueled this growth through a program of bonuses for employees involved in acquiring new businesses. Over $7 million in incentives were distributed between 1997 and 2001, as well as additional annual stipends flowing to the directors of the Managing General Partner.
A series of unusually warm winters began in 1998, negatively affecting CornerStone's earnings. In addition, the partnership was increasingly leveraged, financing acquisitions through debt rather than the issuance of equity. Despite an increasingly destabilizing debt load, CornerStone issued press releases heralding "record results" and increased earnings from the beginning of the class period in 1998 through 2001. The complaint alleges that CornerStone remained an attractive investment because it continued to pay MQDs, and its partnership form offered tax advantages. Analysts agreed.
In July, 2001, CornerStone announced that the Minimal Quarterly Distribution ("MQDs") to common unit holders would be reduced to $0.22. CornerStone discontinued MQDs altogether in January, 2002, also announcing at that time that the company would pursue strategic options, including possible sale or merger. For reasons related to the Enron collapse, CornerStone terminated Arthur Anderson LLP as its auditor on May 23, 2002, retaining Deloitte & Touche in its place. Soon thereafter, in July, 2002, the company terminated individual defendants Baxter, Goedde, and Kittrell, CornerStone's Chief Executive Officer, Chief Financial Officer, and Chief Operating Officer, respectively. In August, 2002, the New York Stock Exchange de-listed CornerStone's common units. Later that year, NorthWestern terminated CornerStone's debt financing, causing CornerStone to default on a $5.6 million bond payment.
In February, 2003, CornerStone released a flood of bad news. In its February 10, 2003 Current Report on Form 8-K, CornerStone revealed its decision to write-down CornerStone's goodwill by approximately $150 million, as well as restate CornerStone's financial statements for fiscal years 2000 and 2001. According to the filing, Deloitte refused to perform the necessary re-audit of these years because of "known errors" in the prior financial statements and "deficiencies" in CornerStone's supporting records. Adding to the deluge, the partnership disclosed that readjusting financial statements for prior periods would require correcting errors in "the allocation of purchase price as it relates to certain acquisitions dating back to 1997" as well as propane tank rental accounting practices.
Lacking a re-audit of fiscal years 2000 and 2001, the Partnership could not obtain an audit of the fiscal year 2002 statements, other than the balance sheet, and was unable to file quarterly reports for periods in late 2002. Deloitte & Touche had refused to issue an opinion on the statements other than the balance sheet due to the absence and disarray of necessary financial records. In a Form 8-K filed on October 17, 2003, the Partnership described the contents of Deloitte's management letter regarding the partnership's fiscal 2002 balance sheet. The letter described failures in partnership accounting, internal controls on related party transactions, financial management, and centralization.
CornerStone filed its last Quarterly Report on Form 10-Q ("10-Q") for the quarter ending March 31, 2002. Since that time, it has failed to submit required filings with the SEC, and the SEC issued a "Wells notice" indicating that SEC staff recommended administrative proceedings against CornerStone to revoke registration of the partnership's common units.
Plaintiffs allege that beginning in July, 1998, the rosy picture publicly reported by individual defendants and CornerStone was knowingly false. Plaintiffs allege that defendants concealed negative business developments in order to keep the value of its common units buoyant and continue to fund acquisitions. Meanwhile, executives negotiated grossly inflated purchase prices for acquisitions in order to receive proportionately large bonuses through the Acquisition Incentive Plan. During the resulting "acquisition frenzy," plaintiffs allege that defendants improperly capitalized costs in violation of generally accepted accounting principles ("GAAP") and knowingly failed to write down the artificially-inflated value of CornerStone's goodwill, enabling defendants to improperly increase EBITDA and report improperly inflated net income. In turn, by developing a fraudulent system of propping up CornerStone's net income and operating cash flows, defendants could avoid violations of debt covenants.
CornerStone and the individual defendants separately filed motions to dismiss the case on March 22, 2003, but CornerStone's intervening bankruptcy proceeding removed defendants' cases from this court's active calendar. On November 19, 2004, this court granted the individual defendants' unopposed motion for relief from the order removing this class action from the court's active calendar, and the present motion was rescheduled for hearing.
A motion to dismiss under Federal Rule of Civil Procedure 12(b)(6) "tests the legal sufficiency of a claim." Navarro v. Block, 250 F.3d 729, 732 (9th Cir. 2001). Because Rule 12(b)(6) focuses on the "sufficiency" of a claim rather than the claim's substantive merits, "[o]rdinarily, a court may look only at the face of the complaint to decide a motion to dismiss." Van Buskirk v. Cable News Network, Inc., 284 F.3d 977, 980 (9th Cir. 2002). Under Rule 12(b)(6), "unless it appears beyond doubt that plaintiff can prove no set of facts in support of her claim which would entitle her to relief," a motion to dismiss must be denied. Lewis v. Telephone Employees Credit Union, 87 F.3d 1537, 1545 (9th Cir. 1996) (citation omitted); see also Conley v. Gibson, 355 U.S. 41, 45-46 (1957).
The Private Securities Litigation Reform Act of 1995 ("PSLRA") significantly altered pleading requirements in private securities litigation in order to eliminate meritless claims. In re Silicon Graphics, Inc. Sec. Litig., 183 F.3d 970, 988 (9th Cir. 1999). The statute requires that a securities fraud complaint must plead both fraud and scienter, identifying (1) each statement alleged to have been misleading, (2) the reason or reasons why the statement is misleading, and, (3) if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed. See 15 U.S.C. § 78u-4(b)(1); In re The Vantive Corp. Sec. Litig., 283 F.3d 1079, 1085 (9th Cir. 2002). Allegations are deemed to be held on information and belief, and thus subject to the particularity requirement, unless plaintiffs have personal knowledge of the facts. In re The Vantive, 283 F.3d at 1085, n.3. A complaint must also "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 has defined the requisite state of mind as "deliberate recklessness, at minimum," and requires plaintiffs to plead "particular facts giving rise to a strong inference" of that mental state. See Silicon Graphics, 183 F.3d at 974. "When determining whether plaintiffs have shown a strong inference of scienter, the court must consider all reasonable inferences to be drawn from the allegations, including inferences unfavorable to the plaintiffs." Gompper v. VISX, Inc., 298 F.3d 893, 897 (9th Cir. 2002) (emphasis in original).
Invoking the PSLRA, as well as Federal Rules of Civil Procedure 8 and 12(b)(6), defendants have moved to dismiss plaintiffs' complaint. They argue that plaintiffs' 101-page complaint is a far cry from the "short and plain statement" required by Federal Rule of Civil Procedure 8. In addition, they argue that plaintiffs' claims amount to "fraud in hindsight," which fail to satisfy either the fraud or scienter components of the pleading requirements enumerated in 15 U.S.C. section 78u-4(b)(1). Lastly, the individual defendants argue that plaintiff has failed to state a claim for control person liability under 15 U.S.C. section 78t. As a basis for evaluating these arguments, the court will first summarize the statements identified in the complaint.
I. Statements Identified in the Complaint
Plaintiffs have listed dozens of CornerStone press releases, SEC filings, and analyst reviews as the backbone statements of their securities fraud claims. In addition, the complaint describes information provided by confidential witnesses regarding actions, statements, and omissions by defendants.
Under the incorporation by reference doctrine of the Ninth Circuit, this court is entitled to take documents on judicial notice which are referenced in but not attached to the complaint, as long as they are not subject to authenticity challenges. See Fecht v. The Price Co., 70 F.3d 1078, 1080 n.1 (9th Cir. 1995) cert. denied, 517 U.S. 1136 (1996). Such consideration does not convert the motion into one for summary judgment. Id. On that basis, this court has noticed those submissions by defendants of press releases and SEC filings specifically referenced in the complaint. See Silicon Graphics, 183 F.3d at 986. Plaintiff has not challenged the authenticity of any documents filed by defendant.
CornerStone press releases spanning the class period form a central component of plaintiffs' complaint. Read in chronological order, these press releases describe glowing financial health from the beginning of the class period in 1998 through May 3, 2001. At a sharp turning point, on July 29, 2001, negative disclosures began to tumble forward, with bad news continuing through the end of the class period in February, 2003. The press releases cited in the complaint include the following arc of news from the company:
! July 29, 1998 and August 6, 1998 press releases trumpeted successful acquisitions which added millions of retail gallons of propane and thousands of customers, as well as EBITDA increases attributed to acquisitions. In August, the CEO thanked staff for "industry leading results" despite "very uncooperative weather." Compl. ¶ 130-31.
! November 4, 1998 press release asserted predictable losses due to the summer lapse in propane demand, but increased revenues compared to the same period the previous year. The partnership touted acquisitions and "industry leading growth pace," and the CEO stated that CornerStone is "on pace for a record year." Id. ¶ 136.
! February 3, 1999 press release described a fall in second quarter earnings due to warm weather, but stated that these lackluster results were offset by "higher gross profit margins." CEO Baxter stated that the partnership's growth continued to lead the industry and "positions us beautifully to take advantage of a return to more seasonal weather." Id. ¶ 141.
! May 3, 1999, August 4, 1999, November 2, 1999, February 2, 2000, May 3, 2000 press releases detailed significant increases in EBITDA and net income, attributing these to growth through acquisitions, margin management, and market share expansion of existing operations. Statements in May and August, 1999 announced successful and advantageous acquisitions during the quarters. Id. ¶¶ 145, 149, 155, 164.
! August 2, 2000 press release stated that CornerStone's EBITDA increased significantly, but lagged behind the same quarter in 1999. CEO Baxter explained these results as reflecting continued effects of warm weather and elevated product costs. He asserted that a financing program with CornerStone's banking syndicate, as well as existing debt and equity funding capabilities, "are expected to provide the partnership with adequate sources of capital to meet its operating needs through FY 2001." Id. ¶ 167.
! February 7, 2001 and May 2, 2001 press releases lauded healthy EBITDA and net income increases, results which CEO Baxter called "outstanding" and "a record achievement" which validated the company's business strategy. Id. ¶¶ 178, 182.
! July 27, 2001 press release delivered the first disclosure of bad news, stating that the partnership formed a committee to reduce its MQDs and "promptly address our increased overall level of debt." The press release attributed the changes to the coming expiration of bank credit agreements and the need for financial flexibility. Id. ¶ 186.
! November 5, 2001 and November 30, 2001 press releases announced improved retail EBITDA and a new credit facility. CEO Baxter stated that CornerStone should have sufficient capital, but "continue[s] to work to strengthen [its] balance sheet to gain further financial flexibility." Id. ¶ 197, 201.
! January 18, 2002 press release announced the Credit Suisse First Boston Corporation has been retained to "pursue strategic options, including the possible sale or merger of the partnership." Id. ¶ 202.
! February 6, 2002 and April 29, 2002 press releases announced smaller EBITDA than the prior year and a fall in CornerStone's Fitch rating. Both releases described adverse weather conditions. Id. ¶ 205, 209.
! July 31, 2002 and August 5, 2002 press releases announced that CornerStone elected to default on three classes of its Senior Notes, and that it continued to consider strategic options, including bankruptcy. Id. ¶ 108.
! August 6, 2002 and November 21, 2002 press releases revealed delisting from the New York Stock Exchange and the trading of CornerStone common units on the Pink Sheets. Id. ¶ 109. Tracking the news from these press releases, CornerStone's common units experienced two precipitous falls over this period. Not surprisingly these two falls occurred immediately following the disclosures of July 29, 2001 and January 18, 2002. Id. ¶¶ 188, 203. Between ...