Appeal from the United States District Court for the Northern District of California Marilyn H. Patel, Senior District Judge, Presiding D.C. No. 3:07-cv-06140-MHP
The opinion of the court was delivered by: McKEOWN, Circuit Judge:
Argued and Submitted May 17, 2012-San Francisco, California
Before: Sidney R. Thomas, M. Margaret McKeown, and William A. Fletcher, Circuit Judges.
The panel reversed in part and affirmed in part the dismissal of investors' securities fraud class action alleging violations of §§ 10(b), 20(a), and 20A of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10-b in connection with a restatement of financial results of the company in which the investors had purchased stock.
The panel held that the third amended complaint adequately pleaded the § 10(b), § 20A and Rule 10-b claims. Considering the allegations of scienter holistically, as the Supreme Court directed in Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1324 (2011), the panel concluded that the inference that the defendant company and its chief executive officer and former chief financial officer were deliberately reckless as to the truth of their financial reports and related public statements following a merger was at least as compelling as any opposing inference.
The panel held that the district court properly dismissed the § 20(a) "control person" claims.
This case invokes the old adage that the sum is greater than the parts. National Elevator Industry Pension Fund ("National Elevator"), lead plaintiff on behalf of investors who purchased VeriFone Holdings, Inc. ("VeriFone") stock between August 31, 2006 and April 1, 2008, appeals the dismissal of its securities fraud class action. National Elevator alleged that VeriFone, Douglas Bergeron (the company's Chief Executive Officer and former Chairman of the Board of Directors), and Barry Zwarenstein (the company's former Chief Financial Officer and Executive Vice President), violated §§ 10(b), 20(a), and 20A of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10-b in connection with a December 2007 restatement of financial results.
In three consecutive quarters, VeriFone's preliminary internal reports accurately showed it had fallen short of its earnings and gross margins projections. Three consecutive times, VeriFone's CEO and CFO supervised accounting staff as they made baseless multimillion-dollar adjustments that brought reported results in line with expectations. Each time, the CEO and CFO accepted the adjustments without question, representing publicly that a recent merger was driving the company's success even as the adjustments grew in size and negatively impacted key metrics. National Elevator characterizes the conduct as either intentionally directing a subordinate to make false adjustments or being deliberately reckless in failing to question and account for unsupported entries. In contrast, VeriFone paints itself as the victim of a difficult acquisition complicated by incompatible systems. *fn2
The district court dismissed National Elevator's Third Amended Complaint for failure to sufficiently allege scienter as to each of the defendants. Viewed in isolation, any one allegation may not compel an inference of scienter. However, when we consider the allegations holistically, as the Supreme Court directed in Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1324 (2011), the inference that Bergeron, Zwarenstein, and VeriFone were deliberately reckless as to the truth of their financial reports and related public statements is "at least as compelling as any opposing inference." Id. (citing Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 324 (2007)). We reverse in part and affirm in part. National Elevator adequately pleaded its § 10(b), § 20A and Rule 10-b claims. It did not sufficiently plead its § 20(a) claims, which the district court properly dismissed.
VeriFone, based in San Jose, California, engages in the design, marketing and service of transaction automation systems, including point-of-sale devices that enable secure electronic payments among consumers, merchants, and financial institutions. Its main customers include global financial institutions, payment processors, large retailers, government organizations, and healthcare companies. In November 2006, VeriFone acquired Lipman Electronic Engineering Ltd. ("Lipman"), an Israel-based developer, manufacturer, and seller of electronic payment systems and software, and began integrating the two companies.
VeriFone touted the merger as likely to improve its financial condition, increasing its pro forma gross margin expectations from 41-44% to 42-47%. However, in the five quarters prior to the merger, VeriFone's own gross margins had never exceeded 45.6%; Lipman's had just dropped to 41.9% after five years of declines and were skewed towards low-margin areas. National Elevator alleges that defendants were aware of these facts and knew that "their representations of increasing gross margins of up to 48% during the Class Period had no reasonable basis."
In the three quarters following the merger (the first three quarters of VeriFone's fiscal 2007, referred to as 1Q07, 2Q07, and 3Q07), VeriFone reported gross margins of 47.1%, 48.1%, and 48.2%, respectively, allowing the company to claim the merger was an immediate success. It is undisputed that these reports were false.
In each quarter, VeriFone's initial internal financial reports (known as "flash" reports) painted a different, accurate picture, in which VeriFone's gross margins were well short of its projections. National Elevator alleges that Bergeron and Zwarenstein characterized these results as an "unmitigated disaster" and directed company management to "figure . . . it out" and "fix the problem." The "fixes" focused on accounting decisions, not operations. Zwarenstein and Bergeron gave VeriFone's supply chain controller, Paul Periolat, analyses of the shortfalls and suggested accounting adjustments, but their figures apparently had no basis other than VeriFone's desire to meet market expectations. Nonetheless, Periolat made the adjustments, enabling VeriFone to report results in line with its projections.
National Elevator alleges that these "manipulations were deliberate and pervasive and done for the specific purpose of meeting public guidance" and were made possible by VeriFone's lack of appropriate internal controls. In March 2007, VeriFone auditors Ernst & Young ("E&Y") raised concerns about inventory controls, requesting that VeriFone add "further measures" to address inaccuracies in inventory counts and other deficiencies. VeriFone told E&Y it was addressing the issues, but, as it turns out, any remedial measures did not prevent financial misstatements. Instead, the company continued to double-count and inflate inventory even though Bergeron, who received internal reports showing "a sharp and unprecedented increase in inventory as a result of [Periolat's] adjustments" had earlier stated that reducing inventory was as "important as any goal we've set in the past."
In accordance with accepted standards, E&Y did not audit VeriFone's quarterly reports during fiscal year 2007, relying instead on the accuracy of information from Zwarenstein and Periolat. When E&Y did audit VeriFone's annual financials in November 2007 and Periolat "was unable to explain his adjustments," the accounting irregularities came to light.
On December 3, 2007, VeriFone announced that its consolidated financial statements for 1Q07, 2Q07, and 3Q07 should not be relied upon due to errors in accounting related to the valuation of in-transit inventory and allocation of manufacturing and distribution overhead to inventory. This restatement resulted in reductions to net revenue of approximately $7.7 million, $11.5 million, and $8.4 million in the respective quarters. Those revenue reductions, in turn, resulted in reductions to previously reported income: approximately $11.8 million (with a net loss of $602,000), $10.2 million, and $14.7 million. Cumulatively, operating income for the three quarters fell from $65.6 million to $28.6 million, reflecting an overstatement of 129%. Gross margins were accordingly reduced from 47.1%, 48.1%, and 48.2% to 41.4%, 42.3%, and 41.2%. National Elevator further alleges that VeriFone overstated earnings per share by 600%, 200%, and 418%.
On the day of the restatement, VeriFone shares dropped over 45%, falling from $48.03 to $26.03. The next day, the first of nine securities fraud class actions was filed in the district court. The cases were consolidated pursuant to the Private Securities Litigation Reform Act ("PSLRA"), with National Elevator designated as lead plaintiff.
National Elevator's First Amended Complaint, which was dismissed for failure to adequately plead scienter, advanced six allegations of fraud committed by Bergeron and Zwarenstein. In a Second Amended Complaint, VeriFone, Atkinson, Bondy, and Periolat were added as defendants. The Second Amended Complaint relied on a Securities and Exchange Commission complaint (the "SEC complaint") filed in September 2009. The SEC complaint charged VeriFone and Periolat with books and records violations. Before the district court ruled on VeriFone's motion to dismiss the Second Amended Complaint, National Elevator filed its Third Amended Complaint adding new allegations based on transcripts of SEC investigatory interviews with VeriFone executives and employees. For ease of reference, the complaint at issue in this appeal-the Third Amended Complaint-is simply referred to as the complaint.
The district court concluded that National Elevator's allegations failed to raise a strong inference of scienter with respect to any of the defendants and granted the motion to dismiss with prejudice. In reaching this conclusion, the district court grouped individual allegations by topic and discussed their sufficiency. After determining that the allegations associated with each grouping were insufficient to establish scienter, the district court engaged in a one-paragraph holistic analysis, stating that "[t]here are many allegations in this case, but they fare no better when read in combination than when read independently." National Elevator appeals the dismissal with respect to Bergeron, Zwarenstein, and VeriFone.
II. PLEADING REQUIREMENTS
In our de novo review of the district court's grant of the motion to dismiss for failure to state a claim under Federal Rule of Civil Procedure 12(b)(6) and for failure to allege fraud with particularity under Rule 9(b), we pay particular attention to the heightened pleading requirements for securities fraud cases. These requirements present no small hurdle for the securities fraud plaintiff. A securities fraud complaint under § 10(b) and Rule 10b-5 must satisfy the dual pleading requisites of Federal Rule of Civil Procedure 9(b) and the PSLRA. Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981, 990--91 (9th Cir. 2009). Under Rule 9(b), claims alleging fraud are subject to a heightened pleading requirement, which requires that a party "state with particularity the circumstances constituting fraud . . . ." Fed. R. Civ. P. 9(b). The PSLRA mandates that "the complaint shall specify each statement alleged to have been misleading, [and] the reason or reasons why the statement is misleading . . . ." 15 U.S.C. § 78u-4(b)(1)(B). The PSLRA further provides that the complaint "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)(A).
To satisfy the requisite state of mind element, "a complaint must 'allege that the defendant made false or misleading statements either intentionally or with deliberate recklessness.'" Zucco, 552 F.3d at 991 (citation omitted). Facts showing mere recklessness or a motive to commit fraud and opportunity to do so provide some reasonable inference of intent, but are not sufficient to establish a strong inference of deliberate recklessness. In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 974 (9th Cir. 1999), abrogated on other grounds by South Ferry LP, No. 2 v. Killinger, 542 F.3d 776, 784 (9th Cir. 2008).
The falsity of VeriFone's financial reports is undisputed. The only issue on appeal is whether National Elevator's allegations were sufficient to ...