07 -17 86 -cv E C A v. JP M o rgan C hase
UN ITED STATES CO UR T OF APPEALS FOR THE SECOND CIRCUIT
October Term 2008
Heard: October 20, 2008 Decided: January 21, 2009 Docket No. 07-1786-cv
EC A and LO CA L 134 IB EW JOINT PEN SIO N TR UST O F C HIC AGO, PEN N SECURITY BA NK & TRUST CO., EM PIRE LIFE INSURANCE CO. and BRIAN BARRY, on behalf of the Barry Family LP, individually, and on behalf of all others similarly situated,
Plaintiffs - Appellants,
v. JP M ORGAN CHASE CO., Defendant - Appellee.
Before: KEARSE, SACK, and KELLY, * Circuit Judges.
Appeal from the M arch 30, 2007, judgment of the United States District Court for the Southern District of New York (Sidney H. Stein, District Judge), dismissing the Plaintiffs’ Second Amended Complaint for failure to state a claim
*
The Honorable Paul J. Kelly, Jr., of the United States Court of Appeals for the Tenth Circuit, sitting by designation.
for relief pursuant to Fed. R. Civ. P. 12(b)(6) and for failure to comply with the heightened pleading standard required by Fed. R. Civ. P. 9(b) and the Private Securities Litigation Reform Act, 15 U.S.C. § 78u-4. Plaintiffs contend that they adequately pled materiality and scienter in order to state a claim for securities fraud.
W e affirm.
Craig Spiegel (Steve W . Berman, Erin K .
Flory, Hagens, Berman, Sobol, Shapiro, L.L.P, Seattle, W ashington, Joseph H.
W eiss, David C. Katz, Richard Acocelli, W eiss & Lurie, New York, New York, on the briefs), for Plaintiffs - Appellants.
Bruce D. Angiolillo (Thomas C. Rice, George S. W ang, Simpson, Thacher, & Bartlett, L.L.P., New York, New York, on the brief), for Defendant - Appellee.
PA UL J. KELLY, JR., Circuit Judge.
Plaintiffs, shareholders of JP M organ Chase & Co. (JPM C), appeal from a judgment of the United States District Court for the Southern District of New York, Sidney H. Stein, District Judge, granting JPM C’s Fed. R. Civ. P. 12(b)(6) motion to dismiss for failure to state a claim. The basis of Plaintiffs’ claim, in essence, was that they were defrauded by JPM C’s complicity in Enron Corporation’s financial scandals. In M arch 2005, the district court dismissed without prejudice Plaintiffs’ First Amended Complaint (FAC) for failure to sufficiently allege scienter for all but the allegations involving JPM C’s improper
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characterization of certain transactions (the “M ahonia transactions”) as trades, and for failure to plead materiality adequately with regard to that allegation. See In re JP M organ Chase Sec. Litig., 363 F. Supp. 2d 595, 619-34 (S.D.N.Y. 2005) (“JP M organ Chase I”). Plaintiffs then filed a Second Amended Complaint (SAC). Again, however, the district court concluded that Plaintiffs had only sufficiently pleaded scienter with respect to JPM C’s characterization of the M ahonia transactions, but that these transactions were not material. Accordingly, the district court dismissed the second amended complaint for failure to state a claim, this time with prejudice. In re JP M organ Chase Sec. Litig., No. 02 Civ. 1282, 2007 W L 950132, at *15 (S.D.N.Y. M ar. 29, 2007) (“JP M organ Chase II”). Plaintiffs now appeal the district court’s dismissal. Our jurisdiction arises under 28 U.S.C. § 1291, and we affirm.
Background
The facts preceding this appeal, including the precise nature of the allegations contained in the first and second amended complaints, have been exhaustively set forth in the district court’s opinions below. See JP M organ Chase I, 363 F. Supp. 2d at 602-14; JP M organ Chase II, 2007 W L 950132, at *1- 10. Therefore, we will set forth only a brief recitation of the factual background to this appeal. Because this case presents an appeal from a Fed. R. Civ. P. 12(b)(6) dismissal, the factual allegations in the complaint must be accepted as true. In re Carter-W allace, Inc., Sec. Litig., 220 F.3d 36, 38 (2d Cir. 2000).
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A. The First Amended Complaint In their FA C, Plaintiffs alleged that JPM C 1 and two of its officers, W illiam Harrison, Jr., and M arc J. Shapiro, defrauded JPM C shareholders by making deliberate misrepresentations that artificially inflated the price of JPM C stock and ultimately led to a collapse of JPM C’s share price. JP M organ Chase I, 363 F. Supp. 2d at 601-03. Plaintiffs alleged that JPM C created disguised loans for Enron and concealed the nature of these transactions by making false statements or omissions of material fact in its accounting and Securities and Exchange Commission (SEC) filings. Id. According to the complaint, JPM C created “Special Purpose Entities,” among them an entity called M ahonia Ltd., to facilitate disguised loan transactions with Enron Corporation. Id. at 602-04; FA C ¶¶ 42, 58-61. Allegedly, the creation of M ahonia enabled Enron to conceal its debt from investors because Enron could report the cash flow from JPM C through M ahonia to Enron as revenue from prepaid comm odity trades rather than as loan proceeds. JP M organ Chase I, 363 F. Supp. 2d at 604; FAC ¶¶ 61, 67-69.
Essentially, M ahonia borrowed money from JPM Chase and used that money to buy gas from Enron; M ahonia w ould then satisfy its debt to JPM Chase by providing the gas to JPM Chase, which would resell the gas at a fixed future price back to Enron. In reality . . . neither the physical commodity nor title to it were ever intended to be transferred.
1 Except as necessary for clarification, we refer to the defendant as JPM C even though some of the alleged activities were undertaken by JPM C’s predecessor, The Chase M anhattan Corporation. Chase M anhattan merged with JP M organ to create JPM C prior to this litigation and, therefore, the corporate defendant can be discussed as one entity for most purposes.
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JP M organ Chase I, 363 F. Supp. 2d at 604; see also FAC ¶¶ 71-74. According to the complaint, the commodity transactions lacked economic substance; while a financially settled commodity sw ap would eliminate any price risk, the economic reality is that the transactions were loans. FAC ¶¶ 73-74. Furthermore, JPM C cooperated with Enron in these deceptive practices by mischaracterizing the transactions on its financial statements as trading assets rather than as loans. JP M organ Chase I, 363 F. Supp. 2d at 604-05; FAC ¶¶ 77-80. In return, JPM C earned exorbitant fees. JP M organ Chase I, 363 F. Supp. 2d at 602; FA C ¶¶ 49- 50, 55. M oreover, the complaint alleged that JPM C repeatedly assured investors that it maintained high standards of integrity and credit-risk management throughout the period during which it engaged in transactions with Enron. JP M organ Chase I, 363 F. Supp. 2d at 608-09, 612; FAC ¶¶ 153-57, 161-62, 168-73. Following the collapse of Enron, however, the Senate investigated JPM C’s role in Enron’s fraudulent practices and concluded that JPM C had knowingly engaged in and actively assisted Enron in its sham transactions; the resulting disclosures caused JPM C’s stock to suffer significant losses. JP M organ Chase I, 363 F. Supp. 2d at 608, 613-14; FAC ¶¶ 22, 357-72.
In sum, the FAC alleged that JPM C defrauded its shareholders by, inter alia, downplaying its Enron-related exposure, failing to disclose alleged violations of law in connection with the M ahonia and other transactions, falsely portraying itself as a low-risk company with a reputation for fiscal discipline and integrity, and improperly accounting for the M ahonia prepays as viable trades rather than as
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impaired loans on its financial statements (thereby failing to disclose the credit risk). See JP M organ Chase II, 2007 W L 950132, at *2.
The district court evaluated the allegations in light of the heightened pleading standard under Fed. R. Civ. P. 9(b) and the Private Securities Litigation Reform Act (PSLRA) and found that the FAC failed to plead with the requisite particularity that JPM C made a materially false statement or omitted a material fact, with scienter. JP M organ Chase I, 363 F. Supp. 2d at 619-34. First, the court found that Plaintiffs had failed to allege scienter with any of the allegations, except the alleged improper accounting of the M ahonia transactions as trades rather than loans. 2 Id.; see JP M organ Chase II, 2007 W L 950132, at *3-5. However, the court found that the allegedly improper accounting of the M ahonia transactions as trades rather than loans was not material. JP M organ Chase I, 363 F. Supp. 2d at 630-31; see JP M organ Chase II, 2007 W L 950132, at *5. Accordingly, the court held that the FAC failed to state a claim pursuant to section 10(b) of the Securities and Exchange Act of 1934 (Exchange Act), 15 U.S.C. § 78j. JP M organ C hase I, 363 F. Supp. 2d at 634. The court also dismissed Plaintiffs’ other claims for relief, which included claims under section 15 of the Securities Act of 1933 (Securities Act), 15 U.S.C. § 77o; section 11 of the Securities Act, 15 U.S.C. § 77k; and section 14(a) of the Exchange Act, 15
2 The district court only found adequate allegations of scienter in regard to JPM C and M r. Shapiro, not M r. Harrison. JP M organ Chase I, 363 F. Supp. 2d at 627-28.
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U.S.C. § 78n(a). Id. at 635-36. Because the district court dismissed the claims without prejudice, Plaintiffs were permitted to file the SAC.
B. The Second Amended Complaint As the district court noted in JP M organ Chase II, the SAC consisted mostly of the same allegations present in the FAC, with three general exceptions. The SAC made new allegations relating to (1) JPM C’s alleged downplaying of its Enron-related exposure, (2) JPM C’s alleged misrepresentation of its integrity and risk management, and (3) the allegedly faulty reporting of the M ahonia transactions. JP M organ Chase II, 2007 W L 950132, at *6. The latter two are of the most importance here.
The SAC included new material on Plaintiffs’ allegation that JPM C had misrepresented its integrity. The SAC pointed to charges in the SEC’s civil law suit against JPM C accusing JPM C of aiding and abetting Enron, to Senate hearings where JPM C was accused of “actively assist[ing] Enron,” and to JPM C’s underwriting of securities issued by W orldCom, see generally In re W orldCom, Inc., Sec. Litig., 294 F. Supp. 2d 392, 399-400, 403-404 (S.D.N.Y. 2003), to show that JPM C, in fact, lacked integrity and did not conduct adequate due diligence as claimed in its statements on sound risk management. Id. at *7; SA C ¶¶ 636-39, 587-604, 188-240. The district court again dismissed Plaintiffs’ allegations regarding JPM C’s statements on its integrity and risk management strategy as mere “puffery.” JP M organ Chase II, 2007 W L 950132, at *12. The district court noted that even if these statements were not puffery, they would not be material.
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Id. Finally, the district court added that the SAC's new focus on the SEC investigation, the Senate testimony, and the W orldCom evidence was misguided because those statements pertained to misleading Enron and W orldCom shareholders, not JPM C shareholders. Id.
The SAC also included new allegations relating to Plaintiffs’ contention that JPM C made material misstatements in reporting its transactions w ith M ahonia as viable trading assets. Id. at *8-9. Of particular importance here, the SA C alleged that not only were the M ahonia transactions wrongfully stated as viable trades rather than impaired loans, but they also should have been reported as “related-party transactions” in order to comply with Statement of Financial Accounting Standards No. 57 (SFA S 57). Id.; SA C ¶¶ 242-54; see also Related Party Disclosures, Statement of Fin. Accounting Standards No. 57 (Fin. Accounting Standards Bd. 1982). Plaintiffs alleged that if JPM C had reported the M ahonia transactions as related-party transactions, it would have led to a chain reaction which w ould have revealed Enron’s deceptive finances and JPM C’s alleged complicity. JP M organ Chase II, 2007 W L 950132, at *9; SAC ¶¶ 249-54. The district court rejected this argument. It found that Plaintiffs properly pleaded that M ahonia was a “related party” pursuant to SFA S 57, and that JPM C may have violated generally accepted accounting principles (GAAP) by not reporting the M ahonia transactions as such. JP M organ Chase II, 2007 W L 950132, at *13. But, the court noted that merely alleging a GAAP violation is insufficient to establish scienter, and that Plaintiffs had not alleged any facts suggesting
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fraudulent intent in the GAAP violation. Id. (citing Novak v. Kasaks, 216 F.3d 300, 309 (2d Cir. 2000)). In finding a lack of scienter, the district court noted that the SEC had not charged JPM C with a violation for failing to comply with SFAS 57, suggesting that this defeated any claim of recklessness because it showed that reasonable accountants could differ as to whether SFAS 57 applied to the M ahonia transactions. Id. The district court then noted that even had scienter been proven, the failure to disclose these transactions as related-party transactions would not have been material. According to the district court, the percentage of JPM C’s assets at issue was “quantitatively immaterial,” and, despite Plaintiffs’ “sw eeping” allegations that proper disclosure w ould have brought about discovery of Enron’s fraud, Plaintiffs provided no support explaining how the proper disclosure would have exposed the fraud. Id. at *14.
Having found that the SAC did not sufficiently allege that JPM C acted with scienter in making any material representations or omissions in connection with the purchase or sale of securities, the district court dismissed Plaintiffs’ claims with prejudice. Id. at *15. Plaintiffs appeal the dismissal, presenting several issues. First, Plaintiffs contend that the district court erred by holding that JPM C’s financial reporting concerning the M ahonia transactions and assertions regarding its integrity and risk management were immaterial. Second, Plaintiffs contend that the district court erred by holding that Plaintiffs did not adequately plead scienter. Third, Plaintiffs contend that, because we should find materiality and scienter, the district court erroneously dismissed their additional claims,
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asserted under sections 11 and 15 of the Securities Act and sections 14(a) and 20 of the Exchange Act.
Discussion
W e review de novo the dismissal of a complaint under Rule 12(b)(6), accepting all factual allegations as true and drawing all reasonable inferences in favor of the plaintiff. Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital Inc., 531 F.3d 190, 194 (2d Cir. 2008); Chambers v. Time W arner, Inc., 282 F.3d 147, 152 (2d Cir. 2002). “To survive a motion to dismiss, a complaint must plead ‘enough facts to state a claim to relief that is plausible on its face.’” Ruotolo v. City of New York, 514 F.3d 184, 188 (2d Cir. 2008) (quoting Bell Atl. Corp. v. Twombly, 127 S. Ct. 1955, 1974 (2007)); see ATSI Commc’ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 98 & n.2 (2d Cir. 2007) (applying the Twombly standard in the context of a securities fraud claim). Any complaint alleging securities fraud must satisfy the heightened pleading requirements of the PSLRA and Fed. R. Civ. P. 9(b) by stating with particularity the circumstances constituting fraud. See Tellabs, Inc. v. M akor Issues & Rights, Ltd., 127 S. Ct. 2499, 2508 (2007); ATSI Commc’ns, 493 F.3d at 99. Under the PSLRA, the complaint must “specify each statement alleged to have been misleading, [and] the reason or reasons w hy the statement is misleading,” and “state w ith 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)(1), (2); Tellabs, 127 S. Ct. at
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2508. Therefore, “[w]hile we normally draw reasonable inferences in the non- movant’s favor on a motion to dismiss,” the PSLRA “establishes a more stringent rule for inferences involving scienter” because the PSLRA requires particular allegations giving rise to a strong inference of scienter. Teamsters Local, 531 F.3d at 194. I. Overview of Applicable Law Plaintiffs’ principal securities fraud claims are brought pursuant to section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b). This provision makes it unlawful to “use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may proscribe.” Id. The SEC rule implementing the statute, Rule 10b-5, prohibits “mak[ing] any untrue statement of a material fact or [omitting] to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.” 17 C.F.R. § 240.10b-5(b) (2008). In order to succeed on a claim, a “plaintiff must establish that ‘the defendant, in connection with the purchase or sale of securities, made a materially false statement or omitted a material fact, with scienter, and that the plaintiff’s reliance on the defendant’s action caused injury to the plaintiff.’” Lawrence v. Cohn, 325 F.3d 141, 147 (2d Cir. 2003) (quoting Ganino v. Citizens Utils. Co., 228 F.3d 154, 161 (2d Cir. 2000)); see Lentell v. M errill Lynch & Co., 396 F.3d 161, 172 (2d Cir. 2005); San Leandro Emergency M ed. Group Profit Sharing Plan v. Philip M orris Cos., 75
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F.3d 801, 808 (2d Cir. 1996). In this case, the parties contest whether the complaint adequately alleges (1) a false statement or omission of material fact, and (2) scienter.
A. M ateriality In order to determine whether a misleading statement is material, courts must engage in a fact-specific inquiry. Basic Inc. v. Levinson, 485 U.S. 224, 240 (1988). The materiality of a misstatement depends on whether “‘there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to [act].’” Id. at 231-32 (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)). In other words, in order for the misstatement to be material, “‘there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.’” Id. (quoting TSC Indus., 426 U.S. at 449). Therefore, the determination of whether an alleged misrepresentation is material necessarily depends on all relevant circumstances. Ganino, 228 F.3d at 162. Because materiality is a mixed question of law and fact, in the context of a Fed. R. Civ. P. 12(b)(6) motion, “‘a complaint may not properly be dismissed . . . on the ground that the alleged misstatements or omissions are not material unless they are so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of their importance.’” Id. (quoting Goldman v. Belden, 754 F.2d 1059, 1067 (2d Cir. 1985)) (alteration in original).
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The SEC has provided internal guidance in Staff Accounting Bulletin (SA B) No. 99 regarding the determination of materiality. According to SA B No. 99, both quantitative and qualitative factors should be considered in assessing a statement’s materiality. SA B No. 99 begins the analysis with the quantitative factor. Under this factor, the SEC considers the financial magnitude of the misstatement; while SAB No. 99 suggests a percentage threshold below which the amount is presumptively immaterial, the SEC notes that the challenged amount can be material even though it is below that percentage threshold of assets, liabilities, revenues or net income. See SEC Staff Accounting Bulletin No. 99, 64 Fed. Reg. 45150, 45150-52 (1999). SAB No. 99 also sets out qualitative factors such as, inter alia, (1) concealment of an unlawful transaction, (2) significance of the misstatement in relation to the company’s operations, and (3) management’s expectation that the misstatement will result in a significant market reaction. See id. This Court has deemed SAB No. 99 to be persuasive authority. Ganino, 228 F.3d at 163. While SA B N o. 99 does not change the standard of materiality, w e consider the factors it sets forth in determining whether the misstatement significantly altered the “total mix” of information available to investors.
B. Scienter In order to plead scienter adequately under the PSLRA, a plaintiff must plead “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) (emphasis added). The requisite state of mind in a section 10(b) and Rule 10b-5 action is an
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intent “‘to deceive, manipulate, or defraud.’” Tellabs, 127 S. Ct. at 2504 (quoting Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 n.12 (1976)). In addition to intent, recklessness is a sufficiently culpable mental state for securities fraud in this circuit. Teamsters Local, 531 F.3d at 194; see also Novak, 216 F.3d at 308- 09. Recklessness is defined as “‘at the least, . . . an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.’” Novak, 216 F.3d at 308 (quoting Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978) (other internal quotation marks omitted)).
According to Tellabs, to qualify as a “‘strong inference,’” the inference of scienter must be “more than merely plausible or reasonable – it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.” Tellabs, 127 S. Ct. at 2504-05 (quoting 15 U.S.C. § 78u-4(b)(2)). In determining whether this inference can be reasonably drawn, courts must consider both the inferences urged by the plaintiff and any competing inferences rationally drawn from all the facts alleged, taken collectively. Id. at 2504, 2509. Therefore, the court must ask, “W hen the allegations are accepted as true and taken collectively, would a reasonable person deem the inference of scienter at least as strong as any opposing inference?” Id. at 2511. M oreover, the facts alleged must support an inference of an intent to defraud the plaintiffs rather than some other group. Kalnit v. Eichler, 264 F.3d 131, 140-41 (2d Cir. 2001).
The requisite scienter can be established by alleging facts to show either (1)
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that defendants had the motive and opportunity to commit fraud, or (2) strong circumstantial evidence of conscious misbehavior or recklessness. Ganino, 228 F.3d at 168-69; Novak, 216 F.3d at 307. In order to raise a strong inference of scienter through “motive and opportunity” to defraud, Plaintiffs must allege that JPM C or its officers “benefitted in some concrete and personal way from the purported fraud,” Novak, 216 F.3d at 307-08. M otives that are common to most corporate officers, such as the desire for the corporation to appear profitable and the desire to keep stock prices high to increase officer compensation, do not constitute “motive” for purposes of this inquiry. Id. at 307; Kalnit, 264 F.3d at 139. Rather, the “motive” showing is generally met when corporate insiders allegedly make a misrepresentation in order to sell their own shares at a profit. Novak, 216 F.3d at 308. Alternatively, if Plaintiffs cannot make the “motive” showing, then they could raise a strong inference of scienter under the “strong circumstantial evidence” prong, “though the strength of the circumstantial allegations must be correspondingly greater” if there is no motive. Kalnit, 264 F.3d at 142 (quoting Beck v. M frs. Hanover Trust Co., 820 F.2d 46, 50 (2d Cir. 1987), overruled on other grounds by United States v. Indelicato, 865 F.2d 1370 (2d Cir. 1989) (en banc)). At least four circumstances may give rise to a strong inference of the requisite scienter: where the complaint sufficiently alleges that the defendants (1) “benefitted in a concrete and personal way from the purported fraud”; (2) “engaged in deliberately illegal behavior”; (3) “knew facts or had access to information suggesting that their public statements were not accurate”;
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or (4) “failed to check information they had a duty to monitor.” Novak, 216 F.3d at 311; see Teamsters Local, 531 F.3d at 194. II. Application of the Law to Plaintiffs’ Allegations A. JPM C’s Financial Accounting On appeal, Plaintiffs contend that JPM C made false and misleading statements or omissions that were material by (1) failing to report the M ahonia transactions as related-party transactions, and (2) reporting the M ahonia transactions as trading assets rather than loans. Plaintiffs’ complaint pled that JPM C’s financial reports w ere false and misleading with regard to the M ahonia transactions because JPM C did not report them as related-party transactions. 3 SA C ¶¶ 242-54. Specifically, the complaint pled that the failure to identify the M ahonia transactions as related-party transactions violated GAAP because SFA S No. 57 required JPM C to disclose related-party transactions. Id. Plaintiffs contend that the GAAP violation renders the financial statements presumptively misleading. In addition, Plaintiff’s complaint pled that JPM C’s accounting of
3 According to one text, “[t]he potential problem with related-party transactions is that their economic substance may differ from their legal form. . . . As a result of the potential for misrepresentation, financial statement users are particularly interested in more details about these transactions.” J. David Spiceland, James F. Sepe, M ark W . Nelson & Lawrence A. Tomassini, I Intermediate Accounting 124 (5th ed. 2009). According to another text, “[a] transaction with a related party is not an arm’s-length transaction. . . . M ost auditors assess inherent risk as high for related parties and related party transactions, both because of the accounting disclosure requirements and the lack of independence between the parties involved in the transaction.” Alvin A. Arens, Randal J. Elder, M ark S. Beasley, Auditing and Assurance Services 216 (12th ed. 2008).
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disguised loans as “trading activities” rather than as loans constitutes a false statement. SAC ¶¶ 450-52. Again, the complaint refers to the failure to conform to GAAP and Plaintiffs note that the violation renders the misstatement presumptively misleading. Id.
1. Failure to Report M ahonia as a Related Party Plaintiffs’ essential claim with regard to the failure to disclose M ahonia as a related party is that JPM C violated SFA S 57, which requires that “[f]inancial statements shall include disclosures of material related party transactions.” 4 Related Party Disclosures, SFA S N o. 57 ¶ 2 (Fin. Accounting Standards Bd. 1982). The district court held that Plaintiffs adequately pled a false or misleading statement because they alleged that JPM C “created, controlled, and made decisions on behalf of M ahonia.” JP M organ Chase II, 2007 W L 950132, at *13. W e agree that Plaintiffs alleged with particularity that M ahonia was a related party. W e also agree with the district court that Plaintiffs failed to allege scienter. 5 Id. “[A ]llegations of G AAP violations or accounting irregularities,
4 “W hen related-party transactions occur, companies must disclose the nature of the relationship, provide a description of the transactions, report the dollar amounts of the transactions and any amounts due from or to related parties.” J. David Spiceland et al., I Intermediate Accounting 124 (citing Related Party Disclosures, SFAS No. 57 (Fin. Accounting Standards Bd. 1982)).
5 However, w e disagree to some extent w ith the district court’s reasoning.
The court stated that the fact that the SEC had not charged JPM C with wrongly accounting for these transactions shows that reasonable accountants could differ (continued...)
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standing alone, are insufficient to state a securities fraud claim. . . . Only where such allegations are coupled with evidence of corresponding fraudulent intent might they be sufficient.” Novak, 216 F.3d at 309 (internal quotation marks omitted). Even if there was a GAAP violation, that corresponding evidence is missing here.
a. M otive and Opportunity Plaintiffs advance several allegations which, they argue, demonstrate an adequate motive. First, Plaintiffs argue that JPM C was motivated by a desire to secure above-market interest rates and fees from Enron. SAC ¶¶ 702-24. JPM C allegedly charged an interest rate that was three percent higher than its normal rate and earned excessive fees from other transactions with Enron. SA C ¶¶ 706- 09. Second, Plaintiffs suggest that there was motive to defraud because The Chase M anhattan Corporation was inflating its stock in anticipation of acquiring JP M organ in the merger that ultimately resulted in the creation of JPM C. SAC ¶¶ 673-75. Plaintiffs argue that the allegedly artificially inflated stock allowed it to complete the merger without issuing as many shares as it would have had to issue otherwise. Third, Plaintiffs suggest that the individual defendants in the case, M r. Harrison and M r. Shapiro, had motive to defraud because they sought to
5 (...continued)
as to whether SFAS 57 applied in these circumstances— and, therefore, that JPM C had not acted recklessly. JP M organ Chase II, 2007 W L 950132, at *13. SEC charges simply are not a prerequisite to pleading recklessness with regard to accounting and financial reporting violations.
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increase their compensation and bonuses. Plaintiffs allege that the individual defendants secured significant performance-based compensation benefits based on Chase’s bargain purchase of JP M organ and based on JPM C’s Enron transactions. SA C ¶¶ 696-98.
Each of Plaintiffs’ arguments fails. First, the desire to maximize the corporation’s profits does not strengthen the inference of an intent to defraud because earning “excessive” fees in a competitive marketplace (for as long as it lasts)— far from defrauding the shareholders— actually benefits the shareholders. Earning profits for the shareholders is the essence of the duty of loyalty, and therefore it would be an unusual case where accomplishment of this objective constitutes the requisite motive to defraud the shareholders. This is not such a case. Plaintiff’s argument to the contrary, based on In re Livent, Inc. Noteholders Sec. Litig., 174 F. Supp. 2d 144 (S.D.N.Y. 2001), is unavailing. In that case, while the court did find that the excessive fees the investment bank received provided a strong inference of intent to defraud, the bank’s shareholders did not bring the suit; rather, the shareholders of the company being charged excessive fees brought the suit. Id. at 151-53. Therefore, the case is inapposite; while it supports the contention that excessive fees show motive to defraud another company’s shareholders, it does not support the argument that excessive fees show motive to defraud a company’s own shareholders.
Second, in alleging that Chase inflated its stock price in order to reduce the cost of acquiring JP M organ, Plaintiffs failed to allege a connection between the
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Enron dealings and the acquisition. W hile Plaintiffs rely on Cohen v. Koenig, 25 F.3d 1168, 1170-71, 1173-74 (2d Cir. 1994), that case is inapplicable because it involved misstatements directly relating to the acquisition of another company. Here, the fact that the alleged misstatements began eight years before the acquisition and ended years afterward renders any connection between the events dubious at best. At most, Plaintiffs allege a generalized desire to achieve a lucrative acquisition proposal. Such generalized desires fail to establish the requisite scienter because “the desire to achieve the most lucrative acquisition proposal can be attributed to virtually every company seeking to be acquired,” Kalnit, 264 F.3d at 141, or to acquire another. In this case, the link between the acquisition and the alleged misconduct simply is not close enough to strengthen the inference of an intent to defraud. 6 Finally, the allegation that M r. Harrison and M r. Shapiro had the requisite motive because they received bonuses based on corporate earnings and higher stock prices does not strengthen the inference of fraudulent intent. See Kalnit, 264 F.3d at 139; Novak, 216 F.3d at 307-08. Again, Plaintiffs do not make the particularized showing that existed in the case on which they rely. In Fla. State Bd. of Admin. v. Green Tree Fin. Corp., 270 F.3d 645, 661-62 (8th Cir. 2001), the
6 W e acknowledge that the artificial inflation of stock prices in order to acquire another company may, “in some circumstances,” be sufficient for scienter. Rothman v. Gregor, 220 F.3d 81, 92-94 (2d Cir. 2000). But the inquiry is an “extremely contextual one,” In re Complete M gmt. Inc. Secs. Litig., 153 F. Supp. 2d 314, 328 (S.D.N.Y. 2001), and in this case Plaintiffs simply did not allege a unique connection between the fraud and the acquisition.
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plaintiffs made a showing of a direct link between the compensation package and the fraudulent statements because of the magnitude of the compensation and the defendants’ motive to sweep problems under the rug given one defendant’s expiring contract. Here, the complaint is much more generalized and appears to present the type of allegation that Kalnit dismissed as insufficient. If scienter could be pleaded solely on the basis that defendants were motivated because an inflated stock price or improved corporate performance would increase their compensation, “virtually every company in the United States that experiences a downturn in stock price could be forced to defend securities fraud actions. ‘[I]ncentive compensation can hardly be the basis on which an allegation of fraud is predicated.’” Acito v. IM CERA Group, Inc., 47 F.3d 47, 54 (2d Cir. 1995) (quoting Ferber v. Travelers Corp., 785 F. Supp. 1101, 1107 (D . Conn. 1991)). Therefore, even taking the allegations as a whole, as Tellabs requires, Plaintiffs have failed to create a strong inference of scienter based on motive and opportunity.
b. Strong Circumstantial Evidence of Conscious M isbehavior or Recklessness
Plaintiffs contend that JPM C and the individual defendants knew or had access to information that M ahonia was a related party, yet violated GAAP by failing to disclose the M ahonia transactions as related-party transactions. Plaintiffs argue that they sufficiently alleged JPM C’s knowledge because JPM C had created and controlled M ahonia. Furthermore, Plaintiffs argue that SFA S 57
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clearly required reporting these transactions as related-party transactions. Because JPM C knew that M ahonia was related but did not report it as such, Plaintiffs contend, the allegations in the complaint give rise to a strong inference of scienter. 7 However, Plaintiffs fail to allege sufficient facts to support an inference that JPM C knew that the failure to report M ahonia as a related party was inaccurate. In order to support this inference, Plaintiffs would have to allege facts show ing that JPM C’s transactions with M ahonia were “material,” because the disclosure requirements of SFAS 57 only relate to material related-party transactions. See Related Party Disclosures, SFA S N o. 57 ¶ 2 (Fin. Accounting Standards Bd. 1982); see also Am. Inst. of C ertified Pub. Accountants, Codification of Statements on Auditing Standards AU § 334.11 (2008) (“Related Parties”); Alvin A . Arens et al., Auditing and Assurance Services 216. However, Plaintiffs did not do so. As discussed more fully below in relation to JPM C’s accounting for the M ahonia transactions as trading assets rather than as loans, Plaintiffs failed to plead materiality adequately. Here, the prepay transactions through M ahonia were, as the district court noted, “a minute fraction of assets” on JPM C ’s balance sheet. JP M organ Chase I, 363 F. Supp. 2d at 630-31. As important, if JPM C had disclosed that M ahonia w as a related party, it would only
7 W hile Plaintiffs couch their arguments in terms of “knowledge,” we also consider whether the complaint adequately alleges recklessness, given our holdings that recklessness is sufficient to show scienter. See Teamsters Local, 531 F.3d at 194.
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mean that it would have disclosed (1) the nature of the relationship between JPM C and M ahonia; (2) that JPM C engaged in prepay transactions with M ahonia; (3) the dollar amount of the transactions with M ahonia; and (4) the amount of outstanding obligations. See SAC ¶ 245; JP M organ Chase II, 2007 W L 950132, at *14. These disclosures would not have materially altered the “total mix” of inform ation available to investors. Basic, 485 U.S. at 231-32. W hile the SAC pleaded that disclosure of these transactions as related-party transactions w ould have revealed JPM C’s alleged duplicity with respect to Enron, Plaintiffs fail to plead this allegation with any particularity. Proof of the facts alleged would not give a fact-finder a basis on which it could find that such a chain reaction would have occurred.
Because Plaintiffs have not adequately pleaded that the related-party transactions with M ahonia were material, they did not adequately plead that JPM C knowingly or recklessly failed to comply with SFAS 57. Given that they failed to plead the materiality of the M ahonia transactions, 8 Plaintiffs certainly did not
8 In determining that Plaintiffs fail to plead materiality under SFAS 57, w e also conclude that Plaintiffs necessarily fail to plead materiality for their Rule 10b-5 claim. The Financial A ccounting Standards Board specifically stated that it did not “intend to introduce a new concept of materiality.” Related Party Disclosures, SFA S N o. 57, Appx. A, ¶ 19 (Fin. Accounting Standards Bd. 1982) (consideration of comments on exposure draft). Therefore, a failure to adequately plead that the related party transaction was material for purposes of SFAS 57— necessary to show scienter in this case— is also a failure to plead materiality for purposes of section 10(b) and Rule 10b-5. Accordingly, we hold that Plaintiffs not only failed to plead scienter regarding the failure to disclose M ahonia as a related party, but also failed to plead the materiality of the failure to (continued...)
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plead that defendants had knowledge of the transactions’ materiality. M oreover, Plaintiffs failed to plead recklessness. To plead recklessness through circumstantial evidence, Plaintiffs would have to show, “‘at the least, conduct which is highly unreasonable and which represents an extreme departure from the standards of ordinary care to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.’” Kalnit, 264 F.3d at 142 (quoting In re Carter-W allace, 220 F.3d at 39 (other internal quotation marks omitted)). Plaintiffs have not done so here.
Finally, we note that Plaintiffs’ arguments regarding scienter— at least those that rely on JPM C’s alleged intent to defraud— suffer from a basic problem concerning plausibility. Plaintiffs fail to show an intent to defraud JPM C’s shareholders rather than Enron’s shareholders. Even if the alleged violation of SFAS 57 could give rise to an inference of intent to defraud Enron’s shareholders (on the remote assumption that the JPM C statements might have helped conceal Enron’s financial quandary), such an intent would not necessarily relate to JPM C’s shareholders. Indeed, Plaintiffs have argued that JPM C concealed its transactions w ith Enron in return for excessive fees (w hich, as discussed, actually inured to Plaintiffs’ benefit). It seems implausible to have both an intent to earn excessive fees for the corporation and also an intent to defraud Plaintiffs by losing vast sums of money. See Atl. Gypsum Co. v. Lloyds Int’l Corp., 753 F.
8 (...continued)
disclose M ahonia as a related party.
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Supp. 505, 514 (S.D.N.Y. 1990) (“Plaintiffs’ view of the facts defies economic reason, and therefore does not yield a reasonable inference of fraudulent intent.”). As the district court noted, Plaintiffs “fail to allege facts explaining why, if it was aware of Enron’s problems, [JPM C] would have continued to lend Enron billions of dollars.” JP M organ Chase I, 363 F. Supp. 2d at 621. Even if JPM C was actively engaged in duping other institutions for the purposes of gaining at the expense of those institutions, it would not constitute a motive for JPM C to defraud its own investors. See Kalnit, 264 F.3d at 141.
2. Accounting for the M ahonia Transactions as Trades Rather than as Loans
Plaintiffs contend that JPM C’s accounting of disguised loans as “trading activities” rather than as loans constitutes a false statement. The district court found that the M ahonia transactions were indeed mischaracterized on JPM C’s financial disclosures, JP M organ Chase I, 363 F. Supp. 2d at 626. However, the district court also held that treating the prepaid transactions as trades rather than as loans was immaterial. Id. at 630.
Plaintiffs allege that the misclassification of the loans was material in light of the qualitative factors set out in SA B No. 99. First, according to the complaint, this accounting and reporting misstatement concealed an unlawful transaction because it hid JPM C’s collaboration with Enron’s illegal activities. Allegedly, the disclosure of the true nature of the prepay transactions would have exposed JPM C’s role in the Enron accounting debacle. SAC ¶¶ 249-54.
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Accordingly, the misstatement was material because its purpose was to deceive investors and conceal misconduct. SA C ¶¶ 249, 254. Second, according to the complaint, the misstatement was material because, after JPM C’s actions became public, JPM C stock immediately fell nearly nineteen percent. SA C ¶¶ 251, 588, 603, 606. Third, the complaint alleges that the misstatement was material because it related to JPM C’s relationship with Enron, a relationship which Plaintiffs argue constituted a significant aspect of JPM C’s operations and profitability because Enron was JPM C’s single largest client. SAC ¶¶ 51, 54, 702-19, 726. Accordingly, Plaintiffs contend that three of SAB No. 99’s qualitative factors point to the materiality of the alleged misstatement.
However, the classification of the loans as trading assets w as immaterial in this case. Under the legal standard set forth in Ganino, both quantitative and qualitative factors must be considered in determining materiality. Here, the quantitative factor strongly supports JPM C’s argument that the classification error, if it was one, was immaterial. Although $2 billion in prepay transactions may sound staggering, the number must be placed in context— reclassifying $2 billion out of one category of trading assets (derivative receivables) totalling $76 billion into another category (loan assets) totalling $212 billion does not alter JPM C’s total assets of $715 billion. J. App. 406 (JM PC Annual Report 2000). M oreover, the underlying assets in either classification carry some default risk. As the district court said about this same information, “[c]hanging the accounting treatment of approximately 0.3% of JPM Chase’s total assets from trades to loans
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would not have been material to investors.” JP M organ Chase I, 363 F. Supp. 2d at 631.
W hile G anino held that bright-line numerical tests for materiality are inappropriate, it did not exclude analysis based on, or even emphasis of, quantitative considerations. Ganino, 228 F.3d at 164. According to Ganino, an alleged misrepresentation relating to less than two percent of defendant’s assets, when taken in context, could be immaterial as a matter of law. Id.; see also Parnes v. Gateway 2000, Inc., 122 F.3d 539, 547 (8th Cir. 1997) (finding alleged misrepresentations with regard to two percent of total assets were immaterial as a matter of law); In re W estinghouse Sec. Litig., 90 F.3d 696, 715 (3d Cir. 1996) (stating that a misstatement was immaterial where only one percent of assets was allegedly misclassified). And as the SEC stated in SA B No. 99, “[t]he use of a percentage as a numerical threshold, such as 5% , may provide the basis for a preliminary assumption that . . . a deviation of less than the specified percentage with respect to a particular item on the registrant’s financial statements is unlikely to be material.” SEC Staff Accounting Bulletin No. 99, 64 Fed. Reg. at 45,151. Here, the five percent numerical threshold is a good starting place for assessing the materiality of the alleged misstatement. In this case, the alleged misrepresentation does not even come close to that threshold. An accounting classification decision that affects less than one-third of a percent of total assets does not suggest materiality. However, this preliminary inquiry under the quantitative factor must be supplemented. See Ganino, 228 F.3d at 163. W e go
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on to consider qualitative factors that might contribute to a finding of materiality.
Contrary to Plaintiffs’ assertions, however, the qualitative factors do not adequately demonstrate the materiality of the decision to classify the prepay transactions as loans. O n appeal, Plaintiffs point to three factors set forth in SA B No. 99 as supporting their argument of materiality. The first qualitative factor is whether the misstatement concealed an unlawful transaction. Plaintiffs have not shown that this factor is present. Although they allege that the transaction should have been described differently, see, e.g., SA C ¶ 261, there is no allegation that the transaction itself was illegal. The second qualitative factor, the misstatements’ relation to a significant aspect of JPM C’s operations, also favors JPM C. W hile Plaintiffs allege that Enron is a “key client” of JPM C, it appears clear that JPM C’s transactions with Enron were not a significant aspect of JPM C’s operations, considering the fact that JPM C earned less than .1% of its revenues from Enron-related transactions each year. See SAC ¶ 54 and J. App. 405 (showing that while JPM C earned $30.1 million and $29.8 million in relationship revenues from Enron in 1999 and 2000 respectively, it earned $29.484 billion and $31.557 billion in total net revenues in those years). Finally, the third qualitative factor that Plaintiffs rely on is the market reaction to the public disclosures of JPM C’s role in the Enron collapse. SAB No. 99, while alluding to market reactions as a valid consideration in analyzing materiality, warned that market volatility alone is “too blunt an instrument to be depended on in considering whether a fact is material.” SEC Staff Accounting Bulletin No. 99,
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64 Fed. Reg. at 45,152 (internal quotation marks omitted). Indeed, SA B No. 99 limits the usefulness of this factor to instances w here management expects “that a known misstatement may result in a significant positive or negative market reaction.” Id. Plaintiffs have not alleged facts that would permit the inference that JPM C expected that the alleged misclassification of the loans might result in a significant market reaction. For this reason, the market reaction to Enron’s collapse and JPM C’s involvement in this collapse does not point towards qualitative materiality under SA B No. 99.
These qualitative factors are intended to allow for a finding of materiality if the quantitative size of the misstatement is small, but the effect of the misstatement is large. See Ganino, 228 F.3d at 163. Here, Plaintiffs have failed to allege properly that despite the relatively small size of the allegedly misstated transactions, reporting these transactions as loans instead of trades would have made a qualitative difference in JPM C’s financial statements. To be sure, misclassification of assets does matter (as Plaintiffs point out, it has implications for ratio analysis), but the tenor of the SAC is that JPM C knew that the prepays were worthless all along— an argument that is not only implausible, but also counter-intuitive.
Plaintiffs also argue that, had the transactions been reported properly, the “subterfuge that JPM C and Enron created” would have been exposed, leading to the public becoming aware of JPM C’s involvement with Enron’s misdeeds. See SAC ¶¶ 249, 254. As set forth in the complaint, this allegation is w holly
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conclusory. W hile Plaintiffs make the assertion that the proper accounting would have revealed JPM C’s collusion with Enron, that hardly suggests how the whole arrangement with Enron would have come to light. 9 And, given that assets in either category carry some default risk, we cannot reasonably infer that there was a substantial likelihood that JPM C’s reporting of the transactions as loans rather than as trades would have been viewed by a reasonable investor as having significantly altered the total mix of information made available.
B. JPM C’s Statements Regarding Its Integrity and Risk M anagement Plaintiffs allege that JPM C made numerous misrepresentations regarding its “highly disciplined” risk management and its standard-setting reputation for integrity. SAC ¶ 3 (internal quotation marks omitted). Plaintiffs point to statements such as the assertion that JPM C had “‘risk management processes [that] are highly disciplined and designed to preserve the integrity of the risk management process,’” id.; that it “‘set the standard’ for ‘integrity,’” id.; and that it would “‘continue to reposition and strengthen [its] franchises with a focus on financial discipline,’” id. ¶ 391 (emphasis omitted). See also id. ¶¶ 336, 354, 380, 400, 472, 474, 479, 481. These statements, according to Plaintiffs, were misleading because JPM C’s poor financial discipline led to liability in the
9 W e also note that JPM C did in fact make at least some minimal disclosure regarding the nature of the trades. JPM C’s Annual Report stated, “Loans held for trading purposes are included in Trading Assets and are carried at fair value, with the gains and losses included in Trading Revenue.” J. App. 414. So even if JPM C did not conform to GAAP, it did provide some notice to investors that its trading assets contained loans.
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W orldCom litigation and involvement in the Enron scandal. Id. at ¶¶ 188-240, 636-39. Furthermore, Plaintiffs argue that the statements were material because they related to the integrity and risk-management practices of an investment bank. According to Plaintiffs, the significance of a bank’s reputation is undeniable. Therefore, because the misleading statements at issue related to the bank’s reputation, Plaintiffs conclude that the statements would necessarily be relied upon by a reasonable investor and qualify per se as material.
The statements highlighted by Plaintiffs are no more than “puffery” which does not give rise to securities violations. See Lasker v. N.Y. State Elec. & Gas Corp., 85 F.3d 55, 59 (2d Cir. 1996). The statements are too general to cause a reasonable investor to rely upon them. As in Lasker, these statements did not, and could not, amount to a guarantee that its choices w ould prevent failures in its risk management practices. See id. at 58 (“The Company could not guarantee and did not guarantee . . . that its investment choices w ould yield increased future earnings.” (internal quotation marks omitted)). JPM C’s statements w ere merely generalizations regarding JPM C’s business practices. Such generalizations are “precisely the type of ‘puffery’ that this and other circuits have consistently held to be inactionable.” Lasker, 85 F.3d at 59; see also San Leandro, 75 F.3d at 811 (stating that “such puffery cannot have misled a reasonable investor”).
Plaintiffs conflate the importance of a bank’s reputation for integrity with the materiality of a bank’s statements regarding its reputation. W hile a bank’s reputation is undeniably important, that does not render a particular statement by
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a bank regarding its integrity per se material. In Lasker, it was undisputed that the “financial integrity” of the utility was important to its investors; but we still found that the “broad, general” statements regarding the utility’s financial integrity could not reasonably be relied upon as a guarantee that the company’s “actions would in no way impact [its] finances.” Lasker, 85 F.3d at 59 (internal quotation marks omitted). Here also, JPM C’s statement that it “‘set the standard for best practices in risk management techniques,’” SAC ¶ 336,— like its other similar statements— is so general that a reasonable investor would not depend on it as a guarantee that JPM C would never take a step that might adversely affect its reputation. No investor would take such statements seriously in assessing a potential investment, for the simple fact that almost every investment bank makes these statements. See Lasker, 85 F.3d at 58. Finding that JPM C’s statements constitute a material misrepresentation would bring within the sweep of federal securities laws many routine representations made by investment institutions. W e decline to broaden the scope of securities laws in that manner.
C. Plaintiffs’ Other Claims Because we have concluded that Plaintiffs failed to allege any misstatements or omissions by JPM C that could be found to be material, Plaintiffs’ claims under section 14(a) of the Exchange Act and section 11 of the Securities Act must also fail. See Koppel v. 4987 Corp., 167 F.3d 125, 131-32 (2d Cir. 1999) (section 14(a) claim); M cM ahan & Co. v. W herehouse Entm’t,
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Inc., 65 F.3d 1044, 1047-48 (2d Cir. 1995) (section 11 claim). M oreover, having found that Plaintiffs failed to state a claim under sections 10(b) and 14(a) of the Exchange Act and section 11 of the Securities Act, their control person liability claim pursuant to section 15 of the Securities Act and section 20 of the Exchange Act must also fail for w ant of a primary violation. See SEC v. First Jersey Sec., Inc., 101 F.3d 1450, 1472 (2d Cir. 1996) (“In order to establish a prima facie case of controlling-person liability, a plaintiff must show a primary violation by the controlled person.”); DeM arco v. Edens, 390 F.2d 836, 841 (2d Cir. 1968). III. Conclusion Because Plaintiffs have failed to adequately plead that JPM C made a materially false statement or omitted a material fact with scienter, the district court correctly held that Plaintiffs’ SAC cannot survive JPM C’s Fed. R. Civ. P. 12(b)(6) motion to dismiss.
A FFIR ME D.