Ezra Charitable Tr. v. Tyco

2005 DNH 124

• Court: District Court, D. New Hampshire
• Decided: September 2, 2005
• Docket: MD-02-1335-PB
• Status: Published

Opinion

Ezra Charitable Tr. v . Tyco MD-02-1335-PB 9/2/05

UNITED STATES DISTRICT COURT FOR THE DISTRICT OF NEW HAMPSHIRE

Ezra Charitable Trust, et a l .

MDL No. 02-MDL-1335-PB v. Civil No. 03-CV-1355-PB Opinion No. 2005 DNH 124 Tyco International, Ltd., et a l .

MEMORANDUM AND ORDER

Ezra Charitable Trust (“Ezra”), Mirror Management, Ltd.

(“Mirror Management”), and Robert Bovit have filed an amended

class action complaint against Tyco International, Ltd. (“Tyco”),

its Chairman and Chief Executive Officer, Edward D. Breen, its

Executive Vice President and Chief Financial Officer, David J.

FitzPatrick, and the accounting firm PricewaterhouseCoopers, LLP

(“PwC”). Plaintiffs claim that statements regarding Tyco’s

financial status made by the defendants in late December 2002

violated Sections 10(b) and 20(a) of the Securities and Exchange

Act of 1934 (“Exchange Act”), 15 U.S.C. §§ 78j(b) and 78t(a).

Defendants have moved to dismiss these claims (Doc. Nos. 419 and

4 2 5 ) , arguing, among other things, that plaintiffs have failed to allege facts sufficient to raise a “strong inference” of

scienter. See 15 U.S.C. § 78u-4(b).

I. BACKGROUND

Tyco has been the subject of numerous lawsuits alleging

securities fraud against the company and its former officers,

directors, and auditors arising out of events that occurred

between 1997 and 2002. See, e.g., In re Tyco Int’l Ltd. Sec.

Litig., 2004 WL 2348315 (D.N.H. Oct. 1 4 , 2004) (“Tyco I I ” ) . This

action differs from the others in that it involves a later class

period and targets Tyco’s current CEO and CFO, Breen and

FitzPatrick, rather than the former officers and directors who

allegedly looted the company and oversaw the accounting fraud

schemes that began the cascade of lawsuits.

By the time Breen and FitzPatrick were hired in July and

September 2002, revelations of corporate mismanagement had

imperiled Tyco, making bankruptcy a possibility if the company

failed to pay off $3.855 billion in debt that would become due in

February 2003. Am. Compl. ¶ 5 . To generate the capital

necessary to refinance the debt, Tyco needed to assure the

-2- investing public that it had corrected all of its accounting and

financial statement problems from the past. Id. ¶¶ 5 , 1 0 . It

therefore subjected itself to an extensive investigation of its

past accounting and corporate governance practices. Id. ¶ 3 2 .

The results of this investigation, which was the product of

15,000 lawyer hours and nearly 50,000 accountant hours, were

announced in a Form 8-K and a Form 10-K, both of which were

disclosed to the public on December 3 0 , 2002. Id. ¶ 3 3 .

Plaintiffs allege that these filings contained material

misstatements which, when revealed, caused investors to suffer

significant losses.

According to plaintiffs, the primary set of misstatements

were contained in the Form 8-K. In addition to identifying

various other faulty accounting practices, the Form 8-K explained

that Tyco had improperly recognized as income fees that one of

its major division, ADT, had charged authorized dealers in the

course of purchasing their customer contracts. Id. ¶ 3 6 .

To correct these accounting misstatements, Tyco pledged that it

would reduce its “reported pre-tax earnings during the fiscal

year 2002 by $135 million” and “take a charge of $185.9 million

-3- in fiscal year 2002 representing the amount of revenue

effectively recognized in the fiscal years 1999 to 2001 that

should have been deferred and amortized over the estimated useful

life of the account.” Id. ¶ 3 9 . The Form 10-K made similar

disclosures regarding Tyco’s past accounting practices, and

further specified that the amortization of improperly recognized

income would take place over a ten-year period. Id. ¶ 4 1 .

In addition to these disclosures, the Forms also contained

statements about Tyco’s status in the wake of the investigation.

The Form 8-K stated that Tyco was “not aware of any systemic or

significant fraud related to the Company’s financial statements

or any clear accounting errors that would materially adversely

affect the Company’s reported earnings or cash flow from

operations for the year 2003 and thereafter.” Id. ¶ 3 3 .

PwC, which served as Tyco’s accountant and one of its

consultants, performed an audit of Tyco’s disclosures and

included its endorsement of the Form 10-K as an addendum to the

filing. Id. ¶ 5 5 . PwC’s endorsement stated that:

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of shareholders’ equity and of cash flows present fairly, in all material respects, the financial

-4- position of Tyco International Ltd. and its subsidiaries at September 30, 2002 and 2001, and the results of their operations and cash flows for each of the three years in the period ended September 3 0 , 2002, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the accompanying financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conduct our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

Id. (emphasis in original).

The market reacted favorably to this news and on December

3 1 , 2002, Tyco’s stock price rose from $15.17 per share to a

closing price of $17.08 per share. Id. ¶ 1 0 . Starting on that

day, Tyco was also able to raise $4.375 billion from bond sales

that it then used to repay $3.855 billion in debt. Id.

-5- -6- Tyco’s fortunes changed, however, on March 1 2 , 2003, when it

issued a press release disclosing the fact that it expected to

announce additional “non-cash pre-tax charges that are estimated

to be between $265 million and $325 million for issues identified

primarily in its Fire & Security Services business [ADT].” Id.

¶ 4 6 . Tyco attributed these additional charges to the fact that

it had concluded, as the product of on-going discussions with the

SEC, that the income from the acquisition of customer contracts,

income that it once believed it could include as amortized income

over the course of a ten-year period, could not be considered

income at all, whether amortized or not. Id. ¶ 4 7 . That day,

Tyco’s stock price fell from $14.03 per share to $12.29 per

share. Id. ¶ 1 2 .

Plaintiffs filed suit alleging securities fraud. The

defendants now challenge the sufficiency of plaintiffs’ amended

complaint. I consider their challenge below.

II. STANDARD OF REVIEW

A Rule 12(b)(6) motion to dismiss argues either that the

complaint fails to describe the claims for relief in sufficient

-7- detail, or that the claims are deficient even if they are pleaded

with the requisite specificity. The degree of detail that a

complaint must contain to survive a Rule 12(b)(6) challenge

depends upon the nature of the claims under review. In most

cases, a plaintiff is required to provide only “a short and plain

statement of the claim showing that the pleader is entitled to

relief.” Fed. R. Civ. P. 8(a)(2).

The Private Securities Litigation Reform Act (“PSLRA”)

establishes specific pleading requirements for fraud claims based

on the Exchange Act. See In re Stone & Webster, Inc.,Sec.

Litig., 414 F.3d 1 8 7 , 191 (1st Cir. 2005). Complaints alleging

such claims must “specify each statement alleged to have been

misleading, the reason or reasons why the statement is

misleading, and, 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.” 15 U.S.C. § 78u-4(b)(1). In addition, the PSLRA

requires that a securities fraud complaint plead facts that are

sufficient to give rise to a “strong inference” of scienter. 15

U.S.C. § 78u-4(b)(2). The First Circuit has interpreted this

provision to demand “a recitation of facts supporting a ‘highly

-8- likely’ inference that the defendant acted with the required

state of mind.” Stone & Webster, 414 F.3d at 195 (citing

Aldridge v . A.T. Cross Corp., 284 F.3d 7 2 , 82 (1st Cir. 2002)).

III. DISCUSSION

A. Claims against Tyco, Breen and FitzPatrick

Defendants argue that plaintiffs have failed to recite

sufficient facts in their complaint to support a “highly likely

inference” that Tyco, Breen and FitzPatrick acted with the

requisite scienter. In a § 10(b) action, the requisite scienter

is “a mental state embracing intent to deceive, manipulate, or

defraud.” In re Cabletron Sys., Inc., 311 F.3d 1 1 , 38 (1st Cir.

2002), quoting Ernst & Ernst v . Hochfelder, 425 U.S. 185, 193

n.12 (1976). In determining whether a given defendant acted with

this mental state, the First Circuit has rejected any rigid

formula in favor of a “fact-specific approach.” Id. (citations

omitted).

Plaintiffs’ claims rest on allegations that both Breen and

FitzPatrick knew that the Forms 8-K and 10-K contained material

misstatements and yet released those forms anyway. They rely

-9- most heavily on two sets of alleged misstatements. The first are

those that relate to Tyco’s attempt in the December 3 0 , 2002 Form

8-K and Form 10-K to correct earlier misstatements concerning the

recognition of income resulting from the acquisition of customer

contracts by its ADT division. The second are those claiming

that Tyco no longer suffered from the kind of systemic accounting

problems that could negatively impact its financial standing from

2003 onward.

Plaintiffs support their claim that the Tyco defendants

acted with scienter primarily by asserting that Breen and

FitzPatrick had “motive and opportunity” to deceive the investing

public. According to plaintiffs, Breen and FitzPatrick had a

motive to make the misstatements because they both stood to

receive substantial salaries, bonuses, stock options, and other

employee benefits so long as Tyco remained solvent. In addition

to a $1.5 million salary and a $1.5 million guaranteed bonus for

2003, Breen stood to receive, among other things, a total of 7.35

million stock options at an exercise price of $10 per share, and

one million deferred stock units, all of which would vest within

five years. Am. Compl. ¶ 2 0 . Similarly, in addition to a

$750,000 base salary, FitzPatrick stood to receive 1.65 million

-10- stock options at an exercise price of $16.24 per share, and

200,000 deferred share units, all of which would vest within

three years. Id. ¶ 2 1 . Combined with the additional fact that

defendants made a massive re-restatement in March 2003, only two

months after the December 3 0 , 2002 disclosure, plaintiffs argue

that this evidence is sufficient to raise a “strong inference” of

scienter. I disagree.

As an initial matter, the First Circuit has stated that

“catch-all allegations” based on general assertions of financial

motive and opportunity, without something more, ordinarily will

not satisfy the PSLRA. Cabletron, 311 F.3d at 39 (citing Greebel

v . FTP Software, Inc., 194 F.3d 185, 197 (1st Cir. 1999); Fla.

State Bd. of Admin. v . Green Tree Fin. Corp., 270 F.3d 645, 660

(8th Cir. 2001)); Geffon v . Micrion Corp., 249 F.3d 2 9 , 36 (1st

Cir. 2001) (stating that “[a]t the pleading stage, an allegation

that defendants had the motive and opportunity to make false or

misleading statements is insufficient to support the ‘strong

inference’ of scienter required after the PSLRA”) (citation

omtited). Plaintiffs’ allegations rest primarily on “catch-all

allegations” that Breen’s and FitzPatrick’s personal and

-11- professional fortunes were personally tied to the fortunes of

Tyco and that they therefore had the motive to commit fraud.

These types of claims have been rejected by prior courts, and I

see no reason to depart from their sound reasoning. See, e.g.,

In re Eaton Vance Corp. Sec. Litig., 206 F. Supp. 2d 1 4 2 , 154 (D.

Mass. 2002) (rejecting a securities fraud claim on the ground

that “plaintiffs make general allegations about the defendants’

presumed knowledge about market conditions based on their

positions and motive based on general financial incentives”

alone).

What plaintiffs are left with is a claim that Breen and

FitzPatrick must have known about Tyco’s misstatements in

December 2002, because that information became available in March

2003. This type of claim, referred to by other courts as a

“fraud by hindsight” claim, has been deemed insufficient to meet

the PSLRA’s heightened pleading standards. C f . Carney v .

Cambridge Tech. Partners, Inc., 135 F. Supp. 2d 235, 252 (D.

Mass. 2001) (rejecting the claim that defendants “‘must have

known’ that [a] business was declining, because, viewed in

hindsight, that business in fact was declining”). Again, I see

-12- no reason to depart from this reasoning. I thus hold that

plaintiffs’ claims with respect to Tyco, Breen and FitzPatrick

have not met the standards set forth in the PLSRA.1 These claims

are therefore dismissed.2

B. Claims against PwC

The basis for plaintiffs’ suit against PwC is that PwC

reported in the December 2 0 , 2002 Form 10-K that it had evaluated

the results of the independent investigation of Tyco’s financial

status and concluded that the audit was sound. This, plaintiffs

argue, was a material and fraudulent misstatement.

1 Other than to argue that Breen’s and FitzPatrick’s scienter may be attributed to Tyco, see Tyco I I , 2004 WL 2348315, at * 1 2 , plaintiffs make no independent claims regarding Tyco’s scienter. Their claims against Tyco therefore also fail to meet the PSLRA’s heightened scienter pleading requirement. 2 Plaintiffs also charge that the individual defendants violated § 20(a) of the Exchange Act. Section 20(a) imposes derivative liability on defendants who “control” the primary violators of securities laws. See 15 U.S.C. § 78t(a). A necessary element of a control-person claim under § 20(a) is a primary violation of the securities laws. See, e.g., Greebel, 194 F.3d at 207; Suna v . Bailey Corp., 107 F.3d 6 4 , 72 (1st Cir. 1997). Plaintiffs’ § 20(a) claim depends in its entirety on the existence of an underlying violation of § 10(b). Because plaintiffs’ § 10(b) claim is dismissed, so too is their § 20(a) claim.

-13- Plaintiffs’ scienter argument rests on the assertion that

PwC should have more carefully reviewed Tyco’s financials, and

that its failure to do so constitutes a form of “extreme

recklessness” sufficient to support a viable claim for securities

fraud. See Cabletron, 311 F.3d at 38 (citing Greebel, 194 F.3d

at 196-97, 98-99, for the propositions that “[s]cienter may be

demonstrated by indirect evidence” and “may extend to a form of

extreme recklessness that ‘is closer to a lesser form of

intent’”).

As evidence of scienter, plaintiffs note that (1) PwC draws

a large amount of revenue from Tyco for its accounting and

consulting services; (2) the engagement partner in charge of the

Tyco account at PwC, Richard Scalzo, was found by the SEC to be

“reckless” in his handling of Tyco’s account from 1997-2002; (3)

PwC’s prior experiences with ADT should have placed it on

heightened notice that ADT’s accounting problems likely

persisted, see, e.g., Tyco I I , 2004 WL 2348315, at *13 (stating

the factual basis upon which claims against PwC for malfeasance

that occurred between 1997 and 2002 survived motions to dismiss);

(4) PwC itself had engaged in questionable accounting practices

-14- with respect to Tyco in the past, id.; and (5) PwC’s audit was

inconsistent with various Generally Accepted Accounting

Principles and Standards.

The problem with plaintiffs’ position, however, is that it

lacks a clear factual basis. Plaintiffs rely primarily on claims

about PwC’s behavior with respect to Tyco’s past accounting

malfeasance. Plaintiffs cite no cases, however, suggesting that

a strong inference of scienter as to one set of transactions is

warranted by on assertions that the targeted defendant acted

improperly with respect to matters that are unrelated to the

claims at issue. Nor have plaintiffs provided a convincing

argument that PwC’s financial stake in maintaining its business

relationship with Tyco is sufficient by itself to raise a “highly

likely” inference that it acted with “extreme recklessness.”

To the degree that plaintiffs’ claims rely on the SEC’s

ruling with respect to Scalzo, plaintiffs fail to plead with

particularity the details of the SEC’s findings, making it

impossible to determine whether the decision pertained to the

accounting failures at issue in this case or to other behavior.

In their totality, then, plaintiffs’ assertions are too vague to

-15- give rise to a “highly likely” inference of scienter.

Plaintiffs’ claims against PwC must therefore also be dismissed.

III. CONCLUSION

Defendants’ motions to dismiss are granted (Doc. Nos. 419

and 4 2 5 ) . The clerk is instructed to enter judgment accordingly.

SO ORDERED.

/s/Paul Barbadoro Paul Barbadoro United States District Judge

September 2 , 2005

cc: Counsel of Record

-16-