PETER A. BINKOW #173848 ROBERT ZABB #114405 …securities.stanford.edu/filings-documents/1035/MERQE05_01/200718_r... · Master File No. 5:05-cv-3395 ... For HARRY LAX, plaintiff:

Master File No. 5:05-cv-3395 APPENDIX OF UNPUBLISHED AUTHORITIES IN SUPPORT OF LEAD PLAINTIFF’S OPPOSITION TO THE MOTION TO DISMISS OF PRICEWATERHOUSECOOPERS

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PETER A. BINKOW #173848 ROBERT ZABB #114405 MARC L. GODINO#182689 ANDY SOHRN #241388 GLANCY BINKOW & GOLDBERG LLP 1801 Avenue of the Stars, Suite 311 Los Angeles, California 90067 Telephone: (310) 201-9150 Facsimile: (310) 201-9160 Email: [email protected] JOEL H. BERNSTEIN (admitted pro hac vice) LOUIS GOTTLIEB (admitted pro hac vice) CHRISTOPHER J. KELLER (admitted pro hac vice) ALLAN I. ELLMAN (admitted pro hac vice) LABATON SUCHAROW & RUDOFF LLP 100 Park Avenue New York, New York 10017 Telephone: (212) 907-0700 Facsimile: (212) 818-0477 Email: [email protected] Attorneys for the Mercury Pension Fund Group

UNITED STATES DISTRICT COURT

NORTHERN DISTRICT OF CALIFORNIA

SAN JOSE DIVISION

IN RE MERCURY INTERACTIVE CORP. SECURITIES LITIGATION This Document Relates To: All Actions

) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) )

Master File No.: 5:05-CV-3395 (Consolidated with 3:05-cv-3864; 3:05-cv-4031; and 3:05-cv-4036) APPENDIX OF UNPUBLISHED AUTHORITIES IN SUPPORT OF LEAD PLAINTIFF’S OPPOSITION TO THE MOTION TO DISMISS OF PRICEWATERHOUSECOOPERS Honorable Jeremy Fogel Hearing Date: March 30, 2007 Time: 9:00am Dept: Courtroom 3 Judge: Honorable Jeremy Fogel

Case 5:05-cv-03395-JF Document 197 Filed 01/08/2007 Page 1 of 2

Master File No. 5:05-cv-3395 APPENDIX OF UNPUBLISHED AUTHORITIES IN SUPPORT OF LEAD PLAINTIFF’S OPPOSITION TO THE MOTION TO DISMISS OF PRICEWATERHOUSECOOPERS

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CASES

Tab In re First Merchants Acceptance Corp. Sec. Litig.,

No. 97 c 2715, 1998 U.S. Dist. LEXIS 17760 (N.D. Ill. Nov. 2, 1998)................................ 1 In re Fleming Cos. Sec. & Derivative Litig.,

No 5-03-MD-1530, 2004 U.S. Dist. LEXIS 26488 (E.D. Tex. June 10, 2004).................... 2 In re Nextcard, Inc. Sec. Litig., No. C 01-21029, 2006 WL 708663 (N.D. Cal. Mar. 20, 2006)............................................... 3

Case 5:05-cv-03395-JF Document 197 Filed 01/08/2007 Page 2 of 2

TAB 1

Page 1

LEXSEE 1998 US DIST LEXIS 1776 0

CautionAs of: Jan 08, 200 7

IN RE FIRST MERCHANTS ACCEPTANCE CORPORATION SECURITIESLITIGATION ; THIS DOCUMENT RELATES TO : ALL ACTIONS

Master File No. 97 C 2715

UNITED STATES DISTRICT COURT FOR THE NORTHERN DISTRICT OFILLINOIS, EASTERN DIVISION

1998 U.S. Dist. LEXIS 17760

November 2, 1998, DecidedNovember 4, 1998, Docketed

DISPOSITION : [*I] Deloitte's motion to dismissCounts VI and VIII granted and its motion to dismissCounts I, II ; IV, and VII denied . Shockey, Weisgal andWyant's motion to dismiss Counts I-III denied .

JUDGES : David H . Coar, United States District Judge .

OPINION BY: David H. Coar

COUNSEL: For HARRY LAX, plaintiff: Marvin AlanMiller, Kenneth A . Wexler, Jennifer Winter Sprengel,Miller, Faucher, Cafferty and Wexler, L .L .P ., Chicago,IL .

For HARRY LAX, plaintiff: Mark C. Gardy, Stephen J .Fearon, Jr ., Abbey, Gardy & Squitieri , LLP, Robert P .Sugarman, Steven G Schulman, Samuel H Rudman,Aaron W. Tandy, Milberg , Weiss, Bershad, Hynes &Lerach LLP, New York, NY .

For MI'T'CHELL KAHN, defendant : Ronald DavidMenaker, James J . Moylan, David L . Strauss, Arnstein &Lehr, Chicago, IL.

For PAUL VAN E YL, defendant : Robert Montell Ste-phenson , Terence H. Campbell, Cotsirilos , Stephenson,Tighe & Streicker, Chicago, IL .

For STOWE W WYANT, MARCY H SHOCKEY,SOLOMON A WEISGAL, defendants : Jay A . Canel,Peter M. King, William H . Jones, Leslie Ford Notaro,Cane], Davis & King , Chicago, 11 .

For DELOITTE AND TOUCHE, L .L .P ., defendant : Wil-liam F . Lloyd, Sidley & Austin, Chicago, IL .

OPINION :

MEMORANDUM OPINION AND [*2]ORDE R

This is a consolidated securities action on behalf ofall purchasers of the publicly traded securities of FirstMerchants Acceptance Corporation ("First Merchants"),seeking remedies under the Securities Act of 1993 (the"Securities Act"), the Securities Exchange Act of 1934(the "Exchange Act") and Illinois state law . Before thiscourt are defendant Deloitte & Touche LLP's (" Deloitte)and defendants Marcy Shockey, Solomon Weisgal andStowe Wyant's (collectively , the "Audit Comm ittee De-fendants ") motions to dismiss the First Amended Con .-solidated Class Action Complaint ("first amended com-plaint" or "complaint ") . Deloitte seeks dismissal of allthe claims against it including alleged violations of Sec-tion 11 of the Securities Act . 15 U.S. C. § 77k (Counts Iand 1I) ; alleged violations of Section 10(b) of the Ex-change Act and Rule lOb-5 of the SEC (Count IV) ;common law fraud (Count VI) ; the Illinois ConsumerFraud and Deceptive Business Practices Act (Count VII) ;and negligent misrepresentation (Count VIII) . The AuditCommittee defendants seek to dismiss the claims againstthem under Section I I of the Securities Act (Counts Iand 11) and Section 15 of the Securities Act, [*3] 15U.S.C. § 77o (Count IIl) . For the reasons set forth be-

1998 U .S . Dist . LEXIS 17760, *

low, Deloitte's motion is GRANTED in part and

DENIED in part and the Audit Committee Defendants'motion is DENIED .

1 . Motion to Dismiss Standar d

A motion to dismiss pursuant to Rule 12(b)(6) of theFederal Rules of Civil Procedure does not test whetherthe plaintiff will prevail on the merits , but insteadwhether the plaintiff has properly stated a claim forwhich relief may be granted . Pickrel v. City of Spring-field, Ill., 45 F.3d 1115 (7th Cir. 1995) . A plaintiff failsto state a claim upon which relief may be granted only if"it appears beyond doubt that plaintiff can prove no setof facts in support of his claim which would entitle himto relief." Leahy v. Board of Trustees of Community Col-lege Dist. No. 508, 912 F.2d 917, 921 (7th Cir. 1990)(quoting Conley v. Gibson, 355 US. 41, 44-45, 78 S. Ct.99, 2 L. Ed. 2d 80 (1957)). For purposes of this motion,the court must take all of the well -pleaded factual allega-tions in the First Amended Complaint as true, and con-strue them in the light most favorable to the plaintiffs .Richmond v. Nationwide Cassel, L.P., 52 F. 3d 640, 644(7th Cir . 1995) . In accordance [*4] with this principle,the factual Background which follows assumes the fac-tual accuracy of the allegations in the First AmendedComplaint , without using qualifying terms such as "al-legedly," but should not be understood as representingfactual findings by this court . See Fugman v. Aprogenex,Inc., 961 F. Supp. 1190, 1191 ( .D. Ill. 1997) (Aspen,J .) .

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chants filed a bankruptcy petition revealing that .its networth had in fact been overstated . by approximately $ 90million . (P 7 .)

Deloitte was First Merchants' auditor and certifiedits financial statements throughout the class period . (P 5 .)Each of the Audit Committee defendants were directorsand members of the Audit Committee, and defendantWeisgal was the Chairperson of the Audit Committee .(PP 18-21 .) Plaintiffs allege that throughout the classperiod, First Merchants, through the individual defen-dants including the Audit Committee defendants, issuedfalse and misleading financial statements and press re-leases which grossly inflated First Merchants' incomeand assets by failing to recognize huge uncollectible loancosts as required by Generally Accepted Accounting [*6]Principles ("GAAP"), and by representing that First Mer-chants followed "conservative" accounting practices . (P3 .)

Plaintiffs allege several false and misleading state-ments made by the individual defendants, including theAudit Committee defendants, and certified by Deloitte .Specifically, plaintiffs allege that each 10-K form filedwith the SEC during the class period misrepresented thatthe financial statements had "been prepared in confor-mity with generally accepted. accounting principles andreporting practices," and misrepresented that Deloitte hadaudited First Merchants' annual financial statements "inaccordance with generally accepted auditing standards"("GAAS") . (PP 29, 30 .) n l

II . Backgroun d

First Merchants is a specialty finance company inthe business of buying and servicing sub-prime automo-bile loans . The finance contracts purchased by First Mer-chants were primarily in the credit market for high riskor "sub-prime" borrowers, This market includes borrow-ers trying to establish their credit, previously bankruptborrowers trying the re-establish their credit as well asborrowers who desire longer payment terms . (First Am,Cplt . P 2, hereinafter, "P " .) Plaintiffs include purchas-ers of First Merchants stock and subordinated reset notesin both public offerings and in the aftermarket from Sep-tember 23, 1994 through April 16, 1997 (the "class pe-riod") . (P 1, 12 .)

During the class period, First Merchants followed anaggressive growth policy, taking on longer term, higherrisk contracts, without [* 5] a corresponding increase inits allowance for credit losses . (E.g . PP 43, 61, 64, 67 .)On April 16 and 17, 1997, First Merchants announcedthat reported net income in its financial statements wasoverstated by approximately $ 28 million . (P 6.) As aresult of the Company's announcement, the market priceof First Merchants' common stock and reset notes de-clined significantly. (Id .) On July 11, 1997, First Mer-

nI While plaintiffs have alleged a number ofadditional misrepresentations contained in pressreleases, 10-Q Forms and Annual Reports, thisstatement of facts refers only to alleged misrepre-sentations by Deloitte or the Audit Committee de-fendants .

The 1994 Registration Statemen t

On September 23, 1994, First Merchants [*7] fileda stock registration statement with the SEC for an initialpublic offering of 1,460,000 shares of common stock .The 1994 Stock Registration Statement was signed byAudit Committee defendants Shockey and Wyant,among others . (P 32.) The 1994 Stock RegistrationStatement and prospectus contained First Merchants'financial statements certified by Deloitte for the yearsending May 31, 1992, 1993 and 1994 . (P33 .) The 1994Stock Registration Statement and the prospectus falselyrepresented First Merchants' procedure regarding repos-session of collateral, causing inflation of reported earn-

1998 U . S. Dist . LEX1S 17760, *

ings . (P 35.) In addition, the 1994 Registration Statementand the financial statements incorporated therein falselyunderstated the allowance for bad debts by disregardingthe fact that higher risk loans were being purchased lead-ing to increased rates of defaults , and by violating theCompany's charge -off policy through extensions of timefor payment for delinquent accounts . (P 36.) The 1994Registration Statement and financial statements alsofalsely stated that the financial statements were preparedin accordance with GAAP and that Deloi tt e's audit wasprepared in accordance with GAAS . (P [*8] . )

The 1995 Note Registration Statement , 1995 10-K and1995 Secondary Offering Registration Statemen t

On February 7, 1995, First Merchants fi led anamended Registration Statement for the sale of subordi-nated reset notes (the "1995 Note Registration State-ment" ) . The 1995 Note Registration Statement wassigned by Audit Committee defendants Shockey, Weis-gal and Wyant, among others . (P 40.) Attached to the1995 Note Registration Statement were the same falseand misleading financial statements as attached to the1994 Registration Statement. (P 41 . )

On August 29, 1995, First Merchants filed with theSEC a Form 10-K for the year ending May 31, 1995 .Audit Committee defendants Shockey, Weisgal and Wy-ant signed the 1995 10-K. (P 47.) The 1995 10-K con-tained an Auditors' Report signed by Deloitte stating thatit had audited the Company's financial statements as ofMay 31, 1994 and 1995 . (P 51 .) The 1995 10-K and at-tached financial statements falsely overstated net earn-ings and understated the loan loss allowance and failed tofollow First Merchants' procedures for establishing loanlosses and repossessing collateral . The financial state-ments and Auditors' Report also falsely [*9] stated thatthe financial statements were prepared in accordancewith GAAP and the audit conducted in accordance withGARS . (PP 50-51 .)

On October 2, 1995, First Merchants filed with theSEC an amended Registration Statement for a secondaryoffering of common stock ("Secondary Offering Regis-tration Statement") . (P 54 .) The Secondary Offering Reg-istration Statement was signed by all of the Audit Com-mittee defendants, among others . (Id .) The audited finan-cial statements contained in the Secondary Offering Reg-istration Statement and prospectus for the period endedMay 31, 1995, were the same false and misleading finan-cial statements filed with the 1995 10-K. (P 55,) The1995 stock prospectus also contained the false and mis-leading auditor's report filed with the 1995 10-K . (P 59 .)

The Second 1995 10-K, 1996 Note RegistrationStatement and 1996 10-K

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On April 1, 1996, First Merchants filed a Form 10-Kfor the fiscal year ended December 31, 1995 (the "Sec-ond 1995 10-K") . n2 The Second 1995.10-K and thefinancial statements attached thereto misrepresented FirstMerchants' true earnings by understating the allowancefor loan losses and by failing to follow published proce-dures [*10] for repossession of collateral and to makeappropriate adjustments to the allowance for creditlosses. (P 64.) The Second 1995 10-K also contained anAuditors' Report signed by Deloitte falsely stating thatthe financial statements were prepared in accordancewith GAAP and that its audit was conducted in accor-dance with GAAS . (P 65 . )

n2 In December 1995, the Company an-nounced that it was changing from a May 31year-end to a December 31 year-end, which. iswhy it filed two Form 10-Ks for 1995 . (P 60 .)

On October 29, 1996, First Merchants filed with theSEC a Registration Statement for a sale of 9 .5% subordi-nated reset notes ("1996 Note Registration Statement"),signed by the Audit Committee defendants, among oth-ers . (P 75.) The 1996 Note Registration Statement andprospectus contained financial statements audited byDeloitte for the two-year period ended December 3 1,1995 (May 31, 1994, May 31, 1995 and December 31,1995), and an auditors' report falsely stating that the fi-nancial statements were prepared in accordance [*IIIwith GAAP and that its audit was conducted in accor-dance with GAAS . (P 76, 78 .) The financial statementscontained the same false and misleading statements asthose filed with the two 1995 10-Ks . (Id .) The 1996 NoteRegistration Statement was further false and misleadingbecause, at the time of the 1996 Note Offering, FirstMerchants was technically insolvent -- the cash availableto operate its business was less than S 2 million and theCompany's finance receivables and its principal assetswere under-reserved and overvalued by approximately $28 million . (P 79 .)

On February 4, 1997, Deloitte furnished a letter tothe Audit Committee reflecting "reportable conditions" atFirst Merchants " relating to significant deficiencies inthe design or operation of the internal control structurethat . . . could adversely affect the Company's ability torecord, process, summarize and report financial data con-sistent with the asse rt ions of management in the financialstatements ." (P 82.) Despite this recognition and itswarning to the Company, Deloitte nonetheless ce rt i fi edthe 1996 financial statements and Form 10-K filed withthe SEC on March 28 , 1997 (the "1996 10-K") . The 199610-K also ['12] contained an auditor 's report signed byDeloitte falsely stating that the financial statements were

1998 U .S . Dist . LEXIS 17760 ,

prepared in accordance with GAAP and the audit wasconducted in accordance with GAAS . (P 86.) In fact, lessthan a month after the 1996 10-K was filed, the Com-pany's newly hired Chief Financial Officer, NormanSmagley ("Srnagley"), began to raise questions about theveracity of the financial statements certified by Deloitte,forcing a public announcement that the 1996 financialstatements overstated income by at least $ 3 .5 million . (P6.) A few months later, it was revealed that First Mer-chants' net worth was in fact overstated by approximately$ 90 million . (P 7 . )

GAA1 and GAAS Violation s

Plaintiffs allege that First Merchants' accountingpractices violated several accounting principles and pro-visions of GAAP, including :

(a) The principle that "[a] finance com-pany should maintain a reasonable allow-ance for credit losses applicable to allcategories of receivables through periodiccharges to operating expenses " (AmericanInstitute of Certi fied Public Accountants("AICPA") Audit and Accounting Guide,Audits of Finance Comp anies P 2,04) ;

(b) The principle [* 13] that all "estimatedloss[es] from a loss contingency . . . shallbe accrued by a charge to income" (Fi-nancial Accounting Standards Board("FASB") Statement of Standards, Ac-counting for Contingencies, Statement ofFinancial Accounting Standards No . 5, P8) ;

(c) The principle that financial reportingshould provide information that is usefulto present to [sic] potential investors andcreditors and other users in making ra-tional investment , credit and similar deci-sions (FASB Statement of Concepts No.1, P 34) ;

(d) The principle that financial reportingshould provide information about the eco-nomic resources of an enterprise, theclaims to those resources, and the effectsof transactions, events and circumstancesthat change resources and claims to thoseresources (FASB Statement of ConceptsNo. 1, P 40) ;

(e) The principle that financial reportingshould provide information about an en-

terprise's financial performance during aperiod . Investors and creditors often usehistorical financial information to help inassessing the prospects of an enterprise .Thus, although investment and credit de-cisions reflect investors ' expectationsabout future enterprise performance,[*14] those expectations are commonlybased at least part ly on evaluations of pastenterprise performance (FASB Statementof Concepts No. 1, P 42) ;

(f) The principle that financial reportingshould be reliable in that it representswhat it purports to represent (FASBStatement of Concepts No . 2, PP 58-59) ;

(g) The principle of completeness, whichmeans that nothing is left out of the in-formation that may be necessary to ensurethat it validly represents underlying eventsand conditions (FASB Statement of Con-cepts No . 2, P 79); and

(h) The principle that conservatism beused as a prudent reaction to uncertaintyto try to ensure that uncertainties and risksinherent in business situations are ade-quately considered (FASB Statement ofConcepts No . 2, PP 95, 97) .

(P 94 .)

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Deloitte certified that First Merchants' financialstatements were prepared in accordance with the stan-dards set forth above . In doing so, Plaintiffs allege thatDeloitte violated several principles of GAAS . The fol-lowing allegations pertain to the GAAS principles alleg-edly violated :

. GAAS requires that an audit report statewhether a company's financial statementsare presented in conformity [*151 withGAAP,AU§ 110 .01 .(P97 . )

. GAAS requires that an auditor is re-quired to qualify its opinion if there is anydoubt about a company 's ability to pro-ceed as a going concern . AU § § 341 .02,341 .03 . (P 99. )

. GAAS provides that an inabili ty to ob-tain sufficient competent evidential ma tterconstitutes a restriction on the scope of

1998 U.S . Dist . LEXIS 17760, *

the audit which requires and auditor toqualify or disclaim an opinion. AU §508.17 . (P 100 .) (a) The bad debt write-offs for First Mer -

chants' loans rose from $ 7 .6 million in"GAAS requires that an audit be ade- 1995 to $ 26 .6 million in 1996, a 220 per-

quately planned and assistants be properly cent increase. But First Merchants' badsupervised . AU § 150.02 . Audit planning debt reserves increased by only 20 percent

involves developing an overall strategy between 1995 and 1996 .for the conduct and scope of the audit . AU§ 311 .03 . In planning an audit, the audi- (b) Dramatic increases in the rate of de-tor is required to obtain a knowledge of linquencies approaching the 90 day write -the entity's business, its organization and off limit should also have served as a re doperating characteristics (AU § 311 .07) flag to Deloitte . For example, the numberso that the auditor can identify areas that of loans which were unpaid for more tha nneed special attention . AU § 311 .06, The 61 days in 1996 was more that [sic] 50 0auditor must design the audit to provide percent greater than in 1995 . But again ,reasonable assurance of detecting errors the 1996 bad debt reserves were increase dand irregularities (intentional misstate- by only 20 percent .ments) that are material to the financia lstatements . AU § 316 .05 ." (PP 103, 105 .) (c) Similarly, the dollar value of loan s

more than 61 days overdue increased b y"GAAS requires that the efforts of assis- 39 times for year end May 31, 1995 over

tarts be directed and supervised to assure the comparable period in 1994 . Yet thethat [*16] the objectives of the audit are 1995 loan loss reserves were increased b yaccomplished . AU § 311 .10 . GAAS re- only three time over the same period i nquires that the work performed by each the prior year.assistant be reviewed and evaluated to de -termine whether the audit results are con- (d) The dollar value of loans more than 6 1sistent with the conclusions expressed in days overdue increased by 21 time for th ethe auditor's reports . AU § 311 .13 ." (P six months ended November 30, 199 4104 .) over the comparable period in 1993 . Ye t

the November 30, 1994 loan loss reserve s"The auditor must perform procedures to were only 2 .75 times greater than what

obtain a sufficient understanding of three they had been a year earlier .elements of an entity's internal contro lstructure : the control environment, the ac- (e) [* 18] Between May 31 and Decem-counting system, and control procedures . ber 31, 1995, the number of accounts 6 1AU § 319 .02 . The auditor must document days or more overdue rose by over 20 0his understanding of the entity's internal contracts to 257 and between Decembercontrol structure elements in order to plan 31, 1995 and June 30, 1996 the numberthe audit . § 319.26 ." (PP 105-06 .) almost doubled to 494 ; however, this wa s

not reflected by an increase in the re-serves .

Red Flag Allegations

Within a few weeks after his arrival in mid-March (f) During the class period there were sig-1997, Smagley noted errors in the financial statements nificant increases in the term of the notescertified by Deloitte, leading to the Company's April 16 First Merchants was buying . For example

and 17, 1997, disclosures . (P 6.) Plaintiffs allege that the average length of the notes went from

Deloitte, like Smagley, should have seen the "writing on 48 months during 1994 to 55 months as ofthe wall" with respect to First Merchants' improper ac- December 31, 1996 reflecting borrowerscounting practices, and that Deloitte knowingly or reek- less able to repay their loans

. This in-

lessly disregarded its auditing obligations in certifying crease should have been reflected by in-First Merchants' financial statements . (P 96, 102

.) Plain- creases in the loan loss reserves but etas

tiffs [*17] point to several "red flags" Deloitte ignored not.

or recklessly disregarded :

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1998 U .S . Dist . LEXIS 17760, *

(g) The dollar value of loans more than 61days overdue increased enormously dur-ing certain periods without correspondingincreases in the loans over 91 days over-due which had to be charged off. Whilethe delinquencies between 61 and 90 dayswas 21 times greater in the six monthsended November 31 [sic], 1994 than inthe comparable period of 1993, the dollarvalue of loans which the Companycharged off increased less than threetimes. While the dollar value of loansmore than 61 days overdue increased by39 times for year end May 31, 1995 over[*19] the comparable period in 1994, thedollar value of loans which the Companycharged off increased less than nine times .These anomalies should have served asred flags for the Deloitte to carefully re-view First Merchants records to see ifthese numbers were being manipulated tohide loans which actually became morethan 91 days delinquent or, more im-probably, whether there was simply asurge of payments as delinquent loans ap-proached their 91st day of non-payment .

(P 102 . )

111. Analysis

A. Pleading Requirements Under Rule 9(b) andthe Private Securities Litigation Reform Act of 1995(PSLRA).

"Rule 9(b) requires that 'the circumstances constitut-ing fraud . . . be stated with particularity .'' In re Health-care Compare Corp. Securities Litigation, 75 F. 3d 276,281 (7th Cir. 1996) . Thus, a securities fraud plaintiffmust plead "in detail" the facts surrounding fraud, i .e .,"the who, what, when, where, and how : the first para-graph of any newspaper story." Dileo v . Ernst & Young,901 F2d 624, 627 (7th Cir .), cert. denied, 498 U.S. 941,III S. Ct. 347, 112 L. Ed. 2d 312 (1990). "This require-ment has three main purposes : to protect defendants'reputations, to prevent [*20] fishing expeditions, and toprovide adequate notice to defendants of the claimsagainst them ." Fugman v. Aprogenex, Inc., 961 F. Supp .1190, 1195 (ND. Ill. 1997) .

The PSLRA amends the 1934 Act to raise pleadingstandards in securities fraud cases to a more rigorouslevel, such that the complaint must "state with particular-ity facts giving rise to a strong inference that the defen-dant acted with the required . state of mind ." 15 U.S. C. §78u-4(b)(2) . While the PSLRA does not contain a spe-

Page 6

cific scienter requirement for § 10(b) fraud claims, it isgenerally recognized that the appropriate standard foralleging scienter under the PSLRA is the Second Circuitstandard which requires a plaintiff "to allege facts thatgive rise to a strong inference of fraudulent intent ."Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1128(2d Cir . 1994) .

Defendants argue, however , that the PSLRA createda pleading standard even more stringent than that enun-ciated by the Second Circuit and that mere allegations ofrecklessness no longer suffice to plead scienter under §10(b) . Cou rts in this District have uniformly rejected thisargument, holding that recklessness is still su fficient un-der § [*21] 10(b). See Miller v. Material Sciences Cor-poration, 9 F. Supp. 2d 925, 927 (N.D. 111. 1998) (Get-tleman , J .); Fugman v . Aprogenex, Inc., 961 F Supp. at1195; Rehm v . Eagle Finance Corp., 954 F. Supp. 1246,1252 (N.D. Ill. 1997) (Moran, J .) ; see also In re HealthManagement Securities Litigation , 970 F. Supp. 192, 200(E.D.N.Y. 1997) ( finding argument that recklessness nolonger suffices to plead scienter unpersuasive ) . While theSeventh Circuit has yet to address the question ofwhether the PSLRA completely displaced case law re-garding pleading standards in private securities law, thiscourt agrees with the other courts in this District whohave held that the "§ 78u-4(b)(2) adopts the Second Cir-cuit standard but declines to bind cou rts to the SecondCircuit's interpretation of its standard ." Rehm, 954 F.Supp. at 1252 (Moran, J .) ; Fugman, 961 F. Supp. at 1195(citing Rehm) .

B. Section 10(b) and Rule lOb-5 Allegations .

Count IV of the First Amended Complaint allegesthat Deloitte violated § 10(b) of the 1934 Act and Rule10b-5 . "SEC Rule lOb-5, promulgated under Section10(b) of the Securities Exchange Act of 1934, prohibitsthe making of any untrue [*22] statement of materialfact or the omission of a material fact that would renderstatements made misleading in connection with the pur-chase or sale of any security ." 17 C.F.R. § 240.10b-5 .To state a valid Rule lob-5 claim, a plaintiff must allegethat the defendant (1) made a misstatement or omission,(2) of material fact, (3) with scienter, (4) in connectionwith the purchase or sale of securities, (5) upon whichthe plaintiff relied, and (6) that reliance proximatelycaused plaintiffs injuries ." In re Healthcare CompareCorp., 75 F.3d at 280 (citing Stranslcy v . Cummins En-gine Co ., 51 F. 3d 1329 (7th Cir. 1995)) . In this motion todismiss, Deloitte challenges the sufficiency of plaintiffs'misrepresentation and scienter allegations . n 3

n3 Deloitte also argues that because the firstamended complaint is pled on information andbelief, it fails in its entirety or at least fails to al-

1998 U.S. Dist . LEXIS 17760, *

lege fraud with particularity . The court rejectsthis argument . The complaint sets forth detailedallegations of fraud and alleges substantiallymore than " rumor or hunch ." See Bankers TrustCo. v . Old Republic Ins. Co., 959 F.2d 677, 683-84 (7th Cir. 1992) . The fact that Plaintiffs do nothave all of the specific documents to support theirclaims at this time is not fatal to their complaint .STI Classic Fund v. Bollinger Indus ., Inc., 1996U.S. Dist. LEXIS 21553, 1996 WL 885802 at *2(N.D. Tex . 1996) ("the actual contents of thebooks and records and the [defendant' s] knowl-edge thereof are peculiarly within the Movants'knowledge and control , thereby warranting somerelaxation in the application of Rule 9(b)") .

[*231

1 . Misrepresentation s

In challenging the specificity of Plaintiffs' misrepre-sentation allegations, Deloitte primarily contends that the"what," "why" and "how" of the allegations are lacking .Deloitte's challenges are directed at the sufficiency of theGAAP and GAAS allegations . Plaintiffs allege thatDeloitte falsely stated that the financial statements wereprepared in accordance with GAAP and audited in ac-cordance with GAAS . Deloitte asserts that the complaintfails to allege with particularity why its audit reportswere misleading ; what was materially misstated in thefinancial statements ; and how the financial statementsand Deloitte's audit of those statements violated GAAPand GAAS. The court finds that the allegations in thecomplaint contain sufficient detail to satisfy each ofthese elements .

Deloi tte's contention that plaintiffs fail to suffi-ciently allege why each of the audit reports was mislead-ing is unpersuas ive . The complaint expressly alleges thateach of Deloi tt e ' s audit reports filed in conjunction withthe 10-K Forms and Registration Statements was mis-leading because Deloitte 's opinion that the financialstatements were prepared in accordance [*24] withGAAP and audited in accordance with GAAS was false.An outside auditor can be liable for stating its opinion ona company ' s financial statements if that opinion is falseand misleading . Cashman v. Coopers & Lybrand, 877 F.Supp. 425, 431 (N.D. Ill. 1995) (Castillo, J .) (an account-ant "may be held primarily liable for ce rtifying or issuingrepo rts on . . . financial statements if those repo rts con-tain materially misleading statements or omissions" re-lied upon and incorporated into a prospectus ) (citingDiLeo, 901 F .2d at 627) . Further, the complaint suffi-ciently states why the financial statements containedmaterially misleading statements : " the financial state-ments . . . misrepresented First Merchants ' true earn ingsby understating the allowance for loan losses and by fail-

Page 7

ing to follow published procedures for repossession ofcollateral and to make appropriate adjustments to theallowance for credit losses . " (See e .g , P 33, 47, 63, 64 . )

Similarly , the allegations detail what was materiallymisstated in the financial statements -- the Company'strue earnings and net wo rth. Deloitte complains that thefirst amended complaint fails to state the precise amountof [*25] the overstatement of earnings in each of theaudited financial statements ; which loans were not prop-erly wri tten off, and which collateral was not repossessedaccording to proper procedures , etc . The court agreesthat this information is noticeably absent from the com-

plaint and that, in order to prove its allegations , plaintiffswill be required to fill in these details . However, giventhat most of this information is in the hands of defen-dants, the court finds that plaintiffs have satisfied theirburden at this stage of the litigation . See DiVittorio v.Equidyne Extractive Industries, Inc., 822 F.2d 1242,1247 (2nd Cir . 1987) (requirements of Rule 9 (b) are tobe relaxed where the facts are "peculiarly within the ad-verse parties' knowledge") . Indeed, the true amounts ofFirst Merchant' s reserves, income and net worth cannotbe determined without a re-audit of the Company's fi-nancial records -- records in the hands of defendants andobtainable through discovery .

Moreover, several courts have held that a complaintneed not describe each single specific transaction in de-tail nor allege the precise amount of overstatement on aperiod by period basis . See Cooper v . Pickett, 137 [*26]F.3d 616, 627 (9th Cir. 1997) ("it is not fatal to the com-plaint that it does not describe in detail a single specifictransaction ") ; SEC v. Feminella, 947 F. Supp. 722, 733(S.D.N.Y 1996) (" Rule 9 (b) does not require nor makelegitimate the pleading of detailed evidentiary matter")(quotations omi tted); Klein v. King, 1990 U.S. Dist.LEXIS 5392, 1990 WL 61950 at *I I (N .D. Cal . 1990)(holding that plaintiff was not required to plead the pre-cise dollar amount of the overstatement of earnings inorder to state a claim under Rule lOb -5) . In Feminella,the court rejected the defendant ' s argument that the com-plaint failed to satisfy Rule 9 (b) because the SEC had notalleged the dates or amounts of payments, the manner ofpayments or the total value of payments , finding that "theComplaint provides defendant with fair notice of theSEC's claims , enabling him to prepare a reasonable de-fense ." 947 F. Supp. at 733 . The court agrees that Rule9(b) does not require that plaintiffs state the precise dol-lar amount that earnings and net wo rth were overstatedfor each of the financial statements audited and ce rt ifiedby Deloitte . The complaint sufficiently alleges whichportions of the financial statements were [*27] over-stated (net worth and earn ings) and which port ions un-derstated ( loss reserves), such that Deloitte can prepare areasonable defense to the allegations .

1998 U . S . Dist . LEXIS 17760, *

Deloitte finally argues that the misrepresentation al-legations fail to state how the financial statements andaudit reports violated GAAP and GAAS . The GAAP andGAAS allegations are set forth in substantial detail in thecomplaint and in the background portion of the court'sopinion. Deloitte argues that several of the principlescited in the complaint are not GAAP principles . Thisgoes not to the specificity of the allegations, but towhether Plaintiffs can prove a violation of GAAP orGAAS sufficient to satisfy the scienter requirement. Atthis stage, the court finds the specificity of the account-ing principle violations more than sufficient to satisfyRule 9(b) -- the allegations cite the specific principleviolated and how they were violated ,

Finally, the court finds that the policy considerationsbehind requiring specificity for fraud allegations are met-- the complaint plainly contains enough detail to satisfythe court that this is not a fishing expedition and to pro-vide Deloitte with copious notice of the allegations [*28]against it . Moreover, the allegations in the complaint arenot akin to a "smear campaign" damaging Deloitte'sreputation without sufficient facts to back up the allega-tions . The court accordingly finds sufficient detail in theallegations to conclude that Plaintiffs have pled misrep-resentation with particularity .

2 . Scienter

"Only persons who act with an intent to deceive ormanipulate Rule 10b -5" may be found liable under RulelOb-5 . Securities and Exchange Commission v. Jaku-bowski, 150 F.3d 675, 681 (7th Cir. 1998) . "Recklessdisregard of the truth counts as intent for this purpose ."Id . Under the PSLRA!Second Circuit pleading require-ment, a plaintiff may demonstrate a "strong inference" offraud "either (a) by alleging facts to show that defendantshad both motive and opportunity to commit fraud, or (b)by alleging facts that constitute strong circumstantialevidence of conscious misbehavior or recklessness ."Shields, 25 F.3d at 1128 . While the court finds thatPlaintiff has failed to establish a sufficient motive todemonstrate " motive and opportunity ," n4 plaintiffs havealleged "strong circumstantial evidence of consciousmisbehavior or recklessness . "

n4 The only allegations related to motivepertain to Deloitte's alleged acceptance of a feetoo low to justify a careful audit in order to obtainmore business in the sub-prime auto lending in-dustrv . This Circuit has repeatedly rejected suchallegations, recognizing that an accounting firm's"greatest asset is its reputation for honesty, fol-lowed closely by its reputation for careful work ."Robin v . Arthur Young & Company, 915 F .2d1120, 1127 (7th Cir. 1990) (quoting DiLeo, 901

Page 8

F.2d at 629) . Because Plaintiffs' sole allegation ofmotive is insufficient under the law and is basedon economic irrationality, Plaintiffs fail to meetthe 2nd Circuit motive and opportunity test .

*29

Recklessness in a securities fraud action against anaccountant is de fined as "highly unreasonable conduct,involving not merely simple , or even inexcusable negli-gence , but an extreme departure from the standards ofordinary care, and which presents a danger of misleadingbuyers or sellers that is either known to the defendant oris so obvious that the actor must have been aware of it ."SEC v . Price Waterhouse , 797 F. Supp. 1217, 1240(S.D.N.Y. 1992) (citations and quotation omitted) . Anallegation of recklessness against outside auditors "re-quires more than a misapplication of accounting princi-ples," a plaintiff must allege that " the accounting prac-tices amounted to no audit at all, or an egregious refusalto see the obvious , or to investigate the doubtful , or thatthe accounting judgments which were made were suchthat no reasonable accountant would have made the samedecisions if confronted with the same facts ." Id, (quota-tions and citations omitted ) : Rehm, 954 F. Supp. at 1255.

Moreover, Deloitte correctly points out that , while a"company's overstatement of revenues in violation ofGAAP can constitute a false or misleading statement ofmaterial fact necessary to [*30] establish securities fraudunder Section 10 ( b) and Rule lob -5 violation ," Clark v.TRO Learning, Inc., 1998 U.S. Dist. LEXIS 7989, 1998WL 292382, *2 (N.D. Ill . 1998), a plaintiff cannot showscienter merely by stating that a defendant violatedGAAP . See, e .g., Lovelace v. Software Spectrum Inc ., 78F.3d 1015, 1020-21 (5th Cir. 1996); In re SoftwareToolworks, 50 F.3d 615, 627-28 (9th Cir. 1994), cert .denied , 516 U.S. 907, 116 S. Ct. 274 (1995) ; In reWorlds of Wonder Securities Litigation, 35 F.3d 1407,1426 (9th Cir . 1994), ce rt . denied, 516 U.S. 868, 116 S.Ct. 185 (1995) and cert . denied, 516 U.S. 909, 116 S. Ct.277 (1995) ; Malone v. Microdyne Corp ., 26 F.3d 471,479 (4th Cir. 1994); Health Management, 970 F. Supp.at 203; Rehm, 954 F. Supp . at 1256; Duncan v. Pencer,1996 U.S. Dist. LEXIS 401, 1996 WL 19043 at *10(S .D.N.Y. 1996 ) . However , " although it is true that aviolation ofGAAP will generally will not be su fficient toestablish fraud, when combined with other circumstancessuggesting fraudulent intent, allegations of improperaccounting may support a strong inference of scienter ."Marksman Partners, L.P., 927 F. Supp . 1297, 1313 (C. D .Cal . 1996) .

"Other circumstances suggesting [*31] fraudulentintent" can include the presence of "red flags" or warningsigns that the financial reports are fraudulent, as well as

1998 U .S . Dist , LEXIS 17760, *

the magnitude of the fraud alleged, Miller, 9 F. Supp. 2d

at 928 ("deliberately ignoring "red flags" such as thosealleged here can constitute the sort of recklessness neces-sary to support § 10(b) liability") ; Rehm, 954 F. Supp. at

1256 ("the more serious the error, the less believable aredefendants' protests that they were completely unawareof [the Company's] true financial status and the strongerthe inference that defendants must have known about thediscrepancy"); In re Health Management, 970 F. Supp.at 203 (finding that allegations of accounting firm's igno-rance of red flags presented evidence of fraudulent in-tent); In re Leslie Fay Companies, 835 F. Supp. 167, 175("in cases where small accounting errors only ripplethrough the corporate books, a court may conclude . . .that an accountant's failure to discover his client's fraudwas not sufficiently reckless to sustain a lOb-5 claim . Onthe other hand, when tidal waves of accounting fraud arealleged, it may determine that the accountant's failure todiscover his client's fraud ['321 raises an inference ofscienter on the face of the pleading") .

With these principles in mind, the court finds thatPlaintiffs have offered sufficient facts to survive a mo-tion to dismiss on the issue of scienter, Although plain-tiffs' allegations may be difficult to prove at trial, at thisstage, plaintiffs have alleged specific facts which giverise to a strong inference that Deloitte deliberately ig-nored various warning signs, constituting the reckless-ness necessary to support § 10(b) liability . See Miller, 9F. Supp. 2d at 928.

Plaintiffs allege not only violations of GAAP andGAAS, but that Deloitte deliberately ignored several redflags in the financial statements which would have ex-posed the fraud. n5 Moreover, the complaint containsallegations that the final Form 10-K filed with the SECoverstated First Merchants' net worth by approximately $90 million dollars . The magnitude of the fraud combinedwith the allegation that First Merchants' new Chief Fi-nancial Officer almost immediately discovered the dis-crepancies in the financial statements, suggests a deliber-ate ignorance on the part of Deloitte . Thus, the allega-tions in the complaint, including the magnitude of themisstatements, [*33] the specific GAAP and GAASviolations and the "red flags" together support an infer-ence that Deloitte's audit "amounted to no audit at all oran egregious refusal to see the obvious or investigate thedoubtful ." Accordingly, Deloitte's motion to dismissCount TV is denied .

n5 Deloitte argues that the fact that it ful-filled its duty to report weaknesses in the finan-cial statement absolves it of liability . The ques-tion before the court, however, is whether thecomplaint sufficiently alleges that Deloitte made

Page 9

misrepresentations of material fact by stating thatthe financial statements were prepared in accor-dance with GAAP and whether those representa-tions were made with scienter . The fact thatDeloitte reported weaknesses in the fi nancialstatements yet certified those same financialstatements less than two months later support s,rather than detracts from the allegations of reck-lessness . In the same vein , Deloitte contends thatthe complaint fails to state how it ignored the al-leged red flags or that it did not consider thosered flags in its audits . In other words , Deloitte ar-gues that the complaint should be dismissed be-cause Deloitte might have properly consideredthe warning signs in its audit of the financialstatements . The speci fics of Deloi tte's audit are,however, precisely the type of facts which areparticularly within defendants' knowledge andtherefore, need not be included in the complaint ."In re Leslie Fay, 835 F. Stipp. at 174 .

[*34]

C. Section It Allegations

Both Deloitte and the Audit Committee membersseek a dismissal of the Section I 1 claims (Counts I andI1) . Section 11 imposes civil liability on persons prepar-ing and signing materially misleading registration state-ments . 15 U.S.C. ,7 77k(a) (1998) . A registration state-ment is materially misleading if it contains an untruestatement of material fact or if it omits a material factnecessary to prevent the statement from being mislead-ing. Id , Any person who purchases a registered securityis entitled to sue under this section . Id . "Section I1 im-poses 'a stringent standard of liability on the pa rt ies whoplay a direct role in a registered offering ."' NationsmartCorp. v. Thaman, 130 F.3d 309, 314-15 (8th Cir. 1997)( quoting Herman & MacLean v. Huddleston, 459 U.S.375, 381-82, 103 S. Ct. 683, 74 L. Ed. 2d 548 (1983)),"To establish a prima facie § 11 claim, a plaintiff needshow only that he bought the security and that there wasa material misstatement or omission . Scienter is not re-quired for establishing liability under this section ." Id .Indeed , " the liability of the issuer of a materially mis-leading registration statement is 'vi rtually [*35] abso-lute, even for innocent misstatements ."' Id . (quotingHerman & MacLean, 459 U.S. at 382, 103 S. Ct. at 687).

Deloitte and the Audit Committee defendants posetwo challenges to Plaintiffs ' § 11 claims . First, they con-tend that the allegations fail to plead a material mis-statement with sufficient particularity . Plaintiffs counterthat Rule 9 (b) particularity is not required for § IIclaims , citing authority from other circuit and districtcourts . Defendants cite Sears v. Likens, 912 F.2d 889,892-93 (7th Cir. 1990), which applied Rule 9(b) to a § §

1998 U .S . Dist . LEXIS 17760, *

11 and 15 claims in support of their argument . The courtagrees with Plaintiffs, however, that the court in Searswas not asked to, nor did it , determine whether Rule 9(b)properly applied to § I 1 claims , which do not requirescienter for liability . In a persuasive opinion, the court inNationsmart rejected the argument that Rule 9(b) plead-ing requirements applied to a § 1 l claim. First , the courtnoted that the complaint, like the complaint in this case,expressly disavowed any claim of fraud in connectionwith the § 11 claims . Accordingly, decisions holdingthat claims "grounded in fraud" are subject to Rule [*36]9(b) pleading requirements were inapplicable . n6 130F.3d at 315. The same rationale applies in this case --Counts I and 11 of the amended complaint expressly dis-avow the fraud claims .

n6 The court questions the soundness ofthese decisions in light of the "virtually absolute"liability imposed on issuers of materially mis-leading registration statements . Plaintiffs' pointthat the reasoning in these cases requires the dis-missal of 1933 Act claims every time the 1934Act claims fail to satisfy Rule 9(b) is well taken .It is illogical to require plaintiffs to plead morethan they would have to prove to succeed on a §11 claim standing alone .

Second, the Nationsmart court reasoned that "apleading standard which requires a party to plead par-ticular facts to support a cause of action that does notinclude fraud or mistake as an element comports neitherwith Supreme Court precedent nor with the liberal sys-tem of 'notice pleading' embodied in the Federal Rules ofCivil Procedure ." Id, This court agrees that, [*37] be-cause § 11 does not require proof of fraud for recovery,Rule 9 (b)'s pleading requirements are inapplicable .

In any event, because the court has ruled that thefraud allegations do satisfy the requirements of Rule 9(b)and the PSLRA, defendants' arguments are moot . n 7

n7 The Audit Committee defendants fu rtherargue that the complaint fails to allege that theymade any specific misrepresentations . Liabilityunder § 11, however , includes anyone whosigned the registration statement , or anyone whowas a director (or person performing similarfunctions) of the issuer at the time of filing . 15U.S.C. § 77k (a)( l) & (2) . The complaint ex-pressly alleges that Schockey and Wyant signedthe 1994 Registration Statement (PP 32, 116),and that all of the Audit Commi ttee memberssigned the 1996 Note Registration Statement. (PP

Page 1 0

75, 126.) Further, the complaint alleges that all ofthe Audit Committee defendants , includingWeisgal, were directors of First Merchantsthroughout the class period. (P 19 . )

Finally, both Deloitte [*38] and the Audit Commit-tee defendants argue that Plaintiffs have failed to suffi-ciently plead standing under § 11 . The court finds thatPlaintiffs have sufficiently alleged that certain Plaintiffsand Class Members purchased securities in the 1994stock offering and that certain Plaintiffs and Class Mem-bers purchased in the 1996 reset note offering . (See PP32, 119, 75, 129 .) These allegations meet the pleadingrequirements for a § 11 claim . Herman & MacLean, 459U.S. at 382, 103 S. Ct. at 687. Accordingly, Deloitte'sand the Audit Committee defendants' motions to dismissCounts I and II are denied.

D. Section 15 Allegation s

Count I II of the first amended complaint alleges thatthe Audit Committee defendants are liable under Section15, 15 US.C. § 770, as control persons of First Mer-chants with respect to both the 1994 public stock offeringand the 1996 subordinated reset note offering . Section 15provides, in relevant part:

Every person who, by or through stockownership, agency, or otherwise . . . con-trols any person liable under section []77k . . . of this title, shall also be liablejointly and severally with and to the sameextent as such controlled [*39] person toany person to whom such controlled per-son is liable . . .

15 US. C, § 77o (1998) .

The Audit Committee defendants argue that CountIII should be dismissed because Plaintiffs have failed toallege liability under § 1 I and because they are not "con-trol persons" under the statute . Given the court's rulingthat the complaint states a § 11 claim against the AuditCommittee defendants, the first argument is withoutmerit .

Control person liability is determined under a two-prong test. "First, the "control person" needs to have ac-tually exercised general control over the operations ofthe wrongdoer , and second, the control person must havehad the power or ability -- even if not exercised -- to con-trol the specific transaction or activity that is alleged togive rise to liability ." Donohoe v, Consolidated Operat-ing & Production Corp., 30 Fad 907, 911-12 (7th Cir.1994). Plaintiffs have alleged that :

1998 U .S . Dist . LEX1S 17760, *

Each of these Defendants was a controlperson of the Company with respect to theOfferings referred to in Counts I and 11above by virtue of, among other things,his or her stock ownership and/or positionas a senior executive officer and/or direc-tor of the Company [*40] and had thepower and influence, and exercised thesame, to control the contents of the Com-pany's Registrations Statements, Prospec-tuses . . . Each of these Defendants wasprovided with copies of the Company'sfilings, reports, press releases and otherpublic statements alleged herein to befalse and misleading, prior to or shortlyafter their issuance, and had the abilityand opportunity to prevent their issuanceor cause them to be corrected . Moreover,each of these Defendants was a partici-pant in the Section 11 violations allegedin Counts I and II above, based on theirhaving signed the Registration Statementsor having otherwise participated in theprocess which allowed the Offerings to besuccessfully completed.

(P 135.) Thus, Plaintiffs have alleged both that the AuditCommittee defendants exercised general control over thecontents of the Company's public representations and hadthe ability to control the specific misrepresentations inthe Registration Statements, prospectuses and financialstatements . The court finds these allegations sufficient tomeet the general pleading requirements under Rule 8(a)(2) of the Federal Rules of Civil Procedure . See Na-tionsmart, [*41] 130 F.3d at 315; Goldsmith v. Tech-nolo~y Solutions Company, 1993 U.S Dist. LEIS 6136,1993 WL 150035 (N.D. Ill. 1993) (noting that liability ofthe defendants under Section 15 is wholly dependent ontheir alleged liability under Section 11) , n8 Defendants'motion to dismiss Count III is denied .

n8 The Audit Committee defendants citeBomarko, Inc. v. Hemodynamics, 848 F. Supp.1335 (W.D. Mich. 1993), for the contention thatoutside directors who are also members of theaudit committee are not necessarily controllingpersons . The decision in Bomarko , was renderedpursuant to a motion for summary judgment,however, not a motion to dismiss . Indeed, thecourt relied on the deposition testimony of the de-fendants in concluding that they were not control-ling persons . 848 F, Supp, at 1340 . On summary

Page 1 1

judgment, plaintiffs may very well be unable toprovide sufficient evidence to support its allega-tion that the Audit Committee defendants werecontrolling persons. At this time, however, Plain-tiffs' allegations suffice to withstand a motion todismiss .

[*42]

E. State Law Claim s

Finally, Deloitte seeks dismissal of the various statelaw claims against it including common law fraud, viola-tion of the Illinois Consumer Fraud Act and negligentmisrepresentation (Counts VI-VIII) . The court will ad-dress each of these claims in turn .

1 . Common Law Fraud and Negligent Misrepre-sentation

Claims for common law fraud and negligent misrep-resentation require a showing of actual reliance . Board ofEducation v. A, C, & S, Inc., 131 Ill. 2d 428, 546 N.E.2d580, 137111. Dec. 635 (1989); City of Chicago v . Michi-gan Beach Housing Cooperative, 297 Ill . App. 3d 317,323, 696 N.E.2d 804, 809, 231 111. Dec. 508 (Ist Dist,1998) (the torts of negligent and fraudulent misrepresen-tation differ only in the mental state element -- both re-quire action taken in justifiable reliance on the truth ofthe statement) ; Morse v. Abbott Laboratories, 756 F.Supp. 1108, 1112 (N. D . Ill. 1991) .

Plaintiffs argue that they need not allege direct reli-ance in order to sustain their common law fraud claim,but should be able to assert fraud on the market . Thecourt disagrees . "Plaintiffs' contention that they shouldbe able to proceed on the common law fraud [*43] claimbased on a 'fr aud -on-the-market ' theory, without proof ofindividual reliance, is . . . without merit." In re SoybeanFutures Litigation, 892 F. Supp. 1025, 1030 (N.D . 111.1995) . Plaintiff has not cited , nor has the court found,"any Illinois precedent indicating that Illinois commonlaw recognizes a claim for fraud or negligent misrepre-sentation that does not plead actual direct reliance." Gil-Jbrd Partners v . Sensormatic Electronics Corp., 1997U.S. Dist. LEXIS 19032, 1997 WL 757495 at *12 (N.D .Ill . 1997) (Manning , J .) ; Morse, 756 F. Supp . at 1112 . n 9

n9 Plaintiffs cite Hartmann v . Prudential In-surance Co. of America, 9 Fad 1207 (7th Cir .1993) to support their contention that actual reli-ance need not be pled, However, "Ha rt mannshould be limited to its unusual facts and reason-ing : plaintiffs, who would have been beneficiariesto their deceased father's life insurance policywere it not for the misrepresentations made to thefather by his insurance agent, need not have re-

1998 U .S . Dist . LEXIS 17760, *

lied on the misrepresentations ; their father reliedon the misrepresentations and they were conse-quently harmed . (Citation omitted) Moreover, theforegoing is merely dictum, because the court didnot allow plaintiffs to recover under their fraudtheory ." Caplan v. International Fidelity Insur-ance Co ., 902 F. Supp. 170, 174 (N. D. Ill. 1995).

[*44]

Because Plaintiffs have failed to plead direct, indi-vidual reliance on the alleged misrepresentations, theirfraud and negligent misrepresentation claims cannotstand . See Ventre v . Datronic Rental Corp., 1996 U.S.Dist. LEXIS 17501, 1996 WL 681279 (N.D. 111. 1996)(Coax, J .) ("in cases such as this one where a class actionhas not been ce rt i fied, each individual plaintiff mustplead that he or she relied upon the misrepresentation") .Accordingly , Counts VI and VIII are dismissed .

2 . The Illinois Consumer Fraud and DeceptiveBusiness Practices Act

Deloitte argues for the dismissal of the ConsumerFraud Act claims on two grounds . First, Deloitte arguesthat accountants should be exempt from the ConsumerFraud Act, and second, that Plaintiffs have failed to al-lege fraud with particularity. Deloitte's second argumentis easily dispensed with in light the court's finding thatthe fraud allegations in the complaint satisfy Rule 9(b)'spleading requirements .

Nor does Deloitte's first argument find any supportin the case law. The parties do not dispute that securitiestransactions are subject to the Consumer Fraud Act . SeeLyne v. Arthur Andersen & Co., 772 F. Supp . 1064, 1068(N.D. Ill. 1991) . Deloitte [*45] argues, however, thatlike lawyers and doctors, accountants should not be sub-

Page 1 2

ject to liability under the Act. Deloitte cites a number ofcases exempting doctors and lawyers from the Act andreasons that all "regulated professions" including ac-counting, should be exempt.

The court finds no authority to support Deloitte's po-sition . Indeed, the only direct authority cited rejects theargument that the Consumer Fraud Act does not apply toaccountants who perform accounting services in connec-tion with securities offerings . Lyne, 772 F. Supp. 1064,1068 (N.D. lll . 1991). While noting, in dicta, the strin-gent policing of the legal and medical professions, thecourt found no "indication that Illinois courts would con-sider accountants to be immune from the provisions ofthe Consumer Fraud Act ." Id . Likewise, Deloitte has notprovided, and the court has not found, any additionalevidence indicating a willingness on the part of Illinoiscourts to exempt accountants from the Act. The courttherefore declines Deloitte's invitation to extend exemp-tions under the Illinois Consumer Fraud Act . Accord-ingly, Deloitte's motion to dismiss Count VII is denied .

IV. Conclusion

For the foregoing [*46] reasons, Deloitte's motionto dismiss Counts VI and VIII is granted and its motionto dismiss Counts 1, II, IV, and VII is denied . Shockey,Weisgal and Wyant's motion to dismiss Counts 1-111 isdenied .

Enter :

David H. Coar

United States District Judge

Dated : November 2, 1998

TAB 2

Page I

LEXSEE 2004 US DIST LEXIS 26488

CautionAs of: Jan 08, 2007

IN RE : FLEMING COMPANIES INC . SECURITIES & DERIVATIVELITIGATION, THIS DOCUMENT RELATES TO ALL CASE S

CIVIL ACTION NO. 5-03-MD-1530 (TJW), MDL-153 0

UNITED STATES DISTRICT COURT FOR THE EASTERN DISTRICT OFTEXAS

2004 U.S. Dis t. LEXIS 26488

June 10, 2004 , Decided

SUBSEQUENT HISTORY : Transferred by In re Flem- lett, New York, NY ; Peter E Kazanoff, Simpson Thachering Cos . Inc. Secs. & Derivative Litig., 2005 U.S. Dist . & Bartlett, New York, NY ; Nicholas Even, Haynes andLEXIS 10674 (J.P,M.L ., Apr . 20, 2005) Boone , Dallas, TX .

PRIOR HISTORY: In re Fleming Cos . Sees. & Deriva-tive Litig., 269 F. Supp. 2d 1374, 2003 U.S Dist. LEXIS11029 (J.P.ML., 2003)

DISPOSITION : [*1] Defendants' Motions to Dismissgranted in part and denied in part .

For Wachovia Securities , Inc ., Defend ant : Kenneth RDavid, Simpson Thacher & Bartlett, New York, NY ;Michael J Chepiga, Simpson Thacher & Bartle tt, NewYork, NY; Peter E Kazanoff , Simpson Thacher & Bart-lett, New York, NY ; Nicholas [*2] Even, Haynes andBoone , Dallas, TX .

COUNSEL : For In re : Fleming Companies, Inc ., Securi-ties & Derivative Litigation, Plaintiff : Samuel FranklinBaxter, Attorney at Law, Marshall, TX .

For Named Plaintiffs , Plaintiff: Steven W Pepich, LerachCoughlin Stoia Geller Rudman & Robbins, San Diego,CA .

For In re : Fleming Companies , Inc ., Securities & Deriva-tive Litigation Defendants, Defendant : Diane Marie Su-moski, Carrington Coleman Sloman & Blumenthal LLP,Dallas, TX; Randall Mark Foret, Secore & Waller, Dal-las, TX ; Stephen Cass Weiland , Patton Boggs , Dallas,TX.

For Thomas . Dahlen, Defendant : David Alan Stephan,McManemin & Smith, Dallas, TX .

For Deutsche Bank Securities Inc ., Defendant : KennethR David, Simpson Thacher & Bartlett, New York, NY ;Michael J Chepiga, Simpson Thacher & Bartlett, NewYork, NY; Peter F Kazanoff, Simpson Thacker & Bart-lett, New York, NY ; Nicholas Even, Haynes and Boone,Dallas, TX .

For Lehman Brothers Inc ., Defendant: Kenneth R David,Simpson Thacher & Bartlett, New York, NY ; Michael JChepiga, Simpson Thacher & Bartlett, New York, NY ;Peter E Kazanoff, Simpson Thacher & Bartlett, NewYork, NY; Nicholas Even, Haynes and Boone, Dallas,TX .

For Mark D Shapiro, Defendant : Terence J Hart, MunschHardt Kopf & Harr, Dallas, TX .

For Deloitte & Touche, Defendant : Keefe Michael Bern-stein, Akin Gump etal, Dallas, TX.

For Morgan Stanley & Co . Incorporated, Defendant :Kenneth R David, Simpson Thacher & Bartlett, NewYork, NY; Michael J Chepiga, Simpson Thacher & Bart-

2004 U.S . Dist. LEXIS 26488, *

For Alice M Peterson, Defendant : Diane Marie Sumoski,Carrington Coleman Sloman & Blumenthal LLP, Dallas,TX .

For Carlos M Hernandez, Defendant : Diane Marie Su-moski, Carrington Coleman Sloman & Blumenthal LLP,Dallas, TX .

For Robert S Ramada, Defendant : Diane Marie Sumoski,Carrington Coleman Sloman & Blumenthal LLP, Dallas,TX .

For Carol B Hallett, Defendant : Diane Marie Sumoski,Carrington Coleman Sloman & Blumenthal [*3] LLP,Dallas, TX .

For Archie R Dykes, Defendant : Diane Marie Sumoski,Carrington Coleman Sloman & Blumenthal LLP, Dallas,TX .

For Kenneth M Duberstein, Defendant: Diane MarieSumoski, Carrington Coleman Sloman & BlumenthalLLP, Dallas, TX.

For Herbert M Baum, Defendant : Diane Marie Sumoski,Carrington Coleman Sloman & Blumenthal LLP, Dallas,TX .

For Stephen . Davis, Defendant : Jim L Flegle, Loewin-sohn & Flegle, Dallas, TX .

For Terry Slater , Defendant: S Gene Cauley , CauleyBowman Carney & Williams, Little Rock , Ar; T BrentWalker, Cauley Bowman Carney & Williams , LittleRock, Ar; J Allen Carney, Cauley Bowman Carney &Williams, Li tt le Rock, Ar ; Marcus Bozem an , CauleyBowman Carney & Williams, Little Rock, Ar; Tiffany MWyatt , Cauley Bowman Carney & Williams , Li ttle Rock,Ar ,

For Neal J Rider, Defendant : Stephen Cass Weiland,Patton Boggs , Dallas, TX .

For Anthony Colarich, Movant : S Gene Cauley, CauleyBowman Carney & Williams, Little Rock, Ar ; Tiffany MWyatt, Cauley Bowman Carney & Williams, Little Rock,Ar.

For Raheela Zaman, Movant : S Gene Cauley, CauleyBowman Carney & Williams, Little Rock, Ar ; Tiffany MWyatt, Cauley Bowman Carney & Williams, [*4] LittleRock, Ar .

JUDGES: T. JOHN WARD, UNITED STATESDISTRICT JUDGE .

OPINION BY: T . JOHN WAR D

OPINION :

Page 2

MEMORANDUM OPINION AND ORDE R

1. INTRODUCTIO N

This private securities class action case relates toFleming Companies, Inc . ("Fleming") . Fleming, at onetime the second largest food distributor in the UnitedStates, first foreshadowed problems on July 30, 2002.The problems continued, culminating in a formal SECinvestigation into Fleming's accounting practices, A se-ries of class actions followed, which were consolidated .In April 2003, the company declared bankruptcy andannounced its need to make a massive restatement of itsearnings for 2001 and 2002 . The company has yet tomake any restatements of its earnings . An MDL proceed-ing ensued, and the cases were all transferred to thiscourt for pre-trial handling . The court has appointed alead plaintiff and set a briefing schedule . The plaintiffsfiled their Third Amended Consolidated Class ActionComplaint ("TAC°), The defendants have moved to dis-miss the TAC on various grounds . The court held an oralhearing on the matter and, after considering the motions,responses, the [*5] arguments, and the applicable law, isof the opinion that the following order should issue .

it. FACTUAL BACKGROUND ANDPROCEDURAL POSTURE

The facts are stated in . the light most favorable to theplaintiffs as alleged in the TAC. Baker v. Putnal, 75 F. 3d190, 196 (5th Cir. 1996) . Fleming is a wholesale dis-tributor of groceries . A wholesaler like Fleming pur-chases groceries from vendors and sells them to super-markets and grocery stores . During the 1990s, Flemingstruggled, due in part to its sharp business practices withits customers . Fleming's earnings steadily declined from1995 through 1998, culminating in the termination ofCEO Robert Smith in July, 1998 .

In November 30, 1998, Fleming appointed MarkHansen as CEO and Chairman of the Board . A weeklater, Fleming announced a "Strategic Plan to ImprovePerformance ." One part of the plan was to improve theperformance of Fleming's retail segment . AlthoughFleming had historically been a grocery wholesaler, thecompany identified a retail segment of price impact su-permarkets as a potential growth opportunity . A priceimpact supermarket is a sort of "no frills" approach toselling groceries . Price impact [*6] supermarkets typi-cally cost less to build and operate, lack amenities suchas delis, and, ultimately, pass the savings along to cus-tomers in the form of lower prices . Hansen told share-

2004 U.S . Dist . LEXIS 26488 ,

holders at an annual meeting that Fleming would make astronger and more focused push on retailing than everbefore .

Throughout 1999, 2000, and 2001, Fleming madevarious statements concerning its strategic plan to ana-lysts and investors . Fleming stated in a January 2000,press release that it attributed revenue growth to its em-phasis on Food4Less price impact stores and expectedfuture retail growth on a "same store" basis . To illustrate,Fleming expected that sales in retail stores 1, 2, and 3would increase over the numbers realized by those storesin the preceding year . The court notes that same storesales comparison is important because it allows analystsand investors to evaluate the actual internal growth of thecompany, unclouded by acquisitions or divestitures .

Throughout 2000, Fleming indicated that its focuswould be on price impact stores, at the expense of con-ventional stores. Fleming began to divest its conven-tional stores and, by May, 2001, represented that it hadsold all of its conventional [*7] stores . During that sametime period, Fleming reported earnings growth, attrib-uted in part to the success of its retail strategy . Also dur-ing this time period, Fleming and certain officers madepublic statements touting the success of its retail strategy .One Fleming press release stated, for instance, that Flem-ing's reported 36% net earning increase for the fourthquarter of 2001 "validated our strategic initiatives" relat-ing to price impact supermarkets . (TAC, P 82) . Fleming's10K for 2000 also promoted this retail strategy .

Throughout the first half of 2001, analysts reactedfavorably to Fleming's strategy . Bear, Steams & Co .,Deutsche Banc Alex . Brown, and UBS Warburg all is-sued reports commenting favorably on Fleming's retailoperations focus . (TAC, P 86-88) . Additional analystsresponded favorably throughout the balance of 2001 andinto the first half of 2002 . (TAC, PP 89-92).

All was not well inside Fleming, however . Theplaintiffs allege that Fleming used accounting manipula-tions to inflate its earnings numbers for 2001 and 2002 .The details of this scheme are discussed in more detailbelow; however, for present purposes, it is sufficient tonote that the plaintiffs allege [*81 first that Fleming ex-ecutives instituted a practice wherein Fleming's retail andwholesale divisions would arbitrarily and improperlydeduct amounts payable from vendors' invoices, withoutcause and with no expectation that the vendors wouldapprove the deduction . At the same time, although Flem-ing would reserve for a portion of those deductions, thereserves were often woefully inadequate to cover theamount of deductions . This practice had the effect ofinflating the quarterly and yearly earnings reported bythe company in press releases, SEC quarterly and annual

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reports, and Registration Statements filed in March andJune 2002, for public offerings of securities .

The second significant area of numbers manipula-tions that the plaintiffs attack is the company's reportingof same store sales growth. The plaintiffs allege that cer-tain Fleming executives instituted a practice whereby thereported same store sales figures were inflated, Theseinflated numbers led the investing public to assume thatFleming's retail strategic plan was growing . The plain-tiffs allege that the true same store sales figures, had theybeen revealed, would have shown that Fleming's retailsegment was suffering [*9] and that its price impactformat was not successful .

In July 2002, despite the company ' s statements con-cerning the success of its business strategy , Fleming be-gan to foreshadow problems in its retail segment . OnJuly 30, 2002 , Fleming issued a press release which indi-cated it was evaluating strategic alternatives to its retailsegment, and in particular , its price impact retail stores .The company stated that comparable store sales declined4 .7 percent . At the same time, according to the plaintiffs,Fleming overstated its wholesale earnings and maskedthe extent of retail losses to cushion any decline in stockvalue . Although Fleming reiterated its prior ea rn ingsforecasts, analysts began to doubt the validity of thosenumbers . J.P . Morgan analyst Stephen Chick, for in-stance , cut Fleming from "market perform" to "marketunderperform ." An article in Supermarket News ob-served that Fleming's announcement concerning alterna-tives to its retail segment "appears to have caught mostanalysts by surprise ." (TAC, P 272) .

On September 4, 2002, the Dow Jones Newswire re-leased an article on Fleming which disclosed customerdissatisfaction with certain of Fleming's price impactretail stores, [*101 inventory problems in those stores,and Fleming's practice of taking large vendor deductionsto increase the company's cash flow . Although the articlenoted that the company was not alone in this practice,some of Fleming's unidentified customers said they hadstopped shipping to Fleming because of the practice andone such customer, referring to Fleming, noted that"when it comes to deductions, they're off the scale com-pared to other customers," On September 5 , 2002, theWall Street Journal published the expose' released by theNewswire the day before .

Fleming responded to the September 5, 2002 articleby holding a conference call that day with analysts . Thecompany's CFO, Neal Rider, stated on the conferencecall that Fleming's vendor deductions were "appropri-ately reserved for" and Fleming's CEO stated that "wehave absolutely no issues with how we treated deduc-tions, we reserve against deductions, and we certainlydon't assume 100% collection ." (TAC, P 282). In the

2004 U.S . Dist . LEXIS 26488, *

same conference call, the officers stated that Fleming'sfinancial condition was solid and that the deductionswere an ordinary part of the business , and were an indus-try-accepted practice . Indeed, according to Rider, [*l1]"less than one-tenth of one percent of all the vendors wedeal with, and even a smaller amount of that in terms ofdollars , have a dispute that's risen to the level that we areat an impasse today." (TAC, P 289) . The plaintiffs con-tend that these statements were false .

The stock market reacted adversely to the September4 and 5 articles . On September 3, 2002, Fleming stockwas trading at $ 9 .31 per share . By September 5, thestock closed at S 6 .92 per share, a decline of 26%. Ac-cording to the plaintiffs, even though the stock price de-clined significantly , the statements by Fleming's execu-tives cushioned the fall of the stock because those state-ments represented that the deductions that might reach"impasse" were minimal and that the deductions in anyevent were an industry standard practice and were prop-erly accounted for . (TAC, PP 295-296).

On September 24, 2002, Fleming announced the di-vestiture of its price impact stores . Thereafter, on Octo-ber 23, 2002, Fleming announced its third quarter earn-ings, confirmed its decision to divest its price impactstores, and suggested that its relationship with its largestcustomer, Kmart, might be in jeopardy because ofKmart's bankruptcy [* 12] proceedings and reorganiza-tion .

On November 13, 2002, Fleming announced that theSEC had commenced an informal investigation intoFleming's accounting practices . In particular, the SEC'sinvestigation focused on Fleming's vendor trade practicesand the company's calculation of comparable store salesin its discontinued retail operations . Following Fleming'sJanuary 23, 2003, announcement of a $ 190 million lossin retail operations for 2002, and its announcement of theloss of the Kmart contract in February 2003, Fleming'sCFO insisted that the notion that Fleming would seekbankruptcy protection was "ludicrous ." On February 25,2003, the SEC reclassified its investigation as a formalone.

In February and March, 2003, Fleming's credit rat-ings were downgraded . On March 3, 2003, Fleming an-nounced the resignation of its CEO . Contrary to the pre-vious representations of Fleming's CFO and unable tosecure alternate sources of financing, Fleming announcedon April 1, 2003, that it had filed a voluntary petition forreorganization under Chapter 11 of the BankruptcyCode .

On April 17, 2003, Fleming announced that it wouldrestate its 2001 annual and qua rterly financial statementsand 2002 [* 13] qua rterly financial statements previouslyfiled with the Securities and Exchange Commission and

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that it would revise its previously announced 2002 fourthquarter and annual financial results . The Fleming pressrelease stated in part that "the Company expects that therelated restatements of the results for the full-year 2001and the first three quarters of 2002 will reduce the pre-tax financial results from continuing operations for suchperiods by an aggregate amount of not more than $ 85million ." According to the press release, the restatements"mainly correct the timing of when ce rtain vendor tran s-actions are recognized and the balance of certain reserveaccounts ." (TAC, P 322) . Finally, the press release statedthat Fleming's "fourth quarter 2002 pre-tax loss fromcontinuing operations will be increased by expenses to-taling not more than $ 80 million as a result of a numberof factors , including increased vendor payback rates, theKma rt contract cancellation and corrections identified asa result of the Audit and Compliance Commi ttee's inde-pendent investigation ." (TAC, P 322) . Fleming subse-quently announced it would restate its 2000 annual fi-nancial statements . To date, Fleming [* 14] has not actu-ally made its restatements ,

These securities fraud cases raise the same issues in-volved in the SEC investigation and the announced re-statements. The claims in this case may be divided intotwo categories: those brought under the 1934 Act andthose brought under the 1933 Act . As will be seen, dif-ferent standards apply to each .

In their 1934 Act claims , brought under section 10and Rule IOb(5) promulgated thereunder, the plaintiffscomplain of the conduct of five individual defendants .These defendants are referred to in this opinion either byindividual name or collectively as the 1934 Act Individ-ual Defendants . The 1934 Act Individual Defendantsinclude the following past or present company officers :Mark Hansen, Fleming 's Chief Executive Officer("CEO"), Neal J . Rider , Fleming's Chief Financial Offi-cer ("CFO"), Mark D. Shapiro , Fleming's Chief Account-ing Officer ("CAO"), Thomas Dahlen, a Fleming Execu-tive Vice -President and head of Fleming's Retail Divi-sion , and E . Stephen Davis , a Fleming Executive Vice-President and head of Fleming's Wholesale Division . Theplaintiffs have also asserted securities fraud claims underthe 1934 Act against Deloitte and Touche ("D&T"),[*15] Fleming's outside auditor . The basis for the plain-tiffs' fraud claims against D&T is that D&T conducted itsaudits while ignoring several "red flags" that D&Tshould have investigated and, by failing to do so, actedwith severe recklessness suf ficient to warr ant liabilityunder section 10 .

In their 1933 Act claims, brought under sections 1Iand 12(u)(2) of that act, the plaintiffs complain of theconduct of several additional individuals, namely theoutside directors and any other executive who signed theCompany's Registration Statements filed with the SEC in

2004 U . S . Dist . LEXIS 26488, *

March 2002 and June 2002 . These individuals are re-ferred to in this opinion as the 1933 Act Individual De-fendants . The 1993 Act Individual Defendants includethe following chief officers , directors and general coun-

sel : Mark Hansen, Neal J . Rider, Mark D. Shapiro, Her-bert M. Baum , Kenneth M . Duberstein, Archie R . Dukes,Carol B . Hallett , Robert S . Hamada, Alice M. Peterson,Edward C. Joulian, III , Guy A . Osbo rn and Carlos M .Hernandez . Also, the plaintiffs join as defendants to their1933 Act claims the various underwriters involved in theJune 2002 offering . These defendants are referred toherein as the Underwriter Defendants . f * l6] D&T isalso joined as a defendant to the 1933 Act claims . Thecou rt will sometimes refer to the defendants to the 1933Act claims collectively as the 1933 Act Defendants . Thecou rt now turns to a discussion of the applicable legalstandards , followed by a discussion of securities law,and, finally, to the analysis of the myriad issues raised bythe motions to dismiss .

III. STANDARDS FOR MOTIONS TO DISMISS INSECURITIES LITIGATIO N

A. Rule 12(b)(6)

The court begins with bedrock . Federal Rule of CivilProcedure 12(b)(6) provides for dismissal of a complaintfor "failure to state a claim upon which relief can begranted ." Fed. R. Civ. P. 12(b)(6) . A court may onlydismiss a complaint under Rule 12(b)(6) when it is clearthat the plaintiff can prove no set of facts in suppo rt ofhis claim that would entitle him to relief. Jones v . M.L.Greninger, 188 F3d 322, 324 (5th Cir . 1999) . The courtmust accept as true all well-pleaded facts in the com-plaint, and the complaint is to be liberally construed infavor of the plaintiff. [*17] Abrams v . Baker Hughes,Inc., 292 F.3d 424, 430 (5th Cir. 2002) ; Kaiser Alumi-num & Chem. Sales, Inc. v. Avondale Shipyards, Inc.,677 F.2d 1045, 1050 (5th Cir. 1982) . A plaintiff needonly allege , not prove, sufficient facts to survive a mo-tion to dismiss . Koppel v . 4987 Corp ., 167 F. 3d 125, 133(2d Cir . 1999) . Conclusory allegations, however , or legalconclusions masquerading as factual conclusions will notsuffice to prevent dismissal under Rule 12(b)(6) . S.Christian Leadership Conference v. Supreme Court ofState of La., 252 F.3d 781, 786 (5th Cir. 2001) . Thecourt may consider the totality of the allegations in thecomplaint in their entirety . Haack v. Max Internet Com-munications , Inc., 2002 U.S. Dist. LEXIS 5652, 2002 WL511514, at *5 (N.D. Tex . April 2, 2002) .

Courts apply Rule 12(b)(6) principles to motions todismiss in securities class action cases, but it must beremembered . that a securities cause of action deals pri-marily with very fact- speci fic inquiries . [* 18] 2002 U.S.Dist. LEXIS 5652, [fVL] at *3 ( citing Basic Incorporatedv. Levinson, 485 US. 224, 240, 99 L . Ed. 2d 194, 108 S.

Page 5

Ct. 978 (1988)) . Notwithstanding that the cases are fact-specific , a district court evaluating a motion under Rule12(b)(6) must consider the strict pleading requirementsof Rule 9(b) and the Private Securities Litigation ReformAct ("PSLRA") in a securities fraud case .

B. Rule 9(b)

Rule 9(b) states that "in all averments of fraud ormistake, the circumstances constituting fraud or mistakeshall be stated with particularity," but that "malice, in-tent, knowledge, and other condition of mind of a personmay be averred generally ." Fed. R. Civ. P. 9(b) . Rule9(b) applies to private securities fraud claims under thePSLRA . Abrams, 292 F.3d at 430 . The Fifth Circuit hasheld that the particularity requirement of Rule 9(b) sets"the same standard" required by the PSLRA . ABC Arbi-trage Plaintiffs Group v. Tchuruk, 291 F.3d 336, 349(5th Cir. 2002) . It is settled in this circuit that Rule 9(b)requires the plaintiff "to specify the statements contendedto be fraudulent, identify [* 19] the speaker, state whenand where the statements were made, and explain whythe statements were fraudulent ." Nathenson v . Zonagen,267 F. 3d 400, 412 (5th Cir. 2001) .

C. PSLRA

The express provisions of the PSLRA augment theRule 9 (b) requirements in several respects . The effect isto require plaintiffs to pa rt icularize the allegations offraud so that individual defendants are given fair noticeof the claims against them as well as their alleged rolesin the fraudulent conduct . ABC Arbitrage, 291 F.3d at349 n . 6 . The PSLRA provides in relevant part :

In any private action arising under thischapter in which the plaintiff alleges thatthe defendant (A) made an untrue state-ment of a material fact ; or (B) omitted tostate a material fact necessary in order tomake the statements made, in the light ofthe circumstances in which they weremade, not misleading; the complaint shallspecify each statement alleged to havebeen misleading, the reason or reasonswhy the statement is misleading, and, ifan allegation regarding the statement oromission is made on information and be-lief, the complaint shall state with particu-larity all facts [*201 on which that beliefis formed .

In any private action arising under thischapter in which the plaintiff may recovermoney damages only on proof that the de-fendant acted with a particular state of

2004 U.S . Dist . LEXIS 26488, *

mind, the complaint shall, with respect toeach act or omission alleged to violate thischapter, state with particularity facts giv-ing rise to a strong inference that the de-fendant acted with the required state ofmind .

15 U.S. C. § 78u-4(b)(I)-(2) .

The requirements of the statute are onerous . Thestatute was not, however, enacted to raise the pleadingburdens under Rule 9(b) and § 78u-4(b)(1) to such alevel that facially valid claims, which are not brought fornuisance value or as leverage to obtain a favorable orinflated settlement, must be routinely dismissed on Rule9(b) and 12(b)(6) motions . ABC Arbitrage, 291 F.3d at348. A securities fraud plaintiff need not allege all factsthat may be related to his claims-such a requirement isimpossible at the pleading stage because usually only thedefendants know all the facts related to the alleged fraud .Id. Therefore, the particularity rules should not be inter-preted to require [*21] the pleading of facts which, be-cause of the lack of discovery, are in defendants' exclu-sive possession . Id. Finally, the totality of the complaintdetermines whether a claim has been pled with particu-larity, Goldstein v. MCI Worldcom, 340 F.3d 238, 246-47 (5th Cir. 2003) .

D. Section 10(b) and Rule IOb- 5

In the TAC, plaintiffs seek class certification for aclass on behalf of all persons who purchased or acquiredthe publicly traded equity and debt securities of Flemingbetween May 9, 2001, and February 25, 2003, inclusive,including those who purchased or acquired such Flemingsecurities issued in, pursuant to, or traceable to theMarch 14, 2002 Registration Statement or the June 17,2002 Registration Statement . The private rights of actioninvolved with respect to the securities fraud claims al-leged in the TAC flow from alleged violations of sec-tions 10(b) and 20(a) of the 34 Act and Rule 10b-5 of theSEC, promulgated pursuant to the 1934 Act. The courtnow examines those provisions.

Section 10 (b) provides that it is unlawful for anyperson "to use or employ , in connection with the pur-chase or sale of any security . [*22] . . any manipulativeor deceptive device or contrivance in contravention ofsuch rules and regulations as the [SEC ] may prescribe asnecessary or appropriate in the public interest or for theprotection of investors ." 15 US. C, § 78j(b) . Rule 10b-5states that it is unlawful for any person, directly or indi-rectly, "to employ any device , scheme, or arti fice to de-fraud ; to make any untrue statement of material fact or toomit to state a material fact necessary in order to makethe statements made, in the light of the circumstances

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under which they were made, not misleading ; or to en-gage in any act, practice , or course of business whichoperates or would operate as a fraud or deceit upon anyperson in connection with the purchase or sale of anysecurity ." 17 C.F.R. § 240. IOb-5 .

The intersection of Rule 9 (b), the PSLRA and theelements of a claim under section /0(b) and Rule IOb-5yields a result which requires a plaintiff to allege, in con-nection with the purchase or sale of securities , the fol-lowing :

(1) specify each statement alleged to havebeen misleading, i .e., contended to befraudulent ;

(2) identify the speaker;

(3) state when and [*23] where thestatement was made ;

(4) plead with particularity the contents ofthe false representations ;

(5) plead with particularity what the per-son making the misrepresentation ob-tained thereby ; and

(6) explain the reason or reasons why thestatement is misleading, i .e ., why thestatement is fraudulent .

ABC Arbitrage, 291 F.3d at 350; Nathenson, 267 F. 3d at406-07 . In addition, if an allegation is made on informa-tion and belief, the plaintiff must (7) state with particu-larity all facts on which that belief is formed, i .e ., setforth a factual basis for such belief. ABC Arbitrage, 291F.3d at 350 . This is the who, what, when, where, andhow required under Rule 9(b) and the PSLRA . Id

Section I0(b) and Rule IOb-5 require that the defen-dant make a material misstatement or omission . Withregard to misstatements, the PSLRA establishes a safeharbor shielding a forward-looking statement from liabil-ity where such a statement is made by a natural personunless defendants prove that it was made with "actualknowledge . . . that the statement was false and mislead-ing ." A statement is forward looking if it is [*24 ]

(A) a statement containing a projection ofrevenues, income (including income loss),earnings (including earnings loss) per

2004 U .S . Dist . LEXIS 26488, *

share, capital expenditures, dividends,capital structure, or other financial items ;

(B) a statement of the plans and objectivesof management for future operations, in-cluding plans or objectives relating to theproducts or services of the issuer ;

(C) a statement of future economic per-formance, including any such statementcontained in a discussion and analysis offinancial condition by the management orin the results of operations included pur-suant to the rules and regulations of theCommission;

(D) any statement of the assumptions un-derlying or relating to any statement de-scribed in subparagraph (A), (B), or (C) ;

(E) any report issued by an outside re-viewer retained by an issuer, to the extentthat the report assesses a forward-lookingstatement made by the issuer . . . .

15 U.S.C. § 78u-5(i)(1)(4) . The safe harbor protectsindividuals and corporations from liability for forward-looking statements that prove false if the statement is"accomp an ied by meaningful cautionary statements iden-tifying impo rtant [*25] factors that could cause actualresults to differ materially from those in the forward-looking statement " or where the forward-looking state-ment is immaterial. 15 U.S.C. § 78u-5(c)(1)(A)(i) and(ii) . Where the forward -looking statement is not accom-panied by cautionary language , plaintiffs must demon-strate that the defendant made the statement with "actualknowledge " that it was "false or misleading ." 15 U.S. C. §78u-5(c)(1)(B) . The safe harbor provision does not applywhere the defendants knew at the time that they wereissuing statements that the statements contained false andmisleading information and thus lacked any reasonablebasis for making them .

There is a judicially created equivalent to thePSLRA's "safe harbor" provision , the "bespeaks caution"doctrine , which "operates similarly , protecting state-

ments in the nature of projections that are accompaniedby meaningful cautionary statements and speci fic warn-ings of the risks involved, so as to bespeak caution' to

investors that actual results may differ, thereby shieldingthe statements from section 10(b) and Rule lob-5 liabil-ity ." [*26] In re Enron Corp. Sec ., Derivative & ERISA

Litig., 235 F. Supp . 2d 549, 576 (S. D. Tex. 2002)(quoti n gBryant v. .4vado Brands, Inc., 187 F.3d 1271, 1276 n .7(11th Cir . 1999)) . The Fifth Circuit has rejected the ap-

Page 7

plication of the "bespeaks caution" doctrine as a per sebar to liability . Rubinstein v . Collins, 20 F.3d 160, 162(5th Ctr . 1994) . Under Fifth Circuit precedent, "caution-ary language is not necessarily sufficient in and of itself,to render predictive statements immaterial as a matter oflaw. Rather, . . . materiality is not judged in the abstract,

but in light of the surrounding circumstances ." Id. at167-68 (citing Krim r. BancTexas Group, 989 F.2d1435, 1448-49 (5th Cir. 1993)) . "The appropriate inquiryis whether , under all the circumstances , the omitted factor the prediction without a reasonable basis is one [that]a reasonable investor would consider significant in [mak-ing] the decision to invest , such that it alters the total mixof information available about the proposed investment .'" [*27] Id. at 168 (citing Krim, 989 F.2d at 1445) .

In a similar vein, vague optimistic statements are notactionable because a reasonable investor would not relyon them in deciding to buy or sell securities . In re Enron,235 F. Supp. 2d at 576 . "Vague, loose optimistic allega-tions that amount to little more than corporate cheerlead-ing are puffery ,' projections of future performance notworded as guarantees ,' and are not actionable under fed-eral securities law because no reasonable investor wouldconsider such vague statements material and becauseinvestors and analysts are too sophisticated to rely onvague expressions of optimism rather than specificfacts ." In re Sec . Litig. BMC Software, Inc., 183 F. Supp.2d 860, 888 (S.D. Tex. 2001) (citing Krim, 989 F.2d at1446) .

If allegations regarding the statements or omissionsare made on information and belief, the complaint muststate with particularity sufficient facts to support thatbelief. ABC Arbitrage, 291 F.3d at 353 . The plaintiffsare not required to plead with particularity every singlefact upon which their beliefs concern ing false or [*28]misleading statements are based . Id. If the allegations inthe complaint come from confidential sources, there is norequirement that the sources be named , provided they aredescribed generally in the complaint with sufficient par-ticularity to support the probability that a person in theposition occupied by the source would possess the in-formation pleaded to support the allegations of false ormisleading statements made on information and belief.Id. In that situation , the plaintiffs will have pleadedenough facts to support their belief, even though somearguably relevant facts have been le ft out . Id. Accord-ingly, a complaint can meet the pleading requirement byproviding a sufficient general description of the personalsources of the plaintiffs ' beliefs . Id.

In ABC Arbitrage, the Fifth Circuit found instanceswhere the allegations as to confidential sources had beenboth adequately and inadequately pleaded. The courtfound that "allegations conce rn ing a conversation be-tween a high ranking [ Company ] official' who was a top

2004 U.S . Dist . LEXIS 26488, *

executive of [the Company]"' and one of the company'sexecutive vice presidents were "pleaded with sufficientparticularity to meet the [*29] standard for pleadingsbased on information and belief in that "this executive,and his conversation with the [company ' s executive vicepresident], is described with sufficient particularity tosupport the probability that a person in such a positionwould possess the information pleaded and that, to theextent it is necessary, construing the allegations in thelight most favorable to Plaintiffs , this executive was him-self Plaintiffs source for this information ." Id. at 357 .

On the other hand, with regard to allegations that thecompany had understated its losses, the court held insuf-ficient certain allegations that the source of the informa-tion was consultations and interviews with "Swiss, Thai,and Indonesian business journalists, employees ofDeutsche Telecom and other Alcatel customers through-out the world, trade union officials, and Telecom ana-lysts" in the course of counsel's investigation . Id at 358.These allegations, according to the court, had not beenpleaded with sufficient particularity to withstand the re-quirements of the PSLRA .

Securities fraud claims are, of course, fraud claims .The requirement is that a company officer [*301 or agentacted with a culpable mental state . To that end, "scienter"is a mental state embracing intent to deceive, manipulate,or defraud ." Ernst & Ernst v . Hoch/elder, 425 U.S. 185,193 n.12, 47 L. Ed. 2d 668, 96 S. Ct. 1375 (1976) . ThePSLRA did not alter the substantive scienter requirementfor claims brought under section 10(b) and Rule lob-5 .Nathenson, 267 F.3d at 408 . The court must considercumulatively any evidence of scienter pleaded by theplaintiffs . Tuchman v . DSC Communications Corp., 14F.3d 1061, 1068-69 (5th Cir. 1994) . Therefore, the courtmust consider whether all facts and circumstances "takentogether" are sufficient to support the necessary stronginference of scienter on the part of the plaintiffs .

Under the PSLRA, it is "not enough to particularizefalse statements or fraudulent omissions made by a cor-porate defendant . . . plaintiffs must also particularizeintent allegations raising a strong inference of scienter ."'Goldstein, 340 F.3d at 238 . "For securities fraud plain-tiffs to plead a strong inference of the required state ofmind, they must allege with particularity facts that, as-sumed [*31] to be true constitute persuasive, effectiveand cogent evidence from which it can logically be de-duced that defendants acted" with the required mentalstate . In re Electronic Data Systems Corp . Sec. & ERISALitig., 298 F. Supp . 2d 544 at 556, 2004 WL 52088, at *8(E.D. Tex. 2004)(quoting Coates v. Heartland WirelessCommunications, Inc., 100 F. Supp. 2d 417, 422 (N.D.Tex. 2000)) .

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A plaintiff can demonstrate scienter with allegationsof conscious misconduct or severe recklessness . Abrams,292 F.3d at 439 . Severe recklessness includes "thosehighly unreasonable omissions or misrepresentations thatinvolve not merely simple or even inexcusable negli-gence, but an extreme departure from the standards ofordinary care, and that present a danger of misleadingbuyers or sellers which is either known to the defendantor is so obvious that the defendant must have been awareof it ." Abrams, 292 F.3d at 430 ; Tuchman, 14 F.3d at1067 . Severe recklessness does not require that the de-fendant be aware of the actual falsity of his or her repre-sentation . [*32] In re Triton Energy Ltd. Secs. Litig.,2001 U.S. Dist. LEXIS 5920, 2001 WL 872019, at *10(E. D, Tex. Mar . 30, 2001); see also Abrams, 292 F, 3d at436 (stating an allegation of actual knowledge is not re-quired to withstand a motion to dismiss) .

Securities fraud complaints typically have sufficedto state a claim based on recklessness when plaintiffs"have specifically alleged defendants' knowledge of factsor access to information contradicting their public state-ments" or have "alleged facts demonstrating that defen-dants failed to review or check information that they hada duty to monitor or ignored obvious signs of fraud ."Abrams, 292 F.3d at 432-33 ; ABC Arbitrage, 291 F. 3d at351-54; Novak v. Kasaks, 216 F.3d 300, 308 (2d Cir.2000) . Under such circumstances, defendants knew, ormore importantly, should have known that they weremisrepresenting material facts relating to the corporation .Kalnit v . Eichler, 264 F.3d 131, 138 (2nd Cir. 2001). Inaddition, courts have found sufficient allegations whenplaintiffs have alleged "specific and detailed allegationsabout defendants' [*33] violation of GAAP, as well asother alleged misstatements regarding the company'searnings and technical problems [which] when viewed intheir entirety-supported the claim ." Haack, 2002 US.Dist. LEXIS 5652, 2002 WL 511514, at *7 .

Due to the fact that there will rarely be direct evi-dence of intent to defraud, allegations of circumstantialevidence of conscious misbehavior or recklessness justi-fying a strong inference of scienter will suffice to with-stand dismissal of the securities claims . Goldstein, 340F.3d at 246 ; Nathenson, 267 F. 3d at 424-25 ; Novak, 216F.3d at 307, The individual defendants ' positions andexperience are among the factors that constitute compe-tent evidence of scienter . In re Triton, 2001 U.S. Dist.LEXIS 5920, 2001 WL 872019 , at *I1, But a pleading ofscienter may not rest solely on the inference that defen-dants must have been aware of the misstatement basedon their positions within the company . Abrams, 292 F. 3dat 432. At the same time , some information is so obviousthat the court can infer that the defendants must havebeen aware of it . [*34] Tuchman, 14 Fad at 1067 .Thus, the requisite strong inference of fraud may be es-

2004 U .S . Dist . LEXIS 26488, *

tablished where the complaint sufficiently alleges thatthe defendants ; (1) benefitted in a concrete and personalway from the purported fraud (2) engaged in deliberatelyillegal behavior (3) knew facts or had access to informa-tion suggesting that their public statements were not ac-curate, or (4) failed to check information they had a dutyto monitor . Novak, 216 F. 3d at 311 .

A corporate official, acting with scienter, who onbehalf of the corporation signs a document that is filedwith the SEC that contains material misrepresentations,such as a fraudulent Form 10-K, regardless of whether heparticipated in the drafting of the document, "makes" astatement and may be liable as a primary violator undersection 10(b) for making a false statement . In re EnronCorp. Securities, Derivative & ERISA Litig., 258 F.Supp. 2d 576, 587 (S.D. Tex. 2003) . A misrepresentationalone is not enough, as the mere publication of inaccu-rate accounting figures or failure to follow GAAP, with-out more, does not establish scienter . [*35] Abrams,292 F. 3d at 433. The party must know that it is publish-ing materially false information, or must be severelyreckless in publishing such information. Id. When thenumber, size, timing, nature, frequency, and context ofthe misapplication or restatement are taken into account,the balance of the inferences to be drawn from such alle-gations may shift significantly in favor of scienter . In reTriton, 2001 U.S. Dist. LEXIS 5920, 2001 WL 872019, at*11 .

Rule 10h-S does not impose on a corporation an af-firmative duty to disclose all nonpublic material informa-tion that it has about the corporation, and where a mate-rial omission is alleged, there is no liability under thefederal securities laws unless that corporation has a dutyto disclose such information . SEC v. Fox, 855 F.2d 247,252 (5th Cir. 1988) . The duty to disclose only arises ifthe person is in a position of trust . Id. One instancewhere a duty to disclose is imposed by law on corpora-tions, is when a corporation makes a disclosure of mate-rial fact, voluntarily or involuntarily, the courts haverecognized that there is a duty to make it complete andaccurate . [*36] Rubinstein, 20 F3d at 170 . The FifthCircuit has held that "under Rule lOb-5, a duty to speakthe full truth arises when a defendant undertakes a dutyto say anything ."' Id. In addition, the defendants "have aduty under Rule lOb-5 to correct statements if thosestatements become materially misleading in light of sub-sequent events ." Id. at 170 n.41 .

While allegations of motive and opportunity aloneare insufficient to satisfy the pleading requirements ofthe 13SLRA, appropriate allegations of motive and oppor-tunity may meaningfully enhance the strength of the in-ference of scienter. Nathenson, 267 Fad at 412 . Absentan allegation that the defendants profited from the in-flated stock value or the offerings, such allegations of

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motive and opportunity in and of themselves fail .Abrams, 292 F.3d at 434 (dismissing motive and oppor-tunity allegations that defendants were motivated tocommit fraud by the need to raise capital, the desire forenhanced incentive compensation, and the desire to sellstock at inflated prices) ; see also [*37] Tuchman, 14F3d at 1068-69. Thus, some "motives," particularlythose possessed by almost all corporate executives, donothing to aid a plaintiff in pleading scienter .

Much of the parties' briefing is devoted to the issueof the group pleading or group publication doctrine . Af-ter the plaintiffs filed the TAC and after oral argumentwas held on the motions to dismiss, the Fifth Circuit heldin Southland Securities Corporation v. Inspire Ins. Solu-tions, Inc., 365 F. 3d 353 (5th Cir, 2004), that the grouppleading doctrine did not apply in cases under thePSLRA . The effect of that case is to clarify the pleadingsrequirements in securities fraud cases which, as this onedoes, rely on press releases and SEC documents that arenot attributable to any one person, but instead are pub-lished by the company itself nl The court will thus ex-amine the ramifications of the Fifth Circuit's recent hold-ing by providing an overview of the group publishingdoctrine, followed by a discussion of Southland. Thecourt will then apply Southland and the additional re-quirements discussed above to the allegations of theTAC .

nl The Ninth and Tenth Circuits have continuedto apply the group pleading doctrine followingthe passage of the PSLRA . Howard v. EverexSystems, Inc., 228 Fad 1057, 1065-66 (9th Cir .2000) ; Schwartz v. Celestial Seasonings, Inc.,124 F .3d 1246, 1254 (10th Cir. 1997), The FirstCircuit has yet to decide the issue . In re Cable-tron Systems, Inc ., 311 F.3d 11, 40 (1 st Cir .2002) .

*38

The group pleading or " group publishing" doctrinewas a creation of the courts . The doctrine permi tted"plaintiffs to rely on a presumption that statements in

"prospectuses, registration statements, annual repo rts,press releases, or other group-published information," arethe collective work of those individuals with direct in-volvement in the everyday business of the company ."'Southland, 365 F.3d at 363 (quoting In re Oxford HealthPlans, Inc., 187 F.R.D. 133, 142 (S. D. N.Y. 1999)(quotingin turn fn re Stratosphere Corp. Sec. Litig., 1 F. Supp. 2d1096, 1108 (D. Nev. 1998))) . "Instead of being requiredto plead that a particular defendant actually made, au-thored, or approved an offending statement in a corporate

2004 U .S . Dist. LEXIS 26488, *

communication, the group pleading' doctrine in itsbroadest form allows unattributed corporate statementsto be charged to one or more individual defendants basedsolely on their corporate titles ." Southland, 365 F.3d at363 . Under the doctrine as it existed before the PSLRA,a plaintiff in a securities fraud case did not need to allegeany facts demonstrating an individual defendant's par-ticipation in [*39] the particular communication contain-ing the misstatements or omission where the defendantswere "insiders or affiliates" of the company . Id.

The TAC in this case relies heavily on press releasesand filings with the SEC . The vast majority of the plain-tiffs' complaint is devoted to establishing ( 1) that Flem-ing understated its earnings in 2001 and 2002 (2) thatFleming disclosed those statements of its earnings in thecomp any's press releases, IOQ Forms , 10K Forms, andRegistration Statements . Under Southland, these are thetypes of documents one ordinarily would expect to seeassociated with group pleading because the informationcontained in the forms is generally the result of a col-laborative effort on the pa rt of the officers and agents ofthe company .

The plaintiffs have represented repeatedly that theydo not rely on the group pleadings doctrine . This is asmart move because Southland has now explicitly heldthat they may not . But saying one is not relying on thegroup pleading doctrine only advances the issue part ofthe way . This case is about the overstatement of a com-pany's earnings, and the representations concerning thoseoverstatements are found largely [*40) in corporatedocuments that are the product of collaborative prepara-tion efforts . Southland is clear that under the PSLRA :

corporate officers may not be held re-sponsible for unattributed corporatestatements solely on the basis of their ti-tles, even if their general level of day-to-day involvement in the corporation's af-fairs is pleaded. However, corporatedocuments that have no stated author orstatements within documents not attrib-uted to any individual may be charged toone or more corporate officers providedspecific factual allegations link the indi-vidual to the statement at issue . Such spe-cific facts tying a corporate officer to astatement would include a signature onthe document or particular factual allega-tions explaining the individual's involve-ment in the formulation of either the en-tire document, or that specific portion ofthe document containing the statement .

Southland, 365 F. 3d at 365 .

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Under this language, to the extent the plaintiffs arerelying on representations of Fleming's earnings in pressreleases or SEC filings, it is not enough to plead thatFleming said or did something because the plaintiffs heredo not sue Fleming . [*41] They sue individual defen-dants . As a result , the court must examine the TAC anddetermine whether the plaintiffs have alleged (1) that anyor all of the 1934 Act Individual Defendants signed acorporate document containing a misrepresentation or (2)particular factual allegations explaining an individualdefendant 's involvement in the formulation of either theentire document , or that specific portion of the documentcontaining the statement . Id.

E. Section 20(a) controlling person liability

The previous discussion addressed liability for pri-mary violations of the 1934 Act. Section 20(a) provides abasis for additional liability and states that "every personwho, directly or indirectly, controls any person liableunder any provision of this chapter or of any rule orregulation thereunder shall also be liable jointly and sev-erally with and to the same extent as such controlled per-son to any person to whom such controlled. person isliable, unless the controlling person acted in good faithand did not directly or indirectly induce the act or actsconstituting the violation or cause of action ." 15 U.S.C. §78t(a) [*42] . Since section 20(a) is a secondary liabilityprovision, it is necessary that a primary violation be es-tablished before liability under section 20(a) arises . ABCArbitrage, 291 F.3d at 348 n.57 . Controlling person li-ability under section 20(a) is not subject to the height-ened pleading requirements of Rule 9(b), but is insteadgoverned by Rule 8 . In re Enron Corp, Sec ., Derivative& ERISA Litig., 2003 U.S. Dist. LEXIS 1668, 2003 WL230688, at *12-I3 (S.D. Tex . 2003) . Rule 8 is a "simpli-fied notice pleading standard" that "applies to all civilactions, with limited exceptions," and requires merely astatement that "gives the defendant fair notice of whatthe plaintiffs claim is and the grounds upon which itrests ." Swierkiewicz v. Sorema N.A ., 534 U.S. 506, 152 L .Ed. 2d 1, 122 S. Cr 992 (2002) .

IV. DISCUSSION

A . Analysis of'the 1934 Ael Issues

The court now addresses the various argumentsmade by the 1934 Act Defendants in the light of thestandards set forth above . The 1934 Act Defendants fileda joint .motion to dismiss, and each filed his own separatemotion to dismiss to address issues peculiar to that [*43]defendant . The court will first detail the alleged frauditself; then the court will address the 1934 Act Defen-dants' arguments as presented in their joint brief and will

2004 U . S. Dist . LEXIS 26488 ,

address the individual arguments, to the extent necessary,after considering those positions common to the group .

In the TAC, Lead Plaintiff Jackson Capital Man-agement alleges a scheme by the 1934 Act IndividualDefendants to inflate the price of Fleming securities anddefraud the investing public . The TAC alleges that Flem-ing's external auditors, D&T, had knowledge of the fraudand/or was severely reckless with regard to the fraud andmade materially false and misleading statements to thepublic . The TAC alleges that these 1934 Act IndividualDefendants personally perpetrated the fraud .

Many of the plaintiffs' allegations come from infor-mation provided by four inside sources ("Sources") whoallegedly observed much of the alleged accounting ma-nipulations and the involvement of each of the 1934 ActIndividual Defendants and D&T . According to the TAC,Sources 1 and 4 were financial analyst managers inFleming's retail segment . Sources 2 and 3 were chiefaccountants for two of Fleming's principal wholesaledivisions, j*44] Source i was employed at Flemingfrom the fall of 2001 to the summer of 2002 . Source 4was employed at Fleming from the summer of 2001 toearly 2003 . Source 2 was employed at Fleming from the1980s to 2002 and served as a chief accountant for awholesale division in 2001 and 2002 . Source 3 was em-ployed at Fleming as a chief accountant for a wholesaledivision from 2001 through 2002 .

Because the TAC relies heavily on the Sources, it isimportant to understand the information alleged to bepossessed by them . The TAC alleges that Source 1 "re-ceived detailed weekly repo rts from Fleming ' s retailstores and product category managers "' along with otherfinancial analysts and "compiled Fleming's actual reve-nue, costs, and margin" into "weekly , monthly , and quar-terly reports" and " personally delivered these repo rts tothe top Fleming executives ," including Hansen, Rider,Shapiro , Dahlen , and Davis . (TA.C, P 95). The TAC fur-ther alleges that " Source l saw [similar] report s [ for thewholesale segment ] in the executives ' offices , and . . .reviewed [them ] to assess the retail segment's perform-ance in comparison with the wholesale segment ." (TAC,P 96) .

The TAC alleges that starting in July [*45 ] of 2001through the class period, Source 4 "was responsible forcirculating weekly, monthly, and quarterly retail same-store sales reports throughout the Company ," and that"hard copies of these reports were given directly to De-fendants Hansen and Rider , and electronic copies wereprovided to Defendant Dahlen ." (TAC, P 122) . The TACalleges that from early 2001 through the class period,Sources 2 and 3 had access to company-wide financialinformation and frequently communicated with one an-

Page 1 1

other about accounting issues that affected the variousdivisions. (TAC, P 144) .

The court now turns to the speci fic allegations offraud . It is helpful . to recall , as the court noted in the fac-tual background section of this opinion , that Fleming'spress releases, and SEC filings made various statementsconcerning the company ' s earnings and the success ofFleming's retail operations strategies . As is true in anyfraud claim, the plaintiffs' complaint is that the defen-dants made ce rtain statements with knowledge of infor-mation to the contrary . Bearing this in mind , the courtnow examines the allegations contained in the TAC .

The TAC alleges that Source I prepared earn ingsanalyses prior to the closing [*461 of the books for thevarious report ing periods and that the CFO for the retailsegment "directed that a new revenue or margin number,which they supplied , be substituted for the original num-ber in the analysis, while providing no basis or back-updocumentation for the change ." (TAC, P 98) . Source Istates that "Dahlen was involved in the margin manipula-tions and always received from Source 1 the same infor-mation that the [retail CFO] n2 received ." (TAC, P 98) .

n2 The position of retail CFO during theclass period was filled initially by John Simrelland later Tim Otte. Since the two men are not be-ing sued individually the use of their individualnames is unnecessary .

The TAC further alleges that Source 1 was requiredby the retail CFO to reduce accounts payable by a speci-fied amount in order to account' for deductions' thatFleming planned to claim from as-yet-unidentified ven-dors, for as-yet-unidentified products ." (TAG, P 99) . TheTAC alleges that the standard industry practice was topropose deductions to [*47] vendors for return of mer-chandise, adjustments for incorrect quantities invoiced,adjustments for incorrect pricing, and adjustments pursu-ant to written contractual arrangements, i .e ., co-operativeadvertising agreements and volume discount agreements .(TAG, P 99), The TAC alleges that according to Source1, "Fleming did not follow standard industry practice" inthat they "did not propose deductions ." Fleming unilater-ally took them without authorization from the vendorsand that "there was no basis for concluding that the ven-dors would accept the improper and baseless deduc-tions ." (TAC, P 100) . The TAC alleges that the deduc-tions "had already been accrued by Fleming's accountingdepartment by the time Source 1 was told to change [theearnings analyses], even though the vendor, the product,and the basis for the deduction had not yet been identi-fied ." (TAC, P 101) .

2004 U .S . Dist . LEXIS 26488, *

The plaintiffs also allege that accrual of these unau-thorized, improper, and unsustainable deductions wasdirected by Dahlen and the retail CFO ; and that the retailCFO often accrued deductions, and then asked the finan-cial analyst managers and product category managers todetermine which of the Company's vendors, if any,[*48] would be likely to accept deductions . (TAC, P101) . According to the TAC, Source I stated that"Dahlen and [the retail CFO] manipulated earnings dur-ing the entire time that Source l worked at Fleming ."(TAC, P 102) . Each financial analyst manager had a de-duction worksheet, which was reviewed by higher-levelexecutives . The TAC alleges that "by June 2002, Source1 was emailing Source l's deduction worksheets toDahlen [and the retail CFO] with a frequency of three tofive times a week" and that "even after a deduction wasrejected by a vendor and removed by Source I from theworksheet, the retail executives often reinstated the de-duction." (TAC, P 103) . The TAC alleges that "Hansenand Dahlen directed Source I to deduct from vendors'invoices a two case' deduction [amounting to a $ 3 .5 mil-lion accrual that increased earnings], based on the con-cept that vendors should provide new retail stores withtwo free cases of product," but that they were "over-whelmingly rejected by vendors ." (TAC, P 104) . Further,the TAC alleges that "Fleming didn't correct its financialstatements to reflect any such repayments [of the deduc-tions], nor did the Company stop taking the improperdeductions . [*49] " (TAC, P 105) .

The TAC alleges that the 1934 Act Individual De-fendants and specifically Hansen a ttended Monday meet-ings where the handling of deductions and marginswould be discussed. (TAC, P 106) . The executives alleg-edly reviewed documents showing that sales in Fleming'sretail segment were flat or declining, and that there was adifference between publicly repo rted margins and inter-nally calculated margins . (TAC, P 106) . Further Source 1states that the publicly reported retail margins werehigher than those re flected in the internal analysis seenand discussed by the executives due to manipulationsmade by the retail CFO and directed by Dahlen . (TAC, P107) . According to Sources 1 and 4 Hansen , Rider,Shapiro, and Dahlen received comparisons between thebudget plan and the ea rnings report for the retail storesshowing the actual experienced earn ings shortfalls be-ginning in early 2002 . (TAC, P 108) .

With regard to D&T, the TAC alleges that Source Iprovided back-up for these accrued deductions at D&T'srequest, but that D&T "never asked Source I any ques-tions about the deductions that they were supposedlyexamining ." (TAC, P 109) . The TAC alleges that theretail CFO hired D&T [*50] to validate deductionsclaimed by Fleming retail and that Source I providedinformation to D&T about the deductions . (TAC, P 110) .

Page 1 2

The TAC alleges that both Fleming wholesale and retailtook deductions from vendors on the same product re-sulting in a double accrual of deductions on the books fora single product , (TAC, P 112) . In addition, the TACalleges that when Fleming's wholesale group secured acontract with Kma rt at thin margins , " the retail segmentbooked more and more deductions in order to prop upcompany-wide margins" and "even accrued large dis-puted deductions on its purchases from Fleming's whole-sale segment ." (TAC, P 114) . The TAC alleges that therewas a strong "push for unauthorized , improper , and un-sustainable deductions in Fleming's retail segment re-flecting-serious company-wide problems . "

The TAC alleges that any reserves kept in the eventthat the deductions were reversed were inadequate andwere eventually done away with in order to increaseearnings . (TAC, PP 283-285) . Specifically, according toSource 3 Fleming ' s policy was to reserve against only50% of claimed deductions , but that the wholesale man-agement frequently reversed the reserves to increaseearnings . [*51] (TAC, P 283 ) . Further, according toSource 3 , the accounting managers were told by thewholesale managers at the direction of Fleming ' s corpo-rate management to stop taking reserves in the secondquarter of 2002 . (TAC, PP 284-285).

The plaintiffs also contend that the 1934 Act Indi-vidual Defendants misrepresented the company's samestore sales data . According to Sources I and 4, the TACalleges that "Fleming manipulated its same store' salesdata to show increases in same-store sales ." (TAC, P115) . Specifically, "Fleming's financial analyst managerstracked the real same store sales data" that consistentlyshowed "large declines in same-store sales ." (TAC, P117) . However, the TAC alleges that "Dahlen and [theretail CFO] on numerous occasions manipulated the pub-licly reported same-store sales figures in order to hide theadverse sales trend" by rejecting the data from the finan-cial analysts and "changing the composition of the popu-lation of stores which constituted the Company's samestores ."' (TAC, P 118) .

Specifically, the TAC alleges that "Dahlen and [theretail CFO] often commingled better performing newstores' revenue and earnings with current-year samestore' revenues, [*52] in order to inflate current-yearsame-store revenues and earnings and created the falseimpression of growth" resulting in "revenue and earningsreports [that] did not truly reflect a same store' compari-son as is commonly understood in the retail industry ."(TAC, P 118) . The TAG alleges that, according toSource 4, Rider approved manipulations of same storesales figures required by Dahlen whereby "new stores . .. were being compared with old stores located within twoto five miles of the new stores, but which had beenclosed two or three years before the comparison" result-

2004 U .S . Dist LEXIS 26488, *

ing in a comparison of "stores in their first year of exis-tence with sales at stores in their last year of existence,"(TAC, P 128) . The TAC alleges that "according toSource 1, in November 2001, Fleming ' s retail financialanalyst managers expressed concern to [the retail CFO]that Fleming's retail segment was over - reporting thestrength of its sales , especially its comparable store'sales," but that the retail CFO told them "not to raiseconcerns, or they would lose their jobs." (TAC, P 119) .

Further , the TAC alleges that "according to Sources1 and 4, beginning in 2001 and continuing into 2002,Fleming [*53] also inflated its same store and/or compa-rable store sales figures by including certain sales, re-ferred to as red tag' sales ." n3 (TAC, P 120) . The TAGalleges that " even though red tag sales were not madethrough any Fleming retail store, Fleming would falselyattribute ! the revenue from these sales to the retail storesincluded in its same store and/or comparable store analy-ses, thereby inflating the total amount of same storeand/or comparable store sales ." (TAC, P 120) . The TACalleges that when Source 4 was first given "red tag" salesnumbers by the retail CFO and asked what they were, theretail CFO answered : "You don't want to know." (TAC,P 125) .

n3 "Red tag" sales are one-time transactionsin which Fleming purchased and immediatelysold large lots of a commodity which had beenlocated for Fleming by a broker .

In addition , the TAC alleges that according toSource 1, in at least one instance in late 2001 or early2002, Fleming- at the direction of Dahlen and the retailCFO-reduced the previously reported [*54] same storesales for the year 2000 fiscal year by subtracting $ 1 .3million in red tag sales while at the same time inflatingthe 2001 figure for same store or comparable store salesby at least $ 4 . 7 million in red tag sales . (TAC. P 120) .The plaintiffs allege that same store sales informationwas also misstated by a process called diverting . n4(TAC, P 123) . According to Source 4, Fleming includedthis revenue in "same store " sales figures despite its notbeing attributable to any of the retail stores . (TAC, P123) . The TAC alleges that according to Source 4Dahlen required that red tag and diverting sales be in-cluded in publicly reported same-store sales data . TheTAC alleges that the "total same store and/or comparablestore figure for 2001 was falsely inflated, and the growthfor the same store or comparable store figure was alsofalsely inflated [whereby] the market was misled aboutgrowth in same store sales ." (TAC, P 120),

Page 1 3

n4 "Diverting" is a practice where the retailoperations purchase product and resell it at ahigher price to another company but where theretail operations do not take possession of theproduct or sell it through a particular store .

*55

The TAC alleges that Source 4, from July 2001through the end of the Class Period , "was responsible forcirculating weekly, monthly, and qua rterly retail same-store sales reports throughout the company" which dem-onstrated that same-store sales were declining, and that"hard copies of these reports were given directly to de-fendants Hansen and Rider, and electronic copies wereprovided to defendant Dahlen ," (TAC, P 122) . The TACalleges that Hansen received special sales reports givingeven more current information than Sources 1 and 4 re-ceived showing the declining sales trends. (TAC, P 131) .In addition, at the beginning of 2002, in his "same storesales" report s, " Source 4 began breaking out red tag anddiverting sales into a separate category . . . demonstratingto recipients of the repo rt- including defendants Hansen,Rider, and Dahlen -that Fleming was including in itssame store sales' data that were not attributable to anystores and that same store sales were declining ." (TAC, P124) . Source 4's reports in 2002 also listed same storesales separately in each of Fleming retail's seven regionsshowing that overall same store sales were declining inalmost all of the company ' s regions , [* 56] some at up to20% over the course of a year . (TAC, P 127), In addition,Hansen and Dahlen allegedly personally directed theaccrual of unauthorized, improper , and unsustainabledeductions from vendors ' invoices in the retail segmentand participated in the manipulation of "same store"revenues , in order to create the false impression of reve-nue and earn ings growth. (TAC, PP 459, 462) . Also,Hansen , Shapiro, Rider, and Davis received regular re-ports showing that same -store sales were declining, andthat Fleming was manipulating its same-store sales data .(TAC, P 459) .

The TAC alleges that the actual sales trends clearlyshowed that the price-impact format was not workingaccording to Source 4 . (TAC, P 132). Specifically, be-tween July 2002 and September 2002, defendant Hansenasked Source 4 to chart the trends in sales for newly-opened price-impact stores . (TAC, P 133) . Using datathat had been available to Hansen, Rider, and Dahlenprior to July 2002, Source 4's chart demonstrated that thesales for a typical Fleming store declined consistentlyafter opening, and never increased showing the ineffec-tiveness of the price-impact format. (TAC, P 133) . TheTAC alleges that it was apparent [*57] in 2001 and 2002from reports provided to defendant Hansen that newly-purchased stores were performing poorly and routinely

2004 U . S . Dist . LEXIS 26488, *

were not meeting the revenue and earnings projectionsprepared by Source 4 with information provided to himthat were used to justify the purchases . (TAC, P 134).

The TAC alleges that "with the knowledge and directionof the 1934 Act Individual Defendants , Fleming contin-ued to purchase retail stores based on unrealistic projec-tions in order to create the fiction of a new source ofrevenue to hide the decline in the Company's sales ."(TAC, PP 134, 135) .

The plaintiffs allege that defendants Hansen andDahlen received daily retail store performance reportsfrom the financial analyst managers showing that salesand earnings were declining, yet, they made publicstatements claiming that Fleming's retail segment wasgrowing . (TAC, P 455). In addition, Hansen, Rider,Shapiro, Dahlen, and Davis received weekly, monthlyand quarterly reports showing the revenue, cost, andmargin numbers for the retail segment illustrating a de-cline in sales and earnings, yet, they made public state-ments claiming that Fleming's retail segment was grow-ing. (TAC, P 456) . Also, the TAC [*58] specificallyalleges that Hansen, Rider, Shapiro, Dahlen, and Davisattended Monday meetings where finances were re-viewed and deductions were discussed showing thatFleming's retail sales were flat or declining and that therewas a material difference between reported margins and.internally calculated margins . (TAC, P 457) . Accordingto Source 1, Dahlen had the responsibility for approvingthe publicly reported and margin numbers in the retailsegment despite receiving information from the financialanalyst managers showing declining revenues and mar-gins . (TAC, P 460)

In addition to the vendor deductions and the samestore sales issues, the TAC alleges that according toSources 1 and 4 "Fleming often reported normal[, recur-ring] operating expenses as strategic plan charges' orother one time charges even when the expenses were notrelated to Fleming's strategic plan" despite the "financialanalyst managers stating in meetings with managementthat the charges in question were recurring" thereby "in-creasing its reported margins and falsely suggesting toanalysts and investors that the expenses would not recurin future reporting periods ." {TAC, P 136) .

The above discussion has related [*59] generally tothe company's retail operations . The TAC also allegesthat Fleming "engaged in a series of manipulations dur-ing the Class Period [in its wholesale segment] involvingimproper inflation of revenues and earnings ; the accrualof unauthorized, improper, and unsustainable vendordeductions ; a scheme to obtain unearned promotionalfunds through the use of nonexistent stores; the improperfailure to recognize inventory losses ; and the improperclassification of prior-year expenses ." (TAC, P 137) .

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According to Source 4, Fleming "inflated its earn -ings by booking losses to discontinued operations' whenthe losses were in fact attributable to continuing opera-tions" thereby "overstating the earnings of its continuingoperations and burying the losses in the presumably lessimpo rtant discontinued operations ' category ." (TAC, PP138, 139) . Specifically, following a September 24, 2002press release announcing the divestment of its price-impact Food4Less and Rainbow Foods Stores thesestores were " treated as discontinuing operations, whilethe limited-assortment Yes!Less stores were [still treatedas] continuing operations ." (TAC, PP 138, 139) . Accord-ing to Source 4, "Yes!Less would [*60] sell its excessinventory to the price- impact stores at full price " and the"price-impact stores would then resell the excess inven-tory to . . . another retailer[] at a fifty percent mark-down ." (TAC, P 139) . "In this way, the discontinued'price-impact stores assumed the excess - inventory lossesof the continuing ' Yes! Less stores " thereby overstatingthe earnings for continuing operations . (TAC, P 139) .

According to the plaintiffs, beginning at least asearly as 2000 and continuing through the Class Period,Fleming manipulated its wholesale earnings through ascheme whereby the company ' s internal controls wereweakened and the company's upper management , includ-ing defendants Hansen and Davis, put pressure on thedivisional staff to meet budgeted targets by any meansnecessary . (TAC, P 140) . In early 2001, the companycentralized its accounting operations and terminated di-visional accounting managers and clerks . Essentially, theplaintiffs contend that management put pressure on itsstaff to meet targets even though those goals were unre-alistic . (TAC, P 146, 148) .

According to Source 3, the accountants routinelydiscussed among themselves the Company ' s financialcondition in both [ *61] the wholesale and retail divi-sions based on their access to actual results showinglarge losses and "that Fleming ' s publicly disseminatedrosy consolidated financial statements were completelycontrary to reality ." (TAC, P 151). These accountantseven asked their directors where the publicly claimedprofits were coming from, but received no valid or plau-sible response . (TAC, P 151) . The TAC alleges that afterDecember 2001 these accountants "routinely discussedthe fact that Fleming was a sinking ship that eventuallywould have to declare bankruptcy ." (TAC, P 15]).

The TAC alleges that "one of Fleming wholesale'smost pervasive methods of inflating its earn ings was totake unauthorized, improper, and unsustainable deduc-tions from accounts payable to vendors ." (TAC, P 156) ."According to Sources 2 and 3, Fleming's division offi-cers directed accounting managers to recognize unau-thorized, improper , and unsustainable deductions fromvendors' invoices in order to enable the divisions to meet

2004 U .S . Dist. LEXIS 26488, *

their targets" that eventually " increased in a snowballeffect from period to period," (TAC, P 157) . The TACfurther alleges that "upon determining the amount of thedivision's shortfall to the forecast, [*62] the divisionstaff would fax to the [ accounting ] managers sufficientunauthorized , improper , and unsustainable deductions,backdated to the financial period closing date, to makeup the shortfall ." (TAC, P 158) .

According to Sources 2 and 3, Fleming maintained a"Vendor Compliance Manual " that was "an open check-book ' that authorized division account ants to imposedeductions for any reason that" was used by the divi-sions , "especially those that struggled to meet their tar-gets ." (TAC, P 159) . In one situation Fleming allegedlytook an $ 800 deduction from a vendor because the truckwas late making its delivery . The "deduction documents"sent to vendors "did not identify any speci fic vendor in-voices that were the subject of the deduction " and onevendor said " it would take four months to figure outwhy Fleming took the deduction, and another fourmonths to get it back ."' (TAC, PP 160, 161) . The TACalleges that once the "deduction documents " were pre-pared, the deduction would be accrued even though inmost cases Fleming ended up reinstating all or almost allof the amount deducted from a vendor's invoice . (TAC,PP 161, 163) .

According to Source 3, at one point in July 2002, thedisputed [*63] deductions totaled about $ 100 million atthe corporate level in addition to $ 20 million at the divi-sional level in the wholesale segment. (TAC, P 167). TheTAC alleges that even though the deductions inevitablywould have to be remitted to vendors and the accrualreversed , the deductions nevertheless were accrued be-cause they created the illusion of present earnings . (TAC,P 167). "According to Sources 2 and 3 , in order to com-pensate for the adverse earn ings consequences caused bywriting checks to vendors to cover amounts improperlydeducted, Fleming would initiate another round of unau-thorized , improper, and unsustainable deductions" lead-ing to "a vicious cycle which continually served tofalsely inflate current earnings . . . eventually resulting ina huge charge to ea rn ings ." (TAC, P 166) .

The TAC includes excerpts from a September 5,2002 Wall Street Journal article in its allegations detail-ing complaints from various vendors about the large de-ductions taken by Fleming being unjustified . (TAC, PP171-174, 177- 179), These articles include claims by for-mer Fleming executives and employees that the disputeddeductions amounted to $ 100 million during the middleof 2001 , that [*64] the Fleming managers took the de-ductions at the direction of upper management, thatFleming took deductions for items it never actually putinto distribution due to the c ancellation of orders, and

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that executives resigned after disagreeing with Flemingabout its practices . (TAC, PP 173, 177, 178) .

The plaintiffs allege a variety of other accountingimproprieties . According to Source 3, Fleming inflatedearn ings by booking sales and earn ings to a fictitiousstore in order to earn promotional discounts from ven-dors and then failing to reverse the fictitious earnings .(TAC, PP 180-192) . Also, Fleming, at the direction ofdefendant Shapiro , did not recognize a S 1 million inven-tory loss from continuing operations in 2001 , but insteaddeferred the loss to 2002 and then booked it as a lossfrom discontinued operations . (TAC, PP 193-199) . Flem-ing recognized an inventory surplus of S 6 .2 million andbooked it to income even though it was due to inventorythat actually belonged to one of Fleming 's customers andshould have been offset by a liability . (TAC, P 200) .

Hansen, Shapiro, Rider, and Davis received regularreports showing the revenue, cost, and margin numbersfor the wholesale segment [*65] and were well aware ofthe magnitude and invalidity of massive deductions takenby Fleming. (TAC, P 458) . According to the plaintiffs,Hansen, Rider, and Shapiro participated in meetings withthe financial analyst managers, the retail CFO, and de-fendant Dahlen where internal cost and margin numberswere reviewed and, therefore, defendants Hansen, Rider,Shapiro, and Dahlen either knew or recklessly disre-garded the material differences between Fleming's inter-nal reports and public statements . (TAC, P 461) .

As can be seen, the gist of the plaintiffs' complaint isthat the 1934 Act Individual Defendants made falsestatements concerning Fleming's earnings with knowl-edge of contrary information and/or reckless disregardfor the truth of those earnings statements . The TAC al-leges that the 1934 Act Individual Defendants bad themotive to make materially false and misleading state-ments . (TAC, P 468) . Specifically, the TAC alleges thatthe defendants made the materially false and misleadingstatements in order to facilitate Fleming's offering whichnetted $ 170 million in exchange for stock. S 200 millionin exchange for senior notes, and a $ 975 million in newcredit facilities . (TAC, P 468) . [*66] In addition, theplaintiffs allege that the defendants had the motive tomanipulate earnings since their bonuses were tied di-rectly to reporting certain targeted earnings which weremet in 2001 as a result of the manipulations . (TAC, P469) .

1 . Group Pleading

The 1934 Act Individual Defendants contend thatthe TAC should be dismissed because the plaintiffsimpermissibly rely on group pleading when they makeallegations against the 1934 Act Individual Defendantsas a whole and against Fleming . The plaintiffs respondthat both parties have used the shorthand reference to the

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defendants in their pleadings and that allegations in theTAC against the 1934 Act Individual Defendants are asto each and everyone of them individually . The plaintiffscontend that the only paragraphs that arguably rely ongroup pleading concern the allegations that press releaseswere false and misleading and that the 1934 Act Individ-ual Defendants knew of their falsity . The plaintiffs arguethat there is a reasonable basis for believing that the in-dividuals knew of their falsity based on the rest of theallegations in the TAC . Further, the plaintiffs contendthat the viability of the group pleading [*671 doctrineafter the enactment of the PSLRA is an open issue in thisjudicial district and the Fifth Circuit . Finally, the plain-tiffs respond that the TAC makes adequate allegationsagainst the individuals by name as well .

The Fifth Circuit's recent decision in Southland, dis-cussed above, disposes of many of these issues, First, thecourt rejects the plaintiffs' argument to the extent it relieson the supposed potential "viability" of the doctrine inthis circuit . The doctrine now has no viability at all . Thecourt will not permit the use of such shorthand referencesto "defendants" to meet the particularity requirements ofthe PSLRA . This notwithstanding, the court observesthat the plaintiffs do make substantial allegations thatparticular defendants were identified in press releasesand conference calls with analysts . Likewise, the plain-tiffs note, when appropriate, the signatories to the vari-ous SEC filings . No party has suggested that further re-pleading is necessary at this stage ; accordingly, the courtwill consider the TAC as it stands under the decision inSouthland.

2. Failure to Adequately Identify the Source oftheir "Information and Belief '

The 1934 [*68] Act Individual Defendants nextcontend that the TAC should be dismissed because theplaintiffs have not adequately identified the source of theallegations that are not based on the plaintiffs' personalknowledge . In addition, these defendants contend that noinference of fraud is raised without an adequate showingof the foundation of the Sources' information and its reli-ability . The defendants argue that the TAC fails to de-scribe the details concerning how, when, and where anyof the Sources acquired their information .

The plaintiffs respond by stating that even thoughthey did not disclose the names, they provided informa-tion about the Sources' job positions to support the prob-ability that those persons would possess the informationpleaded to support the allegations, as well as used infor-mation that predated their employment to know that themisrepresentations had been ongoing . The plaintiffs re-spond further by stating that these Sources have personalknowledge of the events, meetings, and internal reportsthat evidence the misrepresentations and personal

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knowledge that the defendants attended the meetings andreviewed the documents and reports .

Applying the standards announced [*69] in ABCArbitrage, the court finds that the plaintiffs have suffi-ciently identified the Sources who provided the informa-tion for their allegations . Although the TAG does notname the Sources, it discloses specific information aboutthe positions held by the Sources, the time period inwhich they worked for the Company, and their job re-sponsibilities . The TAC also discusses how the Sourcesreceived the information underlying the allegations andto whom the information was forwarded . Based on theparticularity with which the allegations discuss theSources themselves and the specifics regarding how theSources acquired the information and knowledge under-lying the allegations, the court holds that the allegationsin the TAC are adequately pleaded to support the prob-ability that the Sources would possess the informationpleaded that support the allegations of false or mislead-ing statements by the defendants .

3. Failure to Plead Fraud with Particularity

The 1934 Act Individual Defendants raise several is-sues with respect to whether the plaintiffs have suffi-ciently pleaded fraud with particularity . First, the defen-dants attack the pleading as it relates to financial reports,[*70] reports on retail stores, and Monday meetings . Thedefendants argue that the TAC does not allege specifi-cally how the Sources know that the 1934 Act IndividualDefendants knew about the improper earnings manipula-tions or knew what was being discussed at the Mondaymeetings, In addition, the defendants contend that thereare no allegations that show that the 1934 Act IndividualDefendants knew that the vendor deductions, same storesales analysis and improper classification of recurringexpenses in the retail segment were improper .

The plaintiffs respond by arguing that the defendantsare merely pointing to isolated paragraphs but that thetotality of the complaint is what is determinative . Withregard to the financial reports, reports on retail stores,and Monday meetings, the plaintiffs posit that theSources prepared the financial reports with the manipula-tions as directed by defendants Dahlen and Hansen andknown to the other 1934 Act Individual Defendants, pre-pared charts of retail store sales growth at the request ofHansen, and that the charts and manipulations were dis-cussed at the Monday meetings.

Although documentary evidence, such as internalreports, may be the basis underlying [*71] the allega-tions in the TAC of false and misleading statements, anunsupported general claim about the existence of confi-dential corporate reports that reveal information contraryto reported accounts is insufficient to survive a motion todismiss . Abrams, 292 F.3d at 432 (stating that plaintiffs

2004 U .S . Dist. LEXIS 26488,

did not point to any particular reports or information-available to the defendants before the announced finan-cial restatements-that are contrary to the restatements andthat it would be easier to infer that they had receivedsuch reports if information were given about who gener-ated the reports, when they were reviewed, how defen-dants responded, etc .). Such allegations must have cor-roborating details regarding the content of allegedly con-trary reports, their authors and recipients . Id. A plaintiffneeds to specify the internal reports, who prepared themand when, how firm the numbers were or which com-pany officers reviewed them . ABC Arbitrage, 291 F.3dat 356. However, the Fifth Circuit has expressly declinedto adopt as a standard the threshold requirement in everycase that the plaintiffs must provide report titles, whenthey were prepared, who prepared [*72] them, to whomthey were directed, their content, and the sources fromwhich plaintiffs obtained this information, Id at 355 .

A complaint can satisfy the PSLRA by providingdocumentary evidence and/or a sufficient general de-scription of the personal sources of the plaintiffs' beliefs .ABC Arbitrage, 291 F.3d at 352 , to this case, the plain-tiffs have satisfied the pleading requirements by provid-ing not only a sufficient factual basis for the internal re-ports, but also a sufficient factual basis for the informa-tion contained in the reports by virtue of the allegationsconcerning the Sources discussed above . The allegationscontain numerous references to reports as outlinedabove, but in each instance the allegations contain suffi-cient factual information concerning the reports as re-quired by ABC Arbitrage and/or are based upon informa-tion provided by the Sources . Therefore, the allegationsin the complaint concerning internal reports are ade-quately pleaded .

Likewise, the allegations concerning the defendantsand the Monday meetings are based on factual allega-tions provided by the Sources . The factual allegations inthe TAC concerning the Sources [*73] support the beliefthat the Sources would possess the information about theMonday meetings . As discussed in ABC Arbitrage, aslong as the factual basis concerning the Sources is ade-quate, the plaintiffs' allegations of false or misleadingstatements based on information provided by the Sourcesare adequate to satisfy the heightened pleading standards .

The court now considers whether the plaintiffs havesufficiently attributed any misrepresentation of fact toany particular 1934 Act Individual Defendant in light ofthe Southland decision. The court will address Fleming'sstatements concerning its earnings, followed by the samestore sales reporting, and conclude with a discussion ofthe defendants' arguments concerning puffery . material-ity and forward-looking statements . At the outset, thecourt agrees with the plaintiffs that Fleming's need torestate its earnings makes the plaintiffs' burden to dem-

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onstrate the falsity of particular earnings statements eas-ier to discharge . The company made a public announce-ment that its earn ings needed to be restated and that therestatement of its earn ings for 2001 and 2002 would ap-proximate $ 85 million , or 79% of Fleming's reportedearnings [*74] for the time period at issue . At this point,the court is not addressing the scienter requirement ;rather, the court is addressing whether the plaintiffs havesufficiently pleaded with particularity the falsi ty of thestatements that any individual defendant made aboutFleming's 2001 and 2002 earnings . The magnitude aloneof the forecasted restatement is a testament to its materi-ality . And, although the court is not at this point address-ing scienter, the size of the restatement shall figure sig-nificantly into the court's calculus concerning whetherthe plaintiffs have adequately pleaded scienter .

The earnings statements made in the May 29, 2001,August 24 , 2001 , and November 15, 2001 Form IOQsfiled with the SEC are pleaded with sufficient pa rticular-ity as against defendant Neal Rider, who signed the FormI OQs for 2001 Q 1 and Q2 . They are also sufficient asagainst defendant Mark Shapiro, who signed the FormIOQ for Q3 of 2001 . The plaintiffs have not alleged howany person other than Rider or Shapiro contributed toany specific port ions of the Form I OQs . Therefore, theclaims based on the Form I OQs are limited to defendantRider and Shapiro , as they signed the forms .

As to the [*75] March 6, 2002 Form 10K filed withthe SEC reporting year end financial information, thestatements of earnings contained therein are pleaded withsufficient particularity as to defendants Hansen, Riderand Shapiro. (TAC, PP 204, 210, 217, 229) . The com-pany's earnings as reported in the Registration Statementfiled in anticipation of the March 2002 Note Offering,which incorporated the Form 10K from 2001 is alsopleaded with particularity as to defendants Hansen, Riderand Shapiro .

With respect to the 2001 earnings reports set forthabove, the plaintiffs have adequately alleged why thestatements are false. The plaintiffs have alleged thatFleming itself has announced that its 2001 earnings in-formation is false, and materially so . In the court's opin-ion, the announcement of the need to restate earningsconstitutes an admission that the information containedin the public filings is false . There is no reasonable ar-gument that could be made that the proposed restate-ment, even though it has not yet occurred, is anythingother than a material one . Consequently, as to the 2001earnings information, the court is persuaded that theplaintiffs have sufficiently alleged the who, what, why,[*76] where, when, and how required by Rule 9(b) asagainst the defendants included above.

2004 U .S . Dist. LEXIS 26488, *

The court now turns to the 2002 earnings informa-tion . First, the plaintiff has pleaded with sufficient par-ticularity the statements contained in Flemings Form10Q filed with the SEC on May 17, 2002 (TAC, P 245)and signed by defendant Shapiro . Second, defendantRider's statements made in the conference call followingthe release of the IQ 2002 results that our EBITDA, forcontinuing operations was $ 32 .6 million for 4.87 percentof sales" is also sufficiently pleaded with particularity .(TAC, P 244). Third, the earnings reported in the June2002 Registration Statement which, in turn, incorporatedthe company's financial results included in the 2001 10Kfiled with the SEC and signed by defendants Hanson,Rider and Shapiro is sufficiently pleaded with particular-ity . Fourth, the earnings reported in the August 27, 2002Form IOQ filed with the SEC and signed by defendantShapiro are pleaded with sufficient particularity . Fifth,with respect to reserves, defendant Rider's statements onthe September 5, 2002 conference call with analysts that"everything would be appropriately reserved for, correct"and [*77] that "less than one-tenth of one percent of allthe vendors we deal with, and even a smaller amount ofthat in terms of dollars, have a dispute that risen to thelevel that we are at an impasse today" are sufficientlypleaded with particularity . Sixth, the court finds that theearnings reported in the company's amended IOQs and10K filed with the SEC on October 16, 2002 for Q 1 andQ2 of 2002 of FY 2001 and signed and/or certified byShapiro, Hansen and Rider are pleaded with particularity .Seventh, the court holds that the representations of earn-ings contained in Fleming's 1OQ for the third quarter of2002 have been pleaded with particularity. That formwas signed by Shapiro and certified by Hansen andRider . Finally, the court holds that the statements madeby Shapiro in the January 23, 2003 conference call arepleaded with sufficient particularity . (TAC, P 311) ,

As to defendant Stephen Davis, the plaintiffs do notallege that Davis personally made any particular oralfalse statements or signed any of the press releases orSEC forms which contained the alleged misstated earn -ings . n5 Consequently, the court examines whether thereare any "particular factual allegations explaining [*78]an individual defendant's involvement in the formulationof either the entire document, or that specific portion ofthe document containing the statement." The closest thatthe plaintiffs come is "during that same period, Fleming'swholesale president-defendant Stephen Davis-with theknowledge and/or reckless disregard of the true facts bythe other 1934 Act Individual Defendants, also utilized avariety of techniques, including the accrual of unauthor-ized, improper and unsustainable deductions from ac-counts payable due to vendors, to inflate earnings in vio-lation of accepted accounting practices." (TAC, P 14) .But the plaintiffs' allegation that Davis performed ac-counting "manipulations" or violated accounting stan-

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dards or that he did so with the knowledge and/or reck-less disregard of the true facts by the other 1934 Act In-dividual Defendants falls far short of alleging specificfacts that Davis prepared any portion of a Fleming reportor that, even if he did, that he did so with the knowledgeor reckless disregard for the truth that the federal securi-ties laws require to maintain a fraud claim . As such, thecourt dismisses the primary liability claims assertedagainst defendant [*79] Stephen Davis undersection 10 .The TAC is also silent as to specific allegations thatDavis possessed the power or authority to control theoperations of the company in general or had specificcontrol over the activity upon which the primary viola-tion is predicated. McNamara v . Bre-X Minerals, Ltd., 46F. Supp. 2d 628, 638 (E.D. Tex. 1999) . The court there-fore dismisses the controlling person claims against himas well ,

n5 The TAC alleges that " . . . Hansen, Rider,Shapiro, Dahlen , and Davis made public state-ments claiming that Fleming's retail segment wasgrowing." (TAC, P 456) . The plaintiffs, however,point to no particular statement made by Davis,making it impossible to gauge whether the re-maining requirements of the PSLRA have beensatisfied . This allegation is, therefore, equivalentto no allegation at all .

The court now turns to a discussion of the state-ments claimed to be corporate puffing, nonmaterial, orforward-looking. The statements primarily under attackby the 1934 Act Defendants [*80] include : (1) state-ments regarding a "culture of thrift" or cost savings inlight of the existence of the Fleming Air Force (2) state-ments regarding Fleming's overvalued retail stores (3)statements regarding Fleming not having a liquidityproblem (4) Fleming's artificially inflated earnings in theOctober 23, 2002 press release and (5) Fleming's artifi-cially inflated earnings in the January 23, 2003 pressrelease . Because the motion to dismiss could be read,however, to challenge a broader range of statements(Joint Motion to Dismiss, p . 18 "moreover, many of thealleged statements are either not material, or they are notfalse and misleading ."), the court has endeavored to ex-amine all of the alleged statements to assess their materi-ality and falsity .

The "culture of thrift" statement is not actionable .The plaintiffs argue that a statement that Fleming insti-tuted "a culture of thrift" was misleading in light of theiruse of jets to fly home on the weekends and that one ofthe Sources knew that the executives had not institutedthis culture . This statement is simply too general to con-

2004 U.S . Dist . LEXIS 26488, *

stitute a material misstatement as required under RuleIOb-5 . [*81] It is more in the nature of a corporatestatement concerning a competitive strength of the com-pany. As the defendants correctly observe, the courtshave consistently held that analysts and investors rely onfacts in making investment decisions, not vague expres-sions of corporate optimism or competitive strengths .Rosenzweig v. Azurix Corp ., 332 F.3d 854, 869-70 (5thCir. 2003), "The generalized, positive statements aboutthe company's competitive strengths, experienced man-agement, and future prospects are not actionable becausethey are immaterial ." Id. at 869 . The TAC does not con-tain any allegations as to why the statement is renderedfalse by the allegations concerning the Fleming AirForce . Therefore, the statement is not actionable .

The next statement involves a January 14, 2003,press release where Fleming announced that it was mark-ing down the "realizable value" of its retail stores by $116 million . The press release stated that "the companywill record a non-cash charge of approximately $ 116million to discontinued operations in the fourth quarter,to adjust the carrying value of the retail assets to theirestimated net realizable value. [*82] " The plaintiffscontend that this is a material misstatement in that thiswrite-down did not result in the assets being adjusted "totheir estimated net realizable value ." The plaintiffs pointto a subsequent press release from April 17, 2003, inwhich the Company announced "an additional impair-ment charge to discontinued operations of approximately$ 90 million related to retail store operations held forsale, due to a reduction in the net realizable value of suchoperations ." Further, plaintiffs allege that the 1934 ActIndividual Defendants, specifically Hansen, Rider, andDahlen, received reports throughout 2001 and 2002showing the declining sales numbers for the retail storesand the lack of success of the retail stores . In the secondhalf of 2002, Source 4 prepared a report charting thetrends in sales for newly-opened price-impact storesshowing that the sales for a typical Fleming store de-clined consistently after opening, and never increased .The plaintiffs conclude that these allegations show thatthe net realizable value after the January 2003 writedown was a material misrepresentation that the 1934 ActDefendants knew was false .

These allegations are not sufficient to [*83] makethe statement actionable . The allegations do not provideenough information to show that the defendants kneweven within a reasonable estimate the actual amount ofthe net realizable value . Measuring the net realizablevalue of a group of assets is not an exact science . TheApril, 2003, write-down easily could have been the resultof the defendants being too optimistic in January of 2003about how much a willing purchaser would pay for theassets or the result of subsequent events in the economy

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or operations . More to the point, the allegations revolvearound the knowledge of the defendants in 2002, butdoes not address the knowledge of the defendants at thetime of the first write-down . As such, the court holds thatthis statement is not actionable .

The third statement that the 1934 Act Defendantsspecifically contend is not adequately pleaded is a state-ment in a January 23, 2003 conference call in which anunidentified officer of the company stated in response toa question suggesting that the Company was having li-quidity problems that "no [we are not dipping lower andlower versus the loan covenants,] . . . three of the fourcovenants, we are consistently-have ample room [*84]underneath those covenants . The one covenant that wekeep bumping up against, at least over the past few quar-ters, is debt-to-EBITDA ." The question posed specifi-cally addressed the loan covenants and Fleming's abilityto meet the loan covenants. The plaintiffs do not provideany specific allegations, other than the Company's even-tual bankruptcy on April 1, 2003, to show that the defen-dant knew the statement was false when it was made andthat the Company did not have ample room underneaththe three covenants. Therefore, the plaintiffs' allegationsare not sufficient to make the statement actionable . n6

n6 As noted above, the court has carefully exam-ined the totality of the allegations in the TAC toassess whether the claimed statements are action-able misrepresentations . The court will detailsome of these statements below, but the partiesshould assume that if the court has not specifi-cally held a statement to be (a) a material misrep-resentation that is (b) pleaded with sufficient par-ticularity, then the court has concluded that thestatement is not actionable under Rule 10b-5 .

The following statements are either toovague to be actionable or are forward-lookingstatements protected by the safe-harbor provisionof the PSLRA : the statement attributed to defen-dant Hansen in the October 24, 2001 press releasethat "our price impact formats, with their highvolumes and low operating costs, are a great fitwith our distribution strategy" (TAC, P 215) ; thestatements in the November 5, 2001 DSN Retail-ing Today article attributed to Hansen that thevalue retailing market represents an opportunityfor expansion with "significant growth potential,"and that the "formats have received overwhelm-ing customer response" (TAC, PP 219-20) ; thestatements in the Form 10K attributed to the sig-natories of the 10K that "our price impact super-markets offer name-brand food and consumable

2004 U .S . Dist, LEXIS 26488, *

goods at significantly lower prices than conven-tional format retail store operators because of themany low-cost features of our stores " and "weexpect to be able to grow our price impact su-permarket operations while incurring lower capi-tal expenditures " (TAC, P 229) ; the statements at-tributed to defendant Dahlen in the April 16,2002 press release conce rn ing Fleming's "excite-ment" about the acquisition of seven new retailstores in the Da llas market (TAC, P 236-37); thestatements in the May 7, 2002 press release at-tributed to defendant Hansen conce rn ing Flem-ing's "outstanding start to 2002" and the com-pany's "keenly focused" strategies (TAC P 239) ;the statements attributed to Hansen in the confer-ence call following the release of the first quarter2002 results that "we are very pleased about thatand feel good about the customer acceptance" andthat he was " almost giddy [about] the progress weare making in this area" (TAC, P 244) ; the state-ments quoted from the June 2002 RegistrationStatement concern ing the successful price impactretail format (TAC, P 250) ; the company 's abilityto secure favorable terms and volume discountson its purchases (TAC, PP 254-56); and thestatement at tr ibuted to Rider in the second can-ference call concerning "closing of the gap"(TAC, P 266) . Although these statements mayhave evidentiary significance in the trial of thiscase, they are not actionable misrepresentationsin. the context of a Rule 106-5 claim .

*85

The next two statements concern the allegations thatthe defendants overstated Fleming's wholesale earn ingsin an October 23, 2002 press release and January 23,2003 press release . (TAC, P 312-313) . The defendantscontend that the allegations are conclusory and refer tothe entire press release quoted in its entirety in a previousparagraph . The defendants are correct , in that plaintiffscannot simply recite portions of publicly discloseddocuments and summarily allege that they are false andmisleading . BMC Software, 183 F. Supp. 2d at 886 . Withrespect to the October 23, 2002 press release, the plain-tiffs do not allege who the earnings information is attrib-uted to; therefore , they have not satisfied Southland. Asto the January 2003 , press release , the allegations spe-cifically attribute the statements only to defendantShapiro; accordingly the cou rt holds that the statementsare only pleaded with sufficient particularity as to thatdefendant .

The plaintiffs' allegations , moreover, specificallystate that "in the October 23, 2002, press release and inthe conference call, the 1934 Act defendants overstated

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Fleming's wholesale earnings" and "in the . . . January23, 2003 press [*861 release[] . _ ., the 1934 Act Individ-ual defendants again knowingly or recklessly overstatedFleming's earnings by failing to account for the manipu-lations described in. this Complaint ." The bullet itemslisted below the allegations are the links to the previousallegations supporting why the statements as to earningswere false . Looking at the totality of the TAC and itsallegations concerning the ongoing use of various ma-nipulations and overstatement of earnings throughout theClass Period up until the announced restatements inApril of 2003, the court fords the allegations sufficient .Therefore, the court finds that the plaintiffs' allegationsare sufficient to plead with particularity the material mis-statements and why they are false and misleading withrespect to the January 2003 press release .

4. Failure to Adequately Plead Scienter

The 1934 Act Individual Defendants and D&T alsocontend that plaintiffs failed to adequately plead allega-tions giving rise to a strong inference of scienter as toeach defendant . The plaintiffs respond by stating thatthey have adequately pleaded scienter against each of the1934 Act Individual Defendants by alleging not onlymotive and [*87] opportunity, the close involvement ofthe individual defendants with the operations of Fleming,the violation of GAAP, and the magnitude of the fraud ;but also the plaintiffs allege direct evidence of scienterby pointing to individual defendants and alleging thatthey directed manipulations resulting in misrepresenta-tions on numerous occasions and knew about discrepan-cies in financial information and either made misstate-ments or omissions about the information or failed tocorrect previous misrepresentations or omissions .

The plaintiffs contend that they have adequatelypleaded scienter against D&T by alleging red flags, nu-merous violations of the accounting and auditing stan-dards, GAAP and GAAS, the simplicity of the account-ing principles violated, the relative ease with which thefraud could have been detected, the magnitude of therestatement, and motive and opportunity. With the abovestandards as to pleading allegations of a strong inferenceof scienter in mind, the court now turns to the allegationsas to each defendant .

Mark Hansen was Chief Executive Officer of Flem-ing from November 1998 until March 3, 2003 . Hansencontends that the allegations of scienter against him are[*88] insufficient. Hansen contends that Fleming's de-duction practices have not been shown with particularityto be fraudulent and thus the allegations are not sufficientto show scienter . Also, Hansen contends that the TAGdoes not state with particularity that he had the informa-tion or knew of the information with regard to allegedlyfraudulent deductions and accounting practices , only that

2004 U .S . Dist, LEXIS 26488, *

he must have known about them . In addition, Hansencontends that the TAC does not specifically state whatwas in the reports and comparisons available to him .Finally, Hansen states that the TAC includes impermis-sible general allegations against the defendants as awhole that is foreclosed due to the fact that the grouppleading doctrine is no longer followed after the enact-ment of the PSLRA .

The plaintiffs urge that Hansen himself publiclytouted Fleming's strategic plan, portrayed himself asknowledgeable concerning Fleming's earnings, sales, andoperations, and represented to the market that earningsand sales were growing . The plaintiffs further contendthat the deduction practices were fraudulent in that theywent beyond industry practices, were done without ven-dor permission, and were improper [*89] and baseless .Specifically, the plaintiffs point to statements by SourceI that deductions were taken and accrued to increaseearnings before Fleming had even identified the vendor,the product, and the basis for the deduction . The plain-tiffs argue that these allegations give rise to a strong in-ference that the deductions were not a legitimate costreduction, but were instead accounting manipulations .

Additionally, plaintiffs point out that Source 1 per-sonally participated in the delivery of reports showingrevenue, cost, and margins in both the wholesale andretail segments to Hansen that showed the true financialpicture for Fleming . The plaintiffs contend that theSources give direct evidence that defendant Hansen wasprovided information showing that Fleming's internally-reported earnings were substantially different from Flem-ing's publicly-reported earnings . Also, the plaintiffs con-tend that Hansen's presence at Monday meetings wherethere were reports showing the discrepancies and discus-sions about the deduction practices supports a stronginference of scienter .

The plaintiffs thus attempt to allege a strong infer-ence of scienter with regard to Hansen with numerousallegations [*90] that he knew of accounting manipula-tions, received reports showing the actual numbers, andmade statements or signed filings containing representa-tions that conflicted with the information that he knewabout or recklessly disregarded . With regard to receivingreports of financial information and attending meetingswhere the manipulations and financial information werediscussed the TAC alleges that Source I "received de-tailed weekly reports from Fleming's retail stores andproduct category managers"' along with other financialanalysts and "compiled Flemings actual revenue, costs,and margin" into "weekly, monthly, and quarterly re-ports" and "personally delivered these reports to the topFleming executives," including Hansen . According toSource 1, Hansen received regular reports showing therevenue, cost, and margin numbers for the wholesale

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segment and was well aware of the magnitude and inva-lidity of massive deductions taken by Fleming. Also, theTAC alleges that the general ledger was published duringthe Class Period to Hansen .

Source 4 also contributed to the allegations relatedto Hansen. Starting in July of 2001 and continuingthrough the class period, Source 4 "was responsible[*91] for circulating weekly, monthly, and quarterlyretail same-store sales reports throughout the Company,"and that "hard copies of these reports were given directlyto Hansen. At the beginning of 2002, in his "same storesales" reports, "Source 4 began breaking out red tag anddiverting sales into a separate category . , . demonstratingto recipients of the report -- including Hansen -- thatFleming was including in its same store sales' data thatwere not attributable to any stores and that same storesales were declining .

According to Sources 1 and 4, Hansen receivedcomparisons between the budget plan and the earningsreport for the retail stores showing the actual experiencedearnings shortfalls beginning in early 2002 . Further,Hansen received special daily retail store performancereports from the financial analyst managers showing thatsales and earnings were declining, yet, he made publicstatements claiming that Fleming's retail segment wasgrowing . In July 2002 and September 2002, defendantHansen asked Source 4 to chart the trends in sales fornewly-opened price-impact stores . Using data that hadbeen available to Hansen prior to July 2002, Source 4'schart demonstrated that [*92] the sales for a typicalFleming store declined consistently after opening, andnever increased showing the ineffectiveness of the price-impact format. In addition, Hansen attended Mondaymeetings where finances were reviewed and deductionswere discussed showing that Fleming's retail sales wereflat or declining and that there was a material differencebetween reported margins and internally calculated mar-gins .

With regard to Hansen's personal participation in themanipulations, the TAC alleges that "Hansen . . . di-rected Source 1 to deduct from vendors' invoices a twocase' deduction [amounting to a $ 3 .5 million accrual thatincreased earnings], based on the concept that vendorsshould provide new retail stores with two free cases ofproduct," but that they were "overwhelmingly rejected byvendors" resulting in only $ 78,000 of the deductionsbeing accepted . Thus, under the plaintiffs' theory andallegations, Hansen personally directed the accrual ofunauthorized, improper, and unsustainable deductionsfrom vendors' invoices in the retail segment and partici-pated in the manipulation of "same store" revenues, inorder to create the false impression of revenue and earn-ings growth . [*93]

2004 U .S . Dist . LEXIS 26488, *

Hansen cites two Fifth Circuit cases that he contendssupport his motion to dismiss : Goldstein v. MCI World-com and Abrams v . Baker Hughes Inc. In Goldstein, thecourt held that the plaintiffs' circumstantial evidencerelating to the timing of accounts receivable write-offs,the magnitude of the write-offs, the defendants' closeinvolvement in the day-to-day operation and manage-ment of the company, and the defendants' positions in thecompany and alleged decision-making roles in writingoff uncollectible accounts failed to sufficiently connectthe defendants to support a strong inference of scienter .340 F3d at 248-54. In Abrams, the court held that theplaintiffs' circumstantial evidence relating to the defen-dants' receipt of financial reports that apprised them ofthe company's true financial status, the company's viola-tions of GAAP, the defendants' desire to raise money andprotect their incentive compensation, and the timing ofthe resignation of certain accounting department em-ployees was insufficient to demonstrate a strong infer-ence of scienter . [*94] 292 F3d at 431-35.

These decisions notwithstanding , the allegationsagainst Hansen taken as a whole sufficiently allege astrong inference of scienter . The allegations in the TACinclude not only circumstantial evidence similar to thatdiscussed in the cases above , but also direct evidence ofHansen's knowledge of and involvement in the scheme,In addition , the weakness of the allegations as to internalreports discussed by the Fifth Circuit in the two casesdiscussed above is not present in this case .

In Abrams, the Fi fth Circuit held that "an unsup-ported general claim about the existence of con fidentialcorporate reports that reveal information contrary to re-ported accounts is insufficient to survive a motion todismiss ." 292 F. 3d at 432 (quoted in Goldstein, 340 F .3dat 253-54) . The court went on to state that "such allega-tions must have corroborating details regarding the con-tents of allegedly contrary reports of their authors andrecipients ." Id. Here, the allegations are supported bySources who worked in the Company ' s accounting de-partment and not only prepared some of the reports dis-cussed at the request of the defendants , [*95] but alsodelivered them to the defendants . Other allegations statethat the Sources saw reports that were prepared by otheraccounting managers , knew the contents of the reports,and knew that the reports were forwarded to the defen-dants.

In ABC Arbitrage the F ifth Circuit held that plain-tiffs could satisfy the reports "standard by specifyingwho prepared internal company reports , how frequentlythe reports were prepared and who reviewed them ." 2 .91F.3d at 356 (quoting In re Scholastic Corp. Sec. Litig.,252 F.3d 63, 72, 73 (2d Cir. 2001)) . Further, the cou rtheld that the allegations as to Monthly Management Re-po rts in the case met the standard because they identified

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the reports as "being prepared monthly by each subsidi-ary's controller's office and transmitted to the defendantsat the beginning of each month to convey informationabout the Telecom sector at each subsidiary by compar-ing actual results to budgeted numbers," Id. at 357 . Theallegations in this case are sufficiently similar and satisfythe standard as well .

In addition , these Sources had knowledge of the ma-nipulations that resulted in the actual numbers in the re-po rts being [*96] different from those reported to thepublic . The defendants contend that allegations wherethe Sources themselves were not actually involved in theevents, but claim to have knowledge of the events areinsufficient. The court in ABC Arbitrage noted that if thedocumentary evidence does not provide an adequate ba-sis for believing that the defendants ' statements or omis-sions are false, then the plaintiffs can satisfy their plead-ing burden with allegations from confidential sources aslong as the sources described would possess the informa-tion pleaded to support the allegations of false or mis-leading statements made on information and belief. 291F.3d at 353 . Here, the allegations as to the documentaryevidence and the Sources are sufficient to give rise to astrong inference of at least severe recklessness as to Han-sen .

Neal Rider was the Chief Financial Officer of Flem-ing from January 2000 to February 2003 . Rider contendsthat the allegations in the TAC against him are insuffi-cient to give rise to a strong inference of scienter becausethey do not show what specific information was alleg-edly provided to him, why that information was false andmisleading, or how he [*97] knew the information wasfalse or that he acted with severe recklessness .

The plaintiffs respond by stating that Rider had ac-cess to all of the same information and reports alleged bythe Sources . In addition, Source 4 specifically states thatRider personally approved the manipulation of same-store sales data, such that the data did not even comparesales for the same stores . The TAC also alleges thatSource I "received detailed weekly reports from Flem-ing's retail stores and product category managers "' alongwith other financial analysts and "compiled Fleming'sactual revenue, costs, and margin" into "weekly,monthly, and quarterly repo rts" and "personally deliv-ered these repo rts to the top Fleming executives ," includ-ing Rider . The TAC further alleges that "Source 1 saw[similar] reports [for the wholesale segment] in the ex-ecutives' offices, and . . . reviewed [them] to assess theretail segment 's performance in comparison with thewholesale segment . "

Rider also allegedly received regular repo rts show-ing that same - store sales were declining, and that Flem-ing was manipulating its same -store sales data . The TAC

2004 U.S . Dist. LEXIS 26488, *

alleges that starting in July of 2001 and continuingthrough the [*98] class period, Source 4 "was responsi-ble for circulating weekly, monthly, and quarterly retailsame-store sales reports throughout the Company," andthat "hard copies of these reports were given directly to .. . Defendant Rider," In addition, at the beginning of2002, in his "same store sales" reports, "Source 4 beganbreaking out red tag and diverting sales into a separatecategory . . . demonstrating to recipients of the report-including Defendant Rider-that Fleming was including inits same store sales' data that were not attributable to anystores and that same store sales were declining." In addi-tion, the TAC alleges that, according to Source 4, Riderapproved manipulations of same store sales figures re-quired by defendant Dahlen whereby "new stores , . .were being compared with old stores located within twoto five miles of the new stores, but which had beenclosed two or three years before the comparison" result-ing in a comparison of "stores in their first year of exis-tence with sales at stores in their last year of existence . "

Further, the TAC alleges that Rider received reportsthroughout 2001 and 2002 showing the declining salesnumbers for the retail stores and [*99] the lack of suc-cess of the retail stores yet, he made public statementsclaiming that Fleming's retail segment was growing. Ac-cording to Sources 1 and 4, Rider received comparisonsbetween the budget plan and the earnings report for theretail stores showing the actual experienced earningsshortfalls beginning in early 2002, Using data that hadbeen available to Rider prior to July 2002, Source 4'schart demonstrated that the sales for a typical Flemingstore declined consistently after opening, and never in-creased showing the ineffectiveness of the price-impactformat .

Finally, the TAC specifically alleges that Rider at-tended Monday meetings where finances were reviewedand deductions were discussed showing that Fleming'sretail sales were flat or declining and that there was amaterial difference between reported margins and inter-nally calculated margins . The TAC specifically allegesthat Rider received regular reports showing the revenue,cost, and margin numbers for the wholesale segment an dwas well aware of the magnitude and invalidity of mas-sive deductions taken by Fleming . The TAC alleges thatRider participated in meetings with the financial analystmanagers , the retail CFO, [*100] and Dahlen whereinternal cost and margin numbers were reviewed and,therefore , Rider either knew or recklessly disregarded thematerial differences between Fleming ' s internal reportsand public statements .

Rider cites In re Capstead Mortgage Corp . Sec .Lilig. to support his contention that the allegations areinsufficient to support a strong inference of scienter . 258F. Supp. 2d 533 (N.D. Tex. 2003) . In that case the plain-

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tiffs attempted to show knowing misconduct by allegingthat senior officers and directors had access to and con-trol over internal corporate data and other non-publicinformation (specifically monthly reports on the corn-pany's intranet and monthly management reports) whichcontradicted their positive representations about thecompany's mortgage servicing operation . Id. at 564-65.The plaintiffs did not specifically identify any particularinternal documents containing the alleged adverse infor-mation, the contents of such adverse or negative informa-tion, when the internal document containing the negativeor adverse information was prepared, by whom it wasprepared, or to whom it was directed . [ * 101 1 Id. at 565.The court stated that plaintiffs must allege facts whichdemonstrate that at the time defendants made representa-tions regarding projected earnings and dividends, defen-dants knew or were severely reckless in not knowinginformation that adversely impacted the earnings . Id. Thecourt specifically held that allegations the defendantswere aware of the adverse information were insufficientdue to the fact that the plaintiffs had not cited any docu-mentary evidence or personal sources to establish thebasis for this belief. Id. In this case, by contrast, theplaintiffs have not only cited documentary evidence andreports with particular facts as to their contents, whoprepared them, and who received them, but the plaintiffshave also cited the Sources to support the allegations asto the reports and their contents and defendants and theirknowledge . The court holds that the TAC pleads specificfacts to support a strong inference of at least severe reck-lessness as against Rider .

Mark Shapiro was Senior Vice President of Financeand Control and Chief Accounting Officer from at least2001 to February 2003, at which time he was appointedChief Financial [*102] Officer and served until lateApril 2003 . Shapiro contends that the allegations areinsufficient to allege a strong inference of scienter .Shapiro contends that a majority of the allegations arenot specific to him but to the management in general andthat when Shapiro is specifically mentioned the TACdoes not provide facts from which one could concludethat Shapiro knew any particular statement to be inaccu-rate when made . Further, Shapiro contends that the alle-gations that he had reports that showed variances anddiscrepancies are not specific enough and that allegationsconcerning the Monday meetings do not state when hewas there or what was discussed at them .

The plaintiffs argue that Shapiro received the reportsand information showing discrepancies between internalfinancial information and publicly-reported numbers andthe deduction practices and participated in Monday meet-ings where flat or declining retail sales, variances be-tween public and internal finances, and deduction prac-tices were discussed . Further, the plaintiffs allege that

2004 U .S . Dist . LEXIS 264S8, *

Shapiro had a central role in the intentional weakening ofFleming's accounting practices, the linchpin of the ma-nipulation scheme, when all [*103] divisional account-ing operations were centralized in Oklahoma City andmanaged by unqualified division reports . This, the plain-tiffs contend, allowed the company to put tight reigns onthe manipulations and oversee them .

In addition, plaintiffs contend that Sources 2 and 3have knowledge of Shapiro's knowledge of and participa-tion in a scheme to defraud vendors to obtain unearnedpromotional funds to inflate its earnings . The plaintiffsallege that Shapiro directly participated in inventory ma-nipulations to inflate earnings and shift losses from con-tinuing operations to discontinued operations .

The TAC alleges that Source 1 "received detailedweekly reports from Fleming's retail stores and productcategory managersalong with other financial analystsand "compiled Flemings actual revenue, costs, and mar-gin" into "weekly, monthly, and quarterly reports" and"personally delivered these reports to the top Flemingexecutives," including Shapiro . According to Sources Iand 4, Shapiro received comparisons between the budgetplan and the earnings report for the retail stores showingthe actual experienced earnings shortfalls beginning inearly 2002 . The TAC also alleges that Shapiro [*104]participated in meetings with the financial analyst man-agers, the retail CFO, and Dahlen where internal cost andmargin numbers were reviewed and, therefore, Shapiroeither knew or recklessly disregarded the material differ-ences between Fleming's internal reports and publicstatements . The TAC specifically alleges that Shapiroattended Monday meetings where finances were re-viewed and deductions were discussed showing thatFleming's retail sales were flat or declining and that therewas a material difference between reported margins andinternally calculated margins .

Under the allegations of the TAC , Shapiro receivedregular reports showing that same-store sales were de-clining, and that Fleming was manipulating its same-store sales data . Also, the TAC alleges that Fleming, atthe direction of Shapiro , did not recognize a $ 1 millioninventory loss from continuing operations in 2001, butinstead deferred the loss to 2002 and then booked it as aloss f ro m discontinued operations . The TAC further al-leges that "Source i saw reports [for the wholesale seg-ment] in the executives ' offices , and . . . reviewed [them]to assess the retail segment's performance in comparisonwith the wholesale [* 105] segment ." The TAC allegesthat Shapiro received regular reports showing the reve-nue, cost, and margin numbers for the wholesale segmentand was well aware of the magnitude and invalidity ofmassive deductions taken by Fleming . On balance, andreading the complaint as a whole, the court is persuaded

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that the allegations raise a strong inference of at leastsevere recklessness against Shapiro .

Thomas Dahlen was Executive Vice President andPresident, Retail and Marketing for Fleming in April2001, and resigned effective December 31, 2002 . Dahlencontends that the allegations are insufficient to support astrong inference of scienter, The court disagrees . TheTAC alleges that Source I "received detailed weeklyreports from Fleming's retail stores and product categorymanagers"' along with other financial analysts and "com-piled Fleming's actual revenue, costs, and margin" into"weekly, monthly, and quarterly reports" and "personallydelivered these reports to the top Fleming executives,"including Dahlen. The TAC further alleges that "SourceI saw [similar] reports [for the wholesale segment] in theexecutives' offices, and . . . reviewed [them] to assess theretail segment's performance [*106] in comparison withthe wholesale segment. "

In addition, Dablen allegedly personally directed theaccrual of unauthorized, improper, and unsustainabledeductions from vendors' invoices in the retail segmentand participated in the manipulation of "same store"revenues, in order to create the false impression of reve-nue and earnings growth . Source 1 states that "Dahlenwas involved in the margin manipulations and alwaysreceived from Source I the same information that the[retail CFO] received ." The TAC further alleges that"accrual of these unauthorized, improper, and unsustain-able deductions was directed by Defendant Dahlen [andthe retail CFO; and that the retail CFO] often accrueddeductions, and then asked the financial analyst manag-ers and product category managers to determine which ofthe Company's vendors, if any, would be likely to acceptdeductions ." In the TAC Source 1 alleges that "Dahlenand [the retail CFO] manipulated earnings during theentire time that Source I worked at Fleming ." The TAGalleges that "by June 2002, Source 1 was emailingSource l's deduction worksheets to Defendant Dahlen[and the retail CFO] with a frequency of three to fivetimes a week" [*107] and that "even after a deductionwas rejected by a vendor and removed by Source I fromthe worksheet, the retail executives often reinstated thededuction . "

The TAC alleges that "Defendant Dahlen directedSource I to deduct from vendors' invoices a two case'deduction [amounting to a $ 3 .5 million accrual that in-creased earnings], based on the concept that vendorsshould provide new retail stores with two free cases ofproduct," but that they were "overwhelmingly rejected byvendors-" Further, Source I states that the publicly re-ported retail margins were higher than those reflected inthe internal analysis seen and discussed by the executivesdue to manipulations made by the retail CFO and di-rected by defendant Dahlen . According to Sources 1 and

2004 U .S . Dist . LEXIS 26488 ,

4, Dahlen received comparisons between the budget planand the earnings report for the retail stores showing theactual experienced earnings shortfalls beginning in early2002 .

The TAC alleges that "Dahlen and [the retail CFO]on numerous occasions manipulated the publicly re-ported same-store sales figures in order to hide adversesales trend" by rejecting the data from the financial ana-lysts and changing the composition of the population[*108] of stores which constituted the Company's samestores ."' Specifically, the TAC alleges that "Dahlen and[the retail CFO] often commingled better performingnew stores' revenue and earnings with current-year samestore' revenues, in order to inflate current-year same-store revenues and earnings and created the false impres-sion of growth" resulting in "revenue and earnings re-ports [that] did not truly reflect a same store' comparisonas is commonly understood in the retail industry ." Inaddition, the TAC alleges that, according to Source 4,Rider approved manipulations of same store sales figuresrequired by Dahlen whereby "new stores . . . were beingcompared with old stores located within two to five milesof the new stores, but which had been closed two or threeyears before the comparison" resulting in a comparisonof "stores in their first year of existence with sales atstores in their last year of existence ." Further, the TACalleges that according to Source 1, in at least one in-stance in late 2001 or early 2002, Fleming -- at the direc-tion of Dahlen and [the retail CFO] -- reduced the previ-ously reported same store sales for the year 2000 fiscalyear by subtracting [* 109] $ 1 .3 million in red tag saleswhile at the same time inflating the 2001 figure for samestore or comparable store sales by at least $ 4 .7 millionin red tag sales ." The TAC alleges that according toSource 4 Dahlen required that red tag and diverting salesbe included in publicly reported same-store sales data . Inaddition, at the beginning of 2002, in his "same storesales" reports, "Source 4 began breaking out red tag anddiverting sales into a separate category . . . demonstratingto recipients of the report -- including Defendant Dahlen-- that Fleming was including in its same store sales' datathat were not attributable to any stores and that samestore sales were declining ." The TAC alleges that Source4, from July 2001 through the end of the Class Period,"was responsible for circulating weekly, monthly, andquarterly retail same-store sales reports throughout thecompany" which demonstrated that same-store saleswere declining, and that "electronic copies were providedto defendant Dahlen ." Using data that had been availableto Dahlen prior to July 2002, Source 4's chart demon-strated that the sales for a typical Fleming store declinedconsistently after opening, and never [* I . 1_0] increasedshowing the ineffectiveness of the price-impact format.The TAC specifically alleges that Dahlen receivedweekly, monthly, and quarterly reports showing the

Page 2 5

revenue, cost, and margin numbers for the retail segmentillustrating a decline in sales and earnings, as well as,received daily retail store performance reports from thefinancial analyst managers showing that sales and earn-ings were declining, yet, he either made or failed . to cor-rect misrepresentations claiming that Fleming's retailsegment was growing.

Also, the TAC specifically alleges that Dahlen at-tended Monday meetings where finances were reviewedand deductions were discussed showing that Fleming'sretail sales were flat or declining and that there was amaterial difference between reported margins and inter-nail), calculated margins . The TAC alleges that defen-dants Hansen, Rider, and Shapiro participated in meet-ings with the financial analyst managers, the retail CFO,and defendant Dahlen where internal cost and marginnumbers were reviewed and, therefore, Dahlen eitherknew or recklessly disregarded the material differencesbetween Fleming's internal reports and public statements .

The TAC includes allegations [*111] that Dahlenmade false and misleading public statements about Flem-ing's financial results, the health of the company, itsprospects for growth, and the true nature and extent ofthe fraud, as well as, disclose false financial informationand made public statements that were false, misleading,and in conflict with the information that the Sources hadpersonally communicated to him . According to Source I,Dahlen had the responsibility for approving the publiclyreported and margin numbers in the retail segment de-spite receiving information from the financial analystmanagers showing declining revenues and margins . Thecourt finds that the allegations are sufficient to support astrong inference of scienter as to Dahlen . The allegationsare specific as to the information that Dahlen possessedand his participation in the accounting manipulations-

D&T was the outside auditor for Fleming beginningin at least 1994 and throughout the Class Period . Defen-dant D&T contends that the plaintiffs failed to ade-quately allege scienter with respect to claims under sec-tion 10(b) of material misrepresentations involvingD&T's issuance of its allegedly false and misleading2001 audit opinion and quarterly [* 1121 Review Re-ports . D&T contends that the TAC is not sufficientlydetailed and argues that the plaintiffs' alternative plead-ing that D&T either "knew" or "should have known" isnot sufficient to show recklessness . Specifically, D&Tstates that the plaintiffs do not allege that the specificvendor deductions actually tested were fraudulent . Fur-ther, D&T points to the TAC's allegations that the fraudwas concealed by Fleming and its employees from D&Tand states that these allegations undercut the plaintiffs'scienter allegations as to D&T . Also, D&T contends thatmotive and opportunity alone do not suffice for an infer-

2004 U .S . Dist, LEXIS 26488, *

ence of scienter . Finally, D&T argues that it is not liableas an aider and a better under Central Bank .

The plaintiffs respond by stating that the followingfacts establish a strong inference of scienter : (1) numer-ous red flags existed that should have alerted D&T ofFleming's fraud, (2) the magnitude of the restatementwas significant, (3) violations of Generally AcceptedAccounting Principles ("GAAP") were repetitive andover several fiscal years , (4) the accounting principlesviolated were relatively simple , (5) D&T failed to obtainsufficient evidentiary support [*1131 for account bal-ances in violation of Generally Accepted Auditing Stan-dards ("GAAS"), ( 6) D&T failed to follow-up on knownaccounting errors in violation of GAAS , (7) the fraudu-lent vendor deduction scheme could have been identifiedwith relative ease, and (8 ) D&T had a fin ancial motive toengage in fraudulent or reckless conduct . The plaintiffscontend that the totality of these allegations in the TACin light of the restatement give rise to a strong inferenceof scienter .

More specifically, the plaintiffs contend that the fol-lowing sixteen red flags existed during the Class Periodthat should have alerted D&T that Fleming was artifi-cially inflating its financial results : (1) a decline in netincome for the years 1995-2000 that gave Fleming anincentive to manipulate its financial results, (2) self-imposed pressure by Fleming by setting aggressive earn-ings targets and unrealistic forecasts, (3) the gutting ofFleming's accounting staff and weakening of internalcontrols and centralization of accounting at the com-pany's headquarters, (4) making non-accountant divisionpresidents responsible for the financial reporting func-tions, (5) shortening of the monthly closing period andincreased [*114] time pressure, (6) entering into largelong-term contract with tight profit margins, (7) im-proper lengthening of the amortization period for long-term assets to reduce expense and increase income, (8)overstatement of inventory at one of the divisions by $ 1million, (9) the remitting of payments by Fleming duringthe time of the 2001 audit field work to vendors whorefused to accept deductions, (10) increase in the vendordeduction account to S 120 million, (11) the eliminationof the reserve against vendor deductions (12) the tying ofexecutive bonuses to targeted earnings and the achieve-ment of those earnings and payment of bonuses equaling200% of the base salaries in 2001, (13) the findings ofErnst & Young of Fleming's excess price charges to itscustomers and demand by the auditor to be transferredaway from Fleming when Fleming would not correct theovercharges, (14) the pending of lawsuits for overcharg-ing customers, (15) Fleming's debit memos for vendordeductions did not identify the vendor invoices fromwhich the deductions were taken, (16) the reporting byboth the wholesale and retail segments of vendor deduc-

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tions from the same product resulting in double accruals .[*115 ]

The plaintiffs state that with regard to testing, the al-legations need only state that the auditor failed to test theitems altogether, or inadequately tested items by select-ing an insufficient sample size, or adequately testeditems but turned a blind eye to errors that were discov-ered. The plaintiffs contend that "should have known"allegations are sufficient and that even though Flemingprovided allegedly false information there was no basisor backup documentation supporting the information andthat if D&T had sought backup in accordance with audit-ing procedures it would have learned of the falsity . Theplaintiffs further contend that motive and opportunity canadd weight to the scienter calculus and that D&T's con-sulting work and corresponding fees amounting to twotimes the audit fees is sufficient motive . Finally, theplaintiffs state that D&T is not alleged to be an aider anda better, but instead is liable as a primary violator uponthe false statements contained in the audit opinion andreview reports . n7

n7 D&T also attacks the standing of one of thelead plaintiffs with respect to plaintiffs' section10(b) claims . D&T contends that the Lead Plain-tiff, Jackson Capital, does not have standing toassert section I0(b) claims on behalf of a putativeclass including purchasers of Fleming bonds be-cause Jackson Capital pleads that it purchasedonly Fleming common stock . The plaintiffs re-spond by stating that a stockholder plaintiff maypress bondholder claims so long as both arose outof the same scheme to defraud . The court findsD&T's argument unpersuasive and rejects it . Atthe pleading stage, Lead Plaintiff Jackson Capitalhas standing to assert a section 10(b) claim onbehalf of purchasers of all securities against a de-fendant who makes "any untrue statement of ma-terial fact in connection with the purchase or saleof any security" because the various purchasers'claims arise out of the same material misstate-ments . 17 C.F.R. § 240.1Ob-5 (emphasis added) .As discussed infra at pages 83-85, under section11 of the 1933 Act, standing is limited to thosepurchasers who purchase securities pursuant to aspecific registration statement containing a mate-rial misstatement because the claim arises out ofthat particular registration statement and the mis-representations made within it . See In re Paracel-sus Corp., 6 F. Supp. 2d 626 (S.D. Tex . 1998) .

[*116]

2004 U .S . Dist. LEXIS 26488, *

With regard to sufficiently alleging scienter againstauditors, courts have held that in assessing the totality ofthe circumstances the following may each contribute insupplying an inference that an auditor performed a reck-less or fraudulent audit : 1) red flags regarding accountingmatters, 2) restated financial statements, 3) an auditor'sfailure to obtain sufficient support for account balances,and 4) an auditor's failure to follow-up on known ac-counting errors . In re Enron, 235 F. Supp. 2d at 677-79,706-07 . The fact that an auditor ignored red flags consti-tutes strong evidence of intentional or reckless conduct .Id Although the existence of a restatement may not byitself satisfy the scienter requirement, a restatement cantip the scales in favor of a finding of scienter when therestatement is viewed with the totality of the circum-stances surrounding the restatement . In re Triton, 2001U.S. Dist. LEXIS 5920, 2001 WL 872019, at *II . A re-statement adds significant weight to the scienter calculusdue to the magnitude of a restatement, the repetitivenessof GAAP violations requiring the restatement, and thesimplicity of the accounting [* 117 1 principles that wereviolated . Id.

Likewise, mere publication of inaccurate accountingfigures or failure to follow Generally Accepted Account-ing Principles (GAAP), without more , does not establishscienter in a section 10(b) action against an accountingfi rm . Abrams, 292 F. 3d at 430, See also Melder v. Mor-ris, 27 F.3d 1097, 1103 (5th Cir . 1994)("boilerplateaverments that the accountants violated particular stan-dards are not, without more , sufficient to support infer-ences of fraud ") ; Umsted v . Andersen LLP, 2003 U.S.Dist. LEXIS 1250, 2003 WL 222621, at *3 (N.D. Tex .Jan. 28, 2003)(noting that there is a judicial consensusthat mere general allegations of violations of GAAPand/or GAAS are insufficient to state a claim for securi-ties fraud ) . The plaintiffs must link such allegations ofviolations of GAAP and/or GAAS with fraudulent intentby showing that the firm deliberately misrepresentedmaterial fact or acted with reckless disregard about accu-racy of its audits or repo rts . [* 1181 Abrams, 292 F.3d at430; Novak, 216 F. 3d at 308 .

Recent cases provide insight about circumstancesunder which allegations of financial restatements and/orGAAP or GAAS violations, under the totality of circum-stances, may constitute important factors in evaluatingwhether scienter has been adequately pleaded . Some ofthe factors recent courts have frequently addressed in-clude : (a) the nature, size, and scope of GAAP viola-tions; (b) the magnitude and frequency of restatements ;and (c) whether the allegations of GAAP violationsand/or restatements are accompanied by allegations ofinsider trading . Securities Litigation Update, SJO14 ALi-ABA 505, 516 (2003) . In addition, in cases where theauditor is the defendant, courts look for "red flags" that

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should have put the auditor on notice of the company'sfinancial improprieties . Id. ; see also, e .g., Ziemba v .Cascade Int'l, Inc., 256 F.3d 1194 (11th Cir. 2001) .

When the defendant is an auditor , allegations thatthe audit was conducted negligently and allegations thatthe defendant lacked adequate internal controls are alsoroutinely found insufficient. On the other hand , courtsappear [*1191 willing to allow a complaint allegingGAAP violations and/or a financial restatement to sur-vive at the pleading stage where the magnitude of theGAAP violation is exceptionally large in propo rt ion topreviously reported numbers , where the allegations areaccompanied by detailed allegations of insider trading, orwhere there are myriad other detailed allegations ofwrongdoing. Securities Litigation Update, SJO14 ALl-ABA 505, 516 (2003) .

For example , in In re Ikon Office Solutions, Inc . Se-curities Litigation , the court found the plaintiff properlypleaded scienter by alleging defendant ( 1) violated audit-ing principles and (2 ) had notes in its accounting fileregarding an audit committee meeting which specificallyreferred to one employee "cooking the books ." 66 F.Supp. 2d 622, 629-34 (E.D. Pa. 1999) . In In re HealthManagement, Inc. Sec. Litig., the court denied an audi-tor's motion to dismiss where plaintiff pleaded violationsof GAAP/GAAS coupled with red flags of suspiciousinventory shipments , and an analyst' s letter alerting theauditor to inflated accounts receivables . [*120] 970 FSupp. 192, 202-03 (E.D.N Y.. 1997) . In Carley CapitalGroup v. Deloilte & Touche, L.L.Y ., the court denied anauditor's motion to dismiss , finding plaintiffs adequatelypleaded scienter by alleging violations of GAAS coupledwith the auditor's unrestricted access to financially re-cords, heavy involvement in management and highlysuspicious revenue manipulations that would have "putprudent auditors on notice ." 27 F. Supp. 2d 1324, 1339-40 (N.D. Ga. 1998) . The court concluded that allegedviolations of accounting principles "when combined witha drastic overstatement of financial results can give riseto a strong inference of scienter . . . [and] the totality andmagnitude of the . . . accounting violations [ may] consti-tute strong circumstantial evidence of reckless or con-scious misbehavior ." Id,

Recently, in In re Worldcom.. Inc. Sec, Litig. thecourt held the pleadings of scienter sufficient as to anoutside auditing firm and denied its motion to dismiss .2003 U.S. Dist. LEXIS 10863, 2003 WL 21488087, at *7(S. D.NY. June 25, 2003) . The court noted that the audi-tor had unlimited access to the company's books andrecords ['/121] and an obligation to review and evaluatethose records in order to form an opinion regarding thecompany's financial statements . The court discussed theobligations of an outside auditor as follows :

2004 U .S . Dist . LEXIS 26488, *

Independent auditors [have unlimited ac-cess to the client's books and records and]are charged with obtaining and evaluatingevidence concerning the assertions madein their client's financial statements . Audi-tors are not entitled to allow representa-tions from a company's management tosubstitute for the auditing procedures thatare necessary to provide a reasonable ba-sis for forming an opinion regarding thefinancial statements that are the subject ofthe audit. In auditing the financial state-ments, an auditor may consider as evi-dence all books of original entry, the gen-eral and subsidiary ledgers, related ac-counting manuals, and records such aswork sheets and spreadsheets supportingcost allocations, computations and recon-ciliations . The underlying accounting datashould be considered when forming anopinion as to the financial statements .Professional auditors are required to actdiligently and in good faith, and to apply aprofessional skepticism to their evaluationof [*122] evidence . An auditor shouldconduct the audit objectively, thoroughlyand carefully. Before certifying financialstatements, an auditor should have an un-derstanding of the factors that may have asignificant effect on the financial state-ments .

2003 U.S. Dist. LEXIS 10863, [WLJ at *34 . The courtfurther noted that the defendant 's books and records con-tained no support for or documentation of the accountingtreatment of signi ficant merger reserves and line costs .The court noted that had the auditor reviewed the com-pany's accounting systems and data, as it was obligatedto do, it would have discovered the lack of documenta-tion and the fraudulent accounting treatment . Addition-ally, the court pointed to the fact that the complaint iden-tified the steps the auditor should have taken and failedto take, and the fraud it would have discovered if it hadtaken those steps . In that case, the defendants pointed tothe subsequent indictments and guilty pleas of formercompany executives showing that the company' s seniormanagement had lied to and concealed the falsi fi cationof the books from the auditors as evidence that the de-fendants lacked scienter . The court rejected [*123] theargument noting that the auditor would have uncoveredthe fraud perpetrated by the company if it had conductedthe review it was required to do before issuing its audit

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opinions and that the auditor's audit opinions included inthe company's year-end financial statements materiallymisrepresented the company's financial state .

In this case, the court fords that the TAC in its total-ity sufficiently alleges scienter as to D&T . To beginwith, the TAC includes allegations substantial allegationsof motive and opportunity . Specifically, the TAC allegesthat D&T served continuously as the company's auditorfrom at least 1994 through the class period . During thattime D&T personnel were present at the company'sheadquarters frequently throughout the year and had con-tinual access to and knowledge of Fleming's private andconfidential corporate, financial, and business informa-tion giving D&T thorough knowledge of all aspects ofFleming's financial history, accounting practices, internalcontrols, and business operations .

Additionally, the TAC's allegations that D&T hadsufficient motive through its work as the company's con-sultant and receipt of consulting fees amounting to twicethat [* 124] of its auditing fees are sufficient to supportan inference of scienter as well . Nathenson, 267 F.3d at412 (holding that motive and opportunity to commitfraud may be facts that add to the scienter calculus) ; seealso In re Global Crossing, Ltd. Sec . Litig ., 322 F. Supp .2d 319 at 345, 2004 WL 763890, at *20-21 (S.D.N. Y.2004)(finding motive allegations sufficient where theauditor generated consulting fees of six times its auditingfees and noting that an auditor may take on "a vestedinterested in the performance and profitability" of itsclient, and consequently "weaken[] its ability to rely onits reputation in countering as irrational' allegations thatit participated in a client's fraud")(quoting In re Mi-croStrategy, Inc . Secs . Litig., 115 F. Supp. 2d 620, 655(E.D. Va. 2000)) . Courts have been especially ready tofind motive pleading adequate to survive dismissal incases where the auditing company plays a dual rule n8with respect to the client . Id. at 20 (collecting cases) .

n8 In 2001 Fleming paid D&T S 1,800,000 inconsulting fees ; $ 400,000 in attestation servicesand $ 1,000,000 in auditing fees .

* 12 5

The allegations surrounding D&T's failure to un-cover the lack of internal controls and accounting ma-nipulations are also pleaded sufficiently to give rise to astrong inference of scienter . Specifically, as to the lack ofinternal controls, the TAC alleges that during the latterpart of 2001 the company terminated the controllers, theaccounts receivable and accounts payable managers, andclerks from each division and centralized its accounting

2004 U .S . Dist. LEXIS 26488, *

operations at the company's headquarters . Further, theTAC alleges that the company terminated its divisionalinternal audit staff and outsourced the function to Ernst& Young. Subsequently, the lone E&Y internal auditorallegedly demanded a transfer to another client afterlearning of the company's widespread improprieties . TheTAC alleges that these conditions -- inadequate staffingof accounting personnel, the absence of documentationsupporting transactions, journal entries, and lack of anyinternal auditing of operations -- required D&T to ex-pand the extent of procedures applied as required byGAAS (AU § 312) . n9

n9 In planning an audit, an auditor must assessthe audit risk by looking at the various risks at is-sue in each audit, such as inherent risk and con-trol risk, to assess the extent and scope of the au-dit ,

*126

With regard to the accounting manipulations, theTAC alleges that the Company accrued large amounts ofunauthorized vendor deductions that D&T failed to dis-cover during its audit and review procedures . The TACalleges that the company violated GAAP by reducingboth its accounts payable and cost of goods sold by theamount of the vendor deductions even before the vendorhad received the debit memorandum and approved thededuction in contravention of FASB Statement No . 5 .nl0 The accrual of these vendor deductions resulted inearnings being overstated by up to $ 120 million at anyone time during 2001 and 2002 amounting to more than10% of the accounts payable during the class period andresulting in a material reduction of accounts payable thatobligated D&T to audit their validity .

n10 In accounting for contingencies, contingen-cies that might result in gains usually are not re-flected in the accounts since to do so might be torecognize revenue prior to its realization .

The TAG alleges that, according to [* 127] Source3, D&T received copies of the debit memorandums in itsaudit packages, but never requested the invoices forwhich the debit memorandums were issued and neverasked any questions, requested supporting documents, orsought verification of any documents or entry in contra-vention of GAAS (AU § § 326 and 330) . nl 1. The TACalleges that if D&T during its interim reviews starting in

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mid-2001 had compared the magnitude of the dollaramount of vendor deductions issued during the fiscalqua rter with the magnitude of the dollar amount of ven-dor deductions issued during the comparable prior pe-riod's quarter and during the immediate proceeding quar-ter in accordance with GAAS (AU § 722) 02, thenD&T would have learned of the huge dollar amount ofunauthorized, improper, and unsustainable deductions .

nil Evidential matter from independent sourcesoutside an entity provides greater assurance of re-liability than that secured solely within the entity .The independent auditor's direct personal knowl-edge, obtained through physical examination, ob-servation, computation, and inspection, is morepersuasive than information obtained indirectly .In the examination of accounts payable, for ex-ample, alternative procedures [to sending writtenconfirmation requests] may include examinationof subsequent cash disbursements, correspon-dence from third parties, or other records to pro-vide evidence for the completeness assertion .

[*128]

n12 During a review of interim financial informa-tion an auditor should compare interim financialinformation with comparable information for theimmediately preceding interim period and forcorresponding previous periods .

The TAC alleges that although the Company createddebit memorandums supporting the deduction amounts,the debit memorandums did not include vendor invoicenumbers that would allow the tracking of the deductionsto the relevant invoice in an attempt to determine its va-lidity . The TAC posits that had D&T adequately testedthe debit memorandums in accordance with GAAS (AU§ 150) n13 to determine their validity by inspectingvendor correspondence, examining signed vendor con-tracts, and inspecting the vendor statements, D&T wouldhave learned that the claimed deductions were after-the-fact and after-delivery de facto unsubstantiated deduc-tions disputed by the vendors . Additionally, the TACalleges that letters from irate vendors disputing largedeductions such as Agrilink Foods Inc ., Kellogg Co .,Unilever PLC, Oil-Dri, Solo Cup Co . were readily avail-able for review by D&T in [* 129] the vendor corre-spondence files . Further, the TAC alleges that the Com-pany's reserve against doubtful deductions to accountspayable was at all times either insufficient to cover the

2004 U.S . Dist . LEXIS 26488, *

extent of the disputed deductions or reversed to eliminateany reserve for the deductions ,

n13 Standard of Field Work No. 3 requires thatsufficient competent evidential matter is to be ob-tained through inspection, observation, inquiries,and confirmations .

With the amount of the deductions allegedly increas-ing to, at one point , upwards of $ 120 million, D&T'sfailure to test the legitimacy of the vendor deductionsand the rese rve account exceed an inference of negli-gence . Finally, the company's announcement in April of2003 of a restatement of earnings of $ 85 million due toaccounting irregularities accounting for 79% of the com-pany's reported earnings for the time period at issue addsto and supports the allegations of a material misrepresen-tation in the company 's financial statements and an infer-ence of scienter. [*130 1 In re MicroStrategy, 115 F.Supp. 2d at 652 (holding that the magnitude of the re-statement and the simplicity of the GAAP principles vio-lated in the case and the ease with which the violationscould be detected suggest a deliberate ignorance on theauditor's part and support an inference of scienter) .Therefore , the court finds that the totality of the allega-tions of scienter in the TAC sufficiently support a stronginference of scienter as to D&T. As a result, D&T's mo-tion to dismiss the 1934 Act claims is denied .

5. Failure to Adequately Plead Loss Causatio n

The 1934 Act Defendants contend that the plaintiffshave failed to adequately plead loss causation . The de-fendants do not dispute that the plaintiffs have ade-quately pleaded transaction causation through the allega-tions of price inflation, but the defendants contend thatthe plaintiffs have failed to allege that the fraudulentconduct was in some reasonably direct way responsiblefor the loss caused by the decline in the price of theirsecurities . The "loss causation" provision in the PSLRAprovides that

In any private action arising under thischapter, the plaintiff shall have the burden[* 131 ] of proving that the act or omissionof the defendant alleged to violate thischapter caused the loss for which theplaintiff seeks to recover damages .

15 U.S.C. § 78u-4(b)(4) . At trial, the plaintiffs will berequired to show that the untruth was in some reasonably

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direct, or proximate, way responsible for their loss . Huddleston v . Herman & MacLean, 640 F.2d 534, 549 (5thCir. 1981). The necessary element of causation includesboth "loss causation" and "transaction causation ."Coates, 26 F. Supp. 2d 910 at 922 . Transaction causa-tion, similar to "but for" causation, is another way ofdescribing reliance and is satisfied by allegations that the"misrepresentations or omissions induced [the plaintiff]to make the investment ." Id. On the other hand, loss cau-sation is satisfied by allegations that the plaintiff "wouldnot have invested had he known the truth, and that theuntruth was in some reasonably direct way responsiblefor the loss ." Id.

At the motion to dismiss stage, the sole inquiry iswhether the plaintiffs adequately plead loss causation,not whether they can prove it . F* 1321 Zuckerman v,Foxmeyer Health Corp., 4 F. Supp. 2d 618, 626 (XD.Ter . 1998) . The PSLRA does not affect causation plead-ings, thus the allegations must only meet the traditional"fair notice" standards . Id. To adequately plead loss cau-sation and survive a motion to dismiss, "plaintiffs needonly allege facts which show that Defendants' omissionsand misrepresentations caused the market price of thestock to be artificially inflated, and therefore to appear tobe a good risk for investment, so that when the truthcame out about the company's condition, the stock lostvalue and Plaintiffs suffered a loss ." Id.

In this case, the plaintiffs' allegations outline the al-leged misrepresentations and omissions leading up to thestock decline that caused the stock to be artificially in-flated . Next, the allegations discuss in detail the se-quence of events starting with Fleming's first press re-lease on July 30, 2002, that caused the stock price to fallfrom $ 16.18 to 10.81, and the subsequent stair step de-cline in the price of the stock following the release ofnegative information from the company and articles inthe financial news culminating with the SEC's upgrading[*133] of its investigation to formal on February 25,2003, after which the price fell from $ 2,97 to $ 1 .85, andthe filing of bankruptcy in April of 2003 . (TAC, PP 6-12) . As in Coates, the plaintiffs allege tremendous dropsin stock price in the days after the "truth" was revealed .26 F. Supp. 2d at 922. The court in Coates noted thateven if the plaintiffs may not ultimately be able to provethat the decline resulted from the announcements, theforegoing allegations are adequate to demonstrate losscausation . Id.

6. Failure to State a Claim for Controlling PersonLiability

The defendants contend that the TAC does not statea claim for liability under section 20(a) of the 1934 Ex-change Act . Specifically , defendants contend that plain-tiffs have not alleged that any of the 1934 Act Individual

2004 U . S. Dist . LEXIS 26488, *

Defendants, in their positions as officers of the Com-pany, controlled any of the other 1934 Act Defendantssuch that liability under section 20(a) could exist forother individuals' primary violations . In addition, thedefendants contend that plaintiffs have failed to ade-quately plead the necessary control to establish section20(a) liability for the actions of [* 1341 Fleming . Finally,the defendants contend that the failure to allege the exis-tence of underlying violations of section 10(b) and RulelOb-5 by either Fleming or any of the 1934 Act Defen-dants negates any claim for controlling person liability .

Section 20(a) provides that:

Every person who, directly or indirectly,controls any person liable under any pro-vision of this title or any rule or regulationthereunder shall also be liable jointly andseverally with and to the same extent assuch controlled person to any person towhom such controlled person is liable,unless the controlling person acted ingood faith and did not directly or indi-rectly induce the act or acts constitutingthe violation or cause of action .

15 US.C. 78t(a) . Since section 20(a) is a secondary li-ability provision , it is necessary that a primary violationbe established before liability under section 20 arises .ABC Arbitrage, 291 F.3d at 348 n . 57 . In consideringwhether the plaintiff has stated a claim under section 20,the court must determine whether the plaintiff has pledfacts sufficient to establish that a defendant was in con-trol of the primary violators. [*135] Control is definedas "the possession , directly or indirectly , of the power todirect or cause the direction of the management and poli-cies of a person , whether through the ownership of vot-ing securities , by contract, or otherwise ." 17 C.F.R. ,¢240.12b-2() ; see G.A. Thompson & Co. v. Partridge,636 F.2d 945, 957 (5th Cir . 1981) .

Under the control person doctrine , officers and di-rectors may be found liable even if they did not make arepresentation themselves or play a significant role in thepreparation of a misrepresentation . In re Enron, 235 F.Supp. 2d at 594-96; G.R. Thompson & Co., 636 F.2d at958 (holding that a plaintiff need not demonstrate "actualpart icipation " in the underlying fraudulent transaction) .However, contro ll ing person liability requires more thanmerely identifying a defendant ' s place in the hierarchy ofthe company or his job title and cannot hinge solely upona defendant' s position or title . Id. at 621 ; Dennis v . Gen-eral Imaging Inc ., 918 F.2d 496, 509-510 (5th Cir .1990) . "[A] person should be presumed to be a control-

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ling person . . . if they occupy a status or position that[*136] ordinarily bestows authority to control the pri-mary violator generally, or specifically with respect tothe matter or affairs that produced the Securities Actviolation ."' In re Enron, 2003 U.S. Dist. LEXIS 1668,2003 WL 230688, at *18 (quoting Loftus C . Carson, II,The Liability of Controlling Persons Under the FederalSecurities Acts, 72 Notre Dame L . Rev. 263, 281-83(1997)). In various cases the Fifth Circuit has providedthe possible alternative or overlapping bases : day-to-daycontrol of the corporation operations ; knowledge of theunderlying primary violation by the controlled person ; orfacts showing the defendant had the requisite power di-rectly or indirectly to control or influence corporate poli-cies . Id. ; see G .A. Thompson & Co., 636 F.2d at 958(holding that in determining whether a plaintiff has madea prima facie showing of "control," a plaintiff must pleadfacts indicating that the defendant "had the requisitepower to directly or indirectly control or influence corpo-rate policy") ; [* 137] 1WcNarnara, 46 F. Supp . 2d at 638(stating that although it has not been explicitly addressedby the Fifth Circuit, it does not appear that a plaintiffmust establish that the defendant "actually participated inthe general, day-to-day control [of the general affairs ofthe company]") .

Federal Rule of Civil Procedure 9(b) and 15 U.S.C.§ 78u-4(b)(2) do not apply to control person claims . Inre Enron, 2003 U.S. Dist. LEXIS 1668, 2003 WL 230688,at *42-45 . The plaintiffs are not required to plead factssupporting every element of a prima facie case, but mustonly provide the defendants fair notice of the plaintiffs'claims and the grounds upon which they rest . Id. Con-trolling persons of a controlled entity are subject to li-ability as a controlling person even where the controlledentity is not joined as long as there are sufficient allega-tions of primary violations of the securities laws by thecontrolled person as an element of the action . SEC v.Savoy, 190 US, App. D. C. 252, 587 F.2d 1149, 1170n.47 (D . C. Cir, 1978) . At this stage, the court has con-cluded that the plaintiffs have pleaded sufficient [*138]facts under the PSLRA to survive the motions to dismissas to certain primary violations alleged against the de-fendants Hansen, Rider, Shapiro and Dahlen . The courtwill, at this stage, deny the motions to dismiss on thegrounds that the plaintiffs have sufficiently pleaded con-trolling person liability as against these named defen-dants . This concludes the court's discussion of the issuesrelated to the 1934 Act claims .

8. Analysis of the 1933 Act Issues

The court now turns to the 1933 Act claims . Theseclaims arise from offerings of Fleming securities to thepublic by means of two allegedly material false and mis-leading Registration Statements in March and June of2002 . The first, a March 2002, exchange offering in-

2004 U . S . Dist . LEXIS 26488, *

volved the issuance of $ 400 million of 5/8% Series DSenior Subordinated Notes in exchange for all out-standing Series B and Series C notes . The second, a June2002, offering involved the sale of 8 million shares ofcommon stock at $ 19 .40 per share and S 200 million of9 1/4% Senior Notes from a previous shelf offering thatallowed for the delayed or continuous sale of up to $ 600million of debt or common stock or some combinationthereof over a two-year [*139] period . The plaintiffsallege that the FY01 financial statements used in bothofferings were materially false and misleading and thatFleming acknowledged later the FY01 financial state-ments were false and need to be restated . In addition, theplaintiffs allege that the registration statements containedmaterially false and misleading statements regardingFlemings' current and historical business and operatingconditions and that D&T falsely represented that its audithad been conducted in conformity with GAAS and thatthe statements fairly presented Fleming's financial condi-tion . The plaintiffs n14 brought actions against the 1933Act Individual Defendants, the Underwriters, and D&T .

n14 The "1933 Act Plaintiffs" include : Mas-sachusetts State Carpenters Pension Fund("MSCPF"), Massachusetts State GuaranteedAnnuity Fund ("MSGAF"), Alaska ElectricalPension Fund ("Alaska Fund"), Anthony Co-larich, David Dickey, Joel Feliciano, RaheelaZaman and Terry Slater.

[*140] The 1933 Act claims do not require a plain-tiff to plead or prove fraudulent conduct and the plain-tiffs expressly disavow all allegations of fraud orscheme . Therefore, the heightened pleading standards ofFederal Rule of Civil Procedure 9(b) do not apply . LoneStar Ladies Inv. Club v. Schlotzsky's Inc ., 238 F.3d 363(5th Cir. 2001) . Notice pleading under Rule 8 is all thatis required to properly state 1933 Act claims . In re En-ron, 235 F. Supp. 2d at 596. That said, the court nowturns to a discussion of liability under the 1933 Act . Spe-cifically, these plaintiffs assert claims under sections 11and 12(a)(2) of that act.

Section 11 imposes liability if any part of a registra-tion statement or prospectus contains an untrue statementof a material fact or omits to state a material fact requiredto be stated therein or necessary to make the statementstherein not misleading and grants standing to sue to anyperson acquiring such security . 15 U.S.C. § 77k(a) . Sec-tion 11 imposes a stringent standard of liability on theparties who play a direct role in a registered offering .[*1411 Herman & MacLean v . 1Huddleston, 459 U.S.375, 381-82, 74 L. Ed. 2d 548, 103 S. Ct. 683 (1983) . Aplaintiff who purchased a security issued pursuant to a

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registration statements need only show a material mis-statement or omission to establish his prima facie case .Id. at 382 . The plaintiffs do not have to allege knowinglyor intentionally false statements in registration statementbecause section 11 claims do not sound in fraud .Schlotzsky's, 238 F.3d at 369. Section 11 does not re-quire a plaintiff to plead or prove scienter . Id. Congres-sional policy underlying section 11 was to create liabilityregardless of fault, Id. If there is a material misstatementor omission in the registration statement, the buyer maysue the issuer, underwriter, or signor of the registrationstatement .

The Fifth Circuit interprets the operative language ofsection I1 to allow suits to be brought by direct buyerson the day an offering closes, as well as subsequent pur-chasers who can trace their securities to the challengedregistration statement , [* 142] Rosenzweig, 332 F. 3d at872-73. To establish standing, the plaintiffs must allegefacts to show that all stock for which they claim damageswas actually issued pursuant to a defective statement, notjust that it might have been , probably was, or most likelywas, issued pursuant to a defective statement .Kri,n v .pcOrder . corn, Inc., 210 F.R.D. 581 (W.D. Tex. 2002) .Where there have been multiple offerings of the sametype of securities , plaintiffs do not satisfy their tracingburden by showing they probably bought stock issuedpursuant to the allegedly false registration statement . Idat 586.

Under section 11 an expert has an affirmative de-fense if it shall sustain the burden of proof that after rea-sonable investigation it had reasonable ground to believeand did believe, at the time such part of the registrationstatement became effective , that the statements thereinwere true and that there was no omission to state a mate-rial fact required to be stated therein or necessary tomake the statement therein not misleading . 15 U.S.C

. 77k(b). A defendant may be shielded from section 1 1liability if the defendant [*143] reasonably, and withoutactual knowledge of any inaccuracies , relies on parts of aregistration statement "purporting to be made on the au-thority of an expert ." 15 USC. § 77k(b)(3)(C) . Exper-tised portions of a registration statement and prospectusinclude those, such as financial statements , that havebeen examined , reported upon and audited by independ-ent auditors . In re Enron, 235 F. Supp. 2d at 598. Anunderwriter may rely on expertised po rtions of a registra-tion statement or prospectus , such as financial statementscert ified by an accountant , unless it had reasonablegrounds to believe the statements were untrue . Id. at 613 .The fact-specific determination of the reasonableness ofa defendant 's investigation or of his reliance on the opin-ion of an expert is not a question properly resolved on amotion to dismiss unless the affirmative defense clearly

2004 U.S. Dist . LEXIS 26488, *

appears on the face of the complaint . In re Enron, 258 F.Supp. 2d at 639.

Section 12(a)(2) imposes liability on a person whooffers or sells a security by means of a prospectus or oralcommunication , which includes an untrue statement of amaterial fact. [* 144] Lewis v . Fresne, 252 F.3d 352,357 (5th Cir. 2001) . A seller is one who either passestitle of the securities to the buyer or one who success-fully solicits the purchase , motivated at least in part by adesire to serve his own financial interests or those of thesecurities owner . Pinter v . Dahl, 486 U.S 622, 647, 100L. Ed. 2d 658, 108 S. Ct. 2063 (1988) . To count as solici-tation , the seller must , at a minimum, directly communi-cate with the buyer . Rosenzweig, 332 F.3d at 871 . Anissuer may be liable only if the plaintiff can allege andprove that an issuer' s role was not the usual one, that itwent farther and became the vendor's agent . Id. Virtuallyall issuers routinely promote a new issue , if only in theform of preparing a prospectus and conducting a roadshow . Lone Star Ladies, 238 F.3d at 370. Section 12(a)does not require a plaintiff to prove scienter either andthe pleadings need only satisfy the liberal pleading re-quirements of Rule 8 of the Federal Rules of Civil Pro-cedure . [' 145] In re Enron , 235 F. Supp . 2d at 596 .

As several of the 1933 Act Defendants raise limita-tions arguments, the court addresses in general the appli-cable limitations period . The 1933 Act requires plaintiffsto bring claims under section 11 or 12(a)(2) "within oneyear after the discovery of the untrue statement or theomission, or after such discovery should have been madeby the exercise of reasonable diligence ." 15 U.S.C. §77m, The Sarbanes-Oxley Act does not extend the limita-tions period for the 1933 Act claims to two years . Theplain language of the Sarbanes-Oxley Act states that theextended limitations period applies "to a private right ofaction that involves a claim of fraud, deceit, manipula-tion, or contrivance . . . as defined in section 3(a)(47) ofthe Securities Exchange Act of 1934 ." The courts haverejected the argument that the Sarbanes-Oxley limita-tions period applies to 1933 Act claims . In re MerrillLynch & Co. Research Reports Sec. Litig., 272 F. Supp.2d 243, 265 (S.D.N Y. 2003) ; [*146] Friedman v. Ray-ovac Corp., 295 F. Supp. 2d 957, 974-75 (W.D. Wis .2003) . Instead, the applicable limitations period to theseclaims is one year after the plaintiffs were put on inquirynotice of their claims as required by Section 77m of the1933 Act .

It is well-settled the inquiry notice may be deter-mined as a matter of law. Jensen v. Snellings, 841 F.2d600, 607 (5th Cir. 1988)(affirming a dismissal whererecord revealed that the plaintiffs had notice of claims) ;Rahr v. Grant Thornton LLP, 142 F. Supp. 2d 793, 796(N D. Tex. 2000) . In this regard, one court has observedthat "where . . . the facts needed for determination of

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when a reasonable investor of ordinary intelligencewould have been aware of the existence of fraud can begleaned from the complaint and papers . . . integral to thecomplaint, resolution of the issue on a motion to dismissis appropriate . . . ." LC Capital Partners, LP v . FrontierIns . Group, Inc ., 318 F,3d 148, 156 (2dCir . 2003) .

In this case , the plaintiffs plead that Fleming issueda press release on July 30, 2002, announcing that its re-tail segment was suffering from declining prices (TAC,[* 147] P 264) . The plaintiffs also allege that on July 31,2002, analysts downgraded Fleming's investment ratingand questioned its reported per-share earnings (TAC, P270-71) . Finally, most impo rtantly , the plaintiffs allegethat the Wall Street Journal published an article on Sep-tember 5, 2002 , that revealed Fleming's practice of tak-ing unauthorized , improper, and unsustainable deduc-tions from vendor's invoices . (TAC, P 281 ) . As a matterof law, the plaintiffs ' own allegations reveal that, at thelatest, the plaintiffs ' were on inquiry notice of theirclaims by September 5, 2002 , the date of the Wall StreetJournal art icle exposing the practice of vendor deduc-tions . Thus, limitations expired on the 1933 Act claimsSeptember 5, 2003, one year later , Against this backdrop,the court examines the various limitations arguments .

The 1933 Act Individual Defendants and D&T as-sert that the plaintiffs ' claim against them relating to theMarch 2002 offering of 10 .625% Notes is time-barred . Intheir response , the plaintiffs appear to concede that TerrySlater is the only plaintiff with standing to asse rt a sec-tion II claim relating to the March 2002 RegistrationStatement because he is the only named [* 148 ] plaintiffto have obtained notes in an offer made pursuant to thatstatement . The plaintiffs argue that Terry Slater filed alawsuit in Oklahoma state court on November 14, 2002,within the limitations period . But, what the plaintiffs failto appreciate is that Slater did not sue the 1933 Act Indi-vidual Defendants or D&T in that case . Slater's casejoined only the Fleming Companies , Hansen , Rider, andDahlen . Slater failed to join the 1933 Act Individual De-fendants and D&T until September 12, 2003, more thanone year after limitations commenced . Therefore, theclaims against the 1933 Act Individual Defendants andD&T are time-barred unless saved by an exception,which, as the cou rt will explain, they are not .

Rule I5 (c)(3), governing the relation back of plead-ings, does not apply . The explicit language of the rulestates that an amendment adding a new defendant relatesback only if, among other things , the new defendant"knew or should have known that, but for a mistake con-cerning the identity of the proper par ty , the action wouldhave been brought against the party." The rule does notprotect plaintiffs who "knew of the late-named party atall times but failed to include that [*149] party in theoriginal filing." In re Xchange Inc. Sec . Litig., 2002 US.

2004 U.S . Dist . LEXIS 26488, *

Dist. LEXIS 15909, 2002 WL 7 .96.9661, at *4 (D. Mass.Aug. 26, 2002) . In this case, the identities of the 1933Act Individual Defendants and D&T were readily ascer-tainable, All of the Individual Defendants (save and ex-cept Hernandez) actually signed the March 2002 Regis-tration statement, and D&T's role as the auditor wasplain from the face of the statement . (See, e.g., MarchRegistration Statement, p . 106, identifying independentauditor as D&T) . And, even with respect to Hernandez,the plaintiffs here make no argument that they were mis-taken as to his identity or that it was not readily ascer-tainable . The court grants the 1933 Act Individual De-fendants' and D&T's motions to dismiss the plaintiffs'claims under the 1933 Act relating to the March 2002offering because they are barred by the applicable one-year statute of limitations . Resolution of the limitationsquestion makes it unnecessary to consider the 1933 ActIndividual Defendants' and D&T's alternative argumentthat the March 2002 exchange offer is exempt from theprovisions ofsection 11 .

The 193 3.Act Individual Defendants, Defendant[*150] D&T, and the Underwriter Defendants (collec-tively, "1933 Act Defendants") also contend that the sec-tion 11 claim should be dismissed because the claimsbased on the June 2002 offering are time barred . The1933 Act Defendants urge, with respect to the June 2002offering, that the plaintiffs' claims relating to the pur-chase of 9 .25% Notes are barred because one of theoriginal plaintiffs, MSCPF, did not purchase notes in theoffering and plaintiff Alaska Fund, which did purchasenotes in that offering, was not joined as a party-plaintiffuntil September 12, 2003, after limitations had expired .The court disagrees .

The linchpin of the 1933 Act Defendants' argumentis that MSCPF lacked standing to pursue claims on be-half of the note purchasers when it filed its February 20,2003, complaint because it only purchased stock . It is notdisputed that MSCPF filed suit within the limitationsperiod and its pleading, on behalf of a class, allegingviolations of federal law in connection with the sale of"Fleming Securities" issued in or traceable to the June2002 Offering, placed the defendants named thereinplainly on notice of these claims . There is authority thatsuggests that a class representative [*151] who pur-chased stocks can represent purchasers of debt instru-ments in the same lawsuit . In re Enron Corp . Sec. Litig.,206 F.R.D. 427, 445 (S.D. Tex . 2002)(noting "there is norequirement that the claims of all plaintiffs and classmembers must be identical") ; Endo v. Albertine, 147F.R.D. 164, 167 (+V.D. 111. 1993)("[A] class of plaintiffswho purchased different types of securities may properlybe certified with a representative party who only pur-chased one type of security .") ; In re Saxon Sec. Litig.,1984 US. Dist. LEXIS 19223, 1984 WL 2399, at *7

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(S.D.N.Y. Feb. 23, 1984)( holding that "debenture holdershave an interest identical to that of the holders of com-mon stock in demonstrating a common course of fraudu-lent conduct") .

The 1933 Act Defendants contend these cases are

distinguishable, and these parties say that the cases con-cerned the propriety of class representation under Rule

23, not jurisdictional standing . The 1933 Act Defendantspoint to the holding in In re Paracelsus Corp., 6 F. Supp.

2d 626 (S.D. Tex . 1998), where the court hold that pur-chasers of stock issued pursuant to one registrationstatement [*152] did not have standing to sue on behalf

of purchasers of notes issued out of a companion state-

ment, It is true that Paracelsus addressed the concept of

standing and dismissed, on standing grounds, the claims

of plaintiffs who had not purchased bonds issued pursu-ant to the registration statement at issue . In that case,

however, the two types of securities were issued pursuant

to separate registration statements. The claims of the note

purchasers had to be linked under section I1 to the regis-

tration statement pursuant to which the company issuedthe notes. Otherwise, the statutory requirements of sec-tion 11 failed .

The point of Article III standing and the more spe-cific statutory standing concept addressed in Paracelsusis to ensure that the named plaintiff has a personal stakein the outcome of the litigation and that the plaintiff pur-chases "securities" as that term is defined by the Act is-sued pursuant to a particular registration statement . Inthis case, it is not disputed that the stocks and the noteswere issued pursuant to a single registration statement,nor is it disputed that MSCPF bought securities issuedpursuant to the registration statement . MSCPF had inFebruary [*153] 2003, and continues to have a personalstake in the outcome of the case sufficient to warrantArticle Ill standing on the section 11 claims .

Contrary to the 1933 Act Defendants' argument, thecase law holds that purchasers of one type of securityhave standing to sue on behalf of purchasers of othertypes of security issued pursuant to a single registrationstatement . The court in In re Worldcorn, Inc. Sec. Litig.,2004 U.S. Dist. LEXLS 4240, 2004 WL 555697, at *6-7(S.D.N.Y. March 19, 2004), recently rejected a similarargument when it held that purchasers of one type ofdebt security (domestic) had standing to pursue claims ofpurchasers of a second type of debt security (foreign)issued pursuant to the same registration statement) . Simi-larly, the court in In re MobileMedia Secs . Litig., 28 F.Supp . 2d 90!, 911 (D.N..J. 1998) was faced with an ar-gument that stock purchasers lacked standing to repre-sent the interests of note purchasers and held that theplaintiffs had "sufficiently alleged individual cognizableinjuries pursuant to section 11 and section 12(a)(2)" toconfer standing . [*154] The court therefore rejects the

2004 U.S . Dist . LEXIS 26488, *

argument that section 11 claims related to notes issuedpursuant to the June 2002 Registration Statement arebarred by the statute of limitations . Resolution of thisquestion in this manner renders it unnecessary to con-sider the plaintiffs ' alternative arguments that AmericanPipe & Constr. Co. V . Utah, 414 U.S. 538, 551, 38 L . Ed.2d 713, 94 S. Ct. 756 (1974) applies to this case to tolllimitations until the addition of Alaska Fund to this casein the September, 2003 or that Rule 15 permits the rela-tion back of Alaska Fund' s claims to the date ofMSCPF's February 2003 complaint .

The 1933 Act Defendants also argue that atermar-ket purchasers of Flem ing`s common stock cannot "trace"their purchases to the June 2002 Registration Statement,and therefore, section 11 claims asserted on their behalfshould be dismissed . In the Fifth Circuit, aftermarketpurchasers who can trace their purchase to the chal-lenged registration statement have standing to bring asection 11 claim . Rosenzweig, 332 F.3d at 873 . Bearingin mind that the case is still in the pleading stage, thecourt rejects the 1933 Act Defendants' argument . Here,[*1551 the TAC specifically alleges that "Plaintiffs andthe other members of the Subclasses purchased the Flem-ing Securities that were issued pursuant and traceable tothe March and June 2002 Registration Statements ."(TAC, P 509) . The plaintiffs have sufficiently pleadedsection 11 standing with their allegation that the mem-bers of the class purchased the securities that were "is-sued pursuant and traceable to" the pertinent registrationstatements . Whether and to what extent the plaintiffs willbe able to prove tracing is a different question and is onewhich, in any event, is not susceptible to decision in thecurrent posture of this case .

The 1933 Act Individual Defendants and D&T alsocontend that the plaintiffs' section 12(a)(2) claims shouldbe dismissed because they are not "sellers" of securities .Section 12(a)(2) provides that a person who "offers orsells" a security by means of a prospectus or oral com-munication that contains a materially false statement orthat omits to state certain material facts shall be liable toany person purchasing such security from him . 15 U.S.C.§ 771(a) . A section 12(a)(2) "seller" is either (1) the per-son who actually passes [* 156] title to the buyer, or (2)"the person who successfully solicits the purchase, moti-vated at least in part by a desire to serve his own finan-cial interests or those of the securities owner ." Pinter,486 US. at 647 .

The March and June 2002 offerings were firm com-mitment underwritings . As such, investors purchasedsecurities not from Fleming, but from the underwriters orbroker-dealers who purchased from the underwriters .Consequently, as a matter of law, the 1933 Act Individ-ual Defendants and D&T cannot be sellers under thetitle-passing definition adopted by the Supreme Court .

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As to the second definition, the plaintiffs allege inconclusory fashion that each defendant named in CountV "solicited and/or was a substantial factor in the pur-chase by plaintiffs of securities in the offerings ." (TAC,P 517). What is required under Pinter is that the nameddefendant "successfully solicit" the purchase . To thatend, the court agrees with the defendants that solicitationis a legal term of art and that conclusory allegations in apleading or legal conclusions masquerading as factualconclusions will not suffice to prevent a motion to dis-miss . [* 157] Fernandez-Monies v. Allied Pilots Assn,987 F. 2d 278, 284 5th Cir. 1993) .

The Fifth Circuit has narrowly circumscribed thescope of section 12(a)(2) liability under the second Pin-ter definition. The court has held that to count as "solici-tation," the seller must, at a minimum, directly commu-nicate with the buyer . Rosenzweig, 332 F.3d at 871 . Anissuer, like Fleming (and, by extension, its directors andits auditor), is liable under section 12(a)(2) only if theplaintiff can allege and prove "that an issuer's role wasnot the usual one; that it went farther and became a ven-dor's agent ." Id. (quoting Lone Star Ladies Inv . Club v.Schlotzsky's, Inc., 238 Fad 363, 370 (5th Cir . 2001)) .This is because virtually all issuers promote their securi-ties in some fashion, either by preparing prospectuses orconducting road shows . Lone Star Ladies, 238 F.3d at370 . The TAC is bereft of allegations that the 1933 ActIndividual Defendants or D&T directly communicatedwith the purchasers of the securities or assumed the un-usual role of the vendors' agents. The plaintiffs havefailed to allege sufficient facts to prevent [*158] dis-missal of the section 12(a)(2) claims against the 1933Act Individual Defendants and D&T, and the courtgrants the motion to dismiss those claims .

The Underwriter Defendants are named as defen-dants under sections 11 and 12(a)(2) of the 1933 Actwith respect to their role in the June 2002 Offering . Mostof their arguments have been addressed previously; how-ever, they make a separate, distinct argument which theyassert entitles them to a dismissal of all of the 1933 Actclaims against them . According to the Underwriter De-fendants, they were entitled to rely on the accuracy ofFleming's financial statements because those statementswere "expertised . "

As noted above . section 11 of the 1933 Act containsa safe harbor from liability for underwriters who rea-sonably rely upon "expertised " po rtions of a registrationstatement . 15 U.S.C. § 77k (b) (3)(C) . Likewise, under-writers are shielded from liabil ity for a claim under sec-tion 12(a)(2) if they rely on the "expe rtised " portions ofan offering prospectus . In re Worlds of Wonder Sec.Litig., 814 F. Supp . 850, 867-68 0N.D. Cal. 1993), affdin relevant part, 35 F. 3d 1407 (9th Cir. 1994) [* 159] .Unfortunately for the Underwriter Defendants , this ques-

2004 U .S . Dist, LEXIS 26488, *

tion is generally not proper for resolution by a motion todismiss, because the underwriter bears the burden ofproof to show that it had no reason to believe and did notbelieve that the expertised po rt ions of the registrationstatement were untrue . In re Enron Corp . Sec. Derivative& ERTSA Litig., 258 F. Supp. 2d 576 (S.D. Tex. 2003) ;Grin v. PaineWebber, Inc., 84 F. Supp . 2d 508, 512-13(S.D.N.I'. 2000); In re Chambers Development Sec.Litig., 848 F. Supp . 602, 624 (W.D. Pa. 1994) . The courtrejects the Underwriter Defendants ' argument that theirentitlement to this affirmative defense is apparent fromthe face of the TAC and therefore denies the UnderwriterDefendants' motion to dismiss the 1933 Act claims lev-eled against them .

Finally, the Underwriter Defendants assert that theplaintiffs have not sufficiently alleged standing to pursuetheir section 12(a)(2) claim against them. As noted, sec-tion 12(a)(2) liability is narrow. Standing exists undersection 12(a)(2) and Pinter when a plaintiff can pleadand prove that a seller actually passed title to a buyer .The [* 160] Underwriter Defendants argue that the TACfails to allege that the plaintiffs acquired title in theirsecurities from the Underwriter Defendants, such that thefirst definition of "seller" under Pinter is satisfied .

The TAC alleges that "the Underwriter Defendantsoffered for sale and sold the securities purchased byplaintiffs and the members of the Subclass . . . ." (TAC, P516) . This allegation is susceptible to two constructions :the first is that the Underwriter Defendants offered forsale and sold the securities directly to the plaintiffs ; thesecond is that the Underwriter Defendants offered forsale and sold the securities fi rst to another who then soldto the plaintiffs . As section 12(a)(2) only permits a pur-chaser to recover against his direct seller, the courtagrees with the Underwriter Defendants that the plain-tiffs have not sufficiently alleged section 12(a)(2) stand-ing with this allegation, Nor have the plaintiffs suffi-ciently articulated how or if they had direct communica-tion with the Underwriter Defendants such that they sat-isfy the second Pinter definition . It may be, however,that the plaintiffs are able to satisfy these requirements .They are [*161] granted leave to do so within ten (10)days after the date of the entry of this opinion if they can .The court has canvassed the remaining arguments insupport of the various motions to dismiss and, to the ex-tent they have not been specifically addressed in thisopinion, they are now rejected .

V. CONCLUSION

In accordance with the above opinion and for thereasons more fully expressed herein the court ORDERS

Page 3 6

that the following motions be disposed of as indicatedbelow :

. Defendant Mark D . Shapiro's Motion to Dismiss Plain-tiffs' Third Consolidated Amended Class Action Com-plaint and Brief in Support (Docket it 15) GRANTEDIN PART AND DENIED IN PART

. Defendant E . Stephen Davis' Motion to Dismiss ThirdConsolidated Amended Class Action Complaint andBrief in Support Thereof (Docket # 16) GRANTE D

1934 Act Defendants' Joint Motion to Dismiss Pursuantto Rides 9(b) and 12(b)(6) and the Private SecuritiesLitigation Reform Act of 1995 and Memorandum of Lawin Support (Docket # 17) GRANTED IN PART ANDDENIED IN PART

. Defendant Neal Rider's Supplemental Motion to Dis-miss Pursuant to Rules 9(b) and 12(b)(6) and the PrivateSecurities Litigation [*162] Reform Act of 1995 andMemorandum of Law in Support (Docket # 18)GRANTED IN PART AND DENIED IN PART

, Defendant Thomas Dahlen's Individual Motion to Dis-miss Plaintiffs' Third Consolidated Amended Class Ac-tion Complaint and Brief in Support (Docket 9 19)GRANTED IN PART AND DENIED IN PAR T

. Motion to Dismiss Third Consolidated Amended ClassAction Complaint and Brief in Support Thereof of De-fendant Mark Hansen (Docket # 20) GRANTED INPART AND DENIED IN PART

. Motion to Dismiss of Defendants Lehman BrothersInc ., Deutsche Bank Securities Inc., Wachovia Securi-ties, Inc ., and Morgan Stanley & Co . Incorporated(Docket # 21) GRANTED IN PART AND DENIEDIN PART

. Defendant Deloitte & Touche LLP' s Motion to Dismissand Suppo rting Brief (Docket ;Y 22) DENIE D

1933 Act Individual Defendants' Motion to DismissPlaintiffs' Third Consolidated Amended Class ActionComplaint and Supporting Brief (Docket # 25)GRANTED IN PART AND DENIED IN PART

So ORDERED and SIGNED this 10th day of June,2004 .

T. JOEIN WARD

UNITED STATES DISTRICT JUDGE

TAB 3

slaw.Not Reported in F .Supp .2dNot Reported in F .Supp.2d, 2006 WL 708663 (N .D .Cal .)(Cite as : Not Reported in F .Supp .2d)

HBriefs and Other Related Document sIn re Nextcard, Inc, SecuritiesLitigationN.D.Cal .,2006 .Only the Westlaw citation iscurrently available .NOT FOR CITATION

United States District Court, N .D. California,San Jose Division .

In re NEXTCARD, INC, SECURITIESLITIGATION .

No. C 01 -21029 JF (RS).

March 20, 2006 ,

Christopher Paul Seefer, Milberg Weiss et . al . LLP,Jeffrey W. Lawrence , Lerach Coughlin Stoia GellerRudman & Robbins LLP, San Francisco, CA, Eric J .Belfi , Murray, Frank & Sailer LLP, New York, NY,Marc A, Ta az, Schiffrin & Barroway LLP, Radnor,PA, William S. Lerach , Lerach Coughlin Stoia GellerRudman & Robbins LLP, San Diego, CA, for RussellBallati on Behalf of Himself and All Others SimilarlySituated .Jo A nn Bull, Jeffrey W . Lawrence , Lerach CoughlinStoia Geller Rudman & Robbins LLP, Christopher PaulSeefer, Milberg Weiss et, al . LLP, San Francisco, CA,Eric J . Belfi , Murray, Frank & Sailer LLP, New York,NY, Tamara J . Driscoll , Lerach Coughlin Stoia GellerRudman & Robbins LLP, Seattle, WA, Alan Schulman,

Alicia M. Duff, Bernstein Litowitz Berger &Grossmann LLP, San Diego, CA, for JacksonvillePolice and Fire Pension Fund .Adam J . Levitt , Marv Jane Edelstein Fait , WolfHaldenstein Adler Freeman Herz LLC, Chicago, IL,Eric J . Belfi , Murray, Frank & Sailer LLP, Fred T.lsquith , Wolf Haldenstein Adler Freeman & Herz,Gustavo Bruckner, Thomas Hamilton Burt , WolfHaldenstein Adler Freeman Herz LLP, New York, NY,Marc S . Henze], Law Offices of Marc S . Henze[, BalaCynwyd, PA, for Market Street Securities Inc . onBehalf of Himself and all Others Similarly Situtated .Ira M. Press , Kirby Mcinerney & Squire LLP, Eric J .Belfi , Murray, Frank & Sailer LLP, New York, NY,Lionel Z. Glancy, Michael M . Goldberg , Glancy &Binkow LLP, Los Angeles, CA, Patrick V . Dahlstrom,Pomerantz Haudek Block Grossman & Gross LLP,Chicago, IL, for Edward Toptani on His Own Behalfand on Behalf of All Others Similarly Situated Plaintiff .Eric J . Belfi, Murray, Frank & Sailer LLP, Laurence M .Rosen , The Rosen Law Firm, P .A., New York, NY,Jeffrey C. Block, Berman Devalerio & Pease LLP,

Page 1

Boston, MA, Joseph J . Tabacco, Jr. , Berman DevalerioPease Tabacco Burt & Pu, San Francisco, CA, for KerriVittimberga .Laurence M . Rosen , The Rosen Law Firm, P.A., Eric J .Belfi , Murray, Frank & Sailer LLP, New York, NY,Nicole Laval lee, Berman Devalerio Pease Tabacco Burt& Pu, San Francisco, CA, for Frank Vittimberga .John S . Yun , Securites & Exchange Commission, SanFrancisco, CA, for Securities and ExchangeCommission .Bruce J . Hidhman., Highman, Highman & Ball, SanFrancisco, CA, for Richard Goebel, Daniel Springer .Jonathan C . Dickey , Paul J . Collins , Gibson, Dunn &Crutcher LLP, Palo Alto, CA, for Nextcard, Inc .,Robert Linderman .Shirli Fabbri Weiss, Paul A . Reynolds , DLA PiperRudnick Gray Cary U .S . LLP, San Diego, CA, Paul J .Collins, Gibson, Dunn, Crutcher LLP, Palo Alto, CA,for Jeremy R. Lent .Jordan David Eth , Margaret L . Wu, Morrison &Foerster, San Francisco, CA, Paul J . Collins , Gibson,Dunn, Crutcher LLP, Palo Alto, CA, for Yinzi Cai .David M. Jollev, Richard Allen Jones , Covington &Burling, San Francisco, CA, Jonathan C . Dickey , PaulJ . Co ll ins . Gibson, Dunn & Crutcher LLP, Palo Alto,CA, for John V . Hashman .James McManis, William Faulkner, McManis Faulkner& Morgan, San Jose, CA, Charles Thomas Kimmett , J .Andrew Keyes, Williams & Connolly LLP,Washington, DC, for Safi U . Qureshey .Bruce A . Ericson , Jacob R. Sorensen , Kristin M .Lefevre, Pillsbury Winthrop Shaw Pittman LLP, SanFrancisco, CA, Paul J . Collins , Gibson, Dunn, CrutcherLLP, Palo Alto, CA, for Bruce Rigione .Jeffrey W. Lawrence, Lerach Coughlin Stoia GellerRudman & Robbins LLP, San Francisco, CA, forStephen Schleicher, M .D .Joy Ann Bull, Lerach Coughlin Stoia Geller Rudman &Robbins LLP, Alan Schulman , Bernstein LitowitzBerger & Grossmann LLP, San Diego, CA, ChristopherPaul Seefer , Milberg Weiss et. al . LLP, Jeffrey W .Lawrence, Lerach Coughlin Stoia Geller Rudman &Robbins LLP, San Francisco, CA, Tamara J . DriscollLerach Coughlin Stoia Geller Rudman & Robbins LLP,Seattle, WA, for M. Richard Andrews .

ORDER DENYING MOTIONS TO DISMISSSECOND AMENDED COMPLAINT AS T O

DEFENDANTS LENT, HASHMAN, RIGIONEAND CAI; AND GRANTING MOTION TO

DISMISS SECOND AMENDED COMPLAIN T

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WITHOUT LEAVE TO AMEND AS TODEFENDANT QURESHEY

JEREMY FOGEL , J .*1 THIS DOCUMENT RELATES TO ALLACTIONS .

[Doc . Nos . 263, 266, 267, 269 , 272, 277, 278 ]

Before the Court are motions to dismiss Plaintiffs'consolidated second amended class action complaint("SAC") brought by Defendants Jeremy Lent ("Lent"),John Hashman ("Hashman"), Bruce Rigione("Rigione"), Yinzi Cai ("Cai"), and Safi Qureshey("Qureshey") . The Court has considered the parties'papers as well as the oral arguments presented at thehearing on October 28, 2005 . For the reasons discussedbelow, the motions to dismiss will be denied as toDefendants Lent, Hashman, Rigion.e and Cai, andgranted without leave to amend as to DefendantQureshey.

1 . BACKGROUND

This is a stock-drop securities class action suitoriginally filed against NextCard, Inc . ("NextCard")and several of its officers and directors. The Courtdismissed Plaintiffs' first amended consolidated classaction complaint ("FAC") with leave to amend onFebruary 7, 2005, and Plaintiffs filed the operative SACon April 27, 2005, alleging in great detail a scheme bywhich NextCard and several of its officers and directorsused "accounting gimmickry" to inflate the company'sfinancial results . In broad outline, Plaintiffs' claims areas follows:

NextCard was an Internet-based provider of consumercredit that offered an online credit approval system fora Visa card through its wholly-owned subsidiary,NextBank.m' SAC ¶ 2 . Between April 19, 2000 andOctober 30, 2001 ("the class period"), NextCard andseveral of its officers and directors made false ormisleading statements to the market indicating that theInternet credit card business was a success and wasgrowing at a dramatic rate . Id. at ¶ ¶ 143-166 . FormIOQs and IOKs filed during this period misrepresentedthe company's financials and were not prepared inaccordance with GAAP . L ' Id. at ¶ ¶ 132-39 .Specifically, the company "understated its loan lossallowances, provision for loan losses and charge-offrates by improperly reclassifying certain credit losses asfraud losses and employing inappropriate methodologyfor determining loan loss allowances ." Id at ¶ 135 .These practices allowed the company to overstate its

Page 2

reported net interest income and understate its netlosses during the class period. Id. The company alsounderstated its risk-weighted assets and overstated itsrisk-based capital ratio by failing to include in its risk-weighted assets credit losses that had been classified asfraud losses and sold to third parties . Id.

FN I . For ease of reference, NextCard andNextBank are referred to collectively as"NextCard" or "the company . "

FN2 . Generally Accepted AccountingPrinciples .

On October 31, 2001, the company issued a pressrelease stating that, as a result of discussions with theOffice of the Comptroller of the Currency ("OCC") andthe Federal Deposit Insurance Corporation ("FDIC"),the company needed to take several steps to increase itsreserves and limit its lending activities . Id. at ¶ 1 13 .These steps included substantially increasing loan lossallowances; tightening underwriting criteria ;reclassifying previously recognized fraud losses ascredit losses; and increasing risk weighted assets bymore than $500 million . Id. at ¶ ¶ 113-14. Thesedisclosures caused NextCard's stock to decline 84% to$.87 per share . Id. at ¶ 117. On February 7, 2002, theOCC closed NextBank and appointed the FDIC asReceiver . Id. at ¶ 121 . The company was delisted fromNASDAQ on March 18, 2002 and filed for bankruptcyon November 14, 2002 . Id. at ¶ 123 . The OCC, FDICand SEC initiated separate investigations into theevents leading up to the company's demise, Id, at 11122 .

*2 Plaintiffs allege a claim under § 10(b) of theSecurities Exchange Act of 1934 ("Exchange Act")against Defendants Lent, Hashman, Rigione and Cai,and a control person claim under to § 20(a) againstthese four individuals plus Defendant Qureshey .E

FN3 . Plaintiffs do not assert claims againstNextCard because of the company'sbankruptcy. Plaintiffs have reached settlementwith respect to claims against NextCard'soutside auditor, Ernst & Young, LLP .

II . DISCUSSIO N

B . Section 10 (b) Claim

1 . Elements Of A § 10(b) Claim

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The United States Supreme Court has clarified that onlytwo types of conduct give rise to liability under § 10(b)and Rule 10-b(5) promulgated thereunder : ( 1) themaking of a material misstatement or omission or (2)the commission of a manipulative act. Central BankDenver v . First Interstate Bank of Denver, N.A ., 51 .1U .S . 164, 177, 114 S .Ct . 1439_128 L .Ed.2d 119 (1994).

While Plaintiffs assert that Defendants engaged in a" fraudulent scheme" during the class period , see SAC ¶4, a straightforward reading of the SAC makes clearthat the gravamen of Plaintiffs' § 10(b) claim is thatDefendants committed fraud on the market by means ofmaterial misstatements or omissions. Under the fraudon the market theory, it is assumed that an investor whobuys or sells stock at the price set by an efficientmarket does so in reliance on the integrity of that price .Basic, Inc. v. Levinson 485 U .S . 224, 247, 108 S .Ct .978, 99 L .Ed.2d 194 (1988) . Because publicly availableinformation is reflected in the market price, aninvestor 's reliance on the price necessarily means thatthe investor is relying upon any public materialmisrepresentations or omissions . Id.

Plaintiffs do not use the term "fraud on the market,"and cast a number of their allegations in terms of thealleged "scheme" entered into by Defendants .However, Plaintiffs identify the common classquestions as : (a) whether Defendants issued false andmisleading statements during the class period ; (b)whether Defendants acted with scienter in issuing suchstatements ; (c) whether Defendants are liable as controlpersons of the company ; (d) whether the market priceof NextCard stock during the class period wasartificially inflated because ofDefendants' conduct ; and(e) whether class members have been damaged . SAC ¶19 . Accordingly, while allegations that Defendantswere involved in a "scheme" are relevant to paint apicture of what was going on at the company during theclass period, and may be relevant to the question ofscienter, the Court's focus must be on the allegedmisrepresentations and omissions made by Defendants .

The elements of a § 10(b) claim involving publicly

traded securities are as follows : (1) a materialmisrepresentation or omission ; (2) scienter; (3) a

connection with the purchase or sale of a security ; (4)reliance, often referred to in fraud on the market cases

as "transaction causation" ; (5) economic loss ; and (6)

loss causation , i .e ., a causal connection between the

material misrepresentation and the loss . DuraPharmaceuticals, . inc._ v. Broudo, 544 U.S . 336, 12 5

S .Ct. 1627, 1631, 161 L .Ed .2d 577 2~ 005) .

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A dispute has arisen between the pa rt ies as to whetherPlaintiffs may use the "group published pleadingdoctrine ." Prior to the passage of the Private SecuritiesLitigation Reform Act of 1995 ("PSLRA"), Pub . L . No,104-67 (1995), the Ninth Circuit held in a number ofcases that when false or misleading information isconveyed in prospectuses, registration statements,annual reports, press releases, or other group publishedstatements , it is reasonable to presume that thestatements are the result of the collective actions of thecompany's officers. See, e.g., Blake v. Dierdorff, 856F.2d 1365, 1369 (9th Cir . 1988); YTool v. TandemComputers, Inc . . 818 F.26 1433, 1440 (9th Cir .1987) , Itis an open question in this circuit whether the grouppublished pleading doctrine survives the PSLRA . Somedistrict courts within the circuit have concluded that thegroup published doctrine is alive and well . See, e.g., Inre Secure Computing Corp. Sec. Litig. 120 F . Supp .2810, 821-22 (N .D.Cal .2000) ( collecting cases ) ; SiliconGraphics Sec. Litig., 970 F .Supp. 746, 759N.D.Cal .1997 . Other district courts have concluded

the opposite . See, e.g., In re immune Response Sec .Litig. . 375 F.Supp.2d 983, 1031 (S .D.Cal2005) ; In reSvncor Intern. Cor Sec. Litig., 327 F .Supp.2d 1149,1171-72 (C .D.Cal .2004) .

*3 The Fifth Circuit, the only circuit squarely to

address the issue, has concluded that the grouppublished pleading doctrine does not survive thePSLRA because the doctrine is inconsistent with

PSLRA requirements that statements or omissions be

set forth with particularity as to each defendant and that

scienter be pleaded in a manner sufficient to give rise to

a strong inference that each defendant acted with therequired state of mind , Southland .Sec. Corp. v ._IN.Spire

Ins. Solutions, Inc., 365 F.3d 353, 364-65 (5th

Cir .2004) .

This Court adopts the reasoning of the decisionsconcluding that the group published pleading doctrineno longer is viable after the PSLRA . As noted by theFifth Circuit, it appears to be totally inconsistent withthe particularity requirements of the PSLRA to holdcorporate officers "responsible for unattributedcorporate statements solely on the basis of their titles,even if their general level of day-to-day involvement inthe corporation's affairs is pleaded ." Southland, 365F .3d at 365 .

The Court's conclusion makes little difference in thepresent case, because Plaintiffs do not rely solely on thegroup published pleading doctrine, but also allegeexplicitly that Defendants Lent, Hashman, Rigione andCai participated in the preparation of the company'spress releases and SEC filings . Section 10(b) liability

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extends to those who substantially contribute to thedrafting of the allegedly misleading statements . See .-Inre Homestore . corn, Inc. Sec. Litig., 252 F .Supp .2d1018, 1041 (2003) (holding that § 10(b) extends onlyto those "connected in some material way to thedrafting of the statements made to the investingpublic"), Plaintiffs allege that Lent, Hashman, Rigioneand Cai "participated in the preparation and review ofthe Company's press releases and SEC filings . Thus,the false and misleading statements included in pressreleases and SEC filings were made by and areattributable to all of the defendants because the pressreleases and SEC filings were the collective actions ofthese defendants ." SAC ¶ 16 .

2 . Pleading Standards For § 10(b) Claim

Claims asserted under the Exchange Act as amended bythe PSLRA must meet heightened pleadingrequirements . For example, a claim based upon amaterial misrepresentation or omission must "specifyeach statement alleged to have been misleading" aswell as "the reason or reasons why the statement ismisleading ." 15 U .S .C. ~ 78u-4(b)(l)(B . If anallegation regarding the statement or omission is madeon information and belief, the complaint "shall statewith particularity all facts on which that belief isformed." Id. In addition , a claim based upon a materialmisrepresentation or omission must "state withparticularity facts giving rise to a strong inference thatthe defendant acted with the required state of mind ." 15U.S .C. § 78u-4(b)(2) . When a claim is based upon aforward- looking statement, the required state of mindgenerally is "actual knowledge" that the statement isfalse or misleading . 15 U.S .C. 78u-5(c){ l)(B) .

Otherwise , the required state of mind is, at a minimum,"deliberate recklessness ." In re Silicon Graphics Inc .Sec. Lirig. 183 F .3d 970, 977 (1999) .

*4 In order meet the pleading standard for scienter, theplaintiff "must provide, in great detail, all the relevantfacts forming the basis of her belief ." Silicon Graphics,183 F .3d at 985 . " `[T]he complaint must containallegations of specific contemporaneous statements orconditions that demonstrate the intentional ordeliberately reckless false or misleading nature of thestatements when made." ' In re Read Rite Corp . Sec .Liti . 335 F.3d 843, 846 (9th Cir .2003) (quotingRonconi v. Larkin, 253 F.3d 423, 432 (9th Cir .2001) ) . Itis insufficient that the allegations raise a "reasonableinference" that the defendants acted with the requisitestate of mind ; the allegations must be sufficientlyparticularized to raise a "strong inference ." Id. at 848-49 .

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Unusual or suspicious stock sales may constitutecircumstantial evidence of scienter. Silicon Graphics.183 F.3d at 986. However, "insider trading issuspicious only when it is `dramatically out ofline withprior trading practices at times calculated to maximizethe personal benefit from undisclosed insideinformation." ' Id. (quoting In re Apple Computer Sec.{,itig., 886 F .2d 1109 . 1 1 17 9th Cir .I989)) . A plaintiffrelying upon stock sales therefore must allege specificfacts regarding the circumstances of the alleged stocksales, such as the amount of shares sold, the percentageof shares sold in comparison to the volume of sharesthat could have been sold, the timing of the sales andwhether the sales were consistent with prior tradinghistory . Id. When determining the percentage of sharessold, stock options must be considered ; there is noreason to distinguish vested stock options from sharesbecause the former easily can be converted to sharesand sold immediately . Id.

3 . Statements Of Lent, Hashman, Rigione and Ca i

In its order dismissing the FAC with leave to amend,the Court identified a number of material misstatementsalleged to have been made by Defend ants, butconcluded that Plaintiffs had not sufficiently allegedthat the statements were false or misleading , or thatDefendants had acted with the requisite scienter . TheCourt concludes that Plaintiffs have cured these defectsin their SAC . Plaintiffs adequately allege a number ofstatements and why those statements were false ormisleading when made . SAC ¶ ¶ 142-166, Theydescribe in detail the a ll eged financial difficulties of thecompany and Defendants ' attempts to conceal thesedifficulties through inappropriate accounting practices .Finally, Plaintiffs identify the specific accountingpractices, explain why those practices violated GAAPand why the company's resulting financials weremisleading . Id. at ¶ ¶ 132-139 .

Plaintiffs also allege in detail facts demonstrating thatthe individual defendants knew about , and part icipatedin, the allegedly inappropriate accounting practices .SAC ¶ ¶ 11-14 . Defendants argue that even ifDefendants knew about the accounting practices thatultimately were deemed inappropriate- for example, thatthe company was reclassifying credit losses as fraudlosses-the SAC does not allege facts demonstrating thatDefendants knew the accounting practices wereinappropriate at the time. Defendants claim that theOCC's later determinations that the company had actedinappropriately surprised Defendants and the indust ry .While Defendants certainly may re-as sert this argument

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in future motion practice, the Court concludes that forpurposes of the instant motions to dismiss Plaintiffshave alleged facts sufficient to raise a strong inferencethat Defendants knew that the accounting practiceswere inappropriate . For example, Plaintiffs point toDefendant Hashman's handwritten notation regarding"2/3 more quarters of accounting gimmickery," alongwith numerous internal emails, reports and memorandafocused on ways to reclassify loans to make thecompany's financial picture look better. Id at ¶ 11(h)-

(m) . Plaintiffs also allege that Defendants changed thecompany's accounting practices during the class period,for example, the ways in which the company calculatedloan loss reserves, in order to make the company'sfinancial picture look better. Id. at ¶ 11(o) . Plaintiffsdescribe how the individual defendants met daily todevise ways to reduce loan losses . Id at ¶ 12(e) .Defendant Cai was warned by a senior officer of thecompany that the new treatment of fraud losses andcredit losses was inappropriate . Id at ¶ 12(f) .Defendant Lent received weekly status reportsregarding the need to reclassify more credit losses intofraud losses . Id. at ¶ 13(e) . Defendant Rigione receivedmemoranda informing him that the company wasadjusting its charge-off rates after excluding delinquentloans that had been categorized as loans for sale, andRigione knew that this methodology was improper . Id.at ¶ 14(f)-(g) .

*5 The Court concludes that the factual allegations inthe SAC, taken as a whole, are sufficient to give rise toa strong inference of Defendants' scienter . The Court isnot persuaded by Defendants' argument that thecertification of the company's financials by its outsideauditor, Ernst & Young, LLP ("E & Y"), negates orweakens the inference of scienter . Plaintiffs originallynamed E & Y as a defendant in this action based uponallegations that E & Y was a knowing participant in ascheme to defraud the market and in colluded inaccounting improprieties . E & Y has settled withPlaintiffs . Under these circumstances, the fact that E &Y certified the financials does not raise an inferencethat the financials were appropriate or that Defendantswere entitled to rely upon E & Y's certification .

The Court notes that three of the four Defendantsnamed in the § I0(b) claim sold stock during the classperiod . While the stock sales resulted in large moneta ryprofits (approximately $ 7 .5 million for Lent), thepercentage of stock sold was not excessive ( less than15% for Lent) and it is not clear that the sales were outof line with prior activity. Plaintiffs do allege, however,that the sales occurred after Lent instructed companyemployees not to sell stock for fear of depressing thestock price . SAC ¶ 142 . It is somewhat suspicious that

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three out of the four individual defendants sold anyway .

In summary, the Court concludes that Plaintiffs havecured the defects noted in the Court's prior order, andhave alleged facts sufficient to state a § 10(b) claimagainst Defendants Lent, Hashman, Rigione and Cai .

B. Section 20(a) Clai m

Section 20(a) of the Exchange Act imposes joint andseveral liability on any "person who, directly orindirectly, controls any person liable" for securitiesfraud , "unless the controlling person acted in good faithand did not directly or indirectly induce" the violations .15 U .S .C . 5 78t(a). Plaintiffs allege a § 20 (a) claimagainst Lent, Hashman , Rigione and Cai, and alsoagainst Qureshey .

The Court concludes that Plaintiffs have alleged asufficient factual basis to impose control personliability against Lent, Hashman, Rigione and Cai .Plaintiffs allege with particularity what positions eachof these individuals held, and how and to what extentthese individuals participated in the day to dayworkings of the company . SAC ¶ ¶ 11-14 .

However, the Court concludes that Plaintiffs have notalleged a sufficient factual basis to impose controlperson liability against Qureshey . Unlike the otherindividual defendants, Qureshey was an outsidedirector of the company and a member of the AuditCommittee and Compensation Committee . SAC ¶15(a) . The Court is unaware of any authority for theproposition that an outside director may be held liableunder § 20(a) . Moreover, while Plaintiffs do allege thatQureshey met with the company's CFO to reviewaccounting policies, financial statements and the like,Plaintiffs do not allege that Qureshey was involved inthe day to day management of the company . See SAC ¶¶ 15(b)-(g) . Accordingly, the § 20(a) claim againstQureshey is subject to dismissal .

*6 Leave to amend is to be granted with extremeliberality in securities fraud cases , because theheightened pleading requirements imposed by thePSLRA are so difficult to meet . Eminence Capital, LLCv. Aspeon, Inc., 316 F .3d 1048, 1052 (9th Cir.2003) .The United States Supreme Court has art iculated theapplicable standard as follows :In the absence of any apparent or declared reason-suchas undue delay, bad faith or dilatory motive on the partof the movant , repeated failure to cure de ficiencies byamendments previously allowed, undue prejudice to theopposing party by virtue of allowance of th e

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amendment, futility of amendment, etc .-the leavesought should, as the rules require, be "freely given ."

Faman v. Davis, 371 . U .S . 178, 182, 83 S .Ct. 227, 9L.Ed.2d 222 (1962) . Here, given the nature ofQureshey's position with the company, and the absenceof authority for holding an individual in his positionliable under § 20(a), together with the fact thatPlaintiffs have failed to assert a viable claim againstQureshey on two separate occasions, the Courtconcludes that granting leave to amend the § 20(a)allegations against Qureshey would be futile .Accordingly, the Court concludes that leave to amendis not appropriate notwithstanding the liberal standardsset forth above .

III . ORDER

(1) The motions to dismiss of Defendants Lent,Hashman , Rigione and Cai are DENIED ; an d(2) The motion to dismiss of Defendant Qureshey isGRANTED WITHOUT LEAVE TO AMEND .

N .D.Cal ., 2006 .In re Nextcard , Inc . Securities Litigatio nNot Reported in F.Supp .2d, 2006 WL 708663(N.D .Cal . )

Briefs and Other Related Documents (Back to ton )

• 2006 WL 1417117 (Trial Pleading) Answer ofDefendant John V . Hashman ; Demand for Jury Trial(Apr . 19, 2006) Original Image of this Document(PDF)• 2006 WL 14171 18 (Trial Pleading) Defendant YinziCai's Answer to the Second Consolidated AmendedComplaint (Apr. 19, 2006) Original Image of thisDocument (PDF)• 2006 WL 1417119 (Trial Pleading) Answer ofDefendant Bruce Rigione to Second AmendedComplaint (Apr. 19, 2006) Original Image of thisDocument (PDF)• 2006 WL 1417116 (Trial Pleading) Jeremy R . Lent'sAnswer to Consolidated Second Amended Class ActionComplaint for Violations of the Federal Securities Law(Apr. 18, 2006) Original Image of this Document(PDF)• 2005 WL 2868447 (Trial Motion, Memorandum andAffidavit) Defendant Safi U. Qureshy's Reply Brief inSupport of the Motion to Dismiss the ConsolidatedSecond Amended Complaint (Sep. 26, 2005) OriginalImage of this Document (PDF)• 2005 WL 2868448 (Trial Motion, Memorandum and

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Affidavit) Defendant Jeremy Lent's Separate ReplyBrief in Support of Motion to Dismiss ConsolidatedSecond Amended Complaint (Sep . 26, 2005) OriginalImage of this Document (PDF)• 2005 WL 2868449 (Trial Motion, Memorandum andAffidavit) Response of Defendants Yinzi Cai, JohnHashman, Jeremy Lent and Bruce Rigione to Plaintiffs'Opposition to Defendants' Supplemental Request forJudicial Notice (Sep . 26, 2005) Original Image of thisDocument (PDF)- 2005 WL 2868450 (Trial Motion, Memorandum and .Affidavit) Joint Reply Memorandum of Yinzi Cai, JohnV. Hashman, Jeremy Lent, and Bruce Rigione inSupport of Motions to Dismiss Second AmendedConsolidated Class Action Complaint (Sep . 26, 2005)Original Image of this Document (PDF)• 2005 WL 2868452 (Trial Motion, Memorandum andAffidavit) Defendant John V . Hashman's SeparateReply Memorandum of Points and Authorities inSupport of Motion to Dismiss Second AmendedConsolidated Class Action Complaint (Sep . 26, 2005)Original Image of this Document with Appendix (PDF)• 2005 W L 2868453 (Trial Motion, Memorandum andAffidavit) Objection of Defendants Yinzi Cai, JohnHashman, Jeremy Lent and Bruce Rigione toDeclaration of Christopher P . Seefer (Sep . 26, 2005)Original Image of this Document (PDF)- 2005 WL 2868456 (Trial Motion, Memorandum andAffidavit) Defendant Yinzi Cai's Reply Memorandumof Points and Authorities in Support of her Motion toDismiss Consolidated Second Amended Class ActionComplaint (Sep. 26, 2005) Original Image of thisDocument (PDF)• 2005 WL 2868457 (Trial Motion, Memorandum andAffidavit) Reply of Defendant Bruce Rigione inSupport of Motion to Dismiss Consolidated SecondAmended Class Action Complaint (Sep . 26, 2005)Original image of this Document (PDF )• 2005 WL 2613691 (Trial Motion, Memorandum andAffidavit) Lead Plaintiffs' Opposition to SupplementalRequest for Judicial Notice of Defendants Yinzi Cai,John Hashman, Jeremy Lent and Bruce Rigione (Aug .31, 2005) Original Image of this Document (PDF )• 2005 WL 2613699 (Trial Motion, Memorandum andAffidavit) Lead Plaintiffs' Opposition to Defendants'Motions to Dismiss the Consolidated Second AmendedClass Action Complaint (Aug. 31, 2005) OriginalImage of this Document (PDF )• 5 :01 cv21029 (Docket) (Nov. 05, 2001 )

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