USCA1 Opinion
September 18, 1992
UNITED STATES COURT OF APPEALS
FOR THE FIRST CIRCUIT
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No. 91-2241
No. 92-1026
AMY GREENSTONE, AND ALL OTHERS SIMILARLY SITUATED,
Plaintiffs, Appellants,
v.
CAMBEX CORPORATION, ET AL.,
Defendants, Appellees.
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APPEALS FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF MASSACHUSETTS
[Hon. Edward F. Harrington, U.S. District Judge]
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Before
Breyer, Chief Judge,
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O'Scannlain,* and Cyr, Circuit Judges.
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Roger W. Kirby with whom Jeffrey H. Squire, Kaufman, Malchman,
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Kaufmann & Kirby, Thomas G. Shapiro, Gretchen Van Ness, and Shapiro
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Grace & Haber were on brief for appellants.
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John D. Donovan, Jr. with whom Andrew C. Pickett and Ropes & Gray
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were on brief for appellees.
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*Of the Ninth Circuit, sitting by designation.
BREYER, Chief Judge. The question on this appeal
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is whether the appellant's complaint states a claim for
fraud under the federal securities laws, 15 U.S.C. 78j(b),
a claim that she must plead "with particularity." Fed. R.
Civ. P. 9(b). The district court held that it did not, and
it dismissed the complaint. We affirm that decision.
I
The Allegations
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The plaintiff (and appellant), Amy Greenstone,
filed a securities fraud claim against Cambex Corporation
and several of its officers. Her complaint, in essence,
says (1) that Cambex would sell its Cambex memory boards for
use in IBM computers; (2) that it would accept IBM memory
boards as "trade-ins;" (3) that a lessor of IBM computers
claimed that Cambex's business was unlawful, sued Cambex and
won; and (4) that Cambex should have disclosed the threat of
such a lawsuit in advance. Her complaint more specifically
alleged:
l. Cambex Corporation makes various computer
products, including memory boards.
2. In 1989 and 1990 Cambex sold memory boards for
use in IBM computers. The Cambex customer would
replace the IBM memory board in his IBM computer
with a Cambex memory board. Cambex would accept,
as a trade-in in part payment for its memory
board, the IBM memory board that the Cambex board
had replaced. Cambex then would either resell the
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IBM memory board or lease the IBM memory board, to
others, thereby obtaining additional revenue.
3. If the Cambex customer had an IBM computer that
he had leased, rather than bought, Cambex would
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sometimes return the IBM board to the IBM computer
before the customer returned the IBM computer to
the IBM computer lessor.
4. In 1989 and 1990 Cambex's financial statements
showed significant revenues from this "IBM memory
board replacement" activity. During this time
Cambex issued other public statements, which said,
for example, that its sale of Cambex's
"substantially better" memory boards, and resale,
or lease, of less desirable IBM memory boards
taken as trade-ins, made a "steady contribution to
revenues and profits," helped bring about
"steadily improving results," helped account for
Cambex's "sound performance," and, in general,
helped Cambex maintain profits.
5. On Friday, February 1, 1991, IBM Credit (a
subsidiary of IBM and a lessor of IBM computers)
filed a lawsuit against Cambex. IBM Credit
claimed in essence that the terms of its leases
prohibited its lessees (and Cambex) from removing
IBM's memory boards and selling, or leasing, them
to others without IBM Credit's approval.
6. About one month later, Cambex and IBM Credit
settled the lawsuit. Cambex agreed to pay IBM
about $6 million and "to comply with IBM Credit's
terms and conditions of its subleases."
7. Throughout 1989 and 1990 Cambex executives
knew that Cambex did not have the legal right to
take, and to resell or lease, the IBM memory
boards.
8. On January 22, 1991, just before IBM's lawsuit,
she bought 500 shares of Cambex stock at a price
of $14 5/8 per share. About two weeks later, just
after the IBM lawsuit became public, she sold the
shares at $12 7/8 per share, a loss of $1.75 per
share, or 12% of the purchase price. During those
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two weeks, Cambex stock had suddenly climbed to
$18 per share, from which height it fell, on the
day the lawsuit was announced, to 11 3/4, closing
the day at $13 1/4 per share.
The complaint goes on to claim, in general terms,
that the facts set forth show that Cambex and its officers
violated the securities law -- law that forbids any person
"in connection with the purchase or sale" of securities, to
make an
untrue statement of a material fact or
to omit to state a material fact
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necessary in order to make the
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statements made, in the light of the
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circumstances under which they were
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made, not misleading . . . .
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17 C.F.R. 240.10b-5(b)(emphasis added). The complaint
argues that Cambex's financial statements, though literally
true, were "misleading" in "light of the circumstances under
which they were made," for they failed to disclose Cambex's
potential legal liability to IBM lessors.
The district court concluded that the complaint
did not state an actionable claim because it failed to meet
the requirement of Fed. R. Civ. P. 9(b), which says:
In all averments of fraud . . . the
circumstances constituting fraud . . .
shall be stated with particularity.
The complaint did not set forth "the circumstances
constituting fraud . . . with particularity." (Emphasis
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added). For this reason, it dismissed the complaint. The
court also refused to permit the plaintiff to file an
amended complaint. She now appeals.
After examining both the complaint and the
proposed amended complaint, we conclude that neither sets
forth a claim of securities fraud with sufficient
particularity. In explaining our conclusion, we shall focus
on the proposed amended complaint, which, essentially,
reiterates the initial complaint with additional detail.
(Our conclusions apply to the initial complaint a fortiori).
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II
The Financial Statements
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The complaint lists specific statements that it
says mislead by omission. Many of these statements consist
of figures, e.g. revenue, income and profit figures, on
Cambex's 1989 and 1990 income statements and balance sheets,
filed with the SEC in those years. The statements are
accurate and could not mislead unless, given the
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circumstances, an investor would normally have expected to
find some kind of qualification of the figures, disclosing a
significant potential liability. Generally Accepted
Accounting Principles, with which the SEC ordinarily
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requires compliance, set forth rules that govern such
disclosures. The kindof potential liability at issuehere is
a loss contingency involving an
unasserted claim or assessment when
there has been no manifestation by a
potential claimant of an awareness of a
possible claim or assessment. . . .
Financial Accounting Standards Board Statement No. 5, 10.
The rules say that financial statements need not disclose
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this kind of potential liability unless:
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it is considered probable that a claim
will be asserted and there is a
reasonable possibility that the outcome
will be unfavorable.
Id.; see Loss & Seligman, Securities Regulation 652-57
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(1989) (discussing application of FASB Statement No. 5 to
the disclosure of unasserted legal claims); S.E.C.
Accounting Release (Dec. 20, 1973) ("[P]rinciples,
standards, and practices promulgated by the FASB in its
Statements and Interpretations will be considered by the
Commission as having substantial authoritative support, and
those contrary to such FASB promulgations will be considered
to have no such support." (footnotes omitted)); S.E.C. v.
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Steadman, Nos. 91-5090, 91-5130, 1992 WL142065, 7 (D.C. Cir.
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June 26, 1992) (considering FASB No. 5 in SEC suit alleging
that company failed to disclose contingent liability).
Given the kinds of qualifications that investors would
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necessarily expect financial statements to disclose, we do
not see how these financial statements could have materially
misled unless, at the time Cambex filed its financial
statements, Cambex (and its officers) knew that the future
IBM Credit suit was "probable." The question is whether the
complaint alleges specific facts sufficient to support that
claim.
Conclusory Allegations. The complaint says, in
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conclusory fashion, (1) that Cambex "knew" that IBM Credit's
leases forbade Cambex's memory trade-ins and (2) that the
defendants "knowingly or recklessly" published misleading
financial statements. Appellant argues that at least the
first of these assertions satisfies Rule 9(b), for that rule
permits averments of "knowledge" in "general[]" terms. Rule
9(b), however, also requires the plaintiff to plead "the
circumstances constituting fraud . . . with particularity."
Fed. R. Civ. P. 9(b). And, one cannot avoid the latter
requirement simply through a general averment that
defendants "knew" earlier what later turned out badly.
Case law requires a plaintiff to do more. The
courts have uniformly held inadequate a complaint's general
averment of the defendant's "knowledge" of material falsity,
unless the complaint also sets forth specific facts that
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make it reasonable to believe that defendant knew that a
statement was materially false or misleading. See, e.g.,
Wexner v. First Manhattan Co., 902 F.2d 169, 172 (2d Cir.
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1990) ("Although scienter need not be alleged with great
specificity, plaintiffs are still required to plead the
factual basis which gives rise to a 'strong inference' of
fraudulent intent." (citation omitted)); DiLeo v. Ernst &
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Young, 901 F.2d 624, 629 (7th Cir.) ("Although Rule 9(b)
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does not require 'particularity' with respect to the
defendants' mental state, the complaint still must afford a
basis for believing that plaintiffs could prove scienter."),
cert. denied, 111 S. Ct. 347 (1990); Romani v. Shearson
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Lehman Hutton, 929 F.2d 875, 878 (1st Cir. 1991) ("Although
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a plaintiff need not specify the circumstances or evidence
from which fraudulent intent could be inferred, the
complaint must provide some factual support for the
allegations of fraud. The requirement that supporting facts
be pleaded applies even when the fraud relates to matters
peculiarly within the knowledge of the opposing party."
(citations omitted)); Wayne Inv., Inc. v. Gulf Oil Corp.,
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739 F.2d 11, 14 (1st Cir. 1984) (same); Luce v. Edelstein,
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802 F.2d 49, 54 n. 1 (2d Cir. 1986) ("To satisfy Rule 9(b)
[with respect to matters peculiarly within the opposing
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party's knowledge], the allegations must be accompanied by a
statement of the facts upon which the belief is founded.");
Craftmatic Sec. Litig. v. Kraftsow, 890 F.2d 628, 645 (3d
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Cir. 1989) ("[E]ven under a non-restrictive application of
[Rule 9(b)], pleaders must allege that the necessary
information lies within defendants' control, and their
allegations must be accompanied by a statement of the facts
upon which the allegations are based.").
Were the law otherwise, a complaint could evade
too easily the "particularity" requirement in Rule 9(b)'s
first sentence. Suppose, for example, that in 1991 a
corporation projects substantial revenues in the upcoming
year. Suppose the corporation's actual 1992 sales are 50%
less than predicted. To permit a securities fraud complaint
to state, without more, that the corporation's executives
"knew" in 1991 about the likely decline in 1992 sales would
sanction what Judge Friendly called "fraud by hindsight,"
Denny v. Barber, 576 F.2d 465, 470 (2d Cir. 1978), a
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practice that courts have not allowed. To understand the
type of "particularity" that this Circuit has required, we
have examined Romani. In that case, this Circuit considered
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a complaint that charged that a company's rosy financial
predictions made in mid-1986 were misleading. See 929 F.2d
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at 877-79. The complaint conceded that early 1986 had been
profitable but, to show knowledge of falsity, it pointed (1)
to the company's later, actual poor financial performance in
1987-1989, see id. at 877, and (2) to a company document
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that said the company had begun to experience cash flow
problems in late 1986 or early 1987, only a few months after
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it had predicted a bright future. See id. at 878-79. This
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court found that these allegations were not specific enough
to meet the Rule 9(b) threshold. See id. at 880.
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The "hindsight" at issue in Romani involved
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inferring, from later poor performance, earlier knowledge
that such later performance was likely. The "hindsight" at
issue here involves inferring, from a later lawsuit, earlier
knowledge that such a lawsuit was likely. A general
averment of such knowledge, without more, will not do. We
must decide whether the specific facts alleged in the
complaint before us are different enough from those at issue
in Romani to warrant a different legal result.
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Specific Factual Allegations. As appellant points
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out, her complaint does more than make a simple conclusory
assertion of "knowledge" of falsity (or "misleading
incompleteness"). It also alleges four specific facts that,
appellant claims, offer adequate support for the proposition
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that the defendants, in 1989 or 1990, knew that an IBM
Credit lawsuit (or the like) was probable.
First, the complaint points out that IBM Credit
did, in fact, bring a lawsuit in early 1991, only a few
months after Cambex filed a financial statement that omitted
to mention this potential future liability. The bringing of
the lawsuit tends to show its earlier likelihood. And, the
existence of that likelihood helps support (in an
evidentiary sense) an inference that defendants knew about
that likelihood.
We can understand how sometimes a later lawsuit,
say a lawsuit charging bribery by a top company official,
might constitute fairly strong evidence of earlier
knowledge, say that the top official knew (a few weeks or
months before) of the liability-causing, underlying facts.
But, sometimes the later lawsuit would not readily permit
such an inference. All depends upon the lawsuit's subject
matter and the underlying circumstances. In this case, the
appellant's complaint is not specific. It describes IBM
Credit's allegations in general terms; it does not set forth
the IBM Credit lease language; nor does it offer any factual
reason to believe that Cambex feared a lawsuit based on that
language. To the contrary, the complaint makes clear that
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Cambex publicized its IBM memory "trade-in" practice with a
candor that seems inconsistent with knowledge of illegality
or fear of a lawsuit. See S.E.C. v. Steadman, Nos. 91-5090,
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91-5130, 1992 WL142065, 4 (D.C. Cir. June 26, 1992). Once
we look past the complaint's conclusory characterizations to
the facts that it characterizes, we cannot find, in those
facts, a lawsuit based upon the kind of egregiously illegal
practice the illegality of which Cambex officials, earlier,
would have had to have known. Cf. Barker v. Henderson,
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Franklin, Starnes & Holt, 797 F.2d 490, 497 (7th Cir. 1986)
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(case against, say, conspirator "may not rest on a bare
inference that the defendant 'must have had' knowledge of
the facts.").
Second, the complaint says that a Cambex officer
sold stock in Cambex before IBM Credit filed its lawsuit.
Insider trading in suspicious amounts or at suspicious
times, of course, could help the appellant. See In Re Apple
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Computer Sec. Litig., 886 F.2d 1109, 1117 (9th Cir. 1989),
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cert. denied, 496 U.S. 943 (1990). But the complaint does
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not tell us when the Cambex officer sold the stock. And,
the complaint indicates that the insider sold his shares at
an average price under $14, only about 75 cents higher than
the $13 1/4 price at which Cambex stock sold after IBM
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Credit announced its suit. The stock sale allegation does
not help the plaintiff.
Third, the complaint says that the defendants'
"knowledge is shown by the fact that Cambex agreed with its
customers to 'restore' IBM memory units at the end of the
customer's lease term with IBM credit." This fact tends to
show that Cambex believed it was supposed to return IBM
memory boards in leased computers to IBM. But, it also
shows that Cambex did so. It shows nothing about Cambex's
knowledge of the likely legality or illegality of Cambex
accepting IBM memory boards and re-leasing them during the
period of the IBM computer's lease from IBM Credit. One can
as easily argue that Cambex thought returning the boards to
the IBM machine would satisfy IBM Credit, as argue the
contrary.
Fourth, the complaint alleges that Cambex quickly
settled the lawsuit for a large amount of money (more than
$5 million). We agree that this allegation helps the
appellant. She can reasonably argue that it helps to
support a chain of inferences: 1) that the suit was valid,
2) that its underlying assertion (that IBM Credit's leases
gave IBM Credit the right to control Cambex's use of IBM
memories) was true, 3) that Cambex must have known this
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earlier, and 4) that Cambex therefore must have known
earlier that a lawsuit (or the equivalent) was probable. In
our view, however, this single, factual keystone -- the
settled lawsuit -- is not strong enough to bear the great
overarching weight of factual inference the plaintiff wishes
it to support.
Our conclusion, in part, reflects logic. The
inferential links are weak. Does the quick settlement, for
example, suggest pre-lawsuit knowledge and recalcitrance or
post-lawsuit surprise? And, how does the fact of settlement
circumvent the vagueness of pre-lawsuit circumstances we
have discussed above?
Our conclusion, in part, reflects precedent. The
complaint before us resembles too closely the complaints in
Romani and other "fraud by hindsight" cases to permit a
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different result here. See e.g., Romani, 929 F.2d at 880;
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Bryson v. Royal Business Group, 763 F.2d 491, 494 n.7 (1st
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Cir. 1985); Sinay v. Lamson & Sessions Co., 948 F.2d 1037,
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1042 (6th Cir. 1991); Dileo, 901 F.2d at 628 (citing Denny);
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Berliner v. Lotus Dev. Corp., 783 F. Supp. 708, 710 (D. Mass
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1992); Urbach v. Sayles, 779 F. Supp. 351, 358 (D.N.J.
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1991). Finally, our conclusion, to a degree, reflects
policy. Given the costs of lawsuits to the parties, the
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public problems associated with overcrowded court dockets,
and the correlative public and private benefits of
settlements, we fear a rule of law that would discourage
settlements by permitting securities fraud plaintiffs to
make their claims by pointing to later-settled lawsuits and
nothing more.
For these reasons, we believe that Rule 9(b)
forbids a plaintiff to assert a fraud claim simply by
pointing to a later-settled lawsuit the factual relation of
which to earlier fraud is as uncertain as that described in
the complaint before us.
III
Other Arguments
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We consider two additional arguments that
appellant might make in response to our analysis. First,
appellant's complaint, as she has written it, focuses less
upon the IBM Credit lawsuit than our opinion implies.
Rather, the complaint frequently refers to the defendants'
knowledge, not of the lawsuit, but of certain critical facts
underlying the lawsuit, such as the fact that IBM Credit,
not Cambex, owned the IBM memories that Cambex took in
trade. The problem with these allegations (and with any
argument based on them) is that the complaint nowhere
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explains how these facts (facts about rights to control
memories) are material, except insofar as they formed a
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basis for IBM Credit's legal claim, which claim, in turn,
led to a significant Cambex financial loss. As far as the
complaint is concerned, Cambex's financial statements could
have misled through omission only insofar as they omitted to
disclose the likelihood of that potential loss-causing
lawsuit. And, for reasons stated in Part II, the complaint
does not set forth sufficient specific facts to justify a
belief that the defendants knew that the loss-causing
lawsuit was likely.
Second, the complaint sets forth a host of Cambex
statements, other than income statements and balance sheets,
related to Cambex's IBM memory trade-in activity and its
profitability. It says that Cambex, in making these
(literally accurate) statements, materially misled investors
by failing to qualify them by noting the likelihood that the
activity would create considerable Cambex liability to IBM
Credit. And, these statements may be subject to a different
potential liability-disclosing standard than formal income
statements or balance sheets. See, e.g., 17 C.F.R.
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229.303(a)(3)(ii) (requiring description of "known trends
or uncertainties that have had or that registrant reasonably
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expects will have a material favorable or unfavorable
impact. . . ."); S.E.C. Rel. Nos 33-6835, 34-26831 (May 18,
1989) (under 229.303, "A disclosure duty exists where a
trend, demand, commitment, event or uncertainty is both
presently known to management and reasonably likely to have
material effects on the registrant's financial condition or
results of operation.")
We need not investigate the merits of this claim,
however, nor need we decide whether the appropriate standard
is knowledge (1) that an IBM Credit lawsuit was "probable"
or (2) that the lawsuit (or some similar loss) was
"reasonably likely". Whether the standard is one or the
other or yet some third similar standard (such as
"reasonably expects"), we should reach the same result. The
complaint, for the reasons set forth in Part II, fails
adequately to specify facts that would meet any of them. We
cannot find specific factual allegations in the complaint
that set forth a basis for the conclusion that Cambex or its
officers knew of a significant possibility of loss flowing
from the IBM Credit leases prior to the time IBM Credit
filed its lawsuit.
For these reasons, the judgment of the district
court is
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Affirmed.
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