United States District Court, E.D. Pennsylvania
April 27, 2004.
ARGENT CLASSIC CONVERTIBLE ARBITRAGE FUND L.P. AND ARGENT CLASSIC CONVERTIBLE ARBITRAGE FUND (BERMUDA);
RITE AID CORP., et al.
The opinion of the court was delivered by: STEWART DALZELL, District Judge
Two arbitrageurs, Argent Classic Convertible Arbitrage Fund L.P.
("Argent") and Argent Classic Convertible Arbitrage Fund (Bermuda) L.P.
("Argent Bermuda", and with Argent, "the Argent Companies") invested
heavily in securities of Rite Aid Corporation ("Rite Aid") throughout the
late 1990s. When details of an alleged $1.6 billion accounting fraud at
Rite Aid surfaced, the Argent Companies filed this action against Rite
Aid, several of its former executives and its former auditor. We now
address the defendants' motions to dismiss.*fn1 Factual Background
Rite Aid operates one of the largest retail drugstore chains in the
United States. Second Am. Compl. ("Compl.") ¶ 30. Beginning sometime
before 1997, Rite Aid's top executive officers included Chairman of the
Board of Directors and Chief Executive Officer Martin L. Grass; President
and Chief Operating Officer Timothy J. Noonan; and Executive Vice
President and Chief Financial Officer Frank M. Bergonzi. Id. 11
31-33. KPMG served as Rite Aid's auditor and principal accounting firm.
Id. ¶ 39.
The Argent Companies, which are two associated investment funds,
acquired positions in two types of Rite Aid securities between September
4, 1997 and October 25, 1999. Id. ¶¶ 1-2; see also
id. Ex. A (listing transactions). First, they sold short shares of
Rite Aid common stock.*fn2 The Argent Companies also invested in Rite
Aid 5-1/4% convertible bonds due on September 15, 2002.*fn3 These
investments were complementary parts of the Argent Companies' "convertible arbitrage" strategy,
which sought to hedge the risk that declining common stock price would
depress conversion value with the profits that short sales of common
stock would generate if stock prices fell. Although convertible arbitrage
could insulate the Argent Companies from declining conversion value, it
could not protect them from plummeting straight-bond value. Id.
¶¶ 6, 45-49. Because their arbitrage strategy did not protect them
from exposure to risk of Rite Aid defaulting on the convertible bonds,
the Argent Companies carefully reviewed the statements that Rite Aid made
in its financial disclosures and relied on those statements to assess
Rite Aid's creditworthiness before purchasing securities. See, e.g.,
id. ¶¶ 4, 5, 44, 50.
As it turned out, however, their reliance was misplaced. Beginning at least in 1997, Rite Aid systematically used
improper accounting practices that inflated its earnings and created a
false impression of its creditworthiness. See, e.g., id. ¶¶
8, 11, 61, 189-201. As Rite Aid's top executives, Grass, Noonan, and
Bergonzi were aware of these practices (or at least recklessly allowed
them to continue), id. ¶¶ 35-38, and KPMG allegedly assisted
this deception by knowingly (or recklessly) issuing unqualified opinions
that Rite Aid's financial statements fairly presented its financial
position and results of operations in accordance with generally accepted
accounting principles ("GAAP"), id. ¶¶ 10, 20, 39-41,
Still, these accounting improprieties would not begin to emerge until,
at the earliest, March 12, 1999, when Rite Aid revealed that its earnings
would be significantly lower than expected. See id. ¶¶ 1-2,
106-120. Between September 4, 1997 and March 11, 1999, the Argent
Companies conducted scores of transactions in Rite Aid common stock and
convertible bonds, and they realized an aggregate gain of almost $1.6
million on these trades. After taking their profits, the Argent Companies
with two immaterial exceptions*fn4 owned no Rite Aid
common stock or convertible bonds between March 11, 1999 and September
21, 1999. While the Argent Companies were either making money on Rite Aid
securities or holding no significant position in them, Rite Aid pursued a
strategy that ultimately accelerated the disclosure of its murky
accounting practices. On November 17, 1998, Rite Aid issued a press
release announcing that it had agreed to purchase PCS, a pharmacy
benefits manager that Eli Lilly and Co. owned, for $1.5 billion, an
acquisition Rite Aid hoped to finance with stock. Id. ¶ 89.
As one of the preliminary steps in the PCS acquisition, Rite Aid filed a
Form S-4 with the SEC. Id. ¶ 94. On December 21, 1998, the
SEC asked Rite Aid for explanations of certain aspects of its 1998
financial statements. See id. ¶ 97. Rite Aid responded to
the SEC's request on January 12, 1999, but the response continued to
obscure the full extent of Rite Aid's financial problems. Id.
Rite Aid completed the PCS acquisition on January 22, 1999, paying the
$1.5 billion purchase price with cash borrowed from J.P. Morgan.
Id. ¶ 89, 104. To retire this debt, Rite Aid planned to
issue up to $3 billion in new equity securities, but Grass, Noonan, and
Bergonzi allegedly knew that investors would not participate in such an
offering unless Rite Aid appeared to be in a solid financial position.
Id. ¶¶ 104-105. To make the offering more attractive, they
allegedly used many accounting gimmicks to inflate Rite Aid's profits.
When even these gambits failed to generate sufficient earnings, Rite Aid
on March 12, 1999 predicted that its earnings for the fourth quarter of
fiscal year 1999 would be between $0.30 to $0.32 per share, significantly
lower than the $0.52 per share that analysts had expected. Id.
¶¶ 12, 106-120. On March 29, 1999, Rite Aid officially announced its
fourth quarter earnings as $0.28 per share. Id. ¶ 121.
In February, 1999, as the SEC was scrutinizing Rite Aid's statements in
the context of an imminent offering of up to $3 billion in securities,
and with a fiscal 1999 audit looming, Michael Cover, the KPMG partner who
had supervised the 1997 and 1998 audits, took a leave of absence from the
firm. KPMG assigned Michael Hussey to oversee the 1999 audit.
Id. ¶¶ 61(b)(i), 123. Hussey quickly discovered some of Rite
Aid's accounting deficiencies, and he insisted on restating its past
earnings. Id. ¶ 124. On June 1, 1999, Rite Aid filed its
Form 10-K for fiscal year 1999 with the SEC, and this document recognized
that Rite Aid had overstated its earnings in 1997, 1998, and the interim
quarters of 1999 by $23.4 million. Id. ¶¶ 13, 54, 125-129,
133.*fn5 Grass removed Bergonzi as Chief Financial Office on June 14,
1999, but Bergonzi continued to work at Rite Aid. Id. ¶ 33.
Joseph Speaker became Rite Aid's new CFO. Id. ¶ 142.
On June 24, 1999, KPMG drafted a letter to Rite Aid's Audit Committee that expressed concern about Rite Aid's management
and internal accounting controls. KPMG delivered the June 24 letter to
the Audit Committee at its June 30, 1999 meeting. Id. ¶¶ 19,
61(b)(i), 139, 178-180. KPMG claims that it told the Audit Committee at
that meeting that it would not be in a position to issue quarterly review
reports until Rite Aid addressed its concerns. KPMB also said that it was
no longer willing to rely on Bergonzi's representations.*fn6 Rite Aid
denies that KPMG ever made these statements. Id. ¶ 140.
During the week of July 9, 1999, Hussey and another KPMG partner met
with Speaker and Rite Aid's new Controller to discuss the concerns aired
before the Audit Committee. At this meeting, Hussey gave Speaker a list
of thirty "Rite Aid Corp. Accounting Considerations" that is,
changes that KPMG would require Rite Aid to make to its accounting
practices before it would certify Rite Aid's fiscal 2000 financial
statements. Id. 11 21, 61(b) (ii), 142.
On September 22, 1999, Rite Aid cancelled a meeting with analysts that
it had already postponed twice, and this decision created grave concern
among analysts and credit rating agencies. See id. ¶¶ 15,
153-156. The Argent Companies, however, began that day to purchase Rite
Aid convertible bonds again, and they accumulated a $58 million position
in the bonds by October 25, 1999. Id. Ex. A.
After discovering more irregularities, Speaker brought his concerns
about Rite Aid's accounting practices to the Audit Committee on October
7, 1999. Id. ¶¶ 163-165. The Committee suggested that
Speaker hire an outside accountant to address his concerns, and Speaker
selected Ten Eyck Associates, Inc. Four days later, Rite Aid announced
that it planned to restate its earnings for the second time in six
months. Within a week, Rite Aid's Board of Directors had pressured Grass
to resign from his positions as Chairman and Chief Executive Officer.
Id. ¶¶ 16, 31, 165-171.
On November 2, 1999, Rite Aid filed its Form 10-Q for the second
quarter of fiscal year 2000. The Form revealed that Rite Aid had restated
its previously reported 1999 and 2000 earnings, reducing them by about
$500 million. Id. ¶¶ 17, 54, 172-174. Finally, on November
10, 1999, Rite Aid warned analysts and investors not to rely on its
earlier profit forecasts. Id. ¶¶ 18, 175-176. KPMG resigned
as Rite Aid's auditor soon thereafter. Id. ¶ 177.
Throughout December of 1999, the Argent Companies liquidated their
positions in Rite Aid securities. They took a loss of more than $4.3
million on their convertible bonds, and they earned less than $20,000 in
profit from short sales of common stock. Id. Ex. A. By the end
of 1999, Argent Bermuda owned convertible bonds with a face value of
$24.5 million and was short 11,100 shares of common stock. Argent held
convertible bonds with $17 million face value and had sold short 12,600 shares
of common stock. Id.
To uncover the full scope of the fraud, Rite Aid retained Deloitte to
audit its 1997, 1998, and 1999 financial statements. Id. ¶
182. Two hundred accountants are said to have worked on Deloitte's $50
million investigation, and they uncovered dozens of previously undetected
accounting improprieties. See id. ¶ 61(a), at 26-36. On
July 11, 2000, Rite Aid filed a Form 10-K for fiscal year 2000. The Form
restated Rite Aid's earnings for 1997, 1998, and 1999 and revealed that
Rite Aid's original financial statements had overstated earnings by $1.6
billion. Id. ¶¶ 9, 22-23, 54, 186. Grass and Bergonzi
ultimately each pled guilty to charges of criminal conspiracy to defraud.
Id. ¶ 58.
In all, the Argent Companies claim to have lost more than $10 million
as a result of the alleged $1.6 billion accounting fraud, and they hope
to recover from Rite Aid, Grass, Noonan, Bergonzi,*fn7 and KPMG.
Plaintiffs' five-count complaint which by virtue of plaintiffs'
opt-outs survives the now-final class action settlements we approved in
2001 and 2003*fn8 alleges that the defendants violated Sections 10(b), 18 and 20(a) of the
Securities Exchange Act of 1934 (the "Act") and that they committed
common law fraud. The defendants have moved to dismiss the complaint for
failure to state claims upon which relief may be granted.*fn9 Analysis
A. Section 10(b)
Counts 1 and 2 of the Complaint allege that the Rite Aid Defendants and
KPMG, respectively, violated Section 10(b) of the Act, which makes it
illegal "[t]o use or employ, in connection with the purchase or sale of
any security registered on a national securities exchange . . . any
manipulative or deceptive device or contrivance. . . . "
15 U.S.C. § 78j(b) (2003). To clarify this broad language, Rule 10b-5(b)
specifies that it is illegal "[t]o make any untrue statement of a
material fact . . . in connection with the purchase or sale of any
security." 17 C.F.R. § 240.10b-5(b) (2004). Our Court of Appeals has
further explained that, to state a valid claim for a violation of Section
10(b) and Rule 10b-5, a plaintiff must show that "the defendant (1) made
a misstatement or an omission of a material fact (2) with scienter (3) in
connection with the purchase or the sale of a security (4) upon which the
plaintiff reasonably relied and (5) that the plaintiff's reliance was the
proximate cause of his or her injury." In re IKON Office Solutions,
Inc., 277 F.3d 658, 666 (3d Cir. 2002); see also Sowell v.
Butcher & Singer, Inc., 926 F.2d 289, 296 (3d Cir. 1991)
(collapsing the first and third elements).
Here, the defendants do not dispute that the Argent Companies have
adequately alleged that there were misstatements of material fact in
connection with the purchase and sale of securities, so we focus only on
the elements of reliance, loss, and scienter.
"It is axiomatic that a private action for securities fraud must be
dismissed when a plaintiff fails to plead that he or she reasonably and
justifiably relied on an alleged misrepresentation." Semerenko,
223 F.3d at 178. Courts sometimes use the phrase "transaction causation"
to describe the requisite reliance because a plaintiff must establish
that, "but for the fraudulent misrepresentation, the investor would not
have purchased or sold the security." See Newton, 259 F.3d at
172. Whatever the locution, "[r]eliance provides the requisite causal
connection between a defendant's misrepresentation and a plaintiff's
injury." Basic Inc. v. Levinson, 485 U.S. 224, 243,
108 S.Ct. 978, 989 (1988). A plaintiff may establish reliance either
directly or presumptively. See Semerenko, 223 F.3d at 178 ("Recognizing
that the requirement of showing direct reliance presents an unreasonable
evidentiary burden in a securities market where face-to-face transactions
are rare . . ., this court has adopted a rule that creates a
presumption of reliance in certain cases.").
a. Fraud on the Market Presumption
Although not the only situation where courts may presume reliance,
see Newton, 259 F.3d at 174-75 (discussing the Affiliated
Ute presumption), the parties here focus on whether the defendants'
alleged "fraud on the market" for Rite Aid securities entitles the Argent Companies to a presumption of
The fraud on the market theory posits that the price of a security in
an efficient market reflects all publicly available information about the
security. See Peil v. Speiser, 806 F.2d 1154, 1161 n.10 (3d
Cir. 1986). When someone makes a statement about the security that is
misleading but is not yet recognized as such, the security's price will
change to reflect the addition of the misleading statement to the overall
mix of publicly available information about the security. Because
purchasers "rely on the price as an indication of the stock's value,"
courts presume that purchasers rely indirectly on the misleading
statement when they purchase a security in an efficient market at a price
that reflects the misleading statement, even if they did not actually and
directly rely on the misleading statement when they purchased the
security. Id. at 1160-61; see also In re Burlington Coat
Factory Sec. Litig., 114 F.3d 1410, 1419 n.8 (3d Cir. 1997)
(sketching outline of fraud on the market theory). Ultimately, the Argent
Companies are entitled to the fraud on the market "presumption of
reliance if [they] bought securities in an efficient market." Pinker
v. Roche Holdings Ltd., 292 F.3d 361, 373 (3d Cir. 2002).
Implicitly conceding that the Argent Companies have adequately pled
that the market for Rite Aid common stock was efficient, Rite Aid argues
only that plaintiffs are not entitled to the fraud on the market
presumption of reliance with respect to their transactions in Rite Aid convertible bonds because they
have not alleged that the bond market was efficient. See Rite
Aid Mem. Supp. Mot to Dismiss at 18-19. The complaint, however, states
that "[t]he market for Rite Aid securities was at all times an efficient
market," Compl. ¶ 52, and it explains that the "market for Rite Aid
securities promptly digested new and current information regarding Rite
Aid from all publicly available sources and reflected such information in
the price of Rite Aid securities," id. ¶ 52(e). Like common
stock, convertible bonds are securities, so we cannot agree with Rite
Aid's suggestion that the complaint fails to allege that the bond market
was efficient, especially when we are required to draw all inferences in
the plaintiffs' favor. The Argent Companies may not be able to prove that
the bond market was actually efficient, but their allegations are
specific enough to survive a motion to dismiss.
Even though the pleading was adequate, both Rite Aid and KPMG contend
that, as a matter of law, the Argent Companies are not entitled to the
fraud on the market presumption of reliance because of their investment
strategy. See Rite Aid Mem. Supp. Mot to Dismiss at 15-18; KPMG
Mem. Supp. Mot to Dismiss at 23-26. In support of this argument, they
principally rely on Zlotnick v. Tie Communications,
836 F.2d 818 (3d Cir. 1988),*fn10 a case that requires close examination.
In January, 1983, Albert Zlotnick sold short 1000 shares of Technicom
stock "because he concluded that the stock was overvalued."*fn11
Id. at 819. Technicom's controlling shareholders later issued
several misleading press releases that artificially inflated the stock's
price. By March of 1983, Zlotnick decided to cut his losses by covering
his short sales at the inflated price. Though Zlotnick lost about
$35,000, he would have gained approximately $12,000 if he had waited
until June, when Technicom released more realistic earnings estimates, to
cover. Id. The district court concluded that Zlotnick had not
sufficiently alleged reliance, so it dismissed Zlotnick's Section 10(b)
claim. Id. at 820.
On appeal, Zlotnick argued that the district court should have presumed
reliance based on the fraud on the market theory. After explaining that
the fraud on the market presumption arose from a "theory of indirect
actual reliance," the Court of Appeals continued:
The fraud-on-the-market theory creates a threefold
presumption of indirect reliance. First, this
court presumes that the misrepresentation affected
the market price. Second, it presumes that a
purchaser did in fact rely on the price of the
stock as indicative of its value. Third, it
presumes the reasonableness of that reliance. All
of these presumptions are necessary to establish
Id. at 822. The court found that it would be illogical to
make any of these presumption "in this case." Id. Zlotnick's
claim that he sold short because he believed that the market overvalued
Technicom stock could not be reconciled with the fraud on the market
theory's requirement that a stock must trade on an efficient market that
incorporates all available information into price.*fn12
Zlotnick was not entitled to the fraud on the market presumption, the
Court of Appeals reversed the district court's dismissal and remanded the
case so that Zlotnick would have an opportunity to prove actual, direct
reliance. Id. at 824.
Defendants read Zlotnick as establishing a per se
rule that short sellers or even arbitrageurs are not
entitled to the fraud on the market presumption of reliance, but we do
not understand the case to stand for such a broad proposition. The Court
of Appeals carefully limited its holding to the allegations in the complaint before it, and the critical allegation
that Zlotnick sold Technicom shares short because he believed they were
overvalued has no analogue in the complaint here. In short,
Zlotnick held only that a plaintiff who sells short because he
believes that a stock is overvalued is not entitled to the fraud on the
market presumption.*fn13 See also In re Western Union Sec.
Litig., 120 F.R.D. 629, 637 (D.N.J. 1988) (Gerry, C.J.) ("Zlotnick
concerned a short sale of stock, where the point of selling a stock is
that the seller believes the price of that stock overestimates its true
value, i.e., that the market price is not an accurate
valuation. Such is hardly the case in the instant action, where
plaintiffs charge in part that they did rely on the market
price when purchasing their stock to reflect its actual value."). Because
the Argent Companies allege that they sold Rite Aid stock short as a
hedge against potential declines in convertible bond prices,
see Compl. ¶ 47, we decline to hold that they are not entitled to the fraud on the market
presumption of reliance as a matter of law.
To summarize, we hold that Zlotnick does not require us to
withhold from the Argent Companies the benefit of the fraud on the market
presumption of reliance. They have adequately pled that Rite Aid
securities traded in efficient markets, so they are, for now, entitled to
that presumption. Thus, we shall not dismiss the Section 10(b) claim for
failure to plead presumptive reliance. The defendants will have ample
opportunity to rebut the presumption of reliance with a "showing that
severs the link between the alleged misrepresentation and either the
price received (or paid) by the plaintiff, or his decision to trade at a
fair market price." Basic, 485 U.S. at 248, 108 S.Ct. at 992;
see also Semerenko, 223 F.3d at 179 n.7 (3d Cir. 2000)
(discussing how defendants may rebut the presumption of reliance).
b. Direct Reliance
Even if Rite Aid and KPMG were correct that the Argent Companies are
not entitled to the fraud on the market presumption of reliance, we would
not dismiss the Section 10(b) claims unless they also failed to plead
direct reliance adequately.*fn14 The complaint clearly explains that the Argent Companies "carefully
assessed Rite-Aid's creditworthiness . . . through an evaluation of,
inter alia, the Company's financial results, including its
financial and operating performance, as reported in the Company's 10-K
and quarterly filings with the SEC." Compl. ¶ 50; see also
id. ¶¶ 63-188 (specifying sometimes in excruciating
detail the statements on which the Argent Companies relied).
Based on their analysis of these materials, plaintiffs decided to invest
in Rite Aid securities. See id. ¶ 44. If they had "been
aware of Rite Aid's true financial condition," they "would not have
engaged in any transactions in Rite Aid securities whatsoever and/or
would not have engaged in these transactions at the prices at which they
did." Id. ¶ 51.
Still, Rite Aid advances four reasons why the complaint's allegations
of direct reliance are insufficient. First, it claims that the Argent
Companies have not pled direct reliance because these allegations are
"inconsistent with plaintiffs' stated investment strategy, which had
nothing to do with the fundamentals [of] the Company." Rite Aid Mem.
Supp. Mot. to Dismiss at 19. This argument, however, suffers from a fatal
defect: it relies on the Argent Companies' "stated investment strategy"
while ignoring their actual "statement" of that strategy. The complaint
clearly explains that "convertible arbitrageurs pursue a strategy, but
such a strategy depends upon materially accurate financial disclosure." Compl. ¶ 45. In view
of this allegation, Rite Aid's claim that the Argent Companies' "stated
investment strategy" does not depend on accurate financial
information simply errs.
Rite Aid also points out that the Argent Companies' alleged investment
strategy involved selling common stock short and that they stopped making
short sales "after January 1999." Rite Aid Mem. Supp. Mot. to Dismiss at
21. Because plaintiffs only allege direct reliance in connection with
their stated strategy and because they stopped engaging in that strategy
by early 1999, Rite Aid contends that they have failed to plead direct
reliance with respect to any transactions that occurred after August of
1999. See id. at 20-21. This argument fails for two reasons.
First, the Argent Companies did engage in short sales in
October of 1999, see Compl. Ex. A, so Rite Aid's argument
begins from a faulty premise. Second, we infer that decreased frequency
of short sales after January of 1999 is the logical outgrowth of
and is not at all inconsistent with the Argent Companies'
explanation of their convertible arbitrage strategy.*fn15 Although the
complaint does not explicitly harmonize its description of convertible arbitrage with the Argent Companies'
sporadic 1999 short sales, we must give plaintiffs the benefit of every
reasonable inference. See Trump Hotels & Casino Resorts, Inc. v.
Mirage Resorts Inc., 140 F.3d 478, 483 (3d Cir. 1998).
Rite Aid's third argument is that especially with respect to
the transactions that they completed after August, 1999 the
Argent Companies have "fail[ed] to link each alleged purchase or sale to
an alleged misrepresentation." See Rite Aid Reply at 6 (quoting
Glaser v. Enzo Biochem, Inc., 303 F. Supp.2d 724, 750 (E.D.
Va. 2003)). While Rule 9(b) clearly requires Rite Aid to state its claim
"with particularity," we believe that Glazer's "linking" rule imposes a
pleading requirement that the purposes of the Rule cannot justify.*fn16
In this case, Rite Aid has received notice of a non-frivolous claim based
on misrepresentations that it has already admitted, and the Argent
Companies have alleged that they actually and directly relied on those
misrepresentations when they traded in Rite Aid securities. Requiring
plaintiffs to link particular misrepresentations with particular trades
in their allegations of direct reliance would impose additional burdens without significantly improving the
quality of notice to defendants and without affording much added
protection from reputation endangering and extortionate frivolous
suits. Thus, we decline to follow Glazer's holding.
Finally, Rite Aid suggests that the Argent Companies could not have
actually relied on its financial statements after September 22, 1999,
because Rite Aid had already restated its earnings once and had cancelled
a meeting with analysts. Rite Aid Mem. Supp. Mot. to Dismiss at 21-22.
Recently, our Court of Appeals rejected a similar argument, finding that
"although the truth about [defendant's illegal activities] might have
begun to emerge" before the plaintiff purchased securities,
"the full extent of [its] illegal activities was not disclosed" until
after the plaintiff had purchased them. See Pinker v. Roche Holdings
Ltd., 292 F.3d 361, 374 (3d Cir. 2002). Argent's case is
indistinguishable from Pinker because, although Rite Aid had
partially disclosed its alleged fraud before September 22, 1999, it did
not advise investors not to rely on any of its previous disclosures until
November 10, 1999.
In short, Rite Aid has not suggested any persuasive reason for us to
conclude that the Argent Companies have failed to plead direct reliance
with the particularity required by Rule 9(b). Thus, we hold that the
complaint alleges that plaintiffs actually and directly relied on the
defendants' statements with sufficient specificity to survive a motion to
dismiss. 2. Loss
Just as one must plead reliance on the defendant's misstatement, the
"plaintiff must establish . . . that plaintiff's reliance on
defendant's misstatement caused him or her injury" to survive a motion to
dismiss a Section 10(b) claim. In re Burlington Coat Factory Sec.
Litig., 114 F.3d 1410, 1417 (3d Cir. 1997). This "loss" element
consists of two parts. First, the plaintiff must allege that he or she
suffered economic loss. "If economic loss is evident, then plaintiff must
prove a `sufficient causal nexus between the loss and the alleged
[nondisclosure].'" Newton v. Merrill Lynch, Pierce, Fenner &
Smith, 259 F.3d 154, 177 (3d Cir. 2001) (quoting Semerenko v.
Cendant Corp., 223 F.3d 165, 184 (3d Cir. 2000)). That is, the
plaintiff must also plead loss causation.
a. Economic Loss
Because plaintiffs cannot recover when they have not been injured,
"[f]allure to show actual damages is a fatal defect in a Rule 10b-5 cause
of action." Newton, 259 F.3d at 177-78 (quotation and citation
omitted). The traditional measure of damages and the measure that
the Argent Companies seek to recover, see Pls.` Supplemental
Mem. at 2 is the "out-of-pocket" rule. Sowell v. Butcher
& Singer, Inc., 926 F.2d 289, 297 (3d Cir. 1991). According to
this rule, a plaintiff's damages are equal to the difference between what
it paid to purchase securities and how much it received when it sold
those securities.*fn17 See In re Cendant Corp. Litig.,
264 F.3d 201, 242 n.24 (3d Cir. 2001).
Applying the out-of-pocket rule is fairly straightforward when a
plaintiff purchases and sells the same number of shares in only two
transactions. For example, if Shannon Shareholder purchased 100 shares of
Dirty Drugs stock at a price of $5 per share on January ¶ and sold
those shares for $3 per share on February 1, then his out-of-pocket loss
would be $200. If he sold the 100 shares for $7 each on February 1, then
Shannon would turn a tidy $200 profit, and he would have no claim against
Dirty Drugs, even if, with scienter, it had made material
misrepresentations upon which he relied.
The hypothetical becomes more complex, but not particularly
problematic, when there are multiple sales that all generate either gain
or loss. For instance, suppose that Shannon sold 50 of his Dirty Drugs
shares for $4 per share on January 15 and the remaining 50 shares for $3
per share on February 1. He would have lost $50 on the January 15 sale
and $100 on the February ¶ sale, for a total loss of $150. Without
too much trouble, one can imagine a parallel scenario in which Shannon enjoyed a profit.
Shannon would have greater difficulty, however, when some of his sales
generated a gain and some generated a loss. In this iteration, imagine
that Shannon still sold 50 of his shares for $4 per share on January 15,
for a $50 loss, but Dirty Drugs's share price then began to rise. When
Shannon sold the remaining 50 shares on February 1, they were able to
fetch $6 each, and Shannon realized a $50 gain. The $50 gain from the
February ¶ sale would offset the $50 loss from the January 15 sale,
so Shannon would have suffered no total loss. Despite the fact that there
was no total loss, can Shannon recover the $50 that he lost from the
January 15 sale?
Everyone can agree that a Section 10(b) claim does not lie when there
is no loss, but the question posed by the Dirty Drugs hypothetical is how
we should determine when there is a loss. We could use a "cumulative"
methodology that includes offsetting gains in its loss calculation, but,
for the reasons that follow, we prefer a "transaction-based" methodology
that allows claims for unprofitable transactions (assuming that
plaintiffs have adequately alleged the other elements of a Section 10(b)
claim) without offsetting the recoverable loss with gains from profitable
transactions.*fn18 The language of Section 10(b) and Rule 10b-5 is more consistent with a
transaction-based methodology than a cumulative one. Both provisions make
it illegal for someone to make materially misleading statements "in
connection with the purchase or sale of any security."
15 U.S.C. § 78j(b) (2004); 17 C.F.R. § 240.10b-5 (2004). By using the singular
nouns "purchase" or "sale", Congress and the SEC focus on each
transaction individually. Neither the statute nor the Rule authorize any
sort of aggregation of purchases or sales that could sanction the
The Court of Appeals has also approved of disaggregation. In one case,
a district court had decided not to certify a putative class's Section
10(b) claim, in part, because it found that "the question of economic
loss remained unique to each investor." Newton, 259 F.3d at
179. The Court of Appeals "agree[d] with the District Court's finding
that plaintiffs' claims would require individual treatment to determine
actual injury." Id. To be sure, the court did not address
whether that "individual treatment" should proceed according to a
cumulative or a transaction-based methodology, but its statement does
reflect concern that aggregation could obfuscate the identification of
where economic loss occurs.
We also prefer the transaction-based methodology because we see no
principled limits to the aggregation implicit in a cumulative methodology. If we were to aggregate profitable and
unprofitable transactions, we would have to identify which transactions
to aggregate. To return to our hypothetical, how would we proceed if
Shannon lost $200 on other transactions in September and gained $100 on
October transactions. Would we aggregate the September and October
transactions? If so, could we also aggregate them with the January and
February transactions? There is no limit to the possible combinations,
and more importantly no justifiable way to select the
We are aware that a transaction-based methodology generates higher
calculated damages than a cumulative methodology because the former
ignores profitable transactions and the latter includes them to offset
unprofitable transactions, but this feature is not indefensible. If one
conceptualizes every multiple-share transaction as multiple single-share
transactions, then any apparent unfairness to defendants dissipates.
Returning to the Dirty Drugs hypothetical, we described Shannon
Shareholder as purchasing 100 shares on January 1, selling 50 shares on
January 15, and disposing of the other 50 shares on February 1. We could
have described the January ¶ transaction as two purchases of 50
shares each. We also might have said that Shannon disposed of one of
these 50-share blocks for a $50 loss on January 15, and he disposed of
the other 50-share block for a $50 gain on February 1. This conception of
Shannon's trans-actions reflects the underlying economic realities as
completely as our original description of a single 100-share purchase, but it
clarifies our conclusion. Shannon is entitled to recover his $50 loss of
January 15 because that loss was attributable to his purchase and sale of
50 identifiable shares. It would be inequitable to deprive him of any
recovery because his purchase and sale of 50 different shares
happened to be profitable.
For all of these reasons, we hold that a transaction-based methodology
should be used to determine whether the Argent Companies suffered an
out-of-pocket economic loss. Thus, we shall dismiss those parts of the
Section 10(b) claims based on profitable transactions.
b. Loss Causation
In addition to alleging economic loss, a plaintiff must allege loss
causation to satisfy the loss element of a valid Section 10(b) claim.
"Loss causation demonstrates that the fraudulent misrepresentation
actually caused the loss suffered." Newton, 259 F.3d at 173.
Though our Court of Appeals has held that a plaintiff may establish loss
causation by proving that he purchased a security at a market price that
was artificially inflated due to a fraudulent misrepresentation, see
Scattergood v. Perelman, 945 F.2d 618, 624 (3d Cir. 1991), the
plaintiff will not have shown loss causation if he sold the security
before public disclosure of the misrepresentation caused the price to
decline, see Semerenko v. Cendant Corp., 223 F.3d 165, 185 (3d
Cir. 2000) ("In the absence of a correction in the market price, the cost
of the alleged misrepresentation is still incorporated into the value of the security and may be recovered at any time
simply by reselling the security at the inflated price.").
Between September 4, 1997 and September 21, 1999, the Argent Companies
allege that the price of Rite Aid securities reflected the defendants'
misrepresentations about Rite Aid's financial condition. Although they
traded heavily in Rite Aid securities during this period, the
misrepresentations did not begin to become incorporated into the
securities' prices until September 22, 1999, the date when Rite Aid
cancelled a meeting with analysts. Because the misrepresentations could
not have affected price until then, the Argent Companies have not alleged
that the defendants' misrepresentations were the legal cause of their
losses on their pre-September 22, 1999 transactions.*fn19 Thus, we shall
dismiss the parts of the Section 10(b) claims that are based on those
KPMG contends that the Argent Companies cannot demonstrate that KPMG's
misrepresentations caused the losses that arose after September 21, 1999
because KPMG did not report on the "most recent" financial statements available at those times. KPMG
Mem. Supp. Mot. to Dismiss at 29-35. This argument ignores that the
market price of Rite Aid securities reflected all of the information in
the statements that KPMG had audited until Rite Aid, on November 10,
1999, warned analysts not to rely on them. KPMG is correct that prices
also reflected the information about fiscal year 2000, but the addition
of these data did not make the 1997, 1998, and 1999 statements
irrelevant. Rather, an investor interpreting the 2000 data would
necessarily rely on the earlier statements to determine whether Rite
Aid's financial position was improving or deteriorating. Because the
complaint, read in the light most favorable to the Argent Companies,
supports the inference that they continued to rely on the financial
statements that KPMG had audited to provide context for the fiscal year
2000 statements, the Argent Companies have pled that KPMG contributed to
the losses that they realized after September 21, 1999.
c. Second Supplemental Memorandum
As we have already explained, the Argent Companies have failed to plead
economic loss from their profitable transactions, and they have failed to
plead loss causation for the transactions that occurred before September
21, 1999. Thus, we shall dismiss the parts of their Section 10(b) claims
that relate to those transactions.
To identify the transactions for which the Argent Companies cannot
recover, we directed the Argent Companies to submit a Second Supplemental
Memorandum ("Memorandum") analyzing the 126 transactions on which they realized a gain or loss between
September 5, 1997 and December 31, 1999*fn21 using a transaction-based
methodology. Though they draw different inferences from the Memorandum's
calculations, the defendants have not challenged the accuracy of those
calculations, and we have verified many of those calculations.*fn22 The
Memorandum reveals the following break-down of the 126 transactions by
date and profitability: Loss Causation
9/4/97 to 9/22/99 to Total
9/21/99 12/31/99 Transactions
Not Unprofitable 40 2 42
Unprofitable 73 11 84
Transactions 113 13 126
As this table summarizes, the Argent Companies lost money on 84 of
the 126 transactions, so they have failed to show economic loss for the
other 42 transactions. Of the 84 unprofitable transactions, 73 occurred
before September 22, 1999. Thus, the Argent Companies have pled loss
causation for only 11 unprofitable transactions that occurred between
September 5, 1997 and December 31, 1999. These transactions involved the
following sales of convertible bonds:
Entity Date of Sale Face Amount of Loss
Argent 12/2/99 $1,000,000.00 $371,250.00
Argent 12/2/99 $1,081,000.00 $401,825.75
Argent 12/3/99 $2,000,000.00 $519,000.00
Argent 12/3/99 $1,000,000.00 $229,420.50
Argent 12/3/99 $4,000,000.00 $1,023,887.94
Argent 12/6/99 $1,000,000.00 $163,777.00
Argent 12/13/99 $660,000.00 $59,417.82
Argent Bermuda 12/3/99 $4,000,000.00 $1,225,100.00 Argent Bermuda 12/6/99 $1,000,000.00 $167,000.00
Argent Bermuda 12/6/99 $1,000,000.00 $122,888.50
Argent Bermuda 12/13/99 $840,000.00 $75,622.68
Total $17,581,000.00 $4,359,190.19
To summarize, the Argent Companies have adequately pled that the
defendants caused them to lose slightly more than $4.3 million between
September 5, 1997 and December 31, 1999.
As of December 31, 1999, the Argent Companies still held convertible
bonds with a face value of $41.5 million and had yet to cover short sales
of 23,700 shares of Rite Aid stock. Although the Memorandum explains that
they lost slightly more than $8 million on these positions, the complaint
does not allege whether they gained or lost from them. Had the defendants
challenged this failure to plead economic loss with the particularity
that Rule 9(b) requires, they might have prevailed. Defendants' failure
to raise this issue suggests, however, that they have not suffered any
prejudice from the lack of particularity, so we shall not reach out to
consider dismissing sua sponte the portions of the Section
10(b) claims attributable to post-1999 transactions.
As with loss and reliance, the Argent Companies must plead scienter
adequately if their complaint is to survive a motion to dismiss. See
Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193, 96 S.Ct. 1375,
1381 & n.12 (1976). The PSLRA "specifically requires that a securities fraud complaint `state
with particularity facts giving rise to a strong inference that the
defendant acted with the required state of mind.'" Oran v.
Stafford, 226 F.3d 275, 288 (3d Cir. 2000) (quoting
15 U.S.C. § 78u-4(b)(2)). In interpreting the "strong inference"
requirement, our Court of Appeals has explained that "[p]laintiffs must
either (1) identify circumstances indicating conscious or reckless*fn23
behavior by defendants or (2) allege facts showing both a motive and a clear
opportunity for committing the fraud." In re Burlington Coat Factory
Sec. Litig., 114 F.3d 1410, 1422 (3d Cir. 1997) (footnote added);
see also In re Advanta Corp. Sec. Litig., 180 F.3d 525, 534-35
(3d Cir. 1999) (discussing standards for pleading scienter in light of
PSLRA). Because the Rite Aid Defendants do not argue that the complaint
fails to allege scienter adequately, we concentrate solely on the
allegations regarding KPMG.
KPMG strenuously argues that the Argent Companies have not stated with
particularity any facts giving rise to a strong inference that it acted
with scienter, see KPMG Mem. Supp. Mot. to Dismiss at 35-53,
but we believe that a fair reading of the complaint belies that
contention. According to the complaint, KPMG assigned a new partner, Michael Hussey, to Rite Aid in early 1999,
and Hussey "soon discovered . . . that the KPMG workpapers for audits
of prior years were grossly deficient." Compl. ¶ 124. Although KPMG
usually completed its audits by the end of April, senior KPMG partners
labored at Rite Aid over Memorial Day weekend to complete the fiscal year
1999 audit. Id. ¶ 124(d). On May 28, 1999, KPMG finally
issued an unqualified opinion that Rite Aid's financial statements
conformed with GAAP. Id. ¶ 129. Despite this opinion, later
developments revealed that these statements overstated Rite Aid's
earnings by $1.6 billion. Id. ¶ 133. On June 24, 1999, KPMG
drafted a letter to Rite Aid's Audit Committee advising that it could not
issue quarterly review reports until Rite Aid improved its internal
controls. Id. ¶ 178. Plaintiffs explain that KPMG's concern
about its potentially "catastrophic liability for its reckless 1997 and
1998 audits and false audit opinions" led it to issue the unqualified
1999 opinion when it knew that Rite Aid's accounting practices were
seriously flawed. See id. ¶ 136. These flaws were so
obvious that an outside consultant identified some of them "[i]n a matter
of days." Id. ¶ 166.
The allegations that we have just rehearsed are sufficiently
"particular" to satisfy the requirements of Rule 9(b) and the PSLRA.
Taken together, they suggest that KPMG acted recklessly when it issued
its unqualified opinion on Rite Aid's fiscal year 1999 financial
statements in the face of accounting practices so flawed that KPMG itself
would not issue another opinion without significant reform and so blatant that outsiders
perceived them almost immediately. Moreover, KPMG, as Rite Aid's auditor,
had the opportunity to make the fraudulent representations about Rite
Aid's compliance with GAAP, and it had the motive to make those
misrepresentations to conceal its negligent if not
reckless-conduct in previous fiscal years. In short, the Section 10(b)
claim contains sufficient allegations about KPMG's scienter to survive
the motion to dismiss.
B. Remaining Federal Claims
In Counts 3 and 4, the complaint alleges that the defendants violated
Sections 20(a) and 18 of the Act, respectively.
Section 18 of the Act "creates a cause of action for materially
misleading registration statements." Westinghouse Elec. Corp. v.
Franklin, 993 F.2d 349, 356 (3d Cir. 1993); see also
15 U.S.C. § 78r (2004). In support of their motions to dismiss the
Section 18 claim, the defendants essentially reiterate their arguments
about loss and reliance.*fn24 For the same reasons that we did not
accept those arguments fully in the Section 10(b) context, and because we
understand the loss and reliance elements of Sections 10(b) and 18 to be
coterminous, we shall grant the motions to dismiss the Section 18 claim only to the
same extent that we granted the motions to dismiss the Section 10(b)
The Argent Companies also assert a claim against Grass, Noonan, and
Bergonzi for violations of Section 20(a) of the Act,
15 U.S.C. § 78t(a) (2004). That section imposes joint and several liability
on one who controls a corporation that violates federal securities laws. The
Individual Defendants suggest that we should dismiss this claim because
the Argent Companies failed to plead their other federal claims
adequately and a Section 20(a) claim will not lie when there are no
actionable independent underlying violations of the Act. See In re
Advanta Corp. Sec. Litig., 180 F.3d at 541; see also In re
Rockefeller Center Properties. Inc., 311 F.3d 198, 211 (3d Cir.
2002) ("[I]t is well-settled that controlling person liability is
premised on an independent violation of the federal securities laws.").
Because we read the allegations in the complaint as sufficient to state
claims for violations of Sections 10(b) and 18 of the Act, we shall not
dismiss the Section 20(a) claim.
C. Common Law Fraud
Finally, the Argent Companies assert a claim of common law fraud
against all defendants in Count 5. To survive a motion to dismiss a fraud
claim, a plaintiff must plead "(1) a representation; (2) which is
material to the transaction at hand; (3) made falsely, with knowledge of
its falsity or recklessness as to whether it is true or false; (4) with
the intent of misleading another into relying on it; (5) justifiable reliance on
the misrepresentation; and (6) the resulting injury was proximately
caused by the reliance." Gibbs v. Ernst, 647 A.2d 882, 889,
538 Pa. 193, 207 (1994); see also Sowell v. Butcher &
Singer, Inc., 926 F.2d 289, 296 (3d Cir. 1991). The defendants
believe that the fraud claim should be dismissed because it suffers from
the same deficiencies as the Section 10(b) claims. See KPMG
Mem. Supp. Mot. to Dismiss at 57. To the extent that parts of the Section
10(b) claims are adequate, however, we shall grant the motion to dismiss
the common law fraud claim only in part.
Scienter, reliance, and loss are essential elements of all Section
10(b) claims. Though the Argent Companies have pled scienter and reliance
adequately, parts of their Section 10(b) claims must be dismissed for
failure to plead loss. Specifically, we shall dismiss those parts of the
Section 10(b) claims that are based on profitable transactions and those
parts based on transactions that occurred before September 22, 1999. We
shall also dismiss the parts of the Section 18, Section 20(a), and common
law fraud claims based on those transactions.
An appropriate Order follows. ORDER
AND NOW, this 27th day of April, 2004, upon consideration of defendant
Rite Aid Corporation's ("Rite Aid"'s)*fn25 motion to dismiss (docket
entry # 28), plaintiffs' memorandum of law in opposition to Rite Aid's
motion, Rite Aid's reply to plaintiffs' memorandum,*fn26 defendant KPMG,
LLP's ("KPMG"'s) motion to dismiss (docket entry # 27), plaintiffs'
memorandum of law in opposition to KPMG's motion, KPMG's reply to
plaintiffs' memorandum, plaintiffs' supplemental memorandum concerning
loss calculation, plaintiffs' second supplemental memorandum concerning
loss calculation, Rite Aid's response to the supplemental memoranda,
Noonan's unopposed motion to join Rite Aid's response to the supplemental memoranda (docket entry #
49), and KPMG's response to the supplemental memoranda, and in accordance
with the accompanying Memorandum, it is hereby ORDERED that:
1. Noonan's motion to join Rite Aid's response to the supplemental
memoranda is GRANTED;
2. Rite Aid's motion to dismiss is GRANTED IN PART;
3. KPMG's motion to dismiss is GRANTED IN PART;
4. Those parts of Counts I through V that are based on unprofitable
transactions or on transactions that occurred before September 22, 1999
5. Defendants shall ANSWER the second amended complaint by May 14,
6. Counsel for all parties shall APPEAR in our Chambers at 1:00 p.m. on
May 24, 2004 for a pretrial conference.