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
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 ...