On Appeal from the United States District Court for the District of New Jersey D.C. Civil Action No. 05-cv-2319 (Honorable Mary L. Cooper).
The opinion of the court was delivered by: Scirica, Chief Judge.
Before: SCIRICA, Chief Judge, FISHER and ROTH, Circuit Judges.
This is a shareholders securities action, putatively a class action, alleging defendants made false or misleading statements about earnings growth potential and pricing pressure in violation of the Securities and Exchange Act of 1934. Shareholders' central theory is that investors and analysts viewed the key to Avaya's success to be its ability to increase sales revenues without cutting prices. The District Court granted defendants' motion to dismiss for failure to meet the pleading requirements of the Private Securities Litigation Reform Act of 1995 (PSLRA). We will affirm in part and reverse in part and remand for proceedings consistent with this opinion.
Defendant Avaya Inc. sells communications products and services.*fn1 Shareholders allege Avaya, through its Chairman and CEO, defendant Peterson, and its CFO, defendant McGuire, (1) affirmatively denied unusual price competition was occurring during the class period, despite knowing there was price competition that was hurting profit margins; and (2) issued baseless financial projections and positive portrayals to the market despite knowing the projections and portrayals were impossible to fulfill in light of intense price competition and problems with the company's "go-to-market" (GTM) strategy.*fn2 Shareholders support their claims through a variety of circumstantial allegations of falsity and knowledge, including the accounts of confidential witnesses (CWs), analyst reports, and alleged "admissions" by Peterson and McGuire.
Statements during three separate portions of the class period form the basis of Shareholders' claims: (1) in late October 2004, after the start of Avaya's 2005 fiscal year (FY2005), Avaya, through Peterson and McGuire, announced results for FY2004 and made projections for FY2005; (2) in late January 2005, Avaya announced results for the first quarter of FY2005 and made positive portrayals; (3) in the first two weeks of March 2005, McGuire allegedly increased his revenue projections for FY2005 and made false or misleading comments about the state of Avaya's business. All of the statements fall into one of two general categories. First, there are "pricing-pressure statements," in which McGuire and Peterson are alleged to have falsely denied Avaya was offering unusual discounts and facing significant pricing pressure from market rivals. Second, there are "forecast-related statements," in which defendants projected financial results (such as operating margin and revenue growth) and made positive portrayals, notably the statement that Avaya was "on track" to achieve its goals or projections.
The Complaint alleges the following facts.*fn3
On October 26, 2004, Avaya released financial results for FY2004 and the fourth quarter of 2004 (Q4 FY2004), which had ended September 30, 2004. A press release stated in part: "We have entered the new year well positioned to translate our ongoing success in the marketplace into enhanced shareholder value." In a conference call for analysts and investors, Peterson elaborated: "Clearly we are enjoying significant momentum in the marketplace, and we are converting that momentum into increased profitability and financial strength. Underlying this momentum are our Company's strategic advantages." Peterson added that "[t]he end result is that today we are a stronger more competitive organization that enjoyed [sic] significant potential . . . to further build shareholder value." When asked about prospects for operating margins, McGuire said he expected continued improvement in FY2005. Peterson commented on pricing: "I'd say pricing as a general comment is not different than what it has been. There continues to be . . . pressure in the market, it's a very competitive marketplace but I wouldn't say there's anything particularly noteworthy in the trend line one way or the other."*fn4
On October 29, Avaya issued a set of financial projections. For FY2005, the company projected an operating margin*fn5 of 8.5% to 9% and revenue growth of 25% to 27%. For FY2006, it projected an operating margin of 10% to 12%. McGuire and Peterson spoke at a conference and made positive portrayals, focusing particularly on the 8.5% to 9% estimate for operating margin.
On January 25, 2005, defendants announced Avaya's financial and operational results for Q1 FY2005. The results were "in line with, or better than, analysts' expectations." First quarter operating income grew 70% year-over-year and the gross margin percentage*fn6 was 47.3%. Total revenues grew 18% compared with Q1 FY2004.*fn7 Notably, defendants stated: "Our first quarter results position us to meet our goals for the year"; and "we are on track to meet our goals for the year, even though there were some aspects of our performance that are below our expectations and that we are working on to improve."*fn8
During a conference call with analysts, Peterson reiterated Avaya's FY2005 expectations:
Growing revenue 25 to 27 percent. Increasing operating income by 40 percent. Increasing our annualized margin to the 8.5 to 9 percent range, which would put us on the trajectory to go beyond that in 2006. All those things are on track. We do have a business that is somewhat more seasonal in its pattern than some of our data industry brethren, and this is a fall-over or holdover of the telecom business even though these things are merging in IP telephony. But we think that we had a solid quarter that is positioning us well to go on through the rest of the year and achieve those goals.
We will obviously report to you as we make that progress at the very least in our quarterly results. And if there is something particularly important, we will come to you before that, but otherwise assume that we are on track and going to make that-going to deliver on those promises as the year goes on.
On March 2, 2005, McGuire adjusted Avaya's projected annual revenue growth to 28%*fn9 and noted that "we are building on the momentum that we've got in the market relative to the technology lead, our applications, . . . and our global services." In response to analyst inquiries about the effect of pricing pressure from Cisco, McGuire stated that Cisco is "a good competitor . . . to have relative to the pricing environment. . . .
[I]f they start a price war in IP telephony, they're only going to further exacerbate the pressure they've got on gross margins. So in that regard, I kind of view them as a nice competitor to have because that's a problem they've got to live with." Similarly, on several occasions in March, McGuire said there were no significant changes to the pricing environment. See Statement of Garry McGuire, CFO, Avaya, Fourth Annual JMP Securities Research Conference (Mar. 2, 2005) ("Pricing environment is not significantly different. I mean, there are people that will buy a deal from time to time, but in general, the pricing environment is-has been fairly stable."); Statement of Garry McGuire, CFO, Avaya, Morgan Stanley Semiconductor and Systems Conference (Mar. 7, 2005) ("[C]learly from time to time people will want to buy a deal here or there, but the market itself has been fairly stable with just modest declines over the last 12 months."); Statement of Garry McGuire, CFO, Avaya, Deutsche Bank Securities Inc. IT Hardware Conference (Mar. 10, 2005) ("Pricing has been fairly steady for the last couple of years. . . . I don't see any reason that that would change significantly. I think that in the last year or so, it has really been a 2-horse race with us and Cisco in the IP telephony area.").
Also in March, analyst reports identified potential obstacles faced by Avaya. On March 4, 2005, members of the Buckingham Research Group performed a sales channel check and concluded that Avaya was experiencing "weak" spending for its products and had fired sales staff in order to cut costs. The analysts predicted Avaya's actions would "negatively effect [sic] growth." In addition, a March 21, 2005, Equity Research Update by Lehman Brothers analysts reported that Avaya resellers had indicated that the company was "offering aggressive [30--40%] discounts for its mid-range products (150--400 lines) since [the] beg[inning] of March ."*fn10
Lehman Brothers characterized the discounts as "quite unusual" and warned that if the promotion were highly successful, "Avaya's product margins would be somewhat impacted."
On April 19, 2005,*fn11 Avaya announced that it would be unable to meet its previously stated goals for growing revenues, operating income, and operating margin in FY2005. Avaya's Q2 FY2005 revenues increased 21% compared to the revenue in Q2 FY2004. The revenue growth "reflected the impact of Avaya's recent acquisitions and revenue growth internationally." But "U.S. product and services revenues declined year-over-year." On April 20, 2005, Avaya's stock price dropped approximately 25%-from $10.69 to $8.01.*fn12
Peterson blamed internal problems, especially the GTM strategy, for the missed benchmarks. See Statement of Don Peterson, Chairman and CEO, Avaya, Q2 2005 Avaya Earnings Conference Call (Apr. 19, 2005) ("[W]ell over a majority of this shortfall I would attribute more to issues related to us than issues related to the market. . . . I think most of this [sic] are things that if I have to get to and fix and therefore they're within our control and we will fix them and get back on track."); id. ("The implementation of our new go-to-market strategy . . . is taking longer and has been somewhat more disruptive than we had envisioned. While we still believe it is the right strategy and it will ultimately strengthen our presence in the marketplace it has in the short-term negatively affected our direct sales in the U.S.").
McGuire noted that during the first two months of the second quarter, Avaya was "tracking slightly at or just a little bit below the quarter before" and was "track[ing] well for March closure both on the indirect and the direct side." According to McGuire, "all of the indicators that we had gave us comfort that that would come through." But Avaya was "caught . . . by surprise in the last week" of the quarter when distributors decided not to "reload" at the rates they had done in the past and when Avaya was unable to close several deals during the quarter.
Also, in response to questions about discounting, McGuire stated: "There is no new specific discounting policy we put in place. I can tell you that our discounts were relatively black or improved in most parts of the world, except for international direct where they were up slightly." During a conference call with Merrill Lynch on April 28, 2005,*fn13
McGuire was asked about "some reports published recently saying that Avaya gave a 30% to 40% discount in the first quarter." McGuire responded: "Now, I hear the noise that, yes, we were out with a 30% to 40% discount on a program in last quarter. . . . [I]t's not unusual . . . . And quite frankly, a 30% to 40% discount is not out of the norm for any of these programs."
Based on the following "true facts," Shareholders allege a "two-pronged fraud scheme to increase Avaya's stock price."
Shareholders' Br. 5. First, Shareholders allege that, beginning in October 2004, and continuing throughout the class period, defendants denied that Avaya was offering unusual price discounts and that its profit margins were being impaired. Shareholders contend the "true facts" show Avaya was in fact encountering serious pricing pressures and was forced to grant unusually large discounts in negotiations with clients, which would manifest themselves in less-profitable contracts booked in subsequent quarters (since the negotiation process "regularly lasted months"), eviscerating margins. Second, Shareholders allege the financial projections Avaya released on October 29, 2004, and reaffirmed in January and March 2005, were false or misleading. According to Shareholders, defendants knew the projections could not be achieved because of unusual pricing discounts and declining sales due to Avaya's sales force realignment under the GTM strategy, which impaired both earnings and revenues.
CW3 is a confidential witness and former Global Contract Manager who worked at Avaya "for many years prior to leaving in November 2004" and who "participated in the negotiation of contracts with many of Avaya's biggest clients," including work on the top forty accounts in the U.S. According to CW3, "Avaya's operational model had essentially broken down" in the months prior to his November 2004 departure, "resulting in Avaya's inability to compete with the business models of rivals in the industry such as Cisco and AT&T Solutions." CW3 asserts it was "well-recognized within Avaya that its business model faced significant problems" and that its inability to compete with an "outsourcing" product offered by AT&T Solutions allowed numerous large clients, such as Merrill Lynch and Citigroup, to pressure Avaya "as a means of winning substantial price concessions." Citigroup allegedly forced Avaya to accept a 20% price reduction with no change in services because Avaya feared losing Citigroup to AT&T Solutions's "outsourcing" product. In the months leading up to the beginning of the class period, CW3 contends "defendants realized Avaya's margins on business with relatively small accounts . . . had substantially declined," so that it had become unprofitable to negotiate such contracts. Avaya shifted to a policy of non-negotiation on those accounts, leading to a decline in business as Avaya lost those accounts to competitors.
CW4 is a former Avaya employee "who was at the Company prior to and throughout the Class Period and who was responsible for evaluating the profitability of special bids in the Services organization," which allegedly provided half of Avaya's revenues. See Shareholders' Br. 11. According to CW4, "Avaya gave substantial discounts to win business in the period leading up to the beginning of the Class Period through May 2005." The customers receiving such discounts were among Avaya's largest. CW4 provided the names of four of the customers. CW4 stated that, historically, Avaya gave 20% discounts to 20% of its special bid customers. But between January and May 2005, at the request of the sales force, Avaya management gave 20% discounts to 80% of its special bid customers. In 2004 and 2005, "Avaya was facing substantial competition from newer companies that were aggressively pursuing Avaya's customers by competing on price."*fn14 "[I]n many instances Avaya was granting price concessions in excess of 30%--40% in order to win business . . . ."*fn15 Finally, CW4 contends, Avaya inherited a number of low-margin contracts from its acquisition of a company called Expanets in October 2003. This problem allegedly continued throughout the class period, and by March 2005, Avaya was "happy to merely break even on such contracts."
CW5, a former Senior Client Executive at Avaya from 2001 until March 2004, said Avaya's GTM strategy had begun in October 2003 and involved reassigning Client Executives from larger "enterprise" accounts to "mid-market" accounts.
CW5 realized in October 2003 that the GTM strategy would cause "a substantial loss of business already in the pipeline." The effect of the GTM strategy was that "many customers lost confidence and trust in Avaya and certain large sales were lost." For example, CW5 allegedly lost $7 million in sales through 2004, "including lucrative contracts with ACS in Utica, New York for $1.5 million and a $750,000 deal with Alcoa." According to CW5, these and other similar FY2004 losses attributable to the GTM strategy "were to have a substantial impact on Avaya's financial results during the Class Period" because Avaya's "sales cycle" for enterprise accounts ranged from six months to a year and a half.
Two CWs (a former Director of Operations for Global Solutions Sales and Support and a former Senior Client Executive) claimed McGuire established the financial projections on a "top-down basis," meaning he did not solicit input from salespeople. The resulting forecast was allegedly "dictated" from the top and was not realistically attainable. Finally, according to CW3, Avaya fired employees in September 2004 "specifically because the Company's business was not doing well," demonstrating that despite the "positive spin" Peterson and McGuire issued in October 2004, internally they were "taking drastic steps to reduce costs" in order to meet the projections.
The District Court granted defendants' motion to dismiss under the Private Securities Litigation Reform Act (PSLRA) for three reasons: (1) some statements defendants allegedly made were "forward-looking" and protected under the PSLRA's Safe Harbor provision; (2) other alleged statements were not actionably false or misleading; and (3) with respect to remaining statements that may have been actionable, Shareholders failed to plead facts giving rise to a strong inference of scienter as the PSLRA requires. See Charatz v. Avaya, Inc., No. 05-2319 (MLC), 2006 WL 2806229, at *12--20 (D.N.J. Sept. 28, 2006). Shareholders timely appealed.*fn16
We exercise plenary review over the District Court's dismissal of the Complaint for failure to meet the pleading requirements of the PSLRA and over the District Court's interpretation of the federal securities laws. Winer Family Trust v. Queen, 503 F.3d 319, 325 (3d Cir. 2007).
A. Section 10(b) and Rule 10b-5
Section 10(b) of the Securities Exchange Act of 1934 prohibits the "use or employ[ment], in connection with the purchase or sale of any security . . ., [of] any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe." 15 U.S.C. § 78j(b). Rule 10b-5, promulgated by the Securities and Exchange Commission, makes it unlawful
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
To state a claim for securities fraud under Rule 10b-5, plaintiffs must "allege defendants made a misstatement or an omission of material fact with scienter in connection with the purchase or the sale of a security upon which plaintiffs reasonably relied and plaintiff's [sic] reliance was the proximate cause of their injury." Winer Family Trust, 503 F.3d at 326. Although Shareholders' Complaint focuses on the statements of McGuire and Peterson, liability for these statements, if they were fraudulent, can also be imputed to Avaya because "[a] corporation is liable for statements by employees who have apparent authority to make them." Makor Issues & Rights, Ltd. v. Tellabs Inc. (Tellabs II), 513 F.3d 702, 708 (7th Cir. 2008) (citing Am. Soc'y of Mech. Eng'rs, Inc. v. Hydrolevel Corp., 456 U.S. 556, 568 (1982); In re Atlantic Fin. Mgmt., Inc., 784 F.2d 29, 31--32 (1st Cir. 1986)).
Avaya does not dispute that the following elements of the cause of action are properly pleaded: materiality, reliance, loss causation, and damages. Falsity and scienter are disputed. With respect to falsity, Shareholders must specify each allegedly misleading statement and the reasons why the statement is misleading. Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499, 2508 (2007). Scienter is a "mental state embracing intent to deceive, manipulate, or defraud," Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 ...