Court: District Court, E.D. Virginia; March 10, 2014; Federal District Court
Defendants have raised various objections to the United States Magistrate Judge’s Report and Recommendation (R.R.), which included three key suggestions: granting plaintiffs' motion for judicial notice of another lawsuit, denying two motions to dismiss from defendants Bowyer and a group of others, and partially granting and partially denying a third motion to dismiss from defendant Sabol. Following a de novo review of the R.R., the Court finds no clear error in the factual and procedural history outlined in the R.R. and adopts this section as accurate.
Specifically, defendant Bowyer's January 13, 2014 objections include assertions that the R.R. did not adequately address his claim of a valid affirmative defense, disputes the pleading standard for 'control person' liability under Section 20(a) of the Securities and Exchange Act of 1934, and challenges the sufficiency of facts regarding his status as a 'control person.' Similarly, Sabol's objections focus on the denial of her motion to dismiss in part, the timeliness of the plaintiffs' claims, and the recommendation for allowing a second opportunity to amend the complaint regarding direct liability claims against her. Additionally, the group of defendants known as the Director Defendants collectively object to the R.R.'s finding that the amended complaint provides sufficient facts to characterize them as 'control persons' under the Exchange Act.
On January 27, 2014, Plaintiffs submitted three briefs to the Court in response to previous objections but did not contest the Magistrate Judge’s recommendation to partially grant Sabol’s motion to dismiss. Under the Federal Magistrates Act, parties can file written objections to the magistrate's proposed findings within 14 days. The district court must conduct a de novo review of any portions of the report to which objections are made, while unchallenged portions can be adopted without such review if there is no clear error. The Court found no clear error in the Magistrate Judge’s report regarding the unobjected-to recommendations, particularly noting that Plaintiffs did not object to the partial granting of Sabol’s motion to dismiss or to the judicial notice of a complaint filed by the SEC against Sabol. Consequently, the Court adopted these findings, granting Sabol’s motion to dismiss Count I related to Section 10(b) of the Exchange Act and allowing judicial notice of the SEC complaint, clarifying that taking notice does not imply acceptance of the allegations as true.
The Court also addressed objections raised in the three filings, which challenged the report on several grounds: the application of the wrong legal test for 'control person' liability, insufficient factual basis for alleging that defendants were 'control persons,' failure to address Bowyer’s affirmative defense claim, improper conclusions regarding the timeliness of the claims, and the recommendation for Plaintiffs to amend their complaint. The Court rejected each objection.
Count I of the Amended Complaint brings direct liability claims against Commonwealth Bankshares, Inc. and certain executives under Section 10(b) of the Exchange Act. Count II asserts derivative liability claims, termed "control person liability," against individuals such as Bowyer and Sabol, based on Section 20(a) of the Exchange Act. These claims are predicated on the allegation that the individuals controlled those who committed the direct Section 10(b) violations. A valid claim for control person liability requires two elements: a predicate violation of Section 10(b) and control by the defendant over the primary violator. The debate revolves around whether a third element, "culpable participation," is necessary to establish a prima facie case. Some courts hold that it must be pled, while the majority, including several circuit courts, assert that only the two elements are needed. The Fourth Circuit has endorsed the majority's view, indicating that once a prima facie case is established, the burden shifts to the defendant to demonstrate a lack of culpable participation or knowledge. The court emphasizes adherence to established precedent, clarifying that the Supreme Court's reversal of a prior ruling did not alter the relevant pleading standards.
The Court aligns with the MicroStrategy analysis, affirming that under the Exchange Act and specifically Section 20(a), plaintiffs are not required to plead "culpable participation" in their complaints to establish a claim. It finds that the Fourth Circuit's Carpenter case is not relevant to the pleading standard since it was addressed at the summary judgment stage with affirmative defenses involved. Consequently, the Court adopts the Magistrate Judge's reasoning and denies motions to dismiss based on the absence of "culpable participation."
Addressing objections from defendants regarding the sufficiency of the amended complaint in identifying them as "control persons," the Court cites the Fourth Circuit’s definition of "control" for Rule 20(a) violations. A plaintiff must plead facts showing that the defendant had the power to control the entity liable at the time of the violation, without needing to demonstrate actual control. The definition of control encompasses both actual and legally enforceable control, with emphasis on the potential power to influence corporate activities. The determination of control person liability is generally a factual question inappropriate for resolution at the motion to dismiss stage unless no facts can be inferred to suggest control.
Plaintiffs allege that Sabol, Bowyer, and the Director Defendants had significant control over the operations and decision-making of Commonwealth, particularly regarding the dissemination of allegedly false and misleading statements. The amended complaint outlines Sabol’s role as CFO and Principal Accounting Officer, and details the involvement of Bowyer and the Director Defendants as members of the Board of Directors and various subcommittees. Most notably, Bowyer and nearly all Director Defendants served on the audit committee, responsible for reviewing financial statements and internal reports, while all participated in the executive committee, which acted on behalf of the Board between meetings. The investment committee was tasked with managing investment policies. The complaint identifies numerous allegedly fraudulent financial reports, including annual 10-K and quarterly 10-Q filings, and specifies that Sabol signed nearly all of these reports, while Bowyer and the Director Defendants signed at least two. The legal precedent cited indicates that mere status as CFO is insufficient for control allegations unless the claims directly relate to official financial reports.
The Court conducted a de novo review and accepted the Magistrate Judge's recommendation that the amended complaint presents adequate factual allegations to establish a Rule 20(a) control person liability claim against Sabol, Bowyer, and the Director Defendants. The claims are not solely based on their roles as Board members. Key points include:
1. All defendants signed at least two allegedly fraudulent financial statements, which is a critical factor.
2. Sabol's role as CFO and the audit committee memberships of Bowyer, Goldmeier, Moss, Perlin, Young, and Payne imply their responsibility for the accuracy of financial disclosures. Case law supports that audit committee members who sign corporate financial documents can be held liable under Section 20(a) of the 1934 Act.
3. Bowyer and the Director Defendants were also part of the executive committee, which wielded significant power between Board meetings.
4. The complexity of control is a factual issue inappropriate for resolution via a Rule 12(b)(6) motion, as control can be defined by the power to direct corporate management and policies.
5. The amended complaint sufficiently alleges that the defendants had the power to control Commonwealth's activities, including its financial reporting and internal control policies.
6. The defendants' signatures on the fraudulent financial statements are critical evidence of their control, as their roles in governance render those signatures significant.
The Court asserts that these factors collectively establish the necessary control for liability under the applicable law.
Board members' knowledge of the false records they signed is irrelevant at this stage, as sufficient allegations of scienter have been made regarding multiple individuals directly violating Section 10(b). Section 20 of the Exchange Act does not require proof of a control person's state of mind, leading to the denial of motions to dismiss 'control person' liability claims in Count II of the amended complaint.
Defendant Bowyer's objections regarding the failure to address his affirmative defense are rejected. The Court concludes that the amended complaint does not conclusively support Bowyer's claim of a valid affirmative defense, as it lacks sufficient facts to resolve this issue. The allegations do not clarify what was concealed from Bowyer, his access to evidence of wrongdoing, or his knowledge when signing false financial reports. Bowyer’s argument about his resignation in June 2010 does not warrant dismissal since misconduct allegedly continued after his departure, and does not prove he was unaware of prior wrongdoing.
Defendant Sabol's objections concerning the timeliness of claims are also rejected. Sabol argues a reasonable investor would have initiated an investigation in January 2010 following the restatement of Commonwealth's third-quarter results. However, the Court finds Sabol fails to demonstrate that the amended complaint's allegations necessitate an investigation at that time or that such an investigation would have quickly uncovered any fraud. The statute of limitations in private securities actions begins when a plaintiff discovers or should have discovered the facts constituting the violation, whichever occurs first.
Sabol's assertion regarding the likelihood of discovering fraud lacks factual support, as she claims that an investor investigating in January 2010 would have inevitably uncovered the fraud within months. While she cites Cohen v. USEC, Inc. to support this claim, she neglects to mention that in Cohen, the relevant information was publicly accessible, unlike the circumstances in the current case. Sabol does not provide evidence that an investor in January 2010 had access to information revealing the fraud. Consequently, her affirmative defense fails under Rule 12(b)(6) because the necessary facts do not appear in the amended complaint. The Supreme Court clarifies that the limitations period for securities fraud does not commence until a diligent plaintiff could have discovered the facts constituting the violation, including intent to deceive. Although an investor may have noticed signs of inaccuracy in Commonwealth's financial reports, the limitations period is not triggered until it is apparent that such inaccuracies were intentional. Sabol has not demonstrated that prior to the two-year limit before the lawsuit was filed, a reasonable investor could access evidence of intentional deceit regarding financial inaccuracies. Therefore, the Court agrees with the Magistrate Judge's recommendation to deny Sabol's motion to dismiss based on timeliness. Regarding the recommendation for the Plaintiffs to be granted leave to amend their complaint, although Sabol agrees with the dismissal of the claims, she objects to the leave due to alleged futility and potential prejudice from having to answer again. After a thorough review, the Court adopts the Magistrate Judge's recommendation for leave to amend, despite the Plaintiffs not filing a formal motion for it.
Plaintiffs' failure to file a formal motion might typically warrant dismissal with prejudice, but the Court chooses not to do so here. Plaintiffs attempted to incorporate allegations against Sabol from a related case (SEC v. Woodard, Civ. No. 2:13cv16) through judicial notice, which provided Sabol prior notice of the allegations intended for inclusion in the amended complaint. The potential prejudice to Sabol from having to respond to another complaint is mitigated by the fact that he has already addressed these allegations in the separate civil case. Consequently, the proposed amendments are not deemed futile or prejudicial, aligning with the principle that leave to amend should be freely granted under Federal Rule of Civil Procedure 15(a). The Court grants Plaintiffs' request to amend the complaint regarding Sabol’s allegations from the referenced case.
After reviewing the Report and Recommendation (R. R.) from the Magistrate Judge, the Court adopts the findings and recommendations. Plaintiffs’ motion for judicial notice of the other pending lawsuit is granted, but the Court does not treat the facts from that case as evidence in the current case. The motions to dismiss from Defendants Bowyer and the Director Defendants are denied, while Sabol's motion is partially granted, dismissing the direct liability Section 10(b) claims without prejudice. The Court denies Sabol's other arguments related to Section 20(b) liability and the timeliness of the suit. Plaintiffs have ten days to file their Second Amended Complaint. Additionally, the Court notes considerations regarding Rule 17 and the capacity of an incarcerated inmate to be sued, as the case progresses. Bowyer's request for dismissal of Counts I and II is denied, as Count I does not name him and does not challenge the allegations against the named defendants.
Sabol's first objection asserts that the Magistrate Judge incorrectly applied the pleading standard for 'control persons' under Section 20(a) and claims that the amended complaint fails to show she qualifies as such. The Court agrees with the Plaintiffs, clarifying that the heightened pleading standard for scienter in Section 10(b) does not apply to the 'control' requirement in Section 20(a). Instead, only Rule 8(a)'s general pleading standard is necessary. The amended complaint provides additional facts supporting the assertion that the Director Defendants are control persons, such as their involvement in loans and related party transactions, and ownership in Commonwealth.
The sufficiency of allegations against defendants Fentriss and Uppalapati is more contentious because they were not on the audit committee, which directly oversaw financial reporting accuracy. However, both signed allegedly fraudulent financial statements, including the 2009 10-K, which misrepresented internal control deficiencies. Additionally, both held significant roles on various committees, with Fentriss owning about 7% of Commonwealth stock and Uppalapati facilitating material related party transactions. The Court concludes that sufficient facts exist in the amended complaint to plausibly allege Fentriss and Uppalapati as control persons.
Bowyer argues that references to the criminal conviction of Woodard, Commonwealth’s CEO, support his good faith defense. While the report does not dwell on this, it notes that claims of deception by the Directors are affirmative defenses to be addressed later in the proceedings. The Plaintiffs have alleged enough to support Section 20(a) liability. Even if Bowyer were aware of senior officers' misconduct, the possibility exists that he distanced himself from the Board due to this knowledge, indicating that the complexity of his good faith defense requires further factual exploration.
