In Re: Comshare, Incorporated Securities Litigation. Harry M. Hoffman v. Comshare, Inc.

Citations: 183 F.3d 542; 1999 WL 460917Docket: 97-2098

Court: Court of Appeals for the Sixth Circuit; August 23, 1999; Federal Appellate Court

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In the case **In re Comshare, Incorporated Securities Litigation**, the U.S. Court of Appeals for the Sixth Circuit addressed an appeal from shareholders of Comshare, Inc. challenging the dismissal of their class action complaint for securities fraud, which alleged violations of the Securities Exchange Act of 1934. The appeal centered on whether the plaintiffs could meet the heightened pleading standards established by the Private Securities Litigation Reform Act of 1995, specifically whether they could survive a motion to dismiss by demonstrating a strong inference of recklessness or motive and opportunity.

The defendants included Comshare, a software development company, and several of its officers and directors. Comshare, publicly traded on NASDAQ, primarily generated revenue from international sales and software licensing. The court affirmed the district court's judgment of dismissal but did so on different grounds. The case was not a class action due to the district court's stay on class certification pending the resolution of the motion to dismiss, resulting in a consolidation of several related cases.

Nine Plaintiffs—Harry and Deborah Hoffman, Donald Knuth, Nancy Totten, Mark Cook, Oleg Kohkhlov, Paul Knapp, Christopher Yost, and Gabriel Briceno—are involved in this legal action. Most purchased shares of Comshare common stock after July 30, 1996, except for Totten and Kohkhlov, who bought shares before and after that date. Collectively, the Plaintiffs own 17,621 shares, constituting 0.18% of Comshare's stock. Comshare's revenue derives from software license fees, maintenance service fees, and consulting services, with a policy of recognizing revenue only after a customer contract is fully executed and the software shipped. Plaintiffs contend that recognizing revenue from sales before payment violates both Comshare's policy and Generally Accepted Accounting Principles (GAAP).

On July 30, 1996, Reuters reported a delay in Comshare's quarterly report due to an incomplete audit of its UK subsidiary. Subsequently, on August 6, 1996, Comshare announced that it was also delaying the release of its annual financial results pending a detailed audit, prompted by the discovery of undisclosed conditions attached to certain UK orders amounting to approximately $4 million. Following this news, Comshare's stock price dropped significantly. On September 5, 1996, after completing its audit, Comshare reported a decrease in quarterly revenue and acknowledged that violations of revenue recognition policies had occurred, specifically relating to foreign orders. Corrective measures were taken, including management changes and new order procedures.

The Hoffmans filed the first complaint on August 9, 1996, with subsequent complaints from Yost, Totten, Knapp, and Knuth filed within a two-week period, all alleging a class period from April 17, 1996, to August 6, 1996. On October 16, 1996, the parties moved to consolidate the actions, which the district court granted, allowing the Plaintiffs to file a Consolidated Amended Complaint.

Plaintiffs submitted their Complaint on December 13, 1996, extending the class period from August 2, 1995, to August 21, 1996, and including Defendant Walker. The Complaint alleges that all Defendants participated in a fraudulent scheme by knowingly or recklessly misrepresenting revenue, violating § 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, which led Plaintiffs to purchase Comshare stock at inflated prices. It asserts that the individual Defendants are liable as “controlling persons” under § 20(a) of the same Act and claims that Defendants Wrathall, Crandall, and Jehle made negligent misrepresentations about Comshare’s finances. Plaintiffs argue that improper revenue recognition for conditional sales constituted securities fraud, alleging that this was part of a deliberate scheme to inflate stock prices for personal gain through their compensation plans tied to stock value. 

On January 31, 1997, Defendants filed a Motion to Dismiss, asserting they discovered revenue recognition errors during a 1996 audit, specifically regarding 'side letters' that made certain sales conditional. They contend that they rectified these issues following the audit findings. The district court granted the motion to dismiss all claims with prejudice on September 18, 1997, leading Plaintiffs to file a timely appeal on October 9, 1997. The case will involve interpreting the Private Securities Litigation Reform Act of 1995 (PSLRA), with the appeals court reviewing the dismissal de novo and accepting the Complaint's well-pleaded facts as true, only dismissing if no facts could support a claim for relief. The appeals court can also affirm the dismissal based on alternative reasoning not addressed by the district court.

To establish a claim under § 10(b) of the Securities and Exchange Act of 1934 and Rule 10b-5, a plaintiff must demonstrate that a misstatement or omission of a material fact occurred in connection with the purchase or sale of securities, which was made with scienter, that the plaintiff justifiably relied on, and which proximately caused their injury. 'Scienter' is defined as the intent to deceive, manipulate, or defraud. Establishing a defendant's liability requires the plaintiff to allege sufficient scienter in their complaint. Furthermore, allegations of securities fraud must comply with the heightened pleading standard of Rule 9(b) of the Federal Rules of Civil Procedure, which mandates that fraud claims be stated with particularity.

The Supreme Court has noted that litigation under Rule 10b-5 carries unique challenges, particularly the potential for groundless claims to disrupt corporate operations through extensive discovery. In response to concerns about abusive litigation practices, Congress enacted the Private Securities Litigation Reform Act (PSLRA) in 1995, which specifically requires plaintiffs to provide particularized facts that create a strong inference of the defendant's required state of mind for each alleged act or omission. Failure to meet this requirement can lead to dismissal of the complaint upon a defendant's motion. The PSLRA does not alter the scienter required for proving securities fraud but instead modifies the pleading requirements necessary to withstand a motion to dismiss.

The Private Securities Litigation Reform Act (PSLRA) does not define the "required state of mind" necessary for actions under the Securities Act. Prior to the PSLRA, the Second Circuit had a stringent standard for pleading scienter under § 10(b) and Rule 10b-5, requiring either strong circumstantial evidence of conscious or reckless behavior by the defendant or facts showing the defendant's motive and opportunity to commit fraud. Plaintiffs argue that the PSLRA adopted this standard, allowing them to survive dismissal by alleging recklessness or motive and opportunity. Conversely, defendants assert that Congress intended for the PSLRA to impose a more stringent pleading requirement, necessitating a "strong inference" of knowing or intentional conduct.

The court concludes that, under the PSLRA, plaintiffs may plead scienter by alleging facts that create a strong inference of recklessness, but not merely by showing motive and opportunity. The court rejects any interpretation requiring specific facts indicating knowing misrepresentation. The PSLRA explicitly states that plaintiffs must "state with particularity facts giving rise to a strong inference" of the required state of mind, yet it does not define that state of mind for § 10(b) or Rule 10b-5 cases. The PSLRA does not alter the substantive law regarding scienter, which remains the requisite mental state for liability in securities fraud actions. Before examining legislative intent, the court emphasizes the need to analyze what constitutes scienter in securities fraud law, recognizing that Congress was aware of the existing legal context when enacting the PSLRA, thus leaving the definition of "scienter" unchanged. The Supreme Court has defined "scienter" as the intent to deceive, manipulate, or defraud.

The Court in Hochfelder ruled that negligence cannot establish liability under § 10(b) or Rule 10b-5, emphasizing that 'scienter' involves intent, although recklessness may sometimes be viewed as intentional conduct. The Court did not definitively conclude whether recklessness could lead to civil securities liability under these provisions. Subsequent to Hochfelder, most circuits concluded that recklessness can qualify as scienter under § 10b and Rule 10b-5, with the Sixth Circuit explicitly stating that recklessness meets the scienter requirement. Courts have adopted a strict definition of recklessness, distinguishing it from negligence, and defining it as highly unreasonable conduct that significantly deviates from ordinary care. Under the Private Securities Litigation Reform Act (PSLRA), plaintiffs can survive dismissal by presenting facts showing a strong inference of recklessness. However, mere evidence of a defendant’s motive and opportunity does not qualify as scienter; rather, it may only support an inference of scienter when coupled with allegations of reckless or knowing conduct. Thus, to satisfy PSLRA requirements, plaintiffs must allege facts indicating reckless behavior, as allegations based solely on motive and opportunity are insufficient.

The district court applied an incorrect legal standard in its analysis of the PSLRA (Private Securities Litigation Reform Act) pleading requirements. It improperly prioritized legislative intent and history over the statutory language, wrongly suggesting that the PSLRA adopted stricter Second Circuit pleading standards. The court referenced a House Conference Report stating the intent to strengthen pleading requirements without codifying prior case law, noting that the PSLRA does not include language about motive, opportunity, or recklessness. It also cited Congress's rejection of a Senate bill that would have allowed plaintiffs to meet the new standard by alleging motive or circumstantial evidence of recklessness. However, the appellate court disagreed with the district court's conclusion that plaintiffs must show a strong inference of knowing misrepresentation or intent to survive dismissal. The appellate court clarified that while the PSLRA modified pleading requirements to necessitate a "strong inference" of scienter, it did not alter the underlying state of mind requirements for securities fraud, which still includes recklessness. Therefore, the court rejected the district court's position and affirmed that plaintiffs can survive dismissal by alleging facts that support a strong inference of recklessness.

The court evaluated the PSLRA pleading standard in relation to the Plaintiffs' allegations against individual Defendants regarding securities fraud. Plaintiffs argued that the Defendants had a financial motive to inflate Comshare's stock prices and profited from selling shares at these inflated prices, suggesting they had the opportunity to commit fraud. However, the court noted that merely showing motive and opportunity was insufficient to establish a strong inference of scienter. The Plaintiffs failed to demonstrate that the Defendants acted with recklessness or that the errors in revenue recognition were obvious. The court emphasized that the mere failure to adhere to GAAP does not constitute a securities fraud claim. The Plaintiffs' assertions that Defendants were aware of or indifferent to the errors lacked factual support and relied on speculative beliefs rather than concrete evidence. Additionally, without specific facts indicating warning signs or reasons for Defendants to question revenue reporting, the allegations did not meet the necessary legal standard. The court affirmed that speculation and conclusory statements cannot support claims of securities fraud, and that allegations of subsequent revelations do not imply prior knowledge or intent to deceive. As a result, Plaintiffs did not adequately plead scienter, leading to the proper dismissal of the Complaint by the district court.

The absence of records confirming the finality of sales in Comshare's UK subsidiary does not inherently suggest recklessness unless there is evidence that Comshare typically expected such documentation from its subsidiaries. The court emphasizes that recklessness or intentional misconduct cannot be assumed merely from a parent company's dependence on its subsidiary's internal controls. The plaintiffs failed to present facts indicating that Comshare should have been aware of revenue recognition errors at its UK subsidiary or that it ignored significant warning signs before these errors were included in public disclosures. Consequently, the complaint does not sufficiently imply a strong inference of scienter under § 10(b) and Rule 10b-5. Although the plaintiffs sought permission to replead, citing the ambiguity of PSLRA pleading standards at the time of their initial filing, they later expressed no desire to do so. Therefore, the district court's dismissal of the plaintiffs' complaint with prejudice is upheld. Additionally, it is noted that Comshare reported consolidated financial statements and publicly disclosed its subsidiaries, countering claims that it presented itself as a single entity without acknowledgment of its UK operations. The judgment of the district court is affirmed.

The American Institute of Certified Public Accountants, in an amicus brief, expresses concern that securities fraud allegations based solely on recklessness could lead to liability for accountants and other defendants perceived as deep pockets, irrespective of their actual culpability. However, it is established that recklessness, defined as being closer to intent than mere negligence, constitutes scienter for securities fraud. The view that the Private Securities Litigation Reform Act (PSLRA) establishes a uniform substantive standard for scienter rather than a procedural heightened pleading standard is not supported. The Third Circuit has offered a different interpretation regarding "motive and opportunity" under the PSLRA. 

The district court’s reliance on certain cases to narrow the pleading requirement to a strong inference of knowing misrepresentation is questioned, as subsequent rulings have either modified or weakened these interpretations. For instance, a later published decision in the same case as the unreported opinion cited by the district court included "deliberate recklessness" in its definition of misconduct. Further, contrary opinions from the same courts indicate that recklessness was not eliminated by the PSLRA, reflecting a split within the District of Massachusetts on this issue. 

The legislative history of the PSLRA suggests Congress aimed to alter pleading standards rather than substantive requirements, indicating that plaintiffs can survive dismissal by alleging a strong inference of recklessness. However, the history remains ambiguous, warranting reliance on the statute itself rather than its unclear legislative intent. Lastly, while plaintiffs assert that individual defendants are liable as "controlling persons" of Comshare, such liability requires that the entity has violated the Securities Act. Since the plaintiffs have not established a Securities Act violation by Comshare, the claim for "controlling person" liability does not proceed.