Chill v. General Elec. Co.
| Decision Date | 27 November 1996 |
| Docket Number | No. 1534,D,1534 |
| Citation | 101 F.3d 263 |
| Parties | , Fed. Sec. L. Rep. P 99,353, 36 Fed.R.Serv.3d 437 Daniel CHILL, Plaintiff-Appellant, Paul Kay, Giza Schectman, Mayer Ballas, Douglas Marshall, Steven J. Weiss, M.D. Profit Sharing Plan and Michelle Ruder, Appellants, v. GENERAL ELECTRIC COMPANY, Defendant-Appellee. ocket 95-9175. |
| Court | U.S. Court of Appeals — Second Circuit |
Abraham Rappaport, Morris & Morris, Wilmington, DE, and Joel Seligman, University of Arizona College of Law, Tucson, AZ (Irving L. Morris, Karen L. Morris, Abraham Rappaport, Patrick F. Morris, Seth D. Rigrodsky, Morris & Morris, New York City; Stull, Stull & Brody, New York City; Weiss & Yourman, New York City; Schiffrin & Craig, Ltd., Bala Cynwyd, PA; Wolf Haldenstein Adler Freeman & Herz, New York City; Timothy J. Dennin, P.C., New York City; Krause & Kalfayan, San Diego, CA, of counsel), for Plaintiff-Appellant and Appellants.
Louis B. Kaden, Davis Polk & Wardwell, New York City (Robert F. Wise, Jr., Davis Polk & Wardwell, New York City, of counsel), for Defendant-Appellee.
Before: MINER, JACOBS and PARKER, Circuit Judges.
Plaintiff-appellant Daniel Chill and appellants (collectively, the "plaintiffs") appeal from a judgment entered in the United States District Court for the Southern District of New York (Keenan, J.) dismissing the complaint and denying plaintiffs leave to amend. The district court found that plaintiffs failed to allege facts that supported their claim that defendant-appellee General Electric Company ("GE") committed securities fraud in reporting the false profits generated by a bond trader at its subsidiary, Kidder, Peabody & Co., Inc. ("Kidder"). For the reasons that follow, we affirm the judgment of the district court.
GE is a large and diverse public company with 12 major, separately-managed operating businesses. One of these 12 businesses is GE Capital Services, Inc. ("GE Capital"), which is GE's financial services unit. At the time of the events at issue in this action, GE Capital itself was comprised of 24 separate businesses, one of which was Kidder, a full-service investment bank and securities broker-dealer. Each of these separate businesses reported their quarterly and annual financial results to GE, which reported the results of all its businesses on a consolidated basis.
GE had acquired 80 percent of Kidder for $620 million in 1986. Shortly thereafter, an insider trading scandal was exposed at Kidder, resulting in a $26 million fine paid to the Securities and Exchange Commission ("SEC") and the implementation of a compliance system at Kidder to detect fraudulent trading. Kidder's business declined, with losses of $53 million posted in 1989, and $54 million in 1990. In 1990, GE acquired the remaining 20 percent of Kidder in a $550 million bailout transaction. Following this transaction, Kidder began turning a profit, and did so throughout 1991, 1992 and 1993.
Beginning in late 1991, Orlando Joseph Jett, one of the traders at Kidder's government bond trading desk, allegedly began a scheme to generate false profits in order to increase his year-end, performance-based bonuses. Jett secretly entered thousands of fictitious STRIPs 1 trades into Kidder's computerized trading system. These entries made it appear as if Jett's trading activities were generating substantial profits for Kidder. These "phantom" trades, which were designed to be hidden from Kidder's management and auditors, existed only in Kidder's computers and generated only fictitious and unrealizable profits. Jett continued this scheme through March of 1994. In total, the false trades resulted in $350 million in false profits for Kidder, and over $10 million in performance-based bonuses for Jett. The scheme also masked Kidder's real STRIPs trading activities over this period, which resulted in actual losses in excess of $85 million.
In April of 1994, Kidder discovered Jett's scheme. Kidder informed GE Capital, and Jett was fired on April 17, 1994. GE announced on April 17, 1994 that it would take a one-time $350 million charge to its first quarter 1994 earnings to adjust for the false profits that had been recorded at Kidder from 1991 through 1994. GE and Kidder also announced that they had retained Gary G. Lynch, a former Director of Enforcement at the SEC, to conduct an internal investigation of Kidder and report on how the Jett scheme remained undetected despite Kidder's internal controls. 2 In addition, GE made changes in Kidder's top management.
Shortly after GE announced its discovery of the scheme, ten class action suits were filed, each on behalf of a class of those who had purchased GE stock during the year prior to the disclosure of the scheme. According to each complaint, the earnings of Kidder, and thus GE, had been overstated as a result of Jett's scheme and thereby had artificially inflated the market price of GE stock. Seven of these actions named GE as a defendant, and the other three actions named as defendants Kidder and several of its officers and directors (the "Kidder defendants").
Pursuant to an order of the district court, all the suits against GE were consolidated into one action, and all the suits against the Kidder defendants were consolidated into a separate action. The order of the district In October of 1994, the plaintiffs filed an amended complaint against GE. In their amended complaint, the plaintiffs alleged that they had purchased GE stock, or entered into put or call options for GE stock, between April 13, 1993 and April 17, 1994 (the "Class Period"), "based, inter alia, on materially false and misleading press releases and financial statements GE filed with the [SEC]." As stated in the complaint, "GE recorded hundreds of millions of dollars in profits throughout the Class Period it clearly knew or was wholly reckless in not knowing were manufactured out of thin air and that each quarter masked substantial trading losses totalling about $85 million in the aggregate." The plaintiffs alleged that "GE intentionally, knowingly or recklessly turned a blind eye to numerous 'red flags' ... alerting [GE] that the 'profits' Kidder appeared to be generating throughout the Class Period were fictive," in order "to justify its 1986 acquisition of Kidder." In addition, the plaintiffs alleged that "GE knowingly, intentionally or recklessly issued materially false and misleading statements regarding its financial controls system." Accordingly, the plaintiffs alleged that GE had engaged in securities fraud, in violation of section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and of Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder.
court also provided for discovery and the filing of an amended complaint in each action.
On December 20, 1994, GE moved to dismiss the amended complaint for failure to state a claim. In its Opinion and Order dated October 4, 1995, the district court granted the motion. 3 The district court found that the plaintiffs had failed to allege facts that established scienter on the part of GE. The court further stated that "[t]he mere fact that GE's financial reporting was inaccurate does not establish scienter." The court stated that the plaintiffs "fail to successfully allege that GE's reporting of [Kidder's false] earnings was the type of highly unreasonable or reckless activity that may give rise to actionable securities fraud." According to the court, "the red flags [noted by the plaintiffs] might have been warnings to Kidder's internal auditors or to any outside accountants, but that does not constitute intentional, knowing or reckless activity on GE's part." The court concluded that the plaintiffs
fail to allege strong circumstantial evidence of conscious misbehavior or recklessness by the defendant that would approximate intentional misconduct. Kidder had its own internal control mechanisms and GE had a right to rely on Kidder to monitor its own financial reporting. To so rely is not evidence of recklessness. It is evidence of mismanagement at most and mismanagement is not necessarily securities fraud.
The court also found that GE's alleged violations of Generally Accepted Accounting Principles ("GAAP") and SEC accounting regulations did not support a section 10(b) claim, because the plaintiffs failed to successfully allege fraudulent intent. Accordingly, the district court found that the plaintiffs failed to state a section 10(b) claim.
The court declined to grant the plaintiffs leave to replead the complaint. The court stated that it "does not believe that Plaintiffs could ever successfully replead the scienter element of a Section 10(b) claim and for that reason the Court will not permit Plaintiffs to replead their Complaint." This appeal followed.
In order to state a cause of action under section 10(b) and Rule 10b-5, "a plaintiff must plead that in connection with the purchase or sale of securities, the defendant, acting with scienter, made a false material representation or omitted to disclose material information and that plaintiff's reliance on defendant's action caused [plaintiff] injury." Acito v. IMCERA Group, Inc., 47 F.3d 47, 52 (2d Cir.1995) (alteration in original and quotation We review de novo the district court's dismissal of an action pursuant to Fed.R.Civ.P. 12(b)(6), and accept as true the facts alleged in the complaint. First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763, 765 (2d Cir.1994), cert. denied, 513 U.S. 1079, 115 S.Ct. 728, 130 L.Ed.2d 632 (1995); see Acito, 47 F.3d at 51. "Generally, we will uphold a district court's dismissal of a claim only if it appears that the plaintiff can prove no set of facts upon which relief may be granted." Acito, 47 F.3d at 51 (quotation omitted).
omitted). The plaintiffs argue that the district court erred in finding that they failed to allege facts...
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