N.M. State Inv. Council v. Llp

• Citation: 641 F.3d 1089
• Decision Date: 14 April 2011
• Docket Number: No. 09–55632.,09–55632.
• Court: United States Courts of Appeals. United States Court of Appeals (9th Circuit)
• Parties: NEW MEXICO STATE INVESTMENT COUNCIL, Lead Plaintiff, Plaintiff–Appellant,andSonam Bakshi, individually and on behalf of all others similarly situated; Bakers Local No. 433 Pension Fund; Minnesota Bakers Union Pension Fund; Twin Cities Bakery Drivers Pension Fund, Plaintiffs,v.ERNST & YOUNG LLP, Defendant–Appellee,andHenry Samueli; William J. Ruehle; Broadcom Corporation; David A. Dull; Alan E. Ross; Werner F. Wolfen; George L. Farinsky, Defendants.

641 F.3d 1089

11 Cal. Daily Op. Serv. 4415

2011 Daily Journal D.A.R. 5352

NEW MEXICO STATE INVESTMENT COUNCIL, Lead Plaintiff, Plaintiff–Appellant,andSonam Bakshi, individually and on behalf of all others similarly situated; Bakers Local No. 433 Pension Fund; Minnesota Bakers Union Pension Fund; Twin Cities Bakery Drivers Pension Fund, Plaintiffs,

v.ERNST & YOUNG LLP, Defendant–Appellee,andHenry Samueli; William J. Ruehle; Broadcom Corporation; David A. Dull; Alan E. Ross; Werner F. Wolfen; George L. Farinsky, Defendants.

No. 09–55632.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted Nov. 1, 2010.Filed April 14, 2011.

Thomas A. Dubbs (argued), Joseph A. Fonti, and Stephen W. Tountas, Labaton Sucharow LLP, New York, NY, for lead plaintiff-appellant New Mexico State Investment Council.

Robert B. Hubbel (argued), Michael M. Farhang, and Alexander K. Mircheff, Gibson, Dunn & Crutcher LLP, Los Angeles, CA, for defendant-appellee Ernst & Young, LLP.Appeal from the United States District Court for the Central District of California, Manuel L. Real, District Judge, Presiding. D.C. No. 2:06–CV–05036–R–CW.Before: JOHNNIE B. RAWLINSON and ALFRED T. GOODWIN, Circuit Judges, and JACK ZOUHARY, District Judge.^*

OPINION

ZOUHARY, District Judge:

Introduction

Lead Plaintiff New Mexico State Investment Council, individually and on behalf of all others similarly situated (“Plaintiffs”), appeals the district court's grant of Defendant Ernst & Young's (“EY”) Motion to Dismiss. The claims against EY stem from a securities class action complaint against Broadcom Corporation (“Broadcom”), certain Broadcom officers and directors, and Broadcom's auditor EY (collectively, “Defendants”), for a fraudulent $2.2 billion stock options backdating scheme. Plaintiffs specifically allege that EY, as Broadcom's auditor, knew of, or recklessly disregarded, Broadcom's fraudulent backdating actions yet issued unqualified audit opinions attesting to the validity of Broadcom's financial statements. The district court granted EY's Motion to Dismiss, finding the Consolidated Amended Class Action Complaint (“Complaint”) failed to adequately plead scienter against EY.

Plaintiffs contend on appeal that the Complaint contains well-pled factual allegations sufficient to survive a motion to dismiss. EY argues dismissal was proper and, in the alternative, the district court's judgment should be affirmed based on Plaintiffs' failure to sufficiently plead loss causation, a ground the district court explicitly did not reach.¹

Procedural History and Background

Procedural History

This case finds its roots in a large accounting fraud related to stock option backdating. Broadcom, a semiconductor company with revenues in excess of $2.5 billion in 2006, fraudulently overstated its net earnings, and understated its compensation expense, by more than $2.2 billion between 2000 and 2006 due to improper accounting of backdated stock options.

In October 2008, Plaintiffs filed a Consolidated Amended Class Action Complaint on behalf of all persons who purchased Broadcom Class A common stock between July 21, 2005 and July 13, 2006. The Complaint seeks damages under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Securities Exchange Commission Rule 10b–5 for Defendants' fraudulent accounting practices, alleging they caused Broadcom's stock price to be artificially inflated.

Defendants moved to dismiss. The district court heard oral argument in February 2009 and granted Defendant EY's Motion to Dismiss, stating: “I think the allegations are deficient on actual knowledge of the defendant ..., and I think there's a little bit of a heavier burden of allegations on accountants on the question of scienter.” “Plaintiff has failed adequately to plead scienter as against EY[.]”

The Complaint

The lengthy Complaint includes nearly thirty-five pages of allegations that EY, as Broadcom's auditor, was complicit in a stock option backdating scheme involving options to purchase over 239 million shares of Broadcom stock between 1998 and 2005. Broadcom used stock options as part of a compensation package for officers, directors, and key employees. The recipient of the option was given the opportunity to purchase a certain number of shares of company stock at a given price on or after a predetermined date.² Broadcom's option plan provided for a vesting schedule of four years, meaning an employee could only exercise his or her option over a four-year period.

Backdating of options is akin to betting on a horse race after the horse has already crossed the finish line. Backdating of options occurs when a company's officers or directors responsible for administering the stock option plan monitor the price of the company stock and then award a stock option grant as of a certain date in the past when the share price was lowest, thus locking in the largest possible gain for the option recipient.

A backdated option is not in and of itself improper under the law or accounting principles. See Edward J. Goodman Life Income Trust v. Jabil Circuit, Inc., 594 F.3d 783, 788 (11th Cir.2010). However, when a company chooses to issue such “in the money” options (so called because the options represent an immediate paper profit), accounting principles require the company to record an expense for the “profit,” treated as compensation to the option recipient over the vesting period. If the company does not properly record the back-dated options, then the company's reported net income is overstated for each of the years the options vest, potentially deceiving the market and investors.

The Restatement and EY Opinion

Broadcom engaged in an improper stock option backdating scheme that required the company to restate its financial statements in January 2007 for fiscal years 1998 to 2005 (the “Restatement”). The Restatement acknowledged that Broadcom had improperly accounted for $2.2 billion in income, largely due to improper option backdating. Additionally, every financial statement, and quarterly and annual report issued during the time period covered by the Restatement, was false and misleading. As a result, Broadcom agreed to a civil penalty of $12 million in connection with a SEC civil securities fraud investigation, and various Broadcom officers and directors face civil and criminal charges.

The crux of Plaintiffs' claim is that EY, in its role of auditor issuing the unqualified 2005 Opinion, knew of, or was deliberately reckless in not knowing, that the 2005 Opinion was materially false and misleading due to Broadcom's stock option backdating scheme. The 2005 Opinion covered three years of Broadcom's financial statements (2003–05), stating that the financial statements “present fairly, in all material respects, the consolidated financial position of Broadcom Corporation at December 31, 2005 and 2004, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with generally accepted accounting principles [ (“GAAP”) ].” The 2005 Opinion also stated that EY had performed the audit in accordance with generally accepted auditing standards (“GAAS”).

Allegations Against EY

Plaintiffs' allegations that EY had the required scienter for a fraud claim, namely that EY knew, or was deliberately reckless in not knowing, about the fraudulent option backdating, are as follows:

• EY knew the material consequences of a May 2000 backdated option grant that would have resulted in a $700 million charge to Broadcom's financial results but, despite violations of GAAS, signed off on the grant without obtaining documentation;

• EY knew that several significant option grants were approved on dates when Broadcom's compensation committee was not legally constituted due to the death of one of the two committee members;

• EY presided over corrective reforms in 2003 to prevent and detect any future instances of improper stock option awards without questioning the integrity of Broadcom's accounting for options granted prior to the corrective reforms;

• EY knew that there was insufficient documentation for nearly half of the $2.2 billion in backdated option grants in violation of GAAS;

• EY knew that Broadcom's internal controls were weak and failed to expand the scope of its audit procedures as required under GAAS; and

• EY was deliberately reckless in ignoring a number of “red flags” that should have alerted them to the potential for material misstatements related to stock-based compensation.

The Complaint includes additional details with respect to each of the above allegations, and Plaintiffs argue that these detailed allegations, both individually and collectively, support a strong inference that EY had the necessary scienter to survive a Motion to Dismiss.

Standard of Review

We review de novo challenges to a dismissal for failure to state a claim under Federal Civil Rule 12(b)(6). Livid Holdings, Ltd., 416 F.3d at 946. Such review is generally limited to the face of the complaint, materials incorporated into the complaint by reference, and matters of judicial notice. Metzler Inv. GMBH v. Corinthian Colls., Inc., 540 F.3d 1049, 1061 (9th Cir.2008) (citing Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322, 127 S.Ct. 2499, 168 L.Ed.2d 179 (2007)). In undertaking this review, we will “accept the plaintiffs' allegations as true and construe them in the light most favorable to plaintiffs,” Gompper v. VISX, Inc., 298 F.3d 893, 895 (9th Cir.2002), and will hold a dismissal inappropriate unless the complaint fails to “state a claim to relief that is plausible on its face,” Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570, 127 S.Ct. 1955, 167 L.Ed.2d 929 (2007).

Allegations of Scienter

To adequately plead scienter, a securities fraud complaint must “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” 15 U.S.C. § 78u–4(b)(...