Cape Ann Investors LLC v. Lepone, CIV. 00-11531-RGS.

• Decision Date: 15 December 2003
• Docket Number: No. CIV. 00-11531-RGS.,CIV. 00-11531-RGS.
• Citation: 296 F.Supp.2d 4
• Parties: CAPE ANN INVESTORS LLC v. Donald E. LEPONE, Robert F. Burns, Noreen Gottfredsen and Deloitte & Touche LLP James R. Young, as Trustee of the Nutramax Litigation Trust v. Donald E. Lepone, Robert F. Burns, Noreen Gottfredsen, and Deloitte & Touche LLP
• Court: U.S. District Court — District of Massachusetts

296 F.Supp.2d 4

CAPE ANN INVESTORS LLC v. Donald E. LEPONE, Robert F. Burns, Noreen Gottfredsen and Deloitte & Touche LLP

James R. Young, as Trustee of the Nutramax Litigation Trust v. Donald E. Lepone, Robert F. Burns, Noreen Gottfredsen, and Deloitte & Touche LLP

No. CIV. 00-11531-RGS.

United States District Court, D. Massachusetts.

December 15, 2003.

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Thomas J. Dougherty, Skadden, Arps, Slate, Meagher & Flom LLP, Boston, MA, Ian D. Roffman, Boston, MA, for Deloitte & Touche, Defendant.

Reid M. Figel, Kevin B. Huff, Silvija A. Strikis, Kellogg, Huber, Hansen, Todd & Evans, Washington, DC, for James R. Young, Trustee.

Noreen Gottfredsen, Beverly, MA, for Noreen Gottfredsen, Defendant.

Mark C. Hansen, Kellogg, Huber, Hansen, Todd & Evans, Washington, DC, for Cape Ann Investors, Plaintiff.

Andrea J. Robinson, Jeffrey B. Rudman, Hale and Dorr, LLP, Boston, MA, for Donald E. Lepone, Noreen Gottfredsen, Robert F. Burns, Defendants.

MEMORANDUM AND ORDER ON DEFENDANT DELOITTE'S MOTION TO DISMISS THE SECOND AMENDED COMPLAINT

STEARNS, District Judge.

BACKGROUND¹

This case arose out of the bankruptcy of a once seemingly promising dietware company, NutraMax Products, Inc. (NutraMax). According to the Second Amended Complaint, the failure of NutraMax was caused by a massive internal accounting fraud, the uncovering of which precipitated the company's meltdown. Defendant Deloitte & Touche LLP (Deloitte), the outside accountant, gave NutraMax clean bills of audit health in 1996, 1997, and 1998, despite private warnings to NutraMax's Audit Committee of "reportable conditions" involving improper inventory valuation, understated expensing, and insufficient bad debt reserves. In the spring or summer of 1999, a newly installed Chief Operating Officer reported to NutraMax's Board of Directors that an internal investigation had revealed a $70 million discrepancy between NutraMax's claimed and actual assets. The Board promptly fired the senior officers of the company. A subsequent restatement of earnings imploded NutraMax's balance sheet from a positive $21 million to a negative $46 million.

As day follows dawn, Deloitte and the ousted officers fell into the cross hairs of litigation. Suit was initially brought by Cape Ann Investors LLC (Cape Ann), an investors' syndicate whose substantial equity position in NutraMax had been rewarded with a seat on the Board of Directors and the Audit Committee. Shortly after the suit was filed, NutraMax sought Chapter 11 bankruptcy protection. Cape Ann then assigned its claims to the NutraMax Litigation Trust (Trust), an entity created by the Bankruptcy Court to pursue any potentially recoverable assets.

On March 9, 2001, James R. Young, the Trustee, filed an Amended Complaint against Deloitte,² alleging federal securities law violations and state law claims of fraud, misrepresentation, malpractice, and violations of the Massachusetts Consumer Protection Act. The Amended Complaint consolidated all pre-petition claims against Deloitte. These fell into three classes: (1) the claims of NutraMax itself; (2) the claims of NutraMax's senior secured lenders (the Creditors); and (3) the claims of Cape Ann and various other unnamed NutraMax shareholders who had "purchased or otherwise acquired NutraMax common stock when its price was artificially inflated by [Deloitte's] false statements ..., as well as those ... who were induced to maintain their investment in NutraMax common stock by [Deloitte's] false statements" (the Electing Shareholders). Second Amended Complaint, ¶ 15. The claims of all class members were assigned to the Trust for the sole benefit of the Electing Shareholders.

On October 31, 2001, this court dismissed the federal claims as timed-barred. See Cape Ann Investors LLC v. Lepone, 171 F.Supp.2d 22 (D.Mass.2001). The court reasoned that Cape Ann, as a member of NutraMax's Audit Committee, was on notice as of November 28, 1997 (when Deloitte submitted the second management letter disclosing "reportable conditions"), of an impending injury and had failed to undertake a diligent investigation. "[H]ad Cape Ann done what its fiduciary duty required it to do, it would have discovered the fraud, if not in 1997, certainly by 1998, when Deloitte sounded the third alarm." Id. at 27. Consequently, the court ruled that Cape Ann's federal claims (which were brought on August 1, 2000) were barred by Rule 10b-5, which requires that an action be brought within one year after a plaintiff discovers the facts constituting a violation, or in the case of fraudulent concealment, within one year of the time when the plaintiff, in the exercise of reasonable diligence, should have discovered the fraud. The court further ruled that the federal claims of the "new plaintiffs" ( the Creditors and the Electing Shareholders) were wholly separate from those asserted by Cape Ann and therefore did not under Fed.R.Civ.P. 15(c)(3), relate back to the filing date of Cape Ann's original complaint. Thus, the court ruled that these claims (filed on March 9, 2001) were also barred by the Rule 10(b)-5 statute of limitations.³ Finally, the court declined to exercise supplemental jurisdiction over the Trust's state law claims.

The Trust then appealed. On September 10, 2002, the First Circuit affirmed in part and reversed in part. The Court of Appeals agreed with the district court's analysis of the relation-back issue and affirmed the ruling that the federal claims of the "new plaintiffs" were time-barred. Young, 305 F.3d at 17. On the other hand, while acknowledging it a "close case on the facts," the Court ruled that "we do not think that a court could conclude, on the bare bones of the amended complaint, either that the management letters amounted to storm warnings or that those communications inexorably placed Cape Ann on inquiry notice. By like token, it cannot be said, as a matter of law, that Cape Ann failed to exercise diligence commensurate with its knowledge." Id. at 12. Consequently, the Court of Appeals vacated the dismissal as to Cape Ann and remanded that aspect of the case to the district court for further proceedings.

Prior to the First Circuit's decision, in response to the district court's declination of supplemental jurisdiction, the Trustee filed a complaint in the Massachusetts Superior Court (the State Law Complaint). Deloitte promptly removed the State Law Complaint to the federal district court and moved to dismiss, arguing that the State Law claims as plead were preempted by the Securities Litigation Uniform Standards Act (SLUSA), 15 U.S.C. § 78bb. The Trustee, with similar alacrity, moved to remand, a motion which the court denied without prejudice. It then stayed proceedings pending the decision by the Court of Appeals. On June 13, 2003, after that decision had issued, the Trustee moved to dismiss the Amended Complaint's federal cause of action and renewed the motion to remand the State Law Complaint. The court allowed the motion to amend, which left pending in the district court two essentially identical complaints. The court then indicated that it would address Deloitte's preemption argument in the context of the Trustee's renewed motion to remand, and it does so now.

DISCUSSION AND RULINGS OF LAW

1. SLUSA provides that:

No covered class action based upon the statutory or common law of any State or subdivision thereof may be maintained in any State or Federal court by any private party alleging —

(A) a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security; or

(B) that the defendant used or employed any manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security.

15 U.S.C. § 78bb(f)(1). SLUSA preemption requires a showing of four elements: (1) a "covered class action;" (2) based on state law; (3) involving a "covered security;" and (4) an allegation that the defendant misrepresented or failed to disclose a material fact "in connection with the purchase or sale of such security." Riley v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 292 F.3d 1334, 1342 (11th Cir.2002).

2. The Amended Complaint insofar as the Electing Shareholders are concerned describes a covered class action. SLUSA preempts "any single lawsuit in which damages are sought on behalf of more than 50 persons or prospective class members...." 15 U.S.C. § 78bb(f)(5)(B). Deloitte asserts that the Trustee seeks damages on behalf of more than 50 persons "on information and belief." The Trustee, while not disclosing the precise number of Electing Shareholders that he represents, does not dispute the assertion, and I therefore conclude that the first element of SLUSA is satisfied.

3. The Trust is not, as the Trustee contends, "one person" within the meaning of SLUSA. The Act defines a unitary entity as one "not established for the purpose of participating in the action." 15 U.S.C. § 78bb(f)(5)(D). The Trust Agreement describes the primary purpose of the Trust as "prosecuting the Causes of Action contributed to it ... and distributing to the Class 6 Beneficiaries [the Electing Shareholders] the assets of the Trust remaining after payment of all claims against or assumed by the Trust." Litigation Trust Agreement § 3.1. The Trustee's argument that the Trust is a unitary entity because it was created not to pursue any particular action, but all "such actions as necessary to recover on behalf of beneficiaries," makes no sense conceptually or legally. Id. § 1.1.⁴ Nor does the fact that the Trustee is empowered to exercise discretionary powers not normally associated with a Rule 23 class representative make any material difference under SLUSA.⁵ The Trustee's fiduciary duty is to use whatever powers he has been granted for the benefit of the Electing Shareholders. In that respect, his role is no different than that of any shareholder class representative. Finally, the...