Ezra Charitable Trust v. Tyco Intern., Ltd.

• Decision Date: 27 September 2006
• Docket Number: No. 05-2762.,05-2762.
• Citation: 466 F.3d 1
• Parties: EZRA CHARITABLE TRUST, Mirror Management, Ltd., Robert Bovit, Plaintiffs, Appellants, v. TYCO INTERNATIONAL, LTD., Edward D. Breen, David J. Fitzpatrick, PricewaterhouseCoopers, LLP., Defendants, Appellees.
• Court: U.S. Court of Appeals — First Circuit

466 F.3d 1

EZRA CHARITABLE TRUST, Mirror Management, Ltd., Robert Bovit, Plaintiffs, Appellants, v. TYCO INTERNATIONAL, LTD., Edward D. Breen, David J. Fitzpatrick, PricewaterhouseCoopers, LLP., Defendants, Appellees.

No. 05-2762.

United States Court of Appeals, First Circuit.

Heard June 7, 2006.

Decided September 27, 2006.

Kenneth J. Vianale, with whom Vianale & Vianale LLP, Biron L. Bedard and Cook & Molan, P.A. were on brief, for appellants.

Francis P. Barron, with whom Stephen S. Madsen, Cravath, Swaine & Moore LLP, Edward A. Haffer and Sheehan, Phinney, Bass & Green, were on brief for appellees, Tyco International LTD., Edward D. Breen and David J. Fitzpatrick.

Michael P. Carroll, with whom Michael S. Flynn, Davis Polk & Wardwell, Arnold Rosenblatt, Cook, Little, Rosenblatt & Manson, P.L.L.C., Christian M. Hoffman, Lisa C. Wood and Foley Hoag LLP were on brief, for appellee PricewaterhouseCoopers LLP.

Before SELYA, LIPEZ, and HOWARD, Circuit Judges.

HOWARD, Circuit Judge.

Plaintiffs Ezra Charitable Trust, Mirror Management, Ltd., and Robert Bovit brought this action pursuant to Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b) and 78t(a), against defendants Tyco International, Ltd., Edward R. Breen (Tyco's chief executive officer), David J. Fitzpatrick (Tyco's chief financial officer), and PricewaterhouseCoopers, LLP (Tyco's auditor)("PwC"). The district court dismissed the action as to all defendants on the ground that the amended class action complaint did not adequately allege scienter under the Private Securities Litigation Reform Act ("PSLRA"), 15 U.S.C. § 78u-4(b), and plaintiffs appealed. We affirm.

I.

We present the facts as set forth in the amended class action complaint and the SEC filings relied upon in the complaint. See Gross v. Summa Four, Inc., 93 F.3d 987, 991 & 994 n. 6 (1st Cir.1996).

The context of this action—viz., the travails of Tyco—is well-known. Plaintiffs recount at some length the reported abuses of Tyco's past officers and directors, notably chief executive officer Dennis Kozlowski, chief financial officer Mark Swartz, chief corporate counsel Mark Belnick, and director Frank Walsh. In 2002, as revelations of misconduct surfaced, there was a major shake up at Tyco. Tyco commissioned a massive internal investigation led by the law firm of Boies Schiller & Flexner, which was aided by various accounting firms. All told, over 15,000 attorney hours and 50,000 accountant hours were invested.¹ As a consequence, Tyco disclosed the alleged misconduct of its prior management and made necessary accounting adjustments. The changes were costly, as Tyco's Form 10-K report for fiscal 2002 showed a net loss of over nine billion dollars, a stark contrast from its nearly four billion dollars of profit in fiscal year 2001, and over four and a half billion dollars profit in fiscal year 2000. As part of Tyco's clean-up, new senior officers and directors were appointed. Breen was made the chief executive officer in July 2002, and Fitzpatrick was made the chief financial officer in September 2002.

Plaintiffs' action focuses on the initial results of the clean-up, spanning the period between December 30, 2002 and March 12, 2003.² Plaintiffs allege that the cleanup fell well short of sanitizing Tyco's books, and that new management perpetuated a fraud in the accounting for ADT, one of Tyco's largest subsidiaries.

Plaintiffs allege that ADT, a provider of security systems, purchased customer contracts from its authorized dealers and accounted for the transactions in the following improper manner. First, ADT would ostensibly agree to purchase a customer contract from a dealer for $1000. Second, the dealer would ostensibly agree to pay ADT $200 as reimbursement for ADT's expenses in connection with acquiring the contract (the "connection fee"). Third, ADT would remit the $800 net amount to the dealer (the only cash that changed hands), record the acquisition of the contract at the full price of $1000, and record a $200 expense offset (income). Significantly, ADT's actual expenses related to each contract were de minimis—$5 for a credit check—and ADT recorded the difference ($195) as income. Plaintiffs allege that this was "Alice in Wonderland" accounting because Generally Accepted Accounting Principles ("GAAP") require that intangible assets such as these contracts be recorded at their actual cost (here $805), and because no income is to be recognized under such circumstances. Thus, according to plaintiffs, these transactions permitted Tyco/ADT to fraudulently overstate ADT's income and assets.

Plaintiffs allege that the defendants made actionable misrepresentations in connection with these transactions. First, in its 12/30/02 Form 8-K filed with the SEC, Tyco's management disclosed the results of the internal investigation and stated that Tyco was "not aware of any systemic or significant fraud related to the Company's financial statements or of any clear accounting errors that would materially adversely affect the Company's reported earnings or cash flow from operations for the year 2003 and thereafter." The Form 8-K also purported to correct ADT's accounting, noting that to the extent the connection fee exceeded actual costs, it "should be deferred and amortized over the estimated useful life of an acquired customer relationship" (ten years). As a consequence, the Form 8-K reported that 2002 earnings would be reduced by $135 million, and that a $185.9 million charge to earnings would be taken to adjust income improperly recognized in fiscal years 1999 to 2001 (a $320.9 million adjustment in all). Tyco's Form 10-K, filed on 12/30/02, largely echoed the Form 8-K's representations. Notably, it stated that "new senior management has no reason to believe that the financial statements included in this report are not fairly stated in all material respects." As to ADT's contract acquisitions, the Form 10-K noted that fees received from dealers, in excess of actual costs incurred, would be amortized over ten years as a "deferred credit." The 10-K also included PwC's audit opinion, dated December 23, 2002, which stated:

In our opinion, the accompanying consolidated balance sheets and related consolidated statements of operations, of shareholders' equity and of cash flows present fairly, in all material respects, the financial position of Tyco International, Ltd. and its subsidiaries at September 30, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2002, in conformity with accounting principles generally accepted in the United States of America.... We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America....

Plaintiffs assert that these releases contained four fraudulent misstatements by the Tyco defendants: (1) that Tyco's accounting had been corrected; (2) that the financial statements fairly presented Tyco's status; (3) that all material accounting issues, particularly those involving ADT, had been corrected; and (4) that ADT would receive a $320.9 million revenue stream over the next ten years. Plaintiffs maintain that these representations were false because there were still major problems in ADT's books, notably that the income recognized from dealer "connection fees" to ADT was "imaginary," and that the contracts acquired were being recorded at an artificially inflated cost. Plaintiffs assert that the defendants corrected only a technical, inconsequential error—that the "imaginary" income was being recognized too quickly (immediately rather than over the life of the contract)— in their initial restatement, but knowingly permitted more significant errors—the improper recognition of income and the inflation of asset value—to remain unaltered. Plaintiffs also allege that PwC, knowing of the errors in ADT's books, nonetheless wrongfully issued a "clean" audit opinion.

Plaintiffs allege that the fraud was brought to light in March 2003, when Tyco essentially admitted the fraud in a press release and subsequent Form 10-Q. In a March 12, 2003 press release, Tyco stated that, pursuant to ongoing discussions with the SEC, it expected "to take non-cash, pre-tax charges between $265 million and $325 million for issues identified primarily in [ADT]." Tyco also announced that the president of ADT, Jerry Boggess, and other senior ADT managers, had been fired. Tyco stock dropped significantly on the news. Plaintiffs say that defendants acknowledged in their 3/31/03 Form 10-Q that they had been in ongoing discussions with the SEC about their accounting for the dealer fees and were changing their accounting for the non-refundable dealer charges to treat them properly as a reduction in ADT's costs in acquiring the contracts.³

Plaintiffs also allege that Tyco falsely attributed the March 2003 accounting corrections to a then-recently issued accounting requirement from the Financial Accounting Standards Board's Emerging Issues Task Force ("EITF")—EITF 02-16—which had nothing to do with the relevant accounting issue. Plaintiffs assert that the proper accounting principle is and was located in Accounting Research Bulletin ("ARB") 43, which has been in effect since 1953.

Plaintiffs also emphasize the actions of PwC's audit engagement partner for Tyco, Richard Scalzo. The SEC, in an Accounting and Auditing Enforcement Action dated August 13, 2003, barred Scalzo from practicing accounting before it based on its finding that Scalzo had violated Section 10(b) and Rule 10b-5 and committed improper professional conduct in connection with his audits of Tyco for fiscal years 1997-2001. See 2003 WL 21938985 (S.E.C. Release No.1839). Essentially, the SEC concluded that Scalzo was on notice of prior management's misconduct, failed to take the necessary steps required by Generally Accepted Auditing Standards ("GAAS"), and...