Fidel v. Farley, 02-6143.

• Decision Date: 16 December 2004
• Docket Number: No. 02-6143.,02-6143.
• Parties: Bernard FIDEL; Reich & Tang Asset Management L.P.; Stanley J. Mical; Lutgarda C. Mical; Yitz Grossman/Yitz Grossman Charitable Trust; and Arnold H. Simon, on behalf of themselves and all others similarly situated, Plaintiffs-Appellants, Tom Maiden, on behalf of himself and all others similarly situated, et al., Plaintiffs, v. William FARLEY; G. William Newton, Defendants, Ernst & Young L.P., Defendant-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 220

392 F.3d 220

Bernard FIDEL; Reich & Tang Asset Management L.P.; Stanley J. Mical; Lutgarda C. Mical; Yitz Grossman/Yitz Grossman Charitable Trust; and Arnold H. Simon, on behalf of themselves and all others similarly situated, Plaintiffs-Appellants Tom Maiden, on behalf of himself and all others similarly situated, et al., Plaintiffs, v. William FARLEY; G. William Newton, Defendants Ernst & Young L.P., Defendant-Appellee.

No. 02-6143.

United States Court of Appeals, Sixth Circuit.

Argued: April 21, 2004.

Decided and Filed: December 16, 2004.

COPYRIGHT MATERIAL OMITTED

ARGUED: Eric A. Isaacson, Lerach, Coughlin, Stoia, Geller, Rudman & Robbins, San Diego, California, for Appellants. Stanley J. Parzen, Mayer, Brown, Rowe & Maw, Chicago, Illinois, for Appellees. ON BRIEF: Eric A. Isaacson, Joseph D. Daley, Lerach, Coughlin, Stoia, Geller, Rudman & Robbins, San Diego, California, Ronald R. Parry, Parry, Deering, Futscher & Sparks, Covington, Kentucky, for Appellants. Stanley J. Parzen, Bradley J. Andreozzi, Mayer, Brown, Rowe & Maw, Chicago, Illinois, Lora S. Morris, Muse & Morris, Louisville, Kentucky, for Appellees.

Before: SUHRHEINRICH and GIBBONS, Circuit Judges; LAWSON, District Judge.^*

OPINION

GIBBONS, Circuit Judge.

Plaintiffs-appellants, a class consisting of investors who purchased Fruit of the Loom stock between September 29, 1998, and November 4, 1999 ("Class Period"), filed suit against defendants William Farley, Fruit of the Loom's Chairman, Chief Executive Officer, and Chief Operating Officer; G. William Newton, Fruit of the Loom's Senior Vice President of Finance and Chief Financial Officer; and defendant-appellee Ernst & Young, Fruit of the Loom's auditor, under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j, and Securities and Exchange Commission Rule 10b-5, 17 C.F.R. § 240.10b-5. The plaintiffs alleged in their original complaint that Farley and Newton had knowingly or recklessly misrepresented Fruit of the Loom's condition during the Class Period in a successful effort to artificially inflate the price of the company's stock. They also alleged that Ernst & Young participated in the fraud by knowingly or recklessly issuing an unqualified audit opinion approving Fruit of the Loom's 1998 financial statements and by consenting to that audit opinion's inclusion in investor solicitation materials for a $250 million securities offering.

All three defendants filed motions to dismiss under Federal Rule of Civil Procedure 12(b)(6). The district court denied Farley's and Newton's motions, holding that the plaintiffs had satisfactorily alleged that the two Fruit of the Loom officers had acted knowingly or recklessly (i.e., with scienter) when they made public statements about Fruit of the Loom and its financial condition during the Class Period that did not accurately reflect the company's condition. The district court granted Ernst & Young's motion to dismiss because the plaintiffs failed to adequately plead scienter.

Subsequently, the district court granted leave to amend the complaint. After the plaintiffs filed an amended complaint, Ernst & Young moved to dismiss it with prejudice. The district court granted its motion to dismiss and a motion for entry of final judgment under Federal Rule of Civil Procedure 54(b).

In their appeal to this court, the class members contend that the district court erred in dismissing their complaint because the complaint sufficiently alleges a claim against Ernst & Young under Section 10(b) of the Securities Exchange Act and Rule 10b-5. Alternatively, the class members argue that the district court improperly denied their request to further amend the complaint. For the following reasons, we affirm the judgment of the district court.

I.

Fruit of the Loom, a clothing manufacturer, experienced financial difficulties in the mid-1990s. The company undertook a major restructuring effort beginning in 1995 by outsourcing almost all of its sewing and manufacturing operations from the United States to "maquiladora" plants in the Caribbean and South America. At the same time, it began upgrading its management information, inventory, and production control systems with the consulting assistance of Ernst & Young. The restructuring and systems changes led to significant quality control and inventory management problems. Fruit of the Loom suffered losses of almost $500 million dollars in 1997, and its stock fell from $38 a share in December 1996 to $23 a share in December 1997.

By 1998, it appeared that Fruit of the Loom's financial position was improving. Its stock was selling at over $30 a share in August 1998. The company reported revenues of $1.678 billion, net income of $146.9 million, and earnings per share of $2.04 for the nine months ending September 1998. In addition to reporting these figures, Fruit of the Loom told investors that its inventory and production problems were resolved.

During this same period, Fruit of the Loom announced that it planned to reorganize as a corporation in the Cayman Islands, a move that would lower its corporate tax rate. In order to accomplish the reorganization, however, Fruit of the Loom needed to redeem $250 million in senior notes that were due in October 1999, but would have their maturity accelerated by the reorganization in the Cayman Islands. Fruit of the Loom did not have the money to repurchase or pay off these notes. It would later participate in a May 1999 securities offering in order to raise the funds necessary to move forward with the reorganization.

Fruit of the Loom's stock fell sharply in September 1998. Although trading at over $30 a share in August 1998, the stock fell to just under $14 a share in late September. Investors voiced concern that Fruit of the Loom was accumulating excess inventories that would hurt future profits.

To address these concerns, Fruit of the Loom told investors that it would materially reduce levels of finished goods and raw materials inventory by slowing production for a few days at its plants. Fruit of the Loom attributed losses suffered during the fourth quarter of 1998 to this downturn in production, but told investors that the inventory reduction would have a long-term favorable impact. The company predicted significant revenue and earnings growth during 1999.

By January 1999, Fruit of the Loom's stock increased to $19 a share. The company forecast continued financial recovery in the following months. William Farley, Fruit of the Loom's Chairman and Chief Executive Officer, told investors that the restructuring, started a few years prior, was essentially complete and that the company was making progress towards an "acceleration of profitable growth." Fruit of the Loom also forecast earnings per share of over $2.00 in 1999 and $2.30 in 2000.

On February 16, 1999, Ernst & Young issued a report to Fruit of the Loom's Board of Directors based on its audit of the company's financial statements. It stated in pertinent part the following:

We have audited the accompanying consolidated balance sheet of Fruit of the Loom, Inc. and Subsidiaries as of January 2, 1999 and December 31, 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended January 2, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

...

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Fruit of the Loom, Inc. and Subsidiaries at January 2, 1999 and December 31, 1997, and the consolidated results of their operations and cash flows for each of the three years in the period ended January 2, 1999, in conformity with generally accepted accounting principles.

Ernst & Young subsequently issued an unqualified audit report as to Fruit's 1998 financial statements.

In March 1999, Fruit of the Loom privately placed $250 million of new notes with investors. The private placement was designed to raise the money necessary to proceed with the Cayman Islands reorganization. In May 1999, Fruit of the Loom exchanged the privately placed notes with freely tradeable notes registered with the Securities and Exchange Commission. As part of the issuance of the freely tradeable notes, Fruit of the Loom filed a registration statement. Ernst & Young consented to the incorporation by reference of its audit report reviewing 1998 financial data in the registration statement. It stated in a letter that:

We consent to the reference to our firm under the caption "Experts" in the Registration Statement (Form S-4) and related Prospectus of Fruit of the Loom, Inc. relating to the exchange offer of $250,000,000 8 7/8% Senior Notes due 2006 and to the use of the report dated February 16, 1999, except for "Subsequent Events" note, as to which the date is March 25, 1999, with respect to the consolidated financial statements of Fruit of the Loom, Inc. and to the use of our report dated May 21, 1999 with respect to the balance sheet of Fruit of the Loom, Ltd.

We also consent to the incorporation by reference therein of our report dated February 16, 1999, except for "Subsequent Events" note, as to which the date is March 25, 1999 with respect to the consolidated financial statements and schedule of Fruit of the Loom, Inc. included in its Annual Report (Form 10-K) for the year ended January 2, 1999, filed with the Securities and Exchange Commission.

The registration statement incorporating Ernst & Young's audit report dated February 16, 1999 was issued on May 25, 1999.

Fruit of the Loom experienced disappointing financial results throughout 1999. For first quarter 1999, the company reported that sales were $408 million, down $49 million from first quarter 1998. As a result, the stock suffered a loss of $0.13...