Greebel v. FTP Software Inc., No. 98-2194

• Court: United States Courts of Appeals. United States Court of Appeals (1st Circuit)
• Writing for the Court: LYNCH
• Citation: 194 F.3d 185
• Parties: (1st Cir. 1999) LAWRENCE M. GREEBEL, RICHARD CRANE, BRIAN D. ROBINSON, and JOHN and ANN SOMERS on behalf of themselves and all others similarly situated, Appellants, v. FTP SOFTWARE, INC.; ROBERT W. GOODNOW, Jr.; PENNY C. LEAVY; DOUGLAS F. FLOOD; JONATHAN RODIN; CHARLOTTE H. EVANS; and DAVID H. ZIRKLE, Appellees. Heard
• Docket Number: No. 98-2194
• Decision Date: 09 June 1999

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194 F.3d 185 (1st Cir. 1999) LAWRENCE M. GREEBEL, RICHARD CRANE, BRIAN D. ROBINSON, and JOHN and ANN SOMERS on behalf of themselves and all others similarly situated, Appellants,
v.
FTP SOFTWARE, INC.; ROBERT W. GOODNOW, Jr.; PENNY C. LEAVY; DOUGLAS F. FLOOD; JONATHAN RODIN; CHARLOTTE H. EVANS; and DAVID H. ZIRKLE, Appellees. No. 98-2194 United States Court of Appeals for the First Circuit Heard June 9, 1999.
Decided Oct. 8, 1999.

APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF MASSACHUSETTS

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Copyrighted Material Omitted

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Stephen Moulton, with whom Nancy Freeman Gans and Moulton & Gans, LLP, and Sanford P. Dumain, with whom Samuel H. Rudman and Milberg Weiss Bershad Hynes & Lerach LLP, were on brief, for appellants.

Bruce G. Vanyo, with whom Jerome F. Birn, Jr., Rebecca A. Mitchells, and Wilson

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Sonsini Goodrich & Rosati, were on brief for appellee FTP Software, Inc.

Jeffrey B. Rudman, with whom Peter J. Macdonald and Hale and Dorr LLP, were on brief, for individual appellees.

Harvey J. Goldschmid, General Counsel, Jacob H. Stillman, Solicitor, Eric Summergrad, Deputy Solicitor, and Luis de la Torre, Attorney, on brief for amicus curiae Securities and Exchange Commission.

Before Torruella, Chief Judge, Noonan^* and Lynch, Circuit Judges.

LYNCH, Circuit Judge.

This case requires us for the first time to interpret the provisions of the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u-4. Plaintiffs, purchasers of FTP Software stock from July 14, 1995 to January 3, 1996, brought suit under sections 10(b) and 20(a) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b), 78t(a). During the period of plaintiffs' purchases, the stock reached a high of $38.875 per share. On January 4, 1996, the company announced that sales growth had declined and that it would have lower earnings. That same day, the stock price fell 52% on heavy trading, from $25.25 to $11.875 per share. By August 9, 1996, the stock price was $8 per share. Plaintiffs' suit was filed on March 3, 1996. It was dismissed on September 24, 1998. See Greebel v. FTP Software, Inc., 182 F.R.D. 370, 376 (D. Mass. 1998).

We affirm the dismissal of the complaint under the standards we now adopt:

1. The PSLRA imposes requirements for pleading with particularity that are consistent with this circuit's prior rigorous requirements for pleading fraud with particularity under Fed. R. Civ. P. 9(b).

2. The PSLRA mandates neither the adoption nor the rejection of particular patterns of evidence to prove fraud and scienter, and thus does not alter this circuit's prior law on these points.

3. The PSLRA does, significantly, impose a requirement that pleadings raise a "strong" inference of scienter rather than a merely "reasonable" inference of scienter.

4. The PSLRA does not alter the previous definition of scienter, one that in this circuit includes a narrowly defined concept of recklessness which does not include ordinary negligence, but is closer to being a lesser form of intent.

I.

The district court denied defendants' first motion to dismiss largely on the basis of the complaint's allegations that defendants had routinely "whited out" the contingency terms inserted by customers into purchase orders; this was allegedly done in furtherance of a scheme to inflate revenues by improperly booking contingent transactions as final sales. After limited discovery, the district court concluded that plaintiffs could not prove the white-out claims and entered judgment on those claims. The defendants renewed their motion to dismiss the complaint,² and the plaintiffs, in response, sought to make their allegations of fraud more specific by referring to discovered documents, but did not formally move to amend. The district court dismissed the complaint with prejudice, thus effectively denying the plaintiffs an opportunity to amend their complaint. The court did so without deciding whether, in light of the new evidence and allegations, the complaint was adequate to survive.

Plaintiffs appeal saying that summary judgment on the white-out allegations was inappropriate; that they are given refuge by Rule 56(f); that the dismissal of the remaining allegations was improper; and

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that they were entitled to amend their complaint.

II

The complaint alleges the following. FTP Software, Inc. develops, markets, and supports Internet and Intranet software for personal computers and networks. By the beginning of the Class Period³ (from July 14, 1995 to January 3, 1996), the demand for FTP's software was diminishing because many of FTP's clients were either developing the technology themselves or acquiring competing systems from other manufacturers, such as Microsoft and Netscape. Microsoft, for example, was incorporating networking capabilities into its new Windows 95 software, free of additional charge. In addition, FTP was struggling to keep pace with "revolutionary" technological developments that threatened to render its software obsolete. In response, FTP and several of its directors and officers⁴ through fraudulent schemes inflated FTP's stock price and then made various false statements and material omissions.

Plaintiffs allege that FTP failed to disclose the threats to its continued success, as well as several "questionable" sales practices. These included the making of "warehouse shipments" -- that is, booking a fictitious sale of a product to a non-existent buyer, shipping that product to a warehouse for storage, and then eventually returning it to FTP. According to plaintiffs, one FTP employee who complained about these shipments, and who refused (in at least one instance) to sign for the product return, was dismissed as a result of his protest, all before the Class Period. Other objectionable sales practices included excessively discounted sales (as high as 90%) and "channel stuffing" activity that compressed sales and orders into the final weeks of a fiscal quarter, with the intention of "cosmetically" improving the reported results for that quarter. Finally, plaintiffs say that FTP failed to disclose its practice of inducing distributors to purchase more product than they needed by promising that the distributors could return the unsold product. Distributors would send their orders to FTP with a notation that they were entitled to return any unsold product. FTP then booked these sales as revenue, but because FTP understood that recognizing such sales as revenue was improper (because of a right of return existed), it allegedly instructed the sales force to white-out these right-of-return notations on the distributors' order forms.

FTP also made several statements that the plaintiffs characterize as false or materially misleading. On July 14, 1995, the first day of the Class Period, David Zirkle, FTP's President and Chief Executive Officer, reported FTP's financial performance results for the second fiscal quarter of 1995. Zirkle declared: "We are pleased with our performance for the second quarter. Sales continue to be strong in both our U.S. and international channels." Zirkle also touted the release of several new products, stating that "[t]hese products should help us achieve our revenue objective for the second half of 1995." Plaintiffs argue that these comments "falsely convey[ed] the impression that sales were, and would continue to be, healthy and strong" and that this false impression was deliberately aided by FTP's failure to disclose that in or around January 1995, the French Post Office canceled its planned purchase of $10 million of FTP products "due to the impending release of 'Windows '95.'"

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On the same day, Zirkle discussed FTP's impending corporate "reconfiguration" into two business units. He predicted that "FTP Software [would] lead the market in providing applications and support that make it possible to share information and access resources across workgroups, LAN's, enterprise networks and the global Internet." After this announcement, FTP's stock fell from $31.75 to $28.25. Zirkle dismissed this decline as merely "a 'knee-jerk' reaction to the short-term impact of the restructuring on earnings," and on the next trading day, the stock recovered, closing at $30.875. Plaintiffs argue that these comments were misleading because Zirkle did not disclose that FTP's costly investments in its reorganization would have to be continued over the long term.

FTP's management team next met with "the investment community and with securities analysts" to promote the company's products and stock. One securities firm rated FTP as a "long-term buy." Plaintiffs assert that this report "and the estimates contained therein were based upon communications with the management of FTP and were of a nature that could only have been provided (or be based on specific information provided) by [FTP] and its management."

Meanwhile, several of the individual defendants sold some of their FTP stock. In total, the six individual defendants sold over $23 million in stock during the Class Period.

Zirkle made another false statement, plaintiffs say, on October 25, 1995, when he reported FTP's financial results for the third quarter of fiscal year 1995:

This was another excellent quarter for FTP. Sales continue to grow both in our U.S. and international channels . . . . Our new ventures are also off to a good start with revenues of $2.7 million. . . . These new products have been well received by our channel partners and customers and will help us in our efforts to achieve fourth quarter revenue objectives.

Plaintiffs assert that the "new ventures" Zirkle referred to were failing to generate the expected new business.

On November 15, 1995, FTP filed its Form 10-Q report for the third quarter of 1995 with the SEC. The report revealed a dramatic increase in accounts receivable for the fiscal year ending on December 31, 1994. FTP explained that:

Such an increase is primarily...