Hollin v. Scholastic Corp.
| Decision Date | 01 August 2000 |
| Docket Number | RICHARD,DEFENDANTS-APPELLEE,Docket No. 00-7517 |
| Citation | 252 F.3d 63 |
| Parties | (2nd Cir. 2001) IN RE: SCHOLASTIC CORPORATION SECURITIES LITIGATION LAWRENCE B. HOLLIN, INDIVIDUALLY AND ON BEHALF OF ALL OTHERS SIMILARLY SITUATED, PLAINTIFF, RICHARD TRUNCELLITO AND THE CITY OF PHILADELPHIA, APPELLANTS, v. SCHOLASTIC CORPORATION AND RAYMOND MARCHUK,ROBINSON, DEFENDANT |
| Court | U.S. Court of Appeals — Second Circuit |
Jeffrey A. Klafter, New York, New York (Bernstein Litowitz Berger & Grossmann, LLP, New York, New York; Stephen A. Whinston, Douglas M. Risen, Berger & Montague, P.C., Philadelphia, Pennsylvania, of counsel), for Appellants.
Michael J. Chepiga, New York, New York (Felecia L. Stern, Michael A. Berg, Simpson Thacher & Bartlett, New York, New York, of counsel), for Defendants-Appellees.
Before: Cardamone, Calabresi, Circuit Judges, and HAIGHT*, District Judge.
On this appeal we construe a complaint in a securities fraud case brought by stockholders against a book publisher and one of its officers. It is the book publisher's practice to count as income the proceeds of any book it sells to a retailer or distributor, while at the same time granting to such buyers a full right of return. The number of returns is therefore critical to profitability in the publishing business because when returns occur the publisher not only has unsold inventory back on its hands, but, also, income it has previously declared never materializes.
Plaintiffs allege that during the class period defendants knew returns had increased significantly, and that this negative corporate development later precipitated a large loss and a steep plunge in the company's publicly traded stock. The company is said to track book returns on a monthly and weekly basis, and to have daily information available to it from other sources as well. But despite such data establishing an adverse trend, the company announced publicly that its return rates were running at normal levels.
Defendants maintain, in effect, that there are no allegations in the complaint that would support proofs of either false statements or a fraudulent intent. To the contrary, we think plaintiffs sufficiently allege an unusual business model which, if proven, ignored alarmingly high returns that function as an obvious straw to show which way the wind was blowing in this book business. They may also be able to prove that the defendant officer, represented to stock analysts to be a key spokesperson, cashed in 80 percent of his stock while disseminating information that the company was not experiencing financial difficulties. For a spokesperson to cash in his own stock can in appropriate circumstances be like a ship's captain exiting into the safety of a lifeboat while assuring the passengers that all is well. A jury could find defendants liable for such behavior if its existence were supported by sufficient evidence. As such, plaintiffs in our view have survived the pleading stage of this securities fraud litigation.
Lawrence B. Hollin, individually and on behalf of all others similarly situated, began the instant class action securities fraud suit against defendant Scholastic Corporation, a book publishing company, and its officer Richard Robinson in the United States District Court for the Southern District of New York (Keenan, J.). The complaint asserted claims pursuant to § 10(b) of the Securities Exchange Act of 1934 (Exchange Act), 15 U.S.C. § 78j(b) (1994), Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5 (2000), and § 20(a) of the Exchange Act, 15 U.S.C. § 78t(a) (1994).1 A consolidated amended complaint was filed August 13, 1997 and dismissed on December 15, 1998 following a Rule 12(b)(6) motion brought by defendants, see In re Scholastic Corp. Sec. Litig., No. 99 Civ. 2447, 1998 WL 872422 (S.D.N.Y. Dec. 15, 1998), and the district court granted plaintiffs leave to amend.
On March 8, 1999 court-appointed lead plaintiffs Richard Truncellito and the City of Philadelphia filed a corrected second consolidated amended class action complaint. They named Scholastic and Raymond Marchuk, who serves as Scholastic's vice president for finance and investor relations, as defendants. The plaintiff class includes those persons who purchased Scholastic common stock during the class period and who sustained damages allegedly because defendants made materially false and misleading statements and concealed adverse facts regarding their publishing business, thereby causing plaintiffs to purchase the stock at artificially inflated prices.
Defendants in response filed another motion to dismiss under Rule 12(b)(6), arguing that plaintiffs failed to state a claim and failed to plead fraud with particularity, as required under Federal Rule of Civil Procedure 9(b) and the Private Securities Litigation Reform Act (Securities Reform Act), Pub. L. No. 104-67, 109 Stat. 737 (1995). The district court granted the motion. See In re Scholastic Corp. Sec. Litig.(Scholastic Corp.), No. 99 Civ. 2447, 2000 WL 91939 (S.D.N.Y. Jan. 27, 2000).
On appeal, we examine the factual allegations set out in plaintiffs' second amended complaint in some detail, assuming them, as we must, to be true. Novak v. Kasaks, 216 F.3d 300, 305 (2d Cir.), cert. denied, 121 S. Ct. 567 (2000).
Plaintiffs' allegations reveal that Scholastic is a leading publisher and distributor of children's books, classroom and professional magazines, and other educational products, which it sells through retail distributors, book clubs, book fairs, classrooms and libraries. In the years leading up to 1996-1997, Scholastic's best-selling product was "Goosebumps," a series of "scary" children's books. Prior to December 1996, defendants had expanded Goosebumps distribution to mass merchandisers and other non-traditional retailers. This change in strategy was presented to the public as a significant positive development.
What the public did not know was that Scholastic shipped books to retailers and distributors with a full right of return. In so doing, Scholastic could, under generally accepted accounting principles, record revenues upon shipment to the retailer so long as an adequate reserve provision existed for books that might be returned. In June 1996, Scholastic announced through a press release that it was adopting Statement of Accounting Standard 121, which requires a more frequent evaluation of inventory and a write-down when appropriate.
Prior to its change in distribution strategy, Scholastic boasted one of the lowest book return rates in the children's book publishing industry. On September 12, 1996 Merrill Lynch issued a report on Scholastic's return rates that incorporated statements made at a meeting with senior Scholastic officers that included defendant Marchuk. These officers represented that the company's return rate historically ran at 15 to 20 percent, as compared to 35 percent rates at other book publishers, Goosebumps books were being returned at even less than 20 percent, and while the expansion into the mass retail market could cause the return rate to rise, it would rise only "modestly." Scholastic officials added that "the issue of managing return exposure is one that gets considerable management attention." No one at Scholastic corrected this report when it appeared.
First quarter results, ending August 31, 1996, recorded a loss worse than had been experienced in the same quarter the previous year. Nevertheless, on September 19, 1996 Merrill Lynch issued another report derived from statements by company officials that Scholastic's "return rates remain among the lowest in the industry at less than 20%, which might suggest that Goosebumps has been somewhat underdistributed."
The class period in this lawsuit begins on December 10, 1996, the day Scholastic issued a press release announcing a net income for the second quarter of the 1997 fiscal year, which ended November 30, 1996. The income represented a 24 percent increase over the comparable period for the prior year. The class period ends on February 20, 1997, when Scholastic issued another press release announcing an expected third quarter loss of 70 to 80 cents per share. Prior to this release, Scholastic had expressed "comfort" with income estimates of 64 to 73 cents per share. Scholastic's news of an expected loss also contrasted with estimates by stock analysts that Scholastic would realize a net income of approximately 69 cents per share. The February 20 press release stated further that Scholastic would take a $13 million pre-tax special charge consisting of a reserve for anticipated additional book returns. The next day, Scholastic stock fell 40 percent or $24.75 per share. Another $11 million special charge for book returns was taken in the following quarter. Industry analysts thereafter questioned the credibility of Scholastic management with respect to what officials knew and how long they had known it before Scholastic made the third quarter announcement.
What happened between the December 10, 1996 and February 20, 1997 press releases forms the basis for plaintiffs' lawsuit. Defendants are alleged to have disseminated false information, withheld damaging truthful information and failed to update prior public statements that had become materially misleading. In addition, defendant Marchuk is alleged to...
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