New England Health Care Pension v. Ernst & Young

• Decision Date: 09 July 2003
• Docket Number: No. 01-6523.,01-6523.
• Citation: 336 F.3d 495
• Parties: NEW ENGLAND HEALTH CARE EMPLOYEES PENSION FUND, On Behalf of Itself and All Others Similarly Situated, Plaintiff-Appellant, v. ERNST & YOUNG, LLP, Defendant-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

336 F.3d 495

NEW ENGLAND HEALTH CARE EMPLOYEES PENSION FUND, On Behalf of Itself and All Others Similarly Situated, Plaintiff-Appellant, v. ERNST & YOUNG, LLP, Defendant-Appellee.

No. 01-6523.

United States Court of Appeals, Sixth Circuit.

Argued: May 1, 2003.

Decided and Filed: July 9, 2003.

Eric A. Isaacson (argued and briefed), Joesph D. Daley (briefed), Milberg, Weiss, Bershad, Hynes & Lerach, San Diego, CA, for Appellant.

Stanley J. Parzen (argued and briefed), Jeffrey W. Sarles (briefed), Mayer, Brown, Rowe & Maw, Chicago, IL, Frank P. Doheny, Jr., (briefed), R. Kenyon Meyer, Dinsmore & Shohl, Lora S. Morris, (briefed), Muse & Morris, Louisville, KY, for Appellee.

Before: NELSON and COLE, Circuit Judges; ROSEN, District Judge.^*

OPINION

DAVID A. NELSON, Circuit Judge.

Private lawsuits impliedly authorized under § 10(b) of the 1934 Securities Exchange Act, the Supreme Court held in Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350, 111 S.Ct. 2773, 115 L.Ed.2d 321 (1991), are subject to the statutory limitations provision established in § 9(e) of the Act. Private securities fraud actions must thus be "brought within one year after discovery of the facts constituting the violation and within three years after such violation." See 15 U.S.C. § 78i(e).

The present action, a § 10(b) securities fraud case brought by an investor against an accounting firm, is barred by the one-year statute of limitations if the word "discovery," as used in the statute, extends to constructive discovery as well as actual discovery. The plaintiff investor having been put on "inquiry notice" of the alleged fraud more than one year before the filing of the complaint, in other words, the question is whether such notice suffices to bar the action.

Like a number of our sister circuits, we believe that inquiry notice is sufficient to trigger the running of the one-year limitations period. The district court dismissed this case on grounds that involved the three-year statutory period, among other things, but we shall affirm the dismissal under the one-year provision without reaching the grounds found persuasive by the district court.

I

This case has its origins in financial difficulties experienced by clothing manufacturer Fruit of the Loom, Inc. ("Fruit") in the 1990s. According to the plaintiff, Fruit's stock "collapse[d]" in November of 1995 as a result of market changes and poor management. Fruit took steps to improve performance in 1996, but it became clear by the fourth quarter that Fruit would not meet its financial goals for the year. Therefore, the plaintiff has alleged, Fruit's management instituted a "pull-forward" program of early shipments, which was designed to accelerate recognition of 1997 revenues into the fourth quarter of 1996. Fruit ended up reporting financial results for 1996 that were much higher than expected, and Fruit's stock rebounded.

Fruit's 1996 financial statements were audited by Ernst & Young, LLP ("Ernst"), the defendant herein. According to the plaintiff, the statements violated generally accepted accounting principles ("GAAP") by failing to write down overvalued inventory and fixed assets and failing to accrue certain liabilities, as well as by improperly recognizing 1997 revenue in 1996. In a report dated February 12, 1997, however, Ernst certified that Fruit's 1996 financial statements "present fairly, in all material respects, the consolidated financial position of [Fruit] ... and the consolidated results of [its] operations and [its] cash flows ... in conformity with generally accepted accounting principles." The report stated further that Ernst had conducted its audit of Fruit's statements "in accordance with generally accepted auditing standards" ("GAAS").

In March of 1997, Fruit filed its Form 10-K — which included the 1996 financial statements and Ernst's February 12 audit report — with the Securities and Exchange Commission ("SEC"). The next month, Fruit distributed the financial statements and Ernst's certification to its shareholders as part of an annual report. Also in April, Fruit reported its results for the first quarter of 1997 — results that were down from the first quarter of 1996 and that fueled a decline in the value of Fruit stock. Fruit reported its second-quarter results, which were again below 1996 levels, in July. The plaintiff contends that Fruit's first and second quarter financial statements, which were reviewed by Ernst, departed from GAAP.

On July 9, 1997, Fruit filed a registration statement with the SEC in connection with a public offering of securities. The registration statement included Fruit's financial statements for 1996 and the first two quarters of 1997, incorporated Ernst's February 12 audit report by reference, and included a letter in which Ernst consented to the use of its report. On August 6, 1997, Fruit filed an amendment to the July 9 registration statement. The amendment, like the original registration statement, incorporated Ernst's audit report and included Ernst's consent to the use of that report.

For the third and fourth quarters of 1997, Fruit reported large losses. In January of 1998, the value of Fruit's stock dropped to slightly more than half of what it had been in March of 1997.

On July 1, 1998, New England Health Care Employees Pension Fund ("New England"), undertaking to act on behalf of itself and other purchasers of Fruit stock, sued Fruit and several of its directors and officers for securities fraud. New England alleged that the defendants intentionally overstated earnings on Fruit's financial statements for 1996 and the first two quarters of 1997, and that the defendants made additional public statements about Fruit's performance and prospects that were intentionally false (including representations that the financial statements adhered to GAAP). Ernst was not named as a defendant.

While that case was pending, Fruit entered bankruptcy. Then, on June 28, 2000 — nearly two years after the filing of the suit against Fruit — New England brought the present action against Ernst. New England's complaint, which substantially repeated the earlier allegations of fraud by Fruit and its directors and officers, alleged that Ernst participated in the fraud by certifying the 1996 financial statements as consistent with GAAP, stating that it audited the statements in accordance with GAAS, and consenting to the use of its audit report in Fruit's offering documents. According to New England, Ernst's statements and letters of consent were fraudulent because Ernst was aware of evidence contradicting Fruit's reported results for 1996 and the first two quarters of 1997.

Ernst moved for dismissal under Rule 12(b)(6), Fed.R.Civ.P., arguing that the action was time-barred and that New England had failed to allege particular facts supporting an inference of scienter, i.e., an inference that Ernst either knew its statements to be false or was reckless in assessing their truth. The district court granted the motion. The court noted that Ernst's audit report of February 12, 1997, was made more than three years before the filing of suit, and it held that Ernst's consent letters of July 9 and August 6, 1997, did not re-start the three-year repose period prescribed by 15 U.S.C. § 78i(e). The court further held that New England had not pleaded "with particularity facts giving rise to a strong inference that [Ernst] acted with the required state of mind" in accordance with the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u-4(b)(2). The district court rejected Ernst's argument that the action was barred by the one-year statute of limitations, see 15 U.S.C. § 78i(e), holding that it was not necessarily true that New England knew or should have known of Ernst's alleged fraud before June 28, 1999.

The dismissal being without prejudice, New England filed an amended complaint against Ernst in March of 2001. Ernst again moved to dismiss the complaint, and the district court again granted the motion. The court rejected New England's argument that Ernst's consent letters constituted new misrepresentations made within the three-year period of repose — that were materially different from the misrepresentations allegedly contained in the February 12 audit report. The court also held that New England still had not pleaded sufficient facts showing scienter. The complaint was dismissed with prejudice, and this timely appeal followed.

II

We review the dismissal of New England's complaint de novo. See, e.g., In re Comshare, Inc. Securities Litigation, 183 F.3d 542, 547 (6th Cir.1999). In doing so, we may affirm the judgment of the district court on any ground supported by the record. See id. at 547-48.

A

Securities fraud litigation under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Securities and Exchange Commission Rule 10b-5, 17 C.F.R. § 240.10b-5, must be commenced, as we have seen, "within one year after the discovery of the facts constituting the violation...." 15 U.S.C. § 78i(e); see Lampf, 501 U.S. at 364, 111 S.Ct. 2773, where the Supreme Court borrowed the limitations provisions of § 9(e) of the 1934 Act, 15 U.S.C. § 78i(e), for actions brought under § 10(b) and Rule 10b-5.

Reading the language of § 9(e), narrowly, New England argues that only actual discovery of fraud can start the one-year limitations period. Ernst counters that the period begins to run upon "inquiry notice" of fraud — meaning, under one interpretation, the point at which the plaintiff should have discovered the fraud through reasonably diligent inquiry.

New England is correct, of course, that § 9(e) refers only to "discovery" as the trigger of the limitations period. Unlike some other federal statutes of limitations — notably, § 13 of the Securities Act of 1933, which allows actions based on false offering documents to be brought "within one year after the discovery" of the false statement "or after such discovery...