Reilly v. U.S. Physical Therapy, Inc.

• Decision Date: 23 July 2018
• Docket Number: 17 Civ. 2347 (NRB)
• Parties: SEAN REILLY, individually and on behalf of all others similarly situated, Plaintiff, v. U.S. PHYSICAL THERAPY, INC., CHRISTOPHER J. READING, LAWRANCE W. MCAFEE, JON C. BATES, and GLENN W. MCDOWELL Defendants.
• Court: U.S. District Court — Southern District of New York

SEAN REILLY, individually and on behalf ofall others similarly situated, Plaintiff, v. U.S. PHYSICAL THERAPY, INC., CHRISTOPHER J. READING,LAWRANCE W. MCAFEE, JON C. BATES, and GLENN W. MCDOWELL Defendants.

17 Civ. 2347 (NRB)

UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK

July 23, 2018

MEMORANDUM AND ORDER

NAOMI REICE BUCHWALD UNITED STATES DISTRICT JUDGE

I. INTRODUCTION

This federal securities class action was filed on behalf of all persons and entities who purchased or otherwise acquired the securities of defendant U.S. Physical Therapy, Inc. ("USPH" or the "Company") between November 6, 2014 and March 16, 2017, inclusive (the "Class Period"). Plaintiffs¹ alleged that USPH and four individual defendants, Christopher J. Reading, Lawrance W. McAfee, Glenn W. McDowell, and Jon C. Bates, violated Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act") and Rule 10b-5 promulgated thereunder, and that theindividual defendants violated Section 20(a) of the Exchange Act. Before the Court is defendants' motion to dismiss pursuant to Federal Rule of Civil Procedure 12(b)(6).² Because plaintiffs failed to adequately plead scienter, the motion to dismiss is granted.

II. BACKGROUND

The following allegations are drawn from plaintiffs' second amended complaint ("SAC") (ECF No. 26), and are assumed to be true for the purposes of this motion. See Glob. Network Commc'ns, Inc. v. City of New York, 458 F.3d 150, 154 (2d Cir. 2006). We also consider any statements or documents incorporated into the AC by reference, legally required public disclosure documents filed with the Securities and Exchange Commission ("SEC"),³ and documentspossessed by or known to the plaintiffs and upon which they relied in bringing this action.⁴ See ATSI Commc'ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 98 (2d Cir. 2007).

A. Factual Background

1. USPH

USPH is a Nevada corporation headquartered in Houston that is traded on the New York Stock Exchange. SAC ¶ 12. It operates outpatient physical therapy clinics that provide pre- and post-operative care and treatment for orthopedic-related disorders, sports-related injuries, preventative care, rehabilitation of injured workers, and neurological-related injuries. SAC ¶ 24. Throughout the Class Period, defendant Christopher J. Reading served as USPH's CEO and Director, defendant Lawrance W. McAfee served as CFO, Executive Vice President, and Director, defendantGlenn W. McDowell served as COO, and defendant Jon C. Bates served as Corporate Controller and Vice President. SAC ¶¶ 13-16.

USPH has grown nationally over the last twelve years through strategic acquisitions of outpatient physical therapy clinics. SAC ¶ 26. As of December 31, 2016, USPH operated 423 of its 540 clinics as "Clinic Partnerships." SAC ¶ 26. Under this arrangement, USPH owns a 1% general partnership and a 49-99% limited partnership interest in these clinics, with the therapists who manage the clinics owning the remaining interest as limited partners. SAC ¶ 25.⁵ USPH refers to the partnership interests owned by the managing therapists as "non-controlling interests." SAC ¶ 25.

Under UPSH's agreements with some of its managing therapists, it is required to redeem the therapist's non-controlling interest if his or her employment ceases at any time after a specified number of years from the date that therapist acquired his or her non-controlling interest. 2016 10-K at 5. Under other agreements, USPH has the right, but not the obligation, to purchase the therapist's non-controlling interest upon termination of his or her employment. Id.

2. USPH's Accounting Practices for Non-Controlling Interests

The alleged securities fraud in this case concerns USPH's accounting practices for its managing therapists' non-controlling interests. We begin by providing some background information on accounting practices for non-controlling interests, which, according to the Financial Accounting Standards Board ("FASB"), "can be complex." Accounting Standards Codification Topic 480, Subtopic 10, Section 99 at 7 (Fin. Accounting Standards Bd. 2009), Vigna Decl. Ex. V, ECF No. 31-22 ("Ex. V"). FASB Accounting Standard Codification ("ASC") 480-10-S99 provides detailed guidance as to whether redeemable preferred stock should be classified as "temporary equity" or "permanent equity." Id. At its most basic level, this ASC provides that "equity instruments with redemption features that are not solely within the control of the issuer" should be classified as temporary equity. Id. at 7. ASC 480-10-S99 does "not attempt to deal with the conceptual question of whether such a security is a liability." Id. at 2.

By contrast, ASC 480-10-25 provides guidance as to whether certain financial instruments should be classified as a liability or an equity. Accounting Standards Codification Topic 480 Subtopic 10, Section 25 (Fin. Accounting Stds. Bd. 2009), Vigna Decl. Ex. X, ECF No. 31-24 ("Ex. X"). ASC 480-10-25 provides that "[a] mandatorily redeemable financial instrument shall be classified asa liability unless the redemption is required to occur only upon the liquidation or termination of the reporting entity." Id. at 1.

USPH historically accounted for the managing therapists' non-controlling interests as either permanent or temporary equity. SAC ¶ 28. If a managing therapist could require USPH to purchase his or her non-controlling interest, typically after a defined period of time set forth in a limited partnership agreement (the "Holding Period"), the Company reclassified the recorded value of the non-controlling interest as temporary equity under the line item "Redeemable Non-Controlling Interests" or "RNCI." Id. The recorded value was the fair value of the non-controlling interest on the date the Company acquired a controlling interest in the partnership adjusted for any earnings attributable to the partnership and distributions made after acquisition. Id. If the Company deemed it probable that the managing therapist would assert his or her redemption rights or the Company reached an agreement to purchase some or all of the therapist's interest, the redeemable non-controlling interest was adjusted to its then-current redemption value. SAC ¶ 29. Each quarter, USPH would assess the probability that the redemption rights would be triggered, and accounted for the redeemable non-controlling interests accordingly. SAC ¶ 30.

USPH described its historical accounting practices for redeemable non-controlling interests in the "Significant Accounting Policies" section of its 2013-15 10-Ks as follows:

The Company recognizes non-controlling interests as equity in the consolidated financial statements separate from the parent entity's equity. The amount of net income attributable to non-controlling interests is included in consolidated net income on the face of the statements of net income. Changes in a parent entity's ownership interest in a subsidiary that do not result in deconsolidation are treated as equity transactions if the parent entity retains its controlling financial interest. The Company recognizes a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss is measured using the fair value of the non-controlling equity investment on the deconsolidation date.

When the purchase price of a non-controlling interest by the Company exceeds the book value at the time of purchase, any excess or shortfall is recognized as an adjustment to additional paid-in capital. Additionally, operating losses are allocated to non-controlling interests even when such allocation creates a deficit balance for the non-controlling interest partner.

The non-controlling interests that are reflected as redeemable non-controlling interests in the consolidated financial statements consist of those outside owners that have certain redemption rights that are currently exercisable, and that, if exercised, require that the Company purchases the non-controlling interest of the particular limited partner. At December 31, [of the applicable year], the redeemable non-controlling interests reflect the book value of the respective non-controlling interests. The redeemable non-controlling interests will be adjusted to the fair value in the reporting period in which the Company deems it probable that the limited partner will assert the redemption rights and will be adjusted each reporting period thereafter. The adjustments are charged to additional paid-in capital and are not reflected in the statements of net income. Although, the adjustments are not reflected in the statements of net income, currentaccounting rules require that the Company reflects the charge in the earning per share calculation.

2015 10-K at 44-45; 2014 10-K at 41; 2013 10-K at 46-47; SAC ¶ 90.

3. USPH's 2014-2015 Correspondence with the SEC

USPH and the SEC exchanged correspondence beginning in October 2014 regarding the Company's accounting practices for its non-controlling interests. SAC ¶¶ 32-39. On October 15, 2014, the SEC sent a comment letter addressed to defendant Reading that asked, inter alia, whether it was proper for USPH to include a separate line item in its earnings per share reconciliation for earnings per share from revaluations of its redeemable non-controlling interests, rather than to include this item within its basic and diluted earnings per share from continuing operations. SAC ¶ 33; Ex. J at 4; see 2Q 2014 10-Q at 13. The letter referred to ASC 480-10-S99-3A-22, which discusses the appropriate earnings per share treatment of certain non-controlling interests. SAC ¶ 33; see Ex. V at 13-14.

On October 29, 2014, USPH responded to the SEC's letter, stating that its reporting of the revaluation of the redeemable non-controlling interests was in accordance with FASB ASC 480-10-S99-3A-22, and that its "reporting the Revaluation as a separate line gives our investors the ability to compare our Company's current results from operations to prior periods as well as to the operating...