Young v. Lepone

Decision Date10 September 2002
Docket NumberNo. 01-2622.,01-2622.
Citation305 F.3d 1
PartiesJames R. YOUNG, as Trustee of the Nutramax Litigation Trust, Plaintiff, Appellant, v. Donald E. LEPONE et al., Defendants, Appellees.
CourtU.S. Court of Appeals — First Circuit

David C. Frederick, with whom Mark C. Hansen, Silvija A. Strikis, Leo R. Tsao, Kellogg, Huber, Hansen, Todd & Evans, P.L.L.C., Robert M. Thomas, Jr., and Thomas & Associates were on brief, for appellant.

Thomas J. Dougherty, with whom David S. Clancy, Kara E. Fay, and Skadden, Arps, Slate, Meagher & Flom LLP were on brief, for appellee Deloitte & Touche LLP.

Before BOUDIN, Chief Judge, SELYA, Circuit Judge, and GREENBERG,* Senior Circuit Judge.

SELYA, Circuit Judge.

We confront here two intricate variations on a standard theme — the invocation of a limitations defense to federal securities claims. The general scenario is distressingly familiar: shareholders of a publicly-held company allege that the corporate officers systematically inflated earnings, concealed losses, and treated the company's books as works of fiction. The shareholders further allege that their natural guardians — the company's outside accountants — perpetuated this massive fraud through perfunctory audits and certified financial statements that they knew (or consciously avoided knowing) were materially false and misleading.

The district court ruled that all the federal securities claims were barred by the applicable one-year statute of limitations. See Cape Ann Investors, LLC v. Lepone, 171 F.Supp.2d 22 (D.Mass.2001). We conclude that this ruling is partially correct and partially incorrect. As to the federal securities claim asserted by the original plaintiff, the primary issue is whether management letters from the accounting firm effectively placed this plaintiff (an investor who held a seat on the company's board of directors and the audit committee) on inquiry notice of possible fraud. Given our inability to resolve that highly nuanced issue based solely on the face of the amended complaint, we vacate the lower court's order of dismissal in pertinent part and remand for further proceedings. As to the later-filed claims asserted by the remaining shareholders, we reach a different result. Because those plaintiffs (and their claims) lacked a sufficient identity of interest with the original complainant (and its claims), Federal Rule of Civil Procedure 15(c)(3) does not apply; the claims are not entitled to relate back to the date when the suit was first filed; and, accordingly, the claims are time-barred. We therefore affirm that portion of the district court's ukase.

I. BACKGROUND

We glean the facts from the amended complaint, stripped of any rhetorical gloss. Aulson v. Blanchard, 83 F.3d 1, 3 (1st Cir.1996). We then trace the travel of the case and offer a roadmap for our exploration of the instant appeal.

A. The Facts.

At the times relevant hereto, NutraMax Products, Inc. ("NutraMax" or "the company") was a Delaware corporation that maintained its principal offices in Gloucester, Massachusetts. The company's shares were traded on the NASDAQ stock exchange. Donald E. Lepone served as its chief executive officer, Robert F. Burns as its chief financial officer, and Noreen Gottfredsen as its controller.

NutraMax's fiscal year ran from October 1 through September 30. Like all publicly-held corporations, it issued annual financial statements within ninety days after the close of each fiscal year. For each of the years here in question — 1996, 1997, and 1998—it represented that these financial statements were prepared in accordance with generally accepted accounting principles ("GAAP").1 The company's independent auditor, Deloitte & Touche LLP ("Deloitte"), placed its imprimatur on each of these financial statements. In so doing, Deloitte expressly certified that: (1) it had conducted its audit in accordance with generally accepted auditing standards ("GAAS");2 (2) NutraMax's financial statements had been prepared in accordance with GAAP and fairly presented the company's financial position and operational results in all material respects; and (3) Deloitte could provide reasonable assurances, based on its audits, that the financial statements contained no material misrepresentations.

In connection with its presentation of audited financial statements, Deloitte wrote an annual "management letter" to the audit committee designated by NutraMax's board of directors. Those letters contained comments that Deloitte deemed pertinent to management's assessment of the financial condition of the company and the reliability of its accounting systems. In the management letter submitted under date of November 28, 1997, Deloitte concluded that certain deficiencies in the company's internal control structure constituted "reportable conditions."3 Specifically, that letter highlighted a number of weaknesses in NutraMax's inventory control and valuation procedures, identified a $291,000 variance in an inventory account, pointed out under-accruals of various expenses, and noted that the company had failed to earmark adequate reserves for bad debts. Deloitte nonetheless certified the 1997 financial statements without any substantial qualification. Much the same pas de deux occurred the following year. On November 24, 1998, Deloitte wrote to NutraMax's audit committee identifying reportable conditions involving inventory control and valuation, but proceeded to certify the company's financial statements for fiscal 1998 without substantial qualification. On both occasions, Deloitte's representatives assured the audit committee that the reportable conditions did not denote material weaknesses in NutraMax's reporting systems (and, therefore, did not pose a significant risk of skewing the company's financial statements). Moreover, Deloitte assured the audit committee that, "as required by GAAS," its audit for each of these years "would provide reasonable assurance of detecting irregularities or illegal acts by NutraMax management and employees."

In 1999, NutraMax's board of directors installed a new chief operating officer ("COO"). It did not take him long to note glaring inadequacies in the company's accounting procedures and internal controls. Suspecting that the books and records contained serious irregularities, the COO recommended that the board engage outside counsel to conduct a full investigation into the company's accounting records, systems, and procedures. The board complied, and the law firm designated by the board engaged a team of forensic accountants. In the spring or summer of 1999 — the amended complaint is vague as to the exact timing — the investigators concluded that NutraMax's management had failed to write down worthless inventory, improperly accrued expenses, booked bogus journal entries, and incorrectly adjusted the accrual dates on various receivables. As a result, a myriad of accounts required multimillion dollar adjustments.

The denouement occurred on August 18, 1999, when NutraMax publicly announced that it had (1) ousted Lepone and Burns, (2) delayed the release of an earnings report for the third quarter, and (3) decided that it would be necessary to restate its financials for certain previous years. In the wake of this announcement, the price of NutraMax's common stock plummeted. NutraMax subsequently wrote down its assets by over $75,000,000 and restated its net worth from a positive figure of $21,200,000 to a negative figure of $46,600,000. On October 15, 1999, NASDAQ delisted the company. On November 12, 1999, Deloitte withdrew its audit reports for the 1996, 1997, and 1998 fiscal years.4 Less than six months later, NutraMax filed for bankruptcy protection under Chapter 11. See 11 U.S.C. §§ 1101-1174.

B. The Proceedings Below.

On August 1, 2000, Cape Ann Investors, LLC ("Cape Ann"), a major NutraMax shareholder, sued Lepone, Burns, Gottfredsen, and Deloitte in the United States District Court for the District of Massachusetts. Cape Ann's complaint charged that the three former officers had systematically falsified NutraMax's financial statements by inflating earnings, refusing to write off outdated inventory, and manipulating the company's accounting records to misrepresent its financial performance and condition. The complaint further charged that Deloitte had facilitated the former officers' fraudulent misconduct by conducting perfunctory audits of the company's finances — audits that fell far short of GAAS. Cape Ann alleged that the defendants' malfeasance violated both federal securities law, see Securities Exchange Act of 1934, 15 U.S.C. § 78j; SEC Rule 10b-5, 17 C.F.R. § 240.10b-5, and state law.

At this point, we shift our focus momentarily to NutraMax's Chapter 11 reorganization. In the course of that proceeding — which is pending in Delaware — the bankruptcy court established the NutraMax Litigation Trust ("the Trust"). The Trust became the assignee of several sets of claims. Only one such set is of interest here: all claims by persons who held NutraMax common stock prior to the bankruptcy filing and who either voted to approve the reorganization plan or elected thereafter to assign their claims to the Trust. By voting in favor of the reorganization plan, Cape Ann became a participant in the Trust. Since Cape Ann's position is distinct from that of the other shareholders who have assigned their rights to the Trust, we emulate the district court, see Cape Ann, 171 F.Supp.2d at 23-24, and refer to Cape Ann by name while referring to the other electing shareholders as the "new plaintiffs."

On March 9, 2001, the Trust filed an amended complaint that, inter alia, sought to substitute the Trust for Cape Ann as the named plaintiff in the securities fraud action and to add claims assigned to it by the new plaintiffs.5 Deloitte moved to dismiss the amended complaint, asserting, inter alia, that the...

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