In re Tyco Int’l Ltd., MDL MDL-02-1335-B 10/14/04

UNITED STATES DISTRICT COURT FOR THE DISTRICT OF NEW HAMPSHIRE

In re Tyco International, Ltd. Multidistrict Litigation (MDL 1335)

MDL DOCKET NO. 02-1335-B SECURITIES ACTION Case N o . 02-266-B Opinion NO.

MEMORANDUM AND ORDER

Plaintiffs have filed a consolidated complaint alleging

multiple securities law violations against Tyco International

Ltd., three of its former officers, L . Dennis Kozlowski (former

Chief Executive Officer), Mark H . Swartz (former Chief Financial

Officer), and Mark A . Belnick (former Chief Corporate Counsel),

two of its former directors (Frank E . Walsh, J r . and Michael A .

Ashcroft) (collectively the “Tyco defendants”), and its

independent accountant and auditor (PricewaterhouseCoopers

(“PwC”)).

Defendants have filed motions to dismiss arguing that the

consolidated complaint fails to state viable claims for relief. -2- I . STANDARD OF REVIEW

Defendants challenge the consolidated complaint pursuant to

Fed. R. Civ. P. 12(b)(6). A Rule 12(b)(6) challenge argues

either that the complaint fails to describe the claims for relief

in sufficient detail or that the claims are deficient even if

they are pleaded with the requisite specificity. Defendants make

both arguments.

The degree of detail that a complaint must contain to

survive a Rule 12(b)(6) challenge depends upon the nature of the

claims under review. In most cases, a plaintiff is required to

provide only “a short and plain statement of the claim showing

that the pleader is entitled to relief.” Fed. R. Civ. P.

8(a)(2). While this requirement is simply stated, it has been

difficult to apply in practice. A plaintiff is not required to

plead evidence when a claim is governed by Rule 8(a)(2), but she

must do more than simply recite the elements of the claim in a

conclusory fashion. See Eastern Food Servs., Inc. v . Pontifical

Catholic Univ. Servs. Ass’n,

, 9 (1st Cir. 2004). For

cases that fall in the middle of these two extremes, all that can

be said is that the complaint must “set forth factual

allegations, either direct or inferential, respecting each

-3- material element necessary to sustain recovery under some

actionable legal theory.” United States v . Melrose-Wakefield

Hosp.,

2 0 , 240 (1st Cir. 2004)(quoting Gooley v . Mobil

Oil Corp.,

(1st Cir. 1988)). Such factual

allegations may be based either on personal knowledge or

“information and belief.” See Langadinos v . American Airlines,

Inc.,

8 , 73 n.8 (1st Cir. 2001).

Special pleading requirements apply to fraud claims. Fed.

R. Civ. P. 9(b) states that “[i]n all averments of fraud or

mistake, the circumstances constituting fraud or mistake shall be

stated with particularity.” Rule 9(b) requires “that the

plaintiff’s averments of fraud specify the time, place, and

content of the alleged false or fraudulent representations.”

Melrose-Wakefield Hosp., 360 F.3d at 226. Moreover, when a cause

of action sounding in fraud is based on “information and belief,”

Rule 9(b) directs the plaintiff to plead sufficient supporting

facts to permit a conclusion that the alleged belief is

reasonable. See id. In contrast, “[m]alice, intent, knowledge,

and other conditions of mind of a person may be averred

generally.” Fed. R. Civ. P. 9 ( b ) .

-4- The Private Securities Litigation Reform Act (“PSLRA”), 15

U.S.C. § 78u-4(b), establishes specific pleading requirements for

fraud claims based on the Securities Exchange Act of 1934

(“Exchange Act”). Complaints alleging such claims must “specify

each statement alleged to have been misleading, the reason or

reasons why the statement is misleading, and, if an allegation

regarding the statement is made on information and belief, the

complaint shall state with particularity all facts on which the

belief is formed.” 15 U.S.C. § 78u-4(b)(1). In addition, the

PSLRA requires that a securities fraud claim plead facts with

particularity that are sufficient to give rise to a “strong

inference” of scienter. 15 U.S.C. § 78u-4(b)(2). Although the

PSLRA’s pleading requirements are demanding, they are not

insurmountable. The real question is whether the allegations as

a whole provide enough supporting detail to warrant a conclusion

that its requirements have been satisfied. See In re Cabletron

Sys., Inc.,

1 , 40 (1st Cir. 2002).

The parties disagree as to whether the PSLRA can ever be

satisfied through “group pleading.” See

(describing

group pleading). Insofar as the group pleading doctrine merely

-5- permits a plaintiff to rely on a presumption that statements

contained in corporate press releases, SEC filings, and other

similar company documents are the collective work of the

company’s executive officers, the doctrine does not appear to be

inconsistent with either the PSLRA or Rule 9 ( b ) . See Serabian v .

Amoskeag Bank Shares, Inc.,

5 7 , 367-68 (1st Cir. 1994)

(applying a limited version of the group pleading doctrine to

securities fraud claims under Rule 9(b)); see also In re Raytheon

Sec. Litig.,

3 1 , 152-53 (D. Mass. 2001) (holding

that group pleading doctrine survives PSLRA). Whether a similar

inference is warranted when it comes to a company’s directors,

however, will depend upon the unique facts of each case.

Further, the doctrine does not relieve a plaintiff of the duty to

plead sufficient facts as to each defendant to support a strong

inference that the defendant acted with scienter. Accordingly,

when it comes to group pleading, the ultimate question is whether

the facts of the case make it reasonable to apply the doctrine in

the way that plaintiffs propose.

-6- II. ANALYSIS

Plaintiffs have asserted claims based on §§ 10(b), 14(a),

20(a), and 20(A) of the Exchange Act and §§ 1 1 , 12(a)(2) and 15

of the Securities Act of 1933 (“Securities Act”). I evaluate the

sufficiency of each claim in turn.

A. Section 10(b)

Defendants adopt a “divide and conquer” strategy in

challenging plaintiffs’ § 10(b) claims. They argue that the

consolidated complaint alleges two distinct fraud schemes: one

that involves looting and another that involves fraudulent

accounting practices. They then attack the complaint’s

sufficiency by challenging each scheme as if it were described in

a separate complaint. While I adopt a similar organizational

structure in responding to defendants’ arguments, I reject their

premise that the two schemes are unrelated. Instead, a careful

reading of the consolidated complaint reveals that it is based on

allegations that the accounting fraud and looting schemes are

both interrelated and interdependent. In essence, plaintiffs

charge that Tyco’s senior management operated the company as a

criminal enterprise in which fraudulent accounting practices were

-7- used to generate cash to fund Tyco’s acquisition strategy. The

looting, in turn, occurred both to benefit the individual

defendants and to create incentives to continue with the

accounting fraud. As I will explain, the relationship between

the two schemes is important to consider when analyzing several

of defendants’ arguments.

1. Looting Claims

a. Santa Fe Industries, Inc. v . Green

The Tyco defendants rely on Santa Fe Industries, Inc. v .

Green,

(1977) for the proposition that plaintiffs’

looting allegations describe mere corporate mismanagement that

cannot support a claim under the securities laws. This argument

is based both on a misreading of Santa Fe Industries and on a

mischaracterization of plaintiffs’ looting claims.

Santa Fe Industries concerned a challenge by minority

shareholders to a parent corporation’s attempt to merge with its

partially owned subsidiary under Delaware’s short form merger

statute, Del. Code Ann. Tit. 8 , § 253. The short form merger

statute permits a parent corporation that owns at least 90% of

its subsidiary’s stock to merge with the subsidiary by offering

-8- to acquire the minority shareholders’ stock at a price specified

by the parent. See Santa Fe Indus.,

. If the

minority shareholders are dissatisfied with the proposed price,

the statute permits them to file suit in state court to recover

the difference between the proposed price and the stock’s fair

value. See

. The plaintiffs in Santa Fe Industries

filed an action in federal court charging that the parent had

violated § 10(b) by attempting to use the short form merger

statute to acquire their stock at substantially less than its

fair market value. See id. at 467. The Supreme Court rejected

the § 10(b) claim and the case has since been widely cited for

the proposition that “[t]o the extent that [a] claim comprises

allegations of mismanagement, it is not cognizable under the

securities laws.” Shaw v . Digital Equip. Corp.,

(1st Cir. 1996); see also In re Advanta Corp. Sec. Litig.,

(3d Cir. 1999); Decker v . Massey-Ferguson,

Ltd.,

1 1 , 115 (2d Cir. 1982).

It is important to bear in mind when considering Santa Fe

Industries, however, that the complaint that was before the court

in that case did not allege that the defendants had made any

-9- misstatements or omissions of material fact in connection with

the purchase or sale of a security. See id. at 474 (recognizing

that “the finding of the District Court, undisturbed by the Court

of Appeals, was that there was no ‘omission’ or misstatement in

the information statement accompanying the notice of merger”).

Thus, the decision does not necessarily preclude a claim such as

the one at issue here, which is based on the concealment of

allegedly material information concerning corporate misconduct

rather than on the underlying misconduct itself.

Defendants nevertheless argue that a plaintiff can never be

permitted to base a § 10(b) claim on a failure to disclose

corporate misconduct if the misconduct would support a breach of

fiduciary duty claim under state law. Otherwise, they argue,

quintessentially state law claims could always be transformed

into federal securities law violations merely by alleging that

defendants failed to disclose the misconduct. But this argument

overstates the case. In Estate of Soler v . Rodriguez,

(1st Cir. 1995), the First Circuit flatly rejected the view that

an otherwise actionable claim under § 10(b) is barred by Santa Fe

Industries merely because it is based on a failure to disclose

-10- conduct that can be remedied through a breach of fiduciary duty

claim under state law. See id. at 5 6 .

Other circuits have struggled in the wake of Santa Fe

Industries to articulate a more nuanced standard to distinguish

cases in which the failure to disclose mismanagement will support

a § 10(b) claim from those in which it will not. Four circuit

opinions illustrate these efforts. In Kas v . Financial General

Bankshares, Inc.,

(D.C. Cir. 1986), the District of

Columbia Circuit acknowledged that a § 10(b) claim cannot be

based on a failure to disclose mismanagement where the omission’s

materiality depends solely on either a legal judgment that the

defendants’ conduct amounts to a breach of fiduciary duty or a

determination that the defendants’ motives were improper. Id. at

513. At the same time, however, the court recognized that “Santa

Fe certainly does not preclude liability under sections 10(b) and

14(a) where a proxy statement fails to disclose either that a

member of management has a personal stake in the corporate

decision being made or that some special relationship exists

between a member of management and some party with interests

adverse to the shareholders.” Id. The Third Circuit, in In re

Craftmatic Sec. Litig.,

(3d Cir. 1989) similarly

-11- suggested that Santa Fe Industries will bar an otherwise

actionable § 10(b) claim where the omitted information is

material only because it would “place potential investors on

notice that management is culpable of a breach of faith or

incompetence . . . .” Id. at 640. In Panter v . Marshall Field &

Co.,

(7th Cir. 1981), the Seventh Circuit determined

that Santa Fe Industries will bar a § 10(b) claim that is based

on the failure to disclose mismanagement when the “central

thrust” of the claim is mismanagement rather than the concealment

of material information from investors. Id. at 289. Finally, in

7547 Corp. v . Parker & Parsley Dev.,

(5th Cir. 1994),

the Fifth Circuit concluded that the complaint before it stated a

viable claim under § 10(b) notwithstanding the defendants’

agreement that it was based on the failure to disclose fiduciary

breaches because “the breaches of fiduciary duty held violative

of rule 10-b(5) included some element of deception.” Id. at 231

(quoting Santa Fe Indus.,

).

I need not determine which circuit court’s test best

separates actionable mismanagement claims from a nonactionable

claims because the complaint at issue here would survive

dismissal under any plausible test. Unlike other cases in which

-12- § 10(b) claims have been dismissed on the basis of Santa Fe

Industries, this case concerns an alleged failure to disclose

material information about compensation and related party

transactions that must be accurately disclosed to investors

pursuant to SEC regulations. See discussion infra Part II.A.1.d.

Moreover, the consolidated complaint alleges that the omitted

information was material, not merely because it demonstrated an

exercise of poor judgment or even a lack of good faith by senior

management, but because it concerned the transfer of hundreds of

millions of dollars from Tyco to the individual defendants in

unauthorized compensation for their participation in a larger

criminal scheme to inflate the price of Tyco’s stock through

fraudulent accounting practices. Such allegations plainly amount

to more than the type of mere mismanagement that cannot serve as

the basis of a viable § 10(b) claim after Santa Fe Industries.

b. Fraud “in connection with” the sale or purchase of a security

Defendants next argue that the looting allegations will not

support a § 10(b) claim because the looting did not occur “in

connection with” the purchase or sale of a security. 15 U.S.C. §

78j(b). In essence, defendants argue that the looting claims

-13- consist of nothing more than charges of self-dealing by the

individual defendants at Tyco’s expense. These charges, they

argue, have nothing to do with the purchase or sale of any

security. This argument mischaracterizes the plaintiffs’ looting

claims.

A fair reading of the consolidated complaint demonstrates

that plaintiffs base their looting claims not on the looting

itself, but on misrepresentations and omissions that Tyco and the

individual defendants allegedly made about the looting in various

SEC filings. In a case such as this, which involves a publicly

traded security, the “in connection with” requirement is

satisfied “by showing that the misrepresentations in question

were disseminated to the public in a medium upon which a

reasonable investor would rely, and that they were material when

disseminated.” Semerenko v . Cendant Corp.,

(3d

Cir. 2000); see also McGann v . Ernst & Young,

9 0 , 392-

93 (9th Cir. 1996); In Re Ames Dep’t Stores, Inc. Stock Litig.,

(2d Cir. 1993). As investors plainly are

entitled to assume that SEC filings are accurate and complete,

and plaintiffs have sufficiently claimed that the

misrepresentations and omissions concerning looting were

-14- material,1 plaintiffs easily satisfy the “in connection with” the

sale or purchase of a security requirement.

c. Scienter

Tyco argues that the scienter of the individual defendants

cannot be attributed to it because it was an innocent victim of

the looting. In making this argument, Tyco invokes the “adverse

interest” exception to the general rule that “scienter alleged

against the company’s agents is enough to plead scienter for the

company.” In re Cabletron,

0 . The adverse interest

exception potentially applies where “an agent secretly is acting

adversely to the principal and entirely for his own or another’s

purposes . . . .” Restatement (Second) of Agency § 282; see also

Wight v . BankAmerica Corp.,

9 , 87 (2d Cir. 2000)

(applying New York l a w ) .

1 Although defendants argue otherwise, their position on this point is so insubstantial that it does not require extensive analysis. An omitted fact is material if its disclosure “would have been viewed by a reasonable investor as having significantly altered the ‘total mix’ of information made available.” Basic, Inc. v . Levinson,

2 4 , 231-32 (1988). Moreover, materiality generally presents a question of fact for the jury. See Gebhardt v . ConAgra Foods, Inc.,

2 4 , 829 (8th Cir. 2003). Specific allegations that senior management looted a company of hundreds of millions of dollars in previously undisclosed benefits clearly presents a triable argument that the undisclosed information was material.

-15- Tyco’s argument is unavailing for two reasons, each of which

is independently sufficient to resolve the matter. First,

plaintiffs contend that the adverse interest exception is

inapplicable because the individual defendants did not act

“entirely for their own benefit” when they engaged in the

looting. Instead, plaintiffs argue that the consolidated

complaint can fairly be read to charge that the looting was a

part of a larger scheme to artificially inflate the price of

Tyco’s stock through fraudulent accounting practices. According

to plaintiffs, the accounting fraud scheme benefitted Tyco by

allowing it to generate cash through stock sales and borrowing to

fund its acquisition strategy, and the looting furthered the

fraud scheme by giving the individual defendants a financial

incentive to implement the scheme. While plaintiffs ultimately

may not be able to prove this theory at trial, it is sufficient

at this stage of the proceedings to rebut Tyco’s reliance on the

adverse interest exception.

Plaintiffs alternatively argue that the adverse interest

exception is itself subject to an exception “when an innocent

third-party relies on representations made with apparent

authority.” Donald C . Langevourt, Agency Law Inside the

-16- Corporation: Problems of Candor and Knowledge, 71 U . Cin. L . Rev.

1187, 1214 (2003); see also Restatement (Third) of Agency, § 5.04

(Tentative Draft N o . 4 , 2003). The exception potentially applies

here to the extent that plaintiffs qualify as innocent third

parties who were justified in believing that the individual

defendants were acting with Tyco’s authority when they made the

misstatements and omissions on which the looting claims are

based.

I agree with plaintiffs that the adverse interest exception

is inapplicable when a corporate officer or director makes a

material misstatement or omission to an innocent third-party

while acting with the apparent authority of the corporation for

whom he works. The First Circuit, in In re Atlantic Financial

Management,

(1st Cir. 1986), recognized as much when

it held that “a corporation’s liability for an agent’s misrepre-

sentations may rest upon a theory of ‘apparent authority.’”

at 31-32 (quoting Restatement (Second) of Agency, § 8 ) . Although

the misrepresentations that were at issue in that case were not

adverse to the corporate defendants’ interests, the risk

allocation policies that led the court to apply the apparent

authority doctrine to misstatements generally apply with equal

-17- force when the misstatements are adverse to the corporation’s

interests. Compare In re Atlantic,

(fair and

efficient allocation of risk favors application of apparent

authority doctrine to § 10(b) claim) with Restatement (Third) of

Agency § 5.04 cmt. C (Tentative Draft N o . 4 , 2003) (fair and

efficient allocation of risk justifies innocent party exception

to adverse interest rule). Accordingly, because the consolidated

complaint properly pleads both that the plaintiffs are innocent

parties and that the individual defendants acted with apparent

authority when they allegedly made the misstatements and

omissions on which the looting claims are based, the complaint

sufficiently alleges that the scienter of the individual

defendants is attributable to Tyco.

d. Duty to disclose

Tyco next argues that the looting claims are not actionable

because it was not required to disclose the looting.

A § 10(b) claim cannot be based on a failure to disclose

information unless the omitted information was material and the

defendant was under a duty to disclose i t . See Gross v . Summa

Four, Inc.,

8 7 , 992 (1st Cir. 1996). The First Circuit

has recognized three circumstances in which a corporation may be

-18- required to disclose material, nonpublic information. The first

is when the corporation has made a statement of material fact

that becomes false or misleading if the undisclosed information

is omitted. See Gross,

. The second is when

insiders trade stock or a corporation issues stock on the basis

of the undisclosed information. See Shaw,

. The

third is when a statute or regulation requires the information to

be disclosed. See Gross,

n.4; Shaw,

n.3. Plaintiffs rely on the third circumstance, claiming

that Tyco was required to disclose the looting under items 402

and 404 of SEC Regulation S-K.

Item 402 requires “the disclosure of all plan and non-plan

compensation awarded t o , earned by, or paid to” the corporation’s

directors, its CEO, its four most highly compensated executive

officers, and up to two additional individuals who would have

been among the most highly paid if they had been executive

officers.

. Item 404 requires the disclosure

of “transactions” involving more than $60,000 between the

corporation and its directors, executive officers, nominees for

director positions, individuals who own more than 5% of a

corporation’s stock, and immediate family members of any person

-19- subject to the disclosure requirement.

.

Plaintiffs argue that Tyco was required to disclose the looting

either as compensation or as related party transactions.

Tyco offers three arguments in opposition. First, it

asserts that it was not required to disclose the looting because

looting involves the taking of property without authorization.

Items 402 and 4 0 4 , by contrast, apply only if a corporation is a

willing participant in a financial transaction. I disagree.

This is not a case of routine theft by a low-ranking employee,

which obviously would not be covered by Items 402 and 404.

Instead, plaintiffs charge that Kozlowski, Swartz, and other

senior executives ran Tyco as a criminal enterprise and that

Kozlowski authorized the looting as compensation for

participation in a larger scheme to artificially inflate the

price of Tyco’s stock. Defendants have failed to present a

persuasive case that the benefits authorized by a corporation’s

CEO are exempt from disclosure under Items 402 and 404 merely

because the benefits were concealed from the corporation’s

directors.

Tyco’s second argument is that it was not required to report

the looting because its board of directors did not learn of it

-20- until long after it occurred. As I have explained in discussing

Tyco’s scienter argument, because Kozlowski’s knowledge of the

looting is attributable to Tyco, this contention does not relieve

Tyco of liability.

Finally, Tyco argues that plaintiffs cannot base their

claims on Items 402 and 404 because these regulations do not give

rise to a private right of action for damages. This argument

fails because although plaintiffs rely on Items 402 and 404 to

establish that Tyco had a duty to disclose the looting, they base

their cause of action on § 10(b), rather than on the disclosure

regulations themselves. It is no longer open to dispute that a

private right of action exists to enforce § 10(b) when the

elements of a § 10(b) violation are present. See Herman &

MacLean v . Huddleston,

(1983). I find no

support in the language, structure, or purpose of Items 402 and

404 to support defendants’ argument that a person who fails to

disclose material information that is required by items 402 and

404 cannot be sued for damages pursuant to § 10(b) when the other

elements of a § 10(b) claim have been satisfied.

-21- 2. Accounting Fraud Claims

Plaintiffs dedicate more than 220 paragraphs of the

consolidated complaint to a recitation of allegedly false and

misleading statements and omissions by the defendants concerning

Tyco’s financial condition. In a separate section, they describe

several accounting schemes that defendants allegedly used to

mislead investors. Then, they attempt to support their stated

belief that the specified statements were misleading by citing to

findings in the Boies reports2 that Tyco engaged in “aggressive

accounting” of the types described in the consolidated complaint

and by pointing to billions of dollars in restatements and

corrections that Tyco was required to make to address past

accounting errors. They seek to support their claim that

defendants acted with scienter by charging that: (1) the targeted

accounting practices plainly violated Generally Accepted

Accounting Principles (“GAAP”) and thus were unlikely to have

2 The Boies reports were the result of a limited investigation of Tyco, conducted in 2002 by the law firm Boies, Schiller & Flexner, LLP at Tyco’s direction. The investigation was principally restricted to “the integrity of the company’s financials and the possible existence of systemic or significant fraud, or other improper accounting that would materially adversely affect the Company’s reported earnings or cashflow from operations in 2003 or thereafter.” Compl. ¶¶ 2 8 , 665.

-22- been innocently adopted; (2) the identified restatements are so

large that they are indicative of fraud; and (3) the allegations

of massive looting and hundreds of millions of dollars in stock

sales by insiders at inflated prices give rise to a strong

inference that the defendants acted with scienter. Finally, the

plaintiffs assert that they suffered compensable injuries that

were caused, at least in part, by the alleged accounting fraud.

Not surprisingly, defendants argue that these allegations are not

described in sufficient detail to survive a motion to dismiss. I

examine defendants’ most significant arguments in turn.

a. Identification of misleading statements and omissions

The PSLRA requires a plaintiff pleading securities fraud to

“specify each statement alleged to have been misleading.” 15

U.S.C. § 78U-4(b)(1). Plaintiffs satisfy this requirement by

identifying hundreds of specific statements in press releases,

quarterly (Form 10-Q) and annual (Form 10-K) reports, other SEC

forms including 8-K’s, S-8’s and S-4’s, proxy statements,

statements made by several of the individual defendants during

conference calls with the media, and statements from third

parties that identify individual defendants as the source of

-23- their information. The sheer quantity of these statements

prevents me from describing all of them and, in any event, such a

recitation is not required. See In re Cabletron,

-

33. Nevertheless, I list a few to illustrate the general tone

of the consolidated complaint:

2000 10-K incorrectly listed net income as $4,519.9 million (Compl. ¶ 462);

2000 Proxy Statement falsely listed Kozlowski and Swartz as having no outstanding loans from Tyco (Compl. ¶ 317);

• 2000 Annual Report to Shareholders falsely stated that Tyco’s “exceptional financial results” were the product of its “growth-on-growth” strategy (Compl. ¶ 467);

• January 17, 2001 Conference Call where CEO Kozlowski misleadingly reported that revenue was up 21% for the quarter as a result of organic growth (Compl. ¶ 477);

• March 16, 2001 Form S-3 and related Prospectus incorporated the same materially false and misleading statements set forth in Tyco’s Annual Report on Form 10-K for fiscal year ended September 30, 2000, Tyco’s 10-Q’s and Form 8-K’s, and the Consent of PwC, dated March 14, 2001, permitting the incorporation by reference of PwC’s materially false and misleading report, dated October 24, 2000 (Compl. ¶ 500-03);

2001 10-K incorrectly listed net income for fiscal 2001 as $3,970.6 million (Compl. ¶ 571).

These statements and others of similar ilk adequately specify the

“time, place, and content” of each allegedly misleading

-24- statement. Aldridge v . A.T. Cross Corp.,

2 , 78 (1st

Cir. 2002).

PwC charges that plaintiffs have failed to identify any

misstatements that it made on Tyco’s behalf, but a careful review

of the consolidated complaint reveals that plaintiffs base their

claims against PwC on its allegedly false statements in audit

letters, dated October 2 1 , 1999, October 2 4 , 2000, and October

1 8 , 2001, that Tyco’s financial statements had been prepared in

accordance with GAAP and that PwC’s audits of Tyco had been

conducted in accordance with Generally Accepted Accounting

Standards (“GAAS”). Compl. ¶¶ 169-72. These allegations

identify the misstatements on which plaintiffs’ claims are based

with the partiality required by the PSLRA.

b. Reasons why statements are misleading

The PSLRA also requires a plaintiff to explain why each

specifically identified statement is misleading. See 15 U.S.C. §

78U-4(b)(1). Plaintiffs seek to satisfy this requirement by

describing several different accounting schemes that defendants

allegedly used to artificially inflate the price of Tyco’s stock.

First, they claim that Tyco caused several specified acquisition

targets to overstate reserves, pre-pay expenses, and engage in

-25- other similar actions prior to the acquisition to make it appear

that the target company was growing more rapidly after the

acquisition than in fact was the case. Second, they charge that

Tyco failed to properly disclose a $4.5 billion impairment to the

goodwill of one of its subsidiaries. Third, they claim that Tyco

improperly recognized as earnings hundreds of millions of dollars

in excess reimbursements from independent dealers at another of

its subsidiaries, rather than spreading the reimbursements over

the life of the dealer contracts as GAAP requires. Finally, they

charge that Tyco failed to disclose certain specified practices

that violated federal income tax laws.3

Defendants counter that these allegations are insufficient

because plaintiffs have not properly linked their theories of

accounting fraud to the specific statements that they claim are

misleading. Condemning plaintiffs’ organizational approach as

impermissible “puzzle pleading,” they argue that the PSLRA

requires a plaintiff to separately identify each allegedly

3 The consolidated complaint also charges that Tyco misleadingly failed to disclose hundreds of acquisitions and failed to employ sufficient internal accounting controls. It is unclear whether these allegations are intended to stand as independent accounting fraud claims or whether they merely support the complaint’s central allegations.

-26- misleading statement and immediately thereafter list the reasons

why the statement is misleading. The consolidated complaint

fails to meet this requirement, defendants claim, because it

lists all of the misleading statements in one section but

describes the accounting schemes that make the statements

misleading in different sections. Although I am sympathetic to

defendants’ contention that the consolidated complaint is

difficult to decipher, I do not agree that it is so poorly

drafted that it violates the PSLRA. After identifying each

specific misleading statement, the complaint refers readers to

other sections that list multiple reasons why the statement is

misleading. This is a reasonable way to address a complicated

securities fraud case. It does not violate the PSLRA merely

because it makes the complaint difficult to understand.

Defendants next argue that the consolidated complaint is

deficient because it fails to identify specific amounts by which

various accounts were misstated. The PSLRA, however, does not

require such specificity if the complaint otherwise provides a

detailed description of the fraud schemes. See Aldridge,

1 . Plaintiffs support their claim that Tyco engaged in

acquisition accounting fraud by identifying several acquisition

-27- targets and describing the types of charges and other financial

machinations that occurred at the target companies before the

acquisitions were completed. When describing their allegation

that Tyco failed to properly record impairments to goodwill,

plaintiffs identify the affected subsidiaries and the amount by

which the goodwill was overstated. In describing Tyco’s alleged

failure to properly account for dealer reimbursements, plaintiffs

again identify the affected subsidiary, describe the fraud scheme

in detail and explain how the improper accounting affected the

accuracy of Tyco’s financial statements. Finally, plaintiffs

explain that Tyco allegedly committed undisclosed tax fraud by

instructing companies with which it was doing business to direct

rebate checks to offshore subsidiaries of Tyco where they would

not be subject to United States income taxes. No more is

required to satisfy this aspect of the PSLRA.

PwC argues that the consolidated complaint fails to

sufficiently explain why the statements on which plaintiffs’

claims against it are based were misleading. Again, I disagree.

Much like the complaint in Kinney v . Metro Global Media, Inc.,

(D.R.I. 2001), plaintiffs charge the

company’s independent accountant with issuing unqualified audit

-28- reports certifying the company’s financial statements for

specific years and claiming that the audits were performed in

conformity with GAAS. Also, as in Kinney, the complaint lists a

number of auditing standards and principles allegedly violated by

PwC which, taken as a whole, render the certified financial

statements materially misleading.4 Here, as in Kinney, the

4 The consolidated complaint lists the numerous GAAP violations that are alleged to have occurred during the class period. These include: (1) the improper accounting for acquisitions; (2) manipulation of accounting reserves for the purpose of inflating Tyco’s reported operating result; (3) failure to timely recognize expenses, including impairment of corporate assets; (4) failure to disclose material related party transactions (the corporate looting explained in Part II.A.1. supra); (5) engaging in “aggressive” accounting for the purpose of inflating Tyco’s reported results; (6) failure to appropriately restate previously issued and materially misleading financial statements; (7) improper recognition of “reimbursements” from independent dealers; (8) failure to disclose accounting policies in accordance with GAAP; and (9) the failure to disclose material contingent liabilities and significant risks and uncertainties. The consolidated complaint additionally lists audit violations of GAAS by PwC. These include: (1) violation of GAAS Standard of Reporting N o . 1 that requires the audit report to state whether the financial statements are presented in accordance with GAAP; (2) violation of GAAS Standard of Reporting N o . 4 because PwC should have stated that no opinion on Tyco’s financial statements could be reported; (3) violation of GAAS General Standard N o . 2 that requires independence in mental attitude be maintained by the auditor; (4) violation of SAS N o . 54 in that PwC failed to perform the audit procedures required in response to possible improper acts by Tyco; (5) violations of SAS N o . 1 and N o . 53 by failing to adequately plan its audit and

-29- “[p]laintiffs specified each statement they alleged to be

misleading [(the audit statements of financial statements, dated

October 2 1 , 1999, October 2 4 , 2000, and October 1 8 , 2001 (Compl.

¶¶ 2 4 , 170-72), and registration statements and prospectuses

filed during the class period that incorporated PwC’s audit

reports with PwC’s consent (E.g., Compl. ¶¶ 2 4 , 173, 286))] and

specified the reasons why the statements were allegedly

properly supervise the work and carry out procedures reasonably designed to search for and detect the existence of errors and irregularities that would have a material effect upon the financial statements; (6) violation of GAAS General Standard N o . 3 which requires that due professional care must be exercised by the auditor; (7) violation of GAAS Standard of Field Work N o . 2 , which requires the auditor to make a proper study of existing internal controls, including accounting, financial, and managerial controls, to determine whether reliance thereon is justified; and (8) violation of SAS N o . 82 in that it failed to adequately consider the risk that the audited financial statements were free from material misstatements, whether caused by errors or fraud, and that PwC ignored several risk factors, including: (a) an excessive interest by management in maintaining or increasing the entity’s stock price through the use of aggressive accounting; (b) a failure by management to display and communicate an appropriate attitude regarding internal controls and the financial reporting process; (c) management displaying a particular disregard for regulatory authority; (d) management continuing to employ an ineffective accounting or internal auditing staff; (e) significant party- related transactions not in the ordinary course of business oro with related entities not audited or audited by another firm; and (f) significant bank accounts or subsidiary or branch operations in tax-haven jurisdictions for which there appears to be no clear business justification.

-30- misleading [(violations of GAAP, violations of GAAS, failure to

report inadequate internal controls at Tyco, failure to report

looting behavior, etc.)]. . . .” Id. at 179. And like the court

in Kinney, these detailed allegations are sufficient to survive a

motion to dismiss even under the heightened pleading standards of

the PSLRA. Id.

c. Facts supporting belief that statements are misleading

The PSLRA requires a plaintiff to explain with particularity

why allegations made on information or belief are reasonable. 15

U.S.C. 78U-4(a)(1). Defendants argue that plaintiffs have failed

to satisfy this requirement with respect to their acquisition

accounting fraud claims.

A careful review of the consolidated complaint reveals that

plaintiffs have pleaded sufficient facts to support their

asserted belief that defendants engaged in acquisition accounting

fraud. Plaintiffs devote more than 20 paragraphs to a

specification of facts that they claim support their belief on

this point. Although several of their assertions are based on

newspaper accounts and reports from independent analysts,

plaintiffs also cite to admissions by Tyco such as its statement

-31- that “there were instances where prior management appeared to

influence the management of an acquisition target into adopting

accounting treatments that ‘over-accrued’ expenses prior to an

acquisition’s consummation or otherwise exceed what was permitted

by GAAP.” Compl. ¶ 106. When these allegations are viewed in

the context of the complaint as a whole, they are sufficient to

satisfy this aspect of the PSLRA.

d. Scienter

Defendants next argue that the consolidated complaint does

not support a strong inference that they acted with scienter.

“Liability under section 10(b) and Rule 10b-5 . . . requires

scienter, ‘a mental state embracing intent to deceive,

manipulate, or defraud.’” In re Cabletron,

(quoting Ernst & Ernst v . Hochfelder,

, 193 n.12

(1976)). Scienter also “may extend to a form of extreme

recklessness that ‘is closer to a lesser form of intent.’” In re

Cabletron,

(quoting Greebel v . FTP Software, Inc.,

(1st Cir. 1999); see also Aldridge,

2 . Under the PSLRA, “the plaintiff must . . . show that the

inferences of scienter are both reasonable and strong.”

-32- Aldridge,

(quotations omitted). The First

Circuit, however, has “rejected any rigid formula for pleading

scienter, preferring to rely on a ‘fact-specific approach’ that

proceeds case by case.” In re Cabletron,

(quoting

Aldridge,

2 ) ; see also Greebel,

.

While scienter can be established through direct evidence of

“conscious wrongdoing,” other types of evidence also may be

considered. “[T]he plaintiff may combine various facts and

circumstances indicating fraudulent intent - including those

demonstrating motive and opportunity - to satisfy the scienter

requirement.” Aldridge,

2 .

Although by no means exhaustive, some of the types of

circumstantial evidence that have been found to be relevant in

pleading scienter are: (1) GAAP violations, see In re Cabletron,

9 ; (2) accounting shenanigans, see id.; Geffon v .

Micrion Corp.,

9 , 36 (1st Cir. 2001); (3) large-scale

fraudulent practices over time, see In re Cabletron,

9 ; (4) stock sales by insiders, see, e.g., In re Cabletron,

; (5) the quick settlement of an ancillary fraud

suit, see Greenstone v . Cambex Corp.,

2 , 26-27 (1st

-33- Cir. 1992); (6) disregard for the most current financial

information when making statements, see Glassman v .

Computervision Corp.,

1 7 , 627 (1st Cir. 1996); (7) the

self-interest of defendants in saving their own salaries or jobs,

see Serabian,

; and (8) financial restatements, see

Aldridge,

3 . While no single factor will generally

be sufficient to support a strong inference of scienter, a

combination of several factors may satisfy the requirement. See

In re Cabletron,

0 .

Plaintiffs have identified several different factors in this

case that are collectively sufficient to support a strong

inference that Kozlowski, Swartz, and Belnick acted with

scienter. First, plaintiffs describe a massive fraud scheme

perpetrated by the company’s senior management over an extended

period of time. Second, they claim that the various accounting

schemes employed by the defendants violated well-established

accounting practices and, in some cases, were adopted in

disregard of advice provided by the company’s outside auditors.

Third, they claim that Kozlowski, Swartz, and Belnick reaped

hundreds of millions of dollars in benefits during the course of

-34- the fraud scheme in undisclosed compensation, related party

transactions, and stock sales at inflated prices. While no one

of these factors standing alone would be sufficient, the

consolidated complaint as a whole pleads enough culpable facts to

give rise to a strong inference that these defendants acted with

scienter. Further, as I have explained previously when

discussing plaintiffs’ looting claims (see discussion supra Part

II.A.1.c.), these allegations also satisfy the PSLRA’s pleading

requirements with respect to Tyco because the scienter of its

senior executives can be attributed to the company for whom they

worked.

Walsh and Ashcroft arguably are in a different position from

the other individual defendants because they served as outside

directors. Plaintiffs charge that Walsh served as Tyco’s lead

director and claim that he was actively involved in negotiations

surrounding the CIT acquisition, one of the major transactions on

which the consolidated complaint is based. They also allege that

Kozlowski caused Tyco to pay Walsh a $20 million fee for his work

in connection with the CIT acquisition and that Walsh later

pleaded guilty to a criminal charge in which he admitted that he

-35- knowingly concealed the $20 million payment. These allegations

are sufficient to support a strong inference that Walsh acted

with scienter with respect to his alleged failure to disclose the

$20 million fee. Whether they are also sufficient to support an

inference that he was a culpable participant in the alleged

accounting fraud schemes, however, is a more difficult question

that the parties have not adequately briefed. Because I am not

confident that I can reliably resolve the issue without their

help, I leave its resolution for a later date.

The allegations against Ashcroft, in contrast, do not reach

the necessary threshold to make out a valid claim that he acted

with scienter. The consolidated complaint’s sole claim that he

received undisclosed benefits involved the sale of his Florida

home. The complaint charges that Ashcroft sold the home to his

wife for $100 and that she immediately resold it to a Tyco

employee for $2.5 million. The complaint further charges that

Tyco funds were used to cover the purchase price and that the

home thereafter was used by Kozlowski rather than its nominal

owner. Plaintiffs, however, do not allege that Ashcroft was

aware that the home had been purchased with Tyco funds. This is

-36- in sharp contrast to the allegations against Walsh, because the

complaint asserts that Walsh agreed with Kozlowski to conceal the

$20 million “finders fee.” While the complaint also charges that

Ashcroft signed various SEC filings in his capacity as a

director, and sold in excess of $100 million in Tyco stock during

the class period, it does not allege that he was involved in the

day-to-day management of the company or that he was otherwise

privy to management decisionmaking concerning the allegedly

fraudulent accounting practices. Under these circumstances,

allegations that he signed corporate filings and sold large

amounts of stock are not sufficient, by themselves, to establish

scienter. For this reason, the consolidated complaint does not

state a viable § 10(b) claim against Ashcroft.

Plaintiffs cite several facts to support their contention

that PwC acted with the degree of recklessness that is required

to support a § 10(b) claim against a company’s outside

accountant. First, they allege that PwC had a motive to

acquiesce in the accounting fraud scheme because Tyco was a long-

standing PwC client and had paid PwC more than $51 million in

fees during fiscal year 2001 alone. Second, plaintiffs charge

-37- that PwC had ample opportunity to detect the accounting fraud and

ensure that its statements about Tyco’s financial condition were

correct because PwC personnel were regularly present at Tyco’s

corporate headquarters during the class period and had full

access to the company’s accounting records. Plaintiffs further

charge that the accounting problems at Tyco should have been

readily detectable by PwC during the audit process because Tyco

has since admitted that: its internal accounting controls were

inadequate; it engaged in “aggressive accounting” during the

period covered by PwC’s audit letters; its earnings during the

class period were overstated by $5.6 billion; and its senior

executives looted hundreds of millions of dollars from the

company during the class period. Plaintiffs also cite evidence

that they claim demonstrates that even though PwC was placed on

notice of the existence of loans from Tyco, these loans

nevertheless were not disclosed in the manner required by GAAP.

While no one of these factors alone would be sufficient to

support a strong inference that PwC acted with scienter,

collectively they are sufficient to give rise to a strong

inference that PwC acted with the degree of recklessness required

-38- to support a finding of scienter.5

e. Loss Causation

Defendants next argue that plaintiffs have failed to

adequately plead that the accounting fraud claims caused the

losses for which they are seeking compensation. To survive a

Rule 12(b)(6) challenge to a § 10(b) claim, a plaintiff must

allege that “the act or omission of the defendant alleged to

violate [§10(b)] caused the loss for which the plaintiff seeks to

recover damages.” 15 U.S.C. § 78u-4(b)(4). Two types of

causation must be alleged: “loss causation,” which addresses the

relationship between a misleading act or omission and stock

price, and “transaction causation,” which addresses the

relationship between a misleading act or omission and the

5 PwC argues that the amounts of allegedly unauthorized loans to the individual defendants were in fact disclosed in the aggregate. As plaintiffs note, however, it was not the existence of employee loan programs that were omitted, but the improper transactions between Tyco and the related parties that abused these programs. Plaintiffs claim that PwC’s alleged failure to identify the specific material related party transactions, the nature of the transactions, and the dollar amount for each transaction constituted a breach of GAAP. Disclosing aggregate dollar amounts of outstanding loans in general categories while concealing the details thus does not avoid the misconduct on which plaintiffs’ claim is based.

-39- plaintiff’s decision to buy or sell stock. See CitiBank, N.A. v .

K-H Corp.,

(2d Cir. 1992). Defendants argue

that plaintiffs have failed to properly plead loss causation.

Most courts that have addressed the issue of loss causation

have held that a plaintiff ultimately must prove that a change in

stock price is causally linked to a corrective disclosure of

misleading information. See, e.g., Emergent Capital Inv. Mgmt.,

LLC v . Stonepath Group, Inc.,

(2d Cir. 2003);

Semerenko,

; Robbins v . Koger Prop. Inc.,

, 1447 (11th Cir. 1997); Bastian v . Petren Res. Corp.,

8 0 , 685-86 (7th Cir. 1990); but see Broudo v . Dura

Pharm., Inc.,

(9th Cir. 2003); cert. granted

(change in stock price not required); In re Control Data Corp.

Sec. Litig.,

(8th Cir. 1991) (same).

Defendants adopt this view in arguing that plaintiffs have failed

to sufficiently plead loss causation with respect to their

accounting fraud claims. Their argument is that because the

consolidated complaint explicitly links decreases in Tyco’s stock

price only to disclosures of looting by senior management, the

complaint does not properly plead loss causation with respect to

-40- the accounting fraud claims.

I reject defendants’ argument because it is based on an

unfairly narrow reading of the consolidated complaint. While I

agree that the sole paragraph in the complaint that is expressly

devoted to the subject of loss causation charges that decreases

in Tyco’s stock price were causally linked to disclosures that

senior management allegedly had engaged in looting and other

criminal conduct, the same paragraph also alleges that the price

decreases occurred “as the Tyco defendants fought off attacks on

the credibility of the company’s financial statements and the

integrity of its management.” Compl. ¶ 716. As other paragraphs

make clear, the attacks that defendants were resisting were

directed at many of the accounting machinations on which the

present claims are based. Reading the complaint as a whole, it

thus fairly charges that Tyco’s stock price declined in part

because investors concluded that they could no longer credit the

company’s denials of accounting misconduct. These allegations

are sufficiently particular to survive a Rule 12(b)(6) challenge.

f. Other arguments

Defendants also charge that many of the consolidated

-41- complaint’s allegedly misleading statements are not actionable

because: (1) they qualify as mere puffery; (2) they are forward-

looking statements protected by the PSLRA’s safe harbor

provision,

(a)(1); or (3) they were made by

third parties and cannot be attributed to the defendants. I

decline to consider the merits of these arguments because they

would not produce a complete dismissal of any of the charges even

if they prove to be valid. Defendants may raise these arguments

again later if they can demonstrate that a ruling from the court

would significantly affect the scope of discovery, the

possibility of settlement, or the nature of the trial.

B. Section 14(a)

Section 14(a) of the Exchange Act punishes misleading

statements or omissions of material fact that are made in

connection with the solicitation of proxies. “To prevail on a

Section 14(a) claim, a plaintiff must show that (1) a proxy

statement contained a material misrepresentation or omission

which (2) caused the plaintiff injury and (3) that the proxy

solicitation itself, rather than the particular defect in the

solicitation materials, was ‘an essential link in the

-42- accomplishment of the transaction.’” Gen. Elec. C o . v .

Cathcart,

2 7 , 932 (3d Cir. 1992) (quoting Mills v .

Elec. Auto-Lite Co.,

(1970)). This third step

requires a plaintiff to “establish a causal nexus between the[]

alleged injury and some corporate transaction authorized (or

defeated) as a result of the allegedly false and misleading proxy

statements.” Royal Bus Group, Inc. v . Realist, Inc.,

(1st Cir. 1991).

Plaintiffs base their § 14(a) claims on proxy statements

issued by Tyco on March 1 , 2000, January 2 9 , 2001, and January

2 8 , 2002. Compl. ¶ 731. The consolidated complaint asserts that

these statements sought proxies in order to reelect directors,

allow director remuneration to be set by the board, and reappoint

PwC as Tyco’s auditor. Although the complaint is not clear on

this point, plaintiffs apparently contend that misleading

statements and omissions in the proxy statements led to the

adoption of the specified measures and that these measures, in

turn, injured plaintiffs in their capacities as shareholders.

Defendants argue, among other things, that plaintiffs have

failed to properly plead causation. In making this argument,

-43- they rely primarily on the Third Circuit’s decision in General

Electric C o . v . Cathcart,

(3d Cir. 1992), in which

the court rejected a § 14(a) claim for damages resulting from

alleged mismanagement by directors who were reelected on the

basis of allegedly misleading proxy statements. Id. at 933.

There, the court reasoned that damages that are subsequently

caused by directors who are elected on the basis of misleading

proxy statements are simply too remote from the misleading

statements themselves to support a claim under § 14(a). See id.

Plaintiffs have not attempted to respond to defendants’ plausible

causation argument, and thus they have waived their right to

object to the dismissal of the § 14(a) claims on this basis.

See, e.g., Michelson v . Digital Fin. Servs.,

(1st Cir. 1999) (failure to respond to properly presented

argument constitutes waiver of right to object).

C. Sections 11 & 12(a)(2)

Defendants challege plaintiffs’ claims under §§ 11 and

12(a)(2) of the Securities Act by claiming that plaintiffs have

failed to plead their claims with the particularity required by

Rule 9 ( b ) .

-44- Section 11 creates a right of action for damages by

securities purchasers when registration statements contain untrue

statements of material fact or material omissions, and plaintiffs

can trace their shares to those registration statements. 15

U.S.C. § 77k(a). Under § 1 1 , the company, any signer of the

misleading registration statement, the directors of the company,

and any accountant that certified or prepared any report or

valuation used in connection with the registration statement, may

be held liable. See Versyss Inc. v . Coopers & Lybrand, Etc.,

(1st Cir. 1992) (“Section 11 . . . is remarkably

stringent where it applies, readily imposing liability on

ancillary parties to the registration statement (like

accountants) for the benefit even of purchasers after the

original offering.”). Under § 12(a)(2), all a plaintiff need

show is that he purchased a security pursuant to a prospectus or

oral communication that contained an untrue statement of material

fact or a material omission. 15 U.S.C. § 77l(a)(2). The only

relevant difference between a § 11 and a § 12(a)(2) claim is that

the latter includes oral statements and plaintiffs must

demonstrate that the named defendants were sellers or offerors of

-45- Tyco stock. Compare 15 U.S.C. § 77k(a) with 15 U.S.C. §

77l(a)(2).

Neither § 11 nor § 12(a)(2) requires an allegation of

scienter. See Shaw,

. Nevertheless, the First

Circuit has recognized that “a complaint asserting violations of

[§§ 11 and 12(a)(2)] may yet sound[] in fraud” and thus may be

subject to the rigorous pleading requirements established by Rule

9(b). Id. Defendants argue that plaintiffs’ claim under § 11

and § 12(a)(2) are so steeped in fraud that they are required to

plead their claims with particularity. I disagree.

Even if I assume, as defendants insist, that fraud lies at

the core of plaintiffs’ claims, I would not dismiss otherwise

sufficient claims under §§ 11 and 12(a)(2) merely because they

fail to plead fraud with particularity. Instead, the proper

remedy for a failure to comply with Rule 9(b) would be to strike

any deficient allegations and then assess the sufficiency of the

remaining allegations. See Vess v . CIBA-Geigy Corp., USA,

(9th Cir. 2003); Lone Star Ladies Inv. Club v .

Schlotzsky’s, Inc.,

(5th Cir. 2001); Carlon v .

Thaman (In re Nationsmart Corp. Sec. Litig.),

, 315

-46- (8th Cir. 1997). In the present case, because plaintiffs do not

base their §§ 11 and 12(a)(2) claims on fraud, there are no

allegations of fraud to strike. Further, because the claims

easily satisfy the much less demanding requirements of Rule 8 ( a ) ,

they are not subject to dismissal pursuant to Rule 12(b)(6).

PwC also challenges plaintiffs’ § 11 claim by arguing that

plaintiffs have not sufficiently alleged that their stock

purchases can be traced to a misleading registration statement.

In making this argument, PwC rightly contends that in order to

have standing to bring a § 11 claim, a plaintiff must aver that

the shares he purchased are traceable to the offering covered by

the allegedly misleading registration statement. See, e.g., Krim

v . PcOrder.com, Inc., N o . A-00-CA-776-§,

(W.D.

Tex. May 5 , 2003) (plaintiffs who could not trace securities to

the registration statement lacked standing under § 1 1 ) . Contrary

to PwC’s position, however, plaintiffs have pled traceability by

asserting that they “acquired Tyco shares issued pursuant t o , or

traceable t o , and in reliance o n , the Registration Statements/

Prospectuses.” Compl. ¶ 757. Since a motion to dismiss is not

the appropriate forum to test the veracity of such assertions,

-47- they are sufficient to plead traceability and therefore to

establish plaintiffs’ standing to sue. See In re Ultrafem Inc.

Sec. Litig.,

7 8 , 694 (S.D.N.Y. 2000) (plaintiffs’

allegation in complaint “that they made their purchases ‘pursuant

to and/or traceable to the Registration Statement’” sufficient to

plead traceability and establish standing for § 11 claims).

D. Sections 20(a) and 15

Plaintiffs also assert claims under § 20(a) of the Exchange

Act and § 15 of the Securities Act against Kozlowski, Swartz,

Belnick, Walsh, and Ashcroft. Both sections impose derivative

liability on defendants who “control” primary violators of the

securities laws. See 14 U.S.C. § 78t(a); 15 U.S.C. § 77o.

Because I have already determined that the consolidated complaint

states primary violations under § 10(b) of the Exchange Act and

§§ 11 and 12(a)(2) of the Securities Act, the only remaining

question is whether the complaint sufficiently alleges that the

individual defendants controlled the primary violators. On this

issue, the First Circuit has stated that “the alleged controlling

person must not only have the general power to control the

company, but must also actually exercise control over the

-48- company.” Aldridge,

5 . It also has acknowledged,

however, that “[c]ontrol is a question of fact that ‘will not

ordinarily be resolved summarily at the pleading stage.’” In re

Cabletron,

(quoting 2 T.L. Hazen, Treatise on the

Law of Securities Regulation, § 12.24(1) (4th ed. 2002)).

Only Walsh and Ashcroft present serious arguments for

dismissal of plaintiffs’ “control person” claims. Plaintiffs

respond by noting that both defendants served as directors and

signed allegedly false SEC filings on Tyco’s behalf. However,

“[t]he assertion that a person was a member of a corporation’s

board of directors, without any allegation that the person

individually exerted control or influence over the day-to-day

operations of the company, does not suffice to support an

allegation that the person is a control person . . . .” See

Adams v . Kinder-Morgan, Inc.,

(10th Cir.

2003). The only additional allegations that plaintiffs make with

respect to Ashcroft are that he was a major shareholder and once

served as the CEO of a corporation that Tyco later acquired.

These facts do not add enough evidence of control to salvage

plaintiffs’ control person claims against Ashcroft. Plaintiffs’

-49- claims against Walsh are marginally stronger because the

complaint alleges that Walsh was the company’s lead outside

director, was actively involved in at least one of the major

transactions on which the claims are based, and succeeded in

negotiating a $20 million “finders fee” for himself in connection

with that transaction. This evidence is sufficient, although

barely s o , to survive a motion to dismiss. Accordingly, I grant

Ashcroft’s motion to dismiss the control personal claims against

him, but deny Walsh’s corresponding motion.

E. Section 20A

Plaintiffs next assert claims under § 20A of the Exchange

Act against Kozlowski, Swartz, Belnick, Walsh, and Ashcroft.

Section 20A creates a private right of action for insider

trading. It potentially covers “[a]ny person who violates any

provision of [the Exchange Act] or the rules or regulations

thereunder by purchasing or selling a security while in

possession of material, nonpublic information . . . .” 15 U.S.C.

§ 78t-1. Plaintiffs charge that the individual defendants

violated this provision by selling hundreds of millions of

dollars in Tyco stock without disclosing the looting and

-50- accounting fraud described in the consolidated complaint.

All five individual defendants argue that the § 20A claims

are defective because plaintiffs have failed to sufficiently

allege that they committed underlying violations of the Exchange

Act. As I have explained, this argument is valid only with

respect to Ashcroft.

Walsh also argues that the § 20A claim against him is

invalid because the stock sales on which the claim is based were

made to fund additional purchases of Tyco stock through the

exercise of stock options. Walsh fails to cite any case law to

support this argument. Nor does he explain why such transactions

may never count as stock sales under § 20A. I decline to

speculate about the merits of an argument that has not been

properly developed. Accordingly, I reject his motion to dismiss

on this basis.

F. Statutes of Limitation

Plaintiffs’ claims under § 10(b) and § 20(a) of the Exchange

Act and § 1 1 , § 12(a)(2), and § 15 of the Securities Act are

subject to one-year statutes of limitation that begin to run from

the date that the plaintiffs knew or reasonably should have known

-51- of the facts on which the claims are based.6 See Lampf, Pleva,

Lipkind, Prupis & Petigrow v . Gilbertson,

5 0 , 364 n.9

(1991) (§ 10(b) claims); Westinghouse Elec. Corp. v . Franklin,

, 353 (2d Cir. 1993) (§ 14(a) claims); Dodds v . Cigna

Sec., Inc.,

, 350 n.2 (2d Cir. 1993) (§ 20(a) claims);

Short v . Belleville Shoe Mfg. Co.,

(7th Cir.

1990) (§ 11 and 12(a)(2) claims); Tracinda Corp. v .

DaimlerChrysler AG,

2 , 55 n.5 (D. Del. 2002) (§

15 claims). Defendants argue that plaintiffs’ acquisition

accounting fraud claims are barred by these statutes of

limitation to the extent that they are based on conduct that

occurred more than one year before the complaints asserting the

claims were filed. Plaintiffs respond by contending that their

6 The Sarbanes-Oxly Act, Pub. L . 107-204, created a two- year statute of limitation that potentially applies in proceedings that are commenced after the Act’s June 3 0 , 2002 effective date. See

. The new limitation period covers private rights of action that involve “a claim of fraud, deceit, manipulation, or contrivance in contradiction of a regulatory requirement concerning the securities laws as defined in Section 3(a)(47) of the Securities Exchange Act of 1934.”

. The parties disagree as to whether the two-year limitation period applies to plaintiffs’ Securities Act claims. I decline to resolve this issue because I determine that the claims should not be dismissed even if they are subject to only a one-year limitation period.

-52- claims are not time-barred because they acted promptly after

learning of their potential claims.

A two-part test is used in this circuit to determine whether

a plaintiff has sufficient notice of a securities claim to

trigger the one-year limitations period. First, the party

invoking the statute must demonstrate that sufficient “storm

warnings”7 of fraud were on the horizon to trigger a duty to

inquire further. See Young v . Lepone,

, 9 (1st Cir.

2002). If the defendant satisfies this requirement, the

plaintiff must respond with evidence establishing that even a

reasonably diligent investigation would not earlier have produced

sufficient evidence to permit the filing of a viable complaint.

See id.; see also Marks v . CDW Computer Ctrs.,

(7th Cir. 1997) (“not only must the investor be on notice of the

need to conduct further inquiry, but the investor also must be

able to learn the facts underlying the claim with the exercise of

7 The First Circuit has explained that “storm warnings” exist “[w]hen telltale warning signs augur that fraud is afoot,” such that if the warning signs are “sufficiently portentous,” they may, “as a matter of law be deemed to alert a reasonable investor to the possibility of fraudulent conduct.” Young v . Lepone,

, 8 (1st Cir. 2002).

-53- reasonable diligence”). It is only when a reasonably diligent

investigation would have identified sufficient evidence to permit

the filing of a legally sufficient complaint that the statute of

limitation begins to run. See Young,

. Both parts

of this test present issues of fact. See

Thus, a dispute

about whether sufficient storm warnings were present to deny the

plaintiff the benefit of the discovery rule generally will not be

resolvable on a motion to dismiss, unless it is plain from the

complaint itself that the plaintiffs’ claims are time-barred.

See

; see also LC Capital Partners, L.P. v . Frontier Ins.

Group, Inc.,

4 8 , 155 (2d Cir. 2003).

Defendants attempt to satisfy the first part of this test by

pointing to what they argue are multiple storm warnings that

acquisition accounting fraud was occurring well more than a year

prior to the filing of a complaint. In particular, they point

to: (1) the publication of analysts’ reports and newspaper

articles in October 1999 accusing Tyco of acquisition accounting

fraud; (2) the announcement by Tyco in December 1999 that the SEC

had commenced an investigation into Tyco’s acquisition

accounting; (3) the significant drop in Tyco’s stock price that

-54- followed the announcement of the SEC investigation; and (4) the

commencement of litigation against Tyco based on acquisition

accounting fraud in December 1999.

Plaintiffs challenge the sufficiency of these storm

warnings, but even more persuasively argue that a reasonably

diligent investigation would not have produced enough information

to permit them to earlier file legally sufficient securities

fraud complaints. This is s o , plaintiffs claim, because

defendants denied that they were engaging in acquisition

accounting fraud and took steps to conceal their misconduct.

These steps would have prevented even a diligent investor from

earlier developing the information needed to sue. The most

compelling evidence that plaintiffs cite in support of this point

is the fact that the SEC closed its investigation of Tyco in July

2000 without uncovering the acquisition accounting fraud scheme.

Plaintiffs thus sensibly claim that a reasonable investor could

not have uncovered sufficient evidence to support an acquisition

accounting fraud claim if the SEC, with far greater resources,

was unable to do so itself.

-55- I need not resolve this dispute to dispose of defendants’

argument. It is enough at this stage of the proceedings to say

that this is not a case in which I can determine when the

statutes of limitation began to run based solely on the facts

pleaded in the consolidated complaint.8

III. CONCLUSION

For the reasons set forth in this Memorandum and Order, I

grant defendants’ motions to dismiss to the extent that they seek

dismissal of plaintiffs’ claims under § 14(a) of the Exchange

Act. I also grant Ashcroft’s motion to dismiss plaintiffs’

8 Plaintiffs’ claims are also subject to statutes of repose. The Sarbanes-Oxly Act extended the repose period from three years to five years for private rights of action that are asserted in proceedings that are commenced after July 3 0 , 2002 and that involve “a claim of fraud, deceit, manipulation, or contrivance of a regulatory requirement concerning the securities laws as defined in Section 3(a)(47) of the Securities Exchange Act of 1934.”

. The parties disagree as to whether the Sarbanes-Oxly Act applies to plaintiffs’ Securities Act claims. I decline to resolve this dispute now because it appears that few, if any, of plaintiffs’ claims would be substantially affected by the resolution of this dispute. Defendants may raise this argument later if they can demonstrate that a ruling from the court would significantly affect the scope of discovery, the possibility of settlement, or the nature of the trial.

-56- claims against him under § 10(b), § 20(a) and § 20A of the

Exchange Act and § 15 of the Securities Act. In all other

respects, defendants’ motions to dismiss (Doc. Nos. 4 3 , 4 6 , 4 7 ,

4 9 , 5 0 , and 51) are denied.

SO ORDERED.

Paul Barbadoro Chief Judge

October 1 4 , 2004

cc: Counsel of Record

-57-