Case № 06-2237
United States Court of Appeals
For The Sixth Circuit
Glynn Ley; Public Employees’ Retirement System of Mississippi, Plaintiffs – Appellants,
Visteon Corporation; Peter Pestillo; Michael Johnston; Daniel R. Coulson; James Palmer; Pricewaterhousecooper, L.L.P.,
Defendants – Appellees.
On Appeal From The United States District Court
For The Eastern District of Michigan At Detroit
FINAL BRIEF OF THE APPELLANTS
Oral Argument Requested
STATEMENT IN SUPPORT OF ORAL ARGUMENT
Appellants respectfully request oral argument. Given the relative complexity of the securities fraud claims involved in this case, oral argument will assist the Court in reaching a full understanding of the factual and legal issues raised in this appeal.
STATEMENT OF SUBJECT MATTER AND APPELLATE JURISDICTION
The district court had subject matter jurisdiction pursuant to 28 U.S.C. § 1331 because this action arises under Sections 10(b) and 20(a) of the Federal Securities Exchange Act of 1934 (“Exchange Act”), 15 U.S.C. §§ 78j(b) and 78t(a), and Securities and Exchange Commission (“SEC”) Rule 10b-5, 17 C.F.R. § 240.10b-5. Pursuant to 15 U.S.C. § 78aa, federal district courts have exclusive jurisdiction of violations of the Exchange Act and federal rules promulgated thereunder.
This Court has appellate jurisdiction pursuant to 28 U.S.C. § 1291. On August 31, 2006, the district court entered a final judgment dismissing the claims of Plaintiffs-Appellants Glynn Ley and Public Employees’ Retirement System of Mississippi (“Plaintiffs”) against Visteon Corporation (“Visteon,” or “the Company,”), senior executive officers of Visteon Corporation, including Peter Pestillo, Michael Johnston, Daniel R. Coulson, and James Palmer (“the Individual Defendants”), and Visteon’s auditor, PricewaterhouseCoopers, L.L.P. (“PwC”). (R.49, Order, Apx. p. 144.) Plaintiffs timely filed a notice of appeal on September 28, 2006, within 30 days of the district court’s final order. (R.50, Notice of Appeal, Apx. p. 165.)
STATEMENT OF THE ISSUES FOR REVIEW
- Did the district court err in dismissing Plaintiffs’ Section 10(b) and Rule 10b-5 claims against Visteon and the Individual Defendants based on finding that the fact-intensive truth-on-the-market defense applies at the pleading stage?
- Did the district court err in dismissing Plaintiffs’ Section 10(b) and Rule 10b-5 claims against Visteon and the Individual Defendants based on finding an inadequate pleading of scienter without considering the totality of Plaintiffs’ allegations?
- Did the district court err in dismissing Plaintiffs’ claims against the Individual Defendants as controlling persons under Section 20(a) of the Exchange Act?
- Did the district court err in dismissing Plaintiffs’ Section 10(b) and Rule 10b-5 claims against PwC based on finding inadequate pleading of scienter without considering the totality of Plaintiffs’ allegations?
STATEMENT OF THE CASE
This case involves securities fraud claims brought by Plaintiffs against Visteon, senior executive officers of Visteon, and Visteon’s auditor, PwC. As alleged in the Amended Class Action Complaint filed on September 19, 2005, Plaintiffs’ claims are brought on behalf of themselves and a class of all persons who purchased or otherwise acquired securities in Visteon between June 28, 2000 and January 31, 2005 (the “class period”). (R.12, Am. Compl., p. 2, Apx. p. 48.) Plaintiffs allege that Visteon and the Individual Defendants perpetuated a sophisticated accounting scheme designed to inflate earnings and falsely present Visteon as a viable company independent from its one-time parent, Ford Motor Company (“Ford”). (Id. at p. 3, Apx. p. 49.) Plaintiffs further allege that Visteon’s outside auditor, PwC, consistently aided Visteon in defrauding investors over a four-year period. (Id. at pp. 77-85, Apx. pp. 123-31.)
On December 2, 2005, Visteon and the Individual Defendants filed a Motion to Dismiss Plaintiffs’ claims. (R.19, Visteon Motion to Dismiss, Apx. p. 200.) PwC filed a separate Motion to Dismiss. (R.18, PwC Motion to Dismiss, Apx. p. 169.) After a hearing on May 16, 2006, the district court granted both motions in their entirety on August 31, 2006. (R.49, Order, p. 20, Apx. p. 163) This timely appeal followed.
STATEMENT OF FACTS
Before its incorporation, Visteon operated as the parts division of Ford. (R.12, Am. Compl., p. 2; Apx. p. 48.) On January 5, 2000, Visteon was incorporated as a wholly owned subsidiary of Ford. (Id.) Thereafter, on June 28, 2000, Ford spun off Visteon (the “Spin-Off”) as a separate publicly traded company. (Id. at p. 13, Apx. p. 59.)
Visteon perpetuated the ruse that it was a viable company by making material misrepresentations and omissions regarding its financial situation beginning with the Spin-Off in 2000 and continuing through mid-2005, including: (1) repeatedly reporting inflated earnings over a four-year period, totaling $198 million; (2) failing to disclose material weaknesses in the Company’s internal controls over financial accounting and reporting; (3) issuing financial statements that violated Generally Accepted Accounting Principles (GAAP) both during and after the Spin-Off; (4) failing to recognize losses on contracts with Ford when such losses were inherent at the time of the Spin-Off; (5) making misleading statements regarding the Company’s solvency; and (6) failing to disclose that Visteon was controlled by Ford.
Visteon’s Materially False and Inflated Earnings Reports
On January 31, 2005, Visteon issued a press release that revealed it had been perpetrating a fraud on its investors for most of its existence. On that date, Visteon announced that the Company was reviewing and preliminarily restating its financial results for 2002, 2003 and the first three fiscal quarters of 2004. (Id. at pp. 47-51, Apx. pp. 93-97.) The financial restatements were necessary due to material weaknesses in Visteon’s internal controls that had caused accounting errors in several areas. (Id. at pp. 48, 51, Apx. pp. 94, 97.) In the same announcement, Visteon revealed that it was exploring strategic and structural changes to its Ford “legacy businesses” in an effort to “improve the Company’s cash structure and cost position.” (Id. at p. 49, Apx. p. 90.)
On March 16, 2005, the Company’s financial restatements revealed that it had understated net losses in fiscal years 2001, 2002 and 2003 by $40 million, and by $81 million in the first nine months of 2004 alone. (Id. at pp. 51-57, 68, Apx. p. 97-103, 114.) The Company still had not disclosed the full magnitude of its accounting fraud as of August 10, 2005, when the Company reported that the size of its financial restatement was even larger than previously stated and included an additional $77 million that should have been recorded in periods prior to December 31, 2004. (Id. at p. 60, Apx. p. 106.)
While still not complete as Visteon is yet to certify its financial statements for prior periods, Visteon has already restated – admitted as false – $198 million of Visteon’s earnings originally released in 2001, 2002, 2003 and the first three quarters of 2004. (Id. at pp. 72, 78, 82, Apx. pp. 118, 124, 128.) These earnings restatements, combined with Visteon’s admission that it did not have a sustainable business model because of its ties to Ford, were considered significant by the market. Upon the initial announcement in January 2005, the stock price immediately dropped 6.43% to $7.42 per share. (Id. at p. 51, Apx. p. 97.) The stock price continued to fall after the more detailed revelations in March 2005, reaching a low of $3.14 per share on May 11, 2005. (Id. at p. 57, Apx. p. 103.)
Visteon’s Failure to Disclose Material Weaknesses in Internal Controls
The restatement of earnings for 2001, 2002, 2003, and the first three quarters of 2004 were necessary because of accounting errors in health care, pensions, expendable tooling costs, inventory costs, tax asset valuations, purchasing, freight, accounts receivable, and income taxes. (Id. at pp. 51-53, 91, Apx. pp. 97-99, 137.) When Visteon finally started acknowledging its accounting errors, the Company admitted that it had “concluded that the deficiencies in internal controls that led to the errors constitute a ‘material weakness’ as defined by the Public Company Accounting Oversight Board’s [“PCAOB”] Auditing Standard No. 2.” (Id. at p. 51, Apx. p. 97.)
The auditors’ material weakness comments in its PCAOB report on internal controls indicated that those material weaknesses existed during 2001, 2002, 2003, and 2004. (Id. at p. 69, Apx. p. 115.) Yet those material weaknesses were not disclosed to the market until 2005. (Id.) As early as 2003 Visteon knew that the transfer of its information technology systems would adversely affect the Company’s internal controls over financial reporting. (Id. at pp. 55-56, Apx. pp. 101-02.)
Visteon’s reckless attitude toward internal financial controls continued well into 2005. Starting in 2005, in accordance with new SEC regulations mandated by the Sarbanes-Oxley Act, Visteon’s senior executives signed certificates verifying the integrity and accuracy of the Company’s financial statements. (Id. at pp. 65-66, Apx. pp. 111-12.) Visteon’s Sarbanes-Oxley Certifications applied to financial statements that restated earnings for 2001, 2002, 2003, and the first three quarters of 2004. (Id. at pp. 51-56, 65, Apx. pp. 97-102, 111.) The Certifications were signed by Individual Defendant Johnson as Chief Executive Officer and Individual Defendant Palmer as Chief Financial Officer. (Id. at p. 65, Apx. p. 111.) Yet just five months after those first Sarbanes-Oxley Certifications were signed in March 2005, Visteon announced an additional $77 million in accounting errors for fiscal years 2001-04 that were the result of faulty internal controls. (Id. at p. 60, Apx. p. 106.)
Visteon’s Financial Statements Violated GAAP
Throughout its history, Visteon has consistently released financial information in violation of GAAP. (Id. at pp. 25, 28, 31, 36, 40, 46, Apx. pp. 71, 74, 77, 82, 86, 92.) As required to effectuate the Spin-Off, Visteon and Ford jointly filed with the SEC a Prospectus and Registration Statement dated June 13, 2000 (the “Spin-Off Prospectus”). (Id. at p. 13, Apx. p. 59.) The financial information presented in the Spin-Off Prospectus violated GAAP in numerous ways, including not recognizing losses to assets known at the time. (Id. at p. 25, Apx. p. 71.) Visteon violated GAAP in each of its publicly released financial reports from 2000 to 2004 by not acknowledging losses on Ford contracts, misstating earnings, and not disclosing material weaknesses in internal financial controls. (Id. at pp. 28, 31-32, 36-37, 40-41, 46-47, Apx. pp. 79, 77-78, 82-83, 86-87, 92-93.)
The $77 million in additional losses announced in August 2005 were the product of conscious and willful violations of GAAP, the Company’s own revenue recognition policies and numerous accounting standards set forth by the Accounting Principles Board (APB) and the Financial Accounting Standards Board (FASB). (Id. at pp. 62-63, Apx. pp. 108-09.) According to a former senior finance director at Visteon, a number of Visteon’s GAAP violations were committed intentionally in order to inflate the Company’s financials. (Id. at pp. 61-62, Apx. pp. 107-08.)
Visteon’s Failure to Recognize Losses on Contracts Inherent at the
Time of the Spin-Off
One of Visteon’s most deceptive strategies was the failure to recognize losses from Ford that were known at the time of the Spin-Off. (Id. at pp. 28, 31, 73-74, Apx. pp. 74, 77, 119-20.) Following the Spin-Off, some of those losses were then periodically reported as “special charges,” or losses outside the Company’s normal operating expenses. Visteon announced an asset impairment charge in its very first annual report as a publicly traded company. (Id. at pp. 25-27, Apx. pp. 71-73.) Thereafter, Visteon had material special charges in every year of the class period. (Id. at pp. 25-27, 29, 32, 37, 42, Apx. pp. 71-73, 75, 78, 83, 88.) Most if not all of these special charges had to do with operation consolidations, restructuring of operations and exiting operations that were made a part of Visteon in the Spin-Off. (Id.)
In August 2005, the Company revealed that Ford would reacquire a significant number of the facilities transferred to Visteon in the Spin-Off and that Visteon would record a write down of those facilities by approximately $1 billion due to their cost exceeding market value. (Id. at p. 73, Apx. p. 119.) The write down of the facility costs disguises the fact that $1 billion in losses should have been recognized earlier by Visteon. (Id.)
Misleading Statements Regarding Visteon’s Solvency
Visteon’s statements to the market were in direct contravention of what senior management knew to be true. (Id. at pp. 33-34, Apx. pp. 79-80.) In a press release dated January 23, 2003, Appellee Peter Pestillo, Visteon’s Chairman and CEO, stated that Visteon “had a solid year in 2002.” (Id. at pp. 32-33, Apx. pp. 78-79.) According to a former Human Resources Director of Visteon, in meetings attended by senior Visteon management in late 2002, the internal description of Visteon’s financial condition was that it was “not doing well,” “barely had enough money to pay its bills,” and was “barely liquid.” (Id. at p. 33, Apx. p. 79.)
Similarly dire statements were made in high-level meetings attended in early to mid 2002 and in 2003 by a former senior finance director. (Id. at pp. 33-34, Apx. pp. 79-80.) The meetings were between Visteon and Ford executives and were often attended by Individual Defendants Pestillo and Coulson. (Id.) At those meetings Visteon conveyed to Ford that it would be out of cash in 2004 or 2005 without relief on its labor agreements and other contracts with Ford. (Id. at p. 34, Apx. p. 80.)
Visteon took deceptive steps to maintain the appearance of solvency, long after the truth was known. During the class period, on March 10, 2004, Visteon raised additional capital by issuing a $450 million notes offering, due 2014, bearing an interest rate of 7% per year. (Id. at p. 88, Apx. at p. 134.) In the “Use of Proceeds” section of the Notes prospectus, Visteon explained:
We intend to use these proceeds for the repurchase of up to $250 million of our 7.95% notes due 2005 pursuant to a tender offer anticipated to expire on our about April 2, 2004 and . . . for working capital and other general corporate purposes.
Thus, without this Notes offering, Visteon would have been unable to pay off an upcoming expiring notes offering and faced a potential default, as well as cash flow difficulties in its working capital. Had the market known the truth about Visteon’s financial condition and prospects, it could have never achieved such a favorable interest rate and indeed may have been unable to issue notes at all.
Even when the truth about Visteon’s impending insolvency started to emerge in 2005, Visteon reported its cash flow problems in a way that made it difficult for investors to fully understand the grave state of the company’s finances. Rather than simply revealing that the cash from operations would not be sufficient to cover Visteon’s costs, this information was revealed in two separate notes to the 2004 consolidated financial statements that had to be read together in order to complete the picture. (Id. at pp. 71-73, Apx. pp. 117-19.)
Ford’s Control of Visteon
Beginning with the Spin-Off and continuing throughout the class period, Ford established and maintained control of Visteon in the following interrelated ways: (1) the senior executives of Visteon, including the Individual Defendants, were former Ford executives and maintained loyalty to Ford during and after the Spin-Off (id. at pp. 18, 25, Apx. pp. 64, 71); (2) the terms of the Spin-Off were not negotiated at arms-length with Ford and the contracts between Ford and Visteon were undisclosed related party transactions (id. at p. 24, Apx. p. 70); (3) the labor and pricing contracts negotiated with Ford were so disadvantageous to Visteon as to render it incapable of operating as a profitable company (id. at pp. 21-25, Apx. pp. 67-71); (4) Visteon’s information technology systems were maintained by Ford (id. at pp. 3, 25, Apx. pp. 49, 71); and (5) it was within Ford’s power to keep Visteon afloat by providing financial assistance in the form of contract concessions that amounted to a bailout (id. at pp. 67, 71-73, Apx. p. 113, 117-19). In short, Ford controlled both Visteon’s revenue and expense streams through its contracts with Visteon and did so in such a way that Visteon would not be capable of financial success as an independent entity. (Id. at pp. 28, 31-32, 36, 40, 46-47, Apx. pp. 74, 77-78, 82, 86, 92-93.)
In effect, Visteon operated as an unconsolidated subsidiary or Special Purpose Entity (“SPE”) of Ford. (Id. at p. 67, Apx. p. 113.) Visteon was essentially a repository for Ford operations that had built-in losses. (Id. at pp. 67-68, Apx. pp. 113-14.) As Visteon’s losses with respect to those operations and facilities continued to mount, Ford’s profits from acquiring those parts and systems were increased. (Id. at p. 68, Apx. p. 114.)
While Visteon’s connection to Ford was known to the market, the extent of Ford’s power over Visteon was not disclosed. (Id. at pp. 24-25, Apx. pp. 70-71.) In the Spin-Off Prospectus, Visteon and Ford affirmatively stated that the Spin-Off was “‘in the best interests of Ford, the Visteon business and Ford stockholders, because . . . [it will provide] direct accountability to public investors.’” (Id. at p. 2, Apx. p. 48.) The undisclosed reality, known to Visteon and the Individual Defendants, was that the Spin-Off was solely for the benefit of Ford and that Visteon could not operate as a viable independent company. (Id. at pp. 2-3, Apx. pp. 48-49.)
While the Spin-Off Prospectus stated that Visteon management “may have conflicts of interest” because of their ties to Ford, it was not disclosed that senior Visteon management in fact intended to put the interests of Ford and themselves above the interests of Visteon. (Id. at pp. 17-18, Apx. pp. 63-64.) As Visteon’s former senior finance director observed from working with the Individual Defendants, they were each “‘ong-term Ford people whose loyalties clearly were to Ford.’” (Id. at p. 18, Apx. p. 64.)
The assets and liabilities that would comprise Visteon were determined by Ford in negotiations with Ford executives that were to become Visteon’s management upon the Spin-Off’s completion. (Id.) According to a former senior finance director of Visteon that worked closely with the Individual Defendants, the terms of the Spin-Off were consummated in “rush meetings at 11:00 p.m. at night” and were so unfavorable towards Visteon that the Company was “shackled” from being able to operate as a viable independent company. (Id. at p. 13, Apx. p. 59.) The Spin-Off Prospectus failed to reveal, as required, that the terms of the Spin-Off were not the product of good faith arm’s length transactions between Ford and Visteon. (Id. at pp. 24, 80, Apx. pp. 70, 126.)
The Spin-Off Prospectus did not disclose the full extent of Visteon’s labor costs under United Auto Worker (“UAW”) contracts assumed from Ford. (Id. at pp. 20-22, Apx. pp. 66-68.) Visteon’s Prospectus failed to reveal that the Company would be required to pay its UAW employees 136% more per hour than its competitors. (Id. at p. 21, Apx. p. 67.) In fact, the Spin-Off Prospectus falsely states that the wage differential with its competitors would only be as high as 20-40%. (R.19, Visteon Motion to Dismiss, Ex. 1, p. 9, Apx. p. 249.) According to a former Human Resources Planner for Visteon who was in a position to know the actual differential, there was “absolutely no way Visteon could be competitive.” (R.12, Am. Compl., pp. 21-22, Apx. pp. 67-68.) The Spin-Off Prospectus did not reveal that the UAW contracts would create a cost disadvantage compared to the Company’s competitors of at least $700 million to $1 billion. (Id. at pp. 22, 24-25, Apx. pp. 66, 70-71.)
The deception originating with the Spin-Off Prospectus was continued throughout the next several years. In its public statements and SEC filings during the class period, Visteon never revealed that it was unable to control its labor costs that were 136% greater than the costs of its competition. (Id. at pp. 28, 31, 36, 40, 46, Apx. pp. 74, 77, 82, 86, 92.) Visteon also failed to disclose in those filings that the vast majority of its business was the product of related party transactions with Ford through which Ford exercised control over Visteon. (Id.)
Actions taken by Ford and Visteon in 2005 began to reveal the extent of Ford’s control. In a note to Visteon’s 2004 consolidated financial statements, it was revealed that on March 10, 2005, Ford had agreed to grant Visteon $300 million in concessions on its UAW labor contracts for the year ending December 31, 2005. (Id. at p. 71, Apx. p. 117.) PwC delayed the issuance of its auditor’s report until March 16, 2005, after the agreement with Ford was finalized. (Id. at p. 72, Apx. p. 118.) Apparently without the significant financial concession made by Ford, PwC would have required Visteon to disclose its lack of liquidity or PwC would have had to issue an opinion expressing doubt that Visteon was able to operate as a “going concern.” (Id.) The magnitude of the concessions, and the life-saving boost they gave to Visteon, indicate that Ford was either making a significant profit from the assignment of those employees to Visteon or that Ford agreed to subsidize Visteon by $300 million without receiving any consideration in return. (Id.) Ford’s control over Visteon was further revealed by the 2005 disclosure that Ford subsidized the separation of Visteon’s IT functions from Ford by agreeing to share up to $100 million of Visteon’s IT-related costs. (Id. at p. 68, Apx. p. 114.)
In a press release issued on May 10, 2005, under a section titled “Ford Discussions and Liquidity,” Visteon finally disclosed that, “[a]bsent significant structural changes to Visteon’s U.S. businesses, including an agreement with Ford that will allow the company to achieve a sustainable and competitive business model, the company believes that cash flow from operations, including the impact of the Ford funding agreement, will not be sufficient to fund capital spending, debt maturities and other cash obligations in 2005 . . . .” (Id. at p. 59, Apx. p. 105.) Thus, Visteon finally publicly acknowledged what had been known internally since the Spin-Off in 2000: that Visteon could not exist as an independent company because it was controlled through onerous contracts with Ford. (Id. at p. 67, Apx. p. 113.)
PwC’s Role in Perpetuating Visteon’s Accounting Fraud
Pursuant to its role as Visteon’s independent auditor and accountant, PwC performed an audit on Visteon’s financial statements for the fiscal years ending 2000, 2001, 2002 and 2003. (Id. at pp. 27-28, 30-31, 35, 39-40, Apx. pp. 73-74, 76-77, 81, 85-86.) On March 16, 2005, PwC issued a report identifying deficiencies in Visteon’s internal controls so severe as to constitute “material weaknesses.” (Id. at p. 69, Apx. p. 115.) Although PwC’s comments indicated that those material weaknesses existed in 2001, 2002, 2003, and the first three quarters of 2004, PwC had nevertheless issued unqualified audit opinions on Visteon’s financial statements for those years. (Id.) Even after this disclosure, PwC continued to approve accounting and reporting practices regarding material surcharges and customer rebates that it knew to be flawed. (Id. at p. 62, Apx. p. 108.)
PwC’s repeated approval of Visteon’s flawed accounting was in part a product of PwC’s lack of professional independence. PwC’s independence was impaired by auditing both Ford and Visteon when Ford effectively controlled Visteon through their unusual contractual relationship and other methods described above. (Id. at pp. 77-79, Apx. pp. 123-25.) Given that Visteon was structured to take on Ford’s losses, any significant audit discovery that would benefit Visteon related to the Ford contracts would likely have a detrimental impact on Ford. (Id. at p. 77, Apx p. 123.) For example, PwC did not fulfill its role as Visteon’s independent auditor with respect to the asset valuation at the time of the Spin-Off because to do so would have placed PwC in conflict with Ford. (Id. at pp. 78-80, Apx. pp. 124-26.)
One of the red flags ignored by PwC was Visteon and Ford’s related party transactions. (Id. at pp. 80-81, Apx. pp. 126-27.) Auditing standards require that auditors cannot presume that related party transactions are carried out at arm’s length. (Id. at p. 80, Apx. p. 126.) Yet PwC did not examine whether the transactions between Ford and Visteon were arm’s length transactions and improperly issued an unqualified audit. (Id. at pp. 80-81, Apx. pp. 126-27.)
Finally, by virtue of its longstanding relationship with Visteon and Ford, PwC had intimate knowledge of Visteon’s accounting and financial reporting practices. (Id. at p. 6, Apx. p. 52.) Given this familiarity, PwC either knew or recklessly disregarded the various accounting improprieties, material weaknesses in internal controls, and inflated earnings that falsely boosted Visteon’s stock price and damaged Plaintiffs. (Id.)
SUMMARY OF ARGUMENT
In dismissing Plaintiffs’ securities fraud claims, the district court consistently failed to consider Plaintiffs’ factual allegations as a whole in the proper Rule 12(b)(6) context. In order to state a claim under Section 10(b) of the Securities Exchange Act, or under SEC Rule 10b-5, “a plaintiff must allege: (1) a misrepresentation or omission; (2) of a material fact that the defendant had a duty to disclose; (3) made with scienter; (4) justifiably relied on by plaintiffs; and (5) proximately causing them injury.” City of Monroe Employees Ret. Sys. v. Bridgestone Corp., 399 F.3d 651, 668 (6th Cir. 2005). Regarding the first element of Plaintiffs’ Section 10(b) and Rule 10b-5 claims against Visteon and the Individual Defendants, the district court improperly ruled on this issue without making any findings regarding the actual material misrepresentations and omissions alleged in Plaintiffs’ Amended Complaint. Instead, the court inappropriately made factual findings that the securities market had knowledge of various facts selectively presented by Defendants, and thus any material misrepresentations were excused under the “truth-on-the-market” defense. (R.49, Order, p. 13, Apx. p. 156.) Due to its fact-intensive nature, the truth-on-the-market defense should not be applied at the pleading stage, and the district court erred in doing so. See Asher v. Baxter Int’l Inc., 377 F.3d 727, 735 (7th Cir. 2004); Ganino v. Citizens Utils. Co., 228 F.3d 154, 167 (2d Cir. 2000). The district court further
erred in failing to apply the proper substantive standard for the truth-on-the-market defense, which is that “any material information which insiders fail to disclose must be transmitted to the public with a degree of intensity and credibility sufficient to effectively counter-balance any misleading impression created by the insiders’ one-sided representations.” In re Apple Computer Sec. Litig., 886 F.2d 1109, 1116 (9th Cir. 1989).
The district court similarly erred in holding that Plaintiffs had not adequately pled the scienter element against Visteon and the Individual Defendants, or against PwC. In both cases, the court did not follow this Court’s clear precedent holding that scienter allegations should be considered collectively to determine whether a strong inference of at least recklessness arises. See City of Monroe, 399 F.3d at 683; PR Diamonds, Inc. v. Chandler, 364 F.3d 671, 683 (6th Cir. 2004). Rather, the court considered and rejected the allegations in isolation and did not even discuss most of the allegations argued by Plaintiffs as relevant evidence of PwC’s reckless or knowing state of mind. (R.49, Order, pp. 13-17, 18-20, Apx. pp. 156-60, 161-63.) When properly considered under the totality of the circumstances, Plaintiffs’ allegations raise a strong inference that Visteon, the Individual Defendants, and PwC knowingly or recklessly misled Visteon investors regarding the financial health and viability of the Company. Those alleged facts include accounting improprieties in the amount of $198 million, statements by corporate insiders that at least some of those accounting errors were intentionally designed to inflate earnings, public statements by Individual Defendants that contradicted internal financial information, restatements of earnings made within months of Sarbanes-Oxley Certifications, reporting of financial information in an intentionally confusing manner, and the motive and opportunity to benefit Ford. The inference of scienter is strong because it is as least as compelling as any other inferences that could be raised by the facts alleged. See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499, 2504, 2510 (2007).
Finally, insofar as the district court’s dismissal of Plaintiffs’ Section 20(a) claims against the Individual Defendants as controlling persons was based on its finding that a claim had not been stated against Visteon under Section 10(b), this claim was likewise erroneously dismissed. This Court should reverse the dismissal of Plaintiffs’ securities fraud claims against Visteon, the Individual Defendants, and PwC.
STANDARD OF REVIEW
This Court applies de novo review to the district court’s dismissal of a securities fraud complaint for failure to state a claim upon which relief can be granted. See City of Monroe, 399 F.3d at 664. A complaint should not be dismissed if it contains factual allegations “respecting all the material elements necessary to sustain recovery under some viable legal theory.” Bell Atl. Corp. v. Twombly, 127 S. Ct. 1955, 1969 (2007) (quoting Car Carriers, Inc. v. Ford Motor Co., 745 F.2d 1101, 1106 (7th Cir. 1984)); League of United Latin Am. Citizens (LULAC) v. Bredesen, 500 F.3d 523, 527 (6th Cir. 2007). In rendering its decision, the Court accepts as true the factual allegations in the complaint. Jackson, Tenn. Hosp. Co. v. W. Tenn. Healthcare, Inc., 414 F.3d 608, 611 (6th Cir. 2005); Columbia Natural Res., Inc. v. Tatum, 58 F.3d 1101, 1109 (6th Cir. 1995). In Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499, 2509 (2007), the Supreme Court recently affirmed the applicability of this principle in securities fraud cases, holding that, “faced with a Rule 12(b)(6) motion to dismiss a § 10(b) action, courts must, as with any motion to dismiss for failure to plead a claim on which relief can be granted, accept all factual allegations in the complaint as true.” Therefore, as this Court has repeatedly observed, “[a] court may not grant a Rule 12(b)(6) motion based on disbelief of a complaint’s factual allegations.” Bovee v. Coopers & Lybrand C.P.A., 272 F.3d 356, 360 (6th Cir. 2001)(citing Lawler v. Marshall, 898 F.2d 1196, 1199 (6th Cir. 1990)); see also Bell Atl., 127 S. Ct. at 1965.
In Tellabs, the Supreme Court provided specific guidance for reviewing whether a securities fraud complaint adequately alleges facts giving rise to a “strong inference” of scienter, as required by the heightened pleading standards implemented by the Private Securities Litigation Reform Act of 1995 (the “PSLRA”). The Court instructed that such complaints must be considered in their entirety, explaining that “[t]he inquiry, as several Courts of Appeals have recognized, is whether all the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard.” Tellabs, 127 S. Ct. at 2509. Indeed, this Court has consistently taken this holistic approach. See City of Monroe, 399 F.3d at 683; PR Diamonds, 364 F.3d at 683.
Moreover, the Supreme Court interpreted the “strong inference” standard, holding that, “[t]o qualify as ‘strong’ . . . we hold, an inference of scienter must be more than merely plausible or reasonable – it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.” Tellabs, 127 S. Ct. at 2504-05. Thus, the inference of scienter does not have to be the strongest of competing inferences, but only at least as strong as other, more innocuous inferences. See id. at 2510, 2513. As Justice Scalia acknowledged in his dissent, this approach “giv[es] plaintiffs the edge in close cases.” Id. at 2514 (Scalia, J., dissenting).
THE DISTRICT COURT ERRED IN FINDING THAT VISTEON’S FAILURE TO DISCLOSE MATERIAL INFORMATION IS EXCUSED UNDER THE “TRUTH-ON-THE-MARKET” DEFENSE.
- The District Court’s Analysis of Plaintiffs’ Allegations Was Flawed.
The district court accepted the Defendants’ inaccurate division of Plaintiffs’ claims into a “‘Spin-Off Claim’” and a “‘Restatement Claim.’” (R.49, Order, p. 4 n.3, Apx. p. 147 n.3.) The district court then only evaluated the so-called “Spin-Off Claim” to determine if Plaintiffs had alleged material misrepresentations and omissions, and only analyzed the “Restatement Claim” to determine whether Plaintiffs had raised a strong inference of scienter. (Id. at pp. 7-17, Apx. pp. 150-60.) By limiting its analysis to Defendants’ narrowly defined categories, the district court failed to consider the allegations in their totality.
With regard to the material misrepresentation or omission element of Plaintiffs’ § 10(b) and Rule 10b-5 claims, the trial court stated that it would “offer no finding as to whether Defendant [Visteon] failed to disclose material information.” (Id. at p. 13, Apx. p. 156.) Instead, the court determined that, based on the subset of allegations Defendants characterized as the “Spin-Off Claim,” the market had been made aware of those facts by other sources and any material omission was therefore excused under the “truth-on-the-market” defense. (Id.)
The court’s analysis of this issue was seriously flawed in that it improperly applied the “truth-on-the-market” defense at the pleading stage, made factual findings on disputed material issues of fact, and failed to take Plaintiffs’ allegations as true. Moreover, the district court did not apply the proper substantive standard for the truth-on-the-market defense and failed to consider numerous material misrepresentations and omissions alleged in the Amended Complaint.
- The District Court Made Improper Factual Findings and Failed to Take Plaintiffs’ Allegations as True.
In finding that any misrepresentations or omissions made by Visteon were excusable, the district court effectively held that the undisclosed facts were not material. Under Section 10(b) and Rule 10b-5, a defendant’s statement is only “actionable” if it is “a misrepresentation or omission of a material fact that the defendant had a duty to disclose.” City of Monroe, 399 F.3d at 668. In securities fraud cases, “materiality” is a fact-intensive inquiry. Helwig v. Vencor, Inc., 251 F.3d 540, 555 (6th Cir. 2001). As explained by the Supreme Court, “materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information.” Basic Inc. v. Levinson, 485 U.S. 224, 240 (1988). Specifically, materiality is evidenced by a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” Id. at 231-32 (quotations and citation omitted).
Materiality is ordinarily a question for the trier of fact. See City of Monroe, 399 F.3d at 681. This Court has recognized the fact-intensive nature of the materiality issue, holding that the general rule for securities fraud cases is that at [the motion to dismiss] stage in the proceedings, “‘a complaint may not properly be dismissed . . . on the ground that the alleged misstatements or omissions are not material unless they are so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of their unimportance.’” Helwig, 251 F.3d at 563 (quoting Ganino, 228 F.3d at 162).
The “truth-on-the-market defense,” held by the trial court to bar Plaintiffs’ claims, is simply another way of finding that the defendant’s misrepresentations or omissions are not material. The truth-on-the-market defense is a corollary to the “fraud-on-the-market” theory of liability invoked by Plaintiffs. (R.12, Am. Compl., p. 88, Apx. p. 134.) See Provenz v. Miller, 102 F.3d 1478, 1492, 1492 n.4 (9th Cir. 1996). The fraud-on-the-market theory holds that the plaintiff has the benefit of a presumption that he has relied on the integrity of the stock price established by the market, and thereby also relied on the defendant’s material misstatements or omissions that artificially depressed or inflated the stock price. See Basic, 485 U.S. at 247. Conversely, the “truth-on-the-market defense” is available to show that the market was aware of the true financial situation of the company and that such information is reflected in the stock price. See Ganino,228 F.3d at 167. In other words, “[a] misrepresentation is immaterial if the information is already known to the market because the misrepresentation cannot then defraud the market.” Id.
Like other materiality issues, the truth-on-the market defense is generally not considered to be a proper basis for a motion to dismiss. The Seventh Circuit has held that the “‘truth-on-the-market’ defense is available in principle, as we discussed in Flamm, but not at the pleading stage. . . . it is too early in the litigation to reach such a conclusion.” Asher, 377 F.3d at 735. Similarly, the Second Circuit has held that “[t]he truth-on-the-market defense is intensely fact-specific and is rarely an appropriate basis for dismissing a § 10(b) complaint for failure to plead materiality.” Ganino, 228 F.3d at 167; see also In re Credit Suisse-AOL Sec. Litig., 465 F. Supp. 2d 34, 54 n.22 (D. Mass. 2006) (same); In re Thoratec Corp. Sec. Litig., No. C-04-03168, 2006 U.S. Dist. LEXIS 30602, at *33-*34 (N.D. Cal. May 10, 2006), attached in the Addendum (holding that courts generally may not dismiss a complaint based on the truth-on-the-market defense); Demarco v. Lehman Bros., 309 F. Supp. 2d 631, 636 (S.D.N.Y. 2004) (holding that fact-based arguments about what the market knew are not cognizable in the context of a Rule 12(b)(6) motion).
The district court improperly applied the truth-on-the-market defense at the motion to dismiss stage by making findings that the market was aware of the following five facts: (1) Visteon’s inability to shed unprofitable business lines inherited from Ford; (2) Visteon’s high labor costs; (3) price reductions owed by Visteon to Ford; (4) Visteon’s general dependence on Ford; and (5) Visteon’s reliance upon Ford for information technology services. (R.49, Order, pp. 8-13 , Apx. pp. 151-56.) In making these limited findings about what the market knew and then concluding such knowledge was dispositive, the trial court completely failed to acknowledge that Plaintiffs have brought a selective disclosure case. As recognized in Helwig, a securities fraud claim may be stated for “selective disclosure of information known exclusively to defendants and essential to complete a picture only partially revealed.” Helwig, 251 F.3d at 560. Such claims are based on the principle that, “even absent a duty to speak, a party who discloses material facts in connection with securities transactions ‘assumes a duty to speak fully and truthfully on those subjects.’” Id. at 561 (quoting Rubin v. Schottenstein, 143 F.3d 263, 268 (6th Cir. 1998) (en banc)). Thus, once a company elects to make statements about its financial position or other matters, it is “required to qualify that representation with known information undermining (or seemingly undermining) the claim.” City of Monroe, 399 F.3d at 673.
The district court both ignored the selective disclosure aspect of Plaintiffs’ case and improperly decided factual issues that are in dispute. For example, the district court found that the market was aware of Visteon’s high labor costs based on statements in the Spin-Off Prospectus, news articles dated in 2000 before the Spin-Off, and articles dated in December 2003. (R.49, Order, pp. 9-10, Apx. pp. 152-53.) But Plaintiffs never alleged that Visteon did not disclose that its labor costs were high; rather, Plaintiffs’ complaint is that Visteon did not reveal the truth regarding how high those costs were relative to Visteon’s competition. (R.12, Am. Compl., pp. 21-22, Apx. pp. 67-68; R.19, Visteon Motion to Dismiss, Ex. 1, p. 9, Apx. p. 249.)
In its written opinion, the district court does not address Plaintiffs’ actual claims about Visteon’s misstatements and instead simply finds that the market knew of the higher labor costs. To the extent that the trial court found that the market knew that Visteon’s wage differentials were much higher than originally revealed in the Spin-Off Prospectus, that finding is not supported by any sources before December 2003. (R.49, Order, pp. 9-10, pp. 152-53.) It is a matter of dispute whether the market was aware of the true 136% higher labor costs, confirmed by a corporate insider as absolutely preventing Visteon from being competitive, before December 2003. (R.12, Am. Compl., p. 21-22, Apx. pp. 67-68.)
The district court also failed to take Plaintiffs’ allegations as true and to draw reasonable inferences in favor of the Plaintiffs. The district court improperly failed to consider the statement of Visteon’s former Human Resources Planner that, “there was ‘absolutely no way Visteon could be competitive’ because of the differential in wages paid by Visteon as compared to its competition.” (Id.) In apparently refusing to consider this allegation, the district court stated that, “[i]t’s an opinion . . . . It’s a characterization by someone.” (R.47, Hearing Transcript, p. 44, Apx. p. 1171.) At the pleading stage it is not proper for the district court to be making such judgments. Plaintiffs are entitled to have the allegation of their corporate insider taken as true. See Tellabs, 127 S. Ct. at 2509; Jackson, Tenn. Hosp. Co., 414 F.3d at 611; Columbia Natural Res., 58 F.3d at 1109. The district court’s factual findings about the market’s knowledge are in fact disputed by the allegation of the corporate insider’s testimony. (R.47, Hearing Transcript, p. 44, Apx. p. 1171; R.49, Order, pp. 12-13, Apx. pp. 155-56; R.12, Am. Compl., pp. 21-22, Apx. pp. 67-68.) The district court therefore improperly based its opinion on its disbelief of Plaintiffs’ allegations.
There are other instances of the district court disbelieving Plaintiffs’ factual allegations and disregarding those allegations in its analysis of whether the market was aware of Visteon’s material misrepresentations and omissions. With regard to Plaintiffs’ central allegation that Visteon misrepresented its status as an independent entity when in reality it was operated as a subsidiary or SPE of Ford, the trial court stated at the hearing that the allegation was “a characterization” rather than a fact. (R.47, Hearing Transcript, pp. 54-55, Apx. pp. 1181-82.) As with the wage issue, the district court disregarded Plaintiffs’ actual allegation and instead made findings that the market was aware that Visteon would be reliant on Ford business. (R.49, Order, pp. 10-11, 13, Apx. pp. 153-54, 156.) But again, Plaintiffs did not allege that Visteon failed to disclose that Ford was its main customer and that it would be dependent on Ford for business, but rather that Visteon held itself out to be an independent entity when in fact it had no ability to operate as a viable independent company. (R.12, Am. Compl., pp. 22, 24-25, Apx. pp. 68, 70-71.) The sources relied on by the district court do not address this actual allegation. (R.49, Order pp. 10-11, Apx. pp. 153-54; R.19, Visteon Motion to Dismiss, Exs. 4-7, 11, 14, 17, Apx. pp. 372-433, 468-71, 487-94, 503-07.)
The district court was only able to dismiss Plaintiffs’ allegations against Visteon by improperly applying a fact-specific defense at the pleading stage, mischaracterizing Plaintiffs’ allegations, refusing to take the allegations as true, and failing to accept reasonable inferences. The district court’s improper approach to factual issues at the pleading stage warrants reversal.
- Defendants Did Not Meet Their Heavy Burden Of Demonstrating the Market’s Knowledge of Facts Plaintiffs Allege Were Not Disclosed.
In its discussion and analysis of the truth-on-the-market defense, the district court completely failed to apply the proper standard regarding Defendants’ heavy burden in establishing this defense.(R.49, Order, p. 7, Apx. p. 150.) As held by Apple Computer, “[i]n order to avoid Rule 10b-5 liability, any material information which insiders fail to disclose must be transmitted to the public with a degree of intensity and credibility sufficient to effectively counter-balance any misleading impression created by the insiders’ one-sided representations.” Apple Computer, 886 F.2d at 1116 (emphasis added); accord Provenz, 102 F.3d at 1492-93 (same). The Second Circuit applies this same rule. See Ganino, 228 F.3d at 167. Defendants’ burden in demonstrating the applicability of the truth-on-the-market defense is a heavy one. See Provenz, 102 F.3d at 1493.
Press coverage of the exact fraudulent issues alleged by the plaintiff must reach a critical mass in order to establish the truth-on-the-market defense. As the court in Apple Computer explained, “corporate insiders are not relieved of their duty to disclose material information where that information has received only brief mention in a few poorly-circulated or lightly-regarded publications.” Apple Computer, 886 F.2d at 1116. In Apple Computer, there were at least twenty articles that had been written on the exact issue the plaintiffs claimed was withheld by the defendant corporation. See id. By contrast, in Provenz v. Miller, thirty-one negative analyst reports and articles were not sufficient to “effectively counterbalance” the defendants’ material misstatements when those articles did not mention some of the exact information alleged to be withheld by the defendants in that case. 102 F.3d at 1493.
An analogous situation was addressed by this Court in City of Monroe, where the defendant alleged a truth-on-the-market defense that mischaracterized the facts as alleged by the plaintiffs. City of Monroe, 399 F.3d at 675-76. While the defendant, Firestone, argued that its misrepresentations were not material because the market was already aware of the information, this Court found that argument to be inapposite. Id. at 676. While the market may have been aware of general safety problems with the tires, that did not necessarily mean the public had been informed of the specific information Firestone was alleged to have withheld, including testing data, liability claims and reports of deaths from the malfunctioning tires. See id.; see also Demarco, 309 F. Supp. 2d at 636 (noting that simply establishing general market knowledge about some of the facts at issue was not equivalent to market awareness of the defendant’s misrepresentations).
Here, the district court did not hold Defendants to the standard of demonstrating that the material misrepresentations alleged by Plaintiffs were disclosed to the market by other sources with “a degree of intensity and credibility sufficient to effectively counter-balance any misleading impression” created by Defendants. Apple Computer, 886 F.2d at 1116. In any event, it is clear that Visteon did not meet that burden. As in City of Monroe, the publicly available information about Visteon’s deficiencies as a company did not include most of the facts that Plaintiffs allege Visteon and the Individual Defendants wrongfully withheld. See City of Monroe, 399 F.3d at 676. The district court’s findings that the market knew generally about Visteon’s unprofitable business lines, high labor costs, price reductions to Ford, lack of an information technology department, and reliance on Ford does not establish that the market was also aware that Ford’s labor costs were 136% higher than its competitors and that there was “absolutely no way Visteon could be competitive;” that Visteon was never meant to be viable as an independent company but was designed to operate as a subsidiary of Ford with built-in losses; that Visteon failed to take losses on Ford contracts inherent at the time of the Spin-Off; that Visteon made false statements about the Company’s solvency; that Visteon concealed its poor financial position in order to obtain favorable terms on a notes offering; that Visteon systematically misstated earnings; and that Visteon failed to disclose material weaknesses in its internal financial controls. (R.49, Order, pp. 7-13, Apx. pp. 150-56; R.12, Am. Compl., pp. 21-22, 24-25, 28, 31-33, 36, 40, 46-47, 68-69, 88, Apx. pp. 67-68, 70-71, 74, 77-79, 82, 86, 92-93, 114-15, 134.)
Further, the market’s reaction to Visteon’s revelations in 2005 supports the conclusion that the market had been previously unaware of the true state of Visteon’s financial affairs. Upon the January 2005 announcement of the need to restate earnings and renegotiate the contracts with Ford, Visteon’s stock immediately fell 6.43% to $7.42 per share, reaching a low of $3.14 per share on May 11, 2005. (R.12, Am. Compl., pp. 51, 57, Apx. pp. 97, 103.) This precipitous decline suggests that the market was not aware of the full extent of Visteon’s structural and financial problems, and that the reasonable investor believed the withheld news “significantly altered the ‘total mix’ of information made available” about Visteon. Basic, 485 U.S. at 232.
THE DISTRICT COURT ERRED IN HOLDING THERE WAS INSUFFICIENT EVIDENCE OF SCIENTER TO STATE A CLAIM AGAINST VISTEON AND THE INDIVIDUAL DEFENDANTS UNDER THE EXCHANGE ACT.
- The District Court Did Not Consider Plaintiffs’ Scienter Allegations Under the Totality of the Circumstances.
When evaluating whether scienter has been sufficiently pled under the PSLRA, “this Court employs a totality of the circumstances analysis whereby the facts argued collectively must give rise to a strong inference of at least recklessness.” PR Diamonds, 364 F.3d at 683. In the context of securities fraud, “recklessness” is defined as “‘highly unreasonable conduct which is an extreme departure from the standards of ordinary care.’” Helwig, 251 F.3d at 550 (quoting Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1025 (6th Cir. 1979)). As this Court has explained, “recklessness in securities fraud is an untidy, case-by-case concept.” Id. at 551.
In evaluating whether scienter has been sufficiently pled, a court must “sift Plaintiffs’ allegations individually and then aggregate the nuggets of inference they generate” to determine whether a strong inference arises. PR Diamonds, 364 F.3d at 684. In Tellabs, the Supreme Court repeatedly emphasized the importance of considering the allegations of the complaint as a whole in evaluating whether the “strong inference” standard has been met. See Tellabs, 127 S. Ct. at 2509, 2511. The Court “reiterate[d] . . . that the court’s job is not to scrutinize each allegation in isolation but to assess all the allegations holistically.” Id. at 2511.
The district court’s written opinion did not even purport to consider Plaintiffs’ scienter allegations as a whole. (R.49, Order, pp. 13-17, Apx. pp. 156-60.) In considering and rejecting each scienter allegation in complete isolation, the district court did not apply the proper standard as set forth repeatedly by this Court. See City of Monroe, 399 F.3d at 683; PR Diamonds, 364 F.3d at 683. Reversal is warranted by this failure to consider the inferences raised by the totality of Plaintiffs’ allegations.
- Taken Collectively, Plaintiffs’ Allegations Give Rise to a Strong Inference of Scienter.
When alleging fraud in a § 10(b) action, a plaintiff “must plead facts rendering an inference of scienter at least as likely as any plausible opposing inference.” Tellabs, 127 S. Ct. at 2513. This is a comparative approach that requires weighing the plaintiff’s inferences that the defendant intentionally or knowingly acted wrongfully against any inferences that the defendant’s conduct was nonculpable. See id. at 2510. The inference of scienter does not have to be “irrefutable, i.e., of the ‘smoking-gun’ genre,” but rather only as strong as other plausible explanations. Id. As the Court summed up, “the reviewing court must ask: When the allegations are accepted as true and taken collectively, would a reasonable person deem the inference of scienter at least as strong as any opposing inference?” Id. at 2511.
This Court has held that scienter may be effectively pled with allegations evidencing defendants’ knowledge of the falsity of their statements, or that defendants “could have known of the [falsity], or that their regular procedures should have alerted them” to the falsity of their statements. In re Comshare, Inc. Sec. Litig., 183 F.3d 542, 553 (6th Cir. 1999). In addition, courts look to other circumstantial evidence inferring scienter, including defendant’s “motive and opportunity” to commit the fraud. See id. at 551; Helwig, 251 F.3d at 550-51. In Helwig, this Court identified a number of other factors relevant to the scienter determination, including, inter alia, divergence between internal information and external statements, closeness in time of the fraudulent statement and the later disclosure of inconsistent information, disregard of the most current information when making public statements, and unclear or misleading disclosure of accounting information. See Helwig, 251 F.3d at 552. The Helwig factors are matters to look to after, and in addition to, evaluating allegations of defendants’ knowledge or ability to know the true, undisclosed facts. See Comshare, 183 F.3d at 553. As this Court held, the identified factors are “not exhaustive” and no court has held that the absence of any of the Helwig factors should weigh against finding scienter. Helwig, 251 F.3d at 552.
Here, a strong inference of scienter arises collectively from the following factual allegations: (1) statements by corporate insiders that Visteon intentionally engaged in accounting improprieties in order to inflate earnings; (2) the statement by Individual Defendant Peter Pestillo, then-CEO of Visteon, that the Company had a “solid year” in 2002 when he knew that in fact the Company was barely liquid; (3) the Sarbanes-Oxley Certifications signed by Individual Defendants Michael Johnston and James Palmer that falsely certified Visteon’s financial statements as free from material misstatement and protected by internal controls, particularly in light of the closeness in time between those Certifications in March 2005 and the restated earnings in August 2005; (4) the nature and magnitude of Visteon’s accounting improprieties, amounting to at least $198 million over a four-year period; (5) Visteon’s practice of reporting financial information in such a way that its negative implications could only be understood by someone with a high degree of sophistication; and (6) Visteon’s motive and opportunity to improve Ford’s financial performance by shifting Ford’s losses to Visteon and perpetuating the falsehood that Visteon was a financially viable company. These facts give rise to a strong inference that Visteon and its senior management knowingly falsely represented Visteon’s financial health in order to mislead investors.
1.Visteon Intentionally Engaged In Accounting Fraud to Inflate Earnings.
Plaintiffs have alleged that in some cases Visteon intentionally violated GAAP in order to artificially inflate revenues. Allegations that raise a strong inference that corporate defendants acted with actual knowledge that their financial statements were misleading are, a fortiori, sufficient to raise a strong inference of at least recklessness and satisfy the pleading standards of the PSLRA. See Helwig, 251 F.3d at 562. One of Visteon’s intentional accounting improprieties, not revealed until August 2005, involved the practice of booking customer rebates obtained from suppliers in the year the supplier contract was entered, even though the rebates had not yet actually been received. (R.12, Am. Compl., p. 61, Apx. p. 107.) GAAP requires that such rebates be spread over the life of the contract. (Id.) According to a former senior finance director at Visteon, the Company intentionally violated GAAP in order to “falsely improve the Company’s financial condition by lowering costs through booking future rebates in one period.” (Id.)
A similar fraudulent intent can be inferred from Visteon’s practice of improperly deferring price increases from Visteon’s suppliers. Referred to as “material surcharges,” such price increases were not accounted for in the financial statements in order to make it appear that Visteon was paying the suppliers at the old price, a difference that amounted to $27 million. (Id. at pp. 61-62, 70, Apx. pp. 107-08, 116.) Again, according to a former corporate insider, the motive for this clear GAAP violation was to misrepresent the Company’s financial condition by not reporting “‘the cash that was actually going out the door.’” (Id. at p. 62, Apx. p. 108.) These two particular GAAP violations represent only a few of the accounting violations Visteon committed in nine different categories during the class period. (Id. at pp. 52-53, 60-61, Apx. pp. 98-99, 106-07.) Given the systematic and pervasive nature of Visteon’s accounting improprieties, the evidence that Visteon was intentionally manipulating its books in some areas strongly suggests that the other GAAP violations were likewise designed to mask Visteon’s true financial condition. “After all, books do not cook themselves.” In re McKesson HBOC, Inc. Sec. Litig., 126 F. Supp. 2d 1248,1273 (N.D. Cal. 2000).
2.Intentional Misstatements Regarding Visteon’s Solvency Indicate Scienter.
Further evidence that Visteon’s accounting fraud was intentional is Defendant Peter Pestillo’s statement in January 2003 that Visteon “had a solid year in 2002.” (R.12, Am. Compl., pp. 32-33, Apx. pp. 78-79.) Internally during that same time period at meetings attended by the Individual Defendants, the Company was described as “barely liquid” with “barely  enough money to pay its bills.” (Id. at p. 33, Apx. p. 79.) Defendant Pestillo’s patently false statement about Visteon’s financial stability constitutes a “divergence between internal reports and external statements on the same subject,” recognized in Helwig as a factor relevant to establishing scienter. 251 F.3d at 552.
Despite the blatant nature of Defendant Pestillo’s misrepresentation, the district court found that this statement was not evidence of scienter. (R.49, Order, p. 16, Apx. p. 159.) Rather than actually applying a proper scienter analysis, the court instead concluded that “the statement was ‘corporate optimism,’” and not an actionable material misstatement of fact. (Id.) This conclusion is unsupported and incorrect. As explained by the Supreme Court, “expression of such judgments can be uttered with knowledge of truth or falsity just like more definite statements, and defended or attacked through the orthodox evidentiary process that either substantiates their underlying justifications or tends to disprove their existence.” Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 1093 (1991). Statements of opinion may be actionable because “conclusory terms in a commercial context are reasonably understood to rest on a factual basis that justifies them as accurate, the absence of which renders them misleading.” Id. Thus, in Virginia Bankshares the Court held that an opinion expressed by corporate board members that the stock price was a “high value” and represented a “fair” transaction was actionable because it was capable of being proven or disproven by referencing the financial data underlying the statements. See id. at 1094.
In Helwig, this Court set forth guidelines for determining when a statement of opinion constitutes an actionable statement. Actionable statements of opinion “contain ‘at least three implicit factual assertions: (1) that the statement is genuinely believed, (2) that there is a reasonable basis for that belief, and (3) that the speaker is not aware of any undisclosed facts tending to seriously undermine the accuracy of the statement.’” Helwig, 251 F.3d at 557 (quoting Apple Computer, 886 F.2d at 1113). When Defendant Pestillo made his statement about Visteon having a “solid year,” investors had every right to trust that statement as a truthful statement of Visteon’s financial condition. The fact that Visteon was “barely liquid” would certainly constitute “an undisclosed fact tending to seriously undermine the accuracy of” Pestillo’s statement about Visteon’s solidity. Id.
As demonstrated by Virginia Bankshares, language similar to that used by Defendant Pestillo has been held to be actionable when capable of being disproven with reference to the company’s accurate financial data. 501 U.S. at 1094. Notably, a statement that a company was “on a solid footing” was held to be actionable when the accuracy of the speaker’s basis for that statement was disputed by the plaintiffs. See In re Century Business Servs. Sec. Litig., No. 1:99-CV-02200, 2002 U.S. Dist. LEXIS 26964, at *61-*62 (N.D. Ohio June 27, 2002). In contrast to these “provable” statements, the only case relied on by the district court, In re Ford Motor Co. Securities Litigation, 381 F.3d 563, 570 (6th Cir. 2004), involved completely unverifiable assertions.
The only other reason given by the district court for rejecting Defendant Pestillo’s statement as evidence of scienter was, unaccountably, that “Visteon’s liquidity constraints are not addressed in the complaint . . . [t]herefore, the statement cannot be used to show scienter under the claim as presented.” (R.49, Order, p. 16, Apx. p. 159.) Contrary to the district court’s reasoning, Visteon’s undisclosed liquidity constraints were repeatedly raised in the Amended Complaint, with Visteon’s inability to operate as a financially viable company described as a major part of Visteon’s alleged scheme to defraud investors. (R.12, Am. Compl., pp. 3, 24-25, 28, 31-32, 36, 40, 47, 71-74, Apx. pp. 49, 70-71, 74, 77-78, 82, 86, 93, 117-20.) As detailed above, concealing Visteon’s lack of viability was a major motive behind Defendants’ misstatements about the Company’s earnings.
Thus, the district court offered no legitimate reasons for refusing to consider Defendant Pestillo’s statement as evidence of scienter. Particularly when combined with Plaintiffs’ other allegations of Defendants’ recklessness, Defendant Pestillo’s materially false statement creates an inference of scienter that is at least as likely as the innocent explanation of “corporate optimism.”
3.Sarbanes-Oxley Certifications Strengthen the Inference of Scienter.
Individual Defendants’ Johnston and Palmer’s Sarbanes-Oxley Certifications provide additional inferences of recklessness. In signing the Certifications, Defendants not only certified that they knew of no wrongdoing in reporting Visteon’s financial information, but also that they had taken steps to guarantee that if there were any wrongdoing they would be likely to know about it. (R.12, Am. Compl., p. 65-66, Apx. pp. 111-12.) The Certifications were signed in March 2005, at the same time Visteon was substantially restating its earnings for the years 2001 through 2004 and Defendants were aware of the many problems with internal controls. (Id. at p. 51-57, 65, Apx. pp. 97-103.) Yet just a few short months later, in August 2005, Visteon again restated its earnings for those same years by $77 million (id. at pp. 60-62, 69-70, Apx. pp. 106-08, 115-16), suggesting that Defendants had at least recklessly, if not knowingly, misrepresented the accuracy of Visteon’s financial statements and the effectiveness of the Company’s internal controls. One of the Helwig factors is “closeness in time of an allegedly fraudulent statement or omission and the later disclosure of inconsistent information.” Helwig, 251 F.3d at 552.
While acknowledging that the financial statements certified by Johnston and Palmer contained untrue statements, the district court “decline[d] to interpret the signed certifications as evidence of scienter, as doing so would be to hold the company executives strictly liable for innocent accounting mistakes.” (R.49, Order, p. 16, Apx. p. 159.) The district court’s decision on this issue is contrary to the purpose of the Sarbanes-Oxley Act of 2002 that established the requirement that corporate officers sign off on their companies’ financial statements. As stated in the preamble to the Sarbanes-Oxley Act, the purpose of the law is “[t]o protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws . . . .” Sarbanes-Oxley Act of 2002, H.R. 3763, 107th Congress, pmbl. (2002). Specifically regarding the new executive officer certification requirements, President Bush explained in his signing statement that the legislative purpose of those provisions “relating to certification and accuracy of reports  is to strengthen the existing corporate reporting system . . . .” Statement by President George W. Bush upon Signing H.R. 3763, 38 Wkly. Comp. Pres. Doc. 1286 (July 30, 2002).
In line with the protective purposes of the Act, several courts have recently concluded that Sarbanes-Oxley Certifications can demonstrate a defendant’s reckless state of mind. For example, in In re Lattice Semiconductor Corporation Securities Litigation, No. CV04–1255-AA, 2006 U.S. Dist. LEXIS 262, at *47-*48 (D. Or. January 3, 2006), attached in the Addendum, the court found the Sarbanes-Oxley Certifications to be significant because, “[w]hen a corporate officer signs a document on behalf of the corporation, that signature will be rendered meaningless unless the officer believes that the statements in the document are true.” The Court went on to find that the “Sarbanes-Oxley Certifications give rise to an inference of scienter because they provide evidence either that defendants knew about” the faulty accounting or knowingly misrepresented that the company’s internal controls were adequate. Id. at *50. It has also been recognized that Sarbanes-Oxley Certifications may “demonstrate [that] the person certifying the pronouncement has merely ‘rubber stamped the numbers’ and thereby acted recklessly.” In re Am. Italian Pasta Co. Sec. Litig., No. 05-0725-CV-W-ODS, 2006 U.S. Dist. LEXIS 40548, at *22 n.3 (W.D. Mo. June 19, 2006), attached in the Addendum.
Sarbanes-Oxley Certifications were similarly considered evidence of scienter in In re OCA, Inc. Securities and Derivative Litigation, No. 05-2165, 2006 U.S. Dist LEXIS 90854, at *75 (E.D. La. Dec. 14, 2006), attached in the Addendum. The Certifications were held to support an inference of scienter because, as in Plaintiffs’ case, they “show that both defendants stated that they designed and evaluated [the company’s] control procedures to ensure that they worked to provide them with material information about the company and then certified that the controls were effective, while at the same time failing to disclose serious, unremedied internal control problems.” Id.
While Sarbanes-Oxley Certifications are considered relevant to the scienter analysis, the Certifications only give rise to an inference of scienter when combined with other allegations of the defendant’s recklessness. See Lattice Semiconductor Corp., 2006 U.S. Dist. LEXIS 262 at *50-*51; OCA, Inc., 2006 U.S. Dist. LEXIS 90854 at *75; Am. Italian Pasta Co., 2006 U.S. Dist LEXIS 40548 at *22 n.3. That is the context in which Plaintiffs are asking this Court to consider Johnston’s and Palmer’s Certifications, as just one factor among many supporting an inference of scienter. Thus, contrary to the district court’s conclusion, there is no danger of holding corporate officers “strictly liable” for signing Sarbanes-Oxley Certifications.
4.The Nature and Magnitude of Visteon’s GAAP Violations Support a Strong Inference of Scienter.
The Amended Complaint alleges that Defendants committed a massive accounting fraud by overstating four years of earnings by more than $198 million, finally corrected in three separate restatements in 2005. (R.12, Am. Compl., pp. 47-62, 68-70, Apx. pp. 93-108, 114-16.) This Court has recognized that an inference of recklessness “may be drawn from allegations of accounting violations that are so simple, basic, and pervasive in nature, and so great in magnitude, that they should have been obvious to a defendant.” PR Diamonds, 364 F.3d at 684. Thus, while the mere existence of a GAAP violation alone may not be sufficient evidence of scienter, “the nature of the misapplication of accounting principles – in terms of number, size, timing, frequency, and context – is relevant circumstantial evidence of a defendant’s state of mind.” Id. at 685.
The district court dismissed Plaintiffs’ contention that the nature and magnitude of Visteon’s accounting improprieties gives rise to an inference of scienter, “refus[ing]” to characterize these errors “as ‘so simple, basic and pervasive in nature.’” (R.49, Order, p. 14, Apx. p. 157.) With respect, the accounting errors alleged by Plaintiffs are not as complex as the district court strained to make them. Most of the errors were due either to Visteon’s failure to properly attribute expenses to the proper time period in which those expenses were incurred or simply not recording the expenses at all. (R.12, Am. Compl., pp. 52-53, Apx. pp. 98-99). Moreover, the pervasive nature of Visteon’s GAAP violations can hardly be denied, as these violations were committed over a four-year period in approximately nine different categories. (Id. at pp. 52-53, 60-61, Apx. pp. 98-99, 106-07.)
Notably, Visteon’s materially false and misleading financial statements are largely attributable to its cavalier attitude toward maintaining proper internal controls over the Company’s financial information. (Id. at pp. 51, 55-56, 64, 69-70, Apx. pp. 97, 101-02, 110, 115-16.) The pervasive nature of Visteon’s accounting errors indicates that there were no reliable general controls over the Company’s accounting function. (Id. at 70, Apx. p. 116.) Courts have recognized that evidence of a lack of internal controls is probative of scienter when combined with other allegations of recklessness. See In re Veeco Instruments, Inc., Sec. Litig., 235 F.R.D. 220, 232 (S.D.N.Y. 2006) (holding that a failure to maintain sufficient internal controls to avoid fraud is indicative of scienter); In re Cardinal Health Inc. Sec. Litig., 426 F. Supp. 2d 688, 723, 723 n.48 (S.D. Ohio 2006) (recognizing violation of SEC regulations due to inadequate internal controls as one of many GAAP violations supporting an inference of scienter); Crowell v. Ionics, Inc., 343 F. Supp. 2d 1, 20 (D. Mass. 2004) (holding that allegations of failure to maintain adequate controls are “probative of scienter  and can add to the strength of a case based on other allegations”).
As for the magnitude of Visteon’s misstated earnings, $198 million must be considered significant even to a large company like Visteon. The district court dismissed the importance of this large amount of inflated earnings because the restatements constituted just 5.68% of Visteon’s revenue during the class period. (R.49, Order, pp. 14-15, Apx. pp. 157-58.) However, it has been recognized that “a 6.2% overstatement of annual revenue is not insignificant” when considering the magnitude of a financial misstatement. Croker v. Carrier Access Corp., No. 05-cv-01011-LTB-OES, 2006 U.S. Dist. LEXIS 48603, at *29 (D. Colo. July 18, 2006), attached in the Addendum; see also In re Daou Sys., Inc., Sec. Litig., 411 F.3d 1006, 1020 (9th Cir. 2005) (holding that “prematurely recognizing millions of dollars in revenue is not minor or technical in nature”). Certainly, overstated earnings in the amount of tens of millions of dollars should be sufficient to raise an inference that these large sums were not unnoticed by senior management, particularly combined with Plaintiffs’ other allegations of recklessness.
In its brief consideration of Plaintiffs’ magnitude allegations, the trial court stated that an inference of scienter could not be raised by the magnitude of accounting errors alone, relying on this Court’s opinion in Fidel v. Farley, 392 F.3d 220 (6th Cir. 2004). (R.49, Order, p. 15, Apx. p. 158.) First, this statement demonstrates the district court’s fundamental error in weighing each allegation in isolation. Plaintiffs do not argue that magnitude alone is evidence of recklessness, but only that it is one factor to be considered in combination with other evidence of scienter, such as the evidence of Visteon’s intentional accounting manipulations and misstatements. Moreover, the Fidel case held only that the magnitude of accounting errors alone cannot establish scienter on the part of an outside auditor. See Cardinal Health, 426 F. Supp. 2d at 723 n.49. Therefore, with regard to securities fraud allegations against the company itself or the company’s executive officers, the magnitude of GAAP violations may be considered in the scienter analysis collectively with other allegations. See PR Diamonds, 364 F.3d at 684; Cardinal Health, 426 F. Supp. 2d at 723 n.49.
In sum, Plaintiffs have alleged that Visteon materially misstated its earnings to the tune of $198 million by engaging in a variety of relatively simple accounting manipulations, that those accounting errors persisted over a four-year period and pervaded at least nine different areas of the Company, and that the significant misstatements were attributable to Visteon’s failure to implement adequate internal controls as required by the SEC. Taken as a whole, these allegations support an inference of scienter that is at least as compelling as any opposing inference.
- Visteon Disclosed Accounting Information in an Intentionally Confusing Manner.
Not only did Visteon consistently misrepresent its earnings and its viability as a company, but the disclosures it did make were often presented in an intentionally confusing manner. In this regard, Visteon chose to conceal the losses on the Ford contracts that were inherent at the time of the Spin-Off by reporting those losses in multiple documents that could only be fully understood when read together. One could only discern that those Ford-related losses were regularly reported as “special charges,” or losses outside the Company’s normal operating expense by comparing Visteon’s periodic financial statements with the assets disclosed in the Spin-Off Prospectus. (R.12, Am. Compl., pp. 25-27, 29, 32, 37, 42, Apx. pp. 71-73, 75, 78, 83, 88.) It takes someone with accounting experience, and the knowledge of what documents to review, to unravel the true significance of the large special charges taken by Visteon each year. Likewise, the information that Visteon’s assets were overvalued at the time of the Spin-Off could only be discovered by reviewing financial information for both Ford and Visteon, which shows that Ford took a write down of $1 billion when it reacquired many of those assets in 2005. (Id. at p. 73, Apx. p. 119.)
Similarly, the 2004 consolidated financial statements did not simply state the truth, which was that the cash from operations would apparently not be sufficient to cover operating costs and other cash needs. (Id. at pp. 71-73, Apx. pp. 117-19.) This fact was disclosed piecemeal in two separate notes to the 2004 consolidated financial statements that had to be read together. (Id. at p. 73, Apx. p. 119.) In Note 10 Visteon disclosed that it was highly leveraged as of December 31, 2004 and that its revolving credit agreement in the amount of $565 million expired in June 2005. (Id. at p. 72, Apx. p. 118.) In Notes 14 and 22 it was disclosed that Ford would be granting contract concessions amounting to $300 million. (Id. at p. 71-73, Apx. pp. 117-19.) It appears that the agreements described in Notes 14 and 22 were deemed necessary to prevent Visteon’s auditor from including a paragraph in the report that there was doubt Visteon was a “going concern.” (Id. at p. 71, Apx. p. 117.) The discussion of Visteon’s liquidity concerns and the significance of the Ford agreements should have been presented in Note 1. (Id. at p. 72, Apx. p. 118.) Instead, the division of the information into two places in the report appears intentionally designed to increase the chances that the critical facts would be overlooked by the average investor.
According to Helwig, one of the factors relevant to the scienter inquiry is the “disclosure of information in such a way that its negative implications could only be understood by someone with a high degree of sophistication.” Helwig, 251 F.3d at 552. Visteon’s practice of disclosing information that could only be understood by reviewing two or more documents is additional circumstantial evidence giving rise to a strong inference that Visteon knowingly misled investors.
6.Visteon Had the Motive and Opportunity to Benefit Ford by Maintaining the Ruse of Visteon’s Viability.
Facts demonstrating the Defendants’ motive and opportunity to commit fraud may support a strong inference of recklessness. See id. at 550-51. Motive may be established by showing the “concrete benefits that could be realized by one or more of the false statements and wrongful nondisclosures alleged.” PR Diamonds, 364 F.3d at 690. Plaintiffs have alleged that Visteon was spun off solely for the purpose of benefitting Ford, and Ford stockholders, by allowing Ford to shift its onerous labor contracts and underperforming assets off Ford’s books and onto Visteon’s unsuspecting shareholders. (R.12, Am. Compl., pp. 2-3, 67-68, Apx. pp. 48-49, 113-14.) When decisions were made at Visteon, the purpose and effect was to advance the interests of Ford rather than Visteon. (Id. at p. 18, 22, 25, Apx. pp. 64, 68, 71.) As Visteon’s losses rose, Ford’s profits rose as well. (Id. at pp. 67-68, Apx. pp 113-14.) The Individual Defendants personally benefitted from Ford’s success, as their investment in Ford securities far exceeded their respective holdings in Visteon. (Id. at pp. 6, 81, Apx. pp. 52, 127.) Thus, the motive to increase Ford’s profitability was at the root of Defendants’ accounting tricks and repeated misstated earnings designed to create a false picture of Visteon’s financial stability. (Id. at pp 67-68, Apx. pp. 113-14.)
Part of Visteon’s charade included issuing a notes offering in March 2004, long after the Individual Defendants knew bankruptcy was inevitable without a bailout from Ford, for the purpose of avoiding default on expiring notes and raising additional capital. (Id. at p. 88, Apx. p. 134.) A company’s need for financing, although not dispositive of the issue of scienter, can be considered as part of the totality of the circumstances analysis used by this Circuit. See PR Diamonds, 364 F.3d at 690; In re Microstrategy, Inc. Sec. Litig., 115 F. Supp. 2d 620, 648 (E.D. Va. 2000) (finding defendants’ desire to raise capital through public offerings probative of scienter); In re Complete Mgmt. Inc. Sec. Litig., 153 F. Supp. 2d 314, 328 (S.D.N.Y. 2001) (same).
The “opportunity” to engage in fraud is essentially having “the means and likely prospect of achieving concrete benefits by the means alleged.” PR Diamonds, 364 F.3d at 690 (quoting In re Criimi Mae, Inc., Sec. Litig., 94 F. Supp. 2d 652, 660 (D. Md. 2000)). The Individual Defendants were all long-time Ford employees who negotiated the terms of the Spin-Off in a way that was advantageous to Ford rather than Visteon. (R.12, Am. Compl.,p. 18, Apx. p. 64.) Each of the Individual Defendants held a senior executive position within the Company, was directly involved in the day-to-day operations of the Company at the highest levels, had access to internal corporate communications and documents regarding Visteon’s finances, and personally signed one or more of the public misrepresentations at issue in this case. (Id. at pp. 6-10, Apx. pp. 52-56.) Given the Individual Defendants’ positions of power and authority at Visteon, “there can be little doubt that they could have, had they wanted to, committed” the fraudulent acts alleged by Plaintiff. PR Diamonds, 364 F.3d at 690. Thus, Visteon and the Individual Defendants had both the motive and the opportunity to falsify Visteon’s finances in order to benefit Ford.
As the foregoing discussion demonstrates, Plaintiffs have adequately pled a claim under § 10(b) and Rule 10b-5. In addition, because the Plaintiffs have alleged facts demonstrating the Individual Defendants’ status as control persons, Plaintiffs have stated a claim against the Individual Defendants under § 20(a). See Cardinal Health, 426 F. Supp. 2d at 762; In re Worldcom, Inc. Sec. Litig., 294 F. Supp. 2d 392, 415 (S.D.N.Y. 2003); In re IPO Sec. Litig., 241 F. Supp. 2d 281, 395 (S.D.N.Y. 2003). The district court’s dismissal of Plaintiffs’ Exchange Act claims was erroneous.
THE DISTRICT COURT ERRED IN FINDING THAT PLAINTIFFS DID NOT STATE A CLAIM AGAINST PwC UNDER THE EXCHANGE ACT.
The pleading standards outlined above for stating a claim under Section 10(b) and Rule 10b-5 also apply to Plaintiffs’ allegations against Visteon’s independent auditor, PwC. See PR Diamonds, 364 F.3d at 693. As Visteon’s auditor, PwC assisted Visteon’s financial fraud by repeatedly issuing clean audit reports for financial statements that were prepared using improper accounting practices and that contained demonstrably false financial data. (R.12, Am. Compl., pp. 3, 6, 47-62, 67-70, 74-85, Apx. pp. 49, 52, 93-108, 113-16, 120-131.) The following evidence gives rise to a strong inference that PwC either deliberately or recklessly disregarded the problems with Visteon’s accounting practices: (1) PwC’s failure to maintain its professional independence; (2) the nature and magnitude of Visteon’s GAAP violations known to PwC; (3) PwC’s unqualified audits to Visteon’s related party transactions with Ford in violation of GAAS; and (4) PwC’s intimate knowledge of Visteon’s internal financial information.
- PwC Failed to Maintain Its Professional Independence.
Even prior to being engaged as Visteon’s auditor, PwC served as Ford’s auditor. (R.12, Am. Compl., pp. 77-78, Apx. pp. 123-24.) One of the basic tenets of Generally Accepted Auditing Standards (“GAAS”) is that an auditor must maintain “an independence of mental attitude.” (Id. at p. 77, Apx. p. 123.) Auditing standards provide that an auditor’s independence is impaired by the existence of circumstances which reasonable people believe are likely to influence independence. (Id.) At the time of the Spin-Off and in subsequent audits, PwC’s independence was impaired by auditing both Ford and Visteon when Visteon’s loyalties were to Ford and any significant audit discovery that would benefit Visteon related to the Ford contracts would likely have a detrimental impact on Ford. (Id.) Ford was a long-time customer whose business with PwC amounted to $303.4 million compared to Visteon’s $47.25 million during the same period. (Id. at p. 80 n.5, Apx. p. 126 n.5.)
PwC’s lack of objectivity facilitated the improper approval of the inflated valuation of Visteon’s assets at the time of the Spin-Off. (Id. at pp. 78-80, Apx. pp. 124-26.) Because PwC was also Ford’s auditor at that time, it audited both sides of the transaction where Ford recorded a loss based on the recorded value of the net assets transferred to Visteon, and Visteon used those values as the historical costs on which its separate operations would continue. (Id. at pp. 78-79, Apx. pp. 124-25.) As later revealed when Ford reacquired those assets, at the time of the Spin-Off they were overvalued by $1 billion. (Id. at p. 79, Apx. p. 125.)
PwC, and the district court, improperly made this an issue of fact. PwC claimed that it was independent and impartial and tried to “prove” this independence with evidence that other companies have shared an auditor with their spun-off subsidiaries. (R.18, PwC Motion to Dismiss, pp. 9-10, Apx pp. 186-87.) The district court improperly considered this evidence. (R.49, Order, pp. 18-19, Apx pp. 161-62.) Whether PwC complied with GAAS, and whether PwC lacked independence from Ford when auditing Visteon, are disputed matters to be resolved by the trier of fact. The strong-inference pleading standard does not license the district court to resolve disputed facts at the motion to dismiss stage. Fla. State Bd. of Admin. v. Green Tree Fin. Corp., 270 F.3d 645, 666 (8th Cir. 2001). The district court erred in not properly
- The Nature and Magnitude of Visteon’s GAAP Violations Support a Strong Inference of Scienter On The Part of PwC.
The variety and magnitude of Visteon’s GAAP violations are detailed in Section II.B.4. supra. Those GAAP violations are relevant to PwC’s state of mind because PwC effectively enabled Visteon to use fundamentally flawed accounting practices in preparing its financial statements for 2001, 2002, 2003 and the first three quarters of 2004, by either knowingly or recklessly disregarding obvious and pervasive red flags indicating material deficiencies in Visteon’s operations and internal controls. (R.12, Am. Compl., at pp. 6, 74-85; Apx. pp. 52, 120-31.) PwC’s repeated failure to properly assess Visteon’s internal control failures was revealed on March 16, 2005, when PwC issued a material weakness report on Visteon’s internal controls as of December 31, 2004. (Id. at p. 69, Apx. p. 115.)
Plaintiffs alleged that PwC approved accounting and reporting practices that it knew to be in violation of GAAP. (Id. at pp. 82-83, Apx. pp. 128-29.) According to a former senior finance director at Visteon, PwC had raised concerns with Visteon management regarding the accounting for material surcharges and rebates, but “‘signed off’” on those accounting practices several times. (Id. at p. 62, Apx. p. 108.) Apparently once the earnings restatements were announced in January 2005 and the Audit Committee began its investigation, PwC “changed its mind” about the proper accounting for these transactions. (Id.) The evidence that PwC actually knew about Visteon’s improper accounting practices, but repeatedly decided to issue clean audits regardless of that knowledge, raises a strong inference of scienter
- PwC Improperly Audited Visteon’s Related Party Transactions with Ford.
One product of PwC’s failure to maintain its independence was the improper unqualified audit given to Visteon and Ford’s related party transactions. (Id. at pp. 81, 85, Apx. pp. 127, 131.) A “related party” is defined as affiliates, principal owners and management of the enterprise, as well as “other parties with which the enterprise may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests.” (R.20, Appendix to PwC Motion to Dismiss, Ex. 10, p. 6, Apx. p. 723.)
Auditing standards require that auditors cannot presume that related party transactions are carried out at arm’s length. (R.12, Am. Compl., p. 80, Apx. p. 126.) PwC could not determine that the transactions between Ford and Visteon were arm’s length transactions consistent with GAAS, and therefore improperly issued clean audits. (Id. at p. 81, Apx. p. 127.) Absent evidence that Visteon’s revenues and expenses recognized under contracts with Ford were at arm’s length, the audit opinion issued by PwC should have been either a disclaimer due to a scope restriction or an adverse opinion due to the pervasive potential for transactions that were detrimental to Visteon’s economic interests. (Id. at p. 85, Apx. p. 131.)
PwC’s failure to properly audit Visteon’s related party transactions with Ford perpetuated Visteon’s fraudulent scheme to falsely hold itself out as a viable, independent company. Perhaps more than any other evidence, the evidence of PwC’s disregard for these related party transactions demonstrates that PwC either knew or recklessly disregarded Visteon’s undisclosed status as a de facto subsidiary or SPE of Ford. (Id. at pp. 82, 84-85, Apx. pp. 128, 130-31.)
- PwC’s Intimate Knowledge of Visteon’s Operations Is Further Evidence of Scienter.
The relationship between PwC and Visteon further supports a strong inference of scienter. In In re MicroStrategy, the court found that “the alleged nature and level of PwC’s access to Microstrategy serve as the lens through which PwC’s specific GAAS and GAAP violations must be viewed.” 115 F. Supp. 2d at 653. By virtue of its longstanding relationship with Visteon and Ford, PwC had intimate knowledge of Visteon’s financial information and reporting practices. (R.12, Am. Compl., p. 6, Apx. p. 52.) Thus, when Plaintiffs’ GAAP and GAAS allegations are viewed in the context of PwC’s intimate knowledge of the Company’s financial history, accounting practices, internal controls, and business operations, the inference that PwC acted at least recklessly is strengthened.
In considering Plaintiffs’ scienter allegations against Visteon, the district court disregarded most of Plaintiffs’ scienter evidence and incorrectly stated that Plaintiffs argued “that merely maintaining a ‘relationship between PwC and Visteon supports an inference of scienter.’” (R.49, Order, p. 19, Apx. p. 162.) Rather, Plaintiffs offered numerous allegations regarding PwC’s reckless or knowing state of mind and contend that PwC’s thorough knowledge of Visteon’s operations and its close working relationship with Visteon, “provide important information on the context in which PwC conducted its audits.” In re Microstrategy, 115 F. Supp. 2d at 653. PwC’s knowledge of Visteon’s finances is one factor indicating scienter when considered in the context of PwC’s other actions strongly suggesting recklessness.
For the foregoing reasons, the district court improperly dismissed Plaintiffs’ Section 10(b) and Rule 10b-5 claims against Visteon, the Individual Defendants, and PwC. The district court also erred in dismissing Plaintiffs’ Section 20(a) claims against the Individual Defendants. Therefore, Plaintiffs respectfully request that the district court’s order dismissing Plaintiffs’ claims be reversed.
December 17, 2007.
- ↑ The articles published in 2000 had no concrete information about Visteon’s actual labor costs or how high they would be in comparison to Visteon’s competition. (R.19, Visteon Motion to Dismiss, Exs. 11-12, Apx. pp. 468-75.)