Federal Court Rejects Defense Motion to Dismiss Securities Fraud Class Action Holding that Class Action Complaint Satisfied Heightened Pleading Requirements Under PSLRA and that Applicability of PSLRA’s Safe Harbor Provision Required Factual Development Through Discovery
Plaintiffs filed a securities class action against EVCI and certain officers and directors for violations of Section 10(b) and Section 20(a) of the Securities Exchange Act of 1924 and Rule 10b-5 alleging that defendants misstated EVCI’s financial condition and failed to accurately disclose negative information that would bear directly on EVCI’s profitability. In re EVCI Colleges Holding Corp. Securities Litig., 469 F.Supp.2d 88 (S.D.N.Y. 2006). Defense attorneys argued that the 203-paragraph class action complaint failed to satisfy the heightened pleadings requirements of the federal Private Securities Litigation Reform Act (PSLRA) and had failed to adequately plead scienter. Id., at 91. The district court observed that “[i]f read too literally, the statute would appear to impose on a securities plaintiff the almost insuperable burden of having to file a complaint that is as comprehensive as his closing argument after trial.” Id. The court concluded that the allegations in the class action complaint clearly satisfied the pleadings requirements under the PSLRA and Rule 9(b), and criticized defense attorneys for filing the motion to dismiss, which it characterized as “utterly lacking in merit.”
EVCI is a holding company that provides “on-campus career two year college education” through three entities. Its principal subsidiary is Interboro; this asset “generates the bulk of EVCI’s revenue” which “has grown substantially, from $8.6 million in 2000 to $50.4 million in 2005.” EVCI, at 92. The class action complaint alleged “pervasive fraud in the admissions process at EVCI’s Interboro College – the institution that generated nearly all of EVCI’s revenue during the asserted class period. Id. In brief, Interboro is two-year college, conditionally accredited by the State of New York, that primarily served “minority students from economically disadvantaged backgrounds” who had neither a high school diploma nor a GED, id., at 93. These students were required to pass an “ability-to-benefit” exam (ATB), and required federal and state grants to pay for their education at Interboro, and Interboro limited its tuition to the amounts of the student grants, id. “In other words, Interboro’s revenues derive in substantial part – 94%, to be precise – from publicly funded education grants awarded to students who are both poor and poorly prepared for higher education. And EVCI, in turn, derives nearly all its revenue from Interboro.” Interboro was subject to strict state and federal regulation, and to maintain its conditional accreditation the college had to meet several goals, id.
Interboro’s enrollments increased dramatically, in part because Interboro opened extension centers, resulting in a corresponding increase in revenues for EVCI because “more students meant more money.” EVCI, at 93. EVCI attributed its revenue growth to its “carefully developed strategies,” id., at 93-94. But there were problems. Interboro began operating an extension center without state approval in violation of state law – “a defalcation to which Interboro quickly admitted” – and ultimate refused to permit Interboro to use the site, id., at 94. Additional state-mandated quality control issues existed with another extension center that would have “significant budgeting, planning, scheduling and revenue implications for the college.” Id. State regulators also determined that Interboro’s student retention rate was “not improving, but is getting worse.” Id. EVCI did not accurately disclose these negative events. Id.
In October 2005, the State sent Interboro a draft report – based in part on information obtained from “undercover operatives posing as potential applicants” – that “chronicled fraudulent practices with respect to Interboro’s admissions and financial aid processes.” EVCI, at 94. These practices included encouraging applicants to lie about income in order to qualify for financial aid, and advising investigators who intentionally failed the ATB test that they had passed because “Interboro had changed their answers to achieve the passing grade.” Id., at 94-95. EVCI disclosed some of these findings and its stock “immediately plummeted more than 50% from the previous day’s close, and volume rose from 29,000 shares the day before to 3.65 million shares.” Id., at 95. Additional disclosures followed, and the stock again took a beating, id. Class action lawsuits followed, and discovery revealed that Interboro’s fraudulent admissions practices were known by and encouraged by management. Id., at 95-96.
In considering the motion to dismiss, the federal court readily found that the class action complaint satisfied the pleading requirements of the PSLRA and Rule 9(b). EVCI, at 96-99. In fact, the district court was singularly unimpressed with defense arguments, stating at page 91:
The PSLRA’s effort to weed out strike suits was well-intentioned. Unfortunately, the statute does not protect courts from the defense equivalent – a “strike” motion to dismiss that is utterly lacking in merit. If ever a complaint was well-pleaded under the PSLRA, this one is; if ever a motion to dismiss was utterly lacking in merit, it is this one. (Italics added.)
The district court later concluded, “All in all, the pleading before the court is one of the best supported securities fraud complaints this court has seen in the eleven years since the PSLRA was passed. If this complaint does not pass muster, I cannot imagine what would qualify as an adequate pleading. The motion to dismiss the complaint for failure to plead with the particularity required by Rule 9(b) and the PSLRA is denied.” EVCI, at 99.
With respect to scienter, based on the court’s detailed factual analysis, see EVCI, at 99-101, the federal court held that the class action complaint adequately pleaded scienter because it “alleges facts constituting strong circumstantial evidence of conscious misbehavior or recklessness,” id., at 99.
Finally, the district court rejected defense arguments that the PSLRA’s “safe harbor” provision warranted dismissal of the class action. Defendants argued that the statements underlying the fraud claims “qualify for safe harbor treatment because their statements were either ‘forward looking’ or, when they were not, contained meaningful cautionary language.” EVCI, at 101. As the court explained, “Under the PSLRA’s Safe Harbor Provision, 15 U.S.C. § 78u-5(c), management cannot be held liable for making ‘forward-looking’ statements, which are in the nature of predictions, as long as those statements are accompanied by ‘meaningful cautionary language.’” Id. We do not here summarize the arguments for and against the application of the safe harbor provision; suffice it to say that the federal court concluded at page 103: “[T]his is one of those (probably) rare cases where the Safe Harbor issue is not amenable to final resolution on the pleading, even accompanied by all the relevant press releases and SEC filings. It depends on facts that remain to be developed in discovery.”
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