Florida State Board of Administration v. Green Tree Financial Corp. (270 F.3d 645, 2001)

JOHN R. GIBSON, Circuit Judge.

In this case we must assess the sufficiency of three complaints under the new pleading standards made applicable to securities fraud cases by the Private Securities Litigation Reform Act of 1995, P.L. No. 104-67, 109 Stat. 737. The Florida State Board of Administration, which invests state employees’ pension funds, and two putative classes of investors, one for stock purchasers and one for option traders, have each brought Rule 10b-5 actions against Green Tree Financial Corporation, its CEO, Lawrence Coss, and other executives, on the theory that they fraudulently overstated Green Tree’s financial value. The investors allege that they bought securities in a market affected by this fraud and that when the true facts came to light, Green Tree’s stock price tumbled and they lost their money. The district court held that none of the three complaints pleaded facts giving rise to a strong inference of knowing or reckless misconduct, and so the court dismissed the complaints with prejudice. Florida State Bd. of Admin, v. Green Tree Fin. Corp. (In re Green Tree Fin. Corp. Stock Litig), 61 F.Supp.2d 860, 878 (D.Minn.1999). The Florida Board and both investor classes appeal, contending that their complaints were indeed sufficient to plead securities fraud. We reverse.

I.

For the purpose of a motion to dismiss, we take the facts from the complaints. Green Tree is a financial services corporation that originally specialized in lending money on house trailers, referred to as “manufactured housing,” although it later diversified into other kinds of lending. Because manufactured housing loans are classified as “sub-prime,” the interest rates are very high — as much as 200 to 400 basis points (two to four percentage points) above residential mortgage rates. Green Tree rose to prominence by pioneering the securitization of manufactured housing loans, which means that it pooled large numbers of these loans and put them into a trust, which sold securities for which the loans served as collateral. The securities entitled the purchaser to fixed interest and principal payments under the loans. Importantly, Green Tree did not relinquish all rights under the securitized loans; instead, it retained the right to keep a portion of the loan payments and it retained the obligation to service the loans. Green Tree’s profit was therefore the spread between the interest it charged the borrowers and the interest it promised the instrument-holders, minus Green Tree’s costs of servicing the loans. However, Green Tree retained the risk of losses from loan defaults, as well as the risk that borrowers would prepay their loans before incurring interest charges, so that the expected interest would never materialize. By absorbing these risks, Green Tree could take high-interest-rate manufactured-housing loans and turn them into low-interest-rate securities, thereby creating the profitable spreads that fueled Green Tree’s growth.

As it securitized each loan pool, Green Tree booked a current gain on the transaction, even though the expected profits would not actually come into its coffers until much later and even though the amount of those profits would fluctuate with Green Tree’s success in collecting the loan payments. This “gain-on-sale revenue” was the force that drove Green Tree’s reported earnings during the periods covered by the complaints. Gain-on-sale receivables made up 63.8% of the net revenue that Green Tree originally reported for 1996. In addition to the income, Green Tree also recorded the present value of the securitizations as balance sheet assets called “Excess Servicing Rights Receivable” or “Interest Only Securities.” In 1996 “Excess Servicing Rights Receivable” was the greatest single asset on Green Tree’s balance sheet.

In order to estimate the present value of the securitizations, Green Tree had to assume three things: (1) the discount rate (reflecting the lesser value of a dollar to be paid in the future than a dollar paid today); (2) the loan default rate; and (3) the loan prepayment rate. The numbers chosen for these assumptions played a crucial role in deciding the amount Green Tree would report as earnings on the securitiza-tions and as the value of the Excess Servicing Rights Receivable. Choosing a figure for prepayment rate was especially difficult because if interest rates fell substantially or if other lenders competed aggressively, borrowers would be likely to refinance in large numbers. If that happened, the loans and consequently, the expected profit on them, would simply disappear. A discrepancy between assumed prepayment rates and actual prepayment experience could have a serious effect on Green Tree’s earnings and balance sheet.

The crux of this suit is the investors’ allegation that Green Tree used “unrealistic and unreasonable” assumptions in its gain-on-sale accounting, thus overvaluing its assets and overstating its earnings. In particular, the investors allege that the actual prepayment experience from 1995 to 1997 varied so much from the prepayment rate Green Tree assumed in its gain-on-sale accounting for 1994 and 1995 securiti-zations that Green Tree’s financials and other publicly filed reports during the 1995-1997 period were materially false. The investors concede that Green Tree publicly disclosed its actual prepayment experience. However, they allege the defendants refused to disclose what prepayment assumptions Green Tree had used in its gain-on-sale accounting and that this constituted omission of a material fact necessary to prevent its financial reports from being misleading. Green Tree stated in its public filings with the SEC that its management regularly reevaluated Green Tree’s prepayment assumptions in light of actual experience. According to the complaints, the defendants either knew that the discrepancy between the actual prepayment experience and the assumed rates rendered the financials materially false, or alternatively, recklessly disregarded this fact.

In any event, Green Tree’s assumptions about prepayment rates turned out to be seriously inadequate. Green Tree announced on November 13, 1997, that it planned to increase the prepayment reserve in its 1997 financials by an estimated $125-150 million because of higher than expected prepayment rates on manufactured housing loans. This announcement caused a precipitous decline in Green Tree’s stock price, from $42 to $30.75. The day after the announcement, in a conference call with industry analysts, CEO Coss disclosed the prepayment assumptions Green Tree had been using for the 1994 and 1995 pools. He assured analysts, “I don’t see any set of circumstances that would cause us to [write down the 1994-1995 loan pools] again. And if we thought there was any set of circumstances that would, we would have provided more.” He also stated that a revision of prior earnings was not appropriate.

On January 27, 1998, Green Tree took an addition to its reserves of $190 million, rather than the $125-150 million addition to reserves anticipated in the November announcement. At the same time, it took a $200 million reduction of its previously reported 1996 earnings. In the press release accompanying the financials, Green Tree explained the decision to make larger adjustments than it had announced before; in reviewing its financial modeling, it “determined it had not fully considered the effect upon its interest only securities of partial prepayments (principal curtailments) and the impact that higher prepayments have on projected future interest due to investors on a weighted average basis.” Green Tree’s stock fell as low as $18.

On April 7, 1998, about two months after the close of the class periods, Green Tree announced that it would be acquired by Conseco, Inc., in a merger. On July 6, 1998, Conseco took charges totaling $350 million to write down the carrying value of Green Tree’s interest-only securities, reflecting adjustment to assumptions for prepayment rates, discount rates, and default rates.

The investors allege that several motives prompted the defendants to spread misleading financial information through the market. First, they allege that the compensation of defendant Coss and other Green Tree executives was tied to Green Tree’s financial results, which made the defendants want to maximize Green Tree’s reported earnings. In particular, CEO Coss had a remarkable contract awarding him 2.5% of Green Tree’s pre-tax income (minus other executives’ bonuses). Coss’s contract was to expire December 31, 1996. Accordingly, it was in Coss’s personal interest to report as much income as possible before the expiration of his lucrative contract. Other motives alleged are: (1) the defendants’ desire to maintain a high corporate credit rating to maximize the selling price of the loan pools; and (2) Green Tree’s need to demonstrate exemplary financial results in order to fend off a pending derivative suit alleging that the company wasted corporate assets by paying excessive executive compensation.

The stock purchasers allege that class members bought Green Tree stock from July 15, 1995 through January 27, 1998, and the options traders claim to have traded options from July 15,1995 though January 26, 1998. The Florida State Board alleges that it bought Green Tree stock from January 30, 1996 through January 27, 1998. The investors contend that they bought stock or traded options in a market in which the stock price was artificially inflated because of the defendants’ misrepresentations about Green Tree’s financial condition and that they lost money when the truth came out and the stock price fell.

II.

The stock purchasers’ class, the option traders’ class and the Florida State Board of Administration each filed a complaint alleging that Green Tree and the defendant officers of Green Tree violated section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) (1994), and Rule 10b-5, 17 C.F.R. § 240.10b-5 (2001). They also alleged that the individual defendants were control persons of Green Tree and therefore were liable under section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a) (1994), for Green Tree’s 10b-5 violations.

The defendants moved to dismiss the complaints for failure to state a claim un~ der Fed.R.Civ.P. 12(b)(6) and 9(b) and the pleading provisions of the Private Securities Litigation Reform Act of 1995, 15 U.S.C. §§ 78u-4 and 78u-5 (Supp. V 1999).

Applying section 78u-4(b)(l), which requires that a complaint specify with particularity each statement alleged to have been misleading, the district court held that most of the investors’ factual allegations regarding the misleading statements and omissions were sufficiently particular to survive the dismissal motion. 61 F.Supp.2d at 871. The allegation that the court held not to be “particular” was the stock purchaser class’s allegation that Coss told an unnamed money manager in 1998 that Green Tree had been aware of the prepayment problem for some time, but had hoped it would go away. The district court held that this allegation did not state with particularity the “facts on which [the stock purchasers’] belief is formed,” 61 F.Supp.2d at 871 (quoting 15 U.S.C. § 78u-4(b)(l)), and therefore the court held that allegation did not comply with the statutory pleading requirements. Id. at 872.

The district court then turned to the central issue in this case-whether the complaints met the Reform Act’s requirements for pleading scienter, 15 U.S.C. § 78u-4(b)(2). The district court held that the complaints failed to plead facts giving rise to a strong inference of scienter, as required by statute. 61 F.Supp.2d at 872.

Considering the allegations that the defendants were motivated to exaggerate Green Tree’s financial performance in order to increase the performance-based compensation of Green Tree’s executives, the court held that performance-based compensation alone does not give rise to a strong inference of scienter. Id. at 873 (citing Acito v. IMCERA Group, Inc., 47 F.3d 47, 54 (2d Cir.1995), and Shields v. Citytrust Bancorp. Inc., 25 F.3d 1124, 1130 (2d Cir.1994)). The unusual size of Coss’s performance incentives, while “clearly shocking,” id., did not provide the extra ingredient necessary to establish scienter. Id. Moreover, the court held that the complaints did not even show that the misrepresentations increased Coss’s compensation, since he had to give back a proportional amount of his 1996 compensation after Green Tree restated its 1996 financial results in 1998. Id. The 1995 results were not restated, so the district court held that there was no showing that they were misstated. Id. Coss and the other executives’ 1997 compensation was based on year-end results, which were figured after the revelation of the prepayment problems. Id. The investors argued that even though the defendants may not have actually profited from the misstatements, they could have hoped to do so, and this would supply the motive for fraud. The court responded that any such hope would have been so irrational that it could not be regarded as a motive. Id. at 874. Finally, any possible showing of motive to misrepresent would be rebutted by the fact that defendants Potts, Finn, and Gottesman bought Green Tree stock on the open market during the time period of the alleged fraud. Id. The court rejected the investors’ other theories of motive as well. Id.

The district court then considered whether the complaints contained facts that, in the absence of a showing of motive, nevertheless amounted to strong circumstantial evidence of scienter. The complaints allege that defendants monitored actual prepayment rates as they occurred throughout the periods covered in the complaints. Id. at 875. The investors’ theory was that once the defendants knew the actual prepayments for the 1994 and 1995 pools exceeded their assumed rates, their continued publication of financial statements based on assumptions they knew to be inadequate demonstrates intentional or reckless misrepresentation. Id. The district court held that the complexity of the accounting issue precluded this inference. Id. Amending the assumptions for pools that had already been sold was only one possible response to the problem; other responses would be to increase the assumed prepayment rate for future pools, which the defendants did beginning in 1996, and to increase prepayment reserves, which Green Tree did throughout the relevant period. Id. at 876. Therefore, the district court held that knowledge of the disparity between the prepayment assumptions and actual experience for the 1994 and 1995 pools would not satisfy the statutory pleading requirements without some additional evidence of wrongdoing. Id. at 877.

The investors sought to supply that additional evidence in three ways: (1) by pointing to the restatement of 1996 financial results as an admission that Green Tree knew those results were misleading when published; (2) by alleging that Green Tree’s accounting practices violated generally accepted accounting practices (GAAP) in various respects; and (3) by juxtaposing Green Tree’s publicized estimate of $125-150 million in charge-offs in November 1997 with its actual adjustments of $390 million in January 1998. The court held that the restatement of 1996 results did not amount to an admission of wrongdoing. Id. at 876 and 877 n. 21. The court further held that alleged GAAP violations had to do with making reasonable prepayment assumptions, which was a sufficiently complex task that defendants’ failure to divine the future accurately could not be equated with fraudulent intent. Id. at 877. Nor would the district court infer scienter from the disparity between Green Tree’s November 1997 estimate of charge-offs and the much greater actual charge-offs taken three months later. “[T]he November 13 announcement was expressly preliminary: it informed the market that the negative results expressed therein were not final, and that a final statement would be published after further review.” Id.

The district court concluded that the complaints did not adequately allege scien-ter and therefore dismissed them with prejudice. Id. at 878.

III.

Rule 10b-5, promulgated by the Securities and Exchange Commission under section 10(b) of the Securities Exchange Act, 15 U.S.C. § 78j(b), makes it unlawful

for any person directly or indirectly, by use of any means or instrumentality or interstate commerce, or of the mails or any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

17 C.F.R. § 240.10b-5 (2001). Although not explicitly mentioned in the text of the rule, scienter is nevertheless an essential element of a Rule 10b-5 claim. Alpern v. UtiliCorp United, Inc., 84 F.3d 1525, 1534 (8th Cir.1996). Scienter means “the intent to deceive, manipulate, or defraud.” See Carlon v. Thaman (In re NationsMart Corp. Sec. Litig.), 130 F.3d 309, 320 (8th Cir.1997) (quoting Ernst & ilmst v. Hochfelder, 425 U.S. 185, 193, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976)). Our Circuit ruled before enactment of the Reform Act that recklessness satisfied the Rule 10b-5 scienter requirement, see Alpern, 84 F.3d at 1534, and the defendants do not contend that the Reform Act changed the substantive nature of the scienter requirement. Our Circuit has adopted a definition of recklessness

limited to those highly unreasonable omissions or misrepresentations that involve not merely simple or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and that present a danger of misleading buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it.

Camp v. Dema, 948 F.2d 455, 461 (8th Cir.1991) (stating requirements for establishing aider and abetter liability under Rule 10b-5); see also Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th Cir.1977).

The question before us is whether the facts pleaded in the complaints adequately plead scienter. At the outset we must determine what pleading standard the investors have to satisfy. Complaints brought under Rule 10b-5 and section 10(b) are governed by special pleading rules unique "