Marsden v. Select Med. Corp.

IN THE UNITED STATES DISTRICT COURT
FOR THE EASTERN DISTRICT OF PENNSYLVANIA

CLIFFORD C. MARSDEN and MING XU,
Individually and on Behalf of
All Others Similarly Situated

SELECT MEDICAL CORP., MARTIN
JACKSON, ROBERT A. ORTENZIO,
ROCCO ORTENZIO, and PATRICIA RICE

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CIVIL ACTION

04-4020

MEMORANDUM AND ORDER

JOYNER, J.

April 6, 2006

Via the motions now pending before this Court, Defendants,

Select Medical Corp., Martin Jackson, Robert A. Ortenzio, Rocco

Ortenzio, and Patricia Rice ( “Defendants ”), move to dismiss

Plaintiffs’ Amended Complaint pursuant to Federal Rule of Civil

Procedure 12(b)(6), and to strike various allegations of the

Amended Complaint pursuant to Federal Rule of Civil Procedure

12(f). For the reasons outlined below, the motion to dismiss

shall be DENIED in part and GRANTED in part, and the motion to

strike shall be DENIED.

Background

Plaintiffs, on behalf of themselves and a class of similarly

situated purchasers of the securities of Defendant Select Medical

Corp. (“Select”), brought this suit to recover for alleged

violations of the Securities Exchange Act of 1934 (the “Exchange

Act”). 1 (Am. Compl. at ¶ 1.) During the relevant period, Select

was a health care provider specializing in the operation of long-

term acute care hospitals ( “LTACs” or “LTCHs”). (Am. Compl. at ¶

2.) Select was a publicly-held company whose common stock was

traded on the New York Stock Exchange. (Id. at ¶ 18.) Defendant

Robert A. Ortenzio (“Robert Ortenzio”) is a founder of Select,

and served as Chief Executive Officer, President, and a member of

the Board of Directors at all relevant times. (Id. at ¶ 12.)

Defendant Rocco Ortenzio is also a founder of Select, and served

as Chairman of the Board of Directors at all relevant times.

(Id. at ¶ 14.) Defendant Patricia Rice (“Rice”) was at all

relevant times the Chief Operating Officer of Select. (Id. at ¶

15.) Defendant Martin F. Jackson (“Jackson ”) served as Chief

Financial Officer of Select at all relevant times. (Id. at ¶

16.) Robert Ortenzio, Rocco Ortenzio, Rice, and Jackson (the

“Individual Defendants ”) were all intimately involved with the

health care industry, Select ’s business, and providing

information regarding that business to stockholders and the

market. (See id. at ¶¶ 12-16.)

LTCHs are designed to treat patients with serious and often

complex medical conditions. (Am. Compl. at ¶ 30.) LTCHs must

1The factual background of Plaintiffs ’ claims is complex and
lengthy. We attempt below to summarize the most pertinent
background facts, focusing on the information Plaintiffs allege
was wrongfully withheld from the market.

have provider agreements with Medicare and must have an average

patient stay length of greater than or equal to twenty-five days.

(Id.) As of December, 2003, Select operated seventy-nine LTCHs

and an additional four non-LTCH-certified specialty hospitals or

outpatient rehabilitation clinics. (Id.)

Medicare reimbursements for treatment rendered at Select’s

hospitals comprised a significant percentage of Select ’s income.

(See id. at ¶ 31.) These reimbursements represented 37.3, 40.3

and 46.0 percent of Select’s net operating revenues in 2001,

2002, and 2003 respectively. (Id.) Medicare reimbursement

constituted approximately sixty-nine percent of all specialty

hospital revenues for 2003. (Id.)

As a recipient of Medicare reimbursements, Select was

subject to the regulatory oversight of federal agencies. (Am.

Compl. at ¶ 34.) This oversight included control of and changes

to the payment system for receiving reimbursements. (See id. at

¶¶ 36-43.) Most acute care hospitals are reimbursed under a

prospective payment system ( “PPS”). (

Id. at ¶ 36.) PPS was

instituted to prevent overstatement of costs under the previous

system by establishing fixed reimbursement rates based on

categories of treatment. (Id. at ¶ 36, 37.) Each category or

diagnostic rate group (“DRG”) is based on the national average

cost of treatment for the particular medical condition. (Id. at

¶ 37.) Reimbursement for general acute care hospitals is limited

to six days of care, regardless of whether the actual stay

exceeds that limit. (Id.) LTCHs, whose patients generally

require more costly care and longer stays, were initially

excluded from the PPS system. (Id. at ¶ 38.) This exclusion

created an economic incentive for acute care hospitals to

transfer patients to LTCHs before completing treatment to avoid

losing money if the patient stayed more than six days. (Id. at ¶

39.) The exclusion of LTCHs from PPS also meant that there were

no DRGs to control costs, leaving the LTCH payment system open to

the fraudulent overstatement that had prompted the switch to PPS

for other hospitals. (Id. at ¶ 38.) This less-restrictive

payment system gave a financial incentive to LTCHs to accept

early transfers from general acute care hospitals seeking to

avoid losses. (Id. at ¶ 40.) The most attractive patients,

therefore, were those that could have been treated in a short-

term facility, because they likely required the fewest resources

and thus yield the greatest profit. (Id. at ¶ 40, 42.)

As a result of this structure, health care providers,

including Select, expanded their LTCH operations. (Am. Compl. at

¶ 41.) Select acquired twenty-six new LTCHs between 2001 and

2003. (Id.) To ensure a supply of profitable patients for the

rapidly growing number of LTCH beds, Select instituted a quota

system for Medicare referrals from host hospitals to the LTCH.2

(Id. at ¶ 42.) Select pressured employees to accept only

Medicare referrals, regardless of the level of care actually

appropriate for the patient, and allegedly fired those who did

not meet the established quotas. (Id.)

In August 2002, to eliminate the financial incentives

created by the exclusion of LTCHs from PPS, the Centers for

Medicare and Medicaid Services (“CMS ”) established a PPS system

designed specifically for LTCHs (“LTCH-PPS”). (Am. Compl. at

¶ 43.) The LTCH-PPS was to be phased in over a five year period.

(Id.)

The LTCH-PPS system, though based on DRGs, offered higher

reimbursement rates than those available for general acute care

hospitals. (Id.)

Select’s business began to decline beginning in 2003. (Am.

Compl. at ¶ 44.) Select experienced a decline in patient

admissions and an increase in competition from other companies.

(Id.) The implementation of LTCH-PPS was expected to cover

admissions-related shortfalls, leading to increased pressure to

admit patients that did not require long-term care. (Id.)

Select’s rehabilitation clinics also experienced declines, and

Select failed to meet financial goals, resulting in some office

closures and staff layoffs. (Id.)

2See infra, p.6 for discussion of host hospitals and their
relationship to LTCHs.

Plaintiffs allege that, in order to conceal these setbacks,

Select launched a campaign to acquire LTCHs using the hospital-

within-a-hospital (“HIH”) model. (Am. Compl. at ¶ 47.) Under

the HIH model, Select leases space within an existing general

acute care hospital that acts as the “host. ” ( Id. at 48.) By

the end of 2003, seventy-five of Select ’s eighty-three specialty

hospitals operated as HIHs. (Id. at ¶ 53.)

This arrangement provides a significant benefit to the

tenant LTCH by eliminating capital costs, and also provides lease

income to the host. (Am. Compl. at ¶ 48.) HIHs, however, are

subject to more stringent criteria for Medicare purposes than

free-standing LTCHs to avoid conflicts of interest based on the

close proximity of the host to the HIH-LTCH. (Id. at ¶ 49, n.8.)

Plaintiffs allege that Select, at the direction of Robert

and Rocco Ortenzio, and possibly Rice, exploited this very

proximity by paying “kickbacks” to the host hospital in exchange

for premature referrals of host patients to the HIH-LTCH. (Am.

Compl. at ¶ 50-52.) These referral practices created two

reimbursable episodes –- one for the host’s initial admission and

discharge to the LTCH, and a second for the LTCH’s admission and

eventual discharge. (Id. at ¶ 58.)

Reciprocal arrangements also existed whereby HIH-LTCHs

referred LTCH patients to the host for tests, rather than using

an outside source. (Am. Compl. at ¶ 51.) After discharge to the

host and completion of the testing or procedures, which often

could have been performed by the LTCH itself, patients are

readmitted to the LTCH. (Id. at ¶ 61.) This pattern –- referred

to by Plaintiffs as “patient churning ” –- multiplies the number

of reimbursable events for each patient involved, allowing both

the host and the HIH-LTCH to collect more from Medicare than if

the patient was treated solely by one or the other. (Id.) The

benefits of these practices were enhanced by additional

manipulation of the Medicare reimbursement system, including

shifting DRG classifications or making additional diagnoses to

create new reimbursable events and creating new accounts for

patients readmitted after testing or procedures at the host.

(Id. at ¶¶ 62, 63.)

These practices were successful in increasing referral and

admission rates. (Am. Compl. at ¶ 52.) During the relevant

period, more than half of Select’s referrals came from host

hospitals, and Select acknowledged that host hospitals were

carefully selected based on referral potential. (Id. at ¶ 54.)

The growth in LTCHs and HIH arrangements and concern about

Medicare abuses associated with the HIH model prompted increased

regulatory scrutiny. (Am. Compl. at ¶ 65.) Among the concerned

were CMS and the Medicare Payment Advisory Commission ( “MedPAC”),

an independent federal body formed to advise Congress on issues

affecting Medicare. (Id. at ¶¶ 66, 67.) In the fall of 2002,

MedPAC initiated a study of transfer and referral practices.

(Id. at ¶ 67.) The Office of the Inspector General of the

Department of Health and Human Services (“OIG”) indicated the

intent to conduct a similar investigation in its Fiscal 2003 Work

Plan in September 2002. (Id. at ¶ 68.)

MedPAC public reported on its ongoing study of Medicare

billing abuses in the HIH model through regular public meetings

held at least four times per year. (Am. Compl. at ¶ 72.) At

such a meeting held April 25, 2003, MedPAC questioned the

relationships between HIH-LTCHs and their hosts, particularly the

significantly larger percentage of referrals originating from

primary referrers in comparison to non-HIH LTCHs, as well as

higher profit margins where the host hospital acted as the

primary referrer. (Id. at ¶ 73, 74.) These concerns were

reiterated in MedPAC’s June 2003 report to Congress. ( Id. at ¶

75.) That report specifically described the reimbursement-

multiplying effect of improper transfers and readmissions. (Id.

at ¶ 76.)

At its March 18, 2004 meeting, MedPAC presented the results

of its study and offered “Draft Recommendations ” to Congress.

(Am. Compl. at ¶ 78.) MedPAC recommended limitations on the

types of patients that may be admitted to LTCHs to keep the focus

on medically complex patients that cannot be treated in less

costly settings. (Id. at ¶ 79.) MedPAC also noted that LTCH-PPS

created incentives to admit patients with the least costly needs

within a DRG. (Id.) MedPAC recommended “strong rules” for HIHs

to prevent the discharge of patients purely for financial gain.

(Id.)

In addition to this publicly available information, Select

had further access to information regarding regulatory

investigation of HIH-LTCH practices. Robert Ortenzio acted as a

panelist at a Healthcare Summit sponsored by the American Bar

Association in November 2003. (Am. Compl. at ¶ 81.) Also on the

panel were CMS Chief Administrator Thomas Scully and CMS

Director, Division of Acute Care, Hospital and Ambulatory Policy

Group, Tzvi Hefter. (Id.) The panel discussed proposed Medicare

regulations, including a limit on the number of host-to-HIH

referrals. (Id.) At the Healthcare Summit, Tzvi Hefter clearly

expressed his concerns about abuses and the rationale for such a

limit. (Id. at ¶ 83.)

MedPAC officials visited several of Select ’s locations in

the Fall of 2003 to discuss MedPAC ’s ongoing investigation. (Am.

Compl. at ¶ 84.) Robert and Rocco Ortenzio met regularly with

MedPAC officials to discuss the study and contribute to MedPAC’s

recommendations. (Id. at ¶ 84.) Robert Ortenzio and Rice met

with other Select officials in Fall of 2003 to discuss Select’s

operations as they related to the OIG’s Work Plan, which included

investigation of HIH abuses. (Id. at ¶ 85.)

Select received additional information and sought to

exercise its political influence through Acute Long Term Hospital

Association (“ALTHA”). (Am. Compl. at ¶ 86.) ALTHA acted as a

lobbyist group for LTHCs, and offered exclusive access to

information and influence, including legislative and regulatory

matters. (Id. at ¶ 87.) Robert Ortenzio and Rice both held

positions on ALTHA’s board. ( Id. at ¶ 86.) Information

regarding the twenty-five percent limit was discussed at Select

Company meetings, staff meetings, among concerned employees, and

through internal emails. (Id. at ¶ 95-97.)

On January 1, 2004, Select hired Thomas Scully (“Scully ”),

former Chief Administrator of CMS, to provide government

relations and regulatory advice. (Am. Compl. at ¶ 99.) Scully

was appointed to Select’s Board of Directors on February 11,

2004. (Id.)

On May 11, 2004, Select issued a press release announcing

regulations proposed by CMS that targeted HIH-LTCHs. (Am. Compl.

at ¶ 187.) Under the proposed rule, HIH-LTCHs would not be

reimbursed for any patients transferred from the host hospital in

excess of twenty-five percent of the LTCH’s total admissions.

(Id.) Select acknowledged that, if adopted, this rule would have

disastrous consequences for its business. (Id.)

News of the proposed regulations precipitated a drop in

Select’s stock prices. (Am. Compl. at ¶ 188.) Select’s stock

dropped by forty percent over May 11 and 12, 2004. (Id.)

Downgrades to Select’s stock followed. ( Id. at ¶ 191.)

Plaintiffs allege that Defendants made materially misleading

statements and omitted material information regarding the CMS

proposal, the means by which revenue was being generated, and the

adequacy of internal accounting controls. (Am. Compl. at ¶ 115-

185.) The statements and omissions at issue are presented and

examined in our discussion below of Defendants ’ arguments for

dismissal.

II. Defendants’ Motion to Dismiss

Standards Governing Rule 12(b)(6) Motions to Dismiss

Generally speaking, in considering motions to dismiss

pursuant to Federal Rule of Civil Procedure 12(b)(6), district

courts must “accept as true the factual allegations in the

complaint and all reasonable inferences that can be drawn

therefrom.” Allah v. Seiverling , 229 F.3d 220, 223 (3d Cir.

2000)(internal quotations omitted); see also Ford v. Schering-

Plough Corp., 145 F.3d 601, 604 (3d Cir. 1998). A motion to

dismiss may only be granted where the allegations fail to state

any claim upon which relief may be granted. See Morse v. Lower

Merion School District, 132 F.3d 902, 906 (3d Cir. 1997). The

inquiry is not whether plaintiffs will ultimately prevail in a

trial on the merits, but whether they should be afforded an

opportunity to offer evidence in support of their claims. In re

Rockefeller Center Properties, Inc., 311 F.3d 198, 215 (3d Cir.

2002). Dismissal is warranted only “if it is certain that no

relief can be granted under any set of facts which could be

proved.” Klein v. General Nutrition Companies, Inc., 186 F.3d

338, 342 (3d Cir. 1999)(internal quotations omitted). It should

be noted that courts are not required to credit bald assertions

or legal conclusions improperly alleged in the complaint and

legal conclusions draped in the guise of factual allegations may

not benefit from the presumption of truthfulness. Rockefeller,

311 F.3d at 216. A court may, however, look beyond the complaint

to extrinsic documents when the plaintiff’s claims are based on

those documents. GSC Partners, CDO Fund v. Washington, 368 F.3d

228, 236 (3d Cir. 2004); In re Burlington Coat Factory Sec.

Litg., 114 F.3d 1410, 1426. See also, Angstadt v. Midd-West

School District, 377 F.3d 338, 342 (3d Cir. 2004).

Legal Standard for Securities Fraud Claims

Section 10(b) of the Exchange Act creates a private right of

action for individuals injured by false or misleading statements

or omissions of material fact. Burlington, 114 F.3d at 1417

(internal citations omitted). To state a claim under Section

10(b) and the attendant enforcement provisions of Rule 10b-5, a

plaintiff must allege that the defendants (1) made a misstatement

or omission of material fact, (2) with scienter, (3) in

connection with the purchase or sale of securities, (4) upon

which the plaintiff reasonably relied, and (5) that such reliance

by the plaintiff was the proximate cause of the injury. GSC

Partners, 368 F.3d at 236 (internal citations omitted). To state

a claim under Section 20(a) of the Exchange Act, a plaintiff must

be able to maintain a claim for an underlying violation of the

Exchange Act by a controlling person or entity, and that the

controlling persons were culpable participants in the violation

perpetrated by the entity they controlled. Shapiro v. UJB Fin.

Corp., 964 F.2d 272, 280 (3d Cir. 1992), rehearing en banc

denied, 1992 U.S. App. LEXIS 15567 (3d Cir. 1992).

The Federal Rules of Civil Procedure require that securities

fraud plaintiffs must plead the circumstances surrounding the

alleged fraud with “particularity.” Fed. R. Civ. P. 9(b).

Additionally, claims under the Exchange Act are subject to the

heightened pleading requirements established by the Private

Securities Litigation Reform Act (the “PSLRA ”), 15 U.S.C.

§ 78u-4. The PSLRA represents an attempt by Congress to stem the

perceived abuse of securities fraud complaints by requiring

greater factual particularity when alleging securities fraud.

See Cal. Pub. Employees’ Ret. Sys. v. Chubb Corp. , 394 F.3d 126,

145 (3d Cir. 2004). Under the PSLRA, every securities fraud

claim must

specify each statement alleged to have been misleading,
the reason or reasons why the statement is misleading,
and, if an allegation regarding the statement or
omission is made on information and belief, the

complaint shall state with particularity all facts on
which the belief is formed.

15 U.S.C. § 78u-4(b)(1). Particular facts must also be plead

that give rise to a strong inference of scienter. 15 U.S.C.

§ 78u-4(b)(2).

Discussion

Duty

Defendants argue that Plaintiff ’s claims based on the CMS

proposal must be dismissed because Defendants have no legal duty

to predict the actions of a regulatory agency. (Defs. ’ Mem. in

Support of Mot. of Defs. ’ to Dismiss the Am. Compl. (“Defs.’

Br.”) at 43-50.) Defendants point to cases in which courts have

dismissed shareholder claims that were based on the idea that

defendant could and should have predicted the information or

events that were allegedly misstated or omitted. (Id. at 43-46

(citing In re Craftmatic Sec. Litg., 890 F.2d 628 (3d Cir. 1998);

In re Viropharma Sec. Litg., Civ. A. No. 02-1627, 2003 U.S. Dist.

LEXIS 5623 (E.D. Pa. Apr. 7, 2003); Helwig v. Vencor Inc., 251

F.3d 540 (6th Cir. 2001); Whirlpool Fin. Corp. v. GN Holdings,

Inc., 67 F.3d 605 (7th Cir. 1995); Wieglos v. Commonwealth

Edison, 892 F.2d 509 (7th Cir. 1989).) Courts generally agree

that predictions are immaterial where the alleged omitted

information would have required speculation and would have

minimal value in educating stockholders. See, e.g., Craftmatic,

890 F.3d at 640. Here, however, Plaintiffs ’ allege that

Defendants had actual knowledge of the regulations that would be

proposed. See infra, III.C.3. If, indeed, Defendants possessed

such knowledge, their disclosure of that information would not

require undue speculation. Plaintiffs confirm that they do not

base their claim on the failure of Defendants to predict, but

rather on the failure of Defendants to relate what they actually

knew and to factor that knowledge into the projections and

statements provided to stockholders and the market. (Pls. ’ Mem.

of Law in Opp. to Defs.’ Mot. to Dismiss the Am. Compl. (“Pls.’

Br.”)at 23-28.) Defendants have not persuaded us otherwise.

Thus, we need not determine whether Defendants indeed had a duty

to predict. Rather, we reject Defendants characterization of the

case and decline to dismiss based on any absence of duty.

Materiality

Claims pursuant to 10b-5 must identify a “material

representation or omission of fact. ” (Defs. ’ Br. at 35 (citing

Dura Pharmaceuticals v. Broudo, 125 S. Ct. 1627, 1631 (2005).)

Defendants argue that the statements identified by Plaintiffs

fail to meet this requirement.

Statements of past performance

Defendants argue that Plaintiff ’s claims, to the extent that

they are based on statements regarding Defendants’ past

performance, must fail because “as a matter of law, these

statements about past performance could not have been misleading

even if it had been a known fact that the CMS proposal of a

future regulatory change was ‘imminent and inevitable.’
” (Defs.’

Br. at 52, 56, 58, 59). Defendants fail to sufficiently

establish that the statements regarding past performance

identified by Plaintiffs are not, as a matter of law, misleading.

Defendants make no distinctions among the numerous types of

statements regarding past performance. Defendants instead ask us

to create and apply a bright-line rule that statements regarding

past performance can never be misleading by virtue of knowledge

of future action. Nowhere, however, to Defendants present legal

authority in support of this proposed rule. To the contrary,

courts seem to distinguish between accurate “reports of previous

successes” and those statements made with knowledge of facts

rendering that statement inaccurate or misleading at the time it

was made. See In re Cell Pathways Sec. Litg., Civ. A. No. 99-

752, 2000 U.S. Dist. LEXIS 8584, *31 n.7 (E.D. Pa. June 21, 2000)

(distinguishing In re Advanta Sec. Litg., 180 F.3d 525, 538 (3d

Cir. 1999) on basis that statements were made with actual

knowledge of flaws in projects that were part of basis of

statement); see also Shapiro, 964 F.2d at 281-82 (statements of

historical fact may be actionable where such statements do not

include all information necessary to make statements not

misleading). Thus, Plaintiffs ’ claims based on statements of

past performance will not be dismissed based on Defendants ’

assertion that these claims are not, as a matter of law,

misleading.

Statements of Fact or Law

Defendants claim that certain statements identified by

Plaintiffs cannot be actionable because they are merely

statements of fact or law. (Defs.’ Br. at 58.) Specifically,

Defendants point to statements made by Select in its 2003 10-k

filing regarding its awareness of anti-kickback provisions, the

status of pending litigation, and Select ’s regulatory monitoring

and compliance efforts.

(Id.) Defendants offer no legal

authority for this conclusion, and we find little to distinguish

these statements of fact from the statements of historical fact

discussed above that are actionable where they fail to include

the information necessary to render them not misleading. See

supra, III.C.2.a.

Forward-looking statements

July 28, 2003 Press Release

Defendants assert that the statements identified by

Plaintiff from the July 28, 2003 press release are not

actionable. (Defs.’ Br. at 53.) Plaintiffs ’ specify that the

earnings outlooks for the third and fourth quarters of 2003

presented in this press release were misleading in that they were

increased based, in part, on the expectation of gains resulting

from implementation of the LTCH-PPS in Select’s hospitals. (Am.

Compl. at ¶ 116.)

Defendants argue that because the proposed rule was not

announced until May 11, 2004, projections for the third and

fourth quarters of 2003 made in the July 28, 2003 press release

could not be misleading on the basis of the proposed rule. We

note first that these projections may be misleading on the basis

of the alleged Medicare abuses. Furthermore, that the rule was

not announced by CMS until May of 2004 does not change the fact

that the omission of Defendants ’ alleged knowledge thereof could

be misleading. Defendants argument would entirely undermine the

Exchange Act’s fraud provisions by exempting defendants from

liability for any projections made for periods that concluded

before the revelation of the omitted information.

Next, Defendants argue that this statement, because it

identifies LTCH-PPS as a reason for an upgraded outlook, concerns

entirely different subject matter than the CMS proposal. (Defs.’

Br. at 53.) Defendants, however, cannot defend alleged material

omissions by noting that their statements omitted the same

information on which Plaintiffs ’ claims are based.

Last, Defendants assert that this statement is protected by

the “bespeaks caution” doctrine and the statutory safe harbor.

Under the “bespeaks caution” doctrine, courts have dismissed

securities fraud claims where cautionary language rendered the

alleged misstatement or omission immaterial as a matter of law.

See In re Donald J. Trump Casino Sec. Litg., 7 F.3d 357, 371 (3d

Cir. 1993). Thus, where projections, forecasts, or opinions “are

accompanied by meaningful cautionary statements, the forward-

looking statements will not form the basis for a securities fraud

claim if those statements did not affect the ‘total mix ’ of

information the document provided investors.” Id. Although each

communication must be assessed on a case-by-case basis,

boilerplate warnings merely are generally inadequate. Id.

Rather, to be meaningful, cautionary language must be

“substantive and tailored ” to the specific forward-looking

statements they accompany. Id. at 371-372. In examining

cautionary language, the question is whether those statements

negate the misleading effect of the challenged statements. Id.

at 373 (interpreting and applying Virginia Bankshares, Inc. v.

Sandberg, 111 S. Ct. 2749 (1991)).

The PSLRA safe harbor protects certain forward-looking

statements from Rule 10b-5 liability. See 15 U.S.C. § 78u-5.

The safe harbor applies if the statement or omission is

immaterial or accompanied by sufficient cautionary language or if

the plaintiff cannot prove that the challenged forward-looking

statement was made with “actual knowledge . . . that the

statement was false or misleading. ” Id. at § 78u-5(c)(1).

As this Court has previously stated, the protections of the

“bespeaks caution ” doctrine and the PSLRA ’s safe harbor only

protect statements that are truly forward-looking. See Voit v.

Wonderware Corp., 977 F. Supp. 363, 369 (E.D. Pa. 1999). These

protections do not apply to statements challenged on the basis

that they omitted ‘present facts ’ –- facts known at the time the

statement was made. Id.; Cell Pathways, 2000 U.S. Dist. LEXIS at

*39-40. Because Plaintiffs challenge these statements on the

basis that Defendants withheld present information regarding an

imminent CMS proposal and alleged Medicare abuses that were the

real source of profits for LTCHs, neither the “bespeaks caution”

doctrine nor the statutory safe harbor applies.

ii.

July 29, 2003 Conference Call

Defendants argue that the statement made by Robert Ortenzio

during a July 29, 2003 conference call is not actionable because

it is mere puffery. (Defs.’ Br. at 55.) Courts have found that

some statements of optimism, expectation, or opinion are too

vague and general to be actionable under Rule 10b-5.

Specifically,

[m]aterial representations must be contrasted with
statements of subjective analysis or extrapolations,
such as opinions, motives and intentions, or general
statements of optimism, which “‘constitute no more than
‘puffery’ and are understood by reasonable investors as
such.'” [Advanta], 180 F.3d at 538 (quoting
[Burlington], 114 F.3d 1410, 1428 n.14 []). In other
words, some statements would not alter the total mix of
relevant information available to a reasonable
investor. We have recognized that “although questions

of materiality have traditionally been viewed as
particularly appropriate for the trier of fact,
complaints alleging securities fraud often contain
claims of omissions or misstatements that are obviously
so unimportant that courts can rule them immaterial as
a matter of law at the pleading stage.” [Burlington ],
114 F.3d at 1426.

EP Medsystems, Inc. v. Echocath, Inc., 235 F.3d 865, 872 (3d Cir.

2000).

Robert Ortenzio stated that he was “pleased to report that

[Select] exceeded earnings expectations . . .” and went on to

relate some of the earnings numbers. (Am. Compl. at ¶ 118.) He

also discussed why Select was optimistic that the LTCH-PPS system

would, though “revenue neutral to the industry, ” benefit Select,

citing specific characteristics of Select’s business model. ( Id.

at ¶¶ 119, 120.) Some of Robert Ortenzio’s statement expresses

satisfaction with financial results, but his discussion

highlights aspects of Select’s business that will allow it to

profit from LTCH-PPS where other businesses would not. This type

of specific analysis can hardly be said to be so vague that it is

obviously immaterial as a matter of law.

Defendants similarly argue that the statement of Jackson

during the same conference call was too vague to be anything more

than puffery. In response to an analyst’s question about

Select’s long-term LTCH business, Jackson stated that the profit

margins for the LTCHs would “probably begin to approach what the

margins are in the other acute segments of the business,” and

expressed that it was “achievable ” to make LTCHs as profitable as

general acute care hospitals. (Am. Compl. at ¶ 121.) While

Jackson’s statement is more general than Robert Ortenzio ’s, it

nonetheless is more than a mere statement of optimism. Jackson

draws a specific comparison to other businesses in the industry,

and essentially sets a benchmark for expected results. This is

not so vague that any investor would realize it was immaterial.

Defendants also argue that, even if something more than

puffery, Jackson ’s statement was protected by the “bespeaks

caution” doctrine and the statutory safe harbor. (Defs.’ Br. at

55-56.) As discussed above, because Plaintiffs challenge the

identified statements on the basis that Defendants omitted

present material facts, these protections do not apply. See

supra, III.C.2.c.i. Even if Jackson ’s statement could be said to

be truly forward-looking, his statement “we ’ve not updated the

data” hardly provides meaningful cautionary language as required

for protection under both “bespeaks caution ” and the safe harbor.

Id.

iii. October 29, 2003 Press Release

Defendants assert that because Select achieved the projected

increase in revenue in the Fourth Quarter of 2003, the statements

projecting that increase cannot be misleading. That defendants

achieved the projected results (allegedly through use of abusive

referral and billing practices also omitted from these

statements), does not negate the misleading effect of the

omission. We find no authority that renders projections per se

inactionable once they have been realized. To the contrary,

courts recognize that the key question is not the ultimate truth

of the statements, but whether they mislead by virtue of what

they omit. See, e.g., Cell Pathways, 2000 U.S. Dist. LEXIS at 31

n.7 (noting that “the disclosure required by the securities laws

is not measured by literal truth, but instead by the ability of

the material to accurately inform rather than mislead prospective

buyers”) (internal citations omitted).

Defendants further argue that the “bespeaks caution ”

doctrine and/or the statutory safe harbor protect the statements

of increased financial objectives. (Defs.’ Br. at 54-55.) As

above, however, the challenge to these statements is one of

omission of present facts, making the protections of the

“bespeaks caution ” and PSLRA safe harbor unavailable. See supra,

III.C.2.c.i.

iv.

2003 10-k Filing

Defendants argue that Select’s statement that its “goal is

to open approximately eight to ten new long-term acute care

hospitals each year using primarily [its] ‘hospital within a

hospital’ model ” is not actionable because it is protected by the

“bespeaks caution ” doctrine and safe harbor provisions. (Defs.’

Br. at 57.) Again, the type of challenge here –- that Defendants

omitted facts known at the time the statement was made — makes

those protections unavailable. See supra, III.C.2.c.i.

Additionally, Select asserts that because it continues to

open such hospitals, the statement is not misleading. As

discussed above, the realization of projections or goals does not

negate the misleading nature of statements. Thus, Defendants’

argument is unavailing.

April 27, 2004 press release

Plaintiffs identify the upward revision of financial

objectives for the remainder of 2004 made in the press release of

April 27, 2004 as misleading. (Am. Compl. at ¶ 170-171.)

Defendants argue that this change in Select ’s financial outlook

is protected by the “bespeaks caution ” doctrine and the statutory

safe harbor. (Defs.’ Br. at 59.) As discussed above, however,

Plaintiffs base their claims on omission of facts known to

Defendants at the time the statements were made, making these

protections inapplicable. See supra, III.C.2.c.i.

Defendants further claim that because these statements were

made after any lead plaintiff is alleged to have purchased stock,

they cannot form the basis of liability. (Defs.’ Br. at 60.)

This limitation, however, applies only to the extent that lead

plaintiffs fail to set forth any claims based on statements or

omissions made prior to the last date on which they purchased

stock. Because we have found that Plaintiffs have identified

actionable statements made earlier in the Class Period, we will

not dismiss their claims based on post-Class Period statements.3

vi.

April 28, 2004 Conference Call

Defendants argue that Robert Ortenzio’s statements during an

April 28, 2004 conference call was merely an expression of

optimism and therefore merely inactionable puffery. (Defs. ’ Br.

at 59-60.) Some statements of opinion, expectation, or optimism

are obviously so unimportant that courts can rule them immaterial

as a matter of law at the pleading stage. See supra,

III.c.2.c.ii. Robert Ortenzio recounted some of the results for

the preceding quarter, and noted that Select was “very pleased

with the results of [the] first quarter and the prospects for the

rest of 2004.” (Am. Compl. at ¶ 172.) He also discussed the

importance of the LTCHs, and noted that the specialty hospitals

had exceeded performance expectations. (Id. at ¶ 173.) In

response to an analyst’s questions regarding Select ’s handling of

3Defendants rely on Klein v. General Nutrition Companies,
Inc., 186 F.3d 338, 345 (3d Cir. 1999) for the proposition that
statements made after the last date when a lead plaintiff
purchased stock are per se inactionable. (Defs.’ Br. at 60.)
Their reliance, however, is seriously misplaced. Klein
specifically states that “ [b]ecause appellants have failed to
allege valid claims based on statements made before they
purchased their GNC stock, the post-purchase statements cannot be
a basis for liability.” Klein, 186 F.3d at 345 (emphasis added).
Other courts have declined to extend this rule to situations
where plaintiffs successfully allege claims based on statements
made before the last stock purchase. See, e.g., In re Am. Bus.
Fin. Svcs. Sec. Litg., Civ. A. No. 04-265, 2005 U.S. Dist. LEXIS
10853, *34-35 (E.D. Pa. June 2, 2005).

readmissions of LTCH patients that are transferred to a general

acute care hospital for procedures, Robert Ortenzio specifically

denied that Select had “those types of patients ” moving through

their facilities, and stated that readmissions should not create

additional reimbursable episodes or change the DRG. (Id. at

174.) Again, although Robert Ortenzio does express pleasure with

the previous quarter’s results, he also makes specific statements

as to practices carried out at Select’s medical facilities,

taking his comments far beyond the type of “vague optimism” that

is obviously immaterial.

Defendants further argue that these statements cannot form a

basis for any liability because they were made after any lead

plaintiff allegedly purchased Select stock. As discussed above,

because Plaintiffs have successfully identified actionable

statements made before the last stock purchase, they may go

forward with their claims based on post-Class Period statements

and omissions. See supra, III.C.2.c.v.

Particularized Facts as to Knowledge

Defendants assert that Plaintiffs fail to allege any

particularized facts supporting that Defendants knew or should

have known of the CMS Proposal. (Defs. ’ Br. at 60-74.)

In order

to satisfy the PSLRA’s particularity requirement, Plaintiffs must

allege facts “sufficient to support a reasonable belief as to the

misleading nature of the statement or omission. Chubb, 394 F.3d

at 146 (quoting Novak v. Kasaks, 216 F.3d 300, 314 (2d Cir.

2000), cert. denied, 531 U.S. 1012 (2000)). Defendants address

three categories of information upon which Plaintiffs rely:

publicly available information, private activities, and accounts

of internal meetings and emails.4 (Id.) We disagree with this

piecemeal approach, and find no authority supporting Defendants

implication that each category of information must form a

separate set of particularized factual allegations.

Considering all of the facts alleged and inferences drawn,

we find that Plaintiffs meet their burden under the PSLRA. In

support of their claim that Defendants knew or should have known

of the CMS proposal, Plaintiffs offer factual allegations that

Defendants had access to and were provided with information

concerning both the general and specific nature of the

forthcoming proposal. Information of a more general nature was

provided by MedPAC’s publications, studies, and meetings and

OIG’s work plans and studies, meetings with MedPAC and OIG

personnel, and ALTHA. Plaintiffs specifically allege that these

sources provided Defendants with information that a significant

change in LTCH reimbursements was imminent. (Am. Compl. at ¶ 65-

4Defendants also suggest in passing that prior knowledge of
CMS’s proposed rule is an impossibility because government
regulations prohibit the disclosure of non-public information.
(Defs.’ Br. at 60, n.23.) The compliance of government employees
with government regulations is not the question before us, and we
find Defendants’ reliance thereon on such compliance unpersuasive
and irrelevant.

98.) More specific information was provided at the Healthcare

Summit, where CMS officials reportedly discussed some details of

the proposal and the rationale therefor.5 (Id. at ¶ 81.) The

addition of Scully to Select’s Board of Directors may also have

provided more specific information, given his previous employment

as head of CMS. (Id. at ¶ 99-104.) Regardless of whether these

allegations can, taken separately, support Plaintiffs claims,

they are described with sufficient particularity.

In addition to the allegations as to how Defendants obtained

or could have obtained the information, Plaintiffs make specific

allegations that Defendants actually knew of and discussed the

twenty-five percent rule before its announcement. Defendants

attack the accounts of internal emails, meetings, and discussions

on the basis that the confidential witnesses do not meet the

standard set out in Chubb.

In Chubb, the court examined the sufficiency of a complaint

that relied upon a single internal memorandum and a number of

confidential witnesses to allege facts supporting their

5Defendants classify the Healthcare Summit as publicly
available information such that the market should have responded.
(Defs.’ Br. at 61.) We are not persuaded, however, that
information discussed at the Healthcare Summit can be considered
publicly available in the same sense as published agency reports.
Although the agenda was publicly available, it does not appear
that the contents of the presentations and discussions themselves
were available to the public. In the absence of dissemination of
the contents of the discussions themselves to the public,
Defendants’ reliance on the lack of market reaction is misplaced.

securities fraud claims. Chubb, 394 F.3d at 147. In analyzing

the lone piece of documentary evidence, the Third Circuit found

that, where relying on “internal reports,” a plaintiff must

“specify the internal reports, who prepared them and when, how

firm the numbers were or which company officers reviewed them.”

Id. at 147 (quoting In re Scholastic Corp. Sec. Litg., 252 F.3d

63, 72-73 (2d Cir. 2001), cert. denied sub nom., Scholastic Corp.

v. Truncellito, 534 U.S. 1071 (2001)).

With regard to the confidential witnesses, the court adopted

and applied the analysis used by the Second Circuit to determine

whether the sources had been described with sufficient

particularity. Chubb, 394 F.3d at 146-47 (adopting standard set

out in Novak, supra). Under Novak, confidential sources need not

be named where either (1) “plaintiffs rely on confidential

personal sources but also on other facts ” that provide an

“adequate basis for believing the defendants ’ statements were

false” or (2) sources are described “with sufficient

particularity to support the probability that a person in the

position occupied by the source would possess the information

alleged.” Id. at 146 (quoting Novak, 216 F.3d at 314). The

court found that because the lone document was insufficient, the

confidential sources took on a “heightened importance” and were

thus subject to the closer scrutiny required by Novak because the

allegations rested solely on confidential sources. See id. at

146-48.

The documents relied on here are distinguishable from the

documents in Chubb and Scholastic. The documents found to be

inadequately described in Chubb and Scholastic were internal

reports detailing the defendants ’ own company-generated

statistics. See Chubb, 394 F.3d at 147-48. The documents here

are internal emails providing information to employees about

upcoming regulatory changes. We see no reason that such

documents would require the type of review or mathematical

analysis that courts have found necessary for company-generated

statistical reporting. Furthermore, Plaintiffs allege that the

key document –- the email that actually described efforts as to

improved implementation of the twenty-five percent rule — was

distributed by top executives of Select. (Am. Compl. at ¶ 97.)

This is more detail than provided by the Chubb plaintiffs’

statement that “a memo went out” without reference to where it

came from. See Chubb, 394 F.3d at 147. Thus, we find that the

documents are, given their disparity from the type of documents

relied upon in the cases offered by Defendants, described with

sufficient particularity and can support an inference that the

statements and omissions were materially false or misleading.

Defendants suggest that the confidential witnesses proffered

as recipients of the email must undergo further scrutiny.

(Defs.’ Br. at 66-67.) We find no authority mandating this

cumulative analysis, and note the conspicuous absence of such an

inquiry in Chubb. Thus, we conclude that Plaintiffs have

supplied sufficiently particularized facts, as required under the

PSLRA, in support of their contention that Defendants knew or

should have known of the CMS proposal.

Loss Causation for Improper Revenue and Inadequate

Control Claims

Defendants argue that Plaintiffs, in setting forth their

claims for securities fraud based on improper revenue and

inadequate controls, fail to adequately plead loss causation.

(Defs.’ Br. at 74.) To maintain a securities fraud action,

Plaintiffs must allege that the alleged misstatements or

omissions caused Plaintiffs ’ loss. Dura, 125 S. Ct. at 1634.

Mere allegations of an inflated purchase price are insufficient

to show loss causation. Id. at 1631. Under the Court’s decision

in Dura, plaintiffs proceeding, as here, under a fraud-on-the-

market theory, must allege not only that they paid artificially

inflated prices, but also that the value of the shares fell

significantly after the truth became known. Id.

Here, Plaintiffs allege both that Defendants artificially

boosted stock prices by omitting or misstating material

information and that the revelation of the “truth” –- that

Select’s outlook was far from rosy because many of its most

profitable practices would be forbidden –- caused a dramatic drop

in stock prices. (Am. Compl. at ¶¶ 73-78.) Defendants argue

that Plaintiffs do not sufficiently connect the allegations of

improper revenue and inadequate controls with the resulting drop

in stock prices. Dura, Defendants argue, held that merely

alleging that a particular act or omission “touches upon ”

a later

loss is insufficient.

(Defs.’ Reply at 26.) With regards to

this matter, the Court stated

[g]iven the tangle of factors affecting price, the most
logic alone permits us to say is that the higher
purchase price will sometimes play a role in bringing
about a future loss. It may prove to be a necessary
condition of any such loss, and in that sense one might
say that the inflated purchase price suggests that the
misrepresentation . . . “touches upon ” a later economic
loss. But, even if that is so, it is insufficient. To
“touch upon” a loss is not to
cause a loss, and it is
the latter that the law requires.

Dura, 125 S. Ct. at 1632 (emphasis in original). Defendants

suggest that Plaintiffs have not articulated a sufficient

connection between the alleged inadequate controls and insider

trading and either the losses allegedly suffered or the discovery

of the truth concerning the CMS proposal. That other factors may

contribute to a price drop should not, however, preclude

plaintiffs from pursuing claims based on those other factors.

Rather, allegations that the other factors contributing to the

loss are themselves actionable seem to be the missing link in

cases addressing loss causation. Thus, we find that Plaintiffs

claims of inadequate controls and improper revenue should not be

dismissed on the basis of failure to plead loss causation.

Improper Revenue

Defendants argue that Plaintiffs fail to allege

particularized facts to support a claim that Defendants

improperly generated revenues through kickbacks, premature

patient transfers, and patient churning. (Defs. ’ Br. at 77-82.)

Defendants’ attack hinges on their contention that the

confidential witnesses relied upon by Plaintiffs fail to meet the

Chubb standard discussed above. See supra, III.C.3.

Plaintiffs do not challenge the appropriateness of the Chubb

standard as applied to their confidential witnesses, apparently

acknowledging that their claims rely heavily on those

confidential sources.6 (Pls.’ Br. at 46-50.) Rather, Plaintiffs

assert that the confidential sources are described with

sufficient particularity to support that the individuals cited

plausibly had access to the facts alleged. (Id.) In Chubb, the

court focused on the absence of information regarding when

confidential sources were employed and whether someone in that

position might reasonably have access to the information

6We note that Plaintiffs also rely on some documentary
evidence as discussed above, making the heightened scrutiny of
Chubb less appropriate for confidential witnesses. See supra,
III.C.3. Given Plaintiffs’ approach in responding, and the large
number of confidential witnesses relied upon in the complaint, we
nonetheless consider Defendants’ Chubb arguments.

attributed to the unnamed individual. See Chubb, 394 F.3d at

148-56.

Defendants’ attack focuses on the second portion of the

Chubb analysis –- whether the confidential source had access to

the information. Defendants present two arguments that

Plaintiffs’ confidential witnesses lacked access to the

information alleged.

First, Defendants argue that various confidential witnesses

lacked personal knowledge of any alleged wrongdoing, and can, at

most, repeat “hearsay” in support of Plaintiffs’ claims.

Defendants, however, present no legal authority for the

categorical exclusion of second-hand knowledge. Although the

Chubb court admonished the plaintiffs in that case for failing to

describe whether alleged knowledge was first- or second-hand, the

court did not establish that all testimony of the latter sort was

inherently insufficient. Chubb, 394 at 150. Rather, the type of

“rumors and speculation” deemed categorically insufficient under

Chubb consisted of statements “attributed to no source. . . .”

Id. at 155 (emphasis added). Because the confidential witness

information at issue here is attributed to specific sources and

does not leave to speculation whether the information was first-

or second-hand, it cannot be categorically rejected as

insufficiently plead.

Defendants also argue that Plaintiffs fail to explain how

the confidential witnesses, some of whom were employed at

individual hospitals, had access to information on a “national

scale.” Defendants rely heavily on the Chubb court’s rejection

of the plaintiffs’ attempt to “attribute specific nationwide

information and statistics . . . to former employees who worked

in local branch offices. ” Chubb, 394 F.3d at 155. Unlike Chubb,

however, where nearly all of the confidential sources were former

employees of local branch offices, Plaintiffs here rely on

confidential witnesses who worked at corporate headquarters or on

a regional level, in addition to those who worked in individual

hospitals. Also in contrast to Chubb, the information at issue

here centers on policies and practices, rather than statistics.

See id. at 150-151.

While we agree with the observation in Chubb that the

connection between local employees and national statistics

regarding a department separate from that in which those

employees worked is tenuous, the allegations here are

significantly less speculative. See id. at 148. For example,

while regional billing specialists might not have national

statistics regarding customer retention, it is plausible that

they were privy –- and likely subject –- to billing policies, and

aware of billing trends. (See, e.g., Am. Compl. at ¶¶ 60.)

Another example of the disparity between the witnesses in Chubb

and those proffered by plaintiffs is in the corroborative nature

of the statements by witnesses at different locations. CW1, a

former Regional Director for Select ’s Middle Atlantic Region,

reported that Select instituted quotas for Medicare referrals

from host hospitals, and pressured employees to only accept the

most profitable referrals. (Id. at ¶ 42.) CW3, a Patient

Services Specialist who worked in Arizona reported similar

bullying to increase the admissions statistics by accepting

patients that did not really require long-term care. (Id. at ¶

44.) These corroborating statements seem to be precisely the

type of additional link that the Chubb court sought.

We will not examine each confidential source in detail. As

demonstrated above, Defendants ’ argument ignores significant

distinctions between the Chubb scenario and the information now

before us. We are not persuaded by Defendants ’ conclusory

arguments that the confidential witnesses fail the Chubb test,

and will not dismiss Plaintiffs’ improper revenue claim on that

basis.

Inadequate Controls

Defendants argue that Plaintiffs have not set forth a viable

claim based on the alleged inadequacy of Select ’s internal

controls. Defendants correctly point out that “it is not a

violation of the securities laws to simply fail to . . . provide

sufficient internal controls. ” Shapiro, 964 F.2d at 283.

Plaintiffs do not directly respond to this attack on the

viability of their claims for liability based on inadequate

controls, but focus instead on the value of allegations of

inadequate controls in establishing scienter. (Pls. ’ Br. at 54-

58.) Plaintiffs cannot successfully establish an independent

basis for liability based on Defendants failure to provide

adequate internal controls. Thus, to the extent that Plaintiffs

do attempt to set forth such a claim, it must be dismissed. This

does not, however, affect Plaintiffs ’ ability to pursue their

claim that Defendants made false or misleading statements

regarding the adequacy of their internal controls. See id.

(noting that statements regarding internal controls may be

actionable).

Although it is not entirely clear from their motion,

Defendants appear to attack all “allegations of improper

controls, ” which could arguably include claims based on

misleading statements or omissions with regard to the same.

(Defs.’ Br. at 82-83.) Defendants argue that these allegations

are merely based on the previously discussed claims of kickbacks.

(Id.) Defendants assert that Plaintiffs fail to allege facts

regarding what the controls were and why they were deficient, and

instead rely on the assertion that kickbacks occurred as a result

of insufficient controls. (Id.)

Plaintiffs’ allegations based on inadequate internal

controls are indeed conclusory.7 Even if we considered all the

7Plaintiffs’ allegations regarding internal controls and
GAAP read as follows:

Select did not have effective internal controls in
place needed for accurate financial reporting. Because
the Company lacked such controls, defendants were able
to execute their scheme to defraud Medicare, as
discussed above, by inducing the host hospitals to
refer a significant number of patients in exchange for
kickbacks. As a result of the substantial referrals,
Select overstated revenue and earnings throughout the
Class Period. Accordingly, Select ’s lack of adequate
internal controls rendered Select’s Class Period
financial reporting inherently unreliable and precluded
the Company from preparing financial statements that
complied with GAAP. Nonetheless, throughout the Class
Period, the Company regularly issued quarterly and
financial statements without ever disclosing the
existence of the significant and material deficiencies
in its internal accounting controls and falsely
asserted that its financial statements complied with
GAAP. Moreover, as discussed in ¶¶ 109-111 [describing
alleged cash-skimming scheme through NovaCare billing
system], Select’s lack of controls at the Company’s
NovaCare facilities resulted in egregious errors in the
accounting records because cash receipts were not
properly posted to patient accounts, prior to and
during the Class Period. (Pls. ’ Compl. at ¶ 131.)

[T]he Company violated Section 13(b)(2)(B) of the
Exchange Act by misrepresenting that select maintained
adequate internal controls, when, in fact, Select’s
internal controls were severely deficient, allowing
defendants to engage a [sic] scheme whereby they paid
the host illegal kickbacks in exchange for patient
referrals, resulting in overstatement of Select ’s
revenues and earnings. (Pls.’ Compl. ¶¶ 132(m),
150(m), 169(m).)

For the reasons stated in ¶ 131, defendants
violated Section 13(b)(2) of the Exchange Act by
failing to maintain adequate internal controls and
procedures, which allowed them to engage in the

alleged wrongdoing, rather than just the kickbacks, to be a

result of inadequate controls, Plaintiffs still merely recite the

alleged results of deficient controls. We agree that these

facts, even though plead with sufficient particularity as

discussed above, are not sufficient to support a claim based on

misstatements as to the adequacy of internal controls.

Plaintiffs fail to connect the litany of alleged wrongdoings

to any control or type of control that, if properly established,

would have prevented the same. Plaintiffs do not allege that the

“necessary information [regarding internal controls] lies within

defendants’ control . . . ” such that their failure to identify

any deficient controls may be excused. Cf. Bogart v. Nat’l Comm.

Banks, Inc., Civ. A. No. 90-5032, 1992 U.S. Dist. LEXIS 14958,

*25-26 (D.N.J. Apr. 28, 1992) (rejecting defendants ’ argument

that, to be plead with sufficient particularity, plaintiff must

identify specific internal controls where plaintiff specifically

alleged that necessary information was within defendants’

exclusive control) (quoting Craftmatic, 890 F.2d at 645-46).

The only internal control deficiency Plaintiffs attempt to

describe with any particularity is the alleged NovaCare billing

scheme. See supra, n.7. Plaintiffs do not attempt to create any

connection between this alleged cash-skimming scheme and the

fraudulent Medicare billing and referral schemes . . . ”
(Id. at ¶ 183.)

kickbacks upon which the internal control allegations rely.

Furthermore, courts have rejected attempts to rely on allegations

that corporate defendants “must have known” when they signed a

disclosure that internal controls and procedures were inadequate.

See, e.g., In re Interpool, Inc. Sec. Litg., Civ. A. No. 04-321,

2005 U.S. Dist. LEXIS 18112, *47-48 (D.N.J. Aug. 17, 2005)

(internal citations omitted). Thus, in the absence of

particularized facts, Plaintiffs have not sufficiently stated a

claim based on misstatements regarding the internal controls of

the company.

Defendants further argue that Plaintiffs cannot establish

liability for GAAP violations. Defendants assert that, to state

a claim for liability based on violations of GAAP, Plaintiffs

must allege that “the responsible parties new or should have

known that [the financial statements] were derived in a manner

inconsistent with reasonable accounting practices. ” Christidis

v. First Pennsylvania Mortg. Trust, 717 F.2d 96, 100 (3d Cir.

1983). Plaintiffs GAAP allegations are premised entirely on the

lack of internal controls. See supra, n.7. Because Plaintiffs

have failed to support their internal controls claim with

sufficiently particularized factual assertions, we do not see how

any claim relying thereon can survive. Thus, as currently plead,

Plaintiffs claim that the certifications of GAAP compliance were

false and misleading must fail.

Scienter

Defendants argue that Plaintiffs failed to sufficiently

plead facts giving rise to a strong inference of scienter, and

that their Section 10(b) claims should, therefore, be dismissed.

Scienter is defined as “a mental state embracing intent to

deceive, manipulate, or defraud.” Ernst & Ernst v. Hochfelder,

425 U.S. 185, 193 n.12 (1976). Plaintiffs may successfully plead

scienter either (1) by showing that Defendants had both the

motive and the opportunity to commit fraud, or (2) by presenting

strong circumstantial evidence of “conscious misbehavior or

recklessness.” GSC Partners, 368 F.3d at 237 (internal citations

omitted). The PSLRA requires that Plaintiffs set forth

particular facts giving rise to a strong inference that

Defendants acted with scienter. 15 U.S.C. § 78u-4(b)(2).

Defendants argue that Plaintiffs have failed to meet the PSLRA’s

pleading requirements for either method of establishing scienter.

Conscious misbehavior or recklessness

Defendants attack Plaintiffs’ showing of scienter for its

CMS proposal claims on the basis that Plaintiffs fail to present

circumstantial evidence giving rise to a strong inference of

conscious misbehavior or recklessness. To be reckless, a

statement must be material and involve an “extreme departure from

the standards of ordinary care . . . . ” GSC Partners, 368 F.3d

at 239 (internal citations omitted). The danger that the

statement will mislead must either be actually known to the

defendant or so obvious that the defendant must have been aware

of it. Id.

Defendants argue that Plaintiffs’ circumstantial support for

scienter depends upon the claim that Defendants should have known

of the proposed rule before the proposal was released. Because

Defendants believe these claims to be meritless, they assert that

those claims also cannot support scienter. This argument is

predicated on our rejection of all of Plaintiffs’ claims based on

the CMS proposal. In light of our decision above that dismissal

of those claims is inappropriate, Defendants’ argument is not

persuasive. As discussed above, Plaintiffs plead an array of

facts supporting that Defendants knew or should have known of the

impending regulatory action. These facts, as plead, also support

a strong inference of scienter. If, indeed, Defendants did know,

or should reasonably have known, of upcoming regulatory changes

with a significant negative impact on their business, omission of

that information, particularly when taken together with the

other, positive statements made regarding the business, carries

an obvious danger of misleading. Thus, Plaintiffs have met the

pleading requirements for scienter for their CMS proposal claims,

and we need not analyze whether they have also shown motive and

opportunity for those claims.

Motive and opportunity

Defendants argue that Plaintiffs have not sufficiently

alleged motive and opportunity to support scienter for

Plaintiffs’ claims of insider trading. The mere fact that some

officers sold stock is not enough to support an inference of

fraudulent intent. Advanta, 180 F.3d at 525 (quoting Burlington,

114 F.3d at 1424). Stock sales may, however, support an

inference of scienter where they are “unusual in scope or

timing.” Id. In examining whether the scope or timing of stock

sales is unusual, the Third Circuit has considered how many of

the defendant-officers sold stock, what percentage of total

holdings were traded, whether plaintiffs plead facts supporting

the conclusion that these trades were not routine, and whether

profits from the trades were substantial in comparison to overall

compensation for the sellers. Id. This framework appears to

apply to the exercise of stock options as well as to the sale of

previously purchased shares. Id. Defendants assert that

Plaintiffs fail to sufficiently show that trades by individual

defendants during the class period were unusual in timing or

scope. We disagree.

Plaintiffs allege, and Defendants do not dispute, that each

of the named defendants made substantial trades during the class

period. This distinguishes Plaintiffs ’ claims from those in

Burlington and Advanta, where only some of the defendant-officers

made class-period trades. See Advanta, 180 F.3d at 540.

The significant percentage of holdings traded further

distances this case from Advanta and Burlington. Plaintiffs

allege that Robert Ortenzio sold 48.73%, Rocco Ortenzio sold 46%,

Rice sold 94.33%, and Jackson 78.54% of their respective total

holdings. (Pls. ’ Br. at 60.) In contrast, the sole selling

defendant in Burlington traded only 0.5 percent of his holdings,

and the selling defendants in Advanta traded five to seven

percent of their holdings. Id.

Plaintiffs further allege that these trades were not

routine, both because of their size in comparison to previous

trading, and because of the proximity of many of the trade dates

to dates significant to Defendants ’ statements and the

development of the CMS proposal. (Am. Compl. ¶¶ 215-227.)

Defendants argue that the comparison between class-period and

previous trades is not reliable because there was a blackout

period for an acquisition leading up to the increased trading

activity.

(Defs. ’ Br. at 86-87.) Defendants, at most, establish

that an agreement for the acquisition of Kessler Rehabilitation

Corporation was announced on June 30, 2003 in a press release.

(See id.) Even if such a blackout did occur, Defendants offer no

explanation for the remainder of the compared period, which dates

back to 2001. (See Pls.’ Compl. at

¶ 219.) Furthermore, unlike

in the case on which Defendants rely, Plaintiff ’s allegations do

not stand on this comparison alone. See In re Alpharma Inc. Sec.

Litg., 372 F.3d 137, 152 n.9 (3d Cir. 2004) (noting that

“plaintiffs’ assertion that these defendants had not sold stock

during the preceding fifteen months, standing alone, is

insufficient”) (emphasis added).

Plaintiffs allege that the profits from the stock sales

significantly exceeded the annual compensation of each individual

defendant. Robert Ortenzio’s profits were approximately 12.4

times his annual compensation for 2003, Rocco Ortenzio ’s profits

were approximately 25.5 times his annual compensation for 2003,

Rice’s profits were 10.4 time her annual compensation for 2003,

and Jackson’s profits were 66 times his annual compensation for

2003. (Am. Compl. ¶ 227.) As discussed above, we find that

Plaintiff sufficiently alleges that these gains were not merely

part of the routine exercise of the individual defendants’

compensation packages. Thus, considering all of the factors, we

find the Plaintiff has sufficiently alleged scienter for its

insider trading claims by pleading facts supporting the unusual

timing and scope of trades made during the class period.

As to Defendants ’ assertion that performance bonuses cannot

support an inference of scienter, we find that, although alone

performance bonuses may be insufficient, in conjunction with the

pleading of other specific sets of facts in support of scienter,

the arguable sufficiency of performance bonuses is not decisive.

“Group ” Pleading?

Defendants submit that Plaintiffs ’ claims against individual

defendants cannot survive because they constitute impermissible

“group” pleading.

8 Under group pleading doctrine, plaintiffs can

link otherwise unattributed corporate statements to individual

defendants based solely on their corporate titles and roles.

Courts are divided as to whether the heightened pleading

standards of the PSLRA preclude group pleading. See, e.g., Fin.

Acquisition Ptnrs. v. Blackwell, No. 04-11300, 2006 U.S. App.

LEXIS 3523, *10-11 (5th Cir. February 14, 2006) (noting that the

Tenth Circuit allows group pleading, while the Fifth Circuit does

not). The Third Circuit has not yet addressed this issue, and

the district courts in this circuit have differed. See In re

U.S. Interactive, Inc. Sec. Litg., Civ. A. No. 01-522, 2002 U.S.

Dist. LEXIS 16009, *14 (E.D. Pa. Aug. 23, 2002) (comparing Marra

8Plaintiffs attempt to invoke the group pleading doctrine,
asserting that

[i]t is appropriate to treat the Individual Defendants
as a group for pleading purposes and to presume that
the false, misleading and incomplete information
conveyed in the Company’s public filings, press
releases and other publications as alleged herein are
the collective actions of the narrowly defined group of
defendants identified above.

(Am. Compl. ¶ 20.)

v. Tel-Save Holdings, Inc., 1999 U.S. Dist. LEXIS 7303 (E.D. Pa.

May 18, 1999)(questioning the viability of the group pleading

doctrine) with In re Aetna, Inc. Sec. Litg., 34 F. Supp. 2d 935,

949 (E.D. Pa. 1999)(applying the group pleading doctrine to

determine liability of an outside director)).

This Court, however, need not resolve the question of

whether the group pleading doctrine can survive in light of the

PSLRA’s heightened pleading standards because Plaintiffs have

made sufficiently specific claims as to each individual ’s

involvement in the alleged wrongdoing. Plaintiffs ’ claims rely

on documents personally signed by the Ortenzios and Jackson.

(See Pl.’s Br. at 67; Am. Compl. ¶ 129, 130, 144.) Plaintiffs’

allegations also rely on statements directly attributable to

specific individuals, including statements made in press releases

and conference calls by Robert Ortenzio and Jackson (See Am.

Compl. ¶¶ 118-121, 135, 140). Plaintiffs also alleged that Rice

encouraged illegal kickbacks. (Id. ¶ 50-51.) Thus, although

Plaintiffs attempt group pleading, they also base their claims on

attributable statements, omissions, and actions.

Underlying Violation for Section 20(a) Claims

Defendants’ argue that Plaintiffs’ claims under Section

20(a) must be dismissed as a result of dismissal of the

underlying claims for violations of Rule 10b-5. Because we only

dismiss a limited portion of Plaintiffs ’ claims for Rule 10b-5

violations, the Section 20(a) claims survive except to the extent

that the Rule 10b-5 claims above have been dismissed.

IV. Defendants’ Motion to Strike

Standards Governing Rule 12(f) Motions to Strike

Federal Rule of Civil Procedure 12(f) provides that “[u]pon

motion made by a party . . . the court may order stricken from

any pleading any insufficient defense or any redundant,

immaterial, impertinent, or scandalous matter. ”

Although the

court possesses considerable discretion in addressing a motion to

strike under Rule 12(f), such motions are disfavored and will

usually be denied unless the allegations have “no possible

relation to the controversy and may cause prejudice to one of the

parties or if the allegations confuse the issues.” Plaum v.

Jefferson Pilot Fin. Ins. Co., Civ. A. No. 04-4597, 2004 U.S.

Dist. LEXIS 28968, *5-6 (E.D. Pa. Dec. 22, 2004) (internal

citations omitted).9

Discussion

For the most part, Defendants merely restate their motion to

dismiss arguments based on Chubb. We have addressed this issue

above, and rejected Defendants ’ position. See supra, III.C.3,

9Defendants suggest that Rule 12(f) is properly used as an
enforcement tool for Rule 8(e) ’s requirement of “simple, concise,
and direct” pleading. Defendants present no binding authority
for this argument. Particularly in light of the deficiencies of
Defendants’ request for this extreme relief, we find that such an
extension of our discretion would be inappropriate.

III.C.5. This attempted second bite at the apple has not changed

our thinking on this matter.

Furthermore, we are not persuaded that the Chubb standard is

in any way an appropriate measure of whether allegations should

be stricken under Rule 12(f). Defendants offer no authority for

this proposition. Thus, we will not strike allegations of the

complaint based on Defendants’ Chubb arguments.

In addition to rehashing the Chubb arguments, Defendants ask

this Court to strike numerous allegations as irrelevant,

impertinent, or scandalous. Defendants, however, merely offer

conclusory statements that various allegations will be

prejudicial. Because motions of this type are an extreme remedy,

we will not strike allegations where the movant has offered no

support for claims that prejudice will result.

Conclusion

For all of the reasons set forth above, Defendants ’ motion

to dismiss is denied in part and granted in part, and Defendants’

motion to strike is denied in its entirety pursuant to the

attached order.

IN THE UNITED STATES DISTRICT COURT
FOR THE EASTERN DISTRICT OF PENNSYLVANIA

CIVIL ACTION

04-4020

CLIFFORD C. MARSDEN and MING XU,
Individually and on Behalf of
All Others Similarly Situated

SELECT MEDICAL CORP., MARTIN
JACKSON, ROBERT A. ORTENZIO,
ROCCO ORTENZIO, and PATRICIA RICE

:
:
:
:
:
:
:
:
:

ORDER

AND NOW, this 6th

day of April, 2006, upon consideration

of Defendants’ Motion to Dismiss (Doc. Nos. 24, 25), and all

responses and replies thereto (Doc. Nos. 30, 31, 33, 34), and

Defendants’ Motion to Strike Allegations of the Amended Complaint

(Doc. No. 23), and all responses and replies thereto (Doc. Nos.

32, 35), it is hereby ORDERED as follows:

(a)

Defendants’ Motion to Dismiss is GRANTED in part and

DENIED in part. Plaintiffs ’ claims based on a lack of

internal controls and failure to comply with GAAP are

DISMISSED.

(b)

Defendants’ Motion to Strike Allegations of the Amended

Complaint is DENIED.

BY THE COURT:

s/J.Curtis Joyner

J. CURTIS JOYNER, J.