Case 5:04-cv-04156-JW
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MELVIN R. GOLDMAN (BAR NO. 34097)
mgoldman@mofo.com
JORDAN ETH (BAR NO. 121617)
jeth@mofo.com
MIA MAZZA (BAR NO. 184158)
mmazza@mofo.com
MARK FOSTER (BAR NO. 223682)
mfoster@mofo.com
MORRISON & FOERSTER LLP
425 Market Street
San Francisco, California 94105-2482
Telephone: 415.268.7000
Facsimile: 415.268.7522
Attorneys for Defendants
INFINEON TECHNOLOGIES AG,
INFINEON TECHNOLOGIES NORTH AMERICA
CORP., ULRICH SCHUMACHER, PETER J. FISCHL,
T. RUDD CORWIN, and HEINRICH FLORIAN
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UNITED STATES DISTRICT COURT
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NORTHERN DISTRICT OF CALIFORNIA
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SAN JOSE DIVISION
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In re INFINEON TECHNOLOGIES AG
SECURITIES LITIGATION
CLASS ACTION
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Master File No. C-04-4156-JW
This Document Relates To:
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ALL ACTIONS
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APPENDIX OF UNREPORTED
CASES CITED IN DEFENDANTS'
MOTIONS TO DISMISS THE
SECOND AMENDED COMPLAINT
FOR VIOLATIONS OF THE
FEDERAL SECURITIES LAWS
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Hearing:
Time:
Dept.:
Judge:
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APPENDIX OF UNREPORTED CASES
MASTER FILE NO. C-04-4156-JW
sf-2229073
February 26, 2007
9:00 a.m.
Courtroom 8, 4th floor
Honorable James Ware
Case 5:04-cv-04156-JW
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APPENDIX
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CASES
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In re Adaptive Broadband Sec. Litig.,
No. C-01-1092-SC, 2002 U.S. Dist. LEXIS 5887 (N.D. Cal. Apr. 2, 2002) .............................. 1
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TAB
Allison v. Brooktree Corp.,
No. 97-CV-0852-TW, 1998 WL 34074832 (S.D. Cal. Nov. 27, 1998) ...................................... 2
In re Applied Signal Tech., Inc. Sec. Litig.,
No. C-05-1027-SBA, 2006 WL 1050174 (N.D. Cal. Feb. 8, 2006) ........................................... 3
Bennett v. H&R Block Fin. Adv., Inc.,
No. CV-04-4848-MHP, 2005 WL 2811757 (N.D. Cal. Oct. 27, 2005) ...................................... 4
In re Buca, Inc. Sec. Litig.,
No. 05-1762-DWF, 2006 U.S. Dist. LEXIS 75224 (E.D. Minn. Oct. 16, 2006) ........................ 5
Copperstone v. TCSI Corp.,
No. C-97-3495-SBA, 1999 WL 33295869 (N.D. Cal. Jan. 19, 1999) ........................................6
In re Dura Pharms., Inc. Sec. Litig.,
No. 99-CV0151-L, 2006 WL 2668970 (S.D. Cal. June 2, 2006),
on remand from, 544 U.S. 336 (2005) ........................................................................................ 7
In re ESS Tech., Inc. Sec. Litig.,
No. C-02-04497-RMW, 2004 WL 3030058 (N.D. Cal. Dec. 1, 2004)....................................... 8
In re Impax Labs Sec. Litig.,
No. 5:04-CV-04802-JW, 2006 U.S. Dist. LEXIS 81420 (N.D. Cal. Mar. 1, 2006) ................... 9
J.F. Lehman & Co. v. Treinen,
No. 99-CV-13046-WJR, 2000 U.S. Dist. LEXIS 10329 (C.D. Cal. June 9, 2000) ..................10
Morgan v. AXT,
No. C 04-4362-MJJ, 2005 WL 2347125 (N.D. Cal. Sept. 23, 2005)........................................ 11
In re Netopia, Inc. Sec. Litig.,
No. C-04-03364-RMW, 2005 WL 3445631 (N.D. Cal. Dec. 15, 2005)................................... 12
In re Oak Tech. Sec. Litig.,
No. 96-20552-SW, 1997 WL 448168 (N.D. Cal. Aug. 1, 1997) .............................................. 13
Ryan v. Flowserve Corp.,
No. 03-CV-1769-B, 2006 U.S. Dist. LEXIS 40624 (N.D. Tex. June 9, 2006)......................... 14
Sedona Corp. v. Ladenburg Thalmann & Co.,
No. 03-CIV-3120-LTS (THK), 2005 WL 1902780 (S.D.N.Y. 2005) ...................................... 15
In re Silicon Storage Tech., Inc. Sec. Litig.,
No. C-05-0295-PJH, 2006 WL 648683 (N.D. Cal. Mar. 10, 2006) .......................................... 16
Smith v. Network Equip. Techs., Inc.,
No. C-90-1138, 1990 WL 263846 (N.D. Cal. Oct. 19, 1990)................................................... 17
APPENDIX OF UNREPORTED CASES
MASTER FILE NO. C-04-4156-JW
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In re Tibco Software, Inc.,
No. C-05-2146-SBA, 2006 WL 1469654 (N.D. Cal. May 25, 2006) ....................................... 18
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In re Valence Tech. Sec. Litig.,
No. C-95-20459-JW, 1996 WL 37788 (N.D. Cal. Jan. 23, 1996)............................................. 19
In re VeriSign Corp. Sec. Litig.,
No. C 02-02270 JW, 2005 WL 2893783 (N.D. Cal. Nov. 2, 2005).......................................... 20
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In re VeriSign Corp. Sec. Litig.,
No. C-02-02270-J 2006 U.S. Dist. LEXIS 81419 (N.D. Cal. Apr. 6, 2006)............................. 21
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Dated: November 17, 2006
MORRISON & FOERSTER LLP
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By:
/s/ Mark Foster [e-filing signature]
Attorneys for Defendants
Infineon Technologies AG, Infineon Technologies
North America Corp., Ulrich Schumacher, and
Peter J. Fischl, T. Rudd Corwin, and Heinrich Florian
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LEXSEE 2002 US DIST LEXIS 5887
In re ADAPTIVE BROADBAND SECURITIES LITIGATION; This Document Relates to: ALL ACTIONS
No. C 01-1092 SC
UNITED STATES DISTRICT COURT FOR THE NORTHERN DISTRICT OF
CALIFORNIA
2002 U.S. Dist. LEXIS 5887; Fed. Sec. L. Rep. (CCH) P91,759
April 2, 2002, Decided
April 2, 2002, Filed
DISPOSITION: [*1] Defendants' Motion to Dismiss
DENIED. Defendants' Request for Judicial Notice
GRANTED as to Exhibit A, and DENIED as to Exhibits
B and C.
COUNSEL: For FRANK LETTIERI, JAMES K. NG,
LEON LEYBOVICH, Plaintiffs: Lionel Z. Glancy,
Glancy & Binkow LLP, Los Angeles, CA.
For GLAZER CAPITAL MANAGEMENT, L.P.,
ASSET MANAGEMENT COMPANY, CHICHESTER
OFFSHORE, Plaintiffs: Jeffrey A. Klafter, Bernstein
Litowitz Berger & Grossmann, New York, NY.
For GLAZER CAPITAL MANAGEMENT, L.P.,
ASSET MANAGEMENT COMPANY, CHICHESTER
OFFSHORE, Plaintiffs: Alan Schulman.
For GLAZER CAPITAL MANAGEMENT, L.P.,
ASSET MANAGEMENT COMPANY, CHICHESTER
OFFSHORE, Plaintiffs: Wolfram T. Worms, Bernstein
Litowitz Berger & Grossmann LLP, San Diego, CA.
PETER MCGRATH, CLINT CAVANAUGH, DANA
CHANTER, LARRY COHEN, Plaintiffs: Reed R.
Kathrein, Patrick J. Coughlin, Milberg Weiss Bershad
Hynes & Lerach LLP, San Francisco, CA.
For BART LLOYD, Plaintiff: Reed R. Kathrein, Milberg
Weiss Bershad Hynes & Lerach LLP, San Francisco,
CA.
For DEEPHAVEN MARKET NEUTRAL MASTER
FUND, ADNAN KNAISH, GIULIO CARUSO, PETER
MCGRATH, CLINT CAVANAUGH, BART LLOYD,
DANA CHANTER, LARRY COHEN, Plaintiffs: William S. Lerach, Milberg Weiss Bershad Hynes & Lerach
LLP, San Diego, CA.
For DONALD J. ANGELINI, JR., BEVERLY SAGE,
Plaintiffs: Daniel C. Girard, Robert A. Jigarjian, Girard
Lee & De Bartolomeo, San Francisco, CA.
For DONALD J. ANGELINI, JR., Plaintiff: Anthony K.
Lee, Girard Lee & De Bartolomeo, San Francisco, CA.
For JAMES K. NG, Plaintiff: Michael Goldberg, Glancy
& Binkow LLP, Los Angeles, CA.
For DONALD J. ANGELINI, JR., Plaintiff: Joshua N.
Rubin, Abbey Gardy & Squitieri LLP, James S. Notis,
Abbey Gardy & Squitieri, New York, NY.
For DOUGLAS KEEFER, ROY SCOTT, JR.,
RICHARD J. BOOTH, Plaintiffs: Joseph J. Tabacco, Jr.,
Jennifer S. Abrams, Berman DeValerio Pease Tabacco
Burt & Pucillo, San Francisco, CA.
For DONALD J. ANGELINI, JR., BEVERLY SAGE,
Plaintiffs: Nadeem Faruqi, Shane T. Rowley, Stacey J.
Dana, Faruqi & Faruqi LLP, Mark C. Gardy, Abbey
Gardy LLP, New York, NY.
For DAVID CHANG, SARAH DOUGHTY, Plaintiffs:
Joseph J. Tabacco, Jr., Berman DeValerio Pease Tabacco
Burt & Pucillo, San Francisco, CA.
For BART LLOYD, Plaintiff: Darren J. Robbins, Milberg Weiss Bershad Hynes & Lerach LLP, San Diego,
[*3] CA.
For DEEPHAVEN MARKET NEUTRAL MASTER
FUND, ADNAN KNAISH, GIULIO [*2] CARUSO,
For LEON LEYBOVICH, Plaintiff: Mel E. Lifshitz,
Bernstein Liebhard & Lifshitz, New York, NY.
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2002 U.S. Dist. LEXIS 5887, *; Fed. Sec. L. Rep. (CCH) P91,759
For RICHARD J. BOOTH, DAVID CHANG, Plaintiffs:
Jeffrey C. Block, Michael G. Lange, Berman DeValerio
Pease Tabacco Burt & Pucillo, Boston, MA.
For RICHARD J. BOOTH, Plaintiff: Chauncey Steele,
Berman DeValerio Pease Tabacco Burt & Pucillo, Boston, MA.
defendants: William S. Freeman, Grant P. Fondo, Cooley
Godward LLP, Palo Alto, CA.
JUDGES: Samuel Conti, UNITED STATES DISTRICT
JUDGE.
OPINION BY: Samuel Conti
OPINION:
For RICHARD J. BOOTH, Plaintiff: Charles J. Piven,
Law Offices of Charles J. Piven, Baltimore, MD.
For DAVID CHANG, Plaintiff: Chauncey D. Steele, IV,
Berman DeValerio Pease Tabacco Burt & Pucillo, Boston, MA.
For DAVID CHANG, Plaintiff: Donald J. Enright,
Finkelstein Thompson & Loughran, Mark McNair, Law
Office of Mark McNair, Washington, DC.
For DAVID CHANG, Plaintiff: Christopher T. Heffelfinger, Berman DeValerio Pease Tabacco Burt & Pucillo,
San Francisco, CA.
For DAVID CHANG, Plaintiff: Jody Anderman,
LeBlanc Maples & Waddell, Baton Rouge, LA.
For SARAH DOUGHTY, Plaintiff: Leo W. Desmond,
The Law Offices of Leo W. Desmond, West Palm
Beach, FL.
For DANA CHANTER, Plaintiff: Marc S. Henzel, Law
Offices of Marc S. Henzel, Philadelphia, PA.
For LARRY COHEN, Plaintiff: David B. Kahn, Mark
[*4] E. King, Elissa C. Chase, David B. Kahn & Associates, Northfield, IL.
For DAVID SHEEHY, Plaintiff: Bruce G. Murphy, Law
Offices of Bruce G. Murphy, Vero Beach, FL.
For DAVID SHEEHY, Plaintiff: Francis M. Gregorek,
Francis A. Bottini, Jr., Betsy C. Manifold, Wolf Haldenstein Adler Freeman & Herz LLP, San Diego, CA.
For T. ROBERT LACOUR, Plaintiff: Alfred G. Yates,
Jr., Law Office of Alfred G. Yates Jr., Pittsburgh, PA.
For T. ROBERT LACOUR, Plaintiff: Jeffrey R. Krinsk,
Howard D. Finkelstein, Gregory A. Hartlett, Finkelstein
& Associates, San Diego, CA.
For ADAPTIVE BROADBAND CORPORATION,
FREDERICK D. LAWRENCE, DONNA S. BIRKS,
ORDER DENYING DEFENDANTS' MOTION TO
DISMISS
I. INTRODUCTION
This is a class action filed on behalf of all purchasers
("Plaintiffs") of the publicly-traded securities of Adaptive Broadband Corporation ("Adaptive") against Adaptive and four of its officers: Frederick D. Lawrence
("Lawrence"), Adaptive's former Chief Executive Officer
and Chairman of the Board of Directors; [*5] Donna S.
Birks ("Birks"), Adaptive's former Chief Financial Officer; Daniel Scharre ("Scharre"), Adaptive's former President and Chief Operating Officer and, later, its President,
CEO and Director; and Peter J. Maloney ("Maloney"),
Adaptive's former Senior Vice President of Finance and
later, its Chief Financial Officer (collectively "Defendants"). On October 23, 2001 Plaintiffs filed a Corrected
Consolidated Complaint for violations of the Securities
and Exchange Act of 1934. Specifically, Plaintiffs allege
all Defendants violated Sections 10(b) of the 1934 Act
and Securities and Exchange Commission ("SEC") Rule
10b-5 and that the Individual Defendants violated Section 20(a) of the 1934 Act. Now before the Court are the
Individual Defendants' Motion to Dismiss and Request
for Judicial Notice. For the following reasons, the Individual Defendants' Motion to Dismiss is denied and their
Request for Judicial Notice is granted in part and denied
in part.
II. BACKGROUND
Adaptive is a Delaware corporation based in San
Jose, California. Before it filed for bankruptcy protection
on July 26, 2001, Adaptive supplied equipment related to
broadband wireless communication over the [*6] Internet. As a result of its bankruptcy filing, all proceedings
against Adaptive in this Court are stayed pursuant to 11
U.S.C. § 362(a).
Prior to its bankruptcy filing and throughout the
class period, Adaptive common stock was traded on the
NASDAQ National Market System under the symbol
"ADAP." Changes were made to senior management on
or around January 11, 2001. Prior to January 11, 2001
Defendant Lawrence was Adaptive's Chairman and CEO,
Defendant Birks was its CFO, Defendant Scharre was its
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President and COO and Defendant Maloney was the
Senior Vice President of Finance. After January 11,
2001, Defendants Lawrence and Birks resigned, Defendant Scharre became the CEO, President and Director
and Defendant Maloney became the CFO.
The facts in this case are complicated slightly by the
fact that Adaptive switched operating calendars around
the time the class period began. As of June 2000, Adaptive operated on a fiscal calendar year ending June 30.
The company later transitioned to a calendar ending December 31. For ease of reference, the Court, like the parties, will refer to a quarter by the month in which it
ended, i.e., June 2000 Quarter, etc.
The class period [*7] in this case extends from August 10, 2000 through March 15, 2001. Plaintiffs allege
that the Individual Defendants either participated in directly or sanctioned by virtue of their authority in the
company a scheme to improperly recognize revenue in
violation of Generally Accepted Accounting Principles
(GAAP). According to Plaintiffs, Defendants were motivated by a desire to bolster the company's economic outlook in order to attract a merger partner. Specifically,
Plaintiffs allege that the Individual Defendants overrode
accounting methods and internal company policies to
extend credit to customers with questionable credit histories and to "ship" products to Adaptive's own warehouse
in an attempt to move them off the books. According to
Plaintiffs, contemporaneously with these maneuvers, the
Individual Defendants were reporting to the investing
public grossly overinflated revenue in order to maintain
or raise the price of Adaptive's securities.
Plaintiffs describe statements from four confidential
witnesses who have reported details of Defendants' alleged fraud. Confidential witness 1 ("CW1") is a 15-year
employee of Adaptive and its predecessor, California
Microwave. CWI was a manager [*8] in charge of
Adaptive's order fulfillment department in 2000 until
approximately July 2001. Id. at P 41. CW1 claims that
Adaptive had specific policies for Revenue Recognition
Procedure, Order Entry Procedure and Commercial
Booking Policy, all of which were incorporated into an
Oracle database housing Adaptive's general ledger. Id. at
P 43.
Confidential witness 2 ("CW2") began work at
Adaptive in 1999. In 2000, and until approximately July
2001, CW2 worked in Adaptive's finance division and
reported directly to Defendant Maloney. CW2 generated
regular reports for senior management, including a "BBB
Customer Report" detailing billings, bookings and backlog. Id. at P 42. These reports, which were generated
from Adaptive's Oracle database, were used by senior
management to support Adaptive's SEC filings and its
reports to the investing public and securities analysts. Id.
Confidential witness 3 ("CW3") worked for Adaptive and its predecessor company for 10 years. Id. at P
60. In 2000 and until approximately July 2001, CW3 was
a department head-level information officer in Adaptive's
Rochester, New York offices, the hub of Adaptive's sales
and order administration [*9] department. Id. CW3 reported to Adaptive's Chief Information Officer, Steve
Bringham ("Bringham").
Confidential witness 4 ("CW4") was an administrative assistant who worked for Defendants Lawrence and
Birks between July 2000 and February 2001. Id. at P 63.
For the purposes of a motion to dismiss, the Court
takes all of Plaintiffs' allegations as true. They allege the
following misleading statements:
The Announcement of Fiscal Year 2000 Results
On the first day of the class period, August 10, 2000,
Adaptive issued a press release "prepared by defendants"
and signed by Defendant Lawrence describing financial
information and results of operations. Id. at PP 33, 89.
("August 2000 release"). These same statements were
included in an August 29, 2000 Annual Report on Form
10-K filed with the SEC. Id. at P 33.
In the August 2000 release, Adaptive claimed a 106
percent increase in revenue for the June 2000 Quarter as
compared to the previous quarter. Id. at P 34. Defendants
Lawrence, Scharre and Birks were quoted in the release
touting the company's success. Id. at PP 35-37. These
same three defendants signed the Form 10-K, filed August 29, 2000 for FY2000 which [*10] repeated figures
detailed in the August 2000 Release. In the FY2000 10K, Adaptive reported that it generally recognizes revenue
"upon shipment to a credit-worthy customer." Id. at P 38.
Plaintiffs claim this statement was false and misleading because Adaptive falsified its financial results by
improperly recognizing revenue. According to CW1,
Defendant Maloney overrode these procedures frequently in 2000 to ship products to companies that did
not meet Adaptive's own creditworthiness standards, or
to companies that had canceled orders or never placed
orders in the first place. Id. at P 45. CW1 reported that
Defendants Lawrence and Birks "knew what [Maloney]
was doing" and "consented to his actions." Id. CW1 reported that "no one trusted [Maloney]" when it came to
compliance with internal order procedures. Id.
In particular, CW1 reported that at the end of June
2000, Defendant Maloney overrode Adaptive's procedures for several transactions and created a second set of
accounting records for transactions that violated the procedures and were recommended for rejection by Adaptive's Order Administration Department. Id. at P 46. According to CW1, Defendant Maloney [*11] kept a separate accounting sheet for a $ 4 million purchase from a
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customer called BroadbandNow, which became the subject of arguments between Defendant Maloney and employees in the order administration department and finance division. Id. at P 47. CW1 told Defendant Maloney that the $ 4 million transaction was not supported
by a purchase order. Id. Defendant Maloney responded
that a purchase order would be forthcoming, but CW1
reports it never was. Id. CW1 discussed this issue with
the manager-level head of Adaptive's accounting department, who agreed that recording the transaction was
improper. CW1 reported that Defendant Maloney was
confronted about the transaction by CW1 and the accounting department manager. Id. In addition, CW1 reported that email correspondence from June 2000 between Defendant Maloney and the order administration
department chronicled admonitions to Defendant Maloney about his actions. CW1 and the accounting manager "jokingly" gave Defendant a Monopoly-esque "getout-of-jail-free card" in recognition of their view that
what he was doing was improper. Id.
CW1 reported another alleged improper transaction
in the June 2000 Quarter, this one [*12] with Cybertech
Wireless Inc. ("Cybertech"). Id. at P 48. Cybertech canceled its June 2000 order and was in debt to Adaptive,
having failed to pay for a prior shipment. Id. A customer
support representative, after calling Cybertech to confirm
that it had canceled its order, recommended that Adaptive not ship it. Id. According to CW1, Defendant Maloney extended Cybertech's credit line, overrode the order entry procedures and directed Adaptive to ship the
product to Cybertech anyway. Id. Cybertech refused the
shipment and Adaptive refused the return until December
2000 when it was re-inputted into the Adaptive accounting system. Id.
CW1 describes another transaction with TESSCO
Technologies, Inc. ("TESSCO"), also reflected in the
June 2000 Quarter results. Id. at P 49. Adaptive received
TESSCO's order by email at approximately 11:00 p.m.
on a Saturday night from a TESSCO engineer. Id. This
was unusual since all prior (and subsequent) orders came
via purchase orders on TESSCO letterhead, as specified
by Adaptive's Order Entry procedure. Id. Adaptive's order administration department contacted TESSCO about
the order and was informed that the TESSCO engineer
[*13] had not been authorized to make the purchase and
that TESSCO did not want the product. Id. According to
CW1, Defendant Maloney overrode usual procedure and
directed Adaptive to ship the product to TESSCO.
TESSCO refused to accept it. Id.
According to Plaintiffs, all of these transactions
were reflected in the June 2000 Quarter financial statements. Id. at PP 39, 48, 49.
On March 15, 2001 Adaptive admitted it wrongfully
recorded the Broadband Now transaction. Id. at P 50. On
July 5, 2001, Adaptive admitted that it had wrongfully
recorded a total of $ 4.8 million in revenue, or over 20
percent of the year's total. Id. In its July 5, 2001 Annual
Report on Form 10-K, Adaptive told the SEC that the
results reported in the August release were overstated
because of "two additional revenue transactions, one
relating to an unauthorized shipment and the other to the
inappropriate recognition of a customer deposit, both
recorded in the [June 2000 Quarter], which have also
been restated." Id. at P 51.
Defendant Lawrence's Statements Relating to the
Fuzion Deal
Prior to the class period, on July 18, 2000, Adaptive
issued a press release describing an agreement [*14] it
had entered with Fuzion Wireless Communications
("Fuzion") for the joint development of new technology
for wireless broadband networks. Id. at P 53. On September 22, 2000, Adaptive issued another press release
announcing a $ 100 million contract with Fuzion. Id.
Also on September 22, 2000, Bloomberg quoted Defendant Lawrence's statements about the Fuzion deal. Id. at
P 55. Defendant Lawrence noted that "the contract goes
over a multiple-year period, but there is immediate revenue for the current and following quarters. . . . This will
hit our top-line growth over the next five years, and
when you add up our customer list, you'll see over 50
names and $ 1.5 billion in contracts." Id.
According to Plaintiffs, Lawrence's statement that
revenue would be reflected in the immediate quarter was
false and misleading because Defendants knew that
Fuzion could not place or accept any orders from Adaptive before the close of the September 2000 Quarter. Id.
at P 56. Nonetheless, in an attempt to rush the order
through, Defendants demanded that the order administration department fulfill a $ 13 million order from Fuzion
before the close of the quarter. Id. at P 57. According
[*15] to CW2, Adaptive never received a purchase order
from Fuzion. Id. at P 58. Moreover, CW2 reported that
Fuzion had previously defaulted on an earlier, $ 12 million order, which under normal procedures would preclude its being issued further credit. Id. Nonetheless,
according to Plaintiffs, Adaptive "senior management"
extended Fuzion's credit to allow for another shipment.
Id.
CW1 reported that Fuzion could not accept products
shipped under the new order. Id. According to CW1,
Defendants Maloney, Lawrence and Birks devised a
scheme whereby Fuzion could "lease" storage space at
Adaptive's Sunnyvale, California headquarters. Id. at P
59. Id. CW1 told Defendant Maloney that Adaptive
could not ship to its own warehouse without a written
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lease agreement. Id. CW1 reported that Defendant Maloney overrode procedure and ordered Adaptive to "ship"
the order, consisting of eight or nine tractor loads, to its
own warehouse. Id.
CW3 confirmed the informal arrangement between
Fuzion and Adaptive. CW3 reported that he visited
Adaptive's Sunnyvale, California headquarters in early
July 2000 and noticed 15 pallets of 600 units of merchandise in an Adaptive warehouse. [*16] Id. at P 61.
According to CW3, this struck him as unusual, and when
he asked Bringham about it, he was told that the products
belonged to Fuzion. Id.
CW3 reported that the Fuzion relationship was handled in part by Defendant Scharre. Id. at P 62. According
to CW3, when the Fuzion/Adaptive partnership was announced on July 18, 2000, Defendant Scharre directed
Adaptive employees to provide Fuzion employees with
access to Adaptive's technical information. Id. As an
example, CW3 reported that Fuzion was granted the right
to provide wireless services to Adaptive's Rochester office. Id. CW3 reported that Adaptive employees were
subsequently ordered to terminate all contact with
Fuzion, and that questions from Fuzion employees were
to be referred to Adaptive's counsel. Id. CW3 then contacted Scharre to determine whether he should continue
to provide a Fuzion employee with access to the Rochester facility. Id. Defendant Scharre told CW3 to stall the
Fuzion employee, and not to connect him to Adaptive's
systems. Id. CW3 reported that Fuzion had refused to
pay Adaptive, and was experiencing financial difficulties. Id.
CW4 confirmed that the products Adaptive [*17]
sold to Fuzion were stored at Adaptive's Sunnyvale, California headquarters. Id. CW2 reported that Adaptive's
general ledger did not record the Fuzion order in the first
quarter of FY01 because the order was never received,
nor were the products shipped. Id. at P 64. CW2 generated the BBB Customer Report for senior management to
review. Id. CW2 reported that senior management falsely
altered the report to reflect the first quarter Fuzion sale.
Id.
Announcement of September Quarter 2000 Results
On October 23, 2000, Adaptive released its financial
statements and results of operations for the September
2000 Quarter in a press release disseminated to investors.
Id. at P 65 ("October 2000 release"). On November 3,
2000, Adaptive filed a quarterly report with the SEC on
Form 10-Q reporting these same revenue figures. Id. The
October 2000 release reported revenue for the first quarter of FY2001 of $ 24.2 million, a 42 percent increase
from the previous quarter. Id. at P 66. It also contains
statements from Defendants Lawrence, Birks and
Scharre, making glowing predictions for Adaptive's fu-
ture. Id. at P 67. Defendant Birks predicted a 30 percent
or greater [*18] quarter-to-quarter growth rate, and that
gross margins would increase by 10 percent to 40 percent
by the March 2001 quarter. Id. The October 2000 release
announced a recorded net income of $ 1.7 million in the
September 2000 Quarter compared to a net loss of $ 15.9
million for the June 2000 Quarter and a net loss of $ 3.9
million for the comparable quarter of the previous year.
Id. at P 68.
The Form 10-Q report was signed by Birks. Id. at P
69. It read, in part, "In the opinion of management, the
accompanying unaudited condensed consolidated financial statements contain all adjustments (all of which are
normal and recurring in nature) necessary to present
fairly the financial position, results of operations and
cash flows for the periods presented." Id. at P 89.
Plaintiffs allege that the Fuzion order, worth $ 13
million, was improperly included in the September 2000
Quarter results, rendering the October 2000 release and
the FY01 Form 10-Q false and misleading. Id. at P 70.
On July 5, 2001, Adaptive admitted that its September
2000 Quarter revenues were overstated by 981.6 percent;
$ 21.4 million of the $ 23.6 million in revenue was
wrongly recorded. Id. [*19]
Adaptive also reported in the October 23, 2000 release that it had backlog orders at the close of the September 2000 Quarter totaling $ 72.4 million. Id. at P 66.
According to Plaintiffs, Adaptive's reported backlog of
orders was falsely inflated. Adaptive's invoicing system
was based on 30-day net payment terms. Id. at P 72. If a
customer was 90-days past due or more, it was redflagged for review by Defendant Maloney. Id. CW1 reported that purchase orders received prior to the close of
FY2000 with shipment dates between January and March
2001 that were red-flagged were reported nonetheless.
Id. CW2 reported that in the first and second quarters of
FY2001 certain orders were shipped and never paid for
and never returned, but were recorded by Defendant Maloney as having been returned to inventory anyway. Id. at
P 73.
Announcement of December 2000 Quarter Results
On January 25, 2001, Adaptive issued a press release detailing its results for the December 2000 Quarter.
Id. at P 77. ("January 2001 Release"). It reported revenue
of $ 8.4 million and $ 21.4 million in backlog, after a $
55 million backlog adjustment "due to softness in the
U.S. Competitive [*20] Local Exchange Carrier." Id. It
also admitted Fuzion's default on a $ 12.4 million receivable and Adaptive's deferral of $ 13 million in additional
shipments. Id. n1
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n1 This part of Plaintiffs' Complaint is difficult to follow. According to Plaintiffs, Adaptive
eventually admitted that the December 2000
revenue figures were overstated by 158.3 percent
and that an initial net loss of $ 62.6 million turned
out to be $ 98.9 million. Id. at P 79. But Plaintiffs
fail to direct the Court's attention to when and
where this later admission was made.
Adaptive's Recognition of Accounting Errors
On March 15, 2001, the last day of the class period,
Adaptive issued a press release admitting it had wrongfully recorded $ 4 million in June 2000 Quarter revenue
for a single, major customer, BroadbandNow. Id. at P 80.
The $ 4 million in question represented 23.4 percent of
the $ 17.1 million in revenue reported for the June Quarter 2000. Id. at P 39.
In an April 18, 2001 press release, Adaptive announced [*21] that Defendant Maloney had been replaced as its CFO. Id. at P 81. On May 22, 2001, Adaptive issued a press release announcing its securities had
been delisted by the NASDAQ. Id. at P 83.
On July 5, 2001, Adaptive filed its Annual Report
on Form 10-K with the SEC for the transition period July
1, 2000 to December 31, 2000 ("FY2001 10-K"). Id. at
PP 51, 84. On the form, Adaptive for the first time disclosed the June 2000 "financing commitment" side letter
for the $ 4 million sale to BroadbandNow. Id. Adaptive
told the SEC that it would reverse the transaction, which
had been reflected in the June 2000 quarter. Id. Adaptive
also revealed it was restating "two additional revenue
transactions, one relating to an authorized shipment and
the other to the inappropriate recognition of a customer
deposit," both recorded in the June 2000 quarter. Id.
(quoting FY2001 10-K).
Upon discovering the side letter, Adaptive established a Special Investigation Committee and retained
independent special counsel. Id. at P 84. The committee's
counsel reviewed sales transactions from April 1, 2000 to
December 31, 2000. Id. As a result, Adaptive determined
that extension of [*22] credit to certain customers in the
latter part of 2000 was not supportable, and decided to
restate or reverse revenues recorded in the June, September, and December 2000 quarters. Id. The FY2001 10-K
also disclosed that severance payments to Defendants
Lawrence and Birks were suspended in May 2001. Id.
On July 26, 2001, Adaptive filed for federal bankruptcy protection in the San Jose Division of the Northern District of California Federal Bankruptcy Court. Id.
at P 86. Adaptive has yet to file a restated annual report
for FY2000 and a restated quarterly report for the first
quarter of FY2001. Id.
Adaptive's Proposed Merger with Western Multiplex
The individual defendants owned at least 844,703
shares of Adaptive stock during the class period. (Mem.
of P&A's in Supp. of Defs.' Mot. to Dis. at 2:24). Plaintiffs do not allege that any of the Individual Defendants
sold securities during the class period. Rather, Plaintiffs
allege that the individual defendants were attempting to
artificially inflate the price of the company's stock in an
attempt to attract a merger partner. Plaintiffs support this
hypothesis with certain facts about a potential merger
proposed during [*23] the class period.
On November 13, 2000, Adaptive issued a press release announcing a merger agreement under which it
would be acquired by Western Multiplex Corporation
("Western Multiplex"). Id. at P 74. Under the agreement,
Western Multiplex would issue $ 645 million in stock to
acquire Adaptive, and Defendants Lawrence and Scharre
would join the Board of Directors with Scharre also acting as President and COO. Id.
On January 10, 2001, Adaptive issued a press release announcing that the merger had been called off due
to unfavorable market conditions. Id. at P 75. The release
also announced that Defendants Lawrence and Birks
were retiring from Adaptive, and that Defendant Scharre
had been promoted to CEO and that Defendant Maloney
had been promoted to CFO. Id. at P 75. As noted above,
Defendant Maloney was relieved of the CFO position in
April 2001. Id. at P 81.
III. LEGAL STANDARD
A. Motion to Dismiss
A motion to dismiss will be denied unless it appears
that the plaintiff can prove no set of facts which would
entitle her to relief. Fed. R. Civ. Pro. 12(b)(6); Conley v.
Gibson, 355 U.S. 41, 45-46, 2 L. Ed. 2d 80, 78 S. Ct. 99
(1957); [*24] Gilligan v. Jamco Dev. Corp., 108 F.3d
246 (9th Cir. 1997); Fidelity Financial Corp. v. Federal
Home Loan Bank of San Francisco, 792 F.2d 1432, 1435
(9th Cir. 1986). All material allegations in the complaint
are accepted as true and construed in the light most favorable to the non-moving party. NL Industries, Inc. v.
Kaplan, 792 F.2d 896, 898 (9th Cir. 1986).
B. Securities Fraud
Rule 9(b) provides that "in all averments of fraud or
mistake, the circumstances constituting fraud or mistake
shall be stated with particularity." Fed. R. Civ. P. 9(b).
The allegations must be "specific enough to give defendants notice of the particular misconduct which is alleged to constitute the fraud charged so that they can
defend against the charge and not just deny that they
have done anything wrong." Semegen v. Weidner, 780
F.2d 727, 731 (9th Cir. 1985).
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Rule 9(b) applies to actions brought under the federal securities laws. In re GlenFed, Inc. Sec. Litig., 42
F.3d 1541, 1548 (9th Cir. 1994)(en banc). In 1995, Congress enacted the Private Securities Litigation Reform
Act, ("PSLRA"), to clarify and strengthen [*25] the particularity requirements of Rule 9(b) in the context of
federal securities class actions. In the Ninth Circuit, this
requirement has been interpreted and explained by In re
Silicon Graphics Sec. Litig., 183 F.3d 970 (9th Cir.
1999).
Section 10(b) of the Securities Exchange Act of
1934 provides, in relevant part, that it shall be unlawful
"to use or employ in connection with the purchase or sale
of any security registered on a national securities exchange or any security not so registered, . . . any manipulative or deceptive device or contrivance in contravention
of such rules and regulations as the [SEC] may prescribe..." 15 U.S.C. § 78j(b). Exchange Commission
Rule 10b-5, issued by the SEC to implement Section
10(b), makes it unlawful for any person to use interstate
commerce:
(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 the 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 [*26] 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. A plaintiff bringing a claim under these sections must show: (1) a false and misleading
statement or omission of material fact; (2) reliance; (3)
scienter; and (4) resulting damage. Paracor Fin., Inc. v.
General Elec. Capital Corp., 96 F.3d 1151, 1157 (9th
Cir. 1996).
The PSLRA places additional pleading requirements
on a plaintiff in a securities fraud action. To state a claim
under the PSLRA, for each defendant, a plaintiff 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...[to] state with particularity all facts on which that belief is formed." 15
U.S.C. § 78u-4(b)(1). The plaintiff must also "state with
particularity facts giving rise to a strong inference that
the defendant acted with the required state of mind." 15
U.S.C. § 78u-4(b)(2). The PSLRA further requires that a
district court, upon [*27] motion of the defendant,
"shall" dismiss any complaint that does not meet these
requirements. 15 U.S.C. § 78u-4(b)(3)(A).
C. Control Person Liability
Rule 20(a) of the 1934 Act defines control persons
as: "Every person who, directly or indirectly, controls
any person liable under any provision of this chapter or
of any rule or regulation thereunder . . .." 15 U.S.C. §
78t(a). Such a person "shall also be liable jointly and
severally with and to the same extent as such controlled
to any person to whom such controlled person is liable,
unless the controlling person acted in good faith and did
not directly or indirectly induce the act or acts constituting the violation or cause of action." Id.
D. Judicial Notice
A party requesting judicial notice must show that the
fact in question is not subject to reasonable dispute because it is generally known in the community or "capable
of accurate and ready determination by resort to sources
whose accuracy cannot reasonably be questioned." Fed.
R. Evid. 201(b). In ruling on a motion to dismiss, a district court may take judicial notice of a document if the
plaintiff relies upon it [*28] in her complaint and its
authenticity is not questioned. Parrino v. FHP, Inc., 146
F.3d 699, 706 (9th Cir. 1998). A court may consider
SEC filings incorporated by reference in a complaint.
Ronconi v. Larkin, 253 F.3d 423, 427 (9th Cir. 2001); In
re Silicon Graphics, 183 F.3d at 986.
IV. DISCUSSION
In this securities class action, Plaintiffs claim that
Adaptive falsely reported financial results by improperly
recording revenue in an attempt to inflate its stock price.
According to Plaintiffs, revenue overstatement and inadequate loss recognition was effected by violating generally-accepted accounting principles ("GAAP") and
Adaptive's own internal policies. As a result, FY2000
and FY2001 financial results were materially false and
misleading when made. Plaintiffs claim they would not
have purchased Adaptive stock at the prices they paid, or
at all, if they had known that the market price had been
inflated by Defendants' alleged fraud.
Plaintiffs allege violations of Section 10(b) of the
1934 Act and SEC Rule 10b-5 against all defendants and
violations of Section 20(a) of 1934 Act against the individual defendants. They [*29] request class damages,
interest and costs and any other equitable/injunctive relief as the Court deems just and proper.
The Court will first address whether the Complaint
states facts sufficient to support fraud generally under the
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PSLRA's heightened pleading standards. The Court will
next address whether the Complaint's allegations are
sufficient to support the claim that the individual defendants were control persons under Section 20(a).
A. Section 10(b) and SEC Rule 10b-5
Plaintiffs allege that Defendants engaged in a series
of conscious decisions to falsify financial statements in
order to attract a merger partner and to profit personally
thereby. To support these allegations, Plaintiffs cite reports from four confidential witnesses from inside the
company. They also cite to Adaptive's own public admission that it had misstated its financials, the NASDAQ's
decision to delist Adaptive's stock, reshuffling (and replacement) of top executives and a failed merger attempt
as evidence that Adaptive knowingly, or at least with
deliberate recklessness, defrauded them by engaging in
questionable business practices. Defendants dispute
Plaintiffs' contention that their Complaint [*30] pleads
securities fraud with the necessary particularity.
Under the PSLRA and Rule 9(b), a plaintiff must
show that an alleged false statement was false when
made, and must also plead specific facts creating a strong
inference that the fraud was committed with deliberate
recklessness. In re Silicon Graphics, 183 F.3d at 974;
Ronconi, 253 F.3d at 429. If an allegation regarding a
statement or omission is made on information and belief,
the complaint must state with particularity all facts on
which that belief is based. 15 U.S.C. § 78u-4(b)(1). Allegations are presumed to have been made on information and belief unless and until the plaintiffs demonstrate
they have personal knowledge of the facts. In re Vantive
Corp. Sec. Litig., 283 F.3d 1079, 2002 U.S. App. LEXIS
4231, 2002 WL 398498, at *2 n.3 (9th Cir. 2002).
sight." In re Silicon Graphics, 183 F.3d at 988 (internal
citations omitted).
A securities fraud complaint need not be dismissed
for relying on circumstantial evidence, as long as that
evidence meets the "strong inference" standard. In re
Silicon Graphics, 183 F.3d at 996; In re Northpoint
Comm. Group, Inc. Sec. Litig., 184 F. Supp. 2d 991, 997
(N.D. Cal. 2001). [*32] In order to adequately plead that
statements were intentionally false, misleading or made
with deliberate recklessness, the complaint must allege
specific "contemporaneous statement or conditions"
demonstrating the deliberately reckless or intentional
nature of the statements at the time they were made.
Ronconi, 253 F.3d at 432; In re Vantive, 283 F.3d 1079,
2002 U.S. App. LEXIS 4231, 2002 WL 398498 at *7. In
assessing whether a complaint sufficiently pleads scienter, it must be read in its entirety. In re Silicon Graphics, 183 F.3d at 985.
Plaintiffs argue scienter on many different levels.
First, they argue that GAAP violations in and of themselves support an inference of scienter. They also argue
that by restating its financials, Adaptive effectively admitted that its original filings and releases were knowingly false when made. But most importantly, Plaintiffs
point to a series of deliberate transactions by corporate
executives designed to override standard accounting procedures in an effort to attract a potential buyer for the
company. Plaintiffs argue that collectively, these transactions and the deliberateness with which they were entered into support the necessary [*33] inference that the
fraud alleged was knowing, or at least deliberately reckless.
1. Unnamed Sources
The first prong of the Silicon Graphics formula is
satisfied here; Defendants do not contest that financial
statements for the June, September and December 2000
Quarters were false when made. In their Motion to Dismiss, however, the Individual Defendants deny these
results were knowingly false when made; that is, [*31]
they argue that Plaintiffs' complaint is fatally flawed for
failure to plead the required level of scienter. They explain the readjustment of Adaptive's financial disclosures
as the combined result of the discovery that some transactions had been improperly recorded and the collapse in
the market for Adaptive's product which made prior
credit extensions to certain customers insupportable.
As an initial matter, the Court will address Defendants' concern over Plaintiffs' use of confidential witnesses. Defendants claim the use of unnamed sources
violates the PSLRA's particularity requirement. Defendants demand that Plaintiffs should be required to at least
provide the witnesses' names and titles, or more facts
establishing that they are likely to possess the information attributed to them. Defendants note in particular that
the Complaint is vague as to the starting dates of three of
the four witnesses, suggesting that they may not have
been working at the jobs that gave them access to the
knowledge they are supposed to have until after the
events happened.
In the Ninth Circuit, the required state of mind in a
securities fraud case is actual knowledge or "deliberate
recklessness," or if the statement is forward-looking,
"actual knowledge . . . that the statement was false or
misleading." 15 U.S.C. § 78u-5(c)(1)(B)(i); Ronconi,
253 F.3d at 429. This stricter standard was codified in an
attempt to prevent cases based upon "fraud by hind-
The credibility to be attributed to an anonymous
source should be evaluated on a case-by-case basis. In re
McKesson HBOC, Inc. Sec. Litig., 126 F. Supp. 2d 1248,
1271 (N.D. Cal. 2000). The failure to name sources may
reduce the weight to be allocated to their testimony when
evaluating the complaint's ability to meet the strict requirements for pleading scienter. 126 F. Supp. 2d at
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1272. But [*34] the failure to name sources will not
doom an otherwise well-plead securities complaint. According to Silicon Graphics, a plaintiff need only "mention . . . the sources of [plaintiff's] information." 183
F.3d at 985. This has been interpreted to mean that "it is
possible to identify sources and provide other corroborating details without disclosing names of sources." In re
McKesson, 126 F. Supp. 2d at 1271.
Plaintiffs' Complaint would be more credible if their
sources were named, since, in the context of pleading
securities fraud, the more detail the better. But their refusal to provide this detail is not fatal. Plaintiffs allege
that CW1 was a 15-year employee of Adaptive and its
predecessor, California Microwave, and that in 2000
until approximately July 2001 the witness was a manager
in charge of Adaptive's order fulfillment department.
(Compl. at P 41.) Plaintiffs claim that CW2 began work
at Adaptive in 1999 and from 2000 to July 2001 worked
in Adaptive's finance division and reported directly to
Defendant Maloney. CW2's responsibilities included
generating regular reports for senior management, including a "BBB Customer Report" detailing billings,
[*35] bookings and backlog. Id. at P 42. CW3 worked
for Adaptive and its predecessor company for 10 years.
Id. at P 60. In 2000 and until approximately July 2001,
CW3 was a department head-level information officer in
Adaptive's Rochester, New York office, the hub of
Adaptive's sales and order administration department. Id.
CW3 reported to Adaptive's Chief Information Officer.
Finally, CW4 is described as an administrative assistant
who worked for Defendants Lawrence and Birks between July 2000 and February 2001. Id. at P 63.
Defendants correctly note that Plaintiffs are vague as
to the dates witnesses one through three began work in
their positions. And it is indeed odd that employees
whose descriptions give away so much of their identities
would not let their names be used. But the Court finds
that the failure to name them is more than compensated
for by the fact that the witnesses are long-term employees whose positions are described in detail.
Defendants cite to In re Northpoint, a case in which
the use of eight confidential witnesses could not overcome the PSLRA's particularity requirement. 184 F.
Supp. 2d at 1001. But the Court finds that case to [*36]
be distinguishable. There, Judge Alsup noted that the
complaint never described the witnesses' duties, nor did
it discuss how they came to learn of the information in
the complaint. Id. Here, by contrast, Plaintiffs provide
much more that the four witnesses' titles. For example,
they describe that CW1 had first-hand knowledge of Defendant Maloney's decision to extend credit to certain
customers and to override internal accounting procedures
in the process. They describe how CW2 generated reports and knew first-hand that a report had been altered
to reflect the Fuzion deal. They describe how CW3 saw
for himself the Fuzion's supposedly completed order
stored in Adaptive's Sunnyvale warehouse, a scheme
later confirmed by his supervisor. While less concrete,
the information provided by CW4 confirms the Fuzion
warehouse deal.
This is not to say that everything attributable to
these witnesses is acceptable. CW1's allegations that
Defendants Lawrence and Birks actually "knew what
Peter was doing" and "consented to his actions," and that
"no one trusted [Maloney]" are far too vague. (Compl. P
45). The same goes for CW2's allegations that "certain
orders during [the first and second [*37] quarters of
FY2001] had been shipped to customers, never paid for,
and never returned." Id. at P 73. But the places where the
complaint suffers for vagueness are counterbalanced by
detailed allegations elsewhere. The Court is persuaded
that on the whole, Plaintiffs have provided sufficient
detail as to the job descriptions and responsibilities of
their confidential sources, and the ways in which they
came to know the information pleaded in Plaintiffs' complaint. The fact that they are not named, while not ideal,
does not prove fatal to Plaintiffs' complaint.
2. The Allegedly Misleading Statements n2
n2 The Court notes that while the hard numbers falsely reported in press releases announcing
financial results and corresponding SEC filings
are actionable, the vast majority of the statements
made by the individual defendants to the media
are not. Reasonable investors do not take heed of
puffery when making investment decisions. In re
Northpoint, 184 F. Supp. 2d at 1005 (citing Raab
v. General Physics Corp., 4 F.3d 286, 288-90
(4th Cir. 1990)).
[*38]
a. SEC Filings/Press Releases Announcing Financial
Results
Plaintiffs argue that a series of SEC filings and press
releases announcing financial results were false when
made, and were made with the intent to deceive or with a
deliberately reckless regard for the truth. They attempt to
show scienter with a variety of corroborating circumstantial evidence, the sufficiency of which the Court will
presently address.
1) GAAP violations
Plaintiffs claim that in their zeal to prop up Adaptive's financial health, Defendants deliberately failed to
follow the SEC's admonition that financial statements
filed with the SEC which are not prepared in compliance
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with GAAP are presumed to be misleading and inaccurate. 17 C.F.R. § 210.4-01(a)(1) ("SEC Reg. S-X"). According to Plaintiffs, a failure to follow GAAP demonstrates deliberate recklessness in reporting financial results, and thus, scienter. Defendants disagree.
While it is true that conclusory allegations of GAAP
violations standing alone cannot be used to prove intentional or reckless misconduct, if pled in detail and read in
context, GAAP violations may support an inference of
scienter. In re McKesson, 126 F. Supp. 2d at 1273 [*39]
("After all, books do not cook themselves."); In re Cylink
Sec. Litig., 178 F. Supp. 2d 1077, 1082 (N.D. Cal. 2001);
compare In re Northpoint, 184 F. Supp. 2d at 998 (finding GAAP violations alone to be insufficient proof of
scienter).
GAAP violations are particularly credible evidence
where a plaintiff provides specific amounts by which
revenue was overstated, dates of transactions and/or the
identities of the customers or company employees involved. In re McKesson, 126 F. Supp. 2d at 1273; compare In re Vantive, 283 F.3d 1079, 2002 U.S. App. LEXIS
4231, 2002 WL 398498 at *7 (finding an allegation of
revenue overstatement insufficient where the amount of
overstatement was not specified). Such information is
adequately supplied here. The Broadband Now transaction in and of itself is specific as to amount ($ 4 million),
approximate date (June 2000 Quarter) and customer. In
addition, Plaintiffs provide specific evidence that there
was an internal debate at Adaptive as to whether to override internal policies and GAAP restrictions and book the
transaction. Plaintiffs also provide specific detail as to
the TESSCO and Cybertech transactions, both recorded
in the [*40] June 2000 Quarter.
The Court finds similarly sufficient detail in Plaintiffs' description of the September 2000 Quarter Fuzion
deal for $ 13 million. There is detailed evidence to suggest the customer, amount and approximate date of the
Fuzion transaction, which was booked despite Fuzion's
faulty credit status and the questionable arrangement to
"ship" the order to Adaptive's own warehouse. See In re
Secure Computing Corp. Sec. Litig., 184 F. Supp. 2d
980, 988-89 (N.D. Cal. 2001) ("Secure II")(finding allegations about a scheme to warehouse unfinished products
for which the government would not accept delivery and
treating it as delivered for accounting purposes to support a strong inference of deliberate recklessness under
the PSLRA); compare In re Guess?, Inc. Sec. Litig., 174
F. Supp. 2d 1067, 1077 (C.D. Cal. 2001) (failing to find
sufficient evidence of scienter allegations that did not
amount to anything as "egregious and the booking of
entirely contingent contracts as sales, followed by hiding
the side letters that established the contingencies").
Defendants' suggestion that these transactions might
somehow have been mismanagement, overconfidence
[*41] or "growing pains" is best raised on a motion for
summary judgment or at trial. At this stage in the litigation, by corroborating GAAP violations with detailed
evidence of the contemporaneous decision-making behind the accounting errors, Plaintiffs have set forth sufficient circumstantial evidence that the statements released
to the SEC and the investing public were known to be
false at the time they were made. Ronconi, 253 F.3d at
432 (holding that allegations of deliberate recklessness
must be supported by "contemporaneous statements or
conditions" of knowing falsity). Defendant Maloney's
actions alone -- ignoring basic accounting principles and
refusing to heed warnings from the accounting department about the propriety of his actions in overriding
company policy -- are sufficient to suggest that he knew
what he was doing would lead to falsified financial results.
2) Financial Restatements
Plaintiffs allege that the fact that financials had to be
restated at all supports an inference that they were knowingly false when made. Again, Defendants disagree, citing In re Comshare, Inc. Sec. Litig., 183 F.3d 542, 55354 (6th Cir. 1999).
While it [*42] is true that a one-time restatement,
without more, probably does not create the necessary
strong inference of scienter, In re Northpoint, 184 F.
Supp. 2d at 1003, there is at least one case from the
Northern District of California supporting Plaintiffs' position. In In re Cylink, the Court noted that "the mere fact
that the statements were restated at all supports . . . an
inference [of scienter]." 178 F. Supp. 2d at 1084. Given
the fact that Adaptive was forced to announce restatements at least twice - once on March 15, 2001 and again
on July 5, 2001 - the Court finds that while they would
be insufficient to support a scienter inference on their
own, when coupled with the strong evidence of deliberately reckless accounting, these restatements shore up
and place in context the allegations of fraud.
3) Corporate Reshuffling
As Adaptive's financial difficulties were coming to
light, three of the named individual defendants either left
the company or were moved to new positions. On January 11, 2001 Defendants Lawrence and Birks resigned.
In April 2001, Adaptive Defendant Maloney was replaced as CFO and reassigned. In addition, in May 2001,
severance [*43] payments to Defendants Lawrence and
Birks were suspended. Plaintiffs suggest that these
changes provide further support for an inference of scienter.
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As with the restatement of Adaptive's financials,
these changes, taken alone, would not support scienter.
But because the changes occurred as Adaptive's financials were being restated and as Adaptive was conducting its own internal investigation (which resulted in a
determination that the extension of credit to certain customers was unsupportable), they add one more piece to
the scienter puzzle. This comports with In re McKesson,
where the court inferred that the corporation had a factual basis for firing employees for cause because they
"knew or should have known" of accounting improprieties. 126 F. Supp. 2d at 1274. While Adaptive's actions
do not rise to such a level in this case (no one was publicly fired), the fact that the CFO was moved and former
executives' severance payments were discontinued is
highly suspicious, especially given the additional allegations in the Complaint.
argument about the use of internal reports as it relates to
scienter is therefore unavailing.
5) Motive/Stock sales
Finally, Defendants argue that Plaintiffs' complaint
is fatally flawed in that it fails to allege that any of the
Individual Defendants made any stock sales during the
class period. n3 The Court interprets Defendants' argument to mean that the Complaint fails to demonstrate a
motive for the alleged fraud.
n3 Defendants have requested that the Court
take judicial notice of the fact that Defendant
Scharre's purchased 10,000 shares of Adaptive
stock between January 30, 2001 and February 5,
2001. (Defs. Req. for Judicial Notice, Ex. C).
Plaintiffs oppose the request because the issue of
stock sales was not raised in their Complaint. In
the alternative, Plaintiffs argue that Defendant
Scharre's purchase only supports their theory; he
wanted more shares so that he could sell more
shares post-merger. Because the Court denies the
Request for Judicial Notice, see section IV C, infra, neither argument will be addressed in this
Order.
4) Internal Reports
Defendants take issue with Plaintiffs' reference to internal BBB Reports to support a scienter inference, because [*44] while named, their contents are not alleged
in sufficient detail. Plaintiffs counter that the details in
their Complaint are sufficient; they allege that CW2
drafted some of them (BBB) and that the Fuzion order
was specifically left out of at least one of them. Plaintiffs
also claim that the existence of the BBB reports is corroborated by their witnesses.
Defendants are correct that In re Silicon Graphics
explicitly rejected a plaintiff's attempt to ground scienter
on general, uncorroborated allegations that defendants
had received internal reports. 183 F.3d at 984, 985, 988.
To overcome In re Silicon Graphic's proscription against
vague references to a defendant's access to internal reports, details such as dates and contents of the reports in
question are required. In re Vantive, 283 F.3d 1079, 2002
U.S. App. LEXIS 4231, 2002 WL 398498 at *5.
Plaintiffs actually make few if any references to
company internal reports; their complaint rests on details
wholly unrelated to what company executives were seeing or should have been seeing in internal memoranda.
Unlike those cases in which scienter failed because it
could not be shown that executives should have known
something because they [*45] had access to internal
documents detailing failing company prospects, this case
rests on other evidence, most notably, witness reports
that Defendants were deliberately violating accounting
rules with side agreements and insupportable credit extensions. Indeed, the premise of Plaintiffs' theory of the
case is that Defendants perpetrated a scheme more notable for what was not in the BBB reports generated from
Adaptive's general ledger. In other words, it would not
even matter what the internal documents said, because
according to Plaintiffs, they were doctored. Defendants'
[*46]
Plaintiffs counter that Defendants sought to profit
personally from the proposed Western Multiplex merger
because their stock holdings, if sold to an acquiring
company, were collectively worth $ 14 million. Plaintiffs
hypothesize that a merger with Western Multiplex would
have allowed Defendants to sell all of their stock to the
acquiring company without raising suspicion of insider
trading.
Defendants dismiss this argument as boilerplate and
conclusory. They argue that in addition to Plaintiffs' failure to make it in the original complaint, if this argument
were persuasive, every potential merger would create an
inference of scienter. Moreover, Defendants contend that
the stock they were holding after the merger would have
been devalued once the financials were restated. In support, Defendants cite Florida State Bd. of Admin. v.
Green Tree Fin. Corp, 270 F.3d 645 (8th Cir. 2001), for
the proposition that a motive to overstate revenue to
make a company more attractive to potential buyers is
"too thin a reed on which to hang an inference of scienter
. . .." Id. at 664; see also In re McKesson, 126 F. Supp.
2d at 1274 n. 14 (recognizing [*47] that incentive compensation has been consistently rejected as a motive for
fraud, for if this was enough it "would effectively eliminate the state of mind requirement as to all corporate
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officers and defendants" (quoting Melder v. Morris, 27
F.3d 1097, 1102 (5th Cir. 1994)).
It is true that insider trading, if contemporaneous
with knowingly false statements, tends to directly support the inference that a defendant knew that a statement
she made was false at the time she made it. Ronconi, 253
F.3d at 434. But other motive evidence, while not as
persuasive, is not necessarily unpersuasive if coupled
with other allegations of fraud. See, e.g., Howard v.
Everex Sys., Inc., 228 F.3d 1057, 1064 (9th Cir. 2000)
(holding on summary judgment that a desire to raise
company financing combined with other "red-flags" of a
company's financial condition can be probative of a motive to defraud investors); In re Imperial Credit Indus.
Sec. Litig., 2000 U.S. Dist. LEXIS 2340, No. CV 98-8842
SVW, 2000 WL 1049320, at *3 (C.D. Cal. Feb. 22,
2000) (finding allegations of motive to attract a buyer
"before the company fell apart entirely," while not sufficient to support an inference [*48] of scienter on their
own, "still probative to the inquiry").
The $ 645 million merger agreement would have
made Defendants Lawrence and Scharre members of
Western Multiplex's board of directors, and Scharre
would have become President and COO. (Compl. P 74).
The merger was called off on January 10, 2001, and a
little over six months later, Adaptive filed for bankruptcy. Id. at PP 75, 86. While these facts are not persuasive on their own, when read in light of the facts supporting the deliberately reckless accounting violations, the
Court finds that they support an inference that the individual defendants were falsifying Adaptive's revenue in
an attempt to bail the company out and save and perhaps
increase the value of their shares. In the process, many
investors, including Plaintiffs, could have also been misled.
The Court recognizes that in isolation, this evidence
would not come close to the level required to strongly
infer scienter; as Defendants note, preserving a merger
may provide "an incentive to feign success," but on its
own, a fraud case it does not make. In re Northpoint, 184
F. Supp. 2d at 1003. But under the circumstances, when
Plaintiffs relied [*49] on the misstated revenues and
purchased stock at inflated prices, the fact that Defendants did not sell their own stock matters little. In re
Nuko Info. Sys., Inc. Sec. Litig., 199 F.R.D. 338, 344-45
(N.D. Cal. 2000).
Plaintiffs are only obliged to state some set of facts
giving rise to a strong inference of deliberate recklessness. If they have done so, it is irrelevant whether another, different set of facts might have accomplished the
same thing. In re Cylink, 178 F. Supp. 2d at 1083. Therefore, given the sufficiency of the facts supporting the
deliberately reckless GAAP violations, it makes no dif-
ference that there were no stock sales, or that the Complaint only alludes to internal company reports. These
additional facts provide a backdrop for a portrait of
fraud, painted in sufficient detail to satisfy the Court that
the case is not one of the "fishing expeditions" the
PSLRA was designed to discourage. At this stage, taken
as true, Plaintiffs' pleadings are sufficient to suggest
egregious GAAP violations in necessary detail to support
a scienter inference, and therefore a violation of federal
securities laws.
In sum, the Court finds that the [*50] statements
made about Adaptive's revenue and loss in the June, September and December 2000 Quarters may very well have
been made with a deliberately reckless regard for the
truth. The Complaint provides specific details about a
scheme to overinflate revenue in clear violation of internal policy and federal guidelines. Coupled with a formal
admission that the revenues were overstated in the form
of financial restatements filed with the SEC, public admonition of those involved and the results of Adaptive's
own internal investigation, Plaintiffs have provided sufficient evidence to survive a motion to dismiss.
3. Allegations as to Each Individual Participant
Aside from proving whether the statements themselves were made with the requisite scienter, Plaintiffs
must also satisfy the Court that it can prove who is liable
for making them. Plaintiffs claim Section 10(b) violations against Adaptive and Defendants Lawrence, Birks,
Scharre and Maloney. In addition to arguing that Plaintiffs have failed to allege scienter generally, Defendants
also argue that Plaintiffs have failed to allege scienter
separately as to each of these individual defendants.
As an initial matter, the Court is [*51] convinced
that the allegations pertaining to Defendant Maloney are
specific enough to infer that he acted at least with deliberate recklessness. Plaintiffs allege that he overrode internal revenue recognition policies and refused to reverse
his decision even after being confronted by accounting
staff. (Compl. P 47.) In response, CW1 and another accounting department staffer jokingly gave Defendant
Maloney a "get-out-of-jail free" card in recognition that
he had acted inappropriately. Id. Defendant Maloney is
also alleged to have overridden an internal policy that
orders could not be shipped to Adaptive's own warehouse without a written lease agreement. Id. at P 59.
Again, Defendant Maloney was confronted with the policy and ignored it. Together these allegations are detailed
enough to pinpoint an inference of scienter as to Defendant Maloney.
As to Defendants Lawrence, Birks and Scharre,
Plaintiffs' allegations amount to a series of suggestions
that they "knew" about events, devised the fraudulent
schemes, or spoke publicly about revenue figures they
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knew were false. Plaintiffs rely on the group publication
doctrine and the core operations inference to support
their allegations [*52] of securities fraud against all individual defendants, but as the Court has already determined that the specific allegations as to Defendant Maloney stand on their own, it will only address the doctrine's application to the remaining three: Lawrence,
Birks and Scharre.
a. Group Published Information Doctrine
Defendants take issue with Plaintiffs' reliance on
group published information doctrine, which Defendants
argue has not survived the passage of the PSLRA. The
doctrine, described in Wool v. Tandem Computers, Inc.,
818 F.2d 1433 (9th Cir. 1987), states that a defendant's
participation in securities fraud can be shown by reference to that defendant's position, since false statements
are the collective acts of officers:
In cases of corporate fraud where the false
and misleading information is conveyed
in prospectuses, registration statements,
annual reports, press releases or other
"group-published information," it is reasonable to presume that these are the collective actions of the officers. Under such
circumstances, a plaintiff fulfills the particularity requirement of Rule 9(b) by
pleading the misrepresentations with particularity and where possible [*53] the
roles of the individual defendants in the
misrepresentations.
[Oil, Chemical & Atomic Workers, etc., Local No. 4-228
v. Union Oil Co.], 818 F.2d 437, 440; see also In re
Glenfed Inc. Sec. Litig., 60 F.3d 591, 593 (9th Cir. 1995)
(citing Wool with approval).
Both Wool and In re Glenfed were decided before
the enactment of the PSLRA. According to Defendants,
the PSLRA now requires that falsity and scienter be pled
as to each defendant. 15 U.S.C. § § 78u-4(b)(1)-(2). Defendants acknowledge that the Ninth Circuit has yet to
tackle head-on whether the group published information
doctrine survives the PSLRA, but claim that it is clear
that "its historical underpinnings have been destroyed."
(Mem. P&A's in Supp. of Defs.' Mot. to Dis., 11:21-22.)
Plaintiffs cite numerous cases from the Ninth Circuit
affirming the viability of the group publication doctrine
even after the passage of the PLSRA. See, e.g., In re
Guess?, 174 F. Supp. 2d at 1079-80 (recognizing the
viability of the doctrine); In re Secure Computing Corp.
Sec. Litig., 120 F. Supp. 2d 810, 821-22 (N.D. Cal. 2000)
("Secure I") (collecting Ninth Circuit cases recognizing
the doctrine). The [*54] Court agrees that the doctrine
has not been specifically abrogated, and is still good law
in this Circuit.
In this case, Plaintiffs rely on statements published
in press releases and SEC filings, both of which are subject to the group publication doctrine. Wool, 818 F.2d at
1440. Defendants Lawrence, Birks and Scharre signed
the August 2000 10-K SEC report, which Plaintiffs allege reported knowingly false revenue results for the
June 2000 Quarter. The same three Defendants were
quoted in the October 2000 release announcing Adaptive's September 2000 Quarter financial results, which
Plaintiffs allege falsely overstated revenue by nearly 981
percent. (Compl. PP 38, 66-67, 70.) n4 Under the group
publication doctrine, the statements are presumed to be
the collective acts of Adaptive's officers. At the time of
the August 2000 release, Defendant Lawrence was the
CEO and Chairman of the Board, Defendant Birks was
the CFO and Defendant Scharre was the President and
COO of Adaptive. These were not just officers of the
company, they were the highest ranking officers, and the
Court has no trouble inferring that the press releases and
SEC filings that contain the false statements [*55] were
issued with their blessing.
n4 In the alternative, Plaintiffs rely on the
core operations inference, which states that if a
proper factual foundation is laid, "it may be inferred that facts critical to a business's core operations or an important transaction are known to a
company's key officers." In re Northpoint, 184 F.
Supp. 2d at 998. This requires a minimal showing
that the critical facts were "actually known within
the company." Id. Plaintiffs allege that Adaptive
consciously focused its efforts on their ABAccess products, and that the importance of this
niche supports the inference that the corporate officers would have been well aware of important
transactions relating to it, including the Fuzion
and Broadband Now deals. (Compl. PP 18, 25,
27, 39, 53, 67). Because the Court finds the group
publication doctrine applicable to this case, it
need not address Plaintiffs' core operations inference.
The Court's conclusion is supported by the Ninth
Circuit's recognition in Howard [*56] that when corporate officers sign documents, they attest to their accuracy. 228 F.3d at 1061 ("When a corporate officer signs
a document on behalf of the corporation, that signature
will be rendered meaningless unless the officer believes
that the statements in the document are true."). While it
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is true that a plaintiff cannot make general references to a
defendant's attendance at a meeting or her "hands-on"
managerial style in an attempt to prove scienter, In re
Vantive, 283 F.3d 1079, 2002 U.S. App. LEXIS 4231,
2002 WL 398498 at *4, it is a different matter when an
officer signs a document. In the latter case, the officer is
effectively making a statement herself.
Here, Plaintiffs allege that the FY00 Form 10-K was
signed by Defendants Lawrence, Birks and Scharre and
that the Form 10-Q Report of September 2000 Quarter
results was signed by Birks. By signing the forms, which
are alleged to contain a deliberately reckless and false
report of FY2000 revenue, these Defendants have themselves become liable for securities fraud.
B. Control Person Liability: Section 20(a)
wrongful conduct or exercised actual power to be derivatively liable under section 20(a).")
The Court finds that the allegations that the Individual Defendants held the highest offices in the corporation, spoke frequently on its behalf, and made key decisions in how to present its financial results are sufficient
[*59] to survive Defendants' contention that the Complaint lacks specificity as to control person liability.
Later in the proceedings, when and if Plaintiffs present
evidence of such control, Defendants will have the opportunity to assert a good faith defense of lack of participation. Howard, 228 F.3d at 1065; In re Cylink, 178 F.
Supp. 2d at 1089. Defendants' Motion to Dismiss the
control person liability claims against Defendants Birks,
Maloney, Scharre and Lawrence is therefore denied. n5
Plaintiffs hold the individual defendants responsible
for the alleged fraud as control persons under Section
20(a) [*57] of the 1934 Act. The 1934 Act defines a
control person as someone "who, directly or indirectly,
controls any person liable under any provision of this
chapter or of any rule or regulation thereunder . . .." 15
U.S.C. § 78t(a). Such a person "shall also be liable
jointly and severally with and to the same extent as such
controlled person to any person to whom such controlled
person is liable, unless the controlling person acted in
good faith and did not directly or indirectly induce the
act or acts constituting the violation or cause of action."
Id.
To successfully plead control person liability, Plaintiffs must show a primary violation of the federal securities laws and that each defendant "directly or indirectly"
controlled the violator. Paracor Fin., Inc. v. General
Elec. Capital, 96 F.3d 1151, 1161 (9th Cir. 1996); Hollinger v. Titan Capital. Corp, 914 F.2d 1564, 1575 (9th
Cir. 1990). According to Defendants, Plaintiffs have not
pled control person liability with particularity. Defendants contend that Plaintiffs must allege specific facts to
support each defendant's control over the transaction or
activity that gave rise [*58] to the primary violation.
According to Plaintiffs, the fact that the named individual defendants held important positions in the company is sufficient at the pleadings stage. The Court
agrees. While it is true that the identification of a control
person is "intensely factual," it is also true that a control
person need not be a "culpable participant" in the alleged
fraud. Howard, 228 F.3d at 1065 (citing Hollinger, 914
F.2d at 1575; Paracor, 96 F.3d at 1161). Indeed, at least
one court has determined that allegations that individual
defendants, by virtue of their executive and managerial
positions, could control and influence the company and
did so, are sufficient at the pleadings stage. In re Cylink,
178 F. Supp. 2d at 1089 ("Plaintiffs need not allege that
the individual defendants actually participated in the
n5 As an aside, the Court notes that the Second Claim for Relief in Plaintiffs' Complaint alleges that the individual defendants are liable under Section 20(a) only for their control over
Adaptive, not for their liability for their collective
acts as corporate executives; that is, for their control over each other. The fact that the case is
stayed against Adaptive's pending bankruptcy
may be problematic, since Plaintiffs cannot prove
that Adaptive has committed a primary violation
of federal securities laws until the stay is lifted.
As noted, the establishment of a primary violation is a threshold inquiry in determining control
person liability. Howard, 228 F.3d at 1065. The
parties do not address this in their papers, but the
Court assumes that since the individual defendants themselves are named as Section 10(b) violators, the above analysis applies. According to
the 1934 Act, joint and several liability can be
imposed upon anyone who "controls any person
liable under any provision" of the Act. 15 U.S.C.
§ 78t(a).
[*60]
C. Judicial Notice
Defendants request that the Court take judicial notice of the following documents: 1) Adaptive's Form 10K for the transition period July 1, 2000 to December 31,
2000 filed with the SEC on July 5, 2001 attached to the
Request at Exhibit A; 2) Adaptive's Schedule 14A, Proxy
Statement filed with the SEC on October 2, 2000 attached as Exhibit B to their Request; 3) Two statements
of Changes in Beneficial Ownership ("Form 4s") filed on
behalf of Defendant Scharre with the SEC on February 7,
2001 and March 9, 2001, reflecting Defendant Scharre's
purchases of Adaptive stock, attached as Exhibit C to the
Request. Plaintiffs oppose the Request, arguing that judi-
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cial notice of the truth of documents referred to in a
complaint is not allowed.
Federal Rule of Evidence 201(b) requires a party requesting judicial notice to show that the fact in question
not be subject to reasonable dispute because it is "generally known in the community" or "capable of ready determination by resort to sources whose accuracy cannot
reasonably be questioned." Fed. R. Evid. 201(b). In ruling on a motion to dismiss, a district court may consider
a document, including an SEC filing, if [*61] the plaintiff relies upon it in her complaint and its authenticity is
not questioned. Parrino, 146 F.3d at 705-06; Ronconi,
253 F.3d at 427; In re Silicon Graphics, 970 F. Supp.
746, 751-52 (N.D. Cal. 1997) (noting that the document
must be "referenced in plaintiff's complaint" and "'central' to plaintiff's claim"). Importantly, if facts contained
in a document are disputed, a court may only consider
the document for the limited purpose of recognizing the
fact that the document exists. Lee v. City of LA, 250 F.3d
668, 688-90 (9th Cir. 2001).
Plaintiffs properly concede that the Form 10-K attached as Exhibit A was referenced in the Complaint.
The Court therefore takes judicial notice the fact that the
statements therein were made, but does not take judicial
notice of their truth. Lee, 250 F.3d at 690.
As to Exhibits B and C, Plaintiffs argue they are not
subject to judicial notice at all because they are not referenced or relied upon in the Complaint. According to
Plaintiffs, judicially noticing these documents would
improperly convert the motion to dismiss into a motion
for summary judgment. Branch v. Tunnell, 14 F.3d 449,
454 (9th Cir. 1994). [*62]
Defendants allege that Plaintiffs must have relied on
the Proxy Statement in Exhibit B in order to come up
with the Defendants' exact stock holdings. As far as the
Court can tell, however, Defendants were the first to
mention this number in their Motion to Dismiss. See
Mem. P&A in Supp. of Defs.' Mot. to Dis., 17:15. The
Court cannot see any other relevance for it, thus it will
not be judicially noticed or incorporated by reference
into the Complaint.
As to Exhibit C, Defendant Scharre's Form 4s, Defendants say that as an SEC filing, under In re Silicon
Graphics, it is indisputable that it can be judicially noticed. Defendants allege, moreover, that Plaintiffs necessarily relied on it in their Complaint when they put forth
their theory about Adaptive's motive to inflate the stock
price.
The Court disagrees that there is no dispute as to
whether the Form 4s can be judicially noticed. If the parties dispute its authenticity or the form is not referenced
in a plaintiff's complaint, it will not be noticed. Here,
there is no dispute that Defendant Scharre sold stock, and
the document was filed publicly. But Plaintiffs never
refer to stock sales by any defendant in their Complaint.
[*63] Plaintiffs only raised their theory about motive in
response to Defendants' Motion to Dismiss, which explicitly referred to a lack of stock sales. Therefore, the
Court declines to take judicial notice of the Form 4S.
V. CONCLUSION
For the above-mentioned reasons, Defendants' Motion to Dismiss is hereby DENIED. Defendants' Request
for Judicial Notice is GRANTED as to Exhibit A, and
DENIED as to Exhibits B and C. The parties shall appear
for a status conference on Friday, April 12, 2002 at 10:00
a.m. in Courtroom 1, San Francisco Division. The parties
shall file one joint statement seven days prior to the
status conference.
IT IS SO ORDERED.
Dated: April 2, 2002
Samuel Conti
UNITED STATES DISTRICT JUDGE
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(Cite as: Not Reported in F.Supp.2d)
Briefs and Other Related Documents
Allison v. Brooktree Corp.S.D.Cal.,1998.Only the
Westlaw citation is currently available.
United States District Court,S.D. California.
Murray ALLISON et al., On Behalf of Themselves
and All Others Similarly Situated, Plaintiffs,
v.
BROOKTREE CORPORATION, James A. Bixby,
Jerry E. Canning, Stewart Kelly, Robert W.
Zabaronick, David C. Gelvin, and Edward P.
Holtaway, Defendants.
No. 97-CV-0852TW (POR).
Filed May 5, 1997.
Nov. 27, 1998.
William S Lerach, Milberg WeissBershad Hynes and
Lerach, San Diego, CA, for Murray Allison, On
Behalf of Himself and all others similarly situated,
plaintiff.
William S Lerach, (See above), for Isabel Sperber,
On Behalf of Herself and All Others Similarly
Situated, plaintiff.
Christopher Harold McGrath, Brobeck Phleger and
Harrison, San Diego, CA, for Brooktree Corporation,
defendant.
Christopher Harold McGrath, (See above), for James
A Bixby, defendant.
Christopher Harold McGrath, (See above), for Jerry
E Canning, defendant.
Christopher Harold McGrath, (See above), for David
C Gelvin, defendant.
ORDER GRANTING DEFENDANTS' MOTION
TO DISMISS; GRANTING LEAVE TO
AMENDED SECOND AMENDED COMPLAINT.
WHELAN, J.
INTRODUCTION
*1 By order dated March 10, 1998, plaintiffs' initial
complaint was dismissed with leave to amend under
Rule 12(b)(6). Allison v. Brooktree Corp., 999
F.Supp. 1342 (S.D.Cal.1998). Specifically, the court
found that the complaint did not plead securities
fraud with the particularity required by Section
21D(b)(3) of the Securities Exchange Act of 1934.
This case was subsequently transferred from the
Honorable Jeffrey T. Miller to this court.
Page 1
Now before the court are the plaintiffs' first amended
complaint (“FAC”) and a new motion to dismiss. For
the reasons set forth below, defendants' motion to
dismiss is GRANTED with leave to amend.
FACTS
The facts set forth in the following paragraphs were
derived from Judge Miller's earlier order. See Allison,
999 F.Supp at 1345-1346.
Brooktree is a San Diego based high technology
company that designs, develops, and markets high
performance integrated circuits for use with graphics,
imaging,
communications,
and
multimedia
applications. This class action was brought on behalf
of all purchasers of Brooktree common stock
between February 13, 1995 and February 7, 1996 (the
“class period”).FN1
FN1. Brooktree was publicly traded during
the class period.
The essence of the complaint is that the defendants
made materially false and misleading statements
concerning Brooktree's primary product, the BvT
multimedia chipset. These statements, plaintiffs
allege, indicated that the BvT chipset was
technologically superior to competing products, was
enthusiastically received in the marketplace, was
being incorporated into PC products by several
manufacturers, and would provide strong revenue and
earnings growth for fiscal year 1996 ending
September 30, 1996. FAC ¶ 1.
The amended complaint contends that several
statements in Brooktree's press releases, securities
analyst reports, media interviews with James Bixby
(Brooktree's CEO), and computer industry newspaper
articles were false and misleading in violation of
Section 10(b) of the Securities Exchange Act of
1934, 15 U.S.C. §
78j(b), and Rule 10b-5
promulgated thereunder. 17 C.F.R. § 240.10b-5. A
sampling of the statements include:
(1) On February 13, 1995, at a securities analyst
conference, David Russian, Brooktree's CFO, stated
that revenues would be flat until shipment of the BtV
chipset in the fall and that the company had “received
© 2006 Thomson/West. No Claim to Orig. U.S. Govt. Works.
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strong interest in .. recent trade shows.” FAC ¶ 55.
(2) In a newspaper article on March 9, 1995,
Defendant Bixby stated, “I think we're on the right
track,” and “if we're successful we may get 20
percent” of the multimedia market. FAC ¶ 56.
(3) In a March 14, 1995 securities report, a securities
analyst stated that “Brooktree appears to be offering a
superior product ... even a modest market penetration
rate could have a substantial impact on the company's
financial results.” FAC ¶ 57.
(4) On June 5, 1995 PC Week magazine reported that
Brooktree was “signing up numerous customers” for
its multimedia chipset and that volume shipments of
the chipset were expected for the fourth quarter. FAC
¶ 63.
*2 (5) In a July 28, 1995 interview, Defendant Bixby
stated that Brooktree's “biggest investment” was
about to bear fruit, that several computer
manufacturers had “announced” that they will be
using the chipset, and that Brooktree had “high
expectations” for future growth and that its chipset
would have 3-D capabilities in 1996. FAC ¶ 68.
(6) In late August 1995, defendant Bixby informed
securities analysts that the company expected a
strong ramp up in sales and that it forecast revenues
from multimedia products in fiscal 1996 of $50-$80
million. FAC ¶ 70.
(7) On September 11, 1995, Brooktree issued a press
release stating that “more than a dozen leading PC
system and add-in card vendors” had announced
plans to adopt the BvT chipset in upcoming products.
FAC ¶ 71.
(8) In late October 1995, Defendants Bixby and
Canning allegedly told securities analysts that six
companies had placed orders for the BtV chipset, that
sales of multimedia products could reach $28 million
per quarter by 1996, and that the chipset had a bright
future. FAC ¶ 75.
(9) In a December 4, 1995 newspaper article
Defendant Bixby stated that, after only one quarter,
the BtV chipset has had “strong sales.” FAC ¶ 81.
(10) On February 7, 1996 Brooktree disclosed that its
revenues would suffer for the second quarter of 1996
due to poor sales of its BvT chipset. FAC ¶ 86.
Plaintiffs allege that at the time the statements were
made, defendants knew:(1) that the BtV chipset
lacked compatible software drivers for numerous
operating systems and configurations, that the
product suffered numerous compatibility problems,
that the product was difficult to install and support
add-in cards and software drivers, that the BtV
chipset could not be readily uninstalled, and that
Brooktree prematurely released the product. FAC ¶ ¶
69(b), 69(e).
Page 2
(2) that Brooktree's BtV chipset had only 2D
capabilities even though 3D capabilities were rapidly
becoming essential to success in the multimedia
market. FAC ¶ 69(g).
(3) that the few orders Brooktree had received for the
BvT chipset were “evaluation orders” from secondtier, little known computer companies and that only
one computer company had ever indicated a
willingness to purchase the product in volume. FAC ¶
¶ 82(m), 82(n).
(4) that Brooktree's forecasts for strong sales of the
BvT chipset had no basis given the product's
technological and compatibility problems described
throughout the complaint. FAC ¶ 82(s).
Plaintiffs allege defendants issued thousands of new
stock options to themselves which would vest
immediately upon sale of the company. FAC ¶ 6. To
make the Brooktree appear more attractive to a
potential acquiring company and to inflate the value
of their stock options, defendants allegedly deceived
the investing public about the capabilities for, and
prospects of, Brooktree's BvT chipset product. FAC ¶
7. Plaintiffs contend this fraudulent scheme was
complete when, six months after the end of the class
period, Rockwell announced that it had agreed to
purchase Brooktree for $15 per share and the
defendants profited $11 million from the proceeds of
their stock options.
DISCUSSION
I. Legal Standards
a. Rule 12(b)(6) Motion to Dismiss
*3 A claim should not be dismissed under Rule
12(b)(6) unless it is certain that the law would not
permit the requested relief even if all factual
allegations in the complaint are true. Durning v. First
Boston Corp., 815 F.2d 1265, 1267 (9th Cir.1987);
Mountain High Knitting, Inc. v. Reno, 51 F.3d 216,
218 (9th Cir.1995) (“it must appear beyond doubt
that the plaintiffs [can] prove no set of facts which
would entitle them to relief on their claims”). “We
must accept as true the allegations in the complaint
and decide only whether a plaintiff has advanced
potentially viable claims.” Jacobson v. Hughes
Aircraft Co., 105 F.3d 1288, 1292 (9th Cir.1997).
However, “[c]onclusory allegations of law and
unwarranted inferences are insufficient to defeat a
motion to dismiss for failure to state a claim.” In re
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Verifone Sec. Litig., 11 F.3d 865, 868 (9th Cir.1993).
b. Rule 9(b) and the Particularity Requirement
Federal Rule 9(b) provides that “[i]n all averments of
fraud or mistake, the circumstances constituting fraud
or mistake shall be stated with particularity.”
Fed.R.Civ.P. 9(b). This requires the complaint to
“specify such facts as the times, dates, places,
benefits received, and other details of the alleged
fraudulent activity.” Neubronner v. Milken, 6 F.3d
666, 671 (9th Cir.1993); Warshaw v. Xoma Corp., 74
F.3d 955, 960 (9th Cir.1996) (“a plaintiff must plead
evidentiary facts that support inferences sufficient to
meet the specificity requirements of Rule 9(b)”).
Rule 9(b) applies to any claim that “sounds in fraud,”
including private actions arising under Section 10(b)
and Rule 10b-5. In re GlenFed, Inc. Sec. Litig., 42
F.3d 1541, 1545 (9th Cir.1994); In re Stac
Electronics Sec. Litig., 89 F.3d 1399, 1404 (9th
Cir.1996).
The particularity requirement serves four central
purposes: it (1) “prevents the filing of a complaint as
a pretext for the discovery of unknown wrongs;” (2)
“ensures that allegations of fraud are specific enough
to give defendants notice of the particular misconduct
.. so that they can defend against the charge and not
just deny that they have done anything wrong;” (3)
“protects
potential
defendants-especially
professionals whose reputations in their fields of
expertise are most sensitive to slander-from the harm
that comes from being charged with the commission
of fraudulent acts;” and it (4) “prohibit[s] a plaintiff
from unilaterally imposing upon the court, the parties
and society enormous social and economic costs
absent some factual basis .” Semegen v. Weidner,
780 F.2d 727, 731 (9th Cir.1985).
In this Circuit, Rule 9(b) requires the complaint to
“specify such facts as the times, dates, places,
benefits received, and other details of the alleged
fraudulent activity.” Neubronner v. Milken, 6 F.3d
666, 671 (9th Cir.1993); Warshaw v. Xoma Corp., 74
F.3d 955, 960 (9th Cir.1996) (“a plaintiff must plead
evidentiary facts that support inferences sufficient to
meet the specificity requirements of Rule 9(b)”).
However, “time, place and content allegations, while
necessary, are insufficient by themselves to state a
claim for fraud.” In re Stac Elecs. Sec. Litig., 89 F.3d
1399, 1404 (9th Cir.1996), cert. denied sub. nom, 117
S.Ct. 1105 (1997) (citing In re GlenFed Sec. Litig, 42
F.3d 1541, 1547-1548 (9th Cir.1994) (en banc)).
“The plaintiff must set forth what is false or
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misleading about a statement, and why it is false. In
other words, the plaintiff must set forth an
explanation as to why the statement or omission
complained of was false or misleading.” Id. (quoting
GlenFed, 42 F.3d at 1548). “This can be done most
directly by pointing to inconsistent contemporaneous
statements or information .. which were made by or
available to the defendants.” GlenFed, 42 F.3d at
1549. Thus, the statement must be shown to have
been false or misleading when made. Id.
*4 Rule 9(b) also requires fraud to be pled with
particularity as to each defendant. In re Worlds of
Wonder Sec. Litig., 694 F.Supp. 1427, 1433
(N.D.Cal.1988) (“[e]ach defendant is entitled to
know what misrepresentations are attributable to
them and what fraudulent conduct they are charged
with”).
c. Forward-Looking Statements and the PSLRA
When a defendant's liability is based on a “forwardlooking” statement, the Private Securities Litigation
and Reform Act of 1995 (“PSLRA”) requires
plaintiff to allege specific facts giving rise to a
“strong inference” that the defendant had “actual
knowledge” that the forward-looking statement was
false or misleading. 15 U.S.C. § 78u-5(c)(1)(B)(I);
15 U.S.C. § 78u-4(b)(2). The PSLRA defines a
“forward-looking statement” as a statement
containing (1) a projection of revenues, income, or
earnings; (2) the plans and objectives of management
for future activities; or (3) a prediction of future
economic performance. 15 U.S.C. § 78u-5(I)(1).
II. The Allegedly False and Misleading Statements
The complaint identifies dozens of allegedly false
and misleading statements made by Brooktree and its
officers between February 1995 and January 1996.
These statements must be evaluated for conformance
with both Rule 9(b) and the PSLRA. 15 U.S.C. §
78u-4(b)(1).
Many of the statements contained in the amended
complaint also appeared the initial complaint that was
the subject of Judge Miller's order. See Allison, 999
F.Supp. at 1348-1350. This court will adopt Judge
Miller's analysis to the extent applicable.
A. Statements Made Between 2/13/95 and 4/26/95
[Paragraphs 54-61]
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Most of the other statements contained in paragraphs
55-61 of the amended complaint are essentially the
same statements contained in the initial complaint.
Like before, plaintiffs continue to allege that
defendants
allege
several
misrepresentation
concerning the BvT chipset, including: the chipset
“ha[s] received strong interest in .. recent trade
shows” (FAC ¶ 55), customer interest in the chipset
was “strong” (FAC ¶ 61), “I think we're on the right
track” and “[i]f we're successful, we may get 20
percent” (FAC ¶ 56), “Brooktree appears to be
offering a superior product” (FAC ¶ 57), the new
chipset “would be a significant driver of Brooktree's
future earnings growth” (FAC ¶ ¶ 58, 59, 61), the
chipset was “on-track” to ship in 7/95-8/95 (FAC ¶
58, 59, 60, 61), and because of all these positive
factors, “fundamentals at Brooktree have improved”
(FAC ¶ ¶ 60, 61).
Judge Miller noted that these statements occurred
when the BvT chipset was in an early design phase,
and dismissed them as “soft” projections of future
performance. The court advised the plaintiffs to
“allege temporal facts and any additional allegations
that would undermine the tentative and tentative and
vague nature of the allegedly false and misleading
statements.” Allison, 999 F.Supp. at 1347. The
plaintiffs have not done this.
*5 Plaintiffs have added two additional allegedly
false and misleading statements from Brooktree's
“Corporate Profile,” a document alleged to have been
distributed “[t]hroughout the class period.” The
profile notes that in October of 1994 Brooktree
“unveiled” the BvT chipset which was “unique in its
ability to convert multimedia data types” and
“operated under the common umbrella of a single set
of integrated software drivers.” The document also
contains
the
statement
that
“Brooktree's
semiconductor architectures have resulted in products
with improved performance, increased reliability, and
broader feature sets.” As a matter of law, these
statements are neither false nor misleading.
The statement that Brooktree first announced the BvT
chipset in October 1994 was true. See FAC ¶ 31. As
for the statements concerning the BvT chipset's
“unique ability” and its “integrated software drivers,”
the complaint does not explain why these statements
were false. Next, the court rejects plaintiffs'
suggestion that the comment about Brooktree's
“semiconductor architectures” is a “misrepresentation
of the Chipset's abilities, performance and
reliability.” Plaintiff's Opposition at 9 n. 6. The
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statement is not a description of the BvT chipset or
any other Brooktree product. It is merely the
company's routine assertion that its engineering
approach enables it to build high quality computer
products. No reasonable investor could rely on this
statement. Cf. Wenger v. Lumisys, Inc., 2 F.Supp.2d
1231, 1245 (N.D.Cal.1998) (dismissing similar
statements as nonactionable); Raab v. General
Physics Corp., 4 F.3d 286, 289-290 (4th Cir.1993).
Accordingly, the court DISMISSES WITH
PREJUDICE paragraphs 54, 55, 56, 57, 58, 59, 60,
61, and 62.FN2
FN2. Since the court dismisses these
paragraphs for failure to plead the requisite
particularity, it need not reach arguments
that the statements in these paragraphs are
protected by the PSLRA's statutory safe
harbor, 15 U.S.C. § 78u-5(c)(1)(B)(I); 15
U.S.C. § 78u-4(b)(2). In addition, the court
need not reach arguments that analyst
statements in these paragraphs lacked the
requisite adoption and entanglement.
B. Statements Made After 6/4/95 [Paragraphs 63-84]
Judge Miller previously recognized when analyzing
the initial complaint that these paragraphs contain
statements that “lack the tentative and qualified
nature of the previous statements,” and that “[t]hese
allegations comply with Rule 9(b) and the PSLRA.”
Allison, 999 F.Supp. at 1348. This court holds that
the corresponding statements in the amended
complaint comply with Rule 9(b) for the same
reason. Compliance with the PSLRA is discussed
below.
The amended complaint sets forth a number of
statements painting a rosy picture of the BvT
chipset's engineering progress and industry adoption.
See, e.g., FAC ¶ ¶ 64 (“a number of add-in board
manufacturers had decided to use the BvT chipset”);
67 (“multiple orders ha[d] been booked for shipment
of the company's [BvT] chipset during Q4”); 65
(“[f]inal engineering of the BvT chipset had been
completed”). The complaint presents these statements
along a contemporaneous factual backdrop showing
that Brooktree experienced severe compatibility and
stability problems with the chipset's driver software,
received numerous complaints from potential OEM
customers who would not buy the product until its
quality had improved, and secured a only one
company's commitment to use the chipset in quantity.
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FAC ¶ ¶ 69, 72, 82.
*6 However, many of the statements included in
these paragraphs are “forward-looking” statements
under the PSLRA. 15 U.S.C. § 78u-5(I)(1). Plaintiffs
must plead specific facts creating a strong inference
that the defendants actually knew these forwardlooking statements were false when made. 15 U.S.C.
§ 78u-5(c)(1)(B)(I); 15 U .S.C. § 78u-4(b)(2).
Plaintiffs have failed to allege sufficient facts
strongly suggesting that the defendants knew their
statements concerning Brooktree's future revenue,
FAC ¶ 61, 65, 68, 70, 75, and 80 were false when
made.
Accordingly, the court DISMISSES WITH LEAVE
TO AMEND the forward-looking statements in
paragraphs 61, 65, 68, 70, 75, and 80 and all analyst
statements derived from these statements.
C. Defendants' Liability for Statements by Securities
Analysts
Judge Miller dismissed over a dozen statements from
analysts and third-parties from the initial complaint
because the complaint failed allege that Brooktree
officials had somehow approved or controlled the
content of those statements. Defendants contend that
the third-party and analyst statements in the amended
complaint fare no better than those contained in the
initial complaint and must therefore be dismissed.
To be held liable for unreasonably disclosed thirdparty analyst statements or forecasts, “defendants
must have put their imprimatur, express or implied,”
on those statements. In re Syntex Corp. Sec. Litig., 95
F.3d 922, 934 (9th Cir.1996) (quoting In re VeriFone
Sec. Litig., 784 F.Supp. 1471, 1486 (N.D.Cal.1992),
aff'd 11 F.3d 865 (9th Cir.1993)). This requires
plaintiff to demonstrate (1) that a corporate insider
provided misleading information to a third-party (2)
who, relying on this information, prepared a report
(3) that the insider endorsed or approved. See Stack v.
Lobo, 903 F.Supp. 1361, 1372 (N.D.Cal.1995);
Allison, 999 F.Supp. at 1349.
Furthermore, plaintiff must plead these statements
with the particularity required by Rule 9(b). Syntex,
95 F.3d at 934. This requires plaintiff to (1) identify
specific forecasts and name the insider who adopted
them; (2) identify specific interactions between the
insider and the analyst which gave rise to
entanglement, and (3) state the dates of the acts
which allegedly gave rise to the entanglement
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activity. In re Syntex Corp. Sec. Litig., 855 F.Supp.
1086, 1096 (N.D.Cal.1994), aff'd 95 F.3d 922 (9th
Cir.1996). This rule exists to serves to immunize
defendants from liability for an analyst's forecasts
and predictions:
In today's complex and highly competitive financial
markets, countless analysts, investment managers,
market makers and investment banking firms issue
earnings and revenue forecasts on virtually every
publicly-traded corporation. Forecasts may vary a
great deal. If corporate insiders are held liable under
Rule 10b-5 every time one of these forecasts proves
to be incorrect, they would likely spend more time in
court than running their companies.
*7 In re Caere Corp. Sec. Litig., 837 F.Supp. 1054,
1059 (N.D.Cal.1993) (arguing the entanglement
requirement should be applied strictly).FN3
FN3. The court notes that there is conflict
among federal courts as to whether the
requirements of this rule apply when
insiders provide false and misleading
statements to analysts. Compare In re Cirrus
Logic Sec. Litig., 946 F.Supp. 1446, 1467
(N.D.Cal.1996)
(limiting
the
adoption/entanglement rule to situations
where insiders provide truthful and accurate
statements to analysts) with Stack, 903
F.Supp.
at
1372
(applying
adoption/entanglement when defendants
furnished false and misleading statements to
analysts).
Judge Miller's previous order and the parties'
briefs
tacitly
assume
the
adoption/entanglement rule is applicable
when insiders provide analysts with false
and misleading information. For purposes of
this order the court will do the same.
Defendants move to dismiss all allegations based on
representations made by analysts or third parties.
FAC ¶ ¶ 63, 64, 65, 66, 67, 70, 75, 76, 77, 81, 83,
84. For reasons mentioned below, the court concludes
that: (1) Brooktree's allegedly false and misleading
statements to the press were adequately pled; (2) the
analyst predictions and forecasts did not adequately
pled adoption or entanglement; but (3) the factual
statements contained in the analyst reports were
adequately pled.
1. False and Misleading Statements to the Press
[Paragraphs 63, 81]
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Two of the statements alleged in the initial and
amended complaints are purely factual statements
from Brooktree officials that were subsequently
repeated, without analysis, to the market. First, the
complaint describes a June 1995 article from PC
Week magazine relaying statements from Brooktree
officials indicating that the company was signing up
numerous customers for its BvT chipset. FAC ¶ 63.
Second, a November 1995 article in Electronic News
quoted Bixby as saying that the chipset had “strong
sales after only one quarter.” FAC ¶ 81. Defendants
urge the court to dismiss these statements because
they fail to specify the requisite entanglement and
adoption. Defendant's Brief at 17-18. The court
disagrees.
The rule requiring plaintiffs to allege that defendants
placed their imprimatur on third-party statements
only applies to predictions, forecasts, and other
interpretative statements. The rule does not apply to
third-party statements that merely repeat factual
assertions made by corporate insiders. See Cooper v.
Pickett, 137 F.3d 616, 624 (9th Cir.1997)
(requirement that plaintiff demonstrate the defendants
placed their imprimatur on analyst statements does
not preclude plaintiffs from claiming defendants
made false and misleading statements to securities
analysts intending the analysts communicate those
statements to the market). Thus, these statements are
adequately pled.
2. False and Misleading Analyst Forecasts and
Predictions
Most of the analyst statements in the initial complaint
were dismissed because plaintiffs failed to allege
specific interactions between Brooktree insiders and
analysts that could raise an inference of
entanglement. Allison, 999 F.Supp. at 1349-1350.
Nearly all of the analyst statements in that complaint
were the result of a “one-way” flow of information
from Brooktree representatives to analysts and from
the analysts to the market. See In re Stratosphere
Corp. Sec. Litig., 1 F.Supp.2d 1096, 1115
(D.Nev.1998) (“[a] one way flow of information .. is
insufficient to impose liability based on the analysts'
statements”); Syntex, 95 F.3d at 934. This court finds
that the analyst statements in the amended complaint
fail for the same reason.
*8 The analyst statements in the amended complaint
were based on allegedly false and misleading
information provided by Brooktree executives to
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analysts during conference calls and meetings. FAC ¶
¶ 58, 64, 65, 70, 75. Attempting to remedy the lack
of adoption or entanglement in the initial complaint,
the amended complaint now alleges that unspecified
“follow-up conversations” took place between the
analysts and Brooktree representatives. For example,
one such allegation reads:
On 7/13/95, Lehman Brothers issued a report on
Brooktree, written by White, which was based on and
repeated information provided him in the 7/12/95
conference call and follow-up conversations with
Bixby or Canning. The report forecast [a fiscal year
1996 earnings-per-share] of $.65 .. and stated that
“[t]he outlook of Brooktree continues to improve ...
Brooktree is becoming more attractive.”
FAC ¶ 66. Plaintiffs argue that these allegations of
“follow-up conversations” describe a “regular
practice” where Brooktree insiders subsequently
communicate with analysts “to ensure the resulting
reports favorably portray” Brooktree. Plaintiffs'
Opposition at 19. However, the complaint does not
specify the date, time, number, or content of any of
these follow-up conversations and provides no
additional facts which could raise an inference that
the defendants endorsed, adopted, or somehow
entangled themselves in the analysts' forecasts. FAC
¶ ¶ 65, 66, 67, 76, 77. See Stack, 903 F.Supp. at 1372
(“[p]laintiffs have refined their conclusory
introductory allegations of entanglement by adding
meaningless details about Defendants' contacts with
analysts.. None of these allegations are sufficient to
plead the time, place and nature of the alleged
entanglement”).FN4
FN4.
Two
of
these
“follow-up
conversations” are alleged to have taken
place between securities analysts and
“Bixby or Canning,” further diminishing
their Rule 9(b) compliance FAC ¶ ¶ 66, 67
(emphasis added).
3. False and Misleading Factual Statements in
Analyst Reports
The amended complaint makes numerous allegations
that securities analysts “repeated” false and
misleading factual information provided by
Brooktree insiders during meetings and conference
calls. As discussed previously, when a defendant uses
a securities analyst as a conduit for disseminating
false or misleading information, plaintiffs need not
allege that the defendants placed their imprimatur on
the analyst's statements. See, e.g., Warshaw v. Xoma
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Corp., 74 F.3d 955, 959 (9th Cir.1996). However,
plaintiffs must (1) identify the defendant's false or
misleading factual statement to the analyst, (2)
identify the specific analyst statement that repeats or
incorporates the defendant's false or misleading
statement; and (3) allege that the defendant intended
or knew that the analyst disseminate the false or
misleading information to the public. See
Stratosphere, 1 F.Supp.2d at 1115 n. 16; Cooper, 137
F.3d at 623.
Most of the factual statements from Brooktree
insiders that were “repeated” by securities analysts
were adequately pled in the amended complaint. For
example, in several places the amended complaint
specifically identifies factual statements made by
Brooktree insiders that were subsequently repeated in
the analyst reports. See e.g., FAC ¶ ¶ 75 (Brooktree
insiders informing securities analysts that it received
orders from six computer companies), 76 (subsequent
analyst report stating that six companies have placed
volume orders).
*9 Unfortunately, the amended complaint does not
distinguish or separate the analysts' interpretive
forecasts from the misleading factual information
furnished by Brooktree insiders, and many of the
analyst statements fall somewhere between fact and
opinion. See, e .g., FAC ¶ 67 (analyst report stating,
“[w]e believe .. that the company's elegant chipset
solution is the right product at the right time with a
superior price-performance-functionality profile as
compared to competitive solutions.”)
III. Rule 10b-5 and Pleading Scienter under the
PSLRA
To state a claim under section 10(b) of the Securities
Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule
10b-5 promulgated thereunder, 17 C.F.R. § 240.10b5, plaintiff must allege that there has been (1) a
misstatement or omission (2) of material fact, (3)
made with scienter, (4) on which the plaintiff relied,
which (5) proximately caused his or her injury.
McCormick Fund v. American Companies, Inc., 26
F.3d 869, 875 (9th Cir.1994); McGonigle v. Combs,
968 F.2d 810, 817 (9th Cir.1992), cert. dismissed 506
U.S. 948, 113 S.Ct. 399, 121 L.Ed.2d 325 (1992).
The sole element at issue here is the third-scienter, “a
mental state embracing intent to deceive, manipulate,
or defraud.” Ernst & Ernst v. Hochfelder, 425 U.S.
185, 193 n. 12 (1976).
Section 21D(b)(2) of the PSLRA specifies the
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Page 7
standard for pleading scienter in private Rule 10b-5
actions. Specifically, it mandates that “the complaint
shall, with respect to each act or omission alleged to
violate this title, state with particularity facts giving
rise to a strong inference that the defendant acted
with the required state of mind.” 15 U.S.C. § 78u4(b)(2). If a plaintiff's pleadings fail to satisfy this
requirement, dismissal is mandated. 15 U.S.C. §
78u-4(b)(3).
To date, neither the Ninth Circuit nor any other
federal appeals court has interpreted Section
21D(b)(2) or provided any guidance on the precise
“state of mind” plaintiff is required to plead. All of
the cases interpreting the PSLRA are district court
decisions holding that the PSLRA codified the
standard derived from Second Circuit case law. See,
e.g., Marksman Partners, L.P. v. Chantal
Pharmaceutical Corp., 927 F.Supp. 1297, 1310
(C.D.Cal.1996); Zeid v. Kimberley, 930 F.Supp. 431,
437 (N.D.Cal.1996). At the time the PSLRA was
passed, scienter could be established in Second
Circuit (1) “by alleging facts to show that defendants
had both motive and opportunity to commit fraud,” or
(2) “by alleging facts that constitute strong
circumstantial evidence of conscious misbehavior or
recklessness.” Shields v. Citytrust Bancorp, Inc., 25
F.3d 1124, 1128 (2d. Cir.1994). In Judge Miller's
order dismissing the initial complaint, he correctly
observed that the requisite “strong inference” under
the PSLRA could, depending on the strength of the
allegations, be satisfied by pleading either standard.
Allison, 999 F.Supp. at 1351.
a. Motive and Opportunity to Commit Fraud
*10 Scienter can be pleaded by alleging specific facts
demonstrating motive and opportunity to commit
fraud. Motive entails “concrete benefits that could be
realized by one or more of the false statements and
wrongful nondisclosures alleged” while opportunity
entails “the means and likely prospect of achieving
concrete benefits by the means alleged.” Shields, 25
F.3d at 1130.
Plaintiff contends that defendants were motivated to
engage in deceptive conduct to: (1) protect and
enhance their executive positions and the substantial
compensation and prestige they obtained thereby; (2)
conceal their mismanagement of the BtV chipset
project; and (3) enhance the value of their stock and
stock options so the insiders could “pocket millions
from their Brooktree stock and stock options in any
later acquisition of Brooktree, hopefully at a highly
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inflated price.” FAC ¶ 48.
The first and second motives are easily dismissed. As
a matter of law, allegations that the defendants'
sought to protect their executive positions and
increase their compensation do not, by themselves,
raise a strong inference of scienter. See, e.g., Acito v.
IMCERA Group, Inc., 47 F.3d 47, 54 (2d Cir.1995)
(rejecting as inadequate allegations that corporate
executives committed fraud to achieve an inflated
stock price and increases in executive compensation);
Shields, 25 F.3d at 1130 (stating that “a plaintiff must
do more than merely charge that executives aim to
prolong the benefits of the positions they hold”);
Marksman Partners, L.P. v. Chantal Pharmaceutical
Corp., 927 F.Supp. 1297, 1312 (C.D.Cal.1996);
Ferber v. Travelers Corp., 785 F.Supp. 1101, 1107
(D.Conn.1991). As for the second motive, an
allegation that the defendants sought to conceal their
mismanagement is simply another way of alleging
that they sought to protect their executive positions. It
fails for the same reason.
The third motive is also inadequate. According to
plaintiffs, Brooktree's stock hit an all-time low
sometime in mid-1994 and defendants “knew” at that
time that Brooktree could not survive as an
independent company. FAC ¶ ¶ 5, 50. A sale of the
company would offer salvation and a windfall to
Brooktree insiders, as their stock options would
become exercisable immediately upon a change of
ownership. FAC ¶ ¶ 6, 51. Company insiders
subsequently granted themselves hundreds of
thousands of new stock options while defendant
Bixby “quietly” contacted potential acquirers. FAC ¶
¶ 6, 49, 51. Then, to inflate the price of Brooktree's
stock defendants misrepresented the BvT chipset's
capabilities, customer acceptance and impact on
potential revenues, hoping to sell the company at the
inflated price to an acquiring company. FAC ¶ ¶ 4953. Plaintiffs contend this scheme was thwarted once
accurate information about the BvT chipset's
problems entered the market, causing the stock price
to decline sharply a few months before insiders could
complete a sale of the company. See Plaintiff's
Opposition at 15. The court rejects plaintiff's motive
theory for several reasons.
*11 First, this theory assumes that a company
wishing to acquire Brooktree would base its decision
solely on the false and misleading information
company insiders disseminated to the market. It
assumes that an acquiring company could somehow
overlook the many engineering and compatibility
problems with the company's most important product,
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the BvT chipset. This is at odds with the complaint's
detailed description of technical problems that were
so fundamental that every potential customer that
attempted to use the product rejected it in disgust.
FAC ¶ 11. The court simply cannot accept plaintiffs'
suggestion that a sophisticated acquiring company
could overlook what everyone who ever attempted to
use the BvT chipset immediately discovered.
Second, the factual allegations concerning this
purported motive are not specific enough to satisfy
the PSLRA. For instance, the amended complaint
does not specify why Brooktree insiders “knew” back
in mid-1994 that the company would not survive as
an independent entity. In addition, it fails to allege
specific facts concerning Brooktree's search for a
potential acquiring company. Before the acquisition
in July of 1996, the only specific discussions
Brooktree insiders are alleged to have had concerning
the possible sale of the company were a series of
meetings in “the last half of 1994” with Rockwell and
other unnamed companies. After these meetings, the
defendants decided not to sell the company since its
current stock price was at an all-time low. FAC ¶ 5.
However, the complaint alleges no specific facts
suggesting that Brooktree insiders subsequently made
any efforts to sell the company during the class
period.
b. Opportunity-defendants Kelly, Holtaway, and
Zabaronick
Judge Miller previously held that plaintiffs failed to
adequately allege that defendants Stewart Kelly
(Corporate Quality VP), Edward P. Holtaway
(Communications Strategic Business Unit VP), and
Robert W. Zabaronick (Human Resources senior VP)
had the opportunity to commit fraud. FAC ¶ ¶ 25(d),
25(e), 25(f). The court noted that none of the
allegedly false and misleading statements set forth in
the initial complaint were attributed to any of these
three defendants. The court concluded:
[i]t is difficult to understand-given these defendants'
respective fields of expertise, the nondescript
allegations of access to internal documents, and the
lack of direct or indirect access to the media-how
these defendants would have the opportunity to
control the dissemination of general business and
financial information to the public.
Allison, 999 F.Supp. at 1352. As with the initial
complaint, none of the allegedly false or misleading
statements in the amended complaint came from
these three defendants. However, plaintiffs contend
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that the amended complaint adequately responds to
these problems by alleging that defendants Kelly,
Holtaway, and Zabaronick were all “hands-on
managers” who “deal[t] with important issues facing
Brooktree's business.” FAC ¶ 28. However, this
conclusory allegation does not remedy the amended
complaint's failure to allege any facts suggesting
these defendants had any control over dissemination
of information to the public.
*12 Plaintiffs' continued reliance on the “group
published presumption” is unavailing. Judge Miller
persuasively argued and held in his previous order
that this doctrine did not survive enactment of the
PSLRA. See Allison, 999 F.Supp. at 1350-1351; see
also Coates v. Heartland Wireless Comm., Inc.,
F.Supp , 1998 WL 770495, *13 n. 3 (N.D. Tex. Nov
02, 1998) (same). Plaintiffs urge this court to
reconsider this issue because they contend other
courts have “[o]verwhelmingly” held that the group
publication presumption survives the PSLRA.
Plaintiff's Opposition at 20. However, the cases cited
by plaintiffs are unpersuasive because they do not
thoroughly analyze the impact of the PSLRA on the
group published presumption. Id. at 20 n. 24. Most of
the those either ignore the effect of the PSLRA on the
group published presumption or express reluctance at
being the first court to address the question.
b. Circumstantial Evidence of Conscious
Misbehavior or Recklessness
When motive and opportunity are not apparent, a
plaintiff may plead scienter by alleging specific facts
constituting strong circumstantial evidence of the
defendants' conscious misbehavior or recklessness.
Shields, 25 F.3d at 1128. “Recklessness in private
securities fraud actions is not, however, mere
carelessness or even gross negligence; it instead
embraces a conscious state of mind that is inherently
deceptive.” In re Baesa Sec. Litig., 969 F.Supp. 238,
241 (S.D.N.Y.1997); Decker v. Massey-Ferguson,
Ltd., 681 F.2d 111, 121 (2d Cir.1982) (recklessness
must “approximate an actual intent to aid in the fraud
being perpetrated by the audited company”); Chill v.
General Elec. Co., 101 F.3d 263, 268 (2d Cir.1996).
To plead scienter using this method, the strength of
these
circumstantial
allegations
must
be
correspondingly greater. Beck v. Manufacturers
Hanover Trust Co., 820 F.2d 46, 50 (2d Cir.1987)
cert. denied, 484 U.S. 1005 (1988). Finally, to the
extent a defendant's liability is based on a “forwardlooking” statement, recklessness is not sufficient; the
circumstantial allegations must constitute strong
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evidence that the defendant had “actual knowledge”
that the forward-looking statement was false or
misleading. 15 U.S.C. § 78u-5(c)(1)(B)(I); 15 U.S.C.
§ 78u-4(b)(2); 15 U.S.C. § 78u-5(I)(1) (defining a
“forward-looking” statement).
Plaintiffs contend that scienter is established because
the defendants knew the BvT chipset was suffering
from serious engineering and design problems.
Specifically, plaintiffs contend that, at the time
defendants issued positive statements regarding the
chipset, they knew that: (1) Brooktree ignored a
written internal policy for developing and testing the
BvT chipset's software (FAC ¶ 35); (2) employees
had complained about the Brooktree's inability to
adequately test the product (FAC ¶ 35); (3) reports
from independent testing laboratories in the early part
of 1995 suggested Brooktree's development schedule
for the chipset was too aggressive (FAC ¶ 37); (4)
defendant Bixby sent an internal electronic mail
message to employees at Brooktree detailing
installation and operational problems he encountered
attempting to use the product (FAC ¶ 39); (5) the
company received numerous negative reports on the
product's performance from potential customers
(FAC ¶ 42); and (6) Brooktree's internal database
system tracked the numerous product problems (FAC
¶ 43); Plaintiff's Opposition at 17-18. For several
reasons, these facts do not raise a strong inference
that defendants acted consciously or recklessly.
*13 First, the complaint describes a detailed
electronic mail message sent by defendant Bixby to
Brooktree employees informing them about the
installation and operational problems he experienced
first-hand when he attempted to use BvT chipset.
FAC ¶ 39. While this fact could serve as strong
circumstantial evidence of defendant Bixby's
knowledge of the product's engineering problems at
that time, the complaint is imprecise as to when this
electronic mail message was sent. The complaint
states that Bixby learned of the problems and sent the
mail message “during summer of 1995” and “[b]y
9/95,” a time period that could span four months.
While an exact date is not necessary, more specificity
is needed to place this event in the context of Bixby's
contemporaneous statements. For example, On July
12, 1995 defendant Bixby allegedly told a group of
securities analysts that “[f]inal engineering of the
BvT chipset had been completed.” FAC ¶ 65. If
Bixby's first-hand discovery of the BvT chipset
problems occurred shortly before this date, scienter
would be adequately pled.
Second, the independent testing reports suggesting
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that Brooktree's development schedule was too
aggressive were generated in “early” 1995, long
before the chipset had undergone any significant
development or design. The NTSL Report identified
in the complaint was issued in January of 1995, FAC
¶ 37, only three months after the product was first
announced and at least five three months before
defendants issued the first potentially actionable false
and misleading statement.
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Page 10
Plaintiffs shall have 30 days from the signature date
of this order to file a second amended complaint.
S.D.Cal.,1998.
Allison v. Brooktree Corp.
Not Reported in F.Supp.2d, 1998 WL 34074832
(S.D.Cal.)
Briefs and Other Related Documents (Back to top)
Third, the alleged customer complaints and the
decision to disregard Brooktree's own testing and
quality assurance guidelines raise a strong inference
that defendants were, at worst, negligent in stating
they could successfully sell the product in quantity by
July/August of 1995. To create a strong inference that
the defendants acted consciously or recklessly,
plaintiffs would have to either allege specific facts
showing that the product's problems were
insurmountable or describe other circumstances
suggesting that the products were unsaleable. Allison,
999. F.Supp. at 1354. Without these facts, the
cumulative effect of all of the engineering woes
detailed in the complaint suggest that defendants
were, at most, grossly negligent.
• 2000 WL 34402076 (Trial Motion, Memorandum
and Affidavit) Memorandum of Points and
Authorities in Support of Defendants' Motion to
Dismiss Plaintiffs' Third Amended Complaint (Apr.
7, 2000) Original Image of this Document (PDF)
• 2000 WL 34402168 (Trial Pleading) Third
Amended Complaint for Violation of the Securities
Exchange Act of 1934 (Mar. 7, 2000) Original Image
of this Document (PDF)
• 3:97cv00852 (Docket) (May. 05, 1997)
END OF DOCUMENT
Thus, plaintiffs have failed to adequately allege
scienter under this theory.
IV. Controlling Person Liability under Section 20(a)
Section 20(a) of the Securities Exchange Act of 1934
provides that “[e]very person who .. controls any
person liable under any provision of the ['34 Act]
shall be liable .. unless the controlling person acted in
good faith and did not directly induce” the violations.
15 U.S.C. § 78t(a). The express language of Section
20(a) requires a violation of some other provision of
the 1934 Act. Since plaintiffs have failed to claim
under Section 10(b) or Rule 10b-5, they have failed
to state a claim under Section 20(a).
CONCLUSION
*14 For the foregoing reasons, the court GRANTS
defendants' motion to dismiss plaintiffs' first
amended counterclaim. Specifically, the court:
(1) DISMISSES WITH PREJUDICE paragraphs 54,
55, 56, 57, 58, 59, 60, 61 and 62;
(2) DISMISSES WITH PREJUDICE defendants
Holtaway, Kelly and Zabaronick; and
(3) DISMISSES WITH LEAVE TO AMEND the
remainder of the complaint.
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Briefs and Other Related Documents
In re Applied Signal Technology, Inc. Securities
LitigationN.D.Cal.,2006.
United States District Court,N.D. California.
In re APPLIED SIGNAL TECHNOLOGY, INC.
SECURITIES LITIGATION.
No. C 05-1027 SBA.
Feb. 8, 2006.
Page 1
for disposition without a hearing. The Court hereby
GRANTS Defendants' Motion to Dismiss [Docket
No. 35] and DISMISSES Plaintiff's Consolidated
Amended
Class Action Complaint WITH
PREJUDICE. Accordingly, the Court DENIES
Plaintiff's Motion for Class Certification [Docket No.
25] AS MOOT.
BACKGROUND
A. Background Regarding the Parties
Robert S. Green, Green Welling LLP, San Francisco,
CA, Lead Attorney, Attorney to be Noticed, for Brent
Berson, (Plaintiff).
Mark P. Kindall, Schatz & Nobel, P.C., Hartford, CT,
Attorney to be Noticed, for Brent Berson, (Plaintiff).
Richard A. Maniskas, Schiffrin & Barroway, LLP,
Radnor, PA, Attorney to be Noticed, for Brent
Berson, (Plaintiff).
Alan R. Plutzik, Bramson Plutzik Mahler &
Birhaeuser LLP, Walnut Creek, CA, Lead Attorney,
Attorney to be Noticed, for Frank Whiting,
(Plaintiff).
David A. Priebe, DLA Piper Rudnick Gray Cary U.S.
LLP, East Palo Alto, CA, Lead Attorney, Attorney to
be Noticed, for Applied Signal Technology Inc.,
(Defendant).
Tamara Skvirsky, Schiffrin & Barroway LLP,
Radnor, PA, Attorney to be Noticed, for Brent
Berson, (Plaintiff).
Marc A. Topaz, Schiffrin & Barroway, LLP, Radnor,
PA, Attorney to be Noticed, for Brent Berson,
(Plaintiff).
ORDER
SAUNDRA BROWN ARMSTRONG, J.
[Docket Nos. 25, 35, 36]
*1 This Document Relates To: All Actions.
This matter comes before the Court on the Motion to
Dismiss Plaintiff's Consolidated Amended Class
Action Complaint (the “Consolidated Amended
Complaint”) [Docket No. 35] filed by Defendants
Applied Signal Technology, Inc., Gary Yancey, and
James Doyle (collectively “Defendants”) and
Plaintiff's Motion for Class Certification [Docket No.
25]. Having read and considered the papers presented
by the parties, the Court finds this matter appropriate
1. Applied Signal Technology, Inc.
Defendant Applied Signal Technology, Inc.
(“Applied Signal” or the “Company”) is a California
corporation and a publicly traded company with over
11 million shares of stock outstanding. CAC FN1 at ¶
15. The Company's financial year is not concurrent
with the calendar year. Instead, it ends on the last day
of October of each calendar year and commences on
the first day of November for that calendar year. See
Harris-Sutton Decl. at Ex. H (FY04 Form 10-K) . FN2
FN1. The Consolidated Amended Complaint
is referred to herein as “CAC.”
FN2. For example, for fiscal year 2004, the
first quarter consisted of the months of
November 2003, December 2003, and
January 2004; the second quarter consisted
of the months of February 2004, March
2004, and April 2004; the third quarter
consisted of the months of May 2004, June
2004, and July 2004; and the fourth quarter
consisted of the months of August 2004,
September 2004, and October 2004.
Applied Signal's corporate headquarters are located
in Sunnyvale, California. CAC at ¶ ¶ 7, 23-24;
Harris-Sutton Decl. at Ex. H. The Company also
maintains engineering offices in Annapolis Junction,
Maryland; Salt Lake City, Utah; Herndon, Virginia;
and Hillsboro, Oregon. Harris-Sutton Decl. at Ex. H.
As of January 24, 2004, the Company had 425
employees. CAC at ¶ ¶ 27, 38(a). This number
increased to 450 in February 2004, and to 480
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employees in May 2004. Id. As of December 17,
2004, the Company had a total of 498 employees.
Harris-Sutton Decl. at Ex. H. Of these 498
employees, 290 employees worked within the
Company's engineering organizations. Id.
Applied Signal is in the business of supplying various
United States government agencies with customized
communications signal processing systems, which it
designs, develops, and installs. CAC at ¶ 27. Since
1984, the United States government and various
governmental agencies have accounted for almost all
of the Company's revenues. Id. Although the
government agencies are the Company's primary
customer, purchases occur in two ways: (1) contracts
directly with the government, and (2) subcontracts to
prime contractors. See Harris-Sutton Decl. at Ex. H.
Within the Company's primary customer agencies,
the Company has contracts with approximately
twenty different offices, each with separate budgets
and contracting authority. Id.
In the past two fiscal years, just under three quarters
of the Company's contracts were “cost
reimbursement” contracts, including contracts for the
design, installation, and/or servicing of customized
products. CAC at ¶ 25. Under these contracts, the
Company is reimbursed for direct and indirect costs
and paid a negotiated profit. Id. However, the
Company is not entitled to payment until after its
employees provide the services delineated in the
contract. Id. Further, most of the Company's contracts
contain a provision that allows the Company's
customers to force Applied Signal to stop work on all
or any part of a contract at any time through what is
referred to as a “stop-work order” (“SWO”). Id.
*2 The federal regulations governing stop-work
orders further describe the applicable process as thus:
(a) The Contracting Officer may, at any time, by
written order to the Contractor, require the Contractor
to stop all, or any part, of the work called for by this
contract for a period of [up to] FN3 90 days after the
order is delivered to the Contractor, and for any
further period to which the parties may agree. The
order shall be specifically identified as a stop-work
order issued under this clause. Upon receipt of the
order, the Contractor shall immediately comply with
its terms and take all reasonable steps to minimize the
incurrence of costs allocable to the work covered by
the order during the period of work stoppage. Within
a period of 90 days after a stop-work order is
delivered to the Contractor, or within any extension
of that period to which the parties shall have agreed,
the Contracting Officer shall either-
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FN3. Revisions to the regulations provide
that the 90-day period may be reduced to
less than 90 days. See 48 C.F.R. 52.242-15.
(1) Cancel the stop-work order; or
(2) Terminate the work covered by the order as
provided in the Default, or the Termination for
Convenience of the Government, clause of this
contract.
(b) If a stop-work order issued under this clause is
canceled or the period of the order or any extension
thereof expires, the Contractor shall resume work.
The Contracting Officer shall make an equitable
adjustment in the delivery schedule or contract price,
or both, and the contract shall be modified, in
writing, accordingly, if(1) The stop-work order results in an increase in the
time required for, or in the Contractor's cost properly
allocable to, the performance of any part of this
contract; and
(2) The Contractor asserts its right to the adjustment
within 30 days after the end of the period of work
stoppage; provided, that, if the Contracting Officer
decides the facts justify the action, the Contracting
Officer may receive and act upon a proposal
submitted at any time before final payment under this
contract.
(c) If a stop-work order is not canceled and the work
covered by the order is terminated for the
convenience of the Government, the Contracting
Officer shall allow reasonable costs resulting from
the stop-work order in arriving at the termination
settlement.
(d) If a stop-work order is not canceled and the work
covered by the order is terminated for default, the
Contracting Officer shall allow, by equitable
adjustment or otherwise, reasonable costs resulting
from the stop-work order.
48 C.F.R. 52.242-15. Thus, when a SWO is issued, it
is possible, but not necessarily definite, that future
revenues may be affected. Id.; CAC at ¶ 26.
As such, the Company does not recognize revenue on
its cost-reimbursement contracts until costs-including
labor, materials, and other direct costs and estimated
direct costs-are incurred. CAC at ¶ 26. The Company
refers to future revenues relating to uncompleted
portions of existing contracts as its “backlog.” Id.
The Company's backlog is discussed in Company
press releases, conference calls, and formal Securities
Exchange Commission (“SEC”) filings.
Id.
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However, in each of the Company's public filings,
with respect to future revenues, and other contingent
events, the investing public is expressly warned that
any statements regarding future events are “not
guarantees of future performance and are subject to
certain risks.” See Harris-Sutton Decl. at Ex. A
(FY03 Form 10-K). For example, the Form 10-K for
Fiscal Year 2003 states the following:
*3 This Annual Report on Form 10-K contains
forward-looking statements made pursuant to the
provisions of Section 21E of the Securities Exchange
Act of 1934. These forward-looking statements are
based on management's current expectations and
beliefs, including estimates and projections about our
industry. Forward-looking statements may be
identified by the use of terms such as “anticipates,”
“expects,” “intends,” “plans,” “seeks,” “estimates,”
“believes,” and similar expressions, although some
forward-looking statements are expressed differently.
Statements concerning financial position, business
strategy and plans or objectives for future operations
are forward-looking statements. These statements are
not guarantees of future performance and are subject
to certain risks, uncertainties, and assumptions that
are difficult to predict and may cause actual results to
differ materially from management's current
expectations. Such risks and uncertainties include
those set forth herein under “Summary of Business
Considerations and Certain Factors that May Affect
Future Operating Results and/or Stock Price” and
“Management's Discussion and Analysis of Financial
Condition and Results of Operations.” The forwardlooking statements in this report speak only as of the
time they are made and do not necessarily reflect
management's outlook at any other point in time. We
undertake no obligation to update publicly any
forward-looking statements, whether as a result of
new information, future events, or for any other
reason. However, readers should carefully review the
risk factors set forth in other reports or documents we
file from time to time with the Securities and
Exchange Commission (SEC) after the date of the
Annual Report. These SEC filings, as well as our
latest annual report, can be obtained through our
website at www .appsig.com. In addition, hard copies
can be obtained free of charge through our investor
relations department.
Id. (emphasis added).
Further, the Company provides the following
explanation regarding its backlog to the investing
public:
Our backlog ... consists of anticipated revenues from
the uncompleted portions of existing contracts[.] ...
Page 3
Anticipated revenues included in backlog may be
realized over a multi-year period. We include a
contract in backlog when the contract is signed by us
and by our customer. We believe the backlog figures
are firm, subject only to the cancellation and
modification provisions contained in our contracts.
(See Item 7: “Management's Discussion and Analysis
of Financial Condition and Results of OperationsBacklog.”) Because of possible future changes in
delivery schedules and cancellations of orders,
backlog at any particular date is not necessarily
representative of actual sales to be expected for any
succeeding period, and actual sales for the year may
not meet or exceed the backlog represented. We may
experience significant contract cancellations that
were previously booked and included in backlog.
*4 Id. (emphasis added).
2. The Individual Defendants
At all times relevant to this action, defendant Gary
Yancey (“Yancey”) was the Chairman, President, and
Chief Executive Officer (“CEO”) of Applied Signal.
CAC at ¶ 8. As the CEO, Yancey signed and
certified all SEC quarterly and annual reports. Id.
Additionally, he owned shares of the Company's
stock; although, during the period between January 3,
2005 and January 18, 2005, he sold over forty percent
of his holdings. Id. Also during this period of time,
defendant James Doyle (“Doyle”) was the Company's
Chief Financial Officer (“CFO”) and Vice President
of Finance. Id. at ¶ 9. As the CFO, Doyle
participated in quarterly earnings report conference
calls for the quarters ending in July and October 2004
and January and April 2005. Id. Doyle also signed
and certified all SEC quarterly and annual reports. Id
.
3. Plaintiffs
Lead Plaintiff Frank Whiting (“Plaintiff”), is a
common stock purchaser who purchased shares of
Applied Signal during the relevant time period,
August 24, 2004 and February 22, 2005 (the “Class
Period”). CAC at ¶ ¶ 6, 14. The other members of
the proposed class are persons or entities-other than
the Company, its officers, directors, employees,
affiliates, legal representatives, heirs, predecessors,
successors and assigns, and any entity in which the
Company has a controlling interest or of which the
Company is a parent or subsidiary-who purchased
Applied Signal common stock during the Class
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Period. Id. at ¶ 14.
B. Background Regarding the Confidential Witnesses
The allegations contained in the Consolidated
Amended Complaint are based, in part, on certain
information obtained from the following Confidential
Witnesses:
(a) Confidential Witness No. 1. Confidential Witness
No. 1 (“CW1”) was employed as a software engineer
during the beginning of the Class Period up until
November, 2004. Id. at ¶ 22(a). He worked in
Applied Signal's Annapolis Junction, Maryland
Office. Id. His duties included system and process
design, implementation, testing, life cycle
documentation, design and code review, team
tasking, and scheduling. Id.
(b) Confidential Witness No. 2. Confidential Witness
No. 2 (“CW2”) was employed as a software engineer
in Applied Signal's Maryland office until some
months before the beginning of the Class Period. Id.
at ¶ 22(b).
(c) Confidential Witness No. 3. Confidential Witness
No. 3 (“CW3”) was employed as a software engineer
at Applied Signal's Utah office from well before the
Class Period until January 2005. Id. at ¶ 22(c).
CW3's duties included the design and implementation
of software.
(d) Confidential Witness No. 4. Confidential Witness
No. 4 (“CW4”) was employed as a technical editor at
Applied Signal's Sunnyvale office from before the
beginning of the Class Period until November 2004.
Id. at ¶ 22(d). He was responsible for editing and
proofreading
technical
manuals,
proposals,
presentations, brochures, newsletters, and other
technical and marketing material. Id. He was also
responsible for creating processes and flowcharts for
the Finance Department in accordance with
Sarbanes-Oxley requirements. Id.
C. The Factual Allegations
*5 This action is premised on Plaintiff's theory that
Applied Signal and two of its individual officers,
Yancey and Doyle, (collectively, “Defendants”),
knowingly issued a series of false and misleading
statements regarding Applied Signal in order to
artificially inflate Applied Signal's stock price
throughout the Class Period. In particular, the
Consolidated Amended Complaint is premised on
certain representations Defendants made regarding
the Company's “backlog” and certain SWOs that
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Page 4
were purportedly received by the Company during
the relevant period.FN4 The Consolidated Amended
Complaint is also premised on certain statements
made by the Company concerning the hiring of
personnel. The pertinent facts are set forth below.
FN4. Specifically, the following four SWOs
are relevant to the instant discussion: (1) a
June 2004 SWO (“SWO1”), (2) a May or
June 2004 SWO (“SWO2”), (3) an August
or September 2004 SWO (“SWO3”), and (4)
a December 2004 SWO (“SWO4”). CAC at
¶ ¶ 29, 30, 35.
1. The Third Quarter of Fiscal Year 2004
Applied Signal's third quarter for fiscal year 2004
(“FY04”) commenced on May 1, 2004. During that
quarter, at some point in June 2004, Applied Signal
received a stop-work order (“SWO1”), which
instructed the Company to stop work on a portion of
the Company's largest single contract. CAC at ¶
29(a). In accordance with the instructions provided
by the customer, the Company prepared a proposal
that detailed the tasks that were stopped and
estimated the reduction in contract costs. Id.
Also in June 2004 or possibly in May 2004,
according to CW1, the Wireless Communications
System Division of Applied Signal received another
stop-work order (“SWO2”) on a project for the
United States military that was referred to as
“Cowbird.” Id. at ¶ 30. CW1 knew about SWO2
because it required employees at the Company's
Maryland facility, where he worked, to stop
performing services for the government agency
related to the contract. Id. at ¶ ¶ 22(a), 30(b).
According to CW2, who worked at Applied Signal up
until a few months before August 2004, the contract
implicated by SWO2 was worth about $8 million. Id.
at ¶ ¶ 22(b), 30(b).
On August 24, 2004, Applied Signal issued a press
release and hosted a conference call (“August
Conference Call”) to discuss financial results for the
third quarter of FY04. CAC at ¶ 28. Yancey and
Doyle represented the Company during the August
Conference Call. Id. In the course of that call, Doyle
reported that the Company's backlog was
approximately $111 million.FN5 Id .
FN5. Defendants did not discuss SWO1 or
SWO2 during the call. CAC at ¶ 29.
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Additionally, in the August 24, 2004 press release
(“August 2004 Press Release”), Yancey was quoted
as saying that he was “pleased” that Applied Signal
had “met the challenge” of meeting “aggressive
hiring requirements.” Id. at ¶ 39. During the August
Conference Call, he also stated that the Company had
“been able to stay up with a fairly aggressive growth
requirement, and in particular, hiring of staff and
staff that we can get cleared....” Id. at ¶ 39. In
response to an inquiry from an analyst regarding the
amount of engineers that had been added during the
third quarter, Doyle stated that they had hired about
100 people “year-to-date” and approximately 30
people during the third quarter. Id. Yancey then
stated that the number for the quarter might be lowerpossibly as low as twenty-but that analysts could “go
ahead and use 30 ... and kind of assume we've been
close to linear in our increase.” Id.
*6 On September 9, 2004, Defendants filed a Form
10-Q (“Third QuarterForm 10-Q”) with the SEC,
which reported the $111 million backlog amount that
was disclosed during the August 2004 Conference
Call. Id. at ¶ 29(a). The Third Quarter Form 10-Q
also reported that the Company had received SWO1
and that, pursuant to SWO1, the Company was
instructed to stop work on a portion of its largest
single contract. Id. Additionally, the report stated that
“new orders and backlog [were] expected to be
reduced by approximately $11 to $13 million” after
the completion of negotiations relating to SW01 and
that the Company “anticipate[d] the completion of
these negotiations during the first or second quarter
of fiscal 2005.” FN6 Id.
FN6. The Third Quarter Form 10-Q did not
mention SWO2. CAC at ¶ 30. In fact, to
date, SWO2 has not been mentioned in any
Company public filings. Id. at ¶ 32.
2. The Fourth Quarter of Fiscal Year 2004 and
Disclosures Concerning the Third Quarter of Fiscal
Year 2004
According to CW3, who was employed as a software
engineer at Applied Signal's Utah office at the time,
the Company also received another stop-work order
(“SWO3”) in August or September 2004. Id . at ¶ ¶
22(c), 35(b). SWO3 was purportedly related to a
contract with one of the Company's largest customers
that was worth more than $20 million. Id. at ¶ ¶
35(b). CW3 was aware of SWO3 because he had
been working on the project, which was known as
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Page 5
“Excelsior.” Id. at ¶ 35(b). SWO3 affected the
Multichannel Systems Division (“MSD”) at the Utah
facility, as well as the MSD group in the Company's
Sunnyvale, California facility. Id. At the Sunnyvale
facility, approximately 50 to 75 workers were
involved in the project. Id. CW4, who was employed
as a technical editor at Applied Signal's Sunnyvale
office during August and September 2004, was aware
of SWO3. Id. at ¶ ¶ 22(d), 35(b). According to CW3,
after the Company received SWO3, work on
“Excelsior” stopped for approximately one week. Id.
at ¶ 43. The MSD project then resumed working on
the project for the remainder of the calendar year. Id.
The project was abandoned in January 2005, leaving
the Sunnyvale office a “ghost town.” Id.
On September 13, 2004, following the issuance of the
Third Quarter Form 10-Q, a securities analyst
covering Applied Signal's stock informed investors
that he was changing the rating of the Company's
stock from “buy” to “neutral.” Id. at ¶ 31. The price
of Applied Signal's stock dropped from $37.64, when
the market opened, to $31.78 at the close of market
on September 15, 2004. Id .
3. The First Quarter of Fiscal Year 2005 and
Disclosures Regarding Fiscal Year 2004
According to CW3, the software engineer who
worked in the Company's Utah office during this
time, the Company also received a stop-work order in
December 2004 (“SWO4”). Id. at ¶ ¶ 22(c), 35(c).
SWO4 involved a government agency that had
cancelled other large contracts with Applied Signal in
the past. Id. at ¶ 35(c).
On December 21, 2004, Applied Signal issued a
press release (the December 2004 Press Release”)
and hosted a conference call (“December 2004
Conference Call”) to discuss financial results for the
fourth quarter of FY04. CAC at ¶ 33. Yancey and
Doyle represented the Company during the
December Conference Call and reported that the
backlog for the fourth quarter was $143 million. Id.
The December 2004 Press Release reported that the
Company earned 21 cents per share during the fourth
quarter of FY04, which was below the analysts'
consensus estimate of 29 cents per share. Id. at ¶ 42.
Defendants did not mention SWO2, SWO3 or SWO4
during the call or in the press release. Id. at ¶ 35(a)(c).
*7 Additionally, Doyle reported, during the
December 2004 Conference Call, that the Company
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had added a “net” of 20 employees during the fourth
quarter of FY04. Id. at ¶ 40(a). Doyle then stated that
the Company had “about” 500 employees. Id. at ¶
40(a). According to the Form 10-K for FY04, the
exact number was 498 employees. Id.
The December 2004 Press Release also disclosed that
revenue had only increased by 3% since the previous
quarter. Id. During the December Conference Call, an
analyst, Jay Meier (“Meier”), asked whether anything
unusual had occurred during the fourth quarter since
the Company had not experienced its usual increase
in revenues. Id. at ¶ 42. Doyle and Yancey
responded that Meier was reading too much into the
numbers and that nothing unusual had occurred. Id.
After the December 2004 Conference Call, the price
of the Company's stock declined from $37.22 on
December 21, 2004 to $35.74 at the market's close on
December 22, 2004. Id.
Beginning on January 3, 2005, and continuing
through January 18, 2005, during an open trading
window, Yancey sold 141,400 shares of Company
stock, which represented 43% of his total stock
holdings, at prices ranging from $31.40 to $34 per
share. Id. at ¶ 48.
On January 14, 2005, Defendants filed a its Form 10K for FY04. CAC at ¶ 34. The Form 10-K indicated
that the backlog at the end of FYO4 was $143 million
but that the $143 million could be reduced by $11
million to $13 million in future quarters once
negotiations relating to SWO1 concluded. See HarrisSutton Decl. at Ex. H.
On February 22, 2005, the Company issued a press
release (the “February 2005 Press Release”) and
hosted a conference call (the “February 2005
Conference Call”) concerning the Company's
financial results for the first quarter of FY05, which
ended on January 31, 2005. CAC at ¶ 44. During the
February 2005 Conference Call, the Company
reported that revenue declined almost 25% from the
preceding quarter, with net income and earnings per
share declining as well. Id. To explain these financial
results, Yancey stated:
[W]e are a bit behind on execution on our contracts.
Part of this is for a bit of healthy reason. We've seen
higher-than-anticipated proposal activity in the first
quarter, which has diverted some of our labor
resources to proposal activity. The other phenomena
that we're experiencing is, as we become more an
integrating contractor on some of our programs, as
we've stated before we are evolving to, we find that
invoicing from our subcontractors can have some
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impact on the revenue. And we saw that some of the
invoicing was lagging behind a bit compared to the
work that they were putting in. So we feel that we
will be back on our track of our projected revenue as
we build up our own staff and as the invoicing comes
about.
See Applied Signal Form 8-K, dated February 22,
2005 at Ex. 99 .2.FN7
FN7. Although this SEC filing was not
provided to the Court by the parties, since
the Consolidated Amended Complaint
necessarily relies on it, the Court has taken
judicial notice of it pursuant to Federal Rule
of Evidence 201. See Branch v. Tunnell, 14
F.3d 449, 454 (9th Cir.1994); Steckman v.
Hart Brewing, Inc. 143 F.3d 1293, 1295 (9th
Cir.1998).
The Company's stock price subsequently dropped
from $27.52 per share on February 22, 2005 to
$23.24 at the close of the market on February 23,
2005. Id. at ¶ 45.
D. Procedural History
*8 On March 11, 2005, plaintiff Brent Berson
(“Berson”) filed a complaint in this district on behalf
of himself and on behalf of all persons who
purchased the securities of Applied Signal between
May 25, 2004 and February 22, 2005 (the “Berson
complaint”). In the Berson complaint, Berson
alleged, inter alia, that Applied Signal and certain of
its officers and directors violated Section 10(b) of the
Securities Exchange Act of 1934 (the “Exchange
Act”) and Rule 10b-5 promulgated thereunder, and
Section 20(a) of the Exchange Act, by issuing
materially false and misleading statements.
The proposed class period for the Berson complaint
was May 25, 2004 through February 22, 2005 and the
complaint was premised on the following allegedly
false and misleading statements: (1) the Company's
May 25, 2004 press release concerning the
Company's operating results for the second quarter of
FY04; (2) the Company's second quarter FY04 Form
10-Q; (3) the Company's August 24, 2004 press
release concerning the Company's operating results
for the third quarter of FY04; (4) the Company's third
quarter FY04 Form 10-Q; (5) the Company's
December 12, 2004 press release concerning the
Company's operating results for the fourth quarter of
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FY04 and year-end results for FY04; and (6) the
Company's FY04 Form 10-K. In the complaint,
Berson alleged that the statements were materially
false and misleading because Defendants failed to
disclose or indicate the following: (1) that the
Company lacked the staffing necessary to execute on
current projects while bidding for new business; and
(2) that the Company “struggled to maintain adequate
levels of backlog.” The Berson complaint further
alleged that the aforementioned false and misleading
statements were proven false when the Company
announced its operating results for the first quarter of
FY05 on February 22, 2005.
alleged fraudulent conduct of Applied Signal, and,
therefore, are also liable under Section 20(a) of the
Exchange Act. Unlike the prior Berson and Sameyah
complaints, the proposed class period for the
Consolidated Amended Complaint is August 24,
2004 through February 22, 2005. The Consolidated
Amended Complaint also differs from the prior
complaints in that it now alleges that Defendants'
statements regarding the Company's backlog were
materially false and misleading because they failed to
mention certain stop-work orders purportedly issued
during May 2004 through December 2004.
On April 19, 2005, plaintiff Shalomah Sameyah
(“Sameyah”) filed a complaint in this district on
behalf of himself and on behalf of all persons who
purchased the securities of Applied Signal between
May 25, 2004 and February 22, 2005 (the “Sameyah
complaint”). With the exception of the name of the
plaintiff, the Sameyah complaint-which was drafted
by the same counsel representing Berson-was
identical to the Berson complaint.
LEGAL STANDARD
On May 10, 2005, this Court ordered that the Berson
case and the Sameyah case be deemed related.
On May 10, 2005, plaintiff Frank Whiting filed a
Motion for Appointment of Lead Plaintiff and
Approval of Lead Plaintiff's Selection of Counsel
(“Motion for Appointment of Lead Plaintiff”).
On July 1, 2005, Defendants submitted a Statement
of Non-Opposition to the Motion for Appointment of
Lead Plaintiff. Defendants also requested that the
Berson case and Sameyah case be consolidated by
order of this Court pursuant to Federal Rule of Civil
Procedure 42(a).
On July 13, 2005, the Court consolidated the Berson
and Sameyah cases. Also on that date, the Court
granted the Motion for Appointment of Lead
Plaintiff. Accordingly, Frank Whiting was appointed
to serve as Lead Plaintiff. Plaintiff's choice of counsel
was also approved.
*9 On August 12, 2005, the instant Consolidated
Amended Complaint was filed. In the Consolidated
Amended Complaint, Plaintiff asserts that defendants
Applied Signal, Yancey, and Doyle (“Defendants”)
made untrue statements of material fact and/or
omitted statements of material fact in violation of
Section 10(b) of the Exchange Act and Rule 10b-5.
Plaintiff also contends that Yancey and Doyle
directly or indirectly influenced and controlled the
A. Federal Rule of Civil Procedure 12(b)(6)
Under Federal Rule of Civil Procedure 12(b)(6), a
motion to dismiss should be granted if it appears
beyond a doubt that the plaintiff “can prove no set of
facts in support of his claim which would entitle him
to relief.” Conley v. Gibson, 355 U.S. 41, 45-46
(1957). For purposes of such a motion, the complaint
is construed in a light most favorable to the plaintiff
and all properly pleaded factual allegations are taken
as true. Jenkins v. McKeithen, 395 U.S. 411, 421
(1969); Everest and Jennings, Inc. v. American
Motorists Ins. Co., 23 F.3d 226, 228 (9th Cir.1994).
All reasonable inferences are to be drawn in favor of
the plaintiff. In re Silicon Graphics Inc. Sec. Litig.,
183 F.3d 970, 983 (9th Cir.1999). The court does not
accept as true unreasonable inferences or conclusory
legal allegations cast in the form of factual
allegations. Western Mining Council v. Watt, 643
F.2d 618, 624 (9th Cir.1981); see Miranda v. Clark
County, Nev., 279 F.3d 1102, 1106 (9th Cir.2002).
Although the court is generally confined to
consideration of the allegations in the pleadings,
when the complaint incorporates documents or
alleges the contents of documents, and no party
questions the authenticity of such documents, a court
may also consider such documents when evaluating
the merits of a Rule 12(b)(6) motion. See In re Stac
Electronics Sec. Lit., 89 F.3d 1399, 1405 (9th
Cir.1996).
When the complaint is dismissed for failure to state a
claim, “leave to amend should be granted unless the
court determines that the allegation of other facts
consistent with the challenged pleading could not
possibly cure the deficiency.” Schreiber Distrib. Co.
v. Serv-Well Furniture Co., 806 F.2d 1393, 1401 (9th
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Cir.1986). The Court should consider factors such as
“the presence or absence of undue delay, bad faith,
dilatory motive, repeated failure to cure deficiencies
by previous amendments, undue prejudice to the
opposing party and futility of the proposed
amendment.” Moore v. Kayport Package Express,
885 F.2d 531, 538 (9th Cir.1989). Of these factors,
prejudice to the opposing party is the most important.
See Jackson v. Bank of Hawaii, 902 F.2d 1385, 1387
(9th Cir.1990) (citing Zenith Radio Corp. v.
Hazeltine Research, Inc., 401 U.S. 321, 330-31
(1971)). Leave to amend is properly denied “where
the amendment would be futile.” DeSoto v. Yellow
Freight Sys., 957 F.2d 655, 685 (9th Cir.1992).
B. Federal Rule of Civil Procedure 9(b)
*10 Federal Rule of Civil Procedure 9(b) provides as
follows:
In all averments of fraud or mistake, the
circumstances constituting fraud or mistake shall be
stated with particularity. Malice, intent, knowledge,
and other condition of mind of a person may be
averred generally.
Fed.R.Civ.P. 9(b).
“[The Ninth Circuit] has interpreted Rule 9(b) to
require that ‘allegations of fraud are specific enough
to give defendants notice of the particular misconduct
which is alleged to constitute the fraud charged so
that they can defend against the charge and not just
deny that they have done anything wrong.” ’
Neubronner v. Milken, 6 F.3d 666, 671 (9th Cir.1993)
(quoting Semegen v. Weidner, 780 F.2d 727, 731 (9th
Cir.1985)). “The pleader must state the time, place,
and specific content of the false representations as
well as the identities of the parties to the
misrepresentation.” Schreiber Distributing Co. v.
Serv-Well Furniture Co., 806 F.2d 1393, 1401 (9th
Cir.1986) (citing Semegen, 780 F.2d at 731).
C. Pleading Requirements in Securities Fraud
Actions
Section 10(b) of the Exchange Act makes it unlawful
“for any person ... to use or employ, in connection
with the purchase or sale of any security ... any
manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the
Commission may prescribe[.]” 15 U.S.C. § 78j(b).
Rule 10b-5, promulgated under the authority of
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Section 10(b), in turn, provides that “[i]t shall be
unlawful for any person ... (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. Thus,
the basic elements of a Rule 10b-5 claim are: (1) a
material misrepresentation or omission of fact, (2)
scienter, (3) a connection with the purchase or sale of
a security, (4) transaction and loss causation, and (5)
economic loss. In re Daou Systems, Inc. 411 F.3d
1006, 1014 (9th Cir.2005).
In order to survive a motion to dismiss, a Section
10(b) claim must satisfy three pleading standards.
First, it must meet the general requirements
established by Federal Rule of Civil Procedure 8(a)
that complaints give a short and plain statement of
the claim. Second, it must conform with the
particularity requirements of Rule 9(b). Neubronner
v. Milken, 6 F.3d 666, 671 (9th Cir.1993) (quoting
Semegen, 780 F.2d at 731). Third, it must satisfy the
requirements of the Private Securities Litigation
Reform Act (“PSLRA”).
The PSLRA employs heightened pleading standards
for claims brought under Section 10(b) and, similar to
Rule 9(b), requires pleading with particularity for two
elements in a Section 10(b) claim: (1) falsity and (2)
scienter. See Gompper v. VISX, Inc., 298 F.3d 893,
895 (9th Cir.2002) (citing Ronconi v. Larkin, 253
F.3d 423, 429 (9th Cir.2001)). “If a plaintiff fails to
plead either the alleged misleading statements or
scienter with particularity, the court must dismiss the
complaint.” Carol Gamble Trust 86 v. E-Rex, Inc., 84
Fed.Appx. 975, 977 (9th Cir.2004).
*11 Thus, under both the PSLRA and Rule 9(b), a
plaintiff must specify each statement alleged to have
been misleading and the specific reason or reasons
why such statement is misleading. See 15 U.S.C. §
78u-4(b)(1); Fed.R.Civ.P. 9(b). This is accomplished
by
identifying
either
(1)
inconsistent
contemporaneous statements; or (2) inconsistent
contemporaneous information (such as an internal
document) that was made by or available to the
defendants. In re Splash Technology Holdings, Inc.
Sec. Litig., 2000 WL 1727377, *13 (N.D.Cal.1997);
see also Nursing Home Pension Fund, Local 144 v.
Oracle Corp., 380 F.3d 1226, 1230 (9th Cir.2004).
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“A plaintiff may satisfy [Rule 9(b) ] through reliance
upon a presumption that the allegedly false and
misleading
‘group
published
information’
complained of is the collective action of officers and
directors.” In re GlenFed, Inc. Sec. Litig., 60 F.3d
591, 593 (9th Cir.1995). In cases where the falsities
are conveyed in “group-published information,” for
example, in press releases and annual reports, “it is
reasonable to presume that these are the collective
actions of the officers.” Id. In such a case, a plaintiff
satisfies
Rule
9(b)
“by
pleading
the
misrepresentations with particularity and where
possible the roles of the individual defendants in the
misrepresentations.” Id.; see also In re Cornerstone
Propane Partners, L.P. Sec. Litig., 2005 U.S. Dist.
LEXIS 21469 (N.D.Cal.2005).
The “recent trend among the Ninth Circuit district
courts is that plaintiffs must state with particularity
facts indicating that an individual defendant was
directly involved in the preparation of allegedly
misleading statements published by an organization.”
Cornerstone, 2005 U.S. Dist. LEXIS at *21; see also
In re ESS Tech., Inc. Sec. Litig., 2004 U.S. Dist.
LEXIS 27203 (N.D.Cal.2004). However, “where the
pleading gives some basis for ascribing knowledge,
participation or authorship, and/or control of the
published information to an individual defendant” the
doctrine may be applied. Cornerstone, 2005 U.S.Dist.
LEXIS at *22.
When dealing with allegations based on information
and belief, and not plaintiff's personal knowledge, the
PSLRA imposes further pleading requirements.
“Allegations are deemed to be held on information
and belief, and thus subject to the particularity
requirements, unless plaintiffs have personal
knowledge of the facts .” Cornerstone, 2005
U.S.Dist. LEXIS at *8 (citing In re Vantive Corp.
Sec. Litig., 283 F.3d 1079, 1085 n. 3 (9th Cir.2002)).
Any allegation that is made on information and
belief, must “state with particularity all facts on
which that belief is formed.” 15 U.S.C. § 78u4(b)(1). “Naming sources is unnecessary so long as
the 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 and the complaint contains
adequate corroborating details.” Daou, 411 F.3d at
1015 (citing Nursing Home, 380 F.3d at 1233).
Therefore, to sufficiently plead falsity, a plaintiff
must: (1) identify each alleged misstatement, and in
the case of group published information, ascribe
some authorship or control over the documents to the
individual defendants; (2) state the reasons why the
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statement is misleading; and (3) in the case of
confidential source information, supply an adequate
factual basis to support the source's basis of
knowledge with regard to the information provided.
See 15 U.S.C. § 78u-4(b)(1).
*12 With respect to scienter, the PSLRA also
requires that the plaintiff “state with particularity
facts giving rise to a strong inference that the
defendant[s] acted with the required state of mind”
for each alleged act or omission. 15 U.S.C. § 78u4(b)(2). “Deliberate recklessness” is the required
state of mind and will satisfy scienter if it “reflects
some degree of intentional or conscious misconduct.”
Nursing Home, 380 F.3d at 1230 (citing Silicon
Graphics, 183 F.3d at 977). A complaint will not
survive if it just relies on generic allegations. See
Silicon Graphics, 183 F.3d at 974, 985. To assess
whether a plaintiff has sufficiently pled scienter, a
court must consider “whether the total of plaintiff's
allegations, even though individually lacking, are
sufficient to create a strong inference that defendants
acted with deliberate or conscious recklessness.”
Nursing Home, 380 F.3d at 1230. Additionally, a
court must consider “all reasonable inferences,
whether or not favorable to the plaintiff.” Id. (citing
Gompper, 298 F.3d at 897).
ANALYSIS
I. Defendants' Request for Judicial Notice
As a preliminary matter, the Court notes that
Defendants have requested that the Court take
judicial notice of the following documents, each of
which is attached to the accompanying Declaration of
Tiffany Harris-Sutton (“Harris-Sutton Declaration”):
(1) Applied Signal's Form 10-K for FY03, filed on
January 27, 2004;
(2) Applied Signal's Form 10-Q for the second
quarter of FY04, filed June 9, 2004;
(3) Applied Signal's Form 10-Q for the third quarter
of FY04, filed on September 9, 2004;
(4) Applied Signal's Form 10-K for FY04, filed on
January 14, 2005;
(5) Applied Signal's Form 8-K, filed on August 26,
2004;
(6) Applied Signal's Form 8-K, filed on December
23, 2004;
(7) A chart listing the closing stock prices of Applied
Signal during the Class Period;
(10) A copy of 48 C.F.R. 52.242-15.
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Pursuant to Federal Rule of Evidence Rule 201,
documents that are alleged in a complaint and are
essential to plaintiff's allegations may be judicially
noticed. See Branch v. Tunnell, 14 F.3d 449, 454 (9th
Cir.1994); Steckman v. Hart Brewing, Inc. 143 F.3d
1293, 1295 (9th Cir.1998). A court may also take
judicial notice of “well-publicized stock prices” on a
motion to dismiss. Ganino v. Citizens Utilities Co.,
228 F.3d 154, 167 n. 8 (2nd Cir.2000). Additionally,
a court may take judicial notice of regulations issued
by federal agencies. Citizens for a Better Env't-Cal. v.
Union Oil Co., 861 F.Supp. 889, 897 (N.D.Cal.1994)
(citing Mark v. South Bay Beer Distributors, Inc.,
798 F.2d 1279, 1282 (9th Cir.1986)).
Since Plaintiff does not oppose the taking of judicial
notice of any of these documents, and since judicial
notice is proper, the Court hereby GRANTS
Defendants' Request for Judicial Notice [Docket No.
36].
II. Defendants' Motion to Dismiss
*13 In Defendants' Motion to Dismiss, Defendants
argue that Plaintiff's Consolidated Amended
Complaint must be dismissed because: (1) the
PSLRA's safe harbor provision precludes liability for
any of the purportedly false or misleading statements
related to the Company's backlog; and (2) Plaintiff
has not stated, and cannot state, a cause of action
under Section 10(b) of the Exchange Act or Rule
10b-5 for any of the allegedly false or misleading
statements because the elements of falsity, scienter,
and loss causation are not supported by Plaintiff's
allegations. Since Defendants assert that no liability
can be established under Section 10(b) and Rule 10b5, Defendants also argue that the Section 20(a) claim
against Yancey and Doyle must be dismissed.
A. The Safe Harbor Provision
The first issue that must be addressed is whether the
allegedly false and misleading statements concerning
the Company's backlog are rendered non-actionable
because they are forward-looking statements falling
within the PSLRA's safe harbor provision. The
PSLRA carves out a safe harbor from liability for
forward-looking statements that prove false if the
statement “is identified as a forward-looking
statement and is accompanied by meaningful
cautionary statements identifying important factors
that could cause actual results to differ materially
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from those in the forward-looking statement.” 15
U.S.C. § 78u-5(c)(1)(A)(i); Harris v. Ivax Corp., 182
F.3d 799, 803 (11th Cir.1999). The purpose behind
this safe harbor is to encourage the disclosure of
forward-looking information. See H.R. Conf. Rep.
No. 104-369, 104th Cong. 1st Sess., at 53 (1995).
Whether a statement qualifies for the safe harbor is
an appropriate inquiry on a motion to dismiss. So
long as the safe harbor requirements are met, liability
cannot exist as a matter of law, regardless of the mind
of the person making the statement. Employers
Teamsters Local Nos. 175 and 505 Pension Trust
Fund v. Clorox, 353 F.3d 1125, 1133 (9th Cir.2004).
Forward-looking statements include statements
containing a projection of revenues, income, or
earnings per share, management's plans or objectives
for future operations, or a prediction of future
economic performance. 15 U.S.C. § 78u-5(i)(1)(A)(C). In addition, any statement of “the assumptions
underlying or relating to” these sorts of statements
fall within the meaning of a forward-looking
statement. 15 U.S.C. § 78u-5(i)(1)(D). A presenttense statement can qualify as a forward-looking
statement as long as the truth or falsity of the
statement cannot be discerned until some point in
time after the statement is made. See Harris, 182
F.3d at 805. Statements concerning historical or
current facts are not forward-looking. See Gross v.
Medaphis Corp., 977 F.Supp. 1463, 1473
(N.D.Ga.1997); In re Valujet, Inc. Sec. Litig., 984
F.Supp. 1472, 1479 (N.D.Ga.1997).
With respect to statements regarding backlog, only
four purportedly false and misleading statements are
identified: (1) that the backlog as of the third quarter
of FY04 was “[a]pproximately 11 million,” made
during the August 2004 Conference Call; (2) that the
backlog at the end of the fourth quarter was about
$143 million, made during the December 2004
Conference Call; (3) that the backlog at the end of the
fourth quarter was $143 million, set forth in the
December 2004 Press Release; and (4) that the
backlog at fiscal year-end was $143 million, set forth
in the FY04 Form 10-K.
*14 The Court finds that each of these statements is a
forward-looking statement that was accompanied by
the appropriate cautionary language. Specifically, for
both the August 2004 Conference Call and the
December 2004 Conference Call, Doyle stated the
following:
I'll review our financial performance, but let me
begin with the obligatory safe harbor statement. Our
presentation today may contain forward-looking
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statements which reflect the Company's current
judgment on future events. Because these statements
deal with future events, they are subject to risks and
uncertainties that could cause the actual results to
differ materially. In addition to the factors that may
be discussed in this call, important factors which
could cause actual results to differ materially are
contained in the Company's recent 10-Qs and 10-K.
See Harris-Sutton Decl. at Ex. C (August 24, 2004
Form 8-K); see also id. at Ex. F (December 21, 2004
Form 8-K) (stating same).
The Company's Form 10-Q filing, issued with respect
to the previous quarter, provided the following
additional cautionary language:
Forward-looking statements may be identified by the
use of terms such as “anticipates,” “expects,”
“intends,” “plans,” “seeks,” “estimates,” “believes,”
and similar expressions, although some forwardlooking statements are expressed differently.
Statements concerning financial position, business
strategy, and plans or objectives for future operations
are forward-looking statements. These statements are
not guarantees of future performance and are subject
to certain risks, uncertainties, and assumptions that
are difficult to predict and may cause actual results to
differ materially from management's current
expectations. Such risks and uncertainties include
those set forth in this document under “Summary of
Business Considerations and Certain Factors that
May Affect Future Operating Results and/or Stock
Price.” The forward-looking statements in this report
speak only as of the time they are made and do not
necessarily reflect management's outlook at any other
point in time. We undertake no obligation to update
publicly any forward-looking statements, whether as
a result of new information, future events, or for any
other reason. However, readers should carefully
review the risk factors set forth in other reports or
documents we file from time to time with the
Securities and Exchange Commission (SEC).
See Harris-Sutton Decl. at Ex. B.FN8
FN8. This same language was set forth in
the FY04 Form 10-K. See id. at Ex. H.
In the section entitled “Summary of Business
Considerations and Certain Factors that May Affect
Future Operating Results and/or Stock Price,” the
Company also noted that Applied Signal “depend[s]
on revenues from a few significant contracts, and any
loss, cancellation, reduction, or delay in these
Page 11
contracts could harm our business.” Id.
Additionally, the Form 10-Q for the third quarter of
FY04, which was filed on September 9, 2004,
specifically stated:
Stop-work orders could negatively impact our
operating results and financial condition. Almost all
of our contracts contain stop-work clauses that permit
the other contracting party, at any time, by written
order, to stop work on all or any part of the work
called for by the contract for a period of ninety days.
Within the ninety-day period, the other contracting
party may cancel the stop-work order and resume
work or terminate all or part of the work covered by
the stop-work order. During June 2004, we received a
stop-work order instructing us to stop work on a
portion of our largest single contract. In accordance
with the instructions received from the other
contracting party, we prepared a proposal that
detailed the tasks that were stopped and estimated the
reduction in contract costs. If all the stopped tasks are
terminated, the result could be a significant reduction
in orders and backlog in the period in which it occurs.
There can be no assurance that stop-work orders will
not be received in future periods.
*15 See Harris-Sutton Decl. at Ex. E (emphasis in
original).
Further, the December 2004 Press Release included
the following language:
Except for historical information contained herein,
matters discussed in this news release may contain
forward-looking statements that involve risks and
uncertainties that could cause actual results to differ
materially. Forward-looking statements discussed in
this release include statements as to the Company's
continued growth throughout the year and into the
foreseeable future; the future spending by the U.S.
Government on intelligence gathering; the
Company's ability to hire qualified personnel and
such personnel's ability to obtain security clearances;
the Company's plans for the future, including the
steps it may take and the programs it will emphasize;
the Company's beliefs concerning marketplace
opportunities for its products and services; and
beliefs concerning contractual opportunities for
orders. The risks and uncertainties associated with
these statements include whether orders will be
issued by procurers, including the U.S. Government;
the timing of any orders placed by procurers; whether
the Company will be successful in obtaining
contracts for these orders if they are forthcoming;
whether any contracts obtained by the Company will
be profitable and whether any such contracts might
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be terminated prior to completion; whether the
Company will be able to hire additional qualified
staff as needed; the ability to successfully enter new
marketplaces; the Company's ability to maintain
profitability; and other risks detailed from time to
time in the Company's SEC reports including its
latest Form 10-K filed for the fiscal year ended
October 31, 2003. The Company assumes no
obligation to update the information provided in this
news release.
See id. at Ex. F (December 21, 2004 Form 8-K).
Plaintiff does not dispute that these cautionary
statements were made, but attempts to dismiss the
language as mere “boilerplate” language, devoid of
any meaning. In the context of this litigation,
however, Plaintiff's argument is unavailing. Indeed,
in addition to all of the disclosures set forth above,
the Company consistently described the contingent
nature of the Company's backlog figures in all of its
public filings. For example, the following statement
was set forth in the FY03 Form 10-K and thus
preceded all of the aforementioned cautionary
language:
Our backlog ... consists of anticipated revenues from
the uncompleted portions of existing contracts[.] ...
Anticipated revenues included in backlog may be
realized over a multi-year period. We include a
contract in backlog when the contract is signed by us
and by our customer. We believe the backlog figures
are firm, subject only to the cancellation and
modification provisions contained in our contracts.
(See Item 7: “Management's Discussion and Analysis
of Financial Condition and Results of OperationsBacklog.”) Because of possible future changes in
delivery schedules and cancellations of orders,
backlog at any particular date is not necessarily
representative of actual sales to be expected for any
succeeding period, and actual sales for the year may
not meet or exceed the backlog represented. We may
experience significant contract cancellations that
were previously booked and included in backlog.
*16 See Harris-Sutton Decl. at Ex. A (FY03 Form
10-K) (emphasis added). Given the complete and
thorough nature of the Company's disclosures
regarding the unique structure of its business model,
and the attendant risks, Plaintiff's bare and
unsupported conclusion that the Company's
cautionary statements “lacked meaning” is
completely disingenuous.
Plaintiff's alternative argument that the allegedly
false and misleading statements do not qualify for
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safe harbor protection because the statements were
not, in fact, forward-looking is equally without merit.
Indeed, for the Court to accept Plaintiff's argument, it
would have to completely ignore the fact that
Plaintiff's Consolidated Amended Complaint
expressly identifies the allegedly false and
misleading statements as statements concerning the
Company's backlog. See, e.g., CAC at ¶ 29 (“The
amounts reported as ‘backlog’ by the Defendants on
August 24, 2004 ... were materially false and
misleading because the Defendants failed to disclose
that the Company had received a ‘stop-work order’ in
June 2004”) and ¶ 35 (“The amounts reported as
‘backlog’ by the Defendants on December 21, 2004,
and January 14, 2005, ... were materially false and
misleading”). The Court would also have to ignore
the fact that Plaintiff admits, in the Consolidated
Amended Complaint, that it was widely understood
that the term “backlog” relates to future revenues.
See, e.g., CAC at ¶ 26. Thus, according to Plaintiff's
own allegations, which are based on Plaintiff's own
information and belief, the Company's backlog is, by
definition, merely a “projection of revenue” or a
“prediction of future economic performance,” thus
falling squarely within the safe harbor. See 15 U.S.C.
§ 78u-5(i)(1)(A)-(C). Id . at ¶ 26.
Further, contrary to Plaintiff's current assertion, the
fact that the Company used the word “firm” to
describe its backlog figures in the FY03 Form 10-K
is not sufficient to equate the Company's “backlog”
with “historical data,” such as the Company's actual,
recognized quarterly revenue.FN9 Indeed, even the
passage in the FY03 Form 10-K that Plaintiff relies
on makes clear that “backlog at any particular date is
not necessarily representative of actual sales to be
expected for any succeeding period, and actual sales
for the year may not meet or exceed the backlog
represented.” See Harris-Sutton Decl. at Ex. A.
Additionally, the Company's quarterly filings
continuously reiterated the fact that the “backlog”
consisted of the uncompleted portions of existing
contracts.
FN9. This is a distinction with a significant
difference in the context of a publicly traded
company. See, e.g., Release No. SAB-101,
1999 WL 1100908 (SEC bulletin providing
guidance with respect to revenue
recognition). Ironically, had the Company
actually characterized its potential revenue
as “real” revenue in the manner that Plaintiff
suggests is appropriate, the ramifications
under the applicable SEC rules and
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regulations would
catastrophic.
have
likely
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been
Finally, Plaintiff's argument that the safe harbor is
inapplicable because the Company did not adequately
inform investors with regard to certain events in the
“past”-i.e. “that the government had already issued
‘stop-work orders,” ’-is unpersuasive because it is
premised on Plaintiff's own failure to understand the
inherently contingent nature of a stop-work order.
Indeed, Plaintiff's entire securities fraud theory
relating to backlog is based on Plaintiff's belief that
“the receipt of a ‘stop-work order’ means that any
previously reported ‘backlog’ amounts attributable to
revenue within the scope of the ‘stop-work’ order are
no longer valid.” See CAC at ¶ 26. However, this
statement is not supported by the applicable
regulations or the Company's actual manner of
accounting for its backlog. See 48 C.F.R. 52.242-15
(describing how the receipt of a stop-work begins the
negotiation process and how a stop-work order is
subject to cancellation at any time during this
negotiation period); see also Harris-Sutton Decl. at
Ex. E (Third Quarter FY04 Form 10-Q) (stating that
the Company's backlog would not be reduced until
the negotiations relating to SW01 were completed
and the Company was able to ascertain whether parts
of the applicable contract would actually be
terminated). Even under the lenient pleading standard
afforded to a plaintiff on a 12(b)(6) motion, this
Court “need not accept as true allegations that
contradict facts which may be judicially noticed.”
Mullis v. United States Bankruptcy Ct., 828 F.2d
1385, 1388 (9th Cir.1987), cert. denied, 486 U.S.
1040 (1988). Accordingly, Defendants have
persuasively shown that the safe harbor precludes
liability for all of the allegedly false and misleading
statements relating to the Company's backlog.
Therefore, Plaintiff's claims pertaining to the backlog
are hereby DISMISSED WITH PREJUDICE.
B. Plaintiff's Failure to State a Claim under Section
10(b) of the Exchange Act or Rule 10b-5
*17 Additionally, Defendants have also shown that
Plaintiff has not stated a claim under Section 10(b)
the Exchange Act or Rule 10b-5 with respect to both:
(1) the allegedly false and misleading statements
pertaining to the Company's backlog; and (2) the
allegedly false and misleading statements pertaining
to the Company's hiring of personnel. The sufficiency
of Plaintiff's claims regarding the Company's backlog
will be discussed first.
1. Statements Regarding the Company's Backlog
a. The False and/or Misleading Element
As noted in the previous discussion of the safe harbor
provision, supra, Plaintiff's Consolidated Amended
Complaint is premised on the following four
allegedly false and/or misleading statements
concerning the Company's backlog: (1) the August
2004 Conference Call; (2) the December 2004
Conference Call; (3) the December 2004 Press
Release; and (4) the FY04 Form 10-K. Plaintiff
alleges that the statement concerning the Company's
backlog made during the August 2004 Conference
Call was materially false and/or misleading because
Defendants failed to disclose that, prior to the time
the call took place, the Company had received two
stop-work orders, SWO1 and SWO2. Plaintiff alleges
that statements concerning the Company's backlog
made during the December 2004 Conference Call,
the December 2004 Press Release, and the FY04
Form 10-K were materially false and/or misleading
because Defendants failed to disclose that, at the time
the statements were made, the Company had received
SWO2, SWO3, and SWO4.
As an initial matter, the Court notes that Plaintiff has
not alleged any facts sufficient to show that any of
the statements concerning the Company's backlog
were actually false when made. Indeed, the theory set
forth in Plaintiff's Consolidated Amended Complaint
is that: (1) the statement made in August 2004
regarding the $111 million backlog was false because
the $111 million backlog figure did not account for
SWO1 and SWO2; (2) the statements made in
December 2004 and January 2005 regarding the $143
million backlog was false because the $143 million
backlog figure did not account for SWO2, SWO3, or
SWO4. However, the Company's public statements
make clear that anticipated revenues are not
“debooked” from the total backlog figure until the
contract affected by the stop-work order is actually
terminated. See Harris-Sutton Decl. at Ex. E (Third
Quarter FY04 Form 10-Q) (confirming that the
backlog for the third quarter of FY04 was $111
million, but indicating that it might be reduced in
FY05 if the “stopped tasks are [actually]
terminated.”).
For example, during the December 2004 Conference
Call, an analyst specifically asked whether the $143
million included any potential “debookings,” and
Yancey replied as follows:
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Q: And does the-one more question for you, or two
more questions, please. Does the $143 million
include-is that net of any potential debooking?
A: That includes the $12 million that has not been
debooked.
*18 Q: So it's not net of any potential debooking?
Includes?
A: That's right.
See Harris-Sutton Decl. at Ex. F (December 2004
Form 8-K) (emphasis added).
Again, on February 22, 2005, Yancey responded to
the following questions regarding backlog:
Q: Okay. During the last quarter, you had a nice-Q4
of 2004 was a big bookings quarter and also backlog
came in pretty robust. Can you give us an idea of
where your backlog is right now?
A: Sure, at the end of the first quarter, Jay, it's a little
over $124 million.
Q: And that is not net of any potential debooking,
correct?
A: Well, that's correct.
A: Yes. We had to-we had to figure out how many
negatives was in there, but you're correct. You're
correct.
A: So it still includes the $12 million-the 11 to 13
million in that range-$12 million of anticipated
debooking.
See SEC Form 8-K, filed on February 22, 2005, at
Ex. 99.2 (transcript of February 22, 2005 Conference
Call).
Thus, with respect to SWO2, SWO3, and SWO4,FN10
Plaintiff would have to prove both: (1) that the stopwork orders actually resulted in a termination of all
or a portion of the relevant contracts; and (2) that the
effect of the termination was immediately calculable
in the third or fourth quarters of FY04 or the first
quarter of FY05. Even construed in the light most
favorable to Plaintiff, Plaintiff's Consolidated
Amended Complaint does not contain any allegations
sufficient to meet these requirements.
FN10. Plaintiff's argument that the August
2004 Conference Call statement was false is
foreclosed by the fact that Plaintiff admits
that the statement that backlog was
“approximately $111 million” was, in fact,
correct. See CAC at ¶ 29(a) (“The Third
Quarter Form 10-Q reported the same
‘backlog’ number that the Defendants had
announced in the August Conference
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Page 14
Call.”).
Additionally, in order for Plaintiff to prove that
Defendants' statements were misleading, Plaintiff
would have to show that the Company had a duty to
disclose SWO1 prior to September 9, 2004; that the
Company had a duty to disclose SWO2 during the
August 2004 Conference Call or thereafter; and that
the Company had a duty to disclose SWO3 and
SWO4 as of the time of the December 2004
Conference Call or thereafter. See Gallagher v.
Abbott Labs., Inc., 269 F.3d 806, 809 (7th Cir.2001)
(“Much of plaintiffs' argument reads as if firms have
an absolute duty to disclose all information material
to stock prices as soon as news comes into their
possession. Yet that is not the way the securities laws
work. We do not have a system of continuous
disclosure. Instead firms are entitled to keep silent
(about good news as well as bad news) unless
positive law creates a duty to disclose.”). As
Defendants point out, however, Plaintiff has not
affirmatively alleged such duty, and it clear to the
Court, based on the applicable facts and the law that
has been presented, that no such duty existed. For
example, as to the pertinent facts, the allegations in
the Consolidated Amended Complaint are
ambiguous, at best, as to the: (1) dates the stop-work
orders were issued; (2) the dates the stop-work orders
were to expire; (3) whether the stop-work orders
affected all or part of the relevant contracts; (4)
whether the stop-work orders were subject to any
extensions; (5) whether the stop-work orders actually
resulted in any contract terminations; and (6) the
amount of future revenues affected by the contract
terminations, if such terminations occurred.
*19 Further, in his opposition, Plaintiff does not
identify a single statute or regulation that requires a
company to disclose either the possibility that
contracts with customers may be terminated or the
actual termination of the customer contract. Indeed,
as Defendants aptly note, although the SEC
considered proposing such a regulation, it ultimately
decided against it. See SEC, Final Rule: Additional
Form 8-K Disclosure Requirements and Acceleration
of Filing Date, Release Nos. 33-8400, 34-49424
(Mar. 16, 2004) (declining to adopt Proposed Item
1.03, “Termination or Reduction of a Business
Relationship with a Customer.”). Where, as here, a
plaintiff's complaint is devoid of the pertinent details
and fails to otherwise affirmatively plead the basis
for the duty of disclosure, the Court must dismiss the
claim. See, e.g., In re Digital Island Sec. Litig., 357
F.3d 322, 329 n. 10 (3rd Cir.2004).
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b. Scienter
Plaintiff's Consolidated Amended Complaint also
fails to sufficiently establish scienter. Under the
PSLRA, Plaintiff must allege particular facts giving
rise to a strong inference of scienter. 15 U.S.C. sec
78u-4(b)(2). With respect to SWO1, the Consolidated
Amended Complaint does not plead any facts
showing that the decision to disclose the stop-work
order on September 9th, rather than August 24th, was
the product of fraud or even the product of
recklessness. In fact, the Consolidated Amended
Complaint does not say anything at all with regard to
Doyle or Yancey's state of mind as of August 24,
2004, other than the conclusory assertion that Doyle
and Yancey “did not deny” in the Form 10-Q that
they “knew about [SWO1] at the time that it was first
issued by the government contractor.” See CAC at ¶
29(b). Not only is this insufficient, but the fact that
Defendants disclosed the SWO1 in the Company's
Form 10-Q only two weeks later cuts heavily against
an inference of scienter. See, e.g., In re Segue
Software, Inc. Sec. Litig., 106 F.Supp.2d 161, 170
(D.Mass.2000). The inference of scienter is further
negated by the fact that neither Yancey nor Doyle
sold any stock during this two-week period.
With respect to SWO2, SWO3, and SWO4, the
Consolidated Amended Complaint also fails to set
forth any allegations sufficient to show that Yancey
or Doyle even knew of the stop-work orders, much
less that Yancey and Doyle deliberately attempted to
deceive stockholders by providing false or
misleading information pertaining to the Company's
backlog. To the contrary, as noted previously,
Yancey and Doyle candidly disclosed during the
relevant period that potential debookings affecting
future revenue were not excluded from the
Company's backlog. See Harris-Sutton Decl. at Ex. F
(December 2004 Form 8-K). The Company also
repeatedly warned shareholders in its public filings
that the Company's backlog was not necessarily
representative of actual future sales or revenue.
Further, with respect to Doyle, there is no allegation
that he sold any stock during the Class Period. As to
Yancey, it has not been sufficiently shown that his
stock sales-which occurred during January 2005-were
“dramatically out of line with prior trading practices”
or that they took place during a time specifically
“calculated to maximize the personal benefit from
undisclosed inside information.” See Ronconi v.
Larkin, 253 F.3d 423, 435 (9th Cir.2001). To the
contrary, the allegations in the Consolidated
Page 15
Amended Complaint plainly state that Yancey-like
most of the other shareholders-sold stock after the
Company announced fourth quarter operating results
for FY04 that did not meet the analysts' expectations.
See CAC at ¶ 42 (“Only once in the preceding six
months had more than 1 million shares of Applied
Signal stock traded in a day; at no other time did
volume exceed 600,000 shares in a day.”). The only
allegation in the Consolidated Amended Complaint
that even suggests an inference that the stock sales
were suspicious is Plaintiff's bare assertion that
“Yancey had complete knowledge of the ‘stop-work
orders' and their expected impact on the Company's
revenues and earnings for the quarter.” See CAC at ¶
49. However, this assertion is completely undermined
by the fact that Plaintiff's Consolidated Amended
Complaint does not actually allege any facts showing
that the stop-work orders had any impact on the
Company's recognized revenue or earnings for the
first quarter of FY05. See CAC at ¶ ¶ 44-47.
c. Loss Causation
*20 Finally, Defendants correctly argue that the
Consolidated Amended Complaint does not provide
an adequate basis for the required element of loss
causation for SWO2, SWO3, or SWO4.FN11 Indeed,
the internal inconsistencies of the Consolidated
Amended Complaint actually defeat a finding of loss
causation. For example, as noted above, although
Plaintiff's securities fraud theory is premised on his
contention that the Company's misleading statements
regarding backlog resulted in substantial financial
loss to the shareholders, Plaintiff actually states, in
his Consolidated Amended Complaint, that the price
per share of the Company's stock declined in
December 2004 because the Company announced
that: (1) the earnings would only be 21 cents per
share for the fourth quarter of FY04, as opposed to
the analysts' consensus estimate of 29 cents per share;
and (2) the Company's revenue had only increased by
3%. See CAC at ¶ 42. Plaintiff also states that the
price per share of the Company's stock declined in
February 2005 because the Company reported that
“revenue declined almost 25 percent from the
preceding quarter, with net income and earnings per
share declining as well.” See CAC at ¶ 44.
FN11. Defendants concede in their Motion
that loss causation relating to SWO1 is
adequately plead.
Although Plaintiff vigorously contends, in his
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Opposition brief, that the stop-work orders were the
actual cause of the losses in revenue, the
Consolidated Amended Complaint does not actually
state this. Indeed, the Consolidated Amended
Complaint does not set forth any facts establishing a
causal connection between the contracts purportedly
affected by the stop-work orders and the actual
revenue for the fourth quarter of FY04 or the first
quarter of FY05. Plaintiff's argument that it is
“facially absurd” to assume anything other than that
SWO2, SWO3, and SWO4 directly impacted revenue
in the fourth quarter of FY04 and the first quarter of
FY05 is undermined considerably by the relevant
government regulations concerning stop-work orders,
which expressly provide that stop-work orders are
contingent for a ninety-day period and are otherwise
subject to negotiations, revisions, and extensions.
Plaintiff's argument is further undermined by the fact
that contracts are included in the “backlog” precisely
because the revenue is not recognizable until the
relevant portion of the contract is completed and the
fact that it is undisputed that anticipated revenues
included in the backlog are typically realized over a
multi-year period.
2. Statements Concerning Hiring
Next, with respect to Plaintiff's allegations
concerning the Company's purportedly false and
misleading statements regarding the hiring of
personnel, Defendants have effectively shown that
Plaintiff's Consolidated Amended Complaint fails to
state a claim under Section 10(b) or Rule 10b-5. Over
the course of the entire Class Period, only three
statements concerning hiring are challenged in the
Consolidated Amended Complaint: (1) two statement
made during the August 2004 Conference Call; and
(2) a statement made in the August 2004 Press
Release.FN12
FN12.
The
Consolidated
Amended
Complaint makes mention of other
statements of similar nature made by
Defendants, but these statements fall outside
of the relevant Class Period. See CAC at ¶
38.
*21 Plaintiff first challenges the fact that Yancey
stated, during the August 2004 Conference Call, that
he was “pleased that we've been able to stay up with
a fairly aggressive growth requirement and, in
particular, hiring of staff and staff that we can get
cleared and hiring cleared staff and we believe that
Page 16
we're keeping our program performance on par with
adequate performance to where we will continue to
be looked upon as an asset to the defense community
by the U.S. government.” See Harris-Sutton Decl. at
Ex. C.
The second August 2004 Conference Call statement
challenged by Plaintiff is as follows:
Q: Okay. Thank you. Secondly, how many engineers
did you add during the quarter?
A (Doyle): We've had total hiring of about 100
people year-to-date. Let's see, I don't know Gary,
what, about 30 through the quarter?
A (Yancey): I would have actually guessed maybe
20. It slowed a bit into the summer, although perhaps
not. The simple answer would be to go ahead and use
30, Steve, and kind of assume we've been close to
linear in our increase.
See Harris-Sutton Decl. at Ex. C.
As to the August 2004 Press Release, Plaintiff alleges
that the following statement was false and
misleading:
Regarding the third quarter operating results, Mr.
Gary Yancey, President and Chief Executive Officer
of the Company, commented, “The greatly increased
level of orders compared to fiscal 2003 has
challenged us to meet aggressive hiring requirements
and to control capital expenditures. I am pleased that
we have met these challenges and have been able to
meet our contractual commitments. This has resulted
in our increase in revenue compared to fiscal 2003.”
See id.
a. The False and/or Misleading Element
Plaintiff alleges that the aforementioned statements
were materially false and misleading because “[i]f
Applied Signal had, in fact, added 100 employees
‘year-to-date’ as of August, 2004, as reported by
Defendant Doyle during the August Conference Call,
the Company would have had 525 employees” at the
time of the December 2004 Conference Call and
“should have had approximately 545 employees at
the end of the year.” See CAC at 40(b). As an initial
matter, given that Plaintiff's entire argument is based
on the fact that the Company had 498 employees in
December instead of Plaintiff's speculation that it
should have had 525 or 545 employees, Plaintiff's
claim borders on frivolous. See, e.g., Central
Laborers Pension Fund v. Merix Corp., 2005 WL
2244072, *4 (D.Or.2005) (“Plaintiff cannot meet the
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Slip Copy
Slip Copy, 2006 WL 1050174 (N.D.Cal.), Fed. Sec. L. Rep. P 93,734
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heightened pleading standards applicable to fraud
claims by simply characterizing Defendants'
statements, embedding in those characterizations
assumptions not found in the statements themselves,
and then explaining why Plaintiff's own assumptions
are false.”).
Further, with respect to the element of falsity,
Plaintiff's securities fraud “theory” is hopelessly
flawed. First, as Defendants point out, the statement
made by Doyle in the August 2004 Conference Call
makes clear that Doyle is not referring to a “net” gain
of 100 employees. Thus, a theory that attempts to
prove falsity by comparing Doyle's statement with
the total number of employees within the Company
in December 2004 is inherently defective. Indeed,
there are no allegations in the Consolidated Amended
Complaint showing that the Company did not, in fact,
hire the indicated number of employees. As such,
Plaintiff has not adequately plead that the statements
made by Doyle or Yancey were false. Second, and
more importantly, Plaintiff utterly fails to show how
Doyle and Yancey's statements were misleading.
Indeed, it does not appear that Plaintiff could show
this, as Doyle's and Yancey's answers regarding
hiring are replete with qualifiers such as “I don't
know,” “maybe,” and “I would have guessed.”
b. Scienter
*22 The fact that Doyle and Yancey expressly stated
in the August 2004 Conference Call that they were
not expressing a firm opinion with regard to the exact
number of employee hires, and were only guessing,
also negates a finding that Doyle or Yancey acted out
of deliberate recklessness or with an intent to defraud
shareholders. The inference of scienter is further
negated by the fact that Doyle and Yancey did not
experience any personal gain as a result of the
allegedly false or misleading statements. Indeed,
even Plaintiff admits that Yancey did not sell any
Company stock until after the December 2004
disclosure which clarified the exact number of
Company employees.
c. Loss Causation
Additionally, the Consolidated Amended Complaint
does not establish a causal connection between the
August 2004 statements regarding hiring and the
December 2004 decline in stock price. To the
contrary, as set forth previously, Plaintiff alleges,
instead, that the stock price fell in December because
Page 17
the Company announced that it was not meeting the
analysts' consensus estimate and because the
Company's revenue only increased by 3%. See CAC
at ¶ 42. Plaintiff's contention that the February 2005
decline in stock price is also attributable to the
Company's August 2004 statements is foreclosed by
the fact that Plaintiff admits that the investing public
was apprised of the true number of employees in
December 2004.
In sum, Plaintiff has failed to state claim under
Section 10(b) of the Exchange Act and Rule 10b-5
promulgated thereunder. Accordingly, these causes of
action are hereby DISMISSED.
C. Liability Under § 20(a) of the Exchange Act
With respect to Plaintiff's second cause of action, to
establish “control person” liability under Section
20(a) of the Exchange Act, Plaintiff must show that a
primary violation of Section 10(b) or Rule 10b-5 was
committed and that each individual defendant
“directly or indirectly” controlled the violator. See
Paracor Finance, Inc. v. General Electric Capital, 96
F.3d 1151, 1161 (9th Cir.1996). Since Plaintiff has
not stated a viable Section 10(b) or Rule 10b-5 claim,
Plaintiff's claim under Section 20(a) of the Exchange
Act necessarily fails. Accordingly, the entire
Consolidated Amended Complaint is DISMISSED.
III. Dismissal with Prejudice
Further, given the deficiencies in Plaintiff's
Consolidated Amended Complaint identified herein,
the Court has concluded that it is appropriate to
DISMISS the Consolidated Amended Complaint
WITH PREJUDICE. In making this determination,
the Court finds it important to point out that this case
departs from the usual circumstances where dismissal
with leave to amend is appropriate because the
plaintiff has merely failed to allege, with sufficient
particularity, facts supporting a viable legal theory of
securities fraud. In this case, by way of contrast, the
Consolidated Amended Complaint is defective
because Plaintiff's theory of fraud, itself, is legally
flawed and is premised on either a fundamental
misunderstanding of Applied Signal's business
model, at best, or a blatant misrepresentation of the
pertinent facts. Since Plaintiff could only amend his
Consolidated Amended Complaint to allege
additional facts that are consistent with the facts that
have already been plead, the Court finds that granting
Plaintiff leave to amend in order to augment the
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Slip Copy, 2006 WL 1050174 (N.D.Cal.), Fed. Sec. L. Rep. P 93,734
(Cite as: Slip Copy)
Consolidated Amended Complaint with additional
facts would be futile. Further, since Plaintiff has
already changed his theory of fraud twice,FN13
granting further leave to amend would be highly
prejudicial to Defendants. The typically liberal
standard of allowing leave to amend should not be
employed to require Defendants to defend against an
amorphous, “moving target” securities fraud case that
is not well thought-out or well supported.
Page 46 of 121
Page 18
IT IS FURTHER ORDERED THAT Defendant's
Request for Judicial Notice [Docket No. 36] is
GRANTED.
IT IS FURTHER ORDERED THAT Plaintiff's
Motion for Class Certification [Docket No. 25] is
DENIED AS MOOT.
IT IS SO ORDERED.
FN13. As noted in the discussion of the
procedural history of this case, the
complaints initially filed set forth a different
class period and were not expressly
premised on the statements concerning the
Company's stop-work orders and backlog.
N.D.Cal.,2006.
In re Applied Signal Technology, Inc. Securities
Litigation
Slip Copy, 2006 WL 1050174 (N.D.Cal.), Fed. Sec.
L. Rep. P 93,734
Briefs and Other Related Documents (Back to top)
*23 Further, the Court finds that dismissal without
leave to amend is also appropriate given the length of
time that has passed since the initial complaint was
filed. Indeed, the initial complaint was filed on
March 11, 2005 and the Consolidated Amended
Complaint was filed five months later, on August 12,
2005. Plaintiff has been on notice with regard to the
defects of his Consolidated Amended Complaint
since September 14, 2005, when Defendants filed the
instant Motion to Dismiss. Accordingly, dismissal
with prejudice is warranted on this basis as well. See
Lipton v. Pathogenesis Corp., 284 F.3d 1027, 103839 (9th Cir.2002) (affirming district court's dismissal
with prejudice after finding that: (1) more than six
months had elapsed between the filing of the original
lawsuit and the filing of the consolidated amended
complaint, and (2) three additional months had
passed between the time the defendants filed their
motion to dismiss and the district court's ruling). FN14
• 2005 WL 3607437 (Trial Motion, Memorandum
and Affidavit) Reply Memorandum of Points and
Authorities in Support of Motion to Dismiss
Consolidated Amended Class Action Complaint
(Nov. 14, 2005) Original Image of this Document
(PDF)
• 2005 WL 2869143 (Trial Motion, Memorandum
and Affidavit) Bramson, Plutzik, Mahler &
Birkhaeuser, LLP (Nov. 1, 2005) Original Image of
this Document (PDF)
• 2005 WL 2613644 (Trial Pleading) Consolidated
Amended Class Action Complaint (Aug. 11, 2005)
Original Image of this Document (PDF)
• 4:05cv01027 (Docket) (Mar. 11, 2005)
END OF DOCUMENT
FN14. Further, the Court cannot overlook
the fact that Applied Signal is currently in its
2006 fiscal year, and yet Plaintiff's
Opposition does not even suggest that
Plaintiff is aware of any additional facts or
events that have occurred during this
passage of time that would lend further
support to his case.
CONCLUSION
For all of the reasons set forth above, IT IS HEREBY
ORDERED THAT Defendants' Motion to Dismiss
[Docket No. 35] is GRANTED. The Court hereby
DISMISSES the Consolidated Amended Complaint
WITH PREJUDICE.
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(Cite as: Not Reported in F.Supp.2d)
Briefs and Other Related Documents
Bennett v. H & R Block Financial Advisors,
Inc.N.D.Cal.,2005.Only the Westlaw citation is
currently available.
United States District Court,N.D. California.
William M. BENNETT and Michele L. Borovac,
Individually and on Behalf of All Others Similarly
Situated, Plaintiffs,
v.
H & R BLOCK FINANCIAL ADVISORS, INC.,
and Does 1-10, Defendants.
No. C 04-4848 MHP.
Oct. 27, 2005.
Mark C. Molumphy, Joseph W. Cotchett, Nancy L.
Fineman, Cotchett, Pitre, Simon & McCarthy,
Burlingame, CA, Peter E. Borkon, Schubert & Reed
LLP, San Francisco, CA, for Plaintiffs.
Stephen D. Hibbard, Shearman & Sterling LLP, San
Francisco, CA, for Defendants.
Page 48 of 121
Page 1
FN1. Unless otherwise noted, background
facts are taken from plaintiffs' First
Amended Complaint.
In the largest bankruptcy in United States history, the
Enron Corporation filed for protection under Chapter
11 on December 2, 2001. The consequences of its
collapse are well known: several criminal
prosecutions, the demise of Enron's auditor Authur
Andersen LLP, massive losses by investors, and a
flurry of related securities litigation.
The present action concerns the one-month period
immediately preceding Enron's bankruptcy filing.
Plaintiffs allege, generally, that H & R Block
fraudulently unloaded its holdings of Enron corporate
bonds onto its brokerage clients in response to
internal evaluations of Enron's emerging financial
crisis. Plaintiffs specifically claim that H & R Block
failed to disclose its internal concerns about Enron's
financial stability to its clients, as manifested by H &
R Block's internal communications about Enron and
its decision to create a special incentive program for
the sale of Enron bonds.
MEMORANDUM AND ORDER
PATEL, J.
Re: Motion to Dismiss
*1 William Bennett and Michele Borovac have
brought the present action on behalf of all persons
who purchased Enron corporate bonds from
defendant H & R Block Financial Advisors, Inc. (“H
& R Block”) from October 29, 2001 through
November 27, 2001 (the “class period”). Plaintiffs
allege that defendant violated federal securities laws
by engaging in a fraudulent effort to solicit and sell
$16 million of Enron bonds that were in fact
worthless. The court previously granted defendants'
motion to dismiss for failure to state a claim upon
which relief can be granted, with leave to amend.
Now before the court is defendant's motion to dismiss
plaintiffs' First Amended Complaint. Having
considered the parties' arguments and submissions,
and for the reasons set forth below, the court rules on
the motion as follows.
BACKGROUND FN1
According to plaintiffs, defendant sold $16 million
worth of Enron bonds (referred to as Bonds 1, 2, and
3) to more than 800 H & R Block customers during
the class period. Defendant's internal evaluations,
which were based on public information about
Enron's burgeoning difficulties, concluded that these
bonds were “worthless” due to Enron's “severe and
deteriorating financial problems,” yet the brokerage
firm initiated a widespread sales program for the
bonds in order to “dump” their Enron holdings.
Defendant used a special commission structure that
encouraged the sale of Enron bonds with unusually
high sales credits for brokers. Plaintiffs identify one
specific example of insider opinion on Enron
securities: on October 23, 2001, defendant's Director
of Research notified his representatives and branch
managers that the equity Enron Capital Trust II had
been removed from the approved list of products due
to concern about the company's debt rating.
On November 8, 2004, the National Association of
Securities Dealers (“NASD”) issued a press release
announcing that it was charging H & R Block with
fraud in the sale of Enron bonds to more than 800
customers during the time frame defined herein as the
class period. NASD estimated that H & R Block
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brokers recommended the sale of over $16 million
worth of Enron bonds, and the agency is charging H
& R Block with receiving profits of more than
$500,000.
*2 Just one week later, on November 15, 2004,
plaintiffs filed their original complaint with the law
firm Cotchett, Pitre, Simon, & McCarthy as counsel.
Their motion for appointment as lead plaintiff was
unopposed, and this court granted them lead plaintiff
status on March 1, 2005. The original complaint
alleged violations of section 10(b) of the Securities
and Exchange Act of 1934 and Rule 10(b)(5)
promulgated thereunder, fraud and concealment
under California common law, and breach of
fiduciary duty under California common law.
Defendant moved to dismiss the original complaint
under Federal Rule of Civil Procedure 12(b)(6).
The court granted defendant's motion with respect to
all of plaintiffs' claims. The court found plaintiffs'
state law claims to be preempted and dismissed them
with prejudice. With respect to plaintiffs' section
10(b) claim, the court found that plaintiffs failed to
state a coherent theory of misrepresentation or
omission and reliance, to plead scienter with
sufficient particularity, and to state sufficient
allegations of loss causation.
In response to the court's order, plaintiffs filed the
First Amended Complaint which is the subject of the
instant motion. The First Amended Complaint
clarifies the nature of the alleged material omissions,
adds detail to the allegations of scienter, and recasts
the loss causation allegations in light of Dura
Pharmaceuticals, Inc. v. Broudo, --- U.S. ----, ----,
125 S.Ct. 1627, 1631, 161 L.Ed.2d 577 (2005), which
abrogated the Ninth Circuit standard for proving loss
causation.
Defendant has once again moved to dismiss plaintiffs'
complaint. Defendant argues that the alleged
omissions, as clarified, are neither material nor
misleading, that plaintiffs have still failed to meet the
pleading burden for scienter, and that plaintiffs have
again failed to allege loss causation.
LEGAL STANDARD
A motion to dismiss under Federal Rule of Civil
Procedure 12(b)(6) “tests the legal sufficiency of a
claim.” Navarro v. Block, 250 F.3d 729, 732 (9th
Cir.2001). Because Rule 12(b)(6) focuses on the
“sufficiency” of a claim rather than the claim's
Page 2
substantive merits, “[o]rdinarily, a court may look
only at the face of the complaint to decide a motion
to dismiss.” Van Buskirk v. Cable News Network,
Inc., 284 F.3d 977, 980 (9th Cir.2002). Under Rule
12(b)(6), “unless it appears beyond doubt that
plaintiff can prove no set of facts in support of her
claim which would entitle her to relief,” a motion to
dismiss must be denied. Lewis v. Telephone
Employees Credit Union, 87 F.3d 1537, 1545 (9th
Cir.1996) (citation omitted); see also Conley v.
Gibson, 355 U.S. 41, 45-46, 78 S.Ct. 99, 2 L.Ed.2d
80 (1957).
DISCUSSION
To state a claim under section 10(b), plaintiffs must
allege a material misrepresentation, scienter, a
connection with the purchase or sale of a security,
reliance, economic loss, and loss causation. Zelman v.
JDS Uniphase Corp., 376 F.Supp.2d 956, 964
(N.D.Cal.2005) (Schwarzer, J.) (citing Dura
Pharms., 125 S.Ct. at 1631). Plaintiffs' first
complaint was deficient with respect to several of
these elements; specifically, plaintiffs failed to state a
coherent theory of misrepresentation and reliance, to
plead scienter with sufficient particularity, and to
allege loss causation. With respect to the last
element, plaintiffs' original complaint was filed under
the Ninth Circuit standard for loss causation that was
abrogated by the Supreme Court in Dura
Pharmaceuticals. The court first considers whether
plaintiffs' amended complaint is sufficient under the
new loss causation standard.
I. Loss Causation
*3 As this court has previously noted, the Supreme
Court in Dura Pharmaceuticals endorsed the Second
Circuit test for loss causation, as set forth in Lentell v.
Merill Lynch & Co., 396 F.3d 161 (2d Cir.2005) and
Emergent Capital Investment Management, LLC v.
Stonepath Group, Inc., 343 F.3d 189 (2d Cir.2003).
See Dura Pharms., 125 S.Ct. at 1633-34. Under the
Second Circuit standard, plaintiffs must allege that
the subject of the fraudulent statement or omission
was the proximate cause of the actual loss suffered.
Lentell, 396 F.3d at 173 (quoting Suez Equity
Investors, L.P. v. Toronto-Dominion Bank, 250 F.3d
87, 95 (2d Cir.2001)). Stated differently, plaintiffs
must allege both that the loss was foreseeable and
that the loss was caused by the materialization of the
concealed risk. Id.
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In the First Amended Complaint, plaintiffs allege that
defendant made four material omissions:
(1) that defendant was aware of and concerned about
Enron's “financial problems, including the fact that
the Securities and Exchange Commission was
conducting an investigation into Enron”;
(2) that defendant was aware and concerned that
Enron “had experienced a number of credit rating
downgrades and that the bonds were on a negative
credit watch for additional potential downgrades”;
(3) that defendant had sent communications out via
its intranet notifying brokers that the Enron Capital
Trust II security was removed from defendant's list of
approved securities because of defendant's concerns
about Enron's financial stability; and
(4) that defendant paid its sales representatives an
unusually large bonus for selling Enron securities.
FAC ¶ 4. These alleged omissions consist both of
public information, which was available to the
investing community as a whole, and private
information available only to defendant. Specifically,
the “financial problems” and “rating downgrades”
that formed the basis of defendant's alleged concerns
in omissions (1) and (2) were disclosed to the public
in a number of press releases and articles which are
identified in plaintiffs' complaint. FAC ¶ ¶ 60-70.
Plaintiffs have made no allegations that defendant
possessed insider information about Enron. The fact
that defendant was “monitoring” or concerned about
these events, however, was not public knowledge.
Similarly, any belief defendant may have had about
the financial viability of Enron, as reflected in alleged
omissions (3) and (4), was not public knowledge.
With respect to the publicly available information,
plaintiffs have not alleged and cannot plausibly allege
that the press releases cited in the complaint caused
the later drop in value of the Enron bonds. The
“truth” contained in those press releases had already
“[made] its way into the market place” and affected
the market price of the bonds; plaintiffs have not
alleged that they purchased the bonds at a price
different from their market value on the date of the
sale. See Dura Pharms., 125 S.Ct. at 1632. Instead,
plaintiffs attempt to link the already public
information about Enron's financial instability to
plaintiffs' loss in two ways. First, plaintiffs argue that
the fall in bond value was caused by the same general
phenomenon-Enron's financial instability-that was
the subject of the press releases and articles. FAC ¶
100. It is not adequate, however, to allege that the
subject of defendant's omission has some connection
to the loss in value; “[t]o ‘touch upon’ a loss is not to
cause a loss, and it is the latter that the law requires.”
Page 50 of 121
Page 3
Dura Pharms.; 125 S.Ct. at 1632. Here, the specific
pieces of information that defendant possessed with
respect to Enron's financial instability were already
known to the market and incorporated into the bonds'
prices; their disclosure did not cause the later drop in
value. Plaintiffs' repeated assertion that the drop in
value was within the “zone of risk” of Enron's
financial instability is not a substitute for arguing
causation in fact, but rather relates to the additional
requirement that the loss be foreseeable.
*4 Second, plaintiffs argue that defendant's clients,
who are generally unsophisticated investors, were
unaware
of
Enron's
financial
difficulties
notwithstanding any public disclosures. This
argument conflates loss causation, which requires a
connection between the omission and the drop in
price, with “transaction causation” or reliance, which
requires a connection between the omission and
plaintiffs' decision to purchase the bonds. The
sophistication of plaintiffs is not relevant to loss
causation.
Turning to the portions of the omissions that were not
public knowledge-all of which relate to defendant's
knowledge of and beliefs regarding Enron's financial
condition-plaintiffs have not alleged and cannot
plausibly allege that the revelation of defendant's
opinions affected the value of the Enron bonds. Nor
have plaintiffs alleged that defendant's clients make
up such a large fraction of total investors in Enron
bonds that their subsequent sale of the bonds caused
the bonds' value to decrease. Absent any alleged
connection between defendant's opinions and the
drop in market value, plaintiffs have not alleged loss
causation.
In order to meet the requirements set forth in Dura
Pharmaceuticals, plaintiffs would have to allege that
defendant had in its possession information that, once
it became generally known, caused the bonds' value
to depreciate. Id. at 1633 (citing Restatement
(Second) of Torts § 548A, cmt. b, at 107). Plaintiff
has failed in two successive attempts to allege that
defendant possessed material nonpublic information
about Enron's financial condition or that the release
of defendant's opinions precipitated the bonds' drop
in value. Absent some indication that plaintiffs will
be able to supplement the complaint with such an
allegation in the future, dismissal with prejudice is
appropriate.
II. Other Alleged Defects in the First Amended
Complaint
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Page 51 of 121
Page 4
(N.D.Cal.)
Defendant raises a host of other objections to
plaintiffs' newly formulated claims. First, defendant
argues that the first two alleged omissions cannot be
“materially misleading” because the existence of the
SEC investigation and Enron's debt ratings were
already publicly known. Second, defendant argues
that the third and fourth alleged omissions pertain to
defendant's opinion of Enron, which defendant was
under no duty to disclose. Third, defendant complains
that plaintiffs have not provided any particularized
basis for their knowledge of defendant's internal
evaluations of Enron's financial health or of
defendant's incentive structure for sales of Enron
securities, as required by federal securities law.
Fourth, defendant argues that plaintiffs have not
supplemented their allegations of scienter in any
meaningful way.
Although these arguments may have merit, plaintiffs'
inability to allege loss causation is fatal to their claim
under section 10(b) and the court need not consider
them.
Finally, at oral argument plaintiffs objected that the
court's finding with respect to loss causation leaves
brokerages free to trick their clients into making risky
investments, so long as the brokerages are not in
possession of material nonpublic information. The
court is certainly not pleased by defendant's apparent
disregard for the financial well being of its clients.
Although plaintiffs may lack a meaningful remedy
under federal securities law, the court has not reached
the merits of any of plaintiffs' state law claims, which
are preempted in the class action setting. These
claims-pursued as an individual, rather than as part of
a class action-may have merit, which plaintiffs are
free to explore in an appropriate forum.
Briefs and Other Related Documents (Back to top)
• 2005 WL 3145966 (Trial Motion, Memorandum
and Affidavit) Defendant H&r Block Financial
Advisors, Inc.'s Reply Memorandum of Points and
Authorities in Support of Motion to Dismiss First
Amended Complaint (Oct. 3, 2005) Original Image
of this Document (PDF)
• 2005 WL 2868445 (Trial Motion, Memorandum
and Affidavit) Lead Plaintiffs' Memorandum of
Points and Authorities in Opposition to Defendant
H&r Block Financial Advisors, Inc.'s Motion to
Dismiss (Sep. 13, 2005) Original Image of this
Document (PDF)
• 2004 WL 2654979 (Trial Pleading) Complaint for
Violation of: 1. Violations of Section 10(b) of the
Securities Exchange Act of 1934, Rule 10b-5, 2.
Fraud and Concealment, 3. Breach of Fiduciary Duty
(Nov. 15, 2004)
• 2004 WL 2888556 (Trial Pleading) Complaint for
Violation Of: (Nov. 15, 2004) Original Image of this
Document (PDF)
• 3:04cv04848 (Docket) (Nov. 15, 2004)
END OF DOCUMENT
CONCLUSION
*5 For the above reasons the court hereby GRANTS
defendant's motion to dismiss plaintiffs' First
Amended Complaint with prejudice, except to the
extent that plaintiffs' claims encompass individual
allegations of violations of California law; these
individual claims are dismissed without prejudice.
The clerk shall close the file.
IT IS SO ORDERED.
N.D.Cal.,2005.
Bennett v. H & R Block Financial Advisors, Inc.
Not Reported in F.Supp.2d, 2005 WL 2811757
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1 of 1 DOCUMENT
In re Buca Inc. Securities Litigation
Civil No. 05-1762 (DWF/AJB)
UNITED STATES DISTRICT COURT FOR THE DISTRICT OF MINNESOTA
2006 U.S. Dist. LEXIS 75224
October 16, 2006, Decided
COUNSEL: [*1] For West Palm Beach Police Pension
Fund, individually and on behalf of all others persons
similarly situated, Plaintiff: Avi Garbow, Daniel S Sommers, Herbert E Milstein, Matthew B Kaplan, Cohen
Milstein Hausfeld & Toll, PLLC - DC, Washington,
DC.; Bryan L Crawford, Muria J Kruger, Stacey L Mills,
Heins Mills & Olson, PLC, Mpls, MN.; Jay W Eng, Michael J Pucillo, Berman DeValerio Pease Tabacco Burt
& Pucillo, West Palm Beach, FL.; Steven J Toll, Cohen
Milstein Hausfeld & Toll, Washington, DC.; Wendy H
Zoberman, Berman DeValerio Pease Tabacco Burt &
Pucillo - FL, West Palm Beach, FL.
Gadel's, (collectively, the "Individual Defendants") Motion to Dismiss the Consolidated Class-Action Complaint. In the Amended Complaint (the "Complaint"),
Plaintiffs West Palm Beach Police Pension Fund, Steven
Jones, Charles Booth, and James and Bert-Mary Brady,
individually and on behalf of all other persons similarly
situated (collectively, the "Plaintiffs") allege securities
fraud against Buca and the Individual Defendants (collectively, the "Defendants") in violation of sections 10(b)
and 20(a) of the Securities and Exchange Act of 1934, 15
U.S.C. § 78j(b) (the "Exchange Act"), and Rule 10b-5
promulgated thereunder. For the following reasons, Defendants' motion is granted, but the Court dismisses the
Complaint without prejudice. n1
For Buca, Inc., Pete Mihajlov, Defendants: Michael M
Krauss, Wendy J Wildung, Faegre & Benson LLP, Minneapolis, MN.
For Joseph Micatrotto, Defendant: Joseph T Dixon, Jr,
Wesley T Graham, Henson & Efron, PA, Mpls, MN.;
Kenneth J Walsh, McDonald Hopkins Co, LPA, Cleveland, OH.
For Greg A. Gadel, Defendant: Douglas R Peterson,
Leonard Street and Deinard, Mankato, MN.; Monica L
Davies, Todd A Noteboom, Leonard Street and Deinard,
PA, Minneapolis, MN.
JUDGES: Donovan W. Frank, Judge of United States
District Court.
OPINION BY: Donovan W. Frank
OPINION:
MEMORANDUM OPINION AND ORDER
Introduction [*2]
This class-action lawsuit is before the Court pursuant to Defendants Buca Inc.'s ("Buca" or "the Company")
and Pete Mihaljov's, Joseph Micatrotto's, and Greg
n1 Plaintiffs request that the Court take judicial
notice of 11 documents, all pertaining to separate
actions brought by the Securities and Exchange
Commission ("SEC") and the United States Attorney's Office against Micatrotto, Gadel, and
other individuals. The documents include two
civil complaints filed by the SEC, documents reflecting the settlement of one of the SEC actions,
two criminal complaints brought by the U.S. Attorney's Office, and documents reflecting plea
agreements in the criminal proceedings. Rule 201
of the Federal Rules of Evidence permits the
Court to take judicial notice of a fact that is not
subject to reasonable dispute. Fed. R. Evid.
201(b). A court may take judicial notice of SEC
filings on a motion to dismiss, where the filings
were required by law and were not offered to
prove the truth of the documents' contents. Florida State Bd. of Admin, v. Green Tree Fin. Corp.,
270 F.3d 645, 663 (8th Cir. 2001). Here, these
documents, which are not SEC filings, are being
offered to prove the truth of the matters asserted
in them and are disputed by Defendants. Accord-
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ingly, the Court finds that it is not appropriate to
judicially notice these documents and therefore
denies Plaintiffs' request.
[*3]
Background
Buca is a publicly-held company based in Minneapolis that owns and operates more than 100 "Buca di
Beppo" and "Vinny T's of Boston" restaurants. Micatrotto served as Buca's Chairman and Chief Executive
Officer ("CEO") from July 1999 until May 10, 2004.
Gadel served as Buca's Chief Financial Officer ("CFO"),
Executive Vice President, Secretary and Treasurer from
2001 until December 2004. Mihaljov served as Buca's
Executive Chairman and CEO from May 10, 2004, until
October 15, 2004. Additionally, Mihaljov has served on
Buca's Board of Directors since the Company's inception
in 1993. Plaintiffs are investors who purchased Buca
securities between February 6, 2001, and March 11, 2005
(the "Class Period").
Central to this case is a restatement that Buca issued
on July 25, 2005 ("the July 25, 2005 Restatement"). In
the July 25, 2005 Restatement, Buca announced that it
would restate its annual financial statements for fiscal
years 2000 through 2003 and its quarterly financial results for the first three quarters of 2004. (Id. at P 9.) In
the July 25, 2005 Restatement, Buca admitted that it incorrectly overstated its net income by 121.08%, 64.16%,
and 47.77% for 2001, [*4] 2002, and 2003, respectively. (Id. at P 10.) In pertinent part, the July 25, 2005
Restatement acknowledged that Buca: (1) improperly
booked free meals given to employees as sales; (2) improperly accounted for the Company's real estate leases
and leasehold improvements; and (3) improperly capitalized certain other expenses, all in violation of GAAP.
(App. to Mem. in Supp. of Mot. to Dismiss Consolidated
Am. Compl. ("Ex. List"), P J, at F-12-15.)
Plaintiffs' securities fraud claim arises from numerous alleged material misstatements that Defendants made
during the Class Period. The alleged misstatements were
made in various press releases and SEC filings in which
Defendants announced the Company's financial results.
By restating those financial results in the July 25, 2005
Restatement, Buca admitted that certain portions of the
press releases and SEC filings were incorrect. And because Buca's reported financial results were incorrect,
Plaintiffs claim that Buca's stock price was artificially
inflated. Additionally, Plaintiffs claim that the Individual
Defendants' certifications of adequate internal controls
that were required under the Sarbanes-Oxley Act, 15
U.S.C. § 7241 [*5] , also constituted actionable misstatements. These certifications accompanied Buca's
quarterly earnings statements and averred that the certi-
fying Individual Defendant had disclosed "all significant
deficiencies in the design or operation of internal controls" and "any fraud, whether or not material, that involves management or other employees." (Id. at P 101.)
Plaintiffs allege that when the July 25, 2005 Restatement was issued, the investing public "began to understand the magnitude of the fraud perpetrated by Defendants." (Id. at P 10.) Although the July 25, 2005 Restatement was issued after the end of the Class Period,
Plaintiffs contend that the alleged misrepresentations
were "gradually disclosed" through a series of partial
disclosures beginning in May 2004. (Id. at P 192.) Based
on these alleged partial disclosures, Plaintiffs assert that
"the prior artificial inflation came out of the Company's
common stock price." (Id.) As a result of their purchases
of Buca common stock during the Class Period, Plaintiffs
allege that they suffered economic loss. (Id. at P 11.)
Plaintiffs contend that Defendants engaged in a
fraudulent scheme to inflate revenues, reduce [*6] expenses, and conceal a decline in its comparable restaurant sales growth. (Compl. at P 3.) To carry out these
goals, Plaintiffs allege that Defendants engaged in a
fraudulent accounting scheme by: (1) improperly accounting for free meals served to employees by booking
them as sales; (2) improperly accounting for its restaurant leases; and (3) and improperly capitalizing expenses,
all in violation of Generally Accepted Accounting Principles ("GAAP"). (Id.) Plaintiffs further allege that Buca
lacked adequate internal controls in the accounting and
finance areas and that Buca falsely represented that its
internal controls were adequate and reliable. (Id. at P 6.)
Accounting for Employee Meals
Plaintiffs allege that Defendants engaged in a
scheme to boost comparable restaurant sales, a key indicator of growth, by fraudulently accounting for free employee meals as sales. (Id. at P 31.) Plaintiffs contend
that Buca's management used comparable restaurant
sales as a performance indicator to trigger executive bonuses. (Id.) A former general manager of several Buca di
Beppo restaurants from 1998 to 2002 and a confidential
source in the case, CS-5, alleges that in [*7] early 2001
Micatrotto and Gadel directed each Buca di Beppo restaurant to begin booking free employee meals as sales.
(Id. at 37.) CS-5 alleges that Micatrotto and Gadel directed each restaurant to book employee meals at
roughly $ 100 per night, and to record the meals either as
a "comped meal" or as having been paid by coupons or
promotions. (Id.)
A former senior vice-president of operations from
1999 until April 2005, CS-8, alleges that he overheard
conversations between Company executives in 2003 and
2004, including Micatrotto and Gadel, about the need to
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restate the revenue booked from employee meals. (Id. at
43.) Additionally, from April 2001 until April 2002, CS5 allegedly repeatedly questioned both Micatrotto and
Gadel about the booking of employee meals and specifically asked why the recognition of this revenue was not
disclosed in the Company's public filings and investor
reports. (Id. at 39.) CS-5 allegedly questioned Gadel at
least 10 times during this period and was told by Gadel
that the failure to disclose this revenue recognition was
the result of "an executive decision" and "not to worry
about it." (Id.)
Plaintiffs allege that the material impact [*8] of
booking the employee meals had the effect of boosting
the Company's revenues, rather than impacting the Company's income. (Id. at P 177.) Plaintiffs further allege that
the practice allowed each store to appear to have increased sales of at least $ 700 per week when compared
with same store sales for the same week the prior year.
(Id.) Thus, according to Plaintiffs, this accounting practice resulted in the appearance of increased sales of between $ 2 and $ 7.4 million per year between 2000 and
2003 and more than $ 5 million in the first nine months
of 2004. (Id.)
Plaintiffs allege that the increased sales had the
greatest impact during the first year, from the first quarter of 2001 to the first quarter of 2002. (Id. at P 178.)
During that period, Plaintiffs contend that same store
sales appeared to be increasing. (Id.) Plaintiffs also claim
that during that period, Buca's stock price reached more
than $ 25 per share. (Id.) Plaintiffs allege that Micatrotto
and Mihajlov sold shares of Buca stock in June 2002 at $
18.25 per share. (Id. at P 53.) In particular, Plaintiffs
allege that Micatrotto sold 100,000 shares, exhausting his
holdings and earning $ [*9] 1,260,000. (Id.) Plaintiffs
then allege that on July 17, 2002, shortly after those alleged insider sales, Micatrotto and Gadel announced during Buca's second quarter earnings call that comparable
restaurant sales at its Buca di Beppo restaurants actually
declined 1.3% in the quarter. (Id. at P 54.) Plaintiffs then
allege that in response to this announcement, the Company's stock dropped from $ 13.35 per share on July 16,
2002, to $ 9.26 per share on July 17, 2002. (Id. at P 55.)
In a February 7, 2005 Press Release ("the February
7, 2005 Press Release"), Buca announced that it was discontinuing its practice of booking free meals given to
employees as sales and expenses. (Ex. List, P C.) On
February 11, 2005, in a Form 8-K ("the February 11,
2005 Form 8-K"), Buca announced that its prior practice
of including revenue from its employee meals violated
GAAP and indicated that all such revenue would need to
be removed from its consolidated financial statements.
(Id. at P 173.) The July 25, 2005 Restatement, in which
Buca restated its financial results for 2000 through 2003
and the first three quarters in 2004, reduced Buca's total
sales by approximately 2% for each year [*10] as a result of these accounting violations. (Id. at P 175.) The
July 25, 2005 Restatement explained that the practice of
booking free employee meals as sales did not affect its
net income because sales were always offset by expenses
in the same amount. (Id. at P 176.)
Accounting for Leases and Leasehold Equipment
Plaintiffs also allege that Buca's accounting treatment of its real estate leases and leasehold equipment
were part of its alleged fraudulent scheme to inflate
Buca's stock. (Id. at P 3.) Buca leases both the land and
the building at the majority of its restaurant locations.
(Id. at P 44.) Most of Buca's leases contain options to
renew for additional periods of time. (Id.) Plaintiffs contend that Buca's practice was to amortize its leasehold
improvement and other lease expenses over the course of
the entire lease, including all renewal option periods,
thereby reducing current expenses and increasing net
earnings. (Id. at PP 45-46.) A former accounting manager for Buca, CS-3, alleges that the Company's policy
was to "amortize leasehold improvements over the term
of the lease plus two extensions." (Id. at P 49.)
In the February 7, 2005 Press [*11] Release, Buca
announced that it was reviewing its accounting treatment
of real estate leases and leasehold improvements in light
of recent developments in industry accounting practice.
(Ex. List, P C.) Buca's accounting treatment violated
GAAP standards for lease accounting, which require that
in the amortization of leasehold improvements, an operating lease should be amortized by the lessee over the
shorter of their economic lives or the lease term. (Id. at P
159.) In the February 11, 2005 Form 8-K, Buca announced that it had incorrectly applied the accounting
rules with respect to certain operating lease transactions.
(Id. at P 144.) Buca also stated that it would restate its
previously filed financial statements for fiscal years 1999
through 2003 and the first three quarters of 2004 to correct the GAAP violations. (Id.) Buca restated the financials in the July 25, 2005 Restatement. (Ex. List, P J at F12-15.)
Capitalization of Certain Expenses
In the February 11, 2005 Form 8-K, Buca also announced that it had determined that its policies regarding
capitalization of certain expenditures had not been properly applied and that it was reviewing capitalized
amounts [*12] that should have been treated as repair
and maintenance expenses. (Ex. List, P F at 3.) Buca's
capitalization practice violated GAAP because the expenditures lacked a future economic benefit or service
potential. (Id. at P 163.) In the July 25, 2005 Restatement, Buca announced that it had improperly capitalized
expenditures including pre-opening expenses, decor
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warehouse expense and repairs and maintenance expenses, certain consulting fees, certain contributions to a
conference, construction management expenses and capitalized interest, and had insufficient documentation to
support fixed asset additions and dispositions. (Id. at P
164.) The restatement of these accounting violations resulted in a reduction of income of $ 11.9 million from
2000 through 2003 and the first nine months of 2004.
(Id.)
Alleged Inadequacy of Internal Controls
In addition to the alleged accounting scheme, Plaintiffs allege that Defendants' lack of adequate internal
controls in the accounting and finance areas resulted in
the alleged falsification of Buca's financial statements.
(Id. at P 6.) Plaintiffs allege that the Company's internal
controls were so deficient that Micatrotto [*13] and
Gadel, along with other senior Buca managers, fraudulently misused Company asserts for personal gain. (Id. at
P 7.) Specifically, Plaintiffs assert that in 2002, Micatrotto authorized Buca's purchase of an Italian villa for $
279,000. (Id. at P 63.) Plaintiffs further assert that Micatrotto authorized Buca to spend several hundred thousand
dollars to renovate the villa. (Id.) Although Micatrotto
authorized Buca to purchase and renovate the villa,
Plaintiffs assert that it was later determined that Micatrotto and his wife were listed as owners on the property's title. (Id.)
Additionally, a former senior financial manager who
worked at Buca's headquarters from July 2000 until February 2005, CS-9, alleges that during the Class Period,
Micatrotto and Gadel often requested company checks
for large sums of money without providing any supporting documentation or invoice. (Id. at P 60.) CS-9 further
alleges that several times Gadel asked for blank checks
and responded to CS-9's protest by indicating that "it was
not [CS-9's] concern." (Id.) CS-9 further alleged that
Micatrotto requested and obtained Buca checks for noncompany transactions, such as personal home [*14] improvements and family gifts. (Id. at P 61.)
As further evidence that Buca's internal controls
were inadequate, Plaintiffs allege that Gadel approved
payment of invoices that were fraudulently submitted by
a Buca vendor called EDP Computer Systems ("EDP")
that provided Buca with computer-related services between 1998 and 2003. (Id. at P 66.) Plaintiffs allege that
Gadel had an undisclosed financial interest in EDP and
authorized Buca to enter into financially unfavorable
contracts and transactions with EDP in exchange for
kickbacks to himself. (Id. at P 67.) Further, Plaintiffs
allege that Gadel and John Motschenbacher, a former
Buca Senior Vice President and Chief Information Officer, started a computer-services company called High
Wire Networks ("High Wire") using Buca funds. (Id. at
PP 68-69.) Further, Plaintiffs allege that Gadel and
Motschenbacher authorized Buca to pay invoices to EDP
that included the salaries of 10 High Wire employees.
(Id. at P 70.) According to CS-3, Gadel's response to
questioning about Buca's lack of internal controls was to
"laugh it off." (Id. at P 59.)
Plaintiffs allege that Micatrotto, Mihajlov, and
Gadel all falsely certified [*15] the adequacy and reliability of the Company's internal controls. (Id. at PP 19-21.) Plaintiffs allege that Defendants' actions violated
Item 308 of Regulation S-K, which requires management
to assess the effectiveness of a public company's internal
controls, identify material weaknesses, and disclose to
the company's auditors any significant internal-control
deficiencies. (Id. at P 75.) Additionally, Plaintiffs allege
that Defendants violated Item 404 of Regulation S-K,
which requires that the company disclose any transactions to which it was a party where the amount of the
transaction exceeds $ 60,000 and where any company
director or executive officer had a direct or indirect material interest in such transaction. (Id. at PP 76-77.)
Subsequent Investigations and Lawsuits
In the second quarter of 2004, Buca's Audit Committee authorized an independent investigation regarding
Micatrotto's purchase of the Italian villa. (Id. at P 64.) In
a press release dated May 10, 2004 ("the May 10, 2004
Press Release"), Buca accepted Micatrotto's resignation.
(Id. at P 139.) In the February 7, 2005 Press Release,
Buca announced that the Audit Committee concluded
that [*16] Micatrotto used Company funds for personal
purposes without authorization. (Ex. List, P D.) In the
same release, Buca also announced that the SEC had
issued a formal order of investigation to determine
whether Buca had violated federal securities laws and
that Buca believed the SEC's investigation was initiated
by Micatrotto's resignation. (Id.) Additionally, Buca further stated in that release that it entered into a Separation
Agreement with Micatrotto whereby Micatrotto agreed
to make certain cash payments to Buca and to waive any
rights to receive certain payments under the Buca employee share option plan. (Id.) The Separation Agreement was filed with the SEC on August 6, 2004. (Ex.
List, P H.) The filing also announced that Buca recouped
approximately $ 900,000 from Micatrotto, who transferred title to the Italian villa to Buca. (Id.)
Once it became aware of such actions, Buca also
conducted an internal investigation of Gadel and
Motschenbacher's actions regarding EDP and High Wire.
(Id. at P 72.) On December 2, 2004, Buca issued a press
release announcing Gadel's resignation, but the reasons
were not disclosed. (Id. at P 73.) On July 25, 2005, Buca
filed a [*17] civil lawsuit against Gadel and Motschenbacher in Hennepin County District Court alleging that
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the former executives had improperly used Buca to fund
a computer-related services company that the executives
had founded. (Id. at P 74.)
Plaintiffs allege that Buca's stock price declined as
the truth was gradually disclosed. In particular, Plaintiffs
allege that following the May 10, 2004 Press Release
announcing Micatrotto's resignation, Buca's stock price
fell from $ 6.38 per share on May 7, 2004 to $ 5.24 per
share on May 13, 2004. (Id. at PP 141, 194.) Further,
Plaintiffs allege that following the February 7, 2005
Press Release announcing that the SEC had initiated a
formal investigation to determine whether Buca had violated federal securities laws, Buca's stock price fell from
$ 6.91 per share on February 7, 2005 to $ 6.75 per share
on February 8, 2005. (Id. at PP 142-43.)
Finally, Plaintiffs allege that the price of Buca's
stock fell after a press release was issued on March 11,
2005 ("the March 11, 2005 Press Release") from $ 7.00
per share on March 11, 2005 to $ 6.50 per share on
March 14, 2005. (Id. at P 145.) In the March 11, 2005
Press Release, Buca announced [*18] that it would notify the SEC of the Company's need to delay the filing of
its 2004 Form 10-K in order to complete work on previously announced restatements for fiscal years 2000
through 2003. (Id.) Buca also announced that Motschenbacher and Buca's Controller and Interim CFO, Dan
Skrypek, had been suspended and were being reviewed
for termination. (Id. at P 145.)
On March 14, 2005, after the end of the Class Period, Buca announced that it would not timely file its
2004 Form 10-K. (Id. at P 147.) Buca explained that the
late filing would be due in part to ongoing work on the
Company's restatements, review of its financial reporting
policies and procedures, internal investigation of matters
relating to the Company's recent suspension of two executive officers, and review of internal controls. (Id.)
Two days later, Buca issued a press release announcing
that the Company had terminated the employment of
Motschenbacher and Skrypek. (Id. at P 148.) Plaintiffs
allege that the Individual Defendants falsely approved
the press releases and SEC filings. (Id. at PP 19-21.)
Defendants move to dismiss the Complaint on two
primary grounds: (1) failure to sufficiently plead [*19]
loss causation and (2) failure to allege with particularity
facts giving rise to a strong and reasonable inference that
any Defendant acted with scienter. Additionally, with
respect to Plaintiffs' claims regarding Defendant's accounting treatment of employee meals, Defendants contend that the alleged representation is immaterial and that
these claims should therefore be dismissed.
Discussion
I. Standard of Review
Generally speaking, in deciding a motion to dismiss,
the Court must assume all facts in the complaint to be
true and construe all reasonable inferences from those
facts in the light most favorable to the complainant. Morton v. Becker, 793 F.2d 185, 187 (8th Cir. 1986). However, in the context of a case raising claims of securities
fraud on behalf of a class, the Court must also consider
the complaint in light of the heightened pleading standard established by the Private Securities Litigation Reform Act ("the Reform Act"), 15 U.S.C. § § 78u-4 and
78u-5. Under 15 U.S.C. § 78u-4(b)(2), a complaint must
"state with particularity facts giving rise to a strong inference that [*20] the defendant acted with the required
state of mind." As such, the Court must "disregard 'catchall' or 'blanket' assertions that do not live up to the particularity requirements of the statute." Green Tree, 270
F.3d at 660. And, while a plaintiff is generally entitled,
under Fed. R. Civ. P. 12(b)(6), to all reasonable inferences that may be drawn from the complaint, a claim of
securities fraud can only survive if the allegations "collectively add up to a strong inference of the required
state of mind." Id.
II. Section 10(b) Claim
Plaintiffs allege that Defendants n2 violated section
10(b) of the Exchange Act. Rule 10b-5, promulgated by
the SEC under its section 10(b) authority states:
It shall be unlawful for any person,
directly or indirectly, by the use of any
means or instrumentality of interstate
commerce or of the mails, or of 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 [*21] 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. In order to bring a successful
claim of securities fraud, a plaintiff must establish the
following elements: (1) material misrepresentations or
omissions; (2) made with scienter; (3) in connection with
the purchase or sale of securities; (4) upon which plaintiff relied; and (5) that proximately caused plaintiff's in-
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juries. Alpern v. UtiliCorp United, Inc., 84 F.3d 1525,
1533-34 (8th Cir. 1996) (citing 17 C.F.R. § 240.10b-5
(2001)). The first (material misrepresentation), second
(scienter), and fifth (loss causation) elements are at issue
in this case. The Court will address loss causation first
because it alone is dispositive of this case.
n2 Plaintiffs' section 10(b) arguments interchange
Buca and the Individual Defendants. Therefore,
when the Court dismisses claims against Buca, it
also dismisses the same claims against the Individual Defendants and vice versa.
[*22]
A. Loss Causation
The Defendants first contend that the Complaint
should be dismissed because Plaintiffs have failed to
sufficiently plead loss causation. As stated above, a securities fraud complaint must allege loss causation, which
means "a causal connection between the material misrepresentation and the loss." Dura Pharm., Inc. v. Broudo,
544 U.S. 336, 342, 125 S. Ct. 1627, 161 L. Ed. 2d 577
(2005). In Dura, the Supreme Court held that a plaintiff
cannot satisfy section 10(b)'s loss causation requirement
by alleging that the purchase price was inflated because
of the claimed misrepresentations. Id. at 345. Instead, a
plaintiff must allege that the share price fell significantly
after the truth became known. Id. at 347. Plaintiffs need
not plead loss causation with particularity; rather, a short
and plain statement in accordance with Federal Rule of
Civil Procedure 8(a)(2) is sufficient. See id. at 346.
In the Complaint, Plaintiffs allege that when the alleged "misrepresentations and omissions were gradually
disclosed through a series of partial disclosures beginning with Micatrotto's resignation, [*23] Buca's common stock declined as the prior artificial inflation came
out of the Company's common stock price." (Compl. at P
192.) Plaintiffs point to four alleged partial disclosures
during the Class Period that they claim demonstrate loss
causation: (1) the May 10, 2004 Press Release announcing Defendant Micatrotto's resignation; (2) the February
7, 2005 Press Release concerning the SEC investigation
of Buca; (3) the February 11, 2005 Form 8-K disclosing
the internal review of accounting policies and preliminary determination of GAAP violations; and (4) the
March 11, 2005 Press Release concerning the need to
delay filing the 2004 10-K. Additionally, Plaintiffs contend that in response to these four alleged partial disclosures, the Complaint identifies three separate declines in
Buca's stock value.
Specifically, the Complaint alleges that Buca's stock
price declined 17.8% from its May 7, 2004 closing price
of $ 6.38 per share to $ 5.24 per share on May 13, 2004,
following the May 10, 2004 Press Release announcing
Micatrotto's resignation as Chairman and CEO. (Compl.
at P 141.) The Complaint also specifies that Buca's stock
price declined 2.3% from its February 7, 2005 closing
price [*24] of $ 6.91 per share to a closing price of $
6.75 per share on February 8, 2005, following the February 7, 2005 Press Release announcing that the SEC had
issued a formal order of investigation to determine
whether or not Buca had violated federal securities laws.
(Id. at P 143.) Finally, the Complaint specifies that
Buca's stock price declined 7.1% from its March 11,
2005 closing price of $ 7.00 per share to a closing price
of $ 6.50 per share on March 14, 2005. (Id. at P 146.)
Plaintiffs allege that this last decline in Buca's stock price
followed two alleged partial disclosures--the February
11, 2005 Form 8-K stating that Buca had incorrectly applied the accounting rules with respect to certain operating lease transactions and that Buca would restate its
previously filed financial statements for the fiscal years
1999 through 2004 and the March 11, 2005 Press Release announcing that Buca would file a notification with
the SEC regarding the Company's need to delay the filing
of it annual report for the year ended December 26,
2004.
In response, Defendants contend that Plaintiffs have
not identified any disclosure of the alleged fraud that is
connected to a significant drop [*25] in share price. Defendants note that the Complaint alleges "[w]hen the
truth about BUCA's financial statements was revealed in
July 2005, the investing public began to understand the
magnitude of the fraud perpetrated by Defendants." (Id.
at P 10.) But Defendants further note that the Class Period ended more than four months earlier, in March
2005, before Buca issued the restatement that gave rise
to this suit. Thus, according to Defendants, because the
Class Period ended before the disclosures that Plaintiffs
identify as unveiling the "truth," they have not properly
alleged loss causation. Defendants suggest that Plaintiffs
decided not to extend the Class Period to July 25, 2005,
when the restatement disclosing the financial amounts
was issued, because on July 26, 2005, Buca's share price
actually increased from $ 5.34 to $ 6.25 per share.
Additionally, Defendants contend that Plaintiffs' assertion that the alleged misrepresentations were gradually disclosed beginning with Micatrotto's resignation in
May 2004, also fails to sufficiently plead loss causation.
At the outset of this argument, Defendants explain that
Buca's share price was mostly declining throughout the
Class [*26] Period. Although Buca stock traded at a
high of $ 25.15 during the Class Period on May 30,
2001, by May 7, 2004--three days before Micatrotto's
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resignation was announced and the gradual disclosures
allegedly began, Buca's share price was already down to
$ 6.38 per share. Specifically, Defendants contend that
each of the four alleged partial disclosures of fraud that
Plaintiffs cite either did not disclose the alleged fraud or
did not lead to a drop in Buca's share price.
The Court finds that Plaintiffs have not sufficiently
pleaded loss causation under Dura. Here, the May 10,
2004 Press Release announcing Micatrotto's resignation
mentioned no investigation or accounting issues and thus
disclosed nothing of the alleged fraud. Indeed, the Complaint notes that "[t]he Company did not elaborate on the
reason(s) for the resignation except to state that the
Board and Defendant Micatrotto agreed that it was time
for a management change." (Compl. at P 139.) Thus,
even though the May 19 Press Release was followed by a
drop in stock price, the press release did not disclose the
alleged fraud. Next, although February 11, 2005 Form 8K constituted a partial disclosure of the alleged fraud,
[*27] Plaintiffs failed to identify a significant price drop
in share price following this partial corrective disclosure.
Rather, Buca's share price increased from $ 6.91 on February 7, 2005, to $ 6.96 on February 14, 2005. (Ex. List,
P K.) Finally, although Buca's share price dropped on
March 14, 1005, following the March 11, 2005 Press
Release, that press release did not constitute a corrective
disclosure. Rather, the March 11, 2005 Press Release
stated only that Buca's 2004 Form 10-K would be delayed to complete the previously-announced restatements
and that two officers had been suspended. Thus, the
March 11, 2005 Press Release did not disclose the alleged fraud.
That leaves the Court with the February 7, 2005
Press Release announcing the SEC investigation. Although Plaintiffs identify a drop in Buca's stock price
from $ 6.91 per share on February 7, 2005, to $ 6.75 per
share on February 8, 2005, the Court does not find that
this one drop sufficiently pleads loss causation. This single identification of a drop in Buca's stock price following a partial corrective disclosure negates Plaintiffs' allegation that the fraud was gradually disclosed through a
series of partial disclosures. [*28] Further, the Court
does not find that this decline establishes loss causation
where the share price was trending downward throughout
the Class Period and was already down to $ 6.38 per
share three days before Micatrotto's resignation was announced and the alleged fraud was allegedly gradually
revealed. The fact that Buca's stock price was already
down to $ 6.38 by the time the fraud was allegedly revealed and the artificial inflation allegedly came out of
the stock reveals that other factors had caused the decline. Thus, even applying a notice pleading standard,
Plaintiffs' allegations will not suffice. Drawing all favorable inferences in Plaintiffs' favor, the Court cannot find
sufficient allegations of loss causation required by Dura.
Although the Complaint should be dismissed on the basis
that Plaintiffs have failed to sufficiently plead loss causation, the Court nevertheless addresses the remaining disputed elements.
B. Material Misrepresentation
Next, Defendants contend that, as a matter of law,
Plaintiffs have failed to allege the materiality of the misrepresentations regarding Buca's accounting treatment of
employee meals. Therefore, Defendants contend that
Plaintiffs' [*29] claims based on Buca's accounting
treatment of employee meals should be dismissed. A
misrepresentation or omission is material if there is "a
substantial likelihood that the disclosure of the omitted
fact would have been viewed by the reasonable investor
as having significantly altered the total mix of information made available." Parnes v. Gateway 2000, Inc., 122
F.3d 539, 546 (8th Cir. 1997) (quoting Basic Inc. v. Levinson, 485 U.S. 224, 231-32, 108 S. Ct. 978, 99 L. Ed. 2d
194 (1988)). In many cases, the question of materiality is
a factual question for a jury to decide. Id. In those cases
where the alleged misrepresentation could not have
swayed a reasonable investor, a court may determine, as
a matter of law, that the alleged misrepresentation is immaterial. Id. (citation omitted).
Defendants contend that the fact that the treatment
of employee meals represented only about 2% of Buca's
total sales for fiscal years 2000 through 2003 and for the
first nine months of 2004 renders this claim immaterial
as a matter of law. In particular, Defendants contend that
because Buca reported a 43% increase in sales for the
first quarter of 2002 as compared to the first quarter in
2001, [*30] when the practice allegedly had the greatest
impact, the 2% increase attributable to employee meals
was negligible. Defendants also contend that the alleged
negligible impact is evident when considering Buca's
year-end total sales. For example, Defendants note that
Buca reported a 38% sales increase in fiscal 2001 compared to fiscal 2000 and a 37% increase in fiscal 2002
compared to the prior year. (Compl. at PP 90, 103.) In
response, Plaintiffs assert that the increases Defendants
cite represent total sales, not same store sales. According
to Plaintiffs, when only same store sales are considered,
a 2% increase over the prior year has a material effect on
revenues.
The Court does not find that a 2% increase in total
sales is immaterial as a matter of law. The Court cannot
tell whether a representation was immaterial as a matter
of law solely by considering the amount of the revenue
overstatement. See Gebhardt v. ConAgra Foods, Inc.,
335 F.3d 824, 830 (8th Cir. 2003) ("In our view, the
quantity of a revenue overstatement, in and of itself, is
not sufficient to be dispositive of this issue. Instead, we
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look at the total mix of data available to investors, and
place [*31] the misrepresented data in context.") Thus,
reading the allegation in the light most favorable to the
Plaintiffs, a reasonable factfinder could determine that a
2% increase in total sales is material. Therefore, the
Court denies Defendants' motion with respect to this issue.
C. Scienter
Finally, Defendants contend that the Court should
dismiss the Complaint because the Plaintiffs have failed
to plead facts giving rise to a strong inference that Defendants acted with scienter. Scienter is "the intent to
deceive, manipulate, or defraud." Green Tree, 270 F.3d
at 653 (citations omitted). Plaintiffs must plead facts
giving rise to both a reasonable and strong inference of
scienter. Kushner v. Beverly Enters., Inc., 317 F.3d 820,
827 (8th Cir. 2003). There are three ways in which Plaintiffs can satisfy the scienter requirement: (1) by pleading
specific facts demonstrating "the intent to deceive, manipulate, or defraud"; (2) by pleading specific facts giving rise to the level of "severe recklessness"; or (3) by
pleading allegations of "unusual or heightened" motive
or opportunity. In re K-Tel Int'l, Sec. Litig., 300 F.3d
881, 893-94 (8th Cir. 2002). [*32]
Plaintiffs allege that they have satisfied all three
ways of establishing a strong and reasonable inference of
scienter. Additionally, Plaintiffs allege that they have
satisfied the scienter requirement with regard to their
inadequate internal-controls claim. The Court will address each argument in turn.
1. Intent
Plaintiffs assert that they have pleaded facts that
show Defendants knew that their earnings statements
were materially false and misleading when made because
they knew that their accounting methods violated GAAP.
The Court will address Plaintiffs' argument with respect
to each of the three accounting violations.
The Claims Based On Buca's Accounting Treatment
of Employee Meals
Defendants contend that Plaintiffs have failed to
plead facts that show Defendants knew they were improperly accounting for employee meals during the Class
Period. Plaintiffs point to the statements of several confidential sources to support their allegations of scienter.
First, Plaintiffs note that the Complaint alleges that from
April 2001 to April 2002 CS-5 "repeatedly questioned"
Micatrotto and Gadel "about the booking of the
'[Employee] Meals' and why the recognition of [*33]
this revenue was not disclosed in the Company's public
filings and investor reports." (Compl. at P 39.) Further,
Plaintiffs point out that the Complaint alleges that CS-5
questioned Gadel about this at least 10 times and was
told that the failure to disclose this revenue recognition
was a result of an "executive decision" and that he
"should not worry about it." (Id.)
Additionally, Plaintiffs note that the Complaint alleges that CS-4 stated that in the first quarter of 2004,
CS-4 and other general managers received a voice-mail
message from Micatrotto and Gadel instructing them that
they were no longer allowed to book the employee meals
as sales. Further, Plaintiffs point out that CS-4 alleges
that the Company continued to book employee meals as
revenue through the third quarter of 2004, and, when the
practice stopped, Buca did not timely disclose this accounting change. Finally, Plaintiffs note that the Complaint alleges that CS-8 recalled conversations between
Buca executives in 2003 and 2004, including between
Micatrotto and Gadel, regarding the need to restate the
revenue booked from employee meals. In response, Defendants contend that the Complaint's only allegations of
contemporaneous [*34] knowledge of wrongdoing are
the vague generalizations of confidential sources in no
position to discern the Defendants' motives.
The Court finds that Plaintiffs have failed to plead
facts giving rise to a reasonable and strong inference of
scienter. Allegations of GAAP violations do not, by
themselves, raise an inference of scienter. Ferris, Baker
Watts, Inc. v. Ernst & Young, LLP, 395 F.3d 851, 855
(8th Cir. 2005). Instead, such allegations may only be
sufficient when coupled with evidence of corresponding
fraudulent intent. Id. Thus, plaintiffs must allege "facts
or further particularities that, if true, demonstrate that the
defendants had access to, or knowledge of, information
contradicting their public statements when they were
made." Navarre, 299 F.3d at 742. Although Defendants
practice of booking free employee meals violated GAAP,
Plaintiffs have failed to establish the requisite fraudulent
intent.
Here, the confidential sources are silent regarding
whether the Individual Defendants knew or believed that
the practice of booking employee meals as sales violated
GAAP. Although the Complaint alleges that CS-5 repeatedly questioned Gadel [*35] about Buca's decision
not to publicly disclose its practice of booking employee
meals as sales, CS-5 does not allege that Gadel knew or
believed the practice violated GAAP. Further, although
CS-4 alleges that Micatrotto and Gadel instructed general
managers to stop booking employee meals as sales, CS-4
does not allege that Micatrotto or Gadel knew that the
practice violated GAAP. Likewise, although CS-8 alleges that in 2003 and 2004 executives discussed the
need to restate the revenue booked as employee meals,
CS-8 does not allege that any executive actually concluded that the restatement was required or that Buca or
any of the Individual Defendants adopted this view be-
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fore 2005. In conclusion, the Court finds that the confidential sources' allegations do not establish the requisite
fraudulent intent that would establish scienter. Accordingly, these claims are dismissed on this basis.
The Claims Based on Buca's Accounting for Leases
and Leasehold Equipment
Defendants contend that Plaintiffs' claims based on
Buca's accounting for leases and leasehold improvements
should be dismissed because Plaintiffs have failed to
satisfy the scienter requirement. Defendants contend that
[*36] Buca employed an accounting treatment that had
been widely used in the restaurant business until the SEC
clarified its interpretation of the governing rules in early
2005. Defendants contend that Plaintiffs have failed to
raise a strong inference of scienter because the Complaint alleges only that the original accounting treatment
of leases and leasehold improvements violated GAAP
and required restatement. Defendants contend that Plaintiffs fail to allege that anyone at Buca knew or believed
that the accounting treatment was improper at the time
the original financial results were posted.
In response, Plaintiffs refute Defendants' assertion
that Buca employed an accounting treatment that had
been widely used in the restaurant business until the SEC
clarified its interpretation of the governing rules in early
2005. Plaintiffs' response fails to address the relevant
inquiry. Specifically, Plaintiffs fail to allege the requisite
fraudulent intent coupled with the GAAP violation. Here,
there is no allegation that anyone at Buca knew or believed that the lease accounting method violated GAAP
at the time of the original filings. Because Plaintiffs have
failed to plead such facts, Plaintiffs [*37] have failed to
meet the scienter requirement with regard to their claims
based on Buca's accounting for leases and leasehold
equipment. Accordingly, these claims are dismissed on
this basis.
The Claims Based on Buca's Capitalization of Other
Expenses
Defendants also assert that Plaintiffs' claims based
on Buca's alleged improper capitalization of other expenses should be dismissed because Plaintiffs have failed
to satisfy the scienter requirement. Defendants contend
that the Complaint generally alleges that Buca improperly capitalized various expenses that provide the Company with no future economic benefit or service potential. As a result, Defendants allege that Plaintiffs have
failed to plead the circumstances of the alleged fraud
with particularity. In particular, Defendants contend that
the Complaint pleads no facts demonstrating that anyone
at Buca knew or believed that the capitalization of the
expenses at issue was improper at the time the original
financial results were posted. Finally, Defendants con-
tend that Plaintiffs have abandoned their claims based on
Buca's alleged improper capitalization of other expenses
because in their opposition brief Plaintiffs failed [*38] to
respond to Defendants' arguments.
The Court does not find that Plaintiffs have abandoned these claims because Plaintiffs mention them in
their opposition brief's "statement of facts" and because
Plaintiffs denied abandoning them at oral argument. The
Court, however, finds that Plaintiffs have failed to establish scienter with regard to these claims. Plaintiffs fail to
plead any fact demonstrating that Buca knew or believed
the capitalization was improper at the time the original
financial results were announced.
2. Unusual or Heightened Motive
Next, Defendants assert that Plaintiffs have failed to
establish a strong and reasonable inference of scienter
based on an unusual or heightened motive to commit
fraud. Plaintiffs contend that Defendants were motivated
to allegedly artificially inflate Buca's stock price in order
to: (1) sell stock and exercise their stock options at a
substantial profit and (2) increase their compensation and
bonuses.
a. Stock Sales and Options
Plaintiffs allege that the Individual Defendants were
motivated to inflate Buca's stock price in order to sell
their shares at inflated prices and to exercise their options
using inflated stock as [*39] currency. Plaintiffs contend
that following a May 15, 2002 press release in which
Buca reported positive comparable restaurant sales for
the Buca di Beppo restaurants, Micatrotto sold 100,000
Buca shares for approximately $ 1,260,000 on June 12,
2002. Plaintiffs contend that this sale constituted 100%
of Micatrotto's holdings in Buca. n3 Plaintiffs also contend that Mihajlov also sold 10,000 Buca shares for $
180,000 on June 4, 2002. Plaintiffs contend that Micatrotto's and Mihajlov's sales occurred just prior to the
Company's public announcement on July 17, 2002, that
comparable restaurant sales had declined for the second
quarter and thus constituted an insider stock sale. Plaintiffs contend that this announcement resulted in the
Company's stock price dropping from $ 13.35 per share
on July 16, 2002, to $ 9.26 per share on July 17, 2002. In
addition to Micatrotto's and Mihajlov's July 2002 sales,
Plaintiffs cite various stock sales made by Micatrotto,
Mihajlov, and Gadel between 2000 and 2002, in which
the Individual Defendants earned between $ 85,000 and
$ 1,168,247 for the various sales. Because these sales
occurred during the Class Period, when Defendants were
allegedly reporting [*40] false operating results, Plaintiffs assert that Defendants had a personal stake in sustaining the perception of the viability of Buca's rapidgrowth plans.
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[*41]
n3 Micatrotto refutes the assertion that his June
12, 2002 sale of 100,000 Buca shares exhausted
his holdings. Micatrotto contends that this allegation is not supported by any pleading, confidential source, or exhibit. Micatrotto requests that the
Court take judicial notice under Rule 201 of the
Federal Rules of Evidence of Buca's 2002 Schedule 14A Proxy Statement, filed with the SEC on
April 25, 2002, and Buca's 2003 Schedule 14A
Proxy Statement, filed with the SEC on April 4,
2003. These documents show that as of April 9,
2002, Micatrotto was the beneficial owner of
301,663 Buca shares. (Reply Mem. of Def. Joseph P. Micatrotto in Supp. of Mot. to Dismiss
Pls.' Consolidated Am. Compl., Ex. B. at 7.)
Thus, according to Micatrotto, by selling 100,000
shares, he only divested himself of 33% of his
holdings in Buca. Micatrotto also asserts that
these documents show that by March 31, 2002,
Micatrotto was the owner of 332,867 Buca
shares. (Id. at Ex. A. at 8.) Micatrotto asserts that
he offers these documents not to prove the truth
of the documents' contents, but rather to emphasize that Plaintiffs' allegations against Micatrotto
are disingenuous and lack a factual or legal basis.
In response, Plaintiffs request that the Court
take judicial notice of the Form 4 that Buca filed
with the SEC on June 12, 2002. That Form,
shows "0" securities beneficially owned by Micatrotto following his sale of 100,000 shares of
common stock. Additionally, Plaintiffs request
that the Court take judicial notice of note 9 on
page 8 of the 2002 Schedule 14A that Micatrotto
requests judicial notice of, which shows that the
"shares" beneficially owned by Micatrotto actually consisted of options to purchase 301,663
shares, not actual shares. Finally, Plaintiffs request that the Court take judicial notice of note 11
on page 9 of the 2003 Schedule 14A submitted by
Micatrotto, which states that the 332,867 shares
beneficially owned by Micatrotto as of March 31,
2003 consisted of options to purchase 324,997
shares of common stock and 570 shares owned
by his wife. Thus, Plaintiffs do not object to
Micatrotto's request for judicial notice. The Court
grants Micatrotto's and Plaintiffs' requests to take
judicial notice of the documents, finding that the
Court may appropriately consider these SEC filings on this motion to dismiss and that they do
not go to the truth of the matter asserted. See
Green Tree, 270 F.3d at 663.
Defendants, on the other hand, assert that the stock
sales do not show the requisite motive because the Complaint does not indicate that Gadel's and Mihaljov's sales
were out of line with their prior trading practices. Defendants also contend that Micatrotto's June 2002 sale of
100,000 shares occurred early in the Class Period, before
the price drops of which Plaintiffs complain, and therefore do not establish motive to commit fraud. The Court
agrees.
The Court finds that Plaintiffs have not sufficiently
pled that the Individual Defendants had an unusual or
heightened motive to commit the alleged fraud. "Unusual
insider trading activity during the class period may permit an inference of bad faith and scienter." K-Tel Int'l,
300 F.3d at 895 (citation omitted). But "[i]nsider stock
sales are not inherently suspicious; they become so only
when the level of trading is 'dramatically out of line with
prior trading practices at times calculated to maximize
the personal benefit from undisclosed inside information.'" Navarre, 299 F.3d at 747 (quoting In re Vantive
Corp. Sec. Litig., 283 F.3d at 1079, 1092 (9th Cir.
2002)).
Here, with respect [*42] to Gadel and Mihaljov,
Plaintiffs' Complaint only alleges the number of shares
each defendant sold and the gross profit realized for each
stock sale during the Class Period. Because the Complaint does not indicate how these sales relate to the Defendant's prior sales histories, the Court cannot determine
whether the sales were "unusual in timing and amount."
Id. (finding no showing of unusual trade activity where
"[t]he Class failed to allege the prior history of sales for
the defendants or even the number of shares held by
each"). With respect to Micatrotto's June 2002 sale of
100,000 shares, although noteworthy because this sale
exhausted his holdings, this sale occurred early in the
Class Period, before the price drops of which Plaintiffs
complain. Moreover, Gadel, who allegedly directed the
accounting scheme with Micatrotto, did not sell any of
his shares in June 2002. Additionally, Plaintiffs cite no
authority for the proposition that a single sale by one
executive supports a strong inference of scienter. Thus,
the Court finds that Plaintiffs failed to plead unusual or
heightened motive that would give rise to a reasonable
and strong inference of scienter.
b. Compensation [*43] and Bonuses
Plaintiffs next allege that the Individual Defendants
were motivated to inflate their stock price to increase
their compensation, which was directly tied to certain
performance targets. Plaintiffs contend that, pursuant to
their Employment Agreements, Micatrotto and Gadel
were eligible for bonuses ranging from 35% to over 60%
of their base salary, depending on the number of new
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restaurant openings, total sales, comparable restaurant
sales, and general and administrative expenses. Plaintiffs
further allege that Gadel's agreement used a 2% increase
in comparable restaurant sales as a performance benchmark. Thus, according to Plaintiffs, it is not coincidental
that Defendants' alleged fraudulent booking of employee
meals as revenue allegedly increased same store sales by
more than 2% annually.
In response, Defendants assert that the Complaint
only vaguely alleges that Micatrotto and Gadel were eligible for bonuses that were dependent on achieving certain performance targets, which is nothing unusual for an
executive. The Court agrees and finds that such allegations do not establish unusual or heightened motive to
commit the alleged fraud. "[U]nsupported allegations
[*44] with regard to motives generally possessed by all
corporate directors and officers are insufficient as a matter of law." K-Tel Int'l, 300 F.3d at 894. Such motives
include the desire to maintain a high corporate credit
rating or the appearance of corporate profitability, and
the desire to maintain a high stock price in order to increase executive compensation. Id. (quoting Kalnit v.
Eichler, 264 F.3d 131, 139 (2d. Cir. 2001)).
Plaintiffs' allegations are unremarkable. Plaintiffs
have not pleaded any motive beyond what could be attributed to any corporate officer. The Complaint is silent
as to the amount of the bonuses that Micatrotto and
Gadel received that resulted from increased sales. Moreover, the Complaint is silent as to the total amount of the
bonuses that Micatrotto and Gadel actually received.
Thus, Plaintiffs have not asserted the required "concrete
and personal benefit to the individual defendants" that
resulted from the alleged fraud. See K-Tel, 300 F.3d at
894 (quoting Kalnit, 264 F.3d at 139). Based on the
foregoing, Plaintiffs have not alleged sufficient evidence
to show that the Individual Defendants' [*45] compensation gives rise to a strong and reasonable inference of
scienter.
3. Severe Recklessness
Plaintiffs assert that the Complaint demonstrates severe recklessness when the specific allegations are
viewed in their totality. Plaintiffs may establish scienter
through recklessness by demonstrating "highly unreasonable omissions or misrepresentations involving an
extreme departure from the standards of ordinary care,
and . . . present[ing] 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."
K-Tel Int'l, 300 F.3d at 893 (citations omitted). Absent a
showing of motive and opportunity, the remaining allegations against the defendants must be particularly strong
to constitute an inference of recklessness. Id. at 894.
In particular, Plaintiffs contend that the magnitude
of the restatement, the multiple GAAP violations, and
the alleged lack of internal controls collectively establish
scienter. The Court may consider allegations of scienter
collectively. Green Tree, 270 F.3d at 660. After reviewing Plaintiffs' allegations, the Court is not [*46] persuaded that they establish severe recklessness. Plaintiffs
lump all three GAAP violations together, suggesting that
Defendants engaged in a massive fraudulent accounting
scheme, when the Complaint and Plaintiffs' opposition
brief focus almost exclusively on the accounting violations regarding employee meals. Particularized allegations regarding Defendants' capitalization of certain expenses are conspicuously absent. n4 The Court is not
persuaded that the Plaintiffs' allegations regarding the
GAAP violations, taken together, establish scienter. Furthermore, these GAAP violations, viewed collectively
with Plaintiff's allegations regarding the magnitude of the
restatement and the alleged inadequate internal controls
also are insufficient to give rise to a strong inference of
scienter.
n4 Also conspicuously absent are any specific allegations of fraud related to Mihajlov. Plaintiffs'
Complaint and brief focus almost exclusively on
Gadel and Micatrotto. There is not one allegation
that Mihajlov knew that the various accounting
practices violated GAAP
[*47]
4. Internal Controls
Additionally, Plaintiffs assert that Buca repeatedly
misrepresented that its internal controls were adequate
and reliable and that these misrepresentations establish
scienter. In particular, Plaintiffs allege that Buca's internal controls were so deficient that the Individual at the
time Defendants issued the misstatements. Defendants
and other senior Buca managers were able to misappropriate Company assets. Plaintiffs further assert that the
Complaint alleges facts that establish that Buca's senior
officers knew about the internal control problems. Alternatively, Plaintiffs allege that even if the officers were
unaware of the internal control problems, the weaknesses
were so severe that the Defendants were reckless in not
knowing.
In response, Defendants assert that inadequate internal controls do not give rise to an actionable claim for
securities fraud under section 10(b). Alternatively, Defendants contend that the Complaint fails to plead facts
giving rise to a strong inference of scienter in connection
with the allegedly deficient internal controls. In support
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of this assertion, Defendants contend that Plaintiffs never
specify which internal controls [*48] were deficient,
how so, or when. Further, Defendants contend that Plaintiffs mistakenly argue that the Buca executives' conduct
in signing the Sarbanes-Oxley certifications vouching for
Buca's internal controls, alone, give rise to an inference
of scienter. Defendants also contend that Plaintiffs never
link the alleged deficiencies to the alleged accounting
scheme. Instead, Defendants assert that the Complaint
compels the conclusion that Buca took numerous steps to
address issues involving internal controls, including dismissing or accepting the resignation of certain officers,
conducting internal investigations under the auspices of
the Audit Committee, restating certain financials, and
filing suit against two former officers in state court.
"What impact a Sarbanes-Oxley certification has on
a 10b-5 claim is a relatively novel question." In re
Watchguard Secs. Litig., 2006 U.S. Dist. LEXIS 27217,
2006 WL 2038656, *9 (W.D. Wash. April 21, 2006)
(dismissing plaintiffs' section 10(b) claim, but addressing
plaintiffs' arguments that the certifications of adequate
internal controls constituted actionable misstatements).
At least one district court, however, has held that Sarbanes-Oxley certifications [*49] give rise to an inference of scienter. In re Lattice Semiconductor Corp. Secs.
Litig., 2006 U.S. Dist. LEXIS 262 (D. Or. Jan. 3, 2006).
That court held that, based on the pleadings, the executives' Sarbanes-Oxley certifications showed scienter because the certifications showed that the executives either
knew that an employee was improperly changing accounting journal entries in order to artificially inflate
revenue or that their financial controls were inadequate.
Id. at *50.
Here, because the Court has already dismissed the
Complaint based on Plaintiffs' failure to sufficiently
plead loss causation, the Court does not need to reach the
issue of whether inadequate internal controls give rise to
an inference of scienter. Whether inadequate internal
controls give rise to an actionable claim for securities
fraud under section 10(b), n5 whether Plaintiffs can establish scienter with respect to Gadel and Micatrotto, and
whether Gadel and Micatrotto's actions are attributable to
Buca are questions that the Court need not answer to rule
on this motion. In conclusion, the Court finds that Plaintiffs have failed to sufficiently plead loss causation and
scienter. Plaintiffs' [*50] section 10(b) allegations fail
against Buca and the Individual Defendants as a matter
of law. Accordingly, the Court dismisses Plaintiffs' 10(b)
claims.
n5 The Court notes, however, that even if the allegation could establish an actionable claim, the
Complaint would fail to establish scienter on this
basis with respect to Mihajlov. There is no allegation that Mihajlov was aware of any inadequate
internal controls when he signed the certifications. See Higginbotham v. Baxter Int'l, Inc.,
2005 U.S. Dist. LEXIS 12006, 2005 WL 1272271,
at *5 (N.D. Ill. May 25, 2005) (finding that plaintiffs had not pled scienter where they provided no
specific allegations as to what the deficiencies in
the controls were, nor provided any specific allegations as to the executives' awareness of those
deficiencies).
III. Section 20(a) Claim
Additionally, Plaintiffs allege claims against the Individual Defendants for violations of section 20(a) of the
Securities Exchange Act. "Section 20 of the Exchange
Act extends liability for fraudulent [*51] conduct under
Section 10(b) to individual controlling persons found to
have committed securities fraud." In re Xcel Energy,
Inc., 286 F. Supp. 2d 1047, 1059 (D. Minn. 2003) (citing
15 U.S.C. § 78t(a)). Because Plaintiffs have failed to
properly plead a section 10(b) claim, their section 20(a)
claim must also be dismissed. See Parnes, 122 F.3d at
550 n.12.
Conclusion
Accordingly, IT IS HEREBY ORDERED THAT:
1. Defendants Buca and Mihajlov's Motion to Dismiss the Consolidated Amended Class Action Complaint
(Doc. No. 36) is GRANTED.
2. Defendant Micatrotto's Motion to Dismiss the
Consolidated Amended Class Action Complaint (Doc.
Nos. 41 and 49) is GRANTED.
3. Defendant Gadel's Motion to Dismiss the Consolidated Amended Class Action Complaint (Doc. No.
32) is GRANTED.
4. Plaintiffs' Request for Judicial Notice (Doc. No.
66) is GRANTED.
5. Plaintiffs' Second Request for Judicial Notice
(Doc. No. 67) is DENIED.
6. The Consolidated Class Action Complaint (Doc.
No. 27) is DISMISSED WITHOUT PREJUDICE.
7. The Court GRANTS Plaintiffs' leave to replead.
If Plaintiffs elect to [*52] replead, they must file a second consolidated amended complaint within 45 days
after entry of this Order. The new complaint and any
subsequent motion to dismiss should be abbreviated,
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focusing only on the deficiencies raised by the Court in
this Order.
Dated: October 16, 2006
s/ Donovan W. Frank
Judge of United States District Court
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Not Reported in F.Supp.2d
Not Reported in F.Supp.2d, 1999 WL 33295869 (N.D.Cal.)
(Cite as: Not Reported in F.Supp.2d)
Briefs and Other Related Documents
Copperstone v. TCSI Corp.N.D.Cal.,1999.Only the
Westlaw citation is currently available.
United States District Court, N.D. California.
Albert J. COPPERSTONE and Joseph Siciliano, On
Behalf of Themselves and All Others Similarly
Situated, Plaintiffs,
v.
TCSI CORPORATION, Harvey E. Wagner, Harish
S. Rao, Roger A. Strauch, Daniel H. Miller, John C.
Bolger, Ram A. Banin, William A. Hasler, David G.
Messerschmitt and Paul A. Farmer, Defendants.
No. C 97-3495 SBA.
Jan. 19, 1999.
Alan Schulman, Milberg Weiss Bershad Hynes &
Lerach LLP, San Diego, James Bashian, James V.
Bashian Law Offices, Patricia I. Avery, Wolf Popper
LLP, New York, NY, Jeffrey W. Lawrence, Milberg
Weiss Bershad Hynes & Lerach LLP, San Francisco,
Lawrence W. Schonbrun, Law Offices of Lawrence
W. Schonbrun, Berkeley, for Albert J. Albert J.
Copperstone, on Behalf of Themselves and all Others
Similarly Situated, Joseph Siciliano, Alexander Van
Broek, unnamed class member, Plaintiffs.
Boris Feldman, Wilson Sonsini Goodrich & Rosati,
Palo Alto, Bonita L. Churney, Frank E. Merideth, Jr.,
Bryan Cave McPheeters & McRoberts, Lisa A.
Cohen, Bryan Cave LLP, Santa Monica, Martin H.
Myers, Gray Cary Ware & Freidenrich, Palo Alto, for
TCSI Corporation, Harvey E. Wagner, Harish S. Rao,
Roger A. Strauch, Daniel H. Miller, John C. Bolger,
Ram A. Banin, William A. Hasler, David G.
Messerschmitt, Paul A. Farmer, defendants.
ORDER GRANTING DEFENDANTS' MOTIONS
TO DISMISS
ARMSTRONG, District J.
I. INTRODUCTION
*1 Before the Court are three motions to dismiss
pursuant to Federal Rules of Civil Procedure sections
12(b)(6) and 9(b), and the Private Securities
Litigation Reform Act of 1995 (“PLSRA” or
“Reform Act”), which added Section 21D to the
Securities Exchange Act of 1934, 15 U.S.C. § 78u-4
(1996) (“Exchange Act”). One motion was brought
Page 1
on behalf of Defendants TCSI Corporation (“TCSI”
or the “Company”), Roger A. Strauch (“Strauch”),
Daniel H. Miller (“Miller”), John C. Bolger
(“Bolger”), Ram A. Banin (“Banin”), William A.
Hasler (“Hasler”), David G. Messerschmitt
(“Messerschmitt”), and Paul A. Farmer (“Farmer”).
The other two were filed individually by Defendants
Harvey E. Wagner (“Wagner”) and Harish S. Rao
(“Rao”).FN1
FN1. As the arguments of the moving
Defendants substantially overlap, their
motions will be considered collectively
unless otherwise indicated. Additionally, the
individually named Defendants will be
referred
to
in
the
aggregate
(i.e.“Defendants”)
unless
otherwise
indicated.
Plaintiffs have also cross-moved to strike two
exhibits submitted by the Defendants in support of
their motion.
Having read and considered the papers filed in
connection with the motions, and being fully
informed, the Court grants all Defendants' motions to
dismiss and denies the Plaintiffs' motion to strike.FN2
FN2. Pursuant to Civil Local Rule 7-1(b),
the Court adjudicates the instant matter
without oral argument.
II. BACKGROUND
Plaintiffs Albert J. Copperstone and Joseph Siciliano
bring this securities class action lawsuit against TCSI
and nine of its officers and directors on behalf of
themselves and all persons, with the exception of the
Defendants, their immediate families, and any entity
in which a Defendant has a controlling interest, who
purchased TCSI common stock between October 11,
1995 and September 25, 1996 (the “Class Period”).
TCSI sells object-oriented software, primarily to
companies in the telecommunications industries. In
their Complaint, filed September 24, 1997
(“Complaint”), Plaintiffs allege that all Defendants
violated Section 10(b) of the Exchange Act and
Securities and Exchange Commission (“SEC”), Rule
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10b-5, and that Defendants Wagner, Strauch, and
TCSI violated Section 20(a) of the Exchange Act. In
support of these claims, Plaintiffs allege that the
Defendants pursued a “fraudulent scheme and course
of business that artificially inflated TCSI's stock”
(Compl.¶ 1), allowing the individual Defendants to
sell off a majority of their respective shares of the
Company's stock at premium prices before the stock
plummeted, inflicting monetary damage on the
outside investors (the “Class”) who purchased TCSI
stock during the Class Period. Specifically, Plaintiffs
allege that Defendants, through analysts' reports,
company statements directly to the market, and
financial statements, misrepresented to the
investment community that it was enjoying strong
demand for its products and that its business was
growing, when in truth its products were not selling
and its competitors were taking its market share.
The Complaint sets out a long list of allegedly false
and misleading statements made and/or endorsed by
Defendants in a multitude of settings, beginning with
a company press release on October 11, 1995, and
concluding with TCSI's disclosure of an expected
third quarter loss on September 25, 1996. FN3
Plaintiffs allege that Defendants, through these
statements, repeatedly forecast “strong revenue and
earnings growth for TCSI during 1996 and 1997”
when, in reality, Defendants were aware of “adverse
facts” that would eventually lead to very different
results. (Compl.¶ ¶ 14(l), 50(i), 58(h), 74(k), 84(l),
87(h).) The Complaint centers on allegations that
Defendants, throughout the Class Period, knowingly
concealed the “true facts”, which were, in part: (a)
TCSI's competitive position was being eroded due to
the entry into its marketplace of competitors who
were offering superior and/or lower priced products;
(b) TCSI's customers were no longer willing to fund
research and development expenditures, requiring
TCSI to pick up the cost; (c) TCSI's customers'
decision to stop funding TCSI's development
expenses reflected those customers' diminished
commitment to the Company; (d) demand for TCSI's
object-oriented software had softened; (e) it was very
unlikely that TCSI would obtain a major contract
from a Regional Bell Operating Company (“RBOC”)
during the third quarter of 1996; and (f) TCSI was
experiencing severe difficulties with its large UPS
contract and had been informed by UPS that UPS
would likely terminate the contract during 1996,
which would result in TCSI taking a write-off and
suffering a loss. (See ¶ ¶ 14, 50, 58, 74, 84, 87.)
FN3.
As
the
“false
and
misleading
Page 2
statements” section consumes approximately
40 pages of the 89 page complaint (see
Compl. ¶ ¶ 40-88), direct quotes will only
be used when required to illustrate a point.
*2 As a result of the alleged misrepresentations by
Defendants, TCSI performed extraordinarily well
during the Class Period, enabling Defendants to sell
off a majority of their TCSI stock at artificially
inflated prices. (Compl.¶ 12.) On October 10, 1995,
the day before the beginning of the Class Period,
TCSI's common stock sold at $8 1/2 per share.
Shares sold at $18 5/8 during a March 1996
secondary public offering. The price eventually
peaked at $29 3/4 per share in late June of 1996,
before falling precipitously in late September of 1996
as rumors of a third quarter loss began to circulate
throughout the market. On September 25, 1996,
TCSI, in a press release, confirmed that its revenues
for the third quarter would decline from the prior
quarter and that TCSI would suffer a loss-contrary to
analysts' previous forecasts for the company. On
October 16, 1996, TCSI announced the termination
of its contract with UPS, increasing the third quarter
loss. TCSI stock prices dropped to as low as 5 3/4 in
October of 1996.
Additionally, the Complaint alleges that, during the
Class Period, the individually named Defendants sold
over 4.4 million shares of the TCSI stock they owned
for proceeds of over $80 million, in order “to profit
from the artificial inflation in TCSI's stock price their
violation of law had created before the truth came out
and TCSI's stock price crashed.” (Compl.¶ 106.)
III. LEGAL STANDARDS
A. Federal Rule of Civil Procedure 12(b)(6)
Under Federal Rule of Civil Procedure 12(b)(6), a
motion to dismiss should not be granted unless it
appears beyond a doubt that the plaintiff “can prove
no set of facts in support of his claim which would
entitle him to relief.” Conley v. Gibson, 355 U.S. 41,
45-46 (1957). For purposes of such a motion, the
complaint is construed in a light most favorable to the
plaintiff and all properly pleaded factual allegations
are taken as true. Jenkins v. McKeithen, 395 U.S.
411, 421 (1969); Everest and Jennings, Inc. v.
American Motorists Ins. Co., 23 F.3d 226, 228 (9th
Cir.1994). All reasonable inferences are to be drawn
in favor of the plaintiff. Jacobson v. Hughes Aircraft,
105 F.3d 1288, 1296 (9th Cir.1997).
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When the complaint is dismissed for failure to state a
claim, “leave to amend should be granted unless the
court determines that the allegation of other facts
consistent with the challenged pleading could not
possibly cure the deficiency.” Schreiber Distrib. Co.
v. Sery-Well Furniture Co., 806 F.2d 1393, 1401 (9th
Cir.1986). Leave to amend is properly denied “where
the amendment would be futile.” DeSoto Yellow
Freight Sys., 957 F.2d 655, 658 (9th Cir.1992).
Amendments should be permitted to clarify
ambiguities in the Complaint. See New v. Amour
Pharmaceutical Co., 67 F.3d 716, 722 (9th Cir.1995).
Although the court is generally confined to
consideration of the allegations in the pleadings,
when the complaint is accompanied by attached
documents, such documents are deemed part of the
complaint and may be considered in evaluating the
merits of a Rule 12(b)(6) motion. Hal Roach Studios
v. Richard Feiner & Co., 896 F.2d 1542, 1555 n.19
(9th Cir.1990). In addition, “[o]n a motion to dismiss,
... a court may take judicial notice of facts outside the
pleadings.” Mack v. South Bay Beer Distributors,
Inc., 798 F.2d 1279, 1282 (9th Cir.1986).
*3 In cases alleging securities laws violations,
motions to dismiss are subject to stricter standards
because whether a statement or omission is
misleading to potential investors “requires delicate
assessments of the inferences a ‘reasonable
shareholder’ would draw from a given set of facts
and the significance of those inferences to him, and
these assessments are peculiarly ones for the trier of
fact.” Fecht v. The Price Co., 70 F.3d 1078, 1080
(9th Cir.1995) (citation omitted). Thus, “only if the
adequacy of the disclosure or the materiality of the
statement is so obvious that reasonable minds could
not differ are these issues appropriately resolved as a
matter of law.” Id. at 1081 (internal quotations
omitted).
B. Section 10(b) and Rule 10b-5
Section 10(b) of the 1934 Act makes it unlawful for
any person:
To use or employ, in connection with the purchase or
sale of any security registered on a national securities
exchange[,] ... any manipulative or deceptive device
or contrivance in contravention of such rules and
regulations as the [SEC] may prescribe as necessary
or appropriate in the public interest or for the
protection of investors.
Page 3
15 U.S.C. § 78j(b). Rule 10b-5, enacted thereunder,
makes it unlawful “[t]o make any untrue statement of
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.” 17 C.F.R. § 240.10b-5(b). To
successfully allege a violation of Rule 10b-5, a
plaintiff must show: (1) a false and misleading
statement or omission of material fact; (2) scienter;
(3) reliance; and (4) resulting damages. Paracor Fin.,
Inc. v. General Elec. Capital Corp., 96 F.3d 1151,
1157 (9th Cir.1996).
C. Pleading Standards
1. Federal Rule of Civil Procedure 9(b)
Rule 9(b) provides that “[i]n all averments of fraud or
mistake, the circumstances constituting fraud or
mistake shall be stated with particularity. Malice,
intent, knowledge, and other condition of mind of a
person may be averred generally.” Fed.R.Civ.P. 9(b).
Rule 9(b) applies to actions brought under the federal
securities laws. In re GlenFed. Inc. Sec. Litig., 42
F.3d 1541, 1544 (9th Cir.1994) (en banc).
To comport with Rule 9(b), the complaint must allege
the time, place and content of the alleged fraudulent
representation or omission; the identity of the person
engaged in the fraud; and also set forth the
“circumstances indicating falseness” or “the manner
in which [the] representations [or omissions at issue]
were false and misleading.” Id. at 1547-48. Thus,
Plaintiffs must provide an explanation as to how an
alleged statement or omission was false or misleading
when made. Id. at 1548.
The heightened pleading standard of Rule 9(b) is not
an invitation to disregard the requirement of
simplicity, directness, and clarity of Fed.R.Civ. P. 8.
McHenry v. Renne, 84 F.3d 1172, 1178 (9th
Cir.1996). Every plaintiff filing a complaint in a
federal district court must also prepare his complaint
in conformity with Rule 8, which requires that a
complaint contain “a short and plain statement of the
claim showing that the pleader is entitled to relief,”
Fed.R.Civ.P. 8(a), and that “[e]ach averment of a
pleading shall be simple, concise, and direct,” Fed. R.
Civ P. 8(e).
2. The Reform Act
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*4 To survive a motion to dismiss, a complaint
alleging fraud must meet the heightened pleading
standards set forth in the Reform Act, in which
Congress clarified and strengthened the particularity
requirements of Rule 9(b) as applied in the context of
federal securities class action lawsuits. In re Oak
Tech. Sec. Litig., 1997 WL 448168, *3
(N.D.Cal.1997); Zeid v. Kimberly, 973 F.Supp. 910,
914 (N.D.Cal.1997).
The Reform Act requires that a complaint in a
securities fraud action specify each false and
misleading statement and why each statement is false
and misleading. 15 U.S.C. 78u-4(b)(1)(B). If an
allegation regarding a statement or omission is made
on information and belief, the complaint must state
with particularity the facts on which the belief is
formed. Id. Moreover, the complaint must set forth
particular facts that give rise to a strong inference that
Defendants acted with the required state of mind. 15
U.S.C. § 78u-4(b)(2). A complaint that fails to
comply with any of these requirements must be
dismissed. 15 U.S.C. § 78u-4(b)(3)(A)
Page 4
circumstances where “information and belief” is the
basis for the allegation of fraud. Zeid, 973 F.Supp at
915 (quoting Neubronner v. Milken, 6 F.3d 666, 672
(9th. Cir.1993)). However, to obtain the application
of this relaxed standard, Plaintiffs were required to
state the facts that formed the bases for their
allegations. Id. Therefore, under the Reform Act,
allegations based upon information and belief are
proper so long as the complaint sets forth the facts
that form the basis of the allegations. Id.
Here, Plaintiffs do not explicitly state in the
Complaint that any of the allegations are based upon
“information and belief.” Instead, Plaintiffs state at ¶
124 of the Complaint, in relevant part:
[P]laintiffs have alleged the foregoing based upon the
investigation of their counsel, which included a
review of TCSI's SEC filings, securities analysts'
reports and advisories about the Company, press
releases issued by the Company, media reports about
the company, private investigations and discussions
with consultants, and, pursuant to Rule 11(b)(3),
believe that after reasonable opportunity for
discovery, substantial evidence will likely exist for
the allegations set forth in [the Complaint].
IV. ANALYSIS
In support of their motions to dismiss, Defendants
argue that the claims asserted in the Complaint
consist of nothing more than conclusory allegations
which lack the specificity required by the Reform
Act. In particular, Defendants argue that the
Complaint
insufficiently
pleads
material
misrepresentations, scienter, and controlling person
liability.
Plaintiffs respond that the Complaint adequately
alleges each false and misleading statement, specifies
why each statement was false and misleading, and
recites facts giving rise to a strong inference that the
defendants acted with the requisite state of mind.
*5 Two other courts in the Northern District of
California have held that allegations based on
“investigation of counsel” were not pled on
information and belief and, as such, were not entitled
to the more relaxed pleading standard. See Zeid, 973
F.Supp. at 915; Howard Gunty Profit Sharing v.
Quantum Corp., 1997 WL514993, at *3
(N.D.Cal.1997). This Court is persuaded by the
reasoning of these decisions. Thus, Plaintiffs are
required to conform with the strict pleading
requirements found in 15 U.S.C. § 78u-4(b)(1) and
specify “each statement alleged to have been
misleading” and “the reason or reasons why the
statement is misleading.”
2. Structural Deficiencies
A. Pleading False or Misleading Statements
1. Particularity Requirements
The Reform Act provides that “if an allegation
regarding the statement is made on information and
belief, the complaint shall state with particularity all
facts on which that belief is formed.” 15 U.S.C. §
78u-4(b)(1). This section, in effect, codifies the
courts' pre-Reform Act standard by relaxing the
pleading requirements under Rule 9(b) in
The Complaint fails to comply with the presentation
requirements of Fed.R.Civ. P. 8 and the Reform Act.
Plaintiffs separate the class period into five different
sub-periods of time. Within each sub-period,
Plaintiffs lump together several allegedly misleading
statements by the Defendants followed by a list of
“true facts” allegedly known to the Defendants when
the statements were made. (See Compl. ¶ ¶ 14, 50,
58, 74, 84, 87.) Many of the allegations are repeated
several times without any variation whatsoever. The
Complaint does not indicate which among the nearly
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40 pages of statements are alleged to be false, and
does not follow each allegedly false statement with a
factor or factors showing it to be false. (See id.) This
method of drafting requires the reader to match each
alleged misrepresentation with the corresponding
“true fact” in an attempt to discern any actionable
claim that might exist. Not only does this “puzzlestyle” pleading style fail to comport with Rule 8, it
also violates the Reform Act by failing to specify
why each alleged misstatement was false or
misleading. See Wenger, 2 F.Supp.2d at 1243-44;
Zeid, 973 F.Supp. at 918. Moreover, it renders
effective review and analysis an extremely difficult
task. Plaintiffs filed this deficient Complaint despite
repeated exhortations by several courts in a number
of securities fraud class actions to cease engaging in
this inappropriate form of pleading. See GlenFed, 42
F.3d at 1554 (These “puzzle-style” complaints are
“cumbersome almost to the point of abusiveness” and
“are an unwelcome and wholly unnecessary strain on
defendants and on the court system.”); Zeid, 973
F.Supp. at 918 (“This method of pleading imposes an
unnecessary burden on Defendants and the Court to
sort out the alleged misrepresentations and match
them with the corresponding ‘adverse facts.” ’);
Wenger, 2 F.Supp 2d at 1243 (“Plaintiff merely
throws the statements and the alleged ‘true facts'
together in an undifferentiated clump and apparently
expects the reader to sort out and pair each statement
with a supposedly relevant “ ‘true fact.” ’) Shuster v.
Symmetricom, Inc., 1997 WL 820967, *1 (N.D.Cal
1997) (The Complaint “is confusingly arranged.
Plaintiff sets forth lengthy quotes from various
releases by defendants' officers and a securities
analyst but does not make clear what portion of each
quote constitutes a false representation.”); Strassman
v. Fresh Choice, 1995 WL 743728, *4
(N.D.Cal.1995); (“Rather than simply alleging one
misstatement in one paragraph followed by a
paragraph specifying the reasons for the statements
falsity, Plaintiffs treat the art of pleading much like
the puzzle referred to in GlenFed. The FAC's
deficiencies do not stem simply from its length, but
rather from its requirement that the reader find the
needle in the haystack.”)
*6 This Court finds that Plaintiffs have failed to draft
the Complaint in accordance with Fed.R.Civ.P. 8(a),
which requires a “short and plain statement of the
claim.” Moreover, this Court finds that the Complaint
does not conform with the requirements of the
Reform Act because it fails to specify each statement
alleged to have been misleading and the reason or
reasons why each statement is misleading. 15 U.S.C.
§ 78u-4(b)(1). The Complaint is dismissed in its
Page 5
entirety for these structural deficiencies.
3. Conclusory Factual Allegations
The Complaint also fails because Plaintiffs do not
allege any specific facts that indicate that any of the
alleged “true facts” known to the Defendants existed
before the allegedly misleading statements were
made. (See Compl. ¶ ¶ 14, 50, 58, 74, 84, 87).
Post-Reform Act cases have insisted upon references
to specific facts that would demonstrate that the
statements in question were actually false and
misleading when made. To adequately plead falsity,
the complaint must show (1) facts describing the
undisclosed problems in detail, and (2) facts showing
the problems arose before the allegedly misleading
statements were made. Wenger, 2 F.Supp.2d at 1240.
Allegations regarding general “adverse facts”
allegedly known to the Defendants must be supported
by
specific
references
to
inconsistent
contemporaneous statements by Defendants or
information available to the Defendants at the time
the allegedly misleading statements were made. See
In re Oak Technology Sec. Litig., 1997 WL 448168,
at *5; Hockey, 1997 WL 203704, at *8; Wenger, 2
F.Supp.2d at 1240; Zeid., 973 F.Supp. at 920. The
allegations of “true facts” allegedly known to the
Defendants and listed in the Complaint are
conclusory and fail to provide an adequate
explanation of why the Defendants' statements were
false when made.
The Complaint appears to be Plaintiffs' attempt to
take disclosures made by TCSI in September of 1996
and, through speculation and hindsight, characterize
these statements as facts that were known to the
Defendants since October 1995. See Wenger, 2
F.Supp.2d at 1250. For example, Plaintiffs assert that
TCSI, by December 1995, knew that it “was having
severe difficulties with its large UPS contract and
that due to the additional work and modifications
TCSI was having to perform as part of the contract
the insiders knew it was probable the contract would
ultimately result in a loss for TCSI.” (Compl.¶ ¶
50(e); 58(e); 74(g); 84(h); 87(f)). Yet, Plaintiffs never
refer to a specific fact that would support their
allegation that the Defendants knew anything was
wrong with the UPS contract until October 1996when TCSI disclosed that the UPS contract had been
terminated. Rather, Plaintiffs refer to a statement
made by Strauch in which he acknowledged, in
hindsight, his eventual realization that the UPS
contract no longer was sensible for the company. See
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supra at part B-3. Statements such as this are
insufficient to establish liability under the Reform
Act. See Wenger, 2 F.Supp.2d at 1250.
*7 Similarly, Plaintiffs allege that the Defendants
knew “that it was very unlikely” that TCSI would
close a licensing contract with a Regional Bell
Operating Company. (Compl.¶ ¶ 14(g); 84(g);
87(e)). However, the Complaint fails to refer to any
specific fact that would have put any of the
Defendants on alert to this until the press release on
September 25, 1996, which disclosed that some
anticipated agreements would not close by the end of
the third quarter of 1996. Rather, Plaintiffs vaguely
allege that a Regional Bell “had not committed to
place an order by that time frame and had indicated
that it likely would not place that order before 1997
at the earliest.” (Compl.¶ 84.) This allegation fails to
show “undisclosed problems in detail” or that the any
such problems arose prior to when the allegedly
misleading statements were made. See Wenger, 2
F.Supp.2d at 1240. Such unsupported allegations,
without reference to specific contemporaneous facts
demonstrating falsity, do not suffice.
B. Analysis of the Statements
For purposes of analyzing the sufficiency of the
present Complaint, Plaintiff's allegations are divided
into three categories: (1) false and misleading analyst
reports; (2) false and misleading company
statements; and (3) false financial statements.
1. False and Misleading Analyst Reports
The Complaint alleges that Defendants Strauch,
Farmer, and Wagner, made false and misleading
statements directly to non-party securities analysts
via conference calls, sponsored lunches, and private
communications, with the intent that these analysts
would relay this information to the market. (Compl.¶
¶ 43, 48, 53, 66, 72, 80, 85.) The Complaint also
alleges that these analysts did indeed disseminate this
allegedly false information to the investing public
after, in several instances, “TCSI's top officers”
received, reviewed, and approved the report.
(Compl.¶ ¶ 44-47, 49, 54-55, 63-64, 67-69, 70, 73,
75-77, 81-82, 86.)
Defendants counter that the analysts' reports cannot
form a basis for liability because Plaintiffs do not
allege specific facts showing that the Defendants
were involved with the reports and knew that the
Page 6
reports were false when made.
Until the recent Ninth Circuit opinion in Cooper v.
Pickett, 137 F.3d 616 (9th Cir.1998), to be liable for
misleading statements contained in analysts' reports,
a defendant had to either expressly or impliedly adopt
or endorse the analysts' statements. See In re Syntex
Corp. Sec. Litig., 95 F.3d. 922, 934 (9th Cir.1996)
(citations omitted); In re Stac Sec. Litig., 89 F.3d
1399, 1410 (9th Cir.1996). The Cooper court
explained:
[O]ur decisions in Stac and Syntex did not consider
whether corporate defendants could be directly liable
for misrepresentations to securities analysts. See In re
Cirrus Logic Sec. Litig., 946 F.Supp. 1446, 1467 n.13
(N.D.Cal.1996). Instead, the issue in Stac and Syntex
was whether corporate defendants could be held
liable for analysts' interpretations of defendants
truthful statements. See id. Our decisions in Stac and
Syntex do not preclude plaintiff's claims that
[defendants] made false and misleading statements to
securities analysts with the intent that the analysts
communicate those statements to the market.
*8 137 F.3d at 622-23. Cooper, therefore, allows a
plaintiff to forgo allegations of the defendants'
adoption of the analysts' reports if the statements
made to the securities analysts, which formed the
basis of the report, were misleading and were made
with the intent that they be communicated to the
market. However, the facts of Cooper arose prior to
the passage of the Reform Act, therefore the stricter
pleading requirements outlined above were not
applicable in that case. Plaintiffs must now cast their
Complaint pursuant to the Reform Act.
Consequently, any amended complaint must specify
each statement to an analyst alleged to have been
misleading, succeeded by the reason or reasons why
the statement is misleading. 15 U.S.C. § 78u-4(b)(1).
Because Plaintiffs current Complaint fails to conform
to these requirements, the claims are dismissed
insofar as they are based on misleading statements
made by Defendants to analysts.
To the extent Plaintiffs are relying on the theory that
Defendants adopted the allegedly misleading
statements of the analysts, the Complaint also fails. A
defendant adopts an analyst's statement if he has
“sufficiently entangled” himself with the analyst's
forecasts to render those predictions attributable to
him. In re Caere Corp. Sec. Litig., 837 F.Supp. 1054,
1059 (N.D.Cal.1993). To sufficiently plead adoption,
a complaint must: (1) identify the specific forecasts
and name the insider who adopted them; (2) point to
specific interactions between the insider and the
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analyst which allegedly gave rise to the
entanglement; and (3) state the dates on which the
acts which allegedly gave rise to the entanglement
occurred. Id.
The boilerplate “adoption” sentences found in the
Complaint fail to meet this standard. The sentences
read: “TCSI's top officers received this report before
it was issued and approved it. TCSI later reproduced
this report and distributed it.” (Compl.¶ ¶ 47, 49, 6364, 75-76.) While the specific forecasts are alleged,
neither the identity of the insider who adopted them,
the interactions which gave rise to the entanglement,
nor the dates on which such interactions occurred are
plead.FN4 Without these facts, the securities analysts'
forecasts cannot support a claim of fraud by any of
the Defendants. FN5 In re Caere, 837 F.Supp. at
1060. Plaintiffs' conclusory allegations of adoption
are wholly inadequate. Id.
FN4. Additionally, at least two of the
analysts' reports referred to in the Complaint
do not directly refer to specific misleading
representations made by any of the
Defendants to the analyst nor allege that any
of the Defendants subsequently adopted
these reports. (See Compl. ¶ ¶ 46, 77.)
Without any discernable nexus between the
Defendants and the analysts' reports, the
reports at issue are not actionable. This
nexus must either take the form of a false or
misleading statement from a defendant to
the analyst (Cooper ), or a subsequent
adoption of a false or misleading analysts'
report by the defendants (Stac/Syntex ).
FN5. Plaintiffs' claims of misleading
statements by or to analysts have other
deficiencies as well. Several statements
contained in the analysts' reports are
inactionable, amorphous statements of
corporate optimism. For example, Plaintiffs
allege that Defendants, in various
conference calls, misled analysts by stating:
“The tone of TCSI's business was ‘very
positive” ’ (Compl.¶ 72); “TCSI's business
was ‘on track’,” and “bookings ‘looked
strong’ into the fourth quarter as well.”
(Compl.¶ 85). Statements such as these “are
inactionable because reasonable investors do
not consider ‘soft’ statements or loose
predictions important in making investment
decisions.” Zeid, 973 F.Supp. at 919
(quoting Raab v. General Physics Corp., 4
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F.3d 286, 289-90 (4th Cir.1993). A “soft
statement” or “loose prediction” has been
defined by this Court as a statement that is
“so vague that no reasonable investor would
rely upon them in making his or her
investment decision.” Parnes v. Harris, No.
C 95-2715 SBA, slip op. at 38
(N.D.Cal.1997).
2. False and Misleading Company Statements
The Complaint alleges that on several occasions
during the Class Period, Defendants released false
and misleading statements directly to the market.
These statements came in the form of: (a) Oral
presentations and Quarterly conference calls
(Compl.¶ ¶ 41, 53, 59, 72, 85); (b) TCSI press
releases (Compl. ¶ ¶ 40, 42, 51, 52, 65, 78, 79, 83);
and, (c) a letter included with the 1995 Annual
Report (Compl.¶ ¶ 57);
a. Oral Presentations and Quarterly Conference Calls
The Complaint cites five separate occasions in which
Defendants allegedly provided false information
directly to the market by means of oral presentations
or conference calls. (Compl.¶ ¶ 41, 53, 59, 72, 85.)
The first instance was the Alex. Brown Technology
Seminar on October 11, 1995, where Defendants
Strauch and Farmer spoke. (Compl.¶ 41.) The
second event was a conference call on January 25,
1996 that included large TCSI shareholders, during
which Defendants Wagner, Strauch, and Farmer
made presentations and answered questions;
however, all statements alleged are paraphrased.
(Compl.¶
53.) The third was a “multi-city
Roadshow” prior to the March 1996 stock offering.
However, neither the dates, speakers, or the
statements alleged to be false or misleading are ever
indicated. (Compl.¶ 59.) FN6 The fourth and fifth
occasions were Quarterly conference calls on June 3,
1996, and August 29, 1996, respectively, in which
Defendants Strauch, Farmer, and Banin made
presentations. (Compl.¶ ¶ 72, 85.) Again, the
statements alleged during these calls are paraphrased.
FN6. All allegations regarding the
Roadshow are dismissed for this reason. See
In re Valence Technology Sec. Litig., 1996
WL 37788, *9-10 (N.D.Cal.1996).
*9 The statements alleged during these presentations
cannot support a claim for fraud. In every instance,
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except the presentation at the Alex. Brown
Technology Seminar, the statements are paraphrased.
While paraphrased statements are not per se invalid,
the statements in the Complaint are either too
amorphous (e.g, “the tone of TCSI's was “ ‘very
positive” ’ Compl. ¶ 72) or lack the particularity
required by Rule 9(b) and the Reform Act. See
Wenger, 2 F.Supp.2d at 1246-47. Rather than “stating
with particularity” the content of the alleged
fraudulent statements, as required by Fed.R.Civ.P.
9(b), and “specifying each statement alleged to have
been misleading,” pursuant to the Reform Act,
Plaintiffs repackage most of Defendants' oral
statements in vague and impressionistic terms. For
example, Plaintiffs allege that Strauch, Banin and
Farmer made presentations “stating” that the
Company had a number of highly profitable deals
pending. (Compl.¶ 72.) However, Plaintiffs never
allege who made the statement, what was actually
said, if the profitable deals actually were identified,
and, most importantly, why the statement was false
when made. The “true facts” that follow in ¶ 74 do
little to enlighten the Court as to what rendered this
particular assertion false or misleading at the time it
was made. These paraphrased statements, without
more specificity, fail to support a claim for fraud.
The only direct quotes offered are those attributed to
Defendants Strauch and Farmer while they appeared
for TCSI at the Alex. Brown Technology Seminar.
(Compl.¶ 41.) The vast majority of the alleged false
or misleading representations here are either
statements of historic fact, vague and general
statements of optimism, or publicly known facts.FN7
As such, they are simply not actionable. See In re
Sofamor Danek, 123 F.3d 394, 401 n. 3 (6th
Cir.1997); Raab v. General Physics Corp., 4 F.3d
286, 288-90 (4th Cir.1993); Howard Gunty Profit
Sharing v. Quantum Corp., 1997 WL 514993, *4
(N.D. Cal 1997).
FN7. Examples include the following
statements: “We're particularly excited
about the positioning of OSP”; “TCSI also
offers our customers software at the heart of
new digital wireless telephones”; and
“Currently, we've already reported ten
consecutive quarters, that's through the
second quarter of 1995, of increased
revenues and EPS growth of in excess of 30
percent.” (Compl.¶ 41.)
Of the eight statements recited in ¶ 41 of the
Complaint, only two are potentially actionable. The
Page 8
first quotes Defendant Strauch saying, “[a]t least 5 to
10 million dollars of license fees will be generated in
1996 based on [the object services package].” The
second is also attributed to Defendant Strauch while
speaking about TCSI's new digital wireless telephone
software: “[W]hat we're very excited about is that
next year at least 1 to 2 million dollars of royalties
will be generated by these products ....” What is
missing from these alleged false statements are
specific reasons why the statements are false. The
“adverse facts” that follow in ¶ 50 contain no
explicative particulars revealing how or why Stauch's
predictions were false, misleading, or even
inaccurate.
In sum, the Complaint's allegations of false and
misleading company statements do not meet the
requirements of Rule 9(b) and the Reform Act
because the Complaint fails to specify the reason or
reasons why any of the company statements were
false and misleading when made by reference to
specific, contemporaneous facts.
b. TCSI Press Releases
*10 The Complaint, while containing an impressive
number of allegedly false or misleading statements
found in TCSI press releases, never specifies the
reason or reasons why each statement was false and
misleading when made. 15 U.S.C. § 78u-4(b)(1).
Plaintiffs' broad and conclusory allegations found in
their general “adverse facts” paragraphs are not
supported by any references to specific
contemporaneous facts and cannot provide a
sufficient basis to support a claim of fraud. The Court
orders Plaintiffs to follow each allegedly false and
misleading statement with the reason or reasons that
the statement is alleged to be false or misleading by
referring to specific contemporaneous facts
apparently unearthed by Plaintiffs' “investigation of
counsel.” See Wenger, 2 F.Supp.2d at 1252.
c. Report to Shareholders
The Complaint also alleges false and misleading
statements were made in a letter that accompanied
the 1995 Annual Report, issued March 13, 1996
(Compl.¶ 57). However, Plaintiffs' allegations of
false and misleading statements in this document are
unsupported by specific and contemporaneous facts
indicating their falsity. For instance, an allegedly
false and misleading excerpt from the letter, authored
by Strauch, reads: “We believe this strategy will
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enable TCSI to target new customers with
competitively positioned application ....” (Compl. ¶
57.) The reader of the Complaint must then search
through the following paragraph, ¶ 58, containing
the laundry list of “true facts” allegedly known to all
the Defendants, and glean the fact or facts that might
pertain to this alleged misstatement. The most
relevant “true fact” appears to be ¶ 58(a), which
reads: “That TCSI's competitive position was being
eroded due to the entry into its marketplace of
competitors
(including
Objective
Systems
Integrators) who were offering superior and/or lower
priced products resulting in a slowing of orders or
bookings for TCSI's products.” Plaintiffs do not point
to facts or documents that would corroborate this
assertion such as: (1) the names and prices of the
superior and/or lower priced products that existed
when this statement was issued; or, (2) documents
that would demonstrate that orders or bookings for
TCSI's products were slowing when this statement
was issued. Without more specific facts, there is an
insufficient basis to support a claim of fraud.
3. False Financial Statements
Plaintiffs allege that during the Class Period
Defendants issued false financial statements for the
fourth quarter of 1995 and the second and third
quarters of 1996. (See Compl. ¶ 60, 89-105.) They
allege these statements were false as a result of
TCSI's knowing violations of Generally Accepted
Accounting Principles (“GAAP”). Specifically, the
Complaint alleges that TCSI's violations of GAAP
were accomplished by: (1) TCSI's improper
recognition of service and license fee revenue; and,
(2) TCSI's failure to record a loss on the UPS
contract in a timely manner.
*11 To adequately state a claim for accounting fraud,
a plaintiff must plead facts sufficient to support a
conclusion that the defendants prepared fraudulent
financial statements and that the alleged financial
fraud was material. In re Ross Systems Sec. Litig.,
[Current Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶
98,363 at 90,498 (N.D.Cal.1994). Although the
Complaint need not specify the precise amount of
each error, it must identify specific transactions
underlying the Defendants' alleged accounting
deficiencies. See In re Wells Fargo Sec. Litig., 12
F.3d 922, 926-27 (9th Cir.1993), cert denied sub.
nom., Wells Fargo & Co. v. Greenwald, 513 U.S. 917
(1994); In re Ross Sec. Litig., Fed. Sec. L. Rep. ¶
98,363 at 90,499; Zeid, 973 F.Supp. at 922.
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Page 9
In the Complaint, Plaintiffs do not identify any
particular transactions in which TCSI improperly
recognized revenue. Plaintiffs do specifically identify
some of TCSI's telecommunication customers, and
refer to contracts between TCSI and its customers
that included acceptance contingencies. (Compl.¶
95.) The Complaint also alleges the “results” of the
improper revenue recognition-namely, an increase in
the unbilled receivables account and eventual writeoffs which were falsely attributed to unrelated
divestments. (Compl.¶ 96-97.) However, Plaintiffs
fail to identify any transactions in which TCSI
recorded uncertain revenue. The Complaint only
generally asserts that such transactions took place:
“[I]n order to report growth in revenue and earnings,
TCSI recognized millions of dollars in revenues
where payment was not assured due to acceptance
and other contingencies.” (Compl.¶
95.) The
Complaint does not specify the collection
arrangement with each client, any single transaction
involving TCSI's recognition of uncertain revenue,
dates on which these transactions occurred, or even
approximate amounts involved in each transaction.
See Zeid, 973 F.Supp. 922-23. Without more
particularity, the allegations of accounting fraud
based on unrecognized revenue must fail.
Similarly, the allegation that TCSI failed to record a
loss on the UPS contract in order to overstate
earnings in the fourth quarter of 1995 and first and
second quarters of 1996, lacks any apparent
foundation. Plaintiffs point to the eventual loss that
TCSI incurred after the termination of the contract
was disclosed. However, they fail to offer any
particular contemporaneous statement or transaction
that would demonstrate that any Defendant knew that
the UPS contract would result in a loss. A statement
attributed to Defendant Strauch is Plaintiffs' only
attempt to demonstrate Defendants' intelligence that
the UPS contract was losing money:
When we started deploying this system, the decisions
that we made a couple of years ago regarding
technology, we noticed that there needed to be some
significant rework in order to address the business
requirements of the customer and then we just looked
at that and said that rework no longer made sense,
especially in the context of the fact that it was neither
a core technology, nor a core industry for our
Company, and we agreed to mutually terminate that
agreement.
*12 (Compl.¶ 102.) Close examination of the quote
attributed to Strauch reveals that: (a) it was made
retrospectively, while reflecting on the history of the
TCSI/UPS relationship; and (b) the phrase
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emphasized by Plaintiffs (i.e. “rework no longer
made sense”) obviously referred to the ultimate
reason underlying termination of the contract in
October 1995, and not to his thoughts about the
contract prior to termination. Despite the quantity of
colorful charts which illustrate TCSI's reported
revenue and TCSI's “Reported vs. Estimated Actual
Net Income” (Compl.¶ ¶ 103-104), the Complaint
does not allege specific facts in support of its
allegation of accounting fraud with regard to the UPS
contract or to its allegation of improper revenue
recognition in the case of TCSI's other
telecommunications-related clients.
C. Statutory Safe-Harbor
Defendants argue that at least some of the statements
alleged by plaintiffs are protected by the Reform
Act's safe harbor provision. Specifically, Defendants
argue that the statements contained in TCSI's April
17, 1996 press release, July 18, 1996 press release,
and the prospectus filed by TCSI in March 1996 are
protected by the safe harbor because each is
accompanied by meaningful, cautionary language.
Under the Reform Act's safe harbor provision,
Defendants cannot be held liable for a forwardlooking statement if such statement is “accompanied
by meaningful cautionary statements identifying
important factors that could cause actual results to
differ materially from those in the forward-looking
statements.” 15 U.S.C. § 78u-5(c)(1)(A)(I). The safe
harbor provision of the Reform Act protects only
forward-looking statements, which the Act defines to
include “projection[s] of revenues ... plans and
objectives of management for future operations ...
statement[s] of future economic performance ... any
statement[s] of the assumptions underlying or
relating to any statement described above ... or any
report[s] issued by an outside reviewer retained by an
issuer, to the extent that the report assesses a
forward-looking statement made by the issuer.” 15
U.S.C. § 78u-5(c)(1) and (i)(1).
Defendants' contention that the Reform Act's safe
harbor protects statements contained in the March
1996 prospectus and the press releases of April 17
and July 18, 1996 is erroneous because Plaintiffs do
not allege any forward-looking statements in
connection with these documents. These three
documents are comprised exclusively of statements
relating to past and present performance, and are
devoid of any statements even remotely forwardlooking. (Compl.¶ ¶ 60, 65, 79.) Therefore, the
Page 10
statutory safe harbor is inapplicable.
Defendants make the blanket assertion that all
forward-looking statements in its post-Reform Act
press releases and SEC filings are protected by the
safe harbor because all such statements are
accompanied by meaningful, cautionary language.
(TCSI Mot. at 7.) However, only two such statements
are evident in the entire Complaint. The first is
contained in TCSI's January 22, 1996 press release,
and states, “By satisfying the needs of emerging
service
providers
and
multi-billion
dollar
organizations, we believe we can build a reputation in
the telecommunications industry that may lead to
expanded distribution channels and cross-industry
opportunities.” (Compl.¶ 51.) The second such
statement is contained in TCSI's July 17, 1996 press
release, and states, in regard to the hiring of four new
executives, “[W]e believe the addition of these four
seasoned professionals will better position us to take
advantage of our growing marketplace.” (Compl.¶
78.) These are both “soft” statements of corporate
optimism and, therefore, not actionable under the
federal securities laws. See Wenger, 2 F.Supp. at
1245-46 (“Vague statements of opinion are not
actionable under the federal securities laws because
they are considered immaterial and discounted as
mere ‘puffing’.”) (citing Raab, 4 F.3d at 288-90).
The statutory safe harbor is therefore not invoked by
these statements, thus Defendants' argument fails. 15
U.S.C. § 78u-5(c)(1) (the safe harbor applies only to
statements or omissions of material fact ).FN8
FN8. These two statements are, nonetheless,
insufficient to support a claim under the
federal securities laws because they are
“soft” statements of corporate optimism.
D. The “Bespeaks Caution” Doctrine
*13 Defendants also argue that the judicially created
“bespeaks caution” doctrine compels dismissal. The
“bespeaks caution” doctrine “provides a mechanism
by which a court can rule as a matter of law ... that
defendants'
forward-looking
representations
contained enough cautionary language or risk
disclosure to protect the defendant against claims of
securities fraud.” Worlds of Wonder Sec. Litig., 35
F.3d 1407, 1413 (9th Cir.1994) (quoting Donald C.
Langevoort, “Disclosures that ‘Bespeak Caution’,”
49 Bus.Law. 481, 482-83 (1994). “A motion to
dismiss for failure to state a claim will succeed only
when the documents containing the defendants'
challenged statements include ‘enough cautionary
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language or risk disclosure,’ that ‘reasonable minds'
could not disagree that the challenged statements
were not misleading.” Fecht v. Price Co., 70 F.3d
1078, 1082 (9th Cir.1995) (quoting Worlds of
Wonder, 35 F.3d at 1413). Further, cautionary
language should be “tailored” to the “specific future
projections” at issue in a specific case. J/H Real
Estate, Inc. v.. Abramson, 901 F.Supp. 952, 957
(E.D.Pa.1995) (quoting In re Trump Casino Sec.
Litig., 7 F.3d 357, 371-72 (3d Cir.1993).
Further, cautionary language spread out among
various documents is insufficient to protect
misleading oral statements under the “bespeaks
caution” doctrine. In re Silicon Graphics, Inc. Sec.
Litig., No. C 96-0393, 1996 WL 664639, at *14
(N.D.Cal. Sept. 25, 1996). Therefore, the Court
cannot conclude as a matter of law that the cautionary
language in TCSI's SEC filings warrants dismissal of
the Complaint pursuant to the “bespeaks caution”
doctrine.
Defendants refer to three categories of alleged
misrepresentations that it contends are protected
under this doctrine. These three categories include:
(1) statements that TCSI “misrepresented that a
Regional Bell Operating Company would sign a
licensing contract in the third quarter of 1996”; (2)
statements that TCSI “was otherwise well positioned
to compete”; and (3) statements that TCSI's
customers “would continue to fund its research and
development.” (TCSI Mot. at 10.) According to
defendants, these three categories of statements are
all protected under the “bespeaks caution” doctrine,
based on risk disclosures contained in TCSI's 1995
Form 10-K, TCSI's prospectus filed in March 1996,
and TCSI's quarterly filings on SEC Form 10-Q.FN9
FN9. Defendants' argument is difficult to
analyze due to the vagueness of the above
three categories of statements. Defendants
do not specify which statements are included
within each category. The above categories,
particularly the one referring to statements
that TCSI was “well positioned to compete,”
could conceivably refer to many of the
statements alleged in the Complaint. Rather
than citing to the allegedly misleading
statements in the Complaint, Defendants cite
to the alleged “true facts” embracing the
above categories of statements. (Id.) This
brief-writing strategy, like Plaintiffs'
“puzzle-style” pleading technique, renders
effective review a much more difficult task.
Furthermore, at least some of the warnings found in
TCSI's SEC filings do not directly address
defendants' alleged misrepresentations. For example,
Plaintiffs allege that Defendants made misleading
statements that TCSI “expected to close” and
“anticipat[ed]” closing a contract with a Regional
Bell Operating Company during the third quarter of
1996. (Compl.¶ 81, 85.) According to Defendants,
the following cautionary language contained in
TCSI's March 1996 prospectus should insulate
Defendants from liability for those statements, “[T]he
telecommunications industry ... has recently been
characterized by intense competition in the
development of new technology, equipment, and
customer services.” (Kendrick Decl., Ex. C at 7.)
This cautionary language, however, does not directly
address the specific problems that, according to
Plaintiffs, made it highly unlikely that a contract with
a Regional Bell Operating Company would be
obtained by TCSI during the third quarter of 1996.
FN10
The Court cannot conclude that reasonable minds
could not differ that the challenged statements, in
light of the cautionary language, were not misleading.
Eichen, 977 F.Supp. at 1044 (refusing to dismiss case
under the “bespeaks caution” doctrine where
cautionary language, found in documents other than
the document containing the allegedly misleading
statements, did not directly address the undisclosed
risks); see also Abramson, 901 F.Supp. at 957
(cautionary language should be tailored to the
specific forward-looking statements). The “bespeaks
caution” doctrine does not warrant dismissal of this
Complaint.FN11
All of the forward-looking statements potentially
covered by Defendants' three categories above are
either (a) oral statements, or (b) contained in
documents other than TCSI's SEC filings. Courts are
generally reluctant to hold that a forward-looking
statement is protected by cautionary language
contained in documents other than that which
contains the forward-looking statement. See Powers
v.
Eichen,
977
F.Supp.
1031,
1043-44
(S.D.Cal.1997); Abramson, 901 F.Supp. at 957.
FN10. Plaintiffs allege that it was very
unlikely that TCSI would obtain such a
contract during the third quarter of 1996
because the Regional Bell Operating
Company had not committed to place an
order during that time period and had
indicated that it was not likely to place an
order before 1997 at the earliest. (Compl.¶ ¶
14(g), 84(g), 87(e).)
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FN11. Defendant Harvey E. Wagner also
argues that certain statements are protected
by the “bespeaks caution” doctrine. Mr.
Wagner asserts that, because certain
forward-looking
statements
contain
qualifying words such as “we expect” or
“we believe,” they are therefore protected
under the “bespeaks caution” doctrine.
(Wagner Mot. at 11-12.) Mr. Wagner
misapprehends this doctrine. As already
discussed, the “bespeaks caution” doctrine
only applies where cautionary statements
include sufficient risk disclosure so that
“reasonable minds could not disagree that
the challenged statements were not
misleading.” Fecht, 70 F.3d at 1082.
Further, the cautionary language should
directly address the alleged risks. Eichen,
977 F.Supp. at 1044. Merely prefacing a
forward-looking statement with a clause
such as “we expect” or “we believe” does
not constitute sufficient risk disclosure to
warrant dismissal.
E. Allegations of Scienter
*14 The Reform Act requires that Plaintiffs state with
particularity, for each allegedly misleading statement,
“facts giving rise to a strong inference that the
defendant acted with the required state of mind.” 15
U.S.C. § 78u-4(b)(2). This scienter requirement is
satisfied if Plaintiffs allege either: (1) specific facts
demonstrating that the defendant had a motive and an
opportunity to commit fraud; or (2) specific facts
constituting circumstantial evidence of conscious
behavior or recklessness if the statement is not
forward looking. These allegations cannot be
conclusory in nature. Rather, they must constitute a
substantial factual basis to support a “strong
inference” that the defendant acted with the requisite
state of mind. See Zeid, 973 F.Supp. at 915-918; Oak,
1997 WL 448168, at *3; In re Time Warner, Inc. Sec.
Litig ., 9 F.3d 259, 269 (2d Cir.1993).FN12
FN12. Prior to the Reform Act, the Ninth
Circuit allowed plaintiffs to aver scienter
generally. In re Glen Fed, 42 F.3d at 154547. The Reform Act's “strong inference”
language has significantly heightened the
Ninth Circuit standard and was modeled
upon, but did not codify, the Second
Circuit's pleading standard. H.R. Conf. Rep.
No. 369, 104th Cong., 1st Sess. 41 (1995).
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This is further confused by an ambiguous
legislative history. See Zeid, 973 F.Supp. at
916.
Not
surprisingly,
inconsistent
interpretations of the Reform Act's language
have emerged.
In In re Silicon Graphics, Inc. Sec. Litig.,
1996 WL 664639 (N.D.Cal.1996), the court
construed the Reform Act to remove
recklessness and the “motive and
opportunity” test as bases for liability. The
court concluded that, for each allegedly
misleading statement, a plaintiff must allege
specific facts that constitute circumstantial
evidence of conscious behavior. 1996 WL
664639 at *6.
In contrast, the court in Marksman Partners,
L.P. v. Chantal Pharmaceutical, 927
F.Supp. 1297, 1310 (C.D.Cal.1996),
retained the Second Circuit's two prong
inquiry, thus allowing allegations of either
“motive and opportunity” or “conscious
behavior or recklessness.”
A third interpretation was advanced in Zeid,
973 F.Supp. at 917-918. The court
determined that, where the allegedly
misleading statement is non-forward
looking, a plaintiff must allege specific facts
demonstrating
either
“motive
and
opportunity” or circumstantial evidence of
conscious behavior or recklessness. Id. at
918. Where the allegedly misleading
statement is forward looking, a plaintiff
must plead specific facts showing either
“motive and opportunity” or circumstantial
evidence of conscious behavior. Id.
1. Motive and Opportunity
Motive entails concrete benefits that could be
realized by one or more of the false statements and
wrongful nondisclosures alleged. Shields v. Citytrust
Bancorp, Inc., 25 F.3d 1124, 1129-30 (2d Cir.1994).
Opportunity entails the means and likely prospect of
achieving concrete benefits by the means alleged. Id.
Plaintiffs allege that all the Defendants were
motivated to artificially inflate TCSI's stock price by
disseminating false information to the market in order
to sell their stock for substantial gains. (Compl.¶ ¶
15-16, 29, 106-107.) Plaintiffs also allege that TCSI's
executive compensation program, which awarded
bonuses to insiders based on Company performance,
provided additional incentive to falsify its reported
profits. (Compl. ¶ 30 .)
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In evaluating a Defendant's stock sales as it relates to
scienter, the Reform Act requires the Court to
consider each Defendant's sales separately. See In re
Silicon Graphics, Inc. Sec. Litig., 970 F.Supp 746,
767 (N.D.Cal.1996) ( “Silicon II ”); 15 U.S.C. § 78u4(b)(2). Further, if stock sales are alleged to be
evidence of scienter, the court must consider all of
Defendants' holdings, including vested options.
Silicon II, 970 F.Supp. at 768 (emphasis added). A
Defendant's stock trading will not support a strong
inference of fraud unless the sales are unusual or
suspicious. See Acito v. Imcera Group, Inc., 47 F.3d
47, 54 (2d Cir.1995).FN13
FN13. Prior to the Reform Act, Ninth
Circuit courts did not typically consider the
amount and timing of stock sales on a
motion to dismiss, see, e.g., In re Worlds of
Wonder Sec. Litig, 886 F.3d 1407, 1427 (9th
Cir.1994). However, under the strong
inference standard, Second Circuit courts do
consider this information. See, e.g., Acito, 47
F.3d at 54.
Plaintiffs concede that the Complaint does not
include each Defendant's exercisable vested stock
options. Indeed, their counter-motion seeks to strike
the very proxy statements which contain the relevant
information concerning the Defendants' vested
options (Kendrick Decl. Ex.'s K and L.) Without this
information, the Court cannot properly evaluate
whether Defendants' stock sales were unusual or
suspicious in nature.FN14 Plaintiffs are ordered to
include the vested options held by each Defendant in
pleading the sum total of total stock owned by each
Defendant when the Complaint is amended.FN15
FN14. Plaintiffs offer no legal authority that
would call into question the Silicon
Graphics holding that vested options must
be considered as part of a defendant's stock
holdings.
FN15. In considering the motion to dismiss,
the Defendants have requested the Court to
take judicial notice of the 1996 and 1997
TCSI proxy statements-which are also
required to be filed with the SEC. Plaintiffs
filed a separate, nine-page “Objection to
Consideration of Defendant's 1996 and 1997
Proxy Statements and Counter-Motion to
Strike Exhibits K and L to the Declaration of
Christine Kendrick.”
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Page 13
Case law supports the consideration of the
proxy statements by means of judicial notice
because: (a) they were the only means of
obtaining the individual Defendants' TCSI
stock holdings other than vested optionseven though they were never explicitly
referenced as the source; and, (b) they are
public records whose accuracy cannot be
questioned. See In re Verifone Sec. Litig., 11
F.3d 865, 868 n.2 (9th Cir.1993); Kramer v.
Time Warner, Inc., 937 F.2d 767, 774 (2d
Cir.1991).
*15 Plaintiffs also allege that the TCSI executive
compensation plan, tying salary awards to individual
and Company performance goals, provided motive to
falsify reported profits. (Compl.¶ ¶ 30.) Standing
alone, the existence of executive compensation
dependent upon the attainment of performance goals
is not a sufficient motive for fraud. Acito, 47 F.3d at
54; Salinger v. Protectavision, 972 F.Supp 222, 234
(S.D.N.Y.1997). When combined with unusual or
suspicious stock sales, the “strong inference”
standard may be met. However, until the information
required to determine if, indeed, the Defendants'
stock sales were suspicious or unusual is plead, this
allegation alone will not suffice to satisfy the strong
inference standard.
2. Conscious Misconduct or Recklessness
Plaintiffs may, in the alternative to pleading motive
and opportunity to commit fraud, allege specific facts
constituting circumstantial evidence of conscious
behavior or facts showing recklessness for statements
that are not forward-looking. If this method is used,
the strength of the circumstantial allegations must be
correspondingly greater. Zeid, 973 F.Supp. at 924
(quoting Beck v. Manufacturer's Hanover Trust, 820
F.2d 46, 50 (2d Cir.1987), cert. denied, 484 U.S.
1005 (1988)).
The Complaint's allegations of knowledge or
recklessness by the individual Defendants are
conclusory. Plaintiffs, in Complaint ¶ 22(a)-(i),
allege that each individual Defendant:
[K]new the adverse non-public information about
TCSI's business prospects via access to internal
corporate documents (including the Company's
operating plans, budgets and forecasts and reports of
actual operations compared thereto), conversations
and connections with other corporate officers and
employees, attendance at Board of Directors'
meetings and committees thereof and via reports and
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Not Reported in F.Supp.2d
Not Reported in F.Supp.2d, 1999 WL 33295869 (N.D.Cal.)
(Cite as: Not Reported in F.Supp.2d)
other information provided to him in connection
therewith.
These general allegations could be alleged against
any corporate executive. Without referencing any
specific documents drafted by or available to any
particular Defendant, or any particular conversations
with other Company employees which would
demonstrate the falsity or misleading nature of the
statements when made, there can be no sustainable
allegation of recklessness or conscious behavior. See
Silicon II, 970 F.Supp. at 767 (If plaintiffs are to
create a strong inference of scienter, their allegations
of “negative internal reports” should “include the
titles of the reports, when they were prepared, who
prepared them, to whom they were directed, their
content, and the sources from which plaintiffs
obtained this information.”) Until the Complaint is
amended to include the specific documents and
conversations that Plaintiffs' “investigation of
counsel” has uncovered, the Court does not find that
sufficient circumstantial evidence has been plead to
uphold the Complaint's conclusory allegations of
recklessness or conscious behavior.
F. Liability of Defendants Who Are Not Alleged To
Have Made Any Statement
*16 Defendants Rao, Miller, Bolger, Banin, Hasler,
and Messerschmitt argue that none of the statements
alleged in the Complaint are attributed to them and,
therefore, they cannot be held liable. They base their
argument on the proposition that the Reform Act
abolishes group pleading and because the holding in
Central Bank of Denver v.. First Interstate Bank, 511
U.S. 164 (1994), eliminated “aiding and abetting”
liability for Section 10(b) claims. However, the Ninth
Circuit recognizes the “group published information”
doctrine. Wool v. Tandem Computers, Inc., 818 F.2d
1433, 1440 (9th Cir.1987). Pursuant to this doctrine,
a plaintiff can plead fraud by officers based on
statements in “group published information,” which
has been defined to include prospectuses, registration
statements, annual reports, press releases, and 10-Q
filings. Id. This doctrine, however, has several
limitations that preclude its availability to Plaintiffs
in regard to the allegations against the above named
Defendants. First, the doctrine does not apply to
analyst' reports or oral remarks made by others.
Strassman v. Fresh Choice, Inc., 1995 WL 743728
(N.D.Cal.1995); see also In re Network Equipment
Technologies, Inc., Litig., 762 F.Supp. 1359, 1367
(N.D.Cal.1991). Second, the allegations must still
satisfy the particularity requirements of Rule 9(b) and
Page 14
the Reform Act. In re Oak Technology Sec. Litig.,
1997 WL 448168 *10 (N.D.Cal.1997). In the case of
outside directors, this requires a showing that the
Defendant “either participated in the day-to-day
corporate activities, or had a special relationship with
the corporation, such as participation in preparing or
communicating group information at particular
times.” Id. (quoting In re GlenFed, Inc., 60 F.3d 591,
593 (9th Cir.1995) (“GlenFed II ”)). For corporate
insiders, a plaintiff must plead that the Defendants
were involved in the preparation of the allegedly
misleading statements. Id.
In the instant case, Plaintiffs plead merely that the
Defendants were privy to adverse, non-public
information based on their positions. (Compl.¶ 22.)
This is insufficient to invoke the “group published
information” doctrine. Id. Plaintiffs do not plead any
facts showing that the outside directors were
participants in the day-to-day corporate activities of
TCSI, or that the inside directors were directly
involved in the preparation of the allegedly
misleading statements. Therefore, the group pleading
doctrine cannot be invoked by Plaintiffs. The
Complaint is dismissed as against Defendants Rao,
Miller, Bolger, Banin, Hasler, and Messerschmitt on
this basis as well as the other bases discussed
previously.
G. Rule 20(a) Claims Against Individual Defendants
Rule 20(a) of the 1934 Act provides for controlling
person liability:
Every person who, directly or indirectly, controls any
person liable under any provision of this title or of
any rule or regulation thereunder shall also be liable
jointly and severally with and to the same extent as
such controlled person to any person to whom such
controlled person is liable, unless the controlling
person acted in good faith and did not directly or
indirectly induce the act or acts constituting the
violation or cause of action.
*17 15 U.S.C. § 78t(a). To establish control person
liability, a plaintiff must show that a primary
violation, here, a Section 10(b) violation, was
committed and that the Defendant “directly or
indirectly” controlled the violator. See Oak, 1997 WL
448168 at 14. Because Plaintiffs have not pled
sufficient facts to show a Section 10(b) violation, the
claim under Rule 20(a) is dismissed.
V. CONCLUSION
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Not Reported in F.Supp.2d
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(Cite as: Not Reported in F.Supp.2d)
The Complaint is dismissed for failure to state a
claim upon which relief can be granted. Plaintiffs
have failed to format their Complaint in compliance
with the Federal Rules of Civil Procedure and the
Reform Act. Plaintiffs have failed to adequately
allege the content of many alleged misstatements.
They have failed to demonstrate why any alleged
statement was false. They have failed to allege
contemporaneous facts showing that any of the
alleged statements were false when made. And, they
have failed to allege sufficient facts showing that any
Defendant acted with scienter.
The Court grants Plaintiffs leave to amend. The
amended Complaint shall comply with Rule 8 of the
Federal Rules of Civil Procedure as well as the
following directives:
(1) The amended Complaint should not contain
alleged misstatements which are inactionable on their
face, i.e., accurate statements of historic fact, vague
and general statements of optimism, publicly known
facts, or any vague or impressionistic paraphrasing of
Defendants' actual oral statements; and,
(2) The amended Complaint should set forth each
allegedly false or misleading statement, and follow
each statement with the specific reason or reasons
why the statement was false when made.
Page 15
mentioned, a citizen of the United States and a
resident of the County of San Francisco, over the age
of 18 years, and not a party to or interested in the
within action; that declarant's business address is 222
Kearny Street, 10th Floor, San Francisco, California
94108.
2. That on January 21, 1999, declarant served the
NOTICE OF ENTRY OF ORDER GRANTING
DEFENDANTS' MOTIONS TO DISMISS by
depositing a true copy thereof in a United States
mailbox at San Francisco, California in a sealed
envelope with postage thereon fully prepaid and
addressed to the parties listed on the attached Service
List.
3. That there is a regular communication by mail
between the place of mailing and the places so
addressed.
I declare under penalty of perjury that the foregoing
is true and correct. Executed this 21st day of January,
1999, at San Francisco, California.
N.D.Cal.,1999.
Copperstone v. TCSI Corp.
Not Reported in F.Supp.2d, 1999 WL 33295869
(N.D.Cal.)
Briefs and Other Related Documents (Back to top)
• 4:97cv03495 (Docket) (Sep. 24, 1997)
VI. ORDER
END OF DOCUMENT
For the foregoing reasons,
IT IS HEREBY ORDERED THAT Defendants'
motions to dismiss are GRANTED with leave to
amend no later than three weeks after the filing of
this order.
IT IS FURTHER ORDERED THAT Plaintiffs'
counter-motion to strike TCSI's 1996 and 1997 proxy
statements is DENIED as moot pursuant to the
Court's directive to include each Defendant's vested
stock options in any amended Complaint.
IT IS SO ORDERED.
DECLARATION OF SERVICE BY MAIL
I, the undersigned, declare:
1. That declarant is and was, at all times herein
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Briefs and Other Related Documents
In re Dura Pharmaceuticals, Inc. Securities
LitigationS.D.Cal.,2006.
United States District Court,S.D. California.
In re DURA PHARMACEUTICALS, INC.
SECURITIES LITIGATION,
This Document Relates to: All Actions
No. 99CV0151-L(NLS).
Page 1
(4) shareholders failed to adequately allege scienter
sufficient to impute liability for officers' alleged
involvement in scheme to overload wholesalers with
corporation's pharmaceutical drug;
(5) defendants were not indirectly liable for securities
fraud based on analysts' reports; and
(6) officers and director were not liable as controlling
persons.
June 2, 2006.
Background: Shareholders brought securities fraud
class action against pharmaceutical drug corporation,
several of its officers, and a director, alleging that
defendants' false statements regarding expected
future Food and Drug Administration (FDA)
approval of a new asthmatic spray device artificially
inflated price of stock, and that defendants
misrepresented and omitted critical information
regarding corporation's sales. The District Court,
2000 WL 33176043,Lorenz, J., dismissed without
prejudice, and following filing of amended complaint
dismissed with prejudice. Purchaser appealed. The
Court of Appeals, 339 F.3d 933, reversed and
remanded. After granting certiorari, the Supreme
Court, Justice Breyer, 544 U.S. 336, 125 S.Ct. 1627,
reversed and remanded. On remand, defendants
moved to dismiss.
Motion granted in part and denied in part.
[1] Securities Regulation 349B
60.18
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.17 Manipulative, Deceptive or
Fraudulent Conduct
349Bk60.18 k. In General. Most
Cited Cases
The elements of a securities fraud claim are: (1) a
misrepresentation or omission of a material fact; (2)
scienter; (3) causation; (4) reliance; and (5) damages.
Securities Exchange Act of 1934, § 10b, 15 U.S.C.A.
§ 78j(b); 17 C.F.R. § 240.10b-5.
Holdings: The District Court, Stormes, J., held that:
[2] Federal Civil Procedure 170A
(1)
allegations
that
defendants
made
misrepresentations and omissions regarding expected
future Food and Drug Administration (FDA)
approval of corporation's new asthmatic spray device
adequately pled loss causation, as required under the
Private Securities Litigation Reform Act (PSLRA);
but
170A Federal Civil Procedure
170AVII Pleadings and Motions
170AVII(A) Pleadings in General
170Ak633 Certainty, Definiteness
Particularity
170Ak636 k. Fraud, Mistake
Condition of Mind. Most Cited Cases
(2) shareholders failed to describe sources of their
information regarding alleged misrepresentations and
omissions, as required to adequately allege falsity
and scienter;
Securities Regulation 349B
(3) allegations that defendants misrepresented and
omitted critical information regarding corporation's
sales, in order to increase corporation's stock price,
adequately pled falsity and scienter; but
636
and
and
60.51
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.51 k. In General. Most
Cited Cases
Securities fraud claims must meet requirement of rule
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providing that in “all averments of fraud or mistake,
the circumstances constituting fraud or mistake shall
be stated with particularity,” and, in addition,
requirement under the Private Securities Litigation
Reform Act (PSLRA) that complaint “plead with
particularity both falsity and scienter.” Securities
Exchange Act of 1934, § § 10(b), 21D(b)(2), 15
U.S.C.A. § § 78j(b), 78u-4(b)(2); 17 C.F.R. §
240.10b-5; Fed.Rules Civ.Proc.Rule 9(b), 28
U.S.C.A.
Securities fraud claims must meet requirement of rule
providing that in “all averments of fraud or mistake,
the circumstances constituting fraud or mistake shall
be stated with particularity,” and, in addition,
requirement under the Private Securities Litigation
Reform Act (PSLRA) that complaint “plead with
particularity both falsity and scienter.” Securities
Exchange Act of 1934, § § 10(b), 21D(b)(2), 15
U.S.C.A. § § 78j(b), 78u-4(b)(2); 17 C.F.R. §
240.10b-5; Fed.Rules Civ.Proc.Rule 9(b), 28
U.S.C.A.
[3] Securities Regulation 349B
60.53
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.53 k. Misrepresentation.
Most Cited Cases
Securities Regulation 349B
60.54
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.54 k. Nondisclosure. Most
Cited Cases
When the plaintiff in a securities fraud case alleges
the defendant either made an untrue statement of
material fact, or omitted to state a material fact
necessary to make statements made not misleading,
the Private Securities Litigation Reform Act
(PSLRA) requires the complaint to 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 that belief is
formed. Securities Exchange Act of 1934, § § 10(b),
Page 2
21D(b)(2), 15 U.S.C.A. § § 78j(b), 78u-4(b)(2); 17
C.F.R. § 240.10b-5.
[4] Securities Regulation 349B
60.51
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.51 k. In General. Most
Cited Cases
Regarding scienter, the Private Securities Litigation
Reform Act (PSLRA) requires the complaint in a
securities fraud case to state with particularity facts
giving rise to a strong inference that the defendant
acted with the required state of mind. Securities
Exchange Act of 1934, § § 10(b), 21D(b)(2), 15
U.S.C.A. § § 78j(b), 78u-4(b)(2); 17 C.F.R. §
240.10b-5.
[5] Securities Regulation 349B
60.45(1)
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.43 Grounds of and Defenses to
Liability
349Bk60.45
Scienter,
Intent,
Knowledge, Negligence or Recklessness
349Bk60.45(1) k. In General.
Most Cited Cases
“Scienter,” as required under the Private Securities
Litigation Reform Act (PSLRA) to state a cause of
action for securities fraud, is defined as a mental state
embracing intent to deceive, manipulate, or defraud.
Securities Exchange Act of 1934, § § 10(b),
21D(b)(2), 15 U.S.C.A. § § 78j(b), 78u-4(b)(2); 17
C.F.R. § 240.10b-5.
[6] Securities Regulation 349B
60.53
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.53 k. Misrepresentation.
Most Cited Cases
Under the Private Securities Litigation Reform Act
(PSLRA), when evaluating whether a private
securities fraud complaint survives a motion to
dismiss, the court must determine whether particular
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facts in the complaint, taken as a whole, raise a
strong inference that defendants intentionally or with
deliberate recklessness made false or misleading
statements to investors. Securities Exchange Act of
1934, § § 10(b), 21D(b)(2), 15 U.S.C.A. § § 78j(b),
78u-4(b)(2); 17 C.F.R. § 240.10b-5.
[7] Securities Regulation 349B
60.51
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.51 k. In General. Most
Cited Cases
In a securities fraud case, the requirement to plead all
the facts with particularity, pursuant to the Private
Securities Litigation Reform Act (PSLRA), means
that a plaintiff must provide a list of all relevant
circumstances in great detail. Securities Exchange
Act of 1934, § § 10(b), 21D(b)(2), 15 U.S.C.A. § §
78j(b), 78u-4(b)(2); 17 C.F.R. § 240.10b-5.
[8] Securities Regulation 349B
60.53
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.53 k. Misrepresentation.
Most Cited Cases
To meet Private Securities Litigation Reform Act's
(PSLRA's) pleading requirements in a securities
fraud case, the complaint must contain allegations of
specific contemporaneous statements or conditions
that demonstrate the intentional or the deliberately
reckless false or misleading nature of the statements
when made. Securities Exchange Act of 1934, § §
10(b), 21D(b)(2), 15 U.S.C.A. § § 78j(b), 78u4(b)(2); 17 C.F.R. § 240.10b-5.
[9] Securities Regulation 349B
60.51
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.51 k. In General. Most
Cited Cases
In determining whether plaintiffs in securities fraud
cases have adequately pled scienter, pursuant to the
Page 3
Private Securities Litigation Reform Act (PSLRA),
courts must consider whether the total of plaintiffs'
allegations, even though individually lacking, are
sufficient to create a strong inference that defendants
acted with deliberate or conscious recklessness; when
conducting this analysis, the court must consider all
reasonable inferences, whether or not favorable to the
plaintiffs. Securities Exchange Act of 1934, § §
10(b), 21D(b)(2), 15 U.S.C.A. § § 78j(b), 78u4(b)(2); 17 C.F.R. § 240.10b-5.
[10] Securities Regulation 349B
60.53
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.53 k. Misrepresentation.
Most Cited Cases
When pleadings in securities fraud cases are not
sufficiently particularized, as required by the Private
Securities Litigation Reform Act (PSLRA), or when,
taken as a whole, they do not raise a strong inference
that misleading statements were knowingly or with
deliberate recklessness made to investors, a private
securities fraud complaint is properly dismissed for
failure to state a claim upon which relief may be
granted. Securities Exchange Act of 1934, § § 10(b),
21D(b)(2), 15 U.S.C.A. § § 78j(b), 78u-4(b)(2); 17
C.F.R. §
240.10b-5; Fed.Rules Civ.Proc.Rule
12(b)(6), 28 U.S.C.A.
[11] Securities Regulation 349B
60.53
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.53 k. Misrepresentation.
Most Cited Cases
Allegations that corporation's officers and directors
made misrepresentations and omissions, regarding
expected future Food and Drug Administration
(FDA) approval of corporation's new asthmatic spray
device, which resulted in decline in stock price and
proximately caused shareholders' losses adequately
pled loss causation, as required under the Private
Securities Litigation Reform Act (PSLRA) to state a
securities fraud claim. Securities Exchange Act of
1934, § § 10(b), 21(b)(4), 15 U.S.C.A. § § 78j(b),
78u-4(b)(4); 17 C.F.R. § 240.10b-5.
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[12] Securities Regulation 349B
60.47
[15] Securities Regulation 349B
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.43 Grounds of and Defenses to
Liability
349Bk60.47 k. Causation; Existence
of Injury. Most Cited Cases
One of the elements of a securities fraud cause of
action that a plaintiff must plead and prove is loss
causation. Securities Exchange Act of 1934, § §
10(b), 21D(b)(4), 15 U.S.C.A. § § 78j(b), 78u4(b)(4); 17 C.F.R. § 240.10b-5.
[13] Securities Regulation 349B
60.53
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.53 k. Misrepresentation.
Most Cited Cases
Shareholders failed to describe sources of their
information supporting allegations regarding ongoing problems with development of corporation's
new asthmatic spray device, and knowledge of those
problems on part of corporation's officers and
directors, as required under the Private Securities
Litigation Reform Act (PSLRA) to adequately allege
falsity and scienter, for purposes of securities fraud
claim. Securities Exchange Act of 1934, § § 10(b),
21D(b)(2), 15 U.S.C.A. § § 78j(b), 78u-4(b)(2); 17
C.F.R. § 240.10b-5.
[14] Securities Regulation 349B
Page 4
60.51
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.51 k. In General. Most
Cited Cases
Under the Private Securities Litigation Reform Act
(PSLRA), a securities fraud complaint based on
information and belief has to state with particularity
all facts on which a belief is formed, and in so doing,
the plaintiff must reveal the sources of her
information. Securities Exchange Act of 1934, § §
10(b), 21D(b)(2), 15 U.S.C.A. § § 78j(b), 78u4(b)(2); 17 C.F.R. § 240.10b-5.
60.51
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.51 k. In General. Most
Cited Cases
Under the Private Securities Litigation Reform Act
(PSLRA), when internal reports are the source of a
securities fraud plaintiff's information, the plaintiff
must allege specifics regarding those reports,
including the sources of the plaintiff's information
with respect to the reports, how the plaintiff learned
of the reports, who drafted the reports, which officers
received them, and the contents of those reports.
Securities Exchange Act of 1934, § § 10(b),
21D(b)(2), 15 U.S.C.A. § § 78j(b), 78u-4(b)(2); 17
C.F.R. § 240.10b-5.
[16] Securities Regulation 349B
60.51
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.51 k. In General. Most
Cited Cases
Under the Private Securities Litigation Reform Act
(PSLRA), if the plaintiff in a securities fraud case
relies on the accounts of confidential witnesses to
establish a strong inference of scienter, the complaint
must describe such personal sources with sufficient
particularity to support the probability that a person
in the position occupied by the source would possess
the information alleged. Securities Exchange Act of
1934, § 10b, 15 U.S.C.A. § 78j(b); 17 C.F.R. §
240.10b-5.
[17] Securities Regulation 349B
60.51
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.51 k. In General. Most
Cited Cases
In a securities fraud case in which the plaintiff relies
on the accounts of confidential witnesses to establish
a strong inference of scienter, as required under the
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Private Securities Litigation Reform Act (PSLRA),
an assessment of the reliability of witnesses involves
an evaluation, inter alia, of the level of detail
provided by the confidential sources, the
corroborative nature of the other facts alleged,
including from other sources, the coherence and
plausibility of the allegations, the number of sources,
the reliability of the sources, and similar indicia.
Securities Exchange Act of 1934, § § 10(b),
21D(b)(2), 15 U.S.C.A. § § 78j(b), 78u-4(b)(2); 17
C.F.R. § 240.10b-5.
[18] Securities Regulation 349B
60.53
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.53 k. Misrepresentation.
Most Cited Cases
Securities Regulation 349B
60.54
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.54 k. Nondisclosure. Most
Cited Cases
Allegations that corporation's officers and directors
misrepresented in corporation's statements and
omitted critical information regarding corporation's
sales of pharmaceutical drug, in order to increase
corporation's stock price, adequately pled falsity and
scienter, as required under the Private Securities
Litigation Reform Act (PSLRA) to state a cause of
action for securities fraud, although allegations did
not adequately describe how confidential witness, a
former sales director for corporation, would have
learned information relied on by shareholders, where
complaint provided sufficient information regarding
corporation's former national accounts manager to
support probability that manager would possess
information alleged. Securities Exchange Act of
1934, § § 10(b), 21D(b)(2), 15 U.S.C.A. § § 78j(b),
78u-4(b)(2); 17 C.F.R. § 240.10b-5.
[19] Securities Regulation 349B
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
60.51
Page 5
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.51 k. In General. Most
Cited Cases
In securities fraud cases, the group pleading doctrine,
which allows a presumption that false and misleading
information disseminated through documents were
made by the collective action of the corporation's
officers, did not survive the Private Securities
Litigation Reform Act (PSLRA). Securities
Exchange Act of 1934, § § 10(b), 21D(b)(2), 15
U.S.C.A. § § 78j(b), 78u-4(b)(2); 17 C.F.R. §
240.10b-5.
[20] Securities Regulation 349B
60.51
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.51 k. In General. Most
Cited Cases
Under the Private Securities Litigation Reform Act
(PSLRA), stock sales by corporation's officers were
not sufficient basis upon which to impute liability for
officers' alleged involvement in scheme to overload
wholesalers with corporation's pharmaceutical drug,
as would support shareholders' securities fraud claim
against officers, where shareholders did not allege
that such sales were dramatically out of line with
their prior trading practices, or that those sales were
done at a time maximize profits. Securities Exchange
Act of 1934, § § 10(b), 21D(b)(2), 15 U.S.C.A. § §
78j(b), 78u-4(b)(2); 17 C.F.R. § 240.10b-5.
[21] Securities Regulation 349B
60.45(1)
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.43 Grounds of and Defenses to
Liability
349Bk60.45
Scienter,
Intent,
Knowledge, Negligence or Recklessness
349Bk60.45(1) k. In General.
Most Cited Cases
Unusual or suspicious stock sales can serve as
circumstantial evidence of scienter, as required under
the Private Securities Litigation Reform Act
(PSLRA) to state a securities fraud claim, but not
every sale of stock by a corporate insider shows that
the share price is about to decline. Securities
© 2006 Thomson/West. No Claim to Orig. U.S. Govt. Works.
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Exchange Act of 1934, § § 10(b), 21D(b)(2), 15
U.S.C.A. § § 78j(b), 78u-4(b)(2); 17 C.F.R. §
240.10b-5.
[22] Securities Regulation 349B
60.54
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.54 k. Nondisclosure. Most
Cited Cases
In a securities fraud case, to explain why stock sales
were unusual or suspicious, for purposes of
adequately pleading scienter under the Private
Securities Litigation Reform Act (PSLRA), the
plaintiffs must show the trading was in amounts
dramatically out of line with prior trading practices,
at times calculated to maximize the personal benefit
from undisclosed inside information. Securities
Exchange Act of 1934, § § 10(b), 21D(b)(2), 15
U.S.C.A. § § 78j(b), 78u-4(b)(2); 17 C.F.R. §
240.10b-5.
[23] Securities Regulation 349B
60.51
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.51 k. In General. Most
Cited Cases
Allegations that corporation's officers and directors
had motive and opportunity to inflate information
regarding corporation's sales was insufficient to
adequately plead scienter, as required under the
Private Securities Litigation Reform Act (PSLRA) to
state claim for securities fraud, absent any allegations
inculpating officers and directors in alleged “fire
sale” and “load-in” scheme. Securities Exchange Act
of 1934, § § 10(b), 21D(b)(2), 15 U.S.C.A. § §
78j(b), 78u-4(b)(2); 17 C.F.R. § 240.10b-5.
[24] Securities Regulation 349B
60.53
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.53 k. Misrepresentation.
Most Cited Cases
Page 6
Allegations that corporation's officers and directors
were aware of adverse non-public information
through their positions was insufficient to adequately
plead scienter, as required under the Private
Securities Litigation Reform Act (PSLRA) to state
claim for securities fraud based on officers and
directors' alleged involvement in scheme to overload
wholesalers with corporation's pharmaceutical drug.
Securities Exchange Act of 1934, § § 10(b),
21D(b)(2), 15 U.S.C.A. § § 78j(b), 78u-4(b)(2); 17
C.F.R. § 240.10b-5.
[25] Securities Regulation 349B
60.51
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.51 k. In General. Most
Cited Cases
When reviewing whether a complaint properly states
a securities fraud claim under the Private Securities
Litigation Reform Act (PSLRA), the court must
consider whether the total of plaintiffs' allegations,
even though individually lacking, are sufficient to
create a strong inference that defendants acted with
deliberate or conscious recklessness. Securities
Exchange Act of 1934, § § 10(b), 21D(b)(2), 15
U.S.C.A. § § 78j(b), 78u-4(b)(2); 17 C.F.R. §
240.10b-5.
[26] Securities Regulation 349B
60.51
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.50 Pleading
349Bk60.51 k. In General. Most
Cited Cases
When considering whether a strong inference of
scienter has been pled in securities fraud action
subject to heightened pleading requirements of
Private Securities Litigation Reform Act (PSLRA),
the court must consider all reasonable inferences to
be drawn from the allegations, including inferences
unfavorable to the plaintiffs. Securities Exchange Act
of 1934, § § 10(b), 21D(b)(2), 15 U.S.C.A. § §
78j(b), 78u-4(b)(2); 17 C.F.R. § 240.10b-5.
[27] Securities Regulation 349B
349B Securities Regulation
© 2006 Thomson/West. No Claim to Orig. U.S. Govt. Works.
60.27(4)
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349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.17 Manipulative, Deceptive or
Fraudulent Conduct
349Bk60.27 Misrepresentation
349Bk60.27(4) k. Facts or
Opinions. Most Cited Cases
Statements by corporation's officers and director, that
sales of corporation's pharmaceutical drug were
“strong,” that corporation was “pleased” with its
performance and financial results, and that drug was
“well received” by physicians, were not insulated by
“mere puffery” rule, for purposes of shareholders'
securities fraud claim, alleging that officers and
director artificially inflated corporation's sales to
increase its stock price, where facts alleged led to
strong inference that there was no reasonable basis
for believing such statements to be true, given that
sales were achieved by overloading wholesalers with
the drug. Securities Exchange Act of 1934, § 10b, 15
U.S.C.A. § 78j(b); 17 C.F.R. § 240.10b-5.
[28] Securities Regulation 349B
60.27(5)
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.17 Manipulative, Deceptive or
Fraudulent Conduct
349Bk60.27 Misrepresentation
349Bk60.27(5)
k.
Forecasts,
Estimates, Predictions or Projections. Most Cited
Cases
The “mere puffery” rule precludes liability in a
securities fraud case for vague, generalized, and
unspecific assertions of corporate optimism.
Securities Exchange Act of 1934, § 10b, 15 U.S.C.A.
§ 78j(b); 17 C.F.R. § 240.10b-5.
[29] Securities Regulation 349B
60.27(4)
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.17 Manipulative, Deceptive or
Fraudulent Conduct
349Bk60.27 Misrepresentation
349Bk60.27(4) k. Facts or
Opinions. Most Cited Cases
For purposes of a securities fraud case, statements
that fall within the “mere puffery” rule tend to use
Page 7
terms that are not measurable and not tethered to
facts that a reasonable person would deem important
to a securities investment decision. Securities
Exchange Act of 1934, § 10b, 15 U.S.C.A. § 78j(b);
17 C.F.R. § 240.10b-5.
[30] Securities Regulation 349B
60.27(5)
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.17 Manipulative, Deceptive or
Fraudulent Conduct
349Bk60.27 Misrepresentation
349Bk60.27(5)
k.
Forecasts,
Estimates, Predictions or Projections. Most Cited
Cases
For purposes of a securities fraud claim, the “mere
puffery” rule has its limitations, in that a projection
of optimism becomes actionable when: (1) the
statement is not actually believed; (2) there is no
reasonable basis for the belief; or (3) the speaker is
aware of undisclosed facts tending seriously to
undermine the statement's accuracy. Securities
Exchange Act of 1934, § 10b, 15 U.S.C.A. § 78j(b);
17 C.F.R. § 240.10b-5.
[31] Securities Regulation 349B
60.27(5)
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.17 Manipulative, Deceptive or
Fraudulent Conduct
349Bk60.27 Misrepresentation
349Bk60.27(5)
k.
Forecasts,
Estimates, Predictions or Projections. Most Cited
Cases
Statements by corporation's officers and director
regarding corporation's future plans, objectives, and
business prospects relating to development and
hoped-for Food and Drug Administration (FDA)
approval of a new asthmatic spray device, and its
then newly-acquired pharmaceutical drug product
lines, were not forward-looking, and, thus, were
outside safe harbor provision of Private Securities
Litigation Reform Act (PSLRA), where statements
allegedly misled investors about the current sales and
demand for corporation's drug, and its market share,
and shareholders adequately alleged a strong
inference that statements were made with actual
knowledge of their falsity. Securities Exchange Act
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of 1934, § 21E(c)(1)(A)(i), 15 U.S.C.A. §
5(c)(1)(A)(i).
[32] Securities Regulation 349B
78u-
60.27(5)
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.17 Manipulative, Deceptive or
Fraudulent Conduct
349Bk60.27 Misrepresentation
349Bk60.27(5)
k.
Forecasts,
Estimates, Predictions or Projections. Most Cited
Cases
The safe harbor provision of the Private Securities
Litigation Reform Act (PSLRA) codified the
“bespeaks caution” doctrine, which developed to
address situations in which optimistic projections are
coupled with cautionary language affecting the
reasonableness of reliance on and the materiality of
those projections. Securities Exchange Act of 1934, §
21E(c)(1, 2), 15 U.S.C.A. § § 78u-5(c)(1, 2).
[33] Securities Regulation 349B
60.27(5)
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.17 Manipulative, Deceptive or
Fraudulent Conduct
349Bk60.27 Misrepresentation
349Bk60.27(5)
k.
Forecasts,
Estimates, Predictions or Projections. Most Cited
Cases
For purposes of the safe harbor provision of the
Private Securities Litigation Reform Act (PSLRA), a
forward-looking statement is any statement
regarding: (1) financial projections; (2) plans and
objectives of management for future operations; (3)
future economic performance; or (4) the assumptions
underlying or related to any of these issues. Securities
Exchange Act of 1934, § 21E(c)(1)(A)(i), 15
U.S.C.A. § 78u-5(c)(1)(A)(i).
[34] Securities Regulation 349B
60.40
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.39 Persons Liable
349Bk60.40 k. In General; Control
Page 8
Persons. Most Cited Cases
Corporation's officers and director were not indirectly
liable for securities fraud based on analysts' reports,
absent evidence that they were “sufficiently
entangled” with the analysts' forecasts. Securities
Exchange Act of 1934, § 10b, 15 U.S.C.A. § 78j(b);
17 C.F.R. § 240.10b-5.
[35] Securities Regulation 349B
60.40
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.39 Persons Liable
349Bk60.40 k. In General; Control
Persons. Most Cited Cases
There are two types of securities fraud liability
related to statements made by analysts; (1) a
defendant may be directly liable for false statements
made to analysts in the connection of a sale of a
security, and (2) a defendant may be liable for
statements made by an analyst if the defendant, or a
company or its officers or directors puts an express or
implied imprimatur on the projections by endorsing
or adopting them. Securities Exchange Act of 1934, §
10b, 15 U.S.C.A. § 78j(b); 17 C.F.R. § 240.10b-5.
[36] Securities Regulation 349B
60.40
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.39 Persons Liable
349Bk60.40 k. In General; Control
Persons. Most Cited Cases
A defendant adopts an analysts' report or forecast, as
could lead to indirect liability for securities fraud,
when he or she sufficiently entangles himself or
herself with the analysts' forecasts. Securities
Exchange Act of 1934, § 10b, 15 U.S.C.A. § 78j(b);
17 C.F.R. § 240.10b-5.
[37] Securities Regulation 349B
60.40
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)7 Fraud and Manipulation
349Bk60.39 Persons Liable
349Bk60.40 k. In General; Control
Persons. Most Cited Cases
Corporation's officers and director were not liable as
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controlling persons under Securities Exchange Act in
securities fraud class action, absent underlying
securities violations. Securities Exchange Act of
1934, § 20(a), 15 U.S.C.A. § 78t(a).
[38] Securities Regulation 349B
35.15
349B Securities Regulation
349BI Federal Regulation
349BI(C) Trading and Markets
349BI(C)1 In General
349Bk35.15 k. Controlling Persons.
Most Cited Cases
To establish control person liability, a plaintiff must
show that a primary violation occurred, and that the
defendant exercised actual power or control over the
primary violator. Securities Exchange Act of 1934, §
20(a), 15 U.S.C.A. § 78t(a).
William F. Sullivan, Paul Hastings Janofsky and
Walker, San Diego, CA, for Dura Pharmaceuticals,
Inc. Securities Litigation.
ORDER GRANTING IN PART AND DENYING
IN PART MOTION TO DISMISS THIRD
CONSOLIDATED AMENDED COMPLAINT
LORENZ, District Judge.
*1 This matter came on regularly for a hearing on
Defendants' motion to dismiss the Third Consolidated
Amended Complaint (“TAC”). Patrick J. Coughlin
and Tor Gronborg of Lerach Coughlin Stoia Geller
Rudman & Robbins LLP appeared for the Plaintiffs.
William F. Sullivan of Paul Hastings Janofsky &
Walker appeared for the Defendants.
Having carefully reviewed the parties' briefs, oral
argument, and applicable law, the Court finds the
TAC's allegations regarding Albuterol Spiros fail to
meet the pleading requirements under the Private
Securities Litigation Reform Act of 1995
(“PSLRA”), 15 U.S.C. § § 78u-4(b)(1) and (2), and
that the TAC's allegations regarding Defendants'
statements about Ceclor CD properly state a claim
under the PSLRA against certain Defendants. The
Court therefore GRANTS IN PART and DENIES
IN PART Defendants' motion to dismiss.
BACKGROUND
Plaintiffs bring this action on behalf of purchasers of
shares of Dura Pharmaceuticals, Inc. (“Dura” or the
“Company”) securities from April 15, 1997 to
February 24, 1998 (“Class Period”) including those
Page 91 of 121
Page 9
purchasers who acquired their Dura securities during
the Class Period and held such securities until after
September 23, 1998, November 4, 1998, and
December 4, 1998. (TAC ¶ 1.) Dura was a San
Diego-based developer and marketer of prescription
pharmaceutical products for the treatment of
allergies, asthma and related respiratory conditions.
Id. ¶ 61. The Individual Defendants held the
following positions at Dura during the Class Period:
Cam L. Garner (“Garner”) was President, Chief
Executive Officer, Chief Operations Officer, and
Chairman; James W. Newman (“Newman”) was
Senior Vice President-Finance & Administration and
Chief Financial Officer; Charles W. Prettyman
(“Prettyman”) was Senior Vice PresidentDevelopment and Regulatory Affairs; Walter F.
Spath (“Spath”) was Senior Vice President-Sales &
Marketing; Mitchell R. Woodbury (“Woodbury”)
was Senior Vice President/General Counsel; Julia R.
Brown (“Brown”) was Senior Vice PresidentBusiness Development and Planning; and Joseph C.
Cook (“Cook”) was a director. Id. ¶ 62.
Dura became a publicly-traded company in 1992,
pursuing a business strategy of marketing niche
pharmaceutical drugs. Id. ¶ 1. At that time, Dura
typically purchased the rights to market drugs
developed by large pharmaceutical companies that
were approaching the end of their profitability to
those companies. Id. By 1995, Dura's management
realized that given the Company's size, it would be
increasingly difficult to achieve continued revenue
and earnings per share (“EPS”) growth solely by
acquiring marketing rights to niche drugs. Id. ¶ 2.
Therefore, Dura insiders decided to diversify the
Company's business, and become a medical device
development company and develop its own
proprietary drug products. Id. In 1995, Dura began
developing the Spiros drug delivery system for
Albuterol (“Albuterol Spiros” or “Spiros drug
delivery system”), a method of aerosolizing powders
so that asthma medicines, including Albuterol, could
be inhaled. Id. ¶ 3. This system purportedly would
have advantages over existing inhalers that depended
on the user to successfully coordinate the use of the
inhaler and inhalation of the medication. Id. The
Spiros drug delivery system was a software-driven
device with software programmed to turn on a motor
that activated an impeller inside the device, which in
turn extracted the Albuterol drug compound from the
storage cassette that fit inside the inhaler. Id. ¶ 4.
Dura's insiders created Spiros Development
Corporation (“Spiros I”) to incur Dura's costs of
developing the Spiros drug delivery system. Id. ¶ 5.
Plaintiffs contend development of the inhaler was
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plagued with significant electro-mechanical problems
that plagued Spiros' reliability, and stability problems
with Albuterol.
*2 In August 1996, Dura acquired from Eli Lilly the
marketing rights for Ceclor CD, a prescription
antibiotic. Id. ¶ ¶ 29-30, 67. Ceclor CD is a slowrelease form of Ceclor, a second generation
cephalosporin generically known as cefaclor. Id. ¶
30. Its use decreased in the late 1990s as more
powerful antibiotics with fewer significant side
effects were developed. Id.
Prior to the Class Period, after reaching a then alltime high price of $47.87 on December 31, 1996,
Dura stock fell sharply to $27.87 on April 14, 1997.
Id. ¶ ¶ 7, 168. This decline created problems for
Dura's executives. Id. By early 1997, as Dura was
conducting Phase III clinical trials on Albuterol
Spiros, Defendants were completing a major debt
offering for Dura to obtain working capital to acquire
additional pharmaceutical products. Id. ¶ 19. The
Defendants also knew that Spiros I would exhaust its
financial resources during 1997, and Dura would
have to exercise its option to repurchase Spiros I and
finance a new follow-on Spiros Development Corp.
II entity to continue to pay for the ongoing
development of Albuterol Spiros. Id. ¶ ¶ 6, 19, 168.
In addition, the value of Dura's insiders' existing
stock options to purchase thousands of shares of Dura
stock had been completely wiped out in early 1997
when Dura's stock price dropped, and the cash
bonuses for Dura's top executives were dependent
upon Dura meeting internally set 1997 EPS targets
and Dura's stock price performance during 1997. Id. ¶
¶ 20, 168, 172. For these reasons, it was imperative
to Dura's insiders that they drive Dura's stock higher
during 1997. Id. ¶ 21, 168.
According to Plaintiffs, in their effort to raise Dura's
stock price, beginning in April 1997 and continuing
through the Class Period, Defendants began a
“concerted campaign to falsely persuade investors
that Dura's sales were increasing and that Dura was
successfully completing the development and clinical
trials of the Spiros drug delivery system.” Id. ¶ ¶ 22,
169. Plaintiffs state Defendants concealed problems
with the development of Albuterol Spiros and falsely
represented sales of Ceclor CD were strong. Id. ¶ ¶
23-24, 29. Plaintiffs allege that during the Class
Period, the Individual Defendants engaged in
suspicious insider trading, selling 188,626 shares for
over $7.3 million between May 12, 1997 and July 22,
1997, and selling over 190,000 shares between
November 3, 1997 and January 6, 1998 for $9.2
Page 92 of 121
Page 10
million in proceeds. Id. ¶ ¶ 27-28, 44, 147, 171, 17582.
On the last day of the Class Period, February 24,
1998, Dura revealed that it expected lower-thanforecast 1998 revenues and 1998 EPS due to slowerthan-expected sales of the Ceclor CD and
Nasarel/Nasalide product lines, and the need to
increase the size of its sales force from 270 to over
450 to try to boost sales of existing products. Id. ¶ ¶
45, 159. Dura's stock thereafter dropped from $39.13
on February 24, 1998, to $20.75 on February 25,
1998, an $18.38 per share, 47% one-day decline on a
volume of 32 million shares. Id. One analyst's
reaction to Dura's announcement was that:
*3 Our confidence in management and their
credibility with us has been greatly diminished. As
recently as one month ago, we reviewed our model
with the Company line by line and were guided to
higher Ceclor CD estimates. In our opinion, not too
much could have changed between now and then, and
we believe that this revenue shortfall is not new news
to Dura, but frankly, comes as a surprise to us.
Id.
Dura's business performed poorly during the balance
of 1998. Id. ¶ ¶ 49, 160. Sales of Ceclor CD fell to
only $30 million. Id. ¶ 49. In an April 16, 1998
conference call with analysts, Dura admitted that, at
least by December 1997, the wholesale channels had
been clogged with many months of excess Ceclor CD
inventory. Id. ¶ ¶ 49, 160.
After the Class Period ended, in April 1998, Dura
placed an advertisement in Advance for Managers of
Respiratory Care regarding Albuterol Spiros. Id. ¶
161. On April 30, 1998, the FDA sent Dura a letter of
rebuke stating that: “the journal ad is in violation of
the Federal Food, Drug, and Cosmetic Act (the
“Act”) and its implementing regulations, because it
promotes an unapproved drug by making claims of
safety and efficiency that have not been demonstrated
by substantial evidence (i.e. adequate and wellcontrolled studies).” Id. ¶ 162.
In September 23, 1998, Dura disclosed that it had
submitted additional chemistry and manufacturing
control information requested by the FDA in support
of the original New Drug Application (“NDA”), thus
finally revealing the long-known problems with the
device. Id. ¶ ¶ 46, 163. Dura also conceded that the
Albuterol Spiros launch date had slipped to second
quarter 1999. Id. In response to this announcement,
Dura's stock price declined 28% from $15.25 on
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September 23, 1998 to $10.00 on September 25,
1998. Id.
On November 4, 1998, Dura was forced to report that
the FDA had rejected the Albuterol Spiros NDA
because the Spiros device was not reliable due to its
unacceptably high failure rate and because Dura had
provided insufficient data to demonstrate Albuterol's
stability. Id. ¶ ¶ 47, 164. Defendants stated in a press
release that the FDA “raised no issues on the clinical
data with the inhaler filed in the NDA demonstrating
therapeutic comparability of Albuterol Spiros TM with
Ventolin® (albuterol) MDI using standard lung
function measures.” Id. In response to this disclosure,
the Company's stock price declined 21% from $12.50
to $9.34 on November 3, 1998. Id.
On November 6, 1998, the FDA issued a “Notice of
Violation” to Dura, stating that Dura's press release
sent a message that “misleadingly minimizes the fact
that Dura must conduct a completely new clinical
data [study].” Id. ¶ ¶ 48, 165. Dura removed the
press release from the website, but did not publicly
disclose the November 6, 1998 letter of rebuke until
December 4, 1998. Id. When the FDA's letter was
finally disclosed, Dura's stock price declined an
additional 13% from $12.56 to $10.50. Id.
Ultimately, Dura completely abandoned the
development of the Spiros device for use with
Albuterol because Dura could not overcome the
reliability and stability problems. Id. ¶ ¶ 50, 165.
*4 Plaintiffs filed several class actions alleging
violations of § § 10(b) and 20(a) of the Securities
and Exchange Act and Rule 10b-5 promulgated by
the Securities and Exchange Commission. The cases
were consolidated into the instant case number. By
order dated July 12, 2000, this Court granted
Defendants' motion to dismiss the Consolidated and
Amended Complaint, and dismissed the pleading
without prejudice. Plaintiffs subsequently filed a
Second Consolidated Amended Complaint. This
Court dismissed the Second Consolidated Amended
Complaint. In relevant part FN1, this Court held that
Plaintiffs had not adequately alleged loss causation as
to the misrepresentations regarding Albuterol Spiros.
This Court further found that Plaintiffs' allegations
regarding Ceclor CD sales were insufficient because
“[t]he mere fact that intraquarterly results lagged
behind internal projections does not, without more,
require disclosure.” Glassman v. Computervision
Corp., 90 F.3d 617, 631 (1st Cir.1996). The Court
also held the Complaint's allegations regarding
Ceclor CD were conclusory because although
Page 93 of 121
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Plaintiffs alleged the Company was shipping amounts
of the product “well in excess of the amount justified
by or necessary to keep pace with current
prescription levels and thus Dura had created vastly
excessive amount of inventory of Ceclor CD in the
distribution channel,” the Second Consolidated
Amended Complaint did not provide any factual
support on how Defendants knew at the time the
distribution channels were clogged. Rather, Plaintiffs
alleged that after the Class Period ended, Dura
admitted there was excessive inventory of Ceclor
CD. This Court also held the Second Consolidated
Amended Complaint's allegations regarding scienter
were deficient, analyzing each basis for scienter
individually.
On appeal, the Ninth Circuit reversed. The appellate
court held that Plaintiffs had in fact adequately pled
loss causation because it was sufficient that they
allege the stock price was inflated at the time of
purchase because of Defendants' fraud. Broudo v.
Dura Pharms., Inc., 339 F.3d 933, 938-39 (9th
Cir.2003). The Ninth Circuit agreed with this Court
and found deficient Plaintiffs' allegations of scienter
based on: (1) the existence of reports showing Ceclor
CD sales were below internal projection; (2) stock
sales; and (3) channel stuffing. However, after this
Court dismissed the Second Consolidated Amended
Complaint, the Ninth Circuit held that courts must
also look at scienter allegations collectively. No. 84
Employer-Teamster Jt. Council Pension Trust Fund
v. Am. W. Holding Corp., 320 F.3d 920, 938 (9th
Cir.2003). The Ninth Circuit thus vacated this Court's
finding of no scienter and instructed this Court to
perform the final step of considering Plaintiffs'
allegations collectively when conducting its scienter
analysis. Broudo, 339 F.3d at 940. Finally, the Ninth
Circuit held this Court should have allowed Plaintiffs
to amend the complaint to include, inter alia,
statements by a confidential witness who has direct
knowledge that at least two of the Defendants
discussed how they could make stock analysts
“perceive” that Dura was doing better than it actually
was and that one of the Defendant's oft-stated catch
phrase to employees who questioned his tactics was
“let ‘em catch us.” Id. at 941. The Ninth Circuit held
that “[s]uch allegations are the type that could
demonstrate a strong inference that Dura knowingly
or with deliberate recklessness made false or
misleading statements to investors.” Id.
*5 The United States Supreme Court agreed to hear
the loss causation issue. Last year, the Supreme Court
reversed the Ninth Circuit and held that an inflated
purchase price by itself does not constitute or
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proximately cause the relevant economic loss needed
to allege and prove “loss causation.” Dura Pharms.,
Inc. v. Broudo, 544 U.S. 336, 345-46, 125 S.Ct. 1627,
161 L.Ed.2d 577 (2005). The Court held that a
securities fraud plaintiff must allege and prove that a
defendant's misrepresentation or other fraudulent
conduct proximately caused the plaintiff's economic
loss, and thus must provide defendants with notice of
what the relevant economic loss might be and the
causal connection between the loss and the
misrepresentation. Id. at 346, 125 S.Ct. 1627. The
Court further held that Plaintiffs' Complaint did not
adequately plead loss causation. Id. at 346-47, 125
S.Ct. 1627.
indirectly, by the use of any means or instrumentality
of interstate commerce, or of the mails or of 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 the light of the
circumstances under which they were made, not
misleading, or
*6 (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.
The Ninth Circuit subsequently remanded the case to
this Court for further proceedings, and directed that
Plaintiffs be given an opportunity to amend their
complaint, inter alia, in a manner that complies with
the Supreme Court's requirements for loss causation.
17 C.F.R. § 240.10b-5. The elements of a Rule 10b-5
claim are: (1) a misrepresentation or omission of a
material fact; (2) scienter; (3) causation; (4) reliance;
and (5) damages. In re Daou Sys., Inc. Sec. Litig.,
411 F.3d 1006, 1014 (9th Cir.2005), cert. denied, --U.S. ----, 126 S.Ct. 1335, 164 L.Ed.2d 51 (2006).
APPLICABLE LAW REGARDING MOTIONS TO
DISMISS SECURITIES CLASS ACTIONS
[2] Claims brought under Rule 10b-5 and § 10(b)
must meet Federal Rule of Civil Procedure 9(b)'s
particularity requirement that “[i]n all averments of
fraud or mistake, the circumstances constituting fraud
or mistake shall be stated with particularity.”
Fed.R.Civ.P. 9(b); see Daou, 411 F.3d at 1014;
Yourish v. Cal. Amplifier, 191 F.3d 983, 993 (9th
Cir.1999). In addition, in 1995, Congress enacted the
PSLRA and altered the pleading requirements in
private securities fraud litigation by requiring a
complaint “ ‘plead with particularity both falsity and
scienter.’ ” Daou, 411 F.3d at 1014 (quoting
Gompper v. VISX, Inc., 298 F.3d 893, 895 (9th
Cir.2002)).
A motion to dismiss under Federal Rule of Civil
Procedure 12(b)(6) tests the sufficiency of the
complaint. Navarro v. Block, 250 F.3d 729, 732 (9th
Cir.2001). Dismissal of a claim under this rule is
appropriate only where “it appears beyond doubt that
the plaintiff can prove no set of facts in support of his
claim which would entitle him to relief.” Conley v.
Gibson, 355 U.S. 41, 45-46, 78 S.Ct. 99, 2 L.Ed.2d
80 (1957); Navarro, 250 F.3d at 732. In reviewing a
motion to dismiss under Rule 12(b)(6), the court must
assume the truth of all factual allegations and must
construe them in the light most favorable to the
nonmoving party. Thompson v. Davis, 295 F.3d 890,
895 (9th Cir.2002); Cahill v. Liberty Mut. Ins. Co., 80
F.3d 336, 337-38 (9th Cir.1996). However, legal
conclusions need not be taken as true merely because
they are cast in the form of factual allegations.
Roberts v. Corrothers, 812 F.2d 1173, 1177 (9th
Cir.1987); Western Mining Council v. Watt, 643 F.2d
618, 624 (9th Cir.1981).
[1] Section 10(b) of the Securities Exchange Act of
1934 makes it unlawful to use in connection with the
mails or facilities of interstate commerce any
“manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the
Commission may prescribe.” 15 U.S.C. § 78j(b).
SEC Rule 10b-5, promulgated under section 10(b),
provides:
It shall be unlawful for any person, directly or
[3][4][5] When the plaintiff alleges the defendant
either (1) made an untrue statement of material fact
or (2) omitted to state a material fact necessary to
make statements made not misleading, the PSLRA
requries the complaint to “ ‘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 that belief is
formed.’ ” Daou, 411 F.3d at 1014 (quoting
Gompper, 298 F.3d at 895). Second, regarding
scienter, the PSLRA requires the complaint to “state
with particularity facts giving rise to a strong
inference that the defendant acted with the required
state of mind.” 15 U.S.C. § 78u-4(b)(2); Daou, 411
F.3d at 1014. Scienter is defined as “a mental state
embracing intent to deceive, manipulate, or defraud.”
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Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12,
96 S.Ct. 1375, 47 L.Ed.2d 668 (1976).
[6][7][8][9][10] The Ninth Circuit “incorporate[s] the
dual pleading requirements of § § 78u-4(b)(1) and
(b)(2) into a single inquiry, because falsity and
scienter are generally inferred from the same set of
facts.” In re Read-Rite Corp. Sec. Litig., 335 F.3d
843, 846 (9th Cir.2003); Ronconi v. Larkin, 253 F.3d
423, 429 (9th Cir.2001). Thus, when evaluating
whether a private securities fraud complaint survives
a motion to dismiss, the court “must determine
whether particular facts in the complaint, taken as a
whole, raise a strong inference that defendants
intentionally or [with] deliberate recklessness made
false or misleading statements to investors.” Ronconi,
253 F.3d at 429 (internal quotations omitted); accord
Read-Rite, 335 F.3d at 846. “The requirement to
plead all the facts with particularity means that a
plaintiff must provide a list of all relevant
circumstances in great detail.” Read-Rite, 335 F.3d at
846 (internal quotations omitted); In re Silicon
Graphics Inc. Sec. Litig., 183 F.3d 970, 984 (9th
Cir.1999). “To meet this pleading requirement, the
complaint must contain allegations of specific
contemporaneous ‘statements or conditions' that
demonstrate the intentional or the deliberately
reckless false or misleading nature of the statements
when made.” Ronconi, 253 F.3d at 432; accord ReadRite, 335 F.3d at 846. In determining whether
plaintiffs have adequately pled scienter, courts must
consider “ ‘whether the total of plaintiffs' allegations,
even though individually lacking, are sufficient to
create a strong inference that defendants acted with
deliberate or conscious recklessness.’ ” Am. W., 320
F.3d at 938 (quoting Lipton v. Pathogenesis Corp.,
284 F.3d 1027, 1038 (9th Cir.2002)). When
conducting this analysis, the court must consider all
reasonable inferences, whether or not favorable to the
plaintiffs. Daou, 411 F.3d at 1022. “Where pleadings
are not sufficiently particularized or where, taken as a
whole, they do not raise a ‘strong inference’ that
misleading statements were knowingly or [with]
deliberate recklessness made to investors, a private
securities fraud complaint is properly dismissed
under Rule 12(b)(6).” Ronconi, 253 F.3d at 429;
accord Read-Rite, 335 F.3d at 846.
SUFFICIENCY OF THE ALLEGATIONS OF
VIOLATIONS OF § 10(B) AND RULE 10B-5
*7 Plaintiffs contend Defendants misrepresented the
Company's sales and business performance
throughout the Class Period and thereby inflated
Page 13
Dura's stock price. In particular, Plaintiffs maintain
Defendants made material misrepresentations and
omissions regarding the development of its Albuterol
Spiros product and the sales of Ceclor CD.
I. Albuterol Spiros
A. Allegations Regarding Albuterol Spiros
Plaintiffs allege that, as reported by analysts, Dura's
Albuterol Spiros was an important development for
the company. (TAC ¶ ¶ 97, 125.) According to
Plaintiffs, Dura made numerous misrepresentations
regarding Dura's Albuterol Spiros drug delivery
technology. Specifically, Plaintiffs contend Dura's
1996 Annual Report, which was issued on April 15,
1997, stated the device was a durable system, and
touted the benefits of this product. (TAC ¶ 74.) A
press release issued that day reported better-thanexpected 1Q 1997 results and stated the Company
was continuing to develop its Albuterol Spiros
product.
Id. ¶
75. As a result of these
announcements, Dura's stock rose over 21% from
$27.87 on April 14, 1997 to $34 on April 15, 1997.
Id. ¶ 76.
On April 15, 1997, Oppenheimer & Company, Inc.
(“Oppenheimer”), Alex. Brown, Robertson Stephens
& Co. (“Robertson Stephens”), and William Blair &
Co. (“William Blair”) issued reports on Dura and the
development of Spiros. Id. ¶ 95. These reports were
based on and repeated information provided in: (1) an
April 15, 1997 conference call with securities
analysts in conjunction with the 1996 Annual Report
and press release; and (2) in follow-up conversations
with Garner or Newman. Id. These reports stated that
Spiros' development was on track and Dura would
soon be completing clinical trials. Id. Shortly
thereafter on April 25, 1997, Oppenheimer issued a
report on Dura based on and repeating information
concerning Dura's Spiros development provided in
conversations with Garner and Newman that stated
Albuterol Spiros would be submitted to the FDA
before the end of the year. Id. ¶ 96. On April 28,
1997, UBS Securities (“UBS”) issued a report on
Dura that was based on and repeated information
provided in conversations with Dura executives,
including Garner or Newman, that stated Spiros was
allowing Dura to differentiate itself from a typical
marketing company and the Company would become
more “fully integrated” through the development of
the Spiros inhaler. Id. ¶ 97. The report also stated
that the Company would file an NDA with the FDA
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in the second half of 1997 and expected it to be
approved in the second half of 1998, with Spiros
revenues adding about $58 million to Dura's current
sales base in 1999. Id. Between May 7 to May 9, and
on May 30, 1997, Vector Securities International
(“Vector”), UBS, and William Blair issued similar
reports stating that Dura was still on track to submit
its first Spiros NDA filing in the second half of 1997.
Id. ¶ ¶ 98-99. On May 30, 1997, Alex. Brown and
Vector also reported that Dura would file its NDA for
Albuterol Spiros in the second half of 1997 that could
add $100 million in revenues by 2000. Id. ¶ 99.
*8 Plaintiffs maintain Dura's June 5, 1997 press
release announcing the completion of clinical trials
necessary for an NDA submission for Albuterol
Spiros was false and misleading. Id. ¶ ¶ 100-01. In
that release, David S. Kabakoff, Dura's Executive
Vice President and President and CEO of Spiros
Corp. stated Dura was pleased with the results to date
and was preparing the NDA for filing in the latter
half of 1997. Id. ¶ 100. On June 30, 1997, William
Blair reported that Newman had stated at an
investment conference that Dura planned to file the
Albuterol Spiros NDA by fall of 1997 and that the
Company was continuing to develop the Spiros
product line aggressively. Id. ¶ 103.
On July 15, 1997, Dura reported better-than-expected
Q2 1997 results in a press release, and reiterated that
the Company was on track to file the Albuterol
Spiros NDA in the second half of 1997. Id. ¶ 106.
Also on that date, five analysts issued reports on
Dura that were based on and repeated information
provided in a conference call and in follow-up
conversations with Garner and Newman. Id. ¶ 115.
The analysts reported Dura was on track to file the
Albuterol Spiros NDA in the second half of 1997,
that Albuterol Spiros could be on the market in late
1998 with initial sales of $10 million growing to over
$55 million by 2000, and that Albuterol Spiros would
contribute significantly to Dura's long-term revenue
and earnings growth. Id.
On July 25, 1997, Dura sold $287.5 million in
convertible notes. Id. ¶ 123. In August 1997, analysts
issued reports on Dura that were based on and
repeated information from Garner and Newman
stating that Spiros possessed significant advantages
over alternative inhalers currently marketed or in
development, and the launch of Albuterol Spiros in
the second half of 1998 would be a watershed event
for the Company. Id. ¶ ¶ 124-25. Analysts issued
similar positive reports in September 1997 based on
discussions with Garner and Newman. Id. ¶ 126. On
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October 8, 1997, Dura reported at the UBS Life
Science Conference that the NDA filing for Albuterol
Spiros was expected within days. Id. ¶ 127. On that
day, UBS issued a report that reiterated this
information. Id. ¶ 128.
On these announcements, Dura's stock rose 7.7% to
$52.25-its then all-time high price. Id. ¶ 129. On
October 10, 1997, Dura announced it was going to
exercise its option to buy Spiros for $45.7 million
and then take Spiros public. Id. The public sale
included one common share of a new company,
Spiros II, as well as a warrant to buy one-fourth of a
share of Dura common stock. Id. The initial public
offering was expected to raise between $75 million
and $86.25 million. Id. Dura said it would contribute
some technology and technology rights, as well as
$75 million cash to Spiros II prior to the IPO. Id.
In mid-October, Dura reported better-than-expected
Q3 1997 results. Id. ¶ 131. Plaintiffs contend that in
a conference call and follow-up conversations with
analysts, Defendants reiterated that the NDA for
Albuterol Spiros would be filed in November 1997,
and continued to tout the significance of Albuterol
Spiros on the Company's future revenues. Id. ¶ ¶
132, 142. On November 10, 1997, Dura announced in
a press release that it had submitted an NDA for
Albuterol Spiros with the FDA. Id. ¶ 143. On
December 17, 1997, Dura and Spiros II sold 5.5
million Spiros II units at $16 per unit, raising $88
million in needed new capital. Id. ¶ 144. Each unit
sold consisted of one share of callable common stock
of Spiros II and one warrant to purchase one-fourth
of one share of Dura common stock. Id.
*9 On January 20, 1998, Dura reported better-thanexpected Q4 results via a press release. Id. ¶ 149.
After Dura reported better-than-expected Q4 1997
results, analysts issued reports based on
conversations with Garner or Newman that stated
Dura expected the FDA to approve Albuterol Spiros
by the end of 1998. Id. ¶ ¶ 156-57. The analysts
further reported Dura expected to launch Albuterol
Spiros by early 1999, and that the product would be a
significant portion of the company's revenue. Id. ¶
156.
Plaintiffs contend that contravening their public
praise for the Spiros technology, Defendants knew
since the fall of 1996 that there were serious
reliability problems with the Spiros device and
stability problems with Albuterol. Id. ¶ ¶ 8, 9, 94.
According to Plaintiffs, in October 1996, Robert
Eisele, Vice President of Product Development,
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documented these problems in a list that was
contained in a five to six page document setting forth
necessary items to be addressed before an NDA
could be properly submitted. Id. ¶ ¶ 9-10, 94, 121.
Before Phase III clinical trials began, Dura devised
in-house experiments to test the efficacy of Albuterol
Spiros at certain temperatures and humidity levels.
Id. ¶ ¶ 11, 91. This testing revealed unacceptable
levels of reduced efficacy when Albuterol was
exposed to humidity. Id. According to Plaintiffs,
Dura's own engineers objected to pursuing Phase III
clinical trials because of Albuterol Spiros's reliability
and stability problems. Id. ¶ ¶ 9, 12. Dura was unable
to fix the problems prior to commencing Phase III
clinical trials, and thus started Phase III clinical trials
with versions of Albuterol Spiros that had these
defects and, in fact, changed the device during
clinical trials. Id. ¶ ¶ 15, 90, 93, 117, 120. The
configuration of the product Dura used to conduct
clinical trials was unreliable and plagued by
significant electro-mechanical problems; over 30% of
the inhalers failed. Id.¶ ¶ 13-14, 23, 90, 92, 117, 119.
According to Plaintiffs, Defendants knew, based on
their prior experience with the FDA and the medical
device industry, that the FDA would not approve an
NDA for an unreliable product and unstable drug. Id.
¶ ¶ 92, 119. Industry standards dictated that an NDA
not be filed unless the early return rate was 1% or
less. Id. ¶ ¶ 13, 92, 119. As a result of the inhaler's
reliability problems during Phase III clinical trials,
Dura began making modifications to the inhalers
actually being used in the ongoing clinical trials to
improve reliability. Id. ¶ ¶ 15, 90, 93 117, 120.
Plaintiffs allege all modifications to the device were
documented within the clinical trial results and that
senior management, including Defendant Prettyman,
as Senior Vice President of Regulatory Affairs, had
to sign off on proposed modifications before they
could be made. Id. ¶ ¶ 16, 93, 120. Dura knew this
would invalidate the Phase III clinical trials. Id. ¶ ¶
18, 90, 117.
*10 Plaintiffs contend senior executives were so
concerned about the inhaler's reliability problems that
Dura retained an outside testing facility, Wyle Labs,
to conduct highly accelerated life tests (“HALT”) on
the device while Phase III clinical trials were still
ongoing. Id. ¶ ¶ 18, 146. HALT are extreme
condition tests designed to identify potential
operational failures. Id.
Plaintiffs allege Defendants Garner, Prettyman,
Spath, Woodbury, and Brown were informed during
an executive management meeting held every
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Monday from 8:00 to 10:00 a.m. of the problems
encountered during the Phase III clinical trials and of
Albuterol's stability problems. Id. ¶ ¶ 92, 119.
Further, Defendants Garner and Prettyman attended
weekly Research and Development meetings during
which the Spiros device development team presented
Phase III clinical trial results and stability test results,
and informed Garner and Prettyman that over 30% of
the inhalers failed during clinical trials. Id. ¶ ¶ 11,
92, 102, 119. Minutes were also generated from these
meetings and circulated to senior management. Id. ¶ ¶
11, 17, 92.
Plaintiffs aver that senior management at Dura “were
kept constantly informed of the problems affecting
the inhaler's reliability via product reports prepared
by Mike Ligotke, the Senior Product Engineer for the
Spiros device and Linda Gieschen, the Spiros Project
Leader.” Id. ¶ 17. These reports also contained
information regarding the different configurations of
the inhaler, the different tests being performed, and
the results of those tests. Id. The reports were
prepared for and circulated in advance of and during
weekly research and development meetings attended
by senior management. Id.
Plaintiffs contend that in addition to concealing the
problems with Albuterol Spiros's development, the
Defendants concealed a pre-NDA filing meeting
Dura conducted with the FDA in May 1997. Id. ¶ ¶
24, 101, 122. By the time that meeting occurred,
Dura had completed clinical trials, and had received
95% of the data from the trials concerning chemical
instability, doser reliability and failure rates. Id. ¶ 24.
At that meeting, which included Garner and
Prettyman, the FDA raised concerns regarding the
Spiros device's reliability and with Albuterol's
stability. Id. ¶ ¶ 25, 101, 122.
Plaintiffs further contend there was internal
dissension among Defendants whether to file the
NDA for the Spiros device. Id. ¶ ¶ 12, 28, 145. In
late October or early November 1997, a meeting was
held to discuss the NDA filing. Id. Defendants
Garner and Prettyman attended, and Prettyman made
it clear that he did not want to file the NDA for which
his department, Regulatory Affairs, was responsible,
because he knew based on his prior experience that
the NDA would not be approved by the FDA. Id. ¶ ¶
28, 145. Despite this, he was overruled and Dura
filed the NDA on November 10, 1997. Id.
B. Adequacy of The TAC's Allegations
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*11 Defendants present several challenges to the
TAC's allegations regarding Albuterol Spiros.
Defendants contend Plaintiffs fail to state a claim
because they do not adequately plead loss causation,
and because the TAC does not plead falsity and
scienter with particularity. Defendants further
contend that most of the statements alleged to be
misleading are mere “puffery” or protected by the
PSLRA's safe harbor provision or the bespeaks
caution doctrine. Defendants also contend they
cannot be held liable for statements made by thirdparty analysts.
1. Loss Causation
[11][12] One of the elements of a Rule 10b-5 cause
of action that a Plaintiff must plead and prove is loss
causation. 15 U.S.C. § 78u-4(b)(4); Dura, 544 U.S.
at 341, 125 S.Ct. 1627. As noted above, this Court
dismissed the Second Consolidated Amended
Complaint's allegations regarding Albuterol Spiros on
the basis the pleading did not adequately plead loss
causation. The Ninth Circuit reversed on this issue,
and the Supreme Court reversed the Ninth Circuit,
holding that securities class action plaintiffs must
allege that the misrepresentations proximately caused
the plaintiffs' economic loss. The Supreme Court's
decision did not create a heightened pleading
standard for loss causation: the Court noted its
holding did not affect Rule 8(a)(2)'s applicability.
Dura, 544 U.S. at 346, 125 S.Ct. 1627. The Ninth
Circuit remanded this case to this Court to allow
Plaintiffs an opportunity to amend the complaint in
conformity with the Supreme Court's decision. The
TAC now alleges that Defendants' misrepresentations
regarding Albuterol Spiros artificially inflated Dura's
stock price, (TAC ¶ ¶ 74-76, 95-100, 103, 105-06,
115, 125-29, 132-33, 142-43, 156-57), Defendants
made corrective disclosures regarding Albuterol
Spiros' stability and functionality on September 23,
1998, November 4, 1998, and December 4, 1998, and
the resulting stock drop on those dates. FN2 (TAC 159,
163-65, 183-98, 200.)
Defendants contend Plaintiffs are impermissibly
trying to expand the Class Period through to
December 4, 1998, but they are barred from doing so
by the applicable statute of limitations. The statute of
limitations for this type of claim is one year after the
discovery of the facts constituting the violation and
within three years after such violation. 15 U.S.C. §
78i(e). Defendants state Plaintiffs were on notice of
the events and stock price declines that occurred on
September 23, November 4, and December 4, 1998
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when they filed their action, but they strategically
elected to end the Class Period on February 24, 1998.
Defendants state the statute of limitations has run
regarding these newly added claims and they do not
relate back to the original complaint as the Plaintiffs
who allegedly held stock on these three dates do not
have an identity of interest with the original
Plaintiffs, whose claims and alleged damages were
associated with the 47% price decline that occurred
between February 24, 1998, and February 25, 1998.
*12 The Court is not persuaded by Defendants'
arguments. First, Defendants' statute of limitations
argument is premised on the assumption that
Plaintiffs have added claims or class members, or
attempted to expand the Class Period. A review of
the TAC, however, reveals that Plaintiffs are not
attempting to expand the Class Period or add new
class members. Rather, the TAC explains, in
accordance with Dura, the causal relationship
between Defendants' allegedly fraudulent statements
and the decline in stock price. The earlier complaint
focused on the drop in stock price following Dura's
February 24, 1998 announcement, and failed to
explain how the misrepresentations regarding
Albuterol Spiros touched upon the reasons for the
decline in price. But in the TAC, Plaintiffs allege that
those who purchased shares during the Class Period
and held the stock on September 9, 1998, November
4, 1998, and December 4, 1998 suffered a loss when
information was revealed on those dates showing the
Defendants had misrepresented the development of
Albuterol Spiros. Thus, they have explained how the
misrepresentations regarding Albuterol Spiros
proximately caused economic loss on those dates.
Under the liberal pleading requirements of Rule 8(a),
these allegations are sufficient to meet the loss
causation requirement.
Defendants next argue that Plaintiffs have cited no
authority that allows them to manipulate the class
claims by linking Class Period purchasers with losses
associated with various events and disclosures that
occurred after the close of the Class Period.
Defendants state Plaintiffs are essentially creating a
“holder class” through December 4, 1998, which is
impermissible. Defendants are correct that “holder
classes” are not entitled to sue under Section 10(b).
Williams v. Sinclair, 529 F.2d 1383, 1389 (9th
Cir.1975). However, an improper “holder class” is
comprised of individuals who “neither purchased nor
sold shares in reliance upon the alleged
misrepresentations or concealments.” Id. In this case,
the TAC alleges that Plaintiffs purchased Dura's
shares in reliance on, inter alia, Defendants
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representations
regarding
the
Company's
development of Albuterol Spiros. Accordingly, none
of the Plaintiffs constitute a “holder class.”
Defendants next argue the securities laws
contemplate that the losses for which plaintiffs seek
recovery are those occurring during the class period,
not months or years beyond its termination. In
support, Defendants quote cases where district courts
indicate a plaintiff's loss occurs during the class
period. (Defs.' Mot. To Dismiss at 20, citing In re
Portal Software, Inc. Sec. Litig., No. C-03-5138VRW, 2005 WL 1910923, at *16 (N.D.Cal. Aug. 10,
2005), In re Surebeam Corp. Sec. Litig., No.
03CV1721, 2003 U.S. Dist. LEXIS 25022, at *23
(S.D.Cal. Jan. 5, 2004); Aronson v. McKesson
HBOC, Inc., 79 F.Supp.2d 1146, 1157-58
(N.D.Cal.1999), In re Kirschner Med. Corp. Sec.
Litig., 139 F.R.D. 74, 81-82 (D.Md.1991)). Kirschner
states a class period cannot extend beyond the date
curative information was effectively disseminated to
the market. Kirschner, 139 F.R.D. at 81-82.
However, neither Kirschner nor any of the other
cases the parties cite address whether a securities
fraud claim is barred as a matter of law when the
corrective disclosures occur several months after the
class period ends.
*13 There is some appeal to requiring a corrective
disclosure to occur at the end of the class period. For
instance, in this case, those who purchased Dura's
stock after the Class Period ended and suffered losses
when the truth about Albuterol Spiros was revealed
are, as Plaintiffs' counsel stated in oral argument,
“out of luck.” Although those purchasers suffered
losses as a result of Defendants' alleged
misstatements and omissions regarding Albuterol
Spiros, they will not receive any compensation as
their interests are not represented in this lawsuit. A
rule requiring the corrective disclosure to
immediately follow the end of the Class Period
would ensure such purchasers' interests are protected.
Nevertheless, the Court finds the authority
Defendants cite insufficient to impose such a
requirement. When presented with this case, the
Supreme Court could have held that as a matter of
law Plaintiffs cannot establish loss causation because
the corrective disclosures regarding Albuterol Spiros
were made several months after the Class Period
ended. The Supreme Court did not so hold, and
instead only required the Plaintiffs to properly allege
a causal connection between the economic losses
suffered and the Defendants' misrepresentations.
Dura, 544 U.S. at 346-47, 125 S.Ct. 1627.
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Finally, Defendants argue that Plaintiffs' theory
cannot be squared with other provisions of the
PSLRA, such as the “look-back” provision codified
at 15 U.S.C. § 78u-4(e)(1), which provides for an
upward limitation on damages in a Section 10(b)
securities case. As Plaintiffs point out, however, that
statutory provision does not measure damages based
on the end of the class period. Rather, the PSLRA
requires damages be calculated from the date the
truth is revealed: in other words, the damages are
limited to “the mean trading price of that security
during the 90-day trading period beginning on the
date on which the information correcting the
misstatement or omission that is the basis for the
action is disseminated to the market.” 15 U.S.C. §
78u-4(e)(1).
In sum, the Court concludes the TAC adequately
alleges loss causation regarding Defendants' alleged
misstatements and omissions regarding Albuterol
Spiros.
2. Falsity and Scienter
[13] Defendants maintain the TAC does not
adequately allege falsity and scienter because there
are no factual allegations establishing a strong
inference that, when reporting on the Spiros clinical
trials and the anticipated filing of the NDA, the
Defendants knew that the Spiros product had defects
that would delay or prevent FDA approval, or knew
that any such defects could not be corrected in a
manner to allow for such approval. Defendants also
challenge these allegations on the basis Plaintiffs fail
to state with particularity the facts upon which their
allegations are based.
[14][15][16][17] Plaintiffs do not contend the TAC is
based on their personal knowledge. Accordingly, the
TAC is plead on “information and belief.” In the
Ninth Circuit, a securities fraud complaint based on
information and belief has to “state with particularity
all facts on which [a] belief is formed,” and in so
doing, the plaintiff must reveal “the sources of her
information.” Silicon Graphics, 183 F.3d at 985
(citation and internal quotation marks omitted);
accord Daou, 411 F.3d at 1015. When the source of a
plaintiff's information are internal reports, the
plaintiff must allege specifics regarding those reports:
the sources of the plaintiff's information with respect
to the reports, how the plaintiff learned of the reports,
who drafted the reports, which officers received
them, and the contents of those reports. Silicon
Graphics, 183 F.3d at 985. If a plaintiff relies on the
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accounts of confidential witnesses, the complaint
must describe such personal sources “ ‘with sufficient
particularity to support the probability that a person
in the position occupied by the source would possess
the information alleged.’ ” Nursing Home Pension
Fund, Local 144 v. Oracle Corp., 380 F.3d 1226,
1233 (9th Cir.2004) (quoting Novak v. Kasaks, 216
F.3d 300, 314 (2d Cir.2000)). An assessment of the
reliability of witnesses “ ‘involves an evaluation,
inter alia, of the level of detail provided by the
confidential sources, the corroborative nature of the
other facts alleged (including from other sources), the
coherence and plausibility of the allegations, the
number of sources, the reliability of the sources, and
similar indicia.’ ” Daou, 411 F.3d at 1015 (quoting In
re Cabletron Sys., Inc., 311 F.3d 11, 29-30 (1st
Cir.2002)).
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regarding who generated the testing results and the
minutes, or how Plaintiffs came to learn of these
results. The timeline regarding these allegations is
also only vaguely described as before Phase III
clinical trials; it is not clear whether this in-house
testing pre- or post-dated the Eisele List.
Similarly, the TAC's allegations regarding
modifications to Albuterol Spiros during Phase III
clinical trials require more specificity as to the
sources of Plaintiffs' information. Plaintiffs contend
that modifications to the inhaler “were well
documented within the clinical trial results and
reliability reports and each test run on each
configuration was analyzed in a separate report.” Id.
¶ ¶ 16, 93. Plaintiffs allege Senior Project Engineer
Mike Ligotke and Project leader Linda Gieschen
were responsible for drafting these reports. Id. ¶ 93.
Plaintiffs do not allege who received these reports,
when they were received, or how Plaintiffs came to
learn of those reports.
*14 As an initial matter, the TAC does not identify
any confidential witnesses as the source of Plaintiffs'
information regarding Dura's problems with
Albuterol Spiros and the purported fraudulent efforts
to conceal those problems from the market. Instead,
the TAC's allegations regarding Albuterol Spiros rely
heavily on internal reports that purportedly
documented all the problems with the inhaler's
development. The TAC discusses with some detail
the Eisele List that was prepared in October 1996 by
Dura's Vice President of Product Development, and
which included a list of problems with the Spiros
drug delivery system and the Albuterol cassette.
(TAC ¶ ¶ 9, 94, 121.) Problems identified in the
Eisele List include the reliability of the Spiros device
and stability of Albuterol. Id. ¶ 10. The pleading
further alleges the Eisele List was distributed to
senior management during the weekly executive
management meeting held every Monday. Id. ¶ ¶ 9,
94, 121. Although Plaintiffs do not explain how they
came to learn of the Eisele List, there are sufficient
details regarding this report to indicate its reliability.
Plaintiffs next allege that Defendants “were kept
constantly informed of the problems affecting the
inhaler's reliability via product reports prepared by
Mike Ligotke, the Senior Product Engineer for the
Spiros device and Linda Gieschen, the Spiros Project
Leader.” Id. ¶ 17. The TAC further alleges the
reports were prepared for and circulated in advance
of and during weekly research and development
meetings. Id. However, absent are any allegations
regarding when these reports were generated and
distributed-whether it was during some or all of the
Class Period, or whether these reports were generated
prior to or after the Eisele List. Thus, it is not clear
whether these are the same reports that documented
modifications to the Spiros device during Phase III
clinical trials. Further, there are no allegations
regarding how the Plaintiffs came to learn of those
reports.
However, the TAC does not adequately describe the
sources of Plaintiffs' information supporting the
allegations regarding the on-going problems with the
development of Albuterol Spiros and Defendants'
knowledge of those problems. Plaintiffs allege Dura
conducted in-house testing before Phase III clinical
trials began, and that the testing showed problems
with the drug's efficacy. Id. ¶ ¶ 11, 91. According to
Plaintiffs, Defendants were kept apprised of the
testing results “via chemical stability test results and
analytical reports that were circulated during weekly
product development meetings” and in minutes
generated from product development meetings. Id. ¶
11. Absent from these allegations are any details
*15 Several of the TAC's allegations regarding
Defendants' purported knowledge of problems
plaguing Albuterol Spiros and fraudulent intent are
not attributed to any source. For example, the TAC's
allegations regarding internal dissent over whether to
proceed with clinical trials or file the NDA are not
supported by references to internal documents or
confidential witnesses. Also absent is the source(s) of
Plaintiffs' information regarding Dura's decision to
retain Wyle to conduct HALT. Similarly, the TAC
does not identify the source of Plaintiffs' allegations
regarding the weekly executive management
meetings conducted every Monday from 8:00 to
10:00 a.m. and Research and Development meetings.
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The absence of such allegations are significant
because the crux of Defendants' malfeasance comes
from their decision to forge ahead with clinical trials
and the NDA submission notwithstanding their
inability to remedy the problems identified in the
Eisele List.
For these reasons, the TAC's allegations regarding
Spiros must be dismissed. The Court, however, will
allow Plaintiffs leave to amend the complaint so they
can describe the sources of their information in
accordance with Silicon Graphics, Daou, and
Nursing Home. Because the Court finds the TAC
does not adequately allege the sources of Plaintiffs'
information, it declines to address Defendants'
remaining challenges to these allegations at this time.
II. Ceclor CD
A. Allegations Regarding Ceclor CD
Plaintiffs contend that Defendants misrepresented
and omitted critical information regarding Dura's
sales of Ceclor CD. Specifically, Plaintiffs allege that
on April 15, 1997, Dura announced in a press release
better-than-expected Q1 1997 results, stating that
revenues for the quarter totaled $40.9 million, net
income was $8.8 million, and EPS were $0.19-a 73%
increase from $0.11 in first quarter 1996. (TAC ¶
75.) In this release, Defendants boasted of doubled
revenues overall and singled out Ceclor CD's
purported sales success and trumpeted that Ceclor
CD's “market share” of weekly new prescriptions of
cefalcor had doubled from the end of 1996. Id. Dura's
stock rose over 21% from $27.87 on April 14, 1997,
to $34 on April 15, 2997 as a result of these
announcements. Id. ¶ 76. Approximately two months
later, Defendants delivered a similar message to the
assembled investors and analysts at the William Blair
Investment Conference. Id. ¶ 103.
On July 15, 1997, Dura reported better-than-expected
Q2 1997 results in a press release, stating that net
income for the second quarter totaled $9.3 million, or
$0.20 per share on revenues of $43.6 million
compared to net income of $4.6 million, or $0.12 per
share, on revenues of $18.8 million in the second
quarter that ended June 30, 1996. Id. ¶ 106. Dura's
press release reported that Ceclor CD was wellreceived by physicians. Id.
On October 8, 1997, Dura representatives appeared at
the UBS Life Science Conference. Id. ¶ 127. UBS
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thereafter reported that Dura presented compelling
market share data regarding Ceclor CD's progress in
the U.S. cefaclor cephalosporin franchise, and that
Ceclor registered nearly a three-point sequential
increase in market share between August and
September. Id. Shortly after the conference, Dura
announced better-than-expected 3Q 1997 results,
reporting record earnings for both the third quarter
and nine months year-to-date of 1997, compared to
the same period the previous year. Id. ¶ 131. The
Company stated that net income for the third quarter
totaled $11.3 million, or $0.24 per share, on revenues
of $43.3 million compared to net income of $5.8
million, or $0.14 per share, on revenues of $25.9
million for the third quarter ended September 30,
1996. Id. Dura primarily attributed the increase in
revenues to growth in sales of respiratory
pharmaceuticals, which rose 91% to $36.1 million in
the third quarter of 1997 compared to $18.9 million
in the third quarter of 1996. Id. The pharmaceutical
sales growth was largely due in part to the impact of
new product acquisitions and introductions, such as
Ceclor CD and Nasarel. Id. In a follow-up conference
call, Vector reported Dura's management indicated
that earnings for 1998 could run in the low $1.40's
range. Id. ¶ 132.
*16 On January 20, 1998, Dura reported better-thanexpected Q4 1997 results, stating revenues were at
$53.5 million and $181.3 million for the quarter and
the full year, respectively. Id. ¶ 149. Excluding onetime charges, Dura would have had a net income of
$18.0 million, or $0.37 per share in the quarter, and
$47.4 million, or $0.99 per share for the year,
compared to a net income of $9.9 million, or $0.22
per share for the fourth quarter of 1996 and $24.3
million, or $0.60 per share for the full year 1996. Id.
Dura also reported that its sales from pharmaceuticals
rose 89% to $150.5 million in 1997 compared to
$79.6 million in 1996, due in part to product
acquisitions. Id. In a press release, Garner was quoted
as stating that the Company's Ceclor CD market
share of the oral solid cefaclor market rose from 8%
at the beginning of 1997 to 25% by year-end. Id.
Plaintiffs maintain these representations were false
when made because sales of Ceclor CD were
dropping throughout the Class Period. Id. ¶ ¶ 77(a),
134(a), 150. Plaintiffs attribute the lower sales to the
antibiotic's decreased use as more powerful
antibiotics with fewer significant side effects
developed, the fact the drug was not covered by most
managed-care insurance, and problems with Dura's
sales force. Id. ¶ ¶ 30-33. Actual sales of Ceclor CD
fell from 47,288 units in March 1997 (the month
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before the start of the Class Period) to 39,808 in May
1997 (a month into the Class Period), and then fell to
24,797 units in July 1997. Id. ¶ ¶ 31, 87. According
to Plaintiffs, Dura was artificially inflating its
revenues and EPS by shipping excessive amounts of
Ceclor CD and other products to wholesalers, who
were enticed to take the product by price discounts,
extended payment terms and/or other incentives. Id.
¶ ¶
34-43, 77(b), 134(b), 150. Dura's sales
representatives conducted “load-ins” and “fire sales”
and were instructed to “load wholesalers to the max”
with Ceclor CD, pressuring them to sell even more
Ceclor CD near each quarter's end. Id.¶ ¶ 41, 77(b),
78-82, 134(b), 150.
B. Adequacy of The TAC's Allegations
As with the TAC's allegations regarding Albuterol
Spiros, Defendants contend the pleading's averments
regarding Ceclor CD fail to state a claim because
Plaintiffs have not adequately pleaded the sources of
their information or falsity and scienter with
sufficient particularity. Defendants also argue that
many of the alleged statements about Ceclor CD
were non-actionable statements of general optimism
puffery and cannot form the basis of a securities
claim. Defendants further contend they cannot be
held liable for statements made by third-party
analysts.
1. Falsity and Scienter
[18] Defendants maintain Plaintiffs have not
adequately alleged falsity and scienter regarding
Ceclor CD sales because the majority of Defendants'
statements concern the growth in sales of multiple
Company respiratory pharmaceuticals, and are not
confined to sales of Ceclor CD. In addition, to the
extent internal Company projections allegedly
predicted flat or declining sales, the Company was
not obligated to disclose such projections nor was
such information inconsistent with statements by the
Company about Ceclor CD. Defendants further
contend the allegations regarding Ceclor CD sales
reports address only three time periods-March 1997,
May 1997, and July 1997-only two of which are in
the Class Period, and there are no “specific numbers”
or “percentages of decline” for the balance of the
Class Period after July 1997. According to
Defendants, Plaintiffs improperly attempt to plead
“fraud by hindsight” by republishing Dura's press
releases and analysts' reports and repeating the same
“true facts” that Defendants supposedly “knew,”
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without any evidentiary facts showing why that is so.
Defendants maintain Plaintiffs fail to identify any
contemporaneous materials that contradict any of
Defendants' public statements. Instead, they plead
boilerplate references to “sales reports” and other
internal information. Defendants argue Plaintiffs'
confidential witnesses do not provide sufficient
corroborative details to establish reliability. The
Court disagrees, and finds the TAC adequately
alleges Defendants' knowledge of Ceclor CD's
decreasing sales and their efforts to inflate sales and
earnings through “fire sales” and “load-ins.”
*17 When analyzing the Second Consolidated
Amended Complaint, the Ninth Circuit held that the
existence of reports showing Ceclor CD sales “were
below internal projections and Dura's knowledge of
these reports, coupled with Dura's statements that it
was pleased with sales figures, are not specific facts
that strongly suggest actual intent by Dura to mislead
investors.” Dura, 339 F.3d at 940. The appellate
court stated that “Dura's internal expectations could
have been aggressive and falling short of them may
have been anticipated.” Id. In addition, the Ninth
Circuit stated that channel stuffing “may have some
probative value insofar as the channel stuffing was
done so as to artificially inflate income, but there
may also be other legitimate reasons for attempting to
achieve sales earlier.” Id. The appellate court also
found the complaint's allegations regarding insider
trading were insufficient to establish scienter. Id.
Having carefully reviewed the TAC, the Court finds
this pleading addresses the deficiencies in the Second
Consolidated Amended Complaint identified by the
Ninth Circuit. The TAC's allegations regarding
declining Ceclor CD sales and Defendants' alleged
efforts to inflate sales through “load-ins” and “fire
sales” are sufficiently corroborated by internal
reports and accounts from confidential witnesses.
Although channel stuffing allegations alone may be
insufficient to establish scienter, when viewed as a
whole, as this Court must, the TAC adequately pleads
a scheme by the Defendants to artificially inflate EPS
growth by shipping excess amounts of product to
wholesalers on the final few days of fiscal quarters.
The TAC alleges monthly sales reports were prepared
by Dura's Information Technology Department from
information obtained from IMS, a service that tracks
prescription drug sales. (TAC ¶ 111.) The report
compared actual versus planned sales of Dura's drug
products, and were prepared for and disseminated by
Defendant Spath and kept Defendants apprised of
Dura's drug sales so they knew that such sales were
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below plan and insufficient for Dura to achieve
continued EPS growth.FN3 Id. Plaintiffs do not allege
how they obtained the information from the monthly
reports. However, other allegations of the TAC
corroborate Plaintiffs' theory that Defendants
misrepresented the sales of Ceclor CD for purposes
of increasing Dura's stock price.
In particular, the TAC alleges the participants in the
“fire sale” or “load-in” scheme: Newman, Garner,
Spath, Doug Weiherer (Director of National
Accounts), and Jack Strathmeyer (National Account
Manager). (TAC ¶ ¶ 35, 37, 40, 43, 79, 150.) The
TAC further alleges details of the scheme. In each
quarter in 1997, about two or three weeks before a
quarter's end when it became apparent that the
Company's revenues were going to fall short of
estimates, Dura's national accounts managers flew
into San Diego to attend a sales meeting led by
Defendant Spath and Weiherer aimed at strategizing
on deals and terms that they could offer their
respective third-party distributors as incentives to get
them to take on large quantities of Ceclor CD. Id. ¶ ¶
35, 78. National accounts managers dreaded the
meetings because when they occurred, they knew
they would be directed to participate in what was
referred to as “load-ins.” Id. At these meetings,
Defendant Spath first made some general statements
indicating that he needed the sales reps to generate
more revenue before the end of the quarter so Dura
would meet its quarterly projections. Id. Spath then
left the meeting, and Weiherer got into the details of
how much in revenues the sales managers needed to
generate in order for the Company to meet the
quarterly projections. Id. Weiherer then outlined
specific discounts, payment extensions, and rights of
return that they should offer their respective customer
accounts as incentives to accept large orders of
Ceclor CD. Id. They referred to this practice at Dura
as “loading it in,” a “load-in” or a “fire sale.” Id.
*18 The terms that were typically offered were a 6%
or 12% discount on the price depending on the
volume of the order (higher volume orders received
the higher percentage discount), payment terms of 60,
90, or 120 days rather than the standard 30-day term,
and would allow for returns anywhere from three
months to three years after shipment for full or half
credit on the purchase price. Id. ¶ ¶ 36, 41, 77(b), 79,
107(b), 134, 151. Dura would experience 75%
returns of product sold subject to the load-ins, but
still booked 100% of the revenues in the quarter the
deal was struck, and did not set aside any of the
revenues as a reserve for returns. Id. ¶ ¶ 39, 82. The
significant returns impacted the national account
Page 21
managers' quarterly sales bonuses. Id.
According to Plaintiffs, Weiherer, Spath, and other
upper management would travel to meet with
customer representatives at McKesson, Cardinal,
Bergen Brunswig, and Bindley Western even though
these accounts technically were assigned to the
national account managers. Id. ¶ 37, 80, 151. These
customers constituted up to 60% of Dura's sales. Id. ¶
41. A former national account manager recalls that
“for a VP to call on a specific accounts was unheard
of in this industry” at the time, and it was well-known
at Dura that Weiherer's involvement meant that the
Company was seeking to place a large “load-in”
order of Ceclor CD with these customers. Id. ¶ 80.
The Plaintiffs rely on confidential witnesses for these
allegations; in particular, a former national accounts
manager and a former Dura Regional Sales Director.
Defendants contend these descriptions are
insufficient to meet the Ninth Circuit's particularity
requirements regarding confidential sources, and
points to this Court's decision in Alaska Elec. Pension
Fund v. Adecco S.A., 371 F.Supp.2d 1203
(S.D.Cal.2005). In Adecco, this Court found the bald
allegation that a “former executive” provided
information to be deficient. Adecco, 371 F.Supp.2d
at 1211. There were no facts pled in the complaint
regarding the witness's duties, when the executive
worked at the company, or how the executive would
have come to learn of the facts attributed to him or
her. See id.
Having reviewed the TAC, the Court agrees with
Defendants that the former Dura Regional Sales
Director is not adequately described. In Daou, for
example, the Ninth Circuit found the complaint met
the PSLRA's requirement for confidential witnesses
because those witnesses were described with great
specificity: plaintiffs numbered each witness and
described his or her job description and
responsibilities. Daou, 411 F.3d at 1016. In contrast,
here, there are no allegations regarding the job duties
of the former Regional Sales Director or how that
individual was privy to the information attributed to
him or her. For example, the TAC alleges the former
Regional Sales Director “confirmed that Dura
management, including Garner and additional
defendants, met at the end of November or early
December 1997 to discuss the fact that Dura was not
going to make its 4Q 1997 numbers,” and that the
Defendants discussed “fire sales.” (TAC ¶ ¶ 152,
154.) But there are no allegations as to how the
Regional Sales Director would have come to learn of
this information.
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*19 However, the TAC does provide sufficient
information regarding the former national accounts
manager to support the probability that individual
would possess the information alleged. In particular,
the national accounts manager was responsible for
wholesalers and managed care providers. Id. ¶ 150.
That witness came to learn of the information
attributed to him or her because of that witness's
participation in the quarterly sales meetings and the
subsequent “load-ins” or “fire sales.” See id. ¶ ¶ 35,
37, 78, 80, 150. The witness would also have
information regarding how much Ceclor CD was
returned as it would affect that individual's bonus.
See id. ¶ ¶ 39, 82.
Not only does the TAC contain more detailed
allegations regarding Defendants' purported scheme
to ship excess Ceclor CD, but it also includes
allegations that the Ninth Circuit specifically found
“are the type that could demonstrate a strong
inference that Dura knowingly or with deliberate
recklessness made false or misleading statements to
investors.” Dura, 339 F.3d at 941. These allegations
are that Garner and Newman talked openly and
frequently in public areas at Dura about their plan to
maximize the stock price so that they could “take the
cash and run.” (TAC ¶ 171.) The TAC also alleges
these Defendants openly discussed how they could
make Dura appear more successful than it actually
was. Id. When employees questioned Newman about
these tactics, he replied, “let ‘em catch us.” Id.
According to Plaintiffs, Newman repeated this catch
phrase so often it became part of the Company
vernacular. Id.
Notably, these allegations are properly supported by
a confidential witness. The TAC attributes these
averments to a former finance department employee
who worked closely with Garner and Newman. Id.
Garner also told this witness even before the Class
Period began that he did not intend to stay at Dura for
more than a couple of years, when he expected to
cash out and do other things. Id.
In sum, the Court finds the TAC's allegations
regarding Ceclor CD adequately plead falsity and
scienter regarding Dura's Ceclor CD sales.
2. Which Defendants Are Liable
As discussed above, the TAC adequately alleges
Defendants Newman, Garner, and Spath FN4 were
involved in the scheme to overload wholesalers with
Page 22
Ceclor CD to increase Dura's EPS, and that they
acted with the requisite scienter. However, there are
no allegations implicating Defendants Prettyman,
Woodbury, Brown, or Cook. Instead, it appears the
TAC attempts to impute liability to these Defendants
based on the group pleading doctrine, stock sales,
their positions in the Company, and motive. The
Court does not find these allegations sufficient to
impose liability as to those Defendants.
a. Group Pleading
[19] The group pleading doctrine allows a
presumption that false and misleading information
disseminated through documents were made by the
collective action of the corporation's officers. In re
GlenFed, Inc., 60 F.3d 591, 593 (9th Cir.1995); In re
Syncor Int'l Corp. Sec. Litig., 327 F.Supp.2d 1149,
1171 (C.D.Cal.2004). The Ninth Circuit has not
opined whether this doctrine remains viable after the
enactment of the PSLRA. However, this Court has
joined other courts in this district and concluded the
group pleading doctrine did not survive the PSLRA.
Adecco, 371 F.Supp.2d at 1220-21. Other circuits
have similarly concluded that the group pleading
doctrine conflicts with the PSLRA's scienter
requirement. See, e.g., Makor Issues & Rights, Ltd. v.
Tellabs, Inc., 437 F.3d 588, 602-03 (7th Cir.2006);
Southland Sec. Corp. v. INSpire Ins. Solutions, Inc.,
365 F.3d 353, 364-65 (5th Cir.2004). Accordingly,
the Court finds the group pleading doctrine is not a
basis to impute liability for the Company's statements
regarding Ceclor CD as to Defendants Prettyman,
Woodbury, Brown, or Cook.
b. Stock Sales
*20 [20][21][22] Stock sales by Prettyman,
Woodbury, Brown, and Cook are also an insufficient
basis upon which to impute liability as to these
Defendants. Unusual or suspicious stock sales can
serve as circumstantial evidence of scienter. Ronconi,
253 F.3d at 434; Silicon Graphics, 183 F.3d at 986.
“But not every sale of stock by a corporate insider
shows that the share price is about to decline.”
Ronconi, 253 F.3d at 435. Accordingly, “courts have
repeatedly held that the mere existence of stock sales
does not raise a strong inference of fraudulent intent.
[citation] Plaintiffs have the burden at the pleading
stage of explaining why the stock sales were unusual
or suspicious.” In re PetSmart, Inc. Sec. Litig., 61
F.Supp.2d 982, 1000 (D.Ariz.1999); Ronconi, 253
F.3d at 435; Silicon Graphics, 183 F.3d at 987. To
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meet this burden, the plaintiffs must show the trading
was in amounts “dramatically out of line with prior
trading practices, at times calculated to maximize the
personal
benefit
from
undisclosed
inside
information.” Ronconi, 253 F.3d at 435 (internal
quotations omitted). The Ninth Circuit has identified
three relevant factors when analyzing insider sales: “
‘(1) the amount and percentage of shares sold by
insiders; (2) the timing of the sales; and (3) whether
the sales were consistent with the insider's prior
trading history.’ ” Id. (quoting Silicon Graphics, 183
F.3d at 986).
The Ninth Circuit agreed with this Court's finding
that the Second Consolidated Amended Complaint
did not properly allege Defendants' trading practices
during the Class Period were dramatically out of line
with their prior trading activities. Dura, 339 F.3d at
940. The TAC's allegations regarding these
Defendants' stock sales again fail to plead the
Defendants' stock sales during the Class Period were
dramatically out of line with their prior trading
practices, or that those sales were done at a time
maximize profits. They are therefore insufficient to
impute scienter as to Defendants Prettyman,
Woodbury, Brown, and Cook.
c. Motive
[23] The TAC alleges Defendants set out to drive
Dura's stock higher during 1997 because Defendants
were completing a major debt offering for Dura to
obtain working capital, and because Dura would have
to exercise its option to repurchase Spiros I and
finance a new follow-on Spiros Development Corp.
II entity to continue to pay for the ongoing
development of Albuterol Spiros. (TAC ¶ ¶ 6, 19,
168.) The Court does not find these allegations
sufficient to impute scienter as to Prettyman,
Woodbury, Brown, and Cook vis-à-vis the Ceclor CD
averments. In the absence of any allegations
inculpating them in the “fire sale” and “load-in”
scheme, Dura's need to obtain capital is a generic
business motive courts have found insufficient to
base the requisite mental intent. See, e.g., Lipton, 284
F.3d at 1038 (“If scienter could be pleaded merely by
alleging that officers and directors possess motive
and opportunity to enhance a company's business
prospects, ‘virtually every company in the United
States that experiences a downturn in stock price
could be forced to defend securities fraud actions.’ ”)
(quoting Acito v. IMCERA Group, Inc., 47 F.3d 47,
54 (2d Cir.1995)); PetSmart, 61 F.Supp.2d at 999
(“A desire to present a sound financial profile cannot
Page 23
be viewed, alone, as circumstantial evidence giving
rise to a strong inference of scienter.”).
d. Positions In the Company
*21 [24] Plaintiffs also seek to impute scienter on
Defendants Prettyman, Woodbury, and Brown based
on their positions in the Company, arguing they ran
Dura as “hands-on” managers and as a result of their
executive positions were aware of adverse non-public
information. (See, e.g., TAC ¶ ¶ 83-85, 108-10, 13537.) This Court has held that “a complaint does not
adequately plead scienter by claiming that key
officers knew the true facts by virtue of their ‘handson’ positions and involvement in the day-to-day
management of the company.” In re Peerless Systems
Corp. Sec. Litig., 182 F.Supp.2d 982, 993
(S.D.Cal.2002); accord Adecco, 371 F.Supp.2d at
1217. The Ninth Circuit and district courts in this
circuit have similarly held that a defendant's position
in the company does not, without more, create a
strong inference of scienter. See, e.g., In re Vantive
Corp. Sec. Litig., 283 F.3d 1079, 1087 (9th
Cir.2002); In re Splash Tech. Holdings Inc. Sec.
Litig., 160 F.Supp.2d 1059, 1080-81 (N.D.Cal.2001);
In re Autodesk, Inc. Sec. Litig., 132 F.Supp.2d 833,
843-44 (N.D.Cal.2000). “Rather than presume
individual officer and director defendants must have
known about a fraud by virtue of their positions
within the defendant company, the persuasive force
of each situation must be evaluated individually.”
Adecco, 371 F.Supp.2d at 1217 (internal quotations
omitted). Given the absence of any allegations
entangling Prettyman, Woodbury, and Brown in the
scheme to load wholesalers with Ceclor CD, the
Court finds the TAC's allegations regarding these
Defendants' positions in the Company insufficient to
impute scienter.
e. Allegations in Totality
[25][26] When reviewing whether a complaint
properly states a securities fraud claim under the
PSLRA, the court must consider “ ‘whether the total
of plaintiffs' allegations, even though individually
lacking, are sufficient to create a strong inference that
defendants acted with deliberate or conscious
recklessness.’ ” Daou, 411 F.3d at 1022 (quoting
Nursing Home, 380 F.3d at 1230); Am. West, 320
F.3d at 938. When “considering whether a strong
inference of scienter has been pled, ‘the court must
consider all reasonable inferences to be drawn from
the allegations, including inferences unfavorable to
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the plaintiffs.’ ” Daou, 411 F.3d at 1022 (quoting
Gompper, 298 F.3d at 897). Having reviewed the
allegations in totality, the Court concludes the TAC
fails to state a claim as to Defendants Prettyman,
Woodbury, Brown, and Cook.
3. Puffery
[27][28][29][30] Defendants contend that many of
the statements attributed to the Individual Defendants
are mere “puffery” and optimistic statements about
the future prospects of the Company that cannot form
the basis of a securities claim. “The ‘mere puffery’
rule precludes liability for vague, generalized and
unspecific assertions of corporate optimism.” In re
Ligand
Pharms.,
Inc.
Sec.
Litig.,
No.
04CV1620DMS(LSP), 2005 WL 2461151, at *19
(S.D.Cal. Sept. 27, 2005). “ ‘Statements that fall
within the rule tend to use terms that are not
measurable and not tethered to facts that a reasonable
person would deem important to a securities
investment decision.” Id. (internal quotations
omitted). This rule has its limitations; a projection of
optimism becomes actionable “when (1) the
statement is not actually believed, (2) there is no
reasonable basis for the belief, or (3) the speaker is
aware of undisclosed facts tending seriously to
undermine the statement's accuracy.” Id. (internal
quotations omitted).
*22 The statements regarding Ceclor CD are not
subject to the puffery rule. As discussed above,
Plaintiffs have adequately pleaded the Company's
sales of Ceclor CD were artificially inflated through
the “fire sales” and “load-ins” orchestrated by certain
of the Defendants. Therefore, although statements
that sales and demand for Ceclor CD were “strong,”
that the Company was “pleased” with Dura's
performance and financial results, and that Ceclor
CD was “well received” by physicians are
generalized, the facts alleged in the TAC lead to a
strong inference there was no reasonable basis for
believing such statements to be true because the sales
were achieved by overloading wholesalers with the
product. Accordingly, the puffery rule does not
insulate Defendants from liability.
4. Safe Harbor and “Bespeaks Caution”
[31][32] Courts have refused to impose liability on
statements which “bespeak caution.” This doctrine
“developed to address situations in which optimistic
projections are coupled with cautionary language ...
Page 106 of 121
Page 24
affecting the reasonableness of reliance on and the
materiality of those projections.” In re Worlds of
Wonder Sec. Litig., 35 F.3d 1407, 1414 (9th
Cir.1994). The PSLRA's safe harbor provision
provides that forward-looking statements cannot be
the basis for a securities fraud claim if: (1) the
statement is identified as forward looking and is
accompanied by sufficient cautionary statements; or
(2) the person who made the forward-looking
statement did so without actual knowledge that the
statement was false or misleading. The safe harbor
provision protects both written and oral forwardlooking statements. See 15 U.S.C. § 78u-5(c)(1)-(2).
The Ninth Circuit has held the PSLRA's safe harbor
provision codified the judicially-created bespeaks
caution doctrine. Employers Teamsters Local Nos.
175 & 505 Pension Trust Fund v. Clorox Co., 353
F.3d 1125, 1132 (9th Cir.2004). Accordingly, it is
appropriate to consider the application of the
bespeaks caution doctrine and safe harbor provision
simultaneously. In re Copper Mountain Sec. Litig.,
311 F.Supp.2d 857, 876 (N.D.Cal.2004).
[33] Under the safe harbor provision, a person is not
liable for a “forward looking” statement provided the
statement is identified as such, and is accompanied
“by meaningful cautionary statements identifying
important factors that could cause actual results to
differ materially from those in the forward-looking
statement.” FN5 15 U.S.C. 78u-5(c)(1)(A)(i); Am. W.,
320 F.3d at 936. A “forward-looking statement” “is
any statement regarding (1) financial projections, (2)
plans and objectives of management for future
operations, (3) future economic performance, or (4)
the assumptions ‘underlying or related to’ any of
these issues.” Am. W., 320 F.3d at 936.
Defendants contend that most of the challenged
statements refer to Dura's future plans, objectives,
and business prospects relating to the development
and hoped-for FDA approval of the Spiros products,
and its then newly-acquired Ceclor, Keftab, and
Nasalide/Nasarel product lines. Defendants argue
these statements are forward-looking and thus subject
to the Reform Act's safe harbor provisions.
*23 Defendants contend Dura disclosed the risks
associated with its recent acquisition of Ceclor CD.
For example, the Company's Form 10-Q filed on
October 21, 1997 stated that “[f]ailure to successfully
market and sell Keftab, Ceclor CD, Nasarel or
Nasalide would have a material adverse effect on the
Company's business, financial condition and results
of operations.” (Def.'s Req. for Jud. Not., Ex. Q at
13.) The Court finds neither the safe harbor nor the
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bespeaks caution doctrine insulate Defendants from
liability for their statements regarding Ceclor CD.
repeated information Defendants provided. The Court
disagrees.
The statements regarding Ceclor CD at issue in this
case are not “forward looking.” Plaintiffs allege
Defendants misled investors about the current sales
and demand for Ceclor CD, and that antibiotic's
market share. (See, e.g., TAC ¶ 75 (discussing
Ceclor CD's market share of weekly new
prescriptions); id. ¶ 106 (stating that Ceclor CD is
well-received by physicians)). Accordingly, neither
the safe harbor provision nor the bespeaks caution
doctrine are applicable. Cf. Am. W., 320 F.3d at 93637 (finding statements disclosing a fine imposed and
the present effects of the fine on the company not
covered by the safe harbor provision). Further, even
if these statements were subject to the safe harbor or
bespeaks caution doctrine and were accompanied by
sufficient cautionary statements, as discussed above,
the TAC adequately alleges a strong inference they
were made with actual knowledge of their falsity,
precluding their protection by the safe harbor
provision or bespeaks caution doctrine. Cf. id, at 937
n. 15 (stating that because there was a strong
inference of actual knowledge, the statements were
not protected by the safe harbor provision).
*24 Plaintiffs may “forgo allegations of the
defendants' adoption of the analysts' reports if the
statements made to the securities analysts, which
formed the basis of the report, were misleading and
were made with the intent that they be communicated
to the market.” Copperstone v. TCSI Corp., No. C
97-4395 SBA, 1999 WL 33295869, at *8 (N.D.Cal.
Jan. 19, 1999). However, Plaintiffs' allegations must
conform to the PSLRA's pleading requirements. Id.
Plaintiffs must therefore “specify each statement to
an analyst alleged to have been misleading.” Id. The
TAC does not contain any allegations specifying the
statements Defendants made to analysts. Thus,
insofar as the TAC relies on statements in analysts'
reports, it must be dismissed. Cf. id. (finding
insufficient allegations that defendants made false
and misleading statements to non-party securities
analysts with the intent the analysts would relay the
information to the market); Stratosphere, 1 F.Supp.2d
at 1105 (finding complaint deficient because it did
not allege the time, place, and content of defendants'
statements to the analysts).
5. Statements Made by Third-Party Analysts
[34][35][36] Many of the TAC's allegations attribute
statements by analysts to the Defendants. Defendants
argue they are not liable for those statements because
Plaintiffs do not allege specific facts to support the
conclusion they were “sufficiently entangled” with
the analysts' forecasts. There are two types of liability
related to statements made by analysts. In re
Stratosphere Corp. Sec. Litig., 1 F.Supp.2d 1096,
1115 (D.Nev.1998). “First, a defendant may be
directly liable for false statements made to analysts in
the connection of a sale of a security.” Id. Second, “a
defendant may be liable for statements made by an
analyst if the defendant, or a company or its officers
or directors puts an express or implied imprimatur on
the projections by endorsing or adopting them.” Id.
“A defendant ‘adopts' an analysts' report or forecast
when he or she ‘sufficiently entangled himself [or
herself] with the analysts' forecasts.’ ” Id. (quoting In
re Caere Corp. Sec. Litig. 837 F.Supp. 1054, 1059
(N.D.Cal.1993)).
Plaintiffs
respond
that
“entanglement” allegations are only required where
defendants provided truthful information to analysts
that was made misleading through modification by
the analyst. They contend it is sufficient to have
alleged the analysts' reports were based on and
SUFFICIENCY OF THE ALLEGATIONS OF A §
20(a) VIOLATION.
[37][38] The TAC alleges a claim under § 20(a) of
the 1934 Securities and Exchange Act against
Defendants Newman, Garner, and Spath. Section
20(a) provides for controlling person liability for
every person who, directly or indirectly, controls any
person liable under any of the provisions of this title.
15 U.S.C. § 78t(a). To establish control person
liability, a plaintiff must show that a primary
violation occurred, and that the defendant exercised
actual power or control over the primary violator.
Am. W., 320 F.3d at 945. Defendants argue that
because Plaintiffs fail to state a claim under § 10(b)
and Rule 10b-5, the § 20(a) claim must be dismissed
as well. Heliotrope General, Inc. v. Ford Motor, Co.,
189 F.3d 971, 978 (9th Cir.1999).
The Court agrees that insofar as the § 20(a) claim
relies on the Defendants' misrepresentations
regarding Albuterol Spiros' development, the claim
must be dismissed because the allegations regarding
Spiros have not been pleaded in accordance with the
PSLRA. However, the Court has found the TAC
properly states a violation of § 10(b) and Rule 10b-5
against Garner, Spath, and Newman for
misrepresentations regarding sales and demand of
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Ceclor CD. Accordingly, Defendants' motion to
dismiss the § 20(a) claim as to Garner, Spath, and
Newman is denied insofar as it challenges the TAC's
allegations regarding sales and demand for Ceclor
CD.
CONCLUSION
Having considered the parties' briefs, the record, oral
argument, applicable law, and good cause appearing,
IT IS HEREBY ORDERED:
1. Defendants' motion to dismiss is GRANTED IN
PART AND DENIED IN PART [dock. no. 119].
The Court finds the TAC sufficiently states a claim
under § 10(b) and Rule 10b-5, and § 20(a) against
Defendants Dura, Garner, Newman, and Spath for
their representations and omissions regarding Ceclor
CD. However, the TAC's allegations based on
statements by analysts regarding Ceclor CD, and the
statements regarding Albuterol Spiros are deficient
and therefore DISMISSED WITH LEAVE TO
AMEND.
*25 2. Within 30 days of the date this order is
stamped “Filed,” Plaintiffs may file an amended
complaint that addresses the deficiencies in pleading
discussed above. If Plaintiffs do not file an amended
complaint in the time provided, the TAC shall
proceed against Defendants Dura, Garner, Newman,
and Spath only and as to those Defendants' (not
analysts') representations and omissions regarding
Ceclor CD. Should Plaintiffs choose to proceed only
on those claims, Defendants shall file an Answer to
the TAC within 45 days of the date this order is
stamped “Filed.”
3. Defendants' request for judicial notice is
GRANTED insofar as the Court has relied on those
documents.
IT IS SO ORDERED.
FN1. The Second Consolidated Amended
Complaint
alleges
Defendants
misrepresented the effectiveness of its sales
force, the sales and success of its product
Rondec, and the sales of Nasalide. The TAC
does not rely on those alleged
misrepresentations.
052 No cent-Y cent-R found.
Page 108 of 121
Page 26
February 24, 1998 announcement somehow
caused losses associated with the misleading
information about Albuterol Spiros'
approvability. Defendants contend this
allegation does not meet Dura's standard of
proximate cause because nowhere in the
February 24, 1998 announcement is there
any indication of Spiros' mechanical or
reliability problems. Plaintiffs do not
attempt to defend this allegation in their
opposition to the motion to dismiss.
FN3. Defendants contend the decline in
Ceclor CD sales was due to seasonal
fluctuations in sales of its respiratory
pharmaceuticals. In support for this
statement, Defendants rely on Dura's 1996
Annual Report filed on April 16, 1997, and
request take judicial notice of that document
under Federal Rule of Evidence 201.
Plaintiffs oppose the request. The Court
agrees with Plaintiffs that it is improper to
take judicial notice of a document for the
purpose of proving the truth of the
document's statements. See Troy Group, Inc.
v. Tilson, 364 F.Supp.2d 1149, 1152
(C.D.Cal.2005) (“SEC filings should be
considered only for the purpose of
determining what statements the documents
contain, not to prove the truth of the
documents' contents.”) (internal quotations
omitted). Accordingly, the Court declines to
take judicial notice of the 1996 Annual
Report as evidence the Defendants did not
commit a securities violation.
Plaintiffs do not oppose Defendants' request
the Court take judicial notice of other SEC
filings. Insofar as the Court has relied on
those documents, Defendants' request is
GRANTED.
FN4. Messrs. Weiherer and Strathmeyer
also participated in the alleged scheme to
overload wholesalers with Ceclor CD;
however, they are not Defendants in this
action.
FN5. “There are additional requirements for
oral forward-looking statements.” Am. W.,
320 F.3d at 936 n. 14.
S.D.Cal.,2006.
In re Dura Pharmaceuticals, Inc. Securities Litigation
--- F.Supp.2d ----, 2006 WL 2668970 (S.D.Cal.), Fed.
Sec. L. Rep. P 93,934
FN2. The TAC also alleges that the
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Briefs and Other Related Documents (Back to top)
• 2006 WL 3267481 (Trial Motion, Memorandum
and Affidavit) Reply Memorandum of Points and
Authorities in Support of Defendants' Motion to
Dismiss Plaintiffs' Fourth Consolidated and Amended
Complaint (Nov. 3, 2006) Original Image of this
Document (PDF)
• 2006 WL 3267480 (Trial Motion, Memorandum
and Affidavit) Plaintiffs' Opposition to Defendants'
Motion to Dismiss the Fourth Consolidated Amended
Complaint for Violation of the Securities Exchange
Act of 1934 (Oct. 19, 2006) Original Image of this
Document (PDF)
• 2006 WL 3267513 (Trial Pleading) Fourth
Consolidated Amended Complaint for Violation of
the Securities Exchange Act of 1934 (Jul. 21, 2006)
Original Image of this Document (PDF)
• 2006 WL 3267479 (Trial Motion, Memorandum
and Affidavit) Reply Memorandum of Points and
Authorities in Support of Defendants' Motion to
Dismiss Plaintiffs' Third Consolidated and Amended
Complaint (Jan. 5, 2006) Original Image of this
Document (PDF)
• 2006 WL 851086 (Trial Motion, Memorandum and
Affidavit) Reply Eemorandum of Points and
Authorities in Support of Defendants' Motion to
Dismiss Plaintiffs' Third Consolidated and Amended
Complaint (Jan. 5, 2006) Original Image of this
Document (PDF)
• 2005 WL 3941420 (Trial Motion, Memorandum
and Affidavit) Plaintiffs' Opposition to Defendants'
Motion to Dismiss the Third Consolidated Amended
Complaint for Violation of the Securities Exchange
Act of 1934 (Dec. 1, 2005) Original Image of this
Document (PDF)
• 2005 WL 4891641 (Trial Motion, Memorandum
and Affidavit) Plaintiffs' Opposition to Defendants'
Motion to Dismiss the Third Consolidated Amended
Complaint for Violation of the Securities Exchange
Act of 1934 (Dec. 1, 2005) Original Image of this
Document (PDF)
• 2005 WL 3941419 (Trial Motion, Memorandum
and Affidavit) Memorandum of Points and
Authorities in Support of Defendants' Motion to
Dismiss Plaintiffs' Third Consolidated and Amended
Complaint (Oct. 11, 2005) Original Image of this
Document (PDF)
• 2005 WL 4891640 (Trial Motion, Memorandum
and Affidavit) Memorandum of Points and
Authorities in Support of Defendants' Motion to
Dismiss Plaintiffs' Third Consolidated and Amended
Complaint (Oct. 11, 2005) Original Image of this
Document (PDF)
• 2005 WL 4891639 (Trial Pleading) Third
Page 109 of 121
Page 27
Consolidated Amended Complaint for Violation of
the Securities Exchange Act of 1934 (Aug. 26, 2005)
Original Image of this Document (PDF)
END OF DOCUMENT
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TAB 8
Page 110 of 121
Case 5:04-cv-04156-JW
Document 133
Filed 11/17/2006
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Not Reported in F.Supp.2d
Not Reported in F.Supp.2d, 2004 WL 3030058 (N.D.Cal.)
(Cite as: Not Reported in F.Supp.2d)
Briefs and Other Related Documents
In
re
ESS
Technology,
Inc.
Securities
LitigationN.D.Cal.,2004.Only the Westlaw citation is
currently available.
United States District Court,N.D. California.
In re ESS TECHNOLOGY, INC. SECURITIES
LITIGATION
No. C-02-04497 RMW.
Dec. 1, 2004.
Luke O Brooks, Patrick J. Coughlin, Lionel Z.
Glancy, Michael M. Goldberg, John K. Grant, Robert
A. Jigarjian, William S. Lerach, Kevin Ruf, David R.
Scott, for Plaintiff(s).
Meredith N. Landy, for Defendant(s).
ORDER ON DEFENDANTS' MOTION TO
DISMISS PLAINTIFF'S SECOND AMENDED
COMPLAINT AND STRIKE PORTIONS
THEREOF
WHYTE, J.
[Re Docket No. 89]
Page 1
claims on behalf of class members who
purchased ESST shares after February 27,
2002.
I. BACKGROUND
A. General Nature of Case
This is a securities fraud action brought on behalf of
a proposed class of persons who purchased the
publicly-traded securities of ESST between the dates
of January 23, 2002 and September 12, 2002 (“class
period”). Plaintiff contends that certain ESST officers
and directors made false and misleading statements
concerning ESST's operations and the prospects for
the year 2002. Plaintiff alleges that in December
2001, ESST's founder, defendant Chan, learned that
one of ESST's competitors, MediaTek, had developed
a superior competing chip that would be offered at
approximately the same price as ESST's chip, and
that at least one of ESST's largest customers, Shinco,
intended to shift its business to MediaTek. From this
foundation, plaintiff alleges that various statements
made by defendants between January 23, 2002 and
September 12, 2002 with respect to ESST's financial
outlook were false and misleading.
*1 This Document Relates to: ALL ACTIONS.
Currently before the court is the motion by
defendants ESS Technology, Inc. (“ESST”), Robert
L. Blair (“Blair”), Patrick Ang (“Ang”), Frederick
S.L. Chan (“Chan”), and James Boyd (“Boyd”)
(collectively “defendants”) to dismiss lead plaintiff
Steve Bardack's (“Bardack” or “plaintiff”) Second
Amended Complaint (“SAC”) or to strike portions
thereof. Plaintiff opposes the motions. The motion
was heard on March 19, 2004. The court has read the
moving and responding papers and heard the
argument of counsel. For the reasons set forth below,
the court denies the motion to dismiss Count I as to
defendants Blair, Boyd and ESST except as to
allegations of fraud committed prior to February 27,
2002.FN1 Those allegations are stricken and
dismissed. The motion to dismiss Count I as to
defendants Ang and Chan and Count III as to
defendant Chan is granted. The motion to dismiss
Count II is denied as to all defendants.
FN1. Defendants have not moved to strike
B. Procedural Background
Plaintiff filed this securities fraud action on
September 13, 2002. On January 21, 2003, the court
appointed plaintiff Barrack to serve as lead plaintiff
for the proposed class. Barrack then filed an amended
complaint on February 6, 2003, which defendants
moved to dismiss. However, prior to the noticed May
23, 2003 hearing on the motion, the parties submitted
a stipulation allowing plaintiff to file an amended
complaint and taking defendants' motion off calendar.
Plaintiff then filed a First Amended Complaint
(“FAC”),FN2 on May 20, 2003. The FAC alleged
three causes of action: (1) violation of section 10 of
the 1934 Act and Rule 10b-5 promulgated thereunder
as against all defendants; (2) violation of section
20(a) of the 1934 Act against the individual
defendants; and (3) violation of section 20A of the
1934 Act against defendant Chan. Defendants again
moved to dismiss on June 18, 2003. On October 3,
2003 the court granted defendants' motion to dismiss
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with 30 days leave to amend the complaint.
FN2. This was actually the second amended
complaint filed by Barrack.
*2 On November 3, 2003 plaintiff filed a Second
Amended Complaint (“SAC”). Defendants now
move to dismiss the SAC.
C. Plaintiff's Allegations
Plaintiff alleges that starting on January 23, 2002
with ESST's announcement of fourth quarter results
for 2001, and continuing through September 12, 2002
when ESST revised earnings and revenue downward,
defendants misled investors by making a number of
false and misleading statements designed to boost the
price of the stock. SAC ¶ ¶ 22-37. One motivation
for this purported scheme was the February 1, 2002
Secondary offering of 5.52 million shares of ESST
stock, which raised $45 million for ESST at a price of
$19.38 per share. SAC ¶ 21. According to plaintiff,
negative news about the loss of a major customer,
Shinco, was on the horizon, yet defendants failed to
reveal such information. This omission allegedly kept
the share price inflated, which gave defendants Chan,
Boyd, and Blair an opportunity in the following
months to take profits before the release of negative
information.
Plaintiff's argument focuses in part on his allegation
that ESST's management advised analysts at A.G.
Edwards on September 9, 2002 that the third quarter
was tracking as expected, just three days before
ESST announced that the third quarter revenues
would be between $60 and $64 million, down from
the previous estimate of $86 to $90 million, and that
net earnings would be between $.13 and $.21 instead
of between $.35 and $.38. SAC ¶ 35, Ex. 2. Plaintiff
asserts that ESST knew before the September 9
report to A.G. Edwards that it would not meet
earnings estimates because, in a conference call on
October 23, 2002, Boyd, the Chief Financial Officer
for ESST, admitted “by the late part in August it
became obvious there was going to be a problem with
the quarter.” SAC Ex. 4 (emph.added).
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chips are the primary processors driving digital video
and audio players including DVD, video CD and
MP3 players. Id. Defendant Chan is ESST's founder
and chairman. Defendant Blair is ESST's president
and chief executive officer. Defendant Boyd is
ESST's chief financial officer, and defendant Ang is
ESST's chief operating officer. SAC ¶ ¶ 14(a)-(d),
15. Plaintiff alleges that, with knowledge to the
contrary as early as December 2001, defendant ESST
made a number of positive statements in its filings
and in conference calls during the January 23, 2002
to September 12, 2002 class period.
Plaintiff quotes heavily from numerous press releases
and conference calls made by ESST during the class
period and appears to allege that they were all
intentional falsehoods. Defendants made upward
adjustments to expected first and second quarter
revenues in conference calls and press releases. The
forecasts were met. Defendant ESST failed, however,
to meet its expected third quarter revenue estimates,
which ultimately resulted in a 30% drop in ESST's
share price. The public statements with which
plaintiff takes issue can be divided generally into the
following categories: (1) misleading statements
leading up to the Secondary offering (SAC ¶ ¶ 2122); (2) misleading statements regarding first quarter
revenue and earnings (SAC ¶ ¶
23-26); (3)
misleading statements regarding second quarter
revenue and earnings (SAC ¶ ¶ 27-28, 30); (4)
misleading statements regarding third quarter revenue
and earnings (SAC ¶ ¶ 29-30, 32-35); and (5)
misleading statements about market share and
competition (SAC ¶ ¶ 26-27, 31).
*3 During the class period, plaintiff claims that
certain officers made optimistic forecasts,
downplayed competitive pressures and potential
customer defections, and predicted that ESST would
continue to be the market leader in DVD chips. See,
e.g., SAC ¶ ¶ 26, 31.
A significant portion of plaintiff's allegations that
defendants knowingly made misleading statements
are based on information obtained from anonymous
sources. The court first turns to the SAC's allegations
with respect to the information provided by these
unnamed witnesses. The court will then proceed to
plaintiff's allegations concerning false statements
made and finally to the allegations of scienter.
D. Factual Background
Defendant ESST is a designer, developer, and
marketer of highly-integrated digital processor chips
used in multimedia applications. SAC ¶ 13. ESST
1. Information Provided By Confidential Witnesses
In an attempt to plead the requisite scienter, plaintiff
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presents information allegedly obtained from a
number of confidential witnesses about defendants'
knowledge of the MediaTek product and ESST's
impending losses of sales.
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inference’ of scienter. Even accepting the veracity
and reliability of CW1's contentions, defendants'
actions after learning of this competing chip do not
suggest that defendants knew that ESST would not
meet its earnings projections.
a. Confidential Witness 1
b. Confidential Witness 2
Confidential Witness 1 (“CW1”) voluntarily
contacted plaintiff and “represented that he was
involved in the preparation of ESST's financial
results and had personal contact with Chan and
defendant Blair.” SAC ¶ 16(a). CW1 states:
that Chan learned in December 2001 from Steven
Shen (“Shen”) that MediaTek had developed a new
DVD chip that combined the encoder function with
the servo chip function, that the chip would be
offered at the same price as a single ESST chip,
resulting in a 50% price reduction and that four of
ESST's largest customers, including Shinco, APEX,
Chang Hong and TONIC intended to purchase the
new chip and that Shinco had decided to shift at least
50% of its purchases [from ESST] to MediaTek.
Id. According to CW1, Chan assigned the company's
Hong Kong director, Andy Ho, to confirm this
information. Two days later, the Hong Kong director
advised Chan that “ESST's customers intended to cut
their purchases in six to twelve months.” Id.
Chan then reportedly began looking to acquire a
company with technology that could compete with
MediaTek. Finally, CW1 “states that ESST reacted to
the adverse information regarding the expected
competition with MediaTek, by offering chips at
lower prices to their existing customers so that the
customers would stock-pile the DVD chips.” Id.
Plaintiff provides no information about CW1's job
title, tenure at ESST or job responsibilities. Although
CW1 provides details about what Chan allegedly
learned from Steven Shen about MediaTek's new
DVD chip, and a potential shift in customer
purchases in six to twelve months, plaintiff fails to
state how CW1 came to learn of this information.
Notably, plaintiff fails to establish a nexus between
CW1's job responsibilities and his allegations, so
there is no basis upon which to infer that CW1 had
first hand knowledge of these events, or that he was
basing his information on anything more than rumor.
Further, CW1's allegations regarding customer
purchase orders are vague as to what commitments
those customers had actually made. Since the
information from CW1 lacks meaningful detail and
evidence of reliability, it fails to support a ‘strong
*4 Confidential Witness 2 (“CW2”) was employed as
a software engineer at ESST's corporate headquarters
during the class period. SAC ¶ 16(b). CW2 “states
that in December 2001, ESST implemented a plan to
reduce its workforce in response to expected
competitive pressures in 2002.” Id. CW2 “recalls
being told by his supervisor in December 2001 that
ESST had some ‘tough times ahead’ and that one of
ESST's competitors was ‘going to kick the * * * * out
of us.” ’ Id. CW2 also “recalls that during December
2001, Chan (who typically made one or two business
trips to Asia a quarter) increased the frequency of his
trips to Asia in response to competitive problems and
slipping business in the Far East and made a number
of trips in December,” ostensibly to meet with
customers in Asia who were threatening to cut orders.
Id.
CW2 apparently has no firsthand basis for this
information but relies instead on an unnamed
source.FN3 Accordingly, the information fails to
meaningfully support a ‘strong inference’ of scienter.
Even accepting CW2's basis as adequate, CW2
merely describes pressure from competitors and
ESST's efforts to maintain market share.
FN3. CW2 also alleges a slowdown in
demand in December 2001, a plan to reduce
workforce, “tough times ahead,” and vague
statements about ESST competitors taking
market share. SAC ¶ 16(b). All of these
allegations come from other unnamed
sources, and CW2 has no firsthand basis for
making them.
c. Confidential Witness 3
Confidential Witness 3 (“CW3”) was employed as a
senior software engineer during the class period and
“confirms that ESST began laying off employees in
December 2001.” SAC ¶ 16(c). He does not provide
a basis for his knowledge or his conclusion that the
layoffs were in response to competitive pressure from
MediaTek's new DVD chip.
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d. Confidential Witness 4
Confidential Witness 4 (“CW4”) was an employee in
ESST's IT department during the class period and
states “that beginning in late 2001 ESST was under
considerable pressure to control costs” and that
“ESST was threatened with losing some of its market
share for its DVD chips.” SAC ¶ 16(d).
CW4 provides no nexus between his job duties and
his statement and no foundation upon which to
conclude that the layoffs were in response to
competitive pressures from MediaTek's new DVD
chip or, more significantly, that the layoffs meant that
defendants knew they could not produce and obtain
the numbers represented.
e. Confidential Witness 5
Confidential Witness 5 (“CW5”) was a senior design
engineer at ESST during the class period. CW5 states
“that he had discussions with colleagues in April
2002 regarding the competitive threat presented by
MediaTek and how this was resulting in ESST losing
market share.” SAC ¶ 16(e). CW5 also “recalls that
ESST did not have a chip that could compete with
MediaTek's new offering.” Id. As a senior design
engineer, CW5 would presumably have technical
knowledge about MediaTek's new chip and how it
compared with ESST's product. However, no
foundation is offered as to his knowledge about
ESST's market share.
f. Confidential Witness 6
Confidential Witness 6 (“CW6”) was an applications
engineer at ESST during the class period and states
that ESST started reducing employees in late 2001.
SAC ¶ 16(f). In addition, CW6 attended a new DVD
product demonstration in March 2001 and was told
that a second session would be held in July 2001. CW
6 states that this second session was canceled due to
failure of the DVD product at the initial test stage.
This allegation regarding the reason for the
cancellation lacks a basis for first hand knowledge
and provides no specifics about the product
demonstration, or its significance to the development
by ESST of an upgraded chip, or ESST's ability to
compete with MediaTek or other competitors.
g. Confidential Witness 7
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*5 Confidential Witness 7 (“CW7”) was an employee
at Shinco, one of ESST's customers who allegedly
intended to transfer half of its ESST purchases to
MediaTek. CW7 was a sales director during the class
period and states that “he was responsible for sales of
Shinco's DVD products and was familiar with
Shinco's practices in dealing with suppliers.” SAC ¶
16(g). CW7 states that Shinco has started to shift to a
new “system-on-a-chip” DVD chip in the first half of
2002. Id. CW7 further states that the design and
production of DVD products is a six-to-eight month
process as it requires considerable investment in
research, development and testing, and opines that
“Shinco would have advised ESST of the change to
the new chip in late-2001.” Id.
CW7 provides no basis for knowing first hand that
Shinco's orders to ESST had decreased, or that ESST
knew of Shinco's alleged plan to place fewer orders.
Further, the allegation that Shinco “would have
alerted ESST” in late 2001 of their shift to a new chip
is speculative.
h. Confidential Witness 8
Confidential Witness 8 (“CW8”) was an ESST chip
production planner during the Class period,
responsible for planning and placing wafer and chip
orders with ESST's wafer and chip manufacturers.FN4
SAC ¶ 16(h). During the first quarter of 2002, CW8
states that Patrick Yeto, ESST's Vice President of
Operations (who reported directly to Blair), directed
the department to stop wafer and chip orders from
these manufacturers as a result of MediaTek's
competition. In August 2002, CW8 received an email
from Yeto directing him to cut back production of
certain DVD chips-representing over 30% of ESST's
forecasted revenues-by 20% to 50%.
FN4. Taiwan Semiconductor Manufacturing
Company,
United
Microelectronics
Corporation, Advanced Semiconductor
Engineering, and Silterra.
CW8 also states that ESST's weekly sales flash
reports in August 2002 were actually decreasing
rather than increasing, and these reports were
submitted directly to Blair.
CW8's statement about stopping the purchase of
wafers in the first quarter of 2002 provides little
specific information (e.g. the status of existing
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inventory, length of stoppage, etc.). The alleged
August direction to cut production by 20% to 50%,
although lacking specifics about the circumstances,
does tend to bolster other evidence that by August
ESST knew it would not make its third quarter
earning forecasts.
Page 5
strong inference that defendants were consciously
making false and misleading statements before mid2002 when other evidence suggests ESST recognized
it would have an unfavorable third quarter.
l. Confidential Witness 12
i. Confidential Witness 9
Confidential Witness 9 (“CW9”) was an ESST
Director of Sales responsible for supervising sales to
DVD manufacturers in China during the class period.
SAC ¶ 16(i). CW9 states that ESST knew by May
2002 that ESST was losing market share because of
MediaTek's sales to ESST's customers, including
Shinco.
j. Confidential Witness 10
Confidential Witness 10 (“CW10”) was an ESST
Senior Marketing Manager also responsible for sales
to DVD manufacturers in China during the class
period. SAC ¶ 16(j). CW10 states that ESST realized
it was losing market share to MediaTek and Zoran
Corporation by early 2002, and that this loss would
negatively impact earnings. ESST allegedly had
specific knowledge of loss of market share at Shinco,
and a loss to MediaTek of about 20%. This
information was allegedly conveyed to Lawrence Ko,
a supervisor in ESST's China office.
k. Confidential Witness 11
*6 Confidential Witness 11 (“CW11”) was employed
as a manager of sales administration by ESST during
the class period. CW11 “was aware that competition
from MediaTek constituted a significant problem in
the second half of 2001 and that in late 2001 ESST
was aware of a significant loss of business due to
MediaTek's product introductions of advanced DVD
chips.” SAC ¶ 16(k). ESST's development of a
competing chip was allegedly six to eight months
behind Blair's public representations. In light of these
sales trends and customer migration, CW11 states
that ESST's third quarter public revenue forecasts had
“no meaningful basis.”
Similar to plaintiff's allegations attributed to other
confidential witnesses, the information allegedly
obtained from CW9, CW10 and CW11 lack
meaningful foundation, details and specificity. These
allegations, even taken as true, do not support a
Confidential Witness 12 (“CW12”) was an area sales
manager at ESST during the class period. CW12
states that ESST had two major design cycles each
year, one starting in August for spring release, and
the other in January for August release. SAC ¶ 16(l).
m. Confidential Witness 13
Confidential Witness 13 (“CW13”), an employee at
Dynax Electronics during the class period, merely
identifies Shen as the president of Dynax. SAC ¶
16(m).
2. False Statements
During the Class period, plaintiff alleges that
defendants made various false statements beginning
with one made February 28, 2002 and continuing
until the revelation of the truth on September 12,
2002. Specifically, plaintiff claims that defendants
assured investors in March, April, May, June and
July 2002 that ESST was not at risk of losing
significant market share to competitors, including
MediaTek, Inc., and that ESST would continue to
report large revenue increases throughout 2002.
Defendants stated on July 24, 2002 that ESST
expected to report third quarter 2002 revenues of $86
to $90 million. In an August 8, 2002 ESST press
release, defendants repeated their assurance that third
quarter 2002 revenues would reach $86 to $90
million. One month later, on September 9, 2002,
ESST assured financial analysts that the quarter was
tracking according to expectations. On September 12,
2002, only three days after ESST management
advised that the third quarter was on track, ESST
publicly announced that third quarter revenues would
miss defendants' public forecast of $86 to $90 million
and that revenues would be between $60 and $64
million and that earnings per share would not be
between $.35 and $.38 as previously estimated but
between $.13 and $.21.
In an October 23, 2002 conference call, defendants
admitted that in August 2002 they were aware that
ESST was experiencing critical negative trends.
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During the October 23, 2002 conference call,
defendant Blair stated that sales did not ramp as
expected in mid-August and that the weak demand
impacted all product lines and all geographies.
Defendant Boyd admitted that “by the late part in
August it became obvious there was going to be a
problem with the quarter.” (SAC ¶ 35, Ex. 4).
3. Scienter
*7 Plaintiff claims that the information obtained from
the confidential witnesses shows that defendants
knew they were making false representations.
Plaintiff further contends that ESST knew that it was
facing a significant financial downturn before its
secondary offering completed on February 1, 2002,
and that defendants were motivated not to disclose
that adverse information so that the offering would be
successful. ESST obtained an infusion of $45 million
from the offering. SAC ¶ 19. Plaintiff also alleges
that the individual defendants were further motivated
in their scheme to keep ESST's stock price inflated
because they stood to gain by selling their own shares
during or around the time of the offering.
Plaintiff also claims that defendants engaged in
channel stuffing in order to meet fourth quarter
results in December 2001, to complete the secondary
offering on February 1, 2002, and to benefit Chan so
he could sell $55 million of his shares. Channel
stuffing “is the oversupply of distributors in one
quarter to artificially inflate sales, which will then
drop in the next quarter as distributors no longer
make orders while depleting their excess supply.”
Steckman v. Hart Brewing, Inc., 143 F.3d 1293, 1298
(9th Cir.1998). “[C]hannel stuffing claims may have
some probative value insofar as the channel stuffing
was done so as to artificially inflate income, but there
may also be other legitimate reasons for attempting to
achieve sales earlier.” Broudo v. Dura Pharms., 339
F.3d 933, 940 (9th Cir.2003); see Greebel v. FTP
Software, Inc., 194 F.3d 185, 203 (1st Cir.1999)
(value of channel stuffing evidence weak, and does
not support strong inference of scienter). Here,
plaintiff fails to state with particularity the facts upon
which the allegations of channel stuffing are based.
II. LEGAL STANDARD
To determine whether a private securities fraud
complaint can survive dismissal under Federal Rule
of Civil Procedure 12(b)(6), the court must determine
whether particular facts in the complaint, taken as a
Page 116 of 121
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whole, raise a strong inference that defendants
intentionally or with deliberate recklessness made
false or misleading statements to investors. In Re
Read-Rite, 335 F.3d 843, 846 (9th Cir.2003);
Ronconi v, Larkin 253 F.3d 423, 429 (9th Cir.2001).
“In an effort to deter abusive and frivolous securities
fraud claims, Congress enacted the PSLRA, which
amended the 1934 Act and raised the pleading
standards for private securities fraud claims.” No. 84
Employer-Teamster v. America West Holding
(“America West” ), 320 F.3d 920, 931 (9th Cir.2003)
(citing In re Silicon Graphics Inc. Sec. Litig.
(“Silicon Graphics” ), 183 F.3d 970, 973 (9th
Cir.1999)). “[P]laintiffs proceeding under the PSLRA
can no longer aver intent in general terms of mere
‘motive and opportunity’ or ‘recklessness,’ but
rather, must state specific facts indicating no less than
a degree of recklessness that strongly suggests actual
intent.” Silicon Graphics, 183 F.3d at 979; America
West, 320 F.3d 920 at 931 (“The PSLRA altered the
pleading requirements for private litigants by
requiring that a complaint plead with particularity
both falsity and scienter.”); Ronconi, 253 F.3d at 429
n. 6.
*8 To survive the higher pleading standards required
by the PSLRA, the complaint 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); America West,
320 F.3d at 931. The complaint must also “state with
particularity facts giving rise to a strong inference
that the defendant acted with the required state of
mind.” 15 U.S.C. § 78u-4(b)(2). The dual pleading
requirements of § § 78u-4(b)(1) and (b)(2) are
incorporated into a single inquiry, because falsity and
scienter are generally inferred from the same set of
facts. Read-Rite Corp., 335 F.3d at 846; Ronconi, 253
F.3d at 429. If a plaintiff fails to plead either the
alleged misleading statements or scienter with
particularity, his or her complaint must be dismissed.
See America West, 320 F.3d at 931-32; § 78u4(b)(3)(A). Here, plaintiff relies on the statements of
various confidential witnesses to establish falsity and,
in large part, to show scienter. As discussed below,
the pleading standard is met as to defendants Blair,
Boyd and ESST except as to allegations of fraud
prior to February 27, 2002.
The PSLRA provides a safe harbor from liability for
certain forward-looking statements. Forward-looking
statements contain “a projection of revenues, income,
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or earnings per share, management's plans or
objectives for future operations, and a prediction of
future economic performance.” In re Splash Tech.
Holdings, Inc. Sec. Lit., 160 F.Supp.2d 1059, 1068
(N.D.Cal.2001); 15 U.S.C. § 78u-5(i)(1)(A)-(C).
Assumptions underlying these statements are also
forward-looking. Id.; 15 U.S.C. § 78u-5(i)(1)(D). On
the other hand, statements concerning historical or
current facts are not forward-looking. In re Splash,
160 F.Supp.2d at 1068. For Safe Harbor protection
under the PSLRA to apply, the forward-looking
statements must either be: (1) accompanied by
“meaningful cautionary statements identifying
important factors that could cause actual results to
differ materially;” or (2) must not be made with
actual knowledge of falsity. See 15 U.S.C. § 78u5(c)(1)(A); 15 U.S.C. § 78u-4(b)(1)-(2).) “It is
clearly insufficient for plaintiffs to say that a later,
sobering revelation makes an earlier, cheerier
statement a falsehood.” Yourish v. Cal. Amplifier,
191 F.3d 983, 997 (9th Cir.1999).
“A present-tense statement can qualify as a forwardlooking statement as long as the truth or falsity of the
statement cannot be discerned until some point in
time after the statement is made.” In re Splash, 160
F.Supp. at 1067; Harris v. Ivax Corporation, 182
F.3d 799, 805 (11th Cir.1999), reh'g denied, 209 F.3d
1275 (11th Cir.2000) (classifying the statement “the
challenges unique to this period in our history are
now behind us” as forward-looking). “Whether a
statement qualifies for the safe harbor is an
appropriate inquiry on a motion to dismiss.” In re
Splash, 160 F.Supp.2d at 1068; 15 U.S.C. § 78u5(e).
III. ANALYSIS
A. Section 10(b) of the 1934 Act and Rule 10(b)(5)
Promulgated Thereunder
*9 Plaintiff's SAC lists several statements made by
defendants, in particular several financial projections
for the third quarter of 2002, which are forwardlooking. SAC ¶ ¶ 25-31. For example, plaintiffs cite
defendants' press release dated June 24, 2002, which
updates guidance for the third quarter, stating that
“ESS expects third quarter revenue and earnings to
exceed previous guidance.” Id. at ¶ 29. Other
examples include a press release dated July 24, 2002
where defendants state, “We believe we will maintain
our leadership position in the areas of new products,
features and services.... With these new product
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introductions, we believe we can continue to lead the
high growth market for digital home entertainment
products....” Id. at ¶ 30. This same press release
reiterates defendants' estimate of revenues of $86 to
$90 million with earnings per share o $.35 t0 $.38 for
the third quarter. Id. at ¶ 30. Plaintiff's complaint
also cites a July 24, 2002 conference call, during
which defendants' CEO stated, “I think we will
remain the dominant supplier at Shinco....” Id. at ¶
31. Each of these statements involve predictions
about economic performance, the truth or falsity of
which could not be discerned until some point after it
was made. Similarly, the veracity of statements in
paragraphs 25 through 28 about future trends and
performance issued with first and second quarter
results could not be determined until some point after
the statements were made. Consequently, these
statements are forward-looking, and protected by the
PSLRA Safe Harbor provisions if they were
accompanied by either meaningful cautionary
statements, or the defendants had no actual
knowledge of their falsity.
“Cautionary statements must, within context, be
meaningful; boilerplate, generalized warnings do not
suffice to balance specific predictions.” In re Clorox
Co. Sec. Litig., 238 F.Supp.2d 1139, 1142
(N.D.Cal.2002). In Clorox the plaintiffs claimed that
during an April 22, 1999 conference call Clorox
materially misrepresented the financial health of one
of its companies. Id. at 1144. The court found that the
challenged statements were forward-looking because
a Clorox representative “began the conference call by
asserting that some of her statements would be
forward-looking, and a prediction about future events
is self-evidently a forward-looking statement.” Id. at
1145. The court also found the representative made
meaningful cautionary statements when she “began
the call by disclaiming certainty, and referred
listeners to additional cautions in Clorox's June 30,
1998, Form 10K filing. That filing contained
additional, albeit general, statements about the
potential difficulties Clorox might face and the
potential problems with the merger.” Id. The court
found that these “cautions provide the requisite
contextual warnings for the Safe Harbor provision ...
to apply.” Id.
Defendants' warnings in the instant case are almost
identical to those presented by Clorox. Plaintiff
claims that defendant made misleading statements in
several press releases. However, each of these press
releases warn that the matters discussed in each
respective press release include forward-looking
statements. The releases also disclaim certainty and
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direct readers to defendants' SEC filings (Form 10-K
and Form 10-Q). ESST's Form 10-K for 2001
includes an extensive discussion about increased
pricing pressures, strong competition from
competitors with significant competitive advantages,
and concerns about sales being concentrated with
relatively few distributors and customers. That the
2001 Form 10-K predates the 2002 press releases
does not affect its applicability to statements made in
2002. The Clorox court relied on Clorox's 1998 Form
10-K even though the challenged statements were
made in April 1999. Consequently, it is permissible
to rely on defendants' 2001 10-K to provide
meaningful cautionary statements for the challenged
press releases made in 2002. ESST's press releases,
therefore, contain sufficient meaningful cautionary
language related to its forward-looking statements in
the releases to protect ESST under the PSLRA's Safe
Harbor provisions.
*10 In addition, the evidence does not support the
allegation that defendants had actual knowledge of
the falsity of their statements until sometime in mid2002. Plaintiff relies on the information obtained
from the anonymous sources. “Reliance on
confidential witnesses is not per se improper under
the PSLRA, notwithstanding its requirement that a
plaintiff plead ‘all facts' when making allegations
based on information and belief.” In re Northpoint
Communications Group, Inc., Sec. Litig., 221
F.Supp.2d 1090, 1097 (N.D.Cal.2002) (“Northpoint
II” ) (citing In re McKesson HBOC, Inc., Sec. Litig.,
126 F.Supp.2d at 1271. “To contribute meaningfully
toward a ‘strong inference’ of scienter, however,
allegations attributed to unnamed sources must be
accompanied by enough particularized detail to
support a reasonable conviction in the informant's
basis of knowledge.” Northpoint II, 221 F.Supp.2d at
1097 (citations omitted); In re U.S. Aggregates, Inc.
Securities Litigation, 235 F.Supp.2d 1063, 1075
(N.D.Cal.2002). Such detail should include each
witness' job title, tenure, and a description of his or
her responsibilities while at the company, as this
“background detail allows for a better evaluation of
each witness' basis of knowledge.” Id. Further, when
such allegations must prove a “strong inference” of
scienter, a basis for establishing first hand
knowledge, rather than secondhand rumor, is
required. See id. at 1098. Witnesses must also state
how they came to learn of the information provided.
Northpoint I, 184 F.Supp.2d at 1000. Here, plaintiff
relies on confidential sources but fails in the main to
provide the particularized information that would
permit a reasonable conviction that defendants knew
their forward looking statements were false when
Page 118 of 121
Page 8
made. At most, the sources suggest that ESST faced
competitive pressures, made efforts to contain costs,
and may have learned sometime in mid-August 2002
that their estimates for the third quarter were not
going to be met. They do not permit a strong
inference that defendants knew before mid-2002 that
their revenue and earning estimates could not be met
or that their competitive advantage could not be
maintained.
Plaintiff also points to certain sales of ESST shares
by defendants Blair, Boyd and Chan as showing
scienter. Blair sold 5000 shares at $18.85 per share
on January 23, 2002, 5000 shares on January 24,
2002 at $19.60 per share, 20,000 shares on March 7,
2002 at $25.00 per share and 20,000 shares on March
11, 2002 at $25.01. The total revenue received for
these shares was $1,289,200 (29% of his holdings). It
appears that Blair's sales were disclosed pursuant to a
pre-planned trading program established in December
2001. Request J. Notice Ex. U. Defendant Chan sold
2,300,000 shares on February 6, 2002 at $18.22 per
share and 720,000 shares on March 11, 2002 at
$18.22 for total revenue of $13,118,400 (22% of his
holdings). Defendant Boyd sold 20,000 shares on
May 7, 2002 at $25.78 per share for total revenue of
$515,600 (29% of his shares). Defendant Ang,
ESST's Executive Vice President and Chief
Operating Officer (“COO”), made no sales. The
timing and amounts of these sales do not suggest that
defendants were scheming to keep the price of ESST
shares up while they unloaded part of their holdings.
Sales took place before the first alleged misleading
statement and before there is convincing evidence
that defendants recognized that the third quarter
would be down from expectations. Further, although
the revenue realized from the sales was significant,
the percentage of holdings sold do not suggest an
attempt to unload a majority of their shares.
*11 “Insider stock sales are not inherently
suspicious....” In re Vantive, 283 F.3d at 1092. For
stock sales to be probative of scienter, insider trading
must be “dramatically out of line with prior trading
practices at times calculated to maximize the personal
benefit from undisclosed inside information.” In re
Silicon Graphics, 183 F.3d at 986, quoting In re
Apple Computer Sec. Litig., 886 F.2d 1109, 1117 (9th
Cir.1989). The factors to consider when evaluating
the probity of insider stock sales are: (1) the amount
and percentage of shares sold by the insider; (2) the
timing of the sales; (3) whether the sales were
consistent with the insider's prior trading history. In
re Silicon Graphics, 183 F.3d at 986. Each factor
should be considered, while none is dispositive. See
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In re Vantive, 283 F.3d at 1092-93 (sale of 74% of
shares, while suspicious, did not raise a strong
inference of scienter where remaining factors did not
raise suspicion). Here, the timing of the individual
defendants' insider trading does not support an
inference of scienter. Nor does the percentage of
shares sold. See, e.g., Ronconi, 253 F.3d at 435
(amount sold by CEO and CFO not suspicious where
they sold 10% and 17%, respectively, of shares and
options.); cf. America West, 320 F.3d at 939 (amount
suspicious where nine individual defendants all sold
between 88% and 100% of holdings).
third quarter revenues and earnings were “not
tracking according to expectations” include: (1) the
admission by Blair on October 23, 2002 that “by the
late part in August it became obvious there was going
to be a problem with the [third] quarter;” (2) the
temporal proximity between the September 9, 2002
statement that ESST would meet its estimates and the
September 12, 2002 disclosure that ESST would miss
its forecast by $26 million; and (3) the e-mail from
Yeto to CW8 directing a cutback of certain DVD
chips representing over 30% of ESST's forecasted
revenues by 20%.
Plaintiff argues that three statements made by Boyd
and Blair are not forward-looking. Specifically,
plaintiff cites a September 9, 2002 meeting between
those defendants and A.G. Edwards wherein
defendants stated: (1) the third quarter was
progressing as expected, (2) that third quarter pricing
trends continued to play out as expected without
material variance, and (3) the third quarter was
tracking as expected. Opp. at 8.FN5 Plaintiff is correct
that these are not forward-looking statements,
because their truth or falsity could be determined at
the time they were made. See Harris v. Ivax Corp.,
183 F.3d 799, 866 (11th Cir.1999) (explaining that
observed facts such as “prices have continued to
decline” do not constitute assumptions and are not
forward-looking statements). Thus, the question is
whether the Second Amended Complaint pleads
sufficient facts showing defendants were deliberately
or consciously reckless when making the three
statements. See No. 84 Employer-Teamster Joint
Council Pension Trust Fund v. Am. W. Holding
Corp., 320 F.3d 920, 931 (9th Cir.2003) ( “In this
Circuit the required state of mind [under the PSLRA]
is one of ‘deliberate or conscious recklessness.” ’).
The court concludes that it does.
*12 The temporal proximity between the September
9 assurance and the September 12 announcement that
third quarter revenues would be $26 million short is
not in itself enough to satisfy the requirements of
Rule 9(b). However, it certainly bolsters the
allegations that defendants knew their positive
statements on September 9 were false when made.
See Yourish v. California Amplifier, 191 F.3d 983,
997 (9th Cir.1999).
FN5. The statements made during this
interview became the basis of a subsequent
A.G. Edwards analyst report which stated,
“We had the opportunity to meet with
management
of
ESS
Technology
yesterday[.] The following are the more
salient points from our meeting: Business
Update-Pricing trends continue to play out
as expected, with no material variance either
positively or negatively.... Q3 appears to be
tracking according to expectations.” SAC ¶
35, Ex. 2.
The facts showing that there is a strong inference that
defendants knew before September 12, 2002 that the
The court, in determining whether plaintiff has
sufficiently alleged scienter, can properly consider
the total of the allegations made by plaintiff.
In assessing whether Plaintiffs have sufficiently pled
scienter, we must consider whether the total of
plaintiffs' allegations, even though individually
lacking, are sufficient to create a strong inference that
defendants acted with deliberate or conscious
recklessness. In determining whether a strong
inference of scienter exists, we must consider all
reasonable inferences, whether or not favorable to the
plaintiff.
Nursing Home Pension Fund, Local 144 v. Oracle
Corp., 380 F.3d 1226, 1230 (9th Cir.2004).
Defendants Ang and Chang submit that plaintiff has
failed to allege that they made or participated in any
of the allegedly misleading statements. Plaintiff
counters the SAC is sufficient to hold them in the
case pursuant to the “group-published” doctrine
because of their positions at ESST. Although the law
is not settled as to the effect of the PSLRA on the
“group-published” doctrine, it appears that “[i]n order
to satisfy the stringent pleading requirements of the
PSLRA, a complaint seeking to attribute information
published by an organization to an individual
defendant should state, with particularity, facts
indicating that the individual defendant was directly
involved in the preparation of the allegedly
misleading statements.” In re Lockheed Martin Corp.
Securities Litigation, 272 F.Supp.2d 928, 936
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Not Reported in F.Supp.2d
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(Cite as: Not Reported in F.Supp.2d)
(C.D.Cal.2002). Plaintiff has failed to do this with
respect to defendants Ang and Chang. Therefore, the
motion to dismiss Count I as to them is granted.
B. Section 20(a) of the 1934 Securities Act (Control
Liability)
Plaintiff contends that by reason of their executive
and managerial positions with ESST the individual
defendants had the power and authority to cause
ESST to engage in the wrongful conduct alleged.
Neither side's briefing addresses the control liability
question. However,
[i]n order to prove a prima facie case under Section
20(a), a plaintiff must prove: (1) a primary violation
of federal securities law and (2) that the defendant
exercised actual power or control over the primary
violator. In order to make out a prima facie case, it is
not necessary to show actual participation or the
exercise of power; however, a defendant is entitled to
a good faith defense if he can show no scienter and
an effective lack of participation.
Whether the defendant is a controlling person is an
intensely factual question, involving scrutiny of the
defendant's participation in the day-to-day affairs of
the corporation and the defendant's power to control
corporate actions. “Control” is defined in the
regulations as “the possession, direct or indirect, of
the power to direct or cause the direction of the
management and policies of a person, whether
through the ownership of voting securities, by
contract, or otherwise.”
*13 No. 84 Employer-Teamster Joint Council
Pension Trust Fund v. America West Holding Corp.,
320 F.3d 920, 945 (9th Cir.2003) (internal citations
omitted). In light of the significant and responsible
positions of Chan and Ang, a factual question exists
as to whether they were controlling persons.
C. Section 20A of the 1934 Act
Under Section 20A of the 1934 Securities Act,
[a]ny person who violates any provision of this title
or the rules and regulations thereunder by purchasing
or selling a security while in possession of material,
nonpublic information shall be liable ... to any person
who, contemporaneously with the ... sale of securities
that are the subject of such violation, has purchased
... of the same class.
Plaintiff contends that Chan's sales in on February 6,
Page 10
2002 and February 19, 2002 violated Section 20A.
However, the SAC does not show that Chan had
material nonpublic information in February 2002.
Therefore, Count III is dismissed.
D. Leave to amend
Leave to amend is to be freely granted when justice
so requires. See Fed. R. Civ. P. 15(a); Lopez v. Smith,
203 F.3d 1122, 1127 (9th Cir.2000) (leave to amend
should be granted unless the district court
“determines that the pleading could not possibly be
cured by the allegation of other facts”). Plaintiff has
filed three amended complaints. Because plaintiff has
had ample opportunity to plead a viable complaint,
leave to amend is denied. “[T]he purpose of the
PSLRA would be frustrated if district courts were
required to allow repeated amendments to complaints
filed under the PSLRA.” Miller v. Champion
Enterprises Inc., 346 F.3d 660, 692 (9th Cir.2003);
see Lipton, 284 F.3d at 1039 (where basic facts
alleged and analyzed, and plaintiff cannot cure flaws
in pleading, dismissal with prejudice proper); Silicon
Graphics, 183 F.3d at 991 (denying leave to amend
where defects in pleadings not curable by
amendment).
IV. ORDER
For the foregoing reasons, it is hereby ordered that
the motion to dismiss Count I as to defendants Blair,
Boyd and ESST is denied except as to allegations
pleading fraud prior to February 27, 2002. Those
allegations are stricken and dismissed. The motion to
dismiss Count I as to defendants Ang and Chan and
Count III as to defendant Chan is granted. The
motion to dismiss to Count II is denied as to all
defendants.
Counsel are responsible for distributing copies of this
document to co-counsel that have not registered for
e-filing under the court's CM/ECF program.
N.D.Cal.,2004.
In re ESS Technology, Inc. Securities Litigation
Not Reported in F.Supp.2d, 2004 WL 3030058
(N.D.Cal.)
Briefs and Other Related Documents (Back to top)
• 2006 WL 1785806 (Trial Pleading) ÝCorrected
Proposed¨ Third Amended Complaint for Violations
of the Federal Securities Laws (May 5, 2006)
© 2006 Thomson/West. No Claim to Orig. U.S. Govt. Works.
Case 5:04-cv-04156-JW
Document 133
Filed 11/17/2006
Not Reported in F.Supp.2d
Not Reported in F.Supp.2d, 2004 WL 3030058 (N.D.Cal.)
(Cite as: Not Reported in F.Supp.2d)
Original Image of this Document (PDF)
• 2006 WL 1042097 (Trial Pleading) Class Action
(Mar. 24, 2006) Original Image of this Document
(PDF)
• 2006 WL 1042096 (Trial Motion, Memorandum
and Affidavit) Plaintiff's Response to Defendants'
Miscellaneous Administrative Request to Vacate the
March 14,2006 Hearing on Plaintiff's Discovery
Motion (Mar. 8, 2006) Original Image of this
Document (PDF)
• 2006 WL 728087 (Trial Motion, Memorandum and
Affidavit) Defendants' Reply in Support of Motion
for A Protective Order Against Certain Discovery
(Feb. 28, 2006) Original Image of this Document
(PDF)
• 2006 WL 728088 (Trial Motion, Memorandum and
Affidavit) Plaintiff's Reply in Support of Motion to
Compel Production of Documents Responsive to the
First Set of Document Requests (Feb. 28, 2006)
Original Image of this Document (PDF)
• 2006 WL 709355 (Trial Motion, Memorandum and
Affidavit) Defendants' Opposition to Plaintiff's
Motion to Compel Production of Documents
Responsive to the First Set of Document Requests
(Feb. 21, 2006) Original Image of this Document
(PDF)
• 2006 WL 728086 (Trial Motion, Memorandum and
Affidavit) Plaintiff's Opposition to Defendants'
Motion for A Protective Order Against Certain
Discovery (Feb. 21, 2006) Original Image of this
Document (PDF)
• 5:02cv04497 (Docket) (Sep. 13, 2002)
END OF DOCUMENT
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LEXSEE 2006 US DIST LEXIS 81420
In re IMPAX LABORATORIES, INC. SECURITIES LITIGATION. This Document Relates to All Actions
NO. C 04-04802 JW
UNITED STATES DISTRICT COURT FOR THE NORTHERN DISTRICT OF
CALIFORNIA, SAN JOSE DIVISION
2006 U.S. Dist. LEXIS 81420
March 1, 2006, Decided
COUNSEL: [*1] For Charles Rosen, On behalf of himself and All others similarly situated, Plaintiff: Azra Z.
Medhi, LEAD ATTORNEY, Patrick J. Coughlin, LEAD
ATTORNEY, Willow E. Radcliffe, Lerach Coughlin
Stoia Geller Rudman & Robbins LLP, San Francisco,
CA; Darren J. Robbins, William S. Lerach, Lerach
Coughlin Stoia Geller Rudman & Robbins LLP, San
Diego, CA.
For Thomas Galvin, Jr., MOvant: Robert S. Green,
Green Welling LLP, San Francisco, CA.
JUDGES: James Ware, United States District Judge.
OPINION BY: James Ware
OPINION:
For Edward Mihalik, Plaintiff: Robert S. Green, Green
Welling LLP, San Francisco, CA.
For Dr. Melvin M Owen, Plaintiff: Azra Z. Medhi,
LEAD ATTORNEY, Shana Eve Scarlett, LEAD
ATTORNEY, Lerach Coughlin Stoia Geller Rudman &
Robbins LLP, San Francisco, CA.
For IMPAX Laboratories, Inc., Defendant: Dale E. Barnes, Jr., LEAD ATTORNEY, Bingham McCutchen LLP,
San Francisco, CA; Joseph Otto Click, LEAD
ATTORNEY, Kerry Brainard, Michael Joseph, Blank
Rome LLP, Washington, DC.
For Barry R. Edwards, Charles Hsiao, Larry Hsu, Cornel
C. Spiegler, David S. DollDavid J. Edwards, Defendants:
Joseph Otto Click, LEAD ATTORNEY, Kerry Brainard,
Michael Joseph, Blank Rome LLP, Washington, DC.
For United Food & Commercial Workers Union Local
655, ALF-CIO, Food Employers Joint Pension Plan,
Movant: Monique Winkler, LEAD ATTORNEY, Shana
Eve [*2] Scarlett, LEAD ATTORNEY, Azra Z. Mehdi,
Lerach Coughlin Stoia Geller Rudman & Robbins LLP,
San Francisco, CA; Tricia Lynn McCormick, Lerach
Coughlin Stoia Geller Rudman & Robbins LLP, San
Diego, CA.
For Haiduk Group, Movant: Elizabeth P. Lin, Milberg
Weiss Bershad & Schulman LLP, Los Angeles, CA.
ORDER GRANTING DEFENDANTS' MOTION
TO DISMISS WITH LEAVE TO AMEND
I. INTRODUCTION
Plaintiffs filed a securities class action against Defendants IMPAX Laboratories, and certain of Impax's
senior officers and directors (collectively, "Defendants")
for alleged violations of the Securities Exchange Act of
1934 and Rule 10b-5 promulgated thereunder. Presently
before the Court is Defendants' motion to dismiss Plaintiffs' First Amended Consolidated Complaint ("FAC").
The Court held a hearing on Defendants' Motion on February 6, 2006. Based on the arguments of counsel at the
hearing and on the papers submitted, the Court GRANTS
Defendants' Motion to Dismiss without prejudice.
II. BACKGROUND
Plaintiffs filed the present suit [*3] against Defendants on behalf of all persons who purchased Impax securities between May 5, 2004 and November 3, 2004
("Class Period"), alleging violations of the Securities
Exchange Act of 1934 and Rule 10b-5. Lead Plaintiff
United Food & Commercial Workers Union Local 655,
AFL-CIO, Food Employers Joint Pension Plan ("Union"), and named Plaintiff Dr. Melvin M. Owen purchased Impax securities during the Class Period and
claim losses as a result of Defendants' actions. FAC P89.
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Page 2
2006 U.S. Dist. LEXIS 81420, *
Defendant Impax is a pharmaceutical company that
develops, sells, and markets generic pharmaceuticals,
including variations of bupropion hydrochloride ("bupropion"), which is the generic version of Wellbutrin and
Zyban. FAC P4, 10. Individual Defendants Barry R. Edwards, Dr. Charles Hsiao, Dr. Larry Hsu, Cornel C.
Spiegler, David S. Doll, and David J. Edwards are directors and officers of Impax. FAC P11-17.
Although not a party to this action, Teva Pharmaceutical Industries. Ltd., ("Teva") plays an important role
in both Plaintiffs' and Defendants' versions of the events
in dispute. Teva is a global pharmaceutical company that
entered into a Strategic Alliance Agreement ("SAA")
with Impax in 2001. The SAA [*4] provided that Impax
would supply Teva with all of its requirements for twelve
controlled-release generic products and Impax would
share profits with Teva. FAC P22-23. Under the SAA,
Impax provided Teva with its requirements for the
twelve products, and Teva acquired exclusive marketing
rights for several Impax products, including two bupropion products. FAC P22-23.
The following facts are alleged in the FAC: On May
5, 2004, Impax announced its first ever profitable quarter
("1Q04"), and shares of Impax rose $ 3.70 on trading
volume of almost 3.7 million shares. On August 9, 2004,
Impax again reported a profitable quarter ("2Q04"). The
profits in 1Q04 and 2Q04 were due in significant part to
the sales of bupropion products. FAC P26. On November
3, 2004, Defendants disclosed that certain financial reports would be delayed to allow Impax's independent
auditors more time to complete their review of Impax's
financial statements. Plaintiffs allege that this news
caused the price of Impax to drop 23% on a volume of
6.77 million shares traded. FAC P3. On November 9,
2004, Impax announced a restatement of its financial
results for the first and second quarters of 2004 due to
adjustments made [*5] as a result of consumer credits
granted in March 2004 by Teva on sales of Impax's bupropion products. Plaintiffs claim that Defendants' actions caused an eventual decline in Impax's stock price.
According to Plaintiffs, Defendants inflated the
1Q04 and 2Q04 revenues and failed to accrue adequate
reserves for Teva's customer credits on bupropion. Plaintiffs further allege that 'Defendants caused a build-up of
bupropion even though Impax was not the first-to-market
with a generic Wellbutrin. FAC P27-29. The build-up of
excess inventory is purportedly of particular importance
because the two-year shelf life of bottled bupropion
made the excess inventory obsolete and rendered worthless any inventory returned by Teva's customers. FAC
P29. The first claim for relief in the FAC is for violation
of 10(b) of the Securities and Exchange Act of 1934 and
Rule 10b-5 thereunder, by issuing false or misleading
statements about Impax's reserves, revenues, and income.
The second claim for relief in the FAC alleges a violation of Section 20(a) of the 1934 Act for the acts of Defendants as control persons directing the acts underlying
liability for the first claim for relief. Defendants filed the
instant [*6] motion to dismiss pursuant to the Private
Securities Litigation Reform Act of 1995 ("PSLRA") and
rules 9(b) and 12(b)(6) of the Federal Rules of Civil Procedure, on the grounds that Plaintiffs have failed to plead
their allegations with sufficient particularity.
III. STANDARDS
A. Federal Rules of Civil Procedure
A court may dismiss a complaint pursuant to Rule
12(b)(6) for pleading "insufficient facts under a cognizable legal theory." Robertson v. Dean Witter Reynolds,
Co., 749 F.2d 530, 534 (9th Cir. 1984). When deciding a
motion to dismiss a complaint under Rule 12(b)(6), the
court takes all material allegations in the complaint as
true and construes these material allegations in the light
most favorable to the non-moving party. Sanders v. Kennedy, 794 F.2d 478, 481 (9th Cir. 1986); NL Indus., Inc.
v. Kaplan, 792 F.2d 896, 898 (9th Cir. 1986). However,
the Court will not accept wholly conclusory allegations.
Western Mining Council v. Watt, 643 F.2d 618, 624 (9th
Cir. 1981), cert. denied, 454 U.S. 1031, 102 S. Ct. 567,
70 L. Ed. 2d 474 (1981); Kennedy v. H & M Landing,
Inc., 529 F.2d 987, 989 (9th Cir. 1976). [*7]
In determining the motion to dismiss, the court is
limited to the contents in the complaint. Allarcom Pay
Television, Ltd. v. General Instrument Corp., 69 F.3d
381, 385 (9th Cir. 1995). Documents presented to the
court as attached to the complaint and incorporated
within its allegations, may be considered as part of the
motion to dismiss. See Hal Roach Studios, Inc. v. Richard Feiner & Co., 896 F.2d 1542, 1555 n.9 (9th Cir.
2989). Where a plaintiff fails to attach to the complaint
documents referred to therein, and upon which the complaint is premised, a defendant may attached to the motion to dismiss such documents to show that they do not
support the plaintiff's claim. In re Pacific Gateway Exch.,
Inc. Sec. Litig., 169 F. Supp. 2d 1160, 1164 (N.D. Cal.
2001).
Claims brought under Rule 10b-5 and Section 10(b)
must also meet the particularity requirements of Federal
Rule of Civil Procedure Rule 9(b). In re Daou Sys., Inc.
Sec. Litig., 411 F.3d 1006, 1014 (9th Cir. 2005). Rule
9(b) requires that "[i]n all averments of fraud or mistake,
the circumstances constituting fraud or mistake shall be
stated with particularity. [*8] "
B. Private Securities Litigation Reform Act of 1995
A violation of section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) and SEC Rule
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2006 U.S. Dist. LEXIS 81420, *
10b-5 thereunder, 17 C.F.R. § 240.10b-5 requires (1) a
material misrepresentation or omission of fact, (2) scienter, (3) a connection with the purchase or sale of a security, (4) transaction and loss causation, and (5) economic loss. Dura Pharm., Inc. v. Broudo, 544 U.S. 336,
125 S. Ct. 1627, 1631, 161 L. Ed. 2d 577 (2005). The
Private Securities Litigation Reform Act of 1995
(PSLRA) imposed heightened pleading requirements in
private securities fraud litigation by amending the 1934
Exchange Act to require that a complaint "plead with
particularity both falsity and scienter." In re Daou, 411
F.3d at 1014. Following the PSLRA, a complaint alleging securities fraud 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 that belief is formed." 15 U.S.C. § 78u4(b)(1); [*9] In re Vantive Corp. Sec. Litig., 283 F.3d
1079, 1085 (9th Cir. 2002). Private securities fraud
plaintiffs must now also "state with particularity all facts
which give rise to a strong inference that the defendant
acted with the required state of mind," which is "intentionally or with deliberate recklessness." 15 U.S.C. §
78u-5(b)(2); In re Silicon Graphics Sec. Litig., 183 F.3d
970, 974 (9th Cir. 1999) (facts must come closer to demonstrating intent as opposed to mere motive and opportunity); Ronconi v. Larkin, 253 F.3d 423, 429 (9th Cir.
2001). In an "unusual deviation from the usually lenient
requirements of federal rules pleading," Ronconi v.
Larkin, 253 F.3d at 427, a court in a private securities
fraud "must consider all reasonable inferences to be
drawn from the allegations, including inferences unfavorable to the plaintiffs" to determine "whether, on balance, the plaintiffs' complaint gives rise to a reasonable
inference of scienter." Gompper v. VISX, Inc., 298 F.3d
893, 897 (9th Cir. 2002); Lipton v. PathoGenesis Corp.,
284 F.3d 1027, 1038 (9th Cir. 2002). [*10]
IV. DISCUSSION
Defendants challenge the particularity and sufficiency of Plaintiffs' pleadings with regards to scienter,
loss causation, and the ancillary issue of control group
liability.
A. Scienter
Tracing backwards the causal chain in the FAC, it
appears to the Court that Plaintiffs claim stock losses
arising out of the market's reaction to Defendants' restatement of its reports for 1Q04 and 2Q04. The need for
Defendants to restate reports, in turn, allegedly arose
from Defendants' inflation of revenues for 1Q04 and
2Q04, and various business practices which failed to
mitigate the gap between the inflated figures and the
restated figures. According to Plaintiffs, this inflation of
revenues for lQ04 and 2Q04 and the gap between the
inflated figures and the restated figures was a result of
Defendants' failure to account for the customer credits
given by Teva. During the period in which revenues
were inflated, Defendants allegedly made false and misleading statements regarding Impax's financial condition.
In order for Plaintiffs to plead a "strong inference"
DSAM Global Value Fund v. Altris Software, 288 F.3d
385, 391 (9th Cir. 2002), that [*11] Defendant acted
with scienter as to this purported scheme, Plaintiffs must
allege that Defendants knew or were deliberately reckless in not knowing that the revenues were inflated at the
time the false or misleading statements were made. In
support of its contention that Defendants acted with scienter, Plaintiffs allege facts regarding Defendants' operational control, accounting violations, certifications of
financial reports, insider trading, compensation package,
and Impax's insufficient reserves and excessive inventory. In assessing whether Plaintiffs have sufficiently
pled a strong inference of scienter, the Court considers
all reasonable inferences, whether or not favorable to the
plaintiff. Gompper v. VISX, Inc., 298 F.3d 893, 897 (9th
Cir. 2002).
1. Strategic Alliance Agreement
As an initial matter, taking Plaintiffs' allegation for
the source of the inflated revenues as true, the terms of
the SAA between Impax and Teva seriously undercut an
inference that Defendants knew or were deliberately
reckless in not accounting for customer credits given by
Teva. n1 To the contrary, a reading of the plain language
in the SAA suggests that Teva, not Impax, had [*12] the
obligation to take into account the customer credits that
Teva issued to Teva's customers. The FAC alleges that
Impax granted Teva exclusive marketing rights for its
bupropion products, "shared with Teva in the gross margins from its sale of the products," and "[r]evenues from
the sale of bupropion hydrochloride accounted for approximately 61% of Impax's quarterly total revenues" in
1Q04. FAC P24, 26. Under the SAA, Teva was required
to report "Net Sales and Profit" to Impax on a periodic
basis. n2 The SAA specifies the calculation of "net sales"
as:
[O]n a Product-by-Product basis, the
gross amount invoiced for each of the
Products sold by Teva or Teva's affiliates
on a arms-length basis in each country in
the Territory, less the sum of: (a) trade,
quantity and/or cash discounts, allowances, rebates, retroactive price adjustments, free goods, bad debts, cash incentive payments (e.g. slotting allowance),
and chargebacks; (b) credits or refunds for
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rejected, outdated or returned Product; (d)
cost of short dated product, which is destroyed by Teva or its Affiliateds; (e)
three percent (3%) as a contribution towards selling, administrative and other
similar expenses of [*13] Teva; and (f)
other specifically identifiable amounts included in the Product's gross sales that
will have been or ultimately will be credited and are substantially similar to those
listed above; in each case determined in
accordance with U.S. GAAP.
count Teva's customer credits to Teva's customers, and failing to maintain an adequate reserve
despite the terms of the SAA.
Thus, in order for Plaintiffs to meet their burden of
proving a strong inference of scienter, the seemingly
plain language of the SAA which requires Teva to report
their customer credits to Impax. In other words, Plaintiffs
must plead facts which give rise to a strong inference
that Defendants knew or were deliberately reckless in not
knowing that Teva was not accounting for customer
credits as seemingly required by the SAA.
2. Operational Control
The calculation mandated by the SAA requires that net
sales be reduced by an amount included in gross sales
that "ultimately will be credited." Plaintiffs have not alleged any facts which would indicate that the customer
credits would not reasonably fall into this category. n3
n1 The SAA is in the record at Def. Request
for Judicial Notice, Exh. A, and shall be cited in
this Order as "SAA." The SAA was specifically
referenced to in the FAC, and the Court finds that
it is sufficiently probative on Plaintiffs' claims to
admit and refer to Defendants' submission of the
contract.
n2 Section 11.3 of the SAA at p. 24 reads:
"Within thirty (30) days following each Calendar
Quarter during the Supply Term, Teva shall compute and report to Impax in a mutually acceptable
format the Net Sales and Profit for each Product
in each country in the Territory during that Calendar Quarter... In addition, within seven (7)
business days after the end of each month, Teva
shall provide to Impax information (which could
be good faith estimates if final data is not available) as to the amount of Net Sales, Profit, and
number of units sold of each Product during that
month."
[*14]
n3 At oral argument, counsel for Plaintiffs
indicated that there is an accounting distinction
between "other specifically identifiable amounts
included in the Product's gross sales that will
have been or ultimately will be credited," and
amounts which will ultimately be credited but are
perhaps not "specifically identifiable." Pleading
facts which support such a distinction would add
particularity to Plaintiffs' allegations that Defendants acted with scienter in not taking into ac-
The FAC alleges that Defendants acted with [*15]
scienter based on Defendants' role as senior management
in a relatively small company. Impax had 453 employees
as of February 27, 2004, and only fourteen directors and
executive officers. (FAC P78). As an initial matter, a
statement that "the Individual Defendants as the managers of a small company [are] likely to know of details
related to its most significant strategic alliance partner,
Teva," is insufficient, without more to meet the heightened pleading standards of the PSLRA. See In re Silicon
Graphics Sec. Litig., 183 F.3d 970, 974 (9th Cir. 1999)
(plaintiffs must plead a strong inference, not merely a
reasonable inference of scienter).
Plaintiffs use confidential witnesses to support their
allegation that Defendants acted with scienter by virtue
of their status as directors and/or officers in a relatively
small company. In the FAC, CW4, a human resource
executive at Impax employed prior to the Class Period,
states that all of the Individual Defendants were involved
in all aspects of the business because "with a small company, senior leaders had to be involved in the details."
FAC P78. Also according to CW4 and CW3 n4 , senior
management attended quarterly [*16] meetings at which
some defendants "made a Microsoft PowerPoint presentation that showed the results of the previous quarter and
detailed plans for the next quarter." General allegations
of "hands-on" or "day-to-day" involvement are insufficient bases for scienter. In re Autodesk, Inc. Sec. Litig.,
132 F. Supp. 2d 833, 843-44 (N.D. Cal. 2000) (presuming knowledge based on "hands-on" positions would
"eliminate the necessity for specially pleading scienter,
as any corporate officer could be said to possess the requisite knowledge by virtue of his or her position"). The
presence of confidential witnesses to verbalize this general allegation does not render the general allegation any
more particularized.
n4 CW3, as described in the FAC, is "a
manufacturing technician, employed immediately
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prior to the class period." In this Circuit, confidential witnesses for securities complaints must
be "described with sufficient particularity to support the probability that a person in the position
occupied by the source would possess the information alleged and the complaint contains adequate corroborating details." In re Daou, 411
F.3d at 1015 (citations omitted). It is unclear to
the Court that a person in the position of a manufacturing technician would have knowledge about
the travel plans of the company's senior management, and Plaintiffs have not alleged any other
corroborating facts which would shed light on
this matter.
[*17]
Furthermore, even confidential witnesses' references
in this case to specific Defendants are insufficiently particular to support a strong inference of scienter. As to
Defendant Dr. Larry Hsu, the FAC relies on CW2 to
support an allegation that "several departments reported
directly to Dr. Hsu...Dr. Hsu sat in on high-level interviews in these departments. Dr. Hsu, thus, controlled
significant departments at Impax." FAC P13. Such general allegations, even if about a particular defendant, are
insufficient to support a strong inference of scienter that
Dr. Hsu knew or was deliberately reckless in not knowing that the revenues for 1Q04 and 2Q04 were inflated.
Similarly, the FAC cites the statements of CW6, a
staff accountant throughout the Class Period, as allegations of scienter as to Defendants Doll and Spiegler. According to CW6, Defendants Doll and Spiegler received
"daily sales numbers," where "daily sales to Teva were
shown on the sales report as the manufacturing cost of
the product shipped, and that at month end, Teva would
tell Impax how much product had actually been sold to
its customers." FAC P90. Assuming that a staff accountant would know whether senior management at [*18]
Impax reviews the daily sales numbers, Plaintiffs have
not alleged with sufficient particularity that these sales
numbers showing sales to Teva would be probative of
the numbers actually at issue--namely, revenues generated by Teva's sales to Teva's customers, or any credits
that Teva might have given. Thus, the statements of
CW6 do not lead to a strong inference of scienter as to
Defendants Doll and Spiegler.
In a related allegation, Plaintiffs claim that the "only
reasonable inference" (FAC P75) to be drawn from CFO
Defendant Spiegler's December 2004 resignation from
Impax is that he knew of Impax's accounting violations
and that "the proximity of this announcement to the restatement demonstrates that Spiegler's retirement was no
coincidence." FAC P14(c). Plaintiffs have not provided
particularized allegations beyond this conclusory state-
ment. This District does not, without more, permit an
inference of scienter from the termination of a corporate
officer. In re U.S. Aggregates, Inc. Sec. Litig., 235 F.
Supp. 2d 1063, 1074 (N.D. Cal. 2002).
In short, Plaintiffs have not alleged with sufficient
particularity to support a strong inference of scienter that
Defendants, [*19] by virtue of their status within Impax, acted with scienter with regards to the 1Q04 and
2Q04 revenues.
3. Accounting Violations
Plaintiffs allege that Defendants violated various accounting rules including internal accounting practices,
SEC rules, and federal accounting standards, in reporting
or incorporating the inflated 1Q04 and 2Q04 revenues. It
is well established that even a deliberate violation of
GAAP, without more, is insufficient to establish the requisite scienter. In re Daou, 411 F.3d at 1022 (citing In re
Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th
Cir. 1994)). However, "significant violations of GAAP
standards can provide evidence of scienter so long as
they are pled with particularity." In re McKesson HBOC,
Inc. Sec. Litig., 126 F. Supp. 2d 1248, 1273 (N.D. Cal.
2000).
The particularity standards for permitting a strong
inference of scienter to be drawn from GAAP violations
do not obviate the requirement that a defendant knew or
was reckless in not knowing of the factors underlying the
particularly alleged GAAP violations. Plaintiffs argue
that they have met their burden of pleading scienter because [*20] they have met the particularity pleading
standard stated in Daou and first articulated in McKesson
which requires: "(1) such basic details as the approximate amount by which revenues and earnings were overstated; (2) the products involved in the contingent transaction; (3) the dates of any of the transactions; or (4) the
identities of any of the customers or [company] employees involved in the transaction." In re Daou, 411 F.3d
1006 at 1016 (citing In re McKesson 126 F. Supp. 2d at
1273) (alterations in In re McKesson). This is an incomplete application of Daou. In Daou, the Ninth Circuit
discussed the McKesson standards in the section labeled
"Material Misrepresentations or Omissions." Scienter
was addressed in a separate section which considered
factors beyond pleading materiality with particularity.
For example, the court in Daou recognized that the plaintiffs' complaint stated: "CW9, a regional Sales Vice
President at Daou, confirmed that defendants G. Daou,
D. Daou, and McNeill not only made the decision on
how much revenue to recognize without regard to any
actual percentage of completion, but directed the practice
[*21] of automatically recognizing revenue upon contract signing and ordering of equipment." The language
in the "Scienter" section of Daou indicates that the appli-
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cation of the rule in McKesson requires pleading with
particularity as well as a showing that defendants knew
of the facts from which scienter could be inferred. See
also In re U.S. Aggregates, Inc. Sec. Litig., 235 F. Supp.
2d 1063, 1073 (N.D. Cal. 2002) (finding that plaintiffs
relying on McKesson must also show that the restatement was sizeable and the plaintiff must also plead additional, specific allegations that the defendants had actual
knowledge of relevant facts from which scienter could be
inferred).
Even assuming that there were violations of GAAP,
the Court finds that Plaintiffs have not met their burden
of showing a strong inference of scienter. The restatement in this case was only for two quarters, and in the
end, Impax restated first quarter revenues by 11% and
second quarter revenues by less than one-tenth of one
percent. Additionally, Plaintiffs have not alleged operational control by the Defendants with sufficient particularity to support a finding of scienter. See discussion,
[*22] supra. See also In re Daou, 411 F.3d at 1023 (basing its determination that the plaintiffs had pled scienter
as to GAAP violations with sufficient particularity on a
finding that "plaintiffs have alleged with specificity that
the top executives actually directed the improper revenue
recognition in violation of both GAAP and their own
accounting practices"). Particularly given the reasonable
implications of the SAA, the size of the restatement, and
the failure to allege Defendants' operational control with
specificity, Plaintiffs have fallen short of pleading that
the various alleged accounting violations provide the
requisite scienter. Conclusory allegations of accounting
fraud may not be bootstrapped into proof of intentional
or reckless conduct. In re McKesson, 126 F. Supp. 2d at
1273.
4. Certifications of SEC Filings
Sections 302 and 906 of the Sarbanes Oxley Act requires certain control persons to certify annual and quarterly reports to the SEC. Defendants certified the 10-Q
reports for 1Q04 and 2Q04. Plaintiffs argue that the FAC
contains a strong inference of scienter because it alleges
that Defendants "could not file § 302 certifications [*23]
under Sarbanes-Oxley without knowing these crucial
details" about the accounting violations. (Pl. Opp. at 2.)
Pursuant to § 906, Defendants B. Edwards and Spiegler
certified that "based on [their] knowledge, this quarterly
report does not contain any untrue statement of material
fact" and "based on [their] knowledge, the financial
statements, and other financial information included in
this quarterly report, fairly present, in all material respects, the financial condition, results of operations, and
cash flows of the registrant as of, and for, the periods
presented in this quarterly report." FAC P91. Although
the text of the certification declares knowledge, proving
up scienter for the figures contained within in this fashion is bootstrapping at best.
The § 302 certification signed by Defendants B.
Edwards and Spiegler certify that the certifying officers
have designed disclosure controls and procedures in accordance with Exchange Act Rules 13a-14 and 15d-14
and evaluated the effectiveness of these disclosure controls and procedures. There is no knowledge requirement
regarding the disclosure controls and procedures requirement for § 302, but Plaintiffs have not alleged a
[*24] separate cause of action for failure to maintain
disclosure controls and procedures under § 302. n5 Because Plaintiffs have not alleged a separate violation for
the failure to maintain proper disclosure controls and
procedures and scienter for accounting violations in inflating revenue may not be bootstrapped from the signing
of these certifications, Plaintiffs may not base scienter
for a 10b-5 violation solely on the signing of a § 302 or
§ 906 certification.
n5 It is unclear to this Court whether such a
violation could be asserted.
5. Insider Trading
Significant and suspicious insider trading may be
probative of scienter. No. 84 Employer-Teamster Joint
Council Pension Trust Fund v. America West Holding
Corp, 320 F.3d 920, 944 (9th Cir. 2003). In considering
whether stock sales by insiders raise an inference of scienter a court is to consider "(1) the amount and percentage of shares sold by insiders; (2) the timing of the sales;
and (3) whether the sales were consistent with the insider's [*25] prior trading history." In re Silicon Graphics, 183 F.3d at 986.
a. Magnitude
Under Plaintiffs' calculations, Defendants Doll, B.
Edwards, D. Edwards, and Spiegler disposed of 93%,
98%, 100% and 84% of their shares, respectively, during
the Class Period. FAC P83. Although Plaintiffs exaggerate the magnitude of insider trading in the FAC in erroneously excluding non-exercised exercisable options
from the total number of shares owned as required by In
re Silicon Graphics, 183 F.3d at 986-87 ("actual stock
shares plus exercisable stock options represent the
owner's trading potential more accurately than the stock
shares alone"), the insider trading in this case occurred in
no small quantity. The properly calculated percentage of
shares traded, however, generally falls below the threshold at which a Court finds the trading sufficiently suspicious to create a strong inference of scienter. The trading
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of Defendants Spiegler and Doll who sold 46% and 36%
of their available holdings would be suspicious were it
not for the small quantity of shares actually sold. See In
re Silicon Graphics, 183 F.3d at 987 (insider's sale of
43.6% [*26] of holdings not suspicious because the
sales were only 5% of total insider sales). Defendants
Spiegler and Doll owned significantly far less stock and
exercisable options than the other Defendants, Spiegler's
sales represented only 4% of the shares sold by all Defendants, while Doll's sales represented only 2%.
Defendant D. Edwards, under Plaintiffs' calculations, sold 100% of his stock during the Class Period.
According to Defendants, Defendant D. Edwards sold
0% of his stock during the relevant period. This discrepancy is due to Defendants' definition of the relevant period as only those sales which occurred on June 7, 2004
when Defendants Doll, B. Edwards, and Spiegler sold
their shares. Plaintiffs allege scienter based on Defendants stock sales during the period in which the revenues
were inflated. Accordingly, the stock sales by Defendant
D. Edwards on May 12, 2004 and May 13, 2004 are a
part of Plaintiffs' allegations of scienter based on insider
trading during the Class Period.
b. Timing
The FAC alleges that the Defendants' stock sales occurred at a time when the Defendants knew that the share
price was inflated and would decline once the true concealed facts [*27] became public. In Lipton v. PathoGenesis Corp., the Ninth Circuit held that an insider's
sale of stock after announcement of positive quarterly
results did not give rise to a finding of scienter, particularly where the percentage sold was low. 284 F.3d 1027,
1037 (9th Cir. 2002). In this case, Defendants' sales were
made in the month following Impax's first ever profitable
quarter, a time at which one would expect some stock
sales even absent fraudulently inflated revenues. Even
though Defendants' Doll, B. Edwards, and Spiegler sold
their shares on June 7, 2004, Plaintiffs have not alleged
facts which would indicate the date is of particular importance, or that there was a coordinated effort by three
Defendants to unload stock at once.
Defendant D. Edwards sold his shares on May 12,
2004 and May 13, 2004. The Court does not reach the
question of whether Plaintiffs may allege scienter on
behalf of all Defendants based on Defendant D. Edwards's stock sales during the class period. However, the
sale of 100% of a director's stock during the class period
may be relevant to Plaintiffs' allegations that a Defendant
acted with scienter.
The FAC's allegations regarding Defendants' prior
trading patterns are unclear. This Court is not obligated
to draw all inferences in favor of Plaintiff despite their
failure to plead facts necessary to their position. See In re
Vantive Corp. Sec. Litig., 283 F.3d 1079, 1095 (9th Cir.
2002) ("when a complaint fails to provide us with a
meaningful trading history for purposes of comparison,
we have been reluctant to attribute significance to the
defendant's stock sales").
6. Contingent Compensation
The related allegation that Defendants had a motive
to commit fraud based on their compensation packages
are also insufficient to support a strong inference of scienter. Such legitimate motives concerning compensation
as tied to financial performance are shared by virtually
all corporations and their officers. See Lipton, 284 F.3d
at 1038 ("if scienter could be pleaded merely by alleging
that officers and directors possess motive and opportunity to enhance a company's business prospects, virtually
every company in the United States that experiences a
downturn in stock price could be forced to defend securities fraud actions") (citations [*29] omitted). Accordingly, allegations of such general applicability do not
meet the heightened pleading requirements of the
PSLRA.
7. Insufficient Reserves and Failure to be First to
Market
Plaintiffs have not alleged sufficient particular facts
to support their allegations regarding insufficient reserves and failure of Impax's generic Wellbutrin to be
first to market. Plaintiffs claim that the reserve level and
failure to be first to market are material facts which
should have been disclosed or facts which support a finding of scienter as to inflated revenue. Plaintiffs allege
that Defendants knew that excessive inventory of bupropion products was inevitable because the introduction
of a new product may have required Impax to make a
proportionate upward adjustment to its reserve provisions due to: (1) the newness of the product; (2) the uncertainty of revenues associated with the new product
particularly in light of Impax's failure to be first-tomarket; (3) the lack of a historical basis upon which to
base reserves; and (4) restrictions imposed by the product having a limited shelf life. FAC P40. These factors,
however, are insufficient to support a strong inference of
an actual [*30] intent to defraud. See In re Silicon
Graphics, 183 F.3d at 974. In other words, even if Impax's inventory at some point in time was excessive it
does not follow that Impax's reported revenues were inflated as a result thereof or, more importantly, that Defendants knew of or deliberately caused the inflation.
8. Totality of the Allegations
c. Relative to Prior Trading [*28] History
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Where the complaint's allegations, considered individually, do not raise a strong inference of scienter, the
Court may consider whether the allegations in the aggregate give rise to a strong inference of scienter. In re
Daou, 411 F.3d at 1015. Given the reasonable implications of the SAA, namely that Teva did not have to inform Impax about Teva's customer credits or Teva's own
failure to maintain a reserve, an evaluation of "all reasonable inferences to be drawn from the allegations, including inferences unfavorable to the plaintiffs" Gompper, 298 F.3d at 897, indicates that the FAC still falls
short of a strong inference of scienter.
B. Loss Causation
Plaintiffs must also prove that a defendant's securities fraud caused their economic loss. 15 U.S.C. § 78u4(b)(4). [*31] The statute provides, in relevant part, the
following:
Loss causation. In any private action arising under this chapter, the plaintiff shall
have the burden of proving that the act or
omission of the defendant alleged to violate this chapter caused the loss for which
the plaintiff seeks to recover damages.
Id. Recently, the Supreme Court in Dura clarified the
loss causation pleading and proof requirement in securities fraud cases as the "causal connection between the
material misrepresentation and the loss." Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 125 S. Ct. 1627,
1631, 161 L. Ed. 2d 577 (2005). The Dura court held that
a plaintiff could not satisfy loss causation merely by alleging (and later establishing) that the price of the securities on the date of the purchase was inflated because of
misrepresentation. Id. at 1627. In applying the Dura
framework, the Ninth Circuit recognized that pleading
loss causation is a difficult task. In re Daou Systems,
Inc., 411 F.3d 1006, 1014 (9th Cir. 2005). After assessing plaintiffs' complaint, the Daou court found that the
complaint adequately pled loss [*32] causation because
the allegations, if assumed true, were sufficient to provide the defendant "with some indication that the drop in
Daou's stock price was causally related to Daou's financial misstatements reflecting its practice of prematurely
recognizing revenue before it was earned." Id. at 1026.
The complaint alleged that once the defendants began to
reveal figures showing the company's true financial condition, "the result of prematurely recognizing revenue
before it was earned, led to a 'dramatic, negative effect
on the market, causing Daou's stock to decline to $ 3.25
per share, a staggering 90% drop from the Class Period
high of $ 34.375 and a $ 17 per share drop from early
August 1998.'" Id. (emphasis in the original). Lastly, the
complaint alleged that "Daou's stock price has never recovered and the Company has never been able to match
the artificially inflated revenues reported during the
Class Period." Id. The Daou court concluded that the
plaintiffs adequately pled loss causation.
The FAC alleges that Defendants' November 3, 2004
disclosure to the market signaled difficulties in connection with Impax's bupropion products and overall financial [*33] health and was a precursor to the additional
announcement on November 9, 2004. The November 3,
2004 announcement stated that there was to be a delay in
the release of its third quarter results. On the same day,
Andrx Corporation announced that it would lower its
third quarter revenues due to credits Teva had given on
bupropion. The FAC alleges that following the November 3, 2004 announcement, the price of Impax stock fell
$ 2.93 to $ 10.07, a drop of 23%. However, on November 9, 2004, when Impax actually announced that it
would be restating its results for the first two quarters, its
stock price increased and within two days exceeded the
pre-November 3 closing price.
Although the Court will not reach the loss causation
argument at this time, the Court notes that any amended
complaint would benefit from an explanation as to any
causal connection between the restatements and Plaintiffs' alleged economic loss despite the recovery of Impax's stock price between November 9, 2004 and November 11, 2004. The FAC also includes facts about
Impax's delisting from NASDAQ and reissuance of debentures at a higher interest rate, FAC P6, but at oral
argument, Plaintiffs' counsel acknowledged that [*34]
these facts are not the source of Plaintiffs' economic loss.
C. Control Person Liability
To support a violation of Section 20(a), a plaintiff
must prove: (1) "a primary violation of federal securities
law" and (2) "that the defendant exercised actual power
or control over the primary violator." Howard v. Everex
Sys., Inc., 228 F.3d 1057, 1065 (9th Cir. 2000). "[I]n
order to make out a prima facie case, it is not necessary
to show actual participation or the exercise of power;
however, a defendant is entitled to a good faith defense if
he can show no scienter and an effective lack of participation." Id.
Defendants argue that control person liability does
not exist in this case because there is no primary violation of a federal securities law. Currently, Plaintiffs have
not met the heightened pleading requirements for pleading a primary violation of a federal securities law under
the PSLRA. Accordingly, the dependent control person
liability claim is also dismissed with leave to amend.
V. CONCLUSION
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For the reasons stated above, the FAC is dismissed
without prejudice. Should Plaintiffs wish to file for leave
to file a second amended consolidated [*35] complaint
consistent with this Order, Plaintiffs shall so move on or
before April 21, 2006. The proposed amended complaint
shall be attached to any motion for leave to file an
amended complaint.
Dated: March 1, 2006
/s/ James Ware
United States District Judge
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LEXSEE 2000 US DIST LEXIS 10329
J.F. LEHMAN & COMPANY, INC., a Delaware corporation; J.F. LEHMAN
EQUITY INVESTORS I, L.P., a Delaware limited partnership; J.F. LEHMAN COINVEST PARTNERS I, L.P., a Delaware limited partnership; and PARIBAS
PRINCIPAL INCORPORATED, a New York corporation, Plaintiffs, v. THOMAS
F. TREINEN, an individual; THOMAS J. TREINEN, an individual; JOHN M.
CUTHBERT, an individual; JOHN T. VINKE, an individual, and DOE 1 through
Doe 10, inclusive, Defendants.
NO. CV 99-13046-WJR (JWJx)
UNITED STATES DISTRICT COURT FOR THE CENTRAL DISTRICT OF
CALIFORNIA
2000 U.S. Dist. LEXIS 10329; Fed. Sec. L. Rep. (CCH) P91,046
June 9, 2000, Decided
June 12, 2000, Filed; June 13, 2000, Entered
DISPOSITION: [*1] Motions to dismiss, granted in
part and denied in part; joint motion to strike denied,
joint motion for judicial notice granted in part and denied
in part.
JUDGES: WILLIAM J. REA, United States District
Judge.
OPINION BY: WILLIAM J. REA
OPINION:
COUNSEL: For J F LEHMAN & CO INC, J F
LEHMAN EQUITY INVESTORS I L P, J F LEHMAN
CO-INVEST PARTNERS I L P, PARIBAS PRINCIPAL
INCORPORATED, plaintiffs: Richard C Field, Deborah
Ann Nolan, William H Freedman, Pamela F Worth,
McCutchen Doyle Brown & Enersen, Los Angeles, CA.
For THOMAS F TREINEN, defendant: Ronald D Reynolds, David A Householder, Kaye Scholer Fierman
Hays & Handler, Los Angeles, CA.
For THOMAS J TREINEN, defendant: Vincent J Marella, Mark T Drooks, Bird Marella Boxer & Wolpert,
Los Angeles, CA.
For JOHN M CUTHBERT, defendant: David B Babbe,
Anthony L Press, Benjamin J Fox, Morrison & Foerster,
Los Angeles, CA. John P Martin, John D Vandevelde,
Talcott Lightfoot Vandevelde Sadowsky Medvene &
Levine, Los Angeles, CA.
For JOHN T VINKE, defendant: Allan L Schare,
McDermott Will & Emery, Los Angeles, CA. Anthony
Russo, Stephen Michael Lowry, Magara Lee Crosby,
Russo & Lowry, Los Angeles, CA.
ORDER GRANTING IN PART AND DENYING
IN PART [*2]
DEFENDANTS' MOTIONS TO
DISMISS,
DENYING
DEFENDANTS'
JOINT
MOTION TO STRIKE, AND GRANTING IN PART
AND DENYING IN PART DEFENDANTS' JOINT
MOTION FOR JUDICIAL NOTICE
On May 17, 2000, Defendants' motions to dismiss,
joint motion to strike, and joint motion for judicial notice
came on for a hearing. After oral argument, the Court
took the motions under submission.
The Court has fully considered the arguments, authorities, and exhibits submitted in the briefing and has
fully considered the oral argument. Based on the foregoing, the Court grants in part and denies in part the motions to dismiss, denies the joint motion to strike, and
grants in part and denies in part the joint motion for judicial notice.
I. Background
This is a fraud case arising out of the proposed sale
of Special Devices, Inc. ("SDI"), a company that designs
and manufactures engineered pyrotechnic devices that
are utilized to deploy automobile air-bags or to provide
precision detonations in various aerospace products. See
SAC P 6. Plaintiffs are J.F. Lehman & Company, Inc.
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("JFLC"), J.F. Lehman Equity Investors I, L.P.
("JFLEI"), JFL Co-Invest Partners I, L.P. ("JFLCP"), and
Paribas Principal Inc. n1 [*3] See SAC P 3. Defendants
are Thomas F. Treinen ("Treinen Sr."), the President,
CEO, and Chairman of the Board of SDI, Thomas J.
Treinen ("Treinen Jr."), a Vice President of SDI, John M.
Cuthbert, President of the Automotive Division and a
director of SDI, and John T. Vinke, Vice President and
CEO of SDI. n2 See SAC P 4. On March 6, 2000, Plaintiffs filed a Second Amended Complaint alleging causes
of action for federal securities fraud (claims 1-2), violation of the Racketeer Influenced and Corrupt Organizations Act (claim 3), and common law fraud (claims 4-6).
n3
n1 JFLC is a Delaware corporation with its
principal place of business in Virginia. JFLEI and
JFLCP are Delaware limited partnerships with
their principal place of business in Virginia.
Paribas is a New York corporation with its principal place of business in New York.
n2 Defendants are all California citizens.
n3 Plaintiffs filed their original Complaint on
December 13, 1999 and their First Amended
Complaint on January 26, 2000.
[*4]
To secure a needed capital infusion, Defendants entered into negotiations with Plaintiffs for the recapitalization of SDI and the concurrent acquisition of a controlling interest in SDI by Plaintiffs. See Second Am.
Compl. (hereinafter "SAC") P 8. To facilitate their acquisition of that controlling interest, Plaintiffs created SDI
Acquisition Corporation ("Acquisition Corp."), which
entered into a Merger Agreement with SDI on June 19,
1998. See SAC PP 10, 45. On December 15, 1998 Plaintiffs also executed a Rollover Stockholders Agreement.
See SAC P 58. The recapitalization of SDI was completed on December 15, 1999. See SAC P 57.
Plaintiffs allege that as a result of Defendants' fraud,
they purchased SDI stock at a price far in excess of its
actual value. See SAC P 10. Specifically, Plaintiffs allege that Defendants misrepresented SDI's compliance
with federal, state, and local environmental protection
laws and permitting requirements and overstated SDI's
earnings for the fiscal year ending October 31, 1998. See
SAC P 10.
I. Legal Standard on a Motion to Dismiss
Under Federal Rule of Civil Procedure 12(b)(6), a
party may bring a motion to dismiss [*5] a plaintiff's
claims on the ground that the plaintiff's allegations "fail
to state a claim upon which relief can be granted." FED.
R. Civ. P. 12(b)(6). But courts generally view Rule
12(b)(6) motions with disfavor and grant them only in
extraordinary cases. See United States v. Redwood City,
640 F.2d 963, 966 (9th Cir. 1981); United States v.
White, 893 F. Supp. 1423, 1428 (C.D. Cal. 1995).
Generally, "[a] complaint should not be dismissed
for failure to state a claim unless it appears beyond doubt
that the plaintiff can prove no set of facts in support of
his claim which would entitle him to relief." Conley v.
Gibson, 355 U.S. 41, 45-46, 2 L. Ed. 2d 80, 78 S. Ct. 99
(1957); see also, Parks Sch. of Bus., Inc. v. Symington,
51 F.3d 1480, 1484 (9th Cir. 1995); Elias v. Connett,
908 F.2d 521, 527 (9th Cir. 1990). Thus, dismissal is
proper where there is either a "lack of a cognizable legal
theory" or "the absence of sufficient facts alleged under a
cognizable legal theory." Balistreri v. Pacifica Police
Dep't, 901 F.2d 696, 699 (9th Cir. 1990).
In reviewing a Rule 12(b)(6) motion, [*6] the
Court must construe all allegations contained in the
complaint in the light most favorable to the plaintiff and
must accept as true all material allegations in the complaint as well as any reasonable inferences to be drawn
from them. See, e.g., Hospital Bldg. Co. v. Trustees of
the Rex Hosp., 425 U.S. 738, 48 L. Ed. 2d 338, 96 S. Ct.
1848 (1976); Kugler v. Helfant, 421 U.S. 117, 44 L. Ed.
2d 15, 95 S. Ct. 1524 (1975); NL Indus., Inc. v. Kaplan,
792 F.2d 896, 898 (9th Cir. 1986). Thus, no matter how
improbable the facts alleged are, the Court must accept
them as true for purposes of the motion. See, e.g.,
Neitzke v. Williams, 490 U.S. 319, 326-27, 104 L. Ed. 2d
338, 109 S. Ct. 1827 (1989).
But the Court need not accept unreasonable inferences or unwarranted deductions of fact. See Western
Mining Council v. Watt, 643 F.2d 618, 624 (9th Cir.
1981). Thus, the Court does not have free reign simply to
"use its imagination" in order to determine what, though
not alleged or properly inferred from a complaint, a
plaintiff might possibly be getting at, either factually or
in terms of legal theory. See [*7] Country Nat'l Bank v.
Mayer, 788 F. Supp. 1136, 1139 (E.D. Cal. 1992) (holding that it is "not proper for the court to assume that the
[plaintiff] can prove facts which [he or she] has not alleged, or that the defendants have violated the . . . laws in
ways that have not been alleged.'" (citing Associated
Gen. Contractors v. California State Council, 459 U.S.
519, 526, 74 L. Ed. 2d 723, 103 S. Ct. 897 (1983))).
Similarly, the Court need not accept as true conclusory
allegations or legal characterizations. See, Sherman v.
Yakahi, 549 F.2d 1287, 1290 (9th Cir. 1977); Tran-
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sphase Sys., Inc. v. Southern Cal. Edison Co., 839 F.
Supp. 711, 718 (C.D. Cal. 1993).
Furthermore, the Court may consider as part of the
pleadings to be reviewed any material that is properly
submitted as part of the complaint, such as exhibits. See
Amfac Mtg. Corp. v. Arizona Mall of Tempe, 583 F.2d
426 (9th Cir. 1978). The Court may also take judicial
notice of matters of public record outside the pleadings
without converting the motion to dismiss into one for
summary judgment. See Mullis v. U.S. Bankruptcy
Court, 828 F.2d 1385, 1388 & n.9 (9th Cir. 1987); [*8]
Mack v. South Bay Beer Distribs., 798 F.2d 1279, 1282
(9th Cir. 1986) (abrogated on other grounds) Moreover,
a defendant may attach to its motion to dismiss a document referred to in the plaintiff's complaint to show that
it does not support the plaintiff's claim. See Branch v.
Tunnell, 14 F.3d 449, 454 (9th Cir. 1994). The court's
consideration of such a document does not convert the
motion to dismiss into a motion for summary judgment.
See id.
Finally, although the Court may allow parties leave
to correct defects in their claims, there is no automatic
right to do so, and leave to amend may be denied if
amendment would be futile. See, e.g., Wages v. Internal
Revenue Serv., 915 F.2d 1230, 1235 (9th Cir. 1990);
Hishon v. King & Spalding, 467 U.S. 69, 73, 81 L. Ed. 2d
59, 104 S. Ct. 2229 (1984).
II. Application of Dismissal Standard to Plaintiffs'
Second Amended Complaint
This Court is asked to determine whether Plaintiffs'
Second Amended Complaint alleges facts sufficient to
state a claim. Defendants Treinen Jr., Cuthbert, and
Vinke jointly move to dismiss Plaintiffs' entire complaint
on the grounds [*9] that 1) Plaintiffs have failed to allege sufficient facts demonstrating that Defendants acted
with scienter or made false or misleading statements with
regard to SDI's environmental compliance; 2) Plaintiffs
failed to adequately plead scienter, materiality, or reliance with regard to the alleged accounting misstatement;
and 3) Plaintiffs cannot state a claim for a violation of
RICO. Defendant Treinen Sr. joins this joint motion and
also moves separately to dismiss Plaintiffs' fraud claims
on the grounds that Plaintiffs failed to adequately plead
scienter and justifiable reliance. The jointly moving Defendants also join Defendant Treinen Sr.'s motion.
A. Plaintiffs' Fraud Claims Relating to SDI's Environmental Compliance
Plaintiffs allege that at various times in 1998, Defendants represented that SDI was in substantial compliance with environmental laws and permitting requirements related to the handling, storage, and disposal of
hazardous and toxic substances. This representation was
included in SDI's January 28, 1998 Form 10-K, its March
15, 1998 Confidential Information Memorandum, its
June 1998 Registration Statement, and its August 1998
Offering Memorandum. See SAC PP [*10] 14, 26, 3839. Plaintiffs allege that Defendants similarly represented
in the June 1998 Merger Agreement between Acquisition
Corp. and SDI, and in proxy statements filed with the
SEC on August 18, 1998 and November 10, 1998, that
SDI was in compliance with all applicable environmental
laws and held all material permits. See SAC PP 40-41,
45.
Plaintiffs also allege that certain defendants misrepresented SDI's environmental compliance during a due
diligence review conducted by Plaintiffs' attorneys, Paul,
Weiss, Rifkind, Wharton & Gerrison ("Paul Weiss"). See
SAC P 19. For example, Plaintiffs allege that on two
separate occasions between June 15, 1998 and June 18,
1998, Defendant Treinen Sr. represented in telephone
conversations to Gaines Gwathmey of Paul Weiss that
SDI had been and was disposing of all hazardous waste
through a licensed treatment, storage, and disposal facility and that SDI had not been and was not using an unpermitted tank at its Newhall, California facility to destroy hazardous waste. See SAC PP 23-24. Similarly,
Plaintiffs allege that on June 10, 1998, Defendant Vinke
allegedly represented to Gaines Gwathmey of Paul Weiss
and to Michael Burwell and [*11] Kirk Brunsen of Price
Waterhouse, Plaintiffs' accountants in the recapitalization
transaction, that SDI was in substantial compliance with
applicable environmental laws and permitting requirements. See SAC PP 20-22. Plaintiffs further allege that
on June 10, 1998 Defendant Vinke represented to Gaines
Gwathmey that hazardous waste at SDI's Newhall facility had been and was being disposed of through a licensed treatment, storage, and disposal facility. See SAC
P 21.
Finally, Plaintiffs allege that SDI retained LevineFricke-Recon ("LFR"), an environmental consulting
firm, to perform an environmental site assessment of
SDI's Newhall facility on May 4 and May 8, 1998. See
SAC P 31. Plaintiffs allege that Defendants Treinen Jr.
and Vinke specifically instructed Steve Skaggs, an SDI
employee, to avoid showing the LFR representatives the
portion of the Newhall facility where SDI was allegedly
burning hazardous waste without required permits. See
SAC P 32. Plaintiffs allege that as a result, Defendants
Treinen Jr. and Vinke caused LFR to prepare an assessment report dated May 20, 1998 that omitted any reference to SDI's unlawful disposal activities. See SAC PP
34-35. Plaintiffs [*12] allege that on June 15, 1998, Defendants provided Plaintiffs with a copy of LFR's report.
See SAC P 35.
1. Plaintiffs' securities fraud claims
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Plaintiffs' first and second causes of action are for
violations of section 10(b) of the Securities Exchange
Act of 1934 ("Exchange Act") and Rule 10b-5. A successful federal securities fraud claim under section 10(b)
or Rule 10b-5 requires (1) a misstatement or omission (2)
of material fact (3) made with scienter (4) on which the
plaintiff justifiably relied and (5) that proximately caused
the plaintiff's investment loss. See Gray v. First Winthrop Corp., 82 F.3d 877, 884 (9th Cir. 1996).
The Private Securities Reform Litigation Act ("Reform Act"), which applies to securities fraud claims, requires that plaintiffs plead federal securities violations
with heightened particularity. Under the Reform Act, for
example, a plaintiff must "state with particularity facts
giving rise to a strong inference that the defendant acted
with the required state of mind." 15 U.S.C. § 78u4(b)(2). The Ninth Circuit has held that a private securities plaintiff "must plead, in great detail, facts that constitute [*13] strong circumstantial evidence of deliberately
reckless or conscious misconduct." In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 974 (1999).
Silicon raises the specificity standard for pleading
fraudulent intent to an unprecedented level of fact pleading. Identifying specific internal reports that contradict
contemporaneous public statements is insufficient to
meet the new standard. See id. at 984. Among other
things, plaintiffs must supply a detailed description of the
reports as well as such facts as may indicate their reliability. See id. at 984-85. Simply identifying the content
of the report, the officers who received it, and the department that prepared it is insufficient. See id. at 998
n.24 (Browning, J., dissenting).
Here, Plaintiffs have not met the rigorous standard
relating to scienter established by the Ninth Circuit as to
Defendants Treinen Sr., Cuthbert, and Vinke. Although
Plaintiffs have alleged some facts from which Defendants' intentional misconduct can be inferred, they have
not alleged facts "in great detail" supporting a "strong
inference" of such misconduct.
For example, to establish [*14] scienter on the part
of Defendant Cuthbert, Plaintiffs allege that "between
1992 and 1996, Mr. Enger had at least one conversation
per year with Defendant Cuthbert and corresponded with
Defendant Cuthbert in writing regarding the illegality of
the burning of reactive wastes, which had been and was
being undertaken by SDI on SDI property, in the absence
of an Air Quality Management District ('AQMD') permit
or a permit from the California Department of Toxic
Substances Control ("DTSC"), called a 'Part B Permit,'
and regarding the corresponding need to apply for and
obtain such permits." n4 SAC P 16. Plaintiffs also allege
that Enger "frequently informed" Cuthbert of these facts
between 1996 and 1998. See SAC P 16.
n4 Enger began working for SDI in late 1991
as a Safety Engineer and later as a Facility Manager. See SAC P 16.
Plaintiffs need to allege with greater specificity
when Enger conversed with and wrote to Defendant
Cuthbert. More importantly, however, Plaintiffs fail to
specify the circumstances [*15] under which the communications took place. For example, Plaintiffs do not
specify what Enger actually said or wrote, whether the
conversations took place over the telephone or in person,
and if in person, where the conversations took place. As
to the period between 1996 and 1998, Plaintiffs do not
even allege whether the communications were oral or
written. All of these facts, if properly pled, would bolster
the reliability of Enger's alleged communications for the
purpose of establishing scienter.
Similarly, to establish scienter on the part of Defendants Treinen Sr. and Vinke, Plaintiffs simply allege that
"from 1996 to 1998, Mr. Enger frequently informed Defendants Treinen Sr. . . . and Vinke of the illegality of
SDI's burning of reactive wastes on SDI's property in the
absence of either the needed air permit or a Part B permit, of the corresponding need to apply for and obtain
such permits, and other Environmental Protection
Agency ("EPA") violations, including ground contamination and improper storage of hazardous wastes." SAC P
16. Again, Plaintiffs have failed to plead whether Enger
"informed" Defendants Treinen Sr. and Vinke in writing
or orally, and if orally, whether the [*16] conversations
took place over the telephone or in person. In either case,
Plaintiffs should be more specific as to the circumstances
of the communications, including but not limited to when
and where they took place, how often they took place,
and what specifically was said or written. Moreover,
Plaintiffs fail to provide any specifics as to the alleged
EPA violations.
Accordingly, to the extent Plaintiffs seek to hold Defendants Treinen Sr., Cuthbert, and Vinke liable for federal securities fraud violations relating to SDI's environmental compliance, Defendants' motions to dismiss are
granted and Plaintiffs' first and second causes of action
are dismissed without prejudice and with leave to amend
as to those Defendants. n5
n5 Defendant Treinen Jr. does not argue that
Plaintiffs failed to sufficiently plead scienter as to
him. Accordingly, the Court does not consider
that issue. For the reasons stated in the Court's
analysis of Plaintiffs' common-law fraud claims,
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Plaintiffs' federal securities fraud claims are not
dismissed as to Defendant Treinen Jr.
[*17]
2. Plaintiffs' common-law fraud claims
To state a cause of action for common-law fraud, a
plaintiff must allege that the defendant made a knowing
misrepresentation of fact with the intent to deceive and
that the plaintiff actually and justifiably relied on the
misrepresentation to his detriment. See Seeger v. Odell,
18 Cal. 2d 409, 414, 115 P.2d 977 (1941). Intent is not a
requisite element of a negligent misrepresentation claim,
in that a defendant may be liable if he honestly but unreasonably believed in the truth of the misrepresentation.
See Bily v. Arthur Young & Co., 3 Cal. 4th 370, 407, 834
P.2d 745 (1992).
Here, the allegations in Plaintiffs' Second Amended
Complaint satisfy Rule 9(b). Plaintiffs allege that Defendants represented throughout 1998 that SDI was in compliance with applicable environmental laws and permitting requirements. Plaintiffs further allege that, at all
relevant times, Defendants were aware of and concealed
the existence of unpermitted waste combusters located at
SDI's Newhall facility that had been and were being used
unlawfully to dispose of substantial quantities of excess
explosive powder and other hazardous or potentially
hazardous products by burning. n6 See SAC PP 16, 30,
32-34. Finally, Plaintiffs allege that Defendants knew the
misrepresentations were false when made and that Plaintiffs relied to their financial detriment on those misrepresentations. See SAC PP 15, 17-18, 27-28, 35-36, 42-43,
47-48, 59.
Federal Rule of Civil Procedure 9(b) requires that
"in all averments of fraud or mistake, the circumstances
constituting fraud or mistake shall be stated with particularity." FED. R. CIV. P. 9(b). It is sufficient, however, to
allege scienter generally. See id.; In re Glenfed, Inc. Sec.
Litig., 42 F.3d 1541, 1545 (9th Cir. 1994).
A complaint complies with Rule 9(b) "if it identifies
the circumstances constituting fraud so that a defendant
can prepare an adequate answer from the allegations."
Moore v. Kayport Package Express, Inc., 885 F.2d 531,
540 (9th Cir. 1989). [*18] Allegations in a complaint
must be "specific enough to give defendants notice of the
particular misconduct which is alleged to constitute the
fraud charged so that they can defend against the charge
and not just deny that they have done anything wrong."
Semegen v. Weidner, 780 F.2d 727, 731 (9th Cir. 1986).
While mere conclusory allegations of fraud are insufficient, statements of the time, place, and nature of the
alleged fraudulent activities are sufficient. See Wool v.
Tandem Computers Inc., 818 F.2d 1433, 1439 (9th Cir.
1987). In other words, "the plaintiff must set forth an
explanation as to why the statement or omission complained of was false or misleading." Glenfed, 42 F.3d at
1548.
Rule 9(b) is satisfied most easily when there is direct
evidence of the fraud, meaning "falseness is clear from
the facts that had existed all along and were later revealed." Id. at 1549. In such cases, a plaintiff may simply
set forth these facts, including allegations of time, place,
and scienter, and satisfy Rule 9(b). See id. at 1548. Thus,
a complaint alleging that the plaintiff bought a house
from the defendant, [*19] that the defendant assured the
plaintiff that the house was in perfect shape, and that the
house was in fact built on a landfill or in a highly irradiated area, would satisfy Rule 9(b). See id.; Fecht v. The
Price Co., 70 F.3d 1078, 1083 (9th Cir. 1995).
n6 Defendants object that Plaintiffs failed to
specify which laws were allegedly violated. A
complaint, however, is not defective for this reason, even where a heightened pleading standard
applies. Lee McHenry v. Renne, 84 F.3d 1172,
1179 (9th Cir. 1996) (discussing rule in context
of civil rights action) In any event, Plaintiffs do
allege that SDI operated burn units without an
AQMD permit and a DTSC "Part B Permit."
[*20]
Defendants make several arguments why Plaintiffs'
fraud claims should nevertheless fail. None of these arguments are persuasive. First, Defendants argue that the
alleged misrepresentations in the Confidential Information Memorandum, the Offering Memorandum, the
Merger Agreement, and the SEC filings are not properly
attributed to any particular defendant. This lack of individuation, however, does not render Plaintiffs' Second
Amended Complaint defective. Indeed, false or misleading information conveyed in prospectuses, registrations
statements, annual reports, press releases, or other
"group-published information" are presumed to be the
collective actions of the officers. n7 See Wool, 818 F.2d
at 1440; Schlagal v. Learning Tree Int'l, 1998 U.S. Dist.
LEXIS 20306, 1998 WL 1144581, at *6 (C.D. Cal. Dec.
23, 1998). The "group-pleading" or "group-published
information" doctrine applies where the individual defendants constitute a narrowly defined group of officers
who had direct involvement in the day-to-day affairs of
the corporation. See Wool, 818 F.2d at 1440; Schlagal,
1998 WL 1144581, at *6. Here, it sufficiently appears
from the Second Amended [*21] Complaint that Defendants Treinen Sr., Treinen Jr., Cuthbert, and Vinke constitute a narrowly tailored group of officers who had direct involvement in the day-to-day affairs of SDI. Indeed, these individuals were the President and Chief Ex-
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ecutive Officer, a Vice President, the President of the
Automotive Division, and the Chief Financial Officer,
respectively, of SDI. See SAC P 4.
n7 Regardless, it is apparent that Defendants
Treinen Sr., Vinke, and Cuthbert signed SDI's
Form 10-K filed with the SEC. See Pls.' Request
Jud. Not., Ex. 1.
Second, Defendants argue that any statements they
made regarding SDI's environmental compliance constitute non-actionable opinions. Even if Defendants' statements were opinions in the abstract, however, the Court
could not conclude as a matter of law that they are insufficient to support Plaintiffs' fraud claims. Where a party
affirms an otherwise non-actionable opinion as an existing fact material to a transaction, the statement becomes
an affirmation of fact. See [*22] Crandall v. Parks, 152
Cal. 772, 776, 93 P. 1018 (1908); WITKIN,
SUMMARY OF CALIFORNIA LAW, § 681 (9th ed.,
Vol 5); see also In re Wells Fargo Sec. Litig., 12 F.3d
922, 930 (9th Cir. 1993) ("Statements of . . . opinions, or
beliefs are 'factual' for purposes of the securities laws,
and thus are actionable under § 10(b), if . . . there is [no]
reasonable basis for that belief [or] . . . the speaker is . . .
aware of any undisclosed facts tending to seriously undermine the accuracy of the statement."). It appears clear
from the allegations in Plaintiffs' Second Amended
Complaint that Defendants' statements were intended as
affirmations of an existing fact and were material to
Plaintiffs' decision to acquire a controlling interest in
SDI. Thus, Defendants' statements appear to constitute
affirmations of fact.
Finally, Defendants argue that Plaintiffs cannot
demonstrate that they justifiably relied on Defendants'
alleged misstatements. The basis for Defendants' objection is essentially that Plaintiffs conducted their own due
diligence investigation and therefore had an opportunity
to discover SDI's allegedly unlawful burn activities.
Justifiable [*23] reliance, however, is ordinarily a
question of fact. See Guido v. Koopman, 1 Cal. App. 4th
837, 843 (1992). Only when reasonable minds can reach
no other conclusion may the question of reliance be decided as a matter of law. See id. Reliance is unreasonable
as a matter of law when an investor closes his eyes to a
known risk. See Atari Corp. v. Ernst & Whinney, 981
F.2d 1025, 1030-31 (9th Cir. 1992) (deciding issue of
justifiable reliance on motion for summary judgment).
For example, "it is a well settled rule that where a party
relies on his independent investigation after acquiring all
the knowledge he desires without hinderance, he will not
be heard to say that he relied on the representation of the
other party." Goodman v. Jonas, 142 Cal. App. 2d 775,
793, 299 P.2d 424 (1956).
Here, the Second Amended Complaint discloses that
Plaintiffs conducted an investigation into SDI's environmental compliance. Plaintiffs also allege, however, that
Defendants hindered that process, either by representing
to Plaintiffs' attorneys or accountants that there were no
substantial compliance problems or by effectively causing the preparation [*24] of a misleading environmental
site assessment report. Thus, the Court cannot determine
as a matter of law that Plaintiffs have failed to demonstrate justifiable reliance. To be sure, Defendants raise
questions of fact regarding the scope of Plaintiffs' investigation and the reasonableness of their reliance, but
those questions are more appropriately decided on a motion for summary judgment, where the factual record is
more fully developed.
Accordingly, Defendants' motions to dismiss are denied as to Plaintiffs' fourth through sixth causes of action
for common-law fraud.
B. Plaintiffs' Fraud Claims Relating to the Alleged
Accounting Misstatement
In addition to the environmental allegations, Plaintiffs allege that Defendants overstated SDI's earnings by
$ 638,000 for the fiscal year ending October 31, 1998.
The alleged overstatement resulted from the failure to
record in SDI's financial statements and balance sheets a
retroactive price discount agreement between SDI and
TRW Vehicle Safety System Inc. ("TRW") that was
signed on October 30, 1998 by Defendant Cuthbert. See
SAC PP 50-51. Plaintiffs allege that Defendant Cuthbert
intentionally failed to record the price discount [*25] in
order to inflate SDI's earnings. Lee SAC P 52. Plaintiffs
further allege that in a December 8, 1998 letter to KPMG
Peat Marwick, SDI's auditors, Defendants Treinen Sr.
and Vinke falsely represented that no material transactions were left unrecorded in SDI's accounting records
underlying the financial statements. See SAC P 51. As a
result of the omission of the price discount, Plaintiffs
allege that "SDI's earnings for the fiscal year ending October 31, 1998 were significantly higher than they actually were." SAC P 55.
Plaintiffs' fraud claims are defective, however, because Plaintiffs have failed to sufficiently plead the materiality of the alleged accounting misstatement. Whether
an omission is material "is a determination that requires
delicate assessments of the inferences a reasonable
shareholder would draw from a given set of facts and the
significance of those inferences to him." Fecht, 70 F.3d
at 1080 (internal quotations omitted). To be sure, this
assessment is typically a factual inquiry not determined
as a matter of law. See id. at 1081. But where a complaint fails to plead facts from which an inference of ma-
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teriality can be drawn, [*26] a trier of fact cannot make
a conclusion one way or the other.
Plaintiffs allege simply that the $ 638,000 omission
caused SDI's earnings to appear "significantly higher"
than they actually were. This allegation, however, is the
type of conclusory statement that Rule 9(b) was designed
to prevent. Plaintiffs need to plead evidentiary facts that
help explain why an omission of $ 638,000 would be
material to a reasonable investor. See Glenfed, 42 F.3d at
1548 & n.7. For example, Plaintiffs could allege the
amount of SDI's revenues or earnings for the fiscal year
ending October 31, 1998 and the amount by which revenues or earnings were overstated as a result of the omission. See Schlagal, 1998 WL 1144581, at *6-*7; Marksman Partners v. Chantal Pharmaceutical Corp., 927 F.
Supp. 1297, 1306 (C.D. Cal. 1996); In re Gupta Corp.
Sec. Litig., 900 F. Supp. 1217, 1231 (N.D. Cal. 1994).
Absent such basic information, the Court has no way of
knowing whether an average investor would consider the
alleged omission important.
Accordingly, to the extent Plaintiffs seek to hold Defendants liable for the alleged accounting misstatement,
[*27] Defendants' motions are granted and Plaintiffs'
first, second, fourth, fifth, and sixth causes of action are
dismissed without prejudice and with leave to amend. n8
n8 Plaintiffs' first and second causes of action for federal securities fraud are also defective
as to Defendants Treinen Sr., Treinen Jr., and
Vinke because Plaintiffs have failed to plead facts
in great detail supporting a strong inference that
these defendants acted with the requisite scienter.
Indeed, Plaintiffs have not pled any facts demonstrating that these defendants were aware of the
TRW price discount agreement.
In addition, if Plaintiffs were unaware of the
TRW price discount agreement and/or its effects
on SDI's earnings before the recapitalization of
SDI was completed on December 15, 1998, they
should so indicate in an amended pleading.
C. Plaintiffs' RICO Claim
Plaintiffs' third cause of action is for a violation of
the Racketeer Influenced and Corrupt Organizations Act
("RICO"). To prevail on a RICO claim, a plaintiff must
[*28] establish a "pattern of criminal activity." 18 U.S.C.
§ 1962. At a minimum, a "pattern" requires that the
predicate criminal acts be "related" and "continuous."
H.J. Inc. v. Northwestern Bell Tel. Co., 492 U.S. 229,
239, 106 L. Ed. 2d 195, 109 S. Ct. 2893 (1989). In terms
of the continuity requirement, a RICO plaintiff must allege either a "closed-ended" pattern, in which the crimi-
nal conduct "extended over a substantial period of time,"
or an "open-ended" pattern, in which the predicate acts
"include a specific threat of repetition extending indefinitely into the future." Id.at 242.
Plaintiffs allege that they were the victims of numerous predicate acts, consisting of mail and wire fraud,
extending over a period of eleven months. See SAC PP
72-73. Plaintiffs, however, have failed to demonstrate
that Defendants' conduct constitutes a pattern of racketeering activity.
First, Plaintiffs have not established open-ended
continuity because they have not demonstrated that Defendants' conduct carried with it the threat of future
criminal activity. Defendants' efforts were allegedly directed towards inducing Plaintiffs to acquire [*29] a
controlling interest in SDI. Once the transaction closed,
the alleged fraud was complete. See Medallion Television Enters. v. SelecTV of California, Inc., 833 F.2d
1360, 1363-64 (9th Cir. 1988) (finding no threat of continuing illegal activity where predicate acts concerned a
single, fraudulent inducement to enter joint venture contract); Lipin Enters. Inc. v. Lee, 803 F.2d 322, 324 (7th
Cir. 1986) (fraudulent representations inducing sale of
stock did not constitute a pattern of racketeering activity).
Second, Plaintiffs have not established closed-ended
continuity because they have not demonstrated that Defendants' predicate acts extended over a substantial period of time. In Allwaste, Inc. v. Hecht, the Ninth Circuit
rejected a bright-line rule that predicate acts for the purposes of closed-ended continuity must extend for at least
one year. See 65 F.3d 1523, 1528 (9th Cir. 1995). In
Hecht, the court held that allegations that the predicate
acts "occurred over a substantial period of time, as much
as thirteen months" was sufficient to survive a motion to
dismiss. Id. In Religious Technology Center v. Wollersheim, [*30] however, the Ninth Circuit also held that
"[a] pattern of activity lasting only a few months does
not reflect the 'long term criminal conduct' to which
RICO was intended to apply." 971 F.2d 364, 367 (9th
Cir. 1992) (citing H.J. Inc., 492 U.S. at 242). In support
of that proposition, the court cited a Third Circuit case
holding that a fraudulent scheme lasting eight months
directed at a single entity did not meet the continuity test.
See id. (citing Kehr Packages, Inc. v. Fidelcor, Inc, 926
F.2d 1406, 1418 (3rd Cir. 1991)). Based on these cases,
it does not appear that predicate acts extending over a
period of eleven months satisfies the closed-ended continuity test. See China Trust Bank of New York v. Standard Chartered Bank, 981 F. Supp. 282, 287 (S.D.N.Y.
1997) ("An eleven month period of predicate activity
does not constitute a sufficient pattern.").
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2000 U.S. Dist. LEXIS 10329, *; Fed. Sec. L. Rep. (CCH) P91,046
Accordingly, Defendants' motions to dismiss are
granted and Plaintiffs' third cause of action for a violation of RICO is dismissed with prejudice.
III. Defendants' Joint Motion to Strike
Defendants jointly move to strike the following language from [*31] paragraphs 65, 70, 87, 93, and 99 of
Plaintiffs' Second Amended Complaint: "[Plaintiffs]
have incurred costs and expended sums in excess of the
jurisdiction of this Court and are continuing to incur further costs to bring SDI from a state of noncompliance
with environmental laws, regulations, ordinances, permitting requirements and building code requirements, to
a state of verifiable and assured compliance." Defendants
argue that the costs incurred by SDI to ensure compliance with applicable environmental laws reflect damages
to SDI, not to shareholder Plaintiffs. Defendants' argument is without merit.
In general, a shareholder does not have standing to
bring an action on his own behalf to redress an injury to
the corporation. See Von Brimer v. Whirlpool Corp., 536
F.2d 838, 846 (9th Cir. 1976). An exception to this rule
arises, however, when the injury is to the plaintiff individually, "'as where the action is based on a contract to
which he is a party, or on a right belonging severally to
him, or on a fraud affecting him directly.'" Id. (quoting
Sutter v. General Petroleum Corp., 28 Cal. 2d 525, 530,
170 P.2d 898 (1946)) (emphasis added). [*32]
Here, Plaintiffs do not allege that SDI was damaged
by Defendants' fraud. Rather, Plaintiffs allege that Defendants defrauded them into paying more for a controlling interest in SDI than that interest was actually worth.
Plaintiffs allege that had SDI been in compliance with
applicable environmental laws, as Defendants represented, Plaintiffs would not have purchased SDI stock at
a price far in excess of its actual value. Thus, the cost of
bringing SDI into environmental compliance directly
relates to the damages sustained by Plaintiffs.
The Court does not read the contested language to
mean that Plaintiffs, as majority stockholders, are entitled to all costs incurred by SDI to ensure environmental
compliance. But Plaintiffs would be entitled to such costs
to the extent they reflect the difference in value between
what Plaintiffs invested in SDI and what they should
have invested at closing based on SDI's lack of compli-
ance. n9 Accordingly, the Court denies Defendants' motion to strike.
n9 In addition, as the Court construes them,
Plaintiffs' fraud claims are based only on SDI's
alleged operation of burn units without AQMD
and DTSC permits, not on any other environmental violations that may have existed. Thus,
Plaintiffs clearly are not entitled to recover costs
necessary to achieve compliance with "environmental laws, regulations, ordinances, permitting
requirements and building code requirements" to
the extent such compliance is not related to the
alleged operation of unpermitted burn units.
[*33]
IV. Defendants' Joint Motion for Judicial Notice
Defendants move the Court to take judicial notice of
various documents, most of which are referred to in the
Second Amended Complaint. The Court denies the motion as to two of the documents for which judicial notice
is sought, neither of which were referenced in the Second
Amended Complaint.
Exhibit 8 is a Form S-4 Registration Statement filed
by SDI with the SEC on April 8, 1999. Because the
transaction at issue in this case closed in December 1998,
Exhibit 8 is not relevant to the allegations of fraud in the
Second Amended Complaint.
Exhibit 9 is a page from the Paul Weiss website detailing the biography of Gaines Gwathmey. Exhibit 9
does not contain the kind of information that is "capable
of accurate and ready determination by resort to sources
whose accuracy cannot be reasonably questioned." FED.
R. EVID. 201(b)(2).
Accordingly, the Court does not take judicial notice
of Exhibits 8 and 9. The Court, however, does take judicial notice of Exhibits 1 through 7.
IT IS SO ORDERED.
DATED: June 9, 2000
WILLIAM J. REA
United States District Judge
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Briefs and Other Related Documents
Morgan v. AXT, Inc.N.D.Cal.,2005.Only the
Westlaw citation is currently available.
United States District Court,N.D. California.
Thomas O. MORGAN, et al., Plaintiffs,
v.
AXT, INC. and Morris S. Young, Defendants.
No. C 04-4362 MJJ, C 05-5106 MJJ.
Sept. 23, 2005.
Lionel Z. Glancy, Peter A. Binkow, Mark L.
Labaton, Michael M. Goldberg, Glancy Binkow &
Goldberg LLP, Elizabeth P. Lin, Milberg Weiss
Bershad & Schulman LLP, Los Angeles, CA, for
Plaintiffs.
David Priebe, Shirli Fabbri Weiss, Daivd Banie,
DLA Piper Rudnick Gray Cary LLP, East Palo Alto,
CA, for Defendants.
ORDER DISMISSING PLAINTIFF'S COMPLAINT
WITHOUT PREJUDICE
JENKINS, J.
INTRODUCTION
*1 Before the Court is Defendants' motion to dismiss
this private securities fraud action. Plaintiff Thomas
O. Morgan (“Plaintiff”),FN1 representing a purported
class of all purchasers of AXT, Inc., stock between
February 6, 2001, and April 27, 2004, opposes the
motion. For the following reasons, the Court
GRANTS Defendants' motion to dismiss, but
GRANTS Plaintiff leave to amend.
FN1. In an Order dated February 2, 2005,
the Court granted Plaintiff Morgan's motion
for appointment as lead plaintiff.
FACTUAL BACKGROUND
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Page 1
fiber optic telecommunciations, lasers, light emitting
diodes, satellite solar cells, and consumer electronics
such as cell phones. AXT sells compound
semiconductor non-silicon substrates manufactured
from gallium arsenide, indium phosphide, and
germanium. AXT employs its proprietary Vertical
Gradient Freeze method for manufacturing the nonsilicon substrates. During the period of time at issue
in the instant lawsuit (February 6, 2001, through
April 27, 2004 (the “Class Period”)), AXT also
produced and sold light-emitting diodes (“LEDs”)
and vertical cavity surface emitting laser chips
through its opto-electronic division. AXT sold its
products to original equipment manufacturers
(“OEMs”). The particular testing required and
characteristics of those AXT products were
determined by the OEMs. Defendant Dr. Morris S.
Young (“Defendant Young”) served as the
Company's CEO and Chairman of the Board during
the Class Period.
On February 6, 2001, AXT issued a press release
reporting the Company's strong commitment to its
customers and touting AXT's customers' confidence
in AXT. The press release referenced the Company's
“supply of high quality substrates” and reported that
AXT was “pleased to support [its] strategic
customers' substrate requirements for the year and
believe[d] that the value of the contracts under th[e]
[Supply Guarantee Program] is a good indicator of
[AXT's] ability to deliver continued revenue and
profit expansion.” (Complaint (“Comp.”), ¶ 31.)
On February 26, 2001, the Company filed its annual
report for FY 2000 on Form 10-K with the SEC. The
10-K stated: “We believe that our success is partially
due to our manufacturing efficiency and high product
yields and we continually emphasize quality and
process control throughout our manufacturing
operations.” The 10-K also explained that AXT's
policy was to recognize revenue when its products
were shipped to the customer as long as, inter alia,
there are no customer acceptance requirements and
no remaining significant obligations. (Id., ¶ 32.)
A. Background
Defendant AXT, Inc.'s (“AXT” or the “Company”) is
a publicly-traded company that manufactures
semiconductor parts, known as substrates, used by a
variety of electronic products including wireless and
On April 25, 2001, AXT issued a press release
announcing its financial results for the first quarter of
2001. The Company reported that revenue was up a
record $40.1 million and that net income was up $5
million. In the press release, AXT expressed its belief
that its products' “strong engineering design and
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development capability allows [AXT] to tailor [its]
standard products to meet customer specific
requirements and gives [AXT] competitive
advantages.” (Comp., ¶ 33.) On May 3, 2001, AXT
filed its quarterly report on Form 10-Q with the SEC,
reaffirming the Company's previously announced
financial results for the first quarter of 2001.
*2 On July 25, 2001, AXT issued a press release
announcing its financial results for the second quarter
of 2001. The Company reported that revenue reached
a record $41.3 million and that net income was up
$5.2 million. On August 1, 2001, AXT filed its
quarterly report on Form 10-Q with the SEC,
reaffirming the Company's previously announced
financial results for the second quarter of 2001.
On October 24, 2001, AXT issued a press release
announcing its financial results for the third quarter
of 2001. The Company announced that reported net
losses for the quarter but stated that “strategic
research and development investments are
positioning AXT well for continued leadership” and
that the Company's “VFG gallium arsenide and
indium phosphide substrates continue to offer
superior features for manufacturers of high quality
electronic and opto-electronic devices.” The press
release went on to say that AXT “believe[s] that [it]
remain[s] the world leader in providing both
products.” (Comp., ¶ 38.) On November 7, 2001,
AXT filed its quarterly report on Form 10-Q with the
SEC, reaffirming the Company's previously
announced financial results for the third quarter of
2001.
On February 6, 2002, AXT issued a press release
announcing its financial results for the fourth quarter
of 2001 and for FY 2001. The Company again
reported that its specialized substrates “continue to
offer superior features for manufacturers of high
quality electronic and opto-electronic devices” and
that the Company “expect[ed] an increasing number
of key customers to recognize the superiority of
[AXT's] technology in the future.” (Id., ¶ 40.) On
March 26, 2002, AXT filed its Form 10-K annual
report with the SEC, reaffirming the Company's
previously announced financial results for the fourth
quarter and for FY 2001, and including the same
description of AXT's revenue recognition policy
described in its FY 2000 annual report.
On April 24, 2002, AXT issued a press release
announcing its financial results for the first quarter of
2002. The Company reported net losses for the
quarter but stated that its reputation for LED quality,
Page 22 of 65
Page 2
value, and delivery was growing. On May 3, 2002,
AXT filed its quarterly report on Form 10-Q with the
SEC, reaffirming the Company's previously
announced financial results for the first quarter of
2002.
On July 24, 2002, AXT issued a press release
announcing its financial results for the second quarter
of 2002. The Company reported that revenue
increased 14 % and stated, “We are particularly
pleased with the growth of our LED division, which
has recorded double digit revenue growth for the past
three quarters, efficiently increased manufacturing
capacity to sustain this growth, improved growth
margins, and approached overall profitability.” On
August 15, 2002, AXT filed its quarterly report on
Form 10-Q with the SEC, reaffirming the Company's
previously announced financial results for the second
quarter of 2002. Defendant Young also filed a
certification pursuant to the Sarbanes-Oxley Act that
the “information contained in the Report fairly
presents, in all material respects, the financial
condition and result of operations of the Company.”
*3 On October 23, 2002, AXT issued a press release
announcing its financial results for the third quarter
of 2002. The Company reported that “AXT will
continue to benefit from the strength of our
technology.” (Comp., ¶ 48.) On November 12, 2002,
AXT filed its quarterly report on Form 10-Q with the
SEC, reaffirming the Company's previously
announced financial results for the third quarter of
2002. The Form 10-Q also stated that, “Based on
their evaluation, our principal executive officer and
principal financial officer concluded that our
disclosure controls and procedures are effective.”
On February 5, 2003, AXT issued a press release
announcing its financial results for the fourth quarter
of 2002 and for FY 2002. On March 21, 2003, AXT
filed its Form 10-K annual report with the SEC. In
the 10-K, the Company stated, “the lives of our
substrate products are relatively long and
accordingly, obsolescence has historically not been a
significant factor.” The Company again described its
revenue recognition policy, as it had in its 2000 and
2001 annual reports. The 10-K also contained a
certification, pursuant to the requirements of the
Sarbanes-Oxley Act, averring that the report “does
not contain any untrue statement of material fact or
omit to state a material fact” and that the financial
statements” fairly present in all material respects the
financial condition” of the Company.
On April 23, 2003, AXT issued a press release
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announcing its financial results for the first quarter of
2003. The Company reported net losses for the
quarter. On May 9, 2003, AXT filed its quarterly
report on Form 10-Q with the SEC, reaffirming the
Company's previously announced financial results for
the first quarter of 2003. The 10-Q reported certified
that the Company's “disclosure controls and
procedures are effective.”
On July 23, 2003, AXT issued a press release
announcing its financial results for the second quarter
of 2004. The Company reported net losses. On
August 12, 2003, AXT filed its quarterly report on
Form 10-Q with the SEC, reaffirming the Company's
previously announced financial results for the second
quarter of 2003. The 10-Q again contained a
certification regarding disclosure controls and
procedures as the May 10-Q had.
On October 22, 2003, AXT issued a press release
announcing its financial results for the third quarter
of 2003. The Company again reported net losses. On
November 13, 2003, AXT filed its quarterly report on
Form 10-Q with the SEC, reaffirming the Company's
previously announced financial results for the third
quarter of 2003, and containing certifications
regarding the Company's disclosure controls and
procedures.
On February 4, 2004, AXT issued a press release
announcing its financial results for the fourth quarter
of 2003 and for FY 2003. On March 29, 2004, AXT
filed its Form 10-K annual report with the SEC. The
10-K certified that the Company's disclosure controls
and procedures were effective and that the report
contained no “untrue statement[s] of material fact”
and did not “omit to state a material fact” and that the
financial statements” fairly present in all material
respects the financial condition” of the Company.
*4 On April 27, 2004, AXT issued a press release
revealing that the “first quarter's financial review and
verification process ha[d] been delayed due to an
investigation by AXT's Audit Committee of certain
product testing practices and policies.” (Comp., ¶
64.) The next day, AXT stock dropped by 13.64%. A
day later, AXT's stock dropped further, by nearly
23%, to close at $2.20 per share.
On May 24, 2004, AXT filed its quarterly report on
Form 10-Q with the SEC, announcing that AXT had
“not followed requirements for testing of products
and provision of testing data and information relating
to customer requirements for certain shipments made
over the past several years.” The 10-Q reported that
Page 3
AXT then increased its reserve for sales returns by
$745,000, and recorded a $2.1 million charge for
obsolete inventory manufactured in the previous two
and three years because the specifications of its
products differed from customer orders. AXT also
announced that it had reassigned its CEO and
Chairman of the Board, Defendant Young to head up
AXT's China unit, and had replaced the Company's
independent
auditor,
PriceWaterhouseCoopers
(“PwC”). (Comp., ¶ ¶ 65-68, 70.) Plaintiff Morgan
subsequently filed the instant lawsuit,FN2 claiming
that he and other members of the proposed class who
purchased shares of AXT stock between February 6,
2001, and April 27, 2004, were injured because they
bought AXT stock at artificially-inflated prices which
plummeted when the Company disclosed to the
public the internal investigation into its practices.
FN2. Two separate lawsuits were brought by
investors in AXT stock against AXT and
Defendant Young: (1) City of Harper Woods
Employees Retirement Sys. v. AXT, Inc., 0404362 MJJ, filed on October 15, 2004; and
(2) Robertson v. AXT, Inc., 04-05106 MJJ,
filed on December 2, 2004. In its February
2, 2005, Order, the Court granted Plaintiff
Morgan's motion to consolidate the lawsuits.
B. The Complaint
In his Consolidated Complaint for Violations of the
Federal
Securities
Laws
(hereinafter,
the
“Complaint”), Plaintiff alleges that AXT and
Defendant Young, AXT's former Chairman and Chief
Executive Officer, violated § § 10(b) and 20(a) of
the Securities and Exchange Act of 1934 (“Exchange
Act”), 15 U.S.C. § § 78j(b) and 78(t)a, and Securities
and Exchange Commission (“SEC”) Rule 10b-5, 17
C.F.R § 240.10b-5. According to Plaintiff, during the
Class Period, Defendants knowingly shipped
products that did not conform to customer testing
requirements or specifications. Plaintiff alleges that
Defendants failed to properly account for products
that were defective or could not be sold by
improperly recognizing revenue on those sales even
though Defendants knew the products would be
returned and failing to accrue adequate reserves.
Plaintiff claims that Defendants violated the
securities laws by knowingly issuing false or
misleading statements about AXT's reserves,
revenue, and income (hereinafter, the “financial
statements”), and by knowingly issuing false or
misleading statements touting the quality of AXT's
products and AXT's ability to meet customer
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requirements (hereinafter, the “quality statements”).
In his Complaint, Plaintiff alleges that his claims are
supported by the statements of three confidential
witnesses-a Quality Technician who used to work for
AXT, a former AXT Corporate Vice President, and a
former tester of returned AXT products.FN3 The
former Quality Technician allegedly confirmed that
the Company knowingly shipped to customers
products that did not meet customer specifications,
that the Company was aware that the products would
be returned, and that almost every shipment was, in
fact, returned. Specifically, the technician said that
when AXT conducted specification checks on its
LED wafers for wavelength, luminosity, vision, and
current, the wafers never met all the specifications.
The former tester of returned AXT products allegedly
confirmed that the passivation layer (the top
protective layer) on AXT's LEDs was consistently
weak, making the LEDs easily and irreparably
damaged. The tester allegedly said that AXT knew
this was a problem and lacked adequate product
testing equipment. The former Corporate Vice
President allegedly confirmed that AXT failed to
perform full testing of its products and lacked the
right equipment for testing. (Comp., ¶ ¶ 78-80.)
FN3. In his Complaint, Plaintiff does not
allege that the third confidential witness-the
tester of returned AXT products-was ever an
AXT employee. In his opposition to the
instant motion, however, Plaintiff describes
this witness as a former AXT employee.
*5 Plaintiff alleges that during the Class Period,
Defendants reported that one of the Company's larger
customers, Agilent, had canceled its orders with AXT
because AXT was shipping products that did not
conform to Agilent's specifications. Defendants
characterized the shipping of out-of-spec products as
a one-time event even though, according to Plaintiff,
AXT had shipped products that did not meet
customer specifications to many of its customers.
(Id., ¶ 86.)
On May 20, 2005, Defendants filed the instant
motion to dismiss pursuant to the Private Securities
Litigation Reform Act of 1995 (“PSLRA”), and
Rules 9(b) and 12(b)(6) of the Federal Rules of Civil
Procedure, on the grounds that Plaintiff has failed to
plead his allegations with sufficient particularity.
LEGAL STANDARD
A. Federal Rules of Civil Procedure
A court may dismiss a complaint pursuant to Federal
Rule of Civil Procedure 12(b)(6) for the pleading of
insufficient facts under an adequate theory.
Robertson v. Dean Witter Reynolds, Inc., 749 F.2d
530, 533-34 (9th Cir.1984). When deciding upon a
motion to dismiss pursuant to Rule 12(b)(6), a court
must take all of the material allegations in the
plaintiff's complaint as true, and construe them in the
light most favorable to the plaintiff. Parks School of
Business, Inc. v. Symington, 51 F.3d 1480, 1484 (9th
Cir.1995).
In the context of a motion to dismiss, review is
limited to the contents in the complaint. Allarcom
Pay Television, Ltd. v. General Instrument Corp., 69
F.3d 381, 385 (9th Cir.1995). When matters outside
the pleading are presented to and accepted by the
court, the motion to dismiss is converted into one for
summary judgment. However, matters properly
presented to the court, such as those attached to the
complaint and incorporated within its allegations,
may be considered as part of the motion to dismiss.
See Hal Roach Studios, Inc. v. Richard Feiner & Co.,
896 F.2d 1542, 1555 n. 19 (9th Cir.1989). Where a
plaintiff fails to attach to the complaint documents
referred to therein, and upon which the complaint is
premised, a defendant may attach to the motion to
dismiss such documents in order to show that they do
not support the plaintiff's claim. See Pacific Gateway
Exchange, 169 F.Supp.2d at 1164; Branch v. Tunnell,
14 F.3d 449, 44 (9th Cir.1994) (overruled on other
grounds). Thus, the district court may consider the
full texts of documents that the complaint only quotes
in part. See In re Stay Electronics Sec. Lit., 89 F.3d
1399, 1405 n. 4 (1996), cert denied, 520 U.S. 1103,
117 S.Ct. 1105, 137 L.Ed.2d 308 (1997). This rule
precludes plaintiffs “from surviving a Rule 12(b)(6)
motion by deliberately omitting references to
documents upon which their claims are based.”
Parrino v. FHP, Inc., 146 F.3d 699, 705 (9th
Cir.1998).
Rule 8(a) of the Federal Rules of Civil Procedure
requires only “a short and plain statement of the
claim showing that the pleader is entitled to relief.”
Accordingly, motions to dismiss for failure to state a
claim pursuant to Rule 12(b)(6) are typically
disfavored; complaints are construed liberally to set
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forth some basis for relief, as long as they provide
basic notice to the defendants of the charges against
them. In re McKesson HBOC, Inc. Sec. Litig., 126
F.Supp. 1248, 1257 (N.D.Cal.2000). Where a
plaintiff alleges fraud, however, Rule 9(b) requires
the plaintiff to state with particularity the
circumstances constituting fraud. To meet the
heightened pleading requirements of Rule 9(b), the
Ninth Circuit has held that a fraud claim must contain
three elements: (1) the time, place, and content of the
alleged misrepresentations; and (2) an explanation as
to why the statement or omission complained of was
false or misleading. In re GlenFed, Inc. Sec. Litig., 42
F.3d 1541, 1547-49 (9th Cir.1994).
*6 In the securities context, the
requirements are even more stringent.
pleading
Page 5
The PSLRA's Safe Harbor provision provides that a
securities fraud claim may not lie with respect to a
statement that is “identified as a forward-looking
statement, and is accompanied by meaningful
cautionary statements identifying important factors
that could cause actual results to differ materially
from those in the forward-looking statement.” 15
U.S.C. § 78u-5(c)(1)(A)(I). However, a person may
be held liable if the forward-looking statement is
made with “actual knowledge ... that the statement
was false or misleading.” 15 U.S.C. §
78u5(c)(1)(B); No. 84 Employer-Teamster Joint Council
Pension Trust Fund v. America West Holding Corp.,
320 F.3d 920, 936 (9th Cir.2003); but see In re
Seebeyond Technologies Corp. Sec. Litig., 266
F.Supp.2d
1150,
1164-65
(C.D.Cal.2003)
(disagreeing with the analysis in America West and
finding that a defendant is immune from liability if it
satisfies either 15 U.S.C. § 78u5(c)(1)(A) or (B)).
B. Private Securities Litigation Reform Act
In 1995, Congress enacted the PSLRA to provide
“protections to discourage frivolous [securities]
litigation.” H.R. Conf. Rep. No. 104-369, 104th
Cong., 1st Sess. at 32 (Nov. 28, 1995). The PSLRA
strengthened the already-heightened pleading
requirements of Rule 9(b). Under the PSLRA, actions
based on allegations of material misstatements or
omissions 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 that belief is formed.”
15 U.S.C. § 78u-4(b)(1).
The PSLRA also heightened the pleading threshold
for causes of action brought under Section 10(b) and
Rule 10b-5. Specifically, the PSLRA imposed strict
requirements for pleading scienter. Under the
PSLRA, a complaint must “state with particularity
facts giving rise to a strong inference that the
defendant acted with the required state of mind.” 15
U.S.C. §
78u-4(b)(2). The Ninth Circuit, in
interpreting the PSLRA, has held that “a private
securities plaintiff proceeding under the [PSLRA]
must plead, in great detail, facts that constitute strong
circumstantial evidence of deliberately reckless or
conscious misconduct.” In re Silicon Graphics Inc.,
183 F.3d 970, 974 (9th Cir.1999). If the complaint
does not satisfy the pleading requirements of the
PSLRA, upon motion by the defendant, the court
must dismiss the complaint. See 15 U.S.C. § 78u4(b)(1).
ANALYSIS
I. Request For Judicial Notice
As a threshold matter, the Court addresses
Defendants' request that the Court take judicial notice
of thirteen separate documents, eleven of which are
expressly referenced in Plaintiff's Complaint and two
of which are not. Plaintiff does not object to
Defendants' request.
A. Documents Referenced in Complaint
*7 Defendants ask the Court to judicially notice the
following documents incorporated by reference in
Plaintiff's Complaint: AXT's 10-Ks for the fiscal
years ended December 31, 2000, December 31, 2002,
and December 31, 2003; five AXT press releases,
respectively dated February 6, 2002, October 23,
2002, February 5, 2003, April 23, 2003, and February
4, 2004; AXT's 10-Qs for the quarters ended June 30,
2003, and September 30, 2003; and AXT's Current
Report on SEC Form 8-K, filed on June 24, 2004.
These documents are attached to the Declaration of
David Banie as Exhibits A-K.
Federal Rule of Evidence 201 allows a court to take
judicial notice of a fact “not subject to reasonable
dispute in that it is ... capable of accurate and ready
determination by resort to sources whose accuracy
cannot reasonably be questioned.” Even where
judicial notice is not appropriate, courts may also
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properly consider documents “whose contents are
alleged in a complaint and whose authenticity no
party questions, but which are not physically attached
to the [plaintiff's] pleadings.” Branch v. Tunnel, 14
F.3d 449, 454 (9th Cir.1994).
Here, each of the documents described above is
explicitly incorporated by reference in Plaintiff's
Complaint. (See Complaint, ¶ ¶ 32, 40, 48, 50, 51,
54, 57, 59, 60, 61, 71.) Moreover, the documents are
press releases and SEC filings, both of which are
judicially noticeable in this context. See In re
Homestore.com, Inc. Sec. Litig., 347 F.Supp.2d 814,
817 (N.D.Cal.2004) (the court may take judicial
notice of press releases); In re Calpine Corp. Sec.
Litig., 288 F.Supp.2d 1054, 1076 (N.D.Cal.2003) (the
court may take judicial notice of public filings).
Accordingly, the Court GRANTS Defendants'
request and takes judicial notice of Exhibits A-K to
the Banie Declaration.
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already determined that the Forms 4 should
be judicially noticed on the ground that they
are public documents, the Court declines to
address Defendants' separate grounds for
judicial notice.
2. Exhibit M-AXT's Closing Stock Prices From
February 6, 2001, Through April 29, 2004
Defendants also urge the Court to take judicial notice
of documents reflecting AXT's closing stock prices
during the Class Period. These documents are
attached to the Banie Declaration as Exhibit M. In the
context of a motion to dismiss a securities private
fraud action, a court may take judicial notice of a
company's public stock prices. Homestore.com, 347
F.Supp.2d at 816. Accordingly, the Court takes
judicial notice of these documents.
II. Motion to Dismiss
B. Documents Not Referenced in Complaint
1. Exhibit L-SEC Form 4 filed by Defendant Young
Defendants ask the Court to take judicial notice of
SEC Forms 4 filed on behalf of Defendant Young.
These documents are attached to the Banie
Declaration as Exhibit L. “In a securities action, a
court may take judicial notice of public filings when
adjudicating a motion to dismiss....” Calpine, 288
F.Supp.2d at 1076. The SEC Forms 4 at issue here
are publicly-available documents filed with the SEC.
Accordingly, the Court takes judicial notice of the
documents attached as Exhibit L to the Banie
Declaration.FN4
FN4. Defendants also contend that Exhibit L
should be judicially noticed for two other
independent reasons. First, the Complaint
references Defendant Young's sale of
200,000 shares of AXT stock during the
Class Period. According to Defendants, this
is information that Plaintiff could only have
obtained from reviewing Young's Forms 4,
such that the documents are incorporated by
implicit reference in the Complaint and
should be judicially noticed. Second, the
Forms 4 are central to Plaintiff's allegation
that Defendant Young's Class Period stock
sales are probative of scienter, and should be
judicially noticed on that ground. Having
*8 Defendants contend that Plaintiff's Complaint
should be dismissed because Plaintiff fails to satisfy
the heightened pleading requirements under the
PSLRA, fails to state a claim under Rule 12(b)(6),
and fails to plead fraud with the particularity required
by Rule 9(b). The Court examines Plaintiff's two
claims separately.
A. Plaintiff's First Cause of Action-Violation of
Section 10(b) of the Securities Exchange Act and
Rule 10b-5
Section 10(b) of the Securities Exchange Act (the
“Act”) provides, in part, that it is unlawful “to use or
employ in connection with the purchase or sale of
any security registered on a national securities
exchange or any security not so registered, any
manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the
[SEC] may prescribe.” 15 U.S.C. § 78j(b). Rule 10b5, promulgated under Section 10(b), makes it
unlawful for any person to use interstate commerce:
(a) to employ any device, scheme, or artifice to
defraud; (b) to make any untrue statement of material
fact or to omit to state a material fact necessary in
order to make the statements made, in the 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.
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For a claim under Section 10(b) and Rule 10b-5 to be
actionable, a plaintiff must allege: (1) a
misrepresentation or omission; (2) of material fact;
(3) made with scienter; (4) on which the plaintiff
justifiably relied; (5) that proximately caused the
alleged loss. See Binder v. Gillespie, 184 F.3d 1059,
1063 (9th Cir.1999). A complaint 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 that belief is
formed.” 15 U.S.C. § 78u-4(b)(2). As discussed
above, in order to avoid having the action dismissed,
a plaintiff must “plead with particularity both falsity
and scienter.” Ronconi v. Larkin, 253 F.3d 423, 429
(9th Cir.2001). The Ninth Circuit, in Ronconi,
articulated the rule as follows:
Because falsity and scienter in private securities fraud
cases are generally strongly inferred from the same
set of facts, we have incorporated the dual pleading
requirements of 15 U.S.C. § § 78u-4(b)(1) and (b)(2)
into a single inquiry. In considering whether a private
securities fraud complaint can survive dismissal
under Rule 12(b)(6), we must determine whether
‘particular facts in the complaint, taken as a whole,
raise a strong inference that defendants intentionally
or [with] ‘deliberate recklessness' made false or
misleading statements to investors.’ Where pleadings
are not sufficiently particularized or where, taken as a
whole, they do not raise a ‘strong inference’ that
misleading statements were knowingly or [with]
deliberate recklessness made to investors, a private
securities fraud complaint is properly dismissed
under Rule 12(b)(6).
*9 Id. (citations and internal quotation marks
omitted).
Here, Plaintiff alleges that statements or omissions
attributable to Defendant AXT and Defendant Young
were false and misleading and that Defendants knew
the statements were false and misleading at the time
the statements were made. The statements at issue
can be separated into two general categories: (1)
statements touting the quality of AXT's products and
the Company's ability to meet customer
specifications; and (2) AXT's financial statements.
With respect to both categories of statements,
Defendants contend that Plaintiff has failed to plead
the falsity of the statements with sufficient
particularity and has failed to plead facts that, if true,
would raise a strong inference that Defendants acted
with scienter. Additionally, Defendants assert that
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Plaintiff has failed to adequately plead loss causation
pursuant to the Supreme Court's recent holding in
Dura Pharmaceuticals, Inc. v. Broudo, --- U.S. ----,
125 S.Ct. 1627, 161 L.Ed.2d 577 (2005).
1. FALSITY and SCIENTER
a. Quality Statements
Plaintiff alleges that Defendants made false or
misleading statements regarding the quality of its
products throughout the Class Period. Specifically,
Plaintiff takes issue with the statements contained in
various press releases issued between February 6,
2001, and April 27, 2004, in which Defendants
reported that its products were of high quality,
incorporated strong engineering design, had
competitive advantage, contained superior features,
and met customers' specific requirements. To support
his claim that the quality statements were knowingly
false or misleading, Plaintiff relies on AXT's May 24,
2004, press release disclosing that the Company had
“not followed requirements for testing of products
and provision of testing data and information relating
to customer requirements for certain shipments made
over the past several years,” and on the Company's
subsequent decisions to reassign its CEO, to increase
its reserve for sales returns by $745,000, and to
record a $2.1 million charge for obsolete inventory
manufactured in the prior two and three years.
Plaintiff construes AXT's May 2004 statements and
conduct as an admission by Defendants that the
quality statements were knowingly false when made.
Plaintiff also relies on the statements of the former
AXT Quality Technician, the former AXT Corporate
Vice President, and the former tester of returned
AXT products (collectively, the “witnesses”) to
support falsity and scienter. Finally, Plaintiff claims
that the fact that Agilent, one of AXT's customers,
canceled its orders for AXT substrates during the
Class Period corroborates the witness statements and
Plaintiff's claims that the quality statements were
knowingly false.
Defendants contend that the product quality
statements were, at most, mere puffery, and are not
actionable. In the alternative, Defendants argue that
Plaintiff has not pled sufficiently particularized facts
that the statements were false or misleading when
made nor has Plaintiff pled facts that raise a strong
inference of scienter. The Court addresses each of
Defendants' arguments in turn.
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i. Puffery
*10 “General statements of optimism and ‘puffing’
about a company or product are not actionable.” In re
Foundry Networks, Inc. Sec. Litig., 2003 U.S. Dist.
LEXIS 18200, *47 (N.D. Cal. Aug 29, 2003)
(citation omitted). “Vague, amorphous statements,
like ‘soft forecasts' which are ‘mere puffery,’ are
inactionable because reasonable investors do not
consider ‘soft’ statements or loose predictions
important in making investment decisions.” Id.
(citation omitted). “No matter how untrue a statement
may be, it is not actionable if it is not the type of
statement that would significantly alter the total mix
of information available to investors.” Id. (citing In
re Apple Computer, Inc. Sec. Litig., 243 F.Supp.2d
1012, 1025 (N.D.Cal.2002)). In Foundry Networks,
at issue was the company's statement that its
“business remains on track.” The court held that the
statement was inactionable puffery because the
statement was merely a very general statement of
optimism about the company's financial prospects,
something that reasonable investors would not rely
on when making investment decisions. In No. 84
Employer-Teamster Joint Council Pension Trust
Fund v. Am. W. Holding Corp., 320 F.3d 920 (9th
Cir.2003) (“America West” ), however, the Ninth
Circuit found statements at issue were not
inactionable puffery. Specifically, the court held that
“[a] reasonable investor would find significant the
information regarding a company's deferred
maintenance costs, unsafe maintenance practices, and
possible sanction” because “a reasonable investor
would consider the potential effects of each of these
facts on the overall economic health of the company
as ‘significantly altering’ the ‘total mix’ of
information made available.” Id. at 935; see also
Scritchfield v. Paolo, 274 F.Supp.2d 163, 175
(D.R.I.2003) (statement that company was the “
‘premier provider of high-speed DSL services in the
Northeast corridor’ ... is much more than mere
puffery; it is a statement of [the company's] present
status and capabilities, and connotes that [the
company] is comparatively superior”)).
The lion's share of the statements at issue here appear
to more closely resemble the statements at issue in
America West or Scritchfield than those at issue in
Foundry Networks. For example, statements touting
the superiority of AXT's specific products, such as
the October 24, 2001, press release described in
paragraph 38 of the Complaint, in which AXT
reported that the Company's “VGF gallium arsenide
and indium phosphide substrates continue to offer
Page 8
superior features for manufacturers of high quality
electronic and opto-electronic devices” are far less
generalized than the statements the Foundry
Networks court determined were inactionable. Such
statements strike the Court as information that an
investor would consider when making investment
decisions. However, to make such a determination
would require the Court to make factual findings
which, at this stage in the litigation, would not be
appropriate. Accordingly, the Court finds that
whether the quality statements at issue here are
actionable as material statements is a question for
another day.
ii. Falsity and Scienter Not Sufficiently Pled
*11 Assuming, arguendo, that the quality statements
at issue were not mere puffery and are actionable as
material statements or omissions, the Court now turns
to the question of whether Plaintiff has alleged
sufficiently particularized facts to support his claim
that the quality statements were false or misleading,
and whether Plaintiff has alleged facts that raise a
strong inference of scienter, to survive Defendants'
motion to dismiss.
Plaintiff primarily relies on AXT's post-Class Period
(May 2004) disclosure and the statements of three
confidential witnesses to support his claim that the
product quality statements were false or misleading
and that Defendants knew those statements were false
and misleading when made. Plaintiff also alleges that
Agilent's cancellation of its order of AXT products
during the Class Period supports his claims of falsity
and scienter. Additionally, Plaintiff alleges that
Defendant Young's sale of stock during the Class
Period supports an strong inference of scienter. For
the following reasons, the Court finds that the facts,
as pled, are insufficiently particularized to support
Plaintiff's claim that the quality statements violated
federal securities laws.
(a) Witness Statements FN5
FN5. For purposes of this analysis, the Court
assumes that the witnesses' purported
statements are true since, at this stage in the
proceedings, the Court must view all facts in
the light most favorable to Plaintiff.
According to Plaintiff, the former Quality Technician
allegedly confirmed that the Company knowingly
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shipped to customers products that did not meet
customer specifications, that the Company was aware
that the products would be returned, and that almost
every shipment was, in fact, returned. Specifically,
the technician said that when AXT conducted
specification checks on its wafers for various criteria,
the wafers never met all the specifications. The
former tester of returned AXT products allegedly
confirmed that the passivation layer (the top
protective layer) on AXT's LEDs was consistently
weak, making the LEDs easily and irreparably
damaged. The tester allegedly said that AXT knew
this was a problem and lacked adequate product
testing equipment. The former Corporate Vice
President allegedly confirmed that AXT failed to
perform full testing of its products and lacked the
right equipment for testing. (Comp., ¶ ¶ 78-80.)
These statements, as currently pled, are insufficient to
satisfy create a sufficient factual predicate for
Plaintiff's claims under the PSLRA. First, Plaintiffs'
Complaint fails to explain how any of the witnesses
would have personal and firsthand knowledge of the
facts they allege to be true. See In re Daou Sys., Inc.
Sec. Litig., 411 F.3d 1006, (9th Cir.2005)
(confidential sources must be described “with
sufficient particularity to support the probability that
a person in the position occupied by the source would
possess the information alleged”). For example,
Plaintiff does not explain the job responsibilities of
the Quality Technician and how he or she would
know about the number or proportion of returns of
AXT's products. Second, the Complaint fails to point
to any specific data to support the witnesses'
contentions that AXT's products were being returned.
Third, the Complaint does not sufficiently describe
the timing of the witnesses' observations and
conclusions. Finally, assuming, as the Court must,
that the witnesses' statements are true and AXT's
products were consistently not being tested, did not
meet customer specifications, and were regularly
being returned to the Company, the Complaint
alleges no facts that would allow the Court to infer
that Defendants were aware of these facts. The
Complaint does not allege any process by which
upper management, presumably in charge of issuing
or approving press releases, would have been aware
of product returns or testing practices at the
manufacturing level, much less how each of these
particular confidential witnesses was connected with
Defendants such that they had contemporaneous
knowledge of what AXT and Defendant Young
knew. Accordingly, the witness statements are
insufficient, as currently pled, to support falsity and
scienter here.
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(b) AXT's Post-Class Period Statements and Conduct
*12 Plaintiff contends that AXT's May 24, 2004,
disclosure notifying the public that AXT had “not
followed requirements for testing of products and
provision of testing data and information relating to
customer requirements for certain shipments made
over the past several years” supports his contention
that the quality statements issued during the Class
Period were false and misleading and that Defendants
were aware the statements were false and misleading.
The Court disagrees.
The May 2004 disclosure does not say that every
shipment of every AXT product was non-conforming
such that it can be considered an admission that
AXT's Class Period statements regarding the quality
of its products are rendered false and misleading.
Even if the May 2004 statement admits that some of
AXT's products did not conform to customer
specifications, the statements at issue could still have
been true in that the Company only claimed that its
products were competitive and that its products'
design was strong. Moreover, even assuming the
statements were false or misleading, the post-Class
Period disclosure does not raise a strong inference of
scienter here. The fact that the Company admitted,
after the Class Period, that it had failed to follow
testing requirements on “certain shipments,” is
insufficient to raise a strong inference that
Defendants knew, at the time the quality statements
were made, that the statements were false or
misleading.
(c) Agilent Cancels Orders
Plaintiff alleges that during the Class Period,
Defendants disclosed that one of AXT's larger
customers, Agilent, had canceled its orders for AXT
products because AXT was shipping products that
did not conform to Agilent's specifications. Plaintiff
contends that this corroborates his contention (and
the confidential witness statements) that AXT was
aware that it was shipping non-conforming products
to its customers such that the statements it issued
during the Class Period regarding the quality of its
products and its competitive position in the
marketplace were knowingly false and misleading.
Plaintiff also contends that Defendants were aware
that the problems with the Agilent shipments were
not unique such that its statement to the contrary was
false and misleading. Plaintiff has failed to allege any
facts that support a finding that Defendants knew that
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the non-conforming Agilent shipments were part of a
widespread quality problem with AXT products.
Accordingly, the Court finds that the fact that Agilent
canceled its orders with AXT is insufficient to
demonstrate that the quality statements were
knowingly false when made.
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Plaintiff's first cause of action “lacks sufficient detail
and foundation necessary to meet either the
particularity or strong inference requirements of the
PSLRA,” it must be dismissed. Silicon Graphics, 183
F.3d at 984.
b. Financial Statements
(d) Defendant Young's Stock Sales
(e) Plaintiff's Allegations as a Whole
Plaintiff alleges that during the Class Period,
Defendants knowingly issued financial statements
that overstated revenue, growth margins, and
earnings in violation of GAAP, rendering the
statements false and misleading under the Securities
and Exchange Act. Specifically, Plaintiff contends
that the financial statements were knowingly false or
misleading in light of: (1) the Company's stated
revenue recognition policy requiring that AXT not
recognize revenue where there is a customer
acceptance requirement or remaining significant
obligation; (2) AXT's failure to accrue adequate
reserves; and (3) AXT's failure to take a timely
charge for inventory obsolescence. Plaintiff also
challenges the qualitative statements regarding
internal and disclosure controls contained in the
Sarbanes-Oxley certifications accompanying AXT's
quarterly filings (beginning in April 2002). In support
of these allegations, Plaintiff again relies primarily
upon the Company's May 2004 disclosure and its
subsequent decisions to increase its reserves, charge
for inventory obsolescence, and reassign its CEO.
Plaintiff also again relies on the confidential witness
statements, Agilent's decision to cancel its order, and
Defendant Young's stock sales. Defendants argue that
Plaintiff has failed to allege a particularized factual
basis for his claim that the financial statements
released during the Class Period were false and
involved an improper recognition of revenue, or that
Plaintiff has alleged facts raising a strong inference
that Defendants acted with the requisite scienter. The
Court agrees.
The Court must consider whether the totality of
Plaintiff's allegations, even though individually
lacking, are sufficient to create a strong inference that
Defendants issued allegedly false or misleading
statements touting the quality of AXT's products with
deliberate recklessness, if not actual knowledge.
Lipton, 284 F.3d at 1038. Here, the sum is no greater
than its parts. Plaintiff has failed to allege
particularized facts that could lead the Court to infer
that Defendants intentionally, or with deliberate
recklessness, misrepresented the quality of AXT's
products and its strategic position as compared with
other manufacturers of similar products. Because
*14 It is generally accepted that standing alone,
allegations of GAAP violations do not establish
scienter. In re Worlds of Wonder Sec. Litig., 35 F.3d
1407, 1426 (9th Cir.1994). Rather, to plead
fraudulent intent based on GAAP violations,
plaintiffs must allege facts showing that: (1) specific
accounting decisions were improper; and (2) the
defendants knew specific facts at the time that
rendered their accounting determinations fraudulent.
DSAM Global Value Fund v. Altris Software, Inc.,
288 F.3d 385, 390-91 (9th Cir.2002). Plaintiff has not
met this standard. As discussed supra, Plaintiff only
alleges that Defendants must have been aware that its
Plaintiff also relies on the stock sales of Defendant
Young as an indication of Defendants' scienter with
respect to the quality statements. Generally, stock
sale allegations cannot raise an inference of scienter
unless the plaintiff alleges specific facts showing that
the sales were “dramatically out of line with prior
trading practices at times calculated to maximize the
personal
benefit
from
undisclosed
inside
information.” Silicon Graphics, 183 F.3d at 986.
Among the relevant factors for a court to consider
are: 1) the amount and percentage of shares sold by
insiders; 2) the timing of the sales; and 3) whether the
sales were consistent with the insider's prior trading
history. Id.
*13 Here, Plaintiff alleges that Defendant Young sold
a total of more than 200,000 shares of his personallyheld AXT stock during the Class Period for gross
proceeds of approximately $2.2 million. (Comp. at ¶
91.) Plaintiff alleges no facts about the dates, prices
per share, or sizes of each of Defendant Young's
Class Period sales. Plaintiff also fails to allege that
Defendant Young's sales over the time period in
question were inconsistent with his prior trading
history. In light of the three factors above, Defendant
Young's Class Period sale of stock, as alleged, is not
sufficiently suspicious, without more, to raise a
strong inference of scienter.
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products were flawed and were being shipped to
customers
anyway
based
on
the
vague
representations of three confidential witnesses who
do not describe the basis for their knowledge, the
time period of the general awareness that this practice
was occurring, any contact with AXT's upper
management (or specifically, those making the
accounting and revenue recognition decisions), or
any specific transactions on which revenue was
knowingly improperly recorded. See Northpoint, 184
F.Supp.2d at 998 (“With accounting fraud, ... the
necessary scienter is in general not established
merely by the publication of inaccurate accounting
figures, or failure to follow generally accepted
accounting principles. More is needed.”) Plaintiff has
failed to allege that particular accounting decisions
were improper or facts that support a strong inference
that Defendants were aware of facts that rendered
their accounting decisions fraudulent. In sum,
Plaintiff's generic allegations of accounting fraud fall
short of sufficiently pleading scienter with respect to
Defendants' practice of recognizing revenue.
The other factors upon which Plaintiff relies to
support his claim that AXT's financial statements
were false or misleading are also insufficiently pled.
The Court examines these in turn.
i. AXT's Post-Class Period Statements and Conduct
Plaintiff claims that AXT's post-Class Period
decisions to take a $745,000 reserve, to take a $2.1
million write-off, and to reassign its CEO and
promote its CFO to the top spot at the Company,
demonstrate that the Company's financial statements,
issued during the Class Period, were false when made
and that Defendants knew they were false. The Court
disagrees. These allegations are not pled with the
requisite particularity. Plaintiff contends that AXT's
post-Class Period decisions suggest that the
Company should have increased its reserve for
returns by $745,000 during the Class Period and that
the Company's failure to do so renders the financial
statements
false.
Plaintiff
alleges
no
contemporaneous facts to support that contention
other than the post-Class Period decision to increase
the reserves. This is a classic example of pleading
fraud by hindsight, which is exactly what Congress
intended to eliminate with its adoption of the PSLRA.
See Silicon Graphics, 183 F.3d at 988; Acito v.
IMCERA Group, 47 F.3d 47, 53 (2d Cir.1995)
(“Mere allegations that statements in one report
should have been made in earlier reports do not make
out a claim of securities fraud.”) Similarly, AXT's
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decision to write off $2.1 million for inventory
obsolescence after the close of the Class Period does
not necessarily read back on what the Company
should have done, but did not do, during the Class
Period, or on the falsity of the Company's financial
statements during that period. A “pleading must
provide some particularized support regarding
inventory levels, the defendants' knowledge, and
approximately when [the] plaintiffs think the writedown should have occurred.” In re PETsMART, Inc.
Sec. Litig., 61 F.Supp.2d 982, 993 (D.Ariz.1999).
Plaintiff fails to do so here. Additionally, AXT's
decision to reassign Defendant Young to head up the
Company's China Operations does not support an
inference of scienter here. Management changes “are
not in and of themselves evidence of scienter. Most
major stock losses are often accompanied by
management departures, and it would be unwise for
courts to penalize directors for these decisions.” In re
Cornerstone Propane Partners, L.P., 355 F.Supp.2d
1069, 1092 (N.D.Cal.2005). Plaintiff has not alleged
sufficiently particularized facts with respect to
Young's reassignment to support his claim that the
financial statements were false when made.
*15 Plaintiff also contends that the Sarbanes-Oxley
certifications signed by Defendant Young and filed
with the SEC were false when made. Again, the
Court finds that Plaintiff has not alleged
particularized facts to support his claim that
Defendant Young's averments that he had examined
the Company's internal disclosure controls and
believed they were adequate, were false.
ii. Witness Statements FN6
FN6. For purposes of this analysis, the Court
assumes that the witnesses' purported
statements are true since, at this stage in the
proceedings, the Court must view all facts in
the light most favorable to Plaintiff.
As discussed above, the confidential witness
statements relied on by Plaintiff here are insufficient,
as currently pled, to support falsity or scienter. The
Complaint fails to allege how the witnesses would
have known what accounting effect, if any, product
returns would have on the Company's financial
statements, or how Defendants would have known
that the financial statements it released were false or
misleading in light of the alleged product returns. See
Juniper Networks, Inc. Sec. Litig., 2004 U.S. Dist.
LEXIS 4025, at *8 (N.D.Cal. Mar. 11, 2004)
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(allegations of false financial forecasts are
insufficient where plaintiffs failed to “plead specific
facts demonstrating how the problems being
experienced translated into the need for Juniper to
alter or reduce its publicly issued projections”).
Accordingly, the confidential witness statements, as
currently pled, are insufficient to support falsity and
scienter with respect to the financial statements.
iii. Agilent Cancels Order
Plaintiff contends that AXT's announcement, during
the Class Period, that Agilent had canceled its orders
due to AXT's failure to provide products that met
Agilent's specifications supports his claim that the
financial statements were false when made and that
Defendants knew the statements were false. While
the Agilent order withdrawal suggests that AXT was
not always shipping products that conformed to
customer specifications, Plaintiff fails to allege
sufficiently particularized facts that support his claim
that this meant that the financial statements were
false or that Defendants knew they were false.
iv. Defendant Young's Stock Sales
As discussed supra, Plaintiff fails to allege sufficient
details regarding Defendant Young's sales of stock
during the Class Period that would support the falsity
of the financial statements and Defendants' scienter
with respect thereto.
v. Plaintiff's Allegations as a Whole
As explained above, the Court must consider whether
the totality of Plaintiff's allegations, even though
individually lacking, are sufficient to create a strong
inference that Defendants issued allegedly false or
misleading financial statements with deliberate
recklessness, if not actual knowledge. Lipton, 284
F.3d at 1038. Here, again, the sum is no greater than
its parts. See In re Nash Finch Co. Sec. Litig., 323
F.Supp.2d 956, 964 & n. 9 (D.Minn.2004) (“The
Court finds the collective minutia offered here adds
up to nothing. Just as two plus two will never equal
five, these allegations-whether considered apart or
together-do not add up to a strong inference of
scienter.”) FN7
FN7. At oral argument, Plaintiff alerted the
Court to the recent holding in In re
Page 12
Omnivision Technologies, Inc., 2005 U.S.
Dist. LEXIS 16009, *1 (N.D.Cal. July 29,
2005). The Court finds that that case,
distinguishable on its facts, does not alter the
Court's conclusions here. In Omnivision, it
was undisputed that the company's financial
statements contained errors. This is not the
case here. Additionally, in that case, the
plaintiff alleged facts supporting a finding
that the individual defendants, executives of
the company in question, sold personal
shares of the company's stock dramatically
out of line with their trading history. That
the Omnivision court found that the
plaintiff's complaint survived the defendants'
motion to dismiss, despite the PSLRA's
heightened pleading standard, does not
mandate the same result here.
2. Loss Causation
*16 In Dura Pharmaceuticals, the Supreme Court
clarified that alleging that a misrepresentation caused
an inflated purchase price does not, without more,
demonstrate loss causation. To “touch upon” an
economic loss is insufficient; plaintiffs must
demonstrate an actual causal connection between the
defendant's alleged material misrepresentation and
the economic loss suffered. 125 S.Ct. at 1633. This
holding reversed the Ninth Circuit's jurisprudence on
the subject, pursuant to which a plaintiff could satisfy
the loss causation requirement simply by alleging that
stock price was inflated due to the alleged
misrepresentation.
Here, the Complaint simply states that because
AXT's stock prices dropped significantly after the
Company disclosed its internal investigation,
Plaintiff, and other AXT shareholders who purchased
stock during the Class Period, lost money. However,
Plaintiff has not alleged a proximate, causal
connection between the alleged misrepresentations
contained in AXT's press releases and financial
statements and the consequent decline in AXT stock.
Because other factors may have affected the
Company's stock price during the Class Period,
Plaintiff must allege more than just that the alleged
misrepresentations inflated the stock price. See id.
This is particularly true here where the AXT stock
price fluctuated significantly during the Class Period,
at some points dropping lower than the price of the
stock after the April 27, 2004, disclosure regarding
the Company's internal investigation. FN8 This
suggests that the stock price was, indeed, affected by
factors other than Defendants' alleged false or
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misleading statements. Accordingly, the Court finds,
in light of Dura, that Plaintiff's allegations regarding
loss causation are insufficient. Plaintiff's contention
that the Daou case mandates the contrary result is
specious. In that case, the Ninth Circuit found that
loss causation was sufficiently pled but specifically
held that because the complaint disclosed that the
price of the company's stock had declined, during the
class period, from $34.375 per share to $18.50 per
share, before any corrective disclosure was issued,
any loss suffered between those figures could “not be
considered causally related to Daou's allegedly
fraudulent accounting methods because before the
revelations began ..., the true nature of Daou's
financial condition had not yet been disclosed.” 411
F.3d at 1026-27. Likewise, AXT's stock price dipped
below the price to which it ultimately fell after the
April 2004 disclosure, thus rendering Plaintiff's
attempt to causally link the alleged false statements
with his (and other purported class members')
financial loss insufficiently pled.
FN8. On April 29, 2004, AXT's stock price
dropped to $2.20 per share. Although the
price had, at various points during the Class
Period, been as high as $40 per share, there
was a substantial period of time during the
Class Period in which AXT's stock price
dropped below $2 per share.
B. Plaintiff's Second Cause of Action-Violation of
Section 20(a)
Section 20(a) of the Securities Exchange Act
(“Exchange Act”) provides derivative liability for
those who control others found to be primarily liable
under the Act. In re Ramp Networks, Inc. Sec. Lit.,
201 F.Supp.2d 1051, 1063 (N.D.Cal.2002). Where a
plaintiff asserts a Section 20(a) claim based on an
underlying violation of Section 10(b), the pleading
requirements for both violations are the same. Id. “To
be liable under section 20(a), the defendants must be
liable under another section of the Exchange Act.”
Heliotrope General, Inc. v. Ford Motor Co., 189 F.3d
971, 978 (9th Cir.1999).
Page 13
cause the Company to engage in the wrongful
conduct complained of. Defendants argue that
Plaintiff's Section 20(a) cause of action fails because
Plaintiff has failed to state a cause of action pursuant
to Section 10(b). The Court agrees. Because Plaintiff
has failed to adequately plead the underlying 10(b)
violation, as discussed supra, Plaintiff's Section 20(a)
claim must also be dismissed.
CONCLUSION
For the foregoing reasons, the Court GRANTS
Defendants' Motion to Dismiss without prejudice.
Plaintiff must file an amended complaint within thirty
days of the date of this Order.
This Order terminates docket entry nos. 24 and 25.
IT IS SO ORDERED.
N.D.Cal.,2005.
Morgan v. AXT, Inc.
Not Reported in F.Supp.2d, 2005 WL 2347125
(N.D.Cal.)
Briefs and Other Related Documents (Back to top)
• 2006 WL 1042253 (Trial Motion, Memorandum
and Affidavit) Defendants' Reply in Support of
Motion to Dismiss Amended Consolidated Complaint
(Mar. 14, 2006) Original Image of this Document
(PDF)
• 2006 WL 440801 (Trial Motion, Memorandum and
Affidavit) Memorandum of Points and Authorities in
Opposition to Motion to Dismiss Amended
Consolidated Complaint (Jan. 31, 2006) Original
Image of this Document (PDF)
• 2005 WL 3673019 (Trial Pleading) Amended
Consolidated Complaint for Violations of the Federal
Securities Laws (Nov. 14, 2005) Original Image of
this Document (PDF)
• 3:04cv04362 (Docket) (Oct. 15, 2004)
END OF DOCUMENT
*17 Here, Plaintiff alleges that Defendant Young
acted as a controlling person of AXT within the
meaning of Section 20(a) of the Act and is liable
thereunder for the conduct alleged. Plaintiff claims
that by virtue of Defendant Young's position as CEO
and Chairman of the Board of the Company, he was
responsible for preparing and disseminating AXT's
public releases and had the power and the authority to
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I. BACKGROUND
Briefs and Other Related Documents
In
re
Netopia,
Inc.,
Securities
LitigationN.D.Cal.,2005.Only the Westlaw citation is
currently available.
United States District Court,N.D. California.
In re NETOPIA, INC., SECURITIES LITIGATION
No. C-04-03364 RMW.
Dec. 15, 2005.
Michael David Braun, Andrew M. Schatz, Jeffrey S.
Nobel, Justin S. Kudler, Tricia Lynn McCormick,
Stanley S. Mallison, Robert S. Green, Patrick J.
Coughlin, Darren J. Robbins, William S. Lerach,
Marc A. Topaz, Richard A. Maniskas, Tamara
Skvirsky, Timothy J. Burke, Aaron L. Brody, Jules
Brody, Tzivia Brody, for Plaintiffs.
Howard S. Caro, Michael Ethan Liftik, Sara B.
Brody, Susan D. Resley, Walter F. Brown, Jamaar M.
Boyd, for Defendants.
ORDER DENYING IN PART AND GRANTING IN
PART DEFENDANTS' MOTION TO DISMISS OR
STRIKE
WHYTE, J.
*1 THIS ORDER RELATES TO: ALL ACTIONS
[Re Docket Nos. 81, 82, 85, 90, 100, 102, 103]
Defendants Netopia, Inc., Alan Lefkof, and David
Kadish move to dismiss or strike certain portions of
the consolidated amended complaint.FN1 Kadish
additionally moves to dismiss all claims against him
under Fed.R.Civ.P. 12(b)(6). For the reasons given
below, the court denies the defendants' motions to
dismiss except as to the § 10(b)(5) claim against
defendant Kadish, grants the motion as to the §
10(b)(5) claim against defendant Kadish with twenty
days leave to amend, grants the motion to strike the
allegations in paragraphs twenty-two through thirtyone, and denies the motion to strike other allegations.
FN1. Defendants William Baker and
Thomas Skoulis join this motion. Baker
makes additional arguments why the motion
should be granted; Skoulis does not.
Plaintiffs constitute a class of all those who
purchased Netopia, Inc., common stock from
November 6, 2003, to August 16, 2004. They allege
that Netopia and four of its officers or former
officers-Alan Lefkof, David Kadish, William Baker,
and Thomas Skoulis-engaged in fraudulent
accounting practices that inflated the price of Netopia
stock. After these alleged accounting irregularities
came to light, the price of Netopia stock fell, harming
the plaintiffs. The current complaint alleges two
causes of action: (1) violation of section 10(b) of the
Exchange Act, 15 U.S.C. § 78j(b), and related Rule
10b-5, 17 C.F.R. § 240.10b-5, against all defendants,
and (2) violation of section 20(a) of the Exchange
Act, 15 U.S.C. § 78t(a), against all defendants other
than Netopia.
The complaint contains lengthy narratives about the
defendants' alleged wrongdoing in three Netopia
transactions or attempted transactions. The first
occurrence, referred to by the parties as the “Chicago
transaction,” involved an agreement for Netopia to
supply Interface Computer Communications, Inc.,
(“ICC”) with computer products, which ICC would
in turn sell to the Chicago public school system. The
second occurrence, the “Philadelphia transaction,”
was similar: Netopia was to sell ICC $750,000 worth
of products, which ICC would then sell to the
Philadelphia public school system. In the third
occurrence, the “Swisscom transaction,” Netopia
allegedly shipped a large quantity of products to
Swisscom AG just before the end of a quarter,
distorting the picture of Netopia's business that
investors received.
The Philadelphia transaction is, for the plaintiffs'
action, the main event. Plaintiffs allege that in the
spring of 2003, Netopia began negotiating with ICC
for Netopia to sell ICC software for the Philadelphia
public schools. Consol. Am. Compl. (“CAC”) ¶ 32.
Peter Frankl was the Netopia salesman in charge of
the Philadelphia transaction. Id. By September 2003,
the individual defendants were aware that Frankl was
possibly going to close a deal that would make the
Philadelphia transaction worth at least $500,000. Id. ¶
34. The Philadelphia school system did not have
funds available for the purchase, though, meaning
that the purchase would not take place before the end
of the financial quarter on September 30, 2003. Id. ¶
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35. Lefkof and Skoulis thought the Philadelphia
transaction would help Netopia meet Wall Street
earnings estimates, so had Frankl negotiate a deal
with ICC: ICC would give Netopia a purchase order
for $750,400 worth of software, but the parties would
orally agree that ICC had no obligation to pay
Netopia until the Philadelphia schools ordered
Netopia's software from ICC and paid ICC. Id. ¶ ¶
35-45. Kadish drafted a purchase order for the
transaction which contained no payment terms,
although “Netopia's standard payment terms were
‘net 30.” ’ Id. ¶ ¶ 42-43.
*2 This deal began to unravel almost immediately.
Netopia's accounting department (apparently unaware
of the oral contingency) sent ICC a letter asking ICC
to confirm to KPMG LLP, Netopia's outside auditors,
that ICC owed Netopia $750,400 for software. Id. ¶
46. ICC responded by sending Frankl a letter
confirming that ICC did not owe Netopia anything
for the Philadelphia transaction until the Philadelphia
school system ordered software from ICC and paid
ICC for the software; Frankl received this letter on
October 7, 2003. Id. ¶ ¶ 47-50. In late October, the
Philadelphia school system made clear that it was not
willing to purchase Netopia software anytime soon.
Id. ¶ ¶ 51-52. KPMG learned that Netopia had not
received the $750,400 and asked “Baker, Kadish and
Lefkof about whether is was appropriate to
recognize” revenue from the purchase order. Id. ¶
54.
On November 5, 2003, Netopia reported its financial
results for the quarter and financial year ending
September 30, 2003. Id. ¶ 58. The $750,400 from the
Philadelphia transaction was reported as income for
the quarter and was the difference between Netopia
reporting a net loss or net income for the quarter. Id.
Netopia's stock price rose immediately afterwards. Id.
¶ 59. From November 10 and December 10, 2003,
each of the individual defendants sold off hundreds
of thousands of dollars worth of Netopia stock. Id. ¶
64.
Netopia continued its efforts to get the Philadelphia
school system to purchase software. Id. ¶ ¶ 65-66. In
March 2004, Frankl and Skoulis tentatively brokered
a deal whereby the Philadelphia schools would agree
to purchase $375,000 worth of Netopia software, but
Gateway Inc. would be added as a second middleman
and take a 10 percent fee. Id. ¶ 66. Baker began
asking ICC to start making payments since the sale
was likely to go through. Id. ¶ 68-74. On April 27,
2004, ICC sent Baker and Frankl and e-mail
reiterating that ICC's payments to Netopia were
Page 36 of 65
Page 2
contingent on ICC being paid by the Philadelphia
school system (and now Gateway), and that Netopia
could expect a payment of around $300,000 in midJune. Id. ¶ 75. In May 2004, Gateway received a
purchase order from the Philadelphia school system
for $375,000 worth of Netopia software. Id. ¶ 81. A
month later, Gateway sent ICC a purchase order for
the software in the amount of $337,500 .FN2 Id.
FN2. This amount represents the $375,000
price the Philadelphia school system was
paying, less the 10 percent fee ($37,500) due
to Gateway.
Baker, meanwhile, was still pressing ICC to pay
Netopia $750,000. Id. ¶ 82. ICC's president, David
Andalcio, informed Frankl that it would send Netopia
about $50,000 at the end of June. Id. ¶ 83. Lefkof,
apparently expecting ICC to adhere to its earlier
statement about paying in mid-June, had Imelda
Farrell, Netopia's “Corporate Controller,” send
Andalcio a letter proposing that ICC pay Netopia
$750,400 in installments from June 28, 2004, to
September 15, 2004. Id. ¶ ¶ 84-87. The next day,
June 18, 2004, Andalcio called Farrell, rejecting the
proposed payment plan. Id. ¶ 88. “Kadish then came
to Ms. Farrell's desk, stood over Ms. Farrell and put
the phone to his ear as well, and whispered answers
into Ms. Farrell's ear for her to say in response to Mr.
Andalcio's remarks.” Id. (Plaintiffs do not disclose
the contents of this conversation.)
*3 A week later, Andalcio e-mailed Baker that
Andalcio was uncomfortable with the situation and
had sought the advice of legal counsel. Id. ¶ 91.
Andalcio wrote that, on the advice of counsel, ICC
would not make any payments on the old purchase
order, and requested a new purchase order that
reflected all terms of the agreement between ICC and
Netopia. Id. On July 1, 2004, Kadish e-mailed
Andalcio that Netopia was willing to accept $337,500
as settlement of all claims between them, and
enclosed an agreement to that effect dated June 30,
2004. Id. ¶ 93. Kadish stated that if ICC did not sign
and return the proposed agreement by the next day,
the “offer to compromise” would “be deemed
withdrawn.” Id . Andalcio responded the next day
that his legal counsel had advised him not to sign the
proposed agreement because ICC had done nothing
wrong. Id. ¶ 94.
On July 22, 2004, the audit committee of Netopia's
board of directors announced that it was investigating
Netopia's dealings with ICC. Id. ¶ 96. Two months
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later, KMPG resigned as Netopia's outside auditor
and withdrew its support for Netopia's financial
statements for the year ending September 30, 2003.
Id. ¶ 111. Skoulis and Frankl were fired, and Baker
was forced to resign. Id. ¶ ¶ 97-98.
court also declines to treat this motion to dismiss as
one for summary judgment.
II. ANALYSIS
The defendants move, in the alternative, to strike the
allegations relating to the Chicago and Swisscom
transactions, as well as the January, February, and
April 2004 price drops. A court may strike “any
redundant, immaterial, impertinent, or scandalous
matter.” Fed.R.Civ.P. 12(f). Motions to strike “are
disfavored by the courts, and should not be granted
unless it is clear that the matter to be stricken can
have no possible bearing upon the subject matter of
the litigation.” Naton v. Bank of Cal., 72 F.R.D. 550,
551 n. 4 (N.D.Cal.1976). The defendants indicate
they are concerned about the scope of discovery if the
complaint is this sprawling; the court can imagine
other reasons the defendants want less in the
complaint, such as a desire to cut down on negative
publicity associated with this lawsuit.
A. All defendants' motion to dismiss certain portions
of the complaint
The defendants move to dismiss “allegations about
the Chicago transaction, Swisscom, and certain loss
causation allegations because they do not allege facts
upon which a claim for relief can be based.”
Defendants have not moved to dismiss either cause of
action, and neither the Chicago transaction nor the
Swisscom transaction corresponds directly to either
the plaintiffs' § 10(b) or § 20(a) causes of action. By
its own terms, there does not appear to be any way to
grant partial dismissal of a claim under Fed.R.Civ.P.
12(b)(6). The defendants have not presented the court
with any case where a court has dismissed under
Fed.R.Civ.P. 12(b)(6) only part of a complaint except
individual causes of action, nor can the court find
such a case. The plaintiffs conceded at oral argument
that a motion to strike would be a more appropriate
way to obtain the result they seek.
The court assumes that Fed.R.Civ.P. 12(b)(6)'s
language “failure to state a claim” means the rule
should not be used on subparts of claims; a cause of
action either fails totally or remains in the complaint
under Fed.R.Civ.P. 12(b)(6). See Charles Alan
Wright & Arthur R. Miller, Federal Pleading &
Procedure § 1358 (3d. ed.2004); but see Drewett v.
Aetna Cas. & Sur. Co., 405 F.Supp. 877, 878
(W.D.La.1975) (Fed.R.Civ.P.12(b)(6) “may be used
to challenge the sufficiency of part of a pleading such
as a single count or claim for relief.”). The
defendants do not claim that the plaintiffs' § 10(b) or
§ 20(a) causes of action are missing an essential
element. The defendants' motion to dismiss
allegations about the Chicago and Swisscom
transactions are therefore denied.
*4 Defendants also move to dismiss allegations that
drops in Netopia's stock price in January, February,
and April 2004 stemmed from a September 30, 2003,
overstatement of Netopia's financial condition. As
these time periods also do not correspond to a
particular cause of action, the court likewise denies
this portion of the defendants' motion to dismiss. The
B. All defendants' motion to strike certain portions of
the complaint
The Chicago transaction appears to have been
completed by September 2002. See CAC ¶ ¶ 30-31.
This is well over a year before the beginning of the
class period (November 6, 2003). The four pages of
allegations covering the Chicago transaction are
immaterial under Fed.R.Civ.P 12(f) because they are
not necessary for the plaintiffs to state their § 10(b)
or § 20(a) causes of action. The presence of the
Chicago transaction allegations in the CAC risks
“delay[ ] and confusion of the issues.” See Fantasy,
Inc. v. Fogerty, 984 F.2d 1524, 1528 (9th Cir.1993).
The court will grant the defendants' motion to strike
the allegations concerning the Chicago transaction,
paragraphs twenty-two through thirty-one of the
CAC. Because, though, of the Chicago transaction's
similarity to the Philadelphia transaction, aspects of
the Chicago transaction may still be relevant to the
plaintiffs' case.
The court will not strike the allegations concerning
the Swisscom transaction or the price drops because
they occurred during the class period.
C. Kadish's motion to dismiss all causes of action
against him
Kadish moves to dismiss both causes of action
against him.
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1. The section 10(b) cause of action
“To state a claim under Section 10(b), 15 U.S.C.
78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b5,
[plaintiffs] must allege: (1) a misstatement or
omission (2) of material fact (3) made with scienter
(4) on which [plaintiffs] relied (5) which proximately
caused their injury.” DSAM Global Value Fund v.
Altris Software, Inc., 288 F .3d 385, 388 (9th
Cir.2002). Securities fraud is subjected to a
heightened pleading standard. First, allegations of
securities fraud are subject to the particularity
obligations imposed by Fed.R.Civ.P. 9(b). GlenFed,
Inc. Sec. Litig., 42 F.3d 1541, 1545 (9th Cir.1994).
Fed.R.Civ.P. 9(b) provides that “[i]n all averments of
fraud or mistake, the circumstances constituting fraud
or mistake shall be stated with particularity. Malice,
intent, knowledge, and other condition[s] of mind
may be averred generally.” Second, under the Private
Securities Litigation Reform Act (the “Reform Act”
or the “PSLRA”), Pub.L. No. 104-67, 202 Stat. 737
(1995) (codified at 15 U.S.C. § § 77k, 771, 77z-1,
77z-2, 78a, 78j-1, 78t, 78u, 78u-4, 78u-5), a plaintiff
alleging a § 10(b) 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 that belief is
formed.” 15 U.S.C. § 78u-4(b)(1).
*5 Kadish claims the allegations that he violated §
10(b) contain two fatal defects: there is no allegation
he made a false statement, and the allegations of
scienter are inadequate. Plaintiffs claim they have
met the heightened standard because the Ninth's
Circuit group publication doctrine,FN3 see Wool v.
Tandem Computers, Inc ., 818 F.2d 1433, 1440 (9th
Cir.1987), survived the Reform Act. In Wool, the
Ninth Circuit held that “[i]n cases of corporate fraud
where the false or misleading information is
conveyed in prospectuses, registration statements,
annual reports, press releases, or other ‘grouppublished information,’ it is reasonable to presume
that these are the collective actions of the officers.
Under such circumstances, a plaintiff fulfills the
particularity requirement of Rule 9(b) by pleading the
misrepresentations with particularity and where
possible the roles of the individual defendants in the
misrepresentations.” Id. (citations omitted). The
Ninth Circuit has yet to address the issue of whether
the group-published information doctrine survives the
Reform Act, and other courts are divided on the
question.FN4 See Southland Sec. Corp. v. INSpire Ins.
Solutions, Inc., 365 F.3d 353, 364 (5th Cir.2004).
FN3. This doctrine is also referred to as the
“group pleading doctrine.” See In re Oxford
Health Plans, Inc., 187 F.R.D. 133, 142
(S.D.N.Y.1999).
FN4. It appears that in no case from the
Northern District of California has the
Reform Act been found to have abrogated
the group-published information doctrine,
though few have analyzed the issue
extensively. See In re Adaptive Broadband
Sec. Litig., 2002 U.S. Dist. LEXIS 5887,
*52-53 (N.D.Cal.2002) (Conti, J.) (“[T]he
doctrine has not been specifically abrogated,
and is still good law in this Circuit.”); In re
Secure Computing Corp. Sec. Litig., 120
F.Supp.2d 810, 821 (N.D.Cal.2000)
(Wilken, J.) (“[T]he majority of the district
courts in the Ninth Circuit that have
addressed the issue have concluded that the
group published information presumption
survives the PSLRA”); In re Network
Associates, Inc., Sec. Litig., 2000 WL
33376577, *13 (N.D.Cal.2000) (Alsup, J.)
(finding that allegations against defendants
do not satisfy even the group-published
information doctrine and dismissing for
failure to state a claim).
This court feels that the better view is that the
Reform Act precludes reliance on the grouppublished information doctrine in this case. As noted
in GlenFed, Fed.R.Civ.P. 9(b) and the Reform Act
constitute separate pleading hurdles in securities
fraud cases. Pleading group-published information
may still satisfy “the particularity requirement of
Rule 9(b),” but it does not satisfy the more rigorous
requirements of 15 U.S.C. § 78u-4(b)(1). One
district court noted that
the continued vitality of the judicially created grouppublished doctrine is suspect since the PSLRA
specifically requires that the untrue statements or
omissions be set forth with particularity as to “the
defendant” and that scienter be plead in regards to
“each act or omission” sufficient to give “rise to a
strong inference that the defendant acted with the
required state of mind.” 15 U .S.C. § 78u-4(b)
(emphasis added). To permit a judicial presumption
as to particularity simply cannot be reconciled with
the statutory mandate that plaintiffs must plead
specific facts as to each act or omission by the
defendant.
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Allison v. Brooktree Corp., 999 F.Supp. 1342, 1350
(S.D.Cal.1998).
According to the plaintiffs, paragraphs 100 and 129
of the CAC contain allegations that Kadish made
false statements. Opp'n at 26-27. This paragraph from
the CAC is representative of what plaintiffs claim
sufficiently pleads Kadish violated § 10(b):
On April 19, 2004, after the close of trading in the
market, Netopia issued a press release (the “April
Press Release”). The April Press Release (which
listed Defendant Baker as the “contact” person and
quoted Defendant Lefkof), inter alia, reported a net
loss for the second fiscal quarter of $1.6 million, or a
loss of $0.07 per share and “trade receivables, net” of
$15.185 million. Each of the Individual Defendants
directly participated in the drafting of the April Press
Release. On April 19, 2004, following the issuance of
the April Press Release, Defendants Lefkof and
Baker conducted a conference call (the “April
Conference Call”) with securities analysts and
investors, in which Defendants, inter alia,
represented the net income, revenue and accounts
receivable results reported in the April Press Release.
Each of the Individual Defendants participated in the
drafting of the prepared remarks stated at the outset
of the April Conference Call.
*6 CAC ¶ 100(e); see also id. ¶ ¶ 100(a)-(d), 129.
Such allegations do not, under the Reform Act,
sufficiently plead that Kadish made a false statement,
as the plaintiffs cannot rely on the group-published
information doctrine. Plaintiffs therefore have not
stated a § 10(b) claim against Kadish because the
CAC does not contain an adequate allegation that he
made a false statement.
Furthermore, the allegations that Kadish acted with
scienter are also defective. The Reform Act sets a
high standard for pleading scienter:
In any private action arising under this chapter in
which the plaintiff may recover money damages only
on proof that the defendant acted with a particular
state of mind, the complaint shall, with respect to
each act or omission alleged to violate this chapter,
state with particularity facts giving rise to a strong
inference that the defendant acted with the required
state of mind.
15 U.S.C.A. § 78u-4(b)(2). The Ninth Circuit has
held that the required state of mind in securities fraud
cases is “deliberately reckless or conscious
misconduct,” and that allegations of “mere motive
and opportunity” are insufficient. In re Silicon
Graphics Inc. Sec. Litig., 183 F.3d 970, 974 (9th
Page 39 of 65
Page 5
Cir.1999).
Plaintiffs' allegations do not create “a strong
inference” Kadish was aware that ICC did not owe
Netopia $750,400 before the last alleged
misstatements of April 19, 2004.FN5 Anything Kadish
knew after that date (roughly paragraph seventy-one
of the factual section of the CAC and thereafter) is
not directly relevant to Kadish's scienter. Kadish
claims that the allegations in the CAC support an
inference that he was unaware of the fraud of Lefkof,
Baker, Skoulis, and Frankl. Mot. at 19. The court
agrees that the CAC is not inconsistent with the
theory that Kadish was unaware of the fraud; the
CAC therefore does not “give rise to a strong
inference that” Kadish was aware of the fraud.
FN5. The statements alleged to be
actionable under § 10(b) occurred on
November 5, 2003; December 19, 2003;
January 20, 2004; February 17, 2004; and
April 19, 2004. CAC ¶ 100.
Plaintiffs have alleged that in September 2003,
Kadish drafted a $750,400 purchase order for the
Philadelphia transaction and e-mailed it to other
Netopia employees with the message “Here is the
form of PO we will receive.” CAC ¶ 43. This draft
purchase order contained no payment terms, although
plaintiffs allege that “Netopia's standard payment
terms were ‘net 30.” ’ Id. ¶ ¶ 42-43. Plaintiffs also
claim they have alleged that Kadish was involved in
the cover-up of the true nature of the Philadelphia
transaction. Opp'n at 29. This is doubtful. The
complaint contains an allegation that Skoulis told
Frankl to tell Andalcio that “ ‘everyone knows' (i.e.,
Lefkof, Kadish and Baker)” that the Philadelphia
transaction contained a hidden contingency. CAC ¶
46. This falls far short of creating a strong inference
that Kadish actually knew of the contingency;
plaintiffs have merely alleged that somebody told
somebody else to tell yet a third person that Kadish
knew. Likewise, in April 2004 that “Kadish [was]
becoming extremely concerned about the fact that
Netopia was still carrying the $750,400 as part of its
reported accounts receivables,” id. ¶ 67, that Kadish
sought to have ICC “enter into a payment plan” for
the $750,400, id. ¶ 68, or that Kadish was making
things difficult for Baker, id. ¶
71, are not
inconsistent with the theory that Kadish was unaware
of the contingency and trying to ensure Netopia was
paid $750,400 Kadish believed ICC owed.
*7 Kadish whispering into the ear of Farrell while she
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spoke to Andalcio is certainly suspicious, but
plaintiffs do not provide the substance of Kadish's
instructions to Farrell. Plus, this call occurred on June
18, 2004, after the last alleged misstatement on April
19, 2004.
Kadish's stock sales alone are inadequate to create a
strong inference that Kadish acted with scienter.
Kadish's late 2003 stock sales were made after
Netopia had released favorable financial information;
as the Ninth Circuit has noted, corporate officers
often sell stock after such announcements. Lipton v.
Pathogenesis Corp., 284 F.3d 1027, 1037 (9th
Cir.2002). Plaintiffs make much of the fact that
Kadish did not sell any stock for the forty-four
months preceding his late 2003 sales. Opp'n at 29. As
Kadish points out, selling stock shortly after the
announcement that Netopia had its first positiveincome quarter since mid-2000 is not inherently
suspicious. See Mot. at 22. “Although unusual or
suspicious stock sales by corporate insiders may
constitute circumstantial evidence of scienter, insider
trading is suspicious only when it is dramatically out
of line with prior trading practices at times calculated
to maximize the personal benefit from undisclosed
inside information.” Silicon Graphics, 183 F.3d at
986. While his sale of 63 percent of his Netopia
holdings in late 2003 is “dramatically out of line with
[his] prior trading practices,” the preceding forty-four
months in which Kadish sold no stock largely
corresponds with a period in which Netopia reported
net losses each quarter. Therefore, in light of the lack
of allegations showing Kadish had “undisclosed
inside information,” Kadish's sales are not necessarily
suspicious.
Finally, plaintiffs allege that Kadish's temporary
assignment as the salesman for the Swisscom account
in late 2003 FN6 creates a strong inference that Kadish
was aware of misstatements related to the Swisscom
transaction. Plaintiffs allege that Netopia shipped
“millions of dollars” worth of software to Swisscom
via boat “in the final days of December 2003.” CAC
¶ 116. Accounting rules apparently dictated that
Netopia recognize the revenue from the boat
shipments as soon as they were sent, which was in
December 2003. See id. ¶ 116. Plaintiffs nonetheless
claim that recognizing such revenue in December
2003 distorted Netopia's financial picture, because
Swisscom would need that much less product in the
next quarter. Opp'n at 28-29. Plaintiffs, however, do
not allege anything other than Lefkof appointed
Kadish to manage the Swisscom account; there is no
allegation that Kadish ordered the timing or method
of the shipment, or was even aware software was
Page 6
shipped to Swisscom. This is insufficient under the
Reform Act to show Kadish acted with the requisite
scienter.
FN6. Plaintiffs refer to the quarter ending
December 31, 2003, as “the first quarter of
2004,” CAC ¶ 117, which appears to
comport with Netopia's financial year-end of
September 30, see id. ¶ 58. Plaintiffs thus
seem to allege that the firing of Karl-Heinz
Mumm and the assignment of Kadish to the
Swisscom account occurred “in the early
part of” October, November, and December
2003. See id. ¶ 177.
Even though the plaintiffs' pleading of Kadish's
scienter is inadequate when considered piecemeal,
the court must also consider “whether the total of
plaintiffs' allegations, even though individually
lacking, are sufficient to create a strong inference that
defendants acted with deliberate or conscious
recklessness.” Lipton, 284 F.3d at 1038. Considering
the allegations of the CAC against Kadish as a whole,
the court is compelled to decide that plaintiffs have
not created a strong inference that Kadish acted with
scienter. The drafting of the purchase order and the
whispering into Farrell's ear are particularly
suspicious, but significant details are omitted from
the pleading of these actions. That many of Kadish's
alleged actions are consistent with either Kadish
being part of a conspiracy with the other defendants
or Kadish working against the conspiracy prevents a
strong inference from being drawn either way. As
plaintiffs have not created a strong inference Kadish
acted with scienter, the § 10(b) claim against him
must be dismissed.FN7
FN7. Plaintiffs did not raise allegations that
Kadish engaged in insider trading in
violation of Rule 12b-5 until their opposition
to Kadish's motion to dismiss. See Opp'n at
27-28. Plaintiffs cannot add an insider
trading claim in such a manner, and the
court will not consider it further in
connection with the current motion.
2. The section 20(a) cause of action
*8 Under § 20(a) of the Exchange Act,
Every person who, directly or indirectly, controls any
person liable under any provision of this chapter or of
any rule or regulation thereunder shall also be liable
jointly and severally with and to the same extent as
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such controlled person to any person to whom such
controlled person is liable, unless the controlling
person acted in good faith and did not directly or
indirectly induce the act or acts constituting the
violation or cause of action.
15 U.S.C. § 78t(a). The Ninth Circuit has held that
“[i]n order to prove a prima facie case under § 20(a),
plaintiff must prove: (1) a primary violation of
federal securities laws ... and (2) that the defendant
exercised actual power or control over the primary
violator.” Howard v. Everex Sys., Inc., 228 F.3d
1057, 1065 (2000). Whether a defendant such as
Kadish “is a controlling person is an intensely factual
question, involving scrutiny of the defendant's
participation in the day-to-day affairs of the
corporation and the defendant's power to control
corporate actions.” Kaplan v. Rose, 49 F.3d 1363,
1382 (9th Cir.1994) (internal quotation marks and
citations omitted). “[I]n order to make out a prima
facie case, it is not necessary to show actual
participation or the exercise of actual power;
however, a defendant is entitled to a good faith
defense if he can show no scienter and an effective
lack of participation.” Howard, 228 F.3d at 1065.
The defendant bears the burden of proving he “acted
in good faith and did not directly or indirectly induce
the violations.” Id.
Here, plaintiffs have made out a prima facie case for
a § 20(a) violation by Kadish. The first element is
met: Defendants do not challenge that the CAC
contains an adequately-stated claim for a § 10(b)
violation by Skoulis. The second element is also met:
Plaintiffs allege that Skoulis reported to Kadish. CAC
¶ 11. Kadish bears the burden proving good faith,
which he cannot meet solely with the ambiguous
allegations of the CAC.
D. Plaintiffs' request for leave to amend their
complaint
Plaintiffs request leave to amend their complaint if
any portion of defendants' motion is granted. The
court will grant this request. However, the Ninth
Circuit has noted that complaints in securities fraud
cases can be needlessly verbose. Expressing
frustration with one 113-page complaint, the Ninth
Circuit stated that
To say that the drafting is infelicitous puts matters
too kindly. The complaint is cumbersome almost to
the point of abusiveness. We see nothing to prevent
the district court, on remand, from requiring, as a
matter of prudent case management, that plaintiffs
Page 7
streamline and reorganize the complaint before
allowing it to serve as the document controlling
discovery, or, indeed, before requiring defendants to
file an answer. Complaints fashioned as this one is
are an unwelcome and wholly unnecessary strain on
defendants and on the court system.
*9 In re GlenFed, Inc. Sec. Litig., 42 F.3d 1541, 1554
(9th Cir.1994) (en banc ). This court has similar
feelings regarding the plaintiffs' fifty-page complaint,
and understands the defendants' attempt to prune the
complaint down to a manageable size through their
motion to dismiss or strike. The complaint is
needlessly cumbersome; plaintiffs do not need
anywhere near fifty pages to state two causes of
action against five defendants, even under the
heightened pleading standards of the Reform Act.
In their opposition to the defendants' motion to
dismiss or strike, the plaintiffs filed a thirty-two-page
memorandum of points and authorities. Ten of these
pages are a summary of the factual allegations of the
complaint. See Opp'n at 4-14. This ten-page summary
appears to the court to be a much more useful version
of the complaint, and shows that the plaintiffs can
present the complaint in a shorter form. “[A]s a
matter of prudent case management,” the court will
order plaintiffs to file a streamlined version of their
complaint which does not exceed thirty-five pages
within twenty days of the date of this order. Plaintiffs
may include in their complaint amended allegations
against defendant Kadish.
III. ORDER
For the foregoing reasons, the court
(1) grants Kadish's motion to dismiss the § 10(b)
cause of action against him with twenty days leave to
amend;
(2) grants the defendants' motion to strike paragraphs
twenty-two through thirty-one of the CAC;
(3) otherwise denies the defendants' motion to
dismiss or strike; and
(4) orders plaintiffs to file a streamlined version of
their complaint not exceeding thirty-five pages within
twenty days of the date of this order.
N.D.Cal.,2005.
In re Netopia, Inc., Securities Litigation
Not Reported in F.Supp.2d, 2005 WL 3445631
(N.D.Cal.)
Briefs and Other Related Documents (Back to top)
© 2006 Thomson/West. No Claim to Orig. U.S. Govt. Works.
Case 5:04-cv-04156-JW
Document 133
Filed 11/17/2006
Not Reported in F.Supp.2d
Not Reported in F.Supp.2d, 2005 WL 3445631 (N.D.Cal.)
(Cite as: Not Reported in F.Supp.2d)
• 2006 WL 1417303 (Trial Motion, Memorandum
and Affidavit) Defendants' Memorandum of Points
and Authorities in Opposition to Lead Plaintiffs'
Motion for Class Certification (Apr. 28, 2006)
Original Image of this Document (PDF)
• 2006 WL 1042236 (Trial Pleading) Answer of
Defendant Thomas Skoulis to Second Consolidated
Amended Complaint (Mar. 10, 2006) Original Image
of this Document (PDF)
• 2006 WL 733605 (Trial Pleading) Defendant
William D. Baker's Answer to Plaintiffs' Second
Consolidated Amended Complaint for Violation of
the Federal Securities Laws (Feb. 6, 2006) Original
Image of this Document (PDF)
• 2006 WL 733604 (Trial Pleading) Defendants
Netopia, Inc., Alan B. Lefkof, and David A. Kadish's
Answer to Second Consolidated Amended Complaint
(Feb. 3, 2006) Original Image of this Document
(PDF)
• 2006 WL 440710 (Trial Pleading) Class Action
Second Consolidated Amended Complaint (Jan. 3,
2006) Original Image of this Document (PDF)
• 2005 WL 3607711 (Trial Motion, Memorandum
and Affidavit) Reply Memorandum in Further
Support of Motions to Dismiss Or, in the Alternative
to Strike Allegations From, Plaintiffs' Consolidated
Amended Complaint (Nov. 18, 2005) Original Image
of this Document (PDF)
• 2005 WL 3383080 (Trial Motion, Memorandum
and Affidavit) Memorandum of Points and
Authorities in Opposition to all Defendants' Motions
to Dismiss And/Or Strike (Oct. 13, 2005) Original
Image of this Document (PDF)
• 2005 WL 2613820 (Trial Motion, Memorandum
and Affidavit) Notice of Motion and Motion to
Dismiss, or in the Alternative to Strike Allegations
From, Plaintiffs' Consolidated Amended Complaint
(Aug. 29, 2005) Original Image of this Document
(PDF)
• 5:04cv03364 (Docket) (Aug. 17, 2004)
END OF DOCUMENT
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In
re
Oak
Technology
Securities
LitigationN.D.Cal.,1997.Only the Westlaw citation is
currently available.
United States District Court, N.D. California.
In re OAK TECHNOLOGY SECURITIES
LITIGATION.
No. 96-20552 SW.
Aug. 1, 1997.
ORDER DISMISSING CONSOLIDATED
AMENDED COMPLAINT WITH LEAVE TO
AMEND
SPENCER WILLIAMS, Senior District Judge.
*1 This litigation is a consolidated securities class
action lawsuit filed on behalf of purchasers of the
common stock of Oak Technology, Inc. (“Oak”)
during the period of July 27, 1995 through May 22,
1996 (the “Class Period”) against Oak, twelve
officers and directors of Oak, and Hambrecht and
Quist, Inc. (“H & Q”). On May 21, 1997, after
hearing oral argument, the Court took under
submission the Oak Defendants' (Oak and the twelve
individual Defendants) motion to dismiss Plaintiffs'
Consolidated Complaint and Hambrecht and Quist's
motion to dismiss Plaintiffs' Consolidated Complaint.
After carefully considering the papers, arguments of
counsel, and legal authority, the Court concludes that
Plaintiffs have failed to plead their claims with
particularity as required by Fed.R.Civ.P. 9(b) and the
Securities Litigation Reform Act of 1995 (“Reform
Act”). 15 U.S.C. § 78u-4. Therefore, the Court
DISMISSES Plaintiffs' Consolidated Complaint with
leave to amend.
I. BACKGROUND
Oak manufactures and sells controller chips and
related products for CD-ROM and other multimedia
products for use in personal computers. In February
1995, Oak completed its initial public offering of
common stock, issuing 5.5 million shares.
Oak
conducted a secondary offering in May 1995, issuing
4.6 million additional shares. H & Q participated as
an underwriter in both the initial and secondary
offerings. Oak reported record earnings for the first
three quarters of fiscal year 1996 and Oak common
stock reached a high of $30 3/4 per share in late
Page 44 of 65
Page 1
February 1996. On May 22, 1996, Oak reported to
the public that it expected a loss for the fourth quarter
of fiscal year 1996.
The next day Oak's stock
declined from $16 1/2 per share to $12 1/2 per
share.
Between July 9, 1996 and September 5, 1996 four
federal class action lawsuits were filed against Oak
alleging violations of sections 10(b) and 20(a) of the
Securities Exchange Act of 1934 and Rule
10(b)(5).FN1 On December 18, 1996, this Court
consolidated the four federal actions for all purposes.
Plaintiffs filed a Consolidated Amended Complaint
(“Consolidated Complaint”) on January 31, 1997.
FN1. Additionally, six class action lawsuits
were filed against Oak in California State
Superior Court for the County of Santa
Clara.
The Consolidated Complaint alleges that during the
Class Period, July 27, 1995 through May 22, 1996,
Oak, certain officers and directors of Oak, and H & Q
conducted a fraudulent scheme and course of
business in order to artificially inflate the market
price of Oak common stock. Plaintiffs assert that
throughout the Class Period Oak and its officers and
directors deceived the public by materially misstating
revenue and earnings, failing to adjust its financial
records for obsolete inventory, and engaging in
“sham” transactions with related parties in violation
of Generally Accepted Accounting Principals
(“GAAP”). The Consolidated Complaint also states
that during the Class Period Defendants made
misrepresentations regarding the demand for Oak's
CD-ROM controller chips and the status of new Oak
products in addition to releasing positive forecasts for
revenue and earnings throughout fiscal 1996 and
1997. Plaintiffs contend that Defendants engaged in
this conduct to inflate the market price of Oak's stock
while selling “massive” amounts of personal Oak
stock holdings.
*2 In response to the Consolidated Complaint, the
Oak Defendants filed a motion to dismiss pursuant to
Fed.R.Civ.P. 12(b).
In their motion, the Oak
Defendants assert that Plaintiffs claims, as alleged in
the Consolidated Complaint, fail because:
(1)
Plaintiffs fail to allege any false statements with
sufficient particularity as required by Rule 9(b) and
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the Reform Act; (2) the allegedly false statements in
analysts reports cannot be attributed to the Oak
Defendants; (3) the Consolidated Complaint does not
allege sufficient facts to establish scienter; (4)
Plaintiffs' claims based on omissions are precluded
by the bespeaks caution doctrine; (5) several of the
allegedly false statements are non-actionable positive
statements of optimism; (6) several of Plaintiffs'
claims are based on accurate reports of historical fact;
(7) several claims are based on non-actionable
allegations of corporate mismanagement;
(8)
Plaintiffs fail to plead facts to show loss causation;
and (9) Plaintiffs section 20(a) claim fails because the
Consolidated Complaint fails to state a claim for
primary liability or allege controlling person liability
with particularity.
H & Q filed a separate motion to dismiss contending
that Plaintiffs' claims against H & Q fail because the
Consolidated Complaint does not allege specific facts
showing that H & Q lacked a reasonable basis for its
reports. H & Q also asserts that Plaintiffs cannot
maintain their claims against H & Q because H & Q
does not owe a duty to Plaintiffs in regard to the
allegedly misleading reports because H & Q
disseminated the reports only to its clients.
II. LEGAL STANDARDS
A. Rule 12(b)(6) Standard
A complaint should only be dismissed under Rule
12(b)(6) of the Federal Rules of Civil Procedure
where it appears beyond doubt that no set of facts
could support plaintiff's claim for relief. Conley v.
Gibson, 355 U.S. 41, 47, 78 S.Ct. 99, 2 L.Ed.2d 80
(1957); Durning v. First Boston Corp., 815 F.2d
1265, 1267 (9th Cir.1987), cert. denied, 484 U.S.
944, 108 S.Ct. 330, 98 L.Ed.2d 358 (1987).
A
complaint may be dismissed as a matter of law for
two reasons: (1) lack of a cognizable legal theory, or
(2) insufficient facts under a cognizable theory.
Robertson v. Dean Witter Reynolds, Inc., 749 F.2d
530, 533-34 (9th Cir.1984). In reviewing a motion
under Rule 12(b)(6), all allegations of material fact
are taken as true and must be construed in the light
most favorable to the non-moving party. Durning,
815 F.2d at 1267. However, “conclusory allegations
of law and unwarranted inferences are insufficient to
defeat a motion to dismiss for failure to state a
claim.” In re Verifone Sec. Litig., 11 F.3d 865, 868
(9th Cir.1993).
Page 2
B. Section 10(b) and Rule 10b-5 Claims
Section 10(b) of the Securities Exchange Act of
1934, 15 U.S.C. § 78j, makes it unlawful to use in
connection with “the mails or facilities of interstate
commerce” any “manipulative or deceptive device or
contrivance in contravention of such rules and
regulations as the Commission may prescribe.” Rule
10b-5, promulgated under section 10(b), prohibits the
making of “any untrue statement of a material fact”
or the omission of a material fact that would render
any statements made misleading in the light of
circumstances under which they were made. 17
C.F.R. § 240.10b-5(b). The elements of Rule 10b-5
claim are: (1) a false statement or ar omission of a
material fact; (2) reliance; (3) scienter; and (4)
resulting damages. Paracor Finance v. General
Elec. Capitol Corp., 96 F.3d 1151, 1157 (9th
Cir.1996). If one of these elements is not present,
the claim fails. Id.
C. Pleading Requirements
*3 Complaints alleging fraud must meet the
heightened pleading standards of Fed.R.Civ.P. 9(b),
which requires that “in all averments of fraud or
mistake the circumstances constituting fraud or
mistake shall be stated with particularity.” As part
of the recently enacted Securities Litigation Reform
Act of 1995 (“Reform Act”), Congress clarified and
strengthened the particularity requirements of Rule
9(b) as applied in the context of federal securities
class action lawsuits. Now, to survive a motion to
dismiss, a complaint for violation of the federal
securities laws must meet the heightened pleading
requirements which are set forth in the Reform Act.
15 U.S.C. § 78u-4(b).
First, the complaint must specify each false or
misleading statement. 15 U.S.C. § 78u-4(b)(1). To
satisfy this requirement, a complaint must “state
precisely the time, place, and the nature of the
misleading statements, misrepresentations, and
specific acts of fraud.” Kaplan v. Rose, 49 F.3d
1363, 1370 (9th Cir.1994), cert. denied, 516 U.S.
810, 116 S.Ct. 58, 133 L.Ed.2d 21 (1995).
Second, the Reform Act requires that the complaint
state the reasons why each statement is false or
misleading. 15 U.S.C. § 78u-4(b)(1). In some cases
involving fraud, a plaintiff may explain why a
statement is false or misleading by merely pointing to
facts that were later revealed which, due to their
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nature, were necessarily in existence at the time the
statement was made. In re GlenFed, Inc. Sec. Litig.,
42 F.3d 1541, 1548 (9th Cir.1994) (discussing the
example of a house built on a landfill). Securities
fraud cases, however, typically involve an
intervening event, such as a decline in consumer
demand for the company's products or the appearance
of new competitors, that occurs between the time of
the statement and the time the sobering facts are
revealed. Id. “In the face of such intervening events,
a plaintiff must set forth, as part of the circumstances
constituting fraud, an explanation as to why the
disputed statement was untrue or misleading when
made.” Id. at 1548-49.
This is most easily
accomplished
by
identifying
inconsistent
contemporaneous statements or information made by
or available to the defendants. Id. at 1549.
naming fourteen defendants as participants in the
scheme to defraud. Apparently, Plaintiffs believe
that the sheer volume of their allegations gives
credibility to their claims. However, in the end,
Plaintiffs succeed only in clouding any well-founded
claims with numerous unsupported and conclusory
claims.
Third, with respect to each act or omission, the
complaint must set forth particular facts that give rise
to a strong inference that defendant acted with the
required state of mind. 15 U.S.C. § 78u-4(b)(2). To
satisfy this requirement, the complaint must allege
either (1) specific facts demonstrating that the
defendant had a motive and an opportunity to commit
fraud or (2) specific facts constituting circumstantial
evidence of conscious behavior or recklessness if the
statement is not forward-looking. These allegations
of scienter cannot be conclusory in nature. Rather,
they must constitute a substantial factual basis to
support a “strong inference” that the defendant acted
with the required state of mind.
These particularity requirements may be relaxed as to
matters peculiarly within the defendants' knowledge
and plaintiffs may allege such matters on the basis of
information and belief. Wool v. Tandem Computers
Inc., 818 F.2d 1433, 1439 (9th Cir.1987). However,
if an allegation regarding a statement or omission is
made on information and belief, the Reform Act
requires that the complaint state with particularity all
facts on which the belief is formed. 15 U.S.C. §
78u-4(b)(1).
III. DISCUSSION
*4 In reviewing Plaintiffs' claims, the Court finds two
general deficiencies that pervade the Consolidated
Complaint.
First, Plaintiffs mistake quantity for
particularity. Instead of providing particularity as to
each statement and each Defendant's involvement in
the alleged fraud, Plaintiffs attempt to meet the
requirements of Rule 9(b) and the Reform Act by
alleging a myriad of misleading statements and
Second, Plaintiffs fail to adequately explain why any
of the statements were false when made. “In order to
allege the circumstances constituting fraud plaintiff
must set forth facts explaining why the difference
between the earlier and the later statements is not
merely the difference between two permissible
judgments, but rather the result of falsehood.”
GlenFed, 42 F.3d at 1549.
The Consolidated Complaint sets forth numerous
“adverse material facts” but contains only conclusory
allegations that the “adverse material facts” were in
existence or known by Defendants at the time the
allegedly misleading statements were made. Further,
the Consolidated Complaint is devoid of specific
allegations of contemporaneous facts or information
showing when the adverse facts arose. Thus, the
Court can only conclude that Plaintiffs' allegations of
falsity derive from later, sobering revelations made
by Oak at the end of the Class Period.FN2 As such,
Plaintiffs claims fail to meet the requirements of Rule
9(b) and the Reform Act because “it is clearly
insufficient for plaintiffs to say that the later,
sobering revelations make the earlier, cheerier
statement a falsehood.” GlenFed, 42 F.3d at 1548.
FN2. The Consolidated Complaint provides
that in April and May of 1996, Oak reported
weakening sales for CD-ROM controller
products, due in part to the transition to 6X
and 8X speed drives, excess inventory and
failure to increase sales of multimedia
products. Consolidated Complaint ¶ ¶ 100
and 104.
In addition to these two general deficiencies, the
Consolidated Complaint suffers from several specific
shortcomings which are described below.
A. The Form of Plaintiffs' Allegations
As an initial matter, Plaintiffs' presentation of their
allegations of false and misleading statements makes
it unreasonably difficult for the Court and Defendants
to interpret Plaintiffs' claims. Instead of identifying
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each allegedly false statement in one paragraph and
explaining why each statement was false when made
in the following paragraph, the Consolidated
Complaint groups several allegedly false statements,
often citing long passages with little, if any,
explanation in the surrounding text of which
particular statements were false and why they were
false. Consolidated Complaint ¶ ¶ 54-72, 74-81, 8393.FN3 At the conclusion of each of these groups of
false and misleading statements, the Consolidated
Complaint sets forth the conclusory allegation that
the statements “were false and misleading when
made” and lists “material adverse information” that
was not disclosed by Defendants. ¶ ¶ 73, 82, 95.
the transition from 2x and 4x to 6x and 8x speed
drives; (3) revenues from multimedia products; and
(4) unreserved inventory.
FN3. All subsequent paragraph references
are to the Consolidated Complaint.
*5 For example, paragraphs 54 through 72 of the
Consolidated Complaint present seven pages of
selected statements allegedly made by Oak or
analysts during the time period from July 26, 1995
through September 1995.
However, the vast
majority of adverse facts pertaining to all of these
statements are lumped together in paragraph 73.
Thus, the burden is on the reader to sort out the
statements and match them with the corresponding
adverse facts to solve the “puzzle” of interpreting
Plaintiffs' claims.
This “puzzle-style” pleading has been consistently
criticized by the courts as an “unwelcome and wholly
unnecessary strain on defendants and the court
system.” In re GlenFed, 42 F.3d 1554; See also,
Strassman v. Fresh choice, Inc., 1995 WL 743728,
*4 (N.D.Cal. Dec.7, 1995).
Given the level of
experience of Plaintiffs' counsel, the Court cannot
understand why Plaintiffs' claims are alleged in this
manner. Moreover, now that the Court has stated its
dissatisfaction with this pleading tactic, any amended
complaint that employs this form of pleading will be
summarily dismissed as improper under Fed.R.Civ.P.
8.
B. False and Misleading Statements
Plaintiffs allege that during the Class Period
Defendants conducted a scheme to defraud by
publishing false and misleading statements in press
releases, articles, analysts' statements, and reports.
According to the Consolidated Complaint, these
statements included false information concerning:
(1) CD-ROM controller chip demand and sales; (2)
1. CD-ROM Controller Chip Demand and Sales
Plaintiffs allege that throughout the Class Period
Defendants falsely represented that demand for Oak's
CD-ROM controller chips was “red hot,”
“exceptional” and “increasing” and that sales from
the CD-ROM controller chips would generate strong
earnings growth in fiscal 1996. ¶ ¶ 54, 56, 67, 72, 75,
76, 87 and 92.
According to the Consolidated
Complaint, Defendants made these statements
knowing that certain large customers, including
Toshiba, were beginning to manufacture controller
chips internally and that other customers, including
Mitsumi, Hitachi, Creative Technologies and NEC,
had informed Oak that they would be dramatically
decreasing their purchases from Oak. ¶ ¶ 7 and 73.
However, Plaintiffs merely allege, without providing
any supporting contemporaneous factual allegations,
that these adverse facts arose before Defendants
made the allegedly misleading statements. These
conclusory allegations do not satisfy the requirements
of Rule 9(b) and the Reform Act. Plaintiffs must
allege with particularity when this information was
passed to Defendants and what was said. When
amending their pleading', Plaintiffs should, at a
minimum, include the following information: (1)
when Toshiba informed Oak of its intent to produce
the chips internally; (2) when Toshiba reduced their
purchases as a result of internal production; (3) when
Mitsumi, Hitachi, Creative Technologies and NEC
informed Oak that they would be decreasing their
purchases; (4) when these customers decreased their
purchases; and (5) the approximate amount of these
“dramatic” reductions in purchases.
*6 Plaintiffs also allege that Defendants became
aware of the decline in demand for Oak's CD-ROM
chips through internal reports, presentations, and
regularly scheduled meetings. General allegations of
internal reports, presentations and meetings do not,
however, satisfy the pleading requirements for
federal securities fraud class actions. Hockey v.
Medhekar, 1997 WL 20374, *7 (N.D. Cal. April 15,
1997); Stack v. Lobo, 903 F.Supp. 1361, 1370
(N.D.Cal.1995).
Further, adding the boilerplate
assertion that the reports and presentations were
“regularly prepared” does not provide the requisite
particularity. Stack, 903 F.Supp. at 1370. Rather, to
satisfy the pleading requirements of Rule 9(b) and the
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Reform Act, Plaintiffs must identify specific reports
or presentations and what information was conveyed
in the reports or presentations.
and would contribute to strong revenue growth
throughout 1996 and continue into 1997. ¶ ¶ 54, 56,
87, and 92. For projections such as these to be
actionable under the federal securities laws, Plaintiffs
must demonstrate that the statement was not
genuinely believed, that there was no reasonable
basis for that belief, or that the speaker was aware of
“undisclosed facts tending to seriously undermine the
accuracy of the statement.” In re Apple Computer
Sec. Litig., 886 F.2d 1109, 1113 (9th Cir.1989). In
other words, Plaintiffs must allege facts showing that
Defendants lacked a reasonable basis for their
predictions. Further, these allegations, as with any
allegations of fraud, must be pled with particularity.
Here, Plaintiffs identify one presentation made by
Ben Taniguchi, vice president of the Optical Storage
Business Unit, at a meeting on October 25, 1995.
During the presentation, Taniguchi allegedly
“showed that the sales of Oak's CD-ROM chips
would decline sharply, commencing early in calendar
year 1996.” ¶ 78.
While these allegations
adequately identify the time and preparer of the
internal report, they provide only vague and
conclusory information concerning the content of
Taniguchi's presentation. Further, Plaintiffs fail to
explain how the information in Taniguchi's
presentation differed from statements made by
Defendants following the presentation. Therefore,
Plaintiffs' claims of misleading statements regarding
CD-ROM controller chip demand are insufficient.
2. Transition from 2X and 4X to 6X and 8X Speed
Drives
Plaintiffs allege that Defendants falsely stated that
Oak was prepared for the transition to 6X and 8X
speed drives, was experiencing no problems with the
transition, and continued to benefit from the
transition from double speed to quad speed drives.
Further, they allege that Oak's fourth generation CDROM controller, the OTI-910, supported multiple
drive speeds of 4X, 6X, and 8X, was well received
and would show strong growth during fiscal 1996. ¶ ¶
54, 56, 58, 76, 86 and 87. To demonstrate the falsity
of these statements Plaintiffs allege that the OTI-910
was not new but just a reworked version of a prior
Oak product and “did not work on multiword DMA
and did not support full performance mode 3.” ¶ ¶
73(a) and 82(j). However, Plaintiffs fail to explain
how these alleged shortcomings in the OTI-910
demonstrate that Oak's transition to 6X and 8X speed
drives was failing or that the OTI-910 controller was
defective or not well received. Thus, Plaintiffs have
not sufficiently specified the reason or reasons why
the statements concerning transition to 6X and 8X
speed drives were misleading as required by the
Reform Act. 15 U.S.C. § 78u-4(b)(1).
3. Revenue from Multimedia Products
Plaintiffs also allege that Defendants misled the
public by predicting that Oak's multimedia products
would start generating revenue in early fiscal 1996
*7 In the Consolidated Complaint, Plaintiffs make
the conclusory allegations that Oak was experiencing
“great difficulties” developing its new multimedia
products and that existing multimedia products “were
not doing well.” ¶ ¶ 73, 82 and 95. However,
Plaintiffs fail to provide any specific allegations to
support their conclusory assertions. Thus, Plaintiffs
claims of misleading projections concerning Oak's
multimedia products clearly do not meet the
particularity requirements of Rule 9(b) and the
Reform Act.
Plaintiffs also allege that Defendants misled the
public by stating in an annual report, “[w]e believe
that the substantial synergies among our areas of
expertise, including opportunities for product
integration, provide us with a competitive advantage
in the multimedia marketplace” and “[w]e develop
our core technologies using a consistent set of design
tools, with an emphasis on building scalable and
reusable functional blocks.” ¶ ¶
61 and 63.
Plaintiffs contend that these statements were
materially false because Oak's CD-ROM unit used
different tools and methodologies than Oak's MPEG
and 3-D units and because Oak's blocks were not
reusable, scalable or functional. ¶ ¶ 62 and 64.
These allegations are insufficient for two reasons.
First, Plaintiffs fail to show why the statements were
false. Stating that there are “substantial synergies” is
not a representation that all of Oak's business units
use the same tools and methodologies.
Thus,
alleging that one business unit uses different tools
than two other business units does not demonstrate
that Defendants' statements regarding synergies were
false.
Additionally, Plaintiffs' assertion that “the
blocks developed by the various business units were
not scalable, reusable functional blocks,” is
ambiguous, unsupported and conclusory. ¶ 64.
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Second, vague or amorphous statements cannot serve
as a basis for liability. Raab v. General Physics
Corp., 4 F.3d 286, 288-90 (4th Cir.1993); In re
Syntex Corp., 855 F.Supp. at 1095; Strassman, 1995
WL 743720 at *5. Such statements are inactionable
because reasonable investors do not consider them
important in making investment decisions. Raab, 4
F.3d at 289-90.
Here, the statements regarding
“synergies” and product integration are general,
amorphous comments about Oak's efforts to integrate
its various products and do not refer to any particular
products or even particular business units.
No
reasonable investor would rely on such vague
statements, “and they are certainly not specific
enough to perpetrate fraud on the market.” Id. at 290.
Thus, to the extent that Plaintiffs rely on these
statements of “synergies” and product integration to
establish liability, Plaintiffs' claims are dismissed
with prejudice.
each error, they must identify particular transactions
underlying
Defendants'
alleged
accounting
deficiencies. In re Wells Fargo Sec. Litig., 12 F.3d
922, 926-27 (9th Cir.1993), cert. denied sub nom.,
Wells Fargo & Co. v. Greenwald, 513 U.S. 917, 115
S.Ct. 295, 130 L.Ed.2d 209 (1994); In re Ross
Systems Sec. Litig., Fed. Sec. L. Rep. ¶ 98,363 at
90,499. PCH1H 1. Improper Revenue Recognition
Plaintiffs allege that Oak improperly recognized
revenues on sales where it granted unconditional
rights of return and extended payment terms with
assurances that the customer could return unsold
products. ¶ 117. According to the Consolidated
Complaint, Oak offered these terms to its “chief
Japanese, Singapore and Taiwanese customers,”
resulting in approximately $75 million in overstated
revenues. Id. In a separate paragraph, Plaintiffs state
that Mitsumi Electric, Behavior Tech Computer, and
NEC were “among” Oak's chief customers in Japan,
Singapore, and Taiwan. ¶ 116.
4. Unreserved Inventory
The final category of allegedly misleading statements
warrants minimal commentary. Plaintiffs allege that
Defendants misled the public when they made
assurances that Oak was not accumulating excess
inventory of its CD-ROM controllers and that
controller chip inventory was under control. ¶ ¶ 54
and 87.
However, Plaintiffs fail to specify the
reason or reasons why these assurances were false.
Instead, they rely on the conclusory allegation that
“Oak's inventories of the OTI-910 were increasing
greatly, and Oak would be forced to take writeoffs of
this inventory.” ¶ 82(m). Pleading securities fraud
in such a conclusory manner is well below the
standards set by the Reform Act.
These allegations do not reach the level of
particularity required for maintaining claims based on
fraudulent financial statements. To adequately plead
financial fraud based on improper revenue
recognition, Plaintiffs must allege, at a minimum,
some particular transactions where revenues were
improperly recorded, including the names of the
customers, the terms of specific transactions, when
the transactions occurred, and the approximate
amount of the fraudulent transactions.
Merely
providing the names of “chief customers” and
estimating the net effect of the alleged improper
revenue recognition does not suffice.
2. Related Party Transactions
C. Financial Fraud
*8 Plaintiffs allege that during the Class Period
Defendants committed financial fraud by:
(1)
recognizing revenues in violation of GAAP; (2)
engaging in “sham” transactions with related parties;
and (3) failing to recognize a loss on excess inventory
and purchase commitments in violation of GAAP. To
adequately state a claim for accounting fraud,
Plaintiffs must plead facts sufficient to support a
conclusion that Defendants prepared fraudulent
financial statements and that the alleged financial
fraud was material. In re Ross Systems Sec. Litig.,
[Current Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶
98,363 at 90,498 (N.D.Cal.1994).
Although
Plaintiffs need not specify the exact dollar amount of
Plaintiffs allege that during fiscal 1995 and the first
three quarters of fiscal 1996, an entity named EDEE,
along with another company, Takaya, engaged in
material transactions with Oak. ¶ 121. Plaintiffs
further allege that Oak “controlled” EDEE, which
was located in the same building as Oak's Japanese
subsidiary, and that Oak used EDEE to “park”
inventory.
Id. Therefore, according to Plaintiffs,
Oak violated GAAP by failing to disclose the nature
and effect of these related party transactions.
Once again, Plaintiffs allegations are plagued with
ambiguities. Plaintiffs fail to identify the nature of
the “material transactions” or the amount of any such
transactions.
Plaintiffs also conclude that Oak
controlled EDEE without providing any explanation
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or allegations to support this conclusion. Lastly, the
Consolidated Complaint contains no information to
elucidate Takaya's role in the alleged accounting
fraud or the relationship between Takaya, EDEE and
Oak. Thus, Plaintiffs provide a feeble basis for their
claims of fraudulent related transactions and fall well
short of meeting the pleading requirements of 9(b)
and the Reform Act.
3. Excess Inventory and Purchase Commitments
*9 Plaintiffs allege that in summer and fall of 1995
Oak committed to purchase millions of dollars worth
of wafers during fiscal 1996 and thereafter. ¶ 124.
Plaintiffs further allege that at the time the Oak
Defendants issued the financial statements for the
second and third quarters of fiscal 1996, Defendants
knew that, due to lack of demand for Oak's controller
chips, Oak did not need and would be unable to sell
the wafers it was obligated to purchase. Id. Thus,
Plaintiffs assert that the Oak Defendants should have
recognized a loss on its purchase commitments and
that failure to do so constituted a violation of GAAP.
Id.
This claim of financial fraud regarding excess wafers
attempts to impose liability for a difficult business
decision: when to recognize a loss on inventory that
a company may not use. According to Plaintiffs,
Defendants violated GAAP by failing to recognize a
loss for its purchase commitments during second and
third quarters of fiscal 1996. However, “GAAP is
not a set of rules ensuring identical treatment of
identical transactions; rather, it tolerates a range of
reasonable treatments, leaving the choice among
alternatives to management.” In re Cirrus Logic Sec.
Litig., 946 F.Supp. 1446, 1457 (N.D.Cal.1996).
Thus, at the pleading stage, a plaintiff must allege
facts sufficient to support a finding that the
accounting decision is the result of fraud and not
“merely the difference between two permissible
judgments.” Glenfed, 42 F.3d at 1549.
Here, the Consolidated Complaint does not contain
any specific allegations to support the claim that
Defendants committed fraud by failing to recognize a
loss in the second and third quarters. Rather, the
Consolidated Complaint merely sets forth the
conclusory allegation that Defendants should have
recognized a loss earlier because they were aware
that demand for Oak's controller chips was
“weakening severely and continuing to weaken.” ¶
124. Thus, Plaintiffs once again fail to meet the
particularity requirements of Rule 9(b) and the
Page 7
Reform Act.
D. Liability of the Individual Oak Defendants
In the Consolidated Complaint, Plaintiffs seek to
impose liability not only against Oak and the officers
who released the allegedly misleading statements but
also against Oak's outside directors and various
divisional vice presidents of Oak. Plaintiffs assert
that these Defendants are responsible for the
allegedly misleading statements even though none of
the statements can be directly attributed to them on
the grounds that: (1) they participated in the scheme
to defraud;
(2) they are responsible for the
statements under the group published information
doctrine; and (3) they sold stock while in possession
of material inside information.
1. Scheme to Defraud
Plaintiffs allege that each of the outside director and
vice president Defendants, “as persons selling Oak
common stock, were direct participants in the scheme
to defraud.” ¶ ¶
25-32.
Plaintiffs' general
allegations of Defendants' fraudulent assistance are
misguided.
*10 Pursuant to the Supreme Court's ruling in
Central Bank v. First Interstate Bank, 511 U.S. 164,
114 S.Ct. 1439, 128 L.Ed.2d 119 (1994), this Court,
along with several other courts in this district, have
held that secondary liability claims based on
allegations of “conspiracy” are not actionable under
section 10(b). Stack v. Lobo 1995 WL 241448, *10
(N.D.Cal. Apr.19, 1995);
In re Syntex Corp.
Securities Litigation, 855 F.Supp. 1086, 1097-98
(N.D.Cal.1994).
Here, Plaintiffs' “scheme”
allegations are no more than a thinly disguised
attempt to avoid the impact of the Central Bank
decision. See, e.g., Stack, 1995 WL 241448 at *10
(dismissing the plaintiffs' “scheme” claims with
prejudice) In re Gupta Corp. Securities Litigation,
1994 WL 748988, *28 (N.D.Cal. Dec.9, 1994)
(rejecting the plaintiffs' attempts to recharacterize
non-actionable conspiracy claims as “scheme”
claims, and dismissing such claims with prejudice).
Accordingly, Plaintiffs' claims of participation in a
“scheme” to defraud investors must be dismissed.
2. Group Pleading Exception
Rule 9(b) requires a plaintiff to attribute fraudulent
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acts or statements to a particular defendant.
Schreiber Distributing v. Serv-Well Furniture Co.,
806 F.2d 1393, 1401 (9th Cir.1986). However, the
Ninth Circuit has recognized an exception to this
rule:
In cases of corporate fraud where the false or
misleading information is conveyed in prospectuses,
registration statements, annual reports, press releases,
or other “group-published information,” it is
reasonable to presume that these are the collective
actions of the officers. Under such circumstances, a
plaintiff fulfills the particularity requirement of Rule
9(b) by pleading the misrepresentations with
particularity and where possible the roles of the
individual defendants in the misrepresentations.
outside directors were “privy to inside information”
are insufficient to establish their liability for alleged
misstatements. In re Interactive Network, Inc. Sec.
Litig., 948 F.Supp. 917, 921 (N.D.Cal.1995).
Wool, 818 F.2d at 1440. Notwithstanding the group
pleading exception to Rule 9(b), Plaintiffs must still
set forth the circumstances constituting the fraud.
That is, the group pleading exception does not excuse
Plaintiffs from setting forth the time, place and
content of the alleged misstatements, GlenFed, 42
F.3d at 11547-48, as well as an explanation of why
each of those statements was false when made. Id. at
1549.
As explained above, Plaintiffs have not
alleged with sufficient particularity that Oak's
statements were false when made.
If, upon amendment, Plaintiffs can state with
particularity why Oak's statements were false when
made, Plaintiffs may seek to establish the liability of
the outside director Defendants for those statements.
However, in order to establish the liability of the
outside director defendants for Oak's allegedly
misleading statements, Plaintiffs must satisfy the
requirements for the group pleading exception in the
Ninth Circuit: “To rely upon the ‘group published
information’ presumption, Plaintiffs' complaint must
contain allegations that an outside director either
participated in the day-to-day corporate activities, or
had a special relationship with the corporation, such
as participation in preparing or communicating group
information at particular times.” In Re GlenFed, 60
F.3d 591, 593 (9th Cir.1995).
Moreover, the
allegations concerning the outside director
Defendants' involvement with Oak must satisfy the
particularity requirements set forth by the Reform
Act.
*11 Here, with regard to all of the outside director
Defendants, Plaintiffs allege that “because of [their]
positions with Oak, they knew the adverse non-public
information about Oak's business, finances, products,
markets and present and future business prospects.” ¶
¶ 29, 30, 31, 32. However, general allegations that
Plaintiffs further allege that Defendants King, Black,
and Tomlinson, as members of the Audit Committee
of Oak's Board of Directors, “reviewed and approved
the issuance of Oak's false financial statements
during fiscal 1996.” ¶ ¶ 31, 32. However, Plaintiffs
fail to allege these Defendants' specific roles in the
review and approval of the allegedly false financial
statements. Allegations that outside directors merely
held positions on committees responsible for the
preparation and disclosure of a corporation's finances
are insufficient to set forth the circumstances
constituting fraud with particularity. In re GlenFed,
Inc., 60 F.3d 591, 593 (9th Cir.1995); Rubin v.
Trimble, 1997 WL 227956, at *19 (N.D.Cal.). Thus,
their conclusory allegation does not meet the
stringent pleading requirements of Rule 9(b) and the
Reform Act.
Plaintiffs further make the conclusory allegation that
“Ko was involved in the day-to-day operations of
Oak.” ¶ 29. Again, this general allegation does not
satisfy the strict pleading requirements of Rule 9(b)
and the Reform Act.
Plaintiffs also fail to allege with particularity that Mr.
Hsu was involved in Oak's day-to-day operations, or
that he prepared or communicated group information
to the public.
Thus, with regard to each of the
outside director Defendants, the Consolidated
Complaint fails to allege facts demonstrating their
operational involvement with Oak, a prerequisite for
group pleading.
To establish the liability of the vice president
Defendants under the group pleading exception,
Plaintiffs must satisfy a necessarily stricter
requirement. Since all of the inside officers in a
corporation, by virtue of their positions, are involved
in daily corporate activities, merely pleading as much
is not sufficient to establish their liability under the
group pleading exception. To establish the liability
of these Defendants for Oak's allegedly misleading
statements, Plaintiffs must plead that these vice
presidents were directly involved “not only in the
day-to-day affairs of [Oak] in general but also in [the
preparation of its] financial statements in particular.”
Wool, 818 F.2d at 1440. The existing Complaint
does not allege that these Defendants participated in
the preparation or communication of allegedly
misleading information. Thus, Plaintiffs have failed
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to establish the liability of the vice president
Defendants under the group pleading exception.
sufficiently specified the “adverse non-public
information.” Additionally, Plaintiffs have not pled
with specificity that they traded contemporaneously
with Defendants.
Silicon Graphics, 1996 WL
664639, at *9. Thus, Plaintiffs claims of insider
trading must be dismissed.
3. Insider Trading
*12 Plaintiffs also argue that even if the outside
director and vice president Defendants did not
personally make false and misleading statements to
the public, and even if the group pleading exception
is inapplicable, these Defendants are nonetheless
liable under 10b-5 for failing to disclose adverse nonpublic information known to them when they sold
their stock. ¶ ¶ 12, 14, 133.
In their allegations of insider trading, Plaintiffs rely
on Chiarella v. U.S., 445 U.S. 222, 100 S.Ct. 1108,
63 L.Ed.2d 348 (1979), in which the Supreme Court
established that rule 10b-5 not only bars fraudulent
statements, but in some contexts requires disclosure
of facts known to an insider. “[A] corporate insider
must abstain from trading in the shares of his
corporation unless he has first disclosed all material
inside information known to him.” Chiarella, 445
U.S. at 227.
Plaintiffs, however, confuse distinct theories of
recovery under Rule 10b-5. While an action for
insider trading is indeed an application of Rule 10b-5,
it is not the same as an action based on misleading
statements.
Insider trading involves a failure to
disclose material information; it does not concern
any affirmative misrepresentation.
Moreover, an
allegation of insider trading does not permit alleged
misstatements to be attributed to a group. Thus,
Plaintiffs
cannot
attribute
Oak's
alleged
misrepresentations to the outside director and vice
president Defendants merely by alleging insider
trading.
Further, even as a separate theory of recovery under
10(b)-5 Plaintiffs' claims of insider trading fails.
While the outside director and vice president
Defendants, as Oak “corporate insiders,” had a duty
to disclose material information when selling their
shares in Oak,” Plaintiffs fail to specify what material
information these Defendants possessed. Plaintiffs'
general allegation that, “because of [their] ...
position[s] with Oak,” each of the outside director
and vice president Defendants “knew the adverse
non-public information about Oak's business,
finances, products, markets and present and future
business prospects,” 1 25-32, does not satisfy the
strict pleading requirements of Rule 9(b) and the
Reform Act. As explained above, Plaintiffs have not
E. H & Q's LIABILITY
Defendant H & Q contends that it cannot be liable to
Plaintiffs, who were not clients of H & Q, for the
allegedly misleading statements in its analysts'
reports. In response, Plaintiffs rely on the holdings
of Warshaw v. Xoma Corp., 74 F.3d 955 (9th
Cir.1996) and Fecht v. Price Co., 70 F.3d 1078 (9th
Cir.1995), for the proposition that if a company may
be held liable for publicly disseminating false
information through a securities analyst, then a
securities analyst itself must also be liable to the
public at large for that same information. However,
neither Warshaw nor Fecht involved claims against
securities analysts. Rather, these cases established
that where a public company “intentionally used
[securities analysts] to disseminate false information
to the investing public, ... [it] cannot escape liability
simply because it carried out its alleged fraud through
the public statements of third parties.” Warshaw, 74
F.3d at 959.
*13 Here, Plaintiffs seek to extend the holdings of
Warshaw and Fecht. In so doing, they draw an
abrupt and unwarranted conclusion: “Given that Oak
itself ... can be held liable for using H & Q's analyst
reports as a conduit to the market, it is ridiculous to
suggest that H & Q is immune from liability for
disseminating its own misrepresentations through
those same analyst reports.” Plaintiffs' Opposition at
16 (emphasis omitted). Yet, Plaintiffs' assessment is
based on nothing more than their own normative
judgment. In fact, they do not offer any competent
authority supporting the contention that a securities
analyst owes any duty at all to non-clients. See In re
Valence Technology Securities Litig., 1996 WL 3778,
*9 (N.D.Cal. January 23, 1996). Nevertheless, this
Court will address the issue of H & Q's potential and
actual liability in this case.
1. Omissions in Analyst Reports
H & Q cannot be liable to Plaintiffs under section
10(b) for any omissions in its analyst reports. The
Supreme Court has held that silence in connection
with a purchase or sale of securities may indeed
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operate as a fraud, “[b]ut such liability is premised
upon a duty to disclose arising from a relationship of
trust and confidence between parties to a
transaction.” Chiarella, 445 U.S. at 230. Plaintiffs
do not allege that any such relationship existed here.
No named plaintiff was a client of H & Q. Moreover,
Plaintiffs do not allege that H & Q sold any Oak
stock during the class period; H & Q, that is, was not
a “part[y] to [any] transaction” involving Oak stock.
Thus, H & Q did not owe Plaintiffs a duty to disclose
adverse facts, and it cannot be liable to Plaintiffs for
any omissions in its analyst reports.
the Ninth Circuit rejected this style of pleading: It is
insufficient merely to “set forth conclusory
allegations of fraud ... punctuated by a handful of
neutral facts.” Semegen v. Weidner, 780 F.2d 727,
731 (9th Cir.1985). Thus, the existing Complaint
fails to establish H & Q's liability for alleged
misstatements in its analyst reports.
2. Fraud on the Market Doctrine
While securities analysts cannot be liable to nonclients for omissions in their analyst reports, they can
be liable for affirmative misstatements in those
reports. The “fraud on the market doctrine” provides
a basis for such liability. “In the usual claim under
Section 10(b), the plaintiff must show individual
reliance on a material misstatement. Under the fraud
on the market theory, the plaintiff has the benefits of
a presumption that he has indirectly relied on the
alleged misstatement, by relying on the integrity of
the stock price established by the market.” In re
Apple Computer Sec. Litig., 886 F.2d 1109, 1113-14
(9th Cir.1989).
While the fraud on the market doctrine relaxes the
proof required for the reliance element in class action
securities fraud litigation, In re MDC Holdings
Securities Litig., 754 F.Supp. 785, 800
(S.D.Cal.1990), it does not excuse plaintiffs from the
strict pleading requirements of Rule 9(b) and the
Reform Act. To adequately allege fraud, a plaintiff
must set forth an explanation as to why the disputed
statements were false or misleading when made.
GlenFed, 42 F.3d at 1549. “This can be done most
directly by pointing to inconsistent contemporaneous
statements or information (such as internal reports)
which were made by or available to defendants.” Id.
*14 Here, Plaintiffs allege that by disseminating false
information, H & Q committed a fraud on the market.
However, they do not plead with the requisite
particularity. Plaintiffs fail to cite specifically any
internal documents or other contemporaneous facts
indicating that H & Q did not believe its projections
concerning Oak's performance. Instead, they merely
recite portions of H & Q's analysts' reports and
declare them fraudulent. ¶ ¶ 57, 70, 79, 88, 93, 97,
102. Even before the Reform Act heightened the
pleading requirements in securities fraud litigation,
3. Control Person Liability
Plaintiffs also contend that H & Q is liable as a
control person of Mr. Hsu, who is himself liable, they
argue, as a control person of Oak, for the alleged
false and misleading statements inflating Oak's stock
price. To state a claim for control person liability,
Plaintiffs must establish (1) a primary violation of the
federal securities laws, and (2) “ ‘control’ by the
alleged controlling person.” FN4 First Interstate Bank
of Denver v. Pring, 969 F.2d 891, 897 (10th
Cir.1992).
FN4. In the regulations of the Securities and
Exchange Commission (SEC), “control” is
defined as “the possession, direct or indirect,
of the power to direct or cause the direction
of the management and policies of a person,
whether through the ownership of voting
securities, by contract, or otherwise.” 17
C.F.R. § 230.405.
Here, as noted above, Plaintiffs fail to allege with
particularity that Oak made any actionable
misstatements. Where, as here, there are no primary
violations pled with particularity, all secondary
liability claims must fail as well. See Stack v. Lobo,
1995 WL 241448 at *10.
Furthermore, Plaintiffs have not adequately alleged
that H & Q was a controlling person of Mr. Hsu and
that Mr. Hsu, in turn, was a controlling person of
Oak. In general, the determination of who is a
controlling person for purposes of liability under
section 20(a) is “an intensely factual question,”
Arthur Children's Trust v. Keim, 994 F.2d 1390, 1396
(9th Cir.1993), involving “scrutiny of the defendant's
participation in day-to-day affairs of the corporation
and the defendant's power to control corporate
actions.” Kaplan v. Rose, 49 F.3d 1363, 1383 (9th
Cir.1994).
While Plaintiffs correctly note that
section 20(a) “premises liability solely on the control
relationship,” First Interstate Bank, N.A. v. Pring,
969 F.2d 891, 897 (10th Cir.1992); see also
Hollinger v. Titan Capital Corp., 914 F.2d 1564,
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1575 (9th Cir.1990), they fail to recognize the
requirement that the circumstances of that “control
relationship” be pled with particularity. Here, again,
Plaintiffs have not satisfied the strict pleading
requirements of Rule 9(b) and the Reform Act.
explained above, pursuant to the Supreme Court's
ruling in Central Bank, secondary liability claims
based on allegations of “conspiracy” are not
actionable under section 10(b).
Thus, Plaintiffs'
claims of H & Q's participation in a “scheme” to
defraud investors must be dismissed.
As explained above, Plaintiffs do not allege with
particularity that Mr. Hsu, an outside director of Oak,
“participated in Oak's day-to-day operations,” or that
he had “power to control [Oak's] corporate actions.”
Kaplan, 49 F.3d at 1383. Thus, Plaintiffs fail to
establish the “control relationship” between Mr. Hsu
and Oak required for control person liability.
*15 Moreover, Plaintiffs fail to plead with
particularity the “control relationship” between H &
Q and Mr. Hsu. Plaintiffs allege that “[b]y reason of
H & Q's position as underwriter, broker-dealer and
market maker and its substantial ownership of Oak
common stock, H & Q had the power and authority ...
to cause Hsu to engage in the wrongful conduct
complained of herein.” ¶ 144. However, H & Q's
“position” “does not create any presumption of
control,” Arthur Children's Trust, 994 F.2d at 1397
(quoting 4 Louis Loss & Joel Seligman, Securities
Regulation, 1724 (1990)) (emphasis in original), and
does not by itself sustain an allegation of control
person liability.
In their general allegations,
Plaintiffs do not delineate H & Q's involvement in
Mr. Hsu's “day-to-day affairs” or how H & Q
controlled Mr. Hsu's involvement with Oak.
Furthermore, Plaintiffs fail to address the distinction
between Hambrecht and Quist Asia Pacific, an
overseas entity in which H & Q holds a minority
interest, and H & Q itself. Thus, Plaintiffs do not
satisfy the pleading requirements with respect to the
“control relationship” necessary for control person
liability.
IV. CONCLUSION
For the foregoing reasons, the Court orders that the
Consolidated Complaint is hereby DISMISSED.
Plaintiffs may amend their complaint, in accordance
with this order, within thirty (30) days.
IT IS SO ORDERED.
N.D.Cal.,1997.
In re Oak Technology Securities Litigation
Not Reported in F.Supp., 1997 WL 448168
(N.D.Cal.)
END OF DOCUMENT
In sum, the chain running from H & Q to Oak
through Mr. Hsu has two very weak links. Plaintiffs
have not sufficiently alleged a control relationship
between Mr. Hsu and Oak. Similarly, they have not
adequately specified the control relationship between
H & Q and Mr. Hsu. Therefore, Plaintiffs fail in their
ultimate attempt to establish a control relationship
between H & Q and Oak.
4. The Scheme to Defraud
Finally, Plaintiffs argue that Defendants, in their
efforts “to substantially assist” the “huge insider
sales” of Oak stock, 34(c), participated in a “scheme”
designed to defraud the investing public.
As
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LEXSEE 2006 U.S. DIST. LEXIS 40624
JERRY RYAN, et al., Plaintiffs, V. FLOWSERVE CORPORATION, et al., Defendants.
CIVIL ACTION NO. 3: 03-CV-1769-B ECF
UNITED STATES DISTRICT COURT FOR THE NORTHERN DISTRICT OF
TEXAS, DALLAS DIVISION
444 F. Supp. 2d 718; 2006 U.S. Dist. LEXIS 40624
June 9, 2006, Decided
June 9, 2006, Filed
PRIOR HISTORY: Ryan v. Flowserve Corp., 2006
U.S. Dist. LEXIS 51212 (N.D. Tex., May 31, 2006)
COUNSEL: [**1] For Jerry Ryan, on behalf of himself
and all others similarly situated, Plaintiff: Robert J Hill,
Claxton & Hill, Dallas, TX; Kimberly C Epstein, Lerach
Coughlin Stoia Geller Rudman & Robbins -- San Francisco, San Francisco, CA.
For Alaska Electrical Pension Fund, Plaintiff: Joe Kendall, Willie Briscoe, Provost Umphrey Law Firm -- Dallas, Dallas, TX; Lauren M Winston, Ex Kano S Sams, II,
Kimberly C Epstein, Maria V Morris, Mary K Blasy,
Shana E Scarlett, Shawn A Williams, Willow E Radcliffe, Lerach Coughlin Stoia Geller Rudman & Robbins
-- San Francisco, San Francisco, CA; Tamara J Driscoll,
Lerach Coughlin Stoia Geller Rudman & Robbins -- Seattle, Seattle, WA.
For Massachusetts State Carpenters Pension Fund, Pipefitters, Locals 522 & 633 Pension Trust Fund, Plaintiffs:
Kimberly C Epstein, Mary K Blasy, Lerach Coughlin
Stoia Geller Rudman & Robbins -- San Francisco, San
Francisco, CA; Tamara J Driscoll, Lerach Coughlin Stoia
Geller Rudman & Robbins -- Seattle, Seattle, WA.
For Harold Klagsbald, On Behalf of Himself and All
Others Similarly Situated, Consol Plaintiff: Thomas E
Bilek, Hoeffner & Bilek, Houston, TX; Mel E Lifshitz,
Bernstein Liebhart & Lifshitz, New York, [**2] NY.
For Thomas Butterworth, On Behalf of Himself and All
Others Similarly Situated, Consol Plaintiff: William B
Federman, Federman & Sherwood -- Oklahoma City,
Oklahoma City, OK.
For Robert K Finnell, Individually and on Behalf of All
Others Similarly Situated, Consol Plaintiff: Marc R
Stanley, Martin Woodward, Roger L Mandel, Stanley
Mandel & Iola, Dallas, TX.
For Flowserve Corporation, Defendant: R Thaddeus
Behrens, Haynes & Boone, Dallas, TX; Carrie Lee Huff,
Nicholas Even, Haynes & Boone -- Dallas, Dallas, TX.
For C Scott Greer, Defendant: Richard A Rohan,
Fletcher Yarbrough, Jennifer E Morris, Todd A Murray,
Carrington Coleman Sloman & Blumenthal, Dallas, TX.
For Renee J Hornbaker, Defendant: David W Klaudt,
Charles Watts Flynn, Locke Liddell & Sapp -- Dallas,
Dallas, TX.
For Banc of America Securities LLC, Defendant: Ellen B
Sessions, Melissa J Swindle, Jenkens & Gilchrist -- Dallas, Dallas, TX; Rodney Acker, Jenkens & Gilchrist,
Dallas, TX.
For Credit Suisse First Boston, Defendant: Ellen B Sessions, Jenkens & Gilchrist -- Dallas, Dallas, TX.
For PricewaterhouseCoopers LLP, Defendant: M Byron
Wilder, Gibson Dunn & Crutcher -- Dallas, Dallas,
[**3] TX; Dean J Kitchens, Gibson Dunn & Crutcher -Los Angeles, Los Angeles, CA.
For Credit Suisse First Boston LLC, Defendant: Rodney
Acker, Jenkens & Gilchrist, Dallas, TX; Melissa J Swindle, Jenkens & Gilchrist -- Dallas, Dallas, TX.
For Robert K Finnell, Movant: Marc R Stanley, Stanley
Mandel & Iola, Dallas, TX.
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For Joseph Verga, Movant: Robert J Hill, Claxton &
Hill, Dallas, TX.
JUDGES: JANE J. BOYLE, UNITED STATES
DISTRICT JUDGE.
OPINION BY: JANE J. BOYLE
OPINION:
defense; and that Plaintiffs' claims regarding Defendants'
earnings projections statements are precluded by the
PSLRA's "safe harbor" provision.
On November 18, 2005, the Court heard arguments
on the Defendants' motions to dismiss and denied all
three motions in a ruling from the bench followed by a
written order on November 22, 2005. Defendants now
seek certification on three issues they describe as "controlling questions of law", including:
[*720] MEMORANDUM ORDER DENYING
DEFENDANTS'
MOTION
FOR
INTERLOCUTORY APPEAL UNDER § 1292 (b)
. Whether, in a case predicated on the
fraud-on-the market theory, a plaintiff
must plead that the alleged curative disclosure of the "truth" that resulted in the
plaintiff's losses revealed each material
fact allegedly misrepresented to satisfy
the required element of loss causation;
This is a securities fraud action. The Defendants
move to appeal this Court's interlocutory order denying
their motions to dismiss Plaintiffs' Fifth Amended Complaint. The precise motion before the Court is Defendants' Motion to Certify November 22, 2005 Order for §
1292(b) Interlocutory Appeal (doc. 141). For the reasons
that follow, the motion is DENIED.
. Whether, in a case predicated on the
fraud-on-the market theory, a plaintiff's
claims under Section 11 are barred by the
statutory negative causation defense
where the alleged curative disclosure that
the plaintiff claims resulted [**6] in his
losses did not reveal the facts allegedly
misrepresented in the challenged registration statements; and
I.
BACKGROUND
Defendant Flowserve Corporation, n1 is a worldwide manufacturer of pumps, valves, seals and related
components in the "process industries." Plaintiffs, individuals who purchased publicly traded securities of
Flowserve during the purported class [**4] period, allege that the Defendants violated federal securities laws
by overstating the company's income and understating its
costs in order to conceal its declining financial condition.
As a result, Plaintiffs claim they suffered losses when the
company's true financial condition was revealed in mid2002 and the stock price plummeted "75% from its Class
Period high." (Fifth Am. Compl. PP 13, 328-49)
n1 Along with Flowserve Corporation, Plaintiffs have sued certain officers, auditors and underwriters for the company. For purposes of this
order, the Defendants will be collectively referred
to as "Defendants" or "Flowserve."
Plaintiffs filed this suit in August 2003 accompanied
by a series of pleadings culminating in their 154-page
Fifth Amended Complaint. Flowserve responded with
motions to dismiss pursuant to Rules 12(b)(6) and 9(b) of
the Federal Rules of Civil Procedure and the Private Securities
[*721]
Litigation Reform Act of 1995
("PSLRA"). In their motions, the Defendants [**5] identified numerous perceived pleading deficiencies including-and relevant to this determination-that Plaintiffs
failed to adequately plead loss causation; that Plaintiffs'
claims are barred by the statutory negative causation
. Whether the PSLRA safe harbor for
forward-looking statements protects from
liability projections accompanied by
meaningful cautionary language independent of the speaker's alleged state of
mind.
(Defs. Mot. to Certify ("Mot.") at 2)
Plaintiffs oppose the motion on several grounds, arguing, inter alia, that the Defendants' "controlling questions" are simply fact-bound issues disguised as questions of law for § 1292(b) purposes; that an interlocutory
appeal will "retard" rather than advance the litigation;
and that they will be severely prejudiced by any further
postponement of discovery in this almost three-year-old
case.
II.
§ 1292 (b)
At the outset, it is important to understand the circumstances under which a party may appeal an interlocutory order. This is best approached by first reviewing the
pertinent statutory language and then examining how the
courts have interpreted and applied the provision. Section
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1292(b) expressly permits a district court to certify an
order for interlocutory appeal only if it "involves a controlling question [**7] of law as to which there is substantial ground for difference of opinion and that an immediate appeal from the order may materially advance
the ultimate termination of the litigation." 28 U.S.C.A. §
1292(b) (1994 & Supp. 2005). This terminology was
intended to restrict the category of cases suitable for
permissive appeal, but courts have not always agreed on
the contours of the stated limitations. See 16 CHARLES
A. WRIGHT, ET AL., FEDERAL PRACTICE AND
PROCEDURE § 3929 at 366-67 (2d ed. 1996) [hereinafter WRIGHT & MILLER]. See generally Ahrenholz v.
Bd. of Trustees of the Univ. of Illinois, 219 F.3d 674, 676
(7th Cir. 2000) ("The [§ 1292(b)] criteria, unfortunately,
are not as crystalline as they might be. . . .").
For example, at times, courts including the Fifth
Circuit have held that § 1292(b) appeals are appropriate
under only "exceptional" circumstances or in "big" cases.
Clark-Dietz and Assocs.-Eng'rs v. Basic Constr. Co., 702
F.2d 67, 69 (5th Cir. 1983) (explaining that interlocutory
appeals are permitted only under "exceptional" [*722]
circumstances); see Gottesman v. Gen. Motors Corp.,
268 F.2d 194, 196 (2d Cir. 1959) [**8] (clarifying that
certification should be "strictly limited to the precise
conditions stated in the law"); WRIGHT & MILLER,
supra, § 3929 at 365 & n.10 (internal citations omitted)
(collecting cases holding interlocutory appeal appropriate
only in "big" or "exceptional" cases).
Conversely, at other times courts-the Fifth Circuit
included-have employed a more flexible approach to §
1292(b) appeals. In Hadjipateras v. Pacifica, S.A., Judge
Brown promoted a more relaxed application of the provision:
Each application is to be looked at . . . in
the light of the underlying purpose reflected in the statute. . . . It was a judgesought, judge-made, judge-sponsored enactment. Federal Judges from their prior
professional practice, and more so from
experience gained in the adjudication of
today's complex litigation, were acutely
aware of two principal things. First, certainty and dispatch in the completion of
judicial business makes piecemeal appeal
as permitted in some states undesirable.
But second, there are occasions which
defy precise delineation or description in
which as a practical matter orderly administration is frustrated by the necessity
of a waste of precious judicial [**9] time
while the case grinds through to a final
judgment as the sole medium through
which to test the correctness of some isolated identifiable point of fact, of law, of
substance or procedure, upon which in a
realistic way the whole case or defense
will turn. The amendment was to give to
the appellate machinery of §
1291
through § 1294 a considerable flexibility
operating under the immediate, sole and
broad control of Judges so that within reasonable limits disadvantages of piecemeal
and final judgment appeals might both be
avoided. It is that general approach rather
than the use of handy modifiers-which
may turn out to be Shibboleths-that
should guide us in its application and in
determining whether the procedure specified has been substantially satisfied.
290 F.2d 697, 702-03 (5th Cir. 1961)); see also
WRIGHT & MILLER, supra, § 3929 at 368-69 & n. 16
(quoting Ex parte Tokio Marine & Fire Ins. Co., 322 F.
2d 113, 115 (5th Cir. 1963)) (criticizing other courts'
"epithets" that § 1292(b) is to be "'sparingly applied'").
Regardless of the approach-rigid or more flexiblesome common ground can be gleaned from both ends of
the spectrum. [**10] First, the decision to permit such
an appeal is firmly within the district court's discretion.
Cheney v. U.S. Dist. Court for Dist. of Columbia, 542
U.S. 367, 405 n.9, 124 S. Ct. 2576, 159 L. Ed. 2d 459
(2004) (Ginsburg, J., dissenting) (instructing that discretion for a § 1292 (b) appeal lies "in the first instance in
the district court's sound discretion"). Second, § 1292(b)
is not a vehicle to question the correctness of a district
court's ruling or to obtain a second, more favorable opinion. McFarlin v. Conseco Servs., LLC, 381 F.3d 1251,
1256 (11th Cir. 2004) (quoting S. Rep. No. 85-2434
(1958), reprinted in U.S.C.C.A.N. at 5260-61)). Third,
the issue for appeal must involve a question of law-not
fact. Clark-Dietz, 702 F.2d at 69 (holding that "factreview" issues are inappropriate for § 1292 review). And
a "question of law" does not mean the application of settled law to disputed facts. McFarlin, 381 F.3d at 1258
(citing Ahrenholz, 219 F.3d at 676). Thus, resolving the
issue presented should not require the appeals court to go
"hunting through the record" to see whether "a genuine
issue of material fact may be lurking there. [**11] "
Ahrenholz, 219 F.3d at 676.
Fourth, the issue for appeal must involve a controlling question of law. [*723] Whether an issue of law is
controlling generally hinges upon its potential to have
some impact on the course of the litigation. At one end
of the continuum, courts have found issues to be control-
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ling "if reversal of the district court's opinion would result in dismissal of the action." Strougo ex rel. Brazil
Fund v. Scudder, Stevens & Clark, 1997 U.S. Dist.
LEXIS 12243, No. 96 CIV. 2136 (RWS), 1997 WL
473566, at *7 (S.D.N.Y. Aug. 18, 1997) (citing Klinghoffer v. S.N.C. Achille Lauro, 921 F.2d 21, 24 (2d Cir.
1990)) (other citations omitted). An issue of law has also
been termed controlling where "the certified issue has
precedential value for a large number of cases." Id. On
the other hand, an issue is not seen as controlling if its
resolution on appeal "would have little or no effect on
subsequent proceedings." John C. Nagel, Note, Replacing the Crazy Quilt of Interlocutory Appeals Jurisprudence with Discretionary Review, 44 DUKE L. J. 200,
212 (1994); WRIGHT & MILLER, supra, § 3930 at
424. Between the extremes, courts have found the issue
of [**12] whether an interlocutory appeal involves a
controlling question of law to be "closely tied" to the
requirement that the appeal will materially advance the
ultimate termination of the litigation. WRIGHT &
MILLER, supra, § 3930 at 432; see also Nagel, supra, at
212 (courts have turned to the "materially advance"
prong of § 1292(b) in deciding whether an issue of law
is controlling) (internal citations omitted). In sum, a controlling question of law-although not consistently defined-at the very least means a question of law the resolution of which could materially advance the ultimate
termination of the litigation-thereby saving time and expense for the court and the litigants. WRIGHT &
MILLER, supra, § 3930 at 426 & n.25 (2ded. 1996 &
Supp. 2005) (citing S.E.C. v. Credit Bancorp, Ltd., 103
F. Supp. 2d 223, 227 (S.D.N.Y. 2000)).
A fifth and key concern consistently underlying §
1292 (b) decisions is whether permitting an interlocutory
appeal will "speed up the litigation." Ahrenholz, 219
F.3d at 676. "The institutional efficiency of the federal
court system is among the chief concerns motivating §
1292(b)." Strougo, 1997 U.S. Dist. LEXIS 12243, 1997
WL 473566, at *6 [**13] (citing Forsyth v. Kleindienst,
599 F.2d 1203 (3d Cir. 1979)). Stated another way, §
1292(b) is designed to minimize burdens "by accelerating or . . . simplifying trial court proceedings." WRIGHT
& MILLER, supra, § 3930 at 439.
Finally, there must be substantial ground for difference of opinion over the controlling question of law for
certification under § 1292(b). This factor has been described as the least troubling for district courts.
WRIGHT & MILLER, supra, § 3930 at 419-20 (district
courts "have not been bashful about refusing to find substantial reason to question a ruling of law"). Nonetheless,
of all the § 1292(b) criteria, this one is possibly the least
predictable in application. Perhaps, as one commentary
on § 1292(b) recognized over thirty years ago, this is
because "degrees of legal doubt escape precise quantifi-
cation." Note, Interlocutory Appeals in the Federal
Courts Under 28 U.S.C. § 1292(b), 88 HARV. L. REV.
607, 623 (1975). That same commentary proposed a
standard "that would require a trial court to believe that a
reasonable appellate judge could vote for reversal of the
challenged [**14] order" before the disagreement would
be considered substantial under § 1292(b). Id. Consistent with this line of thought, courts have found substantial ground for difference of opinion where:
a trial court rules in a manner which appears contrary to the rulings of all Courts
of Appeals which have reached the issue,
if the circuits are in dispute on the question and the Court of Appeals of [*724]
the circuit has not spoken on the point, if
complicated questions arise under foreign
law, or if novel and difficult questions of
first impression are presented.
4 Am. Jur. 2d Appellate Review § 128 (2005). But simply because a court is the first to rule on a question or
counsel disagrees on applicable precedent does not qualify the issue as one over which there is substantial disagreement. Id. Nor does a party's claim that a district
court has ruled incorrectly demonstrate a substantial disagreement. Wausau Bus. Ins. Co. v. Turner Constr. Co.,
151 F. Supp. 2d 488, 491 (S.D.N.Y. 2001). In the end,
"substantial" means just that-significantly great.
MERRIAM-WEBSTER'S
COLLEGIATE
DICTIONARY 1174 (10th ed. 1998). [**15]
III.
ANALYSIS
A. Loss Causation Pleading
With the foregoing court opinions and commentary
as a guide, the Court turns its attention to the merits of
Flowserve's motion to certify to determine whether it has
met the prerequisites for a for a § 1292(b) appeal.
Flowserve's first "controlling question" relates to loss
causation pleading and reads:
Whether, in a case predicated on the
fraud-on-the market theory, a plaintiff
must plead that the alleged curative disclosure of the "truth" that resulted in the
plaintiff's losses revealed each material
fact allegedly misrepresented to satisfy
the required element of loss causation.
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Flowserve's contention that this issue is appropriate for a
§ 1292 (b) appeal derives primarily from its interpretation of the Supreme Court's opinion regarding loss causation in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S.
336, 125 S. Ct. 1627, 161 L. Ed. 2d 577 (2005). In Dura,
the Supreme Court tightened the loss causation pleading
standards in fraud-on-the-market cases by doing away
with the "inflated purchase price" method of pleading
loss causation and holding that loss causation could no
longer be established solely by alleging an [**16] artificially inflated purchase price followed by a drop in stock
price. Analyzing whether Flowserve has met its burden
of demonstrating that its first "controlling question"
meets the standards for a § 1292(b) appeal necessarily
begins with a review of the Dura case.
Dura was a securities fraud class action which resolved a circuit split by dealing head-on with the "artificially inflated purchase price" method of pleading loss
causation. The plaintiffs, who bought stock in a pharmaceutical company, alleged that the company made false
statements about anticipated FDA approval of a new
asthmatic spray device which in turn artificially inflated
the company's stock price. When the company later announced lower than expected earnings, the stock price
dropped significantly. Plaintiff-in pleadings subsequently
endorsed by the Ninth Circuit-alleged loss causation as
follows: "'In reliance on the integrity of the market, [the
plaintiffs] . . . paid artificially inflated prices for Dura
securities' and . . . suffered 'damage [s] thereby. . . .'" Id.
at 340 (internal citations omitted).
The narrow issue before the Dura Court was
whether a plaintiff could [**17] satisfy the loss causation pleading and proof requirement "simply by alleging
in the complaint and subsequently establishing that 'the
price' of the security 'on the date of purchase was inflated because of the misrepresentation.'" Id. at 338 (emphasis in original). The Supreme Court found the answer
to that question to be an unequivocal "no."
The Court began its opinion by identifying the basic
elements of a securities fraud action-including the indispensable requirement [*725] that plaintiffs prove "a
causal connection between the material misrepresentation and the loss." Id. at 342. Taking issue with the Ninth
Circuit's approval of the plaintiffs' pleadings, the Court
stated: "normally, [in fraud-on-the-market cases,] an inflated purchase price will not itself constitute or proximately cause the relevant economic loss." Id. Reviewing
the "tangle of factors affecting [stock] price", the Court
concluded that the causal connection between an inflated
purchase price and subsequent shareholder economic
losses was tenuous at best. Id. at 343 ("the most logic
alone permits us to say is that the higher purchase price
will sometimes [**18] play a role in bringing about a
future loss"). The opinion directed that plaintiffs in secu-
rities fraud cases must prove that the defendant's fraudulent conduct "proximately caused [their] economic loss"
and determined that the "'inflated purchase price approach'"-standing alone-was not up to the task. Id. at
344-46.
Addressing separately the pleading requirements for
loss causation, the Dura Court made clear that plaintiffs
could no longer rely solely on allegations of an "artificially inflated purchase price" to demonstrate the essential elements of proximate causation and economic loss.
While the Court found the Dura plaintiffs' loss causation
pleadings inadequate, it did not at the same time adopt
more onerous pleading standards for such allegations.
Rather, the Court clarified that Federal Rule of Civil
Procedure 8(a)(2)'s "short and plain statement" rule
would continue to govern loss causation pleadings. Id. at
346. So long as the allegations provide the defendant
with fair notice of the plaintiff's claims and its grounds,
the Court counseled, the pleadings will pass muster. Id.
This means [**19] that "a plaintiff who has suffered an
economic loss [must] provide a defendant with some
indication of the loss and the causal connection that the
plaintiff has in mind." Id. at 347.
In sum, Dura eliminated the "artificially inflated
purchase price" method of proving loss causation, reemphasized the importance of demonstrating proximate
cause and economic loss and renewed Rule 8 (a) (2)'s
"short and plain statement" rule for such pleadings.
Whether Dura heralded the change in loss causation
pleading standards urged by Flowserve is another matter.
Before moving to that issue, it bears mention that in
various places in its briefing, Flowserve frames the loss
causation "controlling question" for § 1292(b) purposes
in more general terms than in the introduction to its
briefing. n2 To be clear, Flowserve's bottom line here is
that post-Dura, loss causation must be pled in an almost
formulaic manner requiring the plaintiff to plead that the
"alleged curative disclosure of the 'truth' that resulted in
the plaintiff's losses revealed each material fact allegedly
misrepresented [or omitted] to satisfy the required element of loss causation"-a method this Court [**20] will
refer to as "fact-for-fact" pleading.
n2 For example, Flowserve variously frames
the "controlling legal issue" for § 1292 (b)as
"what must be alleged to satisfy the loss causation requirements set forth by Dura, the PSLRA
and Fifth Circuit precedent" (Mot. at 5); "whether
the Complaint's allegations, taken as true: . . .
state a legally viable loss causation theory under
the Supreme Court's decision in Dura" (Reply at
1); and "there is a substantial ground for a difference of opinion regarding whether Plaintiff's loss
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causation theory is legally valid." (Reply at 3).
But it is clear from the entirety of its briefing that
Flowserve rests its argument on the premise that
Dura requires "fact-for-fact" pleading of loss
causation.
[*726] 1. Controlling Question of Law
Plaintiffs first challenge Flowserve's motion to certify the loss causation issue as raising "fact-bound"
pleading issues as opposed to legal questions. Interlocutory appeals have been allowed on pleading issues which
raise difficult [**21] questions of substantive law but
not when the issue raised is a "mere matter of properly
pleading a claim sought to be brought within a recognized and generally sufficient legal theory." WRIGHT &
MILLER, supra, § 3931 at 453, 458-59 (A motion to
dismiss a complaint "may rest . . . on resolution of a
clearly determinative question of law . . . or . . . on questions merely of pleading etiquette.").
Here, the Court is satisfied that Flowserve has raised
an issue of law as opposed to fact regarding the requisite
pleading standards for loss causation post-Dura. As articulated in its "controlling question 1" and accompanying argument, Flowserve contends that Dura requires
Plaintiffs to demonstrate "a direct causal link between
the misstatement and . . . [their] economic loss." (Mot. at
5-6) The "direct causal link", according to Defendants,
cannot be established "with respect to an alleged misrepresentation unless and until there is a revelation of the
truth concerning that misrepresentation followed by a
stock price decline." (Mot. at 5) (emphasis in original)
The Court finds that this adequately raises a legal question as to the post-Dura minimum requirements for
pleading [**22] a "legally viable loss causation theory."
(Reply at 1) Whether it is a controlling question of law is
another matter. Rather than decide that issue, the Court
will assume without deciding that it is a controlling question and move to the "substantial disagreement" requirement where it clearly falls short.
2. Substantial Ground for Difference of Opinion
In determining whether a substantial ground for difference of opinion exists in the context of § 1292(b), the
obvious first task is to identify the opinion at issue and
then weigh the degree of disagreement. In other words,
first and foremost, there must be a discernable opinion
triggering the requisite disagreement. Drawn from its
interpretation of Dura, Flowserve identifies the opinion
at issue as:
Whether, in a case predicated on the
fraud-on-the market theory, a plaintiff
must plead that the alleged curative dis-
closure of the "truth" that resulted in the
plaintiff's losses revealed each material
fact allegedly misrepresented to satisfy
the required element of loss causation.
Implicit in this question and expressed throughout its
briefing is Flowserve's assumption that the Dura opinion
signaled [**23] a change in loss causation pleading requirements beyond its narrow holding on the inflated
purchase price theory. More to the point, from Dura and
from certain Fifth Circuit cases dealing with proximate
cause in other securities fraud contexts, Flowserve extracts "a substantial likelihood" that the Fifth Circuit will
interpret Dura to impose a type of "fact-for-fact" loss
causation pleading requirement. Taking it a step further,
Flowserve submits that, post-Dura, the Fifth Circuit can
reasonably be expected to hold that loss causation in
fraud-on-the-market cases can only be shown by demonstrating that each fact allegedly misrepresented (the
fraud) was also later revealed to the market triggering the
drop in stock price. (Mot. at 7) Applied to this case,
Flowserve's fact-for-fact pleading requirement would
require Plaintiffs to allege that the precise topics of the
alleged misrepresentations-Flowserve's [*727] historical financial statements, statements of debt covenant
compliance and statements regarding the IDP and IFC
acquisitions-were later one-by-one revised and revealed
to the market in truthful terms.
The obvious shortcoming for § 1292(b) purposes is
that Dura [**24] did not, even by way of dicta, express
the opinion Flowserve now claims is the subject of substantial disagreement. As mentioned, the Dura court expressly declined to formulate precise standards for proving loss causation despite a request to do so by the Defendant and the Solicitor General. Evan R. Chesler & J.
Stephen Beke, Loss Causation Post-Dura, 1517 P.L.I.
CORP. LAW & PRAC. COURSE, HANDBOOK
SERIES 1277, 1280 (2005) (citing Transcript of Oral
Argument at 3-9, 11, 18-20, Dura, 544 U.S. at 346 (No.
932)). Outside of rejecting the inflated purchase price
approach, Dura's instructions on loss causation pleadings
were limited to: reaffirming the applicability of Rule 8
(a) (2)'s short and plain statement rule to such pleadings;
requiring that plaintiffs plead loss causation in a way that
provides the defendant "'fair notice'" of their claims and
the grounds underlying them; and suggesting that plaintiffs include allegations that the stock price "fell significantly after the truth became known." Id. at 1282 (citing
Dura, 544 U.S. at 346-47).
The Dura court did not endorse or address
Flowserve's proposed "fact-for-fact" method [**25] of
pleading loss causation. Id. (citing Dura, 544 U.S. at
346) (The Dura court did not purport to address whether
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loss causation allegations must "explicitly allege that the
subject matter of the alleged misrepresentations . . . was
revealed to the market by way of some 'corrective disclosure' that preceded the drop in the price of the stock (or
the economic loss generally)."). "While the Court suggested that the plaintiffs needed to have alleged in some
fashion that 'the truth [regarding the . . . misrepresented
information] became known' before the "'share price
fell'", the Court did not set forth guidelines as to whether
such a revelation . . . must be direct [or] inferential.") Id.
(citing Dura, 544 U.S. at 347). In actuality, Dura "left
the lower federal courts free to continue to develop
somewhat diverse approaches to the pleading of corrective disclosures preceding economic losses." Id.
Thus the "opinion" on which Flowserve seeks Fifth
Circuit guidance and over which it contends there is substantial disagreement is not reasonably drawn from the
Dura case. Nor does any Fifth Circuit case suggest the
interpretation [**26] of Dura urged by Flowserve. In
fact, as pointed out by Plaintiffs, none of the cases relied
upon by Flowserve are apposite to its position on Dura.
n3 Cases and commentary following Dura and directly
addressing the pleading issue substantiate that it did not
effect a material change or foretell a shift in loss causation pleading requirements [*728] other than in the narrow area of inflated purchase price pleadings. See Patrick
J. Coughlin, Eric Alan Isaacson and Joseph D. Daley,
What's Brewing in Dura v. Broudo? The Plaintiffs' Attorneys Review the Supreme Court's Opinion and Its
Import for Securities Fraud Litigation, 37 LOY. U. CHI.
L. J. 1, 17 (2005) ("Clearly the [Dura] Court means for .
. . [pleading loss causation] to be a fairly simple [exercise]. . . .").
N3 Flowserve cites In re Odyssey, 424 F.
Supp. 2d 880 (N.D. Tex. 2005), in support of its
loss causation pleading theory. (Notice of Supp.
Auth. at 1) But In re Odyssey is distinguishable
on several fronts. First, although the district court
in Odyssey observed that the parties disagreed
over "the scope of what Dura now requires a
plaintiff to plead", the court did not endorse or
even reference the type of fact-for-fact pleading
method touted by Flowserve in this case. Odyssey, 424 F. Supp. 2d at 886. Second, the "false financial statements" claim in Odyssey (the only
claim similar to those in this case) was rejectednot on loss causation pleading grounds-but under
the PSLRA's safe harbor provision. Id. at 886-87.
Finally, the language from Odyssey heavily relied
upon by Flowserve as supporting its theory of
loss causation pleading is pulled from a portion
of the opinion addressing the resignation of the
company's CEO-a claim utterly unlike any in this
case. Id. at 887.
[**27]
In its In re Bradley Pharmaceuticals, Inc., Securities
Litigation opinion, a district court in New Jersey
squarely took on the issue of whether the method of
pleading urged here by Flowserve was required postDura. 421 F. Supp. 2d 822 (D. N. J. 2006). The defendants in that case argued that "Dura requires Plaintiffs to
'allege a loss following the 'corrective disclosure' of the
allegedly undisclosed misrepresentation.'" Id. at 828.
They complained that the plaintiffs had not adequately
pleaded loss causation because the alleged corrective
disclosure (an SEC inquiry) did not address the subject
of the alleged misrepresentation (false statements in connection with the "sham" sale of a cold remedy). The district court rejected the defendants' argument with the
following:
We disagree with Defendants' rigid and
dogmatic interpretation of Dura. In Dura,
the Supreme Court only suggested that the
plaintiffs needed to have alleged in some
fashion that 'the truth became known' before 'the share price fell.' However, Dura
did not address what type of events or
disclosures may reveal the truth. Nor did
Dura explain how specific [**28] such
disclosures must be. See In re Winstar
Communications, 2006 U.S. Dist. LEXIS
7618, 2006 WL 473885 (S.D.N.Y. 2006)
(stating that in Dura, "the Court did not
address the means by which the information is imparted to the public. Specifically, Dura did not set forth any requirements as to who may serve as the source
of the information, nor is there any requirement that the disclosure take a particular form or be of a particular quality.")
. . . see finally In re Worldcom, Inc. Sec.
Litig., 388 F. Supp. 2d 319, 347, 2005 WL
2319118, at *23 (S.D.N.Y. 2005) (to satisfy loss causation under Dura, plaintiff
must "establish that his losses were attributable to some form of revelation to the
market of the wrongfully concealed information"). . . .
Guided by a pragmatic understanding of
Dura, the Court concludes that Plaintiffs
have adequately pled loss causation. The
revelation of the "truth" about the [cold
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remedy sale] did not take the form of a
single, unitary disclosure, but occurred
through a series of disclosing events. See,
e.g., Greater Pennsylvania Carpenter's
Pension Fund v. Whitehall Jewellers, Inc.,
2005 U.S. Dist. LEXIS 12971, 2005 WL
1563206 (N.D. Ill. 2005). . [**29] . .
specifically confessed before liability could attach would
discourage candor and inhibit the flow of precise, accurate information between corporations and shareholders.
Because Flowserve's § 1292 (b) motion with respect
to loss causation fails on the "substantial disagreement"
prong, the Court denies this part of the motion on that
ground and will not address the other § 1292 (b) factors.
B. Negative Causation Defense
421 F. Supp. 2d at 828-29 (some internal citation omitted).
In In re Enron Corp. Securities, Derivative and
ERISA Litigation, the district court, in a lengthy analysis
of Dura's effect on loss causation pleading, recognized
that Dura did "not impose heightened or onerous pleading requirements." In re Enron Corp. Secs., Derivative
and ERISA Litig., 2005 U.S. Dist. LEXIS 41240, No.
MDL-1446, 2005 WL 3504860 at *15-19 (S.D. Tex. Dec.
22, 2005); see also In re Daou Sys., 411 F.3d 1006, 1026
(9th Cir. 2005) (another post-Dura opinion upholding
loss causation pleadings-which alleged a sharp drop in
stock price on the heels of a public revelation of the
company's "true financial situation"-as sufficiently alleging pursuant to Dura "some indication that the drop in . .
. stock price was causally related to Daou's financial misstatements"); Greater Pennsylvania Carpenters Pension
Fund v. Whitehall Jewelers, Inc., 2005 U.S. Dist. LEXIS
12971, No. 04-C-1107, 2005 WL 1563206 *5 (N.D. Ill.
June 30, 2005) (where, post-Dura, the district court let
stand a pre-Dura ruling denying a motion [*729] to
dismiss on loss causation grounds-finding allegations of
defendants' [**30] numerous false statements about the
financial condition of the company which were later revealed through partial disclosures relating to the fraud
causing the stock price to drop sufficient to allege loss
causation) (emphasis added).
To sum up, since Dura, the circuits have continued
to vary in their approaches to loss causation pleadingsome with stricter requirements than others. But neither
Dura nor any Fifth Circuit case requires the type of
"fact-for-fact" method of loss causation pleading urged
by Flowserve. Because there is no opinion expressly
requiring or even reasonably suggesting Flowserve's
proposed pleading approach, there is necessarily no substantial disagreement to support an interlocutory appeal.
The circuits' disparate pleading requirements for loss
causation do not amount to a substantial disagreement
over whether fact-for-fact pleading should be required.
Given the Dura Court's expressed allegiance to a "simple
test" for loss causation pleadings under Rule 8 (a) (2),
Flowserve's position favoring fact-for-fact precision in
pleading is even less tenable. Finally, as pointed out by
Plaintiffs, to impose a requirement in securities fraud
cases that [**31] each fact misrepresented be in turn
Flowserve next moves to certify the following question regarding the statutory negative causation defense:
Whether, in a case predicated on the
fraud-on-the market theory, a plaintiff's
claims under Section 11 are barred by the
statutory negative causation defense
where the alleged curative disclosure that
the plaintiff claims resulted in his losses
did not reveal the facts allegedly misrepresented in the challenged registration
statements.
This point merits no discussion because it mirrors the
argument supporting the loss causation pleading issue
above. In other words, to certify the negative causation
question, the Court must accept Flowserve's premise that
Dura requires fact-for-fact loss causation [**32] pleading. Thus for the same reasons set forth in the foregoing
section, the Court rejects the negative causation argument and denies this portion of Flowserve's motion to
certify.
C. Safe Harbor n4
n4 (c) Safe Harbor. --
(1) In general. -- Except as provided in subsection (b), in any private action arising under this title
that is based on an untrue statement of a material fact or omission
of a material fact necessary to
make the statement not misleading, a person referred to in subsection (a) shall not be liable with respect to any forward-looking
statement, whether written or oral,
if and to the extent that -(A) the forward-looking statement
is --
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Flowserve's third controlling question relates to the
PSLRA's "safe harbor" provision:
(i) identified as a
forward-looking
statement, and is
accompanied
by
meaningful
cautionary statements
identifying important factors that
could cause actual
results to differ materially from those
in the forwardlooking statement;
or
(ii) immaterial; or
(B) the plaintiff fails to prove that
the forward-looking statement --
(i) if made by a
natural person, was
made with actual
knowledge by that
person that the
statement was false
or misleading; or
(ii) if made by a
business entity; was
-(I) made by or with
the approval of an
executive officer of
that entity, and
(II) made or approved by such officer with actual
knowledge by that
officer that the
statement was false
or misleading.
[*730] Whether the PSLRA safe harbor
for forward-looking statements protects
from liability projections accompanied by
meaningful cautionary language independent of the speaker's alleged state of
mind.
Reduced to its essence, Flowserve's argument boils down
to a claim that the Court made a mistake in applying the
PSLRA's safe harbor provision and in the process made
an incorrect statement of law regarding the interplay between the two prongs of the provision. More precisely,
Flowserve maintains that, in denying the Defendants'
motions to dismiss, the Court conflated the two independent prongs of the PSLRA's safe harbor provision
and incorrectly stated that Plaintiffs can defeat either
prong by pleading that a defendant had actual knowledge
of a statement's falsity. Citing the text of the safe harbor
statute, its legislative history and a plethora of cases,
Flowserve challenges the Court's suggestion of a "settled
principle" that actual knowledge of falsity defeats either
prong of the provision. (Mot. at 15-20)
The Court agrees with Flowserve on this point.
Nonetheless, that does not qualify [**34] the question
for a § 1292(b) appeal. To elevate the Court's misstatement into an issue appropriate for interlocutory appeal
Flowserve must demonstrate that it meets § 1292(b)'s
standards as a controlling question of law over which
there is substantial ground for difference of opinion and
that an immediate appeal from the order may speed up
the litigation. And the fact that this Court made a statement that conflicts with the weight of authority on the
safe harbor provision does not a substantial disagreement
make. Although, as mentioned, "degrees of legal doubt
escape precise quantification," n5 Flowserve is hard
pressed here to quantify the conflict between this Court's
incorrect assessment of the law and the extensive authority to the contrary as "substantial." Thus, this issue is not
a proper one for an interlocutory appeal and Flowserve's
motion must be denied on this point as well. n6
n5 See Note, Interlocutory Appeals in the
Federal Courts Under 28 U.S.C. § 1292(b), 88
HARV. L. REV. 607 at 623.
15 U.S.C. § 78u-5(c)(1)(A) and (B).
[**33]
n6 Although the Court's sole task here is to
decide Flowserve's motion for interlocutory appeal under § 1292 (b)'s standards, it is important
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to clarify the effect of the Court's incorrect perception of the law on Flowserve's motion to dismiss. Specifically, despite the Court's inaccurate
assessment of the effect of a defendant's state of
mind on the operation of the first prong of the
safe harbor provision, it need not as a consequence reverse that portion of its ruling on the
motion to dismiss. More to the point, to qualify
for safe harbor protection under the first prong,
the statements at issue must be accompanied by
"meaningful cautionary language." The Court has
reviewed those portions of the pleadings that
Flowserve contends are protected under the first
prong of the safe harbor provision and determined that it is impossible without more information (via summary judgment) to tell whether the
cautionary language describes the "principal or
important risks" facing Flowserve at the time
they were made. See Asher v. Baxter Int'l Inc.,
377 F.3d 727, 733 (7th Cir. 2004); Makor Issues
& Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588, 599
(7th Cir. 2006) (quoting Asher, 377 F.3d at 733);
and Marc H. Folladori, Protecting ForwardLooking Statements: The Private Securities Liti-
gation Reform Act of 1995 and Other Safeguards,
1522 P.L.I. CORP. LAW & PRAC. COURSE,
HANDBOOK SERIES 297, 334 (January 2006).
This, in turn, means that the Court cannot presently determine if the accompanying cautionary
language is "meaningful" thus dismissal under the
safe harbor provision is precluded at this time.
[**35]
[*731] IV.
CONCLUSION
For all of the foregoing reasons, the Defendants'
Motion to Certify November 22, 2005 Order for §
1292(b) Interlocutory Appeal (doc. 141) is DENIED.
SO ORDERED.
SIGNED June 9th, 2006
JANE J. BOYLE
UNITED STATES DISTRICT JUDGE
June 13, 2006
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Not Reported in F.Supp.2d
Not Reported in F.Supp.2d, 2005 WL 1902780 (S.D.N.Y.)
(Cite as: Not Reported in F.Supp.2d)
Sedona Corp. v. Ladenburg Thalmann & Co.,
Inc.S.D.N.Y.,2005.Only the Westlaw citation is
currently available.
United States District Court,S.D. New York.
SEDONA CORPORATION, Plaintiff,
v.
LADENBURG THALMANN & CO., INC., et al.,
Defendants.
No. 03Civ.3120(LTS)(THK).
Aug. 9, 2005.
Koerner, Silberberg & Weiner, LLP, By: Maryann
Peronti, Carl Selden Koerner, New York, New York,
for Plaintiff.
Christian Smith & Jewell, By: Gary M. Jewell, James
Christian, Stephen R. Smith, Houston, TX, for
Plaintiff.
Heard, Robins, Cloud, Lubel & Greenwood, LLP,
By: Denman Heard, Houston, TX, for Plaintiff.
Tate Moerer & King, LLP, By: Richard Tate,
Richmond, TX, for Plaintiff.
Hanly Conroy Bierstein & Sheridan, LLP, By:
Thomas I. Sheridan, III, New York, NY, for Plaintiff.
Proskauer Rose LLP, By: Stephen L. Ratner, Peter
J.W. Sherwin, Brian Friedman, New York, NY, for
Defendant Pershing, LLC.
Bahn, Herzfeld & Multer, LLP, By: Richard L.
Herzfeld, New York, NY, for Defendant Wm. V.
Frankel & Co., Inc.
Siller Wilk LLP, By: Jay S. Auslander, Eric Snyder,
Natalie Shkolnik, New York, NY, for Defendants
Thomas Tohn, Michael Vasinkevich, and Joseph
Smith.
Arkin Kaplan LLP, By: Howard J. Kaplan, New
York, NY, for Defendants Ladenburg Thalmann &
Co. and David Boris.
DLA Piper Rudnick Gray Cary U.S. LLP (N.Y.C),
By: Caryn G. Mazin, Howard S. Schrader, New
York, New York, for Defendants Westminster
Securities Corporation, Rhino Advisors, Inc., Amro
International, S.A., Roseworth Group Ltd., Cambois
Finance Inc., Thomas Badian, Ultrafinanz AG, Creon
Management, S.A., and H.U. Bachofen.
Sheldon Eisenberger, By: Sheldon Eisenberger, New
York, New York, for Defendants Markham Holdings
Ltd. and J. David Hassan.
Michael S. Rosenblum, By: Michael S. Rosenblum,
Karen A. Clark, Los Angeles, CA, for Defendant
Page 2 of 96
Page 1
David Sims.
Law Offices of Kenneth A. Zitter, By: Kenneth A.
Zitter, New York, NY, for Defendants Dr. Batliner
and Partner, Dr. Herbert Batliner, and Hans Gassner.
OPINION AND ORDER
SWAIN, J.
*1 Plaintiff Sedona Corporation (“Plaintiff” or
“Sedona”) brings this securities action against
defendants Ladenburg Thalmann & Co., Inc.
(“Ladenburg”); Pershing, LLC (“Pershing”),
Westminster Securities Corporation (“Westminster”);
Wm. V. Frankel & Co., Inc. (“Frankel”); Rhino
Advisors, Inc.
(“Rhino”); Markham Holdings
Limited (“Markham”); Aspen International Ltd.
(“Aspen”); Amro International, S.A., Roseworth
Group Limited, and Cambois Finance Inc.
(collectively, the “Amro Defendants”); Creon
Management, S.A.
(“Creon”); Thomas Badian
(“Badian”); Thomas Tohn (“Tohn”); David Boris
(“Boris”); Michael Vasinkevich (“Vasinkevich”);
David Sims (“Sims”); H.U. Bachofen (“Bachofen”)
and Ultrafinanz AG (collectively, the “Ultrafinanz
Defendants”); Dr. Batliner and Partner, Hans
Gassner, and Dr. Herbert Batliner (collectively, the
“Batliner Defendants”); Joseph A. Smith (“Smith”);
J. David Hassan (“Hassan”); Anthony L.M. Inder
Rieden (“Rieden”); and John Does 1 to 150 (“John
Does”) FN1 (collectively, “Defendants”).FN2 Sedona's
First Amended Complaint (“Compl.”) asserts the
following claims for relief against various
FN3
combinations
of
the
Defendants:
misrepresentation in violation of Section 10(b) of the
Securities Exchange Act of 1934 (“Exchange Act”),
15 U.S.C. § 78j(b) (“Section 10(b)”), and Rule 10b-5
(“Rule 10b-5”) promulgated by the Securities and
Exchange Commission (“SEC”) thereunder (First
Cause of Action); manipulation in violation of
Section 10(b) and Rule 10b-5 (Second Cause of
Action); tortious interference with contract and
tortious interference with business relationship (Third
Cause of Action); violation of Section 1-401 of the
Pennsylvania Securities Act of 1972 (“Pennsylvania
Act”), 70 Pa. Stat. Ann. § 1-401 (Fourth Cause of
Action); common law fraud and deceit (Fifth Cause
of Action); civil conspiracy to commit fraud (Sixth
Cause of Action); breach of contract (Seventh Cause
of Action); disgorgement of profits from fraudulent
and manipulative conduct and restitution under
various provisions of the Exchange Act (Eighth
Cause of Action); breach of fiduciary duty (Ninth
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Cause of Action); negligence (Tenth Cause of
Action); negligent misrepresentation (Eleventh Cause
of Action); and control person liability under Section
20 of the Exchange Act (Twelfth Cause of Action).
(Compl.¶ ¶ 107-67.) Among other relief, Sedona
seeks an accounting of Defendants' profits from sales
of Sedona stock, injunctive relief, and damages of at
least $2,660,000,000.00. (Id. at 68-69.) This Court
has jurisdiction of the instant action pursuant to 28
U.S.C. § 1331.
FN1. “John Does 1 to 150 are fictitious
names alleged for the purpose of substituting
names of defendants whose identity will be
disclosed in discovery and should be made
parties to this action.” (Compl.¶ 29.)
FN2. Defendants Geoffrey M. Lewis
(“Lewis”), The Cuttyhunk Fund Limited c/o
Optima
Fund
Management
L.P.
(“Cuttyhunk”), and the George S. Sarlo
1995 Charitable Remainder Trust (the
“Sarlo Trust”), were dismissed from the
action pursuant to a stipulation so ordered
by District Judge Kimba M. Wood on
December 2, 2003. Defendants Aspen and
Rieden have apparently been served, but
have yet to appear or move in this action.
FN3. Sedona asserts claims 2-4, 6, and 8
against all Defendants; claim 12 against the
Ultrafinanz Defendants, Rhino, Badian, the
Batliner Defendants, Creon, Sims, Hassan,
Rieden, Vasinkevich, Boris, Tohn, and
Smith; claims 1 and 5 against Ladenburg,
Rhino, Markham, Aspen, the Amro
Defendants,
Badian,
Tohn,
Boris,
Vasinkevich, and Smith; claim 7 against
Ladenburg, Markham, Aspen, the Amro
Defendants, and Boris; claim 11 against
Ladenburg, Rhino, Markham, Aspen, and
the Amro Defendants; and claims 9 and 10
solely against Ladenburg. (Compl.¶ ¶ 10767.)
Defendants have interposed a number of motions to
dismiss the Complaint in its entirety with prejudice,
moving pursuant to Rules 12(b)(2), 12(b)(6), and 9(b)
of the Federal Rules of Civil Procedure, as well as
under the Private Securities Litigation Reform Act of
1995 (“PSLRA”). Pursuant to Rule 12(b)(1) of the
Federal Rules of Civil Procedure, certain defendants
also move to dismiss the Plaintiff's state statutory and
common law claims for lack of subject matter
Page 2
jurisdiction under 28 U.S.C. §
1367(c)(3).
Defendants Vasinkevich, Smith, and Tohn further
move for costs and attorneys' fees. Plaintiff also
moves for partial relief from the discovery stay
imposed by the PSLRA,FN4 to obtain document
preservation subpoenas and Wells submissions.
FN4. “In any private action arising under
this chapter, all discovery and other
proceedings shall be stayed during the
pendency of any motion to dismiss, unless
the court finds upon the motion of any party
that particularized discovery is necessary to
preserve evidence or to prevent undue
prejudice to that party.” 15 U.S.C.A. § 78u4(b)(3)(B) (West 2005).
*2 For the following reasons, Defendants' motions to
dismiss are granted in part and denied in part.
Defendants Vasinkevich, Smith, and Tohn's motions
for costs and attorney's fees are denied. Plaintiff's
motions are denied as moot.
BACKGROUND
Plaintiff's allegations in its first Amended Complaint
as to the facts underlying this action are taken as true
for the purposes of these motions. Pennsylvania
corporation Sedona, headquartered in King of
Prussia,
Pennsylvania,
provides
“Customer
Relationship Management (CRM) application
software and services for small to mid-sized
businesses,” specifically targeting institutions that
provide financial services. (Compl.¶ 44.) Sedona
was a leading provider of CRM application software,
but needed to secure more capital in order to fully
capture its own substantial corner of the CRM
application software market. (Id.)
On July 1, 1999, Sedona was solicited by defendants
Vasinkevich and Tohn, who submitted a proposal to
Sedona offering their investment banking and capital
financing services. (Id. ¶ 47.) One month later,
Vasinkevich, who was a principal of defendant
Ladenburg, again solicited Sedona. In an August 19,
1999 letter, Vasinkevich depicted Ladenburg as a
“123-year old full-service investment bank” that
“ha[d] access to more than $50 Billion in investment
capital,” and “specialize[d] in providing a method of
financing that ‘offers market ambiguity as to timing
and dollars raised, keeping short sellers and
arbitrageurs at bay.” ’ (Id.) Sedona accepted
Vasinkevich and Tohn's solicitations. Following the
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August letter, Bill Williams (“Williams”), Sedona's
Chief Financial Officer, engaged in discussions with
Vasinkevich and Tohn, who described Ladenburg as
the “Goldman Sachs of small cap companies” with
funding methods that were “non-toxic” and
“minimized dilution.” (Id. ¶ 51.) In a letter dated
December 28, 1999, Vasinkevich reiterated
Ladenburg's desire and ability to help Sedona realize
the capital investment it required to achieve its
business goals. (Id.)
On the basis of these communications, Sedona
decided to hire Ladenburg as its financial advisor and
investment banker. (Id. ¶ 53.) It was at this time that
Vasinkevich introduced defendant Badian to Sedona
as a major investor. (Id. ¶ 54.) Badian, a principal of
defendant Rhino, assured Sedona that Rhino was an
accredited and long-term investor that had only
Sedona's best interest in mind. (Id.) Sedona
memorialized its hiring decision by signing a January
24, 2000, engagement letter. (Id. ¶ 55.) Shortly
thereafter, Vasinkevich and Tohn persuaded Sedona
to “increase the proceeds of the shelf registration to
$50 Million,” and Williams and defendant Boris,
Ladenburg's Executive Vice President, executed an
amended engagement letter, dated March 8, 2000
(“Engagement Letter”),FN5 reflecting the increase in
the anticipated funding. (Id. ¶ 56.)
FN5. The March 8, 2000 amendment
increased the gross proceeds from the
proposed offering from $15,000,000.00 to
$50,000,000.00. (Compl.¶ 56.)
Ladenburg and Rhino convinced Sedona that they,
along with other investors they would procure,
including Markham, Aspen, Amro, Cuttyhunk, and
the Sarlo Trust, would provide the $50 million. (Id . ¶
¶ 56-57.) The initial financing was arranged through
a February 25, 2000, purchase agreement for
convertible debentures and warrants (“Purchase
Agreement”) executed by defendant Hassan on
behalf of Markham, defendant Rieden on behalf of
Aspen, defendant Bachofen on behalf of Amro, and
Lewis on behalf of Cuttyhunk. (Id. ¶ ¶ 57-62.) Sarlo
Trust also invested in the initial tranche. (Id. ¶ 57.)
The Series G convertible preferred shares (“Series
G”) issued pursuant to the Purchase Agreement
“were issued as a bridge loan to fund Sedona until it
could draw down on the $50 million shelf registration
promised by Ladenburg.” (Pl.'s Mem. of Law in
Opp'n to Defs. Rhino's and Badian's Mot. to Dismiss
at 9 (“Pl.'s Opp'n”); Compl. ¶ 67.) Sedona, however,
never received the full amount of funding from the
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investors, and Sedona now contends that the
defendant investors “never intended to fund any
material part of this $50 million.” (Compl.¶ 64.)
*3 During the first week of March 2000, around the
time the initial financing for the Series G closed,
Sedona's stock traded at its highest volume in history.
(Id. ¶ ¶ 64-66.) “[I]n hindsight,” Sedona claims that
this “irregularit[y]” was a result of the Defendants'
manipulation of the market. (Id. ¶ 64.) That is,
Sedona views this high level of trading as
representing what it characterizes as the “pump”
portion of the Defendants' alleged scheme, with the
stock peaking at a share price of $10.25, “before
beginning its long and continuous slide to its
February 2003 level of $0.19,” as the stock was
systematically “dumped.” (Id. ¶ 66.) Sedona did not
have to wait until February of 2003 to see its stock
plummet, however, as by “June and July of 2000 ...
the stock ... [was] down to a consistent and declining
closing price of around $3.00 per share, a decline in
market capitalization of $195,000,000.00 in
approximately 90 days.” (Id.)
In the Complaint, Plaintiff principally alleges that the
Defendants “manipulate[d] downward the stock price
of Sedona with the cooperation of U.S. brokerdealers and market makers in order to profit from the
manipulation and price decline and to take advantage
of increased conversion rights resulting from the
manipulation.” (Id. ¶ 32.) According to Sedona, this
type of “death spiral” scheme FN6 was not novel to the
Defendants, who are allegedly “accomplished
practitioners of ... stock manipulation and stock
fraud.” (Id. ¶ 33.) In support of its assertion, Sedona
includes in its Complaint a chart listing a number of
companies with drastic reductions in stock price, all
of which, Sedona claims, were the result of similar
manipulations by Defendants. (Id. ¶ 43.) In addition,
Sedona refers to a February 26, 2003, SEC
Complaint (“SEC Complaint”) against defendants
Rhino and Badian concerning their involvement with
Sedona.FN7 The SEC Complaint includes allegations
that Rhino and Badian ignored a Purchase Agreement
provision prohibiting short sales and “engaged in
extensive short selling and pre-arranged trading on
behalf of [their] client prior to exercising the
conversion rights under the [Purchase Agreement].”
(Id. ¶ 36; SEC Compl., Howard J. Kaplan Aff.
(“Kaplan Aff.”) Ex. F ¶ 2.) As a result, “Rhino and
Badian manipulated Sedona's stock price to enhance
a client's economic interest.” (Id.) Rhino and Badian
paid a $1 million dollar fine to settle the SEC claim.
(Compl.¶ 36.)
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FN6. For descriptions of “death spiral
schemes,” see, for example, Endovasc Ltd.,
Inc. v. J.P. Turner & Co., LLC, et al., No. 02
Civ. 7313(LAP), 2004 WL 634171
(S.D.N.Y. Mar. 20, 2004); Nanopierce
Techs., Inc. v. Southridge Capital Mgmt.
LLC, No. 02 Civ. 9767(LBS), 2004 WL
31819207 (S.D.N.Y. Oct. 10, 2002);
Internet Law Library, Inc. v. Southridge
Capital Mgmt., LLC, 223 F.Supp.2d 474
(S.D.N.Y.2002); and Global Intellicom, Inc.
v. Thomason Kernaghan & Co., No. 99 Civ.
642(DLC), 1999 WL 544708 (S.D.N.Y. July
27, 1999).
FN7. Although the SEC Complaint deals
specifically with alleged actions of
defendants Rhino and Badian on behalf of
their client, Amro, Sedona asserts that the
alleged fraudulent actions taken against
Sedona were conducted by all of “the
defendants herein ..., cloaked by the use of
other names, nominee shell companies, and
dummy accounts, along with cooperating
U.S. and Canadian broker dealers and
market participants.” (Compl.¶ 70.)
On November 22, 2000, Sedona entered into a
second convertible debenture purchase agreement
with Amro, which provided Sedona with $3 million
dollars in gross funding. (Kaplan Aff. Ex. E.) Sedona
used approximately $2,246,000 of the proceeds from
that transaction to “retire the Series G.” (Compl.¶
82.) Following the execution of the second purchase
agreement, Rhino and Badian allegedly conducted so
many short sales in Amro's account, that “on March
22, 2001, the [National Association of Securities
Dealers Automatic Quotation system (‘NASDAQ’) ]
placed a short restriction on Sedona stock that
required that any future sales of Sedona would be
subject to a mandatory closeout if there were a failure
to deliver the securities after ten (10) days.” (Id. ¶
88.) Nonetheless, the NASDAQ restrictions did not
prevent Defendants from continuing to sell Sedona's
stock short. Rhino held an account for Amro with a
Canadian broker-dealer who was not a member of the
National Association of Securities Dealers, Inc.
(“NASD”), and thus was not subject to the short sale
restriction. (Id. ¶ 90.) It was through the Canadian
account that Rhino continued to sell short Sedona's
stock, from March 30, 2001 through mid-April 2001.
(Id.)
*4 Several months later, in September 2001, Sedona
Page 4
received an anonymous report “alleging that
manipulation and fraud had been perpetrated against
it.” (Id. ¶ 100.) In October 2001, based upon the
allegations contained in the report, Sedona “refused
to honor any more conversions from the [Purchase
Agreement], and asked the SEC to investigate the
allegations.” (Id.) Amro sued Sedona in the Southern
District of New York on October 24, 2001, Amro
Int'l, S.A. v. Sedona Corp., No. 01 Civ. 9344(NRB)
(the “Amro action”), for Sedona's failure to honor the
conversions. (Id.) The Amro action was ultimately
terminated and Sedona entered into settlement
agreements with Roseworth, Cambois, Amro, and
Rhino (collectively, the “Amro Settlement
Defendants”), that included a release from future
related liability (“the Release”) for each of those
defendants and their affiliates.FN8 (Id. ¶ 101.)
FN8. The Release by its terms also relieves
the “officers, directors, and employees of
such affiliates” from liability. Thus, the
terms of the Release also cover director
defendants
Badian
(Rhino),
Sims
(Roseworth and Cambois), and Bachofen
(Amro).
In the instant action, Sedona asserts that the
Defendants' alleged market manipulation and
fraudulent acts have made it “virtually impossible for
Sedona to obtain additional financing or an
investment of any type, except on a limited basis
through existing shareholders.” (Id. ¶ ¶ 102, 106.)
Further, Sedona alleges that Defendants directly
caused Sedona to be de-listed from the NASDAQ
SmallCap Market on January 9, 2003, allowing
Defendants more freedom to engage in illegal
behavior, “as market participants were now governed
by a less-regulated atmosphere in which to conduct
their manipulative activity.” (Id. ¶ 102.)
DISCUSSION
Motion to Dismiss Standard
In deciding the Defendants' motions brought pursuant
to Federal Rule of Civil Procedure 12(b)(6), the
Court must take as true all well-pleaded facts alleged
in Sedona's First Amended Complaint and draw all
reasonable inferences in Sedona's favor. Leatherman
v. Tarrant County Narcotics Intelligence &
Coordination Unit, 507 U.S. 163, 164 (1993);
Hernandez v. Coughlin, 18 F.3d 133, 136 (2d
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Cir.1994). The Court must not dismiss the complaint
“unless it appears beyond doubt that the plaintiff can
prove no set of facts in support of [its] claim which
would entitle [it] to relief.” Conley v. Gibson, 355
U.S. 41, 45-46 (1957).
Although the Court generally should not look outside
of the pleadings to decide a motion to dismiss a
complaint, the Court may consider “any written
instrument attached to [the complaint] as an exhibit
or any statements or documents incorporated in [the
complaint] by reference.” Rothman v. Gregor, 220
F.3d 81, 89 (2d Cir.2000). Further, in securities
actions, the Court may consider “public disclosure
documents required by law to be, and that have been,
filed with the SEC, and documents that the plaintiffs
either possessed or knew about and upon which they
relied in bringing the suit.” Id. (citations omitted).
Claims Against the Amro Settlement Defendants
The Amro Settlement Defendants move to dismiss the
Complaint as against them on the basis of the Release
executed and delivered by Sedona in connection with
the settlement of the Amro litigation. In apparent
anticipation of such a motion, Sedona pleads in the
Complaint that the Release is void and unenforceable
by reason of having been entered into under “fraud
and duress,” at a time when “Sedona felt that it had
no other option but to settle the outstanding
litigation.” (Compl.¶ 101.) Sedona further argues
that construction of the Release to cover the instant
fraud and related claims would be inequitable
because the Amro Settlement Defendants were
actively working to conceal the relevant facts as to
their conduct at the time the Release was given.
*5 Because the Release contains a New York choice
of law provision and the parties rely on New York
case law in their briefs, the Court interprets the
Release in accordance with New York law. See, e.g.,
Nasik Breeding & Research Farm Ltd. v. Merck &
Co., Inc., 165 F.Supp.2d 514, 526 (S.D.N.Y.2001)
(finding that courts in the Second Circuit “have
routinely enforced similar choice of law provisions
even when a party challenges the contract as
fraudulent” (citations omitted)). Under New York
law, “a valid release which is clear and unambiguous
on its face and which is knowingly and voluntarily
entered into will be enforced as a private agreement
between parties.” DuFort v. Aetna Life Ins. Co., 818
F.Supp. 578, 581 (S.D.N.Y.1993) (quoting Skluth v.
United Merchs. & Mfrs., Inc., 559 N.Y.S.2d 280, 282
(1st Dept.1990)). Such a release will be binding on
Page 5
the parties unless a legal defense such as fraud or
duress is adequately asserted. Id.
The Release provides in pertinent part that:
Sedona Corporation and its officers and directors in
their individual capacity ..., in consideration of good
and valuable consideration received from Amro
International, S.A., its officers, directors, affiliates,
employees, agents, and advisors, including Rhino
Advisors, Inc. (as well as the officers, directors, and
employees of such affiliates and advisors)
(collectively, the “Releasees”), ... in full satisfaction
hereby waive all claims, offsets, and defenses that
they may have or have had against Releasees and
hereby release, forever discharge and agree to hold
harmless Releasees from and against all actions,
causes of action, claims, suits, contracts,
controversies, penalties, offsets, or damages, whether
in law or equity, and whether known or unknown, that
may have occurred prior to the date of this Release,
including, but not limited to, those arising in
connection with the Convertible Debentures and
Warrants Purchase Agreement, dated as of November
22, 2000, ... Sedona Corporation's 5% Convertible
Debentures Due March 22, 2001 (as amended by an
Agreement, dated as of April 26, 2001), and related
Warrants and those asserted or that could have been
asserted as a claim, counterclaim, offset or defense
in, the [Amro action].... This Release shall be
governed by the laws of the State of New York.
(Maryann Peronti Decl. in Support of Pl.'s Mem. of
Law in Opp'n to Amro Defs.' Mot. to Dismiss
(“Peronti Decl.”) Ex. 2 (emphasis added).)
Breadth of the Release
The Release clearly and unambiguously provides that
Sedona waives all claims, “known and unknown,”
against the Releasees, “including but not limited to”
those claims “asserted or that could have been
asserted as a claim, counterclaim, offset or defense
in, the [Amro action].” (Id.) Although Sedona argues
that the Release should not be construed to cover the
alleged fraud at issue in this litigation because
Defendants' alleged market manipulation was being
concealed from Sedona at the time the Amro case was
settled, the Complaint makes it clear that Sedona was
aware of, and raised with the court the possibility of,
market manipulation activity in the course of the
Amro litigation. (See Compl. ¶ 100.) In addition, the
settlement agreement itself includes a provision
under which Amro agreed not to sell short Sedona
stock either directly or through Rhino. Short sales are
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central to Plaintiff's market manipulation allegations
in this case.
*6 Furthermore, the broad language of the Release
specifically includes claims that may not have been
known to the Plaintiff at the time of execution, such
as those asserted herein. Accordingly, the terms of
the Release cover Sedona's current claims. Because
Sedona may, however, be able to prove that it
executed the Release under duress, the Court will not
dismiss Sedona's claims against the Amro Settlement
Defendants, pursuant to the Release, at this stage of
the litigation.
Duress & Fraud Allegations
Under New York law, a contract may be voided on
grounds of duress upon proof that the defendant
exerted an unlawful threat, which precluded the
plaintiff's exercise of free will, during a situation in
which the circumstances permitted no other
alternative for the plaintiff. See Nasik Breeding &
Research Farm Ltd. v. Merck & Co., Inc., 165
F.Supp.2d 514, 527 (S.D.N.Y.2001). Sedona claims
that the Release was entered into under economic
duress, alleging that “[t]he defendants ... took
advantage of Sedona, and threatened litigation and a
default action, at a time when Sedona's finances were
very limited due to the fraudulent misrepresentations
and market manipulations of the defendants.”
(Compl.¶ 101.) Sedona also quotes a January 4,
2002, e-mail from Badian to Marco Emrich, Sedona's
then President and CEO, which “threaten[ed], ‘as I
am sure you are aware, a public company that
defaults on any debt security loses its eligibility for
S-3 registrations and must file the more cumbersome
and expensive SB-2 or S-1 if it wishes to register
shares. There are of course other consequences.” ’
(Id.)
It is well-settled that “[a] threat to do that which one
has the right to do does not constitute duress.”
DuFort v. Aetna Life Ins. Co., 818 F.Supp. 578, 582
(S.D.N.Y.1993) (quoting Gerstein v. 532 Broad
Hollow Road Co., 429 N.Y.S.2d 195, 199 (1st
Dep't.1980)). However, although such threats are not
inherently unlawful, a claim of economic duress may
be viable where threats are made in conjunction with
a financial situation unlawfully caused by a
defendant. See Weinraub v. Int'l Banknote Co., Inc.,
422 F.Supp. 856, 860 (S.D.N.Y.1976) (denying
summary judgment and finding a genuine issue of
material fact as to whether Plaintiff was a victim of
economic duress following the court's determination
Page 6
that, “[i]f the marked decrease in the value of that
stock which jeopardized [plaintiffs'] loan was due to
the misrepresentation and omissions of defendants,
then one could well argue that plaintiffs' position [of
financial hardship] ... was occasioned by the
fraudulent acts of defendants”). “The alleged duress
must [ultimately] be proven to have been the result of
defendant's conduct and not of the plaintiff's own
necessities.” Id. at 859 (citation omitted). Plaintiff
claims such duress here.
The very basis of Sedona's action is the claim that
Defendants', including the Amro Settlement
Defendants', manipulation of its stock led to financial
hardship for Plaintiff. Sedona claims that, once
placed in this situation, it was unable to exercise its
free will by choosing not to settle and execute the
releases. (See Compl. ¶ 101.) This lack of free choice
is “[a] crucial element of coercion or duress.” Korn v.
Franchard Corp., 388 F.Supp. 1326, 1333
(S.D.N.Y.1975). Sedona further alleges that “the
[Settlement Defendants] continued to manipulate
Sedona's stock, as before, during and after the
releases were entered, intentionally concealing the
manipulation from Sedona at the time it entered into
the releases.” (Compl.¶ 101.) The Court finds that
Sedona has sufficiently pled facts on the basis of
which it may be able to defeat enforcement of the
Release. Accordingly, the motion of the Amro
Settlement Defendants to dismiss the Complaint on
the basis of the Release is denied.
Sedona's Federal Securities Claims Are Not Time
Barred
*7 The moving Defendants' principal assertion in
their motions to dismiss is that Sedona brought its
federal securities claims outside of the relevant
statute of limitations period, and that the claims thus
must be dismissed as time barred. After a thorough
review of the Complaint, documents incorporated
therein, and relevant public disclosures, the Court
finds that Plaintiff's federal securities law causes of
action, as presented in the current pleadings, are not
clearly untimely. Therefore, for the reasons explained
below, Defendants' motions to dismiss Sedona's
federal securities fraud claims as time barred are
denied.
Relevant Statute of Limitations
Pursuant to Section 804(b) of the Sarbanes-Oxley Act
of 2002 (“Sarbanes-Oxley”), “a private right of
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action that involves a claim of fraud, deceit,
manipulation, or contrivance in contravention of ...
the [federal] securities laws ... may be brought not
later than the earlier of-(1) 2 years after the discovery
of the facts constituting the violation; or (2) 5 years
after such violation.” 28 U.S.C.A. 1658(b) (West
2002). This statute of limitations applies to all federal
securities actions brought on or after July 30, 2002,
the enactment date of Sarbanes-Oxley. Id. The instant
action was commenced on May 5, 2003.
Whether Sedona Was on Notice of the Alleged
Violations Prior to May of 2001
The passage of the Sarbanes-Oxley Act did not
change the well settled law in this Circuit as to what
constitutes “discovery of facts” sufficient to trigger
the statute of limitations in a securities fraud action.
The statute of limitations begins to run “when a
reasonable investor of ordinary intelligence would
have discovered the existence of fraud.” Newman v.
Warnaco Group, Inc., 335 F.3d 187, 193 (2d
Cir.2003) (quoting Dodds v. Cigna Sec., Inc., 12 F.3d
346, 350 (2d Cir.1993)). Discovery of facts
constituting a violation of the securities laws
“includes constructive or inquiry notice as well as
actual notice.” Id. at 193 (quoting Rothman v.
Gregor, 220 F.3d 81, 96 (2d Cir.2000) (internal
quotation marks omitted)). Inquiry notice arises when
“the circumstances are such as to suggest to a person
of ordinary intelligence the probability that the
person has been defrauded.” Jackson Nat'l Life Ins.
Co. v. Merrill Lynch & Co., Inc., 32 F.3d 697, 701
(2d Cir.1994) (quoting Armstrong v. McAlpin, 699
F.2d 79, 88 (2d Cir.1983) (internal quotations
omitted)). However, “[t]he fraud must be probable,
not merely possible.” Newman, 335 F.3d at 193.
If the relevant information is contained within the
Complaint and the papers incorporated by reference
therein, the question of whether Sedona had notice of
Defendants' alleged fraud may be determined as a
matter of law at the motion to dismiss stage. See, e.g.,
LC Capital Partners, LP v. Frontier Ins. Group, Inc.,
318 F.3d 148, 156 (2d Cir.2003) (noting that it is
appropriate on a motion to dismiss for the Court to
determine whether Plaintiff was aware of the fraud as
long as that information is contained within the
complaint and incorporated papers) and cases cited
therein. The Court must utilize an objective standard
to determine whether the available information was
sufficient to put the plaintiff on inquiry notice. See,
e.g., Clark v. Nevis Capital Mgmt., LLC, No. 04 Civ.
2702(RWS), 2005 WL 488641, at *7 (S.D.N.Y. Mar.
Page 8 of 96
Page 7
2, 2005) (“The test as to when fraud should with
reasonable diligence have been discovered is an
objective one.”) (citing Dodds v. Cigna Sec., Inc., 12
F.3d 346, 350 (2d Cir.1993)).
*8 While Defendants argue that Sedona had
knowledge of the alleged manipulation “no later than
June 2000,” when Sedona's Finance Committee
questioned Vasinkevich about perceived market
manipulation, Sedona, pointing to the lapse of time
between its late 2001 requests that the SEC
investigate trading activities in the company's stock
and the filing of the SEC Complaint against Rhino
and Badian, argues that, if “it took the SEC 17
months ... to bring its complaint” against Badian and
Rhino, “[i]t would not be just to believe that
members of a computer software company could
unravel this labyrinth of deceit in less time.” (Pl.'s
Opp'n at 8.) Nonetheless, it is not necessary for
Sedona to “have notice of the entire fraud being
perpetrated to be on inquiry notice.” Dodds, 12 F.3d
at 351-52. Rather, “the information provided must
trigger notice ‘with sufficient storm warnings to alert
a reasonable person to the probability” ’ of fraud.
Morin v. Trupin, 809 F.Supp. 1081, 1097
(S.D.N.Y.1993) (quoting Quantum Overseas, N.V. v.
Touche Ross & Co., 663 F.Supp. 658, 664
(S.D.N.Y.1987)).
Although Sedona's Complaint and incorporated
documents indicate that Sedona was aware of such
storm warnings, it cannot be said that those initial
storm warnings were sufficient to “alert a reasonable
person to the probability” that defendants in the
instant action were the perpetrators of that fraud.
Further, there is nothing on the face of the Complaint
or in the documents that are relevant at this stage of
the litigation to indicate that reasonable inquiry prior
to May 2001 would have been effective to uncover
sufficient facts to have enabled Sedona to bring suit
against identifiable perpetrators within a limitations
period measured from these early storm warnings.
This is particularly so in light of Sedona's allegations
of the measures certain Defendants took to hide their
alleged fraudulent activity.
For example, Sedona twice queried Vasinkevich, in
his capacity as a Ladenburg representative, about
market irregularities. (See Compl. ¶ ¶ 71-72.)
Vasinkevich denied any wrongdoing, and allegedly
“assur[ed Sedona] that the investors placed through
Ladenburg, which included Markham, Aspen, and
Amro, “were long-term investors,” “were not
responsible for any manipulation or any events which
were not in the best interest of SEDONA; and [that]
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... those investors did not cause, directly or indirectly,
any aspect of SEDONA's continuing stock decline.”
(Id. ¶ 72.) Vasinkevich then represented he could
replace the current investors with new investors,
specifically defendants Roseworth and Cambois,FN9
which were wholly-owned subsidiaries of defendant
Creon. (Id. ¶ ¶ 73-74.)
FN9. Defendants Gassner, Batliner, Batliner
Partners, and Sims all “had the power to
direct or cause the direction of the
management and policies of each of
Roseworth and Cambois.” (Id. ¶ 76.)
Sedona claims that this new group of
defendant investors, who were “known
perpetrators of stock manipulation,”
continued the “conspir[acy] to destroy the
stock price of Sedona.” (Id. ¶ 81.)
The Second Circuit has stated that “reassuring
statements will prevent the emergence of a duty to
inquire or dissipate such a duty.” LC Capital
Partners, 318 F.3d at 155. Such prevention occurs
“only if a[ plaintiff] of ordinary intelligence would
reasonably rely on the statements to allay the
[plaintiff's] concern .” Id. Plaintiff's allegations could
support a determination that Vasinkevich's alleged
representations on behalf of the Ladenburg Investors
FN10
serve to dissipate Sedona's duty to inquire, as an
investor of ordinary intelligence could reasonably
rely on its financial advisor's statements that its
affiliated investors were not involved in any
fraudulent conduct.
FN10. The term “Ladenburg Investors” is
defined by Sedona to include Defendants
Markham, Aspen, Amro, Roseworth,
Cambois, and Boris. (Id. ¶ 41.)
*9 Therefore, on the facts as plead by Plaintiff in the
Complaint and shown in incorporated documents, it
cannot be said that moving Defendants are entitled to
judgment as a matter of law on statute of limitations
grounds, and Plaintiff is entitled to litigate the
question of timeliness of the action.
Certain of the Defendants also move to dismiss
Sedona's Pennsylvania state fraud claim as untimely
and, for substantially the reasons discussed above,
those motions are denied.
The Court now turns to the elements of Defendants'
motions that are directed to Sedona's pleading of its
Page 8
claims for relief.
Certain of Sedona's Fraud Claims Must be Replead
All moving Defendants request the Court to dismiss
Plaintiff's Complaint pursuant to Rule 12(b)(6) for
failure to state a claim upon which relief can be
granted and pursuant to Rule 9(b) for failure to plead
fraud with particularity. For the following reasons,
Defendants' motions to dismiss are granted in part
and denied in part. Plaintiff will be afforded an
opportunity to replead the claims.
Claims for Relief
In its First Claim for Relief, Plaintiff alleges that
Defendants Ladenburg, Rhino, Markham, Aspen, the
Amro Defendants, Badian, Tohn, Boris, Vasinkevich,
and Smith violated Section 10(b) and Rule 10b-5 in
connection with Plaintiff's sales of securities to
Ladenburg and the Ladenburg Investors. Plaintiff
asserts that “Defendant Ladenburg, by and through
its principals, officers, directors or agents, including,
without limitation, Badian, Tohn, Boris, Vasinkevich
and Smith made the misrepresentations and
omissions alleged” in specified paragraphs of the
Complaint. (See Compl. ¶ ¶ 108, 110 and allegations
referenced therein.) Plaintiff asserts that Defendants
Badian, Tohn, Vasinkevich, and Smith each knew the
misrepresentations and omissions were untrue at the
time they were made, and that each reconfirmed
individually misrepresentations he had made as an
agent of Ladenburg, as detailed in specified
paragraphs of the Complaint. (Id. ¶ 109 and
allegations referenced therein.) These Defendants and
Ladenburg are alleged to have acted, together with
the other Defendants named in the First Claim for
Relief, with scienter; Plaintiff further asserts that
their actions “dramatically and adversely affected the
price and terms of” Plaintiff's sales of securities to
Ladenburg and investors placed by Ladenburg. (Id. ¶
¶ 111-12.)
Plaintiff's Fifth Claim for Relief accuses the same
group of Defendants of common law fraud and
deceit, specifically, making the misrepresentations
and omissions of material fact alleged in the
preceding portions of the Complaint. (Id. ¶ ¶ 13032.)
Plaintiff's Second Claim for Relief, asserted against
all of the Defendants named in the Complaint,
accuses all Defendants of violating Section 10(b) and
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Rule 10b-5 by participating in a scheme to defraud
Plaintiff by manipulating the price of Plaintiff's stock.
(Id. ¶ ¶ 114-18.)
Legal Standards
*10 The elements of a Section 10(b) and Rule 10b-5
cause of action premised on material misstatements
or omissions of fact are as follows: Defendants “(1)
made misstatements or omissions of material fact; (2)
with scienter; (3) in connection with the purchase or
sale of securities; (4) upon which plaintiffs relied;
and (5) that plaintiffs' reliance was the proximate
cause of their injury.” Lentell v. Merrill Lynch & Co.,
Inc., 396 F.3d 161, 172 (2d Cir.2005) (quoting In re
IBM Sec. Litig., 163 F.3d 102, 106 (2d Cir.1998)).
Similarly, a properly pled market manipulation claim
under Section 10(b) and Rule 10b-5 requires
allegations of:
(1) damage [to the plaintiffs], (2) caused by reliance
on defendants' misrepresentations or omissions of
material facts, or on a scheme by the defendants to
defraud, (3) scienter, (4) in connection with the
purchase or sale of securities, (5) furthered by the
defendants' use of the mails or any facility of a
national securities exchange.
Nanopierce Techs., Inc. v. Southridge Capital Mgmt.
LLC, No. 02 Civ. 0767(LBS), 2002 WL 31819207, at
*6 (S.D.N.Y. Oct. 10, 2002) (quoting Schnell v.
Conseco,
Inc.,
43
F.Supp.2d
438,
448
(S.D.N.Y.1999)). “The essence of a market
manipulation claim is the allegation of conduct
intended to deceive or defraud investors by
conditioning or artfully affecting the market for
securities.” Internet Law Library, Inc. v. Southridge
Capital Mgmt., LLC, 223 F.Supp.2d 474, 486
(S.D.N.Y.2002).
In order properly to plead a claim for common law
fraud and deceit under New York law, the plaintiff
must allege that (1) the defendant made a material
misrepresentation, (2) the defendant knew the
representation was false, (3) the defendant made the
misrepresentation with the intent to defraud the
plaintiff, (4) the plaintiff reasonably relied upon the
defendant's material misrepresentation, and (5) as a
result of such reliance, the plaintiff suffered damages.
See City of New York v. Cyco.Net, Inc., No. 03 Civ.
383(DAB), 2005 WL 174482, at *33 (S.D.N.Y. Jan.
27, 2005). If plaintiff fails to adequately plead one of
these five essential elements, the claim must be
dismissed. In re Simon II Litig., 211 F.R.D. 86, 139
(E.D.N.Y.2002), vacated on other grounds by 407
Page 10 of 96
Page 9
F.3d 125 (2d Cir.2005).
The pleading standard set forth in Rule 9(b) must also
be met with respect to each of these fraud-based
claims. See Fed.R.Civ.P. 9(b) (“In all averments of
fraud or mistake, the circumstances constituting fraud
or mistake shall be stated with particularity.”); Olsen
v. Pratt & Whitney Aircraft, A Div. of United Techs.
Corp., 136 F.3d 273, 276 (2d Cir.1998)
(“Fed.R.Civ.P. 9(b) requires that all fraud claims be
pleaded with particularity.”); see also AIG Global
Sec. Lending Corp. v. Banc of Am. Sec. LLC, 254
F.Supp.2d 373, 389 (S.D.N.Y.2003) (“A claim for
common law fraud under New York law must also
satisfy the requirements of Fed.R.Civ.P. 9(b).”). To
satisfy the Rule 9(b) pleading standard, a fraud claim
alleging material misstatements or omissions must:
“(1) detail the statements (or omissions) that the
plaintiff contends are fraudulent, (2) identify the
speaker, (3) state where and when the statements (or
omissions) were made, and (4) explain why the
statements (or omissions) are fraudulent.” Eternity
Global Master Fund Ltd. v. Morgan Guar. Trust Co.
of New York, 375 F.3d 168, 187 (2d Cir.2004)
(quoting Harsco Corp. v. Segui, 91 F.3d 337, 347 (2d
Cir.1996)); see also Nanopierce Techs., Inc. v.
Southridge Capital Mgmt. LLC, No. 02 Civ.
0767(LBS), 2002 WL 31819207, at *3 (S.D.N.Y.
Oct. 10, 2002). Further, while “market manipulation
claims are subject to a more relaxed pleading
standard than other claims involving alleged
affirmative misrepresentations[,] ... ‘because the facts
relating to a manipulation scheme are often known
only by the defendants[,]’ ... [a]t a minimum, it is
‘clear that a market manipulation claim must still
specify “what manipulative acts were performed,
which defendants performed them, when the
manipulative acts were performed, and what effect
the scheme had on the market for the securities at
issue.” ” ’ Internet Law Library, Inc. v. Southridge
Capital Mgmt., LLC, 223 F.Supp.2d 474, 486
(S.D.N.Y.2002) (citations omitted).
*11 Certain of the Defendants also move to dismiss
the Complaint pursuant to the PSLRA, which
incorporates the pleading requirements of Section
10(b), Rule 10b-5, and Rule 9(b). Under the PSLRA,
a complaint alleging material misrepresentations
and/or omissions “shall 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 or belief, the complaint shall
state with particularity all facts on which that belief is
formed.” 15 U.S.C.A. § 78u-4(b)(1) (West 2005). As
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to scienter, the PSLRA requires plaintiffs to “state
with particularity facts giving rise to a strong
inference that the defendant acted with the requisite
state of mind.” Id. § 78u-4(b)(2).
The Complaint, which details many alleged
misrepresentations and omissions and the nature of
the alleged scheme, as well as the effect the scheme
allegedly had on the market, Plaintiff's own business
prospects, and financing opportunities, is generally
sufficient to address the securities nexus, reliance,
causation, and damages elements of the relevant
standards. As explained below, it also adequately
alleges scienter as to certain Defendants. It fails,
however, sufficiently to allege common law fraud,
misrepresentations or omissions, and/or market
manipulation, by a number of the named defendants.
Material Misrepresentations & Omissions of Fact
In Plaintiff's First and Fifth Claims for Relief, Sedona
alleges material misrepresentations and omissions of
fact made by certain Defendants. However, of those
particular Defendants, the only ones as to whom
these misrepresentations and omissions are pled with
the requisite particularity are Ladenburg, Rhino,
Badian, Tohn, and Vasinkevich. With respect to these
Defendants, the Complaint specifies statements
made, as well as when and to whom statements were
made, and details allegedly material omissions in
connection with such statements. (See, e.g., Compl. ¶
¶ 39 (Ladenburg), 47-48 (Ladenburg, Vasinkevich,
and Tohn), 50 (Vasinkevich and Ladenburg), 51
(Vasinkevich
and
Tohn),
52
(Ladenburg,
Vasinkevich, and Tohn), 54 (Badian, Rhino, and
Vasinkevich), 56 (Ladenburg, Rhino, Vasinkevich,
and Tohn), 57 (Ladenburg), 71 (Vasinkevich and
Ladenburg), 72 (Vasinkevich), 73 (Vasinkevich and
Ladenburg), 82 (Vasinkevich, Badian, Ladenburg,
Roseworth, Cambois, Rhino, and Creon), 97
(Vasinkevich and Badian), 108 (Ladenburg), 109
(Badian, Tohn, Vasinkevich, and Smith).)
The Complaint does not, however, make any specific
allegations of material misstatements or omissions by
any of the other Defendants named in counts One and
Five. Rather, Plaintiff alleges simply that Ladenburg
represented and acted as “agent for each” of the
Ladenburg Investors (defined in paragraph 41 to
comprise Amro, Markham, Aspen, Cuttyhunk, and
the Sarlo Trust) “in connection with the transactions
complained of herein.” (Id. ¶ 41.) The generalized
references to agency in connection with
“transactions” and representation are insufficiently
Page 10
specific to meet the requirements of Rule 9(b) as to
alleged misrepresentations or omissions by those
defendants, particularly where, as here, Ladenburg is
alleged to have acted on those parties' behalf in
connection with specific financial transactions. The
Complaint is similarly deficient with respect to Boris,
as to whom its allegations are confined to his position
and alleged control relationship with Ladenburg and
his having signed the document increasing the
funding commitment to $50 million, and Smith, as to
whom the Complaint's allegations are confined to
control. In Paragraph 81, Plaintiff alleges merely that
Roseworth and Cambois failed to disclose their
affiliation with Creon, a company managed by Rhino,
in connection with their agreement with Sedona “to
sell equity off their existing shelf registration.” (Id. ¶
81.) Plaintiff does not spell out the materiality of this
omission. The Complaint is devoid of allegations of
misrepresentations or omissions by any of the other
named Defendants.
*12 In a case such as this one, where
misrepresentation claims are asserted against
numerous defendants, “[b]road allegations that
several defendants participated in a scheme, or
conclusory assertions that one defendant controlled
another, or that some defendants are guilty because of
their association with others, do not inform each
defendant of its role in the fraud and do not satisfy
Rule 9(b).” Kolbeck v. LIT America, Inc., 923
F.Supp. 557, 569 (S.D.N.Y.1996). Such allegations
fail to adequately inform the individual defendants of
the charges against them, and “[t]his type of ‘clump
[ing][of] defendants together in vague allegations of
fraud’ is the very type of inadequate pleading that
Rule 9(b) ... sought to prevent.” Endovasc Ltd., Inc.
v. J.P. Turner & Co., LLC, No. 02 Civ. 7313(LAP),
2004 WL 634171, at *6 (S.D.N.Y. Mar. 30, 2004)
(quoting In re Blech Sec. Litig., 928 F.Supp. 1279,
1294 (S.D.N.Y.1996) (alterations in original)).
Accordingly, Defendants Markham, the Amro
Defendants, Boris, and Smith's motions to dismiss
Claims for Relief One and Five of the Complaint are
granted. Ladenburg, Rhino, Badian, Tohn, and
Vasinkevich's motions are denied. Plaintiff has leave
to replead to the extent specified below.
Market Manipulation
Plaintiff's Second Claim for Relief, asserted against
all Defendants, alleges violations of Section 10(b)
and Rule 10b-5 on the basis of market manipulation.
As noted above, the Rule 9(b) pleading standards are
construed in a more relaxed fashion for market
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manipulation claims. A plaintiff must, however, “still
specify ‘what manipulative acts were performed,
which defendants performed them, when the
manipulative acts were performed, and what effect
the scheme had on the market for the securities at
issue.” ’ Internet Law Library, 223 F.Supp.2d at 486
(citation omitted).
Here, the Complaint provides a great deal of detail
regarding the nature of the conduct and techniques
allegedly employed in the market manipulation
scheme, and numerous details regarding transactions
and/or the participation of specific defendants in
transactions. Specific allegations regarding the entry
into, or facilitation of, transactions in aid of the
alleged scheme are made as to defendants Ladenburg,
Rhino, the Amro Defendants, Markham, Aspen,
Vasinkevich, Badian, Tohn, Boris, Frankel,
Westminster, and Pershing. As to the remaining
individual and commercial entity defendants,
however, Plaintiff's allegations are confined to ability
to control the alleged bad actors, or generalized
allegations that “all defendants” engaged in, or are
believed to have engaged in, various categories of
manipulative conduct. Neither allegations of ability
to control or lumped-together accusations of
wrongdoing by undifferentiated groups of
defendants, is sufficient to satisfy Rule 9(b). See, e.g.,
Endovasc Ltd., Inc. v. J.P. Turner & Co., LLC, No.
02 Civ. 7313(LAP), 2004 WL 634171, at *6
(S.D.N.Y. Mar. 30, 2004) (quoting In re Blech Sec.
Litig., 928 F.Supp. 1279, 1294 (S.D.N.Y.1996)
(omissions in original)); Kolbeck v. LIT America,
Inc., 923 F.Supp. 557, 569 (S.D.N.Y.1996).
Accordingly, the motions of Defendants Creon, the
UltraFinanz Defendants, Smith, Sims, the Batliner
Defendants, and Hassan, to dismiss Plaintiff's second
claim for relief, are granted. Plaintiff has leave to
replead as specified below.
Scienter
*13 Certain of the Defendants further argue that the
Complaint fails to plead the scienter element of
Plaintiff's common law, market manipulation, and
misrepresentation and/or omission fraud claims with
sufficient particularity. Fraud claims brought under
the common law and pursuant to Section 10(b), Rule
10b-5, and the PSLRA, must include allegations that
defendants' misrepresentations or omissions, or
challenged schemes, were undertaken with the intent
to defraud the plaintiff. See Lentell v. Merrill Lynch
& Co., Inc ., 396 F.3d 161, 172 (2d Cir.2005)
(quoting In re IBM Sec. Litig ., 163 F.3d 102, 106 (2d
Page 12 of 96
Page 11
Cir.1998)); GFL Advantage Fund, Ltd. v. Colkitt, 272
F.3d 189, 214 (3d Cir.2001) (quoting Rosen v.
Communication Serv. Group, Inc., 155 F.Supp.2d
310, 321 n. 14 (E.D.Pa.2001)); City of New York v.
Cyco.Net, Inc., No. 03 Civ. 383(DAB), 2005 WL
174482, at *33 (S.D.N.Y. Jan. 27, 2005). The
complaint must “plead those events which give rise
to a strong inference that the defendant[ ] had an
intent to defraud, knowledge of the falsity, or a
reckless disregard for the truth.” Caputo v. Pfizer,
Inc., 267 F.3d 181, 191 (2d Cir.2001) (quoting
Connecticut Nat'l Bank v. Fluour Corp., 808 F.2d
957, 962 (2d Cir.1987) (internal quotation marks and
citation omitted)). A plaintiff may support such
inference by sufficiently pleading that the defendant
had “either (a) ... both motive and opportunity to
commit fraud, or (b) by alleging facts that constitute
strong circumstantial evidence of conscious
misbehavior or recklessness.” Nanopierce Techs.,
Inc. v. Southridge Capital Mgmt. LLC, No. 02 Civ.
0767(LBS), 2002 WL 31819207, at *4 (S.D.N.Y.
Oct. 10, 2002) (quoting Kalnit v. Eichler, 264 F.3d
131, 138-39 (2d Cir.2001)). However, Sedona alleges
facts sufficient only to support a strong inference of
intent to defraud on the part of Ladenburg, Rhino,
Markham, Aspen, the Amro Defendants, Boris,
Frankel, and Westminster, to the extent that they
were holders of or managed Sedona's stock.
Sedona alleges that “the structure of the financing
agreement gave the defendants both the motive and
the opportunity to defraud Sedona.” (Compl.¶ 111.)
Specifically, the structure of the convertible stock
and debentures was such that, if Sedona's stock price
were pushed downward, the defendants could acquire
more stock through the conversion, thus providing an
incentive to manipulate Sedona's stock downward.
(Id. ¶ 34.) Indeed, this allegation does give rise to a
strong inference of motive and opportunity as to the
direct holders of the Debentures and their fund
managers, such as Rhino and Ladenburg. FN11
However, that strong inference is lacking as to those
entities' representatives, Badian, Tohn, and
Vasinkevich.
FN11. According to the settlement
agreement between Amro and Sedona,
“Sedona issued and delivered ... Warrants to
Ladenburg ... for 167,576 shares, expiring
November 12, 2003.” (Peronti Decl. Ex. 1.)
“Rhino is listed as the fund manager of
Amro in publicly-filed documents with the
SEC.” (Compl.¶ 62.)
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While the Court could surmise that Badian, Tohn,
and Vasinkevich could profit from these transactions,
it is Plaintiff's duty to allege specifically the relevant
connections. Without more specific allegations as to
why Ladenburg's officers would want to manipulate
Sedona's stock, Sedona fails to plead adequately the
motive requirement as to these three defendants.
Therefore, the motions to dismiss Sedona's Second
Claim for Relief are granted as to Defendants Badian,
Tohn, Vasinkevich, and Pershing, with leave to
replead, and denied as to Defendants Ladenburg,
Rhino, Markham, Westminster, Frankel, Boris, and
the Amro Defendants.
Sedona's Claim for Relief Pursuant to Section 1-401
of the Pennsylvania Act Must be Replead
*14 In its Fourth Claim for Relief, Plaintiff asserts a
claim against all Defendants for violation of the
Pennsylvania Act. The Pennsylvania Act makes it
“unlawful for any person, in connection with the
offer, sale or purchase of any security in
[Pennsylvania], directly or indirectly: (a) [t]o employ
any device, scheme or artifice to defraud; [and] (b)
[t]o make any untrue statement of a material fact or
to omit to state a material fact necessary in order to
make the statements made ... not misleading.” 70 Pa.
Stat. Ann. § 1-401. This provision is “ ‘functionally
identical’ to ... Section 10(b) of the Exchange Act,”
and “is modeled after Rule 10b-5 ... and requires
virtually the same elements of proof.” GFL
Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189, 214
(3d Cir.2001) (quoting Rosen v. Communication
Serv. Group, Inc., 155 F.Supp.2d 310, 321 n. 14
(E.D.Pa.2001)).
The parties disagree as to whether this claim for relief
is precluded by the New York choice-of-law
provisions of: (1) the Engagement Letter between
Sedona and Ladenburg; (2) the Purchase Agreement
between Sedona, Markham, Amro, Aspen, and
Cuttyhunk; (3) the Settlement Agreement among,
Sedona and Amro; and (4) the Releases between
Sedona and the Settlement Defendants.FN12 The
forum selection clause and choice-of-law provision
contained within the Engagement Letter provides in
pertinent part that
FN12. Because Sedona's claim of duress
raises a legitimate question as to whether the
Release is invalid, the Court will not, at this
stage of the litigation, grant motions to
dismiss Sedona's Pennsylvania law claim
Page 13 of 96
Page 12
based on the choice of law provision
contained in the Release.
[Sedona] hereby irrevocably: (a) submits to the
jurisdiction of any court of the State of New York or
any federal court sitting in the State of New York for
the purposes of any suit, action or other proceeding
arising out of the Agreement between [Sedona] and
[Ladenburg] which is brought by or against [Sedona]
or [Ladenburg]; (b) agrees that all claims in respect
of any suit, action or proceeding may be heard and
determined in any such court.... This [Engagement
Letter] shall be governed by and construed in
accordance with the laws of the State of New York,
without regard to conflicts of law principles.
(Engagement Letter, Kaplan Aff. Ex. B at 10.) The
choice-of-law provision in the Purchase Agreement
provides that the “[Purchase Agreement] shall be
governed by and construed in accordance with the
laws of the State of New York applicable to contracts
made in New York by persons domiciled in New
York City and without regard to its principles of
conflicts of laws.” (Purchase Agreement, Kaplan Aff.
Ex. C § 10.1.) Similarly, the choice-of-law provision
contained in the Settlement Agreement states that the
“[Settlement Agreement] shall be governed by and
construed and enforced in accordance with the
internal laws of the State of New York.” (Settlement
Agreement, Peronti Decl. Ex. 1 ¶ 7(e).)
When deciding conflict of laws issues arising in
diversity cases, a federal court must look to the laws
of the forum state. See, e.g ., Klaxon Co. v. Stentor
Elec. Mfg. Co., 313 U.S. 487, 496 (1941); Terwilliger
v. Terwilliger, 206 F.3d 240, 245 (2d Cir.2000); CAP
Gemini Ernst & Young U.S. LLC v. Nackel, No. 02
Civ. 6872(DLC), 2004 WL 569554, at *3 (S.D.N.Y.
Mar. 23, 2004). Under New York law, contractual
choice-of-law provisions are generally valid and
enforceable. Terwilliger, 206 F.3d at 245 (quoting
Marine Midland Bank, N.A. v. United Missouri Bank,
N.A., 643 N.Y.S.2d 528, 530 (N.Y.App.Div.1996)).
Where, as here, there is an express choice-of-law
provision in a contract, “a court is to apply the law
selected in the contract as long as the state selected
has sufficient contacts with the transaction.”
Hartford Fire Ins. Co. v. Orient Overseas Containers
Lines (UK) Ltd., 230 F.3d 549, 556 (2d Cir.2000).
However, “[u]nder New York law, a choice-of-law
provision indicating that the contract will be
governed by a certain body of law does not
dispositively determine that law which will govern a
claim of fraud arising incident to the contract.” Krock
v. Lipsay, 97 F.3d 640, 645 (2d Cir.1996) (citations
omitted). Rather, “in order for a choice-of-law
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provision to apply to claims for tort arising incident
to the contract, the express language of the provision
must be ‘sufficiently broad’ as to encompass the
entire relationship between the contracting parties.”
Id. (finding that choice-of-law provision providing
that “[t]his Mortgage shall be governed by and
construed in accordance with the laws of the
Commonwealth of Massachusetts,” was not
sufficiently broad to apply to a claim of fraudulent
misrepresentation).
*15 Here, Sedona's securities fraud claims asserted
under Pennsylvania law arise incident to transactions
contemplated by the Engagement Letter, Purchase
Agreement, and the Settlement Agreement. The
language of the choice-of-law provisions contained in
the Purchase Agreement and the Settlement
Agreement, which merely refer to actions arising
directly from those contracts, is not sufficiently broad
for the Court to apply the New York choice-of-law
provisions contained therein to defeat Sedona's
Pennsylvania securities law claim. Further the
broader language in the forum selection clause of the
Engagement Letter, which refers to any actions
arising out of the Engagement Letter, does not serve
to expand the scope of the narrower choice-of-law
provision contained in the same contract. See Fin.
One Pub. Co. Ltd. v. Lehman Bros. Special Fin., Inc.,
__ F.3d __, 2005 WL 1619852, at *7 (2d Cir. July
12, 2005) (“Under New York law, ... tort claims are
outside the scope of contractual choice-of-law
provisions that specify what law governs construction
of the terms of the contract, even when the contract
also includes a broader forum-selection clause.”
(citations omitted).) Accordingly, the Court denies
the motions to dismiss Sedona's Pennsylvania Act
claim for relief to the extent the motions rely on the
choice-of-law provisions of the Engagement Letter,
Purchase Agreement, and Settlement Agreement.
However, as noted above, the Pennsylvania Act
“requires virtually the same elements of proof” as a
federal claim brought pursuant to Rule 10b-5. See
GFL Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189,
214 (3d Cir.2001) (quoting Rosen v. Communication
Serv. Group, Inc., 155 F.Supp.2d 310, 321 n. 14
(E.D.Pa.2001)). [Therefore, the motions of
Defendants Boris, Creon, Hassan, Smith, Sims, the
Amro Defendants, the Batliner Defendants, and the
UltraFinanz Defendants to dismiss Sedona's state
claim are granted, with leave to replead.]
Further, there is no private right of action under the
statutory provision Plaintiff cites and Sedona's fourth
claim for relief must for that reason be dismissed.
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See, e.g., In re Catanella & E.F. Hutton & Co., Inc.
Sec. Litig., 583 F.Supp. 1388, 1439 (E.D.Pa.1984)
(finding that the Pennsylvania Act “do[es] not
expressly grant a private remedy”). Nonetheless,
Pennsylvania courts have found that a private right of
action under Section 1-401 is available through
Section 1-501 of the Pennsylvania Act. See, e.g.,
Feret v. First Union Corp., 1999 WL 80374, at *16
(E.D.Pa Jan. 25, 1999) (“ §
1-401 of the
Pennsylvania Securities Act, ... provides a private
cause of action in § 1-501.”). Accordingly, the
Fourth Claim for Relief is dismissed, with leave to
amend the Complaint to assert the Pennsylvania state
fraud claim under Sections 1-401 and 1-501 of the
Pennsylvania Act, as well as to include allegations
sufficient to adequately plead a securities fraud claim
under the Pennsylvania Act.
The Motions to Dismiss Sedona's Control Person
Liability Claim are Denied in Part
*16 Plaintiff's Twelfth Claim for Relief, pursuant to
Section 20 of the Exchange Act, alleges control
person liability as against the UltraFinanz
Defendants, Rhino, Badian, the Batliner Defendants,
Creon, Sims, Hassan, Rieden, Vasinkevich, Boris,
Tohn, and Smith. For the following reasons,
Defendants' motions to dismiss Sedona's control
person liability claim are granted only as to
Defendant Creon.
Pursuant to Section 20(a) of the Exchange Act,
[e]very person who, directly or indirectly, controls
any person liable under any provision of this chapter
or of any rule or regulation thereunder shall also be
liable jointly and severally with and to the same
extent as such controlled person to any person to
whom such controlled person is liable, unless the
controlling person acted in good faith and did not
directly or indirectly induce the act or acts
constituting the violation or cause of action.
15 U.S.C.A. § 78t(a) (West 2005). A plaintiff may
establish a prima facie case of control person liability
under Section 20(a) by showing (1) “a primary
violation ... by the controlled person”; (2) “control of
the primary violator by the targeted defendant”; and
(3) “that the controlling person was in some
meaningful sense a culpable participant in the fraud
perpetrated by the controlled person.” Ganino v.
Citizens Utils. Co., 228 F.3d 154, 170 (2d Cir.2000)
(quoting SEC v. First Jersey Sec., Inc., 101 F.3d
1450, 1472 (2d Cir.1996)). A plaintiff's pleading as to
these elements must meet the requirements of Federal
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Rule of Civil Procedure Rule 8(a), which requires
only a “short and plain statement,” rather than the
particularity requirements of Rule 9(b), since
“[n]either the PSLRA (because scienter is not an
essential element), nor Rule 9(b) (because fraud is
not an essential element), apply to a Section 20(a)
claim.” In re Initial Public Offering Sec. Litig., 358
F.Supp.2d 189, 208 (S.D.N.Y.2004).
In the Complaint, Sedona describes various officer,
director, and other authority relationships with
alleged perpetrators of fraud in support of its control
person liability claim. (See, e.g., Compl. ¶ ¶ 158
(UltraFinanz Defendants, Rhino, and Badian), 159
(Batliner Defendants), 160 (Sims, Creon, Rhino, and
Badian), 161 (Hassan), 162 (Rieden), 164
(Vasinkevich, Boris, Tohn, and Smith), 165
(Badian).) However, Sedona's Section 20(a) claim is
not pled sufficiently as against Defendant Rieden, as
Sedona has not alleged an underlying primary
violation of either Section 10(b) or Rule 10b-5 by
Aspen. Sedona's claim is also insufficient as to
Defendant Creon, since Sedona has failed to allege
facts sufficient to show that Creon was “in some
meaningful sense a culpable participant in the fraud”
allegedly perpetrated by Defendants Roseworth and
Cambois. Rather, in support of its allegation of
control person liability against Creon, Sedona merely
states that “publicly-filed documents with the SEC
indicate that Roseworth and Cambois are whollyowned subsidiaries of Creon.” (Id. ¶ 160.) Therefore,
Defendant Creon's motion to dismiss Sedona's
Twelfth Claim for Relief as against Creon is granted
with leave to replead.
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its own under New York law, a rule that is wellsettled among the courts. See, e.g., Endovasc Ltd.,
Inc. v. J.P. Turner & Co., LLC, et al., No. 02 Civ.
7313(LAP), 2004 WL 634171, at *14 (S.D.N.Y. Mar.
20, 2004) (“There is no cognizable claim for the tort
of civil conspiracy in New York.”); Internet Law
Library, Inc. v. Southridge Capital Mgmt., LLC, 223
F.Supp.2d 474, 490 (S.D.N.Y.2002) (“It is wellsettled that New York law does not recognize an
independent cause of action for civil conspiracy.”).
However, New York law recognizes civil conspiracy
as a cause of action derivative of an underlying tort
claim. See Fisher v. Big Squeeze (N.Y.), Inc., 349
F.Supp.2d 483, 488 (E.D.N.Y.2004) (“A claim for
conspiracy to commit a tort is recognized in New
York only to the extent that the plaintiff well pleads
the underlying tort.”).
Here, Sedona asserts its civil conspiracy to commit
fraud claim against all Defendants in the action.
However, Sedona has only properly alleged securities
and common law fraud claims against Defendants
Ladenburg,
Rhino,
Badian,
Tohn,
Boris,
Vasinkevich, the Amro Defendants, Markham,
Pershing, Westminster, and Frankel. Thus, as to all
other Defendants, there can be no viable civil
conspiracy cause of action, and the Court accordingly
grants their motions to dismiss Plaintiff's Sixth Claim
for Relief, with leave to replead.
The Motions to Dismiss Sedona's Civil Conspiracy
Claim are Granted in Part
As for the Defendants against whom there remain
viable fraud claims, a properly pled claim for civil
conspiracy requires allegations of “(1) a corrupt
agreement between two or more persons, (2) an overt
act, (3) their intentional participation in the
furtherance of a plan or purpose, and (4) the resulting
damage.” Melnitzky v. Rose, 299 F.Supp.2d 219, 227
(S.D.N.Y.2003). Although Sedona has alleged
sufficiently an overt act of fraud with resulting
damage to Plaintiff, there are no allegations of an
express agreement among these particular Defendants
to intentionally participate in a conspiracy to defraud
Sedona. Nonetheless, “[t]he lack of an express
allegation of an agreement is not fatal to the
plaintiff[']s conspiracy claims. The courts have held
that disconnected acts, when taken together, may
satisfactorily establish a conspiracy.” First Fed. Sav.
& Loan Assoc. v. Oppenheim, Appel, Dixon & Co.,
629 F.Supp. 427, 443-44 (S.D.N.Y.1986).
The Supreme Court has noted that “a plaintiff [can]
bring suit for civil conspiracy only if he [has] been
injured by an act that was itself tortious.” Beck, II v.
Prupis, 529 U.S. 494, 501 (2000) (citations omitted).
There is no cognizable claim for civil conspiracy on
*18 Sedona asserts that “[t]he conspiracy is
evidenced by, among other things, the many
connections and interrelationships between the
defendants herein and the pattern of ‘death spiral’
financing schemes caused by the defendants and their
*17 As for the remaining Defendants named in the
claim, it cannot be said that Sedona has not alleged
control and culpable participation, particularly with
respect to Defendant signatories and representatives
of entities which were alleged fund managers and/or
holders of Sedona stock. Accordingly, the motions to
dismiss Sedona's Twelfth Claim for Relief as against
Defendants Rhino, Vasinkevich, Boris, Tohn, Smith,
Badian, Sims, the Batliner Defendants, Hassan, and
the UltraFinanz Defendants, are denied.
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affiliates.” (Compl.¶
134.) Indeed, Sedona's
allegations of (1) significant relationships between
Ladenburg, Vasinkevich, Tohn, Badian, Boris, and
Rhino prior to Ladenburg's affiliation with Sedona;
(2) Ladenburg and Vasinkevich's role in introducing
the Amro Defendants to Sedona as investors; (3)
Ladenburg having knowledge of Rhino's alleged
fraudulent activity in general; (4) Ladenburg and
Rhino as known manipulators of stock; and (5) the
trading relationships and knowledge of impropriety
between Westminster, Frankel, and Pershing, are
sufficient for an inference of a conspiracy.
Accordingly, the motion to dismiss Sedona's sixth
claim for relief is denied as to Ladenburg, Rhino,
Badian, Tohn, Boris, Vasinkevich, the Amro
Defendants, Markham, Pershing, Westminster, and
Frankel.
Sedona Has Not Adequately Pled Tortious
Interference with Contract and Tortious Interference
with Business Relations
In its third claim for relief, Sedona alleges that all
Defendants in the action have tortiously interfered
with certain of Sedona's contracts and with its
business relationships with other entities, as a result
of Defendants, “with knowledge and forethought,
dr[iving] down the price of Sedona's stock so much
that it precluded Sedona from obtaining additional
financing ... [and] from maximizing its ability to
profit from certain contracts.” (Compl. ¶ 120-21.)
Sedona's Complaint fails to plead sufficient facts to
state a cause of action in this regard. The third claim
will therefore be dismissed with leave to replead.
Tortious Interference with Contract
“[W]here there is an existing, enforceable contract
and a defendant's deliberate interference results in a
breach of that contract, a plaintiff may recover
damages for tortious interference with contractual
relations even if the defendant was engaged in lawful
behavior.” NBT Bancorp Inc. v. Fleet/Norstar Fin.
Group, Inc., 664 N.E.2d 492, 496 (N.Y.1996). The
elements of a properly pled tortious interference with
contract claim under New York law are: “(a) that a
valid contract exists; (b) that a third party had
knowledge of the contract; (c) that the third party
intentionally and improperly procured the breach of
the contract; and (d) that the breach resulted in
damage to the plaintiff.” Millar v. Ojima, 354
F.Supp.2d 220, 229-30 (E.D.N.Y.2005) (quoting
Finley v. Giacobbe, 79 F.3d 1285, 1294 (2d
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Cir.1996)). A plaintiff must also “identify a specific
contractual term that was breached.” Id. (quoting
Risley v. Rubin, 708 N.Y.S.2d 377, 378 (1st
Dep't.2000)). Further, allegations of causation are
required, as the plaintiff “must allege in the
complaint that there would not have been a breach
but for defendants' conduct.” Aim Int'l Trading,
L.L.C. v. Valcucine S.P.A., IBI, L.L.C., No. 02 Civ.
1363(PKL), 2003 WL 21203503, at *4 (S.D.N.Y.
May 22, 2003).
*19 In support of its tortious interference with
contract claim, Sedona alleges that Defendants drove
Sedona's stock price down “to such a level that it
[sic] substantially precluded SEDONA from
maximizing its ability to profit from certain contracts,
including those agreements with existing partners,
acquired targets such as Acxiom Corporation, and
potential partners, implementing various parts of its
business plan, completing transactions with third
parties or obtaining additional financing.” (Compl. ¶
120; see also id. ¶ 121.) Knowledge and causation
are alleged as follows: “Defendants ... knew or
should have known that their actions described above
would proximately cause SEDONA to be unable to
complete such business or financing transactions.”
(Id. ¶ 122.)
Plaintiff's allegations are plainly insufficient to
address the most basic elements of the tortious
interference with contract cause of action. Even if the
Court construed Sedona's references to “agreements
with existing partners, acquired targets such as
Acxiom Corporation, and potential partners” as
allegations identifying specific contracts, Sedona
fails to allege any breaches of those contracts. The
Complaint is also devoid of allegations that any
specific Defendants had knowledge of any specific
contracts, or that any Defendant intentionally and
improperly procured the breach of any contract.
Tortious Interference with Business Relations
“Where there has been no breach of an existing
contract, but only interference with prospective
contract rights, ... the plaintiff must show more
culpable conduct on the part of the defendant.” NBT
Bancorp Inc., 664 N.E.2d at 496 (citations omitted).
“[A]s a general rule, the defendant's conduct must
amount to a crime or an independent tort.” Carvel
Corp. v. Noonan, 818 N.E.2d 1100, 1103
(N.Y.2004). Under New York law, in order to plead a
valid claim of tortious interference with business
relations, Sedona must allege that “(1) there is a
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business relationship between the plaintiff and a third
party; (2) the defendant, knowing of that relationship,
intentionally interferes with it; (3) the defendant acts
with the sole purpose of harming the plaintiff, or,
failing that level of malice, uses dishonest, unfair, or
improper means; and (4) the relationship is injured.”
Discover Group, Inc. v. Lexmark Int'l, Inc., 333
F.Supp.2d 78, 86 (E.D.N.Y.2004) (quoting Goldhirsh
Group, Inc. v. Alpert, 107 F.3d 105, 108-09 (2d
Cir.1997)). Sedona must further allege “relationships
with specific third parties with which the
[defendants] interfered,” that those relationships were
“in existence at the time of the interference,” and
“how the defendant[s] interfered in those
relationships.” Aim Int'l, at *22.
Here, Sedona alleges that Defendants' actions
“interfered with the ... business relationships of
SEDONA with all entities who SEDONA intended
would become business partners, transaction targets
and/or financiers, and have jeopardized those
relationships and contracts and caused SEDONA to
lose credibility in those relationships.” (Compl.¶
123.) However, Sedona fails to identify which
particular business relationships it claims were
injured as a result of Defendants' alleged market
fraud and manipulation, and whether any of the
Defendants had knowledge of those relationships.
Sedona also fails to adequately allege in the
Complaint that the Defendants intentionally
interfered with those business relationships. Sedona's
third claim for relief is, accordingly, dismissed as to
all Defendants, with leave to replead.
Sedona's Breach of Contract Claim is Dismissed
*20 Sedona's breach of contract claim is dismissed
for the following reasons. In order to assert a valid
breach of contract claim, the “complaint need only
allege (1) the existence of an agreement, (2) adequate
performance of the contract by the plaintiff, (3)
breach of contract by the defendant, and (4)
damages.” Eternity Global Master Fund Ltd. v.
Morgan Guar. Trust Co. of New York, 375 F.3d 168,
177 (2d Cir.2004) (quoting Harsco Corp. v. Segui, 91
F.3d 337, 347 (2d Cir.1996)); Internet Law Library,
Inc. v. Southridge Capital Mgmt., LLC, et al, 223
F.Supp.2d 474, 490 (S.D.N.Y.2002). The complaint
must also “allege the provisions of the contract upon
which the claim is based.” Valley Cadillac Corp. v.
Dick, 661 N.Y.S.2d 105, 106 (4th Dep't.1997). Thus,
“at a minimum, the terms of the contract, each
element of the alleged breach and the resultant
damages,” must be alleged. Kaplan v. Aspen Knolls
Page 16
Corp., 290 F.Supp.2d 335, 337 (E.D.N.Y.2003).
Although a plaintiff is required only to make a “short
and plain statement” of the breach of contract claim
pursuant to Rule 8(a)(2), the plaintiff still must “give
the defendant fair notice of what plaintiff's claim is
and the grounds upon which it rests.” Swierkiewicz v.
Sorema N.A., 534 U.S. 506, 515 (2002) (quoting
Conley v. Gibson, 355 U.S. 41, 47 (1957)).
In its seventh claim for relief, Sedona alleges that
Defendants Ladenburg, Markham, Aspen, Boris, and
the Amro Defendants were in material breach of
various written and oral agreements. Specifically,
Sedona claims that Ladenburg and the Ladenburg
Investors “failed to fully fund [the] contract”
underlying the Engagement Letter up to $50 million
dollars. (Compl.¶ 136.) In addition, Sedona alleges
that Ladenburg and the Ladenburg Investors
breached most of their oral and written agreements
with Sedona, and that they engaged in unspecified
“acts that were not in the best interest of Sedona.”
(Id. ¶ 137.)
With regard to the Engagement Letter, to the extent
Ladenburg and Boris are the only signatories thereon,
Sedona has adequately pled three of the four required
elements of a breach of contract claim. The
Complaint alleges the existence of the Engagement
Letter, that Ladenburg and Boris breached the
agreement through their failure to procure the $50
million dollar funding, and that Sedona was
“damaged in the amount of at least $160 million by
defendants' breach of contract, in addition to
attorney's fees and interest pursuant to the contract
transactional documents.” FN13 (Id. ¶ 138.) However,
the Complaint fails to allege that Sedona adequately
performed under the contract. Therefore, the Court
dismisses the breach of contract claim as against the
named Defendants herein without prejudice, to the
extent the claim includes a breach of the Engagement
Letter, with leave to replead.
FN13. The Complaint is not clear, however,
as to whether the damages pled represent the
aggregate total damages from all the alleged
breaches, made by all the defendants.
“Oral and Written Agreements”
Although Sedona provides a laundry list of alleged
breaches, the Court, and the Defendants, are left to
guess which of myriad alleged oral and written
agreements Ladenburg, Boris, Markham, Aspen, and
the Amro Defendants are charged with breaching,
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much less what specific provisions of those
agreements were breached. In addition to not
identifying which agreements are referred to in this
claim for relief, Sedona states that “most,” but not all
of the agreements, were breached thus leaving the
reader confused as to both the identity and terms of
the specific agreements and which of the defendants
were alleged to have entered into them. Hence, the
Complaint does not provide Markham, Aspen, the
Amro Defendants, and Ladenburg and Boris, in
relation to contracts other than the Engagement
Letter, with sufficient notice of the breach of contract
charges lodged against them.
existing circumstances;
(c) ... representation or statement which is false,
where the person who made such representation or
statement; (i) knew the truth; or (ii) with reasonable
effort could have known the truth; or (iii) made no
reasonable effort to ascertain the truth; or (iv) did not
have knowledge concerning the representation or
statement made; where engaged in to induce or
promote the issuance, distribution, exchange, sale,
negotiation or purchase within or from this state of
any securities ..., regardless of whether issuance,
distribution, exchange, sale, negotiation or purchase
resulted.
*21 Accordingly, the Defendants' motions to dismiss
Plaintiff's breach of contract claim are granted, but
Plaintiff has leave to replead.
N.Y. Gen. Bus. Law § 352-c(1) (McKinney 1996).
Sedona's Negligence, Negligent Misrepresentation,
and Breach of Fiduciary Duty Claims Fail as a
Matter of Law
Defendants Ladenburg, Markham, Rhino, and the
Amro Defendants assert that Sedona's common law
claims are precluded by the Martin Act, N.Y. Gen.
Bus. Law, Art. 23-A, § 352 (McKinney 1996),
which is New York State's securities, or “blue sky,”
law. Plaintiff contends that the Martin Act should not
apply herein because, for example, the alleged
negligent misrepresentations “were not made in
connection with the purchase or sale of securities in
New York, as they (i) were made to Sedona at its
Pennsylvania offices and (ii) involved, among other
things, the legitimacy of defendants and whether or
not the manipulative actions were taking place.”
(Compl.¶ 154.) It is true that a necessary prerequisite
for a Martin Act preemption of a common law
securities fraud claim is that the underlying
transaction was “within or from” New York. N.Y.
Gen. Bus. Law §
352-c(1); Lehman Bros.
Commercial Corp. v. Minmetals Int'l Non-Ferrous
Metals Trading Co., 179 F.Supp.2d 159, 162
(S.D.N.Y.2001) (recognizing that a finding “that the
transactions were ... “within or from” New York, [is]
a nexus expressly required under the Martin Act”).
The scope of the Martin Act, however, includes more
the actual purchase or sale of securities within or
from New York. Related investment advice and
negotiation over securities are activities within the
Martin Act's purview, as are any
(a) ... fraud, deception, concealment, suppression,
false pretense ...;
(b) ... promise or representation as to the future which
is beyond reasonable expectation or unwarranted by
According to the Complaint, much of the activity
Plaintiff
alleges
involved
negligence,
misrepresentations, or breach of fiduciary duty
occurred in the course of investment advice and
negotiations concerning securities, such as the
convertible debentures and related agreements. For
example, allegedly negligent misrepresentations
included misrepresentations as to “the meritorious
nature of the advisory and consulting services
performed by Ladenburg.” (Compl.¶ 154.) Next,
with respect to the negligence claim, Sedona alleges
that Ladenburg was negligent in its duty “to negotiate
on behalf of Sedona, to advise Sedona with respect to
negotiations engaged in directly by Sedona regarding
contract terms which would be in the best interest of
Sedona, [as well as] to monitor trading activities in
Sedona stock and to advise Sedona regarding such
trading activities.” (Id. ¶ 151.) Finally, in Plaintiff's
breach of fiduciary duty claim, Sedona alleges that
Ladenburg breached its duty to provide the
investment and financial advisory services detailed in
its engagement letter. (Id. ¶ 144.)
*22 The Complaint alleges that Ladenburg, an entity
situated in New York, conducted many of the
complained of transactions with Sedona via
telephone and mailings (including the Engagement
Letter) from New York. In addition, the underlying
securities, though registered to Sedona, a
Pennsylvania company, were allegedly manipulated
and sold short in New York markets. Further, in
alleging proper venue in the Complaint, Sedona
states that “a substantial part of the events or
omissions giving rise to the claims herein occurred in
[the Southern District of New York].” (Id. ¶ 31.)
Thus, on the face of the Complaint, the allegations
Sedona uses as the foundation for its common law
claims involve activity contemplated by the Martin
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Act, and that have a sufficient nexus with New York.
Cf. Lehman Bros. Commercial Corp., 179 F.Supp.2d
at 165 (determining that the negotiation of the sale of
securities between traders located in London, Hong
Kong, and Beijing did not meet the Martin Act
requirement of within or from New York).
Plaintiff further argues that, even if the conduct on
which its common law claims are based fall within
the scope of the Martin Act, Plaintiff's claims are not
preempted by that Act. Plaintiff cites the decisions in
Scalp & Blade, Inc. v. Advest, Inc., 722 N.Y.S.2d
639, 640 (4th Dep't.2001), and Cromer Fin. Ltd. v.
Berger, No. 00 Civ. 2498(DLC), 2001 WL 1112548,
at *4 (S.D.N.Y. Sept. 19, 2001), which held that the
Martin Act did not abrogate claims of breach of
fiduciary duty and negligent misrepresentation (Scalp
& Blade ), and negligence and gross negligence
(Cromer ). See Scalp & Blade, 722 N.Y.S.2d at 640
(“Nothing in the Martin Act ... precludes a plaintiff
from maintaining common-law causes of action
based on such facts as might give the Attorney
General a basis for proceeding civilly or criminally
against a defendant under the Martin Act.”); Cromer,
at *4 (“[T]here is nothing ... in the text of the Martin
Act itself to indicate an intention to abrogate
common law causes of action.”). The Cromer and
Scalp & Blade decisions have, however, been
described as “solitary islands in a stream of contrary
opinion.” Nanopierce Techs., Inc. v. Southridge
Capital Mgmt. LLC, No. 02 Civ. 0767(LBS), 2003
WL 22052894, at *4 (S.D.N.Y. Sept. 2, 2003). Both
Scalp & Blade' s and Cromer' s determinations that
the text of the Martin Act does not include support
for preclusion of common law claims are
insufficiently persuasive in the face of substantial
contrary authority.
The Martin Act provides the New York AttorneyGeneral with the sole discretion to investigate
securities violations within or from the state of New
York. See N.Y. Gen. Bus. Law § 352(1). Allowing
private plaintiffs to pursue a related cause of action
“is not consistent with the legislative scheme
underlying the Martin Act .” CPC Int'l Inc. v.
McKesson Corp., 514 N.E.2d 116, 119 (N.Y.1987).
In particular, causes of action related to a plaintiff's
securities fraud claim that do not include scienter as
an essential element are typically preempted by the
Martin Act, in contrast to a claim requiring intent,
such as a claim for common law fraud. See, e.g.,
Nanopierce, at *4 (“[N]egligent misrepresentation
and breach of fiduciary duty claims ... like the Martin
Act itself, do not require proof of deceitful intent;
common law fraud, however, does.”) This is because
Page 19 of 96
Page 18
allowing a plaintiff to go forward on such a claim
“would effectively permit a private action under the
Martin Act.” Dujardin v. Liberty Media Corp., 359
F.Supp.2d 337, 355 (S.D.N.Y.2005). Indeed, the
weight of authority holds that common law claims of
negligent misrepresentation, negligence, and breach
of fiduciary duty arising from securities fraud are
preempted by the Martin Act. See, e.g., Dujardin,
359 F.Supp.2d at 354-55 (dismissing a negligent
misrepresentation claim as preempted by the Martin
Act); Marcus v. Frome, 329 F.Supp.2d 464, 475-76
(S.D.N.Y.2004) (same); Spirit Partners, L.P. v.
audiohighway.com, No. 99 Civ. 9020(RJW), 2000
WL 685022, at *6 (S.D.N.Y. May 25, 2000) (same);
Nairobi Holdings Ltd. v. Brown Bros. Harriman &
Co., No. 02 Civ. 1230(LMM), 2002 WL 31027550,
at *10 (S.D.N.Y. Sept. 10, 2002) (same); Nanopierce,
at *2-*3 (same); Gabriel Capital, L.P. v. Natwest
Fin.,
Inc.,
137
F.Supp.2d
251,
266-67
(S.D.N.Y.2000) (dismissing a negligence claim as
violative of the Martin Act); Nairobi Holdings Ltd. v.
Brown Bros. Harriman & Co., No. 02 Civ.
1230(LMM), 2002 WL 31027550, at *10 (S.D.N.Y.
Sept. 10, 2002) (dismissing a breach of fiduciary
claim as violative of the Martin Act); Bibeault v.
Advanced Health Corp., No. 97 Civ. 6026(RJW),
1999 WL 301691, at *10 (same), disagreed with on
other grounds by Fin. One Pub. Co. Ltd. v. Lehman
Bros. Special Fin., Inc., __ F.3d __, 2005 WL
1619852, at *6 (2d Cir. July 12, 2005). Further, the
Second Circuit has considered the preclusive nature
of the Martin Act and determined that “principles of
federalism and respect for state courts' interpretation
of their own laws counsel against ignoring the rulings
of those New York courts that have taken up the
issue.” Castellano v. Young & Rubicam, Inc., 257 F
.3d 171, 190 (2d Cir.2001) (upholding district court
dismissal of a breach of fiduciary duty claim pursuant
to the Martin Act).
*23 In light of myriad holdings supporting
preemption, as well as this Court's recent decision in
Dujardin v. Liberty Media Corp., 359 F.Supp.2d 337
(S.D.N.Y.2005), the Court declines Plaintiff's request
to follow the Cromer and Scalp & Blade decisions
with respect to its common law claims sounding in
negligence and breach of fiduciary duty, and
accordingly dismisses Plaintiff's Ninth, Tenth, and
Eleventh Claims For Relief as precluded by the
Martin Act.
Sedona May Not Assert A Claim for Relief Pursuant
to Section 15(c)(1) of the Exchange Act
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Not Reported in F.Supp.2d
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(Cite as: Not Reported in F.Supp.2d)
In its Eighth Claim for Relief, Sedona seeks
disgorgement of profits Defendants made from their
allegedly fraudulent conduct, and restitution for the
damages Sedona incurred as a result of such alleged
conduct. Sedona asserts this claim under three
separate sections of the Exchange Act: (1) Section
3(a)(4)-(5) of the Exchange Act, as amended 15
U.S.C. §
78c(a)(4)-(5), which provides the
definitions for the terms “broker” and “dealer”; (2)
Section 28(a) of the Exchange Act, as amended 15
U.S.C. 78bb(a), which states that the “rights and
remedies provided by [the Exchange Act] shall be in
addition to any and all other rights and remedies that
may exist at law or in equity”; and (3) Section
15(c)(1), as amended 15 U.S.C. § 78o(c)(1), which
prohibits brokers and dealers from using fraudulent
means to “effect any transaction in, or to induce or
attempt to include the purchase or sale of, any
security ... otherwise than on a national securities
exchange of which it is a member.”
Here, the Court need not address the issues of
whether the Defendants in this action are “brokers”
and/or “dealers” as defined by the statute, and if so,
whether those Defendants have conducted
transactions proscribed by Section 15(c)(1). The
Second Circuit has made clear that Section 15(c)(1)
“does not create a private cause of action.” Philips,
Appel & Walden, Inc., 867 F.2d 776, 777 (2d
Cir.1989). While there is case law in this district
suggesting that a party may go forward on a Section
15(c)(1) cause of action, those decisions were
rendered in the context of actions brought by the
SEC, which is a government entity, rather than a
private litigant. See, e.g., SEC v. Tanner, No. 02 Civ.
0306(WHP), 2003 WL 21523978 (S.D.N.Y. July 3,
2003);
SEC
v.
Follick,
No.
00
Civ.
4385(KMW)(GWG), 2002 WL 31833868 (S.D.N.Y.
Dec. 18, 2002). The Court therefore dismisses
Sedona's eighth cause of action in its entirety, with
prejudice.
Further, to the extent Sedona seeks disgorgement
solely as a remedy under its federal securities fraud
claims, since the Court has dismissed the underlying
claims as to certain Defendants, Sedona may not seek
such remedy as to those Defendants on its current
pleading. See Follick, at *8 (“As for the possibility of
disgorgement, the appropriateness of this remedy is
properly determined only in the event [a defendant] is
found liable for the violations of the securities
laws.”).
Plaintiff's Motions to Lift the PSLRA Discovery Stay
Page 19
are Denied as Moot
*24 Also before the Court are Plaintiff's three
separate motions to lift the automatic discovery stay
imposed under the PSLRA during the pendency of a
motion to dismiss. Pursuant to the PSLRA,
In any private action arising under this chapter, all
discovery and other proceedings shall be stayed
during the pendency of any motion to dismiss, unless
the court finds upon the motion of any party that
particularized discovery is necessary to preserve
evidence or to prevent undue prejudice to that party.
15 U.S.C.A. § 78u-4(b)(3)(B) (West 2005). The
instant opinion and order resolves all of the pending
motions to dismiss. Accordingly, Plaintiff's motions
to lift the PSLRA discovery stay are denied as
moot.FN14 See, e.g., In re Sterling Foster & Co., Inc.,
Sec. Litig., 222 F.Supp.2d 216, 288 (E.D.N.Y.2002)
(finding moot Plaintiff's motion to lift the PSLRA
automatic discovery stay since there were no longer
any pending motions remaining in the litigation).
FN14. This Order denies as moot all of
Plaintiff's motions to lift the PSLRA
discovery stay, which have been docketed as
numbers 155, 189, and 206.
Plaintiff's Request to Replead is Granted
The aforementioned defects in the Complaint may be
cured if Plaintiff repleads certain claims for relief in
accordance
with
the
applicable
pleading
requirements. The Court is accordingly granting
Plaintiff's request to replead, within 20 days from the
date of this Opinion and Order, those claims and
causes of action that have been dismissed without
prejudice. See, e.g., Olsen v. Pratt & Whitney
Aircraft, A Div. of United Technologies Corp., 136
F.3d 273, 276 (2d Cir.1998) (“Plaintiffs whose
complaints are dismissed pursuant to Rule 9(b) are
typically given an opportunity to amend their
complaint.”)
CONCLUSION
For the foregoing reasons, Defendants' motions to
dismiss Plaintiff's Claims for Relief are denied in part
and granted in part as follows: (1) Defendant
Ladenburg's motion to dismiss is granted as to
Claims for Relief Three, Four, Seven, Eight, Nine,
Ten, and Eleven, and denied as to Claims for Relief
One, Two, Five, and Six; (2) Defendant Rhino's
© 2006 Thomson/West. No Claim to Orig. U.S. Govt. Works.
Case 5:04-cv-04156-JW
Document 133
Filed 11/17/2006
Not Reported in F.Supp.2d
Not Reported in F.Supp.2d, 2005 WL 1902780 (S.D.N.Y.)
(Cite as: Not Reported in F.Supp.2d)
motion to dismiss is granted as to Claims for Relief
Three, Four, Eight, and Eleven, and denied as to
Claims for Relief One, Two, Five, Six, and Twelve;
(3) the Amro Defendants' motions are granted as to
Claims for Relief One, Three, Four, Five, Seven,
Eight, and Eleven, and denied as to Claims for Relief
Two, and Six; (4) Pershing's motion to dismiss is
granted as to Claims for Relief Three, Four, and
Eight, and denied as to Claims for Relief Two and
Six; (5) Westminster's motion to dismiss is granted as
to Claims for Relief Three, Four, and Eight, and
denied as to Claims for Relief Two and Six; (6)
Frankel's motion to dismiss is granted as to Claims
for Relief Three, Four, and Eight, and denied as to
Claims for Relief Two and Six; (7) Markham's
motion to dismiss is granted as to Claims for Relief
One, Three, Four, Five, Seven, Eight, and Eleven,
and denied as to Claims for Relief Two and Six; (8)
the UltraFinanz Defendants' motions to dismiss are
granted as to Claims for Relief Two, Three, Four,
Six, and Eight, and denied as to Claim for Relief
Twelve; (9) the Batliner Defendants' motions to
dismiss are granted as to as to Claims for Relief Two,
Three, Four, Six, and Eight, and denied as to Claim
for Relief Twelve; (10) Creon's motion to dismiss is
granted as to all Claims for Relief asserted against it;
(11) Badian's motion to dismiss is granted as to
Claims for Relief Two, Three, Four, and Eight, and
denied as to Claims for Relief One, Five, Six, and
Twelve; (12) Tohn's motion to dismiss is granted as
to Claims for Relief Two, Three, Four, and Eight, and
denied as to Claims for Relief One, Five, Six, and
Twelve; (13) Boris' motion to dismiss is granted as to
as to Claims for Relief One, Three, Four, Five,
Seven, and Eight, and denied as to Claims for Relief
Two, Six, and Twelve; (14) Vasinkevich's motion to
dismiss is granted as to as to Claims for Relief Two,
Three, Four, and Eight, and denied as to Claims for
Relief One, Five, Six, and Twelve; (15) Smith's
motion to dismiss is granted as to as to Claims for
Relief One, Two, Three, Four, Five, Six, and Eight,
and denied as to Claim for Relief Twelve; (16) Sims'
motion to dismiss is granted as to all Claims for
Relief asserted against him, except for Claim for
Relief Twelve, which is denied; and (17) Hassan's
motion to dismiss is granted as to as to Claims for
Relief Two, Three, Four, Six, and Eight, and denied
as to Claim for Relief Twelve.
Page 21 of 96
Page 20
Opinion and Order to file and serve an amended
complaint repleading those causes of action that are
dismissed without prejudice. If no such timely
amended pleading is served and filed with respect to
a claim or cause of action, such claim or cause of
action will be dismissed with prejudice and without
further advance notice.
SO ORDERED.
S.D.N.Y.,2005.
Sedona Corp. v. Ladenburg Thalmann & Co., Inc.
Not Reported in F.Supp.2d, 2005 WL 1902780
(S.D.N.Y.)
END OF DOCUMENT
*25 Defendants Tohn, Vasinkevich, and Smith's
motions for costs and disbursements in this action are
denied. Plaintiff's motions for partial relief from the
PSLRA discovery stay are denied as moot.
Plaintiff is given 20 days from the date of this
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Filed 11/17/2006
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Document 133
Filed 11/17/2006
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Not Reported in F.Supp.2d
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(Cite as: Not Reported in F.Supp.2d)
Briefs and Other Related Documents
In
re
Silicon
Storage
Technology,
Inc.N.D.Cal.,2006.Only the Westlaw citation is
currently available.
United States District Court,N.D. California.
In re SILICON STORAGE TECHNOLOGY, INC.,
SECURITIES LITIGATION.
No. C 05-0295 PJH.
March 10, 2006.
Patrick J. Coughlin, Azra Z. Mehdi, Darren J.
Robbins, William S. Lerach, Lerach Coughlin Stoia
Geller Rudman & Robbins LLP, Christopher T.
Heffelfinger, Julie Juhyun Bai, Berman Devalerio
Pease & Tabacco, P.C., Joseph J. Tabacco, Jr., Nicole
Lavallee, Berman Devalerio Pease Tabacco Burt &
Pu, San Francisco, CA, Jason S. Cowart, Marc I.
Gross, Stanley M. Grossman, Patrick V. Dahlstrom,
Pomerantz Haudek Block Grossman & Gross LLP,
New York, NY, for James M. Baker on Behalf of
Himself and all others Similarly Situated, Louisiana
District Attorneys' Retirement System.
Eunice Jooyoun Lee, Jonathan B. Gaskin, Robert P.
Varian, Orrick, Herrington & Sutcliffe LLP, San
Francisco, CA, for Silicon Storage Technology Inc.
ORDER GRANTING MOTION TO DISMISS
PHYLLIS J. HAMILTON, J.
*1 THIS ORDER RELATES TO: ALL ACTIONS
Defendants' motion to dismiss the consolidated
amended complaint came on for hearing before this
court on January 18, 2006. Plaintiffs appeared by
their counsel Jason S. Cowart, and defendants
appeared by their counsel Robert P. Varian and
Jonathan B. Gaskin. Having read the parties' papers
and carefully considered their arguments, and good
cause appearing, the court hereby GRANTS the
motion as follows
INTRODUCTION
This is a proposed class action alleging violations of
the federal securities laws. The plaintiff class consists
of all those who purchased shares of common stock
in defendant Silicon Storage Technology, Inc. (SST)
from April 21, 2004, to December 20, 2004.
Page 1
Plaintiffs allege that SST and six of its officers or
former officers-defendants Bing Yeh, Yaw Wen Hu,
Jack K. Lai, Yasushi Chikagami, Isao Nojima, and
Derek Best-misled investors by overstating SST's
inventory value, by making false statements about the
company's sales prices, and by failing to disclose that
the company lacked adequate internal controls to
ensure that inventory was properly valued. Plaintiffs
assert that they were harmed when SST's stock price
fell more than 22.5%, following an announcement
that SST would write down the value of a portion of
its inventory.
The consolidated amended class action complaint
(“CAC”) alleges a cause of action for violation of §
10(b) of the Securities Exchange Act of 1934, 15
U.S.C. § 78j(b), and related Rule 10b-5, 17 C.F.R. §
240.10b-5, against all defendants; and for violation of
§ 20(a) of the Exchange Act, 15 U.S.C. § 78t(a),
against the six individual defendants.
BACKGROUND
SST is based in Sunnyvale, California, where it
operates three major facilities. According to periodic
reports filed by SST with the SEC, the company is a
leading supplier of “flash memory” semiconductor
devices for the digital consumer, including
networking, wireless communications, and Internet
computing markets. SST offers over 90 products
based on its “Super-Flash” design and manufacturing
process technology, and also licenses its technology
to leading semiconductor companies for use in
various applications. Revenue from the sale of these
products contributed approximately 50% of the
company's revenue during the proposed class period.
During the proposed class period, defendant Bing
Yeh (“Yeh”) was SST's President and Chief
Executive Officer; defendant Yah Wen Hu (“Hu”)
was SST's Executive Vice President and Chief
Operating Officer; defendant Derek Best (“Best”)
was Senior Vice President for Sales and Marketing;
defendant Yasushi Chikagami (“Chikagami”) was an
outside director; defendant Isao Nojima (“Nojima”)
was Senior Vice President, Standard Memory
Product Group; and defendant Jack K. Lai (“Lai”)
was Chief Financial Officer.
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Not Reported in F.Supp.2d
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Plaintiffs allege that throughout the class period,
defendants made materially misleading statements
concerning the value of SST's inventory, which in
turn caused the company's statements of gross profit,
net income, and total assets to be materially
misleading. Plaintiffs claim that defendants knew or
should have known that prices of competing flash
memory products sold by Intel and AMD had been
declining during the class period, that SST's
inventory should have been valued at levels well
below those reported by defendants, and that the
company's gross profits, net income, and total assets
were therefore overstated.
*2 Plaintiffs allege that defendants failed to disclose
that SST's valuation system lacked sufficient controls
to ensure accuracy, and that its valuation process was
completely arbitrary. Plaintiffs assert that “the truth
began to emerge” after the market closed on
December 20, 2004, at which point SST announced it
would write down the value of its inventory by $20$25 million. On this news, the price of the company's
shares, which had closed at $7.01 before the
announcement, fell to a low of $5.43 the following
day, a drop of 22 .5%.
DISCUSSION
A. Legal Standard
A court should dismiss under Federal Rule of Civil
Procedure 12(b)(6) for failure to state a claim only
where it appears beyond doubt that plaintiff can
prove no set of facts in support of the claim which
would entitle the plaintiff to relief. Conley v. Gibson,
355 U.S. 41, 45-46, 78 S.Ct. 99, 2 L.Ed.2d 80 (1957);
Williamson v. Gen'l Dynamics Corp., 208 F.3d 1144,
1149 (9th Cir.2000). All allegations of material fact
are taken as true and construed in the light most
favorable to the nonmoving party. Gompper v. VISX.
Inc., 298 F.3d 893, 895 (9th Cir.2002).
Review is generally limited to the contents of the
complaint. Allarcom Pay Television. Ltd. v. Gen.
Instrument Corp., 69 F.3d 381, 385 (9th Cir.1995).
However, material that is properly presented to the
court as part of the complaint may be considered as
part of a motion to dismiss. Lee v. City of Los
Angeles, 250 F.3d 668, 688-89 (9th Cir.2001). If a
plaintiff fails to attach to the complaint the
documents on which it is based, defendant may attach
to a Rule 12(b)(6) motion the documents referred to
in the complaint to show that they do not support
Page 2
plaintiff's claim. Id. In addition, whether requested or
not, the court may take judicial notice of facts that are
capable of accurate and ready determination by resort
to sources whose accuracy cannot be questioned. See
Fed.R.Evid. 201; see also In re Silicon Graphics,
Inc., Sec. Litig., 183 F.3d 970, 986 (9th Cir.1999).
B. Defendants' Motion to Dismiss
Defendants seek an order dismissing the CAC for
failure to state a claim. Section 10(b) of the Securities
Exchange Act provides, in part, that it is unlawful “to
use or employ in connection with the purchase or sale
of any security registered on a national securities
exchange or any security not so registered, any
manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the
[SEC] may prescribe.” 15 U.S.C. § 78j(b).
SEC Rule 10b-5, promulgated under the authority of
§ 10(b), makes it unlawful for any person to use
interstate commerce
(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 the 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.
*3 17 C.F.R. § 240.10b-5.
To plead securities fraud under Section 10(b) of the
1934 Act, plaintiffs must allege (1) a misstatement or
omission (2) of material fact (3) made with scienter
(4) on which plaintiffs relied (5) which proximately
caused the plaintiffs' injury. DSAM Global Value
Fund v. Altris Software, Inc., 288 F.3d 385, 388 (9th
Cir.2002). Similarly, the elements of a Rule 10b-5
claim are (1) a material misrepresentation (2) made
with scienter (3) in connection with the purchase or
sale of a security, (4) transaction and loss causation,
and (5) economic loss. In re Daou Sys., Inc., Sec.
Litig., 411 F.3d 1006, 1014 (9th Cir.2005).
Under § 20(a) of the 1934 Act, joint and several
liability can be imposed on persons who directly or
indirectly control a violator of the securities laws. 15
U.S.C. § 78t(a). Violation of § 20(a) is predicated
on a primary violation under the 1934 Act.
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Page 25 of 96
Not Reported in F.Supp.2d
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Heliotrope Gen'l, Inc. v. Ford Motor Co., 189 F.3d
971, 978 (9th Cir.1999). Plaintiffs alleging a claim
that individual defendants are “controlling persons”
of a company must allege 1) that the individual
defendants had the power to control or influence the
company, 2) that the individual defendants were
culpable participants in the company's alleged illegal
activity, and 3) that the company violated the federal
securities laws. Durham v. Kelly, 810 F.2d 1500,
1503-04 (9th Cir.1987); see also Howard v. Everex
Sys., Inc., 228 F.3d 1057, 1065 (9th Cir.2000).
Defendants argue that the § 10-b claim should be
dismissed for failure to allege fraud with
particularity, and that the § 20 claim should be
dismissed because plaintiffs fail to state a claim for
primary liability. Defendants also contend that
dismissal is required because the facts before the
court demonstrate that the inventory write-down
could not have taken place prior to the fourth quarter
of 2004, because the demand for and pricing of flash
memory had been increasing, while SST's cost had
been declining. Defendants assert the fact that the
write-down was appropriate in 4Q 2004 but not
before is also confirmed by an audit completed by
PricewaterhouseCoopers after the December 20,
2004, announcement.
Generally, the Federal Rules of Civil Procedure
require that a plaintiff in federal court give a short,
plain statement of the claim sufficient to put the
defendant on notice. See Fed.R.Civ.P. 8(a). However,
Rule 9 imposes a particularized pleading requirement
on a plaintiff alleging fraud or any claim premised on
fraud. See Fed.R.Civ.P. 9(b) (in actions alleging
fraud, “the circumstances constituting fraud or
mistake shall be stated with particularity”).
Under Rule 9(b), the complaint must allege specific
facts regarding the fraudulent activity, such as the
time, date, place, and content of the alleged
fraudulent representation, how or why the
representation was false or misleading, and in some
cases, the identity of the person engaged in the fraud.
In re GlenFed Sec. Litig., 42 F.3d 1541, 1547-49 (9th
Cir.1994). Because the plaintiff must set forth what is
false or misleading about a particular statement, he
must do more than simply allege the neutral facts
necessary to identify the transaction; he must also
explain why the disputed statement was untrue or
misleading at the time it was made. Yourish v.
California Amplifier, 191 F.3d 983, 992-93 (9th
Cir.1999).
Page 3
the Private Securities Litigation Reform Act
(“PSLRA”), which was enacted by Congress in 1995
to establish uniform and stringent pleading
requirements for securities fraud actions, and “to put
an end to the practice of pleading ‘fraud by
hindsight.” In re Silicon Graphics, 183 F.3d at 958.
The PSLRA heightened the pleading requirements in
private securities fraud litigation by requiring that the
complaint plead both falsity and scienter with
particularity. In re Vantive Corp. Sec. Litig., 283 F.3d
1079, 1084 (9th Cir.2002); see also In re Daou Sys.,
411 F.3d at 1014. If the complaint does not satisfy
these pleading requirements, the court, upon motion
of the defendant, must dismiss the complaint. 15
U.S.C. § 78u-4(b)(3)(A).
1. Falsity
Defendants argue that the CAC does not adequately
allege falsity because it does not plead facts showing
that the alleged false statements were false when
made. Under the PSLRA-whether alleging that a
defendant “made an untrue statement of a material
fact” or alleging that a defendant “omitted to state a
material fact necessary in order to make the
statements made, in the light of the circumstances in
which they were made, not misleading”-the
complaint must specify each statement alleged to
have been false or misleading, specify the reason or
reasons why each such statement is misleading, and,
if an allegation regarding the statement or omission is
made on information and belief, state with
particularity all facts on which that belief is formed.
15 U.S.C. § 78u-4(b)(1).
Plaintiffs allege that defendants made false and
misleading statements concerning SST's sales prices,
inventory values, and accounting controls during the
class period, in connection with the release of SST's
quarterly financial returns for the first, second, and
third quarters of fiscal year 2004, as follows: On
April 21, 2004, the first day of the class period, SST
stated in a press release that its inventory was worth
$69.9 million as of the end of the first quarter of
2004.FN1 On May 7, 2004, SST filed its Form 10-Q
for 1Q 2004 with the SEC. The Form 10-Q, which
was signed by Yeh and Lai, repeated the statement
that SST's inventory was worth $69.9 million as of
the end of 1Q 2004. The 10-Q also stated that the
company's gross profit in the first quarter had been
$38.1 million, that its net income had been $14.2
million, and that its total assets were $435 million.
See CAC ¶ 53.
*4 This case is also controlled by the provisions of
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Not Reported in F.Supp.2d
Not Reported in F.Supp.2d, 2006 WL 648683 (N.D.Cal.)
(Cite as: Not Reported in F.Supp.2d)
FN1. The CAC alleges that Yeh also held a
conference call on April 21, 2004, in which
he stated that SST had experienced
“firming” sales prices in the first quarter of
2004 and that the company expected SST's
average selling prices to “continue to
improve” in the second quarter. However, at
the hearing, plaintiffs' counsel indicated that
plaintiffs did not include this statement as
one of the allegedly false and misleading
statements.
On July 21, 2004, defendants allegedly announced in
a press release that average selling prices were
“firming” in 2Q 2004, and that the value of SST's
inventory had increased from $69.9 million in 1Q
2004 to $91 million in 2Q 2004. On August 5, 2004,
SST filed its Form 10-Q for 2Q 2004 with the SEC.
The Form 10-Q, which was signed by Yeh and Lai,
repeated the statement that the value of SST's
inventory was $91 million as of the end of 2Q 2004.
The 10-Q also stated that SST's gross profit in 2Q
2004 had been $48.7 million, that its net income had
been $22 million, and that its total assets were $466
million. See CAC ¶ 58.
*5 On October 20, 2004, SST issued a press release
announcing its results for 3Q 2004. The company
stated that revenue had decreased to $112.2 and that
average sales prices had declined by 7 per cent. It
also stated that the value of SST's inventory was $138
million. In a conference call held the same day, Yeh
allegedly stated that SST had no intention of writing
down its inventory for the fourth quarter of 2004. On
November 15, 2004, SST filed its Form 10-Q for 3Q
2004 with the SEC. The Form 10-Q, which was
signed by Yeh and Lai, repeated the statements that
revenue had decreased to $112.2 million, that average
sales prices had declined by 7 per cent, and that SST's
inventory was valued at $138 million. The 10-Q also
stated that SST's gross profit in 3Q 2004 had been
$39.5 million, that its net income had been $14.5
million, and that its total assets were $482.2 million.
See CAC ¶ ¶ 67, 69, 73.
Plaintiffs allege that these statements were false and
misleading because the value of SST's inventory was
actually less than the amounts stated-$69.9 million in
1Q 2004, $91 million in 2Q 2004, and $138 million
in 3Q 2004-and that consequently, SST's gross profit,
net income, and total assets were less than the
amounts stated. CAC ¶ ¶ 54, 59, 70. They also assert
that the statement that SST did not plan to write
down its inventory in 4Q 2004 was false and
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Page 4
misleading because defendants knew or should have
known that the prices of flash memory manufactured
by SST's competitors AMD and Intel had been
declining during the first three quarters of 2004, that
the value that was assigned to SST's flash memory
was inflated, and that SST would soon have to write
down the value of its inventory. CAC ¶ 74.
In the present motion, defendants assert that the claim
of fraud alleged in the CAC-that defendants
defrauded investors by not announcing the intended
write-down earlier than they did-was based solely on
SST's announcement in December 2004 that it would
take an inventory write-down due to changed market
conditions, and provides a classic example of
pleading “fraud by hindsight.” Defendants contend
that the CAC fails to allege falsity because it does not
specify why, how, or by how much the inventory
valuations allegedly exceeded the “correct”
valuations; does not indicate what valuation might
have been required at a given time; does not identify
any product, or class of products or components in
SST's inventory; provides no allegations as to the
cost or market price at which any product or
component was, or should have been, carried on
SST's books; and alleges no contemporaneous facts
demonstrating why the statements were false or
misleading at the time they were made.
Defendants also argue that the CAC is deficient
because it is largely pled on information and belief,
but fails to include a statement of “all facts” on which
that belief is based, in contravention of the
requirements of the PSLRA. In addition, defendants
assert that other than the allegations that Yeh made
two statements in conference calls, and that Yeh and
Lai signed SST's Form 10-Qs, the CAC does not
allege that any particular defendant made any of the
statements at issue.
*6 In opposition, plaintiffs argue that the CAC
adequately pleads falsity. They contend that the CAC
identifies material misstatements relating to SST's
flash memory inventory values in the first, second,
and third quarters of 2004 (citing to CAC ¶ ¶ 53, 58,
67, 69, 73). They maintain that the CAC explains
why these statements were false, based on
contemporaneous facts-including allegations that
SST's inventory valuation system lacked sufficient
controls to ensure accuracy, that defendants were told
that this system was overstating value, that
defendants stated that market prices were rising or
stabilizing at a time that such prices were in fact
plummeting, and that defendants made these
statements without also disclosing that their
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inventory valuation
arbitrary.”
process
was
“completely
Plaintiffs also point to SST's 2004 Form 10-K, filed
with the SEC on March 31, 2005, in which both SST
and its outside auditors stated,
As of December 31, 2004, [SST] did not maintain
effective controls over accounting for and review of
the valuation of inventory, the income tax provision
and related balance sheet accounts and licensing
revenue because [SST] lacked a sufficient
complement of personnel and a level of accounting
expertise that is commensurate with [SST's] financial
reporting requirements. Specifically, [SST] lacked
sufficient controls over the write down of inventory
to the lower of cost or market, accounting for
complex licensing contracts with multiple elements,
and processes and procedures related to the
determination and review of the quarterly and annual
tax provisions in accordance with generally
acceptable accounting principles in the United
States.... [T]his deficiency could result in a material
missatement to the annual or interim consolidated
financial statements that would not be prevented or
detected. Accordingly, that this control deficiency
constitutes a material weakness.
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AMD's 32-megabyte flash memory declined from
$16.50 to under $8.00. During the same period, the
price of one type of 32-megabyte flash memory sold
by Intel, which competed with products sold by SST,
steadily declined from $21.50 to under $15.00.
*7 Plaintiffs allege further that the average sales price
of flash memory fell for every week during the period
June 13, 2004, through July 31, 2004, and continued
to fall for every week thereafter until at least August
31, 2004. Plaintiffs assert that defendants knew or
should have known that the prices of various types of
flash memory sold by AMD and Intel, which
competed with products sold by SST, from April
through July 2004-specifically, that the price for
which AMD was selling one type of 4-megabyte
flash memory declined from $1.50 to less than $1.35;
the price of one type of AMD's 8-megabyte flash
memory declined from $3.38 to $1.75; the price of
two types of AMD's 16-megabyte flash memory
declined from around $3.75 to around $2.75; and the
price of one type of 32-megabyte flash memory sold
by Intel steadily declined from over $19.00 to under
$7.50.
The court finds that the CAC fails to allege falsity
with particularity as required by the PSLRA and Rule
9(b). While plaintiffs have identified each statement
alleged to be false or misleading, they have not stated
with particularity why each statement was false at the
time it was made.
Finally, plaintiffs allege that the prices of flash
memory sold by AMD and Intel, which competed
with products sold by SST, declined from April
through October 2004-specifically, that the price for
which AMD was selling one type of 1-megabyte
flash memory declined from $1.63 to under $1.00;
the price of one type of AMD's 4-megabyte flash
memory declined from $1.50 to $1.15; the price of
one type of AMD's 8-megabyte flash memory
declined from $3.38 to $1.50; the price of two types
of AMD's 16-megabyte flash memory declined from
over $3.75 to under $2.48; the price of one type of
AMD's 32-megabyte flash memory declined from
over $10.00 to less than $5.00. Plaintiffs also assert
that when Intel announced its 3Q 2004 results on
October 12, 2004, the company indicated that
because flash memory sales prices had fallen, and
there was no reason to believe they would increase, it
would write down the value of its flash memory
inventory. See CAC ¶ 72.
Plaintiffs allege that the statements about SST's
inventory were false because the market price for
various types of flash memory was declining during
the period between April and December 2004.
Plaintiffs assert that from March 2004 through April
21, 2004, the price for which AMD was selling one
type of 32-megabyte flash memory, which competed
with products sold by SST, steadily declined from
$12.50 to just over $10.00, while another type of
However, the CAC states no facts regarding
comparable products in SST's inventory or the cost or
market price of those products.FN2 Nor does the CAC
state the reasons that the values stated at the time of
the quarterly reports for 1Q 2004, 2Q 2004, and 3Q
2004 were inaccurate. For example, the CAC
contains no allegations of contemporaneous
conditions or statements by defendants that contradict
SST's statements regarding inventory valuations, and
Plaintiffs assert that there is no requirement that the
CAC specify SST's sales prices or inventory
valuations on a product-by-product basis. They claim
that the cases cited by defendants say only that such
information is but one way to establish falsity. They
argue that when contemporaneous facts are cited with
sufficient specificity to demonstrate that the
statements at issue were false, it is not necessary to
also include details about specific products in the
inventory valuation.
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identifies no internal report that contradicts the
valuations or suggests that they might be fraudulent.
FN2. Stating the cost or market value of the
products in SST's inventory would be one
way-though not the only way-to allege
contemporaneous facts showing that the
statements regarding inventory valuation
were false when made.
Plaintiffs simply allege, in essence, that because SST
wrote down its inventory in December 2004, the
statements about inventory made prior to that time
must have been false because the inventory turned
out not to be worth what SST had previously said it
was worth. This is, as defendants argue, a classic
example of pleading fraud by hindsight-a type of
pleading that the PLSRA was specifically enacted to
eliminate.
The allegations in the CAC regarding the decline in
prices for flash memory produced by AMD and Intel
do not support the claim that defendants made false
statements regarding SST's financial results during
the first three quarters of 2004, for the reason that the
SST documents referenced in the CAC indicate that
most of the inventory charge was taken on SST's 8megabit and 16-megabit flash memory, while the
AMD and Intel products at issue were 4-megabyte, 8megabyte, 16-megabyte, and 32-megabyte flash
memory. Thus, the AMD and Intel flash memory was
not, as the CAC alleges, a type of flash memory that
“competed with” products sold by SST.FN3
FN3. Moreover, the October 12, 2004, Intel
earnings release cited in CAC ¶ 65, a copy
of which is attached to defendants'
Supplemental Request for Judicial Notice,
says nothing about flash memory prices,
about any decline in such prices, or about
any inventory write-down pertaining to flash
memory products.
*8 The allegations in the CAC that SST's inventory
valuation system lacked sufficient controls to ensure
accuracy and that its inventory valuation process was
“completely arbitrary,” and that defendants were told
that this system was overstating value, are based on
two sources-first, on information allegedly obtained
by plaintiffs from their “confidential informants,” and
second, on a statement in SST's 2004 Form 10-K that
SST had not maintained effective controls over
accounting for and review of the valuation of
Page 6
inventory, and a statement by SST to the same effect
in the same Form 10-K.
The allegations relating to information obtained from
plaintiffs' confidential informants do not plead
particularized facts showing that the statements
regarding the value of SST's inventory were false
when made because, as explained more fully below
in the discussion of scienter, the informants were not
employed at SST during the proposed class period,
and because the CAC does not allege particularized
facts indicating that the informants had personal
knowledge regarding the truth or falsity of the
statements made in 2004 regarding the valuation of
SST's inventory. See In re Daou Sys., 411 F.3d at
1015. Under the PSLRA, “the complaint must
contain allegations of specific ‘contemporaneous
statements or conditions' that demonstrate the
intentional or the deliberately reckless false or
misleading nature of the statements when made.”
Ronconi v. Larkin, 253 F.3d 423, 432 (9th Cir.2001).
The allegations relating to information obtained from
the confidential informants does not meet this
standard.
The statements concerning internal controls made by
SST
and
SST's
external
auditors
PricewaterhouseCoopers in SST's 2004 10-K do not
support plaintiffs' claim that defendants made
materially false statements during the proposed class
period. First, as defendants note, this same boilerplate
language is used in internal control review reports
filed by numerous other technology companies, as
such review is mandated by Section 404 of SarbanesOxley. In the present case, SST and its auditors used
what appears to be standard phrasing, noting that in
the future, the control deficiency “could” result in a
material misstatement to the company's financial
statements. This is not a contemporaneous fact that
shows that the statements about SST's inventory
valuation were false when made in connection with
the release of financial results for the first three
quarters of 2004. Moreover, SST's auditor
PricewatershouseCoopers issued an unqualified audit
opinion, identified no errors in the interim financials,
and did not require SST to restate any of the quarters
prior to 4Q 2004.
2. Scienter
Defendants argue that the CAC should be dismissed
because it fails to plead particularized facts that
strongly suggest actual intent to deceive, manipulate,
or defraud. Under the PSLRA, whether alleging that
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a defendant “made an untrue statement of material
fact” or alleging that a defendant “omitted to state a
material fact,” the complaint must, with respect to
each alleged act or omission, “state with particularity
facts giving rise to a strong inference that the
defendant acted with the required state of mind.” 15
U.S.C. § 78u-4(b)(2); see also In re Vantive, 283
F.3d at 1084. By requiring particularized, detailed
allegations showing a strong inference of scienter, the
PSLRA was intended to “eliminate abusive and
opportunistic securities litigation.” Gompper, 298
F.3d at 897.
*9 In the Ninth Circuit, the required state of mind is
“deliberate or conscious recklessness.” In re Silicon
Graphics, 183 F.3d at 979. Mere motive and
opportunity are not sufficient. Id. Recklessness
satisfies scienter under § 10(b) “only ... to the extent
that it reflects some degree of intentional or
conscious misconduct.” Id. at 977. In assessing
whether plaintiffs have sufficiently pled scienter, the
court should consider “whether the total of plaintiffs'
allegations, even though individually lacking, are
sufficient to create a strong inference that defendants
acted with deliberate or conscious recklessness.” No.
84 Employer-Teamster Joint Council Pension Trust
Fund v. Am. West Holding Corp., 320 F.3d 920, 938
(9th Cir.2003) (citation and quotation omitted); see
also Livid Holdings Ltd. v. Salomon Smith Barney,
Inc., 416 F.3d 940, 948-49 (9th Cir.2005) (district
court should evaluate scienter based on “totality of
the allegations”).
Page 7
the individual defendants. Second, plaintiffs argue
that the CAC pleads facts showing that defendants
knew, or had access to facts that should have made
them aware, that the price of flash memory was
declining in the industry generally, and that the value
assigned to flash memory in SST's inventory should
therefore have been reduced. Third, plaintiffs assert
that scienter is shown by allegations of defendants'
motive to keep the price of SST's stock high,
reflected in insider sales of stock during the class
period, the SST board of directors' authorization of a
stock repurchase program in July 2004, and SST's
acquisition of another company in October 2004.
Finally, plaintiffs argue that defendants' scienter is
also shown by the allegations that defendants violated
Generally Accepted Accounting Principles (GAAP)
and various unspecified SEC regulations, regulations
of national stock exchanges, and customary business
practices.
a. confidential informants
On a Rule 12(b)(6) motion to dismiss a complaint
brought under the PSLRA, when considering whether
plaintiffs have shown a strong inference of scienter,
the district court must also consider “all reasonable
inferences to be drawn from the allegations,
including inferences unfavorable to the plaintiffs.”
Gompper, 298 F.3d at 897 (noting the “inevitable
tension ... between the customary latitude granted the
plaintiff on a [12(b)(6) ] motion to dismiss ... and the
heightened pleading standard set forth under the
PSLRA). In other words, the court must consider all
the allegations in their entirety in concluding
whether, on balance, the complaint gives rise to the
requisite inference of scienter. Id.
*10 The CAC alleges that the information provided
by five confidential informants, and a sixth identified
informant, shows the individual defendants' personal
involvement in, and “hands-on” management of,
SST's business. In pleading fraud under the PSLRA,
plaintiffs may rely on anonymous sources for
information, so long as they plead “corroborating
details” when allegations are based on non-public
information. In re Silicon Graphics, 183 F.3d at 985;
see also In re SeeBeyond Techs. Corp. Sec. Litig.,
266 F.Supp.2d 1150, 1159 (C.D.Cal.2003).
“[P]ersonal sources of information relied upon in a
complaint should be ‘described in the complaint with
sufficient particularity to support the probability that
a person in the position occupied by the source would
possess the information alleged.” ’ Nursing Home
Pension Fund, Local 144 v. Oracle Corp., 380 F.3d
1226, 1233 (9th Cir.2004) (quoting Novak v. Kasaks,
216 F.3d 300, 314 (2nd Cir.2000)). When plaintiffs
rely on facts beyond the information provided by the
confidential witnesses, they need not name their
sources as long as the additional facts provide an
adequate basis for believing that the defendants'
statements were false. Id.
Plaintiffs assert that the “totality of the allegations”
set forth in the CAC establish that defendants
knowingly overvalued SST's inventory. First,
plaintiffs contend that the allegations in the CAC
regarding information obtained from six informants
establish scienter because those allegations show the
personal involvement and “hands-on” management of
Defendants argue that the information provided by
the six informants adds nothing to support the claims
in the CAC, because no informant worked at SST
during the class period, because the informants were
all low-level employees far removed from
management decisions, and because the informants
report guesses, opinions, and suppositions instead of
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facts. Defendants also contend that plaintiffs fail to
allege particularized facts showing that each
individual source occupied a position such that he or
she would possess the information alleged.
Plaintiffs respond that the proposed class period
simply functions to define the plaintiff class, but does
not restrict the universe of relevant or actionable facts
in the case. They contend that while scienter itself
must always be contemporaneous with the alleged
misstatements, the facts supporting an inference of
scienter will not always be. In other words, plaintiffs
argue that the fact that none of the informants worked
at SST during the proposed class period is not
significant, because pre-class period awareness of
events can be relevant to show awareness of certain
facts and therefore to demonstrate scienter.
The court finds that the allegations regarding the six
informants do not create a strong inference that
defendants acted with deliberate or conscious
recklessness with regard to the alleged false
statements concerning SST's inventory valuations and
financial performance during the first three quarters
of 2004. The court first notes three ways in which the
allegations are generally insufficient.
First, the CAC fails to plead with particularity that
each individual informant occupied a position such
that he or she would possess the information alleged,
and the allegations regarding such information are
therefore insufficiently reliable.
*11 Second, none of the six informants was
employed at SST during the proposed class period;
and the only one of the six who worked at the
company at all in 2004 admittedly did not know what
SST was reporting as inventory. Thus, none of the
informants was in a position to know whether
defendants overstated the value of SST's inventory
when the company's financial results were reported
for the first three quarters of 2004. The statements
regarding events that occurred during the period 2000
through 2003 cannot substitute for the required
particularized showing of scienter in 2004.
While it is true that facts relating to pre-class period
events may in certain circumstances contribute to the
creation of an inference of scienter, see, e.g., Zelman
v. JDS Uniphase Corp., 376 F.Supp.2d 956, 970
(N.D.Cal.2005), there must be some connection
between that scienter and the earlier events. Here, the
issue is not pre-class period statements made by
defendants, which can be said to create a strong
inference of scienter in connection with false or
Page 30 of 96
Page 8
misleading statements made during the class period,
but rather a number of largely irrelevant statements
by informants who were not present at SST at the
time of the alleged misrepresentations, and who
appear to have little information regarding either the
valuation of the inventory or the defendants' alleged
“scheme” to misstate the value of the inventory. The
information provided by these informants concerns
events that predated and had no apparent connection
with the alleged misstatements regarding the
valuation of SST's inventory.
Finally, the CAC alleges that one of the informants
provided at least two of the defendants with “excess
inventory reports,” and that at least two of the
informants attended “meetings” at which the
participants discussed issues relating to the amount
and type of products held in inventory, and to the
valuation of inventory. These allegations are
insufficient in light of the Ninth Circuit's decisions in
In re Silicon Graphics, In re Vantive, and In re Daou
Sys..
In In re Silicon Graphics, the court rejected the
plaintiff's attempt to establish scienter through
general allegations that the defendants had received
internal reports, including daily reports, monthly
financial reports, “Stop Ship” reports, and “Flash
Reports.” Id. at 984-98 & n. 14. The court held a
plaintiff can rely on the existence of reports as a
means of establishing knowledge only if the
complaint includes “adequate corroborating details”such as plaintiff's sources of information with respect
to the reports, how the plaintiff learned of the reports,
who drafted the reports, and which officers at the
company received them, in addition to “an adequate
description of their contents.” Id. at 985.
In In re Vantive, the plaintiffs attempted to establish
such scienter by adverting to the defendants' “handson” management style, their “interaction with other
corporate officers and employees, their attendance at
management and board meetings, and reports
generated on a weekly and monthly basis. Relying on
In re Silicon Graphics, the Ninth Circuit held that
such allegations did not adequately establish that the
defendants had knowledge of the supposedly “true
but concealed” circumstances. In re Vantive, 283
F.3d at 1087-88.
*12 As in Silicon Graphics and In re Vantive,
plaintiffs in the present case have failed to cite to any
specific report, to mention any dates or contents of
reports, or to allege their sources of information
about any reports. The allegations are similarly
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deficient, for the same reasons, with respect to the
defendants' attendance at meetings and their “handson” managerial style. See also In re Daou Sys., 411
F.3d at 1022.
The court will now discuss each of the informants.
Plaintiffs identify Confidential Informant No. 1 (CI #
1) as a “business control analyst” employed at SST
from February 2000 through April 2004, who was
“part of a team that monitored inventory on a daily
basis.” According to CI # 1, SST had “a poor and
unreliable system in place for managing and
monitoring inventory.” He/she asserts that defendants
Yeh, Hu, and Tsai FN4 “called the shots” and micromanaged the system, including issues related to
inventory valuation, and that Hu created his own
databases and spreadsheets to track and value
inventory on a daily basis, even though SST kept
track of inventory in a separate software application.
With regard to inventory, this informant believed that
“whatever it was that the company was reporting
was way off the mark” (emphasis added). He/she
indicated that SST continued to manufacture large
amounts of flash memory, even though there were
“no buyers” because the company's officers and
directors feared the company would lose its
manufacturing vendors to competitors if they slowed
down their production lines. CAC ¶ 46-47
FN4. The CAC does not assert a claim
against a defendant “Tsai.”
The CAC provides only a sketchy description of CI #
1's job duties, claiming that he/she was “part of a
team that monitored inventory on a daily basis.”
However, plaintiffs do not identify the other
members of this “team,” and, more significantly, do
not explain what they mean by “monitored
inventory.” Such a job description could include
anything from counting widgets in a box, to moving
inventory from place to place in a warehouse, to
filling customer orders, to preparing spread sheets
showing the types and amount of product in
inventory. It is apparent from the allegations that CI #
1 had no personal knowledge of what SST was
reporting as inventory, but the CAC does not even
provide particularized detail sufficient to show what
this informant knew with regard to inventory
management.
Moreover, in view of CI # 1's claim that SST had a
“poor and unreliable system in place for managing
and monitoring inventory,” it is difficult to see how
any job relating to monitoring inventory would have
Page 31 of 96
Page 9
provided CI # 1 with knowledge of facts creating a
strong inference that defendants acted with deliberate
or conscious recklessness. It is also not clear how
Yeh, Hu, and Tsai could have “micro-managed” a
“poor and unreliable” system. Finally, plaintiffs
provide no basis for CI # 1's opinion that SST
continued to manufacture large amounts of flash
memory, despite the alleged absence of buyers,
because “officials” feared that SST would otherwise
lose its manufacturing vendors to competitors.
Plaintiffs do not explain how CI # 1 learned about the
alleged fears of these officials, or even who the
officials were.
*13 Plaintiffs identify Confidential Informant No. 2
(CI # 2) as an “inventory control analyst” employed
at SST from February 2000 through August 2002. CI
# 2 reported to the director of manufacturing systems,
and was responsible for receiving inventory
shipments, tracking inventory locations, and ensuring
that the actual products in inventory matched those
identified in SST's databases. According to CI # 2,
the Finance Department at SST was excluded from
the inventory valuation process. Instead, “the vice
presidents of the individual units (and in particular
[d]efendant Hu),” made the inventory valuation
decisions. CI # 2 claimed that these valuations were
made “regardless of actual price” and that the overall
valuation process was “arbitrary, with only some
relation to reality.” In this informant's opinion, the
defendants were “unwilling to decrease the value
assigned to inventory” because doing so would be an
admission of their own “engineering mistakes” or
“business errors.” He/she considered it was a “pride
issue”-that defendants created a culture of “hear-noevil-see-no-evil.” CAC ¶ 48.
The CAC provides some description of CI # 2's
duties, although in vague terminology (“receiving
shipments,” “tracking inventory location”) suggesting
that CI # 2 functioned more as a warehouse or
manufacturing plant clerk than as an employee with
some personal knowledge of inventory valuation.
However, this informant left SST in August 2002,
and the CAC alleges no facts showing a basis for any
personal knowledge regarding the valuation of
inventory during the proposed class period. In
particular, the CAC provides no connection between
CI # 2's assertion that the inventory valuation process
was “arbitrary” between February 2000 and August
2002, and plaintiffs claims that defendants knowingly
misrepresented the value of SST's inventory during
the period between April and December 2004.
CI # 2's statement that the Finance Department was
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excluded from the valuation process is contradicted
by CI # 4's statement that former CFO Jeff Garon
(“Garon”) was involved in the decisions regarding
valuation, and is further contradicted by the
allegation in the CAC that defendant Lai, CFO during
the proposed class period, was a participant in the
alleged fraudulent misstatement of inventory values.
In addition, CI # 2's claim that the valuations were
made by “the vice presidents of the individual
business units” and “in particular [d]efendant Hu”
does not provide sufficient detail regarding who
actually made the valuation decisions, how CI # 2
knows who made the decisions, or how he/she knows
that the decisions were made “regardless of actual
price.” Finally, plaintiffs provide no basis for CI # 2's
opinion that defendants would not decrease the value
assigned to inventory because they were unwilling to
admit their own engineering mistakes or business
errors. Indeed, the CAC states no facts showing that
CI # 2 was qualified to psychoanalyze defendants'
motivations with regard to inventory valuation.
*14 Plaintiffs identify Confidential Informant No. 3
(CI # 3) as an individual employed at SST from 2000
through June 2003, who was also employed as a
“production control manager” from 1997 through
2000.FN5 At SST, CI # 3 was responsible for
“tracking shipments and inventory.” He/she is
“certain” that “the vice presidents” were intimately
aware of the amount and type of products held in
inventory because he “participated in” twice-monthly
meetings with “these individuals” concerning this
subject. CAC ¶ 49.
FN5. It is not clear from the CAC whether
CI# 3 worked at SSI during the entire period
from 1997 through 2003, or whether he/she
was a production control manager at some
other company during the period 1997
through 2000, and began working at SST in
2000.
Plaintiffs describe this informant's duties only briefly,
without any indication of what is meant by
“production control” or “tracking shipments and
inventory.” From plaintiffs' description, it is
impossible to tell whether CI # 3 was employed, for
example, as an inventory clerk, entering data
regarding products placed in inventory and shipped
out to customers; or as a shipping or mailroom clerk,
simply packaging products removed from inventory
and shipping them to customers; or in some other
capacity. Thus, it is impossible to tell whether this
informant has any relevant personal knowledge.
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Moreover, CI # 3 left his/her employment at SST in
June 2003, and the CAC states no facts showing a
basis for any personal knowledge regarding the
valuation of inventory during the proposed class
period. In addition, the allegations regarding CI # 3's
participation in meetings with “vice-presidents” lack
sufficient particularized detail to provide a basis for
attributing to CI # 3 any personal knowledge
regarding inventory or inventory valuation. The CAC
does not provide the dates of the meetings, or identify
the attendees or the substance of the matters
discussed. Nor does the CAC identify the “vicepresidents” whom CI # 3 believed were “aware” of
the amount and type of products held in inventory, or
provide any facts showing a basis for CI # 3's belief
that these individuals had this knowledge.
Plaintiffs identify Confidential Informant No. 4 (CI #
4) as a “controller” employed at SST from October
1995 through April 2003. This informant worked
directly for Garon, the then-CFO. CI # 4 is “certain”
that defendant Yeh and defendant Hu reviewed and
monitored the inventory numbers “very, very
carefully” and that defendant Hu and “defendant
Garon” (actually not a defendant) were responsible
for “the final decision about what value to place on
products held in inventory.” CI # 4 “participated in”
monthly and quarterly meetings where inventory
valuation “was discussed” with Yeh, Garon, Hu, and
defendant Best, plus “a former cost accountant” and
“business unit managers,” and claims that
participants in these meetings would “go back and
forth and argue” over whether certain products held
in inventory were sellable, and if so, for what amount
of money. According to this informant, there were a
“ton of red flags” where inventory was concerned, as
warnings were frequently raised within the company
that products held in inventory were out-of-date or
overvalued. CAC ¶ 50.
*15 Plaintiffs do not describe this informant's job
duties, simply stating that he/she was a “controller”
who worked with SST's former CFO. From this
description, it is impossible to tell whether CI # 4 had
a basis for personal knowledge of the facts alleged.
Moreover, CI # 4 left his/her employment at SST in
April 2003, and the CAC alleges no facts showing
any basis for personal knowledge regarding the
valuation of inventory during the proposed class
period. Nor does the CAC provide any particularized
facts showing that CI # 4 had any basis for the
opinion that defendants Yeh and Hu reviewed and
monitored the inventory numbers “very, very
carefully” or that Hu and CFO Garon were
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responsible for decisions regarding inventory
valuation. The CAC asserts that CI # 4 participated in
monthly and quarterly meetings in which inventory
valuation was discussed, but does not provide the
dates of any meetings, or identify the attendees (apart
from Yeh, Garon, Best, and Hu) or any details of the
matters discussed, or of the alleged arguments among
the meeting participants regarding inventory
valuation.
Plaintiffs identify Confidential Informant No. 5 as
employed at SST “through 2003” (no indication of
starting date) as an operations analyst, responsible for
“tracking and locating excess inventory.” In CI # 5's
opinion, SST “often manufactured excess products”
because the executives wanted to build up inventory,
not because there was any actual market demand for
those products. He/she recalled that the operations
department repeatedly told upper management that
products held in inventory were “not moving.”
He/she claims to have provided Yeh and Best with
excess
inventory
reports
that
included
recommendations concerning the likelihood that
products held in inventory could actually be sold.
CAC ¶ 51.
Plaintiffs describe this informant's duties only briefly,
without any indication of what is meant by “tracking
and locating excess inventory.” Moreover, CI # 5 left
his/her employment at SST at the end of 2003, and
the CAC alleges no facts showing any basis for
personal knowledge regarding events that occurred
during the proposed class period. CI# 5 refers to
“excess inventory reports” that he/she allegedly
provided to Yeh and Best, but the CAC provides no
details regarding the author of the reports, or the
dates or contents of the reports, other than as stated
above. In addition, plaintiffs provide no
particularized facts showing that CI # 5 had any basis
for his/her opinion that SST manufactured excess
products because SST's “executives” wanted to build
up inventory. With regard to the claim that the
“operations department” repeatedly communicated to
“upper management” that products in inventory could
not be sold, the CAC does not provide any details
regarding the identity of the employees in the
operations department, the identity of the individuals
in upper management, the dates of these alleged
communications, or any details concerning the
inventory at issue.
*16 Informant Brian Thiemer was employed at SST
from 2001 through 2003 as a “quality assurance
engineer” in the company's “inventory control”
department. He was responsible for “a variety of
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issues related to the [c]ompany's inventory, including
inventory valuation.” He claimed that he regularly
informed his manager Andy Arata (then-director of
quality assurance) and unidentified “senior
management” that the company needed to decrease
the value it was placing on its inventory because such
values did not reflect actual market prices. He
believed that “some inventory” was obsolete and
worth only 10% to 20% of its accounted-for value.
He indicated that his recommendations were
consistently and systematically ignored and rejected
by “senior management” and/or Arata, and that his
frustration concerning the company's unwillingness
to accurately and truthfully value its inventory led
him to quit SST in 2004. CAC ¶ 52.
Plaintiffs describe Thiemer's job duties only briefly,
stating only that he was responsible for a “variety of
issues” related to inventory, including inventory
valuation. However, plaintiffs do not explain
Thiemer's role in the valuation of inventory, or
provide any particularized facts that would provide a
basis for creating a strong inference that defendants
acted with deliberate indifference. Moreover,
Thiemer left his employment at SST at the end of
2003, and the CAC alleges no facts showing any
basis for personal knowledge regarding inventory
valuation during the proposed class period.
Thiemer claims to have “regularly” communicated to
his manager and unidentified “senior management”
that SST's inventory was overvalued, but as with CI #
5, the CAC does not provide the dates of these
alleged communications, or any details concerning
the inventory at issue. In addition, there is no
indication as to who is meant by “senior
management.” Thiemer also claims that “some
inventory” was obsolete, but plaintiffs provide no
detail about this allegedly obsolete product-not the
type, the quantity, or the value.
The allegations regarding these confidential
informants do not, as plaintiffs contend, show
defendants' personal involvement in, and “hands-on”
management of, inventory valuation or any other
particular aspect of SST's business, and do not plead
the particularized facts required to show scienter
under the PSLRA.
b. knowledge of general decline in prices of flash
memory
Plaintiffs contend that defendants' knowledge that
SST's inventory should have been written down
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earlier than it was is shown by the fact that they
knew, or should have been aware, that the selling
prices of flash memory were declining in the industry
during the class period. With regard to 1Q 2004, the
CAC asserts that defendants knew or should have
been aware that from March 2004 through April 21,
2004, the selling prices of AMD's and Intel's 32megabyte flash memory had declined. The CAC also
alleges that defendants knew or should have known
that Forbes reported on May 24, 2004, that the prices
of flash memory had declined because manufacturers
such as Intel and Samsung were offering price
reductions in order to win customers; and that CBS
News reported on June 3, 2004, that while Intel's
flash memory sales had suffered in 2003, its sales
were increasing in 2004 and Intel was winning
market share. See CAC ¶ 56.
*17 With regard to 2Q 2004, the CAC asserts that
defendants knew or should have been aware that the
average sales price of various types of flash memory
sold by AMD and Intel fell for every week during the
period June 13, 2004, through July 31, 2004, and
continued to fall thereafter until at least August 31,
2004. Plaintiffs also claim that defendants knew or
should have known that financial analyst WR
Hambrecht reported on June 8, 2004, that flash
memory prices in 2Q 2004 were 5 per cent lower
than they had been in 1Q 2004 and were likely to
continue to decline in 3Q 2004. Plaintiffs assert that
in response to competition in the flash memory
market, SST was forced, by July 2004, to lower its
prices on some types of flash memory by as much as
4 per cent. See CAC ¶ 61.
With regard to 3Q 2004, the CAC asserts that
defendants knew or should have been aware that the
price of various types of flash memory sold by AMD
was declining, and that the value assigned to flash
memory in SST's inventory should therefore have
been reduced. Plaintiffs also allege that defendants
knew or should have known that when Intel
announced its 3Q 2004 results on October 12, 2004,
it also indicated that because flash memory sales
prices had fallen, and there was no reason to believe
they would increase, it would write down the value of
its flash memory inventory. See CAC ¶ 72.
Defendants argue that this market pricing information
is irrelevant, as the details do not concern SST
products or prices, and do not even involve products
that competed with the 8-megabit SST products that
were the focus of the write-down. They also assert
that the October 12, 2004, Intel earnings release cited
in the CAC says nothing whatsoever about flash
Page 12
memory prices or any purported decline in prices, or
any inventory write-down pertaining to flash memory
prices, but rather reports an inventory write-down as
a result of “lower chipset unit costs,” having nothing
to do with the selling prices of flash memory.
The court finds that the allegations regarding a
decline in prices for AMD and Intel flash memory do
not create a strong inference of scienter. The CAC
does not plead particularized facts showing that
defendants did in fact know these details of industry
prices, news reports, and financial analysts' reports.
Moreover, as previously indicated, the flash memory
produced by AMD and Intel did not have the same
capacity as the flash memory produced by SST, and
the products therefore were not competitive. The
CAC does not explain the relevance of a drop in price
of 8-megabyte, 16-megabyte, and 32-megabyte flash
memory to the valuation of SST's inventory of 8megabit flash memory.
c. motive to inflate price of stock
The CAC alleges that defendants' scienter is shown
by their motive to inflate the price of SST's stock, and
that this motive is shown by defendants' insider
trading, by SST's announcement of a stock
repurchase in July 2004, and by SST's announcement
of its acquisition of another company in October
2004. In the Ninth Circuit, motive and opportunity,
standing alone, are not sufficient to establish scienter.
See In re Silicon Graphics, 183 F.3d at 974 (facts that
indicate a motive to commit fraud and opportunity to
do so may provide some reasonable inference of
intent, but they are not sufficient to establish a strong
inference of deliberate recklessness). However,
motive can be considered as part of the “totality of
the allegations” regarding scienter.
i. insider trading
*18 The CAC alleges that defendants motive to keep
price of stock high, as shown by insider sales of
stock, by Nojima on June 2, 2004, on November 17,
2004, and on December 8, 2004; by Best on August
12, 2004; and by Chikagami on December 14, 15,
and 16, 2004. Plaintiffs assert that the timing of the
November and December 2004 stock sales was
suspicious in view of the fact that the company
announced on December 20, 2004, that it expected to
take a $20-$25 million inventory charge and write
down the value of certain products held in inventory
to their estimated market value, and that the gross
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margin for 4Q 2004 was expected to be in the range
of 1% to 3%, compared with previous estimates of
between 25% and 32%.
The PSLRA “neither prohibits nor endorses the
pleading of insider trading as evidence of scienter,
but requires that the evidence meet the ‘strong
inference’ standard.” In re Daou Sys., 411 F.3d at
1022 (citation and quotation omitted). Stock trades
are only suspicious when “dramatically out of line
with prior trading practices at times calculated to
maximize the personal benefit from undisclosed
inside information.” In re Silicon Graphics, 183 F.3d
at 986. To evaluate suspiciousness of stock sales, the
court should consider the amount and percentage of
shares sold, the timing of the sales, and whether the
sales were consistent with prior trading history.
Nursing Home, 380 F.3d at 1232.
Here, it appears that most of SST's officers and
directors sold no stock during the proposed class
period, and that just as many insiders purchased stock
as sold. Yeh and Lai-the only defendants specifically
alleged to have made false or misleading statements
are not alleged to have sold any stock. Best sold no
shares, but rather transferred some previously
pledged stock as collateral for a loan. Lai and Hu
purchased-not sold-stock during the class period.
Collectively, defendants sold less than 2% of their
total holdings, and SST itself purchased $15 million
worth of its own stock during the class period, at
prices plaintiffs allege were inflated by its own fraud.
Only Nojima and Chikagami sold stock. Nojima's
sales were not out of the ordinary, as those sales were
consistent with his trading pattern and sales for the
preceding seven years. Although Nojima sold no
shares in 2003, he did sell shares every other year
starting in 1998, as shown by his Form 4s filed with
the SEC. Thus, Nojima's sales are insufficient to
create a strong inference of scienter.
Foreign-based outside director Chikagami, who is not
alleged to have personally made any false statement,
did sell a substantial amount of his holdings (total of
66%), and he is the only officer or director whose
stock sales are even marginally suspicious under the
Silicon Graphics standard. However, in view of the
fact that he owned a relatively small number of
shares compared with the officers of the company,
the fact that he did not sell all his shares, the fact that
no one else's sales appear suspicious, and the fact that
other insiders actually purchased shares during the
proposed class period, the court finds that
Chikagami's sales are insufficient to creating a strong
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inference of scienter.
*19 Moreover, even if the court were to find that the
timing or amount of the stock sales was suspicious,
“stock sales are helpful only in demonstrating that
certain statements were misleading and made with
knowledge or deliberate recklessness when those
sales are able to be related to the challenged
statements.” In re Vantive Corp., 283 F.3d at 1093.
Because the CAC fails to plead particularized facts
showing that defendants made false or misleading
statements, such “insufficient allegations of fraud ...
have a spillover effect” on an analysis of insider
sales. Id.
ii. SST's stock repurchase
The CAC alleges that defendants' motive to keep the
price of SST's stock high is also shown by the
announcement on July 29, 2004, that SST's board of
directors had authorized a stock repurchase program
of up to $15 million worth of the company's common
stock. The CAC does not explain how either this
announcement or the repurchase program creates a
strong inference of scienter.
iii. SST's acquisition of G-Plus
The CAC alleges that defendants' motive to keep the
price of SST's stock high is further shown by the
announcement on October 18, 2004, that SST had
signed an agreement to acquire substantially all the
assets of privately-owned G-Plus, Inc., pursuant to
which SST agreed to issue approximately $26 million
in SST stock to G-Plus. The deal closed on
November 5, 2004. Plaintiffs claim that it was in the
interest of the company to keep its share price higher
in order to facilitate this stock-financed transaction.
Allegations that defendants engaged in routine
business activities or were motivated by concerns that
are shared by all companies and executives is not
sufficient to establish scienter. See Lipton v.
Pathogenesis Corp., 284 F.3d 1027, 1038 (9th
Cir.2002) (“[i]f scienter could be pleaded merely by
alleging that officers and directors possess motive
and opportunity to enhance a company's business
prospects, virtually every company in the United
States that experiences a downturn in stock price
could be forced to defend securities fraud actions”).
SST's acquisition of G-Plus is an example of the type
of routine activity and generic motive that cannot
serve as a basis for alleging securities fraud.
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The fact of this merger or buy-out, standing alone, is
insufficient to create a strong inference of scienter.
Moreover, even if the court were to find that this
acquisition provides some small support for an
inference of fraud, the fact of the buy-out would have
to be considered in the context of the fact that SST
and several of its officers purchased millions of
dollars of SST stock during the class period, at prices
that plaintiffs claim were inflated by fraud.
d. alleged violations of GAAP
The CAC alleges that defendants' scienter is shown
by their violation of Generally Accepted Accounting
Principles (GAAP)-specifically, certain principles set
forth in FASB Statement of Concepts Nos. 1 and 2
FN6
-and also by their violation of the requirements of
unidentified “SEC regulations, regulations of the
national stock exchanges and customary business
practices” to disclose the sort of adverse information
that was allegedly concealed by defendants during
the class period.
FN6. As alleged in the CAC, these are (a)
the principle that interim financial reporting
should be based on the same accounting
principles used to prepare annual financial
statements; (b) the principle that financial
reporting should provide information that is
useful to present and potential investors and
creditors and other users in making rational
investment, credit, and similar decisions; (c)
the principle that financial reporting should
provide information about the economic
resources of an enterprise, the claims to
those resources, and effects of transactions,
events, and circumstances that change
resources and claims to those resources; (d)
the principle that financial reporting should
provide information about how management
of an enterprise has discharged its
stewardship responsibility to stockholders
for the use of enterprise resources trusted to
it was violated; (e) the principle that
reporting should provide information about
an enterprise's financial performance during
a period; (f) the principle that financial
reporting should be reliable in that it
represents what it purports to represent was
violated; (g) the principle of completeness,
which means that nothing is left out of the
information that may be necessary to insure
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that it validly represents underlying events
and conditions; (h) the principle that
conservatism be used as a prudent reaction
to uncertainty to try to ensure that
uncertainties and risks inherent in business
situations are adequately considered. CAC ¶
94.
*20 Violation of GAAP standards can provide
evidence of scienter. In re Daou Sys., 411 F.3d at
1016. However, “[t]o support even a reasonable
inference of scienter, much less a strong inference,
the complaint must describe the violations with
sufficient particularity: a general allegation that the
practices at issue resulted in a false report of
company earnings is not a sufficiently particular
claim of misrepresentation.” Id. (citations and
quotations omitted). Put another way, simple
allegations of failure to follow GAAP do not
establish scienter, because scienter requires more
than a misapplication of accounting principles. See,
e.g., In re Worlds of Wonder Sec. Litig., 35 F.3d
1407, 1426 (9th Cir.1994)). In order to distinguish
“deliberate
recklessness”
from
“ordinary
carelessness,” allegations of GAAP violations must
be augmented by facts that shed light on the mental
state of the defendants, rather than conclusory
allegations that defendants must have known of the
accounting failures because of the degree of
departure from established accounting principles. See
DSAM, 288 F.3d at 390-91.
The CAC alleges that “[i]n order to inflate the price
of [SST] stock, [d]efendants intentionally and/or with
deliberate recklessness overstated the value of flash
memory held in inventory in violation of [GAAP],”
and then simply proceeds to list a number of
accounting principles that were allegedly violated by
this overvaluation. CAC ¶ ¶ 91-94. However, the
GAAP allegations contain no facts that shed light on
the mental state of the defendants, and as the CAC
fails generally to allege scienter, the allegations of
GAAP violations contribute nothing. In order to
plead facts showing a strong inference of fraud,
plaintiffs must provide detail-not merely, as here,
simply recite various GAAP provisions and allege in
general terms that the defendants failed to comply
with them.
The CAC does not identify any transaction by name
or date, does not specify any dollar amounts, does not
identify any product or class or products that should
have been written down sooner under these various
accounting principles, does not state what the
appropriate write-down would have been, or when it
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should have been taken, or why a write-down should
have been taken in that amount at that time. Although
the CAC refers to the GAAP provision requiring that
inventory be carried on the balance sheet at the lower
of “cost” or “market value,” the CAC says nothing
about either the cost or the market value of SST's
inventory, and says nothing about how or when the
defendants purportedly became aware of the
allegedly improper accounting practices, but rather
simply refers to general declines in market prices of
flash memory products throughout the industry.FN7
FN7. Plaintiffs acknowledge that “GAAP, as
set forth in Accounting Research Bulletin
(‘ARB’) No. 43, Chapter 4, Inventory
Pricing, requires that inventories be recorded
at the lower of cost or market .” CAC ¶ 93.
At the hearing, however, plaintiff's counsel
conceded that plaintiffs were unable to
provide any information regarding the cost
or market value of SST's inventory. As
explained above, that deficiency is one
reason that plaintiffs' allegations of GAAP
violations are insufficient to create a strong
inference of scienter. That is not to say that
plaintiffs would not theoretically be able to
plead facts sufficient to create a strong
inference of intent or deliberate recklessness
in the absence of details regarding cost or
market value, just that the facts as pled are
not adequate to show GAAP violations as
circumstantial evidence of scienter, under
applicable Ninth Circuit authority. See, e.g.,
DSAM, 288 F.3d at 390-91.
In In re Daou Sys., the Ninth Circuit relied on the
combination of “widespread and significant” inflation
of revenue and “specific allegations of [top
executives'] direct involvement in the production of
false accounting statements” to find the complaint
raised a strong inference of scienter. In re Daou Sys.,
411 F.3d at 1016, 1020, 1023. By contrast, the CAC
makes no specific allegations of defendants' direct
involvement, and instead relies on their general
involvement in the management of SST and their
alleged knowledge that the inventory valuation was
“arbitrary .”
e. group pleading
*21 As a final basis for dismissal, the court finds that
the claims against the individual defendants fail
because the CAC pleads no facts showing that any
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individual defendant made any statement with
scienter. The CAC does not allege that defendants
Hu, Chikagami, Nojima, or Best made any false
statements at all, and does not plead facts sufficient
to create a strong inference that defendants Yeh and
Lai made false statements with scienter. As a
defendant corporation can be deemed to have the
requisite scienter for fraud only if the individual
corporate officer making the statement has the
requisite level of scienter, the claims against SST also
fail on this basis.
Plaintiffs contend that the CAC establishes the
individual defendants' scienter regarding inventory
valuation, citing to ¶ ¶ 46-52 of the CAC (the
“confidential informant” allegations), where plaintiffs
argue, they have alleged that Yeh, Lai, Hum Nojima,
and Best were “participating in monthly and quarterly
meetings in which inventory valuations were
determined;” and where they have also alleged that
defendants “excluded the finance department from
the valuation process” and that Hu created his own
database and spreadsheet to track and value
inventory.
Plaintiffs assert that allegations of a “detail-oriented
management style” make it reasonable to infer that
the individual defendants became aware of the falsity
of statements related to critical business functions.
They note that Yeh and Lai signed the 10-Qs for 1Q
2004, 2Q 2004, and 3Q 2004, that Yeh made all false
oral statements (referring to the October 20, 2004,
conference call), and that the CAC alleges that the
other defendants played active roles in the inventory
valuation process. Thus, they argue, all defendants
are therefore liable for the false statements regarding
the inventory valuations under the group pleading
doctrine, which holds that there is a presumption that
allegedly false and misleading group published
information is “the collective action of officers and
directors.”
The PSLRA requires, with regard to each false or
misleading statement or material omission, that the
complaint “state with particularity facts giving rise to
a strong inference that the defendant acted with the
required state of mind.” 15 U.S.C. § 78u-4(b)(2)
(emphasis added). While the Ninth Circuit did rule in
a pre-PSRLA case, Wool v. Tandem Computers, Inc.,
818 F.2d 1433 (9th Cir.1987), that “it is reasonable to
presume” that false or misleading information
contained in prospectuses, registration statements,
annual reports, press releases, or other “grouppublished information” can be attributed to the
“collective actions of the officers” of the corporation,
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and that a securities fraud plaintiff “fulfills the
particularity requirements of Rule 9(b) by pleading
the misrepresentations with particularity and where
possible the roles of the individual defendants in the
misrepresentations,” id. at 1440, the Ninth Circuit has
not spoken in any officially published opinion on the
question whether the “group pleading” doctrine
applies to allegations of scienter in a case governed
by the PSLRA.FN8
FN8. Other circuits have spoken on this
issue, notably the Fifth Circuit in Southland
Sec. Corp. v. INSpire Ins. Solutions, Inc.,
365 F.3d 353, 364-65 (5th Cir.2004) (noting
conflict among the courts, and holding that
“[t]he ‘group pleading’ doctrine conflicts
with the scienter requirement of the
PSLRA”); see also Makor Issues & Rights,
Ltd. v. Tellabs, Inc., 437 F.3d 588, 602-03
(7th Cir.2006); Phillips v. Scientific-Atlanta,
Inc., 374 F.3d 1015, 1017-18 (11th
Cir.2004).
*22 The court is aware that some judges in this
district have either applied the group-published
presumption without substantive analysis in cases
controlled by the PSLRA, or have found that the
presumption has survived the enactment of the
PSLRA. See, e.g., In re Omnivision Techs., Inc., 2005
WL 1867717 at *5 (N.D.Cal., July 29, 2005); In re
Adaptive Broadband Sec. Litig., 2002 WL 989478 at
*52-53 (N.D.Cal., April 2, 2002); In re Secure
Computing Corp. Sec. Litig., 120 F.Supp.2d 810, 821
(N.D.Cal.2000). Other judges, however, have
concluded that plaintiffs must state with particularity
facts indicating that an individual defendant was
directly involved in the preparation of allegedly
misleading statements published by an organization,
and have found the group-published presumption
inappropriate in light of the pleading standards
imposed by the PSLRA. See, e.g., In re Netopia, Inc.,
Sec. Litig., 2005 WL 3445631 at *5-6 (N.D.Cal.,
Dec.15, 2005); In re ESS Technology, Inc. Sec. Litig.,
2004 WL 3030058 at *12 (N.D.Cal.2004). Until such
time as the Ninth Circuit does speak on this issue,
this court interprets the above-cited provision of the
PSLRA as requiring that plaintiffs plead facts
showing scienter as to each defendant individually. In
other words, plaintiffs must allege the required state
of mind as to each defendant who made an allegedly
misleading statement.
3. Loss Causation
Page 16
Defendants argue that the CAC fails to plead loss
causation, asserting that the boilerplate language in
the CAC is substantially identical to the language
found inadequate by the Supreme Court in Dura
Pharm., Inc. v. Broudo, 544 U.S. 336, 125 S.Ct.
1627, 1630, 161 L.Ed.2d 577 (2005). The CAC
alleges that the overvaluation of inventory and later
disclosure of the lack of internal controls that led to
the overvaluation caused a 22.5% decline in the price
of SST's stock price. The court finds that the
allegations in the CAC do meet the requirements of
Dura.
4. Control Person Liability
Adequate pleading of a primary violation of § 10(b)
is required for a plaintiff to adequately plead control
liability under § 20(a). See 15 U.S.C. § 78t. Because
the CAC fails to state a claim for primary liability
under § 10(b) or Rule 10b-5, the court finds that the
claim for control person liability must be dismissed.
CONCLUSION
In accordance with the foregoing, the motion to
dismiss the consolidated amended complaint is
GRANTED, for failure to allege falsity with
particularity, and for failure to allege scienter as to
any defendant. The totality of plaintiffs' allegations
are insufficient under the heightened pleading
standard of the PSLRA to raise a strong inference
that defendants acted with deliberate or conscious
recklessness in issuing statements regarding the value
of SST's inventory or in failing to disclose that SST
lacked adequate internal controls to ensure that
inventory was properly valued. The dismissal is
WITH LEAVE TO AMEND, and any amended
complaint shall be filed no later than April 14, 2006.
*23 Notwithstanding the fact that the dismissal is
with leave to amend, the court questions whether
plaintiffs will be able to state a claim. The gravamen
of plaintiffs' complaint as presented in the CAC is
that SST mismanaged the valuation of its inventory,
and then failed to disclose that mismanagement. The
allegation that defendants should have written down
the inventory earlier than they did, or should have
disclosed that SST's valuation system was
“arbitrary,” is essentially a claim that there were
material deficiencies in SST's inventory control
procedures. Generally speaking, incidents of
fiduciary misconduct and internal mismanagement
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Not Reported in F.Supp.2d
Not Reported in F.Supp.2d, 2006 WL 648683 (N.D.Cal.)
(Cite as: Not Reported in F.Supp.2d)
are not by themselves sufficient to trigger liability
under the Exchange Act. Santa Fe Indus., Inc. v.
Green, 430 U.S. 462, 478-80, 97 S.Ct. 1292, 51
L.Ed.2d 480 (1977).
IT IS SO ORDERED.
N.D.Cal.,2006.
In re Silicon Storage Technology, Inc.
Not Reported in F.Supp.2d, 2006 WL 648683
(N.D.Cal.)
Briefs and Other Related Documents (Back to top)
• 2006 WL 2702743 (Trial Motion, Memorandum
and Affidavit) Plaintiffs' Opposition to Defendants'
Request for Judicial Notice (Aug. 17, 2006) Original
Image of this Document (PDF)
• 2006 WL 1785822 (Trial Pleading) Second
Consolidated Amended Class Action Complaint
(May 2, 2006) Original Image of this Document
(PDF)
• 2005 WL 3607720 (Trial Motion, Memorandum
and Affidavit) Plaintiffs' Memorandum in Support of
their Opposition to Defendants' Motion to Dismiss
the Consolidated Amended Class Action Complaint
(Nov. 4, 2005) Original Image of this Document
(PDF)
• 2005 WL 451836 (Trial Pleading) Complaint for
Violation of the Federal Securities Laws (Jan. 20,
2005) Original Image of this Document with
Appendix (PDF)
• 3:05cv00295 (Docket) (Jan. 20, 2005)
• 2005 WL 2868820 (Trial Motion, Memorandum
and Affidavit) Defendants' Memorandum of Points
and Authorities in Support of Motion to Dismiss
Plaintiffs' Consolidated Amended Class Action
Complaint (Jan. 4, 2005) Original Image of this
Document (PDF)
END OF DOCUMENT
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Not Reported in F.Supp., 1990 WL 263846 (N.D.Cal.), Fed. Sec. L. Rep. P 95,659
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Page 1
management activities of certain defendants. FN1
Briefs and Other Related Documents
Smith v. Network Equipment Technologies,
Inc.N.D.Cal.,1990.
United States District Court, N.D. California.
SMITH
v.
NETWORK EQUIPMENT TECHNOLOGIES,
INC., et al.
Nos. C-90-1138 DLJ, C-90-1281 DLJ and C-901372 DLJ.
Oct. 19, 1990.
Opinion
JENSEN, District Judge.
*1 This motion to dismiss came on for hearing before
this Court on October 3, 1990. Tower C. Snow, Jr.,
and Dana Welch appeared for defendant Network
Equipment Technologies, Inc.
Doug Schwab
appeared for defendant Barrett Roach. Paul Davies
appeared for defendant Bruce Smith. Blake Harper,
Stuart Savett, Robert Schubert, and Dennis Stewart
appeared representing class plaintiffs in this action
and the related actions.
For the reasons set out
below, Defendants' motion is DENIED IN PART
AND GRANTED IN PART, WITH LEAVE TO
AMEND.
I. BACKGROUND.
This motion arises in a securities fraud class action,
brought under both state and federal law, relating to
Network Equipment Technologies, Inc., (“NET.”)
NET
manufactures
and
sells
high-tech
communications products that allow a business with
geographically disparate offices to link their
personnel through a computer based network. NET
stock is traded publicly through major exchanges.
The allegations in Plaintiffs' Consolidated Amended
Class Action Complaint For Violation of Securities
Exchange Act of 1934 And Pendent State Law
Claims (the “Amended Complaint”) can be
summarized as follows.
The defendants include
NET and individual defendants.
Plaintiffs have
alleged that each individual defendant is an officer of
NET, identified each individual defendants job title,
and offered general averments descriptive of the
During the period covered by the complaint, various
Defendants made false or misleading statements to
the press and financial analysts, filed false or
misleading press releases, filed false or misleading
reports with the SEC, published false or misleading
quarterly reports, and sent at least one false or
misleading letter to all shareholders.
In particular, all of these alleged fraudulent
communications failed to inform investors that NET
had much lower revenues and profits than the
revenue amounts reported to the public. Plaintiffs
have alleged various causes for these allegedly
hidden poor economic figures, most of which focus
on mismanagement of NET's assets and NET's failure
to follow generally accepted accounting principles.
For example, Plaintiffs allege that NET arbitrarily
shipped unordered goods to potential customers,
falsely recorded sales revenue from these shipments,
and then lost money when NET was either forced to
accept the return of the unordered goods or to
convince customers to keep excess shipments by
providing substantial discounts and other costly
incentives.
As a result of Defendants alleged exaggeration of
NET's financial position, NET stock traded at an
artifically high price in excess of $30.00 per share.
Plaintiffs allege with particularity that all individual
defendants, save Daniel Warmenhoven, sold
substantial amounts of NET stock while NET traded
at this artificially high value. Beginning in April of
1990, NET's true financial position became apparent
to investors, and within weeks NET stock was trading
at less than $10.00 per share.
*2 All Defendants have moved to dismiss the
Plaintiffs Amended Complaint for four reasons: (1)
The federal causes of action under Rule 10b-5 FN2
should be dismissed for failure to allege specifically
facts raising an inference of scienter; (2) Certain
individual defendants should be dismissed for failure
to allege particular wrongdoing by them; (3) The
causes of action relating to secondary liability should
be dismissed for failure to allege specifically facts
indicating conspiracy, aiding & abetting, or control of
other wrongdoers; and (4) the pendent state law
fraud claims should be dismissed with prejudice for
failure to state a claim under state law.
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It is important to note that Defendants do not
challenge Plaintiffs allegations regarding the
existence of material misrepresentations and
omissions.
Defendants' motion assumes these
material misrepresentations and omissions have
occurred and directs itself entirely to other elements
of liability, including the scienter requirement and the
requirements of various forms of secondary liability.
After setting out the standard of review for the
purposes of dismissal, the Court treats each of
Defendants' theories separately below.
II. THE APPLICABLE STANDARD.
The question presented by a motion to dismiss is not
whether a plaintiff will prevail in the action, but
whether a plaintiff is entitled to offer evidence in
support of his claim. “[T]he accepted rule [is] that a
complaint should not be dismissed for failure to state
a claim unless it appears beyond doubt the plaintiff
can prove no set of facts in support of his claim
which would entitle him to relief.” Conley v. Gibson,
78 S.Ct. 99, 102 (1957). In the Ninth Circuit, the
Court making this determination must assume that
plaintiff's allegations are true, construe the complaint
in a light most favorable to plaintiff, and resolve
every doubt in plaintiff's favor. United States v. City
of Redwood City, 640 F.2d 963, 966 (9th Cir.1981).
Therefore, the Court will dismiss the complaint or
any claim in it without leave to amend only if “it is
‘absolutely clear that the deficiencies of the
complaint could not be cured by amendment.’ ” Noll
v. Carlson, 809 F.2d 1446, 1448 (9th Cir.1987)
quoting Broughton v. Cutter Laboratories, 622 F.2d
458, 460 (9th Cir.1980) (per curiam)).
III. THE ALLEGATIONS RAISE AN INFERENCE
OF SCIENTER.
Scienter is an element of both primary and secondary
liability under Rule 10b-5.
Scienter has been
defined recently by the Ninth Circuit to embrace the
specific intent to commit wrongful acts or
recklessness, when reckless is defined as follows:
Reckless conduct may be defined as a highly
unreasonable omission, involving not merely simple,
or even inexcusable negligence, but an extreme
departure from the standards of ordinary care, and
which presents a danger of misleading buyers or
Page 42 of 96
Page 2
sellers that is either known to the defendant or is so
obvious that the actor must have been aware of it.
Hollinger v. Titan Capital, 914 F.2d 1564 at 1569
(9th Cir. Sept. 27, 1990) quoting Sunstrand Corp. v.
Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir.)
cert. den., 434 U.S. 875 (1977).
*3 Scienter is a fact specific issue which is normally
left to the trier of fact. Vucinich v. Paine, Weber,
Jackson & Curtis, Inc., 739 F.2d 1434, 1436 (9th
Cir.1984) (per curiam).
Because a defendants state of mind is information
peculiarly within the control of the defendant, Rule
9(b) allows plaintiffs in a fraud action to plead
“malice, intent, knowledge, and other condition of
mind” by general averment. Plaintiffs' complaint
here offers general allegations of extreme
recklessness and intentional misstatement and
omission that meet the express terms of Rule 9(b).
However, case law dealing specifically with the
requirements of pleading under Rule 10b-5 have
supplemented the requirements of Rule 9.
In
addition to general averments of recklessness or
intent, a sufficient complaint for liability under Rule
10b-5 must allege specific facts that give rise to “an
inference of scienter.” Ross v. A.H. Robbins Co.,
Inc., 607 F.2d 545, 558-59 (2nd Cir.1979) cert.
denied, 446 U.S. 946 (1980), reh. denied, 448 U.S.
911; Hudson v. Capital Management International
Inc., [1983-84 Transfer Binder] Fed.Sec.L.Rep.
(CCH) ¶ 99,221 at 95,896 (N.D.Cal.1982) (citing
Ross ); In re Genentech, Inc. Securities Litigation,
[1989-90 Transfer Binder] Fed.Sec.L.Rep. (CCH) ¶
94,960 at 95,372 (N.D.Cal.1989) (citing Ross ). In
the Ninth Circuit, an inference of scienter may be
raised by any facts alleged in the complaint,
including the nature of the underlying fraud or
contemporaneous conduct reflecting knowledge of
the fraud, such as improper insider trading. See
Blake v. Dierdorff, 856 F.2d 1365, 1370 (9th
Cir.1988); Klien v. King, [Current Transfer Binder]
Fed.Sec.L.Rep. (CCH) ¶
95,002 at 95,605
(N.D.Cal.1990).
Construing the complaint liberally, as the Court must
for the purposes of this motion, Plaintiffs have
alleged facts that raise an inference of scienter.
Plaintiffs have alleged that Defendants grossly
inflated the reported revenues of NET by
systematically shipping unordered goods to existing
and potential customers and then reflecting
anticipated payments for these unordered shipments
as revenue. Moreover, Plaintiffs have specifically
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alleged that these practices of shipping unordered
goods and misreporting revenues occurred on a large
scale, affecting over 20% of NET total sales, and
occurred continuously over period of six months.
This practice reflects “an extreme departure from the
standards of ordinary care” in the operation of a
business and presents a danger of misleading
investors-who commonly rely on revenue figures-that
“is so obvious that the [Defendants] must have been
aware of it.” Hollinger, 17504 LEXIS at 12.
In addition to shipping without orders and
misrepresenting the nature of shipments in financial
records, Plaintiffs have specifically alleged that all of
the
individual
defendants,
save
Daniel
Warmenhoven, engaged in insider trading which took
advantage of inflated stock prices based on NET's
misreported revenues. Defendants correctly point
out that insider trading, standing alone, may not give
rise to an inference of scienter. However, in the
context of reckless management and pervasive
misrepresentation in internal financial reports, insider
trading does give rise to an inference of scienter. In
re 3COM Securities Litigation, [1990 Transfer
Binder] Fed Sec.L.Rep. (CCH) ¶ 95,279 at 96,247
(N.D.Cal.1990); In re Genentech, Inc. Securities
Litigation, [1989-90 Transfer Binder] Fed.Sec.L.Rep.
(CCH) ¶ 94,960 at 95,372 (N.D.Cal.1989) (finding a
“strong inference of scienter” where “Genentech was
misstating revenue through the use of misleading
accounting practices [and] [t]his material inside
information remained unknown to other stockholders
until late September 1988, by which time the ...
[D]efendants had allegedly sold more than 500,000
shares of their Genentech stock.”)
*4 Because Plaintiffs have adequately plead specific
facts raising an inference of scienter, Defendants
motion to dismiss the federal claims under Rule 10b5 is DENIED.
IV. PLAINTIFFS GROUP ALLEGATIONS ARE
OVERBROAD.
Defendants argue that Plaintiffs have failed to carry
their pleading burden because Plaintiffs have failed
either to allege particular involvement in the alleged
fraud by each of the individual defendants, or, to
properly use group pleading presumptions that would
eliminate Plaintiffs burden to plead with particularity
regarding each defendant.
Defendants argument
here is persuasive, at least with regard to certain
alleged misrepresentations and defendants.
Page 43 of 96
Page 3
In the Ninth Circuit, where the fraud alleged is fraud
in the internal operation of a corporation, plaintiffs
are allowed to plead claims for fraud against officers
of the corporation using group pleading
presumptions. Wool v. Tandem Computers, Inc., 818
F.2d 1433, 1440 (9th Cir.1987). In particular, where
the misrepresentations alleged take the form of
“group published information,” then plaintiffs may
plead fraud by officers and executives involved in the
day-to-day management of those parts of the
corporation involved in the fraud through general
averment. Id. “Group published information” has
been defined to include “prospectuses, registration
statements, annual reports, press releases” and 10-Q
filings, which were the particular subject of Wool.
Id.
The rationale for such group pleading is simple and
compelling: Facts about fraud flowing from the
internal operation of a corporation are peculiarly-and
often exclusively-within the control of the corporate
insiders who manage the parts of the corporation
involved in the fraud. Requiring specific pleading in
this context would create a substantial barrier for
plaintiffs seeking to allege certain types of corporate
securities fraud.
Plaintiffs rely entirely on group pleading under Wool
in their allegations against the individual defendants.
With regard to most Defendants, and most alleged
misrepresentations, Plaintiffs' group allegations are
sufficient. Certain of Plaintiffs allegations, however,
are insufficient, even within the group pleading
framework established by Wool.
First, Plaintiffs have alleged a number of
misrepresentations that do not involve “group
published information.” Paragraphs 34, 40-42, and
46 of the Amended Complaint allege unattributed
misrepresentations which were communicated in
unidentified forms to financial analysts and the press.
These allegations fail to allege specifically either
particular
misrepresentations
by
identified
defendants, or particular misrepresentation published
through identified forms of group published
information. Thus, these allegations are inadequate
and are stricken from the complaint with leave to
amend.
Second, Plaintiffs have used group pleading
indiscriminately to reach every officer of NET. In
essence, Plaintiffs argue that Wool allows group
pleading against anyone denominated an officer
without regard to the nature of the fraud alleged by
Plaintiffs, or the functional connection between the
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activities of an individual defendant and the activities
involved in the fraud. This facile approach to group
pleading is at odds with the rationale of Wool.
*5 The group pleading presumption allowed by Wool
rests on the assumption that officers involved in the
day-to-day management of a corporation must be
aware of the internal operations of the corporation,
including fraudulent internal operations. In other
words, the group pleading presumption rests on an
assumption that defendants within the group are
functionally related to the alleged fraudulent activity.
This assumed functional relationship cannot plausibly
be extended to encompass every officer of a
corporation where fraud has occurred, regardless of
the nature of the alleged fraud or the functional
responsibilities of given directors.
In large
corporations, with far-flung offices and divisions, the
status of officer or director is not enough in itself to
insure involvement in the group functionally related
to the fraud.
For example, in the present case,
Plaintiffs allege a fraudulent scheme involving
marketing, accounting practices, and fraudulent
releases of information. Plaintiffs do not allege any
improper conduct involving the design or
manufacture of NET's products. Nor have Plaintiffs
alleged the existence of regular meetings,
correspondence, or any other facts which would
indicate, for example, that Walter Gill-NET's Vice
President and Chief Technical Officer-had any
involvement in the management of NET's marketing
or accounting practices. Finally, Plaintiffs have not
linked Gill in any way to the process of drafting or
publishing the financial reports alleged as part of the
overall fraudulent scheme.
Thus, extending the
Wool presumptions to embrace Gill would conflict
with assumption underlying the analysis of Wool.
Equally important, including Gill in the “group”
simply because Gill is nominally a director does not
ultimately disadvantage Plaintiffs here.
Plaintiffs
gain full discovery into NET's internal operations,
including the activities of Gill, through effective
pleading against NET itself and some of NET's
officers. If discovery uncovers that Gill is in fact
involved in the alleged fraudulent activity he may be
added as a defendant at that time.
The fraud alleged here deals with NET's marketing,
accounting practices, and the publication of financial
reports. To place the individual defendants in the
Wool group connected with this scheme the Plaintiffs
have alleged only the corporate positions of the
individual defendants along with general descriptions
Page 4
which, Plaintiffs admitted at oral argument, flow
primarily from Plaintiffs own interpretation of the
title of Defendants' positions. On this scant record
the Court finds that there is insufficient evidence to
bring the following individual defendants within the
Wool group: Walter J. Gill, Vice President and Chief
Technical Officer; Laurence M. Markowitz, Vice
President of Operations; and Anthony P. Russo, Vice
President of Corporate Development. Defendants
argue, and Plaintiffs do not dispute, that these three
individuals are involved in the design and
manufacture of NET's products. Thus, they are not
connected with the scheme alleged by the Plaintiffs,
and cannot be properly included in the “group”
covered by group pleading under Wool.
*6 Since Plaintiffs rely entirely on group pleading
under Wool to state any claim against these three
individuals, the affect of excluding Gill, Markowitz,
and Russo, from the “group” covered by Wool is to
render Plaintiffs complaint insufficient as to these
defendants. Thus, Plaintiffs have failed to state a
claim against Gill, Markowitz, and Russo, and
Defendants motion to dismiss is granted as to these
defendants. Leave is granted to the Plaintiffs to join
these defendants later if discovery uncovers
particular involvement in the fraud by these
individuals. All further references to “the individual
defendants” or “the Defendants” is this Order do not
refer to these three individual defendants.
V. THE SPECIFICITY OF PLEADING REGARDING
SECONDARY LIABILITY.
There are four forms of secondary liability for a
violation of Rule 10b-5: “Control person” liability,
aiding and abetting liability, conspiracy liability, and
respondeat superior liability. Each of these forms of
liability is treated separately below.
A. “Control Person” Liability.
“Control person” liability arises under section 20(a)
of the Securities Exchange Act of 1934, 15 U.S.C. §
78t(a).
Section 20(a) imposes joint and several
liability on persons who directly or indirectly control
violators of Rule 10b-5.
The requirements of
“control person” liability have recently been restated
by the Ninth Circuit in Hollinger v. Titan Capital, --F.2d ----, (9th Cir. Sept. 27, 1990), 17504 LEXIS at
32-33. To state a claim for “control person” liability
Plaintiffs are only required to plead that Defendants
had the power to control other actors who published
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the material misrepresentations which the Defendants
concede exist in this case. Id. (eliminating plaintiffs
burden to show “culpable participation” and creating
defendants burden to show “good faith” as a
defense.)
In their efforts to sufficiently plead that Defendants
controlled the actors who committed violations of
10b-5, Plaintiffs are aided by certain presumptions.
“[W]here, as here, the corporate officers are a
narrowly defined group charged with the day-to-day
operations of public corporation, it is reasonable to
presume that these officers had the power to control
or influence the particular transactions giving rise to
the securities violation.” Wool, 818 F.2d at 1441
(emphasis added). Thus, allegations identifying the
position and responsibilities of an officer, manager,
or director of a corporation may, standing alone,
sufficiently plead the first element of “control.”
Here, Plaintiffs have offered allegations establishing
with respect to each remaining individual plaintiff
that they were part of a group of top managers and
officers who participated in the management of parts
of NET implicated in the fraudulent scheme alleged
by the Plaintiffs. Thus, Plaintiffs have adequately
plead a claim for “control person” liability under
section 20(a).
B. Aiding and Abetting Liability.
*7 To state a claim for aiding and abetting liability,
the Plaintiffs must allege: (1) the existence of an
independent primary violation of Rule 10b-5, (2)
actual knowledge by the Defendants of the wrong
and their role in furthering the wrong; and (3)
substantial assistance in the wrong. Harmsen v.
Smith, 693 F.2d 932, 943 (9th Cir.1982) cert. den.,
464 U.S. 822 (1983). In addition, aider and abettor
liability attaches where Defendants have remained
silent when they had a duty to disclose material
information. Roberts v. Peat, Marwick, Mitchell &
Co., 857 F.2d 646, 652-53 (9th Cir.1988).
For the purposes of this motion, our previous
discussion of Defendants' scienter objections
establishes that Plaintiffs have adequately plead an
independent violation of Rule 10b-5. In addition, we
have already resolved that Plaintiffs have adequately
alleged a culpable mental state on the part of
Defendants. See In re Thortec Securities Litigation,
[1989 Transfer Binder] Fed.Sec.L.Rep. (CCH) ¶
94,330 (N.D.Cal.1989) (finding general averment of
actual knowledge sufficient to plead a claim of aiding
Page 5
and abetting liability). Thus, Defendants argument
regarding aiding and abetting raises only one new
question:
Have Plaintiffs adequately plead
substantial assistance by all Defendants?
Affirmative misstatements to investors which hide or
extend prior violations of Rule 10b-5 constitute
substantial assistance.
Defendants concede that
during the period when unordered goods were being
shipped, and the shipments were improperly recorded
as revenue producing sales, officers and employees
of NET made a number of affirmative misstatements
on behalf of NET to the effect that sales revenues
were high and the economic future for NET was
optimistic.
Defendants argument regarding
substantial assistance boils down to the fact that
Plaintiffs have not specifically linked each and every
defendant with the drafting and publication of a
particular affirmative misstatements.
This argument is erroneous. In the Ninth Circuit, at
the pleading phase, officers, managers, and directors
who participate in the day-to-day management of a
corporation are presumed to be responsible for
“group published information.”
In re Thortec
Securities Litigation, [1989 Transfer Binder]
Fed.Sec.L.Rep. (CCH) ¶ 94,330 (N.D.Cal.1989)
(applying Wool and Blake presumption to “group
published information” for aiding and abetting
liability); see Wool v. Tandem Computers, Inc., 818
F.2d 1433, 1440 (9th Cir.1987) (“control” of “group
published information assumed for “control person”
liability); Blake v. Dierdorff, 856 F.2d 1365, 136970 (9th Cir.1988) (responsibility of management for
“group published information assumed for RICO
liability).
As we have already discussed, Plaintiffs have alleged
that each remaining individual defendant was an
officer of NET who participated the management of
parts of NET implicated in the fraudulent scheme
alleged by the Plaintiffs. In addition, the alleged
misrepresentations and omission all were published
through press releases, quarterly reports, and other
“group published information.” Thus, within the
group pleading framework established by Wool,
Plaintiffs have linked Defendants with affirmative
misstatements, and have adequately plead substantial
assistance.
Defendants motion to dismiss those
portions of the compliant related to aiding and
abetting liability are denied.
C. Conspiracy Liability.
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Not Reported in F.Supp., 1990 WL 263846 (N.D.Cal.), Fed. Sec. L. Rep. P 95,659
(Cite as: Not Reported in F.Supp.)
*8 To state a claim for conspiracy to commit a
violation of Rule 10b-5 the Plaintiffs must allege: (1)
an agreement to commit a violation of Rule 10b-5,
and (2) acts in furtherance of this agreement. Roberts
v. Heim, 670 F.Supp. 1466, 1484 (N.D.Cal.1987). In
contrast to the requirements for pleading other forms
of secondary liability, Plaintiffs are not advantaged
here by presumptions regarding the presence of an
agreement or acts in furtherance.
To adequately
plead conspiracy, Plaintiffs must plead specifically
with regard to each Defendant the existence of an
agreement and acts in furtherance of that agreement.
In re Thortec Securities Litigation, [1989 Transfer
Binder] Fed.Sec.L.Rep. (CCH) ¶
94,330
(N.D.Cal.1989). As Judge Henderson of this District
has stated, “It is not enough ... to show that [the
defendants] might have had a common goal unless
there is a factually specific allegation that they
directed themselves toward [this goal] by virtue of a
mutual understanding or agreement. Roberts v.
Heim, 670 F.Supp. 1466, 1484 (N.D.Cal.1987)
(emphasis added).
Plaintiffs admit that they have not alleged either a
specific agreement or particular acts in furtherance of
the agreement. However, Plaintiffs argue that the
Court should extend the presumptions applied to
other forms of secondary liability to create a
presumption of an agreement and a presumption of
general responsibility for all “group published
information,” which may establish acts in furtherance
of the agreement.
There is some authority for extending the Wool
presumptions to the elements of conspiracy.
On
occasion, this Court has relaxed the requirement that
plaintiffs specifically plead acts in furtherance of the
conspiracy. In re Genentech Securities Litigation,
[1989 Transfer Binder] Fed.Sec.L.Rep. (CCH) ¶
94,813, 95,373 (N.D.Cal.1989). Furthermore, the
existence and terms of a conspiratorial agreement is
information peculiarly within the control of
Defendants, and, as a result, a flexible approach to
pleading an agreement appears appropriate.
Page 46 of 96
Page 6
liability and adopting a new definition of scienter, the
Ninth Circuit's recent opinion in Hollinger reestablishes the viability of a separate cause of action
against principals for the securities frauds committed
by their agents under a theory of respondeat superior.
Hollinger v. Titan Capital, 914 F.2d 1564 at 1577
(9th Cir. Sept. 27, 1990). Respondeat superior is a
common law doctrine which renders the principal
liable for the acts of agents carried out within the
course and scope of their agency. In the case of
fraud involving the internal operation of a
corporation, respondeat superior claims may lie
against NET for the misconduct of NET's employees
and agents in the operation of the corporation.
*9 Respondeat superior claims in the context of
securities fraud are new to the Ninth Circuit.
However, other circuits have applied the doctrine of
respondeat superior in this context for some years,
and the Ninth Circuit has indicated its willingness to
look to these other circuits to define precisely the
requirements of a properly plead cause of action
under the doctrine. Hollinger, Id. at 1575 n. 26.
Plaintiffs are granted leave to amend their complaint
to state a cause of action under the doctrine of
respondeat superior, as that doctrine is discussed in
Hollinger.
VI. PLAINTIFFS STATE LAW FRAUD CLAIMS
SHOULD BE DISMISSED WITHOUT PREJUDICE.
Defendants and Plaintiffs agree that Plaintiffs state
law fraud and negligent misrepresentation claims
should be dismissed because they do not adequately
plead reliance, an essential element to both state law
claims. Defendants, however, have fully briefed the
merits of issue and seek a dismissal with prejudice.
Plaintiffs have not briefed the merits, but argue in
their briefs that the reliance theory they hope to plead
here is currently being considered by the California
Courts of Appeal, and, therefore, dismissal with leave
to replead is proper.
D. Respondeat Superior Liability.
While Plaintiffs' state court appeal does involve a
theory of liability related to Plaintiffs' fraud claims,
Plaintiffs have not raised any issues on appeal
connected with their negligent misrepresentation
claims. The negligent misrepresentation claims have
been finally adjudicated in the state courts, should not
be relitigated here. Plaintiffs cause of action for
negligent misrepresentation under state law is
dismissed with prejudice.
In addition to altering the burdens of “control person”
Defendants state law fraud claims, which are
However, this authority is too weak to merit the
radical extension of Wool sought by the Plaintiffs
here.
Thus, Plaintiffs allegations regarding
conspiracy to violate Rule 10b-5 are dismissed with
leave to amend.
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Not Reported in F.Supp.
Not Reported in F.Supp., 1990 WL 263846 (N.D.Cal.), Fed. Sec. L. Rep. P 95,659
(Cite as: Not Reported in F.Supp.)
implicated in the appeal, are dismissed with leave to
amend following the ruling of the California Court of
Appeal in Mirkin et al. v. Wasserman, et al., No. CA
001122 (2d App.Div.). In addition, the Plaintiffs are
directed to advise the Court of any orders or rulings
that issue from the Mirkin appeal.
• 3:90cv01372 (Docket) (May. 10, 1990)
• 3:90cv01281 (Docket) (May. 01, 1990)
• 3:90CV01138 (Docket) (Apr. 17, 1990)
END OF DOCUMENT
VII. CONCLUSION.
For the reasons set out above, the Court orders the
following:
1. Defendants' motion to dismiss Plaintiffs'
allegations of fraud under Rule 10b-5 for failure to
adequately plead scienter is DENIED.
2. Paragraphs 34, 40 through 42 inclusive, and 46 of
Plaintiffs' Amended Complaint are STRICKEN
WITH LEAVE TO AMEND.
3. Individual defendants Walter J. Gill, Laurence M.
Markowitz, and Anthony P. Russo are DISMISSED
from this suit WITHOUT PREJUDICE. Plaintiffs
are granted LEAVE TO RE-JOIN these defendants if
discovery uncovers evidence that will allow Plaintiffs
to plead particular misconduct by these defendants.
4. Plaintiffs' cause of action for conspiracy to commit
fraud is DISMISSED WITHOUT PREJUDICE AND
WITH LEAVE TO AMEND. Plaintiffs' are granted
LEAVE TO AMEND their Amended Complaint to
plead a cause of action under respondeat superior.
5. Plaintiffs' cause of action for negligent
misrepresentation under state law is DISMISSED
WITH PREJUDICE. Plaintiffs' cause of action for
common law fraud is DISMISSED WITHOUT
PREJUDICE. Plaintiffs are directed to inform the
Court of all material rulings or orders issued by the
California Court of Appeal in the matter of Mirkin, et
al. v. Wasserman, et al., No. CA 001122 (2d
App.Div.).
*10 6. Leave to amend under the terms of this order
is limited to 30 days from the date of this Order.
IT IS SO ORDERED.
N.D.Cal.,1990.
Smith v. Network Equipment Technologies, Inc.
Not Reported in F.Supp., 1990 WL 263846
(N.D.Cal.), Fed. Sec. L. Rep. P 95,659
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Briefs and Other Related Documents
In re Tibco Software, Inc.N.D.Cal.,2006.Only the
Westlaw citation is currently available.
United States District Court,N.D. California.
In re TIBCO SOFTWARE, INC. Securities
Litigation.
No. C 05-2146 SBA.
May 25, 2006.
Douglas John Clark, Ignacio E. Salceda, Kyle
Anthony Wombolt, Wilson Sonsini Goodrich &
Rosati Professional Corporation, Palo Alto, CA, for
Tibco Software, Inc.
ORDER
SAUNDRA BROWN ARMSTRONG, J.
[Docket Nos. 39, 40]
*1 This Document Relates To: All Actions
This matter comes before the Court on Defendants'
Motion to Dismiss Consolidated Amended Complaint
and Request for Judicial Notice. Having read and
considered the arguments presented by the parties in
the papers submitted to the Court, the Court finds this
matter appropriate for resolution without a hearing.
The Court hereby GRANTS the Motion to Dismiss
and GRANTS the Request for Judicial Notice.
BACKGROUND
A. Background Regarding the Parties
1. Tibco Software, Inc.
Defendant Tibco Software, Inc. (hereinafter
“TIBCO” or the “Company”) is a Delaware
corporation with its principal place of business in
Palo Alto, California. Consolidated Amended Compl.
(“CAC”) at ¶
3. TIBCO is engaged in the
development and marketing of business services
software products that enable customers to collect,
analyze, and distribute “real-time” FN1 information
about and within an organization. Id. TIBCO also
Page 1
offers integration solutions products designed
specifically to assist with business consolidations
following acquisitions, mergers, or similar
restructurings. Id. The Company's products are sold
individually or as product “suites” and “complete
solutions.”
FN1. The Company uses the term “real-time
business” to describe doing business in such
a way that organizations can use current
information to execute their critical business
processes and make smarter decisions.
Thompson Decl. at Ex. 1 (FY05 Form 10K).
TIBCO is a publicly traded company. As of the end
of fiscal year 2005, it had approximately 211,136,985
shares of common stock outstanding. Thompson
Decl. at Ex. 1 (FY05 Form 10-K). The Company's
financial year is not concurrent with the calendar
year. Id. Instead, it ends on the last day of November
of each calendar year and commences on the first day
of December for that calendar year. Id. For example,
its 2004 fiscal year end was November 30, 2004.
The Company has approximately 1,500 employees in
offices located throughout Europe, Africa, the Pacific
Rim, and the Americas. Id.
2. The Individual Defendants
At all times relevant to this action, Defendant Vivek
Y. Ranadivé (“Ranadivé”) was the President, Chief
Executive Officer and Chairman of the Board of
Directors of the Company. Id. at ¶ 14. Defendant
Christopher G. O'Meara (“O'Meara”) was, during the
relevant period, the Executive Vice President and
Chief Financial Officer (“CFO”) of the Company. Id.
at ¶ 15. O'Meara stepped down from the CFO
position on October 11, 2005. Thompson Decl. at Ex.
D.
Defendant Sydney Carey (“Carey”) was, during the
relevant period, the Vice President, Corporate
Controller and Chief Accounting Officer of the
Company. CAC at ¶ 16. From March 2002 to
September 2003, defendant Rajesh U. Mashruwala
(“Mashruwala”) was the Executive Vice President,
Office of the CEO. Id. at ¶
17. Thereafter,
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Mashruwala served as the Company's Executive Vice
President, Chief Operating Officer.FN2 Id.
FN2. Randavivé, O'Meara, Carey, and
Mashruwala are collectively referred to
herein as the “Individual Defendants.”
3. Plaintiffs
Lead Plaintiffs (“Plaintiffs”) Ralph Felton and Sathya
Rajasubramanian are common stock holders who
purchased the common stock of TIBCO during the
relevant time period. Id. at ¶ 12. Plaintiffs purport to
represent a class of purchasers of TIBCO stock
between September 21, 2004 and March 1, 2005. Id.
at ¶ 1, 12.
B. Background Regarding the Confidential Witnesses
*2 The allegations contained in the Consolidated
Amended Complaint are based, in part, on certain
information obtained from the following Confidential
Witnesses:
(a) Confidential Witness No. 1. Confidential Witness
No. 1 (“CW1”) was a Managing Director of Channel
Sales at TIBCO in Munich, Germany during most of
the class period until early 2005. CAC at ¶ 25(a).
(b) Confidential Witness No. 2. Confidential Witness
No. 2 (“CW2”) was employed as TIBCO General
Manager within the OEM sales channel in Austin,
Texas from 2003 through 2004. Id. at ¶ 25(b).
(c) Confidential Witness No. 3. Confidential Witness
No. 3 (“CW3”) was a National Account Director at
TIBCO in New York. He was employed by Staffware
from 2001 to June 2004 and then by TIBCO from
June 2004 through early 2005. Id. at ¶ 25(c).
(d) Confidential Witness No. 4. Confidential Witness
No. 4 (“CW4”) first worked as a Finance Director for
the Staffware U.K. subsidiary from 1998 to June
2004. After June 2004, he worked as a Finance
Director for TIBCO until mid-2005. Part of CW4's
responsibilities included the compilation of balance
sheets, profit and loss statements, and tracking assets
and liabilities. CW4 was also responsible for
reviewing the financials and interpreting the
application of accounting rules before submitting the
compiled financials to Staffware corporate. Id. at ¶
25(d).
(e) Confidential Witness No. 5. Confidential Witness
No. 5 (“CW5”) was employed as the Senior Manager
of IT Operations for TIBCO for over five years until
mid-2005. Id. at ¶ 25(e).
(f) Confidential Witness No. 6. Confidential Witness
Page 2
No. 6 (“CW6”) was employed by TIBCO as a PreSales Consultant from early 2005 through the fall of
2005. CW6 was responsible for supporting TIBCO
sales representatives by explaining TIBCO's products
and their capabilities to prospective customers.
According to CW6, TIBCO had a corporate training
group at the Company's headquarters where CW6
was educated about TIBCO products and sales
pitches. Id. at ¶ 25(f).
C. The Factual Allegations
On April 22, 2004, TIBCO announced that it would
acquire Staffware, a European company located in
the United Kingdom and provider of business process
management (“BPM”) solutions. Id. at ¶ ¶ 32-33;
Thompson Decl. at Ex. E (April 23, 2004 Form 8-K).
The Company stated that the acquisition would allow
TIBCO to broaden its solutions for automating and
integrating business processes, and to increase its
distribution capabilities through cross-selling of
products into new geographies and an expanded
customer base. Thompson Decl. at Ex. E. The
Company cautioned investors, however, in the
following manner regarding its expectations
pertaining to the acquisition of Staffware:
This release contains forward-looking statements
within the meaning of the “safe harbour” provisions
of the United States securities laws. All statements
other than statements of historical fact are statements
that could be deemed forward-looking statementsincluding, without limitation, statements regarding (i)
the ability of the acquisition to broaden TIBCO's
solutions for automating and integrating business
processes, (ii) the ability of the combined offering of
the TIBCO platform and the Staffware's technology
to provide an unparalleled solution to today's
marketplace, (iii) the ability of the acquisition to
create a larger software technology leader, (iv) the
ability of TIBCO to deepen its industry expertise in
finance, insurance, telecom and government sectors
as a result of the acquisition, (v) the ability of the
acquisition to increase TIBCO's distribution
capabilities solutions, (vi) the continued development
and support for Staffware's iProcess product and
TIBCO's BusinessWorks Workflow products, (vii)
the optimisation of Staffware's iProcess product to
run with key TIBCO products, (viii) TIBCO's plan to
continue to market, develop and maintain existing
BPM and business integration products, (ix) TIBCO's
plan to deliver a fully interoperable, unified suite in
mid to late 2005 and (x) TIBCO's plan to provide an
upgrade or migration path to current Staffware
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customers and the actual results could differ
materially from what is envisaged by such forwardlooking statements if TIBCO is unable to
successfully integrate the Staffware's business after
the acquisition, if TIBCO is unable to successfully
develop, market and sell the Staffware business
process management and workflow solutions or if the
market for business integration solutions does
develop and grow as is now expected. In addition, the
acquisition may not occur or may not occur in the
time currently contemplated if the shareholders of
Staffware do not accept the offer for their shares to
TIBCO on the terms offered by TIBCO. TIBCO
assumes no obligation to update the forward-looking
statements included in this release.
*3 Thompson Decl. at Ex. E (emphasis added); see
also id. at Ex. F.
On June 7, 2004, during the third fiscal quarter 2004
(“Q3 04”), TIBCO closed the acquisition of
Staffware. Id. at ¶ ¶ 32-33. The total cost of the
Staffware acquisition was approximately $237.1
million, comprised of $139.7 million in cash and the
issuance of 10.9 million shares of TIBCO common
stock, valued at $92.3 million. Id. TIBCO's
acquisition of Staffware was the Company's first
acquisition since 2002. Id. at ¶ 33.
In a Company release dated April 21, 2004, Ranadivé
stated:
We believe business processes are rapidly becoming