The opinion of the court was delivered by: FERN M. SMITH
Plaintiffs in this securities fraud class action suit allege that defendants have violated Sections 10(b), 20(a), and 20A(a) of the Securities Exchange Act of 1934 (the "1934 Act"), 15 U.S.C. §§ 78j(b), 78t(a), 78t-1(a). Plaintiffs bring this action on behalf of themselves and all other persons who purchased stock in Gupta Corporation ("Gupta") between September 13, 1993 and July 6, 1994 (the "class period"). The complaint names as defendants Gupta, six Gupta executives, a corporate shareholder, and two outside directors.
Defendants have filed several motions to dismiss pursuant to Fed. R. Civ. P. 12(b)(6). Plaintiffs have filed a cross-motion to strike four of the exhibits attached to defendants' motions to dismiss. For the reasons set forth below, defendants' motions are granted in part and denied in part. As the exhibits disputed in plaintiffs' motion to strike are not relevant to the Court's decision, plaintiffs' motion to strike is denied as moot.
Gupta is a California corporation that develops and sells client-server system software for personal computer networks. Gupta was founded in 1984 and went public on February 4, 1993 with an initial public offering ("IPO") of 2.2 million shares at $ 18 per share. The company's stock is traded on the NASDAQ Exchange. On the first day of the IPO, Gupta's share price rose to $ 35-1/4. Thereafter, however, the stock price began to decline, reaching $ 14-1/2 by September 1993. In the latter part of 1993, Gupta's stock began to rebound from this low point.
On April 25, 1994, Gupta's management announced that the company had not met revenue expectations for the first quarter of 1994. In response to this announcement, Gupta's stock fell from $ 22-7/8 per share to $ 13-1/2 per share. The stock price remained volatile, but generally continued to decline, over the next several months. On July 6, 1994, Gupta made a statement anticipating substantial losses for the second quarter of 1994. The company's share price fell to $ 8-3/4 per share the next day.
Plaintiffs filed their original complaint on May 2, 1994. On August 4, 1994, plaintiffs filed their first amended complaint, which enlarged the class period to include September 13, 1993 to July 6, 1994. During the class period, Gupta's stock traded as high as $ 30-1/2 per share. By the end of the period, the price fell to $ 8-3/4 per share or lower. Plaintiffs allege that Gupta and the named defendants violated federal securities laws by issuing false and misleading information about the company in an effort to inflate the price of Gupta stock for the purpose of selling their own stock at a substantial profit.
In addition to Gupta Corporation, plaintiffs name six Gupta executives as defendants: Umang Gupta, Chairman of the Board, Chief Executive Officer, and President of Gupta; D. Bruce Scott ("Scott"), Senior Vice President of Research and Development, and a Director of Gupta; Richard M. Noling ("Noling"), Senior Vice President, Finance and Administration and Chief Financial Officer; Nicholas Birtles ("Birtles"), Senior Vice President, European Operations, and subsequently Executive Vice President, Worldwide Sales and Operations; Richard J. Heaps ("Heaps"), Vice President, Business Development and General Counsel; and Reed D. Taussig ("Taussig"), Gupta's Senior Vice President, North American Operations, for most of the class period. The plaintiffs also name as defendants Novell, Inc. ("Novell"), a corporate shareholder of Gupta; Kanwal Rekhi ("Rekhi"), an Executive Vice President and a Director of Novell, who sits on Gupta's Board of Directors; and Douglas C. Carlisle ("Carlisle"), a Director of Gupta and member of the Board of Director's committees on audit and compensation.
I. Plaintiffs' Allegations
After the price of Gupta stock fell to $ 14-1/2 per share in September 1993, defendants devised a plan to boost the stock price in order to sell portions of their personal holdings of Gupta stock at a substantial profit. To achieve this result, defendants made material misrepresentations about Gupta's revenues and general financial condition, and failed to disclose internally known adverse facts concerning Gupta's products, management and competitors. For example, defendants inflated Gupta's financial results by recognizing revenue on sales which were not completed sales under Generally Accepted Accounting Principles ("GAAP"), and defendants failed to disclose that Gupta's sales and marketing efforts were in disarray.
Defendants disseminated false information to the market through false statements of earnings and reports to shareholders, false documents filed with the Securities and Exchange Commission ("SEC"), and false press reports based on the fraudulent financial reports. In addition, defendants held numerous meetings with securities analysts in order to pass the fraudulent information to the market through the analysts' reports.
Defendants' fraud-on-the-market was a success. During the class period, defendants sold 695,000 shares in Gupta Corporation for total proceeds of $ 14.2 million. The individual named defendants and Novell can be held accountable for the deception of the investing public under theories of group published information, control person liability, and insider trading.
Gupta has experienced rapid growth, but fluctuating earnings, over the past several years. The price of Gupta's stock, like that of many other software securities, has been highly volatile throughout its trading history. During the class period, defendants sold only a small fraction of their Gupta stock; as a result, defendants suffered an enormous loss, along with the investing public, when the price of the stock declined.
Plaintiffs' complaint, filed after one significant drop in Gupta's stock price and amended after a second decline, is without merit. Based almost entirely on "information and belief," the complaint's allegations are non-actionable because they are alleged without the required specificity; concern mere expressions of optimism and statements about general economic conditions; and/or are general statements or omissions relating to future performance. Moreover, Gupta is not legally responsible for the statements by analysts, and Gupta's statements "bespeak caution." Finally, none of the statements made by defendants after the date on which plaintiffs filed their original complaint are actionable, because plaintiffs were aware of the company's problems by that date. The allegations against the individual Gupta defendants, the outside directors and Novell are similarly without merit.
A motion to dismiss pursuant to Rule 12(b)(6) tests the sufficiency of the complaint. North Star Int'l v. Arizona Corp. Comm'n, 720 F.2d 578, 581 (9th Cir. 1983). Dismissal of an action pursuant to Rule 12(b)(6) 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." Levine v. Diamanthuset, Inc., 950 F.2d 1478, 1482 (9th Cir. 1991) (quoting Conley v. Gibson, 355 U.S. 41, 45-46, 78 S. Ct. 99, 101-102, 2 L. Ed. 2d 80 (1957)). The Court may dismiss the complaint, or any claims within it, as a matter of law for either of two reasons: (1) lack of a cognizable legal theory, or (2) insufficient facts to support a cognizable legal theory. Robertson v. Dean Witter Reynolds, Inc., 749 F.2d 530, 534 (9th Cir. 1984) (citations omitted). In reviewing a motion to dismiss, the Court must assume that all factual allegations are true, and must construe them in the light most favorable to the non-moving party. North Star Int'l v. Arizona Corp. Comm'n, 720 F.2d 578, 580 (9th Cir. 1983). The Court need not, however, accept legal conclusions pled in the complaint even if they are asserted as "facts." Papasan v. Allain, 478 U.S. 265, 286, 92 L. Ed. 2d 209, 106 S. Ct. 2932 (1986).
When ruling on a motion to dismiss, the court may consider a variety of documents in addition to the complaint. First, the court may consider documents attached to the complaint. 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). Second, the court may consider "documents whose contents are alleged in a complaint and whose authenticity no party questions, but which are not physically attached to the pleading." Branch v. Tunnell, 14 F.3d 449, 454 (9th Cir. 1994), cert. denied, 129 L. Ed. 2d 832, 114 S. Ct. 2704 (1994). Third, the court may review "public disclosure documents required by law to be and which actually have been filed with the SEC." Cortec Indus., Inc. v. Sum Holding L.P., 949 F.2d 42, 47 (2d Cir. 1991), cert. denied, 112 S. Ct. 1561, 118 L. Ed. 2d 208 (1992).
B. Complaints Alleging Fraud
Allegations of fraud must satisfy the requirements of Fed. R. Civ. P. 9(b) to survive a motion to dismiss. Rule 9(b) provides that
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.
The intent of Rule 9(b) is to "prevent the filing of claims merely to discover unknown wrongs." In re GlenFed, Inc. Sec. Litig., 11 F.3d 843, 847 (9th Cir. 1993) (citing Semegen v. Weidner, 780 F.2d 727, 731 (9th Cir. 1985)).
To satisfy the dictates of Rule 9(b), securities class action plaintiffs must allege fraud with enough particularity to give defendants notice of the specific charges against them so that defendants may respond to the charges. Kaplan v. Rose, Fed. Sec. L. Rep. (CCH) P 98,422, 90,874 (9th Cir. 1994); Neubronner v. Milken, 6 F.3d 666, 671-72 (9th Cir. 1993). A complaint satisfies this standard if it "state[s] precisely the time, place, and nature of the misleading statements, misrepresentations, and specific acts of fraud." Kaplan, Fed. Sec. L. Rep. (CCH) P 98,422 at 90,874. See also, Neubronner, 6 F.3d at 672. The requirements of Rule 9(b) may be "relaxed as to matters peculiarly within the opposing party's knowledge," if the plaintiffs cannot be expected to have personal knowledge of the facts prior to discovery. Wool v. Tandem Computers, Inc., 818 F.2d 1433, 1439 (9th Cir. 1987) (citations omitted).
Rule 10b-5, 17 C.F.R. § 240.10b-5, enacted pursuant to Section 10(b) of the 1934 Act, makes it unlawful "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." To successfully allege securities fraud under Rule 10b-5, plaintiffs must allege reliance on a material misstatement, and scienter. See Hanon v. Dataproducts Corp., 976 F.2d 497, 506-07 (9th Cir. 1992).
Plaintiffs may allege reliance using the fraud-on-the-market theory. "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 benefit 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." Apple, 886 F.2d 1109, 1113-14. Defendants may respond to a claim of fraud-on-the-market by asserting that the information allegedly withheld from the market had in fact entered the market. Id. at 1114.
Scienter is defined as an intent to deceive, manipulate or defraud. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193-94 n.12, 47 L. Ed. 2d 668, 96 S. Ct. 1375, reh'g denied, 425 U.S. 986, 48 L. Ed. 2d 811, 96 S. Ct. 2194 (1976); In Re GlenFed, Inc. Sec. Litig., 11 F.3d 843, 847 (9th Cir. 1993); Hanon v. Dataproducts Corp., 976 F.2d 497, 507 (9th Cir. 1992). Consistent with this definition, a complaint must allege facts showing conduct "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 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 Corp., 914 F.2d 1564, 1569 (9th Cir. 1990) (en banc), cert. denied, 499 U.S. 976, 113 L. Ed. 2d 719, 111 S. Ct. 1621 (1991) (citations omitted). Although Rule 9(b) allows scienter to be pled generally, courts have required that the facts pled support a strong inference of fraudulent intent. O'Brien v. National Property Analysts Partners, 936 F.2d 674, 676 (2d Cir. 1991).
B. Accounting Allegations
PP 34-35, 36-37, 39-40, 41, 44-45, 46-50, 51-53, 54, 55, 56, 57-58, 59, 60-65, 67-68, 69-70, 71, 74, 75-76, 88, 89, 90(a), 90(b), 90(c), 90(d), 90(f), 90(g), 90(j), 90(l)
1. Most of Plaintiffs' Allegations of Fraudulent Accounting Do Not Satisfy the Requirements of Rule 9(b) and Rule 10b-5.
Plaintiffs' main contention in this action is that Gupta's financial records for the third and fourth quarters of 1993 and the first quarter of 1994 were materially false because the defendants knowingly utilized accounting practices which violate GAAP. Plaintiffs allege, for example, that
P 90(a): Gupta's third and fourth quarter 1993, year-end 1993, and first quarter 1994 results of operations were materially overstated in violation of GAAP due to Gupta's recording revenue on false sales, failure to take appropriate reserve for returns of product and having inadequate reserves for doubtful accounts receivable[.]
P 88(a): Gupta improperly recognized revenue from software licensing agreements prior to fulfilling its obligations under the agreements and prior to an exchange occurring[.]
P 89(c): Gupta's financial statements issued during the Class Period failed to comply with the accounting principle of conservatism, which requires that a conservative approach be taken in the accounting for transactions and the early recognition of unfavorable events.
Like all other allegations of securities fraud based on Rule 10b-5, plaintiffs' claims must satisfy the particularity requirement of Rule 9(b). With the exception of three specific claims of fraudulent accounting directed at Gupta's results for the first quarter of 1994, plaintiffs' allegations do not meet this threshold test.
The Ninth Circuit, in its most recent application of the requirements of Rule 9(b) to allegations of accounting fraud under Rule 10b-5, upheld the plaintiff shareholders' action against Wells Fargo Bank. In re Wells Fargo Sec. Litig. 12 F.3d 922 (9th Cir. 1993). The Wells Fargo plaintiffs alleged that the bank had set aside insufficient reserves to support the bank's loan portfolio. In finding the allegations actionable, the court emphasized that the shareholders listed specific loans which the bank allegedly overvalued, and estimated the amount of the alleged overvaluation. Id. at 926-27. In rejecting Wells Fargo's position, the court stated
Id. The Wells Fargo court concluded by stating that the shareholders' allegations successfully "distinguish their situation from that of many other [investors] who are adversely affected by business reverses." Id. at 928 (quoting DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th. Cir. 1990), cert. denied, 498 U.S. 941, 112 L. Ed. 2d 312, 111 S. Ct. 347 (1990)).
In short, Wells Fargo requires that allegations, of financial fraud be pled with at least some supporting facts beyond mere observations of adverse financial events. Thus, under Wells Fargo, the assertion that the defendant company increased its reserves for uncollectible accounts receivable is not, by itself, sufficiently indicative of fraud to survive a motion to dismiss. Plaintiffs in this action cannot even point to an historical correction of reserves or revenues, or any other financial incident, to support their allegations of fraudulent accounting in the third and fourth quarters of 1993.
Several courts in this district have applied Wells Fargo to dismiss allegations of accounting fraud which are comparable to or stronger than plaintiffs' claims. For example, in In re Ross Sys. Sec. Litig., Fed. Sec. L. Rep. (CCH) P 98,363 (N.D. Cal. 1994), the court dismissed allegations including the following:
Ross' reserves of only $ 1.5 million for total receivables of $ 33.2 million . . . were understated by at least $ 2 million . . . . Ross was . . . deferring the write-off of these receivables until future quarters where it hopefully would have higher revenues . . .
Defendants knew that revenues had been recognized where the earnings process was not complete, resulting in Ross having to ultimately report charges in excess of $ 4 million against accounts receivable . . .
Id. at 90,498. In dismissing plaintiff shareholders' claims, the Ross court explained that "unlike the allegations upheld in Wells Fargo, where the plaintiff identified nine specific loans not reflected in the company's report of its loan loss reserves, the allegations here do not specify particular transactions underlying defendants' alleged accounting deficiencies." Id. at 90,499.
In Adam v. Silicon Valley Bancshares, 1994 U.S. Dist. LEXIS 2797 (N.D. Cal. 1994), the court dismissed allegations of accounting fraud where "the complaint itemizes the accounting procedures allegedly violated, [but] fails to sufficiently allege any facts about how each of the stated GAAS and GAAP [was] actually violated." Id. at *5. The court noted in a footnote that "in the past, this court as well as other district courts within the Ninth Circuit have held that similar allegations comport with Rule 9(b)'s particularity requirement. However, recent holdings by the Ninth Circuit indicate that such pleadings are not sufficient." Id. at n.1 (citing Wells Fargo and In re GlenFed, Inc. Sec. Litig., 11 F.3d 843 (9th Cir. 1993)) (internal citations omitted).
At least one court in this district dismissed allegations of accounting fraud similar to plaintiffs' claims before Wells Fargo was decided. In Rogal v. Costello, Fed. Sec. L. Rep. (CCH) P 97,245 (N.D. Cal. 1992), the plaintiffs contended that the defendants recognized revenue from transactions that were not yet complete or for which an exchange had not yet taken place. Id. at 95,092. The court dismissed the allegations on the grounds that "plaintiffs have failed to state any factual basis for their conclusions that defendants have committed fraud in preparing their financial statements. They do not cite to a single transaction for which revenue was improperly recognized." Id.
2. Three of Plaintiffs' Allegations of Fraudulent Accounting are Pled with Sufficient Particularity to Satisfy Rule 9(b).
Three of plaintiffs' allegations of financial fraud in the first quarter of 1994 are pled with sufficient particularity to satisfy Rule 9(b). These allegations are that (1) Gupta failed to set aside adequate reserves in the first quarter of 1994 for the possibility that one of the company's main distributors would file for bankruptcy (P 88(c)); (2) Gupta improperly booked $ 1.1 million in sales that were not completed sales under GAAP (P 63); and (3) Gupta failed to make adequate reserves for returns of an old version of Gupta's SQL Windows software when a new version of the product was released (P 88(d)).
On June 2, 1994, Gupta announced that the company was increasing its reserves by $ 1 million to cover potentially uncollectible accounts receivable related to the bankruptcy of a German distributor of the company's products. Plaintiffs allege that Gupta knew of the German company's precarious financial condition by at least late 1993, but continued to make large product shipments to the company without raising reserves.
On July 25, 1994, Gupta revised its results for the first quarter of 1994 by de-booking $ 1.1 million in sales which were originally credited to the period. Plaintiffs allege that the sales were originally booked with the intent to defraud the investing public by inflating the company's stated revenue. Finally, plaintiffs contend that Gupta made inadequate reserve allocations to compensate for the return of obsolete copies of SQL Windows when the company introduced a new version of the product. By alleging specific details of these three allegedly fraudulent accounting entries, plaintiffs have satisfied the requirements of Rule 9(b).
Defendants admit that plaintiffs have stated these three allegations with the particularity required by Rule 9(b). Defendants contend that these claims should nevertheless be dismissed because plaintiffs fail to sufficiently plead scienter or materiality.
With respect to plaintiffs' allegations that Gupta overstated revenues in the first quarter of 1994 and failed to set aside adequate reserves in the same quarter to cover the possible bankruptcy of a German distributor, defendants are mistaken. The materiality of a $ 1.1 million dollar correction to revenue, which causes earnings to be restated from a profit of $ 520,000 to a loss of $ 250,000, and which represents more than 5 percent of total revenues, is beyond question. similarly, a $ 1 million charge against accounts receivable for a company of Gupta's size is material.
Plaintiffs have also adequately alleged scienter with respect to these accounting entries. Plaintiffs allege that defendants' motive for both acts of alleged fraud was to inflate the value of Gupta stock in order to sell Gupta securities for personal or corporate profit. In support of this claim, plaintiffs point to defendants' stock sales during the class period. Plaintiffs demonstrate that the six individual Gupta defendants sold stock for total proceeds of approximately $ 4.2 million; the remaining defendants realized total proceeds of approximately $ 10 million on their sales of Gupta stock.
Defendants counter that they sold only a small fraction of their holdings. Relying on In re Worlds of Wonder Sec. Litig., 35 F.3d 1407 (9th Cir. 1994), and In re Apple Computer Sec. Litig., 886 F.2d 1109 (9th Cir. 1989), cert. denied, 496 U.S. 943, 110 S. Ct. 3229, 110 L. Ed. 2d 676 (1990), defendants assert that sales of such small holdings do not create an inference of scienter. Defendants misinterpret both cases. Both Worlds of Wonder and Apple involved motions for summary judgment. As defendants note, the Apple court found that defendants' sale of 8% of their holdings, valued at $ 84 million, was not probative of bad faith or scienter. In Apple, however, the court noted that the defendants had sold fewer shares in the ten-month class period than they had sold during the ten preceding months. Moreover, the court found that several of the defendants gave credible and wholly innocent explanations for the stock sales during deposition testimony, and these explanations were uncontradicted. Id. at 1117. Similarly, in Worlds of Wonder the Ninth Circuit declined to infer scienter from sales of a "minuscule fraction" of defendants' shares, stating that "after years of discovery, Plaintiffs cannot point to any bit of information traded on by these defendants that was not already known to the market." ...