The opinion of the court was delivered by: Walker, District Judge.
This matter is a consolidated class action arising out of
alleged accounting misstatements and brought on behalf of all
purchasers of Cylink Corporation common stock between April 23
and November 5, 1998, against the company and three former
senior officers, Fernand B Sarrat; John H Daws and Thomas L
Butler. On November 6, 2000, the court entered an order
dismissing without prejudice plaintiffs' original consolidated
complaint on the grounds that plaintiffs failed sufficiently to
allege defendants' state of mind as required by the Private
Securities Litigation Reform Act of 1995 (PSLRA),
15 U.S.C. § 78u-4(b)(2). See 11/6/00 Order (Doc # 80).
Plaintiffs timely filed an amended consolidated complaint
(ACC) on December 6, 2000. Doc # 81. Defendants again move to
dismiss, but this time they have filed three separate motions.
Does # 84, 85 and 88. For the reasons set forth below, the
motions are DENIED IN PART and GRANTED IN PART.
Because this is a motion to dismiss, the following facts
pertinent to the motion at bar come from the ACC.
Cylink is in the business of developing, marketing and
supporting computer broadcast network security products. ACC
(Doc #81), ¶ 6. During the class period, Sarrat was Cylink's
President and CEO; Daws was the CFO and VP of Finance and
Administration and later became the VP of Business Development
and Butler was the VP of Sales and Marketing. Id, ¶¶ 7-9.
Plaintiffs allege that due to the deliberately reckless
conduct of these three senior officers, Cylink made two material
misrepresentations to the market in which Cylink's shares
traded: (1) Cylink's first quarter 1998 revenues were overstated
by $7.8 million or 97.5 percent, id, ¶¶ 22-27; and (2) Cylink's
second quarter 1998 revenues were overstated by $5.7 million or
46 percent, id, ¶¶ 28-33. The misrepresentations were made in
Cylink's Form 10-Q reports to the SEC filed, respectively, on
May 13, 1998, and August 12, 1998. Defendants do not dispute
that these alleged misstatements are sufficiently particularized
to meet the heightened pleading standards of both FRCP 9(b) and
the PSLRA as interpreted in In re Silicon Graphics Inc.
Securities Litigation, 183 F.3d 970 (9th Cir. 1999). Defendants
advance various other grounds for dismissal, but mostly focus on
what they contend is the ACC's failure adequately to allege
scienter of defendants.
Before turning to defendants' specific arguments, a few
familiar principles require mention. In reviewing a FRCP
12(b)(6) motion, all material allegations in the complaint must
be taken as true and construed in the light most favorable to
the plaintiff. See Silicon Graphics, 183 F.3d at 980 n. 10.
Dismissal is appropriate only if 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).
The PSLRA instituted two heightened pleading requirements for
such claims. Silicon Graphics, 183 F.3d at 974. First, a
private securities 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, * * *
state with particularity all facts on which that belief is
formed." 15 U.S.C. § 78u4(b)(1). Second, the 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. § 78u-4(b)(2). The Ninth Circuit has interpreted this second
requirement to obligate the plaintiff "to plead, in great
detail, facts that constitute strong circumstantial evidence of
deliberately reckless or conscious misconduct." Silicon
Graphics, 183 F.3d at 974.
As touched upon above, the court dismissed the original
complaint in this matter because plaintiffs failed to plead
particular facts in that complaint sufficient to establish the
necessary state of mind for any of the defendants. See 11/6/00
Order (Doc # 80). Plaintiffs' principal efforts in this regard
were contained in a section entitled "Defendants' Scienter," in
which plaintiffs set forth three primary allegations regarding
defendants' state of mind. See Compl (Doc # 65), ¶¶ 34-38.
Plaintiffs first pointed to the existence of internal controls
at public companies such as Cylink to imply that the magnitude
of the premature revenue recognized was beyond the capability of
a few "rogue" sales representatives and thus must have been
known by defendants. Id, ¶ 35. Plaintiffs next alleged that
the magnitude of the premature revenue recognition indicated
that defendants either knew or disregarded the problem with
deliberate recklessness. Id. Finally, plaintiffs described a
home loan that Cylink gave to Sarrat, which would be paid down
by Cylink only if it experienced substantial earnings, to
suggest that Sarrat possessed a unique motive to enhance
Cylink's financial performance. Id, ¶ 38. The court concluded
that these allegations, although on the right track, did not
rise to the level necessary to satisfy the PSLRA standard for
pleading state of mind as required by the Ninth Circuit. See
11/6/00 Order (Doc # 80) at 8-15.
In submitting the ACC, plaintiffs completely abandoned these
allegations. Instead, plaintiffs now attempt to plead
defendants' state of mind by setting forth two sets of
allegations in the "Defendants' Scienter" section of the ACC.
See ACC (Doc # 81), ¶¶ 34-51. Plaintiffs also refer to the
information "set forth" in a complaint filed by the SEC on
September 27, 2000, in which the SEC alleges fraudulent revenue
recognition practices by Daws, Butler and one other former
Cylink executive. Rees Decl (Doc # 89), Exh A. Because the ACC
refers to the contents of the SEC complaint and no party
challenges the SEC complaint's authenticity, the court may also
consider the allegations contained therein when evaluating the
sufficiency of plaintiffs' allegations under the PSLRA. See
Parrino v. FHP, Inc., 146 F.3d 699, 705-06 (9th Cir. 1998);
Tunnell, 14 F.3d 449, 453-54 (9th Cir. 1994).
The first set of allegations appear to be designed to describe
the state of mind of Daws and Butler (and derivatively, Cylink).
See id, ¶¶ 38, 40, 43, 45 and 47. Plaintiffs first point to the
"standard of ordinary care for revenue recognition" as
established by the Statement of Financial Concepts No 5 and the
Accounting Standards Executive Committee's Statement of Position
97-2 (hereinafter, GAAP) and allege that these defendants
engaged in an "extreme departure" from this standard by
improperly recognizing revenue on transactions during the first
two quarters of 1998. Id, ¶ 34; see also id, ¶ 27.
Plaintiffs describe in detail five example transactions for
which revenue was allegedly recognized prematurely under GAAP.
Id, ¶¶ 36-47. For instance, plaintiffs allege that Citibank
submitted a purchase order for $1.3 million worth of Cylink's
product in March 1998, but instructed Cylink not to invoice the
sale until Citibank designated the installation site and Cylink
actually shipped the product. Id, ¶ 37. Plaintiffs allege
that, instead, Cylink shipped the equipment to a third party
warehouse to await Citibank's instructions for delivery, but
recorded the purchase order as a sale with set payment dates.
Id. Plaintiffs allege that "[n]o risks of ownership passed to
* * * Citibank and Cylink retained specific performance
obligations," and, accordingly, revenue was improperly
The other four transactions detailed in the ACC are similar in
that for each transaction, revenue was allegedly recognized in
violation of GAAP regulating revenue recognition. See id, ¶¶
39-47. Plaintiffs also point to the information in the SEC
complaint as further support for these allegations against Daws
and Butler. Rees Decl (Doc # 89), Exh A; see ACC (Doc # 81), ¶¶
38, 40, 43, 45 and 47.
The second set of allegations are seemingly directed at
establishing Sarrat's state of mind (and derivatively,
Cylink's). Plaintiffs allege that Sarrat established a 1998
revenue goal of $100 million even though Cylink had never
generated more than $50 million in one year, ACC (Doc # 81), ¶
48, insinuating that Sarrat would later have a reason to
exaggerate the company's financial performance in order to
attain the goal. Plaintiffs also allege that since Sarrat made
his own statement in the April 23, 1998, press release, he was
under a duty to review Cylink's accounts receivable turnover
ratio prior to making such statement. Id, ¶ 49. Plaintiffs
allege that such a review would have disclosed to Sarrat that
revenue was being recognized prematurely, thereby demonstrating
that Sarrat acted with deliberate recklessness. Id, ¶ 50.
With respect to the state of mind of Cylink, plaintiffs allege
that "Cylink's corporate scienter is derivative of, or
concurrent [sic] with that of its officers and directors * * *."
Id, ¶ 35; see also id, ¶ 38, 40, 43, 45, 47 and 51. No
specific allegations of Cylink's scienter distinct from that of
the individual defendants is alleged.
The court first addresses whether plaintiffs have adequately
pled a cause of action under section 10(b) against Daws.
Consistent with each of the defendants, Daws primarily asserts
that the ACC fails sufficiently to allege that he acted with the
required state of mind.