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IN RE CYLINK SECURITIES LITIGATION

August 29, 2001

IN RE CYLINK SECURITIES LITIGATION.


The opinion of the court was delivered by: Walker, District Judge.

ORDER

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.

I

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.

II

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.

A

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); Branch v. 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 recognized. Id.

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.

B

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.

As a threshold matter, the court notes that Daws signed the financial statements for the first two quarters of 1998. As a result, such statements can be attributed, at the very least, to Daws. See Howard v. Everex Systems, Inc., 228 F.3d 1057, 106163 (9th Cir. 2000). "[W]hen a corporate officer signs a document on behalf of the corporation, that signature will be rendered ...


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