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In re Petco Animal Supplies Inc.

UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF CALIFORNIA


November 13, 2006

IN RE PETCO ANIMAL SUPPLIES INC. SECURITIES LITIGATION,

The opinion of the court was delivered by: Marilyn L. Huff, District Judge United States District Court

ORDER DENYING MOTION FOR CLARIFICATION [Docket Nos. 62 & 63]

On August 1, 2006, the Court denied in part and granted in part motions to dismiss this class action securities case. [Docket No. 60] The Court sustained the Consolidated Complaint as to Defendant Petco (and several officers) on one theory of fraud; however, the Court dismissed the Partnership Defendants*fn1 for failure to plead sufficient facts to show their involvement in the alleged fraud. The Court dismissed without prejudice and permitted Lead Plaintiff until September 1, 2006 to file a First Amended Consolidated Complaint. The Partnership Defendants have now filed a motion to clarify that in the event Lead Plaintiff choose not to amend the complaint within the time specified by the August 2006 Order, the dismissal will be with prejudice pursuant to the discovery stay of the Private Securities Litigation Reform Act ("PSLRA").

Initially, the Court ordered the motion submitted on the briefs. Civil Local Rule 7.1(d)(1). After further consideration, however, the Court convened a telephonic conference on November 8, 2006 to discuss the legal issue. Dan Drosman, Esq. appeared for Lead Plaintiff; Eric Waxman, Esq. appeared for the LGP Defendants; Tim Pestotnik, Esq. appeared for the LGP Defendants; and Peter Benzian, Esq. appeared for the Petco Defendants. Having carefully considered the arguments of both sides and for the reasons stated below, the Court DENIES the motion for clarification.

I. Procedural History

Initially, several plaintiffs filed securities class actions against Petco Animal Supplies, Inc. after its April 15, 2005 announcement that it had discovered an accounting error relative to certain under-accrued expenses in its distribution operations. The parties then stipulated to have the several actions consolidated and to select a Lead Plaintiff and Lead Counsel.

In October 2005, Lead Plaintiff filed a Consolidated Complaint against two categories of defendants: first, the Petco corporation and certain executives and officers, and second, the Partnership Defendants, who had once owned Petco. The Consolidated Complaint alleged that the defendants had violated the federal securities laws by issuing false and misleading statements and by engaging in insider trading at artificially-inflated prices. The Class Period began on August 18, 2004.

In January and February 2006, all defendants filed motions to dismiss for failure to state a claim for relief. Fed. R. Civ. P. 12(b)(6). Pursuant to the Private Securities Litigation Reform Act, the filing of those motions to dismiss automatically stayed all discovery pending resolution of the motion. 15 U.S.C. § 78u-4(b)(3)(B); Medhekar v. United States Dist. Ct., 99 F.3d 325, 327 (9th Cir. 1996) (per curiam).*fn2

The motions to dismiss were briefed and argued, and on August 1, 2006, the Court issued its decision. The Court denied the motion by Petco and some of its executives as to the allegations concerning an accounting impropriety, specifically, an alleged practice to defer the recording of incurred distribution expenses in order to make quarterly earnings goals.*fn3 The Court held that Lead Plaintiff had stated a claim, with factual allegations sufficient to demonstrate a strong inference of scienter by some of the Petco Defendants. Those Petco Defendants have answered the Consolidated Complaint and the Magistrate Judge has scheduled an Early Neutral Evaluation Conference for November 11, 2006.

The Court, however, agreed with the Partnership Defendants that the Consolidated Complaint failed to state a claim against them on either a theory of primary liability or as control persons. The Partnership Defendants had owned and managed Petco from 2000 to 2002, at which time they became majority shareholders. By the time the Class Period began in August 2004; however, the Partnership Defendants had sold most of their shares. After October 2004, the Partnership Defendants did not own any Petco common stock, though two individuals connected to the Partnerships continued to serve as outside directors. The Court found no basis for holding a former majority shareholder liable for corporate fraud.

The Court granted Lead Plaintiff leave to amend to attempt to cure the deficiencies, and permitted it until September 1, 2006 to file such an amended complaint. That date has now passed, and Lead Plaintiff has stated that it does not intend, at this time, to amend.

Lead Plaintiff has served subpoenas on the Partnership Defendants to produce various documents. Lead Plaintiff is seeking the discovery against these former parties under the rules that apply to non-parties.

The Partnership Defendants ask the Court to clarify its August 2006 Order to dismiss them with prejudice now that Lead Plaintiff has chosen not to amend the complaint within the time set by the Court.

II. Discussion

The Partnership Defendants contend that Lead Plaintiff is circumventing the discovery stay by leaving them "in a state of limbo without the finality they deserve after prevailing on their Motions to Dismiss." LGP's Br. at 3 ("If the Court were to permit Plaintiffs to discover their way into a viable securities claim against the dismissed defendants, the PSLRA discovery stay would become meaningless and the Congressional intent of the statute vitiated[.]" (quoting In re American Online Time Warner, Inc. Sec. and ERISA Litig., 2004 U.S. Dist. LEXIS 16017, at * 2 (S.D.N.Y. Aug. 11, 2004). They cite a statement from a Ninth Circuit decision that the discovery stay in the PSLRA shows that "Congress clearly intended that complaints in these securities actions should stand or fall based on the actual knowledge of the plaintiffs rather than information produced by the defendants after the action has been filed." Medhekar, 99 F.3d at 326. The Partnership Defendants argue that plaintiffs "should not be able to begin discovery while maintaining that they have a right to later amend their complaint against the dismissed defendants." LGP's Br. at 5. They further reason "that having failed sufficiently to plead a claim against [the Partnership Defendants], Plaintiffs are precluded by the PSLRA from seeking discovery until they amend their Complaint and survive a further motion to dismiss." LGP's Reply Br. at 1.

The Court denies the motion because there is no pending motion to dismiss, thus the language of the discovery stay provision itself does not apply. See In re Lernout & Hauspie Sec. Litig., 214 F. Supp. 2d 100, 104-09 (D. Mass. 2002) (when some but not all defendants had filed motions to dismiss, the PSLRA did not require a discovery stay but district court imposed restrictions on discovery pending resolution of that motion). The PSLRA states that discovery is stayed while a motion to dismiss is pending. The decisions in which courts have enforced this provision have involved situations in which the district court had not yet resolved a first or second motion to dismiss, or where a party had asked the district court to reconsider its ruling. E.g., In re Salomon Analyst AT&T Litig., 373 F. Supp. 2d 252, 254-56 (S.D.N.Y. 2005) (defendants' motion for reconsideration to consider intervening Circuit authority that might compel district court to dismiss defendants was still pending); Powers v. Eichen, 961 F. Supp. 233, 236 (S.D. Cal. 1997) (Battaglia, Magistrate Judge) (defendants' motion for reconsideration pending). Here, the Lead Plaintiff has stated a securities law claim against Petco and various executives. The Consolidated Complaint has been sustained as to the alleged accounting fraud, and the Lead Plaintiff is now relieved of the PSLRA stay and may properly seek discovery to support its theory.

But the Partnership Defendants further contend that the "spirit" of the discovery stay will be violated unless the Court dismisses them with prejudice. They contend that the Lead Plaintiff must choose to amend its complaint against the Partnership Defendants based upon the information currently possessed or accept a dismissal with prejudice. The Partnership Defendants refer to the legislative history of the PSLRA in which Congress stated it wanted to protect potential targets of frivolous securities lawsuits from the expense and burden of "fishing expeditions" by precluding discovery until a district court had sustained the sufficiency of the allegations. See e.g., Medhekar, 99 F.3d at 328 (reviewing legislative history).

The Court has carefully considered the Partnership Defendants' argument in this regard but concludes that they are not entitled to the relief they seek. Controlling Ninth Circuit authority instructs the district courts that "[d]ismissal with prejudice . . . is not appropriate unless it is clear . . . that the complaint could not be saved by amendment." Eminence Capital, LLC v. Aspeon, Inc., 316 F.3d 1048, 1052 (9th Cir. 2003) (per curiam). The Court has not reached that conclusion as to the Partnership Defendants thus the Court cannot dismiss them with prejudice at this stage.

As the Partnership Defendants note, the Lead Plaintiff is seeking discovery from entities for which they have not stated a claim for relief, and this circumstance presents an interesting legal issue. Yet it cannot be said that Lead Plaintiff is "circumventing" the discovery stay. The Partnership Defendants, like any other as yet unknown potential defendant, are protected by the discovery rules that limit the types of discovery that can be pursued against a non-party. As noted, the Lead Plaintiff is issuing subpoenas to the Partnership Defendants as non-parties under the procedures of Rule 45 of the Federal Rules of Civil Procedure. In the event that Lead Plaintiff discovers evidence that would prompt it to seek leave to amend its complaint to add further factual allegations against the Partnership Defendants (or some other individual), it would be required to seek leave of court within the time frame set by the scheduling order and explain why it had not done so within the time set by the Court's August 1, 2006 Order. Cf. Fed. R. Civ. P. 41(b) (involuntary dismissal). That process is not unfairly prejudicial to the Partnership Defendants. Cf. Eminence, 316 F.3d at 1052-53 (district court must explain reason to dismiss complaint without leave to amend, and prejudice to defendant carries most weight). Conversely, if the Court were to dismiss the Partnerships with prejudice, it could lead to a piecemeal appeal process or require a motion for relief from judgment. This scenario is more cumbersome. Under either scenario, the Lead Plaintiff could continue to seek discovery from the Partnership Defendants as non-parties. Thus, the effect on the Partnership Defendants is the same. Cf. Med. Imaging Ctrs. of Am. v. Lichtenstein, 917 F. Supp. 717, 720 (S.D. Cal. 1996). Having considered the competing interests in the current posture of the case, the Court is not persuaded by the Partn ership Defendants' argument that the PSLRA entitles them to immediate dismissal with prejudice. Accordingly, the Court denies their motion for clarification.

CONCLUSION

Upon due consideration of the parties' memoranda and exhibits, a review of the record, and for the reasons set forth above the Court DENIES the motion for clarification filed by the LGP Defendants and joined by the TPG Defendants. [Docket Nos. 62 & 63]

IT IS SO ORDERED.


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