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In re InfoSonics Corp. Securities Litigation

August 7, 2007

IN RE: INFOSONICS CORPORATION SECURITIES LITIGATION


The opinion of the court was delivered by: Honorable Barry Ted Moskowitz United States District Judge

ORDER GRANTING IN PART AND DENYING IN PART MOTION TO DISMISS

Defendants InfoSonics Corp., John J. Althoff ("Althoff"), Jeffrey Klausner ("Klausner"), Joseph Murgo ("Murgo"), Joseph Ram ("Ram"), and Abraham G. Rosler ("Rosler") (collectively "Defendants") have filed a motion to dismiss the Consolidated Amended Class Action Complaint. On July 25, 2007, the Court held oral argument on the motion. For the reasons discussed below, Defendants' motion is GRANTED IN PART AND DENIED IN PART.

I. BACKGROUND

Plaintiffs have filed suit on behalf of a purported class of purchasers of InfoSonics securities between February 6, 2006 and August 9, 2006.

InfoSonics is a distributor of wireless handsets and accessories, providing cell phones and other wireless products to carriers in both the United States and Latin America. Defendant Ram is the founder of InfoSonics as well as its President, CEO, and a Director. Althoff is President of InfoSonics' Latin American operations. Klausner is InfoSonics' Chief Financial Officer. Murgo is InfoSonics' Vice President of North American Sales & Marketing. Rosler is InfoSonics' Executive Vice President and a Director.

Plaintiffs claim that Defendants misled investors with respect to two issues: (1) the improper classification of warrants and the need to restate reported net income for the first quarter of 2006; and (2) an alleged "debacle" involving the sale of VK Mobile 530 phones to InfoSonics' largest U.S. customer, Centennial Wireless ("Centennial"), and its disastrous effect on U.S. sales.

With respect to the first issue, Plaintiffs allege that Defendants improperly delayed disclosing that InfoSonics had improperly accounted for warrants that had been issued in connection with the private placement of common stock. The warrants were initially treated as a derivative liability. On May 8, 2006, InfoSonics issued a press release announcing its financial results for the first quarter of 2006. InfoSonics reported income from a non-cash change in fair value of the warrants. InfoSonics reported net income of $1.738 million.

On June 12, 2006, InfoSonics revealed that it would need to restate its reported net income for the first quarter of 2006 of $1.738 million to $1.173 million because the Company had improperly treated the warrants as a derivative liability. The Company learned that the warrants should have been reclassified as equity from February 17, 2006, the date upon which the SEC declared effective the Company's registration statement on Form S-3 registering the shares underlying the warrants. InfoSonics' stock fell from a close of $24.22 on Friday, June 9, 2006 to a close of $17.38 on June 12, 2006.

Plaintiffs allege that Defendants knew about the improper classification of the warrants and the need to issue a restatement by May 22, 2006, when InfoSonics' auditors allegedly told Klausner that he had "screwed up" and that a restatement was necessary. (Compl. ¶ 76.) On May 31, 2006, InfoSonics announced a two-for-one stock split payable on June 19, 2006 to holders of record on June 9, 2006. As a result of the announcement, shares of InfoSonics surged from $23.47 on May 30, 2006 to $33.53 on June 2, 2006. Plaintiffs allege that although Defendants knew of the need to issue a restatement, Murgo, Rosler, Klausner and Althoff unloaded a total of $1.5 million of their personal holdings of InfoSonics stock.

(Compl. ¶ 76.)

The second issue concerns an alleged "debacle" involving the sale of VK Mobile 530 phones to Centennial and the "derailment" of U.S. sales. InfoSonics had entered into an exclusive distribution agreement with VK Mobile. According to Confidential Witness No. 1 ("CW1"), this exclusive relationship was supposed to be the "mother-lode" for InfoSonics that would have allowed InfoSonics to compete against other distributors to Rural Service Area carriers ("RSAs"). (Compl. ¶ 3.) However, according to CW1, InfoSonics' and VK Mobile's reputation amongst RSAs in the United States was soon ruined when InfoSonics' largest RSA customer in the United States, Centennial, experienced repeated defects in connection with an initial order of 50,000 VK phones in October 2005 and a subsequent order of VK phones in January 2006. (Compl. ¶ 5.)

According to CW1, the Centennial transaction was the "single largest VK Mobile sale" in the United States, and was supposed to be the "big bite" that solidified the positions of both InfoSonics and VK Mobile in the U.S. RSA market. (Compl. ¶ 5.) In October 2005, Centennial placed a $6 million order for 50,000 VK 530 phones. (Compl. ¶ 40.) The first shipment of 20,000 VK 530 phones were to be drop-shipped directly to 80-120 Centennial locations in late October 2005. (Compl. ¶ 72.c.) The remaining 30,000 VK phones were to be shipped to Centennial before the end of 2005. (Id.) Within days of the first shipment, customers began reporting that the touch tone key pad lights would not go out. (Id.)

In November 2005, InfoSonics arranged a "swap out" of the 20,000 VK 530 phones with the help of VK Mobile. (Compl. ¶ 72.c.) However, within days of Centennial receiving the new phones, customers reported that these phones were also defective. (Compl. ¶ 72.d.) The problems were so serious that between December 2005 and February 2006, Korean engineers sent by VK attempted to fix the issues. (Compl. ¶ 72.e.)

In mid-January 2006, Murgo convinced Centennial that InfoSonics really "had a patch this time around." (Compl. ¶ 72.e.) Centennial agreed to order 20,000 new phones in the amount of $2 million -- 10,000 of the phones were to be pink VK 530 phones delivered in conjunction with Valentine's Day and Breast Cancer Awareness month and the other 10,000 were to be a new model called the VK 1000. (Id.) In order to entice Centennial to take this deal, InfoSonics offered to cancel the remaining 30,000 phones from the October 2005 purchase order and paid Centennial additional marketing development funds. (Id.)

InfoSonics shipped the pink VK 530 phones in late January to early February 2006. (Compl. ¶ 72.f.) Within days, the same defect problems were reported. (Id.) According to CW1, before the end of February 2006, Centennial notified InfoSonics that it was pulling the VK phones off the shelves and returning all of the phones to InfoSonics. (Id.) InfoSonics offered to do another "swap-out" but Centennial would not return any of InfoSonics' daily calls or e-mails. (Id.) Around mid-March 2006, Centennial's Senior Vice President, Chuck Hollis, e-mailed Murgo and other senior executives at InfoSonics, stating that Centennial had been forced to institute a program with its customers whereby it exchanged all of the VK Mobile phones for "real phones" from another vendor. (Compl. ¶ 72.g.) Centennial indicated that it was returning all of the VK phones and would seek $1 million in damages. (Id.) By April 2006, InfoSonics had taken back all of the VK 530 phones shipped to Centennial. (Id.)

According to CW1, the Centennial incident caused InfoSonics' and VK Mobile's reputation to suffer so much that InfoSonics' ability to sell in the North American market was derailed. (Compl. ¶¶ 5, 72.h.) As a result, InfoSonics' U.S. revenues plummeted and never recovered. (Id.)

Plaintiffs allege that as the Centennial debacle unfolded, Defendants concealed the problems with the VK 530 phone and continued to affirmatively represent that the product was "well received" and that they were excited about the growth opportunity for VK product in the United States. Defendants also attributed the decline in U.S. sales in the first quarter of 2006 to manufacturing delays.

Plaintiffs allege that by concealing the truth about the Centennial transaction, Defendants artificially inflated the price of shares to the detriment of the Plaintiffs and to the benefit of Defendants who sold their personally-held InfoSonics common stock during the class period as follows: Ram sold 125,000 shares for total proceeds of approximately $1,459,000; Klausner sold 52,000 shares for total proceeds of approximately $799,000; Althoff sold $35,000 shares for total proceeds of approximately $672,000; Murgo sold 55,000 shares for total proceeds of approximately $1,268,000; Rosler sold 90,000 for total proceeds of approximately $1,044,000. (Compl., ¶¶ 18-22.)

On August 9, 2006, InfoSonics announced its financial results for the second quarter of 2006. It was revealed that U.S. sales had again declined dramatically, with only 6% of InfoSoncis' revenue coming from U.S. sales. (Compl., ¶ 66.) Shares of InfoSonics fell more than 26% from a close of $8.51 on August 9, 2006 to a close of $6.25 on August 10, 2006, on more than four times the average trading volume. (Id.) InfoSonics' stock price has never recovered. (Id.)

The Consolidated Amended Class Action Complaint asserts causes of action for (1) violation of section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b), and Rule 10b-5, (2) violation of section 20(a) of the Exchange Act, 15 U.S.C. § 78t, and (3) violation of section 20A of the Exchange Act.

II. DISCUSSION

A. PSLRA Pleading Standards

A securities fraud 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)(1). Further, the 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) (emphasis added). Gompper v. VISX, Inc., 298 F.3d 893, 895 (9th Cir. 2002).

The required state of mind is "a mental state embracing intent to deceive, manipulate, or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 n. 12 (1976). The plaintiff must "state facts giving rise to a strong inference of deliberate recklessness or intent. It is not enough . . . to state facts giving rise to a mere speculative inference of deliberate recklessness, or even a reasonable inference of deliberate recklessness." In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 985 (1999). Courts "should consider all the allegations in their entirety, together with any reasonable inferences that can be drawn therefrom, in concluding whether, on balance, the plaintiffs' complaint gives rise to the requisite inference of scienter." Gompper, 298 F.3d at 897.

In a recent case, the Supreme Court clarified that in determining whether the pleaded facts give rise to a "strong" inference of scienter, the court "must take into account plausible opposing inferences." Tellabs, Inc. v. Makor Issues & Rights, Ltd., __ U.S. __, 127 S.Ct. 2499, 2509 (2007). The Supreme Court explained that the strength of an inference depends on its particular context: "To determine whether the plaintiff has alleged facts that give rise to the requisite 'strong inference' of scienter, a court must consider plausible nonculpable explanations for the defendant's conduct, as well as inferences favoring the plaintiff." Id. at 2510. A complaint will survive a motion to dismiss under the PSLRA "only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged." Id.

B. Analysis

1. The Warrants

Plaintiffs allege that Defendants delayed revealing that the warrants were misclassified. According to CW2, within two weeks of InfoSonics' May 8, 2006 announcement of the financial results for the first quarter of 2006, "InfoSonics' auditors told Defendant Klausner that InfoSonics had 'screwed up,' and that Defendant Klausner had caused the Company to account for the warrants inappropriately, and that InfoSonics would need to restate its 1Q06 financial statements." (Compl. ΒΆ ...


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