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Zucco Partners, LLC v. Digimarc Corp.

February 10, 2009

ZUCCO PARTNERS, LLC; REX BOGGS; KENNARD MCADAM; GLEN THOMAS, PLAINTIFFS-APPELLANTS,
v.
DIGIMARC CORPORATION; BRUCE DAVIS; E. K. RANJIT, DEFENDANTS-APPELLEES.



Appeal from the United States District Court for the District of Oregon Anna J. Brown, District Judge, Presiding D.C. No. CV-04-01390-AJB

The opinion of the court was delivered by: Bybee, Circuit Judge

FOR PUBLICATION

Argued and Submitted August 26, 2008-Seattle, Washington

Filed January 12, 2009; Amended February 10, 2009

Before: Thomas G. Nelson, Michael Daly Hawkins, and Jay S. Bybee, Circuit Judges.

OPINION

Zucco Partners, LLC and other named plaintiffs (collectively, "Zucco"), on behalf of those who purchased publicly-traded securities of Digimarc Corporation ("Digimarc" or "the Company") between April 22, 2003 and July 28, 2004, appeal the District of Oregon's dismissal of their Second Amended Complaint, which alleges that Digimarc (and two of its officers, Bruce Davis and E. K. Ranjit) violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and the regulations promulgated thereunder, including Rule 10b-5. Zucco contends that the district court erred in determining that its complaint failed to allege a strong inference of scienter as required by the Private Securities Litigation Reform Act ("PSLRA") because that court applied a more stringent standard than required by the Supreme Court's recent decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007). Although we have previously evaluated the sufficiency of such claims under the PSLRA by the standards of In re Silicon Graphics Inc. Securities Litigation, 183 F.3d 970 (9th Cir. 1999), and In re Daou Systems, Inc. Securities Litigation, 411 F.3d 1006 (9th Cir. 2005), we have yet to fully explain how the Court's Tellabs decision relates to much of our analysis under those cases.

The district court determined that, pursuant to Daou, the plaintiffs' complaint failed to allege scienter with the requisite particularity to survive dismissal under the PSLRA's heightened pleading standard. Because we hold that the Court's decision in Tellabs does not materially alter the particularity requirements for scienter claims established in our previous decisions, but instead only adds an additional "holistic" component to those requirements, we affirm the district court's dismissal of the complaint with prejudice and hold that Zucco has failed to adequately plead a strong inference of scienter.*fn1

I.

Accounting for the costs of internal software development is not a simple task. In order to comply with Generally Accepted Accounting Principles ("GAAP"), a company that engages in internal software development projects must make subtle differentiations between three stages of development that determine whether expenditures incurred must be "expensed" (recorded immediately on the company's financial statement as a cost incurred) or "capitalized" (recorded as a cost incurred in increments over several financial statements). This distinction is important because if an expenditure is capitalized rather than expensed a company will (in the absence of other factors) look more profitable in the short term (albeit less profitable in the long term) and show a more consistent pattern of reported income-because its expenditures are spread out over a longer period of time. Under GAAP, if a software development project is in the "preliminary project stage," wherein the company is evaluating development and marketing alternatives; or in the "post-implementation/ operation stage," in which the developed software is placed into service, most expenditures related to the project must be expensed. If, however, a project is in the "application development stage," in which management authorizes the project and has settled on a comprehensive development and marketing strategy, most expenditures incurred must be capitalized. Capitalized expenditures are amortized on a straight-line basis over the estimated useful life of the software developed (which, for a company like Digimarc, is generally three to five years).

According to Zucco, Digimarc, a fledgling Delaware corporation headquartered in Oregon, whose business centers on providing secure personal identification documents (such as drivers licenses) based on digital watermarking technology, purposefully manipulated its financial prospects by, inter alia, capitalizing internal software development expenditures that should have been expensed. Zucco's compendious 130-page Second Amended Complaint ("SAC") claims that Digimarc "used two primary accounting manipulations to deceptively bolster Digimarc's financial condition." Namely, Digimarc "capitalize[d] on its asset balance sheet ordinary payroll costs that Digimarc paid to its software engineers and other employees so that the Company could avoid recognizing these expenses on its income statements." Also, Digimarc allegedly "fail[ed] to recognize ordinary expenses incurred by the Company" and instead "improperly moved or retained these expenses in Digimarc's inventory or property and equipment accounts as purported 'project development expenses.' " The net effect of these manipulations, Zucco contends, was to deceive investors into believing that the young corporation had "turned the corner" from its early losses and had become profitable.

On September 13, 2004, Digimarc publicly announced that it had erroneously accounted for internal software expenditures and that due to these accounting errors it had likely overestimated earnings for the previous six quarters. The September announcement listed the improper capitalization of internal software development costs as the most likely source of these accounting errors, and also cited "other project cost capitalization accounting practices" of Digimarc's ID Systems division (acquired from Polaroid in December 2001 and which represented 89 percent of the corporation's revenue in 2003 and 2004) as containing potential errors that "may also result in additional adjustments which may affect prior periods." On September 13, Digimarc estimated these accounting errors to "be in the range of approximately $1.2 million to $2.0 million" and to possibly "require a restatement of prior period financial statements."

Although the full extent of these accounting errors (approximately $2.7 million in overstated earnings) was not revealed until April 5, 2005, when Digimarc's formal restatement was issued, the corporation's September 2004 announcement was enough to trigger a number of class action lawsuits. Zucco, which had purchased fifty shares of Digimarc stock in March 2004 (at a price of $12.76 per share) filed a class action lawsuit in the District of Oregon fifteen days after the corporation's public announcement, alleging that defendants Digimarc, its Chief Executive Officer Bruce Davis, and its former Chief Financial Officer E. K. Ranjit violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and its implementing regulations, including Rule 10b-5. Similar suits, which followed on October 5th and 6th, were eventually consolidated with Zucco's action on December 16, 2004. Two unrelated actions alleging violations of California corporations law, meanwhile, were filed in California state court on October 19th, and subsequently re-filed in the District of Oregon. See In re Digimarc Corp. Derivative Litig., ___ F.3d ___, No. 06-35838, 2008 WL 5171347 (9th Cir. Dec. 11, 2008).

Although there was no question that Digimarc erroneously capitalized expenditures that should have been expensed, the plaintiffs had difficulty providing detailed allegations that the defendants did so either intentionally or with deliberate recklessness. Indeed, Zucco provided the district court with three iterations of its allegations-none of which, according to that court, was sufficient to survive a motion to dismiss. First, after several additional named plaintiffs were added to its consolidated class action, Zucco amended its original class action complaint, adding significant detail to its formerly skeletal allegations. This First Amended Complaint was filed on May 16, 2005, on behalf of all those who purchased the publicly traded securities of Digimarc between April 22, 2003 and July 28, 2004 (the "class period"), and alleged that Digi-marc and the individual defendants engaged in the manipulative accounting methods described above. Digimarc filed a Federal Rule of Civil Procedure 12(b)(6) motion to dismiss the First Amended Complaint, claiming that Zucco had failed to satisfy the loss causation and scienter requirements of section 10(b) of the Securities Exchange Act of 1934, as mandated by the Private Securities Litigation Reform Act, 15 U.S.C. § 78u-4. The district court granted this motion on November 30, 2005. In its order dismissing the complaint, the district court held that Zucco's First Amended Complaint had satisfied the loss causation pleading requirements, but had failed to properly allege scienter. See Zucco Partners, LLC v. Digimarc Corp., No. CV 04-1390-BR (D. Or. Nov. 30, 2005).

The district court dismissed the complaint without prejudice, giving Zucco leave to amend. According to the district court, the Second Amended Complaint was no better. After that complaint was filed on January 17, 2006, Digimarc responded with another motion to dismiss, contending that Zucco had again failed to plead scienter adequately under the PSLRA. This motion was granted on August 4, 2006, when the district court dismissed the complaint with prejudice. See Zucco Partners, LLC v. Digimarc Corp., 445 F. Supp. 2d 1201 (D. Or. 2006). After dismissal, Zucco filed a timely appeal to this Court.

II.

Zucco argues that the district court failed to properly analyze its allegations of scienter under the standard recently expounded by the Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007). We review challenges to a dismissal for failure to state a claim under Federal Rule of Civil Procedure 12(b)(6) de novo. Livid Holdings, Ltd. v. Solomon Smith Barney, Inc., 416 F.3d 940, 946 (9th Cir. 2005). Such review is generally limited to the face of the complaint, materials incorporated into the complaint by reference, and matters of which we may take judicial notice. Metzler Inv. GMBH v. Corinthian Colls., Inc., 540 F.3d 1049, 1061 (9th Cir. 2008) (citing Tellabs, 127 S. Ct. at 2509). In undertaking this review, we will "accept the plaintiffs' allegations as true and construe them in the light most favorable to plaintiffs," Gompper v. VISX, Inc., 298 F.3d 893, 895 (9th Cir. 2002), and will hold a dismissal inappropriate unless the plaintiffs' complaint fails to "state a claim to relief that is plausible on its face." Bell Atl. Corp. v. Twombly, 127 S. Ct. 1955, 1974 (2007). Where, as here, the district court dismisses the complaint without leave to amend, such prejudicial dismissal is reviewed for abuse of discretion, see Gompper, 298 F.3d at 898, and "is improper unless it is clear that the complaint could not be saved by any amendment." Livid Holdings, 416 F.3d at 946.

A.

[1] Section 10(b) of the Securities Exchange Act of 1934 makes it unlawful for "any person . . . [t]o use or employ, in connection with the purchase or sale of any security registered on a national securities exchange . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors." 15 U.S.C. § 78j(b). One such rule promulgated under the Act is SEC Rule 10b-5, which provides, inter alia, "It shall be unlawful for any person . . . [t]o engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security." 17 C.F.R. § 240.10b-5(c).

Section 20(a) of the Act makes certain "controlling" individuals also liable for violations of section 10(b) and its underlying regulations. Specifically, section 20(a) provides:

Every person who, directly or indirectly, controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable, unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.

15 U.S.C. § 78t(a). Thus, a defendant employee of a corporation who has violated the securities laws will be jointly and severally liable to the plaintiff, as long as the plaintiff demonstrates "a primary violation of federal securities law" and that "the defendant exercised actual power or control over the primary violator." No. 84 Employer-Teamster Joint Council Pension Trust Fund v. Am. W. Holding Corp. ("America West"), 320 F.3d 920, 945 (9th Cir. 2003) (quoting Howard v. Everex Sys., Inc., 228 F.3d 1057, 1065 (9th Cir. 2000)) (quotation marks omitted); Paracor Fin., Inc. v. Gen. Elec. Capital Corp., 96 F.3d 1151, 1161 (9th Cir. 1996). This inquiry is normally an "intensely factual question." Paracor Finance, 96 F.3d at 1161 (quoting Arthur Children's Trust v. Keim, 994 F.2d 1390, 1396 (9th Cir. 1993)). Section 20(a) claims may be dismissed summarily, however, if a plaintiff fails to adequately plead a primary violation of section 10(b). See In re Verifone Sec. Litig., 11 F.3d 865, 872 (9th Cir. 1993). See, e.g., In re Metawave Commc'ns Corp. Sec. Litig., 298 F. Supp. 2d 1056, 1087 (W.D. Wash. 2003).

Five elements are required in order to prove a primary violation of Rule 10b-5. In particular, a plaintiff must demonstrate "(1) a material misrepresentation or omission of fact, (2) scienter, (3) a connection with the purchase or sale of a security, (4) transaction and loss causation, and (5) economic loss." Daou, 411 F.3d at 1014. At the pleading stage, a complaint stating claims under section 10(b) and Rule 10b-5 must satisfy the dual pleading requirements of Federal Rule of Civil Procedure 9(b) and the PSLRA.

Federal Rule of Civil Procedure 9(b) provides, "In alleging fraud or mistake, a party must state with particularity the circumstances constituting fraud or mistake. Malice, intent, knowledge, and other conditions of a person's mind may be alleged generally." This requirement has long been applied to securities fraud complaints. See Semegen v. Weidner, 780 F.2d 727, 729, 734-35 (9th Cir. 1985). Accordingly, before 1995 we required "falsity" to be pled with particularity, and "scienter" to be alleged generally. See Ronconi v. Larkin, 253 F.3d 423, 429 n.6 (9th Cir. 2001).

[2] All securities fraud complaints since 1995, however, are subject to the more exacting pleading requirements of the PSLRA, which "significantly altered pleading requirements" in securities fraud cases. Gompper, 298 F.3d at 895 (quotation marks omitted). The PSLRA amended the Securities Exchange Act to require that a complaint "plead with particularity both falsity and scienter." Id. (quoting Ronconi, 253 F.3d at 429). Thus, to properly allege falsity, a securities fraud complaint must now "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." Id. (quoting 15 U.S.C. § 78u-4(b)(1))(quotation marks omitted). To adequately plead scienter, the complaint must now "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). See also Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976).

[3] The Supreme Court recently defined "strong inference" in Tellabs, concluding that a securities fraud complaint will survive a motion to dismiss under Federal Rule of Civil Procedure 12(b)(6) "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." 127 S. Ct. at 2510 (emphasis added). Thus, a court now reviewing a complaint's scienter allegations under the PSLRA must "consider the complaint in its entirety, as well as other sources courts ordinarily examine when ruling on Rule 12(b)(6) motions to dismiss, in particular, documents incorporated into the complaint by reference, and matters of which a court may take judicial notice." Id. at 2509. The court must determine whether "all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard." Id. Finally, when "determining whether the pleaded facts give rise to a 'strong' inference of scienter, the court must take into account plausible opposing inferences." Id. This "inquiry is inherently comparative." Id. at 2510. A court must compare the malicious and innocent inferences cognizable from the facts pled in the complaint, and only allow the complaint to survive a motion to dismiss if the malicious inference is at least as compelling as any opposing innocent inference. See id. at 2510. See also Metzler Investment, 540 F.3d at 1066.

To adequately demonstrate that the "defendant acted with the required state of mind," a complaint must "allege that the defendants made false or misleading statements either intentionally or with deliberate recklessness." Daou, 411 F.3d at 1014-15 (citing Silicon Graphics, 183 F.3d at 974). In Silicon Graphics, we defined the "deliberate recklessness" standard, noting that "we continue[ ] to view it as a form of intentional or knowing misconduct." 183 F.3d at 976. More specifically, "although facts showing mere recklessness or a motive to commit fraud and opportunity to do so may provide some reasonable inference of intent, they are not sufficient to establish a strong inference of deliberate recklessness." Id. at 974. Rather, the plaintiff must plead "a highly unreasonable omission, 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." Id. at 976 (quoting Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569 (9th Cir. 1990); Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977)) (quotation marks omitted).

[4] Although we have developed a set of rules to analyze different types of scienter allegations, we recognize that Tel-labs calls into question a methodology that relies exclusively on a segmented analysis of scienter. We read Tellabs to mean that our prior, segmented approach is not sufficient to dismiss an allegation of scienter. Although we have continued to employ the old standards in determining whether, a plaintiff's allegations of scienter are as cogent or as compelling as an opposing innocent inference, see, e.g., Metzler Investment, 540 F.3d at 1065-69, we must also view the allegations as a whole. See South Ferry LP, No. 2 v. Killinger, 542 F.3d 776, 784 (9th Cir. 2008) ("Tellabs counsels us to consider the totality of the circumstances, rather than to develop separately rules of thumb for each type of scienter allegation."). Thus, following Tellabs, we will conduct a dual inquiry: first, we will determine whether any of the plaintiff's allegations, standing alone, are sufficient to create a strong inference of scienter; second, if no individual allegations are sufficient, we will conduct a "holistic" review of the same allegations to determine whether the insufficient allegations combine to create a strong inference of intentional conduct or deliberate recklessness.

B.

The SAC relies on several types of factual allegations to plead the requisite intentional or deliberately reckless conduct, including (1) statements of six confidential witnesses, (2) Digimarc's April 5, 2005 restatement of earnings, (3) the resignations of Ranjit, two members of the accounting department, and the corporation's auditing firm during the class period, (4) statements made in filing the corporation's Sarbanes-Oxley certifications, (5) the compensation packages of the individual defendants, (6) the stock sales of the individual defendants occurring during the class period, and (7) a private placement by the corporation during the class period. We address each of these ...


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