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In re Dothill Systems Corp. Securities Litigation

March 18, 2009


The opinion of the court was delivered by: Honorable Janis L. Sammartino United States District Judge


(Doc. No. 92.)

Presently before the Court is a motion to dismiss the Third Amended Consolidated Class Action Complaint ("TACC") by Dot Hill Systems Corporation, James L. Lambert, Dana W. Kammersgard, Preston S. Romm, and William R. Sauey*fn1 ("Defendants"). (Doc. No. 92.) For the reasons stated below, the Court GRANTS Defendants' motion to dismiss and DISMISSES WITHOUT PREJUDICE the present action.


A. Facts

Lead Plaintiffs bring this putative class action on behalf of all purchasers of Dot Hill common stock between April 23, 2003 and April 27, 2006. (TACC ¶ 1.)

Dot Hill provides data storage devices (i.e., hard drives), both as stand-alone units and as part of larger storage systems. (Id. ¶ 2.) Dot Hill's devices employ Redundant Array of Independent Disks ("RAID") technology. (Id.) In 2002, facing severe declines in sales and revenue, Dot Hill restructured its business by outsourcing its manufacturing, transitioning to an indirect sales model, and sharply reducing sales and administrative personnel. (Id. ¶ 3.) That same year, Dot Hill secured a contract to provide data storage systems to Sun Microsystems, which became the source of 80--90% of Dot Hill's quarterly revenues. (Id. ¶ 4.)

In September 2003, Dot Hill completed a secondary stock offering that raised approximately $154 million, with the individual defendants selling an additional $23.1 million. (Id. ¶ 6.) Dot Hill used some of the revenues from this offering to purchase Chaparral Network Storage, Inc., a provider of RAID technology, with the intent of integrating Chaparral technology into its own products. (Id. ¶ 7.) Dot Hill's share price increased from $6 at the start of the class period to a peak price of $18, dropped by half in 2004 and early 2005, eventually declined to $4.55 on April 28, 2006 and then subsequently declined to $3 per share. (Id. ¶ 12.)

The TACC alleges four sets of misrepresentations giving rise to Plaintiffs' claim for federal securities fraud. First, Plaintiffs allege that, for the first 3 quarters of 2004, Dot Hill misrepresented

(1) its financial results, and (2) the certification of Dot Hill's disclosure controls. (Id. ¶¶ 27--28.) Plaintiffs allege that Dot Hill admitted the falsity of these statements when it acknowledged "internal control deficiencies that constitute material weaknesses" and attributed those deficiencies to outdated software and inadequate accounting resources. (Id. ¶ 30--35.) According to the TACC, Dot Hill's management knew of the shortcomings in its accounting software through conversations between employees and the executive defendants, but were committed to the software for financial and personal reasons. (Id. ¶ 38.) Management was also allegedly aware of understaffing in the accounting department because of the long hours worked by those employees, the difficulty "clos[ing] the books" each month, and the absence of staff with adequate credentials. (Id. ¶ 40.)

Second, Plaintiffs allege misrepresentations associated with Defendants' remarks about the salutary effects of staff cuts and its business model predicated on outsourced manufacturing and indirect sales. Dot Hill particularly emphasized its annualized revenue figure of more than $1 million per employee. (Id. ¶¶ 42, 44--48.) Dot Hill further represented its expectation that it would continue to operate with fewer than two hundred employees. (Id. ¶¶ 43, 45.) Moreover, during the relevant period, Dot Hill touted that its business model as a success. (Id., ¶¶ 45--48.) The representations that this business model was working well were allegedly false because Dot Hill's business model, rather than making the company sustainably profitable, "had resulted in organizational dysfunction and breakdown." (Id. ¶ 49.) Pointing to inadequate accounting personnel and inexperienced sales staff, Plaintiffs claim that Dot Hill could not perform "basic task[s]" such as "producing materially correct financial statements." (Id. ¶ 50.) The TACC attributes these shortcomings to Defendants' insistence on maintaining per-employee revenue levels above $1 million. (Id. ¶ 52.) Plaintiffs allege that Defendants' representations of "a 'lean' or 'efficient' organization" in 2003--04, including its representations of profits earned during those periods, were effectively false because, if Dot Hill had maintained operating costs and employee headcount at sustainable levels during that period, its financial results would have been much worse. (Id. ¶¶ 55, 58.) Dot Hill's results in subsequent years declined because the company incurred operating costs associated with hiring more accountants and upgrading software and because the incompetent sales force could not secure new customers. (Id. ¶¶ 50, 60.)

Third, Plaintiffs allege that Defendants made misleading representations about Dot Hill's relationship with Sun Microsystems, its largest customer, and the acquisition of Chaparral technologies. (Id. ¶¶ 62--64.). These positive statements included Dot Hill's commitment to making the relationship with Sun successful, (see, e.g., id. ¶ 67) announcements of extensions of the Sun-Dot Hill contract, (see, e.g., id. ¶ 66) and claims that the integration of Chaparral technology into Dot Hill products was "on schedule" and "continuing smoothly." (See, e.g., id. ¶ 75.) Plaintiffs allege that Sun was actually dissatisfied with Dot Hill's services and that Dot Hill acquired Chaparral because Sun demanded that Dot Hill acquire a new source of RAID technology. (Id. ¶ 85.) Further, the integration of the Chaparral technology was progressing more slowly, with the delivery of products to market more remote than Dot Hill was representing. (Id. ¶ 80.) Dot Hill management allegedly must have known about these delays in the Chaparral integration because Defendant Kammersgard, Dot Hill's Chief Technology Officer, kept aware of issues in Dot Hill's product development including those regarding the integration. (Id. ¶ 83.) Plaintiffs claim that the slowness of the Chaparral integration made Sun very dissatisfied, and that, as such, Plaintiff's claims that the companies' relationship was healthy were false. (Id. ¶ 85.) The alleged truth finally came to light on April 28, 2006, when Dot Hill disclosed that Sun had awarded a product development contract to one of Dot Hill's competitors. (Id. ¶ 95.)

Fourth, and finally, Plaintiffs allege that Defendants misrepresented the extent of their success in attracting new customers. (Id. ¶ 87.) These misrepresentations included press releases announcing "agreements" with third parties, and statements proclaiming Dot Hill's intent to pursue additional customers and their success in doing so. (Id. ¶¶ 88--97.) Plaintiffs claim that these statements were misleading because the agreements did not require purchases of Dot Hill products, often failed to generate much revenue, and Defendants were not actually committed to acquiring and keeping new customers. (See, e.g., id. ¶¶ 98, 102, & 105.) Defendants allegedly knew that these statements were false because they were aware of Dot Hill's underqualified sales staff and inadequate investment in business development. (Id. ¶¶ 104--05.)

B. Procedure

The TACC pleads two causes of action for (1) violation of Exchange Act § 10(b) and Rule 10b-5, and (2) controlling person liability under Exchange Act § 20(a). The Hon. Thomas J. Whelan reassigned the action to this Court on September 25, 2007. (Doc. No. 64.) On September 2, 2008, this Court granted Defendants' motion to dismiss Plaintiffs' Second Amended Consolidated Class Action Complaint ("SACC"), and dismissed this case without prejudice. (Doc. No 85.) On October 10, 2008, Plaintiffs filed the TACC. (Doc. No. 88.) Defendants filed the instant motion to dismiss on November 24, 2008. (Doc. No. 92.) Plaintiffs filed their opposition on January 15, 2009 and Defendants filed a reply brief on February 5, 2009. (Doc. Nos. 95 & 97.)


A. Legal Standard

To survive a motion to dismiss, "a plaintiff's obligation to provide the 'grounds' of his 'entitle[ment] to relief' requires more than labels and conclusions, and a formulaic recitation of the elements of a cause of action will not do." Bell Atl. Corp. v. Twombly, 550 U.S. 544, 127 S.Ct. 1955, 1964--65 (2007) (citing Papasan v. Allain, 478 U.S. 265, 286 (1986)). "Factual allegations must be enough to raise a right to relief above the speculative level." Id. at 1965 (internal citations omitted). In reviewing the motion to dismiss, the Court must assume the truth of all factual allegations and construe inferences in the light most favorable to the nonmoving party. Thompson v. Davis, 295 F.3d 890, 895 (9th Cir. 2002); Sprewell v. Golden State Warriors, 266 F.3d 979, 988 (9th Cir. 2001).

A plaintiff "must state with particularity the circumstances constituting fraud." Fed. R. Civ. P. 9(b). Pursuant to the Private Securities Litigation Reform Act ("PSLRA"), the 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). Therefore, plaintiffs must specifically identify the allegedly fraudulent statements or acts of fraud. Kaplan v. Rose, 49 F.3d 1363, 1370 (9th Cir. 1994). And, plaintiffs must plead evidentiary facts including the dates, times, places, and persons associated with each misrepresentation or act of fraud. In re Glenfed, Inc. Sec. Litig., 42 F.3d 1541, 1548--49 n.7 (9th Cir. 1994) (en banc) (superseded by statute on other grounds); Neubronner v. Milken, 6 F.3d 666, 672 (9th Cir. 1993).

The PSLRA requires plaintiffs to "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). Therefore, plaintiffs must also plead scienter with particularity. Roconi v. Larkin, 253 F.3d 423, 429 (9th Cir. 2001); In re Impac Mortgage Holdings, Inc. Sec. Litig., 554 F. Supp. 2d 1083, 1099 (C.D. Cal. 2008). Plaintiffs "must state specific facts indicating no less than a degree of recklessness that strongly suggests actual intent." In re Silicon Graphics, Inc. Sec. Litig., 183 F.3d 970, 979 (9th Cir. 1999). Recklessness amounts to "'an extreme departure from the standards of ordinary care, and... presents a danger of misleading buyers and sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.'" DSAM Global Value Fund v. Altris Software, Inc., 288 F.3d 385, 389 (9th Cir. 2002) (quoting Hollinger v. Titan Cap. Corp., 914 F.2d 1564, 1569 (9th Cir. 1990)). Liability for forward-looking statements, however, attaches only if the plaintiff can prove that the statement was made with actual knowledge of its falsity. 15 U.S.C. § 78u-5(c)(1)(B); No. 84 Employer-Teamster Joint Council Pension Trust Fund v. Am. W. Holding Corp., 320 F.3d 920, 936 (9th Cir. 2003). As recently prescribed by the Supreme Court, to determine the strength of a scienter inference, this Court "must consider plausible nonculpable explanations for the defendants' conduct, as well as inferences favoring the plaintiff." Tellabs, Inc. v. Makor Issues & Rights, Ltd., 550 U.S. 544, 127 S.Ct. 2499, 2510 (2007). The complaint survives "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.

Courts within the Ninth Circuit combine the falsity and scienter pleading requirements into a single inquiry, such that "'the complaint must contain allegations of specific contemporaneous statements or conditions that demonstrate the intentional or the deliberately reckless false or misleading nature of the statements when made.'" In re Read-Rite Corp., 335 F.3d 843, 846 (9th Cir. 2003) (quoting Ronconi v. Larkin, 253 F.3d 423, 432 (9th Cir. 2001)).

When plaintiffs base their allegations on information and belief, "[i]t is not sufficient... to set forth a belief that certain unspecified sources will reveal... facts that will validate [plaintiffs'] claim." Silicon Graphics, 183 F.3d 970 at 985; In re Immune Response Sec. Litig., 375 F. Supp. 2d 983, 1023 (S.D. Cal. 2005). Although a complaint may keep confidential the identities of personal sources, those confidential witnesses "should be 'described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged.'" Nursing Home Pension Fund, Local 144 v. Oracle Corp., 380 F.3d 1226, 1233 (9th Cir. 2004) (quoting Novak v. Kasaks, 216 F.3d 300, 314 (2d Cir. 2000)); Alaska Elec. Pension Fund v. Adecco S.A., 371 F. Supp. 2d 1203, 1211 (S.D. Cal. 2005). A complaint relying on anonymous confidential witnesses must also contain "adequate corroborating details." In re Daou Sys., Inc., 411 F.3d 1006, 1015 (9th Cir. 2005); Adecco, 371 F. Supp. 2d at 1211. Such details might include job descriptions, work responsibilities, position titles, and corporate executives to whom the witnesses reported. Daou Sys., 411 F.3d at 1016. However, the Ninth Circuit has cautioned that a confidential witness's reliance on hearsay "may indicate that [the] confidential witnesses' report is not sufficiently reliable, plausible, or coherent to warrant further consideration under Daou." Zucco Partners, LLC v. Digimarc Corp., - F.3d -, 2009 WL 311070, at *11 n.4 (9th Cir. 2009) (citation omitted). To determine the adequacy of allegations based on confidential witness accounts, the court evaluates "'the level of detail provided by the confidential sources, the corroborative nature of the other facts alleged (including from other sources), the coherence and plausibility of the allegations, the number of the sources, [and] the reliability of the sources.'" Id. at 1015 (quoting In re Cabletron Sys., Inc., 311 F.3d 11, 29 (1st Cir. 2002)); Limantour v. Cray Inc., 432 F. Supp. 2d 1129, 1141--42 (W.D. Wash. 2006).

Also as part of a securities fraud claim, plaintiffs must plead "'loss causation,' i.e., a causal connection between the material misrepresentation and the loss." 15 U.S.C. § 78u-4(b)(4); Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 342 (2005). In other words, "the complaint must allege that the practices that the plaintiff contends are fraudulent were revealed to the market and caused the resulting losses." Metzler Inv. GmbH v. Corinthian Colleges, Inc., 540 F.3d 1049, 1062 (9th Cir. 2008). "A limited temporal gap" from the revelation of the misrepresentation to the stock price decline does not invalidate the loss causation theory. In re Gilead Scis. Sec. Litig., 536 F.3d 1049, 1058 (9th Cir. 2008). Without specifying whether loss causation pleading must satisfy the particularity requirements of FRCP 9(b) or simply provide the "short and plain statement of the claim" of FRCP 8(a)(2), the Ninth Circuit requires "sufficient detail to give defendants ample notice of plaintiffs' loss causation theory, and to give [the court] some assurance that the theory has a basis in fact." Berson v. Applied Signal Tech., Inc., 527 F.3d 982, 989--90 (9th Cir. 2008).

When dismissing a complaint, the Court may deny leave to amend only if it appears with certainty that the plaintiff cannot state a claim and any amendment would be futile. See Fed. R. Civ. P. 15(a) (stating leave to amend "shall be freely given when justice so requires"); DeSoto v. Yellow Freight Sys., Inc., 957 F.2d 655, 658 (9th Cir. 1992); ...

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