MILBERG WEISS BERSHAD
HYNES & LERACH LLP
ALAN SCHULMAN (128661)
MARK SOLOMON (151949)
SALLIE A. BLACKMAN (141830)
600 West Broadway, Suite 1800
San Diego, CA 92101
Telephone: 619/231-1058

- and -

JOHN K. GRANT (169813)
222 Kearny Street, 10th Floor
San Francisco, CA 94108
Telephone: 415/288-4545
ABBEY, GARDY & SQUITIERI, LLP
JILL S. ABRAMS
JAMES J. SEIRMARCO
212 East 39th Street
New York, NY 10016
Telephone: 212/889-3700

BERNSTEIN LITOWITZ BERGER &
GROSSMANN LLP
DANIEL L. BERGER
JEFFREY N. LEIBELL
1285 Avenue of the Americas
33rd Floor
New York, NY 10019
Telephone: 212/554-1400

Attorneys for Lead Plaintiffs and the Class
 
 

A. Lee's Fraudulent Conduct

B. Evidentiary Facts Supporting Plaintiffs' Allegations Against Lee

A. The Facts Alleged Show That Lee Was Privy To Material Nonpublic Information When He Sold Stock And That He Thereby Violated The Securities Laws

B. Lee Is Liable For A Scheme To Defraud

C. Lee Is Presumed Responsible For The Allegedly False Statements And Omissions Under The "Group Published Information" Presumption

D. Lee Is Liable As A Control Person For Certain Alleged False And Misleading Statements

E. Recklessness Liability Has Not Been Eliminated For Non-Forward-Looking Statements

1. The Recklessness Standard

2. Congress Preserved The Existing Recklessness Standard In Private Securities Litigation Reform Act

a. The Text And Structure Of The New Act Shows That Congress Did Not Eliminate Motive, Opportunity And Recklessness As Means Of Establishing Scienter

b. The Legislative History Shows That Congress Intended For Courts To Seek Guidance From Second Circuit Precedents And That Scienter May Be Inferred From Motive, Opportunity Or Recklessness

I. INTRODUCTION AND OVERVIEW

Lee must answer the securities fraud claims directed at him under at least four theories. First, Lee is liable for violating §10(b) under the disclose-or-abstain doctrine, whereby corporate insiders who know material adverse non-public information about the corporation's business may not sell their stock without disclosing that information. Lee sold Diamond stock at inflated prices while he was aware of material undisclosed facts that were adversely affecting Diamond's business. Second, Lee is liable for participating in a scheme to defraud or course of business that operated as a fraud or deceit on purchasers of stock. Third, Lee is presumptively answerable for certain of the allegedly false statements under the group-published-information doctrine, which holds corporate officers and certain directors responsible for corporate communications. Fourth, Lee is liable, absent a showing by him of good faith, as a person who controlled Diamond. 

A. Lee's Fraudulent Conduct

Lee's participation in the alleged fraudulent scheme was direct. As its most senior director who regularly received and reviewed internal management reports, and as the Company's most highly salaried "consultant," Lee knew that the positive statements directed at the market were fundamentally undermined by a host of material adverse facts that had not been disclosed to Diamond's investors. For example, during the Class Period, Lee and the other defendants informed investors that quarterly revenues would far exceed $160 million, and that earnings per share would continue to increase because demand for the Company's communications and connectivity products was "strong" and "solid," and because the Company experienced "higher than expected" sales of its Edge 3-D product. All of these statements were false and misleading when made. ¶¶7, 27. Lee together with his co-defendants knew from the fall of 1995 that demand for Diamond's products was seriously weakening, that the Company was shipping defective products that were being returned at inordinate rates and that he and the Company were suffering from ballooning inventory problems and that they were falsifying Diamond's financial statements in order to conceal the true facts. Id.

Lee also represented, in late 1995, that the Company would introduce a host of new products during the Class Period that would have a positive impact on 1996 earnings, when he knew that those new products were plagued with problems that were bound to have a severe negative impact on the Company's future performance. For example, the Company's supply of the Rockwell chips needed to operate its communications products was so unreliable and erratic that the Company's production line was frequently halted waiting for arrival of the chips. ¶¶8, 27. Lee further represented to the public that the Stealth 64 Video 2001, which was shipped in September 1995, was compatible with Microsoft's windows applications when he knew that the Stealth 64 Video 2001 was not Windows compatible. Id.

In addition, Lee, through his co-defendants, informed investors that the Company would earn at least $1.80 per share in 1996, when there was no reasonable basis for that earnings estimate and, in fact, Lee knew of existing internal problems that made such earnings implausible. ¶¶8, 27. Lee further concealed from investors (1) that the Company had shipped substantial amounts of products, including the Edge 3-D, with expansive and liberal rights of return -- rights that could never honestly be portrayed as "limited" and which were not properly accounted for and adequately disclosed in the Company's financial statements (¶11); (2) that the Company had so "stuffed the distribution channel" with certain products during the first quarter of 1996, that the Company's first quarter financial statements were further materially overstated and the Company's revenue and earning projections for the remainder of 1996 were unattainable (id.); and (3) the large price protection liability Diamond owed to its customers based on its reduction of the prices for Edge 3-D and other products at the end of the first quarter of 1996 (id.) Lee, through his co-defendants, then misrepresented to investors, without a reasonable basis, that Diamond would have a profitable first quarter, with approximately $0.30 per share in earnings for the quarter. ¶12.

Despite his knowledge from the inception of the Class Period of the serious problems plaguing Diamond, Lee withheld this material information from investors because he wanted to take advantage of the artificial inflation in Diamond's stock that he had helped orchestrate, and sell off his own Diamond shares. ¶9. In November 1995, Lee sold 131,993 shares of his Diamond stock at $29.92 per share in Diamond's secondary stock offering, pocketing proceeds of $1,890,884. ¶¶9, 26(b). On December 5, 1995, Lee sold a further 68,795 shares at $31.25 per share, reaping an additional $2,149,844. ¶¶9, 26(b). 

B. Evidentiary Facts Supporting Plaintiffs' Allegations Against Lee

In addition, Lee had knowledge of the adverse factors affecting the Company's business, finances, products, market and present and future business prospects via his regular attendance at Board of Directors and Committee meetings; his communications with the other defendants, including CEO Schroeder and CFO Filler, and his regular receipt of important reports and other corporate documents which contained the adverse information being concealed. ¶26(b). Lee signed the Form S-1 Registration Statement ("Registration Statement") for the Secondary Offering which was filed during the Class Period, on November 21, 1995, with the Securities Exchange Commission ("SEC"). Id. Lee also signed Diamond's year-end 1995 Report on Form 10-K ("Form 10-K"), filed on April 1, 1996 with the SEC. Id. Because Lee signed these public documents, he had the duty and the opportunity to exercise control over their contents. ¶¶26(b), 28. 

II. ARGUMENT

A. The Facts Alleged Show That Lee Was Privy To Material Nonpublic Information When He Sold Stock And That He Thereby Violated The Securities Laws

Lee's contention that the Complaint alleges nothing illegal in Lee's sales is wrong. Insider stock sales are illegal if the insiders possess material undisclosed information. Chiarella v. United States, 445 U.S. 222, 226-30 (1980); accord Dirks v. SEC, 463 U.S. 646, 659-60 (1983); McCormick v. Fund American Cos., 26 F.3d 869, 876 (9th Cir. 1994); Texas Gulf Sulphur Co., 401 F.2d at 848; In the Matter of Cady, Roberts & Co., 40 S.E.C. 907, 912, 1961 SEC LEXIS 385 (1961), Ex. 10 to the Declaration of Sallie A. Blackman, filed concurrently herewith ("Blackman Decl."). "There is no doubt that an individual corporate insider in possession of material nonpublic information is prohibited by the federal securities laws from trading on that information unless he makes public disclosure. He must disclose or abstain from trading." Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1203 (1st Cir. 1996).

Manipulation of securities prices to buy or sell stock also is illegal. See Deutsch v. Flannery, 823 F.2d 1361, 1366 & n.5 (9th Cir. 1987). See also Harris v. United States, 48 F.2d 771, 774-75 (9th Cir. 1931) ("The fraudulent scheme charged . . . was one for the sale of [a mining company's] corporate stock . . . by the manipulation of the price of the stock on the [stock exchanges] and the circulation of false reports concerning the mine through the mails. . . . In fact, the whole scheme centered around the establishment of an alleged stock exchange value which is in fact wholly fictitious."); United States v. Brown, 5 F. Supp. 81, 83-86 (S.D.N.Y. 1933) (reviewing older precedents), aff'd, 79 F.3d 321 (2d Cir. 1935). Such conduct is directly interdicted by the Securities Exchange Act of 1934 (the "Exchange Act") §10(b), which imposes liability for employing "any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe," 15 U.S.C. §78j(b), and by SEC Rule 10b-5 promulgated thereunder, 17 C.F.R. §240.10b-5. Together these provisions make it illegal not just to make false or misleading statements, 17 C.F.R. §240.10b-5(b), but also "[t]o employ any device, scheme, or artifice to defraud," or "[t]o engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person," 17 C.F.R. §240.10b-5(a), (c).⁽²⁾

Insider trading is itself evidence of such a scheme to defraud: "'Insider trading in suspicious amounts or at suspicious times is probative of bad faith and scienter.'" Kaplan v. Rose, 49 F.3d 1363, 1379 (9th Cir. 1994) (quoting In re Apple Computer Sec. Litig., 886 F.2d 1109, 1117 (9th Cir. 1989)). In Kaplan, the Ninth Circuit held that a violation of §10(b) could be found because insiders' stock sales were "not consistent with earlier patterns; they were in large amounts and at sensitive times" when insiders, who had not previously sold stock, disposed of shares at high prices and before the disclosure of bad news. Id. 49 F.3d at 1379-80. In Provenz v. Miller, 102 F.3d 1478 (9th Cir. 1976), the Ninth Circuit again held that insider sales supported a finding of scienter:

Boesenberg sold about 90,000 shares during the class period -- almost six times more stock that he had sold during the twelve months preceding the class period -- for $1,479,650.

The Complaint clearly alleges that Lee was in a position to know the undisclosed adverse information and that he sold $4 million of stock, trading on that knowledge. See Cosmas, 886 F.2d at 13. As the Complaint alleges, Lee is the founder of Diamond and served as its President and CEO for the twelve consecutive years preceding the Class Period. After he "resigned" as CEO and president, Lee continued to draw a yearly salary of over a 1/4 of a million dollars pursuant to a "consultant" agreement with the Company, as well as a bonus equal to that of the CEO. Lee signed the Registration Statement and Form 10K which publicized Diamond's false financial statements and false statements regarding Diamond's products and prospects. ¶26(b). Lee has also served as Chairman of the Board of Diamond for the past 15 years and has regularly attended board meetings. Lee therefore had every reason to know of the adverse factors plaguing the Company, its products and its finances. In short, Lee was a top insider who (1) participated in the management and control of the Company, and (2) enjoyed a special relationship with the corporation.⁽⁴⁾

On a motion to dismiss, the Court is required to accept the facts alleged and to draw every inference in plaintiffs' favor.⁽⁵⁾ Once a suspicious pattern of insider trading is presented, Lee bears the burden of presenting evidence subject to cross-examination to rebut the inference of fraud.⁽⁶⁾ Lee cannot do so and, therefore, is not entitled to have the Complaint against him dismissed on a Rule 12(b)@@@@

(6) motion. Marksman Partners, L.P. v. Chantal Pharm. Corp., 927 F. Supp. 1297, 1312-13 (C.D. Cal. 1996).⁽⁷⁾

B. Lee Is Liable For A Scheme To Defraud

In Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199 n.20 (1976), the Supreme Court referred to the dictionary definitions of §10(b)'s words to find that a "device" is "'[t]hat which is devised, or formed by design; . . . scheme; often, a scheme to deceive . . . .'" (Quoting Webster's International Dictionary (2d ed 1934)). The Court found that a "contrivance" means "'[a] thing contrived or used in contriving; a scheme, plan, or artifice.'" Id. (quoting Webster's). Rule 10b-5's plain language therefore makes it unlawful not just to make misleading statements, 17 C.F.R. §240.10b-5(b), but also "[t]o employ any device, scheme, or artifice to defraud," 17 C.F.R. §240.10b-5(a), or "[t]o engage in any act, practice, or course of business which operates or would operate as a fraud or deceit on any person," 17 C.F.R. §240.10b-5(c). Thus, "Rule 10b-5 liability is not restricted solely to isolated misrepresentations or omissions; it may also be predicated on a 'practice, or course of business which operates . . . as a fraud.'" Blackie v. Barrack, 524 F.2d 891, 903 n.19 (9th Cir. 1975) (citation omitted).

In Affiliated Ute Citizens v. United States, 406 U.S. 128, 152-53 (1972), the Supreme Court observed that "the second subparagraph of [Rule 10b-5] specifies the making of an untrue statement of a material fact and the omission to state a material fact," as conduct which violates the rule, but held that "[t]he first and third subparagraphs are not so restricted." The court held that the defendants violated Rule 10b-5 when they participated in "a 'course of business' or a 'device, scheme or artifice' that operated as a fraud" -- even though these defendants had never themselves said anything that was false or misleading. Id. at 153.⁽⁸⁾ Plaintiffs therefore are not required to prove that Lee personally made a misleading statement in order to establish his participation in a scheme to defraud. It is his failure to speak that establishes his liability for trading on inside information. See Shaw, 82 F.3d at 1203. Silence about material undisclosed facts is a necessary characteristic of insider trading stock manipulation schemes.

Every person who intentionally engages in a "scheme" to defraud is a primary violator of Rule 10b-5 and §10(b), even if he did not personally utter false or misleading statements. ZZZZ Best, 864 F. Supp. at 971. The Supreme Court recognizes that "[i]n any complex securities fraud . . . there are likely to be multiple violators," Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164, 114 S. Ct. 1439, 1455, (1994), and Exchange Act §20(b) specifies that it is "unlawful for any person, directly or indirectly, to do any act or thing which it would be unlawful for such person to do under the provisions of this chapter or any rule or regulation thereunder through or by means of any other person." 15 U.S.C. §78t(b). Thus, the court in Shores v. Sklar, 647 F.2d 462 (5th Cir. 1981), held that a defendant who did not personally issue the statements in a misleading offering circular could be held primarily liable as a participant in a larger scheme to defraud of which that offering circular was only a part.

Here, Lee actually signed the Registration Statement (his signature must mean something) at the same time as he sold $4 million worth of shares.⁽⁹⁾ The insider trading together with the circumstantial evidence of intentional and/or reckless conduct in this case raises a strong inference that Lee engaged in a scheme to defraud -- gutting his (mistaken) argument that he did not personally utter misleading statements. 

C. Lee Is Presumed Responsible For The Allegedly False Statements And Omissions Under The "Group Published Information" Presumption

This is common sense. Directors in order to "direct" their companies generally do know about developments important enough to "eliminate[] a potentially significant source of income for the company." Cosmas, 886 F.2d at 13. The court's analysis in Cosmas is instructive. There plaintiffs alleged that defendants had fraudulently failed to disclose that China had imposed new import restrictions which would severely restrict defendant Inflight's sales to China. The court held that the fact that the individual defendants were alleged to be directors of the company raised a strong inference that they knew of these import restrictions, because the restrictions apparently eliminated a potentially significant source of income for the company.⁽¹⁰⁾ The court held that "[i]n light of the strong inference that the defendants, at the time the allegedly fraudulent statements were made, had knowledge [of the adverse factors'] we conclude that the amended complaint alleges sufficient facts from which it can be inferred that the defendants had the requisite fraudulent intent." Id. Similarly, in this case, plaintiffs alleged that defendants, including Lee, made misleadingly positive representations through a variety of communications -- representations that Lee and his co-defendants knew had no reasonable basis due to existing adverse factors affecting the core of Diamond's business. Lee's status as a director alone gives rise under Cosmas to the strong inference that Lee had knowledge of the adverse factors that made the representations unreasonable. Also here, given Lee's history and status at Diamond, Lee had a particularly "special" relationship with Diamond that renders it all the more likely that he acted collectively with his co-defendants. See GlenFed II, 60 F.3d at 593.⁽¹¹⁾ ¶¶2, 3, 26(b).

It is because of his relationship with Diamond that Lee's reliance on Stack v. Lobo, 903 F. Supp. 1361, 1376 (N.D. Cal. 1995), is entirely misplaced. In Stack, the court concedes that "the group pleading doctrine may be involved as to outside directors" if they "had a special relationship with the corporation." Id. In this case, as indicated, Lee clearly had a special relationship with the corporation he founded twenty-four years ago and he remained Chairman of the Board, a signatory on public filings and a highly paid member of the Compensation Committee which, presumably, must have involved frequent consideration of Diamond's stock as a form of compensation. See In re Xoma Corp. Sec. Litig., [1991-1992 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶96,491, at 92,161 (N.D. Cal. Dec. 30, 1991) where the court held that group published doctrine was inapplicable to the outside directors only because "plaintiffs never allege in their complaint that the outside directors had any special relationship with the corporation . . . . The Xoma court "recognize[d] that the particular facts disclosing these defendants involvement in the fraud may only become known to plaintiffs through discovery" and conceded that "if at the end of discovery plaintiffs have uncovered the particular involvement of any of these outside directors in the fraud, plaintiffs shall [have] leave to join these defendants and to amend their complaint to allege these particular facts." Id.; see also In re Gupta Corp. Sec. Litig., 900 F. Supp. 1217, 1242 (N.D. Cal. 1994) (plaintiffs did not allege that directors enjoy a special relationship with the defendants corporation). 

D. Lee Is Liable As A Control Person For Certain Alleged False And Misleading Statements

Thus, control is not among the "circumstances constituting fraud" that Rule 9(b) requires to be pleaded with particularity. See, e.g., Keys v. Wolfe, 540 F. Supp. 1054, 1065-66 (N.D. Tex. 1982) ("Though plaintiffs' complaint explains each misrepresentation and its falsity without explaining ety and are not themselves "averments of fraud").

Whether a defendant is a control person is a complex factual question that cannot properly be resolved on a motion to dismiss. While status as a director, by itself, may not be enough to establish control in every case, it is at least a "red light." Kaplan, 49 F.3d at 1382; Arthur Children's Trust v. Keim, 994 F.2d 1390, 1397 (9th Cir. 1993); see also Convergent, 108 F.R.D. at 343 ("all directors . . . are presumably members of the controlling group and only compelling evidence to the contrary should remove them from the group"). "[D]ismissal at the pleading stage is appropriate only if the Complaint fails to allege any facts from which it might be inferred that a . . . 'control' relationship existed." Schneider v. Traweek, [1990 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶95,507, at 97,664 (C.D. Cal. Aug. 28, 1990).

Here, plaintiffs have alleged that Lee was Chairman of the Board of Directors of Diamond, a member of its Compensation Committee, its $400,000 per year "consultant" and a signatory to its public filings. Lee has conceded that he owns almost 8% of Diamond's stock and in his Form 4 dated 11/95 he describes himself as a 10% owner. These facts establish that, at this pleading stage, Lee must be considered a controlling person of Diamond under Section 20(a) of the Exchange Act. 

E. Recklessness Liability Has Not Been Eliminated For Non-Forward-Looking Statements

1. The Recklessness Standard

2. Congress Preserved The Existing Recklessness Standard In Private Securities Litigation Reform Act

If Congress had intended for the actual-knowledge requirement to apply to statements outside the safe harbor for forward-looking statements, why did it expressly limit the safe harbor to specifically-identified forward-looking statements, 15 U.S.C. §78u-5(c), made by specified persons, 15 U.S.C. §78u-5(a), and subject to numerous exclusions? 15 U.S.C. §78u-5(b). The exclusion of most statements from the safe harbor's actual-knowledge requirement provisions obviously is designed to preserve recklessness liability for any statements that do not come within the safe harbor, and the statute's provisions limiting its scope are effectively nullified by any holding that the safe harbor's actual-knowledge requirement applies without regard to whether statements are forward-looking.

Accordingly, the court in Chantal, 927 F. Supp. at 1309 n.9, held that there is "no basis to conclude that Congress altered the mental state requirements" finding recklessness still to be sufficient to establish the scienter required for the violation. Id. at 1309 n.9. Chantal further held "that Second Circuit jurisprudence comes closest to approximating the [New Act's] new [pleading] requirements." Id. at 1310. "Notwithstanding defendants' citation to the legislative history . . . the 'motive and opportunity' test has not been discarded." Id.

Judge Williams reached a similar conclusion in Zeid v. Kimberley, 930 F. Supp. 431, 438 (N.D. Cal. 1996): "There are two distinct ways in which a plaintiff may plead scienter without direct knowledge of Defendant's state of mind. First, a plaintiff can allege 'facts constituting circumstantial evidence of either reckless or conscious behavior.' Second, a plaintiff can allege facts 'establishing a motive to commit fraud and an opportunity to do so.'" (Citation omitted.)

Most recently, three other district courts have issued rulings that unequivocally support plaintiffs' contention that the New Act has not abrogated the Second Circuit's "motive and opportunity" test. In the first, Judge Kovachevich of the Florida District Court reaffirmed that the Second Circuit's "motive and opportunity" pleading standard for raising a "strong inference" of scienter remained very much alive in the aftermath of the New Act. Fischler v. AmSouth Bancorporation, No. 96-1567-CIV-T-17A, 1996 U.S. Dist. LEXIS 17670, at *8 (M.D. Fla. Nov. 14, 1996). See Blackman Decl., Ex. 2. In the second, Chief Judge Buchmeyer of the Northern District of Texas, after an independent review of a Magistrate's recommendation denied a motion to dismiss in STI Classic Fund v. Bollinger Indus., Civ. No. 3-96-CV-0823-R (N.D. Tex. Nov. 12, 1996). Blackman Decl. Ex. 3. The Bollinger court expressly adopted the Magistrate's report, which held that "the more persuasive interpretation of the provisions of the [New Act] is that articulated by the court in Marksman Partners." Id., Ex. 3 at 2. It therefore used the "motive and opportunity" test. In the third, Rehm v. Eagle Fin. Corp., Case No. 96-C-2455, 1997 U.S. Dist. LEXIS 767, at *18, (N.D. Ill. Jan. 27, 1997), Judge James B. Moran, Senior Judge of the Illinois District Court held that the Second Circuit rule "best comports with the language, history and purpose of the PSLRA." Blackman Decl., Ex. 4. 

a. The Text And Structure Of The New Act Shows That Congress Did Not Eliminate Motive, Opportunity And Recklessness As Means Of Establishing Scienter

Moreover, the "required state of mind" for a §10(b) violation encompasses recklessness. "Scienter may be satisfied by either proof of actual knowledge or recklessness." Hanon v. Dataproducts Corp., 976 F.2d 497, 507 (9th Cir. 1992); see Anixter v. Home-Stake Prod. Co., 77 F.3d 1215, 1232-33 & n.20 (10th Cir. 1996). The precedents are unanimous. Had Congress intended to overrule the established law and require actual knowledge of falsity, it would have said so. Instead, its choice of the phrase "the required state of mind," was designed to preserve recklessness as a basis of liability for most §10(b) claims.

When Congress eliminated liability for reckless conduct with the New Act, it said so. Thus, Congress chose to provide in §21E a narrow "safe harbor" from recklessness liability for "forward-looking statements."⁽¹⁴⁾ Section 21E's new requirement that plaintiffs prove "actual knowledge" of falsity only for certain forward-looking statements within its provisions would be utterly meaningless if plaintiffs always are required to prove "actual knowledge" of falsity for any §10(b) violation. Section 21E requires "actual knowledge," but only for specified forward-looking statements, made by specified persons. 15 U.S.C. §78u-5(a). Moreover, Congress specifically excluded many statements from the safe harbor and its actual knowledge requirement. 15 U.S.C. §78u-5(b). Extending the safe-harbor's actual knowledge scienter standard to all statements frustrates all of these carefully-framed qualifications and exclusions. Congress clearly intended for recklessness to continue to suffice for liability as to any statements outside the "safe harbor" and many of defendants statements here are not forward-looking statements within the "safe harbor."

Similarly, provisions of the New Act which limit joint liability for reckless conduct carefully preserve the rule that reckless conduct does give rise to liability. Section 21D(g) states that "[f]or purposes of this subsection" only, a defendant "knowingly commits a violation of the securities laws" only if it acts "with actual knowledge" of falsity. 15 U.S.C. §78u-4(g)(10)(A). It specifies that for this subsection alone "reckless conduct by a covered person shall not be construed to constitute a knowing commission of a violation of the securities laws by that covered person," 15 U.S.C. §78u-4(g)(10)(B), but also provides that this does not affect the basic scienter standards for establishing a violation of §10(b): "Nothing in this subsection shall be construed to create, affect, or in any manner modify, the standard for liability associated with any action arising under the securities laws." 15 U.S.C. §78u-4(g)(1). The New Act thus expressly preserves the existing case law holding that recklessness suffices to establish the scienter element for a §10(b) violation. 

b. The Legislative History Shows That Congress Intended For Courts To Seek Guidance From Second Circuit Precedents And That Scienter May Be Inferred From Motive, Opportunity Or Recklessness⁽¹⁵⁾

Even if it is considered, however, the legislative history of §21D(b)(2) directly contradicts this Court's prior conclusion. The legislative history shows that Congress intended for courts to seek guidance from Second Circuit precedents on how a "strong inference" of scienter may be pleaded, and did not intend to reject those decisions adopting motive, opportunity, and recklessness as means of establishing scienter.

The "strong inference" language was added by the Senate Banking Committee in order to bring all courts into line with the Second Circuit precedents on pleading scienter:

The courts of appeals have interpreted Rule 9(b) in different ways, creating distinctly different pleading standards among the circuits.

The Committee does not adopt a new and untested pleading standard that would generate additional litigation. Instead, the Committee chose a uniform standard modeled upon the pleading standard of the Second Circuit. Regarded as the most stringent pleading standard, the Second Circuit requires that the plaintiff plead facts that give rise to a "strong inference" of defendant's fraudulent intent. The Committee does not intend to codify the Second Circuit's caselaw interpreting this pleading standard, although courts may find this body of law instructive.

The legislative history directly contradicts defendants' assertion that the Conference Committee expressly disavowed recklessness, motive and opportunity as methods of establishing liability. The Conference Report (Blackman Decl., Ex. 6) itself says exactly the opposite, that "[i]n applying the 'fair share' rule of proportionate liability to cases involving non-knowing securities violations, the Conference Committee explicitly determined that the legislation should make no change to the state of mind requirements of existing law." Blackman Decl., Ex. 6, Conference Report at 38. Senator Moseley-Braun observed that while "the original House bill abolished liability for reckless conduct; the Senate bill did not, and the Senate position prevailed in conference." 141 Cong. Rec. S17984, col. 3 (Dec. 5, 1995). Representative Bliley, who served as Manager for the House on the Conference Committee, confirmed that with the exception of the safe-harbor and proportionate-liability provisions, "[t]he conference report is careful not to change standards of liability under the securities laws." 141 Cong. Rec. H14040, col. 1 (Dec. 6, 1995).

While some legislators were troubled by the Statement of Managers -- fearing that it might be misinterpreted to call for a more demanding pleading standard than the Second Circuit precedents -- the Managers themselves uniformly understood the Conference Report to adopt the pleading standard from the Second Circuit case law. Senator Dodd explained that it had "adopt[ed] the Second Circuit Court of Appeals standard." 141 Cong. Rec. S17959, col. 2 (Dec. 5, 1995). The Conference Report therefore contrasted with the earlier House Bill, which had "established pleading standards that were so high . . . that it would have been impossible to bring a suit . . . had the [earlier] House language been adopted." Id. (statement of Sen. Dodd).⁽¹⁷⁾ "This legislation, therefore, is using a pleadings standard that has been successfully tested . . . in the real world." 141 Cong. Rec. S17957, col. 3 (Dec. 5, 1995).

Senator Domenici similarly explained that "the conference report adopts the pleading standard utilized by the second circuit court of appeals, where a large number of securities fraud lawsuits are brought." Domenici stated that among its advantages was the body of precedent applying the "strong-inference" standard: "This court-tested standard requires plaintiffs to plead facts in their complaint which give rise to a strong inference of securities fraud." 141 Cong. Rec. S17969, col. 3 (Dec. 5, 1995). Senators Dodd and Domenici knew what they were talking about: They had authored this, "the Dodd-Domenici bill," shepherded it through Congress, and served as Managers for the Senate on the Conference Committee which authored the statement the Court relied on to contradict the statutory text. Other members of the Conference Committee agreed with them, that the statute came from the Second Circuit case law.⁽¹⁸⁾

When Senator Specter asked if the Conference Report repudiated 2nd Circuit case law, Senator Dodd told him that it did not: "Basically, what we intended to do here was to codify the second circuit's pleadings standards." 141 Cong. Rec. S17960, col. 1 (Dec. 5, 1995). Dodd added that courts would be free to follow the 2nd Circuit case law, explaining that although "the committee does not intend . . . to codify the second circuit's case law interpreting this pleading standard," nonetheless "courts may find this body [of] law instructive." 141 Cong. Rec. S17960, col. 1 (Dec. 5, 1995). Senator Dodd elaborated, explaining that

instead of trying to take each case that came under the second circuit, we are trying to get to the point where we would have well-pleaded complaints. We are using the standards in the second circuit in that regard, then letting the courts -- as these matters will -- test. They can then refer to specific cases, the second circuit, [or] otherwise, to determine if these standards are [met] based on facts and circumstances in a particular case. That is what we are trying to do here.

Other legislators took the Managers at their word. Senator Moseley-Braun concluded that, although "[i]n the area of pleading, the House bill [had] adopted a standard that was significantly higher than the second circuit standard, which was the standard adopted in the Senate bill," it was "[t]he Senate position [that] prevailed at conference." 141 Cong. Rec. S17984, col. 3 (Dec. 5, 1995). Senator Hatch agreed that "the legislation adopts the second circuit pleading standard." 141 Cong. Rec. S17966, col. 3 (Dec. 5, 1995). Senator Dole too believed that the bill "adopts the second circuit's pleading standard." 141 Cong. Rec. S17983, col. 1 (Dec. 5, 1995). These statements of legislative intent cannot be disregarded merely because they preceded the president's veto message. Far from controlling the statute's meaning, "the president's characterization of the [New Act] cannot determine what Congress itself intended." John C. Coffee, Jr., The Future of the Private Securities Litigation Reform Act: Or Why the Fat Lady Has Not Yet Sung 51 Bus. Law. 975, 982 (1996). Indeed, "views of opponents of a bill with respect to its meaning . . . are not persuasive." Edward J. DeBartolo Corp. v. Florida Gulf Bldg. & Constr. Trades Council, 485 U.S. 568, 585 (1988). "The fears and doubts of the opposition are no authoritative guide to the construction of legislation." Schwegmann Bros. v. Calvert Distillers Corp., 341 U.S. 384, 394-95 (1951).

In the veto-override debate, the bills proponents confirmed that the New Act's pleading standard came from Second Circuit case law.⁽¹⁹⁾ The bill's proponents argued that whatever it meant, far from controlling interpretation of §21D(b)(2), language in the Statement of Managers should not affect the statute's meaning. Senator Domenici explained: "A statement of managers is not law, everyone knows that." 141 Cong. Rec. S19045, col. 2 (Dec. 21, 1995).⁽²⁰⁾ There is no reason that an ambiguous footnote in the Statement of Managers should control over both the clear language of §21D(b)(2) itself and the expressed intent of Congress that plaintiffs should be able to plead motive, opportunity, and recklessness to establish scienter.

According to the bill's leading proponent, "motive" would provide the necessary "strong inference" of scienter. In debate on the veto override, Senator Dodd quoted a former SEC commissioner, adopting his conclusion that under "the securities litigation conference report, the pleading standard is faithful to the Second Circuit's test." 141 Cong. Rec. S19067, col. 3 (Dec. 21, 1995) (statement of Sen. Dodd, quoting letter of Stanford University Professor Joseph Grundfest). Dodd assured Congress that this "pleading standard articulated by the Second Circuit Court of Appeals is intended simply to require the plaintiff to allege facts sufficient to give rise to a strong inference of motive to defraud." 141 Cong. Rec. S19067, col. 3, (Dec. 21, 1995). Dodd explained:

We have established the standard clearly. We have clearly established the standard of alleging facts with particularity, showing a strong inference of motive.

The Conference Committee's rejection of the Specter amendment, which had sought to insert specific language about motive, opportunity and recklessness, see 141 Cong. Rec. S9170, col. 3 (June 27, 1995), does not mean that Second Circuit precedents were expressly rejected or overruled. Senator Dodd explained that the Specter amendment was rejected for deviating from Second Circuit case law. See 141 Cong. Rec. S19067, col. 3 (Dec. 21, 1995) (quoting Professor Grundfest's characterization of the Specter amendment as "'an incomplete and inaccurate codification of the case law in the Second circuit'"). Senator Dodd explained that, far from foreclosing reliance on Second Circuit precedent, the Conference Committee actually expected courts to look to that court's decisions for guidance:

You could have gone in, I suppose, and said why did you not include the other language [from the 2nd Circuit precedents] here? The problem was, in a sense, by codifying [judicial] guidance you get into an area where you can get some differences of opinion on this. And arguably it could have, I suppose gone back and included all of it, but the decision was to take it out on the assumption that the courts will look to the guidance.

We have met the second circuit standard here, as indicated by the memorandum from Judge Grundfest, Professor Grundfest at Stanford. We have met that standard. We have left out the guidance. That does not mean you disregard it.

These legislators' views cannot reasonably be dismissed as "the statements of only a few individual members" of Congress notwithstanding the contrary view of the Silicon Graphics court. They are the views of Senators whose votes were necessary to override the President's veto by a narrow margin.⁽²¹⁾ They are the carefully-considered views of the legislation's leading proponents -- including the Conference Committee Managers themselves -- offered to explain what the Conference Report, and accompanying Statement of Managers, really meant. The notion that the President's interpretation of the "Dodd-Domenici bill" can control over Senator Dodd and Domenici's own views is wrong: "The fears and doubts of the opposition are no authoritative guide to the construction of legislation." Schwegmann Bros., 341 U.S. at 394-95; see John C. Coffee, Jr., supra, 51 Bus. Law. at 982. Congress overrode the President's veto because it believed his interpretation of the Statement of Managers was wrong, not because it wished to overrule Second Circuit "strong inference" precedents or to abolish recklessness as a basis for liability in most cases. 

F. Plaintiffs Are Entitled To Replead If The Complaint Is Dismissed

III. CONCLUSION

DATED: April 7, 1997

Respectfully submitted,

MILBERG WEISS BERSHAD
HYNES & LERACH LLP

____________________________________
MARK SOLOMON

MILBERG WEISS BERSHAD
HYNES & LERACH LLP
ALAN SCHULMAN
MARK SOLOMON
SALLIE A. BLACKMAN
600 West Broadway, Suite 1800
San Diego, CA 92101
Telephone: 619/231-1058

MILBERG WEISS BERSHAD
HYNES & LERACH LLP
JOHN K. GRANT
222 Kearny Street, 10th Floor
San Francisco, CA 94108
Telephone: 415/288-4545

ABBEY, GARDY & SQUITIERI, LLP
JILL S. ABRAMS
JAMES J. SEIRMARCO
212 East 39th Street
New York, NY 10016
Telephone: 212/889-3700

BERNSTEIN LITOWITZ BERGER &
GROSSMANN LLP
DANIEL L. BERGER
JEFFREY N. LEIBELL
1285 Avenue of the Americas
33rd Floor
New York, NY 10019
Telephone: 212/554-1400

Attorneys for Lead Plaintiffs
and the Class

DIAMOND\DLC02657.BRF

I, the undersigned, declare:

1. That declarant is and was, at all times herein mentioned, a citizen of the United States and a resident of the County of San Diego, over the age of 18 years, and not a party to or interested in the within action; that declarant's business address is 600 West Broadway, Suite 1800, San Diego, California 92101.

2. That on April 8, 1997, declarant served the PLAINTIFFS' MEMORANDUM OF POINTS AND AUTHORITIES IN OPPOSITION TO DEFENDANT CHONG-MOON LEE'S MOTION TO DISMISS AMENDED CONSOLIDATED CLASS ACTION COMPLAINT by depositing a true copy thereof in a United States mailbox at San Diego, California in a sealed envelope with postage thereon fully prepaid and addressed to the parties listed on the attached Service List.

3. That there is a regular communication by mail between the place of mailing and the places so addressed.

I declare under penalty of perjury that the foregoing is true and correct. Executed this 8th day of April, 1997, at San Diego, California.

______________________________

MARY JO MIAL

1. In addition to the issues raised in his separate motion to dismiss, which are addressed in this opposition, Chong-Moon Lee joins in the motion of the other Diamond defendants to dismiss the Complaint. To avoid duplication, plaintiffs' incorporate by reference their opposition to Diamond Defendants' Motion to Dismiss Amended Consolidated Class Action Complaint which is filed concurrently herewith.

2. Here, as elsewhere, emphasis is added unless otherwise noted.

3. At the pleading stage, far less-specific allegations of stock sales suffice to raise a strong inference of intent to defraud. See, e.g., Cosmas v. Hassett, 886 F.2d 8, 12 (2d Cir. 1989) (actual sales not alleged).

4. See 3A William Meade Fletcher, Fletcher Cyclopedia Corporations, §1059, at 111 (1994 Rev.) ("it is a director's duty to keep informed of the corporation's business activities"); Bowerman v. Hamner, 250 U.S. 504, 512 (1919) ("It is their duty to use ordinary diligence in ascertaining the condition of its business and to exercise reasonable control and supervision of its officers."); Francis v. United Jersey Bank, 87 N.J. 15, 432 A. 2d 814, 822 (1981) ("Directors are under a continuing obligation to keep informed about the activities of the corporation.") Blackman Decl., Ex. 11.

5. See NOW v. Scheidler, 510 U.S. 249, 114 S. Ct. 798, 803 (1994); Scheuer v. Rhodes, 416 U.S. 232, 236-37 (1974); Conley v. Gibson, 355 U.S. 41, 45-46 (1957); Blake v. Dierdorff, 856 F.2d 1365, 1368 (9th Cir. 1988).

6. See Provenz, 102 F.3d at 1491; Kaplan, 49 F.3d at 1379-80; Apple, 886 F.2d at 1117; Dolgow v. Anderson, 438 F.2d 825, 828 (2d Cir. 1970).

7. Whether or not Lee's stock sales were related to a charity, and what the material benefits and tax consequences of his sales were, are matters for discovery and not for self-serving statements at the pleading stage. Plaintiffs note, however, that the supposed "charitable" sales appear to be revealed in Lee's Form 4's as sales by Lee's own "Lifetime Unitrust" and by "charitable" trusts bearing Lee's own name. Plaintiffs also note that Lee's Form 4 dated 11/95 describes Lee as a 10% owner of Diamond. See Declaration of Morgan R. Smock filed in support of Lee's Motion to Dismiss, Ex. A.

8. See also Competitive Associates, Inc. v. Laventhol, Krekstein, Horwath & Horwath, 516 F.2d 811, 814 (2d Cir. 1975); see In re Union Carbide Corp, Consumer Products Business Sec. Litig., 676 F. Supp. 458, 466-70 (S.D.N.Y. 1987).

9. Courts have routinely held that signers of documents required to be filed with the SEC are accountable under §10(b) for the statements contained in them. See, e.g., Cosmas, 886 F.2d at 12; Hallet v. Li & Fung, Ltd., [1996-1997 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶99,318, at 95,909 (S.D.N.Y. Aug. 23, 1996); In re Xoma Corp. Sec. Litig., [1991-1992 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶96,491 (N.D. Cal. Dec. 27, 1991); Kolin v. American Plan Corp., [1984-1985 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶92,051, at 91,241 (E.D.N.Y. April 30, 1985). This makes obvious sense since in the eyes of the law, one who knowingly and voluntarily signs a statement makes or adopts the representations therein. See United States v. Felix-Jerez, 667 F.2d 1297, 1299 (9th Cir. 1982) ("the signature operates as suffici be liable because they signed a prospectus containing false financial statements); In In re JWP Inc. Sec. Litig., 928 F. Supp. 1239 (S.D.N.Y. 1996).

10. Id. at 13. See Cohen v. Koenig, 25 F.3d 1168, 1174 (2d Cir. 1994) (fact that defendants "were officers, directors, and majority shareholders of the Koenig Group" and were active managers and thus "'fully familiar with all aspects of [Koenig Group's] businesses and financial conditions and operations'" was sufficient to show that defendants, more likely than not, knew their financial representations were false) (citation omitted).

11. The insider sales raise an inference of knowing participation in a scheme to defraud that makes it reasonable to presume that the "'corporate scheme to defraud was collectively devised'" by all those who benefitted from it, including Lee. GlenFed II, 60 F.3d at 593 (citation omitted).

12. See, e.g., Turkish v. Kasenetz, 27 F.3d 23, 28 (2d Cir. 1994); Cohen, 25 F.3d at 1173 (2d Cir. 1994); In re Time Warner Sec. Litig., 9 F.3d 259, 268-69 (2d Cir. 1993); IUE AFL-CIO Pension Fund v. Herrmann, 9 F.3d 1049, 1057 (2d Cir. 1993); Breard v. Sachnoff & Weaver, Ltd., 941 F.2d 142, 143-44 (2d Cir. 1991); Ouaknine v. MacFarlane, 897 F.2d 75, 79-80, 80-82 (2d Cir. 1990); Cosmas, 886 F.2d at 12-13; Beck v. Manufacturers Hanover Trust Co., 820 F.2d 46, 50 (2d Cir. 1987); Ross v. A.H. Robins Co., 607 F.2d 545, 556 (2d Cir. 1979).

13. In our Ninth Circuit, insider trading or other allegations of motive and opportunity plead scienter. See, e.g., Provenz v. Miller, 102 F.3d at 1491 (stock sales by insiders is evidence of scienter); Fecht, 70 F.3d at 1084 (a corporate offering of securities and insider stock sales "are circumstantial evidence that the defendants knew or had reason to know that the financial condition of the Company was deteriorating well before they disclosed the problems with the expansion program"); Kaplan, 49 F.3d at 1379 (holding that insider stock sales raise an inference of scienter); In re Wells Fargo Sec. Litig., 12 F.3d 922, 931 (9th Cir. 1993) ("allegations of motive and opportunity in the complaint are sufficient to establish a basis for inferring . . . fraudulent intent"); Apple, 886 F.2d at 1117 ("[i]nsider trading in suspicious amounts or at suspicious times is probative of bad faith and scienter"); Deutsch, 823 F.2d at 1365 & n.3 (9th Cir. 1987) (holding that the opportunity to sell options raised an inference of scienter under 2nd Circuit standards); see In re GlenFed, Inc. Sec. Litig., 42 F.3d 1541, 1547 n.6 (9th Cir. 1994) ("GlenFed I") (noting that Deutsch applied Second Circuit law).

14. 15 U.S.C. §78u-5(c)(1)(B). To establish liability for a statement within the "safe harbor," plaintiffs must show that the statement "if made by a natural person, was made with actual knowledge by that person that the statement was false or misleading"; or if made by a business was "made or approved by [an] officer with actual knowledge by that officer that the statement was false or misleading." 15 U.S.C. §78u-5(c)(1)(B)(i), (ii).

15. The legislative history of the New Act referenced herein is attached to the Blackman Decl., as Exs. 6-7, 12.

16. Ex parte Collett, 337 U.S. 55, 61 (1949). "Rather, as long as the statutory scheme is coherent and consistent, there generally is no need for a court to inquire beyond the plain language of the statute." United States v. Ron Pair Enter., 489 U.S. 235, 240-41 (1989). Statements in the legislative history "have never been regarded as sufficiently compelling to justify deviation from the plain language of a statute." United States v. Oregon, 366 U.S. 643, 648 (1961); accord, e.g., Arcadia v. Ohio Power Co., 498 U.S. 73, 81 n.2 (1990) ("the legislative history is overborne by the text"); Hearn, 68 F.3d at 304 ("legislative history -- no matter how clear -- can't override statutory text"); Kenaitze Indian Tribe v. Alaska, 860 F.2d 312, 318 (9th Cir. 1988).

17. 141 Cong. Rec. S17957, col. 3 (Dec. 5, 1995) ("The conference report clarifies current requirements that lawyers should have some facts . . . to back up their assertion of security fraud by adopting most of the reasonable standards established by the U.S. Second Circuit Court of Appeals.") (statement of Sen. Dodd); 141 Cong. Rec. S17959, col. 2 (Dec. 5, 1995) (the conferees intended to "adopt the Second Circuit Court of Appeals standard") (statement of Sen. Dodd).

18. Senator Grams, who served with Dodd and Domenici on the Conference Committee as a Manager for the Senate, confirmed that the legislation provided for "[c]odification of the pleading standard adopted by the second circuit court of appeals." 141 Cong. Rec. S17993, col. 2 (Dec. 5, 1995) (statement of Sen. Grams). Another Conference Committee Manager, Senator D'Amato, explained that the Conference Report "creates a uniform standard for complaints that allege securities fraud," and that "[t]his standard is already the law in New York," i.e., the Second Circuit. "It requires a plaintiff plead facts giving rise to a strong inference of the defendant's fraudulent intent." 141 Cong. Rec. S17934, col. 1 (Dec. 5, 1995) (statement of Sen. D'Amato).

19. Representative Lofgren, for example, explained:

The President says he supports the second circuit standard for pleading. So do I. That is what is included in this bill.

The President objected to the pleading standard. Yet it is the Second Circuit's pleading standard.

Second circuit pleading standard becomes the uniform rule. -- Same as Senate-passed bill; Senator Specter's amendment deleted from conference report.

The objective: . . . To codify the requirements in the 2nd Circuit.

A complaint should outline the facts supporting the lawsuit. . . . Under the Conference Agreement, the complaint must set forth the facts supporting each of the alleged misstatements or omissions and must include facts that give rise to a "strong inference" of scienter or intent. . . . This is a codification of the 2nd Circuit rule.

20. Other legislators agreed. "We know we are going to have the Second Circuit standard applied, and that in fact when legislation is at variance with legislative history or report language, that it is the bill itself that prevails." 141 Cong. Rec. H15218, col. 2 (Dec. 20, 1995) (statement of Rep. Moran). Representative Deutsch rose, as a member of the Conference Committee, to declare that "[r]eport language has no effect on the bill." 141 Cong. Rec. H15220, col. 3 (Dec. 20, 1995).

21. The veto was overridden by a vote of 68 to 30, with one senator voting "present." 141 Cong. Rec. S19180 (Dec. 22, 1995). A veto override requires a two-thirds majority, U.S. Const. Art. I, §7, meaning that the New Act passed with only two votes to spare.
 

22 Aug 1997