|
|
|||
[Web notes:
- Page formatting approximates, but does not match exactly,
that of filed paper document.
- No court-stamped file date on referenced paper copy.]
STEVEN M. SCHATZ, State Bar # 118356 TERRY T. JOHNSON, State Bar # 121569 MARTA CERVANTES, State Bar # 139082 THOMAS J. MARTIN, State Bar # 150039 REBECCA MITCHELLS, State Bar # 151683 WILSON, SONSINI, GOODRICH & ROSATI Professional Corporation 650 Page Mill Road Palo Alto, California 94304-1050 Telephone: (415) 493-9300 Attorneys for Defendants WILLIAM J. SCHROEDER, GARY B. FILLER, HYUNG HWE HUH and DIAMOND MULTIMEDIA SYSTEMS, INC. SUPERIOR COURT OF CALIFORNIA COUNTY OF SANTA CLARA JOANNE PASS, On Behalf of Herself ) CONSOLIDATED CLASS and All Others Similarly Situated, ) ACTIONS: ) Plaintiff, ) CV758927; CV759012 ) and CV759270 v. ) ) MEMORANDUM OF POINTS HYUNG HWE HUH, et al., ) AND AUTHORITIES IN ) SUPPORT OF THE Defendants. ) DIAMOND DEFENDANTS' ) DEMURRER AND MOTION ) TO STRIKE ) ) DATE: November 26, 1996 ) TIME: 9:00 a.m. ) DEPT: 17 ____________________________________) / / /
TABLE OF CONTENTS Page INTRODUCTION AND SUMMARY OF ARGUMENT . . . . . . . . . . . . . . 1 ARGUMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 I. PLAINTIFFS FAIL TO STATE A CAUSE OF ACTION FOR VIOLATIONS OF THE CALIFORNIA CORPORATIONS CODE . . . . . . . . . . . . 2 A. Plaintiffs Fail To Plead the Jurisdictional Prerequisites for Causes of Action Under Sections 25400 and 25500, Because Plaintiffs Do Not Allege That Their Purchases of Diamond Securities Were Made "In this State." . . . . . . . . . . . . . . . . . . . 2 B. The Individual Defendants May Not Be Held Liable Under Sections 25400 and 25500 . . . . . . . . . . . . 4 C. Because Diamond May Not Be Held Liable Under Section 25400 or 25500 For Statements Not Made In Connection with The November 1995 Stock Offering, All Allegations Based on Such Statements Should Be Stricken From the Complaint . . . . . . . . . . . . . . . . . . . . . . 6 II. PLAINTIFFS' SECTION 1709 AND 1710 CLAIMS FAIL BECAUSE PLAINTIFFS FAIL ADEQUATELY TO ALLEGE ACTUAL RELIANCE . . . 7 III. PLAINTIFFS FAIL TO PLEAD FACTS SUFFICIENT TO STATE A CAUSE OF ACTION FOR FRAUD . . . . . . . . . . . . . . . . . . . . 8 A. Defendants Cannot Be Held Liable For the Statements Of Analysts . . . . . . . . . . . . . . . . . . . . . 8 B. Defendants' Alleged Statements Are Not Actionable . . 11 1. Diamond Made No Misrepresentations Regarding The Success of Its Products . . . . . . . . . . . . . 11 a. Diamond's Opinions Regarding Demand For Its Graphics Products Are Not Actionable . . . . 11 b. Plaintiffs Fail To Allege Any Fraudulent Misstatement Regarding The Edge . . . . . . 12 c. Diamond's Statements Regarding The Stealth Are Not Actionable . . . . . . . . . . . . . 14 d. Diamond's Statement Regarding Its ISDN Expectations Are Not Actionable . . . . . . 15 2. Inventory Allegations . . . . . . . . . . . . . . 16 a. Plaintiffs' Inventory Reserve Allegations Fail to State A Cause of Action . . . . . . 16 b. Diamond Disclosed The Risk That Product Transitions Might Result In Obsolete Inventory and Write-Offs . . . . . . . . . . 18 -i-
c. Plaintiffs' Allegations That Diamond Fraudulently Inflated Its Physical Inventory Count Fail To State A Cause Of Action . . . . . . . . . . . . . . . . . 18 3. Plaintiffs' Revenue Recognition Allegations Fail To State A Cause Of Action . . . . . . . . . 19 4. The Complaint Fails To Allege That Diamond's Forecasts Were False . . . . . . . . . . . . . . 20 5. Plaintiffs Fail Adequately To Allege Any Material Omission Concerning Internal Controls and MIS Systems . . . . . . . . . . . . . . . . . 22 6. Plaintiffs Do Not Adequately Allege That Diamond Misrepresented The Value Of Its Acquisitions . . . . . . . . . . . . . . . . . . 23 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 -ii-
TABLE OF AUTHORITIES Page(s) Backman v. Polaroid Corp., 910 F.2d 10 (1st Cir. 1990) . . . . . . . . . . . . . . . . 14 Berliner v. Lotus Dev. Corp., 783 F. Supp. 708 (D. Mass. 1992) . . . . . . . . . . . . . 16 Borow v. nVIEW Corp., 829 F. Supp. 828 (E.D. Va. 1993), aff'd, 27 F.3d 562 (4th Cir. 1994) . . . . . . . . . . . . 16 Cummings v. Farmers Ins. Exchange, 202 Cal. App. 3d 1407 (1988) . . . . . . . . . . . . . . . 12 Denny v. Barber, 576 F.2d 465 (2d Cir. 1978) . . . . . . . . . . . . . . . . 17 DiLeo v. Ernst & Young, 901 F.2d 624 (7th Cir. 1990), cert. denied, 498 U.S. 941 (1990) . . . . . . . . . . . . . . . . . . . . 17 Eldridge v. Tymshare, Inc., 186 Cal. App. 3d 767 (1986) . . . . . . . . . . . . . . . . 12 Fisher v. Acuson Corp., No. C93-20477 RWM, 1995 WL 261439 (N.D. Cal. Apr. 26, 1995) . . . . . . . . . . . . . 9, 12, 19 Freedman v. Louisiana Pacific Corp., 922 F. Supp. 377 (D. Or. 1996) . . . . . . . . . . . . . . 10 Gardner v. Murphy, 54 Cal. App. 3d 164 (1975) . . . . . . . . . . . . . . . . 12 Goldrich v. Natural Y Surgical Specialties, Inc., 25 Cal. App. 4th 772 (1994) . . . . . . . . . . . . 9, 12, 21 Goodman v. Kennedy, 18 Cal. 3d 335 (1976) . . . . . . . . . . . . . . . . . 5, 23 Hall v. Superior Court, 150 Cal. App. 3d 411 (1983), . . . . . . . . . . . . . . . 3 Hudson v. Sherwood Secs. Corp., No. C-86-20344, 1987 U.S. Dist. LEXIS 16019 (N.D. Cal. Nov. 5, 1987) . . . . . . . . . . . . . . . . . 3 In re Activision Sec. Litig., 621 F. Supp. 415 (N.D. Cal. 1985) . . . . . . . . . . . . . 4 In re Apple Computer Sec. Litig., 886 F.2d 1109 (9th Cir. 1989), cert. denied, 496 U.S. 943 (1990) . . . . . . . . . . . . . . . . . . . . 16 In re Caere Corp. Sec. Litig., 837 F. Supp. 1054 (N.D. Cal. 1993). . . . . . . . . . 8, 9, 12 In re Convergent Technologies Sec. Litig., 948 F.2d 507 (9th Cir. 1991) . . . . . . . 13, 14, 15, 18, 19 In re Cypress Semiconductor Sec. Litig., 836 F. Supp. 711 (N.D. Cal. 1993) . . . . . . . . . . . . . .8 In re Cypress Semiconductor Sec. Litig., 891 F. Supp. 1369 (N.D. Cal. 1995) . . . . . . . . 12, 15, 19 In re DSP Group, Inc. Sec. Litig., No. C-95-4025-CAL (N.D. Cal. June 13, 1996) . . . . . . . . 10 In re GlenFed, Inc. Sec. Litig., 60 F.3d 591 (9th Cir. 1995); . . . . . . . 8, 15, 17, 19, 23 In re Gupta Corp. Sec. Litig., 900 F. Supp. 1217 (N.D. Cal. 1994) . . . . . . . . . . . . 12 -iii-
In re Ross Sys. Sec. Litig., [1994-1995 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,363 (N.D. Cal. July 21, 1994) . . . . . . . . 9, 10, 12 In re Sciclone Pharmaceuticals Sec. Litig., No. C-94-1485 SBA (N.D. Cal. May 31, 1989) . . . . . . . . 12 In re Stac Elec. Sec. Litig., 89 F.3d 1399 (9th Cir. 1996) . . . . . 9, 13, 14, 15, 18, 20 In re Software Publishing Sec. Litig., [1994 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶98,094 (N.D. Cal. Feb. 2, 1994) . . . . . . . . . . . 12, 19 In re Syntex Corp. Sec. Litig., 855 F. Supp. 1086 (N.D. Cal. 1994), aff'd, 96 C.D.O.S. 6865 (9th Cir. Sept. 13, 1996) . 9, 10, 12 In re VeriFone Sec. Litig., 11 F.3d 865 (9th Cir. 1993) . . . . . . . . . . . . . . . . 13 In re Victor Technologies Sec. Litig., 102 F.R.D. 53 (N.D. Cal. 1984), aff'd, 792 F.2d 862 (9th Cir. 1986) . . . . . . . . . . . . 3 In re Wall Data Sec. Litig., No. C95-05282, 1995 U.S. Dist., LEXIS 19812 (W.D. Wash. Sept. 13, 1995) . . . . . . . . . . . . . . . . 10 In re Worlds of Wonder Sec. Litig., 35 F.3d 1407 (9th Cir. 1994), cert. denied, 116 S. Ct. 185 (1995) . . . . . . . . 13, 20, 22 Insurance Underwriters Clearing House, Inc. v. Natomas Co., 184 Cal. App. 3d 1520 (1986) . . . . . . . . . . . . . . . 12 Lazar v. Superior Court, 12 Cal. 4th 631 (1996) . . . . . . . . . . . . . 5, 9, 15, 16 Leonard v. NetFrame Sys., Inc., [1995-96 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,982 (N.D. Cal. Aug. 8, 1995) . . . . . . . . . . . 9, 19 Mathews v. Centex Telemanagement, Inc., [1994-1995 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,440, (N.D. Cal. June 8, 1994) . . . . . . . . . . 8, 17 MTC Elecs. Technologies Co. v. Leung, 876 F. Supp. 1143 (C.D. Cal. 1995) . . . . . . . . . . . . 4 McDougall v. Roberts, 43 Cal. App. 553 (1919) . . . . . . . . . . . . . . . . 12, 13 McFarland v. Memorex Corp., 96 F.R.D. 357 (N.D. Cal. 1982) . . . . . . . . . . . . . . 3 Mirkin v. Wasserman, 5 Cal. 4th 1082 (1993) . . . . . . . . . . . . . . . . . 7, 8 Monroe v. Hughes, 31 F.3d 772 (9th Cir. 1994) . . . . . . . . . . . . . . . . 22 Moskowitz v. Vitalink Communications Corp., 751 F. Supp. 155 (N.D. Cal. 1990) . . . . . . . . . . . . . 7 O'Sullivan v. Trident Microsystems, Inc., [1994 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,116 (N.D. Cal. Jan. 31, 1994) . . . . . . . . . . . . 10 People v. Figueroa, 41 Cal. 3d 714 (1986) . . . . . . . . . . . . . . . . . . . 12 Raab v. General Physics Corp., 4 F.3d 286 (4th Cir. 1993) . . . . . . . . . . . . . . . . 12 Richard P. v. Vista Del Mar Child Care Serv., 106 Cal. App. 3d 860 (1980) . . . . . . . . . . . . . . 16, 20 -iv-
Rogal v. Costello, [1992-93 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 97,245 (N.D. Cal. Oct. 8, 1992) . . . . . . . . . . . . . 19 Scholes v. Tomlinson, 145 F.R.D. 485 (N.D. Ill. 1992) . . . . . . . . . . . . . 3, 4 Schultz v. Harney, 27 Cal. App. 4th 1611 (1994) . . . . . . . . . . . . . . . 21 Stack v. Lobo, No. C-95-20049 SW, 1995 WL 241448 (N.D. Cal. Apr. 20, 1995) . . . . . . . . . . . . . . . 17, 19 Stansfield v. Starkey, 220 Cal. App. 3d 59 (1990) . . . . . . . 5, 6, 9, 16, 19, 21 TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438 (1976) . . . . . . . . . . . . . . . . . . . . 15 Tarmann v. State Farm Mutual Auto Ins. Co., 2 Cal. App. 4th 153 (1991) . . . . . . 9, 11, 12, 15, 20, 21 Wilhelm v. Pray, Price, Williams & Russell, 186 Cal. App. 3d 1324 (1986) . . . . . . . . . . . . . . . 20 Zeid v. Kimerley, 930 F. Supp. 431 (N.D. Cal. 1996) . . . . . . . . . . . 10, 23 STATUTES California Corporation Code §25008(a) . . . . . . . . . . . . . . . . . . . . . . . . . 3 §25400 . . . . . . . . . . . . . . . . . . . . . . . . . . 2 § 25400(d) . . . . . . . . . . . . . . . 4, 6, 12, 15, 16, 19 California Civil Code §§ 1709 . . . . . . . . . . . . . . . . . . . . . . . . . . 2 § 1710 . . . . . . . . . . . . . . . . . . . . . . . . . 2, 7 Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67 . . . . . . . . . . . . . . . . . . . . 1 MISCELLANEOUS 5 B. Witkin, California Procedure, § 672, at 122 (3d ed. 1985) . . . . . . . . . . . . . . . . 13 5 B. Witkin, Summary of Cal. Law, § 678, at 779-80 (9th Edition 1988) . . . . . . . . . . . . 20 Harold Marsh & Robert H. Volk, Practice Under the California Corporate Securities Law of 1968 45 (1969) . . . . . . . 3, 6 -v-
INTRODUCTION AND SUMMARY OF ARGUMENT This securities fraud class action is filed on behalf of purchasers of Diamond Multimedia stock from October 1995 to June 1996. Diamond makes graphics accelerators and modems for personal computers. As is the case with many high technology companies, Diamond's stock goes up and down rapidly in response to the latest developments in the ever-changing computer market. When the stock went up, the stockholders gladly accepted the profits. But, as happens almost inevitably, when the stock went down, the plaintiffs' securities class action bar sued, alleging fraud. In the past, this action would have been filed in federal court. However, this case is part of a recent wave of securities fraud class actions filed in the California state courts in reaction to the Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67 ("Reform Act"), passed by Congress with bipartisan support in December 1995. The Reform Act changed federal law in an effort to reduce meritless securities fraud claims in the federal courts, the traditional forum for securities fraud class actions. To avoid the scrutiny of the new law, plaintiffs here have come to state court, attempting to stretch the California securities laws far enough to fit federal-style securities fraud claims. But the California securities laws were never intended to provide a remedy for a nationwide class of investors. The California securities laws are of limited scope and afford remedies only to California purchasers under a narrow set of circumstances. The result is that, despite plaintiffs' lengthy complaints, plaintiffs have failed to state a single cause of action under state law. First, plaintiffs do not and cannot allege that they were California residents or that the transactions of which they complain were initiated or consummated in California - a jurisdictional prerequisite to bringing a cause of action under Sections 25400 and 25500 of the California Corporations Code. Second, plaintiffs' Section 25400 and 25500 causes of action against the individual defendants also fail because plaintiffs do not allege that the individual defendants both sold stock and made misstatements for the purpose of inducing the purchase of their Diamond stock. For the same reason, plaintiffs' Section 25400 and 25500 causes of action against Diamond fail with respect to all -1-
statements made by Diamond except those statements made in connection with Diamond's November 1995 stock offering. Third, plaintiffs' fraud causes of action under Civil Code §§ 1709-1710 fail because plaintiffs do not plead adequately that they actually relied on the alleged misstatements. Such an allegation is expressly required by the California Supreme Court. Finally, all of plaintiffs' causes of action fail because plaintiffs' allegations fail to plead adequately that defendants made an actionable misrepresentation or omission - i.e., plaintiffs fail to plead facts supporting their claims of fraud with the requisite specificity, and plaintiffs also fail to plead facts showing that the supposedly fraudulent statements were false or misleading. ARGUMENT I. PLAINTIFFS FAIL TO STATE A CAUSE OF ACTION FOR VIOLATIONS OF THE CALIFORNIA CORPORATIONS CODE. A. Plaintiffs Fail To Plead the Jurisdictional Prerequisites for Causes of Action Under Sections 25400 and 25500, Because Plaintiffs Do Not Allege That Their Purchases of Diamond Securities Were Made "In this State." The California Corporations Code is not a law of general applicability to all securities transactions throughout the nation. It does not apply to stock purchases by out of state plaintiffs on a national securities exchange. Indeed, the drafters of the California Securities Law of 1968 expressly recognized that the federal securities laws adequately address interstate transactions and stated that the drafters' intent was to "more clearly define the acts which are malum prohibitum and to apply the prohibitions to the intrastate securities market which is the greater state regulatory problem when compared to the interstate market." Drafting Committee of California Securities Law of 1968, Introduction to (Proposed) Corporate Securities Law of 1968, at iii (Oct. 20, 1967) (emphasis added).1 Consistent with this legislative history, the sections of the California Securities Law under which plaintiffs bring their claims apply to transactions "in this state." See Cal. Corp. Code § ____________________ 1 For the convenience of the Court, a copy of this document is attached as Exhibit 1 to the Declaration of Thomas J. Martin ("Martin Ex. ___"). -2-
25400. Under Section 25008(a), a transaction will be deemed to have been made "in this state" only where an offer to buy or sell is made or accepted in California, or the security is delivered in California and both the purchaser and the seller are domiciled in California. Cal. Corp. Code § 25008(a).2 It is not sufficient merely that the defendant is headquartered in California; rather, "the committee agreed that the basis of jurisdiction and regulation should be the offer and sale of securities in this State and should not be related to the principal place of business or corporate domicile." Harold Marsh & Robert H. Volk, Practice Under the California Corporate Securities Law of 1968 45 (1969) (Martin Ex. 2). As one drafter noted in a letter describing the policy rationa "those who purchased Victor stock on the open market at some point after the initial public offering," unless ____________________ 2 See also Hall v. Superior Court, 150 Cal. App. 3d 411, 417 (1983), (finding that "the Corporate Securities Law of 1968 was enacted to effectuate this policy by regulating securities transactions in California . . . [It] applies where there is an offer to sell or buy securities in California") (emphasis added); Hudson v. Sherwood Secs. Corp., No. C-86-20344, 1987 U.S. Dist. LEXIS 16019 at *16-18 (N.D. Cal. Nov. 5, 1987) (dismissing Section 25400 and 25401 claims for failure to allege requisite contacts with California under § 25008); McFarland v. Memorex Corp., 96 F.R.D. 357, 364 (N.D. Cal. 1982) ("[o]nly purchasers who can show the requisite contacts with California can satisfy the jurisdictional limitations of Cal. Corp. Code Section 25008" required to bring claims under Sections 25400, et seq.); Scholes v. Tomlinson, 145 F.R.D. 485, 493 (N.D. Ill. 1992) ("These sections apply only to purchasers who buy a security in California"). 3 Letter of Harold Mar[s]h, Jr., Member of Drafting Committee, to Senator Randolph Collier, member of Committee on Finance, at 5 (April 19, 1968) (Martin Ex. 3). "The committee drafting the bill tried to reach a balanced judgment as to how far it was possible for California to go in asserting jurisdiction over such predominately foreign transactions and, as a matter of policy, how far it should go. The committee first rejected the tests of whether the corporation has its principal office or its business operations in California, since the committee felt that these factors had no logical relevance to the purpose of the statute (which is to protect investors) and that to use such tests of jurisdiction would discourage corporations from establishing their headquarters in this state, to the detriment of its economy . . . . This was a judgment reached by the committee after considerable discussion and consideration of this difficult problem, in an effort to give the greatest possible protection to California investors and at the same time to recognize that California cannot rule the United States." Id. -3-
such purchasers were California residents. See also In re Activision Sec. Litig., 621 F. Supp. 415, 431-32 (N.D. Cal. 1985) (same); MTC Elecs. Technologies Co. v. Leung, 876 F. Supp. 1143, 1147 (C.D. Cal. 1995) (same). Here, there is no allegation that plaintiffs made an offer to purchase in California, accepted an offer to sell in California, or live in California. Complaint ¶¶ 15, 22.4 Diamond's stock is traded on NASDAQ, a national securities market, through which plaintiffs apparently purchased their stock. None of the plaintiffs alleges that he or she purchased stock in Diamond's November 1995 stock offering. Plaintiffs therefore have failed to meet the substantive prerequisites set forth in Section 25008 and cannot maintain a cause of action, either for themselves or as representatives on behalf of the putative class members. See Scholes, 145 F.R.D. at 492-93 (named plaintiffs did not have standing to raise claims subject to requirements of Section 25008). Accordingly, the demurrer to causes of action based upon the California Corporations Code Sections 25400 and 25500 should be sustained. B. The Individual Defendants May Not Be Held Liable Under Sections 25400 and 25500. There is an independent, additional basis for sustaining the individual defendants' demurrer to the causes of action brought under Corporations Code Sections 25400 and 25500: the Complaint does not show that the individual defendants made misstatements for the purpose of selling their stock. Plaintiffs apparently bring their claims under Section 25400(d), which states that it is unlawful for: [A] . . . person selling or offering for sale . . . the security, to make, for the purpose of inducing the purchase or sale of such security by others, any statement which was, at the time and in the light of the circumstances under which it was made, false or misleading . . . and which he knew or had reasonable ground to believe was so false and misleading Cal. Corp. Code § 25400(d)(emphasis added). Section 25500 creates a private right of action against "any person who willfully participates in any act or transaction in violation of Section 25400." ____________________ 4 The three consolidated complaints are virtually identical. Citations to the "Complaint" apply to all three complaints. -4-
Plaintiffs' allegations under Sections 25400 and 25500 against the individual defendants are deficient because plaintiffs fail to plead facts showing that the individual defendants both sold stock and made misleading statements for the purpose of inducing the purchase of that stock. Plaintiffs allege that the individual defendants sold stock, but under the plain language of the statute, simply selling stock is not sufficient to impose liability under Section 25500. The defendant must also make false statements for the purpose of selling the stock. See Goodman v. Kennedy, 18 Cal. 3d 335, 345-46 (1976) (affirming order sustaining demurrer on ground, inter alia, that "section 25400, subdivision (d), is inapplicable to the present case as there is no allegation that defendant made any statement with respect to the stock"). There is absolutely no allegation that defendant Hyung Hwe Huh made any public statements whatsoever -- misleading or otherwise. Plaintiffs therefore have failed to state a claim against him. As to statements allegedly made by defendants Schroeder and Filler, plaintiffs almost invariably fail to plead what the alleged misstatement was and which defendant allegedly made it. Rather, plaintiffs allege generally that misleading statements were made in reports issued by securities analysts; and that these reports were based on conversations with "Schroeder and Filler." See, e.g., Complaint ¶¶ 40; 47; 52. Plaintiffs do not specify what Schroeder or Filler actually said to the analysts, or whether it was Schroeder or Filler who said it. "[G]eneral and conclusory allegations" such as these are insufficient to state a cause of action for fraud under California law. See Lazar v. Superior Court, 12 Cal. 4th 631, 645 (1996); Stansfield v. Starkey, 220 Cal. App. 3d 59, 73 (1990). Plaintiffs must at a minimum identify the actual alleged misstatement and the defendant responsible for the alleged misstatement. In only two instances do plaintiffs identify an allegedly misleading statement attributable to a specific individual defendant, i.e., Bill Schroeder. Complaint ¶¶ 36, 43. However, plaintiffs do not allege that the two statements allegedly made by Mr. Schroeder were made for the purpose of inducing purchases of his stock. According to plaintiffs, Mr. Schroeder made false and misleading statements at a Montgomery Technology Conference on December 5, 1995. Complaint ¶ 36. But while the Company's stock price rose to more than $40 per share shortly thereafter, Schroeder -5-
sold his stock at $29, just before the stock rise he allegedly engineered. See Complaint ¶¶ 8, 85. Plaintiffs' allegations show that Schroeder never took advantage of the allegedly inflated price. Id. Thus plaintiffs' complaint fails adequately to allege that Mr. Schroeder made the alleged statement for the purpose of inducing a purchase of his stock. The only other statement specifically attributed to an individual defendant is Schroeder's statement that the company was implementing new MIS systems and internal controls, which provided the company with "a more professional way to manage its operations." Complaint ¶ 43. Plaintiffs do not even allege that this statement was false -- indeed, they seem to assume it was true. See id.; Complaint ¶ 54. Thus, plaintiffs do not adequately identify any misleading statements made by Schroeder and Filler for the purpose of inducing the purchase of their stock. C. Because Diamond May Not Be Held Liable Under Section 25400 or 25500 For Statements Not Made In Connection with The November 1995 Stock Offering, All Allegations Based on Such Statements Should Be Stricken From the Complaint. Most of the allegations that Diamond violated Corporations Code Sections 25400 and 25500 should be stricken from the Complaint for the same reason. As noted above, Section 25400 imposes liability only where the defendant is both selling stock and making statements to induce the purchase of that stock. See Cal. Corp. Code § 25400(d). Thus, the statute does not impose liability for corporate statements made in corporate reports, press releases or other statements not made in connection with a stock sale or offering by the company. This limitation is meant to prevent companies from incurring liability to a virtually unlimited group of open-market stock purchasers for statements that were neither directed to those purchasers nor meant to induce action on their part. As the authors of the California Corporate Securities Code explained: [Section 25400] repudiates . . . cases . . . in which the [federal] courts held that under Rule 10b-5 a corporation might become liable for trading losses . . . simply because it filed an allegedly false report with the Securities and Exchange Commission, although the corporation was not engaging in any market activity at the time. Under . . . [S]ection [25400] the corporation [that is] not . . . selling or offering for sale or purchasing or offering to purchase the security . . . would not be subject to liability, which if imposed would fall on the other innocent shareholders of the corporation. Any such unlimited liability for any misstatement . . . [w]ould go a long way towards destroying completely the purpose of the . . . securities laws, by terrorizing all corporate officials into never issuing any public information except those reports which they are compelled to file. -6-
1 Marsh & Volk, § 14.05[4], at 14-52 - 14-53. The only stock sale allegedly made by Diamond during the relevant time is the sale of stock in the November 1995 stock offering. See Complaint ¶ 30. Thus, plaintiffs may pursue causes of action under Corporations Code Sections 25400 and 25500 against Diamond only to the extent that Diamond made statements in connection with that stock offering. See Complaint ¶¶ 24-25, 29 (statements made in November 1995 stock offering). These causes of action may not be based on any other statements by Diamond. For this reason, all allegations of misleading statements made by Diamond other than in the stock offering should be stricken from the complaint.5 Complaint ¶¶ 26:9-14; 27:15-25; 28:26-28, 1-14; 39:26-28, 1-3; 50:3-28, 1-18; 51:18-28, 1-21; 60:18-22; 80:9-14; 83:7-16. II. PLAINTIFFS' SECTION 1709 AND 1710 CLAIMS FAIL BECAUSE PLAINTIFFS FAIL ADEQUATELY TO ALLEGE ACTUAL RELIANCE. Plaintiffs' causes of action for fraud under California Civil Code Sections 1709-1710 fail to state a cause of action because plaintiffs fail adequately to plead actual reliance, an essential element of each of these causes of action. In Mirkin v. Wasserman, the California Supreme Court held that plaintiffs asserting a cause of action for deceit pursuant to California Civil Code Sections 1709 and 1710 must "alleg[e] that they actually relied on the misrepresentations." Mirkin, 5 Cal. 4th 1082, 1087 (1993). Mirkin specifically rejected federal court decisions which permit reliance to be presumed in securities fraud cases. Id. at 1108 ("to incorporate [the federal] fraud-on-the- market [presumption of reliance] into the common law of deceit would only bring about difficulties that the state Legislature and the federal courts have apparently attempted to avoid"). The Mirkin court also made clear that conclusory allegations of reliance are not sufficient. Instead, the California Supreme Court affirmed the lower court's decision that plaintiffs must plead that they "actually read or heard the alleged misrepresentations." Id. at 1088, 1108. In Mirkin, the plaintiffs could not make such an ____________________ 5 Plaintiffs' negligent misrepresentation claims based on Civil Code § 1710(b) fail for this reason as well. See e.g., Moskowitz v. Vitalink Communications Corp., 751 F. Supp. 155, 160 (N.D. Cal. 1990) (applying California law). -7-
allegation. Instead, plaintiffs alleged only that they purchased securities "in reliance on said misrepresentations." Id. The Supreme Court held that this was insufficient. Id.6 Here, plaintiffs plead only that they "each relied on one or more of the false statements alleged herein." Complaint ¶ 94. They do not allege that they "actually read or heard the alleged misrepresentations." Plaintiffs' conclusory allegation is essentially identical to the allegation that the California Supreme Court ruled insufficient to withstand a demurrer in Mirkin. Accordingly, the demurrer to plaintiffs' second cause of action should be sustained without leave to amend. III. PLAINTIFFS FAIL TO PLEAD FACTS SUFFICIENT TO STATE A CAUSE OF ACTION FOR FRAUD. Separate and apart from all of the foregoing reasons for sustaining defendants' demurrer, plaintiffs' allegations still fail to state a cause of action for fraud. Plaintiffs' allegations fall into two categories. First, plaintiffs repeatedly allege that the misleading information was contained in reports of securities analysts. Plaintiffs then seek to attribute the statements of these analysts, verbatim, to the defendants. But the defendants cannot be held liable for alleged misstatements they did not make. Second, with respect to the statements the defendants did allegedly make, plaintiffs fail to adequately plead that those statements were false. For these reasons, the demurrer to all causes of action should be sustained. Alternatively, the inadequate allegations should be stricken. A. Defendants Cannot Be Held Liable For the Statements Of Analysts. Plaintiffs challenge several reports issued by securities analysts at brokerage firms, alleging that Diamond should be liable for them. Complaint ¶¶ 31:1-12; 33:17-22; 35:5-10; 37:17-22; 38:23-28, 1-25; 42:4-9; 47:14-18; 49:26-28, 1-2; 53:20-28, 1-4; see ____________________ 6 A number of federal courts have followed the Mirkin decision. See, e.g., In re GlenFed, Inc. Sec. Litig., 60 F.3d 591, 592 (9th Cir. 1995) (affirming dismissal of common law claims for fraud and misrepresentation because plaintiffs had failed to allege actual reliance as required by Mirkin); In re Caere Corp. Sec. Litig., 837 F. Supp. 1054, 1062 (N.D. Cal. 1993) (dismissal for "fail[ure] to plead [actual] reliance with the degree of specificity required under Mirkin"); see also In re Cypress Semiconductor Sec. Litig., 836 F. Supp. 711, 714 (N.D. Cal. 1993)(same); Mathews v. Centex Telemanagement, Inc., [1994-1995 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,440, at 91,035 (N.D. Cal. June 8, 1994) (plaintiffs in a securities case must prove actual reliance on the allegedly misleading statements by all members of the class in order to sustain common law claims for fraud and misrepresentation under California law.) -8-
34:23-28, 1-4; 36:11-16; 40:4-26; 52:21-28, 1-19. Where fraud is alleged against a corporation, plaintiffs must plead facts which "show how, when, where, to whom, and by what means the representations were tendered." Lazar, 12 Cal. 4th at 645; Stansfield, 220 Cal. 3d at 73; see Goldrich v. Natural Y Surgical Specialties, Inc., 25 Cal. App. 4th 772, 782-83 (1994). Plaintiffs must also "allege the names of the persons who made the allegedly fraudulent representations, their authority to speak, to whom they spoke, what they said or wrote, and when it [was] said or written." Lazar, 12 Cal. 4th at 645; Tarmann v. State Farm Mutual Auto Ins. Co., 2 Cal. App. 4th 153, 157 (1991) (citations omitted). Here, plaintiffs have not alleged that any of the analysts had any authority to speak for Diamond. These allegations therefore fail to state a cause of action against Diamond. Federal case law reinforces the conclusion that the plaintiffs have failed adequately to allege the analysts' authority to speak for Diamond. Under federal law, statements of analysts may not be attributed to defendants unless plaintiffs plead facts showing that "'defendants . . . put their imprimatur, express or implied, on the [statements].'" In re Stac Elec. Sec. Litig., 89 F.3d 1399, 1410 (9th Cir. 1996). To plead adequately that the analysts spoke for the company, a plaintiff must show that the company "entangled" itself in the preparation of the analysts' reports. A plaintiff must "(1) identify specific [analyst] forecasts and name the insider who adopted them; (2) point to specific interactions between the insider and the analyst which gave rise to the entanglement; and (3) state the dates on which the acts which allegedly gave rise to the entanglement occurred." In re Ross Sys. Sec. Litig., [1994-1995 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,363, at 90,499 (N.D. Cal. July 21, 1994); In re Syntex Corp. Sec. Litig., 855 F. Supp. 1086, 1097 (N.D. Cal. 1994), aff'd 96 C.D.O.S. 6865 (9th Cir. Sept. 13, 1996); Caere 837 F. Supp. at 1059; Leonard v. NetFrame Sys., Inc., [1995-96 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,982, at 98,781 (N.D. Cal. Aug. 8, 1995) Fisher v. Acuson Corp., No. C93-20477 RMW, 1995 WL 261439, at * 7 (N.D. Cal. Apr. 26, 1995). "Under this standard, it is not sufficient for the plaintiffs simply to allege that the reports were based on information provided by the company and that the company received a draft of the report, or even that the company -9-
contributed to the analysts' reports." In re Wall Data Sec. Litig., No. C95-05282, 1995 U.S. Dist., LEXIS 19812, at *22, 26 (W.D. Wash. Sept. 13, 1995).7 Plaintiffs fail to meet their burden here. With respect to all but two of the analyst reports cited in the complaint, plaintiffs merely allege that Diamond (like every other public company) met with analysts and supplied information to them. See e.g., Complaint ¶¶ 33-35. This is insufficient to make Diamond responsible for the analysts' subsequent reports. With respect to the remaining two analysts' reports, plaintiffs merely allege that Diamond distributed the reports as part of a so-called "Corporate Backgrounder." Complaint ¶ 40. Plaintiffs do not allege when the alleged distribution was made, by whom it was made, or whether the reports were accompanied by an endorsement or a disavowment of the opinions the reports conveyed. These allegations are insufficient to state a claim against the defendants based on the statements of analysts. See Freedman v. Louisiana Pacific Corp., 922 F. Supp. 377, 391-392 (D. Or. 1996) (allegations that company "communicated regularly with securities analysts," and that analysts' statements were published in reliance on false information received "through its officers and 'its investors' relations package'" were deficient). The demurrer to all causes of action should be sustained, or alternatively, allegations of liability based on analysts' statements should be stricken. See Complaint ¶¶ 31:1-12; ____________________ 7 See, e.g., Zeid v. Kimerley, 930 F. Supp. 431, 435 (N.D. Cal. 1996) ("The plaintiff must allege that the insider provided misleading information to an analyst, that the analyst relied on this information in preparing a report, and that the insider somehow endorsed or approved the report prior to or after its publication. "[E]ntanglement requires a two-way flow of information.") (citation omitted); In re DSP Group, Inc. Sec. Litig., No. C-95-4025-CAL, slip op. at 5 (N.D. Cal. June 13, 1996) (dismissing complaint that did "not identify the specific information circulated by defendants, how it was false, the date of the interactions, the identity of participants, or the facts of the claimed direction, approval, guidance, adoption or entanglement." O'Sullivan v. Trident Microsystems, Inc., [1994 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,116, at 98,915 (N.D. Cal. Jan. 31, 1994) (allegations that information in the reports was obtained from the company and that copies of all drafts were provided to the company was insufficient); Wall Data, 1995 U.S. Dist. LEXIS 19812, at *38 (allegations that defendants met with the analysts; made optimistic statements and projections to the analysts; reviewed draft analyst reports incorporating the optimistic projections; and "approved" the reports prior to their release were insufficient, even where the plaintiffs identified that dates of the meetings, the statements made by the defendants, and the substance of the reports); Ross Sys., [1994-1005 Tr. Binder] Fed. Sec. L. Rep. (CCH) at 90,499 (entanglement not sufficient pleaded where plaintiffs alleged that defendants provided information, including detailed guidance, to the analysts, and that company "approve[d]," "knew of," and "endorsed" the reports); Syntex, 855 F. Supp. at 1097 ("one-way flow of information from company to the analyst not sufficient to plead entanglement"). -10-
33:17-22; 34:23-28, 1-4; 35:5-10; 36:11-16; 37:17-22; 38:23-28, 1- 25; 40:4-26; 42:4-9; 47:14-18; 49:26-28, 1-2; 52:21-28, 1-19; 53:20-28, 1-4. B. Defendants' Alleged Statements Are Not Actionable. Plaintiffs allege that Diamond itself made six types of misleading statements: • Plaintiffs allege that Diamond misled the market regarding the success of and demand for its products; • Plaintiffs allege that Diamond's financial statements were misleading because Diamond reported inflated inventory values; • Plaintiffs allege that Diamond's financial statements were misleading because Diamond improperly recognized revenue; • Plaintiffs allege that Diamond's forecasts were false; • Plaintiffs allege that various Diamond statements were misleading because Diamond failed to disclose deficiencies in its MIS systems and internal controls; and • Plaintiffs allege that Diamond misled the market about its acquisitions. As we demonstrate below, none of these allegations adequately plead a cause of action. The demurrer should therefore be sustained, or alternatively, the inadequate allegations should be stricken. 1. Diamond Made No Misrepresentations Regarding The Success of Its Products. Plaintiffs contend that Diamond's statements about the success of its products were false. But upon examining each of the supposedly misleading statements, it becomes clear that none of them will support a cause of action. a. Diamond's Opinions Regarding Demand For Its Graphic solid demand for its products . . ." (Complaint ¶ 51). As a threshold matter, the general statements made by Diamond about these products are not actionable under California law because they are statements of opinion. Tarmann, 2 Cal. App. 4th -11-
at 158. These statements merely convey Diamond's opinion that demand in the December quarter was "strong" and "solid." Such statements of opinion are not actionable. See Tarmann, 2 Cal. App. 4th at 158; McDougall v. Roberts, 43 Cal. App. 553, 557 (1919). These statements are the type of "soft" or "puffing" statements that the federal courts have held are immaterial as a matter of law.8 See Raab v. General Physics Corp., 4 F.3d 286, 289 (4th Cir. 1993) (statements that one of the company's divisions was "poised to carry the growth and success of 1991 well into the future" lacked materiality as a matter of law); Ross Sys., [1994- 1995] Fed. Sec. L. Rep. (CCH) at 90,497 (dismissing statements that defendants were "pleased" with "strong sales").9 They are insufficiently specific to convey concrete information and thus do not have the capacity to materially mislead. See Fisher, 1995 WL 261439, at *4. They thus cannot provide a basis for liability, since the California securities laws proscribe only misstatements of "material fact." Cal. Corp. Code § 25400(d) (emphasis added); see also Goldrich, 25 Cal. App. 4th at 783 (dismissing claims where plaintiff failed to allege misstatement or omission of "material fact"). b. Plaintiffs Fail To Allege Any Fraudulent Misstatement Regarding The Edge. Plaintiffs complain about the allegedly false and misleading nature of Diamond's statements regarding the Edge 3D, but the fact is that Diamond made no statements regarding the product that could ____________________ 8 Few published California decisions address a number of the issues raised in this demurrer. However, numerous California courts have looked to federal decisions interpreting comparable provisions of the federal securities laws in applying the California securities laws, and where applicable, defendants cite those federal decisions here. See, e.g., People v. Figueroa, 41 Cal. 3d 714, 727 (1986); Eldridge v. Tymshare, Inc., 186 Cal. App. 3d 767, 775-76 (1986); Insurance Underwriters Clearing House, Inc. v. Natomas Co., 184 Cal. App. 3d 1520, 1526 (1986). In addition, the California courts look to federal cases where there is a lack of California precedent. See, e.g., Cummings v. Farmers Ins. Exchange, 202 Cal. App. 3d 1407, 1417 (1988); Gardner v. Murphy, 54 Cal. App. 3d 164, 171 (1975). 9 See also In re Software Publishing Sec. Litig., [1994 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,094, at 98,758-59 (N.D. Cal. Feb. 2, 1994) (dismissing statements that company believed it was "well poised" and is "now positioned to effectively compete"); Syntex, 855 F. Supp. at 1096 (dismissing statement that company expected "increased sales" and a "very strong fiscal 1993"); In re Cypress Semiconductor Sec. Litig., 891 F. Supp. 1369,1376 (N.D. Cal. 1995) (dismissing statement that company expected "some improvement in earnings"); In re Gupta Corp. Sec. Litig., 900 F. Supp. 1217, 1235 (N.D. Cal. 1994) (dismissing statement that "15 percent [growth] is the kind of earnings growth that is certainly achievable" and that analysts' estimates were "within reason"). Caere, 837 F. Supp. at 1057 (dismissing statements that company was "well positioned" for growth, had "expanded beyond [its] traditional markets", and had "continuing strong sales); In re Sciclone Pharmaceuticals Sec. Litig., No. C-94-1485 SBA, slip op. at 28-29 (N.D. Cal. May 3, 1989) (dismissing company's statement that "everything we've seen is positive"). -12-
be considered misleading. Plaintiffs challenge the following three alleged affirmative statements: • Diamond's "announce[ment] that it had begun shipping its Edge 3D line" (Complaint ¶ 27); • Diamond's alleged statement that Edge sales were "higher than expected" and would continue to show growth -- a statement plaintiffs attribute to Diamond's January 17, 1996 press release and analyst reports (Complaint ¶¶ 39-40); and • Schroeder's purported statement that the Company's "3-D graphics products would have a major positive impact on the Company in early 1996" (Complaint ¶ 36). Plaintiffs misrepresent the facts. Diamond did not make the latter two alleged statements; analysts did. While plaintiffs purport to quote the company, in reality they are citing the statements of analysts. See Martin Exs. 5 and 6 (Donaldson, Lufkin, & Jenrette report dated January 18, 1996, and Montgomery Securities report dated December 5, 1995). Plaintiffs cite no SEC filing, article, or report that attributes the statements to defendants. Diamond's only reference to the Edge product in its January 17 press release was to advise the market that it was one of the many products it offered for sale, which was clearly true. See Martin Ex.7. Regardless, plaintiffs' complaint does not dispute the accuracy of the above statements. Plaintiffs cannot state a cause of action for fraud when the challenged statements are not alleged to be false. 5 B. Witkin, California Procedure, § 672, at 122 (3d ed. 1985); McDougall, 43 Cal. App. at 556 (fraud and deceit allegations were insufficient where it was not alleged that the representation was in fact untrue). Plaintiffs assert that Diamond's announcement that it was shipping Edge 3D, although accurate, was nevertheless misleading because Diamond should have disclosed that sales of its new Stealth 3D product would "cannibalize" Edge 3D sales. This theory runs afoul of decisions holding that a company has no duty to predict the future market performance of its products. See Stac, 89 F.3d at 1406-07 (company need not predict release of competitive product); In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1420 (9th Cir. 1994) (company not required to predict decline in sales), cert. denied, 116 S. Ct. 185 (1995); In re VeriFone Sec. Litig., 11 F.3d 865, 869 (9th Cir. 1993) ("alleged nondisclosures are, in substance, failures to make a forecast of future events," which are not actionable); In re Convergent Technologies Sec. Litig., 948 -13-
F.2d 507, 516 (9th Cir. 1991). Likewise, Diamond had no duty to disclose the risks to older product lines posed by Diamond's introduction of its new Stealth 3D product, because those are risks of which the market is presumed to be aware. See Convergent, 948 F.2d at 513; see also Stac, 89 F.3d at 1410 (market presumed to know of risk of obsolescence of product competing in a field of rapid technological advances). Additionally, Diamond disclosed the risk that plaintiffs complain was concealed. In both the Prospectus and the Form 10-K, Diamond warned investors of "the rapid product obsolescence which often occurs during product transitions." Prospectus at 12; 10-K at 15. Diamond also warned investors of its dependence on sales of its graphics accelerators, cautioning that those products were "expected to continue to account for a substantial majority of the Company's sales" and that "a decline in demand or average selling prices these products, whether as a result of new product introductions or price competition . . . would have a material adverse impact on the Company's sales and operating results." Complaint ¶ 28 (citing November 7, 1995 Form 10-Q); 10-K at 13. It is axiomatic that a company cannot be held liable for failing to disclose a risk that actually was disclosed. See Stac, 89 F.3d at 1409. c. Diamond's Statements Regarding The Stealth Are Not Actionable. Plaintiffs challenge the following statements about the Company's Stealth product line: • the Stealth 64 Video 2001 provides "powerful graphics and video playback acceleration" (Complaint ¶ 26); and • "[t]he Stealth 64 Video 2001 series is also upgradeable to hardware-based MPEG decompression and also features an additional TV tuner upgrade module that enables live television in a window" (Complaint ¶ 24). Plaintiffs assert that these statements were misleading because they failed to disclose certain design defects, the current unavailability of certain drivers for the products (which made them currently incompatible with certain operating systems), and that only minimal shipments of the TV tuner upgrade module were made in the fourth quarter. Complaint ¶ 32. However, plaintiffs do not allege facts sufficient to show that Diamond had any duty to make the alleged disclosures. The law does not require Diamond to disclose every detail about its product capabilities. See Backman v. Polaroid Corp., 910 F.2d 10,15-16 (1st Cir. 1990) (en banc) -14-
(company need not disclose everything that "might be interesting market-wise"); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 448-49 (1976); Convergent, 948 F.2d at 516 ("a company need not detail every corporate event"; holding that company was not required to disclose problems developing new product); Cypress, 891 F. Supp. at 1376 (there is "no duty to disclose every problem challenge and frustration its officers encountered"). Plaintiffs do not allege that the alleged problems had any material effect on sales, and the California securities laws, like the federal laws, do not require disclosure of facts that are not material. See Cal. Corp. Code § 25400(d) (prohibiting the making of "statements which [are] . . . false or misleading with respect to any material fact. . .) (emphasis added). To the extent plaintiffs rely on their allegations that the problems were "significant", that allegation does not provide the specificity required to state a claim for fraud. Lazar, 12 Cal. 4th 631, 645 (1996); GlenFed, 42 F.3d at 1547-48, 1552 (allegations were deficient where plaintiffs failed to "identify or quantify the number"). Further, the market had to be aware of the capabilities and shortfalls of a product that was then available for sale. Customers who already were purchasing the Stealth line of products must have been well aware of any defects or compatibility issues. If information about product performance was generally available to customers, investors cannot claim the information was not disclosed to the market. See Stac, 89 F.3d at 1409-10. d. Diamond's Statement Regarding Its ISDN Expectations Are Not Actionable. Plaintiffs also challenge Diamond's announcement that its ISDN product was "expected to be shipped by early 1996," claiming that it was false and misleading because Diamond failed to disclose that the product was suffering from delays. Complaint ¶ 29; 38(c). Under California law, Diamond's forward-looking statement regarding the anticipated availability of the ISDN product is not actionable. "To be actionable, a . . . misrepresentation must ordinarily be as to past or existing material facts." Tarmann, 2 Cal. App. 4th at 158. Thus, "[p]redictions as to future events . . . are deemed opinions, and not actionable fraud." Id., citing 5 B. Witkin, -15-
Summary of California Law, Torts, § 678 at 779-80 (9th ed. 1988); Richard P. v. Vista Del Mar Child Care Serv., 106 Cal. App. 3d 860, 865 (1980).10 In addition, investors are presumed to know that products in development may be delayed. See In re Apple Computer Sec. Litig., 886 F.2d 1109, 1111-15 (9th Cir. 1989), cert. denied, 496 U.S. 943 (1990); Borow v. nVIEW Corp., 829 F. Supp. 828, 834 (E.D. Va. 1993), aff'd, 27 F.3d 562 (4th Cir. 1994); Berliner v. Lotus Dev. Corp., 783 F. Supp. 708, 710-11 (D. Mass. 1992). Indeed, plaintiffs do not allege that the delays were in any way material -- or even that the ISDN product was not shipped in early 1996. See Complaint ¶39(c) (alleging that Diamond should have disclosed that the ISDN would be delayed until the middle of the first quarter of 1996, i.e., February). Plaintiffs thus do not allege a material misstatement -- a required element of their claim. 2. Inventory Allegations a. Plaintiffs' Inventory Reserve Allegations Fail to State A Cause of Action. Plaintiffs' allegation regarding Diamond's reserve for obsolete inventory is a classic case of "fraud by hindsight." Plaintiffs argue that Diamond should have written down the value of its inventory earlier, based solely on the fact that Diamond did in fact write down its value at a later date, in the third quarter of 1996. Complaint ¶¶ 58-69. But plaintiffs allege no facts indicating that Diamond's judgments concerning its reserve allocations were incorrect, much less fraudulent, at the time they were made. To support a claim of fraud, the facts demonstrating the falsity must be pled specifically; "general and conclusory allegations do not suffice." Lazar, 12 Cal. 4th at 645 (citations omitted); Stansfield, 220 Cal. App. 3d at 74. A plaintiff suing for fraud must plead facts that show "that each representation was false when made." Stansfield, 220 Cal. App. 3d at 74 (emphasis in ____________________ 10 By its own terms, Section 25400(d) is not applicable to forward-looking statements. Section 25400(d) applies only to a "statement which was, at the time and in the light of the circumstances under which it was made, false or misleading with respect to any material fact." Cal. Corp. Code § 25400(d) (emphasis added). The Legislature's insertion of the words "at the time" is crucial. The truth or falsity of a projection about the future can only be determined as of the time the future events come to pass; it cannot be measured, as the statute requires, "at the time" the projection was made. -16-
original). See also GlenFed, 42 F.3d at 1548 (plaintiffs must plead "why the disputed statement was untrue or misleading when made") (emphasis in original).11 When alleging false financial statements, "plaintiffs must set forth facts explaining why the difference between the earlier and the later statements is not merely the difference between two permissible judgments, but rather the result of a falsehood." GlenFed, 42 F.3d at 1549; Stack v. Lobo, No. C-95-20049 SW, 1995 WL 241448, at *5 (N.D. Cal. Apr. 20, 1995); see also DiLeo, 901 F.2d at 626. That is particularly true in the case of judgments regarding the setting of reserves, which Courts recognize are forecasts about contingencies that may or may not arise in the future. See Mathews, [1994-95 Tr. Binder] Fed. Sec. L. Rep. (CCH) at 91,037. "Reserves are meant to be estimates or predictions of [product demand and manufacturing needs]," which are fraudulent only "if, when they were established, the responsible parties knew or should have known that they were derived in a manner inconsistent with reasonable accounting practices." Id. (citations omitted); see also DiLeo, 901 F.2d at 626-27 ("No matter when a bank [writes down a loan] someone may say that it should have acted sooner. If all that is involved is a dispute about the timing of the writeoff, based on estimates of the probability [of future contingencies], we do not have fraud; we may not even have negligence."). Here, plaintiffs base their entire claim on the difference between Diamond's second quarter inventory valuation and its first quarter inventory valuation -- ignoring the intervening market transition. In the second quarter of 1996 memory chip supplies entered a period of oversupply and prices were dramatically reduced. "When such an event has occurred, it is clearly insufficient for plaintiffs to say that the later, sobering revelations make the earlier, cheerier statement a falsehood." GlenFed, 42 F.3d at 1548 (noting that "a decline in other markets affecting the company's product [and] a shift in consumer demand" are examples of such intervening events). Because that is all plaintiffs do here, their claim for fraud must fail. ____________________ 11 See DiLeo v. Ernst & Young, 901 F.2d 624, 626 (7th Cir. 1990) ("[B]ecause only a fraction of financial deteriorations reflects fraud, plaintiffs may not proffer the different financial statement and rest. Investors must point to some facts suggesting that the difference is attributable to fraud."), cert. denied, 498 U.S. 941 (1990); Denny v. Barber, 576 F.2d 465, 470 (2d Cir. 1978) ("plaintiff has simply seized upon disclosures made in later annual reports and alleged that they should have been made in earlier ones."). -17-
b. Diamond Disclosed The Risk That Product Transitions Might Result In Obsolete Inventory and Write-Offs. Diamond's risk disclosures provide an alternative basis for dismissing plaintiffs' inventory valuation claim, because Diamond disclosed the precise risks that later materialized. Diamond disclosed that its practice was to order components before demand materialized, and that demand might not materialize as anticipated -- resulting in excess inventory and severe price competition. Specifically, Diamond disclosed that: • "[n]otwithstanding the difficulty in forecasting future sales and the relatively small level of backlog . . . , the Company generally must . . . order components . . . months in advance. . . . Excess inventory could result . . . as well as expenses associated with inventory writeoffs" (Prospectus at 7); • "the Company may over purchase certain components, resulting in excess inventory . . . or, in the event of inventory obsolescence or a decline in the market value of such inventory, causing inventory write-offs . . . " (Prospectus at 9); • supply-demand conditions for semiconductor components may change. During periods of oversupply, prices are likely to fall and certain vendors of such semiconductor chips may liquidate their inventories in a rapid manner. . . . such actions could enable competitors of the Company to enjoy . . . a cost advantage vis-a-vis the Company, and any resultant price reduction for competitors' products could require the Company to reduce its prices, thereby depressing the Company's margins or revenues . . . . (10-K at 13); and • "[t]he market for the Company's products is characterized by frequent new product introductions and rapid product obsolescence (Complaint ¶ 66 (citing 10-K)). Those disclosures warned of the specific risks that affected Diamond's inventories, thereby precluding liability. See Stac, 89 F.3d at 1409; Convergent, 948 F.2d at 515. c. Plaintiffs' Allegations That Diamond Fraudulently Inflated Its Physical Inventory Count Fail To State A Cause Of Action. Plaintiffs' allegation that Diamond lied about the value of its inventory in the third quarter of 1995, only to reveal its true value in the first quarter of 1996, fares no better. Plaintiffs plead no facts demonstrating that the physical count done at the end of the third quarter of 1995 was erroneous -- or how or why the "missing" inventory problem was attributable to fraud, rather than an intervening theft or thefts. Thus, plaintiffs' claim amounts to no more than an allegation that the company's revelation of bad news means that earlier statements were false. That allegation is -18-
insufficient to state a claim for fraud. Stansfield, 220 Cal. App. 3d at 74; GlenFed, 42 F.3d at 1548. 3. Plaintiffs' Revenue Recognition Allegations Fail To State A Cause Of Action. Plaintiffs' allegation that Diamond's revenues and earnings were fraudulently inflated lacks any semblance of specificity. First, plaintiffs make sweeping allegations that Diamond offered discounts, rights of return, and extended and deferred payment terms at the end of each quarter in order to maximize sales. Complaint ¶ ¶ 41(c); 54 (c) (d). Even if these allegations were sufficiently specific to state a claim (which they are not), there is nothing impermissible about selling as much product as customers will take; maximizing sales is not fraud and does not result in the improper recognition of revenue under GAAP. See Convergent, 948 F.2d at 515; Cypress, 891 F. Supp. at 1381. Accordingly, these allegations fail to support a contention of false financial statements. Plaintiffs also allege generally that Diamond recorded revenue on contingent sales, granted absolute rights of return, and shipped the wrong product to customers. These allegations lack the requisite specificity, because plaintiffs do not identify the purportedly offending transactions through which the alleged fraud occurred. See GlenFed, 42 F.3d at 1547-48, 1552 (finding allegations of inadequate loan loss reserves deficient where "plaintiffs fail to identify or quantify the number of non- performing assets").12 Plaintiffs do not identify the customers with whom such transactions were made, the date of the transactions, the products sold, the terms under which it was sold, or the amount of revenue involved. The failure to specify the amount of revenue involved also renders it impossible to determine whether the alleged inflation was material, another prerequisite to stating a claim for securities fraud. See Cal. Corp. Code § 25400(d). Plaintiffs also challenge Diamond's practices of offering certain customers price protection and stock balancing, but those practices were fully disclosed to the market. Diamond disclosed that "[t]he Company frequently grants limited rights to customers to return unsold inventories of the Company's products in exchange for new purchases [i.e., stock balancing], as well as price protection." Prospectus at 11; 10-K at 15. The company also disclos p; -19-
balancing, stating that "[t]he Company's future operating results may vary significantly from period to period as a result of . . . product returns or price protection charges" and that there was no assurance "that any future returns or price changes will not have a material adverse effect on operating results, particularly in light of the rapid product obsolescence which often occurs during product transitions." Prospectus at 12; 10-K at 11, 15. Similar disclosures have been held adequate to disclose the information plaintiffs allege was concealed. See Stac, 89 F.3d at 1407-09 (rejecting claims based on disclosed sales practices, which plaintiffs claimed constituted illegitimate "borrowing" against the future); compare Worlds of Wonder, 35 F.3d at 1417-18 (company need not disclose its observance of common industry practices of price protection, stock balancing or occasional practice of giving an unsatisfied customer a refund). 4. The Complaint Fails To Allege That Diamond's Forecasts Were False. Plaintiffs challenge Diamond's statement in an April 18 press release that "As a result [of declines in prices for DRAMS and other components] gross margins are expected to improve in the second quarter." Complaint ¶ 51. See also Complaint ¶¶ 36, 39-40. Diamond cannot be held liable for forecasts that merely turned out to be incorrect. Under California law "[t]o be actionable, a . . . misrepresentation must ordinarily be as to past or existing material facts." Tarmann, 2 Cal. App. 4th at 158. "Predictions as to future events . . . are deemed opinions, and not actionable fraud." Id. (citing 5 B. Witkin, Summary of Cal. Law, § 678, at 779-80 (9th Edition 1988); Richard P., 106 Cal. App. 3d at 865. Accordingly, these contentions are not actionable under California law. Even if a cause of action could be based on a "false opinion," plaintiffs fail to allege that Diamond's forecasts were false. Instead, plaintiffs allege a series of "facts" of which defendants were allegedly aware and which allegedly made defendants' forecasts unreasonable. This cannot satisfy the elements of pleading the falsity of a forecast. It is not enough to allege that a defendant should have known or even knew of facts potentially undermining a forecast; the plaintiff must allege that the speaker did not believe his or her projections and plead the absence of belief with specificity. See Wilhelm v. Pray, Price, Williams & Russell, 186 Cal. App. 3d 1324, 1331 (1986) (plaintiff required to plead specific factual basis for how defendant knew representations were -20-
false when made); Schultz v. Harney, 27 Cal. App. 4th 1611, 1622 (1994) (plaintiff must plead specific facts which show representation by defendant was "knowingly" false); Stansfield, 220 Cal. App. 3d at 74 (dismissing fraud claim on grounds that allegations regarding representation that tax contributions to church were tax exempt failed to allege facts showing that allegations were false each time they were made over an eighteen year period); Goldrich, 25 Cal. App. 4th at 782 ("facts constituting every element of the fraud must be alleged with particularity") (original emphasis); see also 5 B.E. Witkin, Summary of California Law, Torts §§ 677-681 at 778-784. The court in Tarmann was faced with a similar claim in the context of a promise, and specifically "decline[d] to establish a new type of actionable deceit" based on an unreasonable promise. 2 Cal. App. 4th at 159. The court distinguished promises from existing facts, on the ground that promises are only false if the promisor does not intend to perform. Id. The court thus refused to relax the specific intent requirement, holding that a false promise claim could not be based on "an honest but unreasonable intent to perform." Id. Similarly, an opinion is not false just because it is unreasonable. There thus is no basis to establish "a new type of actionable deceit" based on an unreasonable opinion. For example, plaintiffs' allegation that Diamond's purportedly "antiquated" MIS system rendered its forecasts unreasonable does not allege that Diamond's forecast was false (not believed) at the time it was made. Plaintiffs also fail to specify the manner in which the MIS system, which was updated prior to the second quarter, allegedly affected the reliability of the second quarter forecast. Plaintiffs' other allegations similarly fail to show that Diamond did not believe its forecasts. Moreover, Diamond disclosed to the market the many uncertainties inherent in its forecasting process. Diamond disclosed: "[t]he volume and timing of orders received during a quarter are difficult to forecast. Customers generally order on an as-needed basis, and accordingly the Company has historically operated with relatively small backlog. Moreover . . . a disproportionate percentage of the Company's net sales in any quarter may be generated in the last month of a quarter. As a result, a shortfall in sales in any quarter compared to expectations may not be identifiable until the end of the quarter." -21-
Prospectus at 7; 10-K at 13. Plaintiffs cannot complain that information undermining the accuracy of Diamond's forecasts was concealed, or that the market was misled. Plaintiffs also fail to allege when Diamond became aware of a sales shortfall. Obviously, there was no shortfall as of March 30, since Diamond's first quarter revenues were sufficient to meet expectations. To the extent plaintiffs claim that Diamond subsequently became aware that there would be a shortfall, they fail to plead when that occurred, the nature or magnitude of the shortfall, and why Diamond did not believe that sales in the last month of the quarter -- which typically are the highest -- could not make up for any earlier shortfall. Without such allegations, there is no basis to conclude that any of Diamond's statements was false. 5. Plaintiffs Fail Adequately To Allege Any Material Omission Concerning Internal Controls and MIS Systems. Plaintiffs claim that Diamond should have disclosed alleged problems with its internal controls and management information (MIS) systems. Plaintiffs' claim is based solely on Diamond's announcement in January 1996 that the company was missing $3.7 million in inventory, and Schroeder's alleged description of Diamond's former MIS systems, which Diamond had replaced, as "antiquated." Companies need not disclose matters pertaining to their internal controls, however, unless they rise to the level of a "material weakness." Worlds of Wonder, 35 F.3d at 1417; see also Monroe v. Hughes, 31 F.3d 772, 776 (9th Cir. 1994). Plaintiffs do not allege that the auditors found that Diamond's alleged internal control difficulties rose to that level. Moreover, the market was well aware of the company's MIS and internal control challenges. The prospectus warned investors that "[t]he expansion in the scope of the Company's business has resulted in a need for significant investment in infrastructure and systems. . . . The Company's future operating results will depend in large measure on its ability to successfully implement operating, manufacturing and financial procedures and controls . . . [and] to strengthen management information and telecommunications systems . . . " Prospectus at 8. These disclosures are remarkably similar to those the Ninth Circuit held sufficient to warn of the relevant risks in Worlds of Wonder, 35 F.3d at 1417. -22-
Plaintiffs also purport to challenge Diamond's alleged representation that its inventory control issues had been "resolved"-- and were not expected to recur. But plaintiffs allege no facts demonstrating that these statements were false or that these inventory control issues did in fact occur. Plaintiffs point to an inventory write-off in June 1996, but that write-off was due to a decline in market value of the inventory, not loss of inventory or any other "control" issues. Complaint ¶56(d); 57. 6. Plaintiffs Do Not Adequately Allege That Diamond Misrepresented The Value Of Its Acquisitions. Plaintiffs make only vague accusations relating to Diamond's acquisitions. The complaint's primary defect in this regard is that it fails to explain how any allegedly undisclosed information rendered misleading any affirmative statement by Diamond, which is necessary to state a claim for fraud. See Goodman, 18 Cal. 3d at 346 (dismissing claim where plaintiffs alleged neither "any untrue statement of a material fact [n]or any statement that was rendered misleading by the omission of a material fact"); see also GlenFed, 42 F.3d at 1547-49 (alleged omission must be linked with misstatement; court will not find omission by innuendo); Zeid, 930 F. Supp. at 436 (plaintiffs must "specify the reason or reasons why any of the company's statements were misleading when made"). As to the allegedly undisclosed information, plaintiffs' claims are similarly imprecise. Plaintiffs assert that Diamond accounted for the acquisitions "creative[ly]", but they do not allege that the accounting was fraudulent or that it violated GAAP, let alone how or why it may have done so. See Complaint ¶ 6. Plaintiffs also assert that Diamond failed to disclose that Spea had millions of dollars of obsolete inventory. Complaint ¶ 32(g). But plaintiffs' claims are not sufficiently specific -- they do not even allege the amount or the products involved. See GlenFed, 42 F.3d at 1548. Plaintiffs also allege that Diamond failed to disclose a fact that was actually disclosed -- that Spea had millions of dollars of purchase commitments. But Diamond disclosed that it would be required to pay approximately $11 million in Spea debt and anticipated that it would need to provide an additional $10-15 million for near term working capital requirements. Prospectus at -23-
12, 27; November 10-Q at 13. Diamond also disclosed Spea's historical losses, Prospectus at 19-20, and the margin pressure that was and would be caused by the "higher proportion of lower margin European sales." Prospectus at 21; 10-K at 7. CONCLUSION For the foregoing reasons, defendants Diamond Multimedia Systems, Inc., William J. Schroeder, Gary B. Filler, and Hyung Hwe Huh respectfully request that the demurrer be sustained. In the alternative, defendants request that the allegations upon which no cause of action may be based be stricken from the Complaint. DATED: September 16, 1996 Respectfully submitted, WILSON, SONSINI, GOODRICH & ROSATI /s/ By: ______________________________ Marta Cervantes Attorneys for Defendants William J. Schroeder, Gary B. Filler, Hyung Hwe Huh and Diamond Multimedia Systems, Inc. -24-