Diamond Multimedia Systems, Inc. - CV758927 CV759012 CV759270

Stanford University Law School - Securities Class Action Clearinghouse

[Web note: Page formatting approximates, but does not match exactly, that of filed paper document.]

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. )
) DEFENDANTS' REPLY
HYUNG HWE HUH, et al., ) MEMORANDUM IN
) SUPPORT OF THEIR
Defendants. ) DEMURRER AND MOTION
) TO STRIKE
)
) Date: December 12, 1996
) Time: 9:00 a.m.
) Dept: 17
____________________________________)

I. INTRODUCTION AND SUMMARY

In their opening brief, defendants detailed why plaintiffs'

verbose, convoluted Complaint fails to adequately plead essential

elements of plaintiffs' causes of action. In opposing defendants'

demurrer, plaintiffs rely on phantom allegations that do not appear

in the complaint, on sweeping generalities that have little to do

with the specific issues here, and on mistaken characterizations of

defendants' arguments. In short, plaintiffs attempt to deflect

attention from their failure to plead a cause of action. For

example:

• The language and legislative history of Corporations Code

§§25400 and 25500 plainly show that these sections apply

only to in-state securities transactions. Plaintiffs do

not allege any in-state transactions. Instead,

plaintiffs argue that the statute does not have an "in-

state" requirement -- even though the statute clearly

contains the words "in this state."

• Plaintiffs assert in their briefs that defendants (as

opposed to securities analysts) made certain statements,

but the Complaint makes no such allegations.

• Plaintiffs distort the Supreme Court's holding in Mirkin

v. Wasserman, arguing that it endorses use of boilerplate

allegations to meet the reliance element of a fraud

claim. In fact, Mirkin states that there is no fraud

cause of action where plaintiffs never "read or heard the

alleged misrepresentations" -- which plaintiffs do not

allege here.

When the underbrush is cleared from plaintiffs' opposition

brief, it becomes apparent that plaintiffs have failed to plead all

the elements of their causes of action. Accordingly, defendants'

demurrer should be sustained, or in the alternative, their motion

to strike should be granted.

II. PLAINTIFFS FAIL TO STATE A CAUSE OF ACTION UNDER CALIFORNIA
CORPORATIONS CODE SECTIONS 25400 AND 25500

Defendants' opening brief demonstrated that the demurrer to

plaintiffs' causes of action based upon the California Corporations

Code Sections 25400 and 25500 should be sustained because (1)

plaintiffs fail to allege that their purchases or sales were made

"in this state";

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(2) plaintiffs fail to allege that defendants' alleged

misstatements were made in connection with a purchase or sale of

securities; and (3) plaintiffs fail to plead fraud with the

requisite specificity. Plaintiffs do not dispute their failure to

allege these facts. Rather, plaintiffs contend that §§ 25400 and

25500 do not require such allegations. Plaintiffs misinterpret the

law.

A. Plaintiffs Fail to Satisfy the "In This State" Element
of Their §§ 25400 and 25500 Cause of Action.

Corporations Code § 25008 defines the circumstances under

which a securities transaction will be deemed to have been made "in

this state" for purposes of the liability provisions of the

Corporations Code. Plaintiffs do not dispute their failure to meet

the requirements of § 25008. Rather, they argue that §§ 25400 and

25500 do not contain an "in this state" requirement. Plaintiffs

are simply wrong, as demonstrated by ample authority.

The entire intent of the California Securities Laws is to

regulate securities transactions in California. Professor Marsh,

the reporter of the committee that drafted the statute, stated:

"the basis of jurisdiction and regulation should be the offer and

sale of securities in this State." HAROLD MARCH & ROBERT H. VOLK,

PRACTICE UNDER THE CALIFORNIA CORPORATE SECURITIES LAW OF 1968 45

(1969) (Martin Declaration, Ex. 2). Case after case has recognized

the "in-state" limitation. See, e.g., Hall v. Superior Court, 150

Cal. App. 3d 411, 415 (1983) (the California securities laws

regulate securities transactions in California); In re Victor

Technologies Sec. Litig., 102 F.R.D. 53, 60 (N.D. Cal. 1984),

aff'd, 792 F.2d 862 (9th Cir. 1986); and other authority in Def.

Mem. at 2-3.

Consistent with this statutory intent, § 25400 contains in its

very first sentence the phrase "in this State." Because of its

placement in the statute, this phrase in § 25400 governs all of the

five subsections that follow, including subsection (d), upon which

plaintiffs rely here. That subsection prohibits certain conduct

designed to "induce the purchase or sale of such security by

others." Thus, it is clear that plaintiffs' Section 25400 cause of

action may be based only on transactions "in this state." The

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phrase "in this State" is defined in § 25008, which therefore

governs plaintiffs' cause of action.¹ This result is consistent with general rules of construction.

The California Supreme Court long ago established that where the

applicability of a statute is limited by its terms to transactions

occurring within California, it is beyond the judicial province to

expand the statute's reach to transactions outside the state.

North Alaska Salmon Co. v. Pillsbury, 174 Cal. 1, 4 (1916) (the

intention to make a statutory act "operative, with respect to

occurrences outside the state, will not be declared to exist unless

such intention is clearly expressed or reasonably to be inferred").

Plaintiffs cannot contend that the "in this state" requirement does

not apply to § 25400 claims.

The cases do not support plaintiffs' argument that claims

brought under §§ 25400 and 25500, unlike claims brought under the

rest of the California Securities Laws, are not limited to in-state

transactions. Indeed, the Victor court specifically applied the

"in this state" requirement to claims brought under § 25500, the

same statute pursuant to which plaintiffs seek relief here. 102

F.R.D. at 60. See also Scholes v. Tomlinson, 145 F.R.D. 485 (N.D.

Ill. 1992).² Mirkin v. Wasserman, 5 Cal. 4th 1082 (1993), is not to the

contrary. Mirkin does not discuss, let alone dispense with, the

"in this state" requirement for §§ 25400 and 25500 claims. In

Mirkin, the California Supreme Court held that securities class

action plaintiffs must plead and prove actual reliance to assert

fraud and misrepresentation claims under Civil Code §§ 1709-10. By

____________________

¹ Section 25500 merely creates a remedy for violation of Section
25400. Thus, § 25500 is of necessity limited to transactions "in
this state," because § 25400 is so limited.

² Plaintiffs assert that "defendants' meritless territoriality
theory was recently rejected," improperly citing to Jerome Herman
v. Bradley S. Scott, BC133877 (May 29, 1996) and Richard Strausz v.
Charles Gechke, CV755730 (July 1, 1996). Pl. Opp. at 9. Opinions
not ordered published may not be relied upon by a court or a party.
Cal. R. Ct. 977(a). In any event, neither order, attached as
Exhibits 3 and 4 to the Blackman Declaration, clearly sets forth a
rejection of the "in this state" requirement. Moreover, if the
Court were to consider unpublished Superior Court decisions, there
is more recent Superior Court authority which explicitly upholds
the jurisdictional requirement highlighted by defendants here. See
Trieff et al v. Cirrus Logic, Inc., No. H-188961-9 (August 30,
1996) (Order in which Judge Kraetzer, inter alia, sustained
defendants' demurrer to plaintiffs' cause of action for violation
of Corporations Code Section 25400/25500 without leave to amend).
This order is attached as Exhibit A to the Supplemental Declaration
of Thomas J. Martin, filed concurrently herewith.

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way of comparison, the Court added, in dicta, that §§ 25400 and

25500 do not require actual reliance. Id. at 1103-04. Plaintiffs

apparently read the Mirkin court's failure to list all of the other

elements of a § 25400/25500 claim as a new rule of law dispensing

with those elements, but the Mirkin court was neither confronted

with nor analyzed the adequacy of a claim under §§ 25400 and 25500.

The decision therefore cannot reasonably be read to have delineated

each of the requisite elements for pleading such a claim -- nor to

have dispensed with any elements. Cf. Mirkin, at 1099 (refusing

to adopt plaintiffs' interpretation of a case where plaintiffs

relied on "only a single sentence, unsupported by reasoning or

authority. . .").

Accordingly, the demurrer to the first cause of action should

be sustained because plaintiffs fail to allege, as required by §

25008, that they made an offer to purchase Diamond stock in

California, live in California, or purchased stock in California.

B. Plaintiffs Fail to Allege that Defendants' Alleged
Misstatements Were Made In Connection With a
Purchase or Sale of Securities.

1. Diamond's Aftermarket Statements Could Not Have
Been Made To Induce A Purchase Or Sale, Because
Diamond Made No Aftermarket Sales.

Plaintiffs' lengthy argument insisting that §§ 25400 and 25500

provide a remedy for aftermarket transactions is a red herring.

Defendants do not deny that §§ 25400 and 25500 can provide a remedy

for aftermarket transactions in this state; however, plaintiffs

still must demonstrate that the allegedly false statement was made

"for the purpose of inducing the purchase or sale . . . ." Defs.'

Mem. 5:9; Goodman v. Kennedy, 18 Cal. 3d 335, 345-46 (1976). If

Diamond had engaged in aftermarket stock sales, and if Diamond had

made misstatements for the purpose of inducing those transactions,

plaintiffs could have stated a cause of action. However, as

demonstrated in the Opening Brief, Diamond's only stock sales were

in its stock offering in November 1995. Thus, Diamond could not

have made any statements in the aftermarket for the purpose of

inducing a sale of stock -- because Diamond sold no stock.

Plaintiffs may not avoid this result by alleging that Diamond

"aided and abetted" fraudulent aftermarket stock sales by the

individual defendants. Contrary to plaintiffs' assertions, there

is no "aiding and abetting" liability for violation of § 25400.

Section 25500 by its terms makes liable only one who actually

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"participates" in a violation of § 25400, not one who assists a

participant. There is an explicit aiding and abetting provision in

the California Securities Laws. Section 25504.1 creates liability

for any person who "materially assists" in any violation of

specified sections of the securities laws -- and § 25400 is not one

of the sections listed. On the other hand, the very next section,

i.e., § 25401, is listed. The failure to mention § 25400 was not

inadvertent. The California Commissioner of Corporations had

expressly recommended that aiding and abetting liability apply to

Section 25400 in order to make liable "persons who materially

assist in violations of 25400,"³ and the Legislature rejected his

suggestion. The conclusion is obvious: there is no liability for

aiding and abetting a violation of § 25400.

This Court should not do what the California Legislature

expressly refused to do. See, e.g., Gikas v. Zolin, 6 Cal. 4th

841, 852 (1993) (principle of statutory construction that "[t]he

expression of some things in a statute necessarily means the

exclusion of other things not expressed" prevents court from

granting effect to statute other than that specified by the

Legislature). Therefore, plaintiffs' attempt to impose aiding and

abetting liability on defendants pursuant to Section 25400 and

25500 must be rejected.⁴____________________

³ California Department of Corporations, Legislative Analysis of
A.B. 592, attached to Memorandum of David C. Woods, Legislative
Coordinator of Department of Corporations, to Carl Brakensiek (Mar.
25, 1977). See Martin Dec., Ex. 4.

⁴ Section 25400's use of the term "directly or indirectly" does
not create liability for aiding and abetting. In Central Bank of
Denver, N.A., v. First Interstate Bank of Denver, N.A., 114 S.Ct.
1439 (1994), the U.S. Supreme Court refused to read aiding and
abetting liability into Section 10(b) of the Exchange Act of 1934,
even though the statute makes it "unlawful for any person, directly
or indirectly, . . . [t]o use or employ, in connection with the
purchase or sale of any security . . . any manipulative or
deceptive device or contrivance. . . ." 15 U.S.C. §78j(b)
(emphasis added). The Supreme Court concluded that:

the statute prohibits only the making of a material
misstatement (or omission) or the commission of a
manipulative act. . . . The proscription does not
include giving aid to a person who commits a
manipulative or deceptive act.

Central Bank, 114 S.Ct. at 1448. See Exhibit B to the Supplemental
Martin Declaration. Thus, the Supreme Court rejected the very
argument made here, i.e. that the term "directly or indirectly"
creates aiding and abetting liability.

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2. The Individual Defendants Made No Statements
For The Purpose Of Inducing A Purchase Or Sale.

Plaintiffs do not dispute defendants' showing that the

Complaint fails to allege that any statements by the individual

defendants were made "for the purpose of inducing" a purchase or

sale. Def. Mem. at 4-6. Plaintiffs make no allegation that

Defendant Huh made any public statements, and all but two

statements attributed to Defendants Schroeder and Filler fail to

identify the alleged misstatement and its author. The two

remaining statements attributed to Defendant Schroeder were not

alleged to have been made for the purpose of inducing purchases of

stock. Thus, the demurrer to the first cause of action should be

sustained.

C. Because the California Corporations Code Establishes
a Cause of Action For Securities Fraud, Not Negligence,
Plaintiffs Must Plead Their Claims with Particularity.

To avoid the requirement that fraud claims be pled with

specificity, plaintiffs argue that their causes of action under §§

25400 and 25500 may be premised on negligent conduct rather than

fraud. Pl. Opp. at 10. Plaintiffs' assertion is specious. Mirkin

refers to §§ 25400 and 25500 as the "antifraud provisions of state

securities law[s]," for good reason. Mirkin, 5 Cal. 4th at 1102

(emphasis added). Section 25400(d) prohibits sellers from making

materially false representations "for the purpose of inducing the

purchase or sale. . . ." §25400 (emphasis added). Similarly, §

25500 imposes liability only upon a "persons who willfully

participates . . . in violation[s] of Section 25400. . . ." The

standard of "willful" participation in "purposeful" conduct

requires intent, not just negligence. This is therefore a fraud

claim, and must be pled with specificity. See, e.g., Lazar v.

Superior Court, 12 Cal. 4th 631, 644-645 (1996).

Plaintiffs do not allege fraudulent conduct with specificity.

See Def. Mem. at 11-23. For example, plaintiffs make generalized

allegations that Diamond offered discounts, rights of return and

extended payment terms to maximize sales. Cmplt. ¶¶41(c),

54(c)(d). In their opposition brief, plaintiffs step up the

rhetoric, stating that "defendants 'sold' products to certain key

customers on extended or deferred payment terms, or the absolute

right of return and then booked the phoney sales, thereby

falsifying their financial statements. . . ." Opp. at 18; Cmplt.

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¶56(a). This generalized charge of misconduct lacks any semblance

of particularity -- plaintiffs do not specify the products, the

customers, the time frame or the amount of revenue. Similarly,

plaintiffs charge that Diamond's inventory was overstated due to

the Company's "antiquated" MIS system and lack of controls. Cmplt.

¶¶70, 72. Such bald allegations do not specify what portion of

Diamond's inventory was purportedly overstated, nor do they assert

that defendants did not believe in the accuracy of Diamond's

financial statements. Such general allegations of accounting

misconduct do not plead fraud with the required specificity.

III. DIAMOND'S DEMURRER TO THE SECOND CAUSE OF ACTION SHOULD
BE SUSTAINED BECAUSE PLAINTIFFS FAIL TO PLEAD "EYEBALL
RELIANCE" AS IS REQUIRED UNDER SECTIONS 1709-10 OF THE
CIVIL CODE

Diamond argued in its moving papers that to plead the reliance

element of a fraud cause of action, plaintiffs must plead that they

actually read or heard, and relied on, particular alleged false

statements. Plaintiffs counter that, to meet the reliance

requirement, they need merely make the boilerplate allegation that

they "relied on one or more of the false statements alleged

herein." Cmplt. ¶94; Opp. at 14. To avoid their obvious

inconsistency with the Mirkin case, plaintiffs assert that the

issue of pleading reliance "was not before the Mirkin court." Pl.

Opp. at 14.

Plaintiffs' contentions are specious. The Supreme Court in

Mirkin stated: "[t]he question before us is whether plaintiffs, who

cannot allege that they actually read or heard the alleged

misrepresentations, have pled a cause of action for deceit."

Mirkin, 5 Cal. 4th at 1089 (emphasis added). The Court found that

plaintiffs must "alleg[e] that they actually relied on the

misrepresentations" and refused to premise liability on

misstatements that plaintiffs "never heard." Id. at 1087, 1108.

The plaintiffs in Mirkin had originally relied on the same

conclusory allegation made by plaintiffs here -- i.e., that each

plaintiff in the putative class had purchased securities "in

reliance on said misrepresentations." Id. at 1088. When the

Mirkin plaintiffs "conceded they could not plead that they had

actually read or heard the alleged misrepresentations," the trial

court sustained the demurrers with leave to amend. Id. Upon

amendment, plaintiffs attempted to evade this "eyeball reliance"

requirement by invoking the "fraud on the market" theory as a

substitute for reliance, a tactic rejected by the California

Supreme Court. Thus, Mirkin makes clear that there is an "eyeball

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reliance" requirement, i.e., that a plaintiff cannot maintain a

fraud claim unless he or she "actually read or heard the alleged

misrepresentations." Plaintiffs here have not pleaded that they

actually read or heard the alleged misrepresentations.⁵ In an effort to rescue their fraud claim and avoid the holding

in Mirkin, plaintiffs cite to Dake v. Smith, 105 Cal. App. 2d 808,

810 (1951), and argue that "[i]t is sufficient for plaintiffs to

simply plead that they relied upon the misrepresentation and acted

thereon. . . ." Opp. at 13. This is unavailing because the

plaintiff in that case alleged that the misrepresentations were

made directly to him -- in other words, that he "actually . . .

heard the alleged misrepresentations." Mirkin, 5 Cal. 4th at 1088

(emphasis added).

In short, plaintiffs' boilerplate allegation that they "relied

on one or more of the false statements alleged herein" is no

different than the conclusory allegation rejected in Mirkin, i.e.,

that plaintiffs purchased their securities "in reliance on said

misrepresentations."^{6
⁵ Plaintiffs accuse defendants of distorting Mirkin. The
California Supreme Court, however, necessarily concluded that the
Mirkin plaintiffs' boilerplate allegations of reliance were not
sufficient. Otherwise, it would not have affirmed the order
sustaining the demurrer. By affirming, the California Supreme
Court implicitly approved of the trial court's inquiry into whether
plaintiffs could plead "that they had actually read or heard the
alleged misrepresentations." Mirkin, 5 Cal.4th at 1088.

⁶ Plaintiffs also fail to plead the element of reliance with the
required specificity. See Goldrich v. Natural Y Surgical
Specialties, Inc., 25 Cal. App. 4th 772, 783 (1994) ("Reliance is
alleged in equally insufficient terms, with no explanation of how
Mrs. Goldrich could have relied upon something she cannot now
describe in any fashion.").

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that analyst reports were merely "based on" information provided by

the Company, with no indication of what the Company actually said,

who said it, to whom, when, or where.⁷ This type of "hide the

ball" pleading is insufficient under California law. Where fraud

is alleged, 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 (quoting Stansfield v.

Starkey, 220 Cal. 3d 59, 73 (1990)).

Federal cases reinforce the conclusion that plaintiffs'

allegations are defective because they fail to adequately allege

entanglement with, or adoption of, analysts' statements. 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)

specific interactions between the insider and the analyst; and (3)

dates on which the interactions occurred." In re Ross Sys. Sec.

Litig., [1994-95 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,363, at

90,499 (N.D. Cal. July 21, 1994). The Ninth Circuit recently

reinforced this entanglement requirement in In re Syntex Corp. Sec.

Litig., 95 F. 3d 922, 934 (9th Cir. 1996) (citation omitted),

holding that statements of analysts may not be attributed to

defendants unless plaintiff pleads facts showing that "'defendants.

. . put their imprimatur, express or implied, on the

[statements].'" "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 contributed to the

analysts' reports." In re Wall Data Sec. Litig., No. C95-0528Z,

1995 U.S. Dist. LEXIS 19812, at *22, 26 (W.D. Wash. Sept. 13, 1995)

(emphasis added); Syntex, 95 F. 3d at 934 (allegation that

analysts' "statements were the culmination of a one-way flow of

____________________

⁷ See Complaint ¶31 (alleging that the Montgomery report was
"[b]ased upon the Company's representations" and "conversations
with defendants Schroeder and Filler"); ¶33 (alleging that after
"additional conversations between [analyst] Schroeder and
defendant" concerning Diamond's business, "Montgomery . . .
increased EPS projections for 1996 and 1997"); ¶35 (alleging that
analyst made recommendation "based upon comments of defendant
Schroeder"); ¶37 (alleging that Donaldson report was "based on
information provided by defendants"); ¶47 (alleging that report was
"based on information provided to [analyst] by defendants Filler
and Schroeder"); ¶49 (analyst reports forecasting gross margins
were "based on conversations with the defendants"); ¶53 (alleging
that report was "based upon [analyst's] conversations with
defendants Schroeder and Filler").

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information, from Syntex representatives to analysts and from the

analysts to their customers" was insufficient). See Def. Mem. at

8-11. Plaintiffs here have not met these pleading requirements.⁸ It is clear from the vagueness of plaintiffs' pleading that

plaintiffs have merely identified statements made independently by

non-party analysts and are simply asserting -- with no factual

basis whatsoever -- that the statements made by these non-parties

should be attributed to Diamond. It is fundamentally unfair to

subject Diamond to fraud charges and the cost of defense where

plaintiffs cannot plead the specific facts required to justify

attributing those non-party statements to Diamond.

V. CONCLUSION

Defendants respectfully request that their demurrer be

sustained, or alternatively, that their motion to strike be

granted.

Dated: November 25, 1996 WILSON, SONSINI, GOODRICH & ROSATI

/s/
By _______________________________
Terry T. Johnson

Attorneys for Defendants
WILLIAM J. SCHROEDER, GARY B.
FILLER, HYUNG HWE HUH and DIAMOND
MULTIMEDIA SYSTEMS, INC.

____________________

⁸ Plaintiffs assert that defendants adopted analyst reports by
distributing them "for example, in Diamond's 'Corporate
Backgrounder'." Pl. Opp. at 15; Cmplt ¶40. This assertion is
inadequate to plead adoption of the contents of any analyst report.
Plaintiffs fail to allege (i) which reports were supposedly
included in these Corporate Backgrounders (and therefore allegedly
adopted by Diamond), and (ii) what statements of endorsement, or
non-endorsement, were made when Diamond purportedly distributed
these analyst reports. See Freedman v. Louisiana Pacific Corp.,
922 F. Supp. 377, 391-392 (D. Or. 1996) (allegation that analysts'
statements were published in reliance on false information received
"through its officers and 'its investors' relations package'" were
deficient).

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18 Feb 1997