BRUCE G. VANYO, State Bar # 060134
JEROME F. BIRN, JR., State Bar # 128561
IGNACIO E. SALCEDA, State Bar # 164017
TRACY L. TOSH, State Bar #184666
WILSON SONSINI GOODRICH & ROSATI
Professional Corporation
650 Page Mill Road
Palo Alto, California 94304-1050
Telephone: (415) 493-9300

Attorneys for Defendants
NETMANAGE, INC., ZVI ALON, WALTER
AMARAL, UZIA GALIL, JOHN BOSCH
and ROBERT WILLIAMS

NOTICE OF MOTION

MEMORANDUM OF POINTS AND AUTHORITIES

INTRODUCTION AND SUMMARY OF ARGUMENT

ALLEGATIONS OF THE COMPLAINT

ARGUMENT

I. THE COMPLAINT FAILS TO SATISFY THE REFORM ACT'S HEIGHTENED PLEADING STANDARD

A. The Reform Act Dramatically Strengthened Prior Law

B. The Complaint's "Basis of Allegations" Paragraph Is Insufficient As A Matter Of Law

C Plaintiffs Do Not Plead Specific Facts Showing That NetManage's Accounting For Distributor Revenue Was Even Incorrect, Let Alone Fraudulent

D. The Non-Accounting Statements Cannot Support A Claim

1. The Complaint Pleads No Facts That Justify Imputing to Defendants Statements Made by Smith Barney Analysts

2. Statements Of Historical Fact And Vague Statements of Optimism Do Not Support A Claim of Fraud

E. The Individual Defendants' Stock Sales Do Not Provide The Missing "Strong Inference" If Fraudulent Intent

II. PLAINTIFFS FAIL TO PLEAD THAT DEFENDANTS GALIL, BOSCH, OR WILLIAMS MADE ANY FALSE STATEMENT

CONCLUSION

CASES

Acito v. IMCERA Group, Inc.,
     47 F.3d 47, 54 (2d Cir. 1995)

Branch v. Tunnell,
     14 F.3d 449 (9th Cir. 1994)

Central Bank of Denver, N.A. v. First Interstate Bank of Denver , N.A.,
     511 U.S. 164 (1994)

Duncan v. Pencer,
     [1995-1996 Tr. Binder] Fed. Sec. L. Rep. (CCH)
     ¶ 99,043 (S.D.N.Y. Jan. 18, 1996)

Ernst & Ernst v. Hochfelder,
     425 U.S. 185, 197 (1976)

Friedberg v. Discreet Logic Inc.,
     959 F. Supp. 42 (D. Mass. 1997)

Garcia v. United States,
     469 U.S. 70 (1984)

Hockey v. Medhekar,
     No. C-96-0815 MHP, 1997 U.S. Dist. LEXIS 8558
     (N.D. Cal. Apr. 18, 1997)

In re Apple Computer Sec. Litig.,
     886 F.2d 1109 (9th Cir. 1989)

In re Caere Corp. Sec. Litig.,
     837 F. Supp. 1054 (N.D. Cal. 1993)

In re Genentech, Inc. Sec. Litig.,
     [1989 Tr. Binder] Fed. Sec. L. Rep.
     (CCH) ¶ 94,544 (N.D. Cal. July 7, 1989)

In re GlenFed, Inc. Sec. Litig.,
     42 F.3d 1541 (9th Cir. 1994)(en banc)

In re GlenFed, Inc. Sec. Litig.,
     60 F.3d 591 (9th Cir. 1995)

In re Gupta Corp. Sec. Litig.,
     900 F. Supp. 1217 (N.D. Cal. 1994)

In re Kelly,
     841 F.2d 908 (9th Cir. 1988)

In re Ross Systems Sec. Litig.
     [1994-1995 Tr. Binder] Fed. Sec. L. Rep.
     (CCH) ¶ 98,363 (N.D. Cal. July 21, 1994)

In re Stac Elecs. Sec. Litig.,
     82 F.3d 1480 (9th Cir.), superseded, 89 F.3d 1399
     (9th Cir. 1996), cert. denied, 117 S. Ct. 1105 (1997)

In re Stac Elecs. Sec. Litig.,
     89 F.3d 1399 (9th Cir. 1996),
     cert. denied, 117 S. Ct. 1105 (1997)

In re Silicon Graphics, Inc. Sec. Litig.,
[1996-1997 Tr. Binder] Fed. Sec. L. Rep.
     (CCH) ¶ 99,325 (N.D. Cal. Sept. 26, 1996)

In re Silicon Graphics, Inc. Sec. Litig.,
     No. 96-0393 FMS, 1997 U.S. Dist. LEXIS 7551
     (N.D. Cal. May 23, 1997)

In re Software Publishing Sec. Litig.,
     [1993-1994 Tr. Binder] Fed. Sec. L. Rep.
     (CCH) ¶ 98,094 (N.D. Cal. Feb. 2, 1994)

In re Syntex Corp. Sec. Litig.,
     855 F. Supp. 1086 (N.D. Cal. 1995),
     aff'd, 95 F.3d 922 (9th Cir. 1996)

In re Worlds of Wonder Sec. Litig.,
     35 F.3d 1407 (9th Cir. 1994),
     cert. denied, 116 S. Ct. 277 (1995)

Kramer v. Time Warner, Inc.,
     937 F.2d 767 (2d Cir. 1991)

Leonard v. NetFRAME Systems, Inc.,
     [1995-1996 Tr. Binder] Fed. Sec. L. Rep.
     (CCH) ¶ 98,982 (N.D. Cal. Aug. 8, 1995)

Lilley v. Charren,
     [1995-1996 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 99,092
     (N.D. Cal. Feb. 23, 1996)

Lovelace v. Software Spectrum Inc.,
     78 F.3d 1015 (5th Cir. 1996)

Mack v. South Bay Beer Distrib.,
     798 F.2d 1279 (9th Cir. 1986)

Marksman Partners v. Chantal Pharmaceutical Corp.,
     927 F. Supp. 1297 (C.D. Cal. 1996)

Medhekar v. United States District Court,
     99 F.3d 325 (9th Cir. 1996)

Neubronner v. Milken,
     6 F.3d 666 (9th Cir. 1993)

O'Sullivan v. Trident Microsystems, Inc.,
     [1993-1994 Tr. Binder] Fed. Sec. L. Rep.
     (CCH) ¶ 98,116 (N.D. Cal. Jan. 31, 1994)

Powers v. Eichen,
     Civ. 91-1431-B (AJB) (S.D. Cal. Mar. 13, 1997)

Rehm v. Eagle Fin. Corp.,
     954 F. Supp. 1246 (N.D. Ill. 1997)

Resolution Trust Corp. v. Gallagher,
     10 F.3d 416 (7th Cir. 1993)

Rogal v. Costello,
     [1992-1993 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 97,245
     (N.D. Cal. Oct. 8, 1992)

San Leandro Emerg. Med. Group Profit Sharing Plan v. Philip Morris Cos.,
     75 F.3d 801 (2d Cir. 1996)

Siegel v. Lyons,
     [1996-1997 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 99,227
     (N.D. Cal. Apr. 26, 1996)

Spiegler v. Wills,
     60 F.R.D. 681 (S.D.N.Y. 1973)

Stack v. Lobo,
     No. 95-20049-SW, 1995 WL 241448 (N.D. Cal. Apr. 20, 1995)

Weisel v. Kennedy,
     No. C-95-4472-THE (N.D. Cal. Nov. 12, 1996)

Zeid v. Kimberly,
     No. 96-20136 SW (N. D. Cal. May 6, 1997)

Zuber v. Allen,
     396 U.S. 168 (1969)

STATUTES AND RULES

Securities Exchange Act of 1934, Section 20(a),
     15 U.S.C. § 78t

Securities Exchange Act of 1934, Section 21D,
     15 U.S.C. § 78u-4

Securities Exchange Act of 1934, Section 21E(f),
     15 U.S.C. § 78u-5(f)

Securities and Exchange Commission Rule 10b-5,
     17 C.F.R. § 240.10b-5

Fed. R. Civ. P. 9(b)

Fed. R. Civ. P. 12(b)(6)

OTHER LEGISLATIVE MATERIALS

Private Securities Litigation Reform Act of 1995

H.R. Conf. Rep. No. 104-369, 104th Cong., 1st Sess. (1995)

Presidential Veto Message, H.R. Doc. No. 104-150, 104th Cong., 1st Sess. (1995)

Amend. 1485, S. 240, 104th Cong., 1st Sess. (1995)

On September 29, 1997 at 9:00 a.m., Defendants NetManage, Inc., Zvi Alon, Walter Amaral, Uzia Galil, John Bosch, and Robert Williams ("Defendants") will and hereby do move to dismiss all claims alleged in the Complaint, pursuant to Fed. R. Civ. P. 12(b)(6) and the Private Securities Litigation Reform Act of 1995 ("Reform Act"), which added Section 21D to the Securities Exchange Act of 1934, 15 U.S.C. § 78u-4 ("Exchange Act").¹

The issues presented in this motion are: (1) whether plaintiffs' Complaint has alleged with particularity facts giving rise to a "strong inference" that defendants accounting for distributor revenue was both incorrect and done with fraudulent intent, as required by Sections 21D(b)(1) & (2) of the Reform Act; (2) whether plaintiffs' Complaint has alleged with particularity facts giving rise to a "strong inference" that defendants' statements were false and made with fraudulent intent, as required by Sections 21D(b)(1) & (2) of the Reform Act; (3) whether plaintiffs have alleged specific facts showing that statements by securities analysts may be imputed to defendants; (4) whether defendants Galil, Bosch, and Williams may be liable under Section 10(b) where they are not alleged to have made a single false statement.

In December 1995, "prompted by significant evidence of abuse in private securities lawsuits," Congress enacted the Private Securities Litigation Reform Act of 1995 ("Reform Act"). H.R. Conf. Rep. No. 104-369, 104th Cong., 1st Sess. 31 (1995) ("Conf. Rep.").² The Reform Act created "heightened" standards for pleading and proving securities fraud that are much more rigorous than prior law in the Ninth Circuit. Today, in order to survive a motion to dismiss, a complaint must plead all facts in plaintiffs' possession that support their belief that defendants made a false statement. Those facts, in turn, must give rise to a "strong inference" that each defendant acted with the required fraudulent intent.

The Complaint centers on NetManage's announcement on January 12, 1996, that revenue for its fourth quarter of 1995 would be between $30 million - $32 million, compared to market expectations of $34 million - $35 million. See Complaint ¶ 51.³ NetManage explained that while it had "record bookings" in the fourth quarter, it was "not able to recognize some of these bookings as revenue due to our accounting policies." Complaint ¶ 52. This is the statement that plaintiffs allege disclosed a massive accounting fraud. On its face, this statement does not even suggest accounting errors, let alone hint at a fraud. NetManage merely announced that by complying with its accounting policies, it would report a "disappointing" fourth quarter despite record order bookings.

This is the fundamental problem infecting the entire Complaint. Plaintiffs have simply taken NetManage's innocent disclosure that it was complying with its accounting policies, leading to a mildly disappointing revenue shortfall in the fourth quarter, and speculated wildly that NetManage had been improperly recognizing revenue from its distributors throughout 1995. Completely absent from the Complaint is a single specific fact to support plaintiffs' speculation that NetManage fraudulently accounted for distributor revenue during 1995. Plaintiffs do not identify a single transaction that they claim was accounted for improperly. NetManage was never required to publish restated financial statements for prior fiscal periods to correct its accounting. NetManage did not experience a sharp rise in product returns or sales return reserves. The January 12 press release does not even attribute NetManage's revenue shortfall to its distributors. In short, there are no facts alleged that would even suggest a fraud.

This Complaint would have to be summarily dismissed even without the "heightened" pleading standards of the Reform Act. Prior Ninth Circuit law would have compelled dismissal because the Complaint relies on unsubstantiated allegations of accounting fraud. It is a paradigm of "fraud-by-hindsight," mere speculation from a company's later disclosure of bad news that defendants must have known of the bad news earlier and fraudulently concealed it. Indeed, this Complaint takes fraud-by-hindsight to a new level of cynicism. Plaintiffs are speculating that an accounting fraud occurred based on NetManage's disclosure that it was complying with its accounting policies, and where there never was any disclosure that anything was wrong with NetManage's accounting. If this were sufficient to state a fraud claim, every company that complies with its accounting policies could be sued for securities fraud whenever it reported a sales shortfall. For this reason, courts have long thrown out speculative claims of fraud based on unidentified accounting errors.

Application of the Reform Act's rigorous new pleading standards just means that this Complaint should be dismissed without hesitation. Plaintiffs are required to allege all facts in their possession supporting their allegation that NetManage was accounting improperly for distributor revenue, and those facts must give rise to a strong inference that defendants knew that NetManage's accounting was fraudulent. The Complaint alleges no facts. The Court can only conclude that plaintiffs have no facts. Plaintiffs plea that discovery will reveal the factual details to support their allegations runs into the brick wall of the Reform Act's discovery stay. 15 U.S.C. § 78u-5(f). As the Ninth Circuit explained in Medhekar v. United States District Court, "Congress clearly intended that complaints in these securities actions should stand or fall based on the actual knowledge of the plaintiffs rather than information produced by the defendants after the action has been filed." 99 F.3d 325, 328 (9th Cir. 1996) (emphasis added).

NetManage is the company that developed networking software to allow Windows-based computers to use the Internet. From revenue of less than $1 million in 1991, NetManage grew spectacularly to revenue of $71.5 million in 1994. The putative class period focuses on the third and fourth quarters of 1995.

The class period begins on July 25, 1995, with NetManage's announcement of financial results for its second quarter: revenue of $30.2 million 150 percent growth compared to the prior-year quarter and net income of $6.8 million, yielding earnings of $0.16 per share. Complaint ¶ 29. On October 24, 1995, NetManage announced its results for the third quarter: revenue of $32.7 million a 97 percent increase over the prior-year quarter and net income of $7.4 million, yielding earnings of $0.18 per share. Complaint ¶ 42.

The class period ends with NetManage's January 12, 1996 disclosure that results for the fourth quarter would be below the market's expectations, despite record bookings, because NetManage was "not able to recognize some of these bookings as revenue due to our accounting policies." Complaint ¶ 52. On this news, NetManage's stock declined from $14.56 to $10.87 per share. Nevertheless, NetManage still reported a profitable fourth quarter: revenue of $31.2 million, net income of $3.3 million, and earnings of $0.08 per share. More significantly, results for the entire year were extraordinary: NetManage's annual revenue of $125.4 million represented a 75 percent increase over 1994. Complaint ¶ 53.

Plaintiffs waited almost a year before filing this action on January 10, 1997. The day before, the same plaintiffs and the same counsel filed an identical complaint in Santa Clara County Superior Court, alleging violations of state securities laws. Head v. NetManage, Inc., No. 07763295 (Santa Clara Super. Ct.).

Plaintiffs' Complaint alleges that, on July 25 and October 24, 1995, defendants published false financial statements about NetManage's second and third quarters, respectively. Complaint ¶¶ 32, 44, 57-65. Plaintiffs allege that these financial statements were false because NetManage was recognizing revenue improperly on distributor sales; specifically, plaintiffs allege that NetManage was recognizing revenue on sales where distributors had a right of return or there were other contingencies. Complaint ¶¶ 57-65.

The Complaint also alleges that, on July 25 and October 24, 1995, defendants made false statements about NetManage's future prospects. Plaintiffs allege that defendants knew that these statements were false because they knew that NetManage's accounting was improper.

Finally, during the class period, stock analysts at Smith Barney published reports about NetManage. Plaintiffs allege that defendants are liable for the opinions expressed by these analysts as if defendants had voiced these opinions themselves. Complaint ¶¶ 34-37, 40, 49, 51.

Plaintiffs claim that defendants violated Section 10(b) of the Exchange Act, and SEC Rule 10b-5, promulgated thereunder. 17 C.F.R. § 240.10b-5. Plaintiffs also claim that defendants Alon and Amaral are liable under Section 20(a) of the Exchange Act as "controlling persons" of NetManage.

All of plaintiffs' allegations of fraud are premised on the mistaken belief that NetManage was accounting incorrectly for distributor sales revenue. Because plaintiffs do not plead any specific facts demonstrating that NetManage was in fact doing this, plaintiffs have not pleaded specific facts giving rise to a "strong inference" that NetManage was acting fraudulently, and the entire Complaint comes tumbling down.

I. THE COMPLAINT FAILS TO SATISFY THE REFORM ACT'S HEIGHTENED PLEADING STANDARDS

A. The Reform Act Dramatically Strengthened Prior Law.

This Complaint would have been dismissed even under prior Ninth Circuit law. Plaintiffs could not have pled a case of accounting fraud without identifying the specific transactions that were allegedly fraudulent and showing that the amounts in question were material. As the Ninth Circuit explained in In re GlenFed, Inc. Securities Litigation, "[i]n order to allege the circumstances constituting fraud, plaintiff 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." 42 F.3d 1541, 1549 (9th Cir. 1994) (en banc); In re Worlds of Wonder Sec. Litig. 35 F.3d 1407, 1426 (9th Cir. 1994), cert. denied, 116 S. Ct. 277 (1995).

The Reform Act dramatically raises the standard for pleading falsity. Congress found that existing law was permitting "the routine filing of lawsuits . . . whenever there is a significant change in an issuer's stock price, without regard to any underlying culpability of the issuer, and with only faint hope that the discovery process might lead eventually to some plausible cause of action . . . ." Conf. Rep. at 31.⁴ Congress found that Rule 9(b) was not tough enough to"prevent[] abuse of the securities laws by private litigants." Id. at 41. To cure these abuses, Congress expressly created a new, "[h]eightened pleading standard" with "uniform and more stringent pleading requirements to curtail the filing of meritless lawsuits." Id. (emphasis added).

The Reform Act requires plaintiffs to plead with particularity each statement alleged to be misleading and to set forth in detail "the reasons why the statement is misleading." 15 U.S.C. § 78u-4(b)(1)(B). Because plaintiffs' allegations are made on information and belief, plaintiffs must "state with particularity all facts on which that belief is formed." Id. (emphasis added). The Conference Report leaves no doubt that Congress means what it said: "If an allegation is made on information and belief, the plaintiff must state with particularity all facts in the plaintiff's possession on which the belief is formed." Conf. Rep. at 41 (emphasis added). A complaint that does not meet these requirements "shall" be terminated at the pleading stage. 15 U.S.C. § 78u-4(b)(3)(A) (emphasis added)).

Those particularized facts must satisfy the Reform Act's rigorous new standard for pleading scienter. It requires plaintiffs to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." § 21D(b)(2) (emphasis added). This is a dramatic change from prior Ninth Circuit law, which rejected any form of an "inference" test, and allowed scienter to be averred "generally," without any factual basis, "simply by saying that scienter existed." GlenFed, 42 F.3d at 1545, 1547.

Congress expressly rejected the Ninth Circuit's scienter standard.⁵ The Reform Act's "strong inference" pleading standard "is based in part on the pleading standard of the Second Circuit." Conf. Rep. at 41 (emphasis added). To satisfy the Second Circuit's "strong inference" standard, a plaintiff was required to allege either (i) specific facts that "constitut[e] circumstantial evidence of reckless conscious misbehavior," or (ii) "motive and opportunity to commit fraud." San Leandro Emerg. Med. Group Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801, 812-13 (2d Cir. 1996). Although the Second Circuit's standard was "[r]egarded as the most stringent pleading standard," Congress intended to "strengthen" even that tough standard. Congress therefore expressly rejected the "motive and opportunity" and "recklessness" parts of that standard:

Because the Conference Committee intends to strengthen existing pleading requirements, it does not intend to codify the Second Circuit's case law interpreting this pleading standard.FN23/

FN23/ For this reason, the Conference Report chose not to include in the pleading standard certain language relating to motive, opportunity, or recklessness.

Conf. Rep. at 41 & n.23.

The legislative history leaves no doubt that Congress intended to eliminate "motive and opportunity" and "recklessness" as a basis to plead fraudulent intent. The Senate Bill included an amendment proposed by Senator Specter, which would have codified the "motive and opportunity" and "recklessness" parts of the Second Circuit standard. Amend. 1485, S. 240, 104th Cong., 1st Sess. (1995) (Tosh Decl. Ex. C.) The Conference Committee eliminated the Specter Amendment from the final version of the bill, which Congress passed. In vetoing the bill, President Clinton wrote that he could not agree with the deletion of the Specter amendment.⁶ Notwithstanding the President's objections, Congress overrode his veto for the first (and, so far, only) time and passed the Conference Committee's bill.

Several courts have held that the Conference Report, combined with this legislative history, establishes that Congress created a "heightened" pleading standard by eliminating the Second Circuit's "motive and opportunity" and "recklessness" prongs. Judge Smith has twice scrutinized the "strong inference" standard and come to the same conclusion: "In order to state a private securities fraud claim, plaintiffs must create a strong inference of knowing or intentional misconduct." In re Silicon Graphics, Inc. Sec. Litig., No. 96-0393 FMS, 1997 U.S. Dist. LEXIS 7551, at *29 (N.D. Cal. May 23, 1997) ("Silicon Graphics II") (Tosh Decl. Ex. B) (citing Ernst & Ernst v. Hochfelder, 425 U.S. 185, 197 (1976)); In re Silicon Graphics, Inc. Sec. Litig., [1996-1997 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 99,325, at 95,961-62 (N.D. Cal. Sept. 26, 1996) ("Silicon Graphics I") (only approach permitted under Reform Act to plead a strong inference of fraud is to allege specific facts constituting "circumstantial evidence of conscious behavior by defendants."); Friedberg v. Discreet Logic Inc., 959 F. Supp. 42, 49-50 & n.2 (D. Mass. 1997) (Reform Act requires "intent to defraud or knowledge of the falsity"); Powers v. Eichen, Civ. 91-1431-B (AJB), slip op. at 9 (S.D. Cal. Mar. 13, 1997) (Tosh Decl. Ex. E).⁷

B. The Complaint's "Basis of Allegations" Paragraph Is Insufficient As A Matter Of Law.

The Complaint does not meet the Reform Act's rigorous standards. Plaintiffs start with NetManage's statement that its accounting policies prevented it from recording as revenue some of its record order bookings. Plaintiffs then leap to the unreasonable inference that NetManage had been cooking its books by improperly recording distributor revenue earlier in the year. Entirely absent from the Complaint are specific factual allegations about the supposedly fraudulent distributor sales, or specific allegations concerning any events that constitute the allegedly "true" state of affairs when defendants made the allegedly false statements.

Plaintiffs offer nothing but a boilerplate paragraph titled "Basis of Allegations":

Plaintiffs have alleged the foregoing based upon the investigation of their counsel, which included a review of NetManage's SEC filings, securities analysts reports and advisories about the Company, press releases issued by the Company, media reports about the Company and discussions with consultants, and believe that substantial evidentiary support will exist for the allegations set forth ¶¶ 1, 4-9, 17-24, 26, 33, 42, 45, 49-55, 57, 62-66, 68-71 and 73-74 after a reasonable opportunity for discovery.

Complaint ¶ 81. This paragraph does not even attempt to "state with particularity all facts" that form plaintiffs' belief that NetManage committed fraud. Rather, plaintiffs tacitly admit that they require discovery to provide factual support for that belief. The Complaint should be dismissed on this basis alone. See Reform Act § 21D(b)(3)(B), 15 U.S.C. § 78u-4(b)(3)(B) (all discovery shall be stayed during the pendency of a motion to dismiss); Medhekar, 99 F.3d at 328.

Courts applying the Reform Act have expressly rejected the Complaint's conclusory form of pleading. Judges Patel and Smith both have recently dismissed complaints with virtually identical "Basis of Allegations" paragraphs. Judge Patel held that "the [Reform Act], as is evidenced by its strict prohibition of discovery during the pendency of a motion to dismiss, was enacted in part to require plaintiffs to make a showing that the statements at issue were false or misleading prior to discovery." Hockey v. Medhekar, No. C-96-0815 MHP, 1997 U.S. Dist. LEXIS 8558, at *21 (N.D. Cal. Apr. 18, 1997) (Tosh Decl. Ex. F.); Silicon Graphics I, at 95,966 & n. 11 (dismissing complaint; allegations of unspecified "negative internal reports" were boilerplate and identical to five other class action complaints).

Plaintiffs allege no factual basis to believe that defendants knew that NetManage's accounting for distributor revenue was fraudulent or even incorrect. Other than paragraph 81, the Complaint has nothing but boilerplate allegations that defendants received "frequent and extensive information on the success distributors were having in selling the Company's products," or that NetManage's sales force "communicated regularly, both in written and oral form with the top executives regarding failures of certain of the products to sell-through to the extent previously anticipated and as to significant contingencies which remained as to certain of the Company's 'sales.'" Complaint ¶ 23. To date, three different Judges in this District applying the Reform Act have expressly rejected allegations of fraud based on unspecified "internal company reports."

In both Silicon Graphics I and Silicon Graphics II, Judge Smith held that such allegations are insufficient as a matter of law. Judge Smith reasoned that every company's management receives reports from its sales force and other internal reports. If the mere allegation that these reports were "negative" were sufficient, any public company could be sued for fraud whenever its stock price dropped the evil the Reform Act was intended to prevent.Silicon Graphics II, at *62. See also Silicon Graphics I, at 96,966. Judge Patel reached the same conclusion in Hockey v. Medhekar:

C. Plaintiffs Do Not Plead Specific Facts Showing That NetManage's Accounting For Distributor Revenue Was Even Incorrect, Let Alone Fraudulent.

The core of the Complaint is the allegation that NetManage fraudulently recognized revenue on distributor sales to its distributors. Complaint ¶¶ 57, 62. Plaintiffs have concocted this accounting claim from the flimsiest of foundations: NetManage's decision to change between two admittedly acceptable policies of accounting for distributor sales.

Plaintiffs started with NetManage's January 12, 1996 statement that, despite record bookings in the fourth quarter, the company was "not able to recognize some of these bookings as revenue due to our accounting policies." Complaint ¶ 52. From this statement that NetManage was complying with its accounting policies in the fourth quarter, plaintiffs infer that NetManage had been violating those policies in prior quarters. Plaintiffs next compared the accounting policy for distributor sales that NetManage disclosed in its 1995 annual report, and compared it to the policy disclosed in the 1994 annual report. The two policies differ. In 1994, if sales to distributors were subject to a right of return, NetManage estimated the likely returns and set up a sales return reserve, which reduced revenue accordingly.⁹ In 1995, NetManage simply deferred recognizing any revenue on distributor sales until the product was sold by the distributor.¹⁰ Seizing upon this change in accounting policies, plaintiffs' allege that the prior policy must have been not only wrong but the product of fraud.

Plaintiffs do not allege any factual basis to support their nefarious interpretation of NetManage's simple change in accounting policy. Plaintiffs do not and could not allege that either the 1994 or the 1995 method of accounting for distributor sales was incorrect. Thus, even under prior law, plaintiffs would not have alleged facts showing that NetManage's accounting was even incorrect when it published its financial statements. GlenFed, 42 F.3d at 1549 ("plaintiff must set forth, as part of the circumstances constituting the fraud, an explanation as to why the disputed statement was untrue or misleading when made."). In this District, both Judges Williams and Judge Jensen have not hesitated to dismiss accounting fraud allegations premised on nothing but management's choice among acceptable accounting practices.¹¹

Moreover, prior Second Circuit law, which the Reform Act strengthened, recognized that a mere change from one permissible accounting method to another permissible method does not amount to securities fraud as a matter of law. In Spiegler v. Wills, 60 F.R.D. 681 (S.D.N.Y. 1973), the court dismissed a securities complaint, explaining that "the mere allegation of a change in accounting procedure from one accepted practice to another is not sufficient in itself to state a claim upon which relief may be granted, no matter how characterized." Id. at 682-83. The court refused to allow plaintiff to take "neutral facts" and portray them in a sinister light. Id. at 683. "[I]t will not suffice to merely compare present accounting practices with past accounting practices and paste rote [fraud] allegations or action-seeking characterizations thereto. It is the office of a fraud complaint to seek redress for a wrong, not to find one." Id. at 683 (citation omitted).

Indeed, plaintiffs' allegations of fraud are especially improbable because, by the Complaint's own admission, NetManage's policy during the class period (1995) was more conservative than it had been in 1994: rather than recording distributor sales as revenue and trying to estimate the correct sales return reserve (1994 policy), NetManage waited to recognize revenue until its distributors had sold the product to end-users (1995 policy), thereby eliminating any risk that its sales return reserve could be inadequate.¹² NetManage would not have adopted more conservative accounting policies if, as plaintiffs contend, defendants were trying to hype the stock by publishing false financial statements.

Recognizing the weakness of their claim, plaintiffs speculate that NetManage changed its policy in the fourth quarter because "it was in the midst of an audit by its outside accountants who were analyzing the contract terms NetManage had granted many of its reseller customers," and that this caused the fourth quarter revenue shortfall. Complaint ¶ 63. The Complaint, however, does not allege any specific facts to support the allegation that the auditors uncovered accounting errors at the end of 1995. Plaintiffs are simply speculating that, because public companies always are audited after each fiscal year, the accountants must have discovered a fraud. Plaintiffs pointedly overlook that the accountants, the national firm of Arthur Andersen LLP, audited the Company's 1995 financial statements and opined that they complied with generally accepted accounting principles. There are no allegations that Arthur Andersen qualified their audit opinion in any way, or required NetManage to republish its financial statements for prior quarters to correct any improper accounting practices. See 1995 Annual Report at 35 (Tosh Decl. Ex. I.) Arthur Andersen would not have unqualifiedly endorsed NetManage's financial statements for fiscal 1995 if they had discovered, as plaintiffs allege, that NetManage had been improperly recognizing distributor revenue in the first, second, and third quarters of 1995.

Plaintiffs are left with nothing but the most unspecific, generalized allegation that NetManage did not follow its accounting policies. Which sales to which distributors are being challenged? What were the contingencies? What were the amounts of the challenged sales? It is dispositive that plaintiffs cannot specifically identify a single improper transaction, let alone plead facts showing that NetManage's allegedly improper accounting was material to its financial statements in any fiscal quarter. Even before the Reform Act, numerous Judges in this District routinely rejected such allegations, demanding that plaintiffs identify with specificity the transactions they are challenging and show that the amounts in question were material. E.g., In re Ross Systems Sec. Litig. [1994-1995 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,363, at 90,498-99 (N.D. Cal. July 21, 1994) (Jensen, J.).¹³

Plaintiffs cannot just intone the names of Merisel, Ingram Micro, and Tech Data (the major distributors in computer retailing) to satisfy the requirement of identifying customers, transactions, or amounts. Any person telephoning the company can learn the names of its distributors. As Judge Williams stated recently in applying the Reform Act to dismiss similar accounting allegations with prejudice, "[s]imply listing customers and providing general, unsupported estimates of 'improper' sales does not meet the particularity requirements of Rule 9(b) and the Reform Act. Rather Plaintiffs must allege facts regarding the underlying transactions with particularity." Zeid v. Kimberley, slip op. at 28.

The only allegation suggesting that NetManage's accounting was improper is the deliberately mysterious allegation that "NetManage's senior management revealed to at least one analyst that contingency items had existed in customer orders in earlier financial periods." Complaint ¶ 55. Plaintiffs do not plead any facts to support this crucial and phony assertion. Which members of management? Which analyst did they tell? Which customer orders had contingencies? When did these contingencies exist? Were they material? Were NetManage's reserves inadequate? Even under prior law, the Ninth Circuit required such fundamental facts to be pleaded with particularity. E.g., In re Stac Elecs. Sec. Litig., 89 F.3d 1399, 1410 (9th Cir. 1996), cert. denied, 117 S. Ct. 1105 (1997). It is indeed striking that the Complaint quotes other statements from specifically identified analyst reports, but does not identify the source of this crucial allegation.¹⁴

Plaintiffs are merely speculating that NetManage's change from one acceptable accounting policy to another reveals a fraud. Plaintiffs allege no specific facts to support their speculation. Moreover, plaintiffs have failed to satisfy the most basic requirements of any financial fraud claim: they do not identify a single improper transaction, and demonstrate that the accounting error was material and the product of fraudulent intent.

D. The Non-Accounting Statements Cannot Support A Claim.

1. The Complaint Pleads No Facts That Justify Imputing to Defendants Statements Made by Smith Barney Analysts.

This Complaint is unique: it does not allege that defendants made a single specific financial forecast during the class period. Instead, plaintiffs' forecasting claims are based entirely on the opinions and forecasts published by stock analysts at Smith Barney. See Complaint ¶¶ 32, 33-35, 38, 40, 47, 49. Plaintiffs do not allege any specific facts, however, showing that defendants were so entangled with these analysts that defendants effectively adopted Smith Barney's statements as their own.

Ninth Circuit law on analyst entanglement is well developed. Courts have long refused to impose liability on defendants for analyst reports unless plaintiffs plead specific facts showing that "defendants . . . put their imprimatur, express or implied, on the projections." In re Syntex Corp. Sec. Litig., 95 F.3d 922, 934 (9th Cir. 1996) (quoting In re Stac Elecs. Sec. Litig., 82 F.3d 1480, 1492 (9th Cir.), superseded, 89 F.3d 1399 (9th Cir. 1996), cert. denied, 117 S. Ct. 1105 (1997)). The facts underlying defendants' alleged endorsement must be pleaded with particularity. Stac, 89 F.3d at 1410. Plaintiffs must "(1) identify specific 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 Caere Corp. Sec. Litig., 837 F. Supp. 1054, 1059 (N.D. Cal. 1993).¹⁵ The Reform Act's emphasis on particularized factual allegations, particularly where allegations are made on information and belief, means that courts should enforce Ninth Circuit entanglement law that much more strongly.

There can be no dispute that the Complaint fails to plead entanglement. It is devoid of specific factual allegations showing that defendants had anything to do with Smith Barney's reports, much less that defendants placed their "imprimatur" upon the reports. Which defendants provided information? What did they say? How were defendants' and the analyst's statements false? The Complaint is silent. Because plaintiffs do not plead any basis for attributing the Smith Barney reports to defendants, they cannot form a basis for liability.

2. Statements Of Historical Fact And Vague Statements of Optimism Do Not Support A Claim of Fraud.

The few remaining statements challenged by plaintiffs are either statements of historical fact or inactionable "puffery," vague expressions of optimism about the future. The Complaint recites at length from NetManage's quarterly press releases and SEC filings, and alleged statements made during conference calls and meetings with securities analysts. Complaint ¶¶ 29, 30, 32, 38, 41, 43, 44, 47. Most of the quoted material, however, merely describes NetManage's products and customers, repeats historical facts about concluded quarters or fiscal years, or announces acquisitions and strategic partnerships. Except for the alleged accounting improprieties, plaintiffs do not take issue with any of this historical information.

Plaintiffs challenge as false two vaguely optimistic statements made on July 25 and October 24, 1995, by Zvi Alon, NetManage's Chairman and Chief Executive Officer:

• "We are pleased with NetManage's financial performance during this quarter and our continued success in expanding our sales and support capabilities . . . "

• "We are very pleased that our investment in expanded products and services has enabled NetManage to continue with positive growth . . . . We have continued our leadership in TCP/IP applications . . . "

E. The Individual Defendants' Stock Sales Do Not Provide The Missing "Strong Inference" If Fraudulent Intent.

Plaintiffs allege that stock sales by the individual defendants provide circumstantial evidence of their fraudulent intent. Under the Reform Act, stock sales by defendants "will not support a strong inference of fraud unless the sales are unusual or suspicious." Silicon Graphics II, at *64 (citing Acito v. IMCERA Group, Inc., 47 F.3d 47, 54 (2d Cir. 1995)). Plaintiffs contend that the individual defendants' stock sales are suspicious because they supposedly sold a significant percentage of their NetManage stock holdings during the class period. Plaintiffs have understated the individuals' total holdings and thereby overstated the percentages each defendant allegedly sold.

Plaintiffs' huge mistake is to ignore the vested options that several of the individual defendants held. All of these options were as liquid as shares of stock, and could have been exercised and sold immediately; in fact, some of the stock sales at issue were same-day option exercises and sales. Judge Smith has twice applied the Reform Act to dismiss complaints. In both instances, Judge Smith recognized that, if stock sales are alleged to be evidence of scienter, the court must consider all of defendants' available holdings, including vested options. Silicon Graphics II, at *65; Silicon Graphics I, at 95,966-67 (citing Duncan v. Pencer, [1995-1996 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 99,043, at 94,208 (S.D.N.Y. Jan. 18, 1996)). The chart below summarizes defendants' sales and total holdings of NetManage stock:

Thus, the individual defendants did not "bail out" of NetManage stock. Collectively, they sold only 3.6 percent of the shares they could have sold, retaining 10,622,924 shares and vested options through the end of the class period. In Silicon Graphics, Judge Smith held that individual defendants' sales of only 10 percent of their total holdings was insufficient as a matter of law to give rise to a strong inference of fraud. Silicon Graphics II, at *66-68 (individuals' sales of 2.6%, 7.7%, 4.1%, and 6.9%, and overall sales of 10% of total holdings, do not raise strong inference of fraudulent intent).¹⁸

Moreover, the paltry amounts of stock sold by the key executives is strikingly inconsistent with a strong inference of fraud. Although, the core allegation is accounting fraud, NetManage's Chief Financial Officer, Walter Amaral who would be the "head chef" if NetManage were "cooking the books" did not sell a single share of stock during the class period. Likewise, NetManage's Chairman and Chief Executive Officer, Zvi Alon, who allegedly hyped the stock and would have to be the ringleader of any fraud, sold a mere 2.6 percent of his total holdings Mr. Alon held retained than 8.8 million shares of stock and options at the end of the class period. Sales of such minuscule percentages refute any inference of scienter as a matter of law.

Nor is the timing or pattern of the individuals' sales suspicious. Although the 37,400 shares sold by defendant Williams during the class period constituted 22 percent of his holdings, he had sold 45,800 shares during the first half of 1995 before the alleged fraud began. Likewise, defendant Galil, who sold 92,500 shares during the class period, had sold 119,000 shares during the first half of 1995. Defendant Alon also had a pattern of selling stock before the class period, selling 117,000 shares during the first half of 1995. Where a defendant's stock sales during the class period are lower than (or consistent with) his prior sales, the stock sales cannot give rise to a strong inference of fraud. Silicon Graphics II, at *66-68; Hockey, at *33 (dismissing complaint; "defendants sold more shares before the class period than they did during the class period and sold only a small percentage of their collective holdings").

II. PLAINTIFFS FAIL TO PLEAD THAT DEFENDANTS GALIL, BOSCH, OR WILLIAMS MADE ANY FALSE STATEMENT

In Central Bank of Denver, N.A. v. First Interstate Bank of Denver , N.A., 511 U.S. 164 (1994), the Supreme Court held that there is no cause of action for aiding and abetting a violation of Section 10(b). The Court held that Section 10(b) prohibits only "the making of a material misstatement (or omission) or the commission of a manipulative act" and does not impose liability on persons who merely "giv[e] aid to a person who commits a manipulative or deceptive act." Id. at 177 (emphasis added). The Ninth Circuit has held that Central Bank eliminated all non-statutory theories of secondary liability under Section 10(b). In re GlenFed, Inc. Sec. Litig., 60 F.3d 591, 592 (9th Cir. 1995). Thus, a defendant may be sued for securities fraud only where the allegations meet "all of the requirements for primary liability under Rule 10b-5." Central Bank, 511 U.S. at 191; Silicon Graphics II, at *36 (only primary participants in a Section 10(b) violation may be held liable).

In addition to the pleading defects relevant to all defendants, plaintiffs fail to state a claim against Galil, Bosch, or Williams because these defendants are not alleged to have made a false statement. Thus, plaintiffs have not stated a primary violation of Section 10(b). Neubronner v. Milken, 6 F.3d 666, 673 (9th Cir. 1993) (dismissing Section 10(b) claim where plaintiff failed to attribute false or misleading statement to defendant). Plaintiffs do not allege that these defendants are "controlling persons" of NetManage under Section 20(a) of the Exchange Act, 15 U.S.C. § 78t. Accordingly, all claims against these defendants must be dismissed.

For the foregoing reasons, defendants respectfully request that their motion to dismiss be granted.

¹ Defendant Richard Koretz has filed a separate motion to dismiss, and joins in this motion. Defendants Ben-Artzi and Geisler have not been served; accordingly, they do not appear and do not join this motion.

² Attached as Exhibit A to the Declaration of Tracy L. Tosh (Tosh Decl.) filed in support of defendants' motion to dismiss.

³ NetManage's Fiscal quarters are the same as the calendar year. The fourth quarter of 1995 ended on December 31, 1995.

⁴ As a matter of law, the Conference Report is the definitive statement of legislative intent: "[T]he authoritative source for finding the Legislature's intent lies in the Committee Reports on the bill, which 'represen[t] the considered and collective understanding of those Congressmen involved in drafting and studying proposed legislation.'" Garcia v. United States, 469 U.S. 70, 76, 10 F.3d 416, 421 (7th Cir. 1993)(conference report "is the most persuasive evidence of congressional intent besides the statute itself'); In re Kelly, 841 F.2d 908, 912 n.3 (9th Cir. 1988)(committee reports, not "[s]tray comments by individual legislators," provide the best expression of legislative intent.). See also In re Silicon Graphics, Inc. Sec. Litig., No. 96-0393 FMS, 1997 U.S. Dist. LEXIS 7551, at *27(N.D. Cal. May 23, 1997)(Tosh Decl. Ex. B.)

⁵ Congress concluded that Rule 9(b)'s particularity requirement, particularly as interpreted by the Ninth Circuit, "has not prevented abuse of the securities laws by private litigants" and has led to "conflicting ... distinctly different standards" among the courts of appeal. Conf. Rep. at 41.

⁶ President Clinton wrote: "The conferees deleted an amendment offered by Senator Specter and adopted by the Senate that specifically incorporated Second Circuit case law with respect to pleading a claim of fraud. Then they specifically indicated that they were not adopting Second Circuit case law but instead intended to 'strengthen' the existing pleading requirements of the Second Circuit. All this shows that the conferees meant to erect a higher barrier to bringing suit than any now existing." H.R. Doc. No. 104-150, 104th Cong., 1st Sess. (1995)(emphasis added)(Tosh Decl. Ex. D.)

⁷ Plaintiffs no doubt will argue that other courts have held that Congress was merely codifying the Second Circuit's strong inference standard. The courts, however, mistakenly did not consider the Conference Report to be the definitive statement of Congressional intent and ignored the importance of Congress' rejection of the Specter Amendment and the President's veto letter. E.g. Marksman Partners v. Chantal Pharmaceutical Corp., 927 F. Supp. 1297, 1311 (C.D. Cal. 1996); Rehm v. Eagle Fin. Corp., 954 F. Supp. 1246, 1251-52 (N.D. Ill. 1997). In any case, defendants note that this debate is truly academic here because this Complaint could not conceivable satisfy the prior tough standard applied in the Second Circuit.

⁸ Courts reached the same result under prior law. See Philip Morris, 75 F.3d at 801, 812-13 (requiring plaintiffs to specifically indentify alleged negative internal reports, providing names and dates); In re Syntex Corp. Sec. Litig., 855 F. Supp. 1086, 1095 (N.D. Cal. 1995)("[P]laintiffs' allegation that defendants possessed 'internal corporate data known only to them' comes nowhere close to satisfying Fed. R. Civ. P.9(b)."), aff'd, 95 F.3d 922 (9th Cir. 1996).