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WALTER W. HEAD, III, GREGORY SELMANSON, DOMINIC CASTALDO, LEILA WALDMAN and JOHN VELONIS, JR., On Behalf of Themselves and All Others Similarly Situated, Plaintiffs, v. NETMANAGE, INC., ZVI ALON, WALTER AMARAL, UZIA GALIL, JOHN BOSCH, AMATZIA BEN-ARTZI, ROBERT WILLIAMS, RICHARD KORETZ and DAN GEISLER, Defendants. __________________________________________ |
) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) | CASE NO.: C-97-20061-JW DEFENDANTS' MOTION TO PRESERVE AND ENFORCE THE MANDATORY DISCOVERY STAY OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 Date: September 15, 1997 Time: 9:00 a.m. Before: The Hon. James Ware |
TABLE OF CONTENTS
MEMORANDUM OF POINTS AND AUTHORITIES
B. Defendants Have Exhausted Their Options At An Informal Resolution And Before The Superior Court
II. THE COURT HAS THE POWER TO PREVENT DISCOVERY IN THE STATE CASE FROM BEING USED IN THIS ACTION
On September 15, 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 for an Order pursuant to the Private Securities Litigation Reform Act of 1995 ("Reform Act"), the All Writs Act, 28 U.S.C. § 1651, and Fed. R. Civ. P. 26(c), for an Order preventing Lead Plaintiffs and Lead Plaintiffs' Counsel from using any discovery obtained in the parallel state case in this action during such time as the Reform Act's mandatory discovery stay is in effect.
"[P]rompted by significant evidence of abuse in private securities lawsuits," Congress enacted the Private Securities Litigation Reform Act of 1995, H.R. Conf. Rep. No. 104-369, 104th Cong., 1st Sess. 31 (1995) ("Conf. Rep.").1 Foremost among the abusive practices that Congress identified was "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[.]" Id.
Congress' remedy for this abuse was a mandatory stay of discovery pending a motion to dismiss. The discovery stay is designed to stop the routine filing of suits without a factual basis in the hope that discovery will enable plaintiffs to extract a settlement. As the Ninth Circuit has held, "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." Medhekar v. United States Dist. Court, 99 F.3d 325, 328 (9th Cir. 1996) (emphasis added).
This securities class action was filed one day after the same plaintiffs and the same counsel filed an identical securities class action in Santa Clara County Superior Court. Head et al. v. NetManage, Inc. et al., Case No. CV763295 (Santa Clara Sup. Ct.).2 Both actions were filed against the same defendants on behalf of the same putative class: persons who purchased NetManage stock between July 25, 1995, and January 11, 1996. Both actions rely on identical factual allegations. The only difference is that the state complaint alleged claims under California state law, while the federal complaint alleges claims under the Securities Exchange Act of 1934, for which there is exclusive federal jurisdiction.
While discovery currently is stayed in this case because defendants have filed a motion to dismiss, the same plaintiffs and their counsel have launched sweeping discovery in the state case. Plaintiffs have served massive document requests and interrogatories on Defendants, and have also noticed two depositions of NetManage witnesses. Tosh Decl., Exs. D-G . Plaintiffs have also served document subpoenas on NetManage's accountants, Arthur Andersen, its three distributors, Ingram Micro, Merisel, and Tech Data, and a business partner, Microsoft; plaintiffs seek the production of all documents in their files concerning NetManage. Tosh Decl., Exs. H-L. Plaintiffs have brazenly admitted that they intend to use discovery from the state case to bolster this federal case notwithstanding the Reform Act's discovery stay.
The crucial question before this Court is whether the plaintiffs and their counsel who have been certified by this Court as Lead Plaintiffs and Co-Lead Counsel under the Reform Act will nonetheless be allowed to circumvent the Reform Act's mandatory discovery stay through the tactic of a parallel state class action. This question is of overriding importance for the Reform Act and the federal policy interests embodied in its crucial discovery stay provision.
Defendants' concern that state court discovery will be used to circumvent federal policy has become an acute problem in the California federal and state courts. The tactic of filing parallel and identical federal and state class actions in California is now the standard way in which Lead Plaintiffs and their counsel try to skirt the Reform Act's mandatory discovery stay. Defendants have identified at least 33 cases in California and 20 cases in the Northern District alone where there are parallel state and federal securities class actions. See Appendix A to this Memorandum.
The Court should not countenance plaintiffs' blatant attempt to evade federal law. Plaintiffs' right to prosecute this action springs from the Reform Act. The Court certified these plaintiffs and their counsel as Lead Plaintiffs and Lead Plaintiffs' Counsel under the provisions of the Reform Act. Having been anointed under the Reform Act to prosecute this federal action, the Lead Plaintiffs and their Counsel cannot be permitted to evade one of the Reform Act's central requirements.
In this federal case, Defendants filed a motion to dismiss on July 15, 1997. That motion will be heard on September 29, 1997.
In the parallel state case, Defendants demurred to the Original Complaint.3 In response, plaintiffs withdrew their Original Complaint and filed an Amended Complaint. Defendants demurred to the Amended Complaint. That demurrer was sustained in part and overruled in part on July 1, 1997. Plaintiffs will file their Second Amended Complaint on August 15, 1997. Defendants intend to demur again. In response to plaintiffs' extensive discovery requests, defendants moved the Superior Court for an order staying discovery until discovery is permitted in this federal action. That motion was denied on July 11, 1997; defendants are filing a writ of mandamus to the California Court of Appeal.
The Supreme Court has long recognized that securities class actions "'present[] a danger of vexatiousness different in degree and in kind from that which accompanies litigation in general'. . . . Litigation under 10b-5 thus requires secondary actors to expend large sums even for pretrial defense and the negotiation of settlements." Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 189 (1994) quoting Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 739 (1975)).4 Congress passed the Reform Act to end "abuse in private securities lawsuits" and to protect defendants from baseless fraud accusations. Conf. Rep. at 31.
Congress found that "[n]aming a party in a civil suit for fraud is a serious matter. Unwarranted fraud claims can lead to serious injury to reputation for which our legal system effectively offers no redress." Id. at 41. Congress was especially concerned about the "the abuse of the discovery process to impose costs so burdensome that it is often economical for the victimized party to settle[.]" Id. Congress therefore intended to preclude "the routine filing of lawsuits . . . 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 (emphasis added). One of the most important protections that Congress created is the automatic discovery stay: Section 21D(b)(2)(3)(B) provides:
In any private action arising under this title, all discovery and other proceedings shall be stayed during the pendency of any motion to dismiss, unless the court finds upon he motion of any party that particularized discovery is necessary to preserve evidence or to prevent undue prejudice to that party.
(Emphasis added.) The Conference Report leaves no doubt that Congress meant what it said in the statute: "courts must stay all discovery pending a ruling on a motion to dismiss." Conf. Rep. at 37. By so doing, Congress intended to put "[l]imits on abusive discovery to prevent fishing expedition lawsuits." Id.
The discovery stay is one of the centerpieces of the Reform Act. If plaintiffs were permitted to use discovery obtained in parallel state cases to circumvent the discovery stay, Congressional intent to prevent the "routine filing of lawsuits . . . with only faint hope that the discovery process might lead eventually to some plausible cause of action" would be utterly thwarted. As Judge Smith has held in the leading case interpreting the Reform Act's other procedural changes, "courts should be mindful of such policy considerations in construing federal securities law." In re Silicon Graphics, Inc. Sec. Litig., [1996-1997 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 99,325, at 95,963 (N.D. Cal. Sept. 25, 1996).
The Ninth Circuit has left no doubt that Congress expressly intended that complaints should be dismissed that do not have a factual basis: "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." Medhekar v. United States Dist. Courtcite>Kane v. Madge Networks, No. C-96-20652 (N.D. Cal. Jan 13, 1997) (no discovery prior to assessment of viability of pleadings) (Tosh Decl. Ex. O); Novak v. Kasaks, [1996-1997 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 99,307 (S.D.N.Y. Aug. 16, 1996) (no discovery prior to assessment of viability of pleadings); Medical Imaging Centers of America, Inc. v. Lichtenstein, 917 F. Supp. 717, 721-22 (S.D. Cal. 1995) (no discovery before resolution of motion to dismiss; delay resulting from Reform Act's discovery stay not "undue prejudice" in hostile takeover case even though corporate action to be enjoined would occur less than three weeks after hearing).
At the Lead Plaintiff hearing Defendants flagged this issue. The Court expressed its concern that federal interests and defendants' rights under the Reform Act should be protected: "[T]here is a concern in the federal court with respect to protecting the defendants from discovery[;] that is inherent in the federal law with respect to this stay provision." (Transcript) Tosh Decl. Ex. P at 16; see also id. at 17.
Defendants' and the Court's concern is borne out by the events in this case, as well as recent pleadings in another securities case pending in this district, where the same plaintiffs' counsel has filed parallel state and federal cases. In responding to a motion to dismiss in In re IMP, Inc. Securities Litigation, No. C-96-20826-SW(PVT) (N.D. Cal.), plaintiffs have claimed that Judge Williams should not dismiss their complaint because of information they had obtained through discovery in a parallel state court action. See Plaintiffs' Memorandum in Opposition to Defendants' Motion to Dismiss Plaintiffs' Second Amended Consolidated Complaint in In re IMP, Inc. Sec. Litig., No. C-96-20826-SW(PVT) (N.D. Cal.), at 21 (Tosh Decl. Ex. M). This case is heading down the same road. Plaintiff's tactic of parallel filings threatens to undermine one of the cornerstones of the Reform Act, namely Congress' "clear[] inten[t] 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." Medhekar, 99 F.3d at 328.
Defendants' rights under the Reform Act's discovery stay are now threatened. Although discovery is stayed in this Court, there is no similar stay under California law.
Defendants first attempted to resolve this issue informally. Defendants have repeatedly asked Plaintiffs' Co-Lead Counsel to erect an ethical wall between counsel working on the state case and counsel working on the federal action See Letters of Jerome F. Birn, Jr. dated Mar. 3, 1997, and July 21, 1997, and of Ignacio E. Salceda dated July 7, 1997. Tosh Decl. Exs. Q-S. Not only have Plaintiffs' Counsel declined these requests (see letter of Alan Schulman (Mar. 6, 1997) (Tosh Decl. Ex. T), they have stated their intent to use the discovery they obtain in the state action in the federal action, notwithstanding the Reform Act's discovery stay. See Letter of Travis Downs dated June 10, 1997 (Tosh Decl. Ex. U). The Lead Plaintiffs and the five law firms representing them simply refuse to establish an ethical wall between counsel working on the state and federal cases.
Defendants then sought relief from the Santa Clara County Superior Court. Relying on principles of comity for federal law, Defendants moved for an order staying discovery until the federal motion to dismiss is decided. That motion was denied without an opinion; defendants are taking a writ of mandamus to the California Court of Appeal.
Defendants have exhausted all attempts to resolve this issue either informally with plaintiffs, or formally before the Santa Clara County Superior Court. Defendants are left with no choice but to move this Court for an order ensuring that their federal rights under the Reform Act's discovery stay are not nullified by the tactic of filing a duplicative, parallel state class action.
Defendants wish to be crystal clear about the limited relief they are seeking by this motion. Defendants are not asking the Court to enjoin plaintiffs from prosecuting their state court case or to intervene in the Superior Court's decision not to take action to preserve defendants' federal rights. Defendants are moving this Court to exercise its power over the Lead Plaintiffs and their Counsel to preserve defendants' federal rights by limiting what plaintiffs and their counsel are permitted to do in this federal case. Thus, this motion does not implicate the Anti-Injunction Act's prohibition against enjoining state court proceedings. See 28 U.S.C. § 2283.
Defendants propose two solutions to the current problem. The Court could order plaintiffs to erect an ethical wall between the counsel working on the federal and state cases, until such time as discovery is permitted in federal court if ever. Alternatively, the Court could decertify those Lead Plaintiffs and their Counsel who participate in state court discovery, and issue a protective order prohibiting any plaintiffs and counsel who prosecute the federal action from obtaining, directly or indirectly, the fruits of state court discovery. The Court has the power to Order either form of relief pursuant to its supervisory authority over Lead Plaintiffs and their Counsel under the Reform Act, its inherent authority under the All Writs Act to issue any writs necessary to protect its jurisdiction, and Fed. R. Civ. P. 26(c).
The significant federal policy underlying the Reform Act's discovery stay more than authorizes this Court to grant the requested relief.
The Supreme Court itself has commented that in a securities class action plaintiffs may not seek discovery outside the ambit of their allegations for improper purposes:
In deciding whether a request comes within the discovery rules, a court is not required to blind itself to the purpose for which a party seeks information. Thus, when the purpose of a discovery request is to gather information for use in proceedings other than the pending suit, discovery properly is denied.
Oppenheimer Fund, Inc. v. Sanders, 437 U.S. 340, 352 n.17 (1978) (emphasis added); see also Sasu v. Yoshimura, 147 F.R.D. 173, 176 (N.D. Ill. 1993) (denying motion to modify protective order to allow discovery from one case to be used in another case because sharing discovery would violate privacy interests; "no right to use pretrial discovery in one case for the prosecution of another case") (citing Seattle Times Co. v. Rhinehart, 467 U.S. 20. 32-34 (1984)). The Supreme Court derived this principle from cases in which parties were prohibited from pursuing discovery in court beyond that authorized by the Federal Arbitration Act. Oppenheimer, 437 U.S. at 352 n.17.5
Moreover, in other contexts, federal courts have granted protective orders to prevent discovery from one case being used for improper purposes in another case. They have done so where defendants' rights would be infringed, or it appeared that the case where discovery was undertaken was pretextual and solely for the purpose of obtaining discovery otherwise barred.
For example, in Sperry Rand Corp. v. Rothlein, 288 F.2d 245 (2d Cir. 1961), plaintiff filed a trade secrets action in federal court against several former employees. As part of its case management, the district court sequenced discovery so that plaintiffs would conclude their discovery before defendants. After conducting limited discovery, plaintiff filed an action for injunctive relief in state court and intended to use the federal discovery for that purpose.
The district court enjoined plaintiffs from misusing federal discovery in this way; the Second Circuit affirmed. It held that allowing plaintiffs to misuse the federal discovery in support of their state injunctive action would be unfair to defendants, as they had not had the opportunity to conduct their own discovery. Otherwise, the purpose of the federal court's discovery orders would be undermined. Id. at 248. Moreover, the court was concerned that the state case was brought to undermine the federal court's order. Id. at 249.
This case is much stronger than the circumstances that motivated courts to stay merits discovery in suits to compel arbitration, and prompted the Second Circuit to preclude discovery in Sperry Rand. In the arbitration cases, the courts held that all issues including discovery should be resolved in the forum chosen by the parties in their contract. In Sperry Rand, the court was merely enforcing its own protective order, which necessarily required the court to balance the shifting interests of the parties. In passing the Reform Act, Congress did the balancing of interests and overwhelmingly voted to change federal law for these types of cases by enacting a mandatory discovery stay. Here, defendants' rights under the Reform Act unquestionably would be harmed were plaintiffs allowed to use state court discovery to circumvent the Reform Act. By stopping plaintiffs from doing so, the Court would only be applying the Congressional mandate of the Reform Act against the plaintiffs and their counsel who have been certified by this Court under that statute to prosecute this action.
Finally, an order limiting the uses of discovery is far from a novel idea. Indeed, the Judges of the Northern District of California recently adopted proposed Local Rules governing securities cases subject to the Reform Act. Those rules include a Model Protective Order, which states that discovery cannot be used for any purpose other than the pending litigation. See N.D. Cal. Sample Confidentiality Order ¶ 3 ("All information produced or exchanged in the course of this case (other than information that is publicly available) shall be used by the party or parties to whom the information is produced solely for the purpose of this case.") (emphasis added)
This case presents one of the strongest possible situations where this Court should act to preserve federal policy interests. Plaintiffs and their counsel filed an identical lawsuit in San Jose federal court asserting claims under the Reform Act. They could have filed one action in federal court asserting all of their state and federal claims. Or they could have filed just this action and pursued their California claims. Instead, plaintiffs and their counsel want to have it both ways. They want to pursue both federal and state law claims simultaneously without being subject to the federal discovery stay, with the express intent of using the fruits of their state discovery in federal court. Thus, plaintiffs and their counsel have manufactured a conflict between federal statutory law and California procedure that is entirely unnecessary. Having created this conflict by their own actions, plaintiffs cannot be heard to cry "undue prejudice" if the Court puts a stop to it.
In the unlikely event that this federal case survives a motion to dismiss, controlling precedent in California's Sixth Appellate District mandates that the Superior Court refuse to certify plaintiffs' state law class claims; plaintiffs would be required to pursue all of their state and federal class claims in federal court. Schneider v. Vennard, 183 Cal. App. 3d 1340 (1986). To expedite the efficient resolution of this case, defendants have already offered to waive any objections to this Court's exercise of supplemental jurisdiction over the state law claims.6 Plaintiffs have declined to bring all of their claims in this Court. Letter of Alan Schulman, dated Mar. 6, 1997) (Tosh Decl. Ex.T). In light of this controlling California precedent, the relief defendants request makes even more sense because this Court should be in control of all discovery between these parties from the outset.
Plaintiffs cannot be heard to complaint that they will be prejudiced because their federal complaint might be dismissed. Congress made a policy decision that these types of cases were unique, and 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." Medhekar, 99 F.3d at 328. Congress understood and accepted the risk that a small number of federal cases that could have survived the pleading stage with discovery might be dismissed. But Congress concluded that the abuses of the old regime of free-wheeling discovery in search of a claim significantly outweighed this risk. The only exception to the discovery stay that Congress envisioned was for circumstances not present here, such as the "terminal illness of an important witness." Conf. Rep. at 37; see Medical Imaging Centers of America, 917 F. Supp. at 721-22 (discovery stay not "undue prejudice" in hostile takeover case despite imminence of corporate action). That plaintiffs' federal complaint might be dismissed for failure to allege facts that state a claim is not "undue prejudice" it is precisely the result that Congress intended.
Enforcing the Reform Act's discovery stay against the Lead Plaintiffs and their counsel does not raise a legitimate concern that evidence will go stale or be lost. The quid pro quo for the discovery stay is the Reform Act's prohibition against the willful destruction or alteration of relevant evidence. See Reform Act § 21D(b)(3)(C), 15 U.S.C. § 78u-4(b)(3)(C). The non-parties who are subject to valid subpoenas are already bound to preserve the requested evidence. See Novak v. Kasaks, [1996-1997 Tr. Binder] Fed. Sec. L. Rep. ¶ 99,307, at 95,862 (applying automatic discovery stay but ordering subpoenaed non-parties to preserve responsive documents). In addition, defendants would not object if the non-parties subject to state subpoenas were served with federal subpoenas and instructed to preserve documents until this Court orders that discovery may proceed.
The Lead Plaintiffs in this case are represented by five separate law firms, all of whom are experienced in prosecuting securities class actions. Surely these five experienced law firms could find a way to separate into two groups, one group to conduct discovery in the state case, and the other to defend their federal complaint, and thereby honor the Reform Act's discovery stay. For the foregoing reasons, the Court should issue an Order as follows:
The Court should impose an ethical wall to prevent any of the Lead Plaintiffs and their Counsel in this case from obtaining, directly or indirectly, the fruits of any discovery obtained in the state case, until such time as discovery may proceed in this case, if ever;
Alternatively, the Court should disqualify any of the Lead Plaintiffs and their Counsel who participate in state discovery from further participation in this case, and also prohibit any counsel remaining in this case from obtaining, directly or indirectly, the fruits of any discovery obtained in the state case, until such time as discovery may proceed in this VALIGN=top ALIGN=left>
1 The Joint House-Senate Conference Committee Report is attached as Exhibit A to the Declaration of Tracy L. Tosh ("Tosh Decl.") filed in support of this motion; all exhibits referenced in this motion are attached to the Tosh Declaration.
2 Copies of the Original and Amended Complaints filed in state court are attached as Exhibits B and C to the Tosh Decl.
3 Before demurring, Defendants moved for an order that the state case should not proceed as a class action because it was duplicative of the federal action and, therefore, a waste of the parties' and the Court's resources, for the reasons explained in Schneider v. Vennard, 183 Cal. App. 3d 1340 (1986). That motion was denied without prejudice on May 30, 1997. See Tosh Decl. Ex. N.
4 See also Blue Chip Stamps, 421 U.S. at 740-41 ("[I]n the field of federal securities laws governing disclosure of information even a complaint which by objective standards may have very little chance of success at trial has a settlement value to the plaintiff out of any proportion to its prospect of success at trial.").
5 See Mississippi Power Co. v. Peabody Coal Co., 69 F.R.D. 558, 566-67 (S.D. Mis. 1976) (courts routinely stay discovery in case where arbitration is pending, absent "exceptional circumstances") (cited in Oppenheimer); Econo-Car Int'l, Inc. v. Antilles Car Rental, Inc., 61 F.R.D. 8, 10 (D.V.I. 1973) ("In proceedings to compel arbitration, discovery delving into the merits of the grievance to be arbitrated is improper.") (cited in Oppenheimer), rev'd on other grounds, 499 F.2d 1391 (3d Cir. 1974). See also Harry F. Ortlip Co. v. George Hyman Constr. Co., 126 F.R.D. 494 (E.D. Pa. 1989) (same) (citing cases).
6 See Letters of Jerome F. Birn, Jr. dated Mar. 3, 1997, and July 21, 1997, and letter of Ignacio E. Salceda dated July 7, 1997. Tosh Decl. Exs. Q-S.