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Stanford University Law School
- Securities Class Action Clearinghouse
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DESIGNATED FOR PUBLICATION
IN THE UNITED STATES DISTRICT COURT
FOR THE NORTHERN DISTRICT OF CALIFORNIA
SAN JOSE DIVISION
IN RE RATIONAL SOFTWARE | Case No. C-97-21001-JF
SECURITIES LITIGATION |
| ORDER GRANTING IN PART AND
| DENYING IN PART PLAINTIFFS'
| MOTION FOR LIMITED DISCOVERY
| COMPLAINT WITH LEAVE TO AMEND
| [filed Dec. 4, 1998]
| [Docket No. 70]
________________________________|
Plaintiffs' motion for limited discovery was heard on
November 30, 1998. For the reasons set forth below, the motion
is granted in part and denied in part.
I. BACKGROUND
This class action arises from Plaintiffs' allegations that
they were injured as a result of insider stock trading which
occurred on October 8, 1997. On that date, the Chief Executive
Officer of Defendant Rational Software, Paul Levy ("Levy"),
allegedly told a market analyst named Rehan Syed ("Syed") that
Rational would be announcing unexpectedly low third quarter and
year end earnings. Plaintiffs allege that this information was
not then available to the public. Plaintiffs further allege that
upon receiving the information from Levy, Syed immediately
advised the clients of his firm, Defendant Cowen & Co. ("Cowen"),
to sell Rational stock. Large blocks of Rational stock in fact
were sold on October 8, 1997, which caused the stock price to
drop nearly nineteen percent by the end of the trading day.
Plaintiffs, who were not aware that Rational would be announcing
low earnings, assert that they bought Rational stock on October
8, 1997 from persons who were trading on the inside information
disseminated by Syed and Cowen.
Based upon the foregoing allegations, Plaintiffs filed a
consolidated amended complaint on May 29, 1998, asserting federal
and state law insider trading claims against Rational, Levy,
Cowen and Syed. On October 5, 1998, this Court dismissed the
consolidated amended complaint with leave to amend, concluding
that Plaintiffs' allegations as to certain elements of their
claims lacked the particularity required by the provisions of the
Private Securities Litigation Reform Act of 1995 ("Reform Act"),
P.L. 104-67, 109 Stat. 737 (1995). Pursuant to § 101 of the
Reform Act, Plaintiffs now seek discovery in order to obtain
facts necessary to amend their pleading. Defendants oppose the
motion.
II. DISCUSSION
One of the principal policy objectives of the Reform Act was
to establish strict limitations on discovery proceedings in
actions brought pursuant to the Securities Act of 1933 ("1933
Act") and the Securities Exchange Act of 1934 ("1934 Act"). The
Reform Act added identical language to the 1933 Act and 1934 Act
2
providing that:
... all discovery and other proceedings shall be stayed
during the pendency of any motion to dismiss, unless
the court finds, upon the motion of any party, that
particularized discovery is necessary to preserve
evidence or to prevent undue prejudice to that party.
Reform Act, § 101(a) and (b), codified at 15 U.S.C. § 77z-1(b)(1)
and 15 U.S.C. § 78u-4(b)(3)(B). Plaintiffs' motion is based on
their assertion that particularized discovery is necessary to
prevent them from suffering undue prejudice in this case.
Specifically, Plaintiffs seek information from Cowen regarding
its relationship with Rational and from the National Association
of Securities Dealers ("NASD") regarding the identity of persons
who traded Rational stock on October 8, 1997.1
Given the significance of the discovery stay provisions in
the Reform Act's overall statutory scheme, there is a surprising
lack of authority interpreting and applying the exceptions to the
stay contained in the provisions themselves. There are only a
handful of fact-specific published district court decisions and
no appellate decisions which address the subject. For all
practical purposes, the issues presented by the present motion
are a matter of first impression.
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1 Plaintiffs' moving papers include a proposed Request
for Production of Documents directed to Defendant Cowen which
seeks "all analyst reports and drafts of analyst reports
covering Rational for January 1, 1996 to the present" as well as
"all documents concerning or regarding any offers, requests,
plans or committments [sic] for Cowen to provide services to
Rational for any planned or consummated public offering or
private placement of Rational securities." Plaintiffs also
submit a proposed Third Party Subpoena directed to the NASD which
requests "all documents, including but not limited to the Third
Market Trade Report ("TMTR"), that identify which market makers
traded Rational securities on the date October 8, 1997."
3
"The starting point in interpreting a statute is its
language, for if the intent of Congress is clear, that is the end
of the matter." Good Samaritan Hospital v. Shalala, 508 U.S.
402, 409, 113 S.Ct. 2151, 2157 (1993) (internal quotations and
citations omitted); see also United States v. Hockings, 129 F.3d
1069, 1071 (9th Cir. 1997). If the statutory language is
unclear, the Court will attempt to determine Congressional intent
from the legislative history. Hockings at 1071.
Preliminarily, the Court agrees with Defendants that the
discovery stay applies to both the federal and the state law
claims asserted by Plaintiffs in this case. Congress enacted the
Reform Act in response to "significant evidence of abuse in
private securities lawsuits." Statement of Managers for the
Private Securities Litigation Reform Act of 1995, H.R. Conf. Rep.
104-369 (Nov. 28, 1995). Congress was particularly concerned
with "the abuse of the discovery process to impose costs so
burdensome that it is often economical for the victimized party
to settle." Id. Congress' attempt to address these concerns by
establishing a discovery stay in federal securities actions would
be rendered meaningless if securities plaintiffs could circumvent
the stay simply by asserting pendent state law claims in federal
court in conjunction with their federal law claims.2 This Court
____________________
2 Indeed, it has been suggested that many plaintiffs have
filed parallel actions in state and federal court precisely to
avail themselves of less restrictive state discovery rules. See,
e.g., Stong, "Reform, What Reform", Business Law Today, May/June
1998, at p. 36. As Defendants point out, concern about this
practice was one of the major motivations for the recent
enactment by Congress of the Securities Litigation Uniform
Standards Act of 1998, P.L. 105-353, 112 Stat. 3227 (1998) which
effectively precludes future litigation of major securities class
4
therefore holds that the discovery stay mandated by the Reform
Act extends to state law securities fraud claims asserted in a
federal forum in conjunction with federal law claims.
The Court turns next to the language of the stay provisions
requiring application of the discovery stay "during the pendency
of any motion to dismiss." Strictly speaking, there is no
pending motion to dismiss in this case, because the Court has
ruled on the motion and dismissed the consolidated complaint with
leave to amend. However, the plain intent of Congress was to
preclude intrusive and burdensome discovery in securities fraud
actions until the plaintiffs have stated a viable claim. The
Court therefore concludes that the discovery stay is triggered by
the filing of a motion to dismiss and that the stay remains in
effect unless and until the Court determines that the plaintiffs
have alleged facts sufficient to state a cause of action for
securities fraud. The Court notes that Plaintiffs in the present
action have not challenged the applicability of the stay on the
ground that the motion to dismiss no longer is pending.
Finally, the Court turns to the heart of the stay
provisions, i.e., the language requiring that the stay remain in
effect unless the court finds "that particularized discovery is
necessary to preserve evidence or to prevent undue prejudice to
that party." Because Plaintiffs in the present case do not
contend that discovery is necessary to preserve evidence, the
only question before the Court is whether Plaintiffs have shown
that particularized discovery is necessary to prevent undue
prejudice.
____________________
actions in state courts.
5
The Court is aware of only one published decision construing
the meaning of the term "undue prejudice" in this context:
Medical Imaging Centers of America v. Lichtenstein, 917 F.Supp.
717, 720 (S.D. Cal. 1996). In that case a corporation sued a
group seeking to elect an alternative board of directors,
alleging proxy solicitation violations. The corporation asserted
that it would suffer undue prejudice if not allowed to pursue
discovery before an upcoming shareholder's meeting, because if
defendants gained control of the corporation at that meeting,
they would direct the dismissal of the lawsuit. The court,
defining undue prejudice as an "improper or unfair detriment,"
noted that many cases involve contests for corporate control and
concluded that the imminent shareholders' meeting did not create
any special or unique circumstances which would distinguish the
case from any other. Medical Imaging, 917 F.Supp. at 720-22.
The court further noted that even if defendants did gain control
of the corporation, the plaintiff corporation would be able to
address securities violations by means of post-election
remedies.3 Id. at 722. The court stated, however, that it would
have lifted the discovery stay if the plaintiff corporation had
____________________
3 The plaintiff corporation also contended that it needed
to discover whether defendants controlled more than 20% of the
corporation's stock so that it could activate a "poison pill"
provision in the corporation's by-laws which would allow the
remaining shareholders to purchase shares a bargain prices and
thus dilute defendants' voting powers. However, the court found
that the plaintiff had not demonstrated that it wanted to
activate the "poison pill" provision or that it could not do so
based upon a good faith claim that defendants controlled more
than 20% of the stock. Medical Imaging, 917 F.Supp. at 722.
6
demonstrated that refusal to allow discovery would shield the
defendants from eventual liability for violation of securities
laws. Id. at 721 n.3.
This Court adopts the Medical Imaging court's definition of
undue prejudice as an "improper or unfair detriment." Further,
the Court concurs that a plaintiff may demonstrate the existence
of undue prejudice by showing that refusal to allow discovery
will shield the defendants from liability for securities fraud.
The critical question is what a plaintiff must do to make such a
showing. If the discovery restrictions of the Reform Act are to
have any meaning, a plaintiff must be required to allege specific
facts demonstrating more than a vague possibility that a
defendant might have committed fraudulent acts which will be
shielded in the absence of discovery. However, by definition, a
plaintiff seeking particularized discovery prior to the
determination of a motion to dismiss cannot be required to
present facts demonstrating fraudulent conduct with complete
specificity, because a plaintiff who could present such facts in
the absence of discovery would be able to withstand a motion to
dismiss and thus would not be prejudiced by the stay.
In fashioning an appropriate test for determining whether
and to what extent discovery should be permitted, the Court must
be guided by the intent of Congress as expressed in the Reform
Act as a whole. Both the express language of the Reform Act and
the legislative history make clear that Congress intended to
prevent broad, expensive "fishing expeditions" at the expense of
defendants against whom no viable claim has been stated. In this
context, the most reasonable interpretation of § 101 is that
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Congress intended to empower district courts to permit discovery
notwithstanding the stay only if such discovery is very narrow in
scope and then only in order to prevent injustice.
With these principles in mind, this Court holds that a
securities class action plaintiff may establish the existence of
undue prejudice by (1) alleging specific facts which while
insufficient in and of themselves to meet the heightened pleading
requirements of the Reform Act nonetheless give rise to a strong
and credible suspicion that a defendant may be liable for
securities fraud, and (2) demonstrating a reasonable probability
that such defendant is likely to avoid liability absent
discovery. If this threshold showing is made, a plaintiff must
then show that the requested discovery is sufficiently limited
and particularized that permitting the discovery will not defeat
the express intent of the Reform Act by placing an undue legal
and economic burden on the defendant.
Applying the foregoing framework to the present case, the
Court concludes that Plaintiffs have made a threshold showing of
undue prejudice with respect to their need for discovery
regarding the relationship between Cowen and Rational.
Plaintiffs have alleged narrow claims based upon the disclosure
of specific inside information by a specific person on a specific
date and the subsequent "dumping" of large blocks of Rational
stock on that same date. For the most part, Plaintiff's
allegations are supported by specific facts which at a minimum
give rise to an appearance of impropriety on the part of Levy and
Syed. The consolidated complaint was dismissed not because
Plaintiffs' claims as a whole were vague and conclusory but
8
primarily because Plaintiffs failed to allege facts tending to
show that Levy actually received a personal benefit from
disclosing the information or that Syed actually knew that Levy's
disclosure was a breach of fiduciary duty, elements without which
Plaintiffs cannot state a cause of action. Plaintiffs' theory is
that Rational and Cowen had an ongoing relationship whereby
Rational would provide Cowen with confidential information and
Cowen would recommend that its customers buy Rational stock. As
Plaintiffs point out, facts supporting this theory are of a type
likely to be solely within Defendants' possession. Under these
circumstances, even though Plaintiffs have alleged significant
and specific facts in support of their insider trading claims,
there is a reasonable probability that Defendants will be
shielded from liability unless Plaintiffs are permitted to take
limited discovery regarding the relationship between Cowen and
Rational.
Plaintiffs also have made a threshold showing with respect
to their request for the identity of persons who traded Rational
stock on October 8, 1997. Although the Court dismissed
Plaintiffs' state law claims because Plaintiffs did not plead
that they were in privity with traders who knew the inside
information allegedly provided by Levy and Syed,4 Plaintiffs did
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4 Plaintiffs' state law claims are asserted pursuant to
California Corporations Code §§ 25402 and 25502, which impose
liability upon persons who trade on material, non-public
information. However, only persons who actually bought
securities from or sold securities to the wrongdoer may pursue a
claim under these sections. See Cal.Corp.Code §§ 25402, 25502;
Daisy Systems Corp. v. Finegold, 1988 WL 166235, at *5 (N.D. Cal.
Sept. 19, 1988).
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allege specific facts concerning the unusually high volume of
sales of Rational stock on the day in question as well as the
fact that all of the named Plaintiffs purchased Rational stock on
that day. Counsel for Plaintiffs has represented that he has
been unable to ascertain the identity of the traders without the
requested discovery. Given the strength and particularity of
Plaintiffs' showing with respect to the communications between
Levy and Syed and the subsequent plummeting of the price of
Rational stock, the Court again concludes that there is a
reasonable probability that Defendants will be shielded from
liability absent discovery.
The foregoing discussion, however, does not end the present
inquiry. Having concluded that Plaintiffs have made a threshold
showing of undue prejudice, the Court still must evaluate
Plaintiffs' actual discovery requests in light of the policies
embodied in the Reform Act and the reasoning set forth herein.
The Court concludes that as presently framed, Plaintiffs'
document request with respect to Defendant Cowen is grossly
overbroad and would place an inappropriate and undue burden upon
Cowen. While the Court is satisfied that good cause exists for
permitting a narrowly focused inquiry into the nature of the
relationship between Cowen and Rational as of October 8, 1997,
Plaintiffs' request covers a period of almost two years and seeks
without limitation a wide range of documents. Such a request
cannot be characterized as one for particularized discovery.
The Court further concludes that Plaintiffs' third party
10
discovery request for the identity of the "market makers"5 who
traded Rational stock on October 8, 1997 is vague and ambiguous,
and as the Court understands it from counsel's statement at oral
argument, actually only a precursor to a future request for
discovery from the "market makers" of the identity of individual
traders. Although third party discovery does not implicate the
question of burden to named defendants to nearly the same degree
as does discovery directed to the defendants themselves, the
express terms of § 101 preclude any discovery during the pendency
of a motion to dismiss unless the discovery is particularized and
the Court determines that it is necessary to avoid undue
prejudice. In keeping with Plaintiffs' own theory of the case, a
proper request must be limited to the identity of traders whose
sales were sufficiently large to impact the price of Rational
stock on the day in question.
The Court has considered whether it should deny Plaintiffs'
motion outright in light of the deficiencies discussed above or
whether it should grant the motion in part consistent with the
views expressed herein. The Court believes that judicial economy
and an appropriate resolution of the instant litigation will be
served best by taking the latter course. No useful purpose would
be served by inviting a new motion, another round of briefing,
additional months of delay in Plaintiffs' amendment of their
complaint and the briefing and disposition of Defendants'
inevitable motion to dismiss the amended complaint. Attorneys
from both sides of the securities bar as well as academic
____________________
5 The Court assumes that Plaintiffs are referring to
brokerage firms.
11
commentators have lamented the increasing amount of time and
expense consumed by law and motion proceedings in securities
cases.6
Accordingly, the Court will permit Plaintiffs to propound up
to ten (10) interrogatories upon Defendant Cowen for the purpose
of inquiring into the relationship between Levy on the one hand
and Syed and Cowen on the other hand as that relationship existed
on October 8, 1997.7 Plaintiffs' motion will be denied to the
extent that it seeks any other discovery from Cowen. The Court
also will permit Plaintiffs to issue subpoenas to the NASD and
subsequently to any brokerage firms identified by the NASD for
the limited purpose of determining the identity of individuals or
entities which sold or placed orders to sell 25,000 shares or
more of Rational stock on October 8, 1997. Finally, the Court
will extend the date by which Plaintiffs are required to file an
amended complaint to April 5, 1999.
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6 See, e.g., Elias, "Reforms Can't Stop Securities Bar,"
The Recorder, July 6, 1998.
7 Plaintiffs' Notice of Motion makes no reference to any
discovery request directed at Rational or Levy.
12
III. ORDER
Plaintiffs' motion is GRANTED IN PART AND DENIED IN PART as
follows:
(1) Plaintiffs may propound ten (10) interrogatories upon
Defendant Cowen as set forth herein;
(2) Plaintiffs may issue a subpoena to the NASD requesting
the identity of brokerage firms trading Rational stock
on October 8, 1997;
(3) Plaintiffs may issue subpoenas to such brokerage firms
requesting the identity of individuals or entities who
sold or placed orders to sell 25,000 shares or more of
Rational Stock on October 8, 1997;
(4) Plaintiffs' motion is otherwise DENIED; and
(5) Plaintiffs shall file and serve any amended pleading
not later than April 5, 1999.
DATED: 12-4-98
/s/
______________________________
JEREMY FOGEL
United States District Judge
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Copies of order mailed on __________ to:
Lionel Z. Glancy, Esq.
Peter A. Binkow, Esq.
Law Offices of Lionel Z. Glancy
1801 Avenue of the Stars, Suite 308
Los Angeles, CA 90067
Lenard G. Weiss, Esq.
John P. Halfpenny, Esq.
Steefel, Levitt & Weiss
One Embarcadero Center, 30th Floor
San Francisco, CA 94111
Boris Feldman, Esq.
Douglas J. Clark, Esq.
Wilson Sonsini Goodrich & Rosati
650 Page Mill Road
Palo Alto, CA 94304-1050
14