Opinion
Civil No. 04cv1589 JAH(NLS), No. 04CV1943-JAH (NLS).
March 8, 2006
INTRODUCTION
Now before the Court are the separately filed motions to dismiss plaintiffs' second amended consolidated class action complaint by defendants Eric DeMarco, Masood Tayebi, Massih Tayebi, Terry Ashwill, Daniel Stokely, and Wireless Facilities, Inc. (collectively "the Wireless defendants") and defendant KPMG LLP ("defendant KPMG"). The motions have been fully briefed by the parties. After a careful consideration of the pleadings and relevant exhibits submitted by the parties, and for the reasons set forth below, this Court GRANTS IN PART and DENIES IN PART the Wireless defendants' motion and GRANTS KPMG's motion in its entirety.
BACKGROUND
Wireless Facilities ("Wireless") is a company that provides outsourced communication and security systems, as well as engineering and integration services, for the wireless communication industry. See Sec.Am.Compl. ¶ 26, 35-39. Wireless stock is publicly traded on the NASDAQ. Id. ¶ 31. Individual defendants Masood Tayebi, Massih Tayebi, Ashwill, Stokely and DeMarco are officers and directors of Wireless. See id. ¶¶ 20-24. KPMG, a certified public accountancy firm, acted as an outside auditor for Wireless. Id. ¶ 25.Wireless was established in 1994. Id. ¶ 35. Wireless reported, in financial statements filed with the Securities and Exchange Commission ("SEC"), net losses totaling $68.7 million during 2000 through 2003. See id. ¶¶ 48-75. On August 4, 2004, Wireless announced that it intended to restate its financial statements filed with the SEC for the years 2000 through 2003. Id. ¶ 102. Wireless stock prices fell as a result of the announcement. Id. ¶ 103. Wireless filed its official restatement with the SEC on September 20, 2004, stating that Wireless overstated its previous income and assets and indicating combined net losses of $111.6 million during the 2000-2003 period. See id. ¶¶ 11, 107-08, 111-12.
Plaintiffs John Boles and Bassam Yassine ("Lead Plaintiffs") purchased Wireless securities between May 5, 2003 and August 4, 2004 ("the putative Class period"). Id. ¶ 1, 19. The Lead Plaintiffs filed a complaint, on behalf of themselves and all other similarly situated, on August 5, 2004, alleging defendants violated Sections 10(b) and 20(a) of the Securities and Exchange Act and Rule 10b-5 promulgated by the SEC. Various other plaintiffs subsequently filed complaints alleging similar claims. The related cases were consolidated, by stipulation, on August 31, 2004, and Lead Plaintiffs' complaint was designated as the lead case. See Doc. # 5. Lead Plaintiffs filed a consolidated class action complaint on January 31, 2005.
The Wireless defendants filed a motion to dismiss the consolidated class action complaint on March 17, 2005. Defendant KPMG also filed a motion to dismiss that complaint on March 21, 2005. The parties subsequently stipulated to withdraw the motions and allow Lead Plaintiffs to file a first amended consolidated class action complaint, which was filed on April 5, 2005. The Wireless defendants and defendant KPMB, on April 14, 2005, filed their respective motions to dismiss the first amended complaint. The parties again stipulated to withdraw those motions and allow Lead Plaintiffs to file a second amended consolidated class action complaint ("SAC"). The SAC was filed on June 9, 2005.
The instant motions to dismiss the SAC were each filed on July 14, 2005. Lead Plaintiffs filed their oppositions to the motions on August 18, 2005. Reply briefs were filed by all defendants on September 28, 2005. This Court took both motions under submission without oral argument on October 13, 2005. See CivLR 7.1(d.1).
DISCUSSION
The SAC alleges that the defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated by the SEC. Both the Wireless defendants and defendant KPMG move to dismiss the SAC with prejudice pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure.
1. Legal Standard
A motion to dismiss under Federal Rule of Civil Procedure 12(b)(6) tests the sufficiency of the complaint. Navarro v. Block, 250 F.3d 729, 732 (9th Cir. 2001). Dismissal of a claim under this Rule is appropriate only where "it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Conley v. Gibson, 355 U.S. 41, 45-46 (1957); Navarro, 250 F.3d at 732. Dismissal is warranted under Rule 12(b)(6) where the complaint lacks a cognizable legal theory. Robertson v. Dean Witter Reynolds, Inc., 749 F.2d 530, 534 (9th Cir. 1984); see Neitzke v. Williams, 490 U.S. 319, 326-27 (1989) ("Rule 12(b)(6) authorizes a court to dismiss a claim on the basis of a dispositive issue of law."). Alternatively, a complaint may be dismissed where it presents a cognizable legal theory yet fails to plead essential facts under that theory. Robertson, 749 F.2d at 534.
In reviewing a motion to dismiss under Rule 12(b)(6), the court must assume the truth of all factual allegations and must construe them in the light most favorable to the nonmoving party.Cahill v. Liberty Mut. Ins. Co., 80 F.3d 336, 337-38 (9th Cir. 1996). However, legal conclusions need not be taken as true merely because they are cast in the form of factual allegations.Roberts, 812 F.2d at 1177; Western Mining Council, 643 F.2d at 624. When ruling on a motion to dismiss, the court may consider the facts alleged in the complaint, documents attached to the complaint, documents relied upon but not attached to the complaint when authenticity is not contested, and matters of which the Court takes judicial notice. Parrino v. FHP, Inc., 146 F.3d 699, 705-06 (9th Cir. 1998); Branch v. Tunnell, 14 F.3d 449, 453-54 (9th Cir. 1994); MGIC Indem. Co. v. Weisman, 803 F.2d 500, 504 (9th Cir. 1986).
Section 10(b) of the Securities and Exchange Act of 1934 makes it unlawful to use in connection with the mails or facilities of interstate commerce any "manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commissioner may prescribe." 15 U.S.C. § 78j. SEC Rule 10b-5, promulgated under section 10(b), provides:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.17 C.F.R. § 240.10b-5.
In order to properly allege a claim under section 10(b) of the Exchange Act and SEC Rule 10b-5, a plaintiff must state the following: (1) defendants made a false statement or omission with regard to a material fact; (2) in connection with the purchase or the sale of a security; (3) with scienter; (4) upon which plaintiff reasonably relied; (5) to his/her harm or detriment.Binder v. Gillespie, 184 F.3d 1059, 1063 (9th Cir. 1999), cert. denied, 528 U.S. 1154 (2000); Paracor Fin., Inc. v. General Elec. Capital Corp., 96 F.3d 1151, 1157 (9th Cir. 1996).
In December of 1995, Congress enacted the Private Securities Litigation Reform Act of 1995 ("PSLRA") to establish uniform and stringent pleading requirements for securities fraud actions. The PSLRA specifies the required pleading standard for securities fraud actions:
(1) Misleading statements and omissions
In any private action arising under this chapter in which the plaintiff alleges that the defendant —
(A) made an untrue statement of a material fact; or
(B) omitted to state a material fact necessary in order to make the statements made, in the light of the circumstances in which they were made, not misleading;
the complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.15 U.S.C. § 78u-4(b)(1).
In addition, the PSLRA requires complaints alleging federal securities fraud to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." 15 U.S.C. § 78u-4(b)(2). As recently interpreted by the Ninth Circuit, this language requires a private securities plaintiff to plead particular facts that constitute strong circumstantial evidence of deliberately reckless or conscious misconduct. In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 977, 979 (9th Cir. 1999). Recklessness satisfies the scienter requirement only insofar as it reflects some degree of conscious or deliberate misconduct; i.e., "a degree of recklessness that strongly suggests actual intent." Id. at 979. The PSLRA further provides that "the court shall, on the motion of any defendant, dismiss the complaint if the requirements of paragraphs (1) and (2) are not met." 15 U.S.C. § 78u-4(b)(3)(A).
Under Ninth Circuit case law, Rule 9(b) of the Federal Rules of Civil Procedure require a complaint alleging securities fraud to "state precisely the time, place, and nature of the misleading statements, misrepresentations, or specific acts of fraud."Kaplan v. Rose, 49 F.3d 1363, 1370 (9th Cir. 1994). The Rule further requires that the complaint "set forth an explanation as to why the statement or omission complained of was false and misleading." Yourish v. California Amplifier, 191 F.3d 983, 993 (9th Cir. 1999). A complaint may demonstrate the false or misleading character of a statement by identifying inconsistent contemporaneous statements made by the defendants or inconsistent contemporaneous information that was available to the defendants.Yourish, 191 F.3d at 994; DeMarco, 149 F. Supp. 2d at 1223. A complaint may not, however, demonstrate that a statement was false or misleading when made "merely by pointing to later inconsistent statements or conditions." DeMarco, 149 F. Supp. 2d at 1223.
Scienter is a "mental state embracing intent to deceive, manipulate, or defraud." Ernst Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12 (1976); In re Silicon Graphics, 183 F.3d at 975. Although each scienter allegation must be analyzed independently, courts are also required to analyze the allegations collectively, by asking "whether the total of plaintiffs' allegations, even though individually lacking, are sufficient to create a strong inference that defendants acted with deliberate or conscious recklessness." Broudo v. Dura Pharms., 339 F.3d 933, 940 (9th Cir. 2003), overruled on other grounds, Dura Pharms. v. Broudo, 125 S.Ct. 1627 (2005). In securities fraud cases, "when determining whether plaintiffs have shown a strong inference of scienter, the court must consider all reasonable inferences to be drawn from the allegations, including inferences unfavorable to the plaintiffs." Gompper v. VISX, Inc., 298 F.3d 893, 897 (9th Cir. 2002).
2. Analysis
The Wireless defendants, in their motion, contend that the SAC fail to adequately plead (1) scienter; (2) falsity in regards to non-accounting claims; (3) economic loss and loss causation; and (4) allegations under the "group pleading" doctrine. Defendant KPMG moves to dismiss the SAC based solely on Lead Plaintiffs' alleged failure to adequately plead scienter. Both the Wireless defendants and KPMG seek dismissal with prejudice and without leave to amend.
a. The Wireless Defendants' Motion to Dismiss
1. Scienter
In regards to the Wireless defendants' scienter, the SAC alleges that:
[E]ach of the Individual Defendants . . . were privy to non-public information concerning the Company's business, finances, products, markets and present and future business prospects via access to internal corporate documents, conversations and connections with other corporate officers and employees, attendance at management and Board of Directors meetings and committees thereof and via reports and other information provided to them in connection therewith. Because of their possession of such information, the Individual Defendants knew or recklessly disregarded the fact that adverse facts specified herein had not been disclosed to, and were being concealed from, the investing public.SAC ¶ 28.
The SAC further alleges that:
The Individual Defendants participated in the drafting, preparation and/or approval of the various public, shareholder and investor reports, and other communications complained of herein and were aware of, or recklessly disregarded, the misstatements contained therein and omissions therefrom, and were aware of their materially false and misleading nature. Because of their Board membership and/or executive and managerial positions with Wireless, each of the Individual Defendants had access to the adverse undisclosed information about Wireless' financial condition and performance as particularized herein and knew (or recklessly disregarded) that these adverse facts rendered the positive representations made by or about Wireless and its business issued or adopted by the Company materially false and misleading.
SAC ¶ 32. In support of these allegations, the SAC states that certain unnamed current and past employees of the Company have information concerning the alleged misdeeds committed by the individual defendants. See SAC ¶¶ 40-47.
In addition, the SAC states that:
[D]efendants acted with scienter in that defendants knew that the public documents and statements issued or disseminated in the name of the Company were materially false and misleading, knew that such statements or documents would be issued or disseminated to the investing public and knowingly and substantially participated or acquiesced in the issuance or dissemination of such statements or documents as primary violations of the federal securities laws.
. . . The ongoing fraudulent scheme described in this Complaint could not have been perpetrated over a substantial period of time, as has occurred, without the knowledge and complicity of the personnel at the highest level of the Company, including the Individual Defendants.
The fact that the Company has now restated its financial results for fiscal years 2000-2003 and admitted that it reported falsified financial statements throughout the Class Period, constitutes strong circumstantial evidence of defendants' scienter. Not only does the restatement confirm that the Company's reported financial results throughout the Class Period were false, but based on the magnitude, duration and pervasiveness of the fraudulent accounting practices, all of which violated [Generally Accepted Accounting Practices], the Company's restatement constitutes strong circumstantial evidence that each of the Individual Defendants knew, or at a minimum deliberately disregarded, the overwhelming prevalence of improper accounting practices and falsification of the Company's financial results throughout the Class Period.
SAC ¶¶ 204, 205, 206. The SAC also alleges that, during the putative Class period, the individual defendants suspiciously sold personally held shares of stock, received "lucrative compensation packages," and acquired interest in several companies using inflated stock. See SAC ¶¶ 208-214, 215.
Thus, the SAC alleges evidence of the Wireless defendants' scienter through (a) the restatement itself; and (b) the individual defendants' suspicious sale of stock, compensation, and corporate acquisitions. The SAC also lists five confidential witnesses that purportedly possess information supporting the scienter allegations. See SAC ¶¶ 40-47. Lead Plaintiffs' opposition centers on a collective viewing of the scienter allegations. See Opp. to Wireless' Mot at 7.
a. The Restatement
Lead Plaintiffs contend that the magnitude of the restatement itself provides strong evidence of the Wireless defendants' scienter, pointing, in support, to the enormous increase in the reported net loss during the 2000-2003 period and the numerous violations of Generally Accepted Accounting Principles ("GAAP") that occurred. See Opp. to Wireless' Mot. at 7-9 (citing In re Daou Sys. Sec. Litig., 411 F.3d 1006, 1022 (9th Cir. 2005) andIn re McKesson HBOC Secs. Litig., 126 F.Supp.2d 1248, 1269 (N.D.Cal. 2000)). The Wireless defendants contend that the magnitude of the Wireless restatement is not as significant as the restatements found to be strong evidence of scienter in the cases cited by Lead Plaintiffs. See Wireless' Reply at 1-2. The Wireless defendants point out that, in Daou, the Ninth Circuit found scienter only because the complaint contained allegations through twenty-three confidential witnesses who would testify from their personal knowledge about alleged revenue manipulation.Id. at 1 (citing Daou, 411 F.3d at 1019-23). In addition, the Wireless defendants note that, in McKesson, scienter was found because the company "admitted 'senior management had been intentionally (and secretively) booking contingent software transactions as sales for several years,' . . . dismissed employees 'for cause,'" all supported by the complaint containing allegations through fifteen former employees. Id. at 2 (quotingMcKesson, 126 F.Supp.2d at 1273-74. Thus, the Wireless defendants contend that, here, a strong inference of scienter is not present based on the restatement itself because the SAC here lacks the corroborating evidence found in the cited cases. Id.
This Court agrees with the Wireless defendants. The restatement, by itself, does not create "a strong inference that defendants acted with deliberate or conscious recklessness." Broudo, 339 F.3d at 940. Although the GAAP violations and the difference in losses are significant, the restatement alone does not strongly infer that the officers and directors acted deliberately or recklessly in regards to the alleged fraudulent accounting practices. Accordingly, this Court looks to the remainder of Lead Plaintiffs' allegations to determine whether scienter is adequately alleged.
b. The Remaining Scienter Allegations
Lead Plaintiffs first contend that the individual defendants' positions at the Company provide a strong inference of scienter based on the intimacy between the allegedly fraudulent transactions and the defendants. Opp. to Wireless' Mot. at 9-10 (citing, e.g., SAC ¶¶ 156-60). Thus, Lead Plaintiffs claim that it "'strains credulity' to believe that [d]efendants were not aware of many of the accounting improprieties at issue in this case." Id. at 9 (quoting In re Northpoint Communications Group, Inc. Sec. Litig. Consol. Cases, 221 F.Supp.2d 1090, 1104 (N.D.Cal. 2002)). Lead Plaintiffs further claim that the individual defendants' combined sale of millions of dollars worth of Wireless stock during the putative Class period gives rise to a strong inference of scienter, based on the amounts and percentages of the sales, the timing of the sales, and a comparison with the defendants' prior trading histories. Id. at 10-14. Lead Plaintiffs also contend that the individual defendants' "lavish salaries and bonuses" create a strong inference of scienter. Id. at 15.
The Wireless defendants contend that the compensation received by the individual defendants, as well as their positions at the Company, cannot be considered to infer scienter. Reply at 7-8 (citing McKesson, 126 F.Supp.2d at 1274, n. 14 ("Courts have consistently rejected efforts to characterize incentive compensation as a substantial motive for fraud, holding this to be a sufficient motive 'would effectively eliminate the state of mind requirement as to all corporate officers and defendants'") and In re Read-Rite Corp. Secs. Litig., 335 F.3d 843, 848-49 (9th Cir. 2003) (rejecting the argument that defendants' positions at the company give rise to a reasonable inference of scienter under the PSLRA)). The Wireless defendants further contend that the individual defendants' stock sales are not suspicious and, thus, should not be considered in determining whether scienter is adequately alleged. Id. at 2-6. The Wireless defendants point out that: (1) there are no allegations defendants DeMarco and Stokely sold any stock and, in fact, defendant DeMarco actually purchased stock during the relevant period; (2) defendant Ashwill sold only 28.4% of his stock and vested options, not 100% as the SAC alleges; (3) defendant Massih Tayebi's sale of stock should not be considered because Massih Tayebi did not work at the Company during the putative Class period; and (4) the stock sales of neither Massih Tayebi nor Massod Tayebi should be considered suspicious because both Massih Tayebi and Masood Tayebi's small percentage of stock sales (35.2% and 25.6% respectively) occurred over a four year period. Wireless' Reply at 2-4. In addition the Wireless defendants contend that the timing of the stock sales does not equate to suspicious activity. See id. at 5-6.
This Court is unconvinced that the individual defendants' positions at the Company and their compensation create an inference of scienter. Although the individual defendants held upper level management positions at one time or another during the claimed period and received lucrative salaries and bonuses, it does not necessarily follow that upper level management knew, or were aware, of the Company's alleged fraudulent accounting practices. See Read-Rite, 335 F.3d at 848-49; McKesson, 126 F.Supp.2d at 1274, n. 14. As to the individual defendants' stock sales, neither defendant DeMarco or Stokely sold stock during the relevant time period. Thus, there are no allegations demonstrating that defendants DeMarco and Stokely's committed suspicious actions that might create a strong inference of scienter on their parts. However, the stock sales of defendants Massih Tayebi, Masood Tayebi and Ashwill were significant in amount, see SAC ¶ 211, and were in close proximity to the alleged false statements, rendering those defendants' stock sales suspicious. Thus, this Court finds that only the stock sales of defendants Massih Tayebi, Masood Tayebi and Ashwill provide an inference of scienter.
This Court finds it appropriate to include Massih Tayebi's sale of stock even though he was not employed with the Company during the entire putative Class period because he was employed with the Company during the time Lead Plaintiffs allege the fraud took place and during a small part of the putative Class period. See SAC ¶¶ 77-79, 210.
Although the Wireless defendants claim that the percentage of stock sales alleged in the SAC by Lead Plaintiffs is not correct, in ruling on a motion to dismiss, this Court must view the facts alleged as true. See Cahill, 80 F.3d at 337-38.
During the putative Class period, Massih Tayebi's proceeds from the sale of Wireless stock totaled $42,031,957; Masood Tayebi's proceeds totaled $17,243,695; and Ashwill's proceeds totaled $1,868,292. SAC ¶ 211.
c. The Confidential Witnesses
The SAC lists five confidential witnesses that purport to have information concerning the individual defendants' scienter. See SAC ¶¶ 40-47. The Wireless defendants contend that the SAC fails to adequately plead facts to identify the confidential sources or demonstrate that the sources are reliable. See Wireless' Mot. at 13-17.
The allegations in the SAC are based upon investigation of counsel, which is the equivalent to being based upon information and belief. In re Silicon Graphics Sec. Litig., 970 F.Supp. 746, 763-64 (N.D.Cal. 1997). The PSLRA requires plaintiffs pleading on information and belief to "state with particularity all facts" on which their belief is based. 15 U.S.C. § 78u-4(b)(1). Sources need not be named but, if the source is not named, adequate corroborating details must be provided.McKesson, 126 F.Supp.2d at 1271. The McKesson court noted that Silicon Graphics does not "require naming (as opposed to identification) of sources" because "[i]t is possible to identify sources and provide other corroborating details without disclosing the names of the sources." Id. However, "[e]ven when it is not necessary for plaintiff to name sources, plaintiff's failure to identify the sources by name may somewhat reduce the weight to be given information from such unnamed sources in determining whether the allegations of the complaint create a strong inference of scienter, especially where there are relatively few identified sources." Id. at 1272.
Reliability of sources may be shown by stating facts "'with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged.'" Daou, 411 F.3d at 1015 (quoting Nursing Home Pension Fund, Local 144 v. Oracle Corp., 380 F.3d 1226, 1233 (9th Cir. 2004)). The Court determines reliability by assessing "'the level of detail provided by the confidential sources, the corroborative nature of the other facts alleged (including from other sources), the coherence and plausibility of the allegations, the number of sources, the reliability of sources and similar indicia.'" Id. (quoting In re Cabletron Sys., Inc., 311 F.3d 11, 29 (1st Cir. 2002)).
Lead Plaintiffs list five confidential sources: (1) a current employee of Wireless; (2) a former Brazilian controller; (3) a Wireless Project Accountant; (4) a former Sales/Account Manager; and (5) a former Vice President. See SAC ¶¶ 40-47. Specifically, the SAC alleges that a current employee (labeled "CW1") "has provided details concerning the falsification of the Company's financial results, "explaining certain employees of Wireless informed CW1 that "senior management was aware of their foreign tax obligations in 2001" but "conceal[ed] this information from the investing public." Id. ¶ 40. The former Brazilian controller is alleged to have information concerning the booking of revenue "using the percentage-of-completion revenue recognition method" in regards to a contract with Siemens for work in Brazil. Id. ¶ 41. The SAC alleges the former Brazilian controller "stated that the Company would book revenue on the percentage-of-completion revenue recognition method, despite the fact that the Company had not been paid for that work and knew such payment was problematic." Id. The controller is alleged to have discussed the Siemens contract with Masood Tayebi and Stokely during telephone conversations and conference calls.Id. ¶ 42. Similarly, the Wireless Project Accountant is alleged to have stated "that Wireless frequently performed work, billed customers and booked revenue even though it had never received signed contracts from the customers." Id. ¶ 44.
The remaining two confidential sources, a former sales/account manager with Wireless in Mexico City and a former Vice President of Business Development for Latin/Central America and the Carribean, are alleged to have information concerning "certain deals in Mexico with companies that had connections to the Tayebis even though these deals did not always result in Wireless getting the best terms, and even when Wireless personnel were being fired in Mexico because there was not enough work to keep them employed." Id. ¶ 46. The SAC explains, as an example of these allegedly improper deals, that Wireless employed a corporation in which Jay Tayebi, Masood and Massih Tayebi's brother, was a majority owner and Jay Tayebi's girlfriend was a principal, for "technical work" that "charged Wireless 'too much for the services rendered.'" Id. The sales/account manager is alleged to have stated that, based on the special relationship between Jay Tayebi and his brothers, the corporation "charged Wireless for services that had not been performed and for . . . payroll for personnel who were not even working on projects for Wireless." Id. ¶ 47.
The Wireless defendants contend that the allegations concerning these sources "fall short of meeting the requirements set out in Daou" for pleading personal sources of information. Wireless' Mot. at 14. In Daou, the Ninth Circuit found that where a plaintiff describes unnamed confidential witnesses "with a large degree of specificity," the PSLRA's pleading requirements are met. Daou, 411 F.3d at 1016. As an example, the Daou court explained that the plaintiffs sufficiently described one confidential source as:
Confidential Witness #6 ('CW6') is a former Daou executive who worked in the Finance Department. CW6 dealt with audit issues, Security and Exchange ('SEC') reporting and budget matters. As such CW6 was familiar with Daou's process of collecting project cost information. CW6 reported to defendant McGee. Similarly, plaintiffs described Confidential Witness #9 as follows: 'Confidential Witness 9 ('CW9') is a former Daou Regional Vice President of Sales. As Vice President of Sales, CW9 was responsible for reporting weekly or bi-weekly sales information, such as sales status/backlog and forecast/pipeline information to Daou's Vice Presidents and corporate officers.'Id.
The Wireless defendants also contend that the SAC contains insufficient facts to demonstrate the reliability of the confidential sources. The Wireless defendants point out that CW1's statement concerning Wireless' lack of payment for tax obligations is inaccurate because Wireless did not have to pay such tax but merely established an accrual in the event it may have to pay the tax. Wireless' Mot. at 14. The Wireless defendants argue that this inaccuracy "calls into question the . . . reliability of CW1's . . . information." Wireless' Reply at 6. In addition, the Wireless defendants point out that the SAC contains no allegations the former Brazilian controller personally observed any defendant's direct participation in the revenue recognition scheme. Id. The Wireless Project Accountant's information concerning unsigned contracts, according to the Wireless defendants, is also inaccurate because revenue may be recognized for unsigned contracts if there is an obligation to pay on the contract. See Wireless' Mot. at 16 (citing In re Ramp Networks, Inc. Secs. Litig., 201 F.Supp.2d 1051, 1071 (N.D.Cal. 2002)). Lastly, the Wireless defendants point out that neither the sales/account manager nor the Vice President of Business Development are alleged to be employed with Wireless during the putative Class Period. Wireless Reply at 7.
Here, Lead Plaintiffs do not describe their confidential sources' positions at Wireless with the "large degree of specificity" found by the Daou court to meet the PSLRA's standards. Id. Excepting the former Vice President, Lead Plaintiffs provide only sparse specific details about any of the confidential sources' positions with Wireless. For example, CW1 is merely described as "a current employee of the Company." SAC ¶ 40. Lead Plaintiffs also provide only sparse clarifying details, such as this individual's job duties and responsibilities or where the individual works. The Wireless Project Accountant's description contains no clarification other than the witness' job title. See id. ¶ 44. Although the SAC contains a description of when the Brazilian controller, the former sales/account manager and the former Vice President of Business Development were employed, see id. ¶ 41, 46, there is no explanation of those persons' responsibilities at the company. Additionally, with respect to all confidential sources, the SAC fails to allege with sufficient particularity the sources' knowledge of, or access to, information purportedly known or available to the defendants and the basis of that knowledge.
As the Wireless defendants point out in reply, "'[A] job title itself will seldom provide an adequate description of the CW's basis for his or her knowledge.'" Reply at 7 (quoting In re Apple Computer, Inc. Secs. Litig., 243 F.Supp.2d 1012, 1027 (N.D.Cal. 2002)).
For example, the SAC fails to allege whether the sources' knowledge was from creating reports from data containing adverse information for defendants' review, reporting to defendants or receiving directives from defendants post-receipt of adverse information.
This Court is unconvinced that these confidential witnesses are sufficiently described with specificity to meet the PSLRA's requirements. In addition, this Court's review of the SAC reveals no further facts to corroborate the scant information provided by the confidential witnesses. Therefore, this Court finds the allegations presented in the SAC are insufficient to demonstrate the confidential witnesses' information is reliable.
Because the SAC fails to sufficiently describe the confidential sources with specificity and their bases of knowledge, and there is insufficient facts plead to support the confidential witnesses' reliability, this Court finds Lead Plaintiffs' listed confidential sources fail to strengthen the inference of defendants' scienter.
d. The Court's Collective Review
Of the scienter allegations presented by Lead Plaintiffs concerning the Wireless defendants, only the allegations concerning the magnitude of the restatement itself and the allegations concerning three of the five individual defendants' stock sales are sufficiently plead and provide evidence of scienter by the Wireless defendants. This Court finds that, collectively viewed, the scienter allegations contained in the SAC are insufficient "to create a strong inference that defendants acted with deliberate or conscious recklessness."Broudo, 339 F.3d at 940. Accordingly, the Wireless' defendants' motion to dismiss the SAC based on failure to plead scienter with the specificity required under the PSLRA is GRANTED.
2. Non-Accounting Allegations
The Wireless defendants further contend that Lead Plaintiffs fail to adequately allege certain statements contained in the SAC, which the Wireless defendants label as "non-accounting" statements, are false and misleading. See Wireless' Mot. at 19-22 (citing SAC ¶¶ 77-80, 82-85, 87-90, 92-95, 98-99). According to the Wireless defendants, these statements were gleaned from "conference calls and press releases," and "cover a wide range of topics related to Wireless' business." Id. at 19. The Wireless defendants contend these "non-accounting" statements fail to satisfy the PSLRA's specificity requirement of identifying "each alleged false and misleading statement and the reason why each alleged statement was false or misleading when made." Id. (citing 15 U.S.C. § 78u-4(b)(1)). In addition, the Wireless defendants contend that (1) many of the statements are vague and, thus, not actionable; (2) some of the statements are opinions and are not properly plead; and (3) the forward-looking statements fail under Rule 9(b) and the PSLRA. Id. at 19-22.
In opposition, Lead Plaintiffs contend that the challenged statements are "inextricably tied" to statements made concerning the Company's financial results. Opp. to Wireless' Mot. at 19. Lead Plaintiffs explain that "[a]ll of the purported 'non-accounting' statements were made in connection with Wireless' earnings announcements and conference calls, quarterly and annual reports on Forms 10-Q and 10-K," which the SAC clearly alleges are false and misleading. Id. The Wireless defendants point out, in reply, that such an argument is inconsistent with the PSLRA, which requires each statement be identified and the reasons why such statement is alleged to be false and misleading must be stated along with the facts supporting the allegations. Wireless' Reply at 8-9.
The Wireless defendants cite to a recent decision in the Central District of California in which the court dismissed "strikingly similar" non-accounting statements as not plead with the particularity required under the PSLRA. Wireless' Reply. at 9 (citing In re Syncor Int'l Corp. Sec. Litig., 327 F.Supp.2d 1149, 1167 (C.D.Cal. 2004)). The Syncor court determined that the statements, which the court characterized as statements regarding the company's over-all financial success or projections, failed to meet the particularity requirement under the PSLRA. See id., 327 F.Supp.2d at 1169-70. When the statements found lacking in Syncor are compared to the challenged statements here, the similarity is quite noticeable. See id. at 1169 ( e.g., "Syncor is now profitably operating three radiopharmacies and has begun to expand into other types of medical services."); compare SAC ¶ 92 ("Operationally, we have strengthened and diversified our customer base and are well positioned for growth in each in our core markets."). However, the Syncor court found the statements not plead with particularity because a clear "legitimate business reason exist[ed] for the company's general financial success." See Syncor, 327 F.Supp.2d at 1169-70. This Court finds the reasoning behind the decision in Syncor lends no aid in the determination here.
The statements at bar are presented by Lead Plaintiffs in the SAC under the sub-heading entitled "Materially False and Misleading Statements Issued During the Class Period." SAC at 26. The SAC alleges that certain statements presented previously (and not challenged in this motion), "along with those during the Class Period as set forth below, artificially inflated the price of Wireless' stock during the Class Period" beginning May 5, 2003 and ending April 27, 2004. Id. ¶¶ 76, 98. Lead Plaintiffs allege that these statements were materially false and misleading:
The non-challenged statements, presented in the SAC under the sub-heading entitled "Statements Leading up to the Class Period," see SAC at 15, concern the financial results of the Company beginning February 14, 2001 through March 21, 2003. See id. ¶¶ 48-75. Some of these statements were made on the same day as the financial results were announced. See, e.g., id. ¶ 65. This Court's comparison between the two sets of statements reveals that the challenged set of statements are very similar to the non-challenged statements and Lead Plaintiffs allege the same reasons why these statements were false and misleading. See id. ¶¶ 50, 59, 75. Thus, this Court's determination of whether the challenged statements comply with the PSLRA holds true for the non-challenged statements as well.
because they concealed the following: (i) that the Company had materially under reported its burgeoning foreign tax burden; (ii) that the Company failed to record material adjustments related to period cut-off errors, reclassifications, reconciling differences that impacted asset and liability carrying values and the timing of revenue recognition; (iii) that the Company made numerous and material accounting errors as detailed in ¶¶ 110-166; (iv) that the Company lacked adequate internal controls and was, therefore, unable to ascertain the true financial condition of the Company; and (v) that as a result of the above, the Company's financial results were materially inflated at all relevant times.
SAC ¶ 97; see also id. ¶ 99. Some of the challenged statements were made on the same day the financial information was disseminated. See, e.g., id. ¶ 82.
Lead Plaintiffs contend that these statements were false and misleading because the "[d]efendants did not believe their statements since they were aware of undisclosed facts that seriously undermined their statements." Opp. to Wireless' Mot. at 19. In other words, Lead Plaintiffs argue that, because the individual defendants each knew that the financial results were wrong when the statements were made, the statements at issue were necessarily false and misleading. However, this Court has found that the SAC fails to adequately allege scienter on the part of the Wireless defendants. See Section 2.b.5., supra. Without adequate allegations of scienter, Lead Plaintiffs' argument fails because there is no strong inference the Wireless defendants knew the financial results, on which they commented, were false or misleading. Accordingly, this Court finds that the challenged statements set forth in the SAC are not adequately plead with the required particularity. Therefore, the Wireless defendants' motion to dismiss as it relates to these statements is GRANTED.
Because the statements are not plead with the particularity required by the PSLRA and Rule 9(b), this Court need not address the Wireless defendants' remaining arguments concerning these statements. See Wireless' Mot. at 20-22.
3. Economic Loss and Loss Causation
The Wireless defendants contend that the SAC fails to adequately plead economic loss and loss causation. In order for a defendant's misrepresentation or omission to be actionable under Rule 10b-5, a plaintiff must demonstrate loss causation, or "a causal connection between the material misrepresentation and the loss." Dura Pharmaceuticals, Inc. v. Broudo, 125 S.Ct. 1627, 1631 (2005). To satisfy the requirement for loss causation, a plaintiff must show that the misrepresentation or omission directly caused, "or had something to do with" plaintiff's damages. Id.; see also Ambassador Hotel Co., Ltd. v. Wei-Chuan Investment, 189 F.3d 1017, 1027 (9th Cir. 1999). Unlike the stringent requirements for scienter and falsity, no heightened pleading standard is required to plead loss causation to adequately plead loss causation. Id. at 1634. Lead Plaintiffs need only plead a "short and plain statement" that "provide[s] the defendant with 'fair notice' of what the plaintiff's claim is and the grounds upon which it rests." Id.; see Fed.R.Civ.P. 8(a).
In Dura, the Supreme Court concluded allegations of artificially inflated stock prices alone are insufficient to meet Rule 8. Id. Courts interpreting Dura's requirements have found allegations sufficient to plead loss causation where a plaintiff alleges the false and misleading statements caused artificially inflated stock prices and when the truth came out, the stock prices fell. See, e.g., In re Immune Response Sec. Litig., 375 F.Supp.2d 983, 1023-24 (S.D.Cal. 2005); see also Plumbers Pipefitters Local 572 Pension Fund v. Cisco Systems, Inc., 2005 WL 3723202*6 (N.D.Cal.). Here, the SAC alleges that Wireless stock prices were artificially inflated to a high of $18.60 per share during the relevant period. SAC ¶ 220. The SAC further alleges that, after Wireless publicly announced the intention to restate its financial statements for the years 2000-2003, the "stock price plummeted as much as 35.95% from $6.98 on August 4, 2004 to its 52 week low of $4.61 per share at one point on August 4, 2004." SAC ¶ 222. Thus, Lead Plaintiffs allege in the SAC that the economic loss suffered was the decline in stock value, not the artificially inflated stock prices. This Court finds these allegations sufficient to meet Rule 8's pleading requirements for economic loss and loss causation. Accordingly, the Wireless' defendants' motion to dismiss the SAC based on failure to adequately plead economic loss and loss causation is DENIED.
Although the Wireless defendants submit a declaration attesting that the stock prices climbed back to near pre-announcement price by the time the restatement was issued, this Court may not consider such extrinsic evidence when ruling on a motion to dismiss. See Parrino, 146 F.3d at 705-06;Branch, 14 F.3d at 453-54; MGIC Indem. Co., 803 F.2d at 504.
4. "Group Pleading" Doctrine
Lead Plaintiffs present, in the SAC, allegations that the individual defendants, as a group, were responsible for the alleged false and misleading statements. See, e.g., SAC ¶ 30. This "'group pleading' doctrine presumes that false and misleading information conveyed in documents, including press releases, are made by the collective action of a corporation's officers." Immune Response, 375 F.Supp.2d at 1028. The Wireless defendants note that it is unclear whether this "group pleading" doctrine survived the enactment of the PSLRA since the Ninth Circuit has not yet ruled on the issue and the district courts are split. See Wireless' Mot. at 24; see also Immune Response, 375 F.Supp.2d at 1028. However, the Wireless' defendants contend that this Court need not determine whether the "group pleading" doctrine survived the PSLRA because the group pleading allegations presented in this case are unreasonable and, therefore, inapplicable based on the fact that not all defendants were employed at Wireless during the putative Class period. See id. (citing Berry v. Valence Tech. Inc., 175 F.3d 699, 706 (1999) (affirming dismissal of claims concerning misstatements made after defendant had resigned)). Specifically, the Wireless defendants point out that defendant DeMarco joined the Company in November 2003, defendant Ashwill left the Company before the 2003 10-K report was issued, and defendant Massih Tayebi left the Company more than a year before the Class period started. Id. at 24-25.
Lead Plaintiffs, in opposition, urge the Court to find that the group pleading doctrine survived the PSLRA. Opp. to Wireless' Mot. at 23-24. However, Lead Plaintiffs contend that, even if the doctrine is found not to survive, each defendant's liability has been adequately plead based on the premise that there was a scheme to defraud. Id. at 24. The Wireless defendants, in reply, explain that Section 10(b) liability cannot be premised on conspiracy claims and, thus, Lead Plaintiffs may not rely upon a "scheme to defraud" to allege liability upon the individual defendants. Wireless' Reply at 10 (citing In re Glenfed Inc. Sec. Litig., 60 F.3d 591, 592 (9th Cir. 1995) (affirming district court's judgment dismissing conspiracy liability claims as precluded by United States Supreme Court precedent)).
This Court agrees with the Wireless defendants. This Court need not determine whether the group pleading doctrine survived the PSLRA because not all defendants named in the instant complaint were at the Company during the time period at bar and the scheme to defraud or conspiracy theory presented by Lead Plaintiffs has been rejected. Accordingly, the Wireless defendants' motion to dismiss the SAC's allegations concerning group liability is GRANTED.
b. KPMG
KPMG is an outside independent auditing firm that prepared audit reports for Wireless during the relevant period. KPMG contends the SAC fails to adequately plead facts to demonstrate KPMG's scienter pursuant to the stringent standards set forth under the PSLRA. See KPMG's Mot. at 6. Lead Plaintiffs' opposition again centers on a collective review of the scienter allegations. See Opp. to KPMG's Mot. at 8-9.
To establish scienter for independent auditors, a complaint must allege that "accounting practices were so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful . . ." DSAM Global Value Fund v. Altris Software, Inc., 288 F.3d 385, 390 (9th Cir. 2002) (citation omitted). KPMG contends that the SAC fails to allege facts indicating KPMG's audit was so negligent that it amounted to deliberate recklessness or conscious misconduct with an intent to defraud. KPMG's Mot. at 7. According to KPMG, Lead Plaintiffs' allegations are the type of allegations the legislature intended to eliminate by enacting the PSLRA. Id. at 8 (citing S. Rep. No. 104-98 at 21 (1995) (legislation intended to "significantly reduce the number of strike suits brought against defendants who have done nothing wrong but are seen as having deep pockets" and noting that "[a]ccounting firms particularly have been hard hit by securities litigation.").
The SAC outlines KPMG's alleged participation in the fraud. See SAC ¶¶ 177-203. According to Lead Plaintiffs, KPMG "annually reported and falsely represented in unqualified auditor's reports that [Wireless'] financial statements were fairly presented when they were not." SAC ¶ 177. The SAC further alleges that "KPMG falsely represented that it had conducted its audits in accordance with Generally Accepted Auditing Standards ("GAAS"), when it had not." Id. Specifically, the SAC alleges that a strong inference of scienter is demonstrated through (1) the restatement itself; (2) the volume of Wireless' accounting errors; (3) KPMG's motivation for fees and access to Wireless' corporate files; and (4) certain "red flags" that should have alerted KPMG of Wireless' alleged false and misleading financial statements. See id. ¶¶ 177-203. KPMG contends that Lead Plaintiffs' scienter allegations fail to meet the pleading standards required under the PSLRA. See KPMG's Mot. at 6-9. Lead Plaintiffs contend their allegations are sufficient viewed in their totality. See Opp. to KPMG's Mot. at 10.
1. The Restatement
This Court previously found that the restatement by itself does not create a "strong inference of scienter" on the part of the Wireless defendants. See Sec. 2 (A.2.a.) supra. This Court's reasoning also holds true for KPMG. Although the enormity of the restatement itself provides some inference of scienter, the restatement by itself is not enough to create a strong inference that KPMG acted with "deliberate or conscious recklessness."Broudo, 339 F.3d at 940. Therefore, this Court proceeds to an analysis of the remaining scienter allegations and a collective review of all allegations presented in the SAC.
2. The Volume of Accounting Errors
The SAC contains allegations concerning a variety of GAAS violations which Lead Plaintiffs contend provide an inference of scienter on KPMG's part. See SAC ¶ 203; Opp. to KPMG's Mot. at 13. KPMG's contends the allegations are "mere 'boilerplate averments'" which have been found insufficient to support an inference of scienter. KPMG's Mot. at 11 (quoting Melder v. Morris, 27 F.3d 1097, 1103 (5th Cir. 1994)). KPMG notes the Ninth Circuit also found merely alleging non-compliance with GAAS is insufficient by itself to raise a strong inference of scienter. Id. (citing DSAM, 288 F.3d at 390). In addition, KPMG's contends the large number of GAAS violations alleged by Lead Plaintiffs is also insufficient without particularized facts establishing KPMG's knowledge of the wrongdoing. Id. at 11-12 (citing In re U.S. Aggregates, Inc. Sec. Litig., 235 F.Supp.2d 1063, 1072 (N.D.Cal. 2002); Reiger v. Altris Software, Inc. ("Reiger I"), Case No. 98CV0528 TW, 1999 WL 540893*8 n. 8 (S.D.Cal.)).
In opposition, Lead Plaintiffs contend that KPMG's intent is demonstrated by the simplicity of the accounting procedures violated. Opp. to KPMG's Mot. at 15 n. 15 (citing, inter alia, In re Microstrategy Inc. Sec. Litig., 115 F.Supp.2d 620, 624-27, 638 (E.D. Vir. 2000)). Lead Plaintiffs point to seven "simple and fundamental" accounting procedures that were allegedly violated and, according to Lead Plaintiffs, provide strong support for an inference of KPMG's scienter. Id. at 15-16. KPMG, in reply, notes that Lead Plaintiffs presents no explanation as to how the listed GAAP provisions are simple. KPMG's Reply at 8. KPMG explains that even if the "provisions seem relatively simple in comparison to others, the application of that principal can involve significant judgment." Id. (citing In re Bristol-Myers Squibb Sec. Litig., 312 F.Supp.2d 549, 566-67 (S.D.N.Y. 2004) ("While in this case the applicable accounting principle might be simple, i.e., whether all the risks of ownership transferred upon shipment of goods, the application of that principle to the facts is complex."); Shalala v. Guernsey Mem'l Hosp., 514 U.S. 87, 101 (1995) ("There are 19 different GAAP sources, any number of which might present conflicting treatments of a particular accounting question.")).
This Court's review of the SAC reveals that Lead Plaintiffs present at least ten allegations of accounting procedure violations. See SAC ¶¶ 203(a)-(j). This Court finds the accounting procedures, although appearing to be simple procedures, may be complex in application in a large, worldwide corporation. Therefore, this Court finds that the volume of GAAS violations alleged fail to strongly infer scienter on KPMG's part.
For example, the procedure requiring "[a] sufficient understanding of the internal control structure is to be obtained to plan the audit and to determine the nature, timing and extent of the tests to be performed." SAC ¶ 203(e).
3. KPMG's Motivation for Fees and Access to Records
Lead Plaintiffs also allege scienter based on the fact that KPMG's earned fees from auditing Wireless' records and had access to their records. See SAC ¶¶ 181-186. KPMG contends that the Ninth Circuit "conclusively rejected the motive and opportunity test for scienter" and, thus, the allegations fail to satisfy the PSLRA's requirements. KPMG's Mot. at 13 (citing Silicon Graphics, 183 F.3d at 973). According to KPMG, the allegations lack facts to support a charge that "KPMG had an incentive to risk its professional integrity and reputation, and subject itself to criminal and civil liability for securities fraud violations, for the mere prospect of collecting additional fees from one engagement." Id. at 14.
KPMG further contends that the SAC's allegations lack facts to demonstrate KPMG "had the 'means and likely prospect of achieving concrete benefits by the means alleged.'" Id. (quoting Shields v. Citytrust Bancorp., Inc., 25 F.3d 1124, 1130 (2d Cir. 1994)). KPMG points out that other courts have rejected the notion that a strong inference of scienter may be inferred from an auditor's access to corporate documents. Id. at 15 (citing, e.g., Kennilworth Partners L.P. v. Cendant Corp., 59 F.Supp.2d 417, 429-30 (D.N.J. 1999); DSAM, 288 F.3d at 390; In re Van Wagoner Foods, Inc. Sec. Litig., 2004 U.S. Dist. LEXIS 24868 *27-28 (N.D. Cal.)).
Lead Plaintiffs, in opposition, concede the Ninth Circuit "'has found that allegations of a motive to mislead, standing alone, cannot satisfy the heightened scienter standard'" but note the Court is "'not precluded from considering allegations of motive in combination with other allegations of Defendants' intent to mislead or deliberate recklessness.'" Opp. to KPMG's Mot. at 21 (quoting Livid Holding Ltd. v. Salomon Smith Barney, Inc., 403 F.3d 1050, 1057-58 (9th Cir. 2005)). In addition, Lead Plaintiffs contend that motive may be inferred here through the dual role KPMG played (apparently as an auditor and a consultant) while auditing Wireless' accounts. Id. at 22-23 (citing In re Fleming Cos. Sec. Derivative Litig., 2004 U.S. Dist LEXIS 26488 (E.D. Tex.)). According to Lead Plaintiffs, KPMG's receipt of non-audit fees for consulting on at least one of the issues Wireless restated proves motive and provides an inference of scienter. Id. at 23. Lead Plaintiffs also contend that, because the SAC alleges KPMG assisted in creating the tax accounting problems at issue here, the SAC pleads facts supporting the opportunity to commit the fraud. Id. at 23-24.
As KPMG points out, the Ninth Circuit has rejected the notion that an auditor's motive may be inferred from the fact that the auditor received professional fees for services rendered. See Silicon Graphics, 183 F.3d at 973; In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1427 n. 7 (9th Cir. 1994). An auditor's access to records has similarly been rejected as appropriate evidence of scienter. See, e.g., DSAM, 288 F.3d at 390. This Court is unpersuaded that KPMG's "dual role" of consultant and auditor provides sufficient evidence to support scienter.
4. Red Flags
The SAC lists numerous "red flags" which Lead Plaintiffs assert should have alerted KPMG that Wireless' financial statements were false and misleading. See SAC ¶ 191, 198-200. KPMG contends these allegations have been found insufficient to create a strong inference of scienter. See KPMG's Mot. at 17-23 (citing, e.g., Fidel v. Farley, 392 F.3d 220, 228-29 (6th Cir. 2004)). According to KPMG, the red flags alleged by Lead Plaintiffs are not the "smoking gun" type of evidence which might trigger an inference of scienter. Id. at 18. KPMG also points out that some of the red flags were publicly disclosed by Wireless, thereby negating an inference of scienter. Id. KPMG describes the red flags alleged in the SAC as "weak" and "generic" because the allegations fail to include "'specific facts suggesting the independent accountant entertained doubts about the veracity of a client's financial disclosures, either from a client or third party informing the accountant of the client's fraud, or from contemporaneous statements made by the accountant.'" Id. (quoting Reiger v. Price Waterhouse Coopers LLP ("Reiger II"), 117 F.Supp.2d 1003, 1012 (S.D.Cal. 2000)). KPMG points out that more specific red flags than those alleged here have been rejected as insufficient. Id. at 19 (citing, inter alia, DSAM, 288 F.3d at 389-90).
Lead Plaintiffs, in opposition, explain that the SAC details at least three categories of red flags that should have alerted KPMG of the alleged fraud: (a) accounting of goodwill in related-party transactions; (b) KPMG's tax consulting service; and (c) internal control weaknesses. See Opp. to KPMG's Mot. at 17-21; KPMG's Reply at 8-9.
a. Goodwill
The SAC alleges Wireless reported, in 2002, that $16.1 million in goodwill from a Mexican wireless communications company purchased in 1998 was unimpaired but admitted, in 2004, that the goodwill was actually 100% impaired. See SAC ¶ 155-161. Lead Plaintiffs contend that "[b]ecause information was available to KPMG in 2002 that demonstrated Wireless' assets were overstated by $16.1 million, and KPMG was required to carefully evaluate related transactions like this one, it was at least deliberately reckless that KPMG failed to disclose the fraudulent accounting for this related-party transaction." Opp. to KPMG's Mot. at 6. KPMG contends these allegations are conclusory and infers only negligence, at most, not intentional or deliberately reckless conduct. KPMG's Reply at 4-5 (citing DSAM, 288 F.3d at 390).
The admission occurred through an amended Form 10-K filed on September 20, 2004, during a conference call on the same day, and in the restatement. See SAC ¶¶ 159-161.
This Court agrees with KPMG. The Ninth Circuit, in DSAM, found that the auditor defendant "had in its hands the very documentation that clearly showed . . . [a] violation of GAAP . . . yet did not see the obvious" but determined "[t]hat fact does not strongly compel an inference of intentional or deliberately reckless conduct as opposed to ordinary carelessness." Id., 288 F.3d at 390. Similarly, here, although KPMG may have had the information available through its access to Wireless' accounting records, it does not necessarily follow that KPMG's conduct amounts to anything more than mere negligence or carelessness based solely on the fact that the accounting for this goodwill was improper. This Court finds that the allegations concerning the improper accounting of goodwill as a red flag to KPMG fails to provide an inference of scienter.
b. Tax Consulting
Lead Plaintiffs claim that KPMG acted not only as an auditor, but as a tax consultant to the Company and at least one of Wireless' principals. See SAC ¶¶ 185-86, 188. Lead Plaintiffs, noting that "it is undisputed that Wireless' net income was overstated by $14.7 million as a result of its failure to properly accrue for tax contingencies," argue that "[b]ecause KPMG was so intimately involved with the Company's taxes during the time it was fraudulently accounting for them, it is an eminently reasonable inference that KPMG knew how the Company was accounting for its tax contingencies, and that the Company's accounting was improper, based on the facts that existed at the time." Opp. to KPMG's Mot. at 18-19.
KPMG urges the Court not to consider allegations presented by Lead Plaintiffs concerning KPMG's alleged involvement in setting up unlawful tax shelters for other clients. See KPMG's Mot. at 13, n. 11; Opp. to KPMG's Mot. at 19 n. 18. KPMG argues that scienter cannot be inferred from improper conduct alleged to occur in another arena. See KPMG's Mot. at 13, n. 11 (citingFidel v. Farley, 392 F.3d 220, 233 (6th Cir. 2004) (other securities lawsuits filed against defendant not probative of scienter); In re Segue Software, Inc. Sec. Litig., 106 F.Supp.2d 161, 171 (D.Mass. 2000) (fact that defendant named as defendant in another securities lawsuit or "once worked for a company accused of accounting irregularities, borders on calumny.")). Lead Plaintiffs contend that these allegations are properly considered because, unlike the defendants in the cited cases, KPMG has admitted to participating in setting up unlawful tax shelters. Opp. to KPMG's Mot. at 19, n. 18. However, there is no allegation in the SAC that states KPMG admitted to the unlawful conduct. Although Lead Plaintiffs submit two financial news articles as evidence to support their contention that KPMG admitted the unlawful acts, when ruling on a motion to dismiss pursuant to Fed.R.Civ.P. 12(b)(6), this Court may only consider facts alleged in the complaint, documents attached to the complaint, documents relied upon but not attached to the complaint when authenticity is not contested, and matters of which the Court takes judicial notice. Parrino, 146 F.3d at 705-06; Branch, 14 F.3d at 453-54; MGIC Indem. Co., 803 F.2d at 504. The evidence submitted by Lead Plaintiffs does not fit under any of these categories. This Court is persuaded by the reasoning set forth by the courts in the cases cited by KPMG. Therefore, this Court declines to consider the allegations concerning KPMG's participation in setting up unlawful abusive tax shelters for other clients.
This Court finds no inference of scienter from the fact that KPMG may have acted as a tax consultant and auditor to Wireless during the same period. As KPMG points out in reply, there are no facts plead that connect KPMG's tax consulting with any audit of Wireless' foreign tax contingencies accruals at issue in this case. See Reply at 4. In this Court's view, the allegation that KPMG was "intimately involved" with Wireless' tax records due to KPMG's role as tax consultant adds little or no weight to the scienter determination. See Opp. to KPMG's Mot. at 18. Accordingly, this Court finds these allegations fail to create an inference of scienter.
c. Internal Controls
Lead Plaintiffs further contend that weaknesses in the internal controls at Wireless should have put KPMG on notice that there may be fraudulent activity, creating an inference of scienter. See SAC ¶¶ 198-202; Opp. to KPMG's Mot. at 20-21. The SAC alleges Wireless admitted the company's internal controls were deficient. SAC ¶ 201. KPMG claims Lead Plaintiffs' allegations are "bare allegations of a misapplication of accounting principles" which "do not shed light 'on the mental state of the auditors' and at best constitute conclusory allegations that KPMG was negligent in its review of [Wireless'] internal controls." KPMG's Reply at 5 (citing DSAM, 288 F.3d at 390-91). KPMG points out that similar allegations have been rejected as "'boilerplate 'red flags,' present in almost every securities fraud action' that 'do not meet the strong inference requirements of the Reform Act.'" Id. (quoting Reiger II, 117 F.Supp.2d at 1009 n. 5)).
An "internal control" is defined as "a process-effected by an entity's board of directors, management, and other personnel-designed to provide reasonable assurance regarding the achievement of objectives" in financial reporting, operations and compliance with applicable laws and regulations. See Evans Decl., Exh. B (AU § 319.06-.07).
The SAC states that "the sheer volume of Wireless' admitted GAAP violations indicates that KPMG recklessly disregarded the Company's insufficient internal controls.'" SAC ¶ 202. This Court finds this allegation fails to identify the specific internal controls that were insufficient and how KPMG knew about the deficient internal controls. This Court, therefore, finds Lead Plaintiffs' allegations concerning KPMG's disregard of deficient internal controls fails to provide an inference of scienter.
5. The Court's Collective Review
Lead Plaintiffs have alleged KPMG's scienter based on (1) the restatement itself; (2) the volume of Wireless' accounting errors; (3) KPMG's motivation for fees and access to Wireless' corporate files; and (4) certain "red flags" that should have alerted KPMG of Wireless' alleged false and misleading financial statements. See SAC ¶¶ 177-203. This Court has found that only the magnitude of the restatement provides an inference of scienter. The facts alleged regarding the volume of accounting errors, KPMG's access to Wireless' financial records and receipt of professional fees fail to infer scienter on KPMG's part. This Court is unconvinced that the alleged red flags, either individually or collectively, create an inference of KPMG's scienter. Therefore, this Court finds the allegations presented in the SAC fail to adequately allege scienter under the stringent pleading standards of the PSLRA. Accordingly, KPMG's motion to dismiss the SAC for failure to adequately plead scienter is GRANTED.
c. Dismissal With or Without Prejudice
Both the Wireless defendants and KPMG urge this Court to dismiss the SAC with prejudice. See Wireless' Mot. at 25; KPMG's Mot. at 24. Although, as KPMG points out, this is not the first attempt to present a proper pleading, see KPMG's Mot. at 24, this is the first time this Court has had an opportunity to review the allegations and determine whether the claims presented meet the stringent pleading requirements under the PSLRA and Rule 9(b). In addition, this Court notes that denial of leave to amend in securities fraud cases is proper where the plaintiff had previously amended but "declined to say what additional facts they might plead if given the chance to amend." In re Vantive Corporation Sec. Litig., 283 F.3d 1079, 1998 (9th Cir. 2002). Here, Lead Plaintiffs have not yet had the opportunity to explain what facts they might plead to cure the deficiencies. Therefore, this Court finds that Lead Plaintiffs should have the opportunity to file another amended complaint in an attempt to cure the deficiencies presented herein.
CONCLUSION AND ORDER
Based on the foregoing, IT IS HEREBY ORDERED that:
1. The Wireless defendants' motion to dismiss the SAC [doc. # 83] is GRANTED IN PART and DENIED IN PART. The Wireless defendants' motion is DENIED as it relates to the SAC's allegations of economic loss and loss causation and GRANTED in all other respects;
2. KPMG's motion to dismiss the SAC [doc. # 86] is GRANTED in its entirety; and
3. The second amended complaint is DISMISSED without prejudice. Lead Plaintiffs are granted leave to file a third amended complaint in conformance with this Order within forty-five (45) days of the date this Order is stamped filed.