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finding the case under the same circumstances unripe because "the mere filing of lawsuits cannot provide a factual predicate for alleging damages"
Summary of this case from In re Bofi Holding, Inc. S'holder Litig.Opinion
No. C 86-20719 (SW)
September 19, 1988
ORDER GRANTING MOTIONS TO DISMISS IN PART AND DENYING THEM IN PART AND DENYING PLAINTIFF'S MOTION FOR CERTIFICATION
This case came before the court on July 13, 1988, for hearing on defendants' motions to dismiss and on plaintiff's motion for an order pursuant to California Corporations Code § 800. At the conclusion of oral argument, this court ruled that Federal Rule of Civil Procedure 23.1, not Cal. Corp. Code § 800, would govern this derivative suit and took the remaining motions to dismiss under submission. On July 26, 1988, plaintiff moved the court to include in this order the certification language of 28 U.S.C. § 1292 (b).
BACKGROUND:
This case is related to the securities class action suit filed in this court entitled In re Daisy Systems Securities Litigation, (C 86-20127(A) SW) (hereinafter "Daisy class action"). This lawsuit (hereinafter the "Coelho action") is a combination of shareholder derivative claims and individual claims. Plaintiff Coelho, an Idaho citizen and a shareholder of Daisy Systems Corporation, asserts derivative claims under California statutory law and common law (Count IV of his amended complaint) against inside director defendants Aryeh Finegold and David Stamm and against outside director defendants James Harrison, Jeffrey West, Sanford Kaplan, and Max Palevsky. He also asserts individual claims under Section 10(b) of the Exchange Act, 15 U.S.C. § 78j (b), and Rule 10b-5 promulgated thereunder, against Finegold and Stamm.
Coelho has opted out of the Daisy class action litigation.
On September 23, 1987, in the Daisy class action, this court dismissed the federal securities fraud claims against all the outside director defendants. The court held that their connection to the alleged misrepresentations was not pled with sufficient particularity as required under Fed.R.Civ.P. 9(b); furthermore, plaintiff class could not rely on the presumption in Wool v. Tandem Computers, 818 F.2d 1433, 1440 (9th Cir. 1987), that "group-published" information represents the collective actions of the officers because the outside directors were not involved in the "day-to-day" affairs of Daisy. Plaintiff Coelho, in his individual claims, has conformed his amended complaint to this part of the September 23, 1987 order and has not brought individual claims against the outside directors.
These outside directors are named as defendants in the derivative claims of the complaint, however.
However, also in the September 23, 1987 order, this court dismissed seven of the fourteen alleged misrepresentations, holding that they were not actionable under federal securities laws. As a result, the class period was limited to four months, from October 1985 to February 1986. In his individual claims, however, Coelho alleges a sixteen month conspiracy to commit securities fraud stretching from November 1984 through February 1986.
After lengthy oral argument, this court denied class plaintiff's motion for reconsideration on three of the dismissed statements on January 20, 1988.
In the present motions, all the derivative defendants argue that Coelho has standing only to bring derivative claims involving transactions that occurred after January 23, 1986, the date that Coelho bought his stock. These defendants also contend that the common law insider trading claims must be dismissed for failure to state a claim. Derivative defendants Harrison and West also claim that the demand upon the Board, as required under Fed.R.Civ.P. 23.1, was insufficient and that the harm suffered by the company is too speculative. In addition, the outside directors claim that, based on the reasoning of the September 23, 1987 order, they shouldn't be in the derivative suit at all. Furthermore, on the individual claims, defendants Stamm and Finegold move to dismiss all statements made before October 1985.
On his part, plaintiff Coelho seeks an order pursuant to Cal. Corp. Code § 800, holding that he can bring this derivative suit for the entire sixteen month period even though he only owned stock the last two months.
DISCUSSION:
I. The Derivative Claims (Count IV)
A. The Standing Issue
Plaintiff Coelho bought his Daisy stock on January 23, 1986. However, he asserts that the "relevant period" in which defendants' wrongful conduct occurred was November 1984 through February 27, 1986. Rule 23.1 of the Federal Rules of Civil Procedure requires that a derivative plaintiff be a shareholder at the time of the transaction of which the plaintiff complains. Thus, Coelho's failure to allege contemporaneous ownership prior to January 23, 1986, compels dismissal of the derivative count except for those alleged misstatements made after Coelho purchased his stock. Lewis v. Chiles, 719 F.2d 1044, 1047 (9th Cir. 1983) (Rule 23.1 "requires that a derivative plaintiff be a shareholder at the time of the alleged wrongful acts. . . ."). However, Coelho argues that several different theories allow him to pursue this derivative claim in its entirety. Only one of these theories, that Cal. Corp. Code § 800 applies, not Fed.R.Civ.P. 23.1, merits discussion.
Cal. Corp. Code § 800 provides that if a derivative plaintiff can meet a five-pronged test, he or she has standing to sue on the basis of alleged misconduct that occurred before he or she was a stockholder. Coelho argues that Cal. Corp. Code § 800 must apply for three reasons: 1) because this California statute is in conflict with Fed.R.Civ.P. 23.1, 2) because this is a diversity action in which state substantive law controls, Erie Railroad Co. v. Tompkins, 304 U.S. 64 (1938), and 3) because Fed.R.Civ.P. 23.1 does not have the same presumption of procedural validity that the Court in Hanna v. Plumer, 380 U.S. 460 (1965), accorded the Federal Rules of Civil Procedure in general.
The backbone of Coelho's argument that Rule 23.1 is not presumptively procedurally valid is the Advisory Committee's comments to the 1946 amendments to the federal rules in which the Committee recognized that Rule 23.1's predecessor, Rule 23(b), could be considered "a rule [which] deals with a matter of substantive right . . ." (Emphasis added.) Coelho then cites a 1943 United States Supreme Court case, Cohen v. Beneficial Industrial Loan Corp., 337 U.S. 541, 555-57 (1943) in which the Court held that a state law requiring a plaintiff to post security in a derivative action was not merely a procedural requirement. The Court stated that "[t]he very nature of the stockholder's derivative action makes it one in the regulation of which the legislature has wide powers . . . "We conclude that the state has plenary power over this type of litigation." Id. And finally, Coelho points out that under the Rules Enabling Act, 28 U.S.C. § 2072, and a plethora of case law including Burlington Northern Railroad Co. v. Woods, 107 S.Ct. 967 (1987), a Federal Rule of Civil Procedure is not to be applied if it abridges, enlarges or modifies any substantive right created by the state.
Defendants counter with Sax v. World Wide Press, Inc., 809 F.2d 610, 613 (9th Cir. 1987) in which the Ninth Circuit held that
[i]n diversity actions, the characterization of an action as derivative or direct is a question of state law. Once state law characterizes the actions as either derivative or direct, the applicable procedural rules are determined by federal law. In federal courts, derivative suits are subject to the procedural requirements of Fed.R.Civ.P. 23.1.
Id. (Citations omitted.)
Furthermore, defendants point out that plaintiff's Cohen case involved a state statute which was held not to conflict with former Rule 23(b) and has in fact been cited by courts to support application of the contemporaneous ownership rule regardless of contrary state law. See, e.g., Elkins v. Bricker, 147 F. Supp. 609 (S.D.N.Y. 1956); Kaufman v. Wolfson, 136 F. Supp. 939, 940 (S.D.N.Y. 1955).
After careful consideration of the arguments on both sides, this court holds that the contemporaneous ownership rule of Fed.R.Civ.P. 23.1 controls. The Cohen case is clearly distinguishable, and the Ninth Circuit's language in the far more recent Sax decision, although not a case exactly on point, persuades this court that precedent favors the applicability of Rule 23.1.
Furthermore, the court disagrees with plaintiff's view that Rule 23.1 does not share the presumptive validity of Hanna. The Committee merely noted the potential for challenge to Rule 23.1's predecessor if it conflicted with state law. The Committee did not state that the rule was substantive but suggested what should be done if the Court so found. And interestingly, the Advisory Committee omitted any reference to the potential conflict when it drafted its comments on Rule 23.1 itself.
Moreover, this court agrees with the perspective that dismissal of the derivative claims pursuant to Rule 23.1
does not represent a refusal to enforce the state-created claim but is simply a rejection of the particular claimant, a result attributable to the federal court's authority to determine who may assert or defend an action in the national courts.
7C C. Wright, A. Miller, M. Kane, Federal Practice and Procedure § 1829 (1986).
Application of Rule 23.1 does not "abridge" the corporation's right to bring its suit, it simply limits Coehlo's right to be its representative. Therefore, this court DENIES plaintiff's motion for an order pursuant to Cal. Corp. Code § 800 and GRANTS defendants' motion to dismiss all of Coehlo's derivative claims based on misstatements prior to his ownership of Daisy stock.
B. The Demand
Defendants Harrison and West contend that a demand letter sent to the Board of Directors on April 24, 1986, was inadequate because the letter neither specifically named them nor described their wrongdoing with particularity.
The court in Greenspun v. Del E. Webb Corp., 634 F.2d 1204, 1209 (9th Cir. 1980) stated that "[t)he sufficiency analysis under Rule 23.1 looks to the sufficiency of the content of the demand and the sufficiency of the authority of those to whom the demand is presented." To pass muster the demand must "identify the alleged wrongdoers, describe the factual basis of the wrongful acts and the harm caused to the corporation, and request remedial relief." Lewis v. Sporck, 646 F. Supp. 574, 578 (N.D. Cal. 1986).
The demand letter in question was addressed to the Board of Directors and refers to complaints filed in at least ten class action suits. The letter states that "the officers and directors named as defendants in these suits should also be sued by the Company to recover its damages." (Emphasis added.) In the Lewis case the court noted that reference to a complaint sufficiently identifies the wrongdoers for purposes of the demand requirement. 646 F. Supp. at 578. And while defendants Harrison and West were eventually dismissed from the Daisy class action filed in this court, such dismissal does not negate the fact that these defendants had notice of their status as defendants in that litigation at the time the demand was made.
Therefore, defendants Harrison and West's motion to dismiss based on the inadequacy of the demand letter is DENIED.
C. The Speculativeness of the Harm
Defendants Harrison and West also argue that the harm the corporation has suffered or will suffer as a result of defendants' misconduct is too speculative to be the basis of a derivative suit. They claim that as the class action suits have not yet been resolved, there is no way of knowing what harm will be suffered. See Falkenberg v. Baldwin, [1977-78) Fed. Sec. L. Rep. (CCH) paragraph 96,086 (S.D.N.Y. June 13, 1977) (potential injury to corporation arising from suits brought by purchasers was too speculative and uncertain to support derivative action).
Plaintiff contends that Falkenberg is distinguishable from the case at hand because the complaint here alleges that Daisy has already sustained injury in the form of attorneys' fees and costs expended in defense of the class litigation, lost market share, decreased profit margins, lost sales, lost investor confidence and misuse of inside information. However, as discussed below, California does not recognize a derivative cause of action for disgorgement of insider trading profits; in addition, Coelho does not allege that either Harrison or West derived any wrongful gain from insider trading or other misconduct. Therefore, plaintiff is hard pressed to demonstrate that any damage suffered by the corporation from misuse of inside information can be attributed, either legally or factually, to these two defendants. Furthermore, this court agrees with defendants that the mere filing of lawsuits cannot provide a factual predicate for alleging damages. And while damages in the form of lost market share, decreased profit margins and lost sales are sufficiently ascertainable, these losses are not included with the other damages alleged in paragraph 74 of plaintiff's First Amended Derivative Complaint.
Therefore, defendants Harrison and West's motion to dismiss is GRANTED with respect to the speculativeness of the damages. However, plaintiff has forty-five days from the entry of this order to amend his complaint to allege any lost market share, decreased profit margins and lost sales suffered by the corporation as a result of misconduct on the part of these two defendants.
D. The Liability of the Outside Directors
The outside director defendants, Kaplan, Palevsky, Harrison and West, also claim that they shouldn't be in the derivative lawsuit at all because they were dismissed from the Daisy class action. However, as plaintiff points out, the class action securities fraud claims were dismissed against the outside directors because the complaint did not meet the Rule 9(b) pleading "with particularity" requirements for fraud and the outside directors did not fall within the Tandem control group for whom the 9(b) requirements are relaxed. However, the derivative suit against these defendants is for breach of fiduciary duty under Cal. Corp. Code § 309. While the outside director defendants may not be presumed to know the contents of Daisy's annual reports for purposes of § 10(b) liability, the defendants' failure to undertake an adequate review and inquiry of these documents and of Daisy's operations may nonetheless be a breach of the state law duties of care and inquiry. Those directors who have been dismissed from the class action had a duty to investigate and to exercise due care in overseeing the management of Daisy, regardless of whether they were involved in the scheme to defraud.
Therefore, the outside director defendants' motion to dismiss for failure to meet the pleading requirements of Rule 9(b) is DENIED.
E. The common law insider trading claims
One of Coehlo's primary derivative claims is that defendants Finegold, Stamm, Palevsky and Kaplan improperly sold Daisy securities while in possession of material, non-public, adverse information that they misappropriated from Daisy and used for their personal benefit in violation of their fiduciary duties. Defendants move to dismiss these claims on the basis that California does not recognize a derivative cause of action for insider trading.
This court agrees with defendants. The seminal case on derivative insider trading actions, Diamond v. Oreamuno, 24 N.Y.2d 494, 301 N.Y.S.2d 78 (N.Y. 1969), is based entirely on principles of New York common law, and plaintiff can cite no California state court decision which has recognized a Diamond-type cause of action.
Furthermore, the unpublished 1974 decision by Judge Lucas in Loeffler v. Goldblum, No. 73-1034, slip op. at 11-12 (C.D. Cal. 1974), in which he upheld a derivative common law insider trading claim, is based on erroneous predictions of what California courts would do in the immediate future. First, he assumed that other states (specifically Florida) and the federal courts would not hesitate to "assimilate the Diamond principle." Slip op. at 12. However, since the Loeffler decision, both the Supreme Court of Florida and the Seventh Circuit have refused to recognize derivative insider trading claims. Freeman v. Decio, 584 F.2d 186 (7th Cir. 1978); Schein v. Chasen, 313 So.2d 739 (Fla. 1975). Furthermore, Judge Lucas incorrectly concluded that "California' s securities policies support the adoption of Diamond." Slip op. at 13. However, the district court in Fletcher v. Gagosian, Fed. Sec. L. Rep. (CCH) paragraph 71, 356 (S.D. Cal. 1977), examined California's securities policies and concluded that the California legislature intended two provisions of the California Corporations Code, §§ 25402 and 25502, to provide the exclusive basis for an insider trading remedy under California law. These provisions only allow recovery by a person who bought or sold the security from the alleged wrongdoer.
Therefore, the derivative common law insider trading claims are hereby DISMISSED.
II. The Individual Claims (Counts I-III)
The First Amended Derivative Complaint contains ten statements made prior to October 21, 1985, the date the "relevant period" for the class action begins. Defendants Finegold and Stamm move to have all ten of these statements dismissed.
The statements are listed in the appendix attached as Exhibit A to this order.
This court held in its September 23, 1987 order that the statements in the class action made before October 21, 1985, were "generalized descriptions of Daisy's profitability and [went) no further than to offer management's general optimism and expectation of continued success." Furthermore, this court denied class plaintiff's motion for reconsideration of three of the seven dismissed statements after lengthy oral argument.
Statements 8, 9, and 10 are identical to three of the statements previously analyzed and dismissed by this court and are dismissed again without further discussion.
With respect to the remaining seven statements, the threshhold issue is materiality. The inquiry should be whether a reasonable investor would consider a representation important in making an investment decision. Toombs v. Leone, 777 F.2d 465, 469 (9th Cir. 1985).
Defendants emphasize Judge Aguilar's recent observation in In re Apple Computer Securities Litigation, 672 F. Supp. 1552, 1561 (N.D. Cal. 1987) that
in a fraud on the market case, "not every fact must be disclosed." Teamsters Local 282 Pension Trust Fund v. Angelos, 762 F.2d 522, 529 (7th Cir. 1985); see also Promios v. Fair Auto Repair, Inc., 808 F.2d 1273, 1277 (7th Cir. 1987) ("The materiality of a statement or omission depends on [its] context.").
Defendants argue that as the alleged misrepresentations must be "viewed with an appreciation for the context in which they were made," In re Apple, 672 F. Supp. at 1562, Coelho cannot show that the statements are actionable.
A. Statement 1
Daisy's expectation that the November 1984 public offering would provide sufficient funds turned out to be incorrect as evidenced by the February 1985 offering. However, "in the case of a prediction as to the future, that [it turned out to be wrong) does not make the statement untrue when made." Marx v. Computer Sciences Corp., 507 F.2d 485, 490 (9th Cir. 1974). Furthermore, statements containing terms such as "expected" and "possibility" "bespeak caution in outlook and fall far short of the assurances required for a finding of falsity and fraud." Polin v. Conductron Corp., 552 F.2d 797, 806 n. 28 (8th Cir.), cert. denied, 434 U.S. 857 (1977). Accordingly, statement 1 is DISMISSED.
B. Statements 2 and 5
Coelho claims that these two identical statements are false and misleading because Daisy admitted in February 1986 that "historically, a significant portion of each quarter's products ship at the end of the quarter." This admission supposedly demonstrates that in November 1984 and February 1985 Daisy was shipping products prematurely and had not performed adequate testing. However, the allegations as they stand do not support the leap of logic that this "historical practice" was in effect during the time the alleged misstatements were made. Therefore, statements 2 and 5 are DISMISSED.
C. Statement 3
Coehlo alleges that the omitted fact from statement 3 is that the funds were needed to "meet competition and to fund product refinements and development." However, this court holds that such an "omitted fact" is not inconsistent with statement 3. Consequently, statement 3 is DISMISSED.
D. Statement 4
Coehlo contends that statement 4, although an accurate statement of past fact, is misleading because Daisy omitted to state that it could not bring new products quickly to a deliverable stage at the present time. Plaintiff cites Hoffman v. Estabrook Co., 587 F.2d 509, 515 (1st Cir. 1978), in which the court held that a statement of past fact is not insulated from being misleading when it is used to imply future conformity. However, this court disagrees with plaintiff that statement 4 offers an implied prediction about how quickly Daisy would be able to develop new products in the future. Therefore, statement 4 is DISMISSED.
E. Statement 6
The last sentence of statement 6, the sentence in dispute, is a statement of belief. Statements of belief or expectation are only actionable under federal securities laws if they have no reasonable basis in fact. Marx v. Computer Sciences Corp., 507 F.2d 485, 491 n. 7 (9th Cir. 1974). No facts are alleged which indicate that Daisy's stated belief was not reasonable. Statement 6 is DISMISSED.
F. Statement 7
The figures in statement 7 are all accurate. Coelho asserts that the reports are misleading because they failed to disclose that Daisy was facing "increasing competition and customer dissatisfaction with product quality." However, as this court noted in its September 23, 1987 order, the competition and customer dissatisfaction did not materially affect Daisy's business until October 1985. Therefore, statement 7 is not misleading and is hereby DISMISSED.
III. The Motion for Certification
After this court ruled at the July 13th hearing that Rule 23.1's contemporaneous ownership requirement would govern this suit, plaintiff moved to have this ruling certified for interlocutory appeal pursuant to 28 U.S.C. § 1292 (b). However, although the court recognizes that some scholars and commentators have speculated on the applicability of Rule 23.1 in the face of conflicting state law, the great weight of precedent, particularly recent authority, belies such speculations. Therefore, there is no substantial ground for difference of opinion, and the motion for certification is hereby DENIED.
CONCLUSION:
In summary, as to the derivative complaint, all of Coehlo's claims based on alleged misstatements made before his acquisition of Daisy stock on January 23, 1986, are DISMISSED as are all derivative claims based on common law insider trading. Furthermore, the claims against Harrison and West are DISMISSED with leave to amend. As to the individual claims, the ten statements made before October 1985 are also DISMISSED.
IT IS SO ORDERED.
EXHIBIT A APPENDIX
AMENDED COMPLAINT STATEMENT DATE AT PARAGRAPH
1. "The Company expects that the 11/84 8, 26(a) proceeds from the sale of Common Stock in (the November 1984) offering, together with cash flow from operations, will be sufficient, based on the court business plan, to satisfy the Company's working capital requirements at least through fiscal 1985. At such time as the Company requires additional working capital, it anticipates that such capital will be provided by bank borrowings or public or private sales of its securities." (Registration Statement at p. 8.) 2. "To ensure the reliability of 11/84 26(d) system performance in the field, the Company performs extensive testing and `burnin' of its systems during final product integration." (Registratton Statement at p. 21.) 3. "The proceeds (to the Company 2/85 19 from the February 1985 public offering) will be used primarily for additions to working capital and to finance new products and market development." (Registration Statement at p. 4.) 4. "The Company's product development 2/85 28(c) strategy has been to build upon the LOGICIAN'S capabilities." (Registration Statement at p. 9.) 5. "To ensure the reliability of 2/85 28(d) system performance in the field, the Company performs extensive testing and `burnin' of its systems during final product integration." (Registration Statement at p. 21.) 6. "The Company relies on sales 11/84; 21 forecasts rather than backlog 2/85 to establish manufacturing plans. At present, the Company typically ships its systems within 45 days or less of receipt of an order. The Company generally attempts to minimize the time that elapses from receipt of the purchase order to the date of shipment. The Company' believes this strategy is an important element in its marketing program. As a result, the Company believes that backlog as of any particular date may not be representative of the Company's actual, sales for any succeeding period." J (Registration Statement at p. 19.) 7. Daisy reported net income per (Various 20 share as follows: "August 29, dates) 1980 to September 30, 1981 — $.29 loss (2,715,000 shares); fiscal 1982 — $.02 gain (10, 663,000 shares); fiscal 1983 — $.19 gain (13,286,000 shares); fiscal 1984 — $.73 gain (15,095,000 shares); fiscal 1985 — $1.22 gain (17,351,000 shares)." 8. "[D]emand for the Company's 5/14/85 29 existing and newly-introduced products remained strong." 9, 10. Daisy announced the 6/10/85 31 introduction of two new 6/24/84 products (Boardmaster, Siliconmaster].