Opinion
No. 2:00-CV-00S4SPGC
February 10, 2003
MEMORANDUM OPINION AND ORDER DENYING MOTIONS TO DISMISS
Before the court are two motions to dismiss plaintiffs' Second Amended Class Action Complaint: one to dismiss all defendants for failure to state a securities fraud claim under the Securities Act, Exchange Act and the Private Securities Litigation Reform Act (the "Reform Act") and one to dismiss only the Director Defendants. For the reasons stated below, the court DENIES both motions.
15 U.S.C. § 78u-4.
See Memorandum of Points and Authorities in Support of Defendants Anthony B. Evnin, Luke B. Evnin, G. Gary Shaffer, Allan M. Wolfe, and Sigrid Van Bladel's Motion to Dismiss Second Amended Class Action Complaint.
FACTUAL BACKGROUND
Plaintiffs' Second Amended Complaint is a proposed class action against the defendants for allegedly misleading the public regarding Sonic's expected earnings for the third and Fourth quarters of 2000 and fiscal years 2000 and 2001. For purposes of these motions to dismiss, the court must "accept as true all the factual allegations in the reasonable inferences in plaintiffs favor."
Timpanogos Tribe v. Conway, 286 F.3d 1195, 1204 (10th Cir. 2002).
Accepting plaintiffs' version of the facts for now, the court finds as follows. Sonic is a seller of digital hearing aids and hearing aid components which began operating in 1991 and introduced its first hearing aid for sale in 1998. Sonic's first hearing aid was based upon a first-generation hearing aid component (the IC-1 chip), which was supposed to allow doctors to tailor the hearing aid to an individual's specific hearing loss needs. in December 1998, Sonic was in financial trouble: it had incurred $22 million in net losses, $11 million in research and development expenses and had only generated $2 million in revenues. With its troubled financial situation and its new product, Sonic sought to sell its hearing aid components to Starkey, the most dominant competitor in the "fiercely competitive" hearing aid market.
See Second Amended Complaint at ¶¶ 7-8.
Id. at ¶ 8.
Id. at ¶ 9.
Id. at ¶¶ 7, 10.
Sonic signed its first agreement with Starkey in April 1999. Pursuant to the original agreement, Starkey was obligated to purchase 50,000 IC-1 components and to provide Sonic with anon-binding written forecast of its future needs. Starkey placed its order in April 1999; however, it immediately experienced quality problems, starting with routine "calibration problems" and "hybrid failures" and developing into more severe problems. By October 1999, Starkey (and its customers) were encountering "end of life battery problems," which caused the hearing aids utilizing Sonic's IC-1 chip to emanate a high-pitched screaming noise into the user's ear canal. Because of these problems, Starkey was forced to include written notices warning its customers of potential harm. Starkey's problems with Sonic's quality continued to grow in 2000.
Id. at ¶ 10.
Id.
Id. at ¶ 14.
Id.
Id. at ¶¶ 14, 15.
In the meantime, Sonic's agreement with Starkey did not solve Sonic's financial problems. By the end of 1999, Sonic had incurred a $15 million net loss and $7 million in research and development expenses. According to plaintiffs, these financial concerns forced defendants to take Sonic public in an IPO to survive as a viable entity, to satisfy the demands of its largest venture capitalists, and to fund the development of its second generation hearing aid component (the "IC-2 chip"). Plaintiffs allege that in order to succeed in the IPO, and to convince the market that it had a guaranteed source of revenue, defendants approached Starkey in December 1999 with a plan amounting to actionable securities fraud. Specifically, the Second Amended Complaint alleges that defendants Raguskus, Sonic's CEO and President, and Wilson, Sonic's Vice President and CFO, proposed an amended agreement (the "1999 Amendment") that called for annual commitments from Starkey of 100,000 components at $165 for IC-1 chips and $185 for IC-2 chips to be sold one season behind Sonic's introduction of the IC-2 chip to the marketplace. However, plaintiffs allege that Starkey and Sonic never intended to be bound by the 1999 Amendment and in fact entered into a separate oral agreement that "market success, which is linked to quality" would determine Starkey's commitments.
Id. at ¶ 11.
Id.
Id. at ¶ 12.
Id. at ¶ 13.
Id.
Id.
To support their fraud claim, plaintiffs submit a letter from Ruzicka indicating that defendants secured Starkey's signature on the 1999 Amendment solely to increase Sonic's valuations in the IPO. This letter states:
The effect of the Starkey business on your stock valuation is not our concern. in order to help your valuations initially, we agreed to the terms of last December. We told you at that time that future purchases would not be governed by the signed agreement. We stated that market success, which is linked to quality, would determine the level of purchases. Sonic management verbally agreed but has since used the agreement as a weapon to pressure us into buying more bad product with no concern for the quality of the product and the effect on the hearing impaired community.
Letter from Ruzicka to Heide of October 20, 2000, attached as Exhibit I to Second Amended Complaint.
Therefore, accepting plaintiffs' allegations as facts as true for now, Sonic and Starkey's 1999 Amendment may have constituted a sham agreement designed to help Sonic's valuation in the IPO.
Defendants began to sell the IPO at roadshow presentations beginning in April 2000, telling investors that Sonic's business was performing very well and ahead of its plan, with sales to its original equipment manufacturers ("OEM") (of which Starkey represented nearly 90%) generating strong revenue growth, that Starkey had agreed to place orders totaling $16 million of Sonic's components in 2000 and $18 million in 2001, and that Sonic's relationship with Starkey was "strong" and "highly profitable." Defendants also emphasized the importance of the Starkey relationship in Sonic's prospectus and stated that Starkey is "obligated to make minimum purchases for 2000 and 2001 that are greater than the purchases it made in 1999."
Id. at ¶ 15.
Id. at ¶ 16.
Defendants did not mention the alleged separate oral agreement or that Starkey was highly dissatisfied with the IC-1 chip, which Starkey brought to defendant Raguskus' attention on March 15, 2000 (months before the IPO). Plaintiffs also allege that William Austin, Starkey's CEO, and Jerry Ruzicka, Starkey's President, specifically told Raguskus in Austin's hotel suite that they were dissatisfied with the IC-1 chip and that Starkey was encountering serious problems because of the chip. When Raguskus failed to remedy these problems, Starkey slowed down its payments to Sonic and defaulted on $1.6 million in payments to Sonic on the day before the IPO. Defendants did not disclose these problems to investors and completed Sonic's IPO by selling 4.1 million shares for proceeds of $53.9 million.
Id. at ¶ 3.
Id.
Id.
Id. at ¶ 1.
Following the IPO, defendants allegedly misled investors in an attempt to salvage the Starkey relationship and to convince Starkey to take more product. Plaintiffs point to internal Sonic correspondence as evidence that the 1999 Amendment was a sham and that Sonic was proposing and agreeing to materially different terms to get Starkey to place orders. For example, in as few as 26 days after the IPO, defendants reduced Sonic's prices by 40% ($100 for IC-1 and $11 Ofor IC-2), and extended Starkey's payment terms to 180 days at Starkey's request solely to get Starkey to place a 15,000 unit order so that Sonic could report the sale in the second quarter). Sonic shipped the order on June 30, 2000 (the last day of the quarter).
Id. at ¶¶ 17-22.
Id. at ¶ 19.
Id. at ¶¶ 19-20.
Id. at ¶ 78.
Defendants' actions allegedly continued throughout the Class Period. For example, the day before defendants attributed record second quarter results to "strong performance in its hearing aid component business" and told analysts that Starkey was on track to reach its annual minimum requirement for 2000 of $16 million in purchases and $18 million in 2001, defendants made significant concessions in their agreement with Starkey. These concessions are evidenced by an e-mail sent by Wilson on July 24, 2000, in which Sonic agreed to make the IC-2 chip available to Starkey "immediately" and to further slash prices if Starkey agreed to place orders through 2001. Wilson also offered to take back the June 30, 2000 shipment and proposed new payment terms more favorable to Starkey.
Id. at ¶¶ 22, 80.
Id. at ¶ 80, Ex.3.
Id. at ¶ 78, Ex.3.
Starkey did not accept the proposal. Instead, Ruzika met with defendant Raguskus on August 9, 2000 to discuss "broken promises" and further quality problems:
During Andy's August 9th visit to Starkey, these points were discussed, again. At this meeting we expressed the serious nature of the quality issues and resultant damage to Starkey in the marketplace. Sonic management is and has been fully aware of the product failures. The fear of a class action lawsuit due to your management's misrepresentation of the Starkey position relative to the serious nature of the quality issues was revealed during that meeting.
Id. at ¶ 86, Ex. 1 at 3.
Only two weeks later, with no agreement in place, defendants met with analyst Lawrence Keusch of Goldman Sachs and stated that Sonic's relationship with Starkey continued to be "strong" and "highly profitable" and that Starkey continued to he committed to annual sales. Defendants also stated that Sonic and Starkey were considering revising their agreement to give Sonic quarterly sales minimums in exchange for modestly accelerating Starkey's access to newer technology, and that Sonic was on track to meet forecasted results of $15.5 million in revenue and sequential growth of 18% in the third quarter of 2000. Again, defendants did not disclose Sonic's problems with Starkey, the alleged side oral agreement, or that it had made material contractual concessions to Starkey.
Id. at ¶ 82.
Id.
To the contrary, defendants announced on September 11, 2000, that Starkey had placed $8 million in orders for the third and fourth quarters "under the parties' existing agreement." Internal documents, however, reveal that instead of placing the order under the "existing agreement," Raguskus agreed to materially different terms before Starkey placed the order. Specifically, on August 29, 2000, Raguskus agreed to provide Starkey with Sonic's most advanced noise reduction technology in return for the order so that "Sonic [could] issue a press release stating that we have purchase orders for Q3 and Q4 in the amount of $4 million each." Raguskus also agreed to exchange 20,000 IC-1 chips for IC-2 chips "at no charge," to sell Starkey its IC-2 chip at a 20% discount, and to provide engineering support to facilitate the launch of Starkey's products with noise reduction.
Id. at ¶ 84.
Id. at ¶ 85.
Id. at ¶ 86.
Id.
Then, on October 24, 2000, just weeks after representing that Sonic's relationship with Starkey was strong and that Starkey had fulfilled its contractual obligation through FY00, defendants, apparently for the first time, disclosed that Sonic's relationship with Starkey had essentially dissolved and that it had been deteriorating for more than five months. Sonic's stock fell from $10.875 on October 20, 2000 to just $5.50 per share on October 25, 2000 and analysts reduced their FY01 earnings estimates from $0.48 cents per share to just $0.05 cents per share. Sonic then announced a large fourth quarter net loss of more than $1.3 million, with virtually no sales to Starkey and released Starkey from its purported $18 million obligation in FY01.
Id. at ¶¶ 5, 88.
Id.
Id. at ¶ 91.
MOTION TO DISMISS ALL DEFENDANTS
Accepting the well-pleaded factual allegations of the Second Amended Complaint, the court DENIES defendants Motion to Dismiss all defendants. Defendants argue that the allegations fail to state a claim for two reasons: (a) that the heightened pleading requirements of the Reform Act are not met; and (b) that the plaintiffs have failed to state a claim under Sections 11 and 12(a)(2) of the Securities Act. For the reasons explained below, the court disagrees with both arguments.Failure to State a Claim Under the Reform Act
First, defendants argue that under the heightened pleading requirement under the Reform Act, the plaintiffs fail to state a claim. Specifically, defendants contend that plaintiffs' complaint may be reduced to this: the defendants allegedly knew, well before October 24, 2000, that Sonic would ultimately be forced to make the announcement that it made on that date — that Sonic's relationship with Starkey had become a challenge and that Sonic could not count upon Starkey to purchase $18 million of hybrids in 2001. The court disagrees with this synopsis of plaintiffs' allegations. Plaintiffs have alleged particularized facts, which, if later established through discovery, may be actionable securities fraud under the Reform Act.
See Memorandum in support of motion to dismiss all defendants at 18.
The Reform Act "mandates a more stringent pleading standard for securities fraud actions in general, and for scienter allegations in particular." Among other things, the Reform Act requires a plaintiff to: (1) specify each statement alleged to be misleading and the reason or reasons why the statement is misleading; (2) to plead "with particularity all facts" upon which plaintiffs allegations are based; and (3) to "state with particularity facts giving rise to a strong inference" that the defendant acted with fraudulent intent.
City of Philadelphia v. Fleming Companies, Inc., 264 F.3d 1245, 1258-59 (10th Cir. 2001).
15 U.S.C. § 78u-4(b)(1) and (2).
As detailed above, plaintiffs do not make general allegations of fraud, but allege detailed facts including specific statements, dates, people, meetings, letters, and e-mails that provide particularized allegations as required by the Reform Act. of particular importance to the court is plaintiffs' allegation of the allegedly sham agreement memorialized in the 1999 Amendment. This is not a bald assertion, but has some evidentiary support in the October 20, 2000 letter from Ruzicka, Starkey's President, to Heide, Sonic's Vice President of International and OEM Sales. This letter bluntly states that Starkey, "in order to help [Sonic's] valuations initially . . . agreed to the terms of last December" but that "Sonic management verbally agreed [that Starkey would not be bound by 1999 Amendment]." In light of this letter's blunt reference to an arguably sham agreement, combined with the fact that this letter was between the parties' top management, and the other allegations of fraud, the court finds that plaintiffs have sufficiently pled a strong inference of fraudulent intent under the Reform Act.
See Ruzicka letter of October 20, 2000.
To be clear, although the court finds that the alleged sham agreement with Starkey is sufficient to survive a motion to dismiss, the court is not excluding discovery on the other allegations in the Second Amended Complaint. The other allegations, including among other things, that Sonic falsely represented its relationship with Starkey during roadshow presentations "in order to condition the market and investors for the Sonic IPO," and that Sonic's relationship with Starkey was "strong" and "highly profitable," are derivative of the alleged sham agreement. Therefore, discovery on all allegations in the Second Amended Complaint should move forward.
Second Amended Complaint at ¶ 15.
Id.
Failure to State a Claim Under Sections 11 and 12(a)(2)
Second, defendants argue that plaintiffs' claims under Sections 11 and 12(a)(2) of the Securities Act must be dismissed because plaintiffs do not allege that they purchased their securities directly from any of the defendants. Section 11 allows purchasers of registered securities to recover from the issuer, every person who signed the registration statement, and every director of the issuer if the registration statement contained an untrue material fact or omitted to state a required material fact. Similarly, under Section 12(a)(2), one who "offers or sells a security" by means of a prospectus is liable to the purchaser if the prospectus contained material misrepresentations or omissions. The plaintiffs do not need to plead reliance, causation, or scienter in order to recover under Section 12(a)(2).
See 5 U.S.C. § 77k.
See Pinter v. Dahl, 486 U.S. 622, 646 (1988).
Applying these statutes, the court finds that plaintiffs have adequately stated a claim under both Sections 11 and 12(a)(2) of the Securities Act. The Fifth Circuit addressed defendants' argument that to state a claim under Section 12(a)(2), a plaintiff must have purchased securities directly from the defendants, and the Circuit held that an issuer of securities may hold the requisite privity even in a firm commitment underwriting if the issuer is "sufficiently active in promoting the securities as to essentially become the vendor's agent." In this case, the plaintiffs allege that defendants actively promoted the IPO in a nationwide roadshow, including trips to Los Angeles, San Francisco, New York City, and Chicago, made favorable presentations to institutional investors and portfolio managers, made favorable presentations to securities analysts, prepared the false prospectus at issue, and manufactured an agreement with Starkey to promote the issue and increase the price of Sonic's stock in the IPO. The court finds that these allegations support plaintiffs' argument that the level of defendants' involvement in soliciting the IPO is unlike the usual situation in which an issuer routinely promotes a new issue and finds that for purposes of this motion to dismiss, defendants can be fairly classified as agents for the IPO. Accordingly, for purposes of this motion, plaintiffs' Section 12(a)(2) claims do not fail for lack of privity.
Lone Star Ladies Inv. Club v. Schlotzsky's Inc., 238 F.3d 363, 370 (5th Cir. 2001).
See Second Amended Complaint at ¶ 15.
See id.
See id. at ¶¶ 71-72.
See id. at ¶ 13.
Further, the court finds that the Second Amended Complaint adequately alleges that Sonic's Prospectus was materially false and misleading when issued. In particular, plaintiffs allege, among other things, that "Sonic's Prospectus outlined the importance of its relationship with Starkey and represented that the Starkey relationship had guaranteed annual sales to Sonic through 2001, with Starkey being contractually committed to make minimum annual purchases that were greater than the purchases that Starkey made in 1999." In light of the court's finding that plaintiffs have sufficiently alleged that the 1999 Amendment was a sham agreement, the court finds that plaintiffs have adequately alleged that Sonic's May 2, 2000 Prospectus contained materially false and misleading statements when issued. Therefore, plaintiffs' Section 11 and 12(a)(2) claims survive defendants' motion to dismiss.
See id. at ¶¶ 62-63.
Id.
MOTION TO DISMISS THE "DIRECTOR DEFENDANTS"
The court also denies defendants' Motion to Dismiss the Director Defendants. The Director Defendants seek dismissal on two grounds: (a) that they have no primary liability, that is, that they are not responsible for the alleged fraudulent statements; and (b) that the Director Defendants have no secondary liability, that is, that the plaintiffs have foiled to plead that the Director Defendants had control over persons allegedly responsible for the fraud. The court finds that for purposes of a motion to dismiss, the Second Amended Complaint adequately pleads both theories of liability.
Primary Liability
Plaintiffs adequately plead primary liability for the Director Defendants on two separate grounds: (a) that the Director Defendants participated in a scheme to defraud; and (b) that under the "group-published" presumption, the Director Defendants are liable for the corporations' statements at issue.
First, plaintiffs assert that the Director Defendants have primary liability under Rule 10b-5, which makes it "unlawful for any person, directly or indirectly . . . [t]o employ any device, scheme, or artifice to defraud . . . or [t]o 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." This rule has been interpreted as imposing primary liability on all participants in a "practice or course of business" that constitutes a fraud on the market, and is not limited to isolated and individual misrepresentations.
17 C.F.R. § 240.10b-5; see Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 152-53 (1972).
See Blackie v. Barrack, 524 F.2d 891, 904 n. 19 (9th Cir. 1975), cert. denied, 429 U.S. 816 (1976).
Defendants do not disagree that primary liability can be premised on a "scheme to defraud" theory, but argue that plaintiffs have failed to plead "any particularized facts relating to the actions on the part of any individual Director Defendant in furtherance of the alleged scheme to defraud." However, in their complaint, the plaintiffs allege that each Director Defendant engaged in deceptive acts that furthered the alleged scheme to defraud by taking Sonic public without disclosing the troubled Starkey-Sonic relationship and the serious quality issues with Sonic's IC-1 Chip. The plaintiffs specifically allege that it was "at the insistence of the Director Defendants" that Sonic's IPO, which in itself increased the value of the Director Defendants' holdings by $27.4 million, was done. The plaintiffs further allege that the Director Defendants put "considerable pressure" on Sonic officers to "maintain and artificially inflate Sonic's stock price." In light of these allegations, the court finds that plaintiffs have sufficiently plead primary liability on a "scheme to defraud" theory.
Reply Memorandum in Support of the Director Defendants' Motion to Dismiss ("Reply Memo") at 6-7.
See Second Amended Complaint at ¶¶ 56-58.
See Id. at ¶ 58 and ¶ 16.
See Id. at ¶ 59.
Second, the court finds that plaintiffs adequately plead that the Director Defendants have primary liability for the statements at issue under the "group-published" presumption. Under this presumption, a corporation's public documents are considered to be authored by its officers and directors. Therefore, "identifying the individual sources of statement is unnecessary when the fraud allegations arise from misstatement or omissions in group-published documents such as annual reports, which presumably involve collective action of corporate directors or officers." Responsibility "may be imputed to directors if they either participate in day-to-day corporate activities or have a special relationship with the corporation."
Schwartz v. Celestial Seasonings, Inc., 124 F.3d 1246, 1254 (10th Cir. 1997).
Id. at 1246.
Defendants argue that plaintiffs' allegations are insufficient to invoke the "group-published" presumption because plaintiffs do not allege that the Director Defendants participated in Sonic's day-to-day activities or that they had a special relationship with the corporation. The court disagrees. First, plaintiffs allege that the Director Defendants had a "special relationship" with Sonic in that they controlled 50.7% of Sonic's voting shares, that each director was a general partner of the venture capitalists, that the "Director Defendants represent a unified voice on Sonic's Board of Directors," and that "the Director Defendants not only had identical interests as venture capitalists of Sonic, but also several had long-standing personal and business relationships among one another."
See Reply Memo at 3.
See Second Amended Complaint at ¶¶ 32-36.
See Id.
Id. at ¶ 52.
See id. at ¶ 52.
Second, the court also finds that plaintiffs have sufficiently alleged that the Director Defendants participated in the day-to-day activities of Sonic. Specifically, plaintiffs allege that two Director Defendants, L. Evnin and Van Bladel served on Sonic's audit committee and audited some of the very reports that are being litigated in this action: the allegedly false second quarter financial results. Plaintiffs also allege that two other Director Defendants, A. Evnin and Wolfe, served as members of Sonic's compensation committee that determined the salary of Sonic's top executives and required knowing Sonic's operations, profits, losses and expenses. The court finds that these allegations, if later proven, sufficiently allege that the Director Defendants were involved in Sonic's day-to-day activities to a greater degree than traditional outside directors.
See id. at ¶ 48 and ¶ 51.
See id. at ¶ 47 and ¶ 50.
Finally, defendants argue that the "group-published" presumption did not survive the Reform Act. In making this argument, defendants heavily rely on a recent Tenth Circuit decision, City of Philadelphia v. Fleming Companies, Inc. However, Fleming did directly address the question of whether the "group-published" doctrine survived the Reform Act, but rather held that under the heightened standards of the Reform Act, "generalized imputations of knowledge do not suffice [to plead a strong inference of scienter] regardless of defendants' positions within the company." In light of the court's ruling that plaintiffs have adequately pled primary liability on a "scheme to defraud" theory, the court declines to address this issue at this time.
264 F.3d 1245 (10th Cir. 2001).
Id. at 1264.
Secondary Liability
The court also finds that plaintiffs have pled facts which, if later proven, would establish secondary liability. To establish secondary liability, also called "control person" liability, "the plaintiff must establish (1) a primary violation of the securities laws and (2) `control' over the primary violator by the alleged controlling person." This includes allegations of particularized facts "that the defendant actually participated in the operations of the corporation and possessed the power to control the specific transactions or activities upon which the primary violations are predicated." The Tenth Circuit "has expressly `rejected those decisions that may be read to require a plaintiff to show the defendant actually or culpably participated in the primary violation.'"
Fleming, 264 F.3d at 1270-71 (citing Maher v. Durango Metals, Inc., 144 F.3d 1302, 1305 (10th Cir. 1998)).
Wenneman v. Brown, 49 F. Supp.2d 1283, 1290 (D. Utah 1999).
Maher, 144 F.3d at 1305 ( citing First Interstate Bank of Denver, N.A. v. Pring., 969 F.2d 891, 897 (10th Cir. 1992), rev'd on other grounds).
The Second Amended Complaint pleads numerous facts which would render the Director Defendants liable as "control persons." For instance, plaintiffs allege that the Director Defendants controlled Sonic's board of directors, were members of the audit and compensation committees, reviewed Sonic's financial statements, and attended and participated in Sonic's committee meetings and Sonic's operations. Plaintiffs also allege that the Director Defendants were "in frequent contact" with Raguskus and Wilson to get information about Sonic's business and "received copies of Sonic's operating budget reports."
See Second Amended Complaint at ¶¶ 47-51.
See id.
Accepting these allegations in favor of the plaintiffs for now, the court finds that the Second Amended Complaint adequately pleads control person liability. of course, if these allegations are found to be untrue through the discovery process, the defendants could make an appropriate motion to dismiss this theory of liability at a later time.
See Imperial Credit Fed Sec. L. Rep CC'H at 94,233 (C.D. Cal. 2000).
Accordingly, the court DENIES defendants' motion to dismiss all defendants [51-1] and defendants' motion to dismiss the Director Defendants [52-1].
SO ORDERED.