Seinfeld v. Bartz (N.D. Cal. 2002)

NO. C01-2259 THE

February 8, 2002

THELTON E. HENDERSON, Judge.

This matter came before the Court on January 28, 2002, on Defendants' Motion to Dismiss. Following oral argument, the Court issued its ruling from the bench GRANTING Defendants' motion with prejudice. This order describes the rationale for the Court's ruling in more detail.

Plaintiff is a shareholder of Defendant Cisco Systems, Inc. ("Cisco") and brings this suit as a derivative action against the company and its ten directors. At issue in this case is a 1999 amendment to Cisco's Automatic Option Grant Program for outside directors. The amendment, which was approved by shareholder vote at the November 1999 annual meeting, raised the number of stock options granted to outside directors upon joining the board from 20,000 shares to 30,000 shares. Additionally, the amendment raised the number of options granted annually to each continuing outside director from 10,000 shares to 15,000 shares.

Plaintiff alleges that Defendants acted negligently in preparing their statement to solicit proxies to vote in favor of the amendment. The disputed proxy statement states that Cisco paid each outside director, except for Defendant Sarin, a $32,000 annual retainer fee for fiscal year 1999, and that it paid Defendant Sam a $40,000 retainer fee to include board service commencing in September 1998. In addition, the statement represents that each director would receive periodic option grants under the Automatic Option Grant Program and was eligible to participate in the Discretionary Option Grant Program. The statement goes on to explain the number of options granted to each director, as well as the options' exercise prices and vesting requirements.

Plaintiff alleges that Defendants violated SEC proxy rules by failing to include the value of the option grants based on the theoretical Black-Scholes option pricing model. According to Plaintiffs Black-Scholes calculations, the value of the options granted to each of the continuing outside directors in 1998 was $369,500 on November 12, 1998 (the date of the grant) and $1,020,600 on September 27, 1999 (the date of the proxy statement). Plaintiff asserts that Cisco uses Black-Scholes to prepare its annual financial statements, and that it therefore would have been easy for Defendants to include the Black-Scholes valuations in the proxy statement. More significantly, Plaintiff alleges that Defendants' statement of a $32,000 annual retainer fee plus stock options materially misrepresents the compensation of each outside director. Plaintiff contends that, using Black-Scholes, each director received compensation valued at well over $32,000.

In addition, Plaintiff alleges that the following sentence contained in the proxy statement is materially false and misleading: "Unless the market price of the Common Stock appreciates over the option term, no value will be realized from the option grants made to the executive officers." Plaintiff asserts that this statement is false because the grant of stock options results in the immediate realization of value, which is best determined using Black Scholes. Moreover, Plaintiff contends that Defendants should have explained that stock options are valued using Black-Scholes for purposes of the federal estate tax, gift tax, and generation-skipping transfer tax, even if the options need not be so valued for purposes of the federal income tax..

Dismissal is appropriate under Rule 12(b)(6) when a plaintiffs allegations fail to state a claim upon which relief can be granted. Fed.R.Civ.P.12(b)(6). In deciding whether a

Defendants assert that the heightened pleading requirements of Federal Rule of Civil Procedure 9(b) and the Private Securities Litigation Reform Act of 1995 apply to this case. The Court does not reach this issue because Plaintiffs claims fail to survive even the more lenient standards of Rule 12(b)(6).

case should be dismissed, a court may generally only consider the complaint and any attached exhibits that have been incorporated therein.See Lucas v. Dep't of Corrections, 66 F.3d 245, 248 (9th Cir. 1995) (considering material external to the complaint converts the motion into a Rule 56 summary judgment motion); Parks Sch. of Bus., Inc. v. Svmington, 51 F.3d 1480, 1484 (9th Cir. 1995) (exhibits attached to the complaint and incorporated therein by reference are treated as part of the complaint for purposes of Rule 12(b)(6)). The court may also consider "documents whose contents are alleged in a complaint and whose authenticity no party questions, but which are not physically attached to the pleading." Branch v. Tunnell, 14 F.3d 449, 454 (9th Cir. 1994).

The court must accept as true the factual allegations of the complaint and construe those allegations in the light most favorable to the plaintiff. Zimmerman v. City of Oakland, 255 F.3d 734, 737 (9th Cir. 2000). It should not grant dismissal unless "it appears beyond a doubt that [the] plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Steckman v. Hart Brewing. Inc., 143 F.3d 1293, 1295 (9th Cir. 1998); see also Conley v. Gibson, 355 U.S. 41, 45-46 (1957). Moreover, dismissal should be with leave to amend unless it is clear that amendment could not possibly cure the complaint's deficiencies. Steckman, 143 F.3d at 1296.

Plaintiff alleges that Defendants negligently violated Section 14(a) of the Securities Exchange Act of 1934 and Rule 14a-9 of the Securities and Exchange Commission ("SEC"). Section 14(a) makes it unlawful to solicit proxies in violation of SEC rules. 15 U.S.C. § 78n(a) (2002). SEC Rule 14a-9 prohibits solicitation of a proxy by a statement containing either (1) a false or misleading declaration of material fact or (2) an omission of material fact that makes any portion of the statement false or misleading. 17 C.F.R. § 240.14a-9 (2002).

An omitted fact is "material" if "there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote." TSC Industries. Inc. v. Northway Inc., 426 U.S. 438, 449 (1976). A plaintiff does not have to demonstrate that disclosure of the fact in question would have caused a reasonable shareholder to change his or her vote. Id. Instead, it is sufficient to establish a substantial likelihood that, "under all of the circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder." Id. In other words, "there must be a substantial likelihood that the disclosure ofthe omitted fact would have been viewed by the reasonable investor as having significantly altered the `total mix' of information made available." Id.

Failure to Include Black-Scholes Valuations in the Proxy Statement

Here, Plaintiff asserts that the Black-Scholes valuations of the option grants to the outside directors are omitted material facts. As Defendants point out, however, four courts that have considered Plaintiffs argument have rejected it at the pleading stage. See Resnik v. Swartz, No. 00 Civ. 5355 (LMM), 2001 WL 15671 (S.D.N.Y. Jan. 8, 2001); In re 3 Com Corp., Shareholders Litig., No. C.A. 16721, 1999 WL 1009210 (Del.Ch. Oct. 25, 1999); Cohen v. Calloway, 667 N.Y.S.2d 249 (N.Y.App.Div. 1998); Lewis v. Vogelstein, 699 A.2d 327 (Del.Ch. 1997). The courts in all four of these cases held that Black-Scholes valuations are not material as a matter of law. To the parties' and the Court's knowledge, no court has ever held to the contrary. The In re 3 Com court even explicitly considered — and rejected — the plaintiffs argument that the "options have no value unless the market price of the stock rises" statement was misleading. In re 3 Com, 1999 WL 1009210 at *6-8.

While not controlling precedent, the above cases are highly persuasive because of the factual similarities they share with the instant case. In three of the four cases, the plaintiff alleged violation of disclosure laws based on proxy statements that identified outside director compensation in terms of dollar-amount retainer fees and number of stock options, without providing any theoretical calculations. In re 3 Com involved a substantially identical claim to Plaintiffs — i.e., failure to disclose Black-Scholes valuations of option grants when seeking proxies to approve increasing the number of stock options granted to directors. In re 3 Com, 1999 WL 1009210 at *1-2. Lewis also concerned a nearly identical claim, with the only difference being that the case involved solicitation of proxies to adopt, rather than amend, a stock option plan. Lewis, 699 A.2d at 329-30.

The Cohen order does not include a factual background, but the legal analysis indicates a similar, if not identical, fact pattern to the instant case.

Plaintiff attempts to distinguish the three state-court cases — but, notably, does not even mention Resnik in his written opposition — on grounds that they were applying state, rather than federal, law. Plaintiff correctly points out that the plaintiffs in the Delaware cases alleged breach of the state-law-based duty of candor, and not the federally defined Rule 14a-9. However, the New York and Delaware courts applied the same "materiality" standard that this Court is bound to apply under the U.S. Supreme Court's decision in TSC Industries. Thus, the fact that the state cases addressed state-law causes of action does not require this Court to reject the analysis in those cases.

At oral argument, Plaintiff observed that Resnik is currently on appeal to the Second Circuit, suggesting that this Court should therefore not consider the district court's ruling. However, the order of dismissal in Resnik still stands as good law; it has not yet been — and may never be — reversed. Moreover, even if the Court did not considerResnik, Plaintiff would not gain any significant support. It would still be the case that the only courts to have considered claims similar to Plaintiffs have rejected such claims at the plea ding stage.

The New York order does not specify plaintiffs claim, though this Court is willing to assume, as Plaintiffs argue and as Defendants do not dispute, that the claim was based on state law.

While the Delaware courts applied Delaware law to define "materiality," the Delaware standard is identical to that established inTSC Industries. See In re 3 Com, 1999 WL 1009210 at *5. The New York court explicitly cited TSC Industries in its order. Cohen, 667 N.Y.S.2d at 249.

Plaintiff next argues that a Ninth Circuit case, Custom Chrome. Inc. v. Commissioner of Internal Revenue, 217 F.3d 1117 (9th Cir. 2000), requires this Court to break new ground and reject the decisions made by the four courts discussed above. In Custom Chrome, the Ninth Circuit noted in a footnote that Black-Scholes was a reliable method of determining the value of the options at issue in that case. Id. at 1124 n. 10. However, as Defendants correctly point out, the court explicitly distinguished the options at issue — which were issued as part of a loan transaction — from options granted for services rendered. Id. at 1122. In this case, Defendants received options for the services they rendered as Cisco's directors, and Custom Chrome is therefore distinguishable.

Custom Chrome is further distinguishable because tax regulations require that the optiorts in that case be valued at the time of grant.Id. at 1122. Here, by contrast, nothing requires Defendants to calculate the value of the options at time of grant. Plaintiff argues that SEC regulations require Black-Scholes calculations, but he points to no specific regulation that requires them. Item 402(g) of Regulation S-K requires proxy statements to include information on the compensation of directors, but this regulation makes no mention of valuing options. 17 C.F.R. § 229.402 (2002). On the other hand, Item 402(c) requires statements to include "potential realizable value[s] of each grant of options" to executive officers, id., but notably, this provision does not apply to outside directors. Thus, the Court agrees with Defendants that no SEC regulation requires Black-Scholes.

Beyond that, even if Black-Scholes were reliable for purposes of tax regulations governing loans, it does not automatically follow that Black-Scholes calculations are material for purposes of determining whether a proxy statement is false or misleading. As a result, the Ninth Circuit's ruling in Custom Chrome does not diminish the persuasive weight of the four cases that have dismissed claims identical or similar to Plaintiffs.

Similarly, whether Black-Scholes calculations would pass all evidentiary standards required for admissibility under Kumho Tire is inapposite. See Kumho Tire Co. v. Carmichael, 526 U.S. 137 (1999) (describing rules or a missibility of expert testimony). The Court notes with disapproval that Plaintiff presented this argument only at oral argument and not in his written opposition. However, even if Plaintiffs argument is correct — which this Court need not decide — the admissibility of Black-Scholes valuations does not make such calculations material for purposes of Rule 14a-9 analysis.

Plaintiffs main argument to the contrary is that the Court should assume as true his allegation that Black-Scholes is applicable to the options at issue, and that the courts that have ruled on the matter improperly delved into factual issues on motions to dismiss. However, there is no reason to conclude that all four courts incorrectly applied the standard for ruling on a motion to dismiss. Moreover, even if the Court were to accept that Black Scholes were applicable to the options in this case, that does not mean that it must therefore assume as true Plaintiffs assertion that he has stated a valid claim for relief. Whether factual allegations are legally sufficient to state a claim cannot be assumed from the face of a complaint; indeed, that is exactly what a court must decide on a motion to dismiss.

The state courts applied state procedural law, but the respective standards for dismissal are the same as or Rule 12(b)(6) — i.e., accept all factual allegations as true.

Based on the persuasive case law presented by Defendants, and the lack of convincing rebuttal by Plaintiff's this Court rules that, as a matter of law, Black-Scholes valuations are not material for purposes of Rule 14a-9 analysis. Consequently, Plaintiff has not stated a claim for relief, and the Court hereby GRANTS Defendants' motion to dismiss as to this claim. Because omissions must be material in order to be actionable, and Black-Scholes valuations are not material, it is clear that Plaintiff cannot allege any facts that would allow him to state a claim under this theory. Dismissal is therefore with prejudice. Cf. Resnik, 2001 WL 15671at *1 (S.D.N.Y. case dismissing similar claims with prejudice).

Plaintiff argues that his need to conduct further discovery should prevent dismissal of this case with prejudice. However, the Ninth Circuit has expressly stated that complaints in actions such as this one must be able to stand "on the actual knowledge of the plaintiffs rather than information produced by the defendants after the action has been filed."Medhekar v. United States District Court, 99 F.3d 325, 328 (9th Cir. 1996) (per curiam).

Failure to Disclose All Federal Tax Consequences

Plaintiffs second allegation is that the proxy statement is misleading because it fails to disclose all federal tax consequences when it describes the options' federal income tax consequences. However, as Defendants recognize and Plaintiff does not refute, no law or regulation requires Defendants to include the potential treatment of the option grants under the federal estate tax, gift tax, or generation-skipping transfer tax. Nor have Defendants falsely stated that the options have no consequences under these three tax schemes. As a result. Plaintiffs allegation can only give rise to a claim if omission of these tax consequences renders some other statement in the proxy statement false or misleading.

Plaintiff alleges that Defendants' omission renders misleading Defendants' representation that the option grants have no federal income tax consequences at the time of issue. The Court agrees with Defendants that this allegation is illogical. Stating that an act has no federalincome tax consequences does not imply that the act has absolutely no federal tax consequences whatsoever. Plaintiff therefore fails to state a claim. Cf. Stricklin v. Ferland No. Civ. A. 98-3279, 1998 WL 966023 at *7 (E.D. Pa. Nov. 10, 1998) (plaintiff who alleges that the proxy statement could have included additional information, without alleging anything to explain why the statement, as is, was materially misleading, fails to state a claim under Section 14(a)). Accordingly, the Court hereby GRANTS Defendants' motion as to this claim. Dismissal is with prejudice because it is clear that Plaintiff could not cure the deficiencies of his complaint even if given leave to amend.

For the above reasons, this Court GRANTS Defendants' Motion to Dismiss. Plaintiffs complaint is dismissed, with prejudice, in its entirety.