In re Maxwell Technologies Inc., Securities Litigation, No. 3:2013cv00580 - Document 55 (S.D. Cal. 2014)
Court Description: ORDER Granting 50 Motion to Dismiss. If Plaintiff wishes to file an amended consolidated complaint, it must do so no later than 30 days after the date this Order is filed. Signed by Judge Roger T. Benitez on 5/5/2014. (knb)
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In re Maxwell Technologies Inc., Securities Litigation Doc. 55 1 2 3 4 5 6 7 8 UNITED STATES DISTRICT COURT 9 SOUTHERN DISTRICT OF CALIFORNIA 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 IN RE MAXWELL TECHNOLOGIES, INC., SECURITIES LITIGATION. CASE NO. 13-CV-00580-BEN (RBB) ORDER GRANTING MOTION TO DISMISS [Docket No. 50] Before this Court is a Motion to Dismiss filed by Defendants Maxwell Technologies, Inc. (Maxwell), David J. Schramm, and Kevin S. Royal. (Docket No. 50). For the reasons stated below, the Motion is GRANTED. BACKGROUND Maxwell Technologies is a Delaware corporation based in San Diego, CA. Maxwell develops, manufactures, and markets energy storage and power delivery products, with a primary focus on ultracapacitors. Schramm served as CEO and President of Maxwell from July 2007 to December 31, 2013, and reached an agreement to serve as an advisor for two additional years. Royal has been the Senior Vice President, CFO, Treasurer, and Secretary of Maxwell since April 2001. On March 7, 2013, Maxwell announced that it was restating its financial statements for 2011 and the first three quarters of 2012. Maxwell’s sales organization made secret arrangements with certain distributors for special payment terms. The distributors would not have to pay Maxwell until the distributor was paid by the customers. Under Maxwell’s revenue recognition policy, revenue is only to be -1- 13cv580 Dockets.Justia.com 1 recognized where certain conditions are met, including that the collectability of the 2 revenue is “reasonably assured.” (Compl. ¶¶ 29, 134-35). However, Maxwell 3 recognized the revenue from these sales too early, causing the financial statements to 4 overstate revenue. The inaccurate revenue numbers had been included in a number of 5 SEC filings signed by Schramm and Royal. These filings assert that GAAP principles 6 are used and that the financial statements “present fairly the financial position, results 7 of operations, and cash flows” of Maxwell. (Id. ¶ 118). Schramm and Royal also 8 spoke on a number of conference calls about Maxwell and its financial performance. 9 On April 26, 2012, Maxwell announced disappointing financial results for the 10 first quarter of 2012. (Id. ¶¶ 10, 85). A one-day drop of $6.20 per share, from $15.80 11 per share to $9.60 per share, followed. (¶¶ 10, 86, 162). On March 7, 2013, Maxwell 12 announced that there had been errors in past restatements, that it was required to restate 13 results for 2011 and the first three quarters of 2012. (Id. ¶ 11). It also stated that it had 14 to delay its annual report, that there were problems with internal controls and its credit 15 agreement, and announced terminations and resignations of some Maxwell executives. 16 (Id.) The next day, shares fell $1.01. (Id.) On March 19, 2013, Maxwell announced 17 that McGladrey LLP had resigned as the independent accounting firm because it could 18 not rely on management’s representations and continuing internal control deficiencies. 19 (Id. ¶¶ 4, 13, 90). The stock price fell the next day. (Id. ¶ 911). Plaintiff contends that, 20 overall, the stock price dropped more than 70% from the class period high of $21.20 21 per share. (Id.) On April 30, 2013, Maxwell disclosed that the DOJ and SEC had 22 begun investigations. 23 Maxwell published the restated financial statements on August 1, 2013. In total, 24 Maxwell states that $10.1 million in revenue had been recognized prematurely in 2011, 25 and $9.2 million had been recognized prematurely in 2012. (Id. ¶ 154). Maxwell 26 asserts that there were no phony transactions and that, with insignificant exceptions, 27 28 1 The Court notes that the Complaint is inconsistent with respect to the exact size of the drop in the stock price on March 20, 2013. (Compl. ¶¶ 13, 91). -2- 13cv580 1 Maxwell has been paid for all of the problematic sales transactions subject to the 2 restatement. (Mot. at 5; Def. Ex. A at 112). 3 Maxwell’s audit committee conducted an investigation using outside counsel and 4 forensic accountants. Certain Maxwell employees were terminated, and Senior Vice5 President of Sales and Marketing Van Andrews resigned. While the investigation was 6 ongoing, Maxwell’s accountants, McGladrey LLP, resigned. McGladrey stated that 7 they had decided not to accept representations from the current management and that 8 Maxwell lacked sufficient internal controls over revenue recognition. Maxwell hired 9 new accountants, who accepted representations from current management, including 10 both individual defendants. Investigations have been commenced by the Securities and 11 Exchange Commission (SEC) and the Department of Justice (DOJ). 12 In the wake of the restatements, several lawsuits were filed against Maxwell and 13 the individual defendants on behalf of persons or entities that purchased Maxwell 14 stock. On October 24, 2013, this Court consolidated four actions, and appointed The 15 Employees’ Pension Plan of the City of Clearwater as Lead Plaintiff (“Plaintiff”). 16 (Docket No. 44). Plaintiff filed a Consolidated Complaint (Compl.) on January 17, 17 2014. (Docket No. 49). The Complaint, filed on behalf of persons or entities who 18 purchased Maxwell stock between April 29, 2011 and March 19, 2013 (the “Class 19 Period”), asserts two causes of action: (1) violation of Section 10(b) of the Securities 20 and Exchange Act of 1934 (Exchange Act), and (2) violation of Section 20(a) of the 21 Exchange Act. Plaintiff claims that Defendants made false statements about Maxwell’s 22 financial condition and internal controls, and that Schramm and Royal knew of or 23 participated in the secret side arrangements with distributors. 24 25 2 Defendants ask this Court to take judicial notice of documents referenced in the complaint and filed with the United States Securities and Exchange Commission. 26 (Docket No. 50-2). Plaintiff did not state any objection to this Court taking judicial notice of these documents. Documents incorporated by reference in the Complaint and 27 whose authenticity no party questions, are properly considered in a Rule 12(b)(6) motion. E.g., DeMarco v. DepoTech Corp., 149 F. Supp. 2d 1212, 1218 (S.D. Cal. 28 2001) (taking judicial notice of SEC filings referred to in the complaint). Accordingly the Request for Judicial Notice is GRANTED. -3- 13cv580 1 On February 20, 2014, Defendants filed a Motion to Dismiss the Complaint on 2 the grounds that Plaintiff failed to sufficiently allege scienter and that loss causation 3 fails as to the April 26, 2012 announcement. (Docket No. 50). 4 LEGAL STANDARDS 5 Section 10(b) of the Exchange Act makes it unlawful to: 6 use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe as necessary or appropriate in the public interest or for the protection of investors. 7 8 9 10 11 12 13 14 15 16 17 18 15 U.S.C. § 78j(b). Pursuant to that section, the SEC promulgated Rule 10b-5, which makes it unlawful, in relevant part, 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 light of the circumstance under which they were made, not misleading.” 17 C.F.R. § 240.10b-5(b). Section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a), states that a person who: directly or indirectly, controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such a controlled person is liable . . . unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action. 19 Section 20(a) claims may be dismissed summarily if the plaintiff fails to adequately 20 plead a primary violation of section 10(b). Zucco Partners, LLC v. Digimarc Corp., 21 552 F.3d 981, 990 (9th Cir. 2009) (citations omitted). 22 To state a securities fraud claim, a plaintiff must plead (1) a material 23 misrepresentation or omission by the defendant; (2) scienter; (3) a connection between 24 the misrepresentation or omission and the purchase and sale of a security; (4) reliance 25 upon the misrepresentation or omission; (5) economic loss; and (6) loss causation. 26 Mattrix Init. Inc. v. Siracusano, 131 S.Ct. 1309, 1317 (2011); Reese v. Malone, No. 1227 35260, 2014 WL 555911, at *5 (9th Cir. Feb. 13, 2014) (citations omitted). Scienter 28 is “a mental state embracing intent to deceive, manipulate, or defraud.” Ernst & Ernst -4- 13cv580 1 v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). 2 In ruling on a motion to dismiss in a securities fraud class action, the court 3 assumes all factual allegations to be true. Tellabs, Inc. v. Makor Issues & Rights, Ltd., 4 551 U.S. 308, 322 (2007). A court considers the complaint in its entirety, as well as 5 other sources courts ordinary examine when ruling on Rule 12(b)(6) motions to 6 dismiss, such as documents incorporated into the complaint by reference and matters 7 of which a court may take judicial notice. Id. 8 At the pleading stage, a complaint stating claims under section 10(b) and Rule 9 10b-5 must satisfy the dual pleading requirements of Federal Rule of Civil Procedure 10 9(b) and the Private Securities Litigation Reform Act of 1995 (PSLRA). Rule 9(b) 11 requires a party to “state with particularity” the circumstances constituting fraud or 12 mistake, but allows conditions of a person’s mind to be alleged generally. However, 13 the PSLRA applies special requirements to private actions for securities fraud. Where 14 a plaintiff may only recover money damages on proof that a defendant acted with a 15 particular state of mind, the complaint must, as to each alleged act or omission, “state 16 with particularity facts giving rise to a strong inference that the defendant acted with 17 the required state of mind.” 15 U.S.C. § 78u-4(b)(2)(A). 18 The Ninth Circuit has held that in a securities fraud action, plaintiffs must show 19 that defendants engaged in “knowing” or “intentional conduct.” South Ferry LP, No. 20 2 v. Killinger, 542 F.3d 776, 782 (9th Cir. 2008) (citing In re Silicon Graphics, Inc. 21 Sec. Litig., 183 F.3d 970, 975 (9th Cir. 1999)). Reckless conduct can meet the standard 22 to the extent it “reflects some degree of intentional or conscious misconduct,” or what 23 has been termed “deliberate recklessness.” Id. (citing Silicon Graphics, 183 F.3d at 24 977). In pleading deliberate recklessness, the plaintiff must plead a “highly 25 unreasonable omission, involving not merely simple, or even inexcusable negligence, 26 but an extreme departure from the standards of ordinary care, and which presents a 27 danger of misleading buyers or sellers that is either known to the defendant or is so 28 obvious that the actor must have been aware of it.” Zucco, 552 F.3d at 991 (quoting -5- 13cv580 1 Silicon Graphics, 183 F.3d at 976). Facts showing “mere recklessness,” or motive and 2 opportunity to commit fraud, provide some reasonable inference of intent, but are not 3 independently sufficient. Reese v. Malone, 2014 WL 555911, at *7 (citing Silicon 4 Graphics, 183 F.3d at 974). 5 The strong inference is required to be “cogent and compelling, thus strong in 6 light of other explanations.” Tellabs, 551 U.S. at 324. The inquiry is “inherently 7 comparative” and requires that a court consider plausible, nonculpable explanations for 8 the defendant’s conduct, as well as inferences favoring the plaintiff. Id. Although the 9 inference that a defendant acted with scienter need not be irrefutable or the “most 10 plausible” of competing inferences, it must be more that merely “reasonable” or 11 “permissible.” Id. A complaint will survive “only if a reasonable person would deem 12 the inference of scienter cogent and at least as compelling as any opposing inference 13 one could draw from the facts alleged.” Id. The relevant inquiry is “whether all of the 14 facts alleged, taken collectively, give rise to a strong inference of scienter, not whether 15 any individual allegation, scrutinized in isolation, meets that standard.” Id. at 323 16 (emphasis in original). In reviewing the sufficiency of scienter allegations after 17 Tellabs, the Ninth Circuit has conducted a dual inquiry in which it first determines if 18 any allegation, standing alone is sufficient to create a strong inference of scienter. 19 Zucco, 552 F.3d at 992. If not, it examines the complaint holistically to determine if 20 the insufficient allegations combine to create a strong inference of intentional conduct 21 or deliberate recklessness. Id. 22 23 DISCUSSION Defendants argue that Plaintiff has failed to sufficiently allege scienter. They 24 argue that the Complaint does not allege facts giving rise to the “strong inference” that 25 Schramm or Royal were involved in or knew of the secret side arrangements which 26 caused the restatement. (Mot. at 2). 27 Plaintiff points to a number of different allegations which it contends are 28 sufficient to raise a strong inference of scienter, when viewed holistically. Plaintiff -6- 13cv580 1 points to the statements of five confidential witnesses included in the complaint. It also 2 points to a variety of other facts, such as the “noisy” resignation of Maxwell’s auditor, 3 the individual defendants’ performance-based compensation, government 4 investigations, the individual defendant’s role in the corporate structure, and alleged 5 involvement in relevant transactions. Defendants dispute that such allegations give rise 6 to a strong inference, and point to other facts which they contend undermine a strong 7 inference of scienter. 8 This Court individually examined the various allegations raised to determine if 9 they are sufficient to create a strong inference of scienter. As none are individually 10 sufficient, the Court examined them holistically to determine if they create a strong 11 inference of scienter when viewed in combination. As this Court determines that a 12 strong inference of scienter is not created, it will not proceed to unnecessarily consider 13 loss causation. 14 A. Corporate Scienter 15 Plaintiff argues that corporate scienter is satisfied because defendants Schramm 16 and Royal, as well as non-defendant Andrews, were senior-level executives responsible 17 for Maxwell’s core operations and acted with the requisite scienter. (Opp’n at 10). 18 Plaintiff argues that Maxwell’s corporate scienter is “beyond reasonable dispute” 19 because it admitted that Andrews left the company “as a result” of the investigation 20 into wrongdoing. (Opp’n at 4). Plaintiff contends that the scienter of Andrews, 21 Schramm, and Royal can be imputed to Maxwell, and that Maxwell is liable for the 22 securities fraud of its “controlling employees.” (Id.) 23 Defendants do not appear to dispute that the scienter of named individual 24 defendants Schramm or Royal can be imputed to Maxwell, but argues that non25 defendant Andrews’ scienter cannot be so imputed. Defendants argue that the effort 26 to attribute the knowledge of an employee to the company is an attempt to use a 27 “collective scienter” theory which is not the law in this Circuit. (Reply at 1). 28 Defendants cite to Glazer Capital Mgmt., LP v. Magistri, 549 F.3d 736, 744-45 (9th -7- 13cv580 1 Cir. 2008), in which the Ninth Circuit noted a circuit split on the issue, and stated that 2 its precedent did not foreclose the possibility that collective scienter might be 3 appropriate in some circumstances. However, the Ninth Circuit in Glazer required that 4 a plaintiff who rested his claim on three statements in a legal document plead scienter 5 as to the individuals who actually made the false statements in the merger agreement. 6 Id. at 745. The Ninth Circuit did not lay out a test for determining when individual 7 scienter might not be required, but stated that it reached its conclusion based on the 8 “nature and unique context of the alleged misstatements in this case.” Id. 9 This Court has examined the arguments raised by Plaintiff, and has determined 10 that Plaintiff has not demonstrated that collective scienter is applicable here. As in 11 Glazer, this Court looks at the nature and context of the misstatements. Plaintiff’s 12 claims are based upon statements by the individual defendants and in official filings 13 signed by the individual defendants. It is thus necessary to require scienter as to the 14 individuals who were responsible for the statements. This is not a situation in which 15 the fact that Andrews or another employee may have had the requisite knowledge 16 indicated that the individual defendants who made or authorized statements knew they 17 were false when they were made. The fact that Andrews, a non-defendant, allegedly 18 had knowledge of misconduct does not indicate that any statements were made with the 19 necessary mental state. 20 The Court has examined the cases cited by Plaintiff. Although the case law 21 supports holding a corporation responsible for the actions of its executives, Plaintiff 22 does not cite cases that support corporate scienter based only upon the scienter of a 23 non-defendant who did not make or certify the statements at issue. Thus, although this 24 Court agrees with Plaintiff that corporate scienter is alleged if it is sufficiently alleged 25 that Schramm or Royal had the necessary mental state, corporate scienter is not 26 sufficiently alleged under these circumstances where one executive had the knowledge 27 and other, perhaps-innocent executives made the statements. 28 /// -8- 13cv580 1 B. Plaintiff’s Arguments for Individual Scienter 2 Plaintiff’s briefing points to numerous allegations which it contends support a 3 strong inference that Schramm and Royal had the necessary mental state. i. Confidential Witnesses 4 5 The principal argument set forth by Plaintiff is that a strong inference of scienter 6 arises from the statements made by five confidential witnesses who are described and 7 quoted in the Complaint. Plaintiff contends that these statements support the claim that 8 Schramm and Royal engaged in, or knew about, the side deals and improperly realized 9 revenue. Defendants raise numerous challenges to the statements. 10 A complaint relying upon statements from confidential witnesses must pass two 11 hurdles to satisfy the PSLRA pleading requirements. Zucco, 552 F.3d at 995. First, 12 the confidential witnesses must be “described with sufficient particularity to establish 13 their reliability and personal knowledge.” Id. (citing In re Daou Systems, Inc., 411 14 F.3d 1006, 1015-16 (9th Cir. 2005)). Second, the statements themselves must be 15 “indicative of scienter.” Id. (citing Daou, 411 F.3d at 1022). a. Confidential Witness #1 16 17 Confidential Witness #1 (CW1) was Maxwell’s Vice President of Business 18 Development from January 2006 to March 2013. (Compl. ¶ 52 n. 16). CW1 initially 19 reported to Schramm, and after 2010 reported to Andrews and Schramm. (Id.) CW1 20 was fired for purported involvement in the accounting scheme. (Id.) CW1 reports that 21 “things definitely changed” after Andrews arrived and that she3 was taken “out of the 22 loop” on many of the issues in the restatement. (Id. ¶ 52). 23 CW1 reports that she was involved in a shipment of product that was not going 24 to be accepted by the end user. (Id. ¶ 61). She reports that Andrews directed her to 25 speak with Alfatec, the company’s German distributor, and have the shipment delivered 26 to Alfatec. (Id.) CW1 stated that Alfatec knew Maxwell wanted Alfatec to take and 27 28 3 This Court follows Plaintiff’s convention of referring to all confidential witnesses with female pronouns to protect confidentiality. -9- 13cv580 1 store the product, but that Alfatec would not pay for the product at the time. (Id.) CW1 2 stated that this arrangement might not be a problem if it had been properly accounted 3 for by Maxwell. (Id. ¶ 62). The Complaint says that CW1 reported questioning 4 Andrews about changing the terms of the shipment, and Andrews told her that it was 5 “OK’d by David,” presumably referring to Schramm. (Id.) CW1 also states that 6 Andrews was warned by Schramm that he would be fired and allowed to resign, but 7 does not state how she knew Andrews was warned. (Id. ¶ 81). 8 Defendants raise a number of arguments regarding CW1. First, they point out 9 that CW1 and CW4 are both former, disgruntled employees. Plaintiff argues that this 10 goes to the witnesses credibility, and it is not appropriate for this Court to determine 11 credibility issues at this stage. This Court agrees with Plaintiff. The Court will 12 examine the witnesses for indicia of reliability and personal knowledge, but it will not 13 ignore detailed and otherwise reliable allegations simply because the witness might 14 have a motive to lie. See In re Gilead Scis. Sec. Litig., No. C 03-4999, 2009 WL 15 3320492, at *2 (N.D. Cal. Oct. 13, 2009). 16 Second, Defendants argue that the confidential witnesses offer sweeping 17 generalizations, not specific facts. Plaintiff’s description of the confidential witness 18 accounts raises serious problems. In reviewing the Complaint’s characterization of 19 their statements, it is often unclear what the witness actually said, what the Plaintiff has 20 inferred, and what is commentary by the Plaintiff. To the extent that certain ideas were 21 expressed by the witness, their basis is often unclear. In particular, this Court cannot 22 determine from the Complaint whether any of the confidential witnesses had any 23 reason to believe the individual defendants knew there were improprieties. 24 In the case of CW1, for instance, the Complaint reports that CW1 stated that the 25 arrangements might not have been problematic if reported, then states that “However, 26 the Individual Defendants made sure this was not the case in order to boost Maxwell’s 27 sales figures.” (Compl. ¶ 62) The Complaint does not indicate whether CW1 said this 28 or it is Plaintiff’s commentary. If CW1 did say this, it does not explain the basis for the - 10 - 13cv580 1 statement. For instance, the Complaint does not report any statements made by the 2 individual defendants that suggest that they knew the sales were not properly reported 3 to accounting, much less why they did so. The Complaint also states that CW1 4 confirmed that the secret change was ordered by Andrews and Schramm, and the 5 Opposition indicates that CW1 stated that Schramm ordered secret alteration of terms 6 and Andrews carried them out. (Id.; Opp’n at 16). However, the Complaint does not 7 indicate what, if anything, CW1 said to indicate that she concluded that Andrews or 8 Schramm knew it was secret, on what basis she reached that conclusion, or whether 9 either man actually ordered her to do it without telling anyone. This Court therefore 10 cannot tell whether this statement is CW1’s characterization of events or merely 11 Plaintiff’s interpretation of the fact that CW1 was told to change the payment terms. 12 There is also no basis from which this Court could conclude that CW1 had personal 13 knowledge of the fact that Andrews was warned in advance of the terminations. 14 It appears that CW1 was in a position to know about the existence of unreported 15 side arrangements, and might have plausibly learned whether the individual defendants 16 were aware of the sales arrangements and how they were reported to accounting. 17 However, in order for the statement of CW1 to support scienter, Plaintiff must give this 18 Court a sufficiently clear indication of what CW1 actually said and the basis for that 19 statement. With respect to much of the description of CW1’s statement, this Court 20 cannot determine which allegations and comments were made by CW1. To the extent 21 it is clear Plaintiff is relating the statement of CW1, Plaintiff has frequently failed to 22 establish reliability and personal knowledge. Those statements for which reliability 23 and personal knowledge have been established are not sufficiently indicative of 24 scienter. Although Plaintiff’s characterization suggests that CW1 may possess 25 evidence of scienter, Plaintiff has not communicated that evidence in a way that allows 26 this Court to infer scienter. 27 /// 28 /// - 11 - 13cv580 1 2 b. Confidential Witness #2 Confidential Witness #2 (CW2) was Maxwell’s Sales Operations Manager from 3 February 2008 to May 2011. (Compl. ¶ 53 n. 17). CW2 was responsible for sales 4 reporting and client contracts, including the preparation of sales reports and attendance 5 at weekly sales meetings. (Id.) These reports included information about outstanding 6 sales, received orders, unfulfilled sales, and invoiced orders. (Id.) The Complaint 7 alleges that CW2 characterized the environment at Maxwell as becoming more 8 secretive and restrictive after Andrews arrived. (Id. ¶ 53). CW2 is reported as stating 9 that she did not trust Andrews and that he was a typical sales person who “pushed to 10 get stuff done” at the end of quarters. (Id.) CW2 stated that she was “not surprised” 11 by the need for the restatement. (Id.) CW2 reports that Andrews excluded her from 12 weekly sales meetings after he arrived, but that she still sent reports to Andrews. (Id. 13 ¶ 63). CW2 is quoted as saying she was “sure at the time” that there were orders being 14 reported as booked when that was not actually the case. (Id.) CW2 also stated that 15 Andrews addressed issues or discrepancies with the terms of the transaction. (Id.) 16 The account of CW2 does not support a strong inference of scienter. There is 17 no indication in the statement that Schramm or Royal were aware of the side deals, or 18 the fact that the deals were not reported. Indeed, it is not clear that CW2 actually knew 19 anything about the scheme while at Maxwell, much less who was involved. 20 Defendants also correctly point out that CW2 was not working at Maxwell for much 21 of the Class Period. These statements provide little support to infer scienter. 22 23 c. Confidential Witness #3 Confidential Witness #3 (CW3) was Maxwell’s Senior Sales Operations 24 Administrator from September 2011 through June 2012. (Compl. ¶ 64 n. 19). CW3 25 was responsible for entering and processing orders, as well as for overseeing the 26 implementation of a customer relationship system. (Id.) CW3 participated in weekly 27 Accounts Receivable meetings. (Id.) CW3 reported to Andrews and Tara Whiteside, 28 the Business Planning & Sales Operations Manager. (Id.) The Complaint reports that - 12 - 13cv580 1 CW3 talks about the fact that it was “always a scramble” to process Alfatec orders and 2 put the products “on a boat” to count the orders during the reporting period. (Id. ¶ 64) 3 The Complaint states that “CW 3 understood that this was being done so that these 4 orders could be booked as revenue in the quarter about to end even though the 5 Individual Defendants knew this wasn’t the case . . .” (Id.) CW3 stated that Schramm, 6 Royal, and Andrews received flash reports that set forth expected sales, which were 7 “always inflated” because of the sales quota. (Id. ¶ 65). CW 3 is quoted as saying the 8 “integrity of the orders came into question.” (Id.) 9 The Complaint recounts CW3’s description of events involving Maxwell 10 distributor Pana-Pacific. (Id. ¶ 66). CW3 reported that she entered terms for the orders 11 based on purchase orders and invoices, but that the terms were not the same as the 12 terms Andrews verbally extended to Pana-Pacific. (Id.) CW3 stated that Pana13 Pacific’s accounts receivable became past-due and that she raised this issue in the 14 Accounts Receivable meetings, which included Andrews and “on occasion Defendant 15 Royal.” (Id. ¶ 67). CW3 says that Whiteside told her that Andrews had a verbal 16 agreement with Pana-Pacific to extend the payment terms. (Id.) CW3 stated that 17 extending such terms required Royal’s approval, and the Complaint states that “the 18 CFO should have been involved.” (Id.) 19 CW3 also discussed Maxwell’s policy on credit holds. (Id. ¶ 68). She stated that 20 additional orders could only be shipped if one of the individual defendants, usually 21 Royal, released the hold. (Id.) The hold was released on Pana-Pacific despite unpaid 22 receivables. (Id.) CW3 states that Whiteside told her that she should not try to collect 23 from Pana-Pacific because Andrews was “handling it,” and that she should not talk to 24 Andrews about Pana-Pacific. (Id. ¶ 69). CW3 states she expressed concerns to 25 Whiteside. (Id.) CW3 did state that she felt it was “very weird” to be directed to 26 remain silent about the situation. (Id. ¶ 70). 27 CW3’ s account cannot support a strong inference of scienter. Although the 28 Complaint’s discussion of CW3 states that the individual defendants knew that revenue - 13 - 13cv580 1 was being improperly booked, it is unclear whether CW3 ever says this, or if CW3 has 2 any basis to say this. Although the Complaint indicates that CW3 was told to remain 3 silent, this allegation is too ambiguous to help infer scienter. This Court cannot tell if 4 the Complaint was referencing Whiteside’s instructions or one of the individual 5 defendants told her not to talk about the side deals. None of the allegations provide 6 specific facts from which this Court could infer that the individual defendants knew 7 that side deals were not being communicated to the accounting department. At most, 8 it indicates that one or both individual defendants were aware of collection problems 9 and authorized credit hold decisions that allowed additional products to be shipped and 10 improperly booked. It is not, however, clear from the Complaint that Maxwell policy 11 was followed and that either individual defendant actually authorized special terms or 12 lifting credit holds. Plaintiff argues that CW3’s testimony “fatally undermines any 13 claim that Royal and Maxwell were unaware of Pana-Pacific’s undisclosed extended 14 payment terms.” (Opp’n at 15). The Court agrees that it is somewhat undermined. 15 However, even if Schramm and Royal knew about the side deals, this does not indicate 16 that they knew that revenue was improperly booked. Plaintiff also points out that 17 CW3’s account of end-of-period activity was corroborated and that other CWs had 18 suspicions about the revenue being booked. (Id. at 16). However, Plaintiff has not 19 explained how an active sales department and the suspicions of third parties indicates 20 that the individual defendants knew about the improper accounting. 21 22 d. Confidential Witness #4 Confidential Witness #4 (CW4) was Maxwell’s Senior Director of Global Sales 23 and Marketing from August 2012 to March 2013. (Compl. ¶ 71 n.20). CW4 also 24 worked at Maxwell from February 2008 to July 2010 as Director of Sales and 25 Marketing for the Americas. (Id.) From 2012, CW4 was responsible for sales strategy 26 and managing customer relationships, and reported to Schramm and Andrews. (Id.) 27 CW4 was fired for purportedly having a role in the events leading to the restatement. 28 (Id.) CW4 made statements pertaining to both Maxwell business practices, and - 14 - 13cv580 1 conversations overheard during carpool rides. 2 First, the Complaint alleges that CW4 states that the illicit business practices 3 were used with clients worldwide. (Id. ¶ 71). CW4 provides details on the kinds of 4 arrangements that were made. (Id. ¶ 72). CW4 stated that Royal approved extended 5 payment terms, and that only Schramm and Royal could lift a credit hold. (Id.) 6 Although these statements allow an inference that the actions of one or both 7 defendants was necessary to carry out the misconduct, it alone does not establish 8 scienter on the part of Schramm or Royal. The fact that the individual defendants made 9 or should have made decisions on payment terms or credit holds does not indicate that 10 they knew that the effects of those decisions were not properly reported to accounting. 11 Second, CW4 makes claims based on the fact that she “often” joined Schramm 12 and Andrews in their carpools. The Complaint states that she heard “off the record 13 conversations” which Plaintiff alleges “included these problematic business practices.” 14 (Id. ¶ 82). The Complaint states that CW4 recalled Schramm telling Andrews to “take 15 certain actions necessary to ‘make the numbers,’ and that Schramm boasted that he had 16 ‘a clean bill of health’ regarding his participation in these practices.” (Id.) CW4 states 17 that she has a lot of information and can put “a nail in the coffin” of Schramm and 18 Royal. (Id.) CW4 claimed that Schramm and Royal were “spearheading” the 19 fraudulent transactions and were responsible for the matters that were restated. (Id. 20 ¶ 83). She allegedly claims that they “knew everything” and were “guiding it.” (Id.) 21 She states that she was “told what to do” by the individual defendants and that the 22 individual defendants knew what was going on. (Id.) 23 The Court has very carefully examined these allegations. These statements 24 certainly indicate that CW4 may have heard or seen something from which this Court 25 could infer scienter. However, as with the other confidential witnesses, it is not always 26 clear what CW4 actually said. Additionally, this Court cannot actually determine what 27 CW4 claims to have heard. Many of the statements about the role of Schramm and 28 Royal are conclusory and without foundation. It is not clear from the pleadings, or - 15 - 13cv580 1 from the briefing, whether the carpool conversations acknowledged that revenue was 2 improperly recognized, or if the discussion of problematic business practices meant 3 only that Schramm indicated knowledge of the special sales terms. Although CW4 4 believes CW4 has damaging evidence, Plaintiff has not shared any specific facts from 5 which this Court can conclude that CW4 possesses facts giving rise to scienter. e. Confidential Witness #5 6 7 Confidential Witness #5 (CW5) was Maxwell’s Director of Sales and Marketing 8 from June 2010 to October 2012. (Compl. ¶ 73 n. 21). She was responsible for sales 9 to both customers and distributors. (Id.) In her final months, CW5 participated in 10 weekly Days Sales Outstanding meetings with Royal and other executives where they 11 discussed accounts receivables. (Id.) She reported to and interacted with Schramm and 12 Royal. (Id.) 13 According to the Complaint, CW5 discussed the Alfatec arrangements, including 14 the fact that Alfatec was brought in to serve as a buffer and hold inventory. (Id. ¶ 73). 15 CW5 stated that although later deals and purchase orders usually matched the original 16 contract, purchase orders for the transactions in the restatement would not have 17 included the additional terms and concessions. (Id. ¶ 74) She stated that the need to 18 restate revenue was “not a surprise” given the clients’ failure to send payment. (Id.) 19 CW5 also reports that an analyst had asked Schramm why the accounts receivables had 20 grown three-fold, but the sales only grew by a factor of 1.2. (Id. ¶ 75). The Complaint 21 characterizes CW5’s statement as saying that this analyst was not satisfied with 22 Schramm’s answer, that the “analyst published that Schramm’s explanations did not 23 make sense” and that the analyst made efforts to get to bottom of the issue. (Id.) CW5 24 states that the individual defendants began a weekly meeting in May 2012 regarding 25 past-due accounts, which CW5 attributed to the analyst’s inquiry. (Id. ¶ 76). Royal 26 directed this meeting, which would discuss accounts where special payment terms had 27 been extended. (Id.) From this, the Complaint concludes that the individual 28 defendants “were pushing to present financial results that were in line with the - 16 - 13cv580 1 Company’s representations to Wall Street.” (Id.). 2 CW5 also states that while some people at the company blamed lower 3 executives, other people at Maxwell knew that this was not the case. (Id. ¶ 79). CW5 4 said the Defendants needed to produce numbers in order to appear to be a growth stock 5 company. (Id.). CW5 also stated that Andrews, Royal, and Schramm were close 6 friends and that Schramm and Andrews lived in the same community, went to the same 7 country club, and carpooled every day. (Id. ¶ 81). 8 It is unclear from Plaintiff’s characterization of CW5’ s statement whether CW5 9 actually possesses any knowledge from which this Court could conclude there is a 10 strong inference of scienter. The Complaint does indicate that Royal would have been 11 aware of an issue with past-due accounts. However, none of the statements indicate 12 that CW5 heard either individual defendant say anything or knew that the individual 13 defendants heard something that indicates that they knew there was a revenue 14 recognition problem. It is entirely possible from the description that CW5 might have 15 such facts, but Plaintiff must present them clearly; this Court cannot speculate on what 16 CW5 might have meant. The Complaint also fails to indicate if CW5 actually knows 17 what, if anything, the analyst told Schramm. The Complaint’s characterization of her 18 statement as saying the analyst “published” that Schramm’s explanations did not make 19 sense suggests that CW5 was not present and is relying on hearsay from the unnamed 20 analyst. Although hearsay can be considered, it can indicate that a witnesses’ report 21 is “not sufficiently reliable, plausible, or coherent to warrant further consideration 22 under Daou.” Zucco, 552 F.3d at 997 n.4. Here, the fact that CW5 may not have been 23 present undermines this Court’s ability to draw significance from her report that an 24 unnamed individual presented unknown facts to Schramm and got a response that did 25 not satisfy him or her. CW5’ s allegations that the individual defendants and Andrews 26 were friends and shared a social circle do not mean that the individual defendants knew 27 of wrongdoing. It is, however, consistent with the theory that Andrews was working 28 with Royal and Schramm on the scheme and that all three knew about the improperly - 17 - 13cv580 1 recognized revenue. 2 3 f. Conclusion The confidential witness accounts do not indicate that the individual defendants 4 were aware of the recognition problem. The parties are not disputing whether there 5 were accounting improprieties, or the fact that side arrangements were extended. The 6 confidential witness testimony offered by Plaintiff supports an inference that the 7 individual defendants knew that there were some problems with collections, and were 8 aware of special payment terms and credit hold decisions. However, Plaintiff has not 9 indicated that there was anything inherently wrong with extending payment terms or 10 making a special sales arrangement. Such arrangements are a problem when they are 11 not properly taken into account at the accounting stage. The question is thus whether 12 Schramm and Royal knew that the special sales terms were not being properly taken 13 into account in the financial statements. If the confidential witnesses possess any 14 information on this subject, it was not laid out with sufficient clarity for this Court to 15 infer scienter. 16 To the extent Plaintiff is arguing that the level of the individual defendant’s 17 involvement in payment terms and meetings indicates that they must have known there 18 was a problem with the revenue numbers, Plaintiff needs to explain why this is so. The 19 Court cannot speculate. 20 Review of Plaintiff’s pleading and the characterizations of the CW statements 21 in Plaintiff’s Opposition indicates that Plaintiff may be able to make a stronger case if 22 the Complaint is amended to more clearly and completely explain what the CWs know 23 and have said. To the extent the CWs actually heard or saw something that indicated 24 that the individual defendants knew the terms were secret or that sales were improperly 25 booked, Plaintiff should clearly lay these facts out. Plaintiff should avoid 26 characterizing the testimony in a manner that makes it difficult for this Court to 27 differentiate between witness statements and Plaintiff’s own conclusions. 28 /// - 18 - 13cv580 1 2 ii. Andrews Plaintiff alleges that Andrews was the “third in command” who reported directly 3 to Schramm and Royal. (Compl. ¶ 51). Plaintiff claims that the culture of Maxwell 4 changed dramatically, “becoming more secretive and isolationist.” (Id.) It also points 5 to the fact that Maxwell’s financial results increased nearly immediately after Andrews 6 was hired. (Id. ¶ 54). The confidential witness accounts indicate that Andrews had 7 strong personal relationships with the individual defendants, and was actively involved 8 in extending special sales terms and handling past-due accounts. Such allegations may 9 support claims of misconduct by Andrews, but they do not establish that Royal or 10 Schramm were involved. The personal relationship between Andrews and the 11 individual defendants is consistent with their cooperation in a revenue scheme, but the 12 existence of a warm relationship does not indicate that Schramm and Royal knew what 13 Andrews was doing or that they knew that special sales terms were not properly 14 considered in Maxwell’s accounting. 15 16 iii. Auditor’s Resignation Plaintiff argues that the “noisy” resignation of Maxwell’s auditor supports a 17 strong inference of scienter. Plaintiff points to the fact that McGladrey LLP resigned 18 in part because it could not rely on representations from current management and 19 certain third parties. (Opp’n at 18). Plaintiff argues that this is consistent with 20 allegations that Defendants colluded with third parties to improperly recognize revenue 21 through undisclosed arrangements. (Id.) Plaintiff emphasizes that Maxwell disclosed 22 the reasons for the resignation, even though such a disclosure is not generally required. 23 Defendants dispute this. (Reply at 8 (citing 17 C.F.R. § 229.304(a)(1)(v))). 24 Defendants also argue that if McGladrey LLP believed that the CEO and CFO had 25 engaged in fraud, it would have been required to report this fact to the SEC. (Id. at 826 9). Defendants point out that a new auditor relied on management’s representations. 27 Plaintiff argues that this only points to an “economic opportunity” for the new auditor, 28 and is not an implicit blessing of management’s integrity. (Opp’n at 18). - 19 - 13cv580 1 Based on the information alleged, this Court cannot find that the resignation 2 alone gives rise to a strong inference of scienter. One auditor was willing to trust the 3 representations, and one was not. This Court has no information that allows it to draw 4 stronger inferences from one more than the other. An independent auditor’s 5 resignation because it feels it cannot rely on management’s representations may, under 6 certain circumstances, support an inference that the company was misrepresenting or 7 concealing its financial health. In re Am. Apparel, Inc. Shareholder Litig., 855 F. 8 Supp. 2d 1043, 1083 (C.D. Cal. 2012). However, such a recognition by itself does not 9 demonstrate that management acted intentionally or recklessly, rather than acting 10 incompetently, in ignorance, or based on a mistake. See id. at 1084. This Court does 11 not know why McGladrey concluded that it could not rely on the statements of 12 management. There is no indication that McGladrey believed either individual 13 defendant was engaged in the misconduct, and no evidence was presented to suggest 14 that McGladrey had any information about what Schramm or Royal knew about the 15 misconduct. Without additional explanation about the reasons for resigning and the 16 basis for their mistrust, the resignation alone does not indicate that the individual 17 defendants had scienter. However, the fact that McGladrey felt it could not trust the 18 representations of management does indicate that the auditors had doubts about the 19 individual defendants’ willingness to be truthful or forthcoming with respect to the 20 misconduct. The Court considers the resignation in the holistic analysis. 21 22 iv. False Certifications, GAAP Violations, and the Need to Restate Plaintiff points to the false SOX certifications and “numerous admitted GAAP 23 violations” as contributing to a strong inference of scienter. (Opp’n at 19). It 24 emphasizes the importance of the inflated earnings, and claims that if they actually had 25 designed and evaluated internal controls over financial reporting as they stated in the 26 certifications, the “substantially inflated financial results and GAAP violations could 27 not have escaped notice.” (Id. at 19-20). 28 Plaintiff also contends that the admissions made during the restatement provide - 20 - 13cv580 1 strong support for inferring scienter. Plaintiff points to the fact that Maxwell restated 2 nearly two years of financial results and admitted that there was deliberate accounting 3 misconduct. Plaintiff cites to Backe v. Novatel Wireless, Inc., 607 F. Supp. 2d 1145, 4 1161-63 (S.D. Cal. 2009), on reconsideration, 642 F. Supp. 2d 1169, 1186 (S.D. Cal. 5 2009), in which a district court found scienter based in part upon early product 6 shipment, GAAP violations, and the simplicity of the accounting principles involved. 7 Defendants contend that the circumstances of the restatement do not give rise to 8 a strong inference of scienter. (Mot. at 11). They emphasize that merely restating 9 financial statements or failing to follow GAAP is insufficient, without more, to 10 establish scienter. (Id. (citing DSAM Global Value Fund v. Altris Software, Inc., 288 11 F.3d 385, 390 (9th Cir. 2002))). Defendants argue that a financial restatement can 12 suggest that internal controls were ineffective, but that this is not enough to 13 demonstrate that a CEO or CFO acted with scienter. 14 The Court agrees with Defendants that these facts alone do not give rise to a 15 strong inference of scienter. GAAP violations and false certifications can take place 16 where there is no scienter. However, Plaintiff appears to argue in the briefing that, 17 given the nature of the violation, Defendants could not have missed the violations if 18 they evaluated the internal controls as they claimed. Although the large amount at 19 issue suggests Plaintiff’s argument may be plausible, this Court does not have the 20 information to evaluate this argument and conclude there is a strong inference of 21 scienter. Plaintiff has not presented the necessary information about accounting 22 principles and internal controls to allow this Court to evaluate whether the individual 23 defendants should have been or must have been aware of the violations. 24 25 v. Core Operations The Ninth Circuit has stated that as a general matter, corporate management’s 26 general awareness of the day-to-day workings of the business does not establish 27 scienter, at least absent additional allegation of specific information conveyed to 28 management and related to the fraud or other allegations supporting scienter. S. Ferry - 21 - 13cv580 1 LP, No. 2, 542 F.3d at 785 (citation omitted). However, allegations regarding 2 management’s role in a corporate structure may be considered as part of the holistic 3 analysis required in Tellabs, and such allegations can independent satisfy the PSLRA 4 where they are “particular and suggest that defendants had actual access to the disputed 5 information.” Id. at 785-86. Management’s role and the importance of the corporate 6 information may create a strong inference of scienter when made in conjunction with 7 “detailed and specific allegations about management’s exposure to factual information 8 within the company.” Id. at 785; Zucco, 552 F.3d at 1000. In “rare circumstances,” 9 particularized allegations are not needed where the nature of the relevant fact is of such 10 prominence that it would be “absurd” to suggest that management did not have 11 knowledge of it. S. Ferry LP, No. 2, 542 F.3d at 786. 12 Plaintiff asserts that the inference of scienter is strengthened because the revenue 13 recognition scheme involved Maxwell’s “core business.” (Opp’n at 20). Plaintiffs also 14 allege that Maxwell operated under an “executive-centric, top-down organizational 15 structure” in which major changes to contract and payment arrangements had to be 16 approved by senior executives, and material changes to payment terms for sales had to 17 be approved by Royal and/or Schramm. (Compl. ¶ 31). 18 Defendants reject the suggestion that scienter is supported by the individual 19 defendant’s high-level positions and “top-down” corporate structure, and cite to cases 20 in which high rank is insufficient to infer scienter. The Court agrees that rank alone 21 does not suffice to infer scienter. There is also insufficient information before this 22 Court for the Court to conclude that it is “absurd” to suggest that the individual 23 defendants did not have knowledge of the improper accounting. The inflation of 24 revenue arose out of a combination of side deals, many of which were allegedly carried 25 out by Andrews, and the failure to communicate those deals to the people who should 26 have adjusted the revenue reported. Plaintiff has not demonstrated to this Court that 27 lack of awareness of this fact rises to the level of absurdity. 28 The Court also concludes that Plaintiff has not made the necessary “detailed and - 22 - 13cv580 1 specific allegations” about management’s exposure to information to give rise to a 2 strong inference of scienter. Although Plaintiff has alleged that the individual 3 defendants attended sales-related meetings and had access to sales reports, this does not 4 support the inference that the individual defendants must have known about the 5 accounting misconduct. Indeed, it is not clear to this Court exactly what information 6 Schramm and Royal would have had about what revenue was actually counted and 7 whether the meetings and reports should have alerted them to the fact that this 8 information was not accurate. 9 However, the Court does take into consideration in its holistic analysis that the 10 scheme involved core operations of Maxwell’s business and that the individual 11 defendants were allegedly involved or apprised on a regular basis of relevant facts, 12 such as sales and revenue collection. It considers that the organizational structure 13 allegedly required the individual defendants to be involved in certain sales and credit 14 decisions. It also takes into consideration the magnitude of the overstatement, which 15 comprised millions of dollars, and the long duration of the scheme. These facts make 16 it more likely that the individual defendants were or could have been aware of the 17 wrongdoing. 18 19 vi. Approval and Holds Plaintiff’s Complaint alleges that the individual defendants were involved in or 20 informed of various aspects of sales. It alleges that violations were “well-known” to 21 individual defendants because they inflated revenue by secretly modifying the payment 22 terms, but failing to inform accounting so that it was recognized as revenue. (Compl 23 ¶ 58). Plaintiff alleges that they were able to engage in fraud and cover their tracks by 24 lifting the credit holds on the distributors who did not pay them. (Id. ¶ 60) 25 These allegations are insufficient to independently establish a strong inference 26 of scienter. Even if the individual defendants knew about the extension of special 27 terms to certain customers, and authorized lifting credit holds, this does not indicate 28 that they knew there was an accounting problem. Other than conclusory statements, - 23 - 13cv580 1 Plaintiff does not plead any particular facts that indicates that the individual defendants 2 knew that the special terms and side deals were unreported. Plaintiff may be 3 suggesting that individual defendants knew about the side deals, should have known 4 that revenue should therefore not be recognized, and would have seen the inconsistency 5 in financial statements. However, Plaintiff has not pleaded facts from which this Court 6 could make those logical leaps. Close monitoring of accounts and sales does not 7 necessarily indicate that the individual defendants would have known that the final 8 reported accounting numbers were manipulated. Plaintiff has not pled sufficient 9 information about the practices of the company to permit this Court to determine 10 whether the individual defendants could have learned information about particular sales 11 and believed the financial statements to be accurate. 12 However, the Court does consider the fact that the individual defendants had 13 access to some sales information, knew about at least some payment problems, and that 14 company policy called for them to approve lifting credit holds. 15 16 vii. Investigations Defendant argues that as a restatement alone does not give rise to a strong 17 inference of scienter, neither can the “routine consequences” of a restatement. (Mot 18 at 11). Defendants claims that such routine consequences include the signing of 19 certifications, resignations and terminations of officers and employees engaged in 20 intentional misconduct, the company concluding that internal controls are weak, or a 21 government investigation. (Id.) 22 With respect to the post-restatement investigation, Defendants contend that 23 government investigations are routine after a financial restatement. (Id. at 12-13). 24 Plaintiff argues that this fact nonetheless contributes to a strong inference of scienter, 25 especially in the wake of the recognition of other internal control problems. (Opp’n 26 at 21). Without other information regarding the investigation, this Court cannot find 27 that the investigation gives rise to a strong inference of scienter. Even if the 28 investigation reflects the fact that there was misconduct and that there is suspicion that - 24 - 13cv580 1 laws were broken, this does not indicate that Schramm or Royal are suspected of 2 misconduct, much less allow this Court to infer scienter. It is established that there 3 were problems in the financial statements. Plaintiff has not demonstrated how the post4 disclosure investigation supports the conclusion that these particular individuals had 5 the required mental state. 6 Plaintiff also alleges that Maxwell recognized internal control problems before 7 the Class Period. The DOJ and SEC investigated Maxwell and filed actions against 8 Maxwell for violations of the Foreign Corrupt Practices Act (FCPA) that involved the 9 payment of $2.5 million in illicit kickbacks to foreign officials to secure and retain 10 contracts. (Compl. ¶ 33). Plaintiff points to SEC charges that Maxwell did not 11 disclose the material revenues and profits from the bribery scheme, that former 12 Maxwell officers knew about and tacitly approved payments, that payments were not 13 accurately recorded, and that Maxwell failed to implement or maintain a system of 14 effective internal accounting controls. (Id. ¶ 34). Maxwell entered into a deferred 15 prosecution agreement which admitted responsibility (Id. ¶ 35). Plaintiff’s Complaint 16 also cites two recent law enforcement investigations. (Id. ¶¶ 36, 37). In the briefing, 17 Plaintiff cites to case law that points out that, after the occurrence of a crisis that could 18 repeat itself, there is incentive to review results and assess the possibility of future 19 problems. (Opp’n at 21 (citing Reese, 2014 WL 555911, at *8)). 20 Defendants contend that pre-Class Period settlement of “unrelated” FCPA 21 violations in China is irrelevant. (Mot. at 13). They point out that Maxwell disclosed 22 the FCPA violations to the government and claim that Maxwell cooperated with the 23 investigations. They also point out that there were no allegations of wrongdoing 24 against Schramm or Royal. 25 This Court finds that the prior investigation does not give rise to a strong 26 inference of scienter, and does little to increase the plausibility of Plaintiff’s 27 allegations. Schramm and Royal do not appear to be directly implicated in the FCPA 28 misconduct. Although the earlier violations do generally suggest problems in at least - 25 - 13cv580 1 some aspects of Maxwell’s internal controls, there is no evidence before this Court to 2 suggest that these past failings in China dealings made it more likely to have internal 3 control problems with revenue recognition, or that it should have put the individual 4 defendants on alert with regard to internal controls for revenue recognition. 5 C. Defendants’ Arguments in Opposition to Scienter 6 In seeking to dismiss this action, Defendants point to allegations and publicly- 7 available evidence that they contend undermines a finding of a strong inference of 8 scienter. 9 10 i. Stock Holdings and Lack of Sales Defendants argue that allegations of scienter are undermined by the fact that the 11 individual defendants owned a large number of Maxwell shares, and did not sell them. 12 They point out that when the stock price fell as a result of the disclosure, both 13 individual defendants sustained losses. Schramm’s stock was worth $6,273,992 at the 14 Class Period high, and fell to $1,749,023 after the March 19, 2013 disclosure. 15 Schramm also purchased additional Maxwell stock on the open market between June 16 3, 2011 and August 15, 2012. Royal’s stock was worth $1,601,300 at the high point, 17 and fell to $446,400 after the March 19 disclosure. Defendants argue that it is 18 “inconceivable” that they would hold their shares if they knew there was a problem. 19 (Mot. at 8). They further point out that these losses are larger than the 2011 bonuses 20 of $400,000 for Schramm and $135,800 for Royal. (Id. at 7-8). 21 Defendants point to case law in which courts found that a strong inference of 22 scienter is contradicted where individual defendants do not sell their stock or retain a 23 large percentage of stock. (Id. at 8; e.g. In re Wet Seal, Inc. Sec. Litig., 518 F. Supp. 24 2d 1148, 1177-78 (C.D. Cal. 2007) (finding that a lack of tangible personal benefit, 25 including lack of insider sales, weighs against scienter)). This Court has examined the 26 cited cases. To the extent they support Defendants’ contention, they rely on the 27 common-sense notion that a party will generally not engage in illicit behavior that will 28 cause financial losses to himself or herself. - 26 - 13cv580 1 Plaintiff argues that lack of stock sales does not preclude finding a strong 2 inference of scienter. (Opp’n at 22-23). The Ninth Circuit has held that a lack of stock 3 sales by a defendant is not dispositive as to scienter. No. 84 Employer-Teamster Joint 4 Council Pension Trust Fund v. Am. West Holding Corp., 320 F.3d 920, 944 (9th Cir. 5 2003) (finding scienter despite lack of stock sales). Plaintiff also argues that there are 6 many reasons why the lack of sales does not necessarily negate scienter. Plaintiff 7 offers a number of plausible reasons why the defendants might not sell stock despite 8 being aware of the misconduct, including a belief that fraud would continue unabated 9 and recognition that sales could be highly incriminating if the fraud were uncovered. 10 (Opp’n at 23). 11 The fact that there were no stock sales during this period can be interpreted to 12 support an inference that Schramm and Royal were unaware of this misconduct. 13 However, it is also consistent with the inference that the individual defendants 14 mistakenly believed that the fraud would remain hidden and they ultimately would be 15 able to reap the benefits of the inflated stock value. The individual defendants may 16 well have believed that they could engage in fraud and retain their stock without 17 suffering financial losses. 18 19 ii. Individual Defendants’ Bonuses Plaintiff points to Maxwell’s situation before the Class Period. It alleges that it 20 faced increased competition and lost market share. (Compl. ¶ 38). Maxwell reported 21 “significant net losses” between 2007 and 2009. (Id. ¶ 39). Plaintiff contends that this 22 incentivized individual defendants to turn Maxwell’s performance around by padding 23 financial results because their compensation was affected by these results. (Id. ¶ 39). 24 Plaintiff also questions the compensation program, pointing out that despite losses and 25 financial shortcomings, the individual defendants were able to meet the “ever-changing 26 criteria.” (Id. ¶ 40). 27 Defendants contend that the bonuses are insufficient to support scienter. They 28 suggest that the program is an unremarkable plan designed to reward performance for - 27 - 13cv580 1 certain goals. They also point to the fact that the 2011 bonus was lower than the 2010 2 bonus, and that there was no 2012 bonus. (Mot. at 10). 3 The existence of performance-based compensation provides motive for the 4 individual defendants to order or ignore misconduct that would increase revenues. The 5 Court considers this in its holistic review. However, the fact that the individual 6 defendants would benefit personally from apparent improvement in Maxwell’s 7 financial performance does not create a strong inference that the individual defendants 8 had knowledge or were deliberately reckless regarding the misconduct. Plaintiff’s 9 allegations that compensation criteria was manipulated to ensure bonus payment, at 10 most, calls into question the integrity of the compensation committee, but does not 11 make it more likely that the individual defendants knew about accounting misconduct. 12 Indeed, if the existence of performance-based compensation and motive to increase 13 short-term profits were enough to establish scienter, scienter could be found for almost 14 any executive. See Lipton v. Pathogenesis Corp., 284 F.3d 1027, 1038 (9th Cir. 2002) 15 (citation omitted) (“If scienter could be pleaded merely by alleging that officers and 16 directors possess motive and opportunity to enhance a company’s business prospects, 17 ‘virtually every company in the United States that experiences a downturn in stock 18 price could be forced to defend securities fraud actions.’” ). 19 20 iii. Sales Agreement Plaintiff argues that Maxwell benefitted from the misconduct by entering into 21 an agreement relating to the sale of stock, which ultimately produced $10.3 million in 22 net proceeds. (Compl. ¶ 48). These sales took place at allegedly inflated prices several 23 weeks before Maxwell reported disappointing financial results on April 26, 2012. (Id. 24 ¶ 49). The Ninth Circuit has held that stock sales must be “significant enough and 25 uncharacteristic enough to cast doubt on the defendant company’s motives” in order 26 to create a strong inference of scienter. Zucco, 552 F.3d at 1006. Although it netted 27 significant proceeds, Plaintiff has not presented evidence to show that such an offering 28 was uncharacteristic or out of the ordinary. This sale does not create a strong inference - 28 - 13cv580 1 of scienter. 2 3 iv. The Audit Committee’s Investigation and Results Defendants point to the fact that neither Schramm nor Royal was found by the 4 audit committee’s investigation to be aware of the improper arrangements, and that the 5 sales arrangements were never communicated to the finance department. (Mot. at 12). 6 Defendants argue that terminations and resignations of other employees after the 7 investigation, including Andrews, do not prove anything about Schramm or Royal, and 8 show that proper remedial actions were taken. (Id.). 9 Plaintiff argues that the strong inference of scienter far outweighs any competing 10 inference provided by self-serving, self-exonerating findings of the audit committee. 11 (Opp’n at 22). Plaintiff points out that it has not had a chance to examine the audit 12 committee’s investigation and cites to caselaw that recognizes potential problems with 13 relying upon an audit committee’s investigation of its own company. (Id.; In re LDK 14 Solar Sec. Litig., 584 F. Supp. 2d 1230, 1246 (N.D. Cal. 2008) (“[O]fficers and 15 directors are not exonerated when their own audit committee finds nothing wrong in 16 the company’s accounting practices. To rule otherwise would create a huge 17 fox-guards-the-chicken-house loophole in our private securities law enforcement.”)). 18 Defendants reply that the case law cited by Plaintiff indicates that the audit committees 19 finding is not dispositive, not that it is irrelevant, and points out that Plaintiff has not 20 alleged facts questioning the sufficiency of the investigation. (Reply at 7 n.4). 21 The Court takes into account the audit committee’s finding, but does not find it 22 decisive. That the audit committee conducted an investigation and did not find that the 23 individual defendants had knowledge supports the individual defendants’ claim that 24 they lacked scienter. However, this Court will not dismiss the action based on the 25 findings of a committee which have not been presented or examined. The Court does 26 agree that the firings and resignations of non-defendants after the investigation do not 27 necessarily indicate that the individual defendants knew what those employees were 28 doing or participated in the misconduct. - 29 - 13cv580 1 D. Holistic Consideration 2 As discussed above, none of the individual allegations is sufficient to raise a 3 strong inference of scienter. However, the Supreme Court’s decision in Tellabs permits 4 “a series of less precise allegations to be read together to meet the PSLRA 5 requirement.” S. Ferry, 542 F.3d at 784. The Ninth Circuit has cautioned that “[e]ven 6 if a set of allegations may create an inference of scienter greater than the sum of its 7 parts, it must still be at least as compelling as an alternative innocent explanation.” 8 Zucco, 552 F.3d at 1006. 9 Here, the primary innocent explanation is that Schramm and Royal did not know 10 about the improper financial misstatements and the failing in the internal controls, and 11 were not deliberately reckless. After full review of the pleadings and the briefing on 12 scienter, the Court has carefully weighed Plaintiff’s allegations, the competing 13 inferences, and innocent explanations. The Court concludes that, considered 14 holistically, the Complaint as currently pled does not raise a strong inference of 15 scienter. 16 Many of Plaintiff’s allegations are consistent with the individual defendants’ 17 knowledge and participation in improper accounting. However, these facts are also 18 consistent with a scenario in which other employees carried out improper accounting 19 without the knowledge, direction, or deliberate recklessness of the individual 20 defendants. 21 Viewed in the aggregate, Plaintiff alleges that the individual defendants did have 22 some significant pieces of information related to the fraud. The individual defendants 23 had regular access to some sales information, and the accounts of confidential 24 witnesses indicate that Schramm and Royal were or should have been aware of some 25 revenue collection problems. One confidential witness reports learning that some 26 information about possible inconsistencies was given to Schramm. The confidential 27 witness accounts of the structure of the company indicates that one or both of the 28 individual defendants were supposed to be involved in some decisions involving - 30 - 13cv580 1 special sales terms or lifting credit holds. The individual defendants also clearly had 2 information about the revenue numbers, and signed the certifications for the financial 3 statements containing the reported revenue numbers. The restatement indicates that the 4 revenue numbers were substantially overstated for a period of nearly two years. The 5 individual defendants had a financial motive to improve the appearance of the 6 Maxwell’s financial performance, if they believed the fraud would not be discovered. 7 However, this is not sufficient to allow this Court to infer scienter. There are no 8 specific facts alleging that an individual defendant acknowledged that revenue was 9 misreported or ordered anyone to misreport anything. There are no specific allegations 10 about the information accessed by the individual defendants or the nature of the 11 accounting process which, taken in combination, suggest that the individual defendants 12 must have known that there was an accounting deception or were deliberately reckless. 13 This Court also considers the fact that both individual defendants suffered financial 14 losses and that none of the internal or external investigators have yet placed blame on 15 the individual defendants. Although the allegations suggest that it is possible that the 16 individual defendants had the requisite scienter, without additional allegations, 17 Plaintiff’s theory is not as cogent and compelling as the innocent explanation. 18 19 CONCLUSION As Plaintiff has failed to sufficiently allege scienter, the Motion to Dismiss is 20 GRANTED. This Court need not address the loss causation arguments briefly raised 21 by the parties. However, as Plaintiff’s arguments suggest that it may be able to clarify 22 its Complaint and add additional well-pleaded allegations regarding scienter, this Court 23 /// 24 /// 25 /// 26 /// 27 /// 28 /// - 31 - 13cv580 1 grants leave to amend. If Plaintiff wishes to file an amended consolidated complaint, 2 it must do so no later than 30 days after the date this Order is filed. 3 IT IS SO ORDERED. 4 5 DATED: May 5, 2014 6 7 Hon. Roger T. Benitez United States District Judge 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 - 32 - 13cv580
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