In Re: Onyx Software Corporation Securities Litigation 01...

Case 2:01-cv-01346-RSL Document 63

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11111111 III III(IiiIII11111I111111111I1111111111liii 11111111111111111111111111111111111111111111111111 IN('Y 01 013-16 00006063

UNITED STATES DISTRICT COURTWESTERN DISTRICT OF WASHINGTON

AT SEATTLE

In re: No. C01-1346L

ONYX SOFTWARE CORPORATIONSECURITIES LITIGATION

Filed 02/20/2003 Page 1 of 13

ORDER GRANTING IN PARTMOTION TO DISMISS

This matter comes before the Court on defendant Onyx Software Corporation,

Brent R. Frei, Amy E. Kelleran, and Eben W. Frankenberg's "Motion to Dismiss Consolidated

and Amended Complaint." Defendant Dain Rauscher Wessels joined in the motion, but did not

offer any additional arguments on its own behalf. In the context of this motion to dismiss, the

Court must accept the allegations of the complaint as true and construe them in the light most

favorable to plaintiff. See e.g. , In re Syntex Corp. Sec. Litig. , 95 F.3d 922, 925-26 (9t" Cir.

1996). All reasonable inferences must be drawn in favor of plaintiff. See, e.g. , LSO, Ltd. v.

Stroh , 205 F.3d 1146, 1150 n.2 (9`h Cir. 2000). Only those claims for which it appears beyond

doubt that plaintiff can prove no set of facts which would entitle him to relief should be

dismissed. See, e.g. , Wyler Summit Partnership v. Turner Broadcasting Sys., Inc. , 135 F.3d 658,

661 (9" Cir. 1998). However, "[clonclusory allegations of law and unwarranted inferences" will

not defeat a motion under Fed. R. Civ. P. 12(b)(6). In re VeriFone Sec. Litig. , 11 F.3d 865, 868

(9th Cir. 1993).

ORDER GRANTING IN PART 1 ^

MOTION TO DISMISS

Case 2:01-cv-01346-RSL Document 63 Filed 02/20/2003 Page 2 of 13

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Having reviewed the memoranda, declarations, and exhibits submitted by the

parties, the Court finds as follows:

(1) Plaintiff argues that, by misstating financial information regarding fourth quarter

2000 and year-ending revenues, earnings, and earnings per share, defendants misled investors

and violated Section 11 of the Securities Act of 1933, 15 U.S.C. § 77k(a). Section 11 creates a

private remedy for purchasers of a security if any part of the registration statement filed pursuant

to 15 U.S.C. § 77f contained "an untrue statement of a material fact or omitted to state a material

fact required to be stated therein or necessary to make the statements therein not misleading ..."

15 U.S.C. § 77k(a). "The plaintiff in a § 11 claim must demonstrate (1) that the registration

statement contained an omission or misrepresentation, and (2) that the omission or

misrepresentation was material, that is, it would have misled a reasonable investor about the

nature of his or her investment." Kaplan v. Rose , 49 F.3d 1363, 1371 (9t" Cir. 1994).

Plaintiff' s allegations are sufficient to avoid dismissal of the § 11 claim.

According to plaintiff, the financial information provided to the public in January 2000 and

repeated in the Prospectus Supplement filed in connection with the sale of 2.5 million shares of

common stock on February 12, 2000, was incorrect at the time the statements were made.

Defendants urge that the financial information was not "false" because none of the named

defendants, or any of Onyx' upper management, was aware that certain revenues had been

improperly recognized. Defendants' argument incorrectly merges falsity and scienter: the

financial data published in connection with the February Offering was, in fact, incorrect (i.e.,

false) regardless of defendants' state of mind. For purposes of its claims under the Securities Act

of 1933, plaintiff is willing to entertain the possibility that the misstatements were innocently or

negligently made and that the only person who knew that revenue had been improperly

recognized and reported was the salesperson who entered into the forbidden side agreements.

Neither innocence nor negligence is a defense to a claim under § 11, however. Unlike actions

ORDER GRANTING IN PART

MOTION TO DISMISS -2-


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brought under Section 10(b) of the Exchange Act of 1934, 15 U.S.C. § 78j(b), no scienter is

required for liability under § 11. Defendants can be held liable for innocent or negligent material

misstatements or omissions . In re Stac Elecs. Sec. Litig. , 89 F.3d 1399, 1403-04 (9th Cir. 1.996).

Drawing all inferences in favor of plaintiff and assuming it will be able to prove

the facts alleged, the Court finds that a jury reasonably could determine that defendants'

statements regarding the fourth quarter 2000 and year-ending results were false at the time they

were made and would have misled a reasonable investor about the nature of his or her

investment. Plaintiff has, therefore, stated a claim upon which relief can be granted under § 11.

(2) Plaintiff alleges that the Prospectus Supplement was materially misleading and that

the incorrect financial information artificially inflated Onyx' stock price. Reasonable investors

could find a company that had almost attained profitability and met analysts' expectations a

much more desirable investment option than one that was still mired in red ink and had up to

four times greater losses per share in the last quarter of 2000 than the analysts expected. Even if

the Court assumes that a sizeable portion of the S 2.2 million reduction in revenues is attributable

to events which took place after the January and February statements were made, the impact on

the company's balance sheet was still significant given the importance investors ascribe to

actual, rather than projected, profitability and the satisfaction of analysts' expectations.

Defendants argue that investors would not have cared about the loss per share

numbers because the restatement had very little impact on the company's revenues. Such factual

disputes regarding the materiality of the alleged omissions should be determined by the jury. In

re Stac Elecs. , 89 F.3d at 1405. Defendants also argue that the movement of Onyx' stock price

during the relevant period proves that the undisclosed information was immaterial. Plaintiff's

theory of the case, however, is that the inflated revenues and minimal losses reported in January

2000 kept Onyx' stock price from falling as fast as it otherwise would have, resulting in sales at

artificially high prices. While defendants' evidence regarding the unexpected pattern of daily




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price changes and the comparison of Onyx' stock price with those of its nearest competitors

throws doubt on the validity of plaintiff's theory, they are not incompatible. In order to

make a finding of immateriality at this stage of the litigation, the Court would have to be in a

position to find that no reasonable investor would have been misled about the nature of his or her

investment. In re Stac Elecs. , 89 F.3d at 1403-04. Plaintiff has adequately alleged artificial

inflation and materiality, and defendants' arguments to the contrary simply show that there is an

issue of fact regarding "materiality" which should go before the jury. Plaintiffs allegations are

sufficient to survive a challenge to materiality in the context of a motion to dismiss.

(3) Plaintiff has alleged that it purchased "200 shares in the Offering pursuant to the

Offering Documents ." Consolidated and Amended Complaint at ¶ 7. Defendants challenge

plaintiffs ability to prove this allegation . Nevertheless, the allegation stands and is sufficient to

defeat a challenge to plaintiff's standing in the context of this motion to dismiss.

(4) Section 12(a)(2) of the Securities Act of 1933 provides that any person who:

offers or sells a security ... by means of a prospectus or oral communication,

which includes an untrue statement of a material fact or omits to state a material

fact necessary in order to make the statements, in the light of the circumstances

under which they were made, not misleading (the purchaser not knowing of the

untruth or omission), and who shall not sustain the burden of proof that he did not

know, and in the exercise of reasonable care could not have known, of such

untruth or omission, shall be liable ... to the person purchasing such security from

him....

15 U.S.C. § 771. The issue here is whether defendant Onyx, as the issuer of the securities sold in

the February Offering , is liable as an "offerer" or "seller" despite the fact that it did not sell the

securities to plaintiff or any other member of the class . A person who offers or sells a security

may be liable under § 12(a)(2 ) to any person "purchasing such security from him." 15 U.S.C.

§ 771. Although the "purchasing from" language could be read to require a relationship of

contractual privity , the Supreme Court decided that liability under § 12 is not limited to those




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who actually pass title to the purchaser. Pinter v. Dahl , 486 U.S. 622, 645 (1988).' A more

expansive interpretation of "purchasing from" is justified because "[i]n common parlance, a

person may offer or sell property without necessarily being the person who transfers title to, or

other interest in, that property." Pinter , 486 U.S. at 642-43. Furthermore, the Securities Act

defines "offer" to include soliciting an offer to buy. 15 U.S.C. § 77b(3). Thus, a person who

solicits an offer to buy may be liable under § 12(a)(2), despite the fact that such activities may be

carried out by persons other than the actual owner. Pinter, 486 U.S. at 643.

The factual situation before the Supreme Court in Pinter involved an individual

who recommended stocks to his friends and acquaintances. Pinter, the issuer of the securities,

attempted to share its § 12 liability with defendant Dahl, on the ground that Dahl was acting as a

broker when he recommended the purchases at issue in the case. In that context, the Supreme

Court chose an interpretation of § 12 that would impose liability on traditional brokers and

agents without sweeping in individuals who participated in or brought about the offering but

who would not normally be considered a person from whom the buyer purchased the security.

The context presented in this case, however, is the reverse of that which was before the Supreme

Court in Pinter . In this case, the February offering was made pursuant to a "firm commitment"

underwriting, as disclosed in the Prospectus Supplement attached as Exhibit 4 to defendants'

"Request for Judicial Notice." In a firm commitment underwriting, the issuer of the securities,

namely Onyx, sells all of the shares to be offered to one or more underwriters, in this case Dain

Rauscher Wessels, at some discount from the public offering price. Investors purchase shares in

the offering directly from the underwriters, not from the issuer. The interrelated questions that

must be answered here are (1) is a non-owner issuer a "seller" in these circumstances and

In Pinter , the Supreme Court described the class of individuals who may be sued under

12(a)(1) of the Securities Act. The Ninth Circuit has since determined that the standard for

determining liability as a "seller" or "offerer" under § 12(a)(1) also applies under § 12(a)(2). Moore v.

Ka port Package Express, Inc. , 885 F.2d 531, 536 (9`h Cir. 1989).

ORDER GRANTING IN PARTMOTION TO DISMISS -5-


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(2) does the issuance of a Prospectus Supplement, without any more active or direct sales

overtures, constitute solicitation?

Courts which have considered this situation have come to divergent conclusions.

In Shaw v . Digital Equip . Corp. , 82 F.3d 1194, 1215 (1s` Cir. 1996), the Circuit Court focused on

statements contained within Pinter which limited the terms "seller" and "purchased from."

The Court held that the "purchasing ... from" requirement of Section 12 limits the

imposition of liability to "the buyer's immediate seller," and thus, "a buyer cannot

recover against his seller's seller." Pinter, 486 U.S. at 644 n. 21, 108 S.Ct. at 2077

n. 21 (citations omitted). Second, the Court stated that proof the defendant caused

a plaintiffs purchase of a security is not enough to establish that the defendant

"solicited" the sale for Section 12 purposes. See id. at 651, 108 S.Ct. at 2080-81

(explaining that "[t]he `purchase from' requirement of § 12 focuses on the

defendant's relationship with the plaintiff-purchaser" and rejecting use of a test

under which defendant could qualify as a seller if he was a "substantial factor" in

causing the transaction to take place). Finally, the Court indicated that a person's

"remote" involvement in a sales transaction or his mere "participat[ion] in

soliciting the purchase" does not subject him to Section 12 liability. See id. at 651

n. 27, 108 S.Ct. at 2081. A defendant must be directly involved in the actual

solicitation of a securities purchase in order to qualify, on that basis, as a Section

12 "seller."

Shaw , 82 F.3d at 1215. Other courts, relying on Pinter 's "in common parlance" analysis, have

found that an average investor "who studies corporate filings and news releases before

purchasing via a dealer on an impersonal and anonymous market," would reasonably believe that

the corporation is the true seller of the securities. Moore v. Keegan Mgmt. Co. , No. 91-20084

SW, 1991 WL 253003, at *8 (N.D. Cal. Sept. 10, 1991). Under this interpretation of Pinter , the

public distribution of a registration statement or prospectus constitutes solicitation which could

create liability under § 12(a)(2). Kensington v. Oakley, SACV97-808GLTEEX, 1999 WL

816964, at *5 (C.D. Cal. Jan. 14, 1999).

Having reviewed the case law and the arguments of the parties, the Court

concludes that both Onyx and Dain Rauscher Wessels can be liable for misstatements in the



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Prospectus Supplement under § 12(a)(2). Although Pinter contains dicta indicating that a

seller's seller, such as Onyx here, cannot be liable because it is not the entity from which plaintiff

purchased the securities, the Supreme Court was not considering a transaction made pursuant to

a firm commitment underwriting. The Court was clearly willing to impose liability on a non-

owner broker because (1) the broker is the one who conveys information to the purchaser and

(2) the purchaser would naturally view both the broker and the issuer as the "seller." These

factors weigh even more heavily in favor of holding a non-owner issuer liable in the

circumstances presented here. Onyx initiated the public offering, authorized the issuance of the

Prospectus Supplement, and conveyed 2,500,000 shares of common stock to Dain Rauscher

Wessels for the sole purpose of putting them on the market during the February Offering.

Whether Onyx conveyed or retained title prior to the Offering would have very little effect on the

public's perception of the offer. Adjusting the Supreme Court's language to fit this situation, "a

securities [issuer] who solicited the purchase would commonly be said, and would be thought by

the buyer, to be among those `from' whom the buyer `purchased,' even though the [issuer itself]

did not pass title." Pinter, 486 U.S. at 644.

Nor is Onyx a legitimate proxy for the accountants and lawyers who the Supreme

Court placed firmly outside the scope of § 12 liability. Onyx is the entity on whose behalf the

securities were issued. Unlike the accountant or the lawyer, its participation in the drafting,

signing, and filing of the Prospectus Supplement was not limited to the "performance of ...

professional services." Onyx was the primary beneficiary of the Offering, not merely a necessary

cog in the securities wheel. Its issuance of the Prospectus Supplement had as its sole purpose the

solicitation of offers to buy from Dain Rauscher Wessels, with Onyx indirectly reaping the lion's

share of the proceeds. There is no inherent unfairness in exposing the issuer of the securities to

the risk of liability for false statements made in a firm commitment offering. Pinter , 486 U.S. at

651.




Finally, the technical ownership of the shares immediately prior to the offering has

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no substantive effect on the realities of the transaction. The duties and obligations imposed by

§ 12(a)(2) should fall on an issuer who runs its sale through a third-party underwriter to the same

extent as those which fall on an issuer who sells directly to the public. The investor-protection

purposes of this section require no less , such an interpretation is consistent with Pinter , and

imposing liability on the issuer here does no harm to the language of the statute. Pinter , 486 U.S.

at 652-53.

(5) The allegations of plaintiff' s complaint are not sufficient to state a claim against

defendants Frei and Kelleran under Section 15 of the Securities Act of 1933, 15 U.S.C. § 77o.

In order to prove a claim under § 15, plaintiff must establish (1) a primary violation of a

securities law and (2) that the individual had the power to control or influence the particular

transactions giving rise to the securities violation. Howard v. Everex Sys., Inc. , 228 F.3d 1057,

1065-66 (9t" Cir. 2000). Determining whether a person has control under § 15 requires "scrutiny

of the defendant's participation in the day-to-day affairs of the corporation and the defendant's

power to control corporate actions." Kaplan, 49 F.3d at 1382. Simply alleging that a defendant

holds an elevated position in the corporation does not tell us anything about his or her power to

control the transaction which gave rise to the securities violation. In this case, plaintiff has

alleged that defendants Frei and Kelleran were officers and/or directors of Onyx, that they each

owned stock in the corporation, and that they both signed certain documents filed with the SEC.

Consolidated and Amended Complaint at ¶¶ 9-10, 79. Plaintiff does not, however, include any

allegations regarding these defendants' role in the day-to-day operations of Onyx or otherwise

show that they were involved in the issuance of the Prospectus Supplement that forms the basis

of plaintiff's § 11 and § 12(a)(2) claims. Unlike the circumstances presented to the Ninth Circuit

in the past, plaintiff has not alleged that either Frei or Kelleran "had authority over the process of

preparing and releasing" the Prospectus Supplement and/or had "day-to-day oversight of



company operations" sufficient to presume control over the transactions at issue here. Howard ,

228 F.3d at 1065; Wool v. Tandem Computers , Inc. , 818 F .2d 1433, 1441 (9`h Cir. 1987). The2

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bald assertions of "control" are not justified by the factual allegations of the complaint.

(6) In 1995, Congress raised the pleading requirements in private securities litigation in

order to deter the routine filing of shareholder lawsuits whenever a significant change in a

company's stock price occurred. Congress was particularly concerned with litigation based on

nothing more than (1) speculation that the company "must have" engaged in foul play and (2) the

faint hope that the liberal rules of discovery would turn up some supporting evidence. See Joint

Explanatory Statement to the PSLRA, H.R. CONE. REP. No. 104-369 (1995), reprinted in 1995

U.S.C.C.N. 730. In order to state a claim under § 10b of the Exchange Act, plaintiffs "must

allege: (1) a misstatement or omission (2) of a material fact (3) made with scienter (4) on which

[plaintiffs] relied (5) which proximately caused their injury." DSAM Global Value Fund v.

Altris Software , Inc., 288 F.3d 385, 388 (9th Cir. 2002). Private securities plaintiffs must

"specify each statement alleged to have been misleading, the reason or reasons why the statement

is misleading, and, if an allegation regarding the statement or omission is made on information

and belief, the complaint shall state with particularity all facts on which that belief is formed."

15 U.S.C. § 78u-4(b)(1). In order to withstand a motion to dismiss under Fed. R. Civ. P.

12(b)(6), the complaint must, as to each act or omission alleged to violate the securities laws,

"state with particularity facts giving rise to a strong inference that the defendant acted with the

required state of mind ." 15 U.S.C. § 78u-4(b)(2).

There is little consistency within the Circuit Courts with regards to what state of

mind is required in private securities litigation and what type of evidence satisfies the PSLRA's

"strong inference" requirement. In In re Silicon Graphics Inc. Securities Liti ., 183 F.3d 970,

975-77 (9`h Cir. 1999), the Ninth Circuit evaluated the requirements of the PSLRA, its legislative

history, and the prior practice of the courts and determined that the required state of mind for




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purposes of § 78u-4(b)(2) is, at a minimum, a "deliberate recklessness" that reflects some degree

of knowing misconduct. In order to give rise to a "strong inference" of "deliberate

recklessness," securities plaintiffs may no longer rely on evidence which suggests that the

corporation and/or its officers had a motive and opportunity to defraud the market: rather, the

complaint must allege, with particularity, "facts indicating no less than a degree of recklessness

that strongly suggests actual intent." 483 F.3d at 979. Recklessness is defined as "a highly

unreasonable omission, involving not merely simple, or even inexcusable negligence, but an

extreme departure from the standards of ordinary care, and which presents a danger of

misleading buyers or sellers that is either known to the defendant or is so obvious that the actor

must have been aware of it." DSAM Global Value Fund, 288 F.3d at 389.

The Court recognizes that Silicon Graphics and its progeny make it very difficult

for private securities litigants to survive a motion to dismiss unless they possess, at the time of

filing, evidence that defendants had knowledge of, or were deliberately reckless regarding, the

falsity of public statements at the time they were made. Allegations of knowingly false

statements are not enough: they must be supported with references to the facts, documents, and

reports which give rise to a strong inference that defendants acted with knowledge or reckless

indifference. Plaintiffs can no longer file a claim and hope that discovery will provide the

necessary proof.

In the absence of greater particularity and more incriminating facts, we have no

way of distinguishing [plaintiffs') allegations from the countless "fishing

expeditions" which the PSLRA was designed to deter. See H.R. CONF. REP. 104-

369 at 37.

Congress enacted the PSLRA to put an end to the practice of pleading "fraud by

hindsight." See, _e.^. , Medhekar v. United States Dist. Ct. , 99 F.3d 325, 328 (9`n

Cir. 1996) (holding that Congress intended for complaints under the PSLRA to

stand or fall based on the actual knowledge of the plaintiffs rather than information

produced by the defendants after the action has been filed).

Silicon Graphics , 183 F.3d at 988. Thus, the Court finds that the PSLRA and Ninth Circuit




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authority compel a rigorous analysis of the facts alleged to ensure that they satisfy the PSLRA's

heightened pleading standards.

Plaintiff has alleged that Onyx and its officers/directors made false statements

regarding the corporation's revenue recognition practices and its revenues, earnings, and

earnings per share at the end of 2000. The Onyx defendants are accused of having intentionally

made these false statements in order to sell securities at inflated prices and acquire cash for both

the company and defendant Frankenberg. There is no evidence, however, that anyone at Onyx

other than the malfeasing salesperson knew that revenues had been improperly recognized or that

the financial information provided to the public was false at the time the statements were made.

Plaintiff argues that the $2.2 million in revenues that were reversed in August 2001 were of such

magnitude that defendants must have known about the side agreements. This contention is based

on nothing more than speculation. As far as plaintiff and the Court knows, only four of the

seven transactions that were reversed had anything to do with suspected side agreements. Those

four transactions amounted to $797,000 in revenues, approximately .7% of Onyx' originally

reported annual revenues. The existence of a series of accounting errors, each of which was

relatively small in size, does not raise even a weak inference of scienter.2

Nor does a desire to raise cash for expansion, research, credit, or other business-

related purposes give rise to a strong inference of scienter. Lipton v. Pathogen sis Com-, 284

F.3d 1027, 1038 (9`h Cir. 2002). At most, plaintiff has identified motives Onyx may have had to

defraud the market, but such allegations are clearly insufficient under Ninth Circuit law. See

Silicon Graphics , 183 F.3d at 979.

Plaintiff's argument regarding the short time frame between the misstatements in

January through May 2000 and the revelation of the truth in July and August is hardly

2 The remainder of the restated revenue has never been described as anything other than a

reduction based on "facts now available with the benefit of hindsight" to reflect non-payment on certain

transactions. Consolidated and Amended Complaint at ¶ 44.



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compelling. Whether it took defendants two days, two months, or two years to discover the

improper side agreements tells us very little about their state of mind at the time the false

financial information was disseminated to the public. While timing could, in some

circumstances, give rise to an inference of scienter, it is not helpful here.

Finally, defendant Frankenberg's sale of 12.4% of his stock in June 2001 does not,

in the circumstances of this case, raise an inference of knowledge. If, as plaintiff would have it,

Frankenberg was attempting to cash in on a fraud defendants had perpetrated on the market, why

did he sell so little of his stock? Ronconi v. Larkin , 253 F.3d 423, 435 (9`h Cir. 2001). Why did

he sell the stock after it had lost half of its value? Why did the other individual defendants, who

were supposedly in on the fraud, continue to hold their shares throughout the class period? The

fact that defendant Frankenberg decided to sell some of his shares in 2001 tells us very little, if

anything, about defendants' state of mind regarding the false financial information.

Whether considered separately or together, plaintiffs allegations of knowledge are

insufficient to raise a strong inference of scienter under the PSLRA.

(7) In the absence of an underlying violation. of the Securities Exchange Act of 1934,

plaintiff cannot succeed on his "control person" claim under § 20(a). In addition, plaintiff's

allegations of control are deficient for the reasons stated in paragraph 5 above.

(8) Plaintiff has not opposed defendants' motion to dismiss its insider trading claim under

§ 20A of the Securities Exchange Act of 1934.

For all of the foregoing reasons, defendants ' motion to dismiss is GRANTED in

part and DENIED in part. The Court finds that plaintiff has adequately alleged facts which, if

proven could give rise to liability for defendants Onyx, Dain Rauscher Wessels, Frei, and

Kelleran under § 11 of the Securities Act of 1933 and defendants Onyx and Dain Rauscher

Wessels under § I2(a)(2) of the 1933 Act. Plaintiff has not, however, alleged facts to support its




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allegation that defendants Frei and Kelleran were "control persons" under § 15. Because

plaintiff maybe able to supplement its allegations on this issue, it will have sixty days from the

date of this Order in which to amend its allegations of control. Plaintiff does not, however, have

evidence which could support its claims under the Securities and Exchange Act of 1934, nor is

there any hint in the record or arguments of counsel that such evidence is forthcoming. In such

circumstances, those claims are dismissed without leave to amend.

f'1DATED this day of February, 2003.

---1*5u^mx

Ro ert S . LasnikUnited States District Judge

f l ORDER GRANTING IN PART

II MOTION TO DISMISS -13-

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