In re Daou Systems, Inc.

• Decision Date: 21 June 2005
• Docket Number: No. 02-57018.,No. 02-56989.,02-56989.,02-57018.
• Citation: 411 F.3d 1006
• Parties: In re DAOU SYSTEMS, INC., Securities Litigation, Greg Sparling; Eugene Krabbenhoft; Patrick De Kruyff, Esq.; Robert Zaretsky; Rod Ford; Thomas V. Hagman; Richard W. Walsh; Richard Toribio; Paul Rabin, Plaintiffs-Appellants, v. Georges Daou; Daniel Daou; Fred McGee; Robert McNeill; John Moragne; Daou Systems, Inc., Defendants-Appellees. In re Daou Systems, Inc., Securities Litigation, Greg Sparling; Eugene Krabbenhoft; Patrick De Kruyff, Esq.; Robert Zaretsky; Rod Ford; Thomas V. Hagman; Richard W. Walsh; Richar Toribio; Paul Rabin, Plaintiffs-Appellees, v. Georges Daou; Daniel Daou; Fred McGee; Robert McNeill; John Moragne, Defendants, and Daou Systems, Inc., Defendant-Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

411 F.3d 1006

In re DAOU SYSTEMS, INC., Securities Litigation, Greg Sparling; Eugene Krabbenhoft; Patrick De Kruyff, Esq.; Robert Zaretsky; Rod Ford; Thomas V. Hagman; Richard W. Walsh; Richard Toribio; Paul Rabin, Plaintiffs-Appellants, v. Georges Daou; Daniel Daou; Fred McGee; Robert McNeill; John Moragne; Daou Systems, Inc., Defendants-Appellees.

In re Daou Systems, Inc., Securities Litigation, Greg Sparling; Eugene Krabbenhoft; Patrick De Kruyff, Esq.; Robert Zaretsky; Rod Ford; Thomas V. Hagman; Richard W. Walsh; Richar Toribio; Paul Rabin, Plaintiffs-Appellees, v. Georges Daou; Daniel Daou; Fred McGee; Robert McNeill; John Moragne, Defendants, and Daou Systems, Inc., Defendant-Appellant.

No. 02-56989.

No. 02-57018.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted February 12, 2004.

Filed February 2, 2005.

Amended June 21, 2005.

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Eric A. Isaacson, San Diego, CA, for the plaintiffs-appellants-appellees.

Michael P. McCloskey, San Diego, CA, for the defendants-appellees-appellants.

Appeal from the United States District Court for the Southern District of California; M. James Lorenz, District Judge, Presiding. D.C. No. CV-98-01537-L/CGA.

Before BETTY B. FLETCHER, HARRY PREGERSON, and MELVIN BRUNETTI, Circuit Judges.

ORDER AND AMENDED OPINION

BRUNETTI, Circuit Judge.

ORDER

The attached amended opinion is substituted for the original opinion filed on February 2, 2005, slip op. page 1385 and appearing at 397 F.3d 704 (9th Cir.2005). With these amendments, Daou's petition for panel rehearing is denied and plaintiffs' "Motion to Amend Opinion to Conform with Controlling Precedent" is moot.

OPINION

Plaintiffs, a class of former Daou Systems, Inc. ("Daou") investors who purchased Daou common stock between February 13, 1997 and October 28, 1998, allege that defendants Daou, Chief Executive Officer and Chairman of the Board Georges Daou ("G.Daou"), President and Director Daniel Daou ("D.Daou"), Chief Financial Officer and Senior Vice President Fred McGee, Chief Operating Officer and Executive Vice President Robert McNeill, and Director John Moragne systematically and fraudulently violated the Generally Accepted Accounting Principles ("GAAP") in order to artificially inflate the price of Daou's stock. Plaintiffs also allege that they incurred substantial personal losses due to their respective purchases of Daou stock at fraudulently inflated prices. The district court, on several occasions, determined that plaintiffs had failed to state sufficiently particularized claims under the 1933 Securities Act and the 1934 Exchange Act and thrice granted plaintiffs leave to amend. Plaintiffs now appeal the district court's dismissal of their Third Amended Complaint ("TAC") with prejudice. Defendants also cross-appeal the district court's failure to consider, sua sponte, whether to impose sanctions against plaintiffs and plaintiffs' attorneys.

FACTS¹ AND PROCEEDINGS BELOW

Daou created, implemented, and supported computer networking systems for use in the healthcare field. Beginning with its first public offering in February 1997, Daou represented itself as a technologically astute company able to keep pace with the ever-changing medical field. For seven consecutive quarters, Daou reported "record" growing revenues and stated that the company's earnings per share ("EPS") had and would exceed market expectations. Daou allegedly touted "spectacular" results and "strong growth" while also reporting successful employee retention as well as an "extremely strong pipeline position."

Plaintiffs contend that Daou fraudulently inflated the price of its stock by reporting revenues before they were earned, in violation of GAAP. The company employed an accounting method known as the percentage-of-completion ("POC") method, which is used primarily to account for progress on long-term projects. Under this method, revenue from these projects could only be recognized based on the percentage of labor costs incurred to date compared to the total estimated labor costs for the project. Plaintiffs allege, however, that defendants would prematurely recognize revenue in contravention of the POC method. For example, plaintiffs allege that defendants systematically, without regard to labor costs incurred or estimated, recognized 20% of the contract revenue immediately upon signing products contracts, 40% of the contract revenue immediately after the equipment to be installed was ordered, and 50%-60% of the contract revenue as soon as the equipment was configured and tested. Plaintiffs contend that because of such artificial inflation of the price of Daou stock, Daou was able to acquire eleven companies, and Daou executives and their respective family members were able to sell nearly 2.5 million shares for a total of $54.67 million in improper proceeds. Plaintiffs also allege that to their detriment they purchased their Daou shares during the class period at artificially inflated prices and that, had they been aware of Daou's true financial results and condition, they would not have purchased their shares, or at least not at the prices paid.

Defendants counter that their method of accounting did not violate GAAP or their own stated policy, as they revealed in various disclosures that

[c]ontract revenue for the development and implementation of network solutions is recognized on the percentage-of-completion method with progress to completion measured by labor costs incurred to date compared to total estimated labor costs.... Revenues recognized in excess of amounts billed and project costs are classified as contract work in progress.

(emphasis added). The district court agreed and determined that plaintiffs had failed to expose any financial tomfoolery on the part of Daou in its execution of the POC accounting method:

Plaintiffs appear [to] argue that, because there was a variance between recognized and earned revenue, Defendants must have been engaged in accounting fraud. Their allegations that the funds in the work in progress account represented improperly recognized revenue are conclusory and appear to result from circular logic. Plaintiffs simply have not shown that recognizing unearned revenue and earmarking it for the work in progress account is anything but an exercise of Defendants' business judgment.

Such failure, the court concluded, proved fatal to plaintiffs' remaining claims, as, for example, if Daou's statements were not false and misleading, then defendants did nothing requiring an assessment of their scienter in making them. The court consequently dismissed plaintiffs' TAC with prejudice, and this appeal followed.

DISCUSSION

I. Standard of Review

We review dismissals under Federal Rules of Civil Procedure 9(b) and 12(b)(6) de novo. Vess v. Ciba-Geigy Corp. USA, 317 F.3d 1097, 1102 (9th Cir.2003) (citations omitted). "[W]e accept the plaintiffs' allegations as true and construe them in the light most favorable to plaintiffs." Gompper, 298 F.3d at 895 (citations omitted). However, "[c]onclusory allegations of law and unwarranted inferences are insufficient to defeat a motion to dismiss for failure to state a claim." In re VeriFone Sec. Litig., 11 F.3d 865, 868 (9th Cir.1993) (citations omitted). "Dismissal without leave to amend is improper unless it is clear, upon de novo review, that the complaint could not be saved by any amendment." Gompper, 298 F.3d at 898 (citation and internal quotations omitted).

II. Federal Securities Law

Plaintiffs' TAC asserts five claims for relief, alleging (1) violation of section 10(b) and Rule 10b-5 of the 1934 Exchange Act against all defendants; (2) violation of section 20(a) of the 1934 Exchange Act against certain defendants; (3) violation of section 11 of the 1933 Securities Act against certain defendants; (4) violation of section 12(a)(2) of the 1933 Securities Act against certain defendants; and (5) violation of section 15 of the 1933 Securities Act against certain defendants.

a. Section 10(b) of the Exchange Act of 1934

Section 10(b) of the Exchange Act of 1934, 15 U.S.C. § 78j(b), makes it unlawful "for any person ... [t]o use or employ, in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe[.]" SEC Rule 10b-5, promulgated under the authority of section 10(b), in turn, provides:

It shall be unlawful for any person ... (a) To employ any device, scheme, or artifice to defraud,

(b) 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 circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

17 C.F.R. § 240.10b-5. The basic elements of a Rule 10b-5 claim, therefore, are: (1) a material misrepresentation or omission of fact, (2) scienter, (3) a connection with the purchase or sale of a security, (4) transaction and loss causation, and (5) economic loss. See Dura Pharms., Inc. v. Broudo, 544 U.S. ___, 125 S.Ct. 1627, 1631, 161 L.Ed.2d 577 (2005).

It is well established that claims brought under Rule 10b-5 and section 10(b) must meet the particularity requirements of Federal Rule of Civil Procedure 9(b). See Semegen v. Weidner, 780 F.2d 727, 729, 734-35 (9th Cir.1985). Rule 9(b) states that "[i]n all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity. Malice, intent, knowledge, and other condition of mind of a person may be averred generally."

Further, the enactment of the Private Securities Litigation Reform Act ("PSLRA") in 1995 significantly altered pleading requirements in private securities fraud...