In re Digimarc Corp. Derivative Litigation

Decision Date11 December 2008
Docket NumberNo. 06-35838.,06-35838.
PartiesIn re DIGIMARC CORPORATION DERIVATIVE LITIGATION. George Diaz, derivatively on behalf of Digimarc Corporation, Plaintiff-Appellant, v. Bruce Davis; E.K. Ranjit; Phillip J. Monego; Peter W. Smith; Alty Van Luijt; Brian J. Grossi; Jim Roth; James T. Richardson; John Taysom; William A. Krepick; Geoffrey Rhoads; and Digimarc Corporation, a Delaware corporation, Defendants-Appellees.
CourtU.S. Court of Appeals — Ninth Circuit

Marc Umeda, Jeffrey Fink, and Rebecca Peterson, Robbins, Umeda & Fink, LLP, San Diego, CA, for the appellant.

Adam Gonnelli, Lubna Faruqi, and Beth Keller, Faruqi & Faruqi, LLP, New York, NY, for the appellant.

Richard Baum, Julia Markley, and Banu Ramachandran, Perkins Coie LLP, Portland, OR, for the appellees.

Appeal from the United States District Court for the District of Oregon; Ancer L. Haggerty, District Judge, Presiding. D.C. Nos. CV-05-01324-HA, CV-05-01325-HA.

Before: T.G. NELSON, HAWKINS, and JAY S. BYBEE, Circuit Judges.

BYBEE, Circuit Judge:

George Diaz, sometime shareholder of Digimarc Corporation, filed this action derivatively on the corporation's behalf. Diaz alleges that the individual defendants, who are current and former officers and directors of Digimarc, breached their fiduciary duties to the corporation and its shareholders by issuing misleading financial statements and misrepresenting the business and prospects of Digimarc in violation of California corporations law and section 304 of the Sarbanes-Oxley Act, 15 U.S.C. § 7243. The district court dismissed his Sarbanes-Oxley claim on the grounds that there is no private cause of action for a violation of section 304 and then realigned Digimarc as a plaintiff, thereby destroying diversity jurisdiction over Diaz' state law claims. For the reasons explained below, we agree with the district court that there is no private right of action under section 304, and that the District of Oregon accordingly lacked federal question jurisdiction over the suit. We disagree, however, with the district court's realignment of Digimarc as plaintiff for the purpose of determining diversity jurisdiction and therefore remand to that court for proceedings consistent with this opinion.

I

On September 13, 2004, Digimarc, a publicly-traded Delaware corporation headquartered in Oregon (and a self-described "leading supplier of secure personal identification systems" including personal identification documents and driver licenses based on digital watermarking technology), publicly announced that, due to accounting errors, the corporation had likely overestimated earnings for the previous six quarters. The announcement cited the improper capitalization of internal software development costs as the most likely cause of these accounting errors. In short, the corporation had failed to record the costs of internal software development as expenses on its balance sheet, thereby artificially inflating its net earnings over the relevant period.

Although the full extent of the accounting errors (approximately $2.7 million in overstated earnings) was not revealed until April 5, 2005, when Digimarc formally issued a restatement of earnings, class action lawsuits were filed within one month of the September 13, 2004, announcement. On September 28, 2004, a class action complaint alleging violations of sections 10(b) and 20(a) of the Securities Exchange Act was filed (and eventually consolidated with two others) in the District of Oregon. See Zucco Partners, LLC v. Digimarc Corp., 445 F.Supp.2d 1201 (D.Or.2006). The Appellant in this action, meanwhile, filed a shareholder derivative suit in early October against Digimarc and certain of its officers and directors in California Superior Court for San Luis Obispo County. This action, which was consolidated with a similar suit filed by Patrick Sheehan in the same court, pled state law claims for violations of California Corporations Code § 25402, breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment.

Other shareholders sought a more direct means of remediation. Shortly after the California Superior Court actions were filed, Christopher Beasley sent a letter to the Chair of Digimarc's Board of Directors demanding that the Board take action to rectify the alleged breaches of fiduciary duties described in the California Superior Court complaint. The letter specifically demanded the Board "commence a civil action against each of the Directors and Officers to recover for the benefit of the Company" damages for misconduct and disgorgement of bonuses, stock options, and other incentive compensation.

In response to the derivative actions and the demand letter, Digimarc created a Special Litigation Committee ("SLC") by board resolution on January 5, 2005, for the purpose of investigating the breaches of fiduciary duty alleged in the California Superior Court action and the Beasley letter. The Board endowed the SLC with the broad adjudicative power "to undertake and supervise any action necessary and appropriate to implement any [factual findings it made]," and to "determine whether or not the Company shall undertake or defend against any litigation against one or more of the present or former directors or officers of the company."

Initially, Alty van Luijt and Jim Roth, both directors of Digimarc named as defendants in the California Superior Court action, were appointed as sole members of the SLC. On June 6, 2005, however, van Luijt and Roth were replaced by Lloyd Waterhouse, Bernard Whitney, and William Miller—all board members of Digimarc who were not named as defendants in the California Superior Court action and who were not affiliated with the company during the time period at issue. The SLC also retained the law firm Farleigh Witt to assist in the investigation of claims against individual officers and directors. One of the SLC's initial actions was to send a letter dated February 25, 2005 to Beasley inviting him to participate in the investigation. The SLC did not send similar letters to Diaz or Sheehan at that time.

Digimarc's approach to the California action was decidedly less generous. The corporation moved in California Superior Court to dismiss the consolidated derivative action on grounds of forum non conveniens. This motion was granted on July 29, 2005, and the case was dismissed. The court conditioned its order to dismiss on an agreement by Digimarc and the individual defendants to submit to the jurisdiction of an Oregon state court (in which Beasley, unsatisfied with the SLC's letter, had also filed a derivative action), and an agreement that the statute of limitations pertaining to any claims based on the same facts alleged in the California Superior Court actions would be tolled from the date of filing the California Superior Court actions.

Instead of filing in Oregon state court, however, Diaz and Sheehan each added a Sarbanes-Oxley claim and brought separate derivative actions in the District Court for the District of Oregon on August 25, 2005. Specifically, these actions asserted claims for disgorgement under section 304 of the Sarbanes-Oxley Act, 15 U.S.C. § 7243, and state law claims for breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment, and violations of the California Corporations Code. The actions further alleged that the individual defendants, the directors and officers of Digimarc,1 were liable to Digimarc for an unspecified sum of damages and declaratory and equitable relief. The district court consolidated the actions on September 29, 2005.

On September 9, 2005, shortly after the district court actions were filed, the SLC sent a letter to counsel for Diaz and Sheehan, inviting them to "have input in our investigation" and to participate in the next committee meeting on October 5, 2005. Three days later, the SLC sent another letter to Beasley's counsel, advising him of the committee meeting and the ongoing investigation.

A little over a month later, on October 17, 2005, the individual defendants in this case filed a motion to dismiss the consolidated complaint for lack of jurisdiction, pursuant to Federal Rules of Civil Procedure 12(b)(1) and 12(b)(6). The individual defendants argued that because section 304 of the Sarbanes-Oxley Act did not create a private right of action, the district court could not assert federal question jurisdiction over that claim, and that because Digimarc corporation should be aligned as a plaintiff in the action, the parties were not diverse and the district court lacked jurisdiction over the plaintiffs' remaining state law claims.

Meanwhile, after the motion to dismiss was filed but before the district court ruled, the SLC finished its investigation and reported its findings and recommendations on February 18, 2006. The SLC concluded that "[w]ith respect to the facts, ... there was insufficient evidence to establish that any of the defendants violated applicable standards of conduct, intentionally or otherwise," and that "the evidence overwhelmingly indicated that ... there was simply no malfeasance or nonfeasance such that would entitle the Company (or someone suing on its behalf) to prevail on any of the claims alleged in the Derivative Litigation." Accordingly, the SLC recommended that "the defendants' substantial defenses, and the risks, costs, and burden of litigation ... establish[ ] that pursuit of the Derivative Litigation [is] not in the best interest of the Company and its shareholders."

The district court subsequently granted the individual defendants' motion to dismiss on August 11, 2006. The district court concluded that there was no private right of action under section 304, and thus that "plaintiffs lack[ed] standing to assert the only federal law claim alleged in the Complaint." Additionally, the district court...

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