In re Dot Hill Systems Corp. Securities Litigation

• Decision Date: 02 September 2008
• Docket Number: Case No. 06CV228 JLS (WMc).
• Parties: In re DOT HILL SYSTEMS COPORATION SECURITIES LITIGATION.
• Court: U.S. District Court — Southern District of California

594 F.Supp.2d 1150

In re DOT HILL SYSTEMS COPORATION SECURITIES LITIGATION.

Case No. 06CV228 JLS (WMc).

United States District Court, S.D. California.

September 2, 2008.

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Kara Michelle Wolke, Michael M. Goldberg, Glancy, Binkow and Goldberg, Leigh A. Parker, Weiss and Lurie, Los Angeles, CA, Philip C. Tencer, Cooley, Godward, Kronish LLP, Frank J. Johnson, Jr., Johnson Bottini, LLP San Diego, CA, Eric J. Belfi, Murray, Frank and Sailer, Ira M. Press, Kirby McInerney, LLP, New York, NY, for Plaintiffs.

Darcie Tilly, Meghan O'Ryan Spieker, Philip C. Tencer, Cooley, Godward, Kronish LLP., San Diego, CA, for Defendants.

ORDER (1) GRANTING DEFEDANTS' MOTION TO DISMISS WITHOUT PREJUDICE and (2) GRANTING MOTION TO STAY DISCOVERY IN STATE-COURT ACTIONS

JANIS L. SAMMARTINO, District Judge.

Presently before the Court are two motions by Dot Hill Systems Corporation, James L. Lambert, Dana W. Kammersgard, Preston S. Romm, and William R. Sauey¹ ("defendants"). Defendants move to dismiss plaintiffs' second amended consolidated class action complaint ("SACC"). (Doc. No. 73.) Pursuant to the Securities Litigation Uniform Standards Act ("SLSA"), defendants also move for this Court to stay discovery in two state-court actions: In re Dot Hill Systems Corp. Derivative Litigation, San Diego County Superior Court Case No. GIN05287, and Brody v. Dot Hill Systems Corp., et al., San Diego County Superior Court Case No. 37-2007-00073096-CU-SL-CTL. The Court grants the motion to dismiss with leave to amend, and grants the motion to stay discovery.

BACKGROUND

A. Facts

Lead plaintiffs bring this putative class action on behalf of all purchasers of Dot Hill common stock between April 23, 2003 and April 27, 2006. (SACC ¶ 1.)

Dot Hill provides data storage devices (i.e., hard drives), both as stand-alone units and as part of larger storage systems. (SACC ¶ 2.) Dot Hill's devices employ Redundant Array of Independent Disks ("RAID") technology. (Id.) In 2002, facing severe declines in sales and revenue, Dot Hill restructured its business by outsourcing its manufacturing, transitioning to an indirect sales model, and sharply reducing sales and administrative personnel. (Id. ¶ 3.) That same year, Dot Hill secured a contract to provide data storage systems to Sun Microsystems, which became the source of 80-90% of Dot Hill's quarterly revenues. (Id. ¶ 4.)

In September 2003, Dot Hill completed a secondary stock offering that raised approximately $154 million, with the individual defendants selling an additional $23.1 million. (SACC ¶ 6.) Dot Hill used some of the revenues from this offering to purchase Chapparal Network Storage, Inc., a provider of RAID technology, with the intent of integrating Chapparal technology into its own products. (Id. ¶ 7.) Dot Hill's share price increased from $6 at the start of the class period to a peak price of $18, dropped by half in 2004 and early 2005, eventually declined to $4.55 on April 28, 2006 and then subsequently declined to $3 per share. (Id. ¶ 12.)

The SACC alleges five sets of misrepresentations giving rise to plaintiffs' claim for federal securities fraud. First, plaintiffs allege that Dot Hill conceded the material falsity of its financial statements for the first 3 quarters of 2004. (SACC ¶ 29.) In a February 3, 2005 press release, Dot Hill acknowledged "internal control deficiencies that constitute material weaknesses" and attributed those deficiencies to outdated software and inadequate accounting resources. (Id.) Dot Hill repeated the admission of "a material weakness in [its] internal control" via its amended Form 10-Q and 2004 Form 10-K, both filed on March 16, 2005. (Id. ¶ 30). The SACC alleges that Dot Hill's management knew of the shortcomings in its accounting software, as revealed through the "common knowledge" of employee complaints and conversations between employees and the executive defendants. (Id. ¶¶ 37-38.) Also, the management was allegedly aware of understaffing in the accounting department because of the long hours worked by those employees, the problems with late payments, and the absence of staff with adequate credentials. (Id. ¶ 40.)

Second, plaintiffs allege misrepresentations pertaining to the progress of Dot Hill's acquisition of Chapparal technology. Defendants continued to represent that the integration of Chapparal technology into Dot Hill products was "on schedule" and "continuing smoothly," although defendants continually pushed back the expected target date for shipping those products. (SACC, e.g., ¶ 50.) Allegedly, the integration of the technology was progressing more slowly, with the delivery of products to market more remote than Dot Hill was representing. (Id. ¶ 54.) Dot Hill management allegedly must have known about these delays in the Chapparal integration because Kammersgard, Dot Hill's Chief Technology Officer, kept aware of issues in Dot Hill's product development and spoke with employees in those divisions of the company. (Id. ¶ 57.)

Third, plaintiffs allege misrepresentations associated with defendants' remarks about the salutary effects of staff cuts and its business model predicated on outsourced manufacturing and indirect sales. Dot Hill particularly emphasized its annualized revenue figure of more than $1 million per employee. (SACC ¶¶ 61-64.) Dot Hill further represented its expectation that it would continue to operate with fewer than two hundred employees. (Id. ¶¶ 60, 62.) These representations were allegedly false because Dot Hill's business model, rather than making the company sustainably profitable, "had resulted in organizational dysfunction and breakdown." (Id. ¶ 66.) By this statement, plaintiffs mean to refer to Dot Hill's inadequate accounting personnel and inexperienced sales staff. (Id., e.g., ¶¶ 66-67.) Plaintiffs attribute these shortcomings to defendants' insistence on maintaining per-employee revenue levels above $1 million. (Id. ¶ 69.) Plaintiffs allege that defendants' representations of "a `lean' or `efficient' organization" in 2003-04, including its representations of profits earned during those periods, were effectively false because, if Dot Hill had maintained operating costs and employee headcount at sustainable levels during that period, its financial results would have been much worse. (Id. ¶¶ 72, 75.) Dot Hill's results in subsequent years were much worse because the company incurred operating costs associated with hiring more accountants and upgrading software and because the incompetent sales force could not secure new customers. (Id. ¶¶ 67, 77.)

Fourth, plaintiffs allege that defendants provided unduly optimistic representations concerning Dot Hill's relationship with Sun Microsystems, its largest customer. These positive statements included Dot Hill's commitment to making the relationship with Sun successful, along with announcements of extensions of the Sun-Dot Hill contract. (SACC ¶¶ 80, 91.) Plaintiffs allege these statements were false because Sun was actually dissatisfied with Dot Hill's services and "enjoyed a structurally superior position in the relationship that allowed it to dictate terms to Dot Hill[.]" (Id. ¶ 93.) Specifically, plaintiffs allege that Dot Hill acquired Chapparal because Sun demanded that Dot Hill acquire a new source of RAID technology. (Id.) And, the announcements of the contract extensions were allegedly misleading because they failed to disclose the "punitive" terms that Sun imposed on Dot Hill. (Id. ¶ 94.) The alleged truth finally came to light on April 28, 2006, when Dot Hill disclosed that Sun had awarded a product development contract to one of Dot Hill's competitors. (Id. ¶ 95.)

Fifth and finally, plaintiffs allege that defendants misrepresented the extent of their success in attracting new customers. These misrepresentations included press releases announcing "agreements" with third parties because those agreements did not require purchases of Dot Hill products and often failed to generate much revenue. (SACC, e.g., ¶¶ 98, 109.) Defendants alleged knew of the falsity of these misrepresentations because defendants were aware of their underqualified sales staff and inadequate investment in business development. (Id. ¶¶ 110-11.)

B. Procedure

The SACC pleads two causes of action for (1) violation of Exchange Act § 10(b) and Rule 10b-5, and (2) controlling person liability under Exchange Act § 20(a).

The Hon. Thomas J. Whelan reassigned the action to this Court on September 25, 2007. At the time, a fully briefed motion to dismiss the SACC was pending for decision. (Doc. No. 58.) On November 28, 2007, the Court granted the parties' joint motion to stay the litigation pending mediation. (Doc. No. 66.) On February 28, 2008, the parties filed a joint report informing the Court that they could not agree to settlement terms and requesting that the Court set the motion for hearing. (Doc. No. 67.)

The Court held a telephonic status conference on March 5, 2008. In light of recent Supreme Court case law, the parties agreed to vacate defendants' motion to dismiss without prejudice. The Court vacated the motion and set a briefing schedule on the forthcoming renewed motion on March 14, 2008. (Doc. No. 72.)

Defendants refiled their motion to dismiss the SACC on May 1, 2008.² (Doc. No. 73.) Plaintiffs filed their opposition on June 19, 2008. (Doc. No. 74.) Defendants replied on July 24, 2008. (Doc. No. 78.)

Defendants filed their motion to stay state-court discovery on July 11, 2008. (Doc. No. 76.) Plaintiffs from the statecourt derivative action specially appeared to oppose the motion to stay on July 28, 2008. (Doc. No. 80.) The plaintiff in the Brody state-court action never appeared in this action to oppose the motion to stay. Defendants filed their reply on August 7, 2008. (Doc. No. 82.)

The Court held oral argument on the motion to dismiss and the motion to stay on August 14, 2008. The Court then took the matters under...