Zucco Partners, LLC v. Digimarc Corp.

• Decision Date: 12 January 2009
• Docket Number: No. 06-35758.,06-35758.
• Citation: 552 F.3d 981
• Parties: ZUCCO PARTNERS, LLC; Rex Boggs; Kennard McAdam; Glen Thomas, Plaintiffs-Appellants, v. DIGIMARC CORPORATION; Bruce Davis; E.K. Ranjit, Defendants-Appellees.
• Court: U.S. Court of Appeals — Ninth Circuit

552 F.3d 981

ZUCCO PARTNERS, LLC; Rex Boggs; Kennard McAdam; Glen Thomas, Plaintiffs-Appellants, v. DIGIMARC CORPORATION; Bruce Davis; E.K. Ranjit, Defendants-Appellees.

No. 06-35758.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted August 26, 2008.

Filed January 12, 2009.

David F. Rees, Gary M. Berne, and Mark A. Friel, Stoll Stoll Berne Lokting & Lokting P.C., Portland, OR; Lori G. Feldman and Karen T. Rogers, Milberg Weiss LLP, New York, NY, for the plaintiffs-appellants.

Barnes H. Ellis, Lois O. Rosenbaum, and Brad S. Daniels, Stoel Rives LLP, Portland, OR, for the defendants-appellees.

Appeal from the United States District Court for the District of Oregon; Anna J. Brown, District Judge, Presiding. D.C. No. CV-04-01390-AJB.

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

BYBEE, Circuit Judge:

Zucco Partners, LLC and other named plaintiffs (collectively, "Zucco"), on behalf of those who purchased publicly-traded securities of Digimarc Corporation ("Digimarc" or "the Company") between April 22, 2003 and July 28, 2004, appeal the District of Oregon's dismissal of their Second Amended Complaint, which alleges that Digimarc (and two of its officers, Bruce Davis and E.K. Ranjit) violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and the regulations promulgated thereunder, including Rule 10b-5. Zucco contends that the district court erred in determining that its complaint failed to allege a strong inference of scienter as required by the Private Securities Litigation Reform Act ("PSLRA") because that court applied a more stringent standard than required by the Supreme Court's recent decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 127 S.Ct. 2499, 168 L.Ed.2d 179 (2007). Although we have previously evaluated the sufficiency of such claims under the PSLRA by the standards of In re Silicon Graphics Inc. Securities Litigation, 183 F.3d 970 (9th Cir.1999), and In re Daou Systems, Inc. Securities Litigation, 411 F.3d 1006 (9th Cir.2005), we have yet to fully explain how the Court's Tellabs decision relates to much of our analysis under those cases.

The district court determined that, pursuant to Daou, the plaintiffs' complaint failed to allege scienter with the requisite particularity to survive dismissal under the PSLRA's heightened pleading standard. Because we hold that the Court's decision in Tellabs does not materially alter the particularity requirements for scienter claims established in our previous decisions, but instead only adds an additional "holistic" component to those requirements, we affirm the district court's dismissal of the complaint with prejudice and hold that Zucco has failed to adequately plead a strong inference of scienter.¹

I

Accounting for the costs of internal software development is not a simple task. In order to comply with Generally Accepted Accounting Principles ("GAAP"), a company that engages in internal software development projects must make subtle differentiations between three stages of development that determine whether expenditures incurred must be "expensed" (recorded immediately on the company's financial statement as a cost incurred) or "capitalized" (recorded as a cost incurred in increments over several financial statements). This distinction is important because if an expenditure is capitalized rather than expensed a company will (in the absence of other factors) look more profitable in the short term (albeit less profitable in the long term) and show a more consistent pattern of reported income— because its expenditures are spread out over a longer period of time. Under GAAP, if a software development project is in the "preliminary project stage," wherein the company is evaluating development and marketing alternatives; or in the "post-implementation/operation stage," in which the developed software is placed into service, most expenditures related to the project must be expensed. If, however, a project is in the "application development stage," in which management authorizes the project and has settled on a comprehensive development and marketing strategy, most expenditures incurred must be capitalized. Capitalized expenditures are amortized on a straight-line basis over the estimated useful life of the software developed (which, for a company like Digimarc, is generally three to five years).

According to Zucco, Digimarc, a fledgling Delaware corporation headquartered in Oregon, whose business centers on providing secure personal identification documents (such as drivers licenses) based on digital watermarking technology, purposefully manipulated its financial prospects by, inter alia, capitalizing internal software development expenditures that should have been expensed. Zucco's compendious 130-page Second Amended Complaint ("SAC") claims that Digimarc "used two primary accounting manipulations to deceptively bolster Digimarc's financial condition." Namely, Digimarc "capitalize[d] on its asset balance sheet ordinary payroll costs that Digimarc paid to its software engineers and other employees so that the Company could avoid recognizing these expenses on its income statements." Also, Digimarc allegedly "fail[ed] to recognize ordinary expenses incurred by the Company" and instead "improperly moved or retained these expenses in Digimarc's inventory or property and equipment accounts as purported `project development expenses.'" The net effect of these manipulations, Zucco contends, was to deceive investors into believing that the young corporation had "turned the corner" from its early losses and had become profitable.

On September 13, 2004, Digimarc publicly announced that it had erroneously accounted for internal software expenditures and that due to these accounting errors it had likely overestimated earnings for the previous six quarters. The September announcement listed the improper capitalization of internal software development costs as the most likely source of these accounting errors, and also cited "other project cost capitalization accounting practices" of Digimarc's ID Systems division (acquired from Polaroid in December 2001 and which represented 89 percent of the corporation's revenue in 2003 and 2004) as containing potential errors that "may also result in additional adjustments which may affect prior periods." On September 13, Digimarc estimated these accounting errors to "be in the range of approximately $1.2 million to $2.0 million" and to possibly "require a restatement of prior period financial statements."

Although the full extent of these accounting errors (approximately $2.7 million in overstated earnings) was not revealed until April 5, 2005, when Digimarc's formal restatement was issued, the corporation's September 2004 announcement was enough to trigger a number of class action lawsuits. Zucco, which had purchased fifty shares of Digimarc stock in March 2004 (at a price of $12.76 per share) filed a class action lawsuit in the District of Oregon fifteen days after the corporation's public announcement, alleging that defendants Digimarc, its Chief Executive Officer Bruce Davis, and its former Chief Financial Officer E.K. Ranjit violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and its implementing regulations, including Rule 10b-5. Similar suits, which followed on October 5th and 6th, were eventually consolidated with Zucco's action on December 16, 2004. Two unrelated actions alleging violations of California corporations law, meanwhile, were filed in California state court on October 19th, and subsequently re-filed in the District of Oregon. See In re Digimarc Corp. Derivative Litig., 549 F.3d 1223 (9th Cir.2008).

Although there was no question that Digimarc erroneously capitalized expenditures that should have been expensed, the plaintiffs had difficulty providing detailed allegations that the defendants did so either intentionally or with deliberate recklessness. Indeed, Zucco provided the district court with three iterations of its allegations—none of which, according to that court, was sufficient to survive a motion to dismiss. First, after several additional named plaintiffs were added to its consolidated class action, Zucco amended its original class action complaint, adding significant detail to its formerly skeletal allegations. This First Amended Complaint was filed on May 16, 2005, on behalf of all those who purchased the publicly traded securities of Digimarc between April 22, 2003 and July 28, 2004 (the "class period"), and alleged that Digimarc and the individual defendants engaged in the manipulative accounting methods described above. Digimarc filed a Federal Rule of Civil Procedure 12(b)(6) motion to dismiss the First Amended Complaint, claiming that Zucco had failed to satisfy the loss causation and scienter requirements of section 10(b) of the Securities Exchange Act of 1934, as mandated by the Private Securities Litigation Reform Act, 15 U.S.C. § 78u-4. The district court granted this motion on November 30, 2005. In its order dismissing the complaint, the district court held that Zucco's First Amended Complaint had satisfied the loss causation pleading requirements, but had failed to properly allege scienter. See Zucco Partners, LLC v. Digimarc Corp., No. CV 04-1390-BR (D.Or. Nov. 30, 2005).

The district court dismissed the complaint without prejudice, giving Zucco leave to amend. According to the district court, the Second Amended Complaint was no better. After that complaint was filed on January 17, 2006, Digimarc responded with another motion to dismiss, contending that Zucco had again failed to plead scienter adequately under the PSLRA. This motion was granted on August 4, 2006, when the district court dismissed the complaint with prejudice. See Zucco Partners, LLC v. Digimarc Corp., 445 F.Supp.2d 1201 (D.Or.2006). After dismissal, Zucco filed a timely appeal to this Court.

II

Zucco argues that the...