RICHARD J. HOLWELL, District Judge:
Lead Plaintiffs Lawrence F. Glaser and Chen Kuang bring this putative class action against defendants The9 Ltd. ("The9"), Xiaowei Chen, George Lai, Hannah Lee, Tony Tse, and Jun Zhu, alleging violations of Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. § 78j(b), Exchange Act Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5, and Exchange Act Section 20(a), 15 U.S.C. § 78t(a). Plaintiffs allege that between November 15, 2006, and July 15, 2009 (the "Class Period"), defendants fraudulently misrepresented facts relating to the likelihood of their renewal of a certain extremely profitable exclusive license granted them by a third company. Defendants now move to dismiss. For the reasons set forth below, and specifically because plaintiffs fail to adequately plead scienter, defendants' motion is GRANTED in its entirety; and plaintiffs are granted leave to replead their complaint.
For the purposes of the present motion, the following facts—drawn from the complaint, documents incorporated by reference therein, Securities Exchange Commission ("SEC") public disclosure documents, and documents known to the plaintiffs and upon which they relied in bringing this action
Lead Plaintiffs Lawrence F. Glaser and Chen Kuang seek to represent the class of persons who purchased The9's American Depositary Shares ("ADS") and options during the Class Period, November 15, 2006, through July 15, 2009. (Compl. ¶¶ 15, 23.) Defendant The9, incorporated in the Cayman Islands with its principal place of operations in China, operates multiplayer online video games
On February 3, 2004, The9 entered into a contract (the "WoW Contract") with Blizzard's parent company, Vivendi Universal Games ("Vivendi"), to be the exclusive operator of Vivendi's game World of Warcraft
In March 2006, a gaming news website reported that tensions had arisen between The9 and Blizzard over whether operation of WoW's first expansion pack, Burning Crusade, was included in the original deal. (Id. ¶ 36.) And in April 2006, The9 contracted with NCsoft Corporation ("NCsoft") to operate NCsoft's game Guild Wars, a competitor of WoW, in China. (Id. ¶ 37.) Later in April, a different gaming news website reported its belief that Blizzard would "evaluate" partners other than The9 for operation of WoW in China. (Id. ¶ 38.) Moreover, plaintiffs' Confidential Witness One ("CW1")
The Class Period begins on November 15, 2006 and ends on July 15, 2009. (Id. ¶¶ 1, 43.) Plaintiffs allege that defendants, specifically Zhu and Chen, made fraudulently misleading statements during that period that fall generally into three categories. The first category consists of statements allegedly indicating defendants' beliefs that renewal of the WoW Contract was likely. The second is made up of statements allegedly representing either
On November 16, The9 released its third quarter 2006 financial results and held a conference call. (Id. ¶¶ 43-44.) Before the call, The9's Investor Relations ("IR") Manager, stated:
(Kutcher Decl. Ex. 23 at 2 (this passage, stated as above, is hereinafter referred to as "The9's Conference Call Safe Harbor Statement").)
During the November 16, 2006 call, an analyst asked Zhu when Zhu expected Burning Crusade—the WoW expansion pack—to launch in China and whether The9 and Blizzard had had any "new negotiations" regarding Burning Crusade. (Compl. ¶ 44.) Zhu replied that the companies had "always believed that Burning Crusade is part of our original licensing agreement," and that "[d]uring the four years of exclusive license there's no possibility that a company other than The9 can operate Burning Crusade in China." (Id.) Zhu went on to say that The9 and Blizzard were "active in discussion" concerning "the marketing arrangement and the timetable for the Burning Crusade in China," and that "we'll continue to communicate with them in the coming two and a half years." (Id.) Plaintiff alleges those statements were false and misleading because they misrepresented or failed to disclose that
(Id. ¶ 45.) The9's ADS increased from $4.92 to $28.36, a twenty-one percent rise, on November 16. (Id. ¶ 47.) At the same time, Incsight, Ltd. ("Incsight"), a company owned by Zhu sold 86,499 shares of The9 for about $2.37 million between November 15 and November 24, 2006, at an average price of approximately $27.42 per share. (Id. ¶¶ 17(a), 48, 148.)
Despite alleged appearances, however, according to CW4, a former executive at The9, "Zhu told Company executives in early 2007 that he viewed it as very unlikely if not impossible for The9 to be able to renew the WoW Contract." (Id. ¶ 40.) CW4 also claims that "Zhu understood that The9's relationship with Blizzard had been `ruined' by early 2007." (Id.) In addition on May 21, 2007, EA, a competitor to Blizzard in the video game development industry, purchased 15% of The9's shares for $167 million. (Id. ¶ 52.) EA also granted The9 the exclusive right to publish one of EA's games, FIFA Online, a multiplayer
Zhu addressed the EA investment, among other issues, on a May 22, 2007 conference call announcing The9's first quarter 2007 earnings. As with the November 16, 2006 call, the IR Manager stated The9's Conference Call Safe Harbor Statement at the start of the May 22, 2007 call. (Kutcher Decl. Ex. 25 at 1-2.). Later on the call Zhu stated, "we believe The9 is well positioned for sustainable growth." (Compl. ¶ 56.) Zhu also denied that EA's investment would "have any impact on our relationship with Blizzard" because the companies' games were focused on different genres. (Id. ¶ 57.) Finally, to an analyst's question about the possibility of extending the WoW Contract past June 2009, Zhu said, "the relationship between [Blizzard and The9 is] very good, but currently we haven't talked about things beyond '09." (Id. ¶ 59.) The9's ADS increased $4.76, or 12%, to $44.23 on May 22. (See id. ¶ 62.) The ADS reached a Class-Period high of $51.97 on July 13, 2007. (Id. ¶ 64.) Despite the alleged additional misstatements detailed below, however, the ADS' price declined, at first dramatically and then steadily, through the end of the Class Period, July 15, 2009. The9's ADS traded in the mid-$45 range in August 2007; in the $30s in October 2007; at $25 by the end of November 2007; around $20 in January and February 2008; near $25 in May 2008; around $18 and $19 in August and September 2008; at $13 in April 2009 before Blizzard announced that it would not renew the WoW contract with The9; at $10 directly after that announcement; and at $8.68 at the Class Period's close in July 2009. (Id. ¶¶ 65, 75, 83, 85, 90, 97, 106, 110, 157, 159.)
On June 28, 2007, The9 filed its Form 20-F
Fiscal 2006 20-F at 9.
On August 3, 2007, reports again surfaced of rumors on gaming websites concerning tensions between Blizzard and The9. (Compl. ¶ 67.) According to the news articles, however, Blizzard and The9 jointly announced that "`[t]he media reports of disagreements between The9 and [Blizzard] are groundless, ... [Blizzard] and The9's cooperation has been smooth and friendly.'" (Id. ¶ 68 (quoting the article quoting the joint announcement).) Then on August 29, The9 released its second quarter 2007 financial information and an accompanying press release, stating, "with all the [ ] high-caliber games to be launched in the future, we are confident that The9 will continuously capitalize on its unparalleled game portfolio so as to achieve long-term sustainable growth." (Id. ¶ 71.) The August 29 press release contained a safe harbor statement similar to those stated at the start of the conference calls, but which also specifically included that "forward-looking statements can be identified by terminology such as `will,' `expects,' `anticipates,' `future,' `intends,' `plans,' `believes,' `estimates' and similar statements." (Kutcher Decl. Ex. 14 at 11.) The safe harbor provision went on:
(Id. (this passage, stated as above, is hereinafter referred to as "The9's SEC Filing Safe Harbor Statement").)
The9 launched the WoW expansion pack, Burning Crusade, in September 2007. (Compl. ¶ 75.) Then on November 16, 2007, The9 released its third quarter 2007 financial results and held a conference call. Like the November 16, 2006, and May 22, 2007 calls, this call began with the IR Manager reading The9's Conference Call Safe Harbor Statement. (Kutcher Decl. Ex. 26 at 1.) Later in the call, Zhu responded to an analyst's question about extending the WoW Contract. Zhu said, "after [Burning Crusade] was launched we started discussions with [Blizzard] regarding the renewal of the contract as you mentioned. But so far we don't have any comment. But we are very confident to eventually renew the contract of WOW with Blizzard." (Compl. ¶ 77; Kutcher Decl. Ex. 26 at 7.)
Lee resigned as The9's CFO on January 18, 2008, and was replaced by Tse. (Compl. ¶¶ 17(c), 85.) On February 22, 2008, The9 released its fourth quarter 2007 financial results and held a conference call. As with the prior conference calls, the IR Manager read The9's Conference Call Safe Harbor Statement. (Kutcher Decl. Ex. 27 at 2.) Later, in response to an analyst's questions regarding license renewal, Zhu stated, "WoW has been in very strong growth during the past few years and also we are always in very good [sic] relationship with Blizzard.... So I was very confident that we believe that we can renew the contract in '09." (Compl. ¶ 88.) Then,
Tse resigned as The9's CFO on June 7, 2008, and was replaced by Lai. (Id. ¶ 98.) Then on June 30, 2008, The9 filed its Form 20-F for the fiscal year ending December 31, 2007. The9 Limited, Annual Report (Form 20-F) (June 30, 2008) (hereinafter the "Fiscal 2007 20-F"); (see also Kutcher Decl. Ex. 5.) In highlighting risks similar to those mentioned in the Fiscal 2006 20-F, the document stated,
Fiscal 2007 20-F at 6. The form went on to detail the risk presented by potential deterioration of The9's relationship with Blizzard, previously mentioned in the Fiscal 2006 20-F. Fiscal 2007 20-F at 6-7.
On August 8, 2008, The9 released its second quarter 2008 financial results, and held a conference call, again preceded by The9's Conference Call Safe Harbor Statement. (Kutcher Decl. Ex. 28 at 2.) In response to an analyst's question on renewal negotiations, Chen stated, "we at The9 have been in very active discussions with Blizzard . . . and we're continuing our negotiations and we hope that we will have results very soon. At this point, I cannot release any details, but let me just say that we are in very active discussion." (Compl. ¶ 102.) Chen also discussed The9's relationship with Blizzard, saying, "EA's shareholding in The9 does not present a threat or negative conflict of interest to our renewing the license. . . . [And] one thing that's very good that's coming out of the discussions is how we can strengthen our communications between The9 and Blizzard." (Id.) Chen concluded, "we're very positive and optimistic about WoW's continuing performance and growth in China." (Id.)
Though apparently negotiating with The9 about renewal of the WoW Contract, on August 12, 2008, Blizzard announced that it had agreed to license three different games to NetEase.com, Inc. ("Net-Ease"), a competitor of The9. (Id. ¶ 105.) The next day, Bosma sold an additional 500,000 shares of The9 for approximately $11.3 million. (Id. ¶ 107.) Thereafter, more rumors appeared that Blizzard would not renew the WoW Contract with The9. (Id. ¶ 108.) The9 responded by press release on September 5, 2008, stating, "The9 is currently in contract negotiations regarding [WoW's] future operations in China. Recently there have been rumors that surfaced regarding the contract negotiations. These rumors are completely unfounded. The9 encourages all parties to refrain from believing in such rumors. The9 is actively conducting the contract extension negotiations." (Id.) The press release concluded with The9's SEC Filing Safe Harbor Statement. (Kutcher Decl. Ex. 20 at 1.) Then on November 18, 2008, The9 released its third quarter 2008 financials and held a conference call, again at the start of which the IR Manager read The9's Conference Call Safe Harbor
(Id.)
On February 23, 2009, The9 released its fourth quarter 2008 and fiscal year 2008 financial results. (Id. ¶ 124.) The press release, which contained The9's SEC Filing Safe Harbor Statement, indicated that gross profits had increased thirty-five percent and net income forty-five percent from 2007, and attributed those increases to WoW revenues. (Id.; Kutcher Decl. Ex. 20 at 11.) Plaintiffs contend that, in addition to being false and misleading for disclosing neither the tensions between Blizzard and The9 nor The9's management's alleged belief the company would be unable to renew the license, the financial results were false and misleading because The9 had "massive write-offs for FY08" when the non-renewal of the WoW Contract was eventually announced. (Compl. ¶ 125.) The9 held a conference call to discuss the fourth quarter 2008 financials on February 24. (Id. ¶ 126.) After the IR Manager read The9's Conference Call Safe Harbor Statement, Chen responded to questions on WoW Contract renewal negotiations, on when The9 would launch WoW's second expansion pack, Wrath of the Lich King ("WLK"), and on related marketing efforts. (Kutcher Decl. Ex. 31 at 2, 6, 10.) Chen stated,
(Compl. ¶¶ 126-127.)
After leaving Blizzard in 2006, CW1 became an investment consultant specializing in the video game industry. (Id. ¶ 39.) According to him, "it was widely believed" by February 2009 "that Blizzard would not renew the WoW Contract with The9," but would instead license the game to Net-Ease, despite Chen's statements apparently to the contrary. (Id. ¶ 122.) Supporting this allegation is the report of CW3, a "Customer Service Training Manager" at Blizzard, that Blizzard began training Net-Ease personnel in WoW customer service in March 2009. (Id. ¶ 123.) CW3 claims that "The9 would have known these facts." (Id.) Then on April 15, "unofficial reports emerged" that Blizzard had decided to license WoW to NetEase following the termination of The9's license. (Id. ¶ 129.) On April 16, Blizzard and NetEase issued a joint announcement to the same effect.
On July 1, 2009, The9 filed a Form 6-K reporting that "as a result of the non-renewal of the [WoW Contract], as well as [other factors] . . . [The9] will record impairment and certain other charges in its financial statements for the year ended December 31, 2008." (Id. ¶ 137.) The filing indicated that net income would be between fifty-five percent and seventy-five percent lower than as stated in the February 2009 financial results report. (Id.) On July 15, The9 filed it Form 20-F for the fiscal year ended December 31, 2008, which noted a seventy-two percent decrease in revenues between 2007 and 2008, several impairments and other charges to its 2008 financial statements, and concluded,
(Id. ¶¶ 138-142.)
This filing marks the end of the Class Period. Between July 1 and July 15, The9's ADS price fell from $10.15 to $8.68. (Id. ¶ 142.) Plaintiffs claim that (1) defendants' misstatements and omissions caused The9's ADS price to be inflated during the Class Period; and (2) the disclosures starting with Lee's resignation and ending with the report of alterations of the 2008 financial reports caused that price to fall from $21.76 on January 18, 2008, to $8.68 on July 16, 2009. (Id. ¶¶ 154-159.)
Plaintiffs allege that during the Class Period, The9 and the Individual Defendants engaged in several fraudulent, illegal, or otherwise "shady" (Id. ¶ 152(c)) transactions. Plaintiffs claim that since defendants knew or recklessly disregarded that The9 would not be able to renew the WoW Contract, and that The9 and Blizzard were not on amicable terms, these transactions support an inference that The9's management acted with scienter.
Plaintiffs first point to the around $28 million in sales of The9 stock made by Incsight—which was owned by Zhu—during the Class Period.
Plaintiffs also point to around $12 million in sales made by The9's directors and management between December 2006 and September 2008. (See Compl. ¶ 148.) These sales include $3 million by defendant Lee between that December 2006 and March 2008. (See id.) Lee's sales were made pursuant SEC Rule 10b5-1(c)
Defendants also allegedly benefitted from certain manipulations of The9's stock structure and policies. On November 20, 2008, The9's board of directors increased the total shares available for option purchase rights from 2.5 million to 4.5 million. (Id. ¶ 149.) Then on January 8, 2009, The9 adopted a shareholder rights plan under which shareholders would be entitled to purchase, essentially, two shares for the price of one should an outside entity acquire fifteen-percent or more of The9's voting securities (the "Poison Pill"). (Id. ¶ 117.) Plaintiffs allege that The9 "enacted the rights plan to prevent a third-party from acquiring control of [The9] in the event its shares plunged after the market
Plaintiffs also contend that defendants benefitted from certain "related party transactions with [The9]." (Id. ¶ 152.) These transactions, described only in vague terms in the complaint, include (1) Zhu receiving $8 million in kickbacks from purchases of computer equipment from Hewlett-Packard Company; (2) The9 executives receiving "substantial financial benefits" from a written-off investment in a Korean game development company, Ideas; (3) The9 acquiring twelve percent of another Korean game development company, G10; (4) The9 jointly operating its online video games, including WoW, with a separate company partly owned by Zhu, Shanghai IT; (5) a The9 subsidiary granting Zhu and certain employees of the subsidiary stock options; (6) The9 granting Incsight equity warrants; and (7) The9 loaning $1.65 milion to other "employees" to establish their own game development companies. (Id. ¶ 152(a)-(g).)
To survive a Rule 12(b)(6) motion to dismiss, a complaint must allege "enough facts to state a claim to relief that is plausible on its face." Starr v. Sony BMG Music Entertainment, 592 F.3d 314, 321 (2d Cir.2010) (quoting Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 570, 127 S.Ct. 1955, 167 L.Ed.2d 929 (2007)). "A claim has facial plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged." Ashcroft v. Iqbal, ___ U.S. ___, 129 S.Ct. 1937, 1949, 173 L.Ed.2d 868 (2009). If the factual averments permit no reasonable inference stronger than the "mere possibility of misconduct," the complaint should be dismissed. Starr, 592 F.3d at 321 (quoting Iqbal, 129 S.Ct. at 1950). Thus, "[w]here a complaint pleads facts that are `merely consistent with' a defendant's liability, it `stops short of the line between possibility and plausibility of `entitlement to relief.'" Iqbal, 129 S.Ct. at 1949 (quoting Twombly, 550 U.S. at 557, 127 S.Ct. 1955). In applying this standard of facial plausibility, the Court accepts all factual allegations as true, but it does not credit "mere conclusory statements" or "threadbare recitals of the elements of a cause of action." Id. On a motion to dismiss, the Court may properly consider documents referenced in or integral to the complaint, as well as public filings with the SEC. In re IAC/InteractiveCorp, 478 F.Supp.2d 574, 585 (S.D.N.Y.2007).
"To state a claim under § 10(b) and Rule 10b-5, `a plaintiff must allege that the defendant (1) made misstatements or omissions of material fact, (2) with scienter, (3) in connection with the purchase or sale of securities, (4) upon which the plaintiff relied, and (5) that the plaintiff's reliance was the proximate cause of its injury." Local No. 38 Int'l Bhd. of Elec. Workers Pension Fund v. American Express Co., 724 F.Supp.2d 447, 458 (S.D.N.Y.2010) (quoting ATSI Commc'ns Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 105 (2d Cir.2007)). Plaintiffs must also "satisfy the heightened pleading standard of Fed.R.Civ.P. 9(b), which requires that `the circumstances constituting fraud . . . be stated with particularity.'" Id. (quoting Novak v. Kasaks, 216 F.3d 300, 306 (2d Cir.2000)). "Thus `[a] plaintiff cannot base securities fraud claims on speculation and conclusory allegations.'" Plumbers & Steamfitters Local
In addition to Rule 9(b), plaintiffs must also satisfy the pleading requirements of the Private Securities Litigation Reform Act ("PSLRA"). ECA and Local 134 IBEW Joint Pension Trust of Chicago v. JP Morgan Chase Co., 553 F.3d 187, 196 (2d Cir.2009). "In order to plead scienter adequately under the PSLRA, a plaintiff must plead `with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.'" Id. at 198 (emphasis in original). For Section 10(b) and Rule 10b-5 claims, "the required state of mind is `a mental state embracing intent to deceive, manipulate, or defraud.'" Fort Worth Employers' Retirement Fund v. Biovail Corp., 615 F.Supp.2d 218, 225 (S.D.N.Y.2009) (quoting Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 319, 127 S.Ct. 2499, 168 L.Ed.2d 179 (2007)). "[T]o qualify as a `strong inference,' the inference of scienter must be `more than merely plausible or reasonable—it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.'" ECA, 553 F.3d at 198 (quoting Tellabs, 551 U.S. at 314, 127 S.Ct. 2499). "In determining whether this inference can be reasonably drawn, courts must consider both the inferences urged by the plaintiff and any competing inferences rationally drawn from all the facts alleged." Id. Thus, the court "must assess `whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard.'" Local No. 38, 724 F.Supp.2d at 458 (quoting Tellabs, 551 U.S. at 323, 127 S.Ct. 2499). "Moreover, the facts alleged must support an inference of an intent to defraud the plaintiffs rather than some other group." ECA, 553 F.3d at 198 (citing Kalnit, 264 F.3d at 140-41). In the Second Circuit, "[t]he requisite scienter can be established by alleging facts to show either (1) that defendants had the motive and opportunity to commit fraud, or (2) strong circumstantial evidence of conscious misbehavior or recklessness." Id.; In re MRU Holdings Sec. Litig., 769 F.Supp.2d 500, 514-15, 2011 WL 650792, at *12 (S.D.N.Y. Feb. 17, 2011).
To satisfy "motive and opportunity," plaintiffs must allege that defendants "benefitted in some concrete and personal way from the purported fraud." ECA, 553 F.3d at 198. Motives "common to most corporate officers, such as the desire for the corporation to appear profitable and the desire to keep stock prices high to increase officer compensation, do not constitute `motive' for the purposes of this inquiry."
"[M]otive can be shown, however, `when corporate insiders allegedly make a misrepresentation in order to sell their own shares at a profit.'" In re Citigroup Inc. Sec. Litig., 753 F.Supp.2d 206, 233, 2010 WL 4484650, at *22 (S.D.N.Y. Nov. 9, 2010) (quoting ECA, 553 F.3d at 198). "However, the mere fact that insider stock sales occurred does not suffice . . ., [instead] [p]laintiffs must establish that the sales were `unusual' or `suspicious.'" In re Gildan Activewear, Inc. Sec. Litig., 636 F.Supp.2d 261, 270 (S.D.N.Y.2009) (internal quotation marks and citation omitted). Whether trading was unusual or suspicious turns on factors including (1) the amount of net profits realized from the sales; (2) the percentages of holdings sold; (3) the change in volume of insider defendants' sales; (4) the number of insider defendants' selling; (5) whether sales occurred soon after statements defendants are alleged to know to be misleading; (6) whether sales occurred shortly before corrective disclosures or materialization of the alleged risk; and (7) whether sales were made pursuant to trading plans such as Rule 10b5-1 plans. See In re Scholastic Corp. Sec. Litig., 252 F.3d 63, 74-75 (2d Cir.2001); In re SLM, 740 F.Supp.2d at 557-58; In re Gildan Activewear, 636 F.Supp.2d at 270-72; In re AXIS Capital Holdings Ltd., Sec. Litig., 456 F.Supp.2d 576, 596 (S.D.N.Y.2006). Plaintiffs must allege not only the insider defendants' selling activity during the relevant period, but also those defendants' net profits as opposed to gross proceeds, as well as overall percentage changes in defendants' holdings. See In re eSpeed, 457 F.Supp.2d at 290 ("The Complaint also omits necessary information concerning (1) the percentage increase in each defendants' holdings during the class period; and (2) the profit from defendants' sales. In particular, plaintiffs plead that Amaitis and Noviello realized `gross proceeds' of $2.8 million, but the Complaint does not disclose whether either made any profit from the sales."). When a complaint alleges only "incomplete information" concerning insider sales, the court is "free to consider" defendants' SEC filings to fill gaps on motion to dismiss. Id. at 290 n. 182.
"Where motive is not apparent, it is still possible to plead scienter by identifying circumstances indicating conscious behavior by the defendant, though the strength of the circumstantial allegations must be correspondingly greater." In re Citigroup, 753 F.Supp.2d at 233, 2010 WL 4484650, at *22. Under this theory, "a plaintiff must show that the defendant's conduct is at the least[ ] conduct which is highly unreasonable and which represents an extreme departure from the standards of ordinary care to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it." Gissin v. Endres, 739 F.Supp.2d 488, 503 (S.D.N.Y.2010) (internal quotation marks omitted).
For purposes of this action plaintiffs must "specifically allege defendants' knowledge of facts or access to information contradicting defendants' public statements."
On the other hand, actual identification of reports or other documents indicating defendants' recklessness as to their public statements' truth or falsity suggests an inference of scienter strong enough to survive motion to dismiss. See, e.g., In re Citigroup, 753 F.Supp.2d at 237, 2010 WL 4484650, at *26 (strong inference of scienter satisfied when, inter alia, plaintiffs identified a specific "March 2007 report from Citigroup's quantitative credit strategy and analysis group allegedly describ[ing] the risks the subprime meltdown posed to the holders of CDO super senior tranches."); Sgalambo v. McKenzie, 739 F.Supp.2d 453, 481-82 (S.D.N.Y.2010) (finding scienter when the complaint "identifie[d] specific reports or documents that would have indicated that The Officers' public statements regarding the wells and Canadian Superior's inability to meets its financial obligations beginning late 2008 were inaccurate."). Alternatively, a plaintiff may highlight inconsistencies between defendants' corporate activity and alleged misstatements. See In re Citigroup, 753 F.Supp.2d at 237-38, 2010 WL 4484650, at *26-27 ("the Complaint details a number of actions Citigroup took that indicate awareness of the CDO risk. . . . [Plaintiffs']
Plaintiffs may also buttress an argument for strong circumstantial evidence with information obtained from confidential sources. See Local No. 38, 724 F.Supp.2d at 455-56 (doing so); In re PXRE, 600 F.Supp.2d at 526 (same).
Courts however will credit confidential source allegations, generally, in two situations. The first is when those sources' positions and/or job responsibilities are described sufficiently to indicate a high likelihood that they actually knew facts underlying their allegations. See, e.g., In re Scottish Re Group Sec. Litig., 524 F.Supp.2d 370, 392 (S.D.N.Y.2007) (vice president in charge of insurance claim adjudication was sufficiently described to make allegations as to management's awareness of inadequacies in the company's "internal data-gathering system."); In re EVCI Colleges Holding Corp. Sec. Litig., 469 F.Supp.2d 88, 93, 97 (S.D.N.Y.2006) (school's dean of admissions and two admissions officers are sufficiently described to speak to school president's knowledge of fraudulent admissions practices the president himself was alleged to have implemented). Second, when "independent [adequately plead] factual allegations" corroborate a confidential source's statements, the requirement of a description of the source's job is loosened. In re Atlas Air Worldwide Holdings, Inc. Sec. Litig., 324 F.Supp.2d 474, 493 n. 10 (S.D.N.Y.2004) (citing Novak, 216 F.3d at 314); In re Elan Corp., 543 F.Supp.2d at 207 (noting "the corroborative nature of other facts" as a factor relevant to the description requirement);
Two final requirements exist to credit confidential witness testimony. First, as is obvious, confidential sources cannot be used to "merely parrot[ ] . . . conclusory allegations contained in the complaint." In re Sierra Wireless, Inc. Sec. Litig., 482 F.Supp.2d 365, 376 (S.D.N.Y.2007). Second,
Finally, the law is clear that whichever path plaintiffs pursue to plead scienter, plaintiffs must plead an inference of scienter that is at least as strong and compelling as "any competing inferences rationally drawn from all the facts alleged, taken collectively." ECA, 553 F.3d at 198. In other words, the pleadings must satisfy both (1) either the "motive and opportunity" or the "strong circumstantial evidence" requirement; and (2) Tellabs' requirement that the inference drawn from the facts is at least as compelling as any other rational inference. Biovail, 615 F.Supp.2d at 225 ("Regardless of the manner in which a plaintiff attempts to plead scienter, at the end of its evaluation, this Court must be convinced that the inference of scienter is at least as compelling as any competing inferences." (internal quotation marks omitted)); In re PXRE, 600 F.Supp.2d at 528.
Plaintiffs' allegations fail to support a strong inference of scienter based on motive; and even if the allegations did so, that inference is far weaker than the most compelling rational competing inference.
Plaintiffs contend that four allegations support their showing of motive: (1) insider stock sales generating $125 million in proceeds, (Pl.'s Opp'n at 16; Compl. ¶ 148); (2) the "related party transactions" including the investments in Hewlett-Packard equipment and the kickbacks received through those investments, the investments in two Korean game development companies, the joint operation of WoW with a The9 subsidiary, the granting of stock options, and the loans The9 made to its employees to start their own game development companies, (Pl.'s Opp'n at 16; Compl. ¶¶ 152(a)-(g)); (3) the stock dividend The9 declared in January 2009, (Pl.'s Opp'n at 16-17; Compl. ¶ 121); and (4) The9's adoption of its poison pill plan, (Pl.'s Opp'n at 17; Compl ¶ 117.).
Plaintiffs' allegations concerning insider stock sales fail for several reasons. First, those allegations demonstrate only gross proceeds without identifying net profits, and proceeds alone say nothing about a seller's motive. See In re eSpeed, 457 F.Supp.2d at 290. Indeed, the only proceeds even running to Individual Defendants are the $28 million allegedly flowing to Zhu through Incsight's sales and the $3 million flowing to Lee through her Rule 10b5-1(c) sales. (See Compl. ¶ 148.) As to the latter, however, it is well established that "trades under 10b-5-1 plan `do not raise a strong inference of scienter.'" In re Gildan Activewear, 636 F.Supp.2d at 272 (quoting In re IAC, 478 F.Supp.2d at 604); see also Elam v. Neidorff, 544 F.3d 921, 928 (8th Cir.2008) ("Stock sales pursuant to Rule 10b-5 trading plans . . . [are] not suspicious.")."
Finally, even assuming, arguendo, that Incsight's sales were somehow sufficient to establish a plausible inference of motive, that inference is not as strong as the inference of non-fraudulent activity drawn from the facts viewed collectively. Indeed, plaintiffs' own allegations undermine the inference plaintiffs advance. True that Incsight sold about 486,000 shares as The9's ADS price rose from around $23 to its peak of $51.97. (See Compl. ¶¶ 47, 64, 148.) But Incsight retained upwards of 6 million shares as that price continuously fell to $8.68 at the Class Period's end. (See id. ¶ 142); Fiscal 2008 20-F at 67. It defies reason that an entity looking to profit on a fraudulently inflated stock price would hold close to ninety percent of its shares as share prices fell, while knowing that the information illuminating the fraud was seeping into the market. The same is true regarding both (1) Zhu's increase in beneficial holdings, and (2) The9's repurchase of 4.3 million of its own shares during the Class Period. Zhu's increase in holdings and The9's repurchase of shares, at a time during which, plaintiffs allege, The9 was overvalued and heading towards financial ruin, raises precisely the contrary inference from the one suggested by plaintiffs. See In re eSpeed, 457 F.Supp.2d at 290 n. 182 (noting that "dozens of cases dismiss[ ] complaints on scienter grounds where . . . stock sales were found to be de minimis or [where] motive allegations were undermined by increases in total holdings." (alterations in original)); see also In re MRU, 769 F.Supp.2d at 514-15, 2011 WL 650792, at *12 ("The Individual Defendants' purchase and retention of the shares . . . [is] inconsistent with the allegation that [they] harbored information that the Company's financial health was in grave jeopardy.") (internal quotation marks omitted); In re Adelphia Commcn's Corp. Sees, and Derivative Litig., No. 03 MD 1529, 2007 WL 2615928, at *3 (S.D.N.Y. Sept. 10, 2007) ("Where [Plaintiffs'] view of the facts defies economic reason . . . it does not yield a reasonable inference of fraudulent intent.") (citing Kalnit, 264 F.3d at 140-41).
The much stronger inference drawn from plaintiffs' allegations is that though the possibilities existed that Blizzard might not renew the WoW Contract, that The9 and Blizzard's relationship might sour, or that The9's prospects for future growth might turn pessimistic, The9 and its management believed—or at least hoped—that The9 would renew the WoW Contract and would continue to grow. Indeed, Zhu's increase in beneficial ownership, and The9's repurchase of shares and investments in equipment and subsidiaries, "signal[ ] only confidence in the future of [the] company."
As with their contentions regarding motive, plaintiffs' allegations supporting an inference of scienter based on circumstantial evidence also fail both in sufficiency and as compared to the rational competing inference.
Plaintiffs argue that five elements of their pleadings support an inference of scienter drawn from strong circumstantial evidence. These are (1) that the confidential witness allegations indicate that the individual defendants knew of their statements' falsity; (2) that WoW was the "core operation" of The9's business; (3) that The9's Fiscal 2008 20-F eventually wrote down net income by seventy-two percent; (4) that on November 16, 2007, Zhu stated that "after [Burning Crusade] was launched, we started discussions with [Bl]izzard] regarding renewal of the [WoW Contract]," yet on November 18, 2008, Chen said, "we have been conducting the talks with Blizzard [regarding the WoW Contract's renewal] since actually May this year"; and (5) that Lee and Tse both resigned during the class period. (Pl.'s Opp'n at 17-22.) The Court addresses each allegation in turn, before considering them all in their entirety as per the requirement of Tellabs.
Plaintiffs argue that they "have adequately alleged that CW accounts are indicative of scienter." (Pl.'s Opp'n at 20.) But three of the confidential witnesses— CW1, CW2, and CW3—worked for Blizzard, not The9, and plaintiffs make no allegation that those sources ever had any contact with anyone at The9, much less with the Individual Defendants. CW1 and CW2 make allegations solely concerning the corporate environment at Blizzard— they do not make any contention that the "[un]happy[ness]," (Compl. ¶ 39), or "view[s]" (id. ¶ 53), of Blizzard were ever made known to The9. And despite CW3's allegation that The9 "would have known" that Blizzard had started training NetEase personnel to operate WoW in March 2009, (id. ¶ 123), the law is abundantly clear that such allegations are insufficient to support scienter. See Campo, 371 Fed.Appx. at 217 (affirming district court's finding that allegation was insufficient because the confidential source did not allege "whether [any individual defendant] actually accessed or reviewed [the information]."); Local No. 38, 724 F.Supp.2d at 461 (allegations insufficient in "the absence of any allegation that such data had been presented to management . . . [and in] not establish[ing] what specific contradictory information the Individual Defendants received or when they received it."); In re Citigroup, 753 F.Supp.2d at 245, 2010 WL 4484650, at *33 ("[p]laintiffs cannot rely on assertions that the information presented by confidential witnesses was known or common knowledge within the company; these assertions are too vague and conclusory to support a finding" of scienter). Indeed, reliance on CW3's allegation to support scienter is made entirely impossible due to plaintiffs' own pleadings. CW3's allegation is that The9 would have known that Blizzard would not be renewing the WoW Contract when Blizzard
CW4 is perhaps a closer case, but as with the other sources, the Court concludes that his allegations must be discounted. CW4 is described as a former "senior executive" of The9. (Id. ¶ 40.) He alleges that "Zhu told Company executives in early 2007 that he viewed it as very unlikely if not impossible for The9 to be able to renew the WoW Contract." (Id.) In addition, "Zhu understood that The9's relationship with Blizzard had been `ruined' by early 2007." (Id.) Missing from the complaint, however, is any indication of what aspect of The9 or its management CW4 was involved in, what CW4's job duties entailed, what kind of access CW4 had to Zhu, in what form and context Zhu made his alleged statement, or how CW4 was privy to that statement. Such lack of description is, alone, fatal to CW4's allegations. See Local No. 38, 724 F.Supp.2d at 460 (discounting confidential source allegations because no indication that the sources had any contact with any individual defendant); In re American Express Co. Sec. Litig., 2008 WL 4501928, at *8 (same). Plaintiffs' brief states, "CW4 was present when Zhu made these statements." (Pl.'s Opp'n at 21 (citing Compl. ¶¶ 40, 51, 107).) But plaintiffs' complaint does not say that; and the Court can hardly consider assertions made in a legal brief, but not in a pleading. Adams v. New York State Educ. Dep't, 752 F.Supp.2d 420, 425 n. 4, 2010 WL 4742168, at *10 n. 4 (S.D.N.Y. Nov. 18, 2010) ("Although Adams' opposition brief includes many facts not alleged in the fourth amended complaint . . ., the Court cannot consider such facts.") (citing Friedl v. City of New York, 210 F.3d 79, 83-84 (2d Cir. 2000)). Indeed, CW4's allegations are particularly uninformative because they (1) suggest that CW4 got his information not from Zhu but through intermediaries, thus undermining the likelihood that he had personal knowledge of his allegations; and (2) purport to read Zhu's mind. The Court also notes that the alleged statement by Zhu was made six months before Blizzard and The9 together issued a joint statement to the effect that their" relations were "smooth and friendly," (Compl. ¶ 68), further undermining the inference that Zhu knew the companies' relationship was ruined when saying otherwise. Accordingly, CW4's allegations do not give rise to a strong inference of scienter.
Plaintiffs argue that "the fact that [allegedly false or misleading statements] concerned the core operations of [a] company supports the inference that the defendant knew or should have known the statements were false when made." (Pl.'s Opp'n at 17 (quoting In re Atlas Air, 324 F.Supp.2d at 489).) However, that an allegedly fraudulent statement concerned "core operations," standing alone, is insufficient to support strong circumstantial evidence of scienter. Rather, the "core operations" doctrine bolsters the strength of the inference of scienter when plaintiffs have already adequately alleged facts indicating that defendants might have known their statements were false. See In re Reserve Fund Sec. and Derivative Litig., 732 F.Supp.2d 310, 323 (S.D.N.Y.2010) (in discussing "core operations" argument, noting requirement that "accurate information. . . that contradicts or undermines Defendants' assurances as outlined in the
The only allegations in the complaint indicating that any defendant actually had knowledge going to the falsity of his or her statement are the allegations of CW4 that "Zhu told Company executives in early 2007 that he viewed is as very unlikely if not impossible for The9 to be able to renew the WoW Contract," and that "Zhu understood that The9's relationship with Blizzard had been `ruined' by early 2007." (Compl. ¶ 40.)
Plaintiffs argue that "[t]he magnitude of the write-offs related to the loss of the WoW license—causing previously-reported net income to shrink by 72%—adds to the strong inference of scienter alleged." (Pl.'s Opp'n at 18 (citing In re Scholastic, 252 F.3d at 77).) True that "the magnitude of defendant's post-class period write-off," can, with other factual allegations, "constitute[ ] sufficient pleadings as to recklessness." Rothman v. Gregor, 220 F.3d 81, 92 (2d Cir.2000); accord In re Scholastic, 252 F.3d at 77 (finding that $24 million of "special charges," combined with allegation that product in question was being returned in great numbers by purchasers during period of those charges, undermines an inference that defendants were unaware of the falsity of their statements that product was selling well). However, "[w]hile certainly a relevant factor, it is well established that the size of the fraud alone does not create an inference of scienter." In re PXRE, 600 F.Supp.2d at 545. As with the "core operations" doctrine, absent facts indicating that defendants knew of the falsity of their statements, that an eventual write-off was
Plaintiffs also contend that Zhu's November 2007 statement—that The9 had had discussions with Blizzard regarding the possibility of renewal of the WoW Contract after Burning Crusade launched in September 2007—is contradicted by Chens' November 2008 statement—that The9 had been conducting renewal talks since May 2008—and that that contradiction supports a strong inference of scienter. (Pl.'s Opp'n at 18-19.) Plaintiffs argue that a "later statement may suggest that a defendant had a contemporaneous knowledge of the falsity of his [earlier] statement, if the later statement directly contradicts or is inconsistent with the earlier statement." (Id. at 18 (citing In re Read-Rite Corp. Sec. Litig., 335 F.3d 843, 846 (9th Cir.2003), abrogation, on other grounds, recognized by South Ferry LP, No. 2 v. Killinger, 542 F.3d 776 (9th Cir.2008).) While a true statement of the law, plaintiffs' argument fails because they do not allege facts indicating that the earlier statement was "was false and misleading when made." Freudenberg v. E*Trade Fin. Corp., 712 F.Supp.2d 171, 191 (S.D.N.Y.2010); see also In re Nokia Oyj (Nokia Corp.) Sec. Litig., 423 F.Supp.2d 364, 406 (S.D.N.Y.2006) (discounting contradictory statements argument because "there is no allegation in the [complaint] that Nokia had contrary facts suggesting its sales would drop to the level that they ultimately did."). Moreover, the very cases plaintiffs rely on stress the importance that the later, allegedly corrective, statement directly contradict the earlier, allegedly false, statement. See In re Read-Rite, 335 F.3d at 847 (finding statement that certain of defendant's products were fully developed not contradicted by later "admissions" that (1) customer representing thirty-seven percent of sales would cease purchasing if further development was not undertaken; or (2) defendant's CEO rejected customer's ultimatum to same effect). But here, the complaint does not even allege that, in fact, no talks between The9 and Blizzard regarding renewal had occurred prior to May 2008. And it is not directly inconsistent that perhaps multiple rounds of talks began at different times. Indeed, it is not readily apparent even how a statement that the companies were in talks prior to those talks actually beginning—even if false— would suggest a misleading character of (1) statements concerning the quality of the companies' relationship, especially considering
Plaintiffs argue that "[r]esignations, although not themselves sufficient, add to a pleading of circumstantial evidence of fraud." (Pl.'s Opp'n at 21 (citing In re Scottish Re, 524 F.Supp.2d at 394 n. 176).) Again, though a true statement of the law, resignations must be "highly unusual and suspicious." In re Scottish Re, 524 F.Supp.2d at 394 n. 176. Such can be the case when independent facts indicate that the resignation was somehow tied to the fraud alleged, that the resignation somehow alerted defendants to the fraud, or that defendants' scienter was otherwise evident. See id. at 394 (crediting multiple resignations in addition to evidence indicating that defendants' fraud was "tantamount to conscious misbehavior"); Varghese v. China Shenghuo Pharm. Holdings, Inc., 672 F.Supp.2d 596, 603, 608 (S.D.N.Y.2009) (crediting resignation when independent director resigned after sending board of directors email highlighting the half-dozen ways defendant corporation's governance standards were failing); In re Sadia, S.A. Sec. Litig., 643 F.Supp.2d 521, 523-24, 534 (S.D.N.Y.2009) (crediting resignations of chairman and vice chairman that occurred less than two weeks after company's fraud was revealed resulting in fifty percent drop in stock price and losses of $760 million). Here, at best plaintiffs can connect Lee and Tse's resignations to allegedly "inadequate internal controls over financial reporting." (Pl.'s Opp'n at 21 (citing Fiscal 2008 20-F).) But even if both (1) The9 did have inadequate internal controls over financial reporting, and (2) Lee and Tse's resignations were actually tied to those inadequacies, plaintiffs still have not come close to connecting those resignations to the fraud alleged in this case. True that inadequate internal controls might give rise to an inference of a troubled company. But the mere fact that The9 might be troubled does not imply that Zhu or Chen's statements concerning The9's relationship with Blizzard or its prospects for renewing the WoW Contract were false when made. And even if somehow the two could be connected—an argument plaintiffs do not attempt to make—plaintiffs themselves concede that resignations, without some indicia of highly unusual or suspicious circumstances, are insufficient to support the required strong circumstantial evidence of scienter.
Because the Court finds that Plaintiffs have not alleged facts establishing an inference of strong circumstantial evidence supporting scienter, it need not compare that inference against the competing inference that The9 hoped to renew the WoW Contract and therefore made a concentrated effort to achieve that goal. In any event, that inference is stronger than any inference possibly gleaned from the five categories of evidence discussed just above for the same reasons discussed supra at Section II.B.2.a. Indeed, the competing inference of no conscious misbehavior is supported, in addition, by the facts that (1) Blizzard and The9 engaged in over a year of formal, protracted negotiations concerning renewal; and (2) though under no duty to do so, Blizzard and The9 jointly denied the vague internet rumors concerning their relationship and contract renewal. Even if plausible, which the Court holds it is not, plaintiffs' inference that defendants knew their statements were false when made is far less compelling than the inference that defendants believed that they
Plaintiffs also bring claims against the Individual Defendants pursuant to the Exchange Act Section 20(a). Such claims require "(a) a primary violation by a controlled person, (b) actual control by the defendant, and (c) the controlling person's culpable participation in the primary violation." In re Security Capital Assurance, 729 F.Supp.2d at 602. Because plaintiffs here have failed to allege a primary violation, these claims are also dismissed.
"[I]t is the usual practice upon granting a motion to dismiss to allow leave to replead." In re eSpeed, 457 F.Supp.2d at 298. While the Court is uncertain that plaintiffs can cure the pleading deficiencies relating to scienter highlighted in this opinion, the Court grants plaintiffs thirty days from the date of this Opinion and Order in which to refile their complaint.
For the reasons stated above, defendants' motion to dismiss is GRANTED in its entirety. The Clerk of the Court is directed to close this motion
SO ORDERED.
