SEC v. Patel, et al.

2008 DNH 055

• Court: District Court, D. New Hampshire
• Decided: March 24, 2008
• Docket: 07-CV-039-SM
• Status: Published

Opinion

SEC v . Patel, et a l . 07-CV-039-SM 03/24/08 UNITED STATES DISTRICT COURT

DISTRICT OF NEW HAMPSHIRE

Securities and Exchange Commission, Plaintiff

v. Civil N o . 07-cv-39-SM Opinion N o . 2008 DNH 055 Piyush G. Patel; David J. Kirkpatrick; Eric Jaeger; Bruce D. Kay; Robert J. Gagalis; Robert G. Barber, Jr.; Lawrence Collins; Michael A . Skubisz; Jerry A . Shanahan; and Hor Chong (David) Boey, Defendants

O R D E R

The Securities and Exchange Commission (“SEC”) has sued in

eight counts, seeking injunctive relief under 15 U.S.C. § 77t(b)

and 15 U.S.C. §§ 78u(d) & (e) for various alleged violations of

the Securities Act of 1933 (“Securities Act”), the Securities

Exchange Act of 1934 (“Exchange Act”), and certain rules

promulgated thereunder. Before the court is Piyush Patel’s

motion to dismiss. The SEC objects. For the reasons given,

Patel’s motion is granted in part.

The Legal Standard

A motion to dismiss for “failure to state a claim upon which

relief can be granted,” F E D . R . C I V . P . 12(b)(6), requires the court to conduct a limited inquiry, focusing not on “whether a

plaintiff will ultimately prevail but whether the claimant is

entitled to offer evidence to support the claims.” Scheuer v .

Rhodes, 416 U.S. 2 3 2 , 236 (1974). When considering a motion to

dismiss under Rule 12(b)(6), the court “must assume the truth of

all well-plead facts and give the plaintiff[s] the benefit of all

reasonable inferences therefrom.” Alvarado Aguilera v . Negrón,

509 F.3d 5 0 , 52 (1st Cir. 2007) (quoting Ruiz v . Bally Total

Fitness Holding Corp., 496 F.3d 1 , 5 (1st Cir. 2007)). However,

the court need not “credit ‘bald assertions, unsupportable

conclusions, periphrastic circumlocutions, and the like.’” Brown

v . Latin Am. Music Co., 498 F.3d 1 8 , 24 (1st Cir. 2007) (quoting

Aulson v . Blanchard, 83 F.3d 1 , 3 (1st Cir. 1996)). “[A]

complaint is properly dismissed for failure to state a claim

‘only if the facts lend themselves to no viable theories of

recovery.’” Garnier v . Rodríguez, 506 F.3d 2 2 , 26 (1st Cir.

2007) (quoting Phoung Luc v . Wyndham Mgmt. Corp., 496 F.3d 8 5 , 88

(1st Cir. 2007)).

Background

The SEC alleges that from March 2000 through December 2001,

various employees, officers, and directors of Cabletron Systems,

Inc. (“Cabletron”) or its former subsidiaries, Enterasys

2 Networks, Inc. (“Enterasys”) and Aprisma Management Technologies,

Inc. (“Aprisma”) participated in a company-wide scheme to inflate

the revenues of Cabletron and Enterasys for the purpose of

convincing investors that Enterasys was a viable independent

company with consistently strong revenue growth. Patel served as

Cabletron’s Chief Executive Officer, President, and Chairman of

the Board of Directors from June 1999 until August 2001, and on

August 6, 2001, became a consultant to Enterasys and Aprisma.

Turning to the conduct at issue in this case, the SEC

alleges that Enterasys improperly recognized revenue, reported

that improperly recognized revenue in SEC filings and press

releases, and misrepresented material information concerning

improper revenue recognition to outside auditors, or concealed

such information from them. According to the SEC, Enterasys

improperly recognized at least $48 million in revenue, thus

allowing it to overstate earnings, understate operating losses,

and successfully launch itself as an independent public company

on August 6, 2001.

The SEC alleges that improperly recognized revenue was

generated by several kinds of transactions: (1) contingent sales

(detailed in undisclosed side agreements with purchasers) that

allowed, for example, full return, exchange, or cancellation

3 rights; (2) investments in privately held companies that agreed

to use their investment proceeds to purchase Enterasys and

Aprisma products; and (3) so-called “three-corner deals” that

involved placing another company between Enterasys and an

investee company, to disguise purchases of Enterasys products

made with funds invested by Enterasys in the purchaser company.

The complaint discusses in greater detail twelve separate

contingent sales transactions or investment deals (Compl. ¶¶ 63-

137) and mentions in lesser detail seventeen additional sales

transactions (¶¶ 138-55) for which the SEC claims that Enterasys

recognized revenue that was not subject to recognition under

GAAP.

Patel is mentioned by name in the factual allegations

concerning: (1) an investment/purchase deal with Cellit, Inc.

that resulted in the improper recognition of $1,005,000 in

revenue that was reported in the SEC Form 10-Q Enterasys filed

for the first quarter of Transition Year 2001 (Compl. ¶¶ 69-73);

and (2) improper recognition of $701,000 in revenue from sales to

TrustWave Corp. during the fourth quarter of Fiscal Year 2001 and

the first three quarters of Transition Year 2001 (¶ 1 4 5 ) .

4 Regarding the Cellit transaction, the complaint alleges that

Enterasys, with Eric Jaeger1 and Patel’s knowledge, entered into

an agreement with Cellit under which Enterasys invested in Cellit

and Cellit agreed, among other things, to purchase product from

Aprisma. (Compl. ¶ 69.) The complaint further alleges that

Jaeger and Patel knew that: (1) Enterasys did not need Cellit

product (¶ 7 0 ) ; (2) Cellit did not need Aprisma product ( i d . ) ;

(3) the transaction lacked economic substance (¶ 7 1 ) ; (4)

Enterasys entered into the agreement only as a way of recognizing

revenue ( i d . ) ; and (5) the transaction was not completed until

the quarter after Enterasys recognized revenue from it and

reported that revenue in an SEC Form 10-Q (¶ 7 2 ) .

Regarding the TrustWave transaction, the complaint alleges

that

[a]t the time Enterasys recognized revenue from sales to TrustWave, Jaeger and Patel knew that TrustWave did not need Aprisma product and was only purchasing product to enable Aprisma to meet its quarterly revenue goals [and that] the valuation for Enterasys’s reciprocal investment in TrustWave lacked substance and was based on the amount of product TrustWave was willing to purchase from Aprisma.

1 Jaeger served as Cabletron’s Executive Vice President of Corporate Affairs from July 1999 through August 2001 and as a consultant to Enterasys and Aprisma from August 2001 through September 2002. Before becoming Cabletron’s Executive Vice President, he served as the company’s General Counsel.

5 (Compl. ¶ 145.) The SEC further alleges that Jaeger and Patel

knew “that it was improper to recognize revenue for sales to

TrustWave.” (Id.)

The complaint further alleges that: (1) by the first quarter

of Transition Year 2001, Patel, David Kirkpatrick,2 and others,

knowing that the company’s “outside auditor had identified an

investee company’s independent ability to pay for product as an

important prerequisite to recognizing revenue for an investment

. . . developed and carried out a scheme to structure investment

transactions so as to conceal investment related revenue from the

company’s outside auditor” (Compl. ¶ 1 5 6 ) ; (2) in March 2001,

Patel, Kirkpatrick, and Robert Barber3 first presented to

Enterasys’s investment team4 “an investment structure in which

2 Kirkpatrick served as Cabletron’s Chief Financial Officer from August 1990 to August 2001, as Cabletron’s Chief Operating Officer from October 2000 to August 2001, and as Aprisma’s Chief Operating Officer from August 2001 until March 2002, as a member of Aprisma’s Board of Directors from August 2001 until March 2002, and as Chairman of the Board from January 2002 until March 2002. 3 Barber served as Enterasys’s Vice President of Corporate Affairs from April 2000 through April 2001, and was responsible for business development at Enterasys from May through August 2001. 4 The complaint describes the investment team as consisting of Jaeger, Kirkpatrick, Patel, Enrique Fiallo, Barber, Jerry Shanahan, Anthony Hurley, Kay, Robert Gagalis, Gayle Luacaw, and others.

6 the investee company would purchase Enterasys product from a

distributer or ‘channel partner’ rather than from Enterasys

directly to conceal from Enterasys’s outside auditor the link

between Enterasys’s investment and the purchase, for which

Enterasys would record revenue” (¶ 1 5 7 ) ; (3) during “numerous

. . . weekly conference calls” members of Enterasys’s investment

team “openly discussed the purpose of three corner deals: to

conceal from Enterasys’s outside auditor the connection between

investments and purchases, given that the poor financial

condition of investee companies could lead the outside auditor to

conclude that the related revenue did not comport with GAAP”

(¶ 1 5 8 ) ; (4) Patel and Jaeger, after having been briefed on

Enterasys’s deficient sales projections and overstuffed sales

channels, directed Robert Gagalis5 and Enrique Fiallo6 to find

more investments and force more products into the channel by the

end of the quarter (¶ 1 6 1 ) ; and (5) Patel, along with Jaeger,

Barber, Jerry Shanahan,7 Bruce Kay,8 Robert Gagalis, and others

5 Gagalis served as Enterasys’s Executive Vice President, Chief Financial Officer, and Treasurer from July 2001 through October 2002. 6 Fiallo served as Cabletron’s Executive Vice President and Chief Information Officer from November 1998 to February 2000, as Enterasys’s President from February 2000 to August 2001, and as Enterasys’s President, Chairman, and Chief Executive Officer from August 2001 until April 2002. 7 Shanahan served as Cabletron’s Vice President of International Operations from February to September 2000, as

7 “worked together to close more than $20 million in investment-

related sales during the final week of the [second] quarter [of

Transition Year 2001], many of which were structured as three

corner deals to conceal the precarious financial condition of the

investee company from Enterasys’s outside auditor” (¶ 1 6 2 ) .

The SEC asserts that any public statement of earnings that

included improperly recognized revenue was materially false and

that Enterasys made such statements i n : one SEC 10-K form, six

SEC 10-Q forms, three SEC 8-K forms, fourteen representation

letters, and seven press releases. (Compl. ¶ 36.) The complaint

then specifies the amount of overstated revenue and understated

losses reported in each of the identified SEC filings (¶¶ 37-53),

and provides similar specifications for the press releases (¶¶

171-87). The SEC alleges that Patel and Kirkpatrick signed and

caused Enterasys to file four 10-Q forms, one 10-K form, and one

S-8 form (¶ 5 3 ) , and that Patel, along with Kirkpatrick and

Jaeger, “participated in the drafting of [quarterly] earnings

[press] releases” (¶ 1 7 2 ) . In addition, the complaint identifies

Cabletron’s Executive Vice President of Operations and Quality from September 2000 to March 2001, and as Enterasys’s Chief Operating Officer from March 2001 until May 2002. 8 Kay served as Cabletron’s Controller from February 1999 to June 2000, as Enterasys’s Chief Financial Officer from June 2000 until July 2001, and as Enterasys’s Senior Vice President of Finance from July until October 2001.

8 five specific press releases issued by Enterasys and Patel that

contained statements attributed either to Patel directly (¶ 1 7 3 ) ,

or to Enterasys and Patel collectively (¶¶ 175, 1 7 7 , 1 8 0 , 1 8 2 ) .

Discussion

Patel moves to dismiss, arguing that the complaint does not:

(1) allege particularized facts linking him to any of the

transactions discussed in the complaint other than those with

Cellit and TrustWave; (2) allege specific facts giving rise to a

strong inference that he acted with scienter with regard to the

Cellit and TrustWave transactions; or (3) connect him with any

fraudulent conduct in connection with the three-corner

transactions. He also argues that the SEC’s claims regarding

statements made in SEC filings and press releases do not survive

Rule 9(b) and that because the entire complaint sounds in fraud,

it must be dismissed in its entirety because it fails to allege

facts giving rise to a strong inference that he acted with

scienter.9 Because the SEC’s objection to Patel’s motion to

dismiss also serves as an objection to motions filed by Jaeger

and Kirkpatrick, it does not precisely track any of the three

motions to which it objects. Suffice it to say that the SEC

categorically opposes the motion to dismiss. The court begins by

9 He also makes several more specific arguments that will be taken up in due course.

9 setting out the pleading standard, continues with a discussion of

scienter, and concludes by examining the SEC’s complaint on a

claim-by-claim basis.

A. The Pleading Standard

In document n o . 1 3 0 , the order on Lawrence Collins’ motion

to dismiss, the court determined that the “sounds in fraud”

doctrine is the law of this circuit and ruled that the Rule 9(b)

pleading requirements apply to all of the SEC’s claims. That

ruling applies with equal force to Patel’s motion to dismiss, and

the SEC’s arguments to the contrary are rejected for the reasons

given in document n o . 130.

The version of Rule 9(b) in effect when the S E C filed its

complaint provided that “[i]n all averments of fraud or mistake,

the circumstances constituting fraud or mistake shall be stated

with particularity.” F E D . R . C I V . P . 9(b). 1 0 The rule further

provided that “[m]alice, intent, knowledge, and other

condition[s] of mind of a person may be averred generally.” Id.

“In applying [the Rule 9(b)] standard to securities fraud

actions, this circuit has been notably strict and rigorous.” S E C

10 Rule 9(b) was amended effective December 1 , 2007, but the Advisory Committee Notes to the Federal Rules explain that the 2007 amendment was “intended to be stylistic only.”

10 v . Durgarian, 477 F. Supp. 2d 3 4 2 , 348 (D. Mass. 2007) (citing

Greebel v . FTP Software, Inc., 194 F.3d 185, 193 (1st Cir.

1999)).

The particularity “requirement ‘entails specifying in the

pleader’s complaint the time, place, and content of the alleged

false or fraudulent representations.’” Arruda v . Sears, Roebuck

& Co., 310 F.3d 1 3 , 19 (1st Cir. 2002) (quoting Powers v . Boston

Cooper Corp., 926 F.2d 109, 111 (1st Cir. 1991)); see also In re

StockerYale Sec. Litig., 453 F. Supp. 2d 345, 350 (D.N.H. 2006)

(“The rule requires that the particular times, dates, places, or

other details of the alleged fraudulent involvement of the actors

be alleged.”). In addition, “general averments of the

defendants’ knowledge of material falsity will not suffice.”

Serabian v . Amoskeag Bank Shares, Inc., 24 F.3d 3 5 7 , 361 (1st

Cir. 1994) (citing Greenstone v . Cambex Corp., 975 F.2d 2 2 , 25

(1st Cir. 1992)), superseded by statute on other grounds, 15

U.S.C. § 74u-4(b)(2), as recognized in Greebel, 194 F.3d at 197.

Rather, “[c]onsistent with Fed. R. Civ. P. 9 ( b ) , the complaint

must set forth specific facts that make it reasonable to believe

that defendant[s] knew that a statement was materially false or

misleading.” Serabian, 24 F.3d at 361 (citation and internal

quotation marks omitted). Allegations of fraud must be organized

“into discrete units that are, standing alone, each capable of

11 evaluation.” StockerYale, 453 F. Supp. 2d at 350 (quoting In re

Boston Tech., Inc. Sec. Litig., 8 F. Supp. 2d 4 3 , 55-56 (D. Mass.

1998)). And, “where . . . ‘multiple defendants are involved,

each defendant’s role in the fraud must be particularized.’”

Manchester Mfg. Acquisitions, Inc. v . Sears, Roebuck & Co., 802

F. Supp. 595, 600 (D.N.H. 1992) (quoting Shields v . Amoskeag Bank

Shares, Inc., 766 F. Supp. 3 2 , 40 (D.N.H. 1991)).

“In a case where fraud is not an essential element of a

claim, only allegations of fraudulent conduct must satisfy the

heightened pleading requirements of Rule 9(b).” Sparling v . Daou

(In re Daou Sys., Inc., Sec. Litig.), 411 F.3d 1006, 1027 (9th

Cir. 2005) (citing Vess v . Ciba-Geigy Corp. USA, 317 F.3d 1097,

1105 (9th Cir. 2003)). “Allegations of non-fraudulent conduct

need satisfy only the ordinary notice pleading standards of Rule

8(a).” Daou Sys., 411 F.3d at 1027 (citation omitted). “Thus,

if particular averments of fraud are insufficiently pled under

Rule 9 ( b ) , a district court should ‘disregard’ those averments or

‘strip’ them from the claim. The court should then examine the

allegations that remain to determine whether they state a claim.”

Id. at 1028 (citation omitted).

Rule 9(b) may prove fatal to 1933 Securities Act claims grounded in fraud when the complaint makes a wholesale adoption of the securities fraud allegations for

12 purposes of the Securities Act claims. In such cases,

a district court is not required to sift through allegations of fraud in search of some lesser included claim of strict liability. It may dismiss. If it does s o , it should ordinarily accept a proffered amendment that either pleads with the requisite particularity or drops the defective allegations and still states a claim.

Id. (internal punctuation and citations omitted).

B. Scienter

Because Patel’s motion to dismiss substantially relies upon

the argument that the SEC has failed to allege sufficient facts

to give rise to a strong inference that he acted with scienter,

it is necessary to first establish the correct standard for

pleading scienter in an enforcement action brought by the SEC.

Patel argues that the strong-inference-of-scienter standard

applies not just to claims subject to the Private Securities

Litigation Reform Act (“PSLRA”), but also to SEC enforcement

actions. He begins by citing two court of appeals decisions in

private securities fraud actions that describe that standard,

Brody v . Stone & Webster, Inc. (In re Stone & Webster, Inc.,

Securities Litigation, 414 F.3d 1 8 7 , 204 (1st Cir. 2005) and

Serabian, 24 F.3d at 361. He then cites three cases from the

District of Massachusetts for the proposition that the strong-

13 inference standard also applies to SEC enforcement actions,

Durgarian, 477 F. Supp. 2d at 353 (citation omitted), SEC v .

Tambone (Tambone I ) , 417 F. Supp. 2d 1 2 7 , 130-31 (D. Mass. 2006),

and SEC v . Druffner, 353 F. Supp. 2d 1 4 1 , 149-50 (D. Mass. 2005).

In addition to relying upon Durgarian, Tambone I , and Druffner,

Patel points out, correctly, that the court of appeals for this

circuit has held that “[t]he PSLRA’s pleading standard is

congruent and consistent with the pre-existing standards of this

circuit,” Greebel, 194 F.3d at 193, and that its “strict pleading

requirements under Rule 9(b) are . . . consistent with the

PSLRA,” id. at 194 (citing Maldonado v . Dominguez, 137 F.3d 1 , 10

n.6 (1st Cir. 1998)).

For its part, the SEC points to cases from across the

country that stand for the proposition that the “strong-

inference” standard applies only to private securities actions.

See, e.g., SEC v . Sandifur, N o . C05-1631C, 2006 WL 538210, at *7

(W.D. Wash. March 2 , 2006) (“The SEC is correct that the more

stringent pleading requirements set forth in the Private

Securities Litigation Reform Act of 1995 (‘PSLRA’) do not apply

to enforcement actions brought by the Commission. Thus, to

satisfy Fed. R. Civ. P. 9 ( b ) , the SEC need only state that

scienter existed.”) (citation omitted); SEC v . Lucent Techs.,

Inc., 363 F. Supp. 2d 7 0 8 , 717 (D.N.J. 2005) (“The parties appear

14 to agree . . . and the case law supports the conclusion, that the

heightened requirements for pleading scienter under the PSLRA do

not apply to actions brought by the SEC.”) (citing SEC v . Prater,

296 F. Supp. 2d 2 1 0 , 215 (D. Conn. 2003) (“Since actions brought

by the SEC are not considered ‘private litigation,’ the standard

imposed in the PSLRA for pleading scienter does not apply to the

SEC.”); SEC v . ICN Pharm., Inc., 84 F. Supp. 2d 1097, 1099 (C.D.

Cal. 2000) (“[T]he ‘more rigorous’ pleading requirements under

the PSLRA, which go beyond the Rule 9(b) requirements only apply

to private securities fraud actions; they do not apply to a case,

such as this, brought by the SEC.”); SEC v . Blackman, N o . 3:99-

1072, 2000 WL 868770, at *5 (M.D. Tenn. May 2 6 , 2000) (agreeing

with the SEC that the pleading requirement of the PSLRA does not

apply to the SEC)); SEC v . Guenthner, 212 F.R.D. 5 3 1 , 532 n.1 (D.

Neb. 2003) (“the court notes that this is an SEC enforcement

proceeding, not a private securities action and thus it is not

subject to the heightened pleading standards of the . . . PSLRA”)

(citing Marksman Partners, L.P. v . Chantal Pharm. Corp., 927 F.

Supp. 1297, 1308 (C.D. Cal. 1996); In re Credit Acceptance Corp.

Sec. Litig., 50 F. Supp. 2d 6 6 2 , 675 (E.D. Mich. 1999) (finding

that the PSLRA “only applies to private securities fraud

actions,” such as a plaintiff class action suit)).

15 The SEC has the better argument. While obviously not

binding on this court, the authority cited by the SEC from other

jurisdictions is persuasive. Turning to the authority that is

binding on this court, i.e., decisions from the court of appeals

for this circuit, there is no authority for the proposition that

the strong-inference standard applies to SEC enforcement actions.

To be sure, the court of appeals has held that its pre-PSLRA

interpretation of Rule 9(b) is consistent with the standards

established by the PSLRA, see Greebel, 194 F.3d at 193-94, but

the explanation of that holding in Greebel discusses only the

Rule 9(b) requirement that a plaintiff must state with

particularity “the circumstances constituting fraud or mistake.”

Greebel says nothing about the second sentence in Rule 9 ( b ) ,

which allows “[m]alice, intent, knowledge, and other condition of

mind of a person [to] be averred generally.” Stone & Webster,

like Greebel, draws a parallel between the PSLRA’s “clarity-and-

basis” requirement,11 and the “pre-existing Rule 9(b) pleading

standards in this Circuit,” 414 F.3d at 195 (citing Greebel, 194

F.3d at 1 9 3 ) , but draws no such parallel between the PSLRA’s

strong-inference requirement and the circuit’s pre-PSLRA

construction of the second sentence of Rule 9 ( b ) . In short,

there is no basis in either Greebel or Stone & Webster for

15 U.S.C. § 78u-4(b)(1).

16 arguing that the court of appeals has ever construed Rule 9(b) to

require securities fraud plaintiffs of any kind to plead facts

giving rise to a strong inference of scienter.

As noted, Patel relies on Durgarian, Tambone I , and Druffner

as district court cases from this circuit in which the strong-

inference standard has been applied in enforcement actions

brought by the SEC.12 Those opinions cannot support the weight

Patel places on them. The court in Tambone I rejected the SEC’s

argument that it should relax the Rule 9(b) particularity

requirement, 417 F. Supp. 2d at 1 3 1 , but said nothing about the

pleading standard for scienter. Moreover, while both Durgarian

and Druffner appear to have applied the strong-inference standard

in SEC enforcement actions, see Durgarian, 477 F. Supp. 2d at

353; Druffner, 353 F. Supp. 2d at 149-50, it does not appear that

in either case the question of the pleading standard for scienter

was actually contested. Of course, it is difficult to know for

certain, but neither decision distinguished or even cited the

rather large number of cases holding that the strong-inference

standard does not apply to SEC enforcement actions, which

suggests that the issue was not presented to the court. Thus,

12 It is perhaps worth noting that Patel has identified no pre-PSLRA district court case from this circuit that imposed a heightened pleading standard on averments of scienter made by either private securities fraud plaintiffs or the SEC.

17 Durgarian and Druffner are not persuasive regarding the

applicable pleading standard for scienter in SEC enforcement

actions.

In light of the substantial body of persuasive authority

supporting the proposition that the strong-inference standard is

specific to the PSLRA and does not apply to SEC enforcement

actions, and in the absence of an opinion from the court of

appeals for this circuit holding to the contrary, this court is

satisfied that the strong-inference standard does not apply to

SEC enforcement actions. The SEC is entitled, under Rule 9 ( b ) ,

to aver scienter generally. Accordingly, Patel’s reliance upon

the strong-inference standard is misplaced, and any arguments

based upon that standard are necessarily rejected.

C. The SEC’s Claims

As noted above, Patel attacks the SEC’s complaint on a

variety of grounds, some applicable to individual claims, others

applicable to multiple claims or the complaint as a whole. The

SEC’s fifty-page objection is equally complex. For the sake of

clarity, the court will consider Patel’s motion to dismiss on a

18 Counts I & III

In Count I , the SEC claims that all defendants violated

Securities Act section 17(a)(1), while in Count I I I , the SEC

claims that all defendants violated Exchange Act section 10(b)

and Exchange Act Rule 10b-5, either as primary violators or as

aiders and abettors. The claims themselves do not specify the

conduct upon which they are based. Rather, they incorporate, by

reference, all 187 paragraphs of factual allegations in the

complaint. The complaint, in turn, discusses two categories of

statements: those contained in SEC filings and those made in

press releases announcing earnings. According to the SEC, both

the SEC filings and the press releases contained untrue

statements of material fact because the financial results they

reported included revenue from contingent sales and investment-

related purchases, i.e., revenue that was not subject to

recognition under Generally Accepted Accounting Principles

(“GAAP”).

Because “[t]he elements of an action for securities fraud

under Section 10(b) of the Exchange Act (and Rule 10b-5

thereunder) and Section 17(a)(1) of the Securities Act are

substantially the same under the Supreme Court’s precedents,”

Tambone I , 417 F. Supp. 2d at 131 (citing Aaron, 446 U.S. at 695;

19 Ernst & Ernst v . Hochfelder, 425 U.S. 185, 196 (1976)), the court

will consider Counts I and III in a single discussion.13

It appears that Patel is arguing that Counts I and III

should be dismissed because the complaint fails to specifically

allege facts that could support a strong inference that he acted

with scienter. That argument is unavailing, for the reasons

outlined above. He also argues that Counts I and III should be

dismissed because: (1) he is alleged to have had knowledge of

only two transactions, those with Cellit and TrustWave; and (2)

the amount of revenue involved in those two transactions was

sufficiently small, in light of Enterasys’s overall revenue, to

make any misstatement related to those transactions immaterial as

a matter of law. The SEC counters that under the correct legal

standard, it has adequately alleged the materiality of Patel’s

alleged false statements.

Securities Act section 17(a) provides that “[i]t shall be

unlawful for any person in the offer or sale of any securities

. . . by the use of any means or instruments of transportation or

13 Patel takes much the same tack in his motion to dismiss. He frames a single set of arguments that cover Counts I and I I I , because Securities Act section 17(a)(1), Exchange Act section 10(b), and Rule 10b-5 share the same elements, and that also cover the remainder of the claims in the complaint, because those claims all sound in fraud.

20 communication in interstate commerce or by use of the mails,

directly or indirectly . . . to employ any device, scheme or

artifice to defraud.” 15 U.S.C. § 77q(a)(1). Exchange Act

section 10(b) provides that

[i]t shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or any facility of any national security exchange . . . [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 [Securities and Exchange] Commission may prescribe . . . .

15 U.S.C. § 78j(b). Exchange Act Rule 10b-5 provides:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(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 the 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.

21 To succeed on the claims asserted in Counts I and I I I , “the

SEC must show that 1 ) defendants engaged in fraudulent conduct,

2 ) in connection with the purchase or sale of securities, 3 )

through the means or instruments of transportation or

communication in interstate commerce or the mails and 4 ) with the

requisite scienter.” Tambone I , 417 F. Supp. 2d at 131 (citing

SEC v . Graystone Nash, Inc., 820 F. Supp. 863, 870-71 (D.N.J.

1993)). While it is less than clear, given the manner in which

the SEC has framed its claims, it appears that the fraudulent

conduct on which Counts I and III are based consists of allegedly

untrue statements of material fact made in various SEC filings

and press releases.

For an untrue statement of fact to be actionable under

Securities Act section 17(a) and Exchange Act 10(b), it must be

material. Tambone I , 417 F. Supp. 2d at 131. “The boundaries of

materiality in the securities context are clearly enunciated in

[the] case law [of the First Circuit].” Lucia v . Prospect S t .

High Income Portfolio, Inc., 36 F.3d 1 7 0 , 175 (1st Cir. 1994).

Specifically,

[t]he mere fact that an investor might find information interesting or desirable is not sufficient to satisfy the materiality requirement. Rather, information is “material” only if its disclosure would alter the “total mix” of facts available to the investor and “if there is a substantial likelihood that a reasonable

22 shareholder would consider it important” to the investment decision.

Id. (quoting Milton v . Van Dorn Co., 961 F.2d 965, 969 (1st Cir. 1992)). 14

“Materiality is usually a matter for the trier of fact.”

ACA Fin. Guar. Corp. v . Advest, Inc., 512 F.3d 4 6 , 65 (1st Cir.

2007) (citation omitted). “A court is thus free to find, as a

matter of law, that a statement was not false, or not materially

false, only if a jury could not reasonably find falsity or

materiality on the evidence presented.” Stone & Webster, 414

F.3d at 209 (citing TSC Indus., Inc. v . Northway, Inc., 426 U.S.

438, 450 (1976)). As the court of appeals for the Eighth Circuit

has explained, “a complaint that alleges only immaterial

misrepresentations presents an ‘insuperable bar to relief,’ and

dismissal of such a complaint is proper.” Parnes v . Gateway

2000, Inc., 122 F.3d 539, 546 (8th Cir. 1997) (quoting Fusco v .

Xerox Corp., 676 F.2d 3 3 2 , 334 (8th Cir. 1982)).

14 While Lucia was a case brought under Sections 11 and 12(2) of the Securities Act, “[t]he same standard of materiality . . . applies to claims under Section 10(b) and Rule 10b-5 as to claims under Sections 11 and 12(b) of the Securities Act.” Shaw v . Digital Equip. Corp., 82 F.3d 1194, 1217 (1st Cir. 1996) (citation omitted), superseded by statute on other grounds, 15 U.S.C. § 74u-4(b)(2), as recognized in Greebel, 194 F.3d at 197.

23 The untrue statements of material fact alleged by the SEC in

this action consist of overstatements of Enterasys’s revenues and

earnings, and understatements of the company’s losses, contained

in nine SEC filings and seven press releases. Both parties

appear to agree that the “specific facts that make it reasonable

to believe that [Patel] knew that [those] statement[s] [were]

materially false or misleading,” Serabian, 24 F.3d at 3 6 1 , are

the facts related to his participation i n , or knowledge o f ,

improper recognition of the revenue generated by the Cellit and

TrustWave transactions. According to the complaint, that revenue

was directly reported on SEC forms signed by Patel and filed on

June 4 and July 1 0 , 2001, and on SEC forms signed by Fiallo and

Gagalis and filed on October 16 and November 1 4 , 2001.15 (Compl.

¶¶ 4 3 , 4 6 , 4 8 , and 5 1 ) . The complaint further alleges that

information from the forms listed above was incorporated into

four other SEC filings. (¶ 53.) Of the seven press releases

mentioned in the complaint, four reported on the SEC filings

noted above. (¶¶ 1 8 0 , 1 8 2 , 1 8 4 , 186.) As previously stated, the

15 Given that Patel is not alleged to have signed or to have caused Enterasys to file the October 16 and November 14 SEC reports, it is not at all clear that the representations contained therein may be attributed to him, but that is an issue the court need not address, given the immateriality of any overstatement resulting from inclusion of revenue from the TrustWave transaction, as explained below.

24 SEC has identified allegedly false statements attributable to

Patel on both SEC forms and press releases.

The most substantial misrepresentation attributed to Patel

in an SEC filing is the reporting of Enterasys’s performance for

the quarter that ended June 2 , 2001. According to the complaint:

(1) the SEC Form 10-Q signed by Patel reported net revenue of

$306,898,000 (Compl. ¶ 4 6 ) ; (2) revenue was overstated by

$10,869,000 (¶ 4 7 ) ; and (3) the two transactions Patel is alleged

to have known about, those with Cellit and TrustWave, accounted

for $1,543,000 of inappropriately recognized revenue ( i d . ) . In

other words, the improperly recognized revenue directly tied to

Patel through either participation or knowledge was less than

0.51 percent of the revenue Enterasys reported that quarter.16

The complaint further alleges that the “overstatement [of

revenue] caused the loss from operations to be understated by

16 In the three other quarters at issue, improperly recognized revenue directly tied to Patel accounts for an even smaller percentage of the total revenue reported. According to the complaint: the March 2001 Form 10-K reported net revenue for the preceding quarter of $286,016,000 (Compl. ¶ 4 4 ) , $43,000 of which (approximately 0.02 percent) is alleged to have come from the TrustWave transaction (¶ 4 5 ) ; the September 2001 Form 10-Q reported net revenue of $240,181,000 (¶ 4 8 ) , $60,000 of which (approximately 0.02 percent) is alleged to have come from the TrustWave transaction (¶ 4 9 ) ; and the September 2 9 , 2001, Form 10-Q reported net revenue of $105,535,000 (¶ 5 1 ) , $60,000 of which (approximately 0.06 percent) is alleged to have come from the TrustWave transaction (¶ 5 2 ) .

25 approximately $6,000,000 and the net loss to shareholders to be

understated by approximately $3,000,000.” (Id.)

Patel asks the court to determine that even if he is liable

for misrepresenting revenue in SEC filings, the amount of

overstated revenue for which he can be held liable is so small as

to render his false statements immaterial, as a matter of law.

The SEC counters that Patel’s argument fails to acknowledge the

qualitative materiality of the alleged misrepresentations, and

notes that profit statements and earnings reports are of

particular interest to investors.

“[A]lthough overstatement of revenues in violation of GAAP

may support a plaintiff’s claim of fraud, the plaintiff must show

with particularity how the adjustments affected the company’s

financial statements and whether they were material in light of

the company’s overall financial position.” Daou Sys., 411 F.3d

at 1018. Here, the SEC has shown with particularity how Patel’s

alleged false statements affected Enterasys’s financial

statements. Thus, the question is whether those effects were

material, based upon the company’s overall financial position.

“Minor adjustments in a company’s gross revenues are not, as

a rule, deemed material by either accountants or the securities

26 law.” In re Segue Software, Inc. Sec. Litig., 106 F. Supp. 2d

161, 170 (D. Mass. 2000) (citing Greebel, 194 F.3d at 206;

Glassman v . Computervision Corp., 90 F.3d 6 1 7 , 633 (1st Cir.

1996); Chalverus v . Pegasystems, Inc., 59 F. Supp. 2d 226, 234

(D. Mass. 1999)). In Segue Software, the trial court ruled that

“[a]s in Greebel, the overstatement of Segue’s revenues was

insignificant ($1.1 million or 2.6% of Segue’s $41 million in

sales in 1998) and nonsystemic (involving only ten sales out of

hundreds consummated during the two final quarters of 1998).”

106 F. Supp. 2d at 171. Similarly, courts have determined the

following misrepresentations to be immaterial, as a matter of

law: (1) a 0.3 percent ($217 million) overstatement of revenues

over a two-year period, see In re Duke Energy Corp. Sec. Litig.,

282 F. Supp. 2d 1 5 8 , 161 (S.D.N.Y. 2003); (2) a 0.2 percent

understatement of a company’s costs of goods sold, see In re

Burlington Coat Factory Sec. Litig., 114 F.3d 1410, 1426-27 (3d

Cir. 1997); (3) an overstatement of a company’s loan-loss

reserves where “[t]he charge that would have followed the write-

down of this asset would have amounted to merely 0.54% of [the

company]’s net income of $234 million for that quarter,” In re

Westinghouse Sec. Litig., 90 F.3d 696, 715 (3d Cir. 1996); (4) a

two percent ($6.8 million) overstatement of a company’s assets,

see Parnes, 122 F.3d at 547; and (5) a $2 million understatement

of a company’s outstanding loans and a $2 million overstatement

27 its derivative receivables, where the amount involved was about

0.3 percent of the company’s total assets), see In re JP Morgan

Chase Sec. Litig., 363 F. Supp. 2d 595, 630-31 (S.D.N.Y. 2005). 17

Given that persuasive authority, the court has little

difficulty concluding that the false statements in SEC filings

for which Patel could be held liable fail to meet the materiality

requirement, as a matter of law. None of Patel’s allegedly false

statements related to more than one percent of Enterasys’s

quarterly revenue, and three of the four relates to less than one

tenth of one percent of quarterly revenue.

While statements concerning revenue undoubtedly qualify as

qualitatively material, c f . Burlington, 114 F.3d at 1420 n.9

17 In an opinion that not directly on point, the court of appeals for this circuit held that scienter was not demonstrated by the issuance of a revenue report that incorporated between $416,000 and $1.55 million in improperly recognized revenue, when overall revenue for the quarter in question was $37.5 million. See Greebel, 194 F. 3d at 206. In contrast, in Chalverus, the trial court held that the PSLRA’s strong-inference-of-scienter requirement was met by a combination of several factors, including the following:

Pegasystems restated its second quarter revenue from $12,200,000 to $4,700,000 and restated its earnings from a gain of $2.2 million to a loss of $2.8 million. The total amount by which Pegasystems restated its revenue – $7,485,000 – equals 158 percent of its actual revenue for that quarter.

59 F. Supp. 2d at 234 (citation to the record omitted).

28 (“earnings reports are among the pieces of data that investors

find most relevant to their investment decisions”), the concept

of qualitative materiality has its limits:

The district court recognized that the adequacy of loan loss reserves is generally the type of information that would significantly influence a reasonable investor. Westinghouse I , 832 F. Supp. [948,] 972 [(W.D. P a . 1993)] (citing [Shapiro v.] UJB [Fin. Corp.], 964 F.2d [272,] 281 [(3d Cir. 1992)]). However, the court also tested plaintiffs’ complaint to determine whether the allegations regarding loan loss reserves were quantitatively material in this particular case. The district court stated that “[t]he failure to disclose that a loan portfolio is likely to be impaired by some de minimis amount may be ‘relevant’ in that it is the type of information that investors care about, but of such ‘dubious significance’ as to be ‘trivial,’ and ‘hardly conducive to informed decisionmaking,’ so that to reasonable shareholders, such omission must be immaterial as a matter of law.” Id. at 972 (quoting TSC Industries, 426 U.S. at 448- 4 9 ) . We agree. See generally Loss & Seligman, Fundamentals of Securities Regulation 137-41, 479-80 (1995) (quantitative materiality analysis is generally appropriate, though not when “such matters as a conflict of interest or criminal violations are at issue”); see also Ferber v . Travelers Corp., 802 F. Supp. 6 9 8 , 708 (D. Conn. 1992) (omission of extent of second mortgages not material in relation to overall real estate, investment, and asset portfolios); In re First Chicago Corp. Securities Litigation, 769 F. Supp. 1444, 1454 (N.D. Ill. 1991) (total value of alleged bad loan immaterial in relation to size of defendant’s real estate loan portfolio).

Westinghouse, 90 F.3d at 714 (parallel citation omitted). The

court elaborated its reasoning in a footnote that is particularly

relevant:

29 We thus reject plaintiffs’ argument that all misstatements regarding loan loss reserves and nonearning receivables are inherently material. But we also reject defendants’ similarly categorical assertion that materiality must be quantified at a specified percentage of income or assets. Although “a ‘rule of thumb’ of 5-10 percent of net income is widely used as a general materiality criterion” in the accounting profession, see Financial Accounting Standards Board, Accounting Standards: Statements of Financial Accounting Concepts N o . 2 , App. C , ¶ 1 6 7 , at 81 (1989) (citing James W . Pattillo, The Concept of Materiality in Financial Reporting (1976)), the question of materiality must be considered on a case-by-case basis under the standards set forth in T.S.C. Industries and our cases. See also Pattillo, supra, at 12 (advocating consideration of various factors in determining materiality in the accounting profession and concluding that “the single rule-of-thumb materiality criterion of 5%-10% of net income or loss should be used – if at all, and by itself – with extreme caution”).

Id. at 714 n.14. Based upon the reasoning outlined in

Westinghouse, the SEC’s reliance upon the concept of qualitative

materiality is unavailing; the overstatements of revenue in this

case fall far below the “rule-of-thumb” threshold described in

Westinghouse, and the SEC has identified no factors that

compellingly enhance the materiality of the mathematically

negligible overstatements upon which the SEC bases its claims.

In re Kidder Peabody Securities Litigation, 10 F. Supp. 2d

398 (S.D.N.Y. 1998), upon which the SEC relies, does not support

a contrary result. In Kidder Peabody, the defendant argued that

“none of the alleged misstatements [could] be considered material

30 given the amount of the alleged false profits in relation to

[General Electric]’s total earnings.” Id. at 409-10.

Specifically, “none of the alleged misstatements, taken

individually, affected GE’s profits by more than 2.54%, with most

of the alleged misstatements individually affecting GE’s profits

by less than 1%.” Id. at 410. While acknowledging “the appeal

of defendants’ statistical approach,” id., the court found itself

“hard-pressed to find that misstatements of profits totaling over

$338 million dollars are immaterial as a matter of law,” id., and

“decline[d] to adopt a statistical bright line rule to determine

what a reasonable investor would consider significant,” id.

(citing Basic Inc. v . Levinson, 485 U.S. 2 2 4 , 236 n.14 (1988)).

In Kidder Peabody, the false profits were generated by a single

trader at Kidder, then a subsidiary of General Electric. Id. at

402-05. To overcome the defendants’ statistical approach, “the

plaintiffs . . . put forth several theories for why a reasonable

GE investor would have placed particular emphasis on information

related to Kidder,” id., and the court found several of them

persuasive:

First, while the false profits may have been minor compared to GE’s earnings as a whole, they were quite significant to Kidder, accounting for 13.5% of Kidder’s reported profits in 1992 and 45% in 1993. Kidder’s profits, in turn, represented a significant portion of GE’s balance sheet. Buffeted by the false profits, Kidder’s total profits accounted for 7% of GE’s reported earnings in 1993, up from 5% in 1992 and 2% in

31 1991. As a result, news about Kidder may have held special interest to a GE investor. Put differently, $338 million of false profits attributed solely to Kidder might have had greater significance to an investor than the same $338 million dispersed broadly throughout GE’s balance sheet.

Second, the false profits might have been especially important to investors due to Kidder’s visible role in GE’s business. Under this theory, the importance of reports related to Kidder was magnified because investors had been monitoring Kidder’s performance closely since GE purchased Kidder in 1986. In support of this theory, plaintiffs note that when GE announced the purchase of Kidder some analysts believed that the purchase would have a detrimental impact on GE’s stock. These analysts felt that GE’s inexperience in the securities brokerage industry, as well as the volatility of the securities market, made Kidder an unwise acquisition for G E . According to plaintiffs’ expert, these analysts’ fears were realized when Kidder reported at least intermittent losses from 1986 to 1991, despite substantial cash infusions from G E . In this context, Kidder’s reported profits in 1992 and 1993, which included the false profits, took on special significance to investors and analysts who viewed Kidder as a turnaround success story.

In addition to these theories, the Court notes that the materiality of the misstatements must be considered in light of their impact on GE’s reputation, wholly apart from their statistical impact on GE’s reported earnings. Under plaintiffs’ theory, the false profits enabled GE to tout Kidder’s success, thereby allaying analysts’ fears. That this success, at a minimum, was inflated likely would have been significant to a reasonable investor. Moreover, that a prominent subsidiary of GE was able to generate false profits, apparently without GE’s knowledge, arguably raised concerns about GE’s internal controls, efficiency, and integrity, all of which would have been relevant to a reasonable investor. See Ross v . Warner, [No. 77 Civ. 243,] 1980 WL 1474, at *8 [(S.D.N.Y. Dec. 1 1 , 1980)] (discussing materiality of failure to

32 disclose questionable payments in terms of effect on public perception of management’s integrity).

Id. at 411. While the SEC cites Kidder Peabody, it makes no

arguments – much less persuasive ones – that the theories adopted

in that case apply in equal measure – or at all – in this case.

In sum, the court is persuaded that none of the false

statements about revenue attributed to Patel that were made in

SEC filings can meet the materiality requirement.

With regard to the alleged falsity of the press releases,

the SEC alleges that “[t]he Defendants knew that the revenue they

caused Enterasys to improperly recognize was reported in

quarterly press releases that were distributed to the investing

public” (Compl. ¶ 1 7 1 ) , thus indicating that knowledge of

transactions generating revenue inappropriate for recognition

constituted the “specific facts that make it reasonable to

believe that [Patel, Kirkpatrick, and Jaeger] knew that [the]

statement[s] [contained in the press releases were] materially

false or misleading.” Serabian, 24 F.3d at 361. Of the seven

press releases described in the complaint, only the last four

reported results from quarters during which Patel is alleged to

have known about improper revenue recognition. For the other

three, then, the complaint does not “set forth specific facts

33 that make it reasonable to believe that [Patel] knew that [any]

statement [contained in those releases] was materially false or

misleading.” Serabian, 24 F.3d at 361. With respect to the last

four press releases, the complaint makes similar claims,

asserting, for example:

The Defendants falsely represented that [Enterasys] had met Wall Street expectations for earnings per share estimates. When adjustments are made to correct the improper revenue recognized, the understated operating losses, and the understated losses to shareholders, the pro forma earnings per share were $0.02, rather than the income of $0.06 reported.

(Compl. ¶ 181; see also ¶¶ 183, 185, 187.) The complaint alleges

that Enterasys falsely reported that it had met Wall Street

expectations, but it does not say what those expectations

actually were for three of the four press releases. Without any

specificity about the Wall Street expectations that Enterasys

claimed to have met, the complaint does not adequately allege

either the falsity or the materiality of the alleged false

statement. See Serabian, 24 F.3d at 361. The lone press release

for which Wall Street expectations are actually described is the

one issued on March 2 8 , 2001. That release reported on a quarter

in which Enterasys claimed $286,016,000 in revenue and Patel is

alleged to have known about $43,000 of revenue that was,

allegedly, improperly recognized. The magnitude of the alleged

34 misrepresentation – amounting to approximately 0.015 percent of

Enterasys’s quarterly revenue – is insufficient to meet the

requirement by materiality, as a matter of law. Accordingly, the

allegations in paragraphs 1 8 1 , 183, 185, and 187 are insufficient

to support the claims in Counts I and III.

Similarly insufficient are the allegations concerning the

December 2 0 , 2000, press release. (Compl. ¶¶ 177-79.) For one

thing, that press release did not report revenue from either the

Cellit or TrustWave transaction, the only two transactions that

Patel is alleged to have known about. Moreover, while the SEC

asserts, in a conclusory way, that “Patel knew or was reckless in

not knowing that it was improper for Aprisma to recognize revenue

on the transaction with SG Cowen which was subject to exchange

rights” (¶ 1 7 8 ) , and that “[r]emoving the SG Cowen revenue of

approximately $1.9 million from Aprisma’s revenues materially

reduced its sequential growth rate to approximately 2.9% rather

than the 13.4% touted by Patel” ( i d . ) , the complaint’s discussion

of the SG Cowen transaction includes no allegation that Patel had

any knowledge of i t . Thus, the complaint does not set forth

specific facts that make it reasonable to believe that Patel knew

that the statement about Aprisma’s sequential growth rate was

materially false or misleading. See Serabian, 24 F.3d at 361.

35 Because the alleged false statements attributable to Patel

contained in SEC filings are immaterial as a matter of law, and

because the SEC has failed to adequately allege material false

statements attributable to Patel in the press releases, Counts I

and III are dismissed as to Patel to the extent they assert

claims of primary liability. Count III also asserts that Patel

is liable as an aider and abettor. The court’s determination

that the misrepresentations in the SEC filings are immaterial as

a matter of law also applies to the aider and abettor claim. To

the extent the aider and abettor claim is based upon the press

releases, the complaint alleges no act on Patel’s part that could

qualify as a proximate cause of the issuance of a materially

false press release,18 which is the test for aider and abettor

liability. See 15 U.S.C. § 78t(e); SEC v . Power, 525 F. Supp. 2d

415, 422 (S.D.N.Y. 2007) (citations omitted). Accordingly, as to

Patel, Counts I and III are dismissed in their entirety.

Count II

Count II is the SEC’s claim that defendants violated

Securities Act sections 17(a)(2) & (3). 1 9 “The requirements for

18 Obviously, the complaint alleges that Patel “participated in the drafting of the earnings releases” (Compl. ¶ 1 7 2 ) , but it alleges no facts that connect Patel to the inclusion of materially false statements in any of those releases. 19 15 U.S.C. §§ 77q(a)(2) & ( 3 ) .

36 establishing a violation of Section 17(a) are nearly the same as

those required for a claim under Securities Exchange Act Section

10(b) and Rule 10b-5 thereunder, although there is no requirement

for the SEC to demonstrate scienter with respect to subsections

(a)(2) and (a)(3).” Durgarian, 477 F. Supp. 2d at 355 (citing

Aaron, 446 U.S. at 681)).

Patel moves to dismiss Count II on grounds that the SEC’s

complaint does not adequately plead scienter, does not

sufficiently allege specific facts of his participation in the

alleged fraud, and, with regard to Securities Act section

17(a)(2), does not identify any money or property he obtained or

any untrue statement he made. For the same reasons that support

dismissal of Counts I and I I I , Count II is also dismissed as to

Patel.

Count IV

In Count IV, the SEC asserts that all defendants violated

Exchange Act section 13(b)(5) and Rule 13b2-1, which pertain to

internal accounting controls and proscribe the falsification of

corporate books and records. See 15 U.S.C. § 78m(b)(5); 17

C.F.R. § 240.13b2-1. Patel moves to dismiss Count IV, arguing

that the SEC’s complaint does not adequately plead scienter and

does not sufficiently allege his knowledge o f : (1) internal

37 accounting controls that were circumvented or not implemented; or

(2) falsified books, records, or accounts. In its objection, the

SEC challenges defendants’ argument that the “sounds in fraud”

doctrine applies to its claims under section 13 of the Exchange

Act, but the SEC directs the court to no factual allegations in

its complaint that might support its claims under section

13(b)(5) and Rule 13b2-1. It is not the job of the court to sift

through 187 paragraphs of the SEC’s complaint in search of

adequate factual allegations to support its claims. Accordingly,

the court interprets plaintiff’s failure to identify any factual

allegations supporting its section 13(b)(5) and Rule 13b2-1

claims as adequate concession that Count IV does not state a

claim against Patel. Accordingly, Patel is entitled to dismissal

of Count IV.

Count V

In Count V , the SEC claims that all defendants violated

Exchange Act Rule 13b2-2, which prohibits directors and officers

from making false statements to accountants or auditors. Patel

moves to dismiss Count V , arguing that the SEC’s complaint does

not: (1) adequately plead scienter; (2) allege that he made, or

caused to be made, any statements to Enterasys’s auditors; or (3)

plead his knowledge of any false statements made to auditors.

The SEC counters that the complaint adequately alleges that

38 “Patel and Jaeger, as officers, participated in numerous

transactions in which they knew the Company was improperly

recognizing revenues and yet they omitted to disclose this

information to the Company’s auditor.” (Pl.’s O b j . (document n o .

92) at 32.)

The regulatory provision on which Count V is based provides,

in pertinent part:

(a) No director or officer of an issuer shall, directly or indirectly: (1) Make or cause to be made a materially false or misleading statement to an accountant in connection with; or (2) Omit to state, or cause another person to omit to state, any material fact necessary in order to make statements made, in light of the circumstances under which such statements were made, not misleading, to an accountant in connection with: (I) Any audit, review or examination of the financial statements of the issuer required to be made pursuant to this subpart; or (ii) The preparation or filing of any document or report required to be filed with the [Securities and Exchange] Commission pursuant to this subpart or otherwise.

240 C.F.R. § 240.13b2-2.

Notwithstanding the SEC’s contention to the contrary, the

complaint does not allege that Patel participated in “numerous

transactions” in which he knew that Enterasys was improperly

recognizing revenue and yet omitted to disclose this information

39 to the company’s auditor.20 However, even if the complaint did

say what the SEC thinks, Patel would still be entitled to

dismissal of Count V . The SEC relies upon Rule 13b2-2(a)(2),

which makes it improper to omit material facts from statements

made to an accountant, but the prohibition on omitting material

facts is limited to situations where the omitted material facts

were “necessary in order to make statements made, in light of the

circumstances under which such statements were made, not

misleading.” In other words, the rule does not impose upon

directors or officers a duty to report information to

accountants; it merely requires them not to make false statements

to accountants and not to omit information from statements to

accountants, when such an omission would result in a misleading

statement. Here, the complaint identifies no statements Patel

made to the company’s accountants or auditors, much less a

statement that was made misleading by the omission of information

from i t . Without identifying a statement rendered misleading by

the omission of information, the SEC has not stated a claim under

Rule 13b2-2.

20 Rather, read in the light most favorable to the SEC, the complaint alleges that Enterasys entered into the Cellit transaction with Patel’s knowledge (Compl. ¶¶ 69-72) and that Patel “participated in improperly recognizing . . . revenue from sales to TrustWave” because he knew about that transaction (¶ 145).

40 Count VI

In Count V I , the SEC claims that all defendants aided and

abetted Enterasys in violating Exchange Act section 13(a) and

Exchange Act Rules 12b-20, 13a-1, 13a-11, and 13a-13, which

describe the requirements imposed upon issuers of securities to

file various reports with the SEC. See 15 U.S.C. § 78m(a); 17

C.F.R. §§ 240.12b-20, 240.13a-1, 240.13a-11 & 240.13a-13; see

also Ponce v . SEC, 345 F.3d 7 2 2 , 735 (9th Cir. 2003). Patel

moves to dismiss Count V I , arguing that the SEC’s complaint does

not adequately plead: (1) scienter; (2) general awareness of

impropriety; (3) knowledge of falsity; or (4) substantial

assistance in the allegedly fraudulent scheme. The SEC counters

that it adequately alleged Patel’s participation in making false

statements to the SEC by alleging that he signed various SEC

reports or submitted revenue for inclusion in those reports while

knowing that some of the revenue he submitted was not subject to

recognition under either the company’s revenue recognition policy

or GAAP.

Because all of the allegedly false statements attributable

to Patel in SEC filings are immaterial as a matter of law, for

the reasons already discussed, Patel is also entitled to

dismissal of Count V I . See SEC v . Coffman, N o . 06-cv-00088-REB-

BNB, 2007 WL 2412808, at *12 (D. Colo. Aug. 2 1 , 2007) (“the SEC’s

41 claim based on § 13(a) of the Exchange Act, and rules promulgated

thereunder, requires proof of a material misrepresentation or a

materially misleading omission”); c f . Ponce, 345 F.3d at 736

(holding that where conduct alleged to support claims of section

10(b) and Rule 10b-5 violations was also alleged in support of

section 13(a) violations, violation of section 10(b) and Rule

10b-5 established violation of sections 13(a) and 13(b)(2)).

Count VII

In Count V I I , the SEC claims that all defendants aided and

abetted Enterasys in violating Exchange Act section 13(b)(2)(A),

which sets out various requirements for corporate record keeping.

Patel moves to dismiss Count V I I , arguing that the SEC’s

complaint does not adequately plead: (1) scienter; (2) general

awareness of impropriety; (3) knowledge of falsity; or (4)

substantial assistance in the allegedly fraudulent scheme. The

SEC counters that “[t]he complaint alleges [that] the Defendants

caused the Company to keep inaccurate books and records by

entering into contingent sales transactions or three-corner

investment deals in which the true nature of the transactions

[was] not accurately recorded in the Company’s books and

records.” (Pl.’s O b j . at 36.)

42 The statutory provision on which Count VII is based provides

as follows:

Every issuer which has a class of securities registered pursuant to section 78l of this title and every issuer which is required to file reports pursuant to section 78o(d) of this title shall—

(A) make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer.

15 U.S.C. § 78m(b)(2); see also Ponce, 345 F.3d at 735 (“Section

13(b)(2) requires companies to maintain books, records and

accounts accurately and record transactions in conformity with

GAAS.”). Section 13(b)(2)(A) has “been read to require issuers

to employ and supervise reliable personnel, to ensure that

transactions are executed as authorized, to segregate accounting

functions, and to have procedures designed to prevent errors and

irregularities.” SEC v . Yuen, N o . CV 03-4376MRP(PLAX), 2006 WL

1390828, at *42 (C.D. Cal. March 1 6 , 2006). However, unlike

various other provisions of the Exchange Act, section 13(b)(2)

does not require the SEC to establish the materiality of an

alleged inaccuracy in a company’s books and records. See SEC v .

Thielbar, N o . CIV 06-4253, 2007 WL 2903948, at *10 (D.S.D. Sept.

2 8 , 2007) (citing SEC v . World-Wide Coin Invs., Ltd., 567 F.

Supp. 7 2 4 , 748-50 (N.D. G a . 1983)).

43 With regard to aider and abettor liability, the Exchange Act

provides:

For purposes of any action brought by the [Securities and Exchange] Commission under paragraph (1) or (3) of section 78u(d) of this title, any person that knowingly provides substantial assistance to another person in violation of a provision of this chapter, or of any rule or regulation issued under this chapter, shall be deemed in violation of such provision to the same extent as the person to whom such assistance is provided.

15 U.S.C. § 78t(e). Specifically,

[l]iability for aiding and abetting securities fraud under [Exchange Act section 10(b)] attaches only upon a showing that: 1 ) a primary violation was committed, 2 ) the defendant[ ] had a general awareness that [his] conduct was part of an overall activity that was improper, and 3 ) the defendant[ ] knowingly and substantially assisted in the primary violation.

SEC v . Tambone (Tambone I I ) , 473 F. Supp. 2d 1 6 2 , 167-68 (D.

Mass. 2006) (citing Druffner, 353 F. Supp. 2d at 1 5 0 ) . “[M]ere

awareness and approval of the primary violation is insufficient

to make out a claim for substantial assistance.” Power, 525 F.

Supp. 2d at 422 (quoting SEC v . Treadway, 430 F. Supp. 2d 293,

339 (S.D.N.Y. 2006)). Rather, “[t]he aider and abettor’s

substantial assistance must be a proximate cause of the primary

violation.” Power, 525 F. Supp. 2d at 422 (citation omitted).

44 Here, the complaint alleges that Enterasys’s corporate

books, records, and accounts did not reflect the company’s

transactions accurately and fairly because those books and

records reported revenue that should not have been recognized for

a variety of reasons, which is enough to assert the commission of

a primary violation of section 13(b)(2)(A) by Enterasys. In its

objection to Patel’s motion to dismiss, the SEC argues that Patel

aided and abetted that primary violation “by entering into

contingent sales transactions or three-corner investment deals.”

(Pl.’s O b j . at 36.) That argument is not persuasive.

The act of entering into a transaction is sufficiently

attenuated from the process of corporate accounting that mere

participation in a transaction that generates revenue that cannot

later be recognized under GAAP, without more, cannot be a

proximate cause of inaccurate accounting. C f . Ponce, 345 F. 3d

at 738 (holding that defendant “provided substantial assistance

to [a] primary violation of Sections 13(a) and 13(b)(2), by

preparing the financial statements that were eventually filed

with both the quarterly and annual reports, as well as auditing

and certifying the [false] reports that [the company] filed”);

Thielbar, 2007 WL 2903948, at *10 (denying motion to dismiss

section 13(b)(2) aiding and abetting claim when complaint

“contain[ed] several allegations regarding [defendant]’s conduct

45 in falsifying the books and records of NCS . . . and in

circumventing or failing to implement internal accounting

controls); SEC v . Baxter, No C-OF003843 RMW, 2007 WL 2013958, at

*9 (N.D. Cal. July 1 1 , 2007) (denying motion to dismiss section

13(b) aiding and abetting claim when plaintiff alleged that

defendant “participated in drafting . . . false and misleading

disclosures . . . , reviewed the financial statements, directed

the reclassification of unsubstantiated balances to conceal such

balances from the auditors, and signed the management

representation letters”); SEC v . Hopper, N o . Civ.A. H-04-1054,

2006 WL 778640, at *15-16 (S.D. Tex. 2005) (denying motion to

dismiss section 13(b) aiding and abetting claim when plaintiff

alleged that one defendant orchestrated and directed ‘round-trip’

trading scheme without notifying accountants, legal staff, or

external auditors and was provided financial statements

reflecting fictitious revenues generated by that scheme, and

alleged that second defendant was chief accounting officer who

continued to report trades in corporate books and records on a

gross bases, after being instructed to report them on a net

basis); Yuen, 2006 WL 1390828, at *42 (“By directing the shifting

of revenue from the print and channel advertisements to the IPG

platform, Yuen caused Gemstar to create false and misleading

books and records to support this improper revenue recognition

practice. Yuen substantially assisted in Gemstar’s record-

46 keeping violation, and Rule 13b2-1, by directing the improper

recognition of IPG licensing revenue and approving the shifting

of revenues on Gemstar’s books from one advertising platform to

another, in order to recognize IPG advertising revenue.”).

Because the SEC’s allegations do not describe conduct by

Patel sufficiently to establish a causal link to the alleged

falsification of Enterasys’s books, records, and accounts, the

SEC has failed adequately to allege facts that would subject him

to liability as an aider and abettor of Enterasys’s primary

violation of Exchange Act section 13(b)(2)(A). Accordingly,

Patel is entitled to dismissal of Count VII.

Count VIII

In Count VIII, the SEC claims that defendants aided and

abetted Enterasys in violating Exchange Act section 13(b)(2)(B),

which requires any company that issues securities to “devise and

maintain a system of internal accounting controls” that meets

certain specified standards. See 15 U.S.C. § 78m(b)(2); see also

SEC v . Dauplaise, N o . 6:05CV1391 ORL 31KRS, 2006 WL 449175, at *9

(M.D. Fla. Feb. 2 2 , 2006) (footnote omitted) (describing the

characteristics of a system of internal accounting controls).

Patel moves to dismiss Count VIII, arguing that the SEC’s

complaint does not adequately plead: (1) scienter; (2) general

47 awareness of impropriety; (3) knowledge of falsity; or (4)

substantial assistance in the allegedly fraudulent scheme.

While the SEC objects to dismissal of Count VIII, it does

not point to any factual allegations in the complaint concerning

Enterasys’s system of internal accounting controls, and it does

not point to any factual allegations concerning Patel’s role in

establishing or administering any such system. The pleadings in

this case have much in common with those found deficient in

Dauplaise:

The SEC alleges that Bio One failed to devise or maintain the required system of internal accounting controls, and that Shinder aided and abetted that violation. There are no allegations linking Shinder to this violation. Indeed, Shinder is not even mentioned in the background section of the Complaint specifically addressing this violation. Therefore the SEC has failed to state a claim against Shinder for a violation of Section 13(b)(2)(B).

2006 WL 449175, at * 9 . Here, the complaint does not even have a

background section devoted to the SEC’s section 13(b)(2)(B)

claim. In any event, the SEC has failed to adequately allege

either a primary violation of section 13(b)(2)(B) by Enterasys or

conduct by Patel that was a proximate cause of any such

violation. Accordingly, Patel is entitled to dismissal of Count

VIII. Compare SEC v . Cedric Kushner Promotions, Inc., 417 F.

Supp. 2d 326, 337 (S.D.N.Y. 2006) (granting summary judgment to

48 defendant on section 13(b)(2)(B) aider and abettor claim when

plaintiff produced no evidence that defendant “was responsible

for . . . maintaining adequate controls, or that he aided or

abetted any violation with respect to [that] requirement[ ]”) and

Marsden v . Select Med. Corp., N o . Civ.A. 04-4020, 2006 WL 891445,

at *15 (E.D. P a . Apr. 6, 2006) (granting motion to dismiss

section 13(b)(2)(B) claim because “[p]laintiffs fail[ed] to

connect the litany of alleged wrongdoings to any control or type

of control that, if properly established, would have prevented

the same”), vacated in part on other grounds, 2007 WL 518556

(E.D. P a . Feb. 1 2 , 2007); with Thielbar, 2007 WL 2903948, at *10

(denying motion to dismiss section 13(b)(2)(B) aider and abettor

claim when complaint “contained several allegations regarding

[defendant]’s conduct in . . . circumventing or failing to

implement internal accounting controls”) and SEC v . Intelliquis

Int’l, Inc., N o . 2:02-CV-764 PGC, 2003 WL 23356426, at *13

(granting summary judgment to SEC on section 13(b)(2)(B) aider

and abettor claim where complaint adequately alleged primary

violation, alleged that one defendant permitted company to record

certain transactions as sales while knowing that they did not

qualify as such, and alleged that second defendant, retained to

audit financial statements, “essentially abandoned all

responsibility for this job”).

49 Conclusion

For the reasons given, Patel’s motion to dismiss (document

n o . 68) is granted, but without prejudice. See Daou Sys., 411

F.3d at 1028 (explaining that when a claim is dismissed for

failing to satisfy Rule 9 ( b ) , the court “should ordinarily

accepted a proffered amendment that either pleads with the

requisite particularity or drops the defective allegations and

still states a claim”).

SO ORDERED.

s/even J. McAuliffe 'S hief Judge

March 24, 2008

cc: James A. Scoggins, II, Esq. Jeffrey S. Lyons, Esq. Leslie J. Hughes, Esq. Nancy J. Gegenheimer, Esq. Diana K. Lloyd, Esq. John R. Baraniak, Jr., Esq. Lucy J. Karl, Esq. Peter B. Moores, Esq. Steven M. Gordon, Esq. Jeffrey B. Rudman, Esq. Jonathan A. Shapiro, Esq. Miranda Hooker, Esq. Peter A. Spaeth, Esq. Bruce A. Singal, Esq. John C. Kissinger, Esq. Michelle R. Peirce, Esq. Mark B. Dubnoff, Esq. Richard J. McCarthy, Esq. Michael D. Ramsdell, Esq.

50 Jennifer M . Ryan, Esq. Maria R. Durant, Esq. William H . Kettlewell, Esq. Kevin E . Sharkey, Esq. Ann Pauly, Esq. Victor W . Dahar, Esq. Andrew Good, Esq. Philip G. Cormier, Esq. Peter D. Anderson, Esq. William Cintolo, Esq.