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Palladin Partners v. Gaon

August 22, 2006

PALLADIN PARTNERS; PALLADIN OVERSEAS FUND, LTD.; PALLADIN MULTI-STRATEGY PARTNERS, LP; CHEYENNE LLC; PALLADIN OPPORTUNITY FUND, LLC; AND PALLADIN OVERSEES MULTI-STRATEGY FUND, LTD.; PLAINTIFFS,
v.
ISAAC J. GAON, RAYMOND R. KOCH, MARK J. HIRSHHORN, WILLIAM J. ADAMS, DAVID M. MILCH, ROBERT H. FRIEDMAN, WALTER GROSSMAN, MARK BERENBLUT, OLIVER MAGGARD, AND DELOITTE & TOUCHE LLP, DEFENDANTS.



The opinion of the court was delivered by: William J. Martini, U.S.D.J.

OPINION

TABLE OF CONTENTS

I. BACKGROUND .......................................................................................................................1

A. Factual Background.....................................................................................................1

B. Alleged Fraudulent Schemes......................................................................... ..............3

ii. Gross Profit Margin Inflating and Failure to Recognize Losses ......................4

iii. IBM Credit and IBM Global Interrelationship ................................................6

C. Alleged Misstatements and Omissions ......................................................................7

D. Defendants' Liability ..................................................................................................8

II. ANALYSIS ..............................................................................................................................8

A. Standard of Review .....................................................................................................8

B. Service of Process ........................................................................................................9

C. Section 10(b) Claims .................................................................................................10

i. Confidential Witness .........................................................................................12

ii. Failure to Plead Fraud with Particularity.......................................................12

a. Executive Defendants ...........................................................................14

iii. Failure to Plead Misstatements or Omissions ................................................13

1. Impermissible Group Pleading ................................................14

b. Deloitte & Touche ................................................................................17

2. Misstatements Not Actionable..................................................15

iv. Failure to Plead Reliance ...............................................................................17

a. Executive Defendants ...........................................................................19

b. Director Defendants .............................................................................20

1. Actual Knowledge of Fraud .....................................................21

2. Inference of Scienter ................................................................22

c. Deloitte & Touche ................................................................................26

a. Executive Defendants ...........................................................................27

b. Deloitte & Touche ................................................................................28

v. Failure to Plead Scienter with Particularity ....................................................18

vi. Failure to Plea Loss Causation ......................................................................27

D. Section 20(a) Claims ..................................................................................................29

E. Common Law Claims ................................................................................................31

i. Martin Act Does Not Bar Claims ......................................................................31

ii. Breach of Fiduciary Duty ................................................................................32

iii. Negligent Misrepresentation ..........................................................................34

iv. Fraudulent Conveyance ..................................................................................35

III. CONCLUSION ....................................................................................................................35

This matter comes before the Court on four motions to dismiss the Amended Complaint ("Complaint" or "Compl.") pursuant to Federal Rules of Civil Procedure 12(b)(6), 9(b), and the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u-(b)(1). These motions have been filed by all Defendants. There was no oral argument. Fed. R. Civ. P. 78. For the reasons set forth below, the motions are GRANTED in part and DENIED in part.

I. BACKGROUND

A. Factual Background

Plaintiffs are five funds that provided secured financing in the amount of $4.9 million to Datatec Systems, Inc. ("Datatec" or "the Company"), a computer networking company that ultimately went bankrupt. Datatec, a non-party, was a publicly traded Delaware corporation headquartered in New Jersey and provided services installing wiring for and configuring computer networking systems.

Pursuant to a Note Purchase Agreement and related agreements, on July 3, 2003, Plaintiffs collectively lent Datatec $4.9 million in return for Notes in that amount and 875,000 Warrants. On July 28, 2003, Plaintiffs made an additional investment in Datatec, extending Datatec's time to repay the Notes, waiving various rights, and receiving an additional 700,000 Warrants.

Unfortunately, later that year, on December 5, 2003, Datatec retracted its previous earnings estimates for 2004 and announced an expected loss not simply for the second quarter of fiscal 2004 but for the year overall. It further announced that Defendant Gaon, Datatec's CEO, had resigned and that Defendant Director Berenblut had stepped down from his position. The price of Datatec's stock fell 34% following these disclosures.

Next, on December 17, 2003, Datatec quantified an expected second quarter loss of approximately $10 million and announced that it expected to take a restructuring charge of $4.5 million in the next fiscal year. In addition, it disclosed that it had retained outside counsel to conduct an independent audit of the valuation of its long-term contracts. Datatec additionally disclosed that IBM Credit, through which Datatec had been receiving loans, had refused to issue waivers for Datatec's most recent defaults. Datatec's stock dropped another 15% following these disclosures, and its stock was de-listed by NASDAQ shortly thereafter for failure to file a 10-Q for the quarter ended October 31, 2003.

On August 12, 2004, Datatec announced that in the course of reviewing its revenue recognition policies, it found that it had overstated revenues by up to $18 million over prior periods, that up to $10 million in losses previously thought to occur in 2004 actually required recognition in earlier periods, and that its losses for those earlier periods had been understated by about $10 million. The Company further stated that its previous SEC filings and financial statements for the periods ended 2003, 2002, and 2001-including 2002 and 2003 periodic, quarterly and annual reports-"should not be relied upon by investors." (Form 8-K filed 8/12/04.) In December 2004, Datatec filed for bankruptcy, defaulted on the Notes, and the Warrants Plaintiffs received for their investments were rendered worthless.

On June 30, 2005, Plaintiffs filed this suit under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 ("the Act"), 15 U.S.C. §§ 78j(b), 78t(a), 78r, and Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder. Defendants are Isaac J. Gaon ("Gaon"), Datatec's Chairman and CEO during the period in question; Raymond R. Koch ("Koch"), Datatec's Chief Operating Officer during the period in question; Datatec's outside directors William J. Adams, Jr. ("Adams"), David M. Milch ("Milch"), Robert H. Friedman ("Friedman"), Walter Grossman ("Grossman"), Mark L. Berenblut ("Berenblut"), and J. Oliver Maggard ("Maggard"); and the Company's independent accountant Deloitte and Touche LLP ("D&T"). Hereinafter, Gaon ...


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