Dalton Petrie v. Electronic Game Card, Inc.

FOR PUBLICATION

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

DALTON PETRIE, individually and on No. 12-55620

behalf of all others similarly

situated, D.C. No.

Plaintiff, 8:10-cv-00252-

DOC-RNB

and

DR. THOMAS LEE; MARGARET YU; OPINION

SCOTT LOVELL,

Appellants,

v.

ELECTRONIC GAME CARD, INC.; LEE

J. COLE; LINDEN BOYNE; KEVIN

DONOVAN; PAUL FARRELL; EUGENE

CHRISTIANSEN; ANNA HOUSSELS;

LYNNE ROCHELLE ATTIAS;

JONATHAN STEINBERG, as Executor

of the Estate of Lord Leonard

Steinberg,

Defendants-Appellees.

Appeal from the United States District Court

for the Central District of California

David O. Carter, District Judge, Presiding

Argued and Submitted

December 4, 2013—Pasadena, California

2 PETRIE V. ELECTRONIC GAME CARD, INC.

Filed July 30, 2014

Before: Harry Pregerson and Morgan Christen, Circuit

Judges, and Roslyn O. Silver, Senior District Judge.*

Opinion by Judge Christen

SUMMARY**

Securities Fraud

Reversing the district court’s dismissal of an action under

§§ 10(b) and 20(a) of the Securities Exchange Act against

officers and directors of Electronic Game Card, Inc., the

panel held that the court did not properly strike portions of

the third amended complaint and that the complaint

adequately pleaded false statements and scienter.

The panel held that the stricken allegations were not

based on discovery obtained in violation of the Private

Securities Litigation Reform Act, which provides that all

discovery shall be stayed during the pendency of a motion to

dismiss, where the discovery materials were subpoenaed

before the defendant former chief executive officer gave

notice of his intent to file a motion for judgment on the

pleadings. The panel held that a party does not violate a

*

The Honorable Roslyn O. Silver, Senior District Judge for the U.S.

District Court for the District of Arizona, sitting by designation.

**

This summary constitutes no part of the opinion of the court. It has

been prepared by court staff for the convenience of the reader.

PETRIE V. ELECTRONIC GAME CARD, INC. 3

PSLRA discovery stay by relying on materials provided by a

third party pursuant to a valid subpoena issued when no

PSLRA discovery stay was in effect.

The panel held that with the stricken allegations, the third

amended complaint adequately pleaded falsity and scienter.

The panel remanded the case for further proceedings.

COUNSEL

Laurence M. Rosen (argued), The Rosen Law Firm, New

York, New York, for Appellants.

Michael L. Cypers (argued), Crowell & Moring, Los Angeles,

California; Ethan P. Shulman, Crowell & Moring, San

Francisco, California, for Defendant-Appellee Linden Boyne.

Lawrence B. Steinberg, Buchalter Nemer, Los Angeles,

California; Jeffrey J. Greenbaum and Hervé Gouraige, Sills

Cummis & Gross, Newark, New Jersey, for Defendant-

Appellee Lee Cole.

Jonathan D. Cogan (argued), Steven G. Kobre, and Andrew

M. Meehan, Kobre & Kim, New York, New York;

Christopher Kim, Bryan Sheldon, and Lisa J. Yang, Lim,

Ruger & Kim, Los Angeles, California, for Defendants-

Appellees Kevin Donovan, Eugene Christiansen, Paul Farrell,

Anna Houssels, Lynne Rochelle Attias, and Jonathan

Steinberg.

4 PETRIE V. ELECTRONIC GAME CARD, INC.

OPINION

CHRISTEN, Circuit Judge:

Electronic gaming has become ubiquitous; even slot

machines are now made to operate at the push of a button

rather than the pull of a lever. Electronic Game Card, Inc. set

out to further this trend by producing electronic “scratch off”

devices for casinos, lotteries, and other gaming

establishments. The company appeared to be flying high,

with millions of dollars in reported assets as late as

September 2009. But a little over a year later, Electronic

Game Card, Inc. filed for bankruptcy and reported it was

broke.

A group of investors filed suit, alleging that the

company’s former Chief Executive Officer and Chief

Financial Officer violated section 10(b) of the Securities

Exchange Act, and that others violated section 20(a) of the

Act. The Private Securities Litigation Reform Act of 1995

(PSLRA) provides that “all discovery . . . shall be stayed

during the pendency of any motion to dismiss” in a private

securities litigation action. 15 U.S.C. § 78u-4(b)(3)(B). The

complaint at issue in this appeal, the Third Amended

Complaint, was based in large part on discovery materials

subpoenaed before the company’s former CEO gave notice of

his intent to file a motion for judgment on the pleadings.

These materials were not received until after the CEO gave

such notice.

The questions we must decide are: (1) whether the district

court properly struck allegations and exhibits from the Third

Amended Complaint because they were based on discovery

obtained in violation of a PSLRA discovery stay; and

PETRIE V. ELECTRONIC GAME CARD, INC. 5

(2) whether the Third Amended Complaint adequately

pleaded false statements and scienter. For the reasons

explained below, we reverse the district court’s judgment

dismissing this action and remand for further proceedings.

BACKGROUND

In September 2010, the lead plaintiffs (Investors),

appellants here, filed a First Amended Complaint (FAC)

alleging violations of section 10(b) of the Securities

Exchange Act of 1934 by defendants-appellees Lee Cole and

Linden Boyne, and violations of section 20(a) of the Act by

all remaining defendants-appellees. Cole and Boyne are the

former CEO and CFO, respectively, of Electronic Game

Card, Inc. (Company)1. The other individual defendants-

appellees served as Company executives, on its board of

directors, or both.2 Section 10(b) prohibits securities fraud by

use of deceptive and manipulative practices. 15 U.S.C. § 78j;

17 C.F.R. § 240.10b-5. Section 20(a) makes “control

persons” liable for violations of other rules or regulations

under the Act, including securities fraud. 15 U.S.C. § 78t(a).

According to Investors, until 2010 the Company owned

all shares of a subsidiary called Electronic Game Card, Ltd.

(Subsidiary) that operated in the United Kingdom and

Europe. The Subsidiary played an essential role in the

Company’s business. In fact, Investors alleged that “nearly

1

We use “Company” to refer to both Electronic Game Card, Inc., a

Nevada corporation, and its previous iteration as a Delaware corporation.

2

This opinion refers to members of this second group of defendants-

appellees as “Control Persons.”

6 PETRIE V. ELECTRONIC GAME CARD, INC.

all of the Company’s reported revenues and income were

derived from” the Subsidiary.

Under the purported terms of a 2002 agreement through

which the Company acquired all shares of the Subsidiary, if

the Company attempted to “change the Memorandum or

Articles or other governing instruments of [the Subsidiary],”

“change the number of persons constituting the Board of

Directors of [the Subsidiary],” or “change the persons

constituting the Board of Directors of [the Subsidiary],” a

default would be declared and the shares would revert to the

original owners.3

In 2009, Control Persons Kevin Donovan and Eugene

Christiansen assumed control of the Company in place of

Cole and Boyne. The record indicates substantial infighting

during this period. Under new leadership, the Company

removed the Subsidiary’s board, causing ownership of the

Subsidiary’s stock to revert back to its original owner

sometime in early 2010.

In February 2010, the Company announced that its

auditor, Mendoza Berger & Company (Auditor), had

withdrawn its audit opinions of the Company’s financial

statements for fiscal years 2006 to 2008 after becoming

“aware of irregularities in the audit confirmation of a bank

account represented . . . as having been held by [the

Subsidiary].” In May 2010, the Company publicly

announced that these financial statements should no longer be

relied upon because of “significant concerns as to the[ir]

3

The agreement was amended in 2006 in a manner that did not affect

the relevant terms at issue in this case. This opinion refers to both the

agreement and amendment collectively as the “2002 Agreement.”

PETRIE V. ELECTRONIC GAME CARD, INC. 7

integrity.” The Company’s announcement revealed that it

was “concerned that reported revenue may be materially

overstated and that the reported carrying value of its assets

and investments in third-party companies may not be fairly

stated.” Investors alleged that the withdrawal of the

Company’s financial statements and related information in its

annual reports filed with the SEC demonstrated that these

statements were false when made. They also alleged that the

“highly adverse fact” that the Company could lose ownership

of the Subsidiary was hidden from them, “rendering [its]

statements about its ownership of [the Subsidiary], its assets

and revenue stream, materially false and misleading.”

Control Persons moved to dismiss the FAC, and the

district court granted the motion, in part. It dismissed the

10(b) claims against Control Persons, but it did not dismiss

the 20(a) claims. The court ruled that Investors had

adequately pleaded a primary 10(b) violation by the

Company, as well as each moving defendant’s status as a

control person. The court also concluded that Investors

adequately pleaded the Company’s scienter—a prerequisite

to finding a violation of section 10(b)—through its

allegations relating to Cole and Boyne. The court observed:

“none of the Moving Defendants contest the notion that the

[FAC] contains viable allegations of Boyne’s and Cole’s

scienter, which may be imputed to [the Company].” But Cole

and Boyne had not answered the FAC by this point in the

litigation. From the record available on appeal, it appears

they lived abroad and had not been served with the FAC at

the time of the district court’s ruling.

Investors filed their Second Amended Complaint (SAC)

in February 2011. It alleged 10(b) violations by all

defendants except Control Persons Christiansen, Farrell, and

8 PETRIE V. ELECTRONIC GAME CARD, INC.

Houssels, and 20(a) violations against all individual

defendants.

Both the FAC and SAC made substantially similar factual

and legal allegations as to the primary 10(b) violations. In

particular, Investors alleged that the Company and its

management made false statements concerning the

Company’s ownership of the Subsidiary, and that the

subsequent retraction of the Auditor’s opinions shows that the

Company’s public financial statements were false over

several years.4

These basic factual allegations of the Company’s scienter

were not initially challenged by the defendants. After the

district court ruled on Control Person Donovan’s motion to

dismiss the SAC, it set a schedule for discovery, and on June

23, 2011, Investors commenced discovery by issuing a third-

party subpoena to the Company’s Auditor. The subpoena

was returnable on July 25, 2011.

At some point after filing the SAC, Investors managed to

contact Cole, and he agreed to answer the Investors’

allegations. On August 8 or 9, 2011, Cole’s counsel notified

Investors of his intent to file a motion for judgment on the

pleadings. In Cole’s opinion, this notification gave rise to a

stay of discovery under the PSLRA, but Investors

communicated their disagreement with the contention that a

PSLRA discovery stay was in effect.

4

A copy of the 2002 Agreement was not provided to Investors until after

the SAC was filed, but Investors were aware from the outset of the

litigation of the existence of an agreement that caused ownership of the

subsidiary “to revert or transfer to a third party.”

PETRIE V. ELECTRONIC GAME CARD, INC. 9

On August 22, 2011, Investors received materials from

the Auditor in response to their previously-issued discovery

requests. Cole filed a motion for judgment on the pleadings

shortly thereafter, along with a motion to confirm the

existence of a PSLRA discovery stay, and Boyne filed a

motion to dismiss. The district court granted both dispositive

motions without prejudice and denied as moot Cole’s motion

to confirm the existence of a discovery stay.

The Third Amended Complaint (TAC) was filed in

November 2011, and it presents a substantially more detailed

and unified account of the alleged misfeasance by Cole and

Boyne. Specifically, the TAC alleges that Cole and Boyne

actively concealed the existence of the 2002 Agreement from

the Auditor, and perhaps from the Company’s board as well.5

In support of their earlier efforts to have the SAC dismissed,

Cole and Boyne argued that the board knew about the 2002

Agreement, and Boyne pointed to the minutes of a February

1, 2006 board meeting at which the agreement was

supposedly discussed. But Cole and Boyne were the only two

directors listed as “present” for this meeting, and the TAC

asserts that Cole and Boyne either concealed or fabricated

these minutes. In support of this contention, the TAC alleges

that while Cole and Boyne claimed to have provided the

Auditor with all Company board minutes for 2006, discovery

from the Auditor did not include the February 1 minutes,

5

The parties dispute whether the existence of the 2002 Agreement was

disclosed to Control Persons prior to the change in the Subsidiary’s board.

We need not decide this issue, though we note that there is no explanation

in the record why the Company’s leadership would willingly follow a

course (changing the Subsidiary’s board) that would cut off most of the

Company’s revenue, if the Company’s leadership had known the terms of

the 2002 Agreement.

10 PETRIE V. ELECTRONIC GAME CARD, INC.

despite including minutes for other board meetings around the

same time.

The TAC also alleges the Company was able to report

millions of dollars in cash and cash equivalents at the end of

fiscal years 2006, 2007, and 2008 because its financial

statements were wrongfully consolidated with its

Subsidiary’s. Allegedly, much of this cash was represented

to the Auditor as being held in a bank account with Credit

Suisse in Gibraltar, Spain that was controlled by the

Company and its Subsidiary.

Relying on the newly-acquired Auditor discovery

materials, the TAC claims that the multi-million dollar

Gibraltar account never existed. Discovery materials

obtained from the Auditor and appended as exhibits to the

TAC include allegedly false bank audit confirmations and

bank statements on Credit Suisse stationary, which appear to

bear Boyne’s signature.6 The TAC alleges that these forms

also bear forged bank employee signatures and a fabricated

address for a Credit Suisse “Audit Confirmation Unit” in

Malaga, Spain. The exhibits, if authentic and accurate, would

be consistent with Investors’ theory that false representations

concerning the Company’s finances began when Cole and

Boyne were CEO and CFO of the Company, respectively, and

continued while Boyne remained CFO. The TAC alleges that

forms were sent in Credit Suisse’s name to the Auditor in

6

We generally consider exhibits attached to a complaint and

incorporated by reference to be part of the complaint. See Swartz v.

KPMG LLP, 476 F.3d 756, 763 (9th Cir. 2007). Defendants-appellees do

not argue that the exhibits to the TAC may not be considered on any basis

other than their argument that the materials incorporated therein were

obtained in violation of the PSLRA discovery stay.

PETRIE V. ELECTRONIC GAME CARD, INC. 11

order to falsely confirm the existence of bank accounts

represented as the Company’s or the Subsidiary’s.

The TAC alleges that these falsified confirmations were

the reason the Company’s Auditor withdrew its audit

opinions for fiscal years 2006, 2007, and 2008. In support of

this allegation, the TAC includes an exhibit that purports to

be a letter from Credit Suisse stating that a bank account

represented by Boyne as belonging to the Company in fact

belonged solely to Cole and Boyne, not the Company.

Another exhibit appears to be a letter Credit Suisse

subsequently wrote to Control Person Donovan (who had

become the Company’s new CEO) stating that the bank

would be reporting the matter to the Royal Gibraltar Police

and advising the Company to do the same.

Investors allege that the dramatic shift in the Company’s

fortunes, illustrated by the withdrawal of the audit opinions,

was principally explained by its loss of the Subsidiary in

2010. They allege that, had the Auditor known the Company

could lose ownership of the Subsidiary under the terms of the

2002 Agreement, it would not have allowed the Company’s

and Subsidiary’s financial reports to be consolidated because

this would have been contrary to generally accepted

accounting principles (GAAP).7 Investors claim that Cole

7

The TAC cites a provision of GAAP that reads:

A majority-owned subsidiary shall not be consolidated

if control is likely to be temporary or if it does not rest

with the majority owner (as, for instance, if the

subsidiary is in legal reorganization or in bankruptcy or

operates under foreign exchange restrictions, controls,

or other governmentally imposed uncertainties so

12 PETRIE V. ELECTRONIC GAME CARD, INC.

and Boyne concealed the existence of the 2002 Agreement

from the Company’s Auditor because the agreement’s

restrictions on changing the Subsidiary’s board and articles of

association deprived the Company of its ability to exercise

control, and that this limitation, in turn, made the

consolidation of the Company’s financial statements with the

Subsidiary’s inappropriate under GAAP. The TAC alleges

that the Company’s consolidated financial statements were

therefore “false,” and that as a result of this alleged pattern of

fraud, Investors lost the entire value of their investment when

the value of the Company’s stock collapsed. Cole responded

to the TAC by filing a motion to strike several of its exhibits,

and to strike allegations in the TAC that were derived from

the Auditor discovery materials. Cole, Boyne, and Control

Persons filed motions to dismiss the TAC.

The district court ruled that a discovery stay arose

automatically on August 8 or 9 pursuant to the PSLRA, when

Cole announced his intent to file a motion for judgment on

the pleadings. The court opined that Investors “should have

immediately ceased all discovery” at that point.

Acknowledging that motions to strike pleadings are

disfavored, the court nonetheless ruled that Investors “cannot

be permitted to openly flaunt a direct violation of the

PSLRA.” Under Federal Rule of Civil Procedure 12(f), the

court struck the portions of the TAC referring to or relying

upon the Auditor discovery materials, in light of its

severe that they cast significant doubt on the parent’s

ability to control the subsidiary).

Research and Dev. Arrangements, Statement of Fin. Accounting Standards

No. 94, § 13 (Fin. Accounting Standards Bd. 1987).

PETRIE V. ELECTRONIC GAME CARD, INC. 13

conclusion that the materials were obtained in violation of the

PSLRA discovery stay.

The district court ultimately ruled: “Without the stricken

allegations, the TAC does not contain sufficient facts to state

a claim for violations of Section 10(b) or Section 20(a) of the

Exchange Act,” and Investors’ allegations did “not

sufficiently allege falsity or scienter to meet the heightened

pleading requirements of the PSLRA.” The district court

dismissed the TAC with prejudice and entered final judgment

in favor of defendants. Investors appealed.8

JURISDICTION AND STANDARD OF REVIEW

We have jurisdiction over this appeal from the district

court’s final order dismissing the action with prejudice under

28 U.S.C. § 1291. We review the district court’s decision to

strike the pleadings under Rule 12(f) for abuse of discretion.

Nurse v. United States, 226 F.3d 996, 1000 (9th Cir. 2000).

We review dismissal of an action under Rule 12(b)(6) de

novo. See Metzler Inv. GMBH v. Corinthian Colls., Inc.,

540 F.3d 1049, 1061 (9th Cir. 2008). We accept the

appellants’ factual allegations as true and construe them in

the light most favorable to the appellants. Id. “Review is

limited to the complaint, materials incorporated into the

complaint by reference, and matters of which the court may

take judicial notice.” Id. (citing Tellabs, Inc. v. Makor Issues

& Rights, Ltd., 551 U.S. 308, 322 (2007)).

8

The Company filed for bankruptcy and did not participate in this

appeal.

14 PETRIE V. ELECTRONIC GAME CARD, INC.

DISCUSSION

I. The Private Securities Litigation Reform Act’s

Discovery Stay Provision

The PSLRA was enacted in 1995 “in response to several

perceived abuses in securities litigation, including discovery

abuses.” SG Cowen Sec. Corp. v. U.S. Dist. Court for N.

Dist. of Cal., 189 F.3d 909, 911 (9th Cir. 1999). The PSLRA

creates heightened pleading requirements for private

securities fraud actions like this one. Metzler, 540 F.3d at

1054–55. In addition, under the heading “Stay of discovery,”

the PSLRA provides:

In any private action arising under this

chapter, all discovery and other proceedings

shall be stayed during the pendency of any

motion to dismiss, unless the court finds upon

the motion of any party that particularized

discovery is necessary to preserve evidence or

to prevent undue prejudice to that party.

15 U.S.C. § 78u-4(b)(3)(B). Our decision in SG Cowen

analyzed this provision. There, we observed that the PSLRA

discovery stay was designed to avoid the “unnecessary

imposition of discovery costs on defendants.” SG Cowen,

189 F.3d at 911 (quoting H.R. Rep. No. 104-369, at 32

(1995), reprinted in 1995 U.S.C.C.A.N. Sess. 730, 731). We

held that the “failure to muster facts sufficient to meet the

Act’s pleading requirements cannot constitute the requisite

‘undue prejudice’ to the plaintiff justifying a lift of the

discovery stay.” Id. at 913. “‘Congress clearly intended that

complaints in these securities actions should stand or fall

based on the actual knowledge of the plaintiffs rather than

PETRIE V. ELECTRONIC GAME CARD, INC. 15

information produced by the defendants after the action has

been filed.’” Id. at 912 (quoting Medhekar v. U.S. Dist. Ct.

for N. Dist. of Cal., 99 F.3d 325, 328 (9th Cir. 1996)). “The

‘Stay of Discovery’ provision of the Act clearly contemplates

that ‘discovery should be permitted in securities class actions

only after the court has sustained the legal sufficiency of the

complaint.’” Id. at 912–13 (quoting S. Rep. No. 104–98, at

14 (1995), reprinted in 1995 U.S.C.C.A.N. 679, 693)

(emphasis in original).

The district court relied on Federal Rule of Civil

Procedure 12(f) when it struck the portions of the TAC that

were based on the Auditor discovery materials. We review

this ruling for abuse of discretion. Nurse, 226 F.3d at 1000.

Rule 12(f) provides: “The court may strike from a pleading an

insufficient defense or any redundant, immaterial,

impertinent, or scandalous matter.” The district court

emphasized (without elaboration) the term “immaterial,”

which suggests that it struck part of the TAC because it

believed the Auditor’s discovery was rendered immaterial by

Investors’ violation of the statutorily-imposed stay.

We have defined “immaterial” as “that which has no

essential or important relationship to the claim for relief or

the defenses being plead.” Fantasy, Inc. v. Fogerty, 984 F.2d

1524, 1527 (9th Cir. 1993) (citation and internal quotation

marks omitted), rev’d on other grounds, 510 U.S. 517 (1994).

Under this definition, even if the incorporation of the Auditor

discovery materials into the TAC was improper, the

discovery would not be “immaterial” under Rule 12(f).

Evidence of forgery and fraud clearly has an “essential or

important relationship” to Investors’ claim for relief in their

securities fraud action. See Fantasy, Inc., 984 F.2d at 1527.

Nor are the discovery materials “redundant,” “impertinent,”

16 PETRIE V. ELECTRONIC GAME CARD, INC.

or “scandalous” as contemplated by Rule 12(f). The district

court may have cited the “immaterial” provision of Rule 12(f)

to signal that it concluded the discovery could not be

considered because it had been obtained in violation of the

PSLRA’s discovery stay, but this interpretation of Rule 12(f)

does not accord with how our court has defined the term

“immaterial.” See id.

We recognize that the district court may have relied on

Rule 12(f) because Congress did not expressly provide a

remedy for violations of the PSLRA stay. Investors do not

offer any convincing argument that the district court would

not have the discretion to sanction a violation of the PSLRA

stay provision, as it would any court-ordered discovery stay.

Cf. Fed. R. Civ. P. 37(b)(2)(A)(iii) (permitting courts to strike

pleadings when a party fails to obey a discovery order). But

because, as discussed below, we decide the Auditor discovery

materials were not obtained in violation of a PSLRA

discovery stay, we do not need to define the contours of the

district court’s authority to strike pleadings obtained in

violation of this type of stay. Even if a PSLRA discovery

stay arose on August 8 or 9 when Cole announced his intent

to file a motion for judgment on the pleadings, such stay

would not have been violated by the use of discovery

received in response to discovery requests properly issued

before any stay arose.

II. Appellants did not violate the PSLRA discovery stay

provision.

The PSLRA requires that “all discovery and other

proceedings shall be stayed” during a pending motion to

dismiss. 15 U.S.C. § 78u-4(b)(3)(B). Defendants argue that

Investors impermissibly obtained the Auditor discovery

PETRIE V. ELECTRONIC GAME CARD, INC. 17

materials in violation of this stay provision. Their theory

depends on the assumption that the PSLRA prevents the use

of discovery that was properly requested, but received after

a stay arose.9

Our decision in SG Cowen makes clear that no discovery

may proceed until the court has sustained the legal

sufficiency of a complaint. 189 F.3d at 912–13. The

Supreme Court recently noted that the PSLRA “permits

defendants to obtain automatic stays of discovery.”

Chadbourne & Parke LLP v. Troice, 134 S. Ct. 1058, 1063

(2014) (emphasis added).10 When an amended complaint is

filed after an earlier complaint has been upheld (at least in

part), the bulk of district courts have ruled that filing a motion

9

Defendants Cole and Boyne also argue that Investors violated Federal

Rule of Civil Procedure 45 by failing to provide timely notice of the

receipt of the Auditor discovery materials. Rule 45 requires a party to

give notice to other parties before service of a subpoena commanding the

production of documents. Defendants cite no authority holding that notice

must be given upon receipt of discovery when prior notice of the subpoena

was properly provided. Aside from the fact that the district court did not

strike portions of the TAC pursuant to Rule 45, this argument fails

because it appears Investors did provide such notice to all defendants who

had appeared in the action as of the time the subpoena was issued.

10

Most district courts that have directly addressed the question have

recognized that a PSLRA discovery stay arises automatically, without the

need for judicial declaration, upon the filing of a dispositive motion. See,

e.g., In re Am. Funds Sec. Litig., 493 F. Supp. 2d 1103, 1104 (C.D. Cal.

2007); Sedona Corp. v. Ladenburg Thalmann, No. 03 CIV. 3120

LTSTHK, 2005 WL 2647945, at *3 (S.D.N.Y. Oct. 14, 2005). But see

Lane v. Page, No. CIV 06-1071 JB/ACT, 2009 WL 1312896, at *1

(D.N.M. Feb. 9, 2009) (“The Court interprets the PSLRA to require the

Court to stay discovery while a motion to dismiss is pending, but does not

read the statute to automatically stay the case upon the filing of a

motion.”).

18 PETRIE V. ELECTRONIC GAME CARD, INC.

to dismiss the amended complaint also triggers a stay of any

discovery. See, e.g., Fosbre v. Las Vegas Sands Corp., No.

2:10-CV-00765-KJD-GWF, 2012 WL 5879783, at *3 (D.

Nev. Nov. 20, 2012) (“[I]t is proper to impose the stay of

discovery pending the decision on the motion to dismiss the

Second Amended Complaint, notwithstanding that the parties

engaged in discovery prior to its filing.”); McGuire v.

Dendreon Corp., No. C07-800-MJP, 2009 WL 666863 (W.D.

Wash. Mar. 11, 2009); In re Smith Barney Transfer Agent

Litig., No. 05 Civ. 7583 WHP, 2012 WL 1438241, at *2

(S.D.N.Y. Apr. 25, 2012); Sedona Corp., 2005 WL 2647945,

at *3; cf. In re Lantronix, Inc. Sec. Litig., No. CV 02-03899

PA, 2003 WL 22462393, at *2 (C.D. Cal. Sept. 26, 2003)

(refusing to lift stay even when defendant did not challenge

part of plaintiffs’ claim). Nonetheless, assuming that a

discovery stay arose when Cole gave notice of his intent to

file a motion for judgment on the pleadings, we do not read

the statute to have retroactive application; that is, the

admonition that “all discovery and other proceedings shall be

stayed during the pendency of any motion to dismiss” does

not prohibit a party from accepting third-party responses to

properly-issued requests for written discovery.

The common sense reading of the PSLRA’s plain

language “all discovery and other proceedings shall be

stayed” is that no litigant shall take any steps in pursuit of

discovery during the pendency of any motion to dismiss.11

11

The parties do not distinguish between motions to dismiss and

motions for judgment on the pleadings. We therefore assume the PSLRA

discovery stay provision is triggered by a motion for judgment on the

pleadings in the same manner it is trigger by a motion to dismiss. Cf.

Harris v. Cnty. of Orange, 682 F.3d 1126, 1132 (9th Cir. 2012) (internal

citation omitted) (a motion for judgment on the pleadings is the functional

equivalent of a motion to dismiss).

PETRIE V. ELECTRONIC GAME CARD, INC. 19

There is no indication that Investors did so here. Instead, on

June 6, 2011, after the district court had ruled on the first

dispositive motions and upheld part of the FAC, the court

issued a scheduling order allowing the parties to proceed with

discovery. Neither Cole’s counsel nor any other party

represented at the June 6 scheduling conference objected to

the district court’s proposed schedule. The parties (except

Boyne) subsequently exchanged initial disclosures consistent

with the scheduling order, and no party argues on appeal that

the scheduling order was improperly entered. Furthermore,

it is undisputed that there was no dispositive motion

pending—and therefore no discovery stay in effect—as of

June 23, 2011, when Investors subpoenaed records from the

Company’s Auditor. No party objected to the subpoena at

that time, and Cole did not notify Investors of his intent to file

a motion for judgment on the pleadings until August 8 at the

earliest. The subpoena to the Auditor was therefore properly

issued, and the only question here is whether Investors could

permissibly rely on tardy discovery responses, delivered to

them after a PSLRA discovery stay allegedly came into effect

again.

We would expect that if Congress intended a PSLRA

discovery stay to prohibit the use of documents received in

response to previously-issued discovery requests, it would

have said so explicitly. The determinative fact for this appeal

is that Investors subpoenaed the Auditor’s records pursuant

to the district court’s discovery schedule at a time when no

motion to dismiss was pending. The PSLRA was enacted to

reform “abusive practices committed in private securities

litigation.” H.R. Rep. No. 104-369, at 31 (1995), reprinted in

1995 U.S.C.C.A.N. 730, 730. In arguing that Investors

engaged in abusive practices, defendants rely heavily on our

decision in SG Cowen, which noted that “discovery should be

20 PETRIE V. ELECTRONIC GAME CARD, INC.

permitted in securities class actions only after the court has

sustained the legal sufficiency of the complaint.” 189 F.3d at

912–13 (citation and internal quotation marks omitted)

(emphasis in original). But here, the district court did sustain

the sufficiency of the complaint, and it initially allowed

discovery to proceed pursuant to its discovery scheduling

order. None of the defendants objected to this scheduling

order. Even on appeal, no party has asked us to hold that a

district court may not allow discovery in a securities class

action case when a prior complaint has been upheld as to

some parties and no motion to dismiss is pending or

anticipated, simply because the court has not expressly

upheld every part of the complaint as to all parties. This

record does not show that Investors engaged in abusive

practices or violated a statutory stay.

Defendants contend that Investors violated the stay by

incorporating some of the Auditor discovery materials into

the TAC. The purpose of the PSLRA would not be furthered

by the broad reading of the discovery stay provision that

defendants-appellees advocate. The discovery stay was

intended to prevent discovery abuses such as the

“unnecessary imposition of discovery costs on defendants,”

particularly as a means to coerce settlement. SG Cowen,

189 F.3d at 911 (quoting H.R. Rep. No. 104–369, at 32

(1995), reprinted in 1995 U.S.C.C.A.N. 730, 731). Discovery

costs may also affect third parties like the Company’s

Auditor. But if the Auditor was concerned about the costs of

complying with the subject subpoena, it did not object, nor

did it argue that a discovery stay was in effect such that it

PETRIE V. ELECTRONIC GAME CARD, INC. 21

should be relieved of the obligation to respond.12 Similarly,

if defendants believed Investors’ subpoenas were issued

improperly, they could have sought immediate relief from the

court. They did not do so, and we see no basis for such an

objection; defense counsel conceded at oral argument before

our court that no discovery stay was in place when the June

23 subpoena was issued to the Auditor.13

If the receipt of discovery was not a violation of the

PSLRA, surely the use of the discovery materials in the TAC

was not prohibited. The mere reliance on validly-obtained

materials is not an abusive practice, nor does it impose

unnecessary discovery costs on defendants. We hold that a

party does not violate a PSLRA discovery stay by relying on

materials provided by a third-party pursuant to a valid

subpoena issued when no PSLRA discovery stay was in

effect. Because we conclude that Investors did not violate the

PSLRA, we reverse the district court’s order striking portions

of the TAC that incorporated the Auditor discovery materials.

12

Faulkner v. Verizon Commc’ns, Inc., 156 F. Supp. 2d 384 (S.D.N.Y.

2001), cited by defendants, is distinguishable on this basis. In Faulkner,

a third party objected to discovery, and the court refused to lift an existing

PSLRA discovery stay to allow plaintiffs to enforce their subpoena. Id.

at 401–06.

13

Defendants cite Anderson v. First Sec. Corp., 249 F. Supp. 2d 1256

(D. Utah 2002) in support of their argument that plaintiffs may not use

discovery materials obtained when a stay is in effect, but Anderson is

distinguishable. There, plaintiffs violated a specific court order intended

to preserve a PSLRA stay that was undeniably in place. Id. at 1272.

22 PETRIE V. ELECTRONIC GAME CARD, INC.

III. The TAC adequately pleads falsity and scienter.

We now consider whether the full TAC—including the

portions the district court struck pursuant to Rule

12(f)—adequately pleads falsity and scienter as to defendants

Cole and Boyne.

We review the dismissal of a complaint pursuant to

12(b)(6) de novo. Metzler, 540 F.3d at 1061. “The required

elements of a private securities fraud action are: (1) a material

misrepresentation or omission of fact, (2) scienter, (3) a

connection with the purchase or sale of a security,

(4) transaction and loss causation, and (5) economic loss.”

Id. (internal quotations omitted). “[T]he complaint shall

specify each statement alleged to have been misleading, the

reason or reasons why the statement is misleading, and, if an

allegation regarding the statement or omission is made on

information and belief, the complaint shall state with

particularity all facts on which that belief is formed.” 15

U.S.C. § 78u–4(b)(1). “For a misrepresentation to be

material, there must be a substantial likelihood that the

disclosure of the omitted fact would have been viewed by the

reasonable investor as having significantly altered the ‘total

mix’ of information made available.” S.E.C. v. Todd, 642

F.3d 1207, 1215 (9th Cir. 2011) (citation and internal

quotation marks omitted).

A complaint alleging securities fraud must raise a “strong

inference” of scienter. Metzler, 540 F.3d at 1061. To

sufficiently plead scienter, “the complaint must allege that the

defendants made false or misleading statements either

intentionally or with deliberate recklessness.” In re Daou

Sys., Inc., 411 F.3d 1006, 1015 (9th Cir. 2005) (citation

omitted). “[T]he danger of misleading buyers must be

PETRIE V. ELECTRONIC GAME CARD, INC. 23

actually known or so obvious that any reasonable man would

be legally bound as knowing.” In re VeriFone Holdings, Inc.

Sec. Litig., 704 F.3d 694, 702 (9th Cir. 2012) (internal

quotation marks and emphasis omitted). A “strong inference”

of scienter is “more than merely plausible or reasonable—it

must be cogent and at least as compelling as any opposing

inference of nonfraudulent intent.” Tellabs, 551 U.S. at 314.

While motive is helpful in establishing scienter, “the absence

of a motive allegation is not fatal.” Id. at 325. Finally, the

court reviews all allegations holistically, rather than in

isolation, to determine if a complaint is well-pleaded.

Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1324

(2011) (citing Tellabs, 551 U.S. at 326).

The adequacy of the TAC might be a close question if we

were to uphold the decision to strike the Auditor discovery

materials, but because we do not, our task is straightforward.

The TAC alleges that Boyne forged documents and signatures

in order to misrepresent the Company’s assets. An exhibit to

the TAC includes a purported record of a Credit Suisse bank

account in the Subsidiary’s name that was previously

confirmed by Boyne and represented as having a balance of

over 12 million dollars as of September 2009. We must

accept the allegations in the TAC as true, and if the exhibits

incorporated into the TAC are what they purport to be, this

bank account never existed. Investors contend that the

misrepresented assets from this account were reported in

public statements by the Company, including financial

statements for fiscal years 2006, 2007, and 2008. Finally, as

noted, Investors allege that Cole and Boyne knowingly

concealed the existence of the 2002 Agreement from the

Company’s Auditor in order to wrongfully consolidate the

Company’s financial statements with its Subsidiary’s. In

particular, Cole and Boyne allegedly concealed or fabricated

24 PETRIE V. ELECTRONIC GAME CARD, INC.

minutes for a board meeting at which the 2002 Agreement

was purportedly discussed.

We express no opinion on the merits of these factual

allegations. In this appeal, Cole and Boyne do not attempt to

dispute the authenticity of the Auditor discovery materials.

Their focus has been on their assertion that these materials

should not be considered in assessing the sufficiency of the

TAC. Given that we have rejected that assertion, the

allegations described in the preceding paragraph are sufficient

to plead both falsity and scienter under the PSLRA. The

order dismissing this action must be reversed because it was

based on the insufficiency of the falsity and scienter

allegations against Cole and Boyne.

Finally, Control Persons ask us to affirm the district

court’s dismissal of the section 20(a) claims against them

because, they argue, the TAC alleged facts establishing that

they acted in good faith. The district court did not reach this

question; it dismissed the derivative claims alleged against

Control Persons after dismissing the primary 10(b) claims

against Cole and Boyne. It is not our practice to consider

arguments in the first instance on appeal.14 “[O]ur general

assumption is that we operate more effectively as a reviewing

court than as a court of first instance.” Detrich v. Ryan,

740 F.3d 1237, 1248–49 (9th Cir. 2013).

14

We are mindful that at this stage in the litigation, the allegations

against all defendants-appellees in the TAC are just that: allegations that

have not yet been tested in court.

PETRIE V. ELECTRONIC GAME CARD, INC. 25

CONCLUSION

Because the Auditor discovery materials were not

obtained or used in violation of the PSLRA, we reverse the

district court’s decision to strike portions of the TAC.

Considering all of the allegations in the TAC, we conclude

that it adequately pleads both falsity and scienter as to

defendants Cole and Boyne. We reverse the judgment of the

district court and remand this case for further proceedings

consistent with this opinion.

REVERSED and REMANDED.