Federal Judge dismisses security fraud lawsuit against Rackable Systems, Inc.

Marketwatch has a press release from Silicon Graphics, Inc. (SGI) which announces that a securities class action lawsuit against its parent Rackable Systems, Inc. (Rackable) has been dismissed by Northern District of California Judge Judge Claudia Wilken.

A group of shareholders were angry when Rackable explained in February 2006 that it had not paid its use and sales tax outside of the State of California in December 2005.  In January 2007, the company announced it adjusted earnings estimates from $0.25 to $0.75 per share to $0.17 to $0.18 per share.  The share price plummeted from $32.42 to $19.98.  The following quarter the company reported an unexpected loss of $10.2 million which dropped the share price to a little over $11.

Gerald Dull and Vincent Fusco sued as lead plaintiffs for a class of shareholders stating that Rackable and its officers falsely inflated the share price in violation Section 10(b) of the Exchange Act and Rule 10(b)(5).  The Court explained:

To state a claim under § 10(b), a plaintiff must allege: "(1) a misrepresentation or omission of material fact, (2) scienter, (3) a connection with the purchase or sale of a security, (4) transaction and loss causation, and (5) economic loss." In re Gilead Sciences Securities Litig.[] (9th Cir. 2008).

All of these had to be set forth with specificity under rule Federal Rule of Civil Procedure 9(b) which proved to be the downfall for the plaintiffs.  Of those, misrepresentation, scienter, and causation appeared to be lacking.

Misrepresentation involves the logically difficult task of proving a negative.  For each event listed above, Rackable gave a reason: accounting oversight (to the tune of $6M), changes in the marketplace and changes in customer demands.  In order to prove misrepresentation, the plaintiffs would have to show that the officers were knew they were lying when then offered those reasons for missing earnings estimates.  To prove the negative, the plaintiffs needed to show that they have fully examined the range of possibilities which only result in one remaining observable conclusion: fraud.  For instance, they averred that there was a negative internal report that showed that the officers were lying when they made the earnings estimates.  However, the plaintiffs did not have the report and were simply eluding to its existence, which puts the report outside of the observable sphere and fails to prove the negative.  The Ninth Circuit reached the same conclusion in In re Silicon Graphics Securities Litigation.

Scienter or mental state presents the same problem as misrepresentation and demonstrates a need for a smoking gun.  The plaintiffs interviewed 22 confidential witnesses who stated that the finacial problems at Rackable were well known.  However, they did not allege that the problems were not reflected in the earnings estimates.  That failure of observation, fails to state a claim for fraud in the first instance.

Loss causation is a slightly different proof that requires a showing that the misstatements caused the shareholder's loss, rather than anything else.  The plaintiffs make the logical error of post hoc ergo propter hoc ("after this, therefore because of this") which is that they assume that because the share price dropped after the various announcements it is because of those announcements and not anything else.  In 2008, the Ninth Circuit rejected that approach in Metzler Inv. GMBH v. Corinthian Colleges, Inc..

Judge Wilken dismissed the case with prejudice ending the lawsuit pending appeal.

The case is In re Rackable Systems Inc. Securities Litigation No. C 09-0222, and the opinion is below the jump.

Here is the opinion:

In Re Rackable Systems MTD Order