Sparling v. Daou Systems, Inc.

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT

In re: DAOU SYSTEMS, INC., 
SECURITIES LITIGATION,

GREG SPARLING; EUGENE
KRABBENHOFT; PATRICK DE KRUYFF,
Esq.; ROBERT ZARETSKY; ROD No. 02-56989
FORD; THOMAS V. HAGMAN;
D.C. No.
RICHARD W. WALSH; RICHARD
TORIBIO; PAUL RABIN,  CV-98-01537-
L/CGA
Plaintiffs-Appellants,
v.
GEORGES DAOU; DANIEL DAOU;
FRED MCGEE; ROBERT MCNEILL;
JOHN MORAGNE; DAOU SYSTEMS,
INC.,
Defendants-Appellees.


1385
1386 IN RE DAOU SYSTEMS, INC.

In re: DAOU SYSTEMS, INC., 
SECURITIES LITIGATION,

GREG SPARLING; EUGENE
KRABBENHOFT; PATRICK DE KRUYFF,
Esq.; ROBERT ZARETSKY; ROD
FORD; THOMAS V. HAGMAN;
No. 02-57018
RICHARD W. WALSH; RICHARD
TORIBIO; PAUL RABIN, D.C. No.
Plaintiffs-Appellees,  CV-98-01537-
L/CGA
v.
OPINION
GEORGES DAOU; DANIEL DAOU;
FRED MCGEE; ROBERT MCNEILL;
JOHN MORAGNE,
Defendants,
and
DAOU SYSTEMS, INC.,
Defendant-Appellant.

Appeal from the United States District Court
for the Southern District of California
M. James Lorenz, District Judge, Presiding

Argued and Submitted
February 12, 2004—Pasadena, California

Filed February 2, 2005

Before: Betty B. Fletcher, Harry Pregerson, and
Melvin Brunetti, Circuit Judges.

Opinion by Judge Brunetti
1390 IN RE DAOU SYSTEMS, INC.

COUNSEL

Eric A. Isaacson, San Diego, California, for the plaintiffs-
appellants/appellees.

Michael P. McCloskey, San Diego, California, for the
defendants-appellees/appellants.

OPINION

BRUNETTI, Circuit Judge:

Plaintiffs, a class of former Daou Systems, Inc. (“Daou”)
investors who purchased Daou common stock between Febru-
ary 13, 1997 and October 28, 1998, allege that defendants
Daou, Chief Executive Officer and Chairman of the Board
Georges Daou (“G. Daou”), President and Director Daniel
 IN RE DAOU SYSTEMS, INC. 1391
Daou (“D. Daou”), Chief Financial Officer and Senior Vice
President Fred McGee, Chief Operating Officer and Execu-
tive Vice President Robert McNeill, and Director John
Moragne systematically and fraudulently violated the Gener-
ally Accepted Accounting Principles (“GAAP”) in order to
artificially inflate the price of Daou’s stock. Plaintiffs also
allege that they incurred substantial personal losses due to
their respective purchases of Daou stock at fraudulently
inflated prices. The district court, on several occasions, deter-
mined that plaintiffs had failed to state sufficiently particular-
ized claims under the 1933 Securities Act and the 1934
Exchange Act and thrice granted plaintiffs leave to amend.
Plaintiffs now appeal the district court’s dismissal of their
Third Amended Complaint (“TAC”) with prejudice. Defen-
dants also cross-appeal the district court’s failure to consider,
sua sponte, whether to impose sanctions against plaintiffs and
plaintiffs’ attorneys.

FACTS1 AND PROCEEDINGS BELOW

Daou created, implemented, and supported computer net-
working systems for use in the healthcare field. Beginning
with its first public offering in February 1997, Daou repre-
sented itself as a technologically astute company able to keep
pace with the ever-changing medical field. For seven consec-
utive quarters, Daou reported “record” growing revenues and
stated that the company’s earnings per share (“EPS”) had and
would exceed market expectations. Daou allegedly touted
“spectacular” results and “strong growth” while also reporting
successful employee retention as well as an “extremely strong
pipeline position.”

Plaintiffs contend that Daou fraudulently inflated the price
of its stock by reporting revenues before they were earned, in
1
The following facts are taken from plaintiffs’ third amended complaint
and will be assumed true for purposes of the within review. See Gompper
v. VISX, Inc., 298 F.3d 893, 895 (9th Cir. 2002).
1392 IN RE DAOU SYSTEMS, INC.
violation of GAAP. The company employed an accounting
method known as the percentage-of-completion (“POC”)
method, which is used primarily to account for progress on
long-term projects. Under this method, revenue from these
projects could only be recognized based on the percentage of
labor costs incurred to date compared to the total estimated
labor costs for the project. Plaintiffs allege, however, that
defendants would prematurely recognize revenue in contra-
vention of the POC method. For example, plaintiffs allege
that defendants systematically, without regard to labor costs
incurred or estimated, recognized 20% of the contract revenue
immediately upon signing products contracts, 40% of the con-
tract revenue immediately after the equipment to be installed
was ordered, and 50%-60% of the contract revenue as soon as
the equipment was configured and tested. Plaintiffs contend
that because of such artificial inflation of the price of Daou
stock, Daou was able to acquire eleven companies, and Daou
executives and their respective family members were able to
sell nearly 2.5 million shares for a total of $54.67 million in
improper proceeds. Plaintiffs also allege that to their detri-
ment they purchased their Daou shares during the class period
at artificially inflated prices and that, had they been aware of
Daou’s true financial results and condition, they would not
have purchased their shares, or at least not at the prices paid.

Defendants counter that their method of accounting did not
violate GAAP or their own stated policy, as they revealed in
various disclosures that

[c]ontract revenue for the development and imple-
mentation of network solutions is recognized on the
percentage-of-completion method with progress to
completion measured by labor costs incurred to date
compared to total estimated labor costs. . . . Reve-
nues recognized in excess of amounts billed and
project costs are classified as contract work in prog-
ress.
 IN RE DAOU SYSTEMS, INC. 1393
(emphasis added). The district court agreed and determined
that plaintiffs had failed to expose any financial tomfoolery
on the part of Daou in its execution of the POC accounting
method:

Plaintiffs appear [to] argue that, because there was a
variance between recognized and earned revenue,
Defendants must have been engaged in accounting
fraud. Their allegations that the funds in the work in
progress account represented improperly recognized
revenue are conclusory and appear to result from cir-
cular logic. Plaintiffs simply have not shown that
recognizing unearned revenue and earmarking it for
the work in progress account is anything but an exer-
cise of Defendants’ business judgment.

Such failure, the court concluded, proved fatal to plaintiffs’
remaining claims, as, for example, if Daou’s statements were
not false and misleading, then defendants did nothing requir-
ing an assessment of their scienter in making them. The court
consequently dismissed plaintiffs’ TAC with prejudice, and
this appeal followed.

DISCUSSION

I. Standard of Review

We review dismissals under Federal Rules of Civil Proce-
dure 9(b) and 12(b)(6) de novo. Vess v. Ciba-Geigy Corp.
USA, 317 F.3d 1097, 1102 (9th Cir. 2003) (citations omitted).
“[W]e accept the plaintiffs’ allegations as true and construe
them in the light most favorable to plaintiffs.” Gompper, 298
F.3d at 895 (citations omitted). However, “[c]onclusory alle-
gations of law and unwarranted inferences are insufficient to
defeat a motion to dismiss for failure to state a claim.” In re
VeriFone Sec. Litig., 11 F.3d 865, 868 (9th Cir. 1993) (cita-
tions omitted). “Dismissal without leave to amend is improper
unless it is clear, upon de novo review, that the complaint
1394 IN RE DAOU SYSTEMS, INC.
could not be saved by any amendment.” Gompper, 298 F.3d
at 898 (citation and internal quotations omitted).

II. Federal Securities Law

Plaintiffs’ TAC asserts five claims for relief, alleging (1)
violation of section 10(b) and Rule 10b-5 of the 1934
Exchange Act against all defendants; (2) violation of section
20(a) of the 1934 Exchange Act against certain defendants;
(3) violation of section 11 of the 1933 Securities Act against
certain defendants; (4) violation of section 12(a)(2) of the
1933 Securities Act against certain defendants; and (5) viola-
tion of section 15 of the 1933 Securities Act against certain
defendants.

a. Section 10(b) of the Exchange Act of 1934

[1] Section 10(b) of the Exchange Act of 1934, 15 U.S.C.
§ 78j(b), makes it unlawful “for any person . . . [t]o use or
employ, in connection with the purchase or sale of any secur-
ity . . . any manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the Commis-
sion may prescribe[.]” SEC Rule 10b-5, promulgated under
the authority of section 10(b), in turn, provides:

It shall be unlawful for any person . . .

(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 light of the circum-
stances under which they were made, not mislead-
ing, or

(c) To engage in any act, practice, or course of busi-
ness which operates or would operate as a fraud or
 IN RE DAOU SYSTEMS, INC. 1395
deceit upon any person, in connection with the pur-
chase or sale of any security.

17 C.F.R. § 240.10b-5. The elements of a Rule 10b-5 claim,
therefore, are: (1) a misrepresentation or omission of a mate-
rial fact, (2) scienter, (3) causation, (4) reliance, and (5) dam-
ages. See Binder v. Gillespie, 184 F.3d 1059, 1063 (9th Cir.
1999); The Ambassador Hotel v. Wei-Chuan Inv., 189 F.3d
1017, 1025 (9th Cir. 1999) (citation omitted); Paracor
Finance, Inc. v. General Elec. Capital Corp., 96 F.3d 1151,
115 (9th Cir. 1996). The causation element requires a show-
ing of both actual cause (“transaction causation”) and proxi-
mate cause (“loss causation”). The Ambassador Hotel, 189
F.3d at 1025.

[2] It is well established that claims brought under Rule
10b-5 and section 10(b) must meet the particularity require-
ments of Federal Rule of Civil Procedure 9(b). See Semegen
v. Weidner, 780 F.2d 727, 729, 734-35 (9th Cir. 1985). Rule
9(b) states that “[i]n all averments of fraud or mistake, the cir-
cumstances constituting fraud or mistake shall be stated with
particularity. Malice, intent, knowledge, and other condition
of mind of a person may be averred generally.”

[3] Further, the enactment of the Private Securities Litiga-
tion Reform Act (“PSLRA”) in 1995 significantly altered
pleading requirements in private securities fraud litigation by
amending the 1934 Exchange Act to require that a complaint
“plead with particularity both falsity and scienter.” Gompper,
298 F.3d at 895 (quoting Ronconi v. Larkin, 253 F.3d 423,
429 (9th Cir. 2001)); see also Nursing Home Pension Fund,
Local 144 v. Oracle Corp., 380 F.3d 1226, 1230 (9th Cir.
2004). A securities fraud complaint must now “specify each
statement alleged to have been misleading, the reason or rea-
sons 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
1396 IN RE DAOU SYSTEMS, INC.
on which that belief is formed.” Gompper, 298 F.3d at 895
(quoting 15 U.S.C. § 78u-4(b)(1)).

The complaint must also “state with particularity facts giv-
ing rise to a strong inference that the defendant acted with the
required state of mind.” Id. (quoting 15 U.S.C. § 78u-4(b)(2)
(emphasis added in Gompper)); see also In re Silicon Graph-
ics Inc. Sec. Litig., 183 F.3d 970, 974 (9th Cir. 1999) (“Silicon
Graphics”) (facts must come closer to demonstrating intent as
opposed to mere motive and opportunity). The stricter stan-
dard for pleading scienter naturally results in a stricter stan-
dard for pleading falsity, because “ ‘falsity and scienter in
private securities fraud cases are generally strongly inferred
from the same set of facts,’ and the two requirements may be
combined into a unitary inquiry under the PSLRA.” In re
Vantive Corp. Sec. Litig., 283 F.3d 1079, 1091 (9th Cir. 2002)
(“In re Vantive”) (quoting Ronconi, 253 F.3d at 429). Thus,
the complaint must allege that the defendants made false or
misleading statements either intentionally or with deliberate
recklessness. Silicon Graphics, 183 F.3d at 974.

b. Reliance on Confidential Witnesses

[4] Because many of plaintiffs’ allegations come from
accounts of confidential witnesses, their use in satisfying the
PSLRA’s standard of particularity must be addressed. This
circuit in Silicon Graphics cautioned about the use of
unnamed sources in stating that “[i]t is not sufficient for a
plaintiff’s pleadings to set forth a belief that certain unspeci-
fied sources will reveal, after appropriate discovery, facts that
will validate her claim.” Silicon Graphics, 183 F.3d at 985.
Instead, to meet this particularity requirement for personal
sources of information, this circuit has applied the Second
Circuit’s standard that “personal sources of information relied
upon in a complaint should be ‘described in the complaint
with sufficient particularity to support the probability that a
person in the position occupied by the source would possess
the information alleged.’ ” Nursing Home, 380 F.3d at 1233
 IN RE DAOU SYSTEMS, INC. 1397
(quoting Novak v. Kasaks, 216 F.3d 300, 314 (2d Cir. 2000)).
Where plaintiffs rely on both confidential witnesses and on
other facts, “they need not name their sources as long as the
latter facts provide an adequate basis for believing that the
defendants’ statements were false.” Novak, 216 F.3d at 314;
see also Silicon Graphics, 183 F.3d at 985 (complaint should
include “adequate corroborating details”).

[5] The First Circuit has also adopted Novak’s approach of
“look[ing] at all of the facts alleged to see if they ‘provide an
adequate basis for believing that the defendants’ statements
were false.’ ” In re Cabletron Systems, Inc., 311 F.3d 11, 29
(1st Cir. 2002) (citing Novak, 216 F.3d at 314). The First Cir-
cuit added that this approach “involves an evaluation, inter
alia, of the level of detail provided by the confidential
sources, the corroborative nature of the other facts alleged
(including from other sources), the coherence and plausibility
of the allegations, the number of sources, the reliability of the
sources, and similar indicia.” Id. at 29-30.

[6] This circuit’s approach does not necessarily require a
plaintiff to name his or her confidential witnesses. However,
this circuit does strictly adhere to the PSLRA’s mandate that
the complaint “state with particularity all facts on which [a]
belief is formed,” and in so doing, requires that a plaintiff
reveal “the sources of her information.” Silicon Graphics, 183
F.3d at 985 (citation and internal quotation marks omitted). It
is by this circuit’s adoption of the Second Circuit’s standard
for evaluating personal sources of information, augmented by
the First Circuit’s suggested criteria for assessing reliability of
confidential witnesses, that plaintiffs’ complaint here should
be evaluated. So long as plaintiffs reveal with particularity the
sources of their information, the complaint will survive under
the PSLRA. Naming sources is unnecessary so long as the
sources are described “with sufficient particularity to support
the probability that a person in the position occupied by the
source would possess the information alleged” and the com-
plaint contains “adequate corroborating details.” See Nursing
1398 IN RE DAOU SYSTEMS, INC.
Home, 380 F.3d at 1233 (citation and internal quotation marks
omitted); Silicon Graphics, 183 F.3d at 985.

[7] Plaintiffs here describe the confidential witnesses with
a large degree of specificity. Plaintiffs number each witness
and describe his or her job description and responsibilities. In
some instances, plaintiffs provide the witnesses’ exact title
and to which Daou executive the witness reported. For exam-
ple, plaintiffs describe Confidential Witness #6 as follows:
“Confidential Witness #6 (“CW6”) is a former Daou execu-
tive who worked in the Finance Department. CW6 dealt with
audit issues, Security and Exchange (“SEC”) reporting and
budget matters. As such, CW6 was familiar with Daou’s pro-
cess of collecting project cost information. CW6 reported to
defendant McGee.” Similarly, plaintiffs describe Confidential
Witness #9 as follows: “Confidential Witness 9 (“CW9”) is a
former Daou Regional Vice President of Sales. As Vice Presi-
dent of Sales, CW9 was responsible for reporting weekly or
bi-weekly sales information, such as sales status/backlog and
forecast/pipeline information, to Daou’s Vice Presidents and
corporate officers.” Given the specificity of plaintiffs’
descriptions of their confidential witnesses, we hold that
plaintiffs have sufficiently met the PSLRA’s requirements for
confidential witnesses. We next determine whether plaintiffs
have sufficiently pled the elements of a Rule 10b-5 claim in
light of the PSLRA’s heightened pleading standards.

1. Material Misrepresentations or Omissions

[8] If “[p]roperly pled, overstating of revenues may state a
claim for securities fraud, as under GAAP, ‘revenue must be
earned before it can be recognized.’ ” Hockey v. Medhekar,
30 F. Supp. 2d 1209, 1216 (N.D. Cal. 1998) (quoting Provenz
v. Miller, 102 F.3d 1478, 1484 (9th Cir. 1996)) (emphasis in
original). “To properly state a claim for accounting fraud,
plaintiffs must ‘plead facts’ sufficient to support a conclusion
that [d]efendant [ ] prepared the fraudulent financial state-
ments and that the alleged financial fraud was material.” In re
 IN RE DAOU SYSTEMS, INC. 1399
Peerless Systems, Corp. Sec. Litig., 182 F. Supp. 2d 982, 991
(S.D. Cal. 2002) (citations omitted) (alterations in original).

Violations of GAAP standards can also provide evidence of
scienter. Id. (citing Greebel v. FTP Software, Inc., 194 F.3d
185, 203 (1st Cir. 1999)); see also In re McKesson HBOC,
Inc. Sec. Litig., 126 F. Supp. 2d 1248, 1273 (N.D. Cal. 2000)
(“In re McKesson”) (“[W]hen significant GAAP violations
are described with particularity in the complaint, they may
provide powerful indirect evidence of scienter. After all,
books do not cook themselves.”). To support even a reason-
able inference of scienter, much less a strong inference, “the
complaint must describe the violations with sufficient particu-
larity; ‘a general allegation that the practices at issue resulted
in a false report of company earnings is not a sufficiently par-
ticular claim of misrepresentation.’ ” Greebel, 194 F.3d at
203-04 (quoting Gross v. Summa Four, Inc., 93 F.3d 987, 996
(1st Cir. 1996), superseded by statute on other grounds as
recognized in Greebel, 194 F.3d at 197 (“strong” inference
rather than “reasonable” inference now required for scienter)).

When pleading irregularities in revenue recognition, plain-
tiffs should allege “(1) ‘such basic details as the approximate
amount by which revenues and earnings were overstated’; (2)
‘the products involved in the contingent transaction’; (3) ‘the
dates of any of the transactions’; or (4) ‘the identities of any
of the customers or [company] employees involved in the
transactions.’ ” In re McKesson, 126 F. Supp. 2d at 1273
(quoting Greebel, 194 F.3d at 204) (alteration in McKesson).
Plaintiffs need not allege each of those particular details, see
Greebel, 194 F.3d at 204, but they must allege enough infor-
mation so that “a court can discern whether the alleged GAAP
violations were minor or technical in nature, or whether they
constituted widespread and significant inflation of revenue.”
In re McKesson, 126 F. Supp. 2d at 1273.

Plaintiffs here contend that defendants systematically
reported revenue, before it was earned in violation of GAAP.
1400 IN RE DAOU SYSTEMS, INC.
For example, they assert that Daou, “without regard to labor
costs incurred or estimated,” recognized 20% of the contract
revenue immediately upon signing products contracts, 40% of
the contract revenue immediately after the equipment to be
installed was ordered, and 50%-60% of the contract revenue
as soon as the equipment was configured and tested. More-
over, plaintiffs assert that for one contract, the Centura Health
project, certain Field Services personnel were told that they
would receive $100 each if they would go into Daou’s San
Diego warehouse, plug in and turn on certain computers, and,
in turn, bill eight hours of work. One confidential witness
stated that he never received the $100, and when he inquired
about the payment, he was told to “forget it ever happened.”
The only rationale for such occurrence, according to the con-
fidential witness, was so Daou could prematurely recognize
revenue on the Centura Health project.

Similar allegations were made in Gross, 93 F.3d at 995-96,
superseded by statute on other grounds. The plaintiff in Gross
asserted that Summa Four prematurely recognized revenue
upon receipt of orders rather than on shipment of products, a
practice that, in turn, allowed Summa Four to overstate signif-
icantly its revenues and earnings during the class period. Id.
at 995. Gross substantiated such allegations by highlighting
certain statements made by Summa Four executives at a board
meeting indicating their intention to recognize $4.7 million in
late-quarter earnings from the receipt of newly acquired
orders, despite the fact that Summa Four generally required
twelve to twenty weeks to fulfill such orders. Id. at 995-96.
Board minutes also revealed that Summa Four’s chief finan-
cial officer was working on a new “revenue recognition poli-
cy” that was to be “more formalized and somewhat more
restrictive” than its previous policy. Id. at 996.

Although such assertions gave the court “pause,” the court
nonetheless held that Gross’s complaint had not satisfied Rule
9(b)’s heightened pleading standards. Id. “A general allega-
tion that the practices at issue resulted in a false report of
 IN RE DAOU SYSTEMS, INC. 1401
company earnings is not a sufficiently particular claim of mis-
representation to satisfy Rule 9(b).” Id. (citation and internal
brackets omitted). The court determined that Gross had failed
to allege any particulars to support his general allegation of
inflated earnings through the use of improper accounting
methods. “Specifically, he has not alleged the amount of the
putative overstatement or the net effect it had on the compa-
ny’s earnings.” Id. The court cited a number of cases in sup-
port of this conclusion, including Shushany v. Allwaste, Inc.,
992 F.2d 517, 522 (5th Cir. 1993) (allegation that company
had adjusted the accounting of its inventory to inflate reve-
nues and earnings does not sufficiently plead fraud where
complaint does not explain, inter alia, how the adjustments
affected the company’s financial statements and whether they
were material in light of the company’s overall financial posi-
tion), Roots Partnership v. Lands’ End, Inc., 965 F.2d 1411,
1419 (7th Cir. 1992) (allegation that company “failed to
establish adequate reserves for its excessive and outdated
inventory” does not satisfy Rule 9(b) where investor does not
allege “what the reserves were or suggest how great the
reserves should have been”), and Cohen v. Koenig, 25 F.3d
1168, 1173 (2d Cir. 1994) (fraud pled with sufficient particu-
larity by setting out representations made, what financial fig-
ures were given, and what the alleged true financial figures
were).

[9] The case law indicates, therefore, that although over-
statement of revenues in violation of GAAP may support a
plaintiff’s claim of fraud, the plaintiff must show with particu-
larity how the adjustments affected the company’s financial
statements and whether they were material in light of the
company’s overall financial position. The district court here
determined that plaintiffs failed to make such a showing, not-
ing that “despite an exhaustive search of the TAC, the Court
was unable to locate and identify any allegations quantifying
and contrasting the revenue Defendants actually recognized
under the POC method and the revenue Defendants should
have recognized if they had properly applied the POC meth-
1402 IN RE DAOU SYSTEMS, INC.
od” (emphasis in original). “This information,” the court
stated, “is essential to surviving a motion to dismiss in this
context.” Moreover, the court noted, “Plaintiffs simply have
not shown that recognizing unearned revenue and earmarking
it for the work in progress account is anything but an exercise
of Defendants’ business judgment.”

[10] Upon independent review of plaintiffs’ complaint,
however, we find at least some specific allegations of how the
adjustments affected the company’s financial statements and
whether they were material in light of the company’s overall
financial position. The complaint alleges myriad observations
of accounting misfeasance (e.g., alleged manipulation of the
books), and at least some of such allegations reveal that the
amount of revenue Daou formally recognized was completely
unrelated to the amount of labor incurred to date. According
to Daou’s stated method of revenue recognition—the POC
method—Daou was to recognize revenue based on the per-
centage of labor costs incurred to date compared to the total
estimated labor costs for the project. However, plaintiffs
allege, and confidential witnesses corroborate, that

Vice Presidents Ringwall and Mirabile would print
out the ManFact reports containing actual labor and
percent completion submitted by project managers,
for the current month and quarter. According to
CW3, CW4, CW7 and CW16, the ManFact data was
compiled into a Monthly Project Report which was
sent to G. Daou, D. Daou, McGee, and McNeill at
the close of each month and quarter. . . . Based on
the comprehensive Monthly Project Report. G.
Daou, D. Daou, McNeill and McGee would adjust
upward the percent of completion for projects.

If plaintiffs can in fact prove such intentional manipulation of
the accounting principles, they will have shown that Daou’s
public statements regarding recognized revenue were materi-
ally misleading.
 IN RE DAOU SYSTEMS, INC. 1403
Moreover, it appears that the district court conflated two
accounting concepts, earned revenue and that revenue for
which a company was entitled to bill its customers. As stated
above, it is a violation of GAAP to recognize revenue before
it is earned. Provenz, 102 F.3d at 1484. Plaintiffs allege that
“defendants recognized millions of dollars in revenue before
it was earned and without regard to actual labor costs incurred
or total estimated labor costs.” Plaintiffs also provided figures
allegedly indicating the discrepancy between the revenues
Daou recognized and the amount that it was entitled to bill its
customers during certain quarters within the class period.
Defendants explain that “[r]evenues recognized in excess of
amounts billed and project costs are classified as contract
work in progress.” What defendants’ disclosure — that reve-
nue was sometimes being recognized before the customer was
billed — does not reveal is that defendants were recognizing
revenue before it was even earned. An investor would read
defendants’ disclosure of revenues “recognized” as meaning
that the excess revenues recognized were at the very least
earned. As plaintiffs allege, that statement was misleading
because defendants were allegedly recognizing revenue,
before it was earned in violation of GAAP.

Further, systematically recognizing a set amount of reve-
nues before such percentage of labor had been performed and
accounting for such premature recognition simply by dump-
ing those amounts in the work-in-progress account could vio-
late other GAAP principles such as “financial reporting
should provide information that is useful to present and poten-
tial investors and creditors and other users in making rational
investment, credit and similar decisions,” (citing FASB State-
ment of Concepts No. 1, ¶ 34), and “financial reporting
should be reliable in that it represents what it purports to rep-
resent,” (citing FASB Statement of Concepts No. 2,
¶¶ 58-59).

Indeed, plaintiffs allege that “[t]he work in progress
account was comprised almost entirely of contract amounts
1404 IN RE DAOU SYSTEMS, INC.
Daou had recognized as revenue but for which it was not enti-
tled to bill because little or no labor had yet taken place
. . .” (emphasis added). If this were the case, then Daou’s
explanation for its excess revenues may have been misleading
if the revenue reported indeed included amounts for which
Daou was not entitled to bill because little or no labor had yet
taken place. In fact, plaintiffs provide one telling example of
defendants recognizing revenue before a contract was even
signed:

[D]uring the final weeks of the 3Q97, defendants
were desperate to report revenue growth. At the
time, according to CW5 [who allegedly had personal
knowledge of this project], Daou, led by G. Daou,
was in the process of negotiating a multi-million dol-
lar contract with Candler Health Systems. During the
final days of 3Q97, all of the equipment for the Can-
dler Health Systems project was ordered and Daou
immediately recognized 20% of the contract price,
approximately $1-1.5 million, as revenue, before any
contract was signed. By the following quarter, after
the Candler Health Systems project revenues had
been reported, Daou still did not have a contract and
had incurred no actual labor costs. Daou never
received the contract and eventually was forced to
sell the equipment at a loss.

Plaintiffs further describe how this allegedly premature recog-
nition affected Daou’s financial bottom line:

Had Daou reported revenue in line with the amount
it was entitled to bill customers pursuant to its con-
tracts, actually reflecting contract work done to date,
revenue for 3Q97 would have been only $5.9 mil-
lion, 48% less than publicly reported ($11.3 million).
CW13, CW17, and CW 27 confirmed that the dra-
matic growth in Daou’s work in progress account,
increasing $5.4 million from 2Q97 to 3Q97, was the
 IN RE DAOU SYSTEMS, INC. 1405
result of defendants’ premature recognition of reve-
nue.

In addition to pleading the approximate amount by which
revenues and earnings were overstated, plaintiffs also provide
the dates of some of the related transactions and the identities
of the customers and the company employees involved in the
transactions. For example, as noted above, plaintiffs described
an occurrence with the Centura Health project, which alleg-
edly involved several of the confidential witnesses. CW5 indi-
cated that Daou offered him and two other salaried Field
Service employees $100 to come into Daou on the last Satur-
day of June 1997, unpack and plug in computer equipment
ordered for the Centura Health project and immediately
record eight hours of labor. CW5 alleged that the purpose of
this event “was to justify recognizing 30%-40% of the reve-
nue on the Centura Health project in 2Q97.” On another occa-
sion, as noted above, CW5 corroborates other evidence that
Daou recognized 20% of the contract price — $1 to 1.5 mil-
lion — on the Candler Health project before the contract was
even signed. Notably, plaintiffs allege that Daou never
received the Candler Health contract.

[11] From these allegations, we conclude that plaintiffs
have provided enough information for “a court [to] discern
whether the alleged GAAP violations were minor or technical
in nature, or whether they constituted widespread and signifi-
cant inflation of revenue.” See In re McKesson, 126 F. Supp.
2d at 1273. Certainly, prematurely recognizing millions of
dollars in revenue is not minor or technical in nature. Further,
the complaint, although largely repetitive in its assertions,
indicates that these practices allegedly occurred systemati-
cally throughout the class period. We hold, therefore, that
these allegations sufficiently state reasons why the reporting
statements were misleading and, as an allegation made on
information and belief, the facts on which that belief was
formed. See Gompper, 298 F.3d at 895. These allegations
include specific descriptions of how Daou allegedly violated
1406 IN RE DAOU SYSTEMS, INC.
GAAP procedures and, in so doing, misled present and poten-
tial investors by artificially inflating Daou’s revenues above
what should have been reported.

[12] Similarly, we hold that plaintiffs’ claims regarding
employee training and turnover contain sufficient particularity
to support a securities fraud claim. Plaintiffs allege that vari-
ous defendants made statements indicating that Daou insti-
tuted a training program called “Daou University,” at which
Daou employees were taught technical skills and became cer-
tified in computer networking languages and programs. More-
over, plaintiffs contend, in May 1998, D. Daou and McGee
represented that Daou had an ongoing program with local uni-
versities in San Diego whereby Daou brought in college stu-
dents to Daou University to train them in systems and
networking. According to plaintiffs, neither Daou University,
nor the company’s program with local college students,
existed. Plaintiffs further assert that defendants misled poten-
tial investors by understating employee turnover and attrition.

The district court concluded that these allegations lacked
sufficient particularity to be actionable. As to employee attri-
tion, for example, the district court noted:

The one allegation of any substance, Plaintiffs’ con-
tention that employee attrition was actually 40%, not
6.8% as represented by Defendants, does not estab-
lish misrepresentation on Defendants’ part. Defen-
dants’ statements that attrition among technical
employees was at 6.8% was made in July 1998, and
confidential witnesses’ statements that the attrition
rate for all employees was at 40% was made in the
first quarter of 1998.

However, the complaint itself qualifies the allegation of
employee turnover by stating that “[e]mployee turnover, espe-
cially among Field Service engineers, exceeded 40%,”
whereas defendants stated that “attrition within the technical
 IN RE DAOU SYSTEMS, INC. 1407
ranks of employees was only 6.8%.” Such discrepancy
between what Daou executives reported and the allegedly true
state of affairs of Daou’s employ is adequately misleading to
state a claim under 10(b).

[13] We therefore disagree with the district court that
Daou’s alleged misleading statements of employee turnover
and lack of training were not sufficiently particularized to
state a cause of action under the PSLRA’s heightened plead-
ing standards. Plaintiffs provide several accounts of confiden-
tial witnesses claiming that “Daou University” did not in fact
exist and that Daou actually had “no in-house training pro-
gram whatsoever, and according to CW21, the Company was
hiring, among others, untrained mechanics and cable pullers
as computer technicians, not college graduates.” Unlike in In
re Vantive, where the court held insufficient generic allega-
tions of “inadequate training” or “very high salesforce turn-
over,” see In re Vantive, 283 F.3d at 1086-87, the complaint
here contains sufficiently detailed allegations of misleading
statements or omissions regarding Daou’s ability to train and
retain its employees to state a claim even under the PSLRA’s
more rigorous standard.

[14] Plaintiffs’ allegations regarding Daou’s “pipeline”
expectations, however, fail to satisfy the PSLRA’s require-
ments. The complaint alleges that Daou misrepresented its
“pipeline” expectations, stating that its position was “ex-
tremely strong” and “remained healthy and would fuel future
earnings growth,” that “visibility of future earnings was out-
standing,” and that the company’s “momentum was increas-
ing.” Although these projections might have been overly
optimistic when made, they do not rise to the level of a mate-
rial misrepresentation actionable after enactment of the
PSLRA:

Congress enacted the PSLRA to put an end to the
practice of pleading “fraud by hindsight.” See e.g.,
Medhekar v. United States Dist. Ct., 99 F.3d 325,
1408 IN RE DAOU SYSTEMS, INC.
328 (9th Cir. 1996) (holding that Congress intended
for complaints under the PSLRA to stand or fall
based on the actual knowledge of the plaintiffs rather
than information produced by the defendants after
the action has been filed).

Silicon Graphics, 183 F.3d at 988. Under the PSLRA’s “safe
harbor” provisions, plaintiffs must prove that “forward-
looking” statements were made with “actual knowledge” that
they were false or misleading. Id. at 993 (Browning, J., con-
curring in part and dissenting in part) (quoting 15 U.S.C.
§§ 78u-5(c)(1)(B), 77z-2(c)(1)(B)) (internal quotation marks
omitted). Plaintiffs allege that Daou sales executives would
hold weekly or bi-weekly conference calls with McNeill on
the status or outlook of prospective projects, and, based on
these calls, McNeill and assistants would prepare a Pipeline
Report. The complaint further asserts that “[t]he Pipeline
Report contained the arbitrary determination of future busi-
ness based on fixed percentages of proposed contracts’
value.” The complaint describes the method by which Daou
would determine and report its potential sales revenue to ana-
lysts and the market:

The “revenue” listed in the report and provided to
analysts and the market was, according to CW9,
automatically set at 20% of a contract’s total value
if a Daou salesperson had even met with the pro-
spective client to discuss a deal, 50% if Daou had
submitted a deal proposal, 70% if Daou had submit-
ted a formal bid on the deal, 90% if Daou “appeared
to have won” but the deal was not formally closed
and 100% when the sale was formerly closed. The
pipeline figure, despite defendants’ representations,
did not actually reflect contracts Daou would actu-
ally get, and included millions of dollars on projects
that Daou had little or no chance of actually doing.

Plaintiffs provide no specific facts, however, to substantiate
the speculative claim that Daou had little or no chance of
 IN RE DAOU SYSTEMS, INC. 1409
actually obtaining certain contracts. Further, plaintiffs fail to
provide sufficient facts to demonstrate that defendants had
actual knowledge that these optimistic statements were false
and misleading when made. Therefore, we agree with the dis-
trict court that these claims are not actionable under section
10(b).

In sum, however, we find that plaintiffs adequately pled
fraud as to defendants’ alleged misuse of the GAAP protocols
and alleged misstatements regarding employee training and
turnover to survive a motion to dismiss for failure to state a
claim.

2. Scienter

[15] Under the PSLRA’s new standard, a securities fraud
complaint must “state with particularity facts giving rise to a
strong inference that the defendant acted with the required
state of mind.” Gompper, 298 F.3d at 895 (citing 15 U.S.C.
§ 78u-4(b)(2) (emphasis added in Gompper)); see also Silicon
Graphics, 183 F.3d at 974 (facts must come closer to demon-
strating intent as opposed to mere motive and opportunity).
Thus, the complaint must allege that the defendants made
false or misleading statements either intentionally or with
deliberate recklessness. See Silicon Graphics, 183 F.3d at
974. This court considers “whether the total of plaintiffs’ alle-
gations, even though individually lacking, are sufficient to
create a strong inference that defendants acted with deliberate
or conscious recklessness.” Nursing Home, 380 F.3d at 1230
(quoting No. 84 Employer-Teamster Joint Council Pension
Trust Fund v. Am. West Holding Corp., 320 F.3d 920, 938
(9th Cir. 2003)). In considering whether a strong inference of
scienter has been pled, “the court must consider all reasonable
inferences to be drawn from the allegations, including infer-
ences unfavorable to the plaintiffs.” Gompper, 298 F.3d at
897 (emphasis in original).

There are several considerations in determining whether the
totality of plaintiffs’ allegations leads to a strong inference of
1410 IN RE DAOU SYSTEMS, INC.
scienter. General allegations of defendants’ “hands-on” man-
agement style, their interaction with other officers and
employees, their attendance at meetings, and their receipt of
unspecified weekly or monthly reports are insufficient. In re
Vantive, 283 F.3d at 1087. However, specific admissions from
top executives that they are involved in every detail of the
company and that they monitored portions of the company’s
database are factors in favor of inferring scienter in light of
improper accounting reports. See Nursing Home, 380 F.3d at
1234. Moreover, while scienter cannot be established by pub-
lishing inaccurate accounting figures, even when in violation
of GAAP, In re Worlds of Wonder Sec. Litig., 35 F.3d 1407,
1426 (9th Cir. 1994) (“WOW”), significant violations of
GAAP standards can provide evidence of scienter so long as
they are pled with particularity. In re McKesson, 126 F. Supp.
2d at 1273; see also Nursing Home, 380 F.3d at 1234 (“It is
reasonable to infer that the Oracle executives’ detail-oriented
management style led them to become aware of the allegedly
improper revenue recognition of such significant magni-
tude[.]”).

In addition, “the PSLRA neither prohibits nor endorses the
pleading of insider trading as evidence of scienter, but
requires that the evidence meet the ‘strong inference’ stan-
dard.” Greebel, 194 F.3d at 197. “Unusual trading or trading
at suspicious times or in suspicious amounts by corporate
insiders has long been recognized as probative of scienter.”
Id.; see also Nursing Home, 380 F.3d at 1231-32 (considering
suspicious insider stock sales as evidence toward meeting the
“strong inference” standard). At a minimum, however, “the
trading must be in a context where defendants have incentives
to withhold material, non-public information, and it must be
unusual, well beyond the normal patterns of trading by those
defendants.” Greebel, 194 F.3d at 198.

Plaintiffs allege throughout the complaint that defendants
G. Daou, D. Daou, McNeill, and McGee personally directed
Daou’s recognition of revenue, financial reporting and public
 IN RE DAOU SYSTEMS, INC. 1411
statements. They further allege that “[n]ot only were these
four defendants the top executives at Daou, but, according to
CW23, a former executive assistant to one of the defendants,
the Company was run ‘top to bottom’ by G. Daou and D.
Daou, with the assistance of McNeill and McGee.” Further,
the complaint states that “CW9, a regional Sales Vice Presi-
dent at Daou, confirmed that defendants G. Daou, D. Daou,
and McNeill not only made the decision on how much reve-
nue to recognize without regard to any actual percentage of
completion, but directed the practice of automatically recog-
nizing revenue upon contract signing and ordering of equip-
ment.”

In one example noted above, the complaint describes Daou
executives manually adjusting upward POC amounts in what
appears to be in violation of GAAP procedure. CW1 con-
firmed that such practices occurred, and the complaint indi-
cates that G. Daou, D. Daou, McNeill, and “in particular
McGee[ ] presented themselves as knowledgeable about all
aspects of the Company’s finances, including earnings and
revenue recognized under POC accounting.” Plaintiffs further
allege that “[b]ased on the account of numerous witnesses, all
of whom were former members of Daou’s executive,
Accounting, or Field Services staff, defendants not only knew
that the Company’s reported financial results and earnings
forecast were based on fraudulent accounting, but personally
directed the violations of Daou’s stated accounting policy and
GAAP in order to artificially inflate revenues”; and “CW8 . . .
and CW3 . . . both confirmed that it was known throughout
Daou at this time [2Q97] that G. Daou, D. Daou, and McNeill
were engaged in improper revenue recognition . . . .”

[16] These specific allegations of direct involvement in the
production of false accounting statements and reports are even
more probative of scienter than the allegations involved in
Nursing Home, where this court stated that the top executives’
admittedly detail-oriented management style led to a reason-
able inference that the top executives were aware of signifi-
1412 IN RE DAOU SYSTEMS, INC.
cant accounting irregularities. See Nursing Home, 380 F.3d at
1234. Indeed, the facts alleged by plaintiffs lead to an even
stronger inference: plaintiffs have alleged with specificity that
the top executives actually directed the improper revenue rec-
ognition in violation of both GAAP and their own accounting
practices.

Plaintiffs also cite suspicious corporate acquisitions and
insider stock sales to demonstrate defendants’ scienter. They
assert that these events demonstrate that defendants “had
motive to inflate Daou’s stock price and perpetuate the fraud-
ulent scheme and course of business complained of . . . .” The
complaint notes that during the class period, Daou acquired
11 companies by exchanging over 6.6 million shares of Daou
stock. Plaintiffs present a chart that indicates how many Daou
shares “saved” by using artificially inflated stock to purchase
the 11 companies. For example, for Daou to purchase INTE-
GREX Systems Corp. in July 1997, Daou exchanged 700,000
shares of Daou stock valued at $11,400,000; they assert that
had Daou’s stock been properly valued, they would have been
forced to use 1,476,403 additional shares to make the INTE-
GREX purchase. All told, the chart indicates that Daou saved
19,642,865 shares of its stock in the 11 acquisitions by using
its overvalued stock.

The complaint also highlights that defendants G. Daou, D.
Daou, McGee, McNeill, and Moragne, sold a total of
1,477,718 shares during the class period for a total of
$30,512,393, and in so doing, they knowingly “profit[ed]
from the fraud.” Although plaintiffs note that defendants took
advantage of the artificially inflated stock prices, interest-
ingly, defendants did not sell at the height of Daou’s stock
prices; e.g., of the stock G. Daou sold during the class period,
he received a maximum price of $22.86 per share, whereas
Daou’s stock price peaked at $34.375 in September 1997.
Moragne, on the other hand, sold 11,408 shares at the highest
price among defendants who sold stock during the class
period, $31.69 per share in November 1997. Despite the fact
 IN RE DAOU SYSTEMS, INC. 1413
that defendants did not capitalize on Daou’s peak price per
share, plaintiffs nonetheless contend that the sales were made
at suspicious moments: “the fact that 98% of all insider sales
. . . took place on only two trading days (August 15, 1997 and
January 29, 1998) is highly suspect and indicative of coordi-
nated selling among defendants.” Plaintiffs contend that the
sales correspond perfectly with the “huge increase in the price
of Daou stock that immediately followed [defendants’] false
statements and reports . . . .” Plaintiffs also note that, in addi-
tion to the suspicious insider trading by defendants, other
Daou executives as well as defendants’ family members
“dumped” a grand total of 2.5 million shares of Daou stock
during the class period at artificially inflated prices. Another
chart in the complaint explains the percentage of defendants’
sales during the class period compared to their total sales
through December 31, 2000. Sales by defendants G. Daou, D.
Daou, McNeill and Moragne during the class period repre-
sented 100% of their total stock sales as of the end of 2000;
only defendant McGee sold stock after the close of the class
period.

When considered as a whole, plaintiffs’ allegations are suf-
ficient to create a strong inference that all defendants except
Moragne acted with at least deliberate recklessness. The com-
plaint relays specific information from actual witnesses, albeit
unnamed, that defendants knowingly violated GAAP proce-
dures and present more than mere evidence of a motive and
opportunity to commit fraud. Although plaintiffs’ allegations
of Daou’s top-to-bottom management hierarchy, defendants’
suspicious stock sales, or the corporate acquisitions alone
would not likely demonstrate defendants’ scienter, these plus
the complaint’s specific allegations of deliberate accounting
misfeasance create a strong inference of scienter. See Nursing
Home, 380 F.3d at 1234 (“Considered separately, Plaintiffs’
allegations may not create a strong inference of scienter.
However, . . . [w]e find that the totality of the allegations does
create a strong inference that Oracle acted with scienter[.]”);
cf. Silicon Graphics, 183 F.3d at 988 (holding insufficient the
1414 IN RE DAOU SYSTEMS, INC.
plaintiff’s “generic” allegations). Unlike in Silicon Graphics,
this complaint contains sufficient “particularity” and “incrimi-
nating facts” to distinguish the allegations from the countless
“fishing expeditions” which the PSLRA was designed to
deter. See Silicon Graphics, 183 F.3d at 988 (citing H.R.
Conf. Rep. No. 104-369, at 37).

[17] However, we affirm the district court’s dismissal of
defendant Moragne as relates to the section 10(b) and Rule
10b-5 claims. The complaint’s main allegations to establish
scienter against defendant Moragne are suspicious stock sales,
and those allegations, as pled in plaintiffs’ complaint, do not
rise to the level of a strong inference. Importantly, there is
nothing to suggest Moragne was involved in the day-to-day
operations of Daou, much less heavily involved in the details
and personally directing the accounting irregularities. Our
affirmance as to Moragne, however, does not imply that
suspicious stock sales, by themselves, can never lead to a
strong inference. The facts alleged in this complaint simply do
not support a strong inference of scienter.

3. Causation

A court must also consider whether the plaintiff has shown
some causal connection between the fraud and the securities
transaction in question. The Ambassador Hotel, 189 F.3d at
1026; Levine v. Diamanthuset, Inc., 950 F.2d 1478, 1486 (9th
Cir. 1991) (“[The] plaintiff must establish a connection
between the defendant’s alleged misrepresentation and the
security at issue.”). “Deception related to the value or merit
of the securities in question has sufficient connection to secur-
ities transactions to bring the fraud within the scope of
§ 10(b).” The Ambassador Hotel, 189 F.3d at 1026 (citation
omitted).

The causation requirement can be broken down into two
necessary elements: actual cause (“transaction causation”) and
proximate cause (“loss causation”):
 IN RE DAOU SYSTEMS, INC. 1415
[I]n an action brought under Rule 10b-5 for material
omissions or misstatements, the plaintiff must prove
both transaction causation, that the violations in
question caused the plaintiff to engage in the transac-
tion, and loss causation, that the misrepresentations
or omissions caused the harm.

Id. at 1027 (quoting Hatrock v. Edward D. Jones & Co., 750
F.2d 767, 773 (9th Cir. 1984)). Thus, to prove transaction
causation, the plaintiff must show that, but for the fraud, the
plaintiff would not have engaged in the transaction at issue;
to prove loss causation, the plaintiff must demonstrate a
causal connection between the deceptive acts that form the
basis for the claim of securities fraud and the injury suffered
by the plaintiff. Id.

Here, we conclude that plaintiffs have sufficiently demon-
strated defendants’ fraud, such that the “[d]eception related to
the value or merit of the securities in question” creates a suffi-
cient connection to the securities transactions to bring the
fraud within the scope of section 10(b). See id. at 1026 (cita-
tion omitted). Such fraud in disclosing Daou’s financial posi-
tion would likely suffice to prove transaction causation: but
for the fraud, plaintiffs would not have engaged in the trans-
action at issue. See id. at 1027.

As the district court pointed out, however, establishing
“loss causation” is a more difficult task, as the district court
found that Daou’s improper use of the POC method was not
linked to the decline in Daou’s share price. The court stated:

It is undisputed that Daou’s 3Q98 financial results
were dismal, and that this led to the precipitous drop
in the Company’s stock value. However, in the TAC,
Plaintiffs have not adequately been able to link the
decline in share price to any purported improper rev-
enue recognition by Defendants. Plaintiffs point to
the fact that market analysts questioned whether
1416 IN RE DAOU SYSTEMS, INC.
Defendants had been “cooking” Daou’s books after
the 3Q98 results were revealed, but this is merely
speculation. Notably, the TAC does not allege that
there were any negative public statements,
announcements or disclosures at the time the stock
price dropped that Defendants were engaged in
improper accounting practices.

In other words, if the improper accounting did not lead to the
decrease in Daou’s stock price, plaintiffs’ reliance on the
improper accounting in acquiring the stock would not be suf-
ficiently linked to their damages.

An independent assessment of the TAC, however, indicates
that the price of the stock fell precipitously after defendants
revealed figures vastly different than those reported in a press
conference two weeks prior. The complaint also anonymously
quotes an analyst who allegedly stated, “[w]hen you say one
thing on the conference call and report something different on
the 10-Q, that raises concern. . . . You have got to question
whether they are manufacturing earnings.” Although some of
the allegations do call for speculation, the foregoing, if
assumed true, is sufficient to show that the drop in Daou’s
stock price was the direct result of their financial misstate-
ments and, in turn, caused plaintiffs’ damages.

4. Reliance and Damages

Plaintiffs attest that they relied on defendants’ material mis-
representations in choosing to invest in Daou during the class
period and were damaged thereby. Justifiable reliance “is a
limitation on a rule 10b-5 action which insures that there is a
causal connection between the misrepresentation and the
plaintiff’s harm.” Paracor, 96 F.3d at 1159 (citation and inter-
nal quotation marks omitted). If Daou indeed based its public
disclosures of its financial viability on fraudulent accounting,
then, in turn, plaintiffs justifiably relied on such disclosures in
making the decision to invest. Moreover, if plaintiffs indeed
 IN RE DAOU SYSTEMS, INC. 1417
justifiably relied on Daou’s public misrepresentations and, in
turn, bought Daou stock at inflated prices, they incurred dam-
ages from Daou’s fraud. Such assertions are sufficient to sur-
vive a motion to dismiss under Federal Rule of Civil
Procedure 12(b)(6).

b. Plaintiffs’ 1933 Securities Act section 11 claim

Unlike section 10(b), section 11 of the 1933 Securities Act
creates a private remedy for any purchaser of a security if
“any part of the registration statement, when such part became
effective, contained an untrue statement of a material fact or
omitted to state a material fact required to be stated therein or
necessary to make the statements therein not misleading.” 15
U.S.C. § 77k(a). “The plaintiff in a § 11 claim must demon-
strate (1) that the registration statement contained an omission
or misrepresentation, and (2) that the omission or misrepre-
sentation was material, that is, it would have misled a reason-
able investor about the nature of his or her investment.” In re
Stac Electronics Sec. Litig., 89 F.3d 1399, 1403-04 (9th Cir.
1996) (“In re Stac”) (citation and internal quotation marks
omitted). “No scienter is required for liability under § 11;
defendants will be liable for innocent or negligent material
misstatements or omissions.” Id. (citing Herman & MacLean
v. Huddleston, 459 U.S. 375, 382 (1983)).

Although section 11 does not contain an element of fraud,
a plaintiff may nonetheless be subject to Rule 9(b)’s particu-
larity mandate if his complaint “sounds in fraud”:

[T]he plaintiff may allege a unified course of fraudu-
lent conduct and rely entirely on that course of con-
duct as the basis of a claim. In that event, the claim
is said to be “grounded in fraud” or to “sound in
fraud,” and the pleading of that claim as a whole
must satisfy the particularity requirement of Rule
9(b).
1418 IN RE DAOU SYSTEMS, INC.
Vess, 317 F.3d at 1103-04; see also In re Stac, 89 F.3d at
1404-05 (“We now clarify that the particularity requirements
of Rule 9(b) apply to claims brought under Section 11 [of the
1933 Securities Act] when, as here, they are grounded in
fraud.”).

In a case where fraud is not an essential element of a claim,
only allegations of fraudulent conduct must satisfy the height-
ened pleading requirements of Rule 9(b). Vess, 317 F.3d at
1105. “Allegations of non-fraudulent conduct need satisfy
only the ordinary notice pleading standards of Rule 8(a).” Id.
As the Fifth Circuit wrote:

Where averments of fraud are made in a claim in
which fraud is not an element, an inadequate aver-
ment of fraud does not mean that no claim has been
stated. The proper route is to disregard averments of
fraud not meeting Rule 9(b)’s standard and then ask
whether a claim has been stated.

Id. (citing Lone Star Ladies Inv. Club v. Schlotzsky’s Inc., 238
F.3d 363, 368 (5th Cir. 2001) (“Lone Star”)) (emphasis added
in Vess). As the Eighth Circuit elaborated:

The only consequence of a holding that Rule 9(b) is
violated with respect to a § 11 claim would be that
any allegations of fraud would be stripped from the
claim. The allegations of innocent or negligent mis-
representation, which are at the heart of a § 11 claim,
would survive.

Id. (citing Carlon v. Thaman (In re NationsMart Corp. Sec.
Litig.), 130 F.3d 309, 315 (8th Cir. 1997)) (emphasis added
in Vess). “Thus, if particular averments of fraud are insuffi-
ciently pled under Rule 9(b), a district court should ‘disre-
gard’ 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.
 IN RE DAOU SYSTEMS, INC. 1419
A district court need not rewrite a deficient complaint how-
ever. Lone Star, 238 F.3d at 368. 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 purposes of the Securities Act claims. Id.
(citations, internal quotation marks, and emphasis omitted). In
such cases,

a district court is not required to sift through allega-
tions of fraud in search of some “lesser included”
claim of strict liability. It may dismiss. If it does so,
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. at 368-69.

Here, plaintiffs’ TAC “sounds in fraud.” Notably, the first
sentence of the complaint introduces the action as one
“brought on behalf of a class of purchasers of Daou Systems,
Inc . . . . common stock [during the class period], seeking
damages resulting from a fraudulent scheme and course of
business by defendants, which harmed [such] purchasers.”
(emphasis added). Thereafter, the complaint goes on to allege
myriad misrepresentations made by defendants, of which
defendants had full knowledge, which induced plaintiffs’ reli-
ance, and which caused plaintiffs damages. The complaint
fully incorporates all allegations previously averred in the
complaint for purposes of all their claims. Because the com-
plaint makes a “wholesale adoption” of the securities fraud
allegations for purposes of the Securities Act claims, this
court need not “sift through allegations of fraud in search of
some ‘lesser included’ claim of strict liability”; indeed, plain-
tiffs here never rely on such conduct as negligence or mistake
in stating their claims. Cf. Vess, 317 F.3d at 1105-06. Thus,
all of plaintiffs’ claims, whether including an element of fraud
1420 IN RE DAOU SYSTEMS, INC.
or not, must satisfy the heightened pleading standard set out
in Rule 9(b). See In re Stac, 89 F.3d at 1404-05.

To survive dismissal, therefore, plaintiffs must demon-
strate, with particularity, “(1) that the registration statement
contained an omission or misrepresentation, and (2) that the
omission or misrepresentation was material, that is, it would
have misled a reasonable investor about the nature of his or
her investment.” In re Stac, 89 F.3d at 1403-04 (citation and
internal quotation marks omitted). Here, as discussed above,
plaintiffs have shown with sufficient particularity that defen-
dants engaged in materially false revenue reporting in the var-
ious statements disclosed during the class period. Thus,
plaintiffs’ section 11 claims against all defendants, including
defendant Moragne, survive dismissal under Rule 12(b)(6).

c. Plaintiffs’ claims under section 12(a)(2)

Section 12(a)(2) of the 1933 Securities Act imposes civil
liability on any person for use of any instrumentality of inter-
state commerce to offer or sell securities by means of a pro-
spectus or oral communication that includes “an untrue
statement of a material fact or omits to state a material fact
necessary in order to make the statements, in the light of the
circumstances under which they were made, not misleading
. . . .” 15 U.S.C. § 77l(a)(2). To establish liability under sec-
tion 12(a)(2), a plaintiff must allege that the defendants did
more than simply urge another to purchase a security; rather,
the plaintiff must show that the defendants solicited purchase
of the securities for their own financial gain:

The person who gratuitously urges another to make
a particular investment decision is not, in any mean-
ingful sense, requesting value in exchange for his
suggestion or seeking the value the titleholder will
obtain in exchange for the ultimate sale. The lan-
guage and purpose of § 12(1) suggest that liability
extends only to the person who successfully solicits
 IN RE DAOU SYSTEMS, INC. 1421
the purchase, motivated at least in part by a desire
to serve his own financial interests or those of the
securities owner. If he had such a motivation, it is
fair to say that the buyer “purchased” the security
from him . . . .

Pinter v. Dahl, 486 U.S. 622, 647 (1988) (emphasis added).

The purchaser must also demonstrate damages to recover
under section 12. Because section 12 provides that a person
who sells a security through use of material misstatements or
omissions “shall be liable . . . to the person purchasing such
security from him . . . [for] the consideration paid for such
security with interest thereon, less the amount of any income
received thereon, . . . or for damages if he no longer owns the
security,” 15 U.S.C. § 77l(a), there can be no recovery unless
the purchaser has suffered a loss. In re Broderbund/Learning
Co. Sec. Litig., 294 F.3d 1201, 1205 (9th Cir. 2002). “That is
to say, what the purchaser is entitled to is ‘a return of the con-
sideration paid, reduced by the amount realized when he sold
the security and by any “income received” on the security.’ ”
Id. (citing Randall v. Loftsgaarden, 478 U.S. 647, 656 (1986)
(citation omitted)). Causation, however, is not a necessary
element of a prima facie case under section 12 of the Securi-
ties Act. See Casella v. Webb, 883 F.2d 805, 808 & n.8 (9th
Cir. 1989) (holding that if the alleged misrepresentations are
material, a plaintiff is entitled to recovery whether or not the
misrepresentations caused the alleged damage).

[18] The district court failed to reach the issue of whether
Daou and the individual defendants were “directly involved”
in the actual solicitation of a securities purchase because it
had determined that “Plaintiffs’ 12(a)(2) claim necessarily
fails for lack of adequate allegations that Defendants made
any false or misleading statements or omissions of material
fact.” Because we hold that plaintiffs adequately averred
material misrepresentations on the part of defendants’ state-
ments in their various periodic disclosures, the district court
1422 IN RE DAOU SYSTEMS, INC.
must revisit the remaining elements of plaintiffs’ section
12(a)(1) claim to determine whether they are sufficient to sur-
vive dismissal under Rule 12(b)(6).

d. Plaintiffs’ claims under sections 15(a) of the 1933
Securities Act and 20(a) of the 1934 Exchange Act

Section 15(a) of the 1933 Securities Act imposes joint and
several liability upon every person who controls any person
liable under sections 11 or 12. 15 U.S.C. § 77o. Such section
provides:

Every person who, by or through stock ownership,
agency, or otherwise, or who, pursuant to or in con-
nection with an agreement or understanding with one
or more other persons by or through stock owner-
ship, agency, or otherwise, controls any person liable
under sections 77k or 771 of this title, shall also be
liable jointly and severally with and to the same
extent as such controlled person to any person to
whom such controlled person is liable, unless the
controlling person had no knowledge of or reason-
able ground to believe in the existence of the facts by
reason of which the liability of the controlled person
is alleged to exist.

Id. To state a claim under this section, a plaintiff must allege
that the individual defendants had power or influence over the
company and that the individual defendants were culpable
participants in the company’s alleged illegal activity. Durham
v. Kelly, 810 F.2d 1500, 1504 (9th Cir. 1987).

Similarly, section 20(a) of the 1934 Exchange Act provides
that “[e]very person who, directly or indirectly, controls any
person liable under any provision of [chapter 2B] or of any
rule or regulation thereunder shall also be liable jointly and
severally with and to the same extent as such controlled per-
son . . . .” 15 U.S.C. § 78t. “Controlling person” under both
 IN RE DAOU SYSTEMS, INC. 1423
of the above acts is given the same interpretation because
“section 20(a) [of the Exchange Act] is an analogue of section
15 of the Securities Act.” Durham, 810 F.2d at 1503 (citation
omitted) (alteration in original).

[19] Because the district court did not find that Daou or the
individual defendants had engaged in anything but “an exer-
cise of Defendants’ business judgment,” it also rejected plain-
tiffs’ contention that defendants should be liable under
sections 15(a) or 20(a). Again, because we conclude that
plaintiffs have adequately set forth a claim of accounting
fraud, the district court must reassess the viability of plain-
tiffs’ sections 15 and 20 claims as well.

CONCLUSION

Plaintiffs’ complaint, although lengthy and often repetitive,
states a sufficiently particularized claim for accounting fraud
under the heightened pleading standards of the PSLRA.
Accordingly, we need not reach plaintiffs’ request for leave
to amend nor defendants’ request for attorney’s fees. The case
is remanded to the district court for further proceedings con-
sistent with this opinion.

AFFIRMED in part; REVERSED in part and
REMANDED.