Defendants DCI Telecommunications, Inc. ("DCI"), Joseph J.
Murphy ("Murphy"), Russell B. Hintz ("Hintz"), and relief
defendant Grace P. Murphy (collectively "Defendants") have moved
to dismiss the First, Second, and Sixth Claims of the complaint
in their entirety and the Fifth and Seventh Claims in part,
pursuant to Rule 12(b)(6), Fed.R.Civ.P. For the reasons set forth
below, the motion is denied.
Plaintiff Securities and Exchange Commission ("SEC") is a
governmental agency charged with the task of ensuring compliance
with federal securities laws.
DCI is a Colorado corporation headquartered in Stratford,
Murphy, a Connecticut resident, is the Chairman of the Board,
Chief Executive Officer, President, and a major shareholder of
Hintz, a Connecticut resident, is the Chief Financial Officer
Grace Murphy resides in Connecticut with her husband, Joseph
This case involves alleged violations of Generally Acceptable
Accounting Principles ("GAAP") which, if true, may constitute
violations of the books and records provisions and the reporting
provisions of the Securities and Exchange Act of 1934,
15 U.S.C. § 78j(b), 78t(a), (the "Exchange Act"), as well as the
anti-fraud provisions of the Securities Act of 1933, 15 U.S.C. § 77q
(a)(2) & (3), (the "Securities Act").
Specifically, the complaint alleges that the Defendants
improperly accounted for seven acquisitions and grossly
overvalued a purported $15 million contract and $5 million
promissory note, which caused the financial statements in five
Forms 10-K and twelve Forms 10-Q that DCI filed with the SEC over
a five-year period to be materially false and misleading. DCI's
SEC filings allegedly overstated their assets by 40% to 1408%
during this period. In addition, the complaint alleges that DCI
unlawfully raised additional funds by causing its employees to
sell S-8 stock to the public and then "kick back" sales proceeds
On August 18, 2000, Defendants moved to dismiss the First,
Second, and Sixth Claims in the Complaint in their entirety, and
to dismiss the control person elements of the Fifth and Seventh
Claims. In brief, the defendants contend that because the
Complaint fails to aver that the alleged GAAP violations were
intended to, or did, have any impact on DCI's stock price, the
fraud allegations fail to state a claim as a matter of law. With
regard to the sale of unregistered securities claim, Defendants
contend that the SEC has failed to allege the necessary element
of a preexisting plan to ensure DCI received the benefit of its
employees' sale of S-8 stock to the public.
The SEC filed a memorandum in response on September 19, 2000,
and the motion was deemed fully submitted upon the filing of the
Defendants' reply memorandum on September 27, 2000.
I. Motion to Dismiss
In reviewing a motion to dismiss under Rule 12(b)(6), a court
must "accept as true the factual allegations of the complaint,
and draw all inferences in favor of the pleader." Mills v. Polar
Molecular Corp., 12 F.3d 1170, 1174 (2d Cir. 1993) (citing IUE
AFL-CIO Pension Fund v. Herrmann, 9 F.3d 1049, 1052 (2d Cir.
1993)). Dismissal is warranted only when "it appears beyond doubt
that the plaintiff can prove no set of facts in support of his
claim which would entitle him to relief." Conley v. Gibson,
355 U.S. 41, 45-46, 78 S.Ct. 99, 2 L.Ed.2d 80 (1957) (footnote
omitted). See also Bass v. Jackson, 790 F.2d 260, 262 (2d Cir.
A. Claims 1 and 2 State Claims for Violations of the
Anti-Fraud Provisions of the Securities Act and Exchange Act,
and Claim 5 States A Control Person Claim Based on the Acts
Alleged in Claims 1 and 2
Claims 1 and 2 allege that the Defendants violated Section 17
of the Securities Act and Rule 10b-5 of the Exchange Act.*fn1
Section 10(b) was designed to protect investors involved in the
purchase and sale of securities by requiring full disclosure.
Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 477-78, 97 S.Ct.
1292, 1303-04, 51 L.Ed.2d 480 (1977).
Violation of the anti-fraud statutes requires proof that the
Defendants used interstate commerce, and made material false or
misleading misrepresentations and omissions in connection with
the offer, purchase or sale of securities, with scienter. Aaron
v. SEC, 446 U.S. 680, 697, 100 S.Ct. 1945, 1955, 64 L.Ed.2d 611
(1980); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 195, 96
S.Ct. 1375, 1382, 47 L.Ed.2d 668 (1976); SEC v. First Jersey
Secs., Inc., 101 F.3d 1450, 1466-67 (2d Cir. 1996). However,
neither section 17(a)(2) nor section 17(a)(3) of the Securities
Act requires scienter. The Defendants argue that in order to make
out the requisite materiality, scienter and "in connection with"
elements of a securities fraud claim, a complaint must allege
that the price manipulations were intended to, and in fact did,
have some impact on stock prices. Def. Mem. at 3-4. Both parties
agree that, if true, the violations of GAAP meet the element of
misrepresentations or omissions. See Def. Mem. at 3.
A statement or omission is material if "there is a substantial
likelihood that a reasonable shareholder would consider it
important" or, in other words, "there [is] a substantial
likelihood that the disclosure of the omitted fact would have
been viewed by the reasonable shareholder as having significantly
altered the `total mix' of information available." Basic, Inc.
v. Levinson, 485 U.S. 224, 232, 108 S.Ct. 978, 983, 99 L.Ed.2d
194 (1988) (adopting standard of TSC Indus., Inc. v. Northway,
Inc., 426 U.S. 438, 449, 96 S.Ct. 2126, 2132, 48 L.Ed.2d 757
(1976)). "When presented with a Rule 12(b)(6) motion, `a
complaint may not properly be dismissed . . . on the ground that
the alleged misstatements or omissions are not material unless
they are so obviously unimportant to a reasonable investor that
reasonable minds could not differ on the question of their
Ganino v. Citizens Utilities Co., 228 F.3d 154, 162 (2d Cir.
2000) (quoting Goldman v. Belden, 754 F.2d 1059, 1067 (2d Cir.
The Defendants argue that the accounting irregularities were
not material because there is no allegation that DCI stock price
was affected by the overvaluation of assets in the SEC filings.
However, the Supreme Court has warned against "confining
materiality to a rigid formula." Basic, 485 U.S. at 236, 108
S.Ct. at 986. There is no requirement that stock prices fluctuate
as a result of a defendant's misstatements or omissions in order
for them to be material. See United States v. Bilzerian,
926 F.2d 1285, 1298 (2d Cir. 1991) ("whether a public company's stock
price moves up or down or stays the same after [filing] does not
establish the materiality of the statements made, though stock
movement is a factor the jury may consider relevant.").
In this case, DCI allegedly overvalued its assets by 40% to
1408% each year over a five-year period in five Forms 10-K and
twelve Forms 10-Q, and then advertised "record breaking" revenues
in the company's annual reports, press releases, and on its
website. Compl. ¶¶ 1-3, 16-17, 29, 31, 36, 47-51, 55-60, 65,
70-75, 80-85, 90, 102-11. Because the complaint alleges that the
Defendants emphasized their false earnings to potential
investors, and because "earnings reports are among the pieces of
data that investors find most relevant to their investment
decisions," Ganino, 228 F.3d at 164 (citations omitted), it is
reasonable to infer that the misstatements or omissions were not
"obviously unimportant" to the investing public. Therefore, the
materiality element has been adequately pled.
2. Misleading Misrepresentations "In Connection With" the
Offer, Purchase, or Sale of Securities
Defendants advance essentially the same argument with respect
to the "in connection with" element of securities fraud. This
element requires a plaintiff to allege that false financial
information was disseminated into the marketplace in a manner
reasonably calculated to influence the investing public. See
Ames Department Stores, Inc. Stock Litig.,