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United States District Court, S.D. New York

April 12, 2005.

PAULA TAFT, Individually and on Behalf of All Others Similarly Situated, Plaintiffs,

The opinion of the court was delivered by: PETER LEISURE, District Judge


This securities class action arises out of the bankruptcy of KPNQwest N.V. ("KPNQ" or the "Company"). Although a motion to dismiss is pending, Class Plaintiffs have moved to lift the automatic stay of discovery imposed by the Private Securities Litigation Reform Act of 1995 ("PSLRA") in order to obtain a draft of a report ("Report") prepared at the request of the KPNQ bankruptcy trustees ("Trustees") in the Netherlands. On January 14, 2005, this Court referred the motion to the Honorable Frank Maas, United States District Magistrate Judge, for disposition. Subsequently, however, Judge Maas alerted the Court of his conflict in deciding the matter. To expedite resolution of the motion, this Court takes up Judge Maas' mantle in lieu of assigning the motion to another Magistrate Judge. For the reasons set forth below, Class Plaintiffs' motion to lift the stay of discovery is denied. BACKGROUND

I. Alleged Fraud

  The Consolidated Second Amended Class Action Complaint ("Complaint" or "Compl.") is 242 pages long and contains more than 500 paragraphs detailing defendants' alleged fraud. In brief, as alleged in the Complaint, the facts of this case are as follows:*fn1

  Defendants Koninklijke KPN N.V., also known as Royal KPN N.V. ("KPN"), and Qwest Communications International ("Qwest") founded KPNQ as a joint venture on February 26, 1999. (Compl. ¶¶ 50, 57.) The Company "combined the pan-European fiber optic network . . . being developed by KPN with the European Internet-services business of Qwest, to provide European telecommunications and Internet services." (Id.) The resulting entity soon "became one of Europe's largest data communications services companies." (Id.)

  Over the course of its first three years of operation, KPNQ artificially inflated its financial performance in several ways. First, the Company sold both unused network capacity (known as "dark fiber") and active capacity (known as "lit fiber") to other telecommunications providers. (Id. ¶ 11.) The Company should have reported these sales of dark and lit fiber as "network capacity sales," distinct from telecommunications services revenues, in part because the fiber sales were generally nonrecurring. (Id.) Instead, the Company reported its dark fiber sales as "Infrastructure Revenues" and combined its revenues from lit fiber sales with telecommunications revenues, labeling the two "Communications Services Revenues." (Id.) This accounting treatment was materially misleading because it created the impression that sales of lit fiber were recurring revenues and concealed the extent to which the Company's revenue depended upon one-time lit fiber transactions. (Id.) Second, the network capacity sales often took the form of twenty-year leases, known as indefeasible rights of use ("IRUs"). (Id. ¶ 13.) Defendants violated Generally Accepted Accounting Principles by booking the full value of the IRUs in the quarter in which the contracts were executed, rather than spreading their value over the full lease term. (Id. ¶ 14.)

  Third, some of the IRU sales were not in fact sales, but non-cash swaps, known as "hollow swaps," (id. ¶¶ 13, 15), in which the Company purchased network capacity it did not need and sold its parent companies, and others, network capacity that they did not need. (Id. ¶ 15.) Swaps involving KPNQ's parent companies and their affiliates accounted for more than forty percent of the Company's revenue in fiscal years 2000 and 2001. (Id. ¶ 18.)

  Because knowledge of the general contours of the swapping scheme was "widespread throughout the Company," (id. ¶ 26), in addition to KPN and Qwest, the Complaint names as defendants various directors and officers of KPN, KPNQ, and Qwest. (Id. ¶¶ 33-48.) The Complaint does not name KPNQ as a defendant because the Company filed for bankruptcy protection in the Netherlands on May 31, 2002. (Id. ¶ 32.)

  Approximately one month earlier, on April 24, 2002, KPNQ issued a press release announcing that it was "drastically" reducing its revenue guidance for fiscal year 2002. (Id. ¶¶ 10, 235.) Following that press release, there was an "immediate sell-off" resulting in a forty-six percent decrease in the price of KPNQ stock in a single day. (Id. ¶ 236.) Over the course of the next five weeks, the price of KPNQ shares plummeted from $2.00 per share to $0.14 per share. (Id. ¶¶ 253, 256.)

  II. Ensuing Litigation

  The original Complaint in this action was filed on October 4, 2002, with amended Complaints filed on January 9, 2004, and October 15, 2004. (See Docket, Doc. Nos. 1, 13, 37.) The plaintiffs ("Class Plaintiffs") are persons who purchased KPNQ common stock during the Class Period, which is defined as November 9, 1999, through April 24, 2002. (Id. ¶¶ 10, 31.) The Complaint alleges that, during this period, defendants "engaged and participated in a continuous course of conduct to misrepresent the results of [KPNQ's] operations, and to conceal adverse material information regarding the finances, financial condition, and results of operations of [KPNQ]." (Id. ¶ 56.) Class Plaintiffs also allege that defendants engaged in various devices and schemes to defraud in an effort to "maintain an artificially high market price for [KPNQ] common stock." (Id.) This conduct on defendants' part is alleged to give rise to violations of Sections 11 and 15 of the Securities Act of 1933, as amended, and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, as well as Rule 10b-5.

  This class action suit is not the only litigation arising out of KPNQ's demise. On June 25, 2004, the Trustees filed a RICO action ("RICO action") in the District of New Jersey against Qwest and three of the individual defendants named herein. (Id. ¶ 3.)

  III. Draft Report

  After KPNQ sought bankruptcy protection, the Trustees commissioned an investigation by forensic experts, to be memorialized in a formal report analyzing the precipitating cause of the Company's failure and determining where responsibility should lie. (Class Plaintiffs' Memorandum of Law in Support of Motion to Lift the PSLRA Stay of Discovery in Order to Obtain the KPNQwest Bankruptcy Trustees' Report ("Pls.' Mem. of Law") at 1.) To date, the investigation has generated a draft Report, along with some eighteen volumes of supporting documents. (Id.)

  Although the final Report originally was slated to be issued in June 2003, it has been subject to numerous delays. (Compl. ¶ 2.) Class Plaintiffs maintain that they were not concerned about the early delays because "[l]ogical explanations were provided and the release of the [Final] . . . Report was always promised in the near future." (Pls.' Mem. of Law at 3.) For example, in November 2003, one of the Trustees stated that the final Report was being delayed so that its quality could be improved. (See Affidavit of Robert M. Zabb, Esq., in Support of Pls.' Motion to Lift the PSLRA Stay ("Zabb Aff.") Ex. A.) Similarly, in March 2004, Class Plaintiffs learned that the draft Report had been completed in January 2004 and provided "to the parties immediately involved" so that they could comment and make additions. (Id. ¶ 4, Ex. B at 5.) One of the Trustees indicated at the time that the parties' comments were due by May 15, 2004, with the expectation that the final Report would then be issued sixty days later. (Id. ¶ 5.) Thereafter, on August 4, 2004, the Trustees issued a statement indicating that they anticipated issuing the Report to the public "in the next reporting period," unless any of the parties immediately involved submitted "any strong objections." (Id. Ex. C at 3.)

  Despite this apparent progress, on November 5, 2004, one of Class Plaintiffs' counsel had a conversation with one of the Trustees, who advised him that the attorneys for defendants had been "quite successfully attempting to block release of the Trustees' Report." (Id. ¶ 6.) The Trustee further noted that he might not be inclined to release the Report to the public because the only parties who remained interested in its contents were Class Plaintiffs. (Id. ¶ 7.)

  IV. Motion to Lift Stay

  After learning that the final Report might never be made publicly available, Class Plaintiffs sought leave to make this discovery motion, which was filed on December 28, 2004. (Docket, Doc. No. 55.) Qwest was the only defendant to submit a substantive response in which all but one of the other defendants joined. (See Docket, Doc. No. 63.) The holdout defendant was Willem Ackermans, alleged to have served as KPNQ's Executive Vice President and Chief Financial Officer from the beginning of the Class Period until June 11, 2001, (Compl. ¶ 34), who submitted a Response in which he noted that "neither he nor his counsel has ever reviewed the draft Report; they do not possess a copy of it, nor have they ever objected to its publication." (See Defendant Willem Ackermans' Response to Pls.' Motion to Lift the PSLRA Stay ("Def. Ackermans' Resp.") at 2.)

  In their motion papers, Class Plaintiffs advance several reasons why the automatic stay should be lifted so that the draft Report may be produced. First, they raise the specter that a final Report may never be released, and that defendants' Dutch counsel could destroy their copies or return them to the Trustees, thereby, as a practical matter, resulting in the Report's suppression, unless efforts to obtain it through international discovery devices proved successful. (Pls.' Mem. of Law at 5-7.)

  Second, they suggest that they have been unfairly prejudiced because defendants and Trustees have the Report while they do not. (Id. at 8.) Class Plaintiffs argue that, without the Report, they are hindered in formulating a litigation strategy and will be on an unequal footing in terms of settlement discussions. (Id. at 8-9.) They note a recent news story suggesting that Qwest is in "intense mediation talks to settle its stockholder lawsuits." (Zabb. Aff. Ex. D at 1.) In their view, this raises a legitimate concern that others — including the Trustees — may be able to settle their suits, leaving inadequate resources to settle the Class Plaintiffs' litigation. (Pls.' Mem. of Law at 9.)


  I. Automatic Stay Provision of the PSLRA

  The relevant provision of the PSLRA provides that:

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).

  The Second Circuit has yet to provide the district courts with guidance regarding the PSLRA's discovery stay provision. Vacold LLC v. Cerami, No. 00 Civ. 4024, 2001 U.S. Dist. LEXIS 1589, at *22 (S.D.N.Y. Feb. 16, 2001). However, in accordance with the statute, undue prejudice has been defined as "improper or unfair treatment amounting to something less than irreparable harm." In re Vivendi Universal, S.A. Sec. Litig., No. 02 Civ. 5571, 2003 U.S. Dist. LEXIS 7606, at *5 (S.D.N.Y. May 5, 2003) (internal quotation omitted.) The legislative history of the statute indicates that Congress created the stay provision in order to alleviate the "concern that plaintiffs are seeking discovery to coerce a settlement or to support a claim not alleged in the Complaint." See Vacold, 2001 U.S. Dist. LEXIS 1589, at *24 (citing H.R. Conf. Rep. No. 104-369, at 37 (1995); S. Rep. No. 104-98, at 14 (1995)); see also In re Worldcom Sec. Litig., 234 F. Supp. 2d 301, 305 (S.D.N.Y. 2002) ("The legislative history of the PSLRA indicates that Congress enacted the discovery stay in order to minimize the incentives for plaintiffs to file frivolous securities class actions in the hope either that corporate defendants will settle those actions rather than bear the high cost of discovery.") (citations omitted).

  Despite the limited concern of Congress in enacting the stay provision, it is only in exceptional circumstances that a court will lift a PSLRA stay of discovery before a motion to dismiss has been decided. See In re Vivendi, 2003 U.S. Dist. LEXIS 7606, at *4; Vacold, 2001 U.S. Dist. LEXIS 1589, at *5-6. In this District, Courts lifted stays "where defendants might be shielded from liability in the absence of the requested discovery," Vacold, 2001 U.S. Dist. LEXIS 1589, at *5 (citing Global Intellicom, Inc. v. Thomson Kernaghan & Co., No. 99 Civ. 342, 1999 U.S. Dist. LEXIS 5439, at *4 (S.D.N.Y. Apr. 16, 1999) (lifting the stay where plaintiff's redress would be foreclosed absent discovery)), and where plaintiff would be the only major interested party without the crucial information during Court ordered settlement negotiations, see In re Worldcom, 234 F. Supp. 2d at 305.

  II. Preservation of Evidence

  Class Plaintiffs have constructed a scenario which, in their view, mandates production of the draft Report to ensure that it is not destroyed. More specifically, they allege in their memorandum of law that KPNQ's assets are currently being sold as part of the Netherlands bankruptcy proceeding. (Pls.' Mem. of Law at 11.) Based upon this fact, they express fear that all of the copies of the Report will end up in uncertain locations as assets are divested, and that the Trustees eventually will be relieved of their obligations, including any duty that they otherwise might have to help Class Plaintiffs locate a copy of the Report. (Id.) Class Plaintiffs contend that the urgency of the situation is compounded by the collapse of KPNQ's former auditor, Arthur Andersen & Company. (Id.)

  Defendants have an obligation to preserve evidence that they "know?, or should know, may be relevant to actual or foreseeable litigation." Smith v. City of New York, No. 03 Civ. 3048, 2005 U.S. Dist. LEXIS 231, at *21-22 (S.D.N.Y. Jan. 11, 2005). The PSLRA also notes this duty:

During the pendency of any stay of discovery pursuant to this paragraph, unless otherwise ordered by the court, any party to the action with actual notice of the allegations contained in the complaint shall treat all documents, data compilations . . . and tangible objects that are in the custody or control of such person and that are relevant to the allegations, as if they were the subject of a continuing request for production of documents from an opposing party under the Federal Rules of Civil Procedure.
15 U.S.C.A. § 78u-4(b)(3)(C)(i). Indeed, the court may sanction a party for failure to preserve evidence pursuant to Rule 37(b) of the Federal Rules of Civil Procedure and its inherent sanctioning power. Smith, 2005 U.S. Dist. LEXIS 231, at *21; see also 15 U.S.C.A. § 78u-4(b)(3)(C)(ii) ("A party aggrieved by the willful failure of an opposing party to comply [with the preservation of evidence requirement] may apply to the court for an order awarding appropriate sanctions.").

  In this case, however, Class Plaintiffs' fears have no basis. In fact, in its opposition papers, Qwest notes that it advised the Court and Class Plaintiffs' counsel, prior to the filing of the present motion, that "Qwest and its counsel of record [O'Melveny & Myers LLP] . . . are in possession of the [draft] Report." (See letter from Matthew W. Close, Esq., to the Hon. Peter K. Leisure, dated Dec. 17, 2004, at 1.) Additionally, Qwest's counsel assured the Court and Class Plaintiffs' counsel that Qwest and its counsel were preserving the draft Report "in the form in which it was provided to Dutch counsel," and therefore, "it will be available for inspection and copying if and when discovery is permitted in this case." (Id.) Given these representations, there simply is no basis to conclude that the stay must be lifted to ensure that the draft Report is preserved and available for inspection by Class Plaintiffs' counsel should the Complaint survive the motion to dismiss. See Vivendi, 2003 U.S. Dist. LEXIS 7606, at *4-5 (denying motion to lift stay because "the loss or risk of loss of documents [is] minimal" where defendants "made the representation that they have copies of all the documents [in question] . . . and that they must and will be preserved").

  III. Undue Prejudice

  A. Litigation and Settlement Strategy

  Class Plaintiffs also contend that they are unduly prejudiced by the stay because the draft Report would assist them in formulating litigation and settlement strategy. (Pls.' Mem. of Law at 8.) There are several elements to this claim. First, Class Plaintiffs allege that they will be disadvantaged as Qwest rushes to settle lawsuits in which it has been named as a defendant because defendants and Trustees have the draft Report while Class Plaintiffs do not. (Id. at 8-9.) They theorize that as part of this settlement process, Qwest may settle the Trustees' RICO Action, thereby "removing [their] most informed opponent and potentially suppressing the Trustees' Report as part of the settlement agreement." (Id. at 9.) Class Plaintiffs argue that this would reduce their leverage in any settlement discussions and might force them to litigate with a defendant with substantially depleted financial resources. (Id.)

  Class Plaintiffs' prejudice argument therefore hinges on at least three predicate conditions: (1) that Qwest and the Trustees will settle the RICO Action before the motion to dismiss this action is decided; (2) that their settlement will include language intended to keep the draft Report confidential; and, (3) that a court will enforce the confidentiality provisions of that settlement agreement to Class Plaintiffs' detriment.

  This alleged justification for lifting the discovery stay fails for several reasons. First, Class Plaintiffs have provided no evidence that any settlement talks between Qwest and the Trustees actually are underway. Indeed, the newspaper article cited by plaintiffs refers to the settlement of shareholder class action suits, not the RICO Action. (See Zabb Aff. Ex. D.) Consequently, there is no basis for Class Plaintiffs' assertion that defendants are likely to suppress the draft Report as part of a settlement with the Trustees. See In re AOL Time Warner, Inc. Sec. & "ERISA" Litig., No. 02 Civ. 5575, 2003 U.S. Dist. LEXIS 12846, at *6 (S.D.N.Y. July 21, 2003); Vivendi, 2003 U.S. Dist. LEXIS 7606, at *6-7 (declining to lift the automatic stay where there was "no evidence that plaintiffs face the . . . prospect . . . that they would be left without remedy in light of settlement discussions or other intervening events"). Second, even if Qwest were to settle the RICO Action before the motion to dismiss is decided, and the parties were to agree to keep the draft Report confidential as part of that settlement, the draft Report still would be subject to production in this action if it meets the criteria set forth in Rule 26(b)(1) of the Federal Rules of Civil Procedure. See Tribune Co. v. Purcigliotti, No. 93 Civ. 7222, 1996 U.S. Dist. LEXIS 8483, at *1-2 (S.D.N.Y. June 19, 1996) ("Rule 26 of the Federal Rules of Civil Procedure sets the general standards for discovery, including the discovery of settlement-related information."); see also In re Initial Pub. Offering Sec. Litig., No. 21 MC 92, 2004 U.S. Dist. LEXIS 23102, at *24-25 & n. 41 (S.D.N.Y., as amended, Jan. 12, 2004) (same). While the discoverability of the draft Report pursuant to Rule 26(b)(1) need not be decided at this juncture, it is hard to think of a reason why the draft Report would not be relevant to the claims or defenses of the parties to this suit. Moreover, because the draft Report apparently predates any settlement discussions, defendants in this action do not appear to be entitled to even the "modest presumption" against the disclosure of settlement materials that some courts have applied. See, e.g., SEC v. Thrasher, No. 92 Civ. 6987, 1996 U.S. Dist. LEXIS 2141, at *6 (S.D.N.Y. Feb. 26, 1996). The Court will therefore almost certainly be able to order Qwest and its counsel to produce the draft Report if the Complaint survives defendants' motion to dismiss.

  This case is substantially different than In re Worldcom, 234 F. Supp. 2d at 301, upon which Class Plaintiffs place considerable reliance. There, corporate defendant Worldcom was facing numerous investigations, a suit pursuant to the Employment Retirement Income Security Act of 1974 ("ERISA"), and a securities litigation. Id. at 302-03. While certain documents had been produced to government agencies and the creditor's committee, and were likely to be produced to ERISA plaintiffs, the automatic stay of discovery barred their production to plaintiffs in the securities litigation. Id. at 305. Because all of the proceedings against Worldcom were "moving apace," and Judge Denise L. Cote had ordered all of the parties in the ERISA and securities litigations to participate in settlement discussions with defendants, if the discovery stay remained in place, securities plaintiffs would have been the "only major interested party" without access to the documents, which would have put them at a "severe? disadvantage?" in settlement negotiations. Id. at 305-06. Accordingly, based "upon the unique circumstances," Judge Cote lifted the automatic discovery stay. Id. at 305-06; see also In re AOL, 2003 U.S. Dist. LEXIS 12846, at *6 ("[A]lthough Lead Plaintiff asserts that settlement discussions between various Defendants and the government are currently on-going, in contrast to In re Worldcom, Inc. Sec. Litig., supra, where court-ordered settlement discussions had been scheduled and defendant had filed for bankruptcy, in this action Lead Plaintiff's assertions of an impending settlement that could prejudice plaintiffs' possible recovery are premature.")

  By comparison, there has been no showing here that Qwest is involved in settlement discussions with the Trustees. Moreover, counsel for Class Plaintiffs have not been directed to participate in any settlement discussions in which other parties will be better informed of the facts of the case. Finally, it appears that Class Plaintiffs are not the only individuals who are in the dark concerning the draft Report. Indeed, defendant Ackermans and his counsel also have never seen the draft Report. See supra Background Part IV. In these circumstances, Class Plaintiffs simply have not shown, as they must, that they will suffer undue prejudice in the formulation of their litigation or settlement strategy unless the draft Report is made available to them now. 2. Arthur Andersen Documents

  Class Plaintiffs also argue that the draft Report should be produced because it may contain information concerning "the location of Arthur Andersen audit documents pertaining to [KPNQ which] would be invaluable to the truth seeking process." (Pls. Mem. of Law at 11.) They further suggest that they "need to have and follow up on any such information without further delay." (Id.)

  Here, again, the notion that the draft Report contains information concerning the location of Arthur Andersen's documents is sheer speculation. Accordingly, Class Plaintiffs have not made a showing sufficiently specific to justify lifting the stay of discovery. See Vivendi, 2003 U.S. Dist. LEXIS 7606, at *4 ("A party alleging that discovery is necessary to preserve evidence must . . . make a specific showing that the loss of evidence is imminent as opposed to merely speculative.") (internal quotation omitted).


  For the reasons set forth above, Class Plaintiffs' motion to lift the stay of discovery, pursuant to the PSLRA, to allow for the production of the draft of the Trustees' Report is DENIED.


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