T hi s or derand j udgm enti s notbi ndi ng pr ece dent , exce ptunderthe doctr i nes of * l aw of the ca s e, r es j udi cat a, and col l at er ales t oppel . T he courtgener al l ydi s favor s the ci t at i on of or der s and j udgm ent s ; neverthel es s , an or derand j udgm entm aybe ci t ed under the t erm s and condi t i ons of 10th C i r . R . 36. 3. 

## F I LED Unite d St ate s C ourt o f Appe als Te nth Cir c uit 

### Ju ly 14, 2006 Elisab eth A. Shumaker C l erk of C ourt UNI TED S TATES CO URT O F AP PEALS

T E N T H C IR C U IT
J ON M CNAM ARA; RI CHARD L ANDIN, P l ai nti ffs - A pp el l ants , v. P R E -P A ID L E G A L S E R V IC E S , IN C ., HARLAND C. S TONECI P HER; RA N D Y H A RP; K A TH LEE N S. P IN S O N ; P E T E R K . G R U N E B A U M; DA VI D A . SAV ULA ; DELO I TTE & TOU CH E, D efen dan t s - A pp el l ees. N os . 02- 6110 & 02- 6178

ORDE R AND J UDGM EN T * B efor e KE L L Y, L UC E RO and O’ BRI EN , C i rcui tJudg es.

L e a dP lain tiff

s J o n M c N a m a raa n dR ich a rdL a n d in(P lain tiff s), o n b e h a lf

o f a ll peopl e w ho pur chas ed Pr e- Pai d L egalServi ces ( Pr e- Pai d) s t ock fr om M ar ch 18, 1999, th ro u g h M a y1 5 , 2 0 0 1 , b ro u g h t th is s e c u rities f rau da c tio n a g a in st P re -P a id , se v e ra l o f itsT h e fiv e v o lu m e re c o rd in th is c a se c o n sis ts o f o v e r 1 ,8 0 0 p a g e s. W h ile 1 eac h vol um e cont ai ns an i ndex w i t h page number s for l ar ge pl eadi ngs s uch as Pr ePai d D efe ndant s ’ M ot i on t o D i s m i s s and Pr e- Pai d D efe ndant s ’ R eques t for J udi ci al N ot i ce, no page number s or exhi bi t num ber s ar e pr ovi ded for t he n u m e ro u s e x h ib its w h ic h w e re a tta c h e d to th e s e p le a d in g s in th e d is tr ic t c o u rt . T he par t i es ’ fai l ur e t o pr ovi de s uch page and/ or exhi bi t num ber s has m ade d e c id in g th is c a s e u n n e c e s s a ri ly la b o ri o u s . Pr e- Pai d began t r adi ng i t s comm on s t ock on t he N ew Y or k St ock 2 E xchange i n 1999. Pr i or t o M ay 19, 1999, i t t r aded i t s s t ock on t he A m er i can St ock Exchange. 2 s eni oroffi cer s and di r ect or s , and D el oi tt e & T ouche ( D el oi tt e) , Pr e- Pai d’ s i ndepende nt au d ito r. T h e d istric t co u rt d ism iss e dP lain tiff s’ c o m p lain t w ithp re

ju d ice p u rsu a n t to R u le 1 2 (b )(6 ) o f

th e F e d e ra l Ru les o f

C iv il P ro c e du re . P lain tiff s ap p e a l f

ro m th e d ism iss a l, ar gui ng the di s tr i ctcourterr ed i n concludi ng: ( 1) theyhad nots uffi ci entl yal l eged s ci ent er , ( 2) thei rcl ai m s w er e barr ed bythe s t atut e of l i m i t at i ons and ( 3) the truth- on- the m arketdoctr i ne i ns ul at ed D efe ndant s fr om l i abi l i ty . Pl ai nt i ffs al s o as s ertthe di s tr i ct courtabus ed i t s di s cr et i on i n di s m i s s i ng thei rcas e w i th pr ej udi ce, r atherthan pr ovi di ng them an o pp ortun i tyt o am end theircom plai nt t o co rr ecti t s pl eading d efi ci encies . E x erc isi n g juri sd ict ion u n d er 2 8 U . S . C . § 1 2 9 1 , w e a ff irm , co n clud ing the d istri ct co u rt pr oper l ydi s m i s s ed Pl ai nt i ffs ’ compl ai ntw i th pr ej udi ce f orfai l ur e t o adequat el ypl ead scien ter. 1 I . FactualB ackgr ound Form ed i n 1976, Pr e- Pai d i s an O kl ahoma corpor at i on w hi ch des i gns , underw r i t es and market s a vari etyof l egalexpens e pl ans , cal l ed mem ber s hips , acr os s N orth A m er i ca. 2 I n exchange fora fi xed pr emi um , m ember s hips ent i t l e thei rhol der s t o r ece i ve l egalP re -P a id h a s tw o ty p e s o f m e m b e rsh ip s, o p e n -p a n e l an d c lo se d -p a n e l. 3 S u b sta n tially a ll o f

th e m e m b e rsh ip s a re c lo se d -p a n e l, w h ich re q u ire m e m b e rsh ip hol der s t o acc es s l egal s er vi ces t hr ough a net w or k of i ndepende nt l aw fi r m s under cont r act w i t h Pr e- Pai d. C om m i s s i ons ar e pai d t o t he s el l i ng as s oci at e and a ny as s oci at e w ho 4 di r ect l y or i ndi r ect l y r ecr ui t ed t he s el l i ng as s oci at e. A s s oci at es coul d choos e t o r ece i ve l es s t han a t hr ee- y ear advanc e. 5 3 se rv ice s (o r re im b u rse m e n t o f leg a l f e e s in c u rre df

o r su c h se rv ice s) in am a n n e r sim ilar to m edi calr ei m bur s ementpl ans orH M O ’ s . M ember s hips ar e aut om at i cal l yr enew abl e but 3
m a yb e c a n c e lleda t an ytim e f o r f rau d , n o n -p a ym e n t o f

p re m iu m s o r up o n am e m b e rsh ip h o ld e r’s w ritten re qu e st. Pr e- Pai d m arket s i t s m ember s hips thr ough a mul t i - l evelm arket i ng pr ogr am w hi ch enco urages P re- P ai d’s s al es ass ociat es t o sel lm em berships and recruitnew associ at es. S ales a sso ciates a re c o n side redind ep en d en t con tr ac tors an dare p aid b yco m m issi o n . In 4 gener al , w hen an a s s oci at e s el l s a mem ber s hip, Pr e- Pai d advanc es thatas s oci at e a com m i ssi on equ al t o thr ee y ears w orth o f com m i ssi on s. P re- P ai d recoups these 5 “com m i ssi on adv ances” as prem i um s ar e coll ect ed, usuallyon a m on thlybasi s. S h o u l dam e m b e r s h i p l ap s e b e f o r e th r e e ye a r s , th e a s s o c i a t e i s o b l i g a t e dt o “ r e p a y” anyunearned port i on of the comm i s s i on advanc e. T o r e- captur e 50% of anyunearned advanc e, Pr e- Pai d gener at es a “c har ge- back” t o the as s oci at e’ s acc ount . T hi s charge- back is im m e d iate lyd e du c ted f ro m a n yf

u tu re c o m m iss io n a d v a n c e s p a y ab le to th e a ss o c iate forthe s al e of ne w m ember s hi ps . Pr e- Pai d r ecove r s the r emai ni ng 50% byw i thhol di ngPr e- Pai d di d not di s cl os e t hi s addi t i onal m et hod of r ecove r i ng unear ned 6 c o m m is s io n a d v a n c e s u n til 2 0 0 1 . C ompa re P re-P aid’s F o rm 8 -K d ated Jan u ary 2 5 , 2 0 0 1 , at 5 (A p p . V o l. I at A -21 6 ) andPr e- Pai d’ s O r i gi nal For m 10- K for y ear en d ing D ec em b er 3 1 , 2 0 0 0 , at 22 (S u p p . A p p . V o l. I at S A -30 ) w ith P re-P aid’s F o r m 1 0 - K fo r y e a r e n d i n g De c e mb e r 3 1 , 1 9 9 8 , a t 1 6 ( S u p p . Ap p . Vo l . I I a t S A5 8 2 ) andPr e- Pai d’ s For m 10- K for y ear endi ng D ece m ber 31, 1999, at 21 ( Id. at S A -66 3 ). G ener al l y A cce pt ed A ccount i ng Pr i nci pl es ( G A A P) ar e a body of 7 pr onouncement s t hat gover n t he meas ur ement and r epor t i ng of fi nanci al in fo rm a tio n a n d re la te d d is c lo s u re . See Uni t ed St at es v. A r t hur Young & Co. , 465 U . S. 805, 811 n. 7 ( 1984) ( defi ni ng G A A P as "t he conve nt i ons , r ul es , and pr ocedur es t hat defi ne ac cept ed ac count i ng pr act i ces ") . T r adi t i onal l y , acc ount i ng sta n d a rd s h a v e b e e n se t in th e p riv a te s e c to r, alth o u g h th e S E C h a s th e p o w e r to s et s uch s t andar ds for publ i cl y t r aded c om pani es . W hi l e t he A m er i can I ns t i t ut e of C er t i fi ed Publ i c A ccount ant s ( A I C PA ) has i nput i nt o s uch s t andar ds , an in d e p e n d e n t, pr iv a te b o d y , the F in a n c ial A c c o u n tin g S tan d a rd s B o a rd , is p ri m a ri ly re s p o n s ib le fo r s e ttin g a c c o u n tin g s ta n d a rd s . Id. G A A P i ncl udes br oad pr onouncement s as w el l as s om e ver y s peci fi c r ul es for cer t ai n t r ans act i ons , and w het her a par t i cul ar m et hod of r epor t i ng i s cons i s t ent w i t h G A A P i s oft en a m a tter o f

p ro fe ss io n a l ju d g m e n t. 4 futur e comm i s s i ons due an a s s oci at e on ac t i ve/pr i orm ember s hips . N o addi t i onal 6 comm i s s i on advanc es ar e pai d t o an as s oci at e unt i lal lpr evi ous advanc es have be en r ecove r ed. Pr e- Pai d carr i es a r es erve forunr ecove r abl e comm i s s i on advanc es . B etw een 1997 and 1999, Pr e- Pai d i ncr eas ed thi s r es erve fr om $3. 7 m i l l i on t o $4. 5 m i l l i on. A. R e p o rtin go f U n e a rn e d C o m m iss io n A dv a n c es a s A ss e ts Pr e- Pai d r eport s quart er l yand annua l l yt o the Securi t i es and Exchange C o m m iss io n (S E C ) u sin g F o rm s 1 0 -Q a n d1 0 -K , res p e c tiv e ly . Inth e se f o rm s, P re -P a id p ro v id e s its f

in a n c ial s tate m e n ts. T h e se sta tem e n ts a re p re p a re da c c o rd in g to G e n e ra lly A cce pt ed A ccounti ng Pr i ncipl es ( G A A P) and ar e audi t ed byPr e- Pai d’ s i ndepende nt 7 au d it o r. F rom S ep tem b er 1 9 9 4 u n ti l A u g u st 20 0 1 , D eloitt e se rve das P re-P aid’sI n i t s 1995 and 1996 For m 10- K ’ s , Pr e- Pai d r efe r r ed t o t he unea r ned 8 p o rt io n o f

c o m m is s io n a d v a n c e s a s “ C o m m is s io n a d v a n c e s ” o n its b a la n c e s h e e t. (A p p . V o l. II at A

– 4 7 1 ; Su p p . A p p . V o l. I at S A -42 3 . ) In it s 1 9 9 8 an d 1 9 9 9 F o rm 1 0 -K ’s, it re fe rre d to it as “ M e m b e rsh ip c o m m iss io n a d v a n c e s.” (S u p p . A p p . V o l. I I at SA - 595, SA - 676. ) D es pi t e t he name as s i gned, “C om m i s s i on advanc es ” and “M ember s hi p comm i s s i on advanc es ” r epr es ent ed onl y t he unear nedpor t i on of comm i s s i on advanc es . I t w as t hi s unear ned por t i on t hat Pr e- Pai d r ecor ded as an a ss e t. Pr e- Pai d’ s 1997 For m 10- K i s not i n t he r ecor d.

9 5 ind ep en d en t aud it o r. F ro m a t lea st 1 9 9 5 to 2 0 0 0 , P re -P a id , b a se do n its th e o ryth a t ith a darig h t to recei ve u nearnedcom m i ssi on adv ances b ack f rom i t s ass ociat es ( i.e ., a re ce ivab le), r ecor ded unearned

c o m m iss io n a d v a n c e s a s a ss e ts. D u rin g th is s a m e p e rio d , D e lo itt e 8 audi t ed Pr e- Pai d’ s fi nanci als t at ement s and i s s ued unqual i fi ed opi ni ons thatthey conform ed w i th G A A P and fai r l yr epr es ent ed Pr e- Pai d’ s fi nanci alpos i t i on. B . P re-P a id’s 1 9 9 5 , 1 9 9 6, 1 9 9 8 a n d 1 9 9 9 Fo rm 1 0 -K ’s I n i t s 1995, 1996, 1998 and 1999 Form 10- K ’ s , Pr e- Pai d di s cl os ed i t s comm i s s i on advanc e pol i cyand the ac t i ons i tt akes t o r ecoup i t s comm i s s i on advanc es . I ts t at ed that 9 hi s t or i cal l yi thad bee n abl e t o i m m edi at el yr ecove r50% of anyunearned comm i s s i on advanc e thr ough the us e of the char ge- back. H ow ever , Pr e- Pai d w arned i t s comm i s s i on adv ance p oli cyexp oses i tt o the r i sk of u nco l l ect i ble com m i ssi on adv ances. P re- P ai d als o sta ted o n e o f

th e m a jo r f a c to rs a f f e c tin g its p ro f

itab ili tya n dc a sh f

lo w w a s its m e m b e rsh ip p e rsis ten c yra te, w h ich it rep re se n ted a s its ab ili tyto re tain am e m b e rsh ip o n c e it i s w ritten a n dth e re f o re c o llec t p re m iu m s. P re -P a idre p o rte dits m e m b e rsh ip6

per s i s t encyr at e w as 80. 0% for1995, 74. 0% for1996, 73. 8% for1998 and 73. 4% for 1 9 9 9 . B e tw e e n 1 9 9 5 a n d1 9 9 9 , P re -P a id ’s m e m b e rs h ip p re m iu m s in c re a s e df ro m $ 3 1 .2 m i l l i on t o $ 15 7. 2 m i l l i on . D uri ng this sam e t i m e peri od , new m em bership sal es r ose fro m 1 0 9 , 9 2 2 to 5 2 5 , 3 5 2 . T o talu n ea rne dco m m issi o n ad v an ce s also g rew ea ch y ea r, in c re a sin g f

ro m $ 1 2 .5 m ill io n in1 9 9 5 to $ 1 2 0 .6 m ill io n in1 9 9 9 . B e c au se P re -P a id r ecor ded unearned comm i s s i on advanc es as as s et s , as unearned comm i s s i on advanc es i ncr eas ed s o di d Pr e- Pai d’ s t ot alas s et s . B y1999, Pr e- Pai d’ s unearned comm i s s i on ad v an ce s rep rese n ted 6 2 . 2 % o f P re-P aid’s total asse ts ( $ 1 9 3 . 8 m il li o n ). C
. P re-P a id’s Ja n u a ry 2 5 , 2 0 0 1 Fo rm 8 -K O n J anuary25, 2001, i n r es pons e t o publ i c di s cus s i on conce rni ng i t s acc ount i ng tre a tm e n t o f

u n e a rn e dc o m m iss io n a d v a n c e s, P re -P a idf iledaF o rm 8 -K w ithth e S E C “ to pr ovi de det ai l s r egar di ng the ac count i ng tr eatm entof [] comm i s s i on advanc es and e x p e n se s . . . .” (R . A p p . V o l. I at A -2 1 3 .) Inth is F o rm 8 -K , P re -P a ide x p lain e dw h yit be l i e ve d i t s tr e a tmentof un e a rne d c omm i s s i ona dv a nc e s a s a s s e t s c ompl i e d wi th GA A P. S p e c if ica lly , itsta ted th a t b e c au se its “ c o m m iss io n a d v a n c e s re late d ire c tlyto m em berships that r epresenta future econo m i c ben efi t(a s tream of f utur e cash p aym ents ) to b e re c e iv e db y[ P re -P a id ] a s a re su lt o f ap a st tra n sa c tio n (th e o rig in a l m e m b e rsh ip sa le) ,” its c o m m iss io n a d v a n c e s c o n f o rm e dto G A A P ’s d e f

in iti o n o f a ss e ts a s “ p ro b ab le futur e econ om i c ben efi t s obtai ned or contr oll ed b ya part i cularenti tyas a r esul tof p ast tr ans acti ons orevent s . ” (I d. atA - 213- A - 214 ( quot at i ons om i tt ed) . ) B ecaus e the key iss u e w ithre sp e c t to c o m m iss io n a d v a n c e s is re c o v e rab ili ty , P re -P a idth e n p ro c e e d e dtoA l l of t he For m 10- K ’ s fi l ed dur i ng t he cl as s per i od ( i . e. , t he For m 10- 10 K ’s for 19 98 , 19 99 , and 20 00 ) w ere s i gn ed b y t he indi vidual defe nd ants . 7 d isc u ss its m e m b e rsh ip re ten tio n ra tes , it s a c tu a l co m m iss io n a dv a n c e s, th e ir r ecove r abi l i ty , m ember s hi p gr ow th and the expe ct ed l i feti m e value of am ember s hip. N ot abl y , Pr e- Pai d di s cl os ed thatone y earaft erpur chas i ng a mem ber s hip, onl y53. 37% of m e m b e rsh ip h o ld e rs r e m a ina s p a y in g c u sto m e rs. A f tertw o y e a rs, th is f

ig u re dro p s to 3 6 . 9 7 %. D . P re-P aid’s O ri g inal 2 0 0 0 F o rm 1 0 -K I n i t s or i gi nalForm 10- K forthe y earendi ng D ece m ber31, 2000 ( fi l ed w i th the SE C on A pr i l 27, 2001) , Pr e- Pai d agai n r eport ed unearned comm i s s i on advanc es as as s et s , r efe rr i ng t o them as “ M ember s hip comm i s s i on advanc e r ece i vabl es . ” ( Supp. 10 A p p . V o l. I at S A -46 . ) A g ain, D eloitt e issu edan u n qu ali fiedo p inion that P re-P aid’s fi nanci als t at ement s conform ed w i th G A A P. H ow ever , forthe fi r s tt i m e, Pr e- Pai d began w r i t i ng off une arned comm i s s i on advanc es of as s oci at es w ho no l ongerhad anyacti ve m em b ersh ips. A lso f

o r th e f ir st t im e in a F o rm 1 0 -K , P re-P aid re p o rt edthat tw o -y ea rs aft erpur chas i ng a mem ber s hi p, onl y36. 97% of m ember s hip hol der s r emai n as payi ng c u sto m e rs. N e v e rth e les s, w h e n c o m p a re dto 1 9 9 9 , P re -P a ide x p e rie n c e da n in c re a se in m ember s hip pr emi um s and new m ember s hips s ol d. H ow ever , i tonl yr eport ed an addi t i onal4, 973 new as s oci at es and the amountof unearned comm i s s i on advanc es gr ew t o $ 15 6. 1 m i l l i on , repr esent i ng 63 . 1% of it s t otalasset s ( $2 47 . 3 m i l l i on ). Ital so su b sta n tiallyin c re a se dits re se rv e f o r u n c o llec tib le c o m m iss io n a d v a n c e s, in c re a sin g it8

fr om $4. 5 m i l l i on t o $11. 0 m i l l i on. E . SE CI

nves t igat i on I n J anuaryand M ay2001, the SE C ’ s D i vi s i on of C orpor at i on Fi nance ( D i vi s i on) re v iew e dP re -P a id ’s F o rm 1 0 -K ’s f o r 1 9 9 9 a n d2 0 0 0 . O n M a y1 1 , 2 0 0 1 , P re -P a id r ece i ved a l ett erfr om the D i vi s i on advi s i ng Pr e- Pai d thati t s acc ount i ng of unearned comm i s s i on advanc es as as s et s vi ol at ed G A A P. T he D i vi s i on as s ert ed comm i s s i on advanc es s houl d be expe ns ed w hen pai d. O n M ay15, 2001, Pr e- Pai d announce d the D i vi s i on’ s deci s i on. Fol l ow i ng thi s announce m ent , Pr e- Pai d’ s s t ock pr i ce dr opped fr om $19 pers har e t o $14. 10 pers har e. O n M ay16, 2001, Pr e- Pai d i s s ued a pr es s r el eas e, s t at i ng i tcont i nued t o bel i eve i t s acc ount i ng w as i n compl i ance w i th G A A P and announci ng i t s pl ans t o appea l t o the SE C ’ s O ffi ce of the C hi ef A ccount ant( C hi ef A cc o u n tant). P re-P aid a p p ea led to the C h ief A cc o u n tant, w h o co n cu rredw ith the D ivisi o n ’s d ec isi o n . O n Ju ly2 5 , 2 0 0 1 , P re-P aid p ub li ca llyan n o u n ce dthe C h ief A cc o u n tant’s deci s i on. I n thi s pr es s r el eas e, R andyH arp, Pr e- Pai d’ s C hi ef O per at i ng O ffi cer , s t at ed th e d e c isio n w o u ldh a v e am a ter ial a d v e rse e f f e c t o n P re -P a id ’s b a lan c e sh e e t b u t itw o u ld n o t ch a n g e th e c a sh e c o n o m ics o f its b u sin e ss . O n Ju ly3 0 , 2 0 0 1 , P re -P a idd e c id e dn o t to ap p e a lth e Chi e f

Acc o u n t a n t ’ s d e c i s i o n a n da g r e e dt o a me n di t s p r e v i o u s l yf i l e dSEC r eport s and r es t at e i t s fi nanci als t at ement s t o r efl ectthe SE C ’ s conclus i on. F. P re -P a id ’s R esta tedFin a n c ia ls O n February8, 2002, Pr e- Pai d fi l ed an am ended Form 10- K w i th the SE C fory ear9

endi ng D ece m ber31, 2000, w hi ch r es t at ed Pr e- Pai d’ s fi nanci als t at ement s for1998 thr ough 2000 i n acc or dance w i th the SE C ’ s rul i ng. A s a r es ul tof compl y i ng w i th the SE C ’ s rul i ng, forthe y earendi ng D ece m ber31, 2000, Pr e- Pai d’ s t ot alas s et s , l i abi l i t i es and s har ehol der s ’ equi tyw er e r educe d ( i n thator der) fr om appr oxi m at el y$247 m i l l i on, $ 1 0 0 m i l l i o n a n d$ 1 4 7 m i l l i o n t o $ 7 8 m i l l i o n , $ 3 6 m i l l i o n , a n d$ 4 2 m i l l i o n , r e s p e c t i v e l y. F o r y ea r en d ing 1 9 9 9 , P re-P aid’s total asse ts, li ab il ities an dsh are h o lders’ e qu ityw ere r educe d fr om appr oxi m at el y$193 m i l l i on, $79 m i l l i on, and $114 mi l l i on t o $58 m i l l i on, $25 m i l l i on and $33 mi l l i on, r es pecti vel y . T he r e- s t at ed fi nanci als t at ement s fory ear end i ng 19 98 exp eri enced si m i l ar r edu ct i on s. B ecaus e D el oi tt e di s agr eed w i th the SE C ’ s conclus i on, i tw as unabl e t o r enderan unqual i fi ed opi ni on w i th r es pectt o Pr e- Pai d’ s r es t at ed fi nanci al s . T hus , Pr e- Pai d and D e lo itt e re a c h e dam u tu a l ag re e m e n t to e n dth e ir c lien t-au d ito r re latio n sh ip . P re -P a id r et ai ned G r antT hornt on L L P t o audi ti t s r es t at ed fi nanci als t at ement s . O n J anuary30, 2 0 0 2 , G ra n t T h o rn to n iss u e da n u n qu a lifie do p in io n th a t th e re sta ted f in a n c ial s tate m e n ts fa i r l yr e pr e s e nt e d Pr e - Pa i d’ s fi nanc i a lc on di t i ona ndc on fo rmed wi th GA A P. I I . Pr ocedur alB ackgr ound O n J anuary17, 2001, T he W al lStr eetJ ournalpubl i s hed an art i cl e enti t l ed “Pr ePai d L egalD r aw s C r i t i ci s m on A ccounti ng forC om m i s s i ons ” i n w hi ch i tdi s cus s ed the pot ent i alpr obl ems w i th Pr e- Pai d’ s acc ount i ng m ethodol ogyforunearned comm i s s i on advanc es . ( R . A pp. V ol . I I I atA - 729. ) I tnot ed Pr e- Pai d’ s unearned comm i s s i on advanc es w er e bal l ooni ng w hi l e i t s r es erve forunr ecove r abl e advances w as unchange d at10

$4. 5 m i l l i on. I tal s o expr es s ed conc ern overPr e- Pai d’ s abi l i tyt o r ecoup une arned comm i s s i on advanc es , not i ng Pr e- Pai d cannotr ecoup c om m i s s i on advanc es i f an as s oci at e s t ops s el l i ng m ember s hi ps ordoes nothave anym ember s hips ol derthan thr ee y ear s . L as t l y , i ts t at ed thatoverthe pas tfi ve y ear s , Pr e- Pai d had notw r i tt en off any comm i s s i on advanc es as unr ecove r abl e des pi t e H arp’ s admi s s i on thats om e comm i s s i on advanc es w oul d neverbe r ecove r ed thr ough the us e of the char ge- back. A s a r es ul tof thi s art i cl e, Pr e- Pai d’ s s t ock dr opped fr om $22. 6875 t o $20. 875. Fi ve day s l at er , the fi r s tof ni net een c om pl ai nt s w as fi l ed i n the W es t ern D i s tr i ctof O kl ahoma agai ns tPr e- Pai d, H ar l and C . St onecipher( C hi ef Execut i ve O ffi cerand Chai rman o f the Boar d) , H a rp ( Chi e f Ope r a t i ng O ff i c e ra ndBoar d Di r e c t or) , K a thl e e n S. P inso n (C h ief A cc o u n ti n g O ff icer an dB o ardD ir ec tor), P eter K . G run eb au m (B o ard D ir ec tor an dC h airm an o f it s A u d itC o m m ittee) an dD av id A . S av u la (B o ardD ir ec tor) [her ei naft ercol l ecti vel yr efe rr ed t o as Pr e- Pai d D efe ndant s ] underthe Securi t i es and E xchange A ctof 1934 ( E xchange A ct) . O n M ay15, 2001, the di s tr i ctcourtcons ol i dat ed the ca s es and appoi nt ed J on M cN amar a, R i char d L andi n and B r i col eurC api t al M anage m entas l ead Pl ai nt i ffs . O n June 14, 2001, the l ead Pl ai nt i ffs fi l ed a s i xty - four page c ons ol i dat ed amended cl as s acti on compl ai nt( C ons ol i dat ed C om pl ai nt ) on behal f of al lpur chas er s of Pr e- Pai d’ s comm on s t ock fr om M ar ch 18, 1999, thr ough M ay15, 2001, (the clas s peri od ) agai nstP re- P ai d D efen dan t s and D el oitt e, w ho hadno tbeen nam ed as a defe nd ant i n the i nd i vidual com plai nts . T he C ons ol i dat ed C om pl ai ntal l eged Pr e- Pai d D efe ndant s “made fal s e andS ect i on 10 (b) st at es: 11 I t s hal l be unl aw ful for any per s on, di r ect l y or i ndi r ect l y , by t he us e of a ny m eans or i ns t r um ent al i t y of i nt er s t at e comm er ce or of t he mai l s , or of any fac i l i t y of any nat i onal s ecur i t i es excha nge—

. . . (b ) T o u se o r e m p lo y , in c o n n e c tio n w ith th e p u rc h a se o r sa le of any s ecur i t y r egi s t er ed on a na t i onal s ecur i t i es excha nge or any s ecur i t y not s o r egi s t er ed, . . . any m ani pul at i ve or dece pt i ve devi ce or cont r i vance i n cont r avent i on of s uch r ul es and r egul at i ons as t he C o m m iss io n m a y p re sc rib e a s n e c e ss a ry o r a p p ro p ria te in th e p u b lic i nter est or for t he p rot ect i on of invest ors. R ule 10b-5, cod i fi ed at 17 C . F . R . § 2 40 . 10 b-5, provides: 12 I t s hal l be unl aw ful for any per s on, di r ect l y or i ndi r ect l y , by t he us e of a ny m eans or i ns t r um ent al i t y of i nt er s t at e comm er ce, or of t he mai l s or of any fac i l i t y of any nat i onal s ecur i t i es excha nge, ( a) T o empl oy any devi ce, s cheme, or ar t i fi ce t o defr aud, (b ) T o m a k e a n y u n tru e sta tem e n t o f a m a ter ial fa c t o r to o m it t o s t at e a mat er i al fac t nece s s ar y i n or der t o m ake t he s t at ement s m ade, i n t he l i ght of t he ci r cumst ance s under w hi ch t hey w er e made, not m i s l eadi ng, or 11 m isle a d in g p ub lic s tate m e n ts in o rd e r to o v e rsta te P re -P a id ’s e a rn in g s a n dm a ter ially fal s i fy[i t s ] fi nanci alcondi t i on i n or dert o art i fi ci al l yi nfl at e the pr i ce of Pr e- Pai d s t ock” and D el oi tt e “kne w orr eckl es s l ydi s r egar ded Pr e- Pai d’ s true fi nanci aland oper at i ng condi t i on and fa i l ed t o t ake s t eps t o ful l yand fa i r l ydi s cl os e them t o the publ i c. ” ( R . A pp. V ol . I atA - 17- A - 18. ) C ountI , al l eged a gai ns tal lthe def endant s , as s ert ed a vi ol at i on of § 10( b) of the Exchange A ct , 15 U . S. C . § 78j ( b) , and Rul e 10b- 5 pr om ul gat ed 11 ther eunder . C ount2, al l eged a gai ns tthe i ndi vi dualdefe ndant s onl y , cl ai m ed the

12( c) T o engage i n any act , pr act i ce, or cour s e of bus i nes s w hi ch

o p e ra tes o r w o u ld o p e ra te a s a f ra u d o r d e c e it u p o n a n y p e rso n , in c o n n e c t i o n w i t h t h e p u r c h a s e o r s a l e o f a n y s e c u r i t y. S ect i on 20 (a) st at es: 13 E ver y per s on w ho, di r ect l y or i ndi r ect l y , cont r ol s any per s on l i abl e under any pr ovi s i on of t hi s chapt er or of a n y ru le o r re g u latio n th e re u n d e r sh a ll also b e liab le j oi nt l y and s ever al l y w i t h and t o t he s ame ext ent as s uch cont r ol l ed per s on t o any per s on t o w hom s uch cont r ol l ed p e rso n is liab le, u n les s th e c o n tro lli n g p e rso n a c ted in good fai t h and di d not di r ect l y or i ndi r ect l y i nduce t he act or act s cons t i t ut i ng t he vi ol at i on or caus e of a ct i on. 12 in d iv idu a l d e f

e n d a n ts w e re “ c o n tro lli n g p e rso n s” o f P re -P a ida n dth e re f

o re w e re liab le under§ 20( a) of the Exchange A ct , 15 U . S. C . § 78t , forthe al l eged f r audul entconduct 13 o f P re -P a id . (A p p . V o l. I a t A -7 8 .) O n Jul y24, 2001, Pr e- Pai d D efe ndant s fi l ed a mot i on t o di s m i s s the C ons ol i dat ed C om pl ai ntar gui ng Pl ai nt i ffs had notand coul d notpl ead the r equi s i t e s ci ent er . I n the alt ern ati v e, th eyasse rt ed the C o n so li d atedC o m p lai n t fail edb ec au se P re-P aid’s acc ount i ng m ethodol ogyw as ful l ydi s cl os ed t o the market( the truth- on- the market d o c trin e ). O n A u g u st 9 , 2 0 0 1 , D e lo itt e a lso f iledam o tio n to d ism iss . Ina d d iti o n to rei t erat i ng P re- P ai d D efen dan t s’ l ack o f sci enterargum ent, D el oitt e con t end ed P l ai nti ffs’ act i on w as barr ed b ythe st atute of l i m i t at i on s. O n M ar ch 5, 2002, the di s tr i ctcourtgr ant ed both Pr e- Pai d D efe ndant s ’ and De l o i tt e ’ s mo t i o n s t o d i s mi s s wi th p r e j u d i c e a n de n t e r e dj u d g me n ta c c o r d i n g l y . On13

M ar ch 25, 2002, the di s tr i ctcourti s s ued an O r derN unc Pr o T unc corr ecti ng a mi s t ake of fac ti n i t s M ar ch 5, 2002 or derbutotherw i s e l eavi ng i t s deci s i on i nt act . O n M ar ch 29, 2002, Pl ai nt i ffs fi l ed a Rul e 60(b) M ot i on, ori n the al t ernat i ve, a M ot i on for R econs i der at i on. O n A pr i l 2, 2002, theyfi l ed a noti ce of appea l , w hi ch w as amended on A pr i l23, 2002, conce rni ng the court ’ s M ar ch 5 and M ar ch 25, 2002 or der s ( A ppealN o. 02- 6110) . O n M ay20, 2002, the di s tr i ctcourtconcluded Pl ai nt i ffs ’ Rul e 60( b) M ot i on/M ot i on forR econs i der at i on w as m ooti n partas i t s N unc Pr o T unc O r derhad c o rr e c te dP la in tif

f s ’ a lle g e dm is ta k e o f

f a c t. I t d e n ie dth e m o tio n in a ll o th e r r e s p e c ts . O n June 5, 2002, Pl ai nt i ffs fi l ed a noti ce of appea lchal l engi ng the M ay20, 2002 or der ( A ppealN o. 02- 6178) . B oth appea l s w er e cons ol i dat ed. O n A u g u st 9 , 2 0 0 2 , L e a dP lain tiff B ric o leu r M a n a g e m e n t f iledam o tio n w ithth is C o u rt to d ism iss it as a n ap p e llan t, w h ich w a s g ra n ted . D u rin g th e c o u rse o f th is ap p e a l, Pl ai nt i ffs s ett l ed w i th D el oi tt e. C ons equentl y , on February6, 2004, thi s acti on w as part i al l yr emanded t o the di s tr i ctcourtforthe l i m i t ed purpos e of r evi ew i ng and appr ovi ng the s ett l ementagr eement . O n D ece m ber10, 2004, the di s tr i ctcourtappr oved the se ttl e m e n t. O n M a rc h 1 8 , 2 0 0 5 , w e g ra n ted P lain tiff s a n dD e lo itt e ’s s tip u latio n to d ism iss w ithp re

ju d ice D e lo itt e a s a p a rtyto th is ap p e a l. C o n se qu e n tly , o n lyP re -P a id D efen dan t s r em ai n as app el l ees. I I I . D i s cus s i on Pl ai nt i ffs ar gue the di s tr i ctcourterr ed i n di s m i s s i ng thei rC ons ol i dat ed C om pl ai nt b e c au se th e ya d e qu a telyp led sc ien ter , the c o m p lain t w a s tim e lya n dP re -P a idD e f e n d a n tsH ere , in ad d it ion to P lai n ti ffs’ C o n so li d ated C o m p lai n t, the d ist ri ct co u rt 14 cons i der ed document s r efe r r ed t o i n t he compl ai nt , i n par t i cul ar Pr e- Pai d’ s fi l i ngs w it h the S E C . C o n side rati o n o f su ch d o cu m en ts w as p rop er b ec au se th ey w ere c e n tr a l to P la in tiffs ’ c la im s a n d n o n e o f th e p a rt ie s d is p u te d th e ir a u th e n tic ity. Jacobs en v. D es er etB ook, C o. , 2 8 7 F .3 d 9 3 6 , 9 4 1 (1 0 th C ir. 2 0 0 2 ); see also P r ager v. LaF aver , 180 F. 3d 1185, 1189 ( 10t h C i r . 1999) ( hol di ng s uch cons i der at i on i s di s cr et i onar y ) . M or eover , s uch cons i der at i on di d not r equi r e t he di s t r i ct cour t t o conver t Pr e- Pai d D efe ndant s ’ m ot i on t o di s m i s s i nt o one for s u m m a ry ju d g m e n t. G FFC or p. v. A s s oci at ed Whol es al e G r ocers , Inc. , 130 F. 3d 1 3 8 1 , 1 3 8 4 -8 5 (1 0 th C ir . 1 9 9 7 ). 14 cannotr el yon the truth- on- the- m arketdoctr i ne. I n the al t ernat i ve, theycont end they s houl d have be en af

for ded an opportuni tyt o amend thei rcompl ai ntt o corr ectany pleadi ng defici encies . W e r evi ew de novo a di s tr i ctcourt ’ s di s m i s s alof a c om pl ai ntunderR ul e 12( b) ( 6) o f th e F e d e ra l R u le s o f

C iv il P ro c e du re . C i t

y of Ph i ladel

ph i a v. Flem i ngC os. , 264 F. 3d 1 2 4 5 , 1 2 5 7 (1 0 th C ir. 2 0 0 1 ). Inu n d e rta k in g th a t re v iew , w e a c c e p t as tru e a ll w e llp lea d e df

a c tu a l alle g a tio n s in th e c o m p lain t an dv iew th e m inth e lig h t m o st f a v o rab le to th e n o n - m o v i n g p a rty. Id
. W e r evi ew the deni alof l eave t o amend forabus e of 14 d is c re tio n . G r os s m an v. N ovell , I nc. , 1 2 0 F . 3 d1 1 1 2 , 1 1 2 6 (10 th C ir . 1 9 9 7 ). H o w ev er, w her e thatdeni ali s bas ed on the conc l us i on thatamendm entw oul d be futi l e, w e r evi ew d e n o v o . W

at s on ex rel
. W

at s on v. B eckel , 2 4 2 F . 3 d1 2 3 7 , 1 2 3 9 (10 th C ir . 2 0 0 1 ). 1. Sci ent er T he el ement s of a pr i vat e s ecuri t i es fr aud ac t i on under§ 10( b) and Rul e 10b- 5 ar e: ( 1) the def

endantm ade an untrue orm i s l eadi ng s t at ementorom i s s i on of m at er i alfac t , ( 2) th e s t a t e m e n to ro m i s s i o n w a s m a d e i n c o n n e c t i o n w i th th e p u r c h a s e o rs a l e o f as e c u r i ty,Sect i on 10( b) does not pr ovi de for pr i vat e ca us es of ac t i on; s uch ac t i ons 15 a re a ju d ic ia l c re a tio n . Lampf , P l eva, Li

pki nd, P r upi s & Pet igr ow v. G i l ber ts on , 5 0 1 U . S . 3 5 0 , 3 5 8 n . 3 (19 9 1 ). 15 ( 3) the def

endantact ed w i th the r equi s i t e s ci ent er , ( 4) the pl ai nt i ff r el i ed on the fa l s e or m isle a d in g sta tem e n ts, an d(5 ) th e p lain tiff su f f e re de c o n o m ic lo ss a s a re su lt o f h is r el i ance . D ura P harm . , I nc. v. B r oudo , 5 4 4 U .S . 3 3 6 , 3 4 1 -4 2 (2 0 0 5 ); A da m s v. Ki nder- 15 Mor gan, I nc. , 340 F. 3d 1083, 1095 ( 10th C i r . 2003) . T he s ci ent erel ementr equi r es “a m ent als t at e embr aci ng i nt entt o dece i ve, m anipul at e, ordefr aud. ” Flem i ngC os. , 264 F. 3d at1258 ( quot at i ons om i tt ed) . I ti ncludes “know i ng ori nt ent i onalm i s conduct ” and r eckl es s nes s , w hi ch i s “conduc tthati s an extr eme departur e fr om the s t andar ds of or di narycar e, and w hi ch pr es ent s a dange rof m i s l eadi ng buy er s ors el l er s thati s ei ther know n t o the def

endantori s s o obvi ous thatthe ac t orm us thave be en aw ar e of i t . ” I d. (q u o ta tio n s o m itte d ). H o w e v e r, th e re a re lim ita tio n s o n th e re c k le s s n e s s s ta n d a rd . I d. Fori ns t ance , w e w i l l notal l ow al l egati ons of “f r aud byhi nds i ght ” ( i . e. , “al l egati ons that defe ndant s s houl d have ant i cipat ed futur e eve nt s and made cert ai n di s cl os ur es earl i erthan theyactual l ydi d”) oral l egati ons thatthe def endantfai l ed t o di s cl os e know l edge of m a ter ial f

a c ts w ith o u t a f

u rth e r sh o w in g th a t th e d e f e n d a n t kn e w w ith h o ld in g su c h f a c ts w o u ldlik e ly m is le a din v e s to rs . I d. at1260 ( quot at i ons om i tt ed) . M or eover , “al l egati ons of G A A P vi ol at i ons oracc ount i ng i rr egul ar i t i es , s t andi ng al one, ar e i ns uffi ci entt o s t at e a s ecuri t i es fr aud cl ai m ”; s uch al l egati ons m us tbe “c oupl ed w i th evi dence thatthe vi ol at i ons ori rr egul ar i t i es w er e the r es ul tof the def endant ’ s fr audul enti nt entt o m i s l ead i nves t or s . . . . ” I

d. at1261.R ule 9( b) provi des: 16 (b ) F r a u d , M is ta k e , C o n d it io n o f t h e M in d . I n al l aver m ent s of fr aud or m i s t ake, t he ci r cumst ance s cons t i t ut i ng fr aud or m i s t ake s hal l be s t at ed w i t h par t i cul ar i t y . M al i ce, i nt ent , know l edge, and o t h e r c o n d i t i o n o f

m i n d o f

a p e r s o n m a y b e a v e r r e d g e n e r a l l y. E xampl es of abus es t he PSL R A s ought t o el i m i nat e ar e ( 1) t he r out i ne 17 fi l i ng of l aw s ui t s w heneve r an i s s uer ’ s s t ock pr i ce e xper i ence s a s i gni fi cant change , ( 2) cl as s act i on l aw y er s ’ m ani pul at i on of t he cl i ent s t hey r epr es ent , ( 3) abus e of t he di s cover y pr oces s t o i m pos e cos t s s o bur dens om e t hat i t i s oft en economi cal for t he vi ct i m i zed pa r t y t o s et t l e, and ( 4) s har ehol der der i vat i ve a c tio n s filed w ith th e h o p e o f w in n in g lar g e a tto rn e y fe e s o r p riv a te s e ttl e m e n ts w i t h no i nt ent i on of bene fi t t i ng t he cor por at i on ( i . e. , “ s tr ik e s u its ” ). F l em i ng C os. , 264 F. 3d at 1258- 59 & n. 16. 16 Pr i ort o 1995, a pl ai nt i ff pl eadi ng the el ement s of a s ecuri t i es fr aud cl ai m w as r equi r ed t o fol l ow R ul e 9 of the Feder alR ul es of C i vi lPr ocedur e, w hi ch r equi r es s ett i ng forth fr aud al l egati ons w i th part i cul ar i tybutal l ow s condi t i ons of m i nd s uch as m al i ce, i n t e n ta n dkn o w l e d g e t o b e a v e rr e dg e n e r a l l y. A da ms , 3 4 0 F .3 da t 1 0 9 5 . H o w e v e r, in 16 19 95 , i n o rdert o cu rb som e of the abu ses experi enced i n p ri vate s ecuri t i es l aw sui t s, C o n g ress e n ac ted th e P ri v ate S ec u ri ti es L itigation R ef o rm A ct (P S L R A ). I

d. a t 1 0 9 5 . 17 T h e P S L R A h e ig h te n e dth e p le a d in g s ta n d a rd f o r th e f ir s t a n dth ir de le m e n ts . I d. at 1 0 9 5 -9 6 . R e lev a n t h e re is th e P S L R A ’s in c re a se db u rd e n o f p lea d in g th e th irde lem e n t, sc ien ter : I n anypr i vat e ac t i on ar i s i ng underthi s chapt eri n w hi ch the pl ai nt i ff may r ecove rm oneydamages onl yon pr oof thatthe def endantact ed w i th a part i cul ars t at e of mi nd, the compl ai nts hal l , w i th r es pectt o eac h actor om i s s i on al l eged t o vi ol at e thi s chapt er , s t at e w i th part i cul ar i tyfac t s gi vi ng r i s e t o a s tr ong i nfer ence thatthe def endantact ed w i th the r equi r ed s t at e of m i nd.I n P i r r agl i a v. Novel l, Inc. , w e r es ol ved t he t ens i on bet w een t he 18 PSL R A ’ s s t r i ct pl eadi ng r equi r ement s and R ul e 12( b) ( 6) ’ s defe r ence t o t he p lain tiff . 3 3 9 F .3 d 1 1 8 2 , 1 1 8 7 (1 0 th C ir. 2 0 0 1 ). W e h e ld th a t at th e R u le 12( b) ( 6) s t age of

a s ecur i t i es fr aud ac t i on, w e eva l uat e t he s t r engt h of t he pl ai nt i ff’ s s ugges t ed i nfer ence i n t he cont ext of ot her r eas onabl e i nfer ence s t hat m ay be d raw n b ut do no t w ei gh t he p l ai nti ff’s s ug gest ed inference against t hese o th e r i n fe re n c e s to d e te rm in e w h ic h o n e w ill u ltim a te ly p re v a il. Id. a t 1 1 8 7 -8 8 . I n ot her w or ds , w e us e ot her r eas onabl e i nfer ence s t o det er m i ne t he s t r engt h of th e p la in tiff ’s s u g g e s te d in fe re n c e , i . e. , w het her i t i s a “s t r ong” i nfer ence , but not to d e te rm in e w h e th e r p la in tiff ’s s u g g e s te d in fe re n c e is th e c o rr e c t o n e . Id. at 1 1 8 7 -8 8 . A t th e e n d o f th e d a y , “[ i]f

a p lain tiff

p lea d s fa c ts w ith p a rticu lar ity t hat , i n t he over al l cont ext of t he pl eadi ngs , i ncl udi ng pot ent i al l y negat i ve i nfer ence s , gi ve r i s e t o a s t r ong i nfer ence of s ci ent er , t he s ci ent er r equi r ement s of t he R efor m A ct i s s at i s fi ed. ” Id. at 1188. 17 1 5 U . S . C . § 7 8 u -4(b )(2). 18 T o det erm i ne w hethera pl ai nt i ff’ s compl ai ntm eet s thi s heavybur den, w e mustl ook to th e to ta lity o f

th e p la in tif

f’s a lle g a tio n s . A da ms , 3 4 0 F .3 da t 1 1 0 5 ; Flem i ngC os. , 264 F .3 da t 1 2 6 2 -6 3 . A lleg a tio n s o f m o tiv e a n do p p o rtu n itya re re lev a n t inm a k in g th is d e te rm in a tio n . Flem i ngC os. , 264 F. 3d at1262- 63. H ow ever , s uch al l egati ons , s t andi ng a lo n e , a re in s u f

f ic ie n t. I d. I n s um , “[w ] hen r evi ew i ng a pl ai nt i ff’ s al l egati ons of s ci ent er u n d e rth e P S L R A , ac o u rts h o u l d[ ] e x a m i n e th e p l a i n t i f f’ s a l l e g a t i o n s i n th e i re n t i r e ty, w i thoutr egar d t o w hetherthos e al l egati ons fal li nt o defi ned, form al i s t i c cat egor i es s uch as ‘m oti ve an d o pp ortun i ty , ’ and de t erm i ne w hetherthe p l ai nti ff[’s] al l egati on s, t aken as a w hol e, gi ve r i s e t o a s tr ong i nfer ence of s ci ent er . ” I d. at1263. T o det erm i ne w hetherPl ai nt i ffs adequat el ypl ed s ci ent er , w e l ook t o the C ons ol i dat ed C om pl ai nt . I n i t , Pl ai nt i ffs al l ege Pr e- Pai d D efe ndant s i m pr oper l yr ecor ded unearned comm i s s i on advanc es as as s et s i n vi ol at i on of G A A P. T heycl ai m thatby18

re c o rd in g u n e a rn e dc o m m iss io n a d v a n c e s a s a ss e ts, P re -P a idD e f e n d a n ts m a ter ially over s t at ed Pr e- Pai d’ s fi nanci alcondi t i on. A nd, Pl ai nt i ffs cont end Pr e- Pai d D efe ndant s us ed this ov erstatem en t t o laud P re-P aid’s f inan cial suc ce ss an darti ficiall yinf lat e P re-P aid’s s t ock pr i ce. P lai n ti ff s also claim P re-P aid D ef en d an ts violatedG A A P b yco n ti n u ing to rep o rt unearned comm i s s i on advanc es as as s et s , even w hen i tw as cl eartheyw er e unr ecove r abl e, due t o ei thera mem ber s hi p l aps i ng befor e thr ee y ear s orthe as s oci at e ow i ng the advance beco m i ng i nacti ve. T heyassertP re- P ai d D efen dan t s should hav e w ri tt en-off these un recoverabl e com m i ssi on adv ances an d b yfai l i ng t o d o so, gav e i nv est ors the fa l se i m pr es s i on thatPr e- Pai d coul d r ecove rthem underi t s charge- back pol i cy . T heyal s o al l ege P re -P a idD e f

e n d a n ts m isle din v e sto rs b yp o o lin g u n re c o v e rab le c o m m iss io n a d v a n c e s w ith pot ent i al l yr ecove r abl e advances ther ebypr eventi ng an i nves t orfr om det erm i ni ng the true ext entof Pr e- Pai d’ s r i s k. Pl ai nt i ffs furtheral l ege Pr e- Pai d D efe ndant s m i s l ed i nves t or s byr epr es ent i ng that Pr e- Pai d’ s m ember s hi p per s i s t encyr at e r efl ect ed i t s abi l i tyt o r et ai n a mem ber s hip and th e re f o re re c e iv e p re m iu m s o n c e am e m b e rsh ip w a s w ritten . T h e yc o n ten dP re -P a id D efe ndant s cl ai m ed i n thei r1998 and 1999 Form 10K ’ s thatPr e- Pai d’ s per s i s t encyr at e w as 73. 8% and 73. 4% , r es pecti vel y , butunt i l2001 fai l ed t o di s cl os e thatonl y53. 37% of m ember s hip hol der s w er e s t i l l payi ng one y earaft erpur chas i ng a mem ber s hip, onl y36. 97%O n p a g e s tw e lv e a n d tw e n ty -o n e o f th e C o n so lid a ted C o m p lain t, 19 Pl ai nt i ffs s t at e t hat l es s t han 47% of m ember s hi p hol der s r emai n as pay i ng cus t om er s t w o y ear s aft er pur chas i ng a mem ber s hi p. O n pages fi ft een a nd t w ent y - ei ght , t hey r efe r t o t hi s fi gur e as 36. 97% . T he l at t er fi gur e i s cons i s t ent w i t h P re- P ai d’s ow n d i scl osures. 19 w ere s t i l lpay i ng aft er tw o y ears andon l y28 . 66 % aft er three y ears . 19 P lai n ti ff s also asse rtP re-P aid D ef en d an ts m isl edinv esto rs co n ce rnin g P re-P aid’s abi l i tyt o r ecove runearned comm i s s i on advanc es fr om i t s as s oci at es . Speci fi cal l y , they c laim P re -P a idD e f

e n d a n ts f a iledto d isc lo se : (1 ) P re -P a idh isto ric a llyh a dn o t atte m p ted to c o llec t u n e a rn e dc o m m iss io n a d v a n c e s f ro m a ss o c iate s w h o lef

t th e c o m p a n y , (2 ) P re -P a id all o w edasso ciates to ab an d o n ac co u n ts w ith h igh u n ea rne dco m m issi o n ad v an ce s an dstart a n ew ac co u n t w ith o u t pen alty , (3) P re-P aid’s c an ce ll ati o n rates o n m em b ersh ips w ere i ncr eas i ng, ( 4) Pr e- Pai d’ s m ember s hip gr ow th w as s l ow i ng and ( 5) an i ncr eas i ng num berof a ss o c iate s w e re n o t m a k in g n e w sa les . P lain tiff s a lleg e th a t d e sp ite k n o w in g th e se f a c ts (w h ich re du c e dth e lik e lih o o do f re c o v e rin g u n e a rn e dc o m m iss io n a d v a n c e s), P re -P a id D efe ndant s di d nots ubs t ant i al l yi ncr eas e Pr e- Pai d’ s r es erve foruncol l ecti bl e comm i s s i on adv ances. A s t o Pr e- Pai d D efe ndant s ’ m ot i ve t o comm i tfr aud, Pl ai nt i ffs al l ege: 1 . D e f e n d a n ts H a rp a n dP in so n h a db o nu s c o m p e n sa tio n a g re e m e n ts d ire c tlytiedto m eeti ng cert ai n earni ngs pers har e cri t er i a; 2. O n N ovember21, 1997, Pr e- Pai d es t abl i s hed an A s s oci at e I nves tm entSt ock C l ub Pur chas e Pl an w hi ch w as des i gned t o i nduce i t s as s oci at es t o pur chas e Pr e- Pai d s t ock atm arketpr i ce. Pr e- Pai d acqui r ed the s har es t o di s tr i but e t o i t s as s oci at es thr ough thi s Pl an fr om D efe ndantSt onecipher ’ s per s onalhol di ngs . T hus , D efe ndant St onecipheres t abl i s hed an outl ett o r egul ar l ydi s pos e of hi s s har es and w as m ot i vat ed t o m ai nt ai n an art i fi ci al l yi nfl at ed s t ock pr i ce;In it s init ial o rde r of d ism issal on M arc h 5 , 2 0 0 1 , the d ist ri ct co u rt 20 er r oneous l y s t at ed t hat as a r es ul t of t he cha nge of a ccount i ng for unear ned comm i s s i on advanc es , Pr e- Pai d’ s net i ncome for 2000 and t he fi r s t quar t er of 20 3. D efe ndantG runebaum, w ho w as a D i r ect orand the C hai rm an of the B oar d of D i r ect or ’ s A udi tC om m i tt ee, dum ped 23, 000 s har es of hi s s t ock betw een A pr i l24, 2000, and N ovember28, 2000, r educi ng hi s t ot alhol di ngs t o onl y4, 000 s har es ; and 4. D efe ndantSavul a, w ho w as a D i r ect orand Pr e- Pai d’ s m os ts eni ors al es as s oci at e, dum ped 15, 000 s har es ( 37% of hi s hol di ngs ) on O ct ober23, 2000, obt ai ni ng a net pr ofi tof over$500, 000. T he d i stri ctcou rtcon cl ud ed these al l egati on s, t aken i n thei r t otal i ty , did not r ai se r equi s i t e s tr ong i nfer ence of s ci ent er . I tconcluded Pl ai nt i ffs ’ al l egati ons s upport ed an inf ere n ce that P re-P aid D ef en d an ts “at l ea st” v iolated G A A P . (R . A p p . V o l. III at A -74 0 . ) B ec au se G A A P v iolati o n s alo n e a re insu ff ici en t t o su stai n a se cu ri ti es f rau dac ti o n , the c o u rt nextexami ned Pl ai nt i ffs ’ al l egati ons of Pr e- Pai d D efe ndant s ’ m ot i ve t o comm i tfr aud, f i n d i n g th e m l a c k i n g . Al s o c o mp e l l i n g t o th e c o u rtwa s P r e - P a i d ’ s r e p u r c h a s e o f o v e rtwo m ill io n o f

its o w n sh a re s, c o n c lu d in g it i s “ p a ten tlyab su rd ” f o r ac o m p a n yto f

rau du len tly i nfl at e the pr i ce of

i t s s t ock onl yt o then pur chas e the s t ock ats uch i nfl at ed pr i ces w i thout a n yf in a n c ia l b e n e f

it. (I d. atA - 741. ) L as t l y , the di s tr i ctcourtfound convi nci ng the fa ctthat Pr e- Pai d D efe ndant s had oper at ed underw hattheycons i der ed t o be a pr operi nt erpr et at i on o f G A A P f o r se v e n y e a rs, th a t th e yh a dre p o rte du n e a rn e dc o m m iss io n a d v a n c e s a s a ss e ts in Pr e- Pai d’ s SE C fi l i ngs , thattheyhad di s cl os ed i n thes e s ame fi l i ngs thattheycons i der ed thei rcomm i s s i on advanc e pol i cya r i s k s houl d theynotbe col l ect ed oroffs etand thatw hen Pr e- Pai d compl i ed w i th the SE C ’ s rul i ng, i t s aft er - t ax i ncome for2000 and the fi r s tquart er of 2001 w as r educe d bya mer e 8. 5% , “har dl ya pr ecipi t ous r educti on. ” (I d. at A -74 3 . ). 202001 w as onl y r educe d by 8. 5% . Pr e- Pai d D efe ndant s br ought t hi s er r or t o t he

at t ent i on of t he di s t r i ct cour t , w hi ch i n t ur n acknow l edged i t s er r or i n i t s M ar ch 25, 2001 O r der N unc Pr o T unc, s t at i ng t hi s er r or di d not affect i t s di s m i s s al of Pl ai nt i ffs ’ C ons ol i dat ed C om pl ai nt . I n i t s or der deny i ng Pl ai nt i ffs ’ R ul e 60( b) M ot i on/ M ot i on for R econs i der at i on, t he cour t agai n emphasi zed i t w as aw ar e of th e m a g n itu d e o f

P re -P a id ’s r e sta tem e n ts b u t still c o n c lu d e d , b a se d o n a to tality o f th e c ir cu m stan ce s, that P lai n ti ffs h ad fa il ed to ad eq u ately p lead scien ter. W e bel i eve t he di s t r i ct cour t gave t oo m uch w ei ght t o t he fa ct t hat t he 21 S E C n e v e r c h a llen g e d P re -P a id ’s a c c o u n tin g m e th o d o lo g y fo r se v e n y e a rs. W h ile Pr e - Pa i d d i d d i s c l o s e i t s a c c o u n t i n g o f u n e a r n e d c o mmi s s i o n a d v a n c e s i n i t s SEC fi l i ngs , t her e i s no i ndi cat i on i n t he r ecor d conce r ni ng t he fr equenc y or th o ro u g h n e s s o f

th e S E C ’s re v ie w o f

a c o rp o ra tio n ’s q u a rt e rl y a n d a n n u a l r e p o rt s . A b se n t su c h in fo rm a tio n , the S E C ’s s ilen c e fo r se v e n y e a rs m a y m e re ly in d ica te t hat i t never audi t ed Pr e- Pai d’ s r epor t s dur i ng t hat per i od. 21 T hi s cas e maybe a c l os e ca l l , buti ti s di ffi cul tt o t el lbecaus e the compl ai nti s s o r i ch insw e e p in g , g e n e ra lize da n dso m e tim e s c o n c lu so rya lleg a tio n s. P lea d in g p re c isio n c o u ld have be tt eri nform ed the debat e and a i ded the cri t i calanaly s i s nece s s aryt o r es ol ve a mot i on t o di s m i s s . I n the fa ce of a s om ew hatchaoti c compl ai ntthe di s tr i ctcourtunder s t andablycut to th e c h a se . A lth o u g h th e d istric t co u rt listed th e n u m e ro u s a lleg e dG A A P v io latio n s, it appear s the courtdi s t i l l ed the C ons ol i dat ed C om pl ai ntt o the s i ngl e G A A P vi ol at i on conce rni ng the r ecor di ng of unearned comm i s s i on advanc es as as s et s . W hen s o l i m i t ed, the C ons ol i dat ed C om pl ai ntfai l s t o adequat el yal l ege s ci ent erbecaus e ther e i s no evi dence that th is a lleg e dG A A P v io latio n w a s th e re su lt o f P re -P a idD e f

e n d a n ts’ f

rau du len t in ten t to m i s l ead i nves t or s . T he di s tr i ctcourtnot ed Pr e- Pai d’ s SE C fi l i ngs di s cl os ed i tr ecor ded 21 unearned comm i s s i on advanc es as as s et s on i t s bal ance s heet s and w arned i tm i ghtnotbe abl e t o r ecoup une arned comm i s s i on advanc es . I f Pr e- Pai d D efe ndant s i nt ended t o dece i ve i nves t or s , i tm akes l i tt l e s ens e forthem t o overt l ydi s cl os e thei rs cheme t o the SE C andPr e- Pai d s t at ed t he fol l ow i ng conce r ni ng i t s per s i s t ency r at e i n i t s 1999 22 F o r m 1 0 - K: 22 pu bli c. B ut, chari t ablyregar ded , the co m plai nt al l eges m ore subt l e m eans an d p urposes. T he C ons ol i dat ed C om pl ai nti s notl i m i t ed mer el yt o the i m pr operr ecor di ng of u n e a rn e dc o m m iss io n a d v a n c e s a s a ss e ts. P lain tiff s a lso h a v e a lleg e dth a t P re -P a id D e f e n d a n ts im p ro p e rl ym a in ta in e du n re c o v e rab le u n e a rn e dc o m m is s io n a d v a n c e s a s a s s e ts . I n otherw or ds , even a s s um i ng Pr e- Pai d coul d pr operl yr ecor d unearned comm i s s i on a d v a n c e s a s a ss e ts, P lain tiff s a lleg e it w a s im p ro p e r f o r P re -P a idD e f

e n d a n ts to m a in tain su ch asse ts w ith o u t an a d eq u ate rese rve an dd iscl o su re. A n ad eq u ate rese rve an dd iscl o su re w ere necessaryt o inform fi nan ci al st at em ent user s that a m at eri al am ou nt of these c o m m iss io n a d v a n c e s w e re u n c o llec tib le. W h e n P lain tiff s' C o n so lid a ted C o m p lain t is v iew e dinth is c o n tex t, P re -P a id ' s d isc lo su re s d u rin g th e c las s p e rio dd o n o t sh ieldP re -P a id D efe ndant s fr om l i abi l i ty . I ndeed, bycont i nui ng t o m ai nt ai n thes e comm i s s i on advanc es as as s et s w i thoutan ade quat e r es erve and di s cl os ur e, Pr e- Pai d D efe ndant s gave i nves t or s the fal s e i m pr es s i on thatPr e- Pai d coul d r ecoup, and i n fac tw as r ecoupi ng, s uch unearned com m i ssi on s. A compar i s on of Pr e- Pai d’ s 1996, 1998 and 1999 Form 10- K ’ s w i th i t s J anuary25, 2 0 0 1 F o rm 8 -K a n do ri g in a l 2 0 0 0 F o rm 1 0 -K , w h ic h w a s f ile din A p ri l 2 0 0 1 , is m o s t te llin g . In its e a rlierf

ili n g s, P re -P a idsta ted th a t h isto ric a llyit h a db e e n su c c e ss f u l inc o llec tin g h a lf o f its u n e a rn e dc o m m iss io n a d v a n c e s th ro u g h th e u se o f th e c h a rg e -b a c k . It also sta ted its m em bership p ers i st encyrat e w as approx i m at el y73 -74% betw een 1 99 6 an d 1 99 9. In these 22O n e o f th e m ajo r fa c to rs a ffe c tin g [ P re -P a id ’s] p ro fitab ili ty and ca s h fl ow i s M ember s hi p per s i s t ency , w hi ch r epr es ent s t he abi l i t y of [Pr e- Pai d] t o r et ai n a M ember s hi p, and t her efor e r ece i ve fe e s, o n c e it h a s b e e n w ritten . . . . [ P re -P a id ’s] M e m b e rsh ip per s i s t ency r at e meas ur es t he number of M ember s hi ps i n for ce a t t he end of a y ear as a per cent age of t he t ot al of ( i ) M ember s hi ps i n for ce at t he begi nni ng of s uch y ear , pl us ( i i ) new M ember s hi ps s ol d dur i ng su c h y e a r. . . . [P re -P a id ’s] o v e ra ll M e m b e rsh ip p e rsis ten c y ra te coul d become l ow er w hen t he M ember s hi ps i n for ce i ncl ude a hi gher p ro p o rt io n o f

n e w e r M e m b e rs h ip s . (R . S u p p . A p p . V o l. II at S A -6 6 4 .) D e sp ite th is d e sc rip tio n , it is u n c lea r e x a c tly h o w P r e - P a i d c a l c u l a t e s i t s m e m b e r s h i p p e r s i s t e n c y r a t e . B u t , n e e d l e s s t o s a y, beca us e i t i ncl udes m ember s hi ps al r eady i n for ce, i t appea r s t o t el l l i t t l e of Pr eP a id ’s a b ility to re ta in a m e m b e rs h ip o n c e it is w ri tte n . P re -P a id a lso d isc lo se d it h a s th e c o n tra c tu a l rig h t to re q u ire a ss o c iate s to 23 re p a y u n e a rn e d c o m m iss io n a d v a n c e s u p o n th e ir ter m in a tio n o r w h e n it i s d e ter m in e d th a t th e ir e a rn e d c o m m iss io n a d v a n c e s a re in su fficie n t to re p a y th e ir u n e a rn e d a d v a n c e s. H o w e v e r, it c o n c e d e d it h a s n o t ex e rc ise d th is rig h t d u e to th e c o sts a ss o c iate d w ith c o llec tio n e ffo rts a n d to a v o id d isru p tin g its re latio n sh ip w i t h it s ass ociat es. 23 e a rlierf ili n g s, P re -P a idn e v e r w ro te o f f a n yu n e a rn e dc o m m iss io n a d v a n c e s a n do n ly i ncr eas ed i t s r es erve by$300, 000 t o $500, 000 pery ear . H ow ever , i n i t s 2001 fi l i ngs ( w hi ch w er e fi l ed af

t erthe SE C began i t s i nves t i gat i on and af t erPr e- Pai d’ s acc ount i ng m e th o d o lo g ya n dits ab ili tyto re c o up u n e a rn e dc o m m iss io n a d v a n c e s w a s p ub lica lly cr i t i ci zed) , Pr e- Pai d no l ongercl ai m ed hi s t or i cals ucce s s i n col l ecti ng unearned comm i s s i on a d v a n c e s th ro u g h th e u se o f th e c h a rg e -b a c k . In ste a d , itd isc lo se df o r th e f irst tim e th a t in addi t i on t o the us e of the char ge- back, i tr ecove r ed unearned comm i s s i on advanc es by docki ng comm i s s i ons ow ed t o an as s oci at e on pr i orm ember s hips . Pr e- Pai d al s o di s cl os ed 23 forthe fi r s tt i m e thatonl y53. 37% of m ember s hip hol der s w er e s t i l lpayi ng one y earaft erT hi s pr oxy s t at ement i ndi cat es H ar p r ece i ved a $40, 000 bonus i n 1998, 24 1 9 9 9 a n d 2 0 0 0 a n d P in so n re c e iv e d a $ 9 ,0 0 0 b o n u s in 2 0 0 0 a n d a $ 6 ,0 0 0 b o n u s in 1999 and 1998. 24 p u rch asin g a m em b ersh ip an do n ly3 6 . 9 7 % af ter tw o y ea rs. T h ese fig u res stan din stark c o n tra st to P re -P a id ’s c laim e d7 3 -7 4 % p e rsis ten c yra te. F u rth e r, f o r th e f irst tim e , P re -P a id w ro te o f f $ 7 .3 m ill io n inu n e a rn e dc o m m iss io n a d v a n c e s a n dsu b sta n tiallyin c re a se dits r es erve byappr oxi m at el y$6. 5 m i l l i on. B as ed on the above , i tcan be i nferr ed thatPr eP a id ’s d isc lo su re s p rio r to 2 0 0 1 w e re m isle a d in g , in p a rticu lar , tha t itw a s re c o v e rin g its u n e a rn e dc o m m iss io n a d v a n c e s, w h e n inf a c t, i t w a s in c lu d in g c lea rlyu n re c o v e rab le com m i ssi on adv ances as asset s. T he for egoi ng di s cus s es pos s i bl ym at er i alm i s s t at ement s orom i s s i ons , butthatdoes n o t en dth e d isc u ss io n . T h e C o n so lid a ted C o m p lain t is lac k in g interm s o f P re -P a id D efe ndant s ’ m ot i ve t o comm i tfr aud. A s Pl ai nt i ffs have a l l eged, Pr e- Pai d’ s Pr oxy S tate m e n t f

o r th e y e a r 2 0 0 1 re v e a ls th a t D e f e n d a n ts H a rp a n dP in so n re c e iv e db o n u se s if P re -P a ida c h iev e dits e a rn in g s p e r sh a re g o a ls. S tan d in g a lo n e , rec e ip t o f su c h b o n u se s is 24
a n in s u f f ic ie n t m o tiv e a s it is ag e n e ra liz e dm o tiv e s h a re db ya ll c o m p a n ye x e c u tiv e s . See Flem i ngC os. , 2 6 4 F . 3 da t1 2 6 9 - 7 0 ( a l l e g a t i o n s th a tad e f e n d a n td e s i r e dt o p r o t e c th i s o wn p o sition w ith the c o m p an y , h is ex ec u ti v e c o m p en sati o n , o r th e v alue o f h is ow n stoc kare i ns uffi ci entm ot i ves as theyar e s har ed byal lcompanyexec ut i ves ) ( ci t i ng N ovak v
. Kas aks , 997 F. Supp. 425, 430 n. 5 ( S. D . N . Y . 1998) ) . T hati s nott o s ayan exe cut i ve compens at i on packa ge i s nevers us pect . T he ana l y s i s i s fac ts peci fi c and s houl d atl eas tcons i derw hether i ncenti ve paym ent s r ew ar d good m anage m entors i m pl yr ew ar d s t ock per form ancePr e- Pai d D efe ndant s as s er t t hat t he fa ct D efe ndant St oneci pher di d not 25 s el l any s har es dur i ng t he cl as s per i od demonst r at es t hat he di d not s el l any s har es t o t hi s pl an. H ow ever , as s t at ed bel ow , Pr e- Pai d D efe ndant s ’ as s er t i on t hat S to n e c ip h e r d id n o t s e ll a n y s h a re s d u ri n g th e c la s s p e ri o d is b e lie d b y th e re c o rd . T h e re fo re , w ith o u t f

u rth e r e v id e n c e , w e d e c lin e to g iv e c re d e n c e to P re -P a id D efe ndant s ’ cont ent i on t hat D efe ndant St oneci pher di d not s el l any of hi s s har es t o t he pl an. 25 i rr es pecti ve of the company ’ s fi nanci alheal th. W i th r egar d t o the A s s oci at e I nves tm entSt ock C l ub Pur chas e Pl an, ther e i s no i ndi cati on i n the r ecor d thatPr e- Pai d obt ai ned anyof D efe ndantSt onecipher ’ s per s onal sto c kh o ld in g s to f

u n dth is p lan . H o w e v e r, P re -P a idD e f e n d a n ts h a v e a lso n o t ad e qu a tely r efut ed thi s al l egati on. 25 P lain tiff s’ a lleg a tio n s c o n c e rn in g th e o u tsid e d ire c to rs a re m o re c o m p e lli n g , in p a rticu lar , the ir a lleg a tio n s re g a rd in g D e f e n d a n t S a v u la. A c c o rd in g to th e re c o rd , S a v u la so ld1 5 ,0 0 0 sh a re s o n O c to b e r 2 3 , 2 0 0 0 , at ap p ro x im a tely$ 3 8 p e r sh a re . H e a lso so ld ano ther 3, 00 0 shares on N ov em ber 6, 20 00 , at$4 6. 5 a share, w hich w as a m ere $2. 25 l ess than the cl as s per i od hi gh. T hes e s al es amount ed t o 45% of Savul a’ s t ot alhol di ngs and e a rn e dh i m o v e r$ 7 0 0 , 0 0 0 . M e a n wh i l e , h e p u r c h a s e dn o s h a r e s du r i n g th e c l a s s p e r i o d . As t o D efen dan tG runeba um , he sold 19 , 80 0 shares and b ou gh t16 , 50 0 shares duri ng the clas s p eriod . H o w ev er, his sales w ere allat $3 0 -$3 4 a sh are , w h il e a llo f h is pu rch ase s w ere m a d e p u rs u a n t to s to c ko p tio n s w h ic h a llo w e dh im to p u rc h a s e s h a re s a t $ 8 to $ 1 6 p e r s h a re . N everthel es s , hi s s t ock ac t i vi tydur i ng thi s t i m e peri od appear s cons i s t entw i th hi s s t ock act i vitypri or t o the cl ass per i od . H e app ears t o routi nelyacqu i re s t ockthroug h the exerci seFor i ns t ance , i n J une and J ul y of 1996, he exe r ci s ed hi s s t ock opt i ons and 26 p u rc h a s e d 2 2 ,5 0 0 s h a re s a t a p p ro x im a te ly $ 1 -$ 2 a s h a re . In t ho se sam e m on t hs, he s ol d 9, 000 s har es at appr oxi m at el y $20- $24 per s har e. B ase d o n o u r l im it ed rec o rd, G run eb au m ’s “p ri o r t rad ing p rac ti ce s” a re 27 confi ned t o t he per i od J une 1996 t hr ough Febr uar y 1999. H ow ever , w e doubt t he val ue of c om par i ng pr e- and pos t - cl as s per i od t r adi ng i n t hi s cas e. C or r el at i ve t r adi ng behavi or i s i nfor m at i ve onl y i f t he compar i t or occur r ed i n an unt ai nt ed t i m e fr ame. H er e, Pr e- Pai d w as acc ount i ng for unear ned comm i s s i on advanc es as a s s e ts fo r a t le a s t th re e y e a rs p ri o r t o th e c la s s p e ri o d . 26 of s t ock opt i ons and s el l i tata pr ofi t . T hus , G runebaum’ s tr adi ng dur i ng the cl as s per i od 26
w as not “dram at i cal l you tof li ne” w i th h i s pri or tradi ng pract i ces. Se e In re Ap p le 27 C om puterSec. Li t ig. , 886 F. 2d 1109, 1117 ( 9th C i r . 1989) ( concludi ng i ns i dertr adi ng m ay s upporta fi ndi ng of bad f ai th i f s uch tr adi ng i s conduct ed i n amount s “dr amat i cal l youtof l i ne w i th pr i ortr adi ng pr acti ces att i m es cal cul at ed t o m axi m i ze pe r s onalbenef i tfr om u n d is c lo s e din s id e in f

o rm a tio n ” ). In a d d iti o n to a rg u in g th a t P lain tiff s’ a lleg e dm o tiv e s a re in su f f icie n t, P re -P a id D e f e n d a n ts a rg u e o th e r e v id e n c e d e m o n stra tes th e ir c o m p lete lac ko f m o tiv e to c o m m it fr aud. Fi r s t , theyas s ertPr e- Pai d pur chas ed mi l l i ons of dol l ar s of i t s ow n s t ock, ther eby m a k in g P re -P a idth e b ig g e st v ictim o f its o w n a lleg e df

rau d . S e c o n d , the yc laim D e f e n d a n ts St onecipher , H arp and Pi ns on di d nots el lanys t ock dur i ng the cl as s per i od and i n fac t p u rc h a se dsto c k , w ithH a rp b o rro w in g alar g e su m o f m o n e yto d o so . P re -P a idD e f e n d a n ts ar gue Pl ai nt i ffs ’ as s ert i on thattheyfr audul ent l yi nfl at ed the pr i ce of Pr e- Pai d’ s s t ock def

i es e c o n o m ic r e a so n , as it m a k e s n o se n se f o r P re -P a ida n dth e se in d iv idu a l d e f e n d a n ts to pur chas e s t ock theyknew t o be art i fi ci al l yi nfl at ed.P re- P ai d D efen dan t s st at e H arp borrow ed m on ey t o p urchase t hese 28 s har es . T hey poi nt t o a pr om i s s or y not e at t ache d t o Pr e- Pai d’ s or i gi nal 2000 For m 10- K . A l t hough t hi s not e s how s H ar p bor r ow ed appr oxi m at el y $330, 000 f ro m P re -P a id , n o th in g in th is n o te in d ica tes th a t h e b o rro w e d th is m o n e y to p u rc h a se sto c k . T h is is th e se c o n d tim e P re -P a id D e fe n d a n ts h a v e a sk e d u s to i nfer s om et hi ng t he r ecor d does not s uppor t . T hey al s o s t at ed t he SE C per for m ed a re v iew o f

P re -P a id ’s a c c o u n tin g in 1 9 9 4 a n d w h ile it re q u ire d P re -P a id to r emove defer r ed ac qui s i t i on cos t s as as s et s , i t l eft i nt act Pr e- Pai d’ s r ecor di ng of c o m m is s io n a d v a n c e s (r e fe rr e d to in 1 9 9 4 a s “ A s s o c ia te s ’ b a la n c e s ” ) a s a s s e ts . ( Supp. A pp. V ol . I at SA - 291. ) W hi l e Pr e- Pai d di d change i t s acc ount i ng of d e fe r r e d a c q u i s i t i o n c o s t s , t h e r e i s n o i n d i c a t i o n i n t h e r e c o r d t h a t t h e SEC re q u ire d th is c h a n g e . In fa c t, t h e re c o rd e x p re ss ly sta tes P re -P a id c h a n g e d its a c c o u n tin g o f

d e fe rre d a c q u isitio n c o sts to re flec t th e c h a n g e s in its b u sin e ss to 27 Pr e- Pai d D efe ndant s corr ectl yas s ertthatD efe ndant s St onecipher , H arp and Pi ns on boughts har es dur i ng the cl as s per i od. T he r ecor d r evea l s St onecipher , H arp and Pi ns on p u rc h a se d1 0 ,0 0 0 , 4 7 ,0 0 0 a n d3 ,3 0 0 sh a re s, re sp e c tiv e ly . H o w e v e r, P re -P a idD e f e n d a n ts i ncorr ect l ys t at e thatnone of thes e i ndi vi dual s s ol d s har es dur i ng the cl as s per i od. I ndeed, S to n e c ip h e r so ld2 8 ,4 0 0 sh a re s, H a rp so ld1 4 ,2 8 4 sh a re s a n dP in so n so ld6 0 0 sh a re s. W h ile P i n s o n ’ s s a l e s r e p r e s e n t e do n l yas ma l lp o rt i o n o f h e rt o t a ls h a r e s a tth a tt i me ( appr oxi m at el y35, 000 s har es ) , s he s ol d the 600 s har es atappr oxi m at el y$33 a s har e. A lth o u g h sh e p u rch ase d3 , 3 0 0 sh are s du ri n g the c lass p eriod , sh e d id so o n e m o n th b ef o re the cl as s per i od ended and pai d onl yappr oxi m at el y$15 pers har e. M or eover , i n 1998, s he acqui r ed 15, 000 s har es , payi ng a mer e $. 375 pers har e. T her efor e, hers t ock s al es dur i ng the c la s s p e ri o dw e re n o t n e c e s s a ri ly co n s is te n t w ith h e r p re -c la s s p e ri o ds a le s . A s t o D efe ndantH arp, al though he pur chas ed 47, 000 s har es dur i ng the cl as s per i od, he di d s o byexer ci s i ng opt i ons , payi ng $9. 25 pers har e. M eanw hi l e, he s ol d 14, 284 s har es a t ap p ro x im a tely$ 2 6 .0 0 ash a re . W h ile D e f e n d a n t S to n e c ip h e r so ldo n lyasm a ll 28predom i natel y cl osed-pan el m em bershi ps.

T he r ecor d does not r evea l t he pr i ce for w hi ch he a cqui r ed t he r emai ni ng 29 23, 800 s har es he s ol d dur i ng t he cl as s per i od. Pr e- Pai d’ s A m ended For m 10- K for y ear endi ng D ece m ber 31, 2000, 30 w hi ch i s dat ed Febr uar y 1, 2002, s t at es t he boar d of di r ect or s i ncr eas ed t he authori zat i on t o 4 , 00 0, 00 0 shares. 28 per cent age of

hi s one mi l l i on s har es dur i ng the cl as s per i od, he s ol d even as m al l erport i on ( 18, 000 s har es ) pr i ort o the cl as s per i od. O f the s har es he s ol d dur i ng the cl as s per i od, 4, 500 s har es w er e s ol d at$30. 25 a s har e and 100 s har es at$26. 88. A s w i th D efe ndantPi ns on, 29 D efe ndantSt onecipher ’ s one pur chas e dur i ng the cl as s per i od came one month befor e the cl as s per i od ended, payi ng cl os e t o $18 pers har e. A nd w hi l e he pur chas ed 10, 000 s har es du rin g th e c las s p e rio d , b e f o re th e c las s p e rio dh e p u rc h a se do v e r 1 0 0 ,0 0 0 sh a re s a t ro u g h ly $2 -$3 a share. B ased on the ab ov e, w hil e these de fend ants pu rchased shares duri ng the clas s per i od, s uper fi ci al l ydefyi ng economi c r eas on, theydi d s o atl ow pr i ces , w hi ch mi ght change the equat i on. D efe ndant s Pi ns on and St onecipherm ade s t ock pur chas es dur i ng the cl as s per i od butats ubs t ant i al l yl ow ervol um e than thei rpur chas i ng acti vi typr i ort o the cl ass per i od . N evertheles s, no ne o f them app ear t o h ave d um pedtheirshares . M o re c o m p ell ing are P re-P aid D ef en d an ts’ arg u m en ts co n ce rnin g P re-P aid’s r epur chas e of i t s ow n s t ock. T he r ecor d s how s thaton A pr i l6, 1999, Pr e- Pai d announce d a sto c kre p u rc h a se p ro g ra m au th o riz in g m a n a g e m e n t to re a c qu ire up to 5 0 0 ,0 0 0 sh a re s o f its ow n s t ock. D ur i ng s ubs equentboar d m eeti ngs , Pr e- Pai d’ s boar d of di r ect or s i ncr eas ed s uch author i zati on t o 3, 000, 000 s har es . A s of M ar ch 31, 2001, Pr e- Pai d had r epur chas ed 30P re -P a id D e fe n d a n ts a s s e rt in th e ir b ri e f th a t P re -P a id b o u g h t $ 6 2 .5 31 m il li o n w o rt h o f sh are s. T h ey cit e to th e d ist ri ct co u rt ’s M arc h 5 , 2 0 0 2 o rde r. H o w e v e r, in its o rd e r, th e d istric t co u rt re fe rs to th e $ 5 6 .4 m ill io n fig u re . It i s o n ly af ter review ing P re-P aid D efen d an ts’ m o ti o n to d ism iss i n the d ist ri ct co u rt t hat w e s ee how t hey ar r i ved at t hi s fi gur e. A ccor di ng t o t hei r or i gi nal For m 10- K for 2000 and t hei r For m 10- Q for t he quar t er l y per i od endi ng M ar ch 31, 2001, P re -P a id re p u rc h a se d $ 2 9 .4 m ill io n w o rth o f sh a re s in 1 9 9 9 , $ 1 7 .3 m ill io n w o rth of s har es i n 2000, and $12. 8 m i l l i on w or t h of s har es i n t he fi r s t quar t er of 2001, for a t ot al of $59. 5 m i l l i on. A ccor di ng t o i t s M ay 16, 2001 pr es s r el eas e, Pr ePai d pur chas ed anot her $3 m i l l i on w or t h of s har es i n t he s econd qua r t er of 2001 fo r a total of

$ 6 2 . 5 m il li o n w o rt h o f sh are s. W e d erive d the $ 5 6 . 4 m il li o n fig u re fr om Pr e- Pai d’ s For m 10- Q for t he quar t er l y per i od endi ng M ar ch 31, 2001, w hi ch of c our s e di d not i ncl ude t he $3 mi l l i on w or t h of s har es pur chas ed i n t he s e c o n d q u a rt e r o f

2 0 0 1 . H o w e v e r, t h e re s till r e m a in s a d is c re p a n c y o f $ 3 .1 m ill io n ($ 6 2 .5 - ($ 5 6 .4 + $ 3 )). A p p a re n tly , n o t all o f th e sh a re s re p u rc h a se d in 1 9 9 9 w e re th e re su lt o f th e A p ril 1 9 9 9 sto c k re p u rc h a se p ro g ra m . W h ile th is d iffe re n c e is n o t m a ter ial, w e p o in t it o u t to n o te th a t o n c e a g a in P re -P a id D efe ndant s ’ r ecor d ci t at i on i n t hei r br i ef doe s not s uppor t t he pr opos i t i on for w hi ch i t i s ci t ed. 29 2, 456, 991 s har es underthi s pr ogr am for at ot alcons i der at i on of $56. 4 m i l l i on, an ave r age p ri ce o f $ 2 2 . 9 4 p er sh are . T h ere is no all eg ati o n that P re-P aid later so ld the se sh are s fo r a 31 p rof it . T h e d istri ct co u rttho u g h t i t “pa tentlyab su rd” an dco n tr aryto ec o n o m ic sen se f o r a corpor at i on t o art i fi ci al l yi nfl at e the pr i ce of i t s s t ock onl yt o then pur chas e the s t ock ats uch inf lat edp ri ce s. (R . A p p . V o l. III at A -74 1 . ) P lai n ti ff s d isag ree , asse rt ing P re-P aid’s r epur chas e of i t s ow n s t ock atart i fi ci al l yi nfl at ed pr i ces i s onl yabs ur d i f Pr e- Pai d expec t ed to g et ca u g h t. M o reo v er, th eyasse rtthere m ayh av e b ee n o ther rea so n s fo r P re-P aid’s r epur chas e pr ogr am i ncludi ng t o ai d i n the r ecrui tm entof new as s oci at es , t o avoi d the d isc o n ten tm e n t o f

its 2 0 0 ,0 0 0 m e m b e r sa les f o rc e w h o w e re in v e stin g m o n th lyinP re -P a id sto c kv ia th e A ss o c iate In v e stm e n t S to c kC lub P u rc h a se P lan , o r to m o re e a silym a n ip u lateW e al s o not e Pr e- Pai d’ s di r ect or s and exe cut i ves , s ever al of t hem nam ed 32 a s d e fe n d a n ts, c o u ld h a v e in iti a ted th e sto c k re p u rc h a se p ro g ra m in o rd e r to i ncr eas e Pr e- Pai d’ s s t ock pr i ce by decr eas i ng t he s uppl y of i t s s t ock. I n ot her w o rd s, th e se d ire c to rs a n d e x e c u tiv e s c o u ld h a v e sa c rifice d th e c o m p a n y fo r th e ir ow n per s onal gai n. 30 the st ock . T heycl ai m w i tho ut di scoverythere i s no w ayt o k no w P re- P ai d D efen dan t s’

32 true mot i vat i on. H ow ever , none of thes e argum ent s appearas al l egati ons i n the C o n s o lid a te dC o m p la in t. B a se do n th e ab o v e , w e c o n c lu d e P lain tiff s’ C o n so lid a ted C o m p lain t in su f f icie n tly p lead s scien ter. H o w ev er, un li k e the d istri ct co u rt , w e d o n o t believe P lai n ti ff s’ frau dtheo ry i s “pat entlyabsurd. ” T he C on sol i dated C om plai nt r ai ses s om e ser i ou s “r ed flags” conce rni ng Pr e- Pai d D efe ndant s ’ l ong t erm r ecor di ng of unr ecove r abl e unearned c o m m is s io n a d v a n c e s a s a s s e ts a n dth e c re d ib ility o f th e irp re -2 0 0 1 S E C d is c lo s u re s . N everthel es s , i ti s l acki ng i n al l egati ons demonstr at i ng Pr e- Pai d D efe ndant s ’ al l eged f r aud w a s e c o n o m ica llylo g ica l inlig h t o f P re -P a id ’s r e p u rc h a se o f its o w n sto c ka t alle g e d ly in f late dp ric e s. It a lso f

a ils to a d e qu a telya lleg e P re -P a id ’s G A A P v io latio n w a s th e re su lt o f a n in ten t to m isle a din v e sto rs. T h e re f o re , d ism iss a l w a s ap p ro p ria te. W e n o w tu rn to w h e th e r P lain tiff

s s h o u ldh a v e b e e n p ro v id e da n o p p o rtu n ityto a m e n dth e ir c o m p lain t. 2. A m endmentof C om pl ai nt In th e ir o p p o sitio n to P re -P a idD e f e n d a n ts’ m o tio n to d ism iss , P lain tiff s o b liqu e ly re qu e ste dlea v e to a m e n dth e C o n so lid a ted C o m p lain t inth e e v e n t th e c o u rt d e term in e dit w as defici ent. In i t s ordergrant i ng P re- P ai d D efen dan t s’ andD el oitt e’s m oti on s t o d i sm i ss, the di s tr i ctcourtdi d notexpr es s l ydeny , oreven a cknow l edge, Pl ai nt i ffs ’ r eques tforl eaveW hi l e Pl ai nt i ffs ’ compl ai nt w as t i t l ed “Consol i dat ed A m ended 33 Co mp l a i n t , ” i t wa s i n fa c t t h e fi r s t c o mp l a i n t t h e y fi l e d a s a p r o s p e c t i v e c l a s s . ( R. A p p . V o l. I a t A -1 7 .) 31 t o amend. H ow ever , i n i t s conclus i on, the courts t at ed: “B ecaus e i tdoes notappearthatany a m e n d m e n t w o u ldb e su c c e ss f u l ino v e rc o m in g th e p lea d in g d e f icie n c ies , this a c tio n is d is m is s e dw ith p re

ju d ic e , a n daju d g m e n t w ill e n te r.” (R . A p p . V o l. I II a t A -7 4 9 .) P lain tiff s a rg u e th e d istric t co u rt ab u se dits d isc re tio nind e n y in g th e m lea v e to am end . T heyassertthe d i stri ctcou rtden i ed thei r r equ estfor l eave to am endbecau se amendm entw oul d be fut i l e. H ow ever , theycont end the di s tr i ctcourtpr ovi ded no expl anati on as t o w hyamendm entw oul d be futi l e. Pl ai nt i ffs al s o ar gue thatunderthe ci r cumst ance s of thi s cas e l eave t o amend shoul d have be en “f r eelygi ven” be caus e they m a d e atim e lyre qu e st f o r a m e n d m e n t, th e yw e re n o t p re v io u slyg iv e n a n yo p p o rtu n ityto a m e n d a n dP re -P a idD e f e n d a n ts w o u ldn o t b e p re ju d ice d . F e d . R . C iv . P . 1 5 (a ). T h is is 33 esp ec ial lytru e, th eyasse rt , in a s ec u ri ti es f rau dac ti o n , w h ere the p lead ing req u ir em en ts are so ri go rous. A l though Pl ai nt i ffs cont end the di s tr i ctcourterr ed i n denyi ng thei rr eques tforl eave t o amend, no s uch r eques tw as pr oper l ybefor e the court . “[A ] r eques tforl eave t o amend m us tgi ve ade quat e not i ce t o the di s tr i ctcourtand t o the oppos i ng partyof the bas i s of the p ro p o se da m e n d m e n t b e f o re th e c o u rt is re qu ire dto re c o g n ize th a t a m o tio n f o r le a v e to amend i s befor e i t . ” Calderon v. Kan sas D ep’tof Soc. & R eha b. Servs. , 181 F. 3d 1180, 1186- 87 ( 10th C i r . 1999) . T hi s not i ce r equi r ementas s ur es thatw e do not“r equi r e di s tr i ct c o u rts to e n g a g e inin d e p e n d e n t re se a rc h o r re a dth e m in d s o f lit ig a n ts to d e term in e if32

i nform at i on j us t i fyi ng an amendm entexi s t s . ” I d. at1187 ( quot at i ons om i tt ed) . H er e, P l ai nti ffs m ade o nlya cursoryrequestfor l eave to am endatthe co nclusi on of thei r r espon se t o Pr e- Pai d D efe ndant s ’ m ot i on t o di s m i s s . N otonl ydi d theynotpr ovi de a pr opos ed amended compl ai nt , theyal s o fai l ed t o pr offe rw hataddi t i onalevi dence theyw oul d pl ead or h o w s u c h a d d itio n a l e v id e n c e w o u ldre m e dyth e C o n s o lid a te dC o m p la in t’ s d e f ic ie n c ie s . T heym er el yar gued i n a s i ngl e par agr aph thati ti s i m pr opert o denyl eave t o amend ( es peci al l yi n cas es di s m i s s ed forfai l ur e t o adequat el yal l ege f r aud) w hen the pl ai nt i ff doe s notacti n bad fa i th and def endantw oul d notbe pr ej udi ced. I n es s ence , theypl ace d the d istric t co u rt inth e u n ten ab le p o sitio n o f m a k in g th e ir c a se f

o r th e m . S u c h are qu e st is in su f f icie n t. Calderon is in stru c tiv e . T h e re , the p lain tiff c o n c lu d e dh e r m e m o ra n du m in o p p o sitio n to th e d e f

e n d a n ts’ m o tio n to d ism iss w ithasin g le s e n ten c e re qu e stin g lea v e to a m e n dh e r c o m p la in t to c u re a n yd e f e c ts . Calderon , 1 8 1 F . 3 dat 11 8 5 . T h e d istri ct co u rt d idn o t a d d re s s th e p la in tif f’s re qu e s t a n dd is m is s e dth e c a s e w ith p re ju d ic e . I d. at1183, 1 1 8 5 . O n ap p e a l, th e p lain tiff a rg u e dth e d istric t co u rt ab u se dits d isc re tio n inf a ili n g to g ra n t h e r l e a v e to a m e n d . I d. at1185. W e r ej ect ed the pl ai nt i ff’ s ar gum ent , concludi ng the pl ai nt i ff’ s “s i ngl e s ent ence , l acki ng a s t at ementforthe gr ounds foramendm entand dangl i ng a t th e e n do f

h e r m e m o ra n du m , d idn o t r is e to th e le v e l o f am o tio n f

o r l e a v e to a m e n d . B ecaus e a mot i on forl eave t o amend w as neverpr operl ybefor e i t , the di s tr i ctcourtdi d not abus e i t s di s cr et i on i n fai l i ng t o addr es s [the pl ai nt i ff’ s ] r eques tforl eave t o cur e def i ci enci es i n herpl eadi ngs . ” I

d. a t 1 1 8 7 . See al

s o G lenn v. Fi rs tN

at ’ lB ank in G rand Juncti on , 868A l t hough Pr e- Pai d’ s r es t at ed fi nanci al s t at ement s w er e fi l ed af t er t he 34 C o n so li d ated C o m p lai n t, the C o n so li d ated C o m p lai n t con tai n ed P re-P aid’s es t i m at es for t he r es t at ement , w hi ch w er e s i m i l ar i n m agni t ude t o t he ac t ual re s ta te d fin a n c ia l s ta te m e n ts . [ A pp. V ol . I I I at A - 759] A ddi t i onal l y , t he di s t r i ct c o u rt w a s a w a re o f

th e m a g n itu d e o f

P re -P a id ’s r e sta ted fin a n c ial s tate m e n ts w h e n it r u le d o n P la in tiffs ’ R u le 6 0 (b ) m o tio n . [ I d. at A - 919] 33 F .2 d3 6 8 , 3 7 0 (1 0 th C ir. 1 9 8 9 ) (c o n c lu d in g th a t th e d istric t co u rt d idn o t err in f a ili n g to addr es s the pl ai nt i ffs ’ r eques tforl eave t o amend, w hi ch w as m ade i n thei rr es pons e t o the defe ndant s ’ m ot i on t o di s m i s s , becaus e the r eques tdi d notr i s e t o the s t atus of a mot i on and fai l ed t o s etforth anygr ounds forthe r eques t ) . T he s ame i s true her e. W e a lso n o te th a t ev e n a f terth e d istric t co u rt g ra n ted P re -P a idD e f e n d a n ts’ m o tio n to di s m i s s and out l i ned the al l eged de fi ci enci es of the C ons ol i dat ed C om pl ai nt , Pl ai nt i ffs fai l ed to req u est l ea v e to a m en d . In th eir Ru le 60 (b) m o ti o n , P lai n ti ff s arg u edthe d istri ct co u rt m i s under s t ood the fa ct s and err ed on the mer i t s . H ow ever , theynevers ugges t ed amendm entof the compl ai nt . O n appea l , Pl ai nt i ffs cont i nue t o fai lt o pr ovi de any expl anati on as t o how amendm entw oul d cur e the def i ci enci es of the C ons ol i dat ed C om pl ai nt . T heym er el yar gue: “I ndeed, as num er ous addi t i onalfac t s ( i ncludi ng, s i gni fi cantl y , Pr e- Pai d’ s actualr es t at ementof fi nanci alr es ul t s ) came t o l i ghtfol l ow i ng Pl ai nt i ffs ’ fi l i ng of the [Consol i dat ed] C om pl ai nt , and w er e notther efor e partof the r ecor d, the D i s tr i ctC ourtw as i n no pos i t i on t o conclude thats uch s ubs equentl ydi s cover ed i nfo rm at i on w ou l d n ecessar i l yfai l t o cu re the p ercei veddefici encies . ” (A pp el l ants ’ 34 O peni ng B r . at58- 59. ) Y et , Pl ai nt i ffs neverpr offe r ed thi s addi t i onali nform at i on t o the di s tr i ctcourtand t o thi s day , theydo noti ndi cat e w hati nform at i on theyw oul d i nclude i n an34

a m e n d e dc o m p lain t to sa tisf yth e sc ien terre qu ire m e n t. P la in tif f s f a ile dto a d e qu a te ly re qu e s t a m e n d m e n t a n dto s up p o rtth a t r e qu e s t. C o n s e qu e n tly, th e d is tr ic t c o u rtd idn o t e rrin d is m is s in g th is c a s e w ith o u t le a v e to a m e n d . B ecaus e ourconclus i on thatthe di s tr i ctcourtpr oper l ydi s m i s s ed thi s cas e w i th pr ej udi ce f or fai l ur e t o adequat el ypl ead s ci ent erdi s pos es of thi s appea l , w e nee d notaddr es s the t i m el i nes s of Pl ai nt i ffs ’ compl ai ntorthe truth- on- the- m arketdoctr i ne. AF F I RM ED . E n teredfo r th e C o u rt

T err ence L . O ’ B r i en C i r cui tJudge