E. Control Person Claims Under § 20 Against Turcotte, Kim & Flanagan

Plaintiffs also sue Turcotte, Kim, and Flanagan as control persons under § 20 of the
Exchange Act based on misrepresentations relating to plaintiffs’ initial stock purchase and their
subsequent loan pursuant to the promissory note. ‘4 Plaintiffs’ control-person claims under § 20
are derivative claims, and thus are actionable only if plaintiffs adequately allege a primary
violation under § 10(b). Heartland Fin. USA, Inc. v. Fin. Insts. Capital Appreciation Partners 1,
L.P., No, 02 CV 3982, 2002 WL 31819008, at * 8 (N.D. Ill. Dec. 12, 2002). Because plaintiffs
here failed to state a claim under § 10(b) against any of the defendants, plaintiffs’ claims under
§ 20 must be dismissed as well. Jd.

I. Claims Under Section 12(a)(2) and Section 15 of the Securities Act of 1933

Plaintiffs also bring claims against Xentex, Turcotte, Kim and Flanagan under § 12(a)(2)
of the Securities Act relating to thcir initial stock purchase. The PSLRA’s heightened pleading
requirements do not apply to claims under the Securities Act. Adams Golf, 176 F. Supp. 2d at
230, Likewise, neither fraud nor scienter are elements of a Section 12(a)(2) claim. Jn re
Nationsmart Corp. Secs. Litig., 130 F.3d 309, 318 (8th Cir. 1997). Nor need plaintiffs satisfy
Rule 9(b), as long as they are not making allegations of fraud. Flanagan and the Xentex
defendants, however, argue that plaintiffs have no cause of action under § 12(a)(2) because
plaintiffs purchased stock through a private placement, not a public offering. Plaintiffs disagree.

Section 12(a)(2) applies only to public offerings, not private placements. Liability under

'4As noted earlier, plaintiffs did not bring the control-person liability claims under § 20 in
counts separate from the direct liability claims under § 10(b). The § 20 claims are raised against
Turcotte in Counts 9 and 10, against Kim in Counts 24 and 25, and against Flanagan in Counts
18 and 19.

19



general and hence inadequate form, is that at some /ater time the money they invested was used
to pay Batio’s personal expenses. Such an allegation, even if factually specific enough (which
the court doubts) does not support a strong inference that at the time of the November Ist
meeting, looting and misappropriation of corporate funds was occurring at Xentex, and that
Xentex thus made fraudulent misrepresentations in order to continue the looting and
misappropriation.

Plaintiffs have failed to set forth facts demonstrating why most of the misrepresentations
they allege were false. In the few instances whore some “why” information is provided,
plaintiffs have not set forth facts sufficient to give rise to a strong inference that Xentcx (through
its Board and/or corporate officers) knew the statements were false and acted knowingly or
recklessly in making the misstatements. For these reasons, plaintiffs have failed to plead
securities fraud claims against Xentex under § 10(b). Counts 2 and 3 are dismissed.

B. § 10(b) Claims Against Turcotte: Counts 9 and 10

Plaintiffs also claim that Michael Turcotte, Xentex’s Vice President of Accounting and
Control, committed securities fraud in violation of § 10(b) by making misrepresentations in
financial statements distributed prior to the initial stock purchase (Count 9) and prior to the
exccution of the promissory note (Count 10),

Specifically, plaintiffs allege that the Information Statement they received included
financial statements prepared by Turcotte which falsely represented that Xentex owned tooling
worth more than $4.25 million and total assets exceeding $5.3 million. A subsequent financial
statement prepared by Turcotte dated December 31, 2000, less than two months after plaintiffs

invested in Xcntex, represented that Xcntex had just $4.3 million in assets, including only $1.5

13



[Xentex's] securitics.”"” Maton v. Arthur Andersen & Co., No. 91 C 1885, 1991 WL 131184, at
*3 (N.D. Il. July 5, 1991), Here, plaintiffs effectively concede that Flanagan is not liable under
§ 12(a)(2). They argue that as a control person under § 15, Flanagan can be liable for another
person’s primary violation of § 12(a)(2). That is true, but as a control person, he would be liable
only under § 15, not under both §15 and § 12(a)(2). Plaintiffs’ § 12(a)(2) claim against Flanagan
is therefore dismissed.

Flanagan also asscrts that plaintiffs have not adequately pled control-person liability
under § 15. In the Seventh Circuit, plaintiffs seeking to establish control-person liability must
plead two clements: “(1) that the defendant actually exercised general control over the operations
of the entity [that is liable for a primary violation]; and (2) that the defendant had the power or
ability to control the specific acts constituting the primary violation.” Lindelow v. Hill, No. 00 C
3727, 2001 WL 830956, at *9 (N.D. Ill. July 20, 2001) (citing Donohoe v. Consol. Operating &
Prod. Corp., 982 F.2d 1130, 1138-39 (7th Cir, 1992)).”” Simply relying on Flanagan’s status as a
member of the Board of Directors is insufficient to state a control person claim. See, e.g.,
Donovan v. ABC-NACO, Ine., No, 02 € 1951, 2002 WL 1553259, at *6 (N.D. Ill. July 15, 2002)
(fact that defendants were directors insufficient to support control-person liability). But here,
plaintiffs allege a bit more. They contend that Flanagan “actively participated in and controlled

decisions of the Board of Directors” (gencral control), that he helped prepare and/or review the

‘St the November Ist meeting, it was Batio and Tuckcr, not Flanagan, who met with
Plaintiffs and presented them with the opportunity to invest in Xentex.

*°Both Lindelow and Donohoe involved control person liability under § 20, not § 15, but
the same standards apply to both. See In re VMS Secs. Litig., 752 F. Supp. 1373, 1402 (N.D. Til.
1990).

23



+66

not strain to find inferences favorable to the plaintiffs’ which are not apparent on the face of the
complaint,” however. Jn re Allscripts, Inc. Secs. Litig., No. 00 C 6796, 2001 WL 743411, *4
(N.D. Ill. June 29, 2001) (quoting Coates v, II. State Bd. of Ed., 559 F.2d 445, 447 (7th Cir.
1977)). To the extent plaintiffs raise securities fraud claims under § 10(b), they must meet the
heightened pleading requirements of Rule 9(b) as well as § 78u-4(b) in order to state a claim for
fraud. Under Rule 9(b), a plaintiff must plead “the circumstances constituting fraud . . . with
particularity.” Jn re HealthCare Compare Corp. Secs. Litig., 75 F.3d 276, 281 (7th Cir. 1996).
In other words, a plaintiff must allege “the who, what, when, where and how” of the fraud.
DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th Cir. 1990). Since the enactment of the PSLRA
in 1995, the pleading requirements for claims under the Exchange Act are now even higher: the
complaint must “specify cach statement alleged to have becn misleading, [and] the reason or
reasons why the statement is misleading ....” 15 U.S.C. § 78u-4(b)(1)(B). Additionally, with
respect to each alleged misrepresentation or omission, (he complaint must “state with
particularity facts giving rise to a strong inference that the defendant acted with the required state
of mind.” Jd. at § 78u-4(b)(2). These two requirements are closely related. The PSLRA
requires, in the absence of direct evidence of falseness and scienter, the pleading of facts which
justify a strong inference of both elements. See ia re Navarre Corp. Secs. Litig., 299 F.3d 735,
744 (8" Cir. 2002).

The heightened pleading requirements imposed by the PSLRA do not apply to plaintiffs’
claims under § 12(a)(2), however. Although the PSLRA amended both the Securities Act and

the Exchange Act, the heightened pleading requirements imposed by § 78u-4(b) apply only to

claims brought under the Exchange Act. In re Adams Golf, Ine. Secs. Litig., 176 F. Supp. 2d



§ 12(a)(2) extends to any person who “offers or sells a security . . . by means of a prospectus or
oral communication, which includes an untrue statemcnt of a material fact or omits to state a
material fact necessary in order to make the statements .. . not misleading ....” 15 U.S.C.

§ 771(a)(2). As the Supreme Court explained in Gustafson v. Alloyd Co., Inc., 513 U.S. 561,
567-68, 571 (1995), § 12(a)(2) provides for liability only for misstatements in prospectuses or
falsc oral communications relating to such prospectuses. Further, the term “prospectus” is
“confined to documents related to public offerings by an issuer or its controlling shareholders.”
Id. at $69.5 Accordingly, causcs of action brought under § 12(a)(2), where the transaction at
issue was a private placement rather than a public offering, are subject to dismissal. See, e.g.,
Abbell Credit Corp. v. Banc of Am. Sees., L.L.C., No. 01 C 2227, 2001 WL 1104601, at *3 (N.D.
Ill. Sept. 17, 2001) (dismissing § 12(a)(2) claims pursuant to Rule 12(b)(6)); Liberty Ridge LLC
y. Realtech Sys. Corp., 173 F. Supp. 2d 129, 135 (S.D.N.Y. 2001) (same).

Plaintiffs allege that they made their initial stock purchase in a public offering. That
allegation, however, is contradicted by the offering document for plaintiffs’ initial investment.
“Tt is a well-settled rule that when a written instrument [properly before the court as an exhibit]
contradicts allegations in the complaint, .. . the exhibit trumps the allegations.” N. Ind. Gun &

Outdoor Shows, Inc. v. City of South Bend, 163 F.3d 449, 454 (7th Cir. 1998).'° The Information

'SGustafson addressed Section 12(2), which by amendment in 2000 became Scction
12(a)(2).

‘In determining whether to grant the motion to dismiss, the court may properly consider
the Information Siatement, which the Xentex defendants submitted as an exhibit to their brief in
support of their motion to dismiss, because plaintiffs referred to the Information Statement in
their complaint and the document is central to plaintiffs’ claims. Wright v. Assoc. Ins. Cos. Inc.,
29 F.3d 1244, 1248 (7th Cir. 1994). For the same reasons, the court will consider the Promissory
Note and the Amendment to that note. The court will not, however, consider any of the other

20



subject to the requirements of §12(a)(2)."* The Xentex defendants and Flanagan bear the burden
of proving that the private placement excmption applies to the stock sale at issue. UBS Asset
Mgmt. (NY) Inc. v. Wood Gundy Corp., 914 F. Supp. 66, 68 (S.D.N.Y. 1996) (burden of showing
exemption falls on person claiming it),

The Xentex defendants raise no other challenges to plaintiffs’ § 12(a)(2) claims agaist
Xentex (Count 1), Turcotte (Count 8), and Kim (Count 24). Accordingly, those counts survive
the motion to dismiss, Counts 8 and 24 also sought to impose control-person liability under § 15
against Turcotte and Kim, respectively. Claims under § 15 are derivative claims, seeking to
impose joint and several liability against control persons for others’ primary violations of
§ 12(a)(2). Because the Xentex defendants’ only challenge to the § 15 claims was that plaintiffs
failed to allege a primary violation under § 12(a)(2), the control-person claims against Turcotte
and Kim also survive.

Flanagan, on the other hand, raises two additional arguments for dismissal of the claims
against him under the Securities Act. He argues first that plaintiffs failed to properly state a
claim against him under § 12(a)(2) because they do not allege that Flanagan was a seller within
the mcaning of the statute. Liability under § 12(a)(2) is limited to “those who pass title of
securities or solicit their sale.” Danis v. USN Communications, Inc., 73 F. Supp. 2d 923, 936
(N.D, TI]. 1999) (citing Pinter v, Dahl, 486 U.S. 622 (1988)). Thus, individual officers and

directors are not liable “absent allegations that they actually promoted or solicited the sale of

'’These assertions are not necessarily inconsistent with a private placement, however. For
example, Xentex could have achieved 300 investors by means of multiple private placements
with no more than 35 investors per offering.

22



start to be produced in October, 2001.” (SAC 441.) But Kim’s representation that production
of the Voyager computers would start in October was a projection or a forward-looking
statement. “[P]redictions of future performance are inevitably inaccurate because things almost
never go exactly as planned.” Zoghlin v. Renaissance Worldwide, Inc., No. 99 C 1965, 1999 WL
1004624, at *6 (N.D. Ill. Nov. 4, 1999) (quoting Arazie v, Mullane, 2 F.3d 1456, 1468 (7th Cir.
1993)). Forward-looking statements are therefore not actionable unless plaintiffs allege “specific
facts which illustrate that [the defendant’ s] predictions lacked a reasonable basis.” Arazie, 2 F.3d
at 1468, The mere allegation that there were design problems in March 2001 does not support
the inference that there was no reasonable basis for Kim to represent that production would begin
nearly seven months later.

To the extent Counts 25 and 26 scck to hold Kim liable under § 10(b), they are dismissed
for failure to state a claim.

D. § 10(b) Claims Against Flanagan: Counts 18 and 19

Plaintiffs sue Flanagan, a member of Xcntex’s Board of Directors, for misrepresentations
purportedly made in connection with their initial stock purchase (Count 18) and the execution of
the promissory note (Count 19). Neither of these claims satisfy the PSLRA’s heightened
pleading requirements.

With respect to the initial stock purchase, plaintiffs do not allege any direct contact with
Flanagan. Rather, they claim Flanagan is liable for misrepresentations in the Information
Statement because he “played a role in the preparation of said information sheet and/or had
reviewed said Information [Statement] in his capacity as a member of the Xentex Board of

Directors with a substantial financial interest in said corporation.” (SAC 4] 303.) In other words,

17



(3) Xentex, through Batio, informed plaintiffs in May 2001 that the Voyager
computers were essentially complete and assembled;

(4) Xentex, through defendant Brian Flanagan, advised the plaintiff that the
company was able to pay its bills and was not financially depleted;

(5) Xentex, through Flanagan, advised plaintiff that no engineering or mechanical
defects existed regarding the computers and that Xentex was being properly
managed; and

(6) Xentex, through Batio, advised plaintiffs that the money tendered pursuant to
the promissory note would be used for marketing purposes only, as the computers
were assembled and complete.

(SAC fff 53-59.) Plaintiffs’ allegations regarding statements 2, 3 and 4 are deficient under the
PSLRA’s pleading requirements because they failed to plead any specific facts showing the
falsity of those statements at the time they were made.

As for the first statement, plaintiffs allege that the statement that Xentex was capable of
mass producing Voyager computers was false because Xentex, to datc, has never mass-produced
the computers. (Jd. 61.) As explained above, the fact that Xentex has not mass-produced the
computers does not mean that it was never capable of doing so, and thus does not support the
inference that the statement was false when made. Plaintiffs also attempt to show the falsity of
the first statement by alleging that the production schedule Kim gave them “failed to accurately
disclose Xentex[’s] ability to mass-produce the Voyager computers.” (/d. at 62.) Plaintiffs have
again merely stated that the production memo was untrue, without providing facts showing why
it was untrue,

The allegations regarding the falsity of the fourth statement also faller. According to the
complaint, Flanagan’s statement that the company was able to pay its bills and was not

financially depleted was false because in fact, Xentex was deeply in debt, underfunded, and a



or reasons why [each] statement is misleading.” 15 US.C.A.§ 78u-4(b)(1)(B). Further, in the
few instances where plaintiffs provide the reasons why a particular stalement was false, they fail
to plead scienter adequately.

Plaintiffs specifically identify the following representations from the Information
Statement as false:

(1) Xentex had $5.3 million in assets, including $4.25 million in tooling;

(2) Korean Data Systems (“KDS”) had agreed to open a service center for
warranty & repair services;

(3) Xentex expected to launch the Voyager in fourth quarter of 2000°;
(4) KDS had provided approximately $40 million for product financing; and
(5) KDS had agreed to pay for all further product development and tooling costs.

(SAC at 20(a-e)). According to plaintiffs, the first statement was false because Xentex never
had those asscts, and the third statement was false because at the time, “Defendant was in a
position wherein said launch was impossible,” (id. | 23). These are not adequate allegations of
why the subject statements were false: plaintiffs merely allege that the statements were false
because the opposite was true. These arc conclusory allegations, not facts. As for statements 2,
4, and 5, plaintiffs offer no reasons whatsoever explaining why those representations were false.
Plaintiffs have failed to state a securities fraud claim based on the representations in the
Information Statement.

Plaintiffs also allege that Batio and Tucker made oral misrepresentations during the

‘This representation is a forward-looking statement. Such a prediction is not actionable
unless plaintiffs alleged that Xentex lacked a reasonable basis for making it. Zoghlin v.
Renaissance Worldwide, Inc., No. 99 C 1965, 1999 WL 1004624, at *6 (N.D. Ill. Nov. 4, 1999).

“Indeed, with respect to statement 4, there is not even an allegation that the statement was
false, let alone an explanation of why it was false.

6



216, 230 (D. Del. 2001); 15 U.S.C. § 78u-4(b).
With these pleading requirements in mind, the court turns to the counts at issue.
1. Claims Under Section 10(b) and Section 20 of the Exchange Act of 1934
A § 10(b) Claims Against Xentex: Counts 2 and 3
1. For Claims under § 10(b), Plaintiffs Must Identify Specific False
Statements and Provide the Reasons Why Each Statement is
Misleading.
To state a claim under § 10(b) of the Exchange Act for a violation of Rule 10b-5, 17
C.E.R. § 24010b-5, a plaintiff must plead that “the defendant (1) made a misstatement or
omission, (2) of material fact, (3) with scienter, (4) in connection with the purchase or sale of
securities, (5) upon which plaintiff has relicd, and (6) that reliance proximately caused plaintiff's
injuries.” [TealthCare, 75 F.3d at 280. Moreover, as explained above, plaintiffs must satisfy the
pleading requirements imposed by the PSLRA: they must not only specify each statement they
claim was misleading, they must also allege “the reason or reasons why [each] statement is
misleading.” 15 U.S.C.A.§ 78u-4(b)(1)(B). Claiming that a particular statement was untrue is
not enough—plaintiffs must explain, with particularity, the factual basis for their assertion that
the statement was untrue. Clark v. TRO Learning, Inc., No. 97 C 8683, 1998 WL 292382, at *4
(ND, Ml. May 20, 1998).
Plaintiffs in this case fail to state claims under § 10(b) against Xentex because the

complaint is woefully deficient under the PSLRA.’ Although plaintiffs identify numerous

specific statements that they believe were mislcading, they repeatedly fail to provide “the reason

‘The court need not address whether plaintiffs satisfied Rule 9(b). The PSLRA requires
at least as much and more.



they seek to hold him liable for a “group-published” document. “The group pleading doctrine is
generally construed as applying only to high-level corporate officers and directors with direct
involvement in the day-to-day business of the company.” Sutton y, Bernard, No. 00 C 6676,
2001 WL 897593, at *5 (N.D. Ill Aug. 9, 2001). Assuming plaintiffs’ allegations are adequate
under the group pleading doctrine and that the doctrine is applicable to Flanagan, plaintiffs’

§ 10(b) claim against Flanagan nevertheless fails for their failure to comply with the PSLRA’s
requirements that they allege facts indicating why the purported misrepresentations were false
and facts giving rise lo a strong inference of scienter.

Likewise, the § 10(b) claim against Flanagan based on misrepresentations relating to the
promissory note is deficient, Plaintiffs allege that before they executed the promissory note, their
principals had a telephone conversation with Flanagan during which he represented that “Xentox
management was stable and effective, production of the Voyager computers were [sic] on
schedule, [Xentex] was not under funded and he did not know the reason that the CEO of
(Xentex] had quit.” (SAC 4 320.) Plaintiffs, as is their wont, fail to offer any specific facts
indicating that any of these representations were false. They merely allege that Flanagan, as a
Board member, attended Board meetings, had frequent conversations with the former CEO, had
reviewed documentation, and “otherwise knew” the representations werc false. (SAC § 320.)
Such vague allcgations are not nearly factually specific enough to satisfy the PSLRA’s pleading
standards.

Given the aforementioned deficiencics, the court need not address the sufficiency of
plaintiffs’ allegations regarding Flanagan’s scienter. To the extent Counts 18 and 19 raise claims

against Flanagan under § 10(b), they are dismissed.

18



vague; if plaintiffs have such evidence, one would think they would describe with some
particularity what debt, what automobiles, what vacations, and what “other inappropriate
purposes” they are referring to. In any cvent, even if the alleged “facts” are specific enough to
show why the representation was false, they do not provide a basis for inferring that the

representation was false at the time it was made. ““[O]ften there is no reason to assume that what
is truc at the moment plaintiff discovers it was also true at the moment of the alleged
misrepresentation, and that therefore simply because the alleged misrepresentation conflicts with
the current state of facts, the charged statement must have been false.”” City of Philadelphia v.
Fleming Cos., Inc., 264 F.3d 1245, 1260 (10th Cir. 2001) (quoting Jn re GlenFed Sec. Litig., 42
F.3d 1541, 1548-49 (9th Cir. 1994)). As for the statements concerning the origin of the computer
and the lack of any pending lawsuits, plaintiffs probably adequately allege the falsity of those
statements. However, for reasons explained below, even if the allegations regarding each of the
last three oral statements satisfy the “why” requirement of the PSLRA, they fail to satisfy the
Act’s scienter prong.

Additionally, plaintiffs raise a claim against Xentex under § 10(b) based on allegedly
untrue representations made to induce plaintiffs to loan Xentex $650,000 in June 2001 pursuant

to apromissory note.® Plaintiffs plead that:

(1) Kim tendered a production schedule dated March 21, 2001, which represented
that Xentex had the ability to mass produce Voyager computers at that time;

(2) Xentex, through Tucker, tendered a memo dated April 5, 2001 to plaintiffs
representing that Xentex had made all arrangements to possess seventy prototypes
from Asia within 3 weeks from the date of the memo;

‘plaintiffs allege, and defendants at this stage do not contest, that this loan constituted a
sale of securities within the meaning of the Exchange Act.

8



Information Statement (control over specific acts) and that he held a security interest in all of
Xentex’s assets. These allegations are enough to survive a motion to dismiss. Claims under § 15
need only satisfy federal notice pleading standards. Moreover, “[o]rdinarily, whether a defendant
is a ‘controlling person’ . . . is a question of fact that cannot be determined at the pleading stage.”
Lindelow, 2001 WL 830956, at *9.
Conclusion

Both Flanagan’s and the Xentex defendants’ motions to dismiss the federal claims against
them in the Second Amended Complaint are granted in part and denied in part. As explained
above, the claims against Xcntex, Turcotte, Kim, and Flanagan under § 10(b) and § 20 of the
Exchange Act arc hereby dismissed, as is the § 12(a)(2) claim against Flanagan. The claims
against Xentex, Turcotte and Kim under § ]2(a)(2) survive, however, as do the control-person
liability claims against Turcotte, Kim and Flanagan under § 15.

ENTER:

Uy f

[IOAN B. GOTTSCHALL
| United States District Judge

DATED: August 14, 2003

24



———————————

‘Minute Order Furtn (06157)

United States District Court, Northern District of Mlinois

Name of Assigned Judge Sitting Judge if Other
or Magistrate Sudge Joan B. Gottschall than Assigned Judge
CASE NUMBER 02 C 5368 DATE 8/14/2003
CASE Premier Capital Management, LLC, et al. vs. Cohen, et al.
TITLE
MOTION: Tin the following box (a) indicate the party filing the motion, c.g. plaintiff, defendant, 3rd party plaintiff, and (b) state briefly the nature

of the motion being presented.]

DOCKET ENTRY:

a) Qa Filed motion of | use listing in “Motion” box above.]

(2) oO Brief in support of motion due

3) oO Answer brief to motion due____. Reply to answer briefdue____.

(4) a Ruling/Hearing onset for__at__

(5) | Status hearing is set for 09/18/03 at 9:30 A.M..

(6) Oo Pretrial conference{held/continued to] [set for/re-set for]on___—ssetfor oat
(7) o Trial[set for/re-set for]on__— at

(8) im [Bench/Jury trial] [Hearing] held/continued to at_

(9) oO This casc is dismissed [with/without] prejudice and without costs[by/agreement/pursuant to]

OOFRCP4(m) Cl Local Rule 41.1 CERCP41(a)(1) 1 FRCP41(a)(2).

qo) [Other docket entry) Enter Memorandum Opinion and Order. The motion of defendants Xentex
Technologies, Inc., Larry Cohen, Wan Hee Kim, Michacl Turcotte and Ron Falese to dismiss the second amended
complaint [23-1] is granted in part and denied in part, Brian Flanagan’s motion to dismiss [27-1] is also granted
in part and denied in part. The claims against Xentex, Turcotte, Kim, and Flanagan under § 10(b) and § 20 of
the Exchange Act (Counts 2-3, 9-10, 18-19 and 25-26) are hereby dismissed. The § 12(a)(2) claim against
Flanagan is also dismissed, but the § 12(a)(2) claims against Xentex, Turcotte and Kim survive. Likewise, the
§ 15 claims against Turcotte, Kim and Flanagan also survive. This matter is set for a status hearing on September
18, 2003, at 9:30 A.M.

q) i | [For further detail sec order attached to the original minute order.]

No notices required, advised in open court,

No notices required.
uri of notices

Notices mailed by judge's stuff,

2003

Notified counsel by telephone. Mle datictet

7 | Docketing to mail notives,

Mail AO 450 form, 4yno9 Lopisig 7)

Copy to judge/magistrate judge, MY3y9

Py
(p/ courtroom Pl Wd 1 syed
; court
} om -DLi

bagligg Rind
kL contrul k's Office ‘mailing deputy initials

LaAudl

date giled notice



Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). “[RJeckless disregard for the truth counts as
intent” for purposes of § 10(b).'° Chu v. Sabratek Corp., 100 F. Supp. 2d 815, 822 (N.D. Ll.
2000) (quoting SEC v. Jakubowski, 150 F.3d 675, 681 (7th Cir. 1998)). Conclusory allegations
that defendants acted with knowledge that the representations were false and misleading do not
satisfy the PSLRA’s pleading requirements. Plaintiffs “must do more than speculate as to
dcfendants’ motives or make conclusory allegations of scienter; [they] must allege specific
facts.” Rehm v. Eagle Fin. Corp., 954 F. Supp. 1246, 1255 (N.D. Ill. 1997), The facts alleged
must be sufficient to strongly support the inference that at the time the statements were made,
defendants knew, or were reckless in not knowing, that the statements were false.

Even if, as explained above in Section [.A.1, plaintiffs adequately allege the reasons why
three of the oral statements made at the November 1st meeting and two of the oral statements
relating to the promissory note were falsc, they have failed to allege facts giving rise to a strong
inference that defendants made those purported misrepresentations knowingly or recklessly.
With respect to the statements at the November Ist meeting"! and the statements relating to the

promissory note,” plaintiffs plead that “Xcntex, through its Board of Directors and corporate

Recklessness requires, at minimum, “conduct which is highly unreasonable and which
represents an extreme departure from the standards of ordinary care . . . to the extent that the
danger was either known to the defendant or so obvious that the defendant must have been aware
of it.” Rehm v. Eagle Fin, Corp., 954 F. Supp. 1246, 1255 (N.D. Ill. 1997).

"Te, Batio’s and Tucker’s statements that the money would be used for matketing, that
KDS manufactured the computer displayed at the meeting, and that there were no lawsuits
pending against Xentcx.

"7 ¢., Flanagan’s statement that the company was able to pay its bills and was not
financially depleted and Batio’s representation that the money loaned pursuant to the promissory
note would be used only for marketing purposes.

11


defendant in numerous lawsuits based on its failure to pay its bills. (/d. 4 60.) The allegation
that Xentex was deeply in debt and underfunded is conclusory. The allegation that Xcntex was a
defendant in numerous lawsuits based on its failure to pay its bills is more specific, but the court
cannot infer from this allegation that the company was underfunded. Plaintiffs give no
information about the lawsuits in question.® For that matter, a claim for $1000 or even $100,000,
without more, does not show that a company is underfunded.

According to plaintiffs, the sixth statement, Batio’s representation that the money loaned
pursuant to the promissory note would be used only for marketing purposes, was false because
Xentcx actually used the money to pay past due bills and to pay for Batio’s living expenses, car
payments, and vacations. Those vague allegations do not provide any basis for inferring that the
sixth statement was false at the time it was made. City of Philadelphia, 264 F.3d at 1260.
Whcther the sixth statement adequately explains why the statement was false when made is
therefore questionable. But even assuming the complaint adequately alleges why the fourth and
sixth statements were false, plaintiffs have failed to satisfy the PSLRA’s requirements for
pleading scienter in connection with those siatements.

2. The Complaint Lacks Facts Giving Rise to a Strong Inference that Xentex
Acted with Scienter in Violation of § 10(b),

To satisfy the PSLRA’s heightened pleading requirements for scienter, plaintiffs must
“state with particularity facts giving rise to a strong inference that the defendant acted with the
required state of mind.” 15 U.S.C. § 78u-4(b)(2). For a claim under § 10(b), the requisite

scienter is “a mental state cmbracing the intent to deceive, manipulate, or defraud.” Ernst &

°It seems odd that plaintiffs know enough to allege that two lawsuits were pending, yet
entirely fail to identify or describe them.

10



November Ist meeting. The purported ora! misrepresentations were that:

(1) Xentex had made all necessary production arrangements with KDS for mass
production;

(2) KDS had completed the tooling required to mass produce;

(3) all conditions precedent for production of the computers had been
completed and any money sought was for marketing;

(4) the computer presented at the meeting was manufactured and produced by
KDS; and

(5) there were no lawsuits pending against Xentex.

(SAC ff 34(a-e).) For present purposes, the court assumes each of these statements would be
actionable if properly pled. But neither of the first two statements is properly pled. According to
plaintiffs, the first statement was false because the arrangements have never been completed and
the computers have never been mass-produced, again nothing more than the conclusion that the
the opposite of the statements was truc. Moreover, the fact that the computers have never been
mass produced docs not mean that the necessary production arrangements were never made. As
for the sccond oral] statement, plaintiffs claim it was false, but offer no reason why, again failing
to satisfy the PSLRA requirements.

Plaintiffs’ pleading marginally improves with respect to the remaining three oral
statements. They allege the third oral statement was false because the funds plaintiffs invested
were not used for marketing, but rather were used “to pay off unrclated past debt and to purchase
automobiles for Mr. Batio, pay his rent, fund his vacations and for other inappropriate purposes,”

(SAC 437). These allegations, which purport to be based on direct knowledge,’ are suspiciously

7If these allegations are based on information and belief rather than direct knowledge,
plaintiffs have failed set out “with particularity all facts on which that belief is formed” as
required by the PSLRA. 15 U.S.C. § 78u-4(b)(1)(B).

7



Statement plainly states that the offering was a “private placement,” that was “being made
pursuant to Regulation D of the Securities Act of 1933,” that “investors must be ‘accredited
investors’ under Regulation D,” and that no public trading market existed for the shares offered.
(Information Statement at unnumbered p. 2.) Sales of securities made pursuant to Regulation D,
17 CER, § 230.506, are not public offerings.

But despite what the Information Statement says, plaintiffs argue that Xentex’s sale of
securities does not qualify as a private placement under Regulation D. Regulation D applics only
if certain conditions are met, one of which requires that the number of purchasers not exceed.
thirty-five. 17 C.F.R. § 230.506(b)(2)(i). Regulation D also places restrictions on investments
by purchasers who are not accredited investors. See id. at § 230,.506(b)(2)(ii). According to
plaintiffs, “there were over 300 investors in [Xentex] and a large percentage of the investors were
unaccredited.” (Pls.’ Surreply at 9.)'7 If these assertions are true, the offering by which plaintiffs
acquired their Xentex stock would not qualify as a private placement and would have to satisfy
the requirements for a public offering. At this stage, the court must accept their truth. Consistent

with these assertions, plaintiffs could prove that they acquired their stock in a public offering,

documents submitted by the Xentex defendants, i.e., the Worldwide Manufacturing Agrecment,
the Sales and Distribution Licensing Agreement, the list of Due Diligence Documents Delivered
to Copeland Family, or the Subscription Agreement. Although those documents may well be
central to resolution of plaintiffs’ claims, none of those documents were referenced in the
complaint, The exception allowing a court to consider documents referenced in a complaint, and
central to the claims, is a narrow one. “It is not intended to grant litigants license to ignore the
distinction between motions to dismiss and motions for summary judgment ....” Levenstein v.
Salafasky, 164 F.3d 345, 347 (7th Cir. 1998).

'7Byen though these allegations are not in the complaint, the court may consider them. In
opposing dismissal, a plaintiff is allowed to assert additional facts that are consistent with the
complaint to show facts which, if proved, would entitle him to judgment. Early v. Bankers Life
& Cas. Co., 959 F.2d 75, 79 (7th Cir. 1992).

21



Background

According to the complaint, plaintiffs made two investments in Xentex, the first through
a stock purchase, the second in the form of a promissory note. Xentex, through its CEO Jeff
Batio and its Vice Chairman and Exccutive Vice President Douglas Tucker, presented plaintiffs
with an opportunity to invest at a meeting on November 1, 2000. At that time, Xentex was in the
process of developing and launching a flip-pad computer known as the Voyager. During that
meeting, plaintiffs received an Information Statement dated November 1, 2000 (“Information
Statement”}, which contained numerous representations relating to Xentex, the Voyager
computer, and Xentex’s plans for launching the Voyager into the market. In reliance on the
tepresentations made in the Information Statement, as well as certain oral representations made
by Batio and Tucker at the November Ist meeting, plaintiffs invested more than $3.3 million in
Xentex stock. Subsequently, on June 4, 2001, after certain additional representations by various
members of Xentcx’s Board of Directors, plaintiffs loaned Xentex $650,000 in return for a
promissory note. Plaintiffs now claim that the representations made in the Information
Statement, the oral representations made at the November 1st meeting, and the representations
made in connection with the execution of the promissory note were false, and that as a result,
defendants have violated federal sccuritics laws as well as numerous state statutory and common
laws. Flanagan and the Xcntex defendants have moved to dismiss.
Analysis

In evaluating the motions to dismiss, the court accepts all of plaintiffs’ well-pled
allegations in the complaint as true and draws all reasonable inferences in plaintiffs’ favor.

Stachon v. United Consumers Club, Inc., 229 F.3d 673, 675 (7th Cir. 2000). The court need


million in tooling, Plaintiffs claim they relied on the original financial statement when they
invested $3.3 million in Xentex. Turcotte then allegedly prepared another financial statement,
dated March 15, 2001, in which the value of tooling was raised back to $4.25 million, Plaintiffs
plead that this March 15th representation induced them to execute the promissory note and loan
Xentex an additional $650,000, Plaintiffs further allege that in preparing the financial
statements, Turcotte violated Generally Accepted Accounting Procedures (“GAAP”),

Plaintiffs rely on the variations between the financial statements to support their
allegations of fraud. But plaintiffs may not rest a securities fraud claim on the differences
between financial statements. Dileo, 901 F.2d at 627. Rather, “[iJavestors must point to some
facts suggesting that the difference is attributable to fraud... .” Id. Moreover, the allegations
against Turcotte fail to give risc to a strong inference that he knew the statements were false and
acted knowingly or recklessly in making the misstatements. For the most part, plaintiffs make
the same scienter allegations against Turcotte that they alleged against Xentex: that Turcotte,
according to the complaint, made misrepresentations and omissions because Xentex “had
misappropriated and squandered money tendered by previous investors,” “was unable to pay its
bills and drastically nceded funding so that individuals on the Board of Directors could continue
to loot the company.” (SAC 4 179-80, 196-97.) The court has already addressed the
deficiencies of these allegations above.

Plaintiffs also allege that Turcotte made misrepresentations in the financial stalements “to
properly secure his inflated salary and cnsure he was compensated by other [unspecificd] means”
(7d. {| 181, 198), and that he committed various GAAP violations, Plaintiffs’ allegation

regarding Turcotte’s desire to maintain his inflated salary, obviously aimed at establishing his

14


in the Information Statement, their claim is based on the same flawed allegations that form the
basis of the deficient claim against Kentex, and thus fails for the same reasons the claim against
Xentex fails, But plaintiffs also allege that Kim had a direct conversation with them in early
November 2000 in which Kim “failed to disclose the fact that Xentex was drastically
underfunded, was incapable of producing Voyager computers and was the subject of several
lawsuits for failure to pay its bills.” (SAC § 425-26.) These allegations suffer from the same
lack of factual specificity that afflicted the allegations discussed above, and thus cannot sustain a
§ 10(b) claim. Plaintiffs offer no facts showing that Xentex was underfunded or incapable of
producing the computers. Further, plaintiff's conclusory allegations that Kim knew the
representations were falsc and made them in order to induce plaintiffs to invest are wholly
inadequate, for the reasons repeatedly rehearsed above, to constitute facts giving rise to a strong
inference of scienter.

Nor have plaintiffs stated a claim in Count 26 against Kim for misrepresentations relating
to the promissory note. Count 26, like Count 25, is premised on Kim’s failure to disclose that
Xcntex was underfunded, incapable of producing Voyager computers, and involved in several
lawsuits due to its failure to pay bills. Plaintiffs do not allege that Kim had a duty to disclose, or
that he ever even discussed with them, pending lawsuits. They do, however, allege that he made
representations about Xentex’s ability to produce Voyager computers, and thus should have
disclosed that Xentex was incapable of doing so. They claim that in March 2001, Kim learned
that a design problem was holding up production of the computers, and that he procecded to give
them a production schedule dated March 21, 2001 “which represented [Xentex’s] present

position and ability to mass produce Voyager computers, stat[ing] that Voyager computers would

16



relief under both § 10(b) of the Exchange Act of 1934, 15 U.S.C. 78j(b), and § 12(a)(2) of the
Sccurities Act of 1933, 15 U.S.C. 77/(a)(2). For example, plaintiffs bring a claim against Xentex
for allegedly violating § 12(a)(2) in Count J and for violating § 10(b) in Counts 2 and 3.?
Plaintiffs follow the same pattern in their claims against Turcotte, Kim, and Flanagan. Plaintiffs
also scek to impose control-person liability against Turcotte, Kim, and Flanagan.> The court
assumes they bring their control-person liability claims under both § 15 of the Securities Act, 15
U.S.C. § 770, and § 20 of the Exchange Act, 15 U.S.C. § 78t. The Xentex defendants and
Flanagan seek dismissal of all the federal securities claims under Fed. R. Civ. P. 12(b)(6),
asserting primarily that plaintiffs failed to satisfy the heightencd pleading requirements imposed
by the Private Securities Litigation Reform Act of 1995 (“PSLRA”), 15 U.S.C. § 78u-4, as well
as the requirements of Fed. R. Civ, P. 9(b). They also argue that § 12(a)(2) is inapplicable to the
securities offering at issue. Additionally, Flanagan argues that plaintiffs fail to plead violations
of either § 12(a)(2) or § 15 against him.

For the reasons explained below, the claims against Xentex, Turcotte, Kim, and Flanagan
under § 10(b) and § 20 of the Exchange Act are hereby dismissed, as is the § 12(a)(2) claim
against Flanagan. The § 12(a)(2) claims against Xentex, Turcotte and Kim survive, however, as

do the control-person liability claims against Turcotte, Kim and Flanagan under § 15.

laws.

Actually, plaintiffs’ complaint states only that Count | asserts a violation of the
Securities Act whereas Counts 2 and 3 asserted violations of the Exchange Act—they do not
specifically refer to Section 12(a)(2) or Section 10(b) anywhere in the pleading.

3Plaintiffs do not raise the control-person liability claims in separate counts.
Additionally, as with the other federal securitics claims, plaintiffs do not specifically refer to the
section number that was allegedly violated.


UNITED STATES DISTRICT COURT
FOR THE NORTHERN DISTRICT OF ILLINOIS
EASTERN DIVISION

PREMIER CAPITAL MANAGEMENT, L.L.C.,

a Virginia Limited Liability Company, et al.,
Plaintiffs, Case No. 02 C 5368

v.

LARRY COHEN, Individually, BRIAN
FLANAGAN, Individually, WAN HEE KIM,
Individually, JUNG KOH, Individually., et al.,

Judge Joan B. Gottschall

OCKETED

AUG 1 5 2003

)
)
)
)
)
)
)
)
)
)
Defendants. )

MEMORANDUM OPINION & ORDER

Plaintiffs Premier Capital Management, LLC (“Premier Capital”), TMB, LLC and Xen
Investors, LLC have sued defendants Xentex Technologies (““Xentex”), Xentex’s officers and/or
directors Larry Cohen, Brian Flanagan, Wan Hee Kim and Michael Turcotte, Ron Falese, a
Xentex shareholder, Northview Bank and Trust, and the bank's president Blair Robinson,
claiming that defendants violated federal and state securities laws, as well as several state
statutory and common laws. Before the court are two motions to dismiss: the motion of
defendants Xentex, Cohen, Kim, Turcotte and Falese (the “Xentex defendants”) to dismiss the
federal claims raised against them in the second amended complaint (“complaint” or “SAC”),
and defendant Flanagan’s motion to dismiss the federal claims against him. Although both
Flanagan and the Xentex defendants have moved to dismiss all claims against them, this order
pettains only to the federal claims raised in Counts 1-3, 8-10, and 24-26 against Xentex, Turcotte

and Kim, respectively,’ and the federal claims against Flanagan in Counts 17-19. Plaintiffs seek

‘At the Xcntex defendants’ request, the court allowed them to bifurcate briefing and
address first the counts alleging violations of the federal securities laws. Of the Xentex
defendants, only Xentex, Turcotte, and Kim face claims for violations of the federal securities

Ol



officers, made the above-referenced false and misleading statements and/or omissions, although
the Board of Directors and said corporate officcrs knew them to be false, untrue and mislcading.”
(SAC ff 46, 70.) This is merely a conclusion and therefore is inadequate to satisfy the
heightened pleading standards of the PSLRA.

Plaintiffs also allege that defendants made the misrepresentations because Xentex had
“misappropriated and squandered the corporation[’]s money,” “needed to alleviate the
corporation’s extreme financial difficulties,” and sought to enable Xentex’s Board of Directors,
corporate officers, and employees to “loot the corporation for their personal gain.” (Jd. {¥] 43-44;
71-72.) These allegations similarly are devoid of the level of factual specificity required to
satisfy the PSLRA. Plaintiffs “must do more than speculate as to defendants’ motives or make
conclusory allegations of scienter; [they] must allege specific facts.” Rehm, 954 F. Supp. at
1255; see also Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1129 (2d Cir. 1994) (requiring
particularized facts under Rule 9(b) pre-PSLRA). Plaintiffs allege no specific facts to show that
Xentex was experiencing extreme financial difficulties at the time the representations were
made."? Bare allegations that a company has cash flow problems, without factual support, are
insufficient to support a finding of scienter. Rehm, 954 F, Supp. at 1254 n.4. Nor do plaintiffs
plead facts supporting their vague allegations that Xentex’s Board, officers, and employees were

misappropriating, squandcring, and looting Xentex’s money. The most they allege, in highly

In their briefs opposing the motion to dismiss, plaintiffs argue that Xentcx owed
defendant Flanagan $500,000 pursuant to a promissory note, and that he ultimately (/.¢., al a later
time) called that note and forced Xentex into bankruptcy. Notably, the allegations concerning
Flanagan were not incorporated into the allegations against Xentex and have therefore not been
raised against Xentex. In any event, the fact that a start-up company like Xentex owed $500,000
under a promissory note is far from remarkable; indeed, Xentex owed plaintiffs $650,000
pursuant to another promissory note.

12



motive to commit fraud, fails to establish a strong inference of scienter. There is disagreement
among the courts of appeals which have addressed the issue as to the adequacy of allegations of
motive and opportunity, standing alone, to create the necessary strong inference of scicnter. See
Goldstein v. MCI WorldCom, __ F.3d __, Nos, 02-60322, 03-60248, 2003 WL 21738963, at *6
(5" Cir. July 28, 2003). But this court agrecs with the Eighth Circuit’s observation that “having
the motive and opportunity to do wrong are certainly not the same as having the intent to do it,”
and that generally alleging greed as a motive fails even to establish motive, led alone scienter.
Florida State Bd. of Admin. v. Green Tree Fin. Corp., 270 F.3d 645, 655 (8" Cir. 2001). To
establish motive, “a plaintiff must do more than merely charge that executives aim to prolong the
benefits of the positions they hold.” Shields, 25 F.3d at 1130. Further, alleged GAAP violations,
without more, have consistently been held insufficient to give rise to a strong inference of
scienter. In re K-Tel Int'l, Inc. Secs. Litig,, 300 F.3d 881, 890 (8th Cir. 2002); Riggs Partners,
LLC v, Hub Group, Inc., No. 02 C 1188, 2002 WL 31415721, *5 (N.D. Ill. Oct. 25, 2002); Rehm,
954 F. Supp. at 1255.

Counts 9 and 10 fail to meet the PSLRA’s pleading standards and are therefore dismissed
to the extent they raise claims under § 10(b) of the Exchange Act.

Cc §10(b) Claims Against Kim: Counts 25 and 26

Plaintiffs also claim that Dr. Wan Hee Kim, a member of Xentex’s Board of Directors
and chairman of its Executive Committec, committed securities fraud in violation of § 10(b) by
making misrepresentations to them prior to the initial stock purchase (Count 25) and prior to the
execution of the promissory note (Count 26).

To the extent plaintiffs seek to hold Kim directly responsible for misrepresentations made

15