FOR PUBLICATION

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

In re: DAOU SYSTEMS, INC., 

SECURITIES LITIGATION,

GREG SPARLING; EUGENE

KRABBENHOFT; PATRICK DE KRUYFF,

Esq.; ROBERT ZARETSKY; ROD No. 02-56989

FORD; THOMAS V. HAGMAN;

D.C. No. RICHARD W. WALSH; RICHARD  CV-98-01537- TORIBIO; PAUL RABIN,

L/CGA Plaintiffs-Appellants,

v.

GEORGES DAOU; DANIEL DAOU;

FRED MCGEE; ROBERT MCNEILL;

JOHN MORAGNE; DAOU SYSTEMS,

INC.,

Defendants-Appellees. 

1385
In re: DAOU SYSTEMS, INC., 

SECURITIES LITIGATION,

GREG SPARLING; EUGENE

KRABBENHOFT; PATRICK DE KRUYFF,

Esq.; ROBERT ZARETSKY; ROD

FORD; THOMAS V. HAGMAN;

No. 02-57018 RICHARD W. WALSH; RICHARD

TORIBIO D.C. No. ; PAUL RABIN,

Plaintiffs-Appellees,  CV-98-01537-

L/CGA

v.

OPINION GEORGES DAOU; DANIEL DAOU;

FRED MCGEE; ROBERT MCNEILL;

JOHN MORAGNE,

Defendants,

and

DAOU SYSTEMS, INC.,

Defendant-Appellant. 

Appeal from the United States District Court

for the Southern District of California

M. James Lorenz, District Judge, Presiding

Argued and Submitted

February 12, 2004—Pasadena, California

Filed February 2, 2005

Before: Betty B. Fletcher, Harry Pregerson, and

Melvin Brunetti, Circuit Judges.

Opinion by Judge Brunetti

1386 IN RE DAOU SYSTEMS, INC.
COUNSEL

Eric A. Isaacson, San Diego, California, for the plaintiffsappellants/appellees. 

Michael P. McCloskey, San Diego, California, for the

defendants-appellees/appellants. 

OPINION

BRUNETTI, Circuit Judge: 

Plaintiffs, a class of former Daou Systems, Inc. (“Daou”)

investors who purchased Daou common stock between February 13, 1997 and October 28, 1998, allege that defendants

Daou, Chief Executive Officer and Chairman of the Board

Georges Daou (“G. Daou”), President and Director Daniel

1390 IN RE DAOU SYSTEMS, INC.
Daou (“D. Daou”), Chief Financial Officer and Senior Vice

President Fred McGee, Chief Operating Officer and Executive Vice President Robert McNeill, and Director John

Moragne systematically and fraudulently violated the Generally Accepted Accounting Principles (“GAAP”) in order to

artificially inflate the price of Daou’s stock. Plaintiffs also

allege that they incurred substantial personal losses due to

their respective purchases of Daou stock at fraudulently

inflated prices. The district court, on several occasions, determined that plaintiffs had failed to state sufficiently particularized claims under the 1933 Securities Act and the 1934

Exchange Act and thrice granted plaintiffs leave to amend.

Plaintiffs now appeal the district court’s dismissal of their

Third Amended Complaint (“TAC”) with prejudice. Defendants also cross-appeal the district court’s failure to consider,

sua sponte, whether to impose sanctions against plaintiffs and

plaintiffs’ attorneys.

FACTS1 AND PROCEEDINGS BELOW

Daou created, implemented, and supported computer networking systems for use in the healthcare field. Beginning

with its first public offering in February 1997, Daou represented itself as a technologically astute company able to keep

pace with the ever-changing medical field. For seven consecutive quarters, Daou reported “record” growing revenues and

stated that the company’s earnings per share (“EPS”) had and

would exceed market expectations. Daou allegedly touted

“spectacular” results and “strong growth” while also reporting

successful employee retention as well as an “extremely strong

pipeline position.” 

Plaintiffs contend that Daou fraudulently inflated the price

of its stock by reporting revenues before they were earned, in

1The following facts are taken from plaintiffs’ third amended complaint

and will be assumed true for purposes of the within review. See Gompper

v. VISX, Inc., 298 F.3d 893, 895 (9th Cir. 2002). 

IN RE DAOU SYSTEMS, INC. 1391
violation of GAAP. The company employed an accounting

method known as the percentage-of-completion (“POC”)

method, which is used primarily to account for progress on

long-term projects. Under this method, revenue from these

projects could only be recognized based on the percentage of

labor costs incurred to date compared to the total estimated

labor costs for the project. Plaintiffs allege, however, that

defendants would prematurely recognize revenue in contravention of the POC method. For example, plaintiffs allege

that defendants systematically, without regard to labor costs

incurred or estimated, recognized 20% of the contract revenue

immediately upon signing products contracts, 40% of the contract revenue immediately after the equipment to be installed

was ordered, and 50%-60% of the contract revenue as soon as

the equipment was configured and tested. Plaintiffs contend

that because of such artificial inflation of the price of Daou

stock, Daou was able to acquire eleven companies, and Daou

executives and their respective family members were able to

sell nearly 2.5 million shares for a total of $54.67 million in

improper proceeds. Plaintiffs also allege that to their detriment they purchased their Daou shares during the class period

at artificially inflated prices and that, had they been aware of

Daou’s true financial results and condition, they would not

have purchased their shares, or at least not at the prices paid.

Defendants counter that their method of accounting did not

violate GAAP or their own stated policy, as they revealed in

various disclosures that

[c]ontract revenue for the development and implementation of network solutions is recognized on the

percentage-of-completion method with progress to

completion measured by labor costs incurred to date

compared to total estimated labor costs. . . . Revenues recognized in excess of amounts billed and

project costs are classified as contract work in progress. 

1392 IN RE DAOU SYSTEMS, INC.
(emphasis added). The district court agreed and determined

that plaintiffs had failed to expose any financial tomfoolery

on the part of Daou in its execution of the POC accounting

method: 

Plaintiffs appear [to] argue that, because there was a

variance between recognized and earned revenue,

Defendants must have been engaged in accounting

fraud. Their allegations that the funds in the work in

progress account represented improperly recognized

revenue are conclusory and appear to result from circular logic. Plaintiffs simply have not shown that

recognizing unearned revenue and earmarking it for

the work in progress account is anything but an exercise of Defendants’ business judgment. 

Such failure, the court concluded, proved fatal to plaintiffs’

remaining claims, as, for example, if Daou’s statements were

not false and misleading, then defendants did nothing requiring an assessment of their scienter in making them. The court

consequently dismissed plaintiffs’ TAC with prejudice, and

this appeal followed.

DISCUSSION

I. Standard of Review

We review dismissals under Federal Rules of Civil Procedure 9(b) and 12(b)(6) de novo. Vess v. Ciba-Geigy Corp.

USA, 317 F.3d 1097, 1102 (9th Cir. 2003) (citations omitted).

“[W]e accept the plaintiffs’ allegations as true and construe

them in the light most favorable to plaintiffs.” Gompper, 298

F.3d at 895 (citations omitted). However, “[c]onclusory allegations of law and unwarranted inferences are insufficient to

defeat a motion to dismiss for failure to state a claim.” In re

VeriFone Sec. Litig., 11 F.3d 865, 868 (9th Cir. 1993) (citations omitted). “Dismissal without leave to amend is improper

unless it is clear, upon de novo review, that the complaint

IN RE DAOU SYSTEMS, INC. 1393
could not be saved by any amendment.” Gompper, 298 F.3d

at 898 (citation and internal quotations omitted). 

II. Federal Securities Law

Plaintiffs’ TAC asserts five claims for relief, alleging (1)

violation of section 10(b) and Rule 10b-5 of the 1934

Exchange Act against all defendants; (2) violation of section

20(a) of the 1934 Exchange Act against certain defendants;

(3) violation of section 11 of the 1933 Securities Act against

certain defendants; (4) violation of section 12(a)(2) of the

1933 Securities Act against certain defendants; and (5) violation of section 15 of the 1933 Securities Act against certain

defendants. 

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

[1] Section 10(b) of the Exchange Act of 1934, 15 U.S.C.

§ 78j(b), makes it unlawful “for any person . . . [t]o use or

employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in

contravention of such rules and regulations as the Commission may prescribe[.]” SEC Rule 10b-5, promulgated under

the authority of section 10(b), in turn, provides: 

It shall be unlawful for any person . . . 

(a) To employ any device, scheme, or artifice to

defraud, 

(b) To make any untrue statement of a material fact

or to omit to state a material fact necessary in order

to make the statements made, in light of the circumstances under which they were made, not misleading, or 

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or

1394 IN RE DAOU SYSTEMS, INC.
deceit upon any person, in connection with the purchase or sale of any security. 

17 C.F.R. § 240.10b-5. The elements of a Rule 10b-5 claim,

therefore, are: (1) a misrepresentation or omission of a material fact, (2) scienter, (3) causation, (4) reliance, and (5) damages. See Binder v. Gillespie, 184 F.3d 1059, 1063 (9th Cir.

1999); The Ambassador Hotel v. Wei-Chuan Inv., 189 F.3d

1017, 1025 (9th Cir. 1999) (citation omitted); Paracor

Finance, Inc. v. General Elec. Capital Corp., 96 F.3d 1151,

115 (9th Cir. 1996). The causation element requires a showing of both actual cause (“transaction causation”) and proximate cause (“loss causation”). The Ambassador Hotel, 189

F.3d at 1025. 

[2] It is well established that claims brought under Rule

10b-5 and section 10(b) must meet the particularity requirements of Federal Rule of Civil Procedure 9(b). See Semegen

v. Weidner, 780 F.2d 727, 729, 734-35 (9th Cir. 1985). Rule

9(b) states that “[i]n all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with

particularity. Malice, intent, knowledge, and other condition

of mind of a person may be averred generally.” 

[3] Further, the enactment of the Private Securities Litigation Reform Act (“PSLRA”) in 1995 significantly altered

pleading requirements in private securities fraud litigation by

amending the 1934 Exchange Act to require that a complaint

“plead with particularity both falsity and scienter.” Gompper,

298 F.3d at 895 (quoting Ronconi v. Larkin, 253 F.3d 423,

429 (9th Cir. 2001)); see also Nursing Home Pension Fund,

Local 144 v. Oracle Corp., 380 F.3d 1226, 1230 (9th Cir.

2004). A securities fraud complaint must now “specify each

statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation

regarding the statement or omission is made on information

and belief, the complaint shall state with particularity all facts

IN RE DAOU SYSTEMS, INC. 1395
on which that belief is formed.” Gompper, 298 F.3d at 895

(quoting 15 U.S.C. § 78u-4(b)(1)). 

The complaint must also “state with particularity facts giving rise to a strong inference that the defendant acted with the

required state of mind.” Id. (quoting 15 U.S.C. § 78u-4(b)(2)

(emphasis added in Gompper)); see also In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 974 (9th Cir. 1999) (“Silicon

Graphics”) (facts must come closer to demonstrating intent as

opposed to mere motive and opportunity). The stricter standard for pleading scienter naturally results in a stricter standard for pleading falsity, because “ ‘falsity and scienter in

private securities fraud cases are generally strongly inferred

from the same set of facts,’ and the two requirements may be

combined into a unitary inquiry under the PSLRA.” In re

Vantive Corp. Sec. Litig., 283 F.3d 1079, 1091 (9th Cir. 2002)

(“In re Vantive”) (quoting Ronconi, 253 F.3d at 429). Thus,

the complaint must allege that the defendants made false or

misleading statements either intentionally or with deliberate

recklessness. Silicon Graphics, 183 F.3d at 974. 

b. Reliance on Confidential Witnesses

[4] Because many of plaintiffs’ allegations come from

accounts of confidential witnesses, their use in satisfying the

PSLRA’s standard of particularity must be addressed. This

circuit in Silicon Graphics cautioned about the use of

unnamed sources in stating that “[i]t is not sufficient for a

plaintiff’s pleadings to set forth a belief that certain unspecified sources will reveal, after appropriate discovery, facts that

will validate her claim.” Silicon Graphics, 183 F.3d at 985.

Instead, to meet this particularity requirement for personal

sources of information, this circuit has applied the Second

Circuit’s standard that “personal sources of information relied

upon in a complaint should be ‘described in the complaint

with sufficient particularity to support the probability that a

person in the position occupied by the source would possess

the information alleged.’ ” Nursing Home, 380 F.3d at 1233

1396 IN RE DAOU SYSTEMS, INC.
(quoting Novak v. Kasaks, 216 F.3d 300, 314 (2d Cir. 2000)).

Where plaintiffs rely on both confidential witnesses and on

other facts, “they need not name their sources as long as the

latter facts provide an adequate basis for believing that the

defendants’ statements were false.” Novak, 216 F.3d at 314;

see also Silicon Graphics, 183 F.3d at 985 (complaint should

include “adequate corroborating details”). 

[5] The First Circuit has also adopted Novak’s approach of

“look[ing] at all of the facts alleged to see if they ‘provide an

adequate basis for believing that the defendants’ statements

were false.’ ” In re Cabletron Systems, Inc., 311 F.3d 11, 29

(1st Cir. 2002) (citing Novak, 216 F.3d at 314). The First Circuit added that this approach “involves an evaluation, inter

alia, of the level of detail provided by the confidential

sources, the corroborative nature of the other facts alleged

(including from other sources), the coherence and plausibility

of the allegations, the number of sources, the reliability of the

sources, and similar indicia.” Id. at 29-30. 

[6] This circuit’s approach does not necessarily require a

plaintiff to name his or her confidential witnesses. However,

this circuit does strictly adhere to the PSLRA’s mandate that

the complaint “state with particularity all facts on which [a]

belief is formed,” and in so doing, requires that a plaintiff

reveal “the sources of her information.” Silicon Graphics, 183

F.3d at 985 (citation and internal quotation marks omitted). It

is by this circuit’s adoption of the Second Circuit’s standard

for evaluating personal sources of information, augmented by

the First Circuit’s suggested criteria for assessing reliability of

confidential witnesses, that plaintiffs’ complaint here should

be evaluated. So long as plaintiffs reveal with particularity the

sources of their information, the complaint will survive under

the PSLRA. Naming sources is unnecessary so long as the

sources are described “with sufficient particularity to support

the probability that a person in the position occupied by the

source would possess the information alleged” and the complaint contains “adequate corroborating details.” See Nursing

IN RE DAOU SYSTEMS, INC. 1397
Home, 380 F.3d at 1233 (citation and internal quotation marks

omitted); Silicon Graphics, 183 F.3d at 985.

[7] Plaintiffs here describe the confidential witnesses with

a large degree of specificity. Plaintiffs number each witness

and describe his or her job description and responsibilities. In

some instances, plaintiffs provide the witnesses’ exact title

and to which Daou executive the witness reported. For example, plaintiffs describe Confidential Witness #6 as follows:

“Confidential Witness #6 (“CW6”) is a former Daou executive who worked in the Finance Department. CW6 dealt with

audit issues, Security and Exchange (“SEC”) reporting and

budget matters. As such, CW6 was familiar with Daou’s process of collecting project cost information. CW6 reported to

defendant McGee.” Similarly, plaintiffs describe Confidential

Witness #9 as follows: “Confidential Witness 9 (“CW9”) is a

former Daou Regional Vice President of Sales. As Vice President of Sales, CW9 was responsible for reporting weekly or

bi-weekly sales information, such as sales status/backlog and

forecast/pipeline information, to Daou’s Vice Presidents and

corporate officers.” Given the specificity of plaintiffs’

descriptions of their confidential witnesses, we hold that

plaintiffs have sufficiently met the PSLRA’s requirements for

confidential witnesses. We next determine whether plaintiffs

have sufficiently pled the elements of a Rule 10b-5 claim in

light of the PSLRA’s heightened pleading standards. 

1. Material Misrepresentations or Omissions 

[8] If “[p]roperly pled, overstating of revenues may state a

claim for securities fraud, as under GAAP, ‘revenue must be

earned before it can be recognized.’ ” Hockey v. Medhekar,

30 F. Supp. 2d 1209, 1216 (N.D. Cal. 1998) (quoting Provenz

v. Miller, 102 F.3d 1478, 1484 (9th Cir. 1996)) (emphasis in

original). “To properly state a claim for accounting fraud,

plaintiffs must ‘plead facts’ sufficient to support a conclusion

that [d]efendant [ ] prepared the fraudulent financial statements and that the alleged financial fraud was material.” In re

1398 IN RE DAOU SYSTEMS, INC.
Peerless Systems, Corp. Sec. Litig., 182 F. Supp. 2d 982, 991

(S.D. Cal. 2002) (citations omitted) (alterations in original). 

Violations of GAAP standards can also provide evidence of

scienter. Id. (citing Greebel v. FTP Software, Inc., 194 F.3d

185, 203 (1st Cir. 1999)); see also In re McKesson HBOC,

Inc. Sec. Litig., 126 F. Supp. 2d 1248, 1273 (N.D. Cal. 2000)

(“In re McKesson”) (“[W]hen significant GAAP violations

are described with particularity in the complaint, they may

provide powerful indirect evidence of scienter. After all,

books do not cook themselves.”). To support even a reasonable inference of scienter, much less a strong inference, “the

complaint must describe the violations with sufficient particularity; ‘a general allegation that the practices at issue resulted

in a false report of company earnings is not a sufficiently particular claim of misrepresentation.’ ” Greebel, 194 F.3d at

203-04 (quoting Gross v. Summa Four, Inc., 93 F.3d 987, 996

(1st Cir. 1996), superseded by statute on other grounds as

recognized in Greebel, 194 F.3d at 197 (“strong” inference

rather than “reasonable” inference now required for scienter)).

When pleading irregularities in revenue recognition, plaintiffs should allege “(1) ‘such basic details as the approximate

amount by which revenues and earnings were overstated’; (2)

‘the products involved in the contingent transaction’; (3) ‘the

dates of any of the transactions’; or (4) ‘the identities of any

of the customers or [company] employees involved in the

transactions.’ ” In re McKesson, 126 F. Supp. 2d at 1273

(quoting Greebel, 194 F.3d at 204) (alteration in McKesson).

Plaintiffs need not allege each of those particular details, see

Greebel, 194 F.3d at 204, but they must allege enough information so that “a court can discern whether the alleged GAAP

violations were minor or technical in nature, or whether they

constituted widespread and significant inflation of revenue.”

In re McKesson, 126 F. Supp. 2d at 1273. 

Plaintiffs here contend that defendants systematically

reported revenue, before it was earned in violation of GAAP.

IN RE DAOU SYSTEMS, INC. 1399
For example, they assert that Daou, “without regard to labor

costs incurred or estimated,” recognized 20% of the contract

revenue immediately upon signing products contracts, 40% of

the contract revenue immediately after the equipment to be

installed was ordered, and 50%-60% of the contract revenue

as soon as the equipment was configured and tested. Moreover, plaintiffs assert that for one contract, the Centura Health

project, certain Field Services personnel were told that they

would receive $100 each if they would go into Daou’s San

Diego warehouse, plug in and turn on certain computers, and,

in turn, bill eight hours of work. One confidential witness

stated that he never received the $100, and when he inquired

about the payment, he was told to “forget it ever happened.”

The only rationale for such occurrence, according to the confidential witness, was so Daou could prematurely recognize

revenue on the Centura Health project. 

Similar allegations were made in Gross, 93 F.3d at 995-96,

superseded by statute on other grounds. The plaintiff in Gross

asserted that Summa Four prematurely recognized revenue

upon receipt of orders rather than on shipment of products, a

practice that, in turn, allowed Summa Four to overstate significantly its revenues and earnings during the class period. Id.

at 995. Gross substantiated such allegations by highlighting

certain statements made by Summa Four executives at a board

meeting indicating their intention to recognize $4.7 million in

late-quarter earnings from the receipt of newly acquired

orders, despite the fact that Summa Four generally required

twelve to twenty weeks to fulfill such orders. Id. at 995-96.

Board minutes also revealed that Summa Four’s chief financial officer was working on a new “revenue recognition policy” that was to be “more formalized and somewhat more

restrictive” than its previous policy. Id. at 996. 

Although such assertions gave the court “pause,” the court

nonetheless held that Gross’s complaint had not satisfied Rule

9(b)’s heightened pleading standards. Id. “A general allegation that the practices at issue resulted in a false report of

1400 IN RE DAOU SYSTEMS, INC.
company earnings is not a sufficiently particular claim of misrepresentation to satisfy Rule 9(b).” Id. (citation and internal

brackets omitted). The court determined that Gross had failed

to allege any particulars to support his general allegation of

inflated earnings through the use of improper accounting

methods. “Specifically, he has not alleged the amount of the

putative overstatement or the net effect it had on the company’s earnings.” Id. The court cited a number of cases in support of this conclusion, including Shushany v. Allwaste, Inc.,

992 F.2d 517, 522 (5th Cir. 1993) (allegation that company

had adjusted the accounting of its inventory to inflate revenues and earnings does not sufficiently plead fraud where

complaint does not explain, inter alia, how the adjustments

affected the company’s financial statements and whether they

were material in light of the company’s overall financial position), Roots Partnership v. Lands’ End, Inc., 965 F.2d 1411,

1419 (7th Cir. 1992) (allegation that company “failed to

establish adequate reserves for its excessive and outdated

inventory” does not satisfy Rule 9(b) where investor does not

allege “what the reserves were or suggest how great the

reserves should have been”), and Cohen v. Koenig, 25 F.3d

1168, 1173 (2d Cir. 1994) (fraud pled with sufficient particularity by setting out representations made, what financial figures were given, and what the alleged true financial figures

were). 

[9] The case law indicates, therefore, that although overstatement of revenues in violation of GAAP may support a

plaintiff’s claim of fraud, the plaintiff must show with particularity how the adjustments affected the company’s financial

statements and whether they were material in light of the

company’s overall financial position. The district court here

determined that plaintiffs failed to make such a showing, noting that “despite an exhaustive search of the TAC, the Court

was unable to locate and identify any allegations quantifying

and contrasting the revenue Defendants actually recognized

under the POC method and the revenue Defendants should

have recognized if they had properly applied the POC methIN RE DAOU SYSTEMS, INC. 1401
od” (emphasis in original). “This information,” the court

stated, “is essential to surviving a motion to dismiss in this

context.” Moreover, the court noted, “Plaintiffs simply have

not shown that recognizing unearned revenue and earmarking

it for the work in progress account is anything but an exercise

of Defendants’ business judgment.” 

[10] Upon independent review of plaintiffs’ complaint,

however, we find at least some specific allegations of how the

adjustments affected the company’s financial statements and

whether they were material in light of the company’s overall

financial position. The complaint alleges myriad observations

of accounting misfeasance (e.g., alleged manipulation of the

books), and at least some of such allegations reveal that the

amount of revenue Daou formally recognized was completely

unrelated to the amount of labor incurred to date. According

to Daou’s stated method of revenue recognition—the POC

method—Daou was to recognize revenue based on the percentage of labor costs incurred to date compared to the total

estimated labor costs for the project. However, plaintiffs

allege, and confidential witnesses corroborate, that 

Vice Presidents Ringwall and Mirabile would print

out the ManFact reports containing actual labor and

percent completion submitted by project managers,

for the current month and quarter. According to

CW3, CW4, CW7 and CW16, the ManFact data was

compiled into a Monthly Project Report which was

sent to G. Daou, D. Daou, McGee, and McNeill at

the close of each month and quarter. . . . Based on

the comprehensive Monthly Project Report. G.

Daou, D. Daou, McNeill and McGee would adjust

upward the percent of completion for projects. 

If plaintiffs can in fact prove such intentional manipulation of

the accounting principles, they will have shown that Daou’s

public statements regarding recognized revenue were materially misleading. 

1402 IN RE DAOU SYSTEMS, INC.
Moreover, it appears that the district court conflated two

accounting concepts, earned revenue and that revenue for

which a company was entitled to bill its customers. As stated

above, it is a violation of GAAP to recognize revenue before

it is earned. Provenz, 102 F.3d at 1484. Plaintiffs allege that

“defendants recognized millions of dollars in revenue before

it was earned and without regard to actual labor costs incurred

or total estimated labor costs.” Plaintiffs also provided figures

allegedly indicating the discrepancy between the revenues

Daou recognized and the amount that it was entitled to bill its

customers during certain quarters within the class period.

Defendants explain that “[r]evenues recognized in excess of

amounts billed and project costs are classified as contract

work in progress.” What defendants’ disclosure — that revenue was sometimes being recognized before the customer was

billed — does not reveal is that defendants were recognizing

revenue before it was even earned. An investor would read

defendants’ disclosure of revenues “recognized” as meaning

that the excess revenues recognized were at the very least

earned. As plaintiffs allege, that statement was misleading

because defendants were allegedly recognizing revenue,

before it was earned in violation of GAAP. 

Further, systematically recognizing a set amount of revenues before such percentage of labor had been performed and

accounting for such premature recognition simply by dumping those amounts in the work-in-progress account could violate other GAAP principles such as “financial reporting

should provide information that is useful to present and potential investors and creditors and other users in making rational

investment, credit and similar decisions,” (citing FASB Statement of Concepts No. 1, ¶ 34), and “financial reporting

should be reliable in that it represents what it purports to represent,” (citing FASB Statement of Concepts No. 2,

¶¶ 58-59). 

Indeed, plaintiffs allege that “[t]he work in progress

account was comprised almost entirely of contract amounts

IN RE DAOU SYSTEMS, INC. 1403
Daou had recognized as revenue but for which it was not entitled to bill because little or no labor had yet taken place

. . .” (emphasis added). If this were the case, then Daou’s

explanation for its excess revenues may have been misleading

if the revenue reported indeed included amounts for which

Daou was not entitled to bill because little or no labor had yet

taken place. In fact, plaintiffs provide one telling example of

defendants recognizing revenue before a contract was even

signed:

[D]uring the final weeks of the 3Q97, defendants

were desperate to report revenue growth. At the

time, according to CW5 [who allegedly had personal

knowledge of this project], Daou, led by G. Daou,

was in the process of negotiating a multi-million dollar contract with Candler Health Systems. During the

final days of 3Q97, all of the equipment for the Candler Health Systems project was ordered and Daou

immediately recognized 20% of the contract price,

approximately $1-1.5 million, as revenue, before any

contract was signed. By the following quarter, after

the Candler Health Systems project revenues had

been reported, Daou still did not have a contract and

had incurred no actual labor costs. Daou never

received the contract and eventually was forced to

sell the equipment at a loss. 

Plaintiffs further describe how this allegedly premature recognition affected Daou’s financial bottom line:

Had Daou reported revenue in line with the amount

it was entitled to bill customers pursuant to its contracts, actually reflecting contract work done to date,

revenue for 3Q97 would have been only $5.9 million, 48% less than publicly reported ($11.3 million).

CW13, CW17, and CW 27 confirmed that the dramatic growth in Daou’s work in progress account,

increasing $5.4 million from 2Q97 to 3Q97, was the

1404 IN RE DAOU SYSTEMS, INC.
result of defendants’ premature recognition of revenue. 

In addition to pleading the approximate amount by which

revenues and earnings were overstated, plaintiffs also provide

the dates of some of the related transactions and the identities

of the customers and the company employees involved in the

transactions. For example, as noted above, plaintiffs described

an occurrence with the Centura Health project, which allegedly involved several of the confidential witnesses. CW5 indicated that Daou offered him and two other salaried Field

Service employees $100 to come into Daou on the last Saturday of June 1997, unpack and plug in computer equipment

ordered for the Centura Health project and immediately

record eight hours of labor. CW5 alleged that the purpose of

this event “was to justify recognizing 30%-40% of the revenue on the Centura Health project in 2Q97.” On another occasion, as noted above, CW5 corroborates other evidence that

Daou recognized 20% of the contract price — $1 to 1.5 million — on the Candler Health project before the contract was

even signed. Notably, plaintiffs allege that Daou never

received the Candler Health contract. 

[11] From these allegations, we conclude that plaintiffs

have provided enough information for “a court [to] discern

whether the alleged GAAP violations were minor or technical

in nature, or whether they constituted widespread and significant inflation of revenue.” See In re McKesson, 126 F. Supp.

2d at 1273. Certainly, prematurely recognizing millions of

dollars in revenue is not minor or technical in nature. Further,

the complaint, although largely repetitive in its assertions,

indicates that these practices allegedly occurred systematically throughout the class period. We hold, therefore, that

these allegations sufficiently state reasons why the reporting

statements were misleading and, as an allegation made on

information and belief, the facts on which that belief was

formed. See Gompper, 298 F.3d at 895. These allegations

include specific descriptions of how Daou allegedly violated

IN RE DAOU SYSTEMS, INC. 1405
GAAP procedures and, in so doing, misled present and potential investors by artificially inflating Daou’s revenues above

what should have been reported. 

[12] Similarly, we hold that plaintiffs’ claims regarding

employee training and turnover contain sufficient particularity

to support a securities fraud claim. Plaintiffs allege that various defendants made statements indicating that Daou instituted a training program called “Daou University,” at which

Daou employees were taught technical skills and became certified in computer networking languages and programs. Moreover, plaintiffs contend, in May 1998, D. Daou and McGee

represented that Daou had an ongoing program with local universities in San Diego whereby Daou brought in college students to Daou University to train them in systems and

networking. According to plaintiffs, neither Daou University,

nor the company’s program with local college students,

existed. Plaintiffs further assert that defendants misled potential investors by understating employee turnover and attrition.

The district court concluded that these allegations lacked

sufficient particularity to be actionable. As to employee attrition, for example, the district court noted:

The one allegation of any substance, Plaintiffs’ contention that employee attrition was actually 40%, not

6.8% as represented by Defendants, does not establish misrepresentation on Defendants’ part. Defendants’ statements that attrition among technical

employees was at 6.8% was made in July 1998, and

confidential witnesses’ statements that the attrition

rate for all employees was at 40% was made in the

first quarter of 1998. 

However, the complaint itself qualifies the allegation of

employee turnover by stating that “[e]mployee turnover, especially among Field Service engineers, exceeded 40%,”

whereas defendants stated that “attrition within the technical

1406 IN RE DAOU SYSTEMS, INC.
ranks of employees was only 6.8%.” Such discrepancy

between what Daou executives reported and the allegedly true

state of affairs of Daou’s employ is adequately misleading to

state a claim under 10(b). 

[13] We therefore disagree with the district court that

Daou’s alleged misleading statements of employee turnover

and lack of training were not sufficiently particularized to

state a cause of action under the PSLRA’s heightened pleading standards. Plaintiffs provide several accounts of confidential witnesses claiming that “Daou University” did not in fact

exist and that Daou actually had “no in-house training program whatsoever, and according to CW21, the Company was

hiring, among others, untrained mechanics and cable pullers

as computer technicians, not college graduates.” Unlike in In

re Vantive, where the court held insufficient generic allegations of “inadequate training” or “very high salesforce turnover,” see In re Vantive, 283 F.3d at 1086-87, the complaint

here contains sufficiently detailed allegations of misleading

statements or omissions regarding Daou’s ability to train and

retain its employees to state a claim even under the PSLRA’s

more rigorous standard. 

[14] Plaintiffs’ allegations regarding Daou’s “pipeline”

expectations, however, fail to satisfy the PSLRA’s requirements. The complaint alleges that Daou misrepresented its

“pipeline” expectations, stating that its position was “extremely strong” and “remained healthy and would fuel future

earnings growth,” that “visibility of future earnings was outstanding,” and that the company’s “momentum was increasing.” Although these projections might have been overly

optimistic when made, they do not rise to the level of a material misrepresentation actionable after enactment of the

PSLRA:

Congress enacted the PSLRA to put an end to the

practice of pleading “fraud by hindsight.” See e.g.,

Medhekar v. United States Dist. Ct., 99 F.3d 325,

IN RE DAOU SYSTEMS, INC. 1407
328 (9th Cir. 1996) (holding that Congress intended

for complaints under the PSLRA to stand or fall

based on the actual knowledge of the plaintiffs rather

than information produced by the defendants after

the action has been filed). 

Silicon Graphics, 183 F.3d at 988. Under the PSLRA’s “safe

harbor” provisions, plaintiffs must prove that “forwardlooking” statements were made with “actual knowledge” that

they were false or misleading. Id. at 993 (Browning, J., concurring in part and dissenting in part) (quoting 15 U.S.C.

§§ 78u-5(c)(1)(B), 77z-2(c)(1)(B)) (internal quotation marks

omitted). Plaintiffs allege that Daou sales executives would

hold weekly or bi-weekly conference calls with McNeill on

the status or outlook of prospective projects, and, based on

these calls, McNeill and assistants would prepare a Pipeline

Report. The complaint further asserts that “[t]he Pipeline

Report contained the arbitrary determination of future business based on fixed percentages of proposed contracts’

value.” The complaint describes the method by which Daou

would determine and report its potential sales revenue to analysts and the market:

The “revenue” listed in the report and provided to

analysts and the market was, according to CW9,

automatically set at 20% of a contract’s total value

if a Daou salesperson had even met with the prospective client to discuss a deal, 50% if Daou had

submitted a deal proposal, 70% if Daou had submitted a formal bid on the deal, 90% if Daou “appeared

to have won” but the deal was not formally closed

and 100% when the sale was formerly closed. The

pipeline figure, despite defendants’ representations,

did not actually reflect contracts Daou would actually get, and included millions of dollars on projects

that Daou had little or no chance of actually doing.

Plaintiffs provide no specific facts, however, to substantiate

the speculative claim that Daou had little or no chance of

1408 IN RE DAOU SYSTEMS, INC.
actually obtaining certain contracts. Further, plaintiffs fail to

provide sufficient facts to demonstrate that defendants had

actual knowledge that these optimistic statements were false

and misleading when made. Therefore, we agree with the district court that these claims are not actionable under section

10(b). 

In sum, however, we find that plaintiffs adequately pled

fraud as to defendants’ alleged misuse of the GAAP protocols

and alleged misstatements regarding employee training and

turnover to survive a motion to dismiss for failure to state a

claim. 

2. Scienter

[15] Under the PSLRA’s new standard, a securities fraud

complaint must “state with particularity facts giving rise to a

strong inference that the defendant acted with the required

state of mind.” Gompper, 298 F.3d at 895 (citing 15 U.S.C.

§ 78u-4(b)(2) (emphasis added in Gompper)); see also Silicon

Graphics, 183 F.3d at 974 (facts must come closer to demonstrating intent as opposed to mere motive and opportunity).

Thus, the complaint must allege that the defendants made

false or misleading statements either intentionally or with

deliberate recklessness. See Silicon Graphics, 183 F.3d at

974. This court considers “whether the total of plaintiffs’ allegations, even though individually lacking, are sufficient to

create a strong inference that defendants acted with deliberate

or conscious recklessness.” Nursing Home, 380 F.3d at 1230

(quoting No. 84 Employer-Teamster Joint Council Pension

Trust Fund v. Am. West Holding Corp., 320 F.3d 920, 938

(9th Cir. 2003)). In considering whether a strong inference of

scienter has been pled, “the court must consider all reasonable

inferences to be drawn from the allegations, including inferences unfavorable to the plaintiffs.” Gompper, 298 F.3d at

897 (emphasis in original). 

There are several considerations in determining whether the

totality of plaintiffs’ allegations leads to a strong inference of

IN RE DAOU SYSTEMS, INC. 1409
scienter. General allegations of defendants’ “hands-on” management style, their interaction with other officers and

employees, their attendance at meetings, and their receipt of

unspecified weekly or monthly reports are insufficient. In re

Vantive, 283 F.3d at 1087. However, specific admissions from

top executives that they are involved in every detail of the

company and that they monitored portions of the company’s

database are factors in favor of inferring scienter in light of

improper accounting reports. See Nursing Home, 380 F.3d at

1234. Moreover, while scienter cannot be established by publishing inaccurate accounting figures, even when in violation

of GAAP, In re Worlds of Wonder Sec. Litig., 35 F.3d 1407,

1426 (9th Cir. 1994) (“WOW”), significant violations of

GAAP standards can provide evidence of scienter so long as

they are pled with particularity. In re McKesson, 126 F. Supp.

2d at 1273; see also Nursing Home, 380 F.3d at 1234 (“It is

reasonable to infer that the Oracle executives’ detail-oriented

management style led them to become aware of the allegedly

improper revenue recognition of such significant magnitude[.]”). 

In addition, “the PSLRA neither prohibits nor endorses the

pleading of insider trading as evidence of scienter, but

requires that the evidence meet the ‘strong inference’ standard.” Greebel, 194 F.3d at 197. “Unusual trading or trading

at suspicious times or in suspicious amounts by corporate

insiders has long been recognized as probative of scienter.”

Id.; see also Nursing Home, 380 F.3d at 1231-32 (considering

suspicious insider stock sales as evidence toward meeting the

“strong inference” standard). At a minimum, however, “the

trading must be in a context where defendants have incentives

to withhold material, non-public information, and it must be

unusual, well beyond the normal patterns of trading by those

defendants.” Greebel, 194 F.3d at 198. 

Plaintiffs allege throughout the complaint that defendants

G. Daou, D. Daou, McNeill, and McGee personally directed

Daou’s recognition of revenue, financial reporting and public

1410 IN RE DAOU SYSTEMS, INC.
statements. They further allege that “[n]ot only were these

four defendants the top executives at Daou, but, according to

CW23, a former executive assistant to one of the defendants,

the Company was run ‘top to bottom’ by G. Daou and D.

Daou, with the assistance of McNeill and McGee.” Further,

the complaint states that “CW9, a regional Sales Vice President at Daou, confirmed that defendants G. Daou, D. Daou,

and McNeill not only made the decision on how much revenue to recognize without regard to any actual percentage of

completion, but directed the practice of automatically recognizing revenue upon contract signing and ordering of equipment.” 

In one example noted above, the complaint describes Daou

executives manually adjusting upward POC amounts in what

appears to be in violation of GAAP procedure. CW1 confirmed that such practices occurred, and the complaint indicates that G. Daou, D. Daou, McNeill, and “in particular

McGee[ ] presented themselves as knowledgeable about all

aspects of the Company’s finances, including earnings and

revenue recognized under POC accounting.” Plaintiffs further

allege that “[b]ased on the account of numerous witnesses, all

of whom were former members of Daou’s executive,

Accounting, or Field Services staff, defendants not only knew

that the Company’s reported financial results and earnings

forecast were based on fraudulent accounting, but personally

directed the violations of Daou’s stated accounting policy and

GAAP in order to artificially inflate revenues”; and “CW8 . . .

and CW3 . . . both confirmed that it was known throughout

Daou at this time [2Q97] that G. Daou, D. Daou, and McNeill

were engaged in improper revenue recognition . . . .” 

[16] These specific allegations of direct involvement in the

production of false accounting statements and reports are even

more probative of scienter than the allegations involved in

Nursing Home, where this court stated that the top executives’

admittedly detail-oriented management style led to a reasonable inference that the top executives were aware of signifiIN RE DAOU SYSTEMS, INC. 1411
cant accounting irregularities. See Nursing Home, 380 F.3d at

1234. Indeed, the facts alleged by plaintiffs lead to an even

stronger inference: plaintiffs have alleged with specificity that

the top executives actually directed the improper revenue recognition in violation of both GAAP and their own accounting

practices. 

Plaintiffs also cite suspicious corporate acquisitions and

insider stock sales to demonstrate defendants’ scienter. They

assert that these events demonstrate that defendants “had

motive to inflate Daou’s stock price and perpetuate the fraudulent scheme and course of business complained of . . . .” The

complaint notes that during the class period, Daou acquired

11 companies by exchanging over 6.6 million shares of Daou

stock. Plaintiffs present a chart that indicates how many Daou

shares “saved” by using artificially inflated stock to purchase

the 11 companies. For example, for Daou to purchase INTEGREX Systems Corp. in July 1997, Daou exchanged 700,000

shares of Daou stock valued at $11,400,000; they assert that

had Daou’s stock been properly valued, they would have been

forced to use 1,476,403 additional shares to make the INTEGREX purchase. All told, the chart indicates that Daou saved

19,642,865 shares of its stock in the 11 acquisitions by using

its overvalued stock. 

The complaint also highlights that defendants G. Daou, D.

Daou, McGee, McNeill, and Moragne, sold a total of

1,477,718 shares during the class period for a total of

$30,512,393, and in so doing, they knowingly “profit[ed]

from the fraud.” Although plaintiffs note that defendants took

advantage of the artificially inflated stock prices, interestingly, defendants did not sell at the height of Daou’s stock

prices; e.g., of the stock G. Daou sold during the class period,

he received a maximum price of $22.86 per share, whereas

Daou’s stock price peaked at $34.375 in September 1997.

Moragne, on the other hand, sold 11,408 shares at the highest

price among defendants who sold stock during the class

period, $31.69 per share in November 1997. Despite the fact

1412 IN RE DAOU SYSTEMS, INC.
that defendants did not capitalize on Daou’s peak price per

share, plaintiffs nonetheless contend that the sales were made

at suspicious moments: “the fact that 98% of all insider sales

. . . took place on only two trading days (August 15, 1997 and

January 29, 1998) is highly suspect and indicative of coordinated selling among defendants.” Plaintiffs contend that the

sales correspond perfectly with the “huge increase in the price

of Daou stock that immediately followed [defendants’] false

statements and reports . . . .” Plaintiffs also note that, in addition to the suspicious insider trading by defendants, other

Daou executives as well as defendants’ family members

“dumped” a grand total of 2.5 million shares of Daou stock

during the class period at artificially inflated prices. Another

chart in the complaint explains the percentage of defendants’

sales during the class period compared to their total sales

through December 31, 2000. Sales by defendants G. Daou, D.

Daou, McNeill and Moragne during the class period represented 100% of their total stock sales as of the end of 2000;

only defendant McGee sold stock after the close of the class

period. 

When considered as a whole, plaintiffs’ allegations are sufficient to create a strong inference that all defendants except

Moragne acted with at least deliberate recklessness. The complaint relays specific information from actual witnesses, albeit

unnamed, that defendants knowingly violated GAAP procedures and present more than mere evidence of a motive and

opportunity to commit fraud. Although plaintiffs’ allegations

of Daou’s top-to-bottom management hierarchy, defendants’

suspicious stock sales, or the corporate acquisitions alone

would not likely demonstrate defendants’ scienter, these plus

the complaint’s specific allegations of deliberate accounting

misfeasance create a strong inference of scienter. See Nursing

Home, 380 F.3d at 1234 (“Considered separately, Plaintiffs’

allegations may not create a strong inference of scienter.

However, . . . [w]e find that the totality of the allegations does

create a strong inference that Oracle acted with scienter[.]”);

cf. Silicon Graphics, 183 F.3d at 988 (holding insufficient the

IN RE DAOU SYSTEMS, INC. 1413
plaintiff’s “generic” allegations). Unlike in Silicon Graphics,

this complaint contains sufficient “particularity” and “incriminating facts” to distinguish the allegations from the countless

“fishing expeditions” which the PSLRA was designed to

deter. See Silicon Graphics, 183 F.3d at 988 (citing H.R.

Conf. Rep. No. 104-369, at 37). 

[17] However, we affirm the district court’s dismissal of

defendant Moragne as relates to the section 10(b) and Rule

10b-5 claims. The complaint’s main allegations to establish

scienter against defendant Moragne are suspicious stock sales,

and those allegations, as pled in plaintiffs’ complaint, do not

rise to the level of a strong inference. Importantly, there is

nothing to suggest Moragne was involved in the day-to-day

operations of Daou, much less heavily involved in the details

and personally directing the accounting irregularities. Our

affirmance as to Moragne, however, does not imply that

suspicious stock sales, by themselves, can never lead to a

strong inference. The facts alleged in this complaint simply do

not support a strong inference of scienter. 

3. Causation

A court must also consider whether the plaintiff has shown

some causal connection between the fraud and the securities

transaction in question. The Ambassador Hotel, 189 F.3d at

1026; Levine v. Diamanthuset, Inc., 950 F.2d 1478, 1486 (9th

Cir. 1991) (“[The] plaintiff must establish a connection

between the defendant’s alleged misrepresentation and the

security at issue.”). “Deception related to the value or merit

of the securities in question has sufficient connection to securities transactions to bring the fraud within the scope of

§ 10(b).” The Ambassador Hotel, 189 F.3d at 1026 (citation

omitted). 

The causation requirement can be broken down into two

necessary elements: actual cause (“transaction causation”) and

proximate cause (“loss causation”):

1414 IN RE DAOU SYSTEMS, INC.
[I]n an action brought under Rule 10b-5 for material

omissions or misstatements, the plaintiff must prove

both transaction causation, that the violations in

question caused the plaintiff to engage in the transaction, and loss causation, that the misrepresentations

or omissions caused the harm. 

Id. at 1027 (quoting Hatrock v. Edward D. Jones & Co., 750

F.2d 767, 773 (9th Cir. 1984)). Thus, to prove transaction

causation, the plaintiff must show that, but for the fraud, the

plaintiff would not have engaged in the transaction at issue;

to prove loss causation, the plaintiff must demonstrate a

causal connection between the deceptive acts that form the

basis for the claim of securities fraud and the injury suffered

by the plaintiff. Id.

Here, we conclude that plaintiffs have sufficiently demonstrated defendants’ fraud, such that the “[d]eception related to

the value or merit of the securities in question” creates a sufficient connection to the securities transactions to bring the

fraud within the scope of section 10(b). See id. at 1026 (citation omitted). Such fraud in disclosing Daou’s financial position would likely suffice to prove transaction causation: but

for the fraud, plaintiffs would not have engaged in the transaction at issue. See id. at 1027. 

As the district court pointed out, however, establishing

“loss causation” is a more difficult task, as the district court

found that Daou’s improper use of the POC method was not

linked to the decline in Daou’s share price. The court stated:

It is undisputed that Daou’s 3Q98 financial results

were dismal, and that this led to the precipitous drop

in the Company’s stock value. However, in the TAC,

Plaintiffs have not adequately been able to link the

decline in share price to any purported improper revenue recognition by Defendants. Plaintiffs point to

the fact that market analysts questioned whether

IN RE DAOU SYSTEMS, INC. 1415
Defendants had been “cooking” Daou’s books after

the 3Q98 results were revealed, but this is merely

speculation. Notably, the TAC does not allege that

there were any negative public statements,

announcements or disclosures at the time the stock

price dropped that Defendants were engaged in

improper accounting practices. 

In other words, if the improper accounting did not lead to the

decrease in Daou’s stock price, plaintiffs’ reliance on the

improper accounting in acquiring the stock would not be sufficiently linked to their damages. 

An independent assessment of the TAC, however, indicates

that the price of the stock fell precipitously after defendants

revealed figures vastly different than those reported in a press

conference two weeks prior. The complaint also anonymously

quotes an analyst who allegedly stated, “[w]hen you say one

thing on the conference call and report something different on

the 10-Q, that raises concern. . . . You have got to question

whether they are manufacturing earnings.” Although some of

the allegations do call for speculation, the foregoing, if

assumed true, is sufficient to show that the drop in Daou’s

stock price was the direct result of their financial misstatements and, in turn, caused plaintiffs’ damages. 

4. Reliance and Damages

Plaintiffs attest that they relied on defendants’ material misrepresentations in choosing to invest in Daou during the class

period and were damaged thereby. Justifiable reliance “is a

limitation on a rule 10b-5 action which insures that there is a

causal connection between the misrepresentation and the

plaintiff’s harm.” Paracor, 96 F.3d at 1159 (citation and internal quotation marks omitted). If Daou indeed based its public

disclosures of its financial viability on fraudulent accounting,

then, in turn, plaintiffs justifiably relied on such disclosures in

making the decision to invest. Moreover, if plaintiffs indeed

1416 IN RE DAOU SYSTEMS, INC.
justifiably relied on Daou’s public misrepresentations and, in

turn, bought Daou stock at inflated prices, they incurred damages from Daou’s fraud. Such assertions are sufficient to survive a motion to dismiss under Federal Rule of Civil

Procedure 12(b)(6). 

b. Plaintiffs’ 1933 Securities Act section 11 claim

Unlike section 10(b), section 11 of the 1933 Securities Act

creates a private remedy for any purchaser of a security if

“any part of the registration statement, when such part became

effective, contained an untrue statement of a material fact or

omitted to state a material fact required to be stated therein or

necessary to make the statements therein not misleading.” 15

U.S.C. § 77k(a). “The plaintiff in a § 11 claim must demonstrate (1) that the registration statement contained an omission

or misrepresentation, and (2) that the omission or misrepresentation was material, that is, it would have misled a reasonable investor about the nature of his or her investment.” In re

Stac Electronics Sec. Litig., 89 F.3d 1399, 1403-04 (9th Cir.

1996) (“In re Stac”) (citation and internal quotation marks

omitted). “No scienter is required for liability under § 11;

defendants will be liable for innocent or negligent material

misstatements or omissions.” Id. (citing Herman & MacLean

v. Huddleston, 459 U.S. 375, 382 (1983)). 

Although section 11 does not contain an element of fraud,

a plaintiff may nonetheless be subject to Rule 9(b)’s particularity mandate if his complaint “sounds in fraud”: 

[T]he plaintiff may allege a unified course of fraudulent conduct and rely entirely on that course of conduct as the basis of a claim. In that event, the claim

is said to be “grounded in fraud” or to “sound in

fraud,” and the pleading of that claim as a whole

must satisfy the particularity requirement of Rule

9(b). 

IN RE DAOU SYSTEMS, INC. 1417
Vess, 317 F.3d at 1103-04; see also In re Stac, 89 F.3d at

1404-05 (“We now clarify that the particularity requirements

of Rule 9(b) apply to claims brought under Section 11 [of the

1933 Securities Act] when, as here, they are grounded in

fraud.”). 

In a case where fraud is not an essential element of a claim,

only allegations of fraudulent conduct must satisfy the heightened pleading requirements of Rule 9(b). Vess, 317 F.3d at

1105. “Allegations of non-fraudulent conduct need satisfy

only the ordinary notice pleading standards of Rule 8(a).” Id.

As the Fifth Circuit wrote: 

Where averments of fraud are made in a claim in

which fraud is not an element, an inadequate averment of fraud does not mean that no claim has been

stated. The proper route is to disregard averments of

fraud not meeting Rule 9(b)’s standard and then ask

whether a claim has been stated. 

Id. (citing Lone Star Ladies Inv. Club v. Schlotzsky’s Inc., 238

F.3d 363, 368 (5th Cir. 2001) (“Lone Star”)) (emphasis added

in Vess). As the Eighth Circuit elaborated: 

The only consequence of a holding that Rule 9(b) is

violated with respect to a § 11 claim would be that

any allegations of fraud would be stripped from the

claim. The allegations of innocent or negligent misrepresentation, which are at the heart of a § 11 claim,

would survive. 

Id. (citing Carlon v. Thaman (In re NationsMart Corp. Sec.

Litig.), 130 F.3d 309, 315 (8th Cir. 1997)) (emphasis added

in Vess). “Thus, if particular averments of fraud are insufficiently pled under Rule 9(b), a district court should ‘disregard’ those averments or ‘strip’ them from the claim. The

court should then examine the allegations that remain to

determine whether they state a claim.” Id.

1418 IN RE DAOU SYSTEMS, INC.
A district court need not rewrite a deficient complaint however. Lone Star, 238 F.3d at 368. Rule 9(b) may prove fatal

to 1933 Securities Act claims “grounded in fraud” when the

complaint makes a “wholesale adoption” of the securities

fraud allegations for purposes of the Securities Act claims. Id.

(citations, internal quotation marks, and emphasis omitted). In

such cases, 

a district court is not required to sift through allegations of fraud in search of some “lesser included”

claim of strict liability. It may dismiss. If it does so,

it should ordinarily accept a proffered amendment

that either pleads with the requisite particularity or

drops the defective allegations and still states a

claim. 

Id. at 368-69. 

Here, plaintiffs’ TAC “sounds in fraud.” Notably, the first

sentence of the complaint introduces the action as one

“brought on behalf of a class of purchasers of Daou Systems,

Inc . . . . common stock [during the class period], seeking

damages resulting from a fraudulent scheme and course of

business by defendants, which harmed [such] purchasers.”

(emphasis added). Thereafter, the complaint goes on to allege

myriad misrepresentations made by defendants, of which

defendants had full knowledge, which induced plaintiffs’ reliance, and which caused plaintiffs damages. The complaint

fully incorporates all allegations previously averred in the

complaint for purposes of all their claims. Because the complaint makes a “wholesale adoption” of the securities fraud

allegations for purposes of the Securities Act claims, this

court need not “sift through allegations of fraud in search of

some ‘lesser included’ claim of strict liability”; indeed, plaintiffs here never rely on such conduct as negligence or mistake

in stating their claims. Cf. Vess, 317 F.3d at 1105-06. Thus,

all of plaintiffs’ claims, whether including an element of fraud

IN RE DAOU SYSTEMS, INC. 1419
or not, must satisfy the heightened pleading standard set out

in Rule 9(b). See In re Stac, 89 F.3d at 1404-05. 

To survive dismissal, therefore, plaintiffs must demonstrate, with particularity, “(1) that the registration statement

contained an omission or misrepresentation, and (2) that the

omission or misrepresentation was material, that is, it would

have misled a reasonable investor about the nature of his or

her investment.” In re Stac, 89 F.3d at 1403-04 (citation and

internal quotation marks omitted). Here, as discussed above,

plaintiffs have shown with sufficient particularity that defendants engaged in materially false revenue reporting in the various statements disclosed during the class period. Thus,

plaintiffs’ section 11 claims against all defendants, including

defendant Moragne, survive dismissal under Rule 12(b)(6). 

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

Section 12(a)(2) of the 1933 Securities Act imposes civil

liability on any person for use of any instrumentality of interstate commerce to offer or sell securities by means of a prospectus or oral communication that includes “an untrue

statement of a material fact or omits to state a material fact

necessary in order to make the statements, in the light of the

circumstances under which they were made, not misleading

. . . .” 15 U.S.C. § 77l(a)(2). To establish liability under section 12(a)(2), a plaintiff must allege that the defendants did

more than simply urge another to purchase a security; rather,

the plaintiff must show that the defendants solicited purchase

of the securities for their own financial gain:

The person who gratuitously urges another to make

a particular investment decision is not, in any meaningful sense, requesting value in exchange for his

suggestion or seeking the value the titleholder will

obtain in exchange for the ultimate sale. The language and purpose of § 12(1) suggest that liability

extends only to the person who successfully solicits

1420 IN RE DAOU SYSTEMS, INC.
the purchase, motivated at least in part by a desire

to serve his own financial interests or those of the

securities owner. If he had such a motivation, it is

fair to say that the buyer “purchased” the security

from him . . . . 

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

The purchaser must also demonstrate damages to recover

under section 12. Because section 12 provides that a person

who sells a security through use of material misstatements or

omissions “shall be liable . . . to the person purchasing such

security from him . . . [for] the consideration paid for such

security with interest thereon, less the amount of any income

received thereon, . . . or for damages if he no longer owns the

security,” 15 U.S.C. § 77l(a), there can be no recovery unless

the purchaser has suffered a loss. In re Broderbund/Learning

Co. Sec. Litig., 294 F.3d 1201, 1205 (9th Cir. 2002). “That is

to say, what the purchaser is entitled to is ‘a return of the consideration paid, reduced by the amount realized when he sold

the security and by any “income received” on the security.’ ”

Id. (citing Randall v. Loftsgaarden, 478 U.S. 647, 656 (1986)

(citation omitted)). Causation, however, is not a necessary

element of a prima facie case under section 12 of the Securities Act. See Casella v. Webb, 883 F.2d 805, 808 & n.8 (9th

Cir. 1989) (holding that if the alleged misrepresentations are

material, a plaintiff is entitled to recovery whether or not the

misrepresentations caused the alleged damage). 

[18] The district court failed to reach the issue of whether

Daou and the individual defendants were “directly involved”

in the actual solicitation of a securities purchase because it

had determined that “Plaintiffs’ 12(a)(2) claim necessarily

fails for lack of adequate allegations that Defendants made

any false or misleading statements or omissions of material

fact.” Because we hold that plaintiffs adequately averred

material misrepresentations on the part of defendants’ statements in their various periodic disclosures, the district court

IN RE DAOU SYSTEMS, INC. 1421
must revisit the remaining elements of plaintiffs’ section

12(a)(1) claim to determine whether they are sufficient to survive dismissal under Rule 12(b)(6). 

d. Plaintiffs’ claims under sections 15(a) of the 1933

Securities Act and 20(a) of the 1934 Exchange Act

Section 15(a) of the 1933 Securities Act imposes joint and

several liability upon every person who controls any person

liable under sections 11 or 12. 15 U.S.C. § 77o. Such section

provides:

Every person who, by or through stock ownership,

agency, or otherwise, or who, pursuant to or in connection with an agreement or understanding with one

or more other persons by or through stock ownership, agency, or otherwise, controls any person liable

under sections 77k or 771 of this title, shall also be

liable jointly and severally with and to the same

extent as such controlled person to any person to

whom such controlled person is liable, unless the

controlling person had no knowledge of or reasonable ground to believe in the existence of the facts by

reason of which the liability of the controlled person

is alleged to exist. 

Id. To state a claim under this section, a plaintiff must allege

that the individual defendants had power or influence over the

company and that the individual defendants were culpable

participants in the company’s alleged illegal activity. Durham

v. Kelly, 810 F.2d 1500, 1504 (9th Cir. 1987). 

Similarly, section 20(a) of the 1934 Exchange Act provides

that “[e]very person who, directly or indirectly, controls any

person liable under any provision of [chapter 2B] or of any

rule or regulation thereunder shall also be liable jointly and

severally with and to the same extent as such controlled person . . . .” 15 U.S.C. § 78t. “Controlling person” under both

1422 IN RE DAOU SYSTEMS, INC.
of the above acts is given the same interpretation because

“section 20(a) [of the Exchange Act] is an analogue of section

15 of the Securities Act.” Durham, 810 F.2d at 1503 (citation

omitted) (alteration in original). 

[19] Because the district court did not find that Daou or the

individual defendants had engaged in anything but “an exercise of Defendants’ business judgment,” it also rejected plaintiffs’ contention that defendants should be liable under

sections 15(a) or 20(a). Again, because we conclude that

plaintiffs have adequately set forth a claim of accounting

fraud, the district court must reassess the viability of plaintiffs’ sections 15 and 20 claims as well. 

CONCLUSION

Plaintiffs’ complaint, although lengthy and often repetitive,

states a sufficiently particularized claim for accounting fraud

under the heightened pleading standards of the PSLRA.

Accordingly, we need not reach plaintiffs’ request for leave

to amend nor defendants’ request for attorney’s fees. The case

is remanded to the district court for further proceedings consistent with this opinion. 

AFFIRMED in part; REVERSED in part and

REMANDED. 

IN RE DAOU SYSTEMS, INC. 1423