IN THE UNITED STATES DISTRICT COURTFOR THE NORTHERN DISTRICT OF ILLINOIS

EASTERN DIVISIO N

DENNIS CHU, AMBASSADOR WINDOW )AND DOOR .CO . PENSION PLAN AND TRUST, )BRUCE BRAVERMAN, GLENN CHENOT, )CHRISTINE DAVID, SUSAN DORMAN, )JAMES ANTHONY DOUCETTE, STEVE HILL, )JEFFREY MAHLER, HUGHES SCHREPFER, )KEN SCHUTZ, et al ., Individually And )On Behalf of All Others Similarly Situated, )

Plaintiffs, )

v. )

SABRATEK CORPORATION, K . SHAN PADDA,)ANIL K. RASTOGI, STEVEN L. HOLDEN, )DORON C. LEVITAS, VINCENT J . CAPPONI, )STEPHEN L. AXEL, ALAN E. JORDAN, )STEPHAN C. BEAL, ELLIOTT R. MANDELL, )SCOTT P. SKOOGLUND, PETER L. SMITH, )WILLIAM D . LAUTMAN, WILLIAM H. )LOMICKA and KPMG LLP, )

Defendants . )

To: All counsel on attached certificate of service

CASE NO. 99 C 03 5 1

Judge Da i

SEP 15 7000

JUDGE JOHN W. DARRAH

UNITE D STATES DISTRICT COURT

CEP ED2 7 2ooo

NOTICE OF MOTION

PLEASE TAKE NOTICE that on Wednesday, September 2200, 2000, at I

or as soon thereafter as counsel may be heard, we shall appear before the Honorable John W .

Darrah, or such other judge as may be sitting in his stead, in courtroom 2648 of the United State s

Courthouse, 2 1 9 South Dearborn Street, Chicago, Illinois, and shall then and there presen t

Defendant KPMG LLP's Motion for Entry of Judgment, a copy of which is hereby served upo n

you .

Respectfully submitted,

William F . LloydFrank B . VankerHille R. SheppardDavid A. GordonSIDLEY & AUSTINBank One Plaza10 South Dearborn StreetChicago, Illinois 60603(312) 853-700 0

Dated : September 15, 2000

CHI 1087723v1

lu" TC Y~~One of the Attorneys or DefendantKPMG LLP

2

CERTIFICATE OF SERVICE

I, Hille R . Sheppard, one of the attorneys for defendant KPMG LLP, certify that I

caused a copy of the foregoing Notice of Motion, along with Defendant KPMG LLP's Motio n

For Entry of Judgment, to be served by messenger on :

Marvin A. MillerAdam J. LevittMILLER FAUCHER and CAFFERTY LLP30 North LaSalle StreetSuite 3200Chicago, Illinois 60602Tel: (312) 782-4880Fax: (312) 782-448 5

Liaison Counsel for Plaintiffs

Jerold S . SolovyRonald L . MarmerC. John KochDaniel F . LynchJENNER & BLOCKOne IBM PlazaSuite 440 0Chicago, Illinois 60611Tel : (312) 222-9350Fax: (312) 840-7342

Attorneys for Defendants K. Shan Padda, Anil K. Rastogi,

Vincent J. Capponi , Alan F. Jordan , Stephan C. Beal,Elliott Mandel and Scott P . Skooglund

Joseph J . DuffyCorey B . RubensteinSTETLER & DUFFY, LTD .140 South Dearborn StreetSuite 400Chicago, Illinois 60603Tel : (312) 338-0200Fax : (312)338-0070

Attorneys for Defendant Steven L. Holden

Terry F. MoritzSteven A. LevyEverett J . CygalGOLDBERG, KOHN, BELL, BLACK, ROSENBLOOM & MORITZ, LTD .55 East Monroe, 37th Floo rChicago, Illinois 60603Tel: (312) 201-4000Fax: (312) 332-2196

Attorneys for Defendants William D . Lautmanand William H. Lomicka

Lowell E . SachnoffBrian D. RocheMartin E. LubitzSACHNOFF & WEAVER, LTD .30 S. Wacker Drive, Suite 2900Chicago, IL 60606Tel: (312) 207-1000Fax: (312) 207-6400

Attorneys for Doron C. Levitas

and by Federal Express on :

David J . BershadWilliam C. FredericksClifford S . GoodsteinMILBERG WEISS BERSHAD HYNES & LERACH LLPOne Pennsylvania Plaza49th FloorNew York, New York 10119-0165Tel: (212) 594-5300Fax: (212) 868-1229

Lead Counsel for Plaintiffs

and by first-class mail on :

Lester L . LevyCarl L. StineWOLF POPPER LLP845 Third AvenueNew York, New York 10022Tel : (212) 759-4600Fax: (212) 486-2093

Steven J . TollLori FeldmanCOHEN MILSTEIN HAUSFELD & TOLL, P .L.L.C.999 Third AvenueSuite 3 600Seattle, Washington 98104Tel: (206) 521-0080Fax: (206) 521-0166

Fred T . IsquithGregory Nespol eWOLF HALDENSTEIN ADLER FREEMAN & HERZ, LLP270 Madison AvenueNew York, NY 10016Tel : (212) 545-4600Fax : (212) 545-465 3

Roger W. KirbyRandall K. BergerKIRBY McINERNEY & SQUIRE LLP830 Third Avenu eNew York, New York 10022Tel: (212) 371-660 0Fax: (212) 751-2540

Counsel for Plaintiffs and Members of Proposed Plaintiffs' Executive Committee

Joseph D. AmentMUCH SHELIST FREED DENEN13ERG AMENT & RUBENSTEIN, P .C .200 North LaSalle StreetSuite 2100Chicago, Illinois 60601Tel : (312) 346-3100Fax: (312) 621-175 0

Bruce G. MurphyLAW OFFICE OF BRUCE G. MURPHY265 Lloyd's LaneVero Beach, Florida 32963Tel: (561) 231-4202Fax: (801) 650-8213

Terry Rose SaundersLAW OFFICES OF TERRY ROSE SAUNDERS30 North LaSalle StreetSuite 320 0Chicago, Illinois 60602Tel : (312) 346-4456Fax: (312) 782-448 5

Marc H. EdelsonHOFFMAN & EDELSON45 West Court StreetDoylestown, Pennsylvania 18901Tel: (215) 230-804 3Fax: (215) 230-8735

Samuel SpornSCHOENGOLD & SPORN233 Broadway39th FloorNew York, New York 10279Tel: (212) 964-0046Fax: (212) 267-8137

Attorneys for Plaintiffs

Martin J . KaminskyJustin J .K. ChuPOLLACK & KAMINSKY114 W . 47th StreetNew York, New York 1003 6Tel: (212) 575-470 0Fax: (212) 575-6560

Attorneys for Defendants William D . Lautmanand William H . Lomicka

on this fifteenth day of September, 2000 .

Hille R . Sheppard

UNITED STATES DISTRICT COURT ~~•..1NORTHERN DISTRICT OF ILLINOI S

EASTERN DIVISION SEP j 5 ?oo o

DENNIS CHU, AMBASSADOR WINDOWAND DOOR CO. PENSION PLAN ANDTRUST, BRUCE BRAVERMAN, GLENNCHENOT, CHRISTINE DAVID, SUSANDORMAN, JAMES ANTHONY DOUCETTE,STEVE HILL, JEFFREY MAHLER, HUGHESSCHREPFER, KEN SCHUTZ, et al .,Individually And On Behalf of All OthersSimilarly Situated,

UNITED STATES w pgRRAHCase No. 99 C 0351 ATES DISTRICT COURT

Judge Darrah

DOCKETED

SEP 2 7 ZOOQ

Plaintiffs,

V .

SABRATEK CORPORATION, K. SHANPADDA, ANIL K . RASTOGI, STEVEN L.HOLDEN, DORON C . LEVITAS, VINCENTJ. CAPPONI, STEPHEN L . AXEL, ALAN E .JORDAN, STEPHAN C . BEAL, ELLIOTT R.MANDELL, SCOTT P . SKOOGLUND,PETER L. SMITH, WILLIAM D . LAUTMAN,WILLIAM H. LOMICKA and KPMG LLP ,

Defendants .

DEFENDANT KPMG LLP'S MOTION FOR ENTRY OF JUDGMEN T

Defendant KPMG LLP (`KPMG") moves for entry of judgment under Federa l

Rule of Civil Procedure 58. In support of its motion, KPMG states the following grounds :

In a Minute Order dated June 12 , 2000 (attached as Exhibit A), the Court

dismissed the Third Amended Complaint and terminated the case :

The third amended complaint is dismissed without prejudice to thefiling of an amended complaint on or before 8/4/00. Defendants'motions to dismiss . . . are all granted in part and denied in part .Entered Memorandum Opinion and Order ., terminating caseMailed notice

Also on June 12, 2000, the Court issued companion Memorandum Opinions and Orders on

defendants' motions to dismiss the Third Amended Complaint ("Chu I" and "Chu II") (attached

as Exhibits B and C, respectively). In those opinions, the Court "dismiss[ed] with prejudice all

of the plaintiffs' claims regarding FDA approval of the flush syringe 510(k) application and

Sabratek's revenue recognition practices" ; dismissed with prejudice plaintiffs' claims regarding

research and development expenditures as to certain of the individual defendants ; and denied

certain of the other defendants' - including KPMG's --- motions to dismiss plaintiffs' claims

regarding research and development expenditures. (Chu I, p . 17; Chu II , p. 30.) In a Minute

Order dated July 25, 2000 (attached as Exhibit D), the Court denied plaintiffs' motion to

reconsider its prior order and opinions .

2. In dismissing the Third Amended Complaint, the Court granted plaintiffs

leave to file a Fourth Amended Complaint that conformed to the June 12 opinions if they wished

to do so. (Chu I , p. 20 (`an amended complaint that conforms to this opinion will be due on or

before August 4, 2000") ; Chu II, p . 31 ("The current third amended complaint, (R . 42), is

therefore dismissed without prejudice to filing another amended complaint strictly comporting

with the rulings made in this opinion. This amended complaint is due on or before August 4 ,

2000.") .)

In a Minute Order dated July 12, 2000 (attached as Exhibit E), the Court

extended the time for plaintiffs to file their Fou rth Amended Complaint until September 1, 2000 .

4. Plaintiffs did not file a Fourth Amended Complaint . Instead , on August

31, 2000, plaintiffs filed their Notice of Intention to Stand on Corrected Third Amende d

Complaint, which had been dismissed .

2

r T t\

5 . In their Notice, plaintiffs stated that they "believed" that "they cannot fil e

an amended pleading that `drops' any of the claims that have been dismissed without running th e

risk that those claims would then be deemed waived for purposes of a possible appeal ." (Notice,

p . 3 .) KPMG notes that plaintiffs' "belie[ff " is contrary to the law . In Bastian v. Petren

Resources Corp . , 892 F . 2d 680, 682-83 (7th Cir. 1990), the Seventh Circuit held that , in fi ling an

amended complaint, a party does not waive appellate review of claims that have previously bee n

dismissed. Judge Posner explained: "It is not waiver - it is prudence and economy - for partie s

not to reassert a position that the trial judge has rejected." Id. at 683 . See also Carver v. Condie ,

169 F.3d 469, 472 (7th Cir . 1999) (that the plaintiffs filed an amended complaint "does not mea n

that the plaintiffs - the parties aggrieved by the order of dismissal - could not have complained

about the original order . . . upon an appeal or cross-appeal") ; Badger Pharmacal, Inc . v. Colgate-

Palmolive Co . , 1 F .3d 621, 625 (7th Cir. 1993) ("[b]y amending the complaint, [appellant] di d

not waive any challenge to the district court's dismissal of the misrepresentation claims") . 1

1 Plaintiffs' "belie[f]" is particularly surprising, given this authority and the fact that at least 30Seventh Circuit cases - including one handed down a week before plaintiffs filed their notice -make clear that an "appeal of a final judgment renews all issues previously pleaded and resolvedby the trial court in litigation ." E.g:, Grun v . Pneumo Abex Corp ., 163 F.3d 411, 419 (7th Cir.1998) ; Head v . Chicago Sch. Reform Bd. of Trustees, No. 99-3408, 2000 WL 1206482, at *2(7th Cir . Aug. 25, 2000) (nonfinal orders that dismiss certain counts, but that do "not dispose ofall of [plaintiff sl claims . . . become appealable after a final decision is entered") (attached asExhibit F) . In light of Seventh Circuit authority that is directly on point, plaintiffs' reliance onMarx v . Loral Corp . , 87 F .3d 1049 (9th Cir . 1996) (cited in Notice, p . 2), is wholly misplaced .Moreover, KPMG notes that Marx itself recognizes that the Ninth Circuit's rule that amendmentwaives appellate review of an earlier dismissal - from which the panel was not free to depart -has been criticized "as `formalistic,' `rigid,' and `too mechanical ."' Id. at 1056 . Indeed, far fromproviding an example of the "general rule," as plaintiffs assert, no other Circuit holds thatamendment waives appellate review of an earlier dismissal . See, e g , In re CrysenlMontenayEnergy Co., No. 99-5067, 2000 WL 1218817, *3 (2d Cir . Aug. 29, 2000) (attached as Exhibit G)(rejecting Marx: "We see no reason to require repleading of a claim or defense that explicitlyhas been denied."). Moreover, Marx would not be controlling in this case even in the NinthCircuit, because Marx never suggests that amendment would waive appellate review of claims

6. In any event, however, because plaintiffs have chosen to stand on the

dismissed Third Amended Complaint rather than file a Fourth Amended Complaint, the Cour t

should enter final judgment under Rule 58 . See Murphy v . Walker, 51 F .3d 714, 717 n.3 (7th

Cir. 1995) (where plaintiff failed to submit an amended complaint within time allowed for doing

so, "the dismissal became a final decision") ; Otis v. City of Chicago , 29 F.3d 1159, 1165 (7th

Cir. 1994) (en bane) (where plaintiff failed to satisfy Court's condition for reinstating case after

dismissal, dismissal became "final" and court should have entered judgment under Rule 58) .

7. To the extent plaintiffs believe that, in standing on the Third Amende d

Complaint, they have "kept alive" the claims regarding research and development expenditures,

plaintiffs are incorrect . The Court dismissed the Third Amended Complaint in its entirety and

provided specific instructions: plaintiffs were to file a Fourth Amended Complaint if they

wished to proceed . Because they did not do that, the Court should enter final judgment under

Rule 58. See In re Westinghouse Sec . Litig ., 90 F.3d 696, 703 (3d Cir . 1996) (affirming

dismissal where plaintiffs stood on complaint rather than, as district court had ordered,

submitting an amended complaint "containing only those allegations relevant to what were, in

the court's view, the remaining viable claims") ; see also Reid v. Checkett and Pauly, 197 F .3d

318, 320 (8th Cir. 2000) (affirming dismissal with prejudice where plaintiff decided to "stand on

her pleadings" rather than file an amended complaint in accordance with the court's orders) ;

International Marketing, Ltd . v. Archer-Daniels-Midland Co ., 192 F.3d 724, 733 (7th Cir . 1999)

(where plaintiff "chose to stand on its original complaint" rather than amending, court would not

remand to allow plaintiff to pursue claims that had originally been dismissed without prejudice) .

that had been dismissed with prejudice . See id. at 1052 (earlier complaint dismissed with leaveto amend) .

4

1

WHEREFORE, KPMG respectfully prays that judgment against plaintiffs b e

entered under Rule 58 .

Respectfully submitted ,

One of the Attorneys forDefendant KPMG LLP

William F. LloydFrank B . VankerHille R. SheppardDavid A. GordonSIDLEY & AUSTINBank One Plaza10 South Dearborn StreetChicago, Illinois 60603(312) 853-700 0

Dated : September 15, 2000

5CI-fl 2030859v1

EXHIBIT A

UNITED STATES DISTRICT COURTNORTHERN DISTRICT OF ILLINOIS

Michael. W . DobbinsCLERK

William F . LloydSidley & AustinBank One Plaz a10 South Dearborn StreetChicago, IL 60603

Office of the Cler k

------------------------------------------------------------------------------

Case Number : 1 :99-cv-0035 1

Title : Chu v . Sabratek Corp

Assigned Judge : Honorable Ruben Castillo

MINUTE ORDER of 6/12/00 by Hon . Ruben Castillo : Statushearing set for 9 :45 a .m . on 8/9/00 . The third amendedcomplaint is dismissed without prejudice to the filing ofan amended complaint on or before 8/4/00 . Defendants'motins to dismiss [81-1] , [82-1] , [83-11, [85-1] , [86-11,[87-11, [88-11, [89-11, (90-11, [91-11 and (96-1] are allgranted in part and denied in part . Entered MemorandumOpinion and order ., terminating case Mailed notic e

This docket entry was made by the Clerk on June 13, 200 0

ATTENTION : This notice is being sent pursuant to Rule 77(d) of theFederal Rules of Civil Procedure or Rule 49(c) of the FederalRules of Criminal Procedure . It was generated by ICMS ,the automated docketing system used to maintain the civil andcriminal dockets of this District . If a minute order orother document is enclosed, please refer to it fo radditional information .

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To apply for a PACER account, call 1 .800 .676 .6856

IN TILAJNITED STATES DISTRICT COURTFOR THE NORTHERN DISTRICT OF ILLINOIS

EASTERN DIVISION

DENNIS CHU, AMBASSADOR WINDOWAND DOOR CO . PENSION PLAN ANDTRUST, BRUCE BRAVERMAN, et al .,Individually And On Behalf of All OthersSimilarly Situated,

Plaintiffs,

V .

SABRATEK CORPORATION,K . SHAN PADDA, ANIL K . RASTOGI,STEVEN L . HOLDEN, DORON C. LEVITAS,VINCENT J . CAPPONI, ALAN E. JORDAN,STEPHAN C. BEAL, ELLIOT R . MANDELL,SCOTT P . SKOOGLUND, WILLIAM D .LAUTMAN, WILLIAM H . LOMICKA andKPMG LLP,

Defendants .

No. 99 C 035 1

Judge Ruben Castillo

MEMORANDUM OPINION AND ORDE R

Plaintiff Dennis Chu, on behalf of himself and all purchasers of the publicly traded

securities of Sabratek Corporation ("Sabratek") between the period of February 25, 1997 an d

October 6, 1999, seeks remedies under § 10(b) of the Securities Exchange Act of 1934

("Exchange Act") and Rule I Ob-5 .' The plaintiffs contend that Defendant KPMG, LLP

("KPMG") knowingly or recklessly misrepresented material facts in connection with th e

' Today, we issue two opinions resolving numerous motions to dismiss . Here we decideKMPG' s motion to dismiss, ("Chu P') ; in the second opinion we decide the individualdefendants ' motions to dismiss ("Chu II") . Additionally, the plaintiffs have filed a motion forclass certi fication, which has yet to be fully briefed . We refer to the putative plaintiff class as"the plaintiffs" throughout this opinion without expressing any conclusion about the prop riety ofcertifying that putative class .

purchase of Sabratek securiti~, .,vy ce rt ifying that Sabratek 's 1997 and 1998 firs-_/ial reports had

been prepared in conformity with Generally Accepted Accounting P rinciples ("GAAP") and that

it had audited Sabratek' s financial statements in accordance with Generally Accepted Accountin g

Standards ("GAAS") . KPMG filed a motion to dismiss the plaintiffs ' Third Amended Complaint

("complaint"), (R . 42-1), arguing that the plaintiffs have failed to comply with the heightene d

pleading requirements of Rule 9(b) of the Federal Rules of Civil Procedures and the Privat e

Securities Litigation Reform Act of 1995 ("PSLRA"), 15 U.S .C. § 78u-4 (b). We agree wit h

KPMG that the plaintiffs have failed to allege facts which give rise to a strong inference tha t

KPMG either knew or recklessly disregarded Sabratek ' s improper revenue recognition practices .

The plaintiffs have, however, alleged sufficient facts to show that KPMG either knowingly or

recklessly made a material misstatement when it certified approximately $39 million o f

Sabratek 's expenses as int angible assets in violation of GAAP and GAAS. Therefore, we grant

in part and deny in part KPMG' s motion to dismiss .

FACTS

For purposes of a motion to dismiss , this Court accepts as true all well-pleade d

allegations in the complaint and draws all reasonable inferences in favor of the plaintiffs. See

Travel All Over the World, Inc. v. Kingdom of Saudi Arabia, 73 F .3d 1423, 1429 (7th Cir . 1996) .

In accordance with this standard, we recite the facts relevant to KPMG 's motion .

Sabratek Corporation ("Sabratek") incorporated in 1990 with the strategic goal o f

becoming a comprehensive solution provider to the alternative healthcare market . In particular,

Sabratek sought to create a so-called "virtual hospital room" that would enable healthcar e

providers to treat and monitor patients in alternate care facilities . Sabratek's products, whic h

Page 2

include infusion pumps for thedelivery of therapeutic agents and diagnostic anL,i formatio n

systems for patient monitoring, allow healthcare providers to treat high-acuity patients in suc h

places as long-term care facilities, outpatient centers, and patients' homes . With Sabratek' s

products, healthcare providers can reduce operating costs while improving the delivery and

quality of care . (Compl . at 111, 24, 43 .) Since going public in June 1996, Sabratek common

stock experienced dramatic increases in price . At its highest point during the putative class

period, Sabratek common stock reached the price of $38 .75 per share. (Compl. at 11 2, 45 . )

In the meantime, the plaintiffs contend that Sabratek' s business was expe riencing a

number of material adverse problems . Although Sabratek repeatedly touted the benefits of it s

product line, Sabratek experienced significant safety and compliance problems . At all material

times prior to and during the putative class period, Sabratek manufactured its line of Rocap flush

syringes without Food and Drug Administration ("FDA") approvals . (Compl. at ¶ 46.) Sabratek

also began to lose its customer base and experienced a growing level of customer complaint s

about the quality of its products . (Id.) The net effect of these problems was that Sabratek' s

supply of unsold products, specifically its infusion pumps, increased to "damagingly hig h

levels." (Compl. at 15 .) In light of these and other problems, Sabratek began to lose market

share to its competitors .

The plaintiffs allege that starting no later than February 25, 1997, the defendants ,

including KPMG, engaged in an elaborate accounting scheme to conceal Sabratek's declining

sales and other profit-related problems. KPMG was the consultant and auditor who certified

Sabratek's 1997 and 1998 annual financial statements, which were filed with the SEC and

disseminated to the public. The plaintiffs allege, inter alia, that Sabratek engaged (and KPMG

Page 3

acquiesced) in numerous impLe~r revenue- in flating and expense-de flating pra~ s in violatio n

of GAAP. Sabratek ' s improper practices included : ( 1) recognizing revenue on "phony sales" o f

products to entities that had not ordered Sabratek products ; (2) recognizing revenue o n

"inventory parking arrangements"; (3) booking revenue on "consignment sales " where no bon a

fide purchase had been made ; (4) backdating invoices for premature revenue recognition ; (5 )

concealing substantial credits, discounts, and/or rebates offered to distributors ; and (6) payin g

itself "consulting fees" for fictitious consulting services where no money ever exchanged hand s

and no invoices were ever generated . (Compl . at 116, 48-51 . )

In addition, the plaintiffs allege that Sabratek, with the approval of KPMG, structure d

various fraudulent transactions with four entities : Unitron Medical Communications, Inc .

("Unitron"), GDS Technology, Inc . ("GDS"), Healthmagic, Inc. ("Magic"), and Collaborations

in Healthcare, LLC ("Healthcare") . Through their transactions with Unitron, GDS, Magic, an d

Healthcare (collectively "R&D Satellite Entities"), Sabratek reported approximately $39 millio n

of cash disbursements and research expenses as licensing deals, loans, and other "intangibl e

assets ."2 (Compl . at ¶ 53 .)

Sabratek's improper accounting practices artificially depressed Sabratek's expenses and

inflated its reported revenues , income, and earnings per share . Sabratek reported its inflated

figures on its quarterly and annual financial forms, which received positive market feedback .

But on October 7, 1999, after delaying its second qua rter financial statements by two months,

Sabratek announced that its previously reported earnings, as reflected in its 1997 and 199 8

I Sabratek paid Unitron $18 .5 million, GDS $10 .4 million, Magic $10 million, and CIH$2.7 million throughout the putative class period .

Page 4

7 a 7

financial statements , had bee t'erstated by approximately $39 million . Sabr also

announced that its board was considering certain unspecified "other accounting issues" that ha d

been raised by Sabratek 's CFO . Sabratek ' s closing stock price of $1 .03 per share on October 7 ,

1999 represented a dramatic decline of more than 97% from its class period high of $38 .75 pe r

share in September 1997 . (Compl. at ¶j 13, 164 .) On November 17, 1999 the plaintiffs filed thi s

complaint , (R. 42) .

STANDARD OF REVIEW

KPMG's motion to, dismiss the plaintiffs ' securities fraud complaint implicates the

Federal Rules of Civil Procedure 12(b)(6) and 9 (b) as well as the PSLRA. Under Rule 12(b)(6),

we will dismiss a complaint for failure to state a claim only if "it appears beyond doubt that th e

plaintiff can prove no set of facts in support of his claim which would entitle him to relief ." See

Maple Lanes, Inc. v. Messer, 186 F .3d 823, 824-25 (7th Cir. 1999) (quoting Conley v. Gibson ,

355 U.S . 41, 45-46 (1957)) . On a motion to dismiss , this Court draws all inferences and resolves

all ambiguities in favor of the plaintiffs and assumes that all well-pleaded facts are true . See

Long v. Shorebank Dev. Corp., 182 F .3d 548 , 554 (7th Cir . 1999) (citation omi tted).

Rule 9(b) requires plaintiffs to plead "the circumstances constituting fraud . . . with

particularity ." In re Healthcare Compare Corp. Sec. Litig., 75 F .3d 276, 281 (7th Cir. 1996) .

"This means the who, what, when, where, and how : the first paragraph of any newspaper story ."

DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th Cir . 1990) . As a policy matter, the heightened

pleading requirements under Rule 9(b) serves three main purposes : "to protect defendants'

reputations, to prevent fishing expeditions, and to provide adequate notice to defendants of th e

Page 5

claims against them ." Fugma Aprogenex, 961 F. Supp . 1190, 1194 (N .D. I11. 97) (citing

Vicom, Inc. v. Harbridge Merchant Servs., Inc., 20 F .3d 771, 777 (7th Cir . 1994)) .

In addition to the Rule 9(b) requirement, the PSLRA amendments to the Exchange Ac t

raise the pleading standards in securities fraud cases, requiring the plaintiffs to "state wit h

particularity facts giving rise to a strong inference that the defendant acted with the required stat e

of mind." 15 U.S.C. § 78u-4(b)(2). The PSLRA also requires the plaintiffs to "specify eac h

statement alleged to have been misleading , [and] the reason or reasons why the statement i s

misleading ." 15 U.S.C. § 78-4(b)(1) .

With these standards in mind, this Courts takes as true all well-pleaded facts of th e

complaint, but we will dismiss the claim if it fails to satisfy the heightened pleading requirement s

of Rule 9(b) or the PSLRA.

ANALYSIS

KPMG moves to dismiss the plaintiffs' complaint for a failure to state a securities frau d

claim under the heightened pleading requirements of Rule 9(b) and the PSLRA . (Mot. to

Dismiss at 2 .) The Seventh Circuit has explained that in order to state a claim under § 10(b) of

the Exchange Act, a plaintiff must allege that "the defendant (1) made a misstatement or

omission, (2) of material fact, (3) with scienter, (4) in connection with the purchase or sale o f

securities, (5) upon which plaintiff has relied and (6) that reliance proximately caused plaintiff s

injuries." In re HealthCare Compare, 75 F.3d at 280. KPMG argues that the plaintiffs have

failed to plead with particularity that KPMG made a misstatement of material fact . ; KPMG also

3 Although the plaintiffs devote much of the complaint to Sabratek's FDA regulatoryproblems regarding its Rocap division, the plaintiffs do not allege that Sabratek's financia l

Page 6

~ . r

asserts that the plaintiffs haveiled to allege facts which give rise to a strong iL ence that i t

acted with the requisite state of mind.

1. KPMG' s Misleading Statements of Material Fact

KPMG first contends that the plaintiffs' allegations concerning Sabratek's allegedl y

improper financial statements do not establish that KPMG made a misstatement of material fact .

In particular, KPMG argues that the plaintiffs have failed to plead with particularity "what" wa s

materially misstated in the financial statements, "why" its audit reports were misleading, an d

"how" the financial statements and KPMG's audit of those statements violated GAAP and

GAAS. See DiLeo, 901 F.2d at 627. As a threshold matter , under § 10(b) the plaintiffs mus t

sufficiently allege that KPMG either made a false statement of mate rial fact or omitted a mate rial

fact that rendered an affirmative statement misleading . See Searles v. Glasser, 64 F.3d 1061 ,

1065 (7th Cir. 1995) . A misstatement or omission is material if there was a "substantial

likelihood that disclosure of the omitted fact would have been viewed by a reasonable investor a s

having signi ficantly altered the `total mix' of information available ." TSC Indus., Inc. v.

Northway, Inc., 426 U . S. 438 , 449 (1976) . Financial statements filed with the SEC that do no t

conform to the requirements of GAAP are presumptively misleading and inaccurate pursuant t o

SEC regulation . See 17 C.F.R. 210.4-01 (a)(1) . Without a "misstatement of material fact," we

will dismiss a § 10(b) complaint .

statements were materially affected by these problems. Thus, for the purposes of KPMG'smotion to dismiss, we limit our inquiry to the plaintiffs' allegations regarding Sabratek'simproper revenue recognition practices and transactions with the R&D Satellite Entities .

Page 7

After examining the pl.tiffs' allegations, we find unpersuasive KPMG rguments tha t

the plaintiffs have failed to plead with particularity "what," "why," or "how" KPMG' s

certifications of Sabratek' s financial statements were material misstatements . Under the Rule

9(b) and PSLRA pleading requirements, the plaintiffs must with particularity "specify eac h

statement alleged to have been misleading " and "the reason or reasons why the statement i s

misleading ." The complaint specifies that each of KPMG's 1997 and 1998 audit reports wa s

false in that KPMG stated that it had conducted Sabratek's audits in conformity with GAAS an d

that, in its opinion , Sabratek's 1997 and 1998 financial statements were fairly presented, in al l

material aspects, in accordance with GAAP. The complaint also su fficiently states the reasons

the financial statements contained materially misleading statements : the financial statements

misrepresented Sabratek's true earnings by recognizing revenue on "phony sales" and

erroneously classifying $39 million in expenses as intangible assets .

A. KPMG's Certifications Regarding Sabratek's Inflated Earn ings

We first note, but reject , KPMG's argument that the plaintiffs have failed to specify how

its certified financial statements and audit reports violated GAAP and GAAS. KPMG contends,

for example, that there is nothing inherently wrong about Sabratek's so-called "revenu e

in flating" practices . (Mot. to Dismiss at 5). KPMG correctly notes that "there is nothin g

inherently improper in pressing for sales to be made earlier than in the normal course [of

business]," even if doing so is "likely to the detriment of earnings in later quarters ." Greebel v.

FTP Software, Inc., 194 F .3d 185, 202 (1st Cir . 1999) . We agree with KPMG that GAAP doe s

provide for some flexibility in the timing of revenue recognition .

Page 8

However, drawing all ke2sonable inferences in favor of the plaintiffs, w& Aieve that the y

have sufficiently alleged that Sabratek ' s revenue recognition practices violated GAAP . In the

complaint , the plaintiffs point to'several instances when Sabratek, in violation of GAAP,

recognized revenue on transactions even though collection was not reasonably assured . (Compl .

at ¶ 183 .) In December 1997, Sabratek induced Medical Specialties, Inc . to receive $1 .2 million

worth of Sabratek pumps by promising that it could return the pumps at the end of 1998 for ful l

credit . In March 1998, Sabratek shipped almost $1 million worth of inventory to Tacy Medica l

of Fernandina Beach, Florida, even though Tacy Medical had never ordered or previously

distributed the products . (Compi. at ¶ 48.) Also in 1998, Sabratek induced Coram to receive $ 1

to $1 .5 million worth of excess invento ry for which Coram had no current dem and . (Id.)

Another such company; Amtec , received "so many [unordered] excess Sabratek pumps that they

used them as impromptu workspace dividers ." (Id.) These allegations, if true, would show that

Sabratek materially inflated repo rted revenues in violation of GAAP . 4

As the complaint stands, the plaintiffs have specified "each statement alleged to hav e

been misleading" (that Sabratek's 1997 and 1998 financial statements were in accordance wit h

4 See Cooper v. Pickett, 137 F.3d 616, 626-27 (9th Cir. 1997) (a company that"overstates its revenues by reporting consignment transactions as sales . . . makef s] false ormisleading statements of material facts") ; Malone v. Microdyne Corp., 26 F.3d 471, 478 (4th Cir.1994) ("We cannot fi nd a single precedent . . . holding that a company may . . . substantiallyoverstate its revenue by reporting consignment transactions as sales without running afoul ofRule 10b-5"} ; Sirota v. Solitron Devices, Inc., 673 F.2d 566, 572-76 (2d Cir. 1982) (reportingconsignment transactions as sales violates GAAP and § 10(b)) ; Danis v. USN Communications,Inc., 73 F. Supp.2d 923, 935 (N.D. Ill . 1999) (holding that recognition of revenue on fictitioussales violates GAAP and § 10(b)) ; Bell v. Fore Sys., Inc., 17 F. Supp.2d 433, 440 (W.D. Pa .1998) (concluding that claims that defendant engaged in "inventory parking" arrangementsadequately alleged violation of both GAAP and § 10(b)) .

Page 9

Z

GAAP) and "the reason or re L. s why the statement is misleading" (Sabratek t )gnized false

revenue in violation of GAAP) . Although we agree with KPMG that the plaintiffs have failed to

allege several details regarding Sabratek's allegedly improper revenue recognition practices, suc h

as the dollar amounts by which Sabratek's financial statements have been misstated as a result of

these transactions, the plaintiffs have alleged sufficient facts to meet their burden at this stage in

the litigation. See, e.g., Danis, 73 F. Supp.2d at 935, n.6 ("Plaintiffs need not state the amoun t

by which USN's financial statements were in error .") ; In re First Merchants Acceptance Corp.

Sec. Litig., No. 97 C 2715, .1998 WL 781118, at *8-9 (N.D. Ill . Nov. 4, 1998) (agreeing that Rule

9(b) does not require the plaintiffs to describe the precise amount of overstatement) . Having

satisfied the Rule 9(b) and the PSLRA 's pleading requirements , the plaintiffs need not allege

such additional details to survive a motion to dismiss .

B. KPMG's Cer tifications Regarding Sabratek 's Transactions with theResearch and Development Satellite Entities

Similarly, the plaintiffs adequately allege that KPMG made a "misstatement of material

fact" in that KPMG erroneously certified that Sabratek "fairly presented" approximately $3 9

million dollars in expenses as intangible assets . GAAP requires research and development cost s

to be treated as "expenses" and precludes capitalizing the value of a purported "asset" unless i t

has a probable future economic benefit. (Compl. at ¶¶ 176-83 .) Although the plaintiffs have no t

specified the exact manner by which Sabratek structured its deals, the lack of that detail is no t

fatal to meet the "material misstatement " element of the § 10(b) claim. As it stands, the plaintiffs

have specified that Sabratek either never acquired any licensing rights for the money it paid or

that the licensing rights it did receive were for products that were still in development . Under

Page 10

either scenario , the plaintiffs e alleged which po rt ions of Sabratek ' s financia . tements were

overstated (the intangible assets) and which portions were understated (the research and

development related expenses ) in violation of GAAP. See, e.g., Danis, 73 F . Supp .2d at 935 .

"This is sufficient to permit defendants to prepare a defense to the allegation ." Id. The plaintiffs

not only identify each of the R&D Satellite Entities and the nature of each suspected transaction ,

but also plead the dollar amounts of each cash disbursement, the aggregate dollar amount b y

which Sabratek's assets were correspondingly misstated, and the dates of each of the allege d

"loans" and "licensing" transactions . (Compl. at ¶ 55 . )

Having concluded that the plaintiffs have adequately alleged that KPMG "made a

misstatement of material fact," we inquire as to whether the plaintiffs have alleged "facts whic h

give rise to a strong inference" that KPMG acted with the requisite intent .

II. KPMG's Scienter

KPMG contends that the plaintiffs' claim must fail because the facts alleged do no t

support a fording of "a strong inference" of scienter . Scienter, as applied to securities fraud

claims, refers to a mental state embracing the intent to deceive , manipulate or defraud . See Ernst

& Ernst v. Hochfelder, 425 U.S . 185, 193 n .12 (1976) . The Seventh Circuit has long since

interpreted Hochfelder as establishing that "reckless disregard for the truth counts as intent" fo r

the purpose of the § 10(b) scienter requirement . SEC v. Jakubowski, 150 F .3d 675, 681 (7th Cir .

1998) (citing Sundstrand Corp. v. Sun Chem . Corp., 553 F .2d 1033, 1044-45(1977)) .

Page 11

EXHIBIT B

The PSLRA amendm. ._.,s did not change the substantive provision of t .xchange Act' s

scienter requirement .' Every court in this district that has construed the scienter requiremen t

after the PSLRA has concluded that allegations of recklessness continue to be sufficient to state a

claim under § 10(b) . See , e.g., In re System Software Assocs., Inc., No . 97 C 177, 2000 WL

283099 , * 14 (N.D. Ill . Mar . 8, 2000 ) ; Danis, 73 F . Supp . 2d at 937-38 ; In re Spyglass Inc. Sec.

Litig., No. 99 C 512, 1999 WL 543197, at *7 (N .D. Ill . July 21, 1999) . At a minimum ,

recklessness requires "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 know n

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) . As applied to outside auditors ,

recklessness means that "the accounting firm practices amounted to no audit at all, or to a n

egregious refusal to see the obvious, or to investigate the doubtful, or that the accountin g

judgments which were made were such that no reasonable accountant would have made the sam e

decisions if confronted with the same facts ." In re First Merchants, 1998 WL 781118, at * 1 0

(N.D. 111 . Nov . 4, 1998) (citing SEC v. Price Waterhouse , 797 F . Supp . 1217, 1240 (S .D.N.Y .

1992)) ; see also Rehm, 954 F. Supp. at 1255 .

While not changing the substantive requirements , the PSLRA did heighten the pleading

requirements of the Exchange Act's scienter requirement . A post-PSLRA securities fraud

plaintiff must "state with particularity facts giving rise to a strong inference that the defendan t

5 See Greebel, 194 F .3d at 199-200 ; Phillips v. LCIInt'l, Inc., 190 F .3d 609 (4th Cir .1999) ; Bryant v. Avado Brands, Inc., 187 F.3d 1271 (11th Cir. 1999) ; In re Comshare, Inc. Sec.Litig., 183 F.3d 542, 552-53 (6th Cir. 1999) ; In re Advanta Corp. Sec. Litig., 180 F .3d 525, 534(3d Cir. 1999) ; Press v. Chemical Inv. Servs. Corp., 166 F .3d 529, 537-38 (2d Cir . 1999) .

Page 12

acted with the required state ot` iind." 15 U .S .C. § 78-4(b)(2) . The PSLRA doL--tot elaborat e

on what facts or factual situations will give rise to "a strong inference" of intent, and the Sevent h

Circuit has not yet addressed the PSLRA pleading standard . As a threshold matter , this Court

notes that the language of the PSLRA imposes a stricter pleading standard th an that imposed by

Rule 9(b). The Rule 9 (b) standard required securities fraud plaintiffs to allege facts an d

circumstances which gave rise to "a basis for believing that plaintiffs could prove scienter . "

DiLeo, 901 F.2d at 628-29 . Under the PSLRA , securities fraud plaintiffs must al lege facts tha t

afford "a strong inference" for believing that plaintiffs could prove scienter .

As to the particular contours of the factual pleading requirements, there is remarkable

discord among the Circuit Courts .' Several courts in this district have characterized the PSLRA

as effectively codifying the standard employed by the Second Circuit. Danis , 73 F. Supp.2d at

936-37 (N.D. 111 . 1999) (quoting O 'Brien Nat'! Property Analysts Partners, 936 F.2d 674, 676 (2 d

Cir. 1991)) ; In re First Merchants, 1998 WL 781118, at *9. Under the Second Circuit's pleading

requirements, a plaintiff may allege scienter by either (1) showing that the defendants had bot h

the motive and opportunity to commit fraud or (2) establishing strong circumstantial evidence of

conscious behavior or recklessness . See, e.g., Press v. Chemical Inv. Servs. Corp., 166 F .3d 529,

538(2 d Cir. 1999) .

6 Circuit Courts have interpreted the pleading standard under the PSLRA to varyingdegrees of stringency . Compare In re Advanta Corp Sec . Litig., I80 F.3d at 533 (3rd Cir .)(PSLRA "establishes a pleading standard approximately equal in stringency to that of the Secon dCircuit"), with Bryant, 187 F .3d at 1282 (11th Cir .) (PSLRA does not codify the "motive andopportunity" test formulated by the Second Circuit for pleading scienter), and with In re SiliconGraphics Inc. Sec. Litig., 183 F.3d 970, 974 (9th Cir. 1999) ("mere motive and opportunity" isnever enough to establish scienter) .

Page 13

Although this Court L4s the Second Circuit' s standard instructive , wE to that the

PSLRA's only requirement is that the facts alleged must give rise to a "strong inference" of the

defendant's scienter . The types of facts with which a plaintiff pleads scienter factor little into our

analysis, as long the overall facts give rise to a "a strong inference" of scienter . Thus, a plaintiff

may use "motive and opportunity" or "circumstantial evidence" to establish scienter under th e

PSLRA, as long as those facts support a strong inference "that the defendant acted recklessly o r

knowingly ." See Danis, 73 F. Supp.2d at 927 (quoting In re Comshare, Inc. Sec. Litig., 183 F .3d

at 551) .

A. KPMG's Scienter Regarding Sabratek' s Inflated Earnings

KPMG correctly points out what is not enough to raise a s trong inference of scienter. A

company' s overstatement of earnings, revenues , or assets in violation of GAAP does not itself

establish scienter . See, e .g., Lovelace v. Software Spectrum Inc., 78 F .3d I015, 1020-21 (5th Cir .

1996) ; In re Software Toolworks, 50 F.3d 615, 627-28 (9th Cir. 1994) ; Malone v. Microdyne

Corp., 26 F.3d 471, 479 (4th Cir . 1994) ; Health Management , 970 F . Supp. at 203 ; Rehm, 954 F .

Supp. at 1256 . In securities fraud cases, a plaintiff may not simply allege "fraud by hindsight" o r

point to the "before" and the "after" to show that the defendants must have intended to defrau d

them . See DiLeo, 901 F.2d at 628 (citation omitted). Thus, although plaintiffs have sufficientl y

alleged that KPMG made material misrepresentations , the plaintiffs still face a much tougher

burden of alleging facts that give rise to a strong inference that KPMG made those

misrepresentations with knowledge or reckless disregard of the truth .

As to KPMG 's misstatements about Sabratek ' s inflated earnings, we conclude that the

plaintiffs have not met their pleading requirements . In fact, the plaintiffs do not allege any fact s

Page 14

beyond the simple fact of Sah ek's GAAP violations to show that KPMG cert. Sabratek' s

financial statements with the requisite intent . Thus, Sabratek's allegedly improper revenu e

recognition practices cannot give rise to a strong inference that, in rendering its opinion on

Sabratek's financial statements , KPMG acted with fraudulent intent.

B. KPMG's Scienter Regarding Sabratek ' s Transactions with the R&D SatelliteEntities

The plaintiffs have, however, alleged specific facts which give rise to a strong inferenc e

that KPMG either part icipated in, knew about , or deliberately ignored numerous warning signs o f

Sabratek's financial misstatements with the R&D Satellite Companies . Although violations of

GAAP generally are not sufficient standing alone to establish scienter, "when combined with

other circumstances suggesting fraudulent intent, allegations of improper accounting ma y

support a strong inference of scienter ." Marksman Partners , L.P. v. Chantal Pharm . Corp., 927

F. Supp. 1297,1313 (C .D. Cal . 1996) ; Danis, 73 F. Supp.2d at 941-42 . Allegations of obvious

"red flags" or warning signs that financial reports are misstated, as well as the magnitude of th e

fraud alleged, can give rise to a strong inference of fraudulent intent . Miller, 9 F. Supp .2d at 928

(deliberately igno ring "red flags" such as the rapid and unexplained increase in the cost per

pound of carried inventory "can constitute the sort of recklessness necessary to support § 10(b )

liability") ; Rehm, 954 F . Supp . at 1256 ("[t]he more serious the error, the less believable are

defendants' protests that they were completely unaware of [the Company's] true financial statu s

and the stronger the inference that defendants must have known about the discrepancy") ; In re

Health Management, 970 F . Supp. at 203 (finding that allegations of accounting firm's ignorance

of red flags presented evidence of fraudulent intent).

Page 15

The plaintiffs have s`t d sufficient facts to raise a strong inference th&4, 2-MG either

knew about or recklessly disregarded information about Sabratek' s mate rial misstatements with

regard to research and development expenditures. In March 1999, K . Shan Padda ("Padda") ,

Sabratek's CEO and Chairman of the Board during the class pe riod, told one of Sabratek' s

shareholders that Sabratek and KPMG had developed a "brilliant strategy" to fund Sabratek' s

research and development costs "off the balance sheet " by transferring its expenses to Unitron ,

GDS, and Magic as licensing or loan agreements . Padda explained to the shareholder tha t

Sabratek and KPMG had structured these deals so that the later impact of eliminating any fals e

assets from its books would be offset by the benefits of earnings from the finished products .

(Compl. at 1188(a).) Similarly, Padda represented to other Sabratek shareholders that KPMG

worked as a paid consultant on the Unitron and GDS licensing agreements and that KPMG' s

consulting advice in connection with those transactions was the cause of the $39 million i n

accounting restatement announced on October 7, 1999.

Moreover, according to a former Unitron employee familiar with the events that led up t o

the signing of the "licensing agreement" between Unitron and Sabratek, Sabratek informe d

Unitron during the negotiations that it would not do the deal "until its auditors [KPMG] signe d

off on it ." Steven Holden, Sabratek 's CFO at the time , told Unitron management during

negotiations that any agreement would be submitted to KPMG for its review, and that Sabrate k

"couldn't do the deal as a licensing agreement until its auditors said it was kosher ." Holden

thereafter informed Unitron that KPMG had in fact "signed off' on the deal . (Compl. at

¶ 188(c) .)

Page 16

The plaintiffs also poii,_,6 other factors that would have caused all but t ,,_fnost reckles s

auditor to subject these transactions to heightened scrutiny . When Sabratek signed the licensin g

agreements with Unitron and GDS, the $7 million Unitron deal and the $4 million GDS dea l

represented an overall 242% increase in Sabratek' s reported intangible assets . The decision no t

to expense these deals as research and development expenses effectively saved Sabratek' s

reported net income of $7 .2 million for 1997. (Comps. at ¶ I89(a).) Yet, Unitron was a

developmental stage company with no marketable products and virtually no customers .

Unitron's only major product , the MOON network system , was only just entering the testing

phase and was at least 18 months away from entering the market . (Compl . at 1189(b) . )

The magnitude of the fraud alleged combined with the allegation that KPMG participated

in structuring the suspect deals suggests a deliberate ignorance or perhaps even knowledge on th e

part of KPMG. In so concluding , we emphasize that this is still the pleading stage of the case .

Our decision today expresses no opinion as to the truth of the allegations or the plainti ffs' ability

to produce evidence establishing the facts as alleged . But, with respect to the plaintiffs' clai m

that KPMG fraudulently certified Sabratek 's financial statements about its intangible assets, th e

allegations are sufficient to withstand KPMG's motion to dismiss.

Ill. Reliance of Sabratek Convertible Note Holders

KPMG finally argues that claims by the Sabratek convertible note purchasers should b e

dismissed for failure to allege the essential element ofreliance . As KPMG contends, some form

of reliance or causal nexus is an essential element of a § 10(b) cause of action . See Basic v.

Levinson, 485 U.S. at 489 ; Rowe v. Maremont Corp., 850 F .2d 1226, 1233 (7th Cir . 1988) .

Without allegations of some causal connection between the defendant's material misstatemen t

Page 17

and the plaintiff's injury, th~intiffs cannot su rv ive a motion to dismiss . In' , absence o f

actual reliance, however, "an alternative method of establishing causation -- an effect on th e

market price" may support recovery by plaintiffs who never actually read or relied on th e

defendant' s alleged misstatements . See Eckstein v . Balcor Film Investors, 8 F.3d 1121, 112 9

(7th Cir . 1993) .

In addressing KPMG's arguments, we first conclude that the plaintiffs have sufficientl y

pleaded actual reliance on KPMG' s misstatements . (Reply at 3 .) Although the plaintiffs do no t

explicitly state that they "received or read KPMG's audit reports," (Reply at 7), the plaintiffs d o

specify that they relied "directly or indirectly on the false and misleading statements made by

[KPMG]" and that because of KPMG's misstatements , the plaintiffs "acquired Sabratek' s

securities . . . at artificially high prices and were damaged thereby ." (Compl . at ¶ 212 .) The

plaintiffs allege that they were ignorant of the falsity of KPMG's statements and that they had

erroneously believed them to be true . (Compl . at ¶ 213 .) Had the plaintiffs known Sabratek' s

true financial conditions, which KPMG misstated , they "would not have purchased or otherwis e

acquired their Sabratek securities ." (Id.) These allegations are sufficient to withstand KPMG' s

motion to dismiss .

Further, contrary to KPMG's contentions, the plaintiffs have pleaded sufficient facts t o

establish a rebuttable presumption of reliance based on the fraud -on-the-market theory. KPMG

contends that because the plaintiffs have not pleaded that an efficient market exists for Sabratek

convertible notes, the plaintiffs are not entitled to a presumption of reliance under the fraud-on-

the-market theory . (Mot. to Dismiss at 18) . As explained by the Supreme Court ,

Page 18

The fraud on the mark theory is based on the hypothesis that, in an ope . nd developedsecurities market , the p rice of a company 's stock is determined by the available materialinformation regarding the comp any and its business . . . . Misleading statements willtherefore defraud purchasers of stock even if the purchasers do not directly rely on themisstatements . . . . The causal connection between the defend ants' fraud and theplaintiffs' purchase of stock in such a c ase is no less significant than in a case of directreliance on misrepresentations .

Basic Inc. v. Levinson, 485 U.S . 224, 241-42 ( 1988) (citation omi tted) .

The plaintiffs argue , and KPMG concedes , that "the question on a motion to dismiss is

not whether [the] plaintiff has proved an efficient market, but whether he has pleaded one, "

Hayes v. Gross, 982 F .2d 104, 107 (3d Cir . 1992) (emphasis added) . KPMG correctly notes that

the complaint does not specifically allege that Sabratek convertible notes were traded in a n

"efficient market." (Mot. to Dismiss at 19 .) The complaint does state, however, that the note s

were convertible into Sabratek common stock, presumably at the will of the note holder, at a

specified dollar amount . (Compl . at' 100.) The plaintiffs also explicitly detail the existence of

an efficient market for Sabratek common stock . (Compl. at % 201-02.) From these allegations ,

the Court may infer the existence of an efficient market for Sabratek's convertible notes .

Millions of shares of Sabratek common stock were traded on the Nasdaq National Exchange, an d

Sabratek was followed by several securities analysts employed by major brokerage firms .

Inasmuch as there existed an efficient market for Sabratek common stock, this Court als o

concludes that an efficient market existed for Sabratek convertible notes, which were convertibl e

to Sabratek common stock .

Therefore , we conclude that Sabratek convertible note purchasers have sufficientl y

alleged reliance and deny KPMG' s motion to dismiss their claim .

Page 19

1-- i CONCLUSION

KPMG 's motion to dismiss the plaintiffs' complaint , (R. 96- 1), is granted in part and

denied in part as indicated herein . As explained in Chu II, an amended complaint that conforms

to this opinion will be due on or before August 4, 2000 .

A status hearing will be held in open court on August 9, 2000 at 9 :45 a.m.

Entered :

Date: June 12, 2000

udge Ruben C a s t i I I oUnited States District Court

Page 20

EXHIBIT C

IN THE UNITED STATES DISTRICT COURTFOR THE NORTHERN DISTRICT OF ILLINOIS

EASTERN DIVISION

DENNIS CHU, AMBASSADOR WINDOWAND DOOR COMPANY PENSION PLANAND TRUST, and BRUCE BRAVERMAN,et al ., individually and on behalf of all otherssimilarly situated,

Plaintiffs ,

V .

SABRATEK CORPORATION, K . SHANPADDA, ANIL K. RASTOGI, STEVEN L .HOLDEN, DORON C. LEVITAS, VINCENTJ. CAPPONI, ALAN E . JORDAN, STEPHANC . BEAL, ELLIOT R . MANDELL, SCOTT P .SKOOGLUND, WILLIAM C . LAUTMAN,WILLIAM H. LOMICKA, and KPMG LLP ,

Defendants .

No. 99 C 35 1

Judge Ruben Castill o

MEMORANDUM OPINION AND ORDE R

Today we issue two opinions resolving various motions to dismiss this securities fraud

lawsuit . The first opinion denies in part and grants in part Defendant KPMG's motion to dismiss

the claims against it, ("Chu P') . In this opinion, ("Chu IP'), we resolve motions to dismiss by

each of the remaining individual defendants .' (R. 81-1 (Levitas' motion), 82-1 (Lautman and

Lomicka's joint motion), 83-1 (Holden's motion), 85-1 (Padda's motion), 86-1 (Skooglund's

motion), 87-1 (Mandell's motion), 88-1 (Capponi's motion), 89-1 (Jordan's motion), 90-1

(Beal's motion), and 91-1 (Rastogi's motion) .) The individual defendants were all officers or

' Two of the originally named defendants , Peter L . Smith and Stephen L. Axel, weredismissed without prejudice at the behest of the pa rties. (See R. 102, Order of Feb . 29, 2000(dismissing Smith) ; R. 109, Order of Mar . 21, 2000 (dismissing Axel) .)

directors of Sabratek Corporation, a company that manufactured and sold medical supplies fo r

home health care services and that is currently engaged in bankruptcy proceedings . '

The plaintiffs' allege three violations of § 10(b) of the Secu rities Exchange Act of 1934 ,

15 U .S.C . § 78j(b), and SEC Rule 10b-5, 17 C . F .R. § 240 . 10b-5, against the individual

defendants both directly and pursuant to a theory of control person liability, 15 U .S.C . § 78t(a) .

The plaintiffs claim that the individual defendants made false statements regarding imminent

FDA approval of Sabratek's IV flush syringe product line ; improperly declared research and

development expenditures as "intangible assets" ; and artificially inflated the company's reporte d

income from infusion pump sales by various "channel stuffing" activities . According to th e

complaint, Sabratek stock prices sky-rocketed as a result of these false statements and the clas s

members were harmed by purchasing the stock at artificially high prices .

The individual defendants maintain that the complaint - actually the third amende d

complaint, (R. 42) - fails to state any claims against them because (1) all of Sabratek' s

statements regarding FDA approval of the flush syringes fall within the Act's safe harbour

provision for forward- looking statements and (2) the complaint does not allege scienter with

sufficient particularity against any individual defendant on the accounting claiins .4 Additionally ,

Z For this reason, the case against Sabratek is stayed pursuant to the automatic stayprovisions of the United States Bankruptcy Code, 11 U .S .C . § 362 . (See R. 68, Order of Jan. 12,2000.)

3 We have not yet received full briefing on the plaintiffs' motion for class certificationand, thus, have not decided whether this lawsuit is properly brought as a class action .

a Regarding claims by holders of Sabratek convertible notes, the individual defendantsargue that the complaint fails to allege either an efficient market for the notes or reliance by the

(continued . . . )

Page 2

.T

several of the individual defendants contend that the plaintiffs failed to adequately plead contro l

person liability with respect to themselves . '

BACKGROUND

When deciding a motion to dismiss, this Court must accept all well-pleaded factual

allegations in the complaint as true . We must also draw all reasonable inferences in favor of the

plaintiffs .' In addition to considering the factual allegations in the complaint, we may als o

consult documents referred to in the complaint. Before analyzing the substance of the pendin g

motions, we first introduce the parties and the claims .

1 . The Plaintiffs

The plaintiffs in this action fall into two categories : those who purchased Sabratek

common stock between February 25, 1997, when Sabratek purchased Rocap, Inc ., and October 6,

1999, the day before the public learned that Sabratek overstated its earning by more than $39

million; and those who purchased Sabratek's convertible notes between April 8, 1998, when the

notes were offered, and October 6, 1999, when it became clear the notes were virtually worthless .

II. The Individual Defendants

4( . . .continued)note purchasers . This argument is resolved in Chu I and we will not repeat that analysis here .

s The individual defendants submitted joint memoranda in support of their motions todismiss presenting arguments generally applicable to them all . Each individual defendant alsofiled briefs setting forth contentions unique to himself.

6 For this reason, we recite the factual allegations as though they are established, withoutusing conditional language such as "purportedly" or "allegedly." Our use of this technique,however, does not express any opinion regarding the veracity of the plaintiffs' allegations or theplaintiffs' ability to produce evidence establishing the facts recited here .

Page 3

The individual defendants were all officers or directors of Sabratek . According to the

complaint, K . Shan Padda was Sabratek's Chief Executive Officer and Chairman of the Boar d

until his resignation on August 23, 1999 ; Anil K. Rastogi was its President and Chief Operatin g

Officer until his resignation in July 1998; Steven L. Holden was a senior vice president and Chief

Financial Officer until July 1998, when he became the President and Treasurer ; Doron C. Levitas

was Sabratek's Vice President, Chief Administrative Officer, Secretary, and Vice Chairman o f

the Board until his resignation on August 23, 1999 ; Vincent J. Capponi was the Vice President of

Operations until July 1998, when he became the Vice President and Chief Operating Officer ;

Alan E. Jordan was the Senior Vice President of Sales and Marketing until July 1998 ; Stephen C .

Beal was the Vice President of Sales ; Elliott R . Mandell was Vice President and President of the

Rocap Division ; Scott P. Skooglund was the Vice President of Finance and Principal Accountin g

Officer ; William H. Lomicka and William D . Lautman were Sabratek Directors who constitute d

the Board's Audit Committee . (Compl . at ¶ 25 . )

The plaintiffs contend that each of the individual defendants owned Sabratek stock an d

improperly prospered by selling that stock at artificially inflated prices . (Compl . at ¶ 200 . )

Additionally, the plaintiffs assert that, due to their status as upper echelon managers and

directors, the individual defendants knew of and participated in Sabratek's dissemination of fals e

information that caused the artificially high stock prices .

III. The Claims

The plaintiffs allege three basic § 10(b) violations : the defendants lied about FDA

approval for its line of IV flush syringes, falsely declared income from its infusion pump produc t

Page 4

line, and falsely declared income from "intangible assets." We recite briefly the tactual

allegations underlying each claim .

A. FDA Approval of Sabratek 's IV Flush Syringe s

On February 25, 1997, Sabratek purchased the assets of Rocap, Inc ., for $100,000 in

cash, assumption of $961,000 Rocap debt, and $2 .9 million in Sabratek stock to be valued o n

July 1, 1997. (Compl . at ¶ 73 .) Rocap manufactured two products : IV flush syringes and

infusion pumps . IV flush syringes are used to clean intravenous tubes . Rocap constructed the

syringes using FDA-approved component parts - specifically , syringes, saline, and in some cases

heparin, an anticoagulant . At the time of the purchase, the flush syringes were regulated by the

FDA as a "drug," but in April 1997 the FDA notified Sabratek that, in the future, the syringe s

would be regulated as a "medical device ," Because of the change in classification , the FDA

asked Sabratek to submit a 510(k) application establishing that the syringes were "substantiall y

equivalent to" already approved devices or drugs . (R. 93, Defs .' Ex. B, Feb. 24, 1998 FDA

Report at 10.) At that time, the FDA informed Sabratek that it would take no action against th e

syringes until the 510(k) application was decided. (Id. at 11 .) In May 1997, Sabratek submitted

a 510(k) application for the syringes .

The FDA inspected Sabratek 's flush syringe facilities in August and September 1997 . In

December 1997, the FDA warned Sabratek that its manufacture of the syringes did not compl y

with federal regulations and memo rialized those warnings in the February 24, 1998 Report. In

July 1998, the FDA again inspected the flush syringe production and, according to an Augus t

1998 letter to Sabratek, found continuing violations . Finally, on November 24, 1998, Sabrate k

suspended production and distribution of the flush syringes, probably because the FDA denied it s

Page 5

510(k) application . The announcement resulted in a $9 per share dip in the price- of Sabratek' s

stock. (Compl . at 113 9 . )

Throughout this period, Sabratek downplayed the seriousness, or even existence, of it s

regulatory difficulties. It issued two press releases, quoting Rastogi and Holden, stating that th e

company had addressed all of the FDA's concerns and that Sabratek had no reservations abou t

the safety of the syringes . Additionally, Sabratek repeatedly cited the Rocap products, includin g

the flush syringe line, as a major reason for its economic strength and continued growth . Further ,

in its 1997 and 1998 Form 10-Ks, the company stated that it, and its subsidiaries, maintaine d

"comprehensive quality assurance programs," tested all finished products, and complied with al l

federal regulations .

Ultimately, on May 27, 1999, the FDA approved Sabratek's revised 510(k) application

for its saline IV flush syringes ; then, on December 10, 1999, Sabratek received approval for its

heparin IV flush syringes .

B. Sabratek's Declaration of Intangible Assets

The plaintiffs contend that between April 1, 1997 and March 31, 1999 Sabrate k

improperly reported more than $39 million in "licensing fees" and "loans" to four entities whe n

that money actually was used to suppo rt research and development activities . According to th e

plaintiffs, Sabratek accounted for that money as "intangible assets" on its 1997 and 1998 Form

I0-Ks, putting it in the plus column, rather than properly denoting the money as expenses .

Specifically, the plaintiffs allege that Sabratek paid Unitron Medical Communications, Inc ., a

total of $18 .5 million, consisting of $8 .8 million in loans, $7 million in licensing fee payments,

and $2 .7 million under a sales and marketing agreement . Similarly, Sabratek paid GD S

Page 6

Technology, Inc., a total of $10 .4 million, consisting of at least $6 .5 million for exclusive

product rights ; Healthmagic , Inc ., a total of $10 million for licensing fees ; and Collaborations i n

Healthcare , LLC, a total of $2 .7 million for draws under a credit facility . (Compl. at ¶ 54 n .5 . )

The plaintiffs allege that Sabratek' s accounting of this money was false and that th e

money was actually used for research and development of products intended for use i n

Sabratek's planned "virtual hospital room ." They contend that none of the four entities was ever

expected to repay the "loans" and that none produced anything that could be licensed ; instead

Sabratek merely financed their development of products Sabratek wanted developed . According

to generally accepted accounting practices, a company must report research and development

funds as expenses . On October 7, 1999, Sabratek announced that it was restating its earlier

financial statements and reducing its reported earn ings by $39 million. (Compl, at ¶ 163 .)

C. Sabratek 's Improper Reporting of Income on Infusion Pump Sale s

The plaintiffs allege that Sabratek improperly reported revenue on consignment sales an d

nonconforming or defective shipments of infusion pumps . Additionally, Sabratek reported

income from inventory "parked" with "friendly warehouse operators" and back-dated invoices s o

as to credit "sales" of the pumps in earlier fiscal reporting periods . Finally, Sabratek convince d

some of its distributors to accept large shipments of its infusion pumps (and recorded these a s

sales), even though, at the time, the distributors did not have buyers for those products . (Compl .

at ¶¶ 48(a)-(f), 50 . )

The plaintiffs do not allege that any replacement shipments for the nonconforming

shipments were also recorded as sales . Likewise, they do not allege that the products sold on

Page 7

t

consignment, the parked inventory, or pre-buyer shipments were not subsequently old or

subtracted from reported earnings .

ANALYSIS

This Court must determine whether the plaintiffs have adequately stated a claim for relief

under § 10(b) . We will dismiss the complaint only if it appears beyond doubt that the plaintiffs

can prove no set of facts which would entitle them to relief . Thus, we must analyze whether the

plaintiffs have adequately alleged facts supporting their claim that the individual defendants

committed securities fraud by misleading investors as to the probability of FDA approval for the

IV flush syringes and by the various accounting improprieties outlined above .

Federal Rule of Civil Procedure 9(b) requires plaintiffs to plead the circumstances

constituting fraud with particularity . "This means the who, what, when, where, and how: the first

paragraph of any newspaper story." DiLeo v. Ernst & Young, 910 F.2d 624, 627 (71 Cir . 1990) .

The Private Securities Litigation Reform Act of 1995 ("PSLRA") imposes even mor e

stringent pleading standards on private plaintiffs seeking relief under § 10(b) . The PSLRA

requires plaintiffs to "specify each statement alleged to have been misleading ." 15 U.S .C. § 78u-

4(b)(1) . More importantly, the PSLRA requires plaintiffs to "state with particularity facts giving

rise to a strong inference that the defendants acted with the requisite state of mind ." § 78u-

4(b)(2) ; see also § 78u-4(b)(3)(A) ("In any private action arising under this chapter, the court

shall, on motion of any defendant, dismiss the complaint if the requirements of paragraphs (1)

and (2) are not met .") .

As explained more fully in Chu I, the requisite stre of mind in securities fraud cases is

recklessness. Thus, plaintiffs must allege with particularity "`conduct which is highly

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unreasonable and which represnets an extreme departure from the standards of dndnary care . . .

to the extent that the danger was either known to the defendant or so obvious that the defendan t

must have been aware of it ."' Danis v. USN Communications, Inc ., 73 F. Supp.2d 923, 938

(N.D . Ill . 1999) (quoting Rehm v. Eagle Fin. Corp., 954 F . Supp. 1246, 1255 (N .D . Ill . 1997)) .

With these standards in mind, we turn to the individual defendants' arguments : first ,

those regarding FDA approval for the flush syringes and, then, those regarding Sabratek' s

accounting practices .

I . Statements About FDA Approval for Sabratek's Flush Syringe s

The individual defendants contend that the plaintiffs ' allegations regarding FDA approva l

of the flush syringes do not state a claim because each of Sabratek' s statements was forward

looking and properly identified as such. The PSLRA protects forward-looking statements

against charges of fraud "to the extent that the forward-looking statement is identified as a

forward-looking statement, and is accompanied by meaningful cautionary statements identifyin g

important factors that could cause actual results to differ." 15 U.S .C. § 78u-5(c)(1)(A)(i) ; see

also 17 C.F.R § 240.3b-6 (SEC Rule barring fraud claims against forward-looking statement s

when supported by a reasonable basis in fact) .

The plaintiffs respond that some of the statements complained of were outright

falsehoods about historical fact . For example, the plaintiffs cite press releases in which Rastog i

and Holden stated that Sabratek had already addressed the FDA's regulato ry concerns . (See

Compl. at $T 92 ("`We are [sic] frankly surprised when we got this warning le tter,' said

[defendant] Rastogi . `The issues had all been addressed before we got the [December 1997 FDA

warning] letter."'); 127 ("`There were no safety concerns about the company's products ,' which

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include heparin and saline-fil e syringes , Holden said [in response to the Aug 1998 FDA

warning letters] .") . )

Additionally, the plaintiffs point to statements about Sabratek ' s flush-syringe productio n

in various SEC filings . (See Compl. at 11100 (statements in Sabratek's registration statemen t

and prospectus regarding its sale of conve rt ible notes ); 102-04 (statements in Sabratek 's FY 1997

Form 10-K) .) The plaintiffs here complain that Sabratek affirmatively misrepresented that it had

a quality assurance program and had complied with all federal regulations .

The plaintiffs also complain about the individual defendants' sins of omission ,

specifically that the statements contained in the SEC filings did not reveal that Sabratek was

selling the syringes without an approved 501(k) application, that the FDA was requiring suc h

approval, and that the 510(k) application was not likely to be approved . The plaintiffs contend

that these statements and omissions were material because Sabratek's rosy financial forecast s

covered up the danger to its earn ing potential represented by the likelihood that its flush syring e

product line, which accounted for nearly 25% of Sabratek's sales by November 1998, would b e

shut down . (See also Compl. at ¶ 129 (" In later September and early October [ 1998], senio r

Sabratek management gave highly upbeat presentations before two analyst-sponsored [Bea r

Sterns and First Union] healthcare conferences .") . )

Initially we note, although the individual defendants do not argue, that the complain t

clearly shows that Sabratek's regulatory difficulties were known by the investing public . The

complaint cites at least two newspaper a rticles written about that very subject . (See Compl. at

IT 92 (citing a January 13, 1998 news service release announcing the December 1997 FDA

warning letter) ; 126 (citing a September 8, 1998 news serv ice re lease announcing the August

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1998 FDA warning le tters ).) 'plaintiff cannot credibly claim to be misled by a`eompany' s

attempt to hide negative information when that same information is publicly available vi a

alternate channels . See Eckstein v. Balcor Film Investors, 58 F.3d 1162, 1169 (7`h Cir . 1995) (a

company's failure to reveal information already in the public domain is not securities fraud) ;

Wielgos v . Commonwealth Edison Co., 892 F .2d 509, 516 (7`h Cir . 1989) (same) .

Be that as it may, the complaint fails to state a claim for securities fraud against the

individual defendants ' statements regarding the flush syringe product line and the FDA approval

process. First, the affirmative statements in the SEC filings (i .e., that Sabratek and its

subsidiaries operated an internal quality assurance program) are far too attenuated from th e

alleged regulatory problems at the flush syringe manufacturing facility to establish fraud . Nor do

the "quality assurance " statements pretend that Sabratek's internal evaluations were sufficiently

stringent to satisfy FDA regulations or that the internal evaluations would guarantee FD A

approval . In fact, in each of Sabratek's SEC filings submitted to this Court, the company too k

pains to warn investors that

[i]f in the future the FDA concludes that current, modified or new products manufacturedand distributed by the Company require that the products be relabeled, require 510(k)clearance, require new drug approval, or other regulatory approval, the FDA couldprohibit the Company from manufacturing and/or distributing these products until theCompany made the necessary submissions and obtained any required approvals .

(R. 93, Defs.' Ex. K, FY 1997 Form 10-K at I 1 (filed on 3/26/1998) ; see also R. 93, Defs .' Ex.

A, March 17, 1997 Form S- I Registration Statement at 10 ("Rocap currently manufactures an d

distributes its products without any FDA approvals . . . . The FDA could also take regulatory

action against the Company for the Rocap division's manufacture and/or distribution o f

products ."); R. 93, Defs.' Ex. J, July 23, 1997 Form S-3 Registration Statement at 7-8 (same) . )

Page I 1

Moreover, Sabratek ' s statement that it complied with all federal regulation , insofar as its

production of flush syringes is concerned , was true . In April 1997, the FDA shifted gears on it s

classification of the flush syringes, requested a 510(k) application from Sabratek, and told

Sabratek that it would take no action against production and distribution of the syringes until i t

acted on the 510(k) application . Sabratek promptly submitted an application and, in accordanc e

with the FDA' s representation , continued selling the sy ringes until the FDA rejected the

application, at which time Sabratek stopped selling the syringes . The plaintiffs make no factua l

claims supporting their contention that this course of action violated federal regulations, whic h

could have made the statements in Sabratek's SEC filings false .

Further, the complaint is notably vague about how or why the individual defendants kne w

or should have known that the FDA was going to deny Sabratek's initial 510(k) application fo r

the flush syringe product line . Simply receiving a number of letters from the FDA listin g

regulatory shortcomings does not portend ultimate FDA denial of the recipient's application, a s

demonstrated by the FDA 's ultimate approval of Sabratek's revised 510(k) application. The

complaint also fails to allege any facts establishing the falsity of the above-quoted statements b y

Holden and Rastogi that Sabratek had addressed the FDA's written concerns and had no safet y

concerns of its own. Again, the defendants' belief that Sabratek had adequately addressed the

FDA's concerns, although obviously mistaken , was not obviously false . The plaintiffs plead no

additional facts demonstrating the falsity of Rastogi and Holden' s statements .

Finally, given the absence of factual allegations that Sabratek's affirmative statements

were false or that its omissions were material, there is no basis for the plaintiffs' claim that

Sabratek 's optimistic financial predictions were unreasonable in light of the FDA' s actions

Page 12

regarding the flush syringes . 4.ifward- looking statements , which the financial P.--fictions clearly

were, are not fraudulent unless the "projection lacked any reasonable basis at the time it wa s

made." Grassi v. Information Resources, Inc., 63 F.3d 596, 599 (7'h Cir . 1995) ; see also DiLeo,

901 F.2d at 628 ("There is no `fraud by hindsight ."') .

In sum, the plaintiffs have failed to adequately allege fraud with regard to the individua l

defendants' handling of the company's regulatory problems . For this reason, we grant each

individual defendant' s motion to dismiss this claim .

II. Sabratek's Accounting Practices

The individual defendants level two charges against the plaintiffs' fraudulent accountin g

practice claims . First, they argue that the complaint engages in "group pleading," in essenc e

making general allegations of fraud without specifically identifying how each individua l

defendant was involved in the allegedly fraudulent activities . Second, the individual defendant s

contend that the complaint does not allege particular facts giving rise to a strong inference tha t

any of them acted with the requisite intent, namely recklessly.

A. Group Pleading

The plaintiffs sue these defendants both directly, as the individuals directly responsibl e

for the allegedly false and misleading statements complained about, and indirectly, as "contro l

persons" responsible for Sabratek's general operations, including oversight of financial reports t o

the SEC, audits, and press releases . As such, the plaintiffs maintain that "[i]t is appropriate to

treat the Individual Defendants as a group for pleading purposes ."' (Compl. at ¶ 27 . )

Nevertheless, the complaint contains numerous allegations specifically identifying the(continued . . . )

Page 13

The individual defendants , on the other hand , argue that "group pleadingias neve r

appropriate under Rule 9 (b) and that now the PSLRA outright forbids it . Rule 9(b) requires

plaintiffs to "specify which defendants said what to whom and when, unless they [can] show . . .

that the requisite information [is] within the defendant's exclusive knowledge ." Ackerman v .

Northwestern Mut. Life Ins . Co., 127 F.3d 467, 471 (7`h Cir . 1999) (applying Rule 9(b) to

common law fraud claims) (quotation omitted) ; see also Goren v. New Vision Int'1, Inc., 15 6

F.3d 721, 730 (7th Cir. 1998) ("[T]he amended complaint simply treats all the defendants as one ;

such `lumping together' of defendants is clearly insufficient [under Rule 9(b)] to state a RIC O

claim.") . In the context of a securities fraud case, the Seventh Circuit affirmed the dismissal of a

complaint "bereft of any detail concerning who was involved in each allegedly fraudulen t

activity," explaining that `[a] complaint that attributes misrepresentations to all defendants ,

lumped together for pleading purposes, generally is insufficient ."' Sears v. Likens, 912 F.2d 889 ,

893 (71 Cir. 1990) (quoting Design Inc. v. Synthetic Diamond Tech., Inc., 674 F. Supp. 1564,

1569 (N.D . 111 1987)) .

We do not believe, however, that these decisions -Ackerman, Goren, and Sears - dictate

the outcome of this case. In each of those cases, the plaintiffs utterly failed to provide any detail s

regarding the alleged fraudulent activities . See Ackerman, 172 F.3d at 471 ("Although th e

'(. . .continued)individual defendant who made or was responsible for the purportedly false representations .(See, e .g., Compl . at ¶¶ 48(c)(ii) (Jordan authorized a $1 .2 million consignment sale that waslater documented as a sale ) ; 101 (Padda, Rastogi, Levitas, Holden and Skooglund signedSabratek's FY 1997 Form 10-K, which reported artificially inflated sales ) ; 127 (Holdendownplayed Sabratek's regulatory difficulties) .) We address the plaintiffs' specific allegationsbelow and, here, deal only with the propriety of group pleading .

Page 14

T 7

complaint alleges in general tens that the defendants inspired, encouraged, and` bndoned [the

fraudulent activities], it neither associates a particular defendant with a particular set of

statements (oral or written) . . . nor specifies the contents of those statements .") ; Goren, 156 F .3d

at 730 ("These conclusory allegations fail to specify the time, place and content of any of the

misrepresentations attributed to these defendants .") ; Sears, 912 F.2d at 893 ("The plaintiffs fail

to state in any detail what misrepresentations were made by the defendants, to whom these

misrepresentations were made, when these misrepresentations were made, or how these

misrepresentations furthered the alleged fraudulent scheme .").

Here, on the other hand, the plaintiffs have supplied ample detail as to the contents of the

misrepresentations, the date and location of each misrepresentation, and how the

misrepresentations furthered the alleged fraudulent scheme . Essentially, the only detail missing

from the group pleading paragraphs, (Compl . at 1126-30), is how each individual defendant was

supposed to know that the statements complained about were false, and even that is alleged

generally : "Because of their Board membership and/or executive and managerial positions with

Sabratek, each of the Individual Defendants had access to . . . adverse undisclosed informatio n

about Sabratek's business prospects and financial condition and performance," (Compl . at ¶ 29) .

In other words, based on their positions with the company, the individual defendants had access

to inside information that belied the company's public statements. We believe the complaint

provides sufficient detail to satisfy the Rule 9(b) standard .

The individual defendants contend, however, that the PSLRA raised the pleading bar to

such an extent that the complaint must "plead facts establishing scienter both person by person

and act by act ." (R. 133, Joint Reply Mem . at 10.) Section 78u-4(b)(2) declares "the complaint

Page 15

shall, with respect to each act or omission alleged to violate this chapter , state with particularit y

facts giving rise to a strong inference that the defendant acted with the required state of mind ."

Under the plain language of the statute , pleading scienter based exclusively on a defendant' s

corporate position is insufficient to survive a motion to dismiss . See In re Advanta Corp. Sec.

Litig., 180 F.3d 525, 539 (3d Cir . 1999) ("Generalized imputations of knowledge do not suffice ,

regardless of the defendants' position within the company") . The simple fact of a defendant' s

status as an officer or director of a company, without more, does not give rise to a strong

inference that that defendant knew or recklessly disregarded the falsity of statements released b y

the company .

Our decision in Discovery Zone, relied on by the plaintiffs , does not pertain under th e

new standards imposed by the PSLRA . In re Discovery Zone Sec. Litig., 943 F. Supp. 924 (N .D .

111 . 1996) . Clearly, the PSLRA abrogates the standard we art iculated there . See id at 937

("[Scienter] is sufficiently pled if the complaint `affords a basis for believing that plaintiffs coul d

prove scienter ."') (quoting DiLeo, 901 F.2d at 629). Moreover, the plaintiffs in Discovery Zon e

did not exclusively rely on the defendants' status as corporate officers to establish scienter, bu t

also pled other suspicious actions by the defendants suggesting fraud . Id.

Plaintiffs also direct our attention to Danis, which rejected an attack, lodged under the

PSLRA, on the group pleading doctrine . Danis, 73 F . Supp.2d at 939 n .9. We respectfull y

disagree with the Danis decision on this issue . In Danis, the court refused to "abolish al l

remnants of notice pleading and the liberal standards under which motions to dismiss are

viewed" absent direction from the Seventh Circuit . Id. We believe, however, that Congress has

instructed us to do just that : Congress decreed that "the complaint shall, with respect to eac h

Page 16

[fraudulent] act . . ., state with particularity facts . . . that the defendant acted with-tfie required

state of mind ." § 78u-4(b)(2) . This language, even more than Rule 9(b), obliterates notic e

pleading in private securities fraud cases and, by implication, the liberal standards typically use d

to decide motions to dismiss .

To the extent the plaintiffs plead scienter based exclusively on an individual defendant' s

position in Sabratek's hierarchy, their claims must be dismissed . Although the plaintiffs do i n

some cases rely only on an individual defendant's position to allege knowledge of or reckless

indifference to fraud, the problem is not universal . As we noted above, the complaint contain s

numerous allegations specifying activities by the individual defendants that may give rise to a

strong inference of recklessness .

B. Scienter

To survive the current motions , then , the complaint must allege pa rt icular facts givin g

rise to a strong inference that each individual defendant either intended to deceive Sabratek' s

investors or recklessly disregarded the fraudulent nature of Sabratek's public statements . The

plaintiffs must therefore adequately allege facts that, if proven, would establish that th e

individual defendants knew, or recklessly ignored, that Sabratek (1) misrepresented $39 millio n

in research and development expenditures as assets and (2) declared present income from futur e

or non-existent sales, thereby artificially inflating Sabratek's reported worth and, thus, the pric e

of its stock.

The plaintiffs rely on two basic categories of fact to allege scienter: violations of

generally accepted accounting p rinciples ("GAAP violations") and motivation . The GAAP

violations in turn breakdown into allegations regarding Sabratek's improper sales recognitio n

Page 17

practices with regard to its line of infusion pumps and its improper accounting of research and

development expenses .

We conclude that none of the plaintiffs' allegations regarding Sabratek's recognition of

infusion pump sales give rise to a strong inference of fraudulent intent. Nevertheless, with

respect to some of the individual defendants, the magnitude of Sabratek's misstatement of assets

and earnings adequately supports an inference of reckless or intentional misrepresentations .

1 . Generally Accepted Accounting Principle s

The plaintiffs allege that the individual defendants engaged in various accounting

practices that violated generally accepted accounting principles ("GAAP") . Specifically, the

plaintiffs assert that Sabratek recognized income from "phony" sales of infusion pumps and that

it repo rted research and development expenditures as intangible assets, such as licensing

agreements and loans .

In general, bare allegations of GAAP violations are insufficient , standing alone, to raise

an inference of scienter. Danis, 73 F. Supp.2d at 940; Rehm , 954 F . Supp . at 1255 ; see also

Greebel v. FTP Software, Inc ., 194 F.3 d 185, 204 (1' Cir . 1999) ; In re Comshare, Inc . Sec.

Litig., 183 F .3d 542, 553 (61' Cir . 1999) . Instead, the "complaint must also show facts supporting

an inference that [the] defendants recklessly disregarded the deviance or acted with gross

indifference to the misrepresentations in its financial statements ." In re System Software Assocs.,

Inc., No. 97 C 177, 2000 WL 283099, at * 14 (N .D. Ill . Mar. 8, 2000). Facts relevant to this

determination include the magnitude of the accounting error, facts showing that the defendants

had prior notice of the error, and whether a defendant was responsible for calculating and

disseminating the financial information.

Page 18

a. Sabra ek's Infusion Pump Sales

As to the infusion pump sales, the plaintiffs predominantly complain about Sabratek' s

"channel stuffing" activities - that is, shifting income from a later reporting period to an earlie r

reporting period by recognizing sales upon shipment, even when the shipment is of products no t

yet purchased (e .g., consignment sales and inventory parking) . The plaintiffs also allege that

Sabratek reported income on nonconforming and defective shipments and failed to account fo r

customer rebates and credits .

Unfortunately, the plaintiffs' allegations regarding income recorded from these sales are

lacking in the type of detail necessary to support a strong inference of scienter . Although the

plaintiffs provide specific examples of consignment sales, discount sales, and inventory parking ,

(Compl. at ¶ 48(a)-(e)) ; nowhere does the complaint relate these activities to any specific

financial statement . In other words, it is not even clear that Sabratek committed GAAP

violations with respect to these sales - particularly when one considers that Sabratek notified the

investing public that it recognized sales upon shipment . (See, e .g., Defs .' Ex. K, FY 1997 Form

10-K at 27 .) There is nothing inherently suspect with consignment and discount sales, see

Greebel, 194 F.3d at 202-203, and the plaintiffs have not alleged facts showing that in this cas e

the defendants acted improperly . Although allegations that certain practices violate GAAP may

be sufficient to plead a misrepresentation, such assert ions are insufficient to demonstrate a s trong

inference of fraudulent intent .

Also lacking from the complaint is any allegation that the individual defendants who

authorized these sales practices - the complaint specifically names only Beal and Jordan - playe d

any role in calculating or disseminating Sabratek's earnings statements : neither Beal nor Jordan

Page 19

signed-off on Sabratek ' s financial repo rts to the SEC and no other allegations linkthese

defendants to Sabratek' s earnings statements . Likewise, the complaint does not allege that those

defendants responsible for disseminating Sabratek' s financial statements were involved in or

knew about these sales practices .

With regard to allegations that Sabratek failed to account for rebates and credits, th e

plaintiffs offer even fewer specifics . In the lone paragraph providing any information about thi s

allegation, (Compl . at ¶ 48(f)(ii)(b)), the complaint simply states that Sabratek induced it s

distributors to order infusion pumps by promising credits and rebates and then later attempted t o

renege on its promises . This claim is impossibly vague -- it doesn't even state that Sabratek

reported the full purchase price of the pumps as revenue, much less when the promises wer e

made, the value of the rebates and credits, when the sales were reported, or any other informatio n

even faintly suggesting improper activity by Sabratek .

The plaintiffs also claim that Sabratek reported sales on nonconforming goods . Again,

only one paragraph in the complaint sets forth any facts relating to this allegation . (Compl . at

¶ 48(d).) There the complaint states that Sabratek shipped $150,000 worth of "stale" infusio n

pumps (i. e ., pumps with out-of-date inspection stickers) and then, instead of sending "fresh "

pumps, sent new stickers falsely stating that the pumps had been recently inspected . Not only do

the plaintiffs fail to allege how these pumps were accounted for and what ultimately happene d

with the pumps, but it appears that there was no wrongdoing with respect to these pumps .

According to the complaint, pumps must be inspected annually : these pumps were inspecte d

"4/98" and shipped six months later, "in or around October of 1998 ." (Comp] . at ¶ 48 (d).) In

other words, the pumps were not in fact "stale ."

Page 20

Finally, the plaintiffs make a series of allegations that Beal and Jordan regularly fleece d

Sabratek's distributors by making sales directly to the distributors' customers and by violating

exclusivity agreements . (Comps . at 148(f) .) Although, if true, these practices may be unethical

and poorly calculated to further Sabratek 's business interests , we do not see how they support an

inference that the defendants recklessly disregarded financial reports overstating Sabratek' s

earnings .

In sum, the complaint does not tie any of these sales to any misrepresentation : it does no t

reveal when the sales were actually reported as revenues ; by what amount, if any, the sales were

over reported' ; or any other improper impact these sales may have had on Sabratek's financia l

reports. For this reason, no inference of fraudulent intent can be garnered from these allegations.

b. Sabratek's Research and Development Expenditure s

The plaintiffs allege that the individual defendants overstated Sabratek's income from

April 1, 1997 through March 31, 1999 by approximately $39 million by mischaracterizin g

research and development expenditures as "intangible assets ." Specifically, instead of reporting

these expenditures as expenses, Sabratek improperly denoted $39 million as loans, licensing fees ,

exclusive product rights, and marketing agreements . By falsely accounting for these funds ,

e The $39 million overstatement of earning, mentioned earlier in the fact section, is tiedexclusively to the plaintiffs' research and development expenditure allegations . (See Compl. at¶¶ 54, 54 n.5.) Specifically, the plaintiffs identify the amount of money each R & D entityreceived, add those numbers up, and conclude that "[t]his $41 .5 million sum --- after taking intoaccount approximately $2 million in amortization writedowns, [etc .] . . . essentially equals the`approximately $39 million' in accounting restatements that th . Company announced on October7, 1999." (Camp!. at ¶ 54.) Therefore, we analyze the "$39 million overstatement" fact in thecontext of the research and development funds allegations and not here .

Page 21

Sabratek. was able to report significant net earnings, rather than significant losses during th e

relevant time periods .

In support of their contention that the individual defendants acted with the require d

scienter in falsely accounting for these funds, the plaintiffs rely on the magnitude of th e

overstatement of assets (or understatement of expenses ) ; Sabratek 's admission on October 7 ,

1999 that it had overstated earning by $39 million ; statements by Padda that Sabratek's auditor,

KPMG, had helped get Sabratek 's research and development expenses "off the books" ; and the

utter lack of documents supporting the reported "intangible assets ." Additionally, the plaintiffs

point to the remarkable increase in Sabratek ' s "intangible assets ," which at the end of FY 199 6

accounted for only I % of its total assets but by FY 1998 had jumped to 21 % of its total assets ;

the fact that Unitron, which received the lion's share of the money, had no marketable produc t

and was at least 18 months away from going to market with the product Sabratek supposedl y

licensed; and Sabratek's agreements with GDS and Unitron for the option to acquire 100% o f

their assets .

With respect to Padda, Rastogi , Holden , Levitas, Capponi, Skooglund, Lomicka, and

Lautman - that is, each individual defendant except Jordan, Beal, and Mandell - we believe thes e

allegations are sufficient to establish a strong inference that they either deliberately

mischaracterized expenses as assets or recklessly disregarded the veracity of Sabratek's financia l

reports of its assets and earnings .

First, we explain our exclusion of Jordan, Beal, and Mandell, which should help explain

our conclusion regarding the rest of the individual defendants . Absolutely rothing in the

complaint even remotely suggests that Jordan, Sabratek's Senior Vice President of Sales and

Page 22

4 ~ ; T

Marketing, Beal, Sabratek's Vice President of Sales, or Mandell, Sabratek's President of th e

Rocap Division, played any role in structuring the deals between Sabratek and the four researc h

and development entities or in calculating the financial impact of those deals ; none of the thre e

signed Sabratek's SEC filings, none participated in or arranged audits, none is alleged to hav e

engaged in conversations about the deals . Furthermore, none of the three executives occupied a

position obviously involved in Sabratek's finances, development, acquisitions, or even overal l

administration. In other words, the plaintiffs do not allege facts showing that Jordan, Beal, o r

Mandell would have, or should have, been aware of the nature, extent, and impact of Sabratek' s

deals with the research and development entities .

On the other hand, the other individual defendants all were in positions to know the fact s

upon which the plaintiffs rely to show scienter . Whereas the President of Sabratek's Rocap

Division (Mandell) would have no reason to question a licensing agreement with or loan to

Unitron, members of the audit committee (Lornicka and Lautman) would, particularly given th e

radical increase in Sabratek's reported "intangible assets ." Likewise, the Vice President of Sales

(Beal) would have no reason to know about a credit agreement with Collaborations i n

Healthcare, but the Chief Financial Officer (Holden), Principal Accounting Officer (Skooglund) ,

and Chief Operating Officer (Rastogi and , later, Capponi) would, especially conside ring th e

amounts of money involved . Additionally, each of the other individual defendants signed and

disseminated the misleading financial reports .

The specific facts alleged regarding the circumstances surrounding Sabratek's alleged

mischaracterization of the research and development expenses raises a strong inference o f

intentional or reckless falsification of Sabratek's financial statements by those with reason to

Page 23

I

know of those circumstances . or this reason, we deny the motions to dismiss by-adda,

Rastogi, Holden, Levitas, Capponi, Skooglund, Lomicka, and Lautman . On the other hand, th e

complaint does not allege facts from which we can infer that Jordan, Beal, and Mandell knew o r

should have known about the circumstances surrounding Sabratek's accounting of the researc h

and development expenditures . Thus, we turn to whether the plaintiffs' allegations regardin g

motive and opportunity are sufficient to raise a strong inference of intent with respect to Jordan ,

Beal, and Mandell .

2. Motive and Opportunity

The individual defendants focus their challenge to the plaintiffs' accounting claim s

almost exclusively on the "motive and opportunity" allegations . We agree with the defendants

that allegations regarding their desire to (1) maximize Sabratek's earning potential on corporate

debt offerings, (2) retain their positions, and (3) earn production bonuses are insufficient fact s

from which to infer any level of scienter . These are the goals of all corporate executives ; as

such, they do not even remotely suggest fraudulent motivation . See, e .g., In re Next Level Sys.,

Inc. Sec. Litig., No. 97 C 7362, I999 WL 387446, at *9 (N .D. Ill . Mar. 31, 1999) ("Allegations

of motives that are generally held by similarly positioned executives and companies are

insufficient to sustain a claim under the secu rities laws .") (quotation omitted) ; see also Shields v .

Cititrust Bancorp, Inc., 25 F.3d 1124, 1131 (2d Cir. 1994) (Allegation that " defendants made

fraudulent statements intended to inflate the stock price so that they could protect their executiv e

positions and the compensation and prestige they enjoy" is insufficient to plead recklessness .) ;

Tuchman v. DSC Communications Corp., 14 F.3d 1061, 1068 (5 1 Cir. 1994) (Allegations that

"defendants acted 'for the purpose of creating an art ificially inflated picture of DSC's financial

Page 24

l Y ~ t

and operating conditions, incring the Company's market share and gaining a\ .ampetitive

advantage, maintaining an artificially inflated price for the common stock[,] . . . preserving

defendants' positions, perquisites and emoluments of office, securing, maintaining and/or

increasing compensation for themselves, and/or inflating the value of their shares"' are

insufficient to plead recklessness .) (quoting complaint) .

On the other hand, allegations of insider trading, including a secondary offering by inside

shareholders, certainly can be relevant to the issue of a securities fraud defendant's state of mind .

See, e.g., Searls v. Glasser, 64 F.3d 1061, 1068 (7`h Cir. 1995) ("In some cases, an insider' s

suspicious sale of holdings . . . may support an inference of bad faith and scienter ."). The mere

fact that a company's executives and directors sold stock during the class period is not enough :

"Rather, a plaintiff must show that the sale was drastically out of line with prior trading practices

and that the sale was timed to maximize personal benefit from undisclosed inside information . "

In re Systems Software Assocs., Inc. Sec. Litig., No. 97 C 177, 2000 WL 283099, at * 13 (N .D. Ill .

Mar. 8, 2000) (citing Freeman v. Decio, 584 F .2d 186, 197 n .44 (7 '̀ Cir. 1978) ; Rehm, 954 F .

Supp . at 1254) ; see also In re Comshare, Inc. Sec. Litig., 183 F.3d 542, 553 (6' Cir. 1999)

("Indeed, allegations that corporate officers engaged in insider sales at unusual or suspicious

levels is probative of motive.") (quotation omitted) . Thus, to adequately allege scienter based on

insider trades, the plaintiffs must set forth facts establishing that the individual defendants' sales

were suspicious because of the timing and amount of the sales .

Here the plaintiffs, through no fault of their own, cannot show that the individual

defendants' stock sales were drastically out of line with prior sales : none of the individual

defendants was allowed to sell his stock prior to the sales noted in the complaint. Sabratek went

Page 25

I , 4

public in June 1996 . Under theme Terms of its initial public offering, Sabratek imposed a 180-da y

"lock up" prohibiting sales by corporate insiders . Thus , a prior history of sales does not exist an d

we can examine only the level and timing of the insider sales . We focus our analysis on Jordan ,

Beal, and Mandell . '

Beal sold no stock during the purported class period ." Obviously, having made no

insider sales, we can infer no intent by Beal to commit securities fraud .

Mandell sold 87,488 of the 131,593 shares he received as part of the purchase price o f

Rocap and earned approximately $2 .64 million; Jordan sold 219,136 shares and reaped a total

sale price of approximately $5 .4 million . In their response memorandum, the plaintiffs clai m

Jordan received 72,802 outright ; stock options to purchase 149,428 shares at $4 .76, of which

only 101,502 were exercisable prior to the end of 1998 (the relevant period of his sales), and a n

additional 100,000 stock options at $22, of which only 25,000 were exercisable prior to the end

of 1998 . (R. 122, Pls .' Mem. at 40.) These numbers simply do not add up . According to th e

plaintiffs, by the end of 1998, Jordan had only 199,304 shares to sell (72,802 + 101,502 +

25,000), but actually sold 219,136 shares .

Furthermore, the plaintiffs do not attempt to link Jordan and Mandell's insider sales t o

any specific misleading statement by Sabratek regarding its financial health . The complaint list s

9 Having concluded that the plaintiffs adequately alleged scienter against the otherindividual defendants, we need not carefully scrutinize their stock sales . We note, however, thatCapponi, Skooglund, Holden, and Lomicka engaged in VERY modest sales of their personalholdings . With respect to these four defendants, we could draw absolutely no inference of fraudfrom their inside trades .

16 As far as we can tell, he owned only 78 shares. (See Defs.' Ex. U, Beal Form 3 .)Neither the complaint nor the plaintiffs' response memorandum mentions sales by Beal .

Page 26

each individual 's sales by date Compi . at ¶ 200 ), whereas the plaintiffs' respon memorandum

simply lumps each individuals' sales together and argues that his gross earnings establishe s

scienter, (R . 122, Pls .' Mem. at 38-44) . But Jordan sold stock on 14 separate days over a 16-

month period ; somewhat less extreme , Mandell sold his shares on eight different days over a

seven-month period . In fact, Jordan and Mandell did not conduct any sales during the sam e

month." It is impossible to infer, based on these facts, that Mandell and Jordan were part of a

plot to run up stock prices for their own benefit .

Both Jordan and Mandell vigorously declaim any inference of scienter based on thei r

stock sales. Mandell notes that "it is entirely natural for an officer who received shares in

connection with the purchase of [his] business [i.e ., Rocap] to sell those shares [and] recover a

portion of the purchase price ." (R. 146, Mandell Reply Br. at 4.) Further, he points out that he

sold the shares when they became available under the terms of the asset purchase agreement an d

his employment contract . (Id. at 5.) Jordan likewise claims that he sold his stock either when i t

became "unlocked" or when the options vested. (R. 141, Jordan Reply Br. at 4-5 . )

The absence of any allegations linking Sabratek's allegedly false financial representation s

with sales by Mandell and Jordan, especially when viewed in light of the fact that they sold their

stock when it became available to them to sell, definitively establishes that the plaintiffs have no t

adequately alleged scienter against Mandell and Jordan . "A large number of today's corporate

executives are compensated in terms of stock and stock options . It follows then that these

individuals will trade those securities in the normal course of events ." In re Burlington Coat

" Jordan sold stock in April, May, and November 1997, then in February, May, andOctober 1998 . Mandell sold stock in August and September 1997, then in March 1998 .

Page 27

Factory Sec. Litig ., 114 F.3d 110, 1424 (3d Cir . 1997) . Here the plaintiffs prey n no facts fro m

which we can infer anything other than a normal course of events .

ill . Control Person Liability

Several of the individual defendants contend that the complaint fails to state a claim fo r

control person, or secondary, liability for securities fraud against them . 15 U.S.C . 78t (§ 20(a) o f

the 1934 Act) . First, Holden argues that, because the plaintiffs failed to state claim for § 10(b)

liability, their control person liability claim necessarily fails . Holden' s basic premise is flawed .

See Donohoe v. Consolidated Operating Prod. Corp., 30 F.3d 907, 909 (7 " Cir. 1994) (principal s

not charged with direct § 10(b) liability may still be liable as control persons) . Even so, we hav e

concluded that the plaintiffs successfully pled a § I0(b) claim against Holden. Thus, Holden' s

motion to dismiss the § 20(a) claim is denied.

Second, Capponi, Jordan, Beal, Mandell, Lomicka, and Lautman argue that the plaintiff s

pled no facts establishing that they are control persons. The Seventh Circuit has set forth a two-

prong test for determining control person liability : the individual defendants must (1) hav e

exercised actual control over the general operations of Sabratek and (2) have had the ability an d

power to direct (or prevent) the fraudulent statements at issue here . See, e.g., Donohoe, 30 F.3d

at 911-12 ; Discovery Zone, 943 F. Supp. at 943. Thus, we look to the complaint to ascertain

whether the plaintiffs have adequately alleged § 20(a) liability .

Initially we note that § 20(a) does not have a scienter requirement .12 In fact, liability is

premised on a defendant ' s position in the corporate hierarchy . Additionally, we know of no

`Z Good faith, however, is an affirmative defense to a § 20(a) claim .

Page 28

heightened pleading standards applicable to § 20(a) claims : the defendants do n6t fefer to any

and our independent research revealed none . Thus, we apply the Federal Rules' liberal pleading

requirements to this claim and conclude that the complaint adequately alleges § 20 (a) liability

against each of the individual defendants . (See, e.g., Compl . at ¶¶ 217-18.) Although we have

significant reservations about the plaintiffs' ability to prove these allegations, that is a questio n

we may not decide on the pleadings .

Page 29

CONCLUSIO N

For these reasons, we grant in part and deny in part each individual defendant's motion t o

dismiss. (R. 81-1, 82-1, 83-1, 85-1, 86-1, 87-1, 88-1, 89-1, 90-I, and 91-1 .) Specifically, we

dismiss with prejudice all of the plaintiffs' claims regarding FDA approval of the flush syring e

510(k) application and Sabratek's revenue recognition practices . We dismiss the research and

development expenditures claim with prejudice with respect to Jordan, Beal, and Mandell, bu t

deny the motions to dismiss the research and development expenditures claim brought by Padda ,

Rastogi, Holden, Levitas, Capponi, Skooglund, Lomicka, and Lautman . Finally, we deny th e

motions to dismiss the plaintiffs' control person liability claim brought by Holden, Capponi ,

Jordan, Beal, Mandell, Lomicka, and Lautman .1 3

Additionally, we deny Stephen Axel's motion to dismiss , (R. 79-1), as moot because

Axel was dismissed from this action by agreement of the parties . (See R . 109, Order of Mar . 21 ,

2000.)

Finally, we grant the plaintiffs' request, contained in the response memorandum, (see

Pls.' Mem. at 51 n .34), to amend the complaint for a sixth time," but only to the extent allowe d

13 The other defendants - Padda, Rastogi, Levitas, and Skooglund -- did not seekdismissal of the plaintiffs' § 20(a) claim.

14 On January 21, 1999, the plaintiffs filed the original complaint, (R . 1); on June 7,1999, they filed an amended complaint, (R . 23); on October 15, 1999, the filed the secondamended complaint, (R. 35); and on November 17, 1999, they filed the third amended complaint ,(R. 42) . Then, on March 30, 2000, the plaintiffs filed a so-called "Omnibus Motion," (R . 113),which among other things sought to amended the named lead plaintiffs . (We granted that motionon April 11, 2000. (R. 114.)) As this chronology shows, to date the plaintiffs have presentedfive different pleading documents. -'Thus, Thus, the next amendment will be the sixth, even though itprobably will be styled the fourth amended complaint .

Page 30

by the rulings made herein . T plaintiffs filed their fi rst complaint more than Ib. .,Aonths ago ;

they have had plenty of time - and opportunity given that the defendants sought dismissal o f

each complaint filed - to get it right . Plaintiffs alleging fraud are required to get their ducks i n

line before filing a first complaint , much less their sixth . See Ackerman v. Northwestern Mut.

Life Ins. Co., 172 F .3d 467, 469 (7t Cir. 1999) ("The purpose (the defensible purpose anyway) o f

the heightened pleading requirement in fraud cases is to force the plaintiff to do more than th e

usual investigation before filing his complaint .") .

For these reasons, we will not allow the plaintiffs a fifth opportunity to attempt to plea d

the allegations we have dismissed in this opinion ; as stated, those claims are dismissed with

prejudice . The current third amended complaint, (R . 42), is therefore dismissed without

prejudice to filing another amended complaint strictly comporting with the rulings made in this

opinion . This amended complaint is due on or before August 4, 2000 . The Court will hold a

status hearing on August 9, 2000 at 9:45 a .m .

Entered :

judge Ruben CastilloUnited States District Court

Date: June 12, 2000

Page 31

EXHIBIT D

UNITED STATES DISTRICT COURTNO' HERN DISTRICT OF ILLINOI S

Michael W . DobbinsCLERK

William F . LloydSidley & AustinBank One Plaz a10 South Dearborn StreetChicago, IL 60603

Office of the Cler k

Number : 1 :99-cv-00351-------------------------------------------Cas

e Title : Chu v . Sabratek Corp

Assigned Judge : Honorable Ruben Castill o

MINUTE ORDER of 7/25/00 by Hon . Ruben Castillo :On6/12/00, this court resolved motions to dismiss by all ofthe named defendants . The plaintiffs seek reconsiderationof our decision to dismiss with prejudice their improperrevenue recognition claim for failure to adequately allegescienter . The plaintiffs rely on arguments available tothem during the dismissal proceedings, as well as evidencethat the could have, but did not, discover at that time .thus, the plaintiffs do not satisfy the Rule 59 standards .See United States v . 47 W . 644 Route 38, 190 F .3d781, 783(7th Cir . 1999)( 11A party may-not introduce evidence or makearguments in a Rule 59 motion that could or should havebeen presented prior to judgment .") For this reason andbecause the plaintiffs have had more than ample opportunityto amend their complaint, we deny the motion to reconsider(15b-11 . Mailed notic e

This docket entry was made by the Clerk on July 27, 200 0

ATTENTION : This notice is being'sent pursuant to Rule 77(d) of theFederal Rules of Civil Procedure or Rule 49(c) of the FederalRules of Criminal Procedure . It was generated by ICMS ,the automated docketing system used to maintain the civil andcriminal dockets of this District . If a minute order orother document is enclosed, please refer to it fo radditional information .

For scheduled events, motion practices, recent opinions and other information,

EXHIBIT E

UNITED STATES DISTRICT COURTNORTHERN DISTRICT OF ILLINOI S

Michael W . DobbinsCLERK

O Tice of the Clerk

William F . LloydSidley & AustinBank One Plaz a10 South Dearborn StreetChicago, IL 6060 3

1 :9y-cv-00351 --------_..----------------------

"Cas

e Title

: Number

: Chu v . Sabratek Corp

Assigned Judge : Honorable Ruben Castill o

MINUTE ORDER of 7/12/00 by Hon . Ruben Castillo : Statushearing set for 8/9/00 is vacated . Plaintiff's motion forclass certification is granted [159-1] . Parties to submitbriefs on how the class should be defined by 8/11/00 .Plaintiff's motion for leave to conduct discovery isgranted [165-1] . Plaintiffs are given until 9/1/00 to filea 4th Amended Complaint . Status hearing held ; continued to8/16/00 at 9 :15 a .m . Mailed notic e

This docket entry was made by the Clerk on July 13, 200 0

ATTENTION : This notice is being sent pursuant to Rule 77(d) of theFederal Rules of Civil Procedure or Rule 49(c) of the FederalRules of Criminal Procedure . It was generated by ICMS ,the automated docketing system used to maintain the civil andcriminal dockets of this District . If a minute order orother document is enclosed, please refer to it fo radditional information .

For scheduled events, motion practices, recent opinions and other information,visit our web site at www .ilnd .uscourts .gov

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To apply for a PACER account, call 1 .800 .676 .6856

EXHIBIT F

2000 WL 1206482(Cite as : 2000 WL 1206482 ( Cir.(Ill .}}}<KeyCite History >

Only the Westlaw citation is currentlyavailable .

United States Court of Appeals,Seventh Circuit.

Lawrence HEAD, Plaintiff-Appellant,. . . V.

CHICAGO SCHOOL REFORM BOARDOF TRUSTEES, Defendant-Appellee.

No. 99-3408 .

Argued March 30, 2000Decided Aug.. .25, 2000

Former elementary school principal suedschool board, alleging due process violations inconnection with his reassignment toadministrative position. School board movedto dismiss. The United States District Courtfor the Northern District of Illinois, David H .Coar, J., 1999 WL 410005, denied motion inpart. School board moved for summaryjudgment on remaining claims, which motionwas granted, 1999 WL 759512 . Former

principal appealed from both decisions . TheCourt of Appeals, Williams, Circuit Judge,held that: (1) principal's allegations wereinsufficient to support claim of deprivation ofdue process liberty interest in pursuing hisoccupation; (2) principal had no protectableproperty interest in employment beyond termof his contract; (3) principal had protectableproperty interest in completing his contract inaccordance with terms thereof; (4) deprivationof such interest was more than de minimis ; (5)principal received all process due; and (6)question of material fact precluded summaryjudgment on principal's claim for breach ofcontract .

Affirmed in part , reversed in part, andremanded .

[1] Federal Courts a 58 9

170Bk589

District court's ruling on school board's motionto dismiss claims brought against it by former

Page 1

elementary school principal, granting motionas to two claims and denying it as to twoothers, was not "final decision" for purposes ofappeal, in that it was without prejudice anddid not dispose of all claims. 28 U.S.C.A. §1291 ; Fed.Rules Civ.Proc .Rule 12(bX6), 28U.S.C.A .

(2) Federal Courts c,;= 769170Bk769

Nonfinal decisions become appealable after afinal decision is entered . 28 U.S.C.A. § 1291 .

[3] Federal Courts c 769170Bk769

District court's partial grant and partialdenial of school board's motion . to dismissclaims brought against it by formerelementary school principal was renderedappealable by entry of final order grantingschool board's motion for summary judgmenton remaining claims, and by entry of finaljudgment thereon. 28 U.S.C .A. § 1291;Fed.Rules Civ.Proc .Rule 58, 28 U.S .C .A .

[4] Federal Courts Q;- 776170Bk776

[4] Federal Courts «794170Bk794

Court of Appeals reviews dismissal for failureto state a claim de novo, taking a plaintiffsfactual allegations as true and drawing allreasonable inferences in his or her favor.Fed.Rules Civ.Proc .Rule 12(bX6), 28 U .S.C.A.

[5] Federal Civil Procedure c 1773170Ak1773

Claim should be dismissed for failure to statea claim upon which relief can be granted onlyif no relief could be granted under any set offacts that could be proved consistent with theallegations. Fed.Rules Civ.Proc .Rule 12(bX6),28 U.S.C.A .

[6] Constitutional Law € 278.4(1)92k278.4(1 )

Copr. © West 2000 No Claim to Orig . U.S. Govt . Works

Westlaw®

r 2000 WL 1206482(Cite as : 2000 WL 1206482 ( , Cir.(I11 .)))

Claim that a government employer has

infringed an employee's liberty to pursue theoccupation of his or her choice requires that :(1) the employee be stigmatized by theemployer's actions; (2) the stigmatizinginformation be publicly disclosed ; and (3) theemployee suffer a tangible loss of otheremployment opportunities as a result of thepublic disclosure . U.S.C.A. Const.Amend. 14 .

[71 Constitutional Law G= 278.4(1)92k278.4(1 )

Simply labeling a public employee as beingincompetent or otherwise unable to meet anemployer's expectations does not infringe theemployee's liberty to pursue the occupation ofhis or her choice; the employee's good name,reputation, honor, or integrity must be calledinto question in such a way as to make itvirtually impossible for the employee to findnew employment in his chosen field.

[81 Civil Rights C;- 235(3)78k235(3)

Terminated elementary school principal wasnot required to plead sufficient facts toestablish the legal elements of his claim inorder to survive school board's motion todismiss, and allegations in complaint,although conclusory and somewhatincomplete , were adequate to put reader onnotice as to gravamen of former principal'sdue process liberty interest claim. U.S.C .A.Const .Amend . 14; Fed.Rules Civ.Proc .Rule12(bX6), 28 U .S.C.A .

[9] Civil Rights G- 235(3)78k235(3 )

Former elementary school principal'sallegations that school board memberspublished allegations against him amountingto "charges of ineptitude and professional

inadequacies" were insufficient to supportclaim of deprivation of due process libertyinterest in pursuing his occupation, asinsufficient stigma attached to mereallegations of professional incompetence tomake it virtually impossible for formerprincipal to find new employment in his

Page 2

chosen field . U .S .C .A. Const.Amend. 14 .

[101 Constitutional Law cg= 278.4(3)92k278.4(3)

Simple charges of professional incompetencedo not impose the sort of stigma that actuallyinfringes a public employee's liberty interestin pursuing an occupation; only if thecircumstances of an employee's discharge sosully the employee's reputation or characterthat the employee will essentially beblacklisted in his or her chosen profession willit be possible to pursue a due process libertyinterest claim. U.S.C.A. Const .Amend. 14 ,

[111 Constitutional Law c- 277(2)92k277(2 )

Elementary school principal originallyemployed on four-year contract had noproperty interest subject to due processprotections in employment beyond term ofsuch contract , based on inclusion in contract ofrequirement that he be given notice fivemonths before end of contract term regardingwhether contract would be renewed, wherecontract explicitly provided that it expired atend of its stated term and was not' to beconstrued to grant or create any contractualrights or other expectancy of continuedemployment beyond its term. U.S.C.A .Const .Amend. 14 .

[121 Constitutional Law G 277(1)92k277(1 )

"Property interests" are constitutionallyenforceable entitlements to a benefit or right,and can arise directly from state or federallaw, as with a statute granting a benefit, orindirectly through the operation of state orfederal law on certain conduct, as with acontract .

[131 Constitutional Law ! 277(1)92k277(1 )

Mere opportunity to acquire property does notqualify as a property interest protected by theConstitution.

Colir. e West 2000 No Claim to Orig . U.S. Govt. Works

Westlaw

2000 WL 1206482(Cite as: 2000 WL 1206482 ( Cir.(Ill .)))

[14] Federal Courts : 776170Bk776

[141 Federal Courts G - 802170Bk8O2

Reviewing court reviews a district court'sgrant of summary judgment de novo,construing the evidence and the inferencesdrawn from it in the light most favorable tothe non-moving party. Fed.RulesCiv.Proc.Rule 56(c), 28 U .S.C.A.

[15] Constitutional Law 277(2)92k277(2 )

Elementary school principal, as public

employee who by contract and statute could beremoved only on limited grounds, hadconstitutionally protectable property interestin completing his contract in accordance withterms thereof. U.S.C .A. Const .Amend. 14 .

[161 Constitutional Law (F,- 278.4(1)92k278.4(1 )

Deprivation of public employee's propertyinterest in completing his contract inaccordance with terms thereof must be morethan de minimis in order to be actionable .U.S.C .A. Const .Amend. 14 .

[17] Constitutional Law c 278 . 5(2.1)92k278.5(2 .1 )

Alleged deprivation of elementary schoolprincipal's property interest in completing hiscontract in accordance with terms thereof,occasioned by his removal as principal andreassignment to administrative duties at samesalary and benefits as he had received prior toremoval and reassignment , was more than deminimis, where principal also alleged that hewould have received increased salary andbenefits had he continued as principal inaccordance with his contract. U.S.C.A .Const .Amend. 14 .

[17] Schools 147.28345k147 .28

Alleged deprivation of elementary school

Page 3

principal 's property interest in completing hiscontract in accordance with terms thereof,occasioned by his removal as principal andreassignment to administrative duties at samesalary and benefits as he had received prior toremoval and reassignment , was more than deminimis, where principal also alleged that hewould have received increased salary andbenefits had he continued as principal inaccordance with his contract . U.S.C .A.Const.Amend. 14 ,

[18] Constitutional Law q- 278.5(4)92k278 .5(4)

Elementary school principal received allprocess to which he was constitutionallyentitled prior to deprivation of his protectedproperty interest in completing his contractaccording to its terms, where principalreceived adequate notice of principal removalhearing and decisionmaker appointed topreside at hearing was impartial . U .S.C .A .Const.Amend. 14 .

[18] Schools € ' 147.34(1)345k147.34(1 )

[18] Schools c' 147.36345k147 .36

Elementary school principal received a llprocess to which he was constitutionallyentitled prior to deprivation of his protectedproperty interest in completing his contractaccording to its terms, where principalreceived adequate notice of principal removalhearing and decisionmaker appointed topreside at hearing was impartial . U.S.C.A .Const . Amend. 14 .

[19] Constitutional Law «278.4(5)92k278.4(5)

Public employer who removes an employeefrom a job in which the employee has aconstitutionally protected interest mustprovide certain limited pre- terminationprocedures, including, at a minimum: (1) oralor written notice of the charges ; (2) anexplanation of the employer's evidence; and(3) an opportunity for the employee to tell hi s

Copr. a West 2000 No Claim to Orig . U.S. Govt . Works

Westlaw

2000 WL 1206482(Cite as: 2000 WL 1206482 Cir.(Ill .)) )

or her side of the story. U.S.C.A .Const .Amend. 14 .

[201 Constitutional Law 278.4(5)92k278.4(5)

Chosen decisionmaker with respect to publicemployer's decision to remove an employeefrom a job in which the employee has aconstitutionally protected interest must beimpartial . U.S.C .A. Const .Amend. 14 .

[21] Constitutional Law G 278.5(4)92k278.5(4)

School board 's failure to provide elementaryschool principal with elaborate , trial-type

rights, including the ability to cross-examinewitnesses , at pre - termination hearing, did notdeprive principal of due process . U.S.C.A .Const .Amend. 14 .

[21] Schools,*- 147.38345k147.38

School board's failure to provide elementaryschool principal with elaborate , trial-type

rights, including the ability to cross-examinewitnesses , at pre- termination hearing, did notdeprive principal of due process . U.S.C.A .Const .Amend. 14 .

[22] Constitutional Law e 278.5(4)92k278.5(4)

Notice received by elementary school principalof principal removal hearing satisfied dueprocess requirements , where school board sentprincipal two letters over one week prior tohearing, informing him that principal removalhearing had been scheduled and detailing fourparticular grounds on which his removal wasbeing sought , and where principal admittedthat he was fully app rised of charges athearing and was subsequently able to submitbrief in response to evidence presented athearing. U.S.C.A . Const .Amend. 14 .

[22] Schools C= 147.34(1)345k147 .34(1 )

Notice received by elementary school principal

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of principal removal hearing satisfied dueprocess requirements, where school board sentprincipal two letters over one week prior tohearing, informing him that principal removalhearing had been scheduled and detailing fourparticular grounds on which his removal wasbeing sought, and where principal admittedthat he was fully apprised of charges athearing and was subsequently able to submitbrief in response to evidence presented athearing . U .S .C.A. Const .Amend. 14 .

[23] Constitutional Law < '251 .692k251 . 6

Notice of a proceeding is constitutionallyadequate for due process purposes if it isreasonably calculated to apprise interestedparties of the proceeding and afford them anopportunity to present their objections .U.S.C.A. Const . Amend. 14 .

[24] Constitutional Law € 278.5(4)92k278.5(4)

Evidence that adjudicator who presided atremoval hearing called by school board inconnection with removal of elementary schoolprincipal was employed by school board, hadpreviously represented both p rincipal andschool board, and had on prior occasionpresented evidence regarding a controversy atprincipal 's school was insufficient to overcomepresumption of adjudicator 's good faith,honesty, and integrity , and did notdemonstrate that principal was deniedimpartial decisionmaker to whom due processentitled him; principal 's evidence amounted tonothing more than evidence of adjudicator'sprior familiarity with him and his school.U.S.C.A . Const . Amend. 14 .

[24] Schools s=147.36345k147 .36

Evidence that adjudicator who presided atremoval hearing called by school board inconnection with removal of elementary schoolprincipal was employed by school board, hadpreviously represented both principal andschool board, and had on prior occasionpresented evidence regarding a controversy at

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principal's school was insufficient to overcomepresumption of adjudicator's good faith,honesty, and integrity, and did notdemonstrate that principal was deniedimpartial decisionmaker to whom due processentitled him; principal 's evidence amounted tonothing more than evidence of adjudicator'sprior familiarity with him and his school .U.S.C.A. Const .Amend. 14 .

[25] Administrative Law and Procedure9 31415Ak314

Those serving as adjudicators are presumed toact in good faith, honestly, and with integrity .

[26] Administrative Law and Procedure€ 31415Ak314

To overcome the presumption of anadjudicator's good faith, honesty, andintegrity, a plaintiff must come forward withsubstantial evidence of actual or potentialbias, such as evidence of a pecuniary interestin the proceeding, personal animosity towardthe plaintiff, or actual prejudgment of theplaintiff's case .

[27] Administrative Law and ProcedureC~ 31415Ak31 4

Evidence of an adjudicator's prior familiaritywith the plaintiff or his or her situation, oreven of involvement in the particular matterunder consideration, is not adequate by itselfto overcome the presumption of theadjudicator's good faith, honesty, andintegrity .

[281 Constitutional Law € 278 .4(5)92k278.4(5)

For purposes of determining whether aterminated public employee receivedconstitutionally adequate process, it does notmatter if the state provided the procedures itwas required to provide under its own laws .U.S.C.A . Const.Amend. 14 .

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[291 Federal Civil Procedure C 2497.1170Ak2497 . 1

Question of material fact as to whether schoolboard breached elementary school principal'semployment contract by removing him fromhis position and reassigning him toadministrative duties prior to expiration of hiscontract precluded summary judgment onprincipal's breach of contract claim, whereprincipal's removal and reassignment were onstatutory grounds which were not amongcontractually enumerated permissible groundsfor termination. S.H.A. 105 ILCS 5/34-8.3(d) .

[301 Schools 147.28345k147.28

Provision of elementary school principal'semployment contract stating that principalwas required to fulfill obligations placed onhim by state School Code did not incorporateall statutory grounds for termination ofprincipals into principal's contract, wherecontract specifically identified only oneprovision of School Code which could formbasis for termination of contract, as one of fivepermissible grounds for termination. S .H.A .105 ILCS 5/34-85 .Appeal from the United States District Courtfor 'the Northern District of Illinois, EasternDivision. No. 98 C 3943--David H. Coar,Judge.

Before Bauer, Diane P. Wood, and Williams,Circuit Judges .

Williams, Circuit Judge .

*1 Before the start of the 1994-95 school yearLawrence Head accepted a four-year contractto serve as the principal of Chicago'sNathaniel Pope Elementary School . After the1996-97 school year, however, the ChicagoSchool Reform Board of Trustees removedHead from his position and assigned him toadministrative duties in the Department ofSchools and Regions . Believing that the SchoolReform Board of Trustees had violated his dueprocess rights and had breached its contractwith him, Head filed suit against the SchoolReform Board of Trustees . The district court

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rejected Head's claims and Head now appeals .For the reasons stated below, we affirm inpart and reverse in part .

In March of 1994, the Chicago Board ofEducation, [FN1] acting through the LocalSchool Council, hired Head as the principal forNathaniel Pope Elementary School ("PopeElementary") and gave him a four-yearcontract ending June 30, 1998 . By its ownterms, the contract could be terminated onlyon certain limited grounds . [FN2] Similarly,under the Illinois School Code, Head could bedischarged during the term of his contractonly for cause following an extensive anddetailed notice and hearing process. 105 Ill .Comp. Stat . 5/34-85 .

Beginning in 1995, the Board, aided by newlyenacted state laws granting it greater powers,1995 Ill . Laws 89-15, sec . 5, began to step upits efforts to remedy deficient performance inChicago's public schools. Pursuant to theseefforts, in October 1996, Pope Elementary wasidentified as a poorly performing school andwas placed on probation. A school on probationis subject to greater Board oversight and musttake certain steps to improve performance.105 11 1 . Comp. Stat . 5/34-8 .3 . In particular,Head, as Pope Elementary's principal, hadprimary responsibility for implementing aCorrective Action Plan to raise student testscores .

During the 1996-97 school year, the Boardcame to the conclusion that Head was notfulfilling his responsibility in this regard.Therefore, in early June of 1997, HazelStewart, the Education Officer for the regionencompassing Pope Elementary, advised Headthat the Board would seek to remove him asPope Elementary's principal at the end of thatschool year . A letter signed by Chicago PublicSchools CEO Paul Vallas and dated July 2,notified Head that pursuant to 105 Ill . Comp .Stat. 5/34-8 .3(d), which governs schools underprobation, a principal removal hearing wouldbe scheduled for Pope Elementary . Headreceived a second letter signed by Vallas,dated July 3, scheduling the removal hearing

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for July 14 and detailing the criteria theBoard used in deciding to seek his removal .[FN3] A separate letter also notified the schoolcommunity of the principal removal hearing .

Margaret Fitzpatrick presided over the July14 hearing. During the hearing, eightwitnesses presented evidence supportingHead's removal while seven witnessestestified on Head's behalf After the hearing,Head, through his attorney, submitted a briefarguing against his removal. About a weekafter the hearing, Fitzpatrick issued a writtendecision recommending that Head be removedas principal of Pope Elementary . That sameweek, a Chicago Public Schools official, PhillipHansen, criticized Head's performance on acable access program. Then, on July 28, theBoard adopted Fitzpatrick's recommendationand removed Head as principal of PopeElementary .

*2 Following the Board's decision, Head wasassigned to work in the Department of Schoolsand Regions, and from there, he obtained anassignment as a hearing officer . Head'semployment with the Board ended in Augustof 1998, 60 days after the expiration of hiscontract . Throughout this period, Headcontinued to receive the same pay and benefitshe had received as the principal of PopeElementary, though Head claims that he losta salary increase he would have received hadhe remained principal.

Eventually, Head filed suit against the Boardbased on the Board's actions in removing himas principal of Pope Elementary . He raisedessentially four claims: (1) that, without dueprocess, the Board had deprived him of aliberty interest in pursuing his occupation; (2)that, without due process, the Board haddeprived him of a property interest inemployment beyond the term of his contract ;(3) that, without due process, the Board haddeprived him of a property interest inemployment through the end of his contract ;and (4) that the Board had breached itscontract with him. On a motion to dismiss forfailure to state a claim under Fed .R.Civ.P.12(bX6), the district court rejected the first twoof these claims, but allowed the last two

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claims to go forward. [FN4] Later, however, ona motion for summary judgment, the districtcourt rejected Head's remaining claims andentered judgment in the Board's favor . Headappeals the district court's decisions on allfour of his claims .

II

Before we come to the merits of Head'sappeal, we must address a jurisdictional issueraised by the Board . The Board argues that welack appellate jurisdiction to consider Head'schallenge to the district court's decision todismiss, under Fed .R.Civ.P. 12(b )(6), two of hisclaims. The Board claims that the districtcourt dismissed the two claims withoutprejudice, [FN5] and therefore, the dismissaldoes not qualify as an appealable "finaldecision" under 28 U.S.C. sec . 1291.

[1][2][31 While it is true that the districtcourt's ruling on the Board's motion to dismissis not a final decision (not only because it waswithout prejudice, but also because it did notdispose of all of Head's claims, see LeBlangMotors, Ltd . v. Subaru of Am., Inc., 148 F.3d680, 687 (7th Cir.1998) (discussing finality ofdismissals without prejudice); United States v.Ettrick Wood Prods., Inc., 916 F.2d 1211,1216-17 (7th Cir .1990) (discussing finality ofdecisions disposing of fewer than all claimsagainst all parties)), nonfinal decisions become,appealable after a final decision is entered :Badger Pharm., Inc. v. Colgate-Palmolive Co .,1 F.3d 621, 626 (7th Cir,1993) (an appeal froma final decision brings up for review allprevious orders entered in the case) ; Bastian v .Petren Resources Corp ., 892 F.2d 680, 682-83(7th Civ.1990) (same) . And,- tM-t efrict court'sruling on the:- Board's summary judgmentmotion is a final decision . as it resolved alloutstanding claimp.. and made clear thatHead's suit was at an end:'See Otis v . City ofChicago, 29 F.3d 1159, 1163-66 (7th Cir.1994)(en bane). Moreover, the district court entereda formal Fed.R.Civ.P. 58 judgment, whichremoves any doubt as to whether any portionof Head's suit remained active . See Kolman v .Shalala, 39 F.3d 173, 177 (7th Cir .1994) .Accordingly, this court has jurisdiction toconsider all of Head's claims on appeal .

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M A. Claims Resolved in Motion to DismissDecision

*3 [4][5] We consider first the two claims thedistrict court dismissed under Rule 12(bX6)--that, without due process, the Board deprivedHead of a liberty interest in pursuing theoccupation of his choice and that, without dueprocess, the Board deprived Head of a propertyinterest in employment beyond the term of hiscontract. We review such dismissals de novo,taking a plaintiffs factual allegations as trueand drawing all reasonable inferences in hisor her favor. Strasburger v . Board of Educ.,Hardin County Community Unit Sch . Dist .No . 1, 143 F.3d 351, 359 (7th Cir.1998) . Aclaim should be dismissed under Rule 12(bX6)only if "no relief could be granted 'under anyset of facts that could be proved consistentwith the allegations .' " Nance v . Vieregge, 147F.3d 589, 590 (7th Cir .1998) (quoting Hishonv. King & Spalding, 467 U.S. 69, 73, 104 S.Ct .2229, 81 L.Ed.2d 59 (1984)).

1. Liberty Interest Claim

In setting out the basis for his due processliberty interest claim in his complaint, [FN6]Head alleged that the Board (or at leastcertain persons associated with the Board)deprived him of a liberty interest in pursuingthe occupation of his choice by disseminatingfalse allegations regarding his performance asPope Elementary's principal . [FN7] In rulingthat Head's allegations failed to state a claim,the district court concluded that Head had notadequately alleged that the Board deprivedhim of a liberty interest in pursuing hisoccupation. We agree, although for a reasonslightly different than that given by thedistrict court .

[6][7] A claim that a government employerhas infringed an employee's liberty to pursuethe occupation of his or her choice requiresthat (1) the employee be stigmatized by theemployer's actions ; (2) the stigmatizinginformation be publicly disclosed ; and (3) theemployee suffer a tangible loss of otheremployment opportunities as a result of thepublic disclosure . Strasburger, 143 F .3d at356 ; Harris v. City of Auburn, 27 F .3d 1284 ,

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1286 (7th Cir .1994). However, simply labelingan employee as being incompetent orotherwise unable to meet an employer'sexpectations does not infringe the employee'sliberty . Lashbrook v. Oerkfitz, 65 F.3d 1339,1348-49 (7th Cir.1995) . The employee's goodname, reputation, honor, or integrity must becalled into question in such a way as to makeit virtually impossible for the employee to findnew employment in his chosen field . Olivieriv. Rodriguez, 122 F.3d 406, 408 (7th Cir.1997) ;

Lashbrook, 65 F .3d at 1348-49; Colaizzi v .

Walker, 812 F,2d 304, 307 (7th Cir .1987).

[8] The district court based its dismissal ofHead 's due process liberty interest claim on adetermination that Head had not pleadedsufficient facts to establish the legal elementsof his claim. To survive a motion to dismiss,however , Head was not required to plead withsuch particularity . See Veazey V.Communications & Cable of Chicago , Inc., 194F.3d 850, 853-54 (7th Cir . 1999 ) ; Bennett v .Schmidt, 153 F . 3d 516 , 518-19 (7th Cir.1998) .

The allegations in Head 's complaint, althoughconclusory and somewhat incomplete, areadequate to put a reader on notice as to thegravamen of Head's due process libertyinterest claim. As such , the allegations aresufficiently particular to survive a motion todismiss . See Scott v . City of Chicago, 195 F .3d950, 951 -52 (7th Cir . 1999 ) ; Bennett, 153 F .3dat 518-19 .

[9][10] The problem for Head is notinsufficient particularity, but rather too muchparticularity . He alleged in his complaint thatthe Board's published allegations "constitutecharges of ineptitude and professionalinadequacies." If this is true, as we mustassume it to be, Head has pleaded himself outof court by including allegations that establishhis inability to state a claim for relief . SeeBennett, 153 F.3d at 519; Thomas v. Farley,31 F.3d 557, 558-59 (7th Cir .1994) . Simplecharges of professional incompetence do notimpose the sort of stigma that actuallyinfringes an employee's liberty to pursue anoccupation . Lashbrook, 65 F.3d at 1348-49 ;Munson v. Friske, 754 F.2d 683, 693-94 (7thCir.1985) . Only if the circumstances of anemployee's discharge so sully the employee's

reputation or character that the employee willessentially be blacklisted in his or her chosenprofession will it be possible to pursue a dueprocess liberty interest claim. Lashbrook, 65F.3d at 1348-49 (listing charges of immorality,dishonesty, alcoholism, disloyalty,Communism, or subversive acts as the sort ofcharges that infringe an employee's liberty) ;Ratliff v. City of Milwaukee, 795 F.2d 612,625-26 (7th Cir.1986) (concluding that chargesof untruthfulness, neglect of duty, andinsubordination against a police officer imposesufficient stigma) ; see also Olivieri, 122 F .3dat 408; Colaizzi, 812 F.2d at 307. As Head'sallegations of stigma fall short of thisthreshold, he has failed to state a due processliberty interest claim .

2. Property Interest Claim

*4 [11][12][13] Head claims that arequirement, found both in his contract and ina 1996 Board publication, that he be givennotice five months before the end of thecontract term regarding whether his contractwould be renewed, grants him a propertyinterest in employment beyond the term of hiscontract, which the Board could not deprivehim of without due process . After reviewingHead's entire contract (which Head attachedto his complaint), the district court concludedthat Head had no property interest in futureemployment with the Board and thereforecould not state a due process claim. We agree.Property interests are enforceableentitlements to a benefit or right. Board ofRegents v . Roth, 408 U.S. 564, 577, 92 S .Ct .2701, 33 L .Ed.2d 548 (1972); Lashbrook, 65F .3d at 1345 ; Swick v. City of Chicago, 11F.3d 85, 86 (7th Cir.1993). They can arisedirectly from state or federal law (as with astatute granting a benefit) or indirectlythrough the operation of state or federal 'lawon certain conduct (as with a contract) .Lashbrook, 65 F.3d at 1345; Swick, 11 F.3d at86. A mere opportunity to acquire property,however, does not itself qualify as a propertyinterest protected by the Constitution. Kyle v .Morton High Sch ., 144 F.3d 448, 452 (7thCir.1998) (per curiam); Cornelius v . LaCroix,838 F.2d 207, 210-12 (7th Cir .1988) .

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Head's contract with the Board makes it plainthat Head has no enforceable entitlement toemployment beyond the term of the contract .It provides, "This Agreement, including andnot withstanding the procedures set forthherein, shall expire at the end of its statedterm and shall not grant or create anycontractual rights or other expectancy ofcontinued employment beyond the term of thisAgreement ." This provision conclusivelydispels any confusion regarding the possibilityof a property interest in future employmentcreated by the requirement that Head begiven five months notice of whether hiscontract would be renewed. And, there isnothing in the Illinois School Code thatoverrides (or is even inconsistent with) thisaspect of the contract . Cf. Lyznicki v . Board ofEduc., Sch. Dist. 167, Cook County, Ill ., 707F.2d 949, 951-52 (7th Cir.1983) (considering asimilar claim by a principal based on theIllinois School Code) . Accordingly, the districtcourt properly dismissed Head's claim that theBoard unconstitutionally deprived him of aprotected property interest in employmentbeyond the term of his contract .

B. Claims Resolved in Summary JudgmentDecision

*5 [14] We turn next to the two claims onwhich the district court granted summaryjudgment--that, without due process, theBoard deprived Head of a property interest inremaining the principal of Pope Elementarythrough the end of his contractual term ofemployment, and that the Board breached itscontract with him . This court reviews adistrict court's grant of summary judgment denovo, construing the evidence and theinferences drawn from it in the light mostfavorable to the non-moving party . Curran v .Kwon, 153 F.3d 481, 485 (7th Cir .1998) .Summary judgment is appropriate wherethere is no genuine issue of material fact suchthat judgment is proper as a matter of law. Id .(citing Fed.R.Civ.P . 56(c)) .

1 . Due Process Claim

[15][16] In support of his remaining dueprocess claim , Head contends that by

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removing him from his position as principal ofPope Elementary before the end of his

contract, the Board deprived him of a propertyinterest in continuing in that position for theterm of his contract. There can be no doubtthat, as a public employee who by contract andstatute could be removed only on limitedgrounds, Head had a property interest incompleting his contract in accordance with theterms of his contract, one of which specificallymade him principal of Pope Elementary . Jonesv. City of Gary, Ind., 57 F.3d 1435, 1440-41(7th Cir .1995); Vail v. Board of Educ ., 706F.2d 1435, 1437-38 (7th Cir .), affd. by anequally divided Court, 464 U.S. 813, 104 S .Ct .66, 78 L.Ed.2d 81 (1983) . The question theBoard raises , which the district court neveradequately addressed, is whether thedeprivation Head suffered is more than deminimis , as it must be to be actionable . Swickv. City of Chicago, supra, 11 F .3d at 87-88; seealso Dill v. City of Edmond, Okla ., 155 F .3d1193, 1206-07 (10th Cir.1998) (collectingcases) .

(17][18] The Board suggests that becauseHead received the same salary and benefitsafter his removal that he did when he wasprincipal, he, at most, suffered a de ininimisdeprivation of property . The Board'ssuggestion is flawed, however. To begin with,the relevant question is whether Headreceived all the salary and benefits he wouldhave received if he had remained PopeElementary's principal . Head opposed theBoard's summary judgment motion on theground that he did not receive all he wouldhave been due. If he is right, he suffered aninjury that is plainly more than de minimis .See Swick, 11 F.3d at 86-88 (pecuniary lossesqualify as actionable deprivations of property) .Moreover, even if Head did receive all hewould have been due had he remained PopeElementary's principal, he might still havehad a constitutionally protected propertyinterest in remaining in that position . Wehave recognized that a loss of position thatimpedes future job opportunities or has otherindirect effects on future income can inflict anactionable deprivation of property . Swick, 11F.3d at 86 . We need not definitively answerwhether Head has adequately established that

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he possessed a protected property interest in

remaining Pope Elementary's principalthrough the end of his contract, however, sincewe agree with the district court that Head'schallenges to the adequacy of the proceduresafforded him prior to his removal are withoutmerit .

*6 [19][20][211 A public employer whoremoves an employee from a job in which theemployee has a constitutionally protectedinterest must provide certain limited pre-termination procedures, [FN8] including, at aminimum: (1) oral or written notice of thecharges; (2) an explanation of the employer'sevidence; and (3) an opportunity for theemployee to tell his or her side of the story .Cleveland Bd. of Educ. v. Loudermill, 470U.S. 532, 546, 105 S.Ct . 1487, 84 L.Ed.2d 494(1985); Staples v . City of Milwaukee, 142 F .3d383, 385 (7th Cir.1998). Also, the chosendecisionmaker must be impartial . Bakalis v.Golembeski, 35 F .3d 318, 323-26 (7thCir .1994). Head contends that the procedureshe was afforded did not satisfy these minimumrequirements in two respects . (FN91

[22][231 Head first complains that he did notreceive adequate notice of the charges that ledto his removal . We cannot accept thisargument, however. Notice is constitutionallyadequate if it is reasonably calculated toapprise interested parties of the proceedingand afford them an opportunity to presenttheir objections. Memphis Light, Gas & WaterDiv. v. Craft, 436 U.S. 1, 14, 98 S .Ct . 1554, 56L.Ed.2d 30 (1978); Mullane v. CentralHanover Bank & Trust Co ., 339 U.S. 306, 314,70 S.Ct. 652, 94 L.Ed. 865 (1950); HartlandSportsman's Club, Inc . v. Town of Delafield,35 F .3d 1198, 1201 (7th Cir.1994) . In a pair ofletters sent over one week prior to the removalhearing, the Board informed Head that aprincipal removal hearing had been scheduledfor Pope Elementary and detailed fourparticular grounds on which his removal wasbeing sought, see supra note 3. Clearly, Headwas apprised of the removal proceedings, and,while the charges against him may not havebeen as specific as Head would have liked,they were certainly sufficient to allow him todefend himself. In any event, Head admits

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that he was fully apprised of the charges atthe hearing and that afterwards he was ableto submit a brief in response to the evidencepresented at the hearing. For both of thesereasons, we find it impossible to conclude thatHead did not receive adequate notice of thecharges that led to his removal .

[24][25][26J{27] Head also complains thatMargaret Fitzpatrick, the hearing officer whopresided over his removal hearing, was not animpartial decisionmaker. Specifically, Headcontends that Fitzpatrick cannot be consideredan impartial decisionmaker because she wasemployed by the Board, he had no input onher selection, she had previously representedhim and the Board, and she had on a prioroccasion presented evidence regarding anearlier controversy at Pope Elementary . Thoseserving as adjudicators are presumed to act ingood faith, honestly, and with integrity.Withrow v . Larkin, 421 U.S. 35, 47, 95 S.Ct .1456, 43 L.Ed.2d 712 (1975) . To overcome thispresumption, a plaintiff must come forwardwith substantial evidence of actual or

potential bias, such as evidence of a pecuniaryinterest in the proceeding, personal animositytoward the plaintiff, or actual prejudgment ofthe plaintiff's case. Id . ; Bakalis, 35 F .3d at323-26. Evidence of prior familiarity with theplaintiff or his or her situation, or even ofinvolvement in the particular matter underconsideration, is not adequate by itself toovercome the presumption. Withrow, 421 U .S.at 47; Hortonville Joint Sch . Dist . No. 1 v.Hortonville Educ. Ass'n, 426 U .S. 482, 493, 96S.Ct . 2308, 49 L.Ed.2d 1 (1976); Staples, 142F.3d at 387; Panozzo v . Rhoads, 905 F .2d 135,140 (7th Cir .1990) . Viewed in the light mostfavorable to Head, the evidence he relies onamounts to nothing more than evidence ofFitzpatrick's prior familiarity with him andPope Elementary . As such, it does notovercome the presumption of good faith that isafforded adjudicators . Accordingly, Head'sclaim that Fitzpatrick was biased must fail .

*7 [28] As there appears to be no reason todoubt that the Board afforded Headconstitutionally adequate procedures beforeremoving him as principal of PopeElementary, [FN10]the Board was entitled to

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summary judgment on Head's due processproperty interest claim relating to his removalbefore the end of his contractual term ofemployment .

2 . Breach of Contract Claim

[29] Head claims that by removing him fromhis position as principal of Pope Elementarybefore the end of his four-year contractualterm of employment, the Board breached itscontract with him. The district court concludedthat no breach occurred because the IllinoisSchool Code governs Head's contract and, inremoving Head, the Board complied with theprovisions of the Illinois School Coderegarding the removal of a principal from aschool on probation (specifically 105 Il l . Comp .Stat . 5/34-8.3(d)) . Head argues that the districtcourt misinterpreted the contract. We agree .

As the contract between Head and the Boardspecifically makes Head principal of PopeElementary, there can be no doubt that theBoard terminated the contract by removingHead from that position. The question iswhether it had grounds for terminating thecontract. As noted above, see supra note 2, thecontract provides five grounds for termination .Removal of the principal pursuant to 105 111 .Comp. Stat. 5/34-8.3(d) is not one of them, norhas the Board ever suggested that any of thegrounds for termination has been satisfied.The only ground with any connection to thereasons for Head's removal is, "discharge ofthe Principal for cause pursuant toII1 .Rev.Stat . Ch. 122, sec . 34-85." [FN11]But,the Board concedes that it did not follow theprocedures or afford Head the rights providedby sec . 34-85 .

[30] The district court did not considerwhether the Board had established any of thecontractual grounds for terminating itscontract with Head. Instead, the courtconcluded that the contract is governed by,and therefore apparently incorporates, theIllinois School Code, and that if Head wasproperly removed under any provision of theIllinois School Code, there could not be abreach of the contract . This interpretationreads too much into the contract . The contract

Page 1 1

does provide that Head must fulfill theobligations placed on him by the IllinoisSchool Code, but the contract says nothingabout incorporating, wholesale, the variousprovisions of the Illinois School Code relatingto the removal of a principal . There is, forinstance, no term allowing for termination ofthe contract upon "discharge of the principalpursuant to the Illinois School Code ." To thecontrary, the contract specifically identifies asingle provision, sec . 34-85, that must be usedin discharging a principal for cause . As weread the Board's contract with Head, thecontract may be terminated only if one of thefive contractual grounds for termination issatisfied.

*8 Whether by mistake or design, Head'scontract grants him greater rights than theIllinois School Code appears to grant him. TheBoard was obligated to honor thosecontractual rights by satisfying one of the fivecontractual grounds for termination of thecontract. It did not do so . Accordingly, weconclude that the district court erred in rulingthat the Board did not breach its contract withHead .

w

For the foregoing reasons, we conclude thatthere is no merit to Head's due process claims,but that his breach of contract claim shouldhave survived summary judgment .Accordingly, we Affirm in part and Reverse inpart the judgment of the district court, and weRemand the case for further proceedings.

FNI . The Board of Education was subsequentlysupplanted by the School Reform Board of Trustees,which itself was recently replaced by a new Board ofEducation . For simplicity's sake, we will refer to allof these entities simply as the Board . "

FN2. The contract provides :This Agreement may be terminated for any one ofthe following reasons or by any one of the followingmethods :(a) written agreement of the Local School Council,Board of Education and the Principal ;(b) discharge of the Principal for cause pursuant toIll .Rev .S ta t . Ch . 122 , sec . 34-85 :

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(c) closure of the attendance center :(d) death, resignation or retirement of the Principal ;(e) misrepresentation referred to in section IX of thisAgreement [which requires certain truthfulrepresentations to be made] .

FN3 . Specifically, the criteria detailed were :A . Failure of the Principal to effectively and/orsufficiently implement the Corrective Action Plan,which has resulted in deficiencies in any of thefollowing :* School leadership ;* Parent/community partnerships ;* Student centered learning climate ;* Professional development and collaboration;* Quality instruction plan; and

* School management.B . Failure of the school to show sufficient increase

in student scores on the TAP achievement test .

C . Failure of the Principal to effectively and/orsufficiently follow the recommendation(s) of theProbation Manager .D . Failure to improve student attendance and/ordrop-out rate in the school .

FN4. Although the district court purported to simplydeny the Board's motion to dismiss in itsentirety, it is clear from the district court'sorder regarding the motion to dismiss, aswell as its subsequent summary judgmentorder, that it considered these claimsdismissed .

FN5. Actually, the district court 's order is silent on

whether the claims were being dismissed with or

without prejudice . But, since Head does not make anissue of this and it does not matt er to our ultimateconclusion , we will assume that the claims were

dismissed without prejudice .

FN6. We focus here only on what Head alleges in

his complaint . In pleadings subsequent to his

complaint . Head elaborated on the allegations he

made in his complaint . Specifically, he identified

Phillip Hansen's criticism of him on a cable access

program and the letter informing the PopeElementary community of the principal removal

hearing as particular incidents of stigmatizing

publicity, Although we do not consider these

allegations, Head suffers no prejudice because theyare simply sets of facts that could be proved

consistent with the complaint's allegations, which we

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must take into account in any event. See Nance, 147F.3d at 590 .

FN7. Head's complaint might be read more narrowlyto allege simply an injury to his reputation, anallegation that most certainly could not survive amotion to dismiss in light of Paul v . Davis, 424 U.S .693, 96 S .Ct . 1155, 47 L .Ed .2d 405 (1976), whichholds that simple defamation by a government actordoes not give rise to a due process liberty (orproperty) interest violation . Under the applicablestandard of review, however, we are required to giveHead's complaint a generous reading . Therefore, weread Head's complaint to allege more than simpledefamation .

FN8 . Limited pre-termination procedures arepermissible only if full post-termination proceduresare available . Cleveland Bd . of Educ . v . Loudermill,470 U.S . 532, 545-47, 105 S .Ct . 1487, 84 L .Ed .2d494 (1985) . As the parties here do not challenge theproposition that the legal framework governinglimited pretermination procedures applies, weassume full post- termination procedures areavailable .

FN9. Head also suggests, in passing, that the

Board's failure to provide him with more elaborate,

trial-type rights (like the ability to cross-examine

witnesses) deprived him of due process . This is not

so . See Staples, 142 F .3d at 387 (pre-termination

hearing does not require the incidents of a full, trial-

type hearing) .

FN10. The parties, and the district court, have spent

much effort explaining why Head was or was not

entitled to the procedures mandated by one oranother statutory regime. This sort of inquiry is

completely irrelevant, however, to the question of

whether Head received constitutionally adequate

process . For these purposes, it does not matter if the

state provided the procedures it was required to

provide under its own laws . Kyle v . Morton High

Sch ., supra, 144 F .3d at 451-52 .

FN 11 . In 1993, Illinois recodified its laws, and whenit did so, I11 .Rev .Stat . Ch. 122, sec . 34-85 became105 Ill . Comp . Stat . 5/34- 85 .

END OF DOCUMENT

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after the bankruptcy court denied initialmotion for stay pending arbitration did notconstitute express waiver of the defense .

United States Court of Appeals ,Second Circuit. [21 Federal Civil Procedure C 852 .1

170Ak852 . 1In re: CRYSEN/MONTENAY ENERGY CO .,

Debtor .Crysen/Montenay Energy Co ., Debtor-

Appellant,V .

Shell Oil Co. and Scallop Petroleum Co .,Defendants-Appellees .

No. 99.5067.

Argued: April 13, 2000Decided: Aug. 29, 2000

Chapter 11 debtor brought non-core adversaryproceeding against oil company for allegedbreach of oil purchase contracts. Afterarbitration panel ruled in oil company's favor,the Bankruptcy Court, Cornelius Blackshear,J., issued proposed findings of fact andconclusions of law recommending dismissal ofproceeding, and the United States DistrictCourt for the Southern District of New York,Miriam Goldman Cedarbaum, J ., 240 B.R.166, dismissed action. Debtor appealed. TheCourt of Appeals, Jose A. Cabranes, CircuitJudge, held that : (1) failure to includearbitration defense in amended answersfollowing denial of motion for stay pendingarbitration was not express waiver of defense ;(2) failure to seek interlocutory appeal ofdenial of stay motion was not implied waiverof right to enforce arbitration clause ; (3)bankruptcy courts have the power to stay non-core proceedings in favor of arbitration; and(4) district court's de novo review ofarbitration award itself was not warranted .

Amended pleading ordinarily supersedes theoriginal and renders it of no legal effect .

[31 Bankruptcy 303151k3031

Adversary defendants did not impliedly waivetheir ability to move to enforce theircontractual arbitration rights, in adversaryproceeding commenced by Chapter 11 debtor,when they failed to seek immediatelyinterlocutory appeal of denial of timely motionfor stay pending arbitration of debtor's claims,even though litigation continued for eightyears before stay motion was renewed .

(4] Courts G- 99(6)106k99(6)

Law of the case doctrine did not apply to barbankruptcy court from reconsidering; eightyears later, its denial of motion for staypending arbitration of Chapter 11 debtor'sclaims, given that final judgment was notentered during that time .

[5] Courts € ' 99(1)106k99(1 )

Application of the law of the case doctrine isdiscretionary and does not limit a court'spower to reconsider its own decisions prior tofinal judgment .

[6] Bankruptcy G° 303151k303 1

Affirmed.

(1] Bankruptcy e:.- 3031

51k3031

Bankruptcy courts have the power to stay non-core proceedings in favor of arbitration .

[7 1 Bankruptcy o. 303151k3031

Failure of adversary defendants to include anarbitration defense in amended answers filed Bankruptcy courts generally do not have

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discretion to decline to stay non-coreproceedings in favor of arbitration .

[8] Bankruptcy 210551k2105

In reviewing bankruptcy court's proposedfindings of fact and conclusions of law as toarbitration award entered in non-coreproceedings, district court was required toreview de novo bankruptcy court's review ofaward for manifest disregard of the law; denovo review of the arbitration award itself wasnot warranted . 28 U.S.C .A. § 157(c) .Appeal from a judgment of the United States

District Court for the Southern District of NewYork (Miriam Goldman Cedarbaum, Judge )accepting the Proposed Findings of Fact andConclusions of Law of the Bankruptcy Court

(Cornelius Blackshear, Bankruptcy Judge )and dismissing, following arbitration, claimsbrought by a Chapter 11 debtor in a non-core

adversary proceeding . We affirm thejudgment, concluding that: (1) defendants'failure to replead in subsequent answers anaffirmative defense of arbitrability thatalready had been rejected by the BankruptcyCourt did not constitute an express waiver ofthe defense; (2) the failure to pursue aninterlocutory appeal from the denial in 1987 ofa motion to stay in favor of arbitration did notprevent defendants from renewing the motion

in 1995; (3) the Bankruptcy Court had theauthority to stay the non- core proceeding infavor of arbitration; and (4) the DistrictCourt's review of the Bankruptcy Court'srecommended disposition was legallysufficient .

Affirmed.

Richard N . Chassin (Joseph D . Becker andZeb Landsman, on the brief), Becker , Glynn,Melamed & Muffly LLP, New York , NY, forDebtor-Appellant .

Mark L. Weyman , (James L. Michalak, on thebrief), Anderson Kill & Olick, P .C., New York,NY, for Defendants- Appellees .

Before: Newman, Kearse, and Cabranes,Circuit Judges.

Jose A. Cabranes, Circuit Judge :

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*1 Debtor-appellant Crysen/Montenay EnergyCo. ("Crysen") appeals from a judgment of theUnited States District Court for the SouthernDistrict of New York (Miriam GoldmanCedarbaum, Judge ) accepting the ProposedFindings of Fact and Conclusions of Law ofthe Bankruptcy Court (Cornelius Blackshear,Bankruptcy Judge ) and dismissing, followingarbitration, claims brought in a non-coreadversary proceeding. We affirm thejudgment, concluding that : (1) defendants'failure to replead in subsequent answers anaffirmative defense of arbitrability thatalready had been rejected by the BankruptcyCourt did not constitute an express waiver ofthe defense; (2) the failure to pursue aninterlocutory appeal from the denial in 1987 ofa motion to stay in favor of arbitration did notprevent defendants from renewing the motionin 1995; (3) the Bankruptcy Court had theauthority to stay the non-core proceeding infavor of arbitration; and (4) the DistrictCourt's review of the Bankruptcy Court'srecommended disposition was legallysufficient .

BACKGROUND

This action arises out of two contractspursuant to which Crysen sold oil to defendantScallop Petroleum Co . ("Scallop"), formerly a

subsidiary of defendant Shell Oil Co. ("Shell") .In January 1986, Scallop rejected Crysen'sdelivery of over 200,000 barrels of oil becausethe sulfur content of the oil allegedly exceededthe limit specified by the relevant contract .Scallop then refused to allow Crysen to curethe alleged defect, relying on a "time is of theessence" provision to cancel the contract . Asoil prices had fallen in the period betweenagreement and delivery, Scallop purchasedless expensive replacement oil and Crysen wasforced to re-sell the rejected oil at a lowerprice.

Crysen, which in June 1986 had filed apetition for relief under Chapter 11 of theBankruptcy Code, 1 1 U.S.C. § 101 et seq.,commenced an adversary proceeding againstScallop on March 16, 1987 . In its initial

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answer, Scallop relied on a contractualarbitration clause in asserting a "FirstAffirmative Defense of Arbitration." Scallopmoved shortly thereafter to stay the adversaryproceeding in order to submit Crysen's claimsto arbitration, but the Bankruptcy Courtdenied the motion to stay on May 29, 1987 .

*2 Scallop filed three amended answers overthe next fifteen months. After Crysensubsequently filed an amended complaintnaming Shell as a co-defendant, defendantsfiled an answer on January 6, 1989,requesting a jury trial . Collectively, the fouramended answers included thirteen defensesnot pleaded in Scallop's original answer ; innone of the four answers did Scallop or Shellreassert the arbitrability defense offered inScallop's original answer .

In 1990, Crysen moved and defendants cross-moved for summary judgment. TheBankruptcy Court denied the motions on theground that there existed a genuine factualdispute as to whether the oil had conformed tospecifications . Following the decision, theparties engaged in extensive discovery, whichwas not completed until September 1, 1995 .

Crysen then filed a renewed motion forsummary judgment, after which defendantsmoved by order to show cause why theadversary proceeding should not be stayed infavor of arbitration The Bankruptcy Courtsigned the order, entertained argument, andon November 20, 1995, granted the motion tostay. In revisiting and reversing its 1987decision, the Bankruptcy Court relied

exclusively on Hays and Co . v. Merrill Lynch,

Inc., 885 F.2d 1149 (3d Cir.1989), in which theThird Circuit had reversed its own earlierdecision and concluded that district courts lackdiscretion to deny enforcement of anarbitration clause in a non-core adversaryproceeding .

The parties then shifted to arbitration . Afterthe arbitration panel issued an Award onJanuary 27, 1997, denying Crysen's claims intheir entirety, the matter was returned to theBankruptcy Court. Finding no reason tovacate the arbitration award, the BankruptcyCourt issued Proposed Findings of Fact and

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Conclusions of Law recommending that theadversary proceeding be dismissed withprejudice . The District Court accepted theproposed disposition and dismissed the action.See In Re: Crysen/Montenay Energy Co., 240B.R. 166 (S.D.N.Y.1999). This appeal followed .

DISCUSSION

On appeal, Crysen principally asserts threearguments: that defendants waived theircontractual right to arbitrate, that theBankruptcy Court lacked the authority to staythe non-core proceeding in favor of arbitration,and that the District Court's review of theBankruptcy Court's recommended dispositionwas legally insufficient. We address each ofthese arguments in turn .

I. Waiver

A. Express Waiver

*3 [1][2] Crysen asserts that defendantsexpressly waived the affirmative defense ofarbitrability by failing to include it in any ofthe four amended answers that were filedafter the Bankruptcy Court had rejectedScallop's May 1987 motion to stay in favor ofarbitration. It is well settled that an amendedpleading ordinarily supersedes the originaland renders it of no legal effect. See, e.g.,Harris v . City of New York, 186 F .3d 243, 249(2d Cir .1999). However, we have not yetaddressed whether there is a futility exceptionto this rule where a party fails to advance in asubsequent pleading a claim or defense thatalready has been rejected by the court .Somewhat surprisingly, there exists a Circuitsplit on this issue ; the Ninth Circuit requiresrepleading despite obvious futility, see Marxv. Loral Corp., 87 F.3d 1049, 1055-56 (9thCir.1996) (enforcing the Circuit rule butacknowledging that it has been criticized asunduly formalistic, rigid, and mechanical),while the Tenth and Eleventh Circuits do not,see Dunn v. Air Line Pilots Assn, 193 F .3d1185, 1191 n . 5 (11th Cir. 1999), cert. denied, --- U.S. ----, 120 S.Ct. 2197, 147 L .Ed.2d 233(2000); Davis v . TXO Production Corp ., 929F.2d 1515, 1517 (10th Cir .1991). We see noreason to require repleading of a claim or

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defense that explicitly has been denied .Accordingly, we hold that defendants' failureto include an arbitration defense in theamended answers filed after the BankruptcyCourt had denied the initial motion to stay didnot constitute an express waiver of thedefense .

B. Implied Waive r

[3] Nor did defendants impliedly waive theirability to move to enforce their contractualarbitration rights . We have explained:Federal policy strongly favors arbitration asan alternative means of dispute resolution.This preference for arbitration [has] led to itscorollary that any doubts concerning whetherthere has been a waiver are resolved in favorof arbitration. We have often stated thatwaiver of arbitration is not to be lightlyinferred.Nonetheless, a party waives its right toarbitration when it engages in protractedlitigation that prejudices the opposing party .[P]rejudice as defined by our cases refers tothe inherent unfairness--in terms of delay,expense, or damage to a party's legalposition--that occurs when the party'sopponent forces it to litigate an issue andlater seeks to arbitrate that same issue .Incurring legal expenses inherent in thelitigation, without more, is insufficientevidence of prejudice to justify a finding ofwaiver. Thus, we have found that a partywaived its right to arbitration where itengaged in extensive pre-trial discovery andforced its adversary to respond to substantivemotions, delayed invoking arbitration rightsby filing multiple appeals and substantivemotions while an adversary incurredunnecessary delay and expense, and engagedin discovery procedures not available inarbitration .Therefore, in determining whether [a party]has waived its right to arbitration, we willconsider such factors as (1) the time elapsedfrom commencement of litigation to therequest for arbitration, (2) the amount oflitigation (including any substantive motionsand discovery), and (3) proof of prejudice .There is no bright-line rule, however, fordetermining when a party has waived its

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right to arbitration : the determination ofwaiver depends on the particular facts of eachcase .*4 PPG Industries, Inc . v. Webster Auto

Parts Inc ., 128 F.3d 103, 107- 08 (2d Cir.1997)(emphases added) (internal citations andquotation marks omitted) (alteration inoriginal) (concluding that a party that engagedin discovery and filed a substantive motionprior to filing a petition to compel arbitrationhad waived its contractual right to arbitrate) .

The "particular facts" of the instant case donot lend themselves to ready application of thestandard set forth above. In looking to the firstprong under PPG, it is clear that "the timeelapsed from commencement of litigation tothe request for arbitration" was minimal .However, as Crysen emphasizes, Scallop didnot seek an interlocutory appeal of the denialof its timely motion for a stay . With regard tothe second prong, "the amount of litigation(including any substantive motions anddiscovery)" was substantial: The partieslitigated for eight years--six of which followedthe Third Circuit's decision in Hays--includingextensive discovery and cross-motions forsummary judgment . The third PPG prong--proof of prejudice--largely collapses into thesecond; Crysen arguably was prejudicedbecause it had to litigate the action for eightyears. Cf. id. at 107; Cotton v. Slone, 4 F.3d176, 179-80 (2d Cir.1993) (finding prejudicewhere the party seeking to enforce anarbitration clause already had availed itself ofpre-trial discovery, brought substantivemotions, and invoked the powers andprocedures of the district court) .

Had defendants first moved in 1995 for a stayin favor of arbitration--eight years after thesuit had been filed--there could be no doubt ofwaiver under PPG . However, the instant caseis far different than PPG because of themotion to stay filed by Scallop shortly afterthe action was brought in 1987 . Accordingly,the issue facing us here simply was notpresented in PPG: Are defendants responsiblefor the eight years of litigation because ofScallop's failure to take an interlocutoryappeal from the denial of the motion to stay infavor of arbitration? In light of Scallop's

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prompt filing in 1987 of the motion to stay,the strong federal preference in favor ofarbitration, and the policy against finding animplied waiver of arbitration rights whenthere exist "any doubts" on that score, wedecline to disturb the District Court's holdingthat defendants did not impliedly waive theirarbitrability defense .

Our conclusion--that the failure to take aninterlocutory appeal of the denial of themotion to stay did not constitute an impliedwaiver of defendants' arbitrability defense,despite the intervening years of litigation thattook place before the motion was renewed--does not conflict with Cotton because thatdecision relied on a statutory provision thathad not been enacted in 1987, when Scallopfailed to appeal. In Cotton, we held that adefendant had waived his contractual right tocompel arbitration where : (1) the DistrictCourt denied the defendant's motion to compelarbitration; (2) he failed to take aninterlocutory appeal as of right under § 16(a)of the Federal Arbitration Act ("FAA"), 9U.S.C . § 16(aXl); [FN1] and (3) he proceededwith discovery and made several substantivemotions before finally challenging on appealfrom a final (default) judgment the denial ofthe motion to compel. See Cotton, 4 F.3d at179-80. We concluded that "[t]he aims ofsection 16(a) would be defeated if a party couldreserve its right to appeal an interlocutoryorder denying arbitration, allow thesubstantive lawsuit to run its course (whichcould take years), and then, if dissatisfied withthe result, seek to enforce the right toarbitration on appeal from the finaljudgment." Id. at 180. Accordingly, we heldthat the defendant had waived his right tocompel arbitration.

*5 Although Crysen contends that Cottonrequires us to conclude that defendants in theinstant case waived their arbitrabilitydefense, we believe the issue is controlled notby Cotton but by our earlier decision inDrayer v. Krasner, 572 F .2d 348 (2d Cir.1978)(Friendly, J .). The Cotton decision makes noreference to brayer, in which we concludedthat a party that had failed to take anavailable interlocutory appeal of an order

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granting a stay in favor of arbitration did notwaive his right to challenge the arbitrationclause on appeal from a final judgment . InDrayer, the defendants moved for, and theDistrict Court granted, a stay to enforce anarbitration clause in the relevant contract .The plaintiff -Drayer--failed to file aninterlocutory appeal from the stay order,though he could have done so . See Drayer, 572F.2d at 350 . Instead, Drayer waited, lost onthe merits in arbitration, and then on appealattacked the District Court's confirmation ofthe arbitration award, claiming that thecontractual arbitration clause was illegal . Weheld that Drayer had not waived his ability tochallenge the District Court's decision to stayin favor of arbitration, stating that "[f]ailureto take an authorized appeal from, aninterlocutory order does not preclude raisingthe question on appeal from the finaljudgment." Id. at 353 (emphasis added) .

We agree with the District Court, see 240B.R. at 175, that the holdings in these twocases are irreconcilable ; the Cotton decisionsub silentio overruled brayer. IFN2 1 We applybrayer, not Cotton, to the instant case becauseour decision in Cotton focused on the "aims ofsection 16(a)," 4 F.3d at 180, a provision wedescribed as having been "designed to

streamline the appellate aspect of thelitigation process so that parties may realizetheir arbitration rights at the earliest possible

moment." Id. Section 16(a) is not relevant tothe instant case because Scallop's failure totake an interlocutory appeal occurred in May1987, approximately eighteen months prior tothe enactment of the statutory provision atissue in Cotton. Scallop had no right to aninterlocutory appeal under § 16(a) ; Scallop'sright to an immediate appeal instead wasanalogous to Drayer's, [FN3] and, as noted,Drayer's "[fjailure to take an authorizedappeal from an interlocutory order d[id] notpreclude raising the question on appeal fromthe final judgment." [FN4] brayer, 572 F .2dat 353. As defendants had not ixnpliedlywaived the right to contest on appeal from afinal judgment the failure of the BankruptcyCourt to grant the stay, nothing preventedthem from asking the Bankruptcy Court toreconsider its earlier decision in advance of

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the entry of judgment. As the District Courtstated, "[flor Crysen, Congress acted one-and-a-half years too late." 240 B.R. at 176 .

*6 [4][5] In sum, we conclude that despite thefailure to appeal immediately the BankruptcyCourt's denial of the 1987 motion to stay infavor of arbitration, under Drayer defendantscannot be held responsible for the eight yearsof litigation that followed, nor for anyresultant prejudice to Crysen. Accordingly, weconclude that under the standard set forth inPPG, defendants did not waive theirarbitrability defense . IFN5 ]

H . The Bankruptcy Court's Power to Stay

[6] Our recent decision in In re United StatesLines, Inc., 197 F.3d 631, 640-41 (2d Cir .1999),cert. denied, --- U.S. ----, 120 S .Ct . 1532, 146L.Ed.2d 347 (2000), makes it clear thatbankruptcy courts have the power to stay non-core proceedings in favor of arbitration . Inexplaining our holding that bankruptcy courtsin some circumstances retain discretion todecline to stay core proceedings in favor ofarbitration, we noted in U.S. Lines that anyconflict between the Bankruptcy Code, whichfavors centralization of disputes concerning adebtor's estate, and the Arbitration Act, whichadvocates a decentralized approach to disputeresolution,is lessened in non-core proceedings which areunlikely to present a conflict sufficient tooverride by implication the presumption infavor of arbitration. See Hays & Co ., 885F.2d at 1161 . Core proceedings implicatemore pressing bankruptcy concerns, but evena determination that a proceeding is core willnot automatically give the bankruptcy courtdiscretion to stay arbitration.*7 Id. at 640. This statement is pregnant

with the assumption, which we now stateexplicitly, that bankruptcy courts haveauthority to stay non-core proceedings in favorof arbitration.

[7] The issue in U.S. Lines was whether abankruptcy court may decline to stay a coreproceeding in favor of arbitration. As we notedthere, the presumption in favor of arbitrationgenerally will trump the lesser interest of

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bankruptcy courts in adjudicating non-coreproceedings that could otherwise bearbitrated . We also explained that "even" incore proceedings, in which the interest of thebankruptcy court is greater, the bankruptcycourt nonetheless might lack discretion todecline to stay in favor of arbitration. Theunmistakable implication is that bankruptcycourts generally do not have discretion todecline to stay non-core proceedings in favor ofarbitration, and they certainly have authorityto grant such a stay . If, as we suggested inU.S . Lines, bankruptcy courts must stay non-core proceedings, logic compels the conclusionthat they are empowered to do so,notwithstanding Crysen's claim to thecontrary .

The implicit conclusion in U.S. Lines thatbankruptcy courts generally must stay non-core proceedings in favor of arbitration is inharmony with the general principlesgoverning arbitration and bankruptcy law . Wehave explained that "bankruptcy jurisdiction[is] to be construed as broadly as possiblewithin . . . constitutional constraints ." In re BenCooper, Inc ., 896 F.2d 1394, 1398 (2d Cir.),vacated, 498 U.S. 964, 111 S.Ct. 425, 112L.Ed.2d 408 (1990), reinstated, 924 F .2d 36 (2dCir .1991); see also In re S.G. PhillipsConstructors, Inc., 45 F.3d 702, 705 (2dCir .1995). In addition, the Supreme Court hasinstructed that "[t]he Arbitration Act . . .establishes a federal policy favoringarbitration." Shearson/American Express,Inc. v. McMahon, 482 U .S. 220, 226, 107 S .Ct .2332, 96 L.Ed.2d 185 (1987) (internalquotation marks omitted). Crysen's position--that bankruptcy courts may not stay non-coreproceedings in favor of arbitration--is at oddswith both of these principles .

Our strong interest in maximizing scarcejudicial resources likewise supports theconclusion that bankruptcy courts may staynon-core proceedings in favor of arbitration.The Third Circuit's Hays decision--holdingthat district courts must stay non-coreproceedings in favor of arbitration--isgenerally accepted . See, e .g., U.S. Lines, 197

F.3d at 640-41; In re Nat'l Gypsum Co ., 118F.3d 1056, 1066 (5th Cir.1997) (noting that

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Hays "makes eminent sense" and "has beenuniversally accepted") . It would make no senseto find that bankruptcy courts--which areconstituted under 28 U.S .C . § 151 as "unit[s]of the district court"--cannot stay suchproceedings; the absurd result of such adecision would be to force a party seeking astay to go to the district court and have itremove the reference to the bankruptcy courtso that the district court could entertain amotion that, under Hays and its progeny, itcannot deny . We decline to impose on courtsand litigants this wholly unnecessary burden .

III. The District Court's Review Was LegallySufficient

*8 [81 Finally, the District Court's review ofthe Bankruptcy Court's recommendeddisposition, which in turn was based on theAward of the arbitration panel, was entirelyadequate as a matter of law. The statutedelineating a bankruptcy court's authority inadjudicating a non-core proceeding requiresthat a district court undertake a de novoreview of the bankruptcy court's proposedfindings of fact and conclusions of law. See 28U.S.C. § 157(cXl) . [FN6] In the instant case,the District Court properly explained that it"reviews de novo those portions of abankruptcy judge's proposed findings of factand conclusions of law to which any party has[objected]." 240 B.R. at 169. Crysennonetheless claims that the District Courtfailed to comply with the commands of § 157(c)because the Court did not undertake a de novoreview of the arbitration award, but ratherreviewed it for "manifest disregard of thelaw," Id . at 177 . This claim is devoid of merit.Crysen's suggestion--that in a non-coreproceeding a district court must review denovo an arbitration award, not simply thebankruptcy court's own review of that award--is illogical and without support. The DistrictCourt properly reviewed the decision of theBankruptcy, Court by putting itself in theposition of the Bankruptcy Court when itoffered its recommendation--that is, byreviewing the award for manifest disregard oflaw. This is precisely what de novo reviewrequired. [FN7]

CONCLUSION

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To summarize, we hold that :(1) a defendant's failure to include in anamended pleading a defense that already hadbeen rejected explicitly by the trial court didnot constitute an express waiver of thedefense ;(2) the failure to take an interlocutory appealfrom the Bankruptcy Court's denial in 1987of a motion to stay in favor of arbitration,prior to the enactment of 9 U .S.C. § 16(a), didnot prevent defendants from renewing themotion in 1995 ;(3) bankruptcy courts possess the authority tostay non-core proceedings in favor ofarbitration; and(4) the District Court's review of theBankruptcy Court's recommended dispositionwas legally sufficient.

Accordingly, we affirm the judgment of theDistrict Court, which accepted the BankruptcyCourt's Proposed Findings of Fact andConclusions of Law and dismissed Crysen'sclaims .

FNI . Section 16(a), which was enacted onNovember 19, 1988, see Pub.L. No. 100-702,tit. X, § 1019, 102 Stat. 4671, § 15,provides that "[a]n appeal may be takenfrom--(1) an order--(A) refusing a stay ofany action under section 3 of this title . . . ." 9U.S.C. § 16(aXl). Section 3, in turn,provides: If any suit or proceeding be brought inany of the courts of the United States upon any issuereferable to arbitration under an agreement in writingfor such arbitration, the court in which such suit ispending . . . shall on application of one of the partiesstay the trial of the action until such arbitration hasbeen had in accordance with the terms of theagreement . . . .9 U.S .C . § 3 .

FN2. We recognize that the procedural postures ofthe two cases were somewhat different : In brayer,the plaintiff failed to take an immediate appeal fromthe District Court's decision granting a motion tostay the action pending arbitration, and insteadchallenged the order staying the action on appealfrom the District Court's entry of a final judgmentconfirming an adverse arbitration award . See

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Drayer, 572 F .2d at 350, 352-53 . By contrast, thedefendant in Cotton attacked on appeal from a finaljudgment the District Court's denial of his motion tostay the action pending arbitration. See Cotton, 4F.3d at 178 . Neither side has suggested how thisdistinction might be a material one, andwe conclude that the distinction has nobearing on the issue before us: whetherScallop impliedly waived its right toarbitrate by failing to take aninterlocutory appeal from the BankruptcyCourt's initial denial of Scallop's motion tostay in favor of arbitration and then bylitigating the action for eight years beforerenewing the motion to stay .

FN3 . Defendants argue that Scallop had no right in

1987 to an interlocutory appeal of the BankruptcyCourt's decision denying the motion to stay pending

arbitration . We conclude that Scallop, like Drayer,

could have taken an interlocutory appeal under the

doctrine of Enelow v . New York Life Ins . Co ., 293

U.S . 379, 55 S .Ct . 310, 79 L .Ed. 440 (1935), and

Ettelson v . Metropolitan Life Ins . Co ., 317 U .S .

188, 63 S .Ct . 163, 87 L .Ed . 176 (1942) (together,

"Enelow-Ettelson ") . Though the Enelow-Ettelsondoctrine was much-criticized, and eventually was

overturned by the Supreme Court in Gulfstream

Aerospace Corp . v . Mayacamas Corp., 485 U .S .

271, 108 S .Ct . 1133, 99 L .Ed .2d 296 (1988) (itself

largely mooted by the enactment of .§ 16(a) a few

months later), the doctrine was as available to

Scallop in 1987 as it had been to Drayer over a

decade earlier .

FN4 . Because Drayer was the governing law of thisCircuit in 1987, it may well have influencedScallop's decision not to take aninterlocutory appeal of the denial of itsmotion to stay in favor of arbitration.

FN5 . We also reject Crysen's contention that theBankruptcy Court improperly ignored the law of the

case in granting the 1995 motion to stay . Relying on

the intervening Hays decision, the Bankruptcy Court

concluded in 1995 that it improperly had found in1987 that it had discretion to deny a stay in favor of

arbitration . The law of the case doctrine in no way

prevents such reconsideration. As we have

explained, the doctrine "posits that if a court decides

a rule of law, that decision should continue to govern

in subsequent stages of the same case . . . . Application

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of the law of the case doctrine is discretionary anddoes not limit a court's power to reconsider its owndecisions prior to final judgment ." Sagendorf-Teal v .County of Rensselaer, 100 F .3d 270, 277 (2dCir . 1996) (internal quotation marks omitted) ; seealso United States v . Williams, 205 F.3d 23, 34 (2dCir .2000) . In the instant case, the District Court didnot enter final judgment between 1987 and 1995,thereby leaving it wholly within the BankruptcyCourt's discretion to reconsider its prior decision .

FN6. Section 157(c) provides in relevant part that a"bankruptcy judge may hear a proceeding that is nota core proceeding but that is otherwise relatedto a case under title 11. In suchproceeding, the bankruptcy judge shallsubmit proposed findings of fact andconclusions of law to the district court, andany final order or judgment shall beentered by the district judge afterconsidering the bankruptcy judge'sproposed findings and conclusions andafter reviewing de novo those matters towhich any party has timely andspecifically objected . "

FN7. Crysen's claim that the District Court's review

ran afoul of the constitutional concerns that animated

the Supreme Court's plurality opinion in Northern

Pipeline Const . Co . v . Marathon Pipe Line Co ., 458

U.S . 50, 102 S .Ct . 2858, 73 L .Ed.2d 598 (1982), is

equally without foundation . As we have just

explained, in handling this matter the Bankruptcy

and District Courts followed the prescriptions

established by § 157(c) . Congress enacted thatprovision in direct response to Marathon. See

generally U .S . Lines, 197 F .3d at 636-37 (explaining

Marathon, § 157, and the genesis of the core/non-

core distinction) . Because the District Courtcomplied with § 157(c) and reviewed de novo the

recommendations of the Bankruptcy Court, this case

implicates none of the constitutional concerns

identified by the Supreme Court in Marathon .

END OF DOCUMENT

Copr. ' West 2000 No Claim to Orig . U.S. Govt . Works

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