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finding safe harbor warnings sufficient, where warning specified a number of factors which might effect the projections, including the migration to "larger, multi-year deals
Summary of this case from ZACK v. ALLIED WASTE INDUSTRIES, INC.Opinion
No C-03-5138 VRW.
August 10, 2005
ORDER
Plaintiffs in this securities fraud class action face the unenviable task of complying with the stringent pleading requirements imposed on such actions. All too frequently, and once again here, plaintiffs attempt this endeavor by a complaint replete with evidentiary detail, but only a loose (and the court thinks too loose) connection between the wrongful conduct alleged and its effect on the class. The Supreme Court has recently reminded lower federal courts that the heart of a fraud on a securities market is the proximate causal link between the misstatement or omission alleged and the resulting impact on the security's price. Dura Pharms Inc v. Broudo, 125 S Ct 1627 (2005). Despite the rather forgiving interpretation of Dura in this circuit, see In re Daou Systems, Inc Securities Litigation, 2005 WL 1431833 (9th Cir June 21, 2005), the operative pleading here fails to make this connection. Because plaintiffs will be allowed to amend, the court emphasizes the need for plaintiff to allege facts that link defendants' alleged wrongdoing to the class injury. A much shorter, but targeted, pleading may well be more effective in making this connection than the rather distended pleading now at bar. But there are other shortcomings in their pleadings that plaintiffs need to address and it is to these that the court devotes the bulk of this order.
I
Plaintiff John Romeo (Romeo) and plaintiff Pipefitters Local 522 633 Pension Fund Trust (Pipefitters) (collectively, plaintiffs), purporting to represent investors who purchased securities of Portal Software Inc (Portal) between May 20, 2003, and November 13, 2003, inclusive (the "class period"), bring this action under the Securities Exchange Act of 1934 (the "'34 Act") and the Securities Act of 1933 (the "'33 Act"). Plaintiffs allege that defendants Portal, John Little (Little), Howard A Bain III (Bain) and Arthur C Patterson (Patterson) (collectively defendants) violated the Generally Accepted Accounting Principals (GAAP) by artificially inflating the price of Portal's stock and making false and misleading statements on which plaintiffs relied, thereby incurring substantial financial loss from purchasing Portal stock at fraudulently inflated prices. Defendants' move to dismiss (Doc #115) plaintiffs' third consolidated amended complaint (TCAC; Doc #111) for failure to meet the particularity requirement imposed by FRCP 9(b) and the Private Securities Litigation Reform Act (PSLRA) (amendments to the '33 and '34 Acts). Plaintiffs oppose the motion, asserting that the TCAC states sufficiently particularized claims under § 10(b) and § 20(a) of the '34 Act, as well as claims under §§ 11, 12(a)(2) and 15 of the '33 Act.
The court heard argument on these motions on July 7, 2005. Based upon the parties' arguments and the applicable federal law, the court concludes that: (1) the allegations in plaintiffs' complaint are not pled with sufficient particularity under the PSLRA and FRCP 9(b); (2) the allegations are not sufficient to support a strong inference of scienter under the PSLRA; (3) defendants' forward-looking statements are protected by the PSLRA's safe harbor provision; (4) claims under the '33 Act sound in fraud and therefore fail with the '34 Act claims. Accordingly, the court GRANTS defendants' motion to dismiss in its entirety.
II
The factual and procedural history is derived from the TCAC and presumed true for purposes of this motion. Gompper v. VISX, Inc, 298 F3d 893, 895 (9th Cir 2002). Portal provides billing and subscriber management solutions to its clients primarily through its "Infranet" software. Portal charges companies "license fees" for the Infranet product, as well as "service fees" for system implementation, consulting, maintenance and training. Prior to 2001, the majority of Portal's customer base consisted of "dot-com" start-up companies. Following the dot-com market crash of 2001, Portal lost many of its customers and incurred financial losses during fiscal 2002-2003 that wiped out more than 96% of Portal's equity. Portal subsequently began to market its Infranet product to more established and sophisticated business customers, including telecommunications providers.
These new clients required greater customization of the software than had the dot-com startups, which in turn affected the way in which Portal could recognize license fee revenues. Pursuant to GAAP, if a software provider rewrites portions of its product to conform to a client's unique needs, it may not fully recognize the revenue on the license of software until such substantial modification has been performed. Whereas Portal had historically been able to recognize revenue at the time it delivered its Infranet product to the dot-coms, the greater customization required by these new, more established clients required Portal to defer recognizing revenue from much of its contracts until customization was complete. Plaintiffs allege that during the class period, Portal began to manipulate its license fees so it could recognize more revenue "up-front." TCAC at ¶¶ 41-42.
To support their allegations that Portal improperly recognized revenue prematurely and in violation of GAAP, plaintiffs rely on information from four unnamed former Portal employees: (1) a controller; (2) a "Senior Business Analyst'" (3) an accounts receivable and revenue assurance assistant; and (4) a "Senior Marketing Manager." TCAC at ¶¶ 41-54. The first three employees detail three different methods of accounting fraud allegedly undertaken by Portal management during the class period, while the Senior Marketing Manager alleges ongoing product problems and a decreasing market for key elements of Portal's software offering.
The information provided by the former controller involved Portal's method for recognizing licensing revenue. Historically, Portal preliminarily offered its customers a "developmental license," which consisted of a trial version of the software for a few key employees. Portal would charge only a "nominal" amount for this first license. Then, if the client wished to obtain the full Infranet product, Portal would sell the client a "production license" and charge for the bulk of the contract. After fiscal 2004, plaintiffs allege that Portal simply charged a greater portion of the contract price under the developmental license, even though it was still only a trial version and significant modifications yet were to be performed under the production license. Plaintiffs also allege that Portal's outside accountants, Ernst Young, disapproved of this new split license arrangement and reversed Portal's position, a determination which ultimately caused the shortfall in earnings and resulting stock price decline. TCAC at ¶ 43.
Next, the former Senior Business Analyst asserts that he was instructed by company officials, including Bain, to falsify revenue recognition studies to justify premature recognition of revenue. Under GAAP, when a software contract provides for both licensing and services, such as software modification and implementation, the revenue from each element can only be recognized as it is performed, so long as the "fair value" of each element is determinable. If the fair value of each element is not determinable, than recognition of the entire contract must be deferred until all elements have been delivered, or until such time as the fair value of the remaining elements are determinable. The Senior Business Analyst avers that when attempting to discern the fair value of elements of a software arrangement, he was directed by the management to "reverse engineer" the study to reach predetermined results. This employee, who ceased employment several months before the end of the class period, alleges that he was instructed to falsify revenue recognition studies with regard to contracts performed in "Greece, Italy, Columbia [sic] and Spain," including a contract with "Columbia [sic] Mobile." TCAC at ¶ 48.
The third former employee on whom Plaintiffs rely is an accounts receivable and revenue assurance assistant employed during the class period. She alleges that "revenues related to [Portal's] contracts with Onstar . . . [were] materially overstated during the third quarter of fiscal 2004." TCAC at ¶ 49. Specifically, the former employee alleges that Portal would recognize revenue from the support, maintenance and upgrade elements of the software contract, even though the work had not yet been performed. This employee asserts that she obtained this knowledge because one of her duties of employment was to reclassify the prematurely recognized revenue for future quarters. She claims that she talked to her manager about her concerns with the way Portal was classifying revenue, and was subsequently dismissed from her position. TCAC at ¶ 49.
Finally, plaintiffs proffer the testimony of a Senior Marketing Manager to substantiate their allegations that Portal was misrepresenting the demand for its product and concealing significant technical problems with its applications. Specifically, the marketing employee stated that portions of Portal's billing software were being rendered obsolete by Customer Relationship Management (CRM) applications sold by vendors like SAP and Siebel. TCAC at ¶¶ 51-52. Moreover, Portal's Infranet product was having difficulty interfacing with these CRM applications, resulting in unexpected costs and delays for Portal. TCAC at ¶¶ 53-54. Plaintiffs allege that Portal's management failed to disclose these technical difficulties and the declining demand for Portal's product during the class period, thus concealing the true state of Portal's financial health.
Plaintiffs' complaint alleges that the accounting fraud described above was undertaken by defendants to inflate Portal's reported revenue numbers, which were then used by defendants to create false and misleading statements regarding Portal's financial health and future business prospects. According to plaintiffs, these false and misleading statements artificially inflated Portal's stock price and allowed defendants to complete a $60 million secondary offering on September 12, 2003. Plaintiffs' claims for violations of the '33 Act are based on alleged false and misleading statements made in the registration statement and prospectus issued in connection with the secondary offering. TCAC at ¶¶ 142-165. Plaintiffs' claims for violations of the '34 Act are based on alleged false and misleading statements disseminated to the investing public via SEC filings and press releases. TCAC at ¶¶ 166-181.
After the close of the market on November 13, 2003, defendants announced that — due to contract delays, revenue recognition deferrals and service execution issues — Portal expected net losses of $0.36 to $0.40 per share for the third quarter fiscal 2004. These losses were in contrast to the net profits of $0.04 per share that Portal had previously projected for the quarter. Subsequent to the November 11, 2003, announcement, the price of Portal's common shares plummeted 42% to $8.77 in after hours trading. TCAC at ¶ 75. Plaintiffs allege that this decline in Portal's stock price at the end of the class period was "a direct result of the nature and extent of [d]efendant's prior misrepresentations, omissions and fraudulent conduct concerning [Portal's] adverse business and financial conditions finally being revealed to investors and the market" and that plaintiffs "were damaged as a proximate result thereof." TCAC at ¶ 76.
III
As a preliminary matter, the court considers defendants' request for judicial notice (RJN, Doc #119) regarding certain documents attached to the declaration of Randolph Gaw in support of defendants' motion (Gaw Decl, Doc #116). Defendants contend that all the documents so attached are the proper subject of judicial notice pursuant to FRE 201.
Exhibits N through U to the Gaw declaration are Form 4s filed with the SEC regarding the stock sales of the individual defendants and other corporate officers and directors, while exhibits A through H are the SEC filings of defendant Portal. Defendants contend that the court is authorized to take judicial notice of documents filed with the SEC. The court agrees that judicial notice of such documents is proper. See, e.g., Bryant v. Avado Brands, Inc, 187 F3d 1271, 1276 (11th Cir 1999); Allison v. Brooktree Corp, 999 F Supp 1342, 1352 n3 (SD Cal 1998). This conclusion is bolstered by the fact that courts are specifically authorized, in connection with a motion to dismiss a securities fraud complaint, to consider documents and filings described in the complaint under the incorporation by reference doctrine. See, e.g., Ronconi v. Larkin, 253 F3d 423, 427 (9th Cir 2001); In re Silicon Graphics Securities Litigation, 183 F3d 970, 986 (9th Cir 1999). Thus, the court takes notice of all the documents attached to the Gaw declaration that were filed with the SEC.
Exhibits I through M are Portal press releases, which defendants claim contain "safe harbor" warnings regarding any forward-looking statements in the press releases. Judicial notice of these exhibits is proper because the court is required to consider "any cautionary statement accompanying [a] forward-looking statement, which [is] not subject to material dispute, cited by the defendant." 15 USC § 78u-5(e). In addition, the court may take judicial notice of information that was publicly available to reasonable investors at the time the defendant made the allegedly false statements. See In re The First Union Corp Securities Litigation, 128 F Supp 871, 883 (WD NC 2001). This is true of press releases, even if they were not explicitly referenced in the complaint. See Wietschner v. Monterey Pasta Co., 294 F Supp 2d 1102, 1108-09 (ND Cal 2003).
Exhibit V to the Gaw declaration is the "Statement of Position 97-2 Software Revenue Recognition." This is an accounting statement issued by the American Institute of Certified Public Accountants. RJN Doc #19 at 4. Courts may take judicial notice of documents that are alleged in the complaint and whose authenticity no party questions, even when not attached to the complaint. See Branch v. Tunnell, 14 F3d 449, 454 (9th Cir 1994).
Finally, at oral argument on July 7, 2005, plaintiffs submitted to the court three additional documents and requested that the court take judicial notice of them in considering this motion. Doc #130. These documents include (1) a Portal press release dated June 30, 2005; (2) Portal's Form 8-K filed with the SEC on June 27, 2005; and (3) Portal's Form 10-Q for the quarter ending October 31, 2004, filed with the SEC on April 25, 2005. Id. The court takes notice of these documents, which are all public filings capable of judicial notice.
IV Standard of Review
FRCP 12(b)(6) motions to dismiss essentially "test whether a cognizable claim has been pleaded in the complaint." Scheid v. Fanny Farmer Candy Shops, Inc, 859 F2d 434, 436 (6th Cir 1988). FRCP 8(a), which states that plaintiff's pleadings must contain "a short and plain statement of the claim showing that the pleader is entitled to relief," provides the standard for judging whether such a cognizable claim exists. Lee v. City of Los Angeles, 250 F3d 668, 679 (9th Cir 2001). This standard is a liberal one that does not require plaintiff to set forth all the factual details of his claim; rather, all that the standard requires is that plaintiff give defendant fair notice of the claim and the grounds for making that claim. Leatherman v. Tarrant County Narcotics Intell Coord Unit, 507 US 163, 168 (1993) (citing Conley v. Gibson, 355 US 41, 47 (1957)). To this end, plaintiff's complaint should set forth "either direct or inferential allegations with respect to all the material elements of the claim". Wittstock v. Van Sile, Inc, 330 F3d 899, 902 (6th Cir 2003).
Under Rule 12(b)(6), a complaint "should not be dismissed for failure to state a claim unless it appears beyond doubt that plaintiff can prove no set of facts in support of [her] claim which would entitle [her] to relief." Hughes v. Rowe, 449 US 5, 9 (1980) (citing Haines v. Kerner, 404 US 519, 520 (1972)); see also Conley, 355 US at 45-46. All material allegations in the complaint must be taken as true and construed in the light most favorable to plaintiff. See Silicon Graphics, 183 F3d at 980 n10. But "the court [is not] required to accept as true allegations that are merely conclusory, unwarranted deductions of fact, or unreasonable inferences." Sprewell v. Golden State Warriors, 266 F3d 979, 988 (9th Cir 2001) (citing Clegg v. Cult Awareness Network, 18 F3d 752, 754-55 (9th Cir 1994)).
Review of a FRCP 12(b)(6) motion to dismiss is generally limited to the contents of the complaint, and the court may not consider other documents outside the pleadings. Arpin v. Santa Clara Valley Transportation Agency, 261 F3d 912, 925 (9th Cir 2001). The court may, however, consider documents attached to the complaint. Parks School of Business, Inc v. Symington, 51 F3d 1480, 1484 (9th Cir 1995). If a plaintiff fails to attach to the complaint the documents on which the complaint is based, a defendant may attach such documents to its motion to dismiss for the purpose of showing that the documents do not support plaintiff's claim. In re Autodesk, Inc Securties Litigation, 132 F Supp 2d 833, 837 (ND Cal 2000) (citing Branch v. Tunnel, 14 F3d 449, 454 (9th Cir 1994)). This permits the court to consider the full text of a document that the plaintiff's complaint only partially quotes. Autodesk, 132 F Supp 2d at 838 (citing In re Stac Electronics Securities Litigation, 89 F3d 1399, 1405 n4 (9th Cir 1996), cert denied, 520 US 1103 (1997)). Additionally, "[t]he court need not * * * accept as true allegations that contradict matters properly subject to judicial notice * * *." Sprewell, 266 F3d at 988 (citing Mullis v. United States Bankr Ct, 828 F2d 1385, 1388 (9th Cir 1987)).
But these liberal pleading standards described above have been substantially tightened in the context of securities litigation, as will be discussed infra.
V
The TCAC alleges five causes of action. For the first and second causes of action, plaintiffs allege violations of sections 11 and 12(a)(2) of the '33 Act against all defendants. Plaintiffs' first and second causes of action are based on the registration statement Portal filed for its secondary public offering (SPO) in September 2003. Plaintiffs' third cause of action alleges control liability under section 15 of the '33 Act against Little, Bain and Patterson (the "individual defendants"). Plaintiffs' fourth cause of action alleges violations of section 10(b) of the '34 Act and Rule 10b-5 promulgated thereunder against all defendants. Lastly, plaintiffs allege control liability under section 20(a) of the '34 Act against the individual defendants. The court will first address first plaintiffs' claims under the '34 Act before turning to the claims brought under the '33 Act.A Section 10(b) and 20(a) of the Exchange Act of 1934
Section 10(b) of the '34 Act and SEC Rule 10b-5, promulgated thereunder, make it unlawful for any person, in connection with the purchase or sale of any security, to (1) engage in fraud or (2) make an untrue statement regarding a material fact or (3) make a misleading statement by omitting a material fact. 15 U.S.C. § 78j(b); 17 CFR § 240.10b-5. Consequently, the elements of a Rule 10b-5 claim are: (1) a material misrepresentation or omission of fact, (2) scienter, (3) a connection with the purchase or sale of a security, (4) transaction and loss causation, and (5) economic loss. See Dura, 125 S Ct at 1633.Claims brought under Section 10(b) and Rule 10b-5 must first meet the particularity requirements of FRCP 9(b). In re Stac, 89 F3d at 1404; see also In re GlenFed Inc Securities Litigation, 42 F3d 1541, 1545 (9th Cir 1994) (en banc). Rule 9(b) requires a plaintiff alleging fraud to "set forth what is false or misleading about [the] statement and why it is false."GlenFed, 42 F3d at 1548.
Second, a complaint must satisfy the more stringent requirements imposed on securities fraud pleadings by the PSLRA. Specifically, the PSLRA requires that a complaint: (1) "specify each statement alleged to have been misleading [and] the reason or reasons why the statement is misleading * * *" (15 USC § 78u4-(b)(1)); (2) with respect to any such allegations based upon information and belief, "state with particularity all facts on which that belief is formed" ( 15 USC § 78u-4(b)(1)); and (3) "with respect to each act or omission * * * state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind" (15 USC § 17u-4(b)(2)). The required state of mind, or scienter, is met where the complaint alleges that the defendants made the false or misleading statements either intentionally or with deliberate recklessness." In re Daou Systems, Inc Securities Litigation, 2005 WL 1431833 (9th Cir June 21, 2005) (citing Silicon Graphics, 183 F3d at 974) (emphasis added). In securities cases, falsity and scienter "are generally inferred from the same set of facts and the two requirements may be combined into a unitary inquiry under the PSLRA." In re Vantive Corp Securities Litigation, 283 F3d 1079, 1091 (9th Cir 2002) (citations omitted).
Even if plaintiffs meet these heightened pleading requirements, however, the PSLRA carves out a safe harbor from liability if the alleged false or misleading statements were forward-looking and accompanied by meaningful risk warnings. 15 USC § 78u-5(c); see also In re Splash Technology Holdings, Inc Securities Litigation, 2000 US Dist LEXIS 15369, *16 (ND Cal) (Splash I). An analogous doctrine (which predates the enactment of the PSLRA) is the "bespeaks caution" doctrine, which allows a court to rule as a matter of law that defendant's forward-looking statements contained enough cautionary language or risk disclosure to protect against liability. See, e.g., Provenz v. Miller, 102 F3d 1478, 1493 (9th Cir 1996). If a defendant's statements are immunized under either doctrine, dismissal of the complaint is appropriate. See id; Splash I, 2000 US Dist LEXIS at *29.
Defendants challenge the sufficiency of plaintiffs' '34 Act claims on several grounds: (1) plaintiffs' complaint lacks the specificity needed to plead accounting fraud; (2) plaintiffs fail to plead facts raising a strong inference of scienter; and (3) defendants' statements are protected by the PSLRA's safe harbor provision. Before turning to the issue of safe harbor, the court will address the defendants' first two contentions under the "unitary inquiry" advocated in this circuit, as "falsity and scienter are generally inferred from the same set of facts * * *." In re Vantive, 283 F3d at 1091.
1
Defendants contend that the TCAC should be dismissed because plaintiffs have not adequately pled facts to support their allegations of accounting fraud or to support a strong inference of scienter. "If properly pled, overstating of revenues may state a claim for securities fraud, as under GAAP, revenue must beearned before it can be recognized." In re Daou, 2005 WL 141833 at *5 (citations omitted) (emphasis in original). Plaintiffs must plead facts sufficient to support a conclusion that defendants "prepared the fraudulent financial statements and that the alleged financial fraud was material." See id (quotingIn re Peerless Systems, Corp Securities Litigation, 182 F Supp 2d 982, 991 (SD Cal 2002).
Although violations of GAAP standards may provide evidence of scienter, see id, the complaint must allege GAAP violations with sufficient particularity to support a strong inference of scienter. See, e.g., In re McKesson HBOC, Inc Securities Litigation, 126 F Supp 2d 1248, 1273 (ND Cal 2000) ("[w]hen significant GAAP violations are described with particularity in the complaint, they may provide powerful indirect evidence of scienter. After all, books do not cook themselves.".) The inquiry focuses on the specificity of the allegations; "a general allegation that the practices at issue resulted in a false report of company earnings is not a sufficiently particular claim of misrepresentation." In re Daou, 2005 WL 1431833 at *5 (quoting Greebel v. FTP Software, Inc, 194 F3d 185, 203-04 (1st Cir 1999).
The Ninth Circuit recently instructed that complaints stating sufficiently particular accounting irregularities should include: "(1) such basic details as the approximate amount by which revenues and earnings were overstated; (2) the products involved in the contingent transaction; (3) the dates of any of the transactions; or (4) the identities of any of the customers or [company] employees involved in the transactions." In re Daou, 2005 WL 1431833 at *6 (citations and internal quotation marks omitted). Although the complaint need not provide each and every detail described above, it should enable a court to determine whether the alleged fraud "constituted widespread and significant inflation of revenue." Id.
Before reaching the substance of plaintiffs' complaint, the court notes that plaintiffs' allegations are derived, in large part, from information provided by confidential witnesses. The Ninth Circuit requires a particular inquiry to determine if the use of such confidential sources satisfies the PSLRA. See In re Daou, 2005 WL 1431833 at *4. The inquiry focuses on whether unnamed sources of information in the complaint are described "with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged." Nursing Home Pension Fund, Local 114 v Oracle Corp, 380 F3d 1226, 1233 (9th Cir 2001) (quoting Novak v. Kasaks, 216 F3d 300, 314 (2d Cir 2000)). These personal sources need not be named so long as the information they provide is adequately corroborated by other facts. Silicon Graphics, 183 F3d at 985.
In In re Daou, the Ninth Circuit recently adopted the First Circuit's "suggested criteria for assessing reliability of confidential witnesses." In re Daou, 2005 WL 1431833 at *4. These criteria include "the level of detail provided by the confidential sources, the corroborative nature of the other facts alleged (including from other sources), the coherence and plausibility of the allegations, the number of sources, the reliability of the sources, and similar indicia." In re Cabletron Sys Inc, 311 F3d 11, 29 (1st Cir 2002). Moreover, when a complaint relies on unnamed employees, courts generally look for specific descriptions of the employee's relevant duties and responsibilities to evaluate the reliability of their information. See, e.g., In re Daou, 2005 WL 1431833 at *4 (finding that confidential witnesses were described with a "large degree of particularity" where, in all cases, their job description and responsibilities were delineated, and in some cases, plaintiffs identified the executive to whom the employee reported); see also In re Northpoint Communications Group, Inc, 221 F Supp 2d 1090, 1097 (ND Cal 2002) (holding that a second amended complaint cured some specificity problems of original complaint where it set out, in addition to job titles and tenure of confidential witnesses, their responsibilities at the company).
The TCAC relies in large part upon information provided by three unnamed former Portal employees to substantiate allegations that defendants were engaging in accounting fraud in order to overstate revenue. Plaintiffs identify these employees by either their titles or their positions in the company, but generally fail to describe with any particularity the duties of each employee, or how or why they came to be familiar with the information they provide. Despite plaintiffs' failure to specify each employee's duties, in some cases the employees' accounts themselves describe their relevant duties in the course of relating elements of the alleged accounting fraud. Consequently, the court cannot adopt wholesale the allegations provided by the unnamed employees in plaintiffs' complaint. Rather, in determining whether the TCAC adequately pleads violations of the securities laws, the court will rely only on factual allegations which evince reliability through detail, context and corroboration.
With these legal principles in mind, the court turns to plaintiffs' allegation that Portal engaged in accounting fraud by falsely inflating revenues to conceal Portal's precarious financial condition. Specifically, plaintiffs allege that defendants prematurely recognized revenue by (1) improperly categorizing licensing revenue, (2) overstating purported billing rates to recognize greater costs on delivered elements of a contract, (3) manipulating the fair value amount attributable to undelivered items and (4) recognizing revenue before project milestones were approved by customers.
Plaintiffs allege that defendants manipulated license agreements into two parts and improperly priced the first part of the license with the bulk of the contract fee so that they could recognize the revenue prematurely. TCAC ¶¶ 41-43. In support of this allegation, plaintiffs rely entirely on information provided by a former controller. Id. Yet, the former controller's account does not contain inherent indicia of reliability. First, her employment with Portal ended almost a year before the class period even began. TCAC ¶ 41. Consequently, her entire account of Portal's fraudulent revenue recognition practices during the class period are based on second-hand reports from company "insiders." Id ¶ 43. Although she has personal knowledge to support her descriptions of Portal's revenue recognition practices prior to the class period, it is the allegations that Portal made fraudulent changes to these recognition practices during the class period that require "a reasonable conviction in the informant's basis of knowledge." In re NorthPoint, 221 F Supp 2d at 1097. Hence, plaintiffs must describe the job title, job description, duties, and dates of employment for thecontroller's sources before this information can be deemed reliable. Plaintiffs have made no attempt to provide such information about any of the controller's "insiders," and consequently, plaintiffs' allegations regarding improperly bifurcated contracts are not pled with sufficient particularity.
Plaintiffs' next allegations — that defendants "cooked" revenue numbers to recognize revenue prematurely — are somewhat better supported. The TCAC identifies a "Senior Business Analyst" who worked at Portal until July 2003, two months into the class period. Although the complaint again fails specifically to describe this employee's job duties, to whom he reported, or in which department he worked, his account ameliorates the shortfall. As part of his employment, the analyst asserts that he was required to "reverse engineer" revenue recognition studies to reach a predetermined result. TCAC ¶ 45. Moreover, the analyst asserts that he was personally directed to create these false studies by defendant Bain, the CFO. Id ¶ 47. These fabrications involved falsely selecting high billing rates to inflate revenues for work already performed on contracts (Id ¶ 46) or falsely calculating a low value for undelivered elements so that greater revenue could be attributed to the elements already delivered (Id ¶ 47).
Although the Senior Business Analyst only identifies one customer by name for whom he created false revenue recognition studies (Columbia Mobile), he alleges that he was "required to perform analyses that matched management's predetermined results for work performed in * * * Greece, Italy, Columbia and Spain in connection with at least six of Portal's major contracts" and that Portal booked $5 million in revenue as a result of these contracts. Id ¶ 48. Based on his personal involvement in fraudulent activity at the behest of Bain, the court concludes that these allegations potentially support a claim under the '34 Act. Moreover, the court finds that the specificity of the account indicates a level of reliability. Yet because the analyst's account provides no indication of how these alleged manipulations affected Portal's financial earnings statements, further corroboration is necessary to meet the heightened pleading requirements of the PSLRA.
Next, the TCAC alleges that defendants engaged in improper revenue recognition through testimony of an accounts receivable and revenue assurance assistant who allegedly worked at Portal during the class period. TCAC ¶ 49. Again, this employee's account self-identifies her duties and basis for knowledge, mitigating the TCAC's failure to do so. For example, the assistant specifies that "one of [her] duties was to reclassify revenue for future quarters." Id ¶ 49. It was through this work, she alleges, that she came to learn that Portal was improperly recognizing revenue from software licensing contracts. Id. The assistant explains her basis for knowledge: "I have been working with revenue recognition for 12 years, and I understand the way revenue is supposed to be recognized." Id. The assistant's account also alleges a particular contract, with Onstar, for which Portal "materially overstated [revenues] during the third quarter of fiscal 2004." TCAC ¶ 49.
In the Ninth Circuit, "although overstatement of revenues in violation of GAAP may support a plaintiff's claim of fraud, the plaintiff must show with particularity how the adjustments affected the company's financial statements and whether they were material in light of the company's overall financial position."In re Daou, 2005 WL 1431833 at *7. In In re Daou, the panel found that the plaintiff adequately described how "allegedly premature [revenue] recognition affected Daou's financial bottom line" where the complaint pled "the approximate amount by which revenues and earnings were overstated, * * * the dates of some of the transactions and the identities of the customers and the company employees involved in the transactions." Id at *8. For example, the plaintiffs in In re Daou alleged that only $5.9 million was eligible for recognition in the third quarter of 1997, 48% less than the $11.3 million that Daou publicly reported. Id.
In contrast, the TCAC is bereft of such comparisons. Only the Senior Business Analyst alleges a dollar amount — $5 million — for prematurely recognized revenue. Even this figure is unconnected to identified customers or dates, much less a specific quarterly report against which to assess its materiality. Although the accounts receivable assistant allegedly reclassified improperly booked revenues, she does not indicate how much revenue was reclassified or how this affected Portal's financial statements. The controller's statements, lacking in personal knowledge, also fail to specify how much revenue the allegedly improper licensing contracts allowed Portal to recognize prematurely, and how that affected Portal's bottom line.
The TCAC also alleges that defendants engaged in accounting fraud by recognizing "license and service fees under * * * service arrangements prior to customer approval of specific project milestones in violation of the Company's publicly stated revenue recognition practices and policies" and in violation of GAAP. TCAC ¶ 50. To support this allegation, plaintiffs refer only to defendants' disclosure, subsequent to the class period, that it was excluding $700,000 of previously reported revenue for fiscal 2004 due to a customer's refusal to approve project milestones. TCAC ¶ 84. Defendants argue that this disclosure related to a contract performed after the class period, but plaintiffs provide information indicating the restatement related to fiscal 2004. TCAC ¶ 84. Even assuming this revenue was originally announced during the class period, the court finds that plaintiffs' single example of defendants announcement of revenue prior to customer approval does not raise a strong inference of scienter.
Plaintiffs allege that defendants also violated the '34 Act by materially misrepresenting the declining demand for Portal's products and services and failing to disclose severe interface problems that delayed delivery and increased costs. TCAC ¶¶ 51-54. Support for this allegation, however, comes from only one unnamed employee, a Senior Marketing Manager, who worked for only two months of the class period. From this employee's title, the court might infer such a position would afford knowledge of the market for Portal's product. Thus, this account could conceivably provide evidence of the "shrinking market and role for billing software applications." Id ¶ 52. In addition, the employee identifies two vendors, SAP and Siebel, that offered products that "displaced the role previously provided" by aspects of Portal's billing software. Id ¶ 51. But the specificity ends there. The employee fails to identify any of "Portal's large telecommunications customers" for whom customer service applications were no longer required as part of Portal's billing software. Id. And, although the marketing manager alleges that Portal was spending too much time and money due to "excessive bugs and/or interface problems with other applications," these allegations fail to indicate any specific customers, contracts, or dates. Id ¶ 54.
The court finds that plaintiffs' allegations of accounting fraud and material misrepresentations are not pled with sufficient particularity and, consequently, do no raise a strong inference of scienter. Plaintiffs, however, present an alternative basis for demonstrating scienter; the complaint focuses on defendants' stock sales and Portal's SPO to show that defendants had the motive and opportunity to mislead investors deliberately. As discussed in the next section, however, these allegations fail to plead a violation of section 10(b) adequately.
2 Scienter
To demonstrate motive, plaintiffs allege that defendants engaged in insider trading during the class period. The PSLRA "neither prohibits nor endorses the pleading of insider trading as evidence of scienter, but requires that the evidence meet the 'strong inference' standard." Greebel, 194 F3d at 197. While "trading at suspicious times or in suspicious amounts" is probative of scienter, the trading must be "unusual, well beyond the normal patterns of trading by those defendants." Id. Under this standard, the court questions plaintiffs' reliance on the stock sales attributable to "company insiders" to demonstrate defendants' motive to conduct accounting fraud or issue misleading statements. First, defendant Little sold no personal stock. Defendant Bain sold 4,000 shares after exercising 7,500 stock options, which means he did not sell 3,500 shares.
Plaintiffs focus on "89,157 shares of Portal common stock" sold by "Portal insiders." TCAC at ¶ 65. Most of these "insiders," however, are not named defendants, nor do plaintiffs allege they were involved in the fraudulent activity. Moreover, plaintiffs' reliance on "suspicious" stock sales ultimately fails because the stock sales do not appear suspicious at all. For example, plaintiffs focus on the period from May 28, 2003, to July 2, 2003, which was "immediately after" the first earnings announcement of the class period — but also after the announcement of an alliance with Microsoft. TCAC at ¶ 65. Although plaintiffs allege that Portal common stock was artificially inflated during this period, they do not allege that the deal with Microsoft was improper. In fact, plaintiffs ignore the legitimate, positive effect the Microsoft deal might have had on Portal's stock or the role the Microsoft deal might have had in the executives' decision to sell. No attempt is made to delineate the "artificiality" of Portal's stock during this period, which is especially curious since it appears that Portal's stock actuallydropped by several dollars after the first earnings announcement of the class period. TCAC at ¶ 140 (Charting NASDAQ Index). Moreover, plaintiffs fail to demonstrate that the timing of the stock sales was "suspicious" where the TCAC does not provide a comparison of these sales with the executives' "normal patterns of trading." Greebel, 194 F3d at 197.
By contrast, plaintiffs' contention that defendants were motivated to inflate artificially Portal's stock price in the short term in order to conduct a successful secondary public offering and obtain much-needed operating capital does allege facts of a palpable motive for fraud. In fact, Portal raised $60 million in September, just two months before Portal's stock plummeted by over 40%. Plaintiffs allege that Portal's finances were such that the $60 million was absolutely necessary to keep Portal a "going concern." Plaintiffs' Opposition at 21. Accordingly, this motive evidence is stronger than the generic "desire to raise capital" which can be attributed to every company. Metricom, 2004 US Dist LEXIS 7834 at *110. But in the Ninth Circuit, such motive pleading must be combined with allegations of other "red flags" to be probative. In re Vantive, 283 F3d at 1097. As discussed above, plaintiffs' allegations of accounting fraud lack sufficient particularity and cannot be combined with this alleged motive to establish a strong inference of scienter.
3 Safe Harbor
In their motion to dismiss, defendants argue at great length that plaintiffs' TCAC does not adequately plead claims based on false projections or opinions. Defendants are correct that the PSLRA carves out a safe harbor from liability for forward-looking statements that are accompanied by meaningful cautionary language. 15 USC § 78u-5(c); see also In re Copper Mountain Securities Litigation, 311 F Supp 2d 857, 866 (ND Cal 2004) (Walker, J). Under the analogous "bespeaks caution" doctrine, a court may also find as a matter of law that "defendant's forward-looking statements contained enough cautionary language or risk disclosure to protect against liability." Id at 866. Mere boilerplate or generic warnings, however, are insufficient; "[t]he cautionary warning ought to be precise and relate directly to the forward-looking statements at issue." Id at 882. Moreover, this court has previously found that "vague and * * * run-of-the-mill corporate optimism" is not actionable because no reasonable investor would rely on "mere puffery." Id at 868-69.
A close reading of plaintiffs' TCAC reveals that the vast majority of plaintiffs' allegations of "materially false and misleading statements" focus on defendants' statements regarding present or historical facts, such as Portal's past quarterly earnings based on (1) allegedly inflated revenues (TCAC ¶¶ 58, 60, 64, 66, 67); (2) Portal's past and current revenue recognition policies that plaintiffs allege misrepresented the way in which Portal was recognizing revenue (TCAC ¶¶ 61-64, 68-70); (3) omissions of past and current facts regarding declining sales and product demand as well as difficulties marketing Portal's product (TCAC ¶ 64e-f); and (4) omissions of the present fact that Portal was experiencing severe technical problems with its core products, which were eroding its revenue stream (TCAC ¶ 64g). But neither the PSLRA's safe harbor provision nor the bespeaks caution doctrine are applicable to statements of historical fact. See e.g., Livid Holdings Ltd v. Salomon Smith Barney, Inc, 403 F3d 1050, 1056-57 (9th Cir 2005).
In fact, the only forward-looking statements that plaintiffs allege were false or misleading when made are the revenue projections for fiscal 2004 and the subsequent quarter's revenue projections that accompanied Portal's public announcement of financial results for the quarter just concluded. See TCAC ¶ 58 (May 20, 2003, announcement of financial results for quarter ending May 2, 2003); TCAC ¶ 66 (August 19, 2003, announcement of financial results for quarter ending August 1, 2003). These announcements were made in press releases and included defendants' statements that Portal expected revenues to grow by "10-12%" over the prior year and that Portal would "return to pro forma earnings" within the current fiscal year. TCAC ¶ 58.
Both of these statements concerned "a projection of revenues" and "future economic performance" and thus were clearly forward-looking statements under the PSLRA. 15 USC § 78u-5(i);Copper Mountain, 311 F Supp 2d at 880. The court now turns to plaintiffs' argument that defendants' forward-looking statements are unprotected by the PSLRA's safe harbor provision or the bespeaks caution doctrine because (1) the statements were not accompanied by meaningful cautionary language and (2) defendants knew they were false when made.
The court finds that defendants' forward-looking statements were accompanied by cautionary language that was sufficiently specific and meaningful to warn investors of the risks that actually materialized. First, defendants' May 20 and August 19 press releases — which contained the 10-12% profit projection and "return to pro forma earnings" statements — each included "safe harbor" warnings that the statements were forward-looking and subject to uncertainties and risk. Gaw Decl; Exs I and J. Moreover, these press releases specified a number of factors which might effect the projections, including the migration to "larger, multi-year deals, which * * * may dampen near-term growth * * * and add to the volatility of license revenues." Id.
In addition to those warnings contained in the press releases, both press releases referred investors to the Form 10-K for additional warnings. Gaw Decl; Ex C. at 31 ("These and other factors are described in detail in our Annual Report on Form 10-K for the fiscal year ended January 31, 2003 * * *."). Thus, the information in the Form 10-K was incorporated into the "total mix of information in the document" available to reasonable investors, even though the Form 10-K did not actually accompany the press releases. Copper Mountain, 311 F Supp 2d at 876 (citing Fecht v. The Price Co, 70 F3d 1078, 1082 (9th Cir 1995). The Form 10-K contained several pages of detailed and explicit warnings regarding Portal's dependance on a few large customers, the risks associated with long implementation periods, and the numerous variables which could adversely affect revenue recognition for any quarter. Also, the Form 10-K warned that Portal would begin offering "products and services for a 'bundled' price, such that a separate price would not be identified for the product and service components. Such a change may significantly delay the timing of our revenue recognition." Gaw Decl; Ex C at 31 (emphasis added). Because these warnings hew to the actual deficiencies that caused Portal's earnings shortfall — "contract delays and revenue recognition deferrals" with existing large customers — they provided sufficiently specific and material warnings to immunize defendants' forward-looking statements. SeeCopper Mountain, 311 F Supp 2d at 882.
Plaintiffs also assert that, regardless of cautionary language, defendants are liable for their forward-looking statements because they knew them to be false and misleading when made. Plaintiffs are correct that a forward-looking statement cannot be immunized under the PSLRA if it was made with "actual knowledge * * * that the statement was false or misleading." 15 USC 78u-5(c)(1)(B). In this case, however, plaintiffs' argument is unavailing because plaintiffs have failed to demonstrate that the defendants knew that Portal would not achieve 10-12% growth or return to pro forma earnings within the year when the press releases were issued. As discussed above, the TCAC is deficient, in part, in that it fails to allege facts showing how the alleged accounting adjustments materially affected the company's financial statements. See supra IV(A)(1)(i). These facts are necessary not only to plead adequately accounting fraud or scienter on the part of defendants, but also to demonstrate that the defendants knew at the time the earnings projections were announced that Portal could not meet those projections. Accordingly, Defendants' cannot be liable for the forward-looking statements in the May 20 and August 19, 2005, press releases, and plaintiffs' claims premised on these statements must be dismissed.
4 20(a) Control Liability
Section 20(a) provides for "controlling person liability." To establish such liability, plaintiffs must first demonstrate the existence of a violation under Section 10(b) — the "primary violation." Copper Mountain, 311 F Supp 2d at 883 (citation omitted). "[I]n the absence of a viable claim under Section 10(b), any remaining Section 20(a) claims must be dismissed." Id (citations omitted).
Because the court has determined that plaintiffs have failed to state claims under Section 10(b), plaintiffs have "no basis upon which to premise a Section 20(b) claim" and the Section 20(b) claims must also be dismissed.
B Section 11, 12(a)(2) and 15 of the Securities Act of 1933
Plaintiffs also bring claims against defendants for violations of the '33 Act arising out of Portal's secondary public offering in September 2003. In contrast to claims brought under the '34 Act, section 11 of the '33 Act creates a private remedy for a purchaser of a security where "any part of the registration statement, when such part became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statement therein not misleading." 15 USC § 77k(a). "The plaintiff in a § 11 claim must demonstrate (1) that the registration statement contained an omission or misrepresentation, and (2) that the omission or misrepresentation was material, that is, it would have misled a reasonable investor about the nature of his or her investment." In re Stac, 89 F3d at 1403-04. "No scienter is required for liability under § 11; defendants will be liable for innocent or negligent material misstatements or omissions." Id (citations omitted). Before addressing the substance of the '33 Act claims, the court must first determine if they are time barred.
1 Relation Back
Defendants challenge the timeliness of plaintiffs' '33 Act claims. Section 13 of the '33 Act requires that claims under sections 11 and 12(a)(2) be brought "within one year after the discovery of the untrue statement or the omission, or after such discovery should have been made by the exercise of reasonable diligence." 15 USC § 77m. Plaintiffs' first complaint, filed on November 20, 2003, did not include '33 Act claims. These claims were not added until the second amended complaint (SAC), filed on March 30, 2005 (sixteen months later). Defendants argue that plaintiffs discovered the conduct giving rise to the '33 Act claims at least when the first complaint was filed. Consequently, defendants argue that the '33 Act claims are time-barred.
Plaintiffs seek to avoid this bar by asserting that the new claims in the SAC "relate back" to the initial complaint under FRCP 15(c)(2). Rule 15(c)(2) states that an amended complaint relates back to the initial one for statute of limitations purposes if the "claim or defense asserted in the amended pleading arose out of the conduct, transaction, or occurrence set forth * * * in the original pleading." The crux of this inquiry is "whether the opposing party has been put on notice about the claim or defense raised by the amended pleading." SEC v. Seaboard Corporation, 677 F2d 1301, 1314 (9th Cir 1982). This court previously observed that the class notice for the '34 Act claims would have put investors with '33 Act claims on notice. Doc #100. It follows that defendants were also put on notice of the potential for '33 Act claims arising from the same set of facts.
2 Sound in Fraud
Section 11 does not contain an element of fraud, yet a complaint may be subject to the particularity requirements of Rule 9(b) if it "sounds in fraud." Vess v. Ciba-Geigy Corp USA, 317 F3d 1097, 1103 (9th Cir 2003). If the complaint alleges "a unified course of fraudulent conduct and rel[ies] entirely on that course of conduct as the basis of a claim * * * the claim is said to be 'grounded in fraud' or to 'sound in fraud,' and the pleading of that claim as a whole must satisfy the particularity requirement of Rule 9(b)." Id at 1103-1104.
In the TCAC, plaintiffs have made an artful attempt to avoid this requirement by carefully compartmentalizing the counts under the '33 Act and '34 Act. Whereas the '34 Act claims allege that defendants knowingly or recklessly engaged in a fraudulent scheme to overstate revenues, for example, the '33 Act claims merely allege that revenues were negligently overstated. Yet the Ninth Circuit has rejected this approach, finding that such "nominal efforts are unconvincing where the gravamen of the complaint is plainly fraud." In re Stac, 89 F3d at 1405.
The court finds that plaintiffs' Section 11 claim clearly "sounds in fraud." Despite plaintiffs' pains to avoid Rule 9(b), it is clear that the factual allegations upon which the entire complaint rests allege knowing, reckless and willful conduct. For example, plaintiffs allege that defendants "negligently overstated [revenue] due to the Defendants' manipulation of the purported billing rates of Portal's employees." TCAC ¶ 145(d). Yet plaintiffs' factual allegations supporting the manipulation of billing rates unequivocally describes the conduct as intentional and knowing. Id ¶¶ 47, 48. It strains credulity that plaintiffs should allege that the overstatement of revenues was merely "negligent" when it was a allegedly a direct result of defendants' willful manipulation. Plaintiffs cannot avoid the theory they posit throughout the complaint: that defendants fraudulently schemed to inflate revenues. Accordingly, the court finds that the claims under the '33 Act sound in fraud, and therefore fail with the '34 Act claims to meet the heightened pleading requirements of the PSLRA and Rule 9(b).
V Conclusion
For the reasons stated above, the court GRANTS defendants' motion to dismiss in its entirety. Doc #115. Plaintiffs' TCAC is DISMISSED, but plaintiffs may file an amended complaint remedying the pleading deficiencies identified in this order and complying with the following instructions.An amended complaint should specify those misstatements plaintiffs allege were false or misleading, including with regard to each statement: (1) the date made; (2) the speaker; (3) the content; (4) the falsity; (5) the basis for plaintiffs' allegation of falsity; and (6) scienter. The amended complaint should also specify any omissions of fact that defendants were bound to disclose, including with respect to each omission: (1) the date the information became known to the public; (2) the facts omitted; (3) the date the duty to disclose arose; (4) the basis for claiming that omitted information was known to defendants; (5) the basis for claiming that defendants had a duty to disclose; and (6) scienter. Finally, in light of Dura, plaintiffs should endeavor to tether all allegations in the complaint to the price movement of Portal's stock during the class period. Any amended complaint must be filed within sixty (60) days of the date of this order.
IT IS SO ORDERED.