Opinion
No. C 01-00719 WHA
July 24, 2002
ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS' MOTION TO DISMISS
INTRODUCTION
In this securities class action, defendants have moved to dismiss the corrected second consolidated amended complaint. This order holds that the complaint states a timely claim of securities fraud as to some, but not all, of the statements identified as fraudulent therein. It therefore GRANTS defendants' motion in part and DENIES it in part.
STATEMENT
The following facts are taken from the complaint and are assumed true for purposes of this motion. Commtouch is an Israeli corporation with its principal executive offices in Mountain View, California, and Ein Vered, Israel. Gideon Mantel was Commtouch's CEO and a director at the firm during the class period. James Collins was Commtouch's CFO from March 1999 until December 18, 2000. On December 18, 2000, Collins became Commtouch's COO.
Except as necessary to avoid confusion, the corrected second consolidated complaint is referred to as the "complaint" in this order.
During the class period, Commtouch provided outsourced e-mail and other messaging solutions to web-based companies, small websites and businesses worldwide. For web-based companies, it claimed to provide a full-featured, branded, web-based e-mail service in fourteen languages that enhanced online presence and brand image, promoted website "stickiness" and created the opportunity to generate additional revenue from advertising and direct marketing. For small sites and homepages that wanted to offer co-branded e-mail services to their users, it provided free turnkey web-based e-mail. For businesses, it claimed to provide e-mail and communication services to employees and online customers.
On July 13, 1999, Commtouch announced its initial public offering of 3,000,000 shares at $16 per share. The company raised $70.8 million, net of underwriting costs. On February 1, 2000, after the market's close, Commtouch issued a press release entitled, "Commtouch Announces Record Fourth Quarter Earnings and Fiscal Year End Results; Fourth Quarter 1999 Revenues Increase 1.230% Over Fourth Quarter 1998 Revenues" (Compl. ¶ 39). The release reported fourth-quarter and year-end results for 1999. Plaintiff does not attack the announced 1999 results as fraudulent. It does challenge the release's statement, "As of December 31, 1999, the Company had a backlog from contracts amounting to approximately $13.1 million that will be recognized as revenue over future quarters." It also calls out Mantel's comment, "Our positive growth margin in Q4 reached 30.2% and this will only increase in the future" as fraudulent. As will be discussed in more detail below, neither of these statements was identified as part of plaintiff's fraud claim in the original consolidated complaint filed in this case.
Three days later, on February 4, 2000, Commtouch issued another press release entitled, "The Only Publicly Traded Israeli Company That Is a `Pure Internet Company'." In pertinent part, this press release (which reprinted an article about Commtouch) said that investment banks had set target prices of $85-$100 for Commtouch's shares, and that these predictions were based on estimates that Commtouch would have revenues of between $20 million and $30 million in 2000, and up to $65 million in 2001. The release added, "By the middle of 2001 Commtouch should be turning a profit." Furthermore, the release said that Commtouch's "orders" had grown from $6.5 million at the end of September 1999 to $13.1 million at the end of December 1999 (Compl. ¶ 41).
On February 14, 2000, Commtouch announced a $3 million equity investment in another company, ThinkLink. About two months later, at some unidentified point in April 2000, Commtouch reissued a press release that had "purportedly" (according to the complaint) first been published by an independent brokerage firm. The release relayed an analyst's description of Commtouch's business, including its e-mail box count. It also provided, "The analyst expects that [Commtouch] will increase its revenues in FY2000 to $32.4 MM . . . and that in FY2001 total revenues will probably amount to $66MM." The report further announced an expected total annual return of greater than 25 percent over the next 12-18 months (Compl. ¶ 52).
None of the above statements were identified as actionable in plaintiff's first consolidated complaint. In the original complaint, the class period began only on April 19, 2000, after Commtouch announced its results for the first quarter of 2000. This announcement of first-quarter results, along with later announcements of results for the second and third quarters of that year, formed the principal basis of the original consolidated complaint and its allegations regarding fraudulent revenue recognition.
The first challenged statement common to both consolidated complaints follows. In a press release issued April 18, 2000, Commtouch announced first-quarter revenues of $4.3 million, and said that it had a backlog from contracts amounting to approximately $22 million that would be recognized as revenue over future quarters (Compl. ¶ 56). On July 20, 2000, Commtouch reported record revenues of $5.9 million for the second quarter, and a $29 million backlog from contracts that would be recognized as revenue over future quarters (Compl. ¶ 83). In a conference call held that day, Mantel stated, "We remain on target to reach our revenue guidance of approximately $30 million for the year 2000 and a year-to-year growth of 600%" (Compl. ¶ 87). A few weeks later, Commtouch's Chief Strategy Officer (who is not himself named as a defendant) said in an interview with The Wall Street Transcript Corporation, "We estimate approximately $30 million in sales for this year, for the year 2000. This is an increase of over 600% from last year's revenues of $4.3 million." The officer also said, "If you look at our growth rate, quarter-to-quarter, the growth is staggering" (Compl. ¶ 90). Then, on October 25, 2000, Commtouch reported third-quarter revenue of $8.1 million, and a backlog of contracts "amounting to approximately $40 million, representing firm revenue commitments that will be recognized as revenue over future quarters" (Compl. ¶ 95). During a conference call with investors that day, Collins said that "we remain on target to reach revenue goals of approximately $30 million for the year 2000 with year-to-year revenue growth of nearly 600%" (Compl. ¶ 98). One week later, Collins told analysts that Commtouch expected year 2001 revenues to be between $72 and $74 million (Compl. ¶ 11).
In January 2001, Sunil Bhardwaj replaced Collins as Commtouch's CFO. Commtouch almost immediately shut down approximately 300 customers' e-mail service. On February 14, 2001, Commtouch issued a press release announcing that its financial statements for the first, second and third quarters 2000 were false. The release said that Commtouch planned to restate its revenues for these quarters downward from $4.3 million, $5.9 million and $8.1 million to $3.6 million, $5.0 million and $5.2 million. In total, Commtouch would adjust its revenues downward by $4.4 million, with a similar effect on earnings. This press release did not mention any backlogged contracts (Compl. ¶ 103). In explaining the restatement, Bhardwaj said, "we looked back and we said that if an amount was subsequently deemed to be uncollectible, we went back to see if we could satisfy the conditions of collectibility at that time" (Compl. ¶ 119).
On February 1, 2000, Commtouch's stock stood at $35.56 per share. Its highest class-close was $65,175, reached in March 2000. At the close of trading on February 14, 2001, the share price stood at $1.78. It now hovers well below $1 per share.
* * *
The complaint alleges that the revenue announcements for the first quarter, second quarter, and third quarter of 2000 were promulgated with fraudulent intent, and levies a similar charge against several other related statements. It asserts that defendants had several motives for fraud. Among others, first, defendants and several other insiders sold shares in the "extended" class period, i.e., the period between the initial February announcements and the April 2000 release of first-quarter figures. Commtouch also planned to hold a secondary offering during the class period, but this never came to fruition. Second, during the class period Commtouch was involved in a merger transaction that, plaintiff states, would be promoted by an illusion of corporate strength. And third, on January 24, 2001, Commtouch announced that it had secured an equity-line purchase agreement from an institutional investor in which the amount Commtouch would receive was indexed to the value of its shares.
Far more importantly for alleging scienter, plaintiff's complaint includes allegations attributed to eleven confidential witnesses. The original consolidated complaint brought forward some of these witnesses, but identified them only with phony titles. Furthermore, that complaint frequently hedged on whether the witnesses were speaking from their own personal knowledge, or merely regurgitating gossip and innuendo. Given the importance of these witnesses to plaintiff's fraud claim, these deficiencies dictated the dismissal of the original consolidated complaint. Now, plaintiff has returned with a bolstered complaint that supposedly cures these defects. Defendants assert that the new complaint still does not satisfy the pleading standards for securities fraud set forth in the Private Securities Litigation Reform Act of 1995 and In re Silicon Graphics Sec. Litig., 183 F.3d 970 (9th Cir. 1999). Furthermore, defendants claim that several of the allegations in the present pleading are time-barred. The following analysis evaluates these arguments.
ANALYSIS
Defendants move to dismiss the complaint in its entirety for failure to adequately plead a securities-fraud claim. They also move to dismiss certain allegations on the ground that they are barred by the statute of limitations. This order holds that the complaint states a claim as to some, though not all, of the challenged statements therein. It agrees with defendants that certain other statements are time-barred, or otherwise not actionable.
1. General Principles.
The complaint is brought under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, promulgated thereunder. Control-person liability is alleged under Section 20(a) of the Exchange Act. Defendants have moved to dismiss the second consolidated complaint pursuant to FRCP 9(b) and 12(b)(6). Under FRCP 12(b)(6), a motion to dismiss should not be granted unless it appears beyond a doubt that the plaintiff can prove no set of facts in support of his claim that would entitle him to relief. Conley v. Gibson, 355 U.S. 41, 45-46 (1957). To state a claim for a violation of Rule 10b-5, a plaintiff must allege: (1) a misstatement or omission (2) of material fact (3) made with scienter (4) on which plaintiff relied (5) which proximately caused its injury. DSAM Global Value Fund v. Altris Software, Inc., 288 F.3d 385, 388 (9th Cir. 2002). When attacked pursuant to FRCP 12(b)(6), well-pled allegations in a complaint must be treated as true. North Star Int'l v. Arizona Corp. Comm'n, 720 F.2d 578, 580 (9th Cir. 1983).
Notwithstanding the relatively liberal FRCP 12(b)(6) standard, federal securities-fraud suits are subject to demanding pleading requirements. In 1995, Congress enacted the PSLRA to curb what was perceived as a raft of abusive practices in securities-fraud litigation. In raising the bar for securities-fraud suits, the PSLRA toughened the already-stringent requirements for pleading fraud under FRCP 9(b). Under the PSLRA, to adequately allege securities fraud a complaint must specify each statement alleged to have been misleading, the reason or reasons why the statement was misleading and, if an allegation is made on information and belief, all facts upon which that belief is formed. 15 U.S.C. § 78u-4 (b)(1). Significantly, the complaint must also state with particularity facts giving rise to a "strong inference" that the defendant acted with the required state of mind. 15 U.S.C. § 78u-4 (b)(2). "While under Rule 12(b)(6) all inferences must be drawn in plaintiff's favor, inferences of scienter do not survive if they are merely reasonable, as is true when pleadings for other causes of action are tested by motion to dismiss under Rule 12(b)(6). . . . Rather, inferences of scienter survive a motion to dismiss only if they are both reasonable and `strong' inferences." Greebel v. FTP Software, Inc., 194 F.3d 185, 195-96 (1st Cir. 1999) (citations omitted). In this circuit, the required state of mind involves some form of intentional misconduct — either actual knowledge of falsity or "deliberate recklessness" as to the truth or falsity of a statement. In re Silicon Graphics, 183 F.3d at 977.
2. Statute of Limitations.
Defendants raise a statute-of-limitations defense to some of the claims in the present complaint. The first consolidated complaint asserted a class period beginning April 19, 2000, and ending February 13, 2001. The new complaint alleges a longer class period, beginning on February 2, 2000, and ending February 13, 2001. The longer class period owes to certain statements made in February and April 2000, attacked as fraudulent for the first time in the second consolidated complaint. The initial second consolidated complaint was filed on March 14, 2002; a corrected version was filed on March 18, 2002. The original consolidated complaint was filed on October 18, 2001. The first federal securities-fraud complaint in this case, Ravid v. Commtouch Software Ltd., No. C 01-00719 (N.D. Cal.), was filed on February 16, 2001, just days after Commtouch announced its restatement. Defendants argue that plaintiff's late attack upon the February and April 2000 statements in the second consolidated complaint is barred by the statute of limitations, since they were first made a basis of plaintiff's fraud claim more than one year after February 16, 2001.
Claims under Rule 10b-5 must be brought within one year after discovery of the facts constituting the violation. Lampf Pleva, Lipkind, Prupis Petrigrow v. Gilbertson, 501 U.S. 350, 364 (1991). This standard does not require determining precisely when each plaintiff actually knew facts sufficient to make out a fraud claim. Courts can impute knowledge of public information without inquiring into when, or whether, individual shareholders actually knew of the information in question. Berry v. Valence Tech., Inc., 175 F.3d 699, 703 n. 4 (9th Cir. 1999).
The challenged statements in the February 2000 announcements concern improper revenue recognition; those in April 2000, improper revenue recognition and false mailbox counts. The challenged statements in the February 1 press release are (1) "As of December 31, 1999, the Company had a backlog from contracts amounting to approximately $13.1 million that will be recognized as revenue over future quarters" and (2) Mantel's comment, "Our positive growth margin in Q4 reached 30.2% and this will only increase in the future." The challenged statements in the February 4 release are (1) the (inferred) statement that Commtouch would have revenues between $20 million and $30 million in 2000; and (2) the release's comment that Commtouch's "orders" had grown from $6.5 million at the end of September 1999 to $13.1 million at the end of December 1999 (Compl. ¶ 43). The key challenged statements in the April 2000 release are "The analyst expects that [Commtouch] will increase its revenues in FY2000 to $32.4 MM . . . and that in FY2001 total revenues will probably amount to $66 MM" and that Commtouch had an "expected annual return of greater than 25% over the next 12-18 months."
The fraudulent nature of the mailbox announcement has not been adequately pled; this particular allegation, therefore, is not addressed in detail here.
The complaint filed on February 16, 2001, like several others filed in the following weeks (including two by class counsel) alleged that Commtouch published with fraudulent intent false revenue and earnings totals for the first three quarters of 2000. Like most placeholder complaints filed early in a securities class action subject to the PSLRA, the complaint did not support its charge with extensive details; it did not mention either the February 2000 announcements or April 2000 press release at all. Because these announcements were by all accounts issued to the public, however, knowledge of their contents (though not necessarily their alleged fraudulence) can be imputed to plaintiff as of their release date. Berry, 175 F.3d at 703, n. 4. The question, then, is when plaintiff had "notice of the facts constituting the violation"; i.e., when was it on notice that the February 2000 announcements and April 2000 release formed part of the fraud alleged in the February 2001 complaints.
Significantly here, except for the one mailbox allegation (which itself is inadequately pled), the challenged statements in the February 2000 and April 2000 releases all pertain to revenue expectations for future quarters (i.e., first quarter 2000 and beyond). They are thus directly linked to the fraud that has been alleged ever since February 2001. Plaintiff replies that it did not know the "specifics" of certain first-quarter transactions until February 2002. Without those specifics, it says, it could not support a fraud claim directed against the February 2000 or April 2000 statements. This order rejects this excuse. These specifics are just as relevant to the fraud claim going to the announcement made April 18, 2000 (concerning first-quarter 2000 results) as they are to the new statements. Yet even without these details, plaintiff felt it had enough to attack the April 18 announcement as fraudulent.
This conclusion is consistent with In re Stac Elec. Sec. Litig., 89 F.3d 1399 (9th Cir. 1996). In Stac, the plaintiffs attempted to add nine new defendants to a complaint one year and four months after the original complaint was filed. The district court refused to allow this. Stac affirmed the district court's determination that the claims were time-barred, holding, "Given, however, that plaintiffs were quickly aware of or suspected fraud at the time they filed the first complaint, and given further that all of the new defendants were named in the Prospectus and added to the [Second Amended Complaint] on the basis of their corporate positions alone, the district court correctly found that plaintiffs had adequate notice." Id. at 1411. So too here. Given the close nexus between the claims asserted in the February 2001 complaints and the second consolidated complaint, plaintiff had notice of any fraud relating to the February 2000 and April 2000 announcements more than a year before it attacked them for the first time.
Plaintiff raises two other counter-arguments. Both fail to persuade. First, it argues that the one-year limitations period begins to run only upon filing of the consolidated complaint. Plaintiff claims that In re Syntex Corp. Sec. Litig., 95 F.3d 922 (9th Cir. 1996), supports this position. In Syntex, the plaintiffs' second amended complaint contained similar allegations to those in their first amended complaint. The district court found that the plaintiffs had discovered the facts underlying their Rule 10b-5 claim no later than when they filed their first amended complaint. The Ninth Circuit affirmed, stating that the plaintiffs had discovered the facts related to their newly-added claims "by the time" the first amended complaint was filed. Id. at 935. Since the first amended complaint was filed more than a year before the second amended complaint, there was no need for Syntex to look further back in time. Syntex simply does not stand for the proposition that notice can only occur, and the statute of limitations begin to run, upon the procedural formality of filing a consolidated class complaint.
Syntex also deals a mortal blow to plaintiff's alternative argument, that the allegations in its present pleading relate back to those in the first consolidated complaint. As Syntex explained, an amendment adding a party plaintiff relates back to the date of the original pleading only when: (1) the original complaint gave the defendant adequate notice of the claims of the newly proposed plaintiffs; (2) the relation back does not unfairly prejudice the defendant; and (most importantly here) (3) there is an identity of interests between the original and the newly-proposed plaintiffs. 95 F.3d at 935. Plaintiff's argument is tripped up by the third prong of this test. Facing a similar situation, in which the plaintiffs also attempted to extend a class period, Syntex held:
Here, Plaintiffs did not show that the two groups of plaintiffs had an identity of interests. The claims of the proposed plaintiffs are different because the newly proposed class members bought stock at different values and after different disclosures and statements were made by Defendants and analysts. Therefore, Plaintiffs from the original class period would have different interests than those who bought stock after May 26, 1992. Accordingly, the proposed new claims did not relate back.
Ibid. Plaintiff labels this discussion dicta, but a close reading of Syntex indicates it is anything but. Plaintiff also argues in the alternative that Syntex is distinguishable because the plaintiffs there sought to extend the class period at its end, rather than its beginning, without a convincing explanation of why this matters. This is a distinction without a difference.
Given the foregoing discussion, this order rejects plaintiff's attempt to lengthen the class period. Claims against the February 2000 press releases and the April 2000 "booster shot" report are barred by the statute of limitations.
3. Fraud.
This order now turns to plaintiff's claim directed toward the April, July and October 2000 announcements of Commtouch's financial results, and other associated statements made during the April 2000-February 2001 period. The complaint alleges that Commtouch intentionally booked revenue that was never reasonably assured of receipt and even engineered some sham transactions to make it appear that Commtouch was experiencing remarkable revenue growth. According to the complaint, six improperly recorded transactions accounted for the $4.4 million revenue restatement; still other wrongly booked deals were never accounted for, through a restatement or otherwise. This order holds that the complaint, unlike its predecessor, alleges a pervasive pattern of recording revenues without regard to collectibility with sufficient clarity to satisfy the PSLRA and Silicon Graphics — at least with regard to certain statements.
(a) Accounting Principles Bulletin 20.
Analysis begins with the nature of the restatement here. At hearing, much discussion involved the applicability and import of Accounting Principles Bulletin 20. This bulletin provides guidelines for reporting various types of accounting changes and accounting errors. Paragraph 13 of APB 20 provides that a restatement is proper where an error has been made in a previously-issued financial statement. An error exists where there has been (1) a mathematical mistake; (2) mistakes in the application of accounting principles; or (3) oversight or misuse of facts that existed at the time the financial statements were prepared. Paragraph 31 of APB 20 provides that a change in estimate should not be accounted for by a restatement of prior quarters.
Commtouch admittedly restated its revenues, rather than taking a write-off. Plaintiff, noting this, argues that this means Commtouch's restatement followed from one of the three types of errors identified as warranting a restatement in APB 20. Relying on the other allegations in its complaint, plaintiff asserts that the restatement here must have fallen into the "oversight or misuse of facts" category discussed by APB 20. Plaintiff posits that this type of restatement by itself raises eyebrows, providing a solid foundation (though not by itself a capstone) to its fraud claim. Defendants, for their part, argue that APB 20 and its guidelines regarding when to and when not to restate do not apply to the statements at issue in this case, since they presented only unaudited results. And even if APB 20 applied, defendants assert, the fact that Commtouch made a restatement means nothing. The restatement could have been necessitated by a mathematical mistake or error in the application of accounting principles; or Commtouch could merely have violated APB 20's rule regarding when to restate and when not to do so.
At a bare minimum, it is beyond question that, against a backdrop of the guidance provided by APB 20, Commtouch chose to take a restatement rather than a write-off. One must wonder why a restatement was taken if not called for. As for whether APB 20 applied to Commtouch's statements, defendants invoke In re FVC.Com Sec. Litig., 136 F. Supp.2d 1031 (N.D. Cal. 2000). FVC.Com, defendants assert, stands for the principle that APB 20 applies only to audited financial statements. By all accounts, Commtouch's financial statements were unaudited until the year ended. Defendants posit an incorrect reading of both FVC.Com and APB 20. First, APB 20 does not distinguish between audited and unaudited financial statements:
3. The Opinion applies to financial statements which purport to present financial position, changes in financial position, and results of operations in conformity with generally accepted accounting principles. The guides in this Opinion also may be appropriate in presenting financial information in other forms or for special purposes. . . .
Thus the operative dichotomy is between financial statements that purport to present information in conformity with GAAP (or which fall within the "catch-all" in the second sentence excerpted above), and those that do not. And although FVC.Com said that APB 20 did apply to audited financial statements, it never explicitly held that the bulletin did not apply in any circumstance to unaudited statements. Id. at 1037. There may have been no indication in FVC.Com that the figures at issue purported to comport with GAAP.
Here, Commtouch's quarterly totals were not just included in press releases; they were also filed with the SEC. The SEC filings included notes such as (Def. RFJN Exh. G) (emphasis added):
The condensed consolidated financial statements have been prepared by Commtouch Software Ltd., without audit, and include the accounts of Commtouch Software Ltd. and its wholly-owned subsidiaries (collectively "the Company"). Certain information and footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted pursuant to such rules and regulations. In the opinion of the Company, the financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial position at March 31, 2000 and the operating results and cash flows for the reported periods.
The reassurance in the final sentence of this note is sufficient to bring Commtouch's financial statements into APB 20's orbit. And although defendants are correct in saying this does not prove plaintiff's case, or even by itself push the complaint over the PSLRA's pleading bar, it does point toward the conclusion that the restatement here was based on facts available at the time revenue was recorded.
Furthermore, a statement by one of Commtouch's own officers supports an inference that Commtouch restated its revenues based on facts available at the time revenue was recognized. According to the complaint, Sunil Bhardwaj, Commtouch's new CFO, was asked at the time of the restatement how the restated revenues were determined. He replied, "we looked back and we said that if an amount was subsequently deemed to be uncollectible, we went back to see if we could satisfy the conditions of collectibility at that time" (Compl. ¶ 119). The most sensible interpretation of this statement is that the restatement looked at conditions of collectibility as of the time revenue was recorded. Defendants attempt to spin this statement. They say Bhardwaj meant Commtouch looked at conditions of collectibility at the time of the restatement. This interpretation is inconsistent with the fact that Commtouch took a restatement rather than a write-off, however. Moreover, defendants' interpretation is forced and unnatural. As presented in the complaint, "at that time" refers to the time of revenue recognition, not the time of the audit and restatement.
Defendants also say that the complaint's interpretation of this statement conflicts with other announcements Commtouch issued regarding the restatement (Def. RFJN Exh. M, N). This argument asks the Court to review matters of public record for the truth of the matter asserted, and is therefore not cognizable at this time.
(b) Size and Scope of the Restatement.
Plaintiff thus begins with a well-supported allegation that Commtouch made a restatement based on facts available at the time revenue was recorded. This, of course, is not enough to bring about a "strong inference" of at least deliberate recklessness. Yet it is only the starting point for the complaint's allegations. The complaint also emphasizes the size and character of the restatement. The complaint pegs Commtouch's actual revenue for 2000 (after the restatement) at $19.1 million (Compl. ¶ 119). The restatement amounted to $4.4 million, more than 20 percent of total annual revenues. Under different circumstances, it is true, restatements making up a similar proportion of corporate revenues have been held not actionable. See, e.g., In re NorthPoint Comm. Group, 184 F. Supp.2d 991, 1006 (N.D. Cal. 2001). In this case, however, the restatement was not merely a reassessment of an earlier accounting judgment call, such as setting an allowance for bad debt that turned out to be too low. Instead, it consisted of sizeable transactions with six customers, each of which accounted for at least $500,000 in restated revenue. Several of these deals were negotiated through Commtouch's Executive Vice President of Corporate Development. In a company of Commtouch's modest size, it is unlikely that transactions of this scope would fly below the radar of top management, particularly the CEO and CFO. To the contrary, these are exactly the sort of transactions one would expect these officers to scrutinize closely from Day One. Cf. In re PeopleSoft, Inc. Sec. Litig., No. C 99-00472 WHA, 2000 WL 1737936 at *3 (N.D. Cal. 2000).
(c) Confidential Witnesses.
These allegations provide an important foundation to what remain the complaint's core, the confidential witnesses. As mentioned earlier, defendants' motion to dismiss the original consolidated complaint was granted because the confidential-witness allegations therein were inadequately pled. Defects included identification of the witnesses with phony titles and a failure to identify the witnesses' basis of knowledge with regard to the allegations attributed to them.
The confidential-witness allegations in the present pleading improve somewhat on those in the first consolidated complaint. Now, all of the witnesses are identified by their (presumably) correct titles, or, less satisfactorily, by a more general description of their position (e.g., "employed in the finance department during the class period"). As to certain allegations, additional detail is given regarding the witnesses' basis of knowledge. In other instances, however this detail is maddeningly absent. Take, for example, the following allegation attributed to CW3 (identified as a technical director of customer-service support at Commtouch during the class period) (Compl. ¶ 68):
Later in January 2001, Commtouch had a Company-wide meeting in its Mountain View, California offices which included Isabel Maxwell and defendants Mantel and Collins. These executives announced plans to restate earnings from the first, second and third quarters of 2000. The executives indicated that Commtouch had gotten into a "fight" with the Company's auditors over the amount of revenue subject to the restatement and the fact that the auditors were only going to allow Commtouch to report a limited amount of revenue. Commtouch executives did not state at the meeting that they disagreed with the underlying basis for the restatement, but rather the amount.
Isabel Maxwell is alleged to be the President Emeritus of Commtouch (Compl. ¶ 30(b)).
Did CW3 personally attend the meeting? The complaint never says. Who among the executives "indicated" that Commtouch had gotten into a fight with the auditors? The complaint never says. What did that executive (or those executives) specifically say? The complaint never says. What do "indicated" and "fight" mean? The questions could go on. With allegations such as this, plaintiff has failed to heed the first order's (and Silicon Graphics') directive to plead all relevant facts in great detail.
Fortunately for plaintiff, the complaint also includes better-detailed confidential-witness allegations. These allegations, taken with the rest of the complaint, adequately aver that more than mere recklessness was afoot at Commtouch during the class period. The confidential witnesses speak to a pattern and practice of improper revenue recognition with sufficient specificity to induce a strong inference of, at a minimum, deliberate recklessness with regard to certain statements made during the class period.
Specifically, poised against a background of (on their own, insufficient) allegations that Commtouch was engaging in little due diligence and was having substantial problems collecting from customers, the complaint alleges the company was booking revenue as soon as contracts with customers were signed — and before it either performed its end of the contractual bargain or even invoiced the customer. Certain among the restated transactions, the complaint alleges, provide specific examples of this practice. Commtouch's announced revenue policy was (Def. RFJN at E):
Commencing 1998, the Company derives its revenues from providing web-based email services. Revenues from contracts that are not dependent upon the number of mailboxes and provide non-refundable fixed payments are recognized ratably over the contract term. Revenues from contracts specifying a contractual rate per mailbox per month are recognized monthly for mailboxes covered by the respective contracts. Revenues from contracts based on a share of advertising. revenues earned by business partners are recognized when such revenues are earned. Revenues from set up and installation fees are recognized upon installation. Amounts billed or received in advance of service delivery are recorded as deferred revenue.
It is difficult to square this announced policy with the allegations attributed to the confidential witnesses. CW1, identified as an accounts payable and receivables coordinator in Commtouch's headquarters during the class period, reports that the "accounting department booked revenue as soon as the contract was signed on direct orders." CW1 allegedly heard this from Collins: "During first quarter 2000 through third quarter 2000, CW1 overheard Collins tell Commtouch Controller Devyani Patel, `[b]ook revenue as soon as you receive a signed contract'" (Compl. ¶ 66).
CW1 also states that Commtouch rendered services only after booking the revenue, and that customers were invoiced only after services were rendered. In addition, the complaint alleges that starting in March 2000 Commtouch began to ask for commissions back from sales personnel because customers were not paying on their underlying contracts. Several of the confidential witnesses speak to this practice, including CW2, CW6, CW8 and CW9. CW6 and CW8 claim to have had commissions deducted from their own paychecks. This practice, the complaint avers, suggests that Commtouch was reporting revenue as soon as a contract was signed.
Defendants state that the complaint does not explicitly link any specific transaction to the practice (spoken to by CW1) of improperly booking revenue as soon as a contract was signed, without regard to the customer's solvency or ability to pay. In discussing the particular transactions making up the restatement, however, the complaint makes essentially the same charge — that Commtouch deliberately booked revenue in a premature manner. The restated transactions, the complaint alleges, are merely the tip of the iceberg — those deals so egregious that Commtouch's auditors demanded a restatement.
Several confidential witnesses speak to the restatement. One of the more important witnesses is CW9. This witness first appears in the second consolidated complaint. This order has already touched upon allegations attributed to her — she was the source of information regarding the transactions involved in the restatement. She is identified in the complaint as having been one of the "top three" individuals who ran Commtouch's accounting department during the class period (Compl. ¶ 73). According to CW9, the $4.4 million restatement derived primarily from Commtouch's accounting of its relationships with six customers: Mail.com, ThinkLink, NetFront, SaveMail, FreeDrive, and OpenGrid. CW9 states that Commtouch restated $600,000 in revenue from ThinkLink, $750,000 in revenue from NetFront, $500,000 from SaveMail, and $800,000 from Mail.com. CW9 could not identify the amounts attributable to FreeDrive or OpenGrid; plaintiff backs out an aggregate figure of $1.796 million from the total $4.446 million restatement.
From the parties' submissions, it is evident that defendants know CW9's actual identity. To maintain consistency with the complaint, this order will not refer to CW9 by her proper name.
The complaint taps several witnesses for specifics regarding these transactions, including CW9. The details provided vary transaction-by-transaction; so too does the inference of any wrongdoing. For example, with regard to the $800,000 Mail.com transaction, alleged to be a software license-for-software license "barter" deal, the best plaintiff can say is that this is that this transaction is "suspicious" (Compl. ¶ 127). Perhaps, but by without more detail such an allegation does not satisfy the PSLRA's scienter standards. Very few details, let alone suspicious ones, are given as to either the OpenGrid or FreeDrive transactions. Indeed, the OpenGrid transaction is just as easily seen as a garden-variety billing dispute as anything else.
The best-detailed allegations involve ThinkLink and NetFront. Two witnesses — CW9 and CW10 — speak to Commtouch's interactions with ThinkLink. The complaint, building from the allegations of CW9 and CW10, alleges that Commtouch improperly recorded revenue from ThinkLink in connection with an equity investment Commtouch made in the firm. CW9's allegations are strong, but are compromised by the complaint's proviso that CW9 only "confirmed" the allegations attributed to her and by its boilerplate assertion that she was "directly involved" in accounting, without further details provided as to what this means. Her principal allegation regarding the nature of the ThinkLink transaction follows (Compl. ¶ 73):
CW9 confirmed that when Commtouch invested $3 million in ThinkLink, in return Commtouch would be entitled to receive cash payments from ThinkLink once the companies integrated their systems. By April 2000, it was clear that integration would be very difficult. CW9 specifically recalled that Commtouch billed ThinkLink and booked revenue of $425,000 in the first quarter 2000. In response, a ThinkLink representative called Commtouch's Accounting Department about the bill. The ThinkLink representative stated the invoice and amount due to Commtouch was improper because the required level of integration had not been completed.
Substantively similar allegations are attributed to CW10. This witness is not identified by title, just as someone who was "employed by ThinkLink in its finance department" and "directly involved in the negotiations with Commtouch and Collins regarding Commtouch's equity financing of ThinkLink throughout the Class Period." The identification of this witness is arguably too vague to support any confidence in his or her basis of knowledge. CW10 is alleged to have provided plaintiff with the following information (Compl. ¶ 74):
At the time of Commtouch's $3 million equity investment in ThinkLink, Commtouch and ThinkLink agreed that ThinkLink would make quarterly payments to Commtouch. The companies were to integrate their services into a single software product to be marketed by both companies. The integration target date was August of 2000. CW10 learned about this agreement directly from ThinkLink's CFO, who met with Collins in person to close the deal.
According to CW10, it became evident as early as April 2000 that cross-integrating the products was difficult and would not be done on schedule. The parties tried to work out alternative payment schedules and integration time-lines (ibid.):
[I]n April or May 2000, ThinkLink's Controller redrafted the contract with Commtouch and presented it to Collins. The redrafted contract contained a note which specified that ThinkLink would owe $500,000 to $1 million to Commtouch only after the joint integrated product was commercially launched. At the time of the interview, CW10 could not recall the exact amount, i.e., whether the reworked contract required payment for the initial amount or the total amount. Collins agreed to the terms of the agreement. CW10 saw the agreement and learned from ThinkLink's Controller that Collins agreed to those terms.
According to CW10, in June or July 2000, Collins and ThinkLink's Controller agreed to push back the launch date for another three months until October or November 2000. Significantly, the complaint alleges, "CW10 confirmed that ThinkLink did not make a single payment to Commtouch as a result of the contract executed with Commtouch's equity investment" (ibid.).
As for NetFront, the complaint alleges that on February 28, 2000, Commtouch reached an agreement with NetFront under which Commtouch was to promote NetFront's secure e-mail messaging services to Commtouch customers. In exchange, Commtouch would receive $250,000 from NetFront per quarter in promotional fees. NetFront never paid Commtouch these promotional fees. Nevertheless, Commtouch booked $250,000 from NetFront for each of the first three quarters of 2000 (Compl. ¶ 78). And according to CW7, identified only as a "high-ranking executive employed at NetFront during the Class Period," Mantel met with NetFront executives on October 3, 2000, at Commtouch's Mountain View headquarters. NetFront had proposed that the two companies discuss NetFront's inability to pay (it is alleged that NetFront was already delinquent) and its belief that Commtouch had not met its obligations pursuant to the promotion agreement. At that meeting, the NetFront executives told Mantel that NetFront could not pay (Compl. ¶ 79). Nevertheless (according to the complaint, through CW9), Commtouch included $250,000 in revenues from NetFront in its third-quarter results issued just more than three weeks later, on October 25, 2000.
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The context the rest of the complaint adds to these allegations concerning the restatement is crucial. Taken in isolation, the factual allegations concerning ThinkLink, NetFront, etc., would not provoke a sufficient inference of deliberate misconduct, as they could just as easily be squared with non-actionable states of mind. This is particularly true given the gaps within and across the confidential witnesses' allegations. The other facts pled in the complaint, however, cast these transactions in a different light. Requiring plaintiff to plead facts conducive to a strong inference of fraud does not impose upon it a duty to negate every last non-fraudulent possibility, no matter how speculative. In this case, the complaint's allegations dovetail and reinforce each other. They speak to a widespread practice of improperly premature revenue recognition that ultimately led to the restatement of several substantial, top-level transactions upon a year-end audit. Taking the facts in the complaint as true, and granting reasonable inferences in plaintiff's favor, there is enough in the complaint to induce a strong inference that Commtouch acted with deliberate recklessness in promulgating its revenue totals for the first, second and. third-quarters of 2000, and in making certain related statements.
4. Statements That Are Not Actionable.
This means plaintiff may proceed against certain statements attacked in the complaint. The actionable statements will be set forth at the end of this order. Several other statements are not actionable, however. First, the complaint fails to meet the basic requirement of "specify[ing] each statement alleged to have been misleading, [and] the reason or reasons why the statement was misleading" with regard to several statements that could conceivably have been incorporated into the fraud claim. 15 U.S.C. § 78u-4 (b)(1). Plaintiff's counsel are well-trained in crafting a securities-fraud complaint. They know better than to simply aver that an (oftentimes lengthy) statement was made, but never specifically identify how (or which part of) that particular statement was false or misleading. The Court has labored to discern the complaint's method of calling out the statements forming the basis of its claim. Some conceivably questionable statements are not followed by the customary "reasons false or misleading" paragraph. And although bold typeface is used to brand certain challenged statements, it is not used elsewhere. For example, the third-quarter revenue announcement in Paragraph 95 of the complaint, obviously key to plaintiff's case, is not in bold typeface. In light of the rigorous standards for pleading fraud, plaintiff should consider dismissed on this basis all statements not specifically addressed below or identified as actionable at the close of this order.
As for the other statements, the claim against the February 2000 releases and the April 2000 "booster shot" report is dismissed for having been pled for the first time beyond the statute of limitations. Mantel's statement in the press release dated April 25, 2000, is immune as puffery except to the extent that he discussed Commtouch's "strong" first-quarter results. The allegation directed toward the supposed conference call on April 18, 2000, is plainly insufficient (Compl. ¶ 60). Since plaintiffs have pled facts conducive to an inference of deliberate recklessness, but not actual knowledge of falsity, as to these statements, the revenue forecasts issued by Mr. Gerber on August 7, 2000, and by Collins on November 2, 2000, are protected by the PSLRA safe harbor for forward-looking statements. 15 U.S.C. § 78u-5(c)(1). Finally, although it is a close call, the complaint does not plead enough specific facts to state a claim going to the fraudulence of Commtouch's announcement regarding backlogged contracts that were to be booked as revenue in future quarters. As discussed above, the complaint raises a "strong inference" with regard to the premature booking of revenue, not the company's completion of contracts that would later produce revenues. Even when viewed from the perspective offered by these other, stronger allegations, as well as all else in the complaint, there is simply not enough to allow the claim against these statements to go forward.
5. Individual Defendants.
Finally, there is no question but that the purported involvement of both individual defendants had been adequately pled. Several allegations connect each of the individual defendants with the alleged fraud. Furthermore, given the particular allegations at issue here as well as the positions held by the individual defendants, a pleading-stage presumption would arise that they were aware of the type of misconduct alleged. See NorthPoint, 184 F. Supp.2d at 998. In addition, the individual defendants may be held accountable for corporate statements under the group-pleading doctrine, which has survived the PSLRA. See In re Secure Computing Corp, 120 F. Supp.2d 810, 821 (N.D. Cal. 2000).
CONCLUSION
For the foregoing-reasons, this order holds that the statements regarding-revenues, earnings and margins in the press releases issued April 18, 2000, July 20, 2000, and October 25, 2000, are actionable. Also actionable are: (1) Mantel's April 18 statement regarding "strong Q1 2000 results" (Compl. ¶ 57); (2) Mantel's July 20 statement, "We remain on target to reach our revenue guidance of approximately $30 million for the year 2000 and a year-to-year growth of 600%" (Compl. ¶ 87); and (3) Collins' October 25, 2000 statement, "we remain on target to reach revenue goals of approximately $30 million for the year 2000 with year-to-year revenue growth of nearly 600%" (Compl. ¶ 98).
All other statements are not actionable and should not be identified as actionable in the amended complaint plaintiffs shall file not later than September 5, 2002. This complaint also shall not identify as actionable any additional statements than those specified in the paragraph immediately above. Defendants will be required to answer this complaint. A case management order and discovery schedule will follow by separate order.
IT IS SO ORDERED.