Opinion
CIVIL ACTION NO. 07-11151-RWZ.
July 7, 2008
MEMORANDUM OF DECISION AND ORDER
Defendant Steven Forman ("Forman") has moved to dismiss the complaint filed against him by the Securities and Exchange Commission ("SEC") in this action.
I. Background
The complaint alleges that Forman, the former corporate controller of Speechworks International, Inc. ("Speechworks" or the "Company"), and other officers of the Company engaged in a fraudulent scheme to improperly recognize revenue from transactions between Speechworks and Intervoice, Inc. ("Intervoice") in violation of Generally Accepted Accounting Principles ("GAAP") and the Company's own revenue recognition policy. During the relevant period, Speechworks manufactured a variety of speech recognition and related software products, which it sold both directly to end users and indirectly through Original Equipment Manufacturers ("OEMs"). Intervoice, an OEM, manufactured computer hardware systems that were sold directly to both distributors and end users. Intervoice integrated Speechworks' software into its hardware systems, and sub-licensed the software to its customers as part of the systems' sale. Under the written agreement between the parties, Speechworks provided Intervoice with a master copy of software, which Intervoice installed on its products and in combination sold to third parties. Upon the sale, Intervoice owed Speechworks a royalty. The agreement between the parties required Intervoice to provide a "Royalty Report" to Speechworks approximately one month after the close of Intervoice's fiscal quarter. The "Royalty Report" set forth the amount of sales by Intervoice and the resulting royalties to Speechworks. (See Complaint (Docket # 1) ¶¶ 17-20.) According to the complaint, in May 2001, Richard J. Westelman ("Westelman"), Speechworks' Chief Financial Officer ("CFO"), and Rob Roy J. Graham ("Graham"), Intervoice's CFO, orally agreed that Intervoice would prepay (i.e., prior to Intervoice's sale of Speechworks' software to third parties) up to two million dollars in royalties over the second, third, and fourth quarters of 2001. In exchange, Speechworks would buy one million dollars of hardware from Intervoice before it actually needed the equipment. This arrangement violated GAAP and the Company's internal revenue policies because it allowed Speechworks to improperly recognize revenue in advance of the sale of its software to third parties by Intervoice and because its essential terms were not memorialized in a signed writing. (Id. ¶¶ 4, 41-52.) Forman and another Speechworks officer allegedly actively participated in the scheme. The SEC alleges that Forman both directly violated federal securities laws and aided and abetted the Company's violations of such laws.
In a motion to dismiss the court accepts the factual allegations of the complaint as true. Tellabs, Inc. v. Makor Issues Rights, Ltd., ___ U.S. ___, 127 S. Ct. 2499, 2509 (2007).
II. Discussion
A. Counts I and II: Direct Violations of Section 10(b), Rule 10b-5 and Section 17(a)(1)
The elements of an action for securities fraud under Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b) (and Rule 10b-5 thereunder) and Section 17(a)(1) of the Securities Act, 15 U.S.C. § 77q(a), are substantially the same. SEC v. Tambone, 417 F. Supp. 2d 127, 131 (D. Mass. 2006) (citing Aaron v. SEC, 446 U.S. 680, 695 (1980). The SEC must allege that Forman (1) engaged in fraudulent conduct; (2) in connection with the purchase or sale of securities; (3) through the means or instruments of transportation or communication in interstate commerce or the mails; and (4) with the requisite scienter. Id. Forman asserts that the SEC has failed to allege facts showing that he engaged in fraudulent conduct or acted with scienter.
In order to establish that a defendant engaged in "fraudulent conduct," the SEC must allege that he (1) made an untrue statement of material fact; (2) omitted a fact that rendered a prior fact misleading; or (3) committed a manipulative or deceptive act as part of a scheme to defraud. Id. at 132. The complaint alleges that during the period when the Company was overstating its revenue Forman prepared initial drafts of the Company's Forms 10-Q and 10-K, prepared the initial drafts of the financial information that the Company included in its earnings press releases, and provided the financial information used in the scripted portions of earnings calls. (Complaint (Docket # 1) at ¶¶ 23, 25, 60-61.) Forman's alleged role in preparing the false statements is sufficient for liability to attach. See SEC v. KPMG LLP, 412 F. Supp. 2d 349, 375 (S.D.N.Y. 2006) ("primary liability can attach to a corporate officer for a company's false statement where it can be shown that the officer was sufficiently responsible for making the false statement").
Forman vigorously disputes the SEC's allegations regarding his level of involvement in drafting the false statements. However, for purposes of the motion to dismiss the court must accept the allegations as true. Forman does not challenge the materiality of the misstatements.
Although the false statements are not attributed specifically to Forman, the SEC is not required to prove reliance when it brings enforcement actions under the securities laws. KPMG, 412 F. Supp. 2d at 375. "Accordingly, in an SEC enforcement action, there appears to be no reason to impose a requirement that a misstatement have been publicly attributed to a defendant for liability to attach, at least so long as the SEC is able to show that the defendant was sufficiently responsible for the statement." Id.
Under Section 10(b) and Rule 10b-5, the defendant must act with scienter. Scienter is "a mental state embracing intent to deceive, manipulate, or defraud." Ernst Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12 (1976). The SEC must allege that Forman "acted with a high degree of recklessness or consciously intended to defraud." SEC v. Fife, 311 F.3d 1, 9 (1st Cir. 2002). The complaint states:
Count II alleges violations of Section 17(a)(1)-(3). Scienter is required for Section 17(a)(1) claims but need not be alleged for violations of Sections 17(a)(2) or (3). See Aaron, 446 U.S. at 695-97 (1980); SEC v. Fife, 311 F.3d 1, 9 (1st Cir. 2002).
After negotiating the prepaid royalty agreement with Graham, Westelman met with Forman and [another Speechworks officer] and asked them to assist him in evaluating revenue recognition for the arrangement. Forman and [the other officer] then learned that the deal was essentially an oral agreement between Westelman and Graham. . . .
(Compl. ¶ 43.) Forman argues that the complaint fails to allege that he knew about the agreement when he made the misstatements because it alleges only that he learned about it at some unspecified point "after" it was negotiated. However, in deciding a motion to dismiss, I must give plaintiff the benefit of all reasonable inferences. Ezra Charitable Trust v. Tyco Int'l, Ltd., 466 F.3d 1, 6 (1st Cir. 2006). The reasonable inference is that Forman learned of the arrangement shortly after it was made, before the Company recognized revenue for it, and that he therefore knew that the Company's financial statements, press releases, and conference call scripts overstated the Company's revenue. Although defendant makes much of the SEC's inconsistency in alleging on one hand that Forman was actively involved in the scheme, and on the other hand that Forman was reckless in not following up on "red flags" which would have uncovered Westelman's concealed fraud, plaintiffs are permitted to plead alternative claims "regardless of consistency." Fed.R.Civ.P. 8(d)(3). I conclude that the SEC has adequately alleged scienter, albeit barely. Accordingly, Forman's motion to dismiss as to these claims is denied.
See also Compl. ¶ 46 ("Forman knew that under GAAP and Speechworks' publicly disclosed revenue recognition policy, the essential terms and conditions of a transaction . . . had to be documented in a signed writing"); id. ¶ 47 ("Forman . . . allowed Speechworks to improperly record Intervoice's royalty prepayments as revenue in the quarters in which Intervoice committed to make the payments. Westelman and Forman knowingly or recklessly failed to require Speechworks to properly defer the revenue associated with the prepaid royalties to the periods in which the prepaid credit was actually used to satisfy a royalty obligation.").
In this regard, it is important to note that the heightened scienter pleading standards in the Private Securities Litigation Reform Act do not apply to SEC enforcement actions. See 15 U.S.C. § 78u-4(a)(1) ("The provisions of this subsection shall apply in each private action arising under this chapter that is brought as a plaintiff class action") (emphases added).
B. Counts III and IX: Direct Violations of Section 13 and Rule 13b2
The SEC has alleged that Forman circumvented internal controls and falsified accounting records in violation of § 13(b)(5) of the Exchange Act, 15 U.S.C. § 78m(b)(5) and Rule 13b2-1 thereunder, and that he misled Speechworks' accountants in violation of Rule 13b2-2 thereunder. Defendant's challenge to these claims is based on the same argument discussed above, that the SEC has insufficiently alleged that he acted knowingly. As noted in Part II.A., the SEC's scienter allegations are sufficient. Moreover, scienter is not an element of civil claims under § 13. See SEC v. McNulty, 137 F.3d 732, 740-41 (2d Cir. 1998), and cases cited therein. The motion to dismiss as to these claims is denied.C. Counts IV, VI, VII, VIII and X: Aiding and Abetting Speechworks' Violations of Federal Securities Laws
To establish aiding and abetting liability in a § 10(b) claim (Count X), the SEC must allege (1) a primary violation of § 10(b) or Rule 10b-5; (2) general awareness by the defendant that his conduct was part of an overall activity that was improper; and (3) knowing and substantial assistance of the primary violation by the defendant. Tambone, 417 F. Supp. 2d at 136. Defendant does not contest that the SEC has sufficiently alleged a primary violation by Speechworks. Since, as noted earlier, the SEC has adequately alleged that defendant knew of the prepaid royalty arrangement and that he assisted the Company in overstating its revenue through his role in preparing drafts of the Company's financial statements, press releases and earnings calls, it has adequately pled that Forman aided and abetted Speechworks' § 10(b) violation.
The SEC has also alleged that Forman aided and abetted Speechworks' § 13 violations (Counts IV, VI, VII and VIII). Defendant does not contest that the SEC has sufficiently alleged primary violations of § 13 by Speechworks. And the SEC has adequately alleged that Forman knew of Speechworks' conduct and his role in furthering it; moreover, scienter is not required for § 13 civil claims. See supra; see also Ponce v. SEC, 345 F.3d 722, 737 n. 10 (9th Cir. 2003).
III. Conclusion
It is striking that the complaint against Forman — the result of a multi-year investigation in which the SEC subpoenaed documents and obtained testimony from all of the relevant actors — barely passes muster. The SEC notes that it is "not required to catalogue every piece of supporting evidence in the complaint." (Docket # 12, 13 n. 13.) Nonetheless, the complaint does not make out a slam dunk.
Forman's motion to dismiss the complaint (Docket # 9) is DENIED.