Opinion
Civil Action No. 3:02-CV-496-M
November 5, 2003
MEMORANDUM OPINION AND ORDER
Before the Court is Defendant's Motion to Dismiss Plaintiffs' Amended Class Action Complaint. On March 11, 2002, Plaintiffs sued Arthur Andersen L.L.P. ("Andersen") for securities fraud. Plaintiffs claim that Andersen misstated material facts in its audit report for the 1997 financial statements of Intelect Communications, Inc. ("Intelect"). On June 7, 2002, Andersen filed its original Motion to Dismiss, claiming, inter alia, that Plaintiffs failed to state with particularity facts supporting a strong inference of scienter. On January 28, 2003, the Court granted Andersen's Motion to Dismiss for failure to properly plead scienter, but granted Plaintiffs an opportunity to replead. Plaintiffs amended their Complaint on February 27, 2003, filing a corrected copy on March 3, 2003. On April 14, 2003, Andersen again moved this Court to dismiss the Amended Complaint, alleging that Plaintiffs still failed to state with particularity facts supporting a strong inference of scienter. For the reasons stated below the Court DENIES Andersen's Motion to Dismiss, holding that Plaintiffs have sufficiently pled scienter.
ANALYTICAL FRAMEWORK AND STANDARD OF REVIEW
Federal Rule of Civil Procedure 12(b)(6) provides a basis for the dismissal of Plaintiffs' claims if the Complaint fails to state a claim upon which relief can be granted.To state a claim under section 10(b) of the Securities and Exchange Act and Rule 10b-5, a plaintiff must allege (1) a misstatement or omission, (2) of material fact, (3) made with scienter, (4) on which the plaintiff relied, (5) that proximately caused the plaintiff's injury. Tuchman v. DSC Communications Corp., 14 F.3d 1061, 1067 (5th Cir. 1994); Umsted v. Andersen, 2003 WL 222621 at *2 (N.D. Tex., Jan. 28, 2003) (Lynn, J.). The Amended Complaint must also meet the strict pleading requirements for fraud which have developed under the PSLRA and under Federal Rule of Civil Procedure 9(b). Abrams v. Baker Hughes, Inc., 292 F.3d 424, 430 (5th Cir. 2002); Umsted v. Andersen, 2003 WL 222621 at *2 (N.D. Tex., Jan. 28, 2003). In particular, when pleading the element of scienter, a plaintiff must "plead specific facts giving rise to a `strong inference' of scienter." Nathenson v. Zonagen, Inc., 267 F.3d 400, 407 (5th Cir. 2001).
A plaintiff can meet this "pleading obligation based on conscious behavior or severe recklessness of the defendant." Umsted v. Andersen, 2003 WL 222621 at *2 (N.D. Tex., Jan. 28, 2003); Haack v. Max Internet Communications, Inc., 2002 U.S. Dist. LEXIS 5652, at 19 (N.D. Tex Apr. 2, 2002) (Fish, J.) (citing Mortensen v. AmeriCredit Corp., 123 F. Supp.2d 1018, 1023 (N.D. Tex.) (Fitzwater, J.) aff'd, 240 F.3d 1073 (5th Cir. 2000) Krogman v. Sterritt, 1999 WL 1455757, at *3 (N.D. Tex. July 21, 1999) (Maloney, J.). In this case, severe recklessness would mean Andersen misrepresented or omitted material facts in a manner considered an "extreme departure from the standard of ordinary care, and that [Andersen knew or must have known its acts] present[ed] a danger of misleading buyers or sellers" of the stock. Abrams, 292 F.3d at 430; Umsted v. Andersen, 2003 WL 222621 at *2. Here, the Court must consider whether the facts, as alleged in the Amended Complaint, support a strong inference of scienter on the part of Andersen.
ANALYSIS
Andersen argues the Plaintiffs fail to plead sufficient specific facts to support a strong inference of scienter. Andersen asserts that the Amended Complaint again alleges nothing more than that Andersen generally violated professional standards, i.e., generally accepted auditing principles and standards ("GAAP" and "GAAS"), in performing the hitelect audit, and that those violations led to the alleged fraud.
As this Court decided in granting the first Motion to Dismiss, mere general allegations of violations of GAAP and/or GAAS will not support a strong inference of scienter. This Court noted that in cases that have pled sufficient facts to support a strong inference of scienter, the plaintiffs alleged facts that demonstrated that the auditor "had knowledge of facts indicating the financial information it was seeing was false, but failed to act upon it." Umsted v. Andersen, 2003 WL 222621 at * 4 (N.D. Tex. Jan. 28, 2003). This Court ultimately held that the Original Complaint set out no "basis for the conclusion of what Andersen `knew.'" Id.
Plaintiffs now contend that the Amended Complaint goes well beyond alleging mere general violations of GAAP and GAAS. Plaintiffs argue that audit work papers prepared by Andersen during its audit demonstrate that Andersen was well aware of auditing improprieties at Intelect that led to material misstatements of the company's financial well-being. Specifically, the Amended Complaint alleges Andersen's audit work papers indicate that Andersen knew or recklessly disregarded the facts (1) that Intelect had improperly recognized millions of dollars of revenue in 1997 from four of its largest accounts; (2) that Intelect failed to reserve a proper amount for uncollectible receivables; and (3) that Intelect failed to properly accrue warranty costs for product shipped in 1997. The Amended Complaint further alleges that Andersen improperly acquiesced in Intelect's decision not to make audit adjustments proposed by Andersen, and that Andersen failed to issue a going concern qualification in the face of all the facts in its audit work papers.
The Amended Complaint alleges Intelect improperly recognized millions of dollars of income involving (1) Amerix, Opicom, and Optronix, (2) MFS, (3) Telecommunications of Jamaica, Ltd., and (4) Northrup Grumman. The pleading alleges these four customers represented seventy-nine percent of the revenue recognized by Intelect in 1997. The Complaint alleges that Intelect shipped these customers product, but that payment was conditioned on material contingencies — either that the shipped equipment had to pass post-installation functionality tests or that the customer could delay payment to Intelect until the customer was paid by its buyer, after the customer installed the system at a third-party location.
The Amended Complaint also alleges that it is improper to recognize revenue until payment is reasonably certain. Plaintiffs contend that the recognition of revenue from sales to Intelect's largest customers, before material conditions of the sales were satisfied, would mean payment to Intelect was uncertain, and basic accounting would prohibit the early revenue recognition. Pls.' Am. Compl. at 10-13.
The Plaintiffs allege over $9 million from Amerix was improperly recognized as revenue. Intelect sold product to Amerix, and its related entity, Optronix, both California entities. Amerix and Optronix would then ship the products to Opicom, a Korean company, that would then install the equipment for third-party end users in Korea. Opicom would not receive payment until completion of site testing for the installed equipment. Thus, Opicom could not pay Amerix or Optronix until Opicom successfully installed the equipment in Korea. Because of functionality issues, Opicom was having difficulty obtaining payment from third parties, and thus Opicom did not pay Amerix or Optronix, which owed money to Intelect.
All three entities, Amerix, Optronix, and Opicom were managed by Tehan Oh, and the Plaintiffs often refer to these entities collectively as the "Oh entities."
Plaintiffs allege that Intelect was aware of these material contingencies regarding Opicom, and that Intelect knew Amerix and Optronix did not have the money to pay on orders shipped from Intelect until they were paid by Opicom. The Amended Complaint claims that although Amerix's distributor agreement with Intelect required that it open a line of credit with a third party, Amerix failed to do so. Instead, it is alleged, Intelect extended credit to Amerix based on a review of incomplete Amerix financial data and one call to a prior Amerix creditor that had loaned $400,000 to Amerix. By July 23, 1997, Amerix was thirty days past due on $2.8 million owed to Intelect. In October 1997, Amerix requested extended payment terms on $4.73 million in product to be ordered from Intelect in December 1997. As a condition for the extended terms, Intelect requested full payment of the $7 million then outstanding, but later asked for $2 million to be paid on a date certain. Amerix declined to pay on a date certain. Plaintiff claims Intelect shipped additional product to Amerix anyway. By December 1997, Amerix owed Intelect more than $9.82 million. Plaintiffs allege that payment to Intelect was almost completely conditional on Opicom's customers paying Opicom after successful installation, and Opicom in turn paying Optronix and Amerix so they could pay Intelect. Nevertheless, Intelect allegedly recognized more than $9 million in revenue in the fourth quarter of 1997 from sales to Amerix and Optronix. Plaintiff claims that on January 6, 1998, Opicom provided financial statements to Intelect which clarified that Opicom did not have sufficient resources to pay its debt to Amerix.
Plaintiff alleges that Amerix accounted for 59 percent of Intelect's recognized revenue in 1997. Andersen's work papers include a February 16, 1995 memorandum from Ed Ducayet ("Ducayet"), Intelect's Chief Financial Officer and Vice President of Finance, to the Audit Committee of Intelect's Board of Directors, apparently written at the request of Andersen. The February 16 memo acknowledged that Opicom would not invoice its customers until the product had been successfully installed and tested, and that Opicom did not have the financial resources to pay Intelect until it received payment from its customers. Andersen's audit work papers also include a February 22, 1998 memorandum from Walter Gruenes, Andersen's audit partner, to William Henry, Andersen's audit manager, attaching among other things, Opicom's 1997 financials, and a memorandum of understanding between Intelect, Amerix, Optronix, and Opicom, conveying to Intelect a secured note for the companies' outstanding debts to Intelect. These documents indicate that Andersen's audit team had knowledge of Opicom's poor financial statements and inability to pay Intelect until its customers paid Opicom. Further, on an auditor's copy of a meeting agenda item, regarding a $1 million reserve in receivables from Amerix, is the note: "Full disclosure-If not collected by 5/15-We're dead." Plaintiffs allege that Andersen's work papers indicate that Andersen knew that any revenue coming from Amerix, Optronix, or Opicom would be coming, if at all, in 1998, not 1997, that payment was materially conditioned on successful installation by Opicom, and that the Amerix-Optronix revenue thus should not have been recognized by Intelect in 1997.
The Amended Complaint also points out that a significant deflation in value of the Korean currency, of which Andersen was or should have been aware, made the likelihood of payment even more remote, and the recognition of the full amount of revenue from Amerix even more inappropriate.
The Plaintiffs allege that Intelect also improperly recognized $1.8 million in revenue from its contract with MFS. The original contract price was $1.6 million, with a deployment date of July 1997. Intelect had to provide, test, and fully deploy the network before MFS was obligated to pay for it. In addition, Kanas, for whom MFS was a contractor, had to accept the work and pay MFS before MFS could pay Intelect. Notes of a December 11, 1997 meeting, allegedly from Intelect's files, indicate that the MFS network was not going into service until March of 1998 with final approval from Kanas not to occur until November 1998. Despite these projections that material conditions could not be met until well into 1998, Intelect recognized revenue from the MFS contract in 1997.
Plaintiffs allege that Andersen's work papers demonstrate knowledge of these details of the MFS contract. Andersen faxed MFS to confirm that MFS owed Intelect $1.4 million to be paid by November 1997. MFS did not respond to this fax nor to a second fax, but Andersen did no further investigation. However, a January 9, 1998, Andersen work paper indicates that Andersen was aware of the material conditions to payment by MFS. A March 17, 1998 Andersen memo indicates that Andersen specifically asked Intelect whether it was proper to recognize the revenue from MFS with over $1.2 million of it four months past due. Intelect reaffirmed that Intelect would get paid only when Kanas paid MFS. Furthermore, a March 20, 1998, Andersen work paper indicates that Andersen became aware of the technical complexity of the MFS project and the lengthy testing phase that would have to occur before Intelect received payment.
Plaintiffs allege that Intelect improperly recognized $635,000 in revenue from Northrop Grumman. In June 1997, Northrop Grumman ordered a system to install as part of the air traffic control system in Peru. The order conditioned Northrop Grumman's obligation to pay on the system passing factory and site inspections to the satisfaction of the Ministry of Communication and Transportation of Peru. Because of delays, the system did not pass the factory tests until mid-January 1998, did not ship until April 17, 1998, and still had not passed site testing as late as July 1998. Thus, in 1997, Intelect had not satisfied the material conditions that would trigger Northrop Grumman's obligation to pay. Yet, Intellect recognized the full amount of $635,000 in the fourth quarter of 1997.
Further, Plaintiffs allege that Andersen failed to follow up with Northrop Grumman to confirm the validity of the receivable. Andersen's work papers also suggest that Andersen knew Intelect hadn't shipped the product as late as April 1998, but that Intelect was still claiming it had "substantially completed" all of its obligations under the purchase order to justify recognizing the revenue in 1997.
Andersen's work papers indicate that Andersen knew that Intelect used "contract accounting" for only the Northrop Grumman transaction. Plaintiffs allege that this use of contract accounting was improper on its face, yet went unchallenged by Andersen. Plaintiff thus allege that Andersen was aware that Intelect had employed improper accounting to recognize $635,000 in revenue that was not properly recognizable until approval by the customer, an event that did not occur in 1997, but in fact had not occurred as late as July 1998.
Plaintiffs allege that Intelect improperly recognized $166,000 in revenue from Telecommunications of Jamaica ("Telecom Jamaica"), In August 1997, Intelect issued a quote to Telecom Jamaica. The quote specifically conditioned payment to Intelect on Telecom Jamaica deciding to keep the delivered product, after evaluating it. Intelect shipped the product on October 27, 1997 and immediately recognized the $166,000. However, Telecom Jamaica did not complete the evaluation and notify Intelect that it had decided to keep the product until May 1998.
Plaintiffs allege that Andersen's work papers indicate that, on January 5, 1998, Andersen faxed Telecom Jamaica to confirm that Telecom Jamaica owed Intelect $166,000. Telecom Jamaica failed to respond to this fax or as a second fax sent January 11, 1998. Andersen failed to follow up. A February 18, 1998, Andersen work paper also indicates that Andersen discussed the Telecom Jamaica deal with Richard Reierson, Intelect's controller, who confirmed the contingent nature of the Telecom of Jamaica deal.
In addition to the improper recognition of revenue, Plaintiffs also allege four key misrepresentations of which they allege Andersen was aware. First, Andersen knew Intelect failed to set aside appropriate reserves for uncollectible receivables. During its audit, Plaintiffs allege Andersen learned that as of December 31, 1997, $1.9 million of Intelect's receivables were greater than four months past due, and more than $1 million in receivables were between three and four months past due. These accounted for more than 20 percent of Intelect's recognized revenue. By March 1998, when Andersen issued its audit report, these numbers had increased to $2.5 million greater than four months past due and $5.3 million between three and four months past due. At the March 17, 1998 meeting between Andersen and Intelect's Audit Committee, Andersen told Intelect that to comply with GAAP, Intelect would have to increase its bad debt reserves to cover receivables greater than four months old. However, Plaintiff claims Andersen acquiesced to Intelect not doing just that for the 1997 financials.
Plaintiffs allege that Andersen knew as part of its audit process that the majority of warranty repairs required by Intelect would occur within the first six months of a sale. Yet, the Complaint alleges that Andersen's work papers show that Intelect failed to accrue $500,000 of potential warranty costs on $9.7 million of systems it shipped in 1997 and until September 30, 1998.
Plaintiffs allege that at the February 23, 1998, meeting between Andersen and Intelect officers to discuss the audit, Andersen suggested five significant adjustments, including a $1 million adjustment to reserves for the Amerix-Optronix accounts. Plaintiffs allege Intelect declined to make any of the adjustments, and Andersen went along.
Finally, Plaintiffs allege that Andersen failed to issue a going concern qualification to its audit of Intelect's 1997 financial position. Plaintiff claims Andersen's documents show that as late as March 17, 1998, just one week prior to its audit opinion, Andersen intended to issue a "going concern warning" to its Intelect audit. Plaintiff's allege that by March 17, 1998, Andersen was aware of the revenue issues with Amerix, Optronix, MFS, Northrop Grumman, and Telecom of Jamaica and Andersen had suggested that Intelect increase its reserves by $1.2 million. Andersen had also learned that Intelect had not accrued any warranty costs on almost ten million dollars of sales made in 1997. Yet, Andersen acquiesced to the wishes of Intelect management and did not issue a going concern qualification.
Courts have denied motions to dismiss when plaintiffs have alleged "specific and detailed allegations about defendants' violation of GAAP, as well as other alleged misstatements, regarding the company's earnings and technical problems" [which] "when viewed in their entirety — support[ed the claim]." Haack v. Max Internet Communications, Inc., 2002 U.S. Dist. LEXIS 5652 *22-3 (N.D. Tex. April 22, 2002).
In this case, the Original Complaint merely argued from hindsight that Andersen should have put the facts together to find fraud on the part of the Company, but that allegation was deficient under the PSLRA. However, the Amended Complaint alleges that Andersen's audit work papers demonstrate that it recklessly disregarded red flags indicating that Intelect's revenue was substantially overstated, because conditions to payment had not been fulfilled, customers in effect incurred no obligation to pay what had been booked as revenue, payment was highly uncertain, and recognition of revenue from such sales in 1997 was thus improper. Based merely on the allegations in the Complaint, Andersen's audit work papers show that Andersen knew and was concerned that Intelect had failed to reserve a proper amount for uncollectible debts, and that Intelect had not properly accrued warranty costs. Andersen's audit work papers allegedly show that Intelect rejected all audit adjustments proposed by Andersen, but Andersen went along with Intelect's rejection of its conclusions in alleged breach of its auditing obligation.
When the pleaded facts are viewed in their entirety, the Amended Complaint sufficiently alleges that Andersen had knowledge, or recklessly disregarded information suggesting, that the financial information it was seeing was false or faulty, but failed to act upon it. As a result, the Court holds that the Amended Complaint pleads conscious behavior or severe recklessness by Andersen that created a danger that the market would be misled by Intelect's 1997 financials. This alleged activity gives rise to the required strong inference of scienter and sufficiently states a claim upon which relief can be granted.
CONCLUSION
The Court, therefore, DENIES Andersen's Motion to Dismiss under Fed.R.Civ.P. 12(b)(6) and LIFTS THE STAY imposed by this Court's previous order. The parties are to confer and submit a scheduling order within forty-five days.